Introduction

Financial accounting is a specialized branch of accounting that keeps track of a company's

financial transactions. Using standardized guidelines, the transactions are recorded,
summarized, and presented in a financial report or financial statement such as an income
statement or a balance sheet.
Companies issue financial statements on a routine schedule. The statements are
considered external because they are given to people outside of the company, with the
primary recipients being owners/stockholders, as well as certain lenders. If a corporation's
stock is publicly traded, however, its financial statements (and other financial reportings) tend
to be widely circulated, and information will likely reach secondary recipients such as
competitors, customers, employees, labor organizations, and investment analysts.
Definition
Financial accounting is the area of accounting that focuses on providing external users with
useful information. In other words, financial accounting is a way of reporting business
activity and financial information to investors, creditors, and other people outside the
business organization.
Cost accounting
cost accounting assists management by providing analysis of cost behavior, cost-volume-
profit relationships, operational and capital budgeting, standard costing, variance analyses for
costs and revenues, transfer pricing, activity-based costing, and more.
Cost accounting had its roots in manufacturing businesses, but today it extends to service
businesses. For example, a bank will use cost accounting to determine the cost of processing
a customer's check and/or a deposit. This in turn may provide management with guidance in
the pricing of these services.

What are the differences between cost accounting Vs cost accounting

BASIS FOR FINANCIAL
COST ACCOUNTING
COMPARISON ACCOUNTING

Meaning Cost Accounting is an Financial Accounting is an

accounting system, through accounting system that captures the
which an organizationkeeps the records of financial information
track of various costs incurred in about the business to show the
the business in production correct financial position of the
activities. company at a particular date.

Information type Records the information related Records the information which are
to material, labor and overhead,
 BASIS FOR FINANCIAL
COST ACCOUNTING
COMPARISON ACCOUNTING

which are used in the production in monetary terms.

process.

Which type of cost is Both historical and pre- Only historical cost.
used for recording? determined cost

Users Information provided by the cost Users of information provided by

accounting is used only by the the financial accounting are internal
internal management of the and external parties like creditors,
organization like employees, shareholders, customers etc.
directors, managers, supervisors
etc.

Valuation of Stock At cost Cost or Net Realizable Value,

whichever is less.

Mandatory No, except for manufacturing Yes for all firms.

firms it is mandatory.

Time of Reporting Details provided by cost Financial statements are reported at

accounting are frequently the end of the accounting period,
prepared and reported to the which is normally 1 year.
management.

Profit Analysis Generally, the profit is analyzed Income, expenditure and profit are
for a particular product, job, analyzed together for a particular
batch or process. period of the whole entity.

Purpose Reducing and controlling costs. Keeping complete record of the

financial transactions.

Forecasting Forecasting is possible Forecasting is not at all possible.

through budgeting techniques.
 Financial statement analysis
Financial statement analysis (or financial analysis) is the process of reviewing and analyzing
a company's financial statements to make better economic decisions. These statements
include the income statement, balance sheet, statement of cash flows, and a statement of
changes in equity. Financial statement analysis is a method or process involving specific
techniques for evaluating risks, performance, financial health, and future prospects of an
organization.[1]
It is used by a variety of stakeholders, such as credit and equity investors, the government,
the public, and decision-makers within the organization. These stakeholders have different
interests and apply a variety of different techniques to meet their needs. For example, equity
investors are interested in the long-term earnings power of the organization and perhaps the
sustainability and growth of dividend payments. Creditors want to ensure the interest and
principal is paid on the organizations debt securities (e.g., bonds) when due.
Common methods of financial statement analysis include fundamental analysis, DuPont
analysis, horizontal and vertical analysis and the use of financial ratios. Historical
information combined with a series of assumptions and adjustments to the financial
information may be used to project future performance. The Chartered Financial
Analyst designation is available for professional financial analysts.
Objectives of management accounting

