2019
Course: 103
(Cost and Management Accounting)
Full Marks: 80
Time: 3 hours
The figures in the margin indicate full marks for the questions.
1(a) ‘Cost Accounting has become an essential tool for management.’ Give your comment on the statement.
-> Cost Accounting is a conscious and rational procedure by Accountants for accumulating costs and relating such costs to specific products or departments for effective management action.
Cost Accounting establishes budgets, standard costs and actual costs. Cost Accounting is a set of procedures used in refining raw data into usable information for management decision making, for ascertainment of cost of products and services and its profitability.
Cost accounting is a Management Information System which analyses past, present and future data to provide the basis for managerial decision making. Cost Accounting is a system of foresight and not a post-mortem examination; it turns losses into profits, speeds up activities and eliminates wastes.
A Cost Accounting System that simply records costs for the purpose of fixing sale prices has accomplished only a small part of its mission. Cost Accounts are keys to economy in manufacture and are indispensable to the intelligent and economical management of a factory. Cost Accounting is becoming more and more relevant in the ever growing economic scenario. Cost Accounting becomes an important aid to modern management.
Necessity for Cost Accounting System:
A company having a proper cost accounting system will help the management in the following ways:
1. The analysis of profitability of individual products, services or jobs.
2. The analysis of profitability of different departments or operations.
3. The analysis of cost behaviour of various items of expenditure in the organization. This will help in future cost estimation with reasonable accuracies.
4. It locates differences between actual results and expected results. Such differences can be also traced to the individual cost centres with the efficient cost system.
5. It will assist in setting the prices so as to cover costs and generate an acceptable level of profit.
6. The effect on profits of increase or decrease in output or shutdown of a product line or department can be analyzed with by adoption of efficient Cost Accounting System.
7. The costing records serve to analyze the final accounts of a company i.e., the manufacturing, trading and profit and loss accounts, in such a way as to give a detailed explanation of the sources of profit or loss.
8. Cost Accounting data generally serves as a base to which the tools and techniques of Management Accounting can be applied to make it more purposeful and management oriented.
9. The cost ascertainment, allocation, distribution can be efficiently made under efficient costing system.
10. Cost records are the base for the Management Information Systems.
11. The Cost System generates regular performance statements which management need for control purposes.
12. Cost Accounting System is not only applicable to manufacturing organizations or functions but also extended to service organizations and functions.
13. Cost comparisons between different departments, machines and alternative processes help management to maintain maximum efficiency is possible with the adoption of efficient Costing System.
14. The costing information will help in making reliable estimates and will also help in submission of tenders.
15. Costing checks recklessness and avoids occurrence of mistakes.
16. It provides invaluable aid to management in performing its functions of planning, evaluation of performance, control and decision making.
17. It facilitates delegation of responsibility for important tasks and rating of employees.
18. It enables to distinguish profitable and non-profitable activities.
19. It helps in determination of break-even point i.e. the level of activity where the firm reaches no profit no loss situation.
20. It aids in determining and enhancing levels of efficiency and eliminates wastage of men, materials, machines and money. All sorts of wastages are also minimized.
21. The costing information will find a way out in periods of trade depression and competition.
22. It provides data for preparation of periodical Profit and Loss Account.
23. It facilitates the assessment of Excise duty, Customs duty, Income-tax.
24. It helps the government in formulation of policies regarding industry, import, export, taxation, etc.
25. It helps the government in fixation of administered prices, tariff protection, wage level fixation etc.
26. The Costing System will aim at increase in operational efficiency and cost reduction, which helps the consumers in getting reduced prices.
27. It discloses the relative efficiencies of different workers which facilitate to frame suitable wage/reward policies.
28. The efficiency of public enterprises can be compared with the private sector if cost data is available.
29. The operation of Cost System enables Cost Audit which will bring out inefficiencies and frauds.
30. Basing on cost information, the limited resources will be allocated to maximize profitability of the organization.
31. Reliable capital investment decisions can be taken if it is supported with cost data.
Here critically examine the need and importance of cost accounting with reference to the inadequacies of financial accounting.
(a) Costing helps in periods of trade depression and trade competition –
In periods of trade depression the business cannot afford to have leakages which pass unchecked. The management should know where economies may be sought, waste eliminated and efficiency increased. The business has to wage a wax for its survival. The management should know the actual cost of their products before embarking on any scheme of reducing the prices of giving tenders. Adequate costing facilitates this.
(b) Aids in price fixation –
Though economic law & supply and demand and activities of the competitors, to a great extent, determine the price of the article, the cost to the producer does play an important part. The producer can take necessary guidance from his costing records.
(c) Helps in estimate –
Adequate costing records provide a reliable basis upon which tenders and estimates may be prepared. The chances of losing a contract on account of overrating or losing in the execution of a contract due to underrating can be minimized. Thus, “ascertained costs provide a measure for estimates, a guide to policy, and control over current production”.
(d) Helps in channelling production on right lines –
Costing makes possible for the management to distinguish between profitable and non-profitable activities profit can be maximized by concentrating on profitable operations and eliminating non-profitable ones.
(e) Wastages are eliminated –
As it is possible to know the cost of the article at every stage, it becomes possible to chock various forms of waste, such as time, expenses etc. or in the use of the machine, equipment, and tools.
(f) Costing makes comparison possible –
If the costing records are regularly kept, comparative cost data for different periods and various volumes of production will be available. It will help the management in forming future lines of action.
