Account

Principles of Financial Accounting and Management Unit 1
Unit 1 Financial Accounting An Introduction

Structure:
1.1 Introduction
Objectives
1.2 Basic Accounting Concepts
1.3 Double Entry Accounting
1.4 The Accounting Trail
1.5 Financial Statements and their Nature
1.6 The Accounting Equation
1.7 Summary
1.8 Terminal Questions
1.9 Answers
1.1 Introduction
Accounting is an important endeavor: it helps the management of an
organization to have control over its performance. The success of a
business entity depends on the combined effects of four factors land,
labor, capital and management. The contribution of each factor has to be
properly measured and then only the resultant performance of the entity can
be properly evaluated. An outsider does not consider how many engineers,
chartered accountants, and MBAs an organization possesses, to judge its
performance. He may be interested only in the bottom line (i.e. profits) of the
organization. The efforts of each person in that organization are to be
translated into some accounting numbers to find out the financial
performance of that entity. Thus, without accounting, a business entity
cannot communicate with the outside world. Accounting is the language of
business. Accounting is not only necessary for business activities, it is
equally important for all types of non-business economic activities. For
example, accounting is necessary to run a school, a charitable institution,
and even a family.
The accounting system is a major quantitative information system in every
organization. It provides information for four broad purposes.
1. Internal routine reporting to managers for cost planning and cost control
of operations, and performance evaluation of people and activities.
Sikkim Manipal University Page No.: 1

2. Internal routine reporting to managers on the profitability of products,

brand categories, customers, etc.
3. Internal non-routine reporting to managers for strategic and tactical
decisions.
4. External reporting through financial statements to investors, government
authorities and other interested parties.
The first three functions are the domain of management accounting; and,
the fourth function, i.e. external reporting, is truly called financial accounting.
Financial accounting operates under a lot of constraints constraints of
accounting principles, accounting standards etc. whereas management
accounting enjoys greater freedom.
Thus, it can be said that the basic purpose of accounting is to provide
decision-makers with information that is useful in making economic
decisions.
Objectives:
After studying this unit you will able to:
Explain the concept of accounting
Explain the meaning of accounting trail
Explain accounting equation.
1.2 Basic Accounting Concepts

A renowned Accountant once observed that Accounting was born without
notice and reared in neglect. Accounting was first practiced and then
theorized. Certain ground rules were initially set for financial accounting:
these rules arose out of conventions. Therefore, these are called accounting
conventions or concepts. We shall discuss here only the basic accounting
concepts or conventions that are very vital to understand the process of
accounting.
The Entity Concept
A business is an artificial entity distinct from its proprietor(s). A business
entity is an economic unit which owns its assets and has its own obligations.
The owner(s) may have personal bank accounts, real estate, and other
assets, but these will not be considered as assets of the business. A
business entity may be in the form of a sole proprietorship concern,

partnership, or a corporate entity. In case of a sole proprietary form of

business, the sole proprietor is considered fully responsible for the welfare
of the entity and, in the eyes of law, the sole proprietor and the business is
not considered to have a separate existence. For accounting purposes,
however, they are separate entities. A partnership form of business has
more than one owner who have agreed to share profits of a business
carried on by all or any of them acting for all. A corporate entity is a
separate legal entity, entirely divorced from its owners (called equity
shareholders). A sole proprietorship business normally comes to an end
with the expiry of the owner, a partnership firm may cease to operate or, at
least, there will be reconstruction of the agreement on the expiry of an
owner (called partner) but a corporate entity is not disturbed at all on the
expiry of any equity shareholder.
Money Measurement Concept
Each transaction and event must be expressible in monetary terms. If an
event cannot be expressed in monetary terms, it cannot be considered for
accounting purposes. For example, if you successfully pass a Distance
Learning Programme of a university, it will give you a great deal of
satisfaction. But that satisfaction cannot be expressed in monetary terms.
Hence such an event is not fit for accounting. On the other hand, if you are
robbed of Rs. 1,000 in a train journey, the loss suffered can definitely be
expressed in monetary terms. This concept implies that the legal currency of
a country should be used for such measurement.
The Cost Concept
Assets such as land, buildings, plant and machinery etc. and obligations,
such as loans, public deposits, should be recorded at historical cost
(i.e., cost as on acquisition). For example, the land purchased by a business
entity two years back at a cost of Rs. 10 lakh should be shown, as per the
cost concept, at the same amount even today when the current price of the
land may have increased five-fold. Thus, the greatest limitation of this
concept is that it distorts the true worth of an asset by sticking to its original
cost.
The Going Concern Concept
One common argument put forward by the proponents of cost concept is
that the assets are shown at its original cost (net of depreciation) because

these are meant for use for a long period of time and not for immediate
resale. Therefore, the cost concept rests on the assumption that an entity
would continue its operation for a long time. An entity is said to be a going
concern if it has `neither the intention nor the necessity of the liquidation or
of curtailing materially the scale of the operations. This concept is
considered as one of the fundamental accounting assumptions. The
valuation principle of assets and liabilities depend on this concept. If an
entity is not a going concern, its assets and liabilities are to be valued in an
altogether different manner.
The Periodicity Concept
The activities of a going concern are continuous flows. In order to judge the
performance of a business entity, one cannot wait for eternity to see the
business coming to a halt. Therefore, the best way to judge a business is to
have a periodic performance appraisal. Such a period to measure business
performance is called an accounting period. The results of operations of an
entity are measured periodically, i.e. in each accounting period. Different
business units may follow different accounting periods depending on
convenience. For example, one entity may follow calendar year as the
accounting period, while the other one may follow the fiscal year (April to
March) as the accounting period. However, in India, the Income Tax Act,
1961 prescribes that each business unit should follow a uniform accounting
period, i.e., the fiscal year. The Companies Act, 1956 has no such
prescription. Therefore, for tax purpose, every business entity should follow
uniform year, i.e. fiscal year, whereas for accounting purpose, there is no
restriction.
The Accrual Concept
It suggests that incomes and expenses should be recognized as and when
they are earned and incurred, irrespective of whether the money is received
or paid in connection thereof. This concept is used by all businesses that
disclose their financial statements to various interested parties. In fact, the
Companies Act, 1956 provides that accrual concept has to be maintained
for practically all purposes. The alternative to the accrual basis of
accounting is called ash basis of accounting. The law in India provides that
in cases where accrual concept cannot be followed under any
circumstances, cash basis may be followed.

Examples of accrual concept:

1. Rent paid for fifteen months in advance on 1st January 2007. The
business follows calendar year as the accounting year. In this case, rent
for only the first twelve months should be recognized as expenses for
the year 2007.
2. Credit sales for the year 2007 were Rs. 20,00,000. Cash collected from
customs during 2007 was Rs. 15,00,000. In this case, credit sales for
2007 should be considered as Rs. 20,00,000 and not as Rs. 15,00,000.
The Matching Concept
The inherent concept involved in accrual accounting is called matching
concept. Revenue earned in an accounting year is offset (matched) with all
the expenses incurred during the same period to generate that revenue,
thus providing a measure of the overall profitability of the economic activity.
Thus, matching concept is very vital to measure the financial results of a
business. The timing of incurring expenses and earning revenues does not
always match. For example, in case of a seasonal business, majority of
sales may take place only in four months of a year whereas fixed expenses
like salaries, rent etc. are incurred throughout the year. Matching concept
suggests that the expenses incurred to generate revenue are to be matched
against that revenue to find out the profitability.
Concept of Prudence
It says anticipate no profits but provide for all possible losses. Prudence is
the inclusion of a degree of caution in the exercise of the judgments needed
in making the estimates required under conditions of uncertainty, such that
assets or income are not, overstated and liabilities or expenses are not
understated. Expected losses should be accounted for but not anticipated
gains.
The Realization Concept
The realization concept tells that to recognize revenue it has to be realised.
Realization principle does not demand that the revenue has to be received
in cash. Revenue from sales transactions should be recognized when the
seller of goods has transferred to the buyer the property in the goods for a
price and no uncertainty exists regarding the consideration that will be
derived from the sale of goods. Revenue arises from the consideration that
will be derived from the sale of goods. Revenue arising from the use by

others of enterprise resources yielding interest, royalties and dividends

should only be recognized when no uncertainly exists as to its measurability
and collectability.
Self Assessment Questions
1. ______________ has more than one owner who have agreed to share
profits of a business carried on by all or any of them acting for all.
2. __________ is a separate legal entity, entirely divorced from its
owners.
3. __________ suggests that incomes and expenses should be
recognized as and when they are earned and incurred, irrespective of
whether the money is received or paid in connection thereof.
4. The valuation principle of assets and liabilities depend on _________
concept.
1.3 Double Entry Accounting

