Accounting and its Functions

UNIT 1 ACCOUNTING AND ITS

FUNCTIONS
Objectives
After studying this unit, you should be able to appreciate the:
nature and role of accounting;


activities of an accountant; and
roles of accounting personnel and the accounting function in an organization.
Structure
1.1 Introduction
1.2 Scope of Accounting
1.3 Emerging Role of Accounting
1.4 Accounting as an Information System
1.5 Role and Activities of an Accountant
1.6 Accounting Personnel
1.7 Nature of Accounting Function
1.8 Organisation for Accounting and Finance
1.9 Summary
1.10 Key Words
1.11 Self-assessment Questions/Exercises
1.12 Further Readings
1.1 INTRODUCTION
Accounting is often called the language of business. The basic function of any lan-
guage is to serve as a means of communication. In this context, the purpose of ac-
counting is to communicate or report the results of business operations and its various
aspects. Though accounting has been defined in various ways. According to one
commonly accepted definition. "Accounting is the art of recording, classifying and
summarising in a significant manner and in terms of money, transactions and events
which are; in part at least, of financial character and interpreting the results thereof'.
Another definition which is less restrictive interprets accounting as "The process of
identifying, measuring and communicating economic information to permit informed
judgements and decisions by the users of information"
1.2 SCOPE OF ACCOUNTING
The scope of accounting can be presented in a diagrammatic form as shown in
Figure 1.1.
Data creationr and collection is the area which provides raw material for
accounting. The data collected is `historic' in the sense that it refers to events which
have already taken place. Earlier, accounting was largely concerned with what had
happened, rather than making any attempt to predict and prepare for future.
After the historic data has been collected, it is recorded in accordance with generally
accepted accounting theory. A large number of transactions or events have to be
entered in the books of original entry (journals) and ledgers in accordance with the
classification scheme already decided upon. The recording and processing of informa-
tion usually accounts for a substantial part of total accounting work. This type of
5



Source: Adapted from R.J. Bull, Accounting in Business, Butterworths, London, 1969,p.2.
6
Accounting Framework


activity of accounting may be called recordative. The processing method employed
for recording may be manual, mechanical or electronic. Computers are also used
widely in modern business for doing this job.
Data evaluation is regarded as the most important activity in accounting these days.
Evaluation of data includes controlling the activities of business with the help of
budgets and standard costs (budgetary control), evaluating the performance of busi-
ness, analysing the flow of funds, and analysing the accounting information for
decision-making purposes by choosing among alternative courses of action.
The analytical and interpretative work of counting may be for internal or external
uses and may range from snap answers to elaborate reports produced by extensive
research. Capital project analysis, financial forecasts, budgetary projections and
analysis for reorganisation, takeover or merger often lead to research-based reports.
Data evaluation has another dimension and this can be known as the auditive work
which focuses on verification of transactions as entered in the books of account and
authentication of financial statements. This work is done by public professional
accountants. However, it has become common these days for even medium-sized
organisations to engage internal auditors to keep a continuous watch over financial
flows and review the operation of the financial system.
Data reporting consists of two parts-external and internal. External reporting refers
to the communication of financial information (viz., earnings, financial and funds
position) about the business to outside parties, e.g., shareholders, government
agencies and regulatory bodies of the government. Internal reporting is concerned
with the communication of results of financial analysis and evaluation to
management for decision-making purposes.
You will note that accounting theory has been shown in the centre of the diagram.
We will turn to the role of accounting theory in the next unit.
The central purpose of accounting is to make possible the periodic matching of costs
(efforts) and revenues (accomplishments). This concept is the nucleus of accounting
theory. However, accounting is moving away from its traditional procedure-based
record-keeping function to the adoption of a role which emphasises its social impor-
tance.
Activity 1.1
List the various accounting activities that your organisation is undertaking. Can you
ascribe any particular reason as to why your organisation is undertaking these ac-
counting activities?


7
Accounting and its Functions


Accounting Activity Reason
1 1
2 2
3 3
4 4
5 5
6 6
7 7
8 8
1.3 EMERGING ROLE OF ACCOUNTING
The history of accounting indicates the evolutionary pattern which reflects changing
socio-ecoiom conditions and the enlarged purposes to which accounting is applied.
In the present context four phases in the evolution of accounting can be
distinguished.
Stewardship Accounting
In earlier times in history, wealthy people employed `stewards' to manage their
property. These stewards rendered an account of their stewardship to their owners
periodically. This notion lies at the root of financial reporting even today which
essentially involves the orderly recording of business transactions, commonly known
as 'book-keeping'. Indeed the accounting concepts and procedures, in use today for
systematic recording of business transactions have their origin in the practices em-
ployed by merchants in Italy during the 15th century. The Italian method which
specifically began to be known as `double entry book-keeping' was adopted by other
European countries during the 19th century. Stewardship accounting, in a sense, is
associated with the need of business owners to keep records of their transactions, the
property and tools they owned, debts they owed, and the debts others owed them.
Financial Accounting
Financial accounting dates from the development of large-scale business and the
advent of Joint Stock Company (a form of business which enables the public to
participate in providing capital in return for
`
shares' in the assets and the profits of the
company). This form of business organisation permits a limit to the liability of their
members to the nominal value of their shares. This means that the liability of a
shareholder for the financial debts of the company is limited to the amount he had
agreed to pay on the shares he bought. He is into liable to make any further contribu-
tion in the event of the company's failure or liquidation. As a matter of fact, the law
governing the operations (or functioning) of a company in any country (for instance
the Companies Act in India) gives a legal form to the doctrine of stewardship which
requires that information be disclosed to the shareholders

in the form of annual
income statement and balance sheet.
Briefly speaking, the income statement is a statement of profit and loss made during
the year of the report; and the balance sheet indicates the assets held by the firm and
the monetary claims against the firm. The general unwillingness of the company
directors to disclose more than the minimum information required by law and the
growing public awareness have forced the governments in various countries of the
world to extend the disclosure (of information) requirements.

8
Accounting Framework


The importance attached to financial accounting statements can be traced to the need
of the society to mobilise the savings and channel them into profitable investments.
Investors, whether they are large or small, must be provided with reliable and suffi-
cient information in order to be able to make efficient investment decisions. This is
the most significant social purpose of financial accounting.
Cost Accounting
The industrial revolution in England presented a challenge to the development of
accounting as a tool of industrial management. Costing techniques were developed as
guides to management actions. The increasing awareness on the part of entrepreneurs
and industrial managers for using scientific principles of management in the wake of
scientific management movement led to the development of cost accounting. Cost
accounting is concerned with the application of costing principles, methods and
techniques for ascertaining the costs with a view to controlling them and assessing
the profitability and efficiency of the enterprise.
Management Accounting
The advent of management accounting was the next logical step in the developmental
process.
-
The practice of using accounting information as a direct aid to management
is a phenomenon of the 20th century, particularly the last 30-40 years. The genesis of
modern management with its emphasis on detailed information for decision-making
provide a tremendous impetus to the development of management accounting.
Management accounting is concerned with the preparation and presentation of ac-
counting and controlling information in a form which assists management in the
'formulation of policies and in decision-making on various matters connected
.
with
routine or non-routine operations of business enterprise. It is through the techniques
of management accounting that the managers are supplied with information which
they need for achieving objectives for which

they are accountable. Management
accounting has thus shifted the focus of accounting from recording and analysing
financial
;
transactions to using information for decisions affecting the future. In this
sense, management accounting has a vital role to play in extending the horizons of
modern business. While the reports emanating from financial accounting are subject
to the conceptual framework of accounting, internal reports-routine or non-rout
i
ne are
free from such constraints.
Social Responsibility Accounting
Social responsibility accounting is a new phase in the development of accounting and
owes its birth to increasing social awareness which has been particularly noticeable
over the last two decades or so. Social responsibility accounting widens the scope of
accounting by considering the social effects of business decisions
;
in addition to the
economic effects. Several social scientists, statesmen and social workers all over the
world have been drawing the attention of their governments and the people in their
countries to the dangers posed to environment and ecology by the unbridled
industrial growth. The role of business in society is increasingly coming under
greater scrutiny\ The management is being held responsible not only for efficient
conduct of business as expressed in profitability, but also for what it contributes to
social well being and progress. There is a growing feeling that the concepts of growth
and profit as measuredin traditional balance sheets and income statements are too
narrow to reflect the social responsibility aspects of a business.
Human Resource Accounting
Way back in 1964 the first attempt to include figures on human capital in the balance
sheet was made by Hermansson which later. came to be known as Human Resource


9
Accounting and its Functions


Accounting. However there had been a great socio-economic shift in the 1990's with
the emergence of "Knowledge economy", a distinctive shift towards recognition of
human and intellectual capital in contrast to physical capital. Human Resource
Accounting is a branch of accounting which seeks to report and emphasis the impor-
tance of human resources (knowledgeable, trained, loyal and committed employees)
in a company's earning process and total assets. It is concerned with "the process of
identifying and measuring data about human resources and communicating this
information to interested parties". In simple words it involves accounting for invest-
ment in people and replacement costs as well as accounting for the economic values
of people to an organisation. Generally the methods used for valuing and accounting
of human resources are either based on costs or on economic value of human
resources.
,
However providing adequate and valid information on human assets
(capital), which are outside the concept of ownership, in figures is very difficult.
Nevertheless HRA is a managerial tool providing valuable information to the top
management to take decisions regarding adequacy of human resources and thus
encouraging managers to consider investment in manpower in a more positive way.
Inflation Accounting
Inflation Accounting is concerned with the adjustment in the value of assets (current
and fixed) and of profit in the light of changes in the price level. In a way, it is con-
cerned with the overcoming of limitations that arise in financial statements on
account of the cost assumption (that is recording of the assets at their historical or
original cost) and the assumption of stable monetary unit (these are discussed in
detail in the next unit). It thus aims at correcting the distortions in the reported results
caused by price level changes. Generally, rising prices during inflation have the
distorting influence of overstating the profit. Various approaches have been
suggested to deal with this problem.
If this little introduction of HRA and Inflation accounting provokes you to know
more about them, we suggest that you listen to the audio programme "Emerging
Horizons in Accounting and Finance-Part II and III" which deal with these two
topics. You may also read "Money Measurement Concept" explained in the next unit
which has a bearing on inflation accounting.
Activity 1.2
In the context of your organisation, describe some of the cost and management
accounting related activities. Please also identify any particular accounting practice in
the area of social responsibility.
.
.
.
.
.
.
1.4 ACCOUNTING AS AN INFORMATION SYSTEM
While discussing the scope of accounting you must have observed that accounting
involves a series of activities linked with each other, beginning with the collecting,
recording, analysing and evaluating the data, and finally communicating information
to its users. Information has no meaning unless it is linked with a certain purpose.

10
Accounting Framework


Accounting as a social science can be viewed as an information system since it has
all the features of a system. It

has its inputs (raw data), processes (men and
equipment), and outputs (reports and information). If we consider accounting as an
information system, then we are in a position to make some important observations.
First, the goal of the system is to provide information which meets the needs of its
users. If we can correctly identify the needs of the users, we are then able to specify
the nature and character of the outputs of the system. Secondly, it is the output
requirements that . determine the type of data which would be selected as the inputs
for processing into information output.
There are several groups of people who have a stake in a business organisation-
managers, shareholders, creditors, employees, customers, etc. Additionally, the
community at large has economic and social interest in the activities of such
organisations. This interest is expressed at the national level by the concern of
government in various aspects of the firms' activities, such as their economic well-
being, their contribution to welfare, their part in the growth of the national product, to
mention only a few examples.
We shall now briefly discuss what the information needs of various users are.
Shareholders and Investors: Since shareholders and other investors have invested
their wealth in a business enterprise, they are interested in knowing periodically
about the profitability of the enterprise, the soundness of their investment and the
growth prospects of the enterprise. Historically, business accounting was developed
to supply information to those who had invested their funds in business enterprises.
Creditors: Creditors may be short-term or long-term lenders. Short-term creditors
include suppliers of materials, goods or services. They are normally known as trade
creditors. Long-term creditors are those who' have lent money for a long period,
usually in the form of secured loans. The main concern of the creditors is focused on
the credit worthiness of the firms and its ability to meet its financial obligations. They
are therefore concerned with the liquidity of the firms, its profitability and financial
soundness. In other words, it can also be stated that creditors are interested mainly in
information which deals with solvency, liquidity and profitability so that they could
assess the financial standing of the firms.
Employees: The view that business organisations exist to maximise the return to
shareholders has been undergoing change as a result of social changes. A broader
view is taken today of economic and social role of management. The importance of
harmonious industrial relations between management and employees cannot be over-
emphasised. That the employees have a stake in the outcomes of several managerial
decisions is recognised. Greater emphasis on industrial democracy through employee
participation in management decisions has important implications for the supply of
information to employees. Matters like settlement of wages, bonus, and profit sharing
rest on adequate disclosure of relevant facts.
Government: In a mixed economy it is considered to be the responsibility of the
Government to direct the operation of the economic system in such a manner that it
subserves the common good. Controls and regulations on the operations of private
sector enterprises are the hallmark of mixed economy. Several government agencies
collect information about various aspects of the activities of business organisations.
Much of this information is a direct output of the accounting system, for example,
levels of outputs, profits, investments, costs, and taxes, etc. All this information is very
important in evolving policies for managing the economy. The task of the Gov
e
rnment
in managing the industrial economy of the country is facilitated if accounting
information is presented, as far as possible, in a uniform manner. It is clear that if
accounting information is distorted due to manipulations and window-dressing in the

11
Accounting and its Functions


presentation of annual accounts, it will have ill-effects on the measures the government
intends to take and the policies it wishes to adopt.
Management: Organisations may or may not exist for the sole purpose of profit.
However, information needs of the managers of both kinds of organisations are
almost the same, because the managerial process i.e., planning, organising and
controlling is the same. All these functions have one thing in common and it is that
they are all concerned with making decisions which have their own specific
information requirements. The emphasis on efficient and effective management of
organisations has considerably extended the demand for accounting information. The
role of accounting as far as management is concerned was highlighted earlier when
we discussed about management accounting.
Consumers and others: Consumers' organisations, media, welfare organisations and
public at large are also interested in condensed accounting information in order to
appraise the efficiency and social role of the enterprises in different sectors of the
economy, that is, what levels of profits and outputs are being achieved, in what way
the social responsibility is being discharged and in what manner the growth is being
planned by the enterprises in-accordance with the national priorities etc.
The above discussion perhaps has indicated to you that the information needs of the
various users may not necessarily be the same. Sometimes, they may even conflict
and compete with each other. In any case, the objective of accounting information is
to enable information users to make optimum decisions.
1.5 ROLE AND ACTIVITIES OF AN ACCOUNTANT
Having discussed the scope of accounting and its emerging role, we are now in a
position to describe as to who is an accountant. In an attempt to answer this question
we reproduce below some statements in this regard:
a)
b)
c)
d)
e)
f)
g)
An accountant is one who is engaged in accounts-keeping.
An accountant is a functionary who aids control.
An accountant keeps the conscience of an organisation.
An accountant is a professional whose primary duties are concerned with
information management for internal and external use.
An accountant is a fiscal adviser.
An accountant produces an income statement and a balance sheet for an
accounting period and maintains all supporting evidence and classified facts
that lead to the final accounting statements.
An accountant verifies, authenticates, and certifies the accounts of an entity.
Tell us about your reactions. Perhaps you do have your own ideas but our thinking is
that each of the foregoing statements contain some truth in it as it highlights some
aspects of the functions of an accountant, except one statement which presents a
somewhat comprehensive view. Can you identify this statement? We will help you in
doing this.
Statement (a) defines a person who maintains accounts. Statement (f) echoes almost a
similar notion but extends his role to the production of financial statements. The
work implied in these statements is that of score-keeping and the person performing
such activity is known as a financial accountant (or maintenance accountant).
Statement (b) is about the role which an accountant can play in the management control
process. It is concerned with attention-directing and problem-solving. The functionary
may be designated as management accountant (or a controller as in the United States).

12
Accounting Framework


Statement (e) underlines a narrow, specific role of an accountant, though of critical
significance. In view of high incidence of taxes on business in India, tax planning
assumes

a vital role in fiscal management. By planning the operations of the enterprise in
a particular manner, the tax adviser attempts to minimise the liability of the firm by
availing the concessions and incentives provided for in the applicable tax laws.
Statement (g) stresses the `audit', `watchdog', or `certification role' of the accountant
who is not an employee of a business but who performs an external verification of
accounts. Such a functionary is a trained and qualified professional who, like any
other professional, has an educational status and a prescribed code of conduct.
Chartered Accountants in India, England-Wales, and Certified Public Accountants in
USA belong to this category of accountants.
Statement (c) presents the accountant as a conscience-keeper. He is seen as a person
whose mission is to protect and promote the interest of the employer in a positive
manner. He is there to see to it that none of the staff of the organisation carries on this
work in an unethical way or in a manner prejudicial to the long-term legitimate
interests of the firm.
We are now left with statement (d) which defines an accountant as a professional and
underlines his pre-occupation withi management of information for internal use
(management accounting function) and for external use (financial accounting func-
tion). We are sure, our discussion of accounting as an information system has made it
easier for you to comprehend this role of the accountant. We may clarify that
information management is not necessarily associated with sophisticated (or hi-tech)
area of computers. Small firms may `manage' information without a substantial
degree of mechanisation or automation. Often the role of accounting in small
businessis not properly recognised. It is widely known that a large number of small
businesses fail and do not survive beyond a few years. One of the main reasons for
their failure is that they do not have an adequate information system to help their
managers to control costs, to forecast cash needs and to plan for growth.
Organisations which have poor accounting system often find it considerably difficult
to obtain finance from banks and outside investors.
1.6 ACCOUNTING PERSONNEL
There is hardly any organisation which does not have an accountant. His role is all
pervasive and he is involved in a wide range of activities, particularly in a large and
complex organisation. The exact duties of an accountant might differ in different
organisations. However, a broad spectrum of responsibilities can be identified.
The accountants can be broadly divided into two categories, those who are in public
practice and those who are in private employment. The accountants in public practice
offer their services for conducting financial and or cost audit. As such, they are
known as auditors. The auditor examines the books of account and reports on the
balance sheet and profit and loss account of the company as to whether they give a
true and fair view of the state of affairs of the company and its profit respectively.
The auditor in a company is appointed by the shareholders to whom he reports.
Public accountants are generally members of professional bodies like the Institute of
Chartered Accountants of India or the Institute of Cost and Works Accountants of
India. In addition to conducting financial or cost audit (in accordance with the
requirements of the Companies Act), as the case may be, they may also provide
consultancy services for design Qing or improving accounting and management
control systems.
Accountants in employment may be in various business or non-business organisations
to perform a variety of accounting and management control functions. Accountants at
higher levels generally belong to professional accounting bodies but those who are at

13
Accounting and its Functions


lower levels need not be so. Accounting chiefs in different organisations, depending
upon their nature of work, are variously designated as finance officers or internal
auditors or chiefs accounts officers, etc. The term `controller' as the head of the
accounting and finance function is not very popular in India but of late it has been
catching up. Several large organisations, both in the public and private sectors, have
now controllers. Let us have an idea of who these people are and what they do.
Internal Auditor: Internal Auditor is an employee of the organisation in contrast to
an external auditor who is paid a fee for his services. The internal auditor is
responsible for performing monitoring activities and other services, including
designing and operating the system of internal control, auditingthe data reported to
the directors ofthe company, and assisting external auditors. The head ofthe internal
audit function reports directly either to the ch iefexecutive or to the audit committee
of the Board of Directors.
Internal audit includes continuous verification of entries appearing in the books of
account with the original vouchers and proper accounting of assets. Further, it at-
tempts to ensure that the policies and procedures regarding financial matters are
being complied with. Internal auditing is also concerned with administering the
system of internal check so that mistakes, innocent or intentional, are prevented
from taking place.
We should distinguish an internal auditor from an external auditor. While an internal
auditor devotes his entire time and energy to the needs ofone company (i.e, his
employer), an external auditor serves many clients. The primary function ofthe
external auditor, as pointed out earlier, is to safeguard the interests ofthe shareholders
(by whom he is appointed ) by an independent and impartial appraisal ofthe financial
transactions ofthe company so that he could report on the net profit earned by the
company and its financial position. His role is that ofan objective outsider, expressing
expert opinions tothefinancial condition and operating results ofthe client's business.
A part from shareholders, other parties such as banks, lending institutions, govern-
ment agencies, etc. reply on the fairness of such financial reports in making certain
decision about a given company. An auditor is bound by a set of professional regula-
tions which include an examination on technical competence and adherence to a code
of ethical conduct.
Controller : Controller- the other name for Chief Accountant- is usually the head of
the whole area of accounting, including internal audit. He is overall in - charge of all
the activities comprising financial accounting, cost accounting, management account-
ing, tax accounting etc. He exercises authority both for accounting within the
organisation and for external reporting. The external reports include reports to
government revenue collecting and regulatory bodies, such as Company Law Board
and Income Tax . Department He may also supervise the company's internal audit
and control systems. In addition to processing historical data, he is expected to supply
a good deal of accounting information to top management concerning future
operations, in line with the management's planning and control needs. Besides, he is
also expected to supply detailed information to managers in different functional areas
( like production, marketing, etc.) and at different levels of the organisation.
We may enumerate the functions of the controller as follows:
a) Designing and operating the accounting system
b) Preparing financial statements and reports
c) Establishing and maintaining systems and procedures
d) Supervising internal auditing and arranging for external audit
e) Supervising computer applications
f) Overseeing cost control
g) Preparing budgets

14
Accounting Framework


h) Making forecasts and analytical reports
i) Reporting financial information to top management
j) Handling tax matters.
Treasurer : He is the custodian arid manager of all the cash and near-cash resources
of the firm. The treasurer handles credit reviews and sets policy for collecting receiv-
ables (debtors of the firm to whom the firm has sold goods or services) He also
handles relationships with banks and other lending or financial institutions.
The Financial Executive Institute (of United States of America) makes the following
distinction between controllership and treasurership functions:
Controllership Treasurership
Planning and Control Provision of Capital
Reporting and Interpreting Investor Relations
Evaluating and Consulting Short-term Financing
Tax Administration Banking and Custody
Government Reporting Credit and Collections
Protection of Assets Investments
Economic Appraisal Insurance
Finance Officer: Finance is the life blood of business. Procuring financial resources
and their judicious utilisation are the two important activities of financial manage-
ment. Financial management, includes three major decisions: investment decision,
financing decision and dividend decision. Investment decision is perhaps the most
important decision because it involves allocation of resources . It is concerned with
future which being uncertain involves risk. How the firm is allocating its scarce
resources and is planning growth will largely determine its value in the market place.
Financing decision is concerned with determining the optimum financing mix or
capital structure. It examines the various methods by which a firm obtains short-term
and long -term finances through various alternative sources. The dividend decision is
concerned with question like how much of the profit is to be retained and how much
is to be distributed as dividends. The finance manager has to strike a balance between
the current needs of the enterprise for cash and the needs of the shareholders for a
adequate return. The financial management of a large company is usually the respon-
sibility of the finance director who may be in place of, or in addition to the controller.
Often finance manager and controller are inter-changeable terms and only one of
these two positions may be found in a company. The finance manager when there is a
controller also in the organisation, is concerned with implementing the financial
policy of the board of directors, managing liquidity, preparation of budgets and
administration of budgetary control system, managing profitability, etc.
Though financial management is regarded as a separate area, this function is per-
formed in several countries, including India, by the Accountant( or the Financial
Controller) Several large organisations however have a financial executive besides
the ch ief accountant. Often, finance and accountingfunctions are clubbed together in
one persons in small organisations.
Activity 1.3
Please meet one or more of the following personnel in any organisation and talk to
them about their respective roles within the organisation.
Accountant
1
2
3

15
Accounting and its Functions


4
5
Chief Accountant
1
2
3
4
5
Controller
1
2
3
4
5
Finance Manager
1
2
3
4
5
Internal Auditor
1
2
3
4
5
1.7 NATURE OF ACCOUNTING FUNCTION
Accounting is a service function. The chief accounting executive (by whatever name
he is called) holds a staff position except within his own department where he exerts.
authority. This is in contradistinction to the roles played by production or marketing
executives who hold line authority: The role of the accountant is advisory in
character. He works through the authority of the chief executive. The accounts and or
finance department(s) do`not exercise direct authority over line departments. In
decentralised structure with a number of units and divisions, the accounting executive
however exercises what is known as the functional authority over all the accounting
staff deployed in different segments.
There are two facets to the role of the accountant. For the top managers he works as a
watchdog and for middle and lower level managers he acts as
`
helper
'
. The watchdog
role is usually performed through `score-keeping' task of accounting and reporting to

all levels of management. The `helper' role is usually performed through the task of
directing managers' attention to problems and assisting them in solving problems.
Mutual understanding and rapport between the accountant and the manager, in the
tasks of attention-directing and problem-solving can be enhanced if accountant and
his staff frequently interact with the line managers and guide them in matters
concerned with preparation of budgets and control documents with which they might
not be conversant. This will instill confidence among line managers regarding the
reliability of reports.
16
Accounting Framework


1.8 ORGANISATION FOR ACCOUNTING AND
FINANCE
A typical organisation chart for accounting and finance function is presented in
Figure 1.2. You will note that the person at the helm of affairs the Director (Finance)
who is a member of the Board of Directors. Reporting to him may be one or more
general managers. If there is only one General Manager, he may be designated as
General Manager (Finance), or General Manager (Finance and Accounts), or
Controller or Financial Controller. In a large company four or five (as shown in
Figure 1.2) Deputy General Managers incharge of different areas like systems and
data processing, accounts, finance, internal auditing may report to him. Following the
American pattern, a tendency has recently been observed among large companies,
especially in the private sector, to designate General Manager (Finance) as President
(Finance, or Finance and Accounts) and a Deputy General Manager as Vice-
president. Each of these Deputy General Managers is assisted by a number of senior
managers who look after different components of similar activities, e.g., financial
accounting, tax planning and administration, management auditing, etc. Management
audit is a comprehensive review of the various sub-systems of the organisation like
objectives and goals, structure, technical system, personnel policies, (including
succession planning), control and coordination policies and procedures, adequacy and
effectiveness of communication system, etc. This type of audit is usually done by a
team of people comprising the internal resource persons drawn from various
functional areas and external management consultant.
Figure 1.2: Organisation Chart for Accounting and Finance


17
Accounting and its Functions


We hope you now have a reasonably good idea of what accounting is, what its scope
is, and what are the different types of activities which are generally included in
accounting. While basic functions of accounting and finance are performed in all
types of organisations, their relative emphases or relevance might differ in different
types of organisations. Keeping this in view we have prepared an audio programme
"Accounting and Finance Function in Different Types of Organisations" and we
suggest that you listen to this tape. This will not only augment your familiarity with
the basic aspects and functions of accounting but will also develop your appreciation
for relative divergencies.
1.9 SUMMARY
Accounting is an important service activity in business and is concerned with collect-
ing, recording, evaluating and communicating the results of past events. The history
of accounting development reflects its changing role in response to the changing
business and social needs. With the emergence of management accounting, the focus
of ac-counting has been shifting from mere recording of transactions to that of aiding
the management in decisions.
Accounting can be perceived as an information system which has its inputs, process-
ing methods and outputs. The usefulness of accounting lies in its capacity to provide
information to various stakeholders in business so that they could arrive at the correct
decisions.
The top accounting personnel are designated with various nomenclature. The practice
in this regard djffers in different companies. The organisational setting for accounting
and finance function may also vary in different organisations, depending upon their
peculiarities, nature and size of business, technology and structural form. At the helm
of affairs is usually the Director of Accounts and Finance who is a member of the
Board of Directors. Fle is assisted by a General Manager who in turn is helped by
Deputy General Managers incharge of various sub-functions like, accounts, finance,
internal audit, and data processing, etc. Each of the sub-functions is further sub-
divided into activities which are the responsibility of a subordinate manager.
1.10 KEY WORDS
Accountant is a professional who is responsible for the processing of financial data
for score-keeping, attention-directing and problem-solving purposes.
Controller of the management accountant is a staff-functionary who uses accounting
information for management planning and control.
Auditive work of an accountant comprises authentication of accounting statements.
Recordative work extends to routine recording and classified posting of financial
transactions and events.
Score-keeping is the process of data accumulation or record-keeping which enables
interested parties (internal and external) to ascertain how the organisation is
performing.
Attention-directing role of accounting consists of directing managerial attention to
situations where corrective action is needed in the case of unfavourable (or even
favourable) differences in operations, outputs or inputs.
Information system is a system, sometimes formal and sometimes informal, for
collecting, processing, and communicating data at the most relevant time to all levels
of management. The data flowing through the system is helpful to managers for

18
Accounting Framework


decision-making in the areas of planning and control, or is otherwise needed for
financial reporting required under the laws. An essential requirement of information
system is feedback, i.e. communicating the results of performance to operating
managers for needed modifications.
External reporting is the production of financial statements for the use by external
interest groups like, shareholders and government.
Planning is goal identification and decision-making.
Control is the action that implements the planning decision and evaluates perfor-
mance.
Feedback comprises the performance reports which managers can use for improving
their decision-making.
Staff function is performed in an advisory capacity and without line or decision-
making authority.
1.11 SELF-ASSESSMENT QUESTIONS/EXERCISES
1 "Financial Accounting is an extension of Stewardship Accounting".
Comment.
2 What new developments in Accounting have taken place over the past 20-25
years? Examine the main factors which have affected such developments.
3 State the group of persons having an interest in a business organisation and
examine the nature of their information needs.
4 Discuss the role of accountants in modern business organisations.
5 Differentiate between recordative, interpretative and auditive functions of
Accounting.
6 How can accounting reports, prepared on a historical basis after the close of a
period, be useful to managers in directing the activities of a business?
7 Distinguish management accounting from financial accounting.
8 How does the accountant help in the planning and control process of a large
commercial organisation?
9 State whether the following statements are true or false:
a)
b)
c)
To have an accountant is the privilege ofa joint stock True/False
company only.
A controller is entrusted with the responsibilities of True/False
raising funds
Management control differs from engineering True/False
control since the latter is fully automatic and the
former is highly complex.
d) An accountant is the custodian of the properties and True/False
financial interests of a business enterprise.
Answers to Self-assessment Questions/Exercises
9 (a) False, (b) False, (c) True, (d) True,

19
Accounting and its Functions


1.12 FURTHER READINGS
Anthony, Robert N. and James S. Reece, 1987. Accounting Principles, All India
Traveller Book Seller: New Delhi (Chapter I).
Bhattacharya S.K. and John Dearden, 1987. Accounting for Management: Text and
Cases, Vikas Publishing 1-louse: New Delhi. (Chapter I).
Paul Collier, May 09.2003. Accounting for Managers : Interpreting Accounting
Infornration
.
for Decision Making. Wiley Publishers : Canada. (Chapter I),

Accounting System
UNIT 2 ACCOUNTING CONCEPTS AND
STANDARDS
Structure Page Nos.
2.0 Introduction 20
2.1 Objectives 20
2.2 The Accounting Framework 20
2.3 Accounting Concepts 21
2.4 Accounting Standards 30
2.5 The Changing Nature of Generally Accepted
Accounting Principles 31
2.6 Attempts towards Standardisation 31
2.7 Accounting Standards in India 32
2.8 Summary 33
2.9 Key Words 33
2.10 Self-Assessment Questions/Exercises 34
2.11 Further Readings 36

2.0 INTRODUCTION
Any activity that you perform is facilitated if you have a set of rules to guide your
efforts. Further, you find that these rules are of more value to you if they are
standardised. When you are driving your vehicle, you keep to the left. You are in fact
following a standard traffic rule. Without the drivers of vehicles adhering to this rule,
there would be much chaos on the road. A similar principle applies to accounting
which has evolved over a period of several hundred years, and during this time
certain rules and conventions have come to be accepted as useful. If you are to
understand and use accounting reports which is the end product of an accounting
system then you must be familiar with the rules and conventions behind these reports.

2.1 OBJECTIVES
After going through this unit, you should be able to:

l appreciate the need for a conceptual framework of accounting;
l understand and appreciate the Generally Accepted Accounting Principles
(GAAP), and
l develop an understanding of the importance and necessity for uniformity in
accounting practices.

2.2 THE ACCOUNTING FRAMEWORK
The rules and conventions of accounting are commonly referred to as the conceptual
framework of accounting. As with any discipline or body of knowledge, some
underlying theoretical structure is required if a logical and useful set of practices and
procedures are to be developed for reaching the goals of the profession, and for
expanding knowledge in that field. Such a body of principles is needed to help
answer new questions that arise. No profession can thrive in the absence of a
theoretical framework. According to Hendriksen (1977), accounting theory may be
defined as logical reasoning in the form of a set of broad principles that (i) provide a
general frame of reference by which accounting practice can be evaluated, and (ii)
guide the development of new practices and procedures. Accounting theory may also
be used to explain existing practices to obtain a better understanding of them. But the
20


Accounting and its
Functions
Accounting Concepts and
Standards
most important goal of accounting theory should be to provide a coherent set of
logical principles that form the general frame of reference for the evaluation and
development of sound accounting practices.

The American Institute of Certified Public Accountants (AICPA) discusses financial
accounting theory and generally accepted accounting principles as follows:

Financial statements are the product of process in which a large volume of data
about aspects of the economic activities of an enterprise are accumulated, analysed,
and reported. This process should be carried out in accordance with generally
accepted accounting principles. Generally accepted accounting principles incorporate
the consensus at a particular time as to which economic resources and obligations
should be recorded as assets and liabilities by financial accounting, which changes in
assets and liabilities should be recorded, when these changes should be recorded, how
the assets and liabilities and changes in them should be measured, what information
should be disclosed and how it should be disclosed, and which financial statements
should be prepared.

Generally Accepted Accounting Principles (GAAP) encompass the conventions, rules
and procedures necessary to define accepted accounting practice at a particular
time........generally accepted accounting principles include not only broad guidelines
of general application, but also detailed practices and procedures.

(Source: AICPA. Statements of the Accounting Principles Board No.4 Basic
Concept and Accounting Principles Underlying Financial Statement of Business
Enterprises, October, 1970, pp.54-55).

The word principles is used to mean a general law or rule adopted or professed as
a guide to action, a settled ground or basis of conduct or practice. You will note that
this definition describes a principle as a general law or rule that is to be used as a
guide to action. This implies that accounting principles do not prescribe exactly how
each detailed event occurring in business should be recorded. Consequently, there are
several matters in accounting practice that may differ from one company to another.

Accounting principles are man-made. They are accepted because they are believed to
be useful. The general acceptance of an accounting principle (or for that matter, any
principle) usually depends on how well it meets the three criteria of relevance,
objectivity, and feasibility. A principle is relevant to the extent that it results in
meaningful or useful information to those who need to know about a certain business.
A principle is objective to the extent that the information is not influenced by the
personal bias or judgement of those who furnished it. Objectivity connotes reliability
or trustworthiness which also means that the correctness of the information reported
can be verified. A principle is feasible to the extent that it can be implemented
without undue complexity or cost.

2.3 ACCOUNTING CONCEPTS
Earlier, in unit 1, we had described accounting as the language of business. As with
language, accounting has many dialects. There are differences in terminology. In
dealing with the framework of accounting theory, one is confronted with a serious
problem arising from differences in terminology. A number of words and terms have
been used by different writes to express and explain the same idea or notion. Thus,
confusion abounds in the literature insofar as the theoretical framework is concerned.
The various terms used for describing the basic ideas are: concepts, postulates,
propositions, basic assumptions, underlying principles, fundamentals, conventions,
doctrines, rules, etc. Although each of these terms is capable of precise definition,
general usage by the profession of accounting has served to give them loose and
overlapping meanings. The same idea has been described by one author as a concept
and by another as a convention. To take another instance, the idea implied in

21

Accounting System
conservatism has been labelled by one author as a (modifying) convention, by
another as a principle, and by yet another as a doctrine. The wide diversity in
terminology to express the basic framework can only serve to confuse the learner.
Without falling into the trap of this terminological maze, we will explain below,
some widely recognised ideas and we call all of these concepts. We do feel, however,
that some of these ideas have a better claim to be called concepts, while the rest
should be called conventions. Fundamental accounting concepts are broad, general
assumptions that underlie the periodic financial accounts of business enterprises. The
reason why some of these ideas should be called concepts is that they are basic
assumptions and have a direct bearing on the quality of financial accounting
information. The alteration of any of the basic concepts (or postulates) would change
the entire nature of financial accounting.
Business Entity Concept
In accounting we make a distinction between business and the owner. All the records
are kept from the viewpoint of the business, rather than from that of the owner. An
enterprise is an economic unit, separate and apart from the owner, or owners. As
such, transactions of the business and those of the owners should be accounted for,
and reported separately. In recording a transaction, the important question is how
does it affect the business? For example, if the owner of a shop were to take cash
from the cash box for meeting certain personal expenditure, the accounts would show
that cash had been reduced even though it does not make any difference to the owner
himself. Similarly, if the owner puts cash into the business, he has a claim against the
business for capital brought in.
This distinction can be easily maintained in the case of a limited company because a
company has a legal entity (or personality) of its own. Like a human being, it can
engage itself in economic activities of producing, owning, managing, storing,
transferring, lending, borrowing and consuming commodities and services.
Distinction, however, is difficult in the case of partnership, and even more so in the
case of a one-man business. Nevertheless, accounting still maintains separation of
business and owner. This implies that, owners personal and household expenses or
obligations (e.g., expenditure on food, clothing, housing, entertainment, debts,
mortgages, etc.) will not appear in the books of account. It may be clarified that it is
only for accounting purposes that partnerships and sole proprietorships are treated as
separate and apart from the owners though the law does not make such a distinction.
A creditor would be justified in looking to both the business assets and the private
estate of the owner for satisfaction of his claim. One reason for this distinction is to
make it possible for the owners to have an account of the performance from those
who manage the enterprise. The managers are entrusted with funds supplied by
owners, banks, and others; they are responsible for the proper use of the funds. The
financial accounting reports are designed to show how well this responsibility has
been discharged.

& Check Your Progress 1
Apart from the reason mentioned above, can you think of any other reason for the
justification of the Business Entity Concept?
.........................................................................................................................................
.
.........................................................................................................................................
.
.........................................................................................................................................
.........................................................................................................................................
.
22


Accounting and its
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Accounting Concepts and
Standards
& Check Your Progress 2
The proprietor of a firm withdrew Rs. 50,000 for his personal use. This was shown as
an expense of the firm and hence, profits were reduced thereby. Is this right from an
accounting point of view?
.........................................................................................................................................
.........................................................................................................................................
.
.........................................................................................................................................
.............................................................................................
.
& Check Your Progress 3
The proprietor of a firm contributed Rs. 10 lakhs towards the capital of the firm. Does
it means, from an accounting point of view, that the firm had a corresponding liability
towards the proprietor?
.........................................................................................................................................
.........................................................................................................................................
.
.........................................................................................................................................
.............................................................................................
.
Money Measurement Concept
In accounting, only those facts which can be expressed in terms of money are
recorded. As money is accepted not only as a medium of exchange but also as a
measuring rod of value, it has a very important advantage since a number of widely
different assets and equities can be expressed in terms of a common denominator.
Without this adding heterogeneous factors like five buildings, ten machines, six
trucks will not have much meaning.

While money is probably the only practical common denominator and a yardstick, we
must realise that this concept imposes two sever limitations. In the first place, there
are several facts which, though vital to the business, cannot be recorded in the books
of account because they cannot be expressed in money terms. For example, the state
of health of the Managing Director of a company, who has been the key contributor
to the success of business, is not recorded in the books. Similarly, the fact that the
Production Manager and the Chief Internal Auditor are not on speaking terms, or that
a strike is about to begin because labour is dissatisfied with the poor working
conditions in the factory, or that a competitor has recently taken over the best
customer, or that it has developed a better product, and so on will not be recorded
even though all these events are of great concern to the business.

From this standpoint, one could say that accounting does not give a complete account
of the happenings in the business. You will appreciate that all these have a bearing on
the future profitability of the company.

Second, the use of money implies that a rupee today is of equal value to a rupee ten
years back or ten years later. In other words, we assume that there is a stable or
constant value of the rupee. In the accounts, money is expressed in terms of its value
at the time an event is recorded. Subsequent changes in the purchasing power of

23

Accounting System
money do not affect this amount. You are, perhaps, aware that most economies today
are in inflationary conditions with rising prices. The value of a rupee in the 80s has
depreciated to an unbelievably low level in the 90s. Most accountants know fully
well that the purchasing power of a rupee does change, but very few recognise this
fact in accounting books and make an allowance for changing price level. This is so,
despite the fact that the accounting profession has devoted considerable attention to
this problem, and numerous suggestions have been made to account for the effects of
changes in the purchasing power of money. In fact, one of the major problem of
accounting today is to find means of solving the measurement problem, that is, how
to extend the quality and the coverage of meaningful information. It will be desirable
to present, in a supplementary analysis, the effect of price level changes on the
reported income of the business and the financial position.

& Check Your Progress 4
Suppose the Managing Director of a company is killed in a plane crash. To the extent
that an organisation is the lengthened shadow of a man, the real value of the
company will change immediately, and this will be reflected in the market price of
the company shares. Will this have any effect as far as the accounts of the company
are concerned?
.........................................................................................................................................
.
.........................................................................................................................................
.
.........................................................................................................................................
.
.........................................................................................................................................
.
.........................................................................................................................................
.

Continuity Concept
Accounting assumes that the business (an accounting entity) will continue to operate
for a long time in the future, unless there is good evidence to the contrary. The
enterprise is viewed as a going concern, that is, as continuing in operation, at least in
the foreseeable future. The owners have no intention, nor have they the necessity to
wind up or liquidate its operations.

This assumption is of considerable importance, for it means that the business is
viewed as a mechanism for adding value to the resources it uses. The success of the
business can be measured by the difference between output values (sales or revenues)
and input values (expenses). Therefore, all unused resources can be reported at cost
rather than at market values as, according to the continuity concept, the future instead
of selling them out rightly in the market.

The assumption that the business is not expected to be liquidated in the foreseeable
future, in fact, establishes the basis for many of the valuations and allocations in
accounting. For example, depreciation (or amortisation) procedures rest upon this
concept. It is this assumption which underlies the decision of investors to commit
capital to enterprise. The concept holds that continuity of business activity is the
reasonable expectation for the business unit for which the accounting function is
being performed. Only on the basis of this assumption can the accounting process
remain stable and achieve the objective of correctly recording and reporting on the
24


Accounting and its
Functions
Accounting Concepts and
Standards
capital invested, the efficiency of management, and the position of the enterprise as a
going concern. Under this assumption neither higher current market values nor
liquidation values are of particular importance in accounting. This assumption
provides a basis for the application of cost in accounting for assets.

However, if the accountant has good reasons to believe that the business, or some
part
of it, is going to be liquidated, or that it will cease to operate (say within a year or
two), then the resources could be reported at their current values (or liquidation
values).
& Check Your Progress 5
A company bought a building in 2004 at a cost of Rs.50 lakhs. At the end of the
Accounting Year 2004-05, its market value is Rs.70 lakhs. The company revalues the
building at Rs.70 lakhs for the year 2004-05. Is this practice right?
.........................................................................................................................................
.
.........................................................................................................................................
.
.........................................................................................................................................
.
.........................................................................................................................................
.

Cost Concept
The resources (land, buildings, machinery, property rights, etc.) that a business owns
are called assets. The money values assigned to assets are derived from the
cost concept. This concept states that an asset is worth the price paid for, or cost
incurred to acquire it. Thus, assets are recorded at their original purchase price and
this cost is the basis for all subsequent accounting for the assets. The assets shown on
the financial statements do not necessarily indicate their present market worth (or
market values). This is contrary to what is often believed by an uninformed person
reading the statement or report. The term book value is used for the amount shown
in the accounting records.
In the case of certain assets, the accounting values and market values may be similar;
cash is an obvious example. In general, the longer an asset has been owned by the
company the less, are the chances that the accounting value will correspond to the
market value.

The cost concept does not mean that all assets remain on the accounting records at
their original cost for all time to come. The cost of an asset that has a long but limited
life, is systematically reduced during its life by a process called depreciation which
will be discussed at some length in a subsequent unit. Suffice it to say that
depreciation is a process by which the cost of the asset is gradually reduced (or
written off) by allocating a part of it to expense in each accounting period. This will
have the effect of reducing the profit of each period. In charging depreciation the
intention is not to change depreciation equal to the fall in the market value of the
asset. As such, there is no relationship between depreciation and changes in
market value of the assets. The purpose of depreciation is to allocate the cost of an
asset over its useful life and not to adjust its cost so as to bring it closer to the
market value.

25

Accounting System
You must be wondering why assets are shown at cost, even when there are wide
differences between their costs and market values. The main argument is that the cost
concept meets all the three basic criteria of relevance, objectivity and feasibility.
& Check Your Progress 6
A company buys machinery availing heavy discount at Rs. 40,000, but its actual
market price is Rs. 60,000. Should the company show the value of machinery in their
records at Rs. 40,000 or Rs. 60,000?
.........................................................................................................................................
.........................................................................................................................................
.
.........................................................................................................................................
.........................................................................................................................................
.
.........................................................................................................................................
.
Accrual Concept
The accrual concept makes a distinction between the receipt of cash, and the right to
receive it, and the payment of cash and the legal obligation to pay it. In actual
business operations, the obligation to pay and the actual movement of cash may not
coincide. The accrual concept recognises this distinction. In connection with the sale
of goods, revenue may be received (i)before the right to receive arises, or (ii) after the
right to receive has been created. The accrual concept provides a guideline to the
accountant as to how s/he should treat the cash receipt and the rights related thereto.
In the former case the receipt will not be recognised as the revenue of the period for
the reason that the right to receive the same has not yet arisen. In the latter case the
revenue will be recognised even though the amount is received in the subsequent
period.

Similar treatment would be given to expenses incurred by the firm. Cash payments
for expenses may be made before or after they are due for payment. Only those sums
which are due and payable would be treated as expenses. If a payment is made in
advance (i.e., it does not belong to the accounting period in question) it will not be
treated as an expense, and the person who received the cash will be treated as a
debtor until his right to receive the cash has matured. Where an expense has been
incurred during the accounting period, but no payment has been made, the expense
must be recorded and the person to whom the payment should have been made is
shown as a creditor.

& Check Your Progress 7
The accounting year of a firm closes on 31st December each year. The rent for
business premises of Rs. 50,000 for the last quarter could not be paid to the owner on
account of his being away in a foreign country. Should the rent payable be taken into
account for computing the firms income for the accounting year?
.........................................................................................................................................
.
.........................................................................................................................................
.
.........................................................................................................................................
.
26


Accounting and its
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Accounting Concepts and
Standards
.........................................................................................................................................
.
.........................................................................................................................................
.
.........................................................................................................................................
.
.........................................................................................................................................
.
& Check Your Progress 8
A government contractor supplies stationery to various government offices. Some
bills amounting to Rs.10,000 were still pending with various offices at the close of
the accounting year on 31st March. Should the businessman take the revenue of
Rs.10,000 into account for computing the net profit of the period?
.........................................................................................................................................
.
.........................................................................................................................................
.
.........................................................................................................................................
.
.........................................................................................................................................
.
.........................................................................................................................................
.
.........................................................................................................................................
.
.........................................................................................................................................
.
The Concept of Conservatism
The concept of conservatism, also known as the concept of prudence, is often stated
as anticipate no profit, provide for all possible losses. This means an accountant
should follow a cautious approach. Facing a choice, he should record the lowest
possible value for assets and revenues, and the highest possible value for liabilities
and expenses. According to this concept, revenues or gains should be recognised only
when they are realised in the form of cash or assets (usually legally enforceable
debts) the ultimate cash realisation of which can be assessed with reasonable
certainty. Further, provision must be made for all known liabilities, expenses, and
losses whether the amount of these is known with certainty, or is at best an estimate
in the light of the information available. Probable losses in respect of all
contingencies should also be provided for. A contingency is a condition, or a
situation, the ultimate outcome of whichgain or losscannot be determined
accurately at present. It will be known only after the event has occurred (or has not
occurred). For example, a customer has filed a suit for damage against the company
in a court of law. Whether the judgement will be favourable or unfavourable to the
company cannot be determined for sure. Hence, it will be prudent to provide for
likely loss in the financial statements. As a consequence of the application of this
concept, net assets and incomes are more likely to be understated than overstated.

27

Accounting System
Based on this concept is the widely advocated practice of valuing inventory (stock of
goods left unsold) at cost or market price, whichever is lower. You will note that this
convention, in a way, modifies the earlier cost concept. It should be stated that the
logic of this convention has been under stress recently; it has been challenged by
many writers on the ground that it stands in the way of fair determination of profit,
and the disclosure of true and fair financial position of the business enterprise. The
concept is not applied as strongly today as it used to be in the past. In any case,
conservatism must be applied rationally as over-conservatism may result in
misrepresentation.

& Check Your Progress 9
A company is negotiating to get an order for Rs.5 lakhs from XYZ company. It is
confident to get an order and as a result, it shows this order as a part of its sales
revenue. Will you approve such an accounting treatment of probable order to be
obtained in future?
.........................................................................................................................................
.........................................................................................................................................
.
.........................................................................................................................................
.............................................................................................
.
.
.

Materiality Concept
There are many events in business which are trivial or insignificant in nature. The
cost of recording and reporting such events will not be justified by the usefulness of
the information derived. The materiality concept holds that items of small
significance need not be given strict theoretically correct treatment. For example, a
paper stapler costing Rs. 30 may last for three years. However, the effort involved in
allocating its cost over the three-year period is not worth the benefit than can be
derived from this operation. Since the item obviously is immaterial when related to
overall operations, the cost incurred on it may be treated as the expense of the period
in which it is acquired. Some of the stationery purchased for office use in any
accounting period may remain unused at the end of that period. In accounting, the
amount spent on the entire stationery would be treated as an expense of the period in
which the stationery was purchased, notwithstanding the fact that a small part of it
still lies in stock. The value (or cost) of the stationery lying in stock would not be
treated as an asset and carried forward as a resource to the next period. The
accountant would regard the stock lying unused as immaterial. Hence, the entire
amount spent on stationery would be taken as the expense of the period in which such
expense was incurred.
Where to draw the line between material and immaterial events is a matter of
judgement and common sense. There are no hard and fast rules in this respect.
Whether a particular item or occurrence is material or not, should be determined by
considering its relationship to other items and the surrounding circumstances. It is
desirable to establish and follow uniform policies governing such matters.

& Check Your Progress 10
A firm buys an office table for Rs. 800. Though it is, theoretically speaking, an asset
having a life, of more than one year, the firm shows it as an expense of the year, and
reduces the profit for the year. Is this accounting practice justifiable? Give reasons.
28


Accounting and its
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Accounting Concepts and
Standards
.........................................................................................................................................
.........................................................................................................................................
.
.........................................................................................................................................

Consistency Concept
In practice, there are several ways to record an event or a transaction in the books of
account. For example, the trade discount on raw material purchased may be deducted
from the cost of goods and net amount entered in the books, or alternatively trade
discount may be shown as the income with full cost of raw material purchased
entered in the books. Similarly, there are several methods to charge depreciation
(which is a decrease in the value of assets caused by wear and tear, and passage of
time) on an asset, or of valuing inventory. The consistency concept requires that once
a company has decided on one method and has used it for some time, it should
continue to follow the same method or procedure for all subsequent events of the
same character unless it has a sound reason to do otherwise. If for valid reasons the
company makes any departure from the method it has been following so far, then the
effect of the change must be clearly stated in the financial statements in the year of
change.

You will appreciate that much of the utility of accounting information lies in the fact
that one could draw valid conclusions from the comparison of data drawn from
financial statements of one year with data from another year. Comparability is
essential so that trends or differences may be identified and evaluated. Inconsistency
in the application of accounting methods might significantly affect the reported profit
and the financial position. Further, inconsistency also opens the door for
manipulation of reported income and assets. The comparability of financial
information depends largely upon the consistency with which a given class of events
are handled in accounting records year after year.

& Check Your Progress 11

A company had been charging depreciation on a machine at Rs. 10,000 per year for
the first 3 years. Then it began charging Rs. 9,000 for 4th year and Rs. 7,800 for 5th
year and so on. Is this practice justified? Give reasons for your answer.
.........................................................................................................................................
.
.........................................................................................................................................
.
.........................................................................................................................................
.
.........................................................................................................................................
.
.....................................................................................................................................
.
Periodicity Concept
Although the results of the operations of a specific enterprise can be known precisely
only after the business has ceased to operate, its assets have been sold off and
liabilities paid off, the knowledge of the results periodically is also necessary. Those
who are interested in the operating results of a business obviously cannot wait till the
end. The requirements of these parties, therefore, force the accountant to report the

29

Accounting System
changes in the wealth of a firm for some time periods. These time periods in actual
practice vary, though a year is the most common interval as a result of established
business practice, tradition, and government requirements. Some firms adopt the
calendar year, and some others the financial year of the government. But more and
more firms are changing to the natural business year, the end of which is marked by
relatively lower or lowest volume of business activity in the twelve-month period.
The custom of using twelve-month period is applied only for external reporting. The
firms usually adopt a shorter span of interval, say one month or three months, for
internal reporting purposes.

The allocation of long-term costs and the difficulties associated with this process
directly stem from this concept. While matching the earnings and the cost of those
earnings for any accounting period, all the revenues and all the costs relating to the
year in question have to be taken into account irrespective of whether or not they
have been received in cash, or paid in cash. Despite the difficulties that arise in
allocations and adjustments, short-term reports (i.e., yearly reports) are of such
importance to owners, management, creditors, and other interested parties that the
accountant has no option but to resolve such difficulties. Obviously, the utility of the
periodic financial statements outweighs the difficulties.

Some other concepts, e.g., the Matching concept, the Realisation concept and the
Dual Aspect concept are discussed in units 4 and 5, and as such, they have not been
taken up here.

While going through all these concepts, probably you may have developed a feeling
that they sometimes conflict with each other. You are right. We illustrate this by
considering some of these concepts in the context of valuation of business properties.
Suppose a firm acquired a piece of land in 1985 for a price of Rs. 6,00,000. Factory
premises were constructed in 1986, and operations commenced in 1987. The firm has
been successful in achieving the desired profit for the past year. The Balance Sheet (a
statement of assets and liabilities) for the year 2005 is being prepared and Land is
required to be valued. The estimated current market price of this land is Rs.
60,00,000.

Should you recommend that the land be valued at Rs. 60 lakhs? The answer is no,
obviously. Land would be carried on the Balance Sheet at its original cost of
Rs. 6,00,000 only. This decision is supported by several of the concepts discussed in
this section. In the first place, the stability of purchasing power of money implied in
the money measurement concept prevents us from recognising accretion in values
as a result of changing price levels. Then, the realisation concept will not allow
unrealised profits to be included as long as land is held by the company and not sold
away. You may note that the continuity, or going concern concept, makes any
possible market value of land irrelevant for the balance sheet because the firm has to
continue in business, and land will be needed by it for its own use. In this connection,
it could be argued that if land were shown on the balance sheet at its estimated
current market value, the owner might decide to discontinue the business, sell the
land and retire. The principle of objectivity is now introduced into the argument. It
can be easily seen that in a situation like this the cost of acquisition of land at Rs.
6,00,000 in 1985 is the objective fact because it is based on a transaction that actually
took place and this objective evidence is capable of being verified. In contrast, the
estimate of current market value figure may be suspect. It raises many questions. Do
you have a market quotation for an identical plot of land? Has a similar plot of land
been sold recently, and can we pick it up as verifiable evidence of the current market
price? It may be said that even if market price for an identical plot of land is not
available, estimates by an accredited valuer may be accepted as verifiable evidence of
the market price. Further complications may be noticed if buildings and facilities
have been erected on the plot of land. Is it possible to estimate the value of land
without factory buildings and other facilities constructed on it? The answer is a flat
no, and the conservatism concept will then deter you from accepting an estimate of
market value since it cannot be ascertained with reasonable accuracy.
30


Accounting and its
Functions
Accounting Concepts and
Standards

2.4 ACCOUNTING STANDARDS
The basic concepts, discussed in the foregoing paragraphs, are the core elements in
the theory of accounting. These concepts (postulates or conventions), however,
permit a variety of alternative practices to co-exist. As a result, the financial results of
different companies cannot be compared and evaluated unless full information is
available about the accounting methods which have been used. The variety of
accounting practices have made it difficult to compare the financial results of
different companies. Further, the alternative accounting methods have also enabled,
the reporting of different results, even by the same company.

Need for Standards: The information contained in published financial statements is
of particular importance to external users, such as shareholders and investors.
Without such information they would not be able to take the right decisions about
their investments. As in several other countries, Parliament in India specified in the
Companies Act, the type and minimum level of information which companies should
disclose in financial statements. It is the responsibility of the accounting profession to
ensure that the required information is properly presented. It is evident that there
should not be too much discretion to companies and their accountants to present
financial information the way they like. In other words, the information contained in
financial statements should conform to carefully considered standards. Public
confidence in accounting information contained in financial statements will grow if
they are satisfied as to the logic, consistency and fairness of the figures shown
therein. For instance, a company could incur a loss and still pay dividends by
manipulating the loss into a profit. In the long run, this course may have a disastrous
effect on the company and its investors.

You would be better able to appreciate the function of accounting standards by
relating them to the basic purpose of financial statements, which is the
communication of information affecting the allocation of resources. Ideally, such
information should make it possible for investors to evaluate the investment
opportunities offered by different firms and to allocate scarce resource to the most
efficient ones. In theory, this process should result in the capital distribution of
resources within the economy, and should maximise the potential benefit to society.

In this context, unless there are reasonably appropriate standards, neither the purpose
of the individual investor, nor that of the nation as a whole, can be served. The
purpose is likely to be served if the accounting methods used by different firms for
presenting information to investors allow correct comparisons to be made. For
example, they should not permit a company to report profits which result simply from
a change in accounting methods rather than from increase in efficiency. If companies
were free to choose their accounting methods in this way, the consequences might be
that deliberate distortions are introduced, leading eventually to misapplication of
resources in the economy. The relatively less efficient companies will be able to
report fictitious profits, and as a result scarce capital of society will be diverted away
from the more efficient companies which have adopted more strict and consistent
accounting methods.
2.5 THE CHANGING NATURE OF GENERALLY
ACCEPTED ACCOUNTING PRINCIPLES
Generally accepted accounting principles are usually developed by professional
accounting bodies like American Institute of Certified Public Accountants (AICPA)
and Institute of Chartered Accountants of India (ICAI). In developing such principles,
however, the accounting profession has to reflect the realities of social, economic,
legal and political environment in which it operates. Besides academic research,

31

Accounting System
regulatory and tax laws of the government, e.g., Companies Act, 1956, income Tax
Act, 1961, etc., in a large measure, influence the formulation of acceptable
accounting principles. Stock exchanges and other regulatory agencies like the
Securities and Exchange Board of India (SEBI) have laid down rules for disclosure
and the extent of accounting information.

Since the environment, in which business operates, undergoes constant changes as a
result of changes in economic and financial policies of the Government and changes
in the structure of business, continued evaluation of the relevance of generally
accepted accounting principles is required. In this sense, the principles of accounting
are not ever-lasting truths. You will appreciate that it is the development of relevant
accounting principles in tune with the present day needs of the society that would
make it possible for the business enterprises to develop financial statements which
would be acceptable and of value to the end users.

Now, we give you a brief account of the development of standards in the United
Kingdom, the United States of America, India, and other countries.

2.6 ATTEMPTS TOWARDS STANDARDISATION
Standardisation in UK and USA: Though the Institute of Chartered Accountants in
England and Wales began making recommendations since 1942, real progress started
with the establishment of the Accounting Statements Committee (ASC) by the
Institute in 1969 in the wake of public criticism of financial reporting methods which
permitted diverse practices. As a result of diversity in practices some big investors
had suffered heavy losses on their investments in well-known companies. The main
objective of the ASC has been to narrow areas of difference and in the variety in
accounting practices. The procedure used for standardisation is initiated by the issue
of an Exposure Draft on a specific topic for discussion by accountants, and the
public at large. Comments made on exposure draft are taken into consideration when
drawing up a formal statement of the accounting methods for dealing with that
specific topic. The statement is known as a Statement of Standard Accounting
Practice (SSAP). Once the statement of standard accounting practice is adopted by
the accounting profession (the fact that a statement has been issued by the Institute in
itself signifies the acceptance by the profession), any material departure by any
company from the standard practice in presenting its financial reports is to be
disclosed in that report. So far, nineteen statements of standard accounting practice,
in addition to some exposure drafts under consideration, have been issued by the
ASC.

The need for evolving standards in the USA was felt with the establishment of
Securities Exchange Commission (SEC) in 1933. The SEC is the Government agency
that regulates and controls the issuance of, and dealings in, securities of the
companies. A research-oriented organisation called the Accounting Principles Boards
(APB) was formed in 1957 to spell out the fundamental accounting postulates. The
Financial Accounting Standards Board (FASB) was formed in 1973. The FASB
issues statements from time to time, articulating the generally accepted accounting
principles. The constant support given by SEC to FASB pronouncements has given
considerable credibility to its accounting policy statement. The FASB, till 1985, has
issued five statements of concepts and eighty-eight statements of financial accounting
standards.

Standards at International Level: In view of the growth of international trade and
multinational enterprises, the need for standardisation at the international level was
felt. An International Congress of Accountants was organised in Sydney. Australia in
1972 to ensure the desired level of uniformity in accounting practices. Keeping this in
view, the International Accounting Standards Committee (IASC) was formed and
was entrusted with the responsibility of formulating international standards. All the
member countries of IASC resolved to conform to the standards developed by IASC,
32


Accounting and its
Functions
Accounting Concepts and
Standards
or at least to disclose variations from recommended standards. After its formation in
1973, the IASC has issued 40 international accounting statement to date. Another
professional body, the International Federation of Accountants (IFAC) was
established in 1978.

Attempts have also been made in countries in the European Economic Community
(EEC), and in Canada for standardisation of accounting practices regarding disclosure
and consistency of procedures.

2.7 ACCOUNTING STANDARDS IN INDIA
With a view to harmonise varying accounting policies and practices currently in use
in India, the Institute of Chartered Accountants of India (ICAI) formed the
Accounting Standards Board (ASB) in April 1977 which includes representatives
from industry and government. In line with the procedure followed in other countries,
the preliminary drafts prepared by the study groups and approved by ASB are
circulated amongst various external agencies, including the representative bodies of
trade, commerce, and industry. So far, twenty eight standards have been issued by
ASB, a brief description of which is provided in Appendix I to this unit.

The standards are recommendatory in nature in the initial years. They are
recommended for use by companies listed on a recognised stock exchange and other
large commercial, industrial, and business enterprises in the public and private
sectors.
We advise that you read all or at least some of these standards in order to get a feel of
what these standards are all about. What are the policies and procedures of
accounting that these standards aim to standardise and why? Do not worry if you are
unable to understand some of the ideas or expressions contained in the standards.
You may like to come back to these standards after you have been through all the
blocks of this course, in order to have a better grasp of them.