(g) Provides data for periodical profit and loss accounts –
Adequate costing records supply to the management such data as may be necessary for the preparation of profit and loss account and balance sheet, at such intervals as may be desired by the management.
It also explains in detail the sources of profit or loss revealed by the financial accounts thus helps in the presentation of better information before the management.
(h) Aids in determining and enhancing efficiency –
Losses due to wastage of material, the idle time of workers, poor supervision etc., will be disclosed if the various operations involved in manufacturing a product are studied by a cost accountant. The efficiency can be measured and .costs controlled and through it, various devices can be framed to increase efficiency.
(i) Helps in inventory control –
Costing furnishes control which management requires in respect of stock of materials, work-in-progress and finished goods. (This has been explained in detail under the chapter “Material’s”)
(j) Helps in cost reduction –
Costs can be reduced in the long run when alternatives are tried. This is particularly important in the present day context of global competition cost accounting has assumed special significance beyond cost control this way.
(k) Assists in increasing productivity –
The productivity of material and labour is required to be increased to have growth and more profitability in the organization costing renders great assistance in measuring productivity and suggesting ways to improve it.
(b) Explain the term Cost Reduction. What are the objectives of Cost Reduction and how is it different from cost control? Explain.
-> Cost reduction is a planned positive approach to reduce expenditure. It is a corrective function by continuous process of analysis of costs, functions, etc. for further economy in application of factors of production.
The definition given above brings to light the following characteristics 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.
Thus, cost reduction must be a genuine one and should aim at the elimination of wasteful elements in methods of doing things. It should not be at the cost of quality. Cost reduction is a continuous process of critically examining various elements of cost and each aspect of the business (i.e. procedures, methods, products, management including market and finance etc.) is critically examined with a view to improving the efficiency for reducing costs.
Every plan of cost reduction proceeds with this assumption that there is always scope for cost reduction. A continuous research is made into various areas for finding out the best possible methods of performance for ensuring minimum possible costs.
The reduction in costs should be real and permanent. Reduction due to wind falls, changes in government policy like a reduction in taxes (or duties or due to temporary) and measures taken for tiding over financial difficulties do not strictly come under the purview of cost reduction.
Advantages of Cost Reduction:
Cost reduction causes a definite increase in margins. The saving in cost may also be passed to consumers in the form of lower prices or more quantity in the same price. 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. Government may also stand to gain by way of higher tax revenues.
Increased competitive strength to the industry stimulates more exports. Thus, profit is increased by reducing the costs, it can be utilised for expansion of the organisation which will create more employment and overall industrial prosperity.
Cost reduction is essential of a product has to withstand its global market. Brand loyalty is fading away fast. Nowadays consumers have become price and quality conscious. Hence cost reduction is the key for global competitiveness.
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 bonus 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.
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.
The following are the main differences between Cost Control and Cost Reduction:
1. Cost Control focuses on decreasing the total cost of production while cost reduction focuses on decreasing per unit cost of a product.
2. Cost Control is a temporary process in nature. Unlike Cost Reduction which is a permanent process.
3. The process of cost control will be completed when the specified target is achieved. Conversely, the process of cost reduction is a continuous process. It has no visible end. It targets for eliminating wasteful expenses.
4. Cost Control does not guarantee quality maintenance of products. However, cost reduction assured 100% quality maintenance.
5. Cost Control is a preventive function because it ascertains the cost before its occurrence. Cost Reduction is a corrective function.
2(a) Why is reconciliation necessary between financial accounting and cost accounting?
-> When cost and financial accounts are separately maintained by a concern in two different sets of books, the profit shown by cost accounts may not one for costing books and the other for financial books.
The profit or loss shown by the cost books differ from profit or loss shown by financial accounting for a number of reasons. Therefore, it becomes necessary that profit and loss shown by the two sets of books should be reconciled.
Reconciliation of Cost and financial accounting-
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.
Reasons for Reconciliation:
The main reasons of reconciliation are as under:
(i) Arithmetic Accuracy – It helps in checking the arithmetic accuracy and reliability of the cost accounts.
(ii) Reasons for Difference – Reconciliation show the reasons for difference in profit between cost and financial accounts.
Reasons for Disagreement in Profit or Loss A/C:
The main reasons of disagreements are discussed below:
(1) Items Shown Only in Cost Accounts:
There are certain items which are shown in cost accounts only and they are not shown in financial accounts.
They are as under:
(a) Interest on capital charged but not paid.
(b) Fully depreciated assets still are used in the business.
(c) Own building is used and no rent is payable.
(2) Separate Base of Stock Valuation:
Stocks in cost accounts are valued on FIFO or LIFO or Average method, but the stock in financial accounts is valued on the principles of cost or market price, whichever is less. Thus these differences are there in the value of stock shown by the two sets of accounts books.
(3) Separate Base for Depreciation:
The rate and method of charging depreciation may differ in cost accounts and financial accounts. In cost account, machine hour rate, production unit method, may be used for charging depreciation, while in financial accounting straight line or Diminishing method may be used. It will bring a difference in the profit or loss figures.
(4) Under Absorption or over Absorption of Overheads:
In cost accounts overheads are recorded on percentage basis, while in financial accounting, actual expenses are recorded. This may give rise to difference between overheads observed in cost and actual overhead incurred. It will bring difference in profits shown by cost and financial accounting.