The term accounting has been defined by the American Institute of
Accountants (now known as American Institute of Certified Public
Accountants) as the art of recording, classifying and summarizing in a
significant manner and in terms of money, transactions and events which
are, in part at least, of a financial character, and interpreting the results
thereof. Thus, accounting starts with recording and ends in presenting
financial information in a manner which facilitates informed judgments and
decisions by users. The recording of transactions and events follows a
definite rule. Each transaction and/or event has two aspects or sides debit
and credit. Every debit has an equal and opposite credit. This is the crux of
double entry concept. Each transaction should be recorded in such a way
that it affects two sides debit and credit equally.
It may not be out of place to mention here that the principles of the double
entry accounting were first explained in print by Luca Fra Pacioli, an Italian
Mathematician. His book Summa de Arithmetica, Geometria Proportioniet
Proportionalita was published in 1494. Three hundred years later, Johann
Von Goethe, perhaps the most influential writer of the late 18th century,
described Paciolis system as something of timeless beauty and simplicity.
It may sound strange that even in todays advanced age of computers,
Paciolis simple principles still apply.

1.4 The Accounting Trail

We have seen in section 1.3 that the accounting function initiates with the
recording of transactions and events and ends with the presentation of
financial statements. Thus, the sequence of activities in an accounting
process can be shown in figure 1.1.
Transaction/Event
Preparation of Vouchers
Recording in the Primary Books
Posting in the Secondary Books
Preparation of Trial Balance
Preparation and Presentation of Financial Statements

Figure 1.1: The Accounting Trail
Transactions and Events

The Statement of Financial Accounting Concepts (No. 6), issued by the
Financial Accounting Standard Board (FASB) of U.S.A. defines an event as
a happening of consequence to an entity. An event may be an internal
happening or an external incident. For example, when the management of
a business entity negotiates a wage settlement with its Labour Union, it is an
internal event. On the other hand, when the same management recruits a
fresh MBA, it is an external event. However, this does not involve transfer or
exchange of any value instantly. Again, if the same business purchases raw
materials from its supplier, it is an external event and it also involves
exchange of value instantly. Thus, all external events do not involve
immediate exchange of value. The external events that involve transfer of
value between two entities are called transactions.
Preparation of Vouchers
In the present age of information technology, majority of the business
entities use software packages for accounting purposes. The computer
takes care of most of the operations like recording in primary books,
postings in secondary books, preparation of trial balance and finally even
preparation of financial statements. The human intervention normally ends

with the preparation of necessary documents. These documents (popularly
called vouchers) can be of three types Receipt Voucher, Payment
Voucher and Journal Voucher. The receipt voucher is prepared to record all
cash and bank receipts. The payment voucher is prepared to record all cash
and bank payments. The journal voucher is drawn to record all non-cash
transactions and events. The voucher should be filled with all the necessary
information minutely so that the computer takes the details correctly. Each
account will have a unique code number and if the concerned person
commits any mistake in writing the proper code number, the recording by
the computer will be wrong. For example, if salary paid for a particular
month is to be recorded in primary books, codification should be properly
done. Suppose salary account has a code of 101, if the accountant writes
110 as the account code in the payment voucher erroneously, the computer
will sincerely read 110 as the accounts code and the amount will be
recorded in a wrong account. Therefore preparation of vouchers is a vital
step in the accounting process.
The remaining steps of accounting trial will be discussed in subsequent
units.
5. A/An _________ is described as a happening of consequence to an
entity by The Financial Accounting Standard Board (FASB) of U.S.A.
6. The external events that involve transfer of value between two entities
are called ___________.
7. ____________ is drawn to record all non-cash transactions and
events.
1.5 Financial Statements and their nature

Financial statements are the end products of the accounting process.
Financial statements are prepared and presented for external users. The
scope of financial statements is different in different countries. In India, the
term Financial Statements consists of Balance Sheet, Profit and Loss
Account and the Schedules and Notes forming part thereof. The Conceptual
Framework developed by the International Accounting Standards
Committee (IASC) defines the objective of financial statements as to

provide information about the financial position, performance and changes

in financial position of an enterprise that is useful to a wide range of users in
making economic decisions.
There are three elements of Balance Sheet Assets, Liability and Equity.
An asset is a resource legally owned by the enterprise as a result of past
events and from which future economic benefits are expected to flow to the
enterprise. A liability is a present obligation of the enterprise arising from
past events, the settlement of which is expected to result in an outflow from
the enterprise of resources embodying economic benefits. Equity is the
excess of assets over liabilities.
There are two elements of Profit and Loss Account Income and Expense.
Income is an inflow of economic benefits or enhancement of assets or
decrease of liabilities resulting in increases in equity. Expenses are outflow
of economic benefits or depletions of assets or increase/creation of liabilities
resulting in decrease in equity. For example, sale of goods on credit is an
income because it leads to enhancement of assets. Also, a cash sale is an
income as it leads to inflow of economic benefits. Similarly, purchase of raw
materials on credit is an expense (provided the raw material is consumed
during the period) because it results in increase in liabilities and cash
purchases is also an expense as it leads to outflow of economic benefits.
Recognition Criteria of Elements in Financial Statements
An asset is recognized in a financial statement if it satisfies the following two
conditions:
1. The asset has a cost or value that can be reliably measured; and
2. It is expected that future economic benefits will flow to the enterprise out
of the use of that asset.
For example, the investments made by an enterprise in acquiring a building
for official purposes is an asset because future economic benefits will be
derived from the use of that building and the building has a definite cost.
A liability is recognized if the following conditions are satisfied:
1. It is expected that an outflow of resources embodying economic benefits
will result from the settlement of a present obligation, and
2. The amount of settlement can be reliably measured.

The amount at which equity is shown in the balance sheet is dependent on

the measurement of assets and liabilities.
Income is recognized in the financial statement when an increase in future
economic benefits related to an increase in an asset or a decrease of a
liability has arisen that can be measured reliably. Expenses, on the other
hand, are recognized when there has arisen a decrease in future economic
benefits that can be reliably measured and that relate to a decrease in an
asset or an increase of a liability. Expenses are recognized by following the
matching principles (discussed in sub section 1.2). However, when
economic benefits out of an expenditure are expected to arise over several
accounting periods, expenses are to be recognized on a reasonable basis
over the same period. For example, the amount paid to an advertising
agency to carry out advertisements on behalf of a business entity for the
next two years, should be recognised as expense over two accounting
periods either equally or on some other suitable basis (e.g. turnover). On
the other hand, an expenditure is immediately recognized in the financial
statement as expenses if such expenditure is not expected to produce any
future economic benefits. For example, one common expenditure of any oil
extraction business is exploration expenditure. Oil companies spend huge
amount every year on exploration exercises. The benefits of such
exploration exercise normally spread over several accounting periods.
However, if an exploration experiment on a particular oil field proves
abortive, the entire expenditure should be recognized as expenses
immediately.
1.6 The Accounting Equation

