National Institute of Business Management

Chennai - 020
FIRST SEMESTER EMBA/ MBA
Subject: Financial Management
Enrollment No - MBA1/OCT15N/93171446117645F
Attend any 4 questions. Each question carries 25
marks
(Each answer should be of minimum 2 pages / of 300
words)
1. What

are

the

significant

factors

of

Financial

Statements? Discuss the various tools of financial

Analysis.
A financial statement is a formal record of the financial activities of a
business, person, or other entity. For a business enterprise, all the
relevant financial information, presented in a structured manner and in
a form easy to understand, are called the financial statements.
Following are the basic financial statements, accompanied by a
management discussion and analysis:
i) Statement of Financial Position: It is also referred to as a
balance sheet, reports on a company's assets, liabilities, and
ownership equity at a given point in time. An interpretation of the
balance sheet is that on one side are the assets that have been

purchased to be used to increase the profit of the firm. The other side
indicates how these assets were acquired, either by borrowing or by
investing the owners money.
ii) Statement of Comprehensive Income: It is also referred to as
Profit and Loss statement reports on a company's income, expenses,
and profits over a period of time. A Profit & Loss statement provides
information on the operation of the enterprise. These include sale and
the various expenses incurred during the processing state.
iii) Statement of Changes in Equity: It explains the changes of the
company's equity throughout the reporting period.
iv) Statement of cash flows: It is statement of cash flows provides a
summary of the firms operating, investment, and financing cash flows
and reconciles them with changes in its cash and marketable securities
during the period.
v) Notes & disclosures:

It includes a summary of significant

accounting policies and other explanatory notes. The notes typically

describe each item on the balance sheet, income statement and cash
flow statement in further detail. Notes to financial statements are
considered an integral part of the financial statements.
The purpose of Financial Statements
The financial statements are a structured representation of financial
position and financial performance of the entity. The objective of
financial statements information is to provide information about the
financial position, financial performance and cash flows of the entity;
that is useful to a wide variety of users to take their economic

decisions. The financial statements will help users predict future cash
flows, and in particular, their timing and certainty.
Limitations of financial statements
The following are the main limitations of the financial statements:
1) Interim and not final reports: Financial statements do not depict
the exact position and are essentially interim reports.
2) Lack of precision and definiteness: Financial statements may
not be realistic because these are prepared by following certain basic
concepts and conventions.
3) Lack of objective judgment: Financial statements are influenced
by the personal judgment of the accountant.
4) Record only monetary facts: Financial statements disclose only
monetary facts, i.e., those transactions recorded in the books of
accounts which can be measured in monetary terms.
5) Historical in nature: These statements are drawn after the actual
happening of the events.
6) Artificial view: These statements do not give a real and correct
report about the worth of the assets and their loss of value as these
are shown on historical cost basis.
7) Scope of manipulations: These statements are sometimes
prepared according to the needs of the situation or the whims of the
management.
8) Inadequate information: There are many parties who are
interested in the information given in the financial statements but their
objectives and requirements differ.

What is Financial Statement Analysis?

Financial statement analysis is the process of identifying of financial
strengths and weaknesses of the firm by properly establishing
relationship between the items of the balance sheet and the profit &
loss account.
Analysis of financial statements is a process of evaluating relationship
between component parts of financial statements to obtain better
understanding of firms financial position and performance. There are
various methods or techniques that are used in analyzing financial
statements, such as comparative statements, schedule of changes in
working capital, common size percentages, funds analysis, trend
analysis, and ratios analysis.
Objectives of Financial Statement Analysis:
The main objectives of analysis of financial statements are to assess:
1) Present and future earning capacity and profitability of the concern
2) The operational efficiency of the concern as a whole and of its
various parts or departments 3) The short-term and long-term solvency
of the concern for the benefit of the debenture holders and trade
creditors 4) The comparative study in regard to one firm with another
firm or one department with another department 5) The possibility of
developments in the future by making forecasts and preparing budgets
6) The financial stability of a business concern 7) The real meaning and
significance of financial data, and 8) The long-term liquidity of its
funds.