(5) Items Shown Only in Financial Accounts:
These items are classified into 3 categories as under:
(A) Purely Financial Items of Expenses:
It includes the following:
(i) Discount on debentures
(ii) Company expenses on transfer of office
(iii) Fines and penalties
(iv) Goodwill written off, Preliminary expenses written off
(v) Loss on sale of capital asset
(vi) Losses on investments
(vii) Interest on bank loans
(viii) Penalties and damages under law
(ix) Loss due to theft, pilferage etc.
(B) Purely Financial Income Items:
It includes the following:
(i) Rent Receivables
(ii) Interest received on bank deposits
(iii) Transfer fees received
(iv) Dividend and interest received on investments
(v) Profit on sale of capital asset.
(C) Appropriation of Profits:
It includes the following items:
(i) Transfer to reserve
(ii) Income tax, wealth tax
(iii) Dividend paid
(iv) Charitable donation
(v) Charity etc.
Methods of Reconciliation:
The following procedure is recommended for preparing a reconciliation statement:
(1) First of all find out the profits of difference between cost accounts and financial accounts
(2) Take Profit of cost accounts as base
(3) Add items overcharged of expenses in cost accounts
(4) Add items of incomes under recorded in cost accounts
(5) Add amount of under valuation of closing stock in cost Accounts
(6) Deduct amount of over valuation of closing stock in cost accounts
(7) After adding or deducting all the items, the resulting profits will be the profit or loss as per financial books
(8) If the starting point of profit in as per financial account, the above items will be reversed.
Memorandum Reconciliation Account:
This is an alternative method to Reconciliation statement. The profit of cost account is shown on the credit side. All items which are to be added are shown on credit side. All items which are to be deducted are shown on the debit side. The balance figure is known as profit as per financial accounts.
The reconciliation statement is a memorandum reconciliation account to determine the items necessary to bring the balance of cost profit in agreement with the financial profit – Eric L. Kohler, in Dictionary for Accountants.
Once companies follow integrated accounts, there is no contradiction and no need for reconciliation. The financial profit is simply the cost profit as transferred from the Costing Profit and Loss Account. Contrarily, if a separate set of books is maintained for cost and financial accounts, it is rare that the profit figure of the two agrees.
Invariably, the profit shown by the financial accounts is different from that shown in the cost accounts. The difference is not because of errors in either system but due to different accounting requirements. It is important that they are periodically reconciled with each other, lest they should lose their credibility.
The need for reconciliation arises due to the following reasons:
1. To find out the reasons for the difference in the profit or loss in cost and financial accounts.
2. To ensure the mathematical accuracy and reliability of cost accounts in order to have cost ascertainment, cost control and to have a check on the financial accounts.
Reasons for the Difference:
These reasons can be broadly discussed under three headings:
1. Differing treatment of items;
2. Items appearing only in financial accounts; and
3. Items appearing only in cost accounts.
Let these points be explained a little:
1. Differing Treatment of Items:
The treatment accorded to certain items in financial accounts is significantly different from that in cost accounts.
Some of the examples are the following:
i. Basis of Inventory Valuation:
In financial books, as a matter of financial prudence, stocks are valued at cost or market price whichever is lower. But in cost books, the stock of material is valued on the basis of FIFO, LIFO, Average Price, etc. Work-in-process is valued on the basis of prime cost or prime cost plus proportionate factory overheads. The stock of finished goods is valued on the basis of total cost of production. With such a different approach in the two sets of books, it is likely that the profit figures are different.
ii. Recovery of Overheads:
In cost accounts, the recovery of overheads is always based on an estimate and, therefore, under or over recovery. It is generally charged as a percentage on materials, labour, prime cost, percentage on sales, etc. When overheads are charged at predetermined rates, the amount charged or recovered may not be equal to the amount actually incurred.
The difference between the amount incurred and the amount recovered is known as under or over-absorption of overheads. This may be written off to Overhead Adjustment Account or transferred direct to Costing Profit and Loss Account. As a result, the actual amount shown in the financial accounts will now agree with that finally charged in the cost accounts.
However, if this has been carried forward as a balance in the next year, there will be difference in the profits as per the two sets of accounts. Moreover, certain overheads such as selling and distribution might have been ignored in cost accounts.
iii. Depreciation:
The rates and methods of depreciation may be different in cost and financial accounts. In financial accounts, depreciation is charged mainly on the basis of straight line or diminishing balance. But in cost accounts, the basis may be machine hours, units of output, etc. Financial accounts regard depreciation as period cost which varies with the lapse of time, whereas in cost accounts depreciation is regarded as variable expense. This will create difference in the two profits.
iv. Abnormal Losses and Savings:
In financial accounts, abnormal items are merged with their normal headings. Abnormal losses of material or labour for example, will be added to the debits for material and wages. In cost accounts, on the other hand, abnormal wastage, losses or savings are kept outside the manufacturing costs as something with which product costs should not be burdened. Losses as a result of obsolescence, shifting of business to a better site, overhauling of the plant etc. are not entered in the cost accounts.
2. Items Appearing Only in Financial Accounts:
Under this head, three kinds of items could be identified:
i. Purely Financial Charges:
These are the expenses and losses which stand debited only in Trading and Profit and Loss Account and do not form part of the production costs.
Examples are:
(a) Losses of capital assets, arising from sale, exchange or uninsured destruction.
(b) Losses on the sales of investments, building etc.
(c) Interest on bank loans, mortgages, debentures and other borrowed money, if interest on capital is ignored in cost accounts.
(d) Penalties payable for late completion of contracts.
(e) Damages payable by law.