Regarding the position in India, it has been stated that the standards have been
developed without first establishing the essential theoretical framework. Without
such a framework, it has been contended, any accounting standards and principles
developed are likely to lack direction and coherence. This type of shortcoming also
existed in the UK and USA, but then it was recognised and remedied a long time ago.
In the United States, the first task which the FASB undertook was to develop a
conceptual framework project which aimed at defining the objectives of financial
reporting (a sample of which is presented in Appendix II). This was to be followed by
the spelling out of concepts and standards establishing what have been frequently
referred to as generally accepted accounting principles (GAAP). Any attempt to
develop a conceptual framework regarding the objectives of reporting will have to
take into consideration the answers to the following questions:
i) Who are the users of financial reports?
ii) What decisions do these user groups have to take?
iii) What information can be provided that would assist them to take such
decisions?
The objectives, as you have already noted, depend upon the economic, social, legal
and political environment of the country.

At this point it will be useful for you to watch the video programme: Understanding
Financial Statement-Part I.

2.8 SUMMARY

33

Accounting System
Accounting as a field of study in its developmental process has evolved a theoretical
framework consisting of principles or concepts over period of time. These concepts
enjoy a wide measure of support from the accounting profession. That is why they
are known as Generally Accepted Accounting Principles (GAAP) . Several concepts,
and their implications for business and information users, were discussed in this unit.
Since the accounting principles are broad guidelines for general application, they
permit a wide variety of methods and practices. The lack of uniformity in accounting
practice makes it difficult to compare the financial reports of different companies.
Moreover, the multiplicity of accounting practices makes it possible for management
to conceal economic realities by selecting those alternative presentations of financial
result which allow earnings to be manipulated. The financial statements prepared
under such conditions, therefore, may have limited usefulness for several users of
information. This problem has been recognised all over the world and various
professional bodies are engaged in the task of standardising accounting practices.
There is a movement towards consensus building even at the international level. Such
professional bodies, in fact, first look at the practices used by practising accountants
They then try to obtain a refinement of those practices by a process of consensus. It is
in this manner that the theory of accounting is built. In India also, some headway has
been made by establishing twenty eight standards for accounting practice.
2.9 KEY WORDS
Accounting framework includes generally accepted accounting principles (GAAP)
on the basis of which accounting data is processed, analysed, and reported.

Accounting theory is a set of inter-related principles and propositions, which
provide a general framework for accounting practice, and deal with new
developments in the area.

Accrual concept says that an accountant should recognise incomes and expenses
when they have actually accrued, irrespective of whether cash is received or paid.
Consistency concept envisages that accounting information should be prepared on a
consistent basis from period to period, and within periods there should be consistent
treatment of similar items.

Conservatism concept forbids the inclusion of unrealised gains but advocates
provision for possible losses.

Cost Concept states that an asset is to be recorded in books of accounts at a price for,
or at a cost incurred to acquire it.

Entity concept separates the business from owner(s), from the standpoint of
accounting.

Going concern concept refers to the expectation that the organisation will have an
indefinite life. This assumption has an important bearing on how the assets are to be
valued.
Materiality concept admonishes that events of relatively small importance need not
be given a detailed or theoretically correct treatment. They may be ignored for
recording purpose.

Money measurement concept states that all transactions are to be recorded only in
monetary terms and record only those transactions, which can be measured in money
terms. It ignores intangibles like employee loyalty and customer satisfaction, as they
cannot be expressed in money terms. It also assumes records on the basis of a stable
monetary unit.

34


Accounting and its
Functions
Accounting Concepts and
Standards
Objectivity principle requires that only the information based on definite and
verifiable facts are to be recorded.

Periodicity concept divides the life of a business into smaller time periods which are
generally one year, and the accountant is supposed to prepare necessary financial
statements for each time period.

2.10 SELF ASSESSMENT
QUESTIONS/EXERCISES

1. Examine the role of the Entity accounting concepts in the preparation of
financial statements.

2. Is it possible to give a true or a fair view of a companys position using
accounting information?

3. Do you find any of the accounting concepts conflicting with each other? Give
examples.

4. In what way can accounting information help in the proper allocation of
resources?

5. Why should accounting practices be standardised? Explain.

6. What progress has been made in India regarding the standardisation of
accounting practices?

7. Answer whether the following statement are True or False:
a) The materiality concept refers to the state of ignoring small items
from and values accounts.
b) The generally accepted accounting principles ensure a uniform
accounting practice.
c) The conservatism concept leads to the exclusion of all unrealised
profits.
d) Statements of Standard Accounting Practice were formulated by the
Financial Accounting standards Board of USA.
e) The Securities Exchange Commission of USA has played an
important role in evolving the conceptual framework for accounting

8. Conceptual framework of accounting implies:
i) Making entries in the books of accounts
ii) A code of conduct for the accounting profession
iii) General principles for the preparation of accounting information
iv) Planning and control of enterprise operations
v) None of the above.

9. Accounting Standards are statements prescribed by:
i) Law
ii) Government regulatory bodies
iii) Bodies of shareholders
iv) Professional accounting bodies
v) None of the above.

10. Accounting concepts are:
i) Broad assumptions
ii) Methods of presenting financial accounts

35

Accounting System
iii) Bases selected to prepare a specific set of accounts
iv) None of the above.

11. Name the accounting concept violated, in any of the following situations:
a) The Rs, 1,00,000 figure for inventory on a Balance Sheet is the amount for
which it could be sold on the balance sheet date.
b) The Balance Sheet of a retail store which has experienced a gross profit of
40% on sales contains an item of merchandise inventory of Rs.
1,15,00,000: Merchandise inventory (at cost) Rs. 69,00,000.
c) Company M does not charge annual depreciation, preferring instead to
show the entire difference between original cost and proceeds of sale as a
gain or loss in the period when the asset is sold. It has followed this
practice for many years.

Answers to Activities

1. If the separate entity concept is not observed, it becomes difficult to calculate
the profitability of business and ascertain its financial position. It would be
particularly difficult if the owner has several distinct businesses.

2. Proprietary withdrawals reduce the capital of the enterprise unless they are in
lieu of anticipated profits. It is not proper to show them as operating expense.
They are also not admissible as deductions from profits for tax purposes.

3. Yes, because as per the entity concept the business and the proprietor are two
separate entities. If the proprietor contributes some amount towards capital, it
means that the business has a liability to return it to the proprietor.

4. No, the money measurement concept does not permit the recording of such
events. What effect this event will have on the business cannot be objectively
determined.

5. Revaluation violates several concepts like, cost concept, conservatism concept,
and continuity concept. To take credit for an extraordinary gain like this is
normally not considered justified. However, were a substantial gap exists
between the historical cost of a fixed asset and its market value, it has been
observed that the accounting profession has been supporting such revaluations
so that the balance sheet could show a realistic position of the enterprise.

6. As per the cost concept, the company should show the value of machinery in
books of accounts at Rs. 40,000 the price, which is being actually paid.

7. It should be taken into account, otherwise profit will be overstated.

8. It should be taken into account, otherwise profit will be understated.

9. No. Since the order is not actually obtained, the probable sales revenue could
not be recognised as per the conservatism concept.

10. Though the table has a long-term life and as such can be shown as an asset, yet
the materiality concept requires it to be treated as an expense.

11. It violates the consistency concept, unless there is a solid reason for departing
from the earlier practice.

Answer to Self-assessment Questions Exercises

7. a) True b) True c) True d) False e) True.
36


Accounting and its
Functions
Accounting Concepts and
Standards
8. (iii)
9. (iv)
10. (i)
11. (a) Conservatism concept, (b) Cost concept, (c) Periodicity concept.

2.11 FURTHER READINGS
Financial Accounting, Maheshwari, S.N. and S.K. Maheshwari, 2000, Vikas
Publishing House: New Delhi (Chapter 2).

Accounting Principles, Anthony, Robert, N. and J ames Reece, 1987, All India
Traveller Book Seller: New Delhi ( Chapters 1-3).

Accounting, The Basis for Business Decisions, Meigs, Walter, B.and Robert F.
Meigs, 1987, McGraw Hill: New York (Chapter 1).

Accounting Theory, Hendriksen, E. S., 1984, Khosla Publishing House, Delhi
(Chapters 2,3 and 6).

37

Accounting System
Appendix I
Accounting Standards Board

The Institute of Chartered Accountants of India (ICAI) has, so far, issued twenty
eight standards:

Framework for the Preparation and Presentation of Financial Statements

(AS 1) Disclosure of Accounting Policies

(AS 2) Valuation of Inventories

(AS 3) Cash Flow Statements

(AS 4) Contingencies and Events Occurring after the Balance Sheet Date

(AS 5) Net Profit or Loss for the period, Prior Period, and Extraordinary Items and
Changes in Accounting Policies

Announcement Limited Revision to Accounting Standards (AS) 5

(AS 6) Depreciation Accounting

(AS 7) Accounting for Construction Contracts
Revised Accounting Standard (AS) 7, Construction Contracts, 28-05-2002

(AS 8) Accounting for Research and Development

(AS 9) Revenue Recognition

(AS 10) Accounting for Fixed Assets

Announcement Status of certain provisions of AS 10, Accounting for Fixed
Assets, pursuant to the issuance of AS 19, Leases and As 16, Borrowing Costs

(AS 11) Accounting for the Effects and Changes in Foreign Exchange Rates

(AS 11) (Revised 2003). The Effects of Changes in Foreign Exchange Rate
21-02-2003

(AS 12) Accounting for Government Grants

(AS 13) Accounting for Investments

(AS 14) Accounting for Amalgamations

(AS 15) Accounting for Retirement Benefits in the Financial Statement of Employers

(AS 16) On Borrowing Costs

(AS 17) Segment Reporting

Disclosure of corresponding previous year figures in the first year of application of

Accounting Standards (AS) 17, Segment Reporting

Accounting Standard 18, Related Party Disclosures
Applicability of Accounting Standards (AS) 18, Related Party Disclosures
(AS 19) Leases

38


Accounting and its
Functions
Accounting Concepts and
Standards
(AS 20) Earnings Per Share

(AS 21) Consolidated Financial Statements

(AS 22) Accounting for Taxes on Income
Clarification on Accounting Standards (AS) 22, Accounting for Taxes on Income

(AS 23) Accounting for Investments in Associates in Consolidated Financial
Statements

(AS 24) Discontinuing Operations
Announcement Accounting Standards (AS) 24, Discontinuing Operations

(AS 25) Interim Financial Reporting

(AS 26) Intangible Assets

(AS 27) Financial Reporting of Interests in J oint Ventures

(AS 28) Impairment of Assets 30-05-2002

For further details, please visit: http://www.icai.org/resource/o_ac_standard.html

39

Accounting System
Appendix II

Financial Accounting Standards Board (FASB)

Concepts No. 1: Objectives of financial reporting by business enterprises.

The three objectives which are included in concept No. 1 are reproduced below:

1) Financial reporting should provide information that is useful to the present and
potential investors and creditors and other users in making rational investment,
credit and similar decisions. The information should be comprehensible to those
who have a reasonable understanding of business and economic activities and
are willing to study the information with reasonable diligence.

2) Financial reporting should provide information to help present and potential
investors and creditors and other users in assessing the amounts, timing, and
uncertainty of prospective cash receipts from dividends or interest and the
proceeds from the sale, redemption, or maturity of securities or loans. Since
investors and creditors cash flows are related to enterprise cash flows,
financial reporting should provide information to help investors, creditors and
others, assess the amounts, timing, and uncertainty of prospective net cash
inflows to the related enterprise.

3) Financial reporting should provide information about the economic resources of
an enterprise, the claim to those resources (obligations of the enterprise to
transfer resources to other entities and owners equity), and the effects of
transaction, events, and circumstances that change its resources and claims to
those resources.
40
1 Define Accounting and explain its scope. .
' !
2 What are the objectives of Accounting? Name the different parties i nt e~st ed in
accounting information ahd state why they want it.
3 Write notes on :
. a) Advantages of Accounting
b) Branches of Accounting
, c) Accounting Process
'df Types of Accounts
4 Brjefly explain the accounting concepts which guide the accountant at the recording
stage. I
5 +What do you understand by Dual Aspect Concept? Explain its accounting implications.
Note: These: questions will help you to understand the unit better. Try to write
answers for them. But do not submit your answers to the University. These are
for your practice only.
- - - -
UNIT 2 THE ACCOUNTING PROCESS
2.0 Objectives
2.1 Introduction
2.2 Journal
2.2.1 Tv~sactions ReIating to Goods
2.2.2 Receipts and Payments by Chaqucs
2.2.3 'Transactions with the Proprietor
2.2.4 Transactions Relating to Cash Discount
2.2.5 Compound Journal Entry
2.2.6 'Transactions Relating to Bad Dehas
2.3 I ~dger ,
2.3.1 Posting into Ledger
2.3.2 Balancing Ledger Accounts
2.3.3 Significnncc. of Balances
2.4 Trial Balance
2.5 Openidg Entry
2.6 Let Us Sum Up
2.7 Key Words
2.8 Some Useful Books
2.9 Answers to Check Your Progress
2.10 Terminal Questions/Exercises
' After studying this unit you should be able to:
explain what a journal is
8 describe how differen: types of transactions will be recorded in rhe journal
post joumal entries in the concemed ledger accounts
balance a ledger account and cxplain the significance of balances in different types of
accounts
a
prepare a trial balance to test the arithmetical accuracy of recording in the books of
I account
explain what an opening enby is and how it is posted into ledger
2.1 INTRODUCTION
In Unit 1 you learnt that the accounting process involves four stages: (i) recording the
transactions, (ii) classifying-the transactions, (iii) su~nmarising the transactions, and (iv)
interpreting the results. Thus, you are aware that all transactions are recorded first in the
books of original entry viz,, Journal, and then posted into the concerned accounts in the
ledger. You have also learnt the basic accounting concepts to be observed at the recording
"stage and the rules of debit and credit. With the help of these rules we shall discuss in this
unit how various transactions are recorded in the Journal and how they will be posted into
the concemed ledger accounts, We shall also explain how to balance different accounts and
I prepare a Trial Balance in order to test the arithmetical accuracy of the books of account.
2.2 JOURNAL
* .
.Journal is a daily record of business transactions, It is also called a 'Day Book' and is used
for recording all day today transactrons in the order in which they occur. It is a B&k of
prime entry (also called book of original entry) because all transactions are recorded first in.
this book. h e process of recordjnga (ransaction in the journal is called 'Joumalising' and
I the entries made in this book-are. called '~&bhd Eiirries'. The proforma of Journal is given
I in Figure 2.1.
*
I . .
Accounting Fundomentols Flgure 2.1: Journal
The Journal is divided into five columns. The first column is used for writing the date of the .
transaction. It is customary to write the year at the top of the column only once and then in
the next line the month and date are written.
The second column called 'Particulars' column, The names of the two accounts affected by
the transaction are to be recorded in this'column. The name of the account to be debited is
.
written first. The abbreviation 'Dr,' for debit is also written against the name of the account
to be debited. It is written on the same line very close to the L. F. column. In the next line,
the name of the account to be credited is written. It is always preceded by the word 'To'. It
is not necessary to write 'Cr.' against the name of the account to be credited. In the next
line, a brief description of the transaction is also given within brackets. It is called 'Narra-
tion'. After writing the narration a line is drawn in the particulars column to separate one
entry from the other.
A g u n t - 1 Az u n t
The third column L. F. (Ledger Folio) is meant for writing the page number of the ledger
where the concerned account appears. This column is filled at the time of posting into the
ledger. The fourth and the fifth columns are meant for recording the amounts with which the
two accounts have been affected, The amount to be debited is entered in the debit amount
column against the name of the account debited, and the amount to be credited is entered in
the credit amount column against the name of the account credited. Both the amounts will
always beequal.
L. F. Date
Let us take a transaction and see how it will be recorded in the Journal.
Particulars
2.2.1 Transactions Relating to Goods
The term goods refer to articles which are traded by the firm i.e., articles bought for resale.
For example, for a book-seller books are goods, for an electrical store fans and other
electrical items are goods, for a furniture dealer table and chairs are goods. Articles bought
,
for using them in business are not to be treated as goods. They may be fixed assets or
consumables and are to be treated as such in books of account.
Purchased Machinery for Rs.10,000 on May 1,1988
'
In this transaction, the two accounts affected are Machinery Account and Cash Account.
You know both are real accounts. According to rules relating to real accounts, the
Machinery Account is to be debited and the Cash Account is to be credited. The entry will .,
be made in the Journal as follows
/ '
The transactions relating to goods include purchases, sales, purchases returns and sales
returns. Normally, as per rules, when gaods are bought you will debit the Goods Account
and when they are sold you will credit the Goods Account. Similarly, when goods are
returned by your customer you will debit the Goods Account and when you return goods to
the suppliers, you yill credit the Goods Account. In other words, for all transaction relating
to goods you will maiotain only one account viz., Goods Account. But, in practice, five
separate account are maintained, as shown below:
i)
Purchases Account-for recording all purchases of goods
.. .
24.
' ' .- ii)+ Sales Account-for recording all sales of goods
I '
' - '#' .
Date
1988
May I
Glmaginary figure.
Cr.
Amount
Rs.
10,000
Particulars
Machinery Account Dr.
To Cash Account
(Being machinery purchased)
L.F.
22*
Dr.
Amount
Rs.
10,000
iii) Keturns Onwards Accourii or Purchases Returns k~count-for recording goods returned
The Accounting Proces
to suppliers
. iv) Returns Inwards Account or Sales Returns Account-For recording goods returned by
customers
I .
v) Stock Account-for goods in stock (unsold goods) as at the end of the year
Thus, when goods are purchased you will debit the Purchases Account and when they are
sold y ~ u will credit the Sales Account. Similarly, when goods are returned by your
customers you will debit the Returns Inwards Account (or Sales Returns Account) and when
you return goods to the suppliers you will credit Returns Outwards Acwunt (or Purchases
Returns Account). There will be no Goods Account at all. This helps in ascertaining the
amount of purchases and sales more quickly and correctly.
2.2.2 Receipts and Payments by Cheque
You must be aware that most of the.payments in business are made by cheques these days.
This involves the bank where the firm has opened its account. Hence, when payment is
made by cheque, you will credit the Bank Account because bank is the giver. Similarljl,
when payment is received by cheque, the amount will be debited to the Bank Account
because cheque is deposited in the bank who is the receiver.
2.2.3 Transactions with the Proprietor
You have learnt that the business and its proprietor are treated as separate entities. This
implies that separate accounts must be maintained in the ledger for recording transactions
between the proprietor and the business. Usually, two accounts viz., Capital Account and
Drawings Account are maintained for this purpose. Whatever the proprietor brings into the
business is treated as his capital and credited to his Capital Account. Similarly, when he
withdraws cash from the business for his personal use, he is to be debited with the amount
withdrawn by him. Such a debit is given to his Drawings Account. Drawings Account is also
debited when the proprietor takes goods from business for domestic use. Note that the
proprietor can be charged only by the cost of goods taken and not its selling price. In
pr'actice, the cost of such goods are credited to the Purchases Account because it is assumed
that it was purchased for him and should therefore be excluded from the purchases for the
business.
Look at Illustration 1 and study how various transactions are recorded in the Journal.
Illustration 1
Journalise the following transactions in the journal of Krishna.
1988 Rs.
Jan. 1 Commenced business with cash
Paid into Canara'Bank
Goods purchased for cash
Bought furniture and paid by cheque
Bought goods from Anand
Sold gbods for cash
Sold goods to Sunil
Sold goods for cash to Anil
Drew cash for private expenses.
Paid salaries
+;Solution:
JOURNAL
ate' . ( Partiiulars L. F. Dr. I Cr.
Amount I Amount
1988
Cash Account Dr.
'"
( To Capital Account
" 2
R s.
1 0 , ~
(Being c'apital brought in)
Bank Account Dr.
To Cash Accouot
(Being cash deposited into' bank)
- - ----I
Rs. ,
10,000
1
Acco~inting Fundamentals Date
. -
1988
Jan, 4
Particulars
Purchases Account Dr.
To Cash Account
(Being purchases of goods for cash)
,
Furniture Account Dr.
To Bank Account
(Being furniture purchased nnd paid by cheque)
-- -
Purchascll) Account Dr.
To AZ~nd' s Account
(Being goods bought on credit)
Cash Accourit
To Sales Account
(Being goods sold for cash)
Sunil's Account
To Sales Accou~~t
(Being goods sold on credit)
Dr.
Cash Account
To Seles Account
(Being goods sold for cash)
Dr.
Drawings Account
To Cash Account
(Being cash withdrawn for
personal use)
Dr.
S;~luies Account Dr.
To Cash Account
(Beiny payment of snlarics)
Dr.
Amount
-
Rs.
2,000
Note: The following explanations with regard to some transactions will help you to
understand their journal entries,
Jnn, I: The credit has been given to Capital Account because Krishna, the
proprietor of the business, brought cash into the business.
Jan. 2: Cash deposited in Canata Rank implies that a bank accounl has been opened
for the business. Any money deposited in the bank is debited to Bank Account and
any withdrawal frotn the bank is to be credited to Bank Account.
Jan. 4: When goods are purchased you would normally debit Goods Account as
goods come in. But as explained, purchases of goods are debited lo Purchases
Account since no Goods Account is to be maintained.
Jan. 5: Furniture is not goods for this business. It is a fixed asset and hedce debited
to Furniture Account and not the Purchases Account. Since the payment has been
tilade by cheque which leads to withdrawal from the bank, the anlount has been
credited to Bank Account.
Jan, 10: When goods are sold you would nonllally credit the Goods Account as
goods go out. But, as explained earlier, sales of goods are credited to Sales Account
since no Boods Account is to be maintained.
Jan. 29: Any amount withdrawn by the proprietor for personal use is treated as
drawings by the proprietor and hence debited to Drawings Account.
4
2.2.4 Transactions Relating to Cash Discount
There ate two types of discout~ts allowed to customers: (i) trade discount, and ( i i ) cash
di~cbunt, Trade discount is a reduction in selling price allowed at the time of sale. nie
buyer pays only the net price and the recording in books is made for the net amount only.
No entry is made in books for the trade discount. Cash discount, on the other hand, is a
reduction in the net amount due. It is allowed only if the customer makes payment before
the due date. Cash discount must be recorded in the books of account. This is because when
goods were sold to the customer his account was debited with the net amount due. Later,
when he makes the payment and is allowed some cash discount, it must be adjusted in his
personal account so that his account stands cleared.
When cash discount is allowed to the debtor, it is a loss to the business. So, it is debited to
the Discount Allowed Account and credited to the personal account of the debtor. Similarly,
when cash is paid to the creditor (the party from whom goods had been purchased on credit)
he may also allow some cash discount to the business. Such discount will be a gain to the
business. So, it is credited to the Discount Received Account and debited to the personal '
account of the creditor. The entries relating to cash discount will be illustrated under :
Compound Journal Entry (Section 2.2.5).
The Accounting Process
2.2.5 Compound Journal Entry
Someti,mes, two or more transactiuns of the same nature may occur on the same day. In such
2 )
a situation instead of passing a separate entry forteach transaction we may pass a single
journal entry, known as Compound Journal Entry. For example, on May 5, 1988 you sold
goods on credit to Ram for Rs. 600 and to Shyam for Rs. 800. Both of these transactions
took place on the same day (May 5, 1988) and are of the same nature (credit sale of goods).
You can ppss compound entry for both the transactions as follows:
Rs. Rs.
Ram's Account Dr. 500
Shyam's Account Dr. 800
To Sales Account 1,300
(Being goads sold on
credit to them)
A compound Journal entry can also be passed for a transaction which involves more than
two accounts. For example, paid cash to Rarnesh Rs, 950 and he allowed Rs. 50 as discount,
This transaction involves three accounts : (i) Ramesh's Account, (ii) Cash Account, and (iii)
Discount Received Account. As per rules, Ramesh's Account is to be debited with Rs. 1,000
(Rs. 950 for cash and Rs. 50 for discount), Cash Account is to be credited with Rs. 950, and
Discount Received Account is to be credited with Rs. 50. You can pass the following
compound journal entry for this transaction :
Rs. Rs.
Ramesh's Account Dr. 1,000
To Cash Account 950
To Discount Received Account 50
(Being cash paid to him, discount
received RS. 50)
In practice, a compound journal entry is recorded when
i) one account is to be debited and two or more accounts are to be credited, or
ii) two or more accounts are to be debited and one account is to be credited, or
iii) two or more accounts are to be debited and two or more accounts are to be credited.
2.2.6 Transactions Relating to Bad Debts
When a debtor becomes insolvent, the business shall not be able to realise the full amount
due from him. A parf. of it remains unrealized. The unrealised amount is called 'bad debts'.
For example, Rs, 2,000 was due from Kaushal for the goods sold to him on credit. I-Ie
became insolvent and only Rs. 1,200 could be realised from him. The remaining amount of
Rs. 800 will be treated as bad debts. It is a loss to the business and so debited to Bad Debts
Account and credited to the personal account of the debtor. The journal entry for the above
transaction will be:
Rs. Rs.
, Cash Account
Dr. 1,200
Bad Debts Account , Dr. 800
To Kaushal's Account 2,000
(Being Kaushal became
insolvent and only Rs. 1,200
could be recovered) ,
Accouritlng Fundamentals If any amount treated as bad debts is recovered late; on, it shall be a gain to.the business.
Hence, it shall be credited to Bad Debts Recovered Account and debited to Cash Account.
Note that the bad debts so recovered shall not be credited to the personal account of the ,
debtor because his account had already been closed. In the example. given above, suppose
Rs. 800 is recovered from Kaushal later on, the journal entry will be:
::ash Account
Rs.
Dr. 800
Rs.
To Bad Debts Recovered ~c c ount 800
(Being bad debts recovered)
Look at illustration 2 and note how journal entries for transaciions of February 18,25,27
and 29 have been made.
Record the following transactions in the Journal of Sunil Kumar.
1988 Rs.
Feb. 1
,* 2
' 4
" 5
" 6
' 9
" 10
" 12
" 13
" ' 15
" 17
" 18
Commenced business with cash
Paid into Bank
Furniture purchased from Keshav
Goods purchased for cash
Sold gmds to Santosh
Bought goods from Harish
Paid for cartage
Paid for postage
Goods returned by Santosh
Goods returned to Harish
Goods sold for cash
Paid to Keshgv
He alIowed discount
Sold goods t i ~ k a s h -
Received from Santosh .
Allowed hiin discount
Cash drawn for personal use
Paid to Harish by cheque
He, allowed us discount
Paid rent by cheque
Paid salaries
Gkash becomes insolvent and only
Rs. 1500 could be realised from him
An old debt written off as bad in
1987 is recovered
Solution:
Journal '
-rticmlars L.F. ~ r . T--G--
" 2 Bank Alc
To Cash Alc
1988
Feb. 1
(Being cash paid into bank)'
. - --
I
Arnau~~t
--
Rs.
70.000.
. '
40,000
Cash A/c Dr.
To Capital A/c
(Being business commenced with cash)
Amount
Rs.
70,OoQ
~urniture A/c Dr.
To Keshav
(Being furniture bought on credit)
Purchases A/c Dr.
To Cnsli A/c
(Being goods purcliased for cash)
Stuitosh Dr.
To Sales A/c
(Being goods sold on credit)
Purchases A/c Dr.
To I-Iarish
(Being goods purchased on credit)
Cartage A/c
To Cash A/c
(Bcing cartage paid)
Dr.
Postage A/c
To Cash A/c
(Being postage paid)
Dr.
Retun~s Inwards A/c Dr.
To Santosh
(Being goods returned by Santosh)
Harish Dr.
To Returns Outwards A/c
(Being goods returned to Hnrish)
Casli A/c Dr.
To Sales A/c
(Being goods sold for cash)
Kcshav Dr.
To Cnsh A/c
To Discount A/c
(Being cash paid and discount received)
A kush . Dr.
To Sales A/c
(Being goods.sold on credit)
Cash A/c Dr.
Discount A/c , Dr.
To Santosh
(Being cash received and discount allowed)
Drawings A/c Dr.
To Cash A/c
(Being cash withdrawn for personal use)
Harish . Dr.
To Bank A/c
TO Discount A/c
(Being payment made by cheque and
discount received)
Rent A/c Dr,
To Bank A/c
(Being rent paid by cheque)
Salaries A/c Dr.
To Cnsh A/c
(Being salaries paid)
Cash A/c Dr.
Bad Debts A/c Dr.
To Akash
(Being Akash became insolvent and
only Rs. 1,500 could be recovered)
-
Cash A/c Dr.
To Bad Debts Recovered A/c
(Being the amount treated as bad debts
.
in 1987, now recovered)
.---+---. -- -. ---
The Accounting Profess
Accounting Fundamentals
Note: In this illustration you will notice that '
, a) Instead of writing full word ' ~ccount ' its abbreviation 'A/cl has been used
againgt the names of the accounts debited and credited. This is a common
practice. In fact the latest trend is not to write anything, just the name of the
account is enough.
b) The word Account or its abbreviation 'Alc' has not been written against
personal names. This again is a common practice. Writing 'A/cl is confined to
the real and nominal account\ only.
Check Your Progress A
1 What is Journal?
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . L. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . *. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ............
, 2 What is the purpose of writing narration?
. . .
............................ i......iiii,.ii....,i.....ii..iiii..ii.i.i.i.ii...ii.i..........i.i.i...ii.......i....i...i.ii*....i.i.i..i..ii.
3 Name the five accounts which are maintained in lied of Goods Account.
ii) ..................................................................................................................................
iii) .................................................................................................................................
iv) ...................... ... .................................................................................................
v ) .................................... ................................................................................................
-
4 Distinguish between trade discount and cash discount..
. -.!
............................................................................................................................................
5 Indicate the correct alternative in the following cases by putting a tick at the number:
a) Sale of goods to Rakesh for cash should be debited to
i) Rakesh's Account
.
ii) Cash Account
iii) Sales Account
b) Purchase of machinery should be debited to
i) Machinery Account
ii) Goods Account
iii) Equipment Account
c) , Goods returned by Mahesh shopld be debited to
i) Goods Account
ii) Mahesh's Account
iii) Returns Inwards Account
.
d) Wages paid to Ral~im should be debited to
i) Rahim's Account
ii) Wages Account
iii) Repairs Account
e) Loan taken from Vikas should be credited to
i) Vikas's Account
ii) Cash Account
iii) Loan from Vikas Account
f) Cash discount allowed by a creditor should be credited to
i) Creditors Account
ii) Discount Received Account
iii) Allowance Account
g) The amount of bad debts should be debited to
i) Debtor's Account
ii) Bad Debts Account
iii) Discount Account
h) Rupees 500 received from Gopal whose account was previously written off as bad
debts should be credited to
i) Gopal's Account
ii) Bad Debts Account
iii) Bad Debts Recovered Account
2.3 LEDGER
You know that the Journal is just a chronological record of all business transactions. It does
not provide all information regarding a particular item at one place. This makes it difficult to
know the net effect of various transactions affecting a particular item. For example, if you
want to know the amount due to a particular supplier or the amount due from a particular
customer, you will have to go through the whole journal. To overcome lhis difficulty, we
maintain another book called 'Ledger'. In this book we open separate accounts for each item
and all transactions related to a particular item as recorded in journal are posted in the
concerned account. For example, all transactions related to a particular supplier, say Mohan,
are posted to Mohan's Account. Similarly, all cash payments and cash receipts can be posted
to Cash Account. Thus, you will have no problem in knowing the amount due to Mohan or
the balance in Cash Account, and so on. ,
Thus, ledger is a book where all accounts relating to different items are maintained and into
which all journal entries must be posted. In fact, ledger is the principal book of entry which
provides complete information about various transactions relating to all parties and all items
of asset, incomes and expenses. Some persons have even suggested that we should record all
transactions directly into ledger and do away with Journal. But, it is not advisable because in
that case we will not have any date-wise record of the transactions and the details thereof.
Such record is considered necessary for future reference.
You learnt about the 'T' form of an account which divides it into two parts. The left hand
side is called the debit side and the right hand side the credit side. The proper f o m of a
ledger account is gi venh Figure 2.2.
The Accnunting Process
t\ccout11 kt?;: Fundamentals
Figure 2.2 : LEDGER '
Name of the Accopnt
You will notice that both sides of the account have date, particulars, folio and amount
columns. Now, let us see how postings are made into the ledger accounts.
' 2.3.1 Posting into Ledger
The journal entries form the basis for recording in the ledger accounts, and the process of
'
entering transaction in the ledger is called 'Posting'. When a journal entry has to be posted
in the concerned ledger accounts, the following procedure is adopted.
1 ~ v e j journal entry will have to be posted into all those accounts which have been
debited and credited in the journal entry. For example, for cash sales, Cash Account is
debited and Sales Account is credited in the joumal. When this entry is posted in the
ledger, it must be posted in Cash Account as well as in Sales Account.
2 Posting will be made on the debit side of the account which has been debited in the
journal, and the credit side of the account which has been credit@in the journal. In case
of the above example of cash sales, posting will be made on the debit side of Cash
Account, as it has been debited in journal and the credit side of Sales Account, as it had
been credited in the journal.
3 Whether the posting is made on the debit side or the credit side, first of all the date of
the transaction (as given in the journal) will be entered in the date column. The method
of recording the date in the ledger account is the same as in the joumal.
4 While posting on the debit side of an account in the particulars column, we shall write
the name of the account which had been credited in the journal and add the word 'To'
before the name.?irnilarly, while posting on the credit side of an account, we shall write
the name of the account which has been debited in the journal and add the word 'By'
before the name. In case of the above example, we shall write 'To Sales A/c' in the
particulars column on the debit side of Cash Account, and 'By Cash A/c' in the
Particulars Column on the credit side of the Sales Account.
5 The journal entries contain 'narration'. But it is not required in the ledger accounts.
Similarly, there is no need to draw a line between the two entries in an account as is
done in the journal. Note that posting in the ledger account is considered complete only
when both the debit and the credit aspects of all journal entries have been posted.
6 In the folio column, we shall mention the page number of the journal where concerned
journal entry appears. At the same time, the page number of the ledger accounts will be
entered in the 'L, F.' column in the journal so as to complete the cross reference.
7 The amount involved in the journal entry shall be entered in amount columns of both the
accounts.
Now let us take a transaction, joumalise it, and then show how the posting is done in the
ledger. . . .
Purchased machinery for. cash, Rs. 50,000 on April 4,1988: This transaction will appear
in the joumal and the -ledger as undet-: - ..*
f OUHNAL
LEDGER
Date
1988
April 4
Dr.
Dr.
Amount
I
Pnrtlculars L.F
Machinery Account
Cr.
Cr.
Amount
Machinery Alc Dr.
To Cash A/c
(Being machinery phrchased)
- - - -
Dtlts 1 Particulars - I F - I Amount I Date ( Particulars I F I Amount
Cash Account
Rs.
50,000
Date Particulars ( F I Amount 1 Date ( Pnrticulva I P I Amount
Rs.
50,000
2.3,2 Balancing Ledger Accounts
1988
Apr, 4
Whenever one wants to know the net effect of various transactions in a particular account,
wc have to work out its balance, Balance is the difference between the totals of the debit and
the credit side of an account. The process of finding out the balance is known as balnncing,
The procedure for balancing is as follows:
i) Total the two sides of an account.
. i i ) Find out the difference between the totals of the,two sides.
By Machinery A/c
i i i ) Put the difference in the amount column of the side showing less total.
Rb .
50.000
iv) If the difference is entered on the debit side, write against it in the particulars column
'To Balance c/d' (c/d stands for carried down). In case the difference is entered on the
credit side, write against it in the particulars column 'By Balance cld'.
v) Now, total both the sides and you will find that both the totals are equal,
vi) The closing balance (balance c/d) is going to be the opening balance for the subsequent
period, The opening balance is shown on the next date in the account by writing 'To
Balance b/d' (b/d stands for brought down) or 'By Balance b/d' as the case may be.
Note that if the closing balance was on the debit sides, the opening balance would be
shown on the credit side and if the closing balance was shown on the credit side, the
opening balance would be shown on the debit side. In fact, an account is said to have a
debit balwce if its debit side total is bigger and a credit balance if its credit side total is
bigger. Thus, the opening balance is shown according to the nature of the balance i.e.,
the debit balance on the debit side and the credit balance on the credit side.
vii) soittimes the totals of the debit side and the credit side of an account are equal. It
implies that the account has nil balance. In such a situation the account is said to have
closed having no closing and opening balances,
h o k at fllustration 3 and study how various transactions have been recorded in the Journal,
posted into various accounts i n the ledger, and how ledger accoun@ are halnnced.
The Accounting Process
Accounting Fundamentals Illustration 3
Journalise the following transactions, post them into ledger and balance the accouhts.
1987 Rs.
Dec. 1 Anil commenced business with cash
Purchased goods from Prakash
Purchased furniture for cash
Goods sold to Prem
Sold goods to Ramlal
Goods purchased from Ramesh for Cash
Paid wages
Sold goods to Ashok
Ashok returned goods .
Received from Ram La1 in full settlement
Stationery purchased for cash
Goods sold to Arun for cash
Withdrew for personal use
Paid to Prakash
Sold goods to Prem
Received from Prem
Cash sales .
Paid for interest
Received from Ashok
Paid rent
Paid salaries for the month
Prem becomes insolvent and a dividend of 50
paise in the rupee is received.
Solution:
JOURNAL
Date Pnrtlculars I L.. I ~9;u.t I ~ i ! k n t
Putcheses A/c
To Prakash
(Being goods purchased on credit)
To Cash Alc
" 3
1987
Ilec. 1
To Sales A/c
(Being goods sold on cmdit)
Cash A/c Dr.
To Capital A/c
(Being capital brought in)
1 Rs.
1 ,M),oOo
" 5
" 7
To Sales A/c ,
(Being goods sold on credit)
---
Purchases A/c + Dr.
To Cash A/c
(Being goods purchased for
cash)
WagesA/c Dr.
To Cash A/c
(Being wages paid)
Ashok Dr.
To Sales Alc
(Being goods sold on credit)
Returns Inwards AR Dr.
To Ashok
(Being goods returned by him)
--
Cash Alc
Discount A/c
,To Ram La1
(Being cash received in full
settlement of his account)
Dr.
Dr.
Stationery Alc
To Cash A/c
(Being stationery purchased)
Dr.
Cash A/c Dr.
To Sales Alc
(Being goods sold for cash)
Drawings A/c
To Cash A/c
(Being cash withdrawn for
personal use)
Dr.
Pfakash
To Cash A/c
(Being cash paid to Pmkash)
Dr.
Cash A/c
To Prenl
(Being cash received from Prem)
.
23
Cash Alc
To Sales A/c
(Being goods sold for cash)
Prem Dr.
To Sales Alc
(Being goods sold on credit)
27
28
29
Cash Account Dr.
Bad Debts Account Dr.
To Prem
(Being a dividend of 50
paise in a rupee received from Prern)
-
Interest A/c Dr.
To Cash A/c
(Being interest pnid)
Cash A/c Dr.
To Ashok
(Being cash received)
,
Rent A/c Dr.
To Cash A/c
(Being rent paid)
30
The Accounting Process ,
&oc'o
Salaries AIc Dr.
To Cash Alc
Notes:
1 Transaction on December 14: Ram La1 paid Rs, 4,950 in full settlement of Rs, 5,000
due from him on account of the goods sold to him on December 4. It implies that Rs. 50
@s. 5000- Rs. 4,950) was allowed to him as cash discount,
2 Transaction on December 30 : Prem becomes insolvent. The firm could recover only
50 paise in a rupee i.e., 50% of the amount due, Goods worth Rs. 8,000 were sold to him
(Rs. 6,000 on December 3 and Rs. 2,000 on December 23). He paid Rs. 5,000 on
December 25 leaving a balance of Rs, 3,000. Of this, the firm could recover Rs. 1,500
(50% of Rs, 3,000). The remaining amount of Rs. 1,500-has ken treated as bad debts.
' 35
1 (Being salaries paid)
Dr.
1987
Dec. 2
" 5
" 7
" 15
" 20
" 22
" 27
" 29
" 30
" 31
I Rs.
7,000
5,000
100
400
1,1100
20,000
500
2,000
3,000
9 1,450
To capitnl Alc
To Ram Lal
To Sales N c
To Prem
To Salcs Alc
To Ashok
By Furniture Ak
By Purchases A/c
By Wages A/c
by Stationery A/c
By Drn\vitlp A/c
By Prukash
By tn1eres.t AIL'
Ry Rent A/c
By Salaries N c
By Bolarice c/d
Jun. I 1 To Balance bld 1
Purchabes Account
( r - 30,000 Dec. 31 By Balance cld
1988 I
Jan. l I To Balnncc bld
Furniture Account
l u ~ 1 1 To Bvlrnce bld
I I i W l I I I
Returns Idwards Account
1987
bet, 13
1988
Jan. 1
To Ashok
To Balance bld
by Balance c/d
5,w
31 By Cash Nc
By Bad Debts Nc
Sales Account
1987
Dec. 3 1
-
The Accounting Process
By Balancc cld
Rs.
33,000 By 'Prem
By Ram La1
By Ashok
By Cash A/C
By Prem
By Cash A/c
1987
Dec. 3
" 4
" I 1
" 17
" 23
" 26
33,000
By Balance bld
1988
Jnn. 1
Capital Account
Rs.
6,000
5,000
8,000
4,000
2,000
8,000
33,000
1;oo,ooo
1918
Jnn. 1 By Bnlwcc bld
Prakash's Account
Ram Lal's Account
1987.
Dec. 22
" '31
- --
-
TO Cash A/c
To Balance cld
By Purchases A/c
* - - - T - R T T " 5,000 Dec. 14 B y Cash A/c
4,950
By Discount
Rs,
30,000
B y Balance bld
Ashok's Account
Ks.
20,000
10,000
30,000 '
10,000
-
1987
Dec. 2
1988
Jan. I
Discount Allowed Account
1987
Pec. I I
1988
Jan. I
To Sales A/c
To Balance b/d
Rs,
500
7,000
500
W"J0
Rs.
8,000
8,000
500
1987
Dec. 13
" 28
" 31
By Returns
Inwards A/c
By Cash A/c
By Balance C/d
Slation~ry Account
"rh Dec. I5 To Cash A/c
1988
Jan. I To Balance bld
By Balance cld
Drawings Account 1
Dec. 20 To Cash A/c 1,000 Dec. 31
Jan, I To Balance b/d 1 ,000
By Balance cld
Interest Account
i
Rent Account
1
Salaries Account
1987
Dec. 31
Rs.
500
500
1987
Dec. 27
1988
Jan. 1
To Cash A/c
To Balance b/d
1987
Dec. 29
1988
Jan. I
Rs.
-
3,000
By Balance c/d
To Cash A/c
To Balance bld
Rs.
2,000
-
2,000
Bad Debts Account
Rs.
500
1987
Dee. 30
1988
1987
Dec. 31
To Cash A/c
1- 1 31
Rs.
1- 1!5.E
Jan. 1 To Balance bld
By Balance ~ / d
Dec. 30 To Prem
1987 I
1988
Jan. I To Balance b/d
Note: Nominal accounts like Wages Account, Discount Account, Stationery Account, etc. and the accounts
relating to purchases, sales and returns of goods are not to be balanced. As per rules, they are simply
closed by transfer to the Trading and Profit and Loss Account at the time of preparing the final accounts.
In the above illustration, however, they have been balanced for the purpose of preparing the Trial
Balance which is being discussed in the next section,
By Balance c/d
2.3.3 Significance of Balances
Rs.
2
- -
"31
You have learnt that the 'balance' in an account signifies the net effect of all transactions
related to it during a given period. It may be a debit balance or a credit balance or a nil
balance depending upon whether the debit or the credit total is higher. Let us now
understand the significance of a balance in respect of the various types of accounts in the
ledger.
Personal Accounts: Personal accounts are more frequently balanced as compared to any
other class of accounts. Balance in a personal account indicates whether the party concerned
By Balance c/d
owes to thk business or the business is owing to him. When it shows a debit balance, it
The Accounting Process
means that the party owes that amount to the business and he is a debtor to the business.
Similarly, when it shows a credit balance, it would mean that the business owes that amount
to him and he is a creditor of the business. If, however, the account shows a nil balance, it
means that the account has been cleared, nothing is due to him or due from him.
Real Accounts: Real accounts are normally balanced at the end of the accounting period
primarily for the purpose of preparing the final accounts. The Cash Account, however, is
balanced everyday because the actual cash is to be verified and confirmed with the closing
balance shown by Cash Account. All real accounts show a debit balance as these are assets
(property) accounts.
Nominal Accounts: Nominal accounts are not to be balanced. They are simply closed by
transfer to the Trading and Profit aid Loss Accounts, at the time of preparing the final
accounts. However, for the purpose of understanding the procedure involved, nominal
accounts have also been balanced. Even otherwise, the difference between the debit side and
credit side totals have to be worked out for preparing the Trial Balance. Note that the
accounts which relate to expenses or losses will show a debit balance; whereas those reiating
to incomes and gains will have a credit balance. This is because all expenses and losses are
debited and all incomes and gains are credited.
Check Your Progress B
1 State whether each of the following statements is True or False.
i) Ledger is the principal book of entry. . . . . . . . . . . . . . .
ii) Process of joumalising is called posting. . . . . . . . . . . . . . .
iii) Posting will be made on the debit side of the account that
had been debited in the Journal . . . . . . . . . . . . . .
iv) The word 'By' is written before the name of an account in
the particulars column while posting on the credit side
of an account . . . . . . . . . . . . . .
v)
Writing narration is necessary while posting into ledger
accounts ..............
vi) Real accounts always show debit balances . , . . , . . . . . . , , .
2 Why do you balance an account?
I . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . , . , . . . . . . . . . . . , .
............................................................................................................................................
............................................................................................................................................
. ..........,......................................................*.............................,..*...............,..,,,...................
What do you mean by a debit balance of an account?
2.4 TRIAL BALANCE
After posting the journal entries into the ledger and balancing all accounts, we prepare a
statement called Trial Balance. This statement shows the balances of all the accounts which
appear in the ledger. The debit balances are shown in one column and the credit balances in
the other. It is usually prepared just before preparing the final accounts. m e purpose is to
check the arithmetical accuracy of the books of account.
You know that under the Double Entry System for every debit'there is an equal and
corresponding credit. So, the total of debits given to different accounts must be equal to the
Accounting Fundamentals total of credits given to different accounts. Similarly, the total of debit balances in different
accounts must be equal to the total of credit balances in different accounts. Now if the Trid
~ai ance tallies i.e., the total of its debit balances column is equal to the total of its credit
balances column, it would mean that both the aspects of each transaction have been
correctly &corded in the ledger. If, however, the two totals do not tally it implies that some
errors have been committed while posting the transactions into ledger.
There are two methods of preparing the Trial Balance: (i) Totals Method, and (ii) Balances
Method. Under the first method we show the totals of each side of an account in the Trial
Balance. The debit side total of an account is shown h the debit column of the Trial
Balance and the credit side total of the account in the credit column. Under the second
method we show only the balances of each account in the Trial Balance. The second method
is more convenient and commonly used because it eliminates all those accounts which have
nil balance.
Now, let us prepare the Trial Balance from the ledger accounts prepared. Under Illustration
3 you will notice that all the accounts which appear i t 1 the ledger have been included and
their balances entered in the appropriate column. The total of debit balances column in the
Trial Balance is equal to the credit balances column. This means that all postings have been
correctly made i n different ledger accounts.
Trial Balance as on December 31,1987
Cash Account
Capital Account
Furniture Account
Purchases Account
Sales Account
Prakash's Account
Wages Account
Returns Inwards Account
Ashok's Account
Discount Account
Stationery Account
Drawings Account
Interest Account
Rent Account
Salaries Account
Rs.
91,450
7,000
35,000
100
500
500
50
400
1,000
500
2,000
1 3,000
Cr.
Balance
Rs.
1 , ~ , W
33,000
10,000
S. No. L.F. Name of Account
2.5, OPENING ENTRY
Dr.
Balance
16
When an accounting year begins. the previous year's balances in different accounts are
brought forward lo the new books of account. This is done by means of a journal entry-dl
assets accounts are debited and all liabilities accounts (including the proprietor's capital
account) are credited. In case the Capital Account balance is not given, it can be
calculated by deducting the other liabilities from the total assets. This will be clear from
Illustration 4.
Illustration 4
Ashok has the following balances on December 31, 1987: Cash in hand Rs. 5,000, Debtors
Rs, 7,200 (Ramesh Rs. 6,000, Lalwani Rs. 1,200); Stock of goods Rs. 18,800; Machinery
Rs. 8,000, Furniture Rs. 3,000; Creditors Rs. 1,500 (Ravi & Co.) ; Ba* Loan Rs. 3,000.
Pass the opening entry on January 1,1988.
- .
Bad Debts Account
Total
1,500
1,43,OOa 1,43,W
-
Solution :
JOURNAL
' The Accounting ~rqce$s
Date
1988
Jan. 1
Lalwani Dr.
Stock Account Dr.
Machinery Account Dr.
Furniture Account Dr.
To Ravi & Co.
To Bank Loan Account
To Capital Account
(For the balance brought
forward from the previous year)
Particulars
Cash Account Dr.
Ramesl~ Dr.
Posting the Opening Entry into Ledger: The posting of an Opening entry into ledger is
slightly different from the posting of other journal entries. We have to open the accounts for
all items that appear in the opening entry. Then, in the accounts which have.been debited in
opening entry, we shall write 'To Balancb b If' on their debit side, and in the account which
have been credited in the opening entry, we shall write 'By Balance b/f' on their credit side.
The date, folio and amount columns are completed in the usual manner. As a matter of fact,
the accopnts which have been debited and credited through the opening entry merely
represent the closing balances of various personal and real accounts from the previous year.
The ksdng of the opening entry as given in Illustration 4 will be made as follows:
i
Cash Account
L.F.
Ramesh'e Account
Dr.
Amount
Rs.
wJc'
6,000
, Dr. Cr.
lgS8 I
Jan. 1 ToBalance b/f ,
Cr.
Amount
Rs.
1988
Jan. 1
Stock Account
To Balance b/f
1988
Jan. 1
Rs.
5 ,OOO
To Balance b/f
I 1988
Jan. 1 .
1988
Jm:l
Rs.
1,200
To BalanCCb/f
- .
Rs.
18,800
4
..
ToBalana b/f , ,
Rs.
8,000
Ravl & CO.'s Account 1
I
L
- . %
1
Acmunting Fundamentals Furniture Accaunl
Bank Loan Account
I
i
1988
Jan. 1
Rs.
3,000
1988
Jan. I
Capital Account 1
TO 'Balance b/f
By Balance b/f
* ,
-
Rs.
1,500
1988
Jan. 1
2.6 LET US SUM UP
1988
Journal is a book of original entry wherein all business transactions are recorded in n
chronological order. he journd shows the accounts to be debited and those to be credited
in respect of each transaction. The journal does hot provide all information regarding a
particular item at one place. Hence, we maintain another book called Ledger. In ~hi s book
we open separate accounts for each item. An account has two sides, the debit side and the
credit side. When an account is balanced, it shows the net effect of all transactions relating
to that account during a given period, Before preparing a summary in the form of final
accounts, a statement called Trial Balance is prepared to check the arithmetical accuracy of
posting into Ledger. This statement shows the balances of a11the accounts and if the totaI of
debit<.Jalances tally with the total of credit balances it is assumed that the transactions l ~ave
been correctly recorded in the ledger.
By Balance b/f
Rs.
2.7 KEY WORDS
Rs.
3.000
Jan. 1 By Balance b/f 37,500
Bad Debt: The ambunt of d% which is irrecoverable.
Cash Discount: An allowance given by the creditor to the debtor for making prompt
payment of the amount due from him.
Cheque: An instrument used for withrlt,,wing money from the bank.
I
Compound Entry: A journal entry involving more than two accounts. 1
1
Drawings: Amount withdrawn by the proprietor from the business for personal use. .
I
Insolvent: A person who is not in a position to, pay his debts in full and is so declared by
the Court.
Opening Entry: A journal entry passed at the beginning of the year to bring forward the
previous year's assets and liabilities.
Posting: The process of entering transactions into the ledger accounts.
Returns Inwards; Goods returned by customers i.e., sales returns.
Returns Outwards: Goods returned to suppliers i.e., purchase returns.
,
Stock: Goods lying unsold with the business. It also includes unused raw materials and the
stock for semi-finished goods.
Trade Discount: An allowance given by the seller to the buyer on the list price at the time
of sale.
.Good: Articles bought for resale and usually traded by the business unit.
2.8 SOME USEFUL BOOKS
1 Maheshwari, S.N., 1986. Introduction to Accounting, Vikas Publishing House: New
Delhi. (Chapters 3,4)
2 Patil, V.A. and J.S. Korlahalli, 1986. Principles and Practice of Accounting, R. Chand
& Co., New Delhi. (Chapters 4,5)
3 Gupta R.L. and M. Radhaswamy 1986. Advanced Accountancy, Sultan Chand & Sons:
New Delhi. (Chapter 3)
2.9 ANSWERS TO CHECK YOUR PROGRESS
A 3 Purchases Account, $ales Account, Purchases Returns Account, Sales Returns.
Account and Stock Account.
5 (a) ii (b) i , (c) iii (d) ii
(e) iii (0 ii (g) ii (h): iii
B 1 (i) True (ii) False (iii) True
' i: (iv) True (v) False (vi) True
2.10 TERMINAL QUESTIONSlEXERCISES .
\
Questions
1 " Ledger is said to @ the principal book of entry and the transactions can even be .
directly entered into the ledger account." Elaborate on the statement and explain why
Joumal is necessary. t
2 What does balancing an account mean? Explain how an account is balanced?
3 What is the significance of debit and credit balarlce in different types of accounts?
4 What do you pnderstand by opening entry? How is an opening entry posted into the
ledger?
5 What is Trial Balance? Explain how it is prepared?
Exercises
1 Joumalise the following transactions : .
Jan. 1 Mohan commenced business with cash
" 2 Paid into bank
" 3 Purchased goods for cash
" 4 Bought furniture from Karim for cash
" 5 Sold goods for cash
" , 8 Sold goods to Rakesh
" . 10 Paid cartage
"
1 1 Purchased goods from Sunil
" 15 Purchased statiohefy -,
. 9 ,
18 Received commission
Rs.
The Accounting Process
Jan. 20 Received from Rakesh
Allowed him discount
"
25 Returned goods to Sunil
"
28 Paid to SuniI in full settlement
"
30 Paid rent by cheque
" 30 Paid wages
" 3 1 Paid salaries
- :
2 Journalise the following transactions':
1988 Rs.
Jan. 1 Gopal Rao commenced bllsiness with cash 60,000
" 2 Bought a building 20,000
" 4 Purchased furniture from Lalaji on credit 2,000
" 5 Purchased goods for cash 15,000
" 6 Sold goods to Ranga Rao on credit 5 ,000
" 6 Sold goods to Augustine & Co. on credit 8,m
" 8 Purchased goods from Manohar Singh on credit 5 ,000
" 9 Goods returned by Ranga Rao 1 ,000
" 15 Goods returned to Manohar Singh 500
" 17 Purchased goods from Krishna Rao 20,000
" 20 Purchased investments 10,000
" 25 Paid to Manohar Singh 4,500
" 26 Received from Augustine by cheque , 7,000
" 27 Amount drawn for personal use by the proprietor 500
r
400 " 27 Stationery purchased
" 28 Paid to Lalaji in full settlement of his account 1,950
" 30 Salaries paid to clerk 1,200
" ' 30 Electricity charges paid 200
" 31 Ranga Rao became insolvent, Received final
composition of 50 paise in a rupee.
Hint: You can pass a compound journal entry for sales made to Ranga Rao and
Augustine & Co. on January 6, 1988.
3 Far the following transactions, pass journal entries , prepare ledger aecounts and balance
them. .
1987 ' Rs.
Dec. 1 Nagender commenced business with cash ~ , ~ , o c " J
" 2 Bought building 30,000
" 3. Bought machinery .40,000
" 4 Purchased typewriter for cash . 5,008
1
" 6 Purchased stationery 200
" 7 Goods purchased from Mahender 15.000
" 9 Goods sold for cash 10,000
I
" 10 Goads &turned to Mahender 508
" 11 Goods sold to Rameswar 5 . m
" 12 Goods purchased from Mahender for c&h 5 , m
v9
13 Goods rehuned by Rarneswar 1 , m
' 99 14 ' ~eceived fmm Rameswar + 4,000
*
44 " 16 Amount pi d to M&ender ,,; * . 5,000
* 1 1
Dec. 20 Amount drawn for personal use of Nagender
" 22 Telephone bill paid
" 24 Municipal taxes paid
'' 26 Goods sold for cash
" 27 Advertisement expenses paid
" 28 Paid for printing & stationery
" 30 Salaries paid to sales girls
" 3 1 Commission received
The Accounting Process
4 Journalise the following transactions, enter them in the Ledger and prepare the Trial
.Balance.
1988 Rs .
Jan. 1 Siva Prasad started business with 2,50,000
" 2 Bought buildings 1,00,Ooo
" 2 Deposited into bank ' 1,00,000
" 3 Purchased furniture and paid by cheque 50,000
" 4 Purchased stationery 250
" 5 Purchased goods on credit fmm Balaji & Co. 25,000
" 6 Purchased goods on cash 15,000
" 7 Sold goods to Venkateswara & Co. 20,000
" 8 Sold goods on cash 5,000
" 9 Goods returned by Venkateswara & Co. 2,000
" 11 Goods returned to Balaji & Co. . 1,500
" 13 Purchased goods from Vivekananda & Co. 20,000
" 15 Sold goods to Balaji & Co. 10,000
" 16 Repairs paid 2,000
" 18 Goods returned by Balaji & Co. 500
" 20 Paid to Balaji & Co. by cheque 14,000
" 22 Goods returned to Vivekananda & Co. 2,000
" 25 Paid to Vivekananda & Co. 14,000
" 27 Cash received from Venkateswara & Co. 10,000
" 28 Municipal taxes paid 1,000
" 30 Salaries paid 5 ,ooo
" 30 Telepl~one charges paid 450
" 30 Electricity bills'paid 500
(Answer : Total of Trial Balance Rs. 2,92,500)
Note: These questions h d exercises will help you to understand the unit better. Try to *
write answers for them. But do not send your answers to the University. These are
for your practice only.


Prpeaparation and
Analysis of Final Account
Preparation and Analysis of
Final Accounts
UNIT 1 PREPARATION AND ANALYSIS OF
FINAL ACCOUNTS
Structure Page Nos.
1.0 Introduction 5
1.1 Objectives 5
1.2 Trading Account 6
1.2.1 Opening/Closing Stock
1.2.2 Net Purchases
1.2.3 Direct Expenses
1.2.4 Net Sales
1.3 Profit and Loss Account 8
1.4 Difference between Trading and Profit & Loss Account 11
1.5 Balance Sheet 11
1.6 Constructing a Balance Sheet 13
1.7 Classification of Balance Sheets Items 15
1.8 Adjustment Entries 21
1.8.1 Closing Stock
1.8.2 Depreciation
1.8.3 Bad Debts
1.8.4 Provision for Bad and Doubtful Debts
1.8.5 Outstanding Expenses (Assets)
1.8.6 Prepaid Expenses (Assets)
1.8.7 Accrued Income
1.8.8 Income Received in Advance (Liability)
1.9 Summary 26
1.10 Key Words 26
1.11 Solutions/Answers 27
1.12 Further Readings 29

1.0 INTRODUCTION
The primary function of accounting is to accumulate accounting data in order to
calculate the profit and loss made by the business firm during and also to understand
the financial position of the business on a given date. A business can ascertain this by
preparing the Final Accounts. Preparation of final accounts from a trial balance is the
final phase of the accounting process. Final accounts include the preparation of
Trading and Profit and Loss Account and the Balance Sheet, although the Balance
Sheet is not an account but only a statement. Trading and Profit and Loss Account is
simply one account which is usually divided into two sections. The first section is
called the Trading Account and the second section the Profit and Loss Account. In
case of manufacturing concerns, Final Accounts also include the Manufacturing
Account.

1.1 OBJECTIVES
After going through this unit, you should be able to:
define Final Account;
understand their objectives and preparation of Trading and Profit and Loss
Account;
conclude the difference between Trading Account and Profit and Loss Account,
Gross Profit and Net Profit;
understand and explain the terms used in a balance sheet;

5



Understanding and Analysis
of Financial Statements
apply simple principles of valuation of assets;
role of depreciation in valuation and determining the proper profit of a firm;
understand Adjustment entries; and
the importance of adjustment entries to ascertain the financial position of a
business firm.

1.2 TRADING ACCOUNT
Trading account is prepared to ascertain the Gross Profit and Loss of a firm, where
Gross Profit is the excess of net revenue over cost of goods sold (the credit side of the
trading account exceeds the debit side). Similarly, Gross Loss is the excess of cost of
goods sold over net revenue (the debit side of the trading account exceeds the credit
side).

Gross Profit = Net Sales Revenue Cost of Goods Sold
Gross Loss = - (Net Sales Revenue Cost of Goods Sold)

Where:

Net Sales Revenue = Cash Sales + Credit Sales Sales Returns

Cost of Goods Sold = Opening Stock + Net Purchases + Direct Expenses Closing
Stock

Net Purchase = Cash Purchases + Credit Purchases Purchases Returns.

Trading Account is generally prepared in T form. In this case, opening stock,
purchases and direct expenses are shown on the debit side and sales and closing stock
on the credit side of the trading account. The format of the Trading Account is
explained along with the format of Profit and Loss Account.

1.2.1 Opening/Closing Stock
The Opening Stock of goods is the stock of goods in hand at the beginning of an
accounting year. This may include stock of raw material, work-in-progress and
fininshed goods. This appears in the debit column of the trial balance. In the Trading
Account this is the first entry on the debit side. The valuation is usually done at cost or
market price which ever is lower. The Stock of goods in hand at the end of accounting
year is called Closing Stock. Similarly, closing stock may include stock of raw
material, work-in-progress and finished goods. The closing stock is shown on the
credit side of the Trading Account. Closing stock is usually not given in the trial
balance but is given by way of additional information.

1.2.2 Net Purchases
These include goods purchased only for production and selling purposes. Goods used
as assets and not- for- sale are not included in this head. Net purchase is the difference
between purchases and the purchase return, where purchase is the sum of cash and
credit purchase. Note that sometimes, purchased return is known as Return Outward.

1.2.3 Direct Expenses
Direct expenses include all those expenses incurred in bringing the goods to the place
of business or trade or in-production process until the goods are placed in a saleable
position. The following expenses may be considered as direct expenses:
6


Prpeaparation and
Analysis of Final Account
Preparation and Analysis of
Final Accounts
1. Wages paid to workers engaged in production are debited to the trading account
provided the manufacturing account is not prepared separately.

