MODULE 2

MODULE 2
FINANCIAL MANAGEMENT
1) in details the different types of financial ratios?
A)A Ratio is an arthemetical relationship between two figures.
Types Explain of Ratios
Financial Ratio:
A Financial Ration is one of the good method of analysis.Financial ration analysis is a study of ratios between
various items or groups of items in financial statements.These ratios help summaries large amounts of data and to
make qualitative judgment about the financial performance .The ratio indicates a relation ship,which acan be then
judged against a benchmark or yardstick.The standards of comparision are based on.
a.Past ratios calculated for the same business,which help in identifying trends.
b.competitors ratios of some selected competing businesses,which help to compare against others.
C.Industry ratios which help to compare for the sector /industry
d.Projected ratios help in attempting how the future will look like.
The utility of ratio analysis helps on trying inderstand the ability of the business to meet current oobligations,the
extent to which businesshas liquidity in the long term to meet future requirements ,the efficiency with which the
firm is utilizing the assets in getting the sales and profits and the overall performance.
Financial rations are classified in to Six types:
a.Liqudity ratios:liqudity refers to the ability of a firm to meet its obligations of short liabilities with the help of
short tem assets,usually one year.The important liquidity ratios are current ratio and acid test ratio.
b.Leverage ratios:Leverage refers to the use of debt finance ,while debt capital is a cheaper sourceof finance,it
also adds to the risks of the company.Leverage ratios help in assessing the risk arising from the use of debt
capital .The commonly used leverage ratios are :debt equity ratio,interest coverage ratio and debt service
coverage ratio.
c.Turnover ratio:Turnover ratio is also referred to as acivity ratios or asset management ratios ,measure how
efficiently the assets are employed by the firm.The important turnover ratios are inventort turnover
ratio,receivable turn over ration,average collection period,fixed asstes turnover ration,and total assets turnover
ratio.

d.Profit margin ratios:Profit margins reflect the relationship between profits(defined variously) and sales.The
common used profit margin rations are gross profit margin ratio,EBIT /sales ratio & net profit margin ratio.
e.Return on investment ratios:Reflecting the relationship between profit and investment ,return on investment
ratios measure the overall financial performance of the firm.The most important return on investment ratios are
:net income to total assets ration,earning power and return on equity .
f.Valuation ratios:Valuation ratios indicate how the equity stock of the company is assessed in the capital
market.The commonly employed valuation ratios are :price earnings ratio ,yield,and market price to book ratio.
Current ration
Current ratio=Current assets/Current liabilities

Current assets includecash,marketable securities,debtors,inventories,loans and advances,and prepaid

expenses.Current liabilities consist of loans and advances(taken),trade creditors,accrued expenses ,and provisions.
The current ratio ,a very popular financial ratio,measures the ability of the firm to meet its current liabilities current
assets get converted in to cash in the operational cycle of the firm and provide the funds needed to pay current
liabilities.The higher the current ration,the greater the short term solvency.However ,in interpreting the current
ration the composition of current assets much not be overlooked.A firm with a high proportion of current asets in
the form of cash and debtors is more liquid than one with a high proportion of current assetsin the firm of
inventories even though both the firms have the same current ration.

Net worth ratio

Net Worth=equity + reserves

(all money belonging to shareholders)
Debt-equity ratio=net worth/debt
The denominator of this ration consists of all liabilities,short-term as well as long term and the numerator
consists of net worth plus preference capital.In general the higher the debt-equity ration ,the higher the
degree of protection enjoyed by the creditors.
Interest coverage ratio
Interest coverge ratio=earnings before interest and taxes/debt interest
Earnings before interest and taxes are used in the numerator ofthis ratio because the ability of a firm to pay
interest is not affected by tax payment,as interest on debt funds is a tax-deductible expense.This ratio
measures the margin of safety the firm enjoys with respect to its interest burden.A high interest coverage
ration means that the firm can easily meets at interest burden even if earnings before interest and taxed
suffer a considerable decline.A low interest coverage ratio may result in financial problems when earnings
before instesd and taxed decline.Though widely used,this ratio is not a very appropriate measureof
leverage because the source of interest payment is cash flow before interest and taxes ,not earnings before
interest and taxes.In view of this,we use a modified interest coverage ratio.
Interest Coverage ratio=(earnings before interest and taxes +depreciation)/debt
Inventory turnover ratio
Inventory turnover ratio=net sales/inventory
The numerator of this ration is the net sales for the year and the denominator is the average inventory

balance at he end of the previous and completed year.The inventory turnover ratio is deemed to reflect the
efficiency of inventory management.The higher the ratio the more efficient the management of inventories
and vice-versa .However ,this may not always be true.A high inventory turnover ratio may be caused by a
low level of inventory that may result in frequent stock-outs and loss of sales and customer good will.

Receivables turnover ratio

Recievables turnover ratio=net sales on credit/receivables
The receivable turnover ratio and the average collection period are realted as follows
Average collection period=360/recievables turnover ratio
Obviously ,the shorter the average collection period the higher the receivables turnover ratio and vice-versa
.The average collection period may be compared with the firms credit terms to judge the efficiency of
recievables management .Iif the credit sales are not mentioned separetly,you can take total net sales)
Fixed assets turnover ratio
Fixed
Assets turnover ratio=net sales/fixed
The numeratorof this ratio is the net sales for the period and the denominator is the balance in the fixed
assets account at the end of the year.This ratio is supposed to measure the efficiency with which fixed
assets are employed a igh ratio indicates a high degree of efficiency in asset utilization and a low ratio
reflects inefficient use of assets.When the fixed assets of the firm are old and substantially depreciated,the
fixed assets turnover ratio tends to be high because the denominator of the ratio is very low
Gross profit margin ratio
Gross profit margin ratio=gross profit/net sales
This ratio shows the money available after meeting manufacturing costs.It indicates the efficiency of
production as wwell as pricing
Net profit margin ratio
Net profit margin ratio=net profit/net sales

This ratio shows the profits available to shareholders (both) equity and preference as a percentage of net
sales.It indicates efficiency ofproduction,administration,marketing,financing,and tax planning
Return on equity =equity earnings/net worth
The numerator of this ratio is equal to profit after tax less preference dividends.The denominator includes all
cobtributions made by equity share holders (paid up capital+ reserves and surplus).This ratio is alos called
return on net of worth.The return on equity measures the profitability of equity funds invested in the firm.
Price earnings ratio
Price earnins ratio=market price per share/earnings per share

The maret price per share may be the price prevailing on a certain ,or preferably the average price over a
period of time.The earnings per share is simply ,profit after tax divided by the number of outstanding equity
shares.
The price earnings ratio(or the price multiple as it is commonly referred to) is a summary measure ,which
primarly reflects the following factors:growth prospects ,risk characteristics,share holder orientation ,corporate
image and degree of liquidity.