1. Assistance in Planning and Formulation of Future Policies

2. Helps in the Interpretation of Financial Information
3. Helps in Controlling Performance 4. Helps in Organizing
4. Helps in the Solution of Strategic Business Problems
5. Helps in Coordinating Operations
6. Helps in Motivating Employees
7. Communicating Up-to-date Information
8. Helps in Evaluating the Efficiency and Effectiveness of Policies
1. Assistance in Planning and Formulation of Future Policies:
Management accounting assists management in planning the activities of the business.
Planning is deciding in advance what is to be done, when it is to be done, how it is to be done
and by whom it is to be done. It involves forecasting on the basis of available information,
setting goals, framing policies, determining the alternative courses of actions and deciding on
the programme of activities to be undertaken.Thus, planning is making intelligent forecasting.
This forecasting is based on facts. Facts are provided by past accounts on which forecast of
future transactions is made. Management accounting helps management in its function of
planning through the process of budgetary control.

2. Helps in the Interpretation of Financial Information:

Accounting is a technical subject and may not be easily understandable by everyone till the
user has a good knowledge of the subject. Management may not be able to use the accounting
information in its raw form due to lack of knowledge of accounting techniques.Management
accountant presents the information in an intelligible and non-technical manner. This will
help the management in interpreting the financial data, evaluating alternative courses of
action available and guiding the management in taking decisions and having the most desired
financial results.
3. Helps in Controlling Performance:
Management accounting is a useful device of managerial control. The whole organisation is
divided into responsibility centres and each centre is put under the charge of one responsible
person. He will be associated with the planning and framing of the budgets and be required to
execute the plans and standards and deviations are analysed in order to pinpoint the
responsibility.Thus, management accountant helps in controlling the performance of the
different responsibility centres and take suitable actions in order to correct the adverse
deviations by revising the budgets if need be.Management accounting assists management in
location of weak spots and in taking corrective actions against such spots which are not in
conformity with the budgeted performance. Thus, management accounting helps
management in discharging its control function successfully through budgetary control and
standard costing.

4. Helps in Organizing:
Thus management accountant recommends the use of budgeting, responsibility accounting,
cost control techniques and internal financial control. This all needs the intensive study of the
organisation structure. In turn, it helps to rationalise the organisation structure.
5. Helps in the Solution of Strategic Business Problems:
Whenever there is a question of starting a new business, expanding or diversifying the
existing business, strategic business problem has to be faced and solved .Similarly when in a
particular situation, there are different alternatives as whether labour should be replaced by
machinery or not, whether selling price should be reduced or not, whether to export the item
or not etc., a management accountant helps in solving such problems and decision-making.
He provides accounting data to a management with his recommendation as to which
alternative will be the best. For such decisions, the management accountant may take the help
of marginal costing, cost volume profit analysis, standard costing, capital budgeting etc.
Management accounting provides feedback to the management such as what business to
engage in or diversify how to run that business efficiently. This is most important
contribution which the management accountant has made.
6. Helps in Coordinating Operations:
Management accounting helps the management in co-coordinating the activities of the
concern by getting prepared functional budgets in the first instance and then co-coordinating
the whole activities of the concern by integrating all functional budgets into one known as
master budget. Thus, management accounting is a useful tool in coordinating the various
operations of the business.
7. Helps in Motivating Employees:
The management accountant by setting goals, planning the best and economical course of
action and then measuring the performance tries his best to increase the effectiveness of the
organisation and thereby motivate the members of the organisation.
8. Communicating Up-to-date Information:
Management accounting assists management in communicating the financial facts about the
enterprise to the persons who are interested in these facts so that they may be guided to a line
of action to be pursued. Management needs information for taking decisions and for
evaluating performance of the business.The required information can be made available to
the management by means of reports which are an integral part of the management
accounting. Reports are means of communication of facts which should be brought to the
notice of various levels of management so that they may be guided for taking suitable action
for the purposes of control.

