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LESSON 1

INTRODUCTION TO ACCOUNTING

STRUCTURE: 1.1 Introduction

1.2 Objectives of Accounting

1.3 Uses of Accounting Information

1.4 Principles of Accounting

1.4.1 Accounting Concepts

1.4.2 Accounting Conventions

1.5 Some Important Terms used in Book – Keeping

1.6 Summary

1.7 Key Words

1.1 INTRODUCTION:

Accounting can be defined as, àn art of recording, classifying and summarizing in a

significant manner and in terms of money, transactions and events which are, in part at least

of a financial character, and interpreting the result thereof.” Accounting, which involves

recording, classifying and summarizing the transactions of financial nature in order to

compute the results and financial position of the business. Accounting facilitates external

reporting to the owners or shareholders, potential investors, trade creditors, creditors for

expenses, banks and financial institutions, management and employees, society, Income-tax

department, academicians, and other interested parties. As this branch of accounting is based

OBJECTIVES: To explain the meanings and importance of accounting To know the utility of accounting information to various stakeholders To know the principles which guide the preparation and reporting of accounting

statements To familiarize with the frequently used words in accounting

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on historical or past data, it is described as the post-mortem of financial transactions. In

Financial Accounting all the transactions of financial nature are recorded in a book called

Journal in chronological order or in order of their occurrence, then classified in another book

called Ledger and finally summarized into a schedule called Trial Balance, from which an

Income statement is prepared to know the results of the transactions of financial nature in a

business firm as on a particular date and the same are analyzed with the help of the tools of

financial analysis, such as, comparative and common size financial statements, trend analysis,

Ratio analysis, fund flow analysis and cash flow analysis. These days, Double Entry System

of Accounting is followed by every Corporate and also most businesses which are organized

in forms other than Corporate. Hence the subsequent discussion in this chapter and latter

chapters would be on Double Entry System of Book Keeping.

1.2 OBJECTIVES OF ACCOUNTING:

Accounts are maintained

1. To have a permanent record of all mercantile transactions.

2. To maintain records of incomes, expenses and losses in such a way that the net profit or

net loss for any selected period may be readily ascertained.

3. To keep records of assets and liabilities in such a way that the financial position of the

undertaking at any point of time may be readily ascertained.

4. To enable the review and revision of policies in the light of past experience brought to

light by analyzing and interpreting records and reports.

1.3 USERS OF ACCOUNTING INFORMATION:

The importance of accounting is to provide meaningful information about a business enterprise

to those persons who are directly or indirectly interested in the performance and financial

position of business enterprise. Such persons may include owners, creditors, investors,

employees, government, public, research scholars and the managers.

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1. Owners:

The owners of a business furnish capital to be used for the purpose of business. They are

interested to know whether the business has earned a profit or loss during a particular period

and also its financial position on a particular date. They want accounting reports in order to

have an appraisal of past performance and also for an assessment of future prospects.

2. Creditors:

The creditors include suppliers of goods and services, bankers and other lenders of money.

They are interested in the financial stability of the concern before making loans or granting

credit. They look to the ability of the business to pay interest and principal as and when it

becomes due for payment. They also look to the trends of earnings as it ultimately affects the

solvency of a concern.

3. Investors:

Investors look not only the earning capacity of business but also its financial strength and

solvency before deciding whether to subscribe or not for the shares in a Company. They are

interested in steady and good return on their capital, the safety of their capital and appreciation

in the value of the shares.

4. Employees:

Employees are interested in earning capacity of a concern as their salaries, bonus and pension

schemes are dependent on this factor. They have a permanent stake in the business and in order

to have an assurance of steady employment they are very much interested in the stability of the

organization.

5. Government:

Government is interested in accounting statements and reports in order to see the performance

of a particular unit, its cost structure and income in order to impose tax and excise duty.

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6. Public:

The public as consumers is interested in accounting statements in order to know whether control

is exercised on production, selling and distribution expenses in order to reduce the prices of

goods they buy. They can also judge whether the economic resources of the concern are being

utilized for the benefit of the common man or not.

7. Research Scholars:

Such persons are interested in accounting statements and reports in order to get data for proving

their thesis on which they are working and hence to complete their research projects.

8. Managers:

The managers of an enterprise need accounting information for planning, control, evaluation of

performance and decision-making. Their main responsibility is to operate the business so as to

obtain maximum return on capital employed without causing any detriment to the interest of the

stakeholders.

1.4 PRINCIPLES OF ACCOUNTING:

Accounting is a system evolved to achieve a set of objectives. The objective being able to

communicate accounting information, to its users. In order to achieve the goals, we need a set

of rules or guidelines. These guidelines are termed here as Basic Accounting Principles.

In order to ensure authenticity, and comparability in the matter of recording and interpretation

of Accounts, Accounting Principles are followed. These Principles can be divided into

Concepts and Conventions. The following few paragraphs deal with these concepts and

conventions.

1.4.1 ACCOUNTING CONCEPTS:

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The term `concepts’ includes those basic assumptions or conditions upon which the science of

accounting is based. The following are the important accounting concepts. The term Concept

means an idea or thought. Basic Accounting Concepts are the fundamental ideas or basic

assumptions underlying the theory and practice of financial accounting.

1. Separate Entity Concept:

Business is treated separate from the proprietor. All the transactions are recorded in the books

of business and not in the books of the proprietor. The proprietor is treated as a creditor for the

business. When he contributes capital he is treated as person who has invested his amount in

the business. Therefore, capital appears in the liabilities of balance sheet of the Organisation.

The concept of separate entity is applicable to all forms of business organizations. For

example, in case of a partnership business or sole proprietorship business, though the partners

or sole proprietor are not considered as separate entities in the eyes of law, but for accounting

purposes they will be considered as separate entities. The major effects of this concept are

that:

a) Financial position of the business can be easily found out.

b) Earning capacity of business can be easily ascertained.

c) The personal affairs of the owners are not mixed up with that of the business

2. Going Concern Concept:

The assumption is that business will continue to exist for unlimited period of time. There is

neither the intention nor the necessity to liquidate the particular business venture in the

foreseeable future. On account of this concept, the accountant while valuing the assets does not

take into account sale value of assets. Moreover, he charges depreciation on fixed assets on the

basis of their expected lives rather than on their market values.

3. Money Measurement Concept:

Only those transactions are recorded in accounting which can be expressed in terms of money.

Measurement of business in terms of money helps in understanding the state of affairs of the

business in a much better way. For example if a business owns Rs.10,000 of cash, certain

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quantity of raw materials, two factories, 1,000 square feet of building space etc. These amounts

cannot be added together to produce a meaningful total of what the business owns. However, if

these items are expressed in monetary terms such as Rs.10,000 of cash, Rs.12,000 of raw

materials, Rs.2,00,000 of factories, and Rs.50,000 of building, all such items can be added and

much more intelligible and precise estimate about the assets of the business will be available.

The transactions which cannot be expressed in monetary terms fall beyond the scope of

accounting. This is also a limitation of accounting. For example, if a business has got a team of

dedicated and trusted employees, it is definitely an asset to the business but since their monetary

measurement is not possible, they are not shown in the books of the business

4. Cost Concept:

According to this concept, an asset is recorded at its cost in the books of account, i.e., the price

which is paid at the time of acquiring it. This concept is mainly applicable for fixed assets.

Current assets are not affected by it. Cost concept has the advantage of bringing objectivity in

the preparation and presentation of financial statements. In the absence of this concept the

figures shown in the accounting records would have depended on the subjective views of a

person. However, on account of continued inflationary tendencies the preparation of financial

statements on the basis of historical costs, creates problems of credibility in judging the

financial position of the business. This is the reason for the growing importance of inflation

accounting.

5. Accounting period Concept:

According to this concept, the life of the business is divided into appropriate time periods for

studying the results shown by the business after each segment. This is because though the life

of the business is considered to be indefinite (according to going concern concept), the

measurement of income and studying the financial position of the business after a very long

period would not be helpful in taking proper corrective steps at the appropriate time. It is

therefore, absolutely necessary that after each segment or time interval the businessman must

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`stop and `see back’, how things are going. In accounting such a time period or time is called

àccounting period’. It is usually one year.

Every business wants to know the result of his investment and efforts after a certain period.

Usually one-year period is regarded as an ideal for this purpose; it may be 6 months or 2 years

also. This concept helps financial position and earning capacity of one year may be compared

with another year and also in planning and increasing the efficiency of business.

6. Dual Aspect Concept:

This is the basic concept of accounting. According to this concept every business transaction

has a dual effect. The two fold aspects are Receiving of benefit and Giving of equivalent

benefit. For example, if A starts a business with a capital of Rs.10,000. There are two aspects

of the transaction. On the one hand the business has asset of Rs.10,000 while on the other hand

the business owes to the proprietor a sum of Rs.10,000 which is taken as proprietor’s capital.

This expression can be shown in the form of following equation:

Capital (Equities) = Cash (Assets)

10,000 = 10,000

The term àssets denotes the resources owned by a business while the term “Equities” denotes

the claims of various parties against the assets, Equities are of two types. They are owners’

equity and outsiders’ equity. Owners’ equity (or capital) is the claim of owners against the

assets of the business while outsiders’ equity (or liabilities) is the claim of outside parties such

as creditors, debenture-holders against the assets of the business. Since all assets of the

business are claimed by someone (either owners outsiders), the total of assets will be equal to

total of liabilities, thus:

Equities = Assets

OR

Liabilities + Capital = Assets

In the example given above, if the business purchases furniture worth Rs.5,000 out of the

money provided by A, the situation will be as follows:

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Equities =Assets

Capital Rs.10,000 = Cash Rs.5,000 + Furniture Rs.5,000

Subsequently if the business borrows Rs.30,000 from a bank, the new position would be as

follows:

Equities = Assets

Capital Rs.10,000 + Bank Loan Rs.30,000 = Cash 35,000 + Furniture Rs.5,000.

The term àccounting equation’ is also used to denote the relationship of equities to assets.

The equation can be technically stated as “for every debit, there is an equivalent credit”. As a

matter of fact the entire system of double entry book-keeping is based on this concept.

7. Matching Concept:

Every businessman is eager to make maximum profit at minimum cost. Hence, he tries to find

out revenue and cost during the accounting period. In order to ascertain the profit made by the

business during a period, it is necessary that `revenues’ of the period should be matched with

the costs (expenses) of the period. The term `matching’ means appropriate association of

related revenues and expenses. In other words, surplus made by the business during a period

can be measured only when the revenue earned during a period is compared with the

expenditure incurred for earning the revenue. On account of this concept, adjustments are made

for all outstanding expenses, accrued incomes, prepaid expenses and unearned incomes, etc.,

while preparing the final accounts at the end of the accounting period.

8. Realization Concept:

According to this concept revenue is recognized when a sale is made. Sale is considered to be

made at the point when the property in goods passes to the buyer and he becomes legally liable

to pay and not when the actual payment is made. For example, A places an order with B for

supply of certain goods yet to be manufactured. On receipt of order, B purchases raw materials,

employs workers, produces the goods and delivers them to A. A makes payment on receipt of

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goods. In this case the sale will be presumed to have been made not at the time of receipt of the

cash for the goods but at the time when goods are delivered to A.

9. Accounting Equivalence Concept:

The proprietor provides funds for acquisition of assets. Hence the assets owned by the business

must be equal to the funds provided by the proprietor. Funds provided by the proprietor are

called equity. Hence accounting equivalence concept is:

Assets = Equities

In addition to own funds, money is borrowed which is known as liability. Therefore assets are

acquired through equity and liability. Therefore, accounting equation is:

Assets = Owner’s Equity + liabilities

10. Objective Evidence Concept:

This concept relates with the verification of accounting record with Objective evidence.

Objective evidence means study of those documents and vouchers on the basis of which

accounting record has been made. This helps a lot in auditing of accounts and Account remains

free from error and fraud due to existence of vouchers, documents etc.

1.4.2 ACCOUNTING CONVENTIONS:

The term `convention’ includes those customs or traditions which guide the accountant while

preparing the accounting statements. The following are the important accounting conventions:

Convention of Consistency

Convention of Conservatism.

Convention of Full Disclosure.

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Convention of Materiality.

1. Convention of Consistency:

Continuance of same practice for number of years indicates consistency. Whatever accounting

practice has been adopted in one year, the same should be continued in future years also. If

depreciation is charged on fixed assets according to diminishing balance method, it should be

done year after year. This is necessary for the purposes of comparison. However, consistency

does not mean inflexibility. It does not forbid introduction of improved accounting techniques.

If better method is found, it must be followed, but a note for making a change must be in the

accounts. The biggest advantage of this convention is that it facilitates comparison of one

year’s accounts with other years.

2. Convention of Conservation:

Future is uncertain. Though projections may be made about future events, no one can forecast

future with perfect certainty in business. Therefore some arrangement or provision is made to

meet future uncertainties. Every sincere businessman makes an estimate of future losses and

then some provision for it e.g., provision for bad debts is made. However, businessmen mostly

ignore the items of future profits. This tendency is termed as conservatism. Therefore, the

common accounting practices are:

o Do not consider any income or gain till the same is realized in cash.

o Create or make a provision for future expected losses and contingencies on the

basis of past experience.

The convention of conservatism has become target of serious criticism these days especially on

the ground that it goes against the convention of full disclosure. It also gives room to the

accountant to create secrete reserves (e.g. by creating excess provision for bad and doubtful

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debts, depreciation etc.), and the financial statements do not depict a true and fair view of state

of affairs of the business.

3.Convention of Full Disclosure:

Accounting records and statements should be honest and materially informative, Exclusion of

material facts makes them incomplete and unreliable. This convention is gaining more

importance because most of big businesses are run in the form of joint stock companies where

ownership is divorced from management. The Companies Act, 1956, not only requires that

Income Statement and Balance Sheet of a company must give a true and fair view of the state of

affairs of the company but it also gives the prescribed forms in which these statements are to be

prepared. The practice of appending notes to the accounting statements (such as about

contingent liabilities or market value of investments) is pursuant to the convention of full

disclosure. This is done to benefit the proprietor and all those outsiders who are interested in

assessing the efficiency of financial position of the business unit.

4.Convention of Materiality:

Materiality means relative importance. Whether a matter should be disclosed or not in the

financial statements depends on its materiality, i.e., whether it is material or not. According to

this convention accounting record should be made of all material facts. Immaterial items may

either be clubbed with material items and then recorded or these may be ignored. For example

purchase of a waste paper basket, might amount to purchase of a capital asset, since this lasts

for more than a year, but by virtue of the amount involved, it is better treated as revenue

expenditure. Thus, the term `materiality’ is a subjective term. The accountant should regard an

item as material if there is reason to believe that knowledge of it would influence the decision

of the informed investor.

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1.5 SOME IMPORTANT TERMS USED IN BOOK – KEEPING: Before you get into the

specifics of Accounting, you should be familiar with some of the terms which are generally

used in Accounting. A few of them are given below:

Business Transactions: Any exchange of money or money’s worth is called business

transaction. Events like purchase and sale of goods, receipts and payments of cash for

services or on personal accounts are the examples of transactions. When payment for

business activity is made immediately, it is called cash transaction, but when the

payment is postponed to a future date, it is called a credit transaction.

Debtor: A debtor is a person who owes something to the business

Creditor: A creditor is a person to whom something is owing, by the business.

Debit and Credit: To debit an account means to enter the transaction on the debit side

of that account. To credit an account means to enter the transaction on the credit side

of that account.

Capital: It is the amount invested by the proprietor in the business. For the business,

capital is a liability towards the owner. Sometimes it is called òwner’s equity’ i.e.

owners claim against the assets. Owner’s equity or capital is always equal to assets

minus liabilities.

Drawing: It is the value of cash or goods withdrawn from the business by the owner

for his personal use.

Goods: It includes all commodities or articles in which a trader deals.

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Assets: These are the material things or possessions or properties of the business

including the amounts due to it. Examples are Cash and Bank balances, Land and

Building, Plant and Machinery etc.

Liabilities: The term liabilities denote the amounts which the business owes to others

such as loan from bank, creditors for goods supplied, for outstanding expenses etc.

Accounts: An account is a summary of the record of all the transactions relating to a

person, asset, expense or gain. It has two sides-the left hand side called the debit side

and the right hand side called the credit side.

Accounts are of three types Personal, Real and Nominal accounts:

Personal Accounts:

These are the accounts of natural persons (such as Ram”s accounts, Gopal’s account)

artificial persons (such as Uday Ltd., Syndicate Bank’,) and representative personal

account (such as Prepaid Insurance account, outstanding salary account) with whom

the trader deals)

Real Accounts:

Accounts relating to properties or assets of a trader are known as real accounts. It

includes tangible assets such as building, furniture, cash etc., and also intangible

assets such as goodwill, trade marks, patent rights

Nominal Accounts:

Accounts dealing with expenses, losses, gains and incomes are called Nominal

Accounts, e.g. salaries account, wages account, commission account etc.

Real and Nominal Accounts are also called Impersonal accounts because they

do not affect any particular person but affect business in general.

1.6 SUMMARY:

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Accounting can be defined as, àn art of recording, classifying and summarizing in a significant

manner and in terms of money, transactions and events which are, in part at least of a financial

character, and interpreting the result thereof.” Accounting is a system evolved to achieve a set

of objectives. The objective is to communicate accounting information to its users. In order to

achieve the goals, we need a set of rules or guidelines. These guidelines are termed here as

Accounting Principles. The importance of accounting is to provide meaningful information

about a business enterprise to those persons who are directly or indirectly interested in the

performance and financial position of business enterprise. Such persons may include owners,

creditors, investors, employees, government, public, research scholars and the managers.

1.7 KEY WORDS:

Double Entry System of Book Keeping Separate Entity Concept

Going Concern Concept Money Measurement Concept

Cost Concept Accounting period Concept

Dual Aspect Concept Matching Concept

Realization Concept Accounting Equivalence Concept

Objective Evidence Concept Convention of Consistency

Convention of Conservatism. Convention of Full Disclosure.

Convention of Materiality.

Try yourself:

1. Explain the principles of Accounting.

2. Discuss important Accounting Concepts

3. Explain the significance of Accounting conventions.

4. Who are the users of Accounting information?

FURTHER READINGS:

Jain S.P. and Narang, K.L., .Advanced Accountancy, Kalyani Publishers

Mukherjee & Khan, Modern Accountancy, Tata Mcgraw Hill

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LESSON 2 ACCOUNTING CYCLE - I

STRUCTURE

STRUCTURE:


2.2 Journal

2.3 Ledger

2.4 Subsidiary Books- Division Of Journal

2.5 Trial Balance

2.6 Accounting Cycle

2.7 Summary

2.8 Key Words

2.1 INTRODUCTION:

As discussed in the first chapter, businesses aim at earning profit. Entities which do not have

profit earning as an objective also aim to be financially viable. Therefore, earning a profit or

being viable is an important objective which is pursued by all organizations. However, it is

not possible to ascertain whether operations have been viable or not, unless a proper record of

all the transactions is kept in a systematic way.

OBJECTIVES:

Explain importance of Journal, be able to record transactions in the journal

Know the importance of Ledger, be able to do the ledger posting, and Balance the accounts

Describe the importance and utility of Subsidiary books. Prepare the trial balance

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Maintaining such a systematic record of all transaction is called book-keeping and when such

record-keeping moves on to classifying and summarizing, preparation of final reports and

interpretation, we call it accounting.

In India, Accounting had been practised as far back as Mauryan Dynasty times which we can

see from Kautilya’s Artha Shastra. However, the present day accounting has its origins in

Luco Pacioli’s Double Entry System of Accounting. In this chapter, we shall learn to

journalise, and post it into the ledger. The two steps mark the beginning of the Accounting

cycle.

2.2 JOURNAL :

Journal is the book wherein a business transaction is first written or recorded and therefore it

is also known as book of Original Entry. In the French language Jour means day. Journal

therefore is a book where day to day transactions are written. Journal is written

chronologically i.e., it is written date wise, for example; transaction relating January 1 are first

written followed by January 2, January 3 and so on. Journal has columns for Date,

Particulars, Ledger Folio, Debit and Credit. The format is as follows:

Date Particulars LF Debit Amount Credit Amount

1999 Jan 1

1999 Jan 2

1999 Jan 3

In the date column, date of the transaction is recorded, in the particulars column details

relating to the accounts affecting the transaction are recorded. Both the debit and credit

aspects of the transaction are recorded. The Amounts column relating to the debit and credit

are placed side by side. Each transaction entered in the Journal is known as Journal Entry and

the act of entering or writing the transaction in the Journal is known as journalizing. A

Journal Entry is written in a specific form in which account relating to debit is written in the

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first line and Account relating to Credit is written in the second line. While writing the

second line a little space is left and then written as given under.

Date Particulars LF Debit Amount Credit Amount

Ravi’s A/c Dr. 5000

To Cash 5000

Each Journal entry is followed by a narration given in brackets. Narration is the explanation

about the journal entry. For E.g.:

Date Particulars LF Debit Amount Credit Amount Ravi’s A/c Dr.

To Cash

(Paid Cash to Ravi)

5000 5000

While Journalizing the transaction the rules of journalizing need to be followed. The rules of

journalising accounts are as follows:

Personal Accounts (A/cs relating to persons

Debit the Receiver Credit the giver

Real Accounts (A/cs relating to assets)

Debit what comes in Credit what goes out

Nominal Accounts (A/cs relating to expenses, losses, income and gains)

Debit all expenses and losses

Credit all incomes and gains

STEPS TO BE FOLLOWED:

1) Identify the accounts being affected in the transaction.

2) Categorize them into real, nominal and personal

3) Apply the relevant rules of debit and credit

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However, in order to journalize it is very important that you should be to identify and classify

the accounts into proper categories. You should know the category into which a particular

account falls. For example you should know whether Capital Account is a personal account,

nominal account or a real account, only then you can apply the rule related to that category.

Consider, Cash since it is a real account you should apply the rules relating to real account.

And again take Rent since we know that it is a nominal account rules of debit and credit

relating to nominal accounts need to be applied while journalising the transactions. Personal

Accounts relate to Accounts relating to persons. Persons could mean individuals, business

organization, a sole proprietary concern, partnership firm, and so on. It could be a bank, an

educational, institution, a hospital or any institution. The term person includes a natural

person as well as an artificial person.

Real accounts relate to assets. They could be land, building, motor car, machinery, furniture,

cash, goodwill, patents and so on. Assets could be Tangible or intangible. Examples of

intangible assets could be good will, patents, trade and so on.

Nominal accounts relate to expenses, losses, incomes and gains. For eg: Rent, Interest, Salary.

Having understood the meaning of a journal, the rules of journalizing, the style of writing a

journal entry, the format of a journal, the various type of accounts, we shall now try to enter or

write sample business transactions into a Journal.

January 1, 2005 – Ravi Started business with Cash Rs.50000

In this business transaction it is obvious that Cash A/c is affected. We see that Cash is being

brought into the business. So the first account that is affected is Cash and the other is the

Personal A/c of the owner which is called as Capital.

Now since Cash is a real account the rules of debit and credit relating to Real accounts need to

be applied. And the rule is debit what comes in and credit what goes out. We see here that

cash is coming into the business and so we need to debit the Cash A/c.

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The other account affected is the Capital A/c. Capital being a personal account, the rule of

personal a/cs need to be applied. And the rule is debit the receiver and credit the giver. Here

the owner of the business is supplying or giving capital to the business. It may be noted that

business unit is separate from the owner. Therefore we credit the capital a/c of the owner. So

the journal entry will be written thus:

Date Particulars LF Debit Amount Credit Amount Jan 1, 2005 Cash A/c Dr.

To Capital A/c (Being Capital brought in)

50000 50000

If the name is not given it may be written as Cash A/c Dr. To Capital Account.

January 2, 2005 – Bought Furniture Rs.2000

In this transaction you see that one of the accounts is Furniture, the other being Cash. How do

you know that Cash is the other account. It is because you cannot buy anything without

paying. If you have bought furniture it means that you have paid for it. Suppose you feel that

it could be a credit transaction. Then it may be remembered that if it were a credit

transaction, the name of the concern, selling on credit would be given. Since it is not given

we may safely assume that the two accounts affected in this transaction are Furniture A/c and

Cash A/c.

Analysis: After identifying that the two accounts Furniture and Cash are Real accounts

apply the rules of real accounts. Furniture is coming into the organization, debit it. Credit the

cash a/c since it is going out of the organization.

Date Particulars LF Debit Amount Credit AmountJan 2,2005 Furniture A/c Dr.

To Cash A/c (Being Furniture purchased)

2000 2000

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January 3, 2005 Rent paid Rs. 1000

The accounts affected here are Rent and Cash. While Rent is a nominal account (since it is an

expenditure) Cash is a real A/c. Treat Rent as per nominal account rule. Debit all expenses,

rent should therefore be debited. As per Real A/c Rules Credit what goes out, therefore credit

cash account.

Date Particulars LF Debit Amount Credit AmountJan 3, 2005 Rent A/c Dr.

To Cash A/c (Being the rent paid)

1000 1000

It may be noted here, that to whom the Rent is paid is not so important when Cash has

changed hands.

Now having understood the procedure of writing business transactions in a Journal, it is now

the time to get thorough with it. Therefore the following illustrations:

(1) Brought into business Cash Rs.50000, Land Rs.100000, building Rs.250000,

Furniture Rs.20000, Machinery Rs.200000

Date Particulars LF Debit Amount Credit AmountFeb 1, 2005 Cash A/c Dr. 50000 Land A/c Dr. 100000 Building A/c Dr. 250000 Furniture A/c Dr. 20000 Machinery A/c Dr. 200000 To Capital A/c 620000 (Being Capital Brought in)

It may be noted that in Double Entry System of book-keeping, Debit = Credit therefore sum

of all debits (6,20,000) should be equal to a single credit in the above transactions.

Incidentally it may be noted that an entry where there are more than one debit or one credit it

is called combined or a composite entry.

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(2) Purchases Rs.30000

Date Particulars LF Debit Amount Credit AmountFeb 2, 2005 Purchases A/c Dr.

To Cash A/c (Being purchases made or goods purchases)

30000 30000

When goods are purchased they may also be referred to as purchases. That is the reason we

have debited it as purchases rather than as goods.

(3) Purchases from Mohan Raj Rs.45,000


To Mohan Raj A/c (Purchases on credit from Mohan Raj)

45000 45000

Note: It may be noted here that while in the previous entry Cash has been credited, here

Mohan Raj’s name has been credited. That’s because it is a credit transaction (so understood

because the name of the person has been given). In this case cash has not gone out Mohan

Raj’s A/c is a personal account and since Mohan Raj has given the goods and the rule is

credit the giver therefore his name has been credited.

(4) Purchases from Mohan Raj for Cash Rs.35000


To Cash A/c (Being the purchases made on Cash)

35000 35000

Note: How does one know that it is a Cash transaction because it so mentioned. Although

the name of the person transacting is given it is clearly mentioned that it is a Cash transaction

and so Mohan Raj’s name recedes into the background. It is not to be recorded.

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(5) Sales Rs. 25000

Date Particulars LF Debit Amount Credit AmountFeb 5, 2005 Cash A/c Dr.

To Sales A/c (Being Cash Sales made)

25000 25000

(6) Sale made to Ravi Rs.15000

Date Particulars LF Debit Amount Credit AmountFeb 5, 2005 Ravi’s A/c Dr.

To Sales A/c (Being Sales made on Credit to Ravi)

15000 15000

(7) Sale made to Ravi Rs.20000 for Cash


To Sales A/c (Being Cash Sales made to Ravi for Cash)

20000 20000

(8) Machinery purchased Rs.60000

Date Particulars LF Debit Amount Credit AmountFeb 7, 2005 Machinery A/c Dr.

To Cash A/c (Being Machinery Purchased)

60000 60000

It may be noted here that debit is given to machinery and although it is a purchase, purchases

a/c is not debited; because the name of the asset that is machinery is specified and it is to be

differentiated from “Purchases” or “Goods” meant for resale.

23

(9) Sale of Land Rs.500000


To Land A/c (Being Sale of Land)

50000 50000

(10) Cash Withdrawn for Office Use Rs.30000


To Bank A/c (Being Cash withdrawn from Bank for Office use)

30000 30000

(11) Cash withdrawn for personal use – Rs.10000

Date Particulars LF Debit Amount Credit AmountFeb 9, 2005 Drawings A/c Dr.

To Bank A/c (being Cash withdrawn for personal use)

10000 10000

Note: The above drawings are meant for personal use of the entrepreneur and not for office,

so Cash is not entering the Office, therefore Cash is not entered as a debit instead drawings is

to be debited, because to that extent the owner owes to the business.

(12) Rent paid Rs. 750

Date Particulars LF Debit Amount Credit AmountFeb 10, 2005 Rent A/c Dr.

To Cash A/c (Rent paid)

750 750

(13) Rent paid to Shyam Rs.8000

Date Particulars LF Debit Amount Credit AmountFeb 11, 2005 Rent A/c Dr.

