(Cost and Management Accounting)
Full Marks: 80
Time: 3 hours
The figures in the margin indicate full marks for the questions.
1(a) Define ‘Costing’ and ‘Costing accounting’. Describe the importance of cost accounting as a managerial tool.
-> Costing may involve only the assignment of variable costs , which are those costs that vary with some form of activity (such as sales or the number of employees ). This type of costing is called direct costing . For example, the cost of materials varies with the number of units produced, and so is a variable cost.
Costing can also include the assignment of fixed costs , which are those costs that stay the same, irrespective of the level of activity . This type of costing is called absorption costing . Examples of fixed costs are rent, insurance , and property taxes.
Costing is used for two purposes:
1. Internal reporting. Management uses costing to learn about the cost of operations, so that it can work on refining operations to improve profitability . This information can also be used as the basis for developing product prices.
2. External reporting. The various accounting frameworks require that costs be allocated to the inventory recorded in a company’s balance sheet at the end of a reporting period . This calls for the use of a cost allocation system, consistently applied.
Within the areas of both internal and external reporting, costing is most heavily utilized in the area of assigning costs to products. This can be done with job costing , which requires the detailed assignment of individual costs to production jobs (which are small product batches). Another alternative is to use process costing , where costs are aggregated and charged to a large number of uniform products, such as are found on a production line. An efficiency improvement on either concept is to use standard costing , where costs are estimated in advance and then assigned to products, followed by variance analysis to determine the differences between actual and standard costs.
Cost Accounting is a business practice in which we record, examine, summarize, and study the company’s cost spent on any process, service, product or anything else in the organization. This helps the organization in cost controlling and making strategic planning and decision on improving cost efficiency. Such financial statements and ledgers give the management visibility on their cost information. Management gets the idea where they have to control the cost and where they have to increase more, which helps in creating a vision and future plan. There are different types of cost accounting such as marginal costing, activity-based costing, standard cost accounting, and lean accounting. In this article, we will discuss more objectives, advantages, costing and meaning of costs.
It is a process via which we determine the costs of goods and services. It involves the recording, classification, allocation of various expenditures, and creating financial statements. This data is generally used in financial accounting.
This helps us calculate the costs of the various goods. It also involves a suitable presentation of this data for the purposes of cost control and guidance to the management .
It deals with the cost of every unit, job, process, order, service, etc, whichever is applicable and includes the cost of production, cost of selling and cost of distribution.
Features of Cost Accounting:-
1) It is a sub-field in accounting. It is the process of accounting for costs
2) Provides data to management for decision making and budgeting for the future.
3) It helps to establish certain standard costs and budgets.
4) Provides costing data that helps in fixing prices of goods and services
5) Is also a great tool to figure out the efficiency of a unit or a process? It can disclose wastage of time and resources
Types and Classification of Cost Accounting
· Activity Based Costing
- Lean Accounting
- Standard Accounting
- Marginal Costing
Standard costing is a technique where the firm compares the costs that were incurred for the production of the goods and the costs that should have been incurred for the same.
This type of costing is based on the principle of dividing all costs into fixed cost and variable cost.
Fixed costs are unrelated to the levels of production. As the name suggests these costs remain the same irrespective of the production quantities.
Variable costs change in relation to production levels. They are directly proportionate. The variable cost per unit, however, remains the same.
Importance of cost accounting as a managerial tool:-
Cost accounting is of immense importance to management, employees, creditors, government and society in general. These are explained under the following heads:
1. Measurement and Improvement of Efficiency:
The chief advantage to be gained is that Cost Accounting will enable a concern to, first of all, measure its efficiency and then to maintain and improve it. This is done by suitable comparisons and analysis of the differences that may be observed. For example, if materials spent upon a pair of shoes in 2001 come to Rs. 100 and for a similar pair of shoe the amount is Rs. 120 in 2002. It is an indication of decline in efficiency.
Of course, the increase may only be due to increase in price of materials; it may also be due to greater wastage in use of materials or inefficiency at the time of buying so that unnecessary high prices were paid. Comparisons may also be made with average figures for the whole industry (if such figures are available) and with ideal figures which may have been determined before head.
2. Fixation of prices:
In many cases a firm is able to fix a price for its products on the basis of the cost of production. In such a case, price cannot be properly fixed if no proper figures of cost are available. In case of big contracts, no quotation can be made unless the cost of completing that contract can be ascertained.
If prices are fixed without costing information, it is possible that the price quoted may either be too high, in which case orders cannot be obtained, or it may be too low, in which case an order will result in a loss. It is a mistake on the part of any management to believe that mere increase in sales volume will result in profits; increased sales at prices lower than the cost may well lead the concern to the bankrupt court. Only Cost Accounting will reveal what price will be profitable.
3. Guide in Reducing Prices:
In certain periods it becomes necessary to reduce the price even below the total cost. This will be so when there is a depression or slump. Costs, properly ascertained, will guide management in this direction.
4. Information for Proper Planning:
For a proper system of Costing, it is necessary to have detailed information about the facilities available about machine and labour capacity. This helps in proper planning of work so that no section is overworked and no section remains idle.