2. Carriage/freight inwards are transportation expenses incurred to bring the goods
or raw material to the place of the business or to the firms godown/factory. Such
expenses, whether paid or outstanding, are debited to trading account.

3. Octroi is paid when goods enter municipal limits. Octroi paid on goods purchased
is a direct expense and is debited to trading account.

4. Custom duty paid on importing goods for selling purposes is debited to trading
account. If the duty is paid on sales export, it amounts to selling expenses and is
shown in the profit and loss account.

5. Factory rent, insurance, lighting & power and heating are the expenses
incurred to convert raw material into finished goods. Such expenses are debited to
trading account.

1.2.4 Net Sales
It includes both cash and credit sales of goods. From this figure of total sales, sales
return (also called Returns Inward), if any, is deducted in the inner column and the net
sales amount is shown in the outer column on the credit side of the Trading Account.
Sales of assets are not credited to the Trading Account. It should be noted, if goods
have been sold but not yet dispatched, these should not be shown under sales but are
included in closing stock if the property/ownership in the goods has not passed to the
customer. But if the property/ownership in the goods has passed to the customer
goods sold but not yet dispatched it will not be included in closing stock but will be
treated as sales.

Following is the proforma of the Trading Account:

Trading Account
For the Year Ended
Debit Credit
Particular Rs. Particulars Rs.















Opening Stock:
Raw Material
Work-in-Progress
Finished Goods

Net Purchase:
Purchase
Less: Purchase Returns
Direct Expenses
Direct Material
Direct Labour
Profit & Loss Account
(If Gross Profit)

Net sales:
Sales
Less: Sales Return

Closing Stock:
Raw Material
Work-in-Progress
Finished Goods

Transfer to Profit & Loss
Account
(If Gross Loss)



Illustration 1

Prepare the Trading Account from the following details:

Opening stock Rs.25,000; Purchases Rs. 80,100; Carriage Inward Rs. 12,000; Stock at
the end Rs. 15,000; Carriage Outward Rs. 2,000; Office Rent Rs. 5,000;
Sales Rs. 1,40,000; Sales Return Rs. 2,000; Purchases Return Rs. 100.

7



Understanding and Analysis
of Financial Statements
Solution
Trading Account
For the year ending

Particulars Rs. Particulars Rs.

25,000





80,000

48,000




1,38,000

15,000

1,53,000

1,53,000

Opening Stock:
Raw Material
Work-in-Progress
Finished Goods

Net Purchase:
Purchase 80,100
Less: Purchase Returns 100

Profit & loss Account
(Transferred to)




Net sales:
Sales 1,40,000
Less: Sales Return 2,000

Closing Stock:
Raw Material
Work-in-Progress
Finished Goods





& Check Your Progress 1
1) Prepare the Trading Account from the following figures:

Opening Stock 40,000 Power 6,000
Purchases 1,80,000 Octroi 11,000
Carriage Inward 4,000 Freight 8,000
Wages 42,000 Sales 3,20,000
Return Outwards 7,000 Sales Return 10,000

Closing Stock Rs. 60,000.

2) How is Purchases different from Net Purchases?

3) How are Net Sales different from Sales?

1.3 PROFIT AND LOSS ACCOUNT
Profit and Loss Account is prepared in order to discern whether the firm has made net
profit or suffered net loss for a given accounting period. This account deals with
indirect expenses such as administrative, selling and distribution expenses and the
like. Profit and Loss Account starts where trading account ends; in other words it
starts with gross profit on the credit side brought forward from the trading account. In
case of gross loss brought forward from the trading account, profit and loss account
begins with gross loss as the first item on the debit side.

All the indirect/running expenses, incurred on selling and distribution of the goods
and the general administration of the business, are listed on the debit side while all
the items of income and gain are listed on the credit side. When the credit side
(revenue) exceeds the debit (expenses) side, the difference is net profit. But, if the
debit side exceeds the credit side, the difference is net loss. Profit and loss account is
balanced by transferring net profit to the capital account(s) in the balance sheet and
net profit thus increases the capital; the net loss is deducted from the capital
account(s) in the balance sheet and thus decreases the capital.

The following items are debited in the profit and loss account:

1. Administrative Expenses including Office Salaries, Office Rent, Office Lighting,
Printing, Directors Fees, Telephone Rent, Postage, Insurance, etc.
8


Prpeaparation and
Analysis of Final Account
Preparation and Analysis of
Final Accounts
2. Sales and Distribution Expenses including Salesmens salary, Commission,
Travelling expenses, Advertising, Packing expenses, Royalty, etc.
3. Financial Expenses including Interest on loan/Capital, Cash Discount Allowed,
Bad Debts, Bank Charges, etc.
4. Depreciation of Assets and various provisions.
5. Other Expenses and Losses including Loss on Sales of Fixed Assets, Loss by Fire,
by Theft, by Accident, etc.
6. Taxes including Sales Taxes, Income Taxes etc.

The following items are credited in the Profit and Loss Account:
1. Cash Discount Received
2. Interest Received
3. Rent Received
4. Gain on Sale of Fixed Assets
5. Apprentice Premium
6. Dividend Received.

Note: The household and personal expenses of the proprietor paid by the firm do not
appear in the profit and loss account. Rather these are treated as personal drawings of
the proprietor and are deducted from the capital in the balance sheet.

The Following is the proforma of Trading and Profit & Loss Account:

PROFIT AND LOSS ACCOUNT
For the year ended
Debit Credit

Particulars Rs. Particulars Rs.




























Trading Account
(For Gross Loss)

Indirect / office Running
Expenses
Rent
Lighting
Salaries
Insurance
Sundry /General Expenses
Printing and Stationery
Repair
Advertising
Commission Paid
Cash Discount Allowed
Motor Expenses
Warehouse Rent/ Insurance
Packing Expenses
Depreciation
Provision for Doubtful Debts
Interest on Loan
Loss on Sale etc.

Capital Account
(Transfer of Net Profit)
Total


Trading Account
(For Gross Profit)

Income and Gain
Cash Discount Received
Interest Received
Rent Received
Gain on Sale
Bonus Received
Income on Investment etc.

Capital Account
(Transfer of Net Loss)











Total

Note: 1. Either gross profit or gross loss as opening balance will be reflected.
2. Similarly, the ending balance will also reflect either net profit or net loss.


9



Understanding and Analysis
of Financial Statements
Illustration 2:


The Following figures from trial balance has been extracted from the books of
M/s. Naina Prepare the Trading and Profit & Loss Account for the year ended
31 March 2004.

Debit (Rs.) Credit (Rs.)
Drawings 35,000
Building 60,000
Debtors and Creditors 50,000 80,000
Returns 3,500 2,900
Purchases and Sales 3,00,000 4,65,000
Discount 7,100 5,100
Life Insurance 3,000
Cash 30,000
Stock (Opening) 12,000
Bad Debts 5,000
Reserves for Bad Debts - 17,000
Carriage Inwards 6,200
Wages 27,700
Machinery 8,00,000
Furniture 60,000
Salaries 35,000
Bank Commission 2,000
Bills Receivable/Payable 60,000 40,000
Trade Expenses/Capital 13,500 9,00,000

Adjustment: Stock on 31
st
March 2004 was valued at Rs. 50,000.


Solution
M/s. Naina
Trading and Profit & Loss Account
For the Year Ending on 31
st
March, 2004
Debit Credit
Particulars Rs. Particulars Rs.
12,000


2,97,100
27,700
6,200
1,68,500
5,11,500



4,61,500


50,000

5,11,500
7,100
3,000
35,000
2,000
13,500
5,000
1,25,000
1,68,500
5,100
17,000
To Opening Stock
To Purchases 3,00,000
Less: Return 2,900

To Wages
To Carriage Inward
To Gross Profit



To Discount Paid
To Life Insurance
To Salaries
To Bank Commission
To Trade Expenses
To Bad Debts
To Net Profit

1,90,600
By Sales 4,65,000
Less: Return 3,500



By Closing Stock







By Gross Profit
By Discount Received
By Reserve for Bad Debts


1,90,600


Note: Balance Sheet of this Illustration is given on under topic Balance Sheet
10


Prpeaparation and
Analysis of Final Account
Preparation and Analysis of
Final Accounts
1.4 DIFFERENCE BETWEEN TRADING AND
PROFIT AND LOSS ACCOUNT
1. Trading account is prepared in order to calculate gross profit/loss, while the
function of the profit and loss account is to disclose net profit/loss.

2. Trading account deals with the sales and cost of goods sold which includes direct
expenses. But the profit and loss account deals with indirect expenses such as
administrative and financial expenses and the same is charged against gross profit
and other revenues.

3. The result of the trading account in the form of gross profit/loss is transferred to
profit and loss account while the result of profit and loss account in the net
profit/loss is transferred to capital account.

& Check Your Progress 2
1) List all the items debited or credited in the Profit and Loss account.

2) Explain the difference between Trading Account and Profit & Loss Account.

3) Explain the difference between Gross Profit and Net Profit.

4) Prepare Trading and Profit and Loss Account for the year ended 2005.

Particulars Dr. (Rs.) Cr. (Rs.)
Capital 1,00,000
Building 15,000
Drawing 18,000
Furniture 7,500
Motor Car 25,000
Interest Paid for Loan 900
Loan from Ashok @ 12% 15,000
Purchases and Sales 75,000 1,00,000
Opening Stock 25,000
Establishment Ex. 15,000
Wages 2,000
Insurance 1,000
Commission 7,500
Debtors and Creditors 28,100 10,000
Bank Balance 20,000

Closing Stock Rs. 32,000.

1.5 BALANCE SHEET
Balance sheet is concerned with reporting the financial position of an entity at a
particular point in time. This position is conveyed in terms of listing all the things of
value owned by the entity as also the claims against these things of value i.e.
Liabilities. The position as represented by i.e., Assets. The balance sheet is valid only
until another transaction is carried out by the entity.
The above statement can be elaborated by an example:

I want to purchase a car costing Rs. 8,00,000. To do so, I have to borrow
capital/money. A bank agrees to finance me if I can invests. 3,00,000 on my own.

11



Understanding and Analysis
of Financial Statements
Now let us follow the sequence of events when I approach the bank with the proposal.
Granting my ability to repay the loan, the banker will ask two specific questions:
1. What are the things of value you own?
2. How much do you owe, and to whom?
In other words, the banker would like to know what I am worth in material terms. My
replies to the questions could be tabulated as follows:

Claims against things of value Things of value owned by me
Rs. Rs.
Personal loan from friend 1,00,000 Balance with bank 3,50,000
Fixed deposits 1,50,000
Other personal belongings 5,00,000

1,00,000 10,00,000

This implies I own Rs. 10,00,000 worth things of value, Rs. 3,50,000 of this could be
withdrawn at any time in cash. We say I have Rs. 3,50,000 in liquid form. Another
Rs. 1,50,000 is in monetary investment and the remaining Rs. 5,00,000 is in
non-monetary property. Further, I owe Rs. 1,00,000 to friend of mine. In other words,
he has got a claim against the things of value owned by me to the extent of
Rs. 1,00,000. In brief, we can say I am worth Rs. 10,00,000, claim against my worth
is Rs. 1,00,000 and hence my net worth is Rs. 9,00,000. This implies Rs. 9,00,000 is
my own claims against the things of value owned by me or my net worth.
Now I can present my financial position in the following form:

Financial Position Statement 1

Amount owned by me Things of value owned by me
Rs. Rs.
Personal loan from friend 1,00,000 Balance with bank 3,50,000
Own claim or net worth 9,00,000 Fixed deposits 1,50,000
Other personal belongings 5,00,000

10,00,000 10,00,000


Now that the bank grants me the loan of Rs. 5,00,000 and I buy the car for
Rs.8,00,000. After purchase of the car my financial position statement will change as
follows:
Financial Position Statement 2

Claims against things of value Things of value owned
Rs. Rs.
Personal loan from friend 1,00,000 Balance with bank 50,000
Mortgage loan from bank 5,00,000 Fixed deposit 1,50,000
Own claim or net worth 9,00,000 Car 8,00,000
Other personal belongings 5,00,000

15,00,000 15,00,000


Now, as a result of this transaction my worth has increased from Rs. 10,00,000 to
Rs.15,00,000. However, since there is also an equal increase in claims against my
worth in the form of mortgage loan from the bank, my net worth remains the same.
12


Prpeaparation and
Analysis of Final Account
Preparation and Analysis of
Final Accounts
Things of monetary value possessed by an entity are referred to as assets. Accountants
use the term assets to describe things of value measurable in monetary terms.
The amount owed by an entity or individual which represent claims against it or his
assets by outsiders are liabilities. It is the claims of outsiders which are legally
enforceable claims against an individual or entity that are referred to as liabilities.
The assets owned by the entity, less liabilities or outsiders claims, is the net worth.
Since the net worth represents the claims of owner(s) in case of an entity, it is referred
to as owners equity.
Now we can understand that the financial position statement is a summary of the
assets, liabilities and net worth of a firm at a specific point in time.
1.6 CONSTRUCTING A BALANCE SHEET
Having examined the conceptual basis of the balance sheet we will now try to study
the balance sheet itself. We have seen that every transaction affects the financial
position. Since it is not feasible to draw up a balance sheet after every transaction, it
is prepared at the end of a specified period, usually, a year. This period is referred to
as accounting period or fiscal year or financial year. This period as a convention
has become one calendar year, though, there is no accounting justification for it.
Balance sheet preparation is the arrangement of the assets and liabilities of a firm in a
proper or in a systematic way. The balance sheet as prepared at the end of the
accounting period shows the year-end status of each of the assets of the firm and the
various claims on these assets. We could also say that the balance sheet shows the
year-end balance in the asset, liability and capital accounts. It may be clarified that
there are two conventions of preparing the Balance sheet. The American and the
English. According to the American convention, assets are shown on the left hand side
and the liabilities and the owners equity on the right hand side. The English
convention is just the opposite. i.e., assets are shown on the right hand side of the
Balance Sheet and the liabilities and the owners equity on the left hand side. In India,
generally the English conventions are followed. The format given below is the format
of the balance sheet in the order of liquidity, i.e., ease of conversion of the assets into
cash. The more liquid assets is shown first and then the less liquid one appear on the
pro-forma. Similarly, on the liabilities side, current liabilities in order of payment are
shown first, then fixed or long-term and lastly, the capital of the proprietor.
Balance Sheet as on _________

Liabilities Rs. Assets Rs.
Current Liabilities Current Assets
Creditors Cash in Hand
Bills Payable Cash at Bank
Bank Overdraft Stock-in-Trade
Outstanding Expenses Debtors
Income Received in Advance Bills Receivable
Prepaid Expenses
Fixed Liabilities Fixed Assets
Loan Furniture and Fixtures
Mortgage Plant Machinery
Capital Land
Goodwill


The assets of a business can also be shown in the balance sheet in order of
permanence, i.e., in order of the desire to keep them in use.

13



Understanding and Analysis
of Financial Statements
Balance Sheet as on _________

Liabilities Rs. Assets Rs.

Capital Goodwill
Mortgage Patents and Trade Marks
Bank Overdraft Furniture and Fittings
Outstanding Expenses Plant and Machinery
Income Received in Advance Unexpired Expenses
Creditors Stock-in-Trade
Bills Payable Sundry Debtors
Loan Investments
Bills Receivable
Cash in Bank
Cash in Hand




Now, let us examine how the ideas what we have learnt so far could be used in a
business situation. Please recall that based on the entity principle we shall be dealing
with the business as distinct and separate from the owners. We shall demonstrate
this by means of an illustration. Following is the Balance sheet of the above
mentioned profit and loss account:
M/s. Naina
Balance Sheet as on 31
st
March, 2004
Liabilities Rs. Assets Rs.

Capital 9,00,000 Building 60,000
+ Net profit 1,25,000 Machinery 8,00,000
- Drawings 35,000 9,90,000 Furniture 60,000
Bills Payable 40,000 Debtors 50,000
Creditors 80,000 Stock 50,000
Cash 30,000
Bills Receivable 60,000


11,10,000 11,10,000


The following Accounting Concepts would enable us to evaluate the balance sheet:






The dual aspect principle has particular relevance to balance sheet. As per this
principal, every transaction is related as one which has dual effects and hence, it
is recorded on debit side as well as credit side. Due to this, we ensure the
equality of assets to liabilities and owners equity.

All the figures are expressed in monetary units irrespective of its nature. In our
example we had cash, merchandise inventory and shop premises all expressed in
monetary quantities.

All the transactions we reflected were in respect of only the business entity,
and as such, the balance sheet represents the financial position of the business
entity and not that of the owners.

All the valuations were based on the assumption of a going concern, and not
based on liquidated value. As a consequence, the total value of the assets is
written off over a period through a mechanism known as depreciation.

All the assets were based on historical cost as the basis of valuation.
14


Prpeaparation and
Analysis of Final Account
Preparation and Analysis of
Final Accounts
& Check Your Progress 3
Complete the following blanks:

1) Balance sheet is prepared at the end of a specified period. This period in
accounting is variously referred to as:
a) ___________________________ __________________________
b) ___________________________ __________________________
c) ___________________________ __________________________

2) Balance sheet prepared at the end of an year summarises the balances in:
a) __________________ Accounts b) _________________ Accounts
c) __________________ Accounts.

3) Assets on a balance sheet are usually grouped together as:
a) ___________________assets b) ________________ equipment
c) ___________________assets.

4) Claims against the assets on the balance sheet are summarised as:
a) ___________________ liabilities b) ________________ liabilities
c) ___________________equity.

1.7 CLASSIFICATION OF BALANCE SHEETS
ITEMS
The balance sheet lists assets, liabilities and capital separately. It is an accepted
convention that the assets and liabilities are shown into sub-groups and listed in the
order of their liquidity/Permanence.

The balance sheet in our example/format is presented in the T account form. That is
the assets are listed on one side and liabilities and owners equity on the other.

Another commonly used way of presentation is the report form where liabilities and
capital are listed above the assets. However, the presentation matters very little since
the balance sheet represents the equality between assets, liabilities and capital.

Current Assets

Current assets are assets, which will normally be converted into cash within a year or
within the operating cycle. The operating cycle is the duration in time taken by a unit
to convert raw material into finished goods, plus time to sell it and finally, plus time to
get cash from debtors to whom goods are sold. For example, in a simple trading
operation, we use cash to buy merchandise and sell it to recover cash. The operating
cycle in such a situation will consist of the period for which, merchandise inventory,
and receivables are held. The cycle starts with cash and ends with the collection of
cash. Current Assets are liquid and current liabilities can be met from the realisation
of them.

Cash

Cash is usually taken to include currency (legal tender), cheques or any other
document that circulates as cash. Cash is usually classified as a current asset when it is
available for a firms day-to-day operations . It includes cash kept in the cash chest as
also deposits on call on current accounts with banks. If cash is specifically earmarked
for any purpose and not available for transactions it is better classified as other assets.

15



Understanding and Analysis
of Financial Statements
Accounts Receivable

Accounts receivable are amounts owed to the company by debtors. This is the reason
why we also use the term sundry debtors to denote the amounts owed to the firm.
This represents amounts usually arising out of normal commercial transactions. In
other words, accounts receivable or sundry debtors represent unpaid customer
accounts. In the balance sheet illustration these represent amounts owed to the firm by
customers on the balance sheet date. These are also known as trade receivables, since
they arise out of normal trading transactions. Trade receivables arise directly from
credit sales and as such provide important information for management and outsiders.
In most situations these accounts are unsecured and have only the personal security of
the customer.

It is normal that some of these accounts default and become uncollectable. These
collection losses are called bad debts. It is not possible for the management to know
exactly which accounts and what amount will not be collected. However, based on
past experience, it is possible for the management to estimate the loss on the
receivable or sundry debtors as a whole. Such estimates reduce the gross value of
accounts receivable to their estimated realisable value. For instance:

Accounts Receivable 7,50,000
Less: Estimated collection loss at 10% 75,000

Net realisable value of accounts receivable 6,75,000


The estimated collection loss is variously referred to as provision for doubtful debts,
provision for bad debts or provision for collection losses.

It is a usual practice for debts to be evidenced by formal written promises to pay or
acceptance of an order to pay. These formal documentary debts represent Promissory
Notes, Receivable or Bills Receivable. These instruments used in trade are negotiable
instruments and hence enable the trader to assign any of his/her receivables to another
party or a bank for realising immediate liquidity.

It is also usual for accounts receivables to be pledged or assigned mostly to banks
against short-term credits in the form of cash credits or overdrafts.

Inventory

In a trading firm, inventory is merchandise held for sale to customers in the ordinary
course of business. In case of manufacturing firms, inventory would mainly consist of
materials required to manufacture the products, namely, raw materials, materials
remaining with the factory at various stages of completion i.e., work in process and
goods ready for sale or finished goods. Apart from these there may be inventory of
stores and supplies. Thus we have raw material inventory, work in process inventory,
finished goods inventory and stores and supplies inventory.
It is common to refer to inventory as stock-in-trade and thus we could come across
stock of raw materials, stock of work in process and stock of finished goods.
Inventory is usually valued on the basis of lower of cost or market price. Market
price is taken to mean the cost of replacement either by purchase or by reproduction of
the material in question. As a general principle, inventory cost includes all normal
costs incurred to make the goods available at the place where it can be sold or used
are, treated as costs of inventory.

In trading firms, inventory costs include freight-in, transit insurance costs, import or
entry levies as also the invoice cost. Warehouse costs, handling costs, insurance costs
in storage and interest costs are not included as costs. They are treated as expenses of
a period of the firm.
16


Prpeaparation and
Analysis of Final Account
Preparation and Analysis of
Final Accounts
In case of manufacturing units, the valuation of inventory costs is more complex and
involved. As a general rule all costs of materials, labour and plant facilities used for
manufacturing the goods are included in the valuation of inventory.

In valuing inventory at lower of cost or market price, care should be taken to see that
the valuation does not exceed the realisable value or selling price in the ordinary
course of business.

Prepaid Expenses

In many situations, as a custom, some of the item of expenses are usually paid in
advance such as rent, taxes, subscriptions and insurance. The rationale of including
these prepayments as current assets is that if these prepayments were not made they
would require use of cash during the period.

Fixed Assets

Fixed assets are tangible, relatively long-lived items owned by the business. The
benefit of these assets are available not only in the accounting period in which the cost
is incurred but over several accounting periods. Current assets provide benefits to the
organisation by their exchange into cash. In the case of fixed assets, value addition
arises by facilitating the process of production or trade. In other words, benefits from
fixed assets are indirect rather than direct.

All man made things have limited life. In accounting we are concerned with the useful
life of the assets. Useful life is the period for which a fixed asset could be
economically used. This implies that the benefits from the fixed assets will flow to the
organisation throughout its useful life. Another aspect of this is that the cost incurred
in the period of purchase of the asset will be providing benefits over the useful life of
the asset.

Valuation of the fixed assets is usually made on the basis of original cost. However,
since assets have limited life the cost will be expiring with the expiration of the life.
Thus, valuation of the asset is reduced by an amount proportionate to the expired life
of the asset. Such expired cost is referred to as depreciation in accounting.

Fixed assets normally include assets such as land, building, plant, machinery and
motor vehicles. All these items, with the exception of land, are depreciated. Land is
not subject to depreciation and hence shown separately from other fixed assets.

Intangible and Other Assets

Intangible assets are assets or things of value without physical dimensions. They
cannot be touched, they are incorporeal, representing intrinsic value without material
being. One of the most common of these assets is goodwill. Goodwill reflects the
ability of a firm to earn profits in excess of normal return. Almost all firms may have
some goodwill. However, they appear in the books and balance sheet only when it has
been purchased. Usually, when a going concern is purchased, the purchase price paid
in excess of the fair value of the assets is considered goodwill. The amount is
classified as another asset goodwill on the balance sheet. Like fixed assets, the value
of intangible assets should also be expired over a period of time. Such an expiration
cost is called amortisation, similar to depreciation.

Current Liabilities

We have studied that liabilities are claims of outsiders against the business. In other
words, these are amounts owed by the business to people who have lent money or

17



Understanding and Analysis
of Financial Statements
provided goods or services on credit. If these liabilities are due within an accounting
period or the operating cycle of the business, they are classified as current liabilities.
Most of such liabilities are incurred in the acquisition of materials or services forming
part of the current assets. As was the case with current assets, current liabilities are
also listed in the order of their relative liquidity.

Accounts Payable

Accounts Payable or sundry creditors are usually unsecured debts owed by the firm.
These are also referred to as payables on open accounts. They may not be evidenced
by any formal written acceptance or promise to pay. They represent credit purchase of
goods or services for which payment has not been made as on the date of the balance
sheet.

Accrued Liabilities

Accrued liabilities represent expenses or obligations incurred in the previous
accounting period but the payment for the same will be made in the next period. In
many cases where payments are made periodically, such as wages, rent and similar
items, the last months payment may appear as accrued liabilities (especially if the
practice is to pay the same on the first working day of a month). This obligation
shown on the balance sheet indicates that the firm owed the said amount on the
balance sheet date.

Provisions or Estimated Liabilities

Where the liabilities are known but the amounts cannot be precisely determined, we
estimate the liability and provide for it as a liability. A common example is income
tax payable. Unless the tax liability is determined the amount payable cannot be
accurately determined. There could be other examples too, such as product warranty
expenses to be met and so on. The common practice is to estimate these liabilities
based on past experience and make a provision for the same which is shown as a part
of liabilities.

Contingent Liabilities

Contingent liabilities should be distinguished from estimated liabilities. Estimated
liabilities are known liabilities where the amount is uncertain. Contingent liabilities on
the other hand are not liabilities at the current moment. They may become liabilities
only on the happening of a certain event. In other words, both the amount and the
liability (or obligation) are uncertain till the specified event occurs in future. These
may include items like a claim against the company contested in a court. Only if the
court gives an unfavourable verdict, it becomes a liability. They are not listed as
liabilities in the body of the balance sheet. However, if the firm wishes, it may make
same provision for the same.

Long-Term Liabilities

Long-term liabilities are usually for more than one year. They cover almost all the
outsiders liabilities not included in the current liabilities and provisions. These
liabilities may be unsecured or secured. Security for long-term loans, are usually the
fixed assets owned by the firm assigned to the lender by a pledge or mortgage. All
details such as interest rate, repayment commitment and nature of security are
disclosed in the balance sheet. Usually, such long-term liabilities include debentures
and bonds, borrowings from financial institutions and banks.

18


Prpeaparation and
Analysis of Final Account
Preparation and Analysis of
Final Accounts
Capital

We have seen earlier in this unit that the fundamental accounting equality states:
assets = liabilities + owners equity. From the example of balance sheet we can easily
establish this. See Ms. Nainas balance sheet:

Total assets Rs. 1,00,00,000
Total liabilities Rs. 60,00,000
Owners equity Rs. 40,00,000

We also know that the owners equity consists of the contributed capital and the
retained earnings of the firm. Therefore, capital is that part of owners equity which is
contributed by the owners. If Ms. Naina were an individual proprietorship business,
the owners equity will be reflected directly as:

Capital Rs 40,00,000

If M/s. Naina were a partnership firm with four partners W, X, Y and Z all sharing
equally, the capital would be represented as:

Capital Partner W Rs. 10,00,000
Partner X Rs. 10,00,000
Partner Y Rs. 10,00,000
Partner Z Rs. 10,00,000

Total Rs. 40,00,000


Reserves and Surplus

Reserves and surplus or retained earnings normally arise out of profitable operations.
It is a surplus not distributed by the firm as dividends. In other words, these are
profits that are to be retained within the business. When a firm starts its operations it
has no retained earnings. If in the first year it earns say Rs. 10,000 profit and decides
to distribute Rs. 5,000 as dividends, the reserves and surplus at the end of the year will
be Rs. 5,000. During its second year of operation if the firm makes a loss of
Rs. 3,000 then the retained earnings at the end of the year will be Rs. 2,000. Retained
earnings (or reserves and surplus) are in the nature of earned capital for the firm. We
have seen earlier that the dividends are limited to retained earnings. This implies that
at no point in time the original capital of the firm can be distributed as dividend. In
other words, the capital originally contributed is to be maintained intact.

It is possible to allocate profits earned and accumulated as reserves or retained
earnings to be earmarked for specific purposes. The earmarked reserves are not
distributed. Only non-earmarked or free reserves are available for distribution as
dividends.
& Check Your Progress 4
Fill in the blanks:

1) As a convention, items appearing on the balance sheet are listed in the order of
their relative ______________

2) Balance sheet could be presented either in
a) _________________ from, or
b) _____________________________

19



Understanding and Analysis
of Financial Statements
3) Operating cycle is the duration __________________________________

4) Inventories are valued in the balance sheet by applying the principle of
_________________________

5) Accounts receivable are also referred to as ______________________________

6) Expired cost with respect to a fixed asset is referred to as
____________________ expense.

7) Expiration of cost of intangible assets is referred to as
______________________

8) Sundry creditors are also referred to as _________________,
________________

9) We judge an item as a current asset if it is converted into cash during an _______

10) Liquidity refers to nearness of an item to _______________

11) Items classified as current assets are usually listed in the order of their relative
________________

12) The basis of valuation as applied to temporary investment is ________________

13) Asset losses expected out of non-collection of receivables are called __________

14) Formal written/documented debts refer to______________________________

15) Items commonly referred to as inventory include (i) _______, (ii) __________
and (iii) _____________

16) Fixed Assets are valued on the basis of _______________________________

17) Balance sheet is a statement of________________________________________

18) ____________________ represents the owners claim against assets of a
business.

19) _____________________ are claims of outsiders against the business.

20) _____________________________________________ increase owners equity.

21) Amounts owed by a business on account of purchase of inventory are usually
called __________________ or ________________________.

22) Amounts receivable by a firm against credit sales are usually called __________

23) As a general rule all assets are valued at their __________________ to the
business.

24) Owners equity could be understood as comprising two parts: ____________ and
_________________

25) The dual aspect principle ensures an important equality reflected by balance
sheet __________________________

26) All valuations specially those of fixed assets in a balance sheet are based on an
important assumption about the entity as a _____________________________.
20


Prpeaparation and
Analysis of Final Account
Preparation and Analysis of
Final Accounts 1.8 ADJUSTMENT ENTRIES
Accounts are prepared as per accounting concepts, conventions and principles. Since
final accounts are prepared on accrual basis, it becomes necessary to subtract all those
expenses, which are basically paid during the current financial year although
applicable to other accounting period(s). And to add all those expenses, which benefit
the current accounting period either the payment was made or not. Similarly in case of
earnings subtract all those revenue items, received in the current accounting period but
applicable to other accounting period (s). Add all those revenue items, which have
been earned currently but not yet been received. The above stated corrections in the
final account are called Adjustments, which are made with the help of adjusting
entries. Adjustments ensure a proper matching of costs and revenue for obtaining
correct profit or loss for the given accounting period.

Let us see the treatment and impact of some adjustments on final account.

1.8.1 Closing Stock
The value of unsold stock. The stock is valued at cost or market price whichever is
lower. Generally, the closing stock is not given in the trial balance but is given in
adjustments. Closing stock will appear on the credit side of the trading account and
will also appear on the assets side of the balance sheet.

1.8.2 Depreciation
It is the amount charged because of the usage and passage of time. Fixed assets are
used for earning revenue. Therefore, a decrease in their value is considered to be the
operational expenses of business. In order to ascertain true profits and to show the true
value of the assets in the balance sheet, depreciation has to be charged. Depreciation
account is debited while individual asset account is credited and then the profit and
loss account is debited and the while depreciation accounts is credited.

1.8.3 Bad Debts
Bad debts are losses on account of uncollectable debts. When the amount due from
debtors is irrecoverable, it is called bad debts. Bad debts, being loss are closed by
transferring them to the debit side of the profit and loss account. The amount of bad
debts is also deducted from debtors in the balance sheet. If the same appears in the
trial balance, no adjustment entry is needed. In this case, debtors appear at their
adjusted figure.

1.8.4 Provision for Bad and Doubtful Debts
A provision should be made in advance for those debts whose recovery is doubtful
and to writing off bad debts. All enterprises, based on their past experience, create a
provision for doubtful debts to meet such a loss when it happens. This is done for the
purpose of reflecting the debtors in the balance sheet at their true value. Provisions for
bad and doubtful debts appear on the debit side of the profit and loss account and at
the credit side of the provision for bad debts account.

1.8.5 Outstanding Expenses (Liabilities)
Expenses are generally recorded only when they are paid. The failure to record an
unpaid expenses in the accounts results in an understatement of that expense and also
an understatement of a liability. In order to avoid understatement of these expenses
and liabilitie, an adjustment entry is passed by debiting the expense account and,
crediting the personal account of the party to whom such amount is to be paid. If
outstanding expenses appear on the credit side of the trial balance, then they will be
taken to the liability side of the balance sheet.

21



Understanding and Analysis
of Financial Statements
1.8.6 Prepaid Expenses (Assets)
Expenses paid in advance of their use or consumption are known as prepaid expenses.
At the end of the year, a part of the payment remains unconsumed and is treated as an
asset, because its benefit is to be availed of in future. For prepaid expense, the
adjustment entry is made by debiting prepaid expense account and crediting expense
account. If this item appears on the debit side of the trial balance, it will be shown
only on the assets side of the balance sheet. It will not appear in Profit &Loss Account
at all.

1.8.7 Accrued Income (Assets)
Accrued income is an amount earned but not actually received during the accounting
period or till the date of preparation of final accounts for the period concerned. The
first effect of accrued income is to credit the profit and loss account and to show the
same in the assets side of the balance sheet.

1.8.8 Income Received in Advance (Liability)
It is the income received but not earned during the accounting period. In other words,
it is the income for which services are to be rendered in future. This income is
deducted from the concerned income in the credit side of profit and loss account and
is also shown as a liability in the balance sheet.

To see the impact of adjustment entries on the final account (financial condition of
the business firm) lets take the same illustration of Ms. Naina again only including
the some common adjustments in it. And let us check its impact practically by
comparing the transactions of both the illustrations (with or without adjustment
entries).

Revised Illustration 2:

The following figures from the trial balance has been extracted from the books of
M/s. Naina Prepare the Trading and Profit & Loss Account for the year ended
31 March 2004.

Debit (Rs.) Credit (Rs.)
Drawings 35,000
Building 60,000
Debtors and Creditors 50,000 80,000
Returns 3,500 2,900
Purchases and Sales 3,00,000 4,65,000
Discount 7,100 5,100
Life Insurance 3,000
Cash 30,000
Stock (Opening) 12,000
Bad Debts 5,000
Reserves for Bad Debts - 17,000
Carriage Inwards 6,200
Wages 27,700
Machinery 8,00,000
Furniture 60,000
Salaries 35,000
Bank Commission 2,000
Bills Receivable/Payable 60,000 40,000
Trade Expenses/Capital 13,500 9,00,000

Adjustment:
1. Stock on 31
st
March 2004 was valued at Rs. 50,000.
2. Depreciation of building 5%; furniture and machinery is 10% p.a.
3. Trade expenses Rs. 2,500 and wages Rs. 3,500 have not been paid as yet.
22


Prpeaparation and
Analysis of Final Account
Preparation and Analysis of
Final Accounts
4. Allow interest on capital at 5% p.a.
5. Make provision for doubtful debts at 5%.
6. Machinery includes Rs. 2,00,000 of a machinery purchased on 31st December
2003. Wages include Rs. 5,700 spent on the installation of machine.

Solution
M/s. Naina
Trading and Profit & Loss Account
For the year ending on 31
st
March, 2004

Rs.
12,000

2,97,100



25,500
6,200
1,70,700
Rs.

4,61,500


50,000


5,11,500 5,11,500

To Opening Stock
To Purchases 3,00,000
Less: Return 2,900

To Wages 27,700
Less: Installation Charges 5,700
Add: Outstanding 3,500
To Carriage Inward
To Gross Profit c/d




To Discount
To Life Insurance
To Salaries
To Bank Commission
To Trade Expenses 13,500
Add: Outstanding 2,500

To Bad Debts
To Interest on Capital
To Provision for Doubtful Debts
To Depreciation on:
Building
Machine
Furniture



7,100
3,000
35,000
2,000


16,000
5,000
45,000
2,500
3,000
65,143
6,000
3,057

By Sales 4,65,000
Less: Return 3,500


By Closing Stock





By Gross Profit b/d

By Discount Received
By Reserve for Bad and Doubtful
Debts














1,70,700
5,100
17,000

To Net Profit 1,92,800 1,92,800

Ms. Naina
Balance Sheet as on 31
st
March, 2002

Liabilities Rs. Assets Rs.

Capital 9,00,000 Building 60,000
+ Net profit 3,057 Dep. @ 5% 3,000 57,000
+ int. on Capital 45,000
Drawings 35,000 9,13,057 Machinery 8,00,000
+ Wages 5,700
Creditors 80,000 Dep. 65,143 7,40,557
Outstanding Wages 3,500
Bills Payable 40,000 Furniture 60,000
Outstanding Trade Exp. 2,500 Dep. 6,000 54,000

Debtors 50,000
Provision 2,500 47,500

Stock 50,000
Cash 30,000
Bills Receivable 60,000


10,39,057 10,39,057

23



Understanding and Analysis
of Financial Statements

Analyses of the above two Examples

Particular

Illustration 2 Revised Illustration 2
Wages 27,700 25,500
Gross Profit 1,68,500 1,70,700
Trade Expenses 13,500 16,000
Depreciation Nil 74,570
Net Profit 1,11,000 2,630
Building 60,000 57,000
Machinery 8,00,000 7,40,557
Furniture 60,000 54,000
Debtors 50,000 47,500
Capital 9,90,000 9,12,630

The above table is self-explanatory. It shows clearly the importance of adjustment
entries for a business firm and for all concerned parties of the same to ascertain the
correct financial position of the enterprise.

& Check Your Progress 5
1) What is Trading Account? Distinguish between Trial Balance and Profit and Loss
Account

2) Write short note on Final Accounts and Adjustments Entries.


3) What are Adjustments? What is the need of making adjustments while preparing
Final Account?


4) Show the treatment of the following adjustments:

a. Outstanding Expenses
b. Depreciation
c. Bad Debts

5) Prepare the trading account from the following figures of Mr. Deep on 31
st
March
2004.

Opening Stock 34,200
Purchases 1,02,000
Wages 34,500
Returns Outwards 1,740
Power 1,280
Factory Lighting 950
Manufacturing Ex. 9,500
Freight on Purchases 1,860
Sales 2,50,850
Sales Return 3,100

24


Prpeaparation and
Analysis of Final Account
Preparation and Analysis of
Final Accounts
5) The following is the trial balance of Mr. Virat as at 31.03.2005


Debit (Rs.) Credit (Rs.)
Fixed Assets 3,00,000
Debtors 75,000
Opening Stock 2,05,000
Bills Receivables 10,000
12% Investments (1.7.1998) 50,000
Cash in Hand 5,000
Cash in Bank 10,000
Drawings 10,000
Purchases 5,25,000
Sales Return 10,000
Carriage Inwards 5,000
Carriage Outwards 2,000
Rent 3,000
Insurance 3,600
Office Expenses 13,200
Discount Allowed 2,000
Bad Debts 5,000
Interest 2,500
Selling Expenses 15,800
Creditors 1,00,000
Bills Payable 5,600
Loan from Bank 4,000
Sales 6,30,000
Purchase Return 5,000
Discount 1,000

Adjustment:

1. Stock on 31
st
March 2005 was valued at Rs. 42,000.
2. Rent is payable at the rate of Rs. 300 p.m.
3. Insurance premium was paid for the year ending 30
th
June, 2005.
4. Interest on investment is payable half yearly on 30
th
June and 31
st
December.
5. Write off further bad debts Rs. 5000. Also create a provision for doubtful debts
@ 10% on debtors and provision for discount on debtors @ 2%.
6. Create a reserve for discount on creditors @ 2%.
7. Provide for depreciation on fixed assets @ 10%.
Prepare the Trading and Profit and Loss Account for the year ended and Balance
Sheet as on 31
st
March 2005.

6) On 31
st
March 2004 the following trial balance of Sanjeev Tomar was taken out.
Prepare final account for the year after making the following adjustments.


1. Depreciation: 5% of plant and machinery and 10% of fixtures and fittings.
2. Reserve for bad debts 2.5% on Sundry Debtors
3. Insurance unexpired on 31
st
March 2004 Rs. 70
4. Outstanding wages Rs. 800 and Salaries Rs. 350.

25



Understanding and Analysis
of Financial Statements
Trial Balance

Plant and Machinery 55,000
Fixtures and Fittings 1,720
Factory Fuel and Power 542
Office Salaries 3,745
Lighting (Factory) 392
Travelling Expenses 925
Carriage on Sales 960
Cash in Bank 2,245
Sundry Debtors 47,800
Purchases (Adjusted) 66,710
Wages 9,915
Rent and Taxes 1,915
Office Expenses 2,778
Carriage on Purchase 897
Discount 422
Drawings 6820
Stock 1 April 2003 21,725
Manufacturing Expenses 2,680
Sales Return 7,422
Insurance 570
Closing Stock 16,580
Rent Outstancing 150
Sanjeevs Capital 93,230
Sales 1,26,177
Sundry Creditors 22,680
Purchase Return 3,172
Bills Payable 6,422

1.9 SUMMARY
Both the parts, Trading Account and Profit and Loss Account, of Final Account are
interdependent on each other. Gross Profit/loss plays a very special role in the
calculation of net Profit and loss figure. Trading and profit and loss account gives the
true picture of an organisation by showing its revenues and expenses. This account is
normally prepared at the end of the accounting period. Balance Sheet as we have seen
is one of the most important financial statements. It is a periodic summary of the
financial position of the business. It is the statement of assets, liabilities and owners
capital at a particular point in time. This statement in itself does not reveal anything
about the details of the operations of the business. However, a comparison of two
balance sheets could reveal the changes in business position. A realistic understanding
of the operations of the business would require two other statements Cash Flow
Statement and Funds Flow Statement. We shall take them up in subsequent units.

1.10 KEY WORDS
Asset: Anything, tangible or intangible, of monetary value to a business entity;
something which a business entity owns.
Current Assets: All the assets held by a firm with the objective of conversion to cash
within the operating cycle or within one year whichever is longer. Current Assets
include items such as cash, receivables, inventory and prepayments.

26


Prpeaparation and
Analysis of Final Account
Preparation and Analysis of
Final Accounts
Current Liabilities: All those claims against the assets of the firm to be met out of
cash or other current assets within one year or within the operating cycle, whichever is
longer. Usually include items such as accounts payable, tax or other claims payable,
and accrued expenses.

Contingent Liability: A liability which has not been recognised as such by the entity.
It becomes a liability only on the happening of a certain future event. An example
could be the liability which may arise out of a pending lawsuit.

Fixed Asset: Tangible long-lived asset. Usually having a life of more than one year.
Includes items such as land, building, plant, machinery, motor vehicles, furniture and
fixtures.

Intangible Assets: Any long-term assets useful to the business and having no
physical characteristics. Include items such as goodwill, patents, franchises, formation
expenses and copyrights.

Liability: Any amount owed by one person (the debtor) to another (the creditor). In a
balance sheet all those claims against the assets of the entity, other than those of the
owners.

Owners Equity: It is the owners claim against the assets of a business entity. It
could be expressed as total assets of an entity less claims of outsiders or liabilities,
including both contributed capital and retained earnings.

1.11 SOLUTIONS / ANSWERS
Check Your Progress 1
1) Gross Profit Rs. 86,000

2) Net purchase is the difference between purchases and the purchase return

3) Net sales is the difference between sales and the sales return

Check Your Progress 2

4) Gross Profit Rs. 30,000 and Net Profit Rs. 10,600

Check Your Progress 3

1) (a) accounting period (b) fiscal year (c) financial year

2) (a) asset (b) liability (c) capital

3) (a) current (b) property, plant (c) other

4) (a) current (b) long-term (c) shareholders.

Check Your Progress 4

1) Liquidity

2) (a) T account form (b) Report form

3) Is time taken by a unit to convert goods into sales and to collect money from
debtors?
4) Lower of cost or market price

5) Sundry debtors

27



Understanding and Analysis
of Financial Statements
6) Depreciation

7) Amortisation

8) Accounts payable

9) Operating cycle or accounting year

10) Cash

11) Liquidity

12) Lower of cost or market price.

13) Bad debts.

14) Promissory Notes receivable or bills receivable.

15) Raw material (ii) Work-in-Process (iii) Finished goods.

16) Historical cost, less Depreciation.

17) Assets, Liabilities and capital

18) Owners equity

19) Liabilities

20) Profits

21) Accounts payable or sundry creditors

22) Accounts receivable or sundry debtor

23) Original cost

24) Contributed capital and retained earnings

25) Assets = Liabilities + Owners Equity

26) Going concern.

Check Your Progress 5

4) a. Expense Account Dr. (It will go to trading or profit & loss A/c)
To Outstanding Expenses Account
b. Depreciation Account Dr.
To individual Asset Account
Profit and Loss Account Dr.
To Depreciation Account
c. Bad Debts Account Dr.
To Debtors Account

5) Gross Profit Rs. 62,000 and Net Loss Rs. 32,400

6) Gross Profit Rs. 62,000 and Net Loss Rs. 32,400

7) Balance Sheet total Rs. 1,19,366. Net Profit Rs. 2,554, Gross Profit Rs. 18,266.
28


29

Prpeaparation and
Analysis of Final Account
Preparation and Analysis of
Final Accounts 1.12 FURTHER READINGS

1. Financial Accounting, Dr. R.K. Sharma and Dr. R.S. Popli, Kitab Mahal, 2005.

2. Basic Financial Accountinmng, J.R. Monga, Girish Ahuja, Mayur Paperbacks,
2001.

3. Financial Accounting, Horngren C.T. and Harrison, 01/23/2003, Prentice Hall:
New Delhi (Chapter 1).

4. Understanding Financial Statements, Fraser Lyn M. and Aileen Ormiston,
04/10/2003, Prentice Hall: New Delhi (Chapter 2).

5. Basic Accounting Practice, Glantier M. W. E., Underdown B. and A.C. Clark, 1979,
Arnold Hieneman: Vikas Publishing House, New Delhi (Chapter 5, Section 2).

6. Accounting For Management: Text and Cases, Bhattacharya, S. K. and John
Dearden, 1984. (2nd Ed) Vani: New Delhi. (Chapter 3, 10 and 11).

7. Management Accounting, Hingorani, N.L. and A. R. Ramanathan, 1986, Sultan
Chand: New Delhi. (Chapter 3).

57
Construction and Analysis of
Fund Flow and Cash Flow
Statements

UNIT 6 CONSTRUCTION AND ANALYSIS
OF FUND FLOW AND CASH FLOW
STATEMENTS
Objectives
After you have studied this unit, you should be able to:
understand the idea of funds flowing through a business in a dynamic situation
appreciate the role of working capital in the operations of a business



understand the sources and uses of working capital as well as cash during an
accounting period from the financial statements
understand and interpret changes in working capital identifying the causes of
these changes
use the funds flow statement and the cash flow statement as analytical tools.
Structure
6.1 Introduction
6.2 Working Capital and its Need
6.3 Determining Working Capital Requirements
6.4 Sources of Funds
6.5 Uses (Applications ) of Funds
6.6 Factors Affecting Fund Requirements
6.7 Analysing Changes in Working Capital
6.8 Fund Flow Statement
6.9 Importance of Cash and Cash Flow Statement
6.10 Sources and Uses of Cash
6.11 Preparation of Cash Flow Statement
6.12 Summary
6.13 Key Words
6.14 Self Assessment Questions
6.15 Further Readings
6.1 INTRODUCTION
Depending on the user's purpose, the term `funds' may be used differently. Literally,
it means a supply that can be drawn upon. In this sense it is used to mean cash, total
current assets or working capital. We use it here in the sense of working capital
meaning total current assets less current liabilities.
Funds flow is used to refer to changes in or movement of current assets and current
liabilities. This movement is of vital importance in understanding and managing the
operations of a business.
We have seen in the unit dealing with balance sheet that every material transaction
changes the position statement (or Balance Sheet). This in other words implies a
dynamic situation involving continuous movement of resources into the business,


within the business and out of the business. The complexity of these flows increases
with the increasing size and volume of business. Directly or indirectly, all these flow
take place in business through the medium of funds.
58
Understanding
Financial Statements


Funds in the form of cash and cash equivalents, in the right quantity are necessary for
the smooth functioning of any business. The continuous movement of cash within the
business and out of the business could be understood by studying the cash flow
statement.
6.2 WORKING CAPITAL AND ITS NEED
We have earlier defined working capital as total current assets less current liabilities.
This, in other words, means all the assets held by the business with the objective of
conversion into cash (including cash) during an operating cycle of the business. Of
these assets, a part is financed by short-term credits which are to be met during the
operating cycle representing current liabilities. Thus current assets less current
liabilities or working capital implies amount of resources invested in current assets
from sources of finance other than current liabilities. This net amount is also the
amount available for use in the business in the form of fund. Consider the following
example.
Ramsons is a retail outlet dealing in domestic appliances and entertainment electron-
ics equipment, owned by Ram. The investment in the showroom, display counters,'
cash register, furniture, fixtures and so on is Rs. 6,00,000. Ram decides to use straigh
line depreciation at the rate of 10 per cent per annum.
Ramson's estimated sales is Rs. 1,50,000 per month: 50,000 cash sales and
Rs. 1,00,000 on credit to be collected in four equal monthly instalments. All sales are
made at 25 per cent margin on selling price.
Supply and sales constraints would warrant carrying three months sales requirement
in the form of inventory. Similarly, month's cash expense requirements have to be
held in cash balance.
Initial inventory is to be bought for cash and replenishment purchases will receive a
month's credit from suppliers.
Average monthly cash requirements for meeting operating expenses other than
payment for purchases amount to Rs. 26,000. Ram needs to withdraw Rs. 4,000 per
month for his personal needs.
1.
2.
How much working capital will Ramsons require to start operations?
Will he need additional working capital during the first four months? Or will he
have surplus working capital du
r
ing the first four months?
You can instinctively answer these questions by saying that Ramsons needs working
capital to pay for inventory, for expenses and for keeping a safe cash balance. You
can also say that Ramsons will receive funds from operations to meet some of these
requirements. To be more specific, how much money does he require? This could be
done by working out a schedule of cash receipts and cash payments on a monthly
basis. It is also possible for us to prepare proforma monthly profit and loss account
and balance sheet. You can also notice that we have chosen the first four months
consciously since it completes one operating cycle of the business.


RAMSONS: Schedule of Cash Payments
59
Construction and Analysis of
Fund Flow and Cash Flow
Statements

Month Explanation Amount Rs. Total Rs.
January Operating Expenses
Withdrawals
26,000
4,000

30,000
February January Purchases
Operating expenses
Withdrawals
1,12,500
26,000
4,000


1,42,500
March February Purchase
Operating expenses
Withdrawals
1,12,500
26,000
4,000


1,42,500
April March purchases
Operating expenses
Withdrawals
1,12,500
26,000
4,000


1,42,500
RAMSONS: Schedule of Cash Receipts
Month Explanation Amount Rs. Total Rs.
January Cash Sales
Credit Sales of the month-
first installment
50,000

25,000


75,000
February Cash sales
Credit Sales of the month-
first installment
January sales-second installment
50,000
25,000

25,000



1,00,000
March Cash sales
Credit Sales of the month-first instalment
January sales-third instalment
February sales-second instalment

50,000
25,000

25,000

25,000





1,25,000
April Cash sales
Credit Sales of the month-first instalment
January sales-fourth instalment
February sales-third instalment
March sales second instalment

50,000
25,000

25,000

25,000
25,000






1,50,000
Opening balance sheet of Ramsons will be as follows:
RAMSONS: Balance Sheet as of January 1,2003
Assets Rs. Liabilities and
Capital
Rs.
Fixed Assets 6,00,000 Capital 9,67,500
Inventory 3,37,500
Cash 30,000

9,67,500


9,67,500

We have assumed that the entire asset requirements are financed by owner's capital.
Working capital of Ramsons on January 1, 2003 is as follows:
Current Assets: Inventory
Cash
3,37,500
30,000

Total Current Assets 3,67,500
Less: Current Liabilities Nil

Working Capital 3,67,500




RAMSONS: Schedule of Cash Balances
60
Understanding
Financial Statements


January February March April
Opening Balance 30,000 75,000 32,500 15,000
Cash Receipts 75,000 1,00,000 1,25,000 1,50,000
Total Cash available 1,05,000 1,75,000 1,57,500 1,65,000
Less: Cash Payments 30,000 1,42,500 1,42,500 1,42,500

Cash Balance


75,000

32,500

15,000

22,500
RAMSONS: Profit and Loss Account for the Month ending
31
st
January 28
th
February 31
st
March 30
th
April
Sales 1,50,000 1,50,000 1,50,000 1,50,000
Less: Cost
of Sales
1,12,500 1,12,500 1,12,500 1,12,500
Other
Expenses
26,000 26,000 26,000 26,000
Depreciation 5,000 1,43,500 5,000 1,43,500 5,000 1,43,500 5,000 1,43,500

Net Profit:

6,500


6,500

6,500

6,500
RAMSONS: Balance Sheet as at the end of
Assets 31
st
January
2003
28
th
February
2003
31
st
March
2003
30
th
April
2003
Fixed Assets
Less: Depreciation
6,00,000
5,000
6,00,000
10,000
6,00,000
15,000
6,00,000
20,000
Net Fixed Assets 5,95,000 5,90,000 5,85,000 5,80,000
Inventory
Receivables
Cash
3,37500
75,000
75,000
3,37,500
1,25,000
32,500
3,37,500
1,50,00
15,000
3,37,500
1,50,000
22,500
Total Current
Assets
4,87,500 4,95,000 5,02,500 5,10,000
Total Assets 10,82,500 10,85,000 10,87,500 10,90,000
Liabilities and
Capital

Capital
Add: Retained
Earnings
9,67,500
2,500
9,67,500
5,000
9,75,000
1,12,500
9,77,500
1,12,500
Owners Equity
Accounts Payable


9,70,000
1,12,500

10,82,500
9,72,500
1,12,500

10,85,000
9,75,000
1,12,500

10,87,500

9,77,500
1,12,500

10,90,000


RAMSONS: Schedule of Working Capital
61
Construction and Analysis of
Fund Flow and Cash Flow
Statements


31
st
January
2003
28
th
February
2003
31
st
March
2003
30
th
April
2003
Current Assets
Less: Current
Liabilities
4,87,500
1,12,500
4,95,000
1,12,500
5,02,500
1,12,500
5,10,000
1,12,500


3,75,000 3,82,500 3,90,000 3,97,500


Funds From Operations
Net Profit
Add:
Depreciation

6,500
5,000
6,500
5,000
6,500
5,000
6,500
5,000

Total funds
generated from
operations

11,500 11,500 11,500 11,500
Initial Investment (Capital)
Now with the example of Ramsons at hand, it is not difficult for us to understand that
Ramsons have invested the `money to make money'. Where has Ramsons invested
the money? It is easy to answer this question because the balance sheet of the
business tells us what all things Ramsons has done with the money. Refer to the first
balance sheet and you will find Ramsons has fixed assets (show room and facilities),
inventory (goods or merchandise) which he has purchsed for resale and some cash for
meeting expenses and personal needs. This is how Ramsons have invested the capital
to start with. Let us first review these items and accounts receivable:
Cash
It is difficult to perceive cash kept in the vault as an investment. Rather, you would
be thinking that if we invest cash, then how can cash itself be an investment? But you
will realise that a certain minimum amount of cash is necessary for any business.
Take a simple case: if you are a retailer, will you send away a customer who does not
have exact change? However, you can entertain him only if you keel) change. That is
your investment in cash; Similarly, you will have to pay your employees and
suppliers at a specific time. I n order to do that you need cash. Thus investment in
cash is that amount which is required to be kept on hand to meet day-to-day
requirements of cash. This amount is determined after taking into account the
regularity and amounts of inflows of cash, the amount and frequency of outflows, as
also the uncertaintues related to these. Obviously, as your business grows the need
for cash will also grow.
Receivables
In most situations it will be necessary to grant credit to customers. This may be
necessary either because of competition or because of the custom of trade. However,
when we grant credit to customers it implies that we have to finance the cost of
materials for the duration of such credit. In other words, you are financing your
customers' business to the extent of the credit granted. Whenever the business is
expanding, the volume of receivables will also expand. Please note that the need for
financing receivable is not to the full extent of the accounts receivables (sales). You
are actually financing only to the extent of cost of goods sold out of the receivables
(sales) in question.


Inventory, Supplies and Prepaid Expenses
62
Understanding
Financial Statements


You can well appreciate the need for carrying inventory. In order to carry on
operations unhindered we need to have sufficient amount of merchandise on hand
The quantum we have to keep in store will be determined by the availability and
regularity of supply, lead time for delivery and so on. All the same we should carry
some inventory in any case. Similar is the case with non-merchandise inventory such
as office and factory supplies. We have to carry a minimum stock of these to ensure
smooth operations. We also know that there are several expenses which are to be' Lid
before we actually use the services, such as rent, insurance and so on. In other words
we invest your money in these items of assets in order to ensure smooth operations
6.3 DETERMINING WORKING CAPITAL
REQUIREMENTS
Understanding the existing capital needs and how these are financed will help us in
understanding the process of financing of business and the flow of funds within the
business. The first question we have to answer is how much working capital is
needed to start the operation. We could determine the amount of capital required and
compare the same with existing capital to see whether it is sufficient and whether
there is any excess available for future use. Please note that we are not applying
precise techniques of cash management or liquidity planning since that is beyond
the scope of this unit.
We know from Ramsons that operating requirements of the business requires one
month's cash expenses other than payment for creditors to be kept in cash. That is a
minimum of Rs. 30,000 cash on hand is required by Ramsons (including Rs. 4,000
his withdrawal).
Ramsons have to keep three months sales in inventory. This means that during the
first month he starts with three months' sales in the form of inventory. We know that
the sales per month is Rs. 1,50,000 sold at a mark up of 25 per cent on sales.
Therefore, inventory required to be maintained is three times of 75 per cent of sales.
That is, 1,50,000 x .75 x

3 = Rs. 3,37,500
Similarly, we know from the information available that every month one-third of the
sales are made on cash and two-thirds on credit to be collected in four instalments.
This means, cash collection during the month will be cash sales plus one-fourth of
credit sales of the period and one-fourth of three previous months' credit sales.
Similarly, in the first month we will be really making one half of the sales for cash
and the other half of on credit. In our example.
Total Sales Rs. 1,50,000
Cash Sales Rs. 50,000
Credit Sales Rs. 1,00,000
First Instalment in Cash Rs.25,000
Total Cash Collection Rs. 75,000
Credit period of the sales will be as follows:
First month sales on credit less first instalment Rs. 75,000.
This means.
Rs. 75,000 credit for one month
Rs. 50,000 credit for one month
Rs. 25 000 credit for one month


This is equivalent to Rs. 75,000 sales made for two months' credit. In terms of
working capital requirement, we require one month's financing of the cost of sales
with respect to Rs. 1,50,000 sales. That is Rs. 1,12,500 is needed for financing this
amount.
63
Construction and Analysis of
Fund Flow and Cash Flow
Statements

Thus, we could summarise Ramson's need for funds for financing current asset to
start operations, as follows:
Rs
3 months' inventory 3,37,500
One month's expenses as cash 30,000
3,67,500
During the first month Ramsons will sell one-third of the inventory generating Rs.
75,000 in cash and the other half of Rs. 75,000 to be collected in three instalments.
Thus we need some additional funds to finance our granting credit to the customers.
Similarly, we would need to replenish the inventory and make payments for
expenses. We shall examine these with the help of the balance sheet and profit and
loss account of Ramsons for the first four months.
6.4 SOURCES OF FUNDS
We have seen that working capital is required to finance that portion of current assets
which is not financed by current liabilities. We also saw that the investments
represented by current assets are converted into cash during the operating cycle. This
implies that our need for financing is for one such cycle. Under normal circumstances
every unit of investment in working capital is converted into cash at the end of the
cycle at an added value, to the extent of profits.
When we are looking at the possible sources of working capital the most important
source is this `internal generation'. The very idea of internal sources implies that there
is something `external'.
Activity 6.1
1. Please put down what these `internal' and `external' sources are:
....................................................................................................................................
....................................................................................................................................
....................................................................................................................................
....................................................................................................................................
....................................................................................................................................
Internal Sources
When we are looking for sources funds it is but natural to start searching at home.
What do we have? While examining the need for working capital we could also make
an assessment as to whether the existing working capital is sufficient or not. Thus,
the first internal source is any excess working capital that we might be having.
If we have any non-current assets which do not have any use they could be disposed
off, thereby generating additional working capital. Please note that this is not a
regular and continuing source of funds.
We have seen earlier that every profitable sale brings with it funds in excess of what
was expended on the goods sold. In other words, profits generated by the business
contribute towards additional working capital. But you may also notice that whenever


64
Understanding
Financial Statements


1.
2.
3.
we measure profits, we match the revenue against all expenses relating to the
revenue, whether it involves use of funds in the current period or not. Thus the profits
measured do not reflect the actual amount of funds available in order to assess t e
actual funds generated from current operations we should add back to the profits: all
those items of expenses not involving use of funds during the current period. One
major example of such an item is depreciation.
Thus we could summarise the important possible sources of funds as:
Funds generated from operations. That is, profit plus depreciation and o ter
amortisations.
Sale of non-current assets
Any surplus working capital. Did you guess correctly?
Funds from Operations
Refer to Illustration-6.1. The profit and loss account of TIL shows that operations
have provided gross addition of Rs. 360 million to funds during the period. These
funds represent the sale proceeds of goods and services by the company.
We also know what part of these funds is utilised for meeting the cost of input such
as material, personnel and other operating costs. Apart from these we have also to me
t the interest commitments and costs expiration of the machinery and equipment.
However, expiration of costs of the machinery and equipment (Depreciation) is one
item which does not require use of funds in the current period.
TOOLS INDIA LTD.
Summarised Profit and Loss Account
For the year ended December 31, 2002
(Rs. Million)

Sales
Other Income*

Rs.
350
10

Cost of goods sold
360
150

Gross Profit
Profit expenses:
Personal
Depreciation and Amortisation
Other Expenses




60.00
11.90
13.10

210



85
Operating Profits
Less: Interest Expense
125
15

Net Profit before income taxes
Less Provisions for taxes


110
55

Net Profit
Less: Dividends


55
20

Net Profit Retained


Rs. 35
* Other income includes Rs. 1 million profit on sale of furniture.


