Accounting and Finance For Managers

Accounting and Finance for Managers
MBA First Year

Paper No. 1.3
School of Distance Education

Bharathiar University, Coimbatore - 641 046
CONTENTS
Page No.
UNIT-I
Lesson 1 Financial Accounting 7
Lesson 2 Trial Balance 33
Lesson 3 Final Accounts 47
Lesson 4 Depreciation Accounting 67
UNIT-II
Lesson 5 Financial Statement Analysis 87
Lesson 6 Ratio Analysis 95
Lesson 7 Funds Flow Statement Analysis 120
Lesson 8 Cash Flow Statement Analysis 136
UNIT-III
Lesson 9 Cost Accounting & Preparation of Cost Statement 149
Lesson 10 Budgetary Control 167
Lesson 11 Marginal Costing 178
UNIT-IV
Lesson 12 Financial Management 207
Lesson 13 Time Value of Money 214
Lesson 14 Sources of Long Term Finance 222
Lesson 15 Capital Market Developments in India 230
Lesson 16 Indian Financial System 235
Lesson 17 SEBI in Capital Market Issues 240
Lesson 18 Capital Budgeting 246
Lesson 19 Risk and Return 269
UNIT-V
Lesson 20 Cost of Capital 281
Lesson 21 Leverage Analysis 291
Lesson 22 Capital Structure Theories 298
Lesson 23 Working Capital Management 304

ACCOUNTING AND FINANCE FOR MANAGERS
Number of Credit Hours: 3
Subject Description: This course presents the principles of accounting, preparation of financial
statements, analysis of financial statements, costing techniques, financial management and its functions.
Goals: To enable the students to learn the basic principles of accounting and preparation and analysis
of financial statements and also the various functions of financial management.
Objectives: On successful completion of the course the students should have:

1. understood the principles and objectives of accounting.
2. learnt the preparation of financial statements and the various techniques of analyzing the financial
statements.
3. learnt the costing methods and its application in decision making.
4. learnt the basic objectives of financial management , functions and its application in financial decision
making .
UNIT I
Financial Accounting - Definition - Accounting Principles - Concepts and conventions - Trial Balance
Final Accounts (Problems) - Depreciation Methods-Straight line method, Written down value
method.
UNIT II
Financial Statement Analysis - Objectives - Techniques of Financial Statement Analysis: Accounting

Ratios: construction of balance sheet using ratios (problems)-Dupont analysis. Fund Flow Statement
- Statement of Changes in Working Capital - Preparation of Fund Flow Statement - Cash Flow
Statement Analysis- Distinction between Fund Flow and Cash Flow Statement. Problems
UNIT III
Cost Accounting - Meaning - Distinction between Financial Accounting and Cost Accounting - Cost
Terminology: Cost, Cost Centre, Cost Unit - Elements of Cost - Cost Sheet - Problems.
Budget, Budgeting, and Budgeting Control - Types of Budgets - Preparation of Flexible and fixed
Budgets, master budget and Cash Budget - Problems -Zero Base Budgeting.
Marginal Costing - Definition - distinction between marginal costing and absorption costing - Break
even point Analysis - Contribution, p/v Ratio, margin of safety - Decision making under marginal
costing system-key factor analysis, make or buy decisions, export decision, sales mix decision-
Problems
UNIT IV
Objectives and functions of Financial Management - Role of Financial Management in the organisation
- Risk-Return relationship- Time value of money concepts - Indian Financial system - Legal, Regulatory
and tax framework. Sources of Long term finance - Features of Capital market development in India
- Role of SEBI in Capital Issues.
Capital Budgeting - methods of appraisal - Conflict in criteria for evaluation - Capital Rationing -
Problems - Risk analysis in Capital Budgeting.
UNIT V
Cost of Capital - Computation for each source of finance and weighted average cost of capital -EBIT
-EPS Analysis - Operating Leverage - Financial Leverage - problems.
Capital Structure Theories - Dividend Policies - Types of Divided Policy.
Working Capital Management - Definition and Objectives - Working Capital Policies - Factors affecting
Working Capital requirements - Forecasting Working Capital requirements (problems) - Cash
Management - Receivables Management and - Inventory Management - Working Capital Financing -
Sources of Working Capital and Implications of various Committee Reports.
UNIT-I
LESSON
1
FINANCIAL ACCOUNTING
CONTENTS
1.0 Aims and Objectives
1.1 Introduction
1.2 Process of Accounting
1.2.1 What is Cash System?
1.2.2 What is Accrual System?
1.2.3 Value at Which it is to be Recorded ?
1.3 Utility of the Financial Statements
1.3.1 To Management
1.3.2 To Shareholders, Security Analysts and Investors
1.3.3 To Lenders
1.3.4 To Suppliers
1.3.5 To Customers
1.3.6 To Govt. and Regulatory Authorities
1.3.7 To Promote Research and Development
1.4 Accounting Principles
1.5 Accounting Concepts
1.5.1 Money Measurement Concept
1.5.2 Business Entity Concept
1.5.3 Going Concern Concept
1.5.4 Matching Concept
1.5.5 Accounting Period Concept
1.5.6 Duality or Double Entry Accounting Concept
1.5.7 Cost Concept
1.6 Accounting Conventions
1.6.1 Convention of Consistency
1.6.2 Convention of Conservatism
1.6.3 Convention of Disclosure
1.6.4 Persons of Nature
1.6.5 Persons of Artificial Relationship
1.6.6 Persons of Representations
1.6.7 Receiver of the Benefits
1.6.8 Giver of the Benefits
1.7 Real Accounts
1.8 Nominal Accounts
1.9 Transactions in between the Real A/c
1.9.1 What is Movement-In?
1.9.2 What is Movement-Out?
1.10 Journal entries in between the accounts of two different categories
1.10.1 What is meant by Ledger?
1.10.2 Ledgering
1.11 Case Let
1.12 Let us Sum up
1.13 Lesson-end Activity
1.14 Keywords
1.15 Questions for Discussion
1.16 Suggested Readings
Accounting and Finance
for Managers 1.0 AIMS AND OBJECTIVES
In this less we shall discuss about financial accounting. After going through this lesson
you will be able to:
(i) analyse process of accounting and accounting concepts.
(ii) discuss accounting conventions.
1.1 INTRODUCTION
Accounting is a business language which elucidates the various kinds of transactions
during the given period of time. Accounting is defined as either recording or recounting
the information of the business enterprise, transpired during the specific period in the
summarized form.
What is meant by accounting?
Accounting is broadly classified into three different functions viz
Recording
Classifying and Transactions of Financial Nature
Summarizing
Is accounting an equivalent function to book keeping ?
No, accounting is broader in scope than the book keeping., the earlier cannot be
equated to the later. Accounting is a combination of various functions viz
Accounting
Recording of Transactions
Classification
Sum m arisation
Interpretation
American Institute of Certified Public Accountants Association defines the term accounting
as follows "Accounting is the process of recording, classifying, summarizing in a
significant manner of transactions which are in financial character and finally results
are interpreted."
Qualities of Accounting:
l In accounting, transactions which are non- financial in character can not be recorded.
l Transactions are recorded either individually or collectively according to their groups.
l Users should be able to make use of information.
8
Financial Accounting
1.2 PROCESS OF ACCOUNTING
Step 1
Identification of Transaction
Recording
Step 2
Preparation of Business Transactions
Step 3
Recording of Transactions in Journal
Grouping
Step 4
Posting In Ledgers
Summarizing
Step 5
Preparation of Unadjusted Trial Balance
Step 6
Pass of Adjustment Entries
Step 7
Preparation
Preparation of Adjusted Trial Balance
Trading and P& L A/c Balance Sheet
Financial Accounting is described as origin for the creation of information and the
continuous utility of information
After the creation of information, the developed information should be appropriately
recorded. Are there any scales/guide available for the recording of information? Yes,
What are they?
They are as follows
l What to record: Financial Transaction is only to be recorded
l When to record: Time relevance of the transaction at the moment of recording
l How to record: Methodology of recording - It contains two different systems of
accounting viz cash system and accrual system
1.2.1 What is cash system?

The revenues are recognized only at the moment of realization but the expenses are
recognized at the moment of payment. For e.g. sale of goods will be considered under 9
Accounting and Finance this method that only at the moment of receipt of cash out of sale of goods. The charges
for Managers
which were paid only will be taken into consideration but the outstanding, not yet paid
will not be considered. For e.g. Rent paid only will be considered but not the outstanding
of rent charges.
1.2.2 What is accrual system?

The revenues are recognized only at the time of occurrence and expenses are recognized
only at the moment of incurring.
Whether the cash is received or not out of the sales, that will be registered/counted as
total value of the sales.
The next most important step is to record the transactions. For recording, the value of
the transaction is inevitable, to record values, the classification of values must be
1.2.3 Value at which it is to be recorded ?

There are four different values in the business practices, among the four, which one
should be followed or recorded in the system of accounting?
Original Value: It is the value of the asset only at the moment of purchase or acquisition
Book Value: It is the value of the asset maintained in the books of the account. The book
value of the asset could be computed as follows
Book Value = Gross(Original) value of the asset - Accumulated depreciation
Realizable Value: Value at which the assets are realized
Present Value: Market value of the asset
Classifying: It is one of the important processes of the accounting in which grouping of
transactions are carried out on the basis of certain segments or divisions. It can be
described as a method of Rational segregation of the transactions. The segregation
generally into two categories viz cash and non-cash transactions.
The preparation of the ledger A/cs and Subsidiary books are prepared on the basis of
rational segregation of accounting transactions. For example the preparation of cash
book is involved in the unification of cash transactions.
Summarizing: The ledger books are appropriately balanced and listed one after another.
The list of the name of the various ledger book A/cs and their accounting balances is
known as Trial Balance. The trial balance is summary of all unadjusted name of the
accounts and their balances.
Preparation: After preparing, the summary of various unadjusted A/cs are required to
adjust to the tune of adjustment entries which were not taken into consideration at the
time of preparing the trial balance. Immediately after the incorporation of adjustments,
the final statement is readily available for interpretations.
Purposes of preparing financial statements:
l Financial accounting provides necessary information for decisions to be taken initially
and it facilitates the enterprise to pave way for the implementation of actions
l It exhibits the financial track path and the position of the organization
l Being business in the dynamic environment, it is required to face the ever changing
environment. In order to meet the needs of the ever changing environment, the
policies are to be formulated for the smooth conduct of the business
l It equips the management to discharge the obligations at every moment
10 l Obligations to customers, investors, employees, to renovate/restructure and so on.
Financial Accounting
1.3 UTILITY OF THE FINANCIAL STATEMENTS
The financial statements are found to be more useful to many people immediately after
presentation only in order to study the financial status of the enterprise in the angle of
their own objectives.
Check Your Progress
1.3.1 To Management
The financial statements are most inevitable for the management to take rational decisions
to maintain the sustainability in the business environment among the other competitors.
1.3.2 To Shareholders, Security Analysts and Investors

The information extracted from the financial statements are processed by the above
mentioned people to identify not only the financial status but also to determine the qualities
of getting appropriate rate of return out of the prospective investment.
1.3.3 To Lenders
The lenders do study about the business enterprise through the available information of
its financial statements normally before lending. The aim of the study is to analyse the
status of the firm for the worthiness of lending with reference to the payment of interest
periodicals and the repayment of the principal.
1.3.4 To Suppliers
The suppliers are in need of information about the business fleeces before sale of goods
on credit. The Suppliers are very cautious in supplying the goods to the business houses
based on the various capacities of themselves. The most important capacity required as
well as expected from the buyer firms is that prompt repayment of dues of the credit
purchase from the suppliers. This quality of prompt payment could be known through
culling out the information from the balance sheet.
It mainly plays pivotal role in answering the status inquiries about the buyer
1.3.5 To Customers
The legal relationship of the transferability of ownership of the products is obviously
understood through financial information available in the statements. The agreement of
warranty and guarantee is tested through the financial status of the enterprise.
1.3.6 To Govt., and Regulatory Authorities

The taxes to be paid to the central and state govts on the revenues only through
presentation of information.
1.3.7 To Promote Research and Development

For research and development, the amount of investment required is voluminous, which
has to be mobilized from either internally or externally to the requirement of the future
prospects of the enterprise.
The following questions should be answered one after the another in meeting raising
needs of the research and development
l How much to be raised?
l When the required amount to be raised?
l How to raise the required resources?
11
Accounting and Finance The above questions could be answered through immense financial planning exercise by
for Managers
way of extracting and utilizing the financial information from the Accounting statements
of the enterprise.
Check Your Progress
(1) Financial Accounting is

(a) Recording
(b) Classifying
(c) Summarising
(d) Recording, Classifying, Summarizing, Interpretation of financial information

(2) Book value of the asset is
(a) Gross value of the asset - Depreciation
(b) Gross value of the asset
(c) Gross value of the asset - Accumulated depreciation
(d) None of the above
1.4 ACCOUNTING PRINCIPLES

The transactions of the business enterprise are recorded in the business language, which
routed through accounting. The entire accounting system is governed by the practice of
accountancy. The accountancy is being practiced through the universal principles which
are wholly led by the concepts and conventions.
The entire principles of accounting are on the constructive accounting concepts and
conventions
Accounting Concepts
Accounting Conventions
Accounting Principles
1.5 ACCOUNTING CONCEPTS

The following are the most important concepts of accounting:
l Money Measurement concept
l Business Entity concept
l Going Concern concept
l Matching concept
l Accounting Period concept
l Duality or Double Entry concept
l Cost concept
12
1.5.1 Money Measurement Concept Financial Accounting
This is the concept tunes the system of accounting as fruitful in recording the transactions
and events of the enterprise only in terms of money. The money is used as well as
expressed as a denominator of the business events and transactions. The transactions
which are not in the expression of monetary terms cannot be registered in the book of
accounts as transactions.
For e.g. 5 machines, 1 ton of raw materials, 6 fork lift trucks, 10 lorries and so on. The
early mentioned items are not expressed in terms of money instead they are illustrated
only in numbers. The worth of the items are getting differed from one to another. To
record the above enlisted items in the book of accounts, all the assets should be converted
in to money. For e.g. 5 lathe machines worth Rs 1,00,000; 1 ton of raw materials worth
amounted Rs. 15,00,000 and so on.
The transactions which are not in financial in character cannot be entered in the book of
accounts.
Recording of transactions are only in terms of money in the

process
1.5.2 Business Entity Concept

This concept treats the owner as totally a different entity from the business. To put in to
nutshell "Owner is different and Business is different". The capital which is brought
inside the firm by the owner, at the commencement of the firm is known as capital. The
amount of the capital, which was initially invested should be returned to the owner
considered as due to the owner; who was nothing but the contributory of the capital.
For e.g. Mr Z has brought a capital of Rs.1 lakh for the commencement of retailing
business of refrigerators. The brought capital of Rs. 1 lakh has utilized for the purchase
of refrigerators from the Godrej Ltd. He finally bought 10 different sized refrigerators.
Out of 10 refrigerators, one was taken away by the owner Mr. Z
Type of Capital
Real Capital Monetary Capital

10 Refrigerators Rs.1lakh provided
@Rs.1 lakh by Mr. Z
In the angle of the firm

The amount of the capital Rs.1 lakh has to be returned to the owner Mr. Z, which
considered to be as due. Among the 10 newly bought refrigerators for trading, one was
taken away by the owner for his personal usage. The one refrigerator drawn by the
owner for his personal usage led the firm to sell only 9 refrigerators. It means that Rs.
90,000 out of Rs. 1 Lakh is the volume of real capital and the Rs.10,000 worth of the
refrigerator considered to be as drawings; which illustrates the capital owed by the firm
is only Rs. 90,000 not Rs. 1 lakh.
In the angle of the owner
The refrigerator drawn worth of Rs.10,000 nothing but Rs.10,000 worth of real capital
of the firm was taken for personal use as drawings reduced the total volume of the
capital of the firm from Rs.1 lakh to Rs. 90,000, which expected the firm to return the
capital due amounted Rs. 90,000. 13
for Managers
Owner and business organizations are two separate entities
1.5.3 Going Concern Concept

The concept deals with the quality of long lasting status of the business enterprise
irrespective of the owners' status, whether he is alive or not. This concept is known as
concept of long-term assets. The fixed assets are bought in the intention to earn profits
during the season of the business. The assets which are idle during the slack season of
the business retained for future usage, in spite of that those assets are frequently sold out
by the firm immediately after the utility leads to mean that those assets are not fixed
assets but tradable assets. The fixed assets are retained by the firm even after the usage
is only due to the principle of long lastingness of the business enterprise. If the business
disposes the assets immediately after the current usage by not considering the future
utility of the assets in the firm which will not distinguish in between the long-term assets
and short-term assets known as tradable in categories.
Accounting concept for long lastingness of the business enterprise
1.5.4 Matching Concept
This concept only makes the entire accounting system as meaningful to determine the
volume of earnings or losses of the firm at every level of transaction; which is an
outcome of matching in between the revenues and expenses.
The worth of the transaction is identified through matching of revenues which are
mainly generated from the sales volume and the expenses of the firm at every level.
For example, the cost of goods sold and selling price of the pen of ABC Ltd are Rs. 5
and Rs. 10 respectively. The firm produced 100 ball pens during the first shift and out of
100 pens manufactured 20 pens are considered to be damage which cannot be supplied
to the customers, rejected by the quality circle department. There was an order from the
firm XYZ Ltd., which amounted 80 pens to be supplied immediately.
The worth of the transaction of the firm at every level of the transaction is being studied
only through the matching of revenues with the expenses.
At first instance, the firm produced 100 pens which incurred the total cost of Rs 500
required to match with the expected revenues of Rs 1,000; illustrated the level of profit
how much would it accrue if the entire level of production is sold out ?
If the entire production capacity is sold out in the market the profit level would be Rs 500.
Out of the 100 pens manufactured 20 were identified not ideal for supply as damages, the
remaining 80 pens were supplied to the individual retailer The retailer has been dispatched
80 pens amounted Rs 400 which equated to Rs 800 of the expected sales At the moment
of dispatching, the firm expected to earn a profit of Rs 400 at the level of 80 pens supplied.
After the dispatch, the retailer found that 50 pens are in accordance with the order placement
but the remaining are to the tune of the retailers' specifications. Finally, the retailer has
agreed to make the payment of the bill only in accordance with the order placed which
amounted Rs 500 out of the expenses of the manufacturer Rs 250.
This concept facilitates to identify the worth of the transaction at every moment.
Concept of fusion in between the expenses and revenues
1.5.5 Accounting Period Concept
Though the life period of the business is longer in span, which is classified into the
operating periods which are smaller in duration. The accounting period may be either
14 calendar year of Jan-Dec or fiscal year of April-Mar. The operating periods are not
equivalent among the trading firms, which means that the operating period of one firm Financial Accounting
may be shorter than the other one. The ultimate aim of the concept is to nullify the
deviations of the operating periods of various traders in the trading practice.
According to the Companies Act, 1956, the accounting period should not exceed more
than 15 months.
Concept of uniform accounting horizon among the firms to evade

deviations
1.5.6 Duality or Double entry accounting concept
It is the only concept which portrays the two sides of a single transaction. The law of
entire business revolves around only on mutual agreement sharing policy among the
players. How mutual agreement is taking place ?
The entire principle of business is mainly conducted on mutual agreement among the
parties from one occasion to another. The payment of wages are only made by the firm
out of the services of labourers. What kind of mutual agreement in sharing the benefits
is taking place? The services of the labourers are availed by the firm through the payment
of wages. Like-wise, the labourers are regularly getting wages for their services in the
firm.
Payment of Wages = Labourers' service
In the angle of accounting aspects of a firm, the labourer services are availed through
the payment of wages nothing but the mutual sharing of benefits. Availing of services or
taking the services of the labourers only through the cash payment whatever you make
at the end i.e., giving wages.
This is being denominated into two different facets of accounting viz Debit and Credit.
Every debit transaction is appropriately equated with the transaction of credit.
The entire above sample of transactions are being carried out by the firm through the
raising of financial resources. The resources raised were finally deployed in terms of
assets. It means that the total funds raised by the firm is equated to the total investments.
From the below table illustration, it is clearly evidenced that the entire raised financial
resources are applied in the form of asset applications. It means that the total liabilities
are equivalent to the total assets of the firm.
Total Financial Resources Total Assets
Liabilities Assets
Share capital Plant and Machinery
Preference Share Capital Land and Buildings
Debentures/Long Term Borrowings Fixtures and Tools
Retained Earnings Delivery vehicles
Commercial Paper Furniture Industry and office
Public Deposits Office administrative devices
Bank Loan Marketable securities
Overdraft Short-term investments
Pre received Income Closing stock
Outstanding Expenses Pre paid expenses
Sundry Creditors Outstanding Income
Bills Payable Sundry debtors
Provision for Taxation Bill Receivable
Cash at Bank
Cash in Hand
15
for Managers Concept of mutual agreement and sharing of benefits
1.5.7 Cost Concept

It is the concept closely relevant with the going concern concept. Under this concept,
the transactions are recorded only in terms of cost rather than in market value. Fixed
assets are only entered in terms of the purchase price which is a original cost of the
asset at the moment of purchase. The depreciation is deducted from the original value
which is the initial purchase price of the asset will highlight the book value of the asset at
the end of the accounting period. The marketing value of the asset should not be taken
into consideration, Why? The main reason is that the market value of the asset is subject
to fluctuations due to demand and supply forces. The entry of market value of the asset
will require the frequent update of information to the tune of changes in the market. Will
it be possible to record the changes taken place in the market then and there? This is not
only not possible for regular updating of information but also leads to lot of consequences.
Though the firm is ready to register the market value; which market value has to be
taken into consideration? The market value can be bifurcated into two categories viz
Realizable value and Replacement value.
Realizable value is the value of the asset at the moment of sale or realization. Replacement
value is the another value which considered at the moment of replacing the old asset
with the new one. These two cannot be the same at single point of time and the wear
and tear of the asset will play pivotal role in fixing the realization value which has the
demarcation over the later.
1.6 ACCOUNTING CONVENTIONS

Accounting conventions are bearing the practical considerations in recording the
transactions of the business enterprise in systematic manner.
l Convention of consistency
l Convention of conservatism
l Convention of disclosure
1.6.1 Convention of consistency

The nature of recording the transactions should not be changed at any cause or moment.
It should be maintained throughout the life period of the firm. If a firm follows the
straight line method of charging the depreciation since its inception should be followed
without any change . The firm should not alter the method of charging the depreciation
from one method to another. The change cannot be entertained. If any change has to be
incorporated, the valid reason for change should be emphasized.
1.6.2 Convention of conservatism

The conservatism wont give any emphasis on the anticipation of the firm, instead it gives
paramount importance to all possible uneventualities of the firm without considering the
future profits.
The most important of the rule of guidance at the moment of valuing the stock is as
follows:
Stock Valuations:
"Stock of the goods should be valued either market price or cost whichever is lower"
To anticipate the future losses due to default in the payments of the customers;
Provision is created for bad and doubtful debts of the firm in order to meet the losses
16 expected. out of the defaulters.
1.6.3 Convention of disclosure Financial Accounting
According to this convention, the entire status of the firm should be highlighted / presented
in detail without hiding anything; which has to furnish the required information to various
parties involved in the process of the firm.
Next stage is to classify the accounts into various categories.
Classification of Accounts: The entire process of accounting brought under three major
segments ; which are broadly grouped into two categories.
Check Your Progress
(1) Accounting principles are

(a) Accounting concepts only (b) Accounting
conventions
(c) Accounting concepts & conventions only (d) None of the above
(2) Money measurement concept is
(a) Financial transactions only (b) Non financial transactions only
(c) Both (a) & (b) (d) None of the above
(3) Distinction of the assets is on the basis of
(a) Going concern concept (b) Time period concept
(c) Business entity concept (d) Duality concept
(4) The worth of transactions are identified only through
(a) Cost concept (b) Matching concept
(c) Business entity concept (d) Double entry accounting concept
(5) Total Liabilities = Total Assets is dealt
(a) Business entity concept (b) Cost concept
(c) Going concern concept (d) Duality concept
Accounts
Personal Impersonal
Accounts Accounts
Persons Persons Persons Real Accounts Nominal

Out of Out of Out of
Law Relationship Accounts
Nature Representations
The entire accounts of the enterprise is broadly classified into two categories viz Personal
Accounts and Impersonal Accounts. The Impersonal accounts is further classified into
two categories viz Real accounts and Nominal accounts.
What is personal accounts?
It is an account which deals with a due balance either to or from these individuals on
a particular period. It is an account normally reveals the outstanding balance of the firm
to individuals e.g. suppliers or outstanding balance from individuals e.g. customers. This 17
Accounting and Finance is the only account which emphasizes the future relationship in between the business
for Managers
firm and the individuals.
The personal accounts can be classified into three categories.
1.6.4 Persons of Nature

Persons who are nothing but outcome of nature i.e., almighty.
1.6.5 Persons of Artificial relationship

Persons who are made out of artificial relationship through legal structure is known as
organizations, corporate, partnership firm and so on. The companies and partnership
firm are governed by the Companies Act 1956 and the partnership act. The relationship
among the owners of the company or partners of the firm are totally structured through
respective laws.
E.g.: LIC, SBI, Companies are most important illustrations governed by the artificial
relationship among the members through LIC act, SBI act and the Companies act 1956
and so on respectively.
1.6.6 Persons of representations

This classification represents amount outstanding or prepaid in connection with the
individual transactions.
(i) Outstanding of electricity charges: Electricity charges outstanding is with
reference to the electricity board TNEB, Rent prepaid refers that rent of the office
is made as an advance payment for the forthcoming month to the owner of the
building.
The personal account is the account of future relationship; to maintain the relationship
of future in two different angles viz Receiver of the benefits from the firm and
giver of the benefits to the firm.
1.6.7 Receiver of the benefits

For E.g.: The credit sale of the goods worth of Rs 1,500 to Mr X. In this transaction Mr.
X is the receiver of the benefits through the credit sale of the firm. Till the collection of
the sale benefits, the firm should maintain the relationship of business with the Mr. X in
the books of accounts.
1.6.8 Giver of the benefits

For E.g: The credit purchase of the goods worth of Rs 3,000 from Mr. Y. The giver of
the goods nothing but the supplier of the goods Mr. Y should be recorded in the books of
the firm till the payment of dues of the credit purchase. The future relationship is maintained
in the books of the accounts till the payment process is over.
Debit the Receiver

Credit the Giver
1.7 REAL ACCOUNTS

It is a major classification which highlights the real worth of the assets. This is the
account especially deals with the movement of assets. It is an account not only reveals
the value and movement of the assets taking place in between the firm and also other
18 parties due to any transactions.
The movement of the assets can be classified into two categories viz the assets which Financial Accounting
are coming into the firm and the assets which are going out of the firm.
Whenever any movement of the assets taking place with reference to any transactions
either coming into the firm or going out of the firm should be recorded in accordance
with the set golden rules of this account.
Debit What comes in

Credit What goes out
1.8 NOMINAL ACCOUNTS

This is an account deals with the amount of expenses incurred or incomes earned. It
includes all expenses and losses as well as incomes and gains of the enterprise. This
nominal account records the expenses and incomes which are not carried forwarded to
near future.
Debit all the expenses and losses

Credit all incomes and gains
The process of the accounting in normal practice as follows:

The practice starts with the journalizing of entries. After journalisation, the entries passed
in the journal will be passed into the ledger A/c. The immediate next stage is to prepare
the trial balance.
What is meant by the journal entry ?
It is an entry systematically recorded to the tune of golden rules of accounting in the
journal book is known as journal entries.
How the journal entries are entered?
The journal entries are recorded in the sequential order. The order of recording is
conventionally done on the basis of date. The journal entry usually contains two different
parts, which are nothing but two different accounts affecting the transactions.
Date Particulars Ledger Debit Credit
Folio Rs Rs
Number of the To Debit the Name of the Page number in
day in the account the respective
month, Name of To credit the Name of the ledger
the month and account
Year in full
Journalising the entries are different from one transaction to another The difference is
only due to nature and characteristics of the transactions. To journalise as easy as possible,
the systematic approach to be adopted to post the transactions without any ambiguity.
Journalising can be generally categorized into following various categories.
l Taking place within the same natured accounts
l Taking part in between accounts of two different in categories
First, we will discuss the journalizing of entries of the same natured accounts. This can
be classified into various segments
l Transactions only in between the personal accounts
l Transactions only in between the real accounts
Under the category of transactions which affect only the personal accounts are as follows:
19
l Between the persons of the nature
Accounting and Finance l Between the persons of the artificial relationship
for Managers
l Between the persons of Representations
What are the points to observed at the moment of journalizing ?
l The nature of the accounts to be identified
l The accounts to be correlated to the golden rules
l Once the accounts are finalized, the next stage is to pass the entry through proper
debiting and crediting of the accounts respectively.
The meaning of the transaction should be made explicit for easier understanding through
brief and catchy narration to follow as well as evade the ambiguity in near future.
Mr Sundar is a debtor who has paid Rs 1,500, in the bank A/c
Mr. Sundar Bank
Personal A/cs
Persons of Nature
Giver Receiver
l Transaction is identified which is in between two different persons under the

personal A/c, they are nothing but persons of nature.
l The benefits are shared in between two persons viz. Mr. Sundar and Banker who
are nothing but giver and receiver of the benefits respectively.
l It means that Sundar is the giver of Rs 1,500 to Banker who is the receiver of the
same Rs. 1,500.
Debit the Receiver Bank Debit the Melvin A/c
Credit the Giver Sundar Credit the Sundar A/c
Final step is to pass the journal entry

Bank A/c Dr Rs. 1,500
To Sundar A/c Cr Rs. 1,500
(Being cash is paid by sundar to Bank A/c)
1.9 TRANSACTIONS IN BETWEEN THE REAL A/C

Real A/c is an account to highlight the movement of the assets. If any simultaneous
movement is taking place in between two different assets of the enterprise can be
explained with the following example:
Purchase of a Plant and Machinery of Rs.15,000.
The purchase of a plant and machinery is only through cash payment to the vendor.
What are the two different type of assets involved in the movement during the purchase?
There are two different type of assets viz. Cash and Plant & Machinery
To put in nutshell, among the two assets, Cash is one of the current assets and the Plant
& Machinery is one of the fixed assets. In general, these two are brought under the
20 category of assets or applications of the firm.
If the assets are involved in the transaction, Real account should only be referred. Financial Accounting
How the movement of assets is taking place at the moment of purchase ?

The movement of the assets classified into two segments viz. movement in and movement
out.
1.9.1 What is movement - in?
The movement - in is the movement of the assets to the business enterprise. With reference
to above cited example which asset is coming into the business enterprise? Plant &
Machinery is the asset which comes into the business enterprise only at the moment of
purchase.
1.9.2 What is movement - out?
The movement-out is the movement of the assets from the business enterprise. From
the above illustrated example, which asset is going out of the firm during the purchase?
Cash resources are going out of the firm in order to make the payment of the purchase
to the supplier of the assets.
Cash Resources
Business Supplier
Enterprise
Plant & Machinery

Next stage is to highlight the movement of the assets during the purchase
Movement - In Plant & Machinery Debit What Comes in

Movement - Out Cash Resources Credit What goes out
What is coming in ?- Plant & Machinery

What is going out ?- Cash Resources
Plant & Machinery A/c Dr Rs.15,000
To Cash resources A/c Cr Rs.15,000
(Being Plant & Machinery is purchased)
What is the basic point to be registered ?
During the purchase, the plant & machinery worth of Rs.15,000 is coming into the firm,
in turn Rs.15,000 worth of cash resources are going out of the firm. During the cash
purchase, the assets are moving from one entity to another viz. from business enterprise
to supplier and vice versa.
1.10 JOURNAL ENTRIES IN BETWEEN THE ACCOUNTS

OF TWO DIFFERENT CATEGORIES
l Transactions are in between the Real A/c and Personal A/c:
This type of the transaction is mainly governed by one important principle that future
relationship. It major focus on the maintenance of future relationship among the parties
involved, till the realization of the transaction is over.
Goods sold to Gopal Rs.15,000.
Meaning: The goods were sold on credit to Gopal amounted Rs.15,000. 21
Accounting and Finance First, what are the various A/cs involved in the transaction ?
for Managers
There are two different A/cs viz Real A/c and Personal A/c
How Real A/c and Personal A/c are considered for journalizing the entries?
During the sales, irrespective of nature, Goods are moving out of the firm, which finally
will reach the individual Gopal. The goods, which are sold out to Gopal led to movement
of goods out of the firm. Any movement of asset should be referred only to the tune of
Real A/c. The goods which are going out of the firm could be recorded as transaction
under the Real A/c i.e."Credit what goes out". While recording the transaction, it should
not be entered as Goods A/c, Why ? Instead of recording as Goods A/c, which are going
out of the firm should be mentioned only with reason of going out. The reason for goods
going out of the firm is only due to sales; has to registered in the books of accounts at the
time of entering the journal entries.
The second account which gets affected is the personal A/c of representations. The
goods sold out on credit led to register the receiver of goods who has not paid at the
moment of sale. Gopal is the individual received the goods on credit during the sales
expected to make the payment as per the terms of credit period. Till the maturity of the
credit period agreed, the firm should wait and collect the amount from the individual who
is nothing but the receiver of goods.
Movement-out-Real A/c Goods are moving out of the Credit what goes out
firm Sales A/c
Receiver of benefits- Personal A/c Receiver of the goods on credit Debit the receiver
with future relationship Gopal A/c
Next step is to record the journal entry
Gopal A/c Dr Rs.15,000
To Sales A/c Cr Rs.15,000
(Being goods sold on credit to Gopal)
l Transaction in between the Real A/c and Nominal A/c
l Office Rent paid Rs.10,000
What are the two different accounts involved in the above illustrated transaction?
First one is the Rent A/c and another is Cash A/c only due to cash payment at the
moment of making the payment of rent.
What is the nature of Rent A/c?
The Rent which is paid to the owner is an expense out of the benefits derived out of the
asset during the previous month. In accordance with the Nominal A/c all the expenses
are to be recorded, i.e. "Debit all the expenses and losses."
The second is in relevance with the cash payment which finally led to the movement of
cash resources from the firm to the owner of the Asset. This mobility of the assets leads
to movement - out which in connection with the Real A/c is the account for the assets.
Rent paid Expense - Office Rent paid Nominal A/c - Debit All expenses and losses
Movement - out Cash moving out of the firm Real A/c - Credit what goes out
Check Your Progress
(1) Rent paid

(a) Debit - Rent ; Credit - The giver (b) Debit - Cash; Credit - Rent
(c) Debit - Rent; Credit - Cash (d) None of the above
22 (2) Purchase of assets in between the two different accounts

Contd...
(a) Real A/c and Personal A/c (b) Real A/c and Nominal A/c Financial Accounting
(c) Personal A/c and Personal A/c (d) Real A/c and Real A/c
(3) Identify nature of the transactions: Sundar has purchased goods on credit
from M/s Melvin & Co Rs.15,000. The portion of the goods were found to
damaged which worth of Rs 5,000. Sundar immediately returned the damaged
goods to Melvin & Co.
(a) Identify the various types of accounts involved in the above illustrated
transactions.
(b) Pass the journal entries with regards to the nature of accounts involved.
Illustration 1
Pass the following various journal entries.
(i) Jan 1, 2006 Mr. Sundar has started business with a capital of Rs 50,000
(ii) Jan 2,2006 Goods purchased Rs 10,000
(iii) Jan 5, 2006 Goods sold Rs 5,000
(iv) Jan 10, 2006 Goods purchased from Mittal & Co Rs 10,000
(v) Jan 11, 2006 Goods sold to Ganesh & Co Rs 10,000
(vi) Jan 12,2006 Goods returned to Mittal & Co Rs 1,500
(vii) Jan 20,2006 Goods returned from Ganesh Rs 2,000
(viii) Jan 31,2006 Office Rent paid Rs 500
(ix) Feb 2,2006 Interim Cash Dividend paid Rs 3000
(x) Feb 8, 2006 Cash withdrawn from bank Rs 2,000
(i) Jan 1, 2006 Mr. Sundar has started business with a capital of Rs 50,000
Rs Rs
Jan 1, 2006 Cash A/c Dr 50,000
To Sundars capital A/c Cr 50,000
Being capital brought by sundar as cash
(ii) Jan 2, 2006 Goods purchased Rs 10,000

Rs Rs
Jan 2, 2006 Purchase A/c Dr 10,000
To Cash A/c Cr 10,000
Being cash purchase is made

Rs Rs
Jan 5, 2006 CashA/c Dr 5,000
To Sale A/c Cr 5,000
Being cash sale is made
(iv) Jan 10, 2006 Goods purchased from Mittal & Co Rs 10,000
Rs Rs
To Mittal A/c Cr 10,000
Being credit purchase from Mittal
23
Accounting and Finance (v) Jan 11, 2006 Goods sold to Ganesh & Co Rs. 10,000
for Managers
Rs Rs
Jan 11, 2006 Ganesh A/c Dr 10,000
To SaleA/c Cr 10,000
Being credit sale made to Ganesh
(vi) Jan, 12, 2006 Goods returned to Mittal & Co Rs. 1,500
Rs Rs
Jan 12, 2006 Mittal &Co A/c Dr 1,500
To Purchase Return A/c Cr 1,500
(Being the goods returned to supplier Mittal &Co)
(vii) Jan 20, 2006 Goods returned from Ganesh Rs. 2,000
Rs Rs
Jan 20, 2006 Sales ReturnA/c Dr 2,000
To Ganesh&co Cr 2,000
Being sales return made by Ganesh & Co
(viii) Jan 31, 2006 Office Rent paid Rs. 500
Rs Rs
Jan 31, 2006 Office Rent A/c Dr 500
To Cash A/c Cr 500
Being office rent paid
(ix) Feb 2, 2006 Interim Cash Dividend received Rs. 3000

Rs Rs
Feb 2, 2006 Cash A/c Dr 3,000
To Interim Dividend Cr 3,000
Being cash interim dividend received
(x) Feb 8, 2006 Cash withdrawn from bank Rs. 2,000

Rs Rs
Feb 8, 2006 Cash A/c Dr 2,000
To Bank Cr 2,000
Being cash withdrawn from the bank
Classification of transactions is being done only on the basis of preparing the ledger
accounts. The accounts are classified on the basis of nature and characteristics.
How the account transactions are classified ?
The accounts are classified through the preparation of ledger.
1.10.1 What is meant by Ledger?
Ledger is nothing but preliminary book of accounting transactions at which, each account
is separately maintained through the allotment of various pages for exclusive recording.
The exclusive allotment of pages for every account to finalize their balances. Finally,
ledger can be understood that is a document of grouping the transactions under one
heading .
It is a fundamental book of accounts which mainly highlights the status of the accounts.
Example: Plant & Machinerys ledger A/c should reveal the transactions of the sale &
purchase of the plant and machinery.
How the transactions are recorded in the ledger ?
The journal entries which are recorded nothing but posting of the entries in the ledger
book of accounts. Posting / entering the journal entries are routinely carried out
immediately after the transactions.
Prior to discuss the posting of journal entries into the ledger accounts, every body should
24 know the contents of the ledger. The ledger is segmented into two different categories.
Proforma of the Ledger Account Financial Accounting
Dr Name of the Account Cr

Date Particular Date Particulars
To By
Journal entries are divided into two categories viz

1. Debit item of the transaction
2. Credit item of the transaction
Once the journal entries are identified for classification, the entries should be recorded in
accordance with the date order of the transactions in the respective pages.
While recording a transaction, normally a journal entry has got an impact on two or even
three different accounts.
1.10.2 Ledgering
It is a process of recording the transactions under one group from the early process of
journalizing. Without journalizing, ledgering is not meaningful. The process of ledgering
involves with various steps. The process commences from only at the completion of
journalizing and ends at the end of balancing of journal accounts.
Process of Ledgering
Identify the transaction
Krishna started the business with a capital of Rs 50,000
Identify the two accounts involved
Two accounts - Cash A/c & Krishna Capital A/c
Open the ledger accounts involved in the journal entries
Open Ledger accounts Cash A/c & Krishna Capital A/c
Dr Cash A/c Cr Dr Krishna Capital A/c Cr
Enter the journal entry in the Ledger A/c

Cash A/c Dr Rs. 50,000
To Krishnas capital A/c Rs. 50,000
Credit item of the journal transaction Debit item of the journal transaction
Krishna capital A/c to be recorded in Cash A/c to be recorded in the
the debit side of the A/c i.e. Cash A/c credit side of the remaining A/c i.e
Dr Cash A/c Cr Dr Krishna Capital A/c Cr

To Krishna capital Rs. 50,000 By Cash Rs. 50,000
Krishna capital A/c debited into cash A/c Cash A/c credited into Krishna capital A/c 25
Accounting and Finance Next step is to Balance the individual Ledger A/c:
for Managers
How to balance the ledger A/c?
The individual ledger A/c may have more than two transactions during the specified period.
l The first step is to find out the totals of debit and credit side of the ledger account.
l The second step is to compare the totals of the two different sides
l The third step is to find out the total of which side is greater over the other
l The fourth step is to identify the difference among the two different side balances
i.e., debit and credit side totals.
l The fifth step is most important step which balances the difference on the total of
the side which bears lesser total over the greater.
l If the balance of the debit side of the ledger is more than the credit side of the
ledger is called as Debit balance ledger and vice versa in the case of Credit balance
ledger
l The closing balance of one ledger account will become automatically a opening
balance of the same ledger account for next accounting period.
Post the journal entries into respective ledger accounts. And list out their accounting
balances.
(i) Jan 1, 2006 Mr. Sundar has started business with a capital of Rs. 50,000
Rs Rs
Jan 1, 2006 Cash A/c Dr 50,000
To Sundars capital A/c Cr 50,000
Being capital brought by Sundar as cash
(ii) Jan 2, 2006 Goods purchased Rs 10,000
Rs Rs
To Cash A/c Cr 10,000
Being cash purchase is made

Rs Rs
Jan 5, 2006 CashA/c Dr 5,000
To Sale A/c Cr 5,000
Being cash sale is made
(iv) Jan, 10, 2006 Goods purchased from Mittal & Co Rs 10,000
Rs Rs
To Mittal A/c Cr 10,000
Being credit purchase from Mittal
(v) Jan, 11, 2006 Goods sold to Ganesh & Co Rs.10,000

Rs Rs
Jan 11, 2006 Ganesh A/c Dr 10,000
To SaleA/c Cr 10,000
Being credit sale made to Ganesh
(vi) Jan, 12, 2006 Goods returned to Mittal & Co Rs. 1,500
Rs Rs
Jan 12, 2006 Mittal & Co A/c Dr 1,500
To Purchase Return A/c Cr 1,500
Being the goods returned to supplier Mittal & Co
26
(vii) Jan 20, 2006 Goods returned from Ganesh Rs. 2,000 Financial Accounting
Rs Rs
Jan 20, 2006 Sales ReturnA/c Dr 2,000
To Ganesh& co Cr 2,000
Being sales return made by Ganesh & Co
(viii) Jan 31, 2006 Office Rent paid Rs. 500

Rs Rs
Jan 31, 2006 Office Rent A/c Dr 500
To Cash A/c 500
Being office rent paid
(ix) Feb 2, 2006 Interim Cash Dividend received Rs. 3000

Rs Rs
Feb 2, 2006 Cash A/c Dr 3,000
To Interim Dividend Cr 3,000
Being cash interim dividend received
(x) Feb 8, 2006 Cash withdrawn from bank Rs. 2,000
Rs Rs
Feb 8, 2006 Cash A/c Dr 2,000
To Bank Cr 2,000
Being cash withdrawn from the bank
List out the various accounts which are involved in the enterprise during the year?
I. Cash Account
II. Sundar Capital Account
III. Purchase Account
IV. Sales Account
V. Mittal & Co Account
VI. Ganesh & Co Account
VII. Sales Return Account
VIII. Purchase Return Account
IX. Office Rent Account
X. Interim Dividend Account
XI. Bank Account
Dr Cash Account Cr
Date Particular Rs Date Particulars Rs
Jan 1 To Sundar Capital 50,000 Jan 2 By Purchase 10,000
Jan 5 To Sale 5,000 Jan 31 By Office Rent 500
Feb 2 To Interim Dividend 3,000 By Balance c/d 49,500
Feb 8 To Bank 2,000
60,000 60,000
To balance b/d 49,500

Note: Debit side total is greater than the credit side total of the cash account. After
determining the difference, the cash account shows Debit Balance.
27
Accounting and Finance Dr Sundar Capital Account Cr
for Managers
To Balance c/d 50,000 Jan 1 By Cash 50,000
50,000 50,000
` By Balance B/d 50,000
Note: Sundar capital account is having the greater credit balance over the debit balance
account which led to credit balance account.
Dr Purchase Account Cr
Jan 2 To Cash 10,000 By Balance c/d 20,000
Jan 10 To Mittal & Co 10,000
20,000 20,000
To Balance B/d 20,000
Note: Purchase account is bearing the debit balance account
Dr Sale Account Cr
Date Particulars Rs Date Particulars Rs
To Balance c/d 15,000 Jan 5 By Cash 5,000
Jan 11 By Ganesh 10,000
15,000 15,000
By Balance B/d 15,000
Note: Sale account is bearing the credit balance account
Dr Sales Return Account Cr
Jan 20 To Ganesh 2000 By Balance c/d 2000
2000 2000
To Balance B/d 2000

Note: Sales return account is having the debit balance account
Dr Purchase Return Account Cr
To Balance c/d 1,500 Jan 12 By Mittal &Co 1500
1,500

Note: Purchase return account is bearing credit balance account
Dr Mittal & Co Account Cr
Jan 12 To Purchase Return 1,500 Jan 10 By Purchase 10,000
To Balance c/d 8,500
10,000 10,000
Note: Mittal & Co account is having the greater total in the credit side than the debit
side led to credit balance at the closing
28
Dr Ganesh & Co Account Cr Financial Accounting

Jan 11 To Sale 10,000 Jan 20 By Sale Return 2,000
By Balance c/d 8,000
10,000 10,000
Note: Ganesh & Co account is bearing a greater debit side total than the credit side total
which led to have debit balance account
Dr Office Rent Account Cr
Jan 31 To Cash 500 By Balance c/d 500
500 500
To Balance B/d 500
Note: Office rent account is bearing debit balance
Dr Interim Dividend Account Cr
To Balance c/d 3,000 Feb 2 By Cash 3,000
3,000 3,000

Note: Interim dividend account is having the credit balance
Dr Bank Account Cr
To Balance c/d 2,000 Feb 2 By Cash 2,000
2,000 2,000

Note: Bank account is having the credit balance
1.11 CASE LET

Singania Chartered Accountants Firm established in the year 1956, having very good
number of corporate clients. It continuously maintains the quality in audit administration
with the clients since its early inception. The firm is eagerly looking for promising students
who are having greater aspirations to become auditors. The firm is having an objective
to recruit freshers to conduct preliminary auditing process with their corporate clients.
For which the firm would like to select the right person who is having conceptual knowledge
as well as application on the subjects. It has given the following Balance sheet to the
participants to study the conceptual applications. The participants are required to enlist
the various concepts and conventions of accounting.
29
Accounting and Finance Balance sheet as on dated 31st Mar, 2006
for Managers
Liabilities Assets
Capital(A.Pandit) 1,00,000 Building 80,0000
(+) Commission 4,925 Depreciation 2.5% 2,000
1,04,925 78,000
(+)Net profit 11,869 Furniture 23,000
1,16,794 Depreciation 10% 2,050
(-)Drawings 16,000 20,950
1,00,794 Closing stock 1,14,500
Capital( B.Pandit) 1,00,000 Sundry Debtors 25,000
(+)Commission 1,187 Cash in hand 400
1,01,187
(+) Net profit 11,869
1,13,056
(-)Drawings 16,000 97,056
Bank overdraft 29,000
Sundry creditors 12,000
2,38,850 2,38,850
List out the various accounting concepts dealt in the above balance sheet.
Explain the treatment of accounting concepts
Check Your Progress
(1) Financial Accounting is:

(a) Accounting of business transactions
(b) Accounting of Financial transactions only
(c) Accounting of Non-financial transactions
(d) Accounting of both financial and non-financial transactions

(2) Accounting concept is:
(a) Theory of accounting (b) Procedures of accounting
(c) Rules of accounting (d) Practice of accounting

(3) Journal is:
(a) Preliminary step of accounting
(b) Intermediate step of accounting
(c) Both (a) & (b)
(d) Final step of accounting

(4) Ledger account is prepared
(a) On the basis of single entry system of accounting
(b) On the basis of double entry accounting system
(c) Both (a) & (b)
1.12 LET US SUM UP

" Accounting is the process of recording, classifying, summarizing in a significant manner
30
of transactions which are in financial character and finally results are interpreted."
The revenues are recognized only at the moment of realization but the expenses are Financial Accounting
recognized at the moment of payment. The charges which were paid only will be taken
into consideration but the outstanding, not yet paid will not be considered. The revenues
are recognized only at the time of occurrence and expenses are recognized only at the
moment of incurring. The financial statements are found to be more useful to many people
immediately after presentation only in order to study the financial status of the enterprise in
the angle of their own objectives. The entire accounting system is governed by the practice
of accountancy. The accountancy is being practiced through the universal principles which
are wholly led by the concepts and conventions. Money measurement concept tunes the
system of accounting as fruitful in recording the transactions and events of the enterprise
only in terms of money. Business entity concept treats the owner as totally a different
entity from the business. Going concern concept deals with the quality of long lasting status
of the business enterprise irrespective of the owners' status, whether he is alive or not.
Matching concept only makes the entire accounting system as meaningful to determine the
volume of earnings or losses of the firm at every level of transaction. Duality or Double
entry accounting concept is the only concept which portrays the two sides of a single
transaction. The law of entire business revolves around only on mutual agreement sharing
policy among the players. Personal accounts is an account which deals with a due balance
either to or from these individuals on a particular period. Real Accounts is the account
especially deals with the movement of assets. Nominal Accounts is an account deals with
the amount of expenses incurred or incomes earned. It includes all expenses and losses as
well as incomes and gains of the enterprise.
1.13 LESSON-END ACTIVITY

Assume you are a new-appointed Senior Manager of a firm. How what would you
suggest to the accounting department for better accounting circulation?
1.14 KEYWORDS
Record
Accounting
Revenues
Personal Account
Normal Account
Real Account
Classifying
Summarizing
Business Entity Concept
Money Measurement Concept
Going Concern Concept
Matching Concept
Duality Concept
Ledger
1.15 QUESTIONS FOR DISCUSSION

1. Define Accounting.
2. Illustrate the Accounting process. 31
Accounting and Finance 3. Classify the various kinds of values in the accounting process.
for Managers
4. Highlight the journalizing process of accounting.
5. Explain the process of ledgering of transactions of the business firm.
6. Write brief note on the various classification of accounts.
7. Explain the golden rules of accounting.
1.16 SUGGESTED READINGS

M.P. Pandikumar Accounting & Finance for Managers, Excel Books, New Delhi.
R.L. Gupta and Radhaswamy Advanced Accountancy.
V.K. Goyal, Financial Accounting, Excel Books, New Delhi.
Khan and Jain Management Accounting.
S.N. Maheswari Management Accounting.
S. Bhat Financial Management, Excel Books, New Delhi.
Prasanna Chandra, Financial Management Theory and Practice, Tata McGraw
Hill, New Delhi (1994).
I.M. Pandey, Financial Management, Vikas Publishing, New Delhi.
Nitin Balwani Accounting & Finance for Managers, Excel Books, New Delhi.
32
LESSON
2
TRIAL BALANCE
CONTENTS
2.1 Introduction
2.2 Grouping of Various Accounting Transactions
2.3 Preparation of the Trial Balance
2.4 Why the Subsidiary Accounts have to be prepared?
2.4.1 Purchase Book
2.4.2 Purchase Returns Book
2.4.3 Sales Book
2.5 Steps involved in the Sales Book
2.5.1 Sales Return Book
2.6 Steps Involved in the Sales Return Book
2.6.1 Trade Bills Book
2.6.2 Bills Receivable Book
2.7 What is meant by the Cash Transaction?
2.7.1 Double Columnar Cash Book
2.7.2 Three Columnar Cash Book
2.7.3 Multi Columnar Cash Book
2.7.4 Petty Cash Book
2.8 Let us Sum up
2.10 Keywords
2.0 AIMS AND OBJECTIVES

In this lesson we shall discuss about trial balance. After going through this lesson you will
be able to:
(i) discuss grouping of various accounting transactions
(ii) analyse preparation of the trial balance.
2.1 INTRODUCTION
The next most important stage is to prepare the statement (summary) of accounting
balances and their names for the specified accounting period to the tune of principle of
grouping transactions, known as Trial Balance.
Accounting and Finance Trial Balance is a list of accounting balances and their names; of the enterprise during
for Managers
the specified period which includes debit and credit balances of the various balanced
ledger accounts out of the journal entries.
2.2 GROUPING OF VARIOUS ACCOUNTING

TRANSACTIONS
There are eleven different ledger accounts involved out of the journal entries which
already transacted are finally balanced. The balanced ledger accounts should be prepared
as a summary list of their balances and names. The total of both balances are equivalent
to each other. The major reason for the equivalent balances on both sides is only due to
posting of entries to the tune of "Double Entry Accounting Concept (Or) Duality Concept".
This is the concept which equates the total amount of resources raised with the total
amount of applications of the enterprise.
Purposes of preparing the Trial Balance:
l To prepare a statement of disclosure of final accounting balances of various ledger
accounts on a particular date
l To prepare a statement of cross checking device of accounting while in the
process of posting of entries which mainly on the basis of Double entry accounting
principle. It facilitates the accountant to have systematic posting of entries
l It facilitates the enterprise for the preparation of Trading & Profit and Loss Accounts
for the year ended.. and the Balance sheet as on dated ..
l It provides the birds' eye view of accounting balances of various ledger accounts
during the specified period.
2.3 PREPARATION OF THE TRIAL BALANCE

The preparation of the trial balance is classified on the basis of three different accounts
viz
l Real Account (R)
l Nominal Account (N)
l Personal Account (P)
The classification of the transactions not only on the basis of accounts but also on the
basis of payments and receipts. These payments and receipts classification further
segmented into following categories
Payments category - Debit Balance
Debit Balance is the source of following golden rules of the three different accounts
Personal Account - Debit the Receive
Nominal Account-Debit all the expenses and losses
Real Account - Debit what comes in & Debit all assets
l Trading Expense Category (TE)
l Profit and Loss Category (PL)
l Assets- Balance Sheet (BA)
Receipts category-Credit Balance
Credit Balance is the major source of other half of the golden rules of accounting
Personal Account-Credit the Giver
Nominal Account- Credit all income and gains
Real Account- Credit what goes out & Credit all liabilities
l Trading Income Category (TI)
l Profit and Loss Category (PL)
34 l Liabilities - Balance Sheet (BL)
The detailed Proforma of the trial balance is given in the Annexure -I for better Trial Balance
understanding
The following trial balance of the Sundar firm is prepared from the previous list of
journal entries and ledger accounting balances.
Table 2.1: Trial Balance
Sl. No. Particulars Debit Balances Credit Balances
Rs Rs
1. Cash A/c 49,500
2. Sundar Capital A/c 50,000
3. Purchase A/c 20,000
4. SalesA/c 15,000
5. Sales ReturnA/c 2,000
6. Purchase ReturnA/c 1,500
7. Mittal &CoA/c 8,500
8. Ganesh &CoA/c 8,000
9. Office Rent A/c 500
10. Interim Dividend A/c 3,000
11. BankA/c 2,000
Total 80,000 80,000
From the Table 2.1, it is obviously understood that the total amount of debit balances are
equated to the total of credit balances of the enterprise.
The above statement of accounting balances are the resultant out of the ledger accounts
which is easier in preparation only at the moment, the firm has limited number of
transactions.
Check Your Progress
(1) Trial balance is

(a) The statement of accounting balances
(b) The statement of various account names
(c) The statement of accounting balances and their names
(2) Trial balance contains
(a) Debit balance only
(b) Credit balances only
(c) Debit and credit balances only
(3) Trial balance is the statement prepared on the basis of
(a) Business entity concept
(b) Matching concept
(c) Double entry accounting concept
(d) Realization concept
Prepare trial balance from the following text of information extracted from the book of
accounts of Ms. Selvi.
Ms Selvi has brought a monetary capital of Rs. 1,00,000 for the conduct of business on
1st April, 2007. The brought capital was converted into real capital for the business in the
form of tradable goods and commodities. She purchased household articles for trade
which amounted Rs. 60,000. She has bought a service vehicle for Rs 1,500. She keeps
Rs. 20,000 in the form of deposit at bank for contingencies. The remaining balance is
kept in the form of cash in hand for meeting the day today expenses.
35
for Managers 2.4 WHY THE SUBSIDIARY ACCOUNTS HAVE TO BE
PREPARED?
If the transactions of the enterprise are voluminous, to ease the process of posting the
transactions, the transactions should be classified into two categories. The transactions
are segmented one on the basis of regular and another on the basis of non-regular
occurrence.
The regular / frequent occurrence of transactions are recorded only in the separate
books which are known as subsidiary book of accounts or subsidiary journals instead to
record in the regular journal. The infrequent transactions are recorded / posted in the
original journal or Journal proper which do not have any specific subsidiary journal or
subsidiary books.
The subsidiary journals or books are developed by the firms only based on the occurrence
of the transactions. Normally the frequent occurrence of the transactions of the firm are
major formation of the subsidiary books of the accounting system.
The following are the subsidiary books on the major frequent occurrence of transactions
Subsidiary
Books
Cash Non-Cash
Transaction Transaction
Cash Sales Purchase Sales Purchase Bills Bill

Book Book Book Return Return Receivable Payable
Book Book Book Book
Subsidiary books are classified on the basis of transactions viz Cash transactions and
Non-cash transactions
First , let us discuss the Non-cash transactions
What is meant by the Non-cash transaction?
The Non-cash transaction is a transaction out of credit terms and conditions of the
enterprise.
The Non cash transactions shall include the following transactions of the enterprise,
which do not involve any cash ; are as follows
l Credit Sales Book
l Credit Purchases Book
l Credit Sales Return Book
l Credit Purchases Return Book
l Bills Payable Book - Out come of Credit transaction
l Bill Receivable Book - Out come of Credit transaction
2.4.1 Purchase Book

The purchase book is called in other words as purchase journal . It is a book meant for
36 credit purchases only for resale
Proforma of the Purchases Book Trial Balance
Date Name of the Supplier Ledger Folio Inward Invoice No. Amount Rs
The purchase book usually contains various components viz.

Name of the supplier - From whom the raw material were procured on credit
Ledger folio - It is the number of the page where the journal entry is
transacted.
Inward Invoice No - The book contains the invoice number of the credit
purchase of the goods from the supplier
Amount (Rs) -The book contains the value of credit purchase
transactions from the supplier.
Steps involved in posting the entries:
l Posting the entries pertaining to the individual accounts into the Purchase journal
l The total of the purchase journal is determined on monthly and finally should be
posted into debit side of the purchase account- To satisfy the rule of Real Account;
which not only contains the cash purchase but also the credit purchase of the firm
during the year.
2.4.2 Purchase Returns Book

This is a book of goods returned to the supplier which are out of credit purchases.
The return of goods out of the credit purchase is due to non confirmation with the
specification mentioned in the order.
Proforma of the Purchase Returns Book
Date Name of the Customer Ledger Folio Out ward Invoice No. Amount Rs
The purchase returns book consists of various components viz

Name of the supplier - To whom the goods/ raw material purchased , were returned
Ledger folio - It is the number of the page where the journal entry is posted
Debit Note No -It is the page number on the original copy of the document
sent to the firm to whom the goods are sent
Amount (Rs) -The book should illustrate the value of goods/raw materials
returned out of credit purchase
Steps involved:
l Posting the entries of the purchase returns to the individual suppliers' account into
the purchase return journal
l The monthly total of the purchase journal is credited into the purchase return account
2.4.3 Sales Book
It is a book maintained by the enterprise only during the moment of selling the goods on
credit. It is pronounced in other words as sales journal.
Proforma of the Sales Book
Date Name of the Customer Ledger Folio Credit Noted No. Amount Rs
The sales normally contains the following components

Name of the customer - The sales book usually records the name of the buyer
who has been sold the goods or raw materials on credit 37
Accounting and Finance Ledger Folio - The page number where the journal entry is posted / transacted
for Managers
Out Ward Invoice No- This book registers the invoice number of the goods /
raw materials sold out to the buyers on credit.
Amount (Rs)- It is fundamental document to earmark the value of the
goods/raw materials sold out on credit to the various
buyers. It facilitates the firm to identify the amount of
sales transacted on credit as well as to collect the
amount of dues from the buyers.
2.5 STEPS INVOLVED IN THE SALES BOOK

l Sale of the goods/raw materials to the individual buyers are entered on daily basis
l The monthly total of sales book is credited into the sales account of the firm which
includes both the sale transactions of cash as well as credit
2.5.1 Sales Return Book

It is a book which registers the goods sold on credit and received from the buyers. The
sales return from the buyers is due to non confirming to the specifications mentioned at
the moment of placement of the order. It is known as sales return journal.
Proforma of the Sales Return Book
Date Name of the Supplier Ledger Folio Debit Note No. Amount Rs
The following are the various components dealt in the design of the book
Name of the customer - It includes the most important information about the buyer
who returned the goods /raw materials, non-confirming to specifications of the placed.
Ledger folio - It contains the page number of the journal entry posted.
Credit Note No - It is a number on the original copy of the document sent to
the firm from whom the goods are received i.e., buyer
2.6 STEPS INVOLVED IN THE SALES RETURN BOOK

l Sales return of the enterprise from the individual buyers are recorded immediately
after the transactions
l The monthly total of the sales return is posted into the debit side of the sales return
account in accordance with the rule of Real account
2.6.1 Trade Bills Book

The trade bills book can be classified into two categories viz Bills receivable book and
Bills payable book.
2.6.2 Bills Receivable Book

It is a book maintained especially for promissory notes & Bill of exchanges accepted
by the customers out of their dues , as an out come of credit sale of the enterprise.
The bills receivable and promissory notes are nothing but the resultant of the credit
sale transactions of the enterprise not only to safe guard the interest of enterprise but
also to collect the dues from the customers as per the terms of the trade agreed
earlier.
38
Proforma of the Bills Receivable Book Trial Balance
Sl.No. Date From Acceptor Date Term Date of Where Amt How
whom of the Receivable Rs Disposed
Received the Maturity
bill
The various components of the Bills payable book are as follows

From whom Received- The either bill or promissory received from whom? .The name
of the party should entered at the moment of receiving the negotiable instruments of the
trade.
Acceptor - The person / institution who/which accepts the terms of the
bill to make the payment
Date of the bill -At when the bill is drafted/ drawn for obtaining the acceptance
of the buyer ;who bought the goods on credit
Term -Modalities involved in the process of payment of the dues
mentioned in the bill
Date of Maturity - Date at when the bill to be presented for collection from the
customer.
Where payable -The place of amount payable by the customers or buyers who
bought the goods on credit.
Amount (Rs) -It reveals the amount How much to be collected from the
customer through either bill of receivable or promissory note .
How disposed -The process of the collection done should be recorded for future
verification in settling the dues of the customer.. Bills Payable
Book: It is a book of bills payable or promissory notes accepted
by the enterprise to the suppliers at the moment of carrying out
the credit purchase.
Proforma of the Bills Payable Book
Sl.No. Date Name Payee Date Term Date of Where Amt Remarks
of the of the the Payable Rs
Drawer bill Maturity
The following are the some of the important components normally included in the book:
Name of the drawer - Name of the person or concern , who or which draws the bill
nothing but either seller or manufacturer or supplier of the goods
or raw materials.
Payee - To whom the payment has to be paid
Date of the bill - Normally included to know the date at when the bill was drafted
which is under the possession of the seller or supplier.
Date of Maturity - It is the date at when the payment has to be made as per the
terms of trade.
Where payable - At where the amount of the bills to paid
2.7 WHAT IS MEANT BY THE CASH TRANSACTION?

The Cash transaction is a transaction carried out only out of cash . The cash transactions
are recorded in the subsidiary book known as cash book. The cash book can be classified
into three categories
l Single columnar cash book
39
l Double columnar cash book
Accounting and Finance l Three columnar cash book
for Managers
Single columnar cash book: It is a book generally records the transactions into two
classification viz Payments and Receipts. The receipts and payments are recorded in
the debit and credit side of the cash book respectively. The debit and credit side
transactions of the cash book are prefixed with "To" and "By" respectively.
Proforma of the Single columnar Cash Book
Date Receipts Rs Date Payments Rs
To Opening Balance B/d
By Closing Balance B/d
2.7.1 Double Columnar Cash Book
It is another kind of cash book which is nothing but extension of earlier versioned single
columnar cash book. The double columnar cash book includes the operations of the
enterprise into two different categories viz transactions through Cash and Bank. It
means that the entire receipts and payments of the business routed through cash and
bank. The transaction of the business with the bank either at the moment of cash
withdrawal or cash deposit leads to register the movement of cash from one entity to
another through the contra entries.
The contra entries are posted in two different occasions viz cash withdrawal and cash
deposit.
During the cash withdrawal, the movement of cash is depicted below for easier
understanding, which is nothing but the movement of asset from bank to firm.
Firm Bank
Bank Firm
SAVINGS BANK A/c OPERATIONS
Transaction No 1
Jan 5, 2006, Cash withdrawal Rs.10,000 from the bank is having the following journal entry
Cash A/c Dr Rs.10,000
To Bank A/c Cr Rs.10,000
(Being cash withdrawn from the bank A/c)
From the above entry, it is obviously understood that the bank is the giver of the cash
resources from the savings bank a/c and cash receipts are made only due to withdrawal
of cash from the bank
There are two different angles of cash withdrawal one is in the dimension of firm and
another is bank.
Firm Bank
Cash receipts Cash Payments
Dr Proforma of Double columnar cash book Cr

Date Receipts Bank Cash Date Payments Bank Cash
To Balance B/d By Balance
To Bank C1 c/d*
Jan 5 To Cash C2 10,000 Jan 5 By cash C1 10,000
Jan 20 5,000 Jan 20 By Bank C2 5,000
By Balance
B/d
40
* Bank overdraft
The above table of double columnar cash book clearly elucidates the contra entry process Trial Balance
taken place in between two entities viz firm and bank .
2.7.2 Three Columnar Cash Book

It is another dimension of cash book which has three component of operations of the
enterprise viz Cash, Bank and Discount. This cash book is extension of the early one, not
only which incorporates the receipts and payments of the firm through cash and bank
but also discount allowed and received.
Dr Proforma of Three columnar cash book Cr
Date Receipts Bank Cash Discount Date Payments Bank Cash Discount
Allowed Received
To Balance By
B/d Balance
c/d
By
Balance
B/d
Why discount allowed is brought under the debit side?

