1

ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS

Unit Structure: 1.0 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 Objectives Introduction Purposes and Objectives of Financial Statements Nature of Financial Statements Characteristics of Financial Statements Qualities of Ideal Financial Statements Preparation of Financial Statements Vertical Financial Statement Statements of a Proprietor Vertical Statements for Companies Exercise

1.0

OBJECTIVES

After studying the unit the students will be: Know the purpose and objectives of Financial Statements. Understand the nature of Financial Statement. Explain the Characteristics of Financial Statement. Know the qualities of Ideal Financial Statement. Explain the Vertical Format of Financial Statements.

1.1

INTRODUCTION

Government legislations require certain organizations like limited companies, public utilities, and co-operative to maintain proper account and draw financial statement. Public can understand from the financial statement the extent to which a company is discharging its social responsibilities. While issuing shares bonds, financial statement become necessary as prospective investors can judge whether to by the share or bonds, from the information regarding the financial soundness, gathered from the financial statement. Workers union may study the financial statement and ascertain whether they can enforce their demand. Whiten an organization also, financial statement assist the

2 management in taking various decisions. Consumer, all over the world, are becoming increasingly aware of their right and are using financial statement extensionally today to find out the degree of exploitation by the industries. Tax legislature makes it obligatory on the part of business entities to draw fair and objective financial statement. The financial statement serves as instruments to regulate equity and debentures issued by companies.

1.2

PURPOSES AND OBJECTIVES OF FINANCIAL STATEMENTS

Financial statements are very useful as they serve varied affected group having a economic interest in the activities in the business entity. Let us analyse the purpose served by financial statement. a) The basic purpose of financial statement is communicate to their interested users, quantitative and objective information are useful in making economic decisions. b) Secondly, financial statements are intended to meet the specialized needs of conscious creditors and investors. c) Thirdly, financial statements are prepared to provide reliable information about the earning of a business enterprise and it ability to operate of profit in future. The users who are interested in this information are generally the investors, creditors, suppliers and employees. d) Fourthly, financial statements are intended to provide the base for tax assessments. e) Fifthly, financial statement are prepare in a way a provide information that is useful in predicting the future earning power of the enterprise. f) Sixthly, financial statements are prepares to provide reliable information about the changes in economic resources.

g) Seventhly, financial statements are prepares to provide information about the changes in net resources of the organization that result from profit directed activities. Thus, financial statement satisfy the information requirements of a wide cross-section of the society representing corporate managers, executives, bankers, creditors, shareholders investors, labourers, consumers, and government institution.

Executives

Consumers & Society

Trade Creditors

Financial Information
Shareholders & Prospective Investors

Labourers

Bankers

Fig. 1.1 a) Executives : Financial statements provide sufficient accounting information to the executives and managers to enable them to decide on important issues facing them. The common issues facing corporate managers to-day, like efficient capital utilization, maintaining the profitability though cost control, dividend paying capacity of the company and observing credit standards, can be tackled effectively, if the executives have a proper understanding of analysis of the financial statement. b) Bankers : Bankers take precautions before advancing loans to their constituents. Every banker, before sanctioning credit, wishes to be assured the borrowers ability to repay the loans when they become due; to ascertain the companys ability to pay interest charges on loans and their respective due dates. Therefore, they scrutinize and study the financial statements in depth and analyse them to ascertain the borrowers liquidity, solvency, profitability of his business and his financial strength.

4 c) Trade Creditors : Credit facilities mass distributors of goods produced but a manufactures or a wholesalers would not provide credit facilities indiscreetly to everyone. Before opening an account of the trader concerned, the manufacturer and wholesaler studies the financial statements of the trader, supplemented by various trade and bank references, to ascertain his creditworthiness. This information could be obtained from the financial statement. d) Shareholders and Prospective Investors : Shareholders, who have permanent interest in the life and operations of the company, are ever desirous of knowing about their companys year to shareholders are particularly interested in the future of the company. The financial statements provide the share-holders all the information they require. What is said for the shareholders holds equally good for the prospective investors. e) Labourers : Labourers contribute to the earnings of the company and they are the people who work on raw materials with the aid of capital goods to produce wealth. They are also interested in their wages and salaries, bonus and working conditions. As far as bonus, working conditions and other incentives are concerned, they largely depend on the companys profitability and liquidity. The labourers are also interested in the business as a going concern as it only ensures their permanent employment. f) Consumers and society :

Consumers attempt to find out whether they are being exploited by the producers. Society is interested in an enterprises that result in the increase of employment opportunities, wealth and standard of living of the people. They are also concerned about the enterprises contribution to social welfare, environment and national wealth and prestige. Study of financial statements enables the consumers and the society to gain knowledge on these matters.

1.3 NATURE OF FINANCIAL STATEMENTS

Financial statements are plain statements based on historical recorded facts and figures. They are uncompromising in their objectives, nature and truthfulness. They reflect a judicious combination of recorded facts, accounting principles, concepts and conventions, personal judgements and sometimes estimates.

5 Thus, financial statements are affected by three factors i.e., recorded facts, accounting conventions and personal judgements. a) By recorded facts is meant the data contained in statements which have already recorded in accounting records. Example: Cash in hand and at bank, cost of fixed assets, amounts due from customers and due to suppliers of goods are all recorded facts represented numerically. b) Financial statements are prepared by adhering to certain concepts and established conventions. c) In agreement with the recorded facts and accounting concepts and conventions, the role of personal judgements, estimates and opinions, are to be emphasised especially when two or more alternative procedures are available and which are equally acceptable. Example: an asset could be depreciated under several methods, and inventory could be valued under different methods. Under such circumstances, personal opinion and judgement play an important role as to which of the methods are in closer conformity with the accounting standards and concepts in a particular circumstance or case.

1.4 CHARACTERISTICS OF FINANCIAL STATEMENTS

Financial statements are regarded as indices of an enterprises performance and position. As such, extreme care and caution should be exercised while preparing these statements. Financial statements generally reflect the following observable characteristics: a) b) c) d) e) f) g) h) i) j) k) l) Internal Audience Articulation Historical Nature Legal & Economical Consequences Technical Terminology Summarization and Classification Money Terms Valuation Methods Accrual Basis Estimates and Judgement Verifiability Conservatism

6 a) Internal Audience : financial statements are intended for those who have an interest in a given business enterprise. They have to be prepared on the assumption that the user is generally familiar with business practices as well as the meaning and implication of the terms used in that business. b) Articulation : The basic financial statements are interrelated and therefore are said to be articulated. Example : Profit and Loss account shows the financial results of operations and represents an increase or decrease in resources that is reflected in the various balances in the balance sheet. c) Historical Nature : Financial statements generally report what has happened in the past. Though they are used increasingly as the basis for the future by prospective investors and creditors, they are not intended to provide estimates of future economic activities and their effect on income and equity. d) Legal and economic consequences : Financial statements reflect elements of both economics and law. They are conceptually oriented towards economics, but many of the concepts and conventions have their origin in law. Example : Conventions of disclosure and materiality e) Technical Terminology : Since financial statements are products of a technical process called accounting, they involve the use of technical terms. It is, therefore, important that the users of these statements should be familiar with the different terms used therein and conversant with their interpretations and meanings. f) Summarization and Classification : The volume of business transaction affecting the business operations are so vast that summarization and classification of business events and items alone will enable the reader to draw out useful conclusions. g) Money Terms : All business transactions are quantified, measured and related in monetary terms. In the absence of this monetary unit of measurement, financial statements will be meaningless. h) Various Valuation Methods : The valuation methods are not uniform for all items found in a Balance Sheet. Example : Cash is stated at current exchange value; Accounts receivable at net realizable value; inventories at cost or market price whichever is lower; fixed assets at cost less depreciation.

7 i) Accrual Basis : Most financial statements are prepared on accrual basis rather than on cash basis i.e., taking into account all incomes due but not received, and all expenses due but not paid. Need for Estimates and judgement : Under more than one circumstance, the facts and figures to be presented through financial statements are to be based on estimates, personal opinions and judgements. Example : Rate of depreciation, the useful economic life of a fixed asset, provision for doubtful debts are all instances where estimates and personal judgements are involved. k) Verifiability : it is essential that the facts presented through financial statements are susceptible to objective verification, so that the reliability of these statements can be improved. i) Conservatism : Wherever and whenever estimates and personal judgements become essential during the course of preparation of financial statements, such estimates, should be based moderately on a conservative basis to avoid any possibility of overstating the assets and incomes.

j)

1.5 QUALITIES OF IDEAL FINANCIAL STATEMENTS

Financial statements, to serve the purposes of different users, have to be well prepared and presented. The following qualities are recognised as essential for ideal financial statements: a) Clarity b) Intelligibility c) Objectivity d) Emphasis on materiality e) Precision and brevity f) Systematic classification of heads and items g) Consistency.

1.6 PREPARATION OF FINANCIAL STATEMENTS

Let us now see the contents of financial statements and the methodology of constructing them. 1.6.1 Financial Statements :

Financial statements consist of Revenue Account and Balance Sheet. Revenue Account refers to Profit and Loss

8 Account or Income and Expenditure Account or simply Income Statement. Revenue Account may be split up or divided into Manufacturing Account, Trading Account, Profit and Loss Account and Profit and Loss Appropriation Account, Revenue Account is prepared for a period, covering one year. 1.6.2 Objects of preparing Revenue Accounts :

Manufacturing Account is prepared to find out the total Cost of Goods Manufactured in the period. It will also reveal the cost of material consumed, labour and other manufacturing expenses or costs. Trading Account is prepared to ascertain the trading result i.e. gross profit or gross loss made on sale of goods. Profit and Loss Account is prepared covering the same period to ascertain the net profit or net loss during the year under review, from the usual business. Profit and Loss Appropriation Account is prepared wherein all other items of expenses and appropriations are reflected to reveal the net profit or net loss. Generally this includes items related to earlier years or charge of interest or salary payable to proprietor or partners. Sole proprietary concerns, partnership firms and companies prepare the above mentioned accounts. In case of companies, the Revenue Account i.e. profit and loss account is to be prepared taking note of the requirements of Schedule VI Part II to the Companies Act refers to profit and loss account only. 1.6.3 Manufacturing Account : A manufacturing concern may prepare the Manufacturing Account and Trading Account is prepared separately. But in small manufacturing concerns, only one combined account known as Manufacturing and Trading Account may be prepared. The distinction between a Trading Account and a Manufacturing Account is that a Manufacturing Account deals only with all costs and expenses of manufacture. Trading Account deals only with finished goods and expenses relating to them showing the cost of manufacture. Finished goods are those goods which are ready for sale. Such goods may be manufactured in the concern or may be purchased from outside. The cost of goods manufactured as shown by the Manufacturing Account, is transferred to the Trading Account.

9 The purpose of preparing the Manufacturing Account, as already mentioned, is to ascertain the cost of goods manufactured. It should, therefore, include all the expenses relating to manufacture of goods, i.e. purchase of raw materials, i.e. expenses such as carriage, freight etc. and all others expenses incurred to convert raw materials into finished goods. To give a clear idea the elements of cost are enumerated under various heads like prime cost, factory cost etc. Manufacturing or Production A/c is prepared to describe the various elements of cost in creating the finished goods. Cost Elements : There are three major elements of production cost viz. a) Direct materials, b) Direct labour, and c) Factory overheads direct material and direct labour constitute direct cost and the latter constitutes indirect cost. a) Direct Materials : It refers to such materials which are incorporated into the physical units of product manufactured. It is readily and definitely ascertainable. b) Direct Labour : It refers to the labour performed in physical contact with the product. It is the amount of wages paid to the workers who are engaged in converting raw materials into finished goods. It can be easily ascertained. c) Factory or Production overhead : It is not easily assignable to a particular product. It is an indirect cost and includes : i) ii) Indirect labour (foremen, Works manager, Storekeeper etc.) Indirect materials (factory supplies)

iii) Depreciation of factory Building, Plant and machinery. iv) Amortization of parents. v) Insurance on building, machinery and materials etc. vi) Maintenance of factory, and vii) Water, heat, light and parts used in factory.

10 Important point regarding Manufacturing Account : a. Stocks : The distinguishing feature of a manufacturing concern is the type of stock held. A trading concern holds only stock of finished goods. A manufacturing concern holds stock of materials, semi finished or work in process as well as finished goods. b. Direct Material Consumed : It is customary to show in the Manufacturing A/c the value of raw materials consumed for manufacturing goods during a particular period. It is computed as follows :
Rs. Opening stock of Raw Materials Add : Purchase of Raw Materials Add : Carriage or Freight Inwards Less : Rejected or returned Materials Less : Closing stock of Raw Materials XX XX XX XX XX XX

c. Work in Process : This represents materials put in process which is not completely converted in Finished Goods. Opening and closing works in process are shown in the Manufacturing A/c on Debit side and Credit side respectively. However, their figure (difference) appears on the debit side either as an addition or deduction. d. Sale of Scrap : In manufacturing operations there may be certain scrap which may or may not have a sale value. In order to find out correct cost of manufacturing the goods it is necessary to credit manufacturing A/c by the amount of scrap. e. Factory Expenses : These expenses include for processing or manufacturing goods i.e. converting raw materials into finished goods. These include expenses like (1) Power and Fuel, (2) Rent, Rates, Taxes, Insurance, Repairs and Depreciation on assets used for manufacture, (3) Factory Stores and Spares, (4) Factory Supervision.

11 1.6.4 Balance Sheet : Balance Sheet defined : It is not possible to define the whole Balance Sheet except in vague terms. The definition of the balance sheet given by the American Institute Certified Public Accountants is as follows : Balance Sheet is a list of balances in the asset, liability or net worth accounts. This definition is accurate but not meaningful. Accounting Standards Board, India has defined balance Sheet as a statement of the financial position of an enterprise as at a given date which exhibits its assets, liabilities, capital, reserves and other account balances at their respective book values. A more meaningful definition of balance Sheet will be as under: Balance Sheet shows the sources from which funds currently used to operate the business have been obtained (i.e. liabilities and owners equity) and the types of property and property rights, in which these funds are currently locked up (i.e. assets). Balance Sheet may be considered as a summarised sheet of balances remaining in the books of account, after the preparation of the profit and Loss Account. Thus a Balance Sheet can be rightly called as a statement of position as it now contains assets and liabilities generally. It is a document of the financial position of an enterprise, as it indicates what the business owns and what it owes on a particular date. The things that the business owns are called Assets and the various sums of money that it owes are called liabilities (including that of the owners). The term Balance Sheet comes from the fact that the total assets must be equal to total liabilities, they balance each other. The liabilities side shows the various sources from which money made available for the assets, and the assets side shows the way those funds are employed in the business. While preparing final accounts, all nominal accounts from the trial Balance are closed by transferring them to Trading and Profit and Loss Account. The other account balances, not transferred to Revenue Accounts, will be either personal or real accounts A collection of all these balances is known as a Balance Sheet. So, we can rightly term the Balance sheet as a sheet of balances. As we have seen earlier, a balance Sheet is so called because it's two aides must always balance, i.e., the assets

12 must be equal The Liabilities plus owners' funds. This can be expressed in the form of an equation. Assets = Liabilities + Net Capital A = L + NC (Capital + Reserves Fictitious Assets) The entire balance sheet rests on the above equation. Thus, the above equation is called the Balance Sheet Equation or Accounting Equations.

Fig. 1.3 The Balance Sheet is given various titles as follows : 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. General Balance Sheet. Statement of Financial position. Statement of Financial Condition. Statement of Asset and Liabilities. Statement of Resources and Liabilities. Statement of Availability of Resources and their application. Statement of Assets, Liabilities and Capital. Statement of worth. Statement of Net worth. Financial statement, etc.

13 Thus, Balance Sheet may be rightly called as the Statement of Assets and Liabilities that shows the financial position of a business enterprise on a particular date. All items appearing in Balance Sheet are either capital receipts or capital payments or personal accounts and balance of undistributed profits. Why Balance Sheet Balance : Balance sheet is a statement of assets and liabilities. Are business transaction are recorded in the books of accounts under the double entry system recording both the credit and debit aspects of each and every business transaction. The total of all debits must be equal to the total of all credit and therefore, the resulting balance also must be agree. This can also be explained thus : since the liabilities side (left hand side) on the balance sheet shows the sources of fund and the assets side (right hand side) show the employment of funds the total assets must be equal to total liabilities. Function of the Balance Sheets : The three important function performed by balance sheet are : a) It gives the summery of the firms assets and liabilities. b) It is a measure of the firm liquidity. c) It is measure of the firms solvency. Format of Balance Sheets : A balance sheet may be presented in various forms. They are : 1. Conventional format 2. Vertical format 3. Step format. 1. Conventional Format : The conventional from or the customary form of balance sheets is also called horizontal form or account form or T form of the balance sheets. It shows the assets i.e. debit balance on the right and side and liabilities i.e. the credit balances and owners equity on the left hand side. But, in countries like the U.S. and Canada, the assets (debit items) are shown on the left hand side and liabilities (credit items) on the right hand side of the balance sheet. This method of presenting the balance sheet is also known as balance array form.

14 Arrangement of assets and liabilities : In the horizontal form of balance sheet presentation, the assets are shown either in order of liquidity or in order of permanence. The arrangement in order of liquidity shows the order in which the assets could be realized to satisfy business liabilities and the liabilities in the order of earliest, relative maturity or discharge. The order of liquidity is adopted by concern whose operations are mostly cash like banking companies, investment and finance companies, etc. The order of permanency indicates the relative degree of permanency of assets and liabilities .mostly ,manufacturing and trading companies adopted this order of showing fixed assets first followed by less fites and current asset and on the liabilities side , the liability to be paid last as the first , followed by relatively less permanent liabilities. A. in order of liquidity Liability Current Liability Long term liability Capital & Reserve Assets Current Assets Fixed Assets Other Assets

B. in order of permanence Capital & Reserve Long term Liability Current Liability Fixed Assets Current Liability Other Assets

1.7 VERTICAL FINANCIAL STATEMENT STATEMENTS OF A PROPRIETOR:

1.7.1 Income statement Income statement for the year endedRs. Net sales Cross Sales Less : Returns Rs.

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Less : Cost Of Goods Sold Opening Stock Purchase Less : Return Carriage Import Duty Doctor Fright Wages and Salaries Motive Power Depreciation on Machinery Less : Closing Stock Gross Profit Less : Operating Expenses A. Office and Administration Expenses : Staff Salaries Rent, Rates and Taxes Unproductive Wages Repairs Insurance Printing and Stationary Water & Electricity Office Cleaning Postage and Telephones Staff Welfare Expenses Conveyance Charges Misc. Expenses Depreciation on Office Bldg. & Furniture B. Selling Expenses : Carriage Outwards Commission Allowed Travelling Expenses Entertainment Expenses Sales Promotion Expenses Advertising Bad Debts Warehouse Expenses C. Finance Expenses : Cash Discount Bank Charges

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Bad Debts Provision for Discount Provisions for Bad Debts Interest on Loans Net Operating Profit / Loss Add : Non Operating Income Interest Earned Misc. Incomes Profit on sale of Fixed Asset Interest on Loan given to Outsiders Dividend on Investments Compensation received as per Court Order Less : Non Operating Expenses & Losses Loss on sale of Fixed Asset Loss by Fire Penalty Net Profit before Tax Less : Income Tax Net Profit after Tax

1.7.2 Vertical Balance Sheet of a Sole Proprietor Vertical Balance Sheet as on ________
Rs. SOURCES OF FUNDS : Proprietors Funds Capital Add : Net Profit Less : Net Loss Add : Additional Capital Introduced Add : Interest on Capital Less : Drawings Interest on Drawings Reserves General Reserve Capital Reserve Loan Fund Secured Loans Unsecured Loans TOTAL Rs.

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APPLICATIONS OF FUNDS : Fixed Assets Goodwill Land & Building Plant & Machinery Furniture & Fixtures Vehicles Patents & Copyrights Current Assets Stock of goods Debtors Bills Receivable Marketable Investments Cash & Bank Prepaid Expenses Less : Current Liabilities Creditors Bills Payable Bank Overdraft Expenses payable Working Capital TOTAL

18 Balance Sheet as on 31st march, 2009

Rs. SOURCES OF FUND : Own Fund Capital Fund Add : Surplus Add : Donations Funds Prize Trust Funds Investment Fluctuation Fund TOTAL APPLICATIONS Of FUND : Fixed Assets Buildings Furniture Library Books Investments Prize Fund Investments General Investments Current Assets Debtors Outstanding Subscriptions Interest accrued Cash Bank Prize Trust Bank Balance Prepaid Insurance A Current Liabilities Sundry Creditors O/s Salaries Subscriptions in advance B Working Capital (a b) TOTAL 12,500 1,200 350 14,050 125 3,18,970 17,875 2,00,000 3,000 2,400 450 200 7,500 375 250 14,175 2,17,875 73,125 11,000 16,845 1,00,970 18,250 20,000 38,250 3,18,970 2,43,825 20,895 16,000 2,80,720 Rs.

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1.8 VERTICAL STATEMENTS FOR COMPANIES:

1.8.1 Vertical Balance Sheet : Balance Sheet as on _________
Rs. SOURCES OF FUNDS I. SHAREHOLDERS FUNDS A. CAPITAL Equity Share Capital Preference Share Capital Less : Unpaid Calls Add : Forfeited Shares B. RESERVES & SURPLUS Capital Reserve Capital Redemption Reserve Securities Premium General Reserve Sinking Fund Dividend Equalisation Reserve Workmens Compensation Fund Revaluation Reserve Development Reserve Other Reserves P&L A/c Credit Balance LESS : FICTITIOUS ASSETS : P&L A/c Debit Balance Preliminary Expenses Share Issue Expenses Discount on issue of Shares and Debentures Underwriting Commission Formation Expenses Deferred Revenue Expenditure OWN FUND / NET WORTH II. LOAN FUNDS A. SECURED LOANS Debentures Bonds Bank Loans Loans from Financial Institutions Other Loans Rs.

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B. UNSECURED LOANS Debentures Bonds Bank Loans Loans from Financial Institutions Public Deposits Loans from Directors Other Loans TOTAL APPLICATIONS OF FUNDS I. FIXED ASSETS TANGIBLE Land and Building Leasehold Property Plant and Machinery Furniture & Fittings Vehicles Live Stock Railway Sidings (At Cost less Depreciation) INTANGIBLE Goodwill Patents Copy rights Trade Marks & Designs II. INVESTMENT Govt. Securities Shares Debentures Immovable Properties Capital of Partnership Firms Long term Loans given Sinking Fund Investments III. CURRENT ASSETS, LOANS ADVANCES QUICK ASSETS Cash & Bank Debtors (Net) Bills Receivable Marketable Investments &

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LOANS & ADVANCES Other Current Assets Inventory Prepaid Expenses Advance Tax Advance for Goods LESS : CURRENT LIABILITIES QUICK LIABILITIES Creditors Bills Payable Advances Received Expenses Payable Accrued Interest Provision for Taxation Provision for Dividend Unclaimed Dividend OTHER LIABILITIES Bank Overdraft NET CURRENT ASSETS/WORKING CAPITAL TOTAL

1.8.2 Understanding Corporate Balance Sheet : 1. Assets : a. Fixed Assets : Fixed Assets are called long-term assets. They do not flow through the cash cycle of business within one year or the normal operating cycle. They are used over several periods. They are major sources of revenue to the business. They do not vary day in and day out due to routine business transaction. They are intended for long term use in the business. They are called bundle of future services or Sunk Costs. The group of fixed assets consists of the following : a) b) c) d) e) f) Land, Buildings, Plant and Machinery, Vehicles, Furniture & Fittings, Railway sidings,

22 g) Live stock h) Development of Property i) Intangible Assets such as patents, copyrights, goodwill, etc. Classification of Fixed Assets : a) Tangible movable assets; b) Tangible immovable assets; and c) Intangible assets. a) Tangible movable assets are the assets which can be seen, touched and moved from one place to another place. Plant and Machinery, furniture and fixtures, transportation equipments etc. are tangible movable assets. b) Tangible immovable assets are the assets which can be seen and touched but cannot be moved from one place to another place. Such assets include land, buildings, mines, oil wells, etc. c) Intangible assets are the assets which cannot be seen and touched. However, their existence can only be imagined such as patents, trade marks, copyrights, goodwill, etc. Their existence is very important for the business. Intangible assets have several characteristics. Fixed Assets = Tangible Assets + Intangible Assets Characteristics of an Intangible Assets : Intangible Assets : a) enables business managers to attain the goals of profitability, b) is long term in nature, and whose benefit is available to the business for more than the current accounting period, c) has a determinable acquisition cost, except in the case of self generated assets. d) is used in conducting business activities, and e) provides certain rights or privileges to the business. Presentation of Fixed Assets : Gross Block Less Provision for Depreciation Net Blocks

23 b. Wasting Assets : Fixed assets normally get depreciated due to constant use, wear and tear, and efflux of time. Mere passage of time is sufficient for certain fixed assets to lose their values. But there are certain fixed assets known as wasting assets like mines, quarries which do not depreciate due to the passage of time, but depreciation in their value is caused by extraction or depletion. Example : Forests, quarries, mines, oil wells, etc. If there is no extraction from these assets, their values will not decrease but still they can be depreciated under certain special circumstances. The depreciation of these assets is directly related to the output. They are depreciated under Depletion method. The acquisition cost of the asset is reduced in the same proportion as the actual output bears to the quantity of mineral contained in the asset. Alternatively, the depletion cost per unit is calculated and every year it is multiplied by the quantum of output and the amount of depletion is computed. Valuation of Fixed Assets : Most fixed assets are valued at cost. Certain assets depreciate or decrease in value due to usage. The cost of an assets includes its purchase price plus all other expenses necessary or incidental in acquiring and preparing the asset to bring it into usable or working condition. To illustrate, the cost of a fixed asset will include : a) Invoice price, b) Sales tax, c) Cost of shipment and delivery charges to purchaser, such as freight, insurance, customs duty and clearing charges, d) Cost of insurance during installation, e) Installation cost, f) Cost of materials used to set up or operate the asset, and g) Cost of material, labour etc., required to conduct trial runs of the equipment. The cost of an asset is to be written off during the life of the asset on a graduated basis or on time basis or on use basis.

24 Thus, fixed assets will appear in the balance sheet at cost less depreciation. Since fixed assets are not acquired for resale, the expected realizable value of such assets is not taken into account while valuing them for balance sheet purposes. 2. Investments : Investments may be short-term. Short-term investments are marketable securities and they represent temporary investments of idle funds. These investments can be disposed off by the company at its own will at any time. Investments are shown at cost. Cost includes brokerage, fees and all other expenses incurred on acquisition of investments. However, the market value is shown by way of a note. Long-term investments are held for a long time. They are required to be held by the very nature of business. Here the intention of the investor is to retain the securities for a longer period of time. For example, a company engaged in generating electricity may be required to hold the bonds of the Electricity Board. These bonds are retained by the company so long as the company uses electric power. As per Schedule VI of the Indian Companies Act 1956, investments are shown separately, showing the nature of investments and the mode of valuation of various classes of securities. Clear cut distinction should be made between : a) Investments in Government or Trust Securities. b) Investments in shares, debentures or separately fully paid and partly paid shares. bonds showing

The interest of Directors in companies and firms in which investments are made must be stated clearly. Trade investment means an investment by a company in shares and debenture of another company for the purpose of promoting the trade or business interests of the first company. c) Investments in immovable property. (i.e. property held as an investment and not for business purposes) d) Investments in capital of partnership firms. In respect of investments in shares and debentures, they should be shown separately as fully paid and partly paid, and the different classes of shares. Trade investments and other investments should also be shown separately. While preparing the balance sheet, the quoted and unquoted investments and the market value of quoted investments should be shown clearly, as given in the statement below :

25 Quoted investments refer to securities in respect of which permission has been granted to deal in a recognised Stock Exchange. Other investments should be considered as unquoted investments. Note : The interest accrued on investments should be shown under the heading current assets and not under this head. Investments whether Fixed Assets or Current Assets : The answer to this question lies in the classification of investments. Investments, for balance sheet purposes can be classified into long-term investments and marketable investments. This basis of distinction, between long-term and marketable investments, depends on the nature and purposes of such investments. Long term investments are those investments which satisfy any of the following conditions : a) They do not meet the test of ready marketability. b) They are required to be held by the business by the very nature and conditions of the business. Example: Sometimes, an export house is required to subscribe to the shares of the concerned Export Promotion Council. c) They are made to foster operational relationships with other entities. Example: An automobile manufacturing company may subscribe to the share capital of a tyre manufacturing entity. d) Investments may be made to exercise a degree of control over a corporate entity. Example: Recently, in 1982, Modi Rubbers Ltd., acquired controlling interest in Firestone Tyre Company. e) They may be made in order to promote and float a new company. Before issuing the shares of a new company, the promoters may acquire a reasonable percentage of the total interest in the company so that it may create a favourable impression in the minds of the investing public. f) They may be used to develop closer ties with major suppliers or retail outlets.

26 g) They may be acquired to diversify and broad-base the operations of a company. Investments which satisfy any of the above conditions are termed as Long term Investments and classified as fixed assets. Long term investments are Fixed Assets. Marketable Investments are those investments which are acquired by the company by employing its surplus funds or cash temporarily. These investments can be disposed off by the company at its free will and thus convert it into cash as and when the need arises. Hence, these investments are considered as good as cash , and are often called secondary cash resources. Short term investments are grouped under Current Assets. 3. Current Assets and Quick Assets : Current Assets : Current Assets include cash, assets that are likely to become or converted into cash, or assets that are otherwise consumed in the balance sheet date (or within the normal operating business cycle, if it is longer than one year) and the cash thus generated is available to pay current liabilities. Current assets are not intended for long-term use in business. Current assets represent employment of money by the company on a short-term basis. They circulate within the group. For example, cash becomes raw material when material is purchased, material becomes finished goods, finished goods become cash or debtors when sold and so on. Usually, the following assets are classified as current assets : Current Assets include : Stock 1. Stock of raw materials 2. Stock of work in progress 3. Stock of finished goods 4. Stock of packing materials

27 Debtors Gross Less Provision for doubtful debts Cash and Bank 1. Cash on hand 2. Bank Balance Loans and Advances 1. to subsidiary 2. to firms Marketable Investments Other Current Assets: 1. Interest accrued on investments 2. Loose Tools 3. Bills of Exchange 4. Prepaid expenses, advance payment of tax 5. Balances with customs, port, trusts, etc. Current Assets = Stock + Debtors + Cash & Bank + Loans & Advances + Marketable Securities + Other Current Assets In fact, total current assets are known as Gross Working Capital. Current assets less current liabilities are known as net working capital. Quick Assets : These assets are known as near cash assets. In other words, quick assets are those which can be converted into cash quickly. Therefore, they are also known as liquid assets. Cash and bank balances are the most liquid assets. Debtors and cash advances can be converted into cash at a short notice. Therefore, they are also regarded as quick assets. Marketable investments, if can be converted into cash, fall into the category of quick assets. Inventory does not fall in this category of quick assets, since it cannot be converted into cash quickly, as material is to be converted into saleble goods and then they should be sold. If sale is on credit, there is a further delay in realization. Expenses paid in advance do not satisfy the criteria of quick assets. They cannot be converted into cash. They can be received in the form of services. Quick Assets = Current Assets Inventory Prepayments

28 Valuation of Quick Assets : Quick assets, as we have seen earlier, include cash and other assets that are quickly converted into cash. Quick assets are current assets less inventories and prepaid expenses. The quick assets are realized in cash in a very short time. Some of the quick assets may be already in realized form as cash and bank balance. As such, the quick assets should be shown at their realizable value. For Example, Debtors and Bills Receivable are shown less any provision for doubtful debts. In order to arrive at a conservative valuation of these assets, when there are any chances of bad debts or losses in their realization, a provision has to be made to take care of the same and the provision should be shown by way of deduction from the respective asset. Sometimes, it is possible that the realizable value of certain quick assets, like marketable investments, may be more than their cost. Under those circumstances, keeping in line with the convention of conservatism, the investments should be valued at cost or market value whichever is lower. However, it is in agreement with the convention of disclosure, that a note should be provided showing their market value. An illustrative extract of Balance Sheet is provided below : Balance Sheet as at_______ Assets Investments (at cost) (Market value Rs.7,50,000/-) Rs. 5,00,000

If the market value of the marketable securities is lower than the cost, a provision be made to take care of the loss. Nature of Current Assets : 1. Cash on hand : Cash in the balance sheet includes coins, currency, cheques, pay orders, money on deposit in banks, postage stamps, stamp papers, etc. 2. Bank balances : As per the requirements of Indian Companies Act, 1956, bank balance has to be disclosed in the balance sheet as under :

29 Bank Balances: a) With scheduled banks. b) With others. Information has to be disclosed about the balances with scheduled banks on Current Accounts, Call Accounts and Deposit Accounts. In the case of non-scheduled banks, the names of the bankers, the balances lying with each such banker on Current Accounts, Call Accounts and Deposit Accounts and the maximum amount outstanding at any time during the year from each banker, and the nature of interest of any director or his relative of the company in each of them have to be disclosed. The Act has not made any distinction between nationalized and non- nationalized banks. All nationalized banks are scheduled banks. Scheduled banks are those banks whose names appear in the schedule released by the Reserve Bank of India. 3. Sundry Debtors : The ability to buy now and pay later is an accepted fact in business. Selling on account is one of the ways of attracting customers. This creates debtors or accounts receivable. The total amount receivable from debtors should be shown under this heading. The provision for doubtful debts should be deducted from debtors in the balance sheet. Debtors should be classified into two categories as debtors due for more than six months and debtors less than six months. Debtors should also be classified according to their nature and reliability. Debts due by directors or other officers of the Company or any of them , either severally or jointly with any other person, or debts due by firms or private companies respectively, in which any director is a partner is to be separately stated. Debts due from other companies under the same management have to be disclosed with the names of the companies. The maximum amount due by directors or other officers of the company, at any time, during the year, to be shown by way of a note. Debtors appear in the balance sheet as under :

30 Illustration 8 : Balance Sheet as at _____

Rs. Considered Good : Over six months Unsecured Others : Secured Unsecured Considered Doubtful : Less : Provision for Doubtful Debts 28,000 18,00,000 6,00,000 2,00,000 26,28,000 2,00,000 Rs.

24,28,000

Inventories or Stock-in-Trade : Definition and Meaning : In simple words, inventory may be defined as the aggregate of all those items of materials and goods which are held for sale, or for production or for processing. Inventory also includes the goods sent on consignment and remaining with the consignee, goods-intransit, goods sent on sale or return basis and unapproved (reduced to cost), etc. If there are any damaged or obsolete items, they should be excluded from the stock or adequate provision should be made for the same. Stock should be valued at their cost or realizable value whichever is lower. Inventory includes the following : a) Raw Materials, b) Work-in-progress, c) Consumable stores, d) Finished Goods and Merchandise, e) Stores and spare parts, f) Loose tools. Impact of Inventory on Financial Statements : Impact on Balance Sheet : Inventory values have direct impact on current assets and the financial position of the concern. Balance Sheet and the result of operations reflected by Profit and Loss Account will not be true and fair, if inventory is overvalued, since this will lead to over statement of profits. The overstatement of profit in the Profit and Loss Account liability side of balance sheet will be overstated. Under-valuation of inventory leads to understatement of profit.

31 Impact on Income Statement : Valuation of Inventory will affect the cost of goods sold. Cost goods sold is computed as under : Goods available for Sale = Opening Inventory + Purchase during the period Returns Cost of Goods Sold = Goods available for Sale Closing Inventory Cost of goods sold has direct impact on net income. If closing inventory is over-stated, cost of goods sold will be understated and income will be over-stated. If the closing inventory is understated, cost of goods sold will be over-stated and net income will be under-stated. If opening inventory is over-stated, cost of goods sold will be over-stated, and income will be under-stated. If opening inventory is under-stated, cost of goods sold will be under-stated and income will be over-stated. Thus under-valuation or over-valuation of stocks will invariably affect profit or loss and therefore, the Profit and Loss account will not be true, fair and objective. Valuation of Inventory : The above paragraph shows clearly that the value of inventory has strong influence on financial statements. Therefore, inventory should be properly valued. The generally accepted principle of valuation of inventory is cost or market price whichever is lower. This principle is based on the convention of conservatism. Cost of inventory may be computed under FIFO or average cost methods. In financial statements, the method of valuation of inventory should be disclosed. Illustration 9 : Stocks, stores & spare parts : (As Valued & Certified by the Management)
2009 (Rs) a) Stores and Spares (at Cost) b) Stock in Trade : i) Finished Goods (at cost or Estimated Realisable Value, whichever is lower) ii) Saleable Waste (at Estimated Realisable Value) c) Raw materials (at Cost) 13,00,000

10,00,000 2,00,000 50,00,000

32 Floating Assets : Floating Assets are those current assets which are produced or purchased and held in possession with a view to convert them into cash in the normal course of business. They are called floating assets because their balances keep on changing. They do not remain same or fixed. Example : Stock in trade, raw materials, semi finished goods or work-in-progress, sundry debtors, bills receivable etc. Hidden Assets : There are cases, where certain valuable assets are not disclosed in the Balance Sheet, though they exist and the business benefits from them. These assets are termed as Hidden Assets. They may consist of assts which through continue to exist physically either written off completely (charged to revenue) in the year of acquisition or subsequently and therefore do not appear in the balance sheet. They may consist of assets which are generated or created over the period of time for which no specific acquisition cost is incurred like in the case of goodwill generated by running business. The examples of such hidden assets are : a) Machinery in respect which depreciation is allowed to be claimed for @ 100% in the year in which it is put to use. b) Scientific Research assets, which are also allowed to be written off completely under the income Tax Act, in the year in which they are put to use. c) Technical know-how, built up by expenditure on research and development over the years. Normally, R & D expenditure are charged to revenue. d) The value of secret processes or formulae developed. e) Options of lease. f) Cost of licences obtained which are charged against revenue. g) Copyrights. h) Exclusive trading agreements. i) j) Patents, trade marks and brand names. Goodwill created.

It is considered normally to be advantageous to have hidden assets since these assets act as shock- absorbers during periods of adversity. It is no doubt that the position of the business entity is

33 strengthened by these hidden assets, but one should not overlook the fact that what is reflected in the Balance Sheet is not the real financial strength of the organization. 4. Loans and Advances : Loans and advances given are current assets. It includes different types of advances such as advances against salary, advances against machinery, advances to subsidiary, prepaid expenses on account of rent, taxes, insurance, etc. The item, Current Assets, Loans and Advances is divided into two parts : A. Current Assets, and B. Loans and Advances. This may appear as under : Illustration 10 : Balance Sheet as at 31st March, 2009
Assets Loans and Advances : (Unsecured and Considered Good) Advances recoverable in cash or kind or for value to be received : Suppliers Others Duty Drawback Recoverable Deposits Prepaid Expenses Tax deducted at Source Rs. Rs.

10,00,000 2,00,000 1,00,000 2,00,000 50,000 50,000 16,00,000

5. Fictitious Assets : Fictitious Assets are really not assets but debit balances not charged to revenue. These assets cannot be realized or converted into cash. Hey are only expenses incurred (debit items) shown on the assets side of the Balance Sheet. The reason behind such a procedure is that these expenditures could not be suitably charged to the profit and loss account of the year in which they were incurred. Fictitious Assets are not real and are shown in the balance sheet of a company under Miscellaneous Expenditure (to the extent not written off or adjusted) on the Assets side.

34 The examples of fictitious assets are : a) Preliminary expenses. b) Brokerage on issue of shares and debentures. c) Discount on issue of shares and debentures. d) Share or debenture issue expenses. e) Heavy Advertisement and Publicity expenditure. 6. Miscellaneous Expenditure : As we have seen earlier under Fictitious Assets, Miscellaneous Expenditure includes items which satisfy the condition of an asset but do not fit into the concept of fixed assets, investments or current assets. This category includes : a) b) c) d) e) Preliminary Expenses, Commission and Brokerage on issue of shares, Discount on issue of shares, and Development expenditure not adjusted. Interest paid out of capital during construction.

These expenses are to be shown in the balance sheet to the extent to which they are not written off. If any of these expenditures is written off, it is charged to the Profit and Loss Account of that year. Profit & Loss Account : debit balance (to the extend not adjusted) : The debit balance of Profit and loss Account after deduction from uncommitted reserves, i.e., free reserves, if any, should be shown separately. Liquidity of Assets : Liquidity means easy convertibility into cash. Though ultimately all assets are converted into cash, the term liquidity refers not only to the nature of assets but also to the purposes of holding the assets. Thus, fixed assets which are not meant for re-sale with a view to make profit-unlike stock of finished goods are less liquid; Current assets are more liquid, as they are converted into cash within a very short time. Assets are normally arranged in order of permanency i.e., from least liquid to most liquid.

35 But, sole traders normally prefer to arrange their assets in the order of liquidity i.e., from most liquid to least liquid. 1.8.3 Liabilities : The term liability when used in accounting, means a debt. A debt is something that a person or an organization owes to another person or organization. A liability is recognised when a legally binding obligation is created. In other words, Liabilities are the claims of outsiders against the business. It may also be said that liabilities are various amounts that a business owes to outsiders other than the owners. As we have discussed in the first chapter, the business is a separate entity from the proprietors. From this point of view, the funds belongings to the proprietors are also a liability to the business; hence, capital appears on the liabilities side of the Balance Sheet. But the dues to the proprietors will be paid after all other external liabilities are paid off. Technically speaking, all liabilities shown in a balance sheet are claims against all assets shown in it. But, there may be certain cases where a liability has a claim against a specific asset. Even under such circumstances, the liabilities are shown separately, not as a deduction from the specific assets. Example: if machinery worth Rs.50,000/- is purchased on cash payment of Rs.35,000/- and the balance to be paid at a later date, the balance sheet would show Rs.50,000/- against machinery on the assets side and liability of Rs.15,000/- on the liability side. The balance sheet would not show Rs.15,000/- the difference between Rs.50,000/- the value of the asset and Rs.35,000/- the cash payment. Similarly, when 12% mortgage Debentures of Rs.50,00,000/- are issued against the security of Land and Buildings worth Rs.1 Crore, the Debentures will appear on the liabilities side of the balance sheet at Rs.50 Lakhs and Land and Building at Rs.1 Crore on the assets side. a) Debts and obligations. b) Estimates of future debts arising out of past dealings. c) Adjustments to the estimated of future liability for taxes required to apportion actual tax demands over the periods for which taxes are due. d) The constituents of owners equity.

36 Classification of Liabilities : The liabilities of an enterprise may be classified into three categories a) Permanent Funds or Proprietors Funds. b) Semi-permanent Funds or Long-term Borrowings. c) Current liabilities and Provisions.

