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UNIT-1
2) All income and gain are credit balances: As all income and gain are credit balances
they are shown on the credit side e.g sales, purchase return , interest received and discounts
received , interest on investments etc.
3) All assets drawing and reserve on liabilities are debit balances. All these are shown in
the debit balance of the trial balance. e.g furniture bills receivable, plant and machinery
cash in hand , cash at bank ,prepaid expenses, goodwill etc.
4) Capital ,reserve on assets created out of profit and other liabilities are credit balances
and shown on the credit side of the trial balance e.g loan ,bill payable ,outstanding
expenses ,reserve for bad debts, discount on debtors ,general reserve fund ,provident fund
etc.
Classification of assets
1) Liquid assets: are those which are represented by cash or those which can be easily
converted into money such as cash in hand, cash at bank, investments ,bill receivable
2) Fixed assets: are those whish are to be acquired to be retained permanently for purpose
of carrying on business such assets are purchased once and last for many years such as land
and building, machinery, furniture. They are also called long life assets or capital assets.
3) Floating assets :are such assets which are acquired either for purpose of resale or held
temporarily in course of business for their subsequent conversions in to money such as
stock in trade ,book debt etc. The division of fixed asset and floating asset is not permanent
and will depend upon the nature on business. For eg furniture is fixed asset for
businessman but it will be floating asset for those who deal in furniture goods.
4) Wasting assets: are such assets as are consumed through being worked as mines etc e.g
leasehold land , copyright etc.
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5) Fictitious assets: which are not represented by any tangible property such as
preliminary expenses ,prepaid expenses etc.
6) Intangible assets :are those which we cannot see or touch é.g goodwill.
Liabilities
1) Fixed liabilities :such debts that are payable after a long period eg a long term loan.
2) Current liabilities: that are payable time to time e.g bank overdraft ,bills payable etc.
3) Contingent liabilities: such debts that are become payable on happening of specific
incident are called contingent liabilities. For example abc sold goods to Harish for
Rs2000on credit and xyz stands as surety for Harish .however Harish becomes insolvent.
Now xyz has to pay Rs2000 to abc. This amount is a contingent liability for xyz. Following
are the eg of contingent liability
1 Bill discountable before maturity
2 Gaurantee undertaken.
Depreciation
Definition:-
Characteristics of depreciation:-
Causes of Depriciations:-
1) Constant use:- The value of an assets decrease because of its constant use. This is
more applicable on machinery.
2) With the passage of time:- The value of assets also decrease with passage of time.
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3) Accident:- Accident loss may be permanent but it is not continuing and gradual.
4) Absolete scène:- If a better machine comes on a market, the old machine may have
to be scrapped even though they are capable of being run physically.
5) Fall in market price:- Market conditions may charge the market price of current
assets but not book value of fixed assets.
1) To find out net profit:- The business man has to certain expenses in earning
revenue. Fall in value of assets used in this process is a part of cost of should be
shown correct net profit.
2) To find out correct financial position:- If the depreciation is not provided assets
shown in the balance sheet will not show correct values and thus balance sheet will
not provide time picture.
3) For replacement of assets:- The business man takes advantage from use of fixed
assets and time comes when these assets become totally useless and need to be
replaced. By maintaining a depreciation fund or by taking insurance policy out of
depreciation provided, he can easily replace such assets.
4) To spread over a number of year the burden of writing off an assets: - A
business takes a advantage of an assets for many years which he purchases for his
business. If its burden is put on profit and loss A/c of one year it will not be
reasonable. Therefore it is proper that it is spread over a number of years.
5) To give correct information to creditors:- Creditors give loan to businessman and
assets of business stands as surety for such a loan. Thus if these assets are not
shown in balance sheet at their proper value, the creditors may be misguided.
6) Proper ace ant of cost of production:- It is a cost of production if it is not properly
recorded in profit and loss A/c, the cost of production will not be time.
7) Writing off of capital as profit:- If proper depreciation is not accounted for then
profit will be higher and when distributed will affect the capital after sometime the
capital will be thus subs fanatically reduced and would have been distributed in
form of profits.
Method of Depreciation
1) Straight line method or fixed instalment method or original cost line method or
fixed percentage method:-
Under this method, the amount and depreciation is informed from year to year. This
fixed amount of depreciation is charged to profit and loss A/c every year. So this is also
called equal installment method. The annual amount of depreciation can be easily
calculated. Out of cost of assets its scrap value is deducted and it is divided by number
of year of its estimated life. This is the amount of depreciation.
Thus,
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Thus the book value of asset will be zero at the expiry of expected life of assets.
Example:-
If life asset is 10 years, rate of depreciation is 10% of cost every year and cost is rs.
20,000 . then the depreciation will rs. 2000 per annum. If in a first year, the asset may
not have been used for whole of year in that case only proportionate amount will be
provided as depreciation. Suppose in above case asset is installed on 1 April and
account is closed on 31 dec. in that case depreciation for the year will be rs. 1500 i.e.
20,000 * 10 * 9
100 12
Advantages:-
Disadvantages:-
1) In beginning the asset depreciation less and in last years it depreciates more
quickly. But under this method amount of depreciation remain same every year.
2) No provision for interest is mode on value of asset.
3) When machine is old enough its repairing charge increase. But no attention is paid
on this fact under this method.
For Example:-
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A purchased a machine for rs. 11,000 on Jan 1,1986. The estimated life of machine is
10 years. After which its break up value will be rs. 1000 only. Find out amount of
annual depreciation and prepare machinery account for first three years.
Solution:-
= 11000-1000 =1000Rs.
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Dr. Cr.
Date Particulars Amount Date Particulars Amount
1986 To cash 11,000 1986 By Depreciation 1,000
Jan 1 A/c Dec.31 A/c 10,000
Dec.31
11,000 11,000
1988 To
Jan 1 Balance 9,000 1988 By Depreciation 1000
B/d Dec 31 A/c 8000
Dec 31 By Balance C/d
9,000 9,000
1989
Jan To 8000
balance
B/d
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Under this method also cost of assets less estimated scrap value has to be written off
over its estimated useful life. A certain percentage is calculated on book value and not
cost of assets. Thus the amount of depreciations goes on falling every year. The value
of asset never comes to zero under this method.
Adventage:-
1) Under this method there is equal burden of depreciation and repairs on profit loss
A/c
2) The book value of assets never falls to zero.
3) This method is recognized by income tax law.
4) This is very simple.
5) It needs no difficult calculation.
Disadvantages:-
1) Proper and sufficient depreciation is not provided under this method because rate of
depreciation is kept very low.
2) No account is kept of interest on value of assets.
Rate of depreciation cannot be easily decided.
UNIT-2
Management:
Management requires different types of information for the decision making due to
increase in the size and the complexities in the business which can be collected from
financial statement. These statement explain the facts relating to creditability, efficiency,
performance financials, soundness etc. It helps the management not only in the financial
planning but also in the financial control. At the time of financial planning, management
can ascertain the effects of its decisions on the profitability, financial position and
efficiency. Similarly at the time of control, management can find out the rationality and
weakness of its previous decisions and can take the steps to correct them in future.
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Management can determine whether the interest of all the parties are safe and can compare
some of important factors like profit, expenses, financial position, liquidity ,efficiency ,debt
paying capacity with other business.
For Creditors:
Businessman takes two types of loan that is short term and long term. Short term creditors
are interested in debt paying capacity of business in time from the analysis of financial
statements .These creditors can ascertain the liquidity of business. Long term creditors wish
that their loan and interest on them are paid on time. Therefore they are interested in the
financial soundness and profitability of business and if the long term profitability is
satisfactory ,business will be able to pay off the debt with the interest on time
.
For Investors:
The shareholders of the company can evaluate the efficiency of management by financial
analysis and find out whether their investment is safe and whether their capital is being
utilized properly. For this purpose, they can analyse the financial position and earning
capacity of business. They are interested in the maximum rate of dividend and increase in
the market value of shares and with the help of financial analysis ,they can determine the
rate of dividend in the previous year and can forecast the future rate.
For Labour:
Trade unions also analyse the cost and profit of business . They also analyse future earning
capacity of business. They ascertain whether the company’s profit are adequate to pay them
wages. They also determine whether the company can increase their wages and pay them
bonus or not.
For Government:
Through analysis of the financial statement government can determine whether the
provisions of MRTP Act apply on the company or not. Similarly government can decide
whether the company is following different statutory provisions or not.
Public:
Financial statements are also beneficial for the lawyers, researchers and consumers because
they get information about the position of business future growth plans and the
opportunities for advancement.
Taxation authorities: are interested knowing the profits of business so that the income tax
can be imposed there on. Similarly sale tax authorities are interested in the sales and excise
authorities in the production of goods. Thus the financial statement helps them in
determining taxes payable.