5. Control over Materials etc.:
Information about availability of stocks of various materials and stores must be constantly available if there is a good system of Cost Accounting. This helps in two ways. Firstly, production can be planned according to the availability of materials and fresh stocks can be arranged in time when old stocks are exhausted. Secondly, loss due to carelessness or pilferage or any other mischief will be known and, therefore, put down.
6. Decision Regarding Machine vs. Labour:
Some of the important questions before management can be solved only with the help of information about costs. For example, if there is the problem of replacement of labour by machinery, Cost Accounting will at least guide management in finding out what the cost of production will be if either machinery or labour is used.
7. Expansion in Production:
Sometimes it is necessary to decide whether production of one product or the other is to be increased. This problem can also be solved only if proper information about costs is available.
8. Reasons for Losses Detected:
Exact causes of existence of profits or losses will be revealed by a system of Cost Accounting. For example, a concern may suffer not because the cost of production is high or prices are low but because the output is much below the capacity of the concern. It is only Cost Accounting which will reveal this reason for loss. It also helps in distinguishing between expenditure and loss which is necessary and that which is unnecessary, that is to say, between normal and abnormal losses.
9. Helps in Taking Decisions:
Cost Accounting inculcates the habit of making calculations with pencil and paper before taking a decision. It will certainly check recklessness. Also some of the silly mistakes that sometimes occur can be avoided if there is a good Cost Accounting system. To give an instance, a well-known firm once quoted for supply of mosquito nets to the Government at a very low price. It was only after the order was obtained that the firm found that, by mistake, the price of materials was not included in the quotation.
10. Check on Accuracy of Financial Accounts:
A good system of Cost Accounting affords an independent and most reliable check on the accuracy of financial accounts. This check operates through reconciliation of profits shown by Cost Accounts and by Financial Accounts. On the basis of various advantages of Cost Accounting, it can be easily said that ‘a good system of costing serves as a means of control over expenditure and helps to secure economy in manufacture’.
(b) Describe the benefits and limitation of Activity-based costing.
-> The activity-based costing (ABC) system is a method of accounting you can use to find the total cost of activities necessary to make a product. The ABC system assigns costs to each activity that goes into production, such as workers testing a product.
Many businesses use the cost of goods sold (COGS) to determine how much it costs to create a product. But, COGS focuses on direct costs and does not include indirect expenses like overhead. Some businesses take their overhead expenses and allocate them evenly among all products. But because some products use more overhead expenses than others, the cost of making each product is inaccurate under this method. With activity-based costing, you take into consideration both the direct and overhead costs of creating each product. You recognize that different products require different indirect expenses. By assigning both direct and overhead expenses to each product, you can more accurately set prices. And, the activity-based costing process shows you which overhead costs you might be able to cut back on.
Benefits of Activity Based Costing (ABC):
1. Accurate Product Cost:
ABC brings accuracy and reliability in product cost determination by focusing on cause and effect relationship in the cost incurrence. It recognises that it is activities which cause costs, not products and it is product which consumes activities. In advanced manufacturing environment and technology where support functions overheads constitute a large share of total costs, ABC provides more realistic product costs.
ABC produces reliable and correct product cost data in case of greater diversity among the products manufactured such as low-volume products, high-volume products. Traditional costing system is likely to bring errors and approximation in product cost determination due to using arbitrary apportionment and absorption methods.
2. Information about Cost Behaviour:
ABC identifies the real nature of cost behaviour and helps in reducing costs and identifying activities which do not add value to the product. With ABC, managers are able to control many fixed overhead costs by exercising more over the activities which have caused these fixed overhead costs. This is possible since behaviour of many fixed overhead costs in relation to activities now become more visible and clear.
3. Tracing of Activities for the Cost Object:
ABC uses multiple cost drivers, many of which are transaction based rather than product volume. Further, ABC is concerned with all activities within and beyond the factory to trace more overheads to the products.
4. Tracing of Overhead Costs:
ABC traces costs to areas of managerial responsibility, processes, customers, departments besides the product costs.
5. Better Decision Making:
ABC improves greatly the manager’s decision making as they can use more reliable product cost data. ABC helps usefully in fixing selling prices of products as more correct data of product cost is now readily available.
6. Cost Management:
ABC provides cost driver rates and information on transaction volumes which are very useful to management for cost management and performance appraisal of responsibility centres. Cost driver rates can be used advantageously for the design of new products or existing products as they indicate overhead costs that are likely to be applied in costing the product.
7. Use of Excess Capacity and Cost Reduction:
ABC, through the processes of pooling of activity costs and the identification of cost drivers, can lead to a range of applications. These include the identification of spare capacity and the fostering of cost reduction by comparing the resources required under ABC with the resources that are currently provided. This provides a platform for the development of activity-based budgeting in which the resource relationships identified by ABC are used to project future resource requirements.
8. Benefit to Service Industry:
Service organizations, such as banks, hospitals and government departments, have very different characteristics than manufacturing firms. Service organizations have almost no direct costs, most of the costs are overheads and they do not hold stocks of service as the service is consumed when it is produced. Traditional costing has generally been considered inappropriate for these organizations, whereas ABC offers the potential of benefits from improved decision making and cost management.
An ABC system can provide better costing information and help management manage efficiently and gain a better under-standing of the firm’s competitive advantages, strengths and weaknesses. Often, managers recognize needs for a better costing system such as ABC when they are experiencing increased lost sales due to erroneous pricing that resulted from inaccurate costing data.
