Accounting and Finance

Accounting & Finance

Faculty: Ms. Luvnica RastogiEmail id: [email protected]

Imp Website: www.investorwords.com

mailto:[email protected]

http://www.investorwords.com/

Learning Objectives

Introduction

Definition:

Meaning of Accounting

Accounting is an Art Accounting classifies as an art as it helps in

attaining the goal of ascertaining the financial results. Analysis and interpretation of the

financial data is the art of accounting, requiring special knowledge, experience and

judgment.

Accounting classifies as an art as it helps in attaining the goal of ascertaining the financial

results. Analysis and interpretation of the financial data is the art of accounting,

requiring special knowledge, experience and judgment.

Contd.

Involves Recording, Classifying and Summarizing

Recording means systematically writing down the transactions and events in account books soon after their

occurrence. Classifying is the process of grouping transactions or entries of similar nature at a place. This is

done by opening accounts in a book called ledger. Summarizing involves the preparation of reports and

statements from the classified data (ledger), understandable and useful to management and other interested parties. This involves preparation of final

accounts.

Recording means systematically writing down the transactions and events in account books soon after their

occurrence. Classifying is the process of grouping transactions or entries of similar nature at a place. This is

done by opening accounts in a book called ledger. Summarizing involves the preparation of reports and

statements from the classified data (ledger), understandable and useful to management and other interested parties. This involves preparation of final

accounts.

Records Transaction in Terms of Money

Recording business transaction in terms of money is the common measure of

recording and helps in better understanding of the state of affairs of

the business.

Recording business transaction in terms of money is the common measure of

recording and helps in better understanding of the state of affairs of

the business.

Deals with Financial Transactions

Accounting records only those transactions and events which are of

financial character. If a transaction has no financial character, it will not be

measured in terms of money and hence will not be recorded.

Accounting records only those transactions and events which are of

financial character. If a transaction has no financial character, it will not be

measured in terms of money and hence will not be recorded.

Interpretation

Interpretation is the art of interpreting the results of operations to determine the financial position of an enterprise, the progress it has made and how well

it is getting along.

Interpretation is the art of interpreting the results of operations to determine the financial position of an enterprise, the progress it has made and how well

it is getting along.

Accounting involves Communication

The results of analysis and interpretation are communicated to management and to other interested

parties

The results of analysis and interpretation are communicated to management and to other interested

parties

Accounting-- A Means and Not an

End

Keeping accounts is not the primary objective of a person or an entity. On the contrary, the primary objective is to take decision on the basis of the financial facts given by the accounting statements. Thus, the understanding of

accounts is not the basic objective. It only helps to realize a specific objective. As such, accounting is not an end in

itself but a means to an end.

Keeping accounts is not the primary objective of a person or an entity. On the contrary, the primary objective is to take decision on the basis of the financial facts given by the accounting statements. Thus, the understanding of

accounts is not the basic objective. It only helps to realize a specific objective. As such, accounting is not an end in

itself but a means to an end.

Objectives and Functions

• Provides necessary information about the financial activities to the interested parties

• Provides necessary information about the efficiency or otherwise of management with regard to the proper utilization of scarce resources

• Provides necessary information for making predictions (financial forecasting)

• Facilitates to evaluate the earning capacity of a firm by supplying the statement of financial position, the statement of periodical earning, together with the statement of financial activities to various interested parties

Contd…

• Facilitates in decision-making with regard to the changes in the manner of acquisition, utilization, preservation and distribution of scarce resources

• Facilitates in decision-making with regard to the replacement of fixed assets and expansion of the firm

• Provides necessary data to the government to enable it to take proper decisions concerning to duties, taxes, price control etc.

• Devices remedial measures for the deviations of the actual from the budgeted performance

• Provides necessary data and information to managers for internal reporting and formulation of overall policies

Branches of Accounting

Accounting deals with recording, classifying and summarizing the business events that have already occurred. It is, therefore, historical in nature. That is why it is called historical accounting or post-mortem

accounting or more popularly financial accounting. Its aim is to collate the information about income and

financial position on the basis of business events that have taken place during a particular period of time.

Cost accounting deals with the detailed study of cost pertaining to cost ascertainment, cost

reduction and cost control. The emphasis is on historical costs as well as future decision-

making costs.

Management accounting provides information to management not only about cost but also about

revenue, profits, investments etc. to enable managers to discharge their duties more efficiently and effectively. Thus, it provides required database to managers to plan

and control the activities of business.

Social responsibility accounting involves accounting of social costs incurred by an

enterprise and reporting of social benefits created by it.

Users of Accounting Information

(1) Owner(s) Owner(s) refers to a person or a group of persons who has

provided capital for running the business. It refers to an individual in case of proprietor, partners in case of partnership firm and shareholders in case of a joint stock company. The information needs of shareholders have assumed a greater significance in the corporate business world because of the separation of ownership and management in the case of joint stock companies.

Contd.

(2)Managers For managing business profitably, management requires

adequate information about financial results and financial position. By providing this information, accounting helps managers in efficient and smooth running of the business.

(3). Investors Prospective investors would be keen to know about the past

performance of business before making investment in that concern. By analyzing historical information provided by accounting records, they can arrive at a decision about the expected return and the risk involved in investing in a particular business.

Contd.(4). Creditors and Financial

Institutions Whosoever is extending credit or loan to a business enterprise

would like to have information about its repaying capacity, credit worthiness etc. Analyzing and interpreting the financial statements of an enterprise can help in obtaining the required information.

(5). Employees Employees are concerned about job security and future

prospects. Both of these are intimately related with the performance of business. Thus, by analyzing the financial statements, they can draw conclusions about their job security and future prospects.

Contd.(6). Government Government policies relating to taxation, providing subsidies

etc. are guided by the relevance of industries in the economic development of the country. The policies also consider the past performance of industries. Information about past performance is provided by the accounting system. Collection of taxes is also based on accounting records.

(7).Researchers Researchers need financial information for testing hypothesis

and development of theories and models. The required information is provided by accounting system.

Contd.(8). Customers The customers who have developed loyalties toward a

business are those who are certainly interested in the continuance of the business. They certainly want to know about the future directions of the enterprise with which they are associating themselves. The way to information about the enterprise is through their financial statements.

(9).Public Public at large is always interested in knowing the future

directions of an enterprise and the only window to peep inside an enterprise is through their financial statements.

Advantages Of Accounting1. Facilitates to Replace Memory Accounting facilitates to replace human memory by maintaining a

complete record of financial transactions. Human memory is limited by its very nature. Accounting helps to overcome this limitation.

2. Facilitates to Comply with Legal Requirements

3. Facilitates to Ascertain Net Result of Operations

4. Facilitates to Ascertain Financial Position

5.Facilitates the Users to take Decisions

Contd.

6. Facilitates a Comparative Study 7. Assist Management 8. Facilitates Control over Assets 9. Facilitates the Settlement of Tax

Liability 10. Facilitates the Ascertainment of

Value of Business11. Facilitates Raising Loans

Basic Terms in Accounting

1. Capital

Capital generally refers to the amount invested in an enterprise by its owners. For example, paid up share capital in a corporate enterprise. Capital also refers to the interest of owners in the assets of an enterprise.

2. Assets

Assets refer to the tangible objects or intangible rights owned by an enterprise and carrying probable future benefits.


3. Liability

• Liability is the financial obligation of an enterprise other than owners’ funds.

4. Revenue

• Revenue is the gross inflow of cash, receivables or other considerations arising in the course of ordinary activities of an enterprise’s resources yielding interest, royalties and dividends.


5. Cost of Goods Sold

• It is the cost of goods sold during an accounting period. In manufacturing operations, it includes the following:

• • Cost of materials

• • Labor and factory overheads

6. Profit

• Profit is a general term for the excess of revenue over related cost. When the result of this computation is negative, it is referred to as loss.


8. Expenses

• Expense is the cost relating to the operation of an accounting period, or the revenue eared during the period, or the benefit of which do not extend that period.

9. Deferred Expenditure • Deferred expenditure is the expenditure for which payment has been made or a liability incurred but which is carried forward on the presumption that it will be a benefit over a subsequent period or periods. This is also referred to as deferred revenue expenditure.

Sundry Creditor

• Sundry creditor is the amount owed by an enterprise on account of goods purchased or services received, or in respect of contractual obligations. It is also termed as trade creditor or account payable.

Sundry Debtor

• Sundry debtors are persons from whom amounts are due for goods sold or services rendered, or in respect of contractual obligations. These are also termed as debtor, trade debtor and account receivable.

Contingent Asset

• Contingent asset is an asset, the existence, ownership or value of which may be known or determined only on the occurrence or non-occurrence of one or more uncertain future events.

Contingent Liability

• Contingent liability is an obligation relating to an existing condition or situation which may arise in future depending on the occurrence or non-occurrence of one or more uncertain future events.

Accounting Cycle

ACCOUNTING CONCEPTS

• The Business Entity Concept:• Entity concept is an assumption that for an accounting

purposes, the business is separate and different from that of its owners. The entity concept is also known as the concept of an “Enterprise” and is one of the central concepts in accounting. The entity concept may be applied to the whole organization or even to the part of the organization. Thus according to these concepts the business is treated as separate unit from that of its owners, creditors, managers, employees and others.

The Going Concern Concept

• According to this concepts an enterprises has an unlimited existence. Thus the concept of Going Concern Continuity can be expressed as under.“Unless & until there is evidence to the contrary, anenterprise must be considered as continuing largely in itspresent form and with its present purpose”

3. The Money Measurement Concept: -

• The money measurement a concept is an assumption that any accounting transaction is to be measured in money or money’s worth. It is only when a transaction is measured that it can be recorded in the books of an enterprise and the result of the business is determined.

• Thus the measurement of a transaction also has to be in a common denomination (medium).

• Money is this common denominations in which transaction are recorded in the books of account.

4. The concept of Accounting Periodicity: -

• The determination of the income of the enterprise cannot be postponed till the end of the enterprise. Since, according to Going-concern concept there is no limit for the life of the enterprises. Hence the economic activities of the business must be recorded periodically. These period is called as Accounting period & these Accounting period is normally called as “Accounting Year” or “Financial Year” or “Fiscal Year”.

• It is, within this Accounting Year, that the income & expenses (i.e.) costs & revenues are matched with reasonable accuracy to provide significant results.

5. The Historical Cost Concept: -

• According to Historical cost concept, all the transactions are recorded in the books at cost and not at its market value. Thus the underlying ideas of this concept are two forms.a. An asset is recorded at the price paid to acquire it i.e. atcost andb. This cost is the basis of all the subsequent treatment ofthe assets. e.g. depreciation, stock valuation, etc.,

6. The Concept Of Matching Cost and Revenues

• Matching of Expired cost (i.e., expenses) and revenues for the period’s determination of income, is one of the most important concept and procedures of accounting.

• This concept follows the accounting period concept i.e. once an accounting period is determined, within that period, the revenues and its related costs are matched.

• This concepts is one of the most important concept of accounting and has received major attention of accountants. Matching of costs and revenue is the ‘Test reading’ of the results and the success of the business activity. At the same time, it is one of the most difficult accounting problems.