The discount is allowed at the time of receipts out of sale . The discounts are categorized
into two categories viz cash discount and trade discount.
Cash discount is the discount allowed by the firm only at the moment of making the
payment with in the stipulated time frame i.e. 7% @ 10 days means that 7% discount
will be given to the parties who are able to make the payment of dues within 10 days of
stipulated time period.
Trade discount is the discount allowed by the firm to encourage the regular customers to
buy more and more. This type of discount is allowed by the firm only on the total value
of the invoice. The discount is granted on the gross value of the goods purchased by the
regular customer from the enterprise.
Why discount received is brought under the credit side?
The reason for showing the discount received under the credit side of the cash book is
that the amount of discount received availed only during the moment of payment of
overdue only due to credit purchase
2.7.3 Multi columnar Cash Book

The regular receipts and payments on various heads require the firm to design not only
a most suited cash book which is in a position to incorporate all the entries of cash in
nature but also to reduce the excessive labour involved in the process of sorting out
them. To replace the bottlenecks of the three columnar cash book, multi columnar cash
book is developed which is in a position to highlight the receipts and payments of a firm
under various accounting heads within a specified period. Under this system of cash
book, the firm is required to register the payments and receipts of the respective heads
only in the columns especially provided for determining the balance under each at the
end of the specified month.
2.7.4 Petty cash Book

It is a book maintained by the petty cashier who is especially appointed for the purpose
to assist the cashier of the business enterprise in order to meet the day to day expenses
of meager in volume. The cashier normally hands over a certain sum of money to the
petty cashier to meet out tiny expenses of the enterprise based on the early estimation on
the daily requirement e.g., postage, refreshment charges. The meager amount which is 41
Accounting and Finance given by the cashier is known in other words as petty cash or float. The vouchers and
for Managers
receipts are finally examined by the cashier based on the presentation of petty cash
book balance.
Check Your Progress
(1) Subsidiary books are:
(a) Additional records of accounting for future reference
b) To administer only few transactions of the business
(c) Accounting record for the administration of voluminous transactions

(2) Subsidiary books are prepared for:
(a) Cash transactions only
(b) Both cash and Non-cash transactions
(c) Non cash transactions only

(3) Sales book is the record to enter:
(a) Regular credit sale transactions
(b) Regular cash sale transactions
(c) Regular credit and cash sale transactions

(4) The monthly closing balance of purchase book Rs.10,000 to be posted at:
(a) Credit side of the purchase a/c
(b) To be added with the final closing balance
(c) Debit side balance of the purchase a/c

Example 1: The following are extracted information from the books of M/s Brown &
Co. Prepare the trial balance
Particulars Rs Particulars Rs
Sundry Debtors 30,600 Carriage inwards 1,750
Sundry Creditors 10,000 Carriage outwards 1,000
Bills receivable 5,000 Bad debts 950
Plant and machinery 75,000 Bad debts provision 350
Purchases 1,90,000 Office general expenses 1,500
Capital 70,000 Cash at bank 5,300
Free hold premises 50,000 Cash in hand 800
Salaries 21,000 Bills payable 7,000
Wages 24,400 Reserve 20,000
Postage and stationery 1,750 Sales 3,31,700
Closing stock 30,000
The first step is to determine the debit and credit balance of the business transactions in
terms of Expense, Revenue, Assets and Liabilities
42
Trial Balance M/s Brown Trial Balance
Particulars Rs Nature of Particulars Rs Nature of

balance balance
Sundry Debtors 30,600 Debit Carriage inwards 1,750 Debit
Sundry Creditors 10,000 Credit Carriage outwards 1,000 Debit
Bills receivable 5,000 Debit Bad debts 950 Debit
Plant and 75,000 Debit Bad debts provision 350 Credit
machinery
Purchases 1,90,000 Debit Office general expenses 1,500 Debit
Capital 70,000 Credit Cash at bank 5,300 Debit
Freehold premises 50,000 Debit Cash in hand 800 Debit
Salaries 21,000 Debit Bills payable 7,000 Debit
Wages 24,400 Debit Reserve 20,000 Credit
Postage and 1,750 Debit Sales 3,31,700 Credit
stationery
Closing stock 30,000 Debit
Particulars Debit Rs Credit Rs

Sundry Debtors 30,600
Bills receivable 5,000
Plant and machinery 75,000
Sundry Creditors 10,000
Carriage inwards 1,750
Carriage outwards 1,000
Bad debts 950
Bad debts provision 350
Purchases 1,90,000
Capital 70,000
Freehold premises 50,000
Salaries 21,000
Wages 24,400
Postage and stationery 1,750
Office general expenses 1,500
Cash at bank 5,300
Cash in hand 800
Bills payable 7,000
Reserve 20,000
Sales 3,31,700
Total 4,39,050 4,39,050
43
Accounting and Finance Annexure-I
for Managers
Proforma Trial Balance
Debit / Payment Balances Credit / Receipt Balance

Sl. Expenses or Asset A/c Final Sl. Incomes or Liabilities A/c Final
No. A/c No. A/c
Trading Accounting Heads
1. Carriage Inward N TE 1. Sales N TI
2. Carriage N PE 2.
3. Clearing charges- N TE 3.
Import Authority
4. Coal & Coke N TE 4.
5. Energy N TE 5.
6. Factory Expenses N TE 6.
7. Freight charges N TE 7.
8. Fuel & Power N TE 8.
9. Gas & Water N TE 9.
10. Manufacturing N TE 10.
Expense
11. Motive Power N TE 11.
12. Octroi N TE 12.
13. Oil N TE 13.
14. Purchases N TE 14.
15. Purchases N TE 15.
16. Wages N TE 16.
17. Water N TE 17.
18. Return Inward(to be 18.
deducted from Sales)
Profit & Loss Accounting Heads
19. Audit fees N PE 19. Commission received N PI
20. Bad Debt N PE 20. Discount received N PI
21. Advertisement N PE 21. Donation N PI
22. Bank Charges N PE 22. Interest received N PI
23. Clearing charges- N PE 23. Rent received N PI
Cheque
24. Commission Paid N PE 24. Trading profits N PI
25. Depreciation N PE 25.
26. Discount Paid N PE 26.
27. Donation Paid N PE 27.
28. Electricity N PE 28.
29. General Expenses N PE 29.
30. General Expenses N PE 30.
31. Interest on capital N PE 31.
32. Interest N PE 32.
33. Legal charges N PE 33.

34. Lighting charges N PE 34.
35. Miscellaneous expenses N PE 35.
36. Office expenses N PE 36.
37. Packaging charges N PE 37.
38. Printing & Stationery N PE 38.
39. Postage N PE 39.
40. Rent, Rates, Taxes N PE 40.
41. Stable expenses N PE 41.
42. Subscription paid N PE 42.
43. Sundry expenses N PE 43.
44. Travelling expenses N PE 44.
45. Telephone charges N PE 45.
Balance sheet
46. Bank balance P BA 46. Bank loan P BL
47. Bank Deposit P BA 47. Bank overdraft O BL
44 48. Bill Receivable P BA 48. Bills payable P BL
Contd...
49. Cash in deficit P BA 49. Capital P BL Trial Balance
50. Cash in Hand R BA 50. Cash excess P BL
51. Copy right N BA 51. Debentures P BL
52. Deferred Revenue N BA 52. Donation - Building N BL
Expenses
53. Drawings P BL 53. Loan received P BL
Deducted from the
capital
54. Finished goods R BA 54. Loan from Mr Y P BL
55. Fixtures and Fittings R BA 55. Mortgage Loan P BL
56. Furniture R BA 56. Net profit N PL
57. Freehold property R BA 57. Outstanding expenses P BL
58. Goodwill N BA 58. Pre received Income P BL
59. Investment P BA 59. Suppliers P BL
60. Leasehold property R BA 60. Share premium N BL
61. Livestock R BA 61. Suspense receipt P BL
62. Loose Tools R BA 62. Unpaid dividend P BL
63. Outstanding Incomes P BA 63.
64. Patent N BA 64.
65. Petty cash R BA 65.
66. Plant & Machinery R BA 66.
67. Preliminary expenses N BA 67.
68. Prepaid expenese N BA 68.
69. Raw materials N BA 69.
70. Sundry debtors P BA 70.
71. Suspense payment P BA 71.
2.8 LET US SUM UP

Purposes of preparing the Trial Balance include:
To prepare a statement of disclosure of final accounting balances of various ledger
accounts on a particular date.
The classification of the transactions not only on the basis of accounts but also on the basis
of payments and receipts. These payments and receipts classification further segmented
into categories. The subsidiary journals or books are developed by the firms only based on
the occurrence of the transactions. Normally the frequent occurrence of the transactions
of the firm are major formation of the subsidiary books of the accounting system.
The Cash transaction is a transaction carried out only out of cash. The cash transactions
are recorded in the subsidiary book known as cash book. The cash book can be classified
into three categories
l Single columnar cash book
l Double columnar cash book
l Three columnar cash book

Prabhat Kumar is very disturbed. Who says consistent accounting? He asks, Look
at these two statements! Two retailers with identical delivery trucks. I know I sold
them both to these guys less than a week apart. They cost Rs. 6,00,000 and would you
believe it? After one year Kiran Store has depreciated it Rs. 1,00,000. The exclusive
Madams shop took Rs. 2,00,000 depreciation the first year. How can you wear out a
truck hauling around womens clothing so much in one year? It doesnt make sense.
Explain how and why the differences could be justified.
2.10 KEYWORDS
Trial Balance
Subsidiary Journals 45
Accounting and Finance Purchase books
for Managers
Acceptor
Cash Transaction
Double Columnar Cash book
Petty Cash book

1. Write short notes on
(a) Credit balance
(b) Trial Balance
(c) Transaction
(d) Receiver
2. What is the need of having subsidiary Account?
3. What is outward invoice no. meant for?
4. Explain why?
(a) Discount allowed is brought under the debit side
(b) Discount received is brought under the credit side
5. What are the elements of Non cash Transaction?

M.P. Pandikumar, Accounting & Finance for Managers, Excel Books, New Delhi.
R.L. Gupta and Radhaswamy, Advanced Accountancy
Khan and Jain, Management Accounting
S.N.Maheswari, Management Accounting
S. Bhat, Financial Management, Excel Books, New Delhi.
Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi.
46
LESSON
3
FINAL ACCOUNTS
CONTENTS
3.1 Introduction
3.2 Trading Account
3.2.1 Balancing Process
3.3 Profit & Loss Account
3.4 Balance Sheet
3.4.1 Cash Method of Accounting
3.4.2 Mercantile Method of Accounting
3.5 Let us Sum up
3.7 Keywords

In this lesson we shall discuss about final accounts. After going through this lesson you
will be able to:
(i) analyse trading account
(ii) discuss profit and loss account and balance sheet
3.1 INTRODUCTION
The preparation of Final accounts the business firm involves two different stages viz Preparation
of Accounting and Positional Statements of the enterprise. The preparation of Accounting
statements involve two different categories viz Trading account and Profit & Loss account.
The preparation of the positional statement involves only one statement viz Balance
sheet. In this chapter the accounting statements as well as Balance sheet will be elaborately
discussed to the tune of adjustments. First the trading account contents and format are
discussed to determine the Profit and Loss under the trading account of the business
firm, i.e. Gross profit.
Second part of this chapter deals with the preparation of Profit & Loss account in order
to determine the operating profit & loss of the enterprise.
Third part of the chapter involves in the preparation of financial position of the enterprise
in terms of Liabilities and Assets.
3.2 TRADING ACCOUNT

This is first financial statement prepared by the owner of the enterprise to determine the
gross profit during the year through the matching concept of accounting. The gross
Accounting and Finance profit of the enterprise is calculated through the comparison of purchase expenses,
for Managers
manufacturing expenses, and other direct expenses with the sales.
It is prepared normally for one year in accordance with accounting period concept i.e.,
operating cycle of the enterprise which should not exceed 15 months with reference to
the Companies Act 1956.
Dr Trading Account for the year ended . Cr
To Opening Stock XXXX By Cash Sales XXXX
To Cash Purchases XXXX Add Credit Sales XXXX
Add Credit Purchases XXXX By Total Sales XXXX
To Total Purchases XXX Less Sales Return XXX
Less Purchase Return XXX By Net Sales XXXX
To Net Purchases XXXX By Closing Stock XXXX
To Wages XXXX By Gross Loss C/d** XXXX
To Carriage Inward XXXX
To Factory lighting XXXX
To Fuel, Coal, Oil XXXX
To duty on Import of Materials XXXX
To Octroi duty XXXX
To Gross Profit* C/d XXXX
3.2.1 Balancing Process

* Gross profit is the resultant of an excess of the credit side total over the total of debit
side. It means that the gross profit is the excess of incomes in the credit side over the
expenses in the debit side.
Gross Profit = [INCOMES (CREDIT)> EXPENSES(DEBIT)]
** Gross Loss is the outcome of an excess of the debit side total over the total of credit
side. It means that the gross loss is the excess of expenses in the debit side over the
incomes in the credit side.
Gross Loss = [EXPENSES (DEBIT)> INCOMES(CREDIT)]
Illustration 1 with no opening stock and closing stock

Prepare the trading account for M/s Shan &Co Ltd., for the year ended 31st Mar, 2006
Total Purchases during the year Rs. 10, 000
Total Sales during the year Rs. 15, 000
In this problem, the Gross profit is simply found by deducting the sales volume from the
purchases.
Gross profit = Sales Purchases
First step open the Trading account for the year ended 31st Mar, 2006
Solution 1
Trading Account for the ended 31st Mar, 2006
Dr Rs Rs Cr
To Purchases 10,000 To Sales 15,000
To Gross profit c/d 5,000*
Balancing figure(Rs.15,000-Rs.10,000)
*Gross profit Rs. 5, 000 is the resultant of excess income over the expenses.
The total of the credit side more than the debit side total of the trading account.
Illustration 2 with Opening stock, various kinds of purchases and sales, Closing
stock
From the following information, prepare the trading account for the year ended 31st
48 Mar, 2006.
Rs. Final Accounts
Stock on 1st April 2005 (Opening stock) 4, 000

Purchases
i. Cash purchases 20, 000
ii. Credit purchases 50, 000
Sales
i. Cash sales 20, 000
ii. Credit sales 60, 000
Stock on 31st Mar, 2006 (Closing Stock) 6, 000
In this problem, the sales and purchases are given in two different categories viz. cash
and credit. The credit and cash purchases and sales of a firm should be added to
determine the total volume of purchases and sales made during the year.
The purpose of crediting the closing stock in the trading account is to find out the materials
or goods consumed for trading purposes. In order to find out the total amount of goods or
materials consumed during a year, three different components to be separately considered.
l Opening Stock
l Purchases and
l Closing Stock
Opening Stock: It is a stock of goods or raw materials available at the opening of the
accounting period, which is nothing but a closing stock of the yester accounting period
utilized for trading during the current year.
Purchases: Purchase of goods or raw materials is either for resale or manufacturing.
Closing Stock: It is a stock nothing but an outcome of lesser volume of sales than the
aggregate of opening stock and purchases
Material consumed could be calculated
Material consumption=Opening stock + Purchases - Closing stock
The closing stock is credited in the trading account in stead of deducting it directly from
the aggregate of opening stock and purchases during the year. The posting of the closing
stock under the credit side of the trading account not only facilitates the firm to find out
the consumption during the year as well as reduces the cost of goods sold incurred
during the year.
Solution
Trading Account for the year ended 31st Mar, 2006
Dr Rs Rs Cr
To Opening stock 4,000 By Credit sales 20,000
To Credit purchases 20,000 By Cash sales 60,000
To Cash purchases 50,000 By Total sales 80,000
To Total purchases 70,000 By Closing stock 6,000
To Gross profit c/d 12,000
86,000 86,000
By Gross profit B/d 12, 000
Illustration 3
Prepare trading account of M/s Sundar & Sons as on 31st Mar, 2005 from the following
information extracted from the book of accounts
Rs
Opening stock on 1st April 12004 50, 000
49
Purchases
Accounting and Finance Cash 1, 20, 000
for Managers
Credit 1, 00, 000
Sales
Cash 40, 000
Credit 1, 00, 000
Purchase Returns 20, 000
Carriage Inwards 10, 000
Marine insurance on purchase 6, 000
Other direct expenses 4, 000
Sales Returns 30, 000
Stock as on 31st Mar, 2005 10, 000
In this problem, Return out wards and in wards are given in addition to cash and credit
purchases and sales of a firm to find out the Net purchases and the Net sales of the
firm.
Net Sales = Cash Sales + Credit Sales - Sales Returns
Net Purchases = Cash Purchases + Credit Purchases - Purchase Returns
Solution
Trading Account for the year ended 31st Mar, 2005
Dr Rs Rs Cr
To opening stock 50,000 By Cash sales 40,000
To Cash Purchaes 1,20,000 Add:Credit Sales 1,00,000
Add: Credit purchase 1,00,000 By total Sales 1,40,000
To total purchase 2,20,000 Less: Sales Return 30,000
Less: Purchase Return 20,000 By Net Sales 1,10,000
To Net Purchase 2,00,000 By Closing stock 10,000
To carriage Inwards 10,000 By Gross Loss c/d 1,50,000
To Marine Insurance 6,000
To other direct expenses 4,000
2,70,000 2,70,000
To Gross Loss B/d 1, 50, 000

Gross Loss is due to en excess of the debit side total over the credit side total
3.3 PROFIT & LOSS ACCOUNT

It is a second statement of accounting in connection with the earlier to determine the Net
profit/loss of the enterprise out of the early found Gross profit/loss. This is an accounting
statement matches the administrative, selling and distribution expenses with the gross
profit and other incomes of the enterprise.
This is an account prepared for one operating cycle of the firm i.e. 12 months in period.
The transactions are recorded in accordance with golden rules of nominal account. In
the profit & loss account, the expenses and losses are debited and incomes and gains
are credited. The reason for bringing down the gross loss /gross profit of the trading
account into the debit and credit side of Profit & Loss A/c respectively, are only to the
tune of nominal accounting ruling with reference to debit all expenses and losses and
credit all incomes and gains.
The expenses which are matched with the credit total of the profit and loss account.
Classified into various categories
50 i. Administrative Expenses
ii. Selling & Distribution Expenses Final Accounts
iii. Financial Expenses

iv. Legal Expense.
Profit and Loss Account for the year ended..
Dr Rs Rs Cr
To Gross Loss B/d XXXX By Gross Profit B/d XXXX
Balancing figure
Office and Administrative Expenses
To Salaries
To Rent , Rates and Taxes By Rent received
To Office Lighitng
To Printing and Stationery
To Insurance premium
To postage
To General expenses
To miscellaneous expenses
Selling and Distribution Expenses
To Salary to sales staff
To commission charges By commission received
To Advertising expenses
To Carriage outward
To Bad debts
To Packing expenses
Financial Expenses
To interest on capital By interest on drawings
To interest on loans By interest on investments
To trade discount allowed By trade discount received
To cash discount allowed By cash discount received
Maintenance Expenses
To Depreciation on Fixed assets
To Repairs and maintenance of

Productive assets
To loss on sale of assets To profit on sale of assets

Other Expenses
To Provision for debts
To Net profit c/d* By Net loss c/d**
The balancing process of the profit and loss account leads to two different categories
*Net profit is the resultant of excess of income in the credit side over the expenses in
the debit side of the Profit and Loss account
** Net Loss is an outcome of excess of expenses in the debit side over the incomes in
the credit side
Illustration 4
From the following information, Prepare the Profit and Loss account
Debit Credit
Rs Rs
Gross profit from the trading account 1, 00, 000
Manager Salary 30, 000
Office lighting 5, 000
Office Rent 15, 000
Local Taxes 1, 000
Salary paid to salesmen 20, 000 51
Accounting and Finance Commission charges paid 10, 000
for Managers
Legal charges paid 3, 000
Bad debts 1, 500
Advertising charges 25, 000
Package charges 7, 500
Discount allowed 3, 000
Discount received 4, 000
Dividend received 2, 000
Rent received 1, 000
Depreciation charges 10, 000
Repairs and Maintenance 2, 500
Interest on loans 1, 500 500
Dr Profit and Loss account for the year ended Cr
Rs Rs
To Manager Salary 30,000 By Gross profit B/d 1,00,000
To Office lighting 5,000 By Discount received 4,000
To Office Rent 15,000 By Dividend received 2,000
To Salary paid salesman 20,000 By Rent received 1,000
To commission charges 10,000 By Interest received 500
To Legal charges 3,000 By Net Loss c/d* 24,500
To Bad debts 1,500
To Advertising charges 25,000
To Package charges 7,500
To Depreciation charges 10,000
To Repairs and maintenance 2,500
To Interest on loan 1,500
To Local taxes 1000
1,32,000 1,32,000
* Net loss is the excess of the expenses total in the debit side Rs. 24, 500 over the
incomes total in the credit side of the profit and loss account.
3.4 BALANCE SHEET

Balance sheet is the third financial statement which reveals the financial status of the
enterprise through the total amount of resources raised and applied in the form of assets.
This is the fundamental statement of the firm which explores the firm financial stature
through the resources mobilized and investments applied i.e. Liabilities and Assets
respectively. From the early, according to double entry concept or Duality concept, the
balance sheet can be divided into two distinct sides, known as liabilities and assets.
The balance sheet can be disclosed in two different orders
(i) in the order of long lastingness - permanence
(ii) in the order of liquidity
Proforma Balance Sheet as on dated.
(In the order of Long lastingness)
52
Final Accounts
Liabilities Rs Assets Rs
Capital XXXX Land & Building XXXX
Less: Drawings XXX Plant & Machinery XXXX
Add: Net profit XXXX Furniture& fittings XXXX
XXXX Fixtures& tools XXXX
Long-term borrowings XXXX Marketable securities XXXX
Sundry creditor XXX Closing stock XXXX
Bills payable XXX Sundry debtors XXXX
Bank overdraft XXX Bills receivable XXXX
Outstanding expenses XXX Pre paid expenses XXXX
Pre received income XXX Cash at Bank XXXX
Cash in hand XXXX
Total liabilities XXXX Total Assets XXXX
Cash in hand XXXX
Total liabilities XXXX Total Assets XXXX
The downward arrow shows the order / arrangement of the assets and liabilities on the
basis of permanence or long lastingness
The upward arrow shows the order /arrangement of the assets and liabilities on the
basis of liquidity.
Methods of determining the accounting income includes:
i. Cash method of accounting
ii. Mercantile method of accounting
3.4.1 Cash Method of Accounting

Under this method, cash receipts are matched with the cash payments irrespective of
the time period in order to determine the income.
3.4.2 Mercantile Method of Accounting

Under this method, time period is given greater importance than the actual receipts and
payments. It records the receipts and expenses pertaining to the specified period whether
them are actually received /paid or not. The receipts as well as payments of the other
periods should be ignored /eliminated in determining the income of the stipulated duration.
It is popularly known in other words as "Accrual Accounting System".
Next stage is to classify the types of income of the enterprise:
To determine income of the business, what should be in character ? Either in accounting
income or taxable income.
Taxable income can be computed from the transactions of the enterprise but they are
subject to frequent modifications on the tax provisions from one year to another year.
This cannot be uniquely found out unlike the accounting income. The accounting income
should have to be found out only to the tune of accounting principles and concepts.
The process of final accounts diagram is illustrated in the next page for easier
understanding not only to adopt the mercantile system of accounting but also to implement
the duality principle of accounting throughout the transactions.
Check Your Progress
1. Why land and building is given greater priority under the order of permanence?
2. Why cash in hand is given greater priority under the order of liquidity?
Adjustment entries
The adjustment entries are classified into three segments viz on expenses, incomes and others. 53
Accounting and Finance On expenses
for Managers
The adjustment entries on expense can be classified into two categories
(i) Outstanding Expenses: These are incurred expenses but not paid in cash
E.g. Rent of the office is Rs. 22, 000 for 11 months only The enterprise has failed
to remit the payment of last month rent amounted Rs. 2, 000. According to mercantile
system of accounting, the rent of the office, whether fully paid or not, it should be
totally considered for the entire duration to determine the income of the enterprise.
Finally, what is to be done ? The amount of actual rental should be added with the
rent which has not been paid by the enterprise i-e (Rs. 22, 000+Rs. 2, 000=Rs. 24,
000)
Treatment of the transaction
Debit the expense account
Credit the liability i-e of the person to whom the amount to be paid
Profit &Loss A/c:- Add the outstanding amount with the total expenses already paid
Balance sheet:-Include it as an item of responsibility under the liabilities side
(ii) Prepaid expenses: Normally, some of the expenses paid for availing the services
are not fully extracted during the term; which left / unused should be normally
carried forward to the next term. It means that the expense which is paid in
advance to make use of the service for forthcoming period to whom is known as
debtor; the person who keeps the money of the enterprise for the definite duration
is nothing but an asset.
Debit the asset - Advance payment for service
Credit
Profit the expense
&Loss A/c:- Deduct the prepaid amount from the total expenses already paid
Balance sheet:-Include it as an item of application under the assets side
Next major segment in the adjustment entry is on Incomes

l Income Outstanding
l Perceived Income
(iii) Income outstanding: It happens during the enterprise then and there ; which means
income earned but not received. It happens in the case of certain income of dividend
on shares, interest on loans granted not yet received. The income earned but not
received is also an income that should be credited in the income account to know
the total volume of the income pertaining to the accounting period. The income
earned but not received is nothing but an asset not yet received. The income not
yet received from whom should be debited as an asset due to the enterprises'
money income with the other person / institution.
Profit &Loss A/c:- Add the income outstanding amount to the total incomes already received
Balance sheet:-Include it as an item of unrealized income under the assets side i.e the firms money
with the others
(iv) Income received in advance: Any income received in advance cannot be considered
as an income which should be calculated and deducted from the total income
received; known as advance receipt. It is the income of the other period; should be
eliminated from the income received in accordance with the mercantilist accounting
system in determining the income. The income which is received in advance
pertaining to the period of non rendered service should removed from the total
income received, in order to determine the original income of the period should be
known exactly. The amount received in advance of non rendered service is the
54
responsibility to return nothing but the liability of the firm.
Debit the Income account Final Accounts
Credit the Income received in advance - Liability of the balance sheet

Profit &Loss A/c:- Deduct the Income received in advance from the total incomes which were
already received.
Balance sheet:-Include it as an item of responsibility for non rendered service under the liabilities
side
(v) Bad debts: Bad debts is the result of credit sales which only due to the inability of
customers / consumers to settle the overdue. The inability may be due to poor
repaying capacity or insolvent during the moment of the sales. The bad debt due to
the inability cannot be deducted from the sales volume which was already transacted.
The debts cannot be recovered has to be treated as a loss of the firm.
Debit all losses of the firm. The losses due to bad debts should be appropriately
effected as well as adjusted in the individuals' account i-e in the consumers' account
who received the goods on credit
Profit &Loss A/c:- Non recovery of credit sales is deemed to be a losses should be debited to
Profit & Loss A/c
Balance sheet:-Non recovery of credit sales should be deducted from the volume of credit sales
transacted by the firm under the Assets side in order to determine the original amount of credit
outstanding
Check Your Progress
1. If the closing stock is given, the effect of the entry is

(a) Profit & Loss A/c Credit Balance Sheet- Liabilities
(b) Profit & Loss A/c-Debit Balance Sheet- Liabilities
(c) Trading A/c- Credit Balance Sheet-Assets
(d) Trading A/c- Debit Profit & Loss A/c- Credit

2. The income received in advance is
(a) Asset of the enterprise
(b) Income of the enterprise
(c) Liability of the enterprise
(d) Expense of the enterprise

3. The depreciation charge is only to the tune of
(a) Convention of consistency
(b) Time period concept
(c) Business entity concept
(d) Convention of conservatism

4. The value of the asset shown in the balance sheet is
(a) Book Value
(b) Market value
(c) Realisable value
(d) Original value

5. Rent paid in advance is to be effected 55
Contd...
Accounting and Finance (a) Deduct the amount from the Original rent paid P&L A/c
for Managers
(b) Include the rent paid in advance as an item of current asset- Balance sheet
(c) Deduct the rent paid in advance in the Trading A/c
(d) Both (a) & (b)
Illustration 5
From the following information extracted from the books of Jain & Co, Prepare Trading,
Profit & Loss A/c for the year ended and Balance sheet as on that date.
Purchase 90,300
Sales 1,37,200
Return inward 2,200
Stock 1.1.96 40,000
Drawing 5,000
Building 30,000
Machinery 20,000
Furniture 8,000
Debtors 25,000
Wages 3,000
Rent and Rates 1,500
Bad debts 1,000
Cash 3,500
Investment 10,000
Postages 2,500
Insurance 2,000
Return outwards 1,300
Capital 50,000
Creditors 24,000
Interest 500
Commission 3,250
Provision Bad debts 750
Bank O/d 40,000
Salaries 11,000
Total 2,57,000 2,57,000
Additional Information:
1. Value of the stock on 31. 12. 96 Rs. 65, 000
2. Goods worth Rs 800 for his personal use of the proprietor
3. Rs. 400 of insurance paid is nothing but advance payment
4. Salary Rs. 1000 for the month of Dec 1996 has not yet paid outstanding
5. Charge depreciation
a. Building 2% per annum
b. Machinery 10% per annum
c. Furniture 15% per annum
6. Maintain provision for doubtful debts @ 5% on sundry debtors. Prepare Trading
and Profit & Loss Account of Jain & Co for the year ended 1995-96
Dr Rs Rs Rs Rs Cr
To Opening stock 40,000 By Sales 1,37,200
To Purchases 90,300 (-) Return Inward 2,200
(-)Purchase Return 1,300 1,35,000
(-) Goods taken by 800 By Closing Stock 65,000
56 proprietor
Contd...
To Net purchases 88,200 Final Accounts
To Wages 3,000
To Carriageinward 2,000
To Gross Profit c/d 66,800
(Balancing figure)
2,00,000 2,00,000
To Rent & Rates 1,500 By Gross profit B/d 66,800
To Bad Debts 1000 By Commission 3,250
To Postages 2,500 By Interest 500
To Insurance 2,000
(-) Prepaid 400
1,600
To Salaries 11,000
(+)O/s of Salary 1,000
12,000
To New Provision 5% 1,250
on Sundry Debtors-
Rs.25,000
(-)Old Provision 750
500
To Depreciation
Building 2% 600
Machinery 10% 2,000
Furniture15% 1,200 3,800
To Net profit c/d 47,650
(Balancing figure)
70,550 70,550
Balance Sheet as on 31st Dec, 1996

Liabilities Rs Rs Assets Rs Rs
Capital 50,000 Building 30,000
(+)Net Profit 47,650 (-)Depreciation 2% 600
transferred from
P&L Account
(-)Drawings 29,400
Cash + Goods 5,800
Rs5000+Rs.800
91,850 Machinery 20,000
Bank OD 40,000 (-)Depreciation 10% 2,000
Creditors 24,000 18,000
Salary O/s 1,000 Furniture 8,000
(-)Depreciation 15% 1,200
6,800
Debtors 25,000
(-)Provision 1,250
23,750
Investment 10,000
Prepaid Insurance 400
Cash in hand 3,500
1,56,850 1,56,850
Illustration 6
From the following information drawn from the books of M/s Sundaran & Co prepare
Trading, Profit & Loss account for the year ended 31st Mar, 2004 and Balance sheet as
on dated
Particulars Debit (Rs.) Credit (Rs.)
Sundarans Capital 1,81,000
Sundarans Drawings 36,000
Plant and Machinery Balance on 1st April 2003 1,20,000
Plant and machinery additions on 1st Oct,2003 25,000
Stock opening 95,000
Purchases 7,82,000
Return Inwards 12,000 57
Contd...
Accounting and Finance Sundry debtors 20,600
for Managers Furniture & Fixture 15,000
Freight duty 2,000
Rent Rate and Taxes 24,600
Printing stationery 3,800
Trade expenses 5,400
Sales 9,80,000
Return outwards 3,000
Postage & Telegsundaram 800
Provision for bad debts 400
Discounts 1,800
7,200
Rent of the premises sub let for the year upto 30th Sept2004
Insurance charge 2,700
Salaries & wages 31,300
Cash in hand 6,200
Cash at bank 30,500
Carriage outwards 500
Total 12,13,400 12,13,400
Additional Information
1. Stock on 31st Mar, 2004 Rs. 94, 600
2. Write off Rs. 600 as bad debts
3. Provision for doubtful debts 5%on debtors
4. Create a provision on for discount on debtors & Reserve for creditors 2%
5. Provide a depreciation on furniture and fixture at 5% per @
6. Plant machinery depreciation 20%
7. Insurance unexpired Rs. 100
8. A fire occurred on 25th Mar 2004 in God own and the stock of the value of the 5000
destroyed fully insured the insurance admitted claim fully yet to be paid.
Trading account M/s. Sundaran &Co for the year ended 2003-04
Dr Rs Rs Rs Rs Cr
To opening stock 95,000 By sales 9,80,000
To Purchase 7,82,000 (-) Return 12,000 9,68,000
(-)Returns 3000 Closing stock 94,600
To Net purchases 7,79,000 Goods 5,000
destroyed by
fire
Freight Duty 2,000
To Gross Profitc/d 1,91,600
10,67,600 10,67,600
Profit & Loss Account of M/s. Sundaran &Co for the year ended 2003-04
Dr Rs Rs Rs Rs Cr
To Carriage Outwards By Gross profit B/d 1,91,600
500 Transferred from trading
account
To rent, rate and taxes 24,600 By discount 1,800
To painting & 3,800 By Rent of Sublet 7,200
stationery
Trade expenses 5,400 (-) Advance receipt rent of 3,600
sublet for 6 months:7,200/12
monts= Rs.600 P.M
For 6 months
Postage and telegram 800 3,600
Insurance charge 2,700 By 2% reserve on sundry 800
58 creditors
Contd...
(-) unexpired 100 Final Accounts
2,600
Salaries and wages 31,300
ToDepreciation 750
Furniture and Fixture
@5% on Rs.15,000
1st April 2003@20%
on Rs.1,20,000 (12
months)
1st Oct,2003 @20% on
Rs.25,000(6 months)
26,500
To Bad debts write off 600
To New provision 1000
(-)Old provision 400
To provision to be 600
created
To discount on debtors 380
2%
To Net profit c/d 99,970
Transferred to Balance
sheet
1,97,800 1,97,800
Balance sheet of M/s. Sundaran &Co as on dated 31st Mar, 2004

Rs Rs Rs Rs
Liabilities Assets
Capital 1,81,000 Furniture & fixture 15,000
(+)Net profit 99,970 Depreciation @ 5% 750
(-)Drawings 36,000 14,250
2,44,970 Plant Machinery 1,20,000
Sundry creditors 40,000 Depreciation 24,000 96,000

@ 20%
(-)2% Reserve 800 Plant Machinery 25,000
39,200 Depreciation @20% 2,500
for 6 months
Pre received rental 3,600 22,500
income
Insurance unexpired 100
Sundry debtors 18,620
Goods fire insurance 5,000
Cash at bank 30,500
Cash in hand 6,200
2,87,770 2,87,770
Illustration 7
From the following figures extracted from the books of M/s Amal &Vimal 31st Mar, 02
Particulars Debit(Rs) Credit (Rs)
Opening stock 30,000
Purchases 1,10,000
Sales 2,50,000
Building 55,000
Wages 23,000
Bills payable 10,000
Furniture 9000
Salaries 42,000
59
Advertisement 24,000
Contd...
Accounting and Finance Coal and coke 2,000
for Managers Cash at bank 14,000
Pre paid wages 1,000
Depreciation fund investment 25,000
Machinery at cost(Rs.10,000 New) 60,000
Bad debts 3,000
Depreciation fund 25,000
Rent rate and taxes 4,000
Trade expense 4000
Capital Amal 50,000
Vimal 40,000
Petty expenses 4,000
Provision for doubtful debts 1,000
Gas and water 1,200
Cash in hand 800
Outstanding rent 400
Bank loan 34,600

4,35,000 4,35,000
Adjustment entries:
a. The partners share profit and losses Amal 2/5 and Vimal 3/5
b. closing stock Rs. 15, 000
c. stock valued at Rs. 10, 000 was destroyed by fire but insurance company admitted
a claim of 8, 500 only and the claim is not yet paid.
d. Wages include Rs. 2, 000 for installation of anew machinery on 1st Dec., 2005
e. Depreciate the machinery at 10% per annum
Trading account of M/sVimal & Amal & Co for the year ended 2001-02
Dr Rs Rs Rs Rs Cr
To opening stock 30,000 By sales 2,50,000
To purchases 1,10,000 By closing stock 15,000
To wages 23,000 By goods destroyed 10,000
(-)Erection 2,000
21,000
To Coal and coke 2,000
To Gas and water 1,200
To Carriage inwards 3,000
To Gross profitc/d 1,07,800
2,75,000 2,75,000
Profit & Loss account of M/s Vimal& Amal &Co for the year ended 2001-02
Dr Rs Rs Rs Rs Cr
To Salaries 42,000 By Gross 1,07,800
profitB/d
To Advertisement 24,000
To Bad debts 3,000
To Trade expenses 4,000
To Rent, rates & Taxes 4,000
To Depreciation(d) 5,400
To Insurance Loss 10,000
Admitted claim 8,500
1,500
To petty expenses 4,000
To Net profit l
Amal 7,960
Vimal 11,940
19,900
60 Total 1,07,800 Total 1,07,800
Balance sheet of M/s Vimal & Amal &Co as on dated 31st Mar, 2002 Final Accounts
Liabilities Rs .Rs Assets Rs Rs

Capital Amal 50,000 Depreciation 25,000
investment
(+) Net profit 7,960 Plant and Machinery 62,000
57,960 (-) Depreciation 5,400
Capital Vimal 40,000 56,600
(+) Net profit 11,940 Furniture 9,000
51,940 Building 55,000
Depreciation fund 25,000 Sundry debtors 20,000
Bank loan 34,600 Provision for bad 1000
debts
Sundry creditors 24,000 19,000
Out standing 8,500
Insurance claim
Outstanding rent 400 Pre paid wages 1000
Bills payable 10,000 Cash at bank 14,000
Cash in hand 800
2,03,900 2,03,900
SS Jain Bros for the year ended 31st Dec., 2003

Capital 6,00,000
Drawings 12,000
Buildings 2,00,000
Furniture and fittings 30,000
Depreciation on Reserve
Buildings 10,000
Furniture 3,000
Depreciation for the year 13,000
Purchases 4,00,000
Sales 5,00,000
Debtors 1,20,000
Establishment charges 20,000
Electricity charges 6,575
Postage and telegram 1,284
Travelling and conveyance 3,816
Advance for sales commission 1,000
Insurance 2,500
Rent received 12,000
Motor van (purchased 1.1.03) 80,000
Motor van maintenance 23,425
Fixed deposit (1.9.2003) 1,00,000
Cash in hand 1,823
Cash at bank 1,47,977
Due to the difference in the trial balance, an examination of the goods was conducted
which reveals following errors.
Rs. 25 paid to the conveyance was debited to motor van maintenance account
Rs. 2, 000 drawn from bank towards for establishment charges was omitted to posted in
to ledger.
Cash column in the cash book on the receipt side stands excess total by Rs. 400
Adjustment entries:
a. Establishment of charges have been paid only up to Nov & provision of Rs 2, 000
61
has to be made for Dec.
Accounting and Finance b. Electricity charges are O/s Rs. 25
for Managers
c. () commission on total sales is payable to salesmen, towards which Rs. 1000 as
paid in advance.
d. Fixed deposit earns interest at 9% per annum
e. Provide depreciation 20% per annum on motor car
f. Closing stock 31st Dec., 2003
To prepare the trial balance, the following necessary corrections should be made on the
respective accounting heads given.
I. Rs. 25 paid to the conveyance was debited to motor van maintenance account-
The errors to be rectified which is known as error without affecting the trial balance.
Rs. 25 should be deducted from the Motor maintenance account for the wrong
entry debited already but at the same time right entry has to be made under the
conveyance account through the addition of Rs. 25 i.e., Rs. 25 to be debited.
To put it in to nutshell, Rs 25 should be deducted from the total of Motor maintenance
account in order to cancel the wrong debit entry i.e.
Rs. 23, 425-Rs. 25=Rs. 23, 400
To effect the correct entry, Rs. 25 should be to the original conveyance account
i.e.
Rs. 3, 816+Rs. 25= Rs. 3, 841/-
II. Rs. 2, 000 was drawn from the bank omitted in the establishment charges account;
which is meant for the purpose. -
Rs. 2, 000 should be added to the establishment charges account total in order to
identify the total of establishment charges.
Total establishment charges = Rs. 22, 000+ Rs. 2000= Rs. 24, 000
III. Cash column in the cash book on the receipt side excess total Rs. 400 i.e. Rs. 400
excess total should corrected on the given balance of cash in hand in order to
determine the real volume of cash in hand.
Real volume of cash in hand = Rs. 1, 823-Rs. 400 = Rs, 1423
Now we have to illustrate the corrected trial balance by incorporating the above
given changes.
Particulars Trial Balance Debit Rs Credit Rs
Capital 6,00,000
Drawings 12,000
Buildings 2,00,000
Furniture & Fittings 30,000
Depreciation Reserve 13,000
Purchases 4,00,000
Sales 5,00,000
Debtors 1,20,000
Establishment charges Rs.20,000 22,000
Electricity charges 6,575
Postage & telegram 1,284
Traveling& Conveyance 3,841
Advance for salesmen commission 1,000
Insurance 2,500
62 Rent received 12,000
Contd...
Motor van (purchased 1.1.2003 80,000 Final Accounts
Motor van maintenance 23,400
Fixed deposit 1,00,000
Cash in hand 1,423
Cash at bank 1,47,977
Depreciation 13,000
Total 11,65,000 11,65,000
Dr Trading account for the year ended 31st Dec, 2003 Cr
Rs Rs Rs Rs
To Purchases 4,00,000 By Sales 5,00,000

By Closing stock 1,00,000
To Gross profit c/d 2,00,000
6,00,000 6,00,000
Profit & Loss account for the year ended 31st Dec, 2003
To Insurance 2,500 By Gross 2,00,000
profitB/d
To motor 23,400 By Rent received 12,000
maintenance
To establishment 22,000 Interest received 3,000
charge
Dec provision 2,000
24,000
To Traveling & 3,841
conveyance
To Postage and 1,284
telegram
To electricity charges 6,575
O/s E.B charges 25
6,600
To depreciation 13,000
To sales commission 1,000
paid
To commission O/s 1,500
2,500
To Depreciation of 16,000
motor van @ 20%
To Net profit c/d 1,21,875
2,15,000 2,15,000
Balance sheet as on dated 31st Dec, 2003
Liablities Rs Rs Assets Rs Rs
Capital 6,00,000 Cash in hand 1,423
(+)Net profit 1,21,875 Cash at bank 1,47,977
7,21,875 Fixed Deposit 1,00,000
(-)Drawings 12,000 Interest 3,000
7,09,875 Motor van 64,000
Sundry creditors 40,000 Sundry debtors 1,20,000
Provision for 2,000 Building 2,00,000
establishment
charges
Electrical charges 25 (-)Reserve 10,000 1,90,000
O/s Commission 1,500 Furniture 30,000
(-) Reserve 3,000 27,000
Closing stock 1,00,000
7,53,400 7,53,400
63
Accounting and Finance Pandit Broths for the year ended 31st Mar, 2006
for Managers
Capital A.Pandit 1,00,000
B.Pandit 1,00,000
Drawings A Pandit 16,000
B.Pandit 16,000
Buildings 80,000
Furniture & fittings 20,000
Purchases 2,00,000
Sales 3,00,000
Stock 1.4.2005 50,000
Wages & salaries 44,000
Rates & Taxes 1,600
Office expenses 60,000
Cash in hand 400
Cash at Bank O/D 29,000
Freight inwards 28,000
Total 5,41,000 5,41,000
Adjustment:
a. Closing stock Rs. 1, 14, 500
b. There was fire in the premises on 25th Nov, 2005, which damaged the portion of
the stock the loss was estimated Rs. 17, 500
c. A. Pandit is the in-charge of purchases of stock item & he is to be paid 2. 5% on
such purchases
d. A steel table purchased 1st Feb Rs. 3, 000 debited to purchase account
e. B. Pandit who looks after all aspect other than purchases is entitled to the
commission of 5% on Net profits of after charging commission
f. Depreciation is to be charged at 2. 5% per annum on building & 10% on furniture
fittings profits or losses or share equally for the partners.
Dr Trading account for the year ended 2005-06 Cr
Rs Rs Rs Rs
To Opening Stock 50,000 By Sales 3,00,000
Purchases 2,00,000 By Closing stock 1,14,500
(-)Purchase of table 3,000 By Goods Loss by fire 17,500
1,97,000
(+)Commission to 4,925
A.Pandit
2,01,925
To Carriage inwards 28,000
To Wages & Salary 44,000
To Gross profit 1,08,075
c/ d
Total 4,32,000 Total. 4,32,000
Dr Profit & Loss account for the ended 2005-06 Cr

To Rates & Taxes 1,600 By Gross profitB/d 1,08,075
To office expenses 60,000
To Depreciation Building 2,000
To Depreciation
Existing Furniture 2,000
64 20,00010/100
Contd...
New Furniture Final Accounts
300010/1002/12 50
2050
To Loss on fire 17,500
To commission B.Pandit 1187
To Net profit C/d
A.Pandit 11,869
B.Pandit 11,869 23,738
1,08,075 1,08,075
Balance sheet as on dated 31st Mar, 2006
Liabilities Assets
Capital(A.Pandit) 1,00,000 Building 80,0000
(+) Commission 4,925 Depreciation 2.5% 2,000
1,04,925 78,000
(+)Net profit 11,869 Furniture 23,000
1,16,794 Depreciation 10% 2,050
(-)Drawings 16,000 20,950
1,00,794 Closing stock 1,14,500
Capital( B.Pandit) 1,00,000 Sundry Debtors 25,000
(+)Commission 1,187 Cash in hand 400
1,01,187
(+) Net profit 11,869
1,13,056
(-)Drawings 16,000 97,056
Bank overdraft 29,000
2,38,850 2,38,850
3.5 LET US SUM UP

Trading Account is first financial statement prepared by the owner of the enterprise to
determine the gross profit during the year through the matching concept of accounting.
The purpose of crediting the closing stock in the trading account is to find out the materials
or goods consumed for trading purposes. In order to find out the total amount of goods or
materials consumed during a year, three different components to be separately considered.
l Opening stock
l Purchases and
l Closing Stock
Profit & Loss Account is a second statement of accounting in connection with the earlier
to determine the Net profit/loss of the enterprise out of the early found Gross profit/loss.
Balance sheet is the third financial statement which reveals the financial status of the
enterprise through the total amount of resources raised and applied in the form of assets.

If it is uncertain whether an expenditure will benefit one or more than one accounting
period, or whether it will increase the capacity or useful life of an operational asset, most
firms will expense rather than capitalise the expenditure. Why?
3.7 KEYWORDS
Trading account: It is the accounting statement of revenues and expenses 65
Accounting and Finance Balance Sheet: It is nothing but a positional statement of assets and liabilities of the firm
for Managers
on a particular date
G. P- Gross profit: Resultant of excess of trading incomes over the expenses
G. L-Gross Loss: Resultant of excess of trading expenses over the incomes/ revenues
N. P- Net profit: Resultant of excess of Profit & Loss incomes /revenues over the
expenses
N. L-Net Loss: Resultant of excess of Profit & Loss expenses over the incomes

1. Illustrate the interrelationship in between the accounting statements and statement
of position.
2. Highlight the effect of the following entries in the
(a) Closing stock
(b) Interest received in advance
(c) Rent outstanding
3. Explain the various accounting concepts and conventions through additional
information or adjustments.
4. Illustrate various kinds of drawing and their treatment in the financial statements.

M. P Pandikumar Accounting & Finance for Managers, Excel Books, New Delhi.
R. L. Gupta and Radhaswamy, Advanced Accountancy
V. K. Goyal, Financial Accounting, Excel Books, New Delhi.
S. N. Maheswari, Management Accounting
I. M. Pandey, Financial Management, Vikas Publishing, New Delhi.
66
CHAPTER
4
DEPRECIATION ACCOUNTING
CONTENTS
4.1 Introduction
4.2 Meaning of Depreciation
4.3 Reasons and Aims of Depreciation
4.3.1 Reasons for Depreciating
4.3.2 Aims of Charging Depreciation
4.4 Methods for Charging Depreciation
4.4.1 Straight Line Method
4.5 Diminishing Balance/Written Down Value Method
4.6 Dissimilarities in between the Straight Line Method and Written Down Value Method
4.7 Let us Sum up
4.9 Keywords

In this lesson we shall discuss about depreciation accounting. After studying this lesson
(i) discuss meaning of depreciation
(ii) analyse reasons and aims of depreciation
(iii) understand methods for charging depreciation
4.1 INTRODUCTION
The depreciation accounting is mainly based on the concept of income. The concept of
income is matching of revenues with expenses. The goods purchased are frequently
matched through immediate sale or within a year. The crux of the concept of income is
that the expenses are to be matched against the revenues. The ultimate aim of matching
is done in order to determine the volume of profit or loss of the transaction. If the assets
are nothing but long term assets procured by the enterprise should be matched against
Accounting and Finance the revenues of them. The matching of expenditure of the assets incurred by the firm at
for Managers
the time of purchase against the revenues is the hard core task of the firm. Why it is
being considered as a cumbersome task in matching ? The benefits/revenues of the
fixed assets expected to accrue for many number of years but not within a year. The
initial investment on the assets at the time of purchase should be matched against the
revenue pattern of the same year after year in order to find out the profitability of the
long term investment. To have an effective matching against the revenues on every
year, the amount of purchase has to be stretched. The stretching of expenses into many
years is known as depreciation.
4.2 MEANING OF DEPRECIATION

It is a matching in between the fixed charge expense against the current years revenue.
The remaining /left which is unrecovered portion should be carried forward to forthcoming
years in order to match against the respective revenues
What is the ultimate of the purpose of the depreciation?
The ultimate purpose of the depreciation is to replace the fixed assets only at the moment
of becoming useless through the current revenues.
According to Dickens, depreciation is the permanent and continuous diminution in
the quality /quantity / value of the asset.
In simple words to understand the terminology depreciation is the permanent decrease in
the value of the fixed assets.
4.3 REASONS AND AIMS OF DEPRECIATION
4.3.1 Reasons for Depreciation

(1) Wear and Tear of the Asset: The long term assets are becoming less efficient and
poor quality in operations due to the continuous usage of the asset.
(2) Exhaustion: Nothing will be remaining due to the continuous extraction of
resources. The resources in the oil wells, mine fields will become nothing due to
continuous extraction should be replaced by new exploration. To invest on the new
exploration in order to have continuous exploration which requires the depreciation
as a charge against the revenues of the fields.
Example, Oil & Natural Gas Corporation Ltd. (ONGC) indulges in the process of
new oil exploration projects through research projects. Then the new projects should
be identified and invested by huge initial investment outlay through the current
revenues out of the existing projects on account of replacement due to depletion of
resources..
(3) To Face Technological Obsolescence: To replace the old machinery with new
machinery before the expiry of the economic life period of the asset in order to
maintain the efficiency and economy of the asset. The type writer was replaced by
the electronic typewriter during the yester periods of office automation. To replace
the old type writer which is not efficient as well as economical, should be replaced
by the new electronic typewriter through the depreciation charge on the old one.
(4) Accident: The value of the asset mainly depends upon the efficiency and economy;
68
which gets affected due to the accident.
4.3.2 Aims of Charging Depreciation Depreciation Accounting
l To recover the cost: The depreciation charge is a mean to recover the cost of
operations of the enterprise. More specifically to recover the cost of asset procured
which is in usage.
l To facilitate the induction of new asset: To replace the old one, the new asset has
to be purchased only with the help of depreciation charge
l To find out the correct P&L accounting balance
l To know the original position of the enterprise through proper adjustments on the
fixed assets
Check Your Progress
(1) Depreciation is
(a) Capital expenditure (b) Revenue expenditure
(c) Expense (d) Non recurring expenditure
(2) Depreciation accounting facilitates to know
(a) Original value of the asset (b) Realisable value of the asset
(c) Book value of the asset (d) Both (a) & (c)
(3) Depreciation is an item to be recorded finally in the
(a) Trading account (b) Profit & Loss account
(c) Balance sheet (d) Profit & Loss A/c and
Balance Sheet
4.4 METHODS FOR CHARGING DEPRECIATION

There are various methods of depreciation:
1. Straight line method
2. Depletion or Output method
3. Machine hour rate method
4. Diminishing Balance or Written down method
5. Sum of digits method
6. Annuity method
7. Sinking fund method
8. Insurance policy method
Among the above mentioned methods, Straight line method and Diminishing balance or
written down method are more important methods. These two methods are preferable
and renowned methods among the industrialists in charging the depreciation on the fixed
assets. The first method is as follows
4.4.1 Straight Line Method

This method, depreciation is calculated as a fixed proportion on the original value of the
asset. The depreciation is charged as fixed in volume on the original value of the asset
at which it was purchased. The original value of the asset is nothing but the purchase
value of the asset.
69
Accounting and Finance Illustration 1
for Managers
I. Cost of Machine Rs. 1, 00, 000
Estimated life of the machine 5 years
Scrap value-Nil
Cost of the machine - Scrap value
Depreciation =
Economic Life period of the asset in years
According to the concept of depreciation, the value of the asset is dispersed throughout
the life of the period in order to match against the respective earnings of the year after
year The purchase value of the asset is an expenditure to be stretched to many number
of years in order to equate with the revenues. To equate the revenues, the scrap value of
the asset at the end of the life period is realized should be deducted and apportioned to
the total number of the economic life period of the asset. The aim of deducting the scrap
value of the asset is reducing the original value of the investment
Rs. 1, 00, 000

Deprecation = = Rs. 20, 000
5
To understand the above calculation, the following table is most inevitable
Value of the asset (Begin) Rs Depreciation Rs Value of the asset End Rs
Col.1 Col.2 Col 3=Col.1-Col.2
st
1 year .1,00,000 20,000 80,000
2nd year-.80,000 20,000 60,000
3rd year-.60,000 20,000 40,000

th
4 year-.40,000 20,000 20,000
5th year-.20,000 20,000 0
From the above table, Rs. 20, 000 is charged on every year to recover Rs. 1, 00, 000
during its life period i.e. 5 years
Illustration 2
Original value of the investment- Rs. 1, 00, 000
Scrap value Rs. 10, 000
Life of the asset -5 years
Rs. 1,00,000 - Rs.10,000 Rs. 90.000

Deprecation = = = Rs. 18.000
5 year 5 year
To understand the methodology of straight line depreciation, the following table will illustrate
the process
Value of the asset (Begin) Rs Depreciation Rs Value of the asset End Rs
st
1 year .1,00,000 18,0000 .82,000
nd
2 year-.82,000 18,0000 .64,000
3rd year-.64,000 18,0000 46,000

th
4 year-.46,000 18,0000 28000
5th year-.28,000 18,0000 10,000(Scrap value )*

70
l The scrap value of the asset is expected to realize only at the end of the life period Depreciation Accounting
of the asset i.e. 5 years.
Illustration 3
Mr. Shankar purchased machine for Rs. 90, 000 on 1st April 1999. It probable working
life was estimated at 5 years and its probable scrap value at the end of that time is Rs.
10, 000. You are required to prepare necessary account based on straight
line method of depreciation for five years
To prepare the various accounts of the enterprise connected to depreciation is as follows
The depreciation charge process is carried out in three stages

l The asset to be initially purchased- Purchase entry has to be carried out. How the
purchase is made ? While making the purchase there are two different accounts
get affected which are normally known as real accounts. At the moment of purchase
on one side the asset is coming inside the firm ; on the other side the cash resources
are depleted due to the payment of purchase bill of the asset.
Dr. Rs Cr. Rs
1 April,1999 Plant & Machinery A/c 90,000
To Cash A/c 90,000
Being plant & machinery purchased
l The next account involved in the process of accounting is depreciation account.

Before transacting the depreciation entry in the books of accounts, we must find
the amount of depreciation to be charged against on every years revenue.
l The amount of depreciation is to be calculated as follows:
Original value of the asset - Scrap value

Deprecation =
Estimated life of the asset in years
Rs. 90,000 -10,000
= = Rs. 16,000
5 year
l Depreciation is a fixed charge to be calculated on the value of the asset on every

year and deducted from the original value. Depreciation is nothing but charged as
an expenditure against the revenues in accordance with the matching concept.
Hence the depreciation non recurring expenditure account and the plant &
machinery account should be debited and credited respectively
l For the accounting entry I year depreciation Rs Rs
31st March, 2000 Depreciation A/c Dr 16,000
To Plant Machinery A/c Cr 16,000
Being the first year depreciation is charged
l For the accounting entry II year depreciation Rs Rs

st
31 March, 2001 Depreciation A/c Dr 16,000
To Plant Machinery A/cCr 16,000
Being the second year depreciation is charged
71
Accounting and Finance l For the accounting entry III year depreciation Rs Rs
for Managers
Being the Third year depreciation is charged
l For the accounting entry IV year depreciation Rs Rs

st
31 March, 2003 Depreciation A/c Dr 16,000
Being the fourth year depreciation is charged
l For the accounting entry V year depreciation Rs Rs

Being the fifth year depreciation is charged
l The next account involved is the scrap value account which amounted Rs 10, 000
While selling the residual portion of the asset, the firm is able to receive Rs. 10, 000
as receipt as cash. The sale of residual part of the machinery leads to bring cash
resources inside the firm and inturn the plant and machinery is going out of the
firm.
l For the accounting entry of scrap value Rs Rs
31st March, 2004 Cash A/c Dr 10,000
Being the residual part of the machinery is sold
l The next transaction is the final transaction pertaining to the posting of depreciation
accounting balance under the P& L account
l It is nothing but the transfer of Depreciation accounting balance into P&L account
At the end of every year immediately after finalizing the accounting balance of
depreciation is regularly posted under the P&L account.
l The journal entry transfer is carried out as follows
l For the I year depreciation transfer to P&L A/c Rs Rs
st
31 March, 2000 P&L A/c Dr 16,000
To Depreciation A/c Cr 16,000
Being the first year depreciation is transferred to P&L A/c
l For the II year depreciation transfer to P&L A/c Rs Rs

31st March, 2001 P&L A/c Dr 16,000
72 Being the second year depreciation is transferred to P&L A/c

l For the III year depreciation transfer to P&L A/c Rs Rs Depreciation Accounting
31st March, 2002 P&L A/c Dr 16,000
Being the third year depreciation is transferred to P&L A/c
l For the IV year depreciation transfer to P&L A/c Rs Rs

st
31 March, 2003 P&L A/c Dr 16,000
Being the fourth year depreciation is transferred to P&L A/c
l For the V year depreciation transfer to P&L A/c Rs Rs

st
31 March, 2004 P&L A/c Dr 16,000
Being the fifth year depreciation is transferred to P&L A/c
The preparation of Plant & Machinery account : It is very simple to prepare the machinery
Ledger account
Dr Plant & Machinery I Yr Cr
1 April,1999 To Cash A/c 90,000 31 st By Depreciation 16,000

Mar,2000
By Balance c/d
transferred to
Second year Plant & Machinery
A/C 74,000
90,000 90,000
To Balance B/d 74, 000

Dr Plant & Machinery A/c II Yr Cr

st
1 April,2000 To Balance B/d 74,000 31 By Depreciation 16,000
Mar,2001
(transferred from I Yr
Plant & Machinery) By Balance c/d
transferred to
III Yr Plant & Machinery A/C
58,000
74,000 74,000
73
Accounting and Finance Dr Plant & Machinery A/c III Yr Cr
for Managers
1 April, To Balance B/d 58,000 31st By Depreciation 16,000

Mar,2002
2001 (transferred from II Yr Plant &
Machinery)
By Balance c/d
(transferred to IV Yr
Plant &
Machinery A/C) 42,000
58,000 58,000
Dr Plant & Machinery A/c IV Yr Cr

1 April, To Balance B/d 42,000 31st By Depreciation 16,000
2002 (transferred from III Yr Mar,2003
Plant & Machinery) By Balance c/d
(transferred to V Yr
Plant &
Machinery A/C) 26,000
42,000 42,000
Dr Plant & Machinery A/c VYr Cr
1st April, To Balance B/d 26,000 31st By Depreciation 16,000

Mar,2004
2003 (transferred from IV Yr Plant &
Machinery)
By Cash 10,000
26,000 26,000
The next ledger account to be prepared is Depreciation A/c

Depreciation A/c
Date Particulars Amount Rs Date Particulars Amount Rs
31st To Plant & 16,000 31st By P& L A/c 16,000

Mar,2000 Machinery Mar,2000
31St To Plant & 16,000 31St By P& L A/c 16,000




74
Illustration 4 Depreciation Accounting
M/s Muruganand &Co is a trader bought furniture costing Rs 2, 20, 000 for his new
branch on 1st April, 2000. As the furniture bought was superior quality material. The
auditors estimated its residual valued at Rs. 20, 000 after a working life of ten years.
Further additions were made into the same category on 1st Oct, 2001 and 1st April, 2002
which costing Rs 16, 800 and Rs. 19, 000 (with a scrap value of Rs 800 and Rs. 1000
respectively). The trader closed his accounts on 31st Mar every year and wanted to
apply straight line method of depreciation. Show the furniture a/c for four years.
First step is to find out the depreciation of the furniture for various number of years i-e 4
years. The depreciation is to be calculated on every year.
The most important point to be borne in our mind while calculating depreciation, the
following points to be taken into consideration
First, is there any % of depreciation charge given. If given, the depreciation to be
calculated on the volume of available balance at the end.
Secondly, if the % of depreciation charge is not given in our problem, How the volume of
depreciation can be calculated ?
The depreciation can be calculated as follows
Original value of the asset - Scrap value
Deprecation =
Life period of the asset
In this problem, due to absence of depreciation %, the above illustrated formula should
have to be applied throughout the problem
Date of Purchase First Second Third Total
Furniture furniture Furniture Depreciation
cost
2000 2001 2002
Particulars
Rs
Rs Rs Rs
Cost of the furniture R1 2,20,000 16,800 19,000
Scrap value at the end (-) 20,000 800 1000

R2
Depreciable value of the 2,00,000 16,000 18,000

furniture R3
Life of the furniture R4 10 years 10 years 10 years
Depreciation R5=R3/R4 20,000 1,600 1,800
Depreciation for 2000-01 20,000 ------ ------- 20,000
Depreciation for 2001-02 20,000 For 6 months ------- 20,800

800
Depreciation for 2002-03 20,000 1,600 1,800 23,400
Depreciation for 2003-04 20,000 1,600 1,800 23,400
75
Accounting and Finance Accounting Entries are as follows:
for Managers
ACCOUNTING ENTRIES FOR THE ACCOUNTING YEAR

2000-2001
During the year 1st April 2, 000; Rs. 2, 20, 000 worth of furniture was bought
Rs Rs
1 April,2000 Furniture A/c Dr 2,20,000
To Bank A/cCr 2,20,000
Being the furniture is purchased
Depreciation for the year 2000 for the first furniture Rs Rs

31st Mar,2001 Depreciation A/cDr 20,000
To Furniture A/c 20,000
Being depreciation charged

FOR 2001-02
Second new furniture bought during the month 1st Oct, 2001 Rs Rs
1 April, 2001 Furniture A/c Dr 16,800
To Bank A/c 16,800
Being new furniture procured
Depreciation for the first furniture

Being the depreciation charged
Depreciation for the second furniture

31st March, 2002 Depreciation A/c Dr 800
To Furniture A/c 800
Being the depreciation charged for the second furniture for 6 months

FOR 2002-03
Third new furniture bought during the month of 1st April, 2002
1st April, 2002 Furniture A/c 19,000
To Bank A/c 19,000

76 Being the furniture purchased during the year
Depreciation charged for the first furniture Depreciation Accounting
Being the depreciation charged for the first furniture
Depreciation charged for the second furniture

Being the depreciation charged for the second furniture
Depreciation for the third furniture

Being the depreciation charged for the third furniture
ACCOUNTING ENTRIES FOR THE FOURTH YEAR 2003-04

Depreciation charged for the first furniture
Being the depreciation charged for the first furniture
Depreciation charged for the second furniture

Being the depreciation charged for the second furniture
Depreciation for the third furniture

Being the depreciation charged for the third furniture
In the next step, the furniture account to be prepared for every year
Furniture A/c (2000-01)
Date Particulars Amount Date Particulars Amount

Rs Rs
1April,2000 To Bank 2,20,000 31 Mar,2001 By Depreciation 20,000
By Balance c/d 2,00,000
2,20,000 2,20,000
31st Mar, 2001 To Balance B/d 2, 20, 000 77

Accounting and Finance Furniture A/c (2001-02)
for Managers

Rs Rs
1April,2001 To Balance B/d 2,00,000 31 By Depreciation 20,000

st
Mar,2002
1 Oct ,2001 To Bank 16,800 By Depreciation 800
2,16,800 2,16,800
31st Mar, To Balance B/d 1,96,000

2002
31st Mar, 2002 To Balance B/d 1, 96, 000

Furniture (2002-03)

Rs Rs
st st
1 April, To Balance B/d 1,96,000 31 By Depreciation 20,000
s2002 M ar,2003
1 St April, To Bank 19,000 By Depreciation 1,600

2002
By Depreciation 1,800
2,15,000 2,15,000
st
31 To Balance B/d 1,91,600
M ar,2003

Furniture (2003-04)

Rs Rs
st st
1 April, To Balance B/d 1,91,600 31 March, By Depreciation 20,000
2003 2004
1,91,600 1,91,600
31 March, To Balance B/d 1,68,200

2004
31 Mar, 2004 To Balance B/d 1, 68, 200
Merits
l It is simple to calculate only due to fixed depreciation charge on the value of the
asset
l The value of the asset is depleted to either zero or scrap value of the asset
l This method is most suited for patents trade marks and so on
78
Demerits Depreciation Accounting
l The utility of the asset is not considered at the moment of charging constant
depreciation over the asset
l During the later years of the asset, the efficiency will automatically come down
and simultaneously the maintenance cost of the asset will rigger up which is illogical
in charging fixed charge throughout the life period of the asset
4.5 DIMINISHING BALANCE/WRITTEN DOWN VALUE

METHOD
This method also having the same methodology in charging depreciation on the fixed
assets like fixed percentage Though it is bearing similar approach in charging
depreciation but different in application from the straight line method. Under this method,
the depreciation is charged on the value of the asset available at the beginning of the
year.
The following formula highlights the application of this method in charging depreciation
= 1-(S/C)1/n
The meaning of the above illustrated formulae is discussed through the explanation of
two different components.
First one is (S/C)1/n , the ration of the scrap value of the asset on the original value of
the asset is appropriately apportioned throughout the life period of the assets. It is nothing
but the percentage of scrap value widened across the life period of the asset. Once the
scrap value percentage is known, the next important step is to determine the depreciable
value of the asset. The depreciable value of the asset can be derived by deducting the
percentage from No 1.
Illustration 5
Life of the asset (n)=3 years
Expected scrap value at the end of 3 years= Rs. 12, 800
Original Investment=Rs. 2, 00, 000
Find out the percentage of depreciation to be charged
Under this method, to charge depreciation as well as to find out the value of the asset as
on a particular date, the depreciation percentage must be given. In this problem,
depreciation % is not given, in order to determine the above illustrated formulae should
be applied
= 1-(S/C)1/n
=1-(Rs. 12, 800/Rs. 2, 00, 000)(1/3)
=1-4/10=6/10=60%
The following workings will obviously facilitate to understand the charge of depreciation
The value of the Asset at the beginning of 1st Year = Rs. 2, 00, 000
(-) Depreciation 60% on Rs. 2, 00, 000 (Original value ) = Rs. 1, 20, 000
Value of the asset at the beginning of 2nd Year = Rs. 80, 000
(-)Depreciation 60% on Rs 1, 20, 000. (Book Value) = Rs. 48, 000
79
Accounting and Finance Value of the asset at the beginning of 3rd Year = Rs. 32, 000
for Managers
(-)Depreciation 60% on Rs 32, 000( Book Value) = Rs. 19, 200
Value of the asset at the end of the year = Rs. 12, 800
Check Your Progress
(1) Treatment of Depreciation in the Profit &Loss A/c is

(a) Profit & Loss A/c Dr (b) Fixed Asset A/c Dr
To Depreciation A/c To Profit & Loss A/c
(c) Depreciation A/c Dr (d) Depreciation A/c Dr
To Fixed Asset A/c To Profit & Loss A/c
(2) Under straight line method, depreciation is charged on
(a) The value of the asset at the beginning (b) The average value of the asset
(c) The value of the asset at the end (d) None of the above
4.6 DISSIMILARITIES IN BETWEEN THE STRAIGHT

LINE METHOD AND WRITTEN DOWN VALUE METHOD
Under this method of charging depreciation unlike the straight line method, the percentage
is usually given for calculation.
While calculating this method, the depreciation is calculated on two different values
Depreciation
Depreciation for initial year Depreciation for subsequent years
Depreciation on original value - at the Depreciation on Book value during

beginning later period
Illustration 6
On 1st April, 2000, a firm purchases machinery worth Rs. 3, 00, 000. On 1 st Oct, 2002 it
buys additional machinery worth Rs. 60, 000 and spends Rs. 6, 000 on its erection. The
accounts are closed normally on 31 Mar. Assuming the annual depreciation to be 10%
Show the machinery account for 3 years under the written down value method.
ACCOUNTING JOURNAL ENTRIES FOR THE YEAR 2000-01

During the year 1st April 2, 000; Rs. 3, 00, 000 worth of machinery was bought
Rs Rs
1 April, 2000 Machinery A/c Dr 3,00,000
To Bank A/c Cr 3,00,000
80 (Being the machinery is purchased)

Depreciation for the year 2000 for the first machinery Rs Rs Depreciation Accounting
31st Mar,2001 Depreciation A/c Dr 30,000
To Machinery A/c 30,000
(Being depreciation charged )
ACCOUNTING JOURNAL ENTRIES FOR THE YEAR 2001-02

Depreciation for the year 2001 for the first machinery Rs Rs
st
31 Mar,2001 Depreciation A/c Dr 27,000
(Being depreciation charged)
JOURNAL ENTRIES FOR THE YEAR 2002-03

During the year 2002 new machinery worth of Rs. 60, 000 was purchased. Before
determining the volume of depreciation, the amount of original value of the machinery
should be found out.
Original value of the asset = The purchase price of the asset + Erection charges incurred
= Rs. 60, 000 + Rs. 6, 000 = Rs. 66, 000
Rs Rs
1 April,2002 Machinery A/c Dr 66,000
To Bank A/c Cr 66,000
(Being the machinery is purchased)
Depreciation for the year 2002 for the first machinery Rs Rs

st
31 Mar,2003 Depreciation A/c Dr 24,300
(Being depreciation charged )
Depreciation for the year 2002 for the second machinery Rs Rs

31st Mar,2003 Depreciation A/cDr 3,300
(Being depreciation charged)
After passing the journal entries, the next step is to prepare ledger account of machinery
Machinery A /c (2000-01)
Dr Cr
Rs Rs
1st To Bank 3,00,000 31st By Depreciation 30,000
April,2000 Mar,2001
3,00,000 3,00,000
31st To Balance B/d 2,70,000
Mar,2001 Transfer to
Machinery A/c
(20001-02) 81
Accounting and Finance MachineryA/c (2001-02)
for Managers
Dr Cr
Rs Rs
1st To Balance B/d 2,70,000 31 st By Depreciation 27,000
April,2000 Mar,2001
2,70,000 2,70,000
st
31 To Balance B/d 2,43,000
Mar,2001 Transfer to
Machinery A/c
(2002-03)
Machinery A/c (2002-03)

Dr Cr
Rs Rs
1st To Balance B/d 2,43,000 31 st By Depreciation 24,300
April,2000 Mar,2001 First machinery
1st Oct,2002 To Bank 66,000 By Depreciation 3,300
Second machinery
3,09,000
31st To Balance B/d 2,81,400
Mar,2003

Merits:
l The depreciation is charged under this method only in line with the efficiency. It
means that during the early years of the usage, the efficiency of the asset is more
than that of the later part of the life of the asset.
l The depreciation volume under this method is greater during the early years of the
asset than the later periods of the asset.
l It evades the possibility of incurring losses due to obsolescence.
Demerits:
l It is a tedious method in computation.
l Under this method, the book value of the asset at end of the economic life period is
never equivalent to zero.
Suitability: This method is most suitable in the case of depreciating the worth of patent
which is subject greater risk of technological obsolescence. This method is most suitable
in the case of patent design of a car, cellular phone design, pharmaceutical patent and so
on. These are having greater technological risk which prefers the firms to write off the
expenditures in more volume during the early years in order to recover the investment
through matching early period revenues. Early recovery is better the principle
4.7 LET US SUM UP

Depreciation is the permanent and continuous diminution in the quality /quantity / value
of the asset. The long term assets are becoming less efficient and poor quality in
82 operations due to the continuous usage of the asset. The value of the asset mainly
depends upon the efficiency and economy; which gets affected due to the accident. Depreciation Accounting
According to the concept of depreciation, the value of the asset is dispersed throughout
the life of the period in order to match against the respective earnings of the year after
year The purchase value of the asset is an expenditure to be stretched to many number
of years in order to equate with the revenues. The value of the asset after deducting the
depreciation from the value of the asset at the beginning.