9. Helps in Evaluating the Efficiency and Effectiveness of Policies:

Management accounting also lays emphasis on management audit which means evaluating
the efficiency and effectiveness o£ management policies. Management policies are reviewed
from time to time to make an improvement in them so that maximum efficiency may be
achieve
 UNIT -II
RATIO ANALYSIS
Introduction Ratio analysis is the process of determining and interpreting numerical
relationships based on financial statements. A ratio is a statistical yardstick that provides a
measure of the relationship between two variables or figures.
Definition Ratio analysis is the process of examining and comparing financial information
by calculating meaningful financial statement figure percentages instead of comparing line
items from each financial statement.
Classification of Ratios:

Financial ratios can be classified under the following five groups:

1) Structural

2) Liquidity

3) Profitability

4) Turnover

5) Miscellaneous.
1. Structural group:

The following are the ratios in structural group:

i) Funded debt to total capitalisation:

The term ‘total’ capitalisation comprises loan term debt, capital stock and reserves and

surplus. The ratio of funded debt to total capitalisation is computed by dividing funded debt

by total capitalisation. It can also be expressed as percentage of the funded debt to total

capitalisation. Long term loans Total capitalisation (Share capital + Reserves and surplus +

long term loans)

ii) Debt to equity:
Due care must be given to the; computation and interpretation of this ratio. The definition of

debt takes two foremost. One includes the current liabilities while the other excludes them.

Hence the ratio may be calculated under the following two methods:

Long term loans + short term credit + Total debt to equity = Current liabilities and provisions

Equity share capital + reserves and surplus (or)

Long-term debt to equity =

Long – term debt / Equity share capital + Reserves and surplus

iii) Net fixed assets to funded debt:

This ratio acts as a supplementary measure to determine security for the lenders. A ratio of

2:1 would mean that for every rupee of long-term indebtedness, there is a book value of two

rupees of net fixed assets:

Net Fixed assets funded debt

iv) Funded (long-term) debt to net working capital:

The ratio is calculated by dividing the long-term debt by the amount of the net working

capital. It helps in examining creditors’ contribution to the liquid assets of the firm.

Long term loans Net working capital

2. Liquidity group:
It contains current ratio and Acid test ratio.

i) Current ratio:
It is computed by dividing current assets by current liabilities. This ratio is generally an

acceptable measure of short-term solvency as it indicates the extent to which he claims of

short term creditors are covered by assets that are likely to be converted into cash in a period
corresponding to the maturity of the claims. Current assets / Current liabilities and provisions

+ short-term credit against inventory

ii) Acid-test ratio:

It is also termed as quick ratio. It is determined by dividing “quick assets”, i.e., cash,

marketable investments and sundry debtors, by current liabilities. This ratio is a bitterest of

financial strength than the current ratio as it gives no consideration to inventory which may

be very a low- moving.

3. Profitability Group:
It has five ratio, and they are calculated as follows :

4. Turnover group:
It has four ratios, and they are calculated as follows:
5. Miscellaneous group:
It contains four ratio and they are as follows:

Standards for comparison:

For making a proper use of ratios, it is essential to have fixed standards for comparison. A

ratio by itself has very little meaning unless it is compared to some appropriate standard.

Selection of proper standards of comparison is a most important element in ratio analysis.

The four most common standards used in ratio analysis are; absolute, historical, horizontal

and budgeted. Absolute standards are those which become generally recognised as being
desirable regardless of the company, the time, the stage of business cycle, or the objectives of

the analyst. Historical standards involve comparing a company’s own’ past performance as a

standard for the present or future. In Horizontal standards, one company is compared with

another or with the average of other companies of the same nature. The budgeted standards

are arrived at after preparing the budget for a period Ratios developed from actual

performance are compared to the planned ratios in the budget in order to examine the degree

of accomplishment of the anticipated targets of the firm.

Limitations:

The following are the limitations of ratio analysis:

1. It is always a challenging job to find an adequate standard. The conclusions drawn from

the ratios can be no better than the standards against which they are compared.

2. When the two companies are of substantially different size, age and diversified products,,

comparison between them will be more difficult.

3. A change in price level can seriously affect the validity of comparisons of ratios computed

for different time periods and particularly in case of ratios whose numerator and denominator

are expressed in different kinds of rupees.

4. Comparisons are also made difficult due to differences of the terms like gross profit,

operating profit, net profit etc.

5. If companies resort to ‘window dressing’, outsiders cannot look into the facts and affect

the validity of comparison.

6. Financial statements are based upon part performance and part events which can only be

guides to the extent they can reasonably be considered as dues to the future.
7. Ratios do not provide a definite answer to financial problems. There is always the question
of judgment as to what significance should be given to the figures. Thus, one must rely upon

one’s own good sense in selecting and evaluating the ratios.