7. The Accrual Concept

• This concept is also called the Accrual theory of Accounting or Accrual Accounting It means a system of recording revenues and expenses of particular accounting period.

• Whether or not they are receive or paid in cash, at the time of accounting. It is also known as “Mercantile System of Accounting” as contrasted to “ Cash system of Accounting. In cash system of accounting, the revenues are recorded only when received, whether due or not. Payments i.e. expenses are also recorded irrespective of the fact whether they pertain to the period concerned or not.

• For matching of costs and revenue under accrual concept, all revenues related to current year, whenever received, and all costs of the current year, whenever paid, must be taken into account.

CONVENTIONS

Consistency: This concept states that once the organisation has decided on

a method, it should use the same method subsequently unless there is a valid reason for a change of method. If frequent changes are made it is not possible to carry out comparisons on an inter-period or interfirm basis. If a change is necessary it has to be highlighted. e.g. if depreciation is charged on diminishing balance method, it should be done year after year.

Disclosure

• All significant information should be disclosed. The disclosure concept states that all significant information should be disclosed and all insignificant information should be disregarded. However, there are no definite rules to separate the two. For recording purposes also only significant events are recorded in detail taking into consideration the cost of detailed record keeping

Materiality :

The accountant should attach importance to material details and ignore insignificant details. The question what constitutes a material detail is left to the discretion of the accountant. An item is material if there is reason to believe that knowledge of it would influence the decision of the informed investor.

a) Materiality of information b) Materiality of amountc ) Materiality of procedure.

Conservatism

• This convention means a caution approach or policy of "play safe". This convention ensures that uncertainties and risks inherent in business transactions should be given a proper consideration. If there is a possibility of loss, it should be taken into account at the earliest. On the other hand, a prospect of profit should be ignored up to the time it does not materialise. On account of this reason, the accountants follow the rule 'anticipate no profit but provide for all possible losses'.

DOUBLE ENTRY SYSYTEM

• Double-entry accounting is a method of record-keeping that lets you track just where your money comes from and where it goes.

• Using double-entry means that money is never gained nor lost---it is always transferred from somewhere (a source account) to somewhere else (a destination account). This transfer is known as a transaction, and each transaction requires at least two accounts.

• An account is a record for keeping track of what you own, owe, spend or receive.

Contd…

• For example, we buy machinery for Rs. 300,000. • It has brought two changes, machinery increases by Rs

300,000 and cash decreases by an equal amount. • While recording this transaction in the books of accounts,

both the changes must be recorded. In accounting language these two changes are termed "as a debit change" & "a credit change".

Contd…

• Thus we see that for every transaction there will be two entries, one debit entry and another credit entry.

• For each debit there will be a corresponding credit entry of an equal amount.

• Conversely, for every credit entry there will be a corresponding debit entry of an equal amount.

• So, the system under which both the changes in a transaction are recorded together, one change is debited, while the other change is credited with an equal amount, is known as double entry system.

ACCOUNTING EQUATION• The equation that is the foundation of double entry

accounting. The accounting equation displays that all assets are either financed by borrowing money or paying with the money of the company’s shareholders. Thus, the accounting equation is

Contd…

• The balance sheet is a complex display of this equation, showing that the total assets of a company are equal to the total of liabilities and shareholder equity. Any purchase or sale has an equal effect on both sides of the equation, or offsetting effects on the same side of the equation.

• The accounting equation is also written as

Liabilities = Assets – Shareholder Equity OR

Shareholder Equity = Assets – Liabilities.

Examples…

TransactionNumber

Assets Liabilities Shareholder'sEquity Explanation

1 + 6,000 + 6,000 Issuing stocks for cash or other assets

2 + 10,000 + 10,00

0Buying assets by borrowing money (taking a loan from a bank or simply buying on credit)

3 − 900 − 900 Selling assets for cash to pay off liabilities: both assets and liabilities are reduced

4 + 1,000 + 400 + 600 Buying assets by paying cash by shareholder's money (600) and by borrowing money (400)

5 + 700 + 700 Earning revenues

6 − 200 − 200 Paying expenses (e.g. rent or professional fees) or dividends

7 + 100 − 100 Recording expenses, but not paying them at the moment

8 − 500 − 500 Paying a debt that you owe

9 0 0 0Receiving cash for sale of an asset: one asset is exchanged for another; no change in assets or liabilities

TransactionNumber

Assets LiabilitiesShareholder'sEquity

Explanation

Journal• Introduction:- Accounting is the art of recording, classifying and

summarizing the financial transactions and interpreting the results thereof. Thus, the accounting cycle involves the following four major phases:

1. Recording of transactions-- This is done in a book called journal.

2. Classifying the transactions-- This is done in a book called ledger.

3. Summarizing the transactions-- This includes preparation of trial balance, profit and loss account and balance sheet of the business.

4. Interpreting the results-- This involves computation of various accounting ratios etc. to know about the liquidity, solvency and profitability of the business.

• A journal records all daily transactions of a business in the order of their occurrence. A journal may, therefore, be defined as a book containing a chronological record of transactions.

Journal Journal

The Performa of a journal is as follows:

Rules of Debit and Credit • All transactions in the journal are

recorded on the basis of rules of debit and credit. For this purpose, transactions have been classified into three categories:

i. Transactions relating to persons ii. Transactions relating to properties and

assetsiii. Transactions relating to incomes and

expenses

Contd..

• On the basis of above rules, it is necessary to keep the accounts in respect of the following:

i. Each person with whom it deals (customer, suppliers)

ii. Each property or asset which it owns (building, machinery etc.)

iii. Each item of income and expense (commission, rent, salary etc.)

Personal Accounts Personal accounts include the accounts of persons with whom the business

deals. These accounts can be further classified into three categories:

a. Natural Personal Account Natural personal account means persons who are creations of God. For

example, Vijay’s a/c, Hary’s a/c etc. b. Artificial Person Account Artificial person account includes accounts of corporate bodies or institutions

which are recognized as persons in business dealings. For example, government, club, limited company, cooperative society etc.

c. Representative Personal Account Representative personal account is the account which represents a person or

a group of persons. For example, when the rent is due to landlord, an outstanding rent account represents the account of a landlord to whom the rent is payable.

Real Accounts Real accounts may be of the following types:

a. Tangible Real Account

Tangible real accounts are those which relate to such things that can be touched, felt and measured. For example, cash a/c, building a/c, furniture a/c etc.

b. Intangible Real Account

These accounts represent such things which cannot be touched but, however, can be measured in terms of money. For example, patent a/c, goodwill a/c etc.

Nominal Accounts

Nominal accounts are opened in the books of accounts to simply explain the nature of the transactions. They do not really exist. For example, salary paid to employee, rent paid to landlord etc. Nominal accounts mainly include accounts of expense, losses, income and gains.

RULES OF ACCOUNTING

Analysis Of Business Transaction

1. Determine the 2 accounts which are involved in the transaction.

2. Classify the above two accounts under Personal , Real and Nominal.

3. Find out the rules of debit and credit for the above two accounts.

4. Identify which account is to be debited and which account is to be credited.

EXAMPLES OF JOURNAL ENTRIES

COMPOUND JOURNAL ENTRY Sometimes, there are a number of transactions on the same

date relating to one particular account or of one particular nature. Such entries can be passed by way of a single journal entry instead of passing individual journal entries. It may be recorded in any of the following three ways:

1. A particular account may be debited while several accounts may be credited.

2. A particular account may be credited while several accounts may be debited.

3. Several accounts might debited as well as credited.

OPENING ENTRY

In the case of a running business, the assets and liabilities appearing in the pervious year’s balance sheet will have to be brought forward to the next year. This is done by the means of a journal entry which is known as “opening entry.” All assets are debited while all liabilities are credited. The excess of assets over liabilities is the proprietor’s capital and is credited to his capital account

Example:-

Pass the opening entry on 1.1.2001 on the basis of the following information taken from the business of Mr. Shubham. 1. Cash in hand-- Rs. 20,000 2. Sundry Debtors-- Rs. 60,000 3. Stock in Trade-- Rs. 40,000 4. Plant and Machinery-- Rs. 50,000 5. Land and Building-- Rs. 1,00,000 6. Sundry Creditors-- Rs. 1,00,000

Solution:-

Discount

• An incentive that a seller offers to a buyer in return for paying a bill owed before the scheduled due date. The seller will usually reduce the amount owed by the buyer by a small percentage or a set dollar amount. If used properly, cash discounts improve the days-sales-outstanding aspect of a business's cash conversion cycle.

• For example, a typical cash discount would be if the seller offered a 2% discount on an invoice due in 30 days if the buyer were to pay within the first 10 days of receiving the invoice.

Providing a small cash discount would be beneficial for the seller as it would allow him to have access to the cash sooner. The sooner a seller receives the cash, the earlier he can put the money back into the business to buy more supplies and/or grow the company further.

• Cash Discount

Trade Discount

• A discount on the list price granted by a manufacturer or wholesaler to buyers in the same trade.

• Suppose A buys from B $200 worth of goods. He is allowed a discount of 10% from the list price. Then he would have to pay only $180 to B. Suppose the terms had stipulated that he be allowed a discount of 10% and 5% off from the list price. This would not give him a deduction of 15% from the $200

Cash Discount Trade Discount

Is a reduction granted by supplier from the invoice price in consideration of immediate or prompt payment

Is a reduction granted by supplier from the list price of goods or services on business consideration re: buying in bulk for goods and longer period when in terms of services

As an incentive in credit management to encourage prompt payment Allowed to promote the sales

Not shown in the supplier bill or invoice Shown by way of deduction in the invoice itself

Cash discount account is opened in the ledger

Trade discount account is not opened in the ledger

Allowed on payment of money Allowed on purchase of goods

It may vary with the time period within which payment is received

It may vary with the quantity of goods purchased or amount of purchases made

• LEDGER is the principal book of accounts which contains various accounts. An account is a summarized record of similar transactions during an accounting period relating to a particular person or thing. Therefore, all the accounts, whether real, nominal or personal, are collected in the ledger.

FORMAT

• Dr. Title of the Account Cr

POSTING

• Posting means the process of transferring all the debit and credit items from the journal onto the accounts maintained in the ledger. Each amount entered in the debit column of the journal is posted by entering it on the debit side of the account in the ledger with relevant details. Similarly, each amount entered in the credit column is posted by entering it on the credit side of the account in the ledger with relevant details.

The procedure of posting is as follows:1. Enter the debit aspect of the transaction entered in journal on the debit side of the

account in the ledger with all the relevant details in the respective column.

2. In the folio column of the journal, the page number of the ledger in which posting is done is entered.

3. Now enter the credit aspect of the transaction in the journal on the credit side of the account in the ledger with all the relevant details in the respective column.

4. The entering of the folio number on the corresponding page, as explained in the point number two above, is to be repeated in the case of credit item.

5. It is customary to prefix the name of the account credited and entered on the debit side of the account in the ledger with word “To.”

6. Similarly, the name of the account debited and entered on the credit side of the account in the ledger is prefixed with “By.”

Balancing of Ledger Account• The totals of the debit side and credit side of an account are

taken to ascertain the difference between the two sides. • This difference is known as the balance on the account. The

total of the heavier side is entered on the lighter side for arriving at the balance.

