Unit 4 Financial Management

In the words of John J. Hampton, the term finance can be defined as the management of

the flows of money through an organization, whether it will be a corporation, school, bank

or government agency.

Definition of Finance According to F.W.Paish, Finance may be defined as the position of

money at the time it is wanted.

According to Howard and Upton, “finance may be defined as that administrative area or set

of administrative functions in an organization which relates with the arrangement of each

and credit so that the organization may have the means to carry out the objectives as

satisfactorily as possible.

In the words of Bonneville and Dewey, Financing consists in the raising, providing,

managing of all the money, capital or funds of any kind to be used in connection with the

business.

As put forth by Hurband and Dockery in his book ‘Modern Corporation Finance’, finance is

defined as “an organism composed of a myriad of separate enterprise, each working for its

own ends but simultaneously making a contribution to the system as a whole, some force is

necessary to bring about direction and co-ordination. Something must direct the flow of

economic activity and facilitate its smooth operation. Finance is the agent that produces

this result”.

The Encyclopedia Britannica defines finance as "the act of providing the means of

payment." It is thus the financial aspect of corporate planning which may be described as

the management of money

Function of financial management can be divided into two categories:

a) Executive Finance Functions:

The finance manager takes important financial decisions by his experience, expertise,

capability and qualifications. The decision taken will have long term financial implications

in the present as well as future of the firm. Some of the important executive functions of

financial management are as follows:

1. Investment Decision/Capital Budgeting Decision (amount invested in business):

This involves the decision of allocation of capital or commitment of fund to long term asset

which would yield benefits in the future. One of its main tasks is measuring the prospective

profitability of new investment. The investment decision determines the total amount of

assets held by the firm, the composition of these assets, and the business risk complexion

of the firm as perceived by the supplier of capital. The essence of investment decision is

that return from the investment would exceed the firms required rate of return on capital.

Asset: value-benefit-future/ company own and control / not in intention of sales

Expense: value-benefit-already taken

2.Financing Decision:

This is the second important function to be performed by financial manager. He/She must

decide when, where and how to acquire funds to meet the firm’s investment needs. The

firm must maintain an optimal mix of equity and debt capital, also known as capital

structure. The firm’s capital structure is said to be optimum when market value of shares is

maximized.

Equity = Assets – Liabilities (bank loan)

Time –> Asset (increases) –> Equity (increases)

Time –> Liabilities (increases: more bank loan) –> Equity (decreases)

3. Dividend Decision (Part of profit given to shareholders):

The financial manager should make a sound dividend policy that determines whether the

firm should distribute dividend or not. If the firm should distribute dividend, then how

much should be distributed. Since, the optimal dividend policy maximizes the value of the

firm, it is one of the important aspects of decision making.

4. Liquidity Decision:

Liquidity is defined as the ability of a firm to make its short term obligations. The

management of current assets affects the liquidity of the firm. Hence, current assets should

be managed efficiently for safeguarding the firm against the danger of illiquidity and

insolvency.

There is always conflict between profitability and liquidity while managing current assets.

If a firm does invest sufficient funds in current assets, it may become illiquid whereas it

would lose profitability as idle current assets would not earn anything. Therefore, the

finance manager should estimate the firm’s needs for current assets and make sure that

funds would be made available when needed.

5. Financial Forecasting:

Financial Forecasting includes the estimation of financial requirement and development of

finance structure. The finance manager should ensure adequate availability of cash for the

smooth operation of the firm. Therefore, forecasting should also be made regarding the

technical changes, situation of capital market, funds necessary for investment, returns from

proposed investment projects, and the demand for the firm’s product.

6. Analysis and appraisal of financial performance:

The financial manager should perform various financial analysis in order to appraise the

finance performance of the business such as ratio analysis, funds flow analysis, break-even

analysis, trend analysis, etc.

7. Advising to the top level Management:

Another important function of finance manager is to advise the top level management

about the financial position of the firm. He should provide advice on some crucial financial

problems by giving the comparative study of different financial alternatives.

8. Procurement of fund:

The finance manager should try to find out the sources of fund and procure them. He

should decide how much fund should be raised from different sources through detailed

financial planning.

9. Allocation of fund to all parts of Organization:

It includes the proper allocation of funds to the different departments in accordance with

their need.

10. Pricing:

Pricing is a crucial part of decision making. If the goods and services were priced lower

priced, then the firm would find difficulty in covering its operating cost. The firm would

lose competitive strength if priced excessively. Hence, the finance manager should

evaluate the impact of pricing policy on profitability. This helps to determine the price of

the firm’s product in a reasonable way.

11. Control:

The finance manager should have the centralized control over the firm’s activities. For this,

he should interact with other executives. This ensures the efficient operation of the firm.

b) Routine Functions:

This includes those functions which are performed by lower-level employee. These

functions help management to take important decisions. These functions include:

Supervision of cash flows and protection of cash balance.

Protection and safety of financial documents

Recording, keeping and reporting.

Preservation of accounting document.

Preparing financial statements.

Management of credit.

Disbursement (pay loan) and collection of credit.

Making incentive schemes such as insurance and pension.

Management of payroll (salary list), tax-related matters, inventory, fixed assets,

computer operators, etc.

Objectives of Financial Management

1. To ensure regular and adequate supply of funds to the concern.

2. To ensure adequate returns to the shareholders (Stocks and share) this will depend

upon the earning capacity, market price of the share, expectations of the

shareholders.

3. To ensure optimum funds utilization. Once the funds are procured, they should be

utilized in maximum possible way at least cost.

4. To ensure safety on investment, i.e., funds should be invested in safe ventures so

that adequate rate of return can be achieved.

5. To plan a sound capital structure: There should be sound and fair composition of

capital so that a balance is maintained between debt and equity capital (investment

in business).

6. Wealth Maximization: The one of the most important objective of financial managers

is to maximize the value of shares of their shareholders.

7. Profit Maximization

Sources of Finance:

Internal Source of Finance:

1. Retained Equity Earnings:

This implies retaining the earnings of the shareholders for internal reinvestment. Every

rupee retained is a rupee with-held from distribution to existing shareholders. While doing

so, management must do something to maintain the interest of shareholders.

2. Depreciation Provisions: (a reduction in the value of an asset over time)

Depreciation provisions represent the maintenance of a capital stock to replace the

existing machinery (due in particular to wear and tear) when it becomes uneconomical to

use. Depreciation provision is a major source of internally generated funds.

3. Deferred Taxation:

Due to the time-lag between the earning of profit and payment of the appropriate taxation,

the funds, represented by the tax liability, are available for use.

4. Personal Funds Saved or Inherited:

In order to win confidence of external financiers, it is very necessary that the owner must

have assets of his own to invest in the firm.

External Source of Finance:

1. Savings:

People save a percentage of their salary for a ‘rainy day’ (reserved amount of money to be

used in times when regular income is disrupted or decreased). With the money thus saved,

people purchase life insurance, buy stocks and bonds, and buy shares or deposit in a bank.

Thus saved money is made available to business enterprises for further use and investment.

It may be said that almost all capital for investment in business and industry comes from

savings of people.

2. Loans:

Money can be borrowed from the following sources for starting or expanding the

business:

(i) Friends and relations,

(ii) Money lending institutions, and

(iii) Commercial and other banks, etc.

When money is borrowed, it becomes obligatory that the interest should be paid in time

and the loan be paid back on the mutually agreed (agreement) date.