An ABC system has the most impact on firms that have areas with large, increasing expenses or have numerous products, services, customers, processes, or a combination of these. Examples are plants that produce standard and custom products, high-volume and low-volume products, or mature and new products.
Firms that accept small and large orders, offer standard and customized deliveries, or satisfy all customers including those who demand frequent changes and services either before or after the delivery, and customers who hardly ever request special services can benefit substantially from activity-based costing systems.
Limitations of Activity-based costing:-
1. Expensive and Complex:
ABC has numerous cost pools and multiple cost drivers and therefore can be more complex than traditional product coating systems. It can prove costly to manage ABC system.
2. Selection of Drivers:
Some difficulties emerge in the implementation of ABC system, such as selection of cost drivers, assignment of common costs, varying cost driver rates etc.
3. Disadvantages to Smaller Firms:
ABC has different levels of utility for different organisation such as large manufacturing firm can use it more usefully than the smaller firms. Also, it is likely that firms depending on cost-plus pricing can take advantages from ABC as it gives accurate product cost. But those firms who use market based prices may not favour ABC. The level of technology and manufacturing environment prevailing in different firms also affect the application of ABC.
4. Measurement Difficulties:
The main costs and limitations of an ABC system are the measurements necessary to implement it. ABC systems require management to estimate costs of activity pools and to identify and measure cost drivers to serve as cost allocation bases. Even basic ABC systems require many calculations to determine costs of products and services. These measurements are costly. Activity cost rates also need to be updated regularly.
2(a)(i) Distinguish between Job costing and Process costing.
-> 1. In job costing, the cost is calculated after the completion of the job, but in process costing the cost of each job is determined.
2. Job costing is used in cases where products produced are unique in nature, and process costing is used for the standardized products produced.
3. In a job, casting losses can be segregated, but in the case of later loses are bifurcated on the bases of processes.
4. Transfer cost is not considered in job costing when the job is shifted from one assignment to another. In the case of process costing, the cost of the previous processing stage is transferred to the next processing stage.
5. There is less scope of reduction of cost in job costing, whereas for the process costing there is a higher scope of reduction of cost.
6. Job costing is suitable for industries that design and produce products based on the customer’s Process costing is useful for industries where mass production is possible.
7. In job costing WIP may or may not be present, but for process costing WIP may be present at the beginning and end of the period.
8. Special treatment is required for each job in job costing; whereas in process costing there is no need for special treatment for each process.
9. In job costing each job is different from another , so it has individuality. But, in later, products are produced in large volume and consequently, therefore it does not have individuality.
10. In job costing, the time and materials are considered while calculating the cost of the job so record keeping of all these things is an important and tedious task. Whereas, in the process casting the cost is aggregated so record keeping is an easy
11. Job costing makes the billing process easier for customers as well as the owners since the details of the exact costs are possible to be specified.
(b) Why it s necessary for reconciliation of cost and financial accounts? State the reasons for differences between profits shown by both the sets of accounts.
-> There are certain items, which appear in financial books only and not recorded in cost accounting books. Similarly, there may be some items, which appear in cost accounts only and do not find place in the financial books.
The following items of expenditures/losses appear only in financial books:
1. Interest on bank loans, mortgage, debentures, etc.
2. Expenses on stamp duty, discount and other expenses relating to issue and transfer of shares and debentures.
3. Fines and penalties.
4. Loss on sale of fixed assets.
5. Loss on sale of investments.
The following items of incomes/gains are recorded in the financial books only:
1. Interest received on bank deposits and other investments.
2. Dividend received on investment in shares.
3. Rental income, etc.
4. Fees received on issue and transfer of shares, etc.
5. Profit on sale of fixed assets
6. Profit on sale of investments.
Besides the above, there are special or abnormal items of expenditure and income, which are not included in the cost of production. If they are included, cost ascertainment will not be correct.
1. Excessive or avoidable rejections.
2. Defective work and spoilage.
3. Heavy losses of stores.
4. Loss due to theft or pilferage.
5. Loss on account of natural calamities.
6. Abnormal idle time.
7. Unexpected large incomes and other abnormal gains.
Other reasons for the difference between the results of two sets of books are:
1. Wages – Often in cost accounts, direct wages are charged on the basis of predetermined rates whereas in financial accounts actual expenditure on wages is recorded.
2. Overheads – In cost accounts, overheads are generally absorbed on the basis of a predetermined overhead rate whereas in financial accounts actual expenditure on overheads is recorded.
3. Depreciation – Depreciation may be charged on different bases in financial and cost accounts. For example, in financial accounts, it may be charged according to written down value method recognized by the Income Tax Act whereas in cost accounts it may be charged on the basis of the life of the machine in terms of production hours.
4. Valuation of Closing Stock – Different methods of valuation of closing stock adopted in cost and financial accounts also cause difference between the results of two sets of books. In financial accounts, the method generally followed is cost or market price, whichever is less, while in cost accounts only cost is the basis.
5. Notional Charges – Sometimes, notional charges such as interest on capital, rent for own premises, salary of owner-manager, etc. are included in cost accounts. But they do not appear in financial accounts, as there are no actual out go on these items.