• When the total of the debit side exceeds the total of the credit side, the balance is said to be in debit, i.e. known debit balance.

• When the total of the credit side exceeds the total of the debit side, it means that the account has a credit balance.

• The balancing of the account is necessary to ascertain the net effect whether debit or credit on the account.

TRIAL BALANCE

• Trial balance is a list of debit and credit balances extracted from the ledger on a particular date. Since for every debit entry there is a corresponding credit entry of the equivalent amount, the total of the debit and credit balances should agree in equal amount.

• A trial balance essentially proves the arithmetical accuracy of the entries passed in the books of account and is derived from ledger where all accounts find a place.

• Trial balance is prepared after striking the balance of various accounts in the ledger.

OBJECTIVES OF PREPARING TRIAL BALANCE

1. It forms the very basis on which final accounts are prepared. 2. It helps in knowing the balance on any particular account in

the ledger. 3. It is a test of arithmetical accuracy.

Note:- A trial balance is not a conclusive proof of the absolute accuracy of the account. It does not indicate the absence of an error. So, a non-tailed trial balance indicates the presence of book keeping error.

ERRORS DISCLOSED BY THE TRIAL BALANCE

• Wrong posting of entries, e.g., a debit entry of Rs. 500 for purchase of furniture wrongly posted as Rs. 50 in the account

• Omission of posting, e.g., when a debit entry of Rs. 500 for purchase of furniture has not been posted at all

• Duplication of posting, e.g., when a debit entry of Rs. 500 for purchase of furniture has been posted twice to the account

• Wrong side of posting, e.g., when debit entry is posted on the credit side or credit entry is posted on the debit side. That is, when debit entry of Rs. 500 is posted on the credit side and vice-versa

Contd..

• Errors in casting the totals of debit or credit side of the trial balance

• Wrong transfer of balances to the trial balance • Omission of entering the balance of account in the trial

balance • Balance of cash book omitted to be recorded in the trial

balance • Wrong balancing of account

ERRORS NOT DISCLOSED BY THE TRIAL BALANCE

(a) Errors of omission to record any transaction. (b) Posting of wrong amount to both debit and credit side of the account. (c) Error made in the posting of debit or credit entry is compensated by an

identical error of equal amount. These errors are known as errors of compensation.

(d) Errors made in posting a transaction on the correct side of wrong account.

(e) Erroneously recording a transaction twice. These are known as errors of duplication.

(f) Errors of principle when the accounting principle is disregarded. For example, a capital item treated as revenue item and vice versa. That is, purchase of furniture posted to purchase a/c.

Trial Balance as on 30th April 2009

Basic Principles of Preparing Final Account (Capital and Revenue)

CAPITAL EXPENDITURE 1. Capital expenditure is that expenditure the benefits of which are not fully

consumed in a year but spread over several years. 2. It is the expenditure which results in the purchase or acquisition of asset or

property. 3. It is the expenditure incurred in connection with the purchase of asset. 4. It is the expenditure incurred to bring an old asset into working condition. 5. It is the expenditure incurred for extending or improving an existing asset

to increase its productivity or to increase the earning capacity of business or to decrease working expenditure.

REVENUE EXPENDITURE 1. Revenue expenditure is the expenditure which benefits in the

current accounting year. It is not carried forward to the next year or years.

2. It is the expenditure which is incurred in the normal course of business to run the business and to maintain the fixed assets of business.

3. It is the expenditure which is incurred on purchase of goods meant for resale or to purchase materials which will be used to convert them into final product.

Therefore, revenue expenditure is a recurring expenditure made to maintain the business. The amount spent is generally small and the benefit is for a short period which is not more than a year. All revenue expenditure are charged to trading and profit and loss account.

DEFERRED REVENUE EXPENDITURE

• Deferred revenue expenditure is the expenditure which is originally revenue in nature but the amount spent is so large that the benefit is received for not a year but for many years.

• A proportionate amount is charged to profit and loss account of each year and balance is carried forward to subsequent years as deferred revenue expenditure.

• It is shown as an asset in the balance sheet, e.g., heavy expenditure incurred on advertisements.

CAPITAL RECEIPTS

• Capital receipts are the receipts which are not received in the ordinary course of business. These are non-recurring receipts.

• Money obtained from the sale of fixed assets or investments, issue of shares or debentures, loans taken are some of the examples of capital receipts.

• Capital receipts are shown as liability reduced from assets appearing in the balance sheet.

REVENUE RECEIPTS

• Revenue receipts are receipts obtained in the normal course of business. It is a receipt against supply of goods or services.

• The money obtained from sales, interest, dividend, transfer fees etc. are examples of revenue receipts. Revenue receipts are credited to profit and loss account.

CAPITAL PROFIT

• Those profits which are not earned during the regular course of business and which are not earned on account of the day-to-day trading activities of the business are capital profits. For example, profit on sale of asset and premium received on issue of shares.

• These types of profits are normally not taken to profit and loss account but are shown in the liabilities side of the balance sheet.

CAPITAL LOSSES

The losses which are not suffered during the regular course of business are called capital losses. For example, discount on issue of shares.

INCOME STATEMENTS

Introduction After the agreement of trial balance, a trader closes

ledger accounts with a view to ascertain the following aspects:

• Gross profit • Net profit • Financial position of the firm

TRADING ACCOUNT

The goods account is split up and separate accounts are opened as follows:

• Opening stock account, i.e. stock at commencement • Purchase account including both cash and credit purchases • Sales account including both cash and credit sales • Returns inwards account, i.e. total goods returned by customers • Returns outwards account, i.e. total goods returned to vendors • Closing stock account, i.e. stock of goods at the end

These separate accounts, in total, are ultimately transferred to a common heading called trading account.

Contd..

• In order to find out the gross profit or gross loss of a business, a trading account is prepared.

• This account gives the overall profit of the business relating to an accounting period which is subject to deduction of general administrative, selling and other expenses.

• Gross profit is the difference between sale proceeds of a particular period and the cost of the goods actually sold during that period.

The format of trading account is as follows:

PROFIT AND LOSS ACCOUNT • Profit and loss account is prepared with a view to ascertain the

profit or loss on account of business activity during an accounting period.

• Profit and loss account is also an account like other accounts in the ledger which discloses the net effect in the form of profit or loss resulting from settling off the expenses incurred against the revenue earned during the accounting period.

• The difference between total revenue and total expenses represents net income or net loss according to whether the difference is positive or negative.

• In this regard, it is pertinent to note that all the expenses incurred for the period are to be debited to this account, whether paid or not. Likewise, all revenue earned, whether received or not, are to be credited to this account.

Contd…• The balance of a trading account showing gross profit or gross loss

becomes the opening transfer entry of this account on the credit or debit side respectively.

• All the revenue expenses appear on the debit side including those expenses which do not find a place in the trading account.

• The losses on sale of capital asset or any abnormal loss also appear on the debit side. The credit side of the account shows the revenue earned including the non-trading income like interest on bank deposit or securities, dividend on shares, rent of let-out property, profit arising from sale of fixed assets etc. after transfer of all the nominal accounts from the trial balance to the profit and loss account.

• The net result of the profit and loss account is ascertained by balancing it. If the credit side is more than the debit side, it indicates net profit for the period.

• Conversely, if the debit side is more than the credit side, it indicates net loss for the period.

PROFIT AND LOSS ACCOUNT

BALANCE SHEET

• The American Institute of Certified Public Accountants defines balance sheet as “a tabular statement of summary of balances (debits and credits) carried forward after an actual and constructive closing of books of account and kept according to the principles of accounting.”

Contd…

• The balance sheet is one of the important statements depicting the financial strength of the company. On one hand, it shows the properties which were utilized and on the other, the sources of those properties.

• The balance sheet shows all the assets owned by the company and all the liabilities and claims it owes to owners and outsiders.

• The balance sheet is prepared on a particular date. The right hand side shows properties and assets. Usually, there is no particular sequence for showing various assets and liabilities.

FORM AND CONTENTS OF BALANCE SHEET

• The balance sheet is generally divided into parts, i.e. assets, liabilities and capital. It is usually prepared in the horizontal form. The assets are shown on the right hand side and capital and liabilities on the left hand side.

• The order of assets and liabilities is either on liquidity basis or on permanency basis. When balance sheet is prepared on liquidity basis, large liquid assets like cash in hand, cast at bank, investments etc. are shown first and small liquid assets later. On liabilities side, the liabilities to be paid in the short period are shown first, long-term liabilities next and capital in the last.

• The liquidity form is suitable for banking and other financial companies. When balance sheet prepared on permanency basis, on assets side, fixed assets are shown first and liquid assets later. On liabilities side, the capital is shown first, long-term liabilities next, and short-term and current liabilities in the last.

EXPLANATION OF BALANCE SHEET ITEMS

1. Share Capital

Share capital is the first item on the liabilities side of a balance sheet. Authorized and issued capital is shown giving the number of shares and their amount. The number of shares for which public has applied (subscribed capital) are mentioned along with the type of capital, i.e. preference share capital and equity share capital. If the capital is issued for other than cash, the amount of such capital is mentioned.

SECURED LOANS

All those loans against which securities are given are shown under this category. Debentures are shown under this heading. Loans and advances from bank, subsidiary companies etc. should be shown separately and the

nature of securities should also be mentioned. UNSECURED LOANS These are the loans and advances against which the company has not

given any security. The items included here are deposits, loans and advances from subsidiary companies and loans and advances from other sources. Short-term loans from banks and other sources are also shown in this category. Short-term loans include those which are due for not more than one year on the balance sheet.

CURRENT LIABILITIES AND PROVISIONS

(a) Current liabilities include the following:

• Acceptances • Sundry creditors • Subsidiary companies • Advance payments and unexpired

discounts • Unclaimed dividends • Other liabilities, if any • Interest accrued but not paid on

loans

(b) Following items are included under provisions:

• Provision for taxation • Proposed dividends • Provision for contingencies • Provision for provident fund

scheme • Provision for insurance, pension

and similar staff benefits schemes • Other provisions

ASSETS SIDE

1. Fixed Assets • Fixed assets are those which are purchased for use over a long period. These assets are meant to increase production capacity of the business.

• They are not acquired for sale but are used for a considerable period of time.

• The balance sheet is prepared to show the financial position of the concern. These assets should be shown in such a way that balance sheet depicts true financial position of the business.

2. Investments • Investments are shown by giving

their nature and mode of valuation. Investments under various sub-heads such as investments in government or trust securities, in shares, debentures and bonds, and in immovable properties are given separately in the inner column of the balance sheet.

3. Current Assets

• Current assets are such assets as in the ordinary and natural course of business move onward through the various processes of production, distribution and payment of goods, until they become cash or its equivalent by which debts may be readily and immediately paid.

