(Cost and Management Accounting)
Full Marks: 80
Time: 3 hours
The figures in the margin indicate full marks for the questions.
1(a) Discuss the meaning of Activity Based Costing. What are the benefits of Activity Based Costing? State its differences with Conventional 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.
For example, you make soap. Soap A requires more overhead, like testing, than Soap B. Using activity-based costing, you assign the right overhead costs to the appropriate products. That way, your overhead is higher for Soap A than B.
Five Basic Components of ABC:
Resources are what organizations spend their money on—the categories of costs that are recorded. Resource is defined as an economic or money element that is applied or used in the performance of activities. Salaries and materials, for examples, are resources used in the performance of activities. Additional examples of resources include repair, inspection, rent, depreciation, utilities, insurance, and supplies. Most ABC systems currently exclude costs like income taxes and interest expense that are not used in the performance of activities.
2. Resource Drivers:
Resource drivers are the basis for tracing resources to activities. Resource driver is defined as a measure of the quantity of resource consumed by an activity. An example of a resource driver is the percentage of total square feet of space occupied by an activity. This factor is used to trace a portion of the cost of operating the facilities to the activity.
An activity is a unit of work. If you go to u restaurant for lunch/dinner, a waiter or waiters might perform the following units of work:
i. Seat customer and offer menu
ii. Take your order
iii. Send orders to kitchen
iv. Bring food
v. Replenish beverages
vi. Determine and bring bill
vii. Collect money and give change
viii. Clear table
Each of these is an activity and the performance of each activity consumes resources that cost money.
Activities represent work performed in an organization. The cost of activities is determined by tracing resource to activities using the resource drivers. An example of how the salaries of a receiving department of a manufacturing company might be traced to receiving department activities. In this example, the resource is receiving department salaries.
The activities are as follows receive materials, unload trucks, move material, schedule receipts, expedite material, and resolve vender errors. The resource driver is a percentage of people’s time devoted to each receiving department activity. While percentage of people’s time was selected as the resource driver in this example, as an alternative, the head count of people assigned to each activity or the hours devoted to each activity could have been used as the resource driver.
4. Activity Cost Drivers:
Like a resource driver that is used to trace resource to activities, an activity cost driver is used to trace activity costs to cost objects. Activity driver is defined as a measure of the frequency and intensity of the demands placed on activities by cost objects. An activity driver is used to assign costs to cost objects.
A cost driver is an activity which generates cost. A cost driver is a factor, such as the level of activity or volume, that causally affects costs (over a given time span). That is, a cause-and-effect relationship exists between a change in the level of activity or volume and a change in the level of the total costs of that cost object. Thus, cost drivers signify factors, forces or events that determine the costs of activities. Based on activity usage (consumption), activity costs are traced to cost objects.
Features or Characteristics of Activity Based Costing:-
1. The total cost is divided into two types i.e. fixed cost and variable cost which is necessary to provide quality information to design a suitable cost system in a manufacturing concern.
2. The proper distinction is made between the cost behaviour patterns.
3. The cost behaviour patterns are volume related, diversity related, events related and time related.
4. The appropriate cost driver has to be identified for tracing the overhead to a product.
5. The cost drivers dictate the cost behaviour pattern.
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. Example 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.
Distinguish between activity based costing and conventional costing:-
1. The real change Activity-Based Costing implements in the cost structure of the organisation lies in the treatment of allocation of overheads while the conventional system allocates costs between products on the basis of machine-hours or labour-hours.
2. Traditionally companies distribute their overhead, between different products in the same ratio as the respective costs of direct labour in these products. Hence if a unit of the product A consumes twice as many labour-hours as a unit of product B, the total overhead cost per unit is also distributed between product A and product B in the same ratio. As such, manufacturer of the two products uses the overheads, in a production that bears no relationship with labour costs.
3. The result of using Actively-Based costing is found to be a dramatic one. The respective costs of different products are often found to be as much as 50% higher or lower than those computed under the conventional costing system.
(b) Narrate the objectives and features of cost reduction. State the major areas in which cost reduction is usually possible.
-> Objectives of cost reduction:-
1. Cost reduction provides a basis for more dividends to the shareholders, more bonuses to the staff and more retention of profit for expansion of the business which will create more employment and overall industrial prospects.