(f) Losses due to scrapping of machinery before the expiry of its life i.e. obsolescence loss.
(g) Expenses of the company’s transfer office.
(h) Discounts on bonds, debentures etc.
ii. Purely Financial Incomes:
These are the incomes and gains which stand credited only in the Profit and Loss Account and are outside the scope of manufacture.
Examples are:
(a) Interest received on bank deposits
(b) Rent receivable
(c) Interest, dividends etc. received on investments.
(d) Profits made on the sale of fixed assets and capital expenditures charged specifically to revenue.
(e) Transfer fees received.
iii. Appropriations of Profit:
These represent the appropriations or distribution of profits.
Being charges against net profit, items like the following appear in the Profit and Loss Appropriation Account and not in cost accounts:
(a) Taxation
(b) Dividends paid
(c) Transfer to Debenture Redemption Fund or Sinking Fund for repayment of liabilities.
(d) Transfer to general reserve or any other reserve to strengthen the financial structure.
(e) Amounts written off as goodwill, preliminary expenses, underwriting commission, and expenses of capital issues.
(f) Charitable donations.
3. Items Appearing Only in the Cost Accounts:
There are some expenses which are included only in cost accounts.
Examples are:
(a) Notional interest—when management decides to charge interest on capital employed. Even if the interest is not paid, it will be included while calculating the cost,
(b) Notional rent—even if no rent is paid when a factory is being run in the premises owned, notional rent will be included in the cost books.
3(a) What do you mean by Working Capital Management? What are the elements of Working Capital Management?
-> The term ‘ working capital management’ primarily refers to the efforts of the management towards effective management of current assets and current liabilities. Working capital is nothing but the difference between the current assets and current liabilities. In other words, an efficient working capital management means ensuring sufficient liquidity in the business to be able to satisfy short-term expenses and debts.
In a broader view, ‘working capital management’ includes working capital financing apart from managing the current assets and liabilities. That adds the responsibility for arranging the working capital at the lowest possible cost and utilizing the capital cost-effectively.
OBJECTIVES OF WORKING CAPITAL MANAGEMENT
The primary objectives of working capital management include the following:
§ Smooth Operating Cycle: The key objective of working capital management is to ensure a smooth operating cycle. It means the cycle should never stop for the lack of liquidity whether it is for buying raw material, salaries, tax payments etc.
§ Lowest Working Capital: For achieving the smooth operating cycle, it is also important to keep the requirement of working capital at the lowest. This may be achieved by favourable credit terms with accounts payable and receivables both, faster production cycle, effective inventory management etc.
§ Minimize Rate of Interest or Cost of Capital : It is important to understand that the interest cost of capital is one of the major costs in any firm. The management of the firm should negotiate well with the financial institutions, select the right mode of finance, maintain optimal capital structure etc.
§ Optimal Return on Current Asset Investment: In many businesses, you have a liquidity crunch at one point of time and excess liquidity at another. This happens mostly with seasonal industries. At the time of excess liquidity, the management should have good short-term investment avenues to take benefit of the idle funds.
For a detailed understanding, you may consider referring, Objectives of Working Capital Management .
IMPORTANCE OF EFFECTIVE WORKING CAPITAL MANAGEMENT
Although the importance of working capital is unquestionable in any type of business. Working capital management is a day to day activity, unlike capital budgeting decisions. Most importantly, inefficiencies at any levels of management have an impact on the working capital and its management. Following are the main points that signify why it is important to take the management of working capital seriously.
§ Ensures Higher Return on Capital
§ Improvement in Credit Profile & Solvency
§ Increased Profitability
§ Better Liquidity
§ Business Value Appreciation
§ Most Suitable Financing Terms
§ Interruption Free Production
§ Readiness for Shocks and Peak Demand
§ Advantage over Competitors
WORKING CAPITAL MANAGEMENT STRATEGIES
Working capital management strategies deal with the cost of capital factor. The question is – How the costs of capital are optimized? A business has a choice to select between short-term vs. long-term sources of capital. Normally, the short term funds are cheaper to long-term but risky. Short term funds are risky in terms of risk of refinancing and risk of rising interest rates. Once they mature, they may not be refinanced by the same financial institution and there is a possibility of revision in interest rate every time they are renewed.
Let’s divide a firm’s capital investment into two i.e. investment in fixed assets and investment in working capital. Let’s safely assume that long-term funds finance the fixed assets. Now remaining is working capital. Let us further divide working capital into two i.e. permanent and temporary working capital. The nature of permanent working capital is similar to fixed assets i.e. that level of investment in working is always present and remaining part keeps fluctuating. The working capital management strategies define how these two types of working capital are financed.
§ Hedging (Maturity Matching) Strategy – This strategy follows the principal of finance i.e. long-term funds to finance long-term assets and vice versa. In this strategy, the maturities of currents are matched with the maturity of its financing instrument. It does not have any cushion or flexibility in case of any delay in the realization of current assets. Although it is a very ideal strategy but involves a high risk of bankruptcy.
§ Conservative – It’s a safer strategy where the apart from financing the whole of the permanent working capital, it finances a part of temporary working capital also.
§ Aggressive – It’s a high-risk strategy where the apart from financing the whole of the temporary working capital, it finances a part of permanent working capital also.
§
ADVANTAGES OF WORKING CAPITAL MANAGEMENT
§ Working capital management ensures sufficient liquidity when required.
§ It evades interruptions in operations.
§ Profitability maximized.
§ Achieves better financial health.