In section 1.5, we have stated that a balance sheet has three elements
Assets, Liabilities, and Equity. We have also stated that equity is the
residual interest of owners in assets over liabilities. Thus, the relationship
among these three elements of the balance sheet can be expressed with
the help of an equation, known as the Fundamental Accounting Equation:
(1)..
Assets (A) = Liabilities (L) + Equity (E)
The above equation has a unique feature in the sense that all business
transactions will affect the equation in such a way that either the equality will

be maintained or a new equality be achieved. This is possible because of

the operation of the double entry concept. Every business transaction can
be explained in terms of its effect on the accounting equation.
The increase in owners equity (E) can normally occur in the following
situations:
(a) There has been a fresh injection of funds by the owners (e.g. in terms of
equity capital in case of a corporate entity).
(b) There has arisen a surplus (excess of income over expenses).
Infusion of funds by owners is an occasional feature and not a recurring
phenomenon. Thus, if, for the sake of simplicity, we consider only situation
(b) to be the cause of a change in owners equity, the equation (1) can be
written as:
(2)..
A= L + EO+(Y-X)
Where, EO is the equity at the beginning of an accounting period, Y is the
income recognized in the same accounting period and X is the expenses
recognized during that period.
8. A balance sheet has three elements Assets, ________, and Equity.
9. _________ is the residual interest of owners in assets over liabilities.
10. Complete the following Fundamental Accounting Equation.
Assets (A) = _________ + Equity (E)
1.7 Summary
Accounting involves recording, classifying and summarizing, in a
meaningful way, transactions and events which are of a financial
character, and interpreting the results thereof.
Basic accounting concepts are ground rules for financial accounting.
These concepts are very vital for understanding the process of
accounting.
Double entry accounting demands that each debit should have an
equal and opposite credit. The transactions and events are recorded in
books of accounts by following double entry accounting.

The Accounting trail shows the process of accounting. Accounting

function initiates with the recording of transactions and events and ends
with the presentation of financial statements.
Financial statements consist of the Balance Sheet, Profit and Loss
Account, and the schedules and notes forming part thereof.
The Accounting equation shows the relationship of different elements
of a balance sheet.
Fundamental Accounting Assumptions: Going concern, consistency,
and accrual are the three fundamental accounting assumptions. These
underlie the preparation and presentation of financial statements.
Debit: It is derived from the Latin word debeo meaning owned to me,
the proprietor
Credit: It is derived from the Latin word `credo meaning trust or believe
Asset: An asset is a resource legally owned by the enterprise as a
result of past events and from which future economic benefits are
expected to flow to the enterprise.
Liability: A liability is a present obligation of the enterprise arising from
past events, the settlement of which is expected to result in an outflow of
resources embodying economic benefits from the enterprise.
Income: It is an inflow of economic benefits or enhancement of assets
or decrease of liabilities resulting in increase in equity.
Expenses: Expenses are an outflow of economic benefits or depletion
of assets or increase/creation of liabilities resulting in decrease in equity.
Equity: It is the residual interest of owners in assets over liabilities.

1. Study and evaluate the accounting trail of a manufacturing organization.
2. Briefly explain the Entity Concept and Money Measurement Concept
of accounting.
3. What are the elements of financial statements? Explain, in brief, the
recognition criteria of elements of financial statements.
4. What is double entry accounting?

1.9 Answers to SAQs and TQs

1. Partnership
2. A corporate entity
3. The Accrual Concept
4. The Going Concern Concept
5. Event
6. Transactions
7. The journal voucher
8. Liabilities
9. Equity
10. Liabilities (L)
Terminal Questions:
1. Open ended
2. Refer to 1.2.1 & 1.2.2
3. Refer to 1.5 & 1.5.1
4. Refer to 1.3

Unit 2 Primary Books

Structure:
2.1 Introduction
Objectives
2.2 Ground Rules of Journalisation
2.3 Types of Journals
2.4 Summary
2.6 Answers
2.1 Introduction
A primary book is a book of first entry or prime entry. When a happening
satisfies the nature of transaction or an event, the first place of recording the
transaction is the primary book. If a transaction is omitted from recording in
the primary book, the transaction will not have any reflection in the
subsequent accounting process. Therefore, recording in primary books is an
essential step in the accounting process. The primary books are popularly
known as journals. The accounting equation, as discussed in section 1.6 of
Unit I, shows that each transaction has a dual effect. The steps involved in
Journalisation of transaction are as follows:
1. Identify a transaction or an event.
2. Identify the elements of the transaction.
3. Apply the ground rule of Journalisation to confirm the dual effect.
4. Journalise, i.e. record in the primary books.
The double entry concept states that every transaction has two aspects
debit and credit. If one element of the transaction is debited, another
element will undoubtedly be credited to maintain the dual effect.
Objectives:
After studying this unit you will be able to:
explain Ground rules of journal entry.
explain various types of journals.
prepare cash book.

2.2 Ground Rules of Journalisation

The following ground rules should be followed in recording the elements of
transactions in journals:
1. Increase in assets and decrease in liabilities (also equity) = Debit
2. Decrease in assets and increase in liabilities (also equity) = Credit
3. Expenses and losses = Debit
4. Income and gains = Credit
A typical journal has the following format:
Journal
Voucher Ledger Dr. Cr.
Date Particulars
No. Folio Amount Amount
Rs. Rs.
Let us now see how transactions are recorded in the journal by following the
ground rules with the help of the following illustration:
Illustration 1
Mr. X started business on 1st January 2007 with Rs. 50,000. He entered
into the following transactions during January 2007:
Jan. 2 Purchased furniture worth Rs. 20,000
Jan. 3 Purchased goods worth Rs. 1,00,000 paying Rs. 15,000 cash and
balance payable after three months.
Jan. 4 Sold goods for cash worth Rs. 25,000
Jan. 6 Paid rent for hiring office space Rs. 5,000
Jan. 10 Purchased stationery worth Rs. 2,500
Jan. 15 Sold goods on credit Rs. 1,20,000
Jan. 20 Amount received from a customer Rs. 19,500 in full settlement of
his owings of Rs. 20,000
Jan. 21 Advertisement expenses incurred Rs. 2,500
Jan. 25 Advance paid to a supplier Rs. 10,000
Jan. 31 Paid salary for the month Rs. 20,000
Transaction No. 1: Jan 1, Capital introduced into the business by the

owner Rs. 50,000:
The two elements present in the transaction are:
i) Cash, and
ii) Owners capital (or simply capital/equity). The transaction has resulted
in an increase in cash (an asset) and an increase in capital (or equity).
As per ground rule (a) increase in asset is debit and as per ground
rule (b) increase in equity is credit. Thus, cash is to be debited and
capital is to be credited.
Journal
Date Particulars
Rs. Rs.
Jan 1 Cash Account Dr. 50,000
To capital Account 50,000
(Capital contributed by
Mr.X)
Transaction No. 2: Jan. 2, Purchased furniture worth Rs.20,000

Two elements are: (i) Furniture (asset), and (ii) Cash (asset)
The transaction has resulted in an increase in one asset (furniture) and
decrease in the other asset (cash). By applying the ground rule the
following journal entry is passed:
Journal

Date Particulars
Rs. Rs.
Jan 2 Furniture Account Dr. 20,000
To cash Account 20,000
(Purchased)
furniture in cash)
Transaction No. 3: Jan. 3, Purchased goods worth Rs.1,00,000 paying
Rs.15,000 cash and balance payable after three months:
The elements are:
i) Purchases of goods (expenses)
ii) Cash (asset), and
iii) Creditors or suppliers (liability)
The transaction has resulted in an increase in expense (debit), a decrease

in assets (credit) and an increase in liabilities (credit). Here we have two
credits and one debit but the effect is such that the summation of the two
credits is exactly equal to the debit.
Journal
Voucher Ledger Dr.Cr.

Date Particulars
Rs. Rs.
Jan 3 Purchases Account Dr. 1,00,000
To cash Account 15,000

To creditors Account 85,000
(Goods purchased worth
Rs.1,00,000 partly paid in cash )
Transaction No. 4: Jan. 4, sold goods for cash Rs.25,000

The elements are: (i) cash (asset), and (ii) Sales (income)
There has been an increase in assets (debit) and an increase in income
(credit).
Journal
Date Particulars
Rs. Rs.
To Sales Account 25,000
(sold goods for cash)
Transaction No. 5: Jan. 6, paid rent for hiring office space Rs. 5,000
The elements are: (i) Rent (expenses) and (ii) Cash (asset). The transaction
has resulted in an increase in expenses (debit) and a decrease in assets
(credit).