2. Cost reduction will provide more money for labour welfare schemes and thus improve men- management relationship.
3. Cost reduction will help in making goods available to the consumers at cheaper rates. This will create more demand for the products, economies of large scale production, more employment through industrialisation and all-round improvement in the standard of living.
4. Cost reduction will be helpful in meeting competition effectively.
5. Higher profit will provide more revenue to the government by way of taxation.
6. As a result of reduction in cost, export price may be lowered which may increase total exports.
7. Cost reduction is obtained by increasing productivity. Therefore, a developing country, like India, which suffers from shortage of resources, can develop faster if it makes the best use of resources by increasing productivity.
8. Cost reduction lays emphasis on a continuous search for improvement which will improve the image of the firm for long-term benefits.
Features of Cost reduction:-
1. The reduction must be a real one in the course of manufacture or services rendered. Real cost reduction comes through greater productivity. Greater productivity may be through (1) obtaining a large quantity of production from the same facilities; (2) using materials of lower price and of different quality without, however, sacrificing the quality of the finished product, i.e., reducing cost through the process of substitution; (3) simplifying the process of manufacture without sacrificing the quality of the finished product; (4) changing features of the product suitably without sacrificing the quality of the product etc.
2. The reduction must be a permanent one. It is short-lived if it comes through reduction in the prices of inputs, such as materials, labour etc. The reduction should be through improvements in methods of production from research work.
3. The reduction should not be at the cost of essential characteristics, such as quality of the products or services rendered.
The major areas in which cost reduction is usually possible are:-
2(a) Explain the possible reasons for differences between profits shown by cost accounts and financial 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.
3(a) What is Comparative Income Statement? Discuss the utility of such a statement.
-> A Comparative Income Statement shows the operating results for a number of accounting periods and helps the reader of such statement to compare the results over the different periods for better understanding and also for detailed analysis of variation of line wise items of Income Statement .
1. Comparative Income Statement format combines several Income Statements as columns in a Single Statement which helps the reader in analyzing trends and measures the performance over different reporting periods.
2. It can also be used to compare two different companies operating metrics as well. Such Analysis helps in comparing the performance with another business which can be used to analyze how companies react to market conditions affecting the companies belonging to the same Industry.
3. Thus Comparative Income Statement is an important tool through which the result of operations of a business (or say operation of the business of different companies) over multiple accounting periods can be analyzed to understand the various factors contributing to the change over the period for better interpretation and analysis.
4. It helps various stakeholders of business and also Analyst community to analyze the impact of business decisions over the company’s top line and bottom line and helps in identifying various trends over the period which otherwise would have been difficult and time-consuming.
5. Comparative Income Statement shows absolute figures, changes in absolute figures, absolute data in terms of percentages and also as an increase (or decrease) in terms of percentages over the different periods. With the help of a Comparative Income Statement format in one snapshot, the performance of a company over different periods can be compared and changes in expense items and Sales can be easily ascertained.
Types of Comparative Income Statement:-
1. Horizontal Analysis
One of the popular techniques of Comparative Income Statement which shows the change in amount both in absolute and percentage terms over a period of time. It helps in easy analysis of trends and as such also known as Trend Analysis. One can easily observe growth patterns and seasonality using the Horizontal Analysis Technique .
2. Vertical Analysis
Another technique which exhibits Comparative Income Statement in terms of relative size of line items is the Vertical Analysis . This technique enables easy comparison of Income Statement of companies of different size as well. It shows each item on the Income Statement as a percentage of Base figures (which is usually the Sales figure) with the statement. Under this, all components of Income Statement are shown as a percentage of Sales such as Gross Profit , Net Profit, and Cost of Sales etc which makes it very handy to use even when comparing of different as it removes the Size biases and makes analysis more easy and understandable. It is mostly used for individual statement for a reporting period but can also be used for timeline analysis.
1. It makes analyses simple and fast as past figures can easily be compared with the current figures without the need for referring to separate past Income Statements.
2. It makes comparison across different companies also easy and helps in analyzing the efficiency both at Gross Profit Level and Net Profit Level.
3. It shows percentage changes in all line items of the Income Statement which makes analysis and Interpretation of Top Line (Sales) and Bottom Line (Net Profit) easy and more informative.
1. Financial Data reported in Comparative Income Statement is useful only if same accounting principles are followed in the preparation of such statements. In the case where deviation is observed such Comparative Income Statement will not serve the intended purpose.
2. Comparative Income Statement is not of much use in cases where the company has diversified into new business lines which have impacted the Sales and Profitability drastically.