Techniques or Tools of Financial Statements Analysis:

i)

Comparative

financial

statement

analysis:

Comparative

Financial Statement Analysis is a form of horizontal analysis where

Financial Statements of two or more years or of two or more different
companies or of a company and its industry are compared, analyzed
and interpreted. Advantages of this analysis are that changes in
components of Assets and Liabilities can easily be known at a glance
through Comparative Balance Sheet. Comparative Income statements
identify trend of changes in sales, gross profit, operating profit, net
profit, etc. It helps to determine long-term and short-term solvency
position of the firm. Disadvantage of Comparative Analysis is that it
might express misleading disclosure if certain external factors like
market conditions, business risk, etc. are not taken into consideration.
ii) Common size analysis: Common size analysis allows us to
compare one companys Financial Statements to another companys or
to the industry average. It exhibits the absolute figures of the items
appearing in Financial Statements of two or more years or two or more
firms. It also exhibits the percentage figure of every item in Financial
Statements as a percentage of the pre-selected base item. In commonsize income statement, all items are converted in percentage terms of
sales. Such conversion helps the firm to ascertain how much portion of
its sales is used up in cost of sales, operating expenses, interest, tax,
etc. It helps to know short-term and long-term financial position of an
enterprise. Disadvantages of this analysis are that no comparative

study is done between the years and it does not consider the time
value of money.
iii) Trend analysis: Trend analysis is a form of Horizontal Analysis of
Financial Statements between two or more years. It indicates the trend
of individual item of FSs over a period of time. It helps to analyze the
trend of each such item and, thus, helps the management in the
process of present and future policy-making. It is a useful tool for interfirm comparison. It helps in analyzing growth in financial activities of
the firm at a glance. One of the disadvantages of trend analysis is that
changes in market conditions are not considered in trend analysis.
Trend ratios become incomparable if the same accounting practices are
not followed.

It does not take into consideration the price level

changes.
iv) Funds Flow Statement / Analysis): This statement is prepared
in order to reveal clearly the various sources where from the funds are
procured to finance the activities of a business concern during the
accounting period and also brings to highlight the uses to which these
funds are put during the said period.
v) Cash Flow Statements Analysis): This statement is prepared to
know clearly the various items of inflow and outflow of cash. It is an
essential tool for short-term financial analysis and is very helpful in the
evaluation of current liquidity of a business concern. It helps the
business in the efficient cash management and internal financial
management.
vi) Statement of changes in working capital: This statement is
prepared to know the net change in working capital of the business

between two specified dates. It is prepared from current assets and

current liabilities of the said dates to show the net increase or decrease
in working capital.
vii) Ratio Analysis: It is done to develop meaningful relationship
between individual items or group of items usually shown in the
periodical

financial

statements

published

by

the

concern.

An

accounting ratio shows the relationship between the two inter-related

accounting figures as gross profit to sales, current assets to current
liabilities, loaned capital to owned capital etc.
Trend percentage Analysis:
Trend analysis calculates the percentage change for one account over
a period of time of several years. Trend percentage states several
years' financial data in terms of a base year. The base year equals
100%, with all other years stated in some percentage of this base.
Steps in computing Trend Percentages:
i)

A year is chosen as the base year and the figures as appearing in

Financial Statements of that year are assigned as 100.

ii)

Necessary adjustments for price level should be made in the

figures of other years compared to the base year.

iii)

Now, trend percentages are to be computed in the following

manner: Trend Percentage = (Current years figure/Base years
figure)100

iv)

Conclusion is then to be drawn studying the trend patterns of

various items and also taking into account absolute values of the
concerned items.

Limitations of trend ratios:

1) Trend ratios become incomparable if the same accounting practices
are not followed. 2) Trend ratios do not take into consideration the
price level changes.
3) Trend ratios must always be read with absolute data on which they
are based; otherwise the conclusion may be misleading.
4) Trend ratio have to be interpretated in the light of certain nonfinancial

factors

like

economic

conditions,

government

policies,

changes in income and its distribution etc.