Precautions in using raito analysis

Companies are different and their operations may vary,thus setting comparisions may be
difficult ,sometimes even misleading
Changes in prices,market mix,products ,etc.may change the alaysis
Accounting records historical data,so some figures may be irrelevant
Predicting the future is difficult

Acocunting norms are different for different companies and even companies some times change
their accounting norms,making analysis difficult

2.Explain in detail basic financial statements?

Financial Statements represent a formal record of the financial activities of an entity. These are written
reports that quantify the financial strength, performance and liquidity of a company. Financial Statements
reflect the financial effects of business transactions and events on the entity.
Four Types of Financial Statements
The four main types of financial statements are:
1.

Statement of Financial Position

Statement of Financial Position, also known as the Balance Sheet, presents the financial position of
an entity at a given date. It is comprised of the following three elements:
o

Assets: Something a business owns or controls (e.g. cash, inventory, plant and machinery,
etc)

Liabilities: Something a business owes to someone (e.g. creditors, bank loans, etc)

Equity: What the business owes to its owners. This represents the amount of capital that
remains in the business after its assets are used to pay off its outstanding liabilities. Equity
therefore represents the difference between the assets and liabilities.

View detailed explanation and Example of Statement of Financial Position

2.

Income Statement
Income Statement, also known as the Profit and Loss Statement, reports the company's financial
performance in terms of net profit or loss over a specified period. Income Statement is composed of
the following two elements:
o

Income: What the business has earned over a period (e.g. sales revenue, dividend income,
etc)

Expense: The cost incurred by the business over a period (e.g. salaries and wages,
depreciation, rental charges, etc)

Net profit or loss is arrived by deducting expenses from income.

View detailed explanation and Example of Income Statement

3.

Cash Flow Statement

Cash Flow Statement, presents the movement in cash and bank balances over a period. The
movement in cash flows is classified into the following segments:
o

Operating Activities: Represents the cash flow from primary activities of a business.

Investing Activities: Represents cash flow from the purchase and sale of assets other than
inventories (e.g. purchase of a factory plant)

Financing Activities: Represents cash flow generated or spent on raising and repaying share
capital and debt together with the payments of interest and dividends.

View detailed explanation and Example of Cash Flow Statement

4.

Statement of Changes in Equity

Statement of Changes in Equity, also known as the Statement of Retained Earnings, details the
movement in owners' equity over a period. The movement in owners' equity is derived from the
following components:
o

Net Profit or loss during the period as reported in the income statement

Share capital issued or repaid during the period

Dividend payments

Gains or losses recognized directly in equity (e.g. revaluation surpluses)

Effects of a change in accounting policy or correction of accounting error

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Statement of Financial Position [Balance Sheet]

Definition
Statement of Financial Position, also known as the Balance Sheet, presents the financial position of an entity
at a given date. It is comprised of three main components: Assets, liabilities and equity.
Statement of Financial Position helps users of financial statements to assess the financial soundness of an
entity in terms of liquidity risk, financial risk, credit risk and business risk.
Example
Following is an illustrative example of a Statement of Financial Position prepared under the format
prescribed by IAS 1 Presentation of Financial Statements.

Statement of Financial Position as at 31st December 2013

Notes 2013

2012

USD

USD

ASSETS
Non-current assets
Property, plant & equipment
Goodwill
Intangible assets

9
10
11

130,000
30,000
60,000
220,000

Current assets
Inventories
Trade receivables
Cash and cash equivalents

12
13
14

12,000
25,000
8,000
45,000
265,000

50,000
250,000

100,000
50,000
15,000
165,000

100,000
40,000
10,000
150,000

TOTAL ASSETS

120,000
30,000
50,000
200,000

10,000
30,000
10,000

EQUITY AND LIABILITIES

Equity
Share capital
Retained earnings
Revaluation reserve
Total equity

4
5

Non-current liabilities
Long term borrowings

35,000

50,000

Current liabilities
Trade and other payables
Short-term borrowings
Current portion of long-term borrowings
Current tax payable

7
8
6
9

35,000
10,000
15,000
5,000

25,000
8,000
15,000
2,000

Total current liabilities

Total liabilities
TATAL EQUITY AND LIABILITIES

65,000
100,000
265,000

50,000
100,000
250,000

You may download a free blank excel template of the statement of financial position. The template is prelinked with the cash flow statement and statement of changes in equity.

Classification of Components
Statement of financial position consists of the following key elements:
Assets
An asset is something that an entity owns or controls in order to derive economic benefits from its use.
Assets must be classified in the balance sheet as current or non-current depending on the duration over
which the reporting entity expects to derive economic benefit from its use. An asset which will deliver
economic benefits to the entity over the long term is classified as non-current whereas those assets that are
expected to be realized within one year from the reporting date are classified as current assets.
Assets are also classified in the statement of financial position on the basis of their nature:

Tangible & intangible: Non-current assets with physical substance are classified as property, plant
and equipment whereas assets without any physical substance are classified as intangible assets.
Goodwill is a type of an intangible asset.

Inventories balance includes goods that are held for sale in the ordinary course of the business.
Inventories may include raw materials, finished goods and works in progress.

Trade receivables include the amounts that are recoverable from customers upon credit sales. Trade
receivables are presented in the statement of financial position after the deduction of allowance for
bad debts.

Cash and cash equivalents include cash in hand along with any short term investments that are
readily convertible into known amounts of cash.

Liabilities
A liability is an obligation that a business owes to someone and its settlement involves the transfer of cash
or other resources. Liabilities must be classified in the statement of financial position as current or noncurrent depending on the duration over which the entity intends to settle the liability. A liability which will
be settled over the long term is classified as non-current whereas those liabilities that are expected to be
settled within one year from the reporting date are classified as current liabilities.
Liabilities are also classified in the statement of financial position on the basis of their nature:

Trade and other payables primarily include liabilities due to suppliers and contractors for credit
purchases. Sundry payables which are too insignificant to be presented separately on the face of
the balance sheet are also classified in this category.

Short term borrowings typically include bank overdrafts and short term bank loans with a
repayment schedule of less than 12 months.

Long-term borrowings comprise of loans which are to be repaid over a period that exceeds one year.
Current portion of long-term borrowings include the installments of long term borrowings that are
due within one year of the reporting date.

Current Tax Payable is usually presented as a separate line item in the statement of financial
position due to the materiality of the amount.