3. Shares:

Funds are collected by issuing shares to public. The number of authorized shares that can

be issued and the value of each share are specified. This is decided on the basis of the

capital to be collected by issuing shares. Shares are issued for raising funds either when

starting a new concern or when it is decided to expand and improve upon the existing one.

The main division of share capital is into:

i. Preference Shares:

Preference shares, as the name implies, have some preferential rights over other types of

shares, e.g., dividend is first paid on preference shares and then on ordinary shares.

Preference shares are entitled to a fixed dividend out of the profit. If the company faces a

difficult period and is unable to pay dividends, quite possible, the preference shareholders

may exert their powers and take over control from ordinary shareholders. This happens

when the preference dividends are in arrears.

Preference shares may be further classed as:

(a) Cumulative Preference Shares:

They are entitled to a fixed annual dividend. If this full dividend cannot be paid in any year

(because of less profits to company), the rest of deficit can be paid out of future profits,

(i.e., profits of next year).

(b) Non-Cumulative Preference Shares:

They are entitled to a fixed annual dividend, but the shareholders cannot ask for arrears

from future profits if in any year the company fails to make enough profits to pay fixed

dividends for that year.

(c) Participating Preference Shares:

They are entitled to a fixed annual dividend plus something from the surplus left after

paying dividend to ordinary shareholders.

ii.. Ordinary Shares:

Ordinary shareholders are generally paid a higher rate of dividend than that of preference

shareholders but they carry greater risks. Dividend on ordinary shares is paid only after

doing so on preference shares. There is no limit of dividend in case of ordinary shares.

Ordinary shareholders may get very high rewards in one prosperous year of increased

business and no dividend if the business encounters a difficult period. The ordinary shares

may sometimes be called as Equity Shares or Equities.

iii. Deferred Shares:

Deferred shares are issued to founders or promoters of the business enterprise. Dividend

on deferred shares is paid in the last, i.e., first of all, dividend on preference shares is

distributed, then it is paid on ordinary shares and in the end whatever profit is left is shared

by the deferred shareholders.

4. Debentures:

Business corporations having good record of earnings and favourable prospects of

expansion, in search for outside (external) funds to support operations and growth, may

raise capital by borrowing it on a formal document known as a Debenture. Debenture is a

certificate of indebtedness issued by the corporation.

A fixed rate interest is paid on debentures and the amount is repayable after the stated

number of years. The essential relationship between the company and the (bond)

debenture-holder is that of debtor-creditor. Debentures are generally un-secured bonds

which have no claim on any specific asset of the company but are backed by the earning

power and general credit of the company as viewed by the investor.

For this reason, only companies with a very good profit record and a high financial

standing can hope to sell unsecured bonds or debentures. The issue of debentures can be

a very useful method of raising finance at reasonable cost.

Shares: partner (profit of company) Dividend

Debentures: short term loan Interest

Bonds: Long term loan Interest

Characteristics of debentures and the difference from shares:

5. Corporate Bonds:

Corporate bonds are of two types:

i. Unsecured bonds or Debentures as discussed above, and

ii. Secured bonds, in which case some form of claim on the assets of the corporation is tied

if the corporation fails to pay interest to the investor or does not return his money back

after the stated number of years.

Mortgage bonds are examples of secured bonds.

6. Public Deposits:

Public may be asked to deposit their money directly with the company for a fixed

long/short period ranging from half a year to seven years.

7. Taking in Partners:

Capital may be raised by adding partners in the business who are ready to invest in the

firm.

8. Bank Loans:

Short term loans are easily available from commercial and other banks on reasonable

interest rates.

9. Hire Purchase (rent):

The hirer makes a deposit, he gets the machinery (goods), etc., he needs and then he pays a

number of periodical money instalments. At the end of a period when all the instalments

have been paid, the possession of the goods passes to the hirer.

10. Sale and Lease Back:

For getting funds, a company may sell some of its property to an investment company with

a right to lease back at an agreed rent.

11. Equipment Leasing:

Many types of fixed assets such as land, equipment, machinery, etc., can be obtained on

lease for a number of years on rental basis.

12. Profit Plowback:

The whole profit is not distributed to shareholders or owners as dividends, rather a portion

of it is retained in the business and used to finance expansion and growth of the concern.

13. Credit Facilities:

A useful source of short-term finance is to obtain goods and services on credit.

14. Trade Credit:

Trade credit is the financial assistance available from other firms with whom the business

has dealings.

15. Special Institutions:

Finance may be obtained by borrowing from an Insurance company, Investment company,

Industrial development corporation, etc.

Capital required for a business can be classified under two main categories

(i) Fixed Capital, and

(ii) Working Capital.

Every business needs funds for two purposes-for its establishment and to carry out its day-to-day operations.

Long-term funds are required to create production facilities through purchase of fixed assets such as plant and machinery, land, building, furniture, etc. Investments

in these assets represent that part of firm’s capital which is blocked on a permanent or fixed basis and is called fixed capital.

Funds are also needed for short-term purposes for the purchase of raw materials, payment of wages and other day-to-day expenses, etc. These funds are known as working capital.

In simple words, working capital refers to that part of the firm’s capital which is required for financing short term or current assets such as cash, marketable securities, debtors and inventories. (Retailer: Producer delay and consumer delay)

Funds, thus, invested in current assets keep revolving fast and are being constantly converted into cash and these cash flows out again in exchange for other current assets. Hence, it is also known as revolving or circulating capital or short-term capital.

In the words of Shubin, “Working capital is the amount of funds necessary to cover the cost of operating the enterprise.”

According to Genestenberg, “Circulating capital means current assets of a company that are changed in the ordinary course of business from one form to another, as for example, from cash to inventories, inventories to receivables, receivables into cash.”

TYPES OF WORKING CAPITAL

There are two concepts of working capital:

(i) Gross concept, and

(ii) Net concept.

(i) Gross Concept of Working Capital:

The gross working capital refers to the total fund invested in (total) current assets.

Current assets are those assets which are easily converted into cash within a time

period of one year.

It includes cash in hand and at bank, short term securities, debtors, bills receivable,

prepaid expenses, accrued expenses and inventories like raw materials, work-in-

progress, stores and spare parts, finished goods.

The gross concept of working capital refers to the firm’s investment in above current

assets.

Amount of current assets that a business firm has to maintain for its day to day operations Example: Stocks of retail shops = current assets (that can be converted

into cash within one operating cycle or max. One year = working capital of retail shop

Current assets: cash, bank balance, stock and inventories (raw material,

stock in process, finished goods) Retail shops: Computers for accounting of shop are not current assets

(ii) Net Concept of Working Capital:

The term net working capital refers to the excess of current assets over current

liabilities.

In other words, the amount of current assets that would remain in a firm after all its

current liabilities are paid.

Current liabilities are those claims of outsiders to the business enterprise which are payable within a period of one year, and include bills payable, outstanding expenses, short-term loans, advances and deposits, bank overdraft, proposed dividend, provision for taxation etc.

Net Working Capital = Current Assets—Current liabilities

Current Assets: Cash in hand and bank balance, Bills Receivable, Inventories (raw

material, work-in progress, stores, spares, finished goods), surplus funds and others

Current liabilities: Bills payable, dividend payable, Bank overdraft and others

Sr. No.

Gross Working Capital Net Working Capital

1 Total amount available for financing the current assets

To meet its operating expenses and current liabilities

2 Total sum of current assets Current asset - current liabilities 3 If gross concept of working capital is

used, there will always be positive working capital as it represents only current assets.

If net concept of working capital is used, there may be positive, negative or zero (nil) working capital.