§ Develops competitive advantage due to streamlined operations.
DISADVANTAGES OF WORKING CAPITAL MANAGEMENT
§ It only considers monetary factors. There are non-monetary factors that it ignores like customer and employee satisfaction, government policy, market trend etc.
§ Difficult to accommodate sudden economic changes.
§ Too high dependence on data is another downside. A smaller organization may not have such data generation.
§ Too many variables to keep in mind say current ratios, quick ratios, collection periods, etc.
Elements of Working Capital:
Current Assets:
Current assets are those assets which are convertible into cash within a period of one year and are those which are required to meet the day to day operations of the business. The working capital management, to be more precise the management of current assets. The current assets are cash or near cash resources.
These include:
(a) Cash and bank balances,
(b) Temporary investments,
(c) Short-term advances,
(d) Prepaid expenses,
(e) Receivables,
(f) Inventory of raw materials, stores and spares,
(g) Inventory of work-in-progress, and
(h) Inventory of finished goods.
Current Liabilities:
Current liabilities are those claims of outsiders which are expected to mature for payment within an accounting year.
These include:
(1) Creditors for goods purchased,
(2) Outstanding expenses,
(3) Short-term borrowings,
(4) Advances received against sales,
(5) Taxes and dividends payable, and
(6) Other liabilities maturing within a year.
Gross and Net Working Capital:
Generally the working capital has its significance in two perspectives. These are gross working capital and net working capital is called ‘balance sheet approach of working capital.
Gross Working Capital:
The term ‘gross working capital’ refers to the firm’s investment in current assets. According to this concept working capital refers to a firm’s investment in current assets. The amount of current liabilities is not deducted from the total of current assets.
The concept of gross working capital is advocated for the following reasons:
(a) Profits of the firm are earned by making investment of its funds in fixed and current assets. This suggests the part of the earning relate to investment in current assets. Therefore, aggregate of current assets should be taken to mean the working capital.
(b) The management is more concerned with the total current assets as they constitute the total funds available for operating purposes than with the sources from which the funds come.
(c) An increase in the overall investment in the firm brings an increase in the working capital. Net Working Capital The term ‘net working capital’ refers to the excess of current assets over current liabilities and it is the difference between current assets and current liabilities.
The net working capital is a qualitative concept which indicates the liquidity position of a firm and the extent to which working capital needs may be financed by permanent source of funds. The concept looks into the angle of judicious mix of long-term and short-term funds for financing current assets. A portion of net working capital should be financed with permanent sources of funds.
Permanent Working Capital:
The magnitude of investment in working capital may increase or decrease over a period of time according to the level of production. But, there is a need for minimum level of working capital to carry its business irrespective of change in level of sales or production. Such minimum level of working capital is called ‘permanent working capital’ or ‘fixed working capital’.
It is the irreducible minimum amount necessary for maintaining the circulation of current assets. The minimum level of investment in current assets is permanently locked-up in business and it is also referred to as ‘regular working capital’. It represents the assets required on continuing basis over the entire year.
The permanent component current assets which are required throughout the year will generally be financed from long-term debt and equity. Tandon committee has referred to this type of working capital as ‘core current assets’.
Core current assets are those required by the firm to ensure the continuity of operations which represents the minimum levels of various items of current assets viz., stock of raw materials, stock of work-in- process, stock of finished goods, debtor’s balances, cash and bank etc. This minimum level of current assets will be financed by the long-term sources and any fluctuations over the minimum level of current assets will be financed by the short-term financing.
Temporary Working Capital:
It is also called as ‘fluctuating working capital’. It depends upon the changes in production and sales, over and above the permanent working capital. It is the extra working capital needed to support the changing business activities. It represents additional assets required at different items during the operation of the year.
A firm will finance its seasonal and current fluctuations in business operations through short-term debt financing. For example, in peak seasons, more raw materials to be purchased, more manufacturing expenses to be incurred, more funds will be locked in debtor’s balances etc. In such times excess requirement of working capital would be financed from short-term financing sources.
The management of working capital is concerned with maximizing the return to shareholders within the accepted risk constraints carried by the participants in the company. Just as excessive long-term debt puts a company at risk, so an inordinate quantity of short-term debt also increases the risk to a company by straining its solvency.
The suppliers of permanent working capital look for long-term return on funds invested whereas the suppliers of temporary working capital will look for immediate return and the cost of such financing will also be costlier than the cost of permanent funds used for working capital.
Positive and Negative Working Capital:
The net working capital of a firm may be positive or negative.
(a) The ‘positive net working capital’ represents the excess of current assets over current liabilities.
(b) Sometimes the net working capital turns to be negative when current liabilities are exceeding the current assets. The ‘negative working capital’ position will adversely affect the operations of the firm and its profitability. The chronic negative working capital situation will lead to closure of business and the enterprise is said to be ‘technically insolvent’.
Disadvantages of Negative Working Capital:
The disadvantages suffered by a company with ‘negative working capital’ are as follows:
(a) The company is unable to take advantage of new opportunities or adapt to changes.
(b) Fixed assets cannot be used effectively in situations of working capital shortage.
(c) The operating plans cannot be achieved and will reduce the profitability of the firm.
(d) It will stagnate the growth of the firm.
(e) Employee morale will be lowered due to financial difficulties.
(f) The operating inefficiencies will creep into daily activities.
(g) Trade discounts are lost. A company with ample working capital is able to finance large stocks and can, therefore, place large orders.