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2) Increase in the current assets means increase in the working capital.
3) Decrease in the current assets causes decrease in the working capital.
4) Increase in the current liabilities causes decrease in the working capital.
5) Decrease in current liabilities increase in the working capital.
6) Increase in the current assets and the simultaneous increase in the current liabilities
does not effect the working capital
7) Decrease in the current assets and the simultaneous decrease in the current
liabilities does not effect the working capital.
1) This statement is useful in finding the answers to some important financial questions:
a) Where has the profit gone?
b) Why is the dividend not increasing?
c) How could the dividend be distributed in the certain period even after less profit or when
net losses were suffered by the business?.
d)Why is the net working capital less even after the adequate profit?.
e) Why is the net working capital high although the business suffered losses?.
f) Why should the funds be borrowed to purchase new plant and the equipment when there
is already necessary cash available.?
3)Helpful in determining dividend policy: Sometimes the business has adequate profits
but it does not have cash to distribute dividend. In such case fund flow statement helps the
manager determine proper dividend policy .It helps decide whether to distribute the
dividend or not. If it is distributed then from where and how much funds will be managed
for it.
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4) Helpful in deciding the financial policies:
This statements helps the financial manager in ascertaining how much of long term funds
have been used for acquiring the fixed assets. For the efficient financial management of
long term loans and for the management of permanent working capital .short term funds
should never be used for the payment of long term loans or for the purchase of the fixed
assets. It can create the problems for the payment of the current liabilities in future. Thus
the funds flow statement helps in the policy determination .
6) Helpful in planning for future. Future plans can be made on the basis of funds flow
statement. If business plans to expand it helps ascertain how much funds will be available
from the business operations and how much funds will have to be raised from the other
sources.
8) Useful in other firms: Other firms can compare their fund flow statement with the
statement of an efficient firm and can ascertain the deficiencies of their financial manager.
They can take the steps to remove these deficiencies.
9) Useful to shareholders: Shareholders also get the information about the financial
policies with the help of fund flow statement . They can know how the funds have been
used in the business. Are their interest safe? Is the dividend being distributed out of profits
or other sources ?To what extent is the business dependent on the outside loans? how the
amount has been received from issue of new shares or debentures been used? On the basis
of this information they can take their investment decisions.
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Utilities of cash flow statement
The purpose of cash flow statement is to provide information about the cash flows
associated with the period of operations and also about the entity’s investing and financing
activities during the period. This information is important to shareholders, part of whose
investment return (dividends) is dependent on cash flows a and to lenders, whose interest
payment and principal repayment require the use of cash. The welfare of other constituents
of a company including its employees, its suppliers, and the local bodies that may levy
taxes on it, depends to varying degrees on the company’s activity to generate adequate cash
flows to fulfill its financial obligations. The usefulness of cash flow statement can be
summarized as follow:
1) Predict future cash flows:-
The cash flow statement makes it possible to predict the amounts, timing and uncertainty of
future cash flows on the basis of what has happened in the past. This approach is better
than accrual basis data presented by profit and loss account and the balance sheet.
2) Determine the ability to pay dividends and other commitments:-
A cash flow statement indicates the sources and uses of cash under suitable headings
such as operating, investing and financing activities. Shareholders are interested in
receiving dividends on their investments in the shares. Creditors want to receive their
interest and principal amount on time. The statement of cash flows helps investors and
creditors to predict whether the business can make these payments.
3) Show the relationship of net income to changes in the business cash:- Usually
cash and net income move together. High levels of income tend to lead to increase
in cash and vice-versa. A company’s cash balance can decrease when its net income
is high, and cash can increase when income is low. The users want to know the
difference between the net profit and net cash provided by operations. The net
profit shows the progress of the business during the year while cash flow is related
more to the liquidity of the business. The users can assess the reliability of net
profit with the help of cash flow statement.
4) Efficiency in cash management:- Cash flow analysis helps in evaluating financial
policies and cash position. It facilities the management to plan and co-ordinate the
financial operations properly. The management can estimate how much funds are
needed, from which source they will be derived, how much can be generated
internally and how much should be arranged from outside.
5) Discloses the movement cash:- A comparison of cash flow statement for the
previous year with the budget for that year would indicate to what extent the
resources of the enterprise were raised and applied. A comparison of the original
forecast with actual result may highlight trend of movement that might otherwise go
undetected.
Distinction between funds flow and cash flow statements:-
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flows form operating, financing and investment is adjusted to the opening
balance of cash and cash equivalent to arrive at the closing balance.
d) Funds flow analyses is based on a broader concept that is working capital,
while cash-flow analysis proceeds on the narrow concept that is cash, which
is one element of working capital. Thus, cash flow statement provides
details of cash movements whereas the funds flow statement provides the
details of funds movement.
e) Funds flow statement does not contain any opening and closing balance
whereas in cash flow statement, opening as well as closing balance of cash
and cash equivalents is given.
It is derived to explain to management the source of cash and its uses during
period of time, a statement known as cash flow statement is prepared. A statement of
cash flow reports inflows (receipts) and outflows (payment) of cash and its equivalents of
an organization during a particular period. A statement of cash flow reports cash receipts
and payment classified according to major activities-operations, investing and financial
during the period.
Limitation of SC
Standard costing is a powerful mgmt aid in planning, control, & decision-making. But if it
is improperly handled & if due consideration is not given to various constraints in
developing and using standards, it can create problems for mgmt. The following are the
limitation-->
Difficulty in setting standards It is difficult to forecast cost as some of factors
influencing them are unpredictable. Secondly, standards are set by human beings, whose
prejudices and biases are likely to influence the establishment of standards.
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unrealistic. Therefore in real practice ,standards should be revised for every change
operating conditions , but they should be certainly adjusted if the change is significant.
Problems in Variance Analysis :-> Standard costing helps in managerial control through
variance analysis. It is difficult to explain variance when need arises, to distinguish
between controllable & non-controllable elements of variances. Moreover , if a variance is
caused by random factors, it becomes more difficult to explain the variance.
Discouraging Impact of Standards :-> Standards are sometimes considered to have
discouraging impact on efficiency & morale of individuals. Some of recent studies reveal
that workers & supervisors do not welcome standards because they consider them to be
oppressive & resist them.
Unsuitable for Small Firms :-> In small org. , Production operations are simple &
therefore detailed analysis may not be necessary.
Failure due to Top Management Apathy :-> For success , top management should not
only take keen interest in it but should also seek participation of all. At times, it becomes
difficult to seek real support of top management. They may not disagree to idea of
introducing standard cost system but at same time may not take interest in its effective
implementations.
Ratio Analysis
1) Proportion:- If the current assets of a business are Rs. 5,00,000 and current
liabilities Rs. 2,50,000 the proportion of current assets and current liabilities will be
5,00,000:2,50,000 or 2!
2) Percentage:- In it the relationship between 2 numbers is expressed in percentage
form. If the gross profit of business is Rs. 50,000 and sales are Rs. 2,00,000 the
gross profit is 25% of sales i.e.
50,000*100=25%
2,00,000
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Classification of ratio:-
According to purpose:-
a) Liquidity Ratios
b) Profitability Ratios
c) Turnover or performance or Activity Ratios
d) Leverage or Capital structure ratios
a) Liquidity Ratios:- It is also called as working capital or short terms solvency ratio.
For the existence of firm adequate liquidity is essential. Liquidity means ability of
the firm to pay its short terms debts in time, liquidity ratios are calculated to measure
short terms financial position or short
terms solvency of the firm. Commercial banks and short terms creditors are interested
in such type of analysis. Management can also make use of these ratios to find out how
efficiently working capital is being used.
i) Current Ratio:-
This ratio establishes the relationship between current assets and current Liabilities. It is
calculated by dividing current assets by current liabilities. Ideal current ratio is 2% i.e.
current assets should be twice the current liabilities.
Current assts are those assets which are converted into cash within one year or an
operation cycle. They include cash in hand, bank balance, stock, debtors, prepaid
expenses, bills receivable, marketable securities etc.
Current liabilities are those liabilities which have to be paid during one year. These
include creditors, bill payable, outstanding expenses, bank overdrafts etc.
With its help, ability of the business to pay off its short term liabilities is
determined. It helps to find out how many times current assets are there in business as
compared to current liabilities. Current assets should be more then current liabilities so
that despite fall in their prices, current liabilities could be paid easily. If current ratio is
2:1, it means that current liabilities would be paid even if there is 50% fall in the prices
of current assets.
Significance:- The greater this ratio, better will be the short term solvency of firm and
more safe will be the interest of short term creditors. This ratio should neither be too
high not too low.. High ratio is an indicator of weak investment policy of the firm and
low ratio increase the risk in payment of short term debts. High ratio also means that
funds of firm are laying surplus and unutilized.