____________________________________________________________________

2. What is a Fund Flow Statement? Discuss the uses

and preparation of Fund Flow Statements.
A statement prepared of the sources and applications of funds from
where working capital comes and it is utilized. This is called Fund Flow
statement.
Funds Flow Statement is a statement prepared to analyze the reasons
for changes in the financial Position of a company between two
Balance Sheets. It shows the inflow and outflow of funds i.e. Sources
and Applications of funds for a particular period. In other words, a
Funds Flow Statement is prepared to explain the changes in the

Working Capital Position of a Company. There are 2 types of Inflows of

Funds:1. Long Term Funds raised by Issue of Shares, Debentures or Sale of
Fixed Assets
2. Funds generated from Operations
Fund flow statement is complimentary to both balance sheet and profit
and loss account; it brings a clear idea about the movement of funds in
and out of the firm, during a particular period of time.
Thus fund flow statement enumerates various sources from which
funds come in organization and various applications which lead to
usage of funds. It is an important tool to check the efficiency of
management in the firm. It can make future projections about working
capital requirements and thus firm can arrange for those requirements
and can allocate funds in a more efficient manner.
Objectives of Fund Flow Statement
The main purposes of Fund Flow Statement are:
1. To help to understand the changes in assets and asset sources which
are not readily evident in the income statement or financial statement.
2. To inform as to how the cans to the business have been used.
3. To point out the financial strengths and weaknesses of the business
Benefits of Funds Flow Statement
Funds Flow Statement is useful for Long Term Analysis. It is a very
useful tool in the hands of the management for judging the financial

and operating performance of the Company. The Balance Sheet and

the Profit and Loss A/c (Income Statement) fail to provide the
information which is provided by the Funds Flow Statement i.e.
Changes in Financial Position of an enterprise. Such an analysis is of
great help to the management, shareholders, creditors etc
1. The Funds Flow Statement helps in answering the following
questions:

Where have the profits gone?

Why is there an imbalance existing between liquidity position and

profitability position of an enterprise?

Why is the concern financially solid in spite of losses?

2. The Funds Flow Statement analysis helps the management to test

whether the working capital has been effectively used or not and the
working capital level is adequate or inadequate for the requirements of
the business. The Working Capital Position helps the management in
taking policy decisions regarding payment of dividend etc.
3. The Funds Flow Statement Analysis helps the investors to decide
whether the company has managed the funds properly. It also
indicates the Credit Worthiness of a company which helps the lenders
to decide whether to lend money to the company or not. It helps the
management to take policy decisions and to decide about the financing
policies and Capital Expenditure for the future.
Importance of funds flow statement:
Funds flow statement is an important analytical tool for external as well
as internal uses of financial statements. The users of funds flow

statement

can

be

listed

as

under:

1. Managements of various companies are able to review cash budgets

with the aid of funds flow statements. They are extensively used by the
management in the evaluation of alternative finance & investments. In
the evaluation of alternative finance & investment plans, funds flow
statement helps the management in the assessment of long-range
forecasts of cash requirements & availability of liquid resources. The
management can judge the quality of management decisions.
2. Investors are able to measure as how the company has utilized the
funds supplied by them & its financial strength with the aid of funds
statements. They gauge can the company capacity to generate funds
from operations. On the basis of comparative study of the past with the
present, investors can locate & identify possible drains on funds in the
near future.
3. Funds statement serve as effective tools to the management for
economic analysis as it supplies additional information, which cannot
be provided by financial statements, based on historical data.
4. Fund statement explains the relationship between changes in
working capital & net profits. Funds statement clearly shows the
quantum of funds generated from operations.
5. Funds statement helps in the planning process of a company. They
are useful in assessing the resources available and the manner of
utilization

of

resources.

6. Funds statement explains the financial consequences of business

activities. They provide explicit & clear awareness to questions
regarding liquid & solvency positions of the company, distribution of

dividend & whether the working capital has been effective or

otherwise.
7.