To Cash A/c (Rent paid)

8000 8000

24

In the above transaction although name is given since Rent A/c is more important, which is an

expense; therefore rent is debited.

(14) Interest Received Rs.2000


To Interest A/c (Being Interest Received)

2000 2000

(15) Commission Received Rs. 1500


To Commission A/c (Being Commission Received)

1500 1500

(16) Interest on Capital Rs.800

Date Particulars LF Debit Amount Credit AmountFeb 15, 2005 Interest on Capital A/c Dr.

To Cash A/c (Being Interest paid on Capital)

800 800

2.3 LEDGER:

Ledger is a book where account wise information is documented. While the Journal gives data

in chronological form, the ledger gives account wise information. All the transactions related

to a particular account are put at one place. For e.g., if you would like to know the

transactions you carried out with your customer Ravi you need not search throughout the

journal to trace out transactions relating to Ravi instead you go to ledger and locate Ravi’s

A/c thereon and find all the transactions relating to Ravi. It is more useful than the day to day

information provided in the journal. Ledger is the second stage in the Accounting cycle.

From the journal transfer is made into the ledger under various heads of account. This

process of transfer is known as Ledger posting.

25

HOW IS LEDGER POSTING DONE:

Various accounts which are found affected in the journal are opened in the ledger. An

account is in T form. On either side of the account debit and credit aspects are shown. The

name of the account is given on the top. The debit aspects relating to the account are recorded

on the left side, while Credit aspects are recorded on the right side as shown below:

Name of the Account

Debit side Credit side

On debit side, ‘To’ is used as a prefix of the account while on the credit side the word ‘By’ is

prefixed. A look at the Format shall further clarify this:

NAME OF THE ACCOUNT

Dr. Cr.

Date Particulars Dr. side

JF Amount Rs.

Date Particulars Cr. Side

JF Amount Rs.

To … Name of the A/C

By …… Name of the A/c

Now let us post some Journal entries into the ledger.

Example:1

JOURNAL

Date Particulars JF Amount Amount 1.10.2005 Cash A/c – Dr.

To Capital (Being capital brought in)

1,00,000=00 1,00,000=00

2.10.2005 Purchases A/c – Dr. To Cash (Being purchase made)

15,000=00 15,000=00

3.10.2005 Cash A/c – Dr. To Sales (Being Sales made)

20,000=00 20,000=00

Treatment:

26

LEDGER CASH A/C

Dr. Cr.

Date Particulars JF Amount Rs.


1st Oct 2005

To Capital 100000 2nd Oct 2005

By Purchases 15000

3rd Oct 2005

To Sales 20000

CAPITAL A/C Dr. Cr.



1st Oct 2005

By Cash 100000

PURCHASES A/C Dr. Cr.



2nd Oct 2005

To Cash 15000

SALES A/C

Dr. Cr.



3rd Oct 2005

By Cash 20000

It may be noted from the above that in the first transaction cash A/c is showing a debit balance.

Therefore in the Cash A/c the transaction is written on the debit side. It may be noted that

27

when the name of the account having the credit balance is written Viz: in the Cash A/c it is

written as To Capital Account. Whereas in the capital account which shows credit balance it is

written as By Cash A/c on the credit side.

In the second transaction purchases A/c is showing a debit balance and therefore in the

purchases A/c the transaction is written on the debit side as ‘To Cash A/c. Whereas in the

Cash A/c which is showing credit balance it is written as “By purchases”.

In the third transaction Cash A/c is showing a debit balance and therefore on the debit side of

the cash account it is written as ‘To Sales’, while in the Sales A/c it is recorded as ‘By Cash’.

From the above three transactions it is seen as to how ledger posting or transfer of transaction

is made from the journal to the ledger.

Example: 2

Journalise the following transactions and post them in the Ledger:

• Capital brought in Rs.50,000

• Purchases Rs.10,000

• Purchases from Ravi Rs.5,000

• Sales Rs. 8,000

• Sales to Mohan Rs.7,000

JOURNAL

Date Particulars LF Dr. Cr. Cash A/c – Dr.

To Capital A/c (Being Capital brought in)

50,000 50,000

Purchases A/c – Dr.

To Cash A/c

(Being purchases made for Cash)

10,000 10,000

28

Mohan A/c – Dr.

To Sales A/c

(Being Cash Sales made)

7,000 7,000

Cash A/c – Dr.

To Sales A/c

(Being Cash Sales made)

8,000 8,000

Purchases A/c – Dr.

To Ravi A/c

(Purchases made on Credit)

5,000 5,000

CASH A/C

Dr. Cr.

Date Particulars Amount Date Particulars Amount To Capital 50000 By Purchases 10000 To Sales 8000 By Balance C/d 48000 Total 58000 Total 58000

CAPITAL A/C

Dr. Cr.

Date Particulars Amount Date Particulars Amount To Balance C/d 50000 By Cash 50000 Total 50000 Total 50000

PURCHASES A/C

Dr. Cr.

Date Particulars Amount Date Particulars Amount To Cash 10000 By Balance c/d 15000 To Ravi 5000 Total 15000 Total 15000

29

SALES A/C

Dr. Cr.

Date Particulars Amount Date Particulars Amount To balance c/d 15000 By Cash 8000 By Mohan 7000 Total 15000 Total 15000

RAVI A/C Dr. Cr.

Date Particulars Amount Date Particulars Amount To Balance c/d 5000 By Purchase 5000 Total 5000 Total 5000

MOHAN A/C Dr. Cr.

Date Particulars Amount Date Particulars Amount To Sales 7000 By Balance c/d 7000 Total 7000 Total 7000 A brief explanation of how the above entries are posted in the ledger is given below:

In the first transaction we see that Cash A/c is showing a debit balance. Therefore in the Cash

A/c we write “To Capital A/c on the debit side. Capital A/c is showing a credit balance

therefore on the credit side of the capital a/c we write “By Cash”. Similarly in the second

transaction purchases a/c is showing a debit balance and so on the debit side of purchase a/c

we write To Cash and since cash a/c is showing credit balance we write “By purchases” in the

Cash A/c. The other transactions are also posted on the same lines.

In the above manner all the transactions in the journal are referred to and transactions relating

to a particular account are written under that particular head. After such posting is done the

debit and the credit side are totaled up separately to find out which side is heavier. If the debit

side of an account is more than that the credit side of that particular account it is said to

possess debit balance. If the credit side is heavier the account is said to have credit balance.

30

It is very important to know which side of the account is heavier, because it explains the

position of the account. For eg: Consider the following Cash A/c.

CASH A/C.

Dr Cr. Date Particulars Amount Date Particulars Amount

To Balance B/d 30000 By Purchases 10000

To Sales 15000 By Salaries 2000

To Ravi 8000 By Rent 3000

To Commission 3000 By Interest 5000

Total 56000 Total 20000

We see in the above account that the Debit side has total of Rs.56,000 whereas the credit side

has a total of Rs.20000. It is obvious that the debit side is heavier by Rs.36,000. Therefore it

is said that the Cash A/c has a debit balance, the balance being Rs.36000. Debit balance in

the Cash A/c (Rs.36000) implies that in the Cash A/c there is still a balance of Rs.36000 and

it is carried down (C/d) to the next period. That’s why it is written as By Balance C/d. In the

beginning of the next period it is written as to Balance B/d meaning to say that balance has

been brought down from the previous period. Suppose you are closing the account on 31st

January, the balance is carried down on that day and is shown as an opening balance in the

next period. Look at the account shown hereunder:

CASH A/C Dr. Cr.

Date Particulars Amount Date Particulars Amount

To Balance B/d 30000 By Purchases 10000

Jan 2005 To Sales 15000 Jan 2005 By Salaries 2000

To Ravi 8000 By Rent 3000

To Commission 3000 By Interest 5000

31.1.05 By Balance C/d 36000


1.2.05 To Balance b/d 36000

31

What do Debit and Credit Balances mean:

1. If a personal account shows a debit balance it means that the person is a debtor which

means he has to pay money to the firm. If it shows a credit balance he has to receive

money from the firm.

2. If Real accounts show debit balance it means that the firm owns property or asset to

the extent of balance in the account

3. If a nominal account shows a debit balance it means than an expense or loss to that

extent has been incurred by the firm and vice versa.

Posting of a compound entry:

Consider the following Compound Entries and try to understand how these are posted.

Ex:1 Cash A/c – Dr. Rs.10000

Furniture A/c – Dr. Rs.40000

To Capital Account Rs.50000

(Being Capital brought in the form of Cash)

We see that there are two debits for one credit in such a case three accounts are opened. Cash

A/c, Furniture A/c and Capital A/c. Cash A/c shows a debit against the credit of capital

account. Furniture A/c also shown a debit against the credit of Capital A/c which shows a

Credit balance has two details: the Cash A/c and Furniture A/c. Therefore in the Cash A/c

since it is showing the debit balance, on the debit side of the Cash A/c it is written as “To

Capital”. In the Furniture A/c which is also showing debit balance it is written as To Capital

Rs.40000.

In the Capital A/c which has two debits it is written as By Cash Rs.10000 and By Furniture

Rs.40000. Please examine the following accounts.

32

CASH A/C Dr. Cr.

Date Particulars Amount Date Particulars Amount To Capital 10000 By Purchases 10000

FURNITURE A/C Dr. Cr.


To Capital 40000 By Purchases 10000

CAPITAL A/C Dr. Cr.


By Cash 1000

By Furniture 40000

2.4 SUBSIDIARY BOOKS - DIVISION OF JOURNAL

Journal is the book of original entry or the main book where in business transactions are

entered in a chronological order. But when the transactions are too many, quick location of a

particular transaction may not be easily done. Therefore, Journal is divided into 8 parts or

eight subsidiary books viz:

1) Cash Book

2) Purchases Book

3) Sales Book

4) Purchase Returns

5) Sales Returns

6) Bills Receivable

7) Bills payable

8) Journal proper

33

Thus subsidiary books are parts or sub-divisions of a journal. The following paragraphs explain

more about the individual Subsidiary Books.

CASH BOOK

The Cash Book records transactions dealing with receipts and payments of cash. The Format

is given below:

CASH BOOK

Date Receipts L/F Amount Date Receipts L/F Amount

Rs. Rs.

Here it may be seen that a Cash Book looks like a Cash Account. The Cash Book is different

from other subsidiary books since it is two sided. It records two aspects, the receipts aspect as

well as the payments aspect. It serves both the purpose of a journal and also a ledger.

PURCHASES BOOK

The Purchase Book records all the Credit purchases, the Voucher No. Invoice No the Name of

the Creditor and then amount of Purchases are given. The Format of the Purchase Book is

given below:

PURCHASE BOOK

Date Name of the Creditor L/F Invoice No. Amount in Rs.

34

SALES BOOK

The Sales Book, also called the Day Book, records all the Credit Sales. The Voucher No. the

Name of the Debtor and the amount of sales are recorded. The format of the Sales Book is

given below:

SALES BOOK

Date Name of the Debtor L/F Invoice No. Amount in Rs.

PURCHASE RETURNS BOOK

The Purchase Returns Books records all the Returns made out of Credit Purchases. The

format of the purchase returns is given below.

PURCHASE RETURNS BOOK

Date Debit No. Name L.F. Amount in Rs.

Debit Note: It is a note made out in duplicate. The duplicate copy is kept for office record

and the original one is sent to the seller. The party’s account is debited with the amount

written in the purchase returns book.

SALES RETURNS BOOK

Sales Returns Book shows the goods returned by the customers to whom goods have been

sold. The format of the sales return book is given below:

35

SALES RETURNS BOOK

Date Credit Note. Name L.F. Amount in Rs.

Credit note is also like a debit note. It is also made out in duplicate. The duplicate copy is

kept for office record.

BILLS RECEIVABLE BOOK

Bills Receivable Book records the amounts receivable against Bills or exchange by the

business receivable lying with us. The format of the Bills Receivable Book is given below:

BILLS RECEIVABLE BOOK

Date Drawee Tenure Payable at Due Date

BILLS PAYABLE BOOK

The Bills payable book records all the bills payable by the business. The format is given

below.

BILLS PAYABLE BOOK

Date Drawer/Payee Tenure Payable at Due Date

36

JOURNAL PROPER:

This books makes a record of certain special entries like opening Entries, Closing entries,

adjustment entries and rectification entries, transfer entries, Entries relating to dishonour of

promissory notes withdrawal of goods by the proprietor for personal use or loss of goods by

theft, fire etc., Credit purchase of Sale of assets; Bad debts etc., Those transactions which

cannot be entered in any of the seven specific subsidiary books, get entered in the Journal

Proper.

2.5 TRIAL BALANCE:

The fundamental principle of Double Entry System of Book Keeping is that for every debit

there must be a corresponding credit. It follows, therefore, that the sum total of debit amounts

should equal the sum total of credit amounts of ledger at any date.

Trial Balance is a statement of all the debit and credit balances. It is basically prepared to

check the arithmetical accuracy. It is prepared from the balances obtained from the Ledger.

However, it may be noted that the agreement of the Trial balance is not a conclusive proof of

accuracy. Although it points out certain errors, several errors may remain undetected even

after the preparation of the trial balance.

TRIAL BALANCE – THE LINK:

The agreement of the Trial Balance reveals that both the aspects of each transaction have been

recorded and that the books are arithmetically accurate. If the Trial Balance does not agree, it

shows that there are some errors, which must be detected and rectified before the final

accounts are prepared. Thus, Trial balance forms a connecting Link between the ledger

accounts and the final accounts. It is the third stage in the accounting cycle.

37

A specimen of Trial Balance is given below:

TRIAL BALANCE OF _______________ AS ON: _____________

S.No. Name of the Accounts Dr. Balance Cr. Balance

As already said the trial balance may agree and yet there may be some errors. The following

types may remain undetected, even after the tallying of Trial Balance.

i) Omission of an entry in a subsidiary book

ii) A wrong entry in a subsidiary book

iii) Posting an item to the correct side but in the wrong account

iv) Compensating errors

v) Errors of principle

PREPARATION OF TRIAL BALANCE:

Let us take a small example to understand and how a trial balance is prepared. From the

following balances taken from the ledger of Sri Ltd., prepare a trial balance as on 31-3-2004:

Opening Stock 24000 Carriage inwards 100 Traveling Expenses 775 Returns inwards 1200 Rent & Taxes 1050 Sales 42000Salaries & Wages 3145 Purchases 31500Freight out wards 130 Disallowed 450 Discount received 220 Capital Account 57000Commission paid 216 Drawings Account 9000 Bank Account 12054 Bills receivable 16000Sundry debtors 13600 Bills payable 4000 Trade creditors 10000 Closing stock 31600

38

TRIAL BALANCE OF SRI LTD.,AS ON 31-03-2004 Debit

Balances Rs.

Credit Balances Rs.

Opening Stock 24000 Travelling Expenses 774 Rent & Taxes 1050 Salaries & Wages 3144 Freight outwards 130 Bills payable 4000 Carriage Inwards 100 Returns Inwards 1200 Sales 42000 Purchases 31500 Discount allowed 450 Discount received 220 Commission paid 216 Bank account 12054 Sundry debtors 13600 Trade creditors 10000 Capital account 57000 Drawings account 9000 Bills receivable 16000 Total 1,13,220 1,13,220

Note: Closing stock is already included in Purchases and therefore should not be shown in the

Trial Balance. It should be given as an adjustment while preparing Final Accounts.

2.6 ACCOUNTING CYCLE:

Ledger

Journal Trial Balance

Final Accounts

The accounting cycle shows that a business transaction is first entered into Journal, the book

of original entry. From there it is transferred or posted to the Ledger. From the Ledger

39

Balances a Trial Balance is prepared. Trial balance is a statement of debits and credits. From

these balances the Final Accounts are prepared. Thus it may be remembered that the

Accounting Cycle starts with Journal and ends with the Final Accounts. At the Journal stage

documentation of the Business transactions is done, while at the Ledger stage account wise

information is obtained and summarized and at the Trial Balance stage List of Debit and

Credit balances is obtained to check the arithmetical accuracy and at the final accounting

stage the profit or loss position of the business is found out.

2.7 SUMMARY:

Maintaining a systematic record of all transaction is called book-keeping and when such

record-keeping moves on to classifying and summarizing, preparation of final reports and

their interpretation, we call it accounting. Journal is the book wherein a business transaction

is first written or recorded and therefore it is also known as book of Original Entry. Steps to

be followed while journalizing are: Identify the accounts being affected in the transaction;

Categorize them into real, nominal and personal and; apply the relevant rules of debit and

credit. Ledger is a book where account wise information is documented. While the Journal

gives data in chronological form, the ledger gives account wise information. All the

transactions related to a particular account are put at one place .

Journal is the book of original entry or the main book where in business transactions are

entered in a chronological order. But when there are too many transactions, Journal is divided

into 8 parts or eight subsidiary books. Thus subsidiary books are parts or sub-divisions of a

journal. Trial Balance is a statement of all the debit and credit balances. It is basically

prepared to check the arithmetical accuracy. It is prepared from the balances obtained from

the Ledger.

2.8 KEY WORDS: Journal Journalising

Narration Real Account

Nominal Account Personal Account

Ledger Ledger Posting

40

Balancing Debit Balance

Credit Balance Subsidiary Books

Trial Balance

Try Yourself:

1. Journalize the following transactions in the books of Mr. Joy.

April 1, 2004 Capital brought in Rs. 100000

April 2, 2004 Bought Machinery Rs. 50000

April 3, 2004 Purchased Good Rs. 25000

April 5, 2004 Sales Rs. 10000

April 6, 2004 Sales to Shalom Rs. 15000

April 7, 2004 Purchases from Princy Rs. 20000

April 8, 2004 Received to Divya Rs. 15000

April 9, 2004 Received Interest Rs.5000

April 10, 2004 Received Commission Rs.3000

April 11, 2004 Bought Furniture from Teja Ltd on Credit Rs. 10000

April 15, 2004 Paid Salaries Rs.5000

2. Bank A/c Dr. 56000 Discount Dr. 500 To Bills Receivable 5500 Post the above entries.

3. Given below is a Cash account, point out whether Cash book shows Debit or Credit.

CASH A/C Dr. Cr.


1.1.04 To Balance B/d 8000 17.1.04 By Purchases 3000

15.1.04 To sales 2000 19.1.04 By Rent 1000

20.1.04 To Ramya 1000 31.1.04 By Balance C/d 7000


41

4. From the following balances prepare the Trial Balance of MJS Ltd. Purchases 1,57, 500 Sales 2,10,000 Return Inwards 6,000 Carriage Inwards 500 Freight Outwards 650 Salaries & Wages 15,720 Rent & Taxes 5,260 Traveling Expenses 3,870 Opening Stock 1,20,000 Discount allowed 2,250 Discount received 1,100 Commission paid 1,080 Bank account 60,270 Sundry Debtors 68,000 Trade Creditors 50,000 Capital Account 2,85,000 Drawings Account 45,000 Bills Receivable 80,000 Bills Payable 20,000 Closing stock 1,58,000 5. What is Journal?

6. What are the various types of accounts?

7. Explain the rules of Journalising.

8. Classify the following accounts.

a. Capital

b. Cash

c. Furniture

d. Salaries

e. Goodwill

9. What do you mean by ledger posting

10. If a personal account is showing a debit balance, what does it indicate

11. Cash Book records all ----------------------- transactions.

12. Purchases Book records ---------------------.

13. Adjustment entries are written in --------------------.

42

14. Omission of an entry in a Subsidiary book affects the agreement of Trial Balance.(Yes/

No)

15. Compensating Errors go undetected by The Trial Balance.(Yes/ No)

Answers: 1. JOURNAL OF Mr. Joy Date Particulars Debit Rs. Credit Rs. April 1, 2004 Cash A/c Dr.

To Capital A/c (Being Capital Brought)

100000 100000

April 2, 2004 Machinery A/c Dr.

To Cash A/c

(Being purchase of Machinery)

50000 50000

April 3, 2004 Purchases A/c Dr.

To Cash A/c

(Being Goods purchased)

25000 25000

April 5, 2004 Cash A/c Dr.

To Sales A/c

(Being Sales made)

10000 10000

April 6, 2004 Shalom A/c Dr.

To Sales A/c

(Being Credit Sales made to Shalom)

15000 15000

April 7, 2004 Purchases A/c Dr.

To Princy A/c

(Being Credit purchases made)

20000 20000

43


To Sales A/c

(Being Sales made)

15000 15000


To Sales A/c

(Being Sales made)

5000 5000


To Commission A/c

(Being Commission received)

3000 3000

April 11, 2004 Furniture A/c Dr.

To Teja Ltd A/c

(Furniture purchased on Credit)

10000 10000

April 15, 2004 Salaries A/c Dr.

To Cash A/c

(Being Salaries paid)

5000 5000

2. BANK A/C

Dr. Cr.


To Bills

Receivable

5000

DISCOUNT A/C Dr. Cr.


To Bills receivable 500

44

BILLS RECEIVABLE A/C Dr. Cr.


By Bank 5000

By Discount 500

4. Total of Trial Balance – Rs 5,66,100.

8. (a) Personal A/c, (b) Real A/c, (c) Real A/c, (D) Nominal A/c (e) Real A/c.

11. Cash

12. Credit Purchases

13. Journal Proper

14. Yes

15. Yes

FURTHER READINGS: Jain S.P. and K.L. Narang, Fundamentals of Accounting, Kalyani Publishers

Jawaharlal, Financial Accounting, Wheeler Publishing

Nitin Balwani, Accounting and Finance for Managers, Excel Books

45

LESSON 3

ACCOUNTING CYCLE-II (FINAL ACCOUNTS)

STRUCTURE:

3.1 Introduction

3.2 Capital and Revenue Items

3.3 Profit & Loss Account

3.4 Balance Sheet

3.5 Adjustments

3.6 Summary

3.7 Key Words

3.1 INTRODUCTION:

The final stage in the accounting cycle is the preparation of final accounts. It is common

knowledge that the ultimate objective of maintaining accounts is to find out profit or loss

position and also the financial position of the organization concerned.

OBJECTIVES

To be able to appreciate the need for preparation of Final Accounts.

To be able to prepare the Trading A/c

To be able to prepare the Profit and Loss A/c

To be able to prepare the Balance Sheet

46

Final accounts are prepared from the debit and credit balances of the trial balance. Final

accounts are constituted of the profit and loss account (also called Income Statement) and a

statement of assets and liabilities known as the balance sheet.

3.2 CAPITAL AND REVENUE ITEMS:

It may be noted that before preparing final accounts a distinction needs to be made between

capital and Revenue items. While the revenue items are to be shown in the Profit & Loss A/c.

The Balance Sheet records all capital items in the form of the assets and liabilities as on a

particular date.

Capital Expenditure Revenue Expenditure

1) Amount spent on acquiring permanent

asset

1) Amount spent on the conduct of

business and maintenance of capital assets

2) The expenditure adds to the revenue

earning capacity of the business

2) This Expenditure may not do so

3) May add to the value of an existing asset 3) Revenue Expenditure does not add to

any value to net asset

4) shown in the balance sheet 4) Shown in the trading or profit and loss

account

3.3 PROFIT & LOSS ACCOUNT:

As already stated profit and loss A/c shows the net income or net expenditure position of the

business organisation. It consists of two parts namely: Trading A/c and (2) Profit and Loss

A/c. The preparation of the main profit and loss account begins with the Trading Account and

ends with the Profit and Loss account. While Trading Account records the balances which are

47

directly related to the manufacturing the product, the profit and loss account records the

expenses and incomes and expenses, profits and losses which are related to the business but

not directly related to the making of the product saleable.

TRADING ACCOUNT:

There is a distinction even between the Trading account and Profit and Loss A/c. The trading

accounts obtains gross profit or loss. On the debit side, items relating to opening stock,

purchases, wages, carriage, wages, fuel & power, manufacturing expenses, coal, water and

gas, motive power, octroi, import duty, custom duty, consumable, foreman/work managers

salary, Royalty on manufactured goods are taken; That is the cost of good sold is obtained.

On the credit side, sales, closing stock etc are taken. That is the value of net sales is obtained.

The difference between the sales and cost of goods sold gives the gross profit / loss position

of the concerned firm.

PROFORMA OF TRADING A/C

Trading A/c for the year ending : _________

Particulars Amount

Rs.

Particulars Amount

Rs.

Dr. Cr.

To Opening Stock By Sales

To Purchases Less: Sales Returns

To Carriage on purchases

Less: Purchase Returns By Closing stock

To Wages

To Fuel and Power

To Coal, Gas and Water

To Factory Rent

To Gross Profit C/d

Total Total

48

PROFIT AND LOSS A/C:

The profit and loss account is prepared in order to find out the net profit / loss position of the

concern. The expenses and incomes taken in the profit and loss account are of indirect nature

and include the following:- Proforma of Profit And Loss A/C

To gross loss brought down To Office Salaries To Expenses To Advertisement To Traveling Salaries To Expenses incurred on commission To Bad Debts To Godown Rent To Export Expenses To Carriage outwards To Bank charges To Agents commission To Rent, Rates and Taxes To Heating and Lighting To selling and distribution expenses To Printing and Stationery To Postage and Telegram To Telephone Charges To Legal charges To Audit fees To Insurance To General Expenses To Depreciation To Repairs & Maintenance To Discount allowed To Interest on capital To Interest on loans To Discount on bills discounted To Extraordinary expenses To Loss by Fire (Not covered by Insurance) To Net profit transferred to capital A/c

Amount Rs.

By gross profit brought down By Interest Received By Discount Received By Commission Received By Rent from Tenants By Income from Investments By Apprentice premium By Interest on debentures By Income from any other sources By Miscellaneous Revenue receipts By Net loss transferred to Capital A/c

Amount Rs.

49

3.4 BALANCE SHEET:

A balance sheet shows the financial position of a business on a certain fixed date. The

financial position of any concern/organization is shown by its assets on a given date and its

liabilities on that date. The excess of assets over liabilities represents the capital which serves

as a pointer to the financial condition of the concern. It may be noted that a balance sheet is

not an account but a mere statement of assets and liabilities on a particular date. The left hand

side of the balance sheet shows all the liabilities while the right side displays the Assets

position. The specimen proforma of a balance sheet is given below:

BALANCE SHEET OF _________________ COMPANY AS ON : _____________

LIABILITIES Rs. ASSETS Rs. CURRENT LIABILITIES: • Bills payable • Sundry creditors • Bank Overdraft LONG TERM LIABILITIES: • Loan from Bank • Loan from Wife FIXED LIABILITIES: • Capital

LIQUID ASSETS: • Cash in Hand • Cash at Bank FLOATING ASSETS: • Sundry Debtors • Investments • Bills Receivable • Stock in Trade • Prepaid Expenses FIXED ASSETS: • Machinery • Building • Furniture & Fixtures • Motor Car INTANGIBLE ASSETS: • Goodwill • Patents • Copyright • Licenses FICTITIOUS ASSETS: • Advertisement • Miscellaneous Expenses • Profit & Loss A/c

TOTAL

TOTAL

50

In the reverse order of preference the Balance Sheet may be prepared as follows:

BALANCE SHEET

LIABILITIES ASSETS

1. Fixed Liabilities

2. Long Term liabilities

3. Current Liabilities

1. Fictitious Assets

2. Intangible Assets

3. Fixed Assets

4. Floating Assets

5. Liquid Asset

TOTAL: TOTAL:

Thus it goes to say, that the items in the balance sheet may be marshaled either in the order of

permanence or liquidity.

Example:

From the following balances of XYZ Ltd on 31.3.2004 you are required to prepare the

Trading and Profit and Loss Account and a Balance sheet as on that date:

Amount Rs. Amount Rs.

Stock on April 1 1000 Commission (Cr) 400

Bills Receivable 4500 Return Outward 500

Purchases 39000 Trade Expenses 200

Wages 2800 Office Fixtures 1000

Insurance 1100 Cash withdrawal 500

Sundry Debtors 30000 Cash at bank 4750

Carriage Inwards 800 Rent and Taxes 1100

Commission (Dr) 800 Carriage outward 1450

Interest on capital 700 Sales 50000

Stationery 450 Bills payable 3000

Returns inward 1300 Creditors 19650

Capital 17900 Closing stock 25000

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TRADING & PROFIT AND LOSS A/C OF XYZ LTD

FOR THE YEAR ENDING : 31-3-2004

Particulars Amount Rs. Dr.

Particulars Amount Rs. Cr.