Current Ratios main limitation is that it is a quantitative measuring, not a
qualitative one. To ascertain this ratio, all current assets are given equal importance and
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ignore individual attention to assets. There is different in liquidity of various current
assets. Cash is most liquid assts. On the other-hand, stock is least liquid of all current
assets. Debtors, bill recoverable etc. are more liquid as compared to stock but less
liquid then cash.
This ratio establishes the relationship between liquid assets and current liabilities.
Liquid Assets are those assets which can immediately or in a short period be
converted into cash without much loss. Liquid assets do not include stock and prepaid
expenses because stock is less liquid and its prices fluctuates. Prepaid expenses cannot
be realized.
⇒Liquid Assets=Current Assets-stock-Prepaid Expenses an ideal liquid ratio
is 1:1
With the help of this ratio, capacity of firm to pay off its current liabilities
immediately is measured.
iii) Absolute liquidity Ratio or Super Quick Ratio or Super acid test Ratio:-
Ideal absolute liquidity ratio is 0.5:1. It means that for every Rs. 2 liability there should
be super acid assets of 50 paise. This ratio is not used much practically.
The efficiency of a firm depends on the fact how efficiently its assets are being used in
business. The effective utilization of these assets depends on the speed at which these
assets are converted in sales. Higher velocity of their conversion in sales indicates that
assts are being efficiently managed. Various type of turnover ratios are:-
1) Inventory turnover ratio:- This ratio establishes relationship between cost of goods
sold and average inventory. It indicates the fact whether the investment in inventory is
within a proper. Limit or not. With the help of this ratio, it can be ascertained how many
times the stock has been converted in to sales during the year. It helps evaluate inventory
policy of management.
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Inventory turnover Ratio = Cost of goods sold
Average Inventory
OR
= Sales-Gross Profit
Average Inventory
Similarly, if the amount of opening stock is not given in question, closing stock
is taken in place of average stock.
When more then one type of stock is used, for example, stock of raw material
stock of working progress and stock of finished goods, then for calculating turnover ratio
for each component, the fall ratio should be used:-
Significance:-
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and old product in stock etc. To draw meaningful conclusions from this ratio it should be
compared with ratio of previous years and with
that of other firms. This ratio is not standardized because it depends on ratio of
nature of industry.
Precautions:- While using this ratio care must be taken regarding following factors:-
1) Seasonal Conditions:- If the balance sheet is prepared at the time of stock season,
average inventory will be much less which may give a very high turnover ratio.
2) Supply Conditions:- In case of conditions of scarcity, inventory may have to be
kept in high quality for meeting future requirements.
3) Price Trends:-In case of possibility of a rise in prices. Larger inventory may be kept
by business. Reveres will be the case if there is possibility of a fall in prices.
4) Trend of volume of business:- In case there is trend of sales being sufficiently
higher then sales in past, a higher amount of inventory may be kept in past, a higher
amount of inventory may be kept.
Average Account Receivables= Opening (Debtors &B/RS)+ Closing (Debtors & B/Rs)
2
In case information about credit sales and average debtors is missing this ratio is
calculated on the basis of total sales and closing date balances of receivables.
The second ratio related to debtor’s turnover is average collection period. This ratio is
calculated by dividing days in a year by debtor’s turnover ratio. And indicates to what
intent debts have been collected in time.
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Average collection Period
OR
Significance:-
High debtor turnover ratio and low collection period is an indicator of efficient
management of debtors. Higher the debtors turnover ratio better it will be for the business.
Similarly, low collection period indicates that debts are being realized quickly and no
unnecessary funds are blocked in them. On the other hand, high average collection period
means that firm has used liberal credit policy and debts are realized at a slow rate or lesser
efforts to realize debts have been made.
Very small too. Although it indicates lower risk of bed debts but it can affect sales
adversely. Thus debtor’s turnover ratio should not be very high or very low.
Whether average collection period of a business is proper or not it can be
examined by comparing this ratio with ratio of other firms in industry. As compared
to average of industry, a firm should neither use a liberal credit policy not credit
policy should be restrictive. Actual collection period of firm should be compared with
standard and on this basis credit policy can be evaluated. For example, it pre-
determined collection period is 30 days and actual collection period is 45 days, it
means firm is following liberate credit policy and debtors are not being realized in
time.
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4) Working capital turnover ratio:- This ratio indicates whether working capital has
been efficiently used to increase sales.
It indicates how efficiently fixed assets of business have been utilized to increase sales.
Solvency of business is related to its debt paying capacity. With the help of liquidity ratio
short-term solvency of business can be analyzed. Under this head, long-term solvency of
business has been analyzed. Normally the ordinary share holds, debenture holders,
financials institutions and other long term creditors are interested in these ratios. With the
help of these ratios long-term creditors can analyze the capacity of business to pay interest
and principal. Therefore, long-term solvency of business means its ability to pay the long
term debts and interest therefore regularly. Therefore the long term solvency or financial
position has two aspects.
1) The ability to principle on due date
2) The ability to pay interest regularly.
Therefore leverage ratios are divided into two parts. The first type of ratios are those
which establish relationship between debt capital and owned capital. These ratios are
calculated with the help of date in balance sheet. For ex.
Debt-equality ratio, debt to assets ratio, equity to assets ratio etc. i.e under this category.
The second type of ratio are called Coverage ratio, for example, interest coverage
ratio, dividend coverage ratio and total fixed coverage ratio.
1) Debt equity ratio:- The necessary funds for the assets of business are provided by
ordinary share holders, preferential shareholders and creditors. In any business
these should be equitable balance as it affects long-term solvency of business. If a
business procures more funds from the owners of business, it will secure the interest
of creditors. On the other hand, if more funds are borrowed instead of employing
owned capital, it will increase risk for creditors as well as shareholders and may face
differently in future to pay the debt.
This ratio established relationship between the shareholders funds and debt funds. It
can be calculated as under:-
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Debt Equity Ratio= External Equities
Internal Equities
OR
Long-term debt + c. l.
Internal Equities
Or
Generally this ratio of 1:1 is considered satisfactory. This ratio can also be expressed
in various other ways.
First (a) ratio expresses the relationship between long term debts)
Second (b) ratio explains the relationship between share holds funds and total long
term funds.
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Third (c) ratio establishes relationship between long terms debts and share holds
funds.
In case of (a) and (b) a ratio of 0.5:1 and in case of (c) a ratio of 1:1 is considered ideal
and satisfactory.
Significance:-
This ratio is very significant for the evaluation of capital structure of a firm. This
ratio explains the fact in what proportion the owners and creditors of the business
have provided funds. Creditors can know whether their interest is safe or not. If the
shareholders funds are increasing, their interest will continue to be safe. On the other
hand, if the funds provided by creditors are increasing, their interests can be
endangered. If the debt equity ratio are 1:23, it means that for every one rupee of
external liability, there are 2 rs. of shareholders funds, ∴ creditors have a safety
margin of 50%.. If the debt-equity ratio is quite high, creditors of the firm will try to
interfere in the affairs of the firm. The firm may have to bear a burden of fixed
interest changes in the years of low profit. It will also have to accept restrictive
conditions for raising further funds in future. But the owners of business will control
the affairs with their limited funds. If the firm can earn high rate of profit as
compared to the rate of interest payable, it can maximize the return for shareholders
by using high debt equity ratio.
ii) Proprietory Ratio:- It is another form of debt equity ratio and also known as net
worth to total assets ratio. It establishes the relationship between shareholders funds
and total assets of business. Its main objective is to find out how much funds have
been provided by shareholders for investment in assets of business.
Total Assets
The intangible assets like goodwill, potent, etc. should be included to the extent of
their market value.
Significance:-
This ratio is quite significant for the creditors of business. With the help of this ratio,
it can be ascertained in what proportion owners have provided funds for investment
in assets of business. The higher the ratio, the more profitable it is for the creditors
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and the less management will have to depend an external funds. If the ratio is low the
creditors can be suspicions about the repayment of their debt on liquidation of
company ∴ , external funds should be utilized to a limited extent..
Fixed Assets
Fixed Assets are included after changing depreciation. Owners funds are the same as
internal equities in the debt equity ratio. The higher value of proprietor funds over
fixed assets is a measure of long term financial soundness of business. The lower the
the berrer will be for the long term solvency of business because proprietor funds will
be available for working capital also. For example, If the fixed assets are rs. 18000
and proprietary funds are rs. 24,000 this ratio will be
0.75 ( rs. 18,000 ) . It means that 75% of proprietary
Rs. 24,000
Funds are invested in fixed assets and balance 25% are used as working capital. For
industrial units the standard is usually 5% if the ratio is more than one, it means that a part
of fixed assets has been debt capital?
iii) Current assets to proprietary funds ratio:- This ratio establishes relationship
between current assets and proprietary funds. The main objectives of proprietary
fund have been invested in current assets.
iv) Capital gearing ratio:- Establishes relationship between ordinary share capital
and fixed cost bearing securities. In fixed cost bearing capital we include
performance share capital and debt funds.