A specimen of the liabilities side of a balance sheet is shown below, for a clear understanding of the above classification. Illustration 11: AB Ltd. Balance Sheet as at 31st December, 2009
Liabilities Proprietors Funds : Share Capital Reserves Long term loans : 15% Debentures 12% Bank Loan Current Liabilities & Provisions: Bank O/d Creditors Provision for Tax 50,000 15,000 30,000 10,000 Rs. Assets Sundry Assets 65,000 Rs. 1,30,000

40,000

5,000 12,000 8,000

25,000 1,30,000 1,30,000

Let us now discuss the liabilities side in detail. 1.8.4 Proprietors Funds :

These are the funds provided by the proprietors or the shareholders. In case of a sole trading concern, the sole trader is the single proprietor of the business. In case of partnership firms, partners are the proprietors and in case of companies, the shareholders are the proprietors. Proprietors fund represents the interest of the proprietors in the business. This is the amount belonging to the proprietors. Proprietors fund is also called as Proprietors Equity, Owners Funds, Owners Equity, or

37 Shareholders Funds. This is also known as the Net Worth of the business. Owners Equity refers to the claim of the owners and it is made up of: Contributions by the proprietors by way of : Share Capital (May be Equity Share Capital only or Equity and Share Capital) Plus : Reserves Plus : Profit and Loss Account (Cr.) Balance (Surplus) Less : Accumulated Losses Less : Fictitious Assets (If any) Proprietors Funds are regarded as shock absorbers. Any reduction in the value of assets of the company is absorbed by proprietors funds. They provide the margin of safety to the creditors. So long as the reduction in assets does not exceed proprietors funds, creditors have no problem as they can expect full payment of their dues. Owners equity or proprietors funds increase either through fresh investments by the owners or by an increase in the earnings retained i.e., profits not distributed. Retained earnings is the difference between the total earnings to date and the total cash appropriations (dividends, etc,) to date. In other words, retained earnings is that part of the total earnings which have been retained for use in the business. Decrease in owners equity is caused either by withdrawals of cash or assets by the owners or through losses suffered by the business from unprofitable activities. The presentation of proprietors funds in balance sheet depends on the type of business organization and statutory requirements. This can be illustrated as under : 1.8.5 Share Capital : Share capital is the amount that is raised by a company from the public at large, through the issue of shares. There are different concepts of share capital from the legal and accounting points of view. Preference

38 The following chart details the different concepts of capital : Companys Share Capital Authorised Capital (Registered or Nominal Capital)

1. Issued Capital

2. Unissued Capital

1. Subscribed Capital

2. Unsubscribed Capital

1. Called up Capital

2. Uncalled Capital

3. Reserve Capital

1. Paid up Capital

Calls-in-Arrears or Calls Unpaid

A. Authorised Capital : Authorised Capital is the maximum capital a company can raise as mentioned in the Memorandum of Association under its Capital Clause. It is also called as the Registered Capital or Nominal Capital of the Company. B. Issued and Unissued Capital : A company usually does not need the entire registered capital. The capital may be raised as and when necessary. Only a part of the authorised capital may be issued at a time. Issued capital is that part of the authorised capital; which is actually offered to the prospective investors for subscription. Therefore, the issued capital may be equal to or less than the authorised capital. The balance of the authorised capital which is not issued is called the unissued capital. Some authors prefer to define issued capital as the nominal amount of that part of authorised capital which is allotted by the company and includes the shares taken up by the subscribers to

39 the Memorandum of Association. This definition is to keep in line with schedule VI part I of the Indian Companies Act, 1956. C. Subscribed Capital : The issued capital may not be fully subscribed by the public. Subscribed capital is that part of the issued capital which has been subscribed or taken up by the public i.e., aggregate nominal value of the shares for which applications are received from the public. Therefore, the subscribed capital may be equal to or less than the issued capital. D. Called up Capital Uncalled Capital : The company may not need the entire capital subscribed by the public. The company, therefore, may collect the capital in several installments. The called-up capital is that portion of the subscribed capital which has been called or demanded by the company to be paid. The capital that is not demanded from the shareholders is called uncalled capital. E. Paid up Capital : Paid up capital is that part of the called up capital which has been actually paid by the members. The paid-up capital is the called-up amount less calls not paid. (calls unpaid or calls-inarrears). F. Reserve Capital : A company may determine by a special Resolution that any portion of its subscribed capital shall not be called up except in the event of and for the purpose of the company being wound up. Such portion of the subscribed capital not to be called except for the said purpose is known as Reserve Capital. It is that part of the uncalled capital which may only be demanded on winding up or liquidation, but not when the company is a going concern. Reserve Capital is different from Capital reserve, reserves and reserve funds, which are profits of a company set aside or provided for emergencies or to be utilized for a particular purpose.

40 Y Ltd. Balance Sheet as at 31st December, 2009

Rs. Share Capital : Authorised : 45,00,000 Equity Shares of Rs.10/- each. 1,50,000 Preference Shares of Rs.100/- each. Issued : 37,00,000 Equity Shares of Rs.10/- each. 40,000 9.5% Redeemable Cumulative Shares of Rs.100/- each.

4,50,00,000 1,50,00,000 6,00,00,000 3,70,00,000

Preference 40,00,000 4,10,00,000 3,70,00,00

Subscribed : 37,00,000 Equity Shares of Rs.10/- each fully called up. (of the above 10,000 Equity Shares of Rs.10/- each allotted as fully paid up in pursuant to a contract to vendors of machinery, for consideration other than cash) 40,000, 9.5% Redeemable Cumulative Preference Shares of Rs.100/- each fully called. Less: Calls unpaid (Other than Directors)

40,00,000 4,10,00,000 15,000 4,09,85,000

Note : If any amount is due from Directors remaining unpaid in respect of calls, it must be indicated separately. 1.8.6 Reserves and Surplus : A business may have to meet certain unforeseen obligations in future. These obligations may be compulsory or voluntary, foreseen or unforeseen, recurring or non-recurring. Whatever may be the nature of these obligations, it is desirable that the organization makes provision in advance to meet them. If no arrangements are made to meet these obligations, sudden payment may adversely affect the financial health of the company. This may create a drain on financial resources of the company. In order to avoid such a reserve is also termed as Retained Earnings or Plough Back profits. Indian Companies Act requires every company to transfer a specific percentage (upto 10%) of the profits to Reserve accounts. According to Companies Act Reserve shall not .include any amount written off or retained by way of providing for

41 depreciation, renewals or diminution in value of assets or retained by way of providing for any known liability. G. Revenue Reserves or Free Reserves : These reserves represent amounts set aside out of divisible profits. They are appropriations of profits. Reserves may be created for a specific purpose or for a general purpose. Reserve created for a specific purpose is called a specific reserve and a reserve created for a general purpose is called a general reserve. General reserves are free and can be utilized for : a) Payment of Dividends. b) Development and expansion, c) Any other purpose the company thinks proper. General Reserve is also called a revenue reserve or a free reserve. A free reserve is a reserve which is available for any purpose, including payments of dividend. It is not earmarked for any specific purpose. H. Capital Reserves : Schedule VI of the Companies Act does not really define the term Capital Reserve. It states that it shall not include any amount regarded as free for distribution through the Profit and Loss Account. The term capital reserve is used to describe reserves which cannot legally be distributed as dividends e.g., share premium, capital redemption reserve account, etc. Capital reserve is created out of capital profits which do not arise in the normal course of business. the following reserves are capital reserves : a) b) c) d) e) f) g) h) Profits profit to incorporation Profit on redemption of preference shares, Profit on redemption of debentures, Securities premium, Profit on forfeiture of shares, Profit on sales of fixed assets, Profit on revaluation of fixed assets, Capital redemption of fixed assets,

42 Capital Reserves are not available for distribution as dividends; but they can be utilized for : a) b) c) d) e) f) Writing off intangible assets Writing off preliminary expenses Writing of losses on issue of shares and debenture Issue of bonus shares Adjusting the premium payable on redemption of debenture Writing off losses on sales or revaluation of fixed assets.

According to Companies Act 1956 the expression Capital Reserve shall not include any amount regarded as free for distribution through the Profit and loss account; and the expression revenue reserve shall mean any reserve other than a Capital Reserve. However, it may be noted that the profit on revaluation of fixed assets should not be utilized for issue of Bonus Shares; it must be shown separately, say, as Revaluation Reserve. I. Contingency Reserves : Contingency is an unexpected event of adverse nature. In business, such contingencies are not uncommon. A few of them are quoted below : a) b) c) d) e) f) Decline in inventory values. Loss on purchase contracts. Devaluation of currency. Issue of bonus shares, Adjusting the premium payable on redemption of debentures, Writing off losses on sale or revaluation of fixed assets.

According to Companies Act 1956 the expression Capital Reserve shall not include any amount regarded as free for distribution through the Profit and Loss Account; and the expression revenue reserve shall mean any reserve other than a Capital Reserve. A business concern must provide for such probable losses. A reserve which is created to meet the above contingencies is a contingency reserve. Contingency reserve is not charged to Profit & Loss Account. It is created by debiting profit and loss appropriation account and appears in the Balance Sheet on the liability side under the head Reserves and Surplus.

43 J. Secret Reserves : Secret reserves are those reserves which exist but are not disclosed in the balance sheet. They are not created either by debiting Profits and Loss Account or Profit and Loss Appropriation account. Such reserves are created as a result of certain manipulations and adjustments. For example: a) b) c) d) Charging higher rate of depreciation than normal. Charging capital expenditure as revenue expenditure. Under-valuation of inventory and other assets. Creating more provision than is necessary against current liabilities.

Such reserves are built in the financial system. They can be located only by a close scrutiny of the financial statements and not otherwise. Secret Reserve is a double-edged sword, as it may be used to improve the financial position or may be misused by the management for manipulation. Disclosure of Reserves in Balance Sheet : Under each individual head of the reserves, the balance as per last balance sheet, additions thereto and deductions there from should be clearly stated. The word Funds in relation to any Reserve should be used only where such reserve is specifically represented by earmarked investments. In case of securities premium, details of its utilization should be shown in the year of utilization. Under the head Surplus, the balance of Profit Loss Account, after making all appropriations, should be shown. Debit balance of profit and Loss Account should be shown by way of deduction from uncommitted reserves, if any. 1.8.7 Long-term Liabilities :

As we have seen already, a company raises finance either from owners or through external borrowings. External borrowings of a company which constitute its owed funds are important

44 sources of long-term finance. These borrowings are termed as fixed liabilities or term liabilities or long term-loans. They may take various forms such as debentures, public deposits, bank loans, deferred payments, etc. they may be fully secured or partly secured or unsecured. Technically, a long-term liability can be defined as a liability falling due on a date later than the expiration of one whole accounting period. A. Secured loans : It refers to loans which are secured by a fixed or floating charge on the assets of the business. It includes : a) Debunkers, b) Loan and advance from banks, c) Loan and advance from subsidiaries and d) Other loan and advances. The natures of securities should be specified in each case. The interest accrued and due on secured loan should be include under the appropriate subheads under the head secured loan but the interest accrued and not due on secured loans is required to be shown under current liabilities. Loans from directors, securities, treasurers and mangers should be shown under this head, if such loans are guaranteed. In respect of debentures, the terms of redemptions or conversion should be stated. The particulars of any redeemed debentures which the company has power to reissue should be stated by way of note. B. Unsecured loans : It refers to the loans which are not secured by assets of the business. It is not covered by any security. It includes : a) A fixed deposits, b) Loans and advance from subsidiaries, c) Short-term loan and advances: i) from banks, ii) from other, d) Other loans and advance : loan from directors, secretaries, treasurers and managers should be shown separately. Loan Fund = Secured loans + unsecured loans

45 1.8.8 Distinction between Own Fund and owed Fund :

Own Fund 1. Nature 2. Claimant 3. Income 4. Stability of Income 5. Tenure 6. Refund on liquidation 7. Security Owed Fund

It is an internal source of It is an external source of finance. finance. It is a claim of owners. It is a claim of outsiders. It earns dividend. It earns interest. Income is not stable. It is stable. It is a permanent fund. It is refunded last. It is semi-permanent fund. It is refunded before own fund.

The following illustration will make it clear as to how secured and unsecured loans should be shown in the Balance Sheet. Illustration 13: R.K. Ltd. Balance Sheet as at 31st March, 2009 (Extract)
Liabilities Secured Loans : 15% Debentures (Secured against Plant and Machinery) Bank Loan (Secured against Stock-in-trade) Other loans Interest Accrued and Due on Secured Loans Unsecured Loans: Public Deposits From Banks Other Loans and Advances Interest Accrued and Due on Unsecured Loans Rs. 2,00,000 1,00,000 50,000 10,000 Rs.

3,60,000

50,000 40,000 20,000 5,000

1,15,000

1.8.8

Current Liabilities and Provisions :

A. Current Liabilities : Current liabilities are those short-term obligations of an enterprise which mature within one year or within the operating cycle. They constitute short-term sources of finance. Current liabilities arise in the regular current operations of the business.

46 They are as follows : i) ii) iii) iv) vi) vii) Sundry Creditors when goods are purchased Bills Payable by acceptance of bills drawn by creditor Accounts payable Interest accrued but not due Wages and salaries payable outstanding expenses. Unclaimed dividends. Bank Overdraft.

These liabilities are not normally secured and no interest is payable on them with the exception of bank overdrafts. But, interest may be charged when payment of these liabilities becomes overdue. These liabilities, are generally paid off by utilizing current assets or by creating a current liability. The Accounting Principles Board of the American Institute of Certified Public Accountants gives a more detailed definition, as follows : The term current liability is used principally to designate obligations whose liquidation is reasonably expected to require the use of existing resources properly classifiable as current assets, or the creation of other current liabilities. As a balance sheet category, the classification is intended to include obligations for items which have entered into the operating cycle, such as payables incurred in the acquisition of materials, and supplies to be used in the production of goods or in providing services to be offered for sale, collections received in advance of the delivery of goods or in providing services to be offered for sale, collections received in advance of the delivery of goods or performance of services, and debts which from operations, directly related to the operating cycle, such as accruals for wages, salaries, commissions, rentals, royalties and income and other taxes. Other liabilities whose regular ordinary liquidation is expected to occur within a relatively short period of time, usually 12 months, are also intended for inclusion, such as short-term debts arising from the acquisition of capital assets, serial maturities of long-term obligations, amounts required to be expended within one year under sinking fund provisions, and agency obligations arising from collection or acceptance of cash or other assets for the account of third persons. It is thus clear from the above definition that current liabilities are those liabilities that are to be settled within one year either from current assets or by creating current liabilities.

47 B. Provisions : Provision means any amount retained by way of providing for any known liability of which the amount cannot be determined with substantial accuracy. They are at best estimates. Provisions have to be made for maintaining the integrity of assets or for known liabilities. Although the amount of liability is not certain it has to be provided for, on best estimates. The examples of provisions are as under : a) b) c) d) Provision for depreciation on assets. Provision for doubtful debts. Provision for proposed dividends. Provision for taxation.

Provisions relating to specific assets are shown as deduction from the specific assets. C. Quick Liabilities : These are the current liabilities which mature within a very short period of time. Actually all current liabilities are payable within a short period of time. However, there are certain current liabilities such as Bank Overdraft which are not payable immediately or in a very short-time, in practice. Therefore, Bank Overdraft is not considered as a quick liability. It is a permanent arrangement with the banker. Hence, all quick liabilities are current liabilities but all current liabilities are not quick liabilities. Quick Liabilities = Current Liabilities Bank Overdraft 1.8.9 Contingent Liabilities : According to ICAI, Contingent liability refers to an obligation relating to an existing condition or situation which may arise in future depending on the occurrence or non-occurrence of one or more uncertain future events. These liabilities may or may not be converted into actual liabilities at some future date. It is a liability which may or may not occur. But on the date of the Balance Sheet, it is not known definitely whether the liability would arise or not. But as a matter of caution, it is indicated in the balance sheet for the sake of information and disclosure, under the head Contingent Liabilities. This amount is not included in the Balance Sheet figures but shown outside as it is not recorded in the accounts. It is shown as a footnote to the Balance Sheet. The amount of a contingent liability may or may not be known on the date of the balance sheet. The following are some of the examples of Contingent Liabilities :

48 a) Discounted Bills of Exchange. b) Disputed liability on account of income-tax, etc., about which appeal has been filed. c) Uncalled amount on partly paid-up shares and debentures held by the company as investments.

d) Cumulative preference dividend in arrears. e) Matters referred to arbitration. f) Claims not acknowledged as debts. g) Estimated amount of contracts remaining to be executed on capital account and not provided for. h) Guarantees given by the company. i) Bonds executed.

There are two types of contingent liabilities. Certain liabilities, which when paid create an asset of corresponding value. For example, when a liability on account of construction work arises and is paid off, it results in the increased value of assets. Certain other liabilities, when paid off, do not create or increase the value of assets but on the contrary will result in the decrease of assets and cause decrease or increase in revenue expenditure. For example: When the labour court orders to increase wages retrospectively, the discharge of this liability will result in decrease of current assets i.e., cash and increase expenses on wages.

1.9

EXERCISE

1. Discuss the nature of Financial Statement what are the limitation of such statement? 2. Define financial statement analysis. Explain in what ways such an analysis may benefit managerial personal, owners, and creditor. 3. Distinguish between horizontal and vertical analysis of financial statement data.

49 Illustration: Balance Sheet as on 30th September, 2009

Liabilities Rs. Assets Rs. 2,25,000 1,74,586 35,520 52,320 45,790 16,595 3,998 7,500 5,61,309

Paid-up Share Capital 4,75,000 Factory Premises Capital Redemption Reserve 32,500 Plant & Machinery Profits & Loss A/c 12,929 Motor Car Sundry Creditors 25,515 Stock Outstanding Wages 6,415 Debtors Provision for Taxation 8,950 Cash Taxes paid in Advance Preliminary Expenses 5,61,309

Re-arrange the above balance sheet in the form suitable for analysis and calculate the following : a) b) c) d) Total Funds employed, Proprietors Funds, Long-term Liabilities, Current Liabilities.

2
TOOLS OF ANALYSIS OF FINANCIAL STATEMENTS
Unit Structure:

50 2.0 2.1 2.2 2.3 2.4 2.5 2.6 Objectives Introduction Analysis of the Financial Statements Trend Ration and Trend Analysis Comparative Statement Common-size Statement Exercise

2.0

OBJECTIVES

After studying the unit the students will be able to: Explain the meaning of financial statement analysis. Know the meaning and utility of Trend analysis. Understand the meaning of Comparative and Common Size Statements Prepare the Comparative and Common Size Statements from the given information.

2.1

INTRODUCTION

Financial statements are the result of the accounting process which begins with recording of transaction. Accounting process involves recording, classifying and summarizing business transaction. Financial Statement relate to the third process Viz. summarising. The financial statements are based on certain accounting conventions which cannot be said to be fool proof. Various techniques have been developed for the analysis of financial statement the selection of appropriate analytical technique would depend upon the objective of the analysis. Usually group of technique is used for a result oriented analysis. The commonly used techniques are Comparative financial statement, Common trend analysis, Ratio analysis and Fund and Cash flow statement. Any financial statement that reports the comparison of dada of two or more consecutive accounting periods is known as comparative financial statement.

2.2

ANALYSIS OF THE FINANCIAL STATEMENTS

Financial statement analysis is defined as the process of identifying financial strengths and weaknesses of the firm by properly establishing relationship between the items of the balance sheet and the profit and loss account.

51 There are various methods or techniques that are used in analyzing financial statements, such as comparative statements, schedule of changes in working capital, common size percentages, funds analysis, trend analysis, and ratios analysis. Financial statements are prepared to meet external reporting obligations and also for decision making purposes. They play a dominant role in setting the framework of managerial decisions. Following are the limitations of Financial Statements: 2.2.1 Limitation of Financial statement : Following are the limitations of financial statements: 1. The information being of historical nature does not reflect the future. 2. It is the outcome of accounting concept, convention combined with personal judgement. 3. The statement portrays the position in monetary term. The profit or loss position excludes from their purview things which cannot be expressed or recorded in term of money. As the information provided in the financial statements is not an end in itself as no meaningful conclusions can be drawn from these statements alone. However, the information provided in the financial statements is of immense use in making decisions through analysis and interpretation of financial statements. To overcome from the limitations it becomes necessary to analyse the financial statements. The analytical tools generally available to an analyst for this purpose are: 1. 2. 3. 4. 5. 6. 7. Comparative financial and operating Statements Common-size statement Trend ration and trend analysis Average Analysis change in working capital Fund-flow and cost-flow analysis Ratio analysis

(1) Comparative Financial and Operating Statement : Comparative financial statement are of financial position of a business so designed as to provide time perspective to the Consideration of various element of position embodied in such statement The balance sheet and Income Statement I, e. Profit and loss account are prepared in a Comparative from as the impact of the conduct of business is brought to bear on the Balance Sheet, Comparative statement are made to show

52 1. Absolute date (money values or rupee amount). 2. Increases and decreases in absolute data in term of money values. 3. Increases or decreases in absolute data in term of percentage. 4. Comparisons expressed in ration. 5. Percentage of total. Comparative financial statement are very useful to the analyst as they Provide information necessary for the study of financial and operating trend over a period of years They indicate the duration of the movement With respect of the financial position and operating results Financial data become more meaningful When compared with similar data for a previous period or a number of prior periods such statement are very helpful in measuring the effect of the conduct of a business during the period under Consideration The comparative profit and loss account Will present a review of operating activities of the business The comparative balance sheet shows the effect of operations on the assets and liability I, e change in the financial position during the period under consideration. Comparisons loss their significant and tend to become misleading if the date being compared do not reflect the consistent application of generally accepted accounting principles from date to date or period to period The absence of the comparability of statement should be indicated in the footnotes that accompany the financial statement as well as in the accounts report In the preparation of comparative financial statement uniformity is essential Care must be taken to see that all account heads or group of these like administrative expenses; fixed assets; current assets; long term fund short term fund etc have the same connotation Otherwise; comparison will be vitiated.

(2) Common size Statement : Comparative statement that give only the vertical percentage or ration for financial data without giving rupee value are known as common size statement A comparison of two years figures of a concern can be easily made under the companies Act Companies must Show in their profit and loss account and balance sheet the corresponding figures for the previous year. Sometime, however, the figures do not signify anything as the heads of items are regrouped and are in comparable; they should precisely have the some meaning from one year to another.

53 It is better to work out the ratio of various items to sales in term of percentage and enter these also in the statement As common size statement are most valuable in marketing Comparisons between the companies in the some industry. A common size statement shows the relation of each component to the whole. It is useful in vertical financial analysis and comparison of two business enterprises at a certain date. (3) Trend Analysis : The analysis is an important and useful technique of analysis and interpretation of financial statement under the technique the ration of different items for various periods are calculate for the company over a definite period of time say three to five years and then we can analysis trend highlighted by this ratio Trend analysis can be done in three following way. (i) Trend percentage, (ii) Trend ratio, (iii) Graphic and diagrammatic representation. In the statement the percentage column are more relevant than the figure. Utility of Trend Analysis : a) It is a simple technique. it does not involve tedious calculation and required trained experts b) It is brief method to indicate the future trend c) It is reduces the chances of errors as it provides the opportunity to compare the percentage with absolute figures (4) Average Analysis : It is an improment over trend analysis method. When trend ratio have been determined these figure are compared with industry averages These trend can be presented on the graph paper also in the shape of curve in this from the analysis and comparation become more comprehensive and impressive. (5) Statement of changes in Working Capital : To Know an increase or decrease in working capital over a period of time, the preparation of a statement of change in Working Capital is also very useful The statement give an accurate summary of the events That effected the amount of working capital The amount of net working capital as determined by deducting the total of current liability from the total of the current assets It is a rough estimated which may be arrived at by using balance sheet

54 data only But it does not explain the detailed reasons for the changes in working capital and methods of financing additional requirement of working capital Hence the preparation of fund flow statement becomes necessary. (6) Funds flow and Cash flow Analysis : The statement of sources and application of funds also called were got were gone statement provides the missing link in the complement of final account statement It demonstrates the manner by which periods activities call upon and generate the financial resources of the business unit and the resultant ebb and flow of these resources through the temporary reservoirs of firm assets. In the process, it high lights the changes in the financial structure of an undertaking funds flow analysis is a valuable aid to the financial executive and creditor For evaluating the use of funds by the firm and determining how these uses were financed A Funds flow statement indicates where fund come from and the here it was used during the period under review These statement can be prepared separately also The are important tool of communication and are very helpful for financial executives in planning the intermediate and long term financing of the firm. (7) Ratio Analysis : An absolute figure after does not convey much meaning It is only in the light of other information that the significance of a figure is realized A person. S weight is 80 kg. Is he fact? One can not answer this question unless one knows Known unless together with the amount of profit the amount of figures expressed mathematical is called ratio The ratio between 4 and 10 is 0 4 or 40% 0 4 and 40% are ratios Accounting ratio relationships expressed in mathematical terms between figures Which have a causes an effect relationship or which are connected with each other in some manner or the other Obviously no purpose will be served by working out ratio between entirely unrelated figure such as discount on debenture and sales Ratio may be worked out on the basis of figure contained in the financial statement and, therefore, may be classified as follows : (a) Income statement ratio (b) Position statement (balance sheet) ratio, and (c) Inter-statement ratio Ratio as tools for establishing true profitability and financial position of a company may be classified as: 1. Profitability ratios. 2. Turn over ratios

55 3. Financial ratio To say the same thing in different word, ratios will portray the financial position while others will portray the causes that lead to a change in it In the net shall ratio analysis give the answer of the following problem whether the capital structure of the business is in proper order, whether the profitability of the business is satisfactory, Whether the credit policy in relation to sales and purchases is sound and whether the company is credit worthy.

2.3

TREND RATION AND TREND ANALYSIS

This type of analysis is an important and useful technique of analysis and interpretation of financial statement. Under this technique the ration of different items for various periods are calculate for the company over a definite period of time say three to five years and then we can analysis trend highlighted by this ratio 2.3.1 Trend analysis can be done in three following way: (i) Trend percentage, (ii) Trend ratio, (iii) Graphic and diagrammatic representation. In the statement the percentage column are more relevant than the figure. 2.3.2 Utility of Trend Analysis: d) It is a simple technique. it does not involve tedious calculation and required trained experts e) It is brief method to indicate the future trend f) It is reduces the chances of errors as it provides the opportunity to compare the percentage with absolute figures Trend analysis one of the important tool of analyzing the financial data. It computes the percentage change for different variables over a long period and then makes a comparative study of them. The trend percentage helps the analytics to study the changes that have occurred during the period. Such an analysis indicates the progress of business by showing ups and downs in it activity. The calculation of trend percentage involves the following steps. 1) Selection of base year. 2) Assigning a weight of 100 to be value of the variable of the base year and

56 3) Expressing the percentage change in value of variable from base year as shown below. 2.3.3 Following is the example of Trend analysis
Percentage ( + ) Increase or ( - ) Decrease 100 (Base year ) 175 140 150 175 70 110

Years 1980 1981 1982 1983 1984 1985 1986

Sales 20,000 35,000 28,000 30,000 35,000 14,000 22,000

A trend for single financial item is seldom very informative. A comparison of trend for relative items often help to analysis in perfect understanding of the business fact as is clear from the below mentioned comparative balance sheet. Comparative Balance Sheet
1986 Rs. 1987 Rs. 1988 Rs. Trend Percentage ( base year 1988 ) 1986 1987 1988

Assets

A) Current Assets Inventory Debtor Cash balance Total (A) B) Fixed Assets Building Plant Investment Total (B) Total Assets (A + B)

20,000 30,000 20,000 70,000

30,000 50,000 55,000 1,15,000

25,000 60,000 30,000 1,15,000

100 100 100 100

150 167 175 164

125 200 150 164

250,000 1,25,000 80,000 4,55,000 5,25,000

300,000 150,000 1,00,000 5,50,000 6,65,000

3,00,000 1,60,000 1,20,000 5,80,000 6,95,000

100 100 100 100 100

120 120 125 121 127

120 128 150 127 132

2.3.4 ILLUSTRATION: Calculate trend percentage from the following figures of X L td, taking 1979 as the base and interpret.

57

Year 1979 1980 1981 1982 1983

Sales 1,881 2,340 2,655 3,021 3,768

Stock 709 781 816 944 1,154

Profit before tax 321 435 458 527 672

Solution : Trend percentage

Years before 1979 1980 1981 1982 1983 Sales (Rs. in Lakhs) 1,881 2,340 2,655 3,021 3,768 Stock (Rs. in Lakhs) 709 781 816 944 1,154 Profit before Tax (Rs. in Lakhs) 321 435 458 527 672 Sales 100 124 141 161 200 Stock 100 110 115 133 162 Profit Tax 100 136 143 164 209

Interpretation : The study of the above given statement of Trend percentage reveals that (i) The sales of the farm as continuously increased over a period of a five year commencing from 1979. However there has been a substantial increase in the amount of sales in the 1983 when it increased by 39%. (ii) The trend of Stock is also upward although the increase in this item has been constant yet in 1983 the increased has been exceptionally. (iii) The Profit of the firm has increased at much higher rat in comparison to increase in Sale and Stock during the period under study. The overall analysis of the financial items indicated that the firm is doing well, and therefore, its financial position it bound to be good. 2.3.5 Trend percentage: A horizontal comparison of various items one by one along with their percentage to the total can be done to know the trend of that particular item over a period. The study of a trend will indicate

58 the direction of movement over a long time One can gate a better view of things unaffected by short term influences by study of long term trend percentage. For example if the total assets of a company growing steadily at a certain period that is the Percentage over a long period it is increasing steadily it is definitely a good indicator of the growth of a company. If a company is suffering losses uniformly over a long period it is not a good indicator of the operation position of the company. See celebration of a statement showing trend percentage on the next page. In the statement the percentage columns are more relevant that the figures. A horizontal corporation over the reveals the following significant point. 2. Sales volume has been steadily rising over the 10.year period except a small setback in 1979. 3. The percentage of goods consumed has rising over the 10 year period from 34.93 of sales to 42.43 A rise of nearly 25% the rise in staff cost over the 10 year period is nearly 40% from `17.66% of Sales to 24.28%. Similarly, there has been a substantial rise in other expenses from 13.60% to 18.93 of sales. All costs have been rising excepting a small decline in depreciation content. 4. The consequence of the rise in all cost components is the decline in the profit margin. The operating income has declined from 27.35% in 1971 gradually to 7.33% in 1980. In absolute figure through the sales have increased to 2.73 time over a 10 year period, the operating income has declined from Rs.728 Lakhs to Rs.518 Lakhs. However, the after tax profit has increased from Rs.288 Lakhs to Rs.348 Lakhs mainly as a consequence of other sources of other income of and taxation burden. The analysis shows the profitability of a sound and well managed company.

2.4

COMPARATIVE STATEMENT

The comparative statements are important tool of horizontal financial analysis. Financial data become more meaningful when compared with similar data for previous period or a number of previous periods. Such analysis helps as in forming an opinion regarding the progress of the enterprise. 2.4.1 Comparative statements definition: Foulke has defined these statement as statement of financial position of business so designed as to provide time perspective to the consideration of various elements of financial

59 position embodied in such statement. In any comparative statement columns for more than one years position or working can be drawn and figures may be provided. The annual date can be compared with similar monthly or quarterly data can be compared with similar data for the same months or quarterly of previous years. In such statement the figure can be shown at the following value. a. In absolute money value b. Increase or decrease in absolute values c. By the way of percentages d. By the way of commonsize statement Two comparable units can be compared regarding profitability and financial position. The two organization may not have the identical heads of account In order to get over the difficulty, the data must first be property set before comparison In the preparation of comparative financial statement, uniformity is essential. 2.4.2 Importance of Comparative Statement: These statements are very useful in measuring the effect of the conduct of a business enterprise over the period under consideration. Regardless of its financial strength at a given point of time, the enterprises must operate successfully if it hopes to continue as a going concern. The income statement measures the effects of operation. But the progress of these operations may be viewed over number of periods by preparing the income statement in a comparative form. Similarly the effect of operation of financial position and the progress of a business in term of financial position can be presented by means of a comparative balance sheet. The accounting authorities in U. S. A. have strongly recommended and encouraged the preparation of financial statement in the comparative from Recognising the importance of comparative financial date for two years, the Indian companies Act 1956 has made this fact compulsory that in the balance sheet of a company the figure for the previous year should also be given to facilitated comparison. Though the balance sheet is a useful statement, the comparative balance sheet is even more useful for the it contains not only the data of a single balance sheet but also for the past years which may be useful in studying the trends. 2.4.3 Preparation of Comparative Statements: The form of comparative balance sheet consists of two or more columns according to the number of year we prepare the balance sheet, for the date of original balance sheet and columns

60 for the increases or decreases in various items. Here is a proforma of comparative balance sheet for two years ABC Co. Ltd. Specimen of Comparative Balance Sheet for the ended 31st Dec. 1980 and 1981
(Amount in Lakhs of rupees)
Dec. 31 1980 Dec. 31 1981 Increase (+) / Decrease (-) Amount

Rate

Assets : Current Assets : Cash Debtors less reserve for doubtful debts Merchandise Inventory Prepaid Expenses Total Current Assets Fixed Assets : Land and Building less Depreciation Furniture &Fixture less Depreciation Plant and Machinery less Depreciation Total fixed Assets Total Assets Liabilities and Capital : Current Liability : Trend creditors Accrued Expenses Total Current liabilities Equity Capital Retained Earnings Total Capital Total Liabilities and Capital 234 400 634 400 466 866 1,500 510 360 870 500 566 1,066 1,936 + 276 - 40 + 236 + 100 + 100 + 200 + 436 + 108 - 20 + 74 + 50 + 42 + 46 + 58 3.08 1.08 2.74 2.50 2.42 2.46 2.58 480 60 240 780 1,500 720 80 480 1,280 1,936 + 240 + 20 + 240 + 500 + 436 + 100 + 66 + 200 + 128 + 58 2.0 2.66 4.00 2.20 2.58 240 120 260 100 720 80 96 320 80 656 - 160 - 24 + 66 - 20 - 64 - 66 - 40 + 46 - 40 - 18 1.24 1.60 2.46 1.60 1.82

2.4.4 Preparation of a Comparative Income Statement: An Income Statement shows the Net Profit or Net Loss from business operation of a definite accounting period. Like a balance

61 sheet, a comparative income statement show the operating results for a number of accounting periods so that the changes in absolute date from one period to another may be explained and analysis. The Comparative income statement contains the some columns as the comparative balance sheet and provides the same in the figures. Specimen of a Comparative Income Statement ABC Co. Ltd. Comparative Income Statement for the year ended 31st Dec. 1980 and 1981 (Amount in Lakhs of Rupees)
Dec. 31 1980 Net Sales Less : Cost of Goods Sold Gross Profit Operating Expenses : Selling Expenses Gen. and Admn. Expenses Total Operating Expenses Operating Profit Add : Other Income Dividend 44 294 Less : Other Deduction Interest Paid 44 250 Less : Income Tax Net Profit after Tax 124 126 44 248 124 124 Nil -2 Nil -2 Nil - 1.6 Nil - 3.2 50 292 +6 -2 + 2.8 - 1.4 188 94 282 250 182 92 274 242 -6 -2 -8 -8 - 6.4 - 4.2 - 5.6 - 6.4 1370 838 532 Dec. 31 1981 1442 926 516 Increase (+) / Decrease ( - ) Amount + 72 + 88 - 16 % + .6 + 21.0 - 6.4

2.5

COMMON-SIZE STATEMENT

Financial statements that depict financial data in the shape of vertical statement percentage are known as common size statements. Such statements provide readers with vertical analysis of the profit and loss account and balance sheet. In such statement all figure are converted to a common unit by expressing than as percentage of a key figure in the statement. The total of financial statement is reduced to 100 and each item is shown as component to the whole. For example profit and loss account, the figure of each item of the financial expressed as a percentage of sales

62 likewise, assets and liabilities can be shown as percentage of total assets and total equities respectively in common sized balance sheet. Thus expressing each monetary item of financial statement as a percentage of some total of which that item as apart transforms a financial statement what is referred as common size statement such a statement show the relative significance of the items contend in the financial statement and facilitate comparisons. It point out efficiencies and in efficiencies that are otherwise difficult to see and of this reason is a valuable management tool a common size statement is especially useful when data for more than one year are used. Vertical analysis is the procedure of preparing and presenting common size statements. Common size statement is one that shows the items appearing on it in percentage form as well as in dollar form. Common size statements are particularly useful when comparing data from different companies. Common size statements are also very helpful in pointing out efficiencies and inefficiencies that might otherwise go unnoticed Illustration 1 The balance sheet of Shaheen Ltd are given for the year 2007 and 2008 convert them into common size balance size balance sheet and interpret the changes. Balance sheet
Liabilities Equity share Capital reserve Revenue reserve & surplus Trade creditors Bills payable Bank overdraft Provisions 2007 Rs 1,46,800 50,000 20,000 2008 Rs. 1,91,000 70,000 30,000 Assets Buildings Plant and machinery Furniture Freehold property 30,000 80,000 90,000 30,000 40,000 60,000 80,000 20,000 Goodwill Cash balance Sunday debtors Inventories Bills receivable(temporary) 2007 Rs. 1,80,000 40,000 10,000 20,000 25,000 25,000 30,000 70,000 2008 Rs. 2,00,000 55,000 20,000 12,000 30,000 20,000 35,000 57,000

4,46,800

4,91,000

4,46,800

4,91,000

Common size Balance Sheet

63
1987 Assets Amt. (Rs.) A. Current Assets Sundry Debtor Cash balance Inventories Investment (Temporary) Bill Receivable Total (A) 30,000 25,000 70,000 36,500 10,300 1,71,800 6.71 5.59 15.71 8.17 2.30 38.44 35,000 20,000 57,000 42,000 20,000 1,74,000 7.13 4.07 11.60 8.55 4.08 35.43 Percentage Amt. (Rs.) Percentage 1987

B. Fixed Assets Building Plant and Machinery Furniture Freehold Property Goodwill Total (B) Total Assets (A+B) Liabilities C. Current Liabilities Trade Creditors Bill Payable Bank Overdraft Provision Total (C) 30,000 80,000 90,000 30,000 2,30,000 6.17 17.91 20.14 6.71 51.47 40,000 60,000 80,000 20,000 200,000 8.15 12.22 16.29 4.07 40.73 1,80,000 40,000 10,000 20,000 25,000 2,75,000 4,46,800 40.29 8.95 2.24 4.48 5.60 61.5 100.00 2,00,000 55,000 20,000 12,000 30,000 3,17,000 4,91,000 40.75 11.20 4.07 2.44 6.11 64.57 100.00

64

D. Long-term Liabilities Equity Share Capital Reserve Revenue Reserve and Surplus Total (D) Total Liabilities (C+D) 1,46,800 50,000 20,000 2,16,800 4,46,800 32.86 11.19 4.48 48.53 100.00 1,91,000 70,000 30,000 2,91,000 4,91,000 38.90 14.26 6.11 59.27 100.00

Interpretation : 1. Out of every rupee of sales 60.72 per cent in 1986 and 63.63 per cent in 1987 account for cost of goods sold. 2. The percentage ratio of gross profit to sales was 39.28 per cent in 1986 which was reduced 36.37 percent 1987. 3. The operating expenses increased from 15.71 per cent of sales in 1986 to 16.37 per cent in 1987 All this reduced the percentage ratio of net income after taxi to sales from 14.15 per cent in 1986 to 12.00 per cent in 1987. 4. The operating expenses increased from 15.71 per cent of sales in 1986 to 16.37 per cent in 1987 All this reduced to percentage ratio of net income after tax to sales from 14.15 per cent in 1987. In the ultimate analysis it can be said that the operating efficiency of the concern has not been satisfactory during the period under study. Illustration 2 : Following the Balance Sheet of X Co. Ltd and Y Co. Ltd as on 31.12.1990.
Particulars Assets Sundry Debtors Stock Prepaid Expenses Other Current Assets Total Current Assets Fixed Assets (Net) Total Liabilities Sundry Creditors Other Total Current Liabilities Fixed Liabilities Total Liabilities Capital Total X Co. Ltd 27 220 100 11 10 368 635 1,003 42 78 120 225 345 658 1,003 Y Co. Ltd 72 226 174 21 21 514 513 1,027 154 62 216 318 534 493 1,027

65 Interpretation: 1. The study of common size balance show that 61.56 per cent total asset in 1986 were fixed This percentage increased 64.57 per cent 1987 if concern requires considerable investment in fixed assets these percentage might be acceptable if the company needs be acceptable if the company need liquid assets the interested parties might have cause to be concerned about the decreasing trend liquidity. 2. There was a wide shift from the use of creditor provided fund to the use of owner equity fund in 1986 external equity (current liability) and owner equity (long term liability) accounted from 51.47 per cent and 48.73 per cent for external equities and 59.27 per cent for owner equity These changes indicate that the concern has started to use internal sources more frequently than external sources more frequently than external sources in the generation of fund for this business. 3. The concern has not only succeeded in getting its current liability down from 51.47 per cent in 1986 to 40.73 per cent in 1987 of their respective of the total equity In but it has also increased the percentage of its revenue and surplus from 4.48 per cent in 1986 to 6.11per cent in 1987 of other respective total equities. Illustration 3: From the income statement give below you are required to prepare common sized income statement.
Particulars Sales Less : Cost of Goods Sold Gross Profit Operating Expenses Selling and Distribution Expenses Administrative Expenses Total Operating Expenses Net Income before Tax Income Tax (40%) Net Income 12,000 10,000 22,000 33,000 13,000 19,800 16,000 11,000 27,000 33,000 13,200 19,800 1986 Rs. 1,40,000 85,000 55,000 1987 Rs. 1,65,000 1,05,000 60,000

66 Solution : Common size income statement (For the year ending 1986 and 1987)
1986 Amt. (Rs.) Sales Less : Cost of Sales Gross Profit Selling & Distribution Expenses Administrative Exp. Total operating Exp. Net Income before Tax Income Tax (40%) Net Income after Tax 1,40,000 85,000 55,000 12,000 12,000 22,000 33,000 13,000 19,800 Percentage 100.00 60.72 39.28 8.57 7.14 15.71 23.57 9.42 14.15 Amt. (Rs.) 1,65,000 1,05,000 60,000 16,000 11,000 27,000 33,000 13,200 19,800 1987 Percentage 100.00 63.63 36.37 9.70 6.67 16.67 20.00 8.00 12.00

Particulars

Solution: Common Size Balance Sheet (as on 31st December 1992)

X Co. Ltd Amount (Rs. in Lakhs) percentage Assets : A) Current Assets Cash Sundry Debtor Stock Prepaid Expenses Other Total (A) B) Fixed Assets Total (B) Total Assets (A+B) Liabilities : C) Current Liabilities Sundry Debtor Others Total (C) D) Long Term Liabilities Fixed Liabilities Capital Total (D) Total liabilities (C+D) Y Co. Ltd Amount (Rs. in Lakhs) percentage

27 220 100 11 10 368 635 635 1003

2.69 21.93 9.97 1.10 1.00 36.69 63.61 63.31 100.00

72 226 174 21 21 514 513 513 1027

7.01 22.01 16.94 2.04 2.04 50.04 49.96 49.96 100.00

42 78 120 225 658 883 1003

4.19 7.78 11.97 22.43 65.60 88.03 100.00

154 62 216 318 493 811 1027

14.99 6.04 21.03 30.97 48.00 78.97 100.00

67 Comments : 1. The study of common size balance sheet show that 63.31 per cent of total assets of the X. company L t d were fixed whereas the some percentage for Y Co was 49.96. 2. The current liability of X Co L td were 11.97 per cent of total liability and for Y Co L td this percentage was 21.03 both the companies have used more equity capital. Illustration 4 : You given the following common size percentage of AB Company Ltd for 1997 and 1988.
1997 Inventory Debtors Cash Machinery Building Creditors Overdraft Total Current Liabilities Capital Long-term loan Total Liabilities 5.20 10.39 ? 49.35 27.27 20.78 ? 31.17 51.95 16.88 3,85,000 1998 5.83 ? 7.35 45.35 29.59 ? 10.81 ? 49.67 17.91 4,63,000

From the above information, compute the missing common size percentage. Also calculate the value of all assets and liabilities. Solution : Common Size Balance Sheet (as on 31 December 1997 and 1998)
1997 Assets Amt. (Rs.) Assets : A. Current Assets Inventory Debtors Cash Total (A) B. Fixed Assets Machinery Building Total (B) Total Assets (A+B) 1,90,000 10,05,000 2,95,000 3,85,000 49.35 27.27 76.62 100.00 2,10,000 1,37,000 3,47,000 4,63,000 45.35 29.59 74.94 100.00 20,000 40,000 30,000 90,000 5.20 10.39 7.79 23.38 27,000 55,000 34,000 1,16,000 5.83 11.88 7.35 25.06 Percentage Amt. (Rs.) Percentage 1998

68
Liabilities : C. Current Liabilities Creditors Overdraft Total (C) D. Long-term Liabilities Capital Loan Total (D) Total Liabilities (C+D) 2,00,000 65,000 2,65,000 3,85,000 51.95 16.88 68.83 100.00 2,30,000 83,000 3,13,000 4,63,000 49.67 17.91 67.55 100.00 80,000 40,000 1,20,000 20.78 10.39 31.17 1,00,000 50,000 1,50,000 21.59 10.81 32.40

Note : Calculation have been made to the nearest rupee. (i) Calculation of percentage of Cash for 1997 Cash * Current = 23.38* 15.59* = 7.79 = Total Assets Fixed Assets = 100 76.62 = 23.38 ** Inventory + debtor = 5.20 + 10.39 = 15.59

(ii) Calculation of Percentage of overdraft for 1997 Total Current Liability Creditor = 31.17 20.78 = 10.39 (iii) Calculation of percentage of Debtors for 1998 Debtor * Current Assets = 25.06* 13.18 = 11.88 = Total Assets Fixed Assets = 100 74.94 = 25.06

2.6

EXERCISE

1. Define common size financial statement and explain their usefulness during financial statement analysis. 2. Why might it be unwise to predict a farm s financial future based on trend derived from historical financial information? 3. What are the steps involved in the financial statement analysis? 4. Discuss various techniques of financial statement.