Procedure for Reconciliation:
The following procedure may be followed for reconciliation:
1. Ascertain items, which appear in financial accounts but not in cost accounts.
2. Ascertain items that appear in cost accounts only but not in financial accounts.
3. Determine the extent of difference between actual indirect expenses as recorded in financial books and the amount of overheads recovered in cost books.
4. Compare the figures of valuation of stock of raw materials, work-in- progress, stores and finished goods as shown in cost accounts and financial accounts and ascertains the amount of difference.
5. Ascertain other items, which are shown in cost as well as financial accounts but differ in value.
6. Prepare Reconciliation Statement, which is also called Memorandum Reconciliation Statement.
7. Start with the profit as per cost accounts and reach the profit as per financial accounts.
8. Add or deduct, as the case may be, items which differ from financial accounts, and items which are recorded in financial accounts and not in cost accounts. A brief explanation may be given in respect of each addition or deduction.
9. All items of expenditures/losses, which appear in financial accounts but not in cost accounts, will be deducted and all items of income/gains appearing in financial accounts but not in cost accounts will be added. Reverse will be the treatment of items appearing in cost accounts but not appearing in financial accounts.
In the same way adjustment will be made for difference between any items appearing in both the accounts. For example, expenses overcharged in cost accounts will be added to and expenses undercharged in cost accounts will be deducted from the profit as per cost accounts to arrive at the profit as per financial accounts.
10. If reconciliation statement is started with profit as per financial accounts and ended with profit as per cost accounts, the above additions and deductions will be reversed.
11. After making necessary additions and deductions, the resultant figure is profit as per financial accounts.
12. The above reconciliation may be carried out by preparing a memorandum reconciliation account
13. In case of a memorandum reconciliation account, profit as per cost accounts will be the first item on the credit side and items that are added in the reconciliation statement will also appear on the credit side. All the items, which are deducted in the reconciliation statement, will be written on the debit side. The balancing figure will be profit as per financial accounts.
Where cost accounts and financial accounts are kept separately in any organisation, there are chances that both the books may show profit separately. The profits shown by costing books may not agree with the profits shown by financial Books. Therefore, it becomes necessary that the profit and loss shown by both cost accounts and financial accounts should tally to each other. For this purpose reconciliation of both the books are to be made.
Under non-integral system, the question of reconciliation of cost and financial accounts arises. But under the integral accounting system, cost and financial accounts are integrated to one set of books, and there seems to be no necessity to prepare and to reconcile the profits shown by cost as well as shown by financial accounting.
Following are the main causes of difference between the results shown by the cost accounts and the financial accounts:
1. Estimates and Actual:
The cost can be computed either on actual or estimated basis. Since cost accounts are meant to function as a control device it will be appropriate to adopt estimated costing or preferably standard costing system while preparing cost accounts. Estimates or standards can be nearer to the actual but in most cases they cannot be the same. This necessarily means that the profit shown by the cost accounts is bound to be different from the profit shown by the financial accounts.
Following are some of the important items the costs of which may be different in financial books and costing books:
(a) Direct Materials:
The estimated or standard cost of the direct materials purchased or consumed in the production process may be different from the actual costs. This difference will be due to change in price or quantity or both.
(b) Direct Labour:
The estimated or standard cost of direct labour may be different from the actual costs because of differences in wage rates or hours of work or both. Sometimes, workers might have to be paid more due to increased dearness allowance, pay revision, bonus etc. This will cause difference between the profits shown by the two sets of books.
Different methods of charging depreciation may be adopted in cost and financial books. In financial books depreciation may be charged according to fixed instalment method or diminishing balance method etc. while in cost accounts machine hour rate or any other method may be used. This is also an item of overheads and may be one of the reasons of difference between the overheads charged in financial accounts and overheads charged in cost accounts.
2. Valuation of Stocks:
(a) Raw materials – In financial accounts stock of raw materials is valued at cost or market price, whichever is less, while in cost accounts stock can be valued on the basis of FIFO or LIFO or any other method. Thus, the figure of stock may be inflated in cost or financial accounts.
(b) Work-in-progress – Difference may also exist regarding mode of valuation of work-in-progress. It may be valued at prime cost or factory cost or cost of production. The most appropriate mode of valuation is at factory cost in cost accounts. In financial accounts work-in-progress may be valued after considering a part of administrative expenses also.
3. Items Included in Financial Accounts Only:
There are certain items which are included in the Financial Accounts but not in the Cost Accounts.
These include the following:
(a) Appropriation of profits e.g., provision for taxation, transfer to reserves, goodwill, preliminary expenses written off.
(b) Purely financial charges e.g., losses on sale of investments; penalties and fines, expenses on transfer of company’s office.
(c) Purely financial incomes e.g., interest received on bank deposits, profits made on the sale of investments, fixed assets, transfer fees received etc.
4. Items Included in Cost Accounts Only:
There are certain notional items which are excluded from the financial accounts but are charged in the cost accounts:
(i) Charge in lieu of rent where premises are owned.
(ii) Depreciation on an asset even when the book value of the asset is reduced to a negligible figure.
(iii) Interest on capital employed in production but upon which no interest is actually paid (this will be the case when the firm decides to include interest in the overheads).