1. Types on the basis of concept

a) Gross working capital: the total amount of current asset maintained by business firm

b) Net working capital: amount of contribution or margin the business enterprise has to provide to finance the gross working capital (bank or contribution by business promoter)

Net working capital = current asset (GWC) - current liabilities

2. Types on the basis of Time

a) Permanent working capital: example for product Display

b) Variable and Temporary working capital: product for sales product not for showcase

Seasonal Working Capital: (capital required to meet seasonal demand)

There are industries like cold drinks, ice-cream and woollen where the goods are either produced or sold seasonally. So, in such industries, working capital requirements during production or sale seasons will be large and these will start decreasing when the season starts coming-to end.

However, much depends on the policy of management with regard to production or sale of goods. For example, the management of a woollen industry wants to carry on production evenly throughout the year rather than concentrating on its production only in the busy season. In that case the working capital requirements will be low.

Specific working capital: extensive marketing, purchase of goods for stocks in view of future increase in price, Big manufacturing order

Working Capital Management Principle

1. Principle of Risk Variation (Current Assets Policies):

Risk here refers to the inability of a firm to meet its obligations as and when they

become due for payment.

This principle is based on the assumption that the rate of return on investment is

linked with degree of risk in the business.

Risk here refers to the inability of firm to maintain sufficient current assets to pay

its obligations.

If working capital is varied relative to sales, the amount of risk that a firm assumes is

also varied and the opportunity for gain or loss is increased.

In other words, there is a definite relationship between the degree of risk and the

rate of return. As a firm assumes more risk, the opportunity for gain or loss increases.

As the level of working capital relative to sales decreases, the degree of risk

increases.

When the degree of risk increases, the opportunity for gain and loss also increases.

Thus, if the level of working capital goes up (more assets and less liabilities),

amount of risk goes down, and vice-versa, the opportunity for gain is like-wise

adversely affected.

The various working capital policies indicating the relationship between current assets

and sales are depicted below:

2. Principle of Cost of Capital:

Each source of working capital has different cost of capital (interest or dividend). The

degree of risk also differs from one source to another. The type of capital used to finance

working capital directly affects the amount of risk that a firm assumes as well as the

opportunity for gain or loss and cost of capital. A firm should raise capital in such a manner

that a balance is maintained between risk and profit.

3. Principle of Equity Position:

This principle is concerned with planning the total investment in current assets. According

to this principle, the amount of working capital invested in each component should be

adequately justified by a firm’s equity position. Every rupee invested in the current assets

should contribute to the net worth of the firm.

4. Principle of Maturity of Payment:

This principle states that the working capital should be so raised from different sources

that the firm is able to repay them on maturity out of its inflows of funds. Otherwise the

firm would fail to repay on maturity and ultimately, it would find itself into liquidation (no

cash) though it is earning huge profits. This implies that the firm’s ability to repay its short-

term debts depends not on its earnings but on the flow of cash into it.

COSTING

Costing is the classifying, recording and appropriate allocation of expenditure for the

determination of the costs of products or services, and for the presentation of suitably

arranged data for the purpose of control and guidance of management.

Methods of Costing

Different industries follow different methods to establish the cost of their product. This

varies by the nature and specifics of each business. There are different principles and

procedures for performing the costing. However, the basic principles and procedures of

costing remain the same.

Different Methods of Costing

Unit costing: This method is also known as "single output costing." This method of

costing is used for products that can be expressed in identical quantitative units.

Unit costing is suitable for products that are manufactured by continuous

manufacturing activity: for example, mining, cement manufacturing, dairy

operations, or flour mills. Costs are ascertained for convenient units of output.

Job costing: Under this method, costs are ascertained for each work order separately

as each job has its own specifications and scope. Job costing is used, for example, in

painting, car repair, decoration, and building repair.

Contract costing: Contract costing is performed for big jobs involving heavy

expenditure, long periods of time, and often different work sites. Each contract is

treated as a separate unit for costing. This is also known as terminal costing. Projects

requiring contract costing include construction of bridges, roads, and buildings.

Batch costing: This method of costing is used where units produced in a batch are

uniform in nature and design. For the purpose of costing, each batch is treated as an

individual job or separate unit. Industries like bakeries and pharmaceuticals usually

use the batch costing method.

Operating costing or service costing: Operating or service costing is used to ascertain

the cost of particular service-oriented units, such as nursing homes, busses, or

railways. Each particular service is treated as a separate unit in operating costing. In

the case of a nursing home, a unit is treated as the cost of a bed per day, while, for

busses, operating cost for a kilometre is treated as a unit.

Process costing: This kind of costing is used for products that go through different

processes. For example, the manufacturing of clothes involves several processes. The

first process is spinning. The output of that spinning process, yarn, is a finished

product which can either be sold on the market to weavers, or used as a raw material

for a weaving process in the same manufacturing unit. To find out the cost of the

yarn, one needs to determine the cost of the spinning process. In the second step,

the output of the weaving process, cloth, can also be sold as a finished product in the

market. In this case, the cost of cloth needs to be evaluated. The third process is

converting the cloth to a finished product, for example a shirt or pair of trousers.

Each process that can result in either a finished good or a raw material for the next

process must be evaluated separately. In such multi-process industries, process

costing is used to ascertain the cost at each stage of production.

Multiple costing or composite costing: When the output is comprised of many

assembled parts or components, as with television, motor cars, or electronics

gadgets, costs have to be ascertained for each component, as well as with the

finished product. Such costing may involve different methods of costing for different

components. Therefore, this type of costing is known as composite costing or

multiple costing.

Uniform costing: This is not a separate method of costing, but rather a system in

which a number of firms in the same industry use the same method of costing, using

agreed-on principles and standard accounting practices. This helps in setting the

price of the product and in inter-firm comparisons. (Apple: Standards and quality)

Some of the advantages of Cost Accounting are as follows:

1. Measurement and Improvement of Efficiency:

The chief advantage to be gained is that costing will enable a concern to, first of all,

measure its efficiency and then to maintain and improve it. This is done by suitable

comparisons and analysis of the differences that may be observed. For example, if materials

spent upon a pair of shoes in 2001 come to Rs. 100 and for a similar pair of shoe the

amount is Rs. 120 in 2002. It is an indication of decline in efficiency.

Of course, the increase may only be due to increase in price of materials; it may also be

due to greater wastage in use of materials or inefficiency at the time of buying so that

unnecessary high prices were paid. Comparisons may also be made with average figures for

the whole industry (if such figures are available) and with ideal figures which may have

been determined before head.

In any case it is this sort of comparison which tells management about the going up or

coming down of efficiency. The study will certainly indicate the steps to be taken to

remove the causes of inefficiency or to consolidate a factor which leads to greater

efficiency.

2. Profitable and Unprofitable Activities:

It will throw light upon those activities which bring profits and those activities which result

in losses. This will be done only if the cost of each product or each job is ascertained and

compared with the price obtained.

3. Fixation of Prices:

In many cases a firm is able to fix a price for its products on the basis of the cost of

production. In such a case, price cannot be properly fixed if no proper figures of cost are

available. In case of big contracts, no quotation can be made unless the cost of completing

that contract can be ascertained.

If prices are fixed without costing information, it is possible that the price quoted may

either be too high, in which case orders cannot be obtained, or it may be too low, in

which case an order will result in a loss. It is a mistake on the part of any management to

believe that mere increase in sales volume will result in profits; increased sales at prices

lower than the cost may well lead the concern to the bankrupt court. Only Cost Accounting

will reveal what price will be profitable.