Management

of

companies

can

forecast

in

advance

the

requirements of additional capital & can plan its capital issue

accordingly.
8. Fund statement provides clues to the creditors & financial
institutions as to the ability of a company to use funds effectively in
the best interest of the investors, creditors & the owners of the
company.
9. Funds statement indicates the adequacy or inadequacy of working
capital.
10. The information contained in fund flow statement is more reliable,
dependable & consistent as it is prepared to include funds generated
from operations & not net profit after depreciation.
11. Funds flow statement clearly indicate how profits have been
invested, whether investments in fixed assets or inventories or
ploughed back.
How to Prepare a Fund Flow Statement
Preparation of fund flow statement involves preparation of adjusted
profit and loss account which is prepared by excluding the non fund
and non operating items from the initial figure of net profit. Fund flow
statements are prepared by taking the balance sheets for two dates
representing the coverage period. The increases and decreases must
then be calculated for each item.

Finally, the changes are classified under four categories: (1) Long-term
sources, (2) long-term uses, (3) short-term sources, (4) short-term
uses.
Fund flow statements can be used to identify a variety of problems in
the way a company operates. For example, companies that are using
short-term money to finance long-term investments may run into
liquidity problems in the future. Meanwhile, a company that is using
long-term money to finance short-term investments may not be
efficiently utilizing its capital.
Preparation of Fund Flow Statement:
Step I: Prepare Statement of Changes in Working Capital
For preparing the Funds Flow Statement, the first step is to prepare the
Statement of Changes in Working Capital. There may be several
reasons for changes in the Working Capital Position of a Company,
some of which have been discussed below:1. Purchase of Fixed Assets or Long Term Investments without raising
Long Term Funds
2. Payments of Dividends in excess of the Profits earned
3. Extension of Credit to the Customers
4. Repayment of a Long Term Liability or Redemption of Preference
Shares without raising Long Term Resources
Step II: Prepare Funds from Operations
The next Step is to prepare the Funds generated only from the
Operating

Activities

of

the

Business

and

not

from

the

Investing/Financing Activities of the business. Preparation of adjusted

profit and loss account to know fund lost in operations and Preparation
of accounts for non-current items to ascertain the hidden information.
Step III: Preparation of Funds Flow Statement
While preparing the Funds Flow Statement, the Sources and Uses of
Funds are to be disclosed clearly so as to highlight the Sources from
where the Funds have been generated the Uses to which these Funds
have been applied. This Statement is also sometimes referred to as the
Sources and Applications of Funds Statement or Statement of Changes
in Financial Position.
As explained above, the Funds Flow Statement summarizes for a
particular period the resources made available to finance the activities
of an enterprise and the uses to which such resources have been put.
____________________________________________________________________

3. Examine the various tools of Financial Analysis.

Analysis of financial statements is a process of evaluating relationship
between component parts of financial statements to obtain better
understanding of firms financial position and performance. There are
various methods or techniques that are used in analyzing financial

statements, such as comparative statements, schedule of changes in

working capital, common size percentages, funds analysis, trend
analysis, and ratios analysis. It is the process of identifying of financial
strengths and weaknesses of the firm by properly establishing
relationship between the items of the balance sheet and the profit
&loss account.
Techniques or Tools of Financial Statements Analysis:
Ratio Analysis
Ratios are an analyst's microscope; they allow us get a better view of
the firm's financial health than just looking at the raw financial
statements. Ratios are useful both to internal and external analysts of
the firm. It has followings:
Liquidity Ratios
Leverage Ratios
Profitability Ratios
i)

Comparative

financial

statement

analysis:

Comparative

Financial Statement Analysis is a form of horizontal analysis where

Financial Statements of two or more years or of two or more different
companies or of a company and its industry are compared, analyzed
and interpreted. Advantages of this analysis are that changes in
components of Assets and Liabilities can easily be known at a glance
through Comparative Balance Sheet. Comparative Income statements
identify trend of changes in sales, gross profit, operating profit, net
profit, etc. It helps to determine long-term and short-term solvency

position of the firm. Disadvantage of Comparative Analysis is that it

might express misleading disclosure if certain external factors like
market conditions, business risk, etc. are not taken into consideration.
ii) Common size analysis: Common size analysis allows us to
compare one companys Financial Statements to another companys or
to the industry average. It exhibits the absolute figures of the items
appearing in Financial Statements of two or more years or two or more
firms. It also exhibits the percentage figure of every item in Financial
Statements as a percentage of the pre-selected base item. In commonsize income statement, all items are converted in percentage terms of
sales. Such conversion helps the firm to ascertain how much portion of
its sales is used up in cost of sales, operating expenses, interest, tax,
etc. It helps to know short-term and long-term financial position of an
enterprise. Disadvantages of this analysis are that no comparative
study is done between the years and it does not consider the time
value of money.
Difference between Comparative and Common-size analysis:
1) Comparative analysis is statement which compares financial data
from different periods of time. On the other hand, common size ratios
are used to compare financial statements of different-size companies
or of the same company over different periods.
2) It is a form of horizontal analysis/ It is a form of vertical analysis.
3) It is a comparison of different elements of Financial Statements
between two or more years/ It is a comparison of different of elements
of Financial Statements with one chosen base item in the same year.

4) Changes in values of different items in two different years are shown

both in absolute as well as percentage terms/ Changes in values of
different items are shown as percentage of a base item.
5) It fails to exhibit relative importance of individual component in
total/ It shows relative importance of each item of such statement in
whole.
6) It facilitates both intra- and inter-firm comparison/ It mainly
facilitates inter-firm comparison.
7) It is very popular technique of Financial Statement Analysis/ It is not
so popular as compared to Comparative Statement.
Efficiency Ratios
Trend analysis: Trend analysis involves the examination of ratios over
time. Trends, or lack of trends, can help managers gauge their progress
towards a goal. Furthermore, trends can highlight areas in need of
attention. Trend analysis is a form of Horizontal Analysis of Financial
Statements between two or more years. It helps to analyze the trend of
each such item and, thus, helps the management in the process of
present and future policy-making. It is a useful tool for inter-firm
comparison. It helps in analyzing growth in financial activities of the
firm at a glance. One of the disadvantages of trend analysis is that
changes in market conditions are not considered in trend analysis.
Trend percentage Analysis:
Trend analysis calculates the percentage change for one account over
a period of time of several years. Trend percentage states several

years' financial data in terms of a base year. The base year equals
100%, with all other years stated in some percentage of this base.
Steps in computing Trend Percentages:
i)

A year is chosen as the base year and the figures as appearing

in Financial Statements of that year are assigned as 100.

ii)

Necessary adjustments for price level should be made in the

figures of other years compared to the base year.

iii) Now, trend percentages are to be computed in the following

manner: Trend Percentage = (Current years figure/Base years
figure)100 iv) Conclusion is then to be drawn studying the trend
patterns of various items and also taking into account absolute
values of the concerned items.
Limitations of trend ratios:
1) Trend ratios become incomparable if the same accounting practices
are not followed. 2) Trend ratios do not take into consideration the
price level changes.
3) Trend ratios must always be read with absolute data on which they
are based; otherwise the conclusion may be misleading.
4) Trend ratio have to be interpretated in the light of certain nonfinancial

factors

like

economic

conditions,

government

policies,

changes in income and its distribution etc.

Difference between Horizontal and Vertical analysis:
1) When an analyst compares financial information for two or more
years for a single company, the process is referred to as horizontal

analysis/ Vertical analysis reports each amount on a financial

statement as a percentage of another item.2) In addition to comparing
dollar amounts, the analyst computes percentage changes from year
to year for all financial statement balances/ When using vertical
analysis, the analyst calculates each item on a single financial
statement as a percentage of a total. 3) Horizontal analysis can help a
financial statement user to see relative changes over time and identify
positive or perhaps troubling trends/ Vertical analysis allows one to see
the composition of each of the financial statements and determine if
significant changes have occurred.4) It shows comparison of financial
data for several years against a chosen base year/ Under this method
each entry is represented as a percentage of the total account.5) It is
called dynamic analysis of the financial statements/ Vertical analysis is
done to review and analysis the financial statements for a year only
and therefore it is also called static analysis.
Other tools