Thus the funds
'
provided from the operations are in fact the revenues earned from
operations (as also non-operating incomes) less all immediate costs of goods sold
requiring use of funds. In other words, it is net income or profit after taxes plus all the
non-cash expenses, such as depreciation and amortisation.
65
Construction and Analysis of
Fund Flow and Cash Flow
Statements

The funds flow statement would show funds from operations of TIL as follows:
(Rs. in Million)
Operations
Net Income
55
Add: Depreciation and Amortisation 11.90
66.90
Less: Profit on sale of furniture 1.00
65.90 Total funds provided form operations
External Sources
External sources of funds are resources raised from outside the organisation to
augment funds availability for any of the uses to be discussed later. Normally, there
are only two ways of doing this:
1.
2.
By contributing or raising additional capital, and
By increased long-term borrowing.
Please note that short-term creditors are not included as a source of funds since we
have already defined funds as "current assets less current liabilities". Thus, working
capital represents long-term investment in current assets and hence short-term
borrowing will not increase working capital.
The sources of funds, as usually presented in the fund flow statement, are enumerated
below:
Sources of Funds
Operations:
Net Profit after taxes
Add: Depreciation
Other amortisations
Funds provided by operations








New issue of share capital
New issue of debentures/bonds
Additional long-term borrowing
Sale proceeds of fixed assets
Sale of long-term investment


6.5 USES (APPLICATIONS) OF FUNDS
Need for additional Funds
A business would require additional capital for two purposes:
1.
2.
Financing additional fixed assets, and
Financing additional working capital.


It should not be difficult to appreciate the necessity for having adequate fixed
facilities with which to conduct the business. The amount we have invested in the
shop, furniture and fixtures (refer to the example of Ramsons) has created the
facilities for carrying on the business. It also limits the capacity. We cannot expand
our business beyond a certain capacity which is limited by the facilities created by
fixed asses . In case of a manufacturing firm, it will be plant capacity; in case of a
transport undertaking it may be tonnage of trucks, ships or wagons; in case of show
business is and airlines it

may be seating capacity, and so on. Any increase in such
capacity would require additional investment.
66
Understanding
Financial Statements


Thus, investment in fixed assets is required to expand capacity or to improve the
current operation. Usually, addition to investments are judged on the basis of its
ability to reduce the present costs or to increase the present output.
Additional working capital is required to finance Increased holding of inventory,
increased credit to customers and increased cash holding requirements. Obviously
current creditors would finance part of this requirements. Obviously, current creditors
would finance part of this requirement for working capital.
If Ramsons invests in another shop or in expansion of the existing shop, they will
require additional funds for investment in fixed assets as also for increased level o
current assets. You will notice that whenever additional investment is to be made i
non-current assets, we have to use the funds (working capital) available with us ur sss
separate arrangement is made for their financing. Likewise, when non-current asse
are sold they provide funds or result in sources of funds.
We could summarise the usual applications of funds as follows:
1. Acquisition of new non-current assets (fixed assets)
2. Replacement of non-current debt (loans)
3. Payment of dividends
4. Increase in the balance of working capital (current assets-current liabilities)
If the trading or business operations are unsuccessful, they may use

funds rather that
provide funds. The uses of funds, as they are usually presented in the fund flow
statement, are enumerated below:
USES OF FUNDS
Dividends .
Non-operating losses not passed through P & L A/c .
Redemption of redeemable preference share capital .
Repayment of debentures/bonds .
Repayment of long-term loans .
Purchase of fixed assets .
Purchase of long-term investment .
Increase in working capital .
6.6 FACTORS AFFECTING FUND REQUIREMENTS
From the discussions we had earlier, it is not difficult to come to the conclusion that
several factors affect the fund or net working capital requirements.
Fund requirements vary with the nature and type of business. A firm that provides
agency services may require less working capital compared to a firm which carries on
business of merchandising. The merchandising firm of course would. require to carry
some inventory, give credit and so on. However, a firm which manufactures products
may require more working capital than a retailer. The manufacturing company will
have to carry inventory of raw material, work-in-process and finished goods.


Working capital requirements are directly influenced by sales volume. With every
growth in sales volume we need to carry larger inventory, increased number of
customers or receivables as also the operating expenses. It is possible that all the
expenses may not move up proportionately. However, we will have to finance some
of these increases. It is also possible that all the expense may not move up
proportionately. However, we will have to finance some of these increases. It is also
possible that the increase in sales volume could be brought about by granting
extended credits. In other words, by investing more funds we increase the volume of
sales.
67
Construction and Analysis of
Fund Flow and Cash Flow
Statements

Fund requirements for the business may be seasonal. For example in industries using
agricultural raw materials, it may be more advantageous to procure raw materials
during harvest season. In case of consumer retailing it may be necessary to hold large
inventories during festive season. Most of the fund requirements are restricted to a
limited period, and if we provide it on a permanent basis we may have idle funds
during most part of the year.
Yet another important aspect which may condition fund requirement is the velocity
of circulation of current assets. In other words, the length of the operating cycle
will influence the need for funds. Shorter the duration of operating cycle faster is the
conversion of money invested in current assets into cash and hence lesser the need
for net working capital.
Net working capital requirement is also influenced by the terms available from the
suppliers. The credit terms extended by the suppliers will determine the amount of
additional funds required.
A firm which carries a month's inventory and grants one month's credit to customers,
has to fund the inventory cost of two months. If it could avail two months' credit
from the suppliers, the need for holding inventory and funding receivables is nil.
In another situation, suppose the firm carries a balance of Rs.10,000 of accounts
payable, payable in 30 days and an average accounts receivable balance of Rs.
15,000, receivable in 45 days, the firm will have to keep a net working capital for the
difference of receipts from customers and payments to creditors as follows:
Rs.
Fund required to meet payables due within 30 days 10,000
Less: Funds received from customers-
Received in 45 days, that is, Rs.15,000 x 30/45
10,000
Fund required in the form of additional net working capital Nil
Assuming the time taken for collection of receivable is 90 days the situation will be:
Rs.
Fund required to meet payables due within 30 days. 10,000
Less: Funds received form customers- Rs.15,000 x 30/90 5,000

5,000
Fund required in the form of additional net working capital
We could summarise the discussion in respect of the need for working capital by
saying that the ability of the firm to circulate the cash raw material inventory
work-in process finished goods inventory receivables cash is the most vital
and important factor in determining the amount of working capital. However, the
exact amount needed to be invested in all these will be determined by the period and
quantum of holding of each of these elements. This in turn is also influenced by the
factors we have discussed in this sections.


68
Understanding
Financial Statements


6.7 ANALYSING CHANGES IN WORKING CAPITAL
In understanding the financial statements of a company, one of the first steps
involved is the study of the changes in current financial position of the company and
the reasons for the changes. We make an attempt at studying these changes and their
causes by using the data contained in the summarised comparative balance sheet.
(Illustration 6.2) and profit and loss account of Tools India Limited.
Illustration 6.2
Tools India Limited
Balance Sheet as on December 31, 2003
(Rs. in Million)
Assets
Rs.
December 31, 2003
Rs.
December 31, 2003
Rs.
Rs.
Current Assets
Cash
Accounts receivable (Sundry
debtors)
Loans and advances
Other Current Assets
Inventory
Total Current Assets
19.50
32.25

42.58
17.20
12.92






232.00
10.87
20.28

33.82
15.93
99.10







180.00
Fixed Assets
Plant and equipment at cost
Less: Depreciation

Furniture & fixture at cost
Less: Depreciation
152.00
71.00

14.50
2.00

81.00


12.50
133.00
60.00

8.60
2.30

73.00


6.30
Investments 2.00
Intangible Assets
Technical Assistance fees
Less: Amortisation

Total

3.00
0.50

2.50

330.00
1.00
0.30

0.70

260

Liabilities and Capital

Current Liabilities
Acceptance
Sundry Creditors (Accounts
Payable)
Advances against sales
Other liabilities
Interest accrued but not due on
loans
4.74
27.16

26.60
8.86
2.64







70.00
3.02
18.75

20.28
7.95
2.00








52.00
Provisions
For taxation
Proposed dividend
For bonus
Other Provision
25.55
2.25
3.40
3.80




35.00
20.45
2.25
2.35
2.95




28.00

Total current liabilities &
Provisions

105.00

80.00



Long Term Liabilities
Bank loans
10.5% debentures
Loans from Financial Institutions
40.00
25.50
24.50



90.00
32.14
25.50
22.36



80.00
Total Liabilities 195.00 160.00

Capital

Authorised : 5,00,000
shares of Rs. 100 each

Issued Subscribed and
Paid-up 3,73,100 Shares of
Rs. 100 each
Reserves and Surplus

Total

50.00



37.31
97.69

330.00
50.00



37.31
62.69

260.00
69
Construction and Analysis of
Fund Flow and Cash Flow
Statements

As we have studied at the beginning of this unit, the net change in working capital
can be computed easily by subtracting the net working capital at the end of the year
from the net working capital at the beginning of the year.
TOOLS INDIA LTD
Change in Working Capital
(Rs. in Million)
December 31, 2002 December 31, 2003
Current assets 180.00 232.00
Less: Current Liabilities 80.00 105.00
127.00 100.00 Working Capital
Working capital on December 31, 2003 127.00
Working Capital on December 31, 2002 100.00
27.00 Increase in Working Capital
The Rs. 27 million increase in working capital of TIL shows the composite changes
in the operating assets. This does not tell us much in terms of operations of the
business. This change could be the net result of changes in all the accounts covered
by current items. May be there has been qualitative changes resulting from the
depletion of liquid items of current assets and increase in non-liquid items such as
inventory. In order to answer these questions we try to analyse the changes in each of
the working capital accounts.
Statement of changes in working capital
A statement of changes in working capital helps us in locating where these changes
took place. In the first instance we try to show the increase (decrease) in individual
items and then try to classify them in terms of increase and decrease in working
capital. Since working capital is measured by subtracting current liabilities from
current assets, any increase in current assets and any decrease in current liabilities
shows an increase in working capital. Similarly, a decrease in current assets and an
increase in current liabilities represent a decrease in working capital.


The statement of changes in working capital (Table 6.1) shows that the increases in
current assets amounted to Rs. 52 million, a major part of the increase arising out of
cash, receivable and inventory. Decrease in working capital came about mostly from
the increased accounts payable, advances from customers and taxes payable. Total
amount of decrease in working capital resulting from increase in current liabilities
amounted to Rs. 25 million, thus, showing a net increase in working capital of Rs. 27
million.
70
Understanding
Financial Statements


Table 6.1
TOLLS INDIA LTD.
Statement of changes in Working Capital for the year ending December 31, 2000
(Rs. In Million)
Dec. 31
2003
Dec. 31
2002
Increase
(Decrease)
Working Capital
Increase Decrease
Current Assets
Cash
Accounts receivable
Loans and advances
Other current assets
Inventory

Total

19.05
32.25
42.58
17.20
120.92

232.00
10.87
20.28
33.82
15.93
99.10

180.00
8.18
11.97
8.76
1.27
21.82

52.00
8.18
11.97
8.76
1.27
21.82

Current Liabilities &
Provisions

Acceptances
Accounts payable
Advances against sales
Other liabilities
Interest accrued
Taxes payable
Proposed dividend
Bonus payable
Other provisions
4.74
27.16
26.60
8.86
2.64
25.55
2.25
3.40
3.80
3.02
18.75
20.28
7.95
2.00
20.45
2.25
2.35
2.95
1.72
8.41
6.32
0.91
0.64
5.10
-
1.05
0.85
1.72
8.41
6.32
0.91
0.64
5.10
-
1.05
0.85

Total


105.00

80.00

25.00

52.00


25.00

Working Capital


127.00

100.00

27.00


Increasing Working Capital


27.00

6.8 FUND FLOW STATEMENT
An analysis of the fluctuations of current assets and current liabilities i.e. working
capital tells us how the working capital has increased or decreased. We want to know
where the increased working capital is applied if it has increased, and from where
funds have been released if it has decreased. The profit and loss account gives some
indication of the results of operations and its impact on the funds position. We try to
integrate the impact of operations reported in the profit and loss account and balance
sheet by preparing a statement of changes in financial position. It describes the
sources from which fluids were received and the uses to which funds were put. This
statement of changes in financial position is usually referred to as fund flow state-
ment or statement of sources and application funds.
As the title indicates fund flow statement traces the flow of funds through the
organisation. In other words, it shows the sources from where the funds were raised
,

and the uses to which they were put.


The statement of funds flow is usually bifurcated into two logical divisions: sources
of funds or inflows during the periods and uses of funds or applications of funds
during the period. The division showing sources of funds summarises all those
transactions which had the net effect of increasing the working Capital. Uses of funds
on the other hand deal with all those transactions which had the effect of decreasing
the working capital. We shall illustrate the primary structure of flows as follows
(Figure 6.1):
71
Construction and Analysis of
Fund Flow and Cash Flow
Statements


The flow of funds statement gives a summary of the impacts of managerial
decisions. As such it reflects the policies of financing, investment, acquisition and
retirement of fixed assets, distribution of profits, and the success of operations.
Let us further extend illustration 6.2 in order to prepare a Fund Flow Statement. From
a comparative balance sheet and profit and loss account we could obtain most of the
information we require for the preparation of a fund flow statement. We have studied
that changes in net-working capital amount are caused by the changes in non-
working capital items. This could be easily seen from the summarised balance sheet
of TIL (Table 6.2).
We have seen that the net working capital amount increased by Rs. 27 million during
2003, January 1 to December 31. This is other words implies that the working capital
from non-current sources should exceed non-current uses by Rs. 27 million.
The summarised balance sheet shows the net change in each account. That is, it does
not show the increases and decreases separately. Furniture and fixtures value, for
example, has increased by a net amount of Rs. 5.90 million. This increase shows an
application of funds. In reality, this account was both a source and an application of
funds. We purchased new furniture and fixtures worth Rs. 7.90 million (a use of
funds) and sold existing furniture and fixtures which had an original cost of Rs. 2
million and on which depreciation had accumulated to the tune of Rs. 1 million
(a source of funds). Since the purchase transaction was bigger in amount than the sale
transaction, the net result was in the use of funds.


Table 6.2
72
Understanding
Financial Statements


TOOLS INDIA LTD.
Summarised Balance Sheet
(Rs. in Millions)

December
31, 2003
December
31, 2002

Working
Source

Changes in
Capital
Use
Working Capital 127.00 100.00 - 27.00
Fixed Assets
Plant and equipment at cost
Furniture and fixtures at cost
152.00
14.50
133.00
8.60
19.00
5.90
Investments 2.00 - 2.00
Intangible Assets
Technical assistance fees at
cost
3.00

298.50
1.00

242.60
2.00
Long-term Liabilities
Bank loans
10.5% debentures
Loans from Financial
Institutions
40.00
25.50
24.50
32.14
25.50
22.36
7.86

2.14
Allowance and
Amortisations

Accumulated depreciation
Plant and equipment
Furniture and fixtures
Amortisation of technical
assistance fees
71.00
2.00


0.50
60.00
2.30


0.30
11.00



0.20

0.30
Capital
Share capital
Reserves & Surplus
37.31
97.69

298.50
37.31
62.69

242.60

35.00

56.20



56.20
Notes: 1) Furniture and fixtures costing Rs. 2 million with an accumulated
depreciation of Rs. 1 million is sold for cash at Rs. 2 million.
2) Dividend paid during the year amounted to Rs. 2.25 million.
If we are to construct a statement showing sources and uses of funds during the year,
we need additional information. Some of this additional information is available from
the profit and loss account and the appropriation of net income. Some other
information like sales proceeds of assets will have to be obtained from other records
of the company.




Funds Flow statement
73
Construction and Analysis of
Fund Flow and Cash Flow
Statements

(Rs. in Million)
Sources of Funds
Funds from operations:
Net income*
Less profit on sale of furniture
37.25
1.00
36.25


Add: Depreciation, amortization, Provisions:
Plant
Furniture
Technical assistance fee

11.00
0.70
0.20



48.15

Other Sources of Fund

Sale of assets
Bank loan
Institutional loan
2.00
7.86
2.14


12.00
60.15
Uses of Funds


Payment of dividends
Purchase of Plant
Purchase of furniture
Investments
Technical assistance fees
Increase of working capital
2.25
19.00
7.90
2.00
2.00
27.00





60.15
* Net income has been obtained by deducting the previous year's balance of
Reserves and Surplus from the current year's balance i.e. 97.69 minus 62.69
=
35
million. To this, the proposed dividend for the current year of Rs. 2.25 million has
been added (as it must have been taken into account while determining the net
income to be transferred to Reserves and Surplus.
With the necessary background on Profit and Loss Account and Fund Flow
Statement having been prepared, you can now watch the Video Programme
"Understanding Financial Statement-Part II at your study centre.
Activity 6.2
1.
2.
Please list the four main sources of funds in your organisation.
.

List the four main uses of funds in your organisation.
.

.
6.9 IMPORTANCE OF CASH AND CASH FLOW
STATEMENT
Cash is another form of fund although in a narrow sense, it refers to a supply that can
be drawn upon according to the need. Here the term cash includes both cash and cash
equivalents. Cash equivalents are highly liquid short term investments which could
be easily converted into cash without much delay.
It may however be appreciated that the obligations and liabilities of a business arising
on a day to day basis must be met through
"
Cash" or "Cheque". We must also be able
to distinguish between "Profit" and "Cash". One cannot pay the creditors, electricity
bills, tax or even dividend by
"
Net Profit". For such and many other purposes, a
business needs either physical cash or balance or credit limits with banks. Not to be


able to meet the business comitments through cash as and when these arise can spell
disaster for a business even if it has a strong working capital and has earned
handsome profit.
74
Understanding
Financial Statements


So far we had seen that the balance sheet and profit and loss account provide
information about the financial position and the results of operations in a financial
period. The funds flow statement explained earlier traces the flow of funds through
the organisation. But neither of these financial statements can provide information
about the cash flows relating to operating, financing and investing activities.
To ensure that the right quantity of cash is available in accordance with the needs of a
business it is necessary to make a "cash planning" by determining the amount of cash
entering the business (cash inflow) and the cash leaving the business (cash outflow).
The statement which explains the changes that take place in cash position between
two periods is called the cash flow statement.
Cash flow statement is an important tool in the hands of the management for short
term planning and coordinating of various operations and projecting the cash flows
for the future. It presents a complete view about the movement of cash and
identifying the sources from which cash can be acquired when needed. The
comparison of the actual cash flow statement with the projected cash flow statement
helps in understanding the trends of movement of cash and also the reasons for the
success or failure of cash planning.
Cash flow and fund flow statements are similar to each other in many respects. The
main difference however, lies in the fact that the terms "fund" and
"
cash
"
import
different meaning. The term "fund" in fund flow statement has a wide meaning. A
fund flow statement examines the impact of changes in fund's position during the
period under review on the working capital of the concern (working capital refers to
current assets - current liabilities). Cash in the cash flow statement refers only to cash
and or balance with bank, i.e., a small part of the total fund, although very important.
The cash flow statement starts with the opening cash balance, shows the sources from
where additional cash was received and also the uses to which cash was put and ends
up showing the closing balance as at the end of the year or period under review.
Whereas there are

no opening and closing balances in Funds Flow statement. Increase
in current assets or decrease in current liabilities increases the working capital,
whereas the decrease in current assets or increase in current liabilities increases the
cash flow.
6.10 SOURCES AND USES OF CASH
There are various activities undertaken by a business which prove to be either source
or use of cash. These can be classified under three broad categories, i.e., Operating
activities, Investing activities and Financing activities. A brief discussion of each
of these categories is given below:
Operating activities include cash inflows associated with sales, interest and
dividends received and the cash outflows associated with operating expenses
including payments to suppliers of goods or services, payments towards wages,
interest and taxes, etc. Increase or decrease in current assets, e.g., receivables,
inventory as well as increase or decrease in current liabilities, e.g., accounts payable,
wages payable, interest payable, taxes payable also reflect operating activities.
Investing activities refer to long life assets like land and building, plant and
machinery, investments and the like. Acquisitions of these assets imply cash outflow
whereas their disposal means inflow of cash.


Financing activities encompass changes in equity and preference capital, debentures,
long term loans and similar items. Issuance of equity, preference and, debenture
capital as well as raising of long term loans imply cash inflow. Retirement of capital,
dividend payments to shareholders, redemption of debentures, amortisation of long
term loans, on the other hand are associated with cash outflow.
75
Construction and Analysis of
Fund Flow and Cash Flow
Statements

The Cash Cycle: In order to deal with the problem of cash management we must
have an idea about the flow of cash through a firm's accounts. The entire process of
this cash flow is known as Cash Cycle. This has been illustrated in Figures 6.2 and
6.3. Cash is used to purchase materials from which goods are produced. Production
of these goods involves use of funds for paying wages and meeting other expenses.

Figure 6.3: Details of the Cash Cycle



76
Understanding
Financial Statements


(a)
(b)
(c)
(d)
(e)
a)
b)
Goods produced are sold either on cash or credit. In the latter case the pending bills
are received at a later date. The firm thus receives cash immediately or later for the
goods sold by it. The cycle continues repeating itself.
The diagram in Figure 6.2 only gives a general idea about the channels of flow of
cash in a business. The magnitude of the flow in terms of time is depicted in the
diagram given in Figure 6.3. The following information is reflected by Figure 6.3.
Raw material for production is received 10 days after placement of order.
The material is converted into goods for sale in 37 days (15+2+20) from
point of B to E.
The payment for material purchased can be deferred to 17 days (15+2) after
it is received i.e. (the distance of time between points B to D), assuming that
it takes 2 days for collection of payment of the cheque.
The amount of the bill for goods sold is received 32 days (30+2) after the
sale of goods as is depicted by duration of time between point E to G.
The recovery of cash spent till point D is made after 56 days (20+30+2+2+2)
as shown between points D to J.
Managing these inflows (collections) and outflows (disbursements) are discussed in
detail in unit 16 in Block No.5.
Ativity 6.3
Meet a responsible executive of Accounting and Finance Department of a
manufacturing organisation regarding the following:
What is the length of its Cash Cycle?
Cash Cycle is approximately of ..days.
Draw the sequence of Cash Cycle showing its successive events with the
respective number of days.

.
c) Inquire whether or not the organisation is satisfied with its length of cash
cycle. What steps it proposes to take for reducing the Cash Cycle?

.
6.11 PREPARATION OF CASH FLOW STATEMENT
To start with, we need two successive balance sheets and the operating statement or
profit and loss account linking the two balance sheets.
There are two ways in which this statement can be drawn up. One approach

is to start
with the operating cash balance, add/deduct the profit/loss from operation to it and then
proceed to give effect to the change of each item of current assets and liabilities
together with the additions to and reductions in other assets and shareholders funds and
long term liabilities and finally arrive at the closing cash balance. This is known as the
"Profit basis" statement. For the sake of better understanding, the changes in items of
current assets, current liabilities, shareholders' fund, long life assets and long term
liabilities can be organised under the three broad categories of operating, investing and
financing activities (as discussed above), changes measured under each category, the
opening cash balance adjusted to these changes and the closing cash balance arrived at.


The second way is to deal only with cash

receipts and disbursements. This does not
consider non cash items like depreciation, preliminary expenses written off, etc. The
latter type of cash flow statement is known as "Cash basis" statement.
77
Construction and Analysis of
Fund Flow and Cash Flow
Statements

Preparation of a cash flow statement on cash basis is a straight forward exercise and
left to the students. Here, we would take up the cash flow statement on "profit basis"
for further examination. A framework of the steps to be followed for this purpose is
appended below:
Steps involved in preparation of a "Profit basis" cash flow statement:
1.
2.
3.
4.
5.
From the first of the two balance sheets, take the closing cash balance, which
will be the opening cash balance for the purpose of our cash flow statement.
Take the net profit figure. If it is not directly given and you are provided
with only Profit and Loss account balances in both the Balance Sheets,
ascertain it (net profit) by preparing an "Adjusted Profit and Loss account".
For this purpose, all items of profit appropriations as well as non-cash
expenses and income are to be added to and subtracted from the balance of
P&L account, as the case may be. This gives the figure of "Profit from
operation."
Adjust increase or decrease in each item of current assets and current
liabilities to the "Profit from operation" figure to arrive at the
"
Cash from
operation".
Revert back to the "Opening Cash Balance". Add the "Cash from operation"
to it. Also add, cash flow from other sources like non-current assets & non-
current liabilities, e.g., equity and debenture issue, raising term loan, sale of
fixed assets. Deduct, cash outflow to various uses, again involving non-
current or fixed assets and non-current liabilities, e.g., redemption of
preference shares/debentures, retirement of term loan, purchase of fixed
assets, etc.
The balance arrived at (4) above should tally with the closing balance of
cash in the second balance sheet.
Increases and decreases in various items of assets and liabilities as mentioned under
items 3 & 4 above can be optionally organised under operational, investment and
financing activities for clarity sake.
We use the above approach and procedure in preparing a "profit-basis" cash flow
statement in Illustration 6.3.
Illustration 6.3
M/s Navyug Udyog
Balance Sheets as at 31st March, 2002
Rs.
31st March, 2003
Rs.

Assets:
Freehold Property 1,50,000 1,50,000
Plant and Machineries
Less: Depreciation
1,10,000 1,70,000
Goodwill 15,000 5,000
Investment 75,000 1,30,000
Debtors 1,08,000 1,32,000
Stock 70,000 1,02,000
Bills Receivable 42,000 53,000
Cash in hand and at bank 20,000 50,000
Preliminary Expenses 20,000 15,000
6,10,000 8,07,000


Balance Sheets as at 31st March, 2002
Rs.
31st March, 2003
Rs.
Liabilities:
Share Capital 4,00,000 5,00,000
(40,000 Equity Shares @ Rs. 10/- per
share)
60,000
General Reserve 50,000 65,000
Dividend Equalisation Reserve 25,000 15,000
Profit and Loss a/c 40,000 55,000
Sundry Creditors 60,000 67,000
Prov. for Taxation 20,000 35,000
Bills Payable 15,000 10,000
6,10,000 8,07,000
78
Understanding
Financial Statements


Aditional Information:
1.
2.
3.
5.
6.
Shares were issued at a premium of Rs. 1.50' per share.
During the year Taxation liability in respect of 2002 was Rs, 20,000 and
paid.
During the year, Rs. 11,000 was provided for depreciation on Plant and
Machinery.
4. An item of the plant the written down value Rs. 20,000 was sold at Rs.
25,000.
During the year, a dividend @ 7.5% was paid.
Part of the investment costing Rs. 30,000 was sold at Rs. 35,000 and the
profit was taken in Profit and Loss account.
Based on the above information, we first set ourselves to ascertain the cash inflow
and outflow in respect of Investment, Plant and Machineries and Tax, which cannot
be found out by a mere inspection of their balances in two balance sheets. The task is
accomplished by preparing the respective accounts and examining the effects of the
additional information on each of these. This is followed by preparation of an
"
Adjusted Profit and Loss a/c" to find out the actual net profit earned during the
period, in the light of the additional information now available. In the final stage, the
"Cash flow statement" is prepared (Table 6.3).
Investment Account

To Opening balance 75,000 By Sale 35,000
To P & L a/c (profit on sale) 5,000 By Closing balance 1,30,000
To Bank (Purchases) 85,000
1,65, 000 1,65, 000
Plant & Machinery Account
To Opening balance
1,10,000
By Sale 25,000
To P & L a/c (profit on sale)
5,000 By P & L a/c-
depreciation
11,000
To Bank
91,000 By Closing balance 1,70,000
2,06,000 2,06,000


Provision for taxation
79
Construction and Analysis of
Fund Flow and Cash Flow
Statements

To Bank 20,000 By Opening Balance 20,000
By Closing balance 35,000

By P & L a/c 35,000
55,000

55,000
Adjusted Profit and Loss Account
To General Reserve 15,000 By Opening balance 40,000
To Dividend 30,000 By Dividend Equalisn. Reserve 10,000
To Provision for tax 35,000 By Plant and Machineries profit on sale 5,000
To Depreciation 11,000 By Investment-profit on sale.
By profit for the year
(balancing figure)
5,000

1,01,000
To Goodwill 10,000
To Preliminary expenses 5,000
To Closing balance 55,000
1,61,000

1,61,000
Table 6.3
Statement of Cash flow
for the period 1.4 2002 to 31.3.2003
Rs.
Opening Cash balance as on 1.4.2002 20,000
Add/(deduct): Cash flow from
Operating Activities

Net profit (Ref: P&L Adjustment a/c) 1,01,000
Add:
Decrease in current assets
Increase in current liabilities:
Sundry Creditors


Nil

7,000




7,000

Deduct:
Increase in current assets
Debtors
Stock
Bills Receivables



24,000
32,000
11,000




67,000

Decrease in Current liabilities
Bills payable
Payment of tax


5,000
20,000



25,000




92,000




16,000
Add/(deduct): Cash flow from
Investment activities

Add: Sale of Plant & Machineries
Add: Sale of Investment

25,000
35,000


60,000

Deduct: Purchase of Plant and
Machineries
Deduct: Purchase of Investments

91,000
85,000


1,76,000


(1,16,000)
Add/(deduct): Cash flow from
Financing Activities

Add: Issue of share capital
Share premium

1,00,000
60,000

Deduct: Payment of dividend
Closing Cash Balance as on 31.3.2003
1,60,000
30,000

1,30,000

50,000



80
Understanding
Financial Statements


Activity 6.4
Mention the four major operating activities included in a cash flow statement.

.
6.12 SUMMARY
In this unit we have tried to develop the idea of flow of funds within the organisation.
Starting with the funds requirement for an organisation, we have tired to trace the
sources and uses of funds.
We tried to study the important sources of funds, namely, the operations, sale of fixed
assets, long-term borrowings and issue of new capital. Similarly, important uses of
funds were traced to acquisition of fixed assets, payment of dividends, repayment of
loans and capital. The whole exercise reveals the areas in which funds are deployed
and the source from which they are obtained. Finally, we learned how to go about
doing the funds flow analysis with the help of published accounting information.
We learnt, distinguishing between cash and fund as also cash flow statement and
funds flow statement. The importance of cash and cash flow statement was dwelt
upon. Our discussion centered around cash flow statement on
"
cash basis" and "profit
basis". We learnt how to go about doing the cash flow analysis with the help of
accounting information and finally presenting the cash flows in the form of a "cash
flow statement".
6.13 KEY WORDS
Working Capital: Current assets minus current liabilities.
Funds from Operations: The change in working capital resulting from operations.
Difference between inflow of funds in the form of revenue and outflow of funds in
the form of expenses.
Sources of funds: The sources from which we obtain working capital for application
elsewhere. Sources include operations, extraordinary profits, sale of fixed assets, new
long-term borrowings, new issue of capital and the reduction of existing working
capital.
Use of Funds: Also referred to as application of funds means use of additional
working capital and includes amounts lost in operations (Operating loss), acquisition
of fixed assets, working capital used for retiring long-term loans, payment of divi-
dends and amounts utilised to increase working capital.
Cash from Operations: It refers to "Profit from Operation" duly adjusted against the
increase or decrease in the current assets and liabilities.
Cash Equivalents: These are highly liquid short term investments which could be
readily converted to cash and which are subject to an insignificant risk of changes in
value.
Cash Cycle represents the tithe during which cash is tied up in operations.


6.14 SELF-ASSESSMENT QUESTIONS/EXERCISES
81
Construction and Analysis of
Fund Flow and Cash Flow
Statements

1. What is working capital and what factors affect the size of working capital in
an enterprise?
2.
"
Current assets to an extent are financed by current liabilities" Explain.
3.
"
Operations provide funds" Comment.
4. Differentiate between "Schedule of Changes in Working Capital
"
and "Fund
Flow Statement.
5. Does a substantial balance in Retained Earnings indicate the presence of
large cash balance?
6. "Net Profit of a business cannot pay dividend
"
. Comment.
7. Explain the purposes of a cash flow statement.
8. What are the differences between a cash flow statement and funds flow
statement?
9. X Ltd. has a sales revenue of Rs. 1,000. Depreciation for the period is
Rs.200. Other operating expenses are Rs.900. Net loss for the period is
Rs.100.
a)
b)
What is the amount of funds generated from operations during the period by
X Ltd.?
Under what circumstances can the funds from operation be zero?
10. The following information and the balance sheet relate to Shyamsons Ltd.:
SHYAMSONS LTD
Balance Sheet as on 31st December
Year 1 Year 2 Net change during the year
Increase Decrease
Assets Rs. Rs. Rs. Rs.
Cash 10,000 15,000 5,000
Receivables 20,000 25,000 5,000
Inventory 20,000 35,000 15,000
Plant and Machinery Cost 85,000 85,000
Less: Accumulated depreciation (15,000) (10,000) 5,000
Total Assets 1,20,000 1,50,000
Liabilities & Capital
Sundry Creditors
8,000 10,000 2,000
Outstanding expenses 7,000 10,000 3,000
Debentures payable 10,000 5,000 5,000
Long-term loans 5,000 25,000 20,000
Capital 50,000 50,000
Retained earnings 40,000 50,000 10,000
1,20,000 1,50,000
Net profit for the period after charging Rs.5,000 on account of depreciation was Rs.
20,000. A piece of equipment costing Rs.25,000 on which depreciation accumulated
in the amount of Rs. 10,000 was sold for Rs. 10,000. Dividends paid during the year
amounted to Rs. 10,000.


Prepare a Sources and Uses of funds statement in the following format:
82
Understanding
Financial Statements


SHYAMSONS LTD.
Sources and Uses of Funds
(in Rs.)
Uses of funds Sources of Funds
Purchase of Plant and
Machinery
Operations:
Net income

Repayment of
Debentures
Add: Loss in sale of
machinery

Payment of dividends
Increase in working
capital
Add: Depreciation
Sale of equipment
Long-term loan

Total uses of Funds

Total Sources of Funds
11. The Balance Sheet of Bestwood Limited as at 31st March 2002 and 31st
March 2003 are as follows:
31st March 31st March
2002 2003 2002 2003
Rs. Rs. Rs. Rs
Issued share
capital
60,000 80,000 Freehold property
at cost
50,000 50,00C
Profit and Loss
account
54,000 46,000 Equipment (see
note)
36,000 44,400
Corporation tax Stock in trade 32,800 35,600
due: Debtors 27,200 28,000
31st March 2002 12,000 - Bank 4,000 2,000
31st March 2003 - 8,000
Creditors 24,000 26,000
1,50,000 1,60,000 1,50,000 1,60,000
Note: Equipment movements during the year ended 31st March 2003 were:
Cost
Rs.
Depreciation
Rs.
Net
Rs.
Balance at 31st March 2002 60,000 24,000 36,000
Additions during the year 18,000 7,600
Depreciation provided during the year 78,000 31,600
Disposal during year 8,000 6,000
Balance at 31
st
March 2003 70,000 25,600 44,400
The company's summarised profit calculation for the year ended 31st March 2003 revealed:
Sales Rs. Rs.
Gain on Sale of equipment 2,00,000
800

2,00,800
Less: Cost of goods and trading expenses
Depreciation
1,73,200
7,600



1,80,800
Net Profit
Corporation tax on profits of the year
20,000
8,000

Retained profit of the year

12,000



83
Construction and Analysis of
Fund Flow and Cash Flow
Statements

During the year ended 31st March 2003 Bestwood Ltd. made a bonus issue of 1,000
ordinary shares of Rs. 10 each by capitalisation from the profit and loss account.
With the help of the above information, prepare a fund flow statement for Bestwood
Ltd. revealing the sources and applications of funds during the year ended 31st
March 2003.
Answers to self-assessment Questions/Exercises
9.
10.
(a) Funds generated from operations = Rs. 100
(b) When operating cash expenses are equal to operating incomes or
revenues.
Solution:
SHYAM SONS LTD.
Sources and Use of Funds
Use of Funds Rs. Sources of Funds Rs. Rs.
Purchase of Plant and Operations:
Machinery 25,000 Net Income 20,000
Repayment of Debentures 5,000 Add: Loss on sale of Machinery5,000
Payment of dividends 10,000 Add Depreciation 5,000
Increase in net 20,000 30,000
working capital Sale of equipment 10,000
Long-term loan 20,000
60,000 60,000 Total uses of funds Total Sources of Funds

Year 1 Year 2
Current Assets 50,000 75,000
Less: Current Liabilities 15,000 20,000
Working Capital 35,000 55,000
Increase in Working Capital 20,000
11. Decrease in working Capital Rs. 400
Funds from Sale of equipment Rs. 2,800.
6.15 FURTHER READINGS
Fraser Lyn. M and Aileen Ormiston, 04/10/2003 Understanding Financial
Statements, Prentice Hall: New Delhi (Chapter 4).
Pandey, I.M., 1999, Financial Management, Vikas Publishing House : New Delhi
Horngren, Charles T., Sundem Gary, L., 1994 (9th Ed.) Introduction to Management
Accounting, Prentice-Hall: Englewood-Cliffs of India Pvt. Ltd., New Delhi.
(Chapter 14)
Glantier, M. W. E., Underdown B. and A.C. Clark, 1979, Basic Accounting
Practices, Arnold Heineman: New Delhi: (Chapter 6, Section 6).
Hingorani, N.L. and A.R. Ramanathan, 1986, Management Accounting, Sultan
Chand : New Delhi. (Chapter 8).

Financial and
Investment Analysis

UNIT 12 RATIO ANALYSIS
Objectives
The main objectives of the unit are to:
provide a board classification of ratios


identify ratios which are appropriate for control of activities
attempt a system of ratios which responds to the needs of control by management
Structure
12.1 Introduction
12.2 Classification
12.3 The Norms for Evaluation
12.4 Computation and Purpose
12.5 Managerial Uses of the Primary Ratio
12.6 Summary
12.7 Key Words
12.8 Self Assessment Questions/Exercises
12.9 Further Readings
12.1 INTRODUCTION
You have already been exposed to the `Introduction and analysis' of financial
statements in Units 4-6 of this course. By now you might have acquired some
familiarity with financial ratios that provide basic relationships about several aspects
of a business. You may have observed that the Financial media (magazines like
Fortune India, Business India Business World, and dailies like Economic Times,
Financial Express and Business Standard, among many others) presents many of
these ratios to analyse the strengths and weaknesses of individual business firms.
Further, the Bombay Stock Exchange makes one of the most exhaustive efforts in the
country to analyse financial data of a large number of companies through a set of 21
ratios. An internationally cited use of ratios comes in the ranking of the 500 largest
corporations by a financial bi-monthly, viz., Fortune International. This exercise is
based on five basic parameters viz., Sales, Assets, Net Income, Stockholders Equity,
and Number of employees. The nine rating measures derived from these parameters
are: sales change, profits change, net income as a percent of sales, net income as a
per cent of stockholders equity, 10-year growth in earning per share, total return to
investors (latest year and 10-year average), assets per employee, and sales per
employee.
This is not an exhaustive list and you may come across many more sources of
published ratios including the individual companies, many of which now provide
summarised financial information and ratios for the past five or ten years. The point
is that users of ratios are vast, ratios that emerge from financial data are numerous
and uses to which these ratios can be put are many.
16



17
Ratio Analysis


12.2 CLASSIFICATION
Financial ratios have been classified in a variety of ways. You may find the following
broad bases having been employed in current literature:
Primacy Criterion: This distinguishes a measure, which could be considered useful
for all kinds and sizes of business enterprises, from many other measures which are
not so universal in usage. The first one has been called the Primary Ratio (viz., the
Return on Investment or the ROI) and the other category called Secondary measures
includes all other ratios. Such measures will essentially vary among firms, and they
will select only such of those measures as are relevant for their needs. The British
Institute of Management uses this classification for inter-firm comparisons.
Ratios tagged to needs of interest groups: The major interest groups identified for
this purpose are:
a)
b) Owners
c) Lenders
Management
This classification assumes that. management group is different from owner
group.
Management and operational control: Cost of goods sold and gross margin
analysis, profit (net income) analysis, operating expense analysis, contribution
analysis and analysis of working capital.
Owner's viewpoint Net profit to net worth, net profit available (to, equity share-
holders) to equity share capital, earnings per share, cash flow per share and dividends
per share.
Lenders' evaluation: Current Assets to Current Liabilities, Quick Assets (i.e.,
current assets minus inventories) to Current Liabilities, Total Debt to Total Assets,
Long-term Debt to Net Assets, Total Debt to Net Worth, Long-term Debt to Net
Worth, Long-term Debt to Net Assets and Net Profit before Interest and Taxes (i.e.,
NBIT) to Interest.
Fundamental classification Ratios under this classification are grouped according to
a basic function relevant to financial analysis. Four such functional groups have been
generally recognised.
a) Liquidity Ratios are ratios which measure a firm's ability to meet its matur-
ing short-term obligations. The most common ratio indicating the extent of
liquidity or lack of it are current ratio and quick ratio.
b) Leverage Ratios are ratios ' which measure the extent to which a firm has
been financed by debt. Suppliers of debt capital would look to equity as
margin of safety, but owners would borrow to maintain control with limited
investment. And if they are able to earn on' borrowed funds more than the
interest that has to be paid, the return to owners is magnified. (This aspect
has been elaborated and illustrated in the next Unit of Financial and
Operating Leverage). Example include debt to total assets, times interest
earned, and charge coverage ratios.
c) Activity Ratios are ratios which measure the effectiveness with which a firm
is using its resources. Example include Inventory. turnover. Average collec-
tion period, Fixed assets turnover, and Total assets turnover.
d) Profitable Ratios are ratios which measure management
'
s overall effective-
ness as shown by the returns generated on sales and investment. Examples



could be profit (net or gross) margin. Net Profit to total assets or ROI, Net
profit after taxes to Net worth.
18
Financial and
Investment Analysis

One more class of ratios is sometimes added to the four groups specified above. This
is called the `Market Value `group of ratios, which relate investors
'
expectations
about the company
'
s future to its present performance and financial conditions.
Examples would cover Price-earnings (PE) and Market/book-value ratios.
The fundamental classification is probably the most extensively used mode of
presenting financial statement analysis.
Activity 12.1
Table 12.1 on next page lists 21 ratios being computed by the Bombay Stock
Exchange. Tick the board class to which each of the 21 ratios belongs to in the blank
columns of the Table.
You must have begun grouping the ratios on the basis of what you have learnt about
them. However, we would help you in this exercise. The very first ratio and for that
matter the first three ratios are figured on net worth which is a parameter of great
interest to proprietors. Nevertheless, the ratios do not reflect either of the four
fundamental ratios viz., liquidity, leverage, profitability and activity. Also, they are
not primary since they do not measure final profitability of capital (or investment)
committed to the firm. Hence, ratios 1 to 3 are secondary and owner-oriented. Of
course, they do reveal one fundamental aspect viz., stability. The Bombay Stock
Exchange classifies these ratios under the board group of Stability ratios.
This exercise of classification has given you an idea about ratios, which are relevant
for controlling business activities, and the ratio in which top management would be
particularly interested. Obviously, they are activity ratios which we have classified as
`management-oriented' ratios. The primary ratio, which is of universal relevance to
top management, will be specifically explained regarding its rationale and con-
struction in this unit.
You have noticed that the basic flow of activities of a business firm follows a certain
sequence:
Investment decision financing of investment acquisition of resources
deployment of resources disposal of output reinvestment of surplus.
This sequence needs some explanation. A typical business firm would take a decision
to invest after an analysis of the projected inflows and outflows of the project. This
will be followed by a plan to finance the project, which may be debt finance and / or
proprietors' own funds. Finance will then be utilized to build facilities and
commercial output will be obtained as per the project schedule (assuming there are
no over-runs and delays) Sales revenue will follow the disposal of the output and
after meeting all costs and expenses (including tax and finance charges), a decision
will be taken to compensate the owners (dividend decision) and reinvest the balance,
if any.
You will appreciate that the cycle of business activities commences with the deploy-
ment of recourses and terminate in the disposal of output. A business would like to
have as many such cycles as possible during a time period, say a year. Apart from
increasing the number of such cycles during a time period the management would be
interested to reduce costs and expenses to the minimum at each stage of the cycle.
Accounting ratios, which belong to the category of management-oriented activity
ratios, enable business firms to exercise control over operations. The next section of
this unit focuses attention on these ratios.



Ratio Analysis


Table 12.1 : Table listing 21 ratios being computed by the Bombay Stock Exchange
Broad Classes of Ratios
Ratios Primacy Interest Groups Fundamental
Primary Secondary Management Owner Lender Liquidity Leverage Profitability Activity
1 Net worth to Total
2 Net block to Net worth
3
Total liabilities to Net worth

4 Current Assets to Current liabilities
5 Quick Assets to Current liabilities Net
6 Sales to Total assets
7 Net Sales to Net worth + Debentures
8 Net Sales to Plant & Machinery at Cost
9 Sundry Debtors to Average Daily Sales
10 Net profit to Total Capital Employed
11 Net Profit + Debenture Interest to Net worth +
Debentures

12
Net profit to Total Assets

13 Depreciation Reserve to Gross Block
14 Depreciation Provision to Net Block Tax
15 Tax Provision to Pre-tax profit
16 Preference Capital + Debentures to Equity
Capital

17 Debentures to Net worth + Debentures
18 Preference Capital to Net worth + Debentures
19 Equity Capital + Reserve to Net worth +
Debentures

20 Times Debenture Interest covered
21 Times Preference Dividends covered


19


Financial and
20
Investment Analysis

12.3 THE NORMS FOR EVALUATION
You may just be wondering as to how we control activities through ratios. The
answer is not difficult to seek. Ratios that we have identified for control of activities
measures relationships between key elements at any point of time. Such a measure is
then compared with some `norm' and the causes for deviation investigated. An
action-plan is then prepared and implemented to remove the cause(s). For example,
Nagpur Textile Mills Ltd. reports 89 days of inventories held on an average against
net sales during the year 2002. Now, how do we judge if the figure of `89 days' is just
about okay for a firm like Nagpur Textile Mills Ltd.? The following appear to be
the ways for evaluating this figure:
a) Against a trend over time: The following data may be observed for Nagpur
Textile Mill:
Year Average No. of days of inventory*
1998 90
1999 118
2000 115
2001 107
2002 98

b) Against an average of some past period: The relevant data for Nagpur
Textile Mill may be evaluated on the basis of the mean of average number of
days viz., (90 +118 + 115 + 107 + 89)/5 = 519/5 = 104 days approximately.
c) Against an industry average: A certain number of firms chosen (randomly
or otherwise) from textile industry, to which Nagpur Textile Mill Ltd.
belongs, may be used to compute the industry average as a norm. Thus; data
relating to average number of days of inventory of, say, 20 textile units of the
size and type of Nagpur Textile Mills Ltd. may be averaged for a particular
year for which Nagpur Textile's ratio is being evaluated. Period averages for
firms may also be used to obtain a grand mean for evaluation.
d) Against an average of a cross-section sample: The Reserve Bank of India
publishes financial statistics of joint companies. Their sample for the period
1998-99 to 2000-01 included 1927 public limited companies (with paid up
capital of Rs 100 crores and above). Year-wise averages for corporate sector
as a whole are available. In a similar manner, the ICICI publishes elaborate
data on financial performance of companies assisted by them. The latest
study pertains to the year 1984-85 and included 417 companies in different
industry groups. This sample covers around 50 per cent of the total private
corporate sector in terms of paid-up capital. Year-wise average for industry
groupings are available.



Ratio Analysis
Activity 12.2
21


The Study of Financial Performance presents the following data with regard to
inventory turnover of 43 textile companies.
Inventory as % of sales
Year 34 composite
mills
9 spinning
mils
Total 43
mils
1997-98 24.8 25.1 24.8
1998-99 26.5 24.2 26.3
1999-2000 26.4 24.2 26.1
2000-2001 26.0 22.9 25.6
2001-2002 24.4 23.7 24.3
Comment on the suitability of the given data to evaluate the inventory position of
Nagpur Textile Mills Ltd. in the year 2002.

.
12.4 COMPUTATION AND PURPOSE
A summary of management - oriented activity ratio are given below. This describes
the ratios and also their main purposes.
Activity Ratios (Secondary Group)
Ratio Computation
Method
Purpose(s)
I Cost of Goods Sold and Gross Margin Analysis
1. Cost of Goods
sold
Cost of Goods
sold/ Net Sales
2. Gross Margin Net Sales - Cost
of goods sold/net
sales
Provide an idea of gross margin
which in turn would depend on
relationship between prices,
volumes and costs
II Profit Analysis
3. Net Margin Net Profit / Net
Sales
Reflects management's ability to
operate business to recoup all
costs & expenses (including
depreciation, interest and taxes)
and also to provide a compensation
to owners
4. Operating Margin Net operating
Income before
Interest and
Taxes/Net Sales
Provides a view of operating
effectiveness
5. Post-tax Margin Net Profit after
tax but before
Interest*/ Net
Sales
Shows after-tax margin to both
owners and lenders.
* The numerator of post-tax margin may be obtained by adding back to net
profit the after-tax cost of interest on debt which is pre-tax interest times
(1-tax rate)


Financial and

22
Investment Analysis
Ratio Computation Method Purpose(s)
III Expense Analysis
6 Operating Ratio Operating expenses /
Net sales

Reflects the incidence of
operating expenses (which are
defined variously for different
costing systems)
IV Contribution Analysis
7 Total contribution Net sales - directly
variable costs / Net
Sales
Indicates the total margin
provided by operations towards
fixed costs and profits of the
period
V Management of Capital
8 Gross Assets Net Sales/ Total assets
Effectiveness of the use of all
assets viz., current and non-
current.

9 Net Assets
turnover
Net Sales / Total assets -
current liabilities
Effectiveness of assets
employed on the assumption
that current liabilities are
available to the business as a
matter of course, and will
effectively reduce the assets
required to be employed
10 Inventory turnover Net Sales or Cost of
Goods Sold / Average
Inventories
Shows the number of times
inventory replenishment is
required during an accounting
period to achieve a given level of
sales
11 Receivables
turnover
Net Sales / average
receivables
Amount of trade credit allowed
and revolved during a year to
achieve a level of sales.

12 Average collection
period
Average Receivables
X 365

Net Sales

Evaluates the effectiveness of
the credit period granted to
customers.
Activity 12.3
State whether the following statements are True or False :
True False


True False


True False


True False


True False


True False

True False

True False
a)
b)
c)
d)
e)
Cost of goods sold + Gross Margin = Net Sales
Net margin is the only measure of profitability of a
manufacturing firm
Net operating Income (NOI) is the same as Earnings
before Interest and Taxes (EDIT)
The numerator of the ratio called Post-tax margin is
obtained as follows Net profit after interest, depreciation
and taxes + Interest (1-tax rate)
In calculating the operating ratio, all firms employ a
standard definition of operating expenses.
f) The ratio called total contribution can also be
calculated as follows : Fixed costs/Net sales - Variable
costs
g) Net assets turnover is calculated b y Net sales/
Net Fixed Assets + Net Current Assets + Other assets
h) In computing the inventory turnover ratio, cost of goods
sold is a better numerator than net sales


Ratio Analysis
23


i)
j)
The ratio called Average collection period evaluates
all aspects for credit policy
Net sales are gross sales as reduced by returns, rebates and excise duty
True False

True False

You have been through a review of the select ratios, which focus managerial
attention on some of the critical aspects of a firm's activities. You may acquire a
greater degree of confidence in the use of the ratios summarised above if you review
their construction process also. What, therefore, follows is an example relating to a
company from the paper industry. You have to calculate the twelve ratios tabulated in
this section of the unit.
Activity 12.4
Compute the twelve activity ratios for the three years with the help of the following
information, which has been extracted from the annual accounts of Mahud Paper
Industries Ltd. Also offer you comments. On the basis of the limited information
available with you what areas would you identify for control?
Year ending on 31
st
March
20012002 2003 2004
(Amount in Rs. Crores)
Balance Sheet (Select items)
1. Current Assets

38.28 39.74 52.23
2 Of which Inventories 17.89 21.70 22.33 26.37
2A Of which S. Debtors 6.91 10.17 10.49 10.93
3 Net Fixed Assets 47.68 47.18 50.08
4 Total Assets 90.26 91.21 106.60
5. Current Liabilities 41.95 43.87 45.02
Profit & Loss Statement (Select Items)
6 Net Sales 95.09 113.60 155.29
7. Cost of goods sold 80.88 93.12 130.65
8. Directly variable expenses (Wages, salaries and
direct manufacturing expenses)

61.79

73.20

101.41
9. Interest 4.81 4.54 5.44
10. Operating Profit (after depreciation and

interest) .17 .39 2.60
11 Non-operating profit 4.34 2.49 3.27
12. Pre-tax-profit 4.51 2.88 5.87
13. Provision for taxes .80
14. Net Profit 4.51 2.88 5.07
12.5 MANAGERIAL USES OF THE PRIMARY RATIO
The return on investment has been aptly regarded as a primary ratio because it
specifies the relative net profit earned on the capital employed. This is one single
measure where the final outcome of all business activities gets recorded. It provides
not only a vehicle for measuring relative business efficiency but also focuses
attention on whether an adequate return has been earned in accordance with the
expectations of the investors on the capital contributed by them.
In many cases it becomes necessary to disaggregate an organisation into divisions
and the return on divisional investment can be employed to gauge the divisional
performance


Financial and
However, it may be stated that the concept of ROI (Return on Investment) is not free
from ambiguity. This is primarily due to the fact that numerator and denominator of
this ratio i. e. return and capital are subject to differing interpretations. As
standard definitions of these two basic terms do not exist as yet, the firms define the
terms according to their own thinking. While some firms may define investment
quite broadly, others may define it narrowly. As a consequence of this, variations of
ROI are found in practice, e.g.; ROA (i.e. Return on Assets).
24
Investment Analysis

You will appreciate these variations better as you go along with the discussion, and
the illustrations regarding the analysis of ROI.
You may note that the use of ROI which in fact is a combination of some other ratios
was pioneered by Du pont. That is why it is sometimes known as the Du point system
of Financial control.
The Du pont chart is presented in Figure 12.1 and it may be of interest to you to note
the manner in which the various key elements converge into a single measure viz:,
the Return on Investment: The right block charts out the investment made in various
assets and the left block depicts the earnings and costs flowing in and out of the
utilisation of these assets. Both the net income and total assets are then related to
sales to finally yield the single measure, which peaks the pyramid viz., the ROI.
You will notice that Cash, Accounts Receivable, Marketable Securities and Inven-
tories shown on the right block at the bottom are added up as current assets, which
then are added (leftward) to fixed
,
assets. This aggregates into total assets, which are
then divided (rightward) into sales to produce a ratio shown as Total Asset Utilisation
or Total Assets Turnover. A similar kind of measure based on income emerges from
the left block. The bottom four boxes at left sum up Interest Taxes, Depreciation and
other operating costs into Total Costs which are then deducted (rightward) from Sales
to yield Net Income: The Net Income is divided (leftward) into sales to generate
,
a
ratio known as the Net Margin. The two penultimate measures viz., Total Asset
Utilisation and Net Margin are then




Ratio Analysis
multiplied together to figure out the Return on Investment at the top box of the chart.
25


The return on investment may be expressed as a relationship in the following
formula:
ROI = Total Asset Turnover X Net Margin

You may further notice that total assets may be financed partly by owners' funds
(known as equity) and partly by borrowed funds (recognised as debt). Given the
proportion of assets financed by equity, an appropriate measure of Return on Equity
(ROE) may also be derived from the ROI. This will be given by
ROE = ROI/Proportion of Total Assets financed by Equity

The term Total Assets / Equity may be recognised as Equity Multiplier and then ROE
will be equal to ROI times the Equity Multiplier.
Versions of ROI
A large number of variations of ROT are found in practice, depending upon how
Investment and Return are defined Investment may be defined to include any
of the following:
1. Gross capital employed Net fixed assets + total current assets + other
assets
2.
3.
Net capital employed Net fixed assets + net current assets + other
assets
Proprietors' net capital Total assets - (Current liabilities + long-term
employed borrowing + any other outside funds)
4. Average capital employed Opening + closing balances of capital, reserves,
accumulated depreciation and borrowings/2
Similarly, Return may be defined to included any of the following:
1 Gross profit
2 Profits before depreciation, interest and taxes (PBDIT)
3 Profits before depreciation, interest and taxes (excluding capital and
extraordinary nary profits): PBDIT
4 Profits before tax (PBT)
5 Profits before tax (excluding capital and extraordinary profits): PBT*
The following versions of ROI are used in practice :
1. Gross Return on Investment = Gross Profit/Total Net Assets
2. Net Return on Investment = Net Profit/Total Net Assets
3. Return on Capital Employed = Profit before tax + Interest/Net Worth
(ROCE) + Interest bearing debt.
4. ROI (based on PBDIT) = PBDIT as per cent of average capital
Employed


Financial and
5. ROI (based on PBT) = PBT average of capital and
as per cent of reserves.
26
Investment Analysis

Activity 12.5
The following particulars have been selectively taken from the annual accounts of
Kavali Woolen Mills Ltd., for the years 2001, 2002 and 2003.
Particulars Years ending on March 31st
2001 2002 2003
Income Statement
1. Operating profit

18.75

22.78

28.48
2. Interest 6.74 8.90 10.78
3. Gross Profits (1- 2) 12.01 13.88 17.70
4. Depreciation 7.66 8.84 8.84
5. Profit before tax (PBT) : (3 - 4) 4.35 5.04 8.86
6. Tax 0.05 .01 .01
7. Net Profit (5 - 6) 4.30 5.03 8:76
Balance Sheet
1 Fixed Assets (gross)

94.61

112.28

162.16
2. Accumulated Depreciation 26.90 34.34 38.26
3 Net fixed assets (1 - 2 + capital work in
progress)
75.16 107.23 127.66
4 Investments 8.48 10.12 12.29
5 Current Assets 42.61 59.97 75.17
6 Current Liabilities and Provisions 30.95 36.53 56.30
7 Net Current Assets (5 - 6) 11.66 23.44 18.87
8 Total Net Assets (3 + 4 + 7) Financed by 95.30 140.79 158.82
9 Net worth 33.97 39.41 53.16
10 Borrowings 61.33 101,38 105.66
of which long-term 39.27 71.09 63.61
a)
b)
Compute Gross Return on Investment, Net Return on Investment, and Return
on Capital Employed for the three years. What are your conclusions?
Also derive the Return on Equity from the ROI (i.e., Net return on Total Net,
Assets).
Illustration 12.1
EVERLIGHT COMPANY LIMITED
Comparative Balance Sheet
December 31, Year 1 and Year 2

December 31st
Year 1 Year
Assets Rs. Rs.
Cash 1,000 1,200
Bank 6,000 7,500
Accounts Receivable 12,600 14,800
Inventory 18,400 20,500
Repayments 800 850
Land and Building 20,000 24,000


Ratio Analysis
27


Plant and Machinery 30,000 32,000
88,800 1,00,850
Liabilities and Shareholders'
Equity
Bills Payable

4,000

7,850
Accounts Payable 6,400 6,000
Other Current Liabilities 2,000 2,200
Debentures (10%) 20,000 18,000
Preference Shares (12%) 10,000 10,000
Ordinary Shares. Rs. 10 each 40,000 50,000
Retained Earnings 6,400 6,800
88,800 1,00,850
Income and Retained Earnings Statement of the Year Ended December 31, Year 2
Sales Revenue Rs. 60,000
Less Expenses:
Cost of Goods Sold
Rs. 28,000
Selling 8,000
Administrative 6,000
Interest 2,000
Income Tax 6,400
Total Expenses 50,400
Net Income 9,600
Less Dividend :
Preferred
1,200
Ordinary 8,000
9,200
Increase in Retained Earning for Year 2 400
Retained Earnings, December 31, Year 1 6,400
Retained Earnings, December 31, Year 2 6,800
With the above information, let us compute the following ratios
a)
b)
c)
d)
e)
f)
g)
h)
i)
j)
k)
l)
m)
n)
Rate of Return on Assets
Profit Margin (before interest and related tax effect)
Cost of Goods Sold to Sales Percentage
Selling Expenses to Sales Percentage
Operating Expense Ratio
Total Assets Turnover
Accounts Receivable Turnover
Inventory Turnover
Rate of Return on Ordinary Share Equity
Current Ratio
Quick Ratio
Long-Term Debt Ratio
Debt Equity Ratio
Times interest Charges Earned


Financial and
28
Investment Analysis

o)
p)
q)
Earnings per (Ordinary) Share
Price Earning Ratio
Book Value per Ordinary Share
The income tax rate is 40 per cent. The market price of an ordinary share at the end
of Year 2 was Rs. 14.80.
Let us take all these ratios one by one.
a) Rate of Return on Assets.
=
Rs. 9,600 + (1- .40) (Rs. 2, 000) = 11.39 per cent
.5 (Rs. 88,800 + Rs.1,00,850)
b) Profit Margin Ratio
=
Rs. 9,600 + (1-40) (Rs. 2,000) = 18 per cent
Rs. 60,000
c) Cost of Goods Sold to Sales Percentage
=
Rs. 28,000 = 46.67 per cent
Rs. 60,000
d) Selling expenses to Sales Percentage

=
Rs. 8,000 = 13.33 per cent
Rs. 60,000
e) Operating Expense Ratio

=
Rs. 8,000+ Rs. 6,000 = 23.33 per cent
Rs. 60,000
f) Total Asset Turnover

=
Rs. 60,000 = .63 times per year
.5 (Rs. 88,800 + Rs.1,00,850)
g) Accounts Receivable Turnover

=
Rs. 60,000 = 4.3 8 times per year
.5 (Rs. 12,600 + Rs. 1,4,800)
h) Inventory Turnover Ratio

=
Rs.28,000 = 1.44 times per year
.5 (Rs. 18,400 + Rs. 20,500)
i) Rate of Return or Ordinary Share Equity

=
Rs. 9,600 - Rs. 1,200 x 100 = 16.28 per cent
.5 (Rs. 46,400 + Rs. 56,800)
j) Current Ratio
December 31, Year 1 : Rs.38,800 = 3.13:1
Rs.12,400





Ratio Analysis
December 31, Year 2 : Rs. 44,850 = 2.79 : 1
29


Rs
.
16
,
050
k) Quick Ratio :
December 31, Year 1 : Rs.19,600 = 1.56 :1
Rs.12,400
December 31, Year 2: Rs.23500 = 1.46 :1
Rs.16,050
l) Long-term Debt Ratio
December 31, Year 1: Rs.20,000 = 24.86 per cent
Rs. 80,400
December 31, Year 2: Rs. 18,000 = 21.23 per cent
Rs. 84,800
m) Debt Equity Ratio
December31, Year 1 : Rs.20,000 = 43.1
Rs.46,400
December 31, Year 2 : Rs.18,000 = 31.69
Rs. 56,800
(Equity may or may not include retained earnings. Here, retained earnings
have been included)
n) Times Interest Charges Earned
Rs. 9,600 + Rs. 6,400 + Rs: 2,000 = 9 times
Rs: 2,000
o) Earnings per Ordinary Share (EPS)
December 31 Year 2:

=
Rs. 8,40 0 = Rs.1.87
.5 (4000 + 5000)
p) Price-Earnings Ratio
December 31, Year 2:

=
14.80 = 7.91 times
1.87
q) Book Value per Ordinary Share
December 31, Year 1 : = Rs. 46,400 = Rs.11.60
4,000
December 31, Year 2 : = Rs. 56,800 = Rs.11.36
5,000






Financial and
Illustration 12.2
30
Investment Analysis

The information contained in Tables 12.1 to 12.4 relate to a company for the year
2002 and 2003, we shall attempt a comprehensive analysis.
Table 12.1
Megapolitan Company Ltd.
Condensed Balance Sheet for the years ending
December 31, 2003 and December 31, 2002
Increase or (Decrease) Percentage of
total Assets


2003
Rs.
2002
Rs.
Rs. % 2003 2002
ASSETS
Current Assets

1,95,000

1,44,000

51,000

35.4

41.1

33.5
Plant and equipment (net) 2,50,000 2,33,500 16,500 7.1 52.6 54.3
Other Assets 30,000 52,500 (22,500) (42.9) 6.3 12.2
Total 4,75,000 4,30,000 45,000 10.5 100.0100.0
LIABILITIES & CAPITAL
Liabilities:
Current liabilities


56,000


47,000


9,000


(19.1)


11.8


10.9
12% Debentures 1,00,000 1,25,000 (25,000) (20.0) 21.1 29.1
Total 1,56,000 1,72,000 16,000 (9.3) 32.9 40.0

Shareholder's equity



9% preference shares
(Rs. 100 each)
50,000 50,000

10.5 11.6
Equity shares (Rs. 10 each) 1,25,000 1,00,000 25,000 25.0 26.3 23.2
Premium on issue of shares 35,000 20,000 15,000 75.0 7.4 4.7
Retained earnings 1,09,000 88,000 21,000 23.9 22.9 20.5
Total shareholders equity 3,19,000 2,58,000 61,000 23.6 67.1 60.0
Total 4,75,000 4,30,000 45,000 10.5 100.0100.0
Table 12.2
Income statement for the years ended December 31, 2003 and December 31, 2002
Increase or (Decrease) Percentage of net
Sales
2003 2002 Rs. % 2003 2002
Rs. Rs.
Net sales 4,50,000 3,75,000 75,000 20.2 100.0100.0
Cost of goods sold 2,65,000 2,10,000 55,000 26.2 58.9 56.0
Gross profit on sales 1,85,000 1,65,000 20,000 12.1 41.1 44.0
Operating expenses:
Selling 58,500 37,500 21,000

56.0 13.0 10.0
Administrative 63,000 47,500 15,500 32.6 14.0 12.7
Total 1,21,500 85,000 36,500 42.9 27.0 22.7
Operating income 63,500 80,000 (16,500) (20.6) 14.1 21.3
Interest expense 12,000 15,000 3,000 (20.0) 2.7 4.0


Ratio Analysis
Income before income
taxes
51,500 65,000 (13,500) (20.8) 11.4 17.3
Income taxes 14,000 20,000 6,000 (30.0) 3.1 5.3
Net Income 37,500 45,000 (7,500) (16.7) 8.3 12.0
31


Table 12.3
Statement of Retained Earnings
for the years ended December 31, 2003 and December 31, 2002
Increase or (Decrease)
2003 2002 Rs. %
Rs. Rs. Rs.
Retained earnings, beginning of year 88,000 57,500 30,500 53.
Net Income 37,500 45,000 (7,500) (16.7)
1,25,500 1,02,500 23,000 22.
Less : Dividends on equity shares 12,000 10,000 2,000 20.
Dividends on preference shares 4,500 4,500
16,500 14,500 2,000 13.
Retained earnings, end of year 1,09,000 88,000 21,000 23.
Table 12.4
Schedule of Working Capital
as at December 31, 2003 and December 31, 2002
Increase or
(Decrease)
Percentage of
total current items
2003 2002 Rs. % 2003 2002
Current Assets: Rs. Rs.
Cash 19,000 20,000 (1,000) (5.0) 9.7 13.9
Receivables (net) 58,500 43,000 15,500 36.0 30.0 29.9
Inventories 90,000 60,000 30,000 50.0 46.2 41.6
Prepaid expenses 27,500 21,000 6,500 31.0 14.1 14.6
Total current assets 1,95,000 1,44,000 51,000 35.4 100.0 100.0
Current liabilities
Bills Payable 7,300 5,000 2,300 46.0 13.1 10.7
Accounts payable 33,000 15,000 18,000 120.0 58.9 31.9
Accrued liabilities 15,700 27,000 (11,300) (41.9) 28.0 57.4
Total current liabilities 56,000 47,000 9,000 19.1 100.0 100.0
Working capital 1,39,000 97,000 42,000 43.3
Using the information in the above Tables let us consider analyses that would be of
particular interest to:
Equity shareholders
Long-term creditors
Short-term creditors
Equity shareholders : Equity shareholders, present and potential, look primarily to
the company's record of earnings. They are therefore interested in relationships such
as earnings per share (EPS) and dividends per share. Earnings per share are computed
by dividing the income available for equity shareholders by the number of equity
shares outstanding during the year. Any preference dividend must be subtracted from
the net income to ascertain the income available to equity shareholders.