69 5. Write short note on a. b. c. Comparative financial statement Trend analysis Qualification of financial analysis

6. What do you understanding by comparative financial statement? What information is required to prepare a comparative balance sheet? 7. Explain the procedure of preparing common size balance sheet. 8. The following are the balance sheet of a concern as on 31st December, 1987 and 1988. 9. Critically examine the various tools available to the financial analysis. What are the limitations of such tool?

Practical Problems: 1.
1987 Rs. 55,000 20,000 40,000 42,000 1,50,000 40,000 30,000 3,00,000 6,77,000 1988 Rs. 83,000 16,000 50,000 50,000 1,00,000 70,000 48,000 4,00,000 8,17,000 6,77,000 8,17,000 Cash Sundry Debtors Bills Receivable Stock in trend Machinery Building Goodwill 1987 Rs. 25,000 1,60,000 20,000 77,000 80,000 2,00,000 1,15,000 1988 Rs. 18,000 2,00,000 30,000 1,09,000 2,00,000 1,70,000 90,000

Liability Sundry Creditors Bills Payable Proposed Dividend Proposed Dividend 6% Debenture General Reserve Profit and Loss A/c Capital

Assets

Prepare a comparative balance sheet of the concern and study its financial position.

70 2. From the following information prepare a comparative statement and make brief comments. Income Statement (For the year ended 31st March 1987 and 1988)
1987 Rs. 2,80,000 1,92,000 88,000 15,000 18,000 33,000 55,000 22,000 33,000 1988 Rs. 3,10,000 2,22,000 88,000 12,000 18,000 30,000 58,000 23,200 34,800

Particulars Sales Less : Cost of Good Sold Gross Profit Less : Administrative Expenses Selling and Distribution Expenses Total Operating Expenses Net Income before Tax Less : Tax (40%) Net Income after Tax

3. Convert the following balance sheet into common size balance sheet and make brief comments. Balance Sheet (as on 31 March 1983 and 1984)
Liabilities Share Capital 6% Debenture Sundry creditor Provision for doubtful debtor Profit and loss A/c 1983 Rs. 5,00,000 3,40,000 1,60,000 45,000 75,500 1984 Rs. 6,50,000 2,00,000 67,000 3,000 1,65,000 Assets Machinery Building Investment Goodwill Bank balance Inventory Bill receivable 1983 Rs. 2,80,000 3,50,000 2,65,000 70,000 40,000 60,000 40,000 1984 Rs. 3,20,000 3,50,000 2,65,000 55,000 30,000 40,000 25,000

10,80,000

10,85,000

10,80,000

10,85,000

71 4. Following income statement of a business is given the for the year ending 31st December, 1987 and 1988 prepare a common size statement and make comments on the business result. Income Statement (for the ending on 31st Dec. 1987 and 1988)
Particulars Gross Sales Sales Return and Allowance Net Sales Cost of Good Sold Gross Profit from Sales Operating Expenses : Selling Expenses Advertising Expenses Sales Salary Delivery Expenses Depreciation Expenses Total Selling Expenses General and Administrative Expenses Office Salaries Insurance Depreciation Bad Debs Total General and Administrative Expenses Total Operating Expenses Operating Income 50,000 20,000 5,000 3,000 78,000 1,17,000 63,000 75,000 35,000 16,000 12,000 1,38,000 1,87,000 23,000 10,000 12,000 7,000 10,000 39,000 12,000 16,000 5,000 16,000 49,000 1987 Rs. 7,20,000 40,000 6,80,000 5,00,000 1,80,000 1988 Rs. 8,40,000 50,000 7,90,000 5,80,000 2,10,000

72

3
RATIO ANALYSIS AND INTERPRETATION I
Unit Structure : 3.0 Objectives 3.1 Introduction 3.2 Meaning of Ratio 3.3 Modes of Expressing an Accounting Ratio 3.4 Objectives of Ratios 3.5 Classification of Ratios 3.5.1 Traditional Classification 3.5.2 Functional Classification of Ratios 3.5.3 Classification from the view point of user 3.6 Balance Sheet Ratio 3.6.1 Current Ratio 3.6.2 Liquid Ratio 3.6.3 Proprietary Ratio 3.6.4 Stock Working Capital Ratio 3.6.5 Capital Gearing Ratio 3.6.6 Debt-Equity Ratio 3.7 Revenue Statement Ratios 3.7.1 Gross Profit Ratio 3.7.2 Operating Ratio 3.7.3 Expenses Ratio 3.7.4 Net Profit Ratio 3.7.5 Net Operating Profit Ratio 3.7.6 Stock Turnover Ratio 3.8 Combines Ratio / Composite Ratios 3.8.1 Return on Capital Employed 3.8.2 Return on Proprietors Funds 3.8.3 Return on Equity Share Capital 3.8.4 Earning per Share 3.8.5 Dividend Payout Ratio 3.8.6 Price Earnings Ratio 3.8.7 Debt Service Ratio 3.8.8 Debt Service Coverage Ratio 3.8.9 Creditors Turnover Ratio 3.8.10 Debtors Turnover Ratio

73 3.9 Limitations of Ratios

3.0

OBJECTIVES :-

After studying the unit the students will be able to Understand meaning of Ratios. Know the modes of expressing ratios. Know the objectives of ratios analysis. Classify the ratios.

3.1

INTRODUCTION :-

During the half of the 19th century, the bankers have started using accounting ratios for analyzing credit standing of prospective buyer (debtors). But the ratios analysis of bankers was very much restricted to the study of current ratios only. In 1919, Alexander was has criticized such restrictions and narrow analysis and pointed out the possible dangers of such analysis. He expressed in his view that in order is get clear picture of financial health of the business enterprise, one has to take into account various other relationships other than current ratios. Then the ratio analysis is considered as strong and efficient tools of analyzing the financial statement. Ratio analysis is the method or process of expressing relationship between items or group of items in the financial statement are computed, determined and presented. It is an attempt to draw quantitative measures or guides concerning the financial health and profitability of an enterprise. It can be used in trend and static analysis. It is the process of comparison of one figure or item or group of items with another, which make a ratio, and the appraisal of the ratios to make proper analysis of the strengths and weakness of the operations of an enterprise.

3.2

MEANING OF RATIOS :-

A ratio is one figure expressed in terms of another figure. It is mathematical yardstick of measuring relationship of two figures or items or group of items, which are related, is each other and mutually inter-dependent. It is simply the quotient of two numbers. It can be expressed in fraction or in decimal point or in pure number. Accounting ratio is an expression relating to two figures or two accounts or two set accounting heads or group of items stated in financial statement.

74

3.3

MODES OF EXPRESSING AN ACCOUNTING RATIO.

An accounting ratio may be expressed in different ways as under. I) Simple or pure ratio :- It is merely a quotient arrived by simple division of one number by another. Example : When current assets of the business enterprise are Rs. 1, 00,000 and current liabilities are Rs. 25,000. The ratio between current assets and current liabilities will be expressed 1 ,00,000 as 04 OR it is expressed as 4:1. 25,000 II) Percentages :- It is expressed as percentage relationship when simple or pure ratio is multiplied by 100. Example : The current ratio in above example is expressed in percentage by multiplying 4 by 100. i.e. 100 x 4 = 400% III) Rate :- The ratio is expressed as rates which refer to the ratio over a period of time. Example : Stock has turned over 8 times a year. IV) Number of days or week or month :- Certain items of the financial statements are expressed better in the form of days or weeks or months. Example : Debtors' collection period, credit payment period, movement of stock, etc are expressed in days or weeks or months in a year. If stock turnover ratio is 8 times, they movement of stock is expressed as under :
360 8

45 days,

52 8

6.5 weeks or

12 8

1.5 months

V) Rupees :- In this case numerator is divided by denominator and figure of result is expressed in rupees. Example : Earnings per share, dividend per share etc are expressed in rupees. It net profit after tax is Rs. 12,500 and number of shares of a company are 1250. NPAT 12,500 Earning per share = Rs.10 per share No. of shares 1 ,250

75 The ratios are useful for the following parties. 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. Investors, both present as well as potential investors. Financial analysist. Stock broker and stock exchange authorities. Government. Tax Department. Competitors Research analysist and students. Creditors and supplier. Banks and financial institutions. Company's management. Finance managers Mutual funds. Other interested parties like credit rating agencies.

3.4

OBJECTIVES OF RATIOS :-

The accounting ratios are very useful in assessing the performance of business enterprise i.e. financial position and profitability. This is possible to achiever by comparison of ratios of the year or with the previous year. The ratios are worked out to analyse the following aspect or areas of business organization. 1) Solvency: a) Long-term solvency b) Short-term solvency c) Immediate solvency 2) Stability 3) Profitability 4) Operational efficiency 5) Credit standing 6) Structural analysis. 7) Utilization of resources and 8) Leverage or external financing. Check your progress : 1. Define the following terms. a) Percentages c) Rates b) Simple / Pure Ratio d) Ratio 2. Explain the objectives of Ratio analysis.

76

3.5

CLASSIFICATION OF RATIOS: -

The ratios are used for different purposes, for different users and for different analysis. The ratios can be classified as under: a) Traditional classification b) Functional classification c) Classification from users point of view 3.5.1 Traditional classification : As per this classification, the ratios readily suggest through their names, their respective resources. From this point of view, the ratios are classified as follows. a) Balance Sheet Ratio :- This ratio is also known as financial ratios. The ratios which express relationships between two items or group of items mentioned in the balance sheet at the end of the year. Example : Current ratio, Liquid ratio, Stock to Working Capital ratio, Capital Gearing ratio, Proprietary ratio, etc. b) Revenue Statement Ratio :- This ratio is also known as income statement ratio which expresses the relationship between two items or two groups of items which are found in the income statement of the year. Example : Gross Profit ratio, Operating ratio, Expenses Ratio, Net Profit ratio, Stock Turnover ratio, Operating Profit ratio. c) Combined Ratio :- These ratios shows the relationship between two items or two groups of items, of which one is from balance sheet and another from income statement (Trading A/c and Profit & Loss A/c and Balance Sheet). Example : Return on Capital Employed, Return on Proprietors' Fund ratio, Return on Equity Capital ratio, Earning per Share ratio, Debtors' Turnover ratio, Creditors Turnover ratio. 3.5.2 Functional Classification of Ratios : The accounting ratios can also be classified according their functions as follows. a) Liquidity Ratios :- These ratios show relationship between current assets and current liabilities of the business enterprise. Example : Current Ratio, Liquid Ratio.

77 b) Leverage Ratios :- These ratios show relationship between proprietor's fund and debts used in financing the assets of the business organization. Example : Capital gearing ratio, debt-equity ratio, and proprietary ratio. This ratio measures the relationship between proprietors fund and borrowed funds. c) Activity Ratio :- This ratio is also known as turnover ratio or productivity ratio or efficiency and performance ratio. These ratios show relationship between the sales and the assets. These are designed to indicate the effectiveness of the firm in using funds, degree of efficiency, and its standard of performance of the organization. Example : Stock Turnover Ratio, Debtors' Turnover Ratio, Turnover Assets Ratio, Stock working capital Ratio, working capital Turnover Ratio, Fixed Assets Turnover Ratio. d) Profitability Ratio :- These ratios show relationship between profits and sales and profit & investments. It reflects overall efficiency of the organizations, its ability to earn reasonable return on capital employed and effectiveness of investment policies. Example : i) Profits and Sales : Operating Ratio, Gross Profit Ratio, Operating Net Profit Ratio, Expenses Ratio etc. ii) Profits and Investments : Return on Investments, Return on Equity Capital etc. e) Coverage Ratios :- These ratios show relationship between profit in hand and claims of outsiders to be paid out of profits. Example : Dividend Payout Ratio, Debt Service Ratio and Debt Service Coverage Ratio. 3.5.3 Classification from the view point of user : Ratio from the users' point of view are classified as follows. a) Shareholders' point of view :- These ratios serve the purposes of shareholders. Shareholders, generally expect the reasonable return on their capital. They are interested in the safety of shareholders investments and interest on it. Example : Return on proprietor's funds, Return on capital, Earning per share.

78 b) Long term creditors :- Normally leverage ratios provide useful information to the long term creditors which include debenture holders, vendors of fixed assets, etc. The creditors interested to know the ability of repayment of principal sum and periodical interest payments as and when they become due. Example : Debt equity ratio, return on capital employed, proprietary ratio. c) Short term creditors :- The short-term creditors of the company are basically interested to know the ability of repayment of short-term liabilities as and when they become due. Therefore, the creditors has important place on the liquidity aspects of the company's assets. Example : a) Liquidity Ratios - Current Ratio, Liquid Ratio. b) Debtors Turnover Ratio. c) Stock working capital Ratio. d) Management :- Management is interested to use borrowed funds to improve the earnings. Example : Return on capital employed, Turnover Ratio, Operating Ratio, Expenses Ratio.

3.6

BALANCE SHEET RATIOS

3.6.1 Current Ratio : This ratio is also known as working capital ratio. This expresses the relationship between current assets and current liabilities. This ratio is calculated by dividing current assets by current liabilities. It is expressed as pure ratio standard current ratio is 2:1. Means current assets should be double the current liabilities. Current Assets Current Ratio = Current Liabilities a) Current assets includes I) Inventories of raw materials, finished goods, work-in-progress, stores & spare, loose tools, II) Sundry debtors, III) Short-term loan, deposits, advance, IV) Cash on hand and bank, V) Prepaid expenses, accrued income, VI) Bills receivables, VII) Marketable investments, short term securities. b) Current liabilities includes sundry creditors, bills payables, outstanding expenses, unclaimed dividends, interest accrued but not due on secured and unsecured loans, advances received, income received in advance, provision for tax, purposed dividend loan installment of secured and unsecured loan payable within 12 months.

79 c) Significance : This ratio tests the credit strength and solvency of an organization. It shows strength of working capital, it indicates ability to discharge short term liabilities. 3.6.2 Liquid ratio : This ratio expresses the relationship between liquid assets and liquid liabilities. This ratio is also known as quick ratio or acid test ratio. This ratio is calculated by dividing liquid assets by liquid liabilities. Standard quick ratio is 1:1.

Liquid Ratio =

Liquid Assets / Quick Assets Quick or Current Liabilities

a) Liquid assets = Current assets less (Stock, prepaid expenses and advance tax etc) b) Liquid liabilities = Current liabilities less (Bank overdraft and cash credit etc) c) Significance :1) Indicate immediate solvency of enterprise. 2) Unlike CR it is more qualitative concept 3) As it eliminates inventories, it is rigorous test of liquidity. 4) More important for financial institutions. 3.6.3 Proprietary ratio : Proprietary ratio is a test of the financial and credit strength of the business. It establishes relationship between proprietors to total assets. This ratio determines the long term solvency of the company. Alternatively this ratio is also known as Worth Debt Ratio. Net worth to Total Assets Ratio, Equity Ratio, Net Worth Ratio or Assets Backing Ratio, Proprietor's funds to Total Assets Ratio or Share holders Funds to Total Assets Ratio. This ratio is expressed in percentage. a) Formula :Proprietory Ratio= Proprietors' or Shareholders' Fund 100 Total Assets

b) Components :1) Proprietors Funds = Paid up equity + Reserves and surplus less accumulated loss + paid up preference capital. 2) Total assets = Fixed assets + investment + current assets.

80 c) Purpose: - This ratio is exercised to indicate the long term solvency of the business. d) Significance: This ratio shows general financial strength of the business. 1) It determines the extent of trade on equity. 2) It indicates long term solvency of business. 3) It tests credit strength of business. 4) It can be used to compare proprietary ratio with others firms or industry. 3.6.4 Stock-working capital ratio : This ratio establishes relationship between stock and working capital. Alternatively it is known as "Inventory-working capital ratio". a) Formula :Stock-Working Capital Ratio = Stock Working Capital

b) Components :1) Stock (closing stock) 2) Working capital i.e. current assets less current liabilities. It can be expressed in percentage also by multiplying this ratio by 100. c) Purpose :- This ratio shows the extent to which the working capital is blocked in inventories. d) Significance :1) This ratio highlights the predominance of stocks in current financial position of organization. 2) A higher ratio indicates week working capital. 3) This ratio is the indicator of the adequacy of working capital. e) Standard Ratio :- Standard stock working capital ratio is 1:1. 3.6.5 Capital Gearing Ratio : This ratio brings out the relationship between capital carrying fixed rate of interest or fixed dividend and capital that doesn't carry fixed rate of interest or fixed dividend. This ratio indicates degree to which capital has been geared in the capital structure of the company.

81 Alternatively this ratio is also known as "Leverage ratio" or "Financial leverage ratio" or " Capital structure ratio". a) Formula :Capital bearing Fixed Interest or dividend Capital Gearing Ratio= Capital not bearing Fixed Interest or dividend

b) Components :1) Capital bearing fixed interest or dividend comprises of debentures, secured and unsecured loans, and preference share capital. 2) Capital not bearing fixed interest or dividend is equity share capital and reserve & surplus. This ratio also can be expressed in %age by multiplying this ratio by 100. c) Purpose :- This ratio is used to understand the effective capital structure of the company. d) Significance :1) It is mechanism to ascertain the extent to which the company is practicing trade or equity. 2) It brings one balanced capital structure. 3.6.6 Debt Equity Ratio : This ratio express the relationship between external equities and external equities i.e. owners' capital and borrowed capital. a) Formula :Debt equity ratio =
Debt Long Term Debts OR OR Equity Shareholders Fund

Long Term Debts Shareholders Funds + Long Term Debts

b) Components :1) Debts includes all liabilities including short term & long term i.e. mortgage loan and debentures. 2) Shareholders' funds consist of Preference share capital, Equity share capital, Capital and Revenue Reserves, Surplus, etc.

82 c) Significance :1) It shares favorable or non favorable capital structure of the company. 2) It shows long term capital structure. 3) It reveals high margin of safety to creditors. 4) It makes us understand the dependence on long terms debts. d) Standard :- Standard debt- equity ratio is 2:1. It means debts should be double the shareholders funds.

3.7

REVENUE STATEMENT RATIOS: -

Revenue statement ratios are the ratios which highlights the relation between two items from revenue statements i.e. Trading Account and Profit and Loss Account. 3.7.1 Gross profit ratio : Gross profit ratios express the relationship between gross profit and net sales. This ratio is also known as "Turnover ratio" OR "Margin ratio" OR "Gross margin ratio" OR "Rate of gross profit". This ratio is expressed in percentage of net sales. This ratio says about %age gross profit to net sales. a) Formula :Gross Profit Ratio= Gross Profit 100 Sales

b) Components of this ratio are :1) Net sales = Total sales less sales return 2) Gross profit = Sales - Cost of sales 3) Cost of sales = (opening stock + purchases + direct labour + other direct charge) - closing stock c) Significance :1) This ratio analyse the basic profitability of business. 2) It shows the degree to which the selling price per unit may decline without resulting in loss from operations. 3) Yearly comparisons of gross profit ratio reveal the trend of trading results. 3.7.2 Operating Ratio : This ratio studies the relationship between cost of activities and net sales i.e. cost of goods sold and net sales. This ratio

83 shows the percentage of cost of goods sold with net sales. This ratio is expressed in percentage. a) Formula :Operating Ratio = Operating Cost 100 Net Sales

b) Components :- Operating cost is equal to cost of goods sold and other operating expenses like administrative expenses, selling & distribution expenses etc. excluding finance expenses, income taxes, loss on sale of assets, etc. c) Purpose :- Purpose of operating ratio is to ascertain the efficiency of the management regarding operation of business concern. d) Significance :1) It is used to test operational efficiency of business. 2) This ratio is the yardstick which measures the efficiency of all operational activities of business i.e. production, management, administration, sales, etc. e) Limitation of operating ratio :1) It cannot test profitability of business without considering extra - ordinary items. 2) The utility of operating ratio is limited owing to its vulnerability to changes in management decisions. 3.7.3 Expenses Ratio : This ratio explains relationship of items or group of expense to net sales. Such ratios are collectively known as expanses ratio. This is calculated and expressed in percentage. This ratio expresses the percentage of items of expenses with net sales. a) Formula :Expenses Ratio = Item or Group of Expenses Net sales 100

b) Various expenses ratios are as follows :1) Administrative expenses ratio= 2) Selling & Dist. expenses ratio =
Administrative expenses Net sales 100

Selling & Dist. expenses 100 Net sales

84
3) Cost of material consumed ratio=

Cost of material sonsumed Net sales

Manufacturing expenses Sales

100

4) Manufacturing expenses ratio =

100

5) Non-operating expenses ratio =

Non operating expenses Net sales

100

c) Purpose and significance :1) This ratio helps us to know the cause behind overall changes in operating ratio 2) Purpose of this ratio is to take corrective action. 3) It indicates the efficiency of management in controlling expenses and improving profitability. 4) This ratio enables the income tax department to judge the correctness and reliability of income disclosed in income tax returns. 5) Analytical study of this ratio can be judged by trend of expenses. 6) Comparative study of year to year expenses can be possible. 3.7.4 Net profit ratio :Net profit ratio indicates the relationship between net profit and net sales. Net profit can be either operating net profit or net profit after tax or net profit before tax. Alternatively this ratio is also known as "Margin on sales ratio". Normally this ratio is calculated & expressed in percentage. a) Formula :Net profit ratio = Net profit Net sales OR 100 OR NPAT 100 Net sales

OR

NPBT 100 Net sales

ONP 100 Net sales

b) Significance :1) It measures overall profitability of business. 2) It is very useful in judging return on investments. 3) It provides useful inferences as to the efficiency and profitability of business.

85 4) It indicates the portion of net sales is available for proprietors. 5) It is clear index of cost control, managerial efficiency, sales promotion, etc. 3.7.5 Net operating profit ratio : Operating profit ratio indicates the relationship between operating profit and net sales. This ratio is expressed in percentage. a) Formula :Net operating profit ratio= Net operating profit 100 Net sales

b) Components :1) Net operating profit is equal to gross profit minus all operating expenses or sales minus cost of goods sold and operating expenses. 2) Net sales are equal to sales minus sales returns. c) Significance :1) It signifies higher operating efficiency of management and control over operating cost. 2) It indicates profitability of various operations of the organization i.e. buy, manufacture, sales, etc. 3) It shows ability of organization to generate operating profit out of its daily operations. 3.7.6 Stock Turnover Ratio : Stock turnover ratio shows relationship between costs of goods sold and average stock. This ratio is also known as "Inventory Ratio" or "Inventory Turnover Ratio" or "Stock Turn Ratio" or "Stock Velocity Ratio" or "Velocity of Ratio". This ratio measures the number of times of stock turns or flows or rotates in an accounting period compared to the sales affected during that period. This ratio indicated the frequency of inventory replacement. This ratio is expressed as rate. a) Formula :Stock Turnover Ratio = Cost of goods sold Average stock

b) Components :1) Cost of goods sold = Sales Gross Profit

86 2) Average Stock=
Opening stock + closing stock 2

* If opening stock is not given, the closing stock is treated as average stock. c) Alternative method of stock turnover ratio :- This ratio can be calculated by using average stock at selling price at as the denominator. Under this method, average stock at selling price is related to net sales. Net sales Stock Turnover Ratio= Average inventory at selling price d) Purpose :- Purpose of stock turnover ratio is to 1) Calculate the speed at which the stock is being turned over into sales. 2) Calculate the stock velocity to indicate the period takes by average stock to be sold out. 3) Judge how efficiently the stock are managed and utilised to generate sales.

3.8

COMBINES RATIO / COMPOSITE RATIOS :-

Combined or composite ratios relate two items or group of items of which one is from balance sheet and another from revenue statements of an enterprise. 3.8.1 Return on capital employed : This ratio explains the relationship between total profit earned by business and total investment made or total assets employed. It is expressed in percentage. This ratio is also known as "Return on Investment", or "Return on Total Resources". a) Formula :Return on capital employed = Profit before tax Interest 100 Capital Employed

b) Components :1) Net profit before tax, interest & dividends (PBIT) 2) Capital employed Capital employed = i) Equity share capital ii) Add. Preference share capital reserve & surplus iii) Add. Long term borrowings (Term loan + Debentures)

87 iv) Less: Fictitious assets like miscellaneous expenses not written off. v) Less profit & loss A/c Dr. Balance (loss) c) Purpose :1) Purpose of this ratio is to measure overall profitability from the total funds made available by owners and leaders. 2) Purpose of this ratio is to judge how efficient the business concern is in managing the funds at its disposal. d) Significance: 1) This ratio is effective tools to measure overall managerial efficiency of business. 2) Comparison of this ratio with other company and this information can be obtained for determining future course of action. 3) This ratio indicate the productivity of capital employed and measure the operating efficiency of the business. 3.8.2 Return on Proprietors Funds : This ratio measures the relationship between net profit after tax & interest and proprietors fund. This ratio is alternatively known as "Return on proprietors' equity" or "Return on shareholders' investment" or "Investors' ratio". This ratio is expressed in percentage. a) Formula :Return on Proprietor's Fund = Net profit after tax & Interest (NPATI) Pr oprietors' Fund 100

b) Components :1) Net profit after tax and interest 2) Proprietors' funds Term proprietors fund is explained in para 3.6.3 - b) c) Purpose: 1) Purpose of this ratio is to measure the rate of return on the total fund made available by the owners. 2) This ratio helps to judge how efficient the concern is in managing owners' funds at its disposal. d) Significance: 1) This ratio is very significant to prospective investors and shareholders.

88 2) With the help of this ratio company can decide to rise finance from external sources even from public deposit it ratio is satisfactory. 3) Shareholders can expect to capitalize its reserves and issue bonus shares when ratio is higher for reasonable period of time. 3.8.3 Return on equity share capital : This ratio explains relationship between net profit (after tax and interest and dividend on preference share) and equity share holders' funds. This ratio is expressed in percentage. a) Formula :Return on Equity Capital = Net profit after tax less preference dividend Equity share capital 100

Alternatively this ratio may be calculated by using following formula for calculating the return per equity shares.
Return on Equity Shares = Net profit after tax less preference dividend Number of Equity share

b) Components :1) Net profit after tax & interest and preference dividend. 2) Equity share capital by adding reserves or deducting miscellaneous expenditures. c) Purpose :Purpose of this ratio is to calculate amount of profit available to take care of equity dividend, transfer to reserves, etc. d) Significance :1) It is useful to the investors while deciding whether to purchase or sale of shares. 2) This ratio helps to make comparative study of equity capital with other company and it will be appreciate if there is high return. 3.8.4 Earning per share : Earning per share is calculated to find out overall profitability of the organization. It represents earnings of the company whether or not dividends are declared. Earning per share is determined by dividing net profit by the number of equity shares.

89 a) Formula :Earning per shares (EPS) = Net profit after tax - preference dividend Number of Equity share

b) Components :1) Net profit after tax & interest - less preference dividend. 2) No. of equity shares. c) Purpose :Purpose of this ratio is to calculate the amount of profits available on each equity share to take care of equity dividend, transfer to reserves, etc. d) Significance :1) This ratio helps the investors or shareholders to take decision while purchasing or selling shares. 2) This ratio shows the possibilities of issue of bonus shares. 3) Higher ratio indicates overall profitability. 3.8.5 Dividend payout ratio : This ratio shows relationship between dividends paid to equity shareholders out of profit available to the equity share holders. a) Formula: This ratio is calculated as follows. Dividend per equity shares Dividend payout ratio = Earning per shares b) Components: 1) Dividend per equity shares means total dividend paid to equity shareholder dividend by number of equity shares. 2) Earning per shares as per Para 3.8.4. c) Purpose: - Purpose of this ratio is to measure the dividend paying capacity of the company. d) Significance: 1) Higher ratio signifies that the company has utilized the larger portion of its earning for payment of dividend to equity shareholders. 2) It says lesser amount of earning has been retained.

90 3.8.6 Price earnings ratio (PE Ratio) : This ratio measures relationship between market price of equity shares and earnings per share. It is usually expressed as a fraction. a) Formula: Price Earning Ratio= Market price per Equity shares Earning per Equity shares

b) Components: 1) Market price per equity share = quoted price of a listed equity share. 2) Earnings per equity share = as worked out in Para 3.8.4. c) Purpose: 1) Purpose of this ratio is to show the effect of the earning on the market price of the share. 2) It helps the investors while deciding whether to purchase, keep or sell the equity shares. 3) It helps to ascertain the value of equity share. 3.8.7 Debt service Ratio : Debt service ratio shows relationship between net profit and interest payable on loans. This ratio is also called as interest coverage ratio. This ratio is expressed as a pure number. a) Formula :Debt service ratio = Net profit before interest & tax Interest charges

b) Components :1) Profit before interest & tax means net profit before payment of interest on loan and tax. 2) Interest means interest on long term loans. c) Purpose :1) Purpose of this ratio is to measure the interest paying capacity the company. 2) The purpose of this ratio is to find out the number of times the fixed financial charges are covered by income before interest and tax.

91 d) Significance :1) It is important from the lenders' point of view. 2) It indicated whether the company will earn sufficient profits to pay periodical interest charges. 3) It shows that the company will be able is pay interest regularly. 3.8.8 Debt service coverage ratio : Debt service coverage ratio shows the relationship between net profit and interest plus loan installments payable. This ratio is expressed in pure number. a) Formula :Debt service coverage Ratio = Cash profit available for debt servicing Interest + Installment due on loan

b) Components :1) Net profit + non-cash debit to P & L A/c (depreciation + goodwill written off, deferred revenue expenditure written off, loss on sale of fired assets) = cash profit for debit servicing. 2) Interest means interest on long term loan. 3) Installments means installments due on long term loan during the year. c) Purpose :- Purpose of this ratio is to measure the debt servicing capacity of the company. 3.8.9 Creditors Turnover Ratio : This ratio shows relationship between the net credit purchases and the average creditors. This ratio is express as a rate. a) Formula :Creditors' Turnover Ratio= Net credit purchases Average creditors OR Credit purchases Creditors + Bills payable

365 day or 12 months Credit payment period OR (Creditors velocity) = Creditors turnover ratio OR

Creditors + Bills payable Daily credit purchases

92 b) Components: 1) Credit purchases means gross credit purchases minus purchases returns. 2) Average creditors mean average of opening and closing amount of creditors. If details are not given then only closing creditors may be considered as average creditors. 3) Amount of bills payable. c) Purpose: Purpose of this ratio is to. 1) Calculate the speed with which creditors are paid off on aan average during the year. 2) Calculate the creditors' velocity to indicate the period taken by the average creditors to be paid off. 3) Judge how efficiently the creditors are managed. 3.8.10 Debtors' Turnover Ratio : This ratio shows relationship between credit sales and average trade debtors. Alternatively this ratio is known as "accounts receivable turnover ratio" or "turnover of debtors' ratio". This ratio is expressed as a rate. a) Formula :Debtors turnover ratio = Credit sales Average debtors OR Credit sales Accounts receivable

OR

Credit sales Debtors + Bills receivable

Average collections period =

Debtors + Bills Receivable Daily credit sales

365 days Credit sales

OR

365 days or 12 months Debtors turnover ratio

OR

Average debtors

b) Components :1) Sundry debtors 2) Accounts receivables i.e. bills receivables. 3) Average daily sales.

93 c) Purpose :- Purpose of this ratio is to. 1) Calculate the speed with which debtors get settled on an average during the year. 2) Calculate debtors' velocity to indicate the period of credit allowed to average debtors. 3) Judge how efficiently the debtors are managed.

3.9

LIMITATIONS OF RATIOS: -

1. Ratios are mainly based on financial statements therefore weaknesses of financial statements are carried forward in the ratios. 2. Ratios calculated between two unrelated items or groups would be useless. e.g. ratio between cost of goods sold and preliminary expenses. 3. Ratios are just indicators. Just calculation of ratios cannot improve the financial position. Corrective and preventive steps should be taken to improve financial position and profitability of business. 4. Standard ratios changes from industry to industry. Maintenance of ratios is not only the objective but improving the financial stability and solvency and profit maximization should be the objective. 5. Increase or decrease in the ratio may be due to change in the economic factors of the country or due is inflation. Such increase or decrease not due to efficiency or inefficiency of the management of the business organization. 6. It is very difficult make correct inter-comparison of the firm because two firms are not similar in age, size and in system of following accounting policies. 7. Financial statements are prepared at ending the year. It might be subject to window dressing for covering bad financial position and ratios are not reliable which are based on manipulated financial statement. Check your progress : 1. Give the formula and significance of the following ratios. a) Debtors Turnover Ratio b) Earning per share Ratio c) Return on Proprietors Ratio

94 d) Operating Ratio e) Capital Gearing Ratio 2. Give the formula and components of the following ratios. a) Debt Service Ratio b) Price Earning Ratio c) Return of Equity Share Capital Ratio d) Stock Turnover Ratio e) Net Profit Ratio f) Debt Equity Ratio g) Proprietary Ratio

4
RATIO ANALYSIS AND INTERPRETATION II
Unit Structure : 4.0 Objectives 4.1 Illustration 4.2 Exercise

4.0

OBJECTIVES :-

After studying the unit the students will be able to Calculate the ratios if the Balance Sheet and Profit Statements are given.

4.1

ILLUSTRATIONS :-

1. Following is the trading A/c and profit and loss A/c for the year ended 31st December, 2009.

95
Particulars
To Opening Stock To Purchases To Wages To Factory Expenses To Gross Profit c/d

Rs.
40,000 4,00,000 1,00,000 1,40,000 3,80,000 10,60,000

Particulars
By Sales By Closing Stock

Rs.
9,00,000 1,60,000

10,60,000 By Gross Profit b/d By Interest Received 3,80,000 10,000

To Administrative Expenses To Selling Expenses To Interest on Loan To Debenture Interest To Net Profit c/d

1,20,000 80,000 10,000 16,000 1,64,000 3,90,000

3,90,000 By net profit b/d 1,64,000

To Tax Provision To Proposed Dividend To Balance Profit

40,000 40,000 84,000 1,64,000

1,64,000

96 Balance sheet as on 31st December, 2009

Liabilities
Equity share capital (Rs.10) 9% preference share capital 8% debentures Reserves Profit & Loss A/c Short term loan (Repaid within one year) Bank overdraft Sundry creditors Bills payable Provision for tax proposed dividend

Rs.
4, 00,000 3,00,000 2,00,000 1,00,000 60,000

Assets
Land and building Machinery Furniture Goodwill Patents Vehicles

Rs.
3,50,000 3,00,000 2,00,000 1,00,000 1,00,000 2,80,000 1,00,000 1,60,000 1,80,000 60,000

2,00,000 1,50,000 2,80,000 60,000 40,000 40,000

Investment Stock Debtors Bills receivable

18,30,000

18,30,000

Market price of equity share is Rs. 8 calculate the following ratios. a) Current ratio b) Acid test ratio c) Capital gearing ratio d) Stock turnover ratio e) Debtors turnover ratio f) Creditors turnover ratio g) Return on capital employed ratio h) Stock working capital ratio i) Operating ratio j) Earnings per share k) Price earnings ratio l) Net profit ratio m) Gross profit ratio n) Debt equity ratio o) Proprietary ratio p) Operating profit ratio q) Debtors' collection period.

97 Solution :

a) Current Ratio =

Current Assets Current Liabilities

4,00,000 7,70,000

0.519 : 1

b) Acid Test Ratio =

CA Stock CL Bank Overdraft

2,40,000 6,20,000 0.387 : 1

4,00,000 1 ,60,000 7,70,000 1 ,50,000

c) Capital Gearing Ratio

= Pref. Share Capital + Borrowed Funds Equity Share Capital + Reserve Misc. Expenses

3,00,000 2,00,000 4,00,000 1 ,00,000 60,000 NIL

5,00,000 5,60,000
d) Stock Turnover Ratio =

0.893
Cost of Goods Sold Average Stock

5,20,000 1 ,00,000
* Cost of Goods Sold = Sales

5.20 times

Closing Stock 3, 80,000

= 9, 00,000 = 5, 20,000 * Average stock

=

Opening Stock + Closing Stock 2 40,000 1 ,60,000 2

2,00,000 2
e) Debtor Turnover Ratio =

1 ,00,000

Credit Sales Debtors + B.R.

9,00,000 1 ,80,000 60,000

3.75

98

f) Debtor Collection Period =

=

Debtors + B.R. Credit Sales

No. of working days in a year

1,80,000 + 60,000 360 9, 00,000 2,40,000 360 = 96 days 90,000

g) Creditors Turnover Ratio =

Credit Purchases Creditors + BP

4,00,000 2,80,000 60,000 4,00,000 3, 40,000 1.716

h) Return on Capital Employed Ratio

= Profit before Interest & Tax 100 Capital Employed

(1,64,000 16,000) 100 10,60,000 1,80,000 100 10,60,000

i) Stock Working Capital Ratio =

16.98%

Closing Stock Working Capital

1 ,60,000 3,70,000

0.43

j) Operating Ratio =

(Cost of Goods Sold + Operating Expenses) 100 Sales

(5,20,000 1,20,000 80,000 10,000) 100 9,00,000 7,30,000 100 9,00,000 81.11%

99 k) Earnings per Share = Net Profit after Tax and

= Preference Dividend No. of Equity Shares

1,64,000 40,000 27,000 40,000 97,000 40,000

l) Price Earning Ratio =

Rs.2.425

Market price of Equity Shares Earning per Shares

8 2.425
m) Net Profit Ratio =

3.298

Net Profit after Tax & Interest 100 Sales

1,64,000 40,000 100 9,00,000

1 ,24,000 100 9,00,000 13.78%

n) Gross Profit Ratio =

Gross Profit 100 Sales

3,80,000 100 9,00,000

o) Proprietory Ratio =

42.22%

Proprietors Fund 100 Total Assets

8,60,000 100 18,30,000

p) Debt Equity Ratio =

46.99%

Borrowed Fund Proprietor's Fund

2,00,000 8,60,000 0.232 : 1

100
q) Operating Profit Ratio = Operating Profit 100 Sales

1,70,000 100 9,00,000 18.89%

Working Notes: W.N.1 Vertical income statement for the year ended 31st December, 2009. Particulars
1. Net Sales 2. Less: Cost of Goods Sold Opening Stock Purchases Wages Factory Expenses Less: Closing Stock cost of Cost sold 3. Gross Profit 4. Less: Operating Expenses a) Administrative Expenses b) Selling Expenses c) Financing Expenses - Interest on Share Term Loan 5. Operating Profit 6. Add: Nom-operating Income - Interest received 7. Net Profit interest & Tax 8. Less: Interest on Debenture 9. Net Profit before Tax 10. Less: Income Tax 11. Net Profit after Tax 12. Less: Preference Dividend (9% of 3, 00,000) 13. Net Profit available for Equity shareholders. 14. Less: Equity Dividends (40,000 - 27,000) 15. Retained Earnings

Rs.

Rs.

Rs.
9,00,000

40,000 4,00,000 1,00,000 1,40,000

6,80,000 1,60,000 5,20,000 3,80,000

1,20,000 80,000 10,000 2,10,000 2,10,000 1,70,000 10,000 1,80,000 16,000 1,64,000 40,000 1,24,000 27,000 97,000 13,000 84,000

101 W.N.2 Vertical balance sheet as on 31st December, 2009. Particulars

. Sources of Funds I. Owner's / shareholder's funds a) Equity Share Capital b) Reserves & Surplus Reserve P & L A/c c) Preference Share Capital II. Borrowed / Loan Funds 8% Debentures CAPITAL EMPLOYED (I + II) B. Application of funds I. Fixed Assets Land & Building Machinery Furniture Vehicles Goodwill Patents II. Investments III. Working Capital a) Current Assets Quick Assets Debtors Bills Receivables Non-quick Assets Closing Stock b) Less: Current Liabilities Quick Liabilities Creditors Bills Payable Provision for Tax Proposed Dividends Short Term Loan Non-quick Liabilities Bank Overdraft Working Capital (CA-CL) CAPITAL EMPLOYED (I+II+III)

Rs.

Rs.

Rs.