The above items will reduce the profits in Cost Accounts as compared to that in Financial Accounts.
5. Abnormal Gains and Losses:
Abnormal gains or losses may completely be excluded from cost accounts or may be taken to costing profit and loss account. In financial accounts such gains and losses are taken to profit and loss account. As such, in the former case costing profit/loss will differ from financial profit/loss and adjustment will be required. In the latter case, there will be no difference on this account between costing profit or loss and financial profit or loss.
Therefore, no adjustment will be required on this account. Examples of such abnormal gains and losses are abnormal wastage of materials e.g., by theft or fire etc., cost of abnormal idle time, cost of abnormal idle facilities, exceptional bad debts, abnormal gain in manufacturing through processes (when actual production exceeds normal production).
The need for reconciliation will not arise in case of a business where Integral or Integrated Accounting System is in use as there will be only one set of books both for financial and costing records. But where there are separate sets of books, reconciliation is imperative.
Need for reconciliation of cost and financial accounts:-
In case separate set of books are maintained for costing and financial transactions, usually there will be a difference between profit shown by cost accounts and profit shown by financial accounts. However, it is also possible, per chance, that the overall profit shown by two sets of books is the same. Nevertheless all cases, the results shown by both the set of books are to be reconciled to identify the causes of difference (if any) and to establish accuracy of both the sets of books.
When cost accounts and financial accounts are maintained separately, the profit shown by one set of books may not agree with that of the other set. In such a situation, it is necessary to reconcile the results (profit/loss) shown by two sets of books. Such reconciliation proves arithmetical accuracy of data, explains reasons for the difference in the two sets of books and affords reliability to them.
3(b) What is Common-size Statement? What are its objectives? Describe the utility of such a statement.
-> The common-size statements, balance sheet and income statement are shown in analytical percentages. The figures are shown as percentages of total assets, total liabilities and total sales. The total assets are taken as 100 and different assets are expressed as a percentage of the total. Similarly, various liabilities are taken as a part of total liabilities.
These statements are also known as component percentage or 100 per cent statements because every individual item is stated as a percentage of the total 100. The short-comings in comparative statements and trend percentages where changes in items could not be compared with the totals have been covered up. The analyst is able to assess the figures in relation to total values.
Types of Common-size Statement:-
(i) Common-Size Balance Sheet:
A statement in which balance sheet items are expressed as the ratio of each asset to total assets and the ratio of each liability is expressed as a ratio of total liabilities is called common-size balance sheet. The common-size balance sheet can be used to compare companies of differing size. The comparison of figures in different periods is not useful because total figures may be affected by a number of factors. It is not possible to establish standard norms for various assets. The trends of figures from year to year may not be studied and even they may not give proper results.
(ii) Common Size Income Statement:
The items in income statement can be shown as percentages of sales to show the relation of each item to sales. A significant relationship can be established between items of income statement and volume of sales. The increase in sales will certainly increase selling expenses and not administrative or financial expenses.
In case the volume of sales increases to a considerable extent, administrative and financial expenses may go up. In case the sales are declining, the selling expenses should be reduced at once. So, a relationship is established between sales and other items in income statement and this relationship is helpful in evaluating operational activities of the enterprise.
Objectives of Common-size Statement:-
(1) It is beneficial in comparing two or more periods or two or more companies when the productive capacity is not the same.
(2) The comparative significance of each individual item of expenses and incomes stands out clearly.
(3) A study of common size percentage of a company indicates the structure of profit and loss account.
(4) The common size income statement also shows the distribution of profit in form of interest, taxes and dividends.
Utility of Common-size Statement:-
A common size income statement is an income statement in which each line item is expressed as a percentage of the value of revenue or sales. It is used for vertical analysis, in which each line item in a financial statement is represented as a percentage of a base figure within the statement.
Common size financial statements help to analyze and compare a company’s performance over several periods with varying sales figures. The common size percentages can be subsequently compared to those of competitors to determine how the company is performing relative to the industry.
Generally accepted accounting principles (GAAP) are based on consistency and comparability of financial statements. A common size income statement makes it easier to see what’s driving a company’s profits. The common size percentages also help to show how each line item or component affects the financial position of the company. As a result, the financial statement user can more easily compare the financial performance to the company’s peers.
By analyzing how a company’s financial results have changed over time, common size financial statements help investor’s spot trends that a standard financial statement may not uncover. The common size percentages help to highlight any consistency in the numbers over time–whether those trends are positive or negative. Large changes in the percentage of revenue as compared to the various expense categories over a given period could be a sign that the business model, sales performance, or manufacturing costs are changing.
Common size financial statement analysis can also be applied to the balance sheet and the statement of cash flows .
4(a) “Ratios are mechanical and incomplete.” Comment on this statement giving justifications in support of your answer.
-> Ratios are basically figures that represent an element’s value in terms of the other. These are one of the most used techniques of financial analysis. Typically, ratios are used to analyse the performance or for comparison purpose. However, it only gives the final figure but there is no clue about the other essential details.
For instance, in case of profit margin ratio for 2 companies A and B, A can have more margins than B but the sales are less for A and so is the market price per share. These things do not get accounted for the ratio.
Depending on a single ratio leads to an incomplete analysis based on half-knowledge only. It makes interpretation mechanical by limiting it to quantitative values. The context is not complete.