4. Miscellaneous Expenditure • Deferred expenditure is shown

under this heading. Miscellaneous expenditure are the expenses which are not debited fully to the profit and loss account of the year in which they have been incurred. These expenses are spread over a number of years and unwritten balance is shown in the balance sheet. The items under this heading are preliminary expenses, discount allowed on issue of shares or debentures, interest paid out of capital during construction

Contd…

108

The Balance Sheet

• Elements of the balance sheet:– Assets - resources of the firm that are expected to

increase or cause future cash flows (everything the firm owns)

– Liabilities - obligations of the firm to outsiders or claims against its assets by outsiders (debts of the firm)

– Owners’ Equity - the residual interest in, or remaining claims against, the firm’s assets after deducting liabilities (rights of the owners)

109

Classifying Assets and Liabilities

Current assets

Long-term assets

Current liabilities

Long-term liabilities

110

XYZ Ltd.Trial Balance

November 30, 2002

Cash 5,900Purchases 550Land 20,000Accounts Payable 400Amit, Capital 25,000Amit, Drawing 2,000Fees Earned 7,500Wages Expense 2,125Rent Expense 800Commission 450Supplies Expense 800Miscellaneous Expense 275

32,900 32,900

111


November 30, 2002


32,900 32,900

BalanceSheet

112

IncomeStatement


November 30, 2002


32,900 32,900

113

XYZ Ltd.

Balance Sheet Income Statement

1. Assets11 Cash12 Accounts Receivable14 purchases15 Prepaid Insurance17 Land18 Office Equipment

2. Liabilities21 Accounts Payable23 Unearned Rent

3. Owner’s Equity31 Amit, Capital32 Amit, Drawing

4. Revenue41 Sales5. Expenses51 Wages Expense52 Rent Expense54 Commission55 Supplies Expense59 Miscellaneous

Expense

114

Summary

Original evidencerecords

Accountingrecords

FinancialStatements

Sourcedocuments

Journals

Ledger

Trial Balance

Statement of cash flows

Balance Sheet

Profit and LossStatement

ClosingEntries

FORM AND CONTENTS OF BALANCE SHEET

• The balance sheet is generally divided into parts, i.e. assets, liabilities and capital. It is usually prepared in the horizontal form. The assets are shown on the right hand side and capital and liabilities on the left hand side.

• The order of assets and liabilities is either on liquidity basis or on permanency basis. When balance sheet is prepared on liquidity basis, large liquid assets like cash in hand, cast at bank, investments etc. are shown first and small liquid assets later. On liabilities side, the liabilities to be paid in the short period are shown first, long-term liabilities next and capital in the last.

• The liquidity form is suitable for banking and other financial companies. When balance sheet prepared on permanency basis, on assets side, fixed assets are shown first and liquid assets later. On liabilities side, the capital is shown first, long-term liabilities next, and short-term and current liabilities in the last.

Financial Statements

Analysis

The Analysis of Financial Statements

Ratios Analyzing Liquidity Analyzing Activity Analyzing Debt Analyzing Profitability A Complete Ratio Analysis

The Analysis of Financial Statements THE USE OF FINANCIAL RATIOS

– Financial Ratio are used as a relative measure that facilitates the evaluation of efficiency or condition of a particular aspect of a firm's operations and status

– Ratio Analysis involves methods of calculating and interpreting financial ratios in order to assess a firm's performance and status

2

Example

(1) (2) (1)/(2)

Year End Current Assets/Current Liab. Current Ratio

1994 $550,000 /$500,000 1.10

1995 $550,000 /$600,000 .92

3

Interested Parties

Three sets of parties are interested in ratio analysis:

ShareholdersCreditorsManagement

4

Types of Ratio Comparisons

There are two types of ratio comparisons that can be made:

Cross-Sectional Analysis Time-Series Analysis

– Combined Analysis uses both types of analysis to assess a firm's trends versus its competitors or the industry

5

Words of Caution Regarding Ratio Analysis

A single ratio rarely tells enough to make a sound judgment.

Financial statements used in ratio analysis must be from similar points in time.

Audited financial statements are more reliable than unaudited statements.

The financial data used to compute ratios must be developed in the same manner.

Inflation can distort comparisons.

6

Groups of Financial Ratios

LiquidityActivityDebtProfitability

7

Analyzing Liquidity

Liquidity refers to the solvency of the firm's overall financial position, i.e. a "liquid firm" is one that can easily meet its short-term obligations as they come due.

8

Three Important Liquidity Measures

Net Working Capital (NWC) NWC = Current Assets - Current LiabilitiesCurrent Ratio (CR) Current Assets CR = Current LiabilitiesQuick (Acid-Test) Ratio (QR)

Current Assets - InventoryQR = Current Liabilities

9

Analyzing Activity

Activity is a more sophisticated analysis of a firm's liquidity, evaluating the speed with which certain accounts are converted into sales or cash; also measures a firm's efficiency

10

Inventory Turnover (IT)

Average Collection Period (ACP)

Average Payment Period (APP)

Fixed Asset Turnover (FAT)

Total Asset Turnover (TAT)

Cost of Goods SoldIT =

Inventory

Accounts ReceivableACP =

Annual Sales/360

Accounts PayableAPP=

Annual Purchases/360

Sales FAT =

Net Fixed Assets

SalesTAT =

Total Assets

Five Important Activity Measures11

Analyzing Debt

Debt is a true "double-edged" sword as it allows for the generation of profits with the use of other people's (creditors) money, but creates claims on earnings with a higher priority than those of the firm's owners.

12

Measures of Debt

There are Two General Types of Debt Measures–Degree of Indebtedness –Ability to Service Debts

13

Debt Ratio (DR)Debt-Equity Ratio (DER)

Times Interest Earned Ratio (TIE)

Fixed Payment Coverage Ratio (FPC)

Total LiabilitiesDR=

Total Assets

Long-Term DebtDER=

Stockholders’ Equity

Earnings Before Interest & Taxes (EBIT)TIE=

Interest

Earnings Before Interest & Taxes + Lease Payments

FPC= Interest + Lease Payments +{(Principal Payments + Preferred Stock Dividends) X [1 / (1 -T)]}

Four Important Debt Measures14

Analyzing Profitability

– Profitability Measures assess the firm's ability to operate efficiently and are of concern to owners, creditors, and management

– A Common-Size Income Statement, which expresses each income statement item as a percentage of sales, allows for easy evaluation of the firm’s profitability relative to sales.

15

Gross ProfitsGPM=

Sales

Operating Profits (EBIT)OPM =

Sales

Net Profit After TaxesNPM=

Sales

Net Profit After TaxesROA=

Total AssetsNet Profit After Taxes

ROE= Stockholders’ Equity

Earnings Available for Common Stockholder’sEPS = Number of Shares of Common Stock Outstanding

Market Price Per Share of Common StockP/E =

Earnings Per Share

Seven Basic Profitability Measures16

Summarizing All Ratios

An approach that views all aspects of the firm's activities to isolate key areas of concern

Comparisons are made to industry standards (cross-sectional analysis)

Comparisons to the firm itself over time are also made (time-series analysis)

19

Al-Noor Sugar MillsAn Introduction, Common Size financial Statements

By Shah Zaman

About the Mills

• Company InformationAl-Noor Sugar Mills Limited is a public company incorporated in Pakistan under the Companies Act, 1913 (now Companies Ordinance, 1984). Its shares are quoted on Karachi and Lahore Stock Exchange in Pakistan and is principally engaged in the production and sale of refined sugar and medium density fiber board.

Mission Statement

To gain strength through industry leadership in the manufacturing and marketing of sugar and Lasani Wood and to have a strong presence in these product markets while retaining the options to diversify in other profitable venture.To operate ethically while maximizing profits and satisfying customers needs and stake holder's interests.To assist in the socio economic development of Pakistan especially in the rulra areas through industrial expansion and development.

Al-Noor Sugar Mills

Common size Financial Statements Trend analysisCross sectional Analysis

Balance Sheet 2006 2007 2008 2006 2007 2008

ASSETS

Cash 48,694 47,597 86,463 100% 98% 178%

Stores and Spares 131,668 144,818 188,578 100% 110% 143%

Stock in trade 230,809 393,723 1,009,052 100% 171% 437%

trade debts 43,166 28,978 11,314 100% 171% 26%

loans and advances 112,300 144,861 149,526 100% 129% 133%

trade deposits 3,638 5,254 7,164 100% 144% 197%

other receivables 11,081 23,271 417 100% 190% 4%

Total Current assts 100%

Fixed Assets 100%

property plant, Equip 1,472,955 1,527,982 2,264,422 100% 104% 154%

Long term investments 8,607 10,263 37,751 100% 119% 80%

Long term deposits 10,742 11,317 5,071 100% 105% 47%

total assets 2072660 2,338,064 3775726 100% 42%

LIABILITIES & EQUITY

short term liabilities

Trade and other payables 317,484 317,484 526,054 100% 100% 166%

Interest markup accrued 25,138 14,446 28,416 100% 57% 113%

short term borrowings 397,809 270,955 862,684 100% 68% 218%

Current portion of long term liab 105,139 118,679 123,808 100% 113% 123%

provision for income tax 7,460 2,089 0 100% 28% 0%

long term financing 67,470 325,000 237,500 100% 482% 315%

liabilities against assets subject to finance lease 77,568 70,840 28,261 100% 91% 46%

long term deposits 5,035 4,874 4,869 100% 97% 64%

deferred liabilities 344,112 346,074 492,058 100% 101% 122%

Authorized capital (20,000,000, @Rs. 10 each) 200,000 200,000 200,000 100% 100% 100%

Paid up capital 185,703 185,703 185,703 100% 100% 100%

General revenue reserve 190,000 190,000 190,000 100% 100% 100%

Inappropriate profit 111,468 154,659 366,139 100% 139% 310%

total stockholders equity 1

total equity and liabilities 2072660 2,338,04 3775726

Analysis

• In reviewing the basic financial ratios, we will examine the ratios of Al-Noor Sugar Mills for the fiscal years ended September 30, 2008 and September 30, 2007. Al-Noor Sugar Mills is a growing company.

Analysis (Al-Noor Sugar Mills)

By Muhammad Hashim Shah

Analysis

• Note that while Al-Noor Sugar Mills’s earnings rose from 2007 to 2008, the earnings generated per dollar of assets fell over the period. In 2007, Al-Noor Sugar Mills earned 10.22 cents before financing costs on every dollar of average assets; however, in 2008, Al-Noor Sugar Mills earned only 9.63 cents before financing costs on every dollar of average assets. The ratio, return on assets, allows the analyst to compare the earnings generating ability of the company relative to the invested assets.

Analysis- profit margin

• Al-Noor Sugar Mills’s profit margin increased in 2008. For every Rupee in sales, Al-Noor Sugar Mills earned 3 Passas in income before financing costs in 2008 and only 2.61 cents in 2007. Thus, the fall in ROA is not due to the reduction in income before financing costs per Rupee of sales.

Profit Margin

• Al-Noor Sugar Mills’s rise in profit margin in 2008 is due to the reduction of cost of sales rather than to the reduction of selling, general and administrative expenses relative to sales.

Analysis- ROA

• It appears that Al-Noor Sugar Mills’s fall in ROA was driven by a fall in ATO, not a fall in PM. The firm had difficulty generating sales from the assets in 2008 relative to 2007. For every Rupee of average assets, Al-Noor Sugar Mills generated only Rs.3.21 in sales in 2008 while Al-Noor Sugar Mills generated Rs.3.92 in sales in 2007.

Analysis- A/R turnover

• Most of Al-Noor Sugar Mills’s transactions are for cash or credit cards; therefore, the number of days’ sales outstanding is very small, approximately 4 days.

