(Cost and Management Accounting)
Full Marks: 80
Time: 3 hours
The figures in the margin indicate full marks for the questions.
1(a) Define ‘Cost’, ‘Costing’ and ‘Cost accounting’. Explain briefly the nature and objectives of cost accounting.
-> Cost- In a business, cost expresses the amount of money that is spent
on the production or creation of a good or service. Cost does not include a
mark-up for profit.
From a seller’s point of view, cost is the amount of money spent to produce a product or good. If sellers sold their goods at the same price as they cost to produce, then they would break even. This means that they would not lose money on their sales, but their company would not make a profit either.
Therefore, the cost of a product from the buyer’s point of view can be called the price. This is the amount charged for a product by the seller, and it includes both the cost to make the product and the mark-up cost added by the seller to produce a profit.
In accounting, the term cost refers to the monetary value of expenditures for services, supplies, raw materials, labour, products, equipment, etc. Cost is an amount that is recorded in bookkeeping records as an expense.
Planning for costs
Often, when developing a new company’s business plan, organizers will
create cost estimates in order to assess whether the revenues and benefits
of the proposed business will more than cover the costs. This is called a
If costs are underestimated, it can result in a cost overrun once the business begins operations. This means that the costs are higher than income, and the company will lose money.
The Cost Plus model is used by most companies in order to determine a sales price for a product. Cost Plus is when the Price = Cost +/- x %. Here, x indicates the percentage of built in overhead or profit margin that is to be added to the cost.
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.
Nature of cost accounting:-
Cost accounts concerned with ascertainment and control of costs. The information provided by cost-accounting to the management is helpful for cost control and cost reduction through functions of planning, decision making , and control. Initially, they confined it to cost ascertainment and presentation of the same mainly to find out product cost.
With the introduction of large-scale production, the scope was widened and providing information for cost control and cost reduction has assuming equal significance along with finding out the cost of production. To start with cost-accounting was apply in manufacturing activities but now it applies in service organizations, government organizations, local authorities, agricultural farms, Extractive industries and so on.
The guide for the ascertainment of cost of production. It discloses as profitable and unprofitable activities. They help management to eliminate unprofitable activities. It provides information for estimate and tenders. They disclose the losses occurring in the form of idle time spoilage or scrap etc. It also provides a perpetual inventory system.
It helps to make effective control over inventory and for preparation of interim financial statements. They help in controlling the cost of production with the help of budgetary control and standard costing. They provide data for future production policies. It discloses the relative efficiencies of different workers and for fixation of wages to workers.
Objectives of cost accounting:-
1. Cost Ascertainment: The main objective of cost accounts to find out the cost of product, process, job, contract, service or any unit of production. It is done through various methods and techniques.
2. Cost Control: The very basic function of cost accounts to control costs. Comparison of actual cost with standards reveals the discrepancies (Variances). The variances reveal whether the cost is within the control or not. Remedial actions are suggesting controlling the costs which are not within control.
3. Cost Reduction: Cost reduction refers to the real and permanent reduction in the unit cost of goods manufactured or services rendered without affecting the use intended. It can be done with the help of techniques called budgetary control, standard costing, material control, labour control, and overheads control.
4. Fixation of Selling Price: The price of any product consists of total cost and the margin required. Cost data are useful in the determination of selling price or quotations. It provides detailed information regarding various components of cost. It also provides information in terms of fixed cost and variable costs, so that the extent of price reduction can be decided.
5. Framing business policy: It helps management in formulating business policy and decision making. Break-even analysis, cost volume profit relationships, differential costing, etc are helpful in making decisions regarding key areas of the business.
(b) Narrate the concept of cost reduction and cost control. State, in brief, the advantages as well as dangers of cost reduction efforts.
-> Cost Reduction- This can be seen as a strategy wherein the company, not out of necessity, but out of sheer want, may undertake Cost Reduction. Unlike Cost Cutting, wherein the company has to resort to that strategy as a final resort, Cost Reduction can be undertaken to enhance productivity and profit percentage. Cost Cutting is something which a company undergoes unwillingly with most of the times the measures being harsh while the company may undergo willingly in case of Cost Reduction. The cost reduction techniques can be more or less as positive rather than negative.
There are few ground rules in Cost Reduction which are:
1. Cost Reduction should involve reducing and not cutting entirely the costs
2. The reduction should not affect the processes and product quality
3. The process of manufacturing may be improvised without affecting the product quality or nature
4. Features of the product or service may be modified without affecting the quality of the product.
5. Cost reduction should never be applied as a short-term process and it should rather be implemented as a long-term solution.