Companies usually depreciate assets such as buildings even though those assets may be
increasing in value. Give your opinion as an expert.
4.9 KEYWORDS
Depreciation: Continuous reduction/ decrease /diminution in the value of the asset
Depreciation accounting: Recording the entries of depreciation through journal, ledger
accounts of Depreciation, Fixed asset and Profit & Loss account.
Original Value of the asset: The value of the asset at the time of purchase or acquisition
Book Value of the asset: The value of the asset after deducting the depreciation from
the value of the asset at the beginning.
Scrap value of the asset: It is the value at the end of the life period of the asset; at
when the asset cannot be put for further usage.

1. Define Depreciation. Explain the meaning of the term Depreciation.
2. Elucidate the process of Depreciation Accounting.
3. Explain the various methods of depreciation and their merits and demerits.
4. Highlight the suitability of depreciation method to the tune of business environment.

M. P. Pandikumar, Accounting & Finance for Managers, Excel Books, New Delhi.
R. L. Gupta and Radhaswamy, Advanced Accountancy.
Khan and Jain, Management Accounting.
S. N. Maheswari, Management Accounting.
Nitin Balwani Accounting & Finance for Managers, Excel Books, New Delhi.
83
UNIT-II
LESSON
5
FINANCIAL STATEMENT ANALYSIS
CONTENTS
5.1 Introduction
5.2 Definition & Classification of Financial Statement Analysis
5.3 Comparative Financial Statements
5.4 Trend Percentage Analysis
5.5 Let us Sum up
5.7 Keywords

In this lesson we shall discuss about financial statement analysis. After going through
this lesson you will be able to:
(i) understand definition and classification of financial statement analysis
(ii) analyse comparative financial statements and trend percentage analysis
5.1 INTRODUCTION
The financial statements are affording many facts though they are absolute and concrete
in terms; but not in a position to interpret and analyse the stature of the enterprise. To
analyse and interpret, the financial statement analysis is being applied across the financial
statements viz Trading, Profit & Loss Account and Balance sheet.
Under the financial statement analysis, the information available are grouped together in
order to cull out the meaningful relationship which is already available among them; for
interpretation and analysis.
5.2 DEFINITION & CLASSIFICATION OF FINANCIAL

STATEMENT ANALYSIS
According to Kennedy and Muller
The analysis and interpretation of financial statements are an attempt to determine the
significance and meaning of financial statement data so that the forecast may be made
of the prospects for future earnings, ability to pay interest and debt maturities and
profitability and sound dividend policy
The entire financial statement analysis can be classified into various categories
l Comparative financial statements
l Common size financial statements
Accounting and Finance l Trend percentages
for Managers
l Fund flow statements
l Cash flow statements
l Ratio analysis

:
Comparative financial statements
Comparative study of Profit & Loss Accounts and Balance sheets
Comparison in between financial statements Comparison in between the financial statements of various
of two or more years firms or industrial average
Intra firm comparison Inter firm comparison
5.3 COMPARATIVE FINANCIAL STATEMENTS

Objectives of comparative financial statements
l Changes taken place in the financial performance are taken into consideration for
further analysis
l To reveal qualitative information about the firm in terms of solvency, liquidity
profitability and so on are extracted from the analysis of financial statements
l With reference to yester financial data of the enterprise, the firm is facilitated to
undergo for the preparation of forecasting and planning.
The major part of financial statement analysis is mainly focused on the comparative
analysis.
The comparative analysis classified into four different analyses viz
l Comparative Balance sheet
l Comparative Profit and Loss account
l Common Size statement
l Trend percentage
First we will discuss the comparative Balance sheet.
The first and foremost important step is to have the following information and should
take preparatory steps
i. While preparing the comparative statement of balance sheet, the particulars for
the financial factors are required
ii. The second most important for the preparation of the comparative balance sheet is
yester financial data extracted from the balance sheet or balance sheets
iii. The next most important requirement to have an effective comparison with the
yester financial data is current year information extracted from the balance sheet
or balance sheet of the firms.
iv. After having been procured the financial data pertaining to various time periods
are ready for comparison; to determine or identify the level of increase or decrease
taken place in the financial position of the firms
v. To determine the level of increase or decrease in financial position, the percentage
88
analysis to carried out in between them.
Illustration 1 Financial Statement Analysis
From the following information, Prepare comparative Balance sheet of X Ltd.

Particulars 31st Mar,2004 31st Mar,2005
Equit share capital 50,00,000 50,00,000
Fixed Assets 60,00,000 72,00,000
Reserves and surpluses 10,00,000 12,00,000
Investments 10,00,000 10,00,000
Long-term loans 30,00,000 30,00,000
Current assets 30,00,000 21,00,000
Current liabilities 10,00,000 11,00,000
The first step we have to segregate the available information into two different categories
viz Assets and Liabilities
Particulars 2004 Rs 2005 Rs Absolute % %

Change Rs Increase Decrease
Fixed Assets 60,00,000 72,00,000 12,00,000 20 -
Investments 10,00,000 10,00,000 N.C - -
Current assets 30,00,000 21,00,000 (9,00,000) 30
Total Assets 1,00,00,000 1,03,00,000 3,00,000 3 -
Equity share capital 50,00,000 50,00,000 N.C - -
Reserves & surpluses 10,00,000 12,00,000 2,00,000 20 -
Long-term loans 30,00,000 30,00,000 N.C - -
Current liabilities 10,00,000 11,00,000 1,00,000 10 -
1,00,00,000 1,03,00,000 3,00,000 3 -
N. C = No change in the position during the two years

From the above table, the following are basic inferences
l The fixed assets volume got increased 20% from the year 2004 to 2005, amounted
Rs. 12, 00, 000
l Rs 9, 00, 000 worth of current assets decrease from the year 2004 to 2005 recorded
30%
l The total volume of assets recorded 3% increase from the year 2004 to 2005
l It obviously understood that 20% increase taken place on the reserves and surpluses
l It clearly evidenced that the current liabilities of the firm increased 10% from the
year 2004 to 2005
l The firm has not recorded any changes in the investments, equity share capital
and long-term loans
The next one in the comparative financial statement analysis is that Income statement
analysis
Comparative (Income) financial statement analysis: This analysis is being carried out in
between the income statements of the various accounting durations of the firm, with
other firms in the industry and with the industrial average.
This will facilitate the firm to know about the stature of itself regarding the financial
performance. It facilitates to understand about the changes pertaining to various financial
data which closely relevantly connected with the financial performance
l Change in the gross sales
l Change in the net sales 89
Accounting and Finance l Change in gross profit and net profit
for Managers
l Change in operating profit
l Change in operating expenses
l Change in the volume of non operating income
l Change in the non operating expenses
The ultimate purpose of the comparative (Income) financial statement analysis is as
follows
i. To study the income earning and expenditure spending pattern of the firm for two
or more years
ii. To identify the changing pattern of the income and expenditure of the firms. The
preparatory steps for the preparation of the comparative financial statement
(Income) analysis
The first and foremost important step is to have the following information and should
take preparatory steps
i. While preparing the comparative statement of Profit and Loss Account, the
particulars for the financial factors are required
ii. The second most important for the preparation of the comparative Profit & Loss
account is yester financial data extracted from the Profit & Loss A/c or
Profit & Loss Accounts
iii. The next most important requirement to have an effective comparison with the
yester financial data is current year information extracted from the balance sheet
of the firm or of the other firms
iv. After having been procured the financial data pertaining to various time periods
are ready for comparison ; to determine or identify the level of increase or decrease
taken place in the operating financial performance of the firms
v. To determine the level of increase or decrease in financial performance, the
percentage analysis to be carried out in between them.
Illustration 2
Prepare the comparative income statement from the following:
Particulars 2004 Rs 2005 Rs

Sales 2,00,000 2,50,000
Cost of goods sold 1,00,000 1,30,000
1,00,000 1,20,000
Operating expenses 10,000 10,000
Net profit 90,000 1,10,000
Comparative Income Statement
Particulars 2004 Rs 2005 Rs Absolute % %

Change Rs Increase
Decrease
Sales 2,00,000 2,50,000 50,000 25 -

(-)Cost of goods sold 1,00,000 1,30,000 30,000 30 -
1,00,000 1,20,000 20,000 20 -
(-)Operating expenses 10,000 10,000 N.C - -
90 Net profit 90,000 1,10,000 20,000 22.22

From the above table, the following inferences can be had: Financial Statement Analysis
l The firm has registered 25% increase in sales from the year 2004 to 2005
l Cost of goods sold raised 30% from the year 2004 to 2005
l There is no change in the level of operating expenses
l The firm has got 22. 22% increase in the level of net profits from the year 2004 to
2005
Illustration 3
From the following information, prepare a comparative income statement:
Particulars 2001 Rs 2002 Rs
Sales 10,00,000 8,00,000
Cost of goods sold 6,00,000 4,00,000
Administration Expenses 2,00,000 1,40,000
Other Income 40,000 20,000
Income tax 1,20,000 1,40,000
Comparative Income Statement
Particulars 2001 Rs 2002Rs Absolute % %

Change Rs Increase
Decrease
Sales 10,00,000 8,00,000 (2,00,000) - 20
()Cost of goods sold 6,00,000 4,00,000 (2,00,000) - 33.33
4,00,000 4,00,000 - -
() Administration 2,00,000 1,40,000 (60,000) - 30
Expenses
Operating Income 2,00,000 2,60,000 60,000 30 -
(+)other income 40,000 20,000 (20,000) - 50
Total Net Income Before 2,40,000 2,80,000 40,000 - 16.66
tax
Income tax 1,20,000 1,40,000 20,000 16.66 -
Net Income after the tax 1,20,000 1,40,000 20,000 16.66 -
For this problem, the inferences could be enlisted according to the comparative statement
analysis on Profit & Loss Accounts of two different year viz 2001 and 2002.
The next important tool of financial statement analysis is a common size statement
analysis which known as predominant tool in intra firm analysis in studying the share of
each component.
The components are translated into percentage for analysis and interpretations. For
profit and loss account, Net sales is considered as a base for the computation of a share
of each financial factor available.
For Balance sheet, total volume of assets and liabilities are taken into consideration for
the computation of a share of each financial factor available under the heading of assets
and liabilities.
Illustration 4
Prepare the common size statement analysis for the firm ABC ltd
Liabilities 1990Rs 1991Rs Assets 1990Rs 1991 Rs
Share capital 2,00,000 3,00,000 Fixed assets 2,25,000 4,00,000
Reserves and 1,00,000 2,00,000 Stock 1,29,000 2,00,000
surpluses
Bank overdraft 60,000 2,00,000 Quick assets 46,000 2,00,000
Quick liabilities 40,000 1,00,000
4,00,000 8,00,000 4,00,000 8.,00,000 91

for Managers
Common size statement analysis of the Balance sheet of the firm ABC Ltd.
Particulars Amount % of Balance sheet total

Assets 1990 Rs 1991 Rs 1990 1991
Fixed assets 2,25,000 4,00,000 56.25 50
Stock 1,29,000 2,00,000 32.25 25
Quick assets 46,000 2,00,000 11.5 25
Total 4,00,000 8,00,000 100 100
Liabilities
Share capital 2,00,000 3,00,000 50 37.5
Reserves and surpluses 1,00,000 2,00,000 25 25
Bank overdraft 60,000 2,00,000 15 25
Quick liabilities 40,000 1,00,000 10 12.5
4,00,000 8,00,000 100 100
The above illustration highlights the share of every component in the balance sheet out
of the total volume of assets and liabilities.
This will certainly facilitate the firm to easily understand not only the share of every
component but also facilitates to have a meaningful and relevant comparison with various
time horizons.
From the following table, prepare the common size statement analysis:
2000 Rs. 2001 Rs.

Sales 20,00,000 24,00,000
Miscellaneous Income 20,000 16,000
20,20,000 24.16,000
Materials consumed 11,00,000 12,96,000
Wages 3,00,000 4,08,000
Factory expenses 2,00,000 2,16,000
Office expenses 90,000 1,00,000
Interest 1,00,000 1,20,000
Depreciation 1,40,000 1,50,000
Profit 90,000 1,26,000
20,20,000 24,16,000
Common size statements Profit & Loss Account
Particulars 2000 Rs. % Percentage 2001 Rs. Percentage

%
Sales 20,00,000 100 24,00,000 100
Miscellaneous Income 20,000 .9 16,000 .67
20,20,000 100.9 24.16,000 100.67
Materials consumed 11,00,000 54.46 12,96,000 53.64
Wages 3,00,000 14.85 4,08,000 16.82
Factory expenses 2,00,000 9.90 2,16,000 8.92
Office expenses 90,000 4.47 1,00,000 4.95
Interest 1,00,000 4.95 1,20,000 4.92
Depreciation 1,40,000 6.94 1,50,000 6.21
Profit 90,000 4.47 1,26,000 5.21
20,20,000 100.9 24,16,000 100.67
92
Financial Statement Analysis
Check Your Progress
(1) Financial statement analysis is to

(a) Inter firm comparison only
(b) Intra firm comparison only
(c) Industrial average comparison
(d) (a), (b) & (c)

(2) Intra firm analysis is
(a) With in a year
(b) In between the years
(c) Comparison with the projected
(d) (a), (b) & (c)

(3) Comparative financial statement analysis is into
(a) Comparison of Income& Position statements
(b) Common size statements
(c) Trend percentage analysis
(d) (a), (b) & (c)

(4) Main objectives of the Financial statements analysis are
(a) To study the changes in the financial performance
(b) To study the liquidity, solvency of the firm
(c) To undergo financial planning based upon the yester financial performance
(d) (a), (b) & (c)
5.4 TREND PERCENTAGE ANALYSIS

The next important tools of analysis is trend percentage which plays significant role in
analyzing the financial stature of the enterprise through base years performance ratio
computation. This not only reveals the trend movement of the financial performance of
the enterprise but also highlights the strengths and weaknesses of the enterprise
The following ratio is being used to compute the trend percentage
Current year
= 100
Base year
This trend ratio is being computed for every component for many number of years
which not only facilitates comparison but also guides the firm to understand the trend
path of the firm.
5.5 LET US SUM UP

Under the financial statement analysis, the information available are grouped together in
order to cull out the meaningful relationship which is already available among them; for
interpretation and analysis. To reveal qualitative information about the firm in terms of 93
Accounting and Finance solvency, liquidity profitability and so on are extracted from the analysis of financial
for Managers
statements. Comparative (Income) financial statement analysis is being carried out in
between the income statements of the various accounting durations of the firm, with
other firms in the industry and with the industrial average. After having been procured
the financial data pertaining to various time periods are ready for comparison ; to determine
or identify the level of increase or decrease taken place in the operating financial
performance of the firms.

In financial statement analysis, what is the basic objective of observing trends in data
and ratios? Suggest some other standards of comparison.
5.7 KEYWORDS
Balance Sheet
Financial Statement
Financial data
Assets
Firm

1. Write elaborative note on the financial statement analysis.
2. Elucidate the common size statement analysis.
3. List out the objectives of the financial statement analysis.
4. Explain the steps involved in the process of comparative statement of balance
sheet.
5. Write brief note on the trend analysis.
5. 9 SUGGESTED READINGS
94
LESSON
6
RATIO ANALYSIS
CONTENTS
6.1 Introduction
6.2 Definition
6.3 How the Accounting Ratios are Expressed?
6.4 Purpose, Utility & Limitations of Ratio Analysis
6.5 Classification of Ratios
6.6 Short-term Solvency Ratios
6.6.1 Current Assets Ratio
6.7 Standard Norm of the Current Ratio
6.7.1 Implication of High Ratio of Current Assets over the Current Liabilities
6.7.2 Limitation of the Current Ratio
6.7.3 Acid Test Ratio
6.7.4 Super Quick Assets Ratio
6.8 Capital Structure Ratios
6.9 Debtequity Ratio
6.9.1 Long-Term Debt-equity Ratio
6.9.2 Standard Norm of the Debt-equity Ratio
6.9.3 Total Debtequity Ratio
6.10 Proprietary Ratio
6.11 Fixed Assets Ratio
6.12 Standard Norm of the Ratio
6.13 Coverage Ratios
6.13.1 Interest Coverage Ratio
6.13.2 Dividend Coverage Ratio
6.14 Return on Capital Employed
6.15 Stock Turnover Ratio
6.16 Debtors Turnover Ratio
6.16.1 Debtors Velocity
6.16.2 Creditors Turnover Ratio
6.17 Dupont Analysis
6.18 Let us Sum up
6.20 Keywords
In this lesson we shall discuss about ratio analysis. After going through this lesson you
will be able to:
(i) understand purpose, utility and limitations of ratio analysis
(ii) analyse classifications of ratios and Du pont analysis
6.1 INTRODUCTION
The ratio analysis is an one of the important tools of financial statement analysis to study
the financial stature of the business fleeces, corporate houses and so on.
How the ratios are able to facilitate to study the financial status of the enterprise ?
What is meant by ratio?
The ratio illustrates the relationship between the two related variables
What is meant by the accounting ratio?
The accounting ratios are computed on the basis available accounting information
extracted from the financial statements which are not in a position to reveal the status of
the enterprise.
The accounting ratios are applied to study the relationship between the quantitative
information available and to take decision on the financial performance of the firm.
6.2 DEFINITION
According to J. Betty, The term accounting is used to describe relationships
significantly which exist in between figures ratio shown in a balance sheet, Profit
& Loss A/c, Trading A/c, Budgetary control system or in any part of the accounting
organization.
According to Myers Study of relationship among the various financial factors of
the enterprise
6.3 HOW THE ACCOUNTING RATIOS ARE EXPRESSED?

To understand the methodology of expressing the ratios, the expression of ratios are
highlighted in the following discussion
Expression
Quotient Percentage Time Fraction
Current Ratio Net Profit Ratio Stock Turnover Ratio Fixed assets to
/Leverage Ratio capital
6.4 PURPOSE, UTILITY & LIMITATIONS OF

RATIO ANALYSIS
Purposes of the Ratio Analysis are:
l To study the short term solvency of the firm liquidity of the firm
l To study the long term solvency of the firm leverage position of the firm
l To interpret the profitability of the firm Profit earning capacity of the firm
96
l To identify the operating efficiency of the firm. turnover of the ratios
Utility of the Ratio Analysis are: Ratio Analysis
i. Easy to understand the financial position of the firm: The ratio analysis facilitates
the parties to read the changes taken place in the financial performance of the firm
from one time period to another.
ii. Measure of expressing the financial performance and position: It acts as a
measure of financial position through Liquidity ratios and Leverage ratios and also
a measure of financial performance through Profitability ratios and Turnover Ratios.
iii. Intra-firm analysis on the financial information over many number of years:
The financial performance and position of the firm can be analysed and interpreted
with in the firm in between the available financial information of many number of
years; which portrays either increase or decrease in the financial performance.
iv. Inter-firm analysis on the financial information within the industry: The
financial performance of the firm is studied and interpreted along with the similar
firms in the industry to identify the presence and status of the respective firm
among others.
v. Possibility for Financial planning and control: It not only guides the firm to earn
in accordance with the financial forecasting but also facilitates the firm to identify the
major source of expense which drastically has greater influence on the earnings.
Limitations of the Ratio Analysis are:
i. It is dependant tool of analysis: The perfection and effectiveness of the analysis
mainly depends upon the preparation of accurate and effectiveness of the financial
statements. It is subject to the availability of fair presentation of data in the financial
statements.
ii. Ambiguity in the handling of terms: If the tool of analysis taken for the study of
inter firm analysis on the profitability of the firms lead to various complications. To
study the profitability among the firms, most required financial information are
profits of the enterprise. The profit of one enterprise is taken for analysis is Profit
After Taxes (PAT) and another is considering Profit Before Interest and Taxes
(PBIT) and third one is taking Net profit for study consideration. The term profit
among the firms for the inter firm analysis is getting complicated due to ambiguity
or poor clarity on the terminology.
iii. Qualitative factors are not considered: Under the ratio analysis, the quantitative
factors only taken into consideration rather than qualitative factors of the enterprise.
The qualitative aspects of the customers and consumers are not considered at the
moment of preparing the financial statements but while granting credit on sales is
normally considered.
iv. Not ideal for the future forecasts: Ratio analysis is an outcome of analysis of
historical transactions known as Postmortem Analysis. The analysis is mainly
based on the yester performance which influences directly on the future planning
and forecasting ; it means that the analysis is mainly constructed on the past
information which will also resemble the same during the future analysis.
v. Time value of money is not considered: It does not give any room for time value
of money for future planning or forecasting of financial performance ; the main
reason is that the fundamental base for forecasting is taken from the yester periods
which never denominate the timing of the benefits.
Check Your Progress
(1) Ratio is an expression of

(a) Quotient
(b) Time
(c) Percentage
(d) Fraction
(e) (a), (b), (c) & (d)
(2) Accounting ratios are to study
(a) Accounting relationship among the variables 97
Contd...
Accounting and Finance (b) the relationship in between the variables of financial statements
for Managers
(c) The relationship in between the variables of financial statements for analysis
and interpretations
(3) Accounting ratios are
(a) Income statement ratios
(b) Positional statement ratios
(c) Both (a) & (b)
6.5 CLASSIFICATION OF RATIOS

The accounting ratios are classified into various categories on the basis of
1. Financial statements
2. Functions
On the basis of Financial Statements:
I. Income statement Ratios: These ratios are computed from the statements of
Trading, Profit & Loss account of the enterprise. Some of the major ratios are:
GP ratio, NP ratio, Expenses Ratio, and so on.
II. Balance sheet or Positional Statement Ratios: These type of ratios are calculated
from the balance sheet of the enterprise which normally reveals the financial status
of the position i.e. short term, Long term financial position, Share of the owners on
the total assets of the enterprise and so on.
III. Inter statement or Composite Mixture of Ratios: Theses ratios are calculated
by extracting the accounting information from the both financial statements, in
order to identify stock turnover ration, debtor turnover ratio, return on capital
employed and so on.
On the basis of Functions:
I. On the basis of Solvency position of the firms: Short term and Long term solvency
position of the firms.
II. On the basis of Profitability of the firms: The profitability of the firms are
studied on the basis of the total capital employed, total asset employed and so on.
III. On the basis of Effectiveness of the firms: The effectiveness is studied through
the turnover ratios Stock turnover ratio, Debtor turnover ratio and so on.
IV. Capital Structure ratios: The capital structure position are analysed through
leverage ratios as well as coverage ratios.
6.6 SHORT-TERM SOLVENCY RATIOS

To study the short term solvency or liquidity of the firm, the following are various ratios
l Current Assets Ratio
l Acid Test Ratio or Quick Assets Ratio
l Super Quick Assets Ratio
l Defensive Interval Ratio
6.6.1 Current Assets Ratio

It is one of the important accounting ratios to find out the ability of the business fleeces
98 to meet out the short financial commitment This is the ratio establishes the relationship
in between the current assets and current liabilities. Ratio Analysis
What is meant by current assets /Current assets are nothing but available in the form of
cash, equivalent to cash or easily convertible in to cash.
What is meant by the current liabilities?
Current liabilities are nothing but short term financial resources or payable in short span
of time within a year.
Current Assets
Current =
Current Liabilities
Current Ratio
Current Assets Current Liabilities
M arketable Secu ities T rad e cred itors
In ven to ry B an k o verd raft
D eb tors B ills P ayab le
B ill R eceivable P ro visio n fo r taxatio n
P re p aid exp en ses O utstan d in g exp en ses
O utstan d in g In com es P re received in com es
C ash at B an k :
C ash in H an d
6.7 STANDARD NORM OF THE CURRENT RATIO

The ideal norm is that 2:1; which means that every one rupee of current liability is
appropriately covered by Two rupees of current assets.
6.7.1 Implication of High Ratio of Current Assets over the

Current Liabilities
High ratio leads to greater the volume of current assets more than the specified norm
denotes that the firm possess excessive current assets than the requirement portrays
idle funds invested in the current assets.
6.7.2 Limitation of the Current Ratio

Under this ratio, the current assets are equally weighed each other to match the current
liabilities. Under the current ratio, One rupee of cash is equally weighed at par with the
one rupee of closing stock, but the closing stock and prepaid expenses cannot be
immediately realized like cash and marketable securities.
6.7.3 Acid Test Ratio

It is a ratio expresses the relationship in between the quick assets and current liabilities.
This ratio is to replace the bottleneck associated with the current ratio. It considers only
the liquid assets which can be easily translated into cash to meet out the financial
commitments.
99
for Managers Liquid Assets
Acid Test Ratio ( Quick Assets Ratio) =
Current Liabilities
Liquid Asset = Current Assets ( Closing Stock +Pre paid expenses)
Quick
Liquid Assets Ratio
Quick Assets Current liabilities
Marketable Securities Trade creditors
Debtors Bank overdraft
Bill Receivable Bills Payable
Cash at Bank Provision for taxation
Cash in Hand Outstanding expenses
Pre received incomes
Standard norm of the ratio;

The ideal norm is that 1:1 means; One rupee of current liabilities is matched with one
rupee of quick assets.
6.7.4 Super Quick Assets Ratio

It is the ratio which establishes the relationship in between the super quick assets and
quick liabilities of the firm.
The super quick assets are nothing but the current assets which can be more easily
converted into cash to meet out the quick liabilities.
The super quick liabilities are the current liabilities should have to be met out at faster
pace within shorter span in duration.
Super Quick Assets = Cash + Marketable Securities .
Super Quick Liabilities= Current Liabilities Bank Over Draft
Super Quick Assets

Super Quick Assets Ratio =
Super Quick Liabilities
Standard norm of the ratio

Higher the ratio is the better the position of the firm
Illustration 1
From the following calculate current ratio
Current Assets:
Rs
Cash in hand 4,00,000
100 Sundry Debtors 1,60,000
Stock 2,40,000 Ratio Analysis
Current Liabilities:
Sundry creditors 3,00,000
Bills Payable 1,00,000
Current Assets Rs. 8,00,000

Current Ratio = = =2
Current Liabilities Rs. 4,00,000
Illustration 2
The firm satisfies the standard norm of the current asset ratio and Liquid assets ratio
M/s Shanmuga &Co
Balance sheet as on dated 31st Mar, 2005
Particulars Rs. Particulars Rs.
Share capital 42,000 Fixed Assets Net 34,000
Reserve 3,000 Stock 12,400
Annual Profit 5,000 Debtors 6,400
Bank overdraft 4,000 Cash 13,200
Total 66,000 Total 66,000
Current Assets
Current Ratio =
Current Liabilities
Rs. 32,000
=
Rs.16,000
=2
It satisfies the standard norm of the current asset ratio
Quick assets Current Assets - Closing Stock
Liquid assets ratio = =
Current Liabilities Current Liabilities
Rs. 19,600
= = 1.225
Rs. 16,000
The firm financial position satisfies the standard norm of the Liquid assets ratio.
Illustration 3
Liquid Assets Rs. 65,000; Stock Rs. 20,000; Pre paid expenses Rs. 5,000; Working
capital Rs. 60, 000
Calculate current assets ratio and liquid assets ratio
For the computation of current assets ratio, current assets volume must be known. It is
not available in our problem, instead the liquid assets and prepaid expenses are given
together which will facilitate to find the total volume of current assets.
Current Assets= Liquid Asset + Prepaid expenses + closing stock
= Rs. 65,000 + Rs. 5,000+20,000
= Rs. 90,000
The next step is to find out the current liabilities. The volume of current liabilities could
be found out through the available information of working capital.
Net working capital= Current Assets- Current Liabilities
101
Accounting and Finance Rs. 60,000 = Rs. 70,000 - Current liabilities
for Managers
Current liabilities = Rs. 90,000 - Rs. 60,000= Rs. 30,000
From the above, the current ratio could be found out
Rs. 90,000
Current Ratio = =3> 2
Rs. 30,000
The firm satisfies the more than the norm of the current ratio. It means that the firm
keeps excessive current assets more than that of requirement.
Rs. 65,000
Quick Assets Ratio = = 2.17
Rs. 30, 000
The firm keeps more liquid assets than that of the specified norm means that excessive liquid
assets are held by the firm than the requirement in the form of idle not productive in utility.
Illustration 4
The current ratio of Bicon Ltd. is 4.5 :1 and liquidity ratio is 3:1 stock is Rs. 6,00,000 Find
out the current liabilities.
To find out the volume of current liabilities, initially the share of closing stock should be
found out in the total of current assets.
Share of stock =Current Assets Ratio Liquid Assets Ratio
=4.5-3. 0=1.5
Share of the stock=1.5
If the share of the stock is 1.5 which amounted Rs. 6,00,000
What is the volume of current liabilities for the ration of 1?
Rs. 6,00,000
Current Liabilities = = 4,00,000
1.5
6.8 CAPITAL STRUCTURE RATIOS

The capital structure ratios are classified into two categories
l Leverage Ratios Long term solvency position of the firm Principal repayment
l Coverage Ratios Fixed commitment charge solvency of the firm Dividend
coverage and Interest coverage
Capital Structure
Leverage Ratios Coverage Ratios
Debt Equity Ratio Interest Coverage Ratio

Total Debt Equity Dividend Coverage
Ratio
Proprietary Ratio
Fixed assets Ratio
102
Under the capital structure ratios, the composition of the capital structure is analysed Ratio Analysis
only in the angle of long term solvency of the firm.
6.9 DEBT-EQUITY RATIO

It is the ratio expresses the relationship between the ownership funds and the outsiders
funds. It is more specifically highlighted that an expression of relationship in between the
debt and Shareholders funds. The debtequity ratio can be obviously understood into
two different forms
l Long term debtequity ratio
l Total debtequity ratio
6.9.1 Long-term Debt-equity Ratio

It is a ratio expresses the relationship in between the outsiders contribution through debt
financial resource and Share holders contribution through equity share capital, preference
share capital and past accumulated profits. It reveals the cover or cushion enjoyed by
the firm due to the owners contribution over the outsiders contribution.
Debt (Long term debt = Debentures/Term Loans)

Debt - Equity Ratio =
Net worth/Equity (Shareholders' fund)
Higher ratio indicates the riskier financial status of the firm which means that the firm
has been financed by the greater outsiders fund rather than that of the owners fund
contribution and vice versa.
6.9.2 Standard Norm of the Debt-equity Ratio

The ideal norm is that 1:2 which means that every one rupee of debt finance is covered by
the 2 rupees of shareholders fund
The firm should have a minimum of 50% margin of safety in meeting the long term
financial commitments. If the ratio exceeds the specification, the interest of the firm will
be ruined by the outsiders during the moment at when they are unable to make the
payment of interest in time as per the terms of agreement reached earlier. During the
moment of liquidation, the greater ratio may facilitate the creditors to recover the amount
due lesser holding held by the owners.
6.9.3 Total Debt-equity Ratio

The ultimate purpose of the ratio is to express the relationship total volume of debt
irrespective of nature and shareholders funds. If the owners contribution is lesser in
volume in general irrespective of its nature leads to worse situation in recovering the
amount of outsiders contribution during the moment of liquidation.
Short term debt + Long term debt
Total Debt Equity Ratio =
Equity (Shareholders' fund)
6.10 PROPRIETARY RATIO

The ratio illustrates the relationship in between the owners contribution and the total
volume of assets. In simple words, how much funds are contributed by the owners in
financing the assets of the firm. Greater the ratio means that greater contribution made
by the owners in financing the assets.
103
for Managers Owners' Funds or Equity or Shareholders' funds
Pr oprietary Ratio =
Total assets
Standard Norm of the ratio
Higher ratio is better position for the firm as well as safety to the creditors.
6.11 FIXED ASSETS RATIO

The ratio establishes the relationship in between the fixed assets and long term source of
funds. Whatever the source of long term funds raised should be used for the acquisition
of long term assets; it means that the total volume of fixed assets should be equivalent to
the volume of long term funds i.e. , the ratio should be equal to 1
share holders' funds + Outsiders' funds

Fixed Assets Ratio =
Net Fixed Assets
If the ratio is lesser than one means that the firm made use of the short term fund for the
acquisition of long term assets. If the ratio is greater than one means that the acquired
fixed assets are lesser in quantum than that of the long term funds raised for the purpose.
In other words, the firm makes use of the excessive funds for the built of current assets.
6.12 STANDARD NORM OF THE RATIO

The ideal norm of the ratio is 1:1 which means that the long term funds raised only utilised
for the acquisition of long term assets of the enterprise
It facilitates to understand obviously about the over capitalization or under capitalization
of the assets of the enterprise.
6.13 COVERAGE RATIOS

These ratios are computed to know the solvency of the firm in making the periodical
payment of interest and preference dividends. The interest and preference dividends are
to be paid irrespective of the earnings available in the hands of the firm. In other words,
these are known as fixed commitment charge of the firm.
6.13.1 Interest Coverage Ratio

The firms are expected to make the payment of interest on the amount of borrowings
without fail This ratio facilitates the prospective lender to study the strength of the
enterprise in making the payment of interest regularly out of the total income. To study
the capacity in making the payment of interest is known as interest coverage ratio or
debt service coverage ratio.
The ability or capacity is analysed only on the basis of Earnings before interest and taxes
(EBIT) available in the hands of the firms.
Greater the ratio means that better the capacity of the firm in making the payment of
interest as well as greater the safety and vice versa
Earning before interest and taxes

Interest coverage ratio =
Interest
Lesser the times the ratio means that meager the cushion of the firm which may lead to
affect the solvency position of the firm in making payment of interest regularly.
104
6.13.2 Dividend Coverage Ratio Ratio Analysis
It illustrates the firms ability in making the payment of preference dividend out of the
earnings available in the hands of the firm after the payment of taxation. If the size of the
Profits after taxation is greater means that greater the cushion for the payment of
preference dividend and vice versa.
The preference dividends are to be paid without fail irrespective of the profits available
in the hands of the firm after the taxation.
Earnings after taxatation

Dividend coverage ratio =
Preference Dividend

Higher the ratio means that the firm has greater cushion in meeting the needs of preference
dividend payment against Earnings after taxation(EAT) and vice versa
Profitability Ratios
The ratios are measuring the profitability of the firms in various angles viz
l On sales
l On investments
l On capital employed and so on
While discussing the measure of profitability of the firm, the profits are normally classified
into various categories
l Gross Profit
l Net Profit
l Earnings before interest and taxes
l Earnings after taxation and so on
All profitability ratios are normally expressed only in terms of (%). The return is normally
expressed only in terms of percentage which warrant the expression of this ratio to be
also in percentage.
GP Ratio: The ratio elucidates the relationship in between the Gross profit and sales
volume.
It facilitates to study the profit earning capacity of the firm out of the manufacturing or
Trading operations.
Gross Profit 100

Gross Profit Ratio =
Sales
Standard Norm of the ratio:
Higher the ratio is better the position of the firm which means that the firm earns greater
profits out of the sales and vice versa.
NP Ratio: The ratio expresses the relationship in between the Net profit and sales
volume. It facilitates to portray the overall operating efficiency of the firm. The net
profit ratio is an indicator of over all earning capacity of the firm in terms of return out
of sales volume.
Net Profit 100

Net Profit Ratio = 105
Sales
Accounting and Finance Standard Norm of the Ratio:
for Managers
Higher the ratio is better the operating efficiency of the firm which means that the firms
earns greater volume of both operating as well as non operating profit out of sales and Vice
versa.
Operating profit ratio: The operating ratio is establishing the relationship in between
the cost of goods sold and operating expenses with the total sales volume.
Cost of goods sold + Operating expenses 100

Operating ratio =
Net sales
Lower the ratio is better as well as favourable position for the firm, which highlights % of
absorption cost of goods sold and operating expenses out of sales and vice versa. The
lower ratio leads to have the higher margin of operating profit.
Return on Assets: This ratio portrays the relationship in between the earnings and total
assets employed in the business enterprise. It highlights the effective utilization of the
assets of the firm through the determination of return on total assets employed.
Net Profit After Taxes 100

Return on Assets =
Average Total Assets
Standard norm of the ration

Higher the ratio illustrates that the firm has greater effectiveness in the utilization of assets,
means greater profits reaped by the total assets and vice versa.
6.14 RETURN ON CAPITAL EMPLOYED

The ratio illustrates that how much return is earned in the form of Net profit after taxes
out of the total capital employed. The capital employed is nothing but the combination of
both non current liabilities and owners equity. The ratio expresses the relationship in
between the total earnings after taxation and the total volume of capital employed.
Net profit after taxes 100

Return on total capital employed =
Total capital employed

Higher the ratio is better the utilization of the long term funds raised under the capital
structure means that greater profits are earned out of the total capital employed.
Activity turnover ratio: It highlights the relationship in between the sales and various
assets. The ratio indicates that the rate of speed which is taken by the firm for converting
the assets into sales.
6.15 STOCK TURNOVER RATIO

The ratio expresses the speed of converting the stock into sales. In other words, how
fast the stock is being converted into sales in a year? The greater the ratio of conversion
leads to lesser the number of days /weeks /months required to convert the stock into
sales.
Cost of Goods Sold Sales

Stock turnover ratio = Or
Average stock Closing stock
106
Standard norm of the ratio: Ratio Analysis
Higher the ratio is better the firm in converting the stock into sales and vice versa
The next step is to find out the number of days or weeks or months taken or consumed
by the firm to convert the stock into sales volume.
365 days/52 weeks/12 months

Stock velocity =
Creditors Turnover Ratio
Lower the duration is better the position of the firm in converting the stock into sales and
vice versa.
6.16 DEBTORS TURNOVER RATIO

This ratio exhibits the speed of the collection process of the firm in collecting the overdues
amount from the debtors and against Bills receivables. The speediness is being computed
through debtors velocity from the ratio of Debtors turnover ratio.
Net Credit Sales Net Credit Sales

Debtors turnover ration = Or
Average Debtors Debtor + Bills Receivable

Higher the ratio is better the position of the firm in collecting the overdue means the
effectiveness of the collection department and vice versa.
6.16.1 Debtors Velocity

This is an extension of the earlier ratio to denote the effectiveness of the collection
department in terms of duration.
365days/52weeks/12months
Debtors velocity =
Debtor turnover ratio

Lesser the duration shows greater the effectiveness in collecting the dues which means
that the collection department takes only minimum period for collection and vice versa.
6.16.2 Creditors Turnover Ratio

It shows effectiveness of the firm in making use of credit period allowed by the creditors
during the moment of credit purchase.
Credit Purchase Credit Purchase

Creditors Turnover ratio = Or
Average creditors Bills payable + Sundry

Lesser the ratio is better the position of the firm in liquidity management means enjoying
the more credit period from the creditors and vice versa.
365 days/52 weeks/12 months

Creditors velocity =
Creditors Turnover Ratio
107
Accounting and Finance Standard norm of the ratio
for Managers
Greater the duration is better the liquidity management of the firm in availing the credit
period of the creditors and vice versa.
Check Your Progress
(1) Solvency position of the firm studied and interpreted through

(a) Short-term solvency ratios
(b) Long-term solvency ratios
(c) Coverage ratios
(d) (a) (b) & (c)
(2) Efficiency and effectiveness of the firm is studied through
(a) Liquidity ratios
(b) Leverage ratios
(c) Turnover ratios
(d) Profitability ratios
(3) Profitability ratios to study the potential to earn profits on
(a) On Assets
(b) On Capital employed
(c) On Sales
(d) (a) (b) & (c)
Illustration 5
Sundaram &co sells goods on cash as well as credit basis. The following particulars are
extracted from the books of accounts for the calendar 2005
Particulars Rs
Total Gross sales 2,00,000
Cash sales ( included in above) 40,000
Sales returns 14,000
Total Debtors 18,000
Bills receivable 4,000
Provision for doubtful debts 2,000
Total creditors 20,000
Calculate average collection period
To find out the average collection period, first Debtors turnover ratio has to computed
Net Credit sales

Debtors turnover ratio =
Bills receivable + Debtors
Net credit sales= Gross sales cash sales sales return
= Rs. 2, 00, 000 Rs. 40, 000 Rs. 14, 000=Rs. 1, 46, 000
Rs. 1, 46,000
Debtor turnover ratio =
Rs. 4,000 + Rs.18,000
= 6.64 times
365 days 365 days

Debtors velocity = =
Debtors turnover ratio 6.64 times
108
= 55 days
Illustration 6 Ratio Analysis
Find out the value of creditors from the following

Sales Rs. 1,00,000 Opening stock Rs10,000
Gross profit on Sales 10% Closing stock Rs. 20,000
Creditors velocity 73 days Bills payable Rs. 16,000
Note: All purchases are credit purchases
To find out the volume of purchases, the formula of cost of goods sold should taken into
consideration
Cost of goods sold = Opening stock +Purchases- Closing stock
X = Rs. 10,000 + Y Rs. 20,000
Cost of goods sold = Sales Gross profit
= Rs. 1,00,000 10% on Rs 1,00,000
= Rs. 90,000
The next step is to apply the found value in the early equation
Purchases = Rs. 90,000 Rs. 10,000 +Rs. 20,000
= Rs. 1,00,000
To find out the value creditors, the creditor velocity and creditors turnover ratio
365 days
Creditors turnover ratio
Credit purchases
Creditors turnover ratio =
Bills payable + Sundry creditors
Rs.1,00,000
=
Rs.16,000 + Sundry creditors
The next step is to find out the sundry creditors, the reversal process to be adopted
365 days
73 days =
365 days
Creditors turnover ratio = = 5 times
73 days
The next step is to substitute the found value in the equation of creditors turnover ratio
Rs. 1,00,000
Rs. 16,000 + Sundry creditors =
5
Sundry creditors= Rs. 20,000 Rs. 16, 000= Rs. 4,000
Illustration 7
From the following information, prepare a balance sheet show the workings
1. working capital Rs. 75,000
2. Reserves and surplus 1,00,000
3. Bank overdraft 60,000 109
Accounting and Finance 4. Current ratio 1.75
for Managers
5. Liquid Ratio 1,15
6. Fixed assets to proprietors fund .75
7. Long term liabilities Nil
(B.Com. Madras, April 1980)
First step is to find out the current liabilities
Current assets 1.75

Current ratio = =
Current liabilities 1
Working capital = Rs. 75,000 =1.751= 0.75
If 0.75 is the share of working capital, what would be the share of current assets ?
Rs. 75,0001.75
Current assets = = Rs.1,75,000
.75
Working capital = Current assets current liabilities
Current liabilities = Current assets working capital
CL= Rs. 1, 75, 000 Rs. 75, 000=Rs. 1, 00, 000
1.15 = Quick assets

Quick assets ratio = 1. 15 =
Quick liabilities
Quick assets
=
Current liabilities BOD
1.15(Rs. 1,00,000Rs. 60,000) = Quick assets

1.15(Rs. 40,000)= Quick assets
Rs 46, 000= Quick assets
The next step is to find out the amount of the closing stock. This can be found out
through finding out the difference in between the current assets and quick assets.
Closing stock = Current assets Quick assets
= Rs. 1,75,000 Rs. 46,000= Rs. 1,29,000
The next one is to find out the proprietors fund
The fixed assets to proprietors fund is 0.75
This has to be found out on the basis of Double Entry Accounting Concept
Total liabilities = Total Assets....................(1)
Long term funds + Short term financial resources = Total liabilities
In the long term funds, there is no long term liabilities, which means the structure of long
term funds consist of the share holders funds The share holder funds are known as
proprietors fund
Short term financial resources are known as current liabilities
Proprietors fund + Current liabilities = Total liabilities
Current assets + Fixed assets = Total assets
To substitute the values in the equation (1)
110
Proprietors fund + Current liabilities= Current assets + Fixed assets Ratio Analysis
Proprietors fund Fixed assets= Current assets Current liabilities

1 0.75=Rs. 1,75,000 Rs. 1,00,000
0.25=Rs. 75,000
If 0. 25 is bearing the volume of Rs 75, 000; what would be the volume of investment of
fixed assets for 0. 75 and proprietors fund for 1
Rs. 75, 000

proprietor' s fund = Rs. 3,00,000
0.25
0.75 portion of the owners funds are contributed to fixed assets i.e. 0.75 on Rs. 3,00,000
= Rs. 2,25,000
To find out the exact share of the equity share capital, the following formula has to be
used.
Share holders funds = Equity share capital + Reserves and surpluses
In this problem, reserves and surpluses is given
Rs. 3,00,000=Equity share capital +Rs 1,00,000
Equity share capital= Rs. 2,00,000
The balance sheet of the company as on dated
Share capital 2,00,000 Fixed assets 2,25,000
Reserves and surpluses 1,00,000 Stock 1,29,000
Bank overdraft 60,000 Quick assets 46,000
Quick liabilities 40,000
4,00,000 4,00,000
Check Your Progress
(1) Standard norm of the current ratio is

(a) 2:1
(b) 1:. 5
(c) 1:2
(d) 3:1
(2) Super quick assets do not include
(a) Closing stock
(b) Prepaid expenses
(c) Sundry debtors
(d) Both (a) & (b)
(3) Standard norm of the Debt to Capital
(a) 1:2
(b) 1:1
(c) 2:1
(d) 1:5
111
Accounting and Finance Illustration 8
for Managers
Debtors velocity 3 months
Creditors velocity 2 months
Stock velocity 8 times
Capital turnover ratio 2. 5 times
Fixed assets turnover ratio 8 times
Gross profit turnover ratio 25%
Gross profit in a year amounts to Rs. 1, 60, 000. There is no long term loan or overdraft.
Reserves and surplus amount to Rs. 56, 000. Liquid assets are Rs. 1, 94, 666. Closing
stock of the year is Rs. 4, 000 more than the opening stock Bill receivable amount to Rs.
10, 000 and bills payable to Rs. 4, 000
Find out
Sales Closing stock
Sundry debtors Fixed assets
Sundry creditors Proprietors fund
Draft the balance sheet with as many as details possible.
The first step is to find out the sales
Gross profit ratio = 25%
The total volume of gross profit is given = Rs. 1,60,000
Gros Profit
GP ratio = 100
Sales
Rs. 1,60,000
25% = 100
Sales
Rs.1,60,000
Saels = = Rs. 6,40,000
25%
The next step is to find out the closing stock value

In our problem, two important information given are stock velocity and details about the
closing stock in terms of opening stock
Stock velocity = 8 times
Closing stock is Rs. 4, 000 excess of opening stock
The information stock velocity given denotes that the stock turnover ratio.
cost of goods sold

Stock trunover ratio =
Average Stock
Now the volume of cost of goods sold has to be found out from the early available
information i.e., sales and gross profit
Cost of goods sold= Sales Gross profit
= Rs. 6,40,000 Rs. 1,60,000= Rs. 4,80,000
The next step is to find out the volume of average stock through the earlier formula
Rs. 4,80,000
112
8 times =
Average stock
Average stock = Rs. 60,000 Ratio Analysis
The next step is to apply the conditionality with regards to closing stock
Opening Stock + Closing Stock

= Rs. 60,000
2
Opening stock + Opening stock + Rs. 4, 000
= Rs. 60,000
2
2 Opening stock +Rs. 4, 000= Rs. 1, 20, 000

2 Opening stock = Rs. 1, 20, 000 Rs. 4, 000
Opening stock = Rs. 58, 000
Closing stock = Opening stock + Rs. 10, 000= Rs. 58, 000+ Rs. 10, 000=Rs. 68, 000
The next fact is to be found that sundry debtors
To find out the debtors, the most information given debtors velocity and bills receivable
have to be made use of
12 months
Debtors Velocity =
Debtors turnover ratio
12 months
Debtors turnover ratio = = 4 times
3 months
Credit sales
4 times =
Bills receivable + Sundry debrors
Rs. 6,40,000
Rs. 10,000 + Sundry debtors =
4
Sundry debtors = Rs. 1, 60, 000Rs. 10, 000= Rs. 1, 50, 000
The next important stage is to find out the sundry creditors
To find out the sundry creditors, the creditors velocity has to be applied in the formula
In addition to the earlier, one missing information has to be found out i-e Credit purchases
The volume of purchase to be found out through the formula of cost of goods sold
Cost of goods sold= Opening stock +Purchases Closing stock
Rs. 4,80,000 = Rs. 58,000+Purchases Rs. 68,000
Purchases = Rs. 4,80,000Rs. 58,000+Rs. 68,000
= Rs. 4,80,000+Rs. 10,000= Rs. 4,90,000
12 months
12 months
Creditors turnover ratio = 6 times
2 months
Rs. 4,90,000
6 times = + Sundry creditors
Rs. 4,000
Rs. 4,000+ Sundry creditors= Rs. 81,667

Sundry creditors = Rs 77,667 113
Accounting and Finance The next step is to find out the volume of fixed assets
for Managers
This could be found out with the help of fixed assets turnover ratio =5 times
Sales
Fixed assets turnover ratio = 5 times =
Fixed Assets
Rs. 6,40,000
= = Rs.1, 28, 000
5 times
Proprietors fund
Proprietors fund = Fixed assets+ Current Assets Current liabilities
The above equation is coined on the basis of Double accounting concept
Fixed assets + Current assets = Total assets = Total Liabilities
Total Assets Current liabilities = Total Liabilities Current liabilities
Current assets volume is not known, In such cases the stock volume should be added
with the Liquid assets to derive the early mentioned.
Current assets= Closing stock + Liquid Assets
= Rs. 68,000+ Rs. 1,94,666 = Rs2,62,666
Proprietors fund = Rs. 1,28,000+ Rs. 2,62,666 Rs. 81,667
= Rs. 3,08,999
Share capital = Proprietors fund Reserves and surpluses
= Rs. 3,08,999 Rs. 56,000= Rs. 2,52,999
Cash and Bank Balances to be found out in the next stage
Liquid Asset = Rs. 1,94,666

Less : Debtors Rs. 1,50,000
Bills receivable 10,000 Rs. 1,60,000
Rs. 34,666
From the above found information the detailed balance sheet with as many as information
possible to portray
Balance sheet as on dated -
Reserves and surpluses 56.000 Stock 68,000
Bills receivable 4,000 Debtors 1,50,000
Sundry creditors 77,667 Bills receivable 10,000
Cash and Bank Balance 34,666
3,90,666 3,90,666
Illustration 9
From the following particulars, prepare trading, profit and loss account and a balance
sheet
Current ratio -3
Liquid ratio -1.8
114
Bank overdraft Rs. 20,000
Working capital Rs. 2,40,000 Ratio Analysis
Debtors velocity -1 month ; Gross profit ratio -20%

Proprietary ratio (Fixed assets / share holders fund) - .9
Reserves and surpluses -. 25 of share capital
Opening stock Rs. 1,20,000; 8% Debentures Rs. 3,60,000
Long term investments Rs. 2,00,000
Stock turnover ratio -10 times
Creditors velocity -1/2 month
Net profit to share capital -20%
(B. Com Bharathidasan, April 1989)
First step is to find out the current assets and current liabilities through current ratio
Current Assets
Current ratio = =3
Current Liabilities
Current Assets- Current Liabilities = Working capital
3 1 = 2 = Rs. 2, 40, 000
The volume of working capital Rs 2,40,000 is equated to share 2
What is the volume of current liabilities for the share of 1
Current liabilities = Rs. 2, 40, 000 = Rs. 1,20,000
2
The volume of current assets = Rs. 1,20,000 3= Rs. 3,60,000
The next step is to find out the volume of liquid assets
Liquid assetss
Liquid assets ratio = 1.8 =
Liquid Liabilities
When the Bank overdraft is given, the liquid liabilities should be computed.
Liquid liabilities = Current liabilities Bank overdraft
= Rs. 1,20,000 Rs. 20,000 = Rs. 1,00,000
Liquid assets is 1.8 times greater than the Liquid liabilities
Liquid assets = 1.8 Rs. 1,00,000 = Rs. 1,80,000
To find out the volume of the stok
Stock = Current assets Liquid assets
=Rs. 3,60,000 Rs. 1,80,000
= Rs. 1,80,000
The next step is to find out the cost of goods sold
To find out the cost of goods sold, the stock turnover ratio has to be found out
cost of goods sold

10 times =
Average stock
Opening stock + Closing stock Rs.1,20,000 + Rs.1,80,000
Average stock = = = Rs. 1,50,000 115
2 2
Accounting and Finance Cost of goods sold = Rs. 1,50,000 10= Rs. 15,00,000
for Managers
Next step is to find out the volume of sales in order to find out the volume of debtors
The volume of sales could be found out through Gross profit ratio
Sales Profit = Cost of goods sold
100 20=80
The Rs15, 00, 000 worth of cost of goods sold is equated to share of 80
What would be the volume of sales?
Rs.15,00,000
Sales = = Rs.18,75,000
80
Gross profit = Rs. 18, 75, 000 Rs. 15, 00, 000= Rs. 3,75,000
The next step is to find out the volume of debtors
The debtors could be found out with the help of debtors turnover ratio and collection
period
12 months
Debtors velocity or collection period =
Debtors turnover ratio
12 months
Debtors turnover ratio = = 12 times
1 month
Credit Sales
12 times =
Average debtors
Rs. 18,75,000
Average Debtors = = Rs.1,56,250
12
The next step is to find out the creditors. The volume of creditors ; to find out the volume
of the creditors, the creditors turnover ratio and creditors average payment period should
have to be applied
12 months
Creditors average payment period =
12 months
Creditors turnover ratio = = 24times
0.5
credit purchase
Creditors turnover ratio = Average creditors
credit purchase
Average creditors =
24 times
Now the volume of credit purchase to be found out with the help of cost of goods sold
formula
Cost of goods sold= Opening stock+ Purchases- Closing stock
Rs. 15,00,000Rs. 1,20,000+Rs. 1,80,000= Purchases
Rs. 15,60,000 = Purchases
116 Average creditors = Rs. 65,000
The next step is to find out the proprietary fund ; this could be found out by using the ratio Ratio Analysis
proprietary fund to fixed assets ratio
Total Assets= Total Liabilities
Long term liabilities + Short term liabilities = Fixed assets + Current assets + Investments
Share holders fund Fixed assets = Current assets + Investment Current liabilities
Debenture
1 0.9= Rs. 2,00,000+Rs. 3,60,000Rs. 1,20,000Rs. 3,60,000
1 0.9= Rs. 80,000
0.1=Rs. 80,000
If 0.1 share is the volume of Rs. 80,000 what is the volume of proprietary fund for the
share of 1?
The volume of proprietary fund = Rs. 8,00,000
The volume of fixed assets = Rs. 80,000 0.9= Rs. 7,20,000
The next step is to find out the volume of the share capital. This could be found out only
with the help of the ratio given Reserves and surpluses to share capital
Reserves and surpluses = 25 % of share capital
It means that % is Share capital.
Share capital + Reserves and surpluses = Shareholders fund
100+25=125
To find out the share of share capital from the shareholders fund, the following is the
computation
Rs.8,00,000
100 = Rs. 6,40,000 = share capital
125
Reserves and surpluses = 25% on the Share capital
= 25% on Rs. 6,40,000 =Rs. 1,60,000
The last step is to find out the Net profit, which could be found out through the Net profit
to share capital
Net profit is 20% on share capital
Net profit = 20% on Rs. 6,40,000= Rs. 1,28,000
Next stage is to prepare the Trading, Profit & Loss A/c for the year ended and Balance
sheet as on dated
Trading Profit & Loss Account for the year ended
Dr Cr
To opening stock 1,20,000 By sales 18,75.000
To purchases 15,60,000 By closing stock 1,80,000
To Gross profit c/d 3,75,000
20,55,000 20,55,000
To Debenture Interest 8% 28,800 By Gross profit B/d 3,75,000
Rs.3,60,000
To Balancing figure other 2,18,200
expenses
To Net profit c/d* 1,28,000
3,75,000 3,75,000 117
Accounting and Finance Balance sheet as on dated
for Managers
Liabilities Rs Rs Assets Rs Rs
Reserves and 32,000 Investments 2,00,000
Surpluses
Profit during the 1,28,000 1,60,000
year
8% Debentures 3,60,000
Current liabilities Current Assets
Overdraft 20,000 Stock 1,80,000
Creditors 65,000 Debtors 1,56,250
Others 35,000 1,20,000 Other current asset 23,750 3,60,000
12,80,000 12,80,000
6.17 DUPONT ANALYSIS

This was an analysis established by the DUPONT INC. , USA to study the Return on
investment. It was the first company developed the chart which depicted the influences
of Return on Investment. The company underwent for the consideration two important
ratios for the return on investment is Net profit ratio and Capital turnover ratio A change
in the any one of the two ratios that will immediately reflect on the Return on investment.
The various associated factors are considered to study the impact of the profitability of
the firm. This type of analysis to correct the problems not only to identify the with
specific cause which drastically affects the profitability but also to find the possible ways
and means to improve the profitability. Having developed the chart for analysis was
called as DUPONT Chart.
Net profit Sales Cost of goods

sold
Net profit ratio
Sales
Expenses
Administrative,
Selling and
Roce distribtution
Return on expense
capital
employed
sales Working capital Current assets
Capital turnover ratio
Capital Current
employed Fixed asset
liabilities
6.18 LET US SUM UP

The accounting ratios are applied to study the relationship in between the quantitative
information available and to take decision on the financial performance of the firm. The
financial performance and position of the firm can be analysed and interpreted with in
the firm in between the available financial information of many number of years; which
portrays either increase or decrease in the financial performance. The perfection and
effectiveness of the analysis mainly depends upon the preparation of accurate and
effectiveness of the financial statements. It is subject to the availability of fair presentation
of data in the financial statements. Current liabilities are nothing but short term financial
resources or payable in short span of time within a year. The super quick assets are
118 nothing but the current assets which can be more easily converted into cash to meet out
the quick liabilities. Under the capital structure ratios, the composition of the capital Ratio Analysis
structure is analysed only in the angle of long term solvency of the firm. All profitability
ratios are normally expressed only in terms of (%). The return is normally expressed
only in terms of percentage which warrant the expression of this ratio to be also in
percentage.

Identity four ratios or other analytical tools used to evaluate profitability. Explain briefly
how each is computed.
6.20 KEYWORDS
Ratio
Stock term over ratio
Acid Test ratio
Fixed assets ratio
Accounting ratio
GP ratio
Coverage ratio
Stock velocity
Du analysis

1. Define ratio.
2. Define Accounting ratio.
3. What is meant by Accounting ratio analysis ?
4. Elucidate the importance of the ratio analysis.
5. Explain the Liquidity ratios.
6. Highlight the Leverage ratios.
7. Discuss in detail about the Profitability ratios.
8. Illustrate the various kinds of Turnover ratios.
9. List out the limitations of the ratio analysis.