However, ratios are good in providing first-hand information about the performance of the company. There are also other limitations like the historical data in use, open to misinterpretation by a layman etc. Hence, ratios are mechanical and incomplete.
Ratio analysis is a powerful tool of financial analysis. A ratio is defined as the indicated quotient of two mathematical expressions and as the relationship between two or more things. In financial analysis, a ratio is used as an index or yardstick for evaluating the financial position and performance of the Board. The absolute accounting figures reported in the financial statements do not provide a meaningful understanding of the performance and financial position of the Board. An accounting figure conveys meaning when it is related to some other relevant information. In the words of J. Batty, the term accounting ratio is used to describe significant relationships, which exist between figures shown on a balance sheet in a profit and loss account in a budgetary control system or in any other part of the accounting organisation.
Ratio analysis is a technique of analysis and interpretation of financial statements. It is the process of establishing and interpreting various ratios for helping in making certain decisions. However, ratio analysis is not an end in itself. It is only a means of better understanding of financial strengths and weaknesses of a firm.
Calculation of mere ratios does not serve any purpose, unless several appropriate ratios are analyzed and interpreted. There are a number of ratios which can be calculated from the information given in the financial statements, but the analyst has to select the appropriate data and calculate only a few appropriate ratios from the same keeping in mind the objective of analysis. The ratios may be used as a symptom like blood pressure, the pulse rate or the body temperature and their interpretation depends upon the calibre and competence of the analyst.
Uses of Ratio Analysis:
The ratio analysis is one of the most powerful tools of financial analysis. It is used as a device to analyze and interpret the financial health of enterprise. Just like a doctor examines his patient by recording his body temperature, blood pressure, etc. before making his conclusion regarding the illness and before giving his treatment, a financial analyst analyses the financial statements with various tools of analysis before commenting upon the financial health or weaknesses of an enterprise.
‘A ratio is known as a symptom like blood pressure, the pulse rate or the temperature of an individual.’ It is with help of ratios that the financial statements can be analyzed more clearly and decisions made from such analysis. The use of ratios is not confined to financial managers only. There are different parties interested in the ratio analysis for knowing the financial position of a firm for different purposes.
The supplier of goods on credit, banks, financial institutions, investors, shareholders and management all make use of ratio analysis as a tool in evaluating the financial position and performance of a firm for granting credit, providing loans or making investments in the firm. With the use of ratio analysis one can measure the financial condition of a firm and can point out whether the condition is strong, good, questionable or poor. The conclusions can also be drawn as to whether the performance of the firm is improving or deteriorating.
Thus, ratios have wide applications and are of immense use today:
(a) Managerial Uses of Ratio Analysis:
1. Helps in decision-making:
Financial statements are prepared primarily for decision-making. But the information provided in financial statements is not an end in itself and no meaningful conclusion can be drawn from these statements alone. Ratio analysis helps in making decisions from the information provided in these financial statements.
2. Helps in financial forecasting and planning:
Ratio Analysis is of much help in financial forecasting and planning. Planning is looking ahead and the ratios calculated for a number of years work as a guide for the future. Meaningful conclusions can be drawn for future from these ratios. Thus, ratio analysis helps in forecasting and planning.
3. Helps in communicating:
The financial strength and weakness of a firm are communicated in a more easy and understandable manner by the use of ratios. The information contained in the financial statements is conveyed in a meaningful manner to the one for whom it is meant. Thus, ratios help in communication and enhance the value of the financial statements.
4. Helps in co-ordination:
Ratios even help in co-ordination which is of utmost importance in effective business management. Better communication of efficiency and weakness of an enterprise results in better coordination in the enterprise.
5. Helps in Control:
Ratio analysis even helps in making effective control of the business. Standard ratios can be based upon proforma financial statements and variances or deviations, if any, can be found by comparing the actual with the standards so as to take a corrective action at the right time. The weaknesses or otherwise, if any, come to the knowledge of the management which helps in effective control of the business.
6. Other Uses:
These are so many other uses of the ratio analysis. It is an essential part of the budgetary control and standard costing. Ratios are of immense importance in the analysis and interpretation of financial statements as they bring the strength or weakness of a firm.
(b) Utility to Shareholders/Investors:
An investor in the company will like to assess the financial position of the concern where he is going to invest. His first interest will be the security of his investment and then a return in the form of dividend or interest. For the first purpose he will try to asses the value of fixed assets and the loans raised against them. The investor will feel satisfied only if the concern has sufficient amount of assets.
Long-term solvency ratios will help him in assessing financial position of the concern. Profitability ratios, on the other hand, will be useful to determine profitability position. Ratio analysis will be useful to the investor in making up his mind whether present financial position of the concern warrants further investment or not.
(c) Utility to Creditors:
The creditors or suppliers extend short-term credit to the concern. They are interested to know whether financial position of the concern warrants their payments at a specified time or not. The concern pays short- term creditor, out of its current assets. If the current assets are quite sufficient to meet current liabilities then the creditor will not hesitate in extending credit facilities. Current and acid-test ratios will give an idea about the current financial position of the concern.