4,00,000 1,00,000 60,000

1,60,000 3,00,000

8,60,000 2,00,000 10,60,000

3,50,000 3,00,000 2,00,000 2,80,000 1,00,000 1,00,000

13,30,000 1,00,000

1,80,000 60,000 2,40,000 1,60,000 4,00,000

2,80,000 60,000 40,000 40,000 2,00,000 6,20,000 1,50,000 (7,70,000) (3,70,000) 10,60,000

102 2. M/s Raj & Sons presents you the following balance sheet as on 31st December, 2008. Liabilities
Share capital Equity share of Rs. 10 each Reserve fund 7% debentures Overdraft Creditors

Rs.
10,00,000 1,00,000 3,00,000 2,00,000 3,00,000 19,00,000

Assets
Fixed assets Stock Debtors Cash

Rs.
10,00,000 4,00,000 3,00,000 2,00,000

19,00,000

Calculate -

I) Liquidity ratios II) Solvency ratios III) Debt-equity ratio

Solution : 1) Liquidity ratios :-

a) Current Ratio =

Current Assets Current Liabilities

9,00,000 5,00,000

1.8 : 1 or 1.8

b) Acid Test Ratio =

Liquid Assets Liquid Liabilities

Current Assets Stock Current Liabilities Overdrafts

9,00,000 4,00,000 5,00,000 2,00,000 5,00,000 3,00,000 1: 66 : 1

OR If Liquid Liabilities = Current Liabilities, then Acid Test Ratio is as under 5,00,000 1: 1 5,00,000 Stock c) Stock Working Capital Ratio = Working Capital
4,00,000 9,00,000 5,00,000 4,00,000 4,00,000 1: 1

103 2) Solvency ratios :-

(a) Proprietory Ratio =

Shareholders Funds Total Tangible Assets or Total Assets

0.58 : 1 or 0.58

11 ,00,000 19,00,000

100 = 58%

Note: I) Shareholders Fund= Eq. Share Capital + Reserve = 10,00,000 + 1,00,000 = 11,00,000 II) Total Tangible Assets = Total Assets = Rs.19,00,000

(b) Equity to Fixed Assets Ratio =

Shareholders' Funds Fixed Assets

1.1: 1

11,00,000 10,00,000 OR = 1.1

100=11.1%

(c) Equity to Current Assets Ratio =

Shareholders' Funds Current Assets

11,00,000 10,00,000 OR 1.1: 1

= 1.1

100=100%

3) Debt Equity Ratio =

Outsiders' Funds Shareholder's Fund

8,00,000 11 ,00,000

0.73 : 1

Outsider's Fund = Debentures + Creditors + Overdraft = 3,00,000 + 3,00,000 + 2,00,000 = Rs. 8,00,000 OR It outsiders fund = Debentures only

Then Debt Equity Ratio =

Outsiders' Funds Shareholder's Fund

3,00,000 8,00,000

0.373 : 1

104 3. From the following financial statements of M/s Sunny Ltd. calculate. 1) Current Ratio 2) Liquid Ratio 3) Gross Profit Ratio 4) Net Profit Ratio 5) Net Profit to Capital Employed Ratio 6) Fixed Assets Turnover Ratio 7) Sales to Capital Ratio 8) Debtors Turnover Ratio Balance sheet as on 31st March, 2009. Liabilities
Share capital Reserve Profit & Loss A/c Debentures Current Liabilities

Rs.
1, 50,000 60,000 24,000 60,000 1, 52,000

Assets
Fixed Assets (Net) Current Assets Stock Debtors Cash

Rs.
80,000

1, 88,000 1, 64,000 14,000

4, 46,000

4, 46,000

Income statement for the year ending 31st March, 2009 Particulars Sales : Cash Credit Less: cost of sales Gross profit Less: Expenses Warehouse & Transport Administration Selling & Distribution Debenture Interest Net profit before tax Less: Income tax Net profit after tax Rs. 64,000 6,84,000 Rs. 7,48,000 5,96,000 1,52,000

48,000 38,000 28,000 4,000

1,18,000 34,000 4,000 30,000

105 Solution :

1) Current Ratio =

Current Assets Current Liabilities

1,88,000 1,64,000 14,000 1,52,000 3,66,000 1,52,000 2 : 41: 1 2.4078 : 1

2) Liquid Ratio =

Liquid Assets Liquid Liabilities

Current Assets - Stock Liquid Liabilities = Current Liabilities 1,88,000 1,64,000 14,000 1,88,000 1,52,000 3,66,000 1,88,000 1,52,000 1.17 : 1 1,78,000 1.171: 1 1,52,000

3) Gross Profit Ratio =

Gross Profit 100 Sales

20.3208%

1,52,000 100 7, 48,000 20.32%

4) Net Profit Ratio =

Net Profit after Tax 100 Sales 30,000 100 4.010% 7,48,000

4.01% OR Net Profit beforeTax Sales 34,000 100 7,48,000 4.55% 100

4.545%

106

5) Net Profit to Capital Employed =

Net Profit after Tax 100 Capital Employed 30,000 100 2,94,000

10.20%

OR If Net Profit before Tax is considered then Net Profit to Capital employed will be as under. Net Profit before Tax = 100 Capital Employed 34,000 100 2,94,000
11.56%

Capital Employed = Fixed Assets + Investment + Working Capital = 80,000 + 0000 + (3,66,000 - 1,52,000) = 80,000 + 2,14,000 = 2,94,000
6) Fixed Assets Turnover Ratio = Cost of Goods Sold Fixed assets

5,96,000 80,000 7.45 Times

7) Sales to Capital Employed =

Sales Capital Employed 7,48,000 2,94,000

2.54 Times
8) Debtors Turnover Ratio = Net Credit Sales Debtors

6,84,000 1,64,000 4.17 Times

107 4. From the following financial statement of X co. Ltd. for the year ended 31st December, 2009, calculated the following ratios. I) II) III) IV) V) VI) VII) VIII) IX) X) Current Ratio Liquid Ratio Operating Ratio Stock-Turnover Ratio Turnover to Fixed Assets Ratio Return on Total Resources Return on Proprietors Fund Net Profit to Capital Employed Debtors Velocity Creditors' Turnover Ratio. Balance sheet as on 31st March, 2009. Liabilities
Equity Share capital General Reserve Profit & Loss A/c Sundry Creditors

Rs.
5,00,000 3,00,000 2,00,000 2,00,000

Assets
Land & Buildings Plant & Machinery Stock Sundry debtors Cash & Bank

Rs.
3,50,000 2,50,000 3,00,000 2,00,000 1,00,000

12,00,000

12,00,000

Trading and profit & Loss A/c for the ended 31st December 2009.
Particulars To Opening Stock To Purchases (Credit) To Gross Profit Rs. Particulars Rs. 16,00,000 2,00,000

1,00,000 By Sales 8,00,000 By Closing Stock 9,00,000

18,00,000 To Office & Administrative Expenses To Selling & Distribution Expenses To Other Expenses To Net Profit By Gross Profit 2,00,000 By Profit on Sale of Assets 1,00,000 25,000 6,00,000

18,00,000 9,00,000 25,000

9,25,000

9,25,000

108 Solution :
I) Current ratio= Current Assets Current Liabilities 6,00,000 2,00,000
II) Liquid Ratio =

3,00,000 2,00,000 1,00,000 2,00,000

3 :1
2,00,000 1,00,000 2,00,000

Liquid Assets Liquid Liabilities 3,00,000 2,00,000 1.5 : 1

III) Operating Ratio =

Cost of Goods Sold + Operating Expenses Sales 10,25,000 16,00,000 0.64 : 1

7,00,000 3,25,000 16,00,000 OR 0.64 100 = 64%

IV) Stock Turnover Ratio=

COGS Averages Stock

7,00,000 (1,00,000 2,00,000) 2

7,00,000 1,50,000

4.67 Times

V) Turnover to Fixed Assets Ratio =

Turnover Fixed Assets 2.67 : 1

16,00,000 6,00,000
VI) Return on Proprietors Fund =

Net profit after Tax & Interest Proprietor's Fund 6,00,000 10,00,000 OR 0.60 : 1

= 0.60

100=60%

109
VII) Net Profit to Capital Employed = Net Profit after Tax & Interest Capital Employed 6,00,000 10,00,000 OR = 0.60 100 = 60%
VIII) Debtors Velocity Ratio = Debtors 365 Credit Sales 2,00,000 365 16,00,000 46 Days IX) Creditors Velocity = Creditors 365 Credit Purchases 2,00,000 365 8,00,000 91 Days

0.60 : 1

4.2

EXERCISE :-

1. From the following financial statement of Sanket Ltd. calculate the following ratios. a) Current Ratios b) Liquid Ratios c) Stock Turnover Ratio d) Debtors Turnover Ratio e) Operating Ratio f) Capital Gearing Ratio g) Net Profit Ratio h) Stock Working Capital Ratio i) Earnings per Equity Share j) Interest Coverage Ratio k) Creditors Turnover Ratio l) Dividend Payout Ratio m) Gross Profit Ratio

110 Trading and profit & Loss Account for the year ended 31st December, 2009.
Particulars
To Opening Stock To Purchases To Gross Profit c/d

Rs.
1,50,000 12,90,000 2,10,000 16,50,000

Particulars
By Sales By Closing Stock

Rs.
15,00,000 1,50,000

16,50,000 By Gross Profit b/d By Profit on Sale of Fixed Assets 2,10,000 27,500

To Administrative Expenses To Rent & Taxes To Interest To Selling Expenses To Depreciation To Income Tax Provision To Net Profit

20,000 14,000 22,500 11,000 50,000 60,000 60,000 2,37,500

2,37,500

Balance sheet as at 31st December 2009 Liabilities

Equity Share Capital of Rs. 10 each 10% Preference Share Capital General Reserve 12% Debentures Creditors Outstanding Expenses Income Tax Provision

Rs.
2,50,000 50,000 2,00,000 3,50,000 30,000 55,000 65,000 10,00,000

Assets
Fixed Assets Bank Balance Short term Investment Debtors Stock

Rs.
6,50,000 25,000 75,000 1,00,000 1,50,000

10,00,000

The company declared dividend on Equity Shares @ 20%. 2. The condensed balance sheet of Dixit Ltd. as on 31st March 2006 is as follows: Liabilities
Equity Share Capital Reserve 6% Debentures Current Liabilities Bank Overdraft

Rs.
6,00,000 2,00,000 5,00,000 2,00,000 1,00,000

Assets
Fixed Assets Stock Marketable Investment Debtors Cash and Bank balance Preliminary Expenses

Rs.
9,00,000 3,00,000 1,00,000 1,50,000 1,00,000 50,000 16,00,000

16,00,000

111 Net profit for the years was Rs.75,000/-. Prepare a statement suitable for analysis and indicate the soundness of the financial positions of the company by calculating the following ratios and comment on the same. a) b) c) d) e) f) g) Current Ratio Liquid Ratio Proprietary Ratio Return on Capital Employed Return on Proprietors Equity Return on Equity Capital Stock Working Capital Ratio (M.U.B.Com. April 1999)

3. The following is the Balance Sheet of Swapnaja Ltd. as on 31st December 2009. Liabilities
Paid up Capital (Rs.10) Reserves & Profit Debentures Creditors Bills Payable

Rs.
2, 00,000 1, 38,000 2, 00,000 32,000 12,000

Assets
Fixed Assets Stock Debtors Bills Receivable Bank Balance

Rs.
3, 00,000 1, 00,000 1, 22,000 8,000 52,000

5, 82,000

5, 82,000

Sales Rs.4,00,000/-; Gross Profit Rs.1,20,000/-; Net Profit Rs.80,000/-. Rearrange the above Balance Sheet in suitable form for analysis and workout the following ratios. a) b) c) d) e) f) g) h) Net Profit Ratio Gross Profit Ratio Current Ratio Liquid Ratio Return on Capital Employed Debtors Turnover Ratio Earnings per Share Stock Turnover Ratio.

112 Answer :1. a) Current Ratio = 1.72:1 b) Liquid Ratio = 0.97:1 c) Stock Turnover Ratio - 8.6 Times d) Debtors Turnover Ratio - 15 e) Operating Ratio - 89% f) Capital Gearing Ratio - 1.012:1

g) Net Profit Ratio - 4% h) Stock Turnover Ratio - 1.034 i) j) Earnings per Share - Rs.2.2 per share Interest Coverage Ratio - Rs.6.33

k) Creditors Turnover Ratio - 43 l) Dividend Payout Ratio - 0.909

m) Gross Profit Ratio - 14%] 2. a) Current Ratio - 1.83:1 b) Liquid Ratio - 1.25:1 c) Proprietary Ratio - 46.88% d) Return on Capital Employed - 6% e) Return on Proprietors Equity - 10% f) Return on Equity Capital - 12.5% g) Stock Working Capital Ratio - 1.2:1 3. a) Net Profit Ratio - 20% b) Gross Profit Ratio - 33% c) Current Ratio - 6.41:1 d) Liquid Ratio - 4.14:1 e) Return on Capital Employed - 14.87% f) Debtors Turnover Ratio - 3.077

g) Earnings per Share - Rs.04 per share h) Stock Turnover Ratio - 2.8

Note: - Closing Stock = Average Stock

113

5
RATIO ANALYSIS AND INTERPRETATION III
Unit Structure : 5.0 Objectives 5.1 Introduction 5.2 Reverse Ratios or Indirect Ratios 5.3 Illustrations 5.4 Exercise

5.0

OBJECTIVES :-

After studying the unit the students will be able to: Understand the procedure of reverse or indirect ratios. Solve the problems on reverse ratios.

5.1

INTRODUCTION :-

Every business organization prepares their financial statements i.e. income statements and balance sheet on the last date of the year or financial year. The financial statement is prepared in the vertical form and presented before the management for their kind considerations and information. Then the required ratios are calculated, followed by its interpretation and comments on them. This is very effective and important tool of management.

5.2

REVERSE RATIOS OR INDIRECT RATIOS :-

The procedure of reverse or indirect ratios follows in reverse order. In case of indirect ratios, Income statements and balance sheets are prepared, with the help ratios given either in regular format or in vertical format. The reverse or indirect ratios are tricky than direct ratios and to solve them an analytical understanding and conceptual clarity is required. The formulas of all ratios, interrelationship amongst the

114 ratios, the detailed knowledge of income statements and balance sheet with all components and angles is essential. It is the extension of direct ratios. The basis objective of indirect ratio is to check the complete clarity and understanding of entire ratio analysis. This system or angle of ratio analysis checks the arithmetical accuracy of the financial statement.

5.3

ILLUSTRATION :-

1. Calculate from the following details furnished by Swaraj Ltd. I) Current Ratio II) Liquid Ratio III) Creditors Turnover Ratio and Average Credit Period IV) Debtors' Turnover Ratio and Average Credit Period. V) Stock Turnover Ratio. Stock Debtors Cash Creditors Bank Overdraft Outstanding Expenses Total Purchases Cash Purchases Gross Profit Ratio Rs. 8,00,000 1,70,000 30,000 3,00,000 40,000 60,000 9,30,000 30,000 25%

Offer your comments on short term credit position of the company. Comments on individual ratio are not desirable. Solution: -

I) Current Ratio =

Current Assets Current Liabilities 10,00,000 4,00,000 2.5 : 1

8,00,000 1 ,70,000 30,000 3,00,000 40,000 60,000

II) Liquied Ratio =

Liquied Assets Liquid Liabilities 2,00,000 3,60,000 0.55 : 1

1,70,000 30,000 3,00,000 60,000

115

III) a) Creditors Turnover Ratio =

Credit Purchases Average Creditors 9,30,000 30,000 3,00,000 9,00, 000 3,00,000 3 Times

b) Average Credit Period =

No. of Working Days / Months / Week Creditors turnover ratio 365 3 = = 12 3 52 3 121.67 122 Days 4 Months 17.33 17 Weeks

IV) a) Debtors Trunover Ratio =

Credit Sales Average Debtors 12,40,000 1,70,000 7.39 Times

b) Average Credit Period =

No. of Working Days / Months / Week Debtors Turnover Ratio 365 7.29 50.04 Days 7.12 Weeks 1.64 Months

= =

52 7.29

12 7.29

Note: - I) It purchase is 75 - Gross Profit - 25 It purchase 9, 30,000 - ?

116

9,30,000 25 75,000 Gross Profit = Rs. 3,10,000

II) Sales = Purchases + Gross Profit = 9,30,000 + 3,10,000 =12,40,000 Rs. Sales = Rs.12,40,000
V) a) Stock Turnover Ratio = = Cost of Goods Sold Average Stock (Sales - Gross Profit) Average Stock 12,40,000 3,10,000 8,00,000 9,30,000 8,00,000 1.66 Times

b) Stock Velocity Ratio =

No. of Working Days / Months / Weeks Stock Turnover Ratio 365 1.66 313.97 or 314 days 44.73 W eeks 10.32 Months

52 1.66 12 1.66

2. From the following details prepare statement of working capital. I) Stock Turnover Ratio = 6 II) Gross Profit Ratio = 20% III) Debtors Turnover Ratio : 2 months IV) Creditors Turnover Ratio = 73 days V) Gross Profit : Rs.60,000 VI) Closing Stock was Rs.5,000 in excess of Opening Stock Solution :

117
I) Gross profit ratio = 20 = Gross profit 100 Sales 60,000 100 Sales 100 100 5

20 Sales = 60,000
Sales = 60,000

Sales = Rs. 3,00,000

II) Cost of goods sold = Sales Gross profit = 3,00,000 60,000 = Rs. 2,40,000
III) Stock turnover ratio = 6= Average stock = Cost of goods sold Average Stock 2,40,000 Average stock

2,40,000 6

Average stock = 40,000

IV) Calculation of closing stock Let the opening stock be
Average stock = 40,000 2 40,000 80,000 80,000 5,000 2 2 2 75,000 2 ( 2 5,000 2 5,000 5,000
.

5,000)

37,500

118
Opening stock = Rs. 37,500 Closing stock = Opening stock + 5,000 = 37,500 + 5,000 = Rs. 42,500 V) Calculation of debtors
Debtors turnover ratio =
2=

Debtors 12 Credit
Debtors 12 3,00,000 2

12 Debtors = 3,00,000 Debtors =

3,00,000 2 12

Debtors = Rs. 50,000

VI) Creditors turnover ratio = 73 =

Creditors 2,45,000

365 365 73 73

Creditors 2,45,000

365 Creditors = 2,45,000 Creditors = 2,45,000 365

Creditors = Rs. 49,000

VII) Opening stock + Purchase - closing stock = Cost of goods sold 37,500 + Purchase - 42,500 = 2,40,000 Purchases = 2,40,000 + 42,500 - 37,500 Purchases = 2,45,000 Statement of Working Capital Particulars Current Assets Debtors Stock Less: Current Liabilities 50,000 42,500 92,500 Rs. Rs.

119 Creditors Working capital (CA CL) 49,000 49,000 43,500

3. M/s Rajkumar & Co. gives you the following information. Prepare Trading and Profit and Loss Account for the year ended 31st March 2009 and Balance Sheet as on that date. Opening Stock Stock Turnover Ratio Net Profit Ratio on Turnover Gross Profit Ratio on Turnover Current Ratio Long Term Loan Depreciation on Fixed Assets @ 10% Closing Stock Rs.45,000 10 Times 15% 20% 4:1 Rs.1,00,000 Rs.10,000 Rs.51,000

Credit period allowed by suppliers one month. Average debt collection period - Two months. On 31st March 2009 Current Assets consists of Stock, Debtors and Cash only. There was no Bank Overdraft. All Purchases are made on credit. Cash Sales were 1/3rd of Credit Sales. Solution : 1) Stock Turnover Ratio =

Cost of Goods Sold Average Stock

Cost of Goods Sold 45,000 51,000 2 Cost of Goods Sold 96,000 2 Cost of Goods Sold 48,000
10

10 =

10

10

Cost of Goods Sold = 48,000 = 4,80,000 a) Cost of Goods Sold = 48,000

10 = Rs. 4,80,000

b) Gross Profit Ratio 20% on Sales

120 Gross Profit = 20% on Sales = 25% on cost Gross Profit = 25% of Rs.4,80,000 = Rs.1,20,000 c) Total sales = Cost of Goods Sold + Gross Profit = 4,80,000 + 1,20,000 Rs.6,00,000 d) If Cash Sales are 1, Credit Sales are 3 Total Sales are 4

1 Rs.1 ,50,000 4 3 * Credit Sales = 6,00,000 Rs.4,50,000 4

* Cash Sales = 6,00,000
Opening Stock + Purchases + Gross Profit = Sales + Closing Stock

45,000 + Purchases + 1,20,000 = 6,00,000 + 51,000 Purchases = 6,51,000 - (45,000 + 1,20,000) Purchases = 6,51,000 - 1,65,000 = Rs. 4,86,000 3) Calculation of Fixed Assets If depreciation is Rs. 10 Fixed Assets is Rs. 100 If depreciation is Rs. 10,000, Fixed Assets - ? Fixed Assets =

10,000 10 1

Rs. 1, 00,000

Fixed Assets = Rs.1,00,000 4) Calculation of Net profit Net Profit Ratio

Net profit Sales

100

15 1
15

Net profit 6,00,000

100

6, 00,000 = Net Profit 100 15 6,00,000 Net Profit = 100 Rs. 90,000

5)

Calculation of Expenses

121 Expenses + Depreciation + Net Profit = Gross Profit Expenses + 10,000 + 90,000 = 1,20,000 Expenses = 1,20,000 - 10,000 - 90,000 Expenses = Rs.20,000 6) Debtors Collection Period Debtors Collection Period
2 1 12 1
12 Credit Sales Debtors 12 1 4,50,000 n Debtors 2

4,50,000 Debtors

12 Debtors = 2 4, 50,000 Debtors = 4,50,000 2 12 Rs.75,000

7) Creditors Collection Period = 12 Credit Purchases Creditors 12 4,86,000 Creditors

1 1 4,86,000 Creditors

12 1 4,86,000 12

Creditors =

Creditors = Rs. 40,500

8)

Current Ratio = 4:1 Current Assets =

Current Assets Current Liabilities

122

4 1

Current Assets 40,500 4 = Rs. 1,62,000

Current Assets = 40,500

Current Assets = Stock + Debtors + Cash 1,62,000 = 51,000 + 75,000 + Cash Cash = 1,62,000 - 51,000 - 75,000 Cash = 1,62,000 - 1,26,000 Cash = 36,000
9)

Cash = Rs.36,000 Calculation of Capital

Total Assets = Total Liabilities 2,52,000 = Capital + LTL + N.P. + Creditors 2,52,000 = Capital + 1,00,000 + 90,000+ 40,500 Capital = 2,52,000 - 1,00,000 - 90,000 - 40,500 = 2,52,000 - 2,30,500 = 21,500

Trading and profit & Loss A/c for the year ended 31st march 2009.
Particulars To Opening Stock (given) To Purchasing (Bal. figure) To Gross Profit (1b) C/d Rs. 45,000 4,86,000 1,20,000 Particulars By Sales: Credit (I) Cash (I) By Closing (given) Stock Rs. 4,50,000 1,50,000 51,000

6,51,000 To Expenses (Bal. figure) To Depreciation on Fixed Assets (given) To Net Profit (15% of Sales) 90,000 20,000 10,000 By Gross Profit b/d

6,51,000 1,20,000

1,20,000

1,20,000

Balance sheet as at 31st March 2009

Particulars Rs. Rs. Rs.

123
Capital (9) Net profit Long term loan (given) Creditors (7) 21,500 90,000 1,00,000 40,500 Fixed Assets (3) 1,00,000 Less: Depreciation 10,000 Current Assets Cash (8) Stock (given) Debtors (6) 2,52,000 36,000 51,000 75,000 2,52,000 90,000

4. Certain items of the annual accounts of ABC Ltd. are missing as shown below:Trading and profit & Loss A/c for the year ending 31st March 2007.
Particulars To Opening Stock To Purchasing To Direct Expenses To Gross Profit c/d Rs. 4,37,500 ? 1,09,375 ? ? To Administrative Expenses To Interest on Debentures To Provision for Tax To Net Profit 2,66,000 37,500 ? 3,30,000 ? By Gross Profit b/d By Commission Particulars By Sales By Closing Stock Rs. ? ?

? ? 62,500

1, 20,000

Balance sheet as on 31st March 2007

Liabilities Share capital General reserve Profit & Loss A/c (Including opening balance) 10% debentures Creditors Proposed dividend (C.Y) Provision for tax (C.Y) Rs. 6,25,000 ? 1,34,375 ? ? ? ? ? Assets Plant and Machinery Long term loan Stock Debtors Bank Rs. 7,75,000 ? ? ? 78,000

124 You are required to complete the financial statement with the help of the following information:1) Current Ratio is 2:1. 2) Stock Turnover Ratio is 1.60. 3) Proposed dividends are 25% of Share Capital. 4) Gross Profit Ratio is 50%. 5) Transfer to General Reserve is 70% of proposed dividends. 6) Provision for tax is 50% of net profit. 7) There is no opening balance in General Reserve A/c. 8) Creditors Turnover Ratio (on Purchase and Closing Creditors) is 10:2. Solution : I) Proposed dividend = 25% of 6,25,000 = Rs.1,56,250 II) Transfer to General Reserve = 70% of proposed dividend 70% of 1,56,250 = Rs. 1,09,375 III) Provision for Tax - 50% of Net Profit 50% of 3,30,000 = Rs.1,65,000 IV) After debiting provision for tax Rs.1,65,000 to Profit & Loss A/c Gross profit = Total of Dr. Side of P & L A/c - Commission Received Total of Debit side of Profit & Loss A/c = 2,66,000 + 37,500 + 1,65,000 + 3,30,000 = 7,98,500 Gross profit = 7,98,500 - 62,500 Gross profit = 7,36,000 V) Calculation of Sales Gross Profit Ratio =
50

Gross Profit 100 Sales

7,36,000 100 Sales 100 100

50 Sales = 7,36,000 Sales = 7,36,000 50

Sales = Rs. 14, 72,000

125 VI) Calculation of Closing Stock Stock Turnover Ratio

Cost of Goods Sold Average Stock

14,72,000 7,36,000 Average Stock 7,36,000 (Op. Stock + Closing Stock) 2 7,36,000 4,37,500 Closing Stock 2
7,36,000

1.6 1.6

1.6

1.6

4,37,500 Closing Stock 2

(1.6 4,37,500 1.6 Closing Stock) = 7,36,000 2 1.6 Closing Stock = 14,72,000 - 7,00,000 Closing Stock = 7,72,000 1.6 Rs.4,82,500

VII) (Opening stock + Purchases + Direct Expenses + Gross profit) = Sales + Closing stock 4,37,500 + Purchases + 1,09,375 + 7,36,000 = 14,72,000 + 4,82,500 Purchases + 12,82,875 = 19,54,875 Purchases = 19,54,875 - 12,82,875 Purchases = Rs. 6,71,625 VIII) Creditors' Turnover Ratio
10 2

Purchases Creditors
6,71,625 Creditors 6,71,625 2 10

Creditors =

Creditors = 1,34,325

IX) Current Ratio = 2:1

126 Current Liabilities = Creditors + proposed dividend + provision for tax = 1,34,325 + 1,56,250 + 1,65,000 = 4,55,575 Current Assets = Current Liabilities 2 = 4,55,575 2 = 9,11,150 X) Current Assets = Stock + Debtors + Bank 9,11,150 = 4,82,500 + Debtors + 78,000 Debtors = 9,11,150 - 4,82,500 - 78,000 Debtors = 9,11,150 - 5,60,500 Debtors = Rs. 3,50,650

XI) Long Term Investment: Total Liabilities = Total Assets = Rs. 16,99,325 Total Assets = P & M + LTI + Stock + Debtors + Bank 16,99,325 = 7,75,000 + LTI + 4,82,500 + 3,50,650 + 78,000 Long Term Investment = 16,99,325 - 16,86,150 = Rs.13.175 XII) Calculation of Debentures Interest =

Debentures 10 100
Debentures 100 100 10 10

37,500 1

Debentures = 37,500

Rs.3,75,000

Trading and P & L A/c for the year ended 31st March 2007
Particulars To Opening Stock To Purchases (VII) To Direct Expenses To Gross Profit C/d (IV) Rs. 4,37,500 6,71,625 1,09,375 7,36,000 19,54,500 To Administrative Expenses To Interest on Debentures To Provision for Tax (III) 2,66,000 37,500 1,65,000 3,30,000 By Gross Profit b/d By Commission Particulars By Sales (V) By Closing Stock (VI) Rs. 14,72,000 4,82,500

19,54,500 7,36,000 62,500

127
To Net Profit 7,98,500 7,98,500

Balance sheet as at 31st March 2007

Liabilities Share Capital General Reserve (II) Profit & Loss A/c (including opening balance) 10% Debentures (XII) Creditors (VIII) Proposed Dividend (C.Y.) (I) Provision for Tax (C.Y.) (II) Rs. 6,25,000 1,09,375 1,34,375 3,75,000 1,34,325 1,56,250 1,65,000 16,99,325 Assets Plant and Machinery Long Term Investment (XI) Stock (VI) Debtors (X) Bank Rs. 7,75,000 13,175 4,82,500 3,50,650 78,000

16,99,325

5. Complete the Balance Sheet of Titan Ltd. as on 31st December 2009

Liabilities
Share Capital Reserve and Surplus Loan Current Liabilities : Bank Overdraft Creditors

Rs.
3,00,000 ? 30,000 70,000 ? ?

Assets
Fixed Assets Current Assets : Stock Debtors Cash

Rs.
? ? ? ?

Ratio of the company are as follows: 1. Reserves and Surplus to Share Capital - 1:1 2. Sales to Net Worth Ratio is 1:5:1 3. Sales to Debtors Ratio is 6:1 4. Gross Profit Ratio 20% on Sales 5. Net Working Capital is Rs.1,80,000 6. Stock Turnover Ratio is 6 times 7. Current Ratio - 2:5:1 8. Acid test Ratio - 1:5:1 Net worth = Share capital + Reserve and surplus Solution : 1. Calculation of Current Liabilities Current Assets Current Ratio = Current Liabilities

128 Working Capital = Current Assets - Current Liabilities Current Assets = Current Liabilities + Working Capital Current Assets Current Ratio = Current Liabilities

2.5 Current Liabilities + Working Capital = 1 Current Liabilities 2.5 Current Liabilities = CL + WC 2.5 CL = CL + 1,80,000 2.5 CL - CL = 1,80,000 1.5 CL = 1,80,000 CL = 1,80,000 x 1.5 = 2,70,000 = Rs.2,70,000
2. Calculation of Current Assets Current Assets = Current Liabilities + WC = 2,70,000 + 1,80,000 = Rs.4,50,000 Net Worth = Capital + Reserve and Surplus Reserve and Surplus to Share Capital = 1:1 Net Worth = Share Capital + Reserve and Surplus = 3,00,000 + 3,00,000 = Rs.6,00,000 Calculation of Sales Sales to Net Worth = 1.5:1

3.

4.

Sales 1.5 Net Worth 1 Sales = 1.5 x 6,00,000 = Rs.9,00,000

5. Calculation of Debtors Sales to Debtors = 6:1,

Sales 6 Debtors 1 9,00,000 6 Debtors 1 9,00,000 Debtors 6 = 1,50,000 Debtors = Rs.1,50,000

129 6. Stock calculation Stock Turnover Ratio =

Cost of Goods Sold Average Stock

6= 6= 6 1 Stock =

9,00,000 - 20% of 9,00,000 Stock 9,00,000 - 1,80,000 Stock 7,20,000 Stock 7,20,000 6 Rs.1,20,000

7.

Current Assets = Stock + Debtors + Cash 4,50,000 = 1,20,000 + 1,50,000 + cash Cash = 4,50,000 - 1,20,000 - 1,50,000 = 4,50,000 - 2,70,000 = 1,80,000 Cash = Rs. 1, 80,000

8.

Creditors = CL - BOD = 2,70,000 - 70,000 = Rs.2,00,000 Balance sheet as at 31st December 2009
Particulars Rs. 3,00,000 3,00,000 30,000 Assets Fixed Assets (given) Current Assets Stock (6) Debtors (5) 2,00,000 70,000 Cash (7) 1,20,000 1,50,000 1,80,000 Rs. 4,50,000

Share Capital (given) Reserves & Surplus (3) Loan Current Liabilities Creditors (8) Bank Overdraft(given)

9,00,000

9,00,000

5.4

EXERCISES :-

130 1. From the following information of Abhay Ltd. summarized Balance Sheet as at 31st March 2009 prepare

1. 2. 3. 4. 5. 6.

Working Capital Reserve & Surplus Bank Overdraft Fixed Assets Proprietary Ratio Current Ratio Liquid Ratio

Rs. 1,50,000 1,00,000 25,000 0.75 2.5 1.5

Your working notes should be part of the answer. 2. Using the following accounting ratios contruct the Balance Sheet of ABC Ltd. as on 31st December 2009. Balance sheet as on 31st December 2009.
Liabilities Share Capital Reserve & Surplus Bank Loan Creditors Rs. ? ? 2,00,000 ? ? ? Assets Fixed Assets Stock Debtors Rs. ? ? ?

Additional information : 1) 2) 3) 4) 5) 6) 7) 8) Sales for the year (20% cash sales ) Rs. 45,00,000 Gross Profit Ratio = 20% Debtors Turnover Ratio = 12 months Stock Turnover Ratio = 12 Times Debt Equity Ratio (debt / equity) = 20% Reserve and Surplus to Capital = 25% Current Ratio = 2 Fixed Assets Turnover Ratio = 0.20% (Fixed Assets / Sales)

3. From the following information of financial ratios of Star Ltd. prepare Balance Sheet as on 31st March 2009 a) Current Ratio b) Liquid Ratio c) Working Capital 2.5 1.5 Rs.1,50,000

131 d) e) f) g) h) i) Stock Turnover Ratio 5 Gross Profit Ratio 20% Turnover Ratio to Fixed Assets (COGS to FA) 2 Average Debt Collection Period 2.4 months Fixed Assets to Net Worth 0.80 Long Term Debt to Capital and Reserves 7/25

4. M/s Rajesh & Co. gives you the following information. Prepare Trading and Profit & Loss Account for the year ended 31st March 2004 and Balance Sheet as on that date. Opening Stock Stock Turnover Ratio Net Profit Ratio on Turnover Gross Profit Ratio on Turnover Current Ratio Long Term Loan Depreciation on Fixed Assets @ 10% Closing Stock Credit Period allowed by Supplier Average Debt Collection Period 90,000 10 times 15% 20% 4:1 Rs.2,00,000 Rs.20,000 Rs.1,02,000 one month two months

On 31st March 2004 Current Assets consists of Stock, Debtors and Cash only. There was no Bank Overdraft. All Purchases were on made on credit. Cash Sales were 1/3rd of Credit Sales. (M.U. B.Com. April 2006) 5. From the following data, prepare Trading and Profit & Loss A/c a) Sales b) Administration, Selling and Distribution Expenses c) Stock Turnover Ratio d) Net Profit Ratio e) Gross Profit Ratio Rs.10,00,000 Rs.60,000 8 times 20% 35%

Closing Stock is Rs. 8,000 greater than Opening Stock. Answers : Exercise No.

132
1. Capital Rs.5,00,000, Reserve & Surplus Rs.1,00,000, Creditors Rs.75,000, Bank Overdraft - Rs.25,000, Fixed Assets - Rs.4,50,00, Stock - Rs.1,37,500, Liquid Assets - Rs.1,12,500 and Balance Sheet total Rs.7,00,000 2. Share Capital - Rs.8,00,000, Reserve & Surplus - Rs.2,00,000, Bank loan Rs.2,00,000, Creditors - Rs.3,00,000, Fixed Assets - Rs.9,00,000, Debtors Rs.3,00,000, Stock - Rs.3,00,000, Balance Sheet Total - Rs.15,00,000. 3. Net Worth - Rs.3,12,500, Long Term Loan - Rs.87,500, Current Liabilities Rs.1,00,000, Fixed Assets - Rs.2,50,000, Stock - Rs.1,00,000, Debtors Rs.1,00,000, Cash - Rs.50,000, Balance Sheet Total - Rs.5,00,000 4. Cash Sales - Rs.3,00,000, Credit Sales - Rs.9,00,000, Gross Profit Rs.2,40,000, Purchases (Bal. figure) - Rs.9,72,000, Net Profit - Rs.1,80,000, Fixed Assets - Rs.2,00,000, Debtors - Rs.1,50,000, Cash - Rs.72,000, Capital - Rs.43,000, Balance Sheet Total - Rs.5,04,000. 5. Opening Stock - Rs.77,250, Closing Stock - 85,250, Gross Profit Rs.3,50,000, Purchases - Rs.6,58,000, Net Profit - Rs.2,00,000, Other expenses (Bal. figure) - Rs.90,000.

6
CASH FLOW STATEMENT / ANALYSIS
Unit Structure : 6.0 6.1 6.2 Objectives Introduction Preparation of Cash Flow Statement 6.2.1 6.2.2 6.2.3 6.3 6.4 Cash Flow from Operating Activities Cash Flow from Investing Activities Cash Flow from Financing Activities

Illustrations Model Questions

133

6.0

OBJECTIVES:

Objectives of this chapter are to be: Understand the concept of Cash Flow Statement. Study the difference between Cash Flow and Funds Flow. Study the format of preparing Cash Flow Statement. Prepare Cash Flow Statement as per Accounting Standard 3

6.1

INTRODUCTION:

Cash Flow Statement Analysis is another important tool of financial analysis. It involves preparation of Cash Flow Statement for identifying sources and application of cash. Thus, a Cash Flow Statement is a statement depicting change in cash position from one period to another. A proper planning of the cash resources enables the management to have cash available whenever needed and put it to some profitable or productive use in case there is surplus cash available. The term Cash here stands for cash and cash balances. The following are the points of difference between a Cash Flow Statement and a Fund Flow Analysis.

1) A Cash Flow Statement is concerned only with the change in cash position while a funds flow statement is concerned with change in working capital position between two balance sheet dates.

2) A cash flow statement is merely a record of cash receipts and disbursements.

3) Cash flow analysis is more useful to the management as a tool of financial analysis in short period as compared to funds flow statement.

4) Inflow of cash results in inflow of funds but inflow of funds may not necessarily result in inflow of cash.

134
A Cash flow statement is useful for short-term planning. Business enterprise needs sufficient cash to meet its obligations in the near future. A historical analysis of the different securities and applications of cash enables the management to make reliable cash flow projections for the immediate future. Thus, a cash flow statement is an important financial tool for management. However, it has its own limitations. Cash flow statement cannot be equated with the income statement. The cash balance as disclosed by the cash flow statement may not represents the real liquid position of the business.

6.2

PREPARATION OF CASH FLOW STATEMENT:

According to Accounting Standard 3, cash flow statement should be presented in a manner that it reports cash flows, during the period classifying by operating, investing and financing activities.

6.2.1

Cash Flow from operating activities :

Cash flows from operating activities are primarily derived from the pre-revenue producing activities of the enterprise. The following are the examples.

a) Cash received from sale of goods or rendering of services. b) Cash received from fees, royalties, commission etc. c) Cash payment to suppliers of goods and services. d) Cash payment to employees. e) Cash receipts and payments of an insurance company for premiums and claims, annuities and other policy benefits. f) Cash receipts and payments relating to the future contracts.

6.2.2

Cash flow from investing activities :

135
These include activities on which expenditure has been incurred for resources intended to generate future income and cash flows, such as :

a) Cash payment to acquire fixed assets. b) Cash receipts from disposal of fixed assets. c) Cash payments to acquire shares, debentures, debt instruments of other companies. d) Cash receipts from disposal of shares, bonds, debentures etc. e) Cash advances and loans made to third parties. f) Cash receipt from the above.

g) Cash receipts from future contracts. h) Cash payments for future contracts.

6.2.3

Cash flow from financing activities :

These include providers of funds, both capital and borrowing to the company such as :

a) Cash receipts from issuing shares or debentures. b) Cash proceeds from borrowings. c) Cash repayments of amounts borrowed.

6.3

ILLUSTRATION :

1. You are required to calculate the cash from operations from the following

Trading & Profit & Loss Account for the year ended 31st March 2009

136

Particulars To Purchases To Wages To Gross Profit

Dr. Rs.

Particulars

Cr. Rs. 30,00,000

20,00,000 By Sales 5,00,000 5,00,000 30,00,000

30,00,000 5,00,000 50,000

To Salaries To Rent To Depreciation To Goodwill written off To Net profit

2,00,000 By Gross Profit b/f 1,00,000 By Profit on Sale of 1,00,000 50,000 1,00,000 5,50,000 Machinery

5,50,000

Solution :

Calculation of Cash from Operations

Cash from operations: Net Profit as per P&L Account Add: Non-cash items which do not result in outflow of cash: Depreciation Goodwritten off 1,00,000 50,000

Rs. 1,00,000

1,50,000 2,50,000

Less: Profit on Sale of Machinery which is not a part of

50,000

137
operating profit Cash from business operations 2,00,000

2. The Balance Sheet of A Ltd. is given below:

Balance Sheet of A Ltd.

Liabilities

30.03.08 (Rs. In Lakhs)

30.03.09 (Rs. In Lakhs)

Assets

30.03.08 (Rs. In Lakhs) & 10

30.03.09 (Rs. In Lakhs)

Share Capital Reserve & Surplus Bank Loan Creditors

125

Cash 150 Bank

12

10 55 40

13 Debtors 40 Stock 44 Machinery Land Building &

30 35 65

45 25 55

90 230

110 247

230

247

During the year a machine costing Rs. 10 lakhs (Accumulated depreciation Rs. 4 lakhs) was sold for Rs. 5,00,000, the depreciation provided during the year was Rs. 4 lakhs. You are required to prepare cash flow statement.

138

Solution

(i) Working 1 Calculation of cash from operations: Profit made during the year (1300000-100000) Depreciation Loss on Sale of Machinery Decrease in Stock Increase in creditors 4 1 10 4 19 Less: Income in Debtors Cash from operations 15

Rs Lakhs

4 7

Machinery Account

Rs. Lakhs To Balance b/d 65 By By By By 65 Bank Depreciation Loss on Sale Balance c/d

Rs. Lakhs 5 4 1 5 65

Cash Flow Statement (As-3)

139
(Rs. Lakhs) 3 4 1 (Rs. Lakhs)

Cash from Opening activities Net profit made during the year Add: (1) Depreciation (2) Loss on sale of Machinery Operating Profit Capital changes before Working

8 10 4 15 -1

(3) Decrease in Stock (4) Increase in creditors (5) Increase in Debtors

Net Cash from operating activities 2 Cash Flow from Investing Activities: (1) Sale of machinery (2) Purchase of Land and Building Net cash from investing activities 3 Cash flow from financing activities Proceeds from Issue of Shares Repayment of bank loan Net Cash from financing activities Net increase equivalent in cash and cash 25 -15 5

-20 -15

10

Cash and cash equivalent of the beginning Cash and cash equivalent at the end

10 12

3. The following are the summarized Balance Sheet of Z Ltd.

140
31.03.2008 Liabilities Share Capital General Reserve Profit & Loss Secured Loans Creditors Provision for taxation 2,00,000 50,000 30,500 70,000 1,50,000 30,000 5,30,500 Assets Land & Building Plant & Machinery Stock Debtors Cash Bank Goodwill 2,00,000 1,50,000 1,00,000 80,000 500 5,30,500 1,90,000 1,69,000 74,000 64,200 600 8,000 5,000 5,10,800 1,35,200 35,000 5,10,800 2,50,000 60,000 30,600 31.03.2009

Additional information:

(1) Dividend of Rs. 23,000 was paid during the year. (2) Assets of K Ltd were purchased for consideration of Rs. 50,000 payable in shares. The assets purchased were Stock Rs. 20,000 and Machinery Rs. 25,000 (3) Further Machinery was purchased for Rs. 8,000 (4) Depreciation written off on Machinery Rs. 12,000 (5) Income tax paid during the year was Rs. 33,000

141
(6) Loss on Sale of Machinery Rs. 200 was written off to general reserve. You are required to prepare the Cash Flow Statement as per AS-03

Solution

Cash Flow Statement

Cash Flow From Operating Activities: Net Profit made during (100+33,000+10,200+23,000) Add: Depreciation on Building Depreciation on Machinery Operating profit before working capital charges Decrease in Stock Decrease in Debtors Decrease in Creditors Income tax paid the year 66,300 10,000 12,000 88,300 46,000 15,800 -14,800 -28,000 1,07,300

Cash Flow From Investing Activities: Sale of Machinery Purchase of Machinery 1,800 -8,000 -6,200

Cash Flow From Financing Activities: Repayment of Secured Loan Dividend Payment Cash Flow From Financing Activities: Net increase in Cash and Cash equivalent Cash and Cash equivalent at the beginning Cash and Cash (Cash+Bank) equivalent at the end 8,600 -70,000 -23,000 -93,000 8,100 500

142
Working:-

(1)

Calculation of net operating profit :

Rs. Increase in Profit and Loss account (30600-30500) Add: Depreciation 22,000 33,000 10,200 23,000 88,200 88,300

100

Income Tax provision Transfer to Reserve Dividend paid Operating Profit for the year

(2) General Reserve A/c

Rs. To To Machinery (Loss) Balance c/f 200 By 60,000 By 60,200 Balance b/d P&L A/c

Rs. 50,000 10,200 60,200

(3)

Provision for Taxation A/c

Rs. To Bank (Bal.figure) To Balance c/f 35,000 63,000 28,000 By By Balance b/d P&L A/c

Rs. 30,000 33,000

63,000

143
(4) Machinery A/c

Rs. To To To Balance b/d Share Capital Bank 1,50,000 By 25,000 By 8,000 By By 1,83,000 Depreciation General Reserve (Loss) Bank (Balance figure) Balance c/d

Rs. 12,000 200 1,800 1,69,000 1,83,000

(5)

Goodwill is arrived at as under:

Shares issued Less: Assets Purchased Stock Machinery Goodwill 20,000 25,000

50,000

45,000 5,000

4. From the following details relating to the accounts of G M Ltd. Prepare Cash Flow Statement as per AS-3.

Balance Sheet

Liabilities

2008 Rs. In Lakhs

2009 Rs. In Lakhs

Assets

2008 Rs. In Lakhs

2009 Rs. In Lakhs

144
Share capita Reserves & Surplus Debentures Provision for Taxation Proposed Dividend Creditors 10.00 3.00 2.00 1.00 2.00 7.00 25.00 8.00 Machinery 2.10 Building - Investments 0.70 Debtors 1.00 Stock 8.20 Cash & Bank 20.00 7.00 6.00 1.00 5.00 4.00 2.00 25.00 5.00 4.00 7.00 2.00 2.00 20.00

Additional Information:

(1) Depreciation at 25% was charged on the opening balance of machinery. (2) Old machine costing Rs. 50,000 (WDV Rs. 20,000) was sold during the year for Rs. 35,000 (3) Income tax paid during the year was Rs. 50,000 (4) Building was under construction and hence not subject to depreciation. (5) Rs. 50,000 was transferred to reserve during the year.