(h) Cash discounts are lost. Some companies will try to persuade their debtors to pay early by offering them a cash discount, off the price owed.
(i) The advantages of being able to offer a credit line to customers are foregone.
(j) Financial reputation is lost result in noncooperation from trade creditors in times of difficulty.
(k) There may be concerted action by creditors and will apply to court for winding up.
(l) It would be difficult to get adequate working capital finance from banks, financial institutions.
(b) State different types of financial analysis and discuss the limitations of analysis and interpretation of financial statements.
-> 1. On the Basis of Material Used:
According to material used, financial analysis can be of two types:
(a) External analysis, and
(b) Internal analysis.
(a) External Analysis:
This analysis is done by outsiders who do not have access to the detailed internal accounting records of the business firm. These outsiders include investors, potential investors, creditors, potential creditors, government agencies, credit agencies, and the general public.
For financial analysis, these external parties to the firm depend almost entirely on the published financial statements. External analysis, thus serves only a limited purpose. However, the recent changes in the government regulations requiring business firms to make available more detailed information to the public through audited published accounts have considerably improved the position of the external analysis.
Limitations of financial statement analysis
1. Not a Substitute of Judgement
An analysis of financial statement cannot take place of sound judgement. It is only a means to reach conclusions. Ultimately, the judgements are taken by an interested party or analyst on his/ her intelligence and skill.
2. Based on Past Data
Only past data of accounting information is included in the financial statements, which are analyzed. The future cannot be just like past. Hence, the analysis of financial statements cannot provide a basis for future estimation, forecasting, budgeting and planning.
3. Problem in Comparability
The size of business concern is varying according to the volume of transactions. Hence, the figures of different financial statements lose the characteristic of comparability.
4. Reliability of Figures
Sometimes, the contents of the financial statements are manipulated by window dressing. If so, the analysis of financial statements results in misleading or meaningless.
5. Various methods of Accounting and Financing
The closing stock of raw material is valued at purchase cost. The closing stock of finished goods is value at market price or cost price whichever is less. In general, the closing stock is valued at cost price or market price whichever less is. It means that the closing stock of raw material is valued at cost price or market price whichever less is. So; an analyst should keep in view these points while making analysis and interpretation otherwise the results would be misleading.
6. Change in Accounting Methods
There must be uniform accounting policies and methods for number of years. If there are frequent changes, the figures of different periods will be different and incomparable. In such a case, the analysis has no value and meaning.
7. Changes in the Value of Money
The purchasing power of money is reduced from one year to subsequent year due to inflation. It creates problems in comparative study of financial statements of different years.
8. Limitations of the Tools Application for Analysis
There are different tools applied by an analyst for an analysis. Even though, the application of a particular tool or technique is based on the skill and experience of the analyst. If an unsuitable tool or technique is applied, certainly, the results are misleading.
9. No Assessment of Managerial Ability
The results of the analysis of financial statements should not be taken as an indication of good or bad management. Hence, the managerial ability cannot be assessed by analysis.
10. Change of Business Condition
The conditions and circumstances of one firm can never be similar to another firm. Likewise, the business condition and circumstances of one year to subsequent can never be similar. Hence, it is very difficult for analysis and comparison of one firm with another.
5(a) “As a technique of financial analysis, ratios must be used with great precautions.” In the light of the above statement, critically examine the importance of ratios and their limitations.
-> Ratio analysis is the process of determining and interpreting numerical relationships based on financial statements. A ratio is a statistical yardstick that provides a measure of the relationship between two variables or figures.
This relationship can be expressed as a percent or as a quotient. Ratios are simple to calculate and easy to understand. The persons interested in the analysis of financial statements can be grouped under three heads,
i) Owners or investors
ii) Creditors and
iii) Financial executives.
Although all these three groups are interested in the financial conditions and operating results, of an enterprise, the primary information that each seeks to obtain from these statements differs materially, reflecting the purpose that the statement is to serve.
Investors desire primarily a basis for estimating earning capacity. Creditors are concerned primarily with liquidity and ability to pay interest and redeem loan within a specified period. Management is interested in evolving analytical tools that will measure costs, efficiency, liquidity and profitability with a view to make intelligent decisions.
Now, we have previously learned what ratios are. They are a comparison of two numbers with respect to each other. Similarly, in finance, ratios are a correlation between two numbers, or rather two accounts. So two numbers derived from the financial statement are compared to give us a more clear understanding of them. This is an accounting ratio .
Let us take an example. The income for the year from operations is let us say 1, 00,000/- for a given year. The Purchases and other direct expenses cost around 75,000/-. So the Gross Profit of the year is 25,000/-. Now it can be said that the Gross Profit is 25% of the Operations Revenue . We calculate this as
G.P. Ratio = GPSales/Revenue ×100
G.P.Ratio = 25,0001,00,000 ×100
G.P. Ratio = 25%
One factor to be kept in mind is that ratio analysis is used only to compare numbers that make sense and give us a better understanding of the financial statement. Comparing random financial accounts should be avoided.
Objectives of Ratio Analysis
Interpreting the financial statements and other financial data is essential for all stakeholders of an entity. Ratio Analysis hence becomes a vital tool for financial analysis and financial management. Let us take a look at some objectives that ratio analysis fulfils.
1] Measure of Profitability
Profit is the ultimate aim of every organization. So if I say that ABC firm earned a profit of 5 lakhs last year, how will you determine if that is a good or bad figure? Context is required to measure profitability, which is provided by ratio analysis. Gross Profit Ratios , Net Profit Ratio , Expense ratio etc provide a measure of the profitability of a firm. The management can use such ratios to find out problem areas and improve upon them.