Financial and


2003
Rs.
2002
Rs.
Net Income 37,500 45,000
Less Preference dividend 4,500 4,500
Income available to equity shareholders 33,000 40,500
Equity shares outstanding during the year 12,500 10,000
Earnings per (Equity) share 2.64 4.05
32
Investment Analysis

While dividend may be of prime importance to some equity shareholders, it may not
be so for other shareholders. Some shareholders may be interested in receiving a
regular cash income, while others may be more interested in securing capital gains
through rising market prices. In comparing the merits of alternative investment
opportunities, we should therefore relate earnings and dividends per share to the
market, value of shares. Dividends per share divided by market price per share would
give yield rate on equity shares. Dividend yield is of particular importance to those
investors whose objective is to maximise the dividend income from their
investments.
Earnings performance of equity shares is often expressed as price earning ratio by
dividing the market price per share by the annual earnings per share. Thus a share
selling for Rs. 40 and having earnings of Rs. 5 per share in the year just ended may
be stated to have a price-earning ratio of 8 times.
Assuming that the 2,500 additional equity shares issued by the company on January
1, 2003 received the full dividend of 96 paise in 2003, and further assuming the price
of the equity shares at December 31, 2002 and December 31, 2003 as given in Table
12.5, earnings per share and dividend yield may be summarised as follows.
Table 12.5
Earnings and dividends per equity share
Date Assumed
Market
value per
share
Earnings
per share
Price-
earnings
ratio
Dividend
per share
Dividends
yield %
Rs. Rs.
Dec. 31, 2002 18 4.05 4.44 1.00 5.56
Dec. 31, 2003 14 2.64 5.30 0.96 6.86
The decline in market value during 2003 presumably reflects the decrease in earnings
per share. The investors evaluating these shares on December 31, 2003 would
consider whether a price earning ratio of 5.30 and the dividend yield of 6.86 repre-
sented a satisfactory situation in the light of alternative investment opportunities. We
can also calculate the book value per share.
Table 12.6
Book value per equity share

.
2003
Rs.
2002
Rs.
Total shareholder's equity 3,19,000 2,58,000
Less: Preference shareholders equity 50,000 50,000
Equity of ordinary shareholders 2,69,000 2,08,000
Number of shares outstanding 12,500 10,000
Book value per equity share 21.52 20.8



Ratio Analysis
33


1.
2.
Book value indicates the net assets represented by each equity shares. This informa-
tion is helpful in estimating a reasonable price for company shares, especially for
small companies whose shares are not publicly traded. However, the market price of
the shares of a company may significantly differ from its book value depending upon
its future prospects with regard to earnings.
Long-term Creditors: Long-term lenders (or creditors) are primarily interested in
two factors:
The firms ability to meet its interest requirements.
The firms ability to repay the principal of the debt when it falls due.
From the viewpoint of long-term creditors, one of the best indicators of the safety of
their investments may be the fact that, over the life of the debt, the company has
sufficient income to cover its interest requirements by a wide margin. A failure to
cover interest requirements may have serious repercussions on the stability and
solvency of the firm. A common measure of the debt safety is the ratio of income
available for the payment of interest to annual interest expenses, called number of
time interest earned. This computation for Megapolitan Company would be as
follows:
Number of Times Interest Earned
2003
Rs.
2002
Rs.
Operating income (before interest and income taxes) a) 63,500 80,000
Annual interest expense b) 12,000 15,000
Times interest earned (a - b) 5.29 5.33
Long-term creditors are interested in the amount of debt outstanding in relation to the
amount of capital contributed by shareholders. The debt ratio is computed by
dividing long-term debt by shareholders equity as shown below:
Debt Ratio
2003
Rs.
2002
Rs.
Long-term/debt a) 1,00,000 1,25,000
Shareholders equity b) 3,19,000 2,58,000
Debt ratio (a - b) 31.35 48.45
From creditors point of view, the lower the debt ratio (or higher the equity ratio) the
better it is. The lower debt means the shareholders have contributed a bulk of funds
to the business, and therefore the margin of protection to creditors against shrinkage
of assets is high.
Short-term Creditors: Bankers and other short-term creditors have an interest
similar to those of the equity shareholders and debenture holders who are interested
in the profitability and long-term stability of the business. Their primary interest,
however, is in the current position of the firm, i.e. its ability to generate sufficient
funds (working capital) to meet current operating needs and to pay current debts
promptly.
The amount of working capital is measured by the excess of current assets over
current liabilities. What is important to short-term creditors is not merely the amount
of working capital available but more so-is its quality. The main factors affecting the
quality of working capital are (i) the nature of the current assets comprising the
working capital, and (ii) the length of time required to convert these assets into cash.
In this context we can calculate the following ratios:
1 Inventory turnover ratio
2 Account receivable turnover ratio


Financial and
Activity 12.6
34
Investment Analysis

In illustration 12.2 we analysed the financial statements (or information) from the
point of view of three groups of people and calculated certain ratios. But these ratios
by no means were all inclusive. Certain other ratios, useful for these groups of
people, can also be computed. For example, some other ratios useful for equity
shareholders (present and prospective) are: Return on investment (ROI), Leverage
ratio, and Equity ratio.
In the context of illustration 12.2:
a)
b)
Calculate and interprete all such ratios; and
Calculate and interprete some ratios for groups of people other than the three
above who might be interested in the company, e.g., preference shareholders
.........................................................................................................................
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12.6 SUMMARY
A large number of financial ratios are in use. They fulfill a wide variety of objectives
and functions. Managers evaluate performance and exercise control, investors match
their expectations, and lenders undertake credit approvals with their help.
Control of business activity is crucial for efficiency. Managerial action follows
meaningful information flows. Ratios provide a relevant basis, but all ratios may not
serve the objective of control. A profit performance measure, which is widely
prevalent, is the Return of Investment, which is considered a primary yardstick for
the measurement of operational efficiency. A decomposition of this measure into its
key elements as depicted in the Du pont Chart may underline areas, which need
managerial control for achieving the basic goal of maximizing the return on capital
employed in the enterprise
A series of secondary ratios has also been found useful in controlling business
activities. Since production and sales are the key parameters in an efficient conduct
of business activities, most of these ratios are related in some manner to sales and
output. The focus is on revenues and costs and also on the intensity of activity as
measured by the various turnover ratios. Going deeper into the conduct of business
transactions, a larger number of relationships would be uncovered e.g. stores control,
material usage control, labour hours control, machine maintenance quality control,
operating cycle control and so on. But the focus in this unit has been on control of
activities through ratios emerging from informations externally presented.
12.7 KEY WORDS
Primary Ratio is of primary concern for management because it provides an overall
measure of business efficiency and is measured by the much controversial but
nevertheless much widely employed Return on Capital Employed.
PBDIT or Profits before depreciation, interest and taxes. This amounts to gross cash
flow.
Liquidity Ratios measure the short-term solvency of the firm.


Ratio Analysis
Leverage Ratios measure the long-term solvency of the firm and also provide an
idea of the equity cushion for long-term indebtedness.
35


Activity or Turnover Ratios measure the intensity with which resources of the firm
are being utilised.
Average Capital Employed is one-half of the sum total of opening and closing
balances of capital, reserves, accumulated depreciation and long-term debt.
Net Total Assets are obtained by deducting current liabilities from total assets.
Equity Multiplier is used to derive the Return on Equity from the Return on
Investment, and is computed by dividing Equity into total assets.
Ratio Norm is obtained for different kinds of ratios either as an average over time of
the same firm, or an industry average or an average of a cross-section of firms, and is
used to evaluate performance and for control purposes.
Average Collection period is obtained by dividing average accounts receivables
with net credit sales and multiplying the resultant with 365 days of the year. It
suggests the average credit period actually granted during a year.
12.8 SELF-ASSESSMENT QUESTIONS/ EXERCISES
1. List the fundamental accounting ratios. Why are they called fundamental?
2. What are `Stability' ratios?. Can they be classed as fundamental ratios?
3. Enumerate ratios that are appropriate for controlling business activities. What
common criterion/criteria bring them together into one category?
4. Which of the control ratios are more important in your view? Why?
5. Point out the major limitation of Return on Capital Employed as a basis for
comparing one firm with another.
6. What is Return on Equity? Why do we measure it?
7. The ratios measuring management's overall effectiveness as shown by the
return generated on sales and investment are
a) Leverage
b)
c)
d)
a)
b)
c)
d)
e)
a)
b)
c) Gross
d)
a)
b)
ratios
Profitability ratios
Activity ratios
Liquidity ratios
8. According to the Du pont analysis, firms dealing with relatively perishable
commodities would be expected to have.
High profit margins and high turnover
Low profit margins and low turnover
High profit margins and low turnover
Low profit margins and high turnover
None of the above
9. Inventory turnover is defined as_________divided by inventories.
Cost of goods sold
Accounts receivable
profit
Net operating income
10. The primary purpose of the current ratios is to measure a firm's
Use of debt
Profitability


Financial and
36
Investment Analysis

c) Effectiveness
d)
e)
Liquidity
None of these
11. The Du pont System is designed to help pinpoint the trouble if a firm has
relatively low rate of return on equity. It focuses on the total asset turnover
ratio, the profit margin, and the equity/asset ratio True False
12. Because inventories are less liquid than other current assets, the quick ratio is
regarded as being a more stringent test of liquidity than die current ratio. .
True False
13. Other things being constant, (assuming an initial current ratio greater than
1.00) which of the following will not affect the current ratio?
a) Fixed assets are sold for cash
b) Long-term debt is issued to pay off current indebtedness
c) Accounts receivables are colleted
d) Cash is used to pay off accounts payable
e) A bank loan is obtained
14. The average collection period is found by dividing ________ with _________
and then dividing average sales per day into accounts _________. The average
collection period is the length of time that a firm must wait after making a sale
before it receives_________.
15. Individual ratios are of little value in analysing a company's financial
condition. More important is the_________ of a ratio over time, and a
comparison of the company's ratios to_________ ratios.
16. Prabhat Industries profit margin is 6 per cent, its total assets turnover ratio is 2
times, and its equity/total assets ratio is 40%. The company's rate of return on
equity is
(a) 5% (b) 7.5% (c) 12% (d) 30% (e) 20%
17. If the net profit margin for a firm is 20%, and the ROI is 10%, the total assets
turnover ratio must be
(a) 1 (b) 2 (c) .5 (d) .2 (e) Not possible
to compute.
18. Determine the sales of a firm with the financial data given below:
Current ratio 2.7
Quick ratio 1.8
Current liabilities Rs. 6,00,000
Inventory turnover 4 times
a) Rs. 34,00,000
b) Rs.19,60,000
c) Rs. 21,60,000
d) Rs.14,20,000
e) Rs.16,40,000
19. Complete the balance sheet and sales data by filling in the blanks using the
following financial data:
Debt/Net worth 50%
Acid Test ratio 1.4
Total Assets turnover 1.6 times
Days sales outstanding
in accounts receivable
40 days
Gross profit margin 25%
Inventory turnover 5 times




Ratio Analysis
Balance Sheet Rs.

Equity Share Capital
Rs.
25,000
Cash
Accounts Receivable
General Reserve 26,000 Inventories
Accounts Payable Plant & Equipment
Total assets
Total capital and liabilites Sales
Cost of goods sold
37


20. Weldone Co. and Goodluck Co, trade in the same industry but in different
geographical locations. The following data are taken from the 2002 annual
accounts.
Weldone Rs. Goodluck Rs.
Turnover 40,000 60,000
Total operating expenses 36,000 55,000
Average total assets during 2002 30,000 25,000
Attempt the following (ignore taxation):
a)
b)
c)
i)
ii)
Calculate the rate of return on total assets (profit as a percentage of total assets)
for each company.
Analyse the rates of return in part (a) into the net profit percentage and the ratio
of turnover to total assets.
Comment on the relative performance of the two companies in so far as the
information permits. Indicate what additional information you would require to
decide which company is the better proposition from the viewpoint of:
potential shareholder; and
potential loan creditors
21. Abrasives Ltd., has the following turnover ratios presented along with the
corresponding industry averages:
Ratio description Abrasive's ratio Industry average
Sales / Inventory 530/101 = 5 times 10 tithes
Sales / Receivables 530/44 = 12 times 15 times
Sales / Fixed assets 530/98 = 5.4 times 6 times
Sales / Total assets 530/300 = 1.77 times 3 times
Financial analysis of the company is presented on the next page in the form of a Du
Pont Chart. Study the chart, along with the four turnover ratios and industry averages,
and comment on the major weaknesses of the company where managerial attention
must be focused for future control.


Financial and

38
Investment Analysis

Answers or Approaches to Activities
Activity 12.1
Ratio Nos. Broad Class
1 to 3 Secondary, Owners
4 & 5 Secondary, Lenders,, Liquidity
6 to 9 Secondary, Management, Activity
10 to 12 Primary, Management, Profitability, Owners
13 to 15 Secondary, Management, Profitability (Appropriation)
16 to 21 Secondary, Lenders, Leverage
Activity 12.2
a) Nagpur Textile Mills data relating to average number of days of inventory will
have to be converted into inventory ratio as follows:




Ratio Analysis
Assuming the numerator to be 365 days, the inventory turnover ratios for the five
years will be:
39


Year Inventory turnover ratios
1998 100 365 / 90 =24.66
1999 100 365/118 =32.33
2000 100 365 / 115 = 31.51
2001 100 x 365/107 = 2932
2002 100 x 365 / 89 = 24.39
b)
c)
a) True
b) False
c) True
d) True
e) False
f) False
g) True
h)
i)
j) True
Nagpur Textile's is a composite mill. It may, therefore, be appropriate to
compare the inventory ratios for five years with the annual averages of compos-
ite mills for five years. It is manifest that Nagpur Textile's inventory turnover
ratio is higher than the industry average for the years 1999-2001.
The trend for the last four years since 1999 is for the ratio to decline.
Activity 12.3
True because inventory which is the denominator of the ratio is also carried
generally at cost in a world of rising prices.
False because it reflects only the average credit period and does not state
anything about discounts and credit standards.

Activity 12.4
Ratio Information
inputs
Computed ratio for
the year
2001 2002 2003
1. Cost of goods sold (7) (6) 85.06 81.97 84.13
2. Gross margin (6) - (7) (6) 14.94 18.03 15.87
3. Net margin (14) (6) 4.74 2.54 3.26
4. Operating margin (10) + (9) (6) 5.24 4.34 5.18
5. Post-tax margin (14)+ (9) x (13)/(12) 6 9.80 6.53 6.30
6. Operating Ratio (6) - (10) (6) 99.82 99.66 98.33
7: Total Contribution (6) - (8) (6) 35.02 35.56 34.70
8. Gross Assets Turnover (6) (4) 1.05 1.25 1.45
9. Net Assets Turnover (6) (4) - (5) 1.97 2.36 2.52
10. Inventory Turnover (7) (2) 4.09 5.16 6.38
11. Receivables Turnover (6) (2A) 11.13 11.03 14.50
12. Average Collection
Period (Days)
(2A) (6) / 365 32.78 33.10 25.17


Financial and

40
Investment Analysis

Activity 12.5
a) Gross Return on Investment
2001 2002 2003
12.61 9.86 11.14
4.51 3.57 5.81
11.63 9.90 12.61
Net Return on Investment
Return on Capital employed

b) You may first proceed to find out the Equity multiplier viz., Total Net
Assets/Equity for each of the three years, and then multiply the R0I by this
multiplier. Equity multipliers for the three years are as follows:
Years Equity multiplier
2001 95.30/33.97 = 2.81
2002 140.79/39.41 = 3.57
2003 158.82/53.16 = 2.99
Return on Equity 12.67 12.75 17.37
Answers to Self-Assessment Questions/ Exercises
7 (b)
8 (d)
9 (a)
10 (d)
11 (True)
12 (True)
13 (c)
14 annual sales; 360; receivable; cost;
15 Trend; industry average;
16 (d)
17 (c)
18 (c)
19 Accounts payable = Rs. 25,500; Total Capital and Liabilities as well as Total
Assets = Rs. 76,500; Cash = Rs. 22,100; Accounts Receivable = Rs. 13,600;
Inventories = Rs. 24,480; Cost of goods sold = Rs. 91,800; Plant & Equipment
= Rs. 16,320; and Sales = 1,22,400.
20. Weldone Co. Goodluck Co.
a)
b)
Rate of return on total assets 13.3% 20%
Net profit percentage 10% 8.3%
Asset turnover 1.33 times 2.4 times
c) The three ratios provide an estimate

of a company's overall performance. They
are inter-related: =
From the viewpoint of potential investors - shareholders and loan creditors - the
overall performance is important. In what way the profit between the two types of
finance (loan and equity) is apportioned is also of equal importance. They will
therefore need information about capital leverage i.e. the relation-ship between equity
and loan capital and the relationship between profits and interest payments.



41
Ratio Analysis


The potential loan creditor will also require information about security that the.
company can provide.
The potential shareholders are also interested in future dividends as well as current
yields. They will need information about the share prices and earnings per share so
that they could make relevant comparison against similar other investment in terms
of PEE ratio and yield.
21 a) Profit margin not too bad ; assets turnover quite low. Action
required.
b) Inventory per unit of sales higher that other firms. Action required.
Implications and impact of suggested action (like funds released in
the wake of inventory reduction utilized in liquidating debt and
reducing interest burden with improved profit prospects) should be
highlighted.
c) Excess capacity situation may exist, though not with definitiveness
12.9 FURTHER READINGS
Fraser, M. Lyn and Aileen Ormiston, 04/10/2003, Understanding Financial
Statements (Chapter 5) : Prentice Hall.
Khan, M.Y. and Jain, P.K., 2000. Management Accounting (Chapter 4), Tata
McGraw-Hill : New Delhi.
Brigham F. Eugene and Houston F. Joel, 1999, Fundamentals of Financial
Management, 2nd ed. (Chapter 3), Harcourt Brace and Company : Florida.
Fanning, David and M. Pendlebury, 1984, Company Accounts: A Guide, Allen &
Unwin : London.
Bhatia, Manohar L., 1986, Profit Centres: Concepts, Practices and Perspectives,
Somaiya Publications, Bombay (pp, 166-170)
Hingorani N.L. and A.R. Ramanathan, 1986. Management Accounting (Chapter 7)
Sultan Chand: Delhi.
AUDIO PROGRAMME
Role and Regulation of Stock Markets
41

Introduction to Financial
Management
UNIT 1 INTRODUCTION TO FINANCIAL
MANAGEMENT
Structure Page
Nos.
1.0 Introduction 5
1.1 Objectives 6
1.2 Evolution of Financial Management 6
1.3 Significance of Financial Management 6
1.4 Principles of Financial Management 8
1.4.1 Investment Decision
1.4.2 Financing Decision
1.4.3 Dividend Decision
1.4.4 Liquidity Decision
1.5 Objectives of Financial Management 9
1.6 Economic Profit vs. Accounting Profit 11
1.7 Agency Relationship 11
1.7.1 Problems Related with Agency Relationship
1.7.2 Costs of the Agency Relationship
1.8 The Changing Financial Landscape 12
1.9 Organisation of Financial Management 13
1.10 Tasks and Responsibilities of Modern Financial Manager 13
1.11 Summary 15
1.12 Self-Assessment Questions/Exercises 15
1.13 Solutions/Answers 15

1.0 INTRODUCTION
Finance is the application of economic principles and concepts to business decision
making and problem solving. The field of finance broadly consists of three
categories: Financial Management, Investments and Financial Institutions.
i) Financial Management: This area is concerned with financial decision
making within a business entity. Financial management decisions, include
maintaining optimum cash balance, extending credit, mergers and acquisitions,
raising of funds and the instruments to be used for raising funds and the
instruments to be used for raising funds etc.
ii) Investments: This area of finance focuses on the behaviour of financial
markets and pricing of financial instruments.
iii) Financial Institutions: This area of finance deals with banks and other
financial institutions that specialises in bringing supplier of funds together with
the users of funds. There are three categories of financial institutions which act
as an intermediary between savers and users of funds, viz., banks,
developmental financial institution and capital markets.
Financial management is broadly concerned with the acquisition and use of funds by
a business firm. The scope of financial management has grown in recent years, but
traditionally it is concerned with the following:
How large should a firm be and how fast should it grow?
What should be the composition of the firms assets?
What should be the mix of the firms financing?
How should the firm analyse, plan and control its financial affairs?

The past two decades have witnessed several rapid changes on the economic and
corporate front which have an important bearing on how firms are run and managed.
On the one hand we have witnessed economies of several countries opening up

5

Financial Management
and Decisions
thereby throwing new opportunities and on the other hand we have also witnessed
that the growth rate of developed countries are stagnating or even declining. The
impact of these changes is that the firms have to move out of the saturated markets
and explore new markets.

1.1 OBJECTIVES
After going through this unit, you should be able to:
understand the role and scope of financial management;
understand the evolution of financial management;
understand the various decisions taken by financial managers, and
understand the concept of economic and accounting profit.

1.2 EVOLUTION OF FINANCIAL
MANAGEMENT
The evolution of financial management may be divided into three broad phases:
i) The traditional phase
ii) The transitional phase
iii) The modern phase.

In the traditional phase the focus of financial management was on certain events
which required funds e.g., major expansion, merger, reorganisation etc. The
traditional phase was also characterised by heavy emphasis on legal and procedural
aspects as at that point of time the functioning of companies was regulated by a
plethora of legislation. Another striking characteristic of the traditional phase was
that, a financial management was designed and practiced from the outsiders point of
view mainly those of investment bankers, lenders, regulatory agencies and other
outside interests.

During the transitional phase the nature of financial management was the same but
more emphasis was laid on problems faced by finance managers in the areas of fund
analysis planning and control.

The modern phase is characterised by the application of economic theories and the
application of quantitative methods of analysis. The distinctive features of the
modern phase are:
Changes in macro economic situation that has broadened the scope of financial
management. The core focus is how on the rational matching of funds to their
uses in the light of the decision criteria.
The advances in mathematics and statistics have been applied to financial
management specially in the areas of financial modeling, demand forecasting and
risk analysis.
1.3 SIGNIFICANCE OF FINANCIAL
MANAGEMENT
The main objective of financial management is, to make optimum utilisation of
resources which results in maximum profits. The last five decades have witnessed
rapid industrial development and policies of globalisation and liberalisation as a
result of which financial activities have undergone tremendous changes. The success
or the failure of business operations largely depends upon the financial policies
pursued by the firm; as Irwin Friend has said a firms success and even survival, its
6

Introduction to Financial
Management
ability and willingness to maintain production and to invest in fixed or working
capital are to a very considerable extent determined by its financial policies both past
and present. In modern time where the ownership of firms is more dispersed, there is
a separation of ownership and management and the firms are focusing toward social
responsibility the role of financial management has spanned beyond planning and
control. In the words of Ezra Soloman Financial management is properly viewed
as an integral part of overall management rather than as a staff specialty concerned
with fund raising operations. In addition to raising funds, financial management is
directly concerned with production, marketing and other functions within an
enterprise where decisions are made about the acquisition or distribution of assets.
The significance of financial management is discussed as follows:
1) Determination of Business Success: Sound financial management leads to
optimum utilization of resources which is the key factor for successful
enterprises. If we analyse the factors which lead to an enterprise turning sick
one of the main factors would be mismanagement of financial resources.
Financial Management helps in preparation of plans for growth, development,
diversification and expansion and their successful execution.
2) Optimum Utilisation of Resources: One of the basic objectives of financial
management is to measure the input and output in monetary terms. Since
finance managers are responsible for the allocation of resources, they are also
responsible to ensure that resources are used in an optimum manner. In fact, the
failure of business enterprise is not due to inadequacy of financial resources,
but is the result of defective management of financial resources. In a country
like India, where capital is scarce effective utilisation of financial resources is
of great significance.
3) Focal Point of Decision Making: Financial management is the focal point of
decision-making as it provides various tools and techniques for scientific
financial analysis. Some of the techniques of financial management are
comparative financial statement, budgets, ratio analysis, variance analysis,
cost- volume, profit analysis, etc. These tools help in evaluating the profitability of
the project.
4) Measurement of Performance: The performance of the firm is measured by
its financial results. The value of the firm is determined by the quantum of
earnings and the associated risk with these earnings. Financial decisions which
increases earnings and reduces risk will enhance the value of the firm.
5) Basis of Planning, Co-ordination and Control: Each and every activity of
the firm requires resource outlays which are ultimately measured in monetary
terms. The finance department being the nodal department is closely associated
with the planning of most of the activities of the various departments. Since
most of the activities of the firm require co-ordination among various
departments, the finance department facilitates this co-ordination by supplying
the requisite information. Since the result of various activities are measured in
monetary terms, again the finance department is closely involved in control and
monitoring activities.
6) Advisory Role: The finance manager plays an important role in the success
of any organisations.
7) Information Generator for Various Stakeholders: In this modern era where
business managers are trustees of public money, it is expected that the firm
provides information to the various stakeholders about the functioning of the
firm. One of the major objectives of financial management is to provide timely
information to various stakeholders.

1.4 PRINCIPLES OF FINANCIAL MANAGEMENT

7

Financial Management
and Decisions
The broad principles of corporate finance are:
1) Investment Decision
2) Financing Decision
3) Dividend Decision
4) Liquidity Decision

1.4.1 Investment Decision
The firm has scarce resources that must be allocated among competing uses. On the
one hand the funds may be used to create additional capacity which in turn generates
additional revenue and profits and on the other hand some investments results in
lower costs. In financial management the returns, from a proposed investment are
compared to a minimum acceptable hurdle rate in order to accept or reject a project.
The hurdle rate is the minimum rate of return below which no investment proposal
would be accepted. In financial management we measure (estimate) the return on a
proposed investment and compare it to minimum acceptable hurdle rate in order to
decide whether or not the project is acceptable. The hurdle rate is a function of
riskness of the project, riskier the project higher the hurdle rate. There is a broad
argument that the correct hurdle rate is the opportunity cost of capital. The
opportunity cost of capital is the rate of return that an investor could earn by investing
in financial assets of equivalent risk.

1.4.2 Financing Decision
Another important area where financial management plays an important role is in
deciding when, where, from and how to acquire funds to meet the firms investment
needs. These aspects of financial management have acquired greater importance in
recent times due to the multiple avenues from which funds can be raised. Some of the
widely used instruments for raising finds are ADRs, GDRs, ECBs Equity Bonds and
Debentures etc. The core issue in financing decision is to maintain the optimum
capital structure of the firm that is in other words, to have a right mix of debt and
equity in the firms capital structure. In case of pure equity firm (Zero debt firms) the
shareholders returns should be equal to the firms returns. The use of debt affects the
risk and return of shareholders. In case, cost of debt is used the firms rate of return
the shareholders return is going to increase and vice versa. The change in
shareholders return caused by change in profit due to use of debt is called the
financial deverage.

1.4.3 Dividend Decision
Dividend decisions is the third major financial decision. The share price of a firm is a
function of the cash flows associated with the share. The share price at a given point
of time is the present value of future cash flows associated with the holding of share.
These cash flows are dividends. The finance manager has to decide what proportion
of profits has to be distributed to the shareholders. The proportion of profits
distributed as dividends is called the dividend pay out ratio and the retained
proportion of profits is known as retention ratio. The dividend policy must be
designed in a way, that it maximises the market value of the firms share. The
retention ratio depends upon a host of factors the main factor being the existence of
investment opportunities. The investors would be indifferent to dividends if the firm
is able to earn a rate or return which is higher than the cost of the capital. Dividends
are generally paid in cash, but a firm may also issue bonus shares. Bonus share are
shares issued to the existing shareholders without any charge. As far as dividend
decisions are concerned the finance manager has to decide on the question of
dividend stability, bonus shares, retention ratio and cash dividend.
1.4.4 Liquidity Decision
A firm must be able to fulfill its financial commitments at all points of time. In order
to ensure this the firm should maintain sufficient amount of liquid assets. Liquidity
decisions are concerned with satisfying both long and short-term financial
8

Introduction to Financial
Management
commitments. The finance manager should try to synchronise the cash inflows with
cash outflows. An investment in current assets affect the firms profitability and
liquidity. A conflict exists between profitability and liquidity while managing current
assets. In case, the firm has insufficient current assets it may default on its financial
obligations. On the other hand excess funds result in foregoing of alternative
investment opportunities.

) Check Your Progress 1
1) List the three broad phases of evolution of financial management.

2) List the significance of financial management.

3) What are the major principles of financial management?

1.5 OBJECTIVES OF FINANCIAL
MANAGEMENT
For optimal financial decisions, it is essential to define objectives of financial
management. These objectives serve as decision-criterion. Financing is a functional
area of business and, therefore, the objectives of financial management must be in
tune with the overall objectives of the business. The main objectives of business are
survival and growth. In order to survive in the business and to grow, a business must
earn sufficient profits. It must also maintain good relations with investors, employees,
customers and other groups of society. Financial management of an organisation may
seek to achieve the following objectives:
ensure adequate and regular supply of funds to the business,
provide a fair rate of return to the suppliers of capital,
ensure efficient utilisation of capital according to the principles of profitability,
liquidity and safety,
devise a definite system for internal investment and financing,
minimise cost of capital by developing a sound and economical combination of
corporate securities,
co-ordinate the activities of the finance department with the activities of other
departments of the organisation.
Generally, maximisation of economic welfare of its owners is accepted as the
financial objective of the firm. But, the question is, how does one maximise the

9

Financial Management
and Decisions
owners economic welfare? Financial experts differ while finding a solution to this
problem. There are two well known criteria in this regard:
i) Profit Maximisation
ii) Wealth Maximisation.

Profit Maximisation
The basic objective of every business enterprise is the welfare of its owners. It can be
achieved by the maximisation of profits. Therefore, according to this criterion, the
financial decisions (investment, financing and dividend) of a firm should be oriented
to the maximisation of profits (i.e. select those assets, projects and decisions which
are profitable and reject those which are not profitable). In other words, actions that
increase profits are be undertaken and those that decrease profits are to be avoided.
Profit maximisation as an objective of financial management can be justified on the
following grounds:

1) Rational
2) Test of Business Performance
3) Main Source of Inspiration
4) Maximum Social Welfare
5) Basis of Decision-Making

Drawbacks of Profit Maximisation Concept

1) It is vague
2) It ignores time value of money
3) It ignores risks
4) It ignores social responsibility

From the above description, it can be easily concluded that profit maximisation
criterion is inappropriate and unsuitable as an operational objective of financial
management. In imperfect competition, the profit maximisation criterion will
certainly encourage concentration of economic power and monopolistic tendencies.
That is why, the objective of wealth maximisation is considered as the appropriate
and feasible objective as against the objective of profit maximisation.

We shall discuss this criteria in detail and arrive at a satisfactory conclusion to
determine the goals or objectives of financial management.

Wealth Maximisation
The objective of profit maximisation, as discussed above, is not only vague and
ambiguous, but it also ignores the two basic criteria of financial management i.e. (i)
risk and (ii) time value of money. Therefore, wealth maximisation is taken as the
basic objective of financial management, rather than profit maximisation. It is also
known as Value Maximisation or Net Present Value Maximisation. According to
Ezra Soloman of Stanford University, the ultimate objective of financial
management should be the maximisation of wealth. Prof. Irwin Friend has also
supported this view.

Wealth Maximisation means to maximise the net present value (or wealth)
(NPV) of a course of action. It NPV is the difference between the gross present
value of the benefits of that action and the amount of investment required to achieve
those benefits. The gross present value of a course of action is calculated by
discounting or capitalising its benefits at a rate which reflects their timings and
uncertainty.
Superiority of Wealth Maximisation
10

Introduction to Financial
Management
We have discussed the goals or objectives of financial management. Now, the
question arises as to the choice i.e., which should be the goal of financial
management in decision making i.e., profit maximisation or wealth maximisation. In
present day changed circumstances, wealth maximisation is a better objective because
it has the following points in its favour:
It measures income in terms of cash flows, and avoids the ambiguity now
associated with accounting profits as, income from investments is measured on
the basis of cash flows rather than on accounting profits.
It recognises time value of money by discounting the expected income of
different years at a certain discount rate (cost of capital).
It analyses risk and uncertainty so that the best course of action can be selected
from different alternatives.
It is not in conflict with other motives like maximisation of sales or market value
of shares. It helps rather in the achievement of all these other objectives.

Therefore, maximisation of wealth is the operating objective by which financial
decisions should be guided.

1.6 ECONOMIC PROFIT VS. ACCOUNTING
PROFIT
Economic profit is the difference between revenues and costs where costs include
both the actual businesses costs (the explicit costs) and the implicit costs. The
implicit costs are the payments that are necessary to secure the needed resources, the
cost of capital. Accounting profits is the difference between revenues and costs
recorded according to accounting principles. The implicit cost-opportunity cost and
normal profits which reflects the uncertainty and timing of future cash flows are not
taken into consideration in according profits.

Economic Value Added
i) Calculate the firms operating profit
ii) Calculate the cost of capital
iii) Compare operating profit with cost of capital.

A related measure of economic profit is market value added (MVA), which focuses
on the market value of capital as compared to the cost of capital.
Calculate the market value of capital
Calculate the amount of capital invested.
Compare the market value of capital with capital invested.

In theory market value added is the present value of all expected future economic
profits.

In a nutshell financial decisions are concerned, with the firms decision to acquire
and dispose off assets and commitment of funds on a continuous basis. Financial
decisions affect the size, growth, profitability, risk and ultimately, the Value of the
firm.

1.7 AGENCY RELATIONSHIP
When firms are small they usually function as sole proprietorship firms or partnership
firms where owner/partners make the decisions. As the volume and complexity of
business increases the sole proprietorship partnership firms convert themselves into
public limited companies or joint stock companies. With increased geographical

11

Financial Management
and Decisions
spread and other complexities often it is not possible for owners to look after all the
aspects of the business. The decision making power is delegated to the managers
(agents). An agent is a person who acts for, and exerts power on behalf of another
person or group of persons. The person (or group of persons) whom the agent
represents is referred to as the principal. The relationship between the agent and the
principal is an agency relationship. There is an agency relationship between the
managers and shareholders of a company.

1.7.1 Problems Related with Agency Relationship
In an agency relationship the agent is charged with the responsibility of acting for the
principal and in the best interest of the principal. But, it is possible that the agent may
act in a fashion which serves his/her own self-interest rather than that of the principal.
In recent years we have witnessed numerous corporate frauds i.e. Enron, Xerox, etc.,
where the agents had misappropriated the authority vested in them by the principal.
The problems associated with agency relationship can manifest itself in many ways.
The most common being the misuse of power and authority by the managers, which
includes financial misappropriation, using the funds of the company for the personal
self (fringe benefits) etc. In case the reward and compensations are based on certain
parameters, for example sales; managers may indulge in practices which would yield
result in the short run but prove detrimental in the long run, i.e., overstocking the
various intermediaries in the supply chain, offering huge discounts, dumping of
goods in the territory of another manager etc. Another facet of this problem is, where
managers put a little effort towards expanding and exploring the market for new
business. In a nutshell the problems with agency relationship is that the managers act
in a fashion which serves their own interest rather than that of the shareholders.

1.7.2 Costs of the Agency Relationship
In order to minimise the potential for conflict between the principals interest and the
agents interest certain costs are to be incurred by the principal as well as the agent
and the cumulative effect of these costs is referred to as the agency costs. Agency
costs are of three types: monitoring costs, bonding costs and residual cost.

Monitoring Costs
These are the costs incurred by the principal to monitor and limit the actions of the
agent. In companies the shareholders may require the managers to periodically report
on their activities via audited financial statements. The cost of resources spent on
preparing these statements is monitoring cost. Another example is the implicit cost
incurred when the principal limits the decision making power of the agent; by doing
so, the principal may miss profitable investment opportunities. The foregone profit is
the monitoring cost.

Bonding Costs
These are the costs incurred by the agents to assure the principal that they will act in
the best interest of the principal.

Residual Costs
Residual costs is the remaining costs after taking into consideration of the above costs
(i.e., monitoring costs, bonding costs).

1.8 THE CHANGING FINANCIAL LANDSCAPE
The past two decades have been witnessing radical changes in the financial system
world over. The significant changes which has been taking place over the years are:
a) Low interest rate regime
b) Exchange control and convertibility
12

Introduction to Financial
Management
c) Development of capital markets
d) Less intermediation
e) Introduction of hybrid financial instruments
f) Increase in risk exposure
g) Volatility in commodity prices
h) Substantial lowering of custom duty (Removal of trade barriers).

These changes coupled with changing customer needs, technology driven innovations
and regulatory changes are imposing substantial changes in the financial systems
world over.

The impacts of these changes are as follows:
1) Increased competitions have resulted in the rationalisation of pricing and costs.
Companies having high cost structure are being forced to rationalise operations.
2) National financial system is now more closely integrated with international
financial system.

1.9 ORGANISATION OF FINANCIAL
MANAGEMENT
Organisation of financial management means the division and the classification of
various functions which are to be performed by the finance department.

In small organisations where partners or proprietors have main say in the running of
the firm, no separate finance department is established. At the most they may appoint
a person for book keeping and liasioning with banks and debtors.

In medium size organisations a separate department to organise all financial activities
may be created at the top level under the direct supervision of the Board of Directors
or a very senior executive. The important feature of this type of set up is that there is
no further sub division based on various functional areas of finance.

In large size organisations the finance department is further sub divided into
functional areas. In these organisations two main sub-divisions are that of the
Financial Controller and the Treasurer. The Financial Controller is concerned with
planning and controlling, preparation of annual reports, capital and working capital
budgeting, cost and inventory management maintenance of books and records and
pay-roll preparation. The treasurer is concerned with raising of funds both short term
and long term. In addition to this the treasurer is responsible for cash and receivable
management, auditing of accounts, protection and safe keeping of securities and the
maintenance of relations with banks and institutions.

1.10 TASKS AND RESPONSIBILITIES OF
MODERN FINANCIAL MANAGER
The task and responsibilities of finance managers vary from organisation to
organisation depending upon the nature and size of the business, but inspite of these
variations the main tasks and responsibilities of finance manager can be classified as
follows:
a) Compliance with policy and procedures laid by the Board of Directors.
b) Compliance with various rules and procedures as laid by law.
c) Information generation for various stakeholders.
d) Effective and efficient utilisation of funds.
The main tasks and responsibilities of a financial manager are discussed below:
1) Financial Planning and Forecasting: Financial manager is also concerned
with planning and forecasting of production, sales and level of inventory.

13

Financial Management
and Decisions
In addition to this, he has also to plan and forecast the requirement of funds and
the sources from which the funds are to be raised.

2) Financial Management: Fund management is the primary responsibility of the
finance manager. Fund management includes effective and efficient
acquisition, allocation and utilisation of funds. The fund management includes
the following:
Acquisition of funds: The finance manager has to ensure that adequate
funds are available from the right sources at the right cost at the right time.
The finance manager will have to decide the mode of raising fund, whether
it is to be through the issue of securities or lending from the bank.

Allocation of funds: Once funds are acquired the funds have to be
allocated to various projects and services as per the priority fixed by the
Board of Directors.

Utilisation of funds: The objective of business finance is to earn profiles,
which on a very large extent depend upon how effectively and efficiently
allocated funds are utilised. Proper utilisation of funds is based on sound
investment decisions, proper control and asset management policies and
efficient management of working capital.
3) Disposal of Profits: Finance manager has to decide the quantum of dividend
which the company wants to declare. The amount of dividend will depend upon
mainly the future requirement of funds for expansion and the prevailing tax
policy.

4) Maximisation of Shareholders Wealth: The objective of any business is to
maximise and create wealth for the investors, which is measured by the price of
the share of the company. The price of the share of any company is a function
of its present and expected future earnings. The finance managers should
pursue policies which maximises earnings.

5) Interpretation and Reporting: Interpretation of financial data requires skills.
The finance manager should analyse financial data and find out the reasons for
variance from standards and report the same to the management. He should
also assess the likely financial impact of these variances.

6) Legal Obligations: All the companies are governed by specific laws of the
land. These laws relate to payment of taxes, salaries, pension, corporate
governance, preparation of accounts etc. The finance manager should ensure
that a true and correct picture of the state of affairs should be reflected in the
statement of accounts. He should also ensure that the tax returns and various
other information should be submitted on time.

) Check Your Progress 2
1) What are the significant changes taking place in the financial system?

2) List the main tasks and responsibilities of a Financial Manager.
14

Introduction to Financial
Management

1.11 SUMMARY
Financial Management has undergone several changes over the last five decades as
more and more companies are raising funds from markets both domestic and
overseas. The modern phase of financial management is characterised by the
application of economic theories and advanced mathematical and statistical tools.
Financial managements significance is increasing day by day as it play the role of
facilitator among various departments. The objective of the firm has also changed
from profit maximisation to that of wealth maximisation. The agency problem is
concerned with how managers behave when, delegated with decision making powers.

1.12 SELF-ASSESSMENT
QUESTIONS/EXERCISES
1) Finance is the life blood of industry. Elucidate this statement with suitable
illustrations.
2) What is the finance function? Explain in brief the different approaches (or
concepts) to Finance Function.
3) What is Financial Management? How does a modern financial management
differ from traditional financial management?
4) What is meant by Financial Management? What are the salient features of
Financial Management?
5) Define Financial Management and discuss its main functions.
6) Explain the scope of financial management. What role should the financial
manager play in modern enterprise?
7) What do you understand by Financial Management? Discuss its significance
in business management.
8) The importance of financial management has increased in modern times.
Elucidate.
9) Sound Financial Management is a key to the progress for corporation.
Explain.
10) Without adequate finance no business can survive and without efficient
financial management, no business can prosper and grow. Comment on this
statement bringing out the role of financial management.
11) Discuss the objectives and goals of Financial Management.

1.13 SOLUTIONS/ANSWERS

Check Your Progress 1
1) The three broad phases of evolution of financial management are as follows:

15

Financial Management
and Decisions
a) The traditional phase
b) The transitional phase
c) The modern phase

2) The significance of financial management are:
a) Determination of business success
b) Optimum utilisation of resources
c) Focal point of decision making
d) Measurement of performance
e) Basis of planning coordination and control
f) Advisory role
g) Information generator for various stakeholders

3) The broad principles of corporate finance are:
a) Investment Decision
b) Financing Decision
c) Dividend Decision
d) Liquidity Decision

Check Your Progress 2
1) The following are the significant changes taking place in the financial system:
a) Low interest rate regime
b) Exchange control and convertibility
c) Development of capital markets
d) Less intermediation
e) Introduction of hybrid financial instruments
f) Increase in risk exposure
g) Volatility in commodity prices
h) Substantial lowering of custom duty

2) The main tasks and responsibilities of a financial manager are
a) Financial planning and forecasting
b) Financial management
c) Disposal of profits
d) Maximisation of shareholders wealth
e) Interpretation and reporting
f) Legal obligations


16

Time Value of Money
UNIT 2 TIME VALUE OF MONEY
Structure Page Nos.
2.0 Introduction 17
2.1 Objectives 17
2.2 Determining the Future Value 17
2.2.1 Shorter Compounding Period
2.2.2 Effective vs. Nominal Rates
2.2.3 Continuous Compounding
2.3 Annuity 23
2.4 Summary 31
2.5 Self-Assessment Questions/Exercises 32
2.6 Solutions/Answers 35

2.0 INTRODUCTION

The notion that money has time value is one of the most basic concepts of investment
analysis. For any productive asset its value will depend upon the future cash flows
associated with that particular asset. In order to assess the adequacy of cash flows one
of the important parameters is to assess the time value of the cash flows viz., Rs.100
received after one year would not be the same as Rs.100 received after two years.
There are several reasons to account for this difference based on the timing of the cash
flows, some of which are as follows:

there is a general preference for current consumption to future consumption,
capital (savings) can be employed to generate positive returns,
due to inflation purchasing power of money decreases over time,
future cash flows are uncertain.

Translating the current value of money into its equivalent future value is referred to as
compounding. Translating a future cash flow or value into its equivalent value in a
prior period is referred to as discounting. This Unit deals with basic mathematical
techniques used in compounding and discounting.

2.1 OBJECTIVES

After going through this unit, you should be able to:

understand the time value of money;
understand what gives money its time value;
understand the methods of calculating present and future value, and
understand the use of present value technique in financial decisions.

2.2 DETERMINING THE FUTURE VALUE


17
Let us suppose that you deposit Rs.1000 with a bank which pays 10 per cent interest
compounded annually for a period of 3 years. The deposit will grow as follows:

Financial Management
and Decisions
First Year
Principal at the beginning. Interest
for the year (1000x.10) Total
amount
Rs.
1000
100
1100
Second Year

Principal at the beginning. Interest
for the year (1100x.10). Total
Amount
1100
110
1210
Third Year Principal at the beginning. Interest
for the year (1210x.10)
Total Amount
1210
121
1321

To get the future value from present value for a one year period
k) (PV PV FV + =
where PV = Present Value
k = Interest rate
k) (1 PV FV + =
Similarly for a two year period

FV = PV + (PVk) + (PVk) + (PVkk)
Principal amount First period interest
on principal
Second period
interest on the
principal
Second periods
interest on the first
periods interest

FV = PV+PVk+PVk+PVk
2

= PV+2PVk+PVk
2

= PV (1+2k+K
2
) = PV (1+k)
2


Thus, the future value of amount after n periods is (2.1)

FV = PV (1+k)
n

where FV = Future value n years hence
PV = Cash today (present value)
k = Interest rate par year in percentage
n = number of years for which compounding is done

Equation (2.1) is the basic equation for compounding analysis. The factor (1+k)
n
is
refered to as the compounding factor or the future value interest factor (FVIFk,n).
Published tables are available showing the value of (1+k)
n
for various combinations of
k and n. One such table is given in appendix A of this unit.

Example 2.1 Find out the future value of Rs.1000 compounded annually for 10 years
at an interest rate of 10%.

Solution: The future value 10 years hence would be
FV = PV (1+k)
n

FV = 1,000 (1+.10)
10

= 1000(1.10)
10

= 1000 (2.5937)
= 2593.7


18
The appreciation in present value of an amount can also be expressed in terms of
return. A return is the income on investment over each period divided by the amount

Time Value of Money
of investment at the beginning of the period. From the above example the arithmetic
average return would be (2593.7 1000)/1000=159.37% over the ten year period or
15.937% per year. The main drawback of using arithmetic average is that it ignores
the process of compounding. To overcome this, the correct method is to use
geometric average return to calculate overage annual return.

Rearranging the equation 2.1 we get
) 2 . 2 ( 1
PV
FV
n k =
using the values from example 2.1

% 10 10 .
1 10 . 1
1
1000
7 . 2593
1
000 , 1
7 . 2593
10 / 1
10
= =
=
|
.
|

\
|
=
=


2.2.1 Shorter Compounding Period
So far in our discussion we have assumed that the compounding is done annually,
now let us consider the case where compounding is done more frequently. In this case
the equation (2.1) is modified to factor in the change of frequency of compounding.

n m
)
m
k
(1 PV
n
FV

+ =

(2.3)
where FV
n
= Future value after n years
PV = Present Value
K = nominal annual rate of interest
m = Frequency of compounding done during a year
n = number of years for which compounding is done.

If the interest is payable semiannually frequency of compounding is 2, if it is payable
monthly frequency is 12, if it is payable weekly frequency is 52 and so on.

Example 2.2 Calculate the future value of Rs.5000 at the end of 6 years, if nominal
interest rate is 12 per cent and the interest is payable quarterly (frequency = 4)
Solution:

10,164
2.0328 5000
.03) (1 5000
)
4
.12
(1 5000 FV
)
m
k
(1 PV FV
24
4 6
6
n m
n
=
=
+ =
+ =
+ =

The future value of Rs.5000 after 6 years on the basis of quarterly compounding
would be Rs.10 164 whereas in case of semi-annual and annual compounding the
future value would be

19

Financial Management
and Decisions

061 , 10
0122 . 2 5000
) 06 1 ( 5000
)
2
12 .
1 ( 5000 FV
12
2 6
6
=
=
+ =
+ =



9868
) 9738 . 1 ( 5000
6
) 12 . 1 ( 5000
6
FV
=
=
+ =

This difference in future value is due to the fact that interest on interest has been
calculated.

2.2.2 Effective vs. Nominal Rates

In the above example we have seen how the future value changes with the change in
frequency of compounding. In order to understand the relationship between effective
and nominal rate let us calculate the future value of Rs.1000 at the interest rate of 12
per cent when the compounding is done annually, semiannually, quarterly and
monthly.

6 . 1123
) 1236 . 1 ( 1000
) 06 . 1 ( 1000
)
2
12 .
1 ( 1000 FV
1120
) 12 . 1 ( 1000 FV
2
2
1
=
=
=
+ =
=
+ =


8 . 1126
) 1268 . 1 ( 1000
) 01 . 1 ( 1000
)
12
12 .
1 ( 1000 FV
5 . 1125
) 1255 . 1 ( 1000
) 03 . 1 ( 1000
)
4
12 .
1 ( 1000 FV
12
12
4
4
=
=
=
+ =
=
=
=
+ =


From the above calculations we can see that Rs.1000 grows to Rs.1120, Rs.1123.6,
Rs.1125.5 and Rs.1126.8 although the rate of interest and time period are the same. In
the above case 12.36, 12.55 and 12.68 are known as effective rate of interest. The
relationship between the effective and nominal rate of interest is given by
1 )
m
k
1 ( r
m
+ = (2.4)
where r = effective rate of interest

20
k = nominal rate of interest
m = frequency of compounding per year

Time Value of Money
Based on the above stated example the effective interest rate is calculated as follows:

a) Effective interest rate for monthly compounding

68 . 12 1268 .
1 1268 . 1
1 ) 01 . 1 (
1 )
12
12 .
1 ( r
12
12
= =
=
=
+ =


b) Effective interest rate for quarterly compounding

% 55 . 12
1255 . 1 1255 . 1 r
1 ) 03 . 1 ( r
1 )
4
12
1 ( r
4
4
=
= =
=
+ =


c) Similarly the effective interest rate for semi-annual compounding is

36 . 12 1236 . 1 1236 . 1 r
1 ) 06 . 1 ( r
1 )
2
12
1 ( r
2
2
= = =
=
+ =


Doubling Period
One of the first and the most common questions regarding an investment alternative is
the time period required to double the investment. One obvious way is to refer to the
table of compound factor from which this period can be calculated. For example the
doubling period at 3%, 4%, 5%, 6%, 7%, 8%, 9%, 10%, 12% would be approximately
23 years, 18 years, 14 years, 12 years, 10 years, 9 years, 8 years,
7 years, and 6 years respectively.

If one is not inclined to use future value interest factor tables there is an alternative,
known as rule of 72. According to this rule of thumb the doubling period is obtained
by dividing 72 by the interest rate. For example, at the interest rate of 8% the
approximate time for doubling an amount would be 72/8 = 9 years.

A much more accurate rule of thumb is rule of 69. As per this rule the doubling period
is equal to

rate Interest
69
35 . +

Using this rule the doubling period for an amount fetching 10 percent and 15 percent
interest would be as follows.

21

years 95 . 4 6 . 4 35 .
15
69
35 .
years 25 . 7 9 . 6 35 .
10
69
35 .
= + = +
= + = +

Financial Management
and Decisions
2.2.3 Continuous Compounding

The extreme frequency of compounding is continuous compounding where the
interest is compounded instantaneously. The factor for continuous compounding for
one year is eAPR where e is 2.71828 the base of the natural logarithm. The future
value of an amount that is compounded for n years is

FV = PV x e
kn

Where k is annual percentage rate and e
kn
is the compound factor.

Example 2.3: Find the future value of Rs.1000 compounded continuously for 5 year
at the interest rate of 12% per year and contrast it with annual compounding.

12 . 1822
82212 . 1 1000
71828 . 2 1000
71828 . 2 1000
PVe FV : Solution
60 .
N(APR)
5
=
=
=
=
=


3 . 1762
) 7623 . 1 ( 1000
) 12 . 1 ( 1000
) k 1 ( PV FV
5
n
5
=
=
+ =
+ =


From this example you can very well see the effects of extreme frequency of
compounding.
So far in our discussion we have assumed that the interest rate is going to remain the
same over the life of the investment, but now a days we are witnessing an increased
volatility in interest rates as a result of which the financial instruments are designed in
a way that interest rates are benchmarked to a particular variable and with the change
in that variable the interest rates also change accordingly.

In such cases the Future Value is calculated through this equation.

) k 1 ( ... ) k 1 ( ) k 1 ( ) k 1 ( PV FV
n 3 2 1 n
+ + + + + = (2.5)

Where k
n
is the interest rate for period n.

Example 2.4: Consider a Rs.50, 000 investment in a one year fixed deposit and
rolled over annually for the next two years. The interest rate for the first year is 5%
annually and the expected interest rate for the next two years are 6% and 6.5%
respectively calculate the future value of the investment after 3 years and the average
annual interest rate.

Solution:


25 . 267 , 59
) 065 . 1 ( ) 06 . 1 ( ) 05 . 1 ( 000 , 50
) k 1 ( ) k 1 ( ) k 1 ( PV FV
3 2 1
=
+ + + =
+ + + =

Average annual interest rate

22

) wrong ( 58333 .
3
065 . 06 . 05 .
=
+ +


Time Value of Money
By now we know the values of FV, PV, and n. The average annual interest rate would
be

% 8315 . 5 185345 . 1
000 , 50
25 . 59267
k
PV
FV
k
3
3
n
= = =
=


This is also equivalent to

8315 . 5
1 ) 065 . 1 ( ) 06 . 1 ( ) 05 . 1 ( k
3
=
+ + + =


) Check Your Progress 1
1) Calculate the compound value of Rs. 1000, interest rate being 12% per
annum, if compounded annually, semi annually, quarterly and monthly for
2 years.
.
.
.
2) Calculate the future value of Rs. 1000 deposited initially, if the interest is
12% compounded annually for the next five years.
.
.
.
3) Mr. X bought a share 15 years ago for Rs. 10, the present value of which is
Rs. 27.60. Compute the compound growth rate in the price of the share.

.
2.3 ANNUITY
An annuity is defined as stream of uniform period cash flows. The payment of life
insurance premium by the policyholder to the insurance company is an example of an
annuity. Similarly, deposits in a recurring bank account is also an annuity.
Depending on the timing of the cash flows annuities are classified as:
a) Regular Annuity or Deferred Annuity
b) Annuity Due.

The regular annuity or the deferred annuity are those annuities in which the cash flow
occur at the end of each period. In case of an annuity due the cash flow occurs at the
beginning of the period.

Example 2.5: Suppose Mr. Ram deposits Rs. 10,000 annually in a bank for 5 years, at
10 per cent compound interest rate. Calculate the value of this series of deposits at the
end of five years assuming that (i) each deposit occurs at the end of the year (ii) each
deposit occurs at the beginning of the year.

23

Financial Management
and Decisions
Solution: The future value of regular annuity will be
Rs. 1000 (1.10)
4
+ 1000 (1.10)
3
+1000 (1.10)
2
+1000 (1.10) +1000
= 6105.
The future value of an annuity due will be
Rs. 1000 (1.10)
5
+ 1000 (1.10)
4
+1000 (1.10)
3
+1000 (1.10)
2
+1000 (1.10)
= Rs 1000 (1.611) + 1000 (1.4641) + 1000 (1.331) + 1000 (1.21)+1000 (1.10)
= Rs. 6716.
In the above example you have seen the difference in future value of a regular annuity
and annuity due. This difference in value is due to the timing of cash flow. In case of
regular annuity the last cash flow does not earn any interest, whereas in the case of
annuity due, the cash flows earns an interest for one period.
Formula

In general terms the future value of an annuity (regular annuity) is given by the
following formula:

(

+
=

=

+
=
+ +

+ +

+ =
k
1
n
) k 1 (
A
n
1 t
t n
) k 1 (
A
) 6 . 2 ( A ...
2 n
) k 1 ( A
1 n
) k 1 ( A
n
FVA

Future value of an annuity due

) k 1 (
k
1
n
) k 1 (
A
) 7 . 2 (
n
1 t
1 t n
) k 1 ( A
) due ( n
FVA
) k 1 ( A ....
1 n
) k 1 ( A
n
) k 1 ( A
) due ( n
FVA
+
+
=

=
+
+ =
+ + +

+ + +
(
(

Where FVA
n
= Future value of an annuity which has a duration of n periods
A = Constant periodic cash flow
k = Interest rate per period
n = duration of the annuity
The term
(

+
k
1 ) k 1 (
n
is referred to as the future value interest factor for an annuity
(FVIFA
k
,
n
). The value of this factor for several combinations of k and n are given in
the appendix at the end of this unit.

Present Value of an Uneven Series


24
In real life cash flows occurring over a period of time are often uneven. For example,
the dividends declared by the companies will vary from year to year, similarly
payment of interest on loans will vary if the interest is charged on a floating rate basis.
The present value of a cash flow stream is calculated with the help of the following
formula:

Time Value of Money
PV
n
= ) 8 . 2 (
) k 1 (
A
) k 1 (
A
..........
) k 1 (
A
) K 1 (
A
n
1 t
t
t
n
n
2
2 1

+
=
+
+ +
+
+
+ =


Where
PV
n
= present value of a cash flow stream
A
t
= cash flow occurring at the end of the year
k = discount rate
n = duration of the cash flow stream

Shorter Discounting Periods
Sometimes cash flows may have to be discounted more frequently than once a year-
semi-annually, quarterly, monthly or daily. The result of this is two fold (i) the
number of periods increases (ii) the discount rate applicable per period decreases. The
formula for calculating the present value in case of shorter discounting period is

PV = FV
n

m / n
m / k 1
1
(

+
(2.9)
Where m = number of times per year discounting is done.
Example 2.6: Calculate the present value of Rs. 10,000 to be received at the end of
4 years. The discount rate is 10 percent and discounting is done quarterly.