Solution:

Cash Flow Statement for the year ended 31.03.2009

Particulars A) 1. 2. Cash Flow from opening activities Net Profit Add: Non-Cash items Proposed Dividend Provision for Taxation 2.00 0.80

Rs.

Rs.

0.40

145
General Reserve Depreciation 3. 4. Less: Loss on sale of machinery Working Capital Changes Increase in Stock Decrease in Debtors Decrease in Creditors 5. Income Tax Paid Net cash from opening activities B) Cash Flow from Investing activities 1. Purchase of fixed asset 2. Capital expenditure on building 3. Increase in Investment 4. Sale of Machine Net cash Flow from investing Activities C) Cash Flow from financing activities 1. Issue of Shares 2. Issue of Debentures 3. Dividend payment D) Net Increase in Cash (A+B+C) Cash at the beginning of the period Cash at the end of the period 2.00 2.00 -1.00 3.00 2.00 2.00 -3.45 -2.00 -1.00 0.35 - 6.10 -2.00 2.00 -1.20 -1.20 -0.50 3.10 0.50 1.25 4.55 -0.15 4.80

146
Working

Rs. 1) Calculation of Net Profit Reserve and Surplus at the end Less: Reserves & Surplus at the beginning Increase Less: Transfer to Reserve Net Profit 3,00,000 2,10,000 90,000 50,000 40,000

(2)

Machinery A/c

Rs. To To Balance b/d Bank Balancing figures 8,45,000 5,00,000 By 3,45,000 By By Depreciation Cash (Sales) Balance c/f

Rs. 1,25,000 20,000 7,00,000 8,45,000

(3)

Provision for Taxation A/c

Rs. To To Bank Balance c/d 50000 By 100000 By 150000 Balance b/d P&L Bal. figures

Rs. 70000 80000 150000

(4)

Proposed Dividend A/c

147
Rs. To To Bank Balance c/d 1,00,000 By 2,00,000 By 3,00,000 Balance b/d P&L (Bal. figures) Rs. 1,00,000 2,00,000 3,00,000

5. From the following summary of cash/bank account of Anand Ltd. Prepare Cash Flow Statement for the year ended 31st March 2009 in accordance with AS-3 (Revised). The company does not have any cash equivalents.

Cash/Bank A/c

Rs.
To To To To Balance b/d (1.4.09) Issue of equity shares Debtors Sale of fixed assets 50,000 3,00,000 28,00,000 1,00,000 By By By By By By By By 32,50,000 Creditors Purchase of fixed assets General Expenses Wages & Salaries Income Tax Dividend Repayment of Bank Loan Balance c/d (31.03.09)

Rs.
20,00,000 2,00,000 2,00,000 1,00,000 2,50,000 50,000 3,00,000 1,50,000 32,50,000

Solution

Anand Ltd. Cash Flow Statement for the year 31.03.09

148

Particulars A) Cash Flow from opening activities 1 2 Cash receipts from debtors Cash payment to Creditors Cash payment to employees (Wages & Salaries) Cash paid for business expenses Payment of Income Tax

Rs.

Rs.

2800000 -2000000

3 4 5

-100000 -200000 -250000 250000

Net Cash from operating activities B) Cash Flow from investing activities 1 2 Purchased of fixed assets Sale of fixed assets -200000 100000

Net cash from Investing activities C) Cash Flow from Financing Activities 1 2 3 Issue of Equity Shares Repayment of Bank Loan Dividend Payment 300000 -300000 -50000

-100000

Net Cash from financing activities Net increase in cash Cash at the beginning of the period Cash at the end of the period

-50000 100000 50000 150000

6. The Balance Sheet and Income Statement of Bharat Engineering Ltd. are as follows:

Balance Sheet

Liabilities

31.3.08

31.3.09

Assets

31.3.08

31.3.09

149
Share Capital General Reserves Retained Earnings 10% Debentures Bank Loan Creditors Outstanding Expenses Provision for Tax 10.00 12.00 Fixed Assets 25.00 28.00

2.25

2.50

(-) Accumulated Dep.

5.00

6.00

1.10 5.00 2.00 6.60

1.25 4.00 2.50 5.45 Stock Debtors Bank

20.00 4.00 3.00 1.10

22.00 4.50 2.50 1.40

0.05 1.40 28.40

0.30 2.60 30.60

Preliminary Expenses

0.30

0.20

28.40

30.60

Income Statement for the year ended 31.3.06\9

Rs. Lakhs Net Sales Less: Cost of goods sold 40.00 31.00 9.00 2.90 1.00 0.10 4.00 5.00 2.60 2.40 Transfer of General Reserve Payment of Dividend Net Income 0.25 2.00 2.25 0.15

Gross Profit Less: General Expenses Depreciation Preliminary Expenses written off Net Profit Net Provision for Taxation PAT Less:

150
Add: Retained Earning b/d 1.10 1.25

Balance c/d

Solution:

Cash Flow Statement for the year ended 30.03.09

Particulars A) 1 2 Sales Add: Opening Balance of Debtors

Rs. Lakhs 40.00 3.00 43.00

Rs. Lakhs

Less: Closing Balance of Debtors Cash received from Debtors 4 Cash paid to Creditors Cost of Goods sold Add: General Expenses

2.50 40.50 40.50

31.00 2.90 33.90

Add: Opening Balance of Creditors Opening Balance of O/S expenses Closing Stock

6.60 0.05 4.50 45.05

Less: Closing Balance of Creditors 5.45 Closing Balance of O/S. Exp.

151
0.30 Opening stock 4.00 9.75 35.30 Cash Generated from Opening activities Less: Income Tax paid Net cash generated from opening activities B) Cash Flow from Investment Activities Purchase of fixed Assets C) Cash Flow from Financing Activities Loan from Bank Issue of Shares Redemption of Debentures Payment of Dividend Net Cash used in Financing Activities D) E) F) Net Increase in Cash Cash at the beginning of the period Cash at the end of the period 0.30 1.10 1.40 0.50 2.00 -1.00 -2.00 -0.50 -3.00 5.20 1.40 3.80

Note: Cash flow from operating activities can also be calculated using indirect method as follows:

Net Profit as per Income Statement Add: Non Cash Items Depreciation Preliminary Exp. Written off Operating Profit Add: Working Capital Changes Decrease in Debtors Increase in O/S Expenses 0.50 0.25 1.00 0.10 1.10 6.10 5.00

152
Increase in Stock Decrease in Creditors Cash generated from operations -0.50 -1.15 0.90 5.20

4.4 MODEL QUESTIONS :

Q.1

What is a Cash Flow Statement? How is it different from Funds Flow Statement? State whether each of the following statement is True or False. (1) (2) (3) (4) Purchase of goods is an application of funds. A decrease in current liability increase the working capital. Funds-flow refers to change in long term funds. Working Capital is the difference between fixed assets and current assets. Credit sales at Profit increases the working capital.

Q,2

(5) Q.3

From the following Profit & Loss Account you are required to compute cash from operations.

Profit & Loss Account

Rs. To To Salaries Rent 50,000 By 10,000 By Gross Profit b/d Profit on Sale of

Rs. 2,50,000 50,000

153
Land Income Refund Tax 30,000

To To To To To To

Depreciation Loss on Sale of Plant Goodwill written off Proposed Dividends Provision for Taxation Net Profit

20,000 By 10,000 40,000 50,000 50,000 1,00,000 3,30,000

3,30,000

Q.4

The following are the summarized Balance Sheets of B Ltd.:-

Balance Sheet

Liabilities

2008 Rs. In Lakhs

2009 Rs. In Lakhs

Assets

2008 Rs. In Lakhs 41.00

2009 Rs. In Lakhs 40.00

12% Pref. Shares

10.00 Fixed Assets Less: 40.00 Depreciation 50.00 2.00 Debtors 1.20 Stock 7.00 Cash Prepared 11.00 Expenses 4.20 5.80 6.80 88.00

Equity Shares

40.00 40.00

11.00 30.00 20.00 30.00 1.20

15.00 25.00 24.00 35.00 3.50

General Reserve Profit and Loss A/c Debentures

2.00 1.00 6.00

Creditors Provision for Tax Proposed Dividend Bank Overdraft

12.00 3.00 5.00 12.50 81.50

0.30

0.50

81.50

88.00

154

You are required to prepare a Cash Flow Statement.

Q.5

W Ltd supplies you the following Balance Sheets:-

Balance Sheet

Liabilities

2008 Rs. In Lakhs 70.00 12.00 10.00 0.70 & 10.40 103.10

2009 Rs. In Lakhs 74.00 6.00 12.00 0.80

Assets

2008 Rs. In Lakhs 9.00 14.90 49.20 20.00

2009 Rs. In Lakhs 7.80 17.70 42.70 30.00

Share Capital Debentures Creditors RDD Reserve Surplus

Bank Debentures Stock Building

10.40 103.20

Goodwill

10.00 103.10

5.00 103.20

Additional information

(1) Dividends amounted to Rs. 3.50 Lakhs were paid during the year. (2) Building was purchased for Rs. 10 Lakhs. (3) Rs. 5 Lakhs were written off on Goodwill. (4) Debentures of Rs. 6 Lakhs were repaid during the course of the year. You are required to prepare Cash Flow Statement.

155

7
WORKING CAPITAL CONCEPT - I
Unit Structure: 7.0 7.1 7.2 7.3 7.4 7.5 7.6 7.7 7.8 7.9 7.10 7.11 7.12 7.13 Objectives Introduction Meaning of Working Capital Definitions of Working Capital Types of Working Capital Importance or Advantages of adequate working capital Danger of inadequate working capital Danger of excess working capital Factors determining working capital requirement Importance of adequate working capital Sources of working capital Methods of projecting working capital requirements Projection of working capital requirements Exercise

7.0 OBJECTIVES :
After studying the unit the students will be able to: Define Working Capital. Explain types of working capital. Understand the importance of adequate working capital. Elaborate the determinants of working capital. Know the sources of working capital.

7.1 INTRODUCTION :
Capital required for a business can be divided into two categories i.e. Fixed capital and working capital. Fixed capital is the part of total capital which is used for purchasing permanent a fixed asset like land, Buildings, Plant and machinery, furniture and

156 fixtures, vehicles, etc. This capital is invested by organization in the beginning of running the business. In addition to fixed capital an organization requires additional capital for financing day to day activities like purchase of Raw materials, payment of direct and indirect expenses, carrying out production, investment in stocks and stores, receivables and assets to be maintained in the form of cash is generally known as working capital (fluctuating capital). In other words, this capital refers to the investment in current assets such as cash inventory, receivables, etc. All such assets are likely to be convertible into cash within one a year.

7.2 MEANING OF WORKING CAPITAL :

The capital used for performing day to day activities i.e. purchases of Raw material, making payment of direct and indirect expenses, carrying out of production of goods and services, investment in stocks, stores, etc is called as working capital. All assets consisting of working capital revolve around cash. Firstly, cash is used to purchase of raw materials, which when certain expenses are in carried on it gets itself converted into semi finished goods and finally into inventory of finished products. Inventory (finished goods), after adding certain profit margin to it, is sold to the customers, which may take the form of cash or receivables or debtors. Receivables or debtors when realized again take the form of cash and the cycle goes on. The revolving nature of current assets consisting of working capital has been cleared with the help of following chart:

Receivables Cash

Sales Finished goods

Raw materials

Work in progress

Because of this revolving nature of the assets consisting working capital, later is also known as 'fluctuating' or 'floating' or ' circulating' capital.

7.3 DEFINITIONS OF WORKING CAPITAL :

7.3.1 J.M. Mill: - "The sum of the current assets is the working capital of the business"

157 7.3.2 Shubin: - "Working capital is the amount of funds necessary to cover cost of operating the enterprise." 7.3.3 Hoaglandi: - "Working capital is descriptive of that capital which is not fixed. But the more common use of the working capital is to consider it as the difference between the block value of the current assets and current liabilities." 7.3.4 Gerestenberg: - "Circulating capital wears current assets a company that are changed in the ordinary course business from one to another, as for example, from cash inventories, inventories to receivables, and receivables cash." of of to to

7.3.5 The accounting principles of board of American institute of Certified Public Accountants has defined the working capital as under: "Working capital is represented by the excess of current assets or current liabilities and identifies the relatively liquid portion of the total enterprise capital which constitutes a margin or buffer for maturing obligations within the ordinary operating cycle of the business." Thus working capital means investment made by a business organization in short-term current assets like cash, debtors, etc.

7.4 TYPES OF WORKING CAPITAL :

The working capital is classified as under. 7.4.1 Gross working capital: Gross working capital means the total current assets without deducting current liabilities. This equal to the cash balance and the amount blocked in debtors stocks, etc. 7.4.2 Networking capital: Net working capital means total current assets minus total current liabilities. It means net current assets. This capital indicates the amount available to meet short term liabilities or debt of the business organizations. 7.4.3 Permanent of fixed working capital: This capital represents the value of the current assets required on continuing basis over the entire year and for several years. Permanent working capital is the minimum amount of current assets which is needed to conduct business even during the dullest season of the year. Thus, the minimum level of current assets is called permanent or fixed working capital is the part of capital permanently blocked in current assets. This amount changes from year to year depending on growth of the company and the stage of the business cycle in

158 which it operates. It is used to produce goods necessary to satisfy the customer's demand.

It has the following characteristics a) It is classified on the basis of time. b) It constantly changes from one asset to another and continuously remains in the business. c) Size of this capital increases with the growth of business operations. 7.4.4 Temporary or variable working capital This component represents a certain amount of fluctuations in current assets during a short period. These fluctuations are increases or decreases in current assets. Generally these are in cyclical nature. This is called as additional capital required at different times during the operating year. This capital is used to meet seasonal needs of a firm or organization is called seasonal or variable working capital. Additional funds or capital specifically used to meet extraordinary needs or contingencies arising due to strikes, fire, unexpected competition, rising price tendencies launching of advertisement campaigns. Features: a) It is not always gainfully employed, though it may change from one asset to another, as permanent working capital does. b) It is particularly suited to business of a seasonal or cyclical nature. c) It is arranged from temporary source i.e. short term loan, deposits, bank over drafts etc. 7.4.5 Balance sheet working capital: Usually this capital is determined on the basis of current assets and current liabilities shown in closing balance sheet of the concern. It means the net current assets as on last date of the balance sheet. 7.4.6 Cash working capital: This capital is the net current assets if realized at its book value. The cash realized from current appearing is really less than the book value because i) Debtors includes profit margin ii) Depreciation included in over valuation of stock of finished goods. The concept of this capital makes proper adjustment in balance sheet working capital for the items to arrival

159 at cash working capital. The cash working capital indicated the working capital at cost because stocks and debtors are at cost. 7.4.7 Positive working capital: When a net current asset is in positive figure. Therefore it is called positive working capital. This working capital shows favorable liquidity solvency position of the company. 7.4.8 Negative working capital: In this case, difference between current assets and current liabilities is negative figure. Therefore, it is called are negative working capital. It means current liabilities are more than the current assets. This capital indicates lack of liquidity and adverse solvency position of the company.

7.5 IMPORTANCE OR ADVANTAGES OF ADEQUATE WORKING CAPITAL :

Working capital is like the heart of business. If it becomes weak, the business hardly can proper or survive. But no business can run successfully without an adequate amount of working capital. Following are the few advantages give importance of adequate working capital in the business. 1. Cash discount: Adequate amount of working capital enables the firm to avail cash discount facilities offered by suppliers. The amount of cash discount reduces cost of purchases. 2. Creation of goodwill: Adequate amount of working capital enables the firm to make prompt payment of short-term liabilities is the base to create and maintain goodwill. 3. Ability to face crisis: Amount of adequate working capital facilitates to meet situations of crisis and emergencies. It makes able to withstand periods of depression smoothly. 4. Credit-worthiness: It enables the firm to run its business more efficiently because there is no delay in getting loan from bank and other financial institutions on easy and favorable terms and conditions. 5. Regular supply of Raw materials: Adequate amount of working capital permits the carrying of inventories of a level that would enable a business to serve satisfactorily the need of its customers. Thus it ensures regular supply of raw materials for continuing productions in future. 6. Expansion of market: A firm having adequate working capital can create favorable market condition. It is possible to purchases

160 required material at lower rate and holds its inventories for higher rate. Thus it helps to maximize profits. 7. Increase in productivity: Fixed assets of the firm cannot work without sufficient amount of working capital. Because large scale investment in various fixed assets is largely depending on the manner in which its current assets are managed. 8. Research programmes: It is not possible to undertake research programmes, innovations and technical developments without having sufficient amount of working capital in the organizations. 9. High morale: Maintaining of sufficient amount of working capital makes us possible to create environment of security, confidence, high morale among the staff and it helps in creating overall efficiency of the business. 10. Liquidity and solvency: A sound position of working capital enables a firm to make payment of dividends to its investors regularly. This helps in gaining confidence in the mind of investors and also helps in creating favorable market environment to raise additional funds in the near future. 11. Contented labour force: A firm having enough amount of working capital will be in a position to pay its workers well and in advance. This way contented labour force contributes to increased production of quality goods.

7.6 DANGER OF INADEQUATE WORKING CAPITAL:

When a firm had inadequate amount of working capital, it faces the following problems. a) It may not be able to take advantages of cash discount. b) It cannot buy its requirements in bulk and unable to utilize production facilities fully. c) It may not be able to take advantages of profitable business opportunities. d) It may not be able to pay its dividends because of non availability of funds. e) It shows low liquidity leads low profitability. profitability results in low liquidity. Low

161 f) It is not possible to pay short terms liabilities due to inadequate working capital. This leads to borrow loan or funds at high rate of interest. g) Credit worthiness of a firm may be damaged due to lack of liquidity. It will lose its reputation. Thus firm may not be able to get credit liabilities. h) Low liquidity position may lead to liquidate the firm because it cannot be able to meet its debts at the date of maturity.

7.7 DANGER OF EXCESS WORKING CAPITAL :

When a firm has excess working capital arise the following problems. a) A firm may be tempted to over trade and lose heavily. b) A firm may purchase more inventories unnecessarily which leads the problem of theft, waste, losses, etc. c) It created imbalance between liquidity and profitability. d) Excess working capital means idle funds means not earning of profits. In this case rate of return on investments falls. f) It may make greater production which may not have matching demand. Fund will be blocked only. No possibility of profits. g) It may lead carelessness about cost of production. It means there will be high cost of production and it leads to less profit. 7.8

FACTORS DETERMINING WORKING CAPITAL REQUIREMENT :

a) Nature of business: - Working capital requirements of an enterprise are basically related to conduct of the business. Public utility undertakings like electricity, water supply, Railways, etc need very limited working capital because they offer cash sales only and supply services, not products, and as such no funds are tied up in inventories and receivables. But at the same time, trading firm need large amount of working capital in current assets like inventories, cash, receivables etc but they have less investment in fixed assets.

162 b) Terms of purchases and sales: - Credit terms granted by the concerns to its customers as well as credit terms granted by its supplier also affect the working capital. It credit terms of purchases are more favorable and those sales less liberal, less cash will be invested in the inventory. Working capital requirement can be reduced it terms of credit are more. The ratio of credit and cost purchases or sales affect the level of working capital. If firms purchases on credit and sales cash then requires less working capital and if firm purchases on cash and sales on credit, then it requires large working capital. This means funds are tied up in debtors and bills receivables. c) Manufacturing cycle: - The quantum of work capital needed is influenced by the length of manufacturing cycle. The manufacturing process always involves time lag between the time when raw materials are fed into the production line and finished products are finally turned out by it. The length of period of manufacture in turn needs on the nature of product as well as production technology used by a concern. d) Size of business unit: - Amount of working capital requirement is depending on the scale of operation of the business organization. Large business organization performs large business activities which require huge working capital than small scale organization. e) Turnover of inventories: - A business organization having low turnover of inventory would need more working capital where as high turnover of inventory need small or limited working capital. f) Turnover of circulating capital: - The speed with which circulating capital completes its cycle if conversion of cash into inventory of raw material, raw material into finished goods, finished goods into debts and debts into cash, which decides need of working capital in the organization. Slow movement of working capital cycle necessitates large provision of working capital. g) Seasonal variations production: - In case of seasonal production in the industries like sugar, oil, mills, etc need more working capital during peak seasons as well as slack seasons. h) Degree of mechanization: - In highly mechanized concerns having low degree of independence, on labour, requirement of working capital reduced. Conversely, in labour intensive industries greater sum of working shall be required to pay wages and related facilities. i) Growth and expansion: - Every firm wants to grow over a period of time and with the increase in its size, the working capital

163 requirements are bound to increase. The growing company would need, therefore, larger amount of working capital. j) Policy regarding dividend: - Dividend policy of a firm will also influence the working capital position. The company which declares large amount of dividends in the form of cash requires large working capital to pay off such dividends. But sometimes, companies issues bonus shares by way of dividend in such cases working capital requirements will be comparatively less. This is depending on Psychology of shareholders i.e. whether they prefer cash income or capital appreciation. k) Inflation: - A business concern requires more working capital during the inflation period. This factor may be compensated to some extent by rise in selling price of inventory. l) Changes in technology: - Changes in production technology have an impact on the need of more working capital. m) Depreciation policy: - Charges of depreciation on assets do not involve any cash outflows. Depreciation affects tax liability and retention profits. It is allowable expenditure while calculating net profits. Higher depreciation will mean lower disposal of profit and therefore dividend will be paid in smaller amount. Thus cash will be preserved.

7.9

IMPORTANCE CAPITAL :

OF

ADEQUATE

WORKING

a) It enables a company to meet its obligations. b) It ensures solvency position of the company. c) It ensures credit standing of the company. d) It facilitates obtaining credit from banks without problems. e) It enables prompt payment of short terms debts. f) It enables an organization to tide over difficult periods successfully. g) It enables the organization to enhance the goodwill by meeting operational expenses and maturing liabilities in time. h) It improves the prospectus and progress of the company.

164

7.10 SOURCES OF WORKING CAPITAL :

Sources of working capital

Long term source

1) Issue of shares 2) Issue of Debentures 3) Plugging back of profit 4) Loans from banks 5) Public deposits

Short-term source

Internal source 1) Depreciation 2) Taxation provision 3) Accrued expenses

External source 1) Trade credit 2) Credit paper 3) Bank credit 4) Customer's credit 5) Govt. Assistance 6) Loan from directors 7) Security of employees

7.11 METHODS OF PROJECTING CAPITAL REQUIREMENTS :

WORKING

7.11.1 Conventional method: In this method cash flow i.e. inflow and out flow are matched with each other. Greater emphasis is laid down on liquidity of a business organization. 7.11.2 Operating cycle method: This method refers to working capital in a realistic way. The working capital is decided on the basis of length of the operating cycle. It is calculated by dividing operating expenditures by the number of operating cycle.

7.12 PROJECTION OF REQUIREMENTS :

WORKING

CAPITAL

The businessman mainly faces the problem of determination of working capital requirements for financing particular level of activity. The finance manager has to perform the activities of forecasting working capital requirements. This process involves the following aspects. 1) Level of activity: - Estimation of working capital begins with the level of activity. Therefore the finance manager has to ascertain the required quantum of production in advance on the basis of past experience, installed and utilized capacity of the factory and demand.

165 2) Raw materials: - The finance manager has to estimate the quantity and cost of raw materials. Lengths of time of raw materials remain in the store before issue for production is considered longer period of stay of raw material need greater working capital. This must be valued at cost. 3) Labour and overheads: - Expenses incurred on wages and overheads are considered while ascertaining raw materials. 4) Work-in-progress: - While ascertaining work-in-progress the period of processing' or 'period of production cycle' has to be considered. Longer the production cycle, greater the working capital requirement. Therefore, the finance manager has to consider the amount required for raw materials, wages and overheads while estimating volume of production. 5) Finished Goods: - The period of storing finished goods before sale has to be taken into consideration. This is depending on season, sales forecasting, etc. If the sales are seasonable and production is throughout the year, then working capital requirement would be the higher during the slack seasons. 6) Sundry Debtors: - While calculating amount of sundry debtors, period credit allowed to customers is to be taken into consideration. This period is known as "time lag in payment by debtors". If this period is longer, required working capital will be higher in the absence of similar time lag in payment to creditors. The sundry debtors are value at sales price while calculating working capital. 7) Cash and bank balance: - As per past experience every businessman is suppose to know the amount cash float or bank balance necessary to pay day is day payments. This amount is given in the information and added in the amount of working capital required. 8) Prepaid Expenses: - There may be some expenses i.e. insurance, sales promotion would be paid in advance and in this case working capital requirement would be higher is that extent. 9) Sundry Creditors: - The period of credit allowed by supplier has to be taken in to consideration while estimating required amount of working capital. It longer the period credit from suppliers, lower will be the working capital requirements. 10) Creditors for expenses: - Time lag in payment of wages and overheads also should be considered while deciding amount of working capital requirements. If there is no time lag in payment of wages and overheads, more working capital will be required and

166 there will be less requirement of working capital when there is timelag in payment of wages and overheads. 11) Advance from customers: - If and when advance required from customers then there will be lower working capital requirements. 12) Contingencies: - After calculating the amount of working capital as discussed above, a provision for contingencies may be made to make allowances for likely variations. This is the sort of cushion against uncertainties involved in estimating working capital.

7.13 EXERCISE
1. 2. 3. 4. Define Working Capital. Explain the types of Working Capital. No business can run successfully without an adequate amount of Working Capital. Discuss. Which are the Determinants of Working Capital? Write short notes: 1. Importance of Adequate of Working Capital. 2. Danger of Excess Working Capital. 3. Danger of Inadequate Working Capital. 4. Projection of Working Capital Requirements.

167

8
WORKING CAPITAL CONCEPT - II
Unit Structure: 8.0 8.1 8.2 8.3 Objectives Calculation of figures required for working capital projection Illustrations Exercises

8.0 OBJECTIVES :
After studying the unit the students will be able to: Calculate the figures required for Working Capital Projection. Draw the statement of Working Capital. Solve the practical requirement. problems on Working Capital

8.1

CALCULATION OF FIGURES REQUIRED FOR WORKING CAPITAL PROJECTION :

8.1.1 Stock of raw materials: - The cost of raw materials ascertained as under.
Budgeted production (units) p.a x cost of material per unit x Raw material holding period
365 days or 52 Weeks or 12 months

8.1.2 Work-in-progress: - The value of work-in-progress is decided as follows:

Budgeted production p.a (units) x per unit cost x material 100% +
Labour 50% + overload 50%

Process period
365 days or 52 weeks or 12 months

168 8.1.3 Stock of finished goods: - The investment in finished stock by a firm is decided as follows:
Budget production p.a (units) x Cost of goods Produced p.u. x Finished goods holding period 365 days or 52 weeks or 12 months

8.1.4 Investment in debtors: - Debtors are calculated at sales prices as well as at cost price as follows: At sales price
Budgeted credit sales P.a units x Selling Price per unit x Debtors collections period 365 days or 12 months or 52 weeks

At Cost Price
Budgeted credit sales P.a units x Cost of sale per unit x Debtors collections period 365 days or 12 months

8.1.5 Cost and bank balance: - Required amount of cash & bank can be determined on the basis of cash budget. This budgeted cash and bank balance should be enough to meet day to day expenses. This is readily given in the problem and included in the list of current assets. 8.1.6 Advance payment: - The payment of expenses for the period which is not expired. It is calculated as follows. Expenses 365 days or 52 weeks or 12 months

Period of prepayment

8.1.7 Sundry Creditors: - The amount of creditors depends on the credit purchases and the period of credit allowed by supplier is calculated as follows:
Budgeted production p.a units x Cost per unit of raw material x Period of credit allowed 365 days or 52 weeks or 12 months

8.1.8 Creditors for wages & overheads: - It is not necessary to pay wages and expenses immediately which will ease working capital requirements. This amount is calculated as follows:
Budgeted production

Wages or expenses

Lag in payment
365 days or 52

P.a. unit

per unit

169
Weeks or 12 months

8.1.9 Advance from customer: - The amount received from customer in advance along with purchases result into less working capital requirement. This amount is given in the problem. 8.1.10 Proforma of Working Capital Statement XYZ Co. Ltd. Statement of Working Capital Requirement for the period ____ Particulars
A) Current Asset I. Stock of Raw Material II. Stock of WIP a) Raw Material Labour b) Labour c) Overheads III. Stock of Finished Goods a) Raw Material b) Labour c) Overheads

Working
(Units x Rate x Period of holding) (Units x Rate x Processing period) (Units x Rate x Processing period x 1/2) (Units x Rate x Processing Period x 1/2) (Units x Rate x Period of holding) (Units x Rate x Period of holding) Units x Rate x Period of holding) (Units X S.P. x Period of Credit)

Rs.

Rs.
xxx

xxx

xxx xxx xxx xxx xxx xxx xxx

IV. Debtors at S.P. OR Debtors at Cost a) Raw Materials b) Labour c) Overhead V. Prepaid Expenses VI. Advance to Supplier VII. Cash & Bank Total B.Less : Current Liabilities I. Creditors for Materials II. Lag in payment Wages a) Wages b) Overheads

xxx

(Unit x Rate x Period of credit) (Unit x Rate x Period of credit) (Unit x Rate x Period of credit) Units x Rate x Period of Payment

xxx xxx xxx xxx xxx xxx xxx xxxx

(Units x Rate X period of credit) (Units x Rate x Lag in Payment) (Units x Rate x Lag in Payment)

xxx xxx xxx xxx xxxx xxxx xxx

III. Advance from Customers Total C. Net Current Assets (A - B) Add: - Margin of Safety

170
D. Working Capital xxxx

8.2

ILLUSTRATIONS :

Solve problems: 1. Sanket Ltd. had an annual sale of 50,000 units, at Rs.100 per unit. The company works for 50 weeks in the year. The cost details of the company are as follows: Elements of cost Raw Materials Labour Overheads Profit per unit Sales price per unit Cost per unit Rs. 30 10 20 60 40 100

The company has to practice of storing raw materials for 4 week's requirements. Wages and other expenses are paid after a lag of 2 weeks. Further the debtors enjoy a credit of 10 weeks and company gets a credit of 4 weeks from the suppliers. The processing time is 2 weeks and finished goods inventory is maintained for 4 weeks. From the above information prepare a working capital estimates, allowing for a 15% contingency. Solution:Working notes:

50, 000 1, 000 units per week. 50 b) Debtors are valued at selling price and finished goods at sales loss profits. c) It has been assumed that the labour and overheads accrue on an average, so half the labour and overheads would be included in work in progress.
a) Sales per week Statement showing estimation of working capital.
Particulars A. Current Assets I. Stock Raw Materials Work-in-progress Raw materials Labour Overheads Finished goods II. Debtors Working (unit x Rate x Period) Rs. Rs.

(1000 x 80 Rs. x 4 week) (1000 x 30 Rs. x 2 week) (1000 x 10 x 2 weeks x 1/2) (1000 x 20 x 2 weeks x 1/2) (1000 x 60 x 4 weeks) (1000 x Rs. 100 x 10 week) Total Current Assets 60,000 10,000 20,000

1,20,000

90,000 2,40,000 10,00,000 14,50,000

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B. Less: - Current Liabilities I) Creditors II) Outstanding wages III) Outstanding Overheads

(1000 x 30 Rs. x 4 weeks) (1000 x Rs.10 x 2 week) (1000 x 20 x 2 weeks)

1, 20,000 20,000 40,000 1, 80,000

Working Capital (A-B) Add. 15% Con. Reserve Net working capital

1, 27,000 1, 90,500 14, 60,500

2. A factory produces 48,000 units during the year and sells them for Rs. 50 per unit. The cost structure of a product is as follows. Raw Materials Labour Overheads 60% 15% 10% 85% 15% 100%

Profit Selling price

The following additional information is available. I. II. III. IV. V. VI. VII. VIII. The activities of purchasing producing and selling occur evenly through and the year. Raw materials equivalent to 1 months supply is stored in godown. The production process takes are month. Finished goods equal to three month's production are carried in stock. Debtors get two month's credit. Time lag in payment of wages and overheads in 1/2 months. Cash and bank balance is to be maintained at 10% of the working capital. 10% of sales are made at 10% above the normal selling price.

Draw the statement showing working capital requirement of the factory.

172 Solution: Statement showing working capital requirement.

Particulars A. Current Assets I. Stock Raw Materials Work-in-progress - Raw Materials - Labour - Overheads Finished Goods at cost Working (units x Rate x period)
1 12

Rs.

Rs.

(48,000 x (48,000 x (48,000 x (48,000 x (48,000 x

x Rs.30 x 1m) x Rs.30 x 1m) x Rs.7.5 x x Rs.5 x

1 2 1 2

1,20,000 1,20,000 15,000 10,000 1,45,000 5,10,000

1 12 1 12 1 12 1 12 1 12 1 12

m)

m)

x Rs.42.5 x 3 m) x 90% x Rs.50 x 2m) x 10% x Rs.55 x 2m) 3,60,000 44,000

II. Debtors at selling price (48,000 x Normal Higher S.P. (48,000 x Total B. Current Liabilities I. Sundry Creditors II. O/S wages III. O/S Overheads C. Working capital (A-B) Add : 10% for cash & Bank balance i.e. 10% of cost Required working capital (48,000 x (48,000 x (48,000 x (90%) (10%)

4,04,000 11,79,000

1 x Rs.30 x 1.5m) 12 1 1 x Rs.7.50 x 2 m) 12 1 1 x Rs.5 x 2 m) 12

1,80,000 15,000 10,000 2,05,000 9,74,000 1,08,222

(100%)

10,82,222

Working notes. 1) Cost Structure Raw material Labour/Wages Overheads %age 60 15 10 85 Add. Profits Selling price 2) 15 Cost per unit 30.00 7.50 5.00 42.50 7.50 50.00

Sundry debtors Normal selling price 10% above normal selling price

Rs.50.00 Rs.55.00

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3)

5 1 5 50 5 55 10 Cash & Bank balance

974000 10 90 = 10,8,222.222
4) M = Months

Rs. 1, 08,222

3. The Board of Directors of Century Rayon Ltd. requests you to prepare a statement showing requirements of working capital for a forecast level of activity of 52,000 units in the ensuring year (52 weeks) from the following information made available. Cost per unit Rs. Raw Material Labour Overheads Manufacturing Overheads Selling & Distribution 40.00 15.00 20.00 10.00 85.00

Additional Information: a) Selling price - Rs. 100/- per unit. b) Raw material in stock - average 4 weeks. c) Work-in-progress - average 4 weeks. d) Finished goods in stock - average 4 weeks. e) Credit allowed to debtors - average 8 weeks. f) Credit allowed by supplier - average 4 weeks. g) Cash at bank is expected to be Rs. 50,000. h) All sales are a credit basis. i) All the activities are evenly spread out during the year. j) Debtors are to be valued at sales.

174

Solution: Statement of working capital requirement.

Particulars A. Current Assets I. Stock Raw Materials Work-in-progress Raw Materials Labour Overheads Finished Goods at cost (52,000 52 x Rs.40 x 4 weeks) (52,000 52 x Rs.15 x 4 weeks x (52,000 52 x Rs.20 x 4 weeks x (52,000 52 x Rs.75 x 4 weeks) 52 x Rs.100 x 8 weeks)
1 2 1 2

Working (units x Rate x period)

Rs.

Rs.

(52,000 x

1 52

x Rs.40 x 4 weeks)

1,60,000

1,60,000 ) ) 30,000 40,000 2,30,000 3,00,000 8,00,000 50,000 15,40,000

II. Debtors at selling price (52,000 III. Bank Balance

B.Less Current Liabilities Sundry Creditors C. Working Capital (A-B) (52,000 52 x Rs.40 x 4 weeks ) 1,60,000 13,80,000

Working Notes: 1) Particulars Raw materials Labour Manufacturing overheads Cost of goods produced Add: Selling & Distribution Expenses Cost of goods sold Add: Profit Sales price 2) W= weeks Cost per unit Rs. 40.00 15.00 20.00 75.00 10.00 85.00 15.00 100.00

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4. From the following data, prepare a statement showing working capital requirement for the year 2009: a) Estimated activity for the year 1, 95,000 units (52 weeks). b) Stock of raw material 2 weeks and material in progress 2 weeks, 50% of wages and overheads are incurred. c) Finished goods 3 weeks storage. d) Creditors 2 weeks. e) Debtors 4 weeks. f) Outstanding wages and overheads 2 weeks each. g) Selling price per unit Rs. 30. h) Cost analysis per unit is as follows. I. II. III. Raw materials 1/3 of sales. Labour and overheads in the ratio of 3:2 per unit. Profit per unit is Rs. 10

i) Cash balance Rs.50,000 Assume that operations are evenly spread throughout the year. Solution: Working notes 1) Cost structer Rs. Cost per unit for 195000 unit Rs. 10.00 6.00 4.00 20.00 10.00 30.00

Raw Materials Labour Overheads Total Cost Profit Profit Sales price 2) 3) 4) 5)

19,50,000 11,70,000 7,80,000 39,00,000 19,50,000 58,50,000

After deducting profit we get total cost per unit Rs.20. Total cost Rs.20 includes Rs.10 cost of raw materials. Balance Rs.10 per unit will be divided in the ratio of 3:2 i.e. Rs.6 labour and Rs.4 overheads. W = week

176 Statement of working capital requirements for the year 2009.

Particulars A. Current Assets I. Raw Materials II. Work-in-progress Raw Materials Labour Overheads Working (units x Rate x period) (19,5,000 52 x 10 x 2w) Rs. Rs.

75,000

(19,5,000

52 x 10 x 2w)

75,000 22,500 15,000 11, 2,500

(19,5,000 52 x 6 x 2w x 50%) (19,5,000 52 x 4 x 2w x 50%) (19,5,000 (19,5,000 Given Total 52 x 20 x 2w) 52 x 30 x 4w)

III. Finished Goods IV. Debtors V. Cash

1, 50,000 4, 50,000 50,000 8, 37,500

B. Less Current Liabilities I. Creditors II. Outstanding wages III. Outstanding overheads Total C. Working Capital (A-B)

(19,5,000 (19,5,000 (19,5,000

52 x 10 x 2w) 52 x 6 x 2w) 52 x 4 x 2w)

75,000 45,000 30,000 1, 50,000 6, 87,500

5. Sangeet Swapna Ltd. Furnisher in the following information and request you to prepare a statement showing the requirement of working capital for the year ended 31st March 2009. Budgeted for 2009 Production capacity for the year Production Cost structure Crude material Other direct material Wages Overheads Rs. 30 per unit Rs. 20 per unit Rs. 25 per unit Fixed Rs. 9000 p.m. and Rs. 15 variable per unit Profit 25% on sales 10,000 units 90%

177 Other information: I. II. III. IV. Crude oil material remains in the stock for 2 months. Other direct material remains stock for 1 month. Finished goods remain in stock for 2 month. (to be valued at direct cost) Production process takes place 1 month work-in-progress valuation to be made crude material plus direct material at cost; plus 50% of wages and variable overheads. Time lag in payment of wages 1 month and variable overhead half month. Fixed overhead payable quarterly in advance. Crude material purchased from suppliers against advance payment of two months and other direct material suppliers allow credit of 1 month. Credit allowed to customers as under at sales price. a) 50% of invoice price against acceptance of bill for 4 months. b) 25% of invoice of time lag 2 months. IX. X. Bank balance to be maintained Rs. 50,000. Production and sales takes place evenly throughout the year.

V. VI. VII.

VIII.

Solution: Working notes: 1) 2) Estimated production 90% of 10,000 = 9000 units. Cost structure Crude material Other direct material Wages Fixed overhead (9000 x 12) 108000 Variable overheads Total Cost Profit 25% on sales (Means 331/3 of cost) Selling price 3) M = months 9000 Rs. 30.00 20.00 25.00 12.00 15.00 102.00 34.00 136.00

178 Statement of working capital

Particulars A. Current Assets a) I. Stock: Crude Material Other direct material II. Work-in-progress Crude material Other direct material Wages Overheads III. Finished goods b. Debtors c. Bills receivables d. Advance to suppliers e. Prepaid fixed overhead f. Bank balance Total B. Less Current Liabilities I. Creditors II. Outstanding wages III. Outstanding overheads Total C. Working Capital (A-B) Working (units x Rate x period) Rs. Rs.

75,000 (9000 12 (9000 12 Rs.30 2 m) 20 1 m) 45,000 15,000 60,000

(9000 (9000 (9000 (9000

12 12 12 12

30 20 25 15

1 m) 1 m) 1 m 50%) 1 m 50%)

22,500 15,000 9,375 5,625

52,500 1,53,000 51,000 2,04,000 45,000 27,000 50,000 6,42,500

(9000 12 102 2 m) (9000 12 136 1 m 50%) (9000 12 136 4 50%) (9000 12 30 2 m) (9000 x 3 x 1) Given

(9,000 (9,000 (9,000

12 x 20 x 1 m) 12 x 25 x 1 m) 12 x 15 x 0.5 m)

15,000 18,750 5,625 39,375 6,03,125

6. From the books of The Board of KEM Ltd. Pune prepare a statement of working capital requirement to meet the programme planned for the year 2011. 1) Issued share capital 5% Debentures Fixed assets at cost 2) Material Labour Overheads Profit 3) Rs. 4,00,000 Rs. 1,00,000 Rs. 2,50,000 60% 10% 20% 10%

The expected ratio of the cost to selling price are:

Raw materials are in stores for an average of 2 months. Finished goods are kept in warehouse for approximately three months. Production during the previous year was 1,20,000 units and it is planned to maintain this level of activity in the current year also. Each unit of production is expected to be in process for one month. Credit given by suppliers is two months and allowed to customers is 3 months.

4)

5) 6)

179 7) 8) 9) Selling price is Rs. 10 per unit. There is regular production and sales cycle. It is decided to maintain Rs. 30,000 cash balance.

Solution: a) Budgeted output 1, 20,000 units (given). b) Budgeted sales - 1, 20,000 x 10 = Rs. 12, 00,000 c) Cost Structure: R. M. 60% of Rs. 10 = Rs. 6.00 per unit Labour 10% of Rs. 10 = Rs. 1.00 per unit. Overheads 20% of Rs. 10 = Rs. 2.00 per unit. d) Annual expenditure Raw material (1, 20,000 x Rs. 6) = Labour (1, 20,000 x Rs. 1) = Overheads (1, 20,000 x Rs. 2) = Total Profit (1,20,000 x Rs.1) Selling price e) M = months Statement of working capital requirements
Particulars Working (units x Rate x Period) Rs. Rs.