Objectives of Ratio Analysis
Interpreting the financial statements and other financial data is essential for all stakeholders of an
entity. Ratio Analysis hence becomes a vital tool for financial analysis and financial
management. Let us take a look at some objectives that ratio analysis fulfils.

1] Measure of Profitability
Profit is the ultimate aim of every organization. So if I say that ABC firm earned a profit of 5
lakhs last year, how will you determine if that is a good or bad figure? Context is required to
measure profitability, which is provided by ratio analysis. Gross Profit Ratios, Net Profit Ratio,
Expense ratio etc provide a measure of profitability of a firm. The management can use such
ratios to find out problem areas and improve upon them.
2] Evaluation of Operational Efficiency :-Certain ratios highlight the degree of efficiency of
a company in the management of its assets and other resources. It is important that assets and
financial resources be allocated and used efficiently to avoid unnecessary expenses. Turnover
Ratios and Efficiency Ratios will point out any mismanagement of assets.
3] Ensure Suitable Liquidity
Every firm has to ensure that some of its assets are liquid, in case it requires cash immediately.
So the liquidity of a firm is measured by ratios such as Current ratio and Quick Ratio. These
help a firm maintain the required level of short-term solvency.
4] Overall Financial Strength
There are some ratios that help determine the firm’s long-term solvency. They help determine if
there is a strain on the assets of a firm or if the firm is over-leveraged. The management will
need to quickly rectify the situation to avoid liquidation in the future. Examples of such ratios
are Debt-Equity Ratio, Leverage ratios etc.
5] Comparison
The organizations’ ratios must be compared to the industry standards to get a better
understanding of its financial health and fiscal position. The management can take corrective
action if the standards of the market are not met by the company. The ratios can also be
compared to the previous years’ ratio’s to see the progress of the company. This is known as
trend analysis.
Advantages of Ratio Analysis
When employed correctly, ratio analysis throws light on many problems of the firm and also
highlights some positives. Ratios are essentially whistleblowers, they draw the managements
attention towards issues needing attention. Let us take a look at some advantages of ratio
analysis.
 Ratio analysis will help validate or disprove the financing, investment and operating
decisions of the firm. They summarize the financial statement into comparative figures,
thus helping the management to compare and evaluate the financial position of the firm
and the results of their decisions.
 It simplifies complex accounting statements and financial data into simple ratios of
operating efficiency, financial efficiency, solvency, long-term positions etc.
 Ratio analysis help identify problem areas and bring the attention of the management to
such areas. Some of the information is lost in the complex accounting statements, and
ratios will help pinpoint such problems.
 Allows the company to conduct comparisons with other firms, industry standards, intra-
firm comparisons etc. This will help the organization better understand its fiscal position
in the economy.
 UNIT III

FUNDS FLOW STATEMENT

Meaning of Fund Flow Statement:

A fund flow statement is a statement in summary form that indicates changes in terms of
financial position between two different balance sheet dates showing clearly the different
sources from which funds are obtained and uses to which funds are put.It summarizes the
financing and investing activities of the enterprise during an accounting period.If the total of
inflows is greater than the outflows, the excess goes to increase in working capital. If there is
deficit of funds during a particular accounting period, the working capital is impaired. So
fund flow statement is an important tool for working capital management.
Objectives of Fund Flow Statement:
Some of the important objectives of preparing fund flow statement are:
1. Fund flow statement reveals clearly the changes in items of financial position between two
different balance sheet dates showing clearly the different sources and applications of funds.
Thus, it summarizes the financing and investing activities of the enterprise.
2. It also reveals how much of the total funds is being collected by disposing of fixed assets,
how much from issuing shares or debentures, how much from long-term or short-term loans,
and how much from normal operational activities of the business.
3. It also provides information about the specific utilisation of such funds i.e., how much has
been used for acquiring fixed assets, how much for redemption of preference shares,
debentures or short-term loans as well as payment of tax, dividend etc.
4. It helps the management in depicting all inflows and outflows of funds which cause a
change in working capital of a business organisation.