Journal
Date Particulars
Rs. Rs.
Jan 6 Rent Account Dr. 5,000
To Cash Account (Office rent paid) 5,000
Transaction No. 6: Jan 10. Purchased stationery worth Rs.2,500

The elements are: (i) Stationery (expenses) and (ii) Cash (asset). There has
been an increase in expense (debit) and a decrease in assets (credit).
Journal
Date Particulars
Rs. Rs.
Jan 10 Stationery account Dr. 2,500
To Cash Account 2,500
(Purchased stationery items)
Transaction No. 7: Jan. 15 Sold goods on credit Rs.1,20,000

The elements are: (i) Debtors/Customers (assets), and (ii) Sales (income).
The transaction has resulted in an increase in assets (debit) and also an
increase in income (credit).
Journal
Date Particulars
Rs. Rs.
Jan 15 Debtors account Dr. 1,20,000
To Sales Account 1,20,000
(Credit sale of goods)
Transaction No. 8: Jan. 20. Amount received from a customer Rs.19,500

in full settlement of his owings of Rs.20,000:
The elements are: (i) Cash (asset), (ii) Discount (expenses), and
(iii) Debtors (assets). There has been an increase in assets, i.e. cash

(debit), an increase in expenses i.e., discount allowed (debit), and a

decrease in assets i.e. debtors (credit).
Journal
Date Particulars
Rs. Rs.
Discount Account Dr. 500
To Debtors Account 20,000
(cash received from a
customer in full settlement of
his dues of Rs. 20,000)
Transaction No. 9: Jan 21, Advertisement expenses incurred Rs.2,500

The elements are: (i) Advertisement (expenses) and (ii) Cash (asset)
There has been an increase in expenses (debit) and decrease in assets
(credit).
Journal
Date Particulars
Rs. Rs.
Jan 21 Advertisement Exp 2,500
Account Dr.
(Advertisement expenses
Incurred)
Transaction No. 10: Jan 25. Advance paid to a supplier Rs. 10,000
The elements are: (i) Cash (asset) and (ii) Advance to suppliers (asset)
There has been an increase in one asset (debit) and decrease in the other
asset (credit).

Journal
Date Particulars
Rs. Rs.
Jan 25 Advance to suppliers 10,000
Account Dr.
(Advance paid to suppliers)
Transaction No. 11: Jan. 31 Paid salary for the month Rs. 20,000
The elements are: (i) Salary (expenses) and (ii) cash (asset)
There has been increase in expenses (debit) and decrease in assets
(credit).
Journal
Date Particulars
Rs. Rs.
Jan 31 Salary Account Dr. 20,000
(Salary paid for the month)

1. ___________ is a book of first entry or prime entry.
2. If one element of the transaction is debited, another element will
undoubtedly be credited to maintain ___________.
3. While recording the elements of transactions in journals, increase in
assets and decrease in liabilities are shown as ___________.
2.3 Types of Journals

In actual practice, Journalisation does not mean recording of transactions in
only one format of journal. The transactions are categorized as per their
nature and, for each type of transaction, a separate journal is available

where the same has to be recorded. These journals can be of the following
types:
(a) Purchases Day Book : It records credit purchase of merchandise.
(b) Sales Day Book : It records credit sale of goods.
(c) Return Outward Book : It records goods returned to the supplier(s).
(d) Return Inward Book : It records goods returned by the customer(s).
(e) Bills Receivable Book : It records bills accepted by customers.
(f) Bills Payable Book : It records bills raised by suppliers.
(g) Cash Book : It records cash (and bank) receipts and
payments.
(h) Journal Proper : It records all residual transactions.
The formats of the above journals will be discussed in subsequent
paragraphs. All these journals are called day books because transactions
are recorded here date-wise.
a) Purchases Day Book
It records credit purchase of raw materials (in case of a manufacturing
concern), or of goods traded (in case of trading concern). In the illustration
given above, only the transaction of January 3 can be recorded in this book
as below:
Voucher Ledger
Date Particulars Amount
No. Folio
Rs.
Jan 3. M/s.
Purchased goods 85,000
From this purchase day book, the amount of Rs.85,000 will be posted
subsequently in the secondary book, i.e. the ledger. This will be discussed
in the next unit.
b) Sales Day Book
It records credit sale of traded goods. It is necessary to distinguish between
sale of goods and sale of assets. For example, in case of a carpenter,
selling of furniture on credit will be recorded in sale day book because
furniture is the goods traded by the carpenter, whereas if a cloth merchant
sells his furniture on credit, the same will not be recorded in the sales day
book as it is a sale of an asset. From the illustration given above, the
transaction of January 15 can be recorded in this book as below:
Sales Day Book

Voucher Ledger
No. Folio
Rs.
Jan 15 M/s.
Sold Goods 1,20,000
c) Return Outward Book

It is also known as purchases return book. It records goods returned to the
suppliers. Goods may be returned to the suppliers either because of excess
supplies or because of defective supplies.
Example: Goods returned to the supplier MN Ltd. Consisting of 10 packets
of Vanaspati Oil costing Rs.43 per packet because of defective container
design.
Return Outward Book
Voucher Ledger
No. Folio
Rs.
Jan 15 M/s MN Ltd.
10 packets of Vanaspati
Oil @ Rs.43 per packet 430
d) Return Inward Book

Also known as the sales return book. It records goods returned by
customers. Normally customers are given a time during which they can
return the goods for any valid reason.
Example: A customer M/s. AB & Co., returned 5 pieces of T.V. sets sent in
excess of order. The selling price of each T.V. set was Rs.11,000.
Return Inward Book
Voucher Ledger
No. Folio
Rs.
Jan M/s AB & Co. 55,000
5 pcs.of TV sets @
Rs.11,000 each returned

The above entry in the return inward book will be posted in the ledger by
debiting the Return Inward Account and crediting the Customers Account.
This will be discussed in the next chapter.
e & f) Bills Receivable and Bills Payable Books
A bill of exchange is documentary evidence in writing, containing an
unconditional order signed by the maker, directing a certain person to pay a
certain sum of money only to, or to the order of, a certain person, or to the
bearer of the instrument. A bill of exchange becomes legally valid only after
its acceptance. A bill of exchange accepted by a customer is called Bills
Receivable and a bill of exchange drawn by a supplier on the business
entity is called Bills Payable. These books record bills accepted by
customers and drawn by suppliers date-wise. These books help a business
unit to easily find out which bill has become matured on a particular date
and, therefore, it becomes easier to keep track of the bills.
The formats of these books are as below:
Bills Receivable Book

Date of V. Party from Date of Due Place of Amount L.F.
receipt No. whom received Bill date Payment Rs.
Bills Payable Book

Date of Drawn Date of Due Place of Amount L.F.
acceptance Bill Date Payment Rs.
g) Cash book
It records daily cash (including bank) receipts and payments. Its unique
feature is that it serves the purpose of both a book of prime entry and a
book of secondary entry. In other words, the cash book is a journal as well
as a ledger. The simplest form of the cash book is a single column cash
book which records only cash (no bank) receipts and payments. The double
column cash book has two amount columns on either side one for cash

and the other for bank. It may be mentioned here that if a business unit has
more than one bank account (which is quite common), a separate column
should be devoted to each bank account. The highest form of cash book is
a triple column cash book one column for cash, the second column for
bank and the third column for discount. A typical triple column cash book
looks like below:
Cash Book
Dr. Cr.
Date Parti- V.No. L.F. Cash Bank Dis- Date Parti- V.No. L.F. Cash Bank Dis-
culars count culars count
Rs. Rs. Rs. Rs. Rs. Rs.
The cash book is divided vertically into two equal sides the left hand side
(called the debit side) shows cash and bank receipts and discounts allowed,
and the right hand side (called the credit side) shows cash and bank
disbursements and discounts received. The ledger folio indicates the folio-
number of the secondary book where a particular item is subsequently
posted to complete the dual effect.
The importance of cash book is paramount. The final balance at the end of
an accounting period in the cash column indicates the cash balance in hand
and the same should actually tally with the physical cash balance. If
physical cash balance does not tally exactly with the balance of the cash
book, an inquiry must be made into the discrepancy. There may be a
possibility of defalcation of cash. In case of a statutory audit of banks, the
first step of audit is cash verification. The auditors are supposed to visit the
branch on the first day of the accounting year, before the bank opens its
operations for the day. Cash is physically counted either fully or through
test checks and the auditors should satisfy themselves about the
authenticity of the cash balance shown in the cash book.
The balance in the bank column represents the balance (favorable or
unfavorable) with the bank. If the debit side of the bank column is greater
than the credit side, the balance is a favorable balance. On the other hand