4. Guide in Reducing Prices:

In certain periods it becomes necessary to reduce the price even below the total cost. This

will be so when there is a depression. Costs, properly ascertained, will guide management

in this direction.

5. Information for Proper Planning:

For a proper system of Costing, it is necessary to have detailed information about the

facilities available about machine and labour capacity. This helps in proper planning of

work so that no section is overworked and no section remains idle.

6. Control over Materials etc.:

Information about availability of stocks of various materials and stores must be constantly

available if there is a good system of Cost Accounting. This helps in two ways. Firstly,

production can be planned according to the availability of materials and fresh stocks can

be arranged in time when old stocks are exhausted. Secondly, loss due to carelessness or

any other mischief will be known and, therefore, put down.

7. Decision Regarding Machine vs. Labour:

Some of the important questions before management can be solved only with the help of

information about costs. For example, if there is the problem of replacement of labour by

machinery, Cost Accounting will at least guide management in finding out what the cost

of production will be if either machinery or labour is used.

8. Expansion in Production:

Sometimes it is necessary to decide whether production of one product or the other is to

be increased. This problem can also be solved only if proper information about costs is

available.

9. Reasons for Losses Detected:

Exact causes of existence of profits or losses will be revealed by a system of Cost

Accounting. For example, a concern may not suffer because the cost of production is high

or prices are low but because the output is much below the capacity of the concern. It is

only Cost Accounting which will reveal this reason for loss. It also helps in distinguishing

between expenditure and loss which is necessary and that which is unnecessary, that is to

say, between normal and abnormal losses.

10. Helps in Taking Decisions:

Cost Accounting inculcates the habit of making calculations with pencil and paper before

taking a decision. It will certainly check recklessness. Also some of the silly mistakes that

sometimes occur can be avoided if there is a good Cost Accounting system.

11. Check on Accuracy of Financial Accounts:

A good system of Cost Accounting affords an independent and most reliable check on the

accuracy of financial accounts. This check operates through reconciliation of profits shown

by Cost Accounts and by Financial Accounts. On the basis of various advantages of Cost

Accounting, it can be easily said that ‘a good system of costing serves as a means of control

over expenditure and helps to secure economy in manufacture’.

Control Over Expenditure:

A good system of costing serves as a means of control over expenditure in the following

directions:

(a) An efficient system of stores and stock accounting is rendered essential and thus

wastage may be detected and reduced to a minimum.

(b) By adopting the maximum limits for stores, the total capital outlay is controlled and

possible financial loss due to overstocking is avoided.

(c) The centralization of purchasing is facilitated by the use of Cost Accounts and the danger

of liabilities exceeding the current financial resources is avoided.

(d) The maintenance of time and job records for workers discloses the losses incurred from

idle time and indicates the directions in which these losses may be minimized.

(e) The data made available by Cost Accounting are invaluable for the purpose of

comparison, and steps can be taken to reduce the number of unprofitable or more costly

operations, processes etc. in favour of those shown to be more efficient or economical.

Principles of Costing

Every concern must design its own costing system, keeping in view its peculiar

problems.

If financial books can afford the necessary information, separate costing system is

not needed.

Reasonable accuracy is enough; of course, this depends upon the nature of industry.

As a rule, costing information should be collected as and when the work proceeds.

Classification of Costs:

1. Classification of Cost by Nature or Element

2. Functional Classification of Cost

3. Classification of Cost on the Basis of Behaviour

4. Classification of Costs for Managerial Decisions and Control

1. Classification of Cost by Nature or Element:

According to the nature or elements of cost, costs can be broadly classified as:

(a) Direct Costs

(b) Indirect Costs.

(a) Direct Costs:

Direct Costs are the costs which can be conveniently identified with and allocated to a

particular unit of final product. Such costs are treated as the cost of the unit produced. The

examples of direct costs are raw materials, labour and other direct expenses which are

exclusively incurred for a particular unit of cost, i.e., job, product or process.

Hence, direct costs can be further classified as:

(i) Direct Material

(ii) Direct Labour

(iii) Direct Expenses.

All materials which become an integral part of the finished product and which can be

conveniently assigned to specific physical units are called direct material. Direct materials

include all materials specifically purchased or requisitioned for specific cost unit, all primary

packing materials.

Direct Labour cost consists of wages paid to workers directly engaged in manufacturing or

handling a product, job or process. It includes the payment of wages to the workers

engaged on the actual production of the product or an operation or a process; and to the

workers engaged in helping such production operation or process by way of supervision,

maintenance, etc.

All expenses other than the direct material or direct labour that are specifically incurred

for a particular job, product or process are called direct expenses. Direct expenses are also

known as chargeable expenses as they are charged directly to the particular unit of cost

concerned.

Examples of direct expenses are: cost of special tools, patterns, etc., made for a specific

job, product or process, hire charges of a special equipment, excise duty, cost of trial

castings, royalties, freight and insurance on special materials, etc.

(b) Indirect Costs:

Indirect Costs are those costs which cannot be assigned to any particular cost unit, i.e., job,

product or process. Indirect costs are, usually, incurred for the business as a whole and are,

therefore, apportioned among the various cost units (product, job or process) on some

reasonable basis.

Like direct costs indirect costs include:

(i) Indirect Material such as fuel, lubricating oil, small tools, and material consumed for

repairs and maintenance work, miscellaneous stores used in the factory, etc.

(ii) Indirect labour which includes wages of general supervisors, inspectors, workshop

cleaners, store-keepers, time-keepers, etc.

(iii) Indirect expenses such as rent, lighting, insurance, canteen, hospital, welfare

expenses, etc.

Indirect costs are also called ‘Overheads’. Overheads may be further classified as:

(a) Factory Overheads which include all indirect expenses connected with the manufacture

of a product such as lubricants, oil, consumable stores, works manager’s salary, time-

keeper’s salary; factory rent, factory insurance, etc.

(b) Office and Administration Overheads which include all indirect expenses relating to

administration and management of an office such as office rent, office lighting, insurance,

salaries of clerical and executive staff, etc.

(c) Selling and Distribution Overheads which include all indirect costs connected with

marketing and sales such as advertising expenses, salaries of salesmen, indirect packing

material, etc.

2. Functional Classification of Cost:

Functionally, costs can be classified under the following heads:

(a) Prime Cost:

It consists of the costs of direct materials that go into the product, the costs of direct labour

and direct expenses. It is also known as direct cost or first cost.

(b) Factory Cost:

It consists of prime cost plus factory overhead or works expenses or factory on cost.

Factory cost is also known as works cost, production cost or manufacturing cost.

(c) Cost of Production:

Also called office cost, administration cost or gross cost of production, it consists of factory

cost plus office and administrative expenses.

(d) Total Cost or Cost of Sales:

It comprises cost of production plus selling and distribution overheads.