R. L. Gupta and Radhaswamy, Advanced Accountancy
S. N. Maheswari, Management Accounting
Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi. 119
for Managers LESSON
7
FUND FLOW STATEMENT ANALYSIS
CONTENTS
7.1 Introduction
7.2 Meaning & Objectives of Fund Flow Statement Analysis
7.3 Methods of Preparing Fund Flow Statement
7.3.1 Schedule of Changes in Working Capital
7.3.2 Net Profit Method
7.3.3 Sales Method
7.3.4 First Method
7.3.5 Second Method
7.4 Advantages of Preparing Fund Flow Statement
7.4.1 Illustrative Statement of Financing
7.4.2 To fulfil the Primary Objective of the Financial Management
7.4.3 Facilitation through Financial Planning
7.4.4 Guide to Working Capital Management
7.4.5 Indicator of Yester Track Path of the Firm
7.5 Let us Sum up
7.7 Keywords

In this lesson we shall discuss about fund flow statement analysis. After going through
(i) understand meaning and objectives of fund flow statement analysis
(ii) analyse methods of preparing fund flow statement
(iii) discuss advantages of preparing fund flow statement.
7.1 INTRODUCTION
Every business establishment usually prepares the balance sheet at the end of the fiscal
year which highlights the financial position of the yester years It is subject to change in
the volume of the business not only illustrates the financial structure but also expresses
the value of the applications in the liabilities side and assets side respectively. Normally,
Balance sheet reveals the status of the firm only at the end of the year, not at the
beginning of the year. It never discloses the changes in between the value position of the
firm at two different time periods/dates.
The method of portraying the changes on the volume of financial position is the statement
fund flow statement. To put them in nutshell, fund between two different time periods. It is
120
further illustrated that the changes in the financial position or the movement or flow of fund.
Fund Flow Statement Analysis
7.2 MEANING & OBJECTIVES OF FUND FLOW
STATEMENT ANALYSIS
A report on the movement of funds or working capital. In a narrow sense the term fund
means cash and the fund flow statement depicts the cash receipts and cash disbursements/
payments. It highlights the changes in the cash receipts and payments as a cash flow
statement in addition to the cash balances i.e., opening cash balance and closing cash
balance. Contrary to the earlier, the fund means working capital i.e., the differences
between the current assets and current liabilities.
The term flow denotes the change. Flow of funds means the change in funds or in
working capital. The change on the working capital leads to the net changes taken place
on the working capital i.e., especially due to either increase or decrease in the working
capital. The change in the volume of the working capital due to numerous transactions.
Some of the transactions may lead to increase or decrease the volume of working
capital. Some other transactions neither registers an increase nor decrease in the volume
of working capital.
According Foulke A statement of source and application of funds is a technical device designed
to analyse the changes to the financial condition of a business enterprise in between two dates
Various Facets of Fund flow statement are as follows:
l Statement of sources and application of funds
l Statement changes in financial position
l Analysis of working capital changes and
l Movement of funds statement
Objectives of fund flow statement analysis:
(1) It pinpoints the mobilization of resources and the further utilization of resources
(2) It highlights the financing of the general expansion of the business firms
(3) It exemplifies the utilization of debt finance in the structure of financing
(4) It portrays the relationship between the financing, investment, liquidity and dividend
decision of the firm during the given point of time.
7.3 METHODS OF PREPARING FUND FLOW

STATEMENT
Steps in the preparation of Fund Flow Statement:
l First and fore most method is to prepare the statement of changes in working
capital i.e., to identify the flow of fund / movement of fund through the detection
of changes in the volume of working capital.
l Second step is the preparation of Non- Current A/c items-Changes in the volume
of Non current a/cs have to be prepared only in order to quantify the flow fund i-e
either sources or application of fund.
l Third step is the preparation Adjusted Profit& Loss A/c, which already elaborately
discussed in the early part of the chapter.
l Last step is the preparation of fund flow statement.
7.3.1 Schedule of Changes in Working Capital
The ultimate purpose of preparing the schedule of changes in the working capital is to
illustrates the changes in the volume of net working capital which envisages either
sources or application of fund. The schedule of changes are focused as follows:
Increase in Current Assets Increase in Working Capital
Decrease in Current Assets Decrease in Working Capital
Increase in Current Liabilities Decrease in Working Capital
Decrease in Current Liabilities Increase in Working Capital 121

Accounting and Finance Particulars Previous Current Increase Decrease in
for Managers Year Year inWorking inWorking
Capital (+) Capital ()
(A) Current Assets:
Cash In Hand
Cash at Bank
Marketable Securities
Bills Receivable
Sundry Debtors
Closing Stock
Prepaid Expenses
(B) Current Liabilities:

Creditors
Bills Payable
Outstanding expenses
Pre received Income
Provision for doubtful and bad
debts
Net Working Capital(A-B)

Increase/Decrease Working
Capital
The next important step is to prepare that Adjusted profit and loss account
Method of Fund From Operations
Net Profit Method Sales Method

Add Non Operating Expenses
Less-Payments(Application)
Less Non Operating Incomes
The first method is widely used method by all in determining the volume of Fund from
Operations (FFS)
Under the Net Profit Method, Fund flow from operations can be computed
7.3.2 Net Profit Method
Under this method, Fund from operations can be determined in two different ways .The
first method is through the statement format
Net Profit from the Profit & Loss A/c xxxxx
Add:
(A) Non Funding Expenses:
Loss on Sale of Fixed Assets xxxx
Loss on Sale of Long Term Investments xxxx
Loss on Redemption Debentures/Preference Shares xxxx
Discount on Debentures /Share xxxx
(B) Non Operating Expenses:
Depreciation of fixed Assets xxxx
(C) Intangible Assets:
Amortization of Goodwill xxxx
Amortization of Patent xxxx
Amortization of Trade Mark xxxx
(D) Fictitious Assets:
Writing off Preliminary expense xxxx
122 Writing off Discount on Shares/Debentures xxxx
(E) Profit Appropriation Fund Flow Statement Analysis
Transfer to General Reserve xxxx

Less:
(F) Non funding Profits:
Profit on Sale of Fixed Assets xxxx
Profit on Sale of Long Term Investments xxxx
Profit on Redemption Debentures/Preference Shares xxxx
(G) Non Operating Incomes:
Dividend Received xxxx
Interest Received xxxx
Rent Received xxxx
Fund From operations / Fund Lost in Operations xxxxx
The second method of determining the fund from operations under the first classification
is the Accounting Statement Format.
Adjusted Profit & Loss A/c
Dr Cr
To Depreciation xxxx By Opening Balance Profit xxxx
To Goodwill Written off xxxx By Profit on sale of Fixed Assets xxxx
To Patent Written off xxxx By Profit on Sale of Investments xxxx
To Loss on Sale of Fixed Asset xxxx By Profit on redemption of
To Loss on Sale of Investment xxxx Liability xxxx
To Loss on redemption of Liability xxxx By Transfer from General Reserve
To Preliminary Expenses off xxxx xxxx
To Proposed Dividend xxxx By Balancing Figure xxxx
To Transfer to General Reserve xxxx Fund From Operations(FFS)
To Current Year Provision for
Taxation xxxx
To Current Year Provision for
Depreciation xxxx
To Balancing Figure xxxx
(Fund Lost in Operations)
7.3.3 Sales Method
Under this method, the following is the statement format is used to arrive fund flow
from operations:
Sources:
Sales xxxxx
Stock at the end xxxxx
Less:
Application:
Stock at Opening xxxx
Net Purchases (Purchase-Returns) xxxx
Wages xxxx
Salaries xxxx
Telephone expenses xxxx
Electricity charges xxxx
Office stationery expenses xxxx
Other operating cash expenses xxxx
Fund from operations
From the following details calculate funds from operations:
Rs.
Salaries 10,000
Rent 6,000 123
Accounting and Finance Refund of Tax 6,000
for Managers
Profit on Sale of Building 10,000
Depreciation on Plant 10,000
Provision for Taxation 8,000
Loss on Sale of plant 4,000
Closing Balance of Profit & Loss A/c 1,20,000
Opening balance on Profit & Loss A/c 50,000
Discount on Issue of Debentures 4,000
Provision for bad debts 2,000
Transfer to general reserve 2,000
Preliminary expenses written off 6,000
Good will written off 4,000
Dividend Received 10,000
Proposed Dividend 12,000
Calculation of fund from operation
7.3.4 First Method
Closing balance of Profit & Loss A/c 1,20,000
Less Opening Balance 50,000
Balance Forward 70,000
Add: Non Fund / Non Operating Charges:
Depreciation on Plant 10,000
Provision for Taxation 8,000
Loss on Sale of Plant 4,000
Discount on issue of debentures 4,000
Provision for bad debts 2,000
Transfer to general reserve 2,000
Preliminary expenses off 6,000
1,22,000
Less
Refund of Tax 6,000
Profit on Sale of Building 10,000
Dividend Received 10,000
Fund from operations 96,000
7.3.5 Second Method
Adjusted Profit & Loss A/c
Depreciation on Plant 10,000 By Opening Balance B/d 50,000
Provision for Taxation 8,000 By Profit on Sale of Building 10,000
Loss on Sale of Plant 4,000 By Dividend Received 10,000
Discount on issue of debentures 4,000 By Refund of Tax 6,000
Provision for bad debts 2,000 By Balancing Figure 96,000
Transfer to general reserve 2,000 Fund From operations
Preliminary expenses off 6,000
To Closing Profit B/d 1,20,000 1,72,000
1,72,000
124
The next step is to prepare the fund flow statement. The proforma of the fund flow Fund Flow Statement Analysis
statement
Sources of funds Uses of funds
Funds from Business Operation Funds Lost in Operations
Non trading Incomes Redemption of Preference Share Capital
Sale of Non-Current Assets Repayment of Loans
Sale of Long Term Investments Purchase of Long Term Investments
Issue of shares Purchase of Fixed Assets
Acceptance of deposits Payment of Taxes
Long Term Borrowings Payment of Dividends
Decrease in Working Capital Drawings
Loss of Cash
Increase in Working Capital
Check Your Progress
(1) Fund flow means a study of

(a) working capital change
(b) Cash position change
(c) Long investment change
(d) Change in the current liabilities
(2) Normally Working capital means
(a) Current assets- current liabilities
(b) Current assets
(c) Gross working capital
(d) Net working capital
(3) Increase in working capital
(a) Increase in current assets
(b) Increase Net working capital
(c) Increase in current liabilities
(d) Increase in long term source of financing
7.4 ADVANTAGES OF PREPARING FUND FLOW

STATEMENT
Structured analysis on the Working capital of a firm:
It is the only statement to study the changes in the working capital in between two
different periods from the balance sheet of a firm through structured analysis on the
basis of working capital position.
7.4.1 Illustrative Statement of Financing
It is a statement which highlights the role of various kinds of financing not only in the
dimension of project development and expansion but also growth rate of the organization.
Financial Structure
Capital Structure-Long Term Medium &Short term

Financial Resources Financial Resources
External Sources Internal Sources: Institutional Money Market:

Share Capital and Retained lending: Public Deposit,
so on Earnings Banker-Loans & Commercial paper
Advances
125
Accounting and Finance 7.4.2 To fulfil the Primary Objective of the Financial Management
for Managers
It not only elucidates the mode of financing but also the application of resources after
raising. It answers to the following queries viz:
l How the outsider's liabilities are redeemed?
l What is the role of the fund from operation generated?
l How the raised funds applied into business?
l How the decrease in working capital was applied?
l What is the mode of raising of financial resources for an increase in the working
capital?
7.4.3 Facilitation through Financial Planning
The projected fund flow statement from the past performance facilitates the firm to
anticipate the future requirement of financial resources. It guides the management to
prioritize the application in the future to the tune of scarce resources.
7.4.4 Guide to Working Capital Management
It acts as a guide to the management to maintain the working capital at optimum level
through either purchase or sale of marketable securities during the periods of adequate
and inadequate working capital respectively.
7.4.5 Indicator of Yester Track Path of the Firm
The insight on the financial performance of the firm can be had by the lending institutions
through fund flow statement at the time of extending financial assistance to the firm.
Limitations:
l It is an extension of financial statements but it cannot be leveled with the emphasis
of them.
l It is not a resultant of the transaction instead it is an arrangement of among the
available information.
l Projected fund flow statement ever only to the tune of financial statements which
are historic in feature.
Check Your Progress
(1) Adjusted profit and loss account is prepared for

(a) Determining the fund from operations
(b) Determining the fund lost in operations
(c) (a) or (b)
(2) Fund flow statement is categorized into two parts
(a) Fund in flow & Fund out flow
(b) Cash in flow & Cash out flow
(c) Sources & Applications
(3) Fund from operations is
(a) Sources of the firm
(b) Applications of the firm
(c) Neither sources nor applications
126 (d) None of the above
Illustration 1 Fund Flow Statement Analysis
Form the following details prepare a statement showing changes in working capital during
1985:
Balance sheet of Pioneer ltd. as on 31st December
Liabilities 1984 Rs 1985 Assets 1984 1985
Rs. Rs. Rs.
Reserves 1,50,000 1,80,000 Less:Depreciation 3,70,000 4,60,000
Profit and Loss A/c 40,000 65,000 6,30,000 6,60,000
Debentures 3,00,000 2,50,000 Stock 2,40,000 3,70,000
Creditors for goods 1,70,000 1,60,000 Book Debts 2,50,000 2,30,000
Provision for tax 60,000 80,000 Cash in hand 80,000 60,000
Preliminary expeneses 20,000 15,000
12,20,000 13,35,000 12,20,000 13,35,000
(B.com., Bharathidasan November, 1986)
The first step is to prepare the schedule of changes in working capital.
Schedule of changes in working capital
1984 1985 Increase Decrease
In working In working
capital capital
Current asset:
Stock 2,40,000 3,70,000 1,30,000 ------------
Book debts 2,50,000 2,30,000 ------- 20,000
Cash in hand 80,000 60,000 20,000
5,70,000 6,60,000 1,30,000 40,000
Current liability
Creditors for goods 1,70,000 1,60,000 10,000 -------
Working capital 4,00,000 5,00,000 1,40,000 40,000
Increase in working capital 1,00,000 ------------ 1,00,000
5,00,000 5,00,000 1,40,000 1,40,000
Illustration 2
From the following two balance sheet as at December 31, 2004 and 2005. Prepare the
statement of sources and uses of funds.
2004 2005 2004 2005
Liabilities Rs. Rs. Rs. Rs.
Share capital 80,000 90,000
Trade creditors 20,000 46,000
Profit & Loss a/c 4,60,000 5,00,000
Assets
Cash 60,000 94,000
Debtors 2,40,000 2,30,000
Stock in trade 1,60,000 1,80,000
Land 1,00,000 1,32,000
5,60,000 6,36,000 5,60,000 6,36,000
The first step is to prepare the schedule of changes in working capital.
In working In working
captial capital
Current asset:
Cash 60,000 94,000 34,000
Debtors 2,40,000 2,30,000 10,000
Stock in trade 1,60,000 1,80,000 20,000
4,60,000 5,04,000
Current liability
Trade creditors 20,000 46,000 26,000
Working capital 4,40,000 4,58,000 54,000 36,000
Increase in working capital 18,000 ------------- ---------- 18,000
4,58,000 4,58,000 54,000 54,000 127
Accounting and Finance The next step is to prepare the non current accounts of the firm.
for Managers
Dr Land A/c Cr
Rs. Rs.
To Balance B/d 1,00,000
To Cash(Purchase) balancing fig. 32,000 By Balance c/d 1,32,000
1,32,000 1,32,000
Next non-current account item is the share capital account in the liability side.
The closing balance of the share capital is more than that of the opening balance which
means that the firm has undergone the issue of further more share capital.
During the issue of share capital, the cash resources are raised by the firm through the
sale of shares.
Dr Share capital A/c Cr
Rs. Rs.
To Balance c/d 90,000 By Cash( Issue of shares) 10,000
Balancing fig.
By Balance b/d 80,000
90,000 90,000
Then the next step is to prepare the adjusted profit and loss account to determine the
fund from the operations
Dr Adjusted Profit & Loss A/c Cr
Rs. Rs.
By Balance B/d 4,60,000
To Balance c/d 5,00,000 By Fund from operation 40,000
Balancing fig.
5,00,000 5,00,000
The next step is to prepare the fund flow statement of the firm
Fund flow statement
Sources Rs. Applications Rs.
Issue of Shares 10,000 Purchase of Land 32,000
unds from operation 40,000 Increase in working capital 18,000
50,000 50,000
Illustration 3
From the following relating to Panasonic ltd., prepare funds flow statement.
Balance sheet of Pioneer ltd. as on 31st December
Liabilities 1994 1995 Assets 1994 1995
Rs Rs Rs Rs
Reserves 2,00,000 1,00,000 Accounts 2,10,000 3,00,000
receivable
Retained earnings 60,000 1,20,000 Stock 3,00,000 3,90,000
Accounts payable 90,000 2,70,000 Cash 60,000 1,80,000
9,50,000 12,90,000 9,50,000 12,90,000
Additional information:
l The company issued bonus shares for Rs.1,00,000 and for cash Rs.1,00,000
l Depreciation written off during the year Rs.30,000
The first step is prepare the statement of changes in working capital
In working in working
captial capital
Current asset:
Cash 60,000 1,80,000 1,20,000 ----------
128 Contd...
Stock in trade 3,00,000 3,90,000 90,000 ---------- Fund Flow Statement Analysis
Accounts receivable 2,10,000 3,00,000 90,000 ----------
5,70,000 8,70,000
Current liability
Accounts payable 90,000 2,70,000 1,80,000
Working capital 4,80,000 6,00,000 3,00,000 1,80,000
Increase in working capital 1,20,000 1,20,000
6,00,000 6,00,000 3,00,000 3,00,000
The next step is to prepare the non - current account

First non-current asset account should have to be prepared
Dr Fixed Assets A/c Cr
Rs Rs
To Balance B/d 3,80,000 By Depreciation(Adjusted Profit 30,000
&Loss A/c )
To Cash (Purchase) 70,000 By Balance c/d 4,20,000
Balancing fig.
4,50,000 4,50,000
The next non-current account is that non-current liability which is nothing but Share
capital.
Dr Share capital A/c Cr
Rs Rs
To Balance c/d 8,00,000 By Cash( Issue of shares) 1,00,000
By General reserve 1,00,000
By Balance b/d 6,00,000
8,00,000 8,00,000
And another non current account is to be prepared that General reserve account.
Dr General Reserve A/c Cr
Rs Rs
To Share capital 1,00,000 By Balance b/d 2,00,000
To Balance c/d 1,00,000
2,00,000 2,00,000
The next step is to prepare the Adjusted Profit & Loss A/c
Dr Adjusted Profit & Loss A/c Cr
Rs Rs
To (Fixed Assets) depreciation 30,000 By Balance B/d(Retained 60,000
Earnings)
To Balance c/d 1,20,000 By Fund from operation 90,000
Balancing fig.
1,50,000 1,50,000
The next step is to prepare the fund flow statement of the enterprise
Fund flow statement
Sources Rs Applications Rs
Issue of Shares 1,00,000 Purchase of Land 70,000
Funds from operation 90,000 Increase in working capital 1,20,000
1,90,000 1,90,000
Illustration 4
Balance sheets of M/s Black and White as on 1-1-1986 and 31-12-1986 were as follows:
Liabilities 1-1-86 31-12-1986 Assets 1-1-86 31-12-1986
Rs Rs Rs Rs
Creditors 40,000 44,000 Cash 10,000 7,000
Mrs.WhitesLoan 25,000 - Debtors 30,000 50,000
Loan from 40,000 50,000 Stock 35,000 25,000
P.N.Bank
Captial 1,25,000 1,53,000 Machinery 80,000 55,000
Land 40,000 50,000
Building 35,000 60,000
2,30,000 2,47,000 2,30,000 2,47,000 129
Accounting and Finance Additional information
for Managers
During the year machine costing Rs.10,000 (accumulated depreciation Rs.3,000) was
sold for Rs.5,000 . The provision for depreciation against machinery as on 1-1-1986 was
Rs.25,000 and on 31-12-1986 Rs.40,000 Net profit for the year 1986 amounted to
Rs.45,000. You are required to prepare funds flow statement (M.Com MKU April 1980).
The very first step is to prepare the statement of changes in working capital
Changes in working capital in between the various current assets and current liabilities
are as follows:
Statement of changes in working capital
1-1-86 31-12-1986 Increase Decrease
Rs Rs In working In working
capital capital
Current asset:
Cash 10,000 7,000 ----------- 3,000
Debtors 30,000 50,000 20,000 ----------
Stock 35,000 25,000 --------- 10,000
75,000 82,000
Current liability
Sundry creditors 40,000 44,000 ----------- 4,000
Working capital 35,000 38,000 20,000 17,000
Increase in working capital 3,000 3,000
38,000 38,000 20,000 20,000
The next step is to determine the cost of the machinery before the charge of depreciation
i.e., to find out the Gross value of the assets, in other words Original cost of the assets to
be found out at the moment of purchase.
1-1-1986 31-12-1986
Written down value of the machinery extracted Rs.80,000 Rs.55,000
from the balance sheet as on dated
Add: Accumulated depreciation or 25,000 40,000
Provision for depreciation
Original Cost of Machinery 1,05,000 95,000
The ultimate aim is to find out the original cost of the machinery for the preparation of
the machinery account:
Before preparing the Machinery account, the worth of the sale transaction of the
machinery should be found out .
Original cost of the Machinery Rs.10,000
(-)Depreciation Rs.3,000
Machinery worth for sale Rs.7,000
(-)Machinery sold Rs.5,000
Loss on sale of the portion of the machinery sold Rs.2,000
Dr Machinery A/c Cr
Rs Rs
To Balance B/d 1,05,000 By Cash (Sales) 5,000
By Provision for machinery 3,000
By loss on sale(Adjusted profit 2,000
and loss account)
1,05,000 1,05,000
The next one is the provision for depreciation account or Accumulated depreciation
account.
130
Dr Provision for Depreciation A/c Cr Fund Flow Statement Analysis
Rs Rs
To Machinery A/c 3,000 By Balance B/d 25,000
To Balance c/d 40,000 By depreciation provided during 18,000
the current year
43,000 43,000
Dr Capital A/c Cr
Rs Rs
To Drawings (Balancing fig) 17,000 By Balance B/d 1,25,000
To Balance c/d 1,53,000 By Net profit 45,000
1,70,000 1,70,000
Dr Loan P.N. Bank Cr

Rs Rs
By BalanceB/d 40,000
To Balance c/d 50,000 By Cash (Balancing fig) 10,000
50,000 50,000
Dr Mr. White's A/c Cr

Rs Rs
To Cash( Loan paid) 25,000 By Balance B/d 25,000
To Balance c/d -----------
25,000 25,000
The next step is to prepare the Adjusted Profit & Loss Account.
Adjusted Profit & Loss Account
Rs Rs
To Machinery (Loss on sale) 2,000 By Balance B/d -----------
To Provision for taxatio 18,000 By fund from operations 65,000
To Balance c/d(Net profit) 45,000
65,000 65,000
The next step is to prepare the fund flow statement.
Fund flow statement
Sale of machinery 5,000 Purchase of land 10,000
Loan from P.N.Bank 10,000 Purchase of Building 25,000
Fund from operation 65,000 Drawings 17,000
Repayment of Mr White Loan 25,000
Increase working capital 3,000
80,000 80,000
Illustration 5
From the following balance sheets of A Ltd on 31st Dec, 1982 and 1983, you are required
to prepare Fund flow statement
The following are additional information has also been given
l Depreciation charged on plant was Rs.4,000 and on building Rs.4,000
l Provision for taxation of Rs.19,000 was made during the year 1983
l Interim Dividend of Rs.8,000 was paid during the year 1983
Balance sheet
Liabilities 1982 Rs 1983 Rs Assets 1982 Rs 1983 Rs
Share capital 1,00,000 1,00,000 Good will 12,000 12,000
General Reserve 14,000 18,000 Building 40,000 36,000
Profit & Loss A/c 16,000 13,000 Plant 37,000 36,000
Sundry creditors 8,000 5,400 Investments 10,000 11,000
Bills payable 1,200 800 Stock 30,000 23,400
Provision for taxation 16,000 18,000 Bill receivable 2,000 3,200
Provision for doubtful debts 400 600 Debtors 18,000 19,000
Cash 6,600 15,200
1,55,600 1,55,800 1,55,600 1,55,800
131
(M.Com.Madras,1984)
Accounting and Finance The first step is to prepare the Statement of changes in the working capital
for Managers
Statement of changes in working capital
Rs Rs In working In working
capital capital
Current asset:
Stock 30,000 23,400 6,600
Bill receivable 2,000 3,200 1,200
Debtors 18,000 19,000 1,000
Cash 6,600 15,200 8,600
56,600 60,800
Current liability
Sundry creditors 8,000 5,400 2,600
Bills payable 1,200 800 400
Provision for doubtful debts 400 600 200
9,600 6,800
Working capital 47,000 54,000 13,800 6,800
Increase in working capital 7,000 7,000
54,000 54,000 13,800 13,800
The next step is to prepare the non current accounts.

First, Non current asset account to be prepared.
The first non-current asset account is Building account.
Dr Building account Cr
Rs Rs
To Balance B/d 40,000 By (Depreciation)Adjusted profit & 4,000
Loss A/c
40,000 40,000
The next non- current asset account is Plant account
Dr Plant account Cr
Rs Rs
To Balance B/d 37,000 By (Depreciation)Adjusted profit & 4,000
Loss A/c
To Cash (Purchase) 3,000 By Balance c/d 36,000
balancing fig.
40,000 40,000
The next non-current asset account is Investments account.
Dr Investments account Cr
Rs Rs
To Cash(purchase) Balancing 1,000 By Balance c/d 11,000
figure
The next one is the non-current liability account.

Dr General Reserve account Cr
Rs Rs
To Balance B/d 18,000 By Adjusted profit and loss A/c 4,000
(Profit transferred during the
current year)
18,000 18,000
The next non-current liability account is Provision for taxation account
Dr Provision for taxation account Cr
Rs Rs
To Cash(Tax paid previous 17,000 By Balance B/d 16,000
year taxation) Balancing figure
To Balance B/d 18,000 By Adjusted profit & Loss A/c 19,000
(provision for taxation made
during the year)
132 35,000 35,000
The next step is to prepare the Adjusted profit and loss account. Fund Flow Statement Analysis

Rs Rs
To Depreciation Building 4,000 By Balance B/d 16,000
To Depreciation Plant 4,000 By Fund from operations 36,000
To Transfer to General Reserve 4,000
To Provision for taxation 19,000
To Interim dividend 8,000
52,000 52,000
The next step is to prepare the fund flow statement.
Fund flow statement
Fund from operations 36,000 Purchase of the plant 3,000
Purchase of the Investment 1,000
Increase working capital 7,000
Tax paid 17,000
Interim dividend 8,000
36,000 36,000
Check Your Progress
(1) Purchase of plant & machinery Rs.10 lakh through the issue of 1 Lakh
shares at Rs.10 per share ; affect the following accounts
(a) Non current asset and Non current liability accounts
(b) Non current asset and Current liability accounts
(c) Current asset account and Non current liability accounts
(d) Current asset and current liability accounts
(2) XYZ Ltd. has made a credit purchase of Rs.1 lakh worth of goods led to
Rs.1 lakh worth of additional stock of tradable goods for the enterprise,
leads to
(a) Increase in the working capital - Applications
(b) No change in the working capital position -Neither an application nor resource
(c) Decrease in the working capital-Resource
(3) The meaning of the "To cash ( Tax paid)" entry posted in the Provision for
taxation account is
(a) Last year taxation is paid through the current year provision
(b) Current year taxation is paid through the current year provision
(c) Last year tax is paid through the last year taxation
(d) Current year taxation is paid through the last year provision
(4) Profit on sale of the fixed assets are considered to be
(a) Resource to the enterprise
(b) Non operating income
(c) Application of the enterprise
(5) The treatment of current year depreciation with the closing balance of profit
in determining the fund from operations
(a) To be added
(b) To be multiplied
(c) To be deducted
(d) To be divided Contd... 133
Accounting and Finance (6) The redemption bank term loan leads to change in the
for Managers
(a) Non current liability account and current asset account
(b) Current asset account and current liability account
(c) Non current asset account and current liability account
(d) Non current asset account and current liability account
7.5 LET US SUM UP

Normally, Balance sheet reveals the status of the firm only at the end of the year, not at
the beginning of the year. It never discloses the changes in between the value position of
the firm at two different time periods/ dates. A report on the movement of funds or
working capital. In a narrow sense, the term fund means cash and the fund flow
statement depicts the cash receipts and cash disbursements/payments. The projected
fund flow statement from the past performance facilitates the firm to anticipate the
future requirement of financial resources. It guides the management to prioritize the
application in the future to the tune of scarce resources.

In the long run, is it more important for a business to have positive cash flows from its
operating activities, investing activities, or financing activities? Why? Give your opinion.
7.7 KEYWORDS
Fund: Fund means working capital
Flow: Flow means changes occurred in between two different time periods
Statement of changes in working capital: Enlisting the changes taken place in between
the Current assets and current liabilities of two different time horizons
Current assets: Assets which are in the form of cash, equivalent to cash or easily
convertible into cash .
Current liabilities: Short term financial resources of the firm
Non-current assets: Long term assets
Non current liabilities: Long term financial resources
Increase in working capital: Increase in Net working capital i.e. Excess of current
assets over the current liabilities- Applications side of the fund flow
Decrease in working capital: Decrease in Net working capital i.e. Excess of current
liabilities over the current assets - Resources side of the fund flow
Fund from operations: Income generated from only operations
Fund lost in operations: Loss incurred in the operations

1. Define fund.
2. Define flow.
3. What is meant by fund flow ?
134 4. List out the various objectives of preparing the fund flow statement.
Fund Flow Statement Analysis
5. Enumerate the various advantages in the preparation of fund flow statement.
6. Briefly explain the limitations of fund flow statement.
7. What are the steps involved in the process of fund flow statement ?
8. Explain the various methods of determining the fund from/lost (in ) operations.
9. Explain the process of preparing the statement of changes in working capital.
10. Draft the pro forma of the Fund flow statement.
11. Explain any non current account transactions affecting the fund position of the
firm.

R.L. Gupta and Radhaswamy, "Advanced Accountancy".
V.K. Goyal, "Financial Accounting", Excel Books, New Delhi.
Khan and Jain, "Management Accounting".
S.N. Maheswari, "Management Accounting".
S. Bhat, "Financial Management", Excel Books, New Delhi.
Prasanna Chandra, "Financial Management - Theory and Practice", Tata McGraw
I.M. Pandey, "Financial Management", Vikas Publishing, New Delhi.
Nitin Balwani, "Accounting & Finance for Managers", Excel Books, New Delhi.
135
for Managers LESSON
8
CASH FLOW STATEMENT ANALYSIS
CONTENTS
8.1 Introduction
8.2 Meaning & Motives of Cash Flow Statement
8.3 Utility of Cash Flow Statement
8.4 Steps in the Preparation of Cash Flow Statements
8.4.1 Preparation of Adjusted Profit and Loss Account
8.4.2 Comparison of Current Items to determine the Inflow of Cash or Outflow of Cash
8.4.3 Preparation of Cash Flow Statement
8.5 Let us Sum up
8.7 Keywords

In this lesson we shall discuss about cash flow statement analysis. After going through
(i) discuss meaning and motives of cash flow statement.
(ii) analyse utility of cash flow statement and steps in the preparation of cash flow
statements.
8.1 INTRODUCTION
Cash is considered one of the vital sources of the firm to meet day to day financial
commitments. The cash is considered to be as most important source of life blood of the
business. The day to day financial commitments are met out only out of the available
resources. The cash resources are availed through two different type of receipts viz.
sales, dividends, interests known as regular receipts and sale of assets, investments
known as irregular receipts of the business enterprise. To have smooth flow of business
enterprise, it should have ample cash resources for its operations. The availability of
cash resources is mainly depending on the cash inflows of the enterprises. The smoothness
in operations of the enterprise is obtained through an appropriate matching of cash inflows
and cash outflows.
To have smoothness in the operations of the enterprise, the firm should have an appropriate
volume of cash resources at speedier rate as well as more than the financial commitments
of the firm. This smoothness could be attained by way of an appropriate planning analysis
on the cash resources of the firm. The meaningful analysis is only possible through cash
flow statement analysis which facilitates the firm to identify the possible sources of cash
136 as well as the expenses and expenditures of the firm.
Cash Flow Statement Analysis
8.2 MEANING & MOTIVES OF CASH FLOW STATEMENT
The cash flow statement is being prepared on the basis of an extracted information of
historical records of the enterprise. Cash flow statements can be prepared for a year, for
six months , for quarterly and even for monthly. The cash includes not only means that
cash in hand but also cash at bank.
Motives of preparing the cash flow statement:
l To identify the causes for the cash balance changes in between two different time
periods, with the help of corresponding two different balance sheets.
l To enlist the factors of influence on the reduction of cash balance as well as to
indicate the reasons though the profit is earned during the year and vice versa.
8.3 UTILITY OF CASH FLOW STATEMENT

Utility of cash flow statements are as follows:
l To identify the reasons for the reduction or increase in the cash balances irrespective
level of the profits earned by the firm.
l It facilitates the management to maintain an appropriate level of cash resources.
l It guides the management to take futuristic decisions on the prospective demands
and supply of cash resources through projected cash flows.
v How much cash resources are required?
v How much cash requirements could be internally settled?
v How much cash resources are to be raised through external sources?
v Which type of instruments are going to be floated for raising the required
resources?
l It helps the management to understand its capacity at the moment of borrowing for
any further capital budgeting decisions.
l It paves way for scientific cash management for the firm through maintenance of
an appropriate cash levels i-e optimum level cash of resources.
l It avoids in holding excessive or inadequate cash resources through proper planning
of cash resources.
l It moots control through identification of variations occurred in the cash expenses
and expenditures.
Cash flow statement vs Fund flow statement
Cash flow statement Fund flow statement
Cash inflow and outflow are only considered Increase or decrease in the working capital is
registered
Causes & changes of cash position Causes & changes of working capital position
Considers only most liquid assets pertaining to Considers in general i-e current assets ; the
cash resource ; which fosters only for very short duration of the liquidity of the current assets are
span of planning longer in gestation than the liquid assets ; which
paves way for long span of planning
Opening and closing balances of cash resources Increase or decrease of working capital is
are considered for the preparation considered but not the opening and closing
balance for preparation
The flow in the statement means real cash flow The flow in the statement need not be real cash
flow
137
for Managers 8.4 STEPS IN THE PREPARATION OF CASH FLOW
STATEMENTS
Prepare Non current accounts to identify the flow cash
Cash Inflows Cash out flows
Sale of Assets or Investments, Raising Purchase of Assets or Investments, Redemption

of financial resources of financial resources
Balancing Figure
8.4.1 Preparation of Adjusted Profit and Loss Account
Net profit method
Accounting Profit to be adjusted
To find out the cash Profit/Loss
Addition of Non cash & Non

Operating Expenses
Deduction of Non cash & Non

operating Incomes
Cash from operations or Cash lost in operations
138
Cash Flow Statement Analysis
Alternate method:
Decrease in current assets &
Increase in current liabilities
Net Profit
( +)
Increase in current assets &

Decrease in current liabilities
(-)
Sales Method
Cash Sales
Deduct Cash Purchases & Cash Operating Expenses
Cash from operations or Cash lost in operations
8.4.2 Comparison of Current items to determine the inflow of cash or outflow

of cash
Increase in current assets Outflow of cash
Decrease in current assets Inflow of cash
Decrease in current liabilities Outflow of cash
Increase in current liabilities

Inflow of cash
8.4.3 Preparation of cash flow statement

The cash flow statement can be prepared either in statement form or in accounting
format.
Inflow cash Outflow cash
Opening cash balance XXXX Redemption of preference shares XXXX
Cash from in operations XXXX Redemption fo debentures XXXX
Sale of assets XXXX Repayment of loans XXXX
Issue of shares XXXX Payment of dividends XXXX
Issue of debentures XXXX Payment of tax XXXX
Raising of loans XXXX Cash lost in operations XXXX
Collection from debentures XXXX
Refund of tax XXXX
XXXX XXXX
139
for Managers Check Your Progress
(1) Cash flow means

(a) Change in cash position
(b) Change in working capital position
(c) Change in current assets position
(d) Change in current liabilities position
(2) Adjusted profit and loss account is to determine
(a) Cash from operations
(b) Cash lost in operations
(c) Cash from operations or Cash lost in operations
(3) Comparison in between the current assets and current liabilities to determine
(a) Cash inflow
(b) Cash out flow
(c) Both (a) & (b)
(4) Non current accounts are prepared for the cash inflows and cash outflows
on the basis of which of the following relationship
(a) Non current asset account and Cash
(b) Non current liability account and Cash
(c) Both (a) & (b) only
Illustration 1
From the following balances you are required to calculate cash from operations:
Particulars December 31
1992 Rs 1993 Rs
Debtors 1,00,000 94,000
Bills receivable 20,000 25,000
Creditors 40,000 50,000
Bills payable 16,000 12,000
Outstanding expenses 2,000 2,400
Prepaid expenses 1,600 1,400
Accrued Income 1,200 1,500
Income received in advance 600 500
Profit made during the year - 2,60,000
According to net profit method , the cash from operation has to be found out
Cash from operations
= Net profit (+) Decrease in current assets (-) Increase in current assets
& &
Increase in current liabilities Decrease in current liabilities
The next step is to quantify the decrease in current assets and increase in current liabilities,
in order to add with the closing net profit of the given statements and then the added
volume should be deducted from the increase in current assets and decrease in current
liabilities.
140
Cash from operations Rs Rs Cash Flow Statement Analysis
Profit made during the year s
Add
Decrease in debtors 6,000
Increase in creditors 10,000
Outstanding expenses 400
Prepaid expenses 200
16,600
Less
Increase in Bills receivable 5,000
Decrease in Bills payable 4,000
Increase in accrued income 300
Income received in advance 100
9,4000
Cash from operations 2,67,200
Illustration 2
From the following profit and loss account you are required to compute cash from
operations
Profit and loss account for the year ending 31st Dec, 1983
Rs Rs
To salaries 10,000 By Gross profit 50,000
To Rent 2,000 By profit on sale of land 10,000
To Depreciation 4,000 By income tax refund 6,000
To loss on sale of plant 2,000
To Good will written off 8,000
To proposed dividend 10,000
To provision for taxation 10,000
To Net profit 20,000
66,000 66,000
Cash from operations Rs Rs
Net profit made during the year 20,000
Add:
Non cash expenses
Depreciation 4,000
Loss on sale of plant 2,000
Good will return off 8,000
Non operating expenses
Proposed dividend 10,000
Provision for taxation 10,000 34,000
Less
Non cash income
Profit on sale of land 10,000
Non operating income
Income tax refund 6,000 16,000
38,000
Illustration 3
The comparative balance sheets of M/s Ram Brothers for the two years were as follows
Liabilities Mar,31 Assets Mar,31
1984 1985 1984 1985
Capital 3,00,000 3,50,000 Land &Building 2,20,000 3,00,000
Loan from Bank 3,20,000 2,00,000 Machinery 4,00,000 2,80,000
Creditors 1,80,000 2,00,000 Stock 1,00,000 90.000
Bills payable 1,00,000 80,000 Debtors 1,40,000 1,60,000
Loan from SBI 50,000 Cash 40,000 50,000
9,00,000 8,80,000 9,00,000 8,80,000
141
Accounting and Finance Additional Information
for Managers
i. Net profit for the year 1985 amounted to Rs. 1,20,000
ii. During the year a machine costing Rs.50,000 ( accumulated depreciation Rs. 20,000)
was sold for Rs. 26,000. The provision for depreciation against machinery as on 31
Mar, 1984 was Rs.1,00,000 and 31st Mar, 1985 Rs.1,70,000
You are required to prepare a cash flow statement
First step is to prepare non current accounts
Non current account includes both non current liability and asset
First start with non current liability
Dr Capital A/c Cr
Rs Rs
To Drawings. Balancing Fig. 70,000 By Balance B/d (Opening) 3,00,000
To Balance c/d(Closing ) 3,50,000 By Net profit 1,20,000
4,20,000 4,20,000
The next step is to find out the depreciation provided during the year, which affects non
current asset account of the firm is Machinery account.
Before discussing the accounting transactions, the journal entry for provision for
depreciation should be known.
Provision for depreciation Account
Dr Cr
Rs Rs
To Machinery 20,000 By Balance B/d 1,00,000
To Balance C/d 1,70,000 By Adjusted profit and loss 90,000
account ( Depreciation provided
during the year)
1,90,000 1,90,000
Cash sale of the machinery amounted Rs.26,000

What happens during the cash sale of a machinery ?
Debit what comes in - Cash resources are coming in
Credit what goes out- Machinery is going out of the firm
While selling the machinery, it is most important to identify the worth of the sale transaction
of the machinery ?
Original cost of the Asset Rs.50,000
Accumulated Depreciation Rs.20,000
Rs.30,000
Sale price Rs.26,000
Loss on sale of the assets Rs.4,000
Once the loss of the transaction is found out, the amount of the loss should be appropriately
recorded
Machinery Account
Dr Cr
Rs Rs
To Balance B/d (Opening) 5,00,000 By cash sale 26,000
By Profit and loss a/c Loss 4,000
Balancing Fig
By Depreciation Provision 20,000
By Balance c/d(Closing ) 4,50,000
2,80,000+1,70,000
5,00,000 5,00,000
142
Dr Land and Building Cr Cash Flow Statement Analysis
Rs Rs
To Balance B/d(Opening) 2,20,000
To Purchase 80,000 By Balance c/d(Closing ) 3,00,000
3,00,000 3,00,000
The next step is to prepare adjusted profit and loss account
Dr Adjusted profit and loss account Cr
To Machinery A/c(Loss on sale ) Rs. By Balance B/d Rs.
4,000
To Depreciation provided during 90,000 By cash from operations 2,14,000
the year
To Balance c/d 1,20,000
2,14,000 2,14,000
The next most important step is to compare the current assets

Increase in creditors -Rs.20,000 - cash inflow
Loan from SBI -Rs 50,000 -cash inflow
Decrease in stock -Rs.10,000 - cash inflow
Loan repaid -Rs.1,20,000 -cash outflow
Decrease in Bill payable -Rs.20,000 - cash outflow
Cash flow statement
Inflow Rs Out flow Rs
Opening cash balance 40,000 Loan repaid 1,20,000
Creditors 20,000 Bills payable 20,000
Loan from SBI 50,000 Debtors 20,000
Stock 10,000 Land and buildings purchased 80,000
Machinery cash sale 26,000 Drawings 70,000
Cash from operations 2,14,000 Closing cash balance 50,000
3,60,000 3,60,000
Illustration 4
Data ltd, supplies you the following balance on 31st Mar 1995 and 1996
Liabilities 1995 1996 Assets 1995 1996
Share capital 1,40,000 1,48,000 Bank balance 18,000 15,600
Bonds 24,000 12.000 Accounts 29,800 35,400
Receivable
Accounts payable 20,720 23,680 Inventories 98,400 85,400
Provision for debts 1,400 1,600 Land 40,000 60,000
Reserves and 20,080 21,120 Good will 20,000 10,000
Surpluses
2,06,200 2,06,400 2,06,200 2,06,400
Additional information
i. Dividends amounting to Rs 7,000 were paid during the year 1996
ii. Land was purchased for Rs. 20,000
iii. Rs.10,000 were written off on good will during the year
iv. Bonds of Rs.12,000 were paid during the course of the year
v. You are required to prepare a cash flow statement
The first step is to prepare non current accounts
The first step is to prepare non current assets and liabilities account
As far as non current asset account - Land account has to be prepared
Dr Land Cr
Rs Rs
To Balance B/d(Opening) 40,000
To Purchase (Given) 20,000 By Balance c/d(Closing ) 60,000
60,000 60,000 143
Accounting and Finance The non current liability account to be prepared
for Managers
The first non current liability account got affected is Share capital account
Dr Share capital account Cr
Rs Rs
By Balance B/d(Opening ) 1,40,000
To Balance c/d (Closing ) 1,48,000 By cash Balancing figure 8,000
1,48,000 1,48,000
The next non current liability account is that Bonds account
Dr Bond account Cr
Rs Rs
To cash redemption (Given) 12,000 By Balance B/d(Opening ) 24,000
To Balance c/d(Closing ) 12,000
24,000 24,000
The next step is to prepare the Adjusted profit and loss account
Dr Adjusted profit and loss account Cr
To provision for doubtful 200 By Balance B/d 20,080
debts
To Good will written off 10,000 By cash from operations 18,240
To dividends paid 7000
38,320 38,320
The next most important step is to compare the current assets during the two years
Increase in Accounts payable - Rs. 2,960 - Cash inflow
Decrease in Inventories -Rs. 7,000 - Cash inflow
Increase in Bank Balance - Rs. 2,400 -Cash outflow
Increase in accounts receivable -Rs. 5,600 - Cash outflow
The next step is to draft the Cash flow statement
Cash flow statement
Inflow Rs Out flow Rs
Opening cash balance 18,000 Increase in Bills receivable 5,600
Issue of shares 8,000 Purchases of land 20,000
Increase in Bills payable 2,960 Dividends paid 7,000
Decrease in stock 13,000 Bonds repaid 12,000
Cash from operations 18,240 Closing cash balance 15,600
60,200 60,200
Check Your Progress
(1) Cash flow statement analysis is an analysis of short span of analysis due to
(a) Current assets position is only considered
(b) Super quick assets position only considered
(c) Working capital position is considered
(2) How cash flows are denominated in terms of both current assets and current
liabilities?
(a) Increase in current assets & Decrease in current liabilities
(b) Decrease in current assets & Increase in current liabilities
(c) Increase in current assets & Increase in current liabilities
144
Contd...
(d) Both (a) & (b) Cash Flow Statement Analysis
(3) Cash position at the opening and closing comprises of

(a) Cash in hand
(b) Cash at bank
(c) Both cash in hand and at bank
(4) Cash flow analysis superior than the fund flow analysis due to
(a) Shorter span of cash resources are considered
(b) Real cash flows only taken into consideration
(c) Opening & closing cash balances are only considered
(d) (a), (b) & (c)
(5) Sale of the Plant & Machinery falls under the category of
(a) Non current asset sale- cash in flow
(b) Current asset sale - cash out flow
(c) Non current asset sale -cash out flow
8.5 LET US SUM UP

The cash resources are availed through two different type of receipts viz sales, dividends,
interests known as regular receipts and sale of assets , investments known as irregular
receipts of the business enterprise. Cash flow statements can be prepared for a year, for
six months , for quarterly and even for monthly The cash includes not only means that
cash in hand but also cash at bank.

Parle Food Products experiences a considerable seasonal variation in its business. The
high point in the years activity comes in November, the low point in July. During which
month would you expect the companys ratio to be higher? If the company was choosing
a fiscal year for accounting purposes, what advice would you give?
8.7 KEYWORDS
Cash
Cash Flow Statement
Fund Flow Statement

1. Define cash flow.
2. Highlight the steps involved in the process of Cash flow statement analysis.
3. Draw the proforma of the Adjusted profit and loss account.
4. Illustrate the impact of the changes taken place on the current assets and current
liabilities to the tune of cash flows determination of the firm.
145
Accounting and Finance 5. Briefly explain the objectives of preparing the cash flow statement.
for Managers
6. Explain the various utilities of the cash flow statement analysis.
7. Illustrate the various differences in between the cash flow and fund flow statements
analysis.

R.L. Gupta and Radhaswamy, "Advanced Accountancy".
V.K. Goyal, "Financial Accounting", Excel Books, New Delhi.
Khan and Jain, "Management Accounting".
S.N. Maheswari, "Management Accounting".
S. Bhat, "Financial Management", Excel Books, New Delhi.
Prasanna Chandra, "Financial Management - Theory and Practice", Tata McGraw
I.M. Pandey, "Financial Management", Vikas Publishing, New Delhi.
Nitin Balwani, "Accounting & Finance for Managers", Excel Books, New Delhi.
146
UNIT-III
LESSON
9
COST ACCOUNTING & PREPARATION OF COST
STATEMENT
CONTENTS
9.1 Introduction
9.2 Meaning of Cost Accounting
9.2.1 What is a Cost of a Product?
9.3 Cost Classification
9.3.1 By Nature or Element or Analytical Segmentation
9.3.2 By Functions
9.3.3 Direct and Indirect Cost
9.3.4 By Variability
9.3.5 By Controllability
9.3.6 By Normality
9.3.7 By Time
9.3.8 For Planning and Control
9.3.9 For Managerial Decisions
9.4 Distinction between Financial Accounting & Cost Accounting
9.5 Unit Costing
9.5.1 Cost Sheet - Definition
9.5.2 Direct Material
9.5.3 Direct Labour
9.5.4 Direct Expenses
9.5.5 Indirect Material
9.5.6 Indirect Labour
9.5.7 Indirect Expenses
9.6 Direct Cost Classification
9.7 Indirect Cost Classification
9.8 Stock of Raw Materials
9.9 Stock of Semi Finished Goods
9.10 Stock of Finished Goods
9.11 Let us Sum up
9.13 Keywords
In this lesson we shall discuss about cost accounting and preparation of cost statement.
After going through this lesson you will be able to:
(i) discuss meaning of cost accounting and distinction between financial accounting
and cost accounting.
(ii) analyse unit costing and direct, indirect and classification
9.1 INTRODUCTION
Cost accounting is that branch of the accounting information system, which records,
measures and reports information about costs. The primary purpose of cost accounting
is cost ascertainment and its use in decision-making and performance evaluation. It is
also useful in planning and controlling.
9.2 MEANING OF COST ACCOUNTING

It is the process of classifying, recording and appropriate allocation of expenditure for
the determination of costs of products or services through the presentation of data for
the purpose to take decisions and guide the business organization.
The next one important aspect is the differences between the cost accounting and
management accounting.
Sl.No. Point of Difference Cost Accounting Management Accounting
1. Objectives Its main purpose is to Its major objective is to take
ascertain the cost and control decisions through supplement
presentation of accounting
information
2. Scope It deals only with the cost It not only deals with the cost
and related aspects but also revenue. It is wider
than the cost accounting
3. Utilization of Data It uses only quantitative It uses both qualitative and
information pertaining to the quantitative information for
transactions decision making
4. Utility It ends only at the But it starts from where the
presentation of information cost accounting ends; means
that the cost information are
major inputs for decision-
making
5. Nature It deals with the past and But it deals with future
present data policies and course of actions
9.2.1 What is a cost of a product ?

Cost denominates the use of resources only in terms of monetary terms. In brief, cost is
nothing but total of all expenses incurred for manufacturing a product or attributable to
given thing. In clear, the cost is nothing but ascertained expression of expenses in terms
of monetary, incurred during its production and sale.
To ascertain a cost, the firm should atleast smallest division of activity or responsibility
for which costs are accumulated, at where the costs ascertained and controlled. In brief,
cost centre normally a location where a specified activity takes place.
Accumulation of all cost incurred for an activity leads to ascertainment of cost for the
specified activity, but the control is being done by the head or incharge of that activity is
responsible for control of costs of his centre.
Cost Centre
Product Centre Service Centre

150
Product centre is a centre at where the cost is ascertained for the product which Cost Accounting &
Preparation of Cost Statement
passes through the process.
Raw materials Cost centre Finished goods
Cost Ascertainment
Service centre is the centre or division which normally incurs direct or indirect costs but
does not work directly on products. Normally, Maintenance dept. and general factory
office are very good examples of the service centre.
Apart from the above classification, one more important centre is profit centre.
What is meant by profit centre?
It is a centre not only responsible for both revenue as well as expenses but also for the
profit of an activity.
9.3 COST CLASSIFICATION

The costs are classified into various categories according to the purpose and requirements
of the firm. Some of the most important classifications are as follows.
i. By nature or Element or Analytical segmentation
ii. By functions
iii. Direct and Indirect cost
iv. By variability
v. By controllability
vi. By normality
vii. By time
viii. According to planning and control
ix. For Managerial Decisions
9.3.1 By Nature or Element or Analytical segmentation

The costs are classified into three major categories Materials, Labour, and Expenses.
9.3.2 By Functions
Under this methodology, the costs are classified into various divisions or functions of the
enterprise. viz Production cost, Administration cost, Selling & Distribution cost and so on.
The detailed classification is that total of production cost sub classified into cost of
manufacture, fabrication or construction.
And another classification of cost is commercial cost of operations; which is other than
the cost of manufacturing and production.
The major components of commercial costs are known as administrative cost of operations
and selling and distribution cost of operations.
9.3.3 Direct and Indirect Cost

Direct cost: This classification of costs are incurred for the manufacture of a product or
service ; can be conveniently and easily identified. 151
Accounting and Finance Material cost for the product manufacture- Direct material-For garments factory- cloth
for Managers
is the direct material for ready made garments.
Labour cost for production- Labour who directly involved in the production of a product
as well as attributable to single product expenses and so on.
Indirect cost: The costs which are incurred for and cannot be easily identified for any
single cost centre or cost unit known as indirect cost.
Indirect material cost, Indirect labour cost and Indirect expenses are the three different
components of the indirect expenses.
Indirect material- Cost of the thread cannot be conveniently measured for single unit of
the product.
Indirect Labour-Salary paid to the supervisor.
9.3.4 By Variability
The costs are grouped according to the changes taken place in the level of production or
activity.
It may be classified into three categories:
Fixed cost: It is cost which do not vary irrespective level of an activity or production
Rent of the factory, salary to the manager and so on.
Variable cost: It is a cost which varies in along with the level of an activity or production.
e.g. Material consumption and so on.
Semi variable cost: It is a cost which is fixed upto certain level of an activity, then later
it fluctuates or varies in line with the level of production. It is known in other words as
step cost. e.g. Electricity charges.
9.3.5 By Controllability
The cost are classified into two categories in accordance with controllability, as follows:
Controllable costs: Cost which can be controlled through some measures known as
controllable costs. All variable cost are considered to be controllable in segment to some
extent.
Uncontrollable costs: Costs which cannot be controlled are known as uncontrollable
costs. All fixed costs are very difficult to control or bring down; they rigid or fixed
irrespective to the level of production.
9.3.6 By Normality
Under this methodology, the costs which are normally incurred at a given level of output
in the conditions in which that level of activity normally attained.
Normal cost: It is the cost which is normally incurred at a given level of output in the
conditions in which that level of output is normally achieved.
Abnormal cost: It is the cost which is not normally incurred at a given level of output in
the conditions in which that level of output is normally attained.
9.3.7 By time
According to this classification, the costs are classified into Historical costs and
Predetermined costs:
152
Historical costs: The costs are accumulated or ascertained only after the incurrence Cost Accounting &
known as Past cost or Historical costs.
Predetermined costs: These costs are determined or estimated in advance to any

activity by considering the past events which are normally affecting the costs.
9.3.8 For Planning and Control
The following are the two major classifications viz standard cost and budgetary control:
Standard cost is a cost scientifically determined by way of assuming a particular level of

efficiency in utilization of material, labour and indirect expenses.
The prepared standards are compared with the actual performance of the firm in studying
the variances in between them. The variances are studied and analysed through an
exclusive analysis.
Budget: A budget is detailed plan of operation for some specific future period. It is an
estimate prepared in advance of the period to which it applies. It acts as a business
barometer as it is complete programme of activities of the business for the period covered.
The control is exercised through continuous comparison of actual results with the budgets.
The ultimate aim of comparing with each other is to either to secure individuals' action
towards the objective or to provide a basis for revision.
9.3.9 For Managerial Decisions
The major classifications are sunk cost and marginal cost.
Marginal cost is the amount at any given volume of output by which aggregate costs are
changed if the volume of output is decreased or increased by one unit.
9.4 DISTINCTION BETWEEN FINANCIAL ACCOUNTING

& COST ACCOUNTING
The next one important aspect is the differences in between the Financial accounting,
cost accounting and management accounting.
Sl. No. Point of Financial Accounting Cost Accounting
Difference
1. Objectives To determine the volume of Its main purpose is to ascertain the
earnings and financial position cost and control
2. Scope It deals with only the monetary It deals only with the cost and
transactions of the business related aspects
3. Utilization It uses only the financial It uses only quantitative information
of Data transactions alone pertaining to the transactions
4. Utility It reveals the capacity & status It ends only at the presentation of
of the firm information
5. Nature It deals only the past of the It deals with the past and present
firm data
Check Your Progress
1. Fixed cost is the cost under the classification of

(a) Variability (b) Normality
(c) Controllability (d) Functions
153
Contd...
Accounting and Finance 2. Standard costing is brought under the classification of
for Managers
(a) Controllability (b) Functions
(c) Planning and control (d) Both (a) & (c)
3. Marginal costing is classified on the basis of
(a) Variability (b) Managerial decisions
(c) Time (d) Both (a) & (b)
4. Electricity charges incurred by the firm is
(a) Fixed cost (b) Semi-Variable cost
(c) Variable cost (d) None of the above
9.5 UNIT COSTING

Under costing, the role of unit costing is inevitable tool for the industries not only to
identify the volume of costs incurred at every level but also to determine the rational
price on the commodities in order to withstand among the competitors. The determination
of the selling price is being done through the process of determining the cost of the
product. After having been finalized the cost of the product, the profit margin has to be
added in order to derive the final selling price of the product.
9.5.1 Cost Sheet - Definition

"It is a statement of costs incurred at every level of manufacturing a product or service".
"It is a statement prepared to depict the output of a particular accounting period alongwith
break up of costs".
How to find a total cost of the product or service ?
To find the total cost of the product or service, the costs incurred are grouped under
various categories.
Cost
Material Labour Expenses
Direct . Direct . Direct
Indirect Indirect Indirect
O V E R H E A D S
Production Administrative Selling Overheads Distribution

Overheads Overheads Overheads
The cost of the product or service should have to come across many stages. The
determination of the unit cost involves two different major stages viz Direct and Indirect
154 costs.
What is meant by direct cost ? Cost Accounting &
Direct cost is the cost incurred by the firm which can be ascertained and measured for
a product.
Direct cost of the product can be classified into three major categories.
9.5.2 Direct Material
Direct material which is especially used as a major ingredient for the production of a
product. For Example: The wood is a basic raw material for the wooden furniture. The
cost of the wood procured for the furniture is known direct material cost.
The cotton is a basic raw material for the production of yarn. The cost of procuring the
cotton is known as direct material for the manufacturing of yarn.
9.5.3 Direct Labour
Direct labour is the cost of the labour which is directly involved in the production of
either a product or service. For e.g. The cost of an employee who is mainly working for
the production of a product /service at the centre, known as direct labour cost.
9.5.4 Direct Expenses
Direct expenses which are incurred by the firm with the production of either a product
or service. The excise duty, octroi duty are known as direct expenses in connection with
the production of articles and so on.
Indirect cost is the cost whatever incurred by the firm can be ascertained but not measured
more specifically for a product.
9.5.5 Indirect Material
The material which is spent cannot be measured for a product is known as indirect
material. For e.g. the thread which is used for tailoring the shirt cannot be measured or
quantified in specific length as well as ascertained the cost.
9.5.6 Indirect Labour
Indirect labour is the cost of the labour incurred by the firm other than the direct labour
cannot be apportioned. For e.g: Cost of supervisor, cost of the inspectors and so on.
9.5.7 Indirect Expenses
Indirect expenses are the expenses other than that of the direct expenses in the production
of a product. The expenses which are not directly part of the production process of a
product or service known as indirect expenses. For e.g.: Rent of the factory, salesmen
salary and so on.
Advantages of preparing the cost sheet:
1. It is a only statement reveals the cost of the output as well as unit cost of the
output
2. It facilitates the manufacturer to access the control on the costs through breakups
in the cost
3. It extends room for the management to study the variations of the cost with the
help of an effective comparison of standard costs
4. The businessman is able to get an insight on the various components of cost as well
as able to exercise the control on the excessive costs incurred
5. It poses the firm to supply the goods against the orders with reasonable accuracy
in submitting the orders.
Check Your Progress
1. Cost is
(a) An expense incurred (b) An expenditure incurred
(c) An income received (d) None of the above 155
Contd...
Accounting and Finance 2. Cost is
for Managers
(a) Direct cost only (b) Indirect cost only
(c) Both (a) & (b) (d) None of the above
3. Direct cost is
(a) Direct Materials (b) Direct labour
(c) Direct Expenses (d) Prime cost
To find out the unit cost of the product, the statement of cost plays pivotal role in
determining the cost of production, cost of goods sold, cost of sales and selling price of
the product at every stage.
During the preliminary stage of preparing the cost statement of the product, there are
two things to be borne in our mind at the moment of classification.
1. Direct cost classification
2. Indirect cost classification
9.6 DIRECT COST CLASSIFICATION

Under this classification, the direct costs of the product or service are added together to
know the volume of total direct cost. The total volume of direct cost is known as "Prime
Cost"
Direct Materials +Direct Labour+ Direct Expenses = Prime cost
Prime cost
Direct Material
Direct Labour
Direct Expenses
The next stage in the unit costing to find out the factory cost. The factory cost could be
computed by the combination of the indirect cost classification.
9.7 INDIRECT COST CLASSIFICATION

Among the classification of the overheads, the first and foremost is factory overheads.
The factory overheads and work overheads are synonymously used. The factory
overheads are nothing but the indirect costs incurred at the factory site. To find out the
total factory cost or works cost incurred in the factory could be derived by adding the
both direct cost and indirect cost incurred during the factory process.
Factory Cost =Prime cost + Factory overheads
Factory overheads are nothing but the indirect expenses incurred during the industrial
156
process.
Cost Accounting &
Factory cost
Factory overheads Prime cost
Wages for foreman
Electric power
Storekeepers wages
Oil and water
Factory rent
Repairs and Renewals
Depreciation
Check Your Progress
1. Direct materials is
(a) Opening stock + Purchases
(b) Purchases + Closing stock
(c) Opening stock + Purchases closing stock
(d) Purchases Closing stock
2. Salary paid to Supervisor
(a) Manufacturing overheads
(b) Administrative overheads
(c) Direct labour
(d) Selling & Distribution overheads
The next stage in the process of the unit costing is to find out the cost of the production
The cost of production is the combination of both the factory cost and administrative
overheads.
Cost production = Factory cost + Administrative overheads
Administrative overheads is the indirect expenses incurred during the office administration
for the smooth flow production of finished goods.
Cost of Production
Administrative Overheads Factory Overheads
Office Rent
Repairs Office
Office lighting
Depreciation-office
Manager salary
Telephone charges
Postage and telegram
Stationery
157
Accounting and Finance Immediate next stage to determine in the process of unit costing is the component of
for Managers
cost of sales. The cost of sales is the blend of both viz. Selling overheads and cost of
production.
What ever the cost involved in the production process in the factory as well in the
administrative proceedings are clubbed with the selling overheads to determine the cost
of sales.
Cost of sales = Cost of production + Selling overheads
Selling overheads are nothing but the indirect expenses incurred by the firm at the moment
of selling products. In brief, whatever the expenses in relevance with the selling and
distribution are known as Selling overheads.
Cost of sales
Selling Overheads Cost of production
Salesman salary
Carriage outward
Salesmen commission
Travelling expenses
Advertising
Free samples
Ware housing
Delivery charges
The last but most important stage in the unit costing is determining the selling price of the
commodities. The selling price of the commodities is fixed by way of adding both the
cost of sales and profit margin out of the product sales.
Sales = Cost of sales + Margin of Profit
Under the unit costing, the selling price of the product can be determined through the
statement form.
The cost sheet or cost statement is as follows in the determination of the selling price of
the product.
Check Your Progress
1. Overheads is
(a) Manufacturing expenses (b) Administrative expenses
(c) Selling & Distribution expenses (d) a,b, & c
2. Cost of the Cloth incurred at the moment of purchase made by the Ready
garments manufacturer is
(a) Direct materials (b) Indirect materials
(c) Direct expenses (d) Indirect expenses
158
Contd...
3. Salesman salary given by the firm to promote the sales is Cost Accounting &
(a) Direct labour (b) Indirect expenses
(c) Direct expenses (d) Indirect labour
4. Selling price is
(a) Cost of sales (b) Cost of production
(c) Profit margin + Cost of goods sold (d) Profit margin + Cost of sales
Illustration 1
Calculate the prime cost, factory cost, cost of production cost of sales and Profit form
the following particulars:
Rs. Rs.
Direct Materials 2,00,000 Office stationery 1000
Direct wages 50,000 Telephone charges 250
Direct expenses 10,000 Postage and telegrams 500
Wages of foreman 5,000 Salesmens salaries 2500
Electric power 1,000 Travelling expenses 1,000
Lighting :Factory 3,000 Repairs and renewal Plant 7,000
Office 1,000 Office premises 1,000
Storekeepers wages 2,000 Carriage outward 750
Oil and water 10,00 Transfer to reserves 1,000
Rent: Factory 10,000 Discount on shares written 1000
off
:Office 5,000 Advertising 2,500
Depreciation Plant 1000 Warehouse charges 1000
office 2,500 Sales 3,79,000
Consumable store 5,000 Income tax 20,000
Managers salary 10,000 Dividend 4,000
Directors fees 2,500
Cost statement /Cost Sheet
Particulars Rs Rs
Direct Materials 2,00,000
Direct wages 50,000
Direct expenses 10,000
PRIME COST 2,60,000
Factory Overheads:
Wages of foreman 5,000
Electric power 1,000
Lighting :Factory 3,000
Storekeepers wages 2,000
Oil and water 1000
Rent:Factory 10,000
Depreciation Plant 1000
Consumable store 5,000
Repairs and renewal Plant 7,000
35,000
Factory cost 2,95,000
Administration overheads
Rent Office 5,000
Depreciation office 2,500
Contd... 159
Accounting and Finance Managers salary 10,000
for Managers
Directors fees 2,500
Office stationery 1000
Telephone charges 250
Postage and telegrams 500
Office premises 1,000
Lighting Office 1,000
23,750
Cost of production 3,18,750
Selling and distribution overheads
Carriage outward 750
Sales mens salaries 2500
Travelling expenses 1,000
Advertising 2500
Warehouse charges 1000
7,750
Cost of sales 3,26,500
Profit 52,500
Sales 3,79,000
The Next stage in the preparation of the cost statement is to induct the stock of raw
materials, work in progress and finished goods.
9.8 STOCK OF RAW MATERIALS

The raw materials stock should be taken into consideration for the preparation of the
cost sheet. The cost of the raw materials is nothing but the direct materials cost of the
product. The cost of the materials is in other words cost of the materials consumed for
the production of a product.
Particulars Rs
Opening stock of Raw materials XXXXX
(+)Purchases of Raw materials XXXXX
(-)Closing stock of Raw materials XXXXX

Cost of Materials consumed XXXXX
9.9 STOCK OF SEMI FINISHED GOODS

The treatment of the stock of semi finished goods is mainly depending upon the two
different approaches viz prime cost basis and factory cost basis. The factory cost basis
is considered to be predominant over the early one due to the consideration of factory
overheads at the moment of semi finished goods treatment. The indirect expenses are
the expenses converting the raw materials into semi finished goods which should be
relatively considered for the treatment of the stock valuation rather than on the basis of
prime cost.
Particulars Rs
Prime cost XXXXXX
(+)Factory overheads incurred XXXXXX
(+)Opening work in progress XXXXXX
(-)Closing work in progress XXXXXX
Factory cost XXXXXX
160
Cost Accounting &
9.10 STOCK OF FINISHED GOODS Preparation of Cost Statement
The treatment of the stock of finished goods should carried over in between the opening
stock and closing stock and adjusted among them before the finding the cost of goods
sold.
Particulars Rs
Cost of production XXXXX
(+)Opening stock of finished goods XXXXX
(-)Closing stock of finished goods XXXXX
Cost of goods sold XXXXX
Illustration 2
The following data has been from the records of Centre corporation for the period from
June 1 to June 30, 2005
2005 2005
1st Jan 31st Jan
Cost of raw materials 60,000 50,000
Cost of work in progress 24,000 30,000
Cost of finished good 1,20,000 1,10,000
Transaction during the month
Purchase of raw materials 9,00,000
Wages paid 4,60,000
Factory overheads 1,84,000
Administration overheads 60,000
Selling overheads 40,000
Sales 18,00,000
Draft the cost sheet

Cost Sheet
Particulars Rs Rs
Opening stock of raw materials 1sr Jan 60,000
(+)Purchase of raw materials 9,00,000
()Closing stock of raw materials 31st Jan 50,000
Raw materials consumed during the year 9,10,000
(+)Wages paid 4,60,000
Prime cost 13,70,000
(+)Opening stock of semi goods 24,000
()Closing stock of semi goods 30,000
Factory or Works cost 15,48,000
(+)Administration overheads 60,000
Cost of Production 16,08,000
(+)Opening stock of finished goods 1,20,000
()Closing stock of finished goods 1,10,000
Cost of goods sold 16,18,000
(+)Selling overheads 40,000
Cost of Sales 16,58,000
Net profit 1,42,000
Sales 18,00,000
161
for Managers Check Your Progress
1. The cost classifications in the cost sheet is

(a) Functions (b) Variability
(c) Controllability (d) Functions
2. Rs.10,000 paid on every month to the owner of the factory site is
(a) Fixed cost (b) Semi-Variable cost
(c) Variable cost (d) Semi-Fixed cost
Illustration 3
From the following information extracted from the records of the M/s sundaram &co
Stock position of the firm
Particulars Rs 1-4-1994 Rs 31-3-1995
Stock of raw materials 80,000 1,00,000
Stock of finished goods 2,00,000 3,00,000
Stock of work in progress 20,000 28,000
Indirect labour 1,00,000 Administrative expenses 2,00,000
Oil 20,000 Electricity 60,000
Insurance on fixtures 6,000 Direct labour 6,00,000
Purchase of raw materials 8,00,000 Depreciation on Machinery 1,00,000
Sale commission 1,20,000 Factory rent 1,20,000
Salaries of salesmen 2,00,000 Property tax on building 22,000
Carriage outward 40,000 Sales 24,00,000
Prepare cost statement of the M/s Sundaram & Co

Cost Sheet
Particulars Rs Rs
Opening stock of raw materials 1st April,1994 80,000
(+)Purchase of raw materials 8,00,000
(-)Closing stock of raw materials 31st Jan 1,00,000
Raw materials consumed during the year 7,80,000
(+)Direct labour 6,00,000
Factory overheads:
Indirect labour 1,00,000
Oil 20,000
Insurance on fixtures 6,000
Electricity 60,000
Depreciation on machinery 1,00,000
Factory rent 1,20,000
Property tax on factory building 22,000 4,28,000

(+)Opening stock of semi goods 2,0,000
()Closing stock of semi goods 28,000
Factory cost 18,00,000
(+)Administration overheads 2,00,000
162 Contd...
Cost of Production 20,00,000 Cost Accounting &
(+)Opening stock of finished goods 2,00,000
(-)Closing stock of finished goods 3,00,000
Selling overheads:
Sales commission 1,20,000
Salaries of salesmen 2,00,000
Carriage outward 40,000
Profit margin 1,40,000
Sales 24,00,000
Note: Property tax on the plant is to included under the factory overheads. The tax is
paid by the firm on the plant which is engaging in the production process.
Illustration 4
Prepare the cost sheet to show the total cost of production and cost per unit of goods
manufactured by a company for the month of Jan, 2005. Also find the cost of sale and
profit.
Particulars Rs Partiuclars Rs
Stock of raw materials1.1.2005 6,000 Factory rent and rates 6,000
Raw materials procured 56,000 Office rent 1,000
Stock of raw material31.1.2005 9,000 General expenses 4,000
Direct wages 14,000 Discount on sales 600
Plant depreciation 3,000 Advertisement expenses 1,200
Loss on the sale of plant 600 Income tax paid 2000
Sales Rs.,1,50,000
The number of units produced during Jan 2005 was 6,000

The stock of finished goods was 400 and 800 units on 1st Jan, 2005 and 31st Jan, 2005
respectively. The total cost of the units on hand on 1st Jan 2005 is Rs. 5,600. All these
had been sold during the month.
The first and foremost step is to find out the cost per unit i.e. cost production per unit.
The opening stock and their values are given, but at the same time the value of the
closing stock is ascertained by Rs. 3. The total number of units are almost
Particulars Units Rs
Stock of Raw materials 1.1.2005 6,000
(+)Raw materials procured 56,000
()Closing stock of raw material 9,000
Materials consumed 71,000
Direct wages 14,000
Prime cost 85,000
Factory overheads:
Depreciation on plant 3,000
Factory rent and rates 6,000
Factory cost 94,000
Office and Administration overheads:
Office rent 1,000
General expenses 4,000
Cost of production =Rs. 3 per unit 3,000 99,000
(+)Opening stock of finished goods 400 5,600
Contd... 163
Accounting and Finance (-)closing stock of finished goods 800 2,400
for Managers
Selling and distribution expenses
Advertisement expenses 600
Net profit 47,200
Sales 1,50,000
Illustration 5
XYION Co Ltd., is an export oriented company manufacturing internal -communication
equipment of a standard size. The company is to send quotations to foreign buyers of
your product. As the cost accounts chief you are required to help the management in the
matter of submission of the quotation of a cost estimate based on the following figures
relating to the year 1984
Total output (in units ) 20,000
Rs. Rs.
Local Raw materials 20,00,000 Excise duty 4,00,000
Imports of raw materials 2,00,000 Administrative office expenses 4,00,000
Direct labour in works 20,00,000 Salary of the managing director 1,20,000
Indirect labour in works 4,00,000 Salary of the joint managing 80,000
director
Storage of raw materials and 1,00,000 Fees of directors 40,000
spares
Fuel 3,00,000 Expenses on advertising 3,20,000
Tools consumed 40,000 Selling expenses 3,60,000
Depreciation on plant 2,00,000 Sales depots 2,40,000
Salaries of works personnel 2,00,000 Packaging and distribution 2,40,000
Note:
i. Local raw materials now cost 10% more
ii. A profits margin of 20% on sales is kept
iii. The government grants subsidy of Rs. 200 per unit of exports
Prepare the cost statement in columnar form
Cost Statement of XYION Ltd.
Rs Rs
Particulars Cost Rs Rs Unit/Price
Cost20,000
Local raw materials 20,00,000
(+) Increase in local raw materials 2,00,000
22,00,000
(+)Imports of raw materials 2,00,000
Direct Materials 24,00,000
Direct labour 20,00,000
Factory overheads:
Indirect labour in works 4,00,000
Storage of raw materials and spares 1,00,000
Fuel 3,00,000
Tools consumed 40,000
164 Contd...
Depreciation on plant 2,00,000 Cost Accounting &
Salaries of works personnel 2,00,000
Excise duty 4,00,000 16,40,000
Works cost 60,40,000
Administrative & office Expenses 4,00,000
Salaries of Managing director 1,20,000
Salaries of Joint Managing Director 80,000
Fees of directors 40,000 6,40,000
Cost of Production 66,,80,000
Selling & Distribution expenses
Expenses of Advertising 3,20,000
Selling expenses 3,60,000
Sales depots 2,40,000
Packaging and distribution 2,40,000 11,60,000
Cost of sales 80% 78,40,000
Profit Margin 20% 19,60,000
Sales 100% 98,00,000/20,000units 98,00,000 490
Export subsidy per unit 40,00,000 200()
Selling price for local market 58,00,000/20,000units 58,00,000 290
sales
9.11 LET US SUM UP

Cost denominates the use of resources only in terms of monetary terms. In brief, cost is
nothing but total of all expenses incurred for manufacturing a product or attributable to
given thing. In clear, the cost is nothing but ascertained expression of expenses in terms
of monetary, incurred during its production and sale. Service centre is the centre or
division which normally incurs direct or indirect costs but does not work directly on
products. Normally, Maintenance dept. and general factory office are very good examples
of the service centre. Costs which cannot be controlled are known as uncontrollable
costs. All fixed costs are very difficult to control or bring down ; they rigid or fixed
irrespective to the level of production. A budget is detailed plan of operation for some
specific future period. It is an estimate prepared in advance of the period to which it
applies. It acts as a business barometer as it is complete programme of activities of the
business for the period covered. Under costing, the role of unit costing is inevitable tool
for the industries not only to identify the volume of costs incurred at every level but also
to determine the rational price on the commodities in order to withstand among the
competitors. Direct labour is the cost of the labour which is directly involved in the
production of either a product or service. For e.g. The cost of an employee who is
mainly working for the production of a product /service at the centre, known as direct
labour cost. Indirect expenses are the expenses other than that of the direct expenses in
the production of a product. The expenses which are not directly part of the production
process of a product or service known as indirect expenses. For e.g.: Rent of the factory,
salesmen salary and so on.