Fixed cost bearing capital= debentures + performance share capital+
mortgage loan
If in capital structure of firm, fixed cost securities are more than equity share capital it will
be called high capital gearing. On the other hand, amount of fixed cost bearing securities is
less than amount of equity share capital, it will be low capital gearing. The main objective
of having fixed cost bearing capital in capital structure is to maximize return for equity
shareholders. Shareholders get residual profit after paying fixed interest on loans and fixed
rate of dividend to performance shareholders.
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Profitability Ratio: -
These ratios are calculated on the basis of sales. If a firm does not earn adequate profit on
sales, it will be difficult for it to pay operating expenses and the owners will not get any
return. These ratios are as under.
1. Gross profit ratio:- This ratio establishes relationship between gross profit and
sales. It can be calculated as under:-
Cost of goods sold in a trading concern is calculated by adding stock, purchases and
direct expenses and sub trading the closing stock.. In case of firms engaged in
manufacturing of goods, cost of goods sold is equal to the cost of raw material, direct
labor, direct expenses and manufacturing expenses.
Gross profit is the result of ratio on slip among sales and costs and price. It can
be sed or reduced by changing any of these variables. High gross profit is the sign
of efficient management. Increase in price or reduction in costs can also result in high
gross profit ratio. Sometimes, lower
Valuation of opening stock or higher valuation of closing stock, can also increase
gross profit ratio ∴ , the reason for high or low gross profit ratio should be properly
analyzed. These can be several reasons for low gross profit ratio, such as high cost of
production over valuation of opening stock and under valuation of closing stock
reduction in selling price of goods, low demand etc. The rate of gross profit in a
business should be such that divided at the proper rate could be given to the owners
after meeting firms all operations expenses and fixed costs.
22
Example:-
Rs. Rs.
Solutions:-
Net Sales
Price evening ratio= It is calculated by dividing market price of a share by earning per
share.
P/E ratio= Market price of share
Eps
23
This ratio indicates what value of shares fetches from market for each rupee of Eps. It also
tells us whether share of a company are valued high or low.
d) Dividend per share
e) Dividend payout ratio
f) Dividend and Earning yield
g) Price earning ratio.
a) Return on total shareholders funds:- To calculated this ratio net profit taxes are
divided by total shareholders funds. With the help of this ratio, it can be ascertained
how effectively the funds of the shareholders are being utilized. Relative
profitability and soundness can be evaluated by comparing this ratio with that of
other firms. Shareholders’ Funds are also known as Net Worth.
b) Return on equity shareholders’ funds:- Equity shareholders are the actual owners
of business because they bear all risk. They participate in management. They are the
owners of all their profits lefts paying the dividend to performance shareholders.
Therefore, it is essential to evaluate the profitability of the business from viewpoint
of ordinary shareholders. This ratio is calculated by dividing the net profit after
taxes and preference dividend by equity shareholders’ funds.
Return on Equity shareholders’ funds= net profit after tax and preference dividend
c) Earning per share or EPS:- This ratio measures the earning per share available to
ordinary shareholders. Equity shareholders have the right to all profits left after
payment of taxes and preference dividend. This ratio is calculated by dividing the
profit available for equity shareholders by the number of equity shares issued.
Net profit after Tax and Preference Dividend
EPS= Number of Equity Shares
This ratio is quite significant. EPS affects the market value of share. It is an indicator of the
dividend paying capacity of the firm. By comparing the EPS with firm management can
know whether ordinary share capital is being utilized effectively or not.
d) Dividend per share or DPS:- All the profit after tax and preference dividend
available for equity shareholders are not distributed among them as dividend.
Rather apart of it is retained in business. The balance of profits is distributed among
24
equity shareholders. To calculate dividend per share, we divide the profits
distributed as dividend among shareholders by number of equity shares.
Profit distributed to Equity Shareholders
DPS=
Number of Equity Shares
e) Dividend-Payout ratio or D/P ratio:- The ratio is also called pay out ratio. This
ratio establishes relationship between the earning available for ordinary
shareholders and the dividend paid to them.
OR
DPS
D/p= EPS *100
f) Dividend and Earning yield:- One more ratio can be used to evaluate the
profitability from the stand point of ordinary shareholders. It is known as dividend
and earning yield. Earning per share(EPS) and dividend per share (DPS) are
calculated on the basis of book value of share but yield is always calculated on the
basis of market value of sharers. This ratio is also called earning price ratio.
DPS
Dividend yield=
Market value per share
EPS
Earning yield=
Market value per share
Significance of Ratio-Analysis
25
According ratios are useful for understanding financial position of concern. One may
quickly perceive the relationships without working out the ratio, but that merely gives
roughly idea. According ratios are an extremely useful device for analyzing the financial
statements- the B/s and profit and loss
Figures alone convey no meaning. A ratio becomes significant only when considered along
with other figures.
Thus, “Financial ratio are useful because they summaries briefly the results of
detailed and complicated computations.”
Ratio analysis is also helpful it assess the managerial efficiency. It helps to determine
whether the assets are being used optimally or not. They are also useful for diagnosis of
financial health of business concern, which is done by evaluating liquidity, solvency,
profitability, etc. Such an evaluation enables management to assess financial requirements
and capabilities of various business units.
Accounting ratios are also very useful for forecasting purposes. Suppose sale this year are
rs. 10 lakes and average amount of stock in hand were rs. 2,00,000 showing that it is 1/5 of
sales. If the fix wishes to increase sales next year to rs. 2 task
it must be ready to carry a stock of rs. 2,40,000 i.e. 12,00,000/5. Similar other
requirements can be worked out. Look at it in another way. Capital(total) used this year is
Rs 5,0,000 leading to sales of Rs 10,00 000, i.e., two times the capital employed. If the firm
Is thinking of investing another rs.2,00,000 as capital, in the past scale of operations it must
produce an additional scale of rs. 4,00,000 i.e rs. 2,00,000*2. Accounting ratios tabulated
for a number of years indicates the trend of business. This helps in preparation of estimates
for the future. Ratios also help in computing other figures if one figure is available.
Suppose, it is known that ratio of ways to sales is 15%, it is then easy to calculate amt. To
be spent on ways if the amt. Of expected sale is known
Accounting ratios are of great assistance in locating the weak spots in the business even
though overall performance may be quit well. Management can then pay attention to the
weakness and take remedial action for example, if the firm find that the increase in
distribution expenses is more then proportionate to the result achieved, then can be
examined in detailed and depth to remove any wastage that may be there.
26
6) Useful in comparison of performance:-
A firm would like to compare its performance with that of other firms and of industry
in general. The comparison is called “interfere”. If the performance of different units
belonging to the same firm is to be compared, it is called “intra-firm comparison”. Such
comparison is almost impossible without proper accounting ratios, such as progress of a
firm from year to year cannot be measured without the help of ratios.
Creditors can determine short term slovenly of business with the help of ratio analysis.
Financial institutions and long term creditors can determine whether the business is capable
to reply their loan and interest in time. Investors can decide about future investment in the
firm.
By the use of ratio analysis the trend in profit, sales, cost etc. of the previous year can be
determined by analysis of the financial statements and future forecasts based on these
forecasts.
Except in few cases, acting ratios by themselves are not significant- they assume
significance only when compared with the relevant rations of other firms (or of the
industry in general) or of the previous periods. The profit of a firm to sales is 5% :
whether this is satisfactory or not will depend upon the figures for the previous years or
figures for the other firm.
Thus to get the true message from the ratio’s relating to a firm, they must be set
against ratios of previous period or of other firms. The following are the main
limitations of accounting ratios.
Give false results if the ratios are based on incorrect accounting data
Accounting ratios are based on accounting dates. If accounting data is not correct ratio
also suffer from all weaknesses of the accounting system itself. For example, if
inventory values are inflated, not only will one have an encaggerated view of
profitability of the concern, but also of its financial position. Therefore, unless the
balance sheet and the profit and loss account are reliable, the ratios based on there
would not be reliable. Thus, the basis data must be absolutely reliable, if the ratio
worked out on its basis is to be relied upon.
Elements and sub elements of financial statements are not uniquely defined. A firm
may work out ratio on the basis of profit after interest and income tax; another firm
may consider profits before interest but after tax; a third firm may take profits before
interest and tax. Obviously, the ratios that will be worked out will be different and will
27
not be compatible. Before comparison is made, one must see the ratio have been
worked out on the same basis.