7,20,000 1,20,000 2,40,000 10, 80,000 1,20,000 12, 00,000

A. Current Assets I. Stock of Raw materials II. Work-in-progress Raw Materials

1, 20, 000 6 2m 12
1, 20, 000 6 1m 12 1, 20, 000 1 1 m 12 2 1, 20, 000 2 1 m 12 2
60,000

1, 20,000

Labour

5,000

Overheads

10,000

21,000

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III. Finished goods

1, 20, 000 9 3m 12 1, 20, 000 6 3m 12 1, 20, 000 1 3m 12 1, 20, 000 2 3m 12

1, 80,000

2, 70,000

IV. Debtors a) Raw materials

b) Labour

30,000

c) Overheads

60,000

2,70,000 30,000 7, 11,000

V. Cash Total B. Less: Current liabilities Creditors

1, 20, 000 6 2m 12
(A B)

1, 20,000

1, 20,000

Working Capital

5, 91,000

8.3. EXERCISES :
1. You are required to prepare a statement showing the working capital required to finance the level of activity of 27,000 units per year from the following information. Per unit Rs. Raw materials 24.00 Direct labour 6.00 Overheads 18.00 Total Cost 48.00 Profit 12.00 Selling price 60.00 Information: I. II. III. IV. V. VI. VII. Raw materials are in stock an average for two months. Materials are in process on an average for half a month. Finished goods are in stock on an average for two months. Credit allowed by creditors is two months of raw materials supplied. Credit allowed to debtors is three months. Lag in payment a wages is half month. Cash on hand Rs. 4,000 and bank balance Rs. 10,000

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(Ans. Raw materials - Rs. 1,08,000; work in progress - Rs. 40,500; Finished stock - Rs. 2, 16,000; Debtors Rs. 4, 05,000; Creditors Rs. 10, 8,000; Labour/wages Rs. 6,750; working capital Rs. 6, 23,750)

2. From the following data provided by M/s Alfa Ltd. estimate working capital requirements for the year ended 31st March 2006. a) Estimate activity of operation for the year 2, 60,000 units (52 weeks) b) Raw materials remain in stock for 2 weeks and production cycle takes two weeks. c) Finished goods remain in stock for two weeks. d) Two weeks credit is allowed by supplier. e) Four weeks credit is allowed to debtors. f) Time lag in payment of wages and overheads is two weeks. g) Cash and bank balance to be maintained Rs. 25,000 h) Selling price per unit is Rs. 15 i) Analysis of cost per unit as follows: i. ii. iii.

1 Raw material 33 % of sales 3

Labour and overheads in the ratio of 6:4 per unit. Profit is at Rs. 5 per unit.

Assume that operations are evenly throughout the year; wages and overheads accrue similarly. Manufacturing process required feeding a material fully at the beginning. Degree of workin-progress is 50%. Debtors are to be estimated as selling price. (T.Y.B.Com March 2006)
(Ans. Stock Rs. 50,000 work-in-progress Rs. 75,000 debtors Rs.1,00,000, creditors Rs. 50,000, outstanding wages Rs. 30,000, outstanding overheads Rs. 20,000, working capital Rs. 4, 50,000)

3. From the following details, prepare a statement showing working capital requirement for the year ended 31st March 2009. Production Selling price per unit Raw Materials Direct wages Overheads Materials in hand Production time Finished goods in stores 90,000 units Rs. 10.00 60% of selling price 10% of selling price 20% of selling price 2 months requirement 1 month 4 month

182 Credit for material Credit allowed to customers Average cash balance Average bank balance 2 month 3 month Rs. 30,000 Rs. 20,000

Wages and overheads are paid at the beginning of the month following. In Production all the required materials are charged in the initial stage and wages and overheads accrue evenly.
(Ans. Raw materials Rs. 90,000, WIP- Rs. 56,250, Finished goods Rs. 2,70,000, Debtors - Rs. 2, 25,000, Creditors - 90,000, O/s wages Rs. 7,500, O/s overheads Rs. 15,000 - working capital 6, 78,750)

4. From the following data, prepare a statement of working capital requirement for the year 2009 Rs. Budgeted sales Less: cost of materials Direct labour Overheads Net profit It is estimated that: a) Raw materials are carried in stock for one months and finished goods for 15 days only. b) The production cycle take one month. c) One month's credit is granted both for purchase of raw materials and sales of finished goods. d) Production and overheads are even through the year.
(Ans. Raw materials Rs, 9,000, WIP Rs. 18,000 finished goods Rs. 13,500, Debtors Rs. 30,000, Creditors Rs. 9,000, working capital Rs. 61,500)

Rs. 3, 60,000

1, 08,000 1, 44,000 72,000

3, 24,000 36,000

5. The management of Fast and Thin Ltd. desires to know the working capital required with effect from 1st January, 2010 to finance. the production programme. Percentage cost structure of selling price is as follows. Raw Materials Labour Overheads 50% 20% 10%

You are further informed that: a) Raw materials remain in the stores on an average for one month before issue to production.

183 b) Finished goods remain in the godown for 2 months before sales. c) Each unit of production will be in process for one month. d) Credit allowed by creditors is one month and allowed to debtors is 2 months. e) Selling price per unit is Rs. 9.00 f) Production in 2010 is expected to be 1, 00,000 units.
(Ans. Raw materials - Rs. 37,500, work-in-progress- Rs. 48,750, Finished goods - Rs. 1, 20,000, Debtors - Rs. 1, 20,000, Creditors - Rs. 37,500, working capital Rs. 2, 88,750)

CAPITAL BUDGETING

Unit Structure:

9.0 9.1 9.2 9.3 9.4

Objectives Introduction Meaning of a project Project Planning Project Report

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9.5 9.6 9.7 9.8 9.9 9.10 9.11 9.12 9.13 9.14 9.15 9.16 9.17 9.18 9.19 9.20 9.21 Types of projects New concepts of projects Feasibility study and report Project financing Cost of Project Means of Finance Promoters contribution Margin Money Capital structure Optimum capital structure Trading on Equity Servicing of Interest and Debt Sources of long-term finance Institutional considerations Venture Capital Project appraisal Model Questions

9.0

OBJECTIVES :

The objectives of this topic are as follows:

(i) to understand the concept of capital budgeting (ii) to understand the concept of project and budgeting report (iii) to understand the sources of project financing (iv) to understand the important considerations for capital budgeting

9.1

INTRODUCTION :

185

The financial requirements of business can be classified as shortterm and long-term financial requirements. Short-term funds are required for meeting working capital needs. It is usually required for a period up to one year. Long-term funds are required to a great extent for meeting the fixed capital requirements of the business. It is required for a period of 1 to 5 years or more. Fixed capital is required for investment in land, building, plant and machinery, vehicles and furniture etc. Short-term funds are required for making day to day payments like wages, raw materials, traveling, stationery etc. the requirements of short-term funds are usually met by taking short-term loans, overdraft or getting the bills discounted from the banks. The long-term funds are raised by issue of shares, debentures, loans from financial institutions and banks.

Capital investment involves a cash outflow in the immediate future in anticipation of returns of a future date. The planning and control of capital expenditure is called as capital budgeting decisions. Capital budgeting is an art of finding assets that are worth more than their cost of achieve the objectives i.e. optimizing the wealth of a business enterprise. A key challenge for the companies is to identify projects which fit the objectives and promise to be profitable. Capital expenditure decisions usually involve large sums of money, long-time spans and carry some degree of risk and uncertainty. Realistic investment appraisal requires the financial evaluation of many factors such as the choice of size, type, location, timing of investments, taxation, opportunity cost of funds available and alternative forms of financing the projects.

9.2

MEANING OF A PROJECT :

A Project is a scheme for investing resources. It is a proposal of something to be done, plan or scheme. Every business plan is a project. The entrepreneur has to identify an opportunity to undertake a new venture. The business opportunity can be generated through various techniques like market research observations at market places, consultation with experts and brainstorming sessions. The entrepreneur, should conduct cost-benefit analysis of each of every idea. The costs can be measured in terms of resources required to implement the opportunity and the benefits can be measured in terms of sales, profits etc. Thus, a project is a business plan. It describes the future direction of the business. The entrepreneur should prepare a sound business plan in order to exploit the opportunity. A good business plan is important in

186
determining the resources required, obtain the resources and effectively manage the business venture.

9.3

PROJECT PLANNING:

Project planning is deciding in advance the future course of action. The first stage in the process is recognition of opportunities. The involves a continuous search for investment opportunities which are compatible with the firms objective. Survival and profitability are two most important objectives to be achieved. Therefore, each proposal is subjected to a preliminary screening process in order to assess whether it is technically feasible, economically, viable, resources required are available and then expected returns are adequate to compensate for the risks involved. The alternative plans are screened and further investigated. If a proposal satisfies the screening process it is then analyzed in more detail by gathering technical, economic and other details. Projects are also classified into new projects, expansions or improvements and rank them within each classification with respect to profitability, risk and degree of urgency. The alternative projects are evaluated on the basis of the investment cash inflow and outflows. Once evaluation is completed then the best proposal is forwarded to a higher level management for authorization and to take up the project. The project will be implemented, if approved and its progress is monitored with the aid of feedback reports.

9.4

PROJECT REPORT:

A project report is a written document containing complete information about the proposed project. Thus, a project report is a blue print guiding the entrepreneur to reach the destination as envisaged by the entrepreneur. A project report is prepared by an expert after detailed study and analysis of the different aspects of the project. The various aspects of the project includes analysis of the market, technology, finances, manpower, production facilities etc. It is prepared to analyze the extent of opportunities in the proposed project. It is useful to financial institutions, government authorities, investors and the entrepreneur. The project report spells out the advantages and disadvantages of allocating resources of enterprise to the production of specific goods and services. The contents of the project report should be arranged in a logical manner. An original project report runs into several pages.

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9.5 TYPES OF PROJECTS :

There are different types of projects undertaken by the business. The important types of projects are given below:(1) Modernization Project: Modernization projects involve removal of old machines and installation of new machines in their place to cope with dynamic and competitive business environment. Expansion Projects: Expansion projects are undertaken to enlarge the plant capacity with a view to produce a large volume of production than the current level of production. Diversification Projects: Diversification project is an investment decision to set up an entirely new project which is not connected with the exiting line of business. Balancing Projects: New plant and machinery is installed in order to remove the bottlenecks (imbalance) and to increase the capacity utilization of the total plant. In installing balancing equipment, these would be free flow in the process and uninterrupted production is ensured and there will be increase in the revenue. Replacement Project: Replacement of an existing asset with more economic one is a replacement project. By replacement, the operational efficiency is increased, cost of production is reduced, cost of maintenance is reduced and profitability is increased.

(2)

(3)

(4)

(5)

9.6 NEW CONCEPTS OF PROJECTS:

In recent economic liberalization programme in India, few projects are emerging with new concept for financing and execution of project. Such new concepts of projects are given below:

(1)

Building Operate and Transfer (BOT): Under this concept, the private sector is allowed to put the investment in bringing the project and the Government allows them to operate for certain period and then transfer the project to the Government. For example, super express highways. Build, Own and Operate (BOD): Under this concept, the private entrepreneurs are allowed to build the project from their own resources, and then they will own the project and

(2)

188
they are also entitled to operate the project subsequent to their commercial launching. For example, power sector. (3) Lease, Rehabilitate, Operator and Transfer (LROT): Under LROT concept, the Government gives a running plant to the private entrepreneur for rehabilitation to put the plant on profitability track. Turnkey Projects: When a single contractor undertakes the responsibility for the entire work and completes it so that the owner merely turns the key and operates the plant is known as Turnkey project. It covers the complete responsibility of engineering, design, manufacturing, supply, construction and commissioning the project.

(4)

9.7 FEASIBILITY STUDY AND REPORT:

A feasibility study is a preliminary study undertaken to determine a projects viability. The results of the study are used to make a decision whether or not to proceed with the project. It is an analysis of possible, alternative solutions to a problem and a recommendation on the best alternative.

A business plan is prepared only when the business venture is feasible. A feasibility study provides an investigating function. It is conducted by an outside expert. The expert conducting the feasibility study has to work with the group to identify the best alternative for the situation. If the business plan is not feasible, others are made to correct the deficiencies and other alternatives may be explored. The feasibility study covers the following areas:-

(1)

Technical feasibility: It involves the question whether the technology needed for the project exists, the cost of technology and the suitability of the technology to the firm. Market feasibility: It covers the potential impact of consumer demand, supply, competition, price and profits. Economic feasibility: This involves the feasibility of the proposed project to generate economic benefits. Financial feasibility: It involves the capability of the firm to raise appropriate funds needed to implement the proposed project.

(2) (3) (4)

Feasibility report is written document containing in detail the finding of the feasibility study in respect of the project. It is prepared by

189
exports or by lending institutions. It is prepared after conducting the feasibility study. It is useful to find out commercial viability of the project and rate of success or failure of the project.

9.8 PROJECT FINANCING:

The financing decision is an important managerial decision. It influences the shareholders returns and risk. As a result, the market value of the share may be affected by the financing decision. The financing decision relates to the composition of relative proportion of various sources of finance. The financial management weighs the merits and demerits of different sources of finance while taking the financing decisions. A project can be financed from either the shareholders funds or borrowings from outside agencies. The shareholders funds include equity share capital, preference share capital and the accumulated profits whereas borrowings from outsides include borrowed funds like debentures and loans from financial institutions. The borrowed funds have to be paid back with interest and some amount of risk is involved if the principal and interest is not paid. Equity has no fixed commitment regarding payment of dividends or principal amount and therefore no risk is involved. It is the decision of the business to decide the ratio of the borrowed funds and owned funds. Most of the companies use a combination of both the shareholders fund and borrowed funds. Both the types of funds incur cost and it is called cost of capital to the company.

Funds requirement decision and the financing decision are two major areas of financial decision making. Funds requirement decision is concerned with the estimation of the total funds or capital requirements for the business enterprise, while the financing decision is concerned with the sources from which the funds are to be raised. It is also necessary to raise the funds at proper time, and at reasonable cost. Therefore, there should be proper financial planning which includes:

(a) (b) (c)

Estimating the amount of capital to be raised. Determining the form and proportionate amount of securities. Laying down the policies as to the administration of the financial plan.

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9.9

COST OF PROJECT :

Cost of project is the aggregate of costs estimated to be incurred on various heads for bringing the project into existence. The cost of the project usually comprises the following:

(a) (b)

Fixed Capital requirement, and Working capital requirements.

The fixed capital requirements include the following costs:-

i) ii) iii) iv) v) vi)

Land and site development. Factory Building. Plant and Machinery. Other Fixed Assets. Technical know how. Preliminary expenses.

The working capital refers to the capital required for day to day operations of a business enterprise. It includes the following costs.

i) ii) iii) iv)

Purchase of raw materials Payment of wages and salaries. Payment of routine expenses. Contingencies.

9.10 MEANS OF FINANCE:

It is necessary to raise finance from various sources for implementation of the project. The scheme of finance will be determined after consideration of various aspects attached to different sources of finance. The scheme of finance will comprise the following:

(a) (b) (c) (d)

Share capital Preference shares and equity shares. Debentures. Term loan from financial institutions. Unsecured loans banks, promoters, others.

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9.11 PROMOTERS CONTRIBUTION:

The persons who are involved in the implementation of a project are known as promoters. An entrepreneur who promotes the project is also required to participate in the scheme of finance of the project. The extent of promoters contribution in the project is a sign of interest of the promoter in the project. Promoters contribution indicates the extent of their involvement in the project. The promoters contribution can be provided in the form of subscribing to equity and preference shares issued by the company, unsecured loans, seed capital assistance, venture capital assistance and internal accrual of funds. The Bank and Financial institutions normally participate in the scheme of project finance and they ask the promoters to bring in a certain portion of total funds required which is normally between 25% to 50% of the cost of the project into the equity share capital of the company. The promoters contribution can be arranged from outside sources like friends and relatives. For eligibility of the project financing the financial institution may stipulate minimum promoters contribution which is to be arranged by the promoter.

9.12 MARGIN MONEY:

The banks and financial institutions maintain a margin while financing the project cost. They ask the borrowers to bring a certain amount of the cost of the project cost as margin money to safeguard from the changes in the value of assets that are being financed and provided as a security. The quantum of margin money depends upon the creditworthiness of the borrower and nature of security provided to the institution. Margin money is one of the important factors which is evaluated by the financial institutions while considering the project for financial assistance. The margin money required for working capital will be provided in the project cost. The RBI guidelines provide the amount of working capital margin money. The margin money should be brought by the promoters in project financing.

9.13 CAPITAL STRUCTURE :

Capital structure refers to the mix of a firms capitalization and includes long-term sources of funds such as debentures, preference shares, equity shares and retained earnings. The decisions regarding the

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forms of financing their requirements and their relative proportions in total capitalization are known as capital structure decision. A firm has the choice to raise funds for financing its project from different sources in different proportions as follows: (a) (b) (c) (d) (e) Exclusive use of equity capital Use of equity and preference capital Use of equity and debt capital Use of equity, preference and debt capital Use of a combination of debt, equity and preference capital in different proportions.

The choice of combination of these sources is called as capital structure mix.

9.14 OPTIMUM CAPITAL STRUCTURE:

The theory of optional capital structure deals with the issue of the right mix of debt and equity in the long-term capital structure of a firm. This theory states that if a company takes on debt the value of the firm increases up to a point. Beyond that point if debt continues to increase then the value of the firm will start to decrease. If the company is unable to repay the debt within the specified period, then it will affect the goodwill of the company in the market. Therefore, the company should select its appropriate capital structure with due consideration to the factors of debt and equity.

9.15 TRADING ON EQUITY:

The term trading on equity is derived from the fact that debts are contracted and loans are raised mainly on the basis of equity capital. The concept of trading on equity provides that the capital structure of a company should include equity as well as debt. Again the proportion of debt in the capital structure should also be optimal. Those who provide debt have a limited share in the firms earnings and hence want to be protected in terms of earnings and values represented by equity capital. Since fixed charges do not vary with the firms earnings before interest and tax, a magnified effect is produced on earnings per share. The determination of optional level of debt is a formidable task and is a major policy decision. EBIT EPS analysis is a widely used tool to determine the level of debt in a firm.

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9.16 SERVICING OF INTEREST AND DEBT:

In order to analyze the borrowers capacity in payment of interest and debt installment regularly, interest coverage ratio and debt service coverage ratio are considered.

(a) Interest Coverage Ratio:

The interest coverage ratio shows how many times interest charges are covered by funds are available for payment of interest. It is determined as follows:

PBIT Interest Coverage Ratio = -------------------Interest on Debt

Where, PBIT means profit before interest and taxes.

A very high interest coverage ratio indicates that the firm is conservative in using debt and a very low ratio indicates excessive use of debt. Interest cover indicates how many times a company can cover its current interest payments out of current profits.

(b)

Debt-Service Coverage Ratio:

Debt service coverage ratio (DSCR)s is the key indicator to the lender to assess the extent of ability of the borrower to service the loan in regard to timely payment of interest and repayment of loan installment. It indicates whether the business is earning sufficient profits to pay not only the interest charges but also the installments due to the principal amount. The DSCR is calculated as follows: Profit after tax + Depreciation + Interest on Loan

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DSCR = -----------------------------------------------------------Interest on Loan + Loan repayment in a year

A ratio of two or more is considered satisfactory by the financial institution. The higher debt service coverage ratio indicates the better debt servicing capacity of the company.

9.16.1 Illustration 1

Preeti Ltd. has the following data for projections for the next five years. It has an existing term-loan of Rs. 360 lakhs repayable over the next 5 years and has got sanctions for new term loan for Rs. 450 lakhs which is also repayable in 5 years. As a finance manager you are required to calculate (a) interest coverage ratio and (b) debt service covering ratio for each of the 5 years and offer your comments

Rs. In Lakhs
Particulars Profit after tax Depreciation Taxation Interest on Term Loan Repayment of Term Loan 1 480 155 125 162 178 2 575 150 203 125 178 3 635 140 254 87 178 4 650 135 275 50 178 5 685 120 299 16 178

Solution

(a) Calculation of interest coverage ratio:

Particulars PBIT Interest Interest Coverage

1 767 162 4.73

2 903 125 7.22

3 976 87 11.22

4 975 50 19.5

5 1000 16 62.5

Total 4621 440 10.50

(b) Calculation of debt service coverage ratio:

Particulars/Years

Total

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PAT Depreciation Interest on Loan Total Interest on Term Loan Repayment of Term Loan Total DSCR 480 155 162 797 162 178 340 2.34 575 150 125 850 125 178 303 281 635 140 87 862 87 178 255 3.25 650 135 50 835 50 178 228 3.66 685 120 16 821 16 148 164 5.00 3025 700 440 4165 440 860 1300 3.20

(c) Comments: Average interest coverage ratio is 10.50 times and average debt service coverage ratio is 3.20 times. As DSCR is higher than 2 it indicates the better debt servicing capacity of the company. Interest coverage ratio is also higher and it indicates that the company is conservative in using its debt.

9.16.2 Illustration 2

BEST Ltd. is a profit making company having paid up capital of Rs. 100 lakhs consisting of 10 lakh ordinary shares of Rs. 10 each. Currently it is earning an annual pre-tax profit of Rs. 60 lakhs. The companys shares are listed on BSE and are quoted in the range of Rs. 50 to Rs. 80. The management wants to diversify production and has approved a project which will cost Rs. 50 lakhs and which is expected to yield a pre-tax profit of Rs. 40 lakhs per annum. To raise this capital, the following options are under consideration of the management.

(a)

(b) (c)

To issue equity capital for the entire additional amount. It is expected that the new shares (face value of Rs. 10) can be sold at a premium of Rs. 15 each. To issue 16% non-convertible debentures of Rs. 100 each for the entire amount. To issue equity capital of Rs. 25 lakhs (face value of Rs. 10) and 16% non-convertible debentures for the balance amount. In this case, the company can issue shares at a premium of Rs. 40 each

You are required to advise the management as to how the additional capital can be raised, keeping in mind the management wants to maximize the earnings per share to maintain its goodwill. The company is paying income tax at 30%.

Solution:

(a) Calculation of earnings per share under the three options:

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Option I (Rs. Lakhs) Estimated total income i) Current operations ii) New operations PBIT Less: Interest on 16% Debentures Profit before tax Less: Tax @ 30% Profit after tax Number of equity shares (lakhs) EPS 60 40 100 100 30 70 12 5.83

Option II (Rs. Lakhs) 60 40 100 8 92 27.60 64.40 10 6.44

Option III (Rs. Lakhs) 60 40 100 4 96 28.80 67.20 10.50 6.4

Earning per share can be maximized with option II. Hence, it is advised to issue 16 % debentures is the most suitable.

Check your progress

1. Define the following terms: 1. Project 2. Project Planning 3. Project Report 4. Replacement Project 5. Feasibility Study 6. Cost of Project 7. Promoters 8. Margin Money 9. Trading on Equity

9.17 SOURCES OF LONG-TERM FINANCE :

There are different sources of funds available to meet long-term needs of the business. These sources may be broadly classified as under:-

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(a) (b) (c) (d) (e) (a)

Share capital Debenture or bonds Retained earnings Loans from financing institutions Loans from commercial banks. Share Capital:

A public limited company can raise capital from issue of shares to the public. It is called public issue of shares. A private company can raise capital by issue of shares to the friends and relatives but not from the public through public issue. Shares capital is the owners capital. Every company can raise capital by issue of shares. Partnership and sole traders cannot issue shares. Public limited companies can raise any amount of capital by issue of shares because there is no limit on the maximum number of shareholders or members. There are two types of shares.

(i) Preference Shares: Preference shares are those shares which have first preference for payment of dividend and refund of capital at the time of winding up of the company. Long-term funds can be revised by public limited companies through a public issue of shares. The preference shares carry a fixed rate of dividend. If the company cannot raise capital by issue of equity shares due to depression in the stock market, it can raise capital by issue of preference shares. However, a very few companies in India have issued preference shares for raising long-term funds. Preference shares are normally cumulative i.e. the dividend payable in a year of loss gets carried over to the next year till there are adequate profits to pay the cumulative dividends. The Companies Act, 1956 provides that no profit, no dividend.

Preference share capital is a hybrid from of financing because it possesses some characteristics of equity capital and some attributes of debt capital. Preference shares may be convertible which can be converted into equity shares after a certain period. These shares are attractive for projects with a long gestation period. Preference shares can also be redeemable at a certain period. This enables the promoters to withdraw their capital from the company. Preference shares have gained importance after Finance Bill, 1997 as dividends became tax free in the hands of the individual investors and are taxable in the hands of the company as a tax on dividend distribution.

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(ii) Equity or Ordinary Shares: Ordinary shares are those shares which are not preference shares. Ordinary shares are a source of permanent capital. Ordinary shares holders are owners of the company and they undertake the risk of the business. They are entitled to dividends after the income claims of other stakeholders are satisfied. Similarly in the event of winding up, ordinary shareholders can exercise their claim on assets after the claims of the other suppliers of capital have been met. They elect the directors to run and manage the business of the company. The cost of equity shares is usually highest. This is due to the fact that the shareholders expect higher rate or return on their investment as compared to other suppliers of long-term funds. Thus, ordinary shareholders carry a higher amount of risk and so expect a higher return. A company, having substantial ordinary share capital may find it easier to raise funds, in view of the fact that share capital provides a security to other suppliers of funds.

(b) Debenture or Bonds:

Issue of debentures or bonds are sources of borrowed capital. It is a source of long-term capital. A debenture is an acknowledgement of debt issued by a company. Normally the debentures are issued by the public limited companies in private sector. However, bonds are issued by the government companies or public sector undertakings. Debentures or bonds are issued in different denominations ranging from Rs. 100 to Rs. 1000 and carry different rates of interest. A company has to make public issue for issuing debentures or bonds. It is just like issue of shares. The debentures are also traded in the stock market. Thus, debentures provide a more convenient mode of long-term funds. The cost of capital raised through debentures is quite low because the interest payable on debentures can be charged as an expenses before tax. From the investors point of view, debentures offer a more attractive prospect than the preference shares since interest on debentures is payable, whether or not the company makes profits.

Debentures in India, are considered as secured loan. They are protected by a charge on the assets of the company. The debentures can also be convertible debentures. They are partly convertible or fully convertible into shares of the company. Debentures are converted into equity shares as per the terms of the issue in relation to price and the time of conversion. Interest on debentures is fixed at the time of issue and interest on convertible debentures is generally lower than the non-

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convertible debentures. Indian companies have been issuing convertible debentures or bonds with a number of schemes, options, incentives like warrants etc. The issue of convertible debenture has distinct advantages from the point of view of the issuing company. Such an issue enables the management to raise equity capital indirectly without diluting the equity holding, until the capital raised has started earning an added return to support the additional shares. Such securities can also be issued even when the equity market is not very good. Convertible bonds are normally unsecured and, therefore, their issuance may ordinarily not impair the borrowing capacity. The debentures or bonds are issued subject to the SEBI guidelines. Public issue of debentures now require that the issue be rated by a credit rating agency. The credit rating is given after evaluating factors like track record of the company, profitability, debt servicing capacity, creditworthiness and the perceived risk of lending.

(c) Lending-term financial institutions:

Long-term loans are provided by specialized financial institutions in India. The following are the specialized financial institutions:

(1) (2) (3) (4) (5) (6) (7)

The Industrial Finance Corporation of India Industrial Development Bank of India Industrial Reconstruction Corporation of India. Small Industries Development Bank of India Life Insurance Corporation of India State Financial Corporations Exim Bank

Term loans are provided by these institutions at different rates of interest under different schemes of financial institutions. It is also to be repaid according to a stipulated repayment schedule. These institutions stipulate a number of conditions regarding the management and certain other financial policies of the company.

Term loans represent secured borrowings. It is the most important source of finance for new projects. They generally carry a rate of interest inclusive of interest tax depending on the credit rating of the borrower, the perceived risk of lending and the cost of funds. The loans are generally repayable over a period of 6 to 10 years in annual, half yearly or quarterly installments. For large scale projects, all India financial institutions provide the bulk of term finance either singly or in consortium with other financial institutions.

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(d) Loans from commercial banks:

The banks in India also provide term loans to the companies. Banks normally provide term loans to projects in the small and medium scale sectors. The primary role of commercial banks is to cater to the short-term requirements of the industry. However, banks have started taking an interest on term financing of industries in several ways. The proceeds of the term loan from banks are generally used for fixed assets or for expansion of plant capacity. Their repayment is scheduled over a period of time. Term loans proposals involve an element of risk because of changes in the conditions affecting the borrowers. The bank making such a proposal has to access the situation to make a proper appraisal. The decision in such a situation would depend upon various factors affecting the conditions of the industry concerned and the earning potential of the borrower.

(e) Retained earnings:

Retained earnings are the profits retained in the business. Every company retains certain portion of profit every year in the form of reserve. Even the balance of profit after declaration of dividend is also carried forward in the balance sheet. It is known as ploughing back of profits. Such funds belong to the ordinary shareholders and increase the net worth of the company. A public limited company has to plough back a reasonable amount of profit every year keeping in view the legal requirements and its own expansion plans. However, retained earnings can be used by existing and financially sound companies. A new company or a loss making company cannot follow this method. Retained earning is used as a long-term capital without any cost.

9.18 INSTITUTIONAL CONSIDERATIONS :

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The sources from which a business meets its financial requirements can be classified according to the period, ownership and source of generation. The sources of funds according to the period in undue long-term sources of funds such as shares, debentures and term loans and short-term, sources such as public deposits, advances from customers and trade creditors. According to ownership the share capital and retained earnings are owned sources. While debentures and term loans are borrowed funds. According to source of generation, internal sources are retained earnings and funds and external sources such as shares and debentures or term loans.

For the sake of convenience, the different sources of funds can be classified into the three categories. These categories are security financing, internal financing and loan financing. A large number of specialized financial institutions have been set up in the country after independence to meet the specific term financial needs of the companies. They are popularly known as Development Banks. Development banks seek to mobilize scarce resources, such as capital, technology managerial and entrepreneurial talents and channelize them into industrial activities in accordance with plan priorities. It has, therefore, to share its policies, procedures and functions in a way so as to cater to development needs of specific sectors as well as economy in general.

9.19 VENTURE CAPITAL :

The venture capital financing refers to the financing of the new and high risky projects promoted by qualified entrepreneur, who lack experience and funds to give shape to their ideas. Under this scheme, venture capitalists make investment to purchase equity shares or debt securities from inexperienced entrepreneur who undertake risky ventures with a potential of success.

Venture capital financing was first the responsibility of development financial institutions such as the Industrial Development Bank of India, the Technical Development and Information Corporation of India and State Financial Corporations. In the year 1988, the Government of India took a policy initiative and announced guidelines for venture capital funds. In the same year, a technology development fund financed by the levy on all payments for technology, imports was established. This fund was meant to facilitate the financing of innovative and high risk technology programmes through the IDBI.

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SEBI also issued guidelines in 1996 for venture capital funds to follow. These guidelines described a venture capital fund as a fund established in the form of company or trust, which raises money through loans, donations, issue of securities or units and makes or proposes to make investments in accordance with the regulations. This move was instrumental in the entry of various foreign venture capital funds to enter India. The guidelines were further amended in April 2000 with the objective of fuelling the growth of venture capital activities in India. A few venture capital companies operate as both investment and fund management companies, others set up funds and function as asset management companies.

Venture capital is a fund-based financial service. It has emerged the world over to fill gaps in the conventional financing. Venture capital is basically a equity finance in relation to new listed companies. Debt financing is only supplementary to ensure running yield on the portfolio of the venture capitalists. It is a long-term investment in growth-oriented small and medium companies. There is a substantial degree of active involvement of VC institutions with the promoters of venture capital undertakings, to provide managerial skills without interfering in the management. The venture capital financing involves high-risk return spectrum. It is not technology finance though technology finance may form a sub-set of such financing.

The first step in venture capital financing is the selection of the investment. It includes stages of financing methods to evaluate deals and the financial instruments to structure a deal. Early stage includes seed capital, pre-start-up, start up and second round financing. The later stage of venture capital financing covers mezzanine, development capital bridge finance, expansion, buyouts and turn around financing. The venture investments are generally idea-based and growth-based. The structure of venture capital deal is a mix of the available financial instruments i.e. equity and debt. The equity investments include ordinary non-voting deferred, ordinary, preference warrants, cumulative convertible preference and participating preference capital. The main types of debt instruments are conventional loans, conditional loans, income notes, FCDs, PCDs, zero interest bonds, secured premium notes and deep discount bonds.

9.20 PROJECT APPRAISAL:

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Project appraisal is a detailed evaluation of the project to determine the technical feasibility, economic necessity, financial viability of the project and managerial competence required for its successful operation. Such an appraisal is done at two stages: i) ii) by the promoter for identifying the right project and by the financial institution for the purpose of determining whether the project should be financed by them or not.

The promoters have to use project appraisal to ascertain whether the project is expected to give the required rate of return or not. In case of several projects, the promoters may select the project which suits them most keeping in view the urgency, the rate of return and finances required for the project. The project so selected is then submitted to the financial institutions for obtaining the necessary funds.

The financial institutions also use project appraisal technique to ascertain the contribution that the project is likely to make to the national economy and to determine the repaying capacity of the enterprise. This requires the study of technical feasibility, economic necessity and financial viability. Thus, the project appraisal is done by the financial institution to satisfy itself regarding the following:

(i) (ii) (iii) (iv)

The total estimated cost of the project is complete and reasonable. The financial arrangement suggested in the project report is comprehensive and ensures availability of cash at the time of need. The estimates regarding operating cost and earnings are realistic and reasonable. The project will generate necessary cash required for repayment of money borrowed.

9.21 MODEL QUESTIONS :

1 2 3 4

What is a project? What is project financing What are the sources of long-term finance? Explain the concept of financial feasibility of a project. Explain the system of project appraisal followed by the term lending

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institutions in India. 5 Examine the effectiveness of project appraisal and project monitoring by financial institutions. What is project appraisal? appraisal? What are the factors considered in project

What is venture capital financing? What are the methods of venture capital financing? Explain the advantages of equity financing. What is debenture (debt) financing? Why are debentures considered cheaper than equity as a source of long-term finance? Write short notes on the following:a) Debt service coverage ratio. b) Trading on equity c) Promoters contribution d) Project report

8 9

10

10

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CAPITAL BUDGETING TECHNIQUES

Unit Structure:

10.0 10.1 10.2 10.3

Objectives Capital Budgeting Project appraisal techniques Model Questions

10.0 OBJECTIVES:-

The objectives of studying this chapter are: To understand the capital budgeting techniques. To calculate the Net Present Values. To calculate Internal Rate of Return To decide the best Profitable Project

10.1 CAPITAL BUDGETING:

Capital budgeting is a process of planning capital expenditure. It is made to maximize the long-term profitability of the organization. Capital budgeting is a long-term planning exercise in selection of the projects which generates returns over a number of years in future. The heavy expenditure is incurred in the initial years of the project to generate returns over the life of the project. The capital budgeting decision is a decision as to whether or not money should be invested in long-term projects. It is a financial analysis of various proposals of capital expenditure. The finance manager uses various tools and techniques for assisting the management in taking a proper capital investment decision. For the purpose of project appraisal, the cash flow is the incremental cash receipts less the incremental cash expenditure solely attributable to the

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investment. The future costs and revenues associated with each investment alternative are:

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

Capital costs Operating costs Revenue Depreciation Residual value An investment decision implies the choice of an objective, a technique of appraisal, and length of service i.e. the life of the project. The life of the project may be determined by taking into consideration the following factors:

(a) (b) (c)

Technological obsolescence Physical deterioration A decline in demand for the output of the project

10.2 PROJECT APPRAISAL TECHNIQUES:

In order to maximize the return to the shareholders of a company, it is important that the most profitable investment projects should be selected. It is absolutely necessary that the method adopted for appraisal of capital investment proposals is a sound one. Any appraisal method should provide for the following:-

(i) (ii) (iii) (iv)

A basis of distinguishing between acceptable and non-acceptable projects. Ranking of projects in order of their desirability. Choosing among several alternatives. Recognizing the fact that bigger benefits are preferable to smaller ones and early benefits are preferable to later ones.

There are several methods used for evaluating and ranking the capital investment proposals. The basic approach is to compare the investment in the project with benefits derived there-from. Following are the important methods or techniques of capital budgeting:

10.2.1 Pay Back Period:

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The term pay-back period refers to the period in which the project generates the necessary cash to recoup the initial investments. The payback period is generally expressed in years. The method recognizes the recovery of original investment in a project. While deciding between the two or more projects, the usual decision is to accept the project which has a shortest payable payback is a rough measure of liquidity and rate of profitability. Thus, the payback period is the number of years required to recover the cost of the investment. The pay-back period is determined as follows:

Initial Investment Pay-back Period = -----------------------Annual Cash Inflow

Illustration 1

A project requires an initial investment of Rs. 2,00,000 and the annual cash inflows for 5 years are Rs. 60,000, Rs. 80,000, Rs. 50,000, Rs. 40,000 and Rs. 30,000 respectively. What is the payback period?

Year 1 2 3 4 5

Cash Inflows (Rs/) 60,000 80,000 50,000 40,000 30,000

Cumulative Cash Inflows (Rs.) 60,000 1,40,000 1,90,000 2,30,000 2,60,000

The pay-back period falls in the fourth year. In the first 3 years Rs. 1,90,000 are recovered. Rs. 10,000 are left out from the initial investment. The actual pay-back period can be determined as under:-

10,000 Pay-back Period = 3 + --------- x 2 40,000

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= 3 + 0.25 years

= 3.25 years

10.2.2 Accounting Rate of Return:

The capital investment proposals are judged on the basis of their relative profitability. The accounting rate of return is also known as return on investment or return on capital employed. It is normal accounting technique used to measure the increase in profit expected to result from an investment by expressing the net accounting profit arising from the investment as a percentage of that capital invested. The rate of return is determined as follows:-

Average Annual Profit after tax Accounting Rate of Return = -------------------------------------- x 100 Average Investment

Initial investment + Salvage value Average Investment = ----------------------------------------2

The term average annual net profit is the average of earning (after depreciation and tax) over the whole of the economic life of the project. The projects can be ranked on the basis of their accounting rate of return. The project which gives higher rate of return will be preferred for investment.

Illustration 2

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A machine is available for purchase of a cost of Rs. 8,00,000. It is expected to have a life of 5 years and have a scrap value of Rs. 1,00,000 at the end of five years period. The machine will generate the following profits over its life as under:-

Year 1 2 3 4 5

Amount (Rs.) 2,00,000 3,00,000 4,00,000 1,50,000 50,000

The above estimates are profits before depreciation. required to calculate the accounting rate of return.

You are

Solution

Total profit before depreciation over the life of machine = Rs. 11 lakhs

11,00,000 Average Profit = ----------- = Rs. 2,20,000 5

Total Depreciation over the life of the machine

= 8,00,000 1,00,000 = Rs. 7,00,000

7,00,000 Average Depreciation = ----------- = Rs. 1,40,000 5 Average Annual Profit after depreciation

= Rs. 2,20,000 1,40,000

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= Rs. 80,000

Original Investment

= Rs. 8,00,000

80,000 Rate of Return = ------------ x 100 = 10% 8,00,000

8,00,000 + 1,00,000 Average Investment = Rs. ----------------------- = 4,50,000 2 80,000 Accounting Rate of Return = ----------- x 100 4,50,000

= 17.78%

10.2.3 Discounted Cash Flow Technique:

The discounted cash flow technique is an improvement on the pay back period method. It takes into account the interest factor as well as the return after the pay-back period. This method involves the following stages:

(a) (b) (c)

Calculation of cash flows i.e. cash inflows as well as cash outflows, over the full life of an asset. Discounting the cash flows by a discount factor. Aggregating the discount cash inflows and comparing them with the total discounted cash outflows.

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The objective of the firm is to create wealth by using existing and future resources to produce goods and services. In order to create wealth, the discounted cash inflows must exceed the present value of cash outflows. Thus, the net present value is obtained by discounting all cash inflows and outflows attributable to a capital investment project. For this purpose, rate of discount is chosen suitably. There are three methods of discounting cash flows, which are given below:-

(i) Net present value method:

Net present value method (NPV) is the most suitable method used for evaluating the capital investment projects. Under this method cash inflows and outflows associated with each project are worked out. The present value of the cash flows is calculated by discounting the cash flows at the rate of return acceptable to the management. The rate of return is considered as a cut-off rate. It is generally determined on the basis of cost of capital suitably adjusted to allow for the risk element involved in the project. The cash outflows represent the investment and commitments of cash in the project at various points of time. The working capital is taken as a cash outflow in the initial year. The cash inflow represents the net profit after tax but before depreciation. As depreciation is non-cash expenditure, it is added back to the net profit after tax in order to determine the cash inflows. The cash inflows and outflows are discounted at a certain rate and present value of cash flows are calculated. The difference between the present value of cash inflows and present value of cash outflows is called net present value (NPV). If the NPV is positive, the project is accepted and if it is negative, the project is rejected. This exercise involved in calculating the present value is called discounting.

Discounted cash flow is an evaluation of the future net cash flows generated by a project. This method considers the time value of money concept and hence it is considered better for evaluation of investment proposals. If there are mutually exclusive projects, this method is more useful. Thus, the following formula is used to determine the net present value:

Net present value (NVP) = Present value of future cash inflows Present value of cash outflows.

Illustration 3

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An investment project costs Rs. 1,00,000 initially. It is expected to generate cash flow as follows:

Year 1 2 3 4

Cash inflows (Rs.) 50,000 40,000 30,000 20,000

(a) What is the net present value of the project assuming a 10 % risk-free rate? Should the project be accepted?

(b) If the project is risky and it is decided to use a higher rate to allow for the perceived risk. Assuming that rate is 15%, what will be the net present value of the project? Should the project be accepted?

Solution: (a)
Net Present Value at 10% discounting rate Year 1 2 3 4 Cash inflows (Rs) 50000 40000 30000 20000 Discount factor at 10% 0.9091 0.8254 0.7513 0.6830 Present value of cash inflows - Present value of cash outflow Net present value Present value (Rs.) 45455 33056 22539 13660 114710 100000 14700

The project should be accepted at risk free rate of 10% because net present value is positive.

(b)
Net Present Value at 15% discounting rate

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Year Cash inflows (Rs) 50000 40000 30000 20000 Discount factor at 15% 0.8696 0.7561 0.6575 0.5718 Present value of cash inflows - Present value of cash outflow Net present value Present value (Rs.)

1 2 3 4

43480 30244 19725 11436 104885 100000 4885

The project can be accepted at 15% because net present value is positive

(ii) Profitability Index:

The net present value method uses discounted cash flows. It express cash flows in present rupees. The NPV of different projects can be compared. It implies that each project can be evaluated independent of others on its own merit. Sometimes we have to compare a number of projects each involving different amount of cash inflows and outflows. If the cash flows are different and period of the project are also different and two or more projects give positive net present value, then we have to use the technique two or more projects give positive net present value, then we have to use the technique of profitability index which is as follows:

Present value of cash inflows Profitability Index = -----------------------------------Present value of cash outflows

The project is acceptable if the profitability index value is higher.

Illustration 4

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X Ltd is considering purchase of a machine in replacement of an old one. Two models viz. modern and sky are offered at price of Rs. 22.5 lakhs and Rs. 30 lakhs respectively. Further particulars regarding these models are given below:-

Particulars (I) Economic life in years (II) After tax annual cash inflows Years 1 2 3 4 5 6 Years 1 2 3 4 5 6

Modern 5 Rs. Lakhs 5.00 7.50 10.00 9.00 8.50 P.V.Factor 0.893 0.797 0.712 0.636 0.567 0.507

Sky 6 Rs. Lakhs 6.00 8.00 10.00 12.00 10.50 9.50

(III) Present value factors at 12% per annuam are as follows

(a) Evaluate the two proposals. (b) Which model would you recommend any why?