Equity
Equity is what the business owes to its owners. Equity is derived by deducting total liabilities from the total
assets. It therefore represents the residual interest in the business that belongs to the owners.
Equity is usually presented in the statement of financial position under the following categories:

Share capital represents the amount invested by the owners in the entity

Retained Earnings comprises the total net profit or loss retained in the business after distribution to
the owners in the form of dividends.

Revaluation Reserve contains the net surplus of any upward revaluation of property, plant and
equipment recognized directly in equity.

Rationale - Why the balance sheet always balances?

The balance sheet is structured in a manner that the total assets of an entity equal to the sum of liabilities
and equity. This may lead you to wonder as to why the balance sheet must always be in equilibrium.
Assets of an entity may be financed from internal sources (i.e. share capital and profits) or from external
credit (e.g. bank loan, trade creditors, etc.). Since the total assets of a business must be equal to the
amount of capital invested by the owners (i.e. in the form of share capital and profits not withdrawn) and
any borrowings, the total assets of a business must equal to the sum of equity and liabilities.
This leads us to the Accounting Equation: Assets = Liabilities + Equity

Purpose & Importance

Statement of financial position helps users of financial statements to assess the financial health of an entity.
When analyzed over several accounting periods, balance sheets may assist in identifying underlying trends
in the financial position of the entity. It is particularly helpful in determining the state of the entity's liquidity
risk, financial risk, credit risk and business risk. When used in conjunction with other financial statements of
the entity and the financial statements of its competitors, balance sheet may help to identify relationships
and trends which are indicative of potential problems or areas for further improvement. Analysis of the
statement of financial position could therefore assist the users of financial statements to predict the
amount, timing and volatility of entity's future earnings.
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Income Statement | Profit & Loss Account

Definition
Income Statement, also known as Profit & Loss Account, is a report of income, expenses and the resulting
profit or loss earned during an accounting period.

Topic contents:
1.

Definition

2.

Example

3.

Basis of preparation

4.

Components

5.

Purpose & Use

6.

Template

Example
Following is an illustrative example of an Income Statement prepared in accordance with the format
prescribed by IAS 1 Presentation of Financial Statements.

Income Statement for the Year Ended 31st December 2013

2013
Notes
USD
Revenue
Cost of Sales

16
17

Gross Profit

2012
USD

120,000
(65,000)

100,000
(55,000)

55,000
Other Income
Distribution Cost
Administrative Expenses
Other Expenses
Finance Charges

18
19
20
21
22

Income tax

17,000
(10,000)
(18,000)
(3,000)
(1,000)
(15,000)
40,000

Profit before tax

23

Net Profit

45,000
12,000
(8,000)
(16,000)
(2,000)
(1,000)
(15,000)
30,000

(12,000)

(9,000)

28,000

21,000

Basis of preparation
Income statement is prepared on the accruals basis of accounting.

This means that income (including revenue) is recognized when it is earned rather than when receipts are
realized (although in many instances income may be earned and received in the same accounting period).
Conversely, expenses are recognized in the income statement when they are incurred even if they are
paid for in the previous or subsequent accounting periods.

Income statement does not report transactions with the owners of an entity.
Hence, dividends paid to ordinary shareholders are not presented as an expense in the income statement
and proceeds from the issuance of shares is not recognized as an income. Transactions between the entity
and its owners are accounted for separately in the statement of changes in equity.

Components
Income statement comprises of the following main elements:

Revenue
Revenue includes income earned from the principal activities of an entity. So for example, in case of a
manufacturer of electronic appliances, revenue will comprise of the sales from electronic appliance
business. Conversely, if the same manufacturer earns interest on its bank account, it shall not be classified
as revenue but as other income.

Cost of Sales
Cost of sales represents the cost of goods sold or services rendered during an accounting period.
Hence, for a retailer, cost of sales will be the sum of inventory at the start of the period and purchases
during the period minus any closing inventory.
In case of a manufacturer however, cost of sales will also include production costs incurred in the
manufacture of goods during a period such as the cost of direct labor, direct material consumption,
depreciation of plant and machinery and factory overheads, etc.
You may refer to the article on cost of sales for an explanation of its calculation.

Other Income
Other income consists of income earned from activities that are not related to the entity's main business.
For example, other income of an entity that manufactures electronic appliances may include:

Gain on disposal of fixed assets

Interest income on bank deposits

Exchange gain on translation of a foreign currency bank account

Distribution Cost
Distribution cost includes expenses incurred in delivering goods from the business premises to customers.

Administrative Expenses

Administrative expenses generally comprise of costs relating to the management and support functions
within an organization that are not directly involved in the production and supply of goods and services
offered by the entity.
Examples of administrative expenses include:

Salary cost of executive management

Legal and professional charges

Depreciation of head office building

Rent expense of offices used for administration and management purposes

Cost of functions / departments not directly involved in production such as finance department, HR
department and administration department

Other Expenses
This is essentially a residual category in which any expenses that are not suitably classifiable elsewhere are
included.

Finance Charges
Finance charges usually comprise of interest expense on loans and debentures.
The effect of present value adjustments of discounted provisions are also included in finance charges (e.g.
unwinding of discount on provision for decommissioning cost).

Income tax
Income tax expense recognized during a period is generally comprised of the following three elements:

Current period's estimated tax charge

Prior period tax adjustments

Deferred tax expense

Prior Period Comparatives

Prior period financial information is presented along side current period's financial results to facilitate
comparison of performance over a period.
It is therefore important that prior period comparative figures presented in the income statement relate to a
similar period.

For example, if an organization is preparing income statement for the six months ending 31 December
2013, comparative figures of prior period should relate to the six months ending 31 December 2012.

Purpose & Use

Income Statement provides the basis for measuring performance of an entity over the course of an
accounting period.
Performance can be assessed from the income statement in terms of the following:

Change in sales revenue over the period and in comparison to industry growth

Change in gross profit margin, operating profit margin and net profit margin over the period

Increase or decrease in net profit, operating profit and gross profit over the period

Comparison of the entity's profitability with other organizations operating in similar industries or
sectors

Income statement also forms the basis of important financial evaluation of an entity when it is analyzed in
conjunction with information contained in other financial statements such as:

Change in earnings per share over the period

Analysis of working capital in comparison to similar income statement elements (e.g. the ratio of
receivables reported in the balance sheet to the credit sales reported in the income statement, i.e.
debtor turnover ratio)

Analysis of interest cover and dividend cover ratios

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3)What is budget ?Explain types and advantages of budget?