To Opening Stock 1000 By Sales: 50000 Less: Returns I/W 1300

48700

To purchases: 39000 Less: Returns outward 500

38500

By Closing Stock 25000

To wages 2800 To Carriage I/w 800 To Gross Profit C/d 30600 73700 73700 To Insurance 1100 By Gross Profit B/d 30600 To Commission 800 By Commission 400 To Interest on Capital 700 To Rent and Taxes 1100 To Carriage O/w 1450 To net profit transferred to Capital A/c

25200

TOTAL 31000 TOTAL 31000

BALANCE SHEET OF XYZ LTD

AS ON: 31.3.2004

LIABILITIES Rs. ASSETS Rs. Creditors 19650 Cash in hand 500 Bills payable 3000 Cash at Bank 4750 Capital: 17900 Add: Net profit 25200

43100

Bills receivable 4500

Stock 25000 Sundry debtors 30000 Office Fixtures 1000 TOTAL 65750 TOTAL 65750

52

3.5 ADJUSTMENTS:

Bits of information which are received/discovered after the preparation of Trial Balance have

to be accommodated into financial statements. They are, therefore called adjustments. It may

be remembered that sometimes adjustments thus need to be made in the final accounts. Since

the adjustments are given after the trial balance is prepared, they have to be given the two fold

effect. Once they appear in the trading/profit and loss account and the second time in the

balance sheet. These adjustments enable the firm to make its accounts fall in line with the

matching and such other concepts whichmake the final statements of account to reflect the

true and fair view of the affairs of the business. Treatment for some of the adjustments is

given below:

Closing Stock:

This may be shown on the credit side of the Trading account and the Second time on the asset

side of the balance sheet.

Outstanding Expenses:

These are expenses due to be paid but not paid. These expenses should be added to the

amounts already paid and shown in the trading account or the profit and loss account

depending upon whether it is a direct expenditure or indirect expenditure. For Eg:

outstanding wages should be added to “Wages” in Trading account and if it is outstanding

salary should be added to “Salary” account in the profit and loss account. The second effect

is that should it should be shown on the liability side of balance sheet.

Prepaid (Unexpired) Expenses:

These are expenses paid in advance and therefore should be deducted from the respective

expenditure on the debit side of Trading and profit and loss a/c and then shown on the asset

side of the balance sheet. For instance if insurance is prepaid, it should be deducted from

Insurance on the debit side of profit and loss account and should be shown on the asset side of

the Balance sheet as prepaid insurance.

53

Accrued Income:

That income which has been earned but not received during the accounting year is called

accrued income. Such income needs to be added to the respective income on the credit side

of the profit and loss and again on the asset side of the balance sheet.

Income Received In Advance:

Income received but not earned during the accounting year is known as Income received in

Advance. This should be deducted from the respective income in the profit and loss a/c and

should be shown in the balance sheet as a liability.

Depreciation:

This is reduction in the value of the fixed Asset and is usually calculated as a percentage of

the assets. The amount of depreciation is shown on the debit side of profit and loss account

and is to be deducted from the respective asset value in the balance sheet.

Bad Debts:

Debts which cannot be recovered or become irrecoverable are called bad debts. Since this is a

loss for the business it is shown on the debit side of the Profit and Loss account and deducted

from Sundry Debtors on the asset side of the Balance sheet.

Interest on Capital:

This is calculated as a percentage on capital and is shown on the debit side of Profit and Loss

account and added to capital on the liability side of the Balance sheet.

Interest on Drawings:

The two fold effect of this adjustment is that it will be shown on the credit side of profit and

loss account and is added to the amount of drawings on the liability side of the Balance sheet.

Provision for Doubtful Debts:

This is a provision maintained to meet doubtful debts. It is usually calculated as a percentage

on sundry debtors and is shown on the debit side of profit and loss account and is deducted

from sundry Debtors on the asset side of the Balance sheet.

Provision for Discount on Debtors:

In order to encourage prompt payment, discount is given to debtors. To meet the expenses of

discount a provision is maintained on debtors. This provision, known as Discount on Debtors

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is shown on the debit side of the profit and loss account and is deducted from sundry debtors

on the asset side of the balance sheet.

Provision for Discount on Creditors:

This is calculated as a percentage on creditors and is shown on the credit side of Profit and

Loss account and is deducted from sundry creditors on the liability side of the Balance sheet.

Deferred Revenue Expenditure:

Advertisement expenditure is the best example for deferred revenue expenditure. A huge

amount may be spent on advertisement in a single year but the benefits of such advertisements

may be spread over the ensuing years too. Therefore only a part of such expenditure will be

written off each year. The written off expenditure is shown on the debit side of profit and loss

account and the unwritten part of the expenditure is shown on the asset side. Such unwritten

off portions of deferred revenue expenditure from fictitious assets.

Manager’s Commission:

Manager’s Commission may be given at a certain percentage (say 5%) on the net profit (say

Rs.50000) before charging such commission; In such a case commission is calculated as

follows:

Net Profit x Rate of Commission

= 50000 x 5/100 = Rs.2500

But sometimes it is given as after charging such commission, In such a case

commission is calculated as given below:

Profit x % of commission 50000 x 5

------------------------------ ------------ =Rs. 2380.95

100 + % of commission 100 + 5

This commission needs to be put on the debit side of the profit and loss account and is shown

as a liability in the Balance sheet.

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Reserve Fund:

Reserve is created out of profit and loss account. It is shown on the debit side of profit and

loss account and is also shown on the liability side of the Balance sheet.

Example:

From the following Trial Balance of Priya Industries Ltd., prepare Final Accounts after

making the necessary adjustments for the year 31-12-2005

TRIAL BALANCE

Debit Balances Amount

Rs.

Credit Balances Amount

Rs.

Freehold Land 35000 Mortgage Loans 20000

Loose Tools 5600 Bills payable 3400

Plant and Machinery 45500 Sales 121500

Sundry Debtors 18200 Creditors 15600

Cash at bank 11000 Discount 175

Opening Stock: 1.1.2005 10500 Capital 40000

Insurance 300

Bad Debt 560

Bills Receivable 5400

Purchases 50000

Cash in hand 560

Rent, Rates etc 1300

Interest 250

Wages Trade Expenses 10700

Salaries 1560

Repairs 875

Carriage Inwards 350

Discount 290

56

Drawings 2500

Suspense A/c 80

200675 200675

Adjustments:

a) Insurance unexpired to the extent of Rs.90

b) Salaries and Rent are outstanding to the extent of Rs.140 and 60

c) Loose tools are revalued at Rs.4500

d) Allow Interest on capital @ 5% p.a.

e) Make a reserve of 5% Debtors for doubtful debts

f) Closing stock was valued at Rs.30000 on 31.12.2005

TRADING & PROFIT AND LOSS A/C OF XYZ LTD FOR THE YEAR ENDING : 31-3-2004 Particulars Amoun

t Rs. Dr.

Particulars Amount

Rs.

Cr. To Opening Stock 50000 By Sales 121500 To Purchases 50000 By Closing Stock 30000 To Wages 10700 To Carriage Inwards 350 To Gross Profit C/d 79950 TOTAL 151500 151500 To Salaries 1560 Add: O/S Salaries 140

1700

By Gross Profit b/d 79950

To Rent, Rates etc 1300 Add: O/S Rent 60

1360

By Discount received 175

To Trade Expenses 150 To Interest 250 To Bad Debts 5560 To Insurance 300 Less: Prepaid 90

210

57

To RBDD 910 To Interest on Capital 2000 To Loose Tools Written off 1100 To Repairs 875 To Discount allowed 290 To Net Profit Transferred to Capital A/c

70720

TOTAL: 80125 80125

BALANCE SHEET OF PRIYA INDUSTRIES AS AT 31-12-2005

LIABILITIES Rs. ASSETS Rs.

Creditors 15600 Cash in Hand 560

Bills Payable 3400 Cash at Bank 11000

Outstanding Expenses:

Salaries 140

Rent 60

200


Mortgage Loan:

Capital 40000

Less: Drawings 2500

37500

Sundry Debtors

18200

Less: RBDD

910

17290

Add: Net Profit 70720 Closing Stock 30000

Interest on Capital 2000 110220 Prepaid Insurance 90

Suspense A/c (Dr)

Balance

80

Freehold Land 35000

Plant & Machinery 45500

Loose Tools 4500

149920 149920

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Note on Bad Debts, RBDD and Reserve for Discount on Debtors

Bad Debts imply Debts which can not be received. That is out of Debtors this part of the

amount is not going to be received. It is a loss. Therefore it should be shown on the debit

side of profit and loss account.

If Bad debts are given in the adjustments also, such bad debts should be added to the bad

debts given in the trial balance and also shown on the debit side of the profit and loss a/c

The New Bad debts or bad debts given in the adjustments should be deduced from the Sundry

debtors and then the balance of sundry debtors should be shown on the asset side of the

balance sheet.

Example

TRIAL BALANCE

Debit Balances Rs.

Credit Balances Rs.

Sundry Debtors 50000

Bad Debts 1000

Adjustment:

Bad Debts to be further provided Rs.500

Treatment

Profit and loss A/c (Debit Side)

Amount Rs. Amount Rs.

To Bad Debts

Add: New Bad Debts

10000

500

1500

59

Balance Sheet



Less: New Bad Debts 500

49500

Reserve for Bad and Doubtful Debts:

Doubtful Debts imply debts which have not yet become bad but may not be recovered when

Credit Sales are made, usually a percentage of debtors fail to pay. In order to meet the loss

arising out of such bad and doubtful debts a provision is created. This is known as Reserve

for Doubtful Debts or Provision for Doubtful debts. This is calculated on Sundry debtors.

Reserve for Doubtful Debts (RBDD) if given in the Trial balance, should be shown on the

debit side of Profit and loss a/c

If RBDD is given in the adjustments also then there are two ways of showing it. The simple

one is show the New RBDD on the credit side of Profit and loss Account and deduct the new

RBDD from the Debtors in the balance sheet while showing the balance given in the trial

balance on the debit side of the profit and loss account.

The other method is compare the New RBDD with the old RBDD. If new RBDD is more the

difference between the old and the new is put on the debit side of Profit and Loss A/c and the

new RBDD is deducted from the Sundry Debtors. If the New RBDD is less then, the

difference is shown on the Credit side and the new RBDD is deducted from Sundry Debtors.

Example

TRIAL BALANCE

Debit Balances Rs.

Credit Balances Rs.


RBDD Bad Debts 1500

60

Adjustment:

Create a reserve for Doubtful Debts @ 5%

Treatment

Method: 1

Profit and loss A/c

Dr.

Rs.

Cr.

Rs.

To RBDD (old) 1500 By RBDD (New @ 5% on

50000

2500

Balance Sheet



Less: RBDD (New)

2500

47500

Method: 2

Profit and loss A/c

Dr.

Rs.

Cr.

Rs.

To RBDD (New) 2500

Less: Old 1500

1000

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Balance Sheets



Less: RBDD (New)

2500

47500

Example where New Bad Debts provision and also Reserve for Discount on Debtors

need to be maintained.

TRIAL BALANCE

Debit Balances Rs.

Credit Balances Rs.


Bad Debts 500

Bad Provision (RBDD) 1000

Adjustments:

1) Create further Bad Debts Rs.500

2) Create a reserve for bad and doubtful debts @ 5% on Sundry debtors

3) Create a reserve for discount on debtors @ 2%

Treatment:

Profit and loss A/c

Dr.

Rs.

Cr.

Rs.

To RBDD (Old) 1000 By RBDD @ 5% 2475

To Bad Debts 500

Add: New 500

1000

62

To Reserve for Discount on

Debtors @ 2%

940

Balance Sheet



Less: Bad Debts 500

49500

Less RBDD @ 5% on

Rs.49500

2475

47025

Less: Reserve For Discount

on drawings @ 2% on 47025

940=50

46084=50

We thus come to the end of the accounting cycle, by preparing the final statement of accounts,

that is the Profit and Loss Account and the Balance Sheet together with the adjustments

emanating from the additional pieces of information after the preparation of the Trial Balance.

We may here recall the Accounting Cycle we explained to ourselves in Lesson 2.

ACCOUNTING CYCLE:

Ledger

Journal Trial Balance

Final Accounts

The accounting cycle shows that a business transaction is first entered into Journal, the book

of original entry from there it is transferred or posted to the Ledger. From Ledger Balances of

the Trial Balance is prepared. Trial balance is a statement of debits and credits. From these

balances the Final Accounts are prepared. It may be thus remembered that the Accounting

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Cycle starts with Journal and ends with the Final Accounts. At the Journal stage

documentation of the Business transactions is done, while at the Ledger stage account wise

information is obtained and summarized and at the Trial Balance stage List of Debit and

Credit balances is obtained to check the arithmetical accuracy and at the final accounting

stage the profit or loss position of the business concern is ascertained.

3.6 SUMMARY:

The final stage in the accounting cycle is the preparation of final accounts. It is common

knowledge that the ultimate objective of maintaining accounts is to find out operating results

and also the financial position of the organization concerned. Final accounts are prepared

from the trial balance. Final accounts consist of the profit and loss account (also called

Income Statement) and a statement of assets and liabilities known as the balance sheet.

Distinction needs to be made between capital and Revenue items. Profit and loss A/c shows

the net income or net expenditure position of the business organisation. It consists of two

parts namely: (1) Trading A/c and (2) Profit and Loss A/c. The preparation of the main profit

and loss account begins with the Trading Account and ends with the Profit and Loss account.

While Trading Account records the balances which are directly related to the manufacturing

the product, the profit and loss account records the expenses and incomes and expenses,

profits and losses which though related to the business are not directly related to the making

of the product saleable. A balance sheet shows the financial position of a business on a

certain fixed date. The financial position of any concern/organization is shown by its assets

on a given date and its liabilities on that date. The excess of assets over liabilities represents

the capital Bits of information which are received/discovered after the preparation of Trial

Balance have to be accommodated into financial statements. They are, therefore called

adjustments. Since the adjustments are given after the trial balance is prepared, they have to

be given the two fold effect. These adjustments enable the firm to make its accounts fall in

line with the matching and such other concepts to make the final statements of account to

reflect the true and fair view of the affairs of the business.

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3.7 KEY WORDS:

Final Accounts Capital and Revenue Items

Profit & Loss Account Trading Account

Balance Sheet Closing Stock

Outstanding Expenses Prepaid (Unexpired) Expenses

Accrued Income Income Received In Advance

Depreciation Bad Debts

Interest on Capital Provision for Doubtful Debts

Interest on Drawings Provision for Discount on Debtors

Provision for Discount On Creditors Deferred Revenue Expenditure

Reserve Fund

Try yourself:

1. The following is the Trial balance of Seema as on 31st December 2005:

]

Debit Balances Rs. Credit Balances Rs.

Drawings 10000 Capital 100000

Sundry Debtors 80000 Sundry Creditors 60000

Cash in Hand 5000 Loand 40000

Interest 6000 Sales 220000

Opening Stock 15000 Purchase Returns 8000

Cash at Bank 10000 Discount 2000

Land and Buildings 100000 Bills Payable 15000

Sales Returns 5000 Provision for Bad Debts 5000

Bad Debts 6000

Purchases 150000

Carriage Inwards 4000

Establishment Charges 9000

Rent 5000

Advertising 15000

65

Office Expenses 9000

Wages 15000



Additional Information:

a) The stock on hand on kDecember 31, 2005 is Rs.30000

b) Outstanding rent is Rs.1000

c) Prepaid Wages are Rs.2000

d) Bad debts provision is to be maintained at 5 per cent of closing debtorws

You are required to prepare Trading and Profit and Loss Account for the year ending 31st

December, 2005 and a balance sheet as on that date.

FURTHER READINGS: Jain S.P. and K.L. Narang, Fundamentals of Accounting, Kalyani Publishers

Jawaharlal, Financial Accounting, Wheeler Publishing

Nitin Balwani, Accounting and Finance for Managers, Excel Books

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LESSON 4

FINANCIAL STATEMENT ANALYSIS

STRUCTURE:

4.1 Introduction

4.2 Meaning and nature of Financial Statements

4.3 Objectives and types of Financial Statements

4.4 Importance and uses of Financial Statements

4.5 Limitations of Financial Statements

4.6 Meaning of Financial Statement Analysis

4.7 Types and importance of Financial Analysis

4.8 Techniques of Financial Analysis

4.9 Comparative Financial Statement Analysis

4.10 Common size Financial Statement Analysis

4.11 Trend Analysis

4.12 Limitations of financial analysis

4.13 Summary

4.14 Key words

OBJECTIVES:

• Explain the meaning and nature of Financial Statements • Describe the objectives and types of Financial Statements • Recognize the importance and limitations of Financial Statements • Understand the meaning and importance of Financial Analysis • Prepare Comparative and Common size Financial Statements and

interpret them; and • Calculate the Trend Percentages and interpret them.

67

4.1 INTRODUCTION:

In the previous lesson you have understood the preparation of trading account, profit and loss

account and balance sheet. The financial statements viz., the Balance sheet and Profit and loss

account are the end products of the accounting process. The accounting system of a firm

becomes the basis for financial information. The accounting system helps to measure,

compare, analyze and communicate financial data to various interested parties for making

rational decisions. Understanding the nature of financial statements, their form, content and

factors that affect them in projecting the true and fair view of financial position is the basic

foundation for analysis of financial statements.

4.2 MEANING AND NATURE OF FINANCIAL STATEMENTS:

Meaning of Financial statements: Financial statements are the basic and formal means

through which the company communicates financial information to various parties. Financial

statements serve the varied needs of internal and external parties like owners, employees,

management, creditors, investors etc.

According to American Institute of Certified Public Accountants (AICPA) “Financial

statements are prepared for the purpose of presenting a periodical review or report on progress

made by the management and deal with the status of investment in the business and the results

achieved during the period under review”.

Financial statements are prepared for the purpose of disclosing the financial position of the

business concern at a point of time and also operating results during the period under review.

Thus, these are, in one sense, the periodical reports about the progress made by the

management of the business concerns.

Nature of Financial Statements

The data contained in the financial statements are the combined results of recorded facts,

accounting conventions, postulates and personal judgment used in the application of

68

accounting principles. Therefore, it is clear that the financial statements are composed of data,

which are of a combination of:

• Recorded facts

• Accounting conventions adopted to facilitate accounting techniques

• Postulates or assumptions made

• Personal judgment of the accountants in using or applying a particular convention or

postulates.

The financial statements are used by investors and financial analysts to measure the firm’s

performance in order to make investment decisions, so, they should be prepared with utmost

care and contain as much information as possible. The financial statements have to be

prepared in conformity with the GAAP.

4.3 OBJECTIVES OF FINANCIAL STATEMENTS:

A financial statement shows both the performance and the financial position of the concern.

These statements are the primary source of information on the basis of which conclusions are

drawn about the profitability and financial position of the concern. The basic objective of

financial statements is to furnish information required for decision making. The Accounting

Principles Board of America (APB) states the following objectives of financial statements.

• To provide adequate, reliable and periodical information about economic resources

and obligations of a business firm to external parties who have a limited access to

gather data.

• To provide useful financial data to evaluate the firm’s earning capacity and future

potential.

• To supply information which is useful for judging management’s ability to utilize the

resources of the firm effectively

• To disclose, to the extent possible other information related to the financial statements

that is relevant to the users of these statements.

• To disclose, significant policies, concepts, methods followed in the accounting

process.

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• To report the activities of the business concern which are affecting the society and

accounting for them

• To provide information to investors and creditors for predicting, evaluating potential

funds in terms of amount, time and uncertainty

4.3.1 TYPES OF FINANCIAL STATEMENTS:

Financial statements generally refer to two statements viz., Income statement or Profit and

loss account and Balance sheet. Income statement shows only revenue receipts and revenue

payments which are of nominal nature. Balance sheet shows all the balances which are of

capital nature. The statement which shows total of assets and liabilities is known as Balance

sheet. As per Generally Accepted Accounting Principles (GAAP), financial statements

include the following.

• The position statement or balance sheet

• The income statement or profit and loss account

• A statement of changes in owners equity and

• A statement of changes in financial position

The two major financial statements i.e., balance sheet and income statement are required for

external reporting and also for internal needs of the management like planning, forecasting

and control. These two statements are supported by number of schedules, annexure,

supplementing the data contained in the balance sheet and income statement. Apart from these

two financial statements, there is a need to know about changes in funds position and

movement of cash. For this purpose statement of changes in financial position and a cash flow

statement is prepared.

1. Balance Sheet:-

Balance sheet is the most important financial statement which is prepared to measure the

financial position of a concern as on a certain date. The balance sheet communicates

information about assets, liabilities and owners funds for a business firm as on a specific date.

70

Balance sheet is a static document as it shows assets, liabilities and shareholders funds at a

particular point of time. Balance sheet can be called by different names like “Statement of

financial position”, “Statement of assets and liabilities”, Statement of Net Worth and

Statement of Property. The balance sheet can be presented in the accounting form or in the

report form. In the account firm or T form of balance sheet, all assets are shown on the right

hand side and capital and liabilities on the left hand side. Report form is also called vertical

form of balance sheet, where assets and listed on the top of the page and capital and liabilities

are shown below the assets.

2. Profit and Loss Account or Income Statement:-

Profit and loss account reports the operating results of the business during a specific

accounting period. It is usually prepared on “accrued basis”, all expenses incurred and due are

debited to profit and loss account, whether they are actually paid or not and similarly all

incomes earned and due are credited to it whether they are actually received or not. Net profit

or Net loss is the result of these expenses and revenues. This net profit denotes the operational

efficiency of the management. Profit and loss account may be divided into three components.

Trading account

Profit and Loss account

Profit and loss appropriation account

Trading account reflects the gross profit or loss arising out of trading and manufacturing

operations. Whereas profit and loss account reflects the net profit or net loss on account of

operating expenses like administration, selling and financial expenses. On the other hand,

profit and loss appropriation account reflects the various appropriations made out of profits

like dividends, transfer to reserves etc.

The income statement is normally prepared in account form dividing it into two parts known

as debit side and credit side. On the other hand it can also be prepared in a vertical manner

with detailed data. Vertical form of preparing income statements is suitable for further

analysis and providing suitable data for decision-making.

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3. Statement of Changes in Owners Equity:-

Owners equity refers to the shareholders funds which includes paid up share capital, reserves

and surplus, undistributed profits and balance in profit and loss account. It is also known as

profit and loss appropriation account or income disposal statement. This statement reflects the

various appropriations made during the year out of current profits.

4. Statement of Changes in Financial Position:-

This statement is prepared to know the movement of funds either in working capital or cash

during a particular period. The statement of changes in financial position prepared on the

basis of funds or working capital is known as funds flow statement and on the basis of cash is

known as cash flow statement. These two statements depict the causes for changes in financial

position in the form of changes in working capital and changes in cash in the form of sources

and uses between two balance sheet dates.

4.4 IMPORTANCE AND USES OF FINANCIAL STATEMENTS:

The financial statements are mirrorS, which reflects the financial position and operating

strength or weakness of the firm. The impact of business transactions on the financial position

and progress of the enterprise is briefly disclosed by these statements. The users of financial

statements include management, investors, shareholders, creditors, government, bankers,

employees and public at large. They provide not only information about the efficiency of the

management to the various interested parties in the concern but also help in taking rational

decisions. The uses and importance of financial statements are presented below:-

1. As a report of Stewardship:- Management is responsible for the over all performance of

the concern. They make several decisions and therefore, need information. Financial

statements report on the performance of the policies of the management to the shareholders.

2. As a basis for fiscal policy:- The fiscal policies particularly taxation policies of the

government are related with the financial performance of corporate undertakings. Thus,

72

financial statements serve as a basis for industrial, taxation and other social and economic

policies of the government.

3. Basis for dividend policies:- Potential investors, owners get an idea about the firm’s

financial strength and performance from its financial reports. They are generally interested in

the earnings, dividend and growth trends of the firm. The dividend policies of the corporate

sector are linked with the government regulations and financial performance of the company.

Hence financial statements form basis for dividend policies of companies.

4. Basis for granting of credit:- Companies have to borrow funds from banks and other

financial institutions for various purposes. Credit granting institutions are interested in the

continuing profitable performance of the firm, so that they can regularly receive their interest

and principal sum. So, they need accounting information, which is provided by financial

statements to estimate the firm’s performance.

5. Basis for Investment decisions:- Both present and prospective investors are interested in

the financial statements for measuring long term and short term solvency as well as the

profitability of the concern. Their prime considerations in their investment decisions are

security and liquidity of their investment with reasonable profitability. Financial statements

provide information to the investors in taking such important decisions.

6. Aids Government in policy framework:- These statements enable the government to

know whether business is following various rules and regulations or not. These statements

also form a base for framing and amending various laws for the regulation of the business.

7. As a basis for price fixation:- Customers may be interested in financial statements of a

firm, because a careful study of the financial statements may provide information about the

prices being fixed by the firm.

8. Helps trade unions and employees:- Trade unions and employees also make use of the

financial statements of a firm for the purpose of preparing ground for bargain on matters

relating to salary, bonus, fringe benefits, working conditions etc. They analyze the financial

statements for measuring the profitability of the firm.

9. Helpful to stock exchanges:- Financial statements help the stock exchanges to

understand the financial performance of the concerns to enable it to pass on the information to

its members and stock brokers to take decisions about the prices to be quoted.

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In a nutshell, financial statements may be described as a comprehensive index of the financial

affairs of a concern and are useful in many ways to a variety of interested parties.

4.5 LIMITATIONS OF FINANCIAL STATEMENTS:

Financial statements are the result of the accounting process. But the profit or loss figure and

financial position which is disclosed by the Income statement and Balance sheet respectively

cannot be taken to be an exact representation of actual position of the concern. The financial

statements are based on certain accounting concepts and conventions which cannot be said to

be fool proof. The following are the important limitations of financial statements:

(i) Interim and not final reports:- Financial statements do not depict the exact position and

are essentially interim reports. The exact position can be only known if the business is closed.

(ii) Lack of precision and definiteness:- Financial statements may not be realistic because

these are prepared by following certain basic assumptions/concepts and conventions.

(iii)Lack of Objective judgment:- Financial statements are influenced to a major extent by

the personal judgment of the accountant. For example, method of charging depreciation,

valuation of closing stock, amortization of goodwill and treatment of deferred revenue

expenditure etc.

(iv) Records only monetary facts:- Financial statements disclose only monetary facts, i.e.,

those transactions that are recorded in the books of accounts, which can be measured in

monetary terms.

(v) Historical in nature:- These statements are drawn after the happening of the events. They

attempt to present a view of the past performance and have nothing to do with the accounting

for the future.

(vi) Artificial view:- These statements do not give a real and correct report about the worth of

assets and their loss of value as these are shown on historical cost basis.

(vii) Scope for manipulations: These statements are sometimes prepared according to needs

of the situation or the whims of the management. For this purpose under or over valuation of

inventory, over or under charge of depreciation and other such manipulations may be resorted

to.

74

(viii) Inadequate information:- There are many parties who are interested in the information

given in the financial statements but their objectives and requirements may differ. The

financial statements are prepared according to the provisions of the Companies Act, 1956, and

may fail to meet the needs of all the users.

4.5 MEANING OF FINANCIAL STATEMENT ANALYSIS:

Financial statements are the end product of the financial accounting practices. Financial

statements comprise two major statements, namely balance sheet and income statement.

These statements are the records of operating performance with its impact on the financial

position and the progress of the firm. Financial statements are prepared primarily for decision-

making. The information contained in these statements is of immense use in making decisions

through analysis and interpretation of financial statements. Financial analysis is a process of

synthesis and summarization of financial operative data with a view to getting an insight into

the operative activities of a business enterprise. It is the process of identifying the financial

strengths and weakness of the firm by properly establishing relationship between the items of

balance sheet and income statement.

The term financial analysis includes both ‘analysis and ‘interpretation’. The term analysis

means simplification of financial data, by methodical classification of data given in financial

statements. Interpretation means explaining the meaning and significance of the data so

simplified. Thus, analysis and interpretation are closely interlinked and are complimentary to

each other. Analysis is useless without interpretation and interpretation without analysis is

difficult or impossible.

4.6 OBJECTIVES OF FINANCIAL STATEMENT ANALYSIS:

Financial statement analysis is helpful in assessing the financial position and profitability of a

concern. Broadly, the objectives of the analysis are to understand the data contained in the

financial statements with a view to understand the strengths and weaknesses of the firm,

75

thereby enabling to take different decisions regarding the operations of firm. The main

objectives for analysis of financial statements are:-

• To assess the present profitability and operating efficiency of the firm as a whole and to

judge the financial health of the firm.

• To examine the earning-capacity and efficiency of various business activities with the

help of income statements.

• To estimate about the performance efficiency and managerial ability of the management

of a business concern.

• To determine short-term and long term solvency of the business concern with the help of

the Balance sheet

• To enquire about the ‘financial position and ability to pay’ of the concerns seeking loans

and credits.

• To determine the profitability and future prospects of the concern.

• To investigate the future potential of the concern

• To make a comparative study of operational efficiency of similar concerns engaged in the

identical industry.

Thus, the analysis of financial statements helps the management at self-appraisal and also

helps the shareholders to judge the performance of the concern.

4.7 TYPES OF FINANCIAL ANALYSIS:

Various users do the analysis of financial statements from different angles for different

purposes. The analysis of financial statements can be classified into different categories as

under:-

(i) On the basis of the nature of the analyst and the material used by him,

(ii) On the basis of the objective of the analysis, and

(iii)On the basis of the Modus Operandi of the analysis.

76

(i) According to the nature of the analyst and the material used by him:- On this basis the

financial analysis can be external and internal analysis.