When two firms result are being compared, it should be kept in mind that the firm may
follow different accounting polices,. For example, one firm may change depreciation on
the straight-line basis and the other on diminishing value. Such differences will not
make some of the accounting ratios strictly incomparable unless adjustment for
different accounting policies followed is made.
Changes in price level often make comparison of figures for the various years difficult.
For example, the ratio of sales to fixed assets in 1944 would be much higher then 1990
due to rising prices. This is because although sales are recorded in the price level of
1994, fixed assets do not reflect their current value. It should, however, be noted in this
connection that the sales will be expressed in terms of current prices whereas the fixed
assets would be expressed still on the basis of cost which is incurred in past. Hence,
figures of the past years must be adjusted in the light of price level changes before
comparing the ratios of these years.
5) Result may be misleading in the absence of absolute data:-
Ratios, sometimes give a misleading picture in the absence of absolute data from
which such ratios are derived. For ex. One firm produce, 1000 units in one year and
2,000 unit next year; the progress is 100%. Another firm raises production from 6,000
units to 2,000 units the progress in only 33 1 %. The second firm will appear less
active if
3
than first firm if only the rate of increase is compared. It is therefore useful if, along
with ratios, absolutes figures are also studied- unless the firm being studied is equal in
all respects. In fact one should be extremely careful which comparing the results of one
firm with those of another, if two firms offer in any significant manner, say in size
location etc.
Accounting ratios considers quantitative factors and ignore qualitative factors which
distorted conclusions. For ex.- credit are granted to customer on basis of financial position
but ultimately it also depend on managerial ability of customers. Under such circumstance
conclusion derived from ratio analysis would be misleading.
Whatever the conclusions are drawn from anal sing the financial statement, they should not
be based on single ratios; rather all the related ratios should be considered for this purpose.
Single ratio cannot provide all information’s on a particular aspects. For ex. On the basis of
28
all the current assets liquidity position of business can be considered sound but in case the
proportion of stock in current assets is excessive the liquidity position cannot be considered
sound. Therefore all the ratios relating to liquidity should be calculated.
Financial Statements
Statement of
changes in
Income Balance financial position
Statement of
Retained Earnings
Statement Sheet
2. Balance sheet –
It is a statement of financial position of a business at a specified moment of
time. It represents all assets owned by business & equities of owner and outsides against
those assets at that time.
The difference between income statement and balance sheet is that
income statement for a period & balance sheet on a particular date.
29
3. Statement of Retained Earnings –
Retained Earnings means accumulated excess of earnings over losses & dividends.
The balance shown by Income Statement is transferred to balance sheet through this
statement after making necessary appropriations. This statement is also transferred as
Profit & Loss Appropriation A/C.
UNIT-3
Management Accounting
Meaning: The term management accounting refers to accounting for the management i.e.
accounting which provides the necessary information to management for discharging its
functions. The functions of management are planning, organizing ,directing and
controlling. Thus the management accounting provides information to management so that
the planning ,organizing, directing ,controlling of business operation can be done in orderly
manner. It provides information to managers about the planning day to day operation of
business, determining policies and to make the various type of decisions.
Definitions:
According to J. Batty,” Management accounting is the term used to describe accounting
methods, system and technique which coupled with special knowledge and ability, assist
management in its task of maximising profit and minimizes the losses”
According to R. N. Anthony “Management Accounting is concerned with accounting
information that is useful to management”.
According to Anglo American Council of productivity,” management accounting is the
presentation of accounting information in such a way as to assist management in creation
of policy and day to day operation of an undertaking “
2)Modifies data :The data available in financial books are not appropriate to take decision
or for exercising control .These data are modified and classified example the total sale of a
period can be classified on the basis of product ,area sales ,etc.
3)Analysis and interpretation of data :For the effective planning and decision making
,accounting data are analysed in a meaning manner and results are detailed out. For this
purpose ,data are presented in a comparative form and methods to analysed them are used,
such as comparative financial statements ,common size statements , trends ,percentage,
ratios etc.
30
4)Use of qualitative information: It not only provides quantitative but also qualitative
information which helps in decision making. Such information include information
received by special statistical investigation ,engineering accounts, behavioural effects of
different management accounting techniques etc.
5)To help in planning :Management formulates plan for different activities to achieve
business goals. Under these plans policies are determined and budget are prepared. It
provides necessary information about cost and benefits of different alternatives. Sale
budget ,cash budget and expenditure budget are based on forecasts. These forecasts are
made on basis of financial accounting.
6)To help in organization :To implement plans, tasks ,authorities and responsibilities are
assigned to people at work. After the completion of tasks, performance of each department
is evaluated. For this purpose management accounting collects necessary data, to what
extent delegation was effective can be analysed on the basis of information provided by
management accounting.
7To help in motivation: For the efficient and effective implementation of plans it is
necessary to motivate people and through management accounting, management gets the
different accounting information from time to time on the basis of which people are
motivated.
8)To help in coordinated: The budgets prepared by different departments can be self –
contradictory but management accounting removes the contradiction and establishes the
coordination.
10)To help in control: To see whether the work is being done as per the pre determined
plans or not is called control. In management accounting information about the actual
performance of person is compared with pre-determined performance and thereafter
deviations are calculated and efforts are made to remove them. If the standards are not
found to be accurate, necessary changes are made. budgetary and standard control are
important component of management accounting.
11To help in decision making: In management different decisions are made at a different
levels. Management accounting provides information to arrive at the right decision which
are collected from internal and external sources. It also provides data about the cost and
profitability of these alternatives. Some of decision include make or buy decision, fixation
of selling price of product, use of key resources ,drop of product , profit planning etc.
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Basis Management Financial
Accounting Accounting
1)Objective Its main objective is to help It provides information to
management in planning and shareholders, creditors, banks
decision-making. Therefore, government etc. regarding the
it provides information profit or loss and financial
management for its internal use position of business. thus
and it is internal reporting it is external reporting
system. System.
information.
4)Periodicity It needs information regularly The period of financial
at the end of smaller periods statements is quite long
and therefore in management as compared to management
accounting, more emphasis is accounting. Financial state-
laid on providing quick info- ment (balance sheet, profit
rmation and at the smaller or loss account)are normally
intervals. Prepared at the end of year.
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public etc. Similarly ,price
level accounting are prepared
to incorporate price level
changes.
The limitations of financial accounting have made the management to realize the
importance of cost accounting. Whatever may be type of business, it involves expenditure
on labour, material and other items required for the manufacturing of product. As
management has to see that no machine remains idle, efficient & proper utilization of
products is made and costs are properly ascertained. Besides, management, creditors and
employees are benefited in many ways by installation of good costing system. Cost
accounting serves as an important tool in bringing prosperity to nations. Thus, importances
of Cost Accounting are as under –
3) Helps in Estimates –
The chances of losing a contract due to over-rating or under-rating
can be minimized through adequate cost records because costing provides
reliable basis upon which tenders and estimates may be prepared.
33
6) Makes comparison possible – Proper maintenance of costing records
provides various costing data for comparison, which in turn helps
management in formulation of future lines of action.
10) Helps in cost reduction – in long run when alternatives are tried. This is
particularly important in present day content of global competition.
Rectification of Errors
Sometimes businessmen commit errors while posting Ledger. But it is not necessary such
errors may be located at same time. Errors are generally located after accounts have been
closed. Before knowing rectification of error, it is necessary to know kinds of errors. Errors
can be classified as follows –
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A. Errors of Omission –
These are of 2 types –
Purchase book
Jan 1 X Rs.250
Jan 20 Y Rs.310
Jan 31 Z Rs.151
Rs.711
35
Dr. Z A/C Cr.
By Purchase Rs.151
Or
To sundries 211
C. Error of Principle – Such error takes place when a transaction is recorded without
having regard to fundamental principles of book-keeping and accountancy.
Examples: - (1) Capital Expenditure may be treated as revenue expenditure or vice versa
such as expenses incurred in constructing a godown are treated as repairs.
UNIT-4
Cash Budget
Cash budget is an important financial budget. Cash is center of all business decisions. Cash
is invested in business to generate cash.
According to Guttman & Dougal “Cash Budget is an estimate of cash receipts &
disbursement for future period of time”.
Objectives: -
(1). To integrate cash inflows & outflows arising out of various functional budgets at
different time intervals, say monthly, quarterly or yearly.
(2). To assess projected cash deficits, at different time intervals so that finance can be
raised at required time to keep other activities of organization continue as per plan.
36
(3). To assess projected cash surplus at different time intervals and draw investment plans
so that no cash remain idle.
(4). To set limit of cash holding by organization at different point of time for smooth
functioning.
Utility/Importance:-
(1). It ensures that sufficient cash is available when required.
(2). It reveals surplus of cash so that suitable short-term or long-term investment plan may
be worked out.
(5). It shows any expected shortage of cash so that action may be taken e.g. bank overdraft
may be arranged.