Analysis- Inventory turnover

• It has taken Al-Noor Sugar Mills longer to sell its inventory, on average, in 2008 relative to 2007. While it took approximately 44 days on average to sell inventory in 2007, it took Al-Noor Sugar Mills approximately 50 days on average to sell inventory in 2008.

Plant Assets turnover

• Al-Noor Sugar Mills has generated fewer sales per dollar of assets in 2008 relative to 2007. While Al-Noor Sugar Mills generated Rs.14.31 in sales per dollar of average assets in 2007, the average assets generated only Rs.11.73 in sales in 2008. Therefore, part of the explanation for the reduction in asset turnover is the reduction in the productivity of the plant assets at generating sales.

Analysis

• These results suggest that while Al-Noor Sugar Mills did generate greater income and sales in 2008 versus 2007, it generated less income (before financing costs) per dollar of average assets, it took longer to sell its inventory, and it generated fewer sales from each dollar of plant assets.

Analysis-Return on Equity

• Al-Noor Sugar Mills’s ROE has fallen in 2008 but it has not fallen as much as the fall in ROA.

• Note that Al-Noor Sugar Mills’s return on equity is higher than its return on assets. This is due to the use of leverage. Financing with debt and preferred stock can increase the return to common shareholders if the return on assets is greater than the cost of debt.

Analysis- Debt-Asset Ratio

• Al-Noor Sugar Mills has relied more on debt in 2008 relative to 2007. In 2008, 11% of Al-Noor Sugar Mills’s assets are financed with debt while in 2007 only 6% of the assets were financed through debt.

Analysis-Interest Coverage Ratio

• Al-Noor Sugar Mills’s interest coverage ratio has decreased dramatically with the heavier reliance on debt in 2008 relative to 2007.

Analysis- Current Ratio

• Al-Noor Sugar Mills’s current ratio is relatively low. Analysts often suggest that the current ratio of a healthy company should be approximately 2.0. While Al-Noor Sugar Mills’s current ratio is well below 2.0, note that Al-Noor Sugar Mills’s current ratio has increased from 2007 to 2008.

How is Al-Noor Sugar Mills doing?• If you recall, Al-Noor

Sugar Mills had increasing income and increasing sales. The ratios allow us to determine the sales and income relative to the assets and book value that the firm had available to generate income and sales.

Conclusion and Synthesis

• While Al-Noor Sugar Mills did have large increases in sales and earnings in 2008, it did not have increases in profitability.

• Al-Noor Sugar Mills also had high growth in its assets and debt in 2008. Taking into account the assets that Al-Noor Sugar Mills had to use during 2008, Al-Noor Sugar Mills looks less profitable in 2008 relative to 2007 per Rupee of invested assets and book value.

• In addition, its key drivers of operations have become less productive. In particular, Al-Noor Sugar Mills had more difficulty in 2008 in selling inventory and generated fewer sales per dollar of plant assets.

• Ratio analysis leaves one with more insight into Al-Noor Sugar Mills and its changes over the year.

LIABILITES ASSETS

Capital 180 Net Fixed Assets 400

Reserves 20 Inventories 150

Term Loan 300 Cash 50

Bank C/C 200 Receivables 150

Trade Creditors 50 Goodwill 50

Provisions 50

800 800

EXERCISE 1

a. What is the Net Worth : Capital + Reserve = 200b. Tangible Net Worth is : Net Worth - Goodwill = 150 c. Outside Liabilities : TL + CC + Creditors + Provisions = 600

d. Net Working Capital : C A - C L = 350 - 250 = 50 e. Current Ratio : C A / C L = 350 / 300 = 1.17 : 1f. Quick Ratio : Quick Assets / C L = 200/300 = 0.66 : 1

EXERCISE 2

LIABILITIES 2005-06 2006-07 2005-06 2006-07

Capital 300 350 Net Fixed Assets 730 750

Reserves 140 160 Security Electricity 30 30

Bank Term Loan 320 280 Investments 110 110

Bank CC (Hyp) 490 580 Raw Materials 150 170

Unsec. Long T L 150 170 S I P 20 30

Creditors (RM) 120 70 Finished Goods 140 170

Bills Payable 40 80 Cash 30 20

Expenses Payable 20 30 Receivables 310 240

Provisions 20 40 Loans/Advances 30 190

Goodwill 50 50

Total 1600 1760 1600 1760

1. Tangible Net Worth for 1st Year : ( 300 + 140) - 50 = 390

2. Current Ratio for 2nd Year : (170 + 30 +170+20+ 240 + 190 ) / (580+70+80+70) 820 /800 = 1.02

3. Debt Equity Ratio for 1st Year : 320+150 / 390 = 1.21

Exercise 3.

LIABIITIES ASSETS

Equity Capital 200 Net Fixed Assets 800

Preference Capital 100 Inventory 300

Term Loan 600 Receivables 150

Bank CC (Hyp) 400 Investment In Govt. Secu. 50

Sundry Creditors 100 Preliminary Expenses 100

Total 1400 1400

1. Debt Equity Ratio will be : 600 / (200+100) = 2 : 1

2. Tangible Net Worth : Only equity Capital i.e. = 200

3. Total Outside Liabilities / Total Tangible Net Worth : (600+400+100) / 200 = 11 : 24. Current Ratio will be : (300 + 150 + 50 ) / (400 + 100 ) = 1 : 1

LIABILITIES ASSETS

Capital + Reserves 355 Net Fixed Assets 265

P & L Credit Balance 7 Cash 1

Loan From S F C 100 Receivables 125

Bank Overdraft 38 Stocks 128

Creditors 26 Prepaid Expenses 1

Provision of Tax 9 Intangible Assets 30

Proposed Dividend 15

550 550

Q. What is the Current Ratio ? Ans : (1+125 +128+1) / (38+26+9+15) : 255/88 = 2.89 : 1

Q What is the Quick Ratio ? Ans : (125+1)/ 88 = 1.43 : 11

Q. What is the Debt Equity Ratio ? Ans : LTL / Tangible NW = 100 / ( 362 – 30) = 100 / 332 = 0.30 : 1

Exercise 4.

LIABILITIES ASSETS








550 550

Q . What is the Proprietary Ratio ? Ans : (T NW / Tangible Assets) x 100 [ (362 - 30 ) / (550 – 30)] x 100 (332 / 520) x 100 = 64%

Q . What is the Net Working Capital ? Ans : C. A - C L. = 255 - 88 = 167

Q . If Net Sales is Rs.15 Lac, then What would be the Stock Turnover Ratio in Times ? Ans : Net Sales / Average Inventories/Stock 1500 / 128 = 12 times approximately

Exercise 4. contd…

LIABILITIES ASSETS








550 550

Q. What is the Debtors Velocity Ratio ? If the sales are Rs. 15 Lac.

Ans : ( Average Debtors / Net Sales) x 12 = (125 / 1500) x 12 = 1 month

Q. What is the Creditors Velocity Ratio if Purchases are Rs.10.5 Lac ? Ans : (Average Creditors / Purchases ) x 12 = (26 / 1050) x 12 = 0.3 months

Exercise 4. contd…

Exercise 5. : Profit to sales is 2% and amount of profit is say Rs.5 Lac. Then What is the amount of Sales ?

Answer : Net Profit Ratio = (Net Profit / Sales ) x 100 2 = (5 x100) /Sales Therefore Sales = 500/2 = Rs.250 Lac

Exercise 6. A Company has Net Worth of Rs.5 Lac, Term Liabilities of Rs.10 Lac. Fixed Assets worth RS.16 Lac and Current Assets are Rs.25 Lac. There is no intangible Assets or other Non Current Assets. Calculate its Net Working Capital. AnswerTotal Assets = 16 + 25 = Rs. 41 LacTotal Liabilities = NW + LTL + CL = 5 + 10+ CL = 41 Lac Current Liabilities = 41 – 15 = 26 Lac

Therefore Net Working Capital = C. A – C.L = 25 – 26 = (- )1 Lac

Exercise 7 : Current Ratio of a concern is 1 : 1. What will be the Net Working Capital ?

Answer : It suggest that the Current Assets is equal to Current Liabilities hence the NWC would be NIL ( since NWC = C.A - C.L )

Exercise 8 : Suppose Current Ratio is 4 : 1. NWC is Rs.30,000/-. What is the amount of Current Assets ?

Answer : 4a - 1a = 30,000 Therefore a = 10,000 i.e. Current Liabilities is Rs.10,000 Hence Current Assets would be 4a = 4 x 10,000 = Rs.40,000/-

Exercise 9. The amount of Term Loan installment is Rs.10000/ per month, monthly average interest on TL is Rs.5000/-. If the amount of Depreciation is Rs.30,000/- p.a. and PAT is Rs.2,70,000/-. What would be the DSCR ?

DSCR = (PAT + Depr + Annual Intt.) / Annual Intt + Annual Installment = (270000 + 30000 + 60000 ) / 60000 + 120000 = 360000 / 180000 = 2

Exercise 10 : Total Liabilities of a firm is Rs.100 Lac and Current Ratio is 1.5 : 1. If Fixed Assets and Other Non Current Assets are to the tune of Rs. 70 Lac and Debt Equity Ratio being 3 : 1. What would be the Long Term Liabilities?

Ans : We can easily arrive at the amount of Current Asset being Rs. 30 Lac i.e. ( Rs. 100 L - Rs. 70 L ). If the Current Ratio is 1.5 : 1, then Current Liabilities works out to be Rs. 20 Lac. That means the aggregate of Net Worth and Long Term Liabilities would be Rs. 80 Lacs. If the Debt Equity Ratio is 3 : 1 then Debt works out to be Rs. 60 Lacs and equity Rs. 20 Lacs. Therefore the Long Term Liabilities would be Rs.60 Lac.

Exercise 11 : Current Ratio is say 1.2 : 1 . Total of balance sheet being Rs.22 Lac. The amount of Fixed Assets + Non Current Assets is Rs. 10 Lac. What would be the Current Liabilities?

Ans : When Total Assets is Rs.22 Lac then Current Assets would be 22 – 10 i.e Rs. 12 Lac. Thus we can easily arrive at the Current Liabilities figure which should be Rs. 10 Lac

EXERCISE 12. A firm sold its stocks in CASH, in order to meet its liquidity needs. Which of the following Ratio would be affected by this?

1.Debt Equity Ratio2.Current Ratio3.Debt Service Coverage Ratio4.Quick Ratio

EXERCISE 13. A company is found to be carrying a high DEBT EQUITY Ratio. To improve this, a bank may suggest the company to :

1.Raise long term interest free loans from friends and relatives2.Raise long term loans from Institutions3.Increase the Equity by way of Bonus Issue4.Issue Rights share to existing share holders.

EXERCISE 14. Which of the following is a fictitious Asset?

1.Goodwill2.Preliminary Expenses3.Pre-operative expenses4.Book Debts which have become doubtful of recovery

EXERCISE 15. Under which of the following methods of depreciation on Fixed Assets, the annual amount of depreciation decreases?

1.Written Down Value method2.Straight Line method3.Annuity method4.Insurance policy method

EXERCISE 16 Debt Service Coverage Ratio (DSCR) shows :

1.Excess of current assets over current liabilities2.Number of times the value of fixed assets covers the amount of loan3.Number of times the company’s earnings cover the payment of interest and repayment of principal of long term debt4.Effective utilisation of assets

EXERCISE 17. Which of the following is not considered a Quick Asset?