2] Evaluation of Operational Efficiency
Certain ratios highlight the degree of efficiency of a company in the management of its assets and other resources. It is important that assets and financial resources be allocated and used efficiently to avoid unnecessary expenses. Turnover Ratios and Efficiency Ratios will point out any mismanagement of assets.
3] Ensure Suitable Liquidity
Every firm has to ensure that some of its assets are liquid, in case it requires cash immediately. So the liquidity of a firm is measured by ratios such as Current ratio and Quick Ratio. These help a firm maintain the required level of short-term solvency.
4] Overall Financial Strength
There are some ratios that help determine the firm’s long-term solvency. They help determine if there is a strain on the assets of a firm or if the firm is over-leveraged. The management will need to quickly rectify the situation to avoid liquidation in the future. Examples of such ratios are Debt-Equity Ratio , Leverage ratios etc.
5] Comparison
The organizations’ ratios must be compared to the industry standards to get a better understanding of its financial health and fiscal position. The management can take corrective action if the standards of the market are not met by the company. The ratios can also be compared to the previous years’ ratio’s to see the progress of the company. This is known as trend analysis .
Advantages of Ratio Analysis
When employed correctly, ratio analysis throws light on many problems of the firm and also highlights some positives. Ratios are essentially whistleblowers; they draw the management’s attention towards issues needing attention. Let us take a look at some advantages of ratio analysis.
· Ratio analysis will help validate or disprove the financing , investment and operating decisions of the firm. They summarize the financial statement into comparative figures, thus helping the management to compare and evaluate the financial position of the firm and the results of their decisions.
- It simplifies complex accounting statements and financial data into simple ratios of operating efficiency, financial efficiency, solvency , long-term positions etc.
· Ratio analysis helps identify problem areas and bring the attention of the management to such areas. Some of the information is lost in the complex accounting statements, and ratios will help pinpoint such problems.
· Allows the company to conduct comparisons with other firms, industry standards, intra-firm comparisons etc. This will help the organization better understand its fiscal position in the economy.
Importance of Ratio Analysis:-
1. Aid to Measure General Efficiency:
Ratios enable the mass of accounting data to be summarised and simplified. They act as an index of the efficiency of the enterprise. As such they serve as an instrument of management control.
2. Aid to Measure Financial Solvency:
Ratios are useful tools in the hands of management and other concerned to evaluate the firms performance over a period of time by comparing the present ratio with the past ones. They point out firm’s liquidity position to meet its short term obligations and long term solvency.
3. Aid in Forecasting and Planning:
Ratio analysis is an invaluable aid to management in the discharge of its basic function such as planning, forecasting, control etc. The ratios that are derived after analysing and scrutinizing the past result help the management to prepare budgets to formulate policies and to prepare the future plan of action etc.
4. Facilitate Decision-Making:
It throws light on the degree of efficiency of the management and utilisation of the assets and that is why it is called surveyor of efficiency. They help management in decision-making.
5. Aid in Corrective Action:
Ratio analysis provides inter-firm comparison. They highlight the factors associated with successful and unsuccessful firms. If comparison shows an unfavourable variance, corrective actions can be initiated. Thus, it helps the management to take corrective action.
6. Aid in Intra Firm Comparison:
Intra firm comparisons are facilitated. It is an instrument for diagnosis of financial health of an enterprise. It facilitates the management to know whether the firm’s financial position is improving or deteriorating by setting a trend with the help of ratios.
7. Act as a Good Communication:
Ratios are an effective means of communication and play a vital role in informing the position of and progress made by the business concern to the owners and other interested parties. The communications by the use of simplified and summarised ratios are more easy and understandable.
8. Evaluation of Efficiency:
Ratio analysis is an effective instrument which, when properly used, is useful to assess important characteristics of business—liquidity, solvency, profitability etc. A study of these aspects may enable conclusions to be drawn relating to capabilities of business.
9. Effective Tool:
Ratio analysis helps in making effective control of the business- measuring performance, control of cost etc. Effective control is the keynote of better management. Ratio ensures secrecy.
10. Detection of Unfavourable Factors:
Analysis of financial statements enables the analyst to find out the soundness or otherwise of a business. If the analysis reveals financial unsoundness, the factors responsible for such unsoundness can be separated and corrective action taken without loss of time.
Figures, in their absolute forms, shown in the financial statements are neither significant nor able to be compared. In fact, they are dump. But ratios have the power to speak.
Limitations:
No doubt ratios are useful tools yet these should be used with utmost care as these suffer from certain drawbacks/limitations, which are as:
1. Need detailed knowledge. The calculation of ratio is not so much difficult as its interpretation. Ratios are tools of quantitative analysis and not of qualitative analysis. Thus, one should have a fair knowledge of qualitative and quantitative analysis.
2. Lack of reliable data . Ratio can give misleading results if the analyst does not know the reality and correctness of figures, for example, the value of closing stock is overstated profit will be inflated this will result in more taxation when actual profits are less than the profits on which tax has been paid.
3. Different Basis. There are different methods of valuation of closing stock.(i) LIFO (ii) FIFO in both profits will differ. Similarly, profit has different meanings. Someone may say profit before tax and interest, while others may take profit after tax and interest. Similarly, different methods of depreciation each method will show different amount of profit.