Once standard costs are established, what conditions would require the standards to be
revised? Give your opinion.
9.13 KEYWORDS
Cost: Expense incurred at the either cost centre or service centre.
Cost sheet: It is a statement prepared for the computation of cost of a product/service.
165
Accounting and Finance Direct cost: cost incurred which can be easily ascertained and measured for a product.
for Managers
Indirect cost: cost incurred cannot be easily ascertained and measured for a product.
Cost centre: The location at where the cost of the activity is ascertained.
Product centre: It is the location at where the cost is ascertained through which the
product is passed through.
Service centre: The location at where the cost is incurred either directly or indirectly
but not directly on the products.
Profit centre: It is responsibility centre not only for the cost and revenues but also for
profits for the activity.
Prime cost: combination of all direct costs viz Direct materials, Direct labour and Direct
expenses.
Factory cost: It is the total cost incurred both direct and indirect at the work spot during
the production of an article.
Cost of production: It is the combination of cost of manufacturing an article or a product
and administrative cost.
Cost of sales: It is the entire cost of a product.
Selling price or Sales: The summation of cost of sales and profit margin.

1. What is cost classification? Classify it, in detail.
2. What do you mean by unit costing?
3. Explain Direct and Indirect Costing.
4. What is cost-sheet definition?
5. Express Indirect and Direct Expenses.

S.N. Maheswari, Management Accounting.
166
LESSON
10
BUDGETARY CONTROL
CONTENTS
10.1 Introduction
10.2 Types of Budget
10.3 Cash Budget
10.4 Fixed & Flexible Budget
10.4.1 Fixed Budget
10.4.2 Flexible Budget
10.5 Master Budget
10.6 Zero Base Budgeting (ZBB)
10.6.1 Traditional Budgeting vs Zero Base Budgeting
10.6.2 Steps involved Zero Base Budgeting
10.6.3 Benefits of Zero Base Budgeting
10.6.4 Criticism
10.7 Let us Sum up
10.9 Keywords

In this lesson we shall discuss about budgetary control. After going through this lesson
(i) understand types of budget and cash budget
(ii) analyse fixed and flexible budget
(iii) discuss zero base budgeting (ZBB)
10.1 INTRODUCTION
Budget is an estimate prepared for definite future period either in terms of financial or
non financial terms. Budget is prepared for any course of action or business or state or
Nation, as a whole. The budget is usually expressed in terms of total volume.
According to ICMA, England, a budget is as follows "a financial and or quantitative
statements prepared and approved prior to a defined period of time, of the policy to be
pursed during the period for the purpose of attaining a given objective".
It is in other words as " detailed plan of action of the business for a definite period of time".
What is meant by Budget?
It is a statement of financial affairs/quantitative terms of an activity for a defined period,
to achieve the enlisted objectives.
Accounting and Finance for What is budgeting?
Managers
Budgeting is the course involved in the preparation of budget of an activity.
What is Budgetary Control?
Budgetary control contains two different processes one is the preparation of the budget
and another one is the control of the prepared budget.
According to ICMA, England, a budgetary control is " the establishment of budgets
relating to the responsibilities of executives to the requirements of a policy and the
continuous comparison of actual with budgeted results, either to secure by individual
action the objectives of that policy or to provide a basis for its revision".
According to J.Batty "Budgetary control is a system which uses budgets as a mans of
planning and controlling all aspects of producing and/or selling commodities and services".
Preparation of the Budget for definite future
Actual performance has to be recorded
Comparison in between the actual and budget figures
Corrective steps Deviations in between Actual & Budget
Revision of the budget
Check Your Progress
Choose the appropriate answer:

1. Budget is a statement of
(a) Qualitative affairs (b) Quantitative affairs
(c) Financial affairs (d) Both (b) & (c)
2. Budgets can be classified into
(a) By functions (b) By time
(c) By flexibility (d) (a), (b) & (c)
168
Budgetary Control
10.2 TYPES OF BUDGET
The budgets can be classified into three categories:
Budgets
Functions Flexibility Time
Sales Budget Fixed Budget Long Term
Production Budget Flexible Budget Medium Term
Material Budget
Short Term
Labour Budget
Manufacturing overhead budget
Selling overheads budget
Cash budget
10.3 CASH BUDGET

Cash budget is nothing but an estimation of cash receipts and cash payments for specified
period. It is prepared by the head of the accounts department i.e., chief accounts officer.
The utility of the cash budget is as follows:
l To meet the revenue and capital expenditures with adequate funds
l It should highlight the additional requirement cash whenever the need arises
l Keeping of excessive funds available in the business firm wont fetch any return to
the enterprise but this estimate of future cash needs and resources will guide the
firm to plan for an effective investment out of the surplus funds estimated ; enhances
the wealth of the investors through proper investment planning out of the future
funds available.
Cash budget can be prepared in three different ways:
1. Receipts and payments method
2. Adjusted profit and loss account
3. Balance Sheet Method
Cash receipts can be classified into various categories
Cash Receipt
Sales Debtors Bills receivable Dividends Sale of Investments
Other Incomes
169
Accounting and Finance for Cash payments are as follows:
Managers
Cash payments
Purchase of Assets Materials bought Salary paid
Rent paid Other payments
Illustration 1
From the following information prepare a cash budget for the months of June and July
Month Credit sales Credit purchase Manufacturing Selling
Rs Rs Overheads Rs overheads Rs
April 80,000 60,000 2,000 3,000
May 84,000 64,000 2,400 2,800
June 90,000 66,000 2,600 2,800
July 84,000 64,000 2,000 2,600
Additional Information:
1. Advance tax of Rs 4,000 payable in June and in December 1994
2. Credit period allowed to debtors is two months
3. Credit period allowed by the vendors or suppliers
4. Delay in the payment of other expenses one month
5. Opening balance of cash on 1st June is estimated as Rs. 20,000/-
Solution:
First step is in the preparation of a cash budget is to open the statement with the opening
cash balance available.
Secondly, if any cash receipts are available that should be added one after another. In
this problem, Sales can be bifurcated into two classifications, the first one is cash sales.
If the cash sales is given, the amount of cash receipt due to cash sales should have to be
immediately brought under the respective period i-e during the same month or week.
The next is the credit sales of the firm, the volume of sales should only be effected only
at the amount of realization of sales or collection of credit sales from the consumers and
customers. If cash sales is not given instead credit sales only the component given, that
should be added in the list of cash receipts ; by registering the credit period involved for
the customers and consumers. Being as credit sales, the amount of sales realization
should only relevantly be considered during the specified period.
Third step is to list out the various items of cash expenses expected to incur during the
specified period. The text of the problem deals with the delay of making the payment of
expenses is one month in all cases; It means the expenses like Manufacturing overheads,
selling overheads are expected to pay one month later i-e these expenses will be paid
one month after. It means that the May month of other expenses are paid only in the
month of June and during the month of June month expenses are met out.
The purchases requires same kind of treatment in the case of sales. Normally, the
purchases are classified into two divisions viz cash purchases and credit purchases.
The cash purchases should be given effect only at the moment of cash payment is paid
170
on the volume of purchase, but, if the credit purchases are made by the firm, the credit
allowed by the vendor/supplier to make the payments should be relatively considered for Budgetary Control
the expected outflow of cash i-e payment of purchase one month later or two months
later.
The expected time period occurrence of a either cash receipt or cash payment should be
considered for the preparation of the cash budget.
The cash budget should be prepared separately in the statement to derive the closing
balance of the specified year/month. The closing balance of the yester period or previous
period has to be carried forward to the next period as opening balance of the preparation
of a budget. The closing balance of the month June will be the opening balance of the
month July. Once the statement has been completed in the preparation of budget of
respective periods should be consolidated for the specified periods.
Cash Budget for the Months of June and July 1998
Particulars June Rs July Rs
Opening balance 20,000 26,800
Receipts: 80,000 84,000
Sales
Total Cash Receipts I 1,00,000 1,10,800
Payments: 64,000 66,000
Purchases
Manufacturing Overheads 2,400 2,600
Selling Overheads 2,800 2,800
Tax payable 4,000 -------------
Total Payments II 73,200 71,400
Balance I-II 26,800 39,400
Illustration 2
From the estimates of income and expenditure, prepare cash budget for the months from
April to June.
Month Sales Rs Purchases Rs Wages Rs Office Exp. Selling Exp. Rs
Rs
Feb 1,20,000 80,000 8,000 5,000 3,600
Mar 1,24,000 76,000 8,400 5,600 4,000
Apr 1,30,000 78,000 8,800 5,400 4,400
May 1,22,000 72,000 9,000 5,600 4,200
June 1,20,000 76,000 9,000 5,200 3,800
i. Plant worth Rs. 20,000 purchase in June 25% payable immediately and the remaining
in two equal installments in the subsequent months
ii. Advance payment of tax payable in Jan and April Rs 6,000
iii. Period of credit allowed
a. By suppliers 2 months
b. To customers 1 month
iv. Dividend payable Rs.10,000 in the month of June
v. Delay in payment of wages and office expenses 1 month and selling expenses
month. Expected cash balance on 1st April is Rs. 40,000.
Solution:
a. Plant worth Rs 20,000/ purchased, payable immediately is 25% i-e Rs.5,000 should
be paid in the month of June. The remaining cost of the machine has to be paid in
the subsequent months, after June. The payments whatever are expected to make
after June is not relevant as far as the budget preparation concerned.
171
Accounting and Finance for b. Delay in the payment of wages and office expenses is only one month. It means
Managers
wages and office expenses of Feb month are paid in the next month, March.
Selling expense From the above coloured boxes, it is obviously understood that
during the months of April, May and June ; the following will be stream of payment
of selling expenses.
April= Rs. 2,000 of Mar (Previous Month) and Rs. 2,200 of April (Current month)=
Rs.4,200/
May= Rs. 2,200 of April (Previous Month) and Rs.2,100 of May (Current month)=Rs.
4,300/
June= Rs. 2,100 of May (Previous Month) and Rs.1,900 of June (Current
month)=Rs. 4,000/
c. Selling expenses is having the delay of month, which means 50% of the selling
expenses is paid only in the current month and the remaining 50% is paid in the next
Particulars Feb Mar April May June
Selling 3,600 4,000 4,400 4,200 3,800
Expenses
Payment 50% 1,800 2,000 2,200 2,100 1,900
in the current
month
Delay 50%- 1,800 2,000 2,200 2,100 1,900
will be paid in
the subsequent
month
Every month 50% of the selling expenses of the current month and 50% of the previous
month selling expenses are paid together ; the above coloured boxes depict the payment
of 50% of the current selling expenses along with 50% expenses of previous month.
Cash Budget for the Periods ( April and June)
Particulars April Rs May Rs June Rs

Opening Cash Balance 40,000 59,800 95,300
Cash Receipts
Sales 1,24,000 1,30,000 1,22,000
Total Receipts (A) 1,64,000 1,89,800 2,17,300
Payments
Plant Purchased ---------- --------- 5,000
Tax payable 6,000 --------- --------
Purchases 80,000 76,000 78,000
Dividend payable --------- --------- 10,000
Wages 8,400 8,800 9,000
Office expenses 5,600 5,400 5,600
Selling expenses 4,200 4,300 4,000
Total Payments(B) 1,04,200 94,500 1,11,600
Balance (A-B) 59,800 95,300 1,05,700
10.4 FIXED & FLEXIBLE BUDGET

10.4.1 Fixed Budget
It is a budget known as constant budget, never registers the changes in the preparation
of a budget, being prepared for irrespective level of output or production. This budget is
mainly meant for the fixed overheads of the firm which are constant in volume irrespective
level of production. The ultimate utility of the budget is to control the cost as a cost
controlling measure, but the fixed budget is meaningless in having comparison with the
172 actual performance.
10.4.2 Flexible Budget Budgetary Control
Flexible budget is prepared for any level of production as an estimate of statement of all
expenses i-e the expenses are classified into three categories viz variable, semi-variable
and fixed expenses. The structure of the budget for any output is only to the tune of the
actual performance achieved. This is the budget facilitates not only to have comparison in
between various levels of production but also to identify the level of lowest production cost.
Utilities of the flexible budget:
l This budget is most useful tool of analysis in studying the sales at when the
circumstances are not warranting to predict
l It is mostly suited to the seasonal business, where the sales volume is getting differed
from one period to another due to changes taken place in the taste and preferences
of the buyers
l The production is being done on the basis of demand of the products in the market.
The demand of the products is studied only through demand forecasting. The flexible
budget is more applicable in the case of products, which are greatly finding difficult
to forecast the demand
l The budget is prepared only during the time of acute shortage of resources of
production viz Men, Material and so on
Illustration 3
Draft a flexible budget for overhead expenses on the basis of following information and
determine the overhead rates at 70% 80% and 90% plant capacity.
Particulars 70% capacity 80% capacity Rs 90% capacity
Variable Overheads
Indirect Labour ----------------- 24,000 ----------------
Stores including spares ----------------- 8,000 ----------------
Semi-variable overheads ----------------- 40,000 ----------------
Power( 30% fixed ,70%)
Repairs and maintenance ----------------- 4,000 ----------------
80% fixed and 20% variable
Fixed Overheads ----------------- 22,000 -----------------
Depreciation
Insurance ----------------- 6,000 -----------------
Salaries ----------------- 20,000 -----------------
Total overheads ----------------- 1,24,000 -----------------
Solution:
Flexible Budget for the various capacities
Particulars 70% capacity 80% capacity 90% capacity

Variable overheads
Indirect labour 21,000 24,000 27,000
Stores including spares 7,000 8,000 9,000
Semi- variable Expenses - Power*
Fixed 30% 8,000 8,000 8,000
**Variable 28,000 32,000 36,000
Repairs and mainternance
***Fixed 80% 3,200 3,200 3,200
****Variable 20% 700 800 900
Fixed Overheads
Depreciation 22,000 22,000 22,000
Insurance 6,000 6,000 6,000
Salaries 20,000 20,000 20,000
Total Overheads 1,15,900 1,24,000 1,32,100
173
Accounting and Finance for Illustration 4
Managers
The expenses for budgeted production of 10,000 units in a factory are furnished below
Particulars Per unit
Material 70
Labour 25
Variable overheads 20
Fixed overheads (1,00,000) 10
Variable expenses (Direct) 5
Selling expenses (10% fixed) 13
Distribution expenses(20% fixed) 7
Administration expenses(Rs.50,000) 5
Total cost per unit 155
Prepare a budget for production of

i. 8,000 units
ii. 6,000 units
iii. Calculate the cost per unit at both levels
Assume that administration expenses are fixed for all level of production
10,000 units 8,000 units 6,000 units
Per Amount Per Unit Amount Per Unit Amount
Unit Rs Rs Rs Rs Rs
Rs
Production Expenses: 70.00 7,00,000 70.00 5,60,000 70.00 4,20,000
Material
Labour 25 2,50,000 25.00 2,00,000 25.00 1,50,000
Overheads 20 2,00,000 20.00 1,60,000 20.00 1,20,000
Direct Variable 5 50,000 5 40,000 5 30,000
expenses
Fixed Overheads 10 1,00,000 12.5 1,00,000 16.667 1,00,000
Rs.1,00,000
Selling Expenses:
Fixed 1.3 13,000 1.625 13,000 2.167 13,000
Variable 11.7 1,17,000 11.7 93,600 11.7 70,200
Distribution Expenses:
Fixed 1.4 14,000 1.75 14,000 2.334 14,000
Variable 5.6 56,000 5.6 5.6 30,600
Administration 5.0 50,000 6.25 50,000 8.333 50,000
Expensses
Total Cost 155.00 15,50,000 159.425 12,75,400 166.801 10,00,800
Illustration 5
From the following information relating to 1963 and conditions expected to prevail in
1964, prepare a budget for 1964:
State the assumption you have made, 1963 actuals
Sales 1,00,000 (40,000 units)
Raw materials 53,000
Wages 11,000
Variable overheads 16,000
Fixed overheads 10,000
174
1964 prospects Budgetary Control
Sales 1,50,000(60,000 units)

Raw Materials 5 per cent price increase
Wages 10 per cent increase in wage rates
5 per cent increase in productivity
Additional plant One lathe Rs. 25,000
One drill Rs,12,000
(I.C.W.A Inter)
Budget for the year 1964 Rs Rs
Sales for 60,000 units @ Rs. 2.50 1,50,000
Less: Cost production
Raw materials 83,475
Wages 17,286
Variable overhead 24,000
Fixed Overheads 13,700
1,38,461
Estimated Profit 11,539
10.5 MASTER BUDGET

Immediately after the completion of functional or departmental level budgets, the major
responsibility of the budget officer is to consolidate the various budgets together, which
is detailed report of all operations of the firm for a definite period
10.6 ZERO BASE BUDGETING (ZBB)

Zero base budgeting is one of the renowned managerial tool, developed in the year 1962
in America by the Former President Jimmy Carter. The name suggests, it is commencing
from the scratch, which never incorporates the methodology of the other types of budgeting
in determining the estimates. The Zero base budgeting considers the current year as a
new year for the preparation of the budget but the yester period is not considered for
consideration. The future activities are forecasted through the zero base budgeting in
accordance with the future activities.
Peter A Pyher A planning and budgeting process which requires each manager to
justify his entire budget request in detail from scratch (Hence zero base) and shifts the
burden of proof to each manger to justify why he should spend money at all. The approach
requires that all activities be analysed in decision packages which are evaluated by
systematic analysis and ranked in order of importance
This type of budgeting requires the manager to reason out the aim of spending , but in the
case of traditional budgeting is unlike , which are never emphasize the reasons of spending
in terms of expenses.
10.6.1 Traditional Budgeting vs Zero Base Budgeting
Basis of Difference Traditional Budgeting Zero Base Budgeting
Emphasis It is accounting oriented; It is more decision oriented;
emphasis on How Much emphasis on Why
Approach It is monitoring towards the It is towards the achievement of
expenditures objectives
Focus To study the changes in the To study the cost benefit analysis
expenditures
Communication It operates only Vertical It operates in both directions
communication horizontally and vertically
Method It is based on the extrapolation Its decision package is totally
i.e. from the yester figures future based on the cost benefit analysis.
175
projections are carried out
Accounting and Finance for 10.6.2 Steps involved Zero Base Budgeting
Managers
1. The very first step is to prepare the Zero Base Budgeting is to enlist the objectives.
2. The extent of application should be decided in the next phase of the ZBB.
3. The next important stage is to prioritize the activities.
4. The Most important step involved in the process of ABB is cost benefit analysis.
5. The final step is to select, approve the decision packages and finalise the budget.
10.6.3 Benefits of Zero Base Budgeting

1. It acts as guide for the management to allocate the resources more accurately
depends upon the priority for an effective implementation.
2. It enhances capability of the managers who prepares the budget for future action.
3. It paves way for optimum utilization of resources available.
4. It is a technique of utilitarian of the resources with reference to the activity involved
5. It is dome shaped only towards the achievement of organizational goals.
10.6.4 Criticism
1. Non financial matters cannot be considered for the cost & benefit analysis
2. Difficulties involved in the process of ranking of the decision packages
3. It needs more time span for preparation and cost of operations is more and more
10.7 LET US SUM UP

Budgeting is the course involved in the preparation of budget of an activity. Budgetary
control contains two different processes one is the preparation of the budget and another
one is the control of the prepared budget. "Budgetary control is a system which uses
budgets as a mans of planning and controlling all aspects of producing and/or selling
commodities and services". Cash budget can be prepared in three different ways:
1. Receipts and payments method
2. Adjusted profit and loss account
3. Balance Sheet Method
Fixed Budget is a budget known as constant budget, never registers the changes in the
preparation of a budget, being prepared for irrespective level of output or production.

Identify at least three roles budgeting plays in helping managers control a business.
10.9 KEYWORDS
Budget: A financial statement prepared for specified activity for future periods
Budgeting: Activity of preparing the budget is known as budgeting
Budget control: Quantitative controlling technique to assess the performance of the
organization
Cash Budget: It is a statement prepared by the organization to identify the future needs
and receipts of cash from the yester activities
Flexible Budget: It is a financial statement prepared on the basis of principle of flexibility
to identify the cost of the unknown level of production from the existing level of operational
176 capacity.
Budgetary Control
1. Define budget.
2. Define budgetary control.
3. Highlight the various types of budget.
4. Elucidate the process of production budget.
5. Illustrate the methodology of purchase budget.
6. Draw the process of preparing the cash budget.

177
Accounting and Finance for
Managers LESSON
11
MARGINAL COSTING
CONTENTS
11.1 Introduction
11.2 Meaning & Definition of Marginal Costing
11.3 Why Marginal Cost is called as Incremental Cost?
11.4 Why Marginal Cost is called in other words as Variable Cost?
11.4.1 Fixed Cost
11.4.2 Variable Cost
11.4.3 Semi-variable Cost
11.4.4 Method of Difference
11.4.5 Method of Coverages
11.5 Break Even Point Analysis
11.5.1 Break Even Point in Units
11.6 Verification
11.6.1 Selling Price Method
11.6.2 PV Ratio Method
11.6.3 Graph Method
11.7 Margin of Safety
11.8 Determination of Sales Volume in Rupees at Desired Level of Profit
11.9 Applications of Marginal Costing
11.9.1 Make or Buy Decision
11.9.2 Worth of Production
11.9.3 Worth of Purchase
11.10 Accepting the Export Offer
11.11 Key Factor
11.12 Selecting the Suitable Product Mix
11.13 Determining Optimum Level of Operations
11.14 Alternative Method of Production
11.15 Let us Sum up
11.17 Keywords
178
Marginal Costing
In this lesson we shall discuss about marginal costing. After going through this lesson
(i) understand meaning and definition of marginal costing
(ii) analyse break even point analysis
(iii) discuss applications of marginal costing and selecting the suitable product mix.
11.1 INTRODUCTION
It is one of the premier tools of management not only to take decisions but also to fix an
appropriate price and to assess the level of profitability of the products/services. This is
a only costing tool demarcates the fixed cost from the variable cost of the product/
service in order to guide the firm to know the minimal point of sales to equate the cost of
production. It is a tool of analysis highlighting the relationship in between the cost, volume
of sales and profitability of the firm.
11.2 MEANING & DEFINITION OF MARGINAL COSTING

Definition: According to ICMA, London "Marginal cost is the amount at any given
volume of output, by which aggregate costs are charged, if the volume of output is
increased or decreased by one unit."
Meaning: Marginal cost is the cost nothing but a change occurred in the total cost due
to changes taken place on the level of production i.e., either an increase / decrease by
one unit of product..
The firm XYZ Ltd. incurs Rs 1000/- for the production of 100 units at one level of
operation. By increasing only one unit of product i.e. 101 units, the firm's total cost of
production amounted Rs 1010.
Total cost of production at first instance (C')=Rs. 1000/
Total cost of production at second instance (C")=Rs. 1010/-
Total number of units during the first instance (U')=100
Total number of units during the second instance (U")=101
Increase in the level of production and Cost of production:
Change in the level of production in units= U"-U'= U
Change in the total cost of production = C"-C, prime= C
Change (Increase) in the total cost of production C Rs. 10
Marginal Cost = = =
Change (Increase) in the level of production U 1
= Rs. 10
If the same firm reduces the total volume from 100 units to 99 units. The total cost of
production Rs. 990.
Decrease in the Level of production and Cost of production:
Change(Decrease) in the total cost of production C Rs.10

Marginal Cost = = =
Change(Increase) in the level of production U 1
= Rs. 10
179
Managers 11.3 WHY MARGINAL COST IS CALLED AS
INCREMENTAL COST?
From the above example, it is obviously understood that marginal cost is nothing but a
cost which incorporates the incremental changes in the cost of production due to either
an increase or decrease in the level of production by one unit, meant as incremental cost.
11.4 WHY MARGINAL COST IS CALLED IN OTHER

WORDS AS VARIABLE COST?
From the following classifications of cost, the inter twined relationship in between the
variable cost and marginal cost is explained as below
Table 11.1: Statement of Fixed, variable and total costs and per unit
Sl.No. Units Fixed Fixed cost Variable Variable Marginal Total

Cost per unit Cost Cost per unit Cost Rs Cost
Rs Rs Rs Rs ? C/? U Rs
1. 1 500 500 10 10 10 510
2. 50 500 100 500 10 10 1000
3. 100 500 5 1000 10 10 1500
4. 150 500 3.333 1500 10 10 2000
11.4.1 Fixed Cost
It is a cost remains constant or fixed irrespective level of production.

Example: Rent Rs 5,00 is to be paid irrespective level of production. It remains constant/
fixed irrespective of changes taken place on the level of production.
Total fixed Cost Line
Fixed Cost per unit Line
X'- Units
Y'- Cost in Rupees
11.4.2 Variable Cost

It is a cost which varies with level of production.
Variable Cost
Variable cost per unit
180
X'- Units Marginal Costing
Y'- Cost in Rupees

The following are the various components of variable cost.
l Direct Materials: Materials cost consumed for the production of goods
l Direct Labour: Wages paid to the labourers who directly involved in the production
of goods.
l Direct Expenses: other expenses directly involved in the production stream.
l Variable portion of Overheads: Generally the overheads can be classified into
two categories. Viz- Variable overheads and Fixed overheads.
The variable overheads is the cost involved in the procurement of Indirect materials
Indirect labour and Indirect Expenses.
Indirect Material- cost of fuel, oil and soon
Indirect Labour- Wages paid to workers for maintenance of the firm.
From the above table -1 the marginal cost is equivalent to the variable cost per unit of the
various levels of production. The fixed cost of Rs.500 is the cost remains the same at not only
irrespective levels of production but also already absorbed at the initial level of production.
The initial absorption of fixed overhead led the marginal cost to become as variable cost.
11.4.3 Semi-Variable Cost

Another major classification is semi variable/fixed cost which is a cost partly fixed /
variable to the certain level of production or consumption e-g Electricity charges, telephone
charges and so on.
It jointly discards the importance of the fixed cost and the semi- variable cost for analysis
while ascertaining the marginal cost.
Marginal Costing is defined as "the ascertainment of marginal cost and of the effect on
profit of changes in volume or type of output by differentiating between fixed and variable
costs."
In marginal costing, the change in the level of cost of operation is equivalent to variable
cost due to fixed cost component which is fixed irrespective level of outputs.
Importance of Marginal costing:
l The costs are classified into two categories viz fixed and variable cost.
l Variable cost per unit is considered as marginal cost of the product.
l Fixed costs are charged against contribution of the transaction.
l Selling price of the product = marginal cost + contribution.
Contribution
Method of Difference Method of Meeting

Sales- Variable Cost Fixed cost+Profit
Marginal costing profitability statement as follows:

Sales xxxx
Variable Cost xxxx 181
Accounting and Finance for Contribution xxxx
Managers
Fixed Cost xxxx
Profit xxxx
Sales Rs.100,000/-, variable cost Rs.25,000/- and fixed cost Rs.20,000/- find-out the
contribution and profit.
Rs.
Sales 1,00,000
Variable Cost 50,000
Contribution 50,000
Fixed Cost 20,000
Profit 30,000
11.4.4 Method of Difference

Under this method, the contribution can be computed through finding the differences in
between Sales and Variable Cost
i.e. Contribution= Sales Variable Cost= Rs.1,00,000 50,000= Rs.50,000
11.4.5 Method of Coverages

In this method, the contribution is equated with the summation of Fixed cost and Profit.
i.e. Contribution=Fixed Cost+ Profit =Rs.20000+30000=Rs.50,000
Marginal Costing(MC)
Cost Volume Profit Analysis (CVP)
Break Even Point Analysis (BEP)
11.5 BREAK EVEN POINT ANALYSIS

This meaning of the analysis is explained through three different components viz.
Break Divide
Even Equal
Point Place (or) Position
Break Even Point is the point at which the Total Cost is equivalent to Total Revenue. At
the break even point the business neither earns profit nor incurs a loss. It means that the
182 firm's cost is recovered at the minimum level of production.
Marginal Costing
Break Even Point
Total Cost = Total Revenue/ Total Sales
No Profit / No Loss
If Sales > BEP Sales earn profit i.e. Total Sales> Total Cost which leads to earn
profit.
If Sales< BEP Sales incur loss i.e. Total Sales< Total Cost which registers incurrence
of loss.
This Break even point analysis can be interpreted into two classifications. The first
classification is narrow sense of BEP, which mainly emphasizes on BE Point.
The second segment is the broader sense which elucidates the role of BEP towards
managerial decisions
l Fixation of Selling price
l Acceptance of Special / Foreign order
l Incremental Analysis- On cost as well as revenue
l Make or Buy Decision
l Key factor analysis
l Selection of production mix
l Maintaining the specified level of profit and so on
The enlisted decisions will be discussed immediately after the preliminary aspects of
marginal costing i.e. Break even analysis.
Check Your Progress
1. Marginal costing is a study on

(a) Variable costing (b) Profit
(c) Fixed costing (d) Volume of sales
2. BEP means
(a) Break even point (b) Bright even point
(c) Break event point (d) Bright even position
3. BEP is the point at which
(a) Profit & No Loss (b) No Profit & Loss
(c) No profit & No Loss (d) Profit & Loss
4. CVP analysis is the combination of three predominant factors of influence
(a) Cost, Value and Profit (b) Component, Value and Profit
(c) Cost, Volume and Profit (d) None of the above 183
Contd...
Accounting and Finance for 5. In BEP analysis, which cost is to be considered to meet out
Managers
(a) Fixed cost (b) Semi variable cost
(c) Variable cost (d) None of the above
The Break even point in accordance with narrow sense can be classified into two
categories
l Break Even Point in Units
l Break Even Point in Sales
11.5.1 Break Even Point in Units

Illustration 1:
Assume the selling price of product Rs.20/-per unit and variable cost per unit Rs.10/-
and the fixed cost Rs.1000/- Find out the break even point.
Sales Rs.20/-
Variable Cost Rs.10/-
Contribution Rs 10/-
Fixed Cost Rs.1000/-
Profit (-) Rs. 990/-
If the firm produces only one unit, the amount of loss is Rs.990/-. To avoid the amount of
loss how many units are to be produced ?
As already highlighted, BEP is the point at which the firm neither earns profit nor incurs loss.
Profit/Loss is a resultant out of Contribution while meeting out the fixed cost volume of
the transaction. From the above example, the contribution per unit is Rs.10/ not sufficient
to meet out the fixed cost volume of Rs.1000/-. The purpose of finding out the BEP in
units is to identify the level of contribution which is not only equivalent as well as to meet
fixed cost of the transaction but also to avoid loss. To raise the volume of contribution at
par with the fixed cost volume, fixed cost has to be related to the contribution margin per
unit through the ratio given below
Fixed cost= "X" units x Contribution Margin Per Unit
"X" units can be found out from the following
Fixed Cost
"X" units =
Contribution Margin Per Unit
The total number of units "X" which equate the contribution volume of "X" units with the
total fixed cost is the Break Even Point (Units).
Fixed Cost
Break Even Point (Units) =
Rs.1000/-
= = 100 Units
Rs.10/-
The above illustration reveals that how many number of times the contribution margin
per unit should be equivalent to the total fixed cost volume. Hence the number of times
is nothing but the units required to have equivalent volume of contribution to the tune of
184 fixed cost.
Marginal Costing
11.6 VERIFICATION
At the level of 100 units
Sales 100Rs.20 Rs.2,000/
Variable Cost 100Rs.10 Rs.1,000/
Contribution 100Rs.10 Rs.1,000/
Fixed Cost Rs.1,000/
Profit/Loss 0 d
Break Even Point ( Sales Volume Rs):
Break even point in sales can be found out in two methods.
1. Selling Price Method
2. PV Ratio Method.
11.6.1 Selling Price Method

Under this method Break even sales volume in rupees is found out through the product
of Break Even Point in Units and Selling price per unit
BEP (Rs)=Break Even Point (units) Selling price per unit
11.6.2 PV Ratio Method

Under this method, Break even sales volume in rupees can be determined through the
following ratio.
Fixed Cost
BEP(Rs) =
PV ratio
What is PV ratio?
PV ratio is Profit Volume ratio which establishes the relationship in between the profit
and volume of sales. It is a ratio normally expressed in terms of contribution towards
volume of sales. It is expressed in terms of percentage.
Utility of PV ratio:
l To find out the Break Even Point in sales volume
l To identify the desired level of profit at any sales volume
l To determine the sales volume to earn required level of profit
l To identify better product mix among the alternatives available etc.
Sales-Variable Cost Contribution

Profit Volume Ratio (PV ratio) = =
Sales Sales
From the above example
PV ratio at the level of 100 units
Rs.1000/-
PV ratio = 100 = 50%
Rs. 2000/-
PV ratio at the level of one unit
Rs.10/-
PV ratio = 100 = 50%
Rs. 20/-
From the above workings, it obviously understood that every unit of sale contributes
50% towards in covering the fixed cost and profit. 185
Managers Fixed Cost
Break Even Sales:
PV ratio
At the level of 100 units In Percentage
Sales 100Rs.20 Rs. 2,000/ 100%
Variable Cost 100Rs.10 Rs.1,000/ 50%
Contribution 100Rs.10 Rs.1,000/ 50%
Profit/Loss 0 f
PV Ratio = Rs.1000/Rs.2000 = 50%
50 % of what ?
If Rs.100 is Sales ; Rs.50 is Contribution and the remaining Rs.50 variable cost.
Fixed cost Rs.1000 Contribution Rs.1000/

Break even sales = = Rs.2000/ =
50% 50%
At Break even level, the fixed cost volume is equivalent to contribution; the later which
is related in terms of sales i.e. PV ratio will be applicable to the earlier i.e. fixed cost.
Contribution
At Break even sales, Fixed Cost = Contribution; Sales = Sales
Contribution
is the volume which neither earns nor incurs loss.
Illustration 2:
Calculate Break Even Point from the following particulars
Fixed Cost Rs.3,00,000
Variable Cost Per Unit Rs.20/-
Selling Price Per Unit Rs.30/-
Fixed Cost
Break Even Point (Units) =
First Step to find out Contribution margin per unit
Contribution Margin Per Unit = Selling Price Per Unit Variable Cost Per Unit
= Rs.30 Rs.20 = Rs. 10
Rs.3,00,000
= = 30,000 units
Rs.10
Break Even (Rupees) can be found out in two ways
Method I:
= B.E.P (Units) Selling Price
= 30,000 units Rs.30= Rs.9,00,000/-
(Or)
Method II:
Under this method PV ratio component has to be found out
Contribution
PV ratio = 100
186 Sales
Marginal Costing
Rs 10
= 100 = 33.33%
Rs.30
Fixed Cost Rs.3,00,000/

= = = 9000 100 = 900,000/-
PV ratio 33.33%
Illustration 3:
Calculate Break even point Rs.
Sales 6,00,000/-
Fixed Cost 1,50,000/-
Variable Expenses
Direct Material 2,00,000/-
Direct Labour 1,20,000/-
Overhead Expenses 80,000/-
First step to find out the total volume of Variable expenses
Variable Expenses = Direct Material + Direct Labour + Overhead Expenses
= Rs.2,00,000 + 1,20,000 + 80,000 = Rs.4,00,000/-
Second Step to find out the contribution
Contribution = Sales- Variable Expenses
= Rs.6,00,000- 4,00,000= Rs. 2,00,000/-
Third step to find out PV ratio
PV ratio= Contribution/ Sales= Rs,2,00,000/Rs.6,00,00= 1/3
Final Step to find out Break even sales
Fixed Cost Rs.1,50,000

Break Even Point (Rupees) = = = Rs.4,50,000/-
PV ratio 1/3
Note: Break even point in units is not possible to find out due to non availability of selling
price and variable cost per unit ; which constrained the computation of contribution
margin per unit.
Illustration 4:
From the following particulars find out the BEP. What will be the selling price per unit if
BEP is brought down to 900 units?
Variable Cost Rs 75/
Selling price per unit Rs.100/
First step is to find out the Break even Point in Units
Fixed Cost
BEP (Units) =
Contribution Margin per unit
Second step is to find out Contribution margin per unit

Contribution margin per unit = Selling price per unit- variable cost per unit
187
Accounting and Finance for = Rs.100-75 = Rs.25
Managers
Rs.27,000
= = 1080 units
Rs.25
If break even point is reduced to the level of 900 units; what is the new selling price?
First step to find out the contribution margin per unit; contribution margin per unit will be
computed from the BEP (units) formula.
Rs.27,000
BEP (Units) = 900 =
Contribution Margin per unit
Contribution margin per unit = Rs. 27,000/900 units = Rs.30

The second step is to determine the new selling price through the following equation
Contribution = selling price-variable cost; X = Selling Price
Rs.30 = X-Rs.75 ; X = 30+75 = Rs.105/-
The new selling price for new break even level of 900 units is Rs.105/-
11.6.3 Graph Method

Statement of Fixed, variable and total costs and per unit
Sl.No Units Fixed Cost Variable Cost Sales Total Cost
Rs Rs Rs Rs
1) 1 500 10 20 510
2) 50 500 500 1000 1000
3) 100 500 1000 2000 1500
4) 150 500 1500 3000 2000
Cost/ Volume
Rs 3000 TS
2000
1500 TC
BEP
1000 Margin
of Sa fety
500 FC
10
50 100 150
Units
11.7 MARGIN OF SAFETY

Margin of safety is the excess volume of sales over the break even sales. It is highlighted in the
form absolute sales or in percentage. It is the difference in between the actual sales and break
188
even sales. It elucidates the extent in which sales can be reduced without incurring a loss.
Margin of Safety = Actual Sales - Break Even Sales Marginal Costing
(Or)
Profit
=
PV ratio
The greater the margin of safety leads to soundness of the firm's business.
11.8 DETERMINATION OF SALES VOLUME IN RUPEES

AT DESIRED LEVEL OF PROFIT
To determine the sales volume (Rupees) at desired level of profit, the existing formula
for finding out the break even sales has to be redesigned.
Fixed Cost
Break Even Sales (Rupees) =
PV ratio
The above formula is in accordance with the method of coverage i-e covering the fixed
cost and profit.
Contribution = Fixed Cost + Profit
To earn desired level of profit, which the firm intends to earn should have to be combined
with the fixed cost, are the two different components to be covered only in order to find
out the contribution level to the tune of unchanged selling price and variable cost per unit.
Fixed Cost + Desired Level Profit

New volume of Sales (Rupees) =
PV ratio
Illustration 5:
From the following information relating to quick standards ltd., you are required to find
out i) PV ratio ii) break even point iii) margin of safety iv) calculate the volume of sales
to earn profit of Rs.6,000/
Total Fixed Costs Rs.4,500/
Total Variable Cost Rs.7,500/
Total Sales Rs.15,000/-
First step to find out the Contribution volume
Sales Rs 15,000/
Variable Cost Rs. 7,500/
Contribution Rs.7,500/
Fixed Cost Rs.4,500/-
Profit Rs.3,000
(i) Second step to determine the PV ratio
Contribution 7,500
PV ratio = 100 = 100 = 50%
Sales 15,000
Third step to find out the Break even sales
Fixed cost 4,500

(ii) Break even sales = = = 9,000/-
PV ratio 50% 189
Accounting and Finance for (iii) Margin of safety can be found out in two ways
Managers
(a) Margin of Safety = Actual sales- Break even sales
= Rs.15,000-Rs.9,000 = Rs.6,000
Profit Rs.3,000
(b) Margin of Safety = = = Rs.6,000/-
PVratio 50%
(iv) Sales required to earn profit = Rs.6,000/
To determine the sales volume to earn desired level of profit
Fixed cost + Desired Profit

=
PV ratio
Rs.4,500 + Rs.6,000
= = Rs.21,000/-
50%
Illustration 6:
Break even sales Rs.1,60,000
Sales for the year 1987 Rs.2,00,000
Profit for the year 1987 Rs.12,000
Calculate
(a) Profit or loss on a sale value of Rs.3,00,000
(b) During 1988, it is expected that selling price will be reduced by 10%. What should
be the sale if the company desires to earn the same amount of profit as in 1987 ?
The major aim to compute fixed expenses.
In this problem, the profit volume is given which amounted Rs.12,000
Profit = contribution- Fixed expenses
From the above equation, the volume of contribution only to be found out
To find out the volume of contribution, the PV ratio has to be found out
Before finding out the PV ratio, the margin of safety should be found out
Margin of safety = Actual sales - Break even sales
= Rs.2,00,000-Rs.1,60,000 = Rs.40,000
Another formula for to find out the Margin of safety is as follows
Profit
Margin of safety =
PV ratio
Profit Rs.12,000
PV ratio = = = 30%
Margin of safety Rs.40,000
What is PV ratio ?
Contribution
PV ratio = 100
Sales
Contribution
30% =
Rs.2,00,000
190
Contribution = Rs.2,00,000 30% = Rs.60,000 Marginal Costing
Now with the help of the available information, the fixed expenses to be found out from
the illustrated formula
Fixed expenses = Contribution- Profit = Rs.60,000 Rs,12,000 = Rs.48,000
The next one is to find out the corresponding variable cost. The variable cost could be
found out with the help of the following formula
Sales- Variable cost = Contribution
Rs.2,00,000- Rs.60,000= Variable cost= Rs.1,40,000
(a) Profit or loss on the sale value of Rs 3,00,000
For a sale value of Rs.3,00,000 what is the contribution ?
Contribution for Rs.3,00,000 sale= Rs.3,00,000 30%= Rs.90,000
Profit or Loss= Contribution Fixed expenses= Rs.90,000Rs,48,000=
Rs 42,000 (Profit)
(b) Sales to be found out to earn same level of profit
Sale value reduced 10% from the actual
Rs. 2,00,000Rs.20,000 Rs.1,80,000
Variable cost Rs.1,40,000
Contribution Rs.40,000
For the new level of sale volume in rupees, the new PV ratio has to be found out
PV ratio = 100 = 100 = 2/9 times
Sales Rs.1,80,000
The next important step is to determine the volume of the sales to earn the desired
level of profit
Fixed expenses + Desired level profit

=
PV ratio
Rs.48,000 + Rs.12,000
= = Rs.2,70,000
2/9
Illustration 7:
SV ltd a multi product company, furnishes you the following data relating to the year
1979
Particulars First half of the year Second half of the year
Sales Rs.45,000 Rs.50,000
Total cost Rs40,000 Rs.43,000
Assuming that there is no change in prices and variable costs that the fixed expenses are
incurred equally in the two half year periods calculate for the year 1979
Calculate
(a) PV ratio
(b) Fixed expenses
(c) Break even sales
(d) Margin of safety
(C.A. Inter May, 1980) 191
Accounting and Finance for (a) The first step is to find out the PV ratio
Managers
Change in Profit
Formula for PV ratio = 100
Change in Sales
To identify the change in profit, the profits of the two different periods should be
known
Profit= Sales-Total cost
Profit of the first half of the year = Rs.45,000Rs.40,000 = Rs.5,000
Profit of the second half of the year= Rs.50,000Rs.43,000 = Rs.7,000
Change in profit= Rs.7,000Rs.5,000= Rs.2,000
Change in sales= Rs.50,000Rs.45,000=Rs.5,000
Rs.2,000
PV ratio = 100 = 40%
Rs.5,000
(b) Fixed expenses, to find out the contribution should be initially found out
Contribution = Sales PV ratio
= Rs.50,000 40% = Rs.20,000
The fixed expenses to be found out through the following equation
Contribution-Fixed expenses= Profit
Rs.20,000Rs.7,000= Rs.13,000= Fixed expenses
The fixed expenses found only for six months ; for the entire year
= Rs.13,000 2=Rs. 26,000
(c) BE Sales
Fixed expenses Rs. 26,000
= = = Rs.65,000
PV ratio 40%
(d) Margin of safety
= Total sales- BE sales
The next component to be found out is total sales
Total sales = Sale of the first half of the year + Sale of the second half of the year
= Rs.45,000 + Rs.50,000 = Rs.95,000
Margin of safety= Rs.95,000 Rs.65,000= Rs.30,000
Rs. 30,000
Margin of safety in percentage of sales = 100= 31.578%
Rs. 95,000
11.9 APPLICATIONS OF MARGINAL COSTING
11.9.1 Make or Buy Decision

The firms which are routinely in need of spares, accessories are bought from the outsiders
instead of any production or manufacturing, though the requirement is at regular intervals.
Most of the automobile manufacturers are usually buying the components from outside
instead of producing them on their own. The Maruthi Udyog ltd had given a contract to
the Nettur Technical Training Foundation, Bangalore to design the tool for the panel and
to manufacture regularly to the tune of the orders.
The leading four wheeler manufacture in India is buying the panel from the NTTF on
192 contract basis instead of manufacturing.
Why don't they manufacture in spite of buying them from the NTTF ? Marginal Costing
The main reason of buying is cheaper than the production of an article.

Illustration 8
The management of a company finds that while the cost of making a component part is
Rs. 20, the same is available in the market at Rs. 18 with an assurance of continuous
supply.
Give a suggestion whether to make or buy this part. Give also your views in case the
supplier reduces the price from Rs. 18 to Rs. 16.
The cost information is as follows
Material Rs 7,00
Direct Labour Rs. 8.00
Other variable expenses Rs. 2.00
Fixed expenses Rs. 3.00
Total Rs.20.00
The first point to be found out that the contribution of the transaction. The cost of
manufacturing should be compared with the price of the product which is available in the
market.
To find out the worth of the transactions, first the cost of manufacturing should be found
out
Material Rs. 7.00
Direct Labour Rs. 8.00
Other variable expenses Rs. 2.00
Total Rs.17.00
The cost of manufacturing a component is Rs.17.00. While calculating the cost of
manufacturing a component, the fixed expenses was not considered. The fixed expenses
were not considered for computation. Why?
The costs will be incurred irrespective of the production status of the firm; for which the
expenses should not be added.
If the company manufactures the product/ component at Rs.17 which will facilitate to
book profit Rs. 1 from the price of Rs.18 which is available from the market.
The next stage is decision criteria.
11.9.2 Worth of Production

Cost of the production < Price of the product available in the market
The firm is better advised to take the course of production rather than purchase of the
product.
11.9.3 Worth of Purchase

Cost of the production > Price of the product available in the market
The product available in the market is dame cheaper than the manufacturing of a product.
The firm is better advised to buy the product rather than the manufacturing of a product
If the product price comes down to the price of Rs.16 facilitates the firm to save Re 1
from the cost of manufacturing.
193
Managers
A refrigerator manufacturer purchases a certain component @ Rs.50 per unit. If he
manufactures the same product he has to incur a fixed cost of Rs.20,000 and variable
cost per unit is Rs. 40/- when can the manufacturer make on his own or when he can
buy from outside ?
When the requirements is Rs. 5,000 units, will you advise to make or buy?
The very first point to be found that Break even point in units.
The break even point in units at which the cost of buying is equivalent to the cost of
manufacturing.
The cost of purchase per unit - Rs 50/-
If the same product is manufactured, what would be the total cost of manufacture ?
Total cost of manufacture= Total fixed cost + Variable cost
The cost of buying is felt that an exorbitant one than the cost of manufacturing. Having
observed, as a manufacturer undergoes for the manufacturer of a component. If he
manufactures a component, he could save Rs.10=( Rs.50Rs.40) Which in other words
known as contribution per unit
Before finding out the Break even point in units, the contribution of the product should be
found out.
Contribution margin per unit= Selling price in the market Cost of manufacture
Contribution margin per unit is nothing but the amount of savings to the manufacture.
Amount of savings out of the manufacture = Purchase price Variable cost
Though the firm enjoys savings, it is required to additionally incur fixed cost of operations
Rs.20,000
Fixed cost
Break even point in units =
Purchase price- Variable cost
Rs.20,000
= = 2,000 units
Rs.50Rs.40
At 2,000 units, the firm considers both alternatives are incurring equivalent volume of
Cost in manufacturing.
Cost of buying for 2,000 units
=2,000 units Rs.50 per unit= Rs. 1,00,000
Cost of Buying Break even in Rupees
= Rs.20,000 + 2,000 units Rs.40 = Rs.1,00,000
From the above, it obviously understood that both are bearing equivalent amount of
costs. It means both are neither profitable nor non- profitable.
Which one is better for the firm?
No of Units Manufacturing cost Buying cost Decision
@ 2,001 units Rs.20,000+ Rs.80,0040 2001 Rs.50 Manufacturing
=Rs.1,00,040 = Rs.1,00,050 cost < Buying cost
Advisable to
manufacture
@1,999 units Rs.20,000+Rs.79,960 1,999 Rs.50 Manufacturing
=Rs.99,960 Rs.99,950 cost > Buying cost
194 Advisable to Buy
The next step is to identify the worth of either manufacturing the units or buying the units Marginal Costing
at 5,000
If the manufacturer buys from the outsider= 5,000 Rs.50= Rs.2,50,000
If the same manufacturer produces the component instead of buying
=Rs.20,000+ Rs.2,00,000= Rs.2,20,000
From the above, the company is finally advised to manufacture the component due to
low cost of manufacture.
11.10 ACCEPTING THE EXPORT OFFER

Illustration 10
The cost statement of a product is furnished below
Direct material Rs.10.00
Direct wages Rs.6.00
Factory overhead
Fixed Rs1.00
Variable Rs.1.00 Rs.2.00
Administrative expenses Rs.1.50
Selling or distribution overheads
Fixed Rs.0.50
Variable Rs.1.00
Rs.1.50
Selling price per unit Rs.24.00 Rs.21.00
The above figures are for an output of 50,000 units. The capacity for the firm is 65,000
units A foreign customer is desirous of buying 15,000 units a price of Rs.20 per unit.
Advise the manufacturer whether the order should be accepted, what will be your
advise if the order were from the local merchant?
The acceptance of the order is mainly based on the two important covenants viz Additional
cost and Additional revenue.
If the additional demand of the foreign buyer is able to generate the additional revenue
more than the additional cost of the operations, the firm should have to accept the foreign
order.
Decision criteria
Marginal/Additional cost for the additional order of 15,000 units
Per unit (Rs) 15,000 units
Selling price 20 3,00,000
Less:Marginal cost Rs
Direct material 10.00
Direct wages 6.00
Variable overhead
Factory 1.00
Selling & Distribution 1.00 18 2,70,000
2 30,000
The acceptance of the order will generate marginal profit of Rs.30,000 which should be
accepted. The fixed portion of the factory and selling overheads were already met out 195
Accounting and Finance for which should not be included again in the computation of the marginal or additional cost
Managers
of the foreign order placed by the business enterprise.
Instead, If the firm accepts the local order at the rate of Rs.20 which automatically will
spoil the relationship with the very good customers who regularly purchase at the rate of
Rs.24. This will lead to cannibalization of the existing pricing strategy.
11.11 KEY FACTOR

Key factor is nothing but a limiting factor or deterring factor on sales volume, production,
labour, materials and so on.
The limiting factor normally differs from one to another
Volume of sales- the limiting factor is that production of required number of articles
Volume of production- the limiting factors are as follows in adequate supply of raw
materials, labor, inability to sell the produced articles and so on
The limiting factors are studied in the lights of the contribution. The limiting factor is
bearing the inverse relationship with the volume of contribution. To study the worth of
the business proposals among the limiting factors, the contribution is considered as a
parameter to rank them one after another.
Illustration 11
From the following data, which product would you recommend to be manufactured in a
factory, time being the key factor?
Particulars Per unit of Product A Rs Per unit of Product B Rs
Direct Material 24 14
Direct Labor @ Re 1per hr 2 3
Variable overhead Rs.2 per hr 4 6
Selling price 100 110
Standard time to produce 2 Hours 3 Hours
(I.C.W.A.Inter)
The product is being chosen by the manufacturer based on the ability of generating
higher contribution. The higher the contribution leads to a better the position for the firm
The worth of the product is being selected on the basis of
Selling price 100 110
Less :Direct Material 24 14
Variable overhead Rs.2 per hr 4 30 6 23
Contribution 70 87
Standard time to produce 2 Hours 3 Hours
Contribution per hour per product Rs.70/2 Hrs= Rs.35 Rs.87/3 Hrs= Rs 29
From the above calculation, it is obviously understood that the firm is having higher
contribution margin per hour in the case of product A over the other one, portrays the
product A is better than B.
Illustration 12
The following particulars are obtained from costing records of a factory:
Direct Material Rs.20 per Kg 80 320
196
Contd...
Variable overhead 40 80 Marginal Costing
Selling price 400 1,000

Total fixed overheads Rs.30,000
Comment on the profitability of each product during the following conditions:

(a) In adequate supply of raw material
(b) Production capacity is limited
(c) Sales quantity is limited
(d) Sales value limited
The first step is to determine the Contribution per product.
According to the constraints given in the problem, contribution of two products should be
compared.
Selling price 400 1,000
Direct Material Rs.20 per Kg 80 320
Variable overhead 40 220 80 600
Contribution margin per unit 180 400
Now the contribution per unit has found out with the help of above given information the
next step is to study the contribution margin per unit to the tune of given constraints of
the firm.
(a) The first constraint is in adequate supply of the raw material: The raw materials
are considered to be precious due to insufficient supply to the requirement of the
firm. Having considered the scarcity of the raw material, the constraint in availing
the raw material is denominated in terms of ability of contribution generation.
Consumption of raw material
per unit
Cost of raw material per unit Rs 80 = 4 Kgs Rs.320 = 16 Kgs
Cost of material per Kg Rs.20 Rs20
Contribution per Kg Rs. 180 = Rs.45 Rs.400 = Rs.25
4 Kgs 16 Kgs
It obviously understood that the firm enjoys greater contribution margin per k.g in
the case of Product A during the scarcity of raw material than the product B.
(b) Then the production capacity of the firm is subject to the availability of the labour and
the hours normally consumed by them for the production of a single product. Due to
shortage of the labour, the firm should identify the product which requires lesser
labour hours as well as able to generate more contribution margin per labour hour.
In the next step, Contribution margin per hour should be calculated.
Consumption of Labor Hrs
Cost of Labor per unit
Cost of Labor per Hour Rs100 = 10 Hrs Rs.200 = 20 Hrs
Rs.10 Rs10
Contribution per Hr of the Rs. 180 = Rs.18 Rs.400 = Rs. 20
product 10 Hrs 20 Hrs
197
Accounting and Finance for The contribution per hour is greater in the case of the product B, considered to be
Managers
as a better product among the given. It means that the firm has better opportunity
to earn greater contribution in the case of product B than A.
(c) The next one is that sale of the quantities is the major limiting factor. It means that
the vendor finds some what difficulties in selling the articles. While considering the
difficulties in selling the quantities, the firm should identify the product which is able
to generate greater contribution.
From the earlier calculation, it is clearly understood that, the product B is bearing
greater value of contribution margin per unit than the product.
(d) If the sales value is considered to be a limiting factor, to choose one among the
given products PV ratio is being applied as a measure. It means that the sales
value of the products are ignored for comparison in between them. To identify the
better product, irrespective of the price, PV ratio should be applied. The PV ratio
of the Product A & B are calculated as follows
Contribution
Profit volume ratio = 100
Sales
For A = 45%
For B = 40%
The PV ratio is greater in the case of product A than B. The product A has to be
chosen
Check Your Progress
1. Which is the following factor equated to the Contribution at the level of Break Even
Point ?
(a) Fixed cost (b) Sales
(c) Variable cost (d) Semi-Variable cost
2. What is the change to be made on the BEP formula to find out the volume of sales at
the desired level of profit ?
(a) Desired profit (b) Fixed cost
(c) Desired profit with Fixed cost (d) Desired cost + Fixed profit
11.12 SELECTING THE SUITABLE PRODUCT MIX

In the market, dealership is offered by the various companies to the individual intermediaries
in promoting the sale of products. Before reaching an agreement with the company to act
as a dealer, normally every individual consider the profitability of the product mix offered
by the firm. For e-g There are two different companies brought forth their advertisements
in offering the dealership to the individual trading firms viz HCL and IBM.
The profitability under the dealership banner should be appropriately considered prior to
take decision. To take rational decision, the firm should compare the profitability of both
different dealership of two different giant industrial brands. The greater the share of the
profitability in volume will be selected and vice versa.
Check Your Progress
1. If the supply of the material is considered to be scared in the market for two different
units of production of ABC ltd. How the worth of the units of production could be
studied through Key factor analysis?
198
Contd...
(a) Contribution per unit (b) Contribution per labour Marginal Costing
(c) Contribution per hour (d) None of the above

2. While accepting export order, which component of influence should not be taken into
consideration?
(a) Direct material (b) Direct expenses
(c) Direct labour (d) Fixed cost
3. If Licon co ltd wants to induct a product B along with the existing product line, what
would be the deciding factor to undertake or reject?
(a) Composite contribution (b) Fixed cost
(c) Contribution margin per unit (d) None of the above
Illustration 13
From the following information has been extracted of EXCEL rubber products ltd
Direct materials A Rs 16
Direct materials B Rs12
Direct wages A 24 Hrs at 50 paise per hour
Direct wages B 16 Hrs at 50 paise per hour
Variable overheads 150% of wages
Fixed overheads Rs. 1,500
Selling price A Rs.50
Selling price B Rs.40
The directors want to be acquainted with the desirability of adopting any one of the
following alternative sales mixes in the budget for the next period.
(a) 250 units of A and 250 units of B
(b) 400 units of B only
(c) 400 units of A and 100 units of B
(d) 150 units of A and 350 units of B
State which of the alternative sales mixes you would recommend to the management?
The first step is to determine the contribution margin per unit of A and B.
The determination of the contribution of product A and B are through the preparation of
Marginal costing statement.
Particulars Product A Rs Product B Rs
Selling price 50 40
Less: Direct Materials 16 12
Direct wages 12 8
Variable overheads 18 12
Variable cost 46 32
Contribution 4 8
The next step is to determine the profit level of every mix.

(a) 250 units of A and 250 units of B
The first step is to determine the total contribution of the mix. Why the total
contribution has to be found out?
The main reason is to determine the profit level of the mix through the deduction of
the fixed overheads
199
Accounting and Finance for Product of A 250 units Rs.4= Rs.1,000
Managers
Product of B 250 units Rs.8= Rs.2,000
Fixed overheads Rs.1,500
Profit Rs.1,500
(b) 400 units of B only
Product B Contribution 400 units Rs.8 = Rs.3,200
Profit Rs.1,700
(c) 400 units of A and 100 units of B
Product of A 400 units Rs.4 Rs.1,600
Product of B 100 units Rs.8 Rs. 800
Profit Rs.900
(d) 150 units of A and 350 units of B
Product A 150 units Rs.4 Rs.600
Product B 350 units Rs.8 Rs.2,800
Profit Rs.1,900
Mix A B C D
Contribution Rs.1,500 1,700 900 1,900
The profit level among the given various mixes, the mix (d) is able to generate
highest volume of profit over the others
11.13 DETERMINING OPTIMUM LEVEL OF

OPERATIONS
Under this method, the level has to be found out which is having lesser selling price, cost
of operations and greater profits known as optimum level of operations.
Illustration 14
A factory engaged in manufacturing plastic buckets is working at 40% capacity and
produces 10,000 buckets per annum.
The present cost break up for bucket is as under
Material Rs.10
Labour Rs.3
Overheads Rs.5(60% fixed)
The selling price is Rs 20 per bucket
If it is decided to work the factory at 50% capacity, the selling price falls by 3%. At 90 %
200 capacity the selling price falls by 5% accompanied by a similar fall in the prices of material.
You are required to calculate the profit at 50% and 90% capacities and also calculate Marginal Costing
break even point for the same capacity productions. (C.A.Inter May,1976)
The very first step is to compute number of units at every level of capacity i.e. 50% and
90%.
But in this problem, 40 % capacity utilization given which amounted 10,000 units.
10,000
For 50% = units 50 = 12,500 units
40
10,000 units
For 90 % = 90 = 22,500 units
40
The important information is that the changes taken place in the selling price of the
product.
Selling price = Rs.20 @ 40% i.e., 10,000 units
Selling price @ 50% i.e. 12,500 units = Rs.203% on Rs.20 = Rs.19.40
Selling price @90% i.e. 22,500 units=Rs.205% on Rs.20 = Rs.19
While preparing the marginal costing statement, the fixed cost portion should not be
included for the computation of the contribution.
The next step is to prepare the marginal costing statement.
Particulars 50 % capacity(12,500 Units) 90% capacity Rs(22,500 units
Per unit Rs Total Rs Per unitRs TotalRs
Selling price 19.40 2,42,500 19.00 4,27,500
Less: Direct Materials 10 1,25,000 9.50 2,13,750
Direct wages 3 37,500 3 67,500
Variable overheads 2 25,000 2 45,000
Variable cost 15 14.50
Contribution 4.40 55,000 4.50 1,01,250
Fixed costs 30,000 30,000
Profit 25,000 71,250
The last step is to determine that the break even point

Particulars 50 % capacity 12,500 units 90% capacity 22,500 units
Break even point in units Rs.30,000 Rs.30,000
= Fixed cost Rs.4.40 Rs.4.50
Contribution margin per unit =6,818 units =.6,667units
Break even point in value 6,818 units Rs 19.40 6,667units Rs.19
BEP in units Selling price =Rs.1,32,269.2 =Rs.1,26,673
11.14 ALTERNATIVE METHOD OF PRODUCTION

It is a method to identify the best method of production to generate greater contribution
as well as profit. The method which is able to earn greater profit only will be considered,
known as limiting factor method.
Illustration 15
Product X can be produced either by machine A or machine B. Machine A can produce
100 units of X per hour and machine B 150 units per hour. Total machine hours available
during the year are 2,500. Taking into account the following data determine the method
of profitable manufacture. 201
Managers 11.15 LET US SUM UP
"Marginal cost is the amount at any given volume of output, by which aggregate costs
are charged, if the volume of output is increased or decreased by one unit." Marginal
Costing is defined as "the ascertainment of marginal cost and of the effect on profit of
changes in volume or type of output by differentiating between fixed and variable costs."
In marginal costing, the change in the level of cost of operation is equivalent to variable
cost due to fixed cost component which is fixed irrespective level of outputs. Break
Even Point is the point at which the Total Cost is equivalent to Total Revenue. At the
break even point the business neither earns profit nor incurs a loss. It means that the
firm's cost is recovered at the minimum level of production. PV ratio is Profit Volume
ratio which establishes the relationship in between the profit and volume of sales. It a
ratio normally expressed in terms of contribution towards volume of sales. It is expressed
in terms of percentage. Key factor is nothing but a limiting factor or deterring factor on
sales volume, production, labour, materials and so on.
The limiting factor normally differs from one to another
Volume of sales- the limiting factor is that production of required number of articles
In the market, dealership is offered by the various companies to the individual intermediaries
in promoting the sale of products. Before reaching an agreement with the company to act
as a dealer, normally every individual consider the profitability of the product mix offered
by the firm.

Should we evaluate a managers performance on the basis of controllable or non-
controllable costs? Why? Give your opinion.
11.17 KEYWORDS
Marginal cost: Change occurred in the cost of operations due to change in the level of
production.
B E P (Units): It is the level of units at which the firm neither incurs a loss nor earns
profit.
BEP (Volume): It is the level of sales in Rupees at which the firm neither incurs a loss
nor earns profit.
Fixed cost: It is a cost which is fixed or remains the same for irrespective level of
production.
Variable cost: It varies along with the level of production.
Contribution: It is an amount of balance available after the deduction of variable cost
from the sales.
Key factor: Factor of influence on the component of contribution.
PV ratio: Profit volume ration which is nothing but the ratio in between the contribution
and sales.
Desired profit: It is a profit level desired by the firm to earn at the given level of sales
volume.

1. Define marginal cost.
202 2. Define marginal costing.
3. What is Break Even Point Analysis? Marginal Costing
4. Explain the Graphic approach of BEP analysis.

5. Briefly explain the profit volume ratio.
6. Explain the various kinds of managerial decisions.
7. Elucidate the key factor analysis.
8. List out the advantages of marginal costing.
9. Highlight the limitations of marginal costing.