1.Cash and Bank balances2.Bank Fixed Deposits3.Current Book Debts4.Loans and Advances

Exercise 18. From the following financial statement calculate (i) Current Ratio (ii) Acid test Ratio (iii) Inventory Turnover (iv) Average Debt Collection Period (v) Average Creditors’ payment period. C.AssetsSales 1500 Inventories 125Cost of sales 1000 Debtors 250Gross profit 500 Cash 225 C. Liabilities

Trade Creditors 200

(i) Current Ratio : 600/200 = 3 : 1(ii)Acid Test Ratio : Debtors+Cash /Trade creditors = 475/200 = 2.4 : 1(iii) Inventory Turnover Ratio : Cost of sales / Inventories = 1000/125 = 8 times(iv) Average Debt collection period : (Debtors/sales) x 365 = (250/1500)x365 = 61 days(v)Average Creditors’ payment period : (Trade Creditors/Cost of sales) x 365 (200/100) x 365 = 73 days

Questions on Fund Flow Statement

Q . Fund Flow Statement is prepared from the Balance sheet : 1.Of three balance sheets2.Of a single year3.Of two consecutive years4.None of the above.

Q. Why this Fund Flow Statement is studied for ?

1.It indicates the quantum of finance required2.It is the indicator of utilisation of Bank funds by the concern3.It shows the money available for repayment of loan4.It will indicate the provisions against various expenses

Q . In a Fund Flow Statement , the assets are represented by ?

1.Application of Funds2.Sources of Funds3.Surplus of sources over application4.Deficit of sources over application

Q . In Fund Flow Statements the Liabilities are represented by ?

1.Sources of Funds2.Use of Funds3.Deficit of sources over application4.All of the above.

Q . When the long term sources are more than long term uses, in the fund flow statement, it would suggest ?

1.Increase in Current Liabilities2.Decrease in Working Capital3.Increase in NWC4.Decrease in NWC

Q . When the long term uses in a fund flow statement are more than the long term sources, then it would mean ?

1.Reduction in the NWC2.Reduction in the Working Capital Gap3.Reduction in Working Capital4.All of the above

Q. How many broader categories are there for the Sources of funds, in the Fund Flow Statement ?

1. Only One, Source of Funds2.Two, Long Term and Short Term Sources3.Three , Long, Medium and Short term sources4.None of the above.

Cost accountingIntroduction

COST - MEANING

Cost means the amount of expenditure ( actual or notional) incurred on, or attributable to, a

given thing.

COST ACCOUNTING - MEANING

Cost accounting is concerned with recording, classifying and

summarizing costs for determination of costs of products or services,

planning, controlling and reducing such costs and furnishing of

information to management for decision making

COST

MATERIALS LABOUR

OTHER EXPENSES

DIRECTDIRECT DIRECT

INDIRECTINDIRECT

INDIRECT

OVERHEADS

FOH AOH SOH DOH

ELEMENTS

OF

COST

MATERIAL: The substance from which the finished product is made is known as

material.

Direct material is one which can be directly or easily identified in the product Eg: Timber

in furniture, Cloth in dress, etc.

Indirect material is one which cannot be easily identified in the product.

Examples of Indirect material

• At factory level – lubricants, oil, consumables, etc.

• At office level – Printing & stationery, Brooms, Dusters, etc.

• At selling & dist. level – Packing materials, printing & stationery, etc.

LABOUR: The human effort required to convert the materials into finished product is called

labour.

DIRECT LABOUR is one which can be conveniently identified or attributed wholly to a particular job,

product or process.Eg:wages paid to carpenter, fees paid to

tailor,etc.

INDIRECT LABOUR is one which cannot be conveniently identified or attributed wholly to a

particular job, product or process.

Examples of Indirect labour

• At factory level – foremen’s salary, works manager’s salary, gate keeper’s salary,etc

• At office level – Accountant’s salary, GM’s salary, Manager’s salary, etc.

• At selling and dist.level – salesmen salaries, Logistics manager salary, etc.

OTHER EXPENSES are those expenses other than materials and labour.

DIRECT EXPENSES are those expenses which can be directly allocated to particular job, process or

product. Eg : Excise duty, royalty, special hire charges,etc.

INDIRECT EXPENSES are those expenses which cannot be directly allocated to particular job,

process or product.

Examples of other expenses

• At factory level – factory rent, factory insurance, lighting, etc.

• At office level – office rent, office insurance, office lighting, etc.

• At sales & dist.level – advertising, show room expenses like rent, insurance, etc.

How to treat the following?

• Carriage

• Packaging expenses

COST SHEET

DIRECT MATERIALDIRECT LABOUR

DIRECT EXPENSES

PRIME COSTFACTORY OVERHEADS

FACTORY COSTOFFICE OVERHEADS

COST OF PRODUCTIONSELL & DIST OVERHEADS

COST OF SALESPROFIT

SALES

COST SHEET - ADVANCED

OPENING STOCK OF RAW MATERIALS+PURCHASES

+CARRIAGE INWARDS-CLOSING STOCK OF RAW MATERIALS

VALUE OF MATERIALS CONSUMED

+DIRECT WAGES+DIRECT EXPENSES

PRIME COST

+FACTORY OVERHEADS+OPENING STOCK OF WIP-CLOSING STOCK OF WIP

FACTORY COST

(CONT.)

FACTORY COST

+ADMINISTRATIVE OVERHEADS

COST OF PRODUCTION+OPENING STOCK OF FINISHED GOODS-CLOSING STOCK OF FINISHED GOODS

COST OF GOODS SOLD

+SELL. & DIST. OVERHEADS

COST OF SALES+PROFIT

SALES

COST CLASSIFICATION – ON THE BASIS OF

• Nature• Function• Direct & indirect• Variability• Controllability• Normality• Financial accounting classification• Time• Planning and control• Managerial decision making

ON THE BASIS OF NATURE

• MATERIALS

• LABOUR

• EXPENSES

ON THE BASIS OF FUNCTION

• MANUFACTURING COSTS

• COMMERCIAL COSTS – ADM AND S&D COSTS

ON THE BASIS OF DIRECT AND INDIRECT

• DIRECT COSTS

• INDIRECT COSTS

ON THE BASIS OF VARIABILITY

• FIXED COSTS

• VARIABLE COSTS

• SEMI VARIABLE COSTS

ON THE BASIS OF CONTROLLABILITY

• CONTROLLABLE COSTS

• UNCONTROLLABLE COSTS

ON THE BASIS OF NORMALITY

• NORMAL COSTS

• ABNORMAL COSTS

ON THE BASIS OF FIN. ACC

• CAPITAL COSTS

• REVENUE COSTS

• DEFERRED REVENUE COSTS

ON THE BASIS OF TIME

• HISTORICAL COSTS

• PRE DETERMINED COSTS

ON THE BASIS OF PLANNING AND CONTROL

• BUDGETED COSTS

• STANDARD COSTS

ON THE BASIS OF MANAGERIAL DECISION MAKING

• MARGINAL COSTS• OUT OF POCKET COSTS• SUNK COSTS• IMPUTED COSTS• OPPORTUNITY COSTS• REPLACEMENT COSTS• AVOIDABLE COSTS• UNAVOIDABLE COSTS• RELEVANT AND IRRELEVANT COSTS• DIFFERENTIAL COSTS

TERMS IN COST ACCOUNTING• COST UNIT• COST CENTRE• COST ESTIMATION• COST ASCERTAINMENT• COST ALLOCATION• COST APPORTIONMENT• COST REDUCTION• COST CONTROL

METHODS OF COSTING• JOB COSTING• CONTRACT COSTING• BATCH COSTING• PROCESS COSTING• UNIT COSTING• OPERATING COSTING• OPERATION COSTING• MULTIPLE COSTING

TYPES OF COSTING

• UNIFORM COSTING• MARGINAL COSTING• STANDARD COSTING• HISTORICAL COSTING• DIRECT COSTING• ABSORBTION COSTING

Break-even and CVP Analysis

Learning Objectives

• To describe as to how the concepts of fixed and variable costs are used in C-V-P analysis

• To segregate semi-variable expenses in C-V-P analysis

• To identify the limiting assumptions of C-V-P analysis

• To work out the breakeven analysis, contribution analysis and margin of safety

• To understand how to draw a breakeven chart• To compute breakeven point

To assist planning and decision making, management should know not only the budgeted profit, but also:

MARGINAL COSTS, CONTRIBUTION AND PROFIT

• Suppose that a firm makes and sells a single product that has a marginal cost of Rs5 per unit and that sells for Rs.9 per unit. For every additional unit of the product that is made and sold, the firm will incur an extra cost of Rs.5 and receive income of Rs.9. The net gain will be Rs.4 per additional unit. This net gain per unit, the difference between the sales price per unit and the marginal cost per unit, is called CONTRIBUTION.

• Contribution is a term meaning ‘making a contribution towards covering fixed costs and making a profit’

• Before a firm can make a profit in any period, it must first of all cover its fixed costs.

• Breakeven is where total sales revenue for a period just covers fixed costs, leaving neither profit nor loss.

• For every unit sold in excess of the breakeven point, profit will increase by the amount of the contribution per unit.

Cost-Volume-Profit (C-V-P) Relationship

• In marginal costing, marginal cost varies directly with the volume of production or output.

• On the other hand, fixed cost remains unaltered regardless of the volume of output within the scale of production already fixed by management.

• In case if cost behavior is related to sales income, it shows cost-volume-profit relationship.

• In net effect, if volume is changed, variable cost varies as per the change in volume.

• In this case, selling price remains fixed, fixed remains fixed and then there is a change in profit.

Cost Is Based On The Following Factors:

• Volume of production• Product mix• Internal efficiency and the productivity of the

factors of production• Methods of production and technology• Size of batches• Size of plant

• Cost-volume- profit analysis can answer a number of analytical questions. Some of the questions are as follows:

1.What is the breakeven revenue of an organization?

2.How much revenue does an organization need to achieve a budgeted profit?

3.What level of price change affects the achievement of budgeted profit?

4.What is the effect of cost changes on the profitability of an operation?

Revenue required at $. 200 Selling Price

per unit to earn Operating Income of

Fixed costVariable

costper unit

0 1,000 1,500 2,000

2,000 100 4,000 6,000 7,000 8,000 120 5,000 7,500 8,750 10,000 140 6,667 10,000 11,667 13,333

2,500 100 5,000 7,000 8,000 9,000 120 6,250 8,750 10,000 11,250 140 8,333 11,667 13,333 15,000

3,000 100 6,000 8,000 9,000 10,000 120 7,500 10,000 11,250 12,500 140 10,000 13,333 15,000 16,667

• From the above example, one can immediately see the revenue that needs to be generated to reach a particular operating income level, given alternative levels of fixed costs and variable costs per unit.

• For example, revenue of $. 6,000 (30 units @ $. 200 each) is required to earn an operating income of $. 1,000 if fixed cost is $. 2,000 and variable cost per unit is $. 100.