(a) External Analysis:- This type of analysis is done by external parties or outsiders like

creditors, investors, governmental agencies, credit granting institutions etc. who do not have

access to the books of accounts and other related information of the firm. This analysis is

dependent on the published financial data of the firm and so can serve only limited purpose.

(b) Internal Analysis:- The internal analysis is done by the persons who have access to the

internal records and books of accounts of the concern. Such a analysis is done by

management, employees of the firm

(ii) According to the Objectives of the analysis:- On this basis the analysis can be long-term

and short-term analysis.

(a) Long-Term Analysis:- This analysis is made in order to study the long-term financial

stability, solvency and liquidity as well as profitability and earning capacity of a business

concern. This type of analysis helps in the long-term financial planning of the business.

(b) Short-Term Analysis:- This type of analysis is made to determine the short term

solvency, stability and liquidity and as well as to know the earning power of the concern.

Such type of analysis may be helpful for short term financial planning and long term

planning.

(iii) According to the Modus Operandi of the Analysis:- On this basis, the analysis may be

horizontal analysis and vertical analysis.

(a) Horizontal Analysis:- This analysis is also called dynamic analysis. This analysis covers

a period of several years and it gives considerable insights into areas of financial weaknesses

and strengths of the firm.

(b) Vertical Analysis:- This analysis is also called static analysis. This analysis is made on

the basis of only one set of financial statements at a particular period. Different types of ratios

establishing meaningful relationship between the items of financial statements can be

computed to understand the financial position of the firm.

77

4.7.1 IMPORTANCE OF FINANCIAL ANALYSIS:

Financial analysis focuses on managerial performance, corporate efficiency, financial

strengths and weaknesses and credit worthiness of the company. A finance manager must be

well equipped with the different tools of analysis to make rational decisions of the firm. The

importance of financial analysis is not limited to the finance manager alone. Its scope of

importance is quite broad which includes top management, creditors, investors, and

employees.

Financial analysis helps the top management in measuring the company’s operations,

evaluating individual’s performance and also helps in performing the functions of

coordination and control.

A creditor, through an analysis of financial statements appraises not only the ability of the

company to repay but also judges the profitability of the concern to meet all its financial

obligations.

The investors evaluate the efficiency of the firm in terms of solvency, liquidity, profitability

and also future potentiality.

Employees and trade unions analyze the financial statements to assess whether the company

has sufficient profits to afford a wage increase and whether it can absorb a wage increase

through increased productivity or by raising prices.

The use of a particular technique depends by and large on the purpose. A technique used by

one user need not necessarily serve the purpose of another user because of varied interests in

analysis of financial statements.

4.8 TECHNIQUES OF FINANCIAL STATEMENT ANALYSIS

In order to analyze and interpret the data in the financial statements, the analyst may

use any one or more of the methods or tools. The more commonly used tools of financial

analysis are:

• Comparative Financial Statements

78

• Common Size Financial Statements

• Trend percentages

• Ratio analysis and

• Funds Flow Statement

• Cash Flow Statement

In this lesson the first three tools viz, comparative statements, common size statements and

trend analysis are explained and the others are discussed in the subsequent lessons.

4.9 COMPARATIVE FINANCIAL STATEMENT ANALYSIS:

These are the statements showing the financial position of a firm at different periods of time.

Here, both the Income statement and balance sheet are prepared by providing columns for the

figures for both, the current year as well as for the previous year and for the changes during

the year both, in absolute and relative terms. The elements of financial statements are shown

in a comparative form to give an idea about the financial position of two or more periods. In

order to use this method of analysis, it is necessary that the same accounting methods,

procedures, policies, practices are followed consistently from one period to another, or other

wise the very purpose of analysis will be defeated. This type of presentation is useful to the

outsiders to take decisions about the company.

ILLUSTRATION 1:

Convert the following income statement into a comparative Income statement of Anu Ltd. and

interpret the changes in 2005 in the light of the conditions in 2004.

Particulars 2004 2005

Rs. Rs.

Gross Sales 30,600 36,720

Less: Sales Returns 600 700

79

Net Sales 30,000 36,020

Less: Cost of goods sold 18,200 20,250

Gross Profit 11,800 15,770

Less: Operating expenses

Administration expenses 3,000 3,400

Selling expenses 6,000 6,600

Total operating expenses 9,000 10,000

Operating profit 2,800 5,770

Add: Non-operating income 300 400

Total Income 3,100 6,170

Less: Non-operating

expenses

400 600

Net Profit 2,700 5,570

Solution:-

Comparative Income statement for the year 2004 and 2005

Particulars 2004 2005 Increase/Decrease Absolute

change

Rs. Rs. Rs. %

Gross Sales 30,600 36,720 6,120 20.00

Less: Sales Returns 600 700 100 16.67

Net Sales 30,000 36,020 6,020 20.07

Less: Cost of goods sold 18,200 20,250 2,050 11.26

80

Gross Profit 11,800 15,770 3,970 33.64


Administration expenses 3,000 3,400 400 13.33

Selling expenses 6,000 6,600 600 10.00

Total operating expenses 9,000 10,000 1,000 11.11

Operating profit 2,800 5,770 2,970 106.07

Add: Non-operating income 300 400 100 33.33

Total Income 3,100 6,170 3,070 99.03

Less: Non-operating

expenses

400 600 200 50.00

Net Profit 2,700 5,570 2,870 106.30

Interpretation:-

1. The company has made efforts to reduce the cost as the cost of goods sold has reduced

considerably.

2. The gross profit has also increased in 2005 as compared to 2004 as the sales have gone up.

3. The company has also concentrated on reducing the operating expenses; hence, the

percentage of operating profit has increased.

The overall performance of the company has improved in the year 2005

ILLUSTRATION 2

The following are the Balance sheets of Reddy Ltd. at the end of 2004 and 2005. Prepare a

Comparative Balance sheet and study the financial position of the concern.

81

Rs. (‘000)

Liabilities 2004 2005 Assets 2004 2005

Rs. Rs. Rs. Rs.

Equity Share

Capital

600 800 Land &

Buildings

370 270

Reserves &

Surplus

330 222 Plant &

Machinery

400 600

Debentures 200 300 Furniture &

Fixtures

20 25

Long- term

loans

150 200 Other fixed

assets

25 30

Bills payable 50 45 Cash in hand

& at bank

20 80

Sundry

creditors

100 120 Bills

receivable

150 90

Other current

liabilities

5 10 Sundry

debtors

200 250

Stock 250 350

Prepaid

expenses

- 2

1435 1697 1435 1697

82

Solution:-Comparative Balance Sheets of Reddy Ltd. for the years 2004 and 2005

Rs. (‘000)

Assets 2004 2005 Increase/Decrease Absolute

change

Current assets Rs. Rs. Rs. %

Cash & Bank 20 80 60 300

Bills Receivable 150 90 -60 -40

Sundry Debtors 200 250 50 25

Stock 250 350 100 40

Prepaid

expenses

- 2 2 -

Total Current

Assets

620 772 152 24.52

Fixed Assets

Land &

Buildings

370 270 -100 -27.03

Plant &

Machinery

400 600 200 50

Furniture &

Fixtures

20 25 5 25

Other Fixed

Assets

25 30 5 20

Total Fixed

Assets

815 925 110 13.50

83

Total Assets 1435 1697 262 18.26

Liabilities &

Capital

Current

Liabilities

Bills Payable 50 45 -5 -10

Sundry creditors 100 120 20 20

Other Current

Liabilities

5 10 5 100

Total current

liabilities

155 175 20 12.90

Debentures 200 300 100 50

Long term loans 150 200 50 33.33

Total

Liabilities

505 675 170 33.66

Equity share

capital

600 800 200 33.33

Reserves &

Surplus

330 222 -108 -32.73

Total

Liabilities &

Capital

1435 1697 262 18.26

Interpretation:

1.The Comparative Balance sheet of the company reveals that during 2002 there has been an

increase in fixed assets by Rs. 1,10,000 i.e., 13.5% while long term liabilities have relatively

84

increased by Rs. 1,50,000 and Equity share capital has increased by Rs. 2,00,000. This fact

depicts that the policy of the company is to purchase fixed assets from long term source of

finance thereby not affecting the working capital.

2.The current assets have increased by Rs. 1,52,000 i.e., 24.52%. The current liabilities have

increased by only Rs. 20,000 ie. 12.9%. This further confirms that the company has raised

long term finances even for the current assets resulting in an improvement in the liquid

position of the company.

3.Reserves and surplus have decreased from Rs.3.30,000 to Rs. 2,22,000 i.e., 32.73% thus

indicating that the company has utilized reserves and surplus for the payment o dividend to

shareholders with in cash or by issuing bonus shares.

4.The overall financial position of the company is satisfactory.

4.10 COMMON SIZE FINANCIAL STATEMENT ANALYSIS:

Common size financial statements are those in which figures reported are converted into

percentages to some common base. Common size financial statement is a financial tool for

studying the key changes and trends in the financial position and operating results of a

company. In the income statement the sales/total revenue is taken as the base and all the

figures of the income statement are expressed as a percentage of sales/total revenue, similarly

in the balance sheet the total of assets or liabilities is taken as base and all the figures are

expressed as a percentage of this total.

Inter firm or Intra firm comparison with the related industry as a whole is possible with the

help of vertical common size statement analysis. It also facilitates trend analysis of financial

results of a company over a period of time.

ILLUSTRATION 3

Convert the following income statement into a common size income statement and explain the

changes in 2004 in the light of condition prevailing in 2003.

85

2003 2004

Rs. Rs.

Gross Sales 15,300 18,360

Less: Returns and

discount

300 350

Net Sales 15,000 18,010

Less: Cost of sales 9,100 10,125

Gross Profit on

sales

5,900 7,885

Operating

expenses:

Selling expenses 3,000 3,300

Administrative

expenses

1,500 4,500 1,700 5,000

Operating profit 1,400 2,885

Other Income 150 200

Total Income 1,550 3,085

Other expenses 200 300

Net Profit 1,350 2,785

86

Solution:-

2003 2004

Amount in Rs. % of Sales Amount in Rs. % of Sales

Gross Sales 15,300 102 18,360 101.9

Less: Returns

and discount

300 2 350 1.9

Net Sales 15,000 100 18,010 100

Less: Cost of

sales

9,100 60.7 10,125 56.20

Gross Profit on

sales

5,900 39.3 7,885 43.8

Less : Operating

Expenses

Selling expenses 3,000 20 3,300 18.3

Administrative

expenses

1,500 10 1,700 9.4

Total Operating

expenses

4,500 30 5,000 27.7

Operating profit 1,400 9.3 2,885 16.1

Other Income 150 1.0 200 1.1

Total Income 1,550 10.3 3,085 17.2

Other expenses 200 1.3 300 1.7

Net Profit 1,350 9.0 2,785 15.5

87

Interpretation:

The analysis of the above income statement reveals the following points:

1. The percentage of gross profit has increased from 39.3% in 2003 to 43.8% in 2004. This is

due to decline in percentage of cost of goods sold from 60.7% of sales in 2003 to 56.2% in

2004. The decline in % of cost of goods sold may be due to fall in raw material prices and/or

efficiency of the purchasing department.

2. Though the absolute amounts of selling and administration expenses have increased

during the year 2004 but this increase is less than proportionate of the increase in sales.

Because of this the percentage of operating expenses to sales has declined from 30% in 2003

to 27.7% in 2004. This is a sign of company’s operating efficiency and economy in

expenditure.

3. The company’s percentage of net operating profit of sales has increased from 9.3% in

2003 to 16.1% in 2004 due to the combined effect of decrease in cost of goods sold and

operating expenses. This may be possible because of effective management policies of the

concern.

4. The increase in the non-operating income of the business is significant but the

disproportionate increase in non-operating expenses is not justified.

In conclusion it may be said that the company has been operated more efficiently in 2004 as

compared to 2003.

ILLUSTRATION 4

From the following Balance sheet of Rayon Company Ltd. for the year ended 31st December,

1997 and 1998, you are required to prepare a Comparative Common size Balance Sheet.

88

Balance Sheet as on 31st December

( in Lakhs of Rs.)


Rs. Rs. Rs. Rs.

Bills payable 50 75 Cash 100 140

Sundry

Creditors

150 200 Debtors 200 300

Tax payable 100 150 Stock 200 300

6%

Debentures

100 150 Land 100 100

6%

Preference

Capital

300 300 Building 300 270

Equity

Capital

400 400 Plant 300 270

Reserves 200 245 Furniture 100 140

1,300 1,520 1,300 1,520

89

Solution:

Rayon Company Ltd. Common Size Balance Sheet as on 31st December 1997 and 1998

(Figures in percentage)

Particulars 1997 % 1998 %

Assets 100 100

Current Assets:

Cash 7.70 9.21

Debtors 15.38 19.74

Stock 15.38 19.74

Total Current assets 38.46 48.69

Fixed Assets:

Building 23.07 17.76

Plant 23.07 17.76

Furniture 7.70 9.21

Land 7.70 6.68

Total Fixed Assets 61.54 51.41

Total Assets 100 100

Current Liabilities:

Bills Payable 3.84 4.93

Sundry Creditors 11.54 13.16

Taxes payable 7.69 9.86

Total Current liabilities 23.07 27.95

90

Long term liabilities:

6% Debentures 7.69 9.86

Capital & Reserves:

6% Preference share capital 23.10 19.72

Equity share capital 30.76 26.32

Reserves 15.38 16.15

Total shareholders funds 69.24 62.19

Total liabilities and Capital 100 100

Interpretation:

The percentage of current assets to total assets was 38.46 in 1997. It has gone up to 48.69 in

1998. Similarly, the percentage of current liabilities to total liabilities (including capital) has

also gone up from 23.07 in 1997 to 27.95 in 1998. Thus, the proportion of current assets has

increased by a higher percentage say about 10 as compared to increase in the proportion of

current liabilities about 5. This has improved the working capital position of the company.

There has been a slight deterioration in the debt-equity ratio though it continues to be very

sound. The proportion of shareholders funds in the total liabilities has come down from

69.24% to 62.19% while that of the debenture holders has gone up from 7.69% to 9.86%.

4.11 TREND ANALYSIS:

In financial analysis, the direction of changes over a period of time is very important.

Time series or trend analysis of ratios indicates the direction of change. The financial

statement may be analyzed by computing trends of series of information. The procedure

involves selection of a base year and converting all the years’ figures as a percentage of their

value in the base year’s figure. Trend ratios should be studied after considering absolute

figures on which they are based, otherwise, they may give misleading results.

91

Trend Ratio = Present year value x 100

Base year value

ILLUSTRATION 5

Calculate the Trend Ratios from the following figures of X Ltd. taking 2000 as the base year

and comment thereon: (In Lakhs of Rs.)

Year 2000 2001 2002 2003 2004

Sales 1881 2340 2655 3021 3768

Stock 709 781 816 944 1154

Profit before

Tax

321 435 458 527 672

Solution:

Trend Ratios

Year Sales Stocks Profit before tax

Rs. in

lakhs

Trend

ratio

Rs. in

lakhs

Trend

ratio

Rs. in

lakhs

Trend

ratio

2000 1881 100 709 100 321 100

2001 2340 124 781 110 435 136

2002 2655 141 816 115 458 143

2003 3021 161 944 133 527 164

2004 3768 200 1154 163 672 209

92

Interpretation:

The following points are worth noting from the trend ratios:

1. There is continuous increase in the sales in the last five years. This is a favorable tendency

as success of business depends on sales.

2. Though there is increase in quantity of stock during the last five years yet it is

comparatively less than the increase in sales. To keep less stock in spite of increase in the

sales is an indicator of efficient inventory management.

3. Profit before tax is constantly increasing and its percentage increase is always more as

compared to the percentage increase in sales.

In conclusion, it can be said that all the three tendencies are in favour of the business and are

indicator of full efficiency prevailing in the concern.

4.12 LIMITATIONS OF FINANCIAL STATEMENT ANALYSIS:

Though, financial analysis is an important tool of a firm, determining the financial strengths

and weakness of a firm, the analysis is based on the information available in financial

statements. As such, the financial analysis also suffers from the same limitations of financial

statements. Some other limitations are:

• Financial analysis is just a study of interim reports

• Financial analysis does not consider changes in price levels

• Financial analysis considers only monetary facts, non-monetary facts are ignored.

• If there is any change in accounting procedures and practices, the financial analysis

may be misleading.

• The financial statements are prepared on the basis of going concern concept, as such it

does not disclose correct position of the concern

• There is not single tool of analysis which is useful to all types of users

93

4.13 SUMMARY:

An organized collection of data according to logical and consistent accounting procedures is

known as financial statements. The methodical classification of the data given in the financial

statements is called as ‘analysis’ and explaining the meaning and significance of the data so

simplified is termed as ‘interpretation’.

The financial statements generally refers to income statement and balance sheet, statement of

retained earnings, funds flow statement etc. The financial analysis may be external. Internal,

long term, short term, horizontal or vertical.

The financial analysis helps a layman also to understand the statements easily and take

decision wisely with the help of various tools and techniques of financial statement analysis.

Most widely used techniques of financial statement analysis are Comparative statements,

Common size statements, Trend analysis, Ratio analysis, funds flow analysis and cash flow

analysis.

4.14 KEY WORDS:

Financial Statements Financial Analysis

Interpretation External Analysis

Internal Analysis Horizontal Analysis

Vertical Analysis Comparative Statements

Common-size Statement Trend Analysis

Try yourself:

1. Explain the meaning and importance of financial statement analysis.

2. Explain briefly the terms analysis and interpretation of financial statements. What are the

different tools employed for financial analysis?

94

3. Briefly explain how financial information is useful to different users of financial

statements?

Problems

4. From the following Income statement of Vijay Co. Ltd., prepare Comparative and Common

size Income statements for the year 2002 and 2003 and interpret the same.

Particulars 2002 2003

Rs. Rs.

Sales 4,00,000 6,50,000

Purchases 2,00,000 2,50,000

Opening stock 20,600 32,675

Closing stock 32,675 20,000

Salaries 16,0101 18,000

Rent 5,100 6,000

Postage and Stationery 3,200 4,100

Advertising 2,600 4,600

Commission on Sales 3,160 3,500

Interest paid 200 500

Loss on Sale of Asset 4,000 2,000

Profit on Sale of Investment 3,000 4,500

95

5. From the following information, prepare a Comparative and Common size Balance sheet

and interpret the same.

(Rs. ‘000)


Rs. Rs. Rs. Rs.

6% Redeemable Preference

Share Capital

2500

2500

Fixed Assets 17,662 14,806

6 ½% Redeemable

Preference Share Capital

---

3,000

Investments 1,947 2,429

Ordinary Share Capital 5500 13,200 Current Assets:

Reserves & Surplus 2500 3,450 Bills Receivable 1,217 1,584

Profit & Loss Account 116 99 Advance payment

of Tax

1,818

500

Loans and Advances 71,745 51,282 Cash & Bank 2,419 1,886

Sundry Creditors 27,122 14,734 Sundry Debtors 38,700 36,951

Provision for Taxation 5,012 4,578 Stock 52,334 36,769

Customers Credit Balances 1,603 2,079 Stores, Spares and

Tools

1,890

2,042

Accruals ( interest in

securities)

695

237

Unclaimed Dividends 6 109

Provision for Proposed

Dividend

96

1,113 1,420

Provision for Contingent

Liabilities

75

81

Provision for Gratuity --- 198

1,17,987 96,967 1,17,987 96,967

6. From the following data relating to the assets side of Balance sheet of ABC Ltd. for the

period ended 31st December 2000 to 31st December 2003, calculate trend percentages taking

2000 as the base year.

(Rs. in Lakhs)

Particulars 2000 2001 2002 2003

Rs. Rs. Rs. Rs.

Cash 100 120 80 140

Debtors 200 250 325 400

Stock 300 400 350 500

Other Current

Assets

50 75 125 150

Land 400 500 500 500

Buildings 800 1000 1200 1500

Plant 1000 1000 1200 1500

97

FURTHER READINGS:

Khan M.Y. & Jain P.K., Management Accounting, Tata McGraw Hill

Publishing co.Ltd.

Maheswari S.N. , Principles of Management Accounting, Sultan Chand & sons, New

Delhi.

Pandey I.M., Management Accounting, Vikas Publishing House, New Delhi.

Sharma R.K. & Gupta S.K., Management Accounting, Kalyani Publishers, New Delhi.

Made Gowda J. , Management Accounting, Himalaya Publishing House, Mumbai

Saravanavel P. , Management Accounting, Principles and Practice, Crown publishing

House, 1986.

98

LESSON-5

FINANCIAL STATEMENT ANALYSIS: II

(RATIO ANALYSIS)

STRUCTURE:

5.1 Introduction

5.2 Meaning of Ratio and Ratio Analysis

5.3 Objectives of Ratio Analysis

5.4 Uses and Significance of Ratio analysis

5.5 Classification of Ratios

5.6 Profitability Ratios

5.7 Liquidity Ratios

5.8 Activity Ratios

5.9 Leverage Ratios

5.10 Coverage Ratios

5.11 Limitations of Ratio Analysis

5.12 Summary

5.13 Key words

OBJECTIVES:

Explain the meaning of Ratios and Ratio Analysis; State the objectives of Ratio Analysis Grasp the importance of Ratio Analysis; Understand the limitations of Ratios; Classify and interpret different kinds of ratios.

99

5.1 INTRODUCTION:

We have already studied in the preceding chapter that there are various techniques for

analyzing the financial statements, such as Comparative Statements, Common size Statements

and Trend Analysis. The Financial Statements viz., the Balance Sheet and the Profit and Loss

Account are the end products of the accounting process, which are expressed in absolute

monetary units do not provide much scope for understanding the liquidity, solvency

profitability and operational efficiency of the business concern. For a meaningful and realistic

assessment of the financial position and performance of the firm the financial analyst should

try to establish and evaluate the relationships between different items of the Balance sheet and

Profit and loss account. Ratio analysis is one of the most powerful tools of financial analysis,

which is extremely useful in this regard. It is the process of establishing meaningful

relationship between two or more accounting figures of the Balance sheet and/or Profit and

loss account. With the help of ratios financial statements can be analyzed more clearly and

decision-making is facilitated from such analysis.

5.2 MEANING OF RATIO AND RATIO ANALYSIS:

The term ‘ratio’ refers to the arithmetical or quantitative relationship that exists between the

items or variables in the financial statements. In simple language, ratio is the one number

expressed in terms of another and can be calculated by dividing one number with the other.

The relationship between two or more accounting figures/groups is called a ‘financial ratio’ or

‘Accounting ratio’. A financial ratio helps the firm to summarize abundant financial data into

a concise form and further facilitates interpretation and conclusions about the profitability and

solvency of the firm. A ratio may be expressed as quotient or rate or percentage. In financial

analysis, a ratio is used as an indicator or yardstick for evaluating the financial position and

performance of a firm.

100

Since the analysis and interpretation of financial statements is made with the help of ratios, so

it may be called as ratio analysis. Ratio analysis is the process of computing, determining and

interpreting the relationships between two accounting figures based on financial statements.

5.3 OBJECTIVES OF RATIO ANALYSIS:

With the help of ratio analysis one can measure the financial condition of a firm. Ratios act as

an index/barometer of the efficiency of the enterprise. It also facilitates Inter and Intra firm

comparison. The main objectives of ratio analysis are to:

1. To analyze the liquidity position of the firm in terms of long term and short term solvency.

2. To know the credit worthiness of the concern.

3. To analyze the capital structure of the business.

4. To evaluate the firms profitability over a period of time and predict its future capacity.

5. To assess the efficiency of the firm in terms of the various assets employed.

6. To find out the financial health of the firm.

7. To measure the earning power of the concern.

5.4 USES AND SIGNIFICANCE OF RATIO ANALYSIS:

Ratio analysis is one of the most powerful tools of financial analysis. With the help of ratio

analysis we can know the financial health of a firm. Ratios act as an indicator of the efficiency

of the firm. Ratios have wide applications and are of immense use. The important advantages

of ratio analysis are:

• Ratios are important tools, which will help in maximizing profits and minimizing

costs.

• Ratio analysis helps to frame policies for future including capital expenditure

decisions.

• The utility of ratio analysis lies in the fact that it presents data on a comparative basis

and enables drawing conclusions regarding the operating efficiency of a firm.

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• Ratio analysis helps the employees by providing them the information related to the

profitability of the company, which becomes the basis for claiming their benefits.

• Ratio analysis will be useful to the investor in taking decisions relating to investment

by presenting the information relating to financial soundness of the concern.

• Ratios allow comparisons within the firm and with other firms, so that healthy

competition prevails not only between the divisions of the firm but also between the

firms.

• Ratios are helpful to the management in identifying the loopholes of the firm, so that

necessary action can be taken in time.

• The trend ratios enable to know whether the firm has improved its performance over a

period of time.

• Ratio analysis is very much useful to the management in carrying out their functions

like planning, forecasting, coordination and control.

• Ratios enable the financial analyst to summarize and evaluate the financial data to

measure the firm’s performance in terms of solvency and profitability.

• With the help of ratio analysis one can measure the firm’s solvency both long term

and short term efficiency and earning power can be assessed.

5.5 CLASSIFICATION OF RATIOS:

For analysis and interpretation of financial statements ratios can be classified in a number of

ways depending on the basis adopted. They may be classified on the basis of their source,

nature, importance and function.

Ratios which are broadly classified according to the purpose or function, which they are

expected to perform are called as functional ratios, Liquidity ratios, Solvency ratios,

Profitability ratios, Turnover ratios, Coverage ratios are examples of functional ratios.

The ratios have to be studied together in order to determine the financial soundness of the

business. In order that ratios serve as a tool of financial analysis, ratios have to be classified

under the following broad heads.

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• Profitability ratios

• Liquidity ratios

• Activity or turnover ratios

• Financial ratios

• Leverage ratios

• Coverage ratios

5.6 PROFITABILITY RATIOS:

The profitability ratios measure the operational efficiency or the profitability of the concern.

There are different parties who are interested in knowing profits of the firm. Among them

there are three groups of persons who are interested in the analysis of the profitability of the

firm. The shareholders/owners are interested in the ultimate return on their investment; the

management is interested in the overall profitability and operational efficiency of the firm and

the bankers, credit granting institutions, creditors who are interested in the credit worthiness

of the firm. Therefore, every firm should earn sufficient profits in order to discharge its

obligations towards the various parties concerned. Profit is determined by two important

factors i.e. sales and investment. Accordingly, profitability ratios can be calculated under

these two heads.

1. Profitability ratios in relation to sales and

2. Profitability ratios in relation to investment

Every firm should earn adequate profits on each rupee of sales in order to cover its operating

and non-operating expenses (like interest charges etc.). Similarly, the firm should earn

sufficient return on its investment in assets and in terms of capital employed, otherwise the

firm’s survival will be at stake.

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Profitability ratios in relation to Sales:-

Under this category, many ratios are calculated relating to different concepts of profits to

sales. Some of them are:-

Gross Profit Ratio:-

The gross profit ratio is also called the gross margin ratio or average mark up ratio. This ratio

establishes the relationship between Gross profit and Net sales. It is expressed as a percentage

of Gross profit earned on sales. The formula for calculating the gross profit ratio is as under:

Gross Profit Ratio = Gross Profit x 100

Net Sales

Where Gross profit = Net sales – Cost of goods sold

Net Sales = Total sales- Sales Returns

Cost of Goods Sold = Opening stock+ Purchases+ Direct expenses- Closing Stock

The ideal norm for this ratio is higher the ratio, the better it is. A low ratio indicates that there

is a decrease in selling price without a proportionate decrease in cost of goods sold or there is

an increase in cost of production. The gross profit should be sufficient to meet fixed expenses

and non-operating expenses, and for building up of reserves.

Operating Ratio:-

This ratio establishes relationship between operating cost and the net sales, which is expressed

as a percentage of sales. Operating cost is the sum total of the cost of goods sold and other

operating expenses for running the business. But it excludes all non-operating incomes and

expenses like interest and dividends, interest paid on long term borrowings, profit or loss on

sale of fixed assets. It is calculated as follows:

Operating ratio = Operating cost x 100

Net Sales

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Where operating cost = Cost of goods sold+ Administration expenses+ Selling and

Distribution expenses – Financial expenses – Abnormal losses.

Cost of goods sold = Sales – Gross Profit Or

Operating ratio = Cost of Sales x 100

Net Sales

Cost of Sales = Cost of goods sold + Operating expenses

It is always better to have a lower ratio. Higher operating ratio is unfavourable because it

would leave small amount of operating profit for meeting financial charges and for creating

reserves.

Operating Profit Ratio:-

This ratio establishes the relationship between operating profit and Net Sales. It is calculated

as follows:-

Operating Profit Ratio = Operating Profit x 100 Or

Net Sales

Operating Profit Ratio = 100 – Operating ratio

Where Operating profit = Gross profit – Operating expenses.

This ratio should be always on the higher side. The ratio denotes the amount left over after

meeting all the operating costs and operating expenses.