R.L. Gupta and Radhaswamy, Advanced Accountancy.
203
UNIT-IV
LESSON
12
FINANCIAL MANAGEMENT
CONTENTS
12.1 Introduction
12.2 Finance and Related Disciplines
12.2.1 Finance and Economics
12.2.2 Finance and Accounting
12.3 Profit Maximization
12.3.1 Criticism
12.4 Wealth Maximization
12.5 Objectives & Functions of Financial Management
12.6 Let us Sum up
12.8 Keywords

In this lesson we shall discuss about financial management. After going through this
lesson you will be able to:
(i) discuss finance and related disciplines
(ii) analyse profit maximisation and wealth maximisation
(iii) understand objectives and functions of financial management
12.1 INTRODUCTION
The financial management was initially perceived that the study with reference to only
procurement of funds but later it was extended to one more additional feature that efficient
utilization of funds.
It is imperative to understand the meaning of the term Finance
l Money with objective
l Money with purpose
l Money with direction
l Money with target
l Money with achievement
l Money with aim
The above explanation is able to understand the real meaning of the term finance which is
nothing but effective utilization raised money with some purpose to achieve in desired direction.
for Managers 12.2 FINANCE AND RELATED DISCIPLINES
The study of role of finance in the organization is with reference to financial management.
The financial management is the course which has drawn major focus points from the
many more disciplines. To study them, the inter relationship in between the financial
management and other related disciplines.
The following are the related disciplines viz
l Finance and Economics
l Finance and Accounting
l Finance and Marketing
l Finance and production
l Finance and Quantitative Methods
12.2.1 Finance and Economics

The relationship in between these two disciplines are studied in two different headings
viz Micro and Macro economics
The major part of the financial management is to raise the financial resource to the
requirements. While raising the financial resources, the availability is subject to the macro
economic influences.
l Banking system
l Money and capital markets
l Financial intermediaries
l Monetary and credit policies
12.2.2 Finance and Accounting

The two are embedded with different disciplines. The finance is the discipline which is
mainly based on the cash basis of operations but the accounting is totally governed by
the accrual system.
Accounting is mainly vested with the collection and presentation of data, but the finance
is closely connected with the decision making of the organization.
Till this moment, the differences are discussed only to know the role of finance over the
accounting of any organization. The following is the major relationship which lies in
between the finance and accounting as follows "Finance begins where accounting ends"
l Finance and Marketing: These two are disciplines are interrelated to plan for
introduction of new product. The major reason is that the introduction of new
product normally warrants huge sum of money for research and development ;
which needs immense planning and execution to succeed over the other competitors
l Finance and Production: The changes in the production policy of the organization
will impact the capital expenditures. The fixed assets of the organization should be
effectively utilized which neither over capitalization nor under capitalization
l Finance and Quantitative methods: These are inter related to solve complex
problems in order to take decisions.
The objectives of the financial management are classified into two categories viz
l Profit maximization
l Wealth maximization
Let us discuss these two one after the another. The objectives of the financial management
is discussed only to the tune of normative framework in between the financing, investment
208
and dividend functions of the management.
Financial Management
Check Your Progress
Financial management is the course which has drawn major focus points
from the many more disciplines. Discuss.
12.3 PROFIT MAXIMIZATION

The projects are considered on the basis of the following criterion:
If the project is having the scope to have an increase in the volume of profits, the project
is suggested to accept and vice versa.
The financing, investment and dividend decisions of the enterprise is dome shaped towards
the profit maximization.
Under this, the profit is defined in two different angles viz. Owner's and Operational
perspective.
Owners' perspective definition of profit is the share of national income paid to the owners.
Operational perspective defines the term profit as when the output exceeds the inputs of
the process.
The testing, selecting of the assets and projects are normally on the basis of the profitability
of the firm. If the firm is found to be profitable, suggested to accept, otherwise, the
decision is vice versa.
Profit is a test of economic efficiency which is individual aim to achieve at always
though it is closely associated with the social welfare.
12.3.1 Criticism
There is misapprehension about the workability of the private enterprise which normally
strives for the profit maximization but not by considering the welfare of the society
The next most important criticism is that in ability to fit into the practical considerations
The second set of criticism is that the set of technical flaws or set backs associated with
the financial management.
The technical flaws of the profit maximization is studied under three different headings viz:
Ambiguity
Timing of benefits
Quality of benefits
Ambiguity: Profit is to be maximized; which profit has to be maximized? Either Net profit
or Gross profit is to be maximized? Whether the short term or long term profit is to be
maximized? Whether total profit or rate of profit is to be maximized? Whether the return
on the total assets employed or the return on the total capital employed is to be maximized?
The maximization of profit is vague due unclear definition of the term profit.
Timing of Benefits
Project Alternative A Alternative B
Rs Lakh Rs Lakh
Period 1 50 -------
Period 2 100 100
Period 3 50 100
Total 200 200
From the above table, the two alternative projects A and B are found to be identical with
reference to profit maximization due to equivalent volume of profits of them.
Really speaking, these two projects are not identical, why?
209
Accounting and Finance One missing phenomenon is that timing of benefits.
for Managers
The timing of benefits should be relatively given greater importance for weighing the
project at the moment of consideration.
Project alternative A is better than the project alternative B, why?
Project alternative A is able to generate the benefits during the period 1 which is known
as earlier benefits, facilitating the A alternative to go for reinvestment, but in the case of
reinvestment opportunity is denied due to non availability of profits during the early season
i.e. period 1
Quality of Benefits
Project Alternative A Rs Alternative B Rs
Lakh Lakh
Recession 9 0
Normal 10 10
Boom 11 20
Total 30 30
Under the profit maximization, the quality of benefits are not considered what is meant
by the quality of benefits?
It means the certainty of benefits. The more certain the benefits is better the quality of
benefits and vice versa. The profit maximization failed in its attempt to consider the
quality of benefits. It has considered the both project are identical but really they are not.
Alternative B project is more volatile returns in other words they are more uncertain
unlike the project A. The project A is having only least volatility in the earning pattern
during the three seasons. A is the better project which has greater certainty in accruing
benefits over the others, are normally preferred by the risk averters.
12.4 WEALTH MAXIMIZATION

The next important set of objectives taken for discussion is Wealth maximization
Only in order to replace bottlenecks which were associated with the profit maximization.
Wealth maximization means that value / net worth maximization.
The Worth of Action normally happens only at when the Value of benefits are more than
the Cost of its undertaking. In other words, the wealth maximization is defined in the
angle of the concept of cash flows. The Cash flows are clearly dealt only in accordance
with the "CASH SYSTEM"-Definite Connotation
l It eliminates the ambiguity associated with accounting profits
l Second feature - timing of benefits and quality of benefits are jointly considered
l Operational implications of timing of benefits and quality of benefits
The timing and quality of benefits are given greater importance under the wealth
maximization through the incorporation of capitalization rate which is applied to the tune
of risk and timing of benefits associated with the project.
The discounting component mainly depends upon the time and risk preferences of the
owners of the capital
The importance of the wealth maximization is explained through the discount rate
component
Higher the discount Rate reveals that Higher Risk and Higher uncertainty
210
Lower the discount Rate portrays that Lower Risk and Lower uncertainty
The Decision Criterion is based on the comparison in between the Value and Cost Financial Management
The Creation of Value takes place only at when the economic benefits are more than
Cost
The Reduction of wealth just contrary to the earlier which normally produces lesser
Economic Benefits than Cost
The decision of either acceptance or rejection is subject to the net present value
It is imperative to refer the words of Ezra's Solomon to illustrate the importance of the
wealth maximization
"The gross present worth of a course of action is equal to the capitalised value of the
flow future expected benefit, discounted at a rate which reflects their
certainty/uncertainty. Wealth or net present worth is the difference between gross present
worth and the amount of capital investment required to achieve the benefits being
discussed. Any financial action which rates wealth or which has a net present worth
above zero is a desirable one and should be undertaken. Any financial action which does
not meet this test should be rejected. If two or more desirable courses of action are
mutually exclusive, then the decision should be to do that which creates most wealth or
shows the greatest amount of net present worth"
l W = V-C
l W = Net present worth
l V = Gross present worth
l C = Investment required to acquire the asset/purchase the course of action
l V = E/K
l E = Size of the benefits available to the suppliers of capital
l K = capitalization rate reflecting quality and
Timing of benefits attached to E
l E = G(M+I+T)
l G = Average future flow of gross earnings expected from the course of action,
before the maintenance charges, taxation, expected flow of interest, preference
dividend
l M = Average annual required investment to maintain G
l I =Expected flow of annual payments of Interest, Preference Dividend and other
prior charges
l T=Expected annual outflow of taxes
Alternate method:
A1 A2 A3 An
l + + ....... + -C
(1 + K) (1 + K)
1 2
(1 + K) 3
(1 + K) n
A1, A2, A3--------depicts the flow of cash resources from a course of action over the
period of time
K=is an appropriate discount rate
C=Initial outlay to acquire the asset
If the out come is positive means that net present worth is positive i.e., more than the
initial investment, considered to be fruitful for the investment and vice versa
Wealth of the investors= market value of the shareholding of the investors
If net worth is positive then the wealth of the investors will go up ; it means that the
market value of the share holding of the investors will pile up.
It is called in other words as Maximization of market value of the shares.
211
for Managers 12.5 OBJECTIVES & FUNCTIONS OF FINANCIAL
MANAGEMENT
The next aspect is that organization of finance function.
The finance function is classified into two categories viz routine functions and functions
of special importance.
The routine functions are normally Accounting aspects of transactions of the business
enterprise which mainly given controller of the finance department.
The functions of special importance are normally involved in the process of preparing
the policies of the organization with reference to finance administration ; which is mainly
earmarked to the Treasurer of the finance department of the organization
The following are the important functions of the Treasurer which normally have special
importance in characteristics:
l Obtaining finance
l Banking relationship
l Investor relationship
l Short-term financing
l Cash management
l Credit administration
l Investments
l Insurance
The following are the vital functions of the Controller which regularly include:
l Financial accounting
l Internal audit
l Taxation
l Management accounting and control
l Budgeting, planning and control
l Economic appraisal and so on
Check Your Progress
1. Finance is the
(a) Money with motive (b) Money with purpose
(c) Money with objective (d) (a), (b) and (c)
2. Wealth is defined as
(a) Gross cash flow (b) Net cash flows
(c) Initial investment (d) None of the above
3. Why profit maximization is sidelined ?
(a) Ambiguous (b) Lack of quality of benefits
(c) Timing of benefits (d) (a), (b) and (c)
4. Which of the following function is the treasurer of the organisation?
(a) Obtaining finance (b) Financial accounting
(c) Internal audit (d) None of the above
212
Financial Management
12.6 LET US SUM UP
The major part of the financial management is to raise the financial resource to the
requirements. While raising the financial resources, the availability is subject to the macro
economic influences. Accounting is mainly vested with the collection and presentation of
data. But the finance is closely connected with the decision-making of the organization.
The objectives of the financial management are classified into two categories viz
l Profit maximization
l Wealth maximization
Profit is defined in two different angles viz. Owner's and Operational perspective.
Owners' perspective definition of profit is the share of national income paid to the owners.
Operational perspective defines the term profit as when the output exceeds the inputs of
the process. "The gross present worth of a course of action is equal to the capitalised
value of the flow future expected benefit, discounted at a rate which reflects their
certainty/uncertainty. Wealth or net present worth is the difference between gross present
worth and the amount of capital investment required to achieve the benefits.

What factors would you look at while taking capital structure decisions? Give your opinion.
12.8 KEYWORDS
Finance: A study of money with objective and desired direction
Profit: In terms of operations - Input < Output
Treasurer: Who carries out the financial management operation with special importance
Controller: Who carries out the routine functions of finance
Wealth maximization: Net present worth maximization; maximization of the market
value of the shares

1. What is meant by finance?
2. Explain the relationship in between the finance and their related disciplines.
3. Explain the objectives of financial management.
4. Elucidate the profit maximization in detail.
5. List out the drawbacks associated with the profit maximization.
6. Highlight the importance of Wealth maximization.

S.N. Maheswari, Management Accounting
Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi. 213
Managers LESSON
13
TIME VALUE OF MONEY
CONTENTS
13.1 Introduction
13.2 Foundations of The Time Value of Money
13.3 Classifications of The Time Value of Money
13.3.1 Rule of 72
13.3.2 Rule of 69
13.4 Frequency of Compounding
13.5 Effective Rate of Interest
13.6 Future Value of an Annuity
13.6.1 Future Value of Annuity Due
13.6.2 Sinking Fund Factor Method
13.7 Present Value of Single Cash Flow
13.8 Present Value of Annuity
13.9 Capital Recovery Factor Method
13.10 Let us Sum up
13.12 Keywords

This lesson is intended to discuss the concept of time value of money and its role in
studying the viability of the project by comparing the initial investment future benefits.
After studying this lesson you will be able to:
(i) describe concept and components of the time value of money
(ii) classify the time value of money and describe rules of 72 and 69
(iii) understand effective rate of interest and future value of an annuity
13.1 INTRODUCTION
The time value of money has gained greater importance in studying the viability of the
project by comparing the initial investment with the anticipated future benefits. If the
anticipated future benefits are more than the initial investment then the investment is
214 found to be viable in generating the economic benefits.
Why the time value of money principle is warranted to study under the financial Time Value of Money
management ?
The following are the many reasons involved:
To determine the real rate of return
l With reference to Money employment on productive assets
l In an inflationary period, a rupee today has greater purchasing power than rupee in
the future
l The future is uncertain- Individuals prefer current consumption rather than future
consumption
13.2 FOUNDATIONS OF THE TIME VALUE OF MONEY

There are two, one is the time preference of money and another one is reinvestment
opportunity which are identified and inter related with each other.
Early receipt of money paves way for the reinvestment opportunity but the later receipt
does not carry the things.
Time value of money normally contains three different components viz:
Real rate of return: It is the return which consider original return of the investment but
it never considers the inflation rate.
Expected/Anticipated rate of return: It is the positive rate of return normally expected
by every one on the amount of investment from the future.
Risk premiums: This an allowance is normally given to the investors to compensate the
uncertainty.
13.3 CLASSIFICATIONS OF THE TIME VALUE OF

MONEY
The concept of time value of money can be classified into two major classifications:
l Future value of money
l Present value of money
Future value of money: It is further bifurcated into two different categories viz
Future value of single sum and Future value of an Annuity
Present value of money: It is further classified into two major classes viz
Present value of single sum and Present value of and Annuity
Future value of single sum:
l It could be found from the inbound relationship in between the future value of
money and present value of money.
l FVn = PV(1+K)n
FVn = Future Value of Cash Inflow
PV = Initial Cash Flow
K = Annual Rate of Return
N = Life of Investment
Illustration 1
If you deposit Rs.1,000 today in a Indian bank which pays 10% interest, find out the
future value of money after 3 years. 215
Accounting and Finance for Future value of Rs.1,000 after three years will be = Rs.1,000(1+.10)3
Managers
= Rs.1,000(1.331)= Rs. 1,331
Doubling period: It is the period which makes the investment as "Doubled"
There are two different approaches viz
l Rule of 72
l Rule of 69
13.3.1 Rule of 72
The initial amount of investment gets Doubled within which 72/I
I = Interest Rate of the investment
Illustration 2
The amount of the investment is Rs.1,000. The annual rate of interest is 12%. When this
amount of Rs.1,000 will get doubled ?
= 72/12 = 6 years
13.3.2 Rule of 69
The amount method is found to crude method in determining the doubling period which
has its own limitations. The Rule of 69 was developed only in order to remove the
bottlenecks associated with the early model of doubling period.
The rule of 69 is found to be a scientific method as well as rational method in determining
the doubling period of the investment
=.35+ 69/I
Illustration 3
The amount of the investment is Rs.1,000. The annual rate of interest is 11% When this
amount of Rs 1,000 will get doubled?
=.35+ 69/11= 6.6227 yrs
Check Your Progress
1. State Bank of India announces that your money is getting doubled in 99 months.
What is the rate of interest payable ?
2. The next aspect in the Future value of money is interest frequency of
compounding.
13.4 FREQUENCY OF COMPOUNDING

Whenever any compounding is taking place, the following methodology has to be adopted
for the determination of the future value of money.
FV = PV(1+k/m)mxn
M = Number of Times Compounding is done during the year
N = number of years
K = compounding rate
216
Illustration 4 Time Value of Money
How much does a deposit of Rs. 5,000 grow to at the end of 6 years. If the nominal rate
of interest is 12% and frequency is 4 times a year?
The future value of Rs. 5,000 will be
= Rs.5,000(1+.12/4)46
= Rs.5,000(2.033)= Rs.10,165
13.5 EFFECTIVE RATE OF INTEREST

It is the rate of interest at which mount of the principal grows with regards to the rate of
compounding.
r = (1+K/m)m - 1
K = Nominal Rate of Interest
r = Effective Rate of Interest
m = Frequency of Compounding
Illustration 5
A bank offers 8% nominal rate of interest with quarterly compounding.
What is the effective rate of interest ?
R = (1+.08/4)4 -1=1.082-1=.082 i.e 8.2%
13.6 FUTURE VALUE OF AN ANNUITY

l Annuity may be a series of either payments or receipts
l The annuity can be classified into two categories
v Annuity at the end of the period- Regular / Deferred Annuity
v Annuity at the beginning of the period - Annuity Due
Annuity at the end of the period
FVAn = =
[
A (1 + K) n 1 ]
Future Value Interest Factor Annuity (FVIFA)
k
Illustration 6
Suppose you deposit Rs.1,000 annually in a bank for 5 years and your deposits earn a
compound interest rate of 10% What will be value of the deposit at the end of 5 years?
Assuming the each deposit occurs at the end of the year, the future value of this annuity?
FVAn = Rs.1,000(FVIFA) for 10% and 5 years
[(1 + .10)5 -1]

= Rs.1,000
.10
= Rs.1,000 6.105 = Rs.6,105
13.6.1 Future Value of Annuity Due
FVAn = =
[
A (1 + K) n 1 ]
(1+k) 217
k
Managers
If you invest Rs 1,000 at the beginning of every year, for four years. What will be the
value of the investment finally.
FVAn = Rs.1,000
[(1 + .10) 1] (1+.10)
5
.10
= Rs.1,000 6.7155= Rs.6,715.5
Check Your Progress
1. Four annual equal payments of Rs.2,000 are made into a deposit account
that pays 8% interest per year. What is the future value of this annuity at the
end of 4 years ?
2. You can save Rs.2,000 a year for 5 years, and Rs.3,000 a year for 3 years
thereafter. What will these savings cumulate to at the end of 8 years. If the
rate of interest is 10?
13.6.2 Sinking Fund Factor Method

It means that the amount to be deposited at the end of every year for the period of "n"
years at the rate of interest "K" in order to aggregate Re.1 at the end of the period.
A = FVA [K/(1+K)n -1]
Illustration 8
How much you should save annually to accumulate Rs.20,000 by the end of 10 years. If
the saving earns an interest of 12 %?
A = Rs.20,000[.12/(1+.12)10 -1]
= Rs.20,000(.05698)=Rs.1,139
The next most important segment is present value of money. First we will discuss the
present value of single cash flow
Check Your Progress
1. How much you should save annually to accumulate Rs.20,000 by the end of
10 years. If the saving earns an interest of 12%?
2. Mr vinay plans to send his son for higher studies abroad after 10 years. He
expects the cost of these studies to be Rs.1,00,000. How much should he
save annually to have a sum of Rs 1,00,000 at the end of 10 years. If the
interest rate is 12%?
13.7 PRESENT VALUE OF SINGLE CASH FLOW

It is the process in which the future value of single cash flow is reckoned to "0" time
horizon i.e on today.
PVn = FVn /(1+R)n
Illustration 9
Find the present value of Rs.1,000 receivable 6 years hence if the rate of discount is 6 percent
PVn = Rs.1,000/(1+.06)6
= Rs.1,000(.705)
218 = Rs.705
Shorter Discounting Periods Time Value of Money
l The discounting may be frequent in times like intra year compounding, intra month
compounding and so on.
l Subject to
v Number of periods in the analysis- increases
v Discount rate applicable per period decreases
m xn
1
v PV= FV
1 + k /m
v M = number of times discounting

v K = Discount rate
Illustration 10
Consider the following cash inflow of Rs.10,000 at the end of four years. The present
value of cash inflow when the discount rate is 12% and discounting quarterly.
PV = Rs.10,000 (.623)=Rs.6,230
Check Your Progress
To get Rs.20,000, how much should be invested per year (at the end). The important
information of the banking investment reveals the following are the rate of interest
is 10% and the normal compounding process is once in 6 months.
13.8 PRESENT VALUE OF ANNUITY

l Present value of an annuity - Present value of future cash series - To identify the
value of future cash flows on present value
(1 + K) n -1
l PVAn,k = Present value factor annuity
K(1 + k)n
Illustration 11
If you expect to receive Rs.1,000 annually for 3 years, each receipt is expected to be at
the end of the years. What would be the present value of future cash inflows @ discount
rate of 10% ?
PVA n,k = Rs.1,000 (2.487)= Rs.2,487
Check Your Progress
1. What is the present value of an annuity of Rs.2,000 at 10% ?

2. What is the present value of a 4 year annuity of Rs.10,000 discounted at
10 % ?
3. A 10 payments annuity of Rs.5,000 will begin 7 years hence. (The first payment
occurs at the end of 7 years) what is the value of this annuity now if the
discount rate is 12 per cent ?
13.9 CAPITAL RECOVERY FACTOR METHOD
K(1 + k)
A = PVA Reciprocal to Present value of an annuity
(1 + K) n -1 219
Managers
If your father deposits Rs.1,00,000 on retirement in a bank which pays 10% annual
interest. How much can be withdrawn annually for a period of 10 years?
A = PVA(1/PVIFA)
A = Rs.1,00,000 (1/6.145)= Rs.16,273
Present Value of Perpetuity

Perpetuity means that series with indefinite duration
P? = A PVIFA k, ?
Illustration 13
The present value of perpetuity of Rs.10,000@ 10%, how much should be invested on
today ?
A = P?/ PVIFA k, ?
= Rs.10,000/.10= Rs.1,00,000
Check Your Progress
1. Time value of money is applicable in

(a) Pay back period method (b) Accounting rate of return method
(c) Discounted cash flows method (d) None of the above
2. Compounding factor is to determine
(a) Present value (b) Future value
(c) Present value and Future value (d) None of the above
3. Annuity due means that
(a) Series at the end (b) Series at the beginning
(c) Neither at the beginning nor at the end (d) None of the above
4. Capital recovery factor method is to find out the value of annuity through
(a) Present value of an annuity
(b) Reciprocal to the present value of annuity
(c) Future value of annuity
5. Rule of 72 is for
(a) To determine the present value of the cash flows
(b) To find out future value of cash flows
(c) To find out the doubling period
13.10 LET US SUM UP

The time value of money has gained greater importance in studying the viability of the
project by comparing the initial investment with the anticipated future benefits. Real rate
of return is the return which consider original return of the investment but it never considers
220 the inflation rate. Expected/Anticipated rate of return is the positive rate of return
normally expected by every one on the amount of investment from the future. Time Value of Money
Risk premiums is an allowance is normally given to the investors to compensate the

uncertainty.

How much would you invest now at 5% per annum compounded annual if you want to
get Rs. 5,00,000 after 20 years.
13.12 KEYWORDS
Time value of money: Money value in terms of time, money value in between the
present and future
Future value of money: Present value of money in terms of future through compounding
process
Present value of money: Future value of money is reckoned to "0" time period horizon
FVIF: Future value interest factor component for compounding
FVIFA: Future value interest factor component for compounding the series of cash
payments or receipts
PVIF: Present value interest factor of single cash flow
PVIFA: Present value of interest factor of multiple cash flows
Regular annuity: Series which normally happen at the end of the specified horizon
Annuity Due: Series which normally happen at the beginning
Doubling period: During which the amount of the investment gets doubled within the
given compounding factor component
Effective rate of interest: It is the rate of interest which the investment grows

1. Define time value of money
2. Explain the foundations of the time value of money
3. Explain the classifications of the time value of money
4. Illustrate the rule of 69 with live example from the banking industry
5. Explain the applications of the time value of money in the banking companies
6. Which method is applied for EMI calculation by the financing companies?

M.P. Pandikumar Accounting & Finance for Managers Excel Books, New Delhi. 221
Managers LESSON
14
SOURCES OF LONG TERM FINANCE
CONTENTS
14.1 Introduction
14.2 Equity Shares
14.2.1 Sweat Security
14.2.2 Non Voting Shares
14.2.3 Bonus Issue
14.3 Preference Shares
14.3.1 Cumulative Preference Shares
14.3.2 Non Cumulative Preference Shares
14.4 Debentures
14.5 Bonds
14.6 Warrants
14.7 Let us Sum up
14.9 Keywords

In this lesson we will study about long term finances of companies. After studying this
lesson you will be able to:
(i) describe the concepts of equity share, sweat security, non-voting shares and bonus
issues.
(ii) distinguish between cumulative and non-cumulative preference share.
(iii) explain the features of debentures, bonds and warrants.
14.1 INTRODUCTION
The sources of long-term finance could be classified into the following categories:
l Equity shares
l Preference shares
l Debentures
l Bonds
l Warrants
222
The combination of the sources of long-term finance is known as capital structure. From Sources of Long Term Finance
the above classification, we will discuss one after the another.
14.2 EQUITY SHARES

Shares and Stock are synonymous in usage. Shares are the expression of smaller units
of Share capital of the organization. The raising of equity share capital from the investors
in various segments viz Application money, First call money and Subsequent calls money
are collected subject to the capital clause of the Memorandum of Association of the
organization.
After the issue, the share certificates are issued which normally depicts the expression
of right of shares.
Right of Equity Shares:
Sec. 85(2) of the Companies Act, 1956 expresses the right of the equity shareholders
who hold the equity shares
l To vote
l To control the management
l To share the profits
l To claim on the residual portion during the winding up
l To exercise pre-emptive
l To apply the court
l To receive the copy of the statutory report, copy of the annual accounts
l To apply the central government for AGM - failure on the part of the company
l To apply company law board for Extraordinary general meeting
14.2.1 Sweat Security

l It is one kind of Equity share, which was introduced in the Ordinance 1998,
facilitating the companies to acquire the technical know-how, intellectual property
through the issue of equity shares.
l Definition
l The equity shares which are issued at discount to employees and directors and
consideration other than cash for Technical know-how, intellectual property are
known as sweat security.
Normally the sweat security is issued by the companies in two different categories:
l Sweat security which is issued at preferential pricing more specifically for employees
l Sweat security which is issued at face value, that may be either at par or above par
14.2.2 Non Voting Shares

These type of equity shares never carry any voting rights. These type of shares are also
eligible to enjoy the bonus issue and exclusive listing for the holding of the shares. When
Two year Dividends are continuously missing, the nature of the non voting shares will
automatically become as Voting shares. The Non voting shares are to be declared 20%
dividend more than the ordinary dividend. The issue size of the Non voting shares should
not exceed the maximum limit of the voting stock i.e. 25%. 223
Accounting and Finance for 14.2.3 Bonus Issue
Managers
This type of issue is merely considered as book entry in between the two different
sources of long term finance viz Free Reserves and Equity Share capital. This type of
issue is normally restricted to the companies which are having the partly paid equity
shares. The bonus issue is permitted by making the partly paid up shares into fully paid
shares. The bonus issue is normally decided in the board meeting.
14.3 PREFERENCE SHARES

These type of shares are annexed with preferential rights over the equity shares in
sharing the benefits organization at the moment of declaration. It is nothing but the
combination of both equity shares and debentures; why ? It has some features of equity
shares and debenture through redemption. The dividends are normally paid only to the
tune of fixed rat which was agreed only at the moment of issue in between the issuing
company and investors. The dividends are normally declared by them only subject to the
availability of profits.
Type of Preference Shares: The following are the various type of preference shares
which the company normally issues:
14.3.1 Cumulative Preference Shares

The unpaid preference dividends are paid before anything paid to equity shareholders.
The unpaid preference dividends are called in other words as Arrearages. The arrearages
should not go beyond three years. The arrearages never carry any interest rate. If any
provision is available in the Articles of Association, the arrearages are paid to preference
shareholders at the moment of liquidation.
14.3.2 Non Cumulative Preference Shares

The dividends are paid subject to the availability of profits. If the availability of profits
are not sufficient for the declaration of preference dividend, which do not bear any right
to receive. Due to non declaration of dividends during the previous years, these types of
shareholders are not entitled to share in the surplus benefits of the company, but they are
having the right to receive the dividend prior to the equity shareholders in any particular
year.
No Rights to Share in the Surplus Profits

l Right to receive the dividend prior to the equity shareholders in any particular year.
The repayment of share capital normally takes place only at the moment of winding
of the companies.
l Convertible preference shares: These types of shares are issued by the company
along with the right of conversion to convert the holding into equity shares at the
specified period. Normally, during the process of conversion, the companies charge
higher premium from the shareholders. The voting powers, bonus issue, higher
dividends and so on are subject to the availability of rights out of the conversion.
l Redeemable preference shares: Under this category, the amount of raised capital
is subject to redemption/repayment, which means that when any preference shares
are revealing the definite time period of repayment is known as redeemable
preference shares.
l Non redeemable preference shares: These types of preference share never
carry any definite period of repayment but at the moment of winding up the
repayment is made immediately after the creditors.
l Participating preference shares: The type of preference shares facilitates the
holders to share the surplus benefits immediately after declaring the dividend benefits
224 to preference shareholders and equity shareholders.
l Non Participating preference shares: Except the earlier, all are nothing but non Sources of Long Term Finance
participating preference shares in category.
14.4 DEBENTURES
Sec 2(12) of the Companies Act defines "Debenture includes debenture stock, bonds
and any other securities of a company whether constituting a charge on the assets of the
company". Debenture is an evidencing document i.e., long-term promissory note.
Unique Features of the Debentures

l Debentures are issued on indebtedness
l It is an instrument which indicates the time/date schedule of repayment of principal
or interest
l The Charge is created on the assets of the company ; to protect the interest of
lenders. If any default arises - the due amount of either principal or interest will be
claimed through direct or debenture trustees action for the realization assets in
order to secure the debt
Debentures are classified on the following basis:
l On the basis of security
l On the basis of holding
l On the basis of redemption
l On the basis of convertibility
On the basis of Security: Under this type the debentures are further classified into two
categories viz secured and unsecured debentures:
Secured/Naked Debentures: There is no charge on the assets of the company which
means that there is no claim on the company at the moment of default. These debentures
are normally issued by the company through their well built good will during the past.
Secured or Mortgage Debenture: The type of the debentures bearing the security
through the creation of charge either whole or part of the assets of the company are
known as secured or mortgage debentures. These types of debentures warrant registration
and finally immediately after the registration process the title deeds should be deposited
under the custody of the lender.
On the basis of holding: These types of debentures are further divided into two categories
viz Bearer and Registered Debentures.
l Bearer Debenture: The interest periodical is payable to the bearer and transferable
by mere delivery. It never requires registration to enter in the books. The holder is
simply having the eligibility for redemption
l Registered Debentures: The holders are required to register in the register in
accordance with the Sec 152 of the Companies Act.
On the basis of redemption: This classification has two types viz Redeemable and
Irredeemable:
Redeemable Debentures: Redeemable after the expiry period - Re issuance is possible
with reference to Sec 121 of the companies act 1956
Irredeemable Debentures: These debentures are issued to redemption of specific event
which is non happening in nature for indefinite period for e.g. Winding up of the company.
225
Accounting and Finance for On the basis of Conversion: This type of debentures are trifurcated into the following
Managers
viz Fully convertible, Partly convertible and Non convertible:
Fully Convertible Debentures

This type of debentures are fully converted into Equity shares with premium or without
premium. The Conversion is normally takes after expiry of the period. The conversion is
optional purely left with the discretion of the debentureholders which normally ranges in
between 18 and 36 months. The interest periodical is payable till the process of conversion
is over.
Non Convertible Debentures: This type of debentures never carry any option of
conversion to avail the equity shares of the company immediately after conversion. In
other words, these debentures are denial of option of conversion.
Partly Convertible Debentures: Under this category, there are Two parts involved, one
part is meant for conversion; second part is non convertible portion:
l Convertible portion is the portion which can be availed for conversion at or after 18
months upto 36 months, it is at the optional right of the debentureholders.
l Non convertible portion - It does not carry any convertible portion instead it bears
the redeemable portion for redemption after the expiry period.
The next important classification under the long-term sources of finance is Bonds
14.5 BONDS
It is a long-term debt instrument issued by the company to raise the financial resources
from the market, for specific period and it carries fixed rate of interest which has its own
salient features
l Issued at face value i.e Par value and Par or Discount.
l Rate of interest is fixed or flexible i.e. variable / floating rate of bond - coupon rate
of bond.
l Maturity date is specified but not in the case of perpetual bonds.
l Redemption value - in the bond certificate - may be par or premium - terms of the
issue.
l Bonds are traded in the market.
Type of Bonds
l Secured Bond: Issued on the assets of the issuer.
l Unsecured Bond: Issued by the issuer on the basis of name and fame.
l Perpetual bond: Bonds do not have maturity.
l Redeemable bond: Redemption or Repayment of the principal is specified by the
issuer.
l Fixed rate bonds: Rate of Interest is fixed at.
l Flexible/Floating rate bonds: Rate of interest is subject to prefixed norms.
The further more classification of bonds are available. They are following:
Zero Coupon bonds: These bonds are sold at discounted value and will be given at the
face value after the maturity period.
226
Deep discount bonds: It is another kind of zero coupon bond. Large discount is made Sources of Long Term Finance
on their nominal value. Interest is paid only at the time of maturity - 3-25 years.
Pay in kind bonds: This another kind of long-term instrument of raising funds. During
the First three years, these bonds need not pay any interest to the holders of the bonds,
in stead the interest bonds are issued which are known as additional bonds. These additional
bonds are called as baby bonds or kid bonds which are derived out of the parent bond. It
is identified by the many of the companies as wonderful instrument to raise the capital
from the market at the early stage of commencement of business.
The next type long-term instrument is that Warrants.
14.6 WARRANTS
These are nothing but Bearer documents which are title to buy the specified number of
equity shares at specified price during the future period. The life period of the warrants
are normally too long.
The warrants are normally issued by the company only in order to attract the issue of
fixed bearing securities viz preference shares and debentures.
The following are the various type of warrants:
l Detachable warrants: Warrants which are issued along with the host securities;
detachable
l Puttable warrants: The warrants issued are sold back to company before expiry
date
l Naked warrants: Warrants issued without any host securities
Advantages of the warrants
l Making other host securities more attractive
l It facilitates the companies to stand on its own leg and reduces the rate to depend
on the intermediaries
l The exercise of the warrants only during the future period which fosters better
planning for the company
l Lower cost of debt due to greater attraction towards warrants - denominated in
terms of equity shares - which are at later date
l Warrants are highly liquid which means they are traded in the Stock Exchanges
provided the warrants should not be exercised.
Check Your Progress
Select the most appropriate one:

1. Equity share means
(a) Equal share in the volume
(b) Equal share in the assets claim
(c) Equal and Small units of the share capital
2. Preferential share is
(a) Issued at preferential price
(b) Preferential rights over the debentures
(c) Preferential rights over the equity shares
(d) None of the above 227
Contd....
Accounting and Finance for 3. When non voting share will become as a voting shares
Managers
(a) For the continuous payment of dividends
(b) For the continuous non payment of dividends for the period of 3 years
(c) For the continuous payment of dividends
4. In which case the bond are issued instead of interest payment
(a) Naked bonds (b) Pay in kind bonds
(c) Cumulative bonds (d) Secured bonds
5. Non convertible portion of the debenture is
(a) Convertible at later date (b) Irredeemable
(c) Redeemable (d) None of the above
6. Warrants are
(a) Title to buy the preference shares (b) Title to buy debentures
(c) Title to buy the equity shares (d) Title to buy bonds
14.7 LET US SUM UP

Shares and Stock are synonymous in usage. Shares are the expression of smaller units
of Share capital of the organization. The raising of equity share capital from the investors
in various segments. Normally the sweat security is issued by the companies in two
different categories:
l Sweat security which is issued at preferential pricing more specifically for employees
l Sweat security which is issued at face value, that may be either at par or above par
The unpaid preference dividends are paid before anything paid to equity share holders.
The unpaid preference dividends are called in other words as Arrearages.
Debentures are classified on the following basis:
l On the basis of security
l On the basis of holding
l On the basis of redemption
l On the basis of convertibility
Bond is a long-term debt instrument issued by the company to raise the financial resources
from the market, for specific period and it carries fixed rate of interest which has its own
salient features. Warrants are nothing but Bearer documents which are title to buy the
specified number of equity shares at specified price during the future period. The life
period of the warrants are normally too long.

Distinguish between preference and non-preference shares. What are the advantages
of preference share?
14.9 KEYWORDS
Share: smaller unit of the share capital of the company
Preference share: Preferential rights are pegged with this type of a share to share
228 anything from the company prior to the equity shareholders
Bond: Long-term debt instrument Sources of Long Term Finance
Debenture: Long-term debt instrument floated by the company with or without charge
on the assets of the company.
Security: The amount of lending is secured through the charge on the assets
Redemption: Time period of repayment and payment of the principal and interest
respectively are known
Warrants: Title to buy equity shares at the specified price in the future date
Host securities: These are the securities which are normally issued by the company
along with the warrants viz preference share and debenture
Naked warrants: Without any host securities, if any warrants are issued

1. Define equity share.
2. Define debentures.
3. Briefly explain the sweat security.
4. What is meant by preference shares?
5. Explain various types of preference shares.
6. Explain the various types of debentures.
7. Define bonds.
8. Explain the various types of bonds.
9. Define warrants.
10. Explain the advantages of issuing the warrants.
11. Elucidate the various classifications of warrants.
12. Why warrants are issued?

229
for Managers LESSON
15
CAPITAL MARKET DEVELOPMENTS IN INDIA
CONTENTS
15.1 Introduction
15.2 Capital Market Reforms - In General
15.3 Reforms in Primary Market
15.3.1 Reforms in the Primary Market: 1996-97
15.3.2 Reforms in 1997-98
15.3.3 Reforms in 1998-2001
15.4 Reforms in the Secondary Market
15.4.1 Capital Market Reforms: 1996-97
15.5 Let us Sum up
15.7 Keywords

This lesson is intended to discuss about primary and secondary capital markets in India.
(i) describe overall capital market reforms
(ii) explain reforms in primary market
(iii) discuss reforms in secondary market
15.1 INTRODUCTION
The capital market is one of the important constituents of the economy to groom and
develop to attain the required growth rate through the attraction of corpus from not only
in domestic market but also from international markets. In India, the capital market is
more vibrant in the modern days due to many more developments routed through the
structured mechanism of the market. The structured market facilitates to bring forth
many developments in the capital market only in order to facilitate the companies to
230 attract more investors to contribute financial resources to the requirement.
The participation of the investors is subject to the market environment conditions. To Capital Market
Developments in India
attract more investors from the various corners of the market, the developments are
inevitable. The development of the capital market in India are many fold and multi
structured. The series of development could be studied one after the another.
15.2 CAPITAL MARKET REFORMS - IN GENERAL

l Replacement of the office of CCI by the SEBI guidelines during the year 1992,
February
l Exchange of powers of the SCRA/1956 57,2000 were transferred to office of
SEBI - notification issued
l Inducement for investor claims through consume courts and redressal forum of
investor associations
l Permission of the foreign equity participation
l With the permission of RBI, NRIs were permitted to invest in the equity shares and
debentures
l Norms relaxed for the Indian firms to raise financial resources
l Sebi's autonomy reinforced through the Section of 30 - without any consultation of
the central govt
l Introduction of OTCEI and NSE - electronic nationwide trading
15.3 REFORMS IN PRIMARY MARKET

l Merchant banking and banking code installed
l Due diligence certificate from the lead managers
l Disclosure norms
l Companies details - facts and risk factors associated with their projects
l Stock exchanges required to ensure the formalities with the companies during the
issues
l Restriction in the usage of Stock invest - institutional investors
l Disclosure norms for the advertisement
l Underwriting is optional and if it is not carried out due to bring down the issue
cost 90% of the amount offered to the public - should be refunded
l Bonus guidelines were relaxed
l New system introduced for preferential issue - pertaining to pricing
Shri Y H Malegam disclosure requirements and issue procedures
l SEBI to vet the prospectus within 21 days from the date of issue and approval by
the registrar companies is given a time period of 14 days
l Abridged prospectus - should be vetted by the SEBI
15.3.1 Reforms in the Primary Market: 1996-97

l Norms were tightened - to enhance the quality of the paper
l First time issuers - dividend payment record in three of the immediately preceding
five years
l If this requirement is not applicable in the case of companies - appraisal should be
done through commercial banks or financial institutions -10% contribution from the
issuer out of the total size of the issue 231
Accounting and Finance l For banks - no restriction but if the issues are premium priced - two years profitability
for Managers record
l Prohibition on direct or indirect discounts during the moment of allotment
l 90% of the subscription waived due to minimum share holding
l Housing finance companies allowed to function as registered issue facilitating
companies in along with the refinancing from the National housing bank
l The promoters contribution should be in a phased manner if it crosses Rs.100 cr
l Debt securities could be listed in the stock exchanges without any listing of equity
shares.
15.3.2 Reforms in 1997-98

l Entry for unlisted companies modified
l Partly paid up shares should be either fully converted or forfeit
l 3 years profitability required for the unlisted companies for the issuance of share
capital
l For rights issue - Registrar should be separately deputed
l Details of the promoters should be given in the offer document
l Only body corporates allowed to function as merchant bankers
l Merchant bank classifications abolished
l Merchant banks are not permitted to carry out the fund related activities; if any
corporates are available - suitable breathing time was given to restructure the activities
15.3.3 Reforms in 1998-2001

l Entry norms revised
l Pre issue net worth should not be less than 1 cr in 3 preceding years out of 5
l Merchant banks registered with RBI as NBFCs eligible to trade Govt securities
l Mutual funds permitted to derivatives
l Further updating was made in the companies act to protect the investors
l Additional power granted to SEBI for the violation of the companies act
l SEBI compendium 2000 issued
l On line offerings were encouraged by SEBI
l Regulation of rating agencies framed
l ESOP guidelines
l Changes introduced on mutual funds the P.K.Kaul committee
l Issue freedom is given to companies but not less than Re 1
l 100% book building route introduced
15.4 REFORMS IN THE SECONDARY MARKET

l Guidelines with reference to substantial takeovers and acquisitions - disclosures
l Guidelines with regards to mandatory public offer to the investors
l Several mutual funds were allowed
l UTI brought under the sebi
l Advertising code was initiated as well as the requirements of pre-vetting of
advertisement removed
l To improve the role of the Mutual fund as well as to develop the market of mutual
fund in India, mutual funds were given - right to underwrite the public issues and to
make investments in the money market
232 l Jumbo transfer was introduced for the institutions
l Carry forward system of transactions are permitted to SEs after getting the consent Capital Market
Developments in India
and surveillance
l Carry forward transactions are limited in the case of lenders of the transactions
l Carry forward transactions should be disclosed on the basis of scrip and broker at
the beginning of carry forward session
l Capital adequacy norms were introduced
l Depositories were introduced during the year 1995 Sept.; to record the ownership
in the book form
l The introduction of depository requires the changes in the following enactments
v Companies Act
v Stamp Duty Act
v Income Tax Act

l Depositories Act 1996 - promulgated in order to reduce the problems associated
with the handling of securities
l Guidelines for the custodian of securities were clearly drafted
l Custodian of securities- compliance officer should be appointed - to bridge the gap
in between
l Changes are expected to discuss during the monthly meetings of Association of
Custodian of security services
l Bad delivery cell was set up and code was specified
l System of clearing house or clearance corporation to be set up in the stock exchange
l Separate committee has been set up for surveillance - inter stock exchange
transactions
l Mumbai and other stock exchanges were allowed to install terminals - where no
exchange exists - to have on line trading
l Norms of the OTCEI were eased to promote more transactions

l Daily carry forward margin reduced to 10% from 15%
l Over all carry forward increased to Rs.20 crs per broker

l Buy back of securities were permitted
l Circuit breaker system was introduced to control volatility
l Dematerialized trading was installised
l Rolling settlement introduced
l Internet trading was introduced
l Guidelines were issued in the angle of maintaining the transparency
l Clause 49 - to maintain corporate governance introduced
l Stock watch system was introduced
l Steps introduced to reduce the transaction costs
l Trading of stock index and futures - BSE and NSE commenced
l For trading of debt securities - to promote debt market - steps taken

l Golden pegged return funds permitted 233
Accounting and Finance l IPO norms are tightened
for Managers
l Grading of IPOs are suggested
15.5 LET US SUM UP

In India, the capital market is more vibrant in the modern days due to many more developments
routed through the structured mechanism of the market. The development of the capital
market in India are many fold and multi structured. Dematerialisation is Transforming the
physical securities into electronic transformation sheets through the maintenance of Demat
A/c. Book building is a process for identifying the right price of the process.

Discuss critically about the reforms initiated in capital market in India.
15.7 KEYWORDS
IPO: Initial Public offering
BSE: Bombay Stock Exchange
NSE: National Stock Exchange
OTCEI: Over the Counter Exchange of India
SEBI: Securities Exchange Board of India
SCRA: Securities Contract Regulation Act
Grading: Rating from the credit rating agencies
Dematerialisation: Transforming the physical securities into electronic transformation
sheets through the maintenance of Demat A/c
Book building: It is a process for identifying the right price of the process
CCI: Controller of Capital Issues Act
ESOP: Employees Stock Option Scheme

1. Give brief introduction about the capital market reforms in India.
2. Write an elaborate note on the primary market reforms in India.
3. Elucidate the secondary market reforms in India.
4. Why SEBI requires the IPOs to obtain grading from the agencies?

M.P Pandikumar Accounting & Finance for Managers, Excel Books, New Delhi.
234
LESSON
16
INDIAN FINANCIAL SYSTEM
CONTENTS
16.1 Introduction
16.2 Organised Capital Market
16.3 Un-organized Capital Market
16.4 Organized Money Market
16.4.1 Market for Banking Financial Institutions
16.4.2 Market for Non Banking Financial Institutions
16.5 Un-organized Money Market
16.6 Let us Sum up
16.8 Keywords

The purpose of this lesson is to discuss the typical structure of the Indian financial
system. After studying this lesson you will be able to:
(i) describe components of financial markets
(ii) understand organised and unorganised capital markets
(iii) explain various segments of money market
16.1 INTRODUCTION
The Indian financial system coined more particularly immediately after the independence
1947. Since 1947, the role of the financial system is more vibrant in meeting the needs
and demands of not only the country but also the corporate sectors. It outperformed in
the economy for the development of the nation through the collection of saving from the
households for development of the nation as well as the corporate sectors. The Indian
financial system could be bifurcated into two different segments viz.
Capital Market and Money market

These two markets are further classified into organized and unorganized.
Managers Indian financial System
Capital market Money market
Organised Un organized Organised Un organized
Primary market Kerb trading Pawn Brokers
IPOs Bills Market Chit funds
Public Issues Discount Market
Private Placement Gilt edged

Short term financial
Underwriting Short term
instruments market
Institutional offer
Secondary
16.2 ORGANISED CAPITAL MARKET

The capital market which was initially controlled and organized by the Controller of
Capital Issues act and then it was replaced by the Securities Exchange Board of India
for the governance of capital market in India. The capital market in India is known as
regulated in spheres by SEBI then and there.
The organised capital market is bifurcated into two categories viz Primary market and
Secondary market.
Primary market: It is the market for the fresh issuance of securities by the new as well
as existing companies, in order to raise the capital from the investors.
The Primary market is further classified into many segments
Initial Public offering: As a new company registered under the Companies Act 1956 is
permitted to raise the capital from the market through the abridged prospectus.
Public issue: It is another mode of raising the capital from the common public by the
existing companies.
Private placement: During the issue, the larger investment houses are invited for the
subscription of the issue of securities in bulk quantities at a discount price prior to the
issue. After the issue, according to the investment policy of the Institutional investors,
they sell them at higher price to the individual investors. This facilitates the institutional
investors to book profits through the process of private placement.
Underwriting: It is another mode of issuing the securities during the issue, more
particularly this mode of issue is found to be an avenue to off-load the risk of managing
the issue of securities as well as to secure the issue as fully subscribed.
Secondary market: It is the market for the securities which are already available in the
market, to buy and sell among the players. This is the market further classified into two
different categories viz mutualisation and demutualisation of stock exchanges.
Mutualised Stock exchanges: These are the exchanges never have any distinction
among the members, management and governing body of the stock exchange. These
are purely administered by the members/brokers of the stock exchange, e.g.,. Traditional
stock exchanges.
Demutualised stock exchanges: These are separate distinct faces among themselves.
The roles and responsibilities of the brokers, governing body members and people in the
management are clearly defined and performed by them without any ambiguity e.g.
OTCEI, NSE and so on.
236
Indian Financial System
16.3 UN-ORGANIZED CAPITAL MARKET
Due to stringent guidelines of SEBI, unofficial market trading activities are banned only
in order to safeguard the interest of the investors.
Kerb trading which was taken place among the players of the stock market during the
non working hours of the stock exchange. This trading is known in other words as un-
official trading or black trading among the players.
The next segment is nothing but the money market which controlled and monitored by
the Reserve Bank of India.
16.4 ORGANIZED MONEY MARKET

The organised money market can be further segmented into two categories:
16.4.1 Market for Banking Financial Institutions

Under this the entire banking network is administered by RBI, which has the following
many more classification viz Public sector banks, Scheduled banks, Private sector bank,
Co-operative banks, Regional Rural banks and Land development banks
16.4.2 Market for Non Banking Financial Institutions

The non banking financial institutions are nothing but development banks, state financial
institutions
The money market is further divided into various segments viz
Bills market
Discounting market
Acceptance market
Marketable securities market
Gilt edged securities market and so on
Bill market: In this market only, the bills are bought and sold among the players. It is the
market for both commerce bill and finance bill. The commerce bill is nothing but the bill
of exchange defined in accordance with the Sec. 5 of the Negotiable Instruments Act. It
arises only due to credit sales among the parties, only in order to safeguard the interest
of the suppliers who supplied the goods and articles on credit.
Discounting market: It is another most important market for discounting of the bills of
the trade. These are normally carried out by the banking and financial institutions in
addition to Discounting Housing Finance of India which is the apex body for rediscounting
in India next to Reserve Bank of India. The bills are discounted by the banking and non
banking financial institutions only on the basis of the credibility of the parties involved in
the bill who has accepted to make the payment on the maturity of the bill.
Acceptance market: In India, there is no separate acceptance market for accepting the
bills before discounting, but in U.K., there is greater scope for accepting the bill before
the process of discounting. Normally, the discounting is carried out only on the basis of
the extent of acceptance given by the acceptance houses on the bills produced.
Govt Securities market: The govt securities are also tradable in the secondary market
immediately after the issuance. According to the Public debt act, the central and state
govt are empowered to issue the securities to raise financial resources from the public
for developmental aspects of the state or region. 237
Accounting and Finance for The treasury bills are mainly traded in the market immediately after the issuance
Managers
The following are the major type of treasury bills traded in the market are 91 days
treasury bills, 182 days treasury bill and 364 days treasury bill
Bonds market: It is a separate market available to raise the financial resources through
long term debt instrument. The bonds are normally issued by the corporate sectors and
govt organizations. They are many in categories viz
Secured and unsecured bonds
Pay in kind bonds
Redeemable bonds and irredeemable bonds and so on.
16.5 UN-ORGANIZED MONEY MARKET

This particular market is dominated by the pawn brokers, chit funds, nidhis, and so on.
There is no stringent guidelines prevailing to control and monitor the role of the above
mentioned players.
In addition to the above classifications, one more classification is that of insurance
companies which are separately governed by the IRDA
Which has got its own segments as following:
Life insurance sector
Non life insurance sector
Pension funds
Health insurance and so on.
Check Your Progress
What are the main components of Indian financial system?
16.6 LET US SUM UP

The Indian financial system could be bifurcated into two different segments viz. Capital
Market and Money Market.
The money market is further divided into various segments viz
Bills market
Discounting market
Acceptance market
Marketable securities market
Gilt edged securities market and so on.

Examine critically the role of Financial markets in industrial development of India.
16.8 KEYWORDS
Organised Capital Market
238 Primary market
Initial Public offering Indian Financial System
Public issue
Secondary market
Mutualised Stock exchanges
Demutualised Stock exchanges
Unorganized Capital market
Bill market
Discounting market
Acceptance market
Govt Securities market
Bonds market
Un-organized money market

1. Write elaborate note on the organized capital market. Explain the role of SEBI in
controlling the capital market.
2. Draw the role of RBI in controlling and monitoring the various entities in the regulated
money market environment.
3. Explain the various steps involved in the bills market.
4. Illustrate the role of acceptance market.
5. Explain the various type of bonds and treasury bills under the organized money
market.

239
for Managers LESSON
17
SEBI IN CAPITAL MARKET ISSUES
CONTENTS
17.1 Introduction
17.2 Objectives of the SEBI
17.3 Entity of SEBI
17.4 Organisational Grid of the SEBI
17.5 Powers and Functions of SEBI
17.6 Role of SEBI
17.6.1 Promoters Contribution
17.6.2 Disclosures
17.6.3 Book Building
17.6.4 Allocation of Shares
17.6.5 Market Intermediaries
17.6.6 Debt Market Segment
17.6.7 Brokers
17.6.8 Suspension of a Broker
17.6.9 Recent Developments
17.7 Critical Review of SEBI
17.8 Let us Sum up
17.10 Keywords

This lesson is intended to discuss the role of SEBI in regulating the Indian capital market.
(i) describe objectives behind instituting SEBI
(ii) know the organisational structure of SEBI
(iii) understand powers and functions of SEBI
(iv) examine the role of SEBI in Indian financial market
17.1 INTRODUCTION
During the late 80, the GOI decided to replace the Controller of Capital Issues Act, by
way of inducting the Securities Exchange Board of India, in order to introduce the
regulatory environment in the Indian capital market, to pave way for the promotion of
240 congenial and conducive climatic condition for the investing public. Hence the Government
of India has instituted the supreme authority SEBI to monitor and control the proceedings SEBI in Capital Market Issues
of the capital market in the country.
17.2 OBJECTIVES OF THE SEBI

l To replace the office of the following major acts of implementation and to attain
the following objectives:
v Control of Capital Issues Act (1947)
v The Companies Act (1956) - issue, allotment of the securities and disclosures
v Securities contract regulation Act (1956) - to control over the stock exchanges
l In May, 1992 - the controller of issue of capital, pricing of the issues, fixing premia
and rates of debentures were ceased in operation, provided the SEBI was
promulgated.
v Protecting the interest of the investors
v Promoting the development of the securities market
v Regulating the securities market
17.3 ENTITY OF SEBI

l It was registered with the common seal and with the power to acquire, hold and
dispose any property
l Power to sue or to be sued in its own name
l The Head office is situated in Mumbai; in addition the regional offices were
established in the following metropolitan cities viz Kolkata, Chennai and Delhi, to
monitor and control the capital market operations across the country
17.4 ORGANISATIONAL GRID OF THE SEBI

l Six members in the committee
l Headed by the chairman
l One member each from the ministries of Law and Finance
l One member from the officials of Reserve Bank of India
l Two nominees from the central government
l It contains 4 different departments viz Primary department, Issue management and
intermediaries department, Secondary department and Institutional Investment department
17.5 POWERS AND FUNCTIONS OF SEBI

Section 11 of the Act Chapter IV highlights the Powers and Functions of SEBI
l Regulating the business of the stock exchanges
l Regulating the role of the intermediaries
l Registering and regulating of depositories, participants and custodian of securities,
credit rating agencies
l Regulating of mutual funds and venture capital funds
l Prohibiting the unfair trade practices
l Prohibiting of insider trade activities
l Regulating substantial takeovers and acquisitions
l Frequent conduct of research activities
l To conduct any enquiry which warrants the situation to safeguard the interest of 241
the investors
Accounting and Finance Civil Court Procedure 1908: The SEBI has been given additional powers and
for Managers
functionswith reference to Civil Court Procedure 1908 to regulate the capital market in
addition to the above enlisted powers and functions
l Discovery and production of books of account of the errant during the inspection
and enquiry.
l Summoning and enforcing the attendance of the persons to stand before for the
examination of oath.
l Acc to Sec 12 SEBI is empowered to conduct Inspection of books.
17.6 ROLE OF SEBI

l Entry norms for the companies at the moment of raising the capital from the
market:
v The companies are expected to produce 3 years dividend track record of
preceding the issue.
v At the entry level, immediately after listing, important point to be ensured is
that Post issue of networth should be 5 times greater than the Pre issue
networth.
v If it is a manufacturing company without any track record, wants to raise any
capital from the market, the appraisal has to be done through development
banks or commercial banks.
v Having three years track record, the SEBI never vets offer document of the
issue of capital.
17.6.1 Promoter's Contribution

l Promoter's contribution should not be less than 20% and should be made before
the issue.
l If the size of the issues is Rs. 100 cr -50% of the contribution should be made
before the opening of issue and the remaining should be paid before the calls are
made to the investors.
17.6.2 Disclosures
l Acc.Bhave committee- Financial results i.e., unaudited and audited financial results
should be published.
l Risk factors and positions of the company should be highlighted in detail in the
prospectus .
17.6.3 Book Building

l 75% route was specified at the early moment in the process of book building. Then
the book building process was opened to 100% route to the public.
l Sufficient opportunities are to be furnished to the investors to represent through the
terminal to take part in the process of Book building.
l The company during the process requires 30 centers atleast for book building process
to raise the share capital from the market.
17.6.4 Allocation of Shares

l The Minimum application was -100 Nos for subscribing the issue of share capital.
Then the Minimum application was hiked to 500 Nos. Then SEBI has felt that the
Minimum application was too high, which did not pave the small investors to within
242 the available surplus, then the minimum application brought down to 200 Nos.
l Small investors are who hold 1000 shares or few securities SEBI in Capital Market Issues
l Allotment should be done within 30 days from the date of closure of the issue.
During the non allotment of the shares, the company should refund the amount of
the application money.
17.6.5 Market Intermediaries

l The various merchant bank categories were abolished. Each category of issue
intermediary is required to undergo for specific registration process.
l Lead managers who manage the issue of capital should have a networth of Rs.5 cr.
17.6.6 Debt Market Segment

l Depository system for the debt securities were introduced
l Demat facility was specifically introduced for the government securities
l Listing of debt securities need not rely upon the equity listing in the respective
stock exchange
l FIIs were permitted to invest 100% in the debt instruments of the Indian companies
l For the issuance of debt instruments the rating has been mandatory
l Minimum two ratings should be obtained for the issue of debt instrument more than
Rs. 500 cr.
l Rating agency should not be associated with the firm of issuing company
17.6.7 Brokers
l Registration is given - Member of any stock exchange - key factors of
registration - office space, previous experience, man power, selling or buying in securities
l Code of conduct-execution of orders, fairness of deals with the investors, issue of
contract note
l Financial statements - should be submitted within 6 months of the accounting period
l Book of accounts - A minimum of 5 years to be preserved
l Regional offices - Establishment only with reference to attend the complaints of
the small investors at speedy rate - Kolkata, Chennai and Delhi
l SEBI's final controlling measure is suspension and cancellation of the registration
subject to certain conditions
17.6.8 Suspension of a Broker

l Suspension - permanent - dismissal is leading to cancellation of registration - due to
the problem caused
l Violation of rules and regulations
l Fails to submit the true and fair information according to the norms of disclosures
l Untoward conduct with the investor
l Guilt of misconduct
l Poor financial status of the brokers-deterioration
l Stock exchange fees - fail to pay on time to the requirement
l Suspension of the membership 243
Accounting and Finance l Indulges in any act of insider trading of securities
for Managers
l Convicted of a any criminal offence
l Sub-Broker
l Sub- broker- to obtain the registration
l Agreement in between broker & sub-broker
l Deposit should be made with - Broker
l Transfer of securities - without registration of bearing stamps - considered as bad
deliveries in the angle of stock exchanges -July 1, 1997.
17.6.9 Recent Developments

l RBI approval copy is exempted
l FIIs are permitted to invest upto 100% in debt market funds
l FIIs which have securities worth of Rs 100 cr or more than mandatory requirement
is to settle the transaction only through demat mode
l FIIs/NRIs/OCB -30% of the equity of the company in accordance with the union
budget - 1997-98
l It was hiked by the Union Finance Minister during the budget 2000
Check Your Progress
What steps have been taken by SEBI regarding allocation of shares?
17.7 CRITICAL REVIEW OF SEBI

l Disclosures- To present information only for the interest of investors
l Dissemination process - to disclose the information required which leads to undue
delay. The route of dissemination of the information should be through SEBI to
public and by considering the time wastage, the web sites were suggested for
facilitating the investors.
l The Settlement for NSE are - Wednesday - Tuesday, and in the case of BSE-
Monday-Friday
l Leads to more arbitrage transactions which lead to greater fluctuations in the opening
and closing prices of the securities
l Badla trade has been banned due to detrimental to the investors
l Special watch system has to be introduced to the international standards
l Capital adequacy: The capital required to be maintained is less than for intermediaries
but at the same time the capital adequacy should be to the trading volume of them
only in order to avoid the default risk of the investors.
17.8 LET US SUM UP

The Govt of India has instituted the supreme authority SEBI to monitor and control the
proceedings of the capital market in the country. The SEBI has been given additional
powers and functions with reference to civil court procedure 1908 to regulate the capital
market. Recent Developments RBI approval copy is exempted. FIIs permitted to invest
244 upto 100% in debt market funds. FIIs which have securities worth of Rs 100 cr or more
than mandatory requirement is to settle the transaction only through demat mode, FIIs/ SEBI in Capital Market Issues
NRIs/OCB -30% of the equity of the company in accordance with the union budget -
1997-98. It was hiked by the union finance minister during the budget 2000.

Discuss critically the power and functions of SEBI.
17.10 KEYWORDS
Broker: member of the stock exchange, facilitates the client to buy and sell on behalf in
the stock market
Sub-broker: who assists the broker and does the buying and selling transactions for the
client through the broker in the stock exchange
Arbitrage: Buying the security at lesser price at one stock exchange and disposing them
off at higher price at another stock exchange during the same moment
Lead manager: Who takes active role in the process of issue management.

1. When SEBI was established ? For what ?
2. Briefly highlight the objectives of the SEBI.
3. Explain the role of SEBI in administering the primary market.
4. Explain the important enactments on the market intermediaries of the stock market.
5. Elucidate the recent developments with the help of SEBI mandate.
6. What are the steps taken by SEBI to suspend the registration of a broker?
7. Why the companies are expected to highlight about the prospects and risk factors
of the issue with relevance to the project?

M.P. Pandikumar, Accounting & Finance for Managers, Excel Books, New Delhi.
245
Managers LESSON
18
CAPITAL BUDGETING
CONTENTS
18.1 Introduction
18.2 Aim of Capital Budgeting
18.3 Methods of Capital Budgeting
18.3.1 Pay Back Period Method
18.3.2 Accounting or Average Rate of Return
18.3.3 Discounted Cash Flows Method
18.4 Present Value Method
18.5 Capital Rationing
18.6 Divisible Project
18.7 Indivisible Project
18.8 Risk Analysis in Capital Budgeting
18.9 Let us Sum up
18.11 Keywords

(i) decide why capital budgeting is most important decision of the financial management
(ii) describe various objectives and methods of capital budgeting
(iii) distinguish between divisible and indivisible projects.
18.1 INTRODUCTION
The capital budgeting is one of the important decisions of the financial management of the
enterprise. The decisions pertaining to the financial management of the firm are following:
Decisions of Financial Management
Financing Investment Dividend Liquidity
Long Term Investment Short Term Investment
Capital Budgeting Working Capital Management

246
Why the capital budgeting is considered as most important decision over the others? Capital Budgeting
The capital budgeting is the decision of long term investments, which mainly focuses the
acquisition or improvement on fixed assets. The importance of the capital budgeting is
only due to the benefits of the long term assets stretched to many number of years in the
future. It is a tool of analysis which mainly focuses on the quality of earning pattern of
the fixed assets.
The capital budgeting decision is a decision of capital expenditure or long term investment
or long term commitment of funds on the fixed assets.
Charles T. Horngreen A long-term planning for making and financing proposed capital
outlays.
18.2 AIM OF CAPITAL BUDGETING

To make rational investment: The study of capital budgeting on capital expenditures
evades not only over capitalization but also under capitalization. The long-term investment
normally demands heavy volume of investment which is met out by the firm either through
external or internal source of financing. Hence, the amount of capital raised by the firm
should neither greater nor lesser than the investment.
Locking up of capital: The amount invested is requiring longer gestation to recover.
The longer gestation is connected with future horizon in getting back the investment.
The future is uncertain unlike the present. If the longer is the gestation in the future leads
to greater risk involved.
Effect on the profitability of the enterprise: The profitability of the enterprise is mainly
depending on the proper planning of the capital expenditure.
Nature of Irreversibility: The improper/ unwise capital expenditure decision cannot be
immediately corrected as soon as it was found. Once it is invested is invested which
cannot be reversed. The poor investment decision will require the firm either to keep it
as an idle in the form of investment or to unnecessarily meet out fixed commitment
charge of the capital which excessively raised more than the requirement.
18.3 METHODS OF CAPITAL BUDGETING

The methods are the nothing but the instruments of the capital budgeting to study the
quality of the investments/fixed assets. The investments are studied by the firms in the
following angles:
l Based on the number of years taken for getting back the investment Pay Back
Period Method
l Based on the profits accrued out of the investment Accounting Rate of Return/
Average Rate of Return
l Based on the timing of benefits Present value of future benefits of the investment
Discounted cash flow methods
v Based on the comparison in between the cash outlay and receipts discounted
with the help of minimum rate of return - Net present value method
v Based on the identification of maximum rate of return, in between the initial
cash outlay and discounted expected future receipts - Internal Rate of return
method
v Based on the ration in between the present values of cash inflows and outflows
Present value index method
Check Your Progress
(1) Capital budgeting means a study of

(a) Budgeting of long-term capital
(b) Budgeting of short-term capital
247
Contd....
Accounting and Finance for (c) Budgeting of short-term assets
Managers
(d) Worthiness of long-term assets
(2) Capital budgeting tools are classified into
(a) Yearly basis
(b) On the basis of return
(c) On the basis of present value of money
(d) (a), (b) & (c)
(3) Selection criterion are classified into
(i) Acceptance of the investment proposal
(ii) Rejection of investment proposal
(iii) Neither can be accepted nor rejected
(a) (i) only
(b) (ii) only
(c) (iii) only
(d) (iv), (ii) & (iii)
The classification of methods are generally in two categories:
l Traditional methods
v Pay Back Period method
v Accounting Rate of Return
l Discounted cash flow methods
v Net present value method
v Internal Rate of Return method
v Present value index method
v Discounted pay back period method
18.3.1 Pay Back Period Method

What is pay back period?
The pay back period is the period taken by the firm to get back the investment. The pay
back period is nothing but number of years/months/days required by the firm to get back
its investment invested in the project.
To find out the pay back period, the following are two important covenants required:
l Initial outlay / Initial investment/ Original investment
l Cash inflows
How the pay back period is calculated?
The pay back period is calculated by way of establishing the relationship between the
volume of investment and the annual earnings
While calculating the pay back period, the nature of annual earnings should be identified.
The nature of the annual earnings can be classified into two categories:
l Cash flows are equivalent or constant
l Cash flows are not equivalent or constant
If the cash flows are equivalent, How the pay back period is to be calculated ?
The cost of the project is Rs.1,00,000. The annual earnings of the project is Rs.20,000.
Calculate the pay back period.
Initial Investment
Pay back period =
Average Annual Earnings
Rs. 1,00,000
248 = = 5 Years
Rs. 20,000
It is obviously understood that, Rs.20,000 of annual earnings (cash inflows) requires 5 Capital Budgeting
years time period to get back the original volume of the investment.
If the cash flows are not equivalent, How the pay back period is to be calculated ?
The cost of the project is Rs.1,00,000. The annual earnings of the project are as follows
Year 1st 2nd 3rd 4th 5th

Net Income 40,000 30,000 20,000 20,000 20,000
Amount Rs
The ultimate aim of determining the cumulative cash inflows to find out how many
number of years taken by the firm to recover the initial investment.
The next step under this method is to determine the cumulative cash flows
Year Annual Net Incomes Cumulative

Rs cash flows Rs.
1. 40,000 40,000
2. 30,000 70,000 3 years full time required to recover the
3. 20,000 90,000 major portion of investment Rs.90,000
4. 20,000 1,10,000
5. 20,000 1,30,000
The uncollected portion of the investment is Rs,10,000. This Rs.10,000 is collected from
the 4th year Net income / cash inflows of the enterprise. During the 4th year the total
earnings amounted Rs.20,000 but the amount required to recover is only Rs.10,000. For
earning Rs.20,000 one full year is required but the amount required to collect it back is
amounted Rs.10,000. How many months the firm may require to collect Rs.10,000 out
of the entire earnings Rs.20,000?
Pay back period consists of two different components
l Pay back period for the major portion of the investment collection in full course -
E.g.: 3 years
l Pay back period for the left /uncollected portion of the investment
Rs.10,000
For the second category = = 0.5 years
Rs. 20,000
Total pay back period= 3 Years +.5 year = 3.5 years

Criterion for selection: If two or more projects are given for appraisal, considered to be
mutually exclusive to each other for selection, the pay back period of the projects should
tabulated in accordance with the ascending order. The project which has lesser pay
back period only to be selected over the other projects given for scrutiny.
Why lesser pay back has to be chosen?
The reason behind is that the project which has lesser pay back period got faster recovery
of the initial investment through cash inflows/Net income.
Selection criterion
Lesser the pay back period is better for acceptance of the project
Illustration 1: A project costs Rs.2,00,000 and yields and an annual cash inflow of
Rs.40,000 for 7 years. Calculate pay back period
First step is identify the nature of the annual cash inflows
249
Accounting and Finance for In this problem, the annual cash inflows are equivalent throughout life period of the
Managers
project
Initial Investment Rs. 2,00,000

Pay Back Period = = = 5 years
Annual Cash Inflows Rs. 40,000
Illustration 2: Calculate the pay back period for a project which requires a cash outlay
of Rs.20,000 and generates cash inflows of Rs 4,000 Rs.8,000 Rs. 6,000 and Rs. 4,000
in the first, second, third, and fourth year respectively
First step is to identify the nature of the cash inflows
The cash inflows are not equivalent/constant
Year Cash Inflows Cumulative

Rs Cash Inflows
Rs
1. 4,000 4,000
2. 8,000 12,000
3. 6,000 18,000
4. 4,000 22,000
Cost of the project is to be recovered Rs.20,000. The project takes 3 full years time
period to recover the major portion of the initial investment which amounted Rs.18,000
out of Rs.20,000
The remaining amount of the initial investment is recovered only during the fourth year.
The left portion Rs.2,000 has to be recovered only from the fourth year cash inflows of
Rs.4,000.
Pay Back Period = Pay Back period of the major portion + Pay Back period of the
remaining portion
Pay Back period of the major portion = 3 years
Pay Back period of the remaining portio: For the entire earnings of Rs.4,000, the
firm consumed one full year/12 months time period. How many number of months
required to recover Rs.2,000 ?
Rs. 2,000
= 0.5 12 months = 6 months
Rs. 4,000
Total pay back period = 3 years + 6 months = 3 years 6 months

Illustration 3: A project cost of Rs.10,00,000 and yields annually a profit of Rs.1,60,000
after depreciation and depreciation at 12% per annum but before tax 50% calculate pay
back period.
Initial Investment
Pay Back Period =
Annual Cash inflow
In this problem, the initial investment is given which amounted Rs.5,00,000.