Cost Control – Cost control by management means a search for better and more economical ways of completing each operation. Cost control is simply the prevention of waste within the existing environment. This environment is made up of agreed operating methods for which standards have been developed.
Cost control by management means a search for better and more economical ways of completing each operation. Cost control is simply the prevention of waste within the existing environment. This environment is made up of agreed operating methods for which standards have been developed.
These standards may be expressed in a variety of ways, from broad budget levels to detailed standard costs. Cost control is the procedure whereby actual results are compared against the standard so that waste can be measured and appropriate action taken to correct the activity.
Cost control is defined as the regulation by executive action of the costs of operating an undertaking. Cost control aims at achieving the target of sales. Cost control involves setting standards. The firm is expected to adhere to the standards.
There are many advantages of cost reduction.
Some of these are:
1. Cost reduction increases profit:
It 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.
Dangers of Cost Reduction:
The possible dangers of any cost reduction plan may be as follows:
1. Quality may be sacrificed at the cost of reduction in cost: To reduce cost, quality may be reduced gradually and it may not be detected till it has assumed alarming proportion. Quality may be reduced to such an extent that it may not be accepted in the market and the business may be lost to the competitors.
2. In the beginning cost reduction programme may not be liked by the employees and danger may be poised to the programme because success of any cost reduction plan depends upon the willing cooperation and active participation of the employees.
3. It is possible that reduction in cost may not be real and permanent. It may not be based on sound reasons and may be short lived and cost may come back to the original cost level when temporary conditions (i.e. fall in prices of materials) due to which cost has reduced disappear.
4. There may be a conflict between individual objective and organisational objective. It is possible that a head of a particular department may follow activities which may reduce the cost of his department but may lead to increase in cost for the organisation as a whole.
2(a)(i) Explain the essential features of process costing.
-> Process Costing is defined as a branch of operation costing that determines the cost of a product at each stage, i.e. process of production. It is an accounting method which is adopted by the factories or industries where the standardized identical product is produced, as well as it passes through multiple processes for being transformed into the final product.
In simple words, process costing is a cost accounting technique, in which the costs incurred during production are charged to processes and averaged over the total units manufactured . For this purpose, process accounts are opened in the books of accounts, for each process and all the expenses relating to the process for the period is charged to the respective process account.
Features of Process Costing:
The distinctive features of Process Costing are as follows:
1. The process cost centres are clearly defined and all costs relating to each process cost centre are accumulated.
2. The plant has various divisions, and each division is a stage of production.
3. The production is carried out continuously, by way of the simultaneous, standardized and sequential process.
4. The output of a process is the input of another.
5. The production from the last process is transferred to finished stock.
6. The final product is homogeneous.
7. Both direct and indirect costs are charged to the processes.
8. The production may result in joint and by-products.
9. Losses like normal and abnormal loss occur at different stages of production which are also taken into consideration while calculating the unit cost.
10. The output of one process is transferred to another one at a price that includes the profit of the previous process and not at the cost.
11. At the end of the period, if there remains the stock of finished goods,
then it is also expressed in equivalent completed units. It can be
Equivalent units of semi-finished goods or WIP = Actual number of units in process × Percentage of work completed
Process costing is employed by the industries whose production process is continuous and repetitive, as well as the output of one process is the input of another process. So, chemical industry, oil refineries, cement industries, textile industries, soap manufacturing industries, paper manufacturing industries use this method.
(b) Discuss the objectives of reconciliation of cost and financial accounts. Explain the need for reconciliation.
-> 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.
Objectives of reconciliation of cost and 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(a) What is Common-size Statement? Discuss the features and 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.
(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) “A device for making financial data more meaningful is to reduce them to ratios.” Elucidate the statement with justifications.
-> 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 preformed 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) Differentiate between: –
(i) Fixed working capital and variable working capital.
->1. Fixed capital supports the business indirectly. Working capital supports the business directly.
2. Fixed capital is invested in long-term assets. Working capital is invested in current assets.
3. Fixed capital is required before the business starts. Working capital is required after the business gets started.
4. Fixed capital can’t be liquidated into cash immediately. Working capital can be liquidated into cash immediately.
5. Fixed capital serves the business for a very long period of time. Working capital serves the business for a very short period of time.
6. The orientation of fixed capital is strategic. The orientation of working capital is operational.