(d) Utility to Employees:
The employees are also interested in the financial position of the concern especially profitability. Their wage increases and amount of fringe benefits are related to the volume of profits earned by the concern. The employees make use of information available in financial statements. Various profitability ratios relating to gross profit, operating profit, net profit, etc. enable employees to put forward their viewpoint for the increase of wages and other benefits.
(e) Utility to Government:
Government is interested to know the overall strength of the industry. Various financial statements published by industrial units are used to calculate ratios for determining short-term, long-term and overall financial position of the concerns. Profitability indexes can also be prepared with the help of ratios. Government may base its future policies on the basis of industrial information available from various units. The ratios may be used as indicators of overall financial strength of public as well as private sector, in the absence of the reliable economic information, governmental plans and policies may not prove successful.
(f) Tax Audit Requirements:
Section 44 AB was inserted in the Income Tax Act by the Finance Act, 1984. Under this section every assessed engaged in any business and having turnover or gross receipts exceeding Rs. 40 lakh is required to get the accounts audited by a chartered accountant and submit the tax audit report before the due date for filing the return of income under Section 139 (1). In case of a professional, a similar report is required if the gross receipts exceed Rs 10 lakh.
Though ratios are simple to calculate and easy to understand, they suffer from some serious limitations:
1. Limited Use of a Single Ratio:
A single ratio, usually, does not convey much of a sense. To make a better interpretation a number of ratios have to be calculated which is likely to confuse the analyst than help him in making any meaningful conclusion.
2. Lack of Adequate Standards:
There are no well accepted standards or rules of thumb for all ratios which can be accepted as norms. It renders interpretation of the ratios difficult.
3. Inherent Limitations of Accounting:
Like financial statements, ratios also suffer from the inherent weakness of accounting records such as their historical nature. Ratios of the past are not necessarily true indicators of the future.
4. Change of Accounting Procedure:
Change in accounting procedure by a firm often makes ratio analysis misleading, e.g., a change in the valuation of methods of inventories, from FIFO to LIFO increases the cost of sales and reduces considerably the value of closing stocks which makes stock turnover ratio to be lucrative and an unfavourable gross profit ratio.
5. Window Dressing:
Financial statements can easily be window dressed to present a better picture of its financial and profitability position to outsiders. Hence, one has to be very careful in making a decision from ratios calculated from such financial statements. But it may be very difficult for an outsider to know about the window dressing made by a firm.
6. Personal Bias:
Ratios are only means of financial analysis and not an end in itself. Ratios have to be interpreted and different people may interpret the same ratio in different ways.
Not only industries differ in their nature but also the firms of the similar business widely differ in their size and accounting procedures, etc. It makes comparison of ratios difficult and misleading. Moreover, comparisons are made difficult due to differences in definitions of various financial terms used in the ratio analysis.
8. Absolute Figures Distortive:
Ratios devoid of absolute figures may prove distortive as ratio analysis is primarily a quantitative analysis and not a qualitative analysis.
9. Price Level Changes:
While making ratio analysis, no consideration is made to the changes in price levels and this makes the interpretation of ratios invalid.
10. Ratios no Substitutes:
Ratio analysis is merely a tool of financial statements. Hence, ratios become useless if separated from the statements from which they are computed.
11. Clues not Conclusions:
Ratios provide only clues to analysts and not final conclusions. These ratios have to be interpreted by these experts and there are no standard rules for interpretation.
5(a) Explain the meaning of working capital. Describe the factors that affect the amount of working capital requirement.
-> Traditionally, investors, creditors and bankers have considered working capital as a critical element to watch, as important as the financial position portrayed in the balance sheet and the profitability shown in the income statement. Working capital is a measure of the company’s efficiency and short term financial health. It refers to that part of the company’s capital, which is required for financing short-term or current assets such a cash marketable securities, debtors and inventories. It is a company’s surplus of current assets over current liabilities, which measures the extent to which it can finance any increase in turnover from other fund sources. Funds thus, invested in current assets keep revolving and are constantly converted into cash and this cash flow is again used in exchange for other current assets. That is why working capital is also known as revolving or circulating capital or short-term capital.
Formula for Working Capital: “Current Assets – Current Liabilities”
Factors effecting working capital:
• Nature of business: generally working capital is higher in manufacturing compared to service based organizations
• Volume of sales: higher the sale, higher the working capital required
• Seasonality: peak seasons for sales need more working capital
• Length of operating and cash cycle: longer the operating and cash cycle, more is the requirement of working capital
Working capital Approaches:
A) Matching or hedging approach: This approach matches assets and liabilities to maturities. Basically, a company uses long term sources to finance fixed assets and permanent current assets and short term financing to finance temporary current assets.
Example: A fixed asset which is expected to provide cash flow for 5 years should be financed by approx 5 years long-term debts. Assuming the company needs to have additional inventories for 2 months, it will then seek short term 2 months bank credit to match it.
B) Conservative approach: it is conservative because the company prefers to have more cash on hand. That is why, fixed and part of current assets are financed by long-term or permanent funds. As permanent or long-term sources are more expensive, this leads to “lower risk lower return”.
C) Aggressive approach: The Company wants to take high risk where short term funds are used to a very high degree to finance current and even fixed assets.