Ans: A budget is an instrument of the management used as aid in planning, programming and control of
business activity.
Definition: It can be defined as a financial and quantities related statement prepared and approved prior to
a defined period of time (usually for an year), of the policy to be pursued during that period for the purpose
of attaining a given objective.

Budgeting is simply balancing your expenses with your income. If they don't balance and you
spend
more than you make, you will have a problem. Many people don't realize that they spend more
than they earn and slowly sink deeper into debt every year.

It may include income, expenditure and employment of capital.

Financial forecasting is important in this process. Along with this, sensitivity analysis should be carried out
to look at likely scenarios and options. Past performance, characteristics of the business, objectives of
business, financing options, alternatives, the consequences of each should be taken into consideration. This
leads to plans which are known as budgets.
Thus a budget has the following characteristics:
1. It is a written plan of action. Its always expressed in quantitative terms and numbers, which are
translated in financial terms.
2. It is used for cost control purpose and it is one of the most important overall control device
employed by management.
3. A budget represents the financial requirements of different sections of the business during a given
period to achieve an estimated profit based upon a given volume of sales.
4. A budget is based upon the past statistical data and it predicts the estimated labor, sales,
production, and other management requirement for future, i.e. for a defined budgetary period.
5. A budget can be thought of an overall plan for the operation of the business in terms of sales,
production and expenditure.
6. Budgets must have backing /support of the top management and participation along with
commitment by all the concerned to make it a success.
Budgeting: Budgeting is an art of budget making. A good budgeting process shows the manager what he
may expect in sales over the next few months. Thus budgeting implies forecasting and preplanning for the
budget period basing upon past experience, statistical data and present conditions.
Advantages of budgeting:
Forced planning Compels the management to look ahead and become more effective and efficient
in administering the business operations.
Coordinated Operation Helps to coordinate, integrate and balance the efforts of various
departments.
Performance evaluation and control Facilitates control by providing definite expectations in the
planning phase that can be used as a frame of reference for judging the performance.
Effective communication Improves the quality of communication. The enterprise objectives,
budget goals, plans, authority and responsibility and procedures to implement are clearly written
and communicated through budgets to all individuals.
Optimum utilization of resources Optimize the utilization of firms resources, capital and human
and aids in directing the efforts into the most profitable channels.
Productivity improvement It also increases the morale and thereby increases the productivity by
seeking meaningful participation of employees in the formulation of plans and policies.
Profit mindedness Develops an atmosphere of profit mindedness and cost consciousness.
Efficiency Budgeting measures efficiency, permits the management self-evaluation and indicates
the progress in attaining the enterprises objectives.

Budgeting system should always be flexible enough to take advantages of all the opportunities that arise
from time to time. Budgeting allows more freedom to the lower management and they feel free to take
decisions. A flexible and comprehensive budgeting permits the management to readjust plans when a new
situation arises.
Types of Budget:
1. Master Budget:
a.

2.

Operating Budget It relates to the planning of the activities or operations of the enterprise
such as production, sales and purchase.
b. Activity Budget It specifies the operations or activities to be performed during the next year.
The program budget focuses on activities rather than person; it exhibits the expected future in
an impersonal manner.
c. Responsibility Budget It specifies plane in terms of individuals responsibilities. The focus is on
the individuals. The basic purpose of this kind of budget is to achieve control by comparing the
actual performance of a responsible individual with the expected performance.
Financial Budget: Its concerned with the financial implications of the operating budgets. The
expected cash inflows and outflows, financial position and the operating results.
a.
b.

Cash Budget The major objective is to plan cash in such a way that the company maintains
sufficient cash balance to meet its needs and uses the idle cash in the most profitable manner.
Proforma financial statements Proforma financial statements balance sheets and income
statements show the end results of the budget operations.

The preparation of the cash budget and proforma financial statements compels the management to look
ahead and balance its policies and activities.
3. Capital Budget: It involves the planning to acquire worthwhile projects, together with the timings of
the estimated cost and cash flows of each project. Capital budgets are difficult to prepare because
estimates of the cash flows over a long period have to be made which involves great degree of
uncertainty.
It may be defined as the firms decision to invest its current funds most efficiently in the long term
assets in anticipation of respected flow of benefits over a series of years. These decisions would
generally include acquisition, expansion, modernization and replacement of long term assets.
Capital budgeting is a complete process which may be divided into the following phases:
a.
b.
c.
d.
e.
f.

Identification of potential investment opportunities

Assembling of proposed investments
Decision making
Preparation of capital budget and appropriations
Implementations
Performance review

4)Explain the concepts and categories of economics and explain why economics is applicable to
health care sector?
Economics is the systematic study of resource allocation mechanism.It can be applied to any discipline where
scarcity of resources exists and hence choices hae to be made on the effective and efficient use of available
resources.
Resources are every item within the economy that can be utilized to produce and distribute goods and
servies.There are four primary type of resources.
a.Labour:This referes to human resource (skilled and unskilled)
b.Capital:This referes to goods that are used to produce other goods and services(machinery,buildings,tools
etc)
c.Land:This includes all antural resources

d.Manufactured consumables:This comprises every thing else that does not fall under labour ,capital and land
and is manufactured.
Resources can be combined in the production process to produce commodities .Commodities are either final
products which can be used to satisfy wants or can be intermedicate products,which can further be used to
make other commodities.
A resource can be used in three ways:It can be consumed ,it can be invested or it can be exchanged for other
resources or commodity.
Demand :Is defined by desire to buy the services or good,and ability to efford the services or good and the
willingness to pay for it.
The following factors influence the demand for health care:
a.Need for services (as perceived by patient)
b.Patient preferences or choices
c.Income
d.Price of services
e.Travel cost and waiting time
f.Quality of care (again as perceived by the patient)
Supply:Economics define supply as the total quantity of a good or sevice that is available for purchse at a
given price
Utility:Utility in economics refers to the happiness and satisfaction gained from consuming a good or service
Opportunity cost:The value of the next best alternative foregone as a result of the decision or choice
made.Alternatively it can be explained as the level of benefir one could have got from the best alternative
action.
Categories of economics:
Like any academic discipline,economics can be categorized as:
Microeconomics and macroeconomics
Microeconomics is concerned with the decisions taken by the individual consumers and firms and the way
these decisions contribute to the setting of prices and output (micro implies small scale)
Macroeconomics pertain to the interaction between economic aggregates on a broader plane(such as general
price inflation,unemployement that the growth of national output etc)

Positive and normative economics:

Positive economics refers to economic statement that describe how things are. positive statements are
objective statements dealing with matters of fact or they question about how things actually are.Positive
statements are made without obvious value-judgements and emotions.They may suggest an economic
relationship that can be tested by recourse to the available evidence.
Positive economics can be described as what is ,what was ,and what probably will be economics.Statements
are based on economic theory rather than raw emotion.Often these statements will be expressed in the form
of hypothesis thath can be analysed and evaluated.