The annual cash inflow is not given directly; to determine the cash inflow; what is meant
by the cash inflow ?
Cash inflow = Profit after tax + Depreciation
Profit Before taxation = Rs.1,60,000
250
(-)Taxation = Rs. 80,000 Capital Budgeting
Profit after taxation = Rs. 80,000
(+)Depreciation 12% on = Rs. 10,00,000

= Rs. 1,20,000
Annual Cash Inflow = Rs. 2,00,000
Pay Back Period = Rs.10,00,000 = 5 years
= Rs.2,00,000
Illustration 4: A company proposing to expand its production can go in either for an
automatic machine costing Rs.2,24,000 with an estimated life of 5 years or an ordinary
machine costing Rs.60,000 having an estimated life of 8 years. The annual sales and
costs are estimated as follows:
Particulars Automatic Machine Ordinary

Rs Machine Rs
Sales 1,50,000 1,50,000
Costs
Material 50,000 50,000
Labour 12,000 60,000
Variable overheads 24,000 20,000
Compute the comparative profitability of the proposals under the pay back period method.
Ignore Income Tax (I.C.W.A.Final)
The first step is to find out the Annual profits of the two different machines
The next step is to find out the pay back period of the two different machines respectively
Profitability Statement
Automatic Machine Rs Ordinary Machine Rs

Sales 1,50,000 1,50,000
Less : Material 50,000 50,000
Labour 12,000 60,000
Variable overheads 24,000 20,000
Annual profit 64,000 20,000
Pay Back Period
Particulars Automatic Machine Rs Ordinary Machine Rs

Cost of the Machine 2,24,000 60,000
Annual Profit 64,000 20,000
Pay Back Period Rs.2,24,000 Rs 60,000
Initial Investment Rs.64,000 Rs 20,000
Annual profit = 3 years = 3 years
The pay back period method highlights that the ordinary machine is more ideal than the
automatic machine due to lesser pay back period i.e., 3 years. It means that the ordinary
machine is bearing the faster rate in getting back the investment invested than the
251
automatic machine.
Accounting and Finance for The another method to discuss is post pay back impact of the two different machines
Managers
Post pay back profit is the profit of the two different machines after the recovery of the
initial investment. The machine which has greater post pay back profit construe.
Post Pay Back Profit
Particulars Automatic Machine Rs Ordinary Machine Rs
Annual Profit R.No.1 64,000 20,000
Estimated Life R.No.2 5 years 8 years

Pay Back Period R.No.3 3 years 3 years
Post Pay Back Period
R.No. 4=R.No.2-R.No.3 2 years 5 years
Post Pay Back Profit = Rs.64,0002 years = Rs.1,28,000
R.No5=R.No.1R.No.4 = Rs.20,0005years = Rs.1,00,000
Post pay back profit of the Automatic machine is higher than the Ordinary machine ;
which amounted Rs.1,28,000.. It means that the profit of the automatic machine after
the recovery of the initial investment is greater than that of the ordinary machine.
Illustration 5: A company has to choose one of the following two mutually exclusive
projects. Investment required for each project is Rs 30,000. Both the projects have to be
depreciated on straight line basis The tax rate is 50%.
Year Profit Before Depreciation

Project A Rs Project B Rs
1. 8,400 8,400
2. 9,600 9,000
3. 14,000 8,000
4. 14,000 10,000
5. 4,000 20,000
Calculate pay back period
First step is to find out the depreciation under the straight line method
The next step is to determine the pay back period of the both projects A and B respectively
The next step is to compare both pay back periods of two different projects.
The depreciation under the straight line method is as follows
For Project A
Initial Investment Rs. 30,000

= = Rs.6,000
Life of the Project 5 years
For Project B

= = Rs.6,000
Life of the Project 5 years
252
Project A Capital Budgeting
Depreciation
Cash inflows
Depreciation
Cumulative
Profit Before
Depreciation
Profit after
Less Tax
in flows
Years
Cash
Profit
Less
50%
Add
tax
1. 8,400 6,000 2,400 1,200 1,200 6,000 7,200 7,200
2. 9,600 6,000 3,600 1,800 1,800 6,000 7,800 15,000
3. 14,000 6,000 8,000 4,000 4,000 6,000 10,000 25,000
4. 14,000 6,000 8,000 4,000 4,000 6,000 10,000 35,000
5. 4,000 6,000 -(2000) 0 -(2000) 6,000 4,000 39,000
Pay back period = Pay back period of a major portion + Pay back period for remaining
Pay back period of the major portion= the firm has recovered a major portion of the
initial investment of Rs.25,000 within 3 full years out of Rs.30,000
The second half of the equation is that pay back period for the remaining i.e., Rs.5000 of
initial investment which is to be recovered during the fourth year out of Rs.10,000
If Rs.10,000 earned throughout the year /12 months, how many months taken by the
firm in recovering Rs.5,000 out of Rs10,000
Rs. 5,000
= = .5 12 months = 6 months
Rs.10,000
Pay back period (Project A) = 3.6 years

The next stage to find out the pay back period of the project B
Project B
Depreciation
Cash inflows
Depreciation
Cumulative
Profit Before
Depreciation
Profit after
Less Tax
in flows
Years
Cash
Profit
Less
50%
Add
tax
1. 8,400 6,000 2,400 1,200 1,200 6,000 7,200 7,200

2. 9,000 6,000 3,000 1,500 1,500 6,000 7,500 14,700
3. 8,000 6,000 2,000 1,000 1,000 6,000 7,000 21,700
4. 10,000 6,000 4,000 2,000 2,000 6,000 8,000 29,700
5. 20,000 6,000 14,000 7,000 7,000 6,000 13,000 42,700
Rs. 300
Pay back period of the project B= 4 years +
Rs. 13,000
= 4 years +.02 365 days = 4 years + 8 days

= 4 years and 8 days
Pay back period of the project B is greater than that of the earlier Project A. It means
that the Project A is bearing the faster rate in getting back the investment invested.
253
Accounting and Finance for Merits
Managers
l It is a simple method to calculate and understand
l It is a method in terms of years for easier appraisal
Demerits:
l It is a method rigid
l It has completely discarded the principle of time value of money
l It has not given any due weight age to cash inflows after the pay back period
l It has sidelined the profitability of the project.
18.3.2 Accounting or Average Rate of Return:
Under this method, the profits are extracted from the book of accounts to denominate
the rate of return. The profits which are extracted are nothing but after depreciation and
taxation and not cash inflows.
Selection criterion of the projects:
Highest rate of return of the project only is given appropriate weightage.
The Accounting rate of return can be computed as follows
Annual Return
Accounting Rate of Return (ARR)= 100
Original Investment
Average Annual Return

Accounting Rate of Return (ARR)= 100
Average Investment
Average annual return= Average profit after depreciation and taxation of the entire life
of project i.e. for many number of years
Opening Investment + Closing Investment

Average Investment =
2
Opening Investment Scrap

=
2
Illustration 6
Calculate the average rate of return for Projects X and Y from the following
Project X Project Y
Investments Rs.40,000 Rs.60,000
Expected Life 4 years 5 years
Projected net income ( after interest, depreciation and taxes)

Year Project X Rs Project Y Rs
1. 4,000 6,000
2. 3,000 6,000
3. 3,000 4,000
4. 2,000 2,000
5. - 2,000
254 12,000 20,000
If the required rate of return is 10% which project should be undertaken? Capital Budgeting
Average Annual Income

Average Rate of Return = 100
Original Investment
The first step is to find out the average annual income of the two different projects
X and Y
Total income throughout the Project
Average Annual Income =
Life of the Project
Rs.12,000
Average Annual Income( Project X) = = Rs. 3,000
4 years
Rs. 20,000
Average Annual Income ( Project Y) = = Rs. 4,000
5 years
The next step is to find out the Average rate of return :
Rs. 3,000
Average rate of return ( Project X) = 100 = 7.5%
Rs.40,000
Rs.5,000
Average rate of return ( Project Y) = 100 = 8.33%
Rs. 60,000
Both the projects are lesser than the given required rate of return. These two projects
are not advisable to invest only due to lesser accounting rate of return.
Illustration 7
The alpha limited is considering the purchase of a machine to replace a machine which
has been in operation in the factory for the last 5 years.
Ignoring interest pay but considering tax at 50% of net earnings suggest which on the
two alternatives should be preferred. The following are the details
Particulars Old Machine New Machine

Purchase price Rs.80,000 Rs,1,20,000
Economic life of the machine 10 years 10 years
Machine running hours per annum 2,000 2,000
Units per hour 24 36
Wages running per hour 3 5.25
Power per annum 2,000 3,500
Consumable stores per annum 6,000 7,500
Other charges per annum 8,000 9,000
Material cost per unit .50 .50
Selling price per unit 1.25 125
First step is to consider that few assumptions to proceed the problem without any technical
difficulties.
First assumption is that there is no closing stock i.e. what ever goods produced are sold
out in the market.
Second assumption is that the volume of the sales is expected to be remain throughout
the life of the period.
Third assumption is that the depreciation charged by the firm is on the basis of straight
line method. 255
Accounting and Finance for Steps involved in the computation of the accounting rate of return
Managers
The first is to compute the total number of units expected to produce
Total number of units of production = Total machine hours per annum Units per hour
For old machine = 2,000 Hrs 24= 48,000 units
For new machine = 2,000 Hrs 36= 72,000 units
The second step is to determine the volume of annual sale of units:
Total volume of sales = Total number of units Selling price per unit
For old machine = 48,000 units Rs 1.25= Rs.60,000
For new machine = 72,000 units Rs.1.25= Rs.90,000
According to the second assumption, the volume of sales is known as unaffected
throughout the life period of the projects.
The next step is to find out the volume of the wages
Total wages = wages per hour Machine running hours
For old machine = Rs.3 2000 Hrs= Rs.6,000
For new machine = Rs5.25 2000 Hrs=Rs.10,500
The next step is to find out the total material cost
Total material cost per unit = Total number of units Material cost per unit
For old machine = 48,000 .5= Rs.24,000
For new machine = 72,000 .5=Rs.36,000
The last step is to find out the depreciation
Initial investment
Depreciation under straight line method = Economic life period of the asset
For old machine = Rs.8,000

For new machine = Rs.12,000
The next step is to draft the profitability statement of the enterprise under the head of
two different machine viz old and new. To find out the annual income of the enterprise
under two different machines
Profitability Statement
Rs Rs Rs Rs
Sales 60,000 90,000
Less
Direct Material 24,000 36,000
Wages 6,000 10,500
Power 2,000 4,500
Consumable stores 6,000 7,500
Other charges 8,000 9,000
Depreciation 8,000 12,000
54,000 79,500
Profit before tax 6,000 10,500
Tax at 50% 3,000 5,250
Profit after tax 3,000 5,250

The Average rate of return = 100
Original Investment
= 100
256 Average Investment
Capital Budgeting
Average Rate of Return Rs3,000 100 Rs.5,250
On the basis of original Rs.80,000 Rs.1,20,00
investment =3.75% =4.375%
Average Rate of Return Rs.3,000 100 Rs.5,250

On the basis of average Rs.40,000 Rs.60,000
investment =7.5% =8.75%
Merits
l It is simple method to compute the rate of return
l Average return is calculated from the total earnings of the enterprise through out
the life of the firm
l The entire rate of return is being computed on the basis of the available accounting
data
Demerits
l Under this method, the rate of return is calculated on the basis of profits extracted
from the books but not on the basis of cash inflows
l The time value of money is not considered
l It does not consider the life period of the project
l The accounting profits are different from one concept to another which leads to
greater confusion in determining the accounting rate of return of the projects
18.3.3 Discounted Cash Flows Method
Discounted cash flows method
Present value Index Method

Net Present value method Internal Rate of Return method
The discounted cash flows method is the only method nullifies the drawbacks associated
with the traditional methods viz Pay back period method and Accounting rate of return
method. The underlying principle of the method is time value of money. The value of 1
Re which is going to be received on today bears greater value than that of 1 Re expected
to receive on one month or one year later. The main reason is that "Earlier the benefits
better the principle". It means that the benefits whatever are going to be accrued during
the present will be immediately reinvested again to maximize the earnings, so that the
earlier benefits are weighed greater than the later benefits. The later benefits are expected
to receive only during the future which is connected with the future i.e., future is uncertain.
It means that there is greater uncertainty involved in the receipt of the benefits connected
with the future.
Why the time value of money concept is inserted on the capital budgeting tools?
The main reason is that the capital expenditure is expected to extend the benefits for
many number of years. The 1 Re is expected to receive one year later cannot be treated
at par with the 1 Re of 2 years later. This is the only method considers the profitability as
well as the timing of benefits. This method gives an appropriate qualitative consideration
to the benefits of various time periods.
257
Accounting and Finance for The time value of money principle is used for an analysis to study about the quality of the
Managers
investments in receiving the future benefits.
There are general classifications which are as follows
l Net present value method
l Present value index method
l Internal rate of return method
18.4 PRESENT VALUE METHOD

Under this method, the initial outlay or initial investment available in terms of present
value is compared with the present value of future earnings of the enterprise.
Why the present value of the future earnings are found out?
The ultimate reason to find out the present value future earnings is that the comparison
in between inflows and outflows should be meaningful as well as effective. The present
value of the initial outlay cannot be converted into the future value for comparison, even
otherwise the conversion takes place, the comparison cannot be meaningful. To be
meaningful comparison, the future earnings are converted into the present value which
is known as discounting process through the discount rate. The rate at which the future
earnings are discounted is known as required rate of return.
Selection criterion of Net present value method
If the present value of future cash inflows are greater than the present value of initial
investment ; the proposal has to be accepted.
If the present value of future cash inflows are lesser than the present value of initial
investment ; the proposal has to rejected.
Initial Outlay <Present value of Benefits=> +ve NPV:- Project can be accepted
Initial Outlay>Present value of Benefits=>-ve NPV:-Project can be rejected
What is present value index?

The major lacuna of the Net present value method is unable to rank the projects one
after the another, only due to the volume of the investment involved. To rank the projects
meaningfully, the present value index method is adopted. The present value index of the
investment can be calculated with the help of following formula:
Pr esent value of the cash inflows

Present value index method =
Pr esent value of the cash outflows
Selection criterion
If the present value index is greater than one, accept the proposal; otherwise vice versa
Present value index>1:- Accept the investment proposal
Present value index<1:-Reject the investment proposal
What is internal rate of return method?

IRR is the rate at which initial investment is equal to the Present Value of future case in
-flows. Under this method, while matching, these two are known but the rate which is
taken for equation not given or known. The rate of discounting for matching should be
258 determined through trial and error method.
Once the Internal rate of return is found out, the found IRR should be compared with the Capital Budgeting
required rate of return.
Decision criterion
If the IRR is more than the Required rate of return, the project has to be accepted
If the IRR is less than the Required rate of return, the project has to be rejected
Check Your Progress
(1) The utility of discounting principle is

(a) To determine the future value of the cash inflow
(b) To convert the Present value of Initial outlay into Future value
(c) To determine the present value of the future cash inflows for comparison with
the Initial Outlay
(2) Why Discounted cash flows method is considered to be a superior than the
Traditional method ?
(a) Simple to understand
(b) Accuracy
(c) Time value of money
(d) Easy to calculate
Illustration 8
Project ABC Ltd. costs Rs 1,00,000. It produces the following cash flows
Year 1 2 3 4 5
Cash Inflows Rs 40,000 30,000 10,000 20,000 30,000
Present value of .909 .826 .751 .683 .621
Re1 at 10%
Advise either the project to be accepted or not.

Year Cash inflows Present value factor Present value of cash inflows Rs
Rs @10%
1. 40,000 .909 36,360
2. 30,000 .826 24,780
3. 10,000 .751 7,510
4. 20,000 .683 13,660
5. 30,000 .621 18,630
Total Present value of cash inflows 1,00,940
Total present value of cash outlay 1,00,000
Net present value 940(+ve)
The investment proposal has to be accepted only due to positive Net present value.
It means that the present value of the cash inflows are greater than the present value of
the outlay. It means the discounted future earnings are greater than the present initial
investment outlay.
Illustration 9
The Alpha Co Ltd., is considering the purchase of a new machine. Two alternative
machines (A and B) have been suggested, each having an initial coast of Rs.4,00,000
and requiring of Rs.20,000 an additional working capital at the end of 1st year. Earnings
after taxation are expected to be follows
259
Accounting and Finance for Year Cash inflows Present value factor 10%
Managers Machine A Rs Machine B Rs
1. 40,000 1,20,000 .91
2. 1,20,000 1,60,000 .83
3. 1,60,000 2,00,000 .75
4. 2,40,000 1.,20,000 .68
5. 1,60,000 80,000 .62
(CA Final Nov, 1972)
The profitability statement of Two machines -Alpha company
Year Present value factor@ Machine A Machine B

10%
Cash Present Cash Present
Inflow Value Inflow Value
Rs Rs Rs Rs
1. .91 40,000 36,400 1,20,000 1,09,200
2. .83 1,20,000 99,600 1,60,000 1,32,000
3. .75 1,60,000 1,20,000 2,00,000 1,50,000
4. .68 2,40,000 1,63,200 1.,20,000 81,600
5. .62 1,60,000 99,200 80,000 49,600
Present value cash inflows 5,18,400 5,23,200
Present value cash outflows= Rs.4,00,000+ 20,000 4,18,200 4,18,200
X.91
Net present value 1,00,200 1,05,000
In the above problem, among the given machines, the firm is required to chose only one
machinery. To chose the ideal machinery among the given two, the net present value
should be ranked.
The Machine B has been considered as preferable over the machine A due to higher net
present value. The ranking of the machines do not indulge any difficulties. Why it so ?
The main reason is that both machines are having equivalent volume of investment
outlay. Out of the same initial outlays, we can rank that both machines one after the
another based upon the net present value.
Illustration 10
The initial cost of an equipment is Rs. 50,000. Cash inflows for 5 years are estimated to
be Rs.20,000 per year. The management's desired minimum rate of return is 15%.
Calculate Net present value and Excess present value index.
At the end of every year, the firm expects to earn Rs.20,000. The amount expects to
earn Rs.20,000 on every year is nothing but future value of money. The future value of
money should be converted into the present value for having comparison with the initial
investment.
On every Rs.20,000 expected to receive forms a series of future cash inflows which
should be converted into present value.
This conversion process i.e the process of converting the future value into present value
is known as discounting process. For discounting, the rate which is used for the process
pronounced as discount rate or minimum rate of return. The conversion process can be
done in two different ways.
Discounting process :- PV= FV/ (1+r)n
For first year cash inflow Rs.20,000:-
PV=20,000/(1.15)=20,000.870 =Rs.17,400
For second year cash inflow Rs.20,000;-
PV=20,000/(1.15)2 =20,000.756 =Rs.15,120
260
For third year cash inflow Rs.20,000:- Capital Budgeting
PV=20,000/(1.15)3=20,000.658 =Rs.13,160
For fourth year cash inflow Rs.20,000:-
PV=20,000/(1.15)4=20,000.572 =Rs.11,440
For fifth year cash inflow Rs.20,000:-
PV=20,000/(1.15)5=20,000.497 =Rs.9,940
Rs.67,060
OR
Alternately, the discounting can be done as follows
Being Rs.20,000 is nothing but as common cash inflow throughout 5 years of the
project, considered to be a series of cash inflows
Rs.20,000(.870+.756+.658+.572+.497) =Rs.67,060
Net present value = Present value of cash inflows - Present value of cash outlay
=Rs.67,060- Rs.50,000= Rs.17,060
The net present value of the project is +ve. Hence, the project can be accepted.
Illustration 11
A project costs Rs.36,000 and is expected to generate cash inflows of Rs.11,200 annually
for 5 years. Calculate the IRR of the project.
First step is to find out the fake pay back quotient

Pay back = = = 3.214
Annual average return Rs. 11,200
The next step is to locate the pay back quotient in the table M-4. The present value of 1
Re should be computed for 5 number of years.
The location of the pay back quotient is in between the values of table M-4
The value 3.214 which lies in between 3.274 of 16% and 3.199 of 17%
The next step in the IRR calculation is that locating the maximum rate of return which
equates the initial outlay with the cash inflows of various time periods.
While equating the initial outlay with discounted cash inflows at certain percentage will
derive the original rate of return. The process may be started from two different angles
viz
l Low discount rate
l High discount rate
The computation of IRR can be had through either low discount rate or high discount
rate. This is further extended to different methods of calculation., which are as follows
l On the basis of values extracted from the table
l On the basis of volume
261
Accounting and Finance for Calculation on the basis of discount rate table value
Managers
Lower discount Rate Origin value i.e., unknown Higher discount rate
3.274 IRR -3.214 3.199
On the basis of Lower % of discount rate

=Lower discount rate
+
( Pay Back quotient - Higher discount rate)

Discount rate difference
( Lower discount - Higher discount rate)
3.214 3.199
= 17% 1% = 17% .2% = 16.8%
3.274 3.199
Alternately, on the basis of volume, the methodology to be adopted for the determination
of IRR
The cash inflows of Rs.11,200 for 5 years are discounted @ 16% which amounted
Rs.36,668.8. Like wise the cash inflows of the same should be discounted at the rate of
17% which amounted Rs.35,828.8
The next step is to find out the IRR. The IRR can be found out either on the basis of
lower discounted cash inflows or higher discounted cash inflows.
On the basis of discounted cash On the basis of discounted

(+) Rs.36,000-Origin value- (-) cash inflows Higher
inflows Lower rate
Rs.36.668.8 @ IRR rate-Rs.35.828.8
On the basis of discounted cash inflows at lower rate @16%
(Rs.36.668.8 Rs. 36,000) (668.8)

=16% + 1% = 16% + %
(Rs. 36.668.8 - 35.828.8) (840)
=16%+.796=16.796%
On the basis of discounted cash inflows at higher rate @ 10%
(Rs. 36,000 - Rs. 35.828.8) (172)

= 17% - 1%
(Rs. 36.668.8 - 35,828.8) (840)
== 17% -.204=16.796%
Merits of DCF methods
l It is only the best method incorporates the timing of benefits - time value of money
l It considers the economic life of the project
l It is a best method for both even and uneven cash inflows
Demerits of DCF methods
l It involves with tedious method of computation
l It is very difficult to locate or identify the exact discounting factor
l It never performs functions of discounting to the tune of accounting concepts.
262
Illustration 12 Capital Budgeting
XYZ company is considering an investment proposal to install new drilling controls at a

cost of Rs.1,00,000. The facility has a life expectancy of 5 years and no salvage value.
The tax rate is 35%. Assume the firm uses straight line depreciation and the same is
allowed for tax purposes. The estimated cash flows before depreciation and tax form
the investment proposal are as follows:
Year Cash flows Before Tax Rs

1. 20,000
2. 21,384
3. 25,538
4. 26,924
5. 40,770
Calculate the following

1. Pay back period
2. Average rate of return
3. Net present value at 10 percent discount rate
4. Profitability index at 10 percent discount rate
The first and foremost step is to find out the Cash Flows After Taxation
For finding out the Cash flows after taxation, the amount of depreciation i.e non recurring
expenditure should be appropriately considered for calculation. The depreciation has to
be computed in accordance with the stipulation given in the problem. The depreciation
charged by the firm is nothing but straight line method.
Initial Investment - Scrap value

Straight line method of depreciation =
Economic life period of the machine
Rs.1,00,000
= = Rs. 20,000
5 Years
The depreciation has to be deducted initially from the cash flows before taxation, after
the deduction of taxation, the earnings after taxation should be added with the depreciation
which was already deducted in order to find out the total cash flows after taxation. The
purpose of deducting the depreciation is nothing but an amount to be charged under the
Profit & Loss account against the total revenue. Being as a non-recurring expenditure
not created any outflow cash resources. When there is no cash outflow, the amount of
depreciation should be added finally to derive CFAT(Col 7)
Table
Year CFBT Depreciation Profits Taxes Earnings Cash flows after
Col 1 Rs Rs Before Tax (.35) After tax tax Rs
Col 2 Col 3 Rs Col 5 Rs Col7= Col6+Col3
Col 4=Col2- Col6=Col4
Col3 -Col5
1. 20,000 20,000 Nil Nil Nil 20,000
2. 21,384 20,000 1,384 484 900 20,900
3. 25,538 20,000 5,538 1,938 3,600 23,600
4. 26,924 20,000 6,924 2,423 4,500 24,500
5. 40,770 20,000 20,770 7,270 13,500 33,500
22,500 1,22,500
1. Pay back period method: Under this, method most important step is to identify
the nature of the cash flows after taxation. Are they uniform ? No, they are not
even cash flows. Hence, the cumulative cash flows after taxation has to be found
in order to find out the pay back period of the investment.
263
Year Cash flows After Tax Rs Cumulative CFAT Rs
Managers
1. 20,000 20,000
2. 20,900 40,900
3. 23,600 64,500
4. 24,500 89,000
5. 33,500 1,22,500
Pay back period= Pay back period for the major portion of the investment
+
Pay back period for the remaining portion unrecovered
Rs.11,000
= 4 year + = 4 year + .328 year
Rs. 33,500
= 4.328 years
2. Average rate of return (ARR):
Average Income
ARR = 100
Average Investment
Average Income is the average of earnings after taxation of the entire duration.
Why earnings after taxation has to be taken into consideration ? Why not the cash
flows after taxation to be taken for consideration ?
The main purpose of considering the earnings after taxation is that the amount
extracted from the book of accounts and taken for the computation of ARR, and
immediately after the payment of taxation.
Average investment is the average of opening and closing investment. If the
depreciation charge given is nothing but straight line method, automatically final
value of the asset will become equivalent to zero. The closing balance of the asset
/investment is zero.
How the closing balance of the investment could be adjudged as equivalent to
zero?
Table of Depreciation
Year Opening balance of the year Rs Closing balance of the year Rs

1. 1,00,000 80,000
2. 80,000 60,000
3. 60,000 40,000
4. 40,000 20,000
5. 20,000 0
At the end of the year, the closing balance amounted Rs.0 after charging the
depreciation year after year constantly in volume
Opening balance + Closing balance

Average =
2
Rs. 1,00,000 + Rs. 0
=
2
= Rs. 50.000
Rs. 22,500
Average Income = = Rs.4,500
5 years
Rs. 4,500
Average rate of return = 100 = 9%
Rs.50,000
264
3. Net present value method: Capital Budgeting
Under this method, the future cash flow after taxation should be discounted at the
rate 10%
Year Cash flows after tax Present value factor @ 10% Total Present Value Rs
1. 20,000 .909 18,180
2. 20,900 .826 17,263
3. 23,600 .751 17,724
4. 24,500 .683 16,734
5. 33,500 .621 20,803
Total Present value 90,704
Less Initial outlay 1,00,000
Net present value ( 9,296)
The net present value is negative due to excessive investment more that of the
present value of future earnings of the enterprise. Under this method, the investment
is not advisable to procure for the firm's requirements.
4. Profitability Index
The profitability index method is more useful in the case of more number of
investments, having uneven investment outlays, but this problem comes with only
one investment proposal It is much easier to assess even in the case of Net
present value method.
Pr esent value of cash inflows Rs.90,704

Profitability Index (PI) = =
Pr esent value of cash outflows Rs. 100,000
=.90704
The present value index quotient is less than that of the norms which should be
greater than one but it secures only 90704. It means that the present value earnings
are not sufficient to meet the initial cost of the machine.
Check Your Progress
(1) Why the depreciation is added at the end of computation to derive the cash
flow ?
(a) Being as recurring charge
(b) Being considered as tax shield
(c) Being as non recurring charge
(2) Why "0" value is taken as closing balance of the investment for the computation
of Average investment ?
(a) No value for the closing balance
(b) No value due to the application of straight line method of depreciation
(c) No scrap value at the end of the life of the asset
18.5 CAPITAL RATIONING

The capital rationing means that selection of investment proposals with reference to
capital budget by considering the financial constraints. The selection of the investment
proposals should be to the tune of required NPV which the firm wants to earn during the
future. Under the capital rationing, there are two stages involved viz 265
Accounting and Finance for (i) Identification of the investment proposals
Managers
(ii) Selection of investment proposals
The selection of the investment proposals are on the basis of Discounted cash flows
method. The selection of the investment proposals are subject to two different categories
viz indivisible and divisible. The investment which is wholly accepted or rejected due to
decision criterion which is known as indivisible project but the divisible projects are able
to either accept or reject in parts.
18.6 DIVISIBLE PROJECT

A company has Rs. 7 Crore available for investment. It has evaluated its options and has
found that only 4 projects given below have positive NPV. All these investment are
divisible Advise the management which investments projects it should select.
Project Initial Investment Rs Cr NPV Rs Cr PI
X 3.00 .60 1.20
Y 2.00 .50 1.25
Z 2.50 1.50 1.60
W 6.00 1.80 1.30
Project Initial Investment Rs Cr NPV Rs Cr PI

Z 2.50 1.50 1.60
W 6.00 1.80 1.30
Y 2.00 .50 1.25
X 3.00 .60 1.20
Out of the available Rs. 7 Cr, the first two projects selected on the basis of Profitability
index viz Z and W. The total amount of investment required to invest in both the projects
amounted Rs 8.50 Cr but the financial constraint is Rs.7 Cr. By considering the constraint,
the first project fully accepted and the part of the next project W accepted for the
remaining amount of corpus available by considering to maximize the NPV of the project
as a whole.
18.7 INDIVISIBLE PROJECT

A company working against a self imposed capital budgeting constraint of Rs 70 Cr is
trying to decide which of the following investment proposals should be undertaken by it.
All these investment proposals are indivisible as well as independent. The list of
investments along with the investment required and the NPV of the projected cash
flows are given below
Project Initial Investment Rs Cr NPV Rs Cr
A. 10 6
B. 24 18
C. 32 20
D. 22 30
E. 18 20
The D, E and B are the project for making an investment which jointly amounted Rs 64
Cr and the remaining the Rs 6 cr to be invested into the project.
18.8 RISK ANALYSIS IN CAPITAL BUDGETING

In capital budgeting decisions, the risk component of the investment is not taken into
consideration. The risk which is nothing but the business risk of the investment varies
from one to another, to be considered in the real world situations. The risk which is
nothing but the variability in between the actual returns and expected returns. The risk in
the investment has to be incorporated in the discount rate for studying the worth of the
266 project. To incorporate the risk in the discount rate, the meaning of the term risk should
be known and distinguished from the uncertainty. The risk situation is one in which the Capital Budgeting
probabilities of one particular event are known but the uncertainty is the situation in
which the probabilities are not known. In the case of risk situation, the future losses can
be foreseen unlike the uncertainty situation.
The incorporation of the risk factor in the discount rate in accordance with the variability
of the returns. If the variability of the returns are more, the investor may prefer higher
return in the form of risk premium for risky project unlike in the case of government
securities. The government securities are not having any variability in the returns which
require the risk free return to discount only in order to know the worth of the investment
but the risky projects are to be discounted only with the help of higher discount rates.
There quite number of techniques available for incorporating the risk component in the
capital budgeting are follows:
Sensitivity analysis
Standard deviation
Coefficient of variation and so on.
18.9 LET US SUM UP

The capital budgeting is the decision of long term investments, which mainly focuses the
acquisition or improvement on fixed assets. The importance of the capital budgeting is
only due to the benefits of the long term assets stretched to many number of years in the
future. It is a tool of analysis which mainly focuses on the quality of earning pattern of
the fixed assets. The methods are the nothing but the instruments of the capital budgeting
to study the quality of the investments/fixed assets. The pay back period is the period
taken by the firm to get back the investment. The pay back period is nothing but number
of years / months/days required by the firm to get back its investment invested in the
project. The capital rationing means that selection of investment proposals with reference
to capital budget by considering the financial constraints. The selection of the investment
proposals should be to the tune of required NPV which the firm wants to earn during the
future. Under the capital rationing, there are two stages involved viz
(i) Identification of the investment proposals
(ii) Selection of investment proposals

Elucidate the advantages and disadvantages of the traditional methods of capital budgeting.
18.11 KEYWORDS
Capital budgeting: A study on Long term investment decision in terms of quality of
benefits
Pay back period: It is a time period during which the initial investment is recovered
ARR: Accounting rate of return - It is being calculated in accordance with the financial
statements
PV: Present value
IO: Initial outlay which is nothing but initial investment
NPV: Net present value which is the difference in between the Initial investment and
Present value of future cash inflows
IRR: Internal rate of return which is nothing but highest rate of return expected to earn 267
Accounting and Finance for PI: Profitability Index is the ratio in between the present value of future cash inflows
Managers
and present value of initial

1. Define capital budgeting.
2. Highlight the importance of capital budgeting.
3. "Success of the firm relies upon the rational capital budgeting decisions"- Discuss.
4. What are two different classification of capital budgeting tools?
5. Illustrate the Pay back period method with an example.
6. Explain the process of computing the Accounting rate of return and their merits
and demerits.
7. List out the various methods of discounted cash flows.
8. Explain the meaning of IRR and the process of calculating the IRR.
9. List out the merits and demerits of the Discounted cash flows method.

M.P. Pandikumar According & Finance for Managers Excel Books, New Delhi.
268
LESSON
19
RISK AND RETURN
CONTENTS
19.1 Introduction
19.2 Meaning of Return & Rate of Return
19.3 Concept and Types of Risk
19.3.1 Interest Rate Risk
19.3.2 Market Risk
19.3.3 Inflation Risk
19.3.4 Business Risk
19.3.5 Financial Risk
19.3.6 Liquidity Risk
19.3.7 Measurement of Risk
19.4 Risk and Return of the Portfolio
19.4.1 Diversification of the Risk of Portfolio
19.5 Relationship between the Risk and Return
19.6 Let us Sum up
19.8 Keywords

This lesson is intended to study the various aspects of risk and return of investment
projects. After studying this lesson you will be able to:
(i) distinguish between return and rate of return
(ii) describe meaning and types of risk
(iii) diversify the risk of portfolio
(iv) establish relationship between the risk and returns.
19.1 INTRODUCTION
Risk and Return of the investments are interrelated covenants in the selection any
investments, which should be studied through the meaning and definition of risk and
return and their classification of themselves in the first part of this chapter and the
relationship in between them is illustrated in the second half of the chapter.
19.2 MEANING OF RETURN & RATE OF RETURN

Return is the combination of both the regular income and capital appreciation of the
investments.
Accounting and Finance The regular income is nothing but dividend/interest income of the investments. The capital
for Managers appreciation of the investments are nothing but the capital gains of the investments i.e
the difference in between the closing and opening price of the investments.
Return symbolized as follows
D1 + Pt Pt 1
Pt 1
If the price of a share on April 1 (current year) is Rs 25 and dividend received at the end
of the year is Re 1 and the year end price on Mar 31 is Rs. 30
Re 1 + (Rs30 Rs25)
Rate of Return =
Rs.25
=. 24 = 24%
The next aspect is current yield which is nothing but denomination of the income of the
investments only in terms of market price
These two categories, Earnings yield and Capital gains yield
l Annual Income + beginning price
l Annual Income = Rs. 1/Rs. 25 = .04 = 4%*
l Capital Gains = Rs. 5/Rs. 25 = 0.20 = 20%**
Earnings per share
l *Earnings Yield =
Market price per share***
Price Change
** Capital gains yield =
Market price per share***
***Beginning Price of the share/Investment
Stock & Debenture Rate of Return

l If it is a share - Dividend will be the annual income and the second one is a capital
appreciation
l If it is a Debenture - Interest will be the annual income, i.e., coupon rate of interest
And if any capital appreciation is available that could be considered.
19.3 CONCEPT AND TYPES OF RISK

l The variability of the actual return from the expected return which is associated
with the investment /asset known as risk of the investment.
l Variability of return means that the Deviation in between actual return and expected
return which is in other words as variance i.e., the measure of statistics.
l Greater the variability means that Riskier the security/ investment.
l Lesser the variability means that More certain the returns, nothing but Least risky
e.g. Treasury Bills, Savings Deposit.
The risk can be further classified into six different categories
l Interest rate risk
l Inflation risk
l Financial risk
l Market risk
l Business risk and
l Liquidity risk
270
19.3.1 Interest Rate Risk Risk and Return
l It is risk variability in a security's return resulting from the changes in the level of
interest rates.
l Security prices - inverse relationship with
v Recent announcement of the monetary policy by RBI- Hike in CRR 5. 50
points to 6 points; change in the rate of interest - change in the prime lending
rate of the banks - Due to Rs. 14,000 cr. amount to be deposited in the
Reserve Bank of India by the Banks - to curtail the Inflation
Impact on the Security Prices

l If the rate of interest increases then the price of the existing securities will come
down due to more attraction on the new instruments due to lesser demand on the
existing securities more particularly during the periods of inflationary period
l If the rate of interest decreases means that the price of the existing securities will
go up due to lesser attraction on the new investment avenues which are found to
be greater demand for new securities during the periods of deflationary period.
19.3.2 Market Risk

l It refers to variability of returns due to fluctuations in the securities market which is
more particularly to equities market due to the effect from the wars, depressions etc.
l E.g., Greater/lesser investments by the mutual funds, banks, Foreign institutional
investors and so on due to entry into or out of the market reflects the market -
index is the market risk.
19.3.3 Inflation Risk

l Rise in inflation leads to Reduction in the purchasing power which influences only
few people to invest due to
l Interest Rate Risk which is nothing but the variability of return of the investment
due to oscillation of interest rates due to deflationary and inflationary pressures.
19.3.4 Business Risk

l Risk of doing business in a particular industry / environment is known as business
risk. Business risk is nothing but Operational risk which arises only due to the
presence of the fixed cost of operations. The Higher the fixed cost of operations
requires the firm to have Greater BEP to avoid the firm to incur losses. It is normally
transferred to the investors who invest in the business or company, the major reason
is that EBIT of the firm is subject to the fixed cost of operations.
19.3.5 Financial Risk

Connected with the raising of fixed charge of funds viz Debt finance & Preference
share capital. More the application of fixed charge of financial will lead to Greater the
financial Risk which is nothing but the Trading on Equity.
19.3.6 Liquidity Risk

l This is the risk pertaining to the secondary Market, in which the securities can be
Bought and sold quickly and without any concession in the price.
v Liquidity risk reflects only due to the quality of benefits with reference to
certainty of return to receive after some period which is normally revealed in
terms of quality of benefits. The more the certainty of benefits leads to lesser
the liquidity risk and vice versa. 271
Accounting and Finance The government & Treasury bills are bearing greater certainty to receive the benefits
for Managers
which have least probabilities to fail, denominates that is Lesser Liquidity Risk.
The Equity shares of the companies are bearing the Greater Liquidity Risk is subject to
the quality of benefits, due to the declaration of dividends, which is subject to the availability
of earnings i.e., EBIT, EAT, EPS and DPS; which are nothing but the determinants of
Demand and supply them in the market among the investors.
19.3.7 Measurement of Risk

Assessment of risk
Behavioural Statistical
Sensitivity Probability Standard. Co.-variance

Analysis Distribution Deviation
The first one is that sensitivity analysis taken for discussion. It considers all possible
outcomes/return estimates in evaluating risk to study the deviation of the expected returns
which is nothing but the Sense of Variability among return estimates.
It is being studied through the classification of the span of the investments into following
categories viz pessimistic, most likely and optimistic. The above set of classifications are
on the basis of cycle of the industry or product which it belongs or markets the product.
The next one is to highlight the risk component through the sensitivity analysis
Particulars Asset A Asset B
Initial outlay (t = 0) 50 50
Pessimistic 14 8
Most Likely 16 16
Optimistic 18 24
Range 4 16
The risk is nothing but the difference in between the optimistic and pessimistic returns,
in other words range of the returns. The range of the returns is nothing but the difference
in between highest and lowest returns which normally arise during the periods of boom
and recession. The greater the range refers to the greater the amount of risk and vice
versa. From this table we identify that Asset B is found to be more risky than the asset
A, the reason is higher rang in the case of Asset B unlike Asset A; which highlights the
difference in between the returns of optimistic and pessimistic. This method is found to
be a crude method in studying the risk of the securities.
To nullify the bottlenecks associated with the sensitivity analysis, probability distribution
is considered for the discussion of risk to study more in detail than the earlier sensitivity
analysis. The probabilities are assigned to reveal the possibilities of occurrence of the
event which ranges in between 1-100% of occurring.
If it is certain to occur means that P= 1
If is not certain to occur means that Q = 1
Based on the probabilities, the expected return of the investment could be found out
through the multiplication of the respective returns of the horizon which in relevance
with possibility of occurrences.
l Expected rate of return of the security is as follows :- it is weighted average of all
possible returns multiplied by the respective probabilities.
l Probabilities of various Outcomes during the various seasons are known as weights
272 KP
The risk can be determined through the statistical measure of dispersion of returns of an Risk and Return
expected value of return of the security.
l Risk is the Standard deviation of returns from the mean/expected value of return
l Square root of squared deviations of the individual expected returns
( (KK)2 P)1/2
Standard Deviation:
l Greater the standard deviation - Greater the risk
l Does not consider the variability of return to the expected value
l This may be misleading - if they differ in the size of expected values
In order to replace the bottlenecks associated with the standard deviation in studying the
risk of the security, the co-variation is suggested to study the risk of the security
l It is a measure of dispersion/ measure of risk per unit of expected return
l It converts the standard deviation of expected values into relative values to enable
comparison of risks with assets having different expected values.
S.D
Coefficient of variation =
Mean
19.4 RISK AND RETURN OF THE PORTFOLIO

l Portfolio is the Combination of two or more assets or investments.
l Portfolio Expected Return is the weighted average of the expected returns of the
securities or assets in the portfolio.
l Weights are the Proportion of total funds in each security which form the portfolio
l Wj Kj.
l Wj = funds proportion invested in the security.
l Kj = expected return for security J.
l The risk of the portfolio could be determined what it was in the process of individual
assets?
l Benefits of portfolio holdings are bearing certain benefits to single assets.
l Including the various type of industry securities - Diversification of assets.
l The portfolio construction leads to bring down the risk of the portfolio than the risk
of single assets.
l It is not the simple weighted average of individual security.
l Risk is studied through the correlation/co-variance of the constituting assets of the
portfolio. The Correlation among the securities should be relatively considered to
maximize the return at the given level of risk or to minimize the risk.
Correlation of the expected returns of the constituent securities in the portfolio.
l It is a Statistical expression which reveals the securities earning pattern in the
portfolio as together.
l Positive correlation means that Return of the securities in the portfolio are moving
together in same direction.
l Negative correlation which illustrates that the Return of the securities are moving
in opposite direction.
l Zero correlation reveals that there is - No relationship in between the earnings
pattern among the securities of the portfolio.
l The Co-efficient of correlation normally ranges in between 1 and +1. 273
Accounting and Finance 19.4.1 Diversification of the Risk of Portfolio
for Managers
Diversification of the portfolio can be done through the selection of the securities which
have negative correlation among them which formed the portfolio. The return of the
risky and riskless assets are only having the possibilities to bring down the risk of the
portfolio.
The following example will certainly facilitate to understand the diversification process
of the securities in the portfolio through the correlation co efficient of the returns of the
securities which formed the portfolio:
Year Assets/Securities % Portfolio %
A B C AB AC
1 10 18 10 14 10
2 12 16 12 14 12
3 14 14 14 14 14
4 16 12 16 14 16
5 18 10 18 14 18
Expected return 14 14 14 14 14
Standard deviation 2.83 2.83 2.83 0 2.83
The above table reveals that Portfolio AB is the better one to diversify the risk as minimum
as possible, the reason is that the returns of the respective securities are having negative
correlation among A&B unlike A &C. The negative correlation of the returns between
the A&B only facilitated to reduce the risk to the levels of minimum.
The risk of the portfolio cannot be simply reduced by way adopting the principle of
correlation of returns among the securities in the portfolio. To reduce the risk of the
portfolio, the another classification of the risk has to be studied, which are as follows:
The risk can be further classified into two categories viz Systematic and Unsystematic
risk of the securities
Systematic Risk - which cannot be controlled due to market influences which is known
as Uncontrollable risk, cannot be avoided
Unsystematic Risk-Which can be minimized or reduced this type of risk through
diversification of the securities in the portfolio
l Systematic Risk- Unavoidable, Uncontrollable risk - finally Market risk War, inflation,
political developments
l Unsystematic Risk- Avoidable, Controllable risk. Strike, Lock out, Regulation
Systematic Risk: Which only requires the investors to expect additional return/
compensation to bear the
Unsystematic Risk: The investors are not given any such additional compensation to
bear unlike the earlier.
The relationship could be obviously understood through the study of Capital Asset Pricing
Model (CAPM).
l Developed by William F. Sharpe
l Explains the relationship in between the risk and expected / required return
l Behaviour of the security prices
l Extends the mechanism to assess the dominance of a security on the total risk and
return of a portfolio
l Highlights the importance of bearing risk through some premium
l Efficiency of the markets
v Investors are well informed
274 v No transaction costs - No intermediation cost during the transaction
v No single investor is to influence the market Risk and Return
l Investor preferences
v Highest return for given level of risk Or
v Lowest risk for a given level of return
v Risk - Expected value, standard deviation
19.5 RELATIONSHIP BETWEEN THE RISK AND RETURN

l Total Return - Risk free rate of return= Excess return (Risk premium)
l Total return = Risk free return + Risk premium
Kj = Rf + bj (KmRf)
Bj is nothing but Beta of the security i.e., market responsiveness of the security. Beta
differs from one security to another.
It is normally expressed as a b
Non Diversifiable risk of asset or Portfolio

b=
Risk of the Market Portfolio
Risk of the portfolio = After diversification, the risk of the market portfolio is non diversifiable
Check Your Progress
1. Return means
(a) Regular income only (b) Capital appreciation income
(c) (a) & (b) (d) None of the above
2. Risk means
(a) Variability of returns (b) Non variability of returns
(c) Mean of the returns (d) None of the above
3. Interest rate risk means
(a) Affects the price of the existing securities due to change in the rate of interest
(b) Affects the price of the new securities due to change in the rate of interest
(c) Affects the price of the existing and new securities due to change in the rate of
interest
4. Systematic risk is
(a) Controllable (b) Uncontrollable
(c) Neither controllable nor uncontrollable (d) None of the above
5. Beta is
(a) Diversifiable risk
(b) Undiversifiable risk
(c) Neither diversifiable nor undiversifiable
6. Return is
(a) Risk free return
(b) Risk premium 275
Contd...
Accounting and Finance (c) Risk premium pegged with Beta
for Managers
(d) Risk free return and Risk premium pegged with Beta
19.6 LET US SUM UP

The variability of the actual return from the expected return which is associated with the
investment /asset known as risk of the investment. Variability of return means that the
Deviation in between actual return and expected return which is in other words as
variance i.e., the measure of statistics. Greater the variability means that Riskier the
security/ investment. If the rate of interest increases then the price of the existing securities
will come down due to more attraction on the new instruments due to lesser demand on
the existing securities more particularly during the periods of inflationary period. The
govt & Treasury bills are bearing greater certainty to receive the benefits which have
least probabilities to fail, denominates that is Lesser Liquidity Risk. The risk is nothing
but the difference in between the optimistic and pessimistic returns, in other words
range of the returns. The range of the returns is nothing but the difference in between
highest and lowest returns which normally arise during the periods of boom and recession.
The greater the range refers to the greater the amount of risk and vice versa.
Systematic Risk only requires the investors to expect additional return/compensation to
bear the Unsystematic Risk investors are not given to any such additional compensation
to bear unlike the earlier.

How will you diversify the risk of portfolio? Elucidate your answer with your own example.
19.8 KEYWORDS
Risk: Deviation in between the actual return and expected return
Return: It is the combination of regular income and capital appreciation income
Yield: Total earnings in terms of market price
Income yield: Earnings in terms of market price
Interest risk: Deviation of return of the security due to fluctuations of interest
Inflation risk: Deviation of return of the security due fluctuations in the purchasing
power with reference to money supply
Operation risk: Risk which is due to fixed cost of operations
Finance risk: Risk due to the application fixed charge of funds
Beta: Co efficient of market responsiveness of the security
Systematic risk: Risk which cannot be diversified
Unsystematic risk: Risk which can be diversified
Risk free return: Return on risk less investments
Risk premium: Return for the undiversifiable risk to bear
CAPM: Capital Asset Pricing Model for the relationship in between Risk and Return

1. Define return.
2. Define risk.
276
3. Explain different types of risk. Risk and Return
4. Explain different types of return.

5. Explain the various statistical measures available for risk.
6. Define Beta.
7. Elucidate the systematic and unsystematic risk.
8. Highlight importance and assumptions of CAPM.

M. P. Pandikumar Accounting and Finance for Managers, Excel Books, New Delhi.
277
UNIT-V
LESSON
20
COST OF CAPITAL
CONTENTS
20.1 Introduction
20.2 Meaning and Assumptions of Cost of Capital

20.3 Measurement of Cost of Debt
20.4 Cost of Preference Share Capital
20.5 Cost of Retained Earnings
20.6 Weighted Average of Cost of Capital
20.7 Let us Sum up
20.9 Keywords

The purpose of this lesson is to discuss about the cost of capital which is used as a
phenomenon for the decision criterion in the case of studying the worth of long-term
assets. After studying this lesson you will be able to:
(i) understand meaning and assumptions of cost of capital
(ii) describes measurement of cost of debt
(iii) solve problems on cost of debt
(iv) solve problems on cost of preference share of capital
(v) describe cost of retained earnings.
20.1 INTRODUCTION
It is imperative to study the importance of cost of capital to the tune of financing decision
of the firm. The financing decision of the firm normally facilitates the firm to raise the
financial resources to the requirements of the firm. The raising of the financial resources
should be carried out not only to the tune of financial requirements but also it should
mind about the cost of availing the resource; which means that the cost of raising and
applying the resources in and of the organization. The cost is the most limiting factor of
influence for the success of the firm, the reason is that the cost of capital is the major
determinant of success of the business firm. The firm must be facilitated to raise the
financial resources at cheaper cost in order to earn more and more.
Accounting and Finance for The cost of capital is used as a phenomenon for the decision criterion in the case of
Managers
studying the worth of long-term assets, which have got greater importance in the success
of the firm. The cost of capital is instrumented in the Net present value method and
Internal rate of return method of studying the worth of long-term assets under the capital
budgeting decisions of the enterprise.
20.2 MEANING AND ASSUMPTIONS OF COST OF

CAPITAL
l It is the Minimum rate of return which the firm should or must earn only in order to
maintain the value of the shareholders.
Classification of the cost of capital: The cost of capital can be classified into two
categories viz specific cost of capital and weighted cost of capital.
Assumptions
l It is on the basis of Operating Risk i.e., Business Risk of the firm which is nothing
but determinant of influence is Fixed Cost of Operations. The cost of capital is
subject to the volume of fixed cost of operations of the firm.
l On the basis of Financial Risk i.e., with reference to Financial Commitments of
the firm which in other words as financial Risk. The Interest on debenture,
Preference Dividend on Preference share capital should be paid without fail
irrespective of the firms' earnings according to the terms and conditions of the
issue. The greater the fixed financial commitments require the firm to earn more
and more in order to retain the interest of the shareholders of the firm.
l Operational Terms - capital structure remain unchanged; unless the cost of capital
of the firm would change.
l For new projects, funds are raised only at same proportion.
How the cost of capital is to be denominated in terms ?
Whether the cost of capital is to be denominated in terms of after tax or before tax. Why
it has to be expressed in terms of after tax ? Why not the before tax cost should be taken
into consideration?
For appraising the projects, the return of the investments are considered for comparison
which are nothing but the resultant of earnings of the firm immediately after the payment
of tax. To study the quality of the projects, both factors must be at common at parlance
for comparison.
While computing the cost of capital, the cost of specific sources should be to the tune of
after tax only in order to have an effective comparison.
v Then, the cost of capital is further bifurcated into two categories viz Explicit
cost of capital and Implicit cost of capital.
v Explicit cost of capital: The discount rate that equates the present value of
the cash inflows that are incremental to the taking of the financing opportunity
with the present value of its incremental cash outflows.
It is further explained that rate of return of cash flow of the financing opportunity. It
normally takes place only at the moment of raising of financial resources.
l Implicit cost of capital: It is nothing but the Opportunity cost of capital of the
firm to earn through investing elsewhere by the shareholders themselves or by the
company itself. It is rate of return which is associated with the best investment
opportunity for the firm and its shareholders that would have to be forgone, which
were presently considered by the firm.
l Specific cost of specific source of capital: Each source of capital has its own
cost at the moment of raising which form part of the computation of total cost of
282 capital of the firm.
Cost of Capital
20.3 MEASUREMENT OF COST OF DEBT
The cost of the perpetual debt is nothing but the cost of raising the debt financial resource,
in which the time period of repayment of the principal is not known.
This particular specific source has two different classifications viz cost of interest and
cost of debt.
Interest
Cost of interest (Ki) =
Sale value
Tax adjusted Interest

Cost of Debt (Kd) =
Sale value
Problem on Cost of Debt

l A company has 10 percent perpetual debt of Rs.1,00,000. The tax rate is 35 per
cent. Determine the cost of capital (before tax as well as after tax) assuming the
debt is issued at i) at par ii) at 10% discount iii) at 10% premium.
At par
Cost of Interest Cost of Debt
Ki= Rs.10,000/Rs.1,00,000=10% Kd= Rs.10,000(1-.35)/Rs.1,00,000= 6.5%
At Discount
Ki=Rs.10,000/ Rs.90,000= 11.11% Kd= Rs.6,500/90,000= 7.22%
At Premium
Ki= Rs.10,000/Rs.1,10,000=9.09% Kd=Rs 6,500/Rs.1,10,000=5.90%
Check Your Progress
1. A company is considering raising Rs 100 lakh by one of the two alternative

methods. viz 14 percent institutional term loan and 13 percent non - convertible
debentures. The term loan option would attract no major incidental cost. The
debentures would have to be issued at a discount of 2.5 per cent and would
involve Rs. 1 lakh as cost of issue.
Advise the company as to the better option based upon the effective cost of
capital in each case. Assume tax rate of 35 per cent.
The next method of computing the cost of debt is only for the debt finance which knows
the repayment period of the principal and the payment of the interest periodicals.
This process of computation could be divided into two categories
First one is the periodical repayment of the principal along with the periodical payment
of interest periodicals.
COIt + COPn
CIo =
(1 + kd) t
The second one is the lump sum repayment of the principally only at the end of the term
of the debenture. 283
Managers COIt COPn
CIo = t
+
(1+kd) (1+Kd)n
Problem on cost of debt

l A company issues a new 10 percent debentures of Rs.1,000 face value to be
redeemed after 10 years. The debenture is expected to be sold at 5 percent discount.
It will also involve flotation cost of 5 per cent of face value. The companys tax
rate is 35 per cent what would be the cost of debt be ? Illustrate the computations
i) trial and error approach and ii) shortcut method.
Trial Error approach:
The first step is to determine the cash flows involved in the process of the debentures issue
Years Particulars
0 Rs.900 at the moment of raising i.e., cash in flow
during the issue of debentureRs.1,000Rs.50
Rs.50
1-10 Regular flow interest payment
The interest outflow which is subject to the
adjustment of taxation Rs100(1 0.35)=Rs.65
10 Final repayment of the principal
The last payment is nothing but the repayment of
the principal Rs.1,000
10
Rs 65 Rs. 1,000
Rs. 900 = +
T =1 (1+kd) t
(1+Kd) n
The present value of the future cashflows should be found out one after the another.
The determination of present value at 7% and 8%
Years Cash Present value Total Present value
@ 7% @ 8% @7% @ 8%
1-10 Rs.65(Annuity Table) 7.024 6.710 Rs.456.56 Rs.436.15
10 1,000(Single flow table) 0.508 .463 Rs.508.00 Rs.463.00
964.56 899.15
The value of Cost of debt is 8%

The short cut method is as follows
I(1 t) + (f + d + pred - pi)/N
l Kd =
(RV + SV)/2
I=Annual interest payment
T=tax rate
F=Flotation cost
d=Discount on debentures
pred=premium on redemption
pi=premium on issue of debentures
RV=Realisable value
SV=Sale value
Kd= 7.9%
284
Cost of Capital
Check Your Progress
A company issues 11 percent debentures of Rs.100 for an amount aggregating

Rs.1,00,000 at 10 percent premium, redeemable at par after five years. The
companys tax rate is 35 per cent. Determine the cost of debt using the
shortcut method.
20.4 COST OF PREFERENCE SHARE CAPITAL

The next specific source of cost is cost of preference share capital
l Cost of preference share capital - From the angle of interest on the amount of
debentures it is also like a fixed in charge but not contractual obligation, but the
interest payment is contractual in obligation in accordance with the terms and
conditions of the issue agreement reached earlier with the company, irrespective
of the profits earned.
l Preference dividend is to be paid only with reference to availability of profits.
Normally the Expectations of the preference shareholders are nothing but the
preference dividends. The preference shares are classified into two categories viz
Redeemable and Irredeemable
l Let us discuss at first about the Irredeemable preference shares during the issue
The first one is the methodology for the computation of the cost of irredeemable
preference share
Dividend preference share

l Kp =
P0 (1f)
The second methodology incorporates the dividend taxation which is normally
borne by the company during the moment of declaration.
Kp=Dividend prefernce(1+Dt)
Kp =
P0 (1f)
ABC company issues 11 percent irredeemable preference shares of the face value of
Rs. 100 each. Flotation costs are estimated at 5 per cent of the expected sale price a) par
value b) 10% premium c) 5% discount and also compute the Dividend tax at 13.125%
At par
Cost of Preference share capital Cost of preference share with dividend tax
Kp= Rs11./Rs 95.=11.57% Kp = Rs.11(1+.13125) = 13.09%
Rs.95
At Discount
Cost of Preference share capital Cost of preference share with dividend tax
Kp=Rs.11/ Rs.110(.95).= 10.5% Kp = Rs.11(1+.13125) = 13.81%
Rs 110(.95)
At Premium
Cost of Preference share capital Cost of preference share capital with dividend tax
Ki= Rs.11/Rs.95(.95)=12.2% Kd = Rs.11(1+.13125) = 13.78%
Rs 95(.95)
The next methodology under the preference share capital is the cost computation for
redeemable preference share capital. Under this the period of payment of capital is
known along with the payment periodical preference dividends.
285
Managers Dp Pn
l Po (1-f) = t
+
(1+kp) (1+kp)n
Problem on the preference share capital

l Xion Ltd has issued 11% preference shares of the face value of Rs.100 each to be
redeemed after 10 years. Floatation cost is expected to be 5% Determine the cost
of preference shares Kp
10
Rs 11 Rs. 1,000
Rs. 95 = +
T =1 (1+kp)
t
(1+Kd)10
The value of the Kp is lying in between the two rates of discounts viz 11% and 12%
Determination of present value in between 11% and 12%
Year Cash outflow Present value @ Total Present value @ Rs
1 to 10 years Rs11 5.889 5.65 64.78 62.15
10th yr completion Rs.100 .362 .322 35.15 32.20
99.93 94.35
Cost of preference share capital is Kp= 11.9%

The next important cost to be determined is that cost of equity share capital:
l Equity dividends is not at par with Interest and Preference dividends, these two
are subject to fixed in principle. The payment of dividends are subject to the availability
of earnings and the future prospects of the firm in the future to grow.
l Equity shareholders are the last claimants of the company not only in sharing the
profits of the company at the end of every year immediately after anything paid to
the preference shareholders. It never carries any fixed rate of dividends subject
to the availability of profits to disburse.
l Market value of shares are determined by the Equity dividends which are nothing
but the return expect to get.
l Ke= a minimum rate of return which the firm should earn from the equity portion
of financing of the project in order to maintain the value of the share prices.
There are many more models in the computation of cost of equity
i) Dividend valuation model
ii) Capital Asset Pricing Model
l Dividend valuation model: The Cost of equity capital Ke is in terms of required
rate of return to the tune of future dividends to be paid to the investors.
v It is discount rate which equates the present value of future dividends per
share with sale proceeds of a share (after adjusting the expenses of flotation
of a share)
Dividend of the first year1

v Po =
Ke g
Dividend of the first year1 + G

Ke =
286
Po
Problem: Cost of Capital
Dividend per share Re 1 Growth rate = 6% Assuming the market price is Rs. 25
What would be market price of a share after 1 year and 2 year
Ke= Re.1/25+ 6%= 4%+ 6%= 10%
The market price at the end of 1 year
Rs.1.06
P1 = = Rs.26.5
10%-6%
The market price at the end of 2nd year
Rs.1.12
P2 = = Rs.28
10%-6%
l Capital Asset Pricing Model approach: The cost of equity share capital is
computed by registering the Beta with reference to the non diversifiable risk in
addition to the diversifiable risk of the equity share with reference to market
responsiveness.
The basic assumptions of the CAPM approach
(i) The efficiency of the security markets
(ii) Investor preferences
The efficiency of the security markets is embedded with the following assumptions:
(a) All investors are common expectations about the expected returns, variances and
correlation of the expected returns among the various securities in the market
(b) All investors have equivalent amount of information
(c) All investors are rational
(d) No transaction costs
(e) No single investor influence the market
The investors' preference with reference to two different types of returns
(i) Highest level return at minimum level risk or
(ii) Lowest level of risk for given level of return
The above alternatives are subject to two different type of risk viz Systematic and
Unsystematic risk.
Systematic risk which cannot be reduced i.e., undiversifiable risk for which allowances
are given to the investors.
Unsystematic risk which can be reduced to the level of minimum for which no other
allowances are given to the investors.
The allowances are given to the investors only subject to the market responsiveness
Beta coefficient
Ke= Rf+ b(KmRf)
Problem
l The hypothetical ltd wishes to calculate the cost of equity capital using the CAPM
approach. From the information that the risk free rate of return equals 10% ; the
firms beta equals 1.50 and the return on the market portfolio equals 12.5% Compute
the cost of equity capital
Ke= 10% + 1.5(12.5%-10%)=13.75% 287
Managers 20.5 COST OF RETAINED EARNINGS
The next important cost of specific source of capital is cost of retained earnings.
The cost of retained earnings is to be computed on the basis of opportunity cost. It does
not have any direct cost, instead, the amount of retained earnings loses the opportunity
of the investors to earn in the form of dividends due to retained earnings; which are
foregone by them one side and on the other side the earnings which are retained are
invested in some other investments, would be in a position to yield the return, is the cost
of retained earnings.
It could be defined as "cost of retained earnings is the opportunity cost in terms of
dividends foregone by with held from the equity shareholders." The cost of retained
earnings is nothing but the external criterion which is equal to the Ke. Practically speaking,
Ke is more than the Kr due to the floatation cost involved in the process of issue of
shares.
20.6 WEIGHTED AVERAGE OF COST OF CAPITAL

The term cost of capital is nothing but the overall cost of capital which is to be computed
to the tune of the proportion of the funds in the mixture; should computed only to the tune
of assignment of weights. The weight average cost of capital has its own steps to follow
during the process of computation.
l Assigning the weights
l Multiplying the weights with the specific cost of the fund
l Dividing the total cost immediately after adding them together by the summation of
weights
l It is denominated by Ko
The weights are normally classified into two major classification viz
l Marginal weights
l Historical weights
Marginal weights: Assignment of weights to the specific cost by the proportion of the
each fund to be raised to the total fund
Historical weights: The weights are assigned to the specific source of fund to the tune
of the proportion of the fund in the existing capital structure. This type of historical
weight is further classified into two different categories viz:
l Book value weights and Market value weights.
l Book value weights are assigned to the tune of book values to measure the proportion
of each type of capital.
Market value weights are assigned to the tune of market value to measure the proportion
of each type of capital.
Problem
A company has on its books the following amounts and specific cost of each type of capital.
Type of capital Book value Market value Specific cost Rs
Debt Rs.4,00,000 3,80,000 5
Preference 1,00,000 1,10,000 8
Equity 6,00,000 15
Retained earnings 2,00,000 12,00,000 13
13,00,000 16,90,000
288
Determine the weighted average cost of capital using (a) Book value weights and (b) Cost of Capital
Market value weights.
The determination of the weighted average cost of capital using book value weights
Type of capital Market value Specific cost Rs Total costs BV* K

Debt 3,80,000 5 Rs.20,000
Preference 1,10,000 8 8,000
Equity 9,00,000 15 90,000
Retained earnings 3,00,000 13 26,000
16,90,000 1,44,000
Rs.1,44,000
Ko = 100 = 11.1%
Rs.13,00,000
The determination of Market value weights

Type of capital Book value Specific cost Rs Total costs BV* K
Debt Rs.4,00,000 5 19,000
Preference 1,00,000 8 8,000
Equity 6,00,000 15 1,35,000
Retained earnings 2,00,000 13 39,000
13,00,000 2,01,000
Rs.2,01,000
Ko = 100=11.9%
Rs.13,00,000
20.7 LET US SUM UP

The cost is the most limiting factor of influence for the success of the firm, the reason is
that the cost of capital is the major determinant of success of the business firm. The cost
of capital is used as a phenomenon for the decision criterion in the case of studying the
worth of long-term assets. Cost of capital is the minimum rate of return which the firm
should or must earn only in order to maintain the value of the shareholders. The cost of
the perpetual debt is nothing but the cost of raising the debt financial resource, in which
the time period of repayment of the principal is not known. This particular specific source
has two different classifications viz cost of interest and cost of debt.
The term cost of capital is nothing but the overall cost of capital which is to be computed
to the tune of the proportion of the funds in the mixture; should computed only to the tune
of assignment of weights. The weight average cost of capital has its own steps to follow
during the process of computation.

A company has issued 15% preference shares of the face value of Rs.100 each to be
redeemed after 20 years. Flotation cost is expected to be 5% of the expected sales
price. Determine the cost of preference shares.
20.9 KEYWORDS
Cost of capital: It is the minimum rate of return to be earned at which the capital is
raised
Implicit cost of capital: It is the minimum rate of return to be earned by the firm, at the
moment of retaining the earnings, towards the investment decision 289
Accounting and Finance for Explicit cost of capital: It is the cost incurred by the firm at the moment of raising
Managers
Specific cost of capita: It is the cost incurred at every moment for raising the specific
resource of capital
Book value weights: Weights assigned to the tune of the book value of the capital
Weighted average cost of capital: The aggregate of the weighted specific resources
cost of capital is weighted average cost of capital

1. Define cost of capital.
2. Explain the various types of cost of capital.
3. Explain the methodology involved in the process of computing the weighted average
cost of capital.
4. Explain the meaning of assigning the weights on the specific sources of capital.