Classification of Working Capital:
Working capital can be categorized on basis of Concept (gross working capital and net working capital) and basis of time (Permanent/ fixed WC and temporary/variable WC). The two major components of Working Capital are Current Assets and Current Liabilities. One of the major aspects of an effective working capital management is to have regular analysis of the company’s currents assets and liabilities. This helps to take into account unforeseen events such as changes in the market conditions and competitor activities. Furthermore, steps taken to increase sales income and collecting accounts receivable also improves a company’s working capital.
Working Capital in adequate amount:
For every business entity adequate amount of working capital is required to run the operations. It needs to be seen that there is neither excess nor shortage of working capital. Both excess, as well as a shortage of working capital situations, are bad for any business. However, out of the two, inadequacy or shortage of working capital is more dangerous from the point of view of the company operations. Inadequate working capital has its disadvantages where the company is not capable to pay off its short term liabilities in time, difficulty in exploring favourable market situations, day to day liquidity worsens and ROA and ROI fall sharply. On the other hand, one should keep in mind that excess of working capital also leads to wrong indications like idle funds, poor ROI, unnecessary purchase and accumulation of inventories over required level due to low rate of return on investments, all of which leads to fall in the market value of shares and credit worthiness of the company.
Working capital cycle:
The working capital cycle (WCC) is the amount of time it takes to turn the net current assets and current liabilities into cash. The longer the cycle is, the longer a business is tying-up funds in its working capital without earning any return on it. This is also one of the essential parameters to be recorded in working capital management.
Working Capital Management:
Working Capital Management (WCM) refers to all the strategies adopted by the company to manage the relationship between its short term assets and short term liabilities with the objective to ensure that it continues with its operations and meet its debt obligations when they fall due. In other words, it refers to all aspects of administration of current assets and current liabilities. Efficient management of working capital is a fundamental part of the overall corporate strategy. The WC policies of different companies have an impact on the profitability, liquidity and structural health of the organization. Although investing in good long-term capital projects receives more emphasis than the day-to-day work associated with managing working capital, companies that do not handle this financial aspect (working capital) well will not attract the capital necessary to fund those highly visible ventures; in other words, you must get through the short run to get to the long run.
Components associated with WCM:
Often the interrelationships among the working capital components create real challenges for the financial managers. Inventory is purchased from suppliers, sale of which generates accounts receivable and collected in cash from customers to pay off those suppliers. Working capital has to be managed because the firm cannot always control how quickly the customers will buy, and once they have made purchases, exactly when they will pay. That is why; controlling the “cash-to-cash” cycle is paramount.
The different components of working capital management of any organization are:
• Cash and Cash equivalents
• Debtors / accounts receivables
• Creditors / accounts payable
A) Cash and Cash equivalents:
One of the most important working capital components to be managed by all organizations is cash and cash equivalents. Cash management helps in determining the optimal size of the firm’s liquid asset balance. It indicates the appropriate types and amounts of short-term investments along with efficient ways of controlling collection and payout of cash. Good cash management implies the co-relation between maintaining adequate liquidity with minimum cash in bank. All companies strongly emphasize cash management as it is the key to maintain the firm’s credit rating, minimize interest cost and avoid insolvency.
B) Management of inventories:
Inventories include raw material, WIP (work in progress) and finished goods. Where excessive stocks can place a heavy burden on the cash resources of a business, insufficient stocks can result in reduced sales, delays for customers etc. Inventory management involves the control of assets that are produced to be sold in the normal course of business.
For better stock/inventory control:
1. Regularly review the effectiveness of existing purchase and inventory systems
2. Keep a track of stocks for all major items of inventory
3. Slow moving stock needs to be disposed as it becomes difficult to sell if kept for long
4. Outsourcing should also be a part of the strategy where part of the production can be done through another manufacturer
5. A close check needs to be kept on the security procedures as well
C) Management of receivables:
Receivables contribute to a significant portion of the current assets. For investments into receivables, there are certain costs (opportunity cost and time value) that any company has to bear, along with the risk of bad debts associated to it. It is, therefore necessary to have proper control and management of receivables which helps in taking sound investment decisions in debtors. Thereby, for effective receivables management one need to have control of the credits and make sure clear credit practices are a part of the company policy, which is adopted by all others associated with the organization. One has to be vigilant enough when accepting new accounts, especially larger ones. Thereby, the principle lies in establishing appropriate credit limits for every customer and stick to them.
Effectively managing accounts receivables:
1. Process and maintain records efficiently by regularly coordinating and communicating with credit managers’ and treasury in-charges
2. Prepare performance measurement reports
3. Control accuracy and security of accounts receivable records.
4. Captive finance subsidiary can be used to centralize accounts receivable functions and provide financing for company’s sales
D) Management of accounts payable:
Creditors are a vital part of effective cash management and have to be managed carefully to enhance the cash position of the business. One has to keep in mind that purchasing initiates cash outflows and an undefined purchasing function can create liquidity problems for the company. The trade credit terms are to be defined by companies as they vary across industries and also among companies.
Factors to consider:
1. Trade credit and the cost of alternative forms of short-term financing are to be defined
2. The disbursement float which is the amount paid but not credited to the payers account needs to be controlled
3. Inventory management system should be in place
4. Appropriate methods need to be adopted for customer-to-business payment through e-commerce
5. Company has to centralize the financial function with regards to the number, size and location of vendors.