Preparation:-
Particulars Jan(Rs.)
Feb(Rs.) March(Rs.)
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Payment of Dividend
Purchase of Fixed Asset
Purchase of Investment
Total(C)
Closing Balance(D)
=(A+B-C)
Fixed Budget:-
But such revision of becomes a very complicated task. On A/c these limits of fixed budget,
flexible budgeting is preformed.
These budgets are most suited for fixed expenses but they have only a
limited application and in effective as a tool for cost control.
Flexible budget:-
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1) Fixed cost remains fixed irrespective of volume of output.
2) V.c changes with the volume or level of output.
3) Semi-variable costs are partly fixed and partly variable.
1) Where the demand for the product changes a according to change in taste and
fashion.
2) Seasonal flue bat ions in sales and/ or production for example soft drinks industry,
woolen industries, raincoats etc.
3) Where level of activity fluctuate due to frequent introduction of new product.
4) Where customer’s reaction towards a new product is almost impossible to foresee
and to product
5) When production is aimed out only after receiving customer’s order.
6) Where business depends heavily on export markets.
7) Where sales are unpredictable due to typical nature of business and influents of
external factors.
8) Jobs or contracts are under taken which very in size and specification etc.
Significance of F.B:-
A fixed budget is productivity of no uses because the actual level of operation does not
invariably conform to budgeted level of activity. So to overcome this defect flexible budget
is introduced. Flexible budget as compared to fixed budget, has many merits to its credit
which specifies significance of flexible budgeting. Some of the advantages are:-
1) It presents details regarding output, cost sales and profit for varying level of
business operations which makes the managerial analysis more practicable and
feasible .
2) It make possible the comparison of actual performance and budgeted for actual
level of operations in a very easy and understanding way.
3) Fixed budget fails to achieve the objective of cost control and hence flexible budget
becomes an indispensable tools for achieving the onjective of cost reduction and
cost control.
4) Keeping into A/c the exact and precise forecasts for a rigid level of operation can be
made. As such it is useful to for coast for varying level of operation. This is
possible only by adopting flexible budgetary system.
39
On account of above merits the utility of flexible budget greatly increased.
In addition to above, there is some business concern for whom flexible budgeting in
most desirable simply because it is difficult job to prepare precise and accurate
estimates of production / sales.
Ratios:-
A) Profitability ratio or
B) Activity ratio or turnover ratio or performance
C) Financial ratio or solvency ratio
D) Miscellaneous ratio or market test ratio.
40
A B C D
Return on Cop. Turnover Liquidity Earning per share
investment
Return on share Stock Current liquid Pay out
holders
Return on fixed W.Cap Solvency Dividend yield
assets
Gross profit or Total asset Debt-Equity Price earning
gross margin
N.P ratio Debaters Proprietors
Opening ratio Creditors Fixed Assets
Debt-service
Cap gearing
Meaning of Budget
A budget is a detailed plan of operators for some specific future period. It is an estimate
prepared is advance of period to which it applies. It acts as a business barometer as it is
complete programme of activities of business for the period covered.
According to CIMA, London, budget is defined as, “ Financial and quantitative
statement, prepared prior to definite period of time, of policy to be pursued during
that period, for the purpose of attaining a given objectives.”
Thus the essentials of budgets are:-
(A) It is prepared in advance & is based on future plan of actions.
(B) It relates to a future period & is based on objectives to be attained.
(C) It is a statement expressed in monetary & physical units prepared for
implementation of policy formulated by management.
Different types of budgets are prepared by an industrial concern for different
purposes. A sales budget is prepared for purpose of forecasting sales for future
period. A master budget embodies forecasts—for sales & other incomes for
manufacturing, marketing & other expenses besides forecasting the figures for profit
or loss.
Budget V/S Forecasting
A forecasting is a statement of facts likely to occur.
According to CIMA, London , a forecast is, “ a statement of probable events”. At
planning stage it is necessary to prepare forecast of probable courses of action for
business in future. Plans or budget are prepared on the basis of these forecast in order
to achieve objectives of the organization. The forecast of a function need not
necessarily be coordinated which is needed before installation of budget. A forecast is
therefore a basis of budget.
A budget is a statement of planned events generally expressed in financial &
quantitative terms. It is generally evolved from forecast. A forecast denotes some
degree of bossiness while a ‘budget’ denotes a definite target.
41
Basis of Budget Forecast
Destination
(1) Events It relates to planned events i.e. It is concerned with
policy & programmes to be probable events likely to
followed in a future period under happen under anticipated
planned condition. condition during specified
period of time.
(2) Period It is usually planned separately for It may cover a long period
each a/c period. or years.
(3) Coverage It comprises whole business unit It may cover limited
sectional budgets are coordinated functions of business as
into logical whole. sales forecast.
(4) Control It is a tool of control as it It does not connote any
represents actions which can be serve of control as forecast
shaped according to condition is merely a statement of
which may or may not happen. future events.
(5) Process Process of budget starts where The functions of forecast
forecast and converts it into a and with the forecast of
budget. likely events.
(6) Sphere It is made in respect of those It is made in several other
sphere which are related to sphere which may not be
business. connected with budgeting
process.
Purpose of Budgeting
The major purpose of budgets or budgeting are:-
(1) Statement of expectations A firm establishes long range objectives which are
pursued in successive, short run steps in future period of time. A budget is a means to
achieve these goals by maintaining relationship between short run goals & long run.
Objectives of firm. It helps to clarify assumptions underlying future goals.
For example:- If sales target for next year’s formulated, budget gives detail about
prices, quantities, sales effort etc. which are based on number of factors such as
demand and supply, technological changes, economic conditions etc.
(2) Communication: The people of an enterprises should know what goals are, they
should understands and support them. Top management communicates budget to
lower level so as to make them clear what is to be achieved.
(3) Planning It is essential to accomplish goals. It reduces uncertainty and provides
directors
to employees by determining course of actions in advance. Budgeting compiles
management to plan in a comprehensive way. Planning involves what should be done,
how goals may responsibility and be held accountable.
(4) Coordination To implies proper balance b/w labour, material & other resources
so that goals are attained at min cost. The activities of various departments must
remain in harmony with each other. For example, there should be coordinated b/w
activities of production deptt and sales deptt. It is undesirable to produce a product
which cannot be profitable sold to sales deptt. Likewise, sales deptt should not create
demand for product which cannot be produced by production deptt.
42
(5) Control It consists of action necessary to ensure that performance of org.
conforms to plans and objectives. Control of performance is possible with pre
determined standard which are laid down in budget. Thus, budgeting makes control
possible by continuous comparison of actual performance with that of budget so as to
report variations from budget to mgmt of corrective actions.
Essentials of Budgeting:-
A successful and sound budgeting systems is based upon certain pre requisites which
represent mgmt attitude, org structures and managerial approaches necessary for effective
and efficient application of budgeting system. The following are some imp essentials or
(1) Top management support: A budgeting system will fail is it not installed and
supported by top mgmt because it is an important management too. A
company will be able to implement budget plans efficiently if top mgmt has
positive attitude towards budgeting and gives directions for budget
implementations. Budget estimates are generally proposed by line manager but
top management has responsibility of coordinating budget of diff departments
and approving them finally and initiate follow-up procedure to see that there
effective implementation of budgets.
(2) Clear and realistic goals: Budgeting is a means to achieve goals and objectives
and it cannot succeed if goals are not clear because there will be lack of proper
direction, and effort of mgmt will be wasted. Therefore the financial manager
must ansure that objectives and goal have been properly laid down, should be
written in formal terms, reasonable and realistic. Budget goals should not be
set at too high or too low level. Goals set a high level are impossible to attain
and employees don’t put any serious efforts to achieve them. Goals set at a
very low level don’t provide any challenge to employees and they are less
motivated. Goals for an enterprise depend on many factors such as size, age of
enterprise, nature of activities and other factors.
(3) Assignment of Authority and Responsibility: A sound organizational structure
is essential for success of budgetary system. Authorities and responsibilities of
each manager should be clearly identified and established which provide an
effective means to achieve enterprise objectives in efficient manner. If there is
no relationship b/w budgeting system and org structure of enterprise planning
and control would not be effective. In the absence of clear – cut assignment of
authorities and responsibilities either managers cannot be held accountable for
those activities for which they have no responsibilities .
Creation of Responsibility centers: As the large firm cannot be surprised by an individual
or few individuals so for effective control of all activities, each sub unit has certain
activities to perform and its manager is assigned specific authority and responsibilities to
carry out those activities. The sub-unit of an enterprise for purpose of control are called
responsibility center or decision center. The imp criteria of creating it is that unit of org
should be separable and identifiable for operating purposes and perform once measurement
should be possible.