5. The projected fund flow statement helps management to exercise budgetary control and
capital expenditure control in the enterprise.

Management uses fund flow statement for judging the financial and operating performance of
the business.

Importance of Fund Flow Statement:

The importance of fund flow statement may be summarised:

1. Analyses Financial Statements:

Balance Sheet and Profit and Loss Account do not reveal the changes in the financial position
of an enterprise. Fund flow analysis shows the changes in the financial position between two
balance sheet dates. It provides details of inflow and outflow of funds i.e., sources and
application of funds during a particular period.

Hence it is a significant tool in the hands of the management for analysing the past, and for
planning the future. They can infer the reasons for imbalances in the uses of funds in the past
and take corrective measures for the future.
3.Rational Dividend Policy: Sometimes it may happen that a firm, instead of having
sufficient profit, cannot pay dividend due to inadequate working capital. In such
circumstances, fund flow statement shows the working capital position of a firm and helps
the management to take policy decisions on dividend etc.

4. Proper Allocation of Resources: Financial resources are always limited. So it is the duty
of the management to make its proper use. A projected fund flow statement enables the
management to take proper decision regarding allocation of limited financial resources
among different projects on priority basis.

5. Guide to Future Course of Action:The future needs of the fund for various purposes can be
known well in advance from the projected fund flow statement. Accordingly, timely action
may be taken to explore various avenues of fund.

6. Proper Managing of Working Capital: It helps the management to know whether working
capital has been effectively used to the maximum extent in business operations or not. It
depicts the surplus or deficit in working capital than required. This helps the management to
use the surplus working capital profitably or to locate the resources of additional working
capital in case of scarcity.

7. Guide to Investors: It helps the investors to know whether the funds have been used
properly by the company. The lenders can make an idea regarding the creditworthiness of the
company and decide whether to lend money to the company or not.

8. Evaluation of Performance: Fund flow statement helps the management in judging

the financial and operating performance of the company.

Advantages of Funds Flow Statement:

a) Fund Generating Capacity:

With the help of cash flows from operating activities, a Funds Flow Statement helps to
understand the fund generating capacity of the firm which, ultimately, provides valuable
information to the management for taking future courses of action.

(b) Changes in Working Capital Position: A Funds Flow Statement presents either the
increase in Working Capital or Decrease in Working Capital with the help of ‘A Statement of
Exchanges in Working Capital’—which helps us to know from which sources the additional
Capital has been procured, or the application of such funds.

(c) Projected Funds Flow Statement:

A firm can prepare its expected inflows and outflows of cash for future with the help of a
Projected Funds Flow Statement.
(d) Highlights the Causes of Changes:

A Funds Flow statement highlights the significant causes of changes in Working Capital
position between two accounting periods revealing the effect for the same on the liquidity and
solvency position of a firm.

(e) Evaluation of Credit-Worthiness:

Credit Granting Agencies, after careful analysis of a Funds Flow Statement, can evaluate the
creditworthiness of a firm—which helps them to understand the liquidity position.

(f) Highlight the Causes of the Following Contradictions:

(i) Adequate Cash Reserve but insufficient profit

Or,

(ii) Sufficient profit, inadequate cash reserves.

Limitations of Funds Flow Statement:

The Funds Flow Statement is also not free from limitations.

(a) A funds flow statement cannot present a continuous change of financial activities
including the changes of working capital.

(b) Since it is based on financial statement (i.e. Income Statement and Balance Sheet), it is
not a original statement.

(c) A projected Funds Flow Statement does not always present very accurate estimates about
the financial position since it is a historic one.

(d) It is not a substitute of financial statements, i.e. Income Statement and Balance Sheet. It
simply supplies information about the change of Working Capital position which, again,
depends on the data presented by the financial statements.

e) Cash Flow Statement, i.e. changes in cash position, is more important or more informative
than the changes in working capital which is presented by a Funds Flow Statement.
 Unit IV

CASH FLOW STATEMENT

INTRODUCTION

The Statement of Cash Flows report has always been an important financial report, but has
been called different names over the years. It was the "Statement of Changes in Financial
Position," "Statement of Sources and Applications of Funds," and "Changes in Working
Capital."