The various components of total cost can be presented as follows:

1. Prime Cost = Direct Material + Direct Labour + Direct Expenses

2. Factory Cost or Works Cost = Prime Cost + Works Expenses or Factory Expenses

3. Office Cost or Gross Cost of Production = Factory Cost + Administrative and Office

Overheads

4. Total cost or Cost of Sales = Office Cost + Selling and Distribution Overheads

3. Classification of Cost on the Basis of Behaviour:

On the basis of behaviour or variability, costs may be classified as:

(a) Variable Costs:

Costs that vary almost in direct proportion to the volume of production are called variable

costs. The examples of such costs are direct material, direct labour and direct chargeable

expenses, such as electric power, fuel, etc. (depends upon volume of sale or production

units)

(b) Fixed Costs:

Costs which do not vary with the level of production are known as fixed costs. These costs

are called fixed costs because these remain constant irrespective of the level of output. It

must, however, be noted that fixed costs do not remain constant for all times. In fact, in

the long run all costs have a tendency to vary. Fixed costs remain fixed upto a certain

level of production. (Rent, salaries, insurance, taxes)

(c) Semi-variable Costs:

Those costs which are partly fixed and partly variable are called semi-variable costs. These

costs vary with the level of production but not in direct proportion to the level of

production. The examples of such costs are depreciation of machinery, maintenance of

equipment, administrative costs, etc.

4. Classification of Costs for Managerial Decisions and Control:

(a) Controllable and Uncontrollable Costs:

Controllable costs are those costs which can be controlled or influenced by a specified

person or a level of management of an undertaking. Costs which cannot be so controlled or

influenced by the action of a specified individual of an undertaking are known as

uncontrollable costs. The difference in controllable and uncontrollable costs is only in

relation to a particular person or a level of management.

Example: the sales manager has control over the salary and commission of sales

personnel: Controllable costs

For example, a company-wide advertising cost that is allocated by the central office to

different departments is not under the control of the department heads: Uncontrollable

costs

(b) Normal and Abnormal Costs:

Costs which are normally incurred at a given level of output are called normal costs while

the costs which are not normally incurred at a given level of output in the conditions at

which that level is normally achieved, are called abnormal costs.

Normal Costs are the normal or regular costs which are incurred in the normal conditions

during the normal operations of the organization. Example: repairs, maintenance, salaries

paid to employees.

Abnormal Costs are the costs which are unusual or irregular which are not incurred due to

abnormal situation s of the operations or productions. Example: destruction due to fire,

shut down of machinery, lock outs, etc.

(c) Avoidable and Unavoidable Costs:

Avoidable costs are those costs which can be escaped or avoided if some activity of the

business to which they relate is discontinued. Unavoidable costs are those which cannot be

escaped or eliminated.

(d) Shut Down and Sunk Costs:

Those fixed costs which have to be incurred even if production or operations of an

undertaking are discontinued temporarily due to certain reasons such as strike, shortage of

raw material, etc., are called shut down costs. Costs which have been incurred and are

irrelevant in a particular situation are called sunk costs.

Once the company's money is spent, that money is considered a sunk cost. Regardless of

what money is spent on, sunk costs are rupees already spent and permanently lost. Sunk

costs cannot be refunded or recovered. For example, once rent is paid, that rupee amount

is no longer recoverable - it is 'sunk.'

(e) Product Costs and Period Costs:

Costs which are associated with production and which become part of the cost of the

product are called ‘product costs’. The examples of product costs are raw material, direct

wages, etc. Costs which are not associated with production or which are associated with

period for which they are incurred are called ‘period cost’. The examples of period costs are

administration costs, rent, insurance, salesmen salaries, etc.

(f) Differential, Incremental and Decremental Costs:

The difference-in-costs due to change in the level of activity or the method of production is

known as ‘differential cost’. In case, the change increases the cost, it is called incremental

cost and in case, the change decreases the cost, it is called decremental cost.

Examples are fuel price increases, repairs and maintenance cost, rent expenses, etc.

(g) Out of Pocket Costs:

Out of pocket costs in managerial accounting are expenses that could be incurred or

avoided depending on management’s decisions. In other words, an out-of-pocket cost is a

potential future outlay of cash that management needs to decide whether or not to make.

Example: purchase of new equipment

(h) Marginal Costs:

Marginal cost is the cost of producing one additional unit. The marginal cost concept is

based on the distinction between fixed and variable costs. Marginal cost is the total of

variable cost only and fixed costs are ignored for the purpose of marginal cost. The concept

of marginal cost is very useful in making many managerial decisions such as price fixation,

make or by decisions, etc.

It is defined as:

"The cost that results from a one unit change in the production rate".

The marginal cost of the second unit is the difference between the total cost of the

second unit and total cost of the first unit.

For example, the total cost of producing one pen is $5 and the total cost of producing two

pens is 9Rs, then the marginal cost of expanding output by one unit is 4Rs only (9 - 5 =

4Rs).

(i) Opportunity Costs:

Opportunity costs refer to the advantages foregone as a result of adopting one course of

action and not the other. For example, if an owned building is proposed to be used for a

project, the expected rent of the building is the opportunity cost that must be taken into

consideration while evaluating the profitability of the project.

(j) Conversion Cost:

It is the cost of converting or transforming raw materials into finished products. Conversion

cost can be calculated as the total of direct labour, direct expenses and chargeable factory

overheads.

(k) Budget Costs and Standard Cost:

Budget costs are estimated costs prior to a defined period of time. Standard cost is a

‘predetermined cost based on technical estimate for materials, labour and overheads for a

selected period of time and for a prescribed set of working conditions’. Standard costs are

based upon technical assessments whereas budgets are based on historical costs adjusted

to future trends.

(i) Imputed or Hypothetical Costs:

These costs do not involve any expenditure in real sense. They are included in cost accounts

only for taking managerial decisions. For example, the rent of owned building or interest on

owned capital should be taken into consideration while evaluating the profitability of a

project. These costs are also called ‘notional costs’.

Meaning of Break-Even Point:

Break-even point represents that volume of production where total costs equal to

total sales revenue resulting into a no-profit no-loss situation.

If output of any product falls below that point there is loss; and if output exceeds

that point there is profit.

Thus, it is the minimum point of production where total costs are recovered.

Therefore, at break-even point.

Sales Revenue – Total Cost

or, Sales – Variable Cost = Contribution = Fixed Cost

It can be concluded that at break-even point the contribution earned just covers the fixed

cost and, at levels below the point, contribution earned is not sufficient to match the fixed

cost and, at levels above the point, contribution earned more than recovers the fixed cost.

P is the break-even point in the break-even chart where OS and CT—being the sales line

and total cost line—intersects. Loss results in the left side of P, i.e., before the break-even

point is reached, and, beyond P, profit starts to generate. Break-even point has a wide use

in the field of marginal costing and helps to decide the product mix, fixation of selling price,

steps to be taken in long-term planning etc.

Break-even point can be ascertained by using the following formula:

Assumptions Underlying Break-Even Analysis:

The break-even analysis is based on certain assumptions.

They are:

(i) All costs can be separated into fixed and variable components,

(ii) Fixed costs will remain constant at all volumes of output,

(iii) Variable costs will fluctuate in direct proportion to volume of output,

(iv) Selling price will remain constant,

(v) Product-mix will remain unchanged,

(vi) The number of units of sales will coincide with the units produced so that there is no

opening or closing stock,

(vii) Productivity per worker will remain unchanged,

(viii) There will be no change in the general price level.

Uses of Break-Even Analysis:

(i) It helps in the determination of selling price which will give the desired profits.

(ii) It helps in the fixation of sales volume to cover a given return on capital employed.

(iii) It helps in forecasting costs and profit as a result of change in volume.

(iv) It gives suggestions for shift in sales mix.

(v) It helps in making inter-firm comparison of profitability.

(vi) It helps in determination of costs and revenue at various levels of output.

(vii) It is an aid in management decision-making (e.g., make or buy, introducing a product

etc.), forecasting, long-term planning and maintaining profitability.

(viii) It reveals business strength and profit earning capacity of a concern without much

difficulty and effort.