43
72 – 77
Stages in Installing Profit Panning and Control System: -
A comprehensive system of profit planning and control involves the following steps:
A formulation and clear statement of broad, long-range objective of the enterprise;
Determination of the goals of the various departments or sub-unit, and their role and
significance in the accomplishment of broad, long-range objective. This includes
preparation of decentralized product and service plans, plans for growth rates, profit
margins, returns on investment etc.;
Determination of basic policies and strategies to be pursued in the performance of
enterprise goals as well as the department goals;
Formulation of formal budgets and projected statements like cash inflow and outflow;
working capital flows capital budget, statements of costs and revenues, projected balance
sheets etc.
Measurement of actual performance against budgets, plans and standards;
In addition to the planning and budgeting of financial items like sales revenues, costs.
Profit planning also involves logistic and facilitates planning to ensure an adequate supplies
of materials and supplies, and availability of operating capacity to carry out production and
sales during the ensuring period. Likewise, profit-planning leads to good deal of personal
planning so that an adequate and well trained work force is available to achieve the target
set in profit plans. In most cases, sales revenue is the key-index of most other activities
throughout the enterprise.
The process of developing a comprehensive profit plan is too complex and cumbersome for
frequent repetition. The mgmt has to resort to short-period planning in the form of financial
and operating profit plans for the various segments of the enterprise. However, these plans
have to be fitted into the broad and long-range objective reflected in the comprehensive
plan. As a matter of fact, short-range planning is a step to modify broad objectives to meet
the charges within and without the enterprise.
From the above discussion it may be said that all planning and control system necessarily
provide for the –
Setting of profit objectives: - Profit generation is a desirable goal of business enterprise.
Profit objectives may be set in term of a desired rate of return on capital for the enterprise
as a whole. In the setting of this objectives factors like business risk, economic
environment, political situations, market condition, general and specific industry’s rate of
return, will have to be considered by the top mgmt. The general and specific industries rate
of return may serve as an index for formulating rate of return for the enterprise. But, this
will have to be adjusted in the light of specific conditions affecting the enterprise.
Preparation of Profit budget: - The broad profit objectives and the sub-profit objectives, in
order to be accomplished, have to be worked and expressed in absolute terms in the form of
budgets. Budgets should be developed jointly by profit responsible executives, their
subordinates and their immediate superiors. The purpose of this multilevel participation is
to secure a more realistic plan and to increase the motivational impact of the final plan.
Budget process and methods are affected to a great extent by the type of organization
structure and the extent of deviation of authority within the org. It also differ from activity
to activity and from division to division. It also differs from enterprise to enterprise,
depending upon extent of sophistication existing in an enterprise.
Analysis for profit performance:- Budget serve as a guide for action of the operational
manager and also as a tool to measure and compare performance with the budget. Such
comparison b/w budgeted and actual performances of various managers reveals the
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deviation from the planned profit path. Two commonly accepted techniques for analyzing
profit performance are (a) Profit budget performance analysis; and (b) break-even analysis.
Profit planning and control provide a systematic and practical approach for effectively
bringing a greater degree of practicability and success to the mgmt process. In addition, a
sound system of profit planning and control provides the following advantages:
It provides an opportunity for an early and proper consideration of basic policies.
It enables mgmt to plan for the most economical use of resources in the form of labour,
material, capital etc,
It relieves the executives from drudgery of day-to-day problems and enables them to
concentrate and devote more time for planning and creative thinking.
Both standard costing and budgetary control achieve the same objective of minimum
efficiency and cost reductions by establishing predetermined standards, comparing actual
performance with predetermined standards and taking corrective measures where
necessary. Thus, although both are useful tools to the mgmt in controlling costs, they differ
in following respects: -
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performance. expenditure should not normally
exceed.
(5) Projection Standards are Budgets are projections of financial
Projections of cost account because accounts. Because financial
cost accounting deals with accounting deals with overall
individual products, ascertaining efficiency of the business such as
and controlling their costs. And sales functions, purchase functions,
standard costs aim at efficiency at production functions etc.
every point.
(6) Variance In standard costing, variance are In this technique, variances are not
analyzed in detail according to revealed through accounts but are
their originating causes. Thus, revealed in total
Standard costing reveals variances
through different accounts.
(7) Forecasting Standard costs do not tell what the Budgets are anticipated or expected
costs are expected to be but rather costs meant to be used for
what the cost should be under forecasting requirements of material
specific conditions of production , lab our , cash etc.
performance ans as such cannot be
used for the purpose of forecasting
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costs correctly if there is a change in different levels of activity under this
circumstances. type of budget.
(8) Tool for costs It has a limited application and is It has more applications and be used
control ineffective as a tool for cost as a tool for effective cost control.
control.
(9) Fixation of price If the budgeted and actual activity It helps in fixations of price and
and sub mission of levels vary, the correct submission of tenders due to correct
tenders. ascertainment of costs and fixation ascertainment of costs.
of prices becomes difficult.
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It is a widely used technique to study the cost -volume –profit relationship. The narrower
interpretation of term break –even analysis refer to system of determination of that level of
activity where total cost equals total selling price. The broader interpretation refer to that
system of analysis which determines probable profit at any level of activity. It portrays the
relationship between the cost of production ,volume of production and sales value.
Break –even analysis indicates the level of sales at which cost and revenue are in
equilibrium .The equilibrium point is commonly known as break even point,. The break
even point is that point of sales volume at which total revenue is equal to total cost.
It is the most useful technique of profit planning and control. It is a device to explain the
relationship between the cost volume profit .The utility of break even analysis lies in the
following advantages:
6)Diagnostic tool:
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It is useful diagnostic tool. It indicates to management the cause of increasing break even
point and falling profit The analysis of these causes will reveal that what action should be
taken. If break even point as a percentage of capacity is increasing ,it indicates the
unfavourable condition and need immediate action .It is possible that due to plant
expansion absolute break even point may increase. This situation where break even point as
a percentage of capacity may does not increase ,is not unfavourable
.
a)Cost segregation:
It is difficult to classified fixed and variable cost. However some of the can be easily
identified as fixed such as rent of building, or variable such as direct material cost but a
large number of cost belong to mixed category .such cost known as semi-variable cost
consists of fixed as well as variable cost and are difficult to separate.
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will not effect income ,but it is not true since the absorption of fixed cost depends on the
production and not on sales.
2)Limited information: can be presented in a single break even chart. if we have to study
changes of fixed cost ,variable cost and selling prices, a number of charts will have to be
drawn up
Similarly when a number of products are manufactured it would a difficult task to
present information through single break even chart.
3)Short term focus:It is a short term technique of profit planning and can not be used for
the long term planning because it lead to long term decision. For example a company wish
to increase his productive capacity and it may not yield enough revenue in the first year.
Thus in the term of break even analysis company may drop idea of adding to productive
capacity ,but it may be beneficial over a long period of time.
4)NO necessity: There is no necessity of preparing the break even charts on account of the
following reasons:
a)Simple tabulation sufficient: because result of cost and sales can serve the purpose
which is served by break even chart. Hence the need of presentation through chart and
using mathematical tool of break even analysis does not arisen.
b)Conclusive guidance not provided: No conclusive basis for action is provided to
management by technique of breakeven analysis,
c)Difficult to understand: The chart becomes very complicated and difficult to understand
particularly for the non technical man ,if number of lines or curves depicted on graph are
large
d)No basis for comparative efficiency:
Charts does not provide any basis for the comparative efficiency between the different
units. In spite of all above limitation it remain an important tool for the profit planning
what is needed is that financial analyst should understand underlying assumption and their
corresponding limitation and adjust his data appropriately to suits his needs.
Marginal costing
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This will be clear from the following example: A factory produces 500 fans per annum.
The variable cost per fan is Rs 50 .fixed expenses are Rs 10000per annum. Thus the cost
sheet of 500 fans will be as follows:
Variable cost(500 *50) 25000
Fixed cost 10000
2)All cost are classified into fixed and variable cost on the basis of variability .Even semi-
fixed cost are segregated into fixed and variable cost.
3)Variable cost alone are changed to production .fixed cost are recovered from
contribution.
4)Valuation of stock of work in progress and finished goods is done on the basis of
marginal cost.
6)Profit is calculated by deducting the marginal cost and fixed cost from the sales.
7)Cost volume profit (break even)analysis is one of the integral part of the marginal
costing.
8)The profitability of product is based on the contribution made available by each product.
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Are included for ascertain- fixed cost are removed from
Ing the cost. Contribution. Thus marginal cost=
Absorption cost=fixed+ total cost- (-)fixed cost
Variable cost
2) different unit cost are marginal cost per unit will remain
obtained at different level same at different level of output
of output because of because variable expenses vary in
fixed expenses remaining same proportion in which output
same. varies
3)profit difference between sales difference between sales and
and total cost is profit. Marginal cost is contribution
and difference between contribution
and fixed cost is profit or loss.