Application of economics in healthcare

Principles of Health Economics
From a Public Health point of view, health economics is just one of many disciplines that may be used to
analyse issues of health and health care, in particular as one of the set of analytical methods labelled
health services research. But from an economics point of view, health economics is simply one of many
topics to which economic principles and methods can be applied. So, in describing the principles of health
economics, we are really setting out the principles of economics and how they might be interpreted in the
context of health and health care. As Morris, Devlin and Parkin (2007) put it: Health economics is the
application of economic theory, models and empirical techniques to the analysis of decision-making by
individuals, health care providers and governments with respect to health and health care.
There are many different definitions of economics, but a definition given in a popular introductory textbook
(Begg, Fischer and Dornbusch, 2005) is instructive: The study of how society decides what, how and for
whom to produce. In analysing these issues, health economics attempts to apply the same analytical
methods that would be applied to any good or service that the economy produces. However, it also always
asks if the issues are different in health care.
Production, resources, scarcity and opportunity cost
The definition of economics above includes the term to produce, emphasising that economics deals with
both health and health care as a good or service that is manufactured, or produced. All production requires
the use of resources such as raw materials and labour, and we can regard production as a process by which
these resources are transformed into goods:

The inputs to this productive process are resources such as personnel (often referred to as labour),
equipment and buildings (often referred to as capital), land and raw materials. The output of a process
using health care inputs for example health care professionals, therapeutic materials and a clinic - could
be, for example, an amount of health care of a given quality that is provided. How inputs are converted into
outputs may be affected by other mediating factors, for example the environment in which production takes
place, such as whether the clinic is publicly or privately owned.
The key observation of economics is that resources are known to be limited in quantity, but there are no
known bounds on the quantity of outputs that is desired. This both acts as the fundamental driving force for
economic activity and explains why health and health care can and should be considered like other goods.
This issue, known as the problem of scarcity of resources means that choices must be made about what
goods are produced, how they are to be produced and who will consume them. Another way to view this is
that we cannot have all of the goods that we want and in choosing the basket of goods that we will have,
we have to trade off one good for another.
The term economic goods is sometimes used to describe goods and services for which economic analysis is
deemed to be relevant. These are defined as goods or services that are scarce relative to our wants for
them. Health care is such an economic good: first, because the resources used to provide it are finite and
we can only use more of these resources to create health care if we divert them from other uses; and
secondly, because societys wants for health care, that is what society would consume in the absence of
constraints on its ability to pay for it, have no known bounds. Nowhere in the world is there a health care
system that devotes enough resources to health care to meet all of its citizens wants.
Of course, in a national health system, it is likely that the aim is to meet needs rather than wants; this
distinction is discussed below. But it is also the case that meeting one need may mean

Demand for health care, demand for health and need

If we are considering the market for health care, we will be interested in the demand for health care.
However, in considering this demand, it is important to recognise that health care has special
characteristics that may make it different from other goods. One factor is that health care is not usually
demanded because it is in itself pleasurable; in fact it may be unpleasant. Instead, it is demanded mainly to
improve health. So, even if health care is in itself unpleasant, it leads to more pleasure than would
otherwise have been the case.
If health care is only demanded in order to improve health, then is there a demand for health
improvements? Health can indeed be regarded as a good, in fact a fundamental commodity that is
essential to peoples well-being, leading to a demand for improvements in it. Health does have
characteristics that more conventional goods have it can be manufactured; it is wanted and people are
willing to pay for improvements in it; and it is scarce relative to peoples wants for it. However, its
relationship with the demand for health care is not one-to-one, because although health is affected by
health care, it is also affected by many other things and it also affects other aspects of welfare, not just
health care. As a good, health is even more peculiar than health care, because of its characteristics. It is
less tangible than most other goods and cannot be traded it cannot be passed from one person to
another (although obviously some diseases can.)
In the context of ordinary goods and services, economics distinguishes between a want, which is the desire
to consume something, and effective demand, which is a want backed up by the willingness and ability to
pay for it. It is effective demand that is the determinant of resource allocation in market, rather than wants.
But in the context of health care, the issue is more complicated than this, because many people believe
that what matters in health care is not wants or demands, but needs. Health economists generally interpret
a health care need as the capacity to benefit from it. Not all wants are needs and vice versa. For example, a
person may want nutrition supplements, even though these will not produce any health improvements for
them; or they may not want a visit to the dentist even if it would improve their oral health.
The conclusion from this is that the demand for health care can be analysed as if it were any good or
service, but it has peculiarities that may mean that the usual assumptions about the resource allocation
effects of markets do not hold. Moreover, it may well be that people wish resource allocation to be based on
the demand for health or the need for health care, neither of which can be provided in a conventional
market.
Supply
The supply side of the market is analysed in economics in two separate but related ways. One is related to
the resource input / goods output model outlined above, looking at how resource use, costs and outputs are
related to each other within a firm. Some of the issues that this illuminates concern efficiency in production,
which will be discussed below. Others include issues such as economies of scale are there any cost
savings through having larger general practices, for example productivity how many more surgical
operations can a hospital provide if it hires an extra nurse - and factor substitution does allowing dental
hygienists to replace dentists in undertaking certain tasks lower the costs of producing dental care?
The other way in which supply is analysed is so called market structure how many firms are there
supplying to a market and how do they behave with respect to setting prices and output and making profits.
There are two well-known theoretical extremes of market structure. Perfect competition has very many
firms in the market so that none has any real economic power, none makes any profits, prices are as low as
they can be and output is as high as can be. A monopoly has only one firm, which has great market power,
makes as large profits as can be had and has higher prices and lower output. Other models are somewhere
in between. The behaviour of some health care organisations, such as pharmaceutical companies, providers
of services like dentistry, ophthalmic services and pharmaceutical dispensing and for-profit insurance
companies can relatively easily be analysed using these models. It may be more difficult for other
organisations. However, they may provide relevant insights for example regulation of the UK provider
sector is increasingly guided by the use of market forces involving contestability to provide some
competitive pressures for efficiency.
The principle of the margin