Limitations of Break-Even Analysis:

1. Break-even analysis is based on the assumption that all costs and expenses can be clearly

separated into fixed and variable components. In practice, however, it may not be possible

to achieve a clear-cut division of costs into fixed and variable types.

2. It assumes that fixed costs remain constant at all levels of activity. It should be noted

that fixed costs tend to vary beyond a certain level of activity.

3. It assumes that variable costs vary proportionately with the volume of output. In

practice, they move, no doubt, in sympathy with volume of output, but not necessarily in

direct proportions.

4. The assumption that selling price remains unchanged gives a straight revenue line which

may not be true. Selling price of a product depends upon certain factors like market

demand and supply, competition etc., so it, too, hardly remains constant.

5. The assumption that only one product is produced or that product mix will remain

unchanged is difficult to find in practice.

6. It assumes that the business conditions may not change which is not true.

7. It assumes that production and sales quantities are equal and there will be no change in

opening and closing stock of finished product, these do not hold good in practice.

Definition of budgetary control

A system of management control in which actual income and spending are compared with

planned income and spending, so that you can see if plans are being followed and if those

plans need to be changed in order to make a profit.

“According to Brown and Howard, “Budgetary control is a system of controlling costs which

includes the preparation of budgets, coordinating the departments and establishing

responsibilities, comparing actual performance with the budgeted and acting upon results

to achieve maximum profitability.” Weldon characterizes budgetary control as planning in

advance of the various functions of a business so that the business as a whole is controlled.

J. Batty defines it as, “A system which uses budgets as a means of planning and controlling

all aspects of producing and/or selling commodities and services. Welsch relates budgetary

control with day-to-day control process.” According to him, “Budgetary control involves the

use of budget and budgetary reports, throughout the period to co-ordinate, evaluate and

control day-to-day operations in accordance with the goals specified by the budget.”

According to H.S. Wheldon, “By budgetary control, every items of actual cost is so

controlled by vigilant supervision as to make it conform, as nearly as possible, to the

predetermined standards. It has resulted in the elimination of waste and excess costs in

every suitable instance where budgetary control has been properly instituted.”

It performs the following important functions:

1. Budgets present the objectives, plans and programmes of the enterprise and express them in financial and/or quantitative terms in the organisation.

2. Budgets serve as job descriptions. They define the tasks, which have to be performed at various levels in the organisation.

3. Budgetary control involves continuous comparison of actual results with the planned ones and taking corrective actions in the organisation.

Budgets are not only a means of control; they also help the managers in performing other functions of management. Budgeting is closely associated with planning, organising and directing. It also helps in pointing deviations from the planned results. When these deviations are reported to manager, he can control them in time in the organisation.

Objectives of Budgetary Control:

The main purpose of budgetary control is to enable the management to conduct the business in the most efficient manner in the organisation.

According to John Blocker, “Budgetary control is planned to assist the management the allocation of responsibilities and authority, to aid in making estimates and plans for future, to assist in analysis of various between estimated and actual results and to develop basis of measurement or standards with which to evaluate the efficiency of operations.”

In other words, the budgetary control device in the organisation encompasses practically the whole range of management activities right from planning and policy formulation to the final function of control over various activities of the manufacturing enterprise.

Budgetary control has the following specific objectives:

1. Planning:

Budgets are the plans to be pursued during the designed period of time to attain certain

objectives in the organisation. Budgetary control will force the management at all levels to

plan various activities well in advance in the organisation.

Budgets are generally drawn on the basis of forecasts made about market forces, supply

conditions and consumer’s preferences in the organisation. This help in making and

revising business policies in the organisation.

2. Control:

Budgetary control is an important instrument of managerial control in any enterprise. Budgetary control helps in comparing the performance of various individuals and departments with the predetermined standards laid down in various budgets.

Budgetary control reports the significant variations from the budgets to the top management in the organisation. Since separate budgets are prepared for each department becomes easier to determine the weak points and the sources of waste of time, money and resources.

3. Coordination:

Budgetary control involves the participation of a master budget, which helps in bringing effective coordination among different departments of a business enterprise in the organisation. It force the executive to make plans as a group in the organisation. Delays involved in the red tapism (Rigid Rules and regulations) and discussing matters with one another sets procedural wrangles aside.

4. Increase in Efficiency:

Budgetary controls lay down the standards of production, sales, costs and overheads taking into consideration various internal and external factors. This compels and stimulates every department to attain maximum efficiency over the use of men, machine, material, methods and money.

5. Financial Planning:

Budgets are generally expressed in financial terms in the organisation. They provide the estimates of expenditures and revenues in the organisation. This helps the management to make plans about the flow of cash in such a way that it would never run short of working capital in the organization. Cash budget is also useful to convince the financial institution that their loans will be paid back in time.

Benefits of Budgetary Control:

1. Budgeting is an all inclusive management tool. It integrates and ties together various organisational activities in the organization right from planning to controlling.

2. Budgets provide standards against which actual performance can be measured. This helps in taking corrective action, which is an important part of controlling.

3. Budgets are an important tool to coordination in the organisation. In preparation of various budgets, knowledge, skill and experience of many executives are combined and business plans are reduced into concrete numerical terms in the organisation. This leads to proper coordination of the efforts of various departments of the enterprise in the organisation.

4. Budgeting in the organisation helps in reducing unproductive operations by minimizing waste of resources. Budgets are prepared after considerable thought and are directed towards certain aims and objectives.

5. Budgeting in the organisation makes financial planning and control easy. The ultimate effect of budgeting is the thorough examination and scrutinizing the financial aspect of the business enterprise. This helps in optimum use of financial resources of the enterprise.

6. Budgetary control in the organisation facilities ‘control by exception’. It helps in focusing the time and effort of the managers upon areas, which are most important for the survival of the organisation.

7. Budgeting in the organisation is an important device for fixing the responsibility of various positions. The persons occupying various positions can be made to understand their responsibilities with the help of budgets.

Limitations of Budgetary Control:

1. Too much emphasis on budgeting in the organization may bring about rigidity in the enterprise. It may deprive the managers of the flexibility they require in managing their departments.

2. Budgeted estimates in the organisation are generally based on the price level at a particular period of time. These estimates may become useless when there is either inflation or depression in the market.

3. Sometimes budgets in the organization are tested as an end in themselves. Some people may be extra cautious to function within the boundaries of budget figures rather than achieving the enterprise objectives.

4. A budget, which allows liberal expenditure, may be used to hide inefficiency. For instance, a department may be inefficient even though its expenses are within the budget limits in the organisation.

5. Budgetary control in itself does not prevent deviation from appearing. It neither ensures satisfactory results nor control automatically in the organisation. A deliberate effort has to be made in this direction in the organisation.

6. Budgetary control in the organisation requires expenditure of time, money and effort. Moreover, it is not easy to prepare various kinds of budgets in the organisation because of obvious difficulties in forecasting to be used in budgeting.

Essential of Effective Budgetary Control:

Following are requirements of a good system of budgetary control in the organisation

1. Quick Reporting:

A good system of budgetary control in the organisation requires the establishment of such procedures, which will provide reports on the performance of various operations. The reports should reach the persons concerned with the implementation of budgets without any delay so that quick actions may be taken wherever necessary in the organization.

2. Detailed Organization Structure:

There should be a detailed organization structure with precisely designed authorities, responsibilities and lines of communication so that everybody in the organisation understands the significance of objectives in detail.