Expenses Ratio:-

Operating costs comprises of Manufacturing costs, administration expenses and selling and

distribution expenses. In order to know how individual expenses have their impact on sales,

these expense ratios are calculated. These expense ratios are given below:

1. Manufacturing cost ratio = Manufacturing cost x 100

Net Sales

2. Administration expenses ratio = Administration expenses x 100

Net Sales

3.Selling and Distribution expenses ratio = Selling and distribution expenses x100

Net Sales

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Any item of expenditure can be shown as a ratio to sales. A lower expenses ratio is better for

the firm.

Net Profit Ratio:-

It is an important ratio as it indicates the overall profitability of the firm. It is calculated by

dividing net profit by net sales. The purpose of this ratio is to reveal the amount of profit left

to shareholders after meeting all costs and expenses of the business. The ideal ratio is higher

the ratio better it is. Higher ratio indicates greater profitability of the concern. Therefore,

Net Profit ratio = Net profit after tax x 100

Net Sales

Profitability Ratios in relation to Investment:-

Profitability of a firm can be measured in terms of the investment made. The profitability of a

firm can also be analyzed with reference to assets employed in the business. In order to know

how much amount of profits is earned on the investment made on the assets, there are a

number of other profitability ratios, which are calculated for estimating the efficiency of the

concern. The important ratios are discussed here under:

Return on Investment Ratio (ROI Ratio)

This ratio is also known as return on capital employed (ROCE) or over all profitability ratio

or primary ratio. The Profitability of the firm can be analyzed from the point of view of the

total funds employed into the business.

Capital Employed = Equity share capital + Preference share capital + Reserves and Surplus

+Profit and loss account balance+ long-term loans+ Debentures-Fictitious assets.

Alternatively, it is also calculated as

Capital employed = Tangible assets + Intangible fixed assets + Current assets – Current

liabilities

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Fictitious assets means any amount shown on the assets side of the balance sheet such as

preliminary expenses, discount on issue of shares and debentures, debit balance of profit and

loss account, deferred revenue expenditure.

Higher the ratio the better it is. Higher the return on capital employed the more efficient the

firm is. The formula for calculating the ROI is as follows:-

ROCE = Net profit before Interest and Tax x 100

Capital Employed

Return of Assets Ratio (ROA Ratio)

This ratio is calculated to evaluate the profitability of the investment made in the assets of the

firm. It is calculated by the following formula:

ROA = Net Profit after Taxes x 100

Total Assets

Where Total assets = Fixed assets +Current assets +Investments. Fictitious assets are not

included for calculation of this ratio. With the help of this ratio the firm can know whether is

assets are properly utilized or not. Higher the ratio better it is for the company.

Return on Net worth Ratio

A return on shareholders equity is calculated to assess the profitability of the owner’s

investment. The ratio measures the relationship between the Net profit and shareholders

funds. The shareholders equity is also called net worth, which is calculated as follows:-

Net worth (shareholders equity or funds) = Equity share capital+ Preference

share capital+ Reserves and surplus – Fictitious assets.

And Return on Net worth ratio = Net profit after tax x 100

Net worth

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The higher the ratio, the better it is for owners of the company. However, in order to know

whether the returns are adequate or not, inter firm comparisons should be made.

Return on Equity Shareholders Funds

Equity shareholders who are the owners of the company are eligible for all the profits

remaining after paying out all outside claims and preference dividend. This ratio expresses the

equity shareholders return on their investments. It is calculated as

Return on Equity shareholders funds = Profit after tax – Preference Dividend x100

Equity shareholders funds

Where Equity shareholders funds = Equity share capital +Reserves and surplus –Accumulated

losses.

A higher ratio is better for the equity shareholders.

Return on Fixed Assets Ratio

This ratio is calculated to measure the profit after tax earned against the investments made in

fixed assets, to find out whether the assets are properly used or not in the business. It is

calculated as

Return on Fixed Assets ratio = Profit after Tax x 100

Fixed Assets

The higher the ratio, better for the company.

Return on Current Assets Ratio

This ratio is calculated to measure the profit after tax earned against the investments made in

current assets. It is calculated as

Return on Current assets = Profit after Tax x 100

Current Assets

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Return on Working Capital Ratio

Working capital is the capital which is required to meet the day to day operations of the

concern. It is calculated by the following formula:

Working capital = Current assets – Current liabilities

This ratio enables us to understand how the working capital was utilized in running the

business for earning the profits. The ratio is calculated as under:

Return on Working capital ratio = Net profit after interest and tax x 100

Working capital

Earnings per Share (EPS)

The profitability of a firm can also be measured in terms of number of equity shares. This

ratio is known as EPS, which is useful in investment analysis and also financial analysis. EPS

is calculated by employing the following formula:

EPS = Net profit after tax – Preference Dividend

Number of equity shareholders

The higher the EPS, the better is the performance of the company. To assess the relative

profitability of the firm its EPS should be compared with that of similar concerns and the

industry average.

Dividend per Share (DPS)

This ratio establishes the relationship between the net profits distributed after interest and

preference dividend to equity shareholders and the number of equity shares. The purpose of

this ratio is to show dividend paid to equity shareholders on per share basis. It is calculated as:

Dividend per share = Earnings distributed as dividend to equity shareholders

Number of equity shares

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From the present and potential investor’s point of view, a higher dividend per share is a good

sign. A large number of investors are usually interested in DPS rather than in EPS. However,

the company should consider a number of factors before declaring any dividend.

Price Earnings Ratio (PE ratio)

This ratio establishes the relationship between market price of share of a company and EPS

of that company. The PE ratio indicates the expectations of the equity investors about the

earnings of the firm. This ratio helps the shareholders in deciding whether the shares should

be sold or purchased. PE ratio is calculated as follows:

Price Earnings Ratio = Market price per share x 100

EPS

From the point of view of investors, the higher the ratio, the better it is.

Dividend Yield Ratio and Earnings Yield Ratio

The purpose of calculating dividend yield ratio is to know current rate of return to the

shareholders as a percentage of their investment. It is calculated as:

Dividend yield ratio = Dividend per share x 100

Market value per share

The purpose of calculating earnings yield ratio is to evaluate the rate of return of shareholders

in relation to the market value per share. It is calculated as:

Earnings Yield ratio = EPS x 100

Market value per share

The earnings yield and the dividend yield evaluate the profitability of the firm in terms of the

market price of the share. The higher these ratios, the better would be the return to

shareholders and vice versa.

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Dividend Pay-out ratio (D/P ratio)

The DP ratio is the relationship between the DPS and the EPS of the firm. This ratio indicates

as to what proportion of EPS is being declared as dividend and what percentage is retained by

the company in the business. The proportion of retained earnings is equal to 100-DP ratio. DP

ratio is calculated as under:

Dividend Pay out ratio = Dividend per Share

Earning per share

The shareholder must look for a low pay out ratio.

Book value of Equity Share

It is the relationship between the amount of net worth or shareholders funds of the firm, to one

equity share of the business. It is determined as:

Book value of equity share = Equity shareholders funds or Net worth

Number of equity shares

5.7 LIQUIDITY RATIOS:

These ratios are also termed as ‘working capital ratio’ or short-term solvency ratio. These

ratios measure the short-term solvency of the firm. Liquidity is the ability of a firm to meet its

current or short-term obligations when they become due. The short-term creditors like

suppliers of goods, banks which provide short term credit are primarily interested in the

company’s ability to meet its short term obligations. The firm can meet its short term

obligations only when it has sufficient liquid funds. Some of the common liquidity ratios are:

Current Ratio

Liquid Ratio

Absolute Quick Ratio

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Current Ratio /Working Capital Ratio

Current ratio is the most widely used ratio, which studies the short term financial position of

the company. This ratio establishes the relationship between current assets and current

liabilities. For computing this ratio, the following formula is used.

Current ratio = Current Assets

Current Liabilities

This ratio is also called working capital ratio. The reason being the two components of

working capital, i.e., current assets and current liabilities are used for calculating this ratio.

Current assets are the assets, which can be converted into cash within one year. Cash in hand,

cash at bank, inventory/stock, Debtors, bills receivable, short term investments, outstanding

incomes, prepaid expenses, etc are the examples of current assets.

Current liabilities are those liabilities, which are to be paid within one year. Creditors, Bills

payable, outstanding expenses, bank overdraft, tax payable, dividend payable, short term

loans etc are the examples of current liabilities.

The standard norm for the current ratio is 2:1. If the current assets are 2 times of current

liabilities, then the business operations will not be adversely affected as current liabilities can

still be paid. If the ratio is less than 2, the business doesn’t enjoy adequate liquidity. And if the

ratio is more than 2, it implies that funds are idle and has not been invested them properly.

Therefore, every firm should strike a balance between liquidity and profitability.

Quick Ratio or Acid Test Ratio

This ratio measures the relationship between quick current assets and current liabilities. Quick

current assets are those assets, which can be quickly converted in cash without loss of time or

value. It includes all current assets except stock and prepaid expenses.

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Quick assets = Current assets – (Stock + prepaid expenses)

It is an acid test of a concern’s liquidity position. The quick ratio is calculated by dividing

quick assets by current liabilities.

Quick Ratio = Quick Assets

Current liabilities

Sometimes instead of total current liabilities, only those current liabilities are taken, which are

really payable within one year. Then the formula for calculating quick ratio will become:

Quick ratio = Quick Assets/Liquid Assets

Quick liabilities

Generally, a Quick ratio of 1:1 is considered to be ideal. Ratio below 1 is an indicator of

inadequate liquidity and above 1 is also not advisable.

Absolute Quick Ratio or Super Quick Ratio

This ratio establishes relationship between the absolute liquid assets and liquid liabilities.

However, for calculation purposes, it is taken as absolute quick assets to current liabilities.

Absolute quick ratio = Absolute quick assets

Current liabilities

Absolute quick assets = cash in hand + cash at bank + short term marketable securities

Current liabilities

The ideal ratio is 0.5:1. This ratio is a conservative test of liquidity and is not widely used in

practice.

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5.8 ACTIVITY RATIOS OR TURNOVER RATIOS/ PERFORMANCE RATIOS:

Turnover Ratios measure the relationship between sales and various assets. Activity ratios are

employed to evaluate the efficiency with which the firm manages and utilizes its resources

and assets. These ratios are also called turnover ratios, because they indicate the speed with

which assets are being converted or turned over into sales. These activity ratios are also

known as ‘efficiency ratios’, because these ratios indicate the efficiency with which the firm

manages and uses its assets. Some of the important Activity ratios are discussed below:

Capital Employed Turnover Ratio or Capital Turnover Ratio

This ratio examines the efficiency of Capital employed in the business. This ratio indicates the

firms’ ability to generate sales per rupee of the Capital Employed.

Capital Turnover Ratio = Net Sales

Capital Employed

The higher the ratio, the more efficient is the firm in the utilization of owners’ and long term

creditors’ funds.

Total Assets Turnover Ratio

This ratio shows the firms’ ability in earning sales in relation to Total assets employed in the

business. This ratio measures the overall performance and efficiency of the firm. This ratio is

calculated as under:

Total Assets Turnover ratio = Total Sales

Total Assets

The standard norm for this ratio is 2 times. A higher ratio indicates overtrading and lower

ratio indicates that the assets are idle.

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Fixed Assets Turnover Ratio

This ratio indicates the firms’ efficiency in utilizing the fixed assets for generating sales and

earning profits. This ratio is considered important because firms make large investments in

fixed assets for producing sales. It is calculated by dividing net sales by fixed assets.

Fixed Assets Turnover ratio = Net Sales

Net Fixed Assets

Net fixed assets imply fixed assets after depreciation. Normally, a ratio of 5 times is

considered as ideal. The fixed assets turnover ratio can further be divided into turnover of

each item of fixed assets to know the extent of each fixed asset in relation to sales, whether

they have been properly utilized. Then the formula will be:

Plant and Machinery Turnover ratio = Net Sales

Plant and Machinery (Net)

Buildings Turnover Ratio = Net Sales

Buildings (Net)

Current Assets Turnover Ratio

It indicates the efficiency of the firms’ investments in current assets in relation to Net Sales.

This ratio is calculated as :

Current Assets Turnover ratio = Net Sales

Current Assets

A higher ratio indicates the firms efficiency in earning profit by efficient utilization of current

assets and vice versa.

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Working Capital Turnover Ratio

This ratio indicates whether or not working capital has been effectively utilized in making

sales. It is calculated as under:

Working capital Turnover Ratio = Net Sales Or = Cost of goods sold

Net working capital Net Working Capital

There is no standard norm for this ratio. Firms should have adequate and appropriate working

capital to justify the sales generated.

Stock Turnover Ratio or Inventory Turnover Ratio

This ratio indicates the rapidity with which the stock is turned into sales. It also indicates the

efficiency of the firms’ inventory management. It is calculated as under:

Stock Turnover Ratio = Cost of goods sold

Average Inventory

Average Stock = Opening Stock + Closing Stock

2

In case, the information regarding cost of goods sold and average stock is not given, then

stock turnover ratio can be calculated as:

Stock Turnover Ratio = Sales

Closing Stock

Higher the ratio, the better it is for the company, as the ratio shows that the finished stock is

turned over rapidly. Usually a stock turnover ratio of “8” is considered as an ideal one.

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Stock Velocity or Stock Conversion Period

It indicates the time taken by the stock to get converted into sales, which is expressed in terms

of months, weeks or number of days. That is

Stock Velocity (Days) = Average Stock x 365

Cost of goods sold

Or

Stock Velocity (Months) = Average Stock x 12

Cost of goods sold

Or

Stock Velocity (Weeks) = Average Stock x 52

Cost of goods sold

A higher stock velocity is always better.

Debtors/Receivables Turnover Ratio

It establishes the relationship between accounts receivables i.e.(Debtors+Bills receivable) and

credit sales. This ratio indicates the speed with which these debtors are collected which affects

the liquidity position of the firm. Debtors turnover ratio is calculated as under:

Debtors Turnover ratio = Net Credit Sales

Average Trade Debtors

Where net credit sales = credit sales – sales returns

Trade debtors = Sundry debtors+ Bills receivable+ Accounts receivable

Average trade debtors = Opening trade debtors +Closing trade debtors

2

If the information about credit sales and average debtors is not given, then total sales and

closing debtors should be taken for calculating debtors turnover ratio. A debtors turnover ratio

of 10-12 is usually considered as ideal. A higher debtors turnover ratio is an indicator of

sound credit management policy.

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Debt Collection Period Ratio/Debtors Velocity/ Average Collection Period

It shows the time taken for the debtors to get converted into cash. It is calculated as

Debt Collection Period Ratio = No of days or Months or weeks in a year

Debtors Turnover ratio

Lower the period, it is better for the firm and the ideal period is 30-36 days.

Creditors/Accounts Payable Turnover Ratio

It expresses the relationship between creditors and purchases. The purpose of this ratio

is to know the speed with which payments are made to creditors for credit purchases. This

ratio gives the average credit period enjoyed from the creditors and is calculated as:

Creditors Turnover ratio = Net Credit Purchases

Average Creditors

Or

Creditors Turnover ratio = Total Purchases

Closing Creditors

A high ratio indicates that creditors are not paid in time, while a low ratio indicates firms’

inefficiency in availing the credit facility allowed by creditors.

Creditors Velocity/Average Payment Period Ratio

This ratio shows the number of days taken by the firm to pay off its debts and is

calculated as:

Creditors Velocity = Number of days or months or weeks in a year

Creditors Turnover ratio

The average payment period gives an ideal about the number of days the fir m can post pone,

on an average, its payment to the creditors.

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5.9 FINANCIAL AND LEVERAGE RATIOS:

The financial position of the firm can be analyzed from two angles viz., the short term

financial position and the long term financial position. The short-term financial position can

be studied from liquidity ratios, which has already been discussed. The long term creditors

like debenture holders, financial institutions etc. judge the financial soundness of the firm in

terms of its ability to pay interest regularly during the period of loan as well as make

repayment of the principal amount on maturity. The long-term solvency of the firm can be

examined with the help of the leverage or capital structure ratios. These ratios are also known

as ‘long term solvency ratios’ or ‘capital gearing ratios’. There are two aspects of the long-

term solvency of the firm, to repay the principal amount on maturity and pay interest at

periodic intervals. These two aspects give rise to two types of leverage ratios.

1. The first type of leverage ratios, which establishes the relationship between borrowed funds

and owned funds and are computed from Balance sheet. Some of the leverage ratios are:

(a) Debt-Equity ratio

(b) Proprietory ratio

( c) Capital gearing ratio

2. The second type of leverage ratios, which are also called as “coverage ratios’ are computed

from profit and loss account. They are:

(a) Interest coverage ratio

(b) Dividend coverage ratio

Debt-Equity Ratio

This ratio is also called ‘External equities to internal equities ratio. It shows the relationship

between borrowed funds and owners’ funds or external funds (debt) and internal funds

(equity). There are a number of approaches to the calculation of debt equity ratio.

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Debt equity ratio = External equities Or = Total debt

Shareholders funds Internal equities

Total debt includes long-term liabilities and current liabilities. Shareholders funds consist of

equity share capital, preference share capital, capital reserves, revenue reserves, accumulated

profits and other surpluses. However, accumulated losses and deferred expenses are to be

deducted. Another approach is

Debt equity ratio = Long term debt

Shareholders equity

Debt equity ratio of 2:1 is considered ideal. A very high debt equity ratio is unfavourable and

low ratio implies that the creditors are relatively at lower risk.

Proprietory Ratio

This ratio is also known as equity ratio or net worth to total assets ratio. The purpose of this

ratio is to express the obligation of owners in the total value of assets. It gives an idea about

the extent to which the owners have financed the firm. It is calculated as:

Proprietory ratio = Net worth Or = Proprietory funds

Total Assets Total Assets

Where proprietory funds include equity share capital, preference share capital, Reserves and

surplus and undistributed profits and accumulated losses should be deducted. There is no

standard norm for this ratio. But some of the financial expert’s view that proprietory funds

should be from 67% to 75% and outsider’s funds should be from 25% to 33%. A high ratio

implies that the firm is not optimally utilizing its outsider’s funds.

Capital Gearing Ratio

This ratio establishes a relationship between funds bearing fixed interest or fixed dividend and

the equity shareholders funds. The fixed interest bearing funds are debentures and long term

loans and fixed dividend bearing funds are preference shareholders. The proportion of

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debentures and preference share capital to net worth or equity funds is referred to as capital

gearing ratio. It can be calculated as:

Capital Gearing Ratio = Funds bearing fixed interest/fixed dividend

Equity shareholders funds

A firm is said to be highly geared when the sum of preference capital and all other fixed

interest bearing securities is more than the equity capital. On the other hand, a firm is said to

be low geared when the sum of equity capital is more that the sum of preference capital and

all other fixed interest-bearing securities. The ideal norm for this ratio is 2:1.

5.10 COVERAGE RATIOS:

The second type of leverage ratios is coverage ratios. In order to judge the solvency of the

firm the creditors assess the firms’ ability to service their claims. In the same way, preference

shareholders evaluate the firm’s ability to pay the dividend. These aspects are revealed by the

coverage ratios. These ratios measure the ability of the firm to satisfy the claims of creditors,

preference shareholders and debenture holders. These ratios are:

• Interest Coverage ratios and

• Dividend coverage ratios

Interest Coverage Ratio

This ratio is also known as “Debt Service Ratio”. One of the approaches to test the solvency

of the firm is interest coverage ratio. A firm is considered solvent then its business is earning

sufficient profits to pay the interest charges, particularly where payment of fixed interest on

long term loans is concerned. The ratio is calculated as under:

Interest Coverage Ratio = Earnings before interest and tax

Fixed interest charges

A Debt service ratio of around 6 times is normally considered as ideal. Higher the ratio, the

better it is from the point of creditors. But too high a ratio indicates that the firm is very

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conservative in using the debt. On the other hand, a low coverage ratio indicates excessive use

of debt.

Dividend Coverage Ratio

This ratio examines the relationship between net profit after interest and taxes and preference

dividend of preference shares. The objective of this ratio is to show the number of times the

preference dividend is covered by net profit after interest and tax. It also measures the

capacity of a firm to pay dividend to preference shareholders. Thus

Dividend Coverage ratio = Net Profit after interest and tax but before preference dividend

Preference Dividend

The higher the ratio, the better it is from the preference shareholders point of view. This ratio

indicates the safety margin available to the preference shareholders.

Illustration 1

The following is the Balance Sheet of X Ltd., as on 31.12.2003.

Rs. Rs.

Equity Capital

(500 shares of Rs.

100)

5,00,000

Fixed Assets 18,00,000

5,00,000

13,00,000

7% Pref. Capital 1,00,000 Cash 50,000

Reserve & Surplus 4,00,000 10% Investments 1,50,000

6% Debentures 7,00,000 Debtors 2,00,000

Stock 3,00,000 7,00,000

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Creditors 60,000

Bills Payable 1,00,000

Outstanding exp 10,000

Taxation Provision 1,30,000

TOTAL 20,00,000 TOTAL 20,00,000

Additional Information

Net Sales Rs. 30,00,000 Cost of Goods Sold Rs. 25,80,000

Profit before Tax Rs. 2,00,000 Profit after Tax Rs. 1,00,000

Calculate appropriate ratios from the given information.

Solution

From the given information, all the types of ratios, viz., capital structure ratios, liquidity

ratios, activity ratios and profitability ratios, can be calculated.

Capital structure or Leverage ratios

Debt Equity ratio = Long term Debt = Rs. 7,00,000 = 0.7:1 or 70%

Shareholders Equity Rs.10,00,000

OR

= Total Debt = Rs. 10,00,000 = 1:1

Shareholders’ equity Rs. 10,00,000

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Proprietory ratio = Net worth/Total assets

Net worth = Shareholders funds = Rs. 10,00,000

Total assets = Fixed assets + current assets = 13,00,000+ 7,00,000 = Rs. 20,00,000.

Proprietory ratio = 10,00,000/20,00,000 = 0.50

Capital Gearing ratio = Funds bearing fixed interest and fixed dividend = 7,00,000+1,00,000

Equity share holders funds 5,00,000+4,00,000

= 8,00,000/9,00,000 = 0.89

Coverage ratios

Interest Coverage Ratio = EBIT=Rs.2,00,000+Rs. 42,000 = 5.67 times

Interest Rs. 42,000

Preference Dividend Coverage = Profit after Tax =Rs. 1,00,000 = 14.29 times

Pref. Dividend Rs. 7,000

Fixed Charges Coverage = EBIT = Rs. 2,42,000 = 4.94 times

Interest+Pref.Div. Rs.42,000+Rs.7,000

Liquidity ratios

Current Ratio = Current Assets = Rs. 7,00,000 = 2.33:1

Current Liabilities Rs. 3,00,000

Acid Test Ratio = Liquid Assets = Rs. 7,00,000 – Rs. 3,00,000 = 1.33:1

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Current liabilities Rs. 3,00,000

Super Quick Ratio = Cash +Mkt. Securities = Rs. 50,000+ Rs. 1,50,000 = 0.67:1

Current Liabilities Rs. 3,00,000

Activity ratios

Total Assets Turnover =Sales = Rs. 30,00,000= 1.5 times

Total assets Rs. 20,00,000

Capital Employed Turnover

OR

Net Worth Turnover = Sales = Rs. 30,00,000 = 1.76 times

Capital Employed Rs. 17,00,000

Fixed Assets Turnover = Sales =Rs. 30,00,000 = 2.31times

Fixed Assets Rs. 13,00,000

Current Assets turnover= Sales = Rs. 30,00,000 = 4.29 times

Current assets Rs. 7,00,000

Working Capital turnover = Sales = Rs. 30,00,000 =7.5 times

Net working Capital Rs.7,00,000-Rs.3,00,000

Stock Turnover =Sales =Rs. 30,00,000 =10 times

Closing Stock Rs. 3,00,000

Debtors’ turnover = Credit sales Or Total Sales =Rs. 30,00,000 =15times

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Average Drs. Debtors Rs. 2,00,000

Average collection period= Days in a year =365 =24 days

Debtors turnover 15

Profitability ratios

Gross Profit Margin= Sales- Cost of Goods Sold X 100

Sales

=Rs. 30,00,000-Rs. 25,80,000X 100=Rs.4,20,000X100=14%

Rs. 30,00,000 Rs. 30,00,000

Net Profit Margin = Net Profit after Tax X100

Sales

=Rs. 1,00,000 X 100 = 3.33%

Rs. 30,00,000

Return on Assets =Net profit after Tax X100 = = Rs. 1,00,000X100 =5%

Total Assets Rs. 20,00,000

Return on Capital Employed =Profit after Tax=Rs. 1,00,000 =5.88%

Total Capital employed Rs. 17,00,000

Return on Shareholders Equity=Profit After Tax = Rs. 1,00,000 =10%

Shareholders Equity Rs. 10,00,000

126

Return on Equity Shareholders Equity = Profit after Tax-Pref. Dividend

. Equity shareholders’ Equity

=Rs. 1,00,000-Rs. 7,000 = 10.33%

Rs. 9,00,000

Earnings per share = Profit after Tax –Pref. Dividend

No. of Equity Shares

= Rs. 1,00,000-Rs.7,000 = Rs 18.6.

Rs. 5,000

Illustration 2

With the help of the following ratios regarding X Ltd., draw up the Balance Sheet:

Current Ratio 2.5

Liquidity Ratio 1.5

Net Working Capital Rs. 3,00,000

Stock Turnover (cost of Sales/Cl.stock) 6 times

Gross profit ratio 20%

Fixed Assets turnover ratio (On cost of sales) 2 times

Debt collection period 2 months

Fixed assets to shareholders’ net worth 0.80

Reserves and surplus to capital 0.50

127

Solution

The current ratio is given as 2.5 which means that if the current liabilities are 1, the current

assets will be 2.5. The difference between current assets and current liabilities represents the

net working capital = 2.5-1.00 =1.5

But net working capital is given as Rs. 3,00,000 i.e., 1.5= Rs. 3,00,000

Therefore, 1 = 3,00,000 = Rs. 2,00,000 = Current liabilities

1.5

Current assets are 2.5 times of current liabilities.

Therefore, current assets = 2,00,000x2.5= Rs. 5,00,000

Liquidity Ratio = Liquid Assets

Current liabilities

1.5 =Liquid Assets

Rs. 2,00,000

Therefore Liquid Assets= Rs. 2,00,000x 1.5= Rs. 3,00,000

Current Assets –Liquid Assets=Stock

Rs. 5,00,000-Rs.3,00,000= Rs.2,00,000 Therefore Stock =Rs. 2,00,000

Stock Turnover = 6= Cost of Sales =Cost of Sales

Closing Stock 2,00,000

128

Therefore Cost of Sales = Rs. 2,00,000X6 = Rs. 12,00,000

Gross Profit Ratio = 20%= Gross Profit

Sales

i.e., cost of sales = 80% of sales, therefore, sales = cost of salesx100

80

=12,00,000 x 100 =Rs. 15,00,000

80

Fixed assets turnover = Cost of Sales

Fixed Assets

2 =Rs. 12,00,000

Fixed Assets

Therefore Fixed Assets= Rs.12,00,000 = Rs.6,00,000

2

Debt Collection period =No of months in a year

Sales/Debtors

=No. of months in a year X Debtors

Sales

129

2 = 12xDebtors

15,00,000

Therefore, Debtors = Rs. 15,00,000x2/12= Rs. 2,50,000

Fixed Assets to shareholders’ net worth=Fixed Assets = 0.80

Net Worth

=Rs. 6,00,000 = 0.80

Net worth

= Net worth = Rs. 6,00,000= Rs. 7,50,000

0.80

Reserves and Surplus to capital=0.5

Reserves & Surplus/Capital = 0.5

Where as net worth = Share capital + Reserves & Surplus

7,50,000 = Share capital + Reserves & Surplus Or

Share capital = 7,50,000 – Reserves & Surplus

Reserves & Surplus/7,50,000 – Reserves & Surplus = 0.5

7,50,000 x0.5 – 0.5 Resrves &Surplus = Reserves & Surplus

3,75,000 = 1.5 Reserves and Surplus

That is Reserves and surplus = 3,75,000/1.5 = Rs. 2,50,000

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Share Capital = Rs. 5,00,000

Balance Sheet as on ……..

Share capital 5,00,000 Fixed Assets 6,00,000

Reserves& Surplus 2,50,000 Stock 2,00,000

Current Liabilities 2,00,000 Debtors 2,50,000

Long term debt (Bal fig) 1,50,000 Cash 50,000

11,00,000 11,00,000

5.11 LIMITATIONS OF RATIO ANALYSIS:

Ratios analysis plays a pivotal role in the process of Analysis and interpretation of data in the

financial statements. Even though ratio analysis is simple to calculate and easy to understand,

they are not free from certain drawbacks. These limitations are:

1. Limitations of Financial statements:-Ratios are derived from financial statements.

The financial statements suffer from a number of limitations and ratios which are

derived from these statements are also subject to the same limitations.

2. Reliability of the data:- The analyst should know the reliability and soundness of the

figures from which the ratios are calculated. Otherwise, the conclusions may be

misleading.