Economics analyses many economic activities according to marginal principles. Marginal does not mean
small or unimportant; instead it means at the margins of an existing state of affairs, for example the cost or
benefit that will be incurred or gained by changing the allocation of resources slightly. There are two
reasons for this. First, looking at marginal values of economic variables often gives a better view of the
issues faced in decision making. Secondly, an influential economic theory suggests that people do, at least
implicitly, make decisions using marginal principles.
The definition of a marginal change is that it is a change in an economic variable that is caused by the
smallest possible change in another variable. For example, the marginal cost of a good is most widely
defined as the extra cost incurred in producing one more unit of it. That cost could actually be rather large,
even though the change in the amount of the good is small. As an extreme example, suppose that the good
is a particular surgical operation and the surgical unit carrying it out has reached full capacity for its
operating theatre. An extra operation could only be carried out if a new theatre was built, so its marginal
cost would be very high. By contrast, the marginal cost of the last operation performed within the existing
capacity may have been quite small, simply the cost of theatre staff, disposables and subsequent care. This
demonstrates an important point. Marginal cost may vary considerably with respect to the same size of
change in the other variable, depending on the level of that other variable in this case the number of
operations.
A classic example of the importance of looking at marginal costs is the impact of schemes designed to
lower hospital inpatient surgical costs by reducing length of stay through earlier discharge. Hospitals may
have information on the average cost of an inpatient stay, which can be used to calculate an average cost
per day. However, the costs of an inpatient day are not constant. In particular, they may be much smaller
than the average towards the end of the stay, because the average includes a share of the costs of
treatment and perhaps of high dependency care that took place towards the beginning of an inpatient stay.
So, reducing the number of low dependency days at the end of the stay will save far fewer costs than
expected. Marginal costs calculated with respect to an increase or decrease in the number of days would
give a correct estimate of the likely savings.
Similarly marginal benefit might be the extra benefit gained by the consumption of one more unit of a good.
A classic example of the importance of looking at marginal rather than average benefits is a screening
programme which can be carried out with different numbers of sequential tests. The more tests, the more
cases are detected. A programme that used two tests might yield 11 cases per 1,000 people tested rather
than the 10 cases that a one test programme would produce. But if instead of analysing these as a one test
screen and a two test screen, the two tests are analysed as one test followed by another, the marginal
benefit is only 1 case, which does not look so good.
Further use of the concept of the margin is discussed in section 6, and a specific application of this in health
care is discussed in section 8.
Efficiency and equity
Economic analysis usually judges the way in which scarce resources are employed according to two main
criteria: efficiency and equity. These two concepts have technical definitions, which will be described below,
but in very broad terms efficiency refers to obtaining the greatest output for a given set of resources and
equity refers to a fair distribution of that output amongst the population.
Efficiency
Before discussing efficiency in detail, it is useful to give a warning. Although economists are specialists in
the analysis of efficiency and largely agree about what it means and about definitions of different types of
efficiency, the labels given to those types vary. The same concept may be given different names and the
same name may be given to different concepts. Here we will use the labels given in Morris, Devlin and
Parkin (2007). If other texts are consulted, it may be wise to check what is meant if efficiency is referred to,
especially if the terms technical or allocative efficiency are used. They are not necessarily wrong, just
different.
A very broad definition of efficiency has been given by Knapp (1984): The allocation of scarce resources
that maximises the achievement of aims. This is a useful start, because it suggests the very benign nature
of the desire to achieve efficiency. If we have scarce resources and competing uses for them, our aim will be
to obtain the best set of uses, with best defined in whatever way we want. If we decide that the aim of

the health system is to improve the health of the population and we have a fixed health care budget, we
will obtain the biggest health gain if the allocation of scarce health care resources is efficient.
For practical purposes, it is useful to have more precise and technical definitions of efficiency. However, it is
useful first to understand a slightly abstract idea, called Pareto efficiency, which is also (though not
consistently) called allocative efficiency. This arises from an attempt to create a criterion for judging
different allocations of resources to different ends which might be widely acceptable. (Whether it is or not is
in fact debated, but that debate is beyond our aims here.) The suggestion is that we would be able to say
that one allocation is better than another if at least one person is better off under the first allocation and
no-one is worse off. This is called the Pareto criterion. If we change from one allocation of resources to
another, for example if it were possible to make changes to the health care system in terms of the kind of
care that is made available, and this means that some people benefit and no-one is made worse off, then
this is described as a Pareto improvement. If it is not possible to make any such changes, then we have
achieved a Pareto optimum. Another way to view the Pareto optimum is that it is a position where it is not
possible to make anyone better off without making someone else worse off.
If our aim is to make people as well off as possible and we are not concerned about whether some people
are better off than others, then a Pareto optimum is efficient. We cannot further improve the achievement
of our aim because even if we can make someone, or even many people, better off, we do not know if this
is outweighed by those who are made worse off. Of course, there are many allocations of resources that
would be Pareto optimal, some of which would imply great inequalities between different people. If our aims
also took account of this, then we might not view all Pareto optimums as efficient. Nevertheless, ideas of
efficiency in economics do derive from this concept of Pareto efficiency Three types are defined below:

Technical efficiency

Economic efficiency

Social efficiency

Technical efficiency is a concept that is used in considering the production of health and health care. Recall
from section 1.1 that this is a relationship between resource inputs and outputs. Technically efficient
production is achieved if we are producing most output from a set of inputs, or producing a set amount of
output using the fewest inputs. For example, the number of patients that can be treated in an out-patient
clinic depends on the number of medical and nursing staff that are available and other inputs. If the most
that can be provided by one doctor and two nurses is 20 treatments each day, then it is technically
inefficient to provide 19 treatments with that number of staff or to provide 20 treatments with more staff.
Another way of viewing technical efficiency, which is consistent with Pareto efficiency, is that the clinic
cannot undertake more treatments without employing at least one more member of staff. More generally,
production is technically efficient for a given set of inputs if it is only possible to produce more by employing
more of at least one input.
Economic efficiency has a number of different labels, including cost-effectiveness, though that term should
be used carefully, as will be explained in the section on economic evaluation. Technical efficiency is defined
with respect to the physical numbers of inputs, but economic efficiency is interested in the cost of those
inputs. Economic efficiency is achieved if we are producing most output for a given cost, or producing a set
amount of output at the lowest possible cost. Using the example above, some aspects of the treatment
provided in a clinic could be undertaken either by doctors or nurses. It might be technically efficient for 20
treatments to be provided each day by using one doctor and two nurses or two doctors and one nurse. But
if we assume that doctors are more expensive to employ than nurses, then it will be economically efficient
to use the first of these staff mixes. So, although achieving technical efficiency is necessary to achieve
economic efficiency, not all technically efficient ways of producing are economically efficient.
Another way of viewing economic efficiency, which is consistent with Pareto efficiency, is that given the
costs of employing staff, the clinic cannot undertake more treatments without them costing more to
provide. More generally, production is economically efficient for a given set of input prices if it is only
possible to produce more by incurring greater costs.
Social efficiency is a much broader concept than technical and economic efficiency. Both technical
efficiency and economic efficiency concern production, and if the supply side of the market achieves