Solution:
PV = FV
4
PVIF k/m, mn
= 10,000 PVIF 3%, 16
= 10,000 0.623
= Rs. 6230

Determining the Present Value
In the previous sections we have discussed the computation of the future value, now
let us work the process in reverse. Let us suppose you have won a lottery ticket worth
Rs. 1000 and this Rs. 1000 is payable after three years. You must be interested in
knowing the present value of Rs. 1000. If the interest rate is 10 per cent, the present
value can be calculated by discounting Rs. 1000 to the present point of time as
follows.
Value three years hence = Rs. 1000 |
.
|
\
10 . 1
1

|

Value one years hence = Rs. 1000 |
.
|
\
10 . 1
1

|
|
.
|
\
10 . 1
1

|

Value now (Present Value) = Rs. 1000 |
.
|
\
10 . 1
1

|
|
.
|
\
10 . 1
1

|
|
.
|
\
10 . 1
1

|


Formula
Compounding translates a value at one point in time into a value at some future point
in time. The opposite process translates future value into present value. Discounting
translates a value back in time. From the basic valuation equation

FV = PV (1 + k)
n

Dividing both the sides by (1+k)
n
we get

25
PV = FV
( )
n
k
(

+ 1
1
(2.10)

Financial Management
and Decisions
The factor
( )
n
k
(

+ 1
1
is called the discounting factor or the present value interest
factor [PVIF
k,n
]

Example 2.7: Calculate the present value of Rs. 1000 receivable 6 years hence if the
discount rate is 10 per cent.

Solution: The present value is calculated as follows:
PV
kn
= FV
n
PVIF
k,n

= 1,000 ( 0.5645)
= 564.5
Example 2.8: Suppose you are receiving an amount of Rs.5000 twice in a year for
next five years once at the beginning of the year and the other amount of Rs. 5000 at
the end of the year, which you deposit in the bank which pays an interest of
12 percent. Calculate the value of the deposit at the end of the fifth year.

Solution: In this problem we have to calculate the future value of two annuities of
Rs.5000 having duration of five years. The first annuity is an annuity due and the
second annuity is regular annuity, therefore the value of the deposit at the end of five
year would be

67336
577 , 35 765 , 31
) 12 . 1 )( 353 . 6 ( 5000 ) 353 . 6 ( 5000
) k 1 ( ) FVIFA ( A ) FVIFA ( A
) k 1 (
k
1 ) k 1 (
A
k
1 ) k 1 (
A
FVA FVA
5 , 12 5 , 12
n n
) due ( n n
=
+ =
+ =
+ + =
+
(

+
+
(

+
=
+

The value of deposit at the end of the fifth year is Rs. 67,342.

Sinking Fund Factor

Suppose you are interested in knowing how much should be saved regularly over a
period of time so that at the end of the period you have a specified amount. To answer
this question let us manipulate the equation

(

+
=
k
1 ) k 1 (
A FVA
n
n

which shows the relationship between FVA
n
, A, k, and

n
FVA
n
1 ) k 1 (
k
A
(

+
= (2.11)

Equation 2.11 helps in answering this question. The periodic deposit is simply A and
is obtained by dividing FVAn by FVIFA
k,n
. In eq 2.11
(

+ 1 ) k 1 (
k
n
is the inverse of
FVIFA
k,n
and is called the sinking fund factor.


26
Example 2.9: How much should you save annually so as to accumulate
Rs. 20,00,000 by the end of 10 years, if the saving earns an interest of 12 per cent?

Time Value of Money
Solution:

400 , 11 , 1
548 . 17
1
00000 , 20 . Rs
FVIFA
1
000 , 20 . Rs
1 ) k 1 (
k
FVA A
10 %, 12
n
n
=
=
=
(

+
=

Present value of an annuity
Let us suppose you expect to receive Rs.2000 annually for the next three years. This
receipt of Rs.2000 is equally divided. One part viz., Rs.1000 is received at the
beginning of the year and the remaining Rs.1000 is received at the end of the year. We
are interested in knowing the present value when the discount rate is10 per cent. The
cash flows stated above are of two types which are similar to regular annuity and
annuity due. The present value of this cash flow is found out as follows:

a) Present value of Rs.1000 received at the end of each year for three years (Regular
annuity).

. 2479 . Rs
7513 . 0 1000 08264 1000 09091 1000
)
10 . 1
1
( 1000 . Rs )
10 . 1
1
( 1000 . Rs )
10 . 1
1
( 1000 . Rs
3 2
+ +
+ +

b) Present value of Rs.1000 received at the beginning of each year for three year
(annuity due)

2735 . Rs
08264 1000 9091 . 0 1000 1000
)
10 . 1
1
( 1000 . Rs )
10 . 1
1
( 1000 Rs 1000 . Rs
2
=
+ + =
+ +

The present value of this annuity is Rs. 2479+Rs.2735 = Rs. 5214.

Formula
In general terms the present value of a regular annuity may be expressed as follows:

(
(
(

+
+
=
(

+
+
+
+
+
=
+
+
+ +
+
+
=
n
n
n 2
n 2
n
) k 1 ( k
1 ) k 1 (
A
) k 1 (
1
...
) k 1 (
1
k 1
1
A
) k 1 (
A
......
) k 1 (
A
) k 1 (
A
PVN

In case of annuity due

27

Financial Management
and Decisions
) k 1 (
) k 1 ( k
1 ) k 1 (
A PVA
n
n
) due ( n
+
(

+
+
= (2.12)
where PVA
n
= Present value of an annuity which has a duration of n periods
A = Constant periodic flows
k = discount rate

Capital Recovery Factor
Equation 2.12 shows the relationship between PVA
n
, A, K and n. Manipulating it a
bit:
We get
(

+
+
=
1 ) k 1 (
) k 1 ( k
PVA A
n
n
n
(2.13)
(

+
+
1 ) k 1 (
) k 1 ( k
n
n
in equation 2.13 is inverse of PVIFA
k,n
and is called the capital
recovery factor.

Example 2.10: Suppose you receive a cash bonus of Rs.1,00,000 which you deposit
in a bank which pays 10 percent annual interest. How much can you withdraw
annually for a period of 10 years.
From eq.2.13
273 , 16 A
145 . 6
000 , 00 , 1
A
10 PVIFA
1
PVA A
% 10
n
=
=
=

Present value of perpetuity:
A perpetuity is an annuity of an infinite duration

=
(

+
+ +
+
+
+
=
, k
2
PVIFA A PVA
) k 1 (
1
...
) k 1 (
1
) k 1 (
1
A PVA

where PVA

= Present value of a perpetuity

A = Constant annual payment
PVIFA
k,
= Present value interest factor for perpetuity
The value of PVIFA
k
,

is

=
=
+
1 t
t
k
1
) k 1 (
1


28
The present value interest factor of an annuity of infinite duration (perpetuity) is
simply 1 divided by interest rate (expressed in decimal form. The present value of an
annuity is equal to the constant annual payment divided by the interest rate, for
example, the present value of perpetuity of Rs.20, 000 if the interest rate is 10%, is Rs.
2,00,000.

Time Value of Money
) Check Your Progress 2
1) Calculate the present value of Rs. 600 (a) received one year from now
(b) received at the end of five years (c) received at the end of fifteen years.
Assume a 5% time preference rate.

2) Mr. Ram is borrowing Rs. 50,000 to buy a motorcycle. If he pays equal
installments for 25 years and 4% interest on the outstanding balance, what is
the amount of installment? What will be amount of the instalment if quarterly
payments are requested to be made?

3) A bank has offered to pay you an annuity of Rs. 1,800 for 10 years if you
invest Rs. 12,000 today. What rate of return would you earn?

Derivation of Formulas
i) Future Value of an Annuity
Future value of an annuity is
) 1 a ( A ) k 1 ( A ....... ) k 1 ( A ) k 1 ( A FVA
2 n 1 n
n
+ + + + + + =

. gives k) (1 by a1 equation the of sides both g Multiplyin +
) k 1 ( A ) k 1 ( A ... ) k 1 ( A ) k 1 ( A ) k 1 ( ) FVA (
2 1 n n
n
+ + + + + + + = +

(a2)

Subtracting eq. (a1) from eq. (a2) yields
(

+
=
k
1 ) k 1 (
A k FVA
n
n
(a3)
Dividing both sides of eq. (a3) by k yields
(

+
=
k
1 ) k 1 (
A FVA
n
n

ii) Present Value of an Annuity
The present value of an annuity is
) 5 a ( ) k 1 ( A ...... ) k 1 ( A A ) k 1 ( PVA
: gives ) k 1 ( by ) 4 a ( eq of sides both g Multiplyin
) 4 a ( ) k 1 ( A .... ) k 1 ( A ) k 1 ( A k PVA
1 n 1
n
n 2 1
n
+

+ + + + + = +
+
+ + + + + + =
Subtracting eq (a4) from eq (a5) yields:

29
| |
(

+
+
= + =

n
n
n
n
) k 1 ( k
1 ) k 1 (
A ) k 1 ( 1 A k PVa (a6)

Financial Management
and Decisions
Dividing both the sides of eq (a6) by k results in:
(

+
+
=
n
n
n
) k 1 ( k
1 ) k 1 (
A PVA



iii) Present Value of a Perpetuity
+

+ + + + + + + + = ) k 1 ( A ) k 1 ( A ..... ) k 1 ( A ) k 1 ( A PVA
1 2 1
(a7)
Multiplying both the sides of eq (a7) by (1+k) gives:
1 2 1
) k 1 ( A ) k 1 ( A ...... ) k 1 ( A ) k 1 ( A ) k 1 ( PVA
+ +

+ + + + + + + = + = (a8)
subtracting eq (a7) from eq (a8) gives:
) 9 a (
k
A
PVA
A k PVA
: becomes ) 8 a ( . eq o ) k 1 ( As
] ) k 1 ( 1 [ A k PVA
=
=
+
+ =

iv) Continuous Compounding
In Section 2.2.2 we had established a relationship between the effective and nominal
rate of interest where compounding occur n times a year which is as follows:
1 )
m
k
1 ( r
m
+ = (a10)
Rearranging equation a10, it can be expressed as
1 ] )
k / m
k
1 [( r
k k / m
+ = (a11)
Let us substitute m/k by x om eq (a11)
1 ] )
x
1
1 [( r
k
+ = (a12)

In continuous compounding m which implies ) 12 a ( eq in x
... 71828 . 2 e
x
1
1
x
Lim
x
= = |
.
|

\
|
+



From equation (a12) results in
R = e
k
-1
k
e ) 1 r ( = +
Thus the future value of an amount when continuous compounding is done is as
follows:
km
n
e PV FV = (a13)
v) Continuous Discounting

From eq (a12)

km
n
e FV PV

=

30

Time Value of Money
2.4 SUMMARY
Individuals generally prefer possession of cash right now or in the present moment
rather than the same amount at some time in the future. This time preference is
basically due to the following reasons: (a) uncertainty of cash flows (b) preference
for current consumption (c) availability of investment opportunities. In case an
investor opts to receive cash in future s/he would demand a risk premium over and
above the risk free rate as compensation for time to account for the uncertaininty of
cash flows. Compounding and discounting are techniques to facilitate the comparison
of cash flows occurring at different time periods. In compounding future value of cash
flows at a given interest rate at the end of a given period of time are cash flows at a
given interest rate at the beginning of a given period of time is found out. An annuity
is a series of periodic cash flows of equal amount. Perpetuity is an annuity of infinite
duration. Table 2.1 depicts the various formulas used for discounting and
compounding.
Table 2.1: Summary of Discounting and Compounding Formulas

31
Purpose
compound
value of a
lump sum
Given PV Present
Value
Calculate FV
n
Future
value n years hence
Formula
FV
n
= PV (1+k)
n
Doubling
Period
Compound
value of a
lump sum with
shorter
compounding
period
Interest Rate
PV and frequency of
compounding
(m)
Time Required to
double an amount
Future value after n
year (FV
n
)
Rate Interest
69
35 . 0 +
n m
n
)
m
k
1 ( PV FV

+ =
Relationship
between
effective and
nominal rate
Nominal interest rate
(K) and frequency of
compounding (m)
Effective interest rate
(R)
1 )
m
k
1 ( r
m
+ =
Present value
of a single
amount
Future value (FV
n
) Present Value (PV)
n
n n
)
k 1
1
( FV PV
+
=
Future value
of a regular
annuity
Constant periodic
cash flow (A) interest
rate (k) and duration
(n)
Further value of a
regular annuity
(FVA
n
)
]
k
1 ) k 1 (
[ A FVA
n
n
+
=
Future value
of a annuity
due
Constant periodic
cash flow (A) interest
rate (k) and duration
(n)
Future value of an
annuity due FVA
n

(due)
) k 1 ](
k
1 ) k 1 (
[ A FVA
n
) due ( n
+
+
=

Present value
of a regular
annuity
Constant periodic
cash flow (A) interest
rate (k) and duration
(n)
Present value of a
regular annuity PVA
n (

+
+
=
n
n
n
) k 1 ( k
1 ) k 1 (
A PVA
Present value
of an annuity
due
Constant periodic
cash flow (A) interest
rate (k) and duration
(n)
Present value of an
annuity due PVA
n

(due)
) k 1 ](
) k 1 ( k
1 ) k 1 (
[ A PVA
n
n
) due ( n
+
+
+
=

Present value
of a perpetuity
Constant cash flows
(A) and interest rate
(k)
Present value of an
perpetuity

PVA
K
A
PVA =

Financial Management
and Decisions 2.5 SELF-ASSESSMENT QUESTIONS
1) If you are offered two investments, one that pays 5% simple interest per year
and one that pays 5% compound interest per year, which would you choose?
Why?

2) Suppose you make a deposit today in a bank account that pays compounded
interest annually. After one, year, the balance in the account has grown.
a) What has caused it to grow?
b) After two years the balance in the account has grown even more what
has caused the balance to increase during the second year?

3) The Florida Lottery pays out winnings, after taxes, on the basis of 20 equal
annual installments, providing, the first installment at that time when the
winning ticket is turned in.
a) What type of cash flow pattern is the distribution of lottery winnings?
b) How would you value such winnings?

4) Rent is typically paid at the first of each month. What pattern of cash flow, an
ordinary annuity or an annuity due, does a rental agreement follow?

5) a) Under what conditions does the effective annual rate of interest (EAR) differ
from the annual percentage rate (APR)?
b) As the frequency of compounding increases within the annual period what
happens to the relation between the EAR and the APR?

6) Using the appropriate table, calculate the compound factor for each of the
following combinations of interest rate per period and number of compounding
periods:

Number of Periods Interest rate per Period Compound Factor
2 2% -
4 3% -
3 4% -
6 8% -
8 6% -

7) Using the appropriate table, calculate the discount factor for each of the
following combinations of interest rate per period and number of discounting
periods.

Number of Periods Interest Rate per Period Discount Factor
2 2% -
4 3% -
3 4% -
6 8% -
8 6% -

8) Using the appropriate table, calculate the future value annuity factor for each of
the following combinations of interest rate per period and number of payments:
Number of Periods Interest Rate per Period Discount Factor
2 2% -
4 3% -
3 4% -
6 8% -
8 6% -

32

Time Value of Money
9) Using the appropriate table, calculate the present value annuity factor for each
of the following combinations of interest rate per period and number of
payments:
Number of Periods Interest Rate per Periods Discount Factor
2 2% -
4 3% -
3 4% -
6 8% -
8 6% -

10) Using an 8% compounded interest rate per period calculate the future value of

a) Rs.100 investment
b) one period into the future
c) two periods into the future
d) three periods into the future
e) four periods into the future
f) five periods into the future
g) 40 periods into the future.
11) Suppose you deposit Rs.1,000 into a savings account that earns interest at the
rate of 4% compounded annually, what would the balance in the account be:

a) after two years
b) after four years
c) after six years
d) after 20 years
12) You deposit Rs.10,000 in an account that pays 6% compounded interest
per period, assuming no withdrawal:
a) What will be the balance in the account after two periods?
b) after the two periods, how much interest has been paid on the principal
amount?
c) After the two periods, how much interest has been paid on interest?
13) Using an 8% compounded interest rate, calculate the present value of Rs.100 to
be received:
a) one period into the future
b) two periods into the future
c) three periods into the future
d) four periods into the future
e) five periods into the future
f) 40 periods into the future
14) Ted wants to borrow from Fred. Ted is confident that he will have Rs.1, 000
available to pay off Fred in two years. How much will Fred be willing to lend to
Ted in return for Rs.1,000 two years from now if he uses a compounded interest
rate per year of:
(a) 5% (b) 10% (c) 15%?
15) How much would you have to deposit into a savings account that earns 2%
interest compounded quarterly, to have a balance of Rs. 2,000 at the end of four
years if you make no withdrawals?
16) What is the present value of Rs.5, 000 to be received five years from now, if the
nominal annual interest rate (APR) is 12 % and interest is compounded:
(a) Annually (b) Semiannually (c) Quarterly (d) Monthly

33

Financial Management
and Decisions
17) Calculate the future value at the end of the second period of this series of end-of
period cash flows, using an interest rate of 10% compounded per period:
Year End of Year Cash Flow
Year 1 Rs. 2,000
Year 2 Rs. 3,000
Year 3 Rs. 4,000
Year 4 Rs. 5,000

18) An investor is considering the purchase of an investment at the end of Year 0
that will yield the following cash flows:
Year End of Year Cash Flow
Year 1 Rs. 2,000
Year 2 Rs. 3,000
Year 3 Rs. 4,000
Year 4 Rs. 5,000

If the appropriate discount rate for this investment is 10%, what will this
investor be willing to pay for this investment.
19) Calculate the present value (that is the value at the end of period 0) of the
following series of end of period cash flows:
Year End of Year Cash Flow
0 Rs.1,000
Year 2 Rs. 200
2 Rs. 400

20) Suppose the investment promises to provide the following cash flows:
Year End of Year Cash Flow
Year 1 Rs.0
Year 2 Rs.1,000
Year 3 Rs.0
Year 4 Rs.1,000

If interest is compounded annually at 5% what is the value of the investment at
the end of: (a) Year 1 (b) Year 0

21) Calculate the future value at the end of the third period of an ordinary annuity
consisting of three cash flows of Rs.2,000 each. Use a 5% rate of interest per
period.

22) What is the present value of Rs.10 to be received each period forever, if the
interest rate is 6%?

23) If an investor is willing to pay Rs.40 today to receive Rs.2 every year forever,
what is this investors opportunity cost used to value this investment?

24) Calculate the present value of an annuity due consisting of three cash flows of
Rs.1,000 each, one year apart. Use a 6% compounded interest rate per year.

25) Calculate the future value at the end of the third period of an annuity due,
consisting of three cash flows of Rs.1,000 each, each one year apart. Use a 6%
compounded interest rate per year.


34
26) Suppose you have won the Florida Lotto worth Rs.18 million. Further suppose
that the State of Florida will pay you the winnings in 20 annual installments,


35
Time Value of Money
starting immediately, of Rs.9,00,000 each. If your opportunity cost is 10% what
is the value today of these 20 installments?

27) Calculate the required deposit to be made today so that a series of ten
withdrawals of Rs.1,000 each can be made beginning five years from today.
Assume an interest rate of 5% per period of end of period balances.

28) How much would you need to deposit today so that you can withdraw Rs. 4,000
per year for ten years, starting three years from today?

29) Suppose you wish to invest Rs. 2,000 today so that you have Rs. 4,000 six
years from now. What must the compounded annual interest rate be in order to
achieve your goal?
2.6 SOLUTIONS/ANSWERS

Check Your Progress 1
1) i) Annual Compounding Rs. 1,254.
ii) Half year Compounding Rs. 1,262.
iii) Quarterly Compounding Rs. 1,267.
iv) Monthly Compounding Rs. 1, 270.

2) Rs. 1,806

3) 7%

Check Your Progress 2
1) a) Rs. 571.20 b) 470.50 c) 288.60

2) Equal yearly instalment = Rs. 3200.61
Equal quarterly instalment = Rs. 793.28

3) 8.15%



Working Capital
Decisions
UNIT 4 WORKING CAPITAL DECISIONS

Structure Page Nos.

4.0 Introduction 73
4.1 Objectives 74
4.2 Characteristics of Current Assets 74
4.3 Operating Cycle Concepts 76
4.4 Factors Influencing Working Capital Requirements 77
4.5 Sources of Working Capital 78
4.6 Strategies of Working Capital Management 83
4.7 Estimating Working Capital Requirement 84
4.8 Summary 101
4.9 Self-Assessment Questions/Exercises 101
4.10 Solutions/Answers 104

4.0 INTRODUCTION

The decisions regarding long-term investment are based on judgments on future cash
flows, the uncertaininty of these cash flows and the opportunity cost of the funds to be
invested. As far as working capital management decisions are concerned the
underlying criteria are the same but, there is an increased focus on liquidity and
management of operating cycle. Operating cycle refers to the time it takes to convert
current assets (excluding cash) into cash. The operating cycle in part determines how
long it takes for a firm to generate cash from current assets and therefore the risk and
cost of its investment in current assets or working capital. Working capital is the
capital that can be immediately put to work to generate the benefits of capital
investment. Working capital is also known as current capital or circulating capital.

The major difference between long-term financial management and short-term
financial management (also referred to as working capital management) is with
regards to quantum and frequency of cash flows. In case of long-term financial
management the amount of funds dedicated are usually large and one off decisions
whereas, in case of short term financing the amount of funds dedicated are relatively
small and frequently repetitive in nature. The impact of long term financing ranges
over an extended period of time usually 15-20 years or more, whereas, the impact of
short term financing is within the operating cycle usually ranging form three months
to a year.

There are two concepts of working capital:

(i) Gross working capital

(ii) Net working capital

The gross working capital is the total of all current assets. Net working capital is the
difference between current assets and current liabilities. The constituents of working
capital are shown in Table 4.1. Part A of this table shows current assets and part B of
this table shows current liabilities.
Table 4.1: Constituents of current assets and current liabilities
73

Financial Management
and Decisions

Part A Part B
Current Assets
Cash and Bank Balances
Inventories
Raw material and components, work in
progress/process (WIP) finished goods,
trade debtors, loans and advances,
investments, pre-paid expenses
Current Liabilities
Sundry Creditors
Trade Advances
Borrowings (short term)
Outstanding expenses
Taxes and dividends payable,
Other liabilities maturing within a year

This unit deals with certain aspects and considerations related to overall working
capital management and is divided into the following sections:

characteristics of current assets
factors influencing working capital requirements
levels of current assets
current assets financing policy

profit criterion for current assets

operating cycle analysis

impact of inflation on working capital
approaches to bank financing
methods for estimating working capital requirements
source of working capital finance


4.1 OBJECTIVES
After going through this unit, you would be able to:
understand the concept and characteristics of working capital;
understand the difference between net working capital and gross working capital;
understand the concept of operating cycle;
understand how the various factors influence working capital requirements; and
understand the various methods of computing working capital.

4.2 CHARACTERISTICS OF CURRENT ASSETS

Working Capital management is influenced by two characteristics of current assets
which are as follows (i) short life span (ii) swift transformation into other asset forms.

Current assets have a short life span, cash balances can remain idle for 7 to 14 days,
while accounts receivable usually have a life span ranging from 30 to 90 days and
inventories may be held for 30 to 100 days.

Each current asset is transformed into another current asset. This transformation will
depend upon the time and degree of synchronisation of procurement, production, sales
and collection of receivables.

The production process starts with the purchase of raw material resulting in either
decrease in cash or creation of accounts payable. The raw material purchased from the
inventory, which is further processed to produce finished goods. Finished goods are
74


Working Capital
Decisions
sold resulting in either increase in cash or creation of accounts receivable while the
discharge of accounts payable results in cash outflow. The current asset cycle and the
operating cycle are shown in Figures 4.1 and 4.2 respectively.








Receivable
Suppliers
Raw material
Work in process
Cash
Wages, Salaries
Factory Overheads
Accounts
Finished goods
Figure 4.1: Current asset cycle





Collection of Accounts
Receivables
Purchase of Raw Material
Raw Material
Inventory
Work in
Progress
Finished Goods
Sales
Account
Receivable
Cash








Figure 4.2: Operating Cycle
75

Financial Management
and Decisions

4.3 OPERATING CYCLE CONCEPTS
Operating cycle refers to the average time lapse between the acquisition of raw
material and the final cash realisation. This concept is used to ascertain the
requirements of cash working capital to meet the operating expenses. Figure 4.3
depicts the operating cycle and the cash cycle.






Accounts payable
period
PDP
Inventory Period

RMCP+WIPCP+FCGP
Inventory Period

RMCP+WIPCP+FCGP
Stock
arrives Order placed Accounts
Receivable period

(BDCP)



Cash Cycle
Operating cycle
Cash Paid for
material
Firm receives
invoice
Figure 4.3: Operating cycle

From the above figure you can easily estimate that the time which lapses between the
purchase of raw material and the collection of cash for sales is referred to as operating
cycle, whereas the time length between payment of raw material purchases and
collection of cash for sales is referred to as cash cycle.

In the operating cycle the inventory period consists of:

(i) Raw Material Conversion Period (RMCP), which is the time gap between
purchase of raw material and the issuance of raw material for production.

(ii) Work in Progress Conversion Period (WIPCP), which is the time gap between
issuance of raw material and the conversion of raw material into finished
goods.
(iii) Finished Goods Conversion Period (FGCP), which is the time gap between
sale of goods and the transfer of finished goods from shop floor to the
warehouse.
(iv) Book Debt Collection Period (BDCP), which is the time gap between sales
and realisation of cash

Now the length of the operating cycle for direct material can be calculated as follows:

Gross operating cycle = RMCP+WIPCP+FGCP+BDCP
Net Operating Cycle = Gross Operating Cycle PDP
= RMCP+WIPCP+FGCP+BPCP-PDP

Where PDP is the Payment Deferral Period PDP is the credit time extended by
suppliers to pay for the purchases.
76


Working Capital
Decisions
4.4 FACTORS INFLUENCING WORKING
CAPITAL REQUIREMENTS
The working capital needs of a firm are influenced by many factors. The important
ones are as follows:
1. Nature of business: The working capital requirement of a firm is closely related
to the nature of its business. In general businesses with short operating cycles will
require lesser amount of working capital as compared to businesses with longer
operating cycles. The firms engaged in manufacturing and trading will require
more working capital as large amount of funds are locked in inventories and
receivables. In general utility companies and service companies (water supply,
electricity undertakings, telecom companies) will require lesser amount of
working capital as compared to manufacturing and trading concern. Table 4.2
shows the relative proportion of investment in current assets and fixed assets of
certain industries.
Table 4.2: Proportion of current assets and fixed assets
Current Assets % Fixed Assets % Industries
10-20
20-30
80-90
70-80
Hotels and restaurants
Electricity generation and
Distribution
30-40
40-50
60-70
50-60
Aluminum and Shipping
Iron and Steel, Basic
industries, Chemicals
50-60
60-70
40-50
30-40
Tea plantation
Cotton textiles, Sugar
70-80
80-90
20-30
10-20
Edible oils, Tobacco
Trading, Construction

2. Business Cycle: During economic boom there is increased production which
require higher amount of working capital, but this is partly off set by reduced
operating cycle. At the time of economic recession again there would be need
for increased working capital, as large amount of funds would be locked in
inventories and receivables.

3. Seasonal Variations: Commodities with seasonal demand results in increased
level of working capital requirement. This could be offset by scaling down
operations during the lean part of the year and increasing production prior to
demand period. Products manufactured with raw materials, the production of
which is seasonal (agricultural products) would require higher amount of
working capital.
4. Size of Business: Size of the firm is also a determining factor in estimating
working capital requirements. The size of a firm may be measured either in
terms of scale of operations, or assets or sales. Large firms require more amount
of working capital for investment in current assets and also to pay current
liabilities than smaller firms. However, in some cases even a small firm may
need more working capital as a cushion against cash flow interruptions.

5. Change of Technology: Changes in technology generally leads to
improvements in the efficient processing of raw material, decrease in wastages,
higher productivity and more speedy production. All these improvements lead
to reduction in investment in inventories, which in turn leads to reduction in
working capital requirement. If changed technology results in shorter
manufacturing process the lesser would be the requirements of working capital.
77

Financial Management
and Decisions

6. Length of Operating or Working Capital Cycle: As explained in the section
dealing with operating cycle concept of working capital the amount of working
capital will depend upon the duration of operating cycle. The operating cycle in
turn is dependent on many other variables such as length of manufacturing
process, debtors collection period, etc.

7. Firms credit policy: The credit policy of the firm also impacts working capital
needs. A firm following liberal credit policy will require more amount of
working capital, as a large amount of funds would be blocked in debtors.

4.5 SOURCES OF WORKING CAPITAL
Sources of Working Capital Finance
Working capital finance may be classified into the following:
Spontaneous Source of Finance
Finance which naturally arise in the course of business is known as spontaneous
financing. Trade creditors, credit from employees, credit from suppliers of
services, etc., are the examples of spontaneous financing.
Negotiated Financing
Financing which has to be negotiated with lenders, say commercial banks,
financial institutions, general public is known as negotiated financing. This kind
of financing may either be short-term in nature or long-term.
Before spontaneous and negotiated sources of finance, the latter is more expensive
and inconvenient to raise. Spontaneous source of finance reduces the amount of
negotiated financing. Working capital can be classified into long-term and short-
term sources, which can be analysed as shown in Figure 4.4

Internal
- Retained
profit
- Provision
for depre-
ciation
External
- Share capital
- Long term loan
- Debentures
External
- Bank overdraft/
Cash Credit
- Trade deposits
- Public deposits
- Bills discounting
- Short term loans
Internal
- Provision
for tax
- Provision for
dividend
Long term
sources
Short term
sources
Trade credit
- Sundry creditors
- Bills/Notes payable
and others
Spontaneous
sources
Negotiated
sources
Sources of
Working Capital























Figure 4.4: Financing Mix of Working Capital

Trade Credit 78


Working Capital
Decisions
Trade credit is a spontaneous source of finance which is normally extended to
business organization depending on the custom of the trade and competition
prevailing in the industry and relationship of the suppliers and buyers. This
form of business credit is more popular since it contributes to about one-third of
the total short-term credit. The dependence on this source of working capital
finance is higher due to negligible cost of finance as compared to negotiated
finances.

It is a facility whereby business firms are allowed by the suppliers of raw
materials, services, components and parts, etc., to defer immediate payment to a
definite future period. Trade credit is generated when a company acquires
supplies, merchandise or materials and does not pay for them immediately. If a
buyer is able to get the credit without any legal evidence or instrument, it is
termed as Open Account Trade Credit and appears in the Balance Sheet of the
buyer as sundry creditors. When an instrument is given, notably negotiable
instrument, in acknowledgement of the debt, the same appears in the final
statement as Bills or Notes payable.

Invoice Discounting or Factoring
If a company makes sales to a number of customers on credit terms it will have
to wait for two or even three months before its debtors pay what they owe. This
means that the debtors must be financed by the company, and the idea of
factoring is to passover to the finance of debtors from the selling company to a
special factoring, finance company or Bank. The factoring company after
reviewing the amount of the debts and the creditworthiness of the debtors, will
pay the selling company, at the end of the month in which the sales were made,
the amount it can expect to receive from the debtors (less a percentage). In this
way the selling company receives its money one or two months earlier than
would normally be the case. The factoring company will then collect the debts
from the selling companys customers when they fall due.

Bills of Exchange
A bill is defined as an unconditional order in writing, addressed by one person
to another, signed by the person giving it, requiring the person to whom it is
addressed to, to pay on demand, or at a fixed or determinable future time, a sum
certain in money to or to the order of a specified person or to the bearer.

Funds Generated from Operations
Funds generated from operations, during an accounting period, increase
working capital by an equivalent amount. The two main components of funds
generated from operations are profit and depreciation. Working capital will
increase along with the extent of funds generated from operations.

Deferred Tax Payments
Another source of short-term funds similar in character to trade credit is the
credit supplied by the tax authorities. This is created by the interval that lapses
between the earning of the profits by the company and the payment of the taxes
due on them.

Accrued Expenses
Another source of spontaneous short-term financing is the accrued expenses that
arise from the normal conduct of business. An accrued expense is an expense
that has been incurred, but has not yet been paid. For most firms, one of the
largest accrued expenses is likely to be employees accrued wages. For large
firms, the accrued wages held by the firm constitute an important source of
79

Financial Management
and Decisions

financing. Usually, accrued expenses are not subject to much managerial
manipulation.

Working Capital Finance from Banks
Working capital is an essential requirement for any business activity. Banks in
India today constitute the major suppliers of working capital credit to any
business activity. Recently, however, some term lending financial institutions
have also announced schemes for working capital financing.

Bank Overdrafts
Short-term borrowing of the kind made available principally by the clearing
banks in the form of overdrafts is very flexible. When the borrowed funds are
no longer required they can quickly and easily be repaid. It is also
comparatively cheap. The banks will impose limits on the amount they can lend.

Line of Credit
Line of credit is a commitment by a bank to lend a certain amount of funds on
demand specifying the maximum amount of unsecured credit the bank will
permit the customer to borrow at any point of time. The bank will charge extra
cost over the normal rate of interest since it will keep the funds available to be
made use of the funds by the customer at all times.

Revolving Credit
The revolving credit facility will be given by the banker to the customer by
giving certain amount of credit facility on a continuous basis. The borrower will
not be allowed to exceed the limits sanctioned by the bank. Such credit facilities
will be given by the banks to their customers in the form of over draft facility.
In customer financing, credit cards are known for this source of financing.

Bridge Loans
Bridge loans are available from the banks and financial institutions when the
source and timing of the funds to be raised is known with certainty. When there
is a time gap for access of funds, then for speeding up of or implementation of
the projects, bridge loans will be provided. Such loans are repaid immediately
after raising the funds. The cost of bridge loans is normally higher than the
working capital facilities provided by the banks. At present the RBI has put a
restriction on banks in giving bridge loans to curb malpractices in capital market
dealings.

Transaction Loans
These loans are provided by the Banker for short periods for a specific activity
like financing for a civil contract work. When the customer receives payment,
the transaction will be repaid by the customer. The lender will evaluate the
ability of the cash flow of the borrower before sanctioning this type of loan.

Public Deposits
Deposits from the public is one of the important source of finance particularly
for well established big companies with a huge capital base. The period of
public deposits is restricted to a maximum of three years at a time and hence,
this source can provide finance only for short term to medium term, which
could be more useful for meeting the working capital needs of the company. It
is advisable to use the amounts of public deposits for acquiring assets of long-
term nature unless its pay back period is very short. 80


Working Capital
Decisions
Suppliers Line of Credit
Under this scheme, non-revolving line of credit is extended to the seller to be
utilised within a stipulated period. Assistance is provided to manufactures for
promoting sale of their industrial equipments on deferred payment basis. While
on the other hand, this credit facility can be availed of by actual users for
purchase of plant/equipment for replacement of modernisation scheme only.

Hire Purchase and Leasing
It is a most familiar form of medium term financing in acquiring plant and
machinery, vehicles, etc. In hire purchase transactions, the purchaser of goods
will acquire the possession of goods on payment of initial deposit, but the title
to the goods will only be passed on from seller to the purchaser after the
payment of the remaining installments.

Intercorporate Loans and Deposits
In the present corporate world, it is a common practice of companies with
surplus cash to lend to other companies for a short period normally ranging
from 60 days to 180 days. The rate of interest will be higher than the bank rate
of interest and will depend on the financial soundness of the borrower company.
This source of finance reduces the intermediation of banks in financing.

Commercial Paper (CP)
The CP introduced into the Indian financial market, on the recommendations of
the Vaghul Committee has become a popular debt instrument of the corporate
world. CP is a debt instrument for short-term borrowing, that enables highly
rated corporate borrowers to diversify their sources of short-term borrowings,
and provides an additional financial instrument to investors with a freely
negotiable interest rate. The maturity period ranges from three months to less
than a year. Since it is a short-term debt, the issuing company is required to
meet dealers fees, rating agency fees and any other relevant charges.
Commercial paper is short-term unsecured promissory note issued by
corporations with high credit ratings.

Salient Features:
Eligibility Criteria: A company can issue CP only if:
1) Its tangible net worth is not less than Rs. 4 crore as per the latest audited
balance sheet;
2) Its fund based working capital limit is not less than Rs. 4 crore;
3) It has obtained the specified minimum credit rating for issuance of CP
from an approved credit rating agency. Such credit rating should not be
more than 2 months old at the time of issue of the CP;
4) Its borrowal account is classified as standard by the financing bank; and
5) It has a minimum current ratio of 1.33:1 as per the latest audited balance
sheet and the classification of current assets and liabilities are in
conformity with the Reserve Bank guidelines issued from time to time.

Bank Guarantees
Bank guarantee is one of the facilities that the commercial banks extend on
behalf of their clients in favour of third parties who will be the beneficiaries of
the guarantees. In fact, when a bank guarantee is given, no credit is extended
and banks do not part with any funds. There will be only a guarantee to the
beneficiary to make payment in the event of the customer on whose behalf the
guarantee is given, defaults on his commitment. So, if the customer fails to pay
as per the terms of the guarantee, the banker giving the guarantee has to pay and
81

Financial Management
and Decisions

claim reimbursement from his client. The bankers liability arises only if this
customer fails to pay the beneficiary of the guarantee. That is why bank
guarantee limits are known as non-borrowings limits or not-fund limits.

Asset Securitisation
The emerging financial scenario has created a fierce competition among the
companies to raise funds through innovative financial products from the capital
and/or money markets. Additional source of capital can be accessed through
securitisation, relieving the normal receivable/deposit collection process for
finance companies and banks, without disturbing the liabilities side of the
balance sheet. Companies can raise finance and increase their lending activity
thus, enhancing profitability.

Meaning:
The term Securitisation refers to both switching away from bank
intermediation to direct financing via capital market and/or money market, and
the transformation of a previously illiquid asset like automobile loans, mortgage
loans, trade receivables, etc., into marketable instruments.

Securitisation is a process of transformation of illiquid asset into security
which may be traded later in the open market.

Securitisation is the process of transforming the assets of a lending institution
into negotiable instruments.

Consortium Lending and Loan Syndication by Banks
When the individual bank finds it difficult to meet the huge financial
requirements of a borrower, it gives rise to multiple banking which may be in
the form of (i) Consortium Lending or (ii) Loan Syndication.

Consortium Lending: When the financial needs of a single unit are more than a
single bank can cater to, then more than one bank comes together to finance the
unit jointly spreading the risk as well as sharing the responsibilities of
monitoring and finance. The arrangement is called consortium lending and it
enables the industrial units to mobilise large funds for its operations.

Loan Syndication: There are two methods of syndication: direct lending and
through participation.

Direct Lending: In respect of direct lending all the lenders sign the loan
agreement independently with the borrower and agree to lend upto their
respective share. The obligations of the syndicate members are several and
they do not underwrite one another.

Through Participation: In this method of lending the lead bank is the only
lending bank, so far as the borrower is concerned, that approaches the other
lender to participate in the loan. This normally takes place without the
knowledge of the borrower. The lead bank grants a certain portion of the loan
to each participant as agreed. It also agrees to pay to the participants a pro
rata share of receipts from the borrower.
4.6 STRATEGIES IN WORKING CAPITAL
MANAGEMENT

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Working Capital
Decisions
So far banks were the sole source of funds for working capital needs of the business
sector. At present more finance options are available to a Finance Manager to enable
smooth functioning of his/her firm. Depending on the risk exposure of business, two
strategies are evolved to manage working capital.

Conservative Working Capital Strategy

A conservative strategy suggests the carrying high levels of current assets in relation
to sales. Surplus current assets enable the firm to absorb sudden variations in sales,
production plans, and procurement time without disrupting production plans.
Additionally, the higher liquidity levels reduce the risk of insolvency. But lower risk
translates into lower return. Large investments in current assets lead to higher interest
and carrying costs and encouragement for inefficiency. But a conservative policy will
enable the firm to absorb day to day business risks. It assures continuous flow of
operations and eliminates worry about recurring obligations. Under this strategy, long-
term financing covers more than the total requirement for working capital. The excess
cash is invested in short term marketable securities and in need, these securities are
sold off in the market to meet the urgent requirements of working capital.


Secular Growth
Rs.








Time

Long-term
Financing
Investment in
Marketable Securities
Seasonal
Variations

Figure 4.5: Conservative working capital strategy


Aggressive Working Capital Strategy

Under this approach current assets are maintained just to meet the current liabilities
without keeping any cushion for the variations in working capital needs. The core
working capital is financed by long-term sources of capital, and seasonal variations
are met through short-term borrowings. Adoption of this strategy will minimise
investment in net working capital and ultimately lower the cost of financing working
capital. The main drawback of this strategy is that it necessitates frequent financing
and also increases risk as the firm is vulnerable to sudden shocks.
83

Financial Management
and Decisions


Rs.
Seasonal Variations

Short-term
Financing


Secular Growth





Long-term
Financing
Time
Figure 4.6: Aggressive Working Capital Strategy

A conservative current asset financing strategy would go for more long-term finance
which reduces the risk of uncertainty associated with frequent refinancing. The price
of the firm has to pay for adopting of this strategy is higher financing costs since,
long-term rates will normally exceed short term rates. But when such an aggressive
strategy is adopted, sometimes the firm runs into mismatches and defaults.
It is the cardinal principle of corporate finance that long-term assets should be
financed by long-term sources and short-term assets by a mix of long and short-term
sources.

4.7 ESTIMATING WORKING CAPITAL
REQUIREMENTS

The most ticklish problem that is faced by the finance manager is the determination of
the amount of working capital requirement at a particular level of production. To
solve this problem, estimates of future requirements of current assets and cash flows
are made. With the help of these cash flows, future requirements and availability of
cash for current assets are ascertained. For this purpose a working capital forecast is
prepared involving some calculations after taking into consideration the factors
affecting working capital (as discussed above). All these calculations are made on
cash basis. Thus, estimation of working capital is the determination of future cash
requirements of a firm so that the liquidity of financial resources may be maintained.
Following methods are generally used in estimating working capital for the future
period:

a) Operating Cycle Method
b) Net Current Assets Forecasting Method
c) Projected Balance Sheet Method
d) Adjusted Profit and Loss Method
e) Cash Flow Forecast Method

a) Operating Cycle Method
Under this method, total operating expenses for a period are divided by the number of
operating cycles in the relevant period to calculate the cash requirement for working
84


Working Capital
Decisions
capital. Thus, the computation of total operating expenses, operating cycle period and
number of operating cycles in the year is essential for estimating the amount of
working capital, as discussed below:
1. Operating Expenses: These expenses include purchase of raw materials, direct
labour cost, fuel and power, administrative and selling and distribution
expenses for a specific period for which estimates can be obtained from cost
records. Depreciation, write off of intangible assets are not included in these
expenses because these are non-cash items. Similarly, tax and dividend being
appropriation of profits are also excluded from these expenses. Capital expenses
are also not included in it. While estimating the amount of these expenses fact
like changes in product mix, introduction of a new product or discontinuation of
an old product should be made for the changes occurring in expenses and price
level due to internal and environmental factors.

2. Operating Cycle Period: Period of operating cycle means the total number of
days involved in the different stages of operation commencing from the
purchase of raw materials and ending with collection of sale proceeds from
debtors after adjusting the number of days credit allowed by suppliers. Thus,
the operating cycle is the total period involved in different stages of operations,
which may be calculated by using the following formula:
OC = M+W+F+D-C
Here, OC = Operating Cycle Period
M = Material Storage Period
W = Work in Process or Conversion Period
F = Finished Goods Storage Period
D = Debtors Collection Period
C = Creditors Payment Period

Material Storage Period (M) =
n Consumptio Average Daily
Materials Raw of Stock Average

Or
=
Year/365 the for Consumed Material
Stock)1/2 Closing Stock (Opening +


WIP or Conversion Period (W) =
Cost oduction Pr Average Daily
ocess Pr in Work of Stock Average

OR
=
365 / Cost oduction Pr Total
2 / ) WIP g sin Clo WIP Opening ( +


(a) Total Production or Factory Cost is calculated by adding opening stock of
work-in progress in the total of direct material, labour and factory overheads
and deducting from this the closing work-in-progress. Depreciation is
excluded being a non-cash item.
(b) Sometimes the Conversion Period is also known as the Production Cycle
Period. In case, information about this period is given, then conversion period
is not to be calculated with the above formula.

Finished Goods Storage Period (F) =
Sold Goods of Cost ge DailyAvera
Goods Finished of Stock Average

OR

365 / Sold Goods of Cost Total
2 / ) Stock g sin Clo Stock Opening ( +

85

Financial Management
and Decisions

Cost of Goods Sold is calculated by adding excise duty with the factory cost after
adjusting opening and closing stock of finished goods. Administration/selling and
distribution expenses are not considered in it, because, in financial accounting, stock
of finished goods is valued at production or factory cost.

Debtors Collection Period (D) =
Day Per Sales Credit
Debtors Average

OR
365 / Sales Credit Total
2 / .) Drs g sin Clo . Drs Opening ( +

Creditors Payment Period (C) =
365 / Purchases Credit Total
Creditors Average

OR
=
365 / Purchases Credit Total
2 / .) Crs g sin Clo . Crs Opening ( +


Notes: In respect of the above formula the following points are worth noting

The Average value in the numerator stands for the average of opening balance
and closing balance of the respective items. However, if only the closing
balance is available, then even the closing balance may be taken as Average.
The figure 365 represents number of days in a year. However, there is no hard
and fast rule and sometimes even 360 days are considered.
In the calculation of M, W, F, D and C, the denominator is calculated at cost
basis and the profit margin is excluded. The reason being that there is no
investment of funds in profits.
In the absence of any information, total purchases and total sales be treated as
credit.

3. Number of Operating Cycles: The number of operating cycles in a period are
determined by dividing the number of days in a year i.e.365 by the length of net
operating cycle. Expressed as formula-

No. of Operating Cycles =
Period Cycle Operating
365


4. Amount of Working Capital: Once the operating expenses and the number
of operating cycles have been determined, the amount of actual working
capital required is calculated by dividing the total operating expenses for the
period by the number of operating cycles in that period.
For example, if the total operating expenses for the year amounts to Rs. 45,000
and the number of operating cycles in a year are assumed to be 3, the amount of
working capital would be Rs.15,000 (Rs.45000/3).

Alternatively, the working capital may be calculated by using the following
formula:
CS
N
OC
C WC + =
where WC = Working Capital
C = Cash Balance Required
OC = Operating Cycle Period
CS = Estimated Cost of Goods sold
N = Number of days in year
86


Working Capital
Decisions
5. Provision for Contingencies: After ascertaining the amount of working capital
as above, a certain amount say 5% or 10% may be added to cover
contingencies. It is to be noted that facts based on estimates may not be cent
percent accurate. Therefore, this provision is made to cover probable error in
these calculations.

Example 4.1: Himalaya Ltd.s Profit and Loss Account for the year ended
31
st
December 2005 is given below. You are required to calculate the working capital
requirements under operating cycle method.

Trading and Profit & Loss Account
For the year ended 31
st
December, 2005
Particulars Rs. Particulars Rs.
To Opening stock:
Raw Materials
Work-in-Progress
Finished Goods
To Purchases (Credit)
To Wages & Mfg. Expenses
To Gross Profit c/d

To Administrative Exp.
To Selling and Dist.Exp.
To Net Profit

Total

10,000
30,000
5,000
35,000
15,000
1,50,000

15,000
10,000
30,000

55,000
By Sales (Credit)
By Closing stock:
Raw Materials
Work-in-progress
Finished Goods



By Gross Profit b/d


Total

1,00,000

11,000
30,500
8,500

1,50,000
55,000



55,000

Opening and closing debtors were Rs. 6,500 and 30,500 respectively, whereas
opening and closing creditors were Rs 5,000 and Rs. 10,000 respectively.

Solution: Computation of Operating Cycle

1. Raw Material Storage Period:
=
n Consumptio Average Daily
Material Raw of Stock Average

=
365 / 000 , 34 . Rs
2 / ) 000 , 11 000 , 10 . Rs ( +

= days 113
15 . 93 . Rs
500 , 10 . Rs
=

Raw Material Consumed = Opening Stock +Purchases Closing Stock
= Rs.10, 000+35,000-11,000
= Rs.34, 000

2. Conversion or Processing Period
=
Cost oduction Pr ge DailyAvera
ogress Pr in work of Stock Average

=
365 / 500 , 48 . Rs
2 / ) 500 , 30 000 , 30 . Rs ( +

=
88 . 132
250 , 30 . Rs

87

Financial Management
and Decisions

Production Cost: Rs.
Opening Work-Progress 30,000
Add: Material Consumed (as Above) 34,000
Add: Wages and Mfg. Expenses 15,000
79,000
Less: Closing Work-in Progress 30,500
48,500

3. Finished Goods Storage Period
=
Sold Goods of Cost Average Daily
Goods Finished of Stock Average

=
365 / 000 , 45 . Rs
2 / ) 500 , 8 000 , 5 . Rs ( +

= days 55
29 . 123 . Rs
750 , 6 . Rs
=

Cost of goods sold: Rs.
Opening Stock of Finished Goods 5,000
Add: Production Cost (As above) 48,500
53,500
Less: Closing Stock of Finished Goods 8,500
45,000


4. Debtors Collection Period
=
Sales Average Daily
Debtors Average

=
365 / 000 , 00 , 1 . Rs
2 / ) 500 , 30 500 , 6 . Rs ( +

= days 67
97 . 273 . Rs
500 , 18 . Rs
=

5. Creditors Payment Period
=
Purchases Average Daily
Creditors Average

=
365 / 000 , 35 . Rs
2 / ) 000 , 10 000 , 5 . Rs ( +

= days 78
89 . 95 . Rs
500 , 7 . Rs
=

6. Net Operating Cycle Period:
OC = M + W + F + D C
= 113+228+55+67-78
= 385 Days

Computation of Working Capital Requirement
1. Number of Operating Cycle Per Year =
Period Cycle Operating Net
365

= 948 . 0
385
365
=
88


Working Capital
Decisions
2.
Total Operating Expenses:

Rs
Total cost of Production (as per 3) 45,000
Add: Administrative Expenses 15,000
Add: Selling And Distribution Expenses 10,000
70,000

3. Working Capital Required =
year a in Cycles Operating of . No
Expenses Operating Total

= 839 , 73 . Rs
948 . 0
000 , 70 .
=
Rs

Alternatively, CS
N
OC
C WC + =
where WC = Working Capital
C = Cash Balance Required
OC = Operating Cycle Period
CS = Estimated Cost of Goods Sold
N = Number of days in a year
000 , 70 . Rs
365
385
O WC + =
= Rs. 73,835

Note: The difference is due to approximation in the number of operating cycle:

& Check Your Progress 1
1) From the following information taken from SNS Company; calculate the working
capital required using the operating cycle method.

(1) Annual sales are estimated at 1,00,000 units @ 20 per unit.

(2) Production and sales quantities coincide and will be carried on evenly
throughout the year and production cost is: Material Rs. 10; Labour
Rs.4; Overheads Rs. 4 per unit.

(3) Customers are given 60 days credit and 40 days credit is taken from
suppliers.

(4) 30 days of supply of raw material and 15 days supply of finished goods
are kept in stock.

(5) The production cycle is 30 days and all materials are issued at the
commencement of each production cycle.

(6) A cash balance equal to one-third of the other average working capital is
kept for contingencies.

89

Financial Management
and Decisions

2) From the following information, extracted from the books of a manufacturing
company, compute the operating cycle period and working capital required:
Period Covered: 365 days
Average Period Allowed by Supplier: 16 days Rs.
Average total of debtors outstanding 48,000
Raw Material Consumption 4,40,000
Total Production Cost 10,00,000
Total Cost of sales 10,50,000
Sales for the year 16,00,000
Value of Average Stock Maintained:
Raw Material 32,000
Work-Progress 35,000
Finished goods 26,000

b) Net Current Assets Forecasting Method

This is the most practical method of estimating working capital requirements. Under
this method, the finance manager prepares a working capital forecast. In preparing this
forecast, first of all, an estimate of all the current assets is made on a monthly basis.
Thus, estimate of stock of raw materials, amount of raw material that will remain in
process, stock of finished goods and outstanding amount from debtors and other
receipts will have to be made. This should be followed by an estimate of current
liabilities comprising outstanding payments for material, wages, rent, and
administrative and other expenses. The difference between the forecasted amount of
current assets and current liabilities gives the networking capital requirements of the
firm.

To this amount, a flat percentage would be added by way of provision for
contingencies. The resulting figure will be the amount of total estimated working
capital required. From this, bank finance is to be subtracted, if available. The
remaining balance will be the amount of working capital that is to be managed by the
firm. The method of forecasting working capital needs is cash technique as all
transactions are shown on cash cost basis.

Statement showing working Capital Requirements
(A) Current Amount Rs.
(i) Stock of Raw Material (for month consumption) .
(ii) (a) Work-in-Process (for months)
(b) Direct Labour
(c) Overheads
.
.
.

(iii) Stock of finished Goods (for months sales)
(a) Raw Material
(b) (b) Labour
(c) Overheads





(iv) Sundry Debtors or Receivables ( for months sales)
(a) Raw Material
(b) Labour
(c) Overheads




--------------

(v) Payment in Advance (if any)
(vi) Balance of Cash (required to meet day-to-day expenses)


90


Working Capital
Decisions
(B) Current Liabilities
(i) Creditors (for months purchase of Raw Materials)
(ii) Lag in Payment of Expanses
(Outstanding expenses months)
(iii) Others (if any)
Net Working Capital (A) (B)
Add: Provision for Contingencies
Total Working Capital Required

--------------

--------------

------------



Example 4.2: Prepare an estimate of working capital requirements from the following
information of a trading concern:

(a) Projected Annual Sales 1,00,000
(b) Selling Price Rs.8 per unit
(c) Profit Margin on Sales 25%
(d) Average Credit Period Allowed to Customers 8 weeks
(e) Average Credit Period Allowed by Suppliers 4 weeks
(f) Average Stock Holding in terms of Sales Requirement 12 weeks
(g) Allow 10% for Contingencies

Solution:
Statement Showing working Capital Requirements

(a) Current Assets
Stock (12 Weeks)
(Rs.6,00,00012/52)
Debtors (8 weeks)
Rs. 6,00,0008/52)
Rs.
1,38,462
92,308
2,30,770
Less: Current Liabilities
Creditors (4 weeks)
(6,00,0004/52)
Net Working Capital (AB)
46,154
1,84,616
Add: 10% for Contingencies
Total Working Capital Required
18,462

Working Notes

(i) Cost of Goods Sold

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

Profits = Rs. 8,00,000 25% = Rs. 2,00,000

Cost of Sales = Rs. 8,00,0002,00,000= Rs. 6,00,000

(ii) As, it is a trading concern; hence cost of sales is treated as purchases.

(iii) Profits have been ignored because profits may or may not be used as source of
working capital.
91

Financial Management
and Decisions

Example 4.3: On 1
st
January, 2005 the Board of Directors of Paushak Limited wanted
to know the amount of working capital required to meet the programme they have
planned for the year. From the following information, prepare an estimate of working
capital requirements.

Issued Share Capital Rs. 2,00,000
8% Debentures Rs. 50,000
Fixed Assets as on 1
st
January Rs. 1,25,000

Production during the previous year was 60,000 units and it is proposed to maintain
the same during 2005. The expected ratio of cost to selling price are:
Raw Materials 60%; direct wages 10% Overheads 20%.

The following further information is available:

a) Raw materials are expected to remain in the stores on an average for two
months before being issued to the production unit.
b) Each unit of production is expected to be in process for one month.
c) Finished goods will stay in the warehouse awaiting dispatch to customers for
approximately three months.
d) Credit allowed by creditors is two months from the date of delivery of raw
materials.
e) Credit given to debtors is three months from the date of dispatch.
f) Selling price is Rs 5 per unit.

Solution:
Statement Showing working Capital Requirements

(a) Current Assets Rs. Rs.
(i) Stock of raw material (2 months)
(Rs.15,0002)

30,000
(ii) Work-in-Progress (1 month)
Material (Rs.15,0001)
Labour (Rs.2,5001)
Overheads (Rs.5,0001)

15,000
2,500
5000



22,500
(iii) Stock of finished Goods (3 months)
Material (Rs.15,0003)
Labour (Rs.2,5003)
Overheads (Rs.5,0003)

45,000
7,500
15,000



67,000
(iv) Debtors (3 months)
Material (Rs. 15,0003)
Labour (Rs. 2,5003)
Overheads (Rs. 5,0003)

45,000
7,500
15,000



67,000
1,87,500
(B) Current Liabilities:
Creditors for raw Material (2 months)
Rs. 15,0002)
Net working Capital required (AB)


30,000
1,57,500

92


Working Capital
Decisions
Working Notes:

1) Debtors have been valued and calculated on sales basis which would be Rs.
75,000 (60,0005312). Hence, working capital taking Current Assets at
total value
Rs.
Working Capital required as per above statement 1,57,500
Add: Increase in Debtors (Rs. 75,000Rs.67, 500) 7,500
1,65,000

2) Monthly amount of each element of cost is calculated as follows-
Total sales 60,000 5 = Rs. 3,00,000

(a) Raw Materials = 000 , 15 . Rs
12 100
60 000 , 00 , 3
=

(b) Direct Labour = 500 , 2 . Rs
12 100
10 000 , 00 , 3
=

(c) Overheads = 000 , 5 . Rs
12 100
20 000 , 00 , 3
=

3) It is assumed that labour and overhead in the beginning. Hence, full amount of
labour and overhead is included in work-in-progress. If it is assumed that labour
and overheads accrued evenly, half of the amount will be included in work-in-
progress.

4) Additional capital required will be Rs. 35,500 (Rs. 1,57,500-1,25,000), because
Rs. 1,25,000 is available from long-term sources (share capital debentures-
Fixed assets)


& Check Your Progress 2

1) You are required to prepare for the Board of Directors of Suman Ltd. a
statement showing the working capital needed to finance a level of activity of
5,200 units of output. You are given the following information:

Elements of Cost Amount per unit (Rs.)
Raw Material 8
Direct Labour 2
Overheads 6
Total Cost 16
Profit 4
Selling Price 20

(i) Raw Materials are in stock, on an average one month, (ii) Materials are in
process, on an average half a month, (iii) Finished Goods are in stock on an
average 6 weeks, (iv) Credit allowed to Debtors is two months, (v) Lag in
payment of wages is 1
1/2
weeks, (vi) Assume 52 weeks in a year and 4 weeks in
a month.

Cash in hand and at Bank is expected to be Rs. 7,300. You are informed that
production is carried on evenly during the year and wages and overheads accrue
evenly.
93

Financial Management
and Decisions

2) From the following information, you are required to estimate the net working
capital:

Cost Per unit (Rs.)
Raw Material 200
Direct Labour 100
Overhead (excluding Depreciation) 250
Total Cost 550

Estimated data for the forthcoming period are given below:

Raw Material in Stock Average 6 weeks
Work-in-progress (assume 50% completion stage with
full material consumption)
Average 2 weeks

Finished Goods in Stock Average 4 weeks
Credit Allowed by Suppliers Average 4 weeks
Credit Allowed to Debtors Average 6 weeks
Cash at Bank Expected to be Rs.75,000
Selling Price Rs. 800 per unit
Output 52,000 units per annum.

Assume that production is sustained at an even pace during 52 weeks of the
year. All sales are on credit basis.

c) Projected Balance Sheet Method
Under this method, estimates, of different assets (excluding cash) and liabilities
are made taking into consideration the transactions in the ensuring period.
Thereafter, a balance sheet is prepared based on these forecasts. Assets and
liabilities are called Projected balance sheet. The difference between assets
and liabilities of this balance sheet is treated as shortage or surplus cash of that
period. If the total liability is more than total assets, it represents excess cash,
which is not required by the firm. The management may plan for its investment.
On the contrary, if total assets are more than total liabilities, then it indicates the
deficiency of working capital, which is to be arranged by the management either
from bank overdraft or from other sources.

d) Adjusted Profit and Loss Method

In this method, estimated profit is calculated based on transactions of the
ensuing period. Thereafter, increase or decrease in working capital is computed
adjusting the estimated profit by cash inflows and cash outflows. It is like cash
flow statement. A few banks in India use forms for computing working capital
under this method. A specimen of such a form is given below.

Computation of Working Capital

Rs.
Net Income ..
Add: (i) Non-cash Items
Working Capital Provided Operations
Add: (ii) Cash inflow Items ..
Less: Cash Outflow items .
Net Changes in Working Capital ..
e) Cash Forecasting Method
94


Working Capital
Decisions
In this method, estimate is made of cash receipts and payments in the ensuring
period. The difference of these receipts and payments indicates deficiency or
surplus of cash. The management formulates plans to procure the amount of
deficit. This method, in a way, is a form of cash budget.

Example 4.4: Calculate the operating cycle and the working capital requirements
from the following figures:

Balance as at Balance as at
1
st
January 31
st
December
Rs. Rs.
Raw Material 80,000 1,20,000
Work-in-Progress 20,000 60,000
Finished goods 60,000 20,000
Sundry Debtors 40,000 40,000
Wages and Manufacturing Expenses - 2,00,000
Distribution and Other Expenses - 40,000
Purchases of Materials - 4,00,000
Total Sales - 10,00,000

(i) The Company obtains a credit for 60 days from its suppliers.
(ii) All goods were sold for credit.

Solution:

Computation of Operating Cycle

(i) Material Storage Period:
=
n Consumptio Average Daily
Materials Raw of Stock Average


=
365 / 000 , 60 , 3 . Rs
2 / ) 000 , 20 , 1 000 , 80 . Rs ( +

= days 38 . 101
3 . 986 . Rs
) 000 , 00 , 1 . Rs (
=

Material Consumed = Opening Stock + Purchases Closing Stock

= Rs. 80,000 + 4,00,000-1,20,000
= Rs. 3,60,000

(ii) Conversion or Processing Period

Cost Factory Average Daily
progress in Work of Stock Average


=
365 / 000 , 20 , 5 . Rs
2 / ) 000 , 60 000 , 20 . Rs ( +


= days 07 . 28
65 . 424 , 1 . Rs
) 000 , 40 . Rs (
=
Factory Cost: Rs.

95

Financial Management
and Decisions

Opening Work-Progress 20,000
Material Consumed (as above) 3,60,000
Wages and Mfg. Expenses 2,00,000
5,80,000
Less: Closing Work-in-Progress 60,000
5,20,000

(iii) Finished Goods Storage Period

Sold Goods of Cost Average Daily
Good Finished of Stock Average


=
365 / 000 , 60 , 5 . Rs
2 / ) 000 , 20 000 , 60 . Rs ( +


= days 07 . 26
25 . 534 , 1 . Rs
) 000 , 40 . Rs (
=

Cost of Goods sold Rs.