3. Comparison:-Ratios are helpful in analyzing the efficiency of the firm only when

they are compared with the past results of the firm or with the results of the similar

firms. Such comparisons only provide glimpses of the past performance.

4. Change in Accounting practices:- Ratios mislead, whenever there is a change in the

accounting procedures.

131

5. No Fixed Standards:- To make ratios as acceptable norms, there should be some

well acceptable standards. But unfortunately, no such standards exist. They vary from,

industry to industry and from firm to firm.

6. Price Level changes:- Financial statements are based on historical cost concepts and

no consideration is made to the changes in the price levels. And the ratios also suffer

from the same limitations.

7. Ratios alone are not enough:- Ratios are only indicators, they cannot be taken s final

regarding the financial health of the concern. They are only means of financial

analysis and not an end in itself.

8. Absolute figures are distortive:-Ratios are calculated from absolute figures. It is

basically a quantitative analysis and not a qualitative analysis. They can never be

substitute for the raw figures.

9. Difficulty in Definitions:- The differences in the definitions of various items of the

balance sheet and income statement make the interpretation of ratios a difficult task.

Some such items are Net profit, Net worth, and Capital employed which convey

different meanings.

10. Single Ratio is not adequate:-Instead of single ratio, often a number of ratios are

calculated to make a better interpretation of the financial data, which sometimes is

confusing rather than helpful in decision making.

11. Other factors:-Apart from financial factors, other factors like economic, social and

political factors also should be considered to make ratio analysis meaningful.

It may be concluded that ratio analysis is a useful tool of financial analysis, but it

mechanically done, it in not only misleading but also dangerous.

5.12 SUMMARY :

Ratio is a mathematical relationship existing among two or more items in the financial

statements. The process of establishing and interpreting various ratios between figures and

groups of figures may be termed as ‘Ratio analysis’. Ratio analysis helps in ascertaining the

financial condition of a firm. Ratios are used to evaluate the performance such as liquidity,

132

solvency, profitability and operational efficiency of a firm. Though ratio analysis is one of the

most powerful tools of financial management they suffer from some limitations. Ratios

themselves are not of much significance. They become useful only when they are compared

with some standards.

5.13 KEY WORDS: Ratio Ratio Analysis

Primary ratio Profitability Ratios

Liquidity Ratios Activity Ratios

Leverage Ratios Coverage Ratios

Try Yourself:

1. Define the meaning of Ratio.

2. Give two objectives of Ratio analysis.

3. Give two uses of Ratio analysis.

4. Given Net sales Rs. 1,00,000; Gross profit Rs. 60,000. Calculate Cost of goods sold ratio.

5. From the following calculate (i) Operating ratio (ii) Operating profit ratio. Given

Operating cost Rs. 70,000; net sales Rs. 1,00,000.

6. Given Net profit after taxes Rs. 1,12,450; current assets Rs.1,00,000; current liabilities Rs.

80,000. Calculate return on working capital.

7. Name any three Current Assets.

8. Given Current ratio is 2:2; working capital: Rs. 10,000; Calculate Current Assets and

Current liabilities.

9. What is the formula for calculating Price Earnings Ratio?

10. Stock turnover ratio = 6 times, Calculate stock velocity (in days).

11.What for Interest coverage ratio is useful?

12.Average debtors are

13.Given Cash Rs. 20,000, Bill receivable Rs 10,000, Sundry debtors Rs. 50,000, stocks Rs.

40,000, Sundry creditors Rs. 60,000, cost of sales Rs 3,00,000. Calculate working capital

turnover ratio.

133

14.Calculate the Debtors turnover ratio from the following:

total Sales Rs.2,00,000, Cash sales Rs. 40,000, Opening debtors Rs. 20,000, Closing

debtors Rs. 30,000, Opening balance of bills receivable Rs.15,000 and closing balance of bills

receivable Rs. 25,000.

Answers to Try Yourself:

1. A ratio is a numerical relationship existing between two related figures in the financial

statements.

2.1. To assess the profitability of a firm.

2. To find out the financial condition of a firm.

3.1. Ratio analysis facilitates inter firm comparison.

2. Ratio analysis helpful to the management in performing the important functions like

planning, coordination, control and forecasting.

4. COGS = (40,000 x100) / 1,00,000 = 40%

5. (i) Operating ratio =( 70,000 x100) / 1,00,000 =70%

(ii) Operating profit ratio = 100 – Operating ratio = 100 – 70% = 30%

6. Return on working capital = 1,12,450 x 100 /20,000 = 562.25%

7. Cash in hand, Sundry Debtors, Inventory (Stocks)

8. Current liabilities = Rs. 10,000 current assets = Rs. 20,000

9. Price Earning Ratio =Market price of Equity share/Earnings per share

10. Stock velocity ( in days) = 365/6 = 60.83 days.

11. It is useful for knowing the firms debt servicing capacity.

12. Average Debtors =( Opening trade debtors + Closing trade debtors) / 2

13. Working capital turnover ratio = 3,00,000/60,000 = 5 times

14. Debtors turnover ratio = 1,60,000/45,000= 3.56 times

Questions:

1. What do you understand by ratio analysis? Discuss its objectives and limitations.

2. “Ratio analysis is a tool to examine the health of business with a view to make financial

results more intelligible”. Explain.

3. Examine the relationship between Solvency, Liquidity and Profitability?

134

FURTHER READINGS: Battacharya S.K. & Dearden J., Accounting for Management, Vikas Publishing House,

New Delhi.

Khan M.Y. & Jain P.K., Management Accounting, Tata McGraw Hill

Publishing co.Ltd.

Maheswari S.N. , Principles of Management Accounting, Sultan Chand & sons,

New Delhi.

Pandey I.M., Management Accounting, Vikas Publishing House, New Delhi.

Sharma R.K. & Gupta S.K. , Management Accounting, Kalyani Publishers, New Delhi.

135

LESSON 6

FUNDS FLOW ANALYSIS OBJECTIVES:

Define of “Funds” and explain significance of Fund Flow Statements Differentiate between Income, Position, and Funds Flow Statements Illustrate and explain the Preparation of Funds Flow and Cash Flow

Statement Classification of Cash Flow Statement as per AS-3 (Revised)


6.2 Procedure for Preparing Funds Flow Statement

6.3 Financial / Total Resource Basis

6.4 Working Capital Basis

6.5 Cash Basis – Cash Flow Statement

6.6 Status and Applicability of AS-3 (Revised): Cash Flow Statement

6.7 Summary

6.8 Key Words

6.1 INTRODUCTION:

Every company has to prepare its balance sheet at the end of the accounting year. It reveals

the financial position of the company at a certain point of time. However, it does not present

any analysis, as it is simply a statement of assets and liabilities. Its usefulness is, therefore,

limited for analysis and planning purposes. The statement of sources and application of funds

serves the purpose, which is the popularly known as “Funds Flow Statement”. Funds Flow

Statement is a widely used tool in the hands of financial executives for analyzing the financial

performance of a concern. Though it is not mandatory for external reporting, leading

organizations always prepare such a statement along with the balance sheet for internal

136

consumption. This statement shows how the activities of a business have been financed or

how the available financial resources have been used during a particular period.

An income statement is primarily a presentation of revenue and expenses items and

computation of net income for the period and the position statement gives a snapshot of the

assets and liabilities on a specific date. Both these statements do not explain the changes in

assets, liabilities, and owner’s equity. The Funds Flow Statement is a report of financial

operations of a business undertaking. It generally reports changes in current assets and

current liabilities and is much useful for financial executives, financial institutions and

creditors for the analysis of financial position of the company.

Different thinkers interpret the term ‘funds’ differently. They may mean (i) financial

resources (arising from both current and non-current items) (ii) working capital (the

difference between current assets and current liabilities) and (iii) cash. It is critically

important to understand the specific funds movements caused in the business system by daily

management decisions on investment, operations, and financing. Management decisions, in

one form or another, affect the company’s ability to pay its bills, obtain credit from suppliers

and lenders, extend credit to its customers, and maintain a level of operations that matches the

demand for the company’s products or services, supported by appropriate investments. Every

decision has a monetary impact on the ongoing cycle of uses or sources of funds. It is

management’s job to strike a proper balance between the inflows and outflows of funds at all

times and to allow for any changes in level of operations, caused by management decisions or

by outside influences, that may affect these flows.

6.2 PROCEDURE FOR PREPARING FUNDS FLOW STATEMENT:

As there are varied interpretations for “funds”, the preparation of funds flow statement differs

depending on how we define the term. In a very narrow sense, it may mean only “cash”, the

more comprehensive view may capture “financial resources”, and between these two extreme

137

view points lie the “working capital” definition of funds. All the three analytical methods are

discussed below which give further clarity to the concept of flow of funds.

6.3 FINANCIAL RESOURCES BASIS:

Under this technique, a single statement is prepared which captures all the items in the

balance sheet. The “sources” of funds will include a reduction in current assets and fixed

assets and increase in current liabilities and non-current liabilities including equity. On the

other hand, an increase in current assets and fixed assets together with a decrease in current

liabilities and non-current liabilities are recorded under “uses” of funds. As all the items in the

balance sheet are considered, the sources of funds

Illustration 1

From the following details available for two balance sheet dates prepare a statement of

Sources andUses of Funds on Financial Resources Basis.

Liabilities As on 1st As on 31st Assets As on 1st As on 31st

Jan 1986 Dec.1986 Jan 1986 Dec. 1986

Rs. Rs. Rs. Rs.

Share Capital 6,00,000 7,00,000 Fixed Assets 10,20,000 12,40,000

Debentures 2,00,000 5,00,000 Investments 60,000 40,000

General Reserve 3,00,000 4,00,000 Current Assets 4,80,000 8,70,000

P&L a/c 1,20,000 1,40,000 Discount on

Debentures 10,000 ---

Depreciation

Reserve 1,80,000 2,60,000

Provision for

Doubtful Debts 20,000 30,000

138

Current Liabilities 1,50,000 1,20,000

----------- ------------ ------------ -----------

15,70,000 21,50,000 15,70,000 21,50,000

Solution:

Statement of Sources and Uses of Funds

Sources

Increase in Share Capital

Increase in General Reserves

Increase in Profit and Loss Account

Increase in Debentures

Increase in Provisions

Increase in Depreciation Reserve

Decrease in Investments

Decrease in Discount of Debentures

Total Sources

Uses

Increase in Fixed Assets

Increase in Current Assets

Decrease in Current Liabilities

Total Uses

1,00,000

1,00,000

20,000

3,00,000

10,000

80,000

20,000

10,000

6,40,000

2,20,000

3,90,000

30,000

6,40,000

Interpreting the Funds Flow Statement

This company is not able to generate enough funds internally for its capital expenditure

requirements as Rs 2,00,000 generated through an increase in the P&L A/c, General Reserves,

and Depreciation Reserves are less than the increase in Fixed Assets at Rs 2,20,000. Issue of

equity share capital and debentures amounting to Rs 4,00,000 seems to be for meeting the

139

working capital requirements of Rs 3,90,000. While the company’s customers are able to

access further credit, the suppliers are denying credit to this company. This increase in current

assets significantly in the face of decrease in current liabilities is definitely a discouraging

sign.

6.4 WORKING CAPITAL BASIS:

Under this technique, the following three statements are prepared. A proforma of these

statements are given at the end.

(a) Statement of Changes in Working Capital: Where increase in current assets and

decrease in current liabilities increases working capital and decrease in current assets and

increase in current liabilities decreases working capital.

(b) Funds From Operations: The net profit/net loss that is reported by an entity is not the

actual fund position for the accounting year. Hence, we need to make adjustments to the

profit and loss account to arrive at the actual funds generated/lost from operating

activities. To sustain any business, its core activities should generate a positive fund flow.

The very purpose of preparing this statement is to discover the operational excellence of a

company as is reflected in the funds from operations and not get carried away by a healthy

net profits which can never tell the actual story. Hence, to the net profits reported in the

income statement, we need to add all the non-cash expenses like depreciation and

amortization and non-operating items such as dividends and taxes.

(c) Funds Flow Statement: It captures both “sources” and “uses” of funds. All items

which generate fund inflows such as an increase in share capital, term loans, debentures,

sale of assets, decrease in working capital, and funds from operations are recorded under

Sources, while items which result in outflow of funds such as purchase of assets,

redemption of debentures, payment of taxes, payment of dividends, increase in working

capital, and funds lost in operations are recorded under Uses.

140

Statement of Changes in Working Capital

Particulars 31st Dec Changes in Working Capital

----------------------------- --------------------------------

2004 2005 Increase Decrease

==================================================================

Current Assets -- -- ---- ----

Stock --- --- ---- ----

Bills Receivable --- --- ---- ----

Debtors --- --- ---- ----

Cash in Hand --- --- ---- ----

Cash in Bank ` --- --- ---- ----

Prepaid Expenses ---- --- ---- ----

------------------------------------------------------------

Total Current Assets --- --- ---- ----

------------------------------------------------------------

Current Liabilities --- --- ---- ----

Short Term Loans --- --- ---- ----

Bills Payable --- --- ---- ----

Trade creditors --- --- ---- ----

Outstanding Expenses --- --- ---- ----

------------------------------------------------------------

Total Current Liabilities ---- ---- ---- ----

141

------------------------------------------------------------

Net Working Capital (CA-CL)---- ---- ---- ----

------------------------------------------------------------

Net Increase/decrease in Working Capital ---- ----

Funds Form Operations

Net Profit for the current year ----

Add: Non-Fund Items & non-trading Charges

i) Depreciation and Depletion

-----

ii) Amortization of Fictitious and intangible

assets like writing off preliminary expenses, discount on

issue of debentures or preference

shares, Goodwill, Patents etc.

-----

iii) Provision for taxation -----

iv) Appropriation of Retained Earnings such

as Transfer to General Reserve, Sinking Fund etc.

-----

v) Proposed Dividend -----

vi) Less on Sale of fixed assets (if debited to

P&L Account)

-----

-----

Less—Non-Fund items and non-trading incomes

----

i) Dividend received and receivable -----

142

ii) Excess provision written back -----

iii) Profit on sale of fixed assets (if already

credit ed to Profit & Loss account)

-----

iv) Profit on revaluation of fixed assets (if

already credited to Profit & Loss account)

-----

-----

Trading Profit or Funds from Operations ------

Fund Flow Statement (Account Form)

Sources of Funds Rs. Application of Funds Rs.

1. Funds from Operations ----- 1. Loss from operations ------

2. Issue of Share Capital ----- 2. Redemption of Debentures

or preference shares

------

3. Issue of Debentures ----- 3. Repayment of Long-

term loans

------

4. Long-term Loans ----- 4. Purchase of Fixed Assets ------

5. Sale of Fixed Assets ----- 5. Non-trading payments ------

6. Non-trading receipts

-----

6. Increase of Working

Capital

------

7. Decrease in Working

Capital

-----

------

143

Illustration 2. The following is the Balance Sheet of ABC Ltd

(Rs. in lakhs) AS AT AS AT AS AT AS AT 30.6.82 LIABILITIES 30.6.83 30.6.82 ASSETS 30.6.83 Share Capital 13.00 Plant 18.00 (Equity Shares 8.00 Stock 9.50 10.00 of Rs.100 each) 20.00 15.00 Debtors 14.50 10% Redeemable 3.00 Bank Balance 2.50 Preference Shares of 1.00 Miscellaneous 1.00 7.50 Rs.100 each 2,50 0.50 Share Premium 0.25 Capital Redemption -- Reserve 5.00 8.00 General Reserve 4.50 3.00 Profit & Loss a/c 5.00 Provision for 5.00 Taxation 6.00 Current 6.00 Liabilities 2.25

-------- ------ ------ - ------- 40.00 45.50 40.00 45.50 ======================================================================== The following further information is furnished:

1. The Company declared a dividend of 20% for the year ended 30th June 1982, to equity

shareholders on 30th September 1982.

2. The Company issued notice to preference shareholders holding preference shares

of the face value of Rs.5 lakh for redemption at a premium of 5% on 1st December

1982 and the entire proceedings were completed before 31st December 1982 in

accordance with the law.

3. The Company provided depreciation at 10% on the closing balance of plant. During

the year one plant whose book value was Rs.2,60,000 was sold at a loss of Rs.30,000

144

4. Miscellaneous expenditure incurred during the year ended 30th June 1983 Rs.25,000

for share issue and other expenses.

Prepare a statement of sources and application of funds for the year ended 30th June 1983

on net working capital basis.

Solution ABC Ltd

Statement of Changes in Working Capital (Rs.in lakhs) Balance as on 30th June ….. Changes inWorking Capital 1982 1 983 Increase Decrease

(i) Current Assets Stock 8.00 9.50 1.50 --- Debtors 15.00 14.50 -- 0.50 Bank Balance 3.00 2.50 - 0.50 ------- -------- (A) 26.00 26.50 ------- -------

(ii) Current Liabilities and Provisions:

Current Liabilities 6.00 2.25 3.75 -- Provision for Taxation 5.00 6.00 -- 1.00 ------ ------ (B) 11.00 8.25 ------- ------ Working Capital

(A)-(B) 15.00 18.25 Net Increase in Working Capital 3.25 -- -- 3.25 ------- ------ ------ ------ 18.25 18.25 5.25 5.25

(2) Computation of Funds From Operations

Increase in P & L A/c

Add: Non-cash items and Non-operating items

Depreciation

Miscellaneous Expenses Written Off

2.00

0.25

2.00

145

Loss on Sale of Assets

Transfer to General Reserve

Equity Dividends

Funds From Operations

0.30

1.50

2.00

6.05

8.05

Funds Flow Statement for the year ended 30th June 1983

Sources of Fund Amount Application of Fund Amount

(Rs.in lakhs) (Rs. in lakhs)

1. Issue of equity shares 10.00 1. Redemption of pre-

ference shares (at a

Premium of 5%) 5.25

2. Sale of Plant 1.70 2. Purchase of Plant 9.00+

3. Funds from operation 8.05* 3. Equity Dividends 2.00

4. Miscellaneous expenditure 0.25

5. Increase in Working

capital 3.25

--- --------- ---------

19.75 19.75


ABC Ltd has a healthy fund flow from its operations as nearly 40% of the total funds

originated from its core business activities. It has issued ownership securities to the tune of Rs

10.00 lakh to augment the financing of modernization of its plant. A significant portion of

fund flows have been used for discharging preference shares at a premium as per the

commitment made at the time of issue. Dividends to the extent of Rs 2.00 lakh and additional

working capital needs amounting to Rs 3.25 have mopped up the residual funds. Thus, ABC

146

Limited has financed its capital expenditure with long-term sources to enhance its earning

capacity in the future.

Working Notes:

Plant Account

(Rs.in lakhs) (Rs.in lakhs)

To Balance b/d 3.00 By Cash (Sale of Plant)

1.70

To Cash a/c By Adjusted P&L a/c

(Purchase of Plant (loss on sale of Plant) 0.30

being balancing figure) 9.00

By Depreciation 2.00 *

By Balance c/d 1 8.00

---------- -----------

22.0 22.00

*Closing balance of Plant is Rs.18 lakh after charging depreciation @ 10% on closing

balance. Therefore, depreciation must have been charged on 18 x 10/9 = Rs.20 lakh.

Thus, the amount of depreciation comes to Rs.2 lakh i.e., 10% on Rs. 20 lakh.

Illustration 3. The following Balance Sheet of Runbaxy & Co. Ltd., for the years 1984 and

1985 are given. You are required to prepare a Funds Flow Statement on working capital

basis.

147

(Figures are as at 31st December) (000 omitted)

Liabilities 1984 1985

Rs. Rs.

Share Capital … … 150.00 225.00

Share Premium … … ….. 7.50

General Reserve … … 75.00 90.00

P and L Account … … 15.00 25.50

Debentures 6% … … 105.00 75.00

Provision for Depreciation on Plant … 75.00 84.00

Provision for Depreciation on Furniture … 7.50 9.00

Tax … … … 30.00 45.00

Sundry Creditors … … … 129.00 142.50

====== =======

586.50 703.50

Assets 1984 1985

Rs. Rs.

Land .. … … 150.00 150.00

Plant … … … 156.00 150.00

Furniture … … … 10.50 13.50

Investment … … … 90.00 120.00

Debtors … … … 45.00 105.00

Stock … … … 90.00 97.50

Cash … … … 45.00 67.50

======= =======

586.50 703.50

148

Additional information:

(i) Plant purchased for Rs. 6,000 (depreciation value Rs. 3,000) was sold for cash

Rs.1,200 on 30th September 1985.

(ii) On 29th June 1985, Furniture was purchased for Rs. 3,000.

(iii) Depreciation on Plant 8% and Depreciation on Furniture 12½ % on average cost.

(iv) Dividend 22½ % on original Share Capital.

Solution

Statement of Changes in Working Capital

__________________________________________________________________________ 1984 1985 Increase Decrease

I. Current Assets

Debtors … 45,000 1,05,000 60,000 ---

Stock .. 90,000 97,000 7,500 ---

Cash .. 45,000 67,500 22,500 ---

----------- -----------

(A) 1,80,000 2,70,000

II. Current Liabilities:

Tax Liability … 30,000 45,000 --- 15,000

Sundry Creditors 1.29,000 1,42,500 --- 13,500

----------- ----------

(B) 1,59,000 1,87,500

III Working Capital:

(A)-(B) 21,000 82,500

Net Increase in Working

Capital 61,500 --- --- 61,500

---------- --------- -------- ---------

82,500 82,500 90,000 90,000

149

Funds Flow Statement for the year ended 31st December 1985

Sources of Fund Amount Application of Fund Amount

Rs. Rs.

1. Issue of Share Capital 75,000 1. Redemption of

Debentures 30,000

2. Premium on share issued+ 7,500 2. Purchase of Furniture* 3,000

3. Sale of Plant* 1,200 3. Purchase of Investment 30,000

4. Funds from operations* 74,550 4. Payment of Dividend 33,750

5. Increase in Working

Capital 61,500

--------------- --------------

1,58,250 1,58,250

___________________________________________________________________________


This company has to improve its working capital management as most of the resources

generated from business operations are being utilized for meeting the additional working

capital needs. The company is not judiciously applying its funds as investments (non-core

activities) are absorbing a significant amount of funds at Rs 30,000. There is absolutely no

creation of fixed asset to increase the earning capacity in the future and the purpose of

mobilizing equity shares appears to be for discharging debentures and paying dividends.

150

Working Notes:

Plant Account To Balance b/d (1.1.85) 1.56,000 By Cash (sale) 1,200 By P&L a/c (loss on sale) 1,800 By Prov. for Dep. A/c (on Plant sold) 3,000 By Balance c/d (31.12.85) 1,50,000 ------------- ---------------

1,56,000 1,56,000

Provision For Depreciation on Plant Account

Rs. Rs. To Plant a/c By Balance b/d 75,000 (Prov. Written off on (1.1.85) Plant sold) 3,000 By P&L a/c To Balance c/d 84,000 (New Prov. Created @ 8% on Rs.1,50,000) 12,000 --------- -------- 87,000 87,000

Furniture Account Rs. Rs. To Balance b/d 10,500 By Balance c/d 13,500 (1.1.85) (1.1.85) To Cash (Purchase, 3,000 Being balancing figure) --------- -------- 13,500 13,500

151

Provision For Depreciation on Furniture Account Rs. Rs. To Balance c/d By Balance b/d (31.12.85) 9,000 (1.1.85) 7,500 By P&L a/c 1,500* ------- -------

9,000 9,000 *Depreciation on Furniture: 12½ % on Rs.10,500 (opening balance of Furniture) Rs. 1,313 12½ % on Rs.3,000 for 6 months (on Furniture purchased on 29.6.85) Rs. 187 ----------- Rs. 1,500 Funds from Operations

. To Non-trading Items: Rs. Rs.

By Balance b/d 15,000 Depreciation on Plant 12,000 Depreciation on Furniture 1,500 By Fund from operations Loss on sale of Plant 1,800 (being balancing figure) 74,550 Appropriation for Divided 33.750 Transfer to General Reserve 15,000 To Balance c/d 25,500 --------- --------

89,550 89,550

6.5 CASH BASIS- CASH FLOW STATEMENT:

A funds flow statement on cash basis requires preparation of two statements:

(a) Cash From Operations: To the net profits/net losses reported in the income statement,

we need to add all the non-cash expenses like depreciation and amortization, provision for

dividends and taxes together with transfers to reserves; and any decrease in current assets

and increase in current liabilities. Further, we need to deduct any increase in current

152

assets, decrease in current liabilities. The net figure if it is positive, it indicates Cash From

Operations which is a Source and if it were to be negative, it indicates Cash Lost in

Operations which is a Use of funds.

(b) Cash Flow Statement: It captures both “sources” and “uses” of cash. It begins with the

opening balance of cash. To this all items which generate cash inflows such as an increase

in share capital, term loans, debentures, sale of assets, and cash from operations are

recorded under Sources, while items which result in outflow of funds such as purchase of

assets, redemption of debentures, payment of taxes, payment of dividends, and cash lost in

operations are recorded under Uses. Finally, it ends with the closing balance of cash.

Illustration 4

The Comparative Balance Sheets of a company are given below.

1995

Rs.

1996

Rs.

1995

Rs.

1996

Rs.

35,000

6,000

5,180

350

5,020

37,000

3,000

5,920

400

5,280

45,000

7,450

24,600

10,000

5,000

3,900

8,850 21,350

15,000

2,500

Share Capital

Debentures

Creditors

Provision for

Doubtful Debts

Profit & Loss

51,550 51,600

Cash

Book Debts

Stocks

Land

Goodwill

51,550 51,600

Additional information available are:

(i) Dividends paid amounted to Rs.1,750

(ii) Land was purchased for Rs.5,000 and amount provided for the amortization of

goodwill amounted to Rs.2,500.

(iii) Debentures were repaid to the extent of Rs,3,000

153

You are required to prepare a Cash Flow Statement.

Cash From Operations

(Rs)

P&L a/c 1996 … 5,280

Less: P&L a/c 1995 … 5,020

260

Add: Dividend … 1,750

Add: Goodwill written-off 2,500

Add: Decrease in Stocks 3,250

Add: Increase in Provision for Doubtful Debts 50

Add: Increase in Creditors 740

8,550

Less: Increase in Debtors 1,400

-------

Cash from Operations 7,150

====

Cash Flow Statement

Cash Inflow: Rs.

1. Cash Balance 1-1-1996 4,000

2. Issue of Shares 2,000

3. Cash from Operations 7,150

--------

13,650

154

--------

Cash Outflow:

1. Purchase of Land 5,000

2. Payment of Dividend 1,750

3. Repayment of Debentures 3,000

4. Cash Balance on 31-12-1996 3,900

--------

13,650

--------

Interpreting the Cash Flow Statement

There has been a slight dip in the cash balances at the end of the period despite issuing shares

(Rs 2,000) and generating a healthy flow from operating activities (Rs 7,150). This is because

the company acquired land and discharged debt while paying dividends amounting to Rs.

1,750 respectively. The company could have avoided issuing equity if it had skipped

dividends and thereby avoided transaction costs. This would have had a marginal impact on

cash balances at the end of the year. To reduce its overall capital, the company should

leverage by borrowing additional funds to finance the fresh acquisition of fixed assets.

6.6 STATUS AND APPLICABILITY OF AS -3 (REVISED): Cash Flow Statement:

The Institute of Chartered Accountants of India had recently revised AS-3 (Statement of

Changes in Financial Position) issued in 1981. AS-3 (Revised) is mandatory in nature with

effect from 1st April 2001 for all the listed companies and other enterprises whose turnover

exceeds Rs 50 crores for the accounting period.

Preparation of Cash Flow Statement: The cash flow statement of an enterprise should report

cash flows during the period classified by operating, investing, and financing activities in a

manner, which is most appropriate to its business.

155

Operating Activities

Cash flows from operating activities are primarily derived from the principal revenue-

producing activities of the company. Cash flows from operating activities are:

Cash receipts from sale of goods and services;

Cash receipts from royalties, fees, commissions, and other revenues;

Cash payments for all operating expenses;

Cash receipts and cash payments of insurance enterprise for premiums and claims,

annuities and other policy benefits; and

Cash payments or refund of income taxes.

Investing Activities

The investment activities are those that are related to the investment of funds in the fixed

assets and other investments. The separate disclosure of cash flows arising from investing

activities shows the extent to which expenditures have been made for resources intended to

generate future income and cash flows. They can be:

Cash payments to acquire fixed assets, intangibles and those relating to capitalized

research and development costs and self-constructed fixed assets;

Cash receipts from disposal of fixed assets and intangibles;

Cash payments to acquire shares, warrants, or debt instruments of other enterprises

and interests in joint ventures;

Cash advances and loans made to third parties (other than advances and loans

made by a financial enterprise);

Cash receipts from the repayment of advances and loans made to third parties

(other than advances and loans made by a financial enterprise); and

Cash receipt by way of interest, dividend or any other cash income from the

investee enterprise.

156

Financing Activities

These activities include those relating to long-term funds i.e., share capital and borrowings.