Solution: Calculation of Net Present Values

Years 1 2 3 4 5 6 Less

P.V.Factor CFAT 0.893 0.797 0.712 0.636 0.567 0.507 5.00 7.50 10.00 9.00 8.50 -

Modern PV 4.465 5.977 7.120 5.724 5.954 CFAT 6.00 8.00 10.00 12.00 10.50 9.50 2.50

Sky PV 5.358 6.376 7.120 7.632 5.953 6.084 38.523 30.000

Present Value of Cash inflows Present value of cash

29.240 22.500

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outflows Net present value

6.740

8.523

(b) Considering net present value method, both the models have positive net present value and their initial investments are different. Hence, the decision will be based on Profitability Index which is calculated as follows:-

Modern

Sky

Profitability Index

PVCI = --------PVCO = -------

29.240 = 22.500 1.299 -------

38.523

30.00 1.284

(c) As the profitability index of model Modern is higher, it is recommended

(iii) Internal Rate of Return:

Internal rate of return is that rate at which the sum of discounted cash inflows equals the sum of discounted cash outflows. It is the rate which discounts the cash flows to zero. This method also considers the time value of money, the initial cash flows and all future cash flows from the investment. The internal rate of return method does not use the desired rate of return but estimates the discount rate that makes the present value equal to the initial investment. The net present value of the investment will be zero in case of IRR. This estimated rate of return is then compared to a criterion rate of return that can be the companys desired rate of return. Thus, internal rate of return is the maximum rate of interest which a company can afford to pay on the capital invested in a project. A project would quality to be accepted if IRR exceeds the cut-off rate. While evaluating two or more projects, a project which gives a

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higher internal rate of return would be preferred. The internal rate of return can be calculated by using trial and error method.

Illustration 5

X Ltd. is currently under examination a project which will yield the following returns over a period of time:-

Year 1 2 3 4 5

Gross yield Rs. 80,000 80,000 90,000 90,000 75,000

Cost of machinery to be installed amounts to Rs. 2,00,000 and the machine is to be depreciated at 20% per annum at WDV basis. Income tax rate is 30%. If the average cost of raising capital is 10%, would you recommend accepting the project under the internal rate of return method?

Present value of money at rates of interest is as under:-

Year 1 2 3 4 5

At 10 % 0.91 0.83 0.75 0.68 0.62

At 14 % 0.88 0.77 0.67 0.59 0.52

Solution

(a) Evaluation of project under IRR method:

Year

Gross Yield (Rs.) 1 80,000 80,000

Depreciati on (Rs.) 2 40,000 32,000

Balance (Rs.) 3 40,000 48,000

Income Tax (Rs.) 4 12,000 14,400

Net Cash inflows (Rs.) 5 28,000 33,600

CFAT (2+5) 6 68,000 65,600

1 2

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3 4 5 90,000 90,000 75,000 25,600 20,480 81,920 64,400 69,520 - 8,920 19,320 20,856 45,080 48,664 75,000 70,680 69,144 81,920

(b) Calculation of Net present value:-

Year 1 2 3 4 5

CFAT 68,000 65,600 70,680 69,144 81,920

D.F. 10 % 0.91 0.83 0.75 0.68 0.62

D.F. 14% 0.88 0.77 0.67 0.59 0.52

PV @ 10 % 61,880 54,448 53,010 47,018 50,790 2,67,146

PV @ 14% 59,840 50,512 47,356 40,795 42,598 2,41,101

The present value of cash flows at 14% rate works out to Rs. 2,41,101. Therefore, IRR lies above 14%.

The actual IRR can be calculated as follows:

Year

CFAT

D.F.@ 16 % 0.862 0.743 0.641 0.552 0.476

D.F. @ 18 %

D.F.@ 22 % 0.820 0.672 0.551 0.451 0.370

PV (Rs) 58,616 48,741 45,305 38,167 38,994

PV (Rs) 57,596 47,100 43,044 32,912 35,791

PV (Rs) 55,760 44,063 38,945 31,184 30,310

1 2 3 4 5

68,000 65,600 70,680 69,144 81,920

0.847 0.718 0.609 0.516 0.437

2,29,823 2,16,443 2,00,282

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The Net present value at 22% discounting factor is around zero. Hence, the actual IRR is 22 %. As the cost of capital is 10% which is a cut-off rate, and IRR is 22%, the project is recommended.

Illustration 6

The FFM Ltd is in the tax bracket of 35%, and discounts its cash flows at 16%, in the acquisition of an asset worth Rs. 10 lakhs. It is given two offers either to acquire the asset by taking a loan @ 15% per annum repayable in five yearly installments of Rs. 2,00,000 each plus interest or to lease-in the asset at yearly rentals of Rs. 3,24,000 for five years. In both the cases, the installment is payable at the end of the year. Applicable rate of depreciation is 15% using written down value (WDV) method.

You are required to suggest the better alternative PV factor at 16% are as follows:-

Years 1 2 3 4 5

P.V. Factor 0.862 0.743 0.641 0.552 0.476

Solution:

(a) Present value of cash flows under buying options

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Year Principal (Rs.) Interest (Rs.) Depre. (Rs.) Tax ( Rs.) Net Cash Inflows (Rs.) 24,500 2,33,375 2,20,569 2,06,759 1,92,095 D.F. D.V. (Rs.)

1 2 3 4 5

2,00,000 2,00,000 2,00,000 2,00,000 2,00,000

1,50,000 1,20,000 90,000 60,000 30,000

1,50,000 1,27,500 1,08,375 92,118 78,301

1,05,000 86,625 69,431 53,241 37,905

0.862 0.743 0.641 0.532 0.476

2,11,190 1,73,398 1,41,385 1,14,131 91,437 7,31,641

Present value of Cash inflows

(b) Present value of Cash outflows in leasing option

Year

Rental (Rs.)

Tax (Rs.)

Net Cash inflows. (Rs.) 2,10,600 2,10,600 2,10,600 2,10,600 2,10,600

D.F.

P.V. (Rs.)

1 2 3 4 5

3,24,000 3,24,000 3,24,000 3,24,000 3,24,000

1,13,400 1,13,400 1,13,400 1,13,400 1,13,400

0.862 0.743 0.641 0.552 0.476

1,81,537 1,56,476 1,34,995 1,16,251 1,00,246 6,89,505

Present value of cash inflows

As the total present value of cash outflows under leasing option is less than the purchase option, leasing is recommended.

10.3 MODEL QUESTIONS

Q.1

Arvind Ltd. is currently analyzing capital expenditure proposals for the purchase of equipment. The company uses the net present value technique to evaluate projects. The capital budget is limited to Rs. 5,00,000 which the company believe is the maximum capital it can raise. The initial investment and projected net cash flows for each project are given below. The cost of capital of the company is 12%. You are required to compute the NPV of the different projects. Projects Initial Investment (Rs.) A 2,00,000 B 2,00,000 C 2,40,000 D 2,10,000

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Cash inflows st 1 Year nd 2 Year rd 3 Year th 4 Year th 5 Year Q.2 50,000 50,000 50,000 50,000 50,000 40,000 50,000 70,000 75,000 75,000 75,000 75,000 60,000 80,000 1,00,000 75,000 75,000 60,000 40,000 20,000

Which project would you recommend and why? Calculate the internal rate of return of an investment of Rs. 1,36,000 which yields the following cash flows:Year 1 2 3 4 5 Cash inflows (Rs.) 30,000 40,000 60,000 30,000 20,000

Q.3

A choice is to be made between two competing projects which require an equal investment of Rs. 50,000 and are expected to generate net cash flow as under: Year 1 2 3 4 5 6 Project A (Rs.) 25,000 15,000 10,000 12,000 6,000 Project B (Rs.) 10,000 12,000 18,000 25,000 8,000 4,000

The cost of capital of the company is 10%. The following are the present value factors @ 10%. Year PV Factors @ 10 % 1 0.9091 2 0.8264 3 0.7513 4 0.6830 5 0.6209 6 0.5645 Which project should be selected and why? Evaluate the project under: (a) Payback method (b) NPV method.

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11

MANAGEMENT INFORMATION SYSTEM

Unit Structure:

11.0 11.1 11.2 11.3 11.4 11.5 11.6 11.7 11.8 11.9

Objectives Introduction Meaning and Components of Management Information System Need for Management Information System or Role of MIS Purpose and Significance of Management Information System Levels of Management VIS--VIS Information Requirements MIS and Computer Problems in Installing and Operating the MIS Knowledge required for study of MIS Summing Up

11.10 Exercise

11.0 OBJECTIVES

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After studying the unit the students will be able to:

Understand the Components of MIS Know the significance of MIS. Explain the limitations of MIS Know how to overcome from the limitations.

11.1 INTRODUCTION

An organization is in existence with the basic purpose of achieving some objectives. The objectives of an organization may be different from those of another organization. Even for the business enterprises, which belong to the same industry, may have different objectives. An organizations own objectives may be different from time to time. It would not mean that the objectives which were in existence for an organization at one point of time would become extinct at a different point of time. But it could happen that the objectives which were very crucial might have become dormant at a different point of time. For example, an organization whose reputation has been spoilt because of an untoward incident, at that particular point of time would make all the efforts under the earth in order to clear the bad reputation. During such a difficult situation, the objectives even though only short term would be undoing the mistake. Once such a situation has become normal, the organizations objectives would be towards strengthening its operations. Thus the focus would get shifted from repairing the damage to building up the operations. If you take the first situation, the organization has to keep in constant touch will the external agencies, news media and other relevant bodies besides constant sharing of the external and internal information within the organization. In the second situation, the organization needs constant information about the level and volume of operations, its sales and growth in the market share. However, under both the cases, the management needs the information to know about the movement of the company towards attaining its objectives. If the organization is not able to organize the information, which it needs, it may not be able to successfully attain its objectives. Hence the organization will make coordinated efforts in designing a structure within the organization that can provide the information that is needed to reach the desired destination. Such a structure will create and maintain a system that will feed the Management with the information that is needed at any particular point of time. The system that takes care of the Informational needs of an organization is known as the Management Information System. Every system has its components or subsystems. Similarly, a Management Information System also has its own components. The success of an organization depends upon its ability to get the right

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information at the right place for use by the right people at the right time. Even if any one of these requirements is not fulfilled, the organization cannot be successful in its mission.

11.2 MEANING AND COMPONENTS MANAGEMENT INFORMATION SYSTEM

OF

11.2.1 MEANING AND DEFINITION:

According to Kenneth C. Laudon and Jane Price Laudon Management Information Systems means, A Contemporary Perspective, an information system is "a set of procedures that collects (or retrieves), processes, stores, and disseminates information to support decision making and control." In most cases, information systems are formal, computer based systems that play an integral role in organizations. Although information systems are computer based, it is important to note that any old computer or software program is not necessarily an information system. "Electronic computers and related software programs are the technical foundation, the tools and materials, of modern information systems, " Laudon and Laudon wrote. "Understanding information systems, however, requires one to understand the problems they are designed to solve, the architectural and design solutions, and the organizational processes that lead to these solutions." Though it is sometimes applied to all types of information systems used in businesses, the term "management information systems, " or MIS, actually describes specific systems that "provide managers with reports and, in some cases, on-line access to the organization's current performance and historical records, " Laudon and Laudon noted. "MIS primarily serve the functions of planning, controlling, and decision making at the management level." MIS are one of a number of different types of information systems that can serve the needs of different levels in an organization. For example, information systems might be developed to support upper management in planning the company's strategic direction or to help manufacturing in controlling a plant's operations. Some of the other types of information systems include: transaction processing systems, which simply record the routine transactions needed to conduct business, like payroll, shipping, or sales orders; and office automation systems, which are intended to increase the productivity of office workers and include such systems as word processing, electronic mail, and digital filing. Ideally, the various types of information systems in an organization are interconnected to allow for information sharing.

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An 'MIS' is a planned system of the collecting, processing, storing and disseminating data in the form of information needed to carry out the functions of management. In a way it is a documented report of the activities that were planned and executed.

11.2.2 COMPONENTS OF AN EFFECTIVE MIS:

There has to be a well defined Organizational Structure that provides the scope and way for a proper, effective and efficient functioning of a Management Information System. Besides this basic requirement, the following are important components of an effective MIS.

1. Integration with the Objectives of the Organization : Management Information System is a sub-system of the organization. It is an integral part of the Organization. The objectives of the MIS should be integrated with the organizational objectives. Hence there should be a clear statement of purpose or Charter for the MIS which should prescribe as to what is expected in relation to the fulfillment of the objectives of the organization.

2. Organizational Relationship : There should be a clear organizational structure as far as the position of MIS is concerned. Because of the growing importance of the role of information Technology in an organizations strategic Management, there should be a clear definition of the Role, Authority, Responsibility and Accountability of the MIS and the channels of communication. The relevant organization structure of the MIS should be in accordance with the Organizational Philosophy. For example, if the Organizational structure in general is a flat one, the creation of a slot for the MIS should not lead to a thicker organizational structure.

3. Infrastructure : The organization should provide the necessary infrastructure that will facilitate the smooth functioning of the Management Information System. This includes physical infrastructure, hardware, required and a data processing centre with the necessary capabilities.

4. Software : Software is the key as far as any automated Information System is concerned. Under a manual Information System, the

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element of Software may be absent. In an automated Management Information System, the software provides the necessary impetus that is required to exploit the benefits arising out of the revolution in information technology. We have to select the best software that can provide the solutions in the form of best organizational practices that can help the organization to forge ahead remain ahead of others.

5. Technology : Technology is changing fast, its growth changes are measured in terms of nano seconds. But the organization needs to adopt the technology that can be fairly stable and at the same time is able to keep pace with the changing times.

6. Human Resources : Under the Automated Information System the only single asset that is scarce because of the technology revolution is human resource. Their services are at a premium. The organization should be able to recruit the best human resources in order to make the best of the infrastructure, technology and software.

7. Training : Basically because of the scarcity of the skilled human resources available to exploit the opportunities arising out of the Technology revolution, it becomes essential that organizations have to train its existing employees to equip themselves to manage the Management Information System. Even the skilled employees need perpetual training to keep themselves abreast of the latest developments that will enable them to update and adapt to the changing situations.

8. Policies and Procedures : An organizations plans need to be supported by its policies and procedures. Policies and procedures help the management in communicating its aims and directions across the organization and in implementing its plan of action. They also help the operational management in making the decisions in accordance with the managements philosophy. They also ensure a disciplined approach towards attaining the objectives of the organization.

9. Control Mechanism : The design of a new Management Information System and the maintenance of an existing Management Information System is very much influenced by the developments taking place in the information and related Technology. There should be a

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mechanism, which would control the induction of new technology products into the existing system. Any such inductions should be based on the merits of the technology and the product. A cost benefit analysis should be desired wherever possible.

10. Back up and Continuity of Service : Any break down in an automated Management Information System would result in great loss to an organization. The extent of loss could be pecuniary and could even result in legal damages. It would also result in bad reputation to the company. In order to avoid such consequences and in order to ensure continuous growth every organization has to have a sound Backup System. This also includes provision of alternative data processing centers in case of exigencies say on account of fire, floods etc.

11. Communication devices : In the present day business environment, communications among the employees of the company as well as the business partners are talking place more often through electronic mails. Companies are in fact using separate and dedicated tunnels provided by Internet Service Providers or using public e-mail services for communication between units situated at distant places or for sending and receiving. Thus, the use of communication devices and related technology are playing an increasing role. Since the data are coming into the public communication lines, it has to be borne in mind that the data may be lost copied or stolen in transit. An organization should take enough precautions to avoid any such mishaps.

12. Cost benefit analysis : Any decision to invest in a major Information System Asset should be backed by a cost benefit analysis. Even though benefits which are intangible in nature cannot be measured, enough grading system must be in vogue to take into account such benefits as well.

13. Security Policies : In the wake of the organizations Information Asset published in the public and transactions being conducted through the Internet, it is imperative that an organization is devising a safe system of access to the right people and that the unauthorized are not permitted to do any unwanted act. The organizations should device Security Policies and implement them in the best interests of the organization.

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14. Compliance with external requirements : As explained earlier, the information and data including the personal of customers, which happen to be the preserve of the company, are subjected to threats of misuse and intrusion. Any such untoward incident could lead to huge losses to the company in terms of money and reputation.

15. Critical Success Factors : Any success can be judged only against some bench marks. In order to measure the success of an MIS, it should be necessary that certain factors are identified that would indicate the growth or maturity of the MIS as a process of the organization. Comparison of the actual results against those Success Factors is a good measure of performance. Such factors could number of break down, uninterrupted service etc.

11.3 NEED FOR MANAGEMENT SYSTEM OR ROLE OF MIS

INFORMATION

Need :

In the present day of Competition, challenges and uncertainty, it is the world of the survival of the fittest. An organization cannot ignore any opportunities nor any threats. An organizations success lies in managing its Strengths, Weaknesses, Opportunities and Threats. If an organization can effectively manage these factors, it stands to be benefited. Otherwise, it stands only to lose. It has to be appreciated that an organization which wants to manage these factors effectively needs to take the right decisions at the right time. In order to take the right decisions at the right time, the right information should be made available to the right people at the right time in the right manner and in the most efficient way. This will not be possible unless there is a proper and coordinated system of Data Collection, Designing of IS, Processing and Reporting.

Besides the need of MIS for effective decision making, the need also arises from the point of view of planning and controlling. In order to guide the management in planning the allocation of resources of the Company, it becomes essential to know the results of operations. This would help to plan about the allocation and or reallocation of resources and to maximize the benefits.

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Similarly, from the point of view of Controlling, it becomes necessary to know the progress of the organization towards attainment of objectives. Controlling is an important and essential function of Management in ensuring that the organizations objectives are being achieved. It also provides the necessary feedback and rectification mechanism to support the organizational functioning.

When information systems are designed to provide information needed for effective decision making by managers, they are called management information systems. MIS is a formal system for providing management with accurate and timely information necessary for decision making.
The system provides information on the past, present and project future and on relevant events inside and outside the organization . It may be defined as a planned and integrated system for gathering relevant data, converting it in to right information and supplying the same to the concerned executives. The main purpose of MIS is to provide the right information to the right people at the right time.

The Concept of management information systems originated in the 1960s and become the byword of almost all attempts to relate computer technology and systems to data processing in business. During the early 1960s , it became evident that the computer was being applied to the solution of business problem in a piecemeal fashion, focusing almost entirely on the computerization of clerical and record keeping tasks. The concepts of management information systems were developed to counteract such in efficient development and in effective use of the computer. The MIS concept is vital to efficient and effective computer use in business of two major reasons:

It serves as a systems framework for organizing business computer applications. Business applications of computers should be viewed as interrelated and integrated computer based information systems and not as independent data processing job. In emphasizes the management orientation of electronics information processing in business. The primary goal of computer based information systems should be the processing of data generated by business operations.

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A management information system is an integrated man machine systems that provides information to support the planning and control function of manager in an organization. The output of an MIS is information that sub serves managerial functions. When a system provides information to persons who are not managers, then it will not be considered as part of an MIS. For .example, an organization often processes a lot of data which it is required by law to furnish to various government regulatory agencies. Such a system, while it may have interfaces with an MIS, would not be a part of it, Instances of such systems is salary disclosures and excise duty statements. By the same token to sophisticated computer aided design system for engineering purposes would also not be a part of an MIS.

Generally, MIS deals with information that is systematically and routinely collected in accordance with a well-defined set of rules. Thus, and MIS is a part of the formal information network in an organization. Information that has major managerial planning significance is sometimes collected at golf courses. Such information is not part of MIS, however, one- shot market research data collected to gauge the potential of a new product does not come within the scope of an MIS by our definition because although such information may be very systematically collected it is not collected on a regular basis.

Normally, the information provided by an MIS helps the managers to make planning and control decisions. Now, we will see, what is planning and control. Every organization in order to function must perform, certain operations. For Example, a car manufacturer has to perform certain manufacturing activities, a wholesaler has o provide water to its area of jurisdiction. All these are operations that need to be done. Besides, these operations, an organization must make plans for them. In other words it must decide on how many and what type of cars to make next month or what commissions to offer retailers or what pumping stations to install in the next five years.

Also an organization must control the operations in the light of the plans and targets developed in the planning process. The car manufacturer must know if manufacturing operations are in line with the targets and if not, he must make decisions to correct the deviation or revise his plans. Similarly the wholesaler will want to know the impacts that his commissions have had on sales and make decisions to correct adverse trends. The municipal corporation will need to control the tendering process and contractors who will execute the pumping station plans.

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Generally, MIS is concerned with planning and control. Often there are elaborate systems for information that assists operations. For example, the car manufacturer will have a system for providing information to the workers on the shop floor about the job that needs to be done on a particular batch of material. There may be route sheets, which accompany the rate materials and components in their movement through various machines. This system per se provides only information to support operation. It has no managerial decision-making significance. It I not part of an MIS. If, however, the system does provided information on productivity, machine utilization or rejection rates, then we would say that the system is part of an MIS. Generally MIS has all the ingredients that are employed in providing information support to manager to making planning and control decisions. Managers often use historical data on an organizations activities as well as current status data make planning and control decisions. Such data comes from a data base which is contained in files maintained by the organization . This data base is an essential component of an MIS. Manual procedures that are used to collect and process information and computer hardware are obvious ingredients of an MIS . These also form part of the MIS. In summary , when we say that an MIS is an integrated man machine systems that provided information to supports the planning and control function of managers in an origination . It does the following function. - sub serves managerial function - collects stores , evaluates information systematically and routinely - supports planning and control decisions - Includes files , hardware , software , software and operations research models. Effective management information systems are needed by all business organization because of the increased complexity and rate of change of todays business environment . For Example, Marketing manager need information about sales performance and trends, financial manger returns, production managers needs information analyzing resources requirement and worker productivity and personnel manager require information concerning employee compensation and professional development. Thus, effective management information systems must be developed to provide modern managers with the specific marketing , financial, production and personnel information products they required to support their decision making responsibilities .

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An MIS provides the following advantages: 1. It Facilitates planning: MIS improves the quality of plants by providing relevant information for sound decision making . Due to increase in the size and complexity of organizations, managers have lost personal contact with the scene of operations. 2. In Minimizes information overload: MIS change the larger amount of data in to summarized form and there by avoids the confusion which may arise when managers are flooded with detailed facts. 3. MIS Encourages Decentralization: Decentralization of authority is possibly when there is a system for monitoring operations at lower levels. MIS is successfully used for measuring performance and making necessary change in the organizational plans and procedures. 4. It brings Co ordination: MIS facilities integration of specialized activities by keeping each department aware of the problem and requirements of other departments. It connects all decision centers in the organization . 5. It makes control easier: MIS serves as a link between managerial planning and control. It improves the ability of management to evaluate and improve performance . The used computers has increased the data processing and storage capabilities and reduced the cost. 6. MIS assembles, process, Disseminates the information. stores, Retrieves, evaluates and

11.4 PURPOSE AND SIGNIFICANCE MANAGEMENT INFORMATION SYSTEM

OF

At the outset, it can be said that the need for Management Information System arises for the purpose of fulfillment of the objectives of the organization from a broader perspective. Let us briefly discuss the purpose of Management Information System.

1. For meeting the day to day operational requirements : In order to meet the day to day operational requirements of the organization, the Operational Management needs information. Such information needs to be continuously available on a day to day basis. Non-availability of the information would result in operational failure.

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2. For meeting the Managerial requirements : The middle level management needs to manage the organization in accordance with the strategies formulated by the Top Level Management. While the operational requirements of Information are on a day today basis, the Managerial requirements of Information are tactical in nature. It is the Middle level management whose interference is very much essential in cases of the actual performance not in line with the planned results. The Middle level management would not be able to ensure that the strategies of the Top level management are achieved.

3. For directing the Company : It is the Top level management of an organization which directs the strategic movement of the organization. The informational requirements of the Top level management are very vital and crucial. Such information has to be derived from both the internal and external sources. While the internal information would be about the companys operation and the market leadership, the external information covers various aspects like, economic indicators, competition, market share etc.

4. Effective and efficient allocation of resources : An organizations resources are scarce in nature. There are differing needs for the same resources. But at the same time, the Management of an organization need to utilize the resources at their disposal in an effective and efficient way so that the return is the maximum. It entails the allocation of resources among the competing opportunities in such a way that the maximum benefits are reaped. This would help the organization and the economy as a whole.

5. To overcome uncertainty : An organization has to function in an uncertain situation. There are uncertainties from various angles. Uncertainty can arise from economic, political, international, legal, social or cultural situations. Decisions Support Systems and Expert Systems provide information and special analyses which help the management to take into account the factors arising out of such uncertainty. It thus helps an organization to be optimistic in its approach.

6. Contingency Planning : Since Management Information System provides the information about the various factors affecting the functioning the organization at various levels, the Middle level

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management and the top level management are better placed as related to the future in terms of uncertainty. Approaches like what if analysis can help the organization in planning for steps to be taken during an exigency.

7. Different Levels of Information Systems to suit different levels of Management : Different types of Information Systems are available to suit the information requirements of an organization. For example, Transaction Processing System provides the information required at operational levels. Management Information System and the Decision Support System provide the information required at Middle Level Management and the Expert System provides the information at the Strategic level or Top Level Management.

11.5 LEVELS OF MANAGEMENT INFORMATION REQUIREMENTS

VIS--VIS

An organization has got different echelons of Management. The number of levels of Management could be different from one organization to another. This however, would depend upon the Organizational Philosophy of the Management. Some organizations would prefer fat type of organizational structure, while some others would prefer flat type organizational structure. Nowadays, the trend for the organizations is to prefer flat type because of various considerations. Whatever be the nature of philosophy, the informational needs of an organization cannot be different. All the organizations need information. Similarly all the levels of management of an organization need. However, one set of information needs of one level of management in an organization may be needed by a different level of management in another organization. Nonetheless, basically the information needs are not different. From this point of view, the Information System of an organization is divided into 4 categories. They are: 1. Transaction Processing System 2. Knowledge Level System 3. Management Information System and Decision Support System 4. Expert System

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Let us discuss each type of Information System and its requirement for a particular level of Management.

1. Transaction Processing System for Operational Level Management: The largest part of the information is generated through this system. This is at the operational level and is to take care of the routine informational needs of the organization. Some of the Transaction Processing System is the boundary between the external world and the organization. For example, the Sales Order Processing System of a Company provides the link between the Company and its customers. Apart from Sales Order Processing System, there are many other Transaction Processing Systems. They are pay roll processing System, Financial Accounting System, Cash Management, Employee record keeping etc. Transaction processing systems are used at the Operational level management and satisfy the informational requirements of Operational Level Management (e.g. Supervisors). Even the Management Information System that caters to the Informational requirements of the Middle Level Management also sources their most of the data from Transaction Processing Systems. The Operational level management needs to take decisions to solve problems which are simple and well structured. They make decisions, which are not complicated. For example, a credit supervisor has to make a decision on allowing of credit to a customer. He / she has to collect the information about the customer like his previous trade history with the company if he is an existing customer. If he is a new customer, he will obtain the financial results of the customer and decide according to the merits and as per the policy guidelines. Thus, the transaction processing systems cater to the informational requirements of the Operational Level Management. Some examples of TPS used in an organization are given below.

Function

TPS

Sales and Marketing

: Order Tracking, Order Reservation Processing

Processing,

Manufacturing

: Machine Control, Plant Scheduling, Job Scheduling, Malt. Movement Control : Online Securities Management Trading and Cash

Finance

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Accounting : Payroll, Accounts Payable, Receivable and GL Accounting Accounts

Human Resources

: Compensation, Training and Development and Compensation.

2. Knowledge Level System for Knowledge Level Management : This type of System caters to the information requirements of knowledge level of the organization. They help an organization in integration of new knowledge into the business and to in controlling the flow of paper in its offices. There are two sets of Knowledge level people. They are (1) knowledge workers and (2) Data workers. Knowledge workers are like engineers, doctors, lawyers etc. They in fact create new information for the purpose of utilization in the business. Computer aided design is an example of knowledge work system. The data workers consist of primarily Secretaries, Accountants, Record Clerks and Managers. The people, who use, manipulate and disseminate information fall under this category. The system which is used by this category helps to do their work faster. An example is Word processing. Such a system is also known as Office automation System.

3. Management Information System and Decision Support System for Middle Level Management : This caters to the Information requirements of the Middle Level Management. This provides the information not on an instant basis but periodically. Usually the MIS reports are provided every week, fortnight or month or quarter etc. The Middle Level Management would need the information on the growth of the organization towards the attainment of the objectives. The middle level management is vested with the responsibility of running the affairs of the organization as per the directions of the Top level management. In order to ensure that the company moves in the right direction, the Middle Level Management needs the information on the operation of the organization for the purposes of decision making. They also need the information for the purpose of Planning and Controlling. The Management Information System derives its information both from the Transaction Processing System and from external factors to create and design benchmark standards.

4. Executive Support System for Top Level Management : This provides the information to the top management for taking strategic decisions. While all other information systems provide information for making decisions, in respect of structured or semi structured

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problems, the ESS provide the Top Level Management information to address unstructured decisions and create a generalized computing and communications environment rather instead of providing any specific application. They provide information to the top level management on external events such as new tax laws or other regulations or about the competitors besides the summarized information from internal management information system.

The need for different Management Information Systems as discussed above arises from the fact that the natures of problems to be solved are different as far as different levels of Management are concerned. While the problems at the operational level are very structured and routine in nature, the problems at the top level management are semi-structured and involve lot of uncertainty.

11.6 MIS AND COMPUTER

At the start, works in businesses and other organizations, internal reporting was made manually and only periodically, as a by-product of the accounting system and with some additional statistic(s), and gave limited and delayed information on management performance. Previously, data had to be separated individually by the people as per the requirement and necessity of the organization. Later, data was distinguished from information, and so instead of the collection of mass of data, important and to the point data that is needed by the organization was stored. Early on, business computers were mostly used for relatively simple operations such as tracking sales or payroll data, often without much detail. Over time these applications became more complex and began to store increasing amounts of information while also interlinking with previously separate information systems. As more and more data was stored and linked man began to analyze this information into further detail, creating entire management reports from the raw, stored data. The term "MIS" arose to describe these kinds of applications, which were developed to provide managers with information about sales, inventories, and other data that would help in managing the enterprise. Today, the term is used broadly in a number of contexts and includes (but is not limited to): decision support systems, resource and people management applications, Enterprise Resource Planning (ERP), Supply Chain

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Management (SCM), Customer Relationship Management (CRM), project management and database retrieval applications. 11.6.1 Meaning of Computer :

Computer may be defined as an electronic machine capable of manipulation of large volumes of data with accuracy at lightning speeds. It can also store data, accept data, store programmes, accept instructions and report the results after manipulation of data. Thus, it is called as a data processing machine. It is the machine which has revolutionized the whole way of living. i.e. the way we speak, the way we communicate, the way we study, the way we do business, the way we govern ourselves and the way in which entertainment and fun are being brought. It has conquered each and every field whether medicine, business, engineering, education, conferencing, banking etc.

11.6.2 Components Of A Computer System:

Modern computer systems consist of a central processing unit, primary storage, secondary storage, input, output and communication devices. The central processing unit (CPU) manipulates data and controls the other parts of the computer system Primary storage (RAM) temporarily stores data and program instructions during processing.

Secondary storage (hard disk drives) stores data and instructions when they are not used in processing.

Hardware refers to the visible parts of a computer. As you would know, a computer consists of a monitor (like a TV screen), Key board, mouse, cables and the most important of all, the CPU (Central Processing Unit). The aforementioned parts are examples of hardware.

Software is the key for a computer. A computer can be put into use only with the help of software. A computer can only function as per our instructions. We can give different sets of transactions based on our requirements from a computer. For example if we want to use the computer for a Billing application, the instructions relating to such billing

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process will be written together and loaded into the computer. Such set of transactions put together is called software. While hardware is a visible part of a computer, software is an invisible part of a computer. Software is also denoted as programme.

Software is basically of two types. They are Systems software and Applications software. Systems software refers to the programmes which are very essential for the basic functioning of the computer. Such software is essential to start the computer, to act as an interface between the user and the computer outside the application software. Examples of Systems Application software are Operating Systems, (like DOS, OS/2, Unix etc.)

Application Software refers to the actual application packages like, Spread sheet application, Word processing application, pay roll processing application, Financial Accounting Application etc. while Software application package like Spreadsheet package (Lotus 1-2-3, MS Excel, Quattro Pro etc.), Word Processing (Word Processing (World Star, MS Word etc.) are general application software. Software Application packages like Financial Accounting Software and Payroll processing are specific application software.

Firmware represents the software written into the hardware part of a computer. Brain ware represents the human resources involved either in the hardware or software. In includes hardware engineers, technicians, systems analysts, programmers etc. It also includes the users of the computers.

With the introduction of the Internet and the Worldwide Web, students are able to access information faster and more efficiently using modern Computer Systems. In the past, one had to visit national and school libraries and spend large amounts of time accessing information. Presently any individual can quickly access, save and print information from any location. One can access the internet from Cyber Cafes, schools, mobile phones, at home and even at modern libraries through internet service providers and telecommunication links. Apart from the internet, information e.g. encyclopedias, tutorials and documentaries can be accessed from Compact Discs which are read from computer systems.

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In most cases, information systems are formal, computer based systems that play an integral role in organizations. Although information systems are computer based, it is important to note that any old computer or software program is not necessarily an information system. "Electronic computers and related software programs are the technical foundation, the tools and materials, of modern information systems.

A management information system (MIS) is a computer-based system that provides the information necessary to manage an organization effectively. An MIS should be designed to enhance communication among employees, provide an objective system for recording information and support the organization's strategic goals and direction.

11.7 PROBLEMS IN INSTALLING AND OPERATING THE MIS

Management Information System is considered to bring in benefits and opportunities arising out of its implementation. In fact an organization which has gone in for a complete Information System developed by making use of latest developments in Information Technology and applying modem concepts have a lot of expectations to derive from that. The company has to make lot of investments and efforts in order to acquire such up-to date technology, develop an Integrated MIS and implement it. Hence it is essential that the company is expecting returns out of such investments. But in practice, it becomes very difficult that all such investments are bringing in returns as expected. There are challenges and limitations which are making it very difficult to reap the benefits and advantages, which MIS is supposed to bring. We have been seeing many examples of companies going in for ERPs for the sake of going in for ERR. This does not bring in the results as expected. However, the failure is neither because of the technology nor because of the decision. It is only due to the organization's failure in preparing itself to exploit the benefits available with the new technology and concepts.

Limitations :

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ln this discussion we are going to discuss the problems in Installing and operating he MIS and the Limitations of MIS. The following limitations are identified.

1. Heavy Planning Element :

Management Information System helps an organization in the functions of Planning, Organizing, Decision making and Controlling. Management information System provides an organization the capabilities of managing its various processes most effectively and efficiently. The various processes are Marketing and Sales, Manufacturing and Production, Finance and Accounting, Human resources, Inventory Control etc. The outcome of the various processes in relation to the environment within which the organization is functioning is not quite certain. Lot of efforts, time and planning need to be devoted to understand the various processes in the light of the environments viz., Political, economic, social, cultural, legal and various forces namely employees, government, competition etc. This involves lot of outlay in terms of time and money.

2. Difficult to predict the information needs :

The need for information arises for planning, decision-making and control. Different types of information are needed at different times. Again, the nature of information needed depends upon the Environment. As the circumstances and situations keep changing, it is very difficult to precisely predict the information needs. For example, in the case of Decision Support Systems, in order to make what if analysis, we will be making sensitive analysis wherein the expected behaviour of certain factors are analysed. Similarly in the case of an Executive Support System, the behaviour of economic indicators and the expected competition are beyond certainty.

3. Large Data base :

Information Systems are basically based on large volume of data which have been gathered over a period of time. Take the case of expert systems. They are designed to make use of the expertise of the Senior managers who had / have been working and make it available for the

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organization as a whole. In order to make this possible, it becomes necessary to archive large volume of data to be Used under such situations. In the case of new organizations, this may not be possible because of paucity of large volume of data. Even in cases of old Organizations, it becomes very difficult to maintain and protect the data because of many threats associated with it.

4. Coherent Plan of Information System for the whole organization :

Whenever a Management Information System is planned, it should be planned for the organization as a whole. In fact, it should be a comprehensive and integrated one so that communication between different Information Systems across the enterprise or the organization is compatible. However, in practice, such integration rarely happens. Different Information Systems suitable for different Management Levels are prepared separately, without any coherence. Designing and implementing an integrated Management Information System involves lot of planning and time. But at the same time, designing separate MIS results in increased cost and non-compatibility among themselves.

5. Competitive advantage is available only initially :

Organizations, in the present competitive world are continuously striving to be ahead of the competitors. Information technology has been helping companies to be ahead of their competitors by way of implementation of most effective solutions which pave way for best business practices. Implementation of such best business practices Make them gain an edge over other players in the market. However, once other companies realise this, they also go in for more advanced Solutions which make the early movers stagnant in terms of growth. Thus the competitive advantage which an organization gets in the beginning is short term in nature.

6. Get carried away by the competitor's moves :

Many organizations follow their competitors in various aspects. In the same way, when some players in an industry go in for advanced technological solutions and derive advantages, their competitors would be motivated to go in for the same. However, it can not be expected that the

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same solutions or similar solutions can bring in the same advantages which the earlier movers have derived from implementing those solutions.

7. Difficult to make cost - benefit analysis :

Implementation of technologically advanced solutions are expected to bring in benefits. The benefits can be in the form of higher sales revenue or better service to the customers or reduced process costs or expenses. Better service to the customers can build customer loyalty and reputation. Similarly, through effective and efficient Customer Relationship Management and Supply Chain Management Solutions can reduce the inventory level required and thereby reduce the inventory costs. But not all the benefits can be quantified. Benefits like increased revenue and reduced Inventory level are easily measurable. However benefits which arise on account of customer loyalty and reputation can not be measured. No proper techniques are available to measure the benefits in such cases.

8. Top Management's commitment and involvement :

Any new concept need to be supported by the Top Management and well received among the Operational level and Rank and file employees, if the concept is to succeed. As far as implementation is concerned, top management may have concerns about the huge investment required and the expected benefits. Getting the nod from the Top level management would be difficult as one will not be able to convince the top management in terms of the total benefits arising from an MIS or by way of a satisfactory ROI or IRR.

9. Social Impact :

Organizations play an important role in a society. Society also plays an important role in the functioning of an organization. When an organization goes in for an automated Management information System many of its processes tend to get reengineered. In the process the best business practices get implemented. This may involve relocation or retrenchment of labour. An organization's culture and philosophy also may get changed. This would have an impact in the society and affect the

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society's perception about the company which may be either positive or negative.

10. Change in organizational structure :

The role of Information Technology has been very revolutionary in the way the business has been carried out. Prior to that, the role of an Information Technology Officer was known as an EDP in Charge. But with the developments, the role of IT has raised to the level of a Strategic Component from that of an Operational Level. This has resulted in a tremendous change in the organizational structure of a Business. An IT officer was reporting to a Financial Controller or CFO has become a CIO and is reporting to the Top level Management. Even though this has resulted in a welcome change, the resultant structure has brought in some inequalities. This is so because, some part of a CFO's responsibility like "Controls" in organizational practices get overlapped between a CIO and a CFO. 11. Organizational HR policies :

We have seen that there is a change in the role of an IT officer from that of an Operational Level to that of a strategic level. Similarly there has been a quantum change in the HR policies of IT organizations. The Changes in HR policies include increased compensation, employee participation in ownership and management and work schedule. This has created a premium for the knowledge (IT) workers. Designing and implementing effective and efficient requires qualified and experienced IT staff. In the case of a manufacturing organization which recruits IT staff would have to pay higher compensation to the IT staff in comparison with average pay of the existing staff force of the organization. This will result in a sort of insecurity or inferior complex in the minds of the existing non IT staff, which can cause organizational problem.

12. MODEL cannot take into account all the variables - too many and due to changing circumstances.

The IT solution model designed for implementation of an MIS solution takes is in to account all the variables and parameters existing both within an organization and outside relevant to the present business practices. However there cannot be any assurance that the current

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business practices cannot be subject to change. circumstances, the IT model becomes out dated. Under such

13. Business Continuity Planning :

Under traditional MIS most of the operations were carried out manually. In case of disruptions in business, the business operations can be resumed without many hue and cries. But In an automated MIS environment, the MIS and Operations are so integrated that any failure in the system will have huge repercussions in the operations of the Organization. In order to avoid such failures, an organization should have back up procedures and alternate facilities to reduce the impact of any unforeseen failures and to resume the operations of the organization without any loss of time. Alternate facilities would include Sites with all the infrastructure facilities like Computers, Terminals, Printers, Communication facilities etc. Such facilities can be either hired or owned. If the facilities are hired it may not be available at times of need. On the other hand, if they were owned, they would amount to a redundant investment.

14. Exposed to Suppliers and Customers :

In an extended Enterprises Resources Planning, Supply Chain Management and Customer Relationship Management form an integral part of the Information System. In such a case, the quantum of requirements of raw materials can be easily communicated to the suppliers and the requirements of the finished goods by our customers can be easily known. This has a threat of exposure of the organizational data to our suppliers and customers.

15. Security problems :

Because of the availability of the organization's data base in the internal net work, it would be possible for intruders to intrude into the computers in the organization and create heavy losses to the company. This results in Security threats to the organization's resources.

16. Become out dated very often :

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Because of the rapid change in the technology, methods, solutions and practices become outdated very often

17. Training facilities :

We have seen that there are new concepts and new technology products coming into the market every other day. It becomes very essential that the employees of the organization be given training in order to understand the benefits arising out of such new products and concepts and to integrate them into our existing systems. Thus there is a necessity of providing continuous training to the employees. This will increase the HR Costs.

18. Failure will affect the Organization's functioning :

Incase an organization is not able to successfully implement a Management Information System, owing to selection of a wrong model or wrong set of solutions, it would have already caused waste of resources in Terms of the investment in hardware, software, training etc. This would also affect the functioning of an organization in general. Further, the effect of this will be carried forward and will adversely affect our future efforts in implementing different set of solutions as well.

19. Engulf between IT and non-IT employees :

We have seen that the Compensation available for IT resource persons are very high in comparison to the other set of technical and managerial personnel. This has resulted in an engulf between IT and Non-IT employees in the society.

11.8 KNOWLEDGE REQUIRED FOR STUDY OF MIS

As all new technologies and Concepts are not without any limitations, so also with MIS. However, most of the limitations can be

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overcome by observing precautions and following Objective practices for information and related technology. The Information Systems Audit and Control Association, (ISACA) USA has been constantly evolving practices and Control objectives which can reduce the minimize the risks associated with Information and related technology. Presently, the ISACA has advocated COBIT-3. COBIT stands for Controlled Objectives for Information and Related Technology.

Under this methodology, the IT processes are divided into 4 domains viz., 1. 2. 3. 4. Planning and Organization Acquisition and Implementation Delivery Support Monitoring The main objectives under each of the above domains are given below.