Utility of Comparative Income Statement:-
1. Make the Data Simpler and More Understandable: When data for a number of years are put side-by-side in a comparative ‘form it becomes easier to understand them and the conclusions regarding the profitability and financial position of the concern can be drawn very easily.
2. To Indicate the Trend: This helps in indicating the trend of change by putting the figures of production, sales, expenses, profits etc. for number of year’s side-by-side.
3. To Indicate the Strong Points and Weak Points of the Concern: It may also indicate the strong points and weak points of the firm. Management can then investigate and find out the reasons for the weak areas and can take corrective measures.
4. To Compare the Firm’s Performance with the Average Performance of the Industry: Comparative financial statements help a business unit to compare its’ performance with the average performance of the industry.
5. To Help in Forecasting: Comparative study of the changes in the key figures over a period helps the management in forecasting the profitability and financial soundness of the business.
4(a) “Ratio is mechanical and incomplete.” Give comment on this statement with justifications in support of your contention .
-> 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 assess 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.
(b)(i) State the significance of the following ratios and how these are calculated:
1) Inventory Turnover Ratio.
2) Receivable Turnover Ratio.
-> Inventory Turnover Ratio- The inventory turnover ratio is an efficiency ratio that shows how effectively inventory is managed by comparing cost of goods sold with average inventory for a period. This measures how many times average inventory is “turned” or sold during a period. In other words, it measures how many times a company sold its total average inventory dollar amount during the year. A company with $1,000 of average inventory and sales of $10,000 effectively sold its 10 times over.
This ratio is important because total turnover depends on two main components of performance. The first component is stock purchasing. If larger amounts of inventory are purchased during the year, the company will have to sell greater amounts of inventory to improve its turnover. If the company can’t sell these greater amounts of inventory, it will incur storage costs and other holding costs .
The second component is sales. Sales have to match inventory purchases otherwise the inventory will not turn effectively. That’s why the purchasing and sales departments must be in tune with each other.
Significance of Inventory Turnover Ratio:-
(a) It measures the soundness of retailer’s inventory methods.
(b) It also indicates poor inventory planning and lack of controlling techniques.
(c) By improving Inventory Turnover, a retailer can easily increase his profitability by carrying fewer inventories.
(d) Inventory Turnover presents meaningful comparison and informs the retailer about latest trends.
The inventory turnover ratio is calculated by dividing the cost of goods sold for a period by the average inventory for that period.
Inventory Turnover Ratio
Inventory Turnover Ratio= Cost of Goods Sold (divided by) Average Inventory
Average inventory is used instead of ending inventory because many companies’ merchandise fluctuates greatly throughout the year. For instance, a company might purchase a large quantity of merchandise January 1 and sell that for the rest of the year. By December almost the entire inventory is sold and the ending balance does not accurately reflect the company’s actual inventory during the year. Average inventory is usually calculated by adding the beginning and ending inventory and dividing by two.
The cost of goods sold is reported on the income statement .
Receivable Turnover Ratio- Accounts receivable turnover is the number of times per year that a business collects its average accounts receivable . The ratio is used to evaluate the ability of a company to efficiently issue credit to its customers and collect funds from them in a timely manner. A high turnover ratio indicates a combination of a conservative credit policy and an aggressive collections department, as well as a number of high-quality customers. A low turnover ratio represents an opportunity to collect excessively old accounts receivable that are unnecessarily tying up working capital . Low receivable turnover may be caused by a loose or nonexistent credit policy, an inadequate collections function, and/or a large proportion of customers having financial difficulties. It is also quite likely that a low turnover level indicates an excessive amount of bad debt . It is useful to track accounts receivable turnover on a trend line in order to see if turnover is slowing down; if so, an increase in funding for the collections staff may be required, or at least a review of why turnover is worsening.
Receivable Turnover Ratio Formula
The accounts receivable turnover ratio formula is as follows:
Accounts Receivable Turnover Ratio = Net Credit Sales / Average Accounts Receivable
Net credit sales are sales where the cash is collected at a later date. The formula for net credit sales is = Sales on credit – Sales returns – Sales allowances.
Average accounts receivable is the sum of starting and ending accounts receivable over a time period (such as monthly or quarterly), divided by 2.
5(a) “The fate of large scale investment in fixed capital is often determined by a relatively small amount of current assets.” Give your comment on this statement.
-> 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.