Cash flows arising from financing activities may include:

Cash proceeds from issuing shares or other similar instruments;

Cash proceeds from issuing debentures, loans, notes, bonds, and other short or

long-term borrowings;

Cash repayments of amounts borrowed;

Interest or dividend repayments; and

Cash payments for redemption of bonds, debentures, or preference shares.

6.7 SUMMARY:

In this unit, we have discussed the need for constructing a funds flow and cash flow

statements to supplement the information provided by income and position statements. Funds

flow analysis details the financial resources availed and the ways in which such resources are

used during an accounting period. As the sources side captures the funds generated from

operations internally, it explains reasons for liquidity problems of the firm even though it is

earning profits. The changes in working capital position can also be tracked by observing the

surplus / deficit of funds during an accounting period. The top management may, however,

like to know the ability of an enterprise to generate cash and cash equivalents and the timing

and certainty of their generation. This warrants preparation of a cash flow statement, which

provides the information about the cash receipts and cash payments of a firm for a given

period.

6.8 KEY WORDS:

Working capital Total resources; Funds from operations

Cash from operation Cash Flow Statement

Funds Flow Statement

157

Try Yourself:

1) The following Balance Sheet of VST & Co. Ltd., for the years 2004 and 2005 are given.

(Figures are as at 31st March) (Rs in Lakhs) Liabilities 1984 1985 Rs. Rs. Share Capital … … 50.00 75.00 General Reserve … … 75.00 90.00 P and L Account … … 12.00 15.00 Debentures 9% … … 85.00 75.00 Tax … … … 30.00 45.00 Sundry Creditors … … … 48.00 42.00 ====== ======= 300.00 342.00 Assets 1984 1985 Rs. Rs. Land .. … … 50.00 60.00 Plant … … … 75.00 80.00 Furniture … … … 10.00 13.00 Debtors … … … 40.00 65.00 Stock … … … 80.00 87.00 Cash … … … 45.00 37.00 ======= ======= 300.00 342.00 Additional information: Plant purchased for Rs. 4 lakhs (depreciation value Rs. 1 lakh) was sold for Rs. 1,50,000

during the year.

Depreciation to be provided on Plant 10 % and Furniture 12 % on average cost. An interim dividend of Rs 9 lakhs was paid on 1st December.

You are required to prepare Funds Flow and Cash Flow Statements

158

2) Prepare a statement from the figures given below showing application and sources of funds

during the year 1986 under all the three methods learnt in this chapter.

Liabilities As on 1st As on 31st Assets As on 1st As on 31st Jan 1986 Dec.1986 Jan 1986 Dec. 1986

Rs. Rs. Rs. Rs. Share Capital 6,00,000 7,00,000 Fixed Assets 10,20,000 12,40,000 Debentures 2,00,000 4,00,000 Investments 60,000 1,60,000 General Reserve 3,00,000 4,00,000 Current Assets 4,80,000 7,50,000 P&L a/c 1,20,000 1,40,000 Discount on Debentures 10,000 --- Depreciation Reserve 1,80,000 2,60,000 Provision for Doubtful Debts 20,000 30,000 Current Liabilities 1,50,000 2,20,000 ----------- ------------ ------------ ----------- 15,70,000 21,50,000 15,70,000 21,50,000 Additional Information:

During the year equity dividend @ 15% was paid for 1985.

Depreciation amounting to Rs 80,000 was provided on Fixed Assets.

FURTHER READINGS:

Sashi.K.Gupta and R.K.Sharma, Financial Management, Kalyani Publishers,

New Delhi.

Ravi. M.Kishore, Financial Management, Taxmann Allied Services, New Delhi.

159

LESSON-7

COST VOLUME PROFIT ANALYSIS

STRUCTURE


7.2 Assumptions of Breakeven Analysis

7.3 Breakeven Point (BEP)

7.4 Contribution

7.5 Profit- Volume Ratio

7.6 Margin of Safety

7.7 Profit Goal

7.8 Breakeven Analysis in Multi-product Firm

7.9 Applications of BEP Analysis for Managerial Decision Making

7.10 Limitations of CVP Analysis

7.11 Summary

7.12 Key Words

7.1 INTRODUCTION:

Every Organisation, whether commercial or otherwise needs to create a surplus. While

commercial organizations necessarily exist to make a surplus which they would call a profit,

non-commercial organizations also need to make a surplus, if they need to sustain themselves

and survive. Hence every Organisation or firm needs to make a surplus and devise plans to

make a surplus and be financially viable.

OBJECTIVES:

To explain the relationships between cost, volume, selling price and profit

To explain the utility of Breakeven Analysis for Profit Planning To apply Breakeven Analysis for Managerial Decision Making

160

One of the methods of profit planning for manufacturing organizations is the Cost-Volume

Profit-Analysis or C-V-P Analysis for short. This method aims to examine the inter

relationships that exist between cost, selling-price of the product, and the volume of sales on

the profit and use these inter relationships to aid in Profit Planning C-V-P Analysis is

synonymously used with Breakeven Analysis, which is by far the most popular tool of C-V-P

Analysis.

7.2 ASSUMPTIONS OF BREAKEVEN ANALYSIS :

C-V-P Analysis as a tool of profit planning is based on certain assumptions which are

explained below.

1. Segregability of Costs: Breakeven Analysis assumes that all costs can be segregated into

‘Fixed Costs’ and ‘Variable Costs’. Even those costs which are semi-variable in nature can

ultimately be separated into fixed and variable components.

‘Fixed Costs ’: Fixed costs are those costs which are incurred by a firm irrespective of its

level of output. These are the costs which are not directly related to making of the product,

and therefore remain unchanged no matter what the level of production.

‘Variable Costs’: Variable Cost are those costs which are directly involved in the making of

the product and therefore vary in direct sympathy with the level of output.

A point to be noted here is that while Fixed Costs remain constant in aggregate, the per unit

fixed costs varies as the production levels vary, whereas variable costs remain constant per

unit, but change in aggregate as the level of production Changes.

2. Constancy of Selling Price: The second assumption is that the selling price of the firm

products remains constant, no matter what the level of output. This is in contravention to the

normal economic laws of supply and demand where we see that price is a function of supply

and demand.

161

3. Constancy of Product Mix: Another assumption on which CVP Analysis is based is that

the firm produces only one product, i.e., it is a uni-product firm or even if it is a multi-product

firm, the product mix would remain constant and not change.

4. Synchronisation of Production and Sales: CVP Analysis also assumes that there is

perfect harmony between production and sales that all that has been produced will be sold and

therefore there will not be any changes in levels of inventory.

7.3 BREAKEVEN POINT (BEP):

As already explained CVP Analysis mainly depends on the concept called Breakeven Point.

Breakeven Point is that level of output and sales, where the total costs (TC) are equal to Total

Revenues (TR).

TC = TR

TC = FC (fixed costs) + FC (variable costs)

Since costs are equal to revenues, the firm has neither a profit nor a loss at this level of output.

Breakeven Point can be ascertained algebraically using the following:

BQ = F

S-V

Where BQ stands for BEP in quantity or No. of units.

F stands for Fixed Cost.

S stands for Selling Price per unit.

V stands for Variable Cost per unit.

Example:

If S = Rs.10, V = Rs.6 and Fixed Costs are Rs.80,000, BQ =?

BQ = F = 80,000 = 20,000 units

S – V 10 – 6

To verify @ a sales level of 20,000 units

162

Sales Revenue is 20,000 x10 = 2,00,000

Variable cost is 20,000 x 6 = 1,20,000

------------

Contribution 80,000

Less: Fixed costs 80,000

-----------

Profit/Loss NIL

------------

7.4 CONTRIBUTION:

The difference between the Sales Revenue and the Variable Costs is called contribution

because it contributes to the firm to cover the fixed cost and if any balance is left out after

covering fixed cost, the same goes to contribute to the profit of the firm.

Breakeven Point can also be ascertained in terms of value, by simply multiplying BQ by S,

Therefore, Total Sales revenue at which point the firm will break even, in terms of rupees can

be known as under.

BRs = F x S or F

( S – V ) (1 – V/S) Example:

If S = Rs.30, V = Rs.20, and F is Rs. 20,000, Compute the BEP in quantity and Rupees.

BRs = BQ x S or F (1 – V/S)

BQ = 20,000 = 2,000 units

30 – 20

BRs = 10,000 x 30 = Rs. 6,00,000

OR

20,000 = 20,000 x 30 = Rs.6,00,000

( 1 – 20/30 ) 10

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7.5 PROFIT- VOLUME RATIO:

We see that Breakeven point in rupees can be ascertained by using the equation.

BEPRs = F

( 1 – V/S)

Within this formula, the part V/S is called the variable cost ratio, and the entire denominator

is called Contribution Ratio or Profit Volume (P/V) Ratio. Which goes to say that

BEPRs = F

Contribution/P/V Ratio

Example: Budgeted Sales 15,000

Budgeted Variable Cost 9,000

Budgeted Fixed Cost 3,000

Breakeven Sales = F Which is 3,000 = 3000

P/V Ratio 1 – 9000/15000 2/5

OR

3000 x 5 = Rs.7500

2

7.6 MARGIN OF SAFETY:

CVP Analysis can also be used to ascertain the margin of safety. Margin of safety refers to

the volume/value by which sales can decline before the firm begins to incur a loss.

Margin of Safety = Budgeted/Actual Sales – Breakeven Sales

164

Example:

Estimated Sales = Rs.5,00,000

Estimated VC = Rs.3,00,000

Estimated Fixed Costs = Rs.1,00,000

Solution: BQ = F = 80,000 = 20,000 units

S – V 1 – 3/5

Therefore Margin of Safety = Estimated Sales – Breakeven Sales

= 5,00,000 – 2,50,000

= Rs. 2,50,000

Which means that the sales can fall by as much as 50% of value without the firm incurring a

loss.

7.7 PROFIT GOAL:

C-V-P Analysis could also be used to ascertain the sales that need to be generated to achieve

a specified amount of profit.

Desired Sales = F + P

P/V Ratio

Where P stands for desired amount of profit.

Example:

F = Rs.50,000

P = Rs. 50,000

P/V Ratio = 40%

Sales required to earn the desired profit and Rs. 50,000 are = F + P

P/V Ratio

= 50,000+ 50,000 = 1,00,000 = Rs.2,50,000

0. 4 0.4

165

To Verify: Sales 2,50,000

Variable costs 60% 1,50,000

-------------

Contribution 1,00,000

Less: FC 50,000 ------------ Profit 50,000 ==========

Desired After Tax Profit:

Similarly, Sales required to earn a desired after tax profit also can be ascertained by the

slightly modifying the formula.

Sales required to earn a desired Profit after tax (PAT) = F + PAT/ 1 - t P/V Ratio Where t stands for rate of tax.

Example:

Budgeted Sales: Rs 5,00,000; Budgeted Variable costs : Rs 3,00,000

Budgeted Fixed Costs: Rs 1,00,000; Tax rate: 40%

Calculate Sales required to earn desired profit of Rs. 54,000.

Solution:

Sales required to earn desired profit = F+ (Desired Profit/1-Tax rate)

P/V ratio

= 1,00,000+( 54,000/1-.40) = 1,00,000+ (54,000/.6)

0.40 0.40

= 1,00,000+ 90,000 = 1,90,000/0.40 = Rs 4,75,000

0.40

Verification:

Sales 4,75,000

(-) Variable cost @ 60% of Selling Price 2,85,000

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Contribution 1,90,000

(-) Fixed cost 1,00,000

PBT 90,000

(-) Tax @40% 36,000

Profit after tax 54,000

========

7.8 BREAKEVEN ANALYSIS IN MULTIPRODUCT FIRM:

As already explained CVP or Breakeven Analysis is based on the assumption that the costs of

the firm are of two categories i.e., fixed and variable. Variable costs are those costs which are

incurred directly for the purpose of producing the product such as material or labour. These

are, therefore, product costs. Whereas fixed costs are those costs which are incurred by the

firm independent of the output such as rent, insurance and so on. These are not product costs

but are period costs.

A problem which arises with period costs is that they are not apportionable between products

on an absolutely objective basis. This is a major difficulty in computing breakeven point in

multi-product firms. Because, period costs or fixed costs cannot be accurately apportioned or

attributed to different products, BEP cannot be ascertained for individual products in a multi-

product firm. However, individual P/V ratios and the BE point for the firm as a whole is

ascertainable.

Problem: The following data relate to Shalom & Co. for the period ending March 31, 2005.

Product X Y Z

Rs Rs Rs

Sales 1,00,000 1,50,000 2,50,000

Variable Costs 60,000 1,05,000 1,75,000

If total fixed costs are Rs 76,000, calculate the firm’s break-even point and profit.

167

Solution:

BEP Calculations for a Multi- Product Firm

Product

X Y Z Total

Sales mix 20% 30% 50% 100%

Sales revenue(Rs) 1,00,000 1,50,000 2,50,000 5,00,000

Variable Costs (Rs) 60,000 1,05,000 1,75,000 3,40,000

Contribution(Rs) 40,000 45,000 75,000 1,60,000

Fixed Costs(Rs) 76,000

Net Profit (Rs) 84,000

P/V ratio 40% 30% 30% 32%

BEP for the Firm (Rs) = 76,000/0.32

= 2,37,500

Alternate Way of computing the firm’s P/V Ratio:

The firm’s P/V ratio = Σ PVratio x proportion

= 0.4x0.2+0.3x0.3+0.3x0.5

=0.08+0.09+0.15

=0.32 = 32%

7.9 APPLICATIONS OF BEP ANALYSIS FOR MANAGERIAL DECISION

MAKING:

Break-even analysis is very useful in managerial decision-making. It aids decision-making in

umpteen number of situations such a, Fixation of Selling price, Decision relating to the most

profitable product-mix, Decision relating to Make or Buy, Shut down or Continue decisions,

Key factor or Limiting factor, Dropping a Product line, Retaining or replacing a machine,

Substitution of one factor or the other, Diversifying or Non-diversifying etc. Hereunder are a

few illustrations which will help you appreciate the application of this technique for decision

making.

168

Make or Buy Decision

Problem :

A Manufacturing company finds that it costs Rs. 31.50 to make component ‘X’. The same is

available in the market at Rs.28.50 each with an assurance of uninterrupted supply. The

break-down of the cost is

Marginal Cost of ‘X’

Material 13.75

Labour 8.75

Variable 2.50

25.00

Solution:

The Marginal Cost of making is to be compared with the buying price:

Marginal Cost of ‘X’

Material 13.75

Labour 8.75

Variable 2.50

25.00

Since this is less than the cost of buying, then the part has to be made rather than bought. If

purchase price of ‘X’ is Rs.24.50 buying is advantageous.

Fixation of Selling Price

Problem:

A firm produces a single product. The variable cost of producing one unit is Rs.12. The firm

desires to maintain a P/V ratio of 40% to cover fixed cost and earn a reasonable profit.

Determine selling price of each unit.

Should the component be bought or made? Would your

decision change if purchase price of ‘X’ is Rs.2450.

169

Solution:

The firm’s Variable Cost Rs. 12 per unit. The firm intends to maintain 40% P/V ratio or

contribution ratio.

Therefore variable costs are permitted to be 60% of SP; Rs 12 should constitute 60%.

SP = Rs 12 x 100 = Rs.20

60

Alternatively using formula

SP per unit = VC per unit = 12 = Rs.20

1- P/V ratio 1 – 0.4

Quoting Prices for Special Situations:

Problem:

A product has been selling exclusively in Indian market. The manufacturer has received his

first export enquiry and wants to quote as competitively as possible. The latest Indian cost

sheet is as follows. Rs. per unit

Raw materials 17 Direct Labour 6 Services (2/3 variable) 3 Work OH (fixed) 3 Office OH (fixed) 1 --- 30 Profit 3 ----- SP per unit 33

Quote the lowest price.

170

Solution:

Lowest Price per unit for export

Raw Materials 17

Direct labour 6

Services 2

----- -

25

-----

Caveats:

1. Existence of manufacturing capacity should be checked. If spare manufacturing capacity

does not exist, additional fixed costs in terms of adding capacity will have to be incurred.

2. Direct Costs of export order like insurance, specialized packing, export duty should also be

considered

3. Cash subsidy, export incentives to be considered.

Problem :

Due to trade recession, a company is getting inadequate government orders and is operating

below 60%,normal capacity. However, it is a temporary phase and the management has taken

a decision not to retrench labour. An enquiry has been received for 10000 units which can be

manufactured under existing capacity with the following costs.

Direct materials: Rs. 5 per unit

Direct labour : Rs. 2.50 per unit

Time required : 1 hr per unit

Variable OH : 400% direct labour

Fixed OH : 600% direct labout

The lowest price that can be quoted is

Rs.25.

Compute minimum price and substantiate

171

Solution: Per Unit Total

Direct material 5 50,000

Direct labour 2.50 25,000

Variable OH (400% DL) 10 100000

-------- ----------

17.50 175000

--------- ----------

The lowest price is Rs17.50 per unit

Recovery of Rs.25,000 as wages which are for the present fixed cost because of management

decision not to retrench labour.

Shut down or Continue Decisions

Problem :

A company produces a single product. Its selling price and cost of production per unit are as

under.

Output 40,000 units

Material Cost Rs. 2.00

Labout Cost Rs. 2.00

Variable OH Rs. 1.00

Fixed expenses Rs. 2.00

-------------

Total Cost Rs. 7.00

Due to depression the company is not able to sell at the existing price of Rs.8/- per unit.

However, the entire output can be sold at Rs.6/- per unit. Advise whether the company should

continue or close.

172

Solution:

If the product is being sold for Rs.6/-, there is a loss of Rs.1 per unit.

Therefore Total Loss = 1x 40,000

= Rs. 40,000

However, it is recovering Rs,2/- of fixed cost per unit other wise the firm would incur a loss

of Rs.2 x40,000 units = Rs. 80,000. The firm is able to reduce its loss by continuing.

Or

Profit Statement:

Sales Revenue 6 x 40,000 = 2,40,000

(-) VC 2,00,000

Contribution 40,000

(-) FC 80,000

Loss 40,000

Problem :

Lara Company Operates at normal capacity of 1,00,000 unit and sells them @ Rs.60/- per

unit. The unit cost of manufacturing at normal capacities is as follows.

Direct material 16.25

Direct labour 6.50

Variable OH 8.25

Fixed OH 10.00

-----------

Total 41.00

-----------

The variable S&D expenses are Rs.1.50 per unit. Due to recession, the company feels that

only 10,000 units can be sold next year at Rs.50/- per unit. Shut down option is available. In

173

case of shut down fixed manufacturing overhead can be reduced to Rs.7,25,000/- for the next

year. Additional costs of shut down are estimated to be Rs. 1.82,500/-. Advise whether to shut

down or not.

Solution:

To Continue Shut Down

Sales Revenue (10,000x50 5,00,000 Unavoidable FC 7,25,000

(-) VC (10,000x32.50) 3,25,000 Additional shut down cost 1,87,500

-------------- -------------

Contribution 1,75,000 Shut down costs 9,12,500

(-) Fixed Costs 10,00,000 -----------

---------------

Operating Loss 8,25,000

---------------

Therefore since there is greater loss in case of shut down, it is advised to continue.

7.10 LIMITATIONS OF CVP ANALYSIS:

The CVP analysis is subject to the following limitations. C-V-P Analysis as a tool of profit

planning is based on certain assumptions which have been explained earlier. These

assumptions themselves become the major limitations.

Segregability of Costs: Breakeven Analysis assumes that all costs can be segregated into

‘Fixed Costs’ and ‘Variable Costs’. ♦ Not all costs can be easily and accurately separated into

fixed and variable elements. ♦ Total fixed costs do not remain constant beyond certain ranges

of activity levels but increase in a step-like fashion. ♦ It assumes that output is the only factor

affecting costs, but there are other variables which can affect costs, e.g., inflation, efficiency

and economic and political factors.

Constancy of Selling Price: The second assumption is that the selling price of the firm

products remains constant, no matter what the level of output. This is in contravention to the

174

normal economic laws of supply and demand where we see that price is a function of supply

and demand. ♦CVP analysis assumes that costs and sales can be predicted with certainty.

However, these variables are uncertain and the Finance Manager must try to incorporate the

effects of uncertainty into his information.

Constancy of Product Mix: Another assumption on which CVP Analysis is based is that the

firm produces only one product, i.e., it is a uni-product firm or even if it is a multi-product

firm, the product mix would remain constant and not change. However, the sales mix will be

continually changing owing to changes in demand

Synchronisation of Production and Sales: CVP Analysis also assumes that there is perfect

harmony between production and sales that all that has been produced will be sold and

therefore there will not be any changes in levels of inventory. ♦ There is an assumption that

there are either no stocks, or no changes in stock levels. Profit is therefore dependent on the

sales volume. However, when changes in stock levels occur and such stocks are valued using

absorption costing principles, then profit will vary with both production and sales. If sales are

depressed, profit can be raised by increasing production and thereby increasing stock levels.

Profit is therefore a function of two independent variables (sales and production). The

conventional break-even chart is two dimensional and cannot cope with two independent

variables. It is important to note that if stocks are valued using marginal costing principles

then profit is a function of sales, only, and the conventional CVP analysis applies.

7.11 SUMMARY:

Every Organisation, whether commercial or otherwise needs to create a surplus One of the

methods of profit planning for manufacturing organizations is the Cost-Volume Profit-

Analysis or C-V-P Analysis for short. C-V-P Analysis as a tool of profit planning is based on

certain assumptions. CVP Analysis mainly depends on the concept called Breakeven Point.

Breakeven Point is that level of output and sales, where the total costs (TC) are equal to Total

Revenues (TR). CVP Analysis can also be used to ascertain the margin of safety, ascertain

the sales that need to be generated to achieve a specified amount of profit. Sales required to

175

earn a desired after tax profit also can be ascertained Break-even analysis is very useful in

managerial decision-making. It aids decision-making in umpteen number of situations such

as Fixation of Selling price, Decision relating to the most profitable product-mix, Decision

relating to Make or Buy, Shut down or Continue decisions, Key factor or Limiting factor,

Dropping a Product line, Retaining or replacing a machine, Substitution of one factor or the

other, Diversifying or Non-diversifying etc. The CVP analysis, however, is subject to certain

limitations. As a tool of profit planning certain the assumptions on which C-V-P Analysis is

based become its major limitations. However, in the short-run CVP Analysis is of immense

use as a profit planning device.

7.12 KEY WORDS:

Breakeven Point (BEP) Contribution

Profit- Volume Ratio Margin Of Safety

Profit Goal

Try yourself:

1. From the following particulars calculate

(i) BEP in Rs & Units

(ii) Number of units that must be sold to earn a profit of Rs 90,000

Fixed Factory costs : Rs 60,000

Fixed Selling costs: Rs 12,000

Variable Manufacturing cost per unit : Rs 12

Variable Selling cost per unit: Rs3

Selling price per unit: Rs24

Solution: BQ =8000 units; BR =Rs.1,92,000

Required Sales to earn a profit of Rs 90,000 is 4,32,000 units

Further Readings:

I.M. Pandey, Financial Management, Vikas Publishing, New Delhi.

N.K. Prasad, Principles of Cost Accounting, Book Syndicate Private Limited, Calcutta.

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LESSON-8

BUDGETING

STRUCTURE:

8.1 Introduction

8.2 Importance of Budgets

8.3 Pre-requisites for Effective Budgeting

8.4 Process of Budget Formulation

8.5 Types of Budget Formulation

8.6 Techniques of Budgets

8.7 Key words

8.1 INTRODUCTION:

Budgeting is essentially a process of funding the activities needed to achieve the objectives of the

organization, during a definite period of time. “In its most basic form budgeting may be seen as

the financial expression of the sources of funding for and the allocation of such resources to the

various activities of the over a specified time period”1. Thus there are two important steps in the

budgeting process: (a) the determination of funds, and (b) allocation of funds. The scope of

OBJECTIVES:

Explains the meaning and importance of Budgeting

Discusses various types of Budgets

Discusses various techniques of Budgeting

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budgeting to a large extent, depends upon the purposes for which an organization exists, from a

typical government budgeting to a truly business budgeting.

In the early stages of evolution of management in the business, budgeting served almost every

need of the business. Budgeting, thus, was identified with every aspect of management.

“Budgeting is essentially a managerial process. A business budget is a plan covering all phases of

operations for a definite period in the future. It is a formal expression of policies, plans,

objectives and goals laid down in advance by the top management for the concern as a whole and

for each sub division thereof.”2 Budget is an important document prepared by an organization.

The Institute of costs and Works Accountants defined the budget as “a financial and/or

quantitative statement, prepared and approved prior to a defined period of time, of the policy to

be pursued during that period for the purpose of attaining given objective. It may include income,

expenditure and the employment of capital”.3 From the above definition, the characterization of

Budget can be as shown below:

1. It is a financial and or quantitative statement

2. It is prepared in advance pertaining to a definite period, say for one year

3. Its purpose is to attain pre determined objectives

4. It reflects policies of an organization

5. It includes items of income and expenditure

8.2 IMPORTANCE OF BUDGETS:

i) Budget serves as an instrument of Planning and Control.

Planning is the first step in the management process. “Planning function determines

organizational objectives and policies, programmes, schedules, procures and methods for

achieving them. Planning is essentially decision making since it involves choosing among

alternatives and it also encompasses innovation. Thus planning is the decision on any phase of

organisedactivity”.4 Budget is essentially deciding about the alternatives to achieve objectives set

out for the organization as well as for various departments and on allocation of resources to

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achieve the targets during the defined period. Budget enforces a discipline of planned thinking

and action for encompassing entire organization. Budget also decides on which activities need to

be carried out and at what level (volume) and at what cost.

Budget serves also serves as a tool of control. Control is the next step after formulation of

budgets. Control is equally an important element in the managerial process, to ensure that the

actual performance in the organization conforms to plans for realization of objectives set out.

The interest of the management does not end with the formulation of a budget, but extends to

implementing the budget which finally results in the achievement of objective. Thus the scope of

budgeting extends to controlling the activities to conform to the budget. Budgetary control is the

logical extension of budget formulation. The Institute of Cost and Works Accountants defined

the budgetary control as “the establishment of budgets relating the responsibilities of executives

to the requirements of a policy and the continuous comparison of actual with the budgeted results

either to secure individual action the objective of that policy, or to provide a basis for its

revision”. 5 By this definition, budgetary control is considered as a tool of management control

system by measuring the performance, reporting to the different levels of management relating

the budget with actual performance and enabling the management to take corrective action. The

feed back system sometimes leads to correction of plans because of changes in underlying

assumption made in plans. Thus budgetary control will be useful when it aids the management in

monitoring the performance on a continuous basis, comparison and reporting promptly and

accurately.

ii) Budgeting facilities coordination of different functions.

According to Welch “Coordination is the process whereby each sub-division of a concern works

toward the common objective, with due regard for all other sub-divisions and with a unity of

effort”.6 For example, there should be proper balance among the various functions like sales,

production, purchasing, personnel and finance etc to achieve the organizational objectives. This

can be achieved only through proper coordination. Coordination to a great extent depends upon

communication. Coordination is facilitated when each responsible executive is informed as to the

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targets and actual performance with reference to the budget of his area of responsibility, related

functions and for the entire organization.

iii) Budgeting facilitates communication:

Management is effective where there is proper communication so that every body understands in

the same way. Budgeting ensures a two-way communication between top management and floor

level staff. Top management communicates to the floor level staff the budgets which indicate

targets to be achieved and the floor level managers indicate their requirements of resources to

achieve the targets. Finally the budget will be finalized after discussion at various levels.

Secondly, each function or division depends on other functions/divisions to achieve their targets.

A horizontal communication among various departments and functions in the form of group

meetings and discussions will remove misgivings and bring in the necessary cooperation. This is

achieved by budgeting process where in several meetings are held with representatives of all

functions and departments. Only after achieving consensus among various departments the

budget will be finalized. Thus budgeting facilitates important management process of

communication in the organization.

8.3 PRE-REQUISITES FOR EFFECTIVE BUDGETING:

The following mentioned factors should be prevalent for proper budgeting:

1. The budgeting process should be fully supported by top management

2. There should be an organization chart with clear identification of responsibilities for

managing resources and achieving results. It should also depict relationships between

various responsibility centres.

3. Budget manual which prescribes the procedures to be followed and various formats for

preparing the budget

4. All the staff charged with the responsibility of achieving budget should be actively

involved in the formulation of budget

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5. Budget calendar – There should be budget calendar with possible scheduled dates for

initiating budget, communicating approved budgets to various heads of departments,

periodicity of performance reports, revision of budgets etc.

6. Uniform terminology - the budget department should develop uniform terms for common

understanding of all the concerned with the formulation and implementation of budget.

8.4 PROCESS OF BUDGET FORMULATION:

Procedure for budget formulation varies according to nature, needs, resources:

i) Classification of organization structure in terms of functions, programmes and activities

show precise objectives, the work done and the organizational responsibilities by each of them.