1. Planning and Organization : Define a strategic IT plan Define the information architecture Determine the technological direction Define the IT organization and relationships Manage the IT investment Communicate management aims and direction Manage human resources Ensure compliance with external requirements Assess risks Manage projects Manage quality

2. Acquisition and Implementation :

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Identify solutions Acquire and maintain application software Acquire and maintain technology architecture Develop and maintain IT procedures Install and accredit systems Manage changes

3. Delivery & Support : Define service levels Manage third-party services Manage performances and capacity Ensure continuous service Ensure systems security Identify and attribute costs Educate and train users Assist and advise IT customers Manage the configuration Manage problems and incidents Manage data Manage facilities Manage operations

4. Monitoring : Monitor the processes Assess internal control adequacy Obtain independent assurance Provide for independent audit

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11.9 SUMMING UP

Any organization needs information for the purpose of planning, decision making and control. There are different levels of Management in an organization. They are operational Level, Knowledge Level, Middle Level and Top Level Management. The natures of problems which need solutions at the different levels of Management are different in terms of complexity and certainty. Hence separate Information Systems are designed and put into use for the informational needs of the organization. The information systems which cater to the information requirements are Transaction Processing System, Knowledge Work System, Management Information System and Decision Support System and Executive Support System.

11.10 EXERCISE

1.

Discuss the need, significance and purpose of Management Information System. Discuss the need for different Management Information Systems for an organization. What are the different Components of a Management Information System? Explain the problems in installing and operating the MIS.

2.

3.

4.

12

MANAGEMENT INFORMATION SYSTEM AND BUSINESS

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Unit Structure:

12.0 12.1 12.2 12.3 12.4 12.5 12.6 12.7 12.8

Objectives Introduction Types of Information Information Needs of Business Levels of MIS Decision Making Process and the Importance of Information Business Functions and the Informational Needs Summing Up Exercise

12.0 OBJECTIVES

After studying the unit the students will be able to: Explain the types of Information. Know the need of information in the business. Understand the Levels of MIS. Explain the various business functions and the informational need of the function.

12.1 INTRODUCTION

An organization needs to be managed most effectively and efficiently under any given situation. It is to be noted that an organization's outcome depends upon the sum total of the contribution by various functional divisions constituting the organization. In order to manage each such function effectively and efficiently, it becomes essential that each function is handled by an expert who is known as a business manager /

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functional manager / process manager. Every business Manger or Functional Manager or Process Manager needs to make decisions. The manager has to make decisions in order to maximize the benefits by utilization of resources available. When it comes to decision making, it becomes important that the manager gets all the relevant information on time. Unless the decision is made in the light of all the relevant and required information, the decision cannot be a correct one. Hence it is imperative that the informational needs of each function are properly understood and a proper Information System as can help discharge of the Decision-making, Planning and Control functions of a Manager is designed and put in place.

12.2 TYPES OF INFORMATION

Information is basically divided into following categories. They are; 1. Operational 2. Knowledge 3. Tactical 4. Strategic Let us briefly explain the above.

1. Operational :

Operational information is needed by the people at the lower levels of management. Such information is necessary in order to carry out the day to day operations of the management. It helps say for example, to decide on the daily cash requirements or to decides about the daily stock requirements at the show room. Similarly, information like the details about the customers may be needed by a supervisor at the sales counter in order to enable him to take a decision as to whether credit can be allowed or extended. Such information is generated internally. Further the requirement of such information would be very heavy because, of all the decisions taken in a business organization, the number of decisions taken at the operational level would be greater than any other decisions taken at any other level of the organization. It is further to be added that this type of information is used to solve structured problems. By 'structured problems' we mean that the outcomes of a decision are certain at the operational level.

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2. Knowledge level :

Informational requirements of people who are not at the hard core operational level but at the support level are classified under this category. Such people are Accountants, Engineers etc., For example, the information which would be essential by an accountant who would need to know regarding the Tax collectible on sale of goods. Information of this type is also required in situations to solve problems which are structured in nature.

3. Tactic level :

The type of information required at the Middle Level falls under this category. This type of information is required in order to carry out the plans of the top level management. Most of these decisions would be of the nature necessitating the appropriation and allocation of resources. This type of information helps to solve the problems which are less structured in comparison with the other two types of informations.

4. Strategic level :

This type of information is required by the Top level management. Information of this type is required by the Board of directors in order to make strategic decisions which can help them lead the organization ahead of the competitors. It means this type of information helps to solve the problems which are very unstructured. Most of the information required under this category is from external sources, viz, Competition, Market Share, Plans and Strategies of Competitors, Political, Economic and Social situations of the country.

12.3 INFORMATION NEEDS OF BUSINESS

Information requirements of one type of business would be different from another type of business. This is because the Information requirements are dependent upon the nature of business and its business

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objectives. After all, the Information System is expected to help the management in making decisions in order to attain the objectives of the business. For example, if the objective of a business is to become a market leader, the performance of the company in terms of market share would be very relevant information which the Management has to be aware of very frequently. Similarly, in the case of a raw material intensive manufacturing industry, the most critical piece of information would be centered around the wastage of materials. But in the case of a Hotel Industry, the importance would be on the No. of rooms lost without selling. Apparently, the focus in the case of Manufacturing Industry, as it seems is upon the scheduling and production, in the case of Hotel Industry, it is upon Sales and Marketing. In fact, for the same type of business, depending upon the locational requirements or legal requirements or owing to some other external or internal factors, the nature of information requirement, even though fundamentally would be the same, some type of information which would be very relevant and mandatory or critical in nature, in one particular location or environment would not be required or would be irrelevant for the same size and type of business functioning under another location or environment. For example, for a Hotel Industry which is functioning in a place where water is scarce or environment is of great concern, there would be great emphasis on usage of water / disposal of waste while the importance of water may not be that important in a place where water is available in plenty. Thus it is very essential that the Information System should be business objective specific.

12.4 LEVELS OF MIS

The Managerial echelon of a company can be classified into the following levels. a) Supervisory Level b) Knowledge Level c) Middle Managerial Level and d) Strategic Level

a) Supervisory Level : Each level of Management would be in need of information from different perspectives. For example, a supervisor who is a charge of a

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scale of a Sales Counter may have to decide instantaneously whether to extend credit to a particular customer. He may be needing information at that instant in order to decide as to whether to give credit or not. The information he would needing would be supplied by the sales department and the Accounts department. This information is provided by the Transaction Processing Systems viz., Sales Order Processing System and accounts receivable processing system. Any system which produces information at the transaction level is known as Transaction Processing System. Transaction processing system generates the information in large volumes and provides the source data for design of other Information Systems. The transaction processing system is suitable for solving well structured problems.

b) Knowledge Level : The next level of Information System is focused towards the knowledge level of an organization. This level of Management comprises of skilled people like engineers who make use of systems like CAD (Computer aided design) and the white collared people in the office, who make use of systems like word processing, e-mail etc. The first set of knowledge level people creates the information and the second set of people process the data created by the first set. Like Transaction Processing System, the Knowledge Systems is capable of solving only well structured problems.

c) Managerial Level : This level comprises of the Middle Level Management. There are two types of Information Systems used by the middle level management. They are: 1. Management Information System and 2. Decision Support System

The management information system is based on the information generated by the transaction processing system. It caters to the informational requirements of the middle level management, in performing the day to day planning, decision making and controlling functions. It presents the information generated by the transaction processing system

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and knowledge level system in a summarized form. It is prepared periodically, say, every week fortnight or a month. The normal MIS takes into account only the internal factors. The decision Support System takes into account external factors also. For example, operational data like volume of sales. Operational capability etc. of the competitors would be included.

Analytical approaches like sensitivity analysis, what if analysis would find a common place in Decision Support Systems. Management information system is useful for solving structured problems. DSS is used to solve semi-structured problems.

d) Strategic Level : The information system which is used by the top management is known as Executive Support System. The Executive Support System enables the top level management to take Strategic decisions. Apart from containing relevant internal data great emphasis would be given to the external factors. The presentation in the ESS may include graphs, charts etc. to enable better understanding of the internal and external environments. The ESS is used to solve un-structured problems.

12.5 DECISION MAKING PROCESS IMPORTANCE OF INFORMATION

AND

THE

As seen earlier, managers, whether at the lower level or at the middle level or at the top level, have to make decisions. They could reach their objectives only by way effective handling of the Planning, Decision making and controlling functions. He has to plan about his course of actions among the alternative course of actions available, organize the resources required in order to achieve the objectives and perform the controlling activity in order to ensure that the desired results are achieved. In case the desired results are not achieved, he has to make corrective actions immediately.

Let us take an example :

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Assume that a Hypothetical Company is in an industry which is highly raw material intensive. Supposing the Controller of the company wants to reduce the material costs of the product in order to get a strategic advantage over the competitors.

In the course of achieving this objective, three important elements are involved. Viz. Planning, Decision making and controlling.

As a first step, he has to call for a meeting of the concerned executives, discuss with them and then find out the various alternatives available in older of priority and possibility. Subsequently, in consultation with the concerned Middle level executives, a particular course of action has to be chosen. Assuming that of the alternative courses of actions, it has been decided that the wastage of materials has to be reduced to 3%. Once it has been decided that the quantum of wastage of materials has to be reduced, Standards have to be established and the Plan has to be rolled out and there has to be a drive in implementation of it. Once the implementation has been in place, an effective monitoring has to be set in, to monitor the results of the action which the company has gone in for. The monitoring process should collect the data related to the wastage of materials after the new plan of action has been implemented. If the company has been able to reach the desired objective viz., reduction in the cost of materials wastage, the new plan of action may be refined in order to achieve a better result. However, if the company is not able to reach the desired objective, the controlling mechanism should provide for a feedback analysis of the failure to reach the standards established to meet the objective. Based on the analysis, corrective actions have to be taken.

In the above example, you would notice that the Organization has to plan for the course of action, fix standards and Control the result. For all such managerial activities, the management is in need of the information about the present material costs, the cost of wastage of materials at present, the comparative study of the different options or alternative courses of actions, the basis for selection of a particular course of action You would have realised the importance of information for decision making process.

12.6 BUSINESS FUNCTIONS INFORMATIONAL NEEDS

AND

THE

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A business is normally divided into the following functions. 1. 2. 3. 4. 5. 6. 7. 8. Marketing Production Human Resources Purchasing Finance and Accounting Invetory control Project Control Management Reporting

Let us study in detail about the informational requirements of the above mentioned functions.

1. Marketing and informational needs of Marketing function :

Under Marketing the requirement of informational needs can be categorised into the following. a) b) c) d) e) f) g) Competition and Market Share Information on Sales and Sales Forecasting Effectiveness of Marketing Plans. Effectiveness of the Advertisement Plans. Product Mix After Sales service Other Information

a) Competition and Market Share :- A marketing manager's regular informational requirement comprises of the level of competition and the organization's market share on a periodical basis. This information will be required both for a particular period and cumulatively. b) Information on sales and sales forecasting :- In order to keep a vigil on the sales, the Marketing Manager would be in need of the information on sales of different types of products of the company. The analysis has to be made in terms of quantity, area or geographical locations, customer category, market segment etc.. Sales forecasting is an important tool that will help a marketing manager in establishing the sales policy and fixation of targets. Sales forecasting is also needed to estimate the stock of quantities required.

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c) Effectiveness of marketing plans :- An organization can be floating many marketing plans at any point of time. It becomes essential that the Marketing manager needs information about the success of the marketing plans which are launched. For example, he would need to know the incremental quantity of products sold as a result of the launch of a particular marketing plan. d) Effectiveness of advertising plans :- As in the case of Marketing Plans, the effectiveness of Advertising plans has to be analysed, in order to judge their performance. Hence the information on incremental sales of the products would be required in the course of as well as after the implementation of such advertisement plans. e) Product Mix :- Information on the Product mix is essential to enable the Marketing Manager to understand the buying preferences of customers. f) After sales service:- This sort of information is required by a marketing manager in order to give a proper feed back about the quality of production to the production department as well as to study about the satisfaction of the customers with the product. g) Other information :- The following other information also would be required for a marketing manager. Effect of Pricing Policy - What has been the change in the pattern of consumption of the customers after a change in price. Customer Satisfaction - The level of satisfaction of the customers. Market Research - Market research is an important tool in understanding the changing market factors, customers' demands, level of satisfaction or dissatisfaction. Market research will provide a very important clue as to the company's unanswered questions and can provide a valuable guide to the company's top management in devising its marketing and sales strategies from the point of view of its strategic planning. Market research can be conducted by either the organization itself or can be out sourced from other professionals who have expertise in Market research.

2. Production function and Informational needs of Production function :

The Informational requirements of the Production function needs to be interfaced with Sales and Purchasing. Production scheduling is the

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nerve centre of the Production Management System. Production Scheduling involves planning for the Production quantity, the materials required, job scheduling (assigning machine to appropriate skilled labourers) and the maintenance of the Inventory of WIP. The materials to be kept as WIP will form an important input as far as the purchasing function is concerned. A well managed Production function contributes to a better Inventory Control and hence higher Return on Investment. Thus it boils down to the following aspects. a) b) c) Materials Management Production Planning Job Scheduling

3. Human resources Function and Informational requirements:

The importance of Human Resources Function in the "New Economy" age is getting very much important from the point of view of new dimensions attached to the Personnel Management. The revolutionary changes brought in by the "Knowledge employees" in the organizational structures, work practices, training requirements, performance measurement and Compensation methods the informational requirements of the Human Resources Management warrant the necessity to build new information data bases that can help the organization to stay ahead of the Competitors. Different aspects of the HR function that need such information are given below. a) b) c) d) e) Personnel Selection Personnel Recruitment Personnel Training Methods Organizational Policies as related to personnel Performance Evaluation and Compensation Methods

4. Purchasing :

Nowadays in the context of extended Enterprise Resources Planning, the Supply Chain Management is becoming so vital that the participation by the suppliers in the Inventory management process is required to keep inventory of the raw materials at the least possible quantity. Infact, the organizations are moving towards the 'JIT' - Just In Time Inventory practices. Under this practice, the materials will be supplied by our suppliers at the time of need. This will practically eliminate the necessity of Stocking the raw materials beforehand. In order to attain such advantage, the suppliers have to be considered as

259
Business Partners and the Data base about our production plan has to be shared with them. The process also requires selection of vendors who are capable of meeting our requirements without failure even once. This needs information about the suppliers' History and the experience of the firm with them in earlier occasions. A proper procedure has to be in place for development of vendors who can co-operate with the firm regularly on need.

5. Finance and Accounting :

Finance and Accounting has been the main repository of information as far as any organization is concerned. The informational requirements of the Finance and Accounting function is so vast that the whole lot information which study about the performance of the Organization as a whole from different view points need to be property collated and analysed. The Finance function evaluates the Financial Management function from the point of view of maximization of the wealth and value of the shareholders. The Finance function also evaluates the performance of the Organization from the point of view of Profitability, Financial Stability, Solvency and Return on Investment or on Capital Employed. "Accounting function" can be referred to as the single function which needs the largest amount of information in any organization. Such information flows from different sources both internally and externally and from different functional areas. Information requirements with reference to finance and accounting are in relation to the following aspects. 1) 2) 3) 4) 5) 6) 7) Financial Planning and Control. General ledger reporting Accounts Receivable Management Accounts payable Management Compliance with Legal requirements Return on Investment or Return on Capital Employed. Financial Reporting, Analysis and Interpretation Statements.

of

Financial

6. Inventory Control :

While there are certain traditional models like ABC Analysis, VED Analysis, FSND Analysis, Buffer Stock, Maximum Level, Minimum Level etc. The present day's situation is that companies are moving towards the "JIT", which stands for 'Just in time Inventory'. Under this concept, the inventory has to be maintained at virtually 'zero level'. However, for the

260
concept to work, the organization has to adopt the best practices in relation to the Sales forecasting, co-ordination with the Sellers and the buyers, Production scheduling and materials planning. Hence the information on the quantum and schedule of off take by our customers need to be known by the organization and at the same time, the organization should share the information on the quantum of our off take to our suppliers. 7. Project Control :

Any project, whether a short term one or Long term one should adopt techniques of Project control like PERT and CPM. Programme Evaluation and Review Techniques (PERT) help to adopt a modular approach in managing the activities involved in the project and thus enables to control the costs of the project. Critical Path Methods (CPM) help to analyse the most critical path, which will have an impact on the final completion of the project. This analysis would help in weighing alternative ways of allocation of resources in order to complete the project on time, if some exigencies arise.

8. Management Reporting :

There should be an established system of reporting whereby the concerned level of management is supplied with the proper regular and exception reports. The reports help the appropriate management be informed about the progress of the planning. There should be a proper mechanism whereby exceptions are reported without any loss of time, so that appropriate corrective actions are taken without any loss of time and the objectives are achieved. Such reports have to be built into the regular MIS.

12.7 SUMMING UP

Information is very essential in order to carry out the functions of Planning, Decision Making and Control. The organization's activities are divided into various functions in order to enable handling of the functions effectively and efficiently. Both for Long term and short term planning a well established Information system can reduce the uncertainty involved in the decision making process. The information is classified into Operational, knowledge Level, Tactical and Strategic Informations.

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Various techniques and models are available in order to manage different functions effectively. There should be a system of reporting to the Management, who would be kept informed about the progress of planning activities and to enable taking control actions to correct deviations.

12.8 EXERCISE

1. What are the different levels of MIS? 2. How the information is classified? 3. Explain the informational requirements of various Functions of management.

13
OBJECTIVE TYPE QUESTIONS
Chapter 1 Analysis and Interpretation of financial statements
1. Rewrite the following sentences by selecting correct choice. a) An asset which is shown in the balance sheet but it has no real balance. (i) (ii) (iii) (iv) Fixed Asset Current Asset Wasting Asset Intangible Asset

b) An expenditure from which no future benefit is expected. (i) Capital Expenditure

262 (ii) Revenue Expenditure (iii) Deferred Revenue Expenditure (iv) Misc. Expenditure c) Which of the following is not a financial statement? (i) (ii) (iii) (iv) Balance Sheet Profit & Loss account Funds Flow Statement Trial Balance

d) The comparative income statement shows the increase or decrease over______ (i) (ii) (iii) (iv) Previous Year Future Year Current Year Percentage

e) In common size balance sheet analysis, the total assets are taken as (i) (ii) (iii) (iv) 100 % 50 % 10 % 0%

2. Fill in the blanks :(i) In a common size income statement as 100. _____ is taken

(ii)

_______ form of balance sheet shows the assets on the right side and the liabilities on the left side.

(iii) _______ Reserves are not available for distribution of dividend.

263 (iv) Receipts from customer for sale of goods are known as ______ receipts. (v) The excess of current assets over current liabilities is known as ______.

3. Match the following:Group A 1. Bank overdraft 2. Owned Funds 3. Intangible Asset 4. Loss on sale of fixed assets 5. Depreciation Group B Reserve and Surplus Fixed Asset Non-operating Expenditure Current Liability goodwill

4. State whether the following statements are true or false:(i) Issue of shares is an internal source of Finance. (ii) A comparative balance sheet is prepared for the purpose of intra-firm comparison. (i) Common size statements are used for vertical analysis only. (ii) Analysis of profit & loss account means breaking down the profit & loss account into its various components. (iii) Accounting principles are generally accepted guidelines used by accountants for the purpose of preparing the financial statements. Answers: Q 1. (a)- (iii) (b)- (ii) (c)- (iv) (d)- (i)

264 (e)- (i) Q 2. (i) Total Assets (ii) Horizontal (iii) Capital (iv) Revenue (v) Working Capital Q 3. Group A (i) (ii) (iii) (iv) (v) Group B (iv) (i) (v) (iii) (ii)

Q 4. (i) True (ii) False (iii) False (iv) True (v) False

Chapter 2

Ratio Analysis

Q.1 Re write the following sentences by selecting correct choice. i) An Accounting ratio is an expression relating to two _____________ (a) Accounts (b) Figures (c) Balance (d) Assets.

ii) The Balance sheet ratios deal with the relationship between two ____________. (a) Assets (b) Liabilities (c) Items (d) Capital

265
iii) The relationship between capital entitled to fixed rate of return and the capital not so entitled to fixed rate of return is known as: (a) Fixed Capital (b) Working Capital (c) Gearing Capital Capital . iv) Decrease in gross profit ratio may be due to a) Decrease in cost of goods sold b) Increase in selling price c) Overvaluation of Stock (closing) d) Decrease in cost of materials. v) The relationship between net operating profit and net sales is expressed in __________________. (a) Percentage (b) Figures (c) Ratios (d) Standard Deviation. (d) owned

Q.2 Fill in the blanks a) A ratio is one figure expressed in forms of another_______________ b) Leverage ratio measures the relationship between proprietors fund and _______________. c) _________________ is the difference between current assets and current liabilities. d) Those current assets which can be realized immediately at short notice are _________________ assets. e) _________________ Ratio is a test of the financial and credit strength of the business.

Q.3 Match the following: Group A 1. Gross profit Ratio Group B Net Profit

266
2. Current Ratio 3. Operating ratio 4. Capital gearing 5. Stock Turnover ratio Cost of goods sold Trading results Short term liquidity Debenture capital

Q.4 State Whether the following statements are true or false: a) The ratio should be expressed in percentage. b) Over trading means increase in activities without adequate funds. c) It is difficult to establish a standard inventory ratio as inventory levels differ from industry to industry. d) The return on capital employed measures the overall efficiency of the business operations. e) High debtors turnover ratio indicates overall efficiency in collecting receivables. Answers Q.1 Q.2 i b, ii C , iii - C , iv b, v a (d) Quick

(a) Figure (b) Borrowed Funds (c) Working Capital (e) Proprietary

Q.3

1 ---- iii 2 ----- iv 3 --4 --- V 5 --- ii i

Q.4

(a) False (b) True (c) True (d) True (e) False

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Chapter 3

Cash Flow Statement

Q.1 Choose the correct answer:(a) Cash from operations is equal to:(i) Net profit plus increase in outstanding expenses (ii) Net profit plus increase in debtors (iii) Net profit plus increase in stock (iv) Net profit plus Depreciation (b) Increase in the amount of debtors results in:(i) Decrease in cash (ii) Increase in cash (iii) No change in cash (iv) Increase overdraft (c) Cash flow statement reveals the effects of transactions involving:(i) Reduction in cash (ii) Increase in cash (iii) Movement of cash (iv) Bank transactions (d) Net cash flow does not necessarily mean net income (i) Company (ii) Firm (iii) Business (iv) Entity (e) The amount of closing stock put on the credit side of trading account increases the amount of net profit without increasing:(i) Funds from operations (ii) Cash from operations (iii) Surplus from operations of the:-

268
(iv) Deficit from operations

Q 2. Fill in the blanks:(i) A cash flow statement depicts the change in cash position from one ______ to another. (ii) Depreciation does not result in _______ of cash. (iii) Increase in creditors from one period to another will result in ________ of cash from operations. (iv) Payment of tax will result in decrease of cash and hence it is ________ of cash. (v) Cash Flow Statement is a useful ________ instrument. Q 3. Match the following:Group A 1. Cash flow statement 2. Depreciation 3. Funds from operations 4. Opening stock 5. Creditors Group B i Sources of funds ii Reduction in net profit iii Change in cash position iv Increase of cash from operations v Non-cash item of expenses

Q 4. State whether the following statements are true or false:(a) Cash Flow Statement reveals the effects of transactions involving movement of cash. (b) The term Funds means Current assets in case of cash flow analysis. (c) A cash flow statement can very well be equated with an income statement. (d) The funds flow statement and Cash flow statement are one and the same. (e) A company should keep large balance of cash in hand so that it can meet all contingencies.

Answers: Q.1 a iv , b i , c iii , d iii , e ii

269
Q.2 i- period , ii outflow , iii increase , iv application , supplementary Q.3 1 iii 2v 3i 4 ii 5 iv Q.4 a True, b false, c false, d false, e false

Chapter 4

Working Capital

Q.1 Rewrite the following sentences by selecting correct choicea) The period required for the whole operation starting with cash and ending up with Cash plus i) operating cycle ii) Trading Cycle iii) Working Cycle iv) Main Cycle

b) Cross working Capital is equal to i) Total Current Assets ii) Total fixed assets iii) Total Assets

270
iv) Net Assets

c) The cost to be excluded from the cost of goods sold for the purpose of determining working in process and finished goods is i) Interest ii) Depreciation iii) Taxation iv) Dividend

d) The primary objective of Working Capital Management is to manage i) Current Assets ii) Current Liabilities iii) Current Assets and Current Liabilities iv) Fixed Assets

e) It Is a normal principles that current assets should be valued at cost or market value whichever is i) Higher ii) Lower iii) More iv) earlier

Q. 2. Fill in the blanks i) Advances received from customer will ---------------the working capital requirements. ii) Provision for contingencies may be made to make allowances for likely variations or for -------expenses. iii) In valuation of world in progress labor & overheded are assumed to be incurred to the extent of -------------iv) It would be more practical if investment in debtors is a cetined at cost of sales, not as --------price. V) The Capital required to meet seasonal requirements is called as -------working capital.

271

Q.3 Match the following Group A 1) Gross working capital 2) Negative working capital 3) Debtors 4) Bank Balance 5) Net working capital Group B 1. Receivables 2. Excess of current Assets 3. Total current Assets 4. Excess of current liabilities 5. Quick Assets

Q. 4 State whether the following statements are true or false a) Closing stock of raw material is a liquid asset. b) Profit included in debtors is an expense hence; it is a part of current asset. c) Finished goods stock should be valued at FIFO basis. d) Working capital management aims to strike a judicious balance between current assets & current liberalities. e) Prepaid expenses increase the amount of working capital.

Answers:

Q .1. a-i,

b-iii,

c-ii,

d- iii,

e-ii

Q .2 i Reduce

ii unforeseen

iii 50%

iv selling

v- circulating

Q.3

1 -3 2 -4 3 -1 4-5

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5-2

Q .4 a False,

b False,

c False, d True,

e- True

Chapter 5

Capital Budgeting

Q.1 Choose the correct answers and complete the statements. (a) While evaluating capital investment proposals the time value of money is considered in case of (i) Pay back period (ii) IRR (iii) NPV (iv) ARR

(b) Depreciation is included in cost in case of (i) ARR (ii) Payback period (iii) Profitability Index (iv) NPV

273
(c) The cash inflows on account of operations are presumed to have been reinvested at the cut-off rate in case of (i) ARR (ii) DCF method (iii) IRR (iv) PI

(d) Cash flows from a project can be worked out only (i) On the basis of certain probabilities (ii) On the basis of sales (iii) On the basis of depreciation (iv) On the basis of percentages

(e) Theoretically, a firm should undertake all investment proposals which (i) Results in increasing value of the firm (ii) Results in higher IRR (iii) Results in higher cash flows (iv) Results in maximum profits

Q2. Fill in the blanks (i) The cut-off point refers to the point below which a project would not be _______. (ii) Capital budgeting includes both raising of long-term funds as well as their ________. (iii) All capital investment proposals for increasing revenue require additional _______ capital. (iv) Different capital investment proposals have different degrees of risk and ________.

274
(v) The term pay-back refers to the period in which the project will generate the necessary cash to recoup the initial---

Q3. Match the following Group A 1. DCF 2. Pay back period 3. Profitability index 4. Cut off rate 5. IRR Group B i. Accept or Reject ii. Discounts the cash flows to zero iii. NPV iv. Benefit cost ratio v. Recoup initial investment

Q4. State whether the following statements are true or false

(a) The internal rate of return and Net Present Value are synonymous terms. (b) Tax concessions have no role to play in estimating the cash flows from a project. (c) Discounted cash flow technique takes into account the time value of money. (d) Pay back method takes into account the cash flows after the pay back period. (e) Cash flows from a project cannot be estimated accurately.

Answers:

Q.1 a iii , b i , c ii , d i , e i

Q.2 i accepted , ii utilization , iii working ,iv-uncertainty, investment

v-

275
Q.3 1 - iii 2-v 3 - iv 4-i 5 ii

Q.4 a false b false c true d false e true

Chapter 6

MIS reports in computer Environment

Q 1. Rewrite the following sentences by selecting correct choice:-

a) The popular belief is that accuracy in reporting should be of (i) (ii) (iii) Low order High order Medium order

(iv) Top order b) MIS can be defined as a network of information that supports management (i) Decision making

276 (ii) (iii) Reporting Planning

(iv) Controlling c) The potential impact of computers and MIS on middle management level is (i) (ii) (iii) Insignificant Significant Not significant

(iv) Less significant d) Reports on stock levels are given to (i) (ii) (iii) Top management Middle management Lower management

(iv) Managing director

e) The success of MIS depends upon (i) (ii) (iii) Support of middle management Support of top management Support of lower management

(iv) Support of employees

Q.2 Fill in the blanks:-

(1) Operating reports and financial reports are the classification on the basis of _______. (2) The quality of the ________ of MIS is basically governed by the quality of inputs and processes.

277 (3) _______ is the glue that holds the functional systems together. (4) Accuracy in reporting is not of vital _______. (5) The primary objective of MIS reporting is to enable the management to make scientific and ________ decisions.

Q 3. Match the following Group A 1 Regular reports 2 Operating reports 3 External reports 4 Report of overtime 5 Report of idle time Group B i. Control reports ii. Lower management iii. Quarterly reports iv. Middle management v. Shareholder s and Creditors

Q.4 State whether the following statements are true or false:-

(1) Balance sheet is an internal report. (2) The reports should be selective and summarized at the corporate level. (3) Accuracy of data in MIS reports is an absolute ideal. (4) MIS is necessary only for the top management. (5) High accuracy is not required in MIS reports.
Answers:

(1) a ii , b i , c ii , d ii , e ii (2) (i) Functions (v) Sound (3) Group A (ii) Output (iii) Database (iv) Importance

Group B

278 1 2 3 4 5 iii i v iv ii

(4) (i) false (ii) true (iii) false (iv) false (v) true

Revised Syllabus of T.Y.B. Com Financial Accounting and Auditing Paper V Related Applied ComponentIntroduction to Management Accounting

Topics at Glance

Sr. No. 1. Analysis and Statement Ratio Analysis

Topics

No. of Lectures of Financial 25

Interpretation

2. 3. 4.

20 15 10

Cash Flow Statement Working Capital Concept

279
5. 6. Capital Budgeting Concept of environment MIS Reports in computer 15 05

Total

90

280
Sr. No. 1 1.1 Topics

Analysis and Interpretation of Financial Statements Study of Balance sheet and Income Statements/Revenue Statements in Vertical form suitable for analysis. Relationship between items in Balance Sheet and Revenue Statement. Tools of analysis of Financial Statements (i) Trend Analysis (ii) Comparative Statement (iii) Common Size Statement Note: i) Problems Based on trend analysis ii) Short Problems on Comparative and Commonsized statements

1.2

1.3

Ratio Analysis and Interpretation (Based on Vertical Form of Financial Statements) Including Conventional and Functional Classification Restricted toComputation and analysis of ratios (A) Balance Sheet Ratios (i) Current Ratio (ii) Liquid Ratio (iii) Stock Working Capital Ratio (iv) Proprietary Ratio (v) Debt Equity Ratio (vi) Capital Gearing Ratio (B) Revenue Statement Ratios (i) Gross Profit Ratio (ii) Expenses Ratio (iii) Operating Ratio

2.1

281
(iv) Net Profit Ratio (v) Net Operating Profit Ratio (vi) Stock Turnover Ratio (C) Combined Ratios (i) Return on Capital employed (Including Long Term Borrowings) (ii) Return on proprietors Fund (iii) Return on Equity Capital (iv) Earning per share (EPS) (v) Price Earning Ratio (P/E Ratio) (vi) Dividend Pay out Ratio (vii) Debt Service Ratio (viii) Debt service coverage Ratio (ix) Debtors Turnover Ratio (x) Creditors Turnover Ratio 2.2 Different Modes of Expressing Ratios: Rate, Ratio, Percentage, Number etc. Limitations on the use of the Ratios, Inter-action of Ratios. Projection of the Financial Statements from the given ratios and other information. Preparation of Statement of Sources and Application of cash with reference to Accounting Standard No. 3 (Cash Flow Statement) 4 Working Capital-Concept Estimation / Projection of Requirements in case of Trading and Manufacturing Organization. 5 5.1 Capital Budgeting Introduction: (i) Types of capital (ii) Sources of capital

2.3

282
5.2 (i) Evaluation of Capital Expenditure Proposals from given cash flow Concept of Present Value (ii) Techniques of appraisal of investment proposal Pay back period method Average Rate of Return method Net Present Value method Profitability Index method 6 6.1 Concept of MIS Reports in Computer Environment Concept of MIS, Need for MIS, characteristics of MIS, Role of MIS, problems in MIS, Knowledge required for studying MIS. MIS and Business, MIS and Computer.

6.2

Pattern of question paper

Maximum Marks 100

Duration 3 Hours

No of questions to be asked No of questions to be answered Question No. 01 Question No. 02

9 6 20 Marks

Compulsory Practical question Compulsory Objective

16 Marks 16 Marks each

Question No. 03 to Question No. 09

Note: (1) From Question No. 03 to Question No. 09 not more than one question may be theory including short problems/questions. (2) Student to answer any four out of Question No. 03 to Question No. 09.

283
(3) Objective questions to be based on all topics and include Inter alia questions like: (a) Multiple choice (b) Fill in the blanks (c) Match the columns (d) True or False

Reference Books

Title of Books Cost and Accounting

Author /s

Publishers Taxmann

Management Ravi M. Kishore

Essential of Management Accounting Advanced Accounting Financial Accounting

P.N. Reddy

Himalaya

Management Robert S. Kailar

Holl

Management S.R. Varshney

Wisdom

Introduction of Management Accounting Management Accounting

Charles T Horngren

Pearson Education

I.M. Pandey

Vikas House Galgotia

Publishing

Cost and Accounting

Management D.K. Mattal

Management Accounting Fundamentals of Financial Management

Khan and Jain Vyuptakesh Sharma

Tata McGraw Hill Pearson Education

284

Question Paper
Financial Accounting and Auditing Paper-V April 2010 Duration: 3 Hours N.B: Total Marks: 100

(1) Question No.1 and 2 are compulsory and carry 20 Marks and 16 Marks respectively. (2) Attempt any four questions from the rest, carrying 16 Marks each. (3) Working Notes should form part of your answer. (4) Proper presentation and neatness is essentials. (5) Use of simple calculator is allowed.

1. The Management of Kaka Ltd. has asked you to prepare an estimate showing the working capital requirement for 2010-11, alongwith estimated cost sheet. (20) Present position: 2009-10 Operating Capacity 40% , giving output of 40,000 units for the year: Cost Structure per unit:Raw Material Rs. 20 Direct Labour Rs. 15 Overheads Profit Rs. 10 Rs. 5

Estimates for the next year 2010-11 Operating Capacity 60% Cost StructureRaw Material cost to increase by 10% Direct Labour cost to increase by 20% Overheads to increase by 20% Selling Price to increase by 20% The following further information is available: 1. The purchase, production and sales pattern is assumed be even throughout the year. 2. The Raw Materials will remain in stock for 1 month. 3. The production process will take 1 month wherein labour and overheads will accrue evenly during the process. 4. The Finished Goods will remain in the stock for 2 months. 5. The Customers will be allowed a credit of 2 months. 6. The Suppliers will allow a credit of 1 month.

285
7. The time-lag in payment of labour will be 1 month. 8. The time-lag in payment of overheads will be half a month. 9. The cash and Bank Balance is expected to be Rs. 25,000/10. Calulate debtors on cost basis. 11. 20% of the purchase will be on cash basis. 2. (a) Re-write the following sentences by selecting correct choice. (8) A very high current ratio will(a) increase the profitability (b) Not affect the probability (c) Decrease the profitability (d) Will increase Tax liability

One of the following is not liquid asset(a) Cash Balance (b) Bank Balance (c) Stock (d) Marketable investment

A highly geared company exposes to (a) Business risk (b) Financial risk (c) Inflation risk (d) Recession risk

Shareholders Equity does not include(a) Equity share capital (b) Pref. share capital High inventory turnover means(a) Investment tied up in stocks (b) Obsolete goods on stock (c) Adverse impact on liquidity (d) Over Trading Return on Capital employed is known as (a) Return on total Assets (b) Return on fixed Assets (c) Return on investments (d) Return on shareholders fund Standard Acid test ratio is (a) 2 : 1 (b) 3 :1 (c) 1 :1 (d) 4 :1 (c) Reserves and Surplus (d) Bank Loan

In cash flow statement machinery purchased is treated as (a) Operating activity (b) Investing activity (c) Financing activity (d) Extraordinary activity

286
(b) Match the coloumns and rewrite the following sentences (8)
Group A 1 2 3 4 5 6 7 8 Rly sidings Trend Analysis Gross Profit Ratio Retained earnings Dividend layout Payback period Gross working capital Debtors turnover ratio 1 2 3 4 5 6 7 8 9 10 Efficiency Debtors More risk Period of recovery of cash out-lay Current liabilities Earlier year a base year Fixed Assets Trading efficiency Dividend paying ability P & L appropriation A/c Balance Group B in collection from

Total current Assets

3. From the following information for the year ended 31st March, 2010 of M/s. NITIN Ltd. Prepare Balance-sheet with as many details as possible. (16)
Current Ratio Gross Profit Ratio Debtors Turnover Cost of goods sold to creditors (COGS/creditors) Stock Turnover (Cost of Goods sold / Closing Stock) Cash Balance is 10% of Total Current Assets (Including Cash) Fixed Assets at cost Accumulated Depreciation on Fixed Assets Current Liabilities Reserve and surplus is 25% of Equity Share Capital Debt Equity Ratio (Debt/Equity) 2:3 All purchases and sales are on Credit Basis Current liabilities include only Creditors and Bills payable. Rs. 6,00,000 2 25% 4 times 6 6 times

1 th of cost 4
Rs. 1,25,000

4. CHETAN LTD. is considering purchase of a machine two machinesLPX machine and GPX machine are available, each costing Rs. 5,00,000. In comparing profitability of machines, a discounted rate of 10% is to be considered. Expected profits after tax and before Depreciation are as follows: (16)

287
Year LPX machine profit GPX machine profit 1 1,60,000 60,000 2 3 4 5

2,00,000 2,50,000 1,50,000 2,00,000

1,50,000 2,00,000 3,00,000 2,00,000

Indicate which machine would be more profitable under following methods (1) Pay back Period Method (2) Net Present Value Method (3) Pay back profitability The net present value of Re. 1 @ 10% discounting factor is as follows:
Year Present Value Factor 1 0.909 2 0.826 3 0.751 4 0.683 5 0.621

5. Following are the Balance-sheets of Abhishek Products Ltd.(16) Liabilities 31st March, 2009 Rs. 31st March, 2010 Rs. Assets 31st March, 2009 Rs. 31st March, 2010 Rs.

Equity Share 10,00,000 12,00,000 Fixed Capital Assets 10% Pref. Share Capital Capital Redemption Reserve Profit and Loss A/c Sundry Creditors Proposed Equity Dividend Provision Taxation for 5,00,000 ____ 3,00,000 Investments 2,00,000 Stock

11,00,000 13,00,000 2,60,000 7,40,000 2,60,000 8,99,000

57,000

1,00,000 Sundry Debtors

10,50,000 1,50,000 1,00,000

9,90,000 2,10,000 80,000

13,73,000 12,50,000 Bills Receivable 1,50,000 1,80,000 Bank Balance 2,10,000 Cash in Hand 3,35,000 Preliminary Expenses

1,70,000 2,00,000

30,000 20,000

20,000 16,000

Provision for Depreciation

34,50,000 37,75,000 Additional Information:

34,50,000 37,75,000

(1) Preference Shares were redeemed on 1.4.2009. Company pays Preference dividend on 31st March every year. (2) Fixed Assets of Rs. 2,00,000/- were purchased on 31.03.2010 against which equity shares of Rs. 2,00,000/- were issued at par.

288
(3) Dividend received on investment was Rs. 26,000/(4) Proposed Equity Dividend for 2008-09 Rs. 1,50,000/- was paid during 2009-10. (5) Provision for Taxation for 2008-09 Rs. 1,70,000/- was paid during 2009-10. Prepare Cash Flow Statement for the year ended 31st March, 2010 by indirect method as per AS-3 from the above information. 6. M/s. Sudesh Ltd. carrying on Business furnishes their position as on 31st December, 2007, 2008 and 2009 as under : (16)
Liabiliti es Equity Share Capital Pref. Share Capital General Reserve Secured Loan Sundry Creditor s Bills payable 2007 Rs. 3,00,000 2008 Rs. 3,00,000 2009 Rs. 4,00,000 Assets Fixed Assets Investme nts Debtors Stock
Advanced paid

2008 Rs. 3,00,000

2008 Rs. 3,00,000

2009 Rs. 4,00,000

2,00,000

2,00,000

2,50,000

1,00,000

1,00,000

1,00,000

50,000 1,00,000 40,000

1,00,000 1,00,000 80,000

1,00,000 50,000 80,000

1,00,000 50,000 50,000

1,50,000 1,00,000 50,000

2,00,000 50,000 50,000

10,000

20,000

20,000

Cash Bank Discount on Issue of Shares

50,000 25,000 25,000

50,000 40,000 10,000

50,000 45,000 5,000

7,00,000

8,00,000

9,00,000

7,00,000

8,00,000

9,00,000

Prepare vertical Trend Balance-sheet and offer your comments on Net worth and working capital. 7. Rearrange the following Manufacturing and Trading A/c of M/s Dada and Co. in a form suitable for financial analysis. (16) Manufacturing and Trading A/c for the year ended 31st March, 2010
Particulars To Opening Stock: Rs. Particulars By Sales Rs. 9,00,000

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Raw Materials Work in Progress Finished Goods To Purchase of Raw Materials To Freight To Octroi To Import Duty To Direct Wages To Direct Expenses To Factory Power To Factory Salaries To Factory Repairs To Factory Rent To Depreciation on Machinery To Gross Profit Total 72,000 12,000 48,000 4,80,000 12,000 48,000 6,000 1,20,000 36,000 24,000 12,000 36,000 60,000 24,000 66,000 10,56,000 By Sales of Factory Scrap By Closing Stock: Raw Materials Work in Progress Finished Goods 6,000

60,000 18,000 72,000

Total

10,56,000

8. Following is the Profit and Loss Account of Moon Enterprises Ltd. for the year ended 31.03.2010. (16) Particulars To Opening Stock To Purchases To Wages To Factory Expenses To Office Salaries To General Administrative Exps. To Selling Expenses To Depreciation on Machinery To Provision for Tax To Trf. To Gen. Reserve To Net Profit Rs. 4,00,000 9,80,000 2,90,000 1,90,000 1,20,000 1,30,000 1,12,500 2,50,000 1,40,500 2,00,000 2,98,000 31,11,000 Particulars By Sales-Credit 18,00,000 -Cash 7,00,000 By Closing Stock By Sale of Scrap By Dividend Received Rs. 25,00,000 6,00,000 10,000 1,000

31,11,000

You are required to compute the following ratios(1) Gross Profit Ratio (2) Stock-Turnover Ratio (3) Administrative Expenses Ratio (4) Net Profit before Tax Ratio Preparing Revenue Statement in vertical form is not required. 9. (a) Complete the following Comparative Statement of Himalaya Products Ltd. by ascertaining the missing figures. (8)

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Particulars

Gross Profit Less: Expps. Administrative Selling Financial Operating Net Profit

Year ended 31-03-2009 Rs. ? 1,00,000 50,000 ? ?

Year ended 31-03-2010 Rs. ? ? 60,000 25,000 2,00,000

Increase/ % Increase/ (Decrease) (Decrease) Rs. ? ? 20,000 20.00 10,000 5,000 1,00,000 ? 25.00 100.00

(b) Complete the following Income Statement of Narayan Ltd. for the year ended 31st March, 2010 and also prepare Commonsize Revenue statement. (4)
Particulars Net Sales Cost of goods sold Gross Profit (25% on sales) Operating Expenses Operating Net Profit Non Operating Income Non Operating Expenses Net Profit before Tax Rs. 16,00,000 ? ? ? 2,00,000 1,00,000 ? 2,80,000

Less: Less: Add: Less:

(c) Write short note (any one): (i) Essential Requirements of MIS (ii) Concept of Working Capital

(4)