if the credit side of bank column is greater than the debit side, the balance is
an unfavorable balance (called bank overdraft). The balance in the bank
column of the cash book normally does not tally with the balance shown by
the concerned bank. There may be several reasons for such disagreement.
These will be discussed later. But before the bank balance as per cash book
is considered as correct, an in-depth study of the details furnished by the
bank is normally made to ensure that there is no error in the cash book.
Such analysis is done with the help of a statement called the Bank
Reconciliation Statement.
The discount column of the cash book is not balanced. On the contrary,
discount columns of both sides are totaled and shown separately. The debit
side total of the discount column represents discounts allowed to customers
and, hence, it is an expense. The credit side total of the discount column
represents discounts earned from suppliers and, hence, it is an income.
The process of recording in the cash book is explained with the help of an
illustration.
Illustration 2
Given below are the cash and bank transactions of Zupiter Ltd. for the
month of April 2007:
2007
April 1 Opening balance cash Rs.15,200; bank Rs.45,750
April 3 Received a cheque from Mars Ltd., a customer, of Rs.22,850 in full
settlement of their dues of Rs.23,000.
April 4 Withdrew cash from bank Rs.10,000
April 10 Paid salaries by cash Rs.20,500
April 12 Issued cheque to Neptune Ltd., a supplier, of Rs.46,500 in full
settlement of his claim of Rs.47,000
April 15 Cheque received from Mars Ltd., dishonoured by bank.
April 20 Cash received from Pluto Ltd. Rs.15,500
April 25 Collected a cheque from M/s. Ghaziabad Mkt. Rs.16,700 in
settlement of their dues of Rs.17,000
April 30 Deposited Rs.5,000 to bank.
Prepare a triple column cash book.

CASH BOOK
Date Particulars V L Cash Bank Dis- Date Particulars V L Cash Bank Discount
count
N F N F
O O
2007 Rs Rs Rs 2007 Rs Rs Rs
April April
1 To opening 15,200 45,750 4 By cash A/c 10,000
Balance (withdrawal for
Office use
3 To Mars Ltd 22,850 150 10 By salaries A/C 20,500
(Ch.for total (salaries paid)
Dues of Rs.
23000 less
Discount
Rs.150
4 To Bank A/c.(c) 10,000 12 By Neptune Ltd 46,500 500
A/c (iissued
(withdrawal as
cheque for total
Per contra) claim of
Rs.47,000 less
Discount
Rs.500)
20 To Pluto Ltd 15,500 15 By Mars Ltd 22,850

A/c
A/c. cash
(Cheque
received
dishonoured
25 To M/s. 16,700 300 30 By Bank A/c 5,000
Ghaziabad (c )
Mkt.A/c,.
(Deposit as per
collected a
cheque of Contra)
Rs. 16,700 net
of
Discount of
Rs. 300
30 To cash A/c (c 5,000 30 By closing 15,200 10,950
(Cash balance
deposited
40,700 90,300 450 40,700 90,300 500
th th
Note: On 4 April 2007 and 30 April 2007 two contra entries were passed.
Contra entries (denoted by c) are those entries which affect both sides of
the cash book.
Sometimes, an additional cash book is maintained to relieve the main cash
book of the pressure of items of small amounts. Such a cash book is known
as the petty cash book. This is maintained on an imprest cash basis. It
means at the beginning of the petty cash book to met petty expenses. As
soon as the amount is exhausted, the same is replenished from the main
cash book. At any particular point of time, therefore, the cash balance will
consist of balance in the cash column of the main cash book plus the
balance in the petty cash book.
h) Journal Proper
It is the book of orphan entries. That means that, if a transaction does not
find a place in any of the seven primary books mentioned in illustration 1,
the same will be recorded in the journal proper. The following transactions
and events are recorded in the journal proper:
(a) Credit purchase and sale of assets.
(b) Opening entries: At the beginning of an accounting period, the balances
of elements appearing in the balance sheet of the immediately
preceding year are carried forward with the help of a journal entry.
(c) Adjustment and Rectification Entries: Year-end adjustments and
rectification of errors are done in the journal proper. In a real business
situation a large number of adjustment entries are passed on the last
day of the accounting year.
(d) Closing entries.
(e) Any other non- cash transactions not finding a place elsewhere.
4. _____________ records goods returned by the customer(s).
5. __________ records all residual transactions.
6. __________ records credit sale of goods.
7. ____________ records cash (and bank) receipts and payments.
8. Sometimes, an additional cash book is maintained to relieve the main
cash book of the pressure of items of small amounts. Such a cash
book is known as __________.
9. If the credit side of bank column is greater than the debit side, the
balance is an ____________.
2.4 Summary
A primary book is a book of accounts where transactions and events are
recorded in the first instance. Primary books are called journals.
A ground rule is to be followed to record entries in the journals.
There are eight types of primary books.

A cash book is a journal as well as a ledger.

The journal proper is a book of residual entries.
Journal: It is a book of prime or original entry.
Double Entry Concept: Every transaction has two aspects debit and
credit. Each transaction is recorded by giving equal effect to debit and
credit. This is the double entry concept.
Purchases Day Book: It is a primary book which records credit
purchases of merchandise/raw materials.
Sales Day Book: It is a primary book which records credit sales of
merchandise.
Return Outward Book: It records goods returned to suppliers out of
credit purchases.
Bills Receivable Book: It records bills raised on, and accepted by,
customers.
Bills Payable Book: It records bills raised by suppliers.

1. Explain the ground rules of journalisation. Show the format of a typical
journal.
2. What is a journal? What are the different types of journals?
3. State in which journal the following items will be recorded:
(a) Cash purchase of goods Rs. 25,000
(b) Cash purchase of furniture Rs. 30,000
(c) Credit sale of goods Rs. 56,000
(d) Credit sale of furniture Rs. 27,000
(e) Interest accrued on investment Rs. 5,000
(f) Bill accepted by a customer Rs. 7,500
(g) Goods returned by a customer Rs. 3,500
(h) Cheque dishonoured by bank Rs. 2,000
4. Prepare a triple column cash book from the following transactions.
2007
July 1 Opening balance - Cash Rs.26,000; Bank Rs.57,200
July 2 Cash purchases Rs.15,000

July 4 Purchase of goods by cheque gross value Rs.46,000 less

trade discount 2%
July 5 Cash sales Rs.36,000
July 7 Cheque received from customers of Rs.76,500 in full
settlement of dues of Rs.77,000
July 10 Cash withdrawn Rs.10,000
July 15 Payment made to supplier by cheque Rs.54,500, got 1% cash
discount.
July 20 Cheque received from a customer in June 1996 of Rs.75,000
dishonoured.
July 25 Cash deposited Rs.5,600
July 31 Salary paid Rs.10,000 by cash.
2.6 Answers
1. A primary book
2. The dual effect
3. Debit
4. Return Inward Book
5. Journal Proper
6. Sales Day Book
7. Cash Book
8. The petty cash book
9. Unfavorable balance
Terminal Questions
1. Refer to 2.2
2. Refer to 2.1 & 2.3
3. Refer to 2.3
4. Refer to 2.3(g)

Unit 3 Secondary Books

Structure:
3.1 Introduction
Objectives
3.2 Types of Secondary Books
3.3 Posting Techniques in the Ledger
3.4 Summary
3.6 Answers
3.1 Introduction
The main disadvantages of any primary book is that transactions therein are
recorded date-wise and not as per their nature. Thus, if you are an
accountant and your boss wants to know how much is spent on salaries
during a particular year, you have to go through all the pages of the cash
book to finally report the correct figure. This is every time-consuming and
cumbersome. Also, you may find yourself lost in the jungle of entries in the
cash book. As the basic purpose of accounting is to generate meaningful
information in a systemic manner, properly classified, this cannot be
achieved with only primary books. As we all know transactions and events
are raw data. To generate information out or raw data, these are to be
classified in such a manner that necessary information is readily available.
It calls for identifying the nature of various transactions recorded in the
primary books and giving an appropriate name to an identical class of
transactions and, finally, re-recording the transactions in another set of
books according to the defined class. That `another set of books is called
secondary books. It is secondary because transactions are recorded for a
second time. The secondary book is also called a ledger. A ledger is a set
of accounts defined as per the requirements of an organization. An account
records entries of an identical nature. From the secondary book, if you open
the salary account, you can out rightly tell your boss the amount spent
towards salary during an accounting period with an utmost ease.