M.P. Pandikumar Accounting & Finance for Managers, Excel Books, New Delhi.
290
LESSON
21
LEVERAGE ANALYSIS
CONTENTS
21.1 Introduction
21.2 Operating Leverage
21.3 Financial Leverage
21.4 EBIT-EPS Analysis
21.5 Combined Leverage
21.6 Let us Sum up
21.8 Keywords

The main objective of this lesson is to discuss about operation and financial leverages
and their impact. After studying this lesson you will be able to:
(i) describe the concept of operating leverage and calculate the degree of operating
leverage
(ii) explain various aspects of financial leverage
(iii) describe EBIT-EPS analysis to study the impact of the leverage
21.1 INTRODUCTION
Leverage means the fixed commitment of the organization. The fixed commitment of
the organization can be classified into two different categories viz fixed cost of operations
and fixed cost of servicing. The fixed cost of operations are pertaining to the investment
decisions and the fixed cost of servicing with reference to the financing decision.
Fixed cost of operations Investment decisions.
Fixed cost of servicing Financing decisions.
If Revenues are more than the Variable Cost and Fixed Cost, that is called favorable
or otherwise unfavorable.
21.2 OPERATING LEVERAGE

Operating Leverage is connected with the acquisition of assets where as the financial
Leverage is connected with the Financing of activities.
Accounting and Finance Operating leverage: It is a relationship in between the Sales and Earnings before
for Managers
interest and taxes.
Financial leverage: It is a relationship in between the Earnings before interest and
taxes and Earnings per share.
Operating and Financial: In the Operating and Financial leverages, the EBIT is found
as a common phenomenon. During the first part of the chapter, let us discuss about the
operating leverage. It emerges only due to Fixed operating expenses. By and large, the
expenses are classified into two categories viz Fixed and Variable in categories for the
analysis of leverage.
l Operating Leverage is defined as the ability to use fixed operating costs to magnify
the effects of changes in sales on its earnings before interest and taxes.
l Described as % change in profits accompanying the % change in volume.
l "The firms' ability to use fixed operating costs to magnify the effects of changes in
the sales on its earnings before interest and taxes".
l A firms sells products for Rs 100 per unit has variable operating costs of Rs. 50 per
unit and fixed operating cost of Rs. 50,000 per year. Show the various levels of
EBIT that would result from sale of i) 1000 units ii) 2000 units iii) 3000 units.
Case B Base Case A

Level from the base 50% +50%
Sales in units 1,000 2,000 3,000
Sales volume in Rs 1,00,000 2,00,000 3,00,000
Variable cost 50,000 1,00,000 1,50,000
Contribution 50,000 1,00,000 1,50,000
Fixed cost 50,000 50,000 50,000
Profit Zero 50,000 1,00,000
100% +100%
From the above illustration, it is obviously understood that from the two different cases.
Case A illustrates that 50% increase in the volume of sales led to 100% increase in the
volume of profit.
Case B highlights that 50% reduction in the volume of sales led to 100% decrease in the
volume of profit.
It is clearly evidenced that % change in the volume of sales is less than the % change in
the volume of profit.
The next step is to define the Degree of Operating Leverage (DOL)
l DOL is the measure reveals the extent or degree of operating leverage.
l When Operating leverage exists ?
Proportionate change in EBIT of a given change in sales is greater than the Proportionate
in sales
Percentage change in EBIT

DOL = >1
Percentage change in Sales
Case A= 100%/50%= =+2

Case B=(100%)/(50%)=+2
292
By algebraically proven and the following formula has derived to determine the DOL Leverage Analysis
through the alternate methodology
Total Contribution (Base Level)

DOL =
EBIT ( Base Level)
To determine the degree of the operating leverage, from the above illustration which is
applied
DOL= Rs.1,00,000/Rs.50,000= +2
The answer of the DOL has been checked in both directions to the direct methodology.
If there is no fixed operating cost in the manufacturing enterprise ? What would be the
Degree of Operating leverage ?
Particulars Base Level New Level
Units sold 1,000 1,100
Sales price per unit Rs.10 Rs.10
Variable cost per unit 6 6
Fixed operating cost Nil Nil
Calculate the Degree of operating leverage
Total contribution
DOL =
EBIT
To find out the EBIT = Sales -VC=Contribution i.e. EBIT
R400
DOL = = +1
Rs.400
In the alternate methodology, the DOL is as follows:
% change in EBIT 10%

DOL = = = +1
% change in Sales 10
When there is no fixed cost in the cost of operations means that the firm does not have
operating leverage in its operations.
The operating leverage is related to the operating risk of the investments, which means
that fixed cost of operations of the enterprise. It highlights that greater the fixed cost of
operations means that higher the operating risk; which means that greater will be break
even point and vice versa. The greater volume of fixed cost of operations are found to
be more favorable only during the occasion of greater volume of earnings, unless otherwise
the dominance of fixed cost of operations are found to be undesirable to magnify the
volume of EBIT.
21.3 FINANCIAL LEVERAGE

The next leverage is Financial Leverage which arises due to servicing of financial
resources.
l It results from the presence of fixed financial charges in the firms. The fixed
financial charges are nothing but the preference dividend and interest on the fixed
charge financial resources.
l Financial leverage, how the fixed charge financial resources influence the EBIT
of the firm and finally provides earnings to the shareholders. It reveals the ability 293
Accounting and Finance of the firm to make use of "fixed financial charges to magnify the effects of changes
for Managers
in EBIT on the earnings per share".
The other name of the financial leverage is Trading on Equity, which illustrates the
relationship in between the application of the fixed charge of funds in the capital structure
and Earning per share. It is the leverage analysis highlights the relationship in between
the financing decision and investment decision.
The fixed financial charge should pave way for the firm to not only to earn the greater
EBIT but also to magnify the EPS of the shareholders.
l The financial manager of the hypothetical ltd expects that its earnings before
interest and taxes (EBIT) in the current year would amount to Rs.10,000. The
firm has 5 percent bonds aggregating Rs.40,000 while the 10 percent preference
shares amount to Rs. 20,000 what should be the earnings per share (EPS)?
Assuming the EBIT being i) Rs.6,000 Rs.14,000. How EPS is affected ? The firm
tax bracket 35%. Ordinary number of shares 1,000
Case 2 Base Case 1
Level from the base 40% +40%
EBIT 6,000 10,000 14,000
Interest 2,000 2,000 2,000
Earnings Before Interest 4,000 8,000 12,000
Taxes 35% 1,400 2,800 4,200
EAT 2,600 5,200 7,800
Preference dividend 2,000 2,000 2,000
Earnings to share holders 600 3,200 5,800
EPS .6 3.2 5.8
Level 81.25% 81.25%
From the above illustration, 40% increase in the level of EBIT posed 81.25% increase in
the EPS and vice versa.
Financial leverage can be quantified through the Degree of Financial Leverage (DFL)
The degree of financial leverage is defined as the ratio of % change in the EPS and %
change in the EBIT. Which always greater than 1. The degree of financial leverage is
more than one due to presence of fixed charge of financial resources. This profound
relationship is algebraically proven and illustrated that
EBIT
DFL (Base) =
EBITIDp/1t
DFL of the above firm is as follows:
% change in EPS 81.25%

DFL = = = 2.03125
% Change in EBIT 40%
Alternately, the DFL is computed as follows through the following methodology
Rs. 10,000
DFL =
Rs10,000 Rs.2,000Rs.2,000/.65
= 2.03125
The same example drawn for our better understanding by excluding the fixed charge of
financial resources
294
Leverage Analysis
Case B Case A
Level of Change 40% + 40%
EBIT 6,000 10,000 14,000

Taxes 35% 2,100 3,500 4,900
EAT 3,900 6,500 9,100
Earnings to share holders 3,900 6,500 9,100
EPS 3.9 6.5 9.1
% change in EPS
Degree of financial leverage =
% Change in EBIT
+ 40%
Case A = =+1
+40%
40%
Case B = =+1
40%
Alternately, the DFL could be found out as follows:
Rs.10,000
= = +1
Rs.10,00000
It means that the higher Degree of financial leverage means that greater the financial
risk of the firm and vice versa. The greater degree of financial leverage is favorable
only during the greater volume of EBIT to meet the fixed charges unless otherwise, the
firm is required to undergo for liquidation. The interest of the firm may be brought under
the control of the debenture holders and preference shareholders.
21.4 EBIT-EPS ANALYSIS

It is an analysis to study the impact /effect of the leverage. This could be studied through
comparison of various financing plans of EBIT.
(i) Exclusive use of debt
(ii) Exclusive use of Equity shares
(iii) Exclusive use of Preference shares
(iv) Combination of (i), (ii) & (iii)
(v) Combination of (i) & (ii)
(vi) Combination of (ii) & (iii)
(vii) Combination of (i) & (iii)
Among the various plans, we have to identify the best plan which has highest EPS over
the others.
The firm which has highest EPS normally has least volume of fixed financial charge
over the other firms.
What is meant by financial break even point ?
It is the level of EBIT to meet the fixed financial charge of the firm viz Interest on long
term borrowings/Debentures and Preference dividend on Preference shares.
The following formula is used to compute the financial break even point for the firm to
earn at least to cover the fixed financial charges of the firm: 295
Accounting and Finance Financial break even point= I + PD/1t
for Managers
The next analysis is nothing but Indifference point.
Indifference Point:
It is the point at which the EPS and EBIT are nothing but the same for two different
financing plans known as the indifference point.
The indifference point could be found out through the following analyses:
(i) Algebraic approach
(ii) Graphic approach
The measures of the Financial leverage:
They are two in categories:
(i) Stock terms
(ii) Flow terms
Stock Terms: The following are the two ratios viz debt equity ratio and debt + preference
share capital to total capitalization ratio to measure the financial leverage.
Flow terms: The financial leverage means debt service ration and preference dividend
coverage ratio to measure the capacity of the firm in meeting the periodical fixed financial
commitments of the firm.
21.5 COMBINED LEVERAGE

It is the combination of both leverage viz Operating leverage and financial leverage. The
combination means that the product of both leverages viz operating risk and financial
risk, which facilitates to determine the total risk of the firm.
DCL= DOL XDFL
% change in EPS
DCL =
% change in Sales
The combined leverage is nothing but % change in the sales volume of the firm leads to
certain % change in the EPS.
DCL = Contribution/EBITI
Check Your Progress
1. Elucidate the Degree of Financial leverage.

2. Explain the detailed process of EBIT-EPS analysis.
21.6 LET US SUM UP

Leverage means the fixed commitment of the organization. The fixed commitment of
the organization can be classified into two different categories viz fixed cost of operations
and fixed cost of servicing. Operating leverage is a relationship in between the Sales
and Earnings before interest and taxes. Financial leverage is a relationship in between
the Earnings before interest and taxes and Earnings per share. The operating leverage is
related to the operating risk of the investments, which means that fixed cost of operations
of the enterprise. It highlights that greater the fixed cost of operations means that higher
296
the operating risk; which means that greater will be break even point and vice versa.
The greater volume of fixed cost of operations are found to be more favorable only Leverage Analysis
during the occasion of greater volume of earnings, unless otherwise the dominance of
fixed cost of operations are found to be undesirable to magnify the volume of EBIT. The
other name of the financial leverage is Trading on Equity, which illustrates the relationship
in between the application of the fixed charge of funds in the capital structure and
Earning per share. It is the leverage analysis highlights the relationship in between the
financing decision and investment decision. EBIT-EPS analysis is an analysis to study
the impact /effect of the leverage.

Discuss the role of EBIT-EPS analysis in studying the effect of leverage.
21.8 KEYWORDS
Leverage: Fixed commitments of the firm
Operating leverage: It is a measure in the expression of business risk through
quantification of fixed cost
Financial leverage: It is an expression of financial risk due to the presence of fixed
financial commitment of the firm
Combined leverage: Combination of both leverages i.e. Product of Operating and
Financial leverages
Financial break even point: It is a level of EBIT to cover the fixed financial commitment
of the firm
Indifference point: It is the point at which the EBIT and EPS level of the two different
financing plans are nothing but the same.

1. What is leverage ?
2. Classify the type of leverages.
3. Define operating leverage.
4. Explain the Degree of operating leverage.
5. Define the financial leverage.
6. Describe the combined leverage.
7. Define Indifference point.
8. Define Financial break even point.

297
for Managers
LESSON
22
CAPITAL STRUCTURE THEORIES
CONTENTS
22.1 Introduction
22.2 Assumption of the Capital Structure Theories
22.3 Net Income Approach
22.4 Net Operating Income Approach
22.5 ModiglianiMiller Approach
22.6 Traditional Approach
22.7 Types of Dividend Policies
22.7.1 Cash Dividend Policy
22.7.2 Bond Dividend Policy
22.7.3 Property Dividend Policy
22.7.4 Stock Dividend Policy
22.8 Let us Sum up
22.10 Keywords

The purpose of this lesson is to identify the optimum capital structure for business fleeces.
(i) describe different theories of capital structure
(ii) explain aspects of capital structure decision-making
(iii) describe different types of dividend policies
22.1 INTRODUCTION
The capital structure theories are facilitating the business fleeces to identify the optimum
capital structure. The optimum capital structure of the organization differs from one
approach to another due the assumption which are underlying with reference to many
factors of influence. The success of the firm is normally depending upon the rate at
which the financial resources are raised, differs from one organisation to another depends
298
upon the needs. The cost of capital is having greater influence on the EBIT level of the
firm; which directs affects the amount of earnings available to the investors, that finally Capital Structure Theories
reflects on the value of the firm. The more earnings available at the end will lead to
greater return on investment holdings of the investors, would enhance the value of shares
due to greater demand. There are two set of approaches with reference to capital
structure; which normally influences the Value of the firm through the cost of overall
capital(Ko) is one approach called relevance approach capital structure theories and
other do not have any influence on the value of the firm is known as irrelevance approach.
The debt finance in the capital structure facilitates the firm to enhance the value of EPS
on one side on the another side it is subject to the financial leverage with reference to
trading on equity. The application of leverage in the capital structure enhances the value
of the firm through the cost of capital.
The following are the various capital structure theories:

(i) Net income approach
(ii) Net operating income approach
(iii) Modigliani and Miller approach
(iv) Traditional approach
22.2 ASSUMPTION OF THE CAPITAL STRUCTURE

THEORIES
(i) There are only two resources in the capital structure viz Debt and Equity share
capital
(ii) The dividend pay out ration 100% which means that there is no scope for the
retained earnings
(iii) The life of the firm is perpetual
(iv) The total assets of the firm do not change
(v) The total financing remains constant through balancing taking place in between the
debt and share capital
(vi) No corporate taxes; this was removed later
22.3 NET INCOME APPROACH

Algebraically, the relationship between the cost of equity, cost of overall capital and
debt-equity ration are explained as follows:
Ke=Ko+ (KoKi)B/S
Net income approach was developed by Durand, in this he has portrayed the influence
of the leverage on the value of the firm, which means that the value of the firm is subject
to the application of debt i.e., leverage.
In this approach, the cost of debt is identified as cheaper source of financing than equity
share capital. The more application of debt in the capital structure brings down the
overall capital, more particularly 100% application of debt finance leads to resemble the
over all cost of capital as cost of debt. The weighted average cost of capital will come
down due to more application of leverage in the capital structure, only with reference to
cheaper cost of raising than the equity share capital cost.
Ko= Ke(S/V)+Ki(B/V)
The value of the firm is more in the case of lesser overall cost of capital due to more
application of leverage in the capital structure. The optimum capital structure is that at 299
Accounting and Finance when the value of the firm is highest and the overall cost of capital is lowest.
for Managers
V=B+S
V= EBIT/Ko
This approach highlights that the application of leverage influences the overall cost of
capital and that affects the value of the firm.
22.4 NET OPERATING INCOME APPROACH

This another approach developed by Durand, which has underlying principle that the
application of leverage do not have any influence on the value of the firm through the
overall cost of capital. The more application of leverage leads to bring down the explicit
cost of capital on one side and on the other side implicit cost of debt is expected to go up.
How the implicit cost of debt will go up? The more application of debt leads to increase
the financial risk among the investors, that warranted the equity share holders to bear
additional financial risk of the firm. Due to additional financial risk, the share holders are
requiring the firm to pay additional dividends over the existing. The increase in the
expectations of the shareholders with reference to dividends hiked the cost of equity.
Under this approach, no capital structure is found to be a optimum capital structure. The
major reason is that the debt-equity ratio does not influence the cost of overall capital,
which always nothing but remains constant.
It is finally concluded that this approach highlights that application of leverage never
makes an attempt to enhance the value of the firm, in other words which is known as
unaffected by the application of leverage.
22.5 MODIGLIANIMILLER APPROACH

It is the approach, attempts to explain the application of leverage does not have any
influence on the value of the firm through behavioural pattern of the investors. The
behavioural pattern of the investors is taken into consideration for explaining the value of
the firm which is unaffected by the application of debt/leverage in the capital structure
through arbitrage process. The MM approach has three different propositions:
(i) The overall capital structure of the firm is unaffected by the cost of capital an
degree of leverage
(ii) The cost of equity goes up and offset the increase of leverage in the capital structure
(iii) The cut off rate for the investment purposes is totally independent.
For discussion, the proposition is only considered for the study of usage of leverage in
the capital structure, which do not have any impact in the value of the firm.
Assumptions of the MM approach:

This approach is discussed under the perfect market conditions
(i) Securities are divisible infinitely.
(ii) Investors are allowed to buy and sell securities
(iii) Investors are rational to access the information
(iv) No transaction costs involved in the process of the buying and selling of securities
Arbitrage process: It is the process facilitates the individual investors to buy the
investments at lower price at one market and sells them off at higher price in another
market. With the help of arbitrage process, the investors are permitted to shift holding of
the Levered firm to the unlevered firm which is known as undervalued. These two firms
are identical in business risk except in the application of debt finance in the levered firm.
In order to maintain the similar amount of the financial risk of the firm, the investor is
300 required to undergo for personal leverage or home made leverage to maintain the same
proportion of investment in the unlevered firm. During this process, the investor could Capital Structure Theories
save something and this continuous arbitrage process will level the value of the both
firms. It means that the value of the firm is unaffected by the application of leverage
which is explained through the arbitrage process, nothing but behavioural pattern of the
investors.
The same thing could be applied in the case of reverse arbitrage process in between the
Unlevered and levered. This also another kind of process in which the investor could
gain through the transfer of the holdings from the unlevered firm to levered firm.
The value of the firm is unaffected by the application of the leverage in the capital structure.
22.6 TRADITIONAL APPROACH

The traditional approach is known as intermediate approach in between the Net income
approach and NOI approach. The value of the firm and the cost of capital are affected
by the NI approach but the assumptions of the NOI approach are irrelevant. The cost of
overall capital will come down due to the application cheaper source of financing viz
Debt financing to some extent, after certain usage, the application of debt will enhance
the financial risk of the firm, which will require the share holders to expect additional
return nothing but is risk premium. The risk premium which is expected by the investors
will enhance the overall cost of capital.
The optimum capital structure "the marginal real cost of debt, defined to include both
implicit and explicit will be equal to the real cost of equity. For a debt-equity ratio before
that level, the marginal cost of debt would be less than that of equity capital, while
beyond that level of leverage, the marginal real cost of debt would exceed that of equity.
22.7 TYPES OF DIVIDEND POLICIES

The dividend policy is the policy that facilitates the firm to decide how much should be
declared as a dividend. The declaration of dividend is normally to be taken with reference
to the future prospects of the firm. The dividends are normally decided by the board of
directors during the board meeting which may affect other important decisions of the
firm. Most of the companies never think off about the future prospects before the
declaration of the dividends to the shareholders. As a finance manager should emphasize
the importance of declaring or non declaring the dividends which are having greater
influence on the futuristic decisions of the enterprise.
Types of dividend policies:
(i) Cash dividend
(ii) Bond dividend
(iii) Property dividend
(iv) Stock dividend
22.7.1 Cash Dividend Policy

The dividends are paid in terms of cash. This type of dividend normally leads to cash
outflow which has greater influence on the cash position of the firm. At the moment of
declaring the cash dividend, future cash needs should be predetermined and dividends
declared to the share holders.
22.7.2 Bond Dividend Policy

Instead of paying dividend in terms of cash, some companies are issuing bond dividends,
which facilitate them to postpone the immediate cash outflows. Immediately after the
301
Accounting and Finance issuance of bonds, the bond holders are receiving the interest on their holdings besides
for Managers
the bond values to be paid on the due date. This method is not popular in India.
22.7.3 Property Dividend Policy

Instead of paying dividends in cash, some assets are given to the shareholders as dividend
payments. This is also not existing in India.
22.7.4 Stock Dividend Policy

Instead of making the payment of cash dividend, the stock are issued to the existing
shareholders. The company shares are issued to existing share holder which is known
other words as stock dividends.
Check Your Progress
1. Write a note on the ModiglianiMiller approach.

2. Explain the various types of dividend policies.
22.8 LET US SUM UP

The capital structure theories are facilitating the business fleeces to identify the optimum
capital structure. The optimum capital structure of the organization differs from one
approach to another. The cost of capital is having greater influence on the EBIT level of
the firm; which directs affects the amount of earnings available to the investors, that
finally reflects on the value of the firm. Net income approach, the cost of debt is identified
as cheaper source of financing than equity share capital. Net Operating income approach
developed by Durand, which has underlying principle that the application of leverage do not
have any influence on the value of the firm through the overall cost of capital. The more
application of leverage leads to bring down the explicit cost of capital on one side and on
the other side implicit cost of debt is expected to go up. Under this approach, no capital
structure is found to be a optimum capital structure. Arbitrage process is the process
facilitates the individual investors to buy the investments at lower price at one market
and sells them off at higher price in another market. The traditional approach is known
as intermediate approach in between the Net income approach and NOI approach.

Assuming the condition of the original M & M (Miller-Modigliani) approach, state whether
the following statement is true or false:
In a world of perfect capital market, an increase in financial leverage will increase the
market value of the firm.
Provide an intuitive explanation of your answer.
22.10 KEYWORDS
Arbitrage process
Dividend Policies
Cash dividend policy

1. Write the various assumption of the capital structure theories.
302 2. Explain the Net income approach.
3. Elucidate the Net operating approach. Capital Structure Theories
5. Explain briefly about the traditional approach.

6. What is meant by the dividend policy?

303
Managers
LESSON
23
WORKING CAPITAL MANAGEMENT
CONTENTS
23.1 Introduction
23.2 Objectives of the Working Capital Management
23.3 Approaches of the Working Capital
23.4 Determinants of Working Capital
23.5 Working Capital Policies
23.6 Estimation of Working Capital Requirement
23.7 Cash Management
23.7.1 Motives of Holding Cash
23.7.2 Objectives of Cash Management
23.7.3 Basic Problems of Cash Management
23.8 Management of Inventories
23.8.1 Meaning of Inventory
23.8.2 Why Inventory is to be Controlled?
23.8.3 Major Benefits of Inventory Control
23.8.4 Centralised Stores
23.8.5 Decentralised Stores
23.8.6 Central Stores and Sub Stores
23.8.7 Recording Level
23.8.8 Minimum Level/Safety Level
23.8.9 Maximum Level
23.8.10 Danger Level
23.8.11 Average Stock Level
23.8.12 Economic Ordering Quantity
23.8.13 ABC Analysis
23.8.14 VED Analysis
23.9 Receivables Management
23.9.1 Concept of Receivables Management
23.9.2 Objectives of Accounts Receivables
23.9.3 Cost of Maintaining the Accounts Receivables
23.9.4 Factors Affecting the Accounts Receivables
23.9.5 Management of Accounts Payable/Financing the Resources
23.10 Various Committee Reports on Working Capital
23.10.1 Dheja Committee Report 1969
304
Contd...
23.10.2 Tandon Committee Working Capital Management
23.10.3 Chore Committee Report 1979

23.10.4 Marathe Committee Report 1984
23.11 Let us Sum up
23.13 Keywords

(i) describe the objectives of working capital management
(ii) know how to analyse the needs of working capital
(iii) describe how to manage receivables and payables
(iv) explain how inventory is managed in a company.
23.1 INTRODUCTION
The working capital is the amount revolving capital to meet the day today requirements
of the firm. The other facets of the working capital is circulating capital, floating capital
and moving capital which are required to meet the immediate requirements of the firm.
The "working capital" means the funds available for day today operations of the enterprise.
It also represents the excess of current assets over the current liabilities which include
the short-term loans.
Accounting standards Board, The institute of Chartered Accountant of India note the
ASB has used the term working capital and not Net working capital.
23.2 OBJECTIVES OF THE WORKING CAPITAL

MANAGEMENT
Estimating the working capital requirements
The working capital requirements are normally estimated to the tune of production policies,
nature of the business, length of manufacturing process, credit policy and so on.
Sources of the working capital: The requirement of the working capital should be met
with the help of long term and shot term resources. The permanent and temporary
working capital requirements should be met out of long term and short term financial
resource respectively.
23.3 APPROACHES OF THE WORKING CAPITAL

The approaches of the working capital are classified into two categories viz the hedging
approach and conservative approach:
The hedging approach: Under this approach, the maturity of the financial resources
are matched with the nature of assets to be financed.
305
Accounting and Finance for Permanent working capital are financed by the long-term financial resources and the
Managers
seasonal working capital requirements are met out through short term financial resources.
The conservative approach: Acc to this approach, all requirement of the funds should met
out long-term sources. The short-term resources should be only for emergency requirements.
23.4 DETERMINANTS OF WORKING CAPITAL

Following are the major determinants of the working capital:
General nature of Business: The nature of the business should be considered for the
determination of working capital only to the tune of i) cash nature of business ii) sale of
services rather than commodities:
These are things considered only on the basis of stock , book volume of debts and so on.
Production cycle: The need of the working capital is determined on the basis of duration
of the production cycle. The time duration taken by the manufacturing process should be
considered from the stage of raw materials to the stage of finished goods. If the duration
is lengthier may require the firm to keep more amount of working capital to meet out the
requirements and vice versa.
Business cycle: The cycle of the business should be relatively considered for the need
of working capital. The upswing of the business cycle requires the business venture to
invest more amount of working capital due more volume of sales, results out of huge
volume of stock, book debts and so on. During the downswing of the business require
the business to have only lesser volume of working capital due lesser volume of business
and so on.
Production policy: The working capital requirement is determined on the basis of
production policy of the firm. Normally the production policy of the firm is classified on
the basis of two methodologies:
(i) The firm produces the goods then and there to the tune of immediate needs of the
market. This may require the firm to meet adversities due to lack of working capital
to meet out, due to in adequate planning. During the peak season, it requires
enormous working capital which may disturb working conditions of the business
venture.
(ii) The steady production policy by considering the futuristic demands, which will not
disturb the long-term prospects of the business venture due to effective planning.
Credit policy: The credit policy of the firm is another determinant for the determination
of the working capital. There are two different credit policies viz liberal and stringent
credit policies
(i) Liberal credit policy: The liberal credit policy may lead to have greater volume of
book debts, greater credit period, huge amount required for the built of stock; require
the firm to have greater amount of working capital
(ii) Stringent credit policy: Would not require that much of working capital like the
earlier segment.
Growth and Expansion: The growth and expansion prospects of the firm should be
appropriately determined in order to identify the volume of working capital required
during the future, unless otherwise that will badly affect the future development of the
firm.
Acute shortage of the raw materials supply: If the shortage of raw materials is acute,
the firm is required to keep sufficient volume of working capital to have smooth flow of
production process without any interruptions. In such cases the firm should have additional
306 volume of working capital not only to avoid interruptions during the production process
due lack of supply of raw materials, but also to enjoy greater trade discounts during the Working Capital Management
bulk purchase in order to bring down the purchase cost of the raw materials.
Net profit: It is one of the major sources of working capital and practically speaking it is
one of the sources of cash from operations. To maintain the liquidity, the net profit
earning capacity should be maintained forever.
Dividend policy: The cash dividend payment leads to greater amount of cash outflows
which are more essential to the value of the firm to be maintained. The value of the firm
could also be alternately maintained by either through the declaration of bond dividend or
stock dividend or property dividend. The later specified methodologies facilitate the firm
to postpone the cash out flow which normally evade the immediate cash requirement.
Depreciation policy: The depreciation policy of the firm not only facilitates to bring
down the taxable liability but also brings down the profit which enhances the liquidity of
the firm on the other side.
Price level changes: The price level changes require the firm to keep more amount of
working capital to go hand in hand with the price changes which normally affect the
firm's liquidity position. During the periods of inflation, the firm is required to anticipate
the price level changes which drastically affect the working capital position of the firm.
23.5 WORKING CAPITAL POLICIES

The working capital has to be adequately managed by the firm , neither more nor less
than its requirement to meet out the needs. If the working capital is more than the
requirement means that the firm is expected to unnecessarily keep short-term assets
idle in state and vice versa. The maintaining of the working capital management is mainly
depending upon three major influences of the organizations
i) Profitability
ii) Liquidity and
iii) Structural health of the organisation
Why the study of Management of working capital is required ?
If the working capital is less than the requirement means that the volume of current
assets are inadequate to meet the short term obligations of the firm on time, which may
lead to disrepute the name and fame of the organisation.
Contradictorily to the above, if the firm keeps more working capital that means more
volume of current assets are maintained in the investment structure to meet out the short
term obligations of the firm which poses more liquidity but on the other hand it hurdles
the righteous opportunity to invest in the fixed assets to earn more income. The excessive
volume of current assets drastically affects the profitability of the firm due to excess
liquidity out of more amount of current assets.
As a firm should always maintain the righteous volume of working capital not only to
maintain the liquidity of the firm but also to earn adequately from the investment volume
of fixed assets.
The working capital management policies are studied in the following context viz
i) Concerned with profitability, liquidity and risk of the firm
ii) Concerned with the composition of the current assets
iii) Concerned with the composition of the current liabilities
There are two major types of working capital policies
Conservative policy of working capital:
Under this policy, the firm minimizes risk by maintaining a higher level of current assets
307
in meeting the liquidity of the firm.
Accounting and Finance for Aggressive policy of working capital:
Managers
Under this policy , the firm enhances the risk by way of reducing the working capital in
order to earn more and more profits.
23.6 ESTIMATION OF WORKING CAPITAL

REQUIREMENT
The following is the proforma of the working capital requirement
Statement of working capital required
Current Assets:
i) Cash XXXX
ii) Debtors XXXX
iii) Stocks XXXX
iv) Advanced payments XXXX
v) Others XXXX
Less:
Current liabilities
i) Creditors XXXX
ii) Lag in payment of expenses XXXX
iii) Outstanding expenses if any XXXX
Working capital (Current assets-Current liabilities) XXXX
Add: Provision for contingencies XXXX
Net working capital required XXXX
Prepare an estimate of working capital requirement from the following data of the XYZ
Ltd.
a) Projected annual sales volume 2,00,000 units
b) Selling price Rs.10 per unit
c) % of net profit on sales 25%
d) Average credit period allowed to customers 8 weeks
e) Average credit period allowed by suppliers 4 weeks
f) Average holding period of the inventories 12 weeks
g) Allow 10% for contingencies
Statement of working capital requirements
Current Assets Rs
Debtors (8 weeks)Rs.15,00,000 8/52(At cost) 2,30,769.23

Stock (12 weeks) Rs.15,00,000 12/52 3,46,153.38
Less Current liabilities
Creditors (4 weeks) Rs15,00,000 4/52 1,15,384.61
Net working capital 4,61,538.0
Add: 10% contingencies 46,153.8
308 Working capital required 5,07,691.8
Working Capital Management
Check Your Progress
1. The recent release of the finance minister during the budget session on the
special excise duty on the cement industry.
2. How the construction industry is affected ? In what way? Which factor of
influence affects the firm?
23.7 CASH MANAGEMENT

The management of cash resources should not be only in a position to afford liquidity but
also it should not require the firm to keep the cash resources simply idle; which should be
invested in the marketable securities to earn some rate of return whenever the firm feel
excessive holding of cash resources.
23.7.1 Motives of holding cash

Transaction Motive: If the cash outflows are more than that of the cash inflows, the
firms are expected to maintain the cash resources.
Precautionary Motive: Some times the firm may be required to meet out the contingent
needs which could not be foreseen during its life span; warrants the adequate maintenance
of working capital.
Speculative Motive: It is a motive holding the cash resources by the firm to exploit the
opportunities available in the market. If the vendor of raw materials announces that
there is a greater discount towards the bulky purchase of raw materials, may lead the
firm to bring down the cost of purchase. For which, the cash resources are required and
made use of to the tune of announcements.
Compensation motive: Banks provide certain services to the firms only on the basis of
the certain amount of balances in the accounts. That is the motive holding cash resources
to avail services from the banker viz compensation motive.
23.7.2 Objectives of Cash Management

(i) Meeting the cash requirement: Meeting of cash requirements on time which
normally involves in the maintenance of the goodwill of the firm. The firm should
keep the adequate cash balances to meet the requirement which are greater in
importance.
(ii) Minimising the funds locked up in the cash balances: The funds locked up in the
form of cash resources should be more, but it should only to the tune of the requirement.
23.7.3 Basic Problems of Cash Management

(i) Controlling level of cash
(a) Preparing the cash budget: Through the preparation of the budget, the
cash requirement could be identified which would normally facilitate the firm
to trim off the excessive cash in holding.
(b) Providing room for unpredictable discrepancies: The separate amount
should be maintained for the purpose to meet out the discrepancies which are
not easily foreseen.
(ii) Controlling of inflows of cash
(a) Concentration banking: The amount of collection from the local branches
are normally deposited in a particular account of the firm, as soon as the 309
Accounting and Finance for deposit has reached the certain limit , the amount in the respective branch
Managers
account will be transferred to the account at where the firm maintains in the
head office. This process of transfer is normally taking place only through
telegraphic transfer during the early days but on now a days the anywhere
banking is facilitated to transfer the amount of deposit instantaneously.
(b) Lock box system: The process of collection is carried out with the help of
local post offices only in order to avoid the postal delays in the transit . This
system enhances the speed of the collection at rapid and finally the local
branch messenger collects the cheques from the parties through specified
post box allocated for the process of collection.
(iii) Controlling of cash outflows
(a) Centralizing of disbursing the payments: The centralizing the process of
payment may facilitate the enterprise to take advantage of time in settling the
payments i.e., reduces the need of immediate cash requirements.
(b) Stretching payment schedule: It is another methodology to avail the
maximum possible credit period to postpone the payment by making use of
the cash resources most effectively.
(iv) Investing the excessive cash surplus
(a) Determine the need of the surplus cash: Identify the excessive cash
resources which are kept simply idle more than the requirement.
(b) Determination of the various avenues of investment: After identifying
the various investment opportunities , the excessive cash resources should be
invested to earn appropriate rate of return during the slack season at when
the firm does not require greater volume of working capital and vice versa.
Check Your Progress
1. Explain the modern instruments available in the financial market to entertain

the cash management strategies.
2. 1. Cash means
a) Cash in hand b) Cash in hand and at bank
c) Cash in hand, at bank and near d) None of the above
cash i.e marketable securities
2. To avail the trade discount at the moment of bulk purchase is
a) Transaction motive b) Speculative motive
c) Compensating motive d) Precautionary motive
3. Stretching cash payment is
a) Controlling the cash inflow b) Controlling cash outflows
c) a) & b) d) None of the above
23.8 MANAGEMENT OF INVENTORIES

23.8.1 Meaning of Inventory
The inventory includes the following :
l Stock of raw materials: It means that the value of the raw materials stored for
310
the purpose of production in the storage yard. The stock of raw materials can be
classified normally into two categories viz opening stock and closing stock of raw Working Capital Management
materials.
l Stock of work in progress: During the production process, the firm usually stores
the semi finished goods which are neither a raw materials nor finished goods. The
purpose of the storage of work in progress in order to shorten the time duration to
manufacture the finished goods. The value of the semi finished / work in progress
stored in the storage house may be classified into two categories viz opening stock
and closing stock. The finalizing the value of the stock of the work in progress is
inevitable process in transfer pricing. The value of the work in progress normally
expressed in two different ways viz on the basis of prime cost and works cost.
l Stock of finished goods: This is the stage at which the goods are readily available
for selling in the market. The value of the stock of the goods is computed on the
basis of cost of production.
l Stock of Stores supplies, components and accessories.
Inventory
Raw materials Work in progress Finished goods
23.8.2 Why inventory is to be controlled ?

The ultimate purpose of controlling the inventory arises only due to the conflicting and
heterogeneous objectives of the various functional departments of the organizations.
How inventory influences the various department of the organization ?
Normally, the inventory influences on the following departments viz Production Purchase,
Finance and Sales department How it influences the various departments at a time
together.
On/of the Production department: The manager production frequently insists the
organisation to maintain the continuous and uninterrupted supply to have smooth flow
production. This requires the production manager to build ample stock of raw materials.
This is routed through the purchase requisition by the manager production to the purchase
manager.
Less the stock of raw materials and accessories - Risk of Lock out due to
insufficient quantities and vice versa
On/of the Purchase department: Due to the influence from the production manager,
the purchase department is demanded to procure the requirements. As per the requisition
of the production department, meeting the requirements is not tough task but the
department should know about the financial intricacies of the organisation through the
finance department which is especially meant for the purpose.
Lesser the quantum of purchase will lead to lesser financial commitment but expected to
loose the benefits out of the bulk procurement. Not advisable for the materials which
are in scarcity.
Lesser the quantum of purchase - Greater will be cost of procurement and
lesser will the economic benefits and vice versa 311
Accounting and Finance for On/of the Sales department: Due to the market pressure/greater demand of the products
Managers
require the sales department to supply the goods in time as well as to meet the needs and
demands of the intermediaries and consumers. To supply them in time, the sales manager
need not wait for the production cycle to be completed to produce the finished goods. To
save time, the sales manager must be given ample facility to store the finished goods in
the depot not only to meet the needs but also traps and drags the existing customers and
consumers.
More the stock of the finished goods - Better the position for the firm to meet
the needs of the biz environment and more the cost of storage and investment
on the current assets and vice versa
On/of the Finance department : Due to influence from the department of the production,
purchase and sales departments, the finance department is required to concentrate on
the various angles.
It is the only department bearing a difference of opinion in maintaining more volume of
inventory in the firm; which certainly slashes the earning capacity of the firm due to least
volume of assets deploy on the productive purpose.
Lesser the inventory - Higher the risk in meeting the needs of production,
purchase and sales - but better the return of the firm.
For e.g. The famous MNC Jindal Corporation Ltd. has wound up its operations at
industrial site in Bangalore due to the cost of raw materials cost. The transportation cost,
acquisition cost of copper ore gone up due to escalated cost in the biz market. They
were neither to store nor to transport more and more which led to the winding up of
operations of the enterprise at Bangalore.
The following diagram will obviously facilitate the Inventory Control:
Purchase
Department
Finance
Department
Production Sales
Department Department
Inventory control: Inventory control means that maintenance of desired level of inventory
by way of taking into the economic interest of the firm.
The economic interest of the firm differs from one functional dept. to another due to the
heterogeneous objectives. The economic desired benefits of the dept. are illustrated to
the tune of the preceding illustrated diagrams.
Production department: Benefits towards less production cost through mass production.
Purchase department: Benefits towards discounts, carrying cost and so on.
Sales department: Timely supply of the goods to the requirements, facilitates the firm
to earn greater volume of earning. To reduce the operating cycle in duration in order to
realize the economic benefits as early as possible.
Finance department: Benefits towards the carrying cost, storage cost of the entire
312 inventory.
Working Capital Management
23.8.3 Major Benefits of Inventory Control
l It leads to effective utilization of funds only through an appropriate investment on
inventory
l It facilitates to obtain the economic supply of raw materials
l It possess the firm comfortably to meet the needs and wants of the consumers in
time
l It neither allows the firm to undergo the practices of overstocking nor understocking.
l It leads to effectiveness in the material handing which reduces the wastage, pilferage
and so on.
Before discussing the methods of inventory control, every one must obviously understand
the organization of the stores department. The stores department is the only department
which applies all the techniques of inventory control.
The organization of the inventory control are various in dimensions . The organization of
differs from one industry to another industry, one firm to another within the same industry,
from one nature to another, from volume to another. They are as follows:
a) Centralised stores
b) Decentralised stores
c) Central and Sub stores
23.8.4 Centralised Stores

Under this type, the materials are received by and issued at one central place by the
department to the requirements of the other functional departments.
The following diagram will facilitate to understand the organisation structure of the
centralized stores of the manufacturing department. The materials are continuously
received by the stores dept. through the purchase department and the received material
are distributed to the various assisting departments.
This type of organization of stores control has its own advantages and disadvantages in
application
The major advantages are following:
l It requires less space
l It facilitates to minimize the stock investment
l The centralization leads to lower administrative and maintenance cost of stores
313
Accounting and Finance for In addition to the advantages, the present organization suffers with its own limitation
Managers
while in applications; which are following:
l The centralization of stores leads to enhance the cost of transportation as well as
handling cost of materials.
l The centralized system leads to lot of inconvenience and delay to other department
due to distance
l There is a greater risk of calamity loss of materials which are stored under one
roof
l The success is subject to the effectiveness of the transportation
23.8.5 Decentralised Stores

Under this method, the separate stores are maintained by the departments on their own
as well as run by the exclusive store keeper. It ensures the smooth flow material to the
tune of requirements and reduces the time involved in the transit of materials from the
stores to the respective departments. The following diagram will facilitate to have an
insight on the organization of the stores.
23.8.6 Central stores and Sub stores

This is a method which attempts to discard the bottlenecks of the above mentioned as
well as brings forth unique organization of stores. Under this method, each department is
given separate sub store which is within easier access and shorter in distance to supply
the material requirements through the store keeper. The sub store keeper should have to
make requisition to central stores where all the materials are centrally procured and
supplied then and there to the tune of the individual departments.
C e n t r a l S t o r e
S u b Sto re S u b Sto re
W e ld ing D ep t P la n nin g D e pt
P ro d u ction D e p t
The role of the store keeper is most inevitable in controlling the stores. While controlling
the stores, the store keeper should neither disturb the production process nor undergo
the practices of overstocking. By earmarking the above enlisted objectives, every store
keeper is led by the various methods of inventory valuation in addition to various methods
314 of requisitioning of material.
First we will discuss, the various methods of requisitioning of materials. Working Capital Management
23.8.7 Reordering Level

This is the level at which the firm should go for fresh purchase requisition of material
through the store keeper to meet the requirements. The reordering level which takes
into consideration of minimum level of consumption of raw material during the course of
production process as well as the amount material required by the firm during period of
purchase and goods in transit immediately after the order.
Reordering Level
Amount of materials required

Minimum Level
during the periods of consumption
Reordering level=Minimum level of stock for uninterrupted flow of production process

+
Amount of materials required during the periods of consumption
Or
Lead time stock level
Alternate method is available by using the maximum consumption and maximum re-
order period
Re ordering level= Maximum consumption Maximum Re- order period
This method registers the maximum consumption of the firm during the production as
well as the maximum time period required for the supply of required materials.
Under this alternate approach, the firm at any moment will not face any difficulties due
to short supply or insufficient amount of materials.
23.8.8 Minimum Level/Safety level

The firm should at always maintain minimum amount of material in its hands to facilitate
the flow of production process as unaffected .due to short fall in the quantum of materials.
The following points are most important in designing the minimum level of stock:
l Lead time should be predominantly considered to determine the time lag in between
the materials ordered and received. The firm should find out the practical difficulty
of the vendor in supplying the material for the determination for minimum level of
stock.
l Amount of consumption of the material during the lead time
Minimum stock level=Reordering level- (Normal level consumption Normal Reorder
period)
Minimum level = Reorder level + (Average level of consumption Average Reorder
period)
Average and normal level of consumption are synonymous with each other. If normal or
average consumption is not given, the formula is as follows 315
Managers Average consumption = Minimum level consumption + Maximum level consumption
2
23.8.9 Maximum Level

This is the level at which the firm holds maximum quantity of materials as stock during
the process. The ultimate aim of fixing the level of maximum level is that to avoid the
overstocking. If the stock level of the firm exceeds the maximum level already fixed is
known as overstocking level of the firm, more than the requirement.
Why over stocking is considered not advisable ?
l It leads to excessive investment on inventory more than the requirement
l It leads to unnecessary wastage of the materials due to excessive stock
l The excessive storage of materials may certainly affect the price of the product
Maximum stock level= Reordering level+ Reordering quantity - (Minimum consumption
Minimum Reordering period)
23.8.10 Danger level

At this level, the firm should not further issue any materials to the various functional
departments .At the danger level, the purchase department is vested with greater
responsibility to immediately arrange the supply of raw materials in order to maintain the
flow of production as uninterrupted.
The consumption level of the materials is getting varied from one time period to another.
During the specified period , there may be maximum consumption and minimum
consumption, which should be averaged to find the mid point in between the two, in
order to either fulfill the minimum consumption or maximum consumption to the extent
possible.
Why the maximum reorder period is taken into consideration?
The purpose of considering is that the greater period taken by the supplier to supply the
required materials
Danger Level= Average consumption Maximum reorder period
23.8.11 Average Stock Level

Average stock level =Minimum stock level + of the reorder quantity
23.8.12 Economic Ordering Quantity

The ordering of materials usually tagged with three different component of costs viz:
l Acquisition cost of materials
l Ordering cost of materials
l Carrying cost of materials
The ordering quantity of materials may be either larger or meager in volume, which
carries its own advantages and disadvantages.
If the quantity ordered is larger in volume, the following are some of the important
advantages:
l The bulk purchase order reduces the ordering cost of the materials. The greater
the size of the order which leads to reduce the number of the orders in procuring
the materials.
l Quantity discounts: The discount can be classified into two categories viz Trade
discount and Cash discount .
l What is trade discount ?
316
Trade discount is the discount granted by the supplier to the buyer of materials at the Working Capital Management
moment of bulk purchase. This % of discount is greatly possible only during the periods
of greater volume of purchase; which reduces the over all cost of the acquisition.
If the quantity is procured in meager volume, the following are construed as advantages:
l The carrying cost will come down in the case of lesser inventories
l The cost of storage is lesser as far as the meager quantities of materials
l Loss due to deterioration, obsolescence, wastage will be minimum
l Insurance cost is less due to meager volume of materials
2AO
Economic Ordering Quantity =
1
A = Annual requirement in units
O = Ordering cost
I = Cost of storing per year or cost of carrying the inventory
Graph of EOQ:
Total cost
Rupees
Cost of carrying
Ordering cost
Units per order

Insert the picture anpve
Illustration 1
Annual Requirement =20,000 units
Ordering cost= Rs.100 per order
Cost per unit =Rs.4
Carrying cost =16%
Determine the EOQ of the firm and finally justify the EOQ
2AQ
Economic Ordering Quantity (EOQ) =
I
2 20,000 Rs.100
=
0.16% on Rs.4
= 2,500 units
317
Accounting and Finance for The following Table 23.1 illustrates the justification of the EOQ at the 2,500 units level
Managers
Annual requirement of 20,000 units
Particulars 1 2 3 4 5
Size of the Orders 20,000 10,000 5000 2,500 500
Number of order to placed 1 2 4 8 40
= Total Annual Need
Size of the order
Average stock 10,000 5,000 2,500 1,250 250

= Size of the order
2
Average stock value 40,000 20,000 10,000 5,000 1,000

=Average stock cost per unit Rs
Carrying cost 6,400 3,200 1,600 800 160
= Average Stock value 16% Rs
Ordering cost Rs 100 200 400 800 4,000
Total cost Rs 6,500 3,500 2,000 1,600 4,160
Illustration 2
Calculate EOQ
Annual Requirement -1600 units
Cost of materials per unit Rs.40
Cost placing and receiving -Rs.50
Annual carrying cost of inventory -10% on value
2AO
Economic Ordering Quantity (EOQ)=
1
2 1600 Rs.50
EOQ = = 200 units
10% on Rs.40
Illustration 3
Consumption during the year -600 units
Ordering cost Rs. 12 per order
Carrying cost 20%
Price per unit Rs. 20 B.Com. (Punjab)
2AO
Economic Ordering Quantity (EOQ)=
1
2 600 Rs.12
EOQ =
20% on Rs.20
= 60 units
Illustration 4
A manufacturer purchases certain machinery from outside suppliers Rs.60 per unit.
Total annual needs are 800 units. The following are the additional information
Annual return on investments 10%
318
Rent, insurance, taxes per unit per year Rs 2 Working Capital Management
Cost of placing an order Rs.200

Determine the economic order unit
First step to find out the earnings= 10% Rs.60= Rs.6 to be earned from the investment
The amount of rent , insurance , taxes per unit year =Rs 2
I= 10% on Rs.60 + Rs.2= Rs.8
2AO
Economic Order Quantity (EOQ) =
1
2 800 Rs.200
=
10% on Rs.60 +Rs.2
= 200 units
Illustration 5
Given the annual consumption of material is 1,800 units , ordering costs are Rs.2 per
order, price per order price per unit of material is 32 paise and storage costs are 25% per
annum of stock value , find the economic order quantity.
(B.Com. Calicut)
2 AO
Economic Order Quantity (EOQ) =
1
2 1,800 Rs.2
=
25% on 32 paise
= 300 units
Illustration 6
Find out the Re ordering level from the following information
a) Minimum stock 1000 units b) Maximum stock 2000 units c) Time required for
receiving the material 20 days d) Daily consumption of material 100 units
Reordering level = Minimum level + Lead time stock level
The first step is to find out the Lead time stock level
Lead time stock level is nothing but the amount of stock level required by the firm, till the
next fresh receipt of goods, subject to the time normally taken by the supplier to supply.
Lead time stock level= Time required for receiving the material Daily consumption
Lead time stock level= 20 days 100 units per day= 2000 units
Reordering level= 1,000 + 2,000 units= 3,000 units
Illustration 7
Calculate maximum level , minimum level and reordering level from the following data
Reorder quantity 2,000 units
Reorder period 8 to 12 weeks
Maximum consumption 800 units per week 319
Accounting and Finance for Normal consumption 600 units per week
Managers
Minimum consumption 500 units per week
Reordering level = Minimum level + Lead time stock level
Or
= Maximum consumption Maximum lead time
Minimum level= Reordering level (Average consumption Average lead time )
Maximum level= Reorder level + Reorder quantity (Mini consumption Mini Lead
time)
First step is to find out the Re ordering level
Reordering level = 800 units per week 12 weeks= 9,600 units
The next step is to find out the Maximum level
Maximum level = 9,600 units + 2,000 units - (500 units 8 weeks)
= 11,600 units- 4,000 units =7,600 units
The next step is to find out the minimum level . For that Average consumption has to be
found out. The average consumption is nothing but normal consumption. The normal
lead time period is the average of minimum and maximum re order period of the firm in
getting the supply of the materials from the suppliers
Minimum level = 9,600 units (600 units 20/2)
= 9,600 units 6,000 units= 3,600 units
Illustration 8
Two components A and B are used as follows
Normal usage 50 units per week each
Minimum usage 25 units per week each
Maximum usage 75 units per week each
Re order quantity A: 300 units
B: 500 units
Re order period A: 4 to 6 weeks
B: 2 to 4 weeks
Calculate for each component
(B.Com., Madras)
(a) Re order level (b) Minimum level (c) Maximum level and (d) Average stock level
First step is to find out the Reorder level for both A and B components
The maximum usage is common for both A and B components but the reorder period are
different from each other
Reorder level = Maximum consumption /usage Maximum Reorder period
(A)= 75 units 6 weeks= 450 units
(B)=75 units 4 weeks= 300 units
The next step is to determine the Maximum level of both Components A and B
Maximum level = Reordering level + Reordering quantity (Mini Consumption Mini
Lead time)
320
(A)= 450 units + 300 units ( 25 units 4 weeks) = 650 units Working Capital Management
(B)=300 units + 500 units (25 units 2 weeks) = 750 units

Minimum Level = Reordering level ( Average consumption Average lead time)
(4 + 6))
= 450 unit (50 unit
2
(A) = 450 units 250 units = 200 units
(2 + 4))
(B) = 300 unit (50 unit
2
=300 units ( 150 units )=150 units
Average stock level = Minimum stock level + Re order quantity
(A)= 2 00 units + 300 units = 350 units
(B)=150 units+ 500 units = 400 unit
Illustration 9
The following information is available in respect of components of R 100
Maximum stock level 10,000 units
Budgeted consumption Maximum 3,000 units per month
Minimum 1,600 units per month
Estimated delivery period Maximum 4 months
Minimum 2 months
You are required to calculate
(i) Re-order level
(ii) Re-order quantity
Re order level = Maximum consumption maximum lead time
= 3,000 units 4 months=1,200 Units
The Reordering quantity could be found out with the help of Maximum level equation
Let us assume Re ordering quantity =X
Maximum level = Re-ordering level + Re-ordering quantity - (Minimum
consumption Mini Re order period)
= 1,200 units+ (X)-(1,600 units 2 months)
(-X) = 1,200 units-3,200 Units
= 2000 units
X = 2,000 units
In the stores control , there are two important documents viz Bin card system and stores ledger.
Bin Card: Bin card is a record prepared by the store keeper at the moment of issuing
and receiving the materials. It is maintained by the store keeper for physical verification
with accuracy and effectiveness. The inventory control can be accessed through physical
verification then and there, whenever the situation warrants.
The bin card system is adopted by many firms for their inventory control either in the
form of bin tag or stock card hanging outside the rack in order to portray the information 321
Accounting and Finance for immediately to facilitate the store keeper to understand the stock position of the store
Managers
room.
The bin card system is available in two major categories viz:
Two Bin card system: Under this system two different bins are used. As soon as the
goods or materials received by the store keeper, that should be recorded in terms of
quantities. One among the two should be maintained for Re order level and minimum
level another for Maximum stock level.
To alarm the firm neither to store more than the maximum level nor to issue less than the
minimum level of the stock. If the firm once reaches the maximum level, it should
immediately caution the implications due to the overstocking. The same firm, if reaches
the minimum level of stock, it should not go for further issue of materials to functional
department or otherwise, the firm's production may be disturbed due to the poor stocking.
Bin card for Mini and Reorder Bin card for Maximum Level
level
Maximum Level
Reorder Level
Maximum Level
Three Bin Card system: It is an extension of the early method, which incorporates the
lead time stock level in addition to the other level viz Maximum, Reorder and Minimum
level of the stock. Among the three , two cards are exclusively used by the firm in order
to maintain the appropriate stock level, i.e., for maximum stock level and minimum stock
level. The firm should neither to store beyond the maximum level nor to issue less than
the Minimum level. In between, a separate bin card is used only for the Reorder level
and Lead time stock level at which the firm should go for the placement of an order to
get fresh delivery of materials and facilitate the firm to undergo production without any
interruption by considering the time taken by the supplier to supply the ordered materials.
Reorder level
322 Minimum stock level Lead time stock level Maximum stock level
Some other methods of the inventory control Working Capital Management
There are few models exercise the inventory control , which facilitates the firm to avoid
either under or over stocking.
l ABC Analysis
l VED Analysis
23.8.13 ABC analysis

Normally the materials are classified on the basis of the following covenants viz:
l Volume and
l Value
Based on the basis the materials are classified into three categories:
l Lesser percentage in volume and Greater percentage in Value- Category A
l Greater percentage in volume and Lesser percentage in Value - Category B and
l Percentage in volume and Percentage in value are more or less - Category C
This will be explained with the help of following example for insight.
A store has 4,000 items of consumption and a monthly consumption of Rs 20,00,000. 320
items will have a consumption of Rs. 15,00,000. 500 items will account for Rs 4,00,000
and 2,680 items consume material worth Rs.1,00,000 only.
Table of Items and value
Group No. of Items % of Items Value Rs % of Value
A 320 8% 15,00,000 75%
B 1000 25% 4,00,000 20%
The
C importance of 2,680
the analysis is exercising
67% the control on the inventory.
1,00,000 5%
Total 4,000 100% 20,00,000
How the control of the inventory is being exercised ?

l Group A items are high valued items among the other items of the enterprise,
require greater monitoring and controlling.
l Group B items are comparatively lesser in value among the three items given next
to the Group A, require less rigid control and monitoring.
l Group C items are the major volume of items among the 4000 items of the enterprise
which are least in value, need very little control and monitoring.
The following of control of inventory on A, B and C items of the enterprise:
Group No. of Items Level of Control % of Value Rs % of Value

Items
A 320 Rigid Control 8% 15,00,000 75%
B 1000 Moderate Control 25% 4,00,000 20%
C 2,680 Very little Control 67% 1,00,000 5%
From the above table, it is obviously understood that the items which have greater %
(75%) in the total value requires rigid control than any other quantity of materials. The
Group C items are bearing 67% of total consumption amounted which 5% of total value
of the items procured by the enterprise.
323
Accounting and Finance for The Unique features of the ABC analysis:
Managers
Nature A Group of Items B Group of Items C Group of Items
Level of Control Rigid control Moderate control Very little control
Order frequency Frequent ordering- Once in 2 months Once in 6 months

weeks, Fortnights
Lead time problem To be cut off To be reduced Lead time problem

drastically moderately due to clerical should
cut off
Safety stock level Due to greater value- Due to moderate Due to lower value-
least volume safety value-lesser safety High safety stock is
stock to be stock is required required
maintained
System of Purchase Higher value demands Moderate value Lower value needs
centralized system of requires centralized decentralized system
procurement and decentralized of purchase
system of purchase
Supervision By Senior officers By Middle level By clerical staff

managers
Advantages
(1) It guides the management to exercise the control based on the value of goods to
the total composition.
(2) Systematic inventory control can be exercised through this analysis on the basis of
value of the materials. The high value materials of Group A are rigidly controlled
which finally led to lesser investments.
(3) Scientific system facilitates to lessen the storage cost of the inventory.
23.8.14 VED analysis

VED analysis is applied for the inventory control of the manufacturing enterprise.
V-Vital
E-Essential and
D-Desirable
The spare parts are classified into vital, essential and desirable to the crucially to the
production.
The non availability of certain spares for short time leads high cost stock out known as
vital spares.
The non availability of spares cannot be tolerated even for few hours or one day and the
cost of lost production is enormous, known as Essential spares to production.
The absence of spares even more than one week, not affecting the flow production,
known as desirable spares.
Check Your Progress
1) Inventory means
a) Stock of Cash b) Stock of Raw materials, work in
progress and Finished goods
c) Stock of spares d) Both b) & c) only
324 Contd...
2) Inventory control is for the maintenance of Working Capital Management
a) High level of inventory b) Optimum level of inventory

c) Low level of inventory d) Average level of inventory
3) Excessive inventory holding is
a) Better for the firm b) Worse for the firm
c) Neither better nor worse for the firm d) Either better or worse for
the firm
4) The purpose of inventory control is
a) To minimize the excessive stock b) To meet the needs of the
consumer
c) To maintain liquidity d) a),b) & c)
5) Inventory control is in relevance with
a) Storage cost b) Carrying cost
c) Ordering cost d) (a), (b) and (c)
23.9 RECEIVABLES MANAGEMENT
23.9.1 Concept of Receivables Management

The receivables are normally arising out of the credit sales of the firm.
What is meant by the accounts receivable?
It is an asset owed to the firm by the buyer out of the credit sales with the terms and
conditions of repayment on an agreed time period.
Meaning of the receivables management: The receivables out of the credit sales
crunch the availability of the resources to meet the day today requirements. The acute
competition requires the firm to sustain among the other competitors through more volume
of credit sales and in the intention of retaining the existing customers. This requires the
firm to sell more through credit sales only in order to encourage the buyers to grab the
opportunities unlike the other competitors they offer in the market.
23.9.2 Objectives of Accounts Receivables

i) Achieving the growth in the volume of sales
ii) Increasing the volume of profits
iii) Meeting the acute competition
23.9.3 Cost of Maintaining the Accounts Receivables

Capital cost: Due to in sufficient amount of working capital with reference to more
volume of credit sales which drastically affects the existence of the working capital of
the firm. The firm may be required to borrow which may lead to pay certain amount of
interest on the borrowings . The interest which is paid by the firm due to the borrowings
in order to meet the shortage of working capital is known as capital cost of receivables.
Administrative cost: Cost of maintaining the receivables.
Collection cost: Whatever the cost incurred for the collection of the receivables are
known as collection cost.
Defaulting cost: This may arise due to defaulters and the cost is in other words as cost
of bad debts and so on. 325
Managers
23.9.4 Factors Affecting the Accounts Receivables
i) Level of sales: The volume of sales is the best indicator of accounts receivables.
It differs from one firm to another.
ii) Credit policies: The credit policies are another major force of determinant in
deciding the size of the accounts receivable. There are two types of credit policies
viz lenient and stringent credit policies.
Lenient credit policy: Enhances the volume of the accounts receivable due to
liberal terms of the trade which normally encourage the buyers to buy more and
more.
Stringent credit policy: It curtails the motive buying the goods on credit due stiff
terms of the trade put forth by the supplier unlike the earlier.
iii) Terms of trade: The terms of the trade are normally bifurcated into two categories
viz credit period and cash discount
Credit period: Higher the credit period will lead to more volume of receivables, on the
other side that will lead to greater volume of debts from the side of buyers.
Cash discount: If the discount on sales is more , that will enhance the volume of sales
on the other hand that will affect the income of the enterprise.
23.9.5 Management of Accounts Payable/Financing the Resources

It is more important at par with the management of receivable, in order to avail the short
term resources for the smooth conduct of the firm.
23.10 VARIOUS COMMITTEE REPORTS ON WORKING

CAPITAL
The following committees were especially appointed for the purpose to administer the
working capital
i) Dheja Committee Report 1969
ii) Tandon Committee Report 1975
iii) Chore Committee Report 1980
iv) Marathe Committee Report 1984
The various committee report implications are the following:
23.10.1 Dheja Committee Report 1969

"The study carried out on the credit need of the industry and trade and how that needs
inflated and such trends were checked" by the under the chairmanship of Dheja
Committee.
Findings
i) General tendency was found among the firms to avail the bank credit more than
their requirements
ii) Another tendency was among them that the short term credit was generally made
use of by thee for the acquisition of the long term assets
iii) The lending through cash credit should be done on the basis of security in order to
assess the financial position of the firm
326
Recommendations Working Capital Management
i) Appraisal should be done by the bankers on the present and future performance of
the firms
ii) The total dealings are segmented into two categories viz core and short-term needs
iii) The committee suggested the firms to maintain only one account with the one
banker For huge amount of borrowing, consortium was suggested among the
bankers to lend the corporate borrowers
23.10.2 Tandon Committee

The next committee was appointed Tandon Committee 1975, in an intention of granting
loans and advances to the industry on the need basis through the study of the development
proceeds only in order to improve the weaker section of the people.
Findings of the Committee

i) The bank should not reveal this much only to lent to the requirements of the firm in
accordance with lending policy, in spite of that the banks were expected to lend to
the tune of firm's requirement
ii) It should be treated as supplementary source of finance but not as major source of
finance
iii) Loans were lent only in accordance on the basis of the securities produced by the
borrower but not on basis of level of operations
iv) Security compliance wont provide any safety to the banks but the periodical follow
up only should facilitate the banker to get back the amount of loans and advances
lent
Recommendations: It reached the land mark in studying the need of the industries
towards the requirements of the working capital. The committee has submitted its report
on 9th Aug , 1975 by studying the lending policies.
i) Necessary information about the future operations are to be supplied
ii) The supporting current assets should be shown to the banker at the moment of
borrowing
iii) The bank should understand that the bank credit is only for the purposes to meet
out the needs of the borrower but not for any other.
23.10.3 Chore Committee Report 1979

This committee especially constituted only for the purpose to study the sanctionable
limits of the banker and the extent of the loan amount utilization of the borrower. The
another purpose of the committee to appoint that to provide the alternate ways and
means to afford credit facility to the industries to enhance the productive activities in the
country.
i) Continuance of the existing three system of credits by the banker viz cash credit,
loans and bills
ii) No need to bifurcate the cash credit accounts of the borrower for the implementation
of the differential rate of interest
iii) According to the specifications of the borrower, the banker should come to one
conclusion which in normal peak level and non peak level of operations only to the
tune of operations
iv) No frequent sanction of ad hoc limits of borrowing from the banker 327
Accounting and Finance for v) The overdependence on the bank credit should be lessened among the practices of
Managers
the industrialists through emphasizing the need of term finance.
23.10.4 Marathe Committee Report 1984

The fourth committee is Marathe committee which was instituted by the Reserve bank
of India and it submitted the report on 1983. The recommendations were implemented
by the Government of India from April 1,1984.
Recommendations
i) Reasonability of the projection statements are to be studied by the banks more
carefully
ii) Current assets and liabilities are to be classified in accordance with the norms
issued by the Reserve bank of India
iii) Maintenance of the current assets ratio 1.33:1
iv) Timely supply the information stipulated by the bankers
v) Apt supply of annual accounting information
Illustration
ABC Ltd. decides to liberalise credit to increase its sales . The liberalized credit policy
will bring additional sales of Rs. 3,00,000. The variable costs will be 60% of sales and
there will be 10% risk for non-payment and 5% collection cost .Will the company benefit
from the new credit policy ?
Particulars Rs
Additional sales volume 3,00,000
(-) Variable cost 1,80,000
Additional revenue 1,20,000
(-)Non payment risk 10% on additional sales volume 30,000
(-) 5% on collection 15,000
Additional revenue from increased sales due to liberal credit policy 75,000
The new credit policy pave way for the firm to earn Rs.75,000 as an additional revenue
through the volume of incremental sales.
23.11 LET US SUM UP

The "working capital" means the funds available for day today operations of the enterprise.
It also represents the excess of current assets over the current liabilities which include
the short term loans". The working capital requirements are normally estimated to the
tune of production policies, nature of the business, length of manufacturing process,
credit policy and so on. The need of the working capital is determined on the basis of
duration of the production cycle. The time duration taken by the manufacturing process
should be considered from the stage of raw materials to the stage of finished goods. The
cycle of the business should be relatively considered for the need of working capital.
The credit policy of the firm is another determinant for the determination of the working
capital. There are two different credit policies viz liberal and stringent credit policies.
The management of cash resources should be not only in a position to afford liquidity but
also it should not require the firm to keep the cash resources simply idle; which should be
invested in the marketable securities to earn some rate of return whenever the firm feel
excessive holding of cash resources. Banks provide certain services to the firms only on
the basis of the certain amount of balances in the accounts. That is the motive holding
328
cash resources to avail services from the banker viz compensation motive. Timely supply
of the goods to the requirements, facilitates the firm to earn greater volume of earning. Working Capital Management
Reordering Level is the level at which the firm should go for fresh purchase requisition
of material through the store keeper to meet the requirements. There are few models
exercise the inventory control, which facilitates the firm to avoid either under or over
stocking
l ABC Analysis
l VED Analysis

Discuss inventory management as applicable in an industry of your choice.
23.13 KEYWORDS
Working capital: The short term asset meant for day today or immediate financial
commitments
Net working capital: Current assets - current liabilities
Temporary working capital: Which are of immediate importance
Permanent working capital: Which are regular in feature
Cash: coins, notes, currencies and near cash i.e., marketable securities
Cash management: maintain the adequate cash resource and excessive resources
should be invested in the marketable securities
Inventory: Stock of Raw materials, Stock of Work in Progress, Stock of Finished Goods
and Stock of Spares but not Stock of Loose tools.
EOQ: Economic Order Quantity of materials to be ordered/procured
Carrying cost: Cost is incurred for carrying the materials from the place of purchase to
place of production centre/profit centre
Ordering Cost: Cost incurred at the moment of placing the order of goods or materials
e.g. Administration costs, cost of communication and so on.
Maximum level: The stock level of the firm should not be more than the determined
level
Minimum level: The further issues should not be done below the level of the stock of
the firms
Reorder level: At this level, the firm should place an order for the materials to the
requirement
Lead time stock level: This is level required by all the firms to maintain the stock till the
next delivery from the supplier
ABC Analysis: Analysis of exercising the control on the inventory on the basis of value.
Always Better Control Analysis; A- High control for high value goods; B-Moderate
control for lesser value goods and C- Little control on the least value goods
VED Analysis: Vital, Essential and Desirable Analysis Designed for Spares and
accessories
Bin card: Card or Tag used to illustrate the level of the stock position of the certain
materials at the stores
Stores ledger: It is a official record of receipt and issuance of materials or goods in
329
terms of quantities with value of them
Accounting and Finance for Receivables: It is an asset arises at the moment of credit sales, owed to the firm
Managers
Collection cost: Cost of collection incurred by the firm due to collection of receivables
Agency charges, brokerage charges for collection
Default cost: Cost due to bad debts

1. Define the working capital management.
2. Explain the objectives of working capital management.
3. Explain the various components of working capital management.
4. Write detailed note on cash management.
5. Elucidate the various practices of Inventory management.
6. Highlight the importance of the receivable management through various strategies.

S.N.Maheswari, Management Accounting.
330

Accounting and Finance For Managers

Hochgeladen von

Dokumentinformationen

Originaltitel

Copyright

Verfügbare Formate

Dieses Dokument teilen

Dokument teilen oder einbetten

Freigabeoptionen

Stufen Sie dieses Dokument als nützlich ein?

Sind diese Inhalte unangemessen?

Copyright:

Verfügbare Formate

Accounting and Finance For Managers

Hochgeladen von

Copyright:

Verfügbare Formate

Accounting and Finance for Managers

MBA First Year

School of Distance Education

Lesson 1 Financial Accounting 7

Lesson 2 Trial Balance 33

Lesson 3 Final Accounts 47

Lesson 4 Depreciation Accounting 67

Lesson 5 Financial Statement Analysis 87

Lesson 6 Ratio Analysis 95

Lesson 7 Funds Flow Statement Analysis 120

Lesson 8 Cash Flow Statement Analysis 136

Lesson 9 Cost Accounting & Preparation of Cost Statement 149

Lesson 10 Budgetary Control 167

Lesson 11 Marginal Costing 178

Lesson 12 Financial Management 207

Lesson 13 Time Value of Money 214

Lesson 14 Sources of Long Term Finance 222

Lesson 15 Capital Market Developments in India 230

Lesson 16 Indian Financial System 235

Lesson 17 SEBI in Capital Market Issues 240

Lesson 18 Capital Budgeting 246

Lesson 19 Risk and Return 269

Lesson 20 Cost of Capital 281

Lesson 21 Leverage Analysis 291

Lesson 22 Capital Structure Theories 298

Lesson 23 Working Capital Management 304

Number of Credit Hours: 3

Objectives: On successful completion of the course the students should have:

Financial Statement Analysis - Objectives - Techniques of Financial Statement Analysis: Accounting

Capital Structure Theories - Dividend Policies - Types of Divided Policy.

Preparation of Adjusted Trial Balance

Trading and P& L A/c Balance Sheet

1.2.1 What is cash system?

1.2.2 What is accrual system?

1.2.3 Value at which it is to be recorded ?

1.3.2 To Shareholders, Security Analysts and Investors

1.3.6 To Govt., and Regulatory Authorities

1.3.7 To Promote Research and Development

Check Your Progress

(1) Financial Accounting is

(d) Recording, Classifying, Summarizing, Interpretation of financial information

(b) Gross value of the asset

(c) Gross value of the asset - Accumulated depreciation

(d) None of the above

1.4 ACCOUNTING PRINCIPLES

1.5 ACCOUNTING CONCEPTS

Recording of transactions are only in terms of money in the

1.5.2 Business Entity Concept

Real Capital Monetary Capital

In the angle of the firm

1.5.3 Going Concern Concept

Concept of uniform accounting horizon among the firms to evade

Total Financial Resources Total Assets

1.5.7 Cost Concept

1.6 ACCOUNTING CONVENTIONS

1.6.1 Convention of consistency

1.6.2 Convention of conservatism

Check Your Progress

(1) Accounting principles are

Persons Persons Persons Real Accounts Nominal

1.6.4 Persons of Nature

1.6.5 Persons of Artificial relationship

1.6.6 Persons of representations