Differences between Cash flow statement and Funds flow statement

Cash flow statement Funds flow statement

Cash flow statement is prepared to disclose the Funds flow statement is prepared to disclose causes

causes of changes in working capital. of changes in cash and cash equivalents.

It is prepared on accrual accounting basis. It is prepared on cash system of accounting basis.

It does not have an opening and closing balances. It consists of opening and closing balances of cash.

It is prepared for long-range financial planning. It is useful for only short-range financial planning.

It contains only cash, which is one of the

It contains all the components of working capital.
components of working capital.

Funds flow statement has to be prepared by every

Cash flow statement has become quite obsolete.
listed company, as per given prescription

Limitations of Cash Flow Statements-

Cash flow statement is used as a tool of financial statement analysis. Even though, cash flow
statementsuffers from some limitations. Such limitations re listed below.
1. Cash flow statement shows only cash inflow and cash outflow. But, the cash balance
disclosed by the statement cannot reveals the true liquid position of the business.

2. Net Cash Flow disclosed by Cash Flow Statement does not necessarily mean net income of
the business because net income is determined by taking into account both cash and non-cash
items.
3. It does not give complete picture of the financial position of the business concern.
4. The preparation of cash flow statement is only postmortem analysis. There is no projection
of cash in future in this method.
5. It is not a substitute of Income Statement.
6. The accuracy of cash flow statement is based on the balance sheet. If balance sheet is
wrong, the cash flow statement is also wrong.
7. It is not prepared on the basic accounting concept of accrual basis. Hence, the accuracy of
cash flow statement is questionable.
8. It is not suitable for judging the profitability of a firm as non-cash items are not included in
the calculation of cash flow from operating activities.

Use of Cash Flow Statement

1. Since a cash flow statement is based on the cash basis of accounting, it is very useful in
the evaluation of cash position of a firm.

2. A projected cash flow statement can be prepared in order to know the future cash position

of a concern so as to enable a firm to plan and coordinate its financial operations properly. By

preparing this statement, a firm can come to know as to how much cash will be generated into

the firm and how much cash will be needed to make various payments and hence the firm can

well plan to arrange for the future requirements of cash.

3. A comparison of the historical and projected cash flow statements can be made so as to

find the variations and deficiency or otherwise in the performance so as to enable the firm to

take immediate and effective action.

4. A series of intra-firm and inter-firm cash flow statements reveals whether the firm’s

liquidity (short-term paying capacity) is improving or deteriorating over a period of time and

in comparison to other firms over a given period of time.

 5. Cash flow statement helps in planning the repayment of loans, replacement of fixed assets
and other similar long-term planning of cash. It is also significant for capital budgeting
decisions.
6. It better explains the causes for poor cash position in spite of substantial profits in a firm
by throwing light on various applications of cash made by the firm. It further helps in
answering some intricate questions like -what happened to the net profits? Where did the
profits go? Why more dividends could not be paid in spite of sufficient available profit?
7. Cash flow analysis is more useful and appropriate than funds flow analysis for short-term
financial analysis as in a very short period it is cash which is more elevant then the working
capital for forecasting the ability of the firm to meet its immediate obligations.
8. Cash flow statement prepared according to AS-3 (Revised) is more suitable for making
comparisons than the funds flow statement as there is no standard format used for the same.
9. Cash flow statement provides information of all activities classified under operating,
investing and financing activities. The funds statement even when prepared on cash basis, did
not disclose cash flows from such activities separately. Thus, cash flow statement is more
useful than the funds statement.
objectives of cash flow statement.
(a) Measurement of Cash:
Inflows of cash and outflows of cash can be measured annually which arise from operating
activities, investing activities and financial activities.
(b) Generating Inflow of Cash:
Timing and certainty of generating the inflow of cash can be known which directly helps the
management to take financing decisions in future.
(c) Classification of Activities:
All the activities are classified into: operating activities, investing activities and financial
activities which help a firm to analyze and interpret its various inflows and outflows of cash.
(d) Prediction of Future:
A Cash Flow Statement, no doubt, forecasts the future cash flows which helps the
management to take various financing decisions since synchronization of cash is possible.
(e) Assessing Liquidity and Solvency Position:
Both the inflows and outflows of cash and cash equivalent can be known, and, as such,
liquidity and solvency position of a firm can also be maintained as timing and certainty of
cash generation is known, i.e. it helps to assess the ability of a firm to generate cash.
(f) Evaluation of Future Cash Flows:
various information relating to inflows and Whether the cash flow from operating activities
are quite sufficient in future to meet the various payments e.g. payment of
expenses/debts/dividends/taxes.
(g) Supply Necessary Information to the Users:
A Cash Flow Statement supplies outflowsof cash to the users of accounting information
in the following ways:
(i) To assess the ability of a firm to pay its obligations as soon as it becomes due;
ii) To analyze and interpret the various transactions for future courses of action;
(iii) To see the cash generation ability of a firm;
(iv) To ascertain the cash and cash equivalent at the end of the period.
(h) Helps the Management to Ascertain Cash PlanningNo doubt a cash flow statement
helps the management to prepare its cash planning for the future and thereby avoid any
unnecessary trouble.
 UNIT –V