3. Frequent Comparison:

There should be frequent comparison between budget estimates and operating results in the organisation. Alford and Beatty are of opinion that careful analysis of both operating results and budget estimates is the essence of budgetary control in the organisation.

4. Definite Plan:

There should be comprehensive planning in the enterprise. All the operations in the organisation should be planned in clear terms. The administration of the budgets should also be properly planned in the organisation. It must be pre-determined who is to be held responsible for the implementation of budget in the organisation.

5. Responsibility Matched by the Authority:

Those assigned with the responsibility to implement the budgets should also be given the necessary authority to achieve the budgeted targets in the organisation. Lack of sufficient authority will make the implementation of budgets ineffective in the organisation.

6. Participation:

The purpose of budgetary control is to achieve coordination of various functions of the business in the organisation. Therefore, it is essential that participation up to the lowest level in the enterprise be ensured to make the people committed to the budgets. Everybody in the organisation should understand his role in achieving the budgeted targets.

7. Support of the Management:

The top management in the organisation supports a good system of budgetary control. Top management in the organisation should take the preparation of budgets and their implementation seriously in order to achieve the objectives of the enterprise.

8. Flexibility:

Budgets should not be rigid, but flexible enough to allow altering or remodelling in the light of any change in circumstances in the organization. They must be flexible to achieve the desired objectives in the organisation. A good system of budgetary control allows sufficient flexibility to the persons concerned with the implementation of budgets in the organisation.

Precautions in the Use of Budgets:

Following precautions could be taken while preparing and using budgets for the purpose of managerial planning and control:

1. Estimates are not too high to be attained in the organisation.

2. Budgets are not prepared and installed hurriedly in the organization.

3. Administration and supervision of the operations are not insufficient in the organisation.

4. Organisational structure is not defective in the organisation.

5. Accounting and cost systems are not inadequate in the organisation.

6. Statistics of past operations are not inadequate and unreliable in the organisation.

7. Results are not expected in too short period in the organisation.

Types of Budget

a) Sales budget: this involves a realistic sales forecast. This is prepared in units of each

product and also in sales value. Methods of sales forecasting include:

· sales force opinions

· market research

· statistical methods (correlation analysis and examination of trends)

· mathematical models.

In using these techniques consider:

· company's pricing policy

· general economic and political conditions

· changes in the population

· competition

· consumers' income and tastes

· advertising and other sales promotion techniques

· after sales service

· credit terms offered.

b) Production budget: expressed in quantitative terms only and is geared to the sales

budget. The production manager's duties include:

· analysis of plant utilisation

· work-in-progress budgets.

If requirements exceed capacity he may:

· subcontract

· plan for overtime

· introduce shift work

· hire or buy additional machinery

· The materials purchases budget's both quantitative and financial.

c) Raw materials and purchasing budget:

· The materials usage budget is in quantities.

· The materials purchases budget is both quantitative and financial.

d) Labour budget: is both quantitative and financial. This is influenced by:

· production requirements

· man-hours available

· grades of labour required

· wage rates (union agreements)

· the need for incentives.

e) Cash budget: a cash plan for a defined period of time. It summarises monthly receipts

and payments. Hence, it highlights monthly surpluses and deficits of actual cash. Its main

uses are:

· to maintain control over a firm's cash requirements, e.g. stock and debtors

· to enable a firm to take precautionary measures and arrange in advance for investment

and loan facilities whenever cash surpluses or deficits arises

· to show the feasibility of management's plans in cash terms

· to illustrate the financial impact of changes in management policy, e.g. change of credit

terms offered to customers.

Receipts of cash may come from one of the following:

· cash sales

· payments by debtors

· the sale of fixed assets

· the issue of new shares

· the receipt of interest and dividends from investments.

Payments of cash may be for one or more of the following:

· purchase of stocks

· payments of wages or other expenses

· purchase of capital items

· payment of interest, dividends or taxation.

Zero-based budgeting (ZBB) is a method of budgeting in which all expenses must be

justified for each new period. The process of zero-based budgeting starts from a "zero

base," and every function within an organization is analyzed for its needs and

costs. Budgets are then built around what is needed for the upcoming period, regardless of

whether each budget is higher or lower than the previous one.

Example of Zero-Based Budgeting

Suppose a company making construction equipment implements a zero-based budgeting process calling for closer scrutiny of the expenses in its manufacturing department. The company notices that the cost of certain parts used in its final products and outsourced to another manufacturer is increasing 5% every year. The company has the capability to make those parts in-house and with its own workers. After weighing the positives and negatives of making the parts in-house, the company finds that it can make the parts cheaper than the outside supplier.

Instead of blindly increasing the budget by a certain percentage and masking the cost increase, the company can identify a situation in which it can decide to make the part itself or buy the part from the external supplier for its end products. With traditional budgeting, cost drivers within departments may not be identified, while zero-based budgeting is a more granular process that aims to identify and justify expenditures.

Balance Sheet, known as position statement, is a statement which shows the financial

position of the company on a specific date. It lists all the ownership, i.e. assets and owings,

i.e. liabilities of the company.

Profit & Loss Account, on the other hand, also known as income statement is the account

that shows the revenue earned and expenses sustained by the company, during the course

of business, in a financial year.

BASIS FOR COMPARISON

BALANCE SHEET PROFIT AND LOSS ACCOUNT

Meaning A statement that shows company's assets, liabilities and equity at a specific date.

Account that shows the company's revenue and expenses over a period of time.

What is it? Statement Account

Represents Financial position of the business on a particular date.

Profit earned or loss suffered by business for the accounting period

Preparation Prepared on the last day of financial year.

Prepared for the financial year.

Information Disclosed

Assets, liabilities, and capital of shareholders.

Income, expenses, gains and losses.

Accounts Accounts shown in the Balance Sheet do not lose their identity, rather their balance is carry forward to next year as opening balance.

Accounts transferred to Profit and Loss account are closed and cease to exist.

Sequence It is prepared after the preparation of Profit & Loss Account.

It is prepared before the preparation of Balance Sheet.

Definition of Balance Sheet

A Balance Sheet is a statement that shows the financial position of the entity at a given

date. As you have seen that on the top of the Balance Sheet there is, “as at……” written

which mentions the particular date at which it is prepared. It has two broad heads which

are to be tallied. They are – (1) Assets and (2) Equity and Liabilities.

On the asset side, it displays the firm’s current and non-current assets. Current assets are

those assets which can be converted into cash within one year and includes cash in hand,

stock, debtors, bills receivables, cash at bank, marketable securities, etc. Non – current

assets have two parts: Tangible and Intangible assets. Tangible assets are the physical

assets of the company like machinery, building, furniture, land, vehicles, etc. Intangible

assets are the non-physical assets of the company i.e. patents, trademark, goodwill, etc.

On the equity and liabilities side, it displays the shareholder’s fund, current and non-current

liabilities. Shareholders fund includes the shareholder’s equity and reserves and surplus.

Current liabilities are those liabilities which are to be paid within 1 year and includes

creditors, bills payable, short term loan, etc. Non – current liabilities are those liabilities

which are to be paid after a period and includes long-term borrowings, bonds, etc.

Definition of Profit and Loss Account

Profit and Loss Account also known as an income statement or statement of revenue and

expenses. The account represents the financial performance of the entity in a particular

period.

First of all the net sales (sales – sales return) is recorded after that the cost of goods sold is

deducted, and the result is the gross profit of the entity. Now from this gross profit the

office and administration (rent, insurance, printing, and stationery, etc.), selling and

distribution (carriage outwards, bad debts, etc.) expenses are reduced which amounts to

operating profit.