economic efficiency in every market, there is allocative efficiency in production for the economy as a whole.
There is an equivalent concept for the demand side of the market called allocative efficiency in
consumption where, given prices of goods, consumers maximise their utility. If both of these are achieved,
then there is allocative efficiency in the economy as a whole, which is also known as social efficiency. This is
the same as the Pareto efficiency described earlier.
Obviously, this is not a concept likely to be of practical use in health economics, but it is an important idea
for debates about whether markets should be used in health care. It can be shown that if markets work
perfectly, then they will produce a socially efficient economy. To some, this gives a presumption in favour of
market provision. However, if markets do not work perfectly they will not produce a socially efficient
economy. The questions are then how imperfect markets are and whether or not there are alternatives,
such as government provision, that are better.
1.4.2 Equity
Equity is an important criterion for allocation of resources, and it is particularly important in health care
because it is observable that people attach more importance to equity in health and health care than to
many other goods and services. Almost every health care system in the world has equity as an important
policy objective. However, economic analysis of equity is less clear than that of efficiency, except in the
ways in which equity is measured, and there is lower consensus amongst economists about it.
It is important to distinguish equity from equality. Equity is a synonym for fairness and in the context of
health care this means fairness in the distribution of health and health care between people and in the
burden of financing health care. Equality means an equal distribution and the difference between the equity
and equality is that it may not always be fair to be equal. For example, it might be thought to be unfair if
both healthy and sick people are given the same amount of health care. However, equity is often defined
with respect to equality and inequality. For example, it may be considered to be equitable that people who
have an equal need for health care should have equal access to it. This is a very common definition of
equity. However, there could be others, for example:

equal use of health services for equal needs for health care

equal use of health services for equal willingness to pay for that use

equal health outcomes for equal merit

equal health care payments by people for equal ability to pay for that health care

equal expenditure on people for equal health deficit

There are some equity principles that do not take this form. For example, the utilitarian principle is that the
most desirable states of the world are those that maximise societys welfare, even if that involves
inequalities. The maximin principle is if there are inequalities in the distribution of resources, these must
benefit the least well off. The free market principle is that any distribution of resources, even if it produces
very large inequalities, is fair as long as it results from fair trading with a fair starting point for trade.
We might notice that it is likely that all of these equity principles will conflict with each other. But economics
does not really have anything to say about which of these, or others, is the fairest. That is a normative
question, based on individual or collective value judgements and may be best analysed using philosophical
and political analysis. Economics may be able to describe inequalities, but normative analyses is needed to
make judgements of these are inequitable; for example, whether or not inequalities in health care use
across income groups are inequitable.
Economics is useful in considering equity in a systematic way and in measuring inequality. A useful
distinction, which also has roots in philosophy, is between horizontal and vertical equity. Horizontal equity
means the equal treatment of equals for example, do those who are have equal levels of health need
have equal access to health care. Vertical equity means the unequal treatment of unequals for example,
do those who have worse levels of health have greater access to health care.

It is necessary to consider what it is that we wish to be equitable about. Three areas in which equity may be
considered are the finance of health care, the distribution of health care and the distribution of health.
Analysis of equity in the finance of health care mainly concentrates on vertical equity. A particular emphasis
is whether or not health care is financed according to peoples ability to pay, in other words whether or not
people who have different incomes make appropriately different payments. This is encapsulated in the
progressivity of the health care financing system. It is to be expected that rich people will pay more for
health care than poor people; in itself this does not mean that the finance system has any bias towards rich
or poor. However, in a progressive financing system, the proportion of a persons income that is used to
pay for health care rises as income rises. Regressive systems can and do exist, where even though rich
people spend more money on health care than poor people, the proportion of their income that the rich
spend is lower.
Horizontal equity in financing considers whether or not people who have the same income, and therefore
the same ability to pay for health care, make the same payments. Inequities could arise because of the
financing system itself, for example if health care financed by local taxation varies across regions or if
payments are for use of services and the incidence of ill health varies across people who have the same
income.
Horizontal equity in the distribution of health care mainly examines whether or not people with the same
need for health care make the same use of health care services. It is difficult to assess in practice what
equal need means and how it might be measured. For example, if we look at ethnicity or socioeconomic
status, we might agree that these should not in themselves affect the use of health services and are nonneed factors. Of course, different socioeconomic and ethnic groups might have different use of health
services because they have different levels of ill-health, for example, which should affect such use and are
need factors. But if we control for need factors and find that the use of health care services is affected
by non-need factors, there is evidence of horizontal inequity, because people with the same need consume
different amounts of care. Vertical equity in the distribution of health care is usually interpreted to mean
whether individuals with different levels of ill-health have different levels of use that are appropriate to that
difference.
Finally, there is the issue of equity in the distribution of health, which is almost always expressed in terms of
inequalities in health. Health inequalities, particularly those that demonstrate that health levels vary
systematically and inversely with socioeconomic status, are always of some importance in health policy
debates and a major concern of some governments, depending on their political preferences. It may be
argued that this is in fact the only real equity concern, since a concern for equity in health care derives
solely from a concern about the distribution of health.
Although inequalities in health are important to health economists, and derive to some extent from
economic factors, the specifically economic contribution to the analysis of health inequalities is relatively
small compared with that from many other disciplines (McIntyre and Mooney, 2007). The main contribution
of economics is to analyse inequalities in health with respect to individual people rather than social
groupings of various kinds (O'Donnell et al, 2007)

5)Write short notes on

Breakeven volume:
Havinglooked at the above we see that there are fixed costs and variable costs,Break even volume
is that level of quatiyty at which profits are equal to zero.Beyond break even,every additional sale
will yield profit.
Profits=Expenses-Revenue

Thus at break even,profits=0

Then

Total sales=total costs= fixed costs+variable costs

Let us denote the units as X ,variable costs per unit as v.Fixed costs as F and selling price per unit as S
Then for break even

SX=F+VX

X=F/(S-V)

(s-v) is known as the contribution per unit,let us call it C.Contribution is what starts recovering fixed costs and
beyond break even,contribution is what excess you make over variable costs.
So break even quantity

x=F/contribution=F/
C

Some of the assumptions ,which can be held valid for decision making ,are important to consider in this
analysis,First ,we assume cost can be segregated,second,we assume that the sales price is constant,third ,we
assume thath sales mix is constant,fourth,we assume that sales and production /output is synchronized
.Inspite of these assumptions this is a very good analytical tool for planning and budget
Let us see this graphically