Opening Stock of Finished Goods 60,000
Factory Cost (as above) 5,20,200
5,80,000
Less: Closing Stock of Finished Goods 20,000
5,60,000

(iii) Debtors Collection period

=
Sales Average Daily
Debtors Average


=
365 / 000 , 00 , 10 . Rs
2 / ) 000 , 40 000 , 40 . Rs ( +


= days 6 . 14
7 . 739 , 2 . Rs
) 000 , 40 . Rs (
=

Computation of Working Capital Required

1. Operating Cycle Period = M+W+F+D-C
= 101.38 +28.07+26.07+14.60-60
= 110.12 or 110 days


2. Total Cost of Sales Rs

Cost of Goods Sold 5,60,000
Distribution and other Expenses 40,000
6,00,000
3. Cash Working Capital = CS
N
OC
C +
= 822 , 80 , 1 . Rs 000 , 00 , 6 . Rs
365
110
O = +
Example 4.5: Mr. Krishan wishes to commence a new trading business and gives the
following information:

The total estimated sales in a year will be Rs. 12,00,000. 96


Working Capital
Decisions
His expenses are estimated as fixed expenses of Rs. 2,000 per month plus variable
expenses equal to five percent of this turnover.
He expects to fix a sale price for each product which will be 25 percent in excess of
his cost of purchase.
He expects to turnover his stock four times in a year.
The sales and purchases will be evenly spread throughout the year. All sales will be
for cash and purchases on credit, but he expects one months credit for purchases.
He keeps cash in hand to meet one months expenses.
Calculate: (a) His estimated profit for the year;
(b) His average working capital requirements.

Solution:

(a)
Estimated Profit of Mr. Krishan for the year

Sales Rs.
Less: Gross Profit

125
25
000 , 00 , 12
Cost of Goods Sold

Gross Profit (as above)
Less: Expenses:
Fixed ( ) 12 2000
Variable

100
5
000 , 00 , 12

24,000

60,000
12,00,000
2,40,000

9,60,000
2,40,000


84,000
1,56,000


(b) Statement of Average Working Capital Requirements

(A) Current Assets: Rs.
(i) Stock
(ii) Turnover of Stock is 4 times
(iii) Stock Turnover =
t cos at stock Average
Sold Goods of Cost


Or 4 =
Stock Average
000 , 60 , 9 . Rs

So Average Stock = 000 , 40 , 2 . Rs
4
000 , 60 , 9 . Rs
=
(i) Cash
To meet fixed expenses
To meet variable expenses

12
1
100
5
000 , 00 , 12
(ii) Debtors (as all the sales are for cash only)

(B) Current Liabilities
(i) Creditors [1 month/ (12,00,000x1/12)]
(ii) Working Capital Required (A-B)











2,000
5,000
2,40,000











7,000

Nil
2,47,000

1,00,000

1,47,000
Total Purchases = Cost of Goods Sold + Closing Stock

(As it is a new business, there is no opening stock)

= Rs. 9,60,000 + 2,40,000 = Rs. 12,00,000.
97

Financial Management
and Decisions


Example 4.6: Manekchand Ltd. Plans to sell 30,000 units next year. The expected
cost of goods sold is as follows:
Rs. (Per units)

Raw Material 100
Manufacturing Expenses 30
Selling Administration And Finance Expanses 20
Selling Price 200

The duration of various stages of the operating cycle is expected to be as follows:

Raw Material Stage 2 month
Work in Progress 1 month
Fished Goods Stage month
Debtors Stage 1 months

Assuming the monthly sales level of 2,500 units; estimate the gross working capital
requirements if the desired cash balance is 5 % of the gross working capital
requirement.

Solution:
Statement of Gross Working Capital Requirements

Current Assets: Rs. Rs.
(i) Raw Material (2 months)
(Rs. 2,5001002)
(ii) Work in progress (1 month)
Raw material (Rs. 2,5001001)
Mfg. Expenses (Rs. 2,500301)
(iii) Finished good (1/2 months)
Raw Material (Rs. 2,5001005)
Mfg. Expenses (Rs. 2,50030.5)
(iv) Debtors (1 month)
(Rs. 2,5001501)
(v) Cash

(5% of gross working capital i.e., 13,62,5005/95)
Gross Working Capital Required
`


2,50,000
75,500

1,25,000
37,500

5,00,000



3,25,000


1,62,500

3,50,000
13,62,500
71,711
14,34,211
Working Notes:

1. Selling administration and finance expenses are not included in the value of
closing stock of finished goods but added in the cost of sales for valuing
debtors.

2. It is assumed that degree of completion of work-in-progress is 100% as regards
materials, labour and overhead and as such material and manufacturing
expenses for the full period are included in the cost of work-in-progress.
3. It is assumed that all sales are credit sales.
4. Profit has not been treated as source of working capital hence fully ignored.
& Check Your Progress 3
98


Working Capital
Decisions
1) From the following particulars, calculate working capital adding 10% per
annum for contingencies.

(a) Average amount backed up for stocks:
Stock of finished products
Stock of materials and stores

1,000
1,600
(b) Average credit given:
Home market 6 weeks credit
Foreign market 1.5 weeks credit

62,400
15,600
(c) Payment in Advance:
Sales promotion expenses
(Paid quarterly in advance)


1,600
(d) Lag in payment of wages and other expenses:
Wages
Materials and Stores
Office Salaries
Rent
Other expenses

1.5 weeks
1.5 months
0.5 months
6 months
1.5 months

52,000
9,6000
12,480
2,000
9,600

2) M/s. ABC Limited have approached their bankers for their working capital
requirements, who have agreed to sanction the same by retaining the margin as
under.

Raw Material 20% Finished Goods 25%
Stock-in-process 30% Debtors 10%

From the following projections for 2004-2005, you are required to work out:
(i) The working capital required by the company and

(ii) The working capital limits likely to be approved by bankers Estimates for
2004-2005.

Annual Sales: Rs.
Cost Production (including depreciation of Rs. 1,20,000 14,40,000
Raw Material Purchases 12,00,000
Monthly Expenditures 7,05,000
Anticipated Opening Stock of Raw Materials 25,000
Anticipated Closing Stock of Raw Materials 1,40,000
Inventory norms:
Raw Materials 2 months
Work in progress 15 days
Finished Goods 1 months
The company enjoys a credit of 15 days on its purchase and allows one-month
credit to its debtors. On sales orders the company has received an advance of
Rs. 15,000.
You may assume that production is carried out evenly throughout the year and
minimum cash balance desired to be maintained is Rs.10,000.
3) Bharat Company Ltd. sells goods in the home market only and earns a gross
profit of 25 % on sales. For the year ending 31
st
Dec; 2005, the following
figures are available.
Rs.
Material used 1,12,500
Wages paid 90,000
99

Financial Management
and Decisions

Manufacturing expenses (including depreciation 1,35,000
Administrative expenses 30,000
Depreciation 15,000
Sales promotion expenses 15,000
Income Tax payable in four installments which falls in the next
financial year
37,500
Sales 4,50,000

Other particulars are
1. Suppliers of materials provide two months credit;
2. Wages are paid half month in arrear;
3. Manufacturing and administrative expenses are all cash expenses and are
paid one month in arrear;
4. Sales promotion expenses are paid quarterly in advance;
5. Sales are made at one months credit;
6. Company wishes to keep one month stock of raw materials and also of
finished goods;
7. The Company believes in keeping Rs. 25,000 available with it including the
overdraft limit of Rs. 12,500 not yet utilised by the Company.

You are required to ascertain the requirements of working capital for the year
2005.

4) A Performa cost sheet of a Company provides the following particulars:

Element of Cost Amount per unit
Rs.
Raw Materials 80
Direct Labour 30
Overhead 60
Total Cost 170
Profit 30
Selling Price 200

The following further particulars are available:
Raw materials are on stock for one month on an average. Materials are in
process of half month on an average. Finished goods are in stock for one month
on an average. Credit allowed by suppliers is one month. Credit allowed to
debtors is two months. Lag in payment of wages is 2 weeks. Lag in payment of
overhead expenses is one month. 25% of output is sold for cash. Cash in hand
and at bank is expected to be Rs. 30,000.

You are required to prepare a statement showing the working capital needed to
finance a level of activity of 1,04,000 units of production. You may assume that
production is carried on evenly throughout the year. Wages and overhead accrue
similarly and a time period of 4 weeks and 52 weeks is equivalent to a month
and a year respectively.
4.8 SUMMARY

Financial decisions are based on certain considerations the main being the cash flows,
cost and liquidity. Short-term financial decisions or working capital decisions are
100


Working Capital
Decisions
different with regard to quantum and frequency of cash flows. There are two concepts
of working capital:
(i) Gross Working Capital
(ii) Net Working Capital.

The main characteristic of the current asset is that they change their form within one
operating cycle. Working capital requirement is influenced by a variety of factors, the
main among them is nature and size of business. There are various methods of
calculating working capital requirement. In some the base figures are obtained from
financial statements.

4.9 SELF-ASSESSMENT QUESTIONS/EXERCISES

1. Explain the concept of working capital. Are gross and net concepts of working
capital exclusive? Discuss.
2. What is the importance of working capital for a manufacturing firm? What will
be the repercussions if a firm has (a) paucity of working capital (b) excess
working capital?
3. What is the concept of working capital cycle? What is meant by cash
conversion cycle? Why are these concepts important in working capital
management? Give an example to illustrate your point.
4. Briefly explain factors that determine the working capital needs of a firm.
5. How is working capital affected by (a) Sales, (b) Technology and Production
Policy, and (c) Inflation? Explain.
6. Define working capital management. Why is it important to study the
management of working capital as a separate area in financial management?
7. Do you recommend that a firm should finance its current assets entirely with
short term financing? Explain your answer.
8. What methods do you suggest for estimating working capital needs? Illustrate
your answer.
9. Explain the difference between Gross and Net Working Capital.
10. What is the operating cycle concept of working capital?
11. State the difference between fixed and variable working capital.
12. How is working capital affected by the nature of business?
13. Why is excess working capital dangerous?
14. Explain the concept of working capital. What are the constituents of working
capital of a company?
15. What is operating cycle concepts or working capital? How will you determine
the amount of working capital under this method? Explain with examples?
16. Inadequate working capital is disastrous whereas redundant working capital is
a criminal waste. Critically examine this statement.
17. What is the concept of Working Capital? What factors determine the needs of
working capital and how is it measured?
101

Financial Management
and Decisions

18. What is meant by working capital forecasting? Briefly explain the techniques
used in making such forecasts.
19. Write short notes on the following:
(i) Operating Cycle of Working Capital
(ii) Types of Working Capital.

Practical Questions


1. The following data has been taken from the financial records of Meenakshi
Company Ltd.

Raw Material Rs. 40 per units
Direct Labour Rs. 20 per unit
Overheads Rs. 5,40,000 (Total)

The following additional information is also available:
1. The management of the company is planning to manufacture 1,00,000 units in
the coming year. The selling price per unit will be Rs. 125. There is perfect
harmony between output and sales of the Company, which is maintained
throughout the year.
2. The average storage period is 40 days for raw material and 30 days for
finished goods.
3. The company sells goods to its customer on 30 days credit and purchase raw
material on 60 days credit from its suppliers.
4. The duration of the production cycle in the Company is 20 days and the
needed raw material is issued to the production at the beginning of each
production cycle.
5. 20% of the average working capital is kept as extra cash for contingencies.

Assume 360 working days in the operating period, work out an estimate of the
total requirements of working capital for the Company using Operating Cycle
Method.
2. From the following data, compute the duration of the operating cycle and
working capital requirements for each of the two years:

Average Stocks: Year 1 (Rs.) Year 2 (Rs.)
Raw Material 20,000 27,000
Work-in-progress 14,000 18,000
Finished Goods 21,000 24,000
Purchase 96,000 1,35,000
Cost of Goods Sold 1,40,000 1,80,000
Sales 1,60,000 2,00,000
Debtors 32,000 50,000
Creditors 16,000 18,000
Assume 360 days per year for computational purposes.
Forecasting Net Current Assets Methods
3. From the following information, you are required to estimate the working
capital requirements of Mahesh Ltd.

Raw Material Cost 0.75 per units
Overheads Rs. 15,000 per annum
Labour 581/2 p. per unit
102


Working Capital
Decisions
Output and Sales 10,000 units per month
Selling Price Rs. 5.00 per unit
Buffer Stocks to be carried
Raw Materials 2 weeks production
Finished Goods 3 weeks supply

The debtors on an average take 2.25 months credit. Raw Material is received in
uniform deliveries daily and suppliers have to be paid at the end of the month
when goods are received. Other creditors for overheads allow on an average
1 months credit. Calculate the working capital required for February in the
form, for presentation to the Board. For this purpose, you may assume that a
month is a four-week period.

4. The Board of Directors of ABC Engineering Company Ltd. requests you to
prepare a statement showing the working capital requirements forecast for an
expected level of production of 22,000 tonnes. The following information is
available for your computation.

Raw Material to remain in stock on an average 4 weeks
Processing Material in process 2 weeks
Permanent Material in process 200 tonnes
Finished Goods in Stock 6 weeks
Credit allowed to Customers 8 weeks
Expected ratio of material to sale price 72%
Wages and Overheads 22%
Selling Price per ton Rs. 3,000

5. Prepare a working capital forecast from the given below information:

Issued Share Capital Rs. 4,00,000
6% Debentures Rs. 1,50,000
Fixed Assets Rs. 3,00,000

Production during the previous year is 1-lac units. The same level of activity is
intended to be maintained during the year. The expected ratios of cost to selling
prices are:

Raw materials 50% Direct Wages 10% Overheads 25%. The inventory holding
norms are as under:

Raw Material 2 months Consumption
Stock-in-process 2 months cost of production
Finished Goods 4 months cost of sales

Besides sundry Creditors and Sundry Debtors are equivalent to 3 months
purchases and 3 months sales respectively. Selling price is Rs. 6 per unit. Both
production and sales are in regular cycle and wages and overhead accrue
evenly.


6. The Board of Directors of Nanak Engineering Company Private Limited
requests you to prepare a statement showing the working capital requirements
forecast for a level of activity of 1,56,000 units of production. The following
information is available for your calculation:

Raw Material 90
Direct Labour 40
103

Financial Management
and Decisions

Overheads 75
205
Profits 60
Selling Price 265

1) Raw Materials are in stock on an average for one month;
2) Materials are in process on an average two weeks;
3) Finished goods are in stock on an average one-month;
4) Credit allowed by suppliers one month;
5) Time lag in payment from debtors two months;
6) Lag in payment of wages is 1 weeks; and
7) Lag in payment of overheads is one month

20% of the output is sold against cash. Cash in hand and at bank is expected to
be Rs. 60,000. It is to be assumed that production is carried on evenly
throughout the year, wages and overheads accrue similarly and time period of 4
weeks is equivalent to a month and 52 weeks a year.
7. The following data is available from the cost sheet of a Company.
Cost per unit

Raw Material 50
Direct Labour 20
Overhead (including depreciation of Rs. 10) 40
Total Cost 110
Profit 20
Selling Price 130

Additional information:
Average raw material in stock is for one month. Average material in progress is
for half month. Credit allowed by suppliers is one month, credit allowed to
debtors is one month. Average time lag in payment of wages: 10 days; average
time lag in payment of overheads 30 days. 25% of the sales are on cash basis.
Cash balance expected to be Rs. 1,00,000. Finished goods lie in the warehouse
for one month.

You are required to prepare a statement showing the working capital needed to
finance a level of the activity of 50,000 units of output. Production is carried out
evenly throughout the year and wages and overheads accrue similarly. State
your assumptions if any, clearly.

4.10 SOLUTIONS / ANSWERS
Check Your Progress 1
Solution 1
Computation of Operating Cycle
1. Operating Period Days
(i) Raw Material Storage Period 30
(ii) Finished Stock Storage Period 15
(iii) Processing or Conversion Period 30
(iv) Debtors Collection Period 60
135
Less: Creditors Payment Period 40
95
2. Number of Operating Cycle per year 365/95 = 3.842
3. Total Operating Expenses Rs.
Raw Material (1,00,00010) 10,00,000
104


Working Capital
Decisions
Labour (1,00,0004) 4,00,000
Overheads (1,00,0004) 4,00,000

4. Working Capital =
Cycles Operating of . No
Expenses Operating Total

=
95 / 365 or 842 . 3
000 , 00 , 18 . Rs


Add: 1/3 for Contingencies 4,68,493
1,56,164
Total Working Capital Required 6,24,657
Alternatively
CS
N
OC
C WC + =
= 493 , 68 , 4 000 , 00 , 18
365
95
0 = +
Add: 1/3 for Contingencies = 1,56,164
6,24,657

Solution 2:
Computation of Operating Cycle Period
1. Material Storage Period
=
n Consumptio Average Daily
Material Raw of Stock Average

= days 27
48 . 205 , 1
000 , 32
365 / 000 , 40 , 4 . Rs
000 , 32 . Rs
= =
2. Conversion Period
Cost oduction Pr Average Daily
progress in work of Stock Average

days 13
73 . 739 , 2
000 , 35
365 / 000 , 00 , 10 . Rs
000 , 35 . Rs
= =

3. Finished Goods Storage Period
Sales of Cost Average Daily
Goods Finished of Stock Average

days 9
7 . 876 , 2
000 , 26
365 / 000 , 50 , 10 . Rs
000 , 26 . Rs
= =
4. Debtors Collection Period:
=
day per Sales
Debtors Average

= days 11
56 . 383 , 4
000 , 48
365 / 000 , 00 , 16 . Rs
000 , , 48 . Rs
= =

105

Financial Management
and Decisions

1. Operating Cycle Period Days
(i) Material Storage Period 27
(ii) Conversion Period 13
(iii) Finished Goods Storage Period 9

(iv) Debtors Collection Period
11/60
Less: Creditors Payment Period
16/44

2. Number of Operating Cycle Per year 365/44 8.3
3. Total Operating Expenses Rs. 10,50,000
4. Working Capital Required =
Year a in Cycles Operating of . No
Expenses Operating Total

=
3 . 8 . Rs
000 , 50 , 10 . Rs

= Rs. 1,26,506
Alternatively
575 , 26 , 1 . Rs
000 , 50 , 10 . Rs
365
44
0
CS
N
OC
C WC
=
+ =
+ =


Note: A little difference between the two methods is due to approximation.
Check Your Progress 2
Solution 1:
Statement Showing Working Capital Requirements
(A) Current Assets: Rs. Rs.
(i) Stock of Raw Materials (4 weeks):
(ii) Work in process (2 weeks):
Raw Materials (Rs.8002)
Labour (Rs. 2001)
Overheads (Rs.6001)
(iii) Stock of finished Goods (6 weeks):
Raw Materials (Rs.8006)
Labour (Rs 2006)
Overheads (Rs.6006)


1,600
200
600

4,800
1,200
3,600

3,200



2,400




9,600
(iv) Debtors (8weeks):
Raw Materials (Rs.8008)
Labour (Rs.2008)
Overheads (Rs.6008)
(v) Cash as per estimate
(B) Less: Current Liabilities:
(i) Creditors (4 Weeks)
(ii) Lag in payment of wages (1
1/2
Weeks):
Labour (Rs.2001
1/2
)
Working Capital Required (A-B)


6,400
1,600
4,800


3,200

300


12,800
7,300
35,300



3,500
31,800

Working Notes:
(1) Weekly amount of each element of costs calculated as follows:
Total Sales for of the year = 5,200Rs.20 = Rs.1,04,000
(i) Raw Material = 800 . Rs
20 52
000 , 04 , 1
=

106


Working Capital
Decisions (ii) Direct Labour = 200 . Rs
20 52
2 000 , 04 , 1
=

(iii) Overhead = 600 . Rs
20 52
6 000 , 04 , 1
=

Alternative Method

Annual Production = 5,200 units
Weekly production = 5,200/52 = 100 units
Material = 100 Rs.8 = Rs.800
Labour = 100Rs.2 = Rs.200
Overhead = 100Rs.6 = Rs.600
(2) Debtors are calculated at cash cost of sales.
(3) It has been assumed that material is issued at the commencement in each
production cycle, but labour and overheads are incurred in the process of
production. Therefore, half of the amount (one week) is invested in the
process.
(4) Profit may be or may not be a source of working capital. Payment of Income
Tax and Dividend are adjusted in these profits, therefore, profits have not
been considered.

Solution 2
Computation of Net Working Capital
(A) Current Assets Rs. Rs.
(i) Stock of raw Materials (6 weeks)
(Rs. 52,0002006/52)
(ii) Work-in-progress (2 weeks)
Raw Materials (Rs.52, 000 2002/52)
Direct Labour (Rs.52,0001001/52)
Overheads (Rs.52, 0002501/52)
(iii) Stock of Finished Goods (4 weeks)
(52,0008004/52)
(iv) Debtors (6 weeks)
(52,0008006/52)
(v) Cash at Bank



4,00,000
1,00,000
2,50,000

12,00,000



7,50,000

22,00,000

48,00,000
75,000
90,25,000
(B) Current Liabilities
(ii) Creditors (4 Weeks)
(iii) (52,000 400 4/52)





8,00,000
(c) Net Working Capital (A-B) 82,25,000


Working Notes:
(i) Debtors are taken at selling price as the amount of net working capital is to be
calculated. If working capital requirements are to be calculated, then debtors
should be taken at cash cost.

(ii) It is assumed that there is no time lag in payment of overheads.

Check Your Progress 3
Solution 1
Computation of Working Capital Requirements
(A) Current Assets Rs. Rs.
107

Financial Management
and Decisions

(i) Stock of Material and Stores
(ii) Stock of finished Goods
(iii) Books Debts (a) Home (62,4006/52)
(b) Foreign (15,6001.5/52)
(iv) Advance Payment (1,6003/12)

(B) Current Liabilities
(i) Creditors for Stores and Materials
(9,6001.5/12)
(ii) Outstanding expenses:
Wages (52,0001.5/52)
Office Salaries (12,480.5/12)
Rent (2,0006/12)
Other Expenses (9,6001.5/12)
Net Working Capital (A-B)
Add: 10% Contingency Allowance
Average amount of working Capital required



7,200
450






1,500
520
1,000
1,200
5,420
5,230
523
5,753

Working notes:
(i) For calculation purposes, 52 weeks or 12 months in a year are assumed.
(ii) In the absence of cash cost of current assets, the actual working capital will differ
from that of amount computed above.

Solution 2

(i) Statement Showing Working Capital Requirements
(A) Current Assets Rs. Rs.
(i) Cash Balance
(ii) Stock of Raw Materials (2 months)
(Rs. 7,20,0002/12)
(iii) Stock of Work-in-progress (15 days)
(Rs. 10,80,000.5/12)
(iv) Stock of Finished Goods (1months)
(Rs. 10,80,0001/12)
(v) Debtors (1 month)
(Rs. 10,80,0001/12)
(vi) Monthly Expenditure

(B) Current Liabilities
(i) Creditors (15 days)
(Rs. 7,05,000.5/12)
(ii) Advance received from Debtors

Net Working Capital Required (A) (B)














29,375
15,000
10,000

1,20,000

45,000

90,000

90,000
25,000
3,80,000



44,375

3,35,625

(ii) Working capital limits likely to be approved by bankers.
Particulars Required by Co.
(Rs.)
Margin
(Rs.)
Allowed by
bankers (Rs)
A. Raw Materials 1,20,000 20% = 24,000 96,000
B. Work-in-Progress 45,000 30% = 13,500 31,500
108


Working Capital
Decisions
C. Finished Goods 90,000 25% = 22,500 67,500
D. Debtors 90,000 10% = 9,000 81,000
E. Expenses 25,000 NIL
Working Capital Likely to be approved by Bankers. 2,76,000

Working Notes:
Rs.
A Calculation of raw material consumed:
Opening Stock of Raw Material
Add: Purchases

Less: Closing Stock of Raw Material
Annual Consumption

1,40,000
7,05,000
8,45,000
1,25,000
7,20,000
B Cash cost of annual production
Cost of production as given
Less: Depreciation
Rs.
12,00,000
1,20,000
10,80,000

(iii) It is assumed that there is neither opening stock of finished goods nor closing
stock. Hence, cost of sales is taken to Rs. 10,80,000 after deducting
depreciation.

Solution 3

A Current Assets Rs.
(i) Debtors (cash cost of goods sold i.e. (3,67,5002/12) 30,625
(ii) Prepayments: Sales Promotion Expenses (15,0003/12) 3,750
(iii) Stock of Raw Materials (Rs. 1,12,5001/12) 9,375
(iv) Stock of finished good (Rs. 3,22.50012) 26,875
(V) Cash in hand 25,000
Total 956,25
B Current Liabilities
(i) Sundry Creditors (Rs. 1,12,5002/12) 18,750
(ii) Outstanding Expenses:
(a) Wages (Rs. 90,0005/12) 3,750
(b) Mfg. Expenses (Rs. 1,20,0001/12) 10,000
(c) Administration Expenses (Rs. 30,0001/12) 2,500
(iii) Bank Overdraft 12,500
Total 47,500
C Net Working capital Required (A-B) 48,125
Working Notes:

(i) Cash Cost of Production and Total Cost is Calculated as under:
Rs.
Sales 4,50,000
Less: Gross Profit @ 25% on sales 1,12,500
3,37,500
Less: Depreciation 15,000
109

110
Financial Management
and Decisions

Cash Production Cost 3,22,000
Add: Administration Expenses 30,000
Sales Promotion Expenses 15,000
Total Cash Cost 3,67,500
Or
Material Consumed 1,12,500
Wages Paid 90,000
Cash Mfg. Expenses 1,20,000
Cash Production Cost 3,22,500
Add: Administration Expenses 30,000
Sales Promotion Expenses 15,000
Total Cash Cot 3,67,500
(ii) Debtors have been calculated at cash cost.
(iii) Income tax has been ignored because profits are not treated as source of working
capital, while income tax is paid out of profits.
Solution 4
Computation of Working Capital Requirement
A Current Assets: Rs.
(i) Stock of Materials (1 months)
(1,04,000804/52)

6,40,000
(ii) Work-in-progress (1/2 months)
Materials Cost (1,04,000802/52)
Labour Cost (1,04,000301/52)
Overheads (1,04,000601/52)

3,20,000
60,000
1,20,000
(iii) Finished Goods (1 months)
Material Cost (1,04,000804/52)
Labour Cost (1,04,000304/52)
Overheads (1,04,000604/52)

6,40,000
2,40,000
4,80,000
(iv) Debtors (2 months)
(78,000708/52)
20,40,000
30,000
(v) Cash Balance 45,70,000
B Current Liabilities
(i) Creditors for Material (1 months)
(1,04,000804/52)

6,40,000
(ii) Outstanding Expenses
(a) Overheads (1 months) (1,04,000604/52)
(b) Wages (2 weeks) (1,04,000302/52)

4,80,000
1,20,000
12,40,000
C Estimated Requirements of Working Capital (A-B) 33,30,000
Working Notes:

(ii) 25% of production i.e 26,000 units are sold for cash. Hence credit sales are
78,000 units. The cash cost of debtors is calculated on these units.
(iii) It is assumed that full material is issued in the beginning and labour and
overhead accrue evenly. Therefore, their 50% (one week) amount is included
in WIP.
(iv) Profit on cash as well as on credit sales may or may not be the source of
working capital. Income tax and dividends paid are to be adjusted from these
profits. Hence, profits are ignored.

(v) All the overheads are assumed to be variable. Working capital will be
reduced by the amount of depreciation. In absence of these data, estimates
cannot be accurate.
(vi) It is assumed that stock of raw material and finished goods is maintained on
the basis of goods produced.


Cash and Treasury
Management
UNIT 1 CASH AND TREASURY
MANAGEMENT
Structure Page Nos.
1.0 Introduction 5
1.1 Objectives 5
1.2 Facets of Cash Management 6
1.2.1 Motives for Holding Cash
1.2.2 Cash Planning
1.2.3 Determining Optimum Cash Balance
1.3 Methods of Cash Flow Budgeting 12
1.4 Investing Surplus Cash 13
1.5 Cash Collection and Disbursements 14
1.6 Treasury Management 14
1.6.1 Treasury Risk Management
1.6.2 Functions of the Treasury Department
1.7 Summary 18
1.8 Self-Assessment Questions/Exercises 18
1.9 Solutions/Answers 24

1.0 INTRODUCTION
Cash is an important current asset for the operations of business. Cash is the basic
input that keeps business running continuously and smoothly. Too much cash and too
little cash will have a negative impact on the overall profitability of the firm as too
much cash would mean cash remaining idle and too less cash would hamper the
smooth running of the operations of the firm. Therefore, there is need for the proper
management of cash to ensure high levels of profitability. Cash is money, which can
be used by the firm without any external restrictions. The term cash includes notes
and coins, cheques held by the firm, and balances in their (the firms) bank accounts.

It is a usual practice to include near cash items such as marketable securities and bank
term deposits in cash. The basic characteristics of near cash items is that, they can be
quickly and easily converted into cash without any transaction cost or negligible
transaction cost.

In the recent years we have witnessed an increasing volatility in interest rates and
exchange rates which calls for specialised skills known as Treasury Management.
Recent years have also witnessed an expanding economy due to which there is an
increased demand of funds from the industry.

1.1 OBJECTIVES

After going through this unit, you should be able to:

understand the motives for holding cash;
prepare cash budget;
understand how surplus cash is invested;
understand how to reduce collection float, and
understand the role and function of treasury management.
1.2 FACETS OF CASH MANAGEMENT
5

Working Capital
Management
Cash management is concerned with the management of:
Cash inflows and outflows of the firm
Cash flows within the firm
Cash balances (financing deficit and investing surplus).

The process of cash management can be represented by the cash management cycle
as shown in Figure 1.1.





Business
operations
Information
and control
Cash
Collections


Deficit

Surplus

Borrow

Invest











Figure 1.1: Cash Management Cycle

Sales generate cash which is used to pay for operating activities. The surplus cash
has to be invested while deficit has to be borrowed. Cash management seeks to
accomplish this cycle at minimum cost. At the same time it also seeks to achieve
liquidity and control. Cash management assumes more importance than other current
assets because cash is the least productive asset that a firm holds; it is significant
because it is used to pay the firms financial obligations. The main problem of cash
management arises due to the difference in timing of cash inflows and outflows. In
order to reduce this lack of synchronisation between cash receipts and payments the
firm should develop appropriate strategies for cash management, encompassing the
following:
Cash planning: Cash inflows and outflows should be planned. Estimates
regarding cash outflows and inflows for the planning period should be made to
project cash surplus or deficit. Cash budget should be prepared for this
purpose.

Managing cash flows: Cash flows should be managed in such a way, that it,
accelerates cash inflows and delays cash outflows as far as possible.

Optimum cash level: The firm should decide about the optimum cash balance,
which it should maintain. This decision requires a trade of between the cost of
excess cash and the cost of cash deficiency.

Investing surplus cash and financing deficit: Surplus cash should be invested
in short term instruments so as to earn profits as well as maintain liquidity.
Similarly, the firm should also plan in advance regarding the sources to finance
short term cash deficit.

The cash management system design is influenced by the firms products
organisation structure, the market, competition and the culture in which it operates.
Cash management is not a stand-alone function but it requires close coordination,
accurate and timely inputs from various other departments of the organisation.
Cash
payments
6

Cash and Treasury
Management

1.2.1 Motives for Holding Cash
The firms need to hold cash may be attributed to the three motives given below:

The transaction motive
The precautionary motive
The speculative motive.

Transaction Motive: The transaction motive requires a firm to hold cash to conduct
its business in the ordinary course and pay for operating activities like purchases,
wages and salaries, other operating expenses, taxes, dividends, payments for utilities
etc. The basic reason for holding cash is non-synchronisation between cash inflows
and cash outflows. Firms usually do not hold large amounts of cash, instead the cash
is invested in market securities whose maturity corresponds with some anticipated
payments. Transaction motive mainly refers to holding cash to meet anticipated
payments whose timing is not perfectly matched with cash inflows.

Precautionary Motive: The precautionary motive is the need to hold cash to meet
uncertainties and emergencies. The quantum of cash held for precautionary objective
is influenced by the degree of predictability of cash flows. In case cash flows can be
accurately estimated the cash held for precautionary motive would be fairly low.
Another factor which influences the quantum of cash to be maintained for this motive
is, the firms ability to borrow at short notice. Precautionary balances are usually kept
in the form of cash and marketable securities. The cash kept for precautionary motive
does not earn any return, therefore, the firms should invest this cash in highly liquid
and low risk marketable securities in order to earn some returns.

Speculative Motive: The speculative motive refers to holding of cash for investing in
profit making opportunities as and when they arise. These kinds of opportunities are
usually prevalent in businesses where the prices are volatile and sensitive to changes
in the demand and supply conditions.

1.2.2 Cash Planning
Firms require cash to invest in inventory, receivables, fixed assets and to make
payments for operating expenses, in order to increase sales and earnings and ensure
the smooth running of business.

In the absence of proper planning the firm may face two types of situations: i) Cash
deficit, and ii) Cash Surplus. In the former situation the normal working of the firm
may be hampered and in extreme cases this type of situation may lead to liquidation
of the firm. In the latter case the firm having surplus cash may be losing out on
opportunities of earning good returns, as the cash is remaining idle. In order to avoid
these types of conditions the firms should resort to cash planning. Cash planning is a
technique to plan and control the use of cash. It involves anticipating future cash
flows and cash needs of the firm. The main objective of cash planning is to reduce the
possibility of idle cash (which lowers the firms profitability) and cash deficits (which
can cause the firms failure). Cash planning involves developing a projected cash
statement from a forecast of cash inflows and outflows for a given period. These
forecasts are based on present operations or anticipated future operations. The
frequency of cash planning would depend upon the nature and complexity of the
firms operations. Usually large firms prepare daily and weekly forecasts whereas
medium and small firms prepare monthly forecasts.
Cash Forecasting and Budgeting
A cash budget is one of the most significant devices to plan and control cash receipts
and payments. In preparation of a cash budget the following points are considered.
Credit period allowed to debtors and the credit period allowed by creditors to
the firm for goods and services.
7

Working Capital
Management
Payment of dividends, taxes etc., and the month in which such payments are to
be made.
Non-consideration of non-cash transactions (Depreciation). These type of
transactions have no impact on cash flow.
Minimum cash balance required and the amount of credit/overdraft limit
allowed by the banks.
Plan to deal with cash surplus and cash deficit situations.
Debt repayment (time and amount).
Figure 1.2 highlights the cash surplus and cash shortage position over the period of
cash budget for preplanning to take corrective and necessary steps.




00

Cash and Bank +
Balances




0


Figure 1.2: Cash surplus and cash deficit situations
Expected cash and
bank balance with the
mpany co
Bank overdraft limit
J F M A M J J A S O N D
Time
Cash
Deficit
Cash Surplus

1.2.3 Determining Optimum Cash Balance
One of the primary responsibilities of the financial manager is to maintain a sound
liquidity position for the firm so that the dues are settled as and when they mature.
Apart from this the finance manager has to ensure that enough cash is available for
the smooth running of operating activities as well as for paying of interest, dividends
and taxes. In a nut shell there should be availability of cash to meet the firms
obligation as and when they become due. The real dilemma which the finance
manager faces is to decide on the quantum of cash balance to be maintained in such a
way that at any given point of time there is neither cash deficit nor cash surplus. Cash
is a non-earning asset; therefore, cash should be maintained at the minimum level.
The cost of holding cash is the loss of interest/return had that cash been invested
profitably. The cost of surplus cash is the cost of interest/opportunities foregone. The
cost of shortage/deficit of cash is measured by the cost of raising funds to meet the
deficit or in extreme cases the cost of bankruptcy, restructuring and loss of goodwill.
Cash shortage can result in sub-optimal investment decisions and sub-optimal
financing decisions.
The firm should maintain optimum just enough neither too much nor too little cash
balance. There are some models used to calculate the optimum cash balance that a
firm ought to maintain. But the most widely known model is Baumols model. It is
chiefly used when cash flows are predictable.

Optimum Cash Balance: Baumols Model

The Baumol Model (1952) considers cash management problem as similar to
inventory management problem. As such the firm attempts to minimise the total cost,
8

Cash and Treasury
Management
which is the sum of cost of holding cash and the transaction cost (cost of converting
marketable securities to cash). The Baumol model is based on the following
assumptions:
the firm is able to forecast its cash need with certainty,
the opportunity cost of holding cash is known and it does not change over time,
and
the transaction cost is constant.

Let us assume that the firm sells securities and starts with a cash balance of C rupees.
Over a period of time this cash balance decreases steadily and reaches zero. At this
point the firm replenishes its cash balance to C rupees by selling marketable
securities. This pattern continues over a period of time. Since the cash balance
decreases steadily therefore the average cash balance is C/2. This pattern is shown in
Figure 1.3.

Cash Balance

C





O
Time
Average
Cash
Balance
C/2
Figure 1.3: Pattern of Cash Balance: Baumols Model
The firm incurs a holding cost for maintaining a cash balance. It is an opportunity
cost, that is the return foregone on marketable securities. If the opportunity cost is I,
then the firms holding cost for maintaining an average cash balance is as follows:

Holding Cost =I (C/2).

The firm incurs a transaction cost whenever it converts its marketable securities to
cash. Total number of transactions during the year would be the total fund
requirement T divided by the cash balance C i.e., T/C. Since per transaction cost is
assumed to be constant and if per transaction cost is B the total transaction cost would
be B (T/C).

The total cost may be expressed as:

TC =I (C/2) +B (T/C)
Holding
cost
Transaction
cost
where

C = Amount of marketable securities converted into cash per cycle
I = Interest rate earned on marketable securities
T = Projected cash requirement during the period
TC = Total cost or sum of conversion and holding costs.

The value of C which minimises TC may be found from the following equation
I
2bt
* = C
The above equation is derived as follows:
9

Working Capital
Management

Finding the first derivative of total cost function with respect to C.
2
c
bT
2
I
C d
TC d
=
Setting the first derivative equal to zero, we obtain
0
c
bT
2
T
2
=
Solving for C
I
2bt
* C =
One can verify for second derivative condition ensuring C* to be minimized.

Example 1.1: M/s Sunrise Industries estimates its total cash requirement at Rs. 20
million for the next year. The companys opportunity cost fund is 15 per cent per
annum. The company will have to incur Rs. 150 per transaction when it converts its
short term securitites to cash. Determine the optimum cash balance. What is the total
annual cost of the demand for optimum cash balance? How many deposits will have
to be made during the year?

Solution:
C* =
I
2bT

C* =
15 .
) 00 , 000 , 00 , 2 ( ) 150 ( 2

= Rs. 2,00,000

The annual cost will be:
TC =I (C/2) +B

C
T

=0.15

2
00 , 000 , 00 , 2
+ 150

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

=15,000 +15,000
=Rs. 30,000

In this financial year therefore, the company would have to make 100 conversions.

Short Term Cash Forecasts
The important objectives of short-term cash forecast are:
determining operating cash requirement
anticipating short term financing
managing investment of surplus funds.
The short-term cash forecast helps in determining the cash requirement for a
predetermined period to run a business. In the absence of this information the finance
manager would not be able to decide upon the cash balances to be maintained. In
addition to this the information given earlier would also be required to tie up with the
financing bank in order to meet anticipated cash shortfall as well as to draw strategies
to invest surplus cash in securities with appropriate maturities. Some of the other
purposes of cash forecast are:

planning reduction of short and long term debt
scheduling payments in connection with capital expenditure programmes
planning forward purchase of inventories
taking advantage of cash discounts offered by suppliers, and
guiding credit policy.
10

Cash and Treasury
Management

1.3 METHODS OF CASH FLOW BUDGETING
Cash budget is a detailed budget of income and cash expenditure incorporating both
revenue and capital items. For control purposes the years budget is generally phased
into smaller periods e.g., monthly or quarterly. Since the cash budget is concerned
with liquidity it must reflect changes in opening and closing balances of debtors and
creditors. It should also focus on other cash outflows and inflows. The cash budget
shows cash flows arising from the operational budgets and the profit and asset
structure. A cash budget can be prepared by considering all the expected receipts and
payments for budget period. All the cash inflow and outflow of all functional budgets
including capital expenditure budgets are considered. Accruals and adjustments in
accounts will not affect the cash flow budget. Anticipated cash inflow is added to the
opening balance of cash and all cash payments are deducted from this to arrive at the
closing balance of cash.
Format of Cash Budget

Period : First Quarter of 2005


Months
J an. Feb. March

Particulars

Rs. Rs. Rs.
Balance b/d
Receipts:

Cash Sales
. . .
Cash collected from Debtors . . .
Calls on Shares and Debentures . . .
Sales of Investments . . .
Cash Available (A) . . .
Payments:
Cash Purchases
. . .
Payment to Creditors . . .
Wages and Salaries . . .
Expenses paid . . .
Dividend and Tax paid . . .
Repayment of Loans . . .
Purchase of Fixed Assets . . .
Total Payments (B) . . .
Balance c/d (A-B) . . .

) Check Your Progress 1
1) ABC Co. wishes to arrange overdraft facilities with its bankers during the
period April to J une of a particular year, when it will be manufacturing mostly
for stock. Prepare a Cash-Budget for the above period from the following data,
indicating the extent to which the company would require the facilities of the
bank at the end of each month:
(a)
Month Sales
Rs.
Purchases
Rs.
Wages
Rs.
February 1,80,000 1,24,800 12,000
March 1,92,000 1,44,000 14,000
April 1,08,000 2,43,000 11,000
May 1,74,000 2,46,000 10,000
J une 1,26,000 2,68,000 15,000

11

Working Capital
Management
(b) 50% of the credit sales are realised in the month following sales and
remaining 50% sales in the second month following. Creditors are paid in the
following month of Purchase.

(c) Cash in the Bank on 1st April (estimated) Rs. 25,000.
2) A company is expecting Rs. 25,000 cash in hand on 1st April 2005 and it
requires you to prepare an estimate of cash position during the three months,
April to J une 2005. The following information is supplied to you.

Month Sales
Rs.
Purchase
Rs.
Wages
Rs.
Expenses
Rs.
February 70,000 40,000 8,000 6,000
March 80,000 50,000 8,000 7,000
April 92,000 52,000 9,000 7,000
May 1,00,000 60,000 10,000 8,000
J une 1,20,000 55,000 12,000 9,000

Other Information: (a) Period of credit allowed by suppliers is two months;
(b) 25% of sale is for cash and the period of credit allowed to customers for
credit sale is one month; (c) Delay in payment of wages and expenses one
month; (d) Income tax Rs. 25,000 is to be paid in J une 2005.

3) From the following forecast of income and expenditure prepare a cash Budget
for three months ending 30
th
November. The Bank Balance on 1st September is
Rs. 3,000.

Month Sales
Rs.
Purchase Rs. Wages
Rs.
Factory
Exp.
Expenses
Rs.
J uly 24,000 12,000 1,680 1,170 3,000
August 22,950 12,600 1,740 1,230 3,600
September 23,400 11,550 1,740 1,260 4,200
October 2,000 11,250 170 1,530 4,800
November 28,500 13,200 1,770 1,800 3,900


Other Information : (i) A sales commission @ 5% on sales which is due in the
month following the month in which sales dues are collected is payable in
addition to office expenses; (ii) Fixed Assets worth Rs. 19,500 will be purchased
in September to be paid for in October; (iii) Rs. 5,000 in respect of debenture
interest will be paid in October; (iv) The period of credit allowed to customers is
two months and one months credit is obtained from the suppliers of goods;
(v) Wages are paid on an average fortnightly on 1
st
and 16
th
of each month in
respect of dues for periods ending on the date preceding such days; (vi) Expenses
are paid in the month in which they are due.

1.4 INVESTING SURPLUS CASH
The demand for working capital fluctuates as per the level of production, inventory,
debtors, creditors etc. The working capital requirements is not uniform throughout
the year due to the seasonality of the product being manufactured and business
cycles. Apart from this, the working capital requirement would also depend upon the
demand of the product and demand-supply situation of the raw material. Interplay of
all these variables would determine the need for working capital at any point of time.

In situations where the working capital requirement is reduced, it results in excess
cash. This excess cash may be needed when the demand picks up. The firms may
hold this excess cash as buffer to meet unpredictable financial needs. Since this
excess cash does not earn any return the firms may invest this cash balance in
marketable securities and other investment avenues.

Since this excess cash balance is available only for a short period of time, it should be
invested in highly safe and liquid securities. The three basic features safety,
maturity and marketability should be kept in mind while making investment decisions
12

Cash and Treasury
Management
regarding temporary surplus cash. Here safety implies that the default risk (viz.,
payment of interest and principal amount on maturity) should be minimum. Since the
prices of long-term securities are more sensitive to interest rate changes as compared
to short-term securities the firms should invest in securities of short-term maturity.
Marketability refers to convenience, speed and transaction cost with which a security
or an investment can be converted into cash.

Types of Short Term Investment Opportunities

The following short-term investment opportunities are available to companies in
India to invest their temporary cash surplus.

a) Treasury Bills: Treasury Bills are short-term government securities, they are
sold at a discount to their face value and redeemed at par on maturity. They are
highly liquid instruments and the default risk is negligible.

b) Commercial Papers: Commercial papers are short term, unsecured securities
issued by highly creditworthy and large companies. The maturity of these
instruments ranges from 15 days to one year. These instruments are marketable
hence they are liquid instruments.

c) Certificate of Deposits: Certificate of Deposits are papers issued by banks
acknowledging fixed deposits for a specified period of time, they are negotiable
instruments, this makes them liquid.

d) Bank Deposits: Firms can deposit excess/surplus cash in a bank for a period of
time. The interest rate will depend upon the maturity period. This is also a
liquid instrument in the sense that, in case of premature withdrawal only a part
of interest earned has to be foregone.

e) Inter-corporate Deposit: Companies having surplus cash can deposit its funds
in a sister or associate company or to other companies with high credit
standing.

f) Money Market Mutual Funds: Money market mutual funds invest in short
term marketable securities. These instruments have a minimum lock in period
of 30 days and returns are usually two percent above that of bank deposits with
the same maturity.

1.5 CASH COLLECTION AND DISBURSEMENTS
Once the cash budget has been prepared and appropriate net cash flows established
the finance manager should ensure that there does not exist a significant deviation
between projected and actual cash flows. The finance manager should expedite cash
collection and control cash disbursement. There are two types of floats, which would
require the attention of finance managers.

1) Collection Float: Collection float refers to the gap between the time, payment is
made by the customer/debtor and the time when funds are available for use in the
companys bank account. In simple words it is the amount tied up in cheques and
drafts that have been sent by the customers, but has not yet been converted into cash.
The reasons for this type of collection float are:

The time taken in postal transmission
The time taken to process cheques and drafts by the company, and
The time taken by banks to clear the cheques.

13

Working Capital
Management
To reduce this float companies can use various techniques, which are as follows:

a) Concentration Banking: When the customers of the company are spread over
wide geographical areas then instead of a single collection centre the company
opens collection centres at the regional level. The customers are instructed to
remit payments to their specific regional centres. These regional centres will
open bank accounts with the branches of banks where it has collection
potential. These branches will telegraphically or electronically transfer the
collected amount to the Head Office bank account. This system accelerates
cash inflows.

b) Lock Box System: In this system, the customers are advised to mail their
payments to a post office box hired by the firm for collection purposes near
their area. The payments are collected by local banks who are authorised to do
so. They credit the payments quickly and report the transaction to the head
office.

c) Zero Balance Account: In this type of account any excess cash is used to buy
marketable securities. Excess cash is the balance remaining after the cheques
presented against this account are cleared. In case of shortage of cash
marketable securities are sold to replenish cash.

d) Electronic Fund Transfer: Through electronic fund transfer the collection
float can be completely eliminated the other benefit of electronic fund transfer
is instant updation of accounts and reporting of balances as and when required
without any delay.

2) Payment Float: Cheques issued but not paid by the bank at any particular time is
called payment float. Companies can make use of payment float, by issuing cheques,
even if it means as per books of account an overdraft beyond permissible bank limits.
The company should be very careful in playing this float in view of stringent
provisions regarding the dishonouring of cheques, loss of reputation etc.

1.6 TREASURY MANAGEMENT
Treasury management is defined as the corporate handling of all financial matters,
the generation of external and internal funds for business, the management of
currencies and cash flows and the complex strategies, policies and procedures of
corporate finance.

In todays exceptionally volatile financial markets and complex business
environment, successful companies are directing their efforts aggressively to
strengthen their treasury management strategy and tactics for accelerating cash flow,
ensuring better management of unused cash, enhancing the performance of near cash
assets, optimising their capital structure and financing arrangements, identifying and
managing treasury risks and introducing more efficient and control oriented
processes. The role of the Treasury function is rapidly changing to address these
challenges in an effort to achieve and support corporate goals.

Cash has often been defined as King and it is. However, it is no longer good
enough just to mobilise and concentrate cash and then invest it overnight with pre-tax
returns barely exceeding 5% when the cost of short and longer-term debt is
significantly greater. The entire treasury cycle needs to be evaluated more closely.
Questions such as, how can we harvest our cash resources better, where can we
achieve the most efficient utilisation of our financial resources, and what are our
alternative needs to be answered. Treasures and Chief Financial Officer (CFOs) need
to get closer to the process of the overall treasury cash and asset conversion cycle
(sales/revenue generation/cash flow) to better understand how, when and where cash
will flow and then to take steps to enhance its utilisation.

14

Cash and Treasury
Management
An effective, and efficient treasury management operations predicts, analyses
and resolves the following questions which arise during business operations.

Do and will we have enough cash flow and funds available?
Are our near cash assets effectively utilised?
Should we pay down debt? Take on more debt?
Should we hedge our interest and currency risk exposures?
Where do our risks exist? What is the impact of those risks?
How effective is our risk identification and control processes?
How are these risks being mitigated? Are the methods adopted for mitigating
risk effective?
Do we have enough experienced human resources?
Do we have the right tools and technology?
Are we actively identifying opportunities to unlock value?
Are we implementing effectively and are alternatives properly evaluated?
Are our Financial Risks managed within a reasonable tolerance level?

By optimising the treasury operations and related risk management process, the
companies can reap significant benefits such as:

Improve cash flows, enhance return or reduce interest expense.
Put money on the table.
Reduce excessive and unnecessary costs.
Introduce more effective technologies.
Enhance the utilisation of near cash assets.
Better control and mitigate operational and financial risks.
Streamline banking structure.
Strengthen controls and procedures.
1.6.1 Treasury Risk Management
A few of the main focus areas of treasury operations are as follows:
1) Cash Flow-Receipts and Disbursements: Accelerating the collection of cash
receipts and mobilisation/consolidation of cash, improving effectiveness of
lockboxes; cheque clearing, credit card payments, wire transfer systems, and
electronic commerce initiatives to optimise cash utilisation. Design and operate
effective and control oriented payment and disbursement systems.

2) Bank and Financial Institution Relations: Assess global banking and
financial institutions relationships among themselves as well as with domestic
ones and identify ways to maximize the value of these relationships. Enhance
the value received from banking and financial products and implement more
efficient processes and account structures to strengthen global cash and
treasury risk management. Review capital structure and financing arrangements
to maximise the utilisation of financial resources and minimise their cost.

3) Cash Management Controls: Assess and improve controls to minimise
exposure to fraud and other such risks. This also strengthens and supports
internal control initiatives.

4) Cash Forecasting and Information Reporting: Improve the reliability,
accuracy and timeliness of data from domestic and international cash
forecasting models and processes; and improve the effectives of treasury
information reporting.

15

Working Capital
Management
5) International Cash Management: Optimize global cash and treasury risk
Management by improving Foreign Exchange (FX) management system.

6) FX and Interest Rate Management: Evaluate foreign exchange and interest
rate practices and strategy to identify, measure, manage and monitor these
activities. Also, assess opportunities for improvement.

The two main focus areas of treasury operations are: (i) Fund management, and
(ii) Financial risk management. The former includes cash management and asset-
liability mix. Financial risk management includes forex and interest rate management
apart from managing equity and commodity prices and mitigating risks associated
with them.

1.6.2 Functions of the Treasury Department
The important functions of a treasury department are as follows:

a) Setting up corporate financial objectives

Financial aim and strategies
Financial and treasury policies
Financial and treasury systems.

b) Liquidity Management

Working capital management
Money transmission and collection management
Banking relationships.


c) Funding Management

Funding policies and procedures
Sources of funds (Domestic, International, Private, Public)
Types of fund (Debt, equity, hybrid).

d) Currency Management

Exposure policies and procedures
Exchange dealings including, hedging, swaps, future and options
Exchange regulation.

e) Corporate Finance

Business acquisitions and sales
Project finance and joint ventures.

The main functions of the treasury department can be broadly classified as follows:

a) raising of funds
b) managing interest rate and foreign exchange exposure, and
c) maintenance of liquidity.

Raising of funds in not a regular activity. During normal operations the funds which
have already been raised are used for operations, but when the firm opts for new
projects, or when the firms go for backward and forward integration, additional
amount of funds are required. In these cases the treasury department has to look out
for different sources of funds and decide upon the source. The treasury department
16

Cash and Treasury
Management
will also decide the manner in which funds are to be raised viz., it should be either be
through a public issue or private placement, through debt or equity.

With the growing globalisation of economies all over the world, companies are
increasingly exporting and importing goods and services. This gives rise to the
problem of foreign exchange exposure. For example, company A exports goods
worth Rs.44, 000, as of today which is equivalent to $1000 assuming an exchange
rate of Rs.44 =1$. The payment for this export order will be received after 3
months. During this intervening period if the Indian rupee appreciates in comparison
to dollar by 5% i.e., Rs. 41.80 =1$ the effective receipt after 3 months would be
Rs.41, 800 only. In order to avoid this the company could take a forward cover
through which the unfavourable movement in currency prices are evend out.

The main function of the treasury department is to maintain liquidity. Liquidity here
implies the ability to pay in cash the obligations that are due. Corporate liquidity has
two dimensions viz., the quantitative and qualitative aspects. The qualitative aspects
refer to the ability to meet all present and potential demands on cash in a manner that
minimises costs and maximizes the value of the firm. The quantitative aspect refers to
quantum, structure and utilisation of liquid assets.

Excess liquidity (idle cash) leads to deterioration in profits and decreases managerial
efficiency. It may also lead to dysfunctional behaviour among managers such as
increased speculation, unjustified expansion and extension of credit and liberal
dividend. On the other hand a tight liquidity position leads to constraints in business
operations leading to, reduced rate of return and missing on opportunities. Therefore,
the most important challenge before the treasury department is to ensure the proper
level of cash in a firm.
) Check Your Progress 2
1) Optimising treasury operations results in:
...
..
..
2) The main focus areas of treasury operations are:

a)
b) ....
c) ..... ..
d)
.
3) The main functions of treasury department are:
a)
.
b)
.....
c) ...
..
d) .
.

17

Working Capital
Management
1.7 SUMMARY
In this unit we have discussed the motives for holding cash balances. Further we have
discussed cash deficit /surplus situation and how this can be contained through the
use of various models. Cash planning and forecasting is an important component of
cash management and the principal tool for effective cash management is cash
budget. We have also dealt with, how a firm can invest surplus cash and the type of
instruments that a firm should opt for. We have also examined collection float and
payment float and the ways and means to reduce collection float. In the last section
we have discussed the various functions of the treasury department and how an
effective and efficient treasury department will bring down the financial cost and
mitigate risks.

1.8 SELF-ASSESSMENT
QUESTIONS/EXERCISES
1) How do cash flow problem arise? What steps are suggested to overcome the
problem?

2) What are the reasons for holding cash balance?

3) Explain the Baumol model of cash management.

4) Write a short note on Cash Conversion Cycle.

5) Write short notes on the following:

Lock Box system
Zero Balance Accounts.
6) How is temporary cash surplus managed?
7) What is cash flow budget? What are the methods used in the preparation
of cash flow budget?

8) Treasury management mainly deals with working capital management and
financial risk management. Explain.

9) Prepare the Cash Budget of Fashion Fabrics for the months April 2005 to J uly
2005 (four months) from the details given below:
(i) Estimated Sales: (Rs.)
February 2005 12,00,000
March 2005 12,00,000
April 2005 16,00,000
May 2005 20,00,000
J une 2005 18,00,000
J uly 2005 16,00,000
August 2005 14,00,000

(ii) On an average 20% sales are cash sales. The credit sales are realised in the
third month (i.e., J anuary sales in March).

(iii) Purchases amount to 60% of sales. Purchases made in a month are generally
sold in the third month and payment for purchasing is also made in the third
month.

(iv) Variable expenses (other than sales commission) constitute 10% of sales and
there is a time lag of half a month in these payments.

(v) Commission on sales is paid at 5% of sales value and payment is made in the
third month.

18

Cash and Treasury
Management
(vi) Fixed expenses per month amount to Rs. 75,000 approximately.

(vii) Other items anticipated: Due

Interest payable on deposits 1,60,000 (April, 2002)
Sales of old assets 12,500 (May 2002)
Payments of tax 80,000 (J une, 2002)
Purchase of fixed assets 6,50,000 (J uly 2002)

(viii) Opening cash balance Rs. 1,50,000.

Solved Examples
Example 1: Company Ltd. has given the following particulars. You are required to
prepare a cash budget for three months ending 31
st
December 2005.

(i) Rs.
Months Sales Materials Wages Overheads
August 40000 20400 7600 3800
September 42000 20000 7600 4200
October 46000 19600 8000 4600
November 50000 20000 8400 4800
December 60000 21600 9000 5000

Credit terms are:

(ii) Sales/debtors - 10% Sales are on cash basis. 50% of the credit sales are
collected in the following month and the balance too is collected in the
following months:
Creditors Material 2 months
Wages 1/5 month.
Overheads 1/2 month.

(iii) Cash balance on 1
st
October, 2005 is expected to be Rs. 8000.

(iv) Machinery will be installed in August, 2005 at the cost of Rs. 100,000
The monthly instalment of Rs. 5000 will be payable from October onwards.

(v) Dividend at 10% on preference share capital of Rs.300,000 will be paid on
1
st
December 2005.

(vi) Advance to be received for sale of vehicle Rs. 20,000 in December.

(vii) Income-tax (advance) to be paid in December Rs. 5,000.

Solution:
(i) Cash collected from debtors:
Particulars Aug. Sept. Oct. Nov. Dec.
Cash Sales10% 4,000 4,200 4,600 5,000 6,000
Credit sales 90% 36,000 37,800 41,400 45,000 54,000
Collection debtors
1
st
Month 50% 18,900 20,700 22,500
2
nd
Month 50% 18,000 18,900 20,700
Total 36,900 39,600 43,200

(ii) Since the period of credit allowed by suppliers is two months the payment for
19

Working Capital
Management
a purchase of August will be paid in October and so on.

(iii) 4/5
th
of the wages is paid in the month itself and 1/5
th
will be paid in the next
month and so on.

(iv) 1/2 of the overheads is paid in the month itself and will be paid in the next
month and so on.
XYZ Company Ltd.
Cash budget for three months-October to December 2005
(Rs)
Particulars Oct. Nov. Dec.
Opening cash balance 8000 11780 18360
Receipts
Cash Sales 4600 5000 6000
Collection from debtors 36900 39600 43200
Advance from sale of vehicle - - 20000
Total 49500 56380 87560
Payments
Materials (creditors) 20400 20000 19600
Wages 7920 320 8880
Overheads 4400 4700 4900
Machinery (monthly instalment) 5000 5000 5000
Preference dividend - - 30000
Income-tax advance - - 5000
Total 37,720 38,020 73,380
Closing balance 11,780 18,360 14,180

Example 2: On 30
th
September 2002 the balance sheet of M.Ltd. (retailer) was as
under:

Liabilities Rs. Assets Rs.
Equipment (at cost) 20000 Equity shares of
Rs.10 each fully paid 20000 Less: Depreciation 5000
Reserve 10000 15000
Trade creditors 40000 Stock 20000
Proposed dividend 15000 Trade debtors 15000
Balance at bank 35000
85,000 85,000

The company is developing a system of forward planning and on 1
st
October 2005 it
supplies the following information:

Month Sales Purchases
Credit Cash Credit
September 2005 Actual 15000 14000 40000
October 2005 Budget 18000 5000 23000
November 2005 Budget 20000 6000 27000
December 2005 Budget 25000 8000 26000

All trade debtors are allowed one months credit and are expected to settle promptly.

All trade creditors are paid in the months following delivery. On 1
st
October 2005 all
equipments were replaced at a cost of Rs. 30,000. Rs.14, 000 was allowed in
exchange for the old equipment and a net payment of Rs. 16,000 was made. The
proposed dividend will be paid in December 2005.

The following expenses will be paid: Wages Rs. 3000 per month Administration
Rs. 1500 per monthly rent Rs. 3600 for the year upto 30
th
September 2006 (to be paid
in October 2005). You are required to prepare a cash budget for the months of
October November, and December 2005.
20

Cash and Treasury
Management

Solution:
Cash Budget of M. Ltd. for the quarter ending 31
st
December 2005
(Rs.)
Particular

October November December Total

Opening Balance 35,000 (9,100) (12,600) 35000
Cash receipts
Sales
Cash sales of current
month
5000 6000 8000 19000

Collection of credit
sales of previous month
15000 18000 20000 53000

Cash Payment
Payment to creditors (of
preceding month
purchase)
40000 23000 27000 90000
Payment for new
equipment
16000 - - 16000
Wages 3000 3000 3000 9000
Administration
expenses
1500 1500 1500 4500
Rent 3600 - - 3600
Dividend - - 15000 15000
Total (B) 64100 27500 46500 138100
Closing Balance 9100 12600 31100 31100
Total (A) 55,000 1,49,000 15,400 1,07,000

Example 3: From the following details furnished by a business firm, prepare its Cash
Budget for April 2005:

(i) The sales made and collection obtained conform to the following pattern:

Cash Sales 20%
Credit Sales 40% collected during the month of sales
30% collected during the first month
following the month of sale
25% collected during the second month
following the month of sale
5% become bad debts

(ii) The firm has a policy of buying enough goods each month to maintain its
inventory at 2.5 times the following months budgeted sales.

(iii) The firm is entitled to 2% cash discount on all its purchases if bills are paid
within 15 days and the firm avails of all such discounts.

(iv) Cost of goods sold without considering the cash discount is 50% of the sales
value at normal selling prices. The firm records inventory net of discount.

(v) Other information:

Sales (Rs.)

J anuary 2005 (actual) 1,00,000
February 2005 (actual) 1,20,000
March 2005 (actual) 1,50,000
April 2005 (budgeted) 170,000
May 2005 (budgeted) 1,40,000

(Rs.)
Inventory on 31
st
March 2005 2,25,400
Closing cash balance on 31
st
March,
2005
30,000
21

Working Capital
Management
Gross purchases made in March 2005 1,00,000

(vi) Selling general and administration expenses budgeted for April 2005 amounts
to Rs. 45,000 (includes Rs. 10,000 towards depreciation).

(vii) All transactions take place at an even pace in the firm.