After arriving at operating profit operating income (rent received, profit from the sale of

assets, etc.) are added to it while the operating expenses (interest on loan, loss on sale of

assets) are lessened from it which results in the net profit or loss. If the income exceeds

expenses it represents net profit while the expenses exceed income it represents a loss.

Key Differences Between Balance Sheet and Profit & Loss Account

1. The Balance Sheet is prepared at a particular date, usually the end of the financial

year while the Profit and Loss account is prepared for a particular period.

2. The Balance Sheet reveals the entity’s financial position, whereas the Profit & Loss

account discloses the entity’s financial performance, i.e. profit earned or loss

suffered by the business for the accounting period.

3. Balance Sheet is a statement of assets and liabilities. In contrast, Profit & Loss

Account is an account.

4. A Balance Sheet is a gives an overview of assets, equity, and liabilities of the

company, but the Profit and Loss account is a depiction of entity’s revenue and

expenses.

5. Accounts which are transferred to profit and loss account are closed and lose their

identity. On the contrary, those accounts which are transferred to Balance sheet do

not cease to exist rather their balance is carried forward to the next accounting year

and considered as opening balances.

6. The Balance sheet is prepared on the basis of the balances transferred from the

Profit and Loss account.

Conclusion

The Balance Sheet and Profit & Loss Account has its significance. A Balance Sheet enables

the reader of the financial statement to clearly understand the entity’s financial stability,

liquidity, and solvency. The Profit and Loss Account is helpful in comparison of the

performance of the company. The two terms consists items of different nature, and that is

why the chances of getting confused between them are very less.

Make and Buy Decision....

Liquidity ratios

Liquidity ratios analyze the ability of a company to pay off both its current liabilities as they become due as well as their long-term liabilities as they become current.

In other words, these ratios show the cash levels of a company and the ability to turn other assets into cash to pay off liabilities and other current obligations.

Liquidity is not only a measure of how much cash a business has. It is also a measure of how easy it will be for the company to raise enough cash or convert assets into cash.

Assets like accounts receivable, trading securities, and inventory are relatively easy for many companies to convert into cash in the short term. Thus, all of these assets go into the liquidity calculation of a company.

Liquidity ratios (quick ratio or acid test 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.) {Not inventories (6-9 months)}

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.

(When gold is subjected to treatment with muriatic acid (hydrochloric acid) alone, nothing happens. But when \muriatic acid is combined with nitric acid to treat gold, the gold dissolves.)

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.

Formula

Example

Let’s assume Carole’s Clothing Store is applying for a loan to remodel the storefront. The bank asks Carole for a detailed balance sheet, so it can compute the quick ratio. Carole’s balance sheet included the following accounts:

Cash: $10,000 Accounts Receivable: $5,000 Stock Investments: $1,000 Current Liabilities: $15,000

The bank can compute Carole’s quick ratio like this.

As you can see Carole’s quick ratio is 1.07. This means that Carole can pay off all of her current liabilities with quick assets and still have some quick assets left over. (If less than one)

Profitability ratios

Profitability ratios compare income statement accounts and categories to show a company’s ability to generate profits from its operations.

Profitability ratios focus on a company’s return on investment in inventory and other assets.

These ratios basically show how well companies can achieve profits from their operations.

Investors and creditors can use profitability ratios to judge a company’s return on investment based on its relative level of resources and assets.

In other words, profitability ratios can be used to judge whether companies are making enough operational profit from their assets.

In this sense, profitability ratios relate to efficiency ratios because they show how well companies are using their assets to generate profits.

Profitability ratios (Gross margin ratio)

Gross margin ratio is a profitability ratio that compares the gross margin of a business to the net sales.

This ratio measures how profitable a company sells its inventory.

This is the pure profit from the sale of inventory that can go to paying operating expenses.

Gross margin ratio is often confused with the profit margin ratio, but the two ratios are completely different.

Gross margin ratio only considers the cost of goods sold in its calculation because it measures the profitability of selling inventory. Profit margin ratio on the other hand considers other expenses.

Formula

Gross Margin = Net Sales – Cost of Goods Sold

Company A B Net Sales 1,00,000/- 50,00,000/-

Cost of Goods sold 75,000/- 46,50,000/- Gross Margin 25,000 3,50,000/-

Gross Margin Sales (25,000/1,00,000) x 100 = 25% (3,50,000/50,00,000) x 100 = 7%

Gross margin ratio is a profitability ratio that measures how profitable a company can sell its inventory.

It only makes sense that higher ratios are more favorable. Higher ratios mean the company is selling their inventory at a higher profit percentage.

High ratios can typically be achieved by two ways. One way is to buy inventory very cheap. If retailers can get a big purchase discount when they buy their inventory from the manufacturer or wholesaler, their gross margin will be higher because their costs are down.

The second way retailers can achieve a high ratio is by marking their goods up higher. This obviously has to be done competitively otherwise goods will be too expensive and customers will shop elsewhere.

A company with high gross margin ratios mean that the company will have more money to pay operating expenses like salaries, utilities, and rent. Since this ratio measures the profits from selling inventory, it also measures the percentage of sales that can be used to help fund other parts of the business

Debt ratio

Debt ratio is a solvency ratio (the possession of assets in excess of liabilities; ability to pay one's debts) that measures a firm’s total liabilities as a percentage of its total assets.

In a sense, the debt ratio shows a company’s ability to pay off its liabilities with its assets.

In other words, this shows how many assets the company must sell in order to pay off all of its liabilities.

This ratio measures the financial leverage (expecting the profits made to be greater than the interest payable.) of a company. Companies with higher levels of liabilities compared with assets are considered highly leveraged and more risky for lenders.

This helps investors and creditors analysis the overall debt burden on the company as well as the firm’s ability to pay off the debt in future, uncertain economic times.

Formula

The debt ratio shows the overall debt burden of the company—not just the current debt.

Analysis

The debt ratio is shown in decimal format because it calculates total liabilities as a percentage of total assets.

As with many solvency ratios, a lower ratio is more favourable than a higher ratio.

A lower debt ratio usually implies a more stable business with the potential of longevity because a company with lower ratio also has lower overall debt. Each industry has its own benchmarks for debt, but .5 is reasonable ratio.

A debt ratio of .5 is often considered to be less risky. This means that the company has twice as many assets as liabilities. Or said a different way, this company’s liabilities are only 50 percent of its total assets. Essentially, only its creditors own half of the company’s assets and the shareholders own the remainder of the assets.

A ratio of 1 means that total liabilities equals total assets.

In other words, the company would have to sell off all of its assets in order to pay off its liabilities. Obviously, this is a highly leverage firm. Once its assets are sold off, the business no longer can operate.

The debt ratio is a fundamental solvency ratio because creditors are always

concerned about being repaid.

When companies borrow more money, their ratio increases creditors will no longer loan them money.

Example

Dave’s Guitar Shop is thinking about building an addition onto the back of its existing building for more storage. Dave consults with his banker about applying for a new loan. The bank asks for Dave’s balance to examine his overall debt levels.

The banker discovers that Dave has total assets of $1,00,000 and total liabilities of $25,000. Dave’s debt ratio would be calculated like this:

As you can see, Dave only has a debt ratio of .25. In other words, Dave has 4 times as many assets as he has liabilities. This is a relatively low ratio and implies that Dave will be able to pay back his loan. Dave shouldn’t have a problem getting approved for his loan.

https://www.myaccountingcourse.com/financial-ratios