3.2 Types of Secondary Books

Secondary books (or ledgers) can be broadly classified as follows:
General Ledger is a self-sufficient secondary book in the sense that all

entries in the primary books will be posted, directly or indirectly, in this
ledger. On the other hand, Debtors Ledger has separate accounts for each
customer, and it shows the transactions entered into with the customers
(e.g. sale of goods on credit, collections from customers, goods returned by
customers, discount allowed, bad debts and, finally, balance due from
them). Similarly, Creditors Ledger has a separate account for each supplier,
and it shows the transactions entered into with the suppliers (e.g.,
purchases on credit, cash paid to suppliers, goods returned, discount
received and, finally, the balance due to them). The motive behind having
subsidiary ledgers is to reduce the burden on the main ledger. Otherwise,
the individual customers and suppliers accounts will have to be opened in
the General Ledger.
But, as mentioned earlier, the General Ledger is self-sufficient; two control
accounts are maintained in the General Ledger one for debtors and one
for suppliers. These control accounts are called Sundry (or Total) Debtors
Account and Sundry (or Total) Creditors Account. These control accounts
are summarised versions of individual accounts maintained in the subsidiary
ledgers. Therefore, at any particular point of time the summation of the
balances of the debotrs ledger must tally with the balance shown by sundry
debotrs account in the General Ledger. Similarly, the summary of balances
of creditors ledger should tally with the balance shown by sundry creditors
account in the General Ledger. Hence, these accounts in the General
Ledger put a check on the accuracy of the subsidiary ledgers. One

important feature of these control accounts in the General Ledger is that

entries are not posted here individually. Normally, transactions with
customers or suppliers for a period of time (may be a week or a month) are
totalled and only one posting is made for that period.
1. ________ is a self-sufficient secondary book in the sense that all
entries in the primary books will be posted, directly or indirectly, in this
ledger.
2. __________ will have separate accounts for each customer.
3. One important feature of control accounts in the General Ledger is that
___________.
4. The summary of balances of creditors ledger should tally with the
balance shown by _________ in the General Ledger.
3.3 Posting Techniques in the Ledger

Let us take the illustration given illustration 1 of unit 2 and show how the
entries are posted from the journal to the ledger.
GENERAL LEDGER
Capital Account
Dr. Cr.
Date Particulars JF Amount Date Particulars JF Amount
Rs. Rs.
To balance c/d 50,000 Jan 1 By Cash 50,000
50,000 50,000
Note: It may be noted here that an account has two equal sides the left
hand side (the debit side) and the right hand side (the credit side). The `JF
column on either side stands for Journal Folio- the page number of the
journal from which a particular entry is posted. The use of the words `To
and By on the debit and credit side, respectively, of the account is
customary. The journal entry on Jan 1 shows that the owner has introduced
cash (i.e. capital into the business and, as per the journal the capital
account, is credited. Therefore, the posting will be made on the credit side
of the capital account.

Furniture Account
Dr. Cr.
Rs. Rs.
Jan 2 To cash Account 20,000 By Balance c/d 20,000
20,000 20,000
The journal records show that the Furniture Account is debited and the
same has been acquired by cash. Therefore, the entry is posted on the debit
side of the Furniture Account.
Purchases Account
Dr. Cr.
Rs. Rs.
Jan 3 To cash 15,000 By Balance c/d 1,00,000
Account 85,000
To Creditors
Account 1,00,000 1,00,000
Creditors Account
Dr. Cr.
Rs. Rs.
To Balance c/d 85,000 Jan 3 By purchases
Account 85,000
85,000 85,000
You must have noticed from the journal record that on Jan. 3 the creditors
account is credited by Rs. 85,000. So, in the ledger we have credited the
creditors account by the same amount. Do not commit the mistake of
crediting the account by the full amount of the purchases, i.e. Rs.1,00,000

Sales Account
Dr. Cr.
Rs. Rs.
To Balance c/d 1,45,000 Jan 4 By cash Account 25,000
Jan 5 By Debtors
Account 1,20,000
1,45,000 1,45,000
You must have noticed by now that, while making postings in the General
Ledger in a particular account, the name of the other account is written. For
example, in Jan 4 the journal record shows the following entry:
Cash Account Dr. Rs.25,000
To Sales Account Rs.25,000
While posting in the sales account in the ledger we have mentioned By
cash Account; on the credit side. It shows the reason for crediting the sales
account.
Rent Account
Dr. Cr.
Rs. Rs.
5,000 5,000
Stationery Account
Dr. Cr.
Rs. Rs.
2,500 2,500
You must have also noticed that in each account we have used a common
statement (Balance c/d,) on that side (debit or credit) of the account where
there is no amount and put the total of the other side of the account in the

amount column. This is called balancing or closing of account. At the end

of the accounting period, the accounts in the General Ledger cannot be left
open. They are to be closed. The mechanism of `closing involves totaling
that side of the account which is greater in amount and then putting the
difference between that side and the other side as the balancing figure to
square off the account. The suffix `c/d denotes carried down, which
indicates that the balance has been carried down for the next period
pending settlement. Thus, if the total of the debit side of an account is
greater than credit side, the difference is put on the credit side and the same
is called a debit balance (i.e., debit is greater). Similarly, if the credit side of
an account is greater, the difference is put on the debit side and the same is
called a credit balance (i.e., credit is greater). For example, the balance of
the Sales Account as shown above is a credit balance and the balance in
the Rent Account is a debit balance.
Debtors Account
Dr. Cr.
Rs. Rs.
Jan 15 To Sales 1,20,000 Jan 20 By Cash Account 19,500
Account By Discount A/c 500
By Balance c/d 1,00,000
1,20,000 1,20,000
Discount Account
Dr. Cr.
Rs. Rs.
Jan 20 To Debtors 500 By Balance c/d 500
Account
500 500

Advertisement Expenses Account

Dr. Cr.
Rs. Rs.
Jan 21 To cash 2,500 By Balance c/d 2,500
Account
2,500 2,500
Advance to Suppliers Account

Dr. Cr.
Rs. Rs.
Jan 25 To cash 10000 By Balance c/d 10,000
Account
10000 10,000
Salary Account
Dr. Cr.
Rs. Rs.
Jan 31 To cash 20,000 By Balance c/d 20,000
Account
20,000 20,000
It can be seen that no account is opened to record cash entries in the

General Ledger. This is because cash entries are recorded in a journal
(cash book) which also serves the purpose of a ledger. If you want to find
out at the end of January how much cash is left in the business, you have to
refer to the cash book.