of financial analysis are

i) Funds Flow Statement (or analysis): This statement is prepared

in order to reveal clearly the various sources where from the funds are
procured to finance the activities of a business concern during the
accounting period and also brings to highlight the uses to which these
funds are put during the said period.
ii) Cash Flow Statements (or analysis): This statement is prepared
to know clearly the various items of inflow and outflow of cash. It is an
essential tool for short-term financial analysis and is very helpful in the
evaluation of current liquidity of a business concern. It helps the

business in the efficient cash management and internal financial

management.
iii) Statement of changes in working capital: This statement is
prepared to know the net change in working capital of the business
between two specified dates. It is prepared from current assets and
current liabilities of the said dates to show the net increase or decrease
in working capital.
iv) Ratio Analysis: It is done to develop meaningful relationship
between individual items or group of items usually shown in the
periodical

financial

statements

published

by

the

concern.

An

accounting ratio shows the relationship between the two inter-related

accounting figures as gross profit to sales, current assets to current
liabilities, loaned capital to owned capital etc.
Limitations of Financial Statement Analysis:
Analysis of Financial Statements is a very important device but the
person using this device must keep in mind its limitations. The
following are the main limitations of the analysis:
i.

Historical nature of financial statements: The basic nature

of these statements is historical, i.e., relating to the past
period. Past can never be a precise and infallible index of the
future and can never be hundred percent helpful for the future
forecast and planning.

ii.

No substitute for judgment: Analysis of financial Statements

is a tool which can be used profitably by an expert analyst but
may lead to faulty conclusions if used by unskilled analyst. The

result of analysis, thus, should not be taken as judgments or

conclusions.
iii.

Reliability of figures: The reliability of analysis depends on

reliability of the figures of the FSs under scrutiny. The entire
working of analysis will be vitiated by manipulations in the
income statement, window dressing in the balance sheet,
questionable procedures adopted by the accountant for the
valuation of fixed assets and such other factors.

iv) Single year analysis is not much valuable and useful: The
analysis of these statements relating to single year only will have
limited use and value.
iv.

Results may have different interpretation: The results or

indications derived from the analysis of these statements may
be differently interpreted by different users.

v.

Change in accounting methods: Analysis will be effective if

the figure derived from the FSs are comparable. Due to change
in accounting methods the figures of the current period may
have no comparable base, and then the whole exercise of
analysis will become futile and will be of little value.

vi.

Pitfalls in inter-firm comparison: When different firms are

adopting different procedures, records, objectives, policies and
different items under similar headings, comparison will become
more difficult.

vii. Price level changes reduce the validity of the analysis:

The continuous and rapid changes in the value of money, in the
present day economy, also reduce the validity of the analysis.

ix) Shortcoming of the tool of analysis: There are different tools

of analysis available to the analyst. If a wrong tool is used, it may
give misleading results and may lead to wrong conclusions which
may be harmful to the interest of business.
_________________________________________________________________
6. Describe the various aspects of Zero Based budgeting with
its merits and demerits.
Zero Base Budgeting is method of budgeting whereby all activities are
revaluated each time budget is formulated and every item of
expenditure in the budget is fully justified. Thus the Zero Base
Budgeting involves from scratch or zero.
The term zero based budgeting is sometimes used in the personal
finance to describe the practice of budgeting every dollar of income
received, and then adjusting some part of the budget downward for
every other part that needs to be adjusted upward
Zero Based Budgeting is a technique that sets all budgets to nil at
the beginning of the year or period and requires from the
departments that they justify all of their expenditures, not just
those

exceeding

the

budget.