4. Different accounting policies. Different firms follow different policies with regard to depreciation; fixed instalments or Diminishing balance method or stock valuation. LIFO, FIFO, thus profit so calculated will not be comparable unless adjustment for profit is not made.
5. Effect of price level change . While ratios are calculated, no thought is given to inflationary measures which are responsible for change in price level. Thus the whole utility of ratio analysis becomes stand still.
6. Bias Opinion. Ratios are only tools it depends upon the user how to give them Practical shape. For example, profit has different meanings such as E.B.I.T. (Earnings before interest and Tax). Some says profit is before interest. Thus personal opinion differs from business to business.
7. Lack of comparison. Different firms adopt different procedures, records, objectives and policies in such situations comparison will become more complicated.
8. Evaluation. There are different tools for ratio analysis. Which tool is to be needed in a particular situation depends upon the skill, training, intelligence and expertise of the analyst.
(b) Explain the purpose of calculating the following ratios:
(i) Current ratio
-> The current ratio, also known as the working capital ratio, measures the capability of a business to meet its short-term obligations that are due within a year. The ratio considers the weight of total current assets versus total current liabilities . It indicates the financial health of a company and how it can maximize the liquidity of its current assets to settle debt and payables. The Current Ratio formula (below) can be used to easily measure a company’s liquidity.
It is one of the most common ratios for measuring the short-term solvency or the liquidity of the firm. It is the ratio between the Current Assets and Current Liabilities.
In other words, it measures whether there are enough current assets to pay the current debts with a margin of safety for potential losses in the realization of the current assets .
Usually, the ideal current ratio is 2:1. However, the ideal ratio depends on the nature of the business and the characteristics of its current assets and current liabilities. Thus,
Current Ratio = Current Assets / Current Liabilities
Where,
Current Assets = Sundry Debtors + Inventories + Cash-in-hand + Cash-at-Bank + Receivables + Loans and Advances + Disposable Investments + Advance Tax
Current Liabilities = Creditors + Short-term Loans + Bank Overdraft + Cash Credit + Outstanding expenses + Provision for Taxation + Dividend payable
For example, if a company’s current assets are Rs. 5,000 and its current liabilities are Rs. 2,000, then its current ratio is 2.5.
Current Ratio= 5000/2000= 2.5
(ii) Acid and Test Ratio
-> Acid and Test Ratio is also known as Quick ratio. The quick ratio or acid test ratio is a liquidity ratio that measures the ability of a company to pay its current liabilities when they come due with only quick assets. Quick assets are current assets that can be converted to cash within 90 days or in the short-term. Cash, cash equivalents, short-term investments or marketable securities, and current accounts receivable are considered quick assets.
Short-term investments or marketable securities include trading securities and available for sale securities that can easily be converted into cash within the next 90 days. Marketable securities are traded on an open market with a known price and readily available buyers. Any stock on the New York Stock Exchange would be considered a marketable security because they can easily be sold to any investor when the market is open.
The quick ratio is often called the acid test ratio in reference to the historical use of acid to test metals for gold by the early miners. If the metal passed the acid test, it was pure gold. If metal failed the acid test by corroding from the acid, it was a base metal and of no value.
Formula:-
The quick ratio is calculated by adding cash, cash equivalents, short-term investments, and current receivables together then dividing them by current liabilities.
Quick ratio= Cash+ Cash equivalent+ Short term investment+ Current Receivable/ Current Liabilities
Sometimes company financial statements don’t give a breakdown of quick assets on the balance sheet . In this case, you can still calculate the quick ratio even if some of the quick asset totals are unknown. Simply subtract inventory and any current prepaid assets from the current asset total for the numerator. Here is an example.
Quick ratio= Total current assets- Inventory- Prepaid Expenses/ Current Liabilities
The acid test of finance shows how well a company can quickly convert its assets into cash in order to pay off its current liabilities. It also shows the level of quick assets to current liabilities.
(iii) Return on Investments Ratio
-> Return on investment or ROI is a profitability ratio that calculates the profits of an investment as a percentage of the original cost. In other words, it measures how much money was made on the investment as a percentage of the purchase price. It shows investors how efficiently each dollar invested in a project are at producing a profit. Investors not only use this ratio to measure how well an investment performed, they also use it to compare the performance of different investments of all types and sizes.
For example, an investment in stock can be compared to one in equipment. It doesn’t matter what the type of investment because the return on investment calculation only looks that the profits and the costs associated with the investment.
That being said, the ROI calculation is one of the most common investment ratios because it’s simple and extremely versatile. Managers can use it to compare performance rates on capital equipment purchases while investors can calculate what stock purchases performed better.
Formula:-
The return on investment formula is calculated by subtracting the cost from the total income and dividing it by the total cost.
ROI= Investment Revenue- Investment Cost/ Investment Cost
ROI formula is very simplistic and broadly defined. The income and costs are not clearly specified. Total costs and total revenues can mean different things to different individuals. For example, a manager might use the net sales and cost of goods sold as the revenues and expenses in the equation, where as an investor might look more globally at the equation and use gross sales and all expenses incurred to produce or sell the product including operating and non-operating costs.
In this way, the ROI calculation can be very versatile, but it can also be very manipulative depending on what the user wants to measure or show. It’s important to realize that there is no one standardized equation for return on investment. Instead, we’ll look at the basic idea of recognizing profits as a percentage of income. To truly understand the return on an investment presented to you, you have to understand what revenues and costs are being used in the calculation.