• You can also use this to assess what revenue the company needs to breakeven (earn operating income of Re. 0) if, for example, one of the following changes takes place:

• The booth rental at the ABC convention raises to $. 3,000 (thus increasing fixed cost to $. 3,000)

• The software suppliers raise their price to $. 140 per unit (thus increasing variable costs to $. 140)

• The margin of safety is sales quantity minus breakeven quantity. It is expressed in units. The margin of safety answers the “what if” questions, e.g., if budgeted revenue are above breakeven and start dropping, how far can they fall below budget before the breakeven point is reached? Such a fall could be due to competitor’s better product, poorly executed marketing programs and so on

Marginal Cost Equations and Breakeven Analysis

• Sales – Marginal cost = Contribution ......(1)• Fixed cost + Profit = Contribution ......(2)

• By combining these two equations, we get the fundamental marginal cost equation as follows:

• Sales – Marginal cost = Fixed cost + Profit ......(3)

• This fundamental marginal cost equation plays a vital role in profit projection and has a wider application in managerial decision-making problems.

The difference between sales and marginal cost, i.e. contribution, will bear a relation to sales and the ratio of contribution to sales remains constant at all levels. This is profit volume or P/V ratio. Thus,

• P/V Ratio (or C/S Ratio) =Contribution (c) (4) Sales (s)• It is expressed in terms of percentage, i.e. P/V ratio is

equal to (C/S) x 100.

• Or, Contribution = Sales x P/V ratio ......(5)

• Or, Sales =Contribution (6) P/V ratio

Marginal Cost Equations Can Be Applied To The Following Heads:

• Contribution• Break-even Point• P/V Ratio• Margin Of Safety

1. Contribution

• Contribution is the difference between sales and marginal or variable costs. It contributes toward fixed cost and profit. The concept of contribution helps in deciding breakeven point, profitability of products, departments etc. to perform the following activities:

• Selecting product mix or sales mix for profit maximization

• Fixing selling prices under different circumstances such as trade depression, export sales, price discrimination etc.

2. Profit Volume Ratio (P/V Ratio), its Improvement and Application

• The ratio of contribution to sales is P/V ratio or C/S ratio. It is the contribution per rupee of sales and since the fixed cost remains constant in short term period, P/V ratio will also measure the rate of change of profit due to change in volume of sales.

P/V ratio =

Sales – Marginal cost of sales =

Contribution

=

Changes in contribution

=

Change in profit

Sales SalesChanges in

salesChange in sales

• A fundamental property of marginal costing system is that P/V ratio remains constant at different levels of activity.

• A change in fixed cost does not affect P/V ratio. The concept of P/V ratio helps in determining the following:

• Breakeven point• Profit at any volume of sales• Sales volume required to earn a desired quantum of

profit• Profitability of products

• The contribution can be increased by increasing the sales price or by reduction of variable costs. Thus, P/V ratio can be improved by the following:

• Increasing selling price• Reducing marginal costs by effectively utilizing men,

machines, materials and other services• Selling more profitable products, thereby increasing

the overall P/V ratio

3. Breakeven Point

• Contribution = Fixed cost• a. Using Marginal Costing Equation• S (sales) – V (variable cost) = F (fixed cost) + P

(profit) At BEP P = 0, BEP S – V = F• By multiplying both the sides by S and

rearranging them, one gets the following equation:

• S BEP = F.S/S-V

b. Using P/V Ratio

Sales S BEP =Contribution at BEP

=Fixed cost

P/ V ratio P/ V ratio

Thus, if sales is $. 2,000, marginal cost $. 1,200 and fixed cost $. 400, then:

Breakeven point =

400 x 2000= $. 10002000 - 1200

Similarly,

P/V ratio= 2000 – 1200 = 0.4 or 40%

800

So, breakeven sales = $. 400 / .4 = $. 1000

c. Using Contribution per unit

Breakeven point = Fixed cost = 100 units or $. 1000 Contribution per unit

4. Margin of Safety (MOS)• Every enterprise tries to know how much above they are

from the breakeven point. This is technically called margin of safety. It is calculated as the difference between sales or production units at the selected activity and the breakeven sales or production.

• Margin of safety is the difference between the total sales (actual or projected) and the breakeven sales. It may be expressed in monetary terms (value) or as a number of units (volume). It can be expressed as profit / P/V ratio. A large margin of safety indicates the soundness and financial strength of business.

• Margin of safety can be improved by lowering fixed and variable costs, increasing volume of sales or selling price and changing product mix, so as to improve contribution and overall P/V ratio.

Margin of safety = Sales at selected activity – Sales at BEP =

Profit at selected activity

P/V ratio

Margin of safety is also presented in ratio or percentage as follows:

Margin of safety (sales) x 100 %

Sales at selected activity

• A company producing a single article sells it at $. 10 each. The marginal cost of production is $. 6 each and fixed cost is $. 400 per annum. You are required to calculate the following:

• Profits for annual sales of 1 unit, 50 units, 100 units and 400 units

• P/V ratio• Breakeven sales• Sales to earn a profit of $. 500• Profit at sales of $. 3,000• New breakeven point if sales price is reduced by

10%

Particulars Amount Amount Amount Amount

Units produced 1 50 100 400

Sales (units * 10) 10 500 1000 4000

Variable cost 6 300 600 2400

Contribution (sales- VC)

4 200 400 1600

Fixed cost 400 400 400 400

Profit (Contribution – FC)

-396 -200 0 1200

• Profit Volume Ratio (PVR) = Contribution/Sales * 100 = 0.4 or 40%

• Breakeven sales ($.) = Fixed cost / PVR = 400/ 40 * 100 = $. 1,000 Sales at BEP = Contribution at BEP/ PVR = 100 units

• Sales at profit $. 500 Contribution at profit $. 500 = Fixed cost + Profit = $. 900 Sales = Contribution/PVR = 900/.4 = $. 2,250 (or 225 units)

• Profit at sales $. 3,000 Contribution at sale $. 3,000 = Sales x P/V ratio = 3000 x 0.4 = $. 1,200 Profit = Contribution – Fixed cost = $. 1200 – $. 400 = $. 800

• New P/V ratio = $. 9 – $. 6/$. 9 = 1/3

Sales at BEP = Fixed cost/PV ratio =

$. 400

= $. 1,2001/3

Principles of Capital Budgeting

After reading this chapter you should be able to understand:

• The basic concept, rationale for capital investment decisions

• The characteristic features of capital investment decisions

• The steps involved in assessing and evaluating capital investment decisions

• The different types of projects that constitute capital investments

Rationale

• Capital budgeting is based upon identifying opportunities and threats in the environment, as well as internal weaknesses, setting long term goals, formulating action plans and strategies and implementing them with online continuous monitoring and feedback from the systems.

• These decisions have to fulfil the criteria of creating net positive present value for the organization.

Rationale (contd)

• Thus the organization should tap and hold on to every opportunity in the next environment (both external and internal), which creates positive net present value for the shareholders.

• In a competitive environment, every organization has to attract, reward, and retain its shareholders and potential investors.

The Concept

• Capital budgeting decisions are made when a firm is interested in acquisition and investment in long-lived or fixed assets.

• For such purposes, the firm has to draw up long-range plans where realistic and flexible plans are made, taking into account the financing, production, marketing, research etc. components of the project.

The Concept (contd)

• The given investment proposals (projects) are evaluated and selected by the firm on the basis of their merit and finally implemented.

• On-line projects are continually monitored, measured and controlled. Thus feed back helps the firm to improvise its investment and financing decisions.

Figure: Corporate Financial Decisions Including Capital Budgeting Decisions

Characteristics of Capital Budgeting Decisions

• Long term consequences• Large initial investments • High degree of risk• Irreversibility of decisions• Indicator of a firm’s growth potential

• The capital budgeting process determines the direction of the capital investment.

• From the time the company decides to take up investment opportunities, until the time the investments projects are implemented, the company looks for growth.

• The value creation will depend upon the feasibility and profitability of the capital investment decisions.

The Capital Budgeting Process

Figure: Steps in a Typical Capital Budgeting Decision

Estimating and Evaluating Cash Flows

• The capital expenditure decisions are evaluated in terms of their cash flows.

• Before adopting any project, the managers need to estimate the related cash flows i.e. the cash outflows (investment) and the cash inflows (benefits).

• After various adjustments (depreciation and taxes), of different capital budgeting opportunities, the cash flows are estimated and expressed in monetary terms.

• Hence the costs and benefits of each investment proposal is determined to ascertain the net cash income generated from each proposal.

Estimating Cash Flows

Earning before depreciation interest and tax (EBDIT)

Less: Depreciation

= Earning before interest and tax (EBIT)

Less: Interest (external debt)

= Earning before tax (EBT)

Less: Tax

= Profit or earning after tax (PAT/EAT)

Net Cash Flow to equity owners = Profit or earning after tax (PAT/EAT) + Depreciation + CAPEX (Capital expenditure)

• A project will generate INR 10,000, INR 20,000, and INR 30,000 p.a. for three years after initial investment of INR 8,000. Discount rate is 10%. determine the value of net cash flows for the firms at the end of three years?

• Solution: value of initial investment cash outflow (0 yr.) = INR 8,000• Value of cash inflow for the 1st yr. =

• Value of cash inflow for the 2nd yr. =

• Value of cash inflow for the 3rd yr. = • Total value of cash inflows = INR 48140• Value of net cash flow = INR 48140 − 8000 = INR 40140

1%101

000,10

2%101

000,20

3%101

000,30

Example:

The two main categories are dependent and independent projects. • Dependent projects: Projects are said to be dependent when

acceptance/rejection of one project affects the acceptance/rejection of the other project (s). These are also called contingent projects. Contingent projects can be classified as complimentary or substitute projects. Dependent projects, as the name suggests, represent investments that cannot be accepted unless one or more projects are also accepted. For example, we may not be able to purchase and install a new piece of equipment unless we also expand the floor space of our facility. For proper evaluation, dependent projects must be lumped together as a single investment.

Project Categories

Project Categories (contd)

• Complimentary projects: When the combined cash inflows of two projects under consideration is more than the sum of their individual (separate ) cash flows, one can say that these projects are economically dependent and complimentary.

Project Categories (contd)

• Substitute projects: Substitute projects are those where the success of a project is increased by the decision to reject another project. For example, a businessman is considering opening a retail outlet of clothes. There are two possibilities. He can open a retail outlet of men’s wear of a premium brand X and another of a premium brand Y.

Project Categories (contd)• Independent projects: Independent projects are those

projects where the acceptance/rejection of one does not affect the acceptance / rejection of the other, e.g. buying a car , buying a house etc. These are also termed as stand-alone investments where acceptance or rejection of one does not depend on another project. For example, we may be faced with three acceptable independent projects: (a) buy a new car with luxury facilities, (b) purchase a new house, and (c) go out for a holiday tour. Clearly, our acceptance of any one of these projects does not eliminate the others from further consideration – all three could be undertaken.

Capital Budgeting Techniques

After reading this chapter, you should be able to understand:

1. The capital investment selection techniques.2. Non-discounting techniques like payback and the

accounting rate of return method.3. Discounting techniques like the net present value

(NPV) method, internal rate of return (IRR) method, profitability index method and discounted payback method.