Money

is

allocated

to

the

departments based on merit and not based on the previous year

budget plus or minus some percentage such as in many
traditional budgeting systems.
Zero-based budgeting is a technique of planning and decisionmaking

which reverses the working process of traditional

budgeting. In traditional incremental budgeting, departmental

managers justify only increases over the previous year budget
and what has been already spent is automatically sanctioned. No
reference is made to the previous level of expenditure. By
contrast, in zero-based budgeting, every department function is
reviewed

comprehensively

and

all

expenditures

must

be

approved, rather than only increases. Zero-based budgeting

requires the budget request be justified in complete detail by
each division manager starting from the zero-base. The zero-base
is indifferent to whether the total budget is increasing or
decreasing.
Zero based budgeting also refers to the identification of a task or
tasks

and

then

funding

resources

to

complete

the

task

independent of current resourcing.

Applications of Zero Based Budgeting:
There are two steps to the process of zero based budgeting.
The first step is to develop what is called as decision packages. Each
separate activity of the organization is identified and is called as a
decision package. Decision package is actually nothing but a document
that identifies and describes an activity in such a manner that it can be
evaluated by the management and rank against other activities
competing for limited resources and decide whether to sanction the
same or not. It should be ensured that each decision package is
justified in the sense it should be ascertained whether the package is
consistent with the goal of the organization or not.

If the package is consistent with the overall objectives of the

organization, the cost of minimum efforts required to sustain the
decision should be determined.
Alternatives for each decision package are considered in order to
select better and cheaper options. Based on the cost and benefit
analysis a particular decision package/s should be selected and
resources are allocated to the selected package.
The second is to rank the decision packages. The decision package is a
document that identifies and explains the specific and goals and
objectives,

measurement

of

performance,

costs,

benefits

and

alternative courses of action. Ranking of decision packages is then

accomplished at each management level until a comprehensive
agency wide ranking is obtained. Conceptually, zero-base budgeting is
a systemic logical approach to allocating resources where they will do
the most good.
Benefits from Zero Based Budgeting:
The budget process focuses on a comprehensive analysis of
objectives and needs.
Planning and budgeting are combined into a single process.
Managers must evaluate the cost effectiveness of their operations
in detail.
Cost awareness and management participation in planning and
budgeting is expanded at all levels of the organization. Drives
Managers to find cost effective ways to improve operations

 Efficient allocation of resources, as it is based on needs and

benefits.
Detects inflated budgets.
Municipal planning departments are exempt from this budgeting
practice.
Useful for service departments where the output is difficult to
identify.
Increases staff motivation by providing greater initiative and
responsibility in decision-making.
Increases

communication

and

coordination

within

the

organization.
Identifies and eliminates wasteful and obsolete operations.
Identifies opportunities for outsourcing.
Forces cost centers to identify their mission and their relationship
to overall goals.
Limitations of Zero Based Budgeting:
i)

It is a very detailed procedure and naturally if time consuming

and lot of paper work is involved in the same.

ii)

Cost involved in preparation and implementation of this system

is very high.

iii)

Morale of staff may be very low as they might feel threatened if

a particular activity is discontinued.

iv)

Ranking

of

activities

subjective at times.

and

decision-making

may

become

v)

It may not advisable to apply this method when there are non
financial

considerations,

such

as

ethical

and

social

responsibility because this will dictate rejecting a budget claim

on low ranking projects.
vi)

The huge amount of work involved.

vii)

May lead to micro management, offering less time and energy

for the things that really matter.

viii) Does it really lead to a material shift in the use of resources?

ix)

Difficult to define decision units and decision packages, as it is

time-consuming and exhaustive.

x)

Forced to justify every detail related to expenditure. The R&D

department is threatened whereas the production department
benefits.

xi)

Necessary to train managers. Zero-based budgeting must be

clearly understood by managers at various levels to be
successfully

implemented.

Difficult

to

administer

and

communicate the budgeting because more managers are

involved in the process.
xii)

In a large organization, the volume of forms may be so large

that no one

person could read it all. Compressing the

information down to a usable size might remove critically

important details.
xiii) Honesty of the managers must be reliable and uniform. Any
manager that exaggerates skews the results.