Function is a broad grouping of operations which are directed towards accomplishment of a major

purpose of an organization. Programme implies broad category within a function that identifies

end products of major organization. The purpose of a programme is to contribute to the

achievement of the objective of the function to which it belongs. Activity is a division of a

programme into homogenous type of work on schemes. An activity contributes towards

attainment of the end result of the programme to which it belongs.

ii) Establishment of proper measures of work or services to be rendered under each programme

and activity developing appropriate norms or standard for appraisal of performance of each

programme and activity in relating to its objectives.

iii) Construction of accounts along with functional lines is necessary for synchronization of

budget heads and accounting heads.

iv) Budget committee is formed with heads of decisions chaired by the Chief Executive Officer

of the organization and coordinated generally by the head of Finance division also known as

budget officer

v) Chairman of the budget committee or CEO initiates budget process by communicating the

heads of departments broadly indicating the business environment and suggested targets to be

achieved by the organization.

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vi) The heads of department in turn communicates to the various heads of budget centres for

formulating the budgets relating to their respective centres of activities. These centres propose

the requirements of resources, for various activity levels.

vii) After internal discussion with various heads of budget centres, the heads of

departments/functions propose the budgets to the Budget committee.

viii) The Budget Committee discusses the proposals with heads of departments/functions and

draws upon draft budget for the entire organization.

ix) The board of directors finally approves the budget

x) The budget officer communicates the budgets of various departments for implementation.

From the discussion the main advantages of budgeting are as follows:

i) It is an instrument of management

ii) It evaluates factors affecting future of the organization

iii) It promotes cooperation among departments and coordination of different functional heads

iv) It is powerful tool of communication

v) It motivates employees to exceed the provisions performance

vi) It tries to improve efficiency and accountability at various levels of the organization.

Limitations of Budgeting:

i) its success depends upon the support of the top management

ii) it is not a substitute to good management and leadership

8.5 TYPES OF BUDGET:

Budgets can be classified on the basis of time, activities, approach and variability. These are

explained below.

On the basis of time:

Budgets can be classified on the basis of time. Broadly we can classify them into short term,

medium term, and long-term budget. Long-term budgets are used for assessing the long tem

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requirement of funds for meeting long term investments say 5 year to 10 years. This budget can

be considered as capital budget which deals with items of larger investments such as Land,

buildings, investments into new business, products, research and development. The benefits

from these investments can be seen only after long period such as 3 to 5 years. The finances

required for meeting such large and long term investments have to be planned carefully. The

investments have to be evaluated not only from financial (cost/benefits) perspective but also

from other important perspectives. Therefore the long-term budgets are prepared at the highest

level of the organization. Typical capital Budget can look like as shown in Figure:1

FIGURE 1: CAPITAL BUDGET FOR THE PERIOD 2006 TO 2010

(Rs. In Millions)

Items Year

2006 2007 2008 2009 2010

EXPENDITURE

1. Land

2. Buildings

3. Plant & Machinery

4. New Business

5. Technology Development

6. Other Assets

TOTAL

FINANCED BY

1. Internal Resources

2. Loans

3. Equity capital

4. Sales of existing assets/business

TOTAL

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The medium term budget can be referred to beyond one year to 3 years. The short-term

budget is proposed for one year. The Annual budget is broken down monthly budgets to

understand the peaks and troughs and mismatch between income and expenditure.

One the basis of activities / functions:

On the basis of operations / functions two types of budgets are prepared:

8.5.1 Master budget

i) it is based on all departmental activities

ii) it is summary of the budgets of all departments / functions

iii) it shows the full plan of budget period

iv) budget officer prepares it after the departmental budgets prepared by the heads of respective

departments

v) it is recommended by Budgetary Committee to the Board of Directors for approval

vi) After the approval by the Board it is communicated to the top management for

implementation.

vii) A copy of the Budget relating to reach department is sent to respective heads of departments

viii) Master budget includes sales, production cost, including direct labour, direct material,

factory overheads, administrative expenses, profits, profit planning etc.

ix) Master budget can be explained with the following Figure 2

FIGURE 2: MASTER BUDGET OR THE PERIOD _______________

(Amount Rs. In Millions)

Particulars Budgeted period Previous period

Net Sales (Sales – Return)

Less: Manufacturing costs

Direct Material

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Direct Labour

Factory overhead

Gross Profits:


Office Expenses

Selling and Distribution expenses

Operating Profits:

Add: Non-operating income

Less: Non-operating expenses

Net profit before tax

Less: Tax

Profit after Tax

FIGURE 3: BUDGETED BALANCE SHEET AS ON _________________

(Amount in Rs. Millions)

Particulars Budgeted period Previous period

Fixed Assets:

Current Assets

Total Assets

Long term liabilities

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Current Liabilities

Total Liabilities

8.5.2 Cash Budget

Cash forecast precedes a cash budget. A cash forecast is an estimate showing the amount of cash

which would be available during a future period say one year for which organization will develop

budget and requirements for payment of cash to various agencies during the same period. Cash

budget or cash forecasts are instruments of planning rather than control. The need for a cash

budget arises due to following reasons:

i) To ascertain whether cash to the extent needed will be available for running the business.

ii) To maintain liquidity in the organization

iii) To identify in advance likely short falls or surplus cash for the future period so that

necessary steps can be taken to correct the situation.

A format for Cash budget can be as shown in Figure 4.

FIGURE 4: CASH BUDGET FOR THE YEAR -------------------------------

(Amount in Rupees)

Particulars

Total Period 1 Period 2 Period 3 Period 4

Opening Balance

Add Receipts

Sales – cash

Trade debtors

Sale of capital assets

Loans received

Miscellaneous

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Total receipts

Less Payments

Trade creditors

Cash purchases

Wages & salaries

Interest payable

Loans given

Capital expenditure

Taxes

Dividends

Total payments

Closing Balance

Departmental / Activities budget:

i) Budget prepared by every department is known as departmental budget

ii) These budgets will be consolidated into Master budget

iii) These budgets clearly shows the projected performance of the department

iv) It will enable the top management evaluate the performance at departmental level.

Budgets for important departments/activities

8.5.3 Sales Budget

Sales budget is prepared by the sales department by using different techniques.

i) Market Research: Market research tries to find out which of the company’s products can be

sold in a period and in what quantities, at what price and in which market.

ii) Analysis of past sales figures: Application of statistical methods of analysis to past sales data

helps in revealing trends/ trade cycles, seasonal movements, etc so that correct assessment of

potential demand may be made.

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iii) Assessment and reports by salesmen: because of their experience in the market, the sales

men, sales managers can forecast sales realistically. This information should be sought.

iv) Study of general trade and business situation: information on general trade and business

conditions affect sales. Therefore, information is useful to get the feel of the general trade which

helps in fine tuning the sales forecast.

Sales budget can be prepared on product-wise, customer-wise, outlet-wise and on any other

criteria. A format for sales budget can be as shown in Figure 5.

FIGURE 5: SALES BUDGET FOR THE PERIOD--------------------------

(By product)

Month Product 1 Product 2 Product 3 Total Sales amount

Quantity Value Quantity Value Quantity Value

January

February

March

April

May

June

July

August

September

October

November

December

TOTAL

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8.5.4 Production cost budget

i) Direct material cost, direct labour cost and factory overheads (indirect costs) are included

in production cost.

ii) Administration costs are budgeted separately and added as a percentage of total production

cost

iii) If there are more than one product and the product is separately controlled best thing is

to separate the budget for each product and then consolidate the budgets of all products to

arrive at production Budget

iv) Similarly if the production takes place in different plants located separately it is important

that each plant manager prepares budget at the plant level / product level and consolidate the

budgets of all plants to arrive at production budget. The model in Figure 6 shows format for

production cost budget

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FIGURE 6: PRODUCTION COST BUDGET FOR THE PERIOD _________

Particulars Product –

1

Product-

2

Total

Units Nos. / (Weight)

COST:

A. Direct Material

B. Direct Labour

C. Direct Expenses

D. Prime cost (A+B+C)

E. Factory overheads

F. Production cost (D+E)

G. Administration overhead

H. Cost of production

FIGURE 7: MATERIAL COST BUDGET FOR THE PERIOD _________

Particulars RAW MATERIAL UNITS

X Y Z

Units of Raw materials for Budgeted Production

Add: Closing Stock

Less: Opening Stock

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Raw material to be purchased

Price of Raw material per unit Rs.

Cost of Raw materials to be purchased Rs.

8.5.5 Direct labour budget

i) Labour required (i.e., number of employees at different skill levels of different wage rates)

to achieve the targets.

ii) This budget is prepared with the help of labour department which recruit work force

iii) The format is shown for typical labour cost budget in Figure 8

FIGURE 8: DIRECT LABOUR BUDGET

Budget Centre: Period:

Out put : _________ unit of A __________ unit of B __________ unit

of C

Workers Numbers Hours Standard Rate Rs. Total Labour Cost

Rs.

MALE: Skilled Semi Skilled Unskilled

FEMALE: Skilled Semi Skilled Unskilled

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8.5.6 Production overhead budget

i) All production costs other than Direct Materials cost, Direct Labour cost and direct

expenses are included.

ii) Expenditure on repair and maintenance of plant and machinery is included

iii) Fixed and variable expenses are shown separately for purpose of control

iv) Separate records should be maintained for expenses accounted

v) Format for typical production overhead budget is shown in Figure 9

FIGURE 9: PRODUCTION OVER HEAD BUDGET IN THE YEAR ENDING: _____________

Items Total First

Quarter Second Quarter

Third Quarter

Fourth Quarter

Variable:

Supplies

Power

Heat and Light

Maintenance

I) Total Variable

overhead

Fixed

Supervision

Indirect Labour

Insurance

Taxes

Rent

Depreciation

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II) Total Fixed

III) Total production

Over-head

8.5.7 Plant utilization budget

i) This budget is made separately in such organizations where production is largely machine

oriented and machines are highly expensive

ii) This budget includes total number of machines used, initial value, depreciation and book

value of machines, life of machines, operation cost

iii) It helps in evaluating the contribution of every machine

iv) Format for typical plant utilization budget is shown in Figure 10

FIGURE 10: PLANT UTILISATION BUDET FOR THE PERIOD: _______________

Departments Machine No. of workers available

FIGURE 11: ADMINISTRATION OVERHEAD BUDGET

Items of Expenditure

DEPARTMENTS

Total Rs. Accounts Rs.

Budget & Costing

Rs.

Secretarial & Legal

Rs.

Common Expenses

Rs. Rent and Taxes

Salaries

Supplies

Postage

Telephone

Travelling

Audit

Bank

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Interest

Bank Charges

Hired services

Others

TOTAL

8.5.8 Selling and distribution overhead budget

i) Marketing department prepares this budget

ii) Marketing department involves the branch managers, regional and zonal managers in

preparing the budget

iii) Expenditure incurred for selling and distributing the product are included in this budget

iv) Format for typical selling and distribution overhead budget is shown in Figure 11

FIGURE 11: SELLING AND DISTRIBUTION OVERHEAD BUDGET FOR THE

PERIOD_____________

(Amount in Rs.)

Items Total First Quarter

Second Quarter

Third Quarter

Fourth Quarter

A) Variable overheads:

Sales Commission

Carriage

Agents Commission

Other items

Traveling expenses

TOTAL : A

B) Fixed overheads:

Sales Office Salaries

Other fixed expenses of sales office

Advertising

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TOTAL:B

Total selling and distribution

overheads

On the basis of flexibility

8.5.9 Fixed budget

i) Fixed Budget is a budget which is designed to remain unchanged irrespective of the level of

activity actually attained

ii) It is formulated for a fixed level of activity

iii) Fixed Budget has some limitations:

a) it is inadequate from control point of view

b) it does not compare the budgeting cost with cost for actual achievement

iv) This budgeting system is outdated

8.5.10 Flexible budget

i) Flexible Budget is made where demand for commodity is seasonal and change according to

fashions.

ii) Budget is changeable in such conditions

iii) A flexible budget is a budget which consists of variable budget which changes to level of

activity and fixed budget which does not change irrespective of the level of activity.

iv) It is a dynamic budget

v) It provides ready made budget for any level of production

vi) Advantages of flexible budget

a) easy comparison as the budget is adjusted to actual level of achievement

b) it is helpful in uncertainty in sales and production

ILLUSTRATION: With the following data for 50% activity prepare a budget for production at

70% and 100% activity level:

Production at 50% activity 500 Units

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Material Rs. 10 per unit

Labour Rs. 10 per unit

Expenses (40% fixed) Rs.40,000

Administration (30% fixed) expenses Rs.30,000

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Particulars Activity levels

50% 70% 100%

Production (units) 500 700 1000

Direct Costs Rs. Rs. Rs.

Material (Rs. 100 per unit) 50000 70000 100000

Labour (Rs.40 per unit) 20000 28000 40000

Expenses (Rs.10 per unit) 5000 7000 10000

TOTAL DIRECT COSTS 75000 105000 150000

Factory expenses:

Variable (Rs.48 per unit) 24000 33600 48000

Fixed (40% of Rs.40000) 16000 16000 16000

Administration expenses:

Variable (Rs.24 per unit) 12000 16800 24000

Fixed (60% fixed) 18000 18000 18000

TOTAL COST 145000 189400 256000

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Explanation:

i) Variable Factory overhead 60% of Rs.40000 or Rs.24000 for 500 units., i.e., Rs.48 per unit

ii) Variable Administration overhead – 40% of 30000 i.e., Rs.12000 for 500 units i.e., Rs.24 per

unit.

8.6 TECHNIQUES OF BUDGETS:

There are basically four techniques of budgeting:

1. Appropriation budgeting

2. Performance budgeting

3. Planning, programming, budgeting

4. Zero - base budgeting

These techniques are explained below.

8.6.1. Appropriation budgeting

The traditional budgeting is known as appropriation budgeting where the focus is on

appropriation of resources to various activities. Appropriations are approved allocation of

resources for various items of expenses. The focus of appropriation budgeting is on control of

inputs or resources or expenses. Budget is formulated and controlled on the basis of the nature of

expenses such as salaries, travel, maintenance etc. Therefore this technique is also known as line

item budgeting.

Main features of Appropriation budgeting:

1. The budget is functionally oriented. Budgets are formulated with reference to

functions/departments of the organization.

2. The appropriation is based on the past trends in the expenditure on various items such as

salary and travel with some adjustments for increases due to rise in prices of inputs. This is

otherwise known as incremental budgeting.

3. The control is procedure oriented. Financial control is the main objective of this approach

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4. The spending agencies should not spend over and above the approved limit. Thus, budgets

were considered upper limits of expenditure.

5. The proprietary audit is conducted to ensure that the funds are not used for the purpose other

than those authorized.

Advantages of Appropriation budgeting:

1. Budgets are developed on departmental basis. Therefore, budgeting prevents one department

from getting funds at the expense of other department.

2. It is easy to prepare as the budget is based on past data and for line items like salary, travel

etc.

3. It is easy to understand as the budgets are prepared for each department on a gross basis. One

can judge the worth of each department.

4. It helps in establishing financial control on the resources. The departments can not spend a

rupee without prior approval. Budget is an instrument of controlling funds.

5. Control is centralised, uniform and comprehensive.

Limitations of Appropriation budgeting:

1. Since budgets are prepared on the basis of past data, it is likely that inefficiencies of the

previous years are carried forward.

2. As the budget allocations are not done on rational basis, they would tend to inflate the budget

amounts.

3. As the budgets are prepared on the past data, the rigorous analysis of alternatives before

finally approving the allocation is absent.

4. The budgeting system does not relate the output / outcome to the inputs. Therefore the

efficiency and economy in utilization of the resources are not taken care of. Consequential control

is thus absent.

5. The activities / programmes are carried on without examining the need to continue them.

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In view of serious limitations, even the central / state governments which were adopting the

appropriation budgeting techniques, switched over to performance budgeting.

8.6.2 Performance budgeting

In view of serious limitations mentioned above, there was a case to reform the budgeting system

which will ensure allocation of resources on a satisfactory criteria and for controlling the

utilization of resources in the most efficient manner. Performance budgeting system is thus an

improvement over the appropriation budgeting in many ways.

According to Mohinder N Kaura, “Performance budgeting is essentially a multi level and on -

going annual process of management planning and control , which enables an organization to

accomplish its corporate goals by involving people from top to bottom for formulating and

implementing a time bound and realistic action plan”.7

“A performance budget is an operational document which translates the aspirations of an

organization into meaningful and feasible action programmes and activities for realizing the

objectives by integrating financial as well as physical targets of performance on major items of

business or service”. 8 The above definitions do represent the basic characteristics of performance

budgeting system as practical both in industry and government.

Features of Performance Budgeting System:

The main features of the performance budgeting system (PBS) are as follows:

1. It is essentially a performance / output oriented approach. It involves formulating plans,

setting up objectives, laying down policies and relating the proposed activities to the long and

short term objectives.

2. There are three components in PBS; classification of activity, performance measurement and

performance reporting.

3. The main purpose of PBS is to ensure consequential accountability in addition to procedural

accountability.

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4. The structure of performance budget requires that an organization is identified into various

activity centres, known as “Responsibility Centres”. Objectives are specified, costs and outputs

are determined for each centre. The costs are also cross referenced to standard line item /object.

5. This approach requires the determination of a set of activity output measures, establishment of

relationship between these output measures and the cost of conducting activities.

For example, a budget for a purchase department is prepared after identifying the activity,

performance measures and costs. Input cost is expenditure on salaries of staff and other expenses.

The activity is “placing purchase orders on the vendors”. Performance measure is Purchase

Order. Output is number of purchase orders.

Department : Purchase department

Budget for the year 2006-07

Cost : (Input) Rs. 10,00,000 (Salaries etc.)

Purchase orders to be placed with vendors during the year: Rs. 10000 (Output)

Budget allowance : Rs. 100 per purchase order

Thus each department has to identify input cost and output (performance measure).

6. Performance is monitored through the performance measurement, performance reporting and

review.

Advantages of PBS

The Administrative Reforms Commission of Government of India successively stated the

advantages of PBS. They are:

1. Correlate the physical and financial aspects of every function, programme and activity.

2. Improve the budget formulation review and decision making at all levels of operations.

3. Facilitates better appreciation and review.

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4. Enable a more effective performance audit and

5. Measure progress towards accomplishment of long term as well as short term goals.

Implementation difficulties of PBS:

The Performance budgeting system as an approach is still in vogue both in the government

and the industry. However there were some implementation difficulties.

1. The classification of organization structure into functions, programmes, and activities.

2. Measurement of productivity in government is difficult

3. Lack of proper classification of accounts to suit the budget formulation and review.

8.6.3 Planning, Programming Budgeting System (PPBS)

Another technique of budgeting, which has been tried out in the tried out in the 60’s in the US is

known as Planning, Programming Budgeting System (PPBS). According to Peter A Pyhrr, “PPB

was developed to provide a rational and systematic approach to identify and evaluate the costs

and consequences of strategic objectives (Planning) translate the strategic objectives into time

phased men and material needs in each organization (programming) and translate time phased

men and material needs into financial requirements (budgeting) PPB was designed to encourage

analysis of major policy issues and to provide a mechanism to identify the trade offs among

programs aimed at similar objectives”.9

Features of PPBs:

PPBS approach is explicitly linked to a prior planning process.

Objectives are set fort the programmes in specific terms.

The multi year costs and not just next year’s costs are estimated. The estimates are made for the

entire period of the programme.

The information is assembled at the programme level and each functional area or division of the

government

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Consideration is given to alternative means of achieving the objectives

It incorporates techniques of analysis into budgeting by bringing the skills of economists,

engineers, and cost accountants at the decision making level and by moving the budget process

close to control planning and program development function.

PPBs covers total program cost both capital and operating expenditure

The criteria by which one programme alternative will be selected rather than the other will be cost

effectiveness, when output measures are non monetary in nature and cost benefit where output

measures are monitory in nature.

Areas of improvement associated with PPBS:

Carbon identified nine areas of improvement associated PPBs. “These are: 1. Definition of

objectives, 2. Information, 3. Use of analysis in decision making 4. Evaluation of programmes 5.

Management efficiency, 6. Involvement of officials in the budget process, 7. Recognition of the

legitimacy and necessity of analytic argument 8. Comparisons of related programmes in several

agencies, 9. State and local interest.” 10

The PPBS enables the setting up of clear objectives for each programmes; require collection and

display of information on programme inputs and outputs. Thus quality of information is

improved. The use of analytic methods and evaluation of programmes enhances the credibility

of decision making system. Participation of officials in the budgetary process and evaluation of

performance against predetermined programme plans motivate the budgeter in budget

implementation.’

Problems in implementation of PPBS:

a) The experience in implementation of PPBs in the US where it was started was not

encouraging and the implementation became more complex. The main reason is placing over

emphasis on ‘analysis’ rather than on ‘operational cost’.

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b) The programme structure has become another larger unit in the organization structure.

c) Analytical studies proved to be difficult.

8.6.4 Zero base budgeting

Zero base Budgeting (ZBB) is an approach whereby each manager has to justify the resources

for the activity afresh for the accomplishment of objectives. The procedure to be followed in

ZBB, requires questioning of the current or proposed activities and programmes and evaluation

of these in a rational manner so that resources are used in the most efficient and effective

manner. The use of ZBB as a tool of planning and control evoked interest in 1960s. It was first

used in 1964 in the US Department of Agriculture when it prepared zero-base budgets as a

supplementary exercise to its existing budgets. ZBB was used in its full form first in the private

sector organization, Texas Instruments in the US when it was conceived by Peter A Pyhrr who

was working in that organization at that time as staff engineer.

Need for ZBB:

The government is not able to increase revenues to match with the requirements for various

programmes / activities. Similarly industry is facing serious competition. The enterprises have

to perform well in the face of competition. This calls for use of resources by the government and

industry more efficiently and effectively than ever. In this direction Peter A Pyhn raises the

following two questions that are not answered in the traditional budgeting approach. A) How

efficient and effective are the current operations that were not evaluated? B) Should the current

operations be reduced in order to fund high priority new progreammes or increase profit?

These questions are relevant both for the government and the industry. The answer lies in a

unique approach that would compel us to identify and analyze what we were going to set goals,

make necessary operational decisions by evaluating the alternatives during the budgetary

process. Zero – base technique would respond to these needs.

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Steps in Zero base Budgeting:

The following steps generally take place while introducing ZBB.

1. Spelling out by the top management of the discrete activities of decision units

2. Construction of decision packages with a specification of corporate objectives, operational

objectives, standards and alternative performance methods to achieve these objectives

3. Priority ranking of the endorsed projects by the lower management level, followed by a

hierarchical review by higher levels of management with continual consolidated re ranking.

4. Allocation of organizational resources to decision units based on the consolidated ranking of

decision packages accepted and projection of available funds.

5. Monitoring the performance of projects on the basis of criteria established in the approved

decision packages.”11

Decision unit:

The first stage in the general structure of ZBB approach is the identification of organization into

decision units. The decision units are defined as “those parts or components of basic program or

organizational entity for which budget requests are prepared and for which managers make

significant decision on the amount of spending and the scope or quality of work to be

performed.”12 Decision units are typically cost centres, functional groups, and such a marketing

sales, secretarial service, projects such as research and development or major capital projects.

Thus decision units can be compared to responsibility centres in performance budgeting.

Decision Package

“A decision package identifies a discrete activity, function or operation in a definitive manner

for management evaluation and comparison with other activities.”13 Decision packages are

developed at the base level to promote detailed identification of activities and alternatives. P A

Pyhrr observes that the development of decision packages by the managers who are familiar with

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the activities and who will be operationally responsible of the approved budget, will generate

interest in and participation by the managers.

Benefits of ZBB:

1. Identification, justification and evaluation of all activities proposed ensures more effective

allocation of resources.

2. Evaluation of the need for the activity and consideration of alternatives ways of performing

the activity, enables the organization to minimize the costs and strengthens the valve chain.

3. It provides greater flexibility in reallocating the resources.

4. By prioritizing the activities afresh, high priority new programmes can be funded totally or in

part by reducing or eliminating current activities.

5. By identification and logical networking of activities, duplication of effort in the organization

can be eliminated.

6. ZBB is a flexible process. Revisions during budget period can be done without much effort

when the conditions demand as the managers can identify which packages are affected by the

changes in conditions and can revise those specific packages.

7. ZBB requires information at the base activity level for review and evaluation. Collection and

display of information of all activities in the form of decision packages assures the top

management that proper analysis have been done and allows them to take a close look at these

packages.

8. ZBB process requires the managers to identify the activities and evaluate them by cost

/benefit analysis. Normally, the managers are confronted with the decision to choose the best

alternative in conducting the day to day operations. Thus, ZBB provides the opportunity to the

managers acquire and improve the analytical skills.

9. Performance of the managers can be measured in terms of benefits accrued and

accomplishment of goals as stated in decision packages. This can be carried out periodically

during the course of the budget year. These mid course reviews can be taken as a preview to the

planning and budgeting cycle that begin later for the next budgeting year.

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Problems in implementation of ZBB:

1. Managers are suspicious of any process that forces detailed examination of activities which

would probably expose the managers of their inefficiencies to others.

2. The degree of success of implementing ZBB to certain extent depends upon the

communication system obtained in the organization. The organizational climate wherein the

lower level manages are given an opportunity to express views freely and frankly and the senior

level managers have the tenacity to listen to others and face the critical and close review of

activities is important. Absence of this is a major limitation in successful implementation of

ZBB.

3. Absence of formalized policy and planning assumptions or poor communication of these

across the organization proved to be limiting factors in successful implementation of ZBB.

4. Determining the minimum level effort requires judgement on the part of the activity manager.

Establishing this minimum well below the current operating level is unthinkable to many

managers, who prefer to identify the minimum level at their current operating level or some

times above that level.

5. It is difficult to identify work measures for all the activities for evaluation. It is also difficult t

develop data base for future analysis and evaluation.

6. Higher level managers will face difficulty in evaluating the similar packages.

However this approach has been used in various ways other than in the form in which it was

implemented in the US.

4.7 SUMMARY:

Budgeting is essentially a process of funding the activities needed to achieve the objectives of the

organization, during a definite period of time. Budgeting is essentially a managerial process. A

business budget is a plan covering all phases of operations for a definite period in the future. .

Budget enforces a discipline of planned thinking and action for encompassing entire organization.

Budget serves also serves as a tool of control. Budgets can be classified on the basis of time,

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activities, approach and variability. There are basically four techniques of budgeting:

Appropriation budgeting, Performance budgeting, Planning, programming, budgeting, Zero - base

budgeting each with its own advantages, disadvantages and suitability to specific situations.

8.8 KEY WORDS:

Budget Capital budget

Master budget Cash budget

Departmental/functional budget Fixed budget

Flexible budget Appropriation budgeting

Performance budgeting Zero-base budgeting

NOTES AND REFERENCES

1. Cutt James, Rittez Richard. Public Non- profit Budgeting: The Evolution and Application

of Zero-Base Budgeting Toronto, The Institute of Public Administration of Canada, 1984, p.1

2. Welsch Glenn A Budgeting Profit Planning and control Englewood Cliffs, New Jersey,

Prentice Hall Inc. 1964

3. Terminology of Cost Accountancy, the Institute of cost and Works Accountants, London,

1966 in Batty J. Eds. Cost and Management Accountancy for students, London Heinemann,

1970.

4. Farmer Richard N. and Richman Barry M. Comparative Management and Economic

Progress Homewood, Illinois, Richard D Irwin Inc, 1965, p.17

5. Terminology of Cost Accountancy, the Institute of cost and Works Accountants, London,

1966 in Batty J. Eds. Cost and Management Accountancy for students, London Heinemann,

1970.

6. Welsch Glenn A Budgeting Profit Planning and control Englewood Cliffs, New Jersey,

Prentice Hall Inc. 1964

7. Kaura Mohinder N. Performance Budgeting System in Government Organisations Lok

Udyog May 1984

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8. Kaura Mohinder N. Performance Budgeting System in Government Organisations Lok

Udyog May 1984

9. Peter Pyhrr A. Zero Base Budgeting: A Practical Management tool for Evaluating

Expenses New York, John Wiley & sons Inc, 1973 p.142

10. In Peter Pyhrr A. zero –Base Budgeting: A Practical Management tool for Evaluating

Expenses New York, John Wiley & sons Inc, 1973 pp.148-49

11. Kaura Mohinder N. and Mallikharjuna Rao S. Budgeting for Corporate Success: Indian

Practices Calcutta, Indian Accounting Association Research Foundation, 2000

12. General Accounting Office A Glossary of Terms used in Federal Budget office

Washington, March, 1981, p.55

13. Peter Pyhrr A. Zero Base Budgeting: A Practical Management tool for Evaluating

Expenses New York, John Wiley & sons Inc, 1973 p.6

Try yourself:

1. Explain the meaning of budgeting?

2. Explain the importance of budgeting?

3. Discuss the process of budgeting.

4. Explain the following budgets:

a) Master budget b) Sales budget c) Production cost budget d) Flexible budget

5. Write short notes on the following i) Appropriation budgeting ii) Performance

budgeting

iii) Zero-base budgeting