4. The concept and rationale for calculating modified NPV and modified IRR.

5. The concept of capital rationing and understand the selection of projects under capital rationing.

Capital Budgeting Techniques Rationale

Capital budgeting techniques help in:• Identifying, analysing and selecting

investment projects• Evaluation• Feasibility• Valuation

Capital Budgeting Techniques

Techniques used for evaluation of

capital budgeting decisions

Non-discounting cash flow (NDCF) / unsophisticated

techniques

Discounting cash flow (DCF) / sophisticated /

time-adjusted techniques

Capital Budgeting Technique: Methods

1. Non-discounting methods:– payback period (PB)– accounting rate of return (ARR)

2. Discounting methods:– net present value (NPV)– profitability index (PI)– internal rate of return (IRR)– discounted payback period (DBP)– terminal value (TV)

The ARR Method

• The ARR method is also known as the average rate of return method.

• The ARR is determined by dividing average income by average investment.

The ARR Method: An Example A project requires a machine. The cost of the machine is INR 10,000. Its useful life is five years. Depreciation is charged annually according to the straight-line depreciation method. Determine the ARR for the machine.

Solution

The depreciation as per the straight-line method comes out to be 10,000/5 = INR 2,000 p.a. We find the income from the machine for each year. The income generated by the machine in five years is INR 10,000, INR 12,000, INR 15000, INR 20,000 and INR 10,000, respectively.

The ARR Method: An Example (Contd)

Accept/Reject Rule for ARR

• The firm fixes a target or a standard ARR or it considers its cost of capital (k). This is then compared with the given project’s ARR.

• If project’s ARR > target ARR or k, then the project is accepted.

• If project’s ARR < target ARR or k , then the project is rejected.

• If project’s ARR = target ARR or k , then one is indifferent to the project.

Accept/Reject Rule for ARR

Advantages and Disadvantages of the ARR Method

The Payback Period (PB) Method

• The payback period method tells us the number of years required to recover the initial investment made by the firm in the project.

• The payback period is the time period taken to recover the initial cost of the investment.

nThe Payback Period (PB) Method (Contd)

The PB Method: Example 1

From the data given in the table below, calculate the payback period for Projects X and Y.

The PB Method: Example 1 (Contd)

Solution• PB for Project X is achieved in Year 4 as INR 14000 + 16000 +

5000 + 5000 is equal to INR 40,000 of initial investment.• PB for Project Y is achieved in Year 6 as INR 10,000 +• 15000 + 15000 + 5000 + 2000 + 3000 is equal to INR 40,000• of initial investment.• PB for Project X is 4 years and for Project Y is 6 years as the

two projects recover the initial investment of INR 40,000.

The PB Method: Example 2

A company invests INR 40,000 in a new project with expected useful life of 6 years. The cash flows after tax are given for Years 1 through 6 in the table below. Calculate the PB period.

The PB Method: Example 2 (Contd)

Solution

Accept/Reject Rule for the PB Method• The firm presents a standard or a target PB. The PB of the projects is compared with the target PB.

• If project’s PB period > target PB, then the project is rejected.

• If the project’s PB period < target PB, then the project is accepted.

• If the project’s PB period = target PB, then one is indifferent to the project. Acceptance or rejection will make no difference to the value of the firm.

• When n number of projects are to be appraised, then the project with the lowest PB is selected.

Accept/Reject Rule for the PB Method (Contd)

Advantages and Disadvantages of the PB Method

The Discounted PB Method

• The discounted payback is almost the same as the payback method.

• The only difference is that in the discounted payback method, the cash inflows are adjusted with the time value of money and then the payback is calculated.

The Discounted PB Method: An Example

A project requires an investment of INR 150,000 and is expected to generate cash flows of INR 70,000, INR 60,000, INR 30,000, INR 20,000, and INR 10,000 p.a. Find the DPB.

nThe Discounted PB Method: An Example (Contd)

The Profitability Index (PI) Method• The profitability index method is also known as the benefit–

cost ratio analysis. • This method is used when firms have only a limited supply

of capital.

The PI Method: Example 1

The initial cash outlay of a project is INR 1,00,000 and it can generate cash inflow of INR 40,000, INR 30,000 and INR 20,000 in Years 1 through 4. Assume a 10 per cent rate of discount and calculate the PI for the project.

The PI Method: Example 1 (Contd)

SolutionPV of cash inflows at 10 per cent discount rate is:

As the PI is greater than 1, the project should be accepted.

The PI Method: Example 2

• Consider the projects given below and rank them according to their NPV and PI.

The PI Method: Example 2 (Contd)

SolutionThe table below shows the ranks of the three projects:

Accept/Reject Rule for the PI Method

• The accept/reject rule for the PI method is as follows:If PI > 1, then the project proposal is accepted.If PI < 1, then the project proposal is rejected.If PI = 0, then one is indifferent to the project proposal

Advantages and Limitations of the PI Method

The Net Present Value (NPV) Method

The net present value technique involves discounting net cash flows for a project, then subtracting net investment from the discounted net cash flows. The result is called the net present value (NPV).

Calculation of NPV

The NPV Method: Example 1

• Consider for capital budgeting two projects, A and B, which yield the following cash flows over their five-year lives. The cost of capital for the project is 10 per cent. Calculate the NPV of the two projects.

The NPV Method: Example 1 (Contd)

Solution

The NPV Method: Example 2

• The table below shows the CFAT for two machines, A and B. The estimated life of the two machines is 5 years and discount rate is 10 per cent, and cost of the machine is INR 60,000. Determine the NPV of the two projects.

Here, PVIF is present value interest factor of INR 1 at 10% for Year 1 through 5.

The NPV Method: Example 2 (Contd)

Solution

The NPV Method: Excel Application

• A project costs INR 48,000, and has an expected life of 5 years. The CFAT are given for Years 1 through 5. Calculate the NPV of the project at 6 per cent and 7 per cent. CFAT are 10,000, 11,000, 10,500, 14,000, and 12,500 for Years 1 through 5. Calculate the net present value of the project.

The NPV Method: Excel Application (Contd)

Modified NPV

• The modified NPV method is also called the terminal value method. The modified NPV considers the reinvestment of cash flows generated during the project.

Modified NPV: An Example

• A project costs INR 10,000 and has a maturity of 5 years. The cash inflow is INR 5,000 per annum for 5 years. The cost of capital is 10 per cent. If the reinvestment rate is 12 per cent, how would you appraise the project?

Modified NPV: An Example (Contd)

Solution

The above table shows the future value of reinvested cash inflows. Now, we will calculate the present value of the cumulative future value of all the cash inflows. The discount rate is the cost of capital, i.e., 10 per cent.

So, the present value of INR 30,525 is:

Here, the present value of cash inflows is INR 18,956 afterreinvestment and the cash outflow is INR 10,000. Thisresults in net present value of INR 9,726; hence, we should take up the project.

Modified NPV: An Example (Contd)

Internal Rate of Return (IRR)

• IRR is the internal rate of return that a given investment generates over its useful life.

• It is the measured as the return yielded by the investment.

• IRR is a popular, time-adjusted technique and overcomes the disadvantages of the traditional techniques.

• When evaluating an investment it takes into account both the magnitude and timings of expected Cash Flows in every time period of project’s life.

• IRR is the amount of profit you get by investing in a certain project.

• It is a percentage. • An IRR of 10% means you make 10% profit per

year on the money invested in the project.

Internal Rate of Return (IRR) (Contd)

Rationale for IRR

• It's a cutoff rate of return for the investment proposal. • One should avoid an investment or project if its IRR is less than the cost of capital or

minimum desired rate of return.• IRR, basically computes a break-even rate of return. • At IRR, the NPV is zero. • It shows the discount rate below which an investment results in a positive NPV (and should

be selected) and above which an investment results in a negative NPV (and should be rejected).

• IRR is the break-even discount rate, the rate at which the value of cash outflows equals the value of cash inflows.

Calculating IRR: An Example

Projects A and B yield the cash flows shown in the table below over their five year lives. The cost of capital for both projects is 10 per cent. Find both their IRRs.

Calculating IRR: An Example (Contd)

Solution

IRR for Project A is 16.82.

IRR for Project B is 13.28.We see that IRR is greater than the firm’s cost of capital of 10 per cent. In this case, we can say that both the projects can be selected. Thus, if Projects A and B are independent of each other, then both the projects should be accepted because their IRRs are greater than the cost of capital. However, if both the projects are mutually exclusive projects, then Project A should be selected since it has the greater IRR.

Accept/Reject Rule for IRR

The IRR determined (calculated) for a given investment project(s) is compared with the required rate of return (minimum return acceptable by the shareholders), also known as opportunity cost of capital of the firm, i.e., k.– When IRR > k, then one accepts the project proposal.– When IRR < k, then one rejects the project proposal.– When IRR = k, then one is indifferent to the project– proposal.

Advantages and Limitations of IRR

Problems with the IRR Method

Modified IRR (MIRR)

• IRR may become unrealistically high or may give multiple results. In such cases, it is not a wise decision to go by IRR. An answer to this problem is modified internal rate of return (MIRR).

• MIRR is always better as it is a modified approach to IRR. • MIRR is the compound average rate of return per annum that a project generates if its

cash flows are reinvested at a rate different than the project’s IRR.• This rate can ideally be the opportunity cost of capital for the project.

Modified IRR (MIRR) (Contd)

Capital Rationing

• When firms have to take investment decisions under the constrain of fund availability it is termed as Capital rationing.

• Capital budgeting decision taken when amount of funds available with the firm are limited are termed as capital rationing decisions.

• Thus lesser the funds available with the firm, lesser will be the number of profitable investment projects accepted by the firm.

• Under capital rationing the usual capital budgeting decisions have to be restructured in order to maintain the profitability and value addition of the firm.

Types of Capital Rationing

• Hard Capital Rationing: • Hard capital rationing implies that there is constrain on fund available

with the firm by external forces. • The limitations are externally determined. • This happens in imperfect markets where availability of funds from same

source varies for different firms and at different rates. • Same fund may be costly fro some firm and less costly for the other.

• Soft Capital Rationing: • Soft capital rationing occurs when fund constrain is due to internal factors

like management-imposed limits on investment expenditure. • The management may limit the company's further investments, either by

setting a limit on parts of the capital budget or by using a higher cost of capital.

An ExampleA given company has four possible feasible, profitable capital investment proposals. W, X, Y and Z require INR 90,000, INR 63,000, INR 1,35,000 and INR 53,000 of initial investment having present value of benefits as1,41,000, 97,000, 1,61,000 and 61,000, respectively. All the four projects seem lucrative enough for the company to invest. However, the company has only INR 3,00,000 available for investment purpose. How should the company go about investing this amount of INR 3,00,000?

An Example (Contd)

Solution• The table below shows the present value and the profitability

index of the four projects:

An Example (Contd)

• Now, we rank the given projects in descending order of PI and then decide where to allocate the money. As evident from the table, Project X has the highest PI, followed by Projects W, Y and Z in that order. The company has only INR 3,00,000 available. Projects X, W and Y occupy the top three places on the ranking and the total funds required by these projects comes out to be INR 2,88,000. Hence, Projects W, X, Y will be accepted while Project Z will be rejected.

•Thank You

Accounting and Finance

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