Sale
s&
cost

Total
costFixed+vari
able

Break

Fixed
costs

Volume

Let us a take an example

A particular doctor has a clinic ,where his fixed costs are
Rent=Rs 10,000/- per month ,secretary /helper salaries =rs.5,000/- per month ,Telephone,electricity charges
=Rs.3,000/- per month
Billing per patient Rs 200/- and for every patient he spends Rs.100/-in giving medicines ,bandages,etc.How
many patients must the doctor see for break even.
Here F=Rs.18,000/- X=Rs.100, S=Rs.200/- so C=Rs.100/Break even volume =f/c=Rs.18,000/ Rs.100=180 patients
To continue further ,how many patients must he see to have a profit Rs.5000/Rs.5000/-=Rs.200*Rs.18,000/--Rs.100*=Rs.100*Rs.18,000/Rs 23,000=Rs.100*Thus *= 230 patients
Quite often we do not know the volume/quantity,so we have to find the break-even revenue.This as follows
Break even revenue=Fixed costs/(1(v/s))
so take ca doctor who have panned that his total costs will be Rs.4,00,000 /- out of which his fixed costs are
Rs.1,00,000/-.At these costs he expects revenue of Rs.5,00,000/-

b.Depreciation
Depreciation is a systematic and rational process of distributing the cost of tangible assets over the life of
assets.
Depreciation is a process of allocation.
Cost to be allocated = acquisition cot - salvage value
Allocated over the estimated useful life of assets.
Allocation method should be systematic and rational.
Depreciation methods based on time
Straight line method
Declining balance method
Sum-of-the-years'-digits method
Depreciation based on use (activity)
straight Line Depreciation Method

Depreciation = (Cost - Residual value) / Useful life

[Example, Straight line depreciation]

On April 1, 2011, Company A purchased an equipment at the cost of $140,000. This equipment is estimated to have 5 ye
useful life. At the end of the 5th year, the salvage value (residual value) will be $20,000. Company A recognizes depreciation
the nearest whole month. Calculate the depreciation expenses for 2011, 2012 and 2013 using straight line depreciation met
Depreciation for 2011
= ($140,000 - $20,000) x 1/5 x 9/12 = $18,000

Depreciation for 2012

= ($140,000 - $20,000) x 1/5 x 12/12 = $24,000
Depreciation for 2013
= ($140,000 - $20,000) x 1/5 x 12/12 = $24,000

Declining Balance Depreciation Method

Depreciation = Book value x Depreciation rate

Book value = Cost - Accumulated depreciation
Depreciation rate for double declining balance method
= Straight line depreciation rate x 200%
Depreciation rate for 150% declining balance method
= Straight line depreciation rate x 150%
[Example, Double declining balance depreciation]
On April 1, 2011, Company A purchased an equipment at the cost of $140,000.
This equipment is estimated to have 5 year useful life. At the end of the 5th year, the salvage value
(residual value) will be $20,000. Company A recognizes depreciation to the nearest whole month.
Calculate the depreciation expenses for 2011, 2012 and 2013 using double declining balance depreciation method.
Useful life = 5 years --> Straight line depreciation rate = 1/5 = 20% per year
Depreciation rate for double declining balance method
= 20% x 200% = 20% x 2 = 40% per year
Depreciation for 2011
= $140,000 x 40% x 9/12 = $42,000
Depreciation for 2012
= ($140,000 - $42,000) x 40% x 12/12 = $39,200
Depreciation for 2013
= ($140,000 - $42,000 - $39,200) x 40% x 12/12 = $23,520
Double Declining Balance Depreciation Method

Year
2011
2012
2013
2014
2015

Book Value
at the beginning
$140,000
$98,000
$58,800
$35,280
$21,168

Depreciation Rate

Depreciation Expense

40%
40%
40%
40%
40%

$42,000 (*1)
$39,200 (*2)
$23,520 (*3)
$14,112 (*4)
$1,168 (*5)

Book Value at the yearend

$98,000
$58,800
$35,280
$21,168
$20,000

(*1)
(*2)
(*3)
(*4)
(*5)

$140,000 x 40% x 9/12

$98,000 x 40% x 12/12
$58,800 x 40% x 12/12
$35,280 x 40% x 12/12
$21,168 x 40% x 12/12

=
=
=
=
=

$42,000
$39,200
$23,520
$14,112
$8,467

--> Depreciation for 2015 is $1,168 to keep book value same as salvage value.
--> $21,168 - $20,000 = $1,168 (At this point, depreciation stops.)

[Example, 150% declining balance depreciation]

On April 1, 2011, Company A purchased an equipment at the cost of $140,000. This equipment is estimated to
have 5 year useful life. At the end of the 5th year, the salvage value (residual value) will be $20,000.
Company A recognizes depreciation to the nearest whole month. Calculate the depreciation expenses for
2011,2012 and 2013 using double declining balance depreciation method.
Useful life = 5 years --> Straight line depreciation rate = 1/5 = 20% per year
Depreciation rate for double declining balance method
= 20% x 150% = 20% x 1.5 = 30% per year
Depreciation for 2011
= $140,000 x 30% x 9/12 = $31,500
Depreciation for 2012
= ($140,000 - $31,500) x 30% x 12/12 = $32,550
Depreciation for 2013
= ($140,000 - $31,500 - $32,550) x 30% x 12/12 = $22,785
150% Declining Balance Depreciation Method

Year
2011
2012
2013
2014
2015
2016
(*1)
(*2)
(*3)
(*4)
(*5)
(*6)

Book Value
at the beginning
$140,000
$108,500
$75.950
$53,165
$37,216
$26,051

Depreciation
Rate
30%
30%
30%
30%
30%
30%

Depreciation Expense
$31,500 (*1)
$32,550 (*2)
$22,785 (*3)
$15,950 (*4)
$11,165 (*5)
$6,051 (*6)

Book Value at the yearend

$108,500
$75,950
$53,165
$37,216
$26,051
$20,000

$140,000 x 30% x 9/12 = $31,500

$108,500 x 30% x 12/12 = $32,550
$75,950 x 30% x 12/12 = $22,785
$53,165 x 30% x 12/12 = $15,950
$37,216 x 30% x 12/12 = $11,165
$26,051 x 30% x 12/12 = $7,815
--> Depreciation for 2016 is $6,051 to keep book value same as salvage value.
--> $26,051 - $20,000 = $6,051 (At this point, depreciation stops.)