Cash Book (Single Column)

Dr. Cr.
Date Particulars V L.F Amount Date Particulars V L.F. Amount
No. Rs. No. Rs.
Jan 1 To capital 50,000 Jan 2 By Furniture 20,000
Account Account
Jan 4 To sales 25,000 Jan 3 By Purchases 15,000
Account Account
Jan 20 To Debtors 19,500 Jan 6 By Rent Account 5,000
Account By Stationery
Jan 10 Account 2,500
By
Jan 21 Advertisement 2,500
Exp. Account
By Advance to
Jan 25 Suppliers 10,000
Account
By salary 20,000
Account
Jan 31
By Balance c/d 19,500
94,500 94,500
Here, the cash book is maintained in a single column. That is why the
discount account is shown in the General Ledger. If the discount column is
maintained in the cash book then it is not necessary to open a discount
account in the General Ledger.
Let us take another comprehensive illustration to show how entries are
recorded in various journals and then posted to different ledgers.
M/s. XYZ enter into the following transactions during August 2006.
Aug. 1 Purchased goods from M/s. ABC at 60 days credit 25,70,000
Aug. 2 Cash purchases of goods 1,25,000
Aug. 4 Sold goods to Kiran Kumar & Sons for 30 days credit 10,75,000
Aug. 6 Purchased goods from M/s. QRS at 30 days credit 15,25,500
Aug. 7 Accepted a bill drawn by M/s. ABC for supplies 25,70,000
Aug. 8 Bills raised on Kiran Kumar & Sons accepted 10,75,000
Aug. 10 Cash sales 2,25,000
Aug. 12 Sold goods to M/s. Ahmed Bros. for 45 days credit 18,25,000
Aug. 15 Purchased stationery items 75,500

Aug. 18 Sold goods to M/s. Akbar Khan & Sons 5,65,000

Aug. 19 Purchased goods from Tuhin & Sons 6,25,000
Aug. 20 Cash received from M/s. Akbar Khan & Sons 2,25,000
Aug. 21 Cash paid to Tuhin & Sons 1,50,000
Aug. 23 Goods returned by Ahmed Bros. 45,000
Aug. 25 Goods returned to Tuhin & Sons 50,500
Aug. 26 Sold goods to Kakkar & Sons 12,74,000
Aug. 27 Purchased goods from Mankad Bros. 8,76,000
Aug. 28 Cash received from Kakkar & Sons 2,65,000
Aug. 29 Cash paid to Mankad Bros 1,67,000
Aug. 30 Salary paid to staff 2,34,000
Aug. 31 Furniture purchased from Ram Kumar & Sons at 15 days
credit 1,25,000
Opening cash balance at the beginning of August 1,05,000
Solution: We shall start with recording in the primary books.
Cash Book (Without narration)
Dr. Cr.
Date Particulars V J.F Amount Date Particulars V LF. Amount
No. Rs. No. Rs.
Aug 1 To Balance b/d 1,05,000 Aug.2 By Purchase A/c 1,25,000
Aug 10 To sales A/c 2,25,000 Aug 15 By stationery A/c 75,000
Aug 20 To M/s, Akbar 2,25,000 Aug 21 By Tuhin & Sons 1,50,000
Khan & Sons A/c Aug 29 A/c 1,67,000
Aug 25 To Kakkar & Sons 2,65,000 Aug 30 By Mankad Bros 2,34,000
A/c Aug 31 A/c 68,500
By salary A/c
By Balance c/d
8,20,000 8,20,000
Note:
1. The suffix b/d/ denotes brought down. It shows the balance brought
down in the cash book from the previous month. As a rule, the opening
balance in any account starts with the suffix b/d and the closing
balance with the suffix c/d
2. A/c is an abbreviation of Account

Purchase Day Book

Date Particulars V.No. L.F. Amount
Rs.
Aug 1 M/s. ABC Goods purchased 25,70,000
Aug 6 M/s QRS Goods purchased 15,25,500
Aug 19 M/s. Tuhin & Sons Goods purchased 6,25,000
Aug 27 Mankad Bros. Goods purchased 8,76,000
55,96,500
Sales Day Book

Rs.
Aug 4 M/s. Kiran Kumar & Sons sold goods 10,75,000
Aug 12 M/s Ahmad Bros sold goods 18,25,000
Aug 18 M/s. Akbar Khan & Sons sold goods 5,65,500
Aug 26 M/s Kakkar & Sons sold goods 12,74,000
47,39,500
Return Outward Book

Rs.
Aug 25 Tuhin & Sons Goods returned 50,500
50,500
Return Inward Book

Rs.
Aug 23 M/s, Ahmed Book Goods returned 45,000
45,000
Bills Receivable Book

Date V.No. Party from Date of Due Place of Amount LF
whom received Bill Date Payment Rs.
Aug 8 Kiran Kumar & Sons Sept. 11 10,75,000
10,75,000

Bills Payable Book

Date of Drawer Date of Due date Place of Amount LF
acceptance Bill Payment Rs.
Aug 7 M/s ABC Oct. 10 25,70,000
25,70,000
Journal Proper
Date Particulars V.No. L.F. Dr. Amount Cr. Amount
Rs. Rs.
Aug 31 Furniture A/c 1,25,000
To Ram Kumar & Sons
(Furniture purchased at 1,25,000
15 days credit
Due date is normally calculated after giving 3 days grace from the date of
maturity. In this case the bill accepted by Kiran Kumar & Sons was due to
mature on 8th September. So after adding 3 days of grace, the due date is
arrived at. If it is found that the due date is a public holiday then
automatically the day immediately before the public holiday will be the due
date. For example, if the due date falls on 15th August in any case,
automatically for practical purposes the due date will be considered to be
14th August. On the other hand, if the due date happens to be a holiday by
accident, then the immediate next day will be considered as the due date.
After recording every entry in the primary book we shall see how the
postings are done in the secondary book, i.e., the ledger. We shall show
the postings in both the General Ledger and the subsidiary ledgers.
GENERAL LEDGER
Purchase Account
Dr. Cr.
Rs. Rs.
Aug 1 To M/s ABC A/c 25,70,000 Aug 31 By Balance c/d 57,21,500
Aug 2 To cash A/c 1,25,000
Aug 6 To M/s. QRS A/c 15,25,500
Aug 19 Tuhin & Sons A/c 6,25,000
Aug 27 Mankad Bros A/c 8,76,000
57,21,500 57,21,500

Note:1. In purchase and sales accounts, instead of showing each credit

purchase and credit sales entry separately, total credit purchases & sales
for the month can be posted from the day books.
Sales Account
Dr. Cr.
Rs. Rs.
Aug 31 To Balance c/d 49,64,500 Aug 4 By Kiran Kr.& 10,75,000
Sons A/c
Aug 10 By Cash A/c 2,25,000
Aug 12 By Ahmad Bros 18, 25,000
A/c
Aug. 18 By Akbar Khan & 5,65,500
Sons A/c
Aug 26 By Kakkar & Sons 12,74,000
A/c
49,64,500 49,64,500
Return Outward Account

Dr. Cr.
Date Particulars J Amount Date Particulars JF Amount
F Rs. Rs.
Aug 31 To Balance c/d 50,000 Aug 25 By Tuhin & Sons 50,000
50,000 50,000
Return Inward Account

Dr. Cr.
Rs. Rs.
Aug 23 To Ahmed 45,000 Aug 31 By Balance 45,000
Bros A/c c/d
45,000 45,000

Total Debtors Account

Dr. Cr.
Rs. Rs.
Aug 30 To Sundries * 47,39,500 Aug 8 By Bills
Receivable A/c 10,75,000
By Cash A/c
Aug 20 By Return 2,25,000
Aug 23 Inward
A/c 45,000
By Cash A/c 2,65,000
Aug 28 By Balance c/d 31,29,500
Aug 31
47,39,500 47,39,500
* It is the total of credit sales during August taken from the Sales day book.
Total Creditors Account

Dr. Cr.
Rs. Rs.
Aug 7 To Bills payable A/c 25,70,000 Aug 1-30 By Sundries A/c* 55,96,500
Aug 25 To Return
Outward A/c 50,500
Aug 31 To Balance c/d 26,59,000
55,96,500 55,96,500
*It is total of credit purchases during August taken from the Purchases day
book.
Bills Receivable Account
Dr. Cr.
Rs. Rs.
Aug 8 To Kiran 10,75,000 Aug 31 By Balance c/d 10,75,000
Kumar &
Sons A/c 10,75,000 10,75,000