4)Absorption of the apportionment of fix- only variable cost are charged to
overheads ed expences on an arbitr- products. Marginal cost technique
ary basis gives rises to does not lead to over and under
over or under absorption absorption of fixed overheads.
of overheads which
ultimately makes product
cost inaccurate and unreal
-iable.
5) Decisions it is not very helpful in the technique of marginal costing
taking managerial is very helpful in taking managerial
decisions such as whether decisions because it takes into
to accept export order or consideration the additional cost
not, whether to buy or involved only assuming fixed
manufacture. Minimum expences remains constant.
price to be charged during
depression etc.
6)Classification cost are classified according cost are classified according
to functional basis such as to behaviour of cost i.e. fixed
production cost, office or and variable cost.
administrative cost and
selling and distribution cost.
7) Relationship It fails to establish relation cost –volume -profit
ship of cost, volume and relationship is an integral
profit as cost are seldom , part of marginal cost
classified into fixed and studies as cost are classified
variable. Into fixed and variable costs.
With the help of marginal costing technique managerial decisions can be taken regarding
the several matters are discussed as under:
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1)How much to produce: The level of output which is most profitable for a running
concern can be determined. Therefore production capacity can be utilized to the maximum
possible extent.
Ascertainment of most profitable relationship between cost, price and volume of
business shall also assist management in fixing the best selling prices. Thus maximisation
of profit can be achieved and profit planning becomes easier on the basis of applying
marginal costing technique
a)Efficiency and economy of plants :The marginal cost indicates efficiency and economy
of different plants over different ranges of products volume and output
b)No profit no loss point: With the help of technique of break even charts involved under
the marginal costing system point of no profit on loss can be raveled and information can
be presented to the management so as to facilitate the comparisons.
c)Lease or ownership of plant: The cost of lease and ownership are studied and better
alternative is adopted after judging and assessing the minimum sacrifice and maximum
differential gain through technique of marginal costing.
d)Cost control: cost control can be effected through comparing fixed and variable
elements of cost with the budgeted costs.
e)Inventory valuation: Becomes the more realistic when it is based on the marginal cost.
Fruitful results can be derived by combining this technique with the standard costing and
budgetary control technique . T
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Thus we can see technique of marginal costing is of immense value for managerial
decisions.
1)Classifications into fixed into variable elements a difficult task It is tough job to
analysis cost under the fixed and variable elements since the nature of the cost is not certain
in some cases. Certain cost may be partly fixed and partly variable and the division of such
cost into fixed and variable parts separately is based in the assumptions and not facts.
Certain overheads have no relations to volume of output or even with the time thus they
cannot be categorised either fixed or variable .Management decisions regarding bonus to
workers ,facilities to administrative staff etc. are taken without an consideration of time or
production volume.
2)Faulty decisions :If the fixed overheads are not taken into consideration management
decision regarding the price fixing manufacturing the product etc. may prove to be faulty
and deceptive. Marginal costs of the different products may be same, still manufacture of a
particular product may not be profitable on account of heavy fixed costs.
4)Under or over recovery of overheads: As variable overheads are estimated and not
based on the actual, there under and over recovery of overheads may results.
5)Better technique available: The system of budgetary control and the standard costing
serve the purpose better than the marginal costing system. Through variance analysis
impact on the profitability due to changes in the volume and the efficiency can be studied
and hence this technique is not required.
Marginal costing is a very useful tool for the management because of its following
applications:
1)Cost control :Marginal costing divides the total cost into fixed and variable cost and
bring out the reason as to why profits are decreasing in spite of increasing in sales.
Moreover in marginal costing fixed cost are not eliminated at all. These are shown
separately as deduction from contribution instead of merging with cost of sales. This helps
management to control fixed cost in long period as these cost are programmed in advance.
2)Profit planning: ie planning for the future operation in such a way as to maximize the
profit .Absorption costing fails to bring out the correct effect of change in sales price,
variable cost or product mix on profit of concern but that is possible with the marginal
costing.
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will give the higher contribution should be performed if the fixed expenses remain the
same.
4)Decision making
a)Fixation of selling price :Marginal cost of product represents minimum price for that
product and any sale below the marginal cost would lead to loss .The price of product
should be fixed at a level which not only covers the marginal cost but also make the
reasonable contribution to cover the fixed overheads.
b)Maintaining a desired level of profit: The industry has to cut its price of product from
time to time on account of competition, government regulations and other reasons. So the
contribution per unit is reduced while industry is interested in maintaining the minimum
level of its profit. So the volume of sales at which company earned desired level of profit
can be determined through the marginal costing.
c)Selection of suitable product mix: When the factory manufactures more than one
product, a problem is faced by the management as to which product mix will give the
maximum profit. The best product mix is that which yield maximum contribution and the
production of that product should be increased .The product which give the less
contribution should be reduced or closed down. The effect f sales mix can be seen by
comparing p/v ratio and break even point.
f)Exploring the new markets: Decision regarding selling goods in the new markets
(whether Indian or Foreign)should be taken after considering following factors:
1)Whether firm has surplus capacity to meet new demand?.
2)What price is being offered by new market?
3)Whether sale of goods in new market will affect present market for goods?
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g)Shut down or continue: While deciding whether to shut down not a comparison has
been made between1 cost-e.g loss of goodwill ,compensation to workers, packing and
storing cost of plant 2 benefits-e.g saving of fixed cost etc. on account of shut down .In
case benefits exceed the cost it is advisable to shut down or vice- versa.
Advantages of Budgeting
Budgeting is the important management tool, it a way of managing. Many benefits are
derived from budgeting although it is a mean not an end itself. It is feed forward process
that is it makes an evaluation of variables likely to affect the future operation of enterprises,
it predict future with reasonable precision and removes uncertainty to great extent. The
following are some of more signifies advantages of budgeting:
1)Forced planning :Budgeting compels the management to plan for future. The budgeting
process the management look ahead and become the more effective and efficient in
administrating business operation It installs into the managers the habit of evaluating
carefully their problems and related variable before making any decision.
7)Profit mindedness: Budgeting develops the atmosphere of profit mindedness and the
cost conciouness .It helps in preventing waste, reducing expences and attaining desired
return on investments.
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9)Efficiency: It measures efficiency ,permits self evaluation and indicates progress in
attaining enterprises objectives.
Limitations in budgeting
1)Budget plan is based on estimates: Budgeting is not an exact science and it based on
facts and managerial judgement which suffers from personal biases. The success or failure
of budget depends to a large extent upon accuracy of basic estimates or forecasts.
6)Good conflict: If budget set does not matches with the purpose of budgeting of
enterprises then there will be conflict and confuses so there must be harmony with
enterprises aims.
8)Unrealistic targets: Budget will lower morale and productivity if unrealistic targets are
set and if it is used as pressure tactic
Classification of assets
1)Liquid assets: are those which are represented by cash or those which can be easily
converted into money such as cash in hand, cash at bank, investments ,bill receivable
2)Fixed assets: are those whish are to be acquired to be retained permanently for purpose
of carrying on business such assets are purchased once and last for many years such as land
and building, machinery, furniture. They are also called long life assets or capital assets.
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3)Floating assets :are such assets which are acquired either for purpose of resale or held
temporarily in course of business for their subsequent conversions in to money such as
stock in trade ,book debt etc. The division of fixed asset and floating asset is not permanent
and will depend upon the nature on business. For eg furniture is fixed asset for
businessman but it will be floating asset for those who deal in furniture goods.
4)Wasting assets: are such assets as are consumed through being worked as mines etc e.g
leasehold land , copyright etc.
5)Fictitious assets: which are not represented by any tangible property such as preliminary
expenses ,prepaid expenses etc.
6)Intangible assets :are those which we cannot see or touch é.g goodwill.
Liabilities
1)Fixed liabilities :such debts that are payable after a long period eg a long term loan.
2)Current liabilities: that are payable time to time e.g bank overdraft ,bills payableetc.
3)Contingent liabilities: such debts that are become payable on happening of specific
incident are called contingent liabilities. For example abc sold goods to Harish for
Rs2000on credit and xyz stands as surety for harish .however harish becomes insolvent.
Now xyz has to pay Rs2000 to abc. This amount is a contingent liability for xyz. Following
are the eg of contingent liability
1 Bill discountable before maturity
2 Gurantee undertaken.
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past and future data and transactions.
information.
4)Periodicity It needs information regularly The period of financial
at the end of smaller periods statements is quite long
and therefore in management as compared to management
accounting, more emphasis is accounting. Financial state-
laid on providing quick info- ment (balance sheet, profit
rmation and at the smaller or loss account)are normally
intervals. Prepared at the end of year.
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