Solution:
Cash Budget for April 2005
Particulars (Rs.)
Opening balance 30,000
Collection from Sales:
Cash Sales (20% of Rs. 1,70,000) 34,000
Collection against Credit Sales
Feb. 2002 Sales (25% of Rs. 96,000) 24,000
March, 2002 Sales (34% of Rs. 1,20,000) 36,000
April, 2002 Sales (40% of Rs. 1,36,000) 54,400
Total 1,78,400
Payments
For purchases:
March 2002 (Rs. 1,00,000 98% 1/2) 49,000
April 2002 (Rs. 29,400 12) 14,700
Selling, general and Admn. Expense excluding depreciation 35,000
Total 98,700
Budget Closing Cash balance 79,700
Working Notes:
Purchase Budget Gross Net
Desired ending inventory 1,75,000 1,71,500
Add Cost of Sales for April 2002 85,000 83,300
Total requirements 2,60,000 2,54,800
Deduct beginning inventory 2,30,000 2,25,400
Purchases to be made in April, 2002 30,000 29,400

Example 4: Prepare a cash budget for the three months ended 30
th
September 2005
based on the following information:
(Rs.)
Cash in bank on 1
st
J uly, 2005 25000
Monthly salaries and wages (estimated) 10000
Interest payable in August 2005 5000

(Rs.)
Estimated June July August September
Cash sales (actual) 1,20,000 140000 152000 121000
Credit sales 100000 80000 140000 120000
Purchases 160000 170000 240000 180000
Other expenses 18000 20000 22000 21000

Credit sales are collected 50% in the month of sale and 50% in the following month.

Collections from credit sales are subject to 10% discount if received in the month of
sale and to 5% if received in the month following. 10% of the purchase are in cash
and balance is paid in next month.

Solution:
Cash Budget for three months-July 2005 to September 2005
July August September
Opening Balance (i) 25,000 57,500 96,500
Receipts
22

Cash and Treasury
Management
Sales: Cash 1,40,000 1,52,000 1,21,000
Credit Current month 36,000 63,000 54,000
Previous month 47,500 38,000 66,500
Total Receipts (ii) 2,23,500 2,53,000 2,41,500
Total Cash (iii) =(i)+(ii) 2,48,500 3,10,500 3,38,000
Payments:
Purchases Cash 17,000 24,000 18,000
Credit (Previous Month) 1,44,000 1,53,000 2,16,000
Other expenses 20,000 22,000 21,000
Interest - 5,000 -
Salaries and Wages 10,000 10,000 10,000
Total Payment (iv) 1,91,000 2,14,000 2,65,000
Closing Balance (iii)-(iv) 57,500 96,500 73,000
1.9 SOLUTIONS/ANSWERS

Check Your Progress 1
1) Cash Balance April Rs. 56,000; O/D required May Rs. 47,000 but
assumed Rs. 50,000, J une Rs. 1,20,000 Total Rs. 1,70,000.

2) Closing Cash Balance: April Rs. 53,000; May Rs. 81,000 and J une
Rs. 91,000.

3) Closing Cash Balance September Rs. 7,200 October Rs. 15,185 (Cr.);
November Rs. 11,653 (Cr.).
23

Receivables
Management
UNIT 2 RECEIVABLES MANAGEMENT
Structure Page Nos.
2.0 Introduction 25
2.1 Objectives 25
2.2 Terms of Payment 25
2.3 Credit Policy Variables 27
2.4 Credit Evaluation 32
2.5 Monitoring Receivables 34
2.6 Factoring 35
2.7 Summary 37
2.8 Self-Assessment Questions 37
2.9 Solutions/Answers 39

2.0 INTRODUCTION
In the previous unit, we have seen how firms determine their needs for current assets
and manage their holdings in cash and marketable securities. In a typical
manufacturing company the debtors to total asset ratio varies from 20 to 25% which is
a considerable investment of funds. The effective management of this asset will have
a significant effect on the profitability of the company. The receivable (debtors) arise
due to credit sales, which is undertaken in order to encourage customers to purchase
goods or services. Accounts receivable use funds, and tying up funds in these
investments has an associated cost which, must be considered along with the benefits
from enhanced sales of goods and services. In this unit we are going to discuss the
various issues involved in management decisions of extending credit (i.e., accounts
receivable).

2.1 OBJECTIVES

After going through this unit, you should be able to:

understand the need for establishing sound credit policy;
understand the various credit policy variables;
understand the credit evaluation process;
understand the techniques of monitoring receivables, and
understand the concept of factoring.

2.2 TERMS OF PAYMENT
Terms of payment vary widely in practice. At one end, if the seller has financial
resources, s/he may extend liberal credit to the buyers, on the other hand the buyer
pays in advance and finances the entire trade cycle. The terms of credit vary for
different industries and are dictated by prevailing trade practices. In general,
businesses operating in monopoly environment will insist on advance/cash payment
whereas business operating in a competitive environment will extend credit to the
buyers. The major terms of payment are listed below:

Cash Terms

When goods are sold on cash terms, the sales consideration (payment) is received
either before goods are sold (advance payment) or when the goods are delivered (cash
on delivery) Cash term generally exist under the following conditions:

25

Working Capital
Management
(a) when goods are made to order
(b) when the buyer is perceived to be less credit worthy
(c) the seller is in strong bargaining position.

Open Account

Credit sales is generally on open account which implies that the seller ships the goods
to the buyer and thereafter sends the bill (invoice).

Consignment

Under this type of terms, the goods are merely shipped to the consignee; they are not
sold to the consignee. The consignee then sell these goods to the third party. One
should note here that the title of the goods is retained by the seller till they are sold by
the consignee to the third party. Sales proceeds are remitted by the consignee to the
seller.

Negotiable Instruments/Hundi

When the goods are sold on credit either through an open account or through
consignment an formal legal evidence of the buyers obligation is not created. In order
to overcome this a more secure agreement usually in the form of a draft is sought. A
draft represents an unconditional order issued by the seller to the buyer asking the
buyer to pay on demand (demand draft) or at some future certain date (time draft) the
amount specified on the draft. The draft is usually accompanied by the shipping
documents that are deliverable to the drawee when he pays or accepts the draft. Time
drafts can be discounted with the bank. The draft performs four useful functions:

(a) it creates an evidence of buyer obligation
(b) it helps in reducing the cost of finance
(c) it provides liquidity to the seller
(d) it is a negotiable instrument.

Letter of Credit

Under the documentary bills the seller faces a lot of risk the risk of non-payment or
non-acceptance of goods. This poses a major risk for the seller. This additional
security under this method comes from the fact that, the letter of credit is issued by the
bank and not by the party to the contract buyer. This instrument guarantees payment
to the seller on fulfilment of certain conditions specified therein. The Letter of Credit
can be defined as an instrument issued by a bank in favour of the seller (known as
beneficiary) whereby the issuing bank undertakes to pay the beneficiary a certain sum
against delivery of specific documents within a stated period of time. There are many
forms of a letter of credit; the most widely used are as follows:

1) Revocable vs. Irrevocable Letter of Credit
2) Confirmed vs. Unconfirmed Letter of Credit
3) Revolving Letter of Credit
4) Transferable Letter of Credit
5) Back to Back Letters of Credit
6) With Recourse vs. Without Recourse Letter of Credit.


2.3 CREDIT POLICY VARIABLES

26

Receivables
Management
Each company should establish its own credit policy depending upon the ground
situation and the environment in which it is operating. The main objective of the
credit policy is to stimulate sales as well as control expenses and bad debts associated
with granting credit. The following are the main components of a credit policy.
1) credit period to be allowed to general customers
2) credit period to be allowed to special customers and the criteria for defining
special customer to be predefined
3) credit rating system
4) cash discount policy or discount policy for pre-payment by debtors
5) collection policy
6) accounting system and management information system (MIS) for scrutiny and
efficient management of debtors
7) policy for dealing with bad and doubtful debts
8) credit insurance cover
9) proper documentation of credit sales.

If we regroup the above components they can be classified under the four dimensions
of a firms credit policy which are as follows:
a) credit standards
b) credit period
c) cash discount
d) collection effort.

Deciding on the credit policy involves a trade off between sales and expenses/losses.
Decreasing credit standards would increase sales but at the same time would lead to
increase in bad debt losses. The same is true for other variables of credit policy also.
Now let us examine the effect of each of these variables on the net profit on the firm.

Credit Standards

This variable deals with the granting of credit. On one extreme all the customers are
granted credit and on the other extreme none of them are granted credit irrespective of
their credit rating, but in todays competitive environment this is not possible. In
general liberal credit standards lead to increased sales accompanied by higher
incidence of bad debts, tying of funds in accounts receivable and increased cost of
credit collection. Stiff or tight credit standards lead to decreased sales, lower incidence
of bad debts, decreased investment in accounts receivable and decreased collection
cost.

The quantitative effect of relaxing the credit standards on profit can be estimated
by the equation 2.1

) 1 . 2 ( t) 1 ]( ) 1 ( [ I k b S V S NP
n
=

where
NP = Change in net profit
S = Increase in sales
V = Ratio of variable cost to sales
b
n
= Bad debt ratio on new sales
T = Tax rate
K = Cost of capital
I = Increase in receivable investment
I = V ACP
360
S

27

Working Capital
Management
360
S
= Average daily change (increase in sales)
ACP = Average collection period

Now let us see how each component of equation 2.1 affects net profit. S (1V)
represents the increase in gross incremental profit, due to relaxed credit standard and
for this purpose gross profit, is defined as Sales-Variable cost. Sb

n
calculates the
bad debts on incremental sales. The first part of the equation [ S (1V) Sb
n
]
(1-t) represents the post tax operating profit arising out of incremental sales and k I
measures the post tax opportunity cost of capital locked in additional investment on
account of relaxed credit standards. The pre tax operating profit is multiplied by (1t)
in order to get past tax operating profit.

Example 2.1: The current sales of M/s ABC is Rs.100 lakhs. By relaxing the credit
standards the firm can generate additional sales of Rs.15 lakhs on which bad debt
losses would be 10 per cent. The variable cost for the firm is, 80% percent average
collection period ACP is 40 days and post tax cost of funds is 10 percent and the tax
rate applicable to the firm is 40 percent. Find out whether the firm should relax credit
standards or not?

Solution:

NP = [ S (1V) S b
n
] (1t) k I
NP = [15 (1.80) 15.1] (1.4) .10
360
15
40.80
= [3 1.5] (.6) .1333
=.9 .1333
=.76671,00,000
=76,667

Since the impact of change in credit standards results in a positive change in net
profits therefore the proposed change should be accepted.

Credit Period

Credit period refers to the length of time provided to the buyer to pay for their
purchases. During this period no interest is charged on the outstanding amount. The
credit period generally varies from 30 to 90 days and in some businesses even a period
of 180 days is allowed. If a firm allows 45 days of credit with no discount for early
payment credit terms are stated as net 45. In case the firm allows discount for early
payment the credit terms are stated as 1.5/15, net 45 implying that if the payment is
made within 15 days a discount of 1.5 percent is allowed else the whole amount is to
be paid within 45 days.

Increasing the credit period results in increased sales but at the same time entails
increased investment in debtors and higher incidence of bad debts. Decreasing the
credit period would have the opposite result. The effect of increasing the credit period
on net profit can be estimated with the help of equation 2.2.


NP = [ S (1V) Sb
n
] (1 t) k I (2.2)

In this case I is calculated as follows:

I = (ACP
n
ACP
0
)
360
S
) ACP ( V
360
50
n

+

(2.2a)

28

Receivables
Management

where I = increase in investments

ACP
n
= new average collection period
ACP
0
= old average collection period

In equation 2.2a the first term represents incremental investments in receivables
associated with existing sales and the second term represents the investment in
receivables arising from incremental sales.

Example 2.2: M/s ABC has an existing sales of Rs.50 lakhs and allows a credit
period of 30 days to its customers. The firms cost of capital is 10 percent and the ratio
of variable cost to sales is 85. The firm is contemplating on increasing the credit
period to 60 days which would result in an increased sales of Rs.5 lakhs. The bad
debts on increased sales are expected to be 8 percent. The tax rate for M/s ABC is 40
percent. Should the firm extend the credit period?

Solution: I = (ACP
n

ACP
0
)
360
) ( ]
360
0 S
ACP V
S
n
[

+
360
5
60 85 .
360
50
) 30 60 ( +

= I
708333 .
360
50
30 + = I
9 . 99 , 874 , 4 500 , 87 , 4 000 , 00 , 1 8749997 . 4 = = = I
[ ]
750 , 27
000 , 00 , 1 ) 48750 . 21 (.
48750 . ) 6 ( ) 35 (.
875000 . 4 ) 6 (. ] 4 . 75 [.
500 , 87 , 4 10 . ) 04 1 ( ] 08 . 5 ) 015 ( 5 [
) 1 ( ) 1 (
=
=
=
=
=
= I k t
n
Sb V S NP

The increase in credit period results in a negative net profit therefore the credit period
should not be extended.

Cash Discount

Cash discount is offered to buyers to induce them to make prompt payment. The credit
terms specify the percentage discount and the period during which it is available.
Liberal cash discount policy imply that either the discount percentage is increased or
the discount period is increase. This leads to enhanced sales, decrease in average
collection period and increase in cost. The effect of this on net profit can be estimate
by the equation 2.3.

) 3 . 2 ( ) 1 ( ] ) 1 ( [ I k t DIS V S NP + =

where I = Savings in receivables investment

DIS = Increase in discount cost

I =
n n
ACP
S
V ACP ACP
S
360
) (
360
0
0

(2.3a)
DIS = P
0 0 0 n 0 n
d S P d ) S S ( + (2.3b)
where Pn = Proportion of discount sales after liberalising the discount terms.

29

Working Capital
Management
S
0
= Sales before liberalising the discount terms
S = Increase in sales
d
n
= New discount percentage
P
0
= Proportion of discount sales before liberalising the discount terms
d
0
= Old discount percentage

Example 2.3: M/s ABCs present credit terms are 1/10 net 30 which they are planning
to change to 2/10 net 30. The present average collection period is 20 days and the
variable cost to sales ratio is 85 and the cost of capital is 10 percent. The proportion
of sales on which customers currently take discount is .5. After relaxation of discount
terms it is expected that the ACP will reduce to 14 days, sales will increase from
Rs.80 lakhs to Rs 85 lakhs and the proportion of discount sales will increase to .8. Tax
rate for the firm is 40% calculate the effect of above changes on net profit.

Solution: I =
n n
ACP
S
ACP ACP
S
360
) (
360
0
0


= 14
360
5
85 . ) 14 20
360
(
80

= 1.1680555 lakhs
DIS = P
n
(S
0
+ S) d
n
P
0
S
0
d
0

= .96 lakhs
NP = I k ) t 1 ( ] DIS ) v 1 ( S +
=[ 1680555 . 1 1 . ) 4 . 1 ( ] 96 . ) 85 . 1 ( 5 +
= . (. 116805555 . ) 6 (. ) 96 75 +
= .126 + .11680555
= .009194 lakhs

Since the increase in net profit is negative the cash discount policy should not be
liberalised.

Collection Effort

The collection policy of a firm is aimed at timely collection of overdue amount and
consist of the following.

1) Monitoring the state of debtors (account receivable)
2) Reminders
3) Personal letters
4) Telephone calls
5) Personal visit of salesman
6) Restriction of credit
7) Use of collection agencies
8) Legal action.

An efficient and rigorous collection program tends to decrease sales, shorten average
collection period, reduce bad debts percentage and increase the collection expenses,
whereas a lax collection program will have just the opposite effect. The effect of
decreasing the collection effort on net profit can be estimated with the equation 2.4.
NP = [ S (1V) BD] (1 t) k I
where BD = increase in bad debt cost
I = increase in investment in receivables


30

Receivables
Management
0 0 0
0
0
) (
360
) (
360
S b S S b BD
V ACP
S
ACP ACP
S
I
n
n n
+ =

+ =


Example 2.4: M/s ABC is considering relaxing its collection efforts. At present its
sales are Rs.40 lakhs, the ACP is 20 days and variable cost to sales ratio is .8 and bad
debts are .05 per cent. Relaxation in collection effort is exected to push sales up by
Rs. 5 lakhs, increase ACP to 40 days and bad debt ratio to 0.06. ABC tax rate is 40
percent. Calculate the effect of relaxing credit effort on net profit.

Solution:
BD = b
n
(S
0
+ S) b0 S0
= .06 (40+5) - .05 40
= 2.7-2
=.7 lakhs

32 . 18 .
) 666667 . 2 ( 12 . ) 6 (. ] 7 . ) 2 (. 5 [
) 1 ( ] ) 1 ( [
6666667 . 2
9
4
9
20
8 . 40
360
5
) 20 40 (
360
40
360
) (
360
0
0
=
=
=
=
+
+ =

+ =
I k t BD V S NP
I
V ACP
S
ACP ACP
S
I
n n

= .14 lakhs

Since the effect on net profit is negative therefore the credit efforts should not be
relaxed.
Check Your Progress 1
1) As a part of the strategy to increase sale and profit, the sales manager of the
company proposes to sell goods to a group of new customers with 10% risk of
non-payment. This group would require one and a half months credit and is
likely to increase sales by Rs. 1,00,000 per annum. Production and selling
expenses amount to 80% of sales and the income tax rate is 50%. The
companys minimum required rate of return (after tax) is 25%. Should the
sales managers proposal be accepted?

2) Manjit Ltd. is examining the question of relaxing its credit policy. It sells at
present 20,000 units at a price of Rs. 100 per unit, the variable cost per unit is
Rs. 88 and average cost per unit at the current sales volume is Rs. 92. All sales
are on credit, the average collection period being 36 days.

A relaxed credit policy is expected to increase sales by 10% and the
average age of receivables to 60 days. Assuming 15% return, should the firm
relax its credit policy? Assume 360 days in a year.

3) A company wants to adopt a stricter collection policy. While going through
its books the following details are revealed:

The enterprise is at present selling 20,000 units on credit at a price of
Rs. 30 each, the variable cost per unit is Rs. 23 while the average cost per unit

31

Working Capital
Management
is Rs. 27. average collection period is 56 days and the collection expenses
amount to Rs. 8,000 and bad debts are 3%.

If the policy of collection is tightened a sum of Rs. 15,000 more will
be required as collection charges. Bad debts down to 1 percent and collection
period will reduce to 40 days. Sales volume is expected to reduce by 400 units.
Advice the company whether it should implement the decision or not. Assume
20% rate of return on investments.

4) The present credit terms of Padmavati Ltd. are 1/10 net 30. Its annual sales are
Rs. 80,00,000, and average collection period is 20 days. Its variable cost and
average table costs to sales are 0.85 and 0.95 respectively and its cost of capital
is 10 per cent. The proportion of sales on which customers currently take
discount is 0.5. The company is considering relaxing its discount terms of 2/10
net 30. Such relaxation is expected to increase sales by Rs. 5,00,000, reduce the
average collection period to 14 days and increase the proportion of discount
sales to 0.8. What will be the effect of relaxing the discount on the companys
profit? Take year as 360 days.

2.4 CREDIT EVALUATION
One of the important elements of credit management is the assessment of the credit
risk of the customer. While assessing risk two type of errors occur which are as
follows.

Type 1 error: Good customers are misclassified as poor credit risk
Type 2 error: Bad customers are misclassified as good credit risk.

Both the errors are costly. Type 1 error leads to loss of profit on sales and also loss of
good customers. Type II errors leads to bad debts and other costs associated with the
bad debts. These type of errors cant be totally eliminated but a proper credit
evaluation process can reduce these two types of errors. The credit evaluation process
involves the following steps.

1) Credit information
2) Credit investigation
3) Credit limits
4) Collection policy.

Credit Information
In order to ensure that the receivables are collected in full and on due date from the
customers, prior information of their credit worthiness should be available. This
information can be gathered from a variety of sources, which we are going to discuss
shortly. One important thing which needs to be kept in mind while gathering credit
information is that collecting credit information involves cost, therefore the cost of
collecting information should be less than the potential profitability of credit sales.
Another factor which should be borne in mind is that collecting credit information
may involve a lengthy period of time, on account of this the credit granting decision
should not be delayed for long. Depending upon these two factor any or a
combination of the following process may be employed to collect the information.

Financial Statements: Profit and loss a/c and Balance sheet of customers firm
provide valuable insight on the operating financial soundness, sources of funds,
application of funds, and debtors and creditors. The following ratios calculated
from financial statements seems particularly helpful in this context: Current ratio,

32

Receivables
Management
and acid test ratio, debt equity ratio, Earning Before Interest and Taxes (EBIT) to
total assets ratio and return on equity.

Bank References: A customers bank account is also a valuable source of
information regarding the credit worthiness of the customer. A thorough analysis
of bank transactions would reveal the financial behaviour and characteristics of
the customer. Bank references can be obtained either directly or by requesting
the customer to instruct his bank to provide the same.

Trade references: The seller can ask the prospective customer to give trade
references. Trade references are usually of those firms with whom the customer
is having current dealings.

Other Sources: A firm can also obtain information about the prospective
customer from credit rating agencies like (CRISIL, ICRA, CARE) and trade and
industry associations.

Credit Investigation

Once the credit information is gathered the next step is to analyse the gathered
information and isolate those matters, which may require further investigation. The
factors that affect the extent and nature of credit investigation are as follows:

Type of customer, whether new or existing
The customers business line, background and the related trade risks
The nature of products-perishable or seasonal
The size of the customers order and expected further volume of business with
him/her
Companys credit policies and practices
Capacity: Capacity refers to the ability of the buyer to pay the due on time and
is generally judged by the past turnover and the repayment behaviour
Character: Character refers to the willingness of the buyer to pay. The
character of the buyer is generally judged by his/ her past record of payments
and default history if any.
Collateral: Collateral means the security against the credit granted to
customers. A buyer willing to furnish adequate collateral is judged as more
creditworthy as compared to buyers who are unable to furnish any collateral.
Conditions: Conditions here refer to the sensitivity of the buyer to general
economic environment.

Analysis of Credit File: Credit file is a compilation of all the relevant credit
information of the customer. All the credit information collected during the credit
information process is annexed to this file. The information of all the previous
transactions and payments related to it are also recorded in the credit file. Any change
in customers payment behaviour like extension of time delayed payments enhancing
credit limits etc. are also recorded in the credit file. In case of new customers the
credit information collected should be thoroughly analysed and examined and in case
of existing customer the credit file should be analysed while extending credit for
larger accounts or for longer periods.

Analysis of Financial Ratios: Ratios are calculated to determine the customers
liquidity position and ability to repay debts. The ratios so calculated should be
compared with the industry average and the nearest competitors.
Analysis of Business and its Management: Besides analysing the fundamental
strength of the customers business the firm should also take into consideration the
quality of the management and the nature of the customer business. Some business are
inherently risky and granting credit to such customers may prove risky.


33

Working Capital
Management
Credit Limit
A credit limit is the maximum amount of credit, which the firm will extend at a point
of time. It indicates the extent of risk taken by the firm by supplying goods on credit
to a customer. Once the firm has decided to extend credit to the customer the amount
and duration of the credit will have to be decided. The amount of credit to be granted
will depend on the customers financial strength.

Collection Policy
Proper management of receivables require an appropriate collection policy which
outlines the collection procedures. Collection policy refers to the procedure adopted
by a firm to collect payments due on past accounts. The basic objective of the
collection policy is to minimise average collection period and bad debt losses. A strict
collection policy can affect the goodwill and can adversely affect potential future sales
whereas on the other hand a lenient collection policy can lead to increased average
collection period and increased bad debt losses. An optimum collection policy should
aim towards reducing collection expenditure.

2.5 MONITORING RECEIVABLES

A firm needs to continuously monitor and control its receivables to ensure that the
dues are paid on the due date and no dues remain outstanding for a long period of
time. The following two methods are used to evaluate the management of receivables.

1. Average collection period
2. Aging schedule.

Average collection period (ACP): Average collection period is defined as



Sales Credit
365 Debtors
ACP

=

The average collection period so calculated is compared with the firms stated credit
period to judge the collection efficiency. For example, if the firms stated collection
period is 45 days and the actual collection period is 60 days, one may conclude that
the firms collection efforts are lax. An extended credit period leads to liquidity
problems and may also result in bad debts. Two major drawbacks of this method are:

(i) It gives an average picture of collection efforts and is based on aggregate
data. It fails to pin point the receivables which are overdue.
(ii) It is susceptible to sales variation and the period over which sales and
receivable have been aggregated.

Ageing Schedule: The ageing schedule (AS) classifies outstanding accounts
receivable at a given point of time into different age brackets. An illustrative ageing
schedule is given below.

Age Groups (in days) Outstanding (Rs.) Percentage
0-30 45,000 37.50
31-60 15,000 12.50
61-90 10,000 12.50
91-120 30,000 250
Over 120 1,20,000 100.00
The actual aging schedule of the firm is compared with some standard ageing
schedule so as to determine whether accounts receivables are in control. If the greater
proportion receivable are in the higher age schedule than there is a need for some
corrective action.


34

Receivables
Management
2.6 FACTORING
Receivable management is a specialised activity and requires a lot of time and effort
on the part of the firm. Collection of receivables often poses problems, particularly for
small and medium size organisations. Banks do finance receivables but this
accommodation is for a limited period and the seller has to bear the risk in case
debtors default on payment.

In order to overcome these problems the firms can assign its credit management and
collection to specialist organisation known as factoring organisations.

Factoring is financial as well as management support to a firm. Through factoring
non-productive, inactive assets (Book debts or receivables) are assigned to a factor
which may be a bank or a financial institution or any other organisation which in turn
collects receivables from the debtors for a commission. The factoring can be defined
as a business involving a continuing legal relationship between the factor and a
business concern (the client) selling goods and services to trade customers (the
customers) whereby the factor purchases the clients accounts receivable and in
relation thereto, controls the credit extended to customers and administers the sales
ledger.

Factoring Services: The following basic services are provided by the factor apart
from the core service of purchasing receivables.

1) Sales Ledger administration and credit management
2) Credit collection and protection against default and bad debt losses
3) Financial accommodation against the assigned book debts (receivables).

In addition to these services the following services are also being provided by the
factor
1) Providing information about prospective buyers
2) Providing financial counselling
3) Assistance in liquidity management and sickness prevention
4) Financing acquisition of inventories
5) Providing assistance for opening letter of credit for the client.

Types of Factoring
The factoring facilities can be broadly classified in four groups which are as follows:

1) Full service non recourse (old line)
2) Full service recourse factoring
3) Bulk agency factoring
4) Non notification factoring.

Full Service Non Recourse: Under this method the book debts are purchased by the
factor assuming 100 percent credit risk. In case of default by the debtor the whole risk
is borne by the factor. In addition to this the factor may also advance 80-90% of the
books debts immediately to the client. Payments are made directly to the factor by the
customers. The factor also maintains the sales ledger and accounts and prepares age-
wise reports of outstanding book debts. This type of factoring services are specially
suited to the following conditions when,
a) Amounts involved per customer are relatively substantial
b) There are large number of customers of whom the client cant have personal
knowledge

35
c) Clients wish to have 100% cover rather than 70 to 80% cover provided by the
insurance companies.

Working Capital
Management

Full Service Recourse Factoring: In this type of factoring the client has to bear the
risk of default made by the debtors. In case the factor had advanced funds against
book debts on which the customer subsequently defaults the client will have to refund
the money. This type of factoring is more a method of short-term financing rather than
pure credit management and protection service. This type of factoring is suitable for
cases where there is high spread customers with relatively low exposure or where the
client is selling to high risk customers.

Advance Factoring and Maturity Factoring: In both non-recourse and recourse
factoring if the factor advances cash against book debts to the client immediately on
assignment of book debts it is known as advanced factoring. In maturity factoring the
factor makes payment to the client on maturity of book debts i.e., when they are due.
In non-recourse maturity factoring the payment is on maturity or when book debts are
collected or when the customer becomes insolvent. In recourse factoring the factor
pays the client when book debts have been collected.

Bulk Agency Factoring: This type of factoring is basically used as a method of
financing book debts. Under this type of factoring the client continues to administer
credit and maintain sales ledger. The factor finances the book debts against bulk either
on recourse or without recourse. This sort of factoring became popular with the
development of consumer durable market where credit management is not a problem,
but the firms require temporary financial accommodation.

Non-Notification Factoring: In this type of factoring customers are not informed
about the factoring agreement. The factor performs all the usual functions without
disclosing to customer that they own the book debts.

Costs and Benefits of Factoring

There are two types of costs involved in factoring:
1) the factoring commission or service fee, and
2) the interest on advances granted by the factor to the firm.

Factoring commission is paid to cover credit evaluation, collection, maintenance of
sales ledger, other services and to cover bad debt losses. The factoring commission
will depend upon the total volume of receivables, the size of individual receivables
and quality of receivables. The commission for non- recourse factoring is higher than
recourse factoring as the former factor assumes full credit risk.

In India the cost of factoring varies from 2.5% to 4% where as in developed countries
it ranges from 1% to 3%.

The interest on advances is usually higher than the prime lending rates of the bank or
the bank overdraft rate. In the United States of America, factors charge a premium of
2 to 5% over and above the prime interest rate.
The high cost of factoring is partly off set by the benefits of factoring some of which
are as follows:

factoring provide specialised service in credit management, thereby freeing
resources in the form of managements time and attention which they can focus
on core issues of manufacturing and marketing, and

factoring helps the firm to save cost of credit administration due to the scale of
economies and specialisation.
2.7 SUMMARY

36

Receivables
Management
Trade credit creates debtors or accounts receivables. Trade credit is used as a
marketing tool to gain competitive advantage over trade rivals. A firms investment in
accounts receivable would depend upon the volume of credit sales and collection
period. This investment in receivables can be increased or decreased by altering the
credit policy variables. The main variables of credit policy are credit period and cash
discount. The collection efforts of the firm are aimed at reducing bad debt losses and
accelerating collection from slow players. Factoring involves sale of receivables to
specialised firms known as factors. Factoring is basically used to improve liquidity
and for the timely collection of debts. Factors charge interest on advances and
commission for other services.

2.8 SELF-ASSESMENT QUESTIONS/EXERCISES

1) Describe the majors terms of payment in practice.

2) What are the importance dimensions of a firms credit period.

3) Discuss the consequences of lengthening versus shortening of the credit period.

4) Discuss the effects of liberal versus stiff credit standards.

5) What are the effects of liberalising the cash discount policy?

6) Develop a simple system of risk classification and explain its rationale.

7) Once the creditworthiness of a customer has been assessed, how would you go
abut analysing the credit granting decision?

8) What benefits and costs are associated with the extension of credit? How should
they be combined to obtain an appropriate credit policy?

9) What is the role of credit terms and credit standards in the credit policy of a firm?

10) What are the objectives of the collection policy? How should it be established?

11) What will be the effect of the following changes on the level of the firms
receivables?
a. Interest rate increases
b. Recession
c. Production and selling costs increase
d. The firm changes its credit terms from 2/10, net 30 to 3/10, net 30.

13) The credit policy of a company is criticised because the bad-debt losses have
increased considerably and the collection period has also increased. Discuss under
what conditions this criticism may not be justified.

14) What credit and collection procedures should be adopted in case of individual
accounts? Discuss.

Problems
1) The present sales of M/s Ram Enterprises is Rs.50 million. The firm classifies
customers into 3 credit categories: A, B and C. The firm extends unlimited
credit to customers in category A, limited credit to customers in category B, and
no credit to customer in category C. As a result of this credit policy, the firm is

37

Working Capital
Management
foregoing sales to the extent of Rs. 5 million to customers in category B and
Rs 10 million to customer in category C. The firm is considering the adoption of
a more liberal credit policy to customers in category C who would be provided
limited credit. Such relaxation would increase the sales by Rs. 10 million on
which bad debt losses would be 8 per cent. The contribution margin ratio for the
firm is 15 per cent, the average collection period is 60 days, and the cost of
capital is 12 per cent. The tax rate for the firm is 40 per cent. What will be the
effect of relaxing the credit policy on the net profit of the firm?

2) The Aravali Corporation currently provides 45 days of credits to its customer.
Its present level of sales is Rs. 15 millions. The firms cost of capital is 15 per
cent and the ratio of variable costs to sales is 0.80. The firm is considering
extending its credit period to 60 days. Such an extension is likely to push sales
up by Rs. 1.5 million. The bad debt proportion on additional sales would be
5 per cent. The tax rate is 45 per cent. What will be the effect of lengthening the
credit period on the firm?

3) The present credit terms of Lakshmi Company are 1/10, net 30. It sales are
Rs. 12 million, its average collection period is 24 days, its variable cost to sales
ratio is 0.80 and its cost of funds is 15 per cent. The proportion of sales on
which customer currently take discount is 0.3. Bhartya Company is considering
replacing its discount terms to 2/10, net 30. Such relaxation is expected to
increase the proportion of discount sales to 0.7. What will be the effect of
relaxing the discount policy on net profit? The tax rate of the firm is 50 per cent.

4) Shyam Venture is considering relaxing its collection efforts. Presently their
sales are Rs. 50 million, its average collection period 25 days. The relaxation in
collection efforts is expected to push sales up by Rs.6 million, increase the
average collection period to 40 days and raise the bad debts ratio to 0.06. The
tax rate of the firm is 30 per cent.

5) Ram Enterprises sell on terms 2/10 net 45. Total sales for the year is 40 million.
Thirty per cent of the customers pay on the tenth day and avail the discount, the
remaining seventy per cent pay, on average collection period and the average
investment in receivables.

6) Anil & Company sells on terms 1/5 net 15. The total sales for the year are Rs.
10 million. The cost goods sold is Rs. 7.5 million. Customers accounting for 30
per cent of sales take discount and pay on the fifth day, while others take an
average of 35 days to pay.

Calculate:

(a) the average collection period and
(b) the average investment in receivables.

7) Udar Limited is considering a change in its credit terms from 2/10, net 30 to
3/10 net 45. This change is expected to:

a) increase total sales from Rs. 50 million to Rs. 60 million
b) decrease the proportion of customer taking discount from 0.70 to 0.60
c) increase the average collection period from 20 days to 24 days.

The gross profit margin for the firm is 15 per cent and the cost of capital is 12
per cent. The tax rate is 40 per cent.

Calculate:

a) the expected change in profit and
b) the expected cost of increasing the cash discount.

38


39
Receivables
Management
8) The financial manager of a firm is wondering whether credit should be granted
to a new customer who is expected to make a repeat purchase. On the basis of
credit evaluation the financial manager feels that the probability is the customer
will pay 0.85 and the probability that S/he will pay for the repeat purchase
thereby increases to 0.95. The revenues from the sale will be Rs.10,000 and the
cost of sale would be Rs.8,500. These figures apply to both the initial and the
repeat purchase should credit be granted?

9) A firm is wondering whether to sell goods to a customer on credit or not. The
revenue from sales will be Rs. 10,000 and the cost of sale will be Rs 8,000.
What should be the minimum probability that the customer will pay, in order to
sell profitably?

2.9 SOLUTIONS/ANSWERS

Check Your Progress 1
1) Net Benefit Rs. 2,500; Proposal should be accepted. Profit on Additional Sales
Rs. 5,000; Additional Investment in Receivables Rs. 10,000 and cost is
Rs.2,500.

2) Net Profit Rs. 1200. Credit policy should be relaxed. Profit on Additional Sales
Rs. 24,000; Additional Investment in Receivables Rs. 1,52,000 and cost @ 15%
Rs. 22,800; Current Investment in Receivables Rs. 1,84,000; Proposed
Investment in Receivables Rs. 3,36,000.

3) Net Benefit Rs. 17,124. Collection policy should be tightened. Reduction in bad
debt losses Rs. 12,120; and cost of Average Investment in Receivables
Rs.5,004; Loss of Profit on reduced sales Rs. 2,800 and increase in collection
charge Rs. 15,000. Average Investment in Present Plan Rs. 84,000 and in
proposed plan Rs. 58,978.

4) Net Loss of Rs. 9,986. Present discount policy should not be relaxed. Profit on
additional sales Rs. 75,000; Cost savings on average investment in receivables
Rs. 11,014; Present Investment Rs. 4,22,222, proposed Rs. 3,12,083. Increase in
discount Rs. 96,000.






Working Capital
Management
UNIT 3 INVENTORY MANAGEMENT
Structure Page Nos.
3.0 Introduction 40
3.1 Objectives 40
3.2 Reasons for Holding Inventory 40
3.3 Objectives of Inventory Management 41
3.4 Techniques of Inventory Control 42
3.4.1 Traditional Techniques
3.4.2 Modern Techniques
3.5 Summary 52
3.6 Self-Assessment Questions/Exercises 53
3.7 Solutions/Answers 53

3.0 INTRODUCTION
Most firms build and maintain inventories in the course of doing business.
Manufacturing firms hold raw material, work in process, finished goods and spares in
inventories. Financial services firms hold inventories in the form of portfolio of
marketable securities consisting of debt, equity and hybrid instruments. Retails firms
(Shops, shopping malls, super markets etc.) hold inventories to meet demand for
products from customers.

In case of manufacturing firms inventories represents largest asset category, next only
to plant and machinery. The proportion of inventory to total assets ranges between
15 to 30 percent.

Inventory management is not an isolated activity; it requires coordination among the
production, purchasing and marketing departments. Decisions regarding of the
purchase raw material are taken by the purchasing and production department,
whereas work in process inventory is influenced by the production department.
Finished goods inventory levels are decided by both the production and marketing
departments. Since all these decision end up in tying of resources the financial
manager has the responsibility to ensure that the inventories are properly monitored
and controlled.

3.1 OBJECTIVES
After going through this unit, you will be able to:
highlight the need for and nature of inventory;
explain the techniques of inventory management;
highlight the need for analysing inventory problems, and
understand the process for managing inventory.

3.2 REASONS FOR HOLDING INVENTORY
The dictionary defines the word inventory as stock of goods. But, inventory means
such type of assets that will be disposed of in future in the ordinary course of
business. Bolten S.E. has defined it as, inventory refers to the stock-pile of the
product a firm is offering for sale and the components that make up the product. In
other words, inventory is used to represent the aggregate of those items of tangible
assets which are (i) held for sale in ordinary course of the business; (ii) in process of
production for such sale; or (iii) to be currently consumed in the production of goods
or services to be available for sale.

40

Inventory Management
Inventories are held basically to smoothen the operations of the firm. Shortage of
inventory at any point would disrupt operations resulting in either idle time for men
and machine or lost sales. A manufacturing firm may have inventories of different
stages in the production process.
1) Inventory of raw material are held to ensure that the production process is not
disrupted due to shortage of raw material. The amount of raw material
inventory would depend upon the speed at which the raw material can be
procured; the greater the speed, lower would be the level of raw material
inventory. Higher the uncertainty in the supply of raw material, higher would
be the level of raw material inventory.

2) Work in process (WIP) inventories arise in the process of production. These
type of inventories are also referred to as Process Inventories. In case of
simple products the WIP inventories would be less, whereas in case of complex
products requiring various sub-processes and sub-assemblies the work in
process inventory would be high.

3) Finished goods inventories are held to meet customers requirement
promptly. The quantum of finished goods inventory would depend upon:
time required to fill an order from the customer. If the products is of
such nature that any unexpected demand can be met at short notice the
level of inventories would be lower, and

diversity of the product line: Firms selling a wide range of products
generally need to invest more in finished goods.

4) Inventories are also held, so that the order cost is reduced.

5) Spares: An inventory of spare items which are required for the smooth running
of business is also kept.

6) Transaction/Precautionary and Speculative Motives: Inventories which are held
for conducting normal day to day business are known as transaction inventory.
Precautionary inventories are those inventories which are held to ensure that in
case of shortage or adverse price movement, the production process will not be
stopped due to the lack of inventory.

3.3 OBJECTIVES OF INVENTORY
MANAGEMENT
The twin objectives of inventory management are operational and financial. The
operational objective means that the materials and spares would be available in
sufficient quantity on time so that work is not disrupted for want of inventory. The
financial objective means that investment in inventories should not remain idle and
minimum amount of capital should be locked in inventories. The objectives of
inventory management are summarised as follows:
Operating Objectives
1) to ensure continuous supply of materials
2) to ensure uninterrupted production
3) to minimise risks and losses
4) to ensure better customer service
5) to avoiding stock out danger.
Financial Objectives
1) to minimise investment
2) to minimise inventory related costs and
3) to ensure economy in purchasing

41

Working Capital
Management

Factors Affecting Level of Inventory
As stated in the previous sections the firm should maintain its inventory at reasonable
level. The quantum of inventory depends upon several factors, some of the important
factors are mentioned below:

Nature of Business
Inventory Turnover
Nature and Type of Product
Market Structure
Economies of Production
Inventory Costs
Financial Position
Period of Operating Cycle
Attitude of Management

3.4 TECHNIQUES OF INVENTORY CONTROL
Inventory control signifies a planned approach of ascertaining when to buy, how
much to buy and how much to stock so that costs involving buying and storing are
optimally minimum, without interrupting production or affecting sales. There are
various techniques used to control inventory. These techniques are divided into two
categories Traditional Techniques and Modern Techniques
3.4.1 Traditional Techniques
Inventory Control Ratios
For purposes of monitoring the effectiveness of inventory management it is helpful to
ok at the following ratios and indexes: lo

Overall Inventory Turnover Ratio =
cost at s inventorie total Average
sold goods of Cost


Raw Material Inventory Turnover Ratio =
inventory material raw Average
material raw of n consumptio Annual


Work-in-process Inventory Turnover Ratio =
cost at inventory process in work age
e manufactur of Cost

Aver
Finished Goods Inventory Turnover ratio =

cost at goods finished of inve Average
Average Age of Raw Materials in Inventory
ntory
sold goods of Cost

=

Materials Raw of Purchase Daily
cost at Inventory Material Raw Average
Average


Average Age of Finished Goods Inventory =
day per ed manufactur goods of cost Average
Cost at inventory goods finished Average


42

Inventory Management
Out-of-stock Iindex =
ned requisitio times of Number
stock of out times of Number


Spare Parts Index =
Eeuipment Capital of Value
Inventory Parts Spare of Value

Two Bin System
Under this system all inventory items are stored in two separate bins (two bins for
each type of inventory items). In the first bin a sufficient supply of inventory is stored
which is going to be used over a designated period of time. In the second bin a safety
stock is maintained which is going to be used during lead times. As soon as material
in the first bin is consumed an order for further stock is placed and in the meantime
inventory from the second bin is used. On receipt of new order, second bin is restored
and the balance is put in the first bin. In this system depletion of inventory in the first
bin automatically generates a signal to re-order that particular inventory.
Perpetual Inventory System
In this type of system store balances are computed and recorded after each and every
issue and receipt. The main focus of this system is to make available details about the
quantity and value of stock at all points of time. If the balance of any item of
inventory falls below a particular pre-determined level the order is placed for a
further quantity of inventory. In this system physical verification is done after every
issue and receipt as a result of which this system is costly, but at the same time
materials statement, monitoring and follow up action can be smoothly carried out.
Periodic Inventory System
Under this system all stock levels are reviewed after a fixed time interval, depending
upon the importance of the item. Imported items may require a shorter review cycle,
whereas slow moving items may require a longer review cycle. In practice the review
of stock items takes place at the end of the accounting period. At the time of review,
orders are placed for further stocking up to a pre-determined level. Under this system
the order point is not actually determined but the time of review itself is an indication
to place further orders.
) Check Your Progress 1
1) A Publishing house purchases 2,000 units of a particular item per year at a unit
cost of Rs. 20. The ordering cost per order is Rs. 50 and carrying cost is Rs. 25.
Find the optimal order quantity and minimum total cost including purchase
cost.

If a 3% discount is offered by the supplier for purchases in lots of 1,000 or
more, should the publishing house accept the proposal?
2) Keshar Limited uses annually 24,000 kgs. of a chemical which costs Rs. 1.25
per kg. Placing each order costs Rs. 22.50 and the carrying cost is 15% per year
of the inventory cost. Find Economic Order Quantity, number or orders to be
placed per year and the total inventory cost (including cost of material).
(a) If procurement time is 12 days and safety stock (minimum stock) 500
kgs. Find the maximum inventory, re-order point and average inventory.
(b) What will be your decision if the company can get a concession of 5% on
purchase price if it orders 3000 kgs. or more? (Assume 300 days in a
year).

3) Calculate the minimum stock level, maximum stock level and reordering level
from the following information.
(a) Minimum consumption = 100 units per day
(b) Maximum consumption = 150 units per day

43

Working Capital
Management
(c) Normal consumption = 120 units per day
(d) Re-order period = 10 15 days
(e) Re-order quantity = 1,500 units
(f) Normal Re-order period = 12 days.

4) Two components A and B are consumed as follows:

Normal usage 100 units per week each
Minimum usage 50 units per week each
Maximum usage 150 units per week each
Re-order quantity A - 400 units; B - 600 units
Re-order period A 6 to 8 weeks; B 3 to 5 weeks.
Calculate the following for each component:

(i) Re-order Level
(ii) Minimum Level
(iii) Maximum Level
(iv) Average Stock Level

3.4.2 Modern Techniques

Economic Order Quantity (EOQ)
Graphical Methods:
The economic order quantity can also be determined with the help of a graph. Under
this method ordering cost, carrying cost and total inventory costs according to
different lot sizes are plotted on the graph. The point at which the line of inventory
carrying cost and the ordering cost intersect each other is the economic order
quantity. At this point the total inventory cost is also minimum. The function of EOQ
is illustrated below in Figure. 3.1.













In Figure. 3.1 costs like carrying, ordering and total cost are plotted on the vertical
axis (y) and order size is shown on the horizontal axis (x). From Figure. 3.1 one can
easily see that there is an inverse relationship between inventory carrying cost and
ordering cost i.e., inventory carrying cost increases and ordering cost decreases as the
order size increases. In the first instance the total cost line decreases as the order size
increases, but it starts increasing when decrease in ordering cost is more than off set
by the increase in carrying cost.

2800
400
800
1600
2400
1200
2000
Total Inventory Cost
100 200
300 400 500 600 700 800
0
Carrying Cost
Ordering Cost
E.O.Q
Order Size (Units)
Figure 3.1: Function of E.O.Q
C
o
s
t

(
R
u
p
e
e
s
)


44

Inventory Management
Assumption of the EOQ Model
The basic EOQ model is based on the following assumption:
1) The forecast usage/demand for a given period, usually one year, is known
2) The usage/demand is even throughout that period
3) Inventory orders can be replenished immediately (There is no delay in placing
and receiving orders).

There are two distinguishable costs associated with inventories: costs of ordering and
costs of carrying.

Figure 3.1 shows a graph illustrating the behaviour of the carrying cost, the ordering
cost, and the sum of these two costs. The carrying cost varies directly with the order
size (since the average level of inventory is one-half of the order size), whereas the
ordering cost varies inversely with the order size.

EOQ Formula
For determining the EOQ formula we shall use the following symbols:
U = annual usage/demand
Q = quantity ordered
F = cost per order
C = per cent carrying cost
P = price per unit
TC = total costs of ordering and carrying

Given the above assumptions and symbols, the total costs of ordering and carrying
inventories are equal to
C P
2
Q
F
Q
U
TC + =
In the equation, the first term on the right-hand side is the ordering cost, obtained as
the product of the number of orders (U/Q) and the cost per order (F) and the second
term on the right-hand side is the carrying cost, obtained as the product of the average
value of inventory holding (QP/2) and the percentage carrying cost C.

The total cost of ordering and carrying is minimised when:

PC
FU 2
Q=
which can be obtained by putting the first derivative of TC with respect to Q and
equating it with zero.

0
2
PC
Q
UF
dQ
dTC
2
= + =
2UF +Q
2
PC =0
Q
2
PC +2UF
Q
2
=
PC
UF 2

Q =
PC
UF 2

assuming that the second derivative condition is satisfied.

45

Working Capital
Management
The formula embodied in the equation is the EOQ formula. It is a useful tool for
inventory management. It tells us what should be the order size for the purchase of
items and what should be the size of production run for manufactured items.

The EOQ model may be illustrated with the help of the following data relating to the
Ace Company.

U = annual sales =20,000 units
F = fixed cost per order =Rs. 2,000
P = purchase price per unit =Rs. 12
C = carrying cost=25 per cent of inventory value.

Plugging in these values in eq. (3.2) we get.

Q = 164 . 5
25 . 0 12
000 , 20 000 , 2 2
=

Quality Discount and Order Quantity
The standard EOQ analysis is based on the assumption that the price per unit remains
constant irrespective of the size of the order. When quantity discounts are available,
which is often the case, the price per unit is influenced by the order quantity. This
violates the applicability of the EOQ formula. However, the EOQ framework can
still be used as a starting point for analysing the problem. To determine the optimal
order size when quantity discounts are available the following procedure may be
used:
1) Determine the order quantity using the standard EOQ formula assuming no
quantity discount, Call it Q*.
2) If Q* enables the firm to get quantity discount then it represents the optimal
order size.
3) If Q* is less than the minimum order size required for quantity discount (call it
Q) compute the change in profit as a result of increasing the order quantity
from Q* to Q as follow:

+ =
2
PC * Q
2
C ) D P ( ' Q
F
' Q
U
* Q
U
UD

where = change in profit.
U = annual usages/demand
D = discount per unit when quantity discount is available
Q* = economic order quantity assuming no quantity discount
Q = minimum order size required for quantity discount
F = fixed cost of placing an order
P = unit purchase price without discount
C = inventory carrying cost expressed as a percentage.

On the right-hand side of the equation, the first term represents savings in price, the
second term represents savings in ordering cost, and the third term represents the
increase in carrying cost.
4) If the change in profit is positive, Q represents the optimal order quantity. If
the change in profit is negative, Q* represents the optimal order quantity.
To illustrate the above procedure, consider the following data pertaining to Quantum
Ltd.

U = annual usage=10,000 units
F = foxed cost per order =Rs. 150
P = purchase price per unit =Rs. 20
C = carrying cost=25 percent of inventory value

46

Inventory Management
Q = minimum order size required for quantity discount=1,000 units
D = discount per unit =Re.1.

The EOQ assuming no quantity discount is

Q* = units 75
25 . 0 20
000 , 10 150 2
PC
FU 2
=

=

Since Q* is less than Q (1,000), the change in profit as a result of increasing the
order quantity from Q* to Q is

UD +
( )

2
*
2
'
' *
PC Q C D P Q
F
Q
U
Q
U


=10,000 1 + 150
000 , 1
000 , 10
775
000 , 10

( )

2
25 . 0 20 775
2
25 . 0 1 20 000 , 1

=10,000 +435 (2,375 1,938)
=Rs. 9,998.

Since the change in profit is positive, Q=1,000 represents the optimal order quantity.
It should be noted that the above procedure is based on the principle of marginal
analysis. This involves comparing incremental benefits with incremental costs in
moving from one level of inventory to another. This principle may be used to
compare a proposed order quantity with the present order quantity and more
generally for comparing any set of alternatives.

Levels
Mini-Max System
Under this method the maximum and minimum level for each item of inventory are
fixed. These levels serve as a basis for initiating action so that the quantity of each
item is controlled. These levels are not permanent and likely to change with the level
of activity. The maximum level indicates the maximum quantity of an item of
inventory which can be held at a point of time. The maximum level of inventory
would depend upon the following factor:
availability of storage space
lead time (time required in receiving the goods ordered)
availability of working capital
average rate of consumption of material
cost of storage and insurance
risk of obsolescence and deterioration
quantity discounts

Minimum level indicates the quantitative balance of an item of inventory, which must
be maintained in hand at all times. It is a level below which the inventories should not
fall. This level of inventory is held to avoid stock out and consequent stoppage of
production. The minimum level would depend upon:

rate of consumption of material
the maximum and minimum time required to acquire fresh supplies
the re-order level.

Re-order Period (ROP)

47

Working Capital
Management

The standard EOQ model assumes that materials can be procured instantaneously and
hence implies that the firm may place an order for replenishment when the inventory
level drops to zero. In the real world, however, procurement of materials takes time
and hence the order level

must be such that the inventory at the time of ordering
suffices and meet the needs of production during the procurement period which is
also known as Lead Time.

If the usage rate of materials and the lead time for procurement are known with
certainly then the ordering level would simply be:

Lead-time in days for procurement X Average daily usage

When the usage rate and lead time are likely to vary: the reorder level should be
higher than the normal consumption period requirement during the procurement
period in order to provide a measure of safety in the face of variability of usages and
lead time. Put differently, the reorder level should be equal to:
Normal consumption + Safety stock

Safety Stock
What should be the level of safety stock? In a simple situation where only the usage
rate is variable and the maximum usage rate can be specified, the safety stock
required to seek total protection against stock out is:

(Maximum usage rate Average usage rate) Lead time

When both the lead time and usage rate vary, which is often the case and the range of
variation is wide, complete protection against stockout may require an excessively
large safety stock. For example, if the lead time various between 60 days and 180
days with an average value of 90 days and the usage rate varies between 75 units and
125 units per day with an average value of 100 units per day, a safety stock of 13,500
units is required for complete protection against stockout. This has been worked out
as follows:
Maximum possible usage - Normal or Average usage
Maximum daily usage - Average or Normal daily usage
X Maximum lead time Average lead time
125 180 - 100 90 =13,500

Since inventory-carrying costs are proportional to the level of inventories carried, it
rarely makes sense to seek total protection against stockout. In view of the trade-off
between stockout cost and inventory carrying cost, the optimal level of safety stock is
usually much less than the level of safety stock required to achieve total protection
against stockout.
A manufacturing company will require 50,000 units of a product during the next year.
The cost of processing an order is Rs.20 and the carrying cost per units is 50 paise
per year. Lead-time of an order is 5 days and the company will keep a safety stock of
two days usage.

You are required to calculate (i) Economic Order Quantity; (ii) Re-order Point; (iii)
Minimum Inventory; (iv) Maximum inventory and (v) average Inventory. (Assume
250 days in a year.)

S

olution
(i) Economic Order Quantity
EOQ =
C
RO 2

Where; R = Annual Requirements or Usage

48

Inventory Management
O = Ordering cost per order
C = Carrying cost per unit per year
EOQ =
5 . 0 . Re
20 Rs. 000 , 50 2

= 000 , 00 , 40 =2,000 Units

(ii) Re-order Point
R.O.P. = (L UR) +S
Where; L = Lead Time;
U =Usage Rate (50,000 250) =200 (units per day);
S = Safety Stock
R.O.P. = (5 200) +(2 200)
= 1,000 +400 =1,400 Units

(iii) Minimum Inventory
Minimum Inventory is the Safety Stock kept by the company, which are
400 units. If there is no safety stock, minimum inventory will be zero.

(iv) Maximum Inventory
Maximum Inventory = EOQ +Safety Stock
= 2,000 +400
= 2,400 units.
(v) Average Inventory

2
Inventory Minimum Inventory Maximum +

Units 1,400
2
400 2,400
=
+

Order Point Formula
The analysis discussed above tends to be somewhat cumbersome when probability
distributions are most complex and dependent and multi-period cases are involved.
In view of this many firms would find the following formula helpful for calculating
the reorder point.

Recorder Point =S (L) + (L) SR

Where S =Usage
L =lead time needed to obtain additional inventory when the order is placed
R =average quantity ordered
F =stockout acceptance factor.

The value of F, the stockout acceptance factor, depends on the stockout percentage
rate.
Selective Inventory Control (Classification)
ABC Analysis:
ABC analysis [Always Better Control] is an application of the principle of
Management by Exception to the field of inventory control. If we look at the
inventory mix of a firm, it would constitute of hundreds of items. Most of these items
would be inexpensive and the frequency of their use would be less. The remaining
items would be expensive, more frequently used and account for large proportion of
firms investment in inventories.

It would be an expensive and cumbersome act to adopt a common policy and
determination of economic order quantity and reorder point for management of all
these items of inventory. In this technique all the items of inventory are classified in
three categories viz., A, B and C based on the usage rate, rupee value and criticality
of the item.

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Working Capital
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A category items are those inventory items which have maximum usage rate and
constitute 70% to 80% of inventory value, but only 5% to 10% of the inventory
volume. These type of inventories requires frequent monitoring and strict control.
B category items are those inventory items which have moderate value and usage
rate and constitute 20% to 25% of inventory value, but only 20% to 30% of the
inventory volume. These types of inventories require less monitoring and control.
C category items are of low or negligible value and usage rate. The remaining
items of inventory representing 5% to 10% of inventory value, but 60% to 70%
of the total quantity of inventory fall in this category and require general control.



Process of ABC Analysis

Classification: On the basis of expected use, the items of inventory are
classified according to their categories and per unit Price of each item is
determined.
Ascertainment of Total Cost: The total cost is calculated by multiplying the
expected units to be used by the per unit cost.
Rank Determination: Cost-wise rank is determine for each item of inventory.
First rank is assigned to the item with the highest total cost.
Computation of Ratio or Percentage: Two ratios/percentages are calculated
(i) Percentage of number of units of each item to total units of all items. (ii) Total
cost of each item to the total cost of all items.
Determination of ABC Category: ABC categories are formed by combining the
items on the basis of their relative values.


Example 2.1: Dinesh Limited is considering selective control for its inventories.
Using the following datas, prepare the ABC plan.

Items A B C D E F G

Unit 8,000 15,000 5,000 7,5000 5,000 7,000 2,500

Unit Cost (Rs.) 5.50 1.70 30.40 1.50 0.65 5.14 51.20

Solution:
ABC Analysis
Inventory Total Value Item Per Unit
Cost (Rs.)
Units % of
Total
Cumul-
ative %
Total
Cost Rs.
% of
Total
Cumul-
ative %


Cate-
gory

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Inventory Management
C

G

A

F

B

D

E
30.40

51.20

5.50

5.14

1.70

1.50

0.65
5,000

2,500

8,000

7,000

15,000

7,500

5,000
10
15%
5

16
30%
14

30

15 55%

10

15%


45%




100%


1,52,000

1,28,000

44,000

36,000

25,000

11,250

3,250
38
70%
32

11
20%
9

6.38

10%
2.80

0.82

70%


90%




100%




A




B



C




Total 50,000 100% 4,00,000 100%


VED Analysis:
VED (Vital, Essential, Desirable) analysis is a technique used for spare part inventory
analysis and is widely used in the automobile industry specially for the maintenance
of the spare parts inventory. According to this technique, inventory items are
classified as follows:
Vital (V) items constitute such items of inventory, which are vital for continuous
operations. Shortage or absence of these items will bring the production activity
to a halt. These items of inventory are critical for continuous production and
therefore require close monitoring.
Essential (E) items are those items of inventory, which are essential for
continuous production. The difference between vital and essential items is that
the shortage of essential items can be tolerated for a few hours viz., it will not
bring the production process to a halt. The level of these type of inventory is
moderately low.
Desirable (D) items do not have any immediate impact on the production
process, hence inventory of these items may or may not be maintained.

In VED analysis the focus is not on the value of the inventory, but the focus is on
their likely impact on production.

SED Analysis
SDE (Scarce, Difficult and Easy) analysis evaluates the importance of inventory
items on the basis of their availability. As per SDE analysis the inventory items are
grouped into the following categories:
Scarce (S) items are those items which are in short supply. Most of the time these
items are important and essential for continuous production.
Difficult (D) items are those items which can not be produced easily.

Easy (E) items are those items which are readily available in the market.
In SDE analysis the main focus is on the availability of the inventory. This type of
analysis is resorted to when the markets are regulated and input and output is
controlled by the government.
FSN Analysis:
Under this method inventory items are classified according to the usage/consumption
pattern. They are classified as follows:

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Working Capital
Management
Fast Moving (F) items are stored in large quantities as their usage rate is high.
Special attention is given to the inventory level of these types of items.
Slow Moving (S) items are not frequently required by the production department,
hence moderate quantities with moderate supervision are maintained.
Non Moving (N) items are rarely required by the production department, hence
small number of items are kept in stores and less supervision is required for these
kind of inventory items.
In this method the focus is on the frequency of usage of a particular item.
) Check Your Progress 2
1) A Precision Engineering Factory consumes 50,000 units of a component per
year. The ordering, receiving and handling costs are Rs.3 per order while the
trucking costs are Rs.12 per order. Further details are as follows:
Interest cost Rs. 0.06 per unit per year.
Deterioration and obsolescence cost Rs. 0.004 per unit per year.
Storage cost Rs. 1,000 per year for 50,000 units.
Calculate the economic order quantity.

2) A company requires 1,250 units per month of a particular item. Ordering costs
is Rs.50 per order. The carrying cost is 15% per year, while unit cost of the
item is Rs. 10.

Determine economic lot size and minimum total variable cost.

3) The following relations to inventory cost have been established for ABC Ltd.

(a) Orders must be placed in multiples of 100 units.
(b) Requirement for the year are 3,00,000 units.
(c) The purchase price per unit is Rs. 3.
(d) Carrying cost is 25% of the purchase price of goods.
(e) Cost per order placed is Rs. 20.
(f) Desired safety stock is 10,000 units, this amount is on hand initially.
(g) Three days are required for delivery.
Calculate the following:

(i) E.O.Q.
(ii) How many orders should the company place each year.
(iii) At what inventory level should an order be placed?

3.5 SUMMARY
Inventories constitute a significant portion of the current assets ranging form 40 to
60% for manufacturing companies. The manufacturing companies hold investments
in the form of raw material, work in process and finished goods. The three main
motives for holding inventories are transaction, precautionary and speculative. The
various factors which need to be considered while formulating inventory policy are:

(a) Costs
(b) Returns
(c) Risk Factors.
There are two type of costs associated with inventory maintenance which are:
(a) Ordering Costs
(b) Carrying Costs.

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Inventory Management

The Economic Order Quantity (EOQ) is that order quantity which minimises the sum
of ordering and carrying cost. The inventory level at which the firm places order for
further inventory is known as reorder point and it depends on:

(a) lead time
(b) the usage rate.
There are many inventory control systems, the most widely used one is ABC and
FSN System.

3.6 SELF-ASSESSMENT
QUESTIONS/EXERCISES
1) Distinguish between process or movement inventories and organisation
inventories.
2) What purpose is served by inventories?
3) What costs are incurred in the context of inventory managements?
4) What assumptions underlie the basic EOQ model?
5) What is the formula for EOQ? Device it.
6) How would you go about determining the optimal order size when quantity
discount is available? Illustrate your approach with a suitable example.
7) What modification is required in the basic EOQ analysis to cope with the
problem of inflation?

3.7 SOLUTIONS/ANSWERS
Check Your Progress 1

1) EOQ 4.226 units

2) EOQ 1,000 units; Minimum Total Variable Cost Rs. 1,500

3) (i) 4,000 units
(ii) 75
(iii) 12,500
Assume 360 days in a year.

Check Your Progress 2

1) EOQ 200 units; Total Cost Rs. 41,000; Net increase in total cost Rs. 325,
(Not to accept the offer.)
2) EOQ 2,400 kg; No. of orders 10; Total Purchase cost Rs. 30,450.
(a) Maximum Inventory 2,900 kg; ROP 1,460 kg; Average Inventory
1,700 kg.
(b) Discount should be availed; Saving Rs. 1,503.

3) ROL 2,250 units; Minimum Level 810 units; Maximum Level 2,750
units.

4) (i) A 1,200; B 750
(ii) A 500; B 350
(iii) A 1,300; B 1200

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Working Capital
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(iv) A 900; B 775.




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