BREAK EVEN ANALYSIS AND DECISION MAKING

Meaning of Break-Even Point:

Break-even point represents that volume of production where total costs equal to total sales
revenue resulting into a no-profit no-loss situation.
If output of any product falls below that point there is loss; and if output exceeds that point
there is profit.
Thus, it is the minimum point of production where total costs are recovered. Therefore, at
break-even point.
Sales Revenue – Total Cost
or, Sales – Variable Cost = Contribution = Fixed Cost
It can be concluded that at break-even point the contribution earned just covers the fixed cost
and, at levels below the point, contribution earned is not sufficient to match the fixed cost
and, at levels above the point, contribution earned more than recovers the fixed cost.

Break-even point can be ascertained by using the following formula:

Assumptions Underlying Break-Even Analysis:

The break-even analysis is based on certain assumptions.

They are:
i) All costs can be separated into fixed and variable components,
(ii) Fixed costs will remain constant at all volumes of output,
(iii) Variable costs will fluctuate in direct proportion to volume of output,
(iv) Selling price will remain constant,
(v) Product-mix will remain unchanged,
(vi) The number of units of sales will coincide with the units produced so that there is no
opening or closing stock,
(vii) Productivity per worker will remain unchanged,
(viii) There will be no change in the general price level.
Uses of Break-Even Analysis:
(i) It helps in the determination of selling price which will give the desired profits.
(ii) It helps in the fixation of sales volume to cover a given return on capital employed.
(iii) It helps in forecasting costs and profit as a result of change in volume.
(iv) It gives suggestions for shift in sales mix.
(v) It helps in making inter-firm comparison of profitability.
(vi) It helps in determination of costs and revenue at various levels of output.
(vii) It is an aid in management decision-making (e.g., make or buy, introducing a product
etc.), forecasting, long-term planning and maintaining profitability.
(viii) It reveals business strength and profit earning capacity of a concern without much
difficulty and effort.
Limitations of Break-Even Analysis:
1. Break-even analysis is based on the assumption that all costs and expenses can be clearly
separated into fixed and variable components. In practice, however, it may not be possible to
achieve a clear-cut division of costs into fixed and variable types.

2. It assumes that fixed costs remain constant at all levels of activity. It should be noted that
fixed costs tend to vary beyond a certain level of activity.

3. It assumes that variable costs vary proportionately with the volume of output. In practice,
they move, no doubt, in sympathy with volume of output, but not necessarily in direct
proportions..
4. The assumption that selling price remains unchanged gives a straight revenue line which
may not be true. Selling price of a product depends upon certain factors like market demand
and supply, competition etc., so it, too, hardly remains constant.
5. The assumption that only one product is produced or that product mix will remain
unchanged is difficult to find in practice.
6. Apportionment of fixed cost over a variety of products poses a problem.
7. It assumes that the business conditions may not change which is not true.
8. It assumes that production and sales quantities are equal and there will be no change in
opening and closing stock of finished product, these do not hold good in practice.
9. The break-even analysis does not take into consideration the amount of capital employed
in the business. In fact, capital employed is an important determinant of the profitability of a
concern.