Bills payable Account

Dr. Cr.
Rs. Rs.
Aug 31 To Balance c/d 25,70,000 Aug 7 By M/s ABC A/c 25,70,000
25,70,000 25,70,000
Furniture Account
Dr. Cr.
Rs. Rs.
Aug 31 To Ram Aug 31 By Balance c/d 1,25,000
Kumar & sons 1,25,000
1,25,000 1,25,000
Salary Account
Dr. Cr.
Rs. Rs.
Aug 31 To cash A/c 2,34,000 Aug 31 By Balance c/d 2,34,000
2,34,000 2,34,000
Stationery Account
Dr. Cr.
Rs. Rs.
Aug 15 To stationery A/c 75,500 Aug 31 By Balance c/d 75,500
75,500 75,500

Ram Kumar & Sons Account

Dr. Cr.
Rs. Rs.
Aug 31 To Balance c/d 1,25,000 Aug 31 By Furniture A/c 1,25,000
1,25,000 1,25,000
DEBTORS LEDGER
M/s. Kiran Kumar & Sons Account
Dr. Cr.
Rs. Rs.
Aug 31 To Balance c/d 1,25,000 Aug 31 By Furniture A/c 1,25,000
1,25,000 1,25,000
M/s. Ahmed Bros. Account

Dr. Cr.
Rs. Rs.
Aug 12 To sales A/c 18,25,000 Aug 23 By Return 45,000
Inward A/c

18,25,000 18,25,000
M/s. Akbar Khan & Sons Account

Dr. Cr.
Rs. Rs.
Aug 18 To sales A/c 5,65,000 Aug 20 By Cash A/c 2,25,000
5,65,,000 5,65,000

M/s. Kakkar & Sons Account

Dr. Cr.
Rs. Rs.
Aug 26 To sales A/c 12,74,000 Aug 20 By Cash A/c 2,65,000
12,74,000 12,74,000
CREDITORS LEDGER
M/s. ABC Account
Dr. Cr.
Rs. Rs.
Aug 7 To Bills Payable 25,70,000 Aug 1 By Purchases A/c 25,70,000
A/c
25,70,000 25,70,000
M/s. QRS Account

Dr. Cr.
Rs. Rs.
Aug 31 To Balance c/d 15,25,500 Aug 6 By Purchases 15,25,500
A/c A/c
15,25,500 15,25,000
M/s. Tuhin & Sons Account

Dr. Cr.
Rs. Rs.
Aug 21 To cash A/c 1,50,000 Aug 19 By Purchases A/c 6,25,000
Aug 25 To Return
Outward A/c 50,500

6,25,000 6,25,000

M/s. Mankad Bros. Account

Dr. Cr.
Rs. Rs.
Aug 29 To cash A/c 1,67,000 Aug 27 By Purchases 8,76,000
A/c
8,76,000 8,76,000
You may see that the summation of balances in individual accounts of

debtors ledger is equal to the balance in the total debtors account, and the
sum of balances in the creditors ledger is equal to the balance in the total
creditors account.
You may feel confused about why same entries are posted in the total
debtors account, and in individual debtors accounts in the debtors ledger.
This repetition is because of the fact that the total debtors account is a
summarized version of the debtors ledger.
5. State whether the following statements are True or False:
a) At the end of the accounting period the accounts in the General
Ledger can be left open.
b) Summation of balances in individual accounts of debtors ledger is
equal to the balance in the total debtors account.
c) As a rule, the opening balance in any account starts with the suffix
b/d and the closing balance with the suffix c/d.
d) If the total of the debit side of an account is greater than credit
side, the difference is put on the credit side and the same is called
credit balance.
3.4 Summary
A secondary book is a set of accounts defined as per the requirements
of an organization. Entries are posted from the primary books to the
secondary book under appropriate account heads. The secondary book
is also called the ledger.

There are broadly two types of ledgers the General Ledger and the
subsidiary ledger. The subsidiary ledger is further subdivided into the
Debtors Ledger and the Creditors Ledger. These subsidiary ledgers
contain individual customers and suppliers accounts.
The individual accounts in the secondary books are to be closed at the
end of the accounting period.
Posting: It refers to the recording of transactions from journal to the
ledger.
Ledger: It is a book of secondary entries.
Account: A formal record of a particular type of transaction.
Sundry Debtors Account: It is a control account maintained in the
General Ledger which records transactions of individual customers
accounts in a summarized manner.
Sundry Creditors Account: It is a control account maintained in the
General Ledger which records transactions of individual suppliers
accounts in a summarized manner.
Balancing: It refers to the closing of the ledger accounts by putting the
balance (i.e., the difference) on the appropriate side of the account.

1. What are the different types of ledgers?
2. Record the following transactions in journals and subsequently post
them to ledgers:
July 1. Opening Cash balance 1,65,500
July 2 Cash sales 2,60,000
July 3 Cash Purchase 3,50,000
July 4 Credit sales to M/s XYZ 10,75,000
July 6 Credit purchases from M/s. ABC 15,25,000
July 8 Cash received from M/s MN in full settlement
of dues of Rs.1,75,000 1,74,900
July 10 Bills raised by M/s ABC accepted 5,25,000
July 12 Bills raised on M/s XYZ accepted 6,50,000
July 15 Credit sales to Hanif & Sons 13,25,000

July 16 Goods returned by M/s XYZ 25,000

July 18 Goods returned to M/s ABC 40,000
July 20 Credit purchases from Sardar Bros 15,65,000
July 22 Goods sold to Anil & Co 18,20,000
July 24 Cash received from Anil & Co 2,65,000
July 25 Rend paid 1,05,000
July 27 Dividend received 15,000
July 30 Salary paid 1,25,000
3.6 Answers
1. General Ledger
2. Debtors Ledger
3. Entries are not posted here individually.
4. Sundry creditors account
5. True/False Answers
a) False
b) True
c) True
d) False
Terminal Questions
1. Refer to 3.2
2. Refer to 3.3

Unit 4 Trial Balance and Final Accounts
Structure
4.1 Introduction
Objectives
4.2 Preparation of the Trial Balance
4.3 Errors and their Rectification
4.4 Final Accounts
4.5 Summary
4.7 Answers
4.1 Introduction
The Arithmetical accuracy of ledger balances can be ascertained only after
they have been put to test. A separate statement is prepared to test the
accuracy of the ledger balances. Such a statement is called the Trial
Balance balances on trial. In the Trial Balance, the closing balances of
the accounts in the General Ledger are shown along with balances from the
cash book. As the primary and secondary books are maintained on the
double entry concept, the balances in the Trial Balance must tally.
The purpose of preparing a Trial Balance is not only to check the
arithmetical accuracy of ledger balances, but also to have an overview of
the operations of the business as on a particular date. A Trial Balance is
prepared not only at the year end but also on weekly, monthly, quarterly and
half yearly basis. These interim Trial Balances are used as control steps.
For example, if the Trial Balance as on 31st January shows the salary figure
at Rs.13.20 lakhs, and the Trial Balance as on 28th February shows the
salary figure at 35.50 lakhs, it must be examined why the salary has
increased significantly whether there has been any salary revision during
February, or fresh recruitments have been made, or there is an accounting
error. It may be mentioned here that the salary figure as per the February
Trial Balance is a cumulative figure; it includes salary for January as well.
A Trial Balance is not a part of books of account. It is drawn as a separate
statement and this becomes the source document for preparing external
financial statement i.e., Profit and Loss Account and the Balance Sheet. A

Trial Balance consists of all the elements of financial statements assets,

liabilities, equity, income and expenses.
Objectives
After studying this unit you will able to
prepare Trial Balance
explain the concept of rectification of errors
prepare final accounts
4.2 Preparation of the Trial Balance

From the comprehensive illustration given in section 3.3 of unit 3, we can
show how the Trial Balance is to be prepared. We make only one additional
assumption that the capital of M/s XYZ as on 1st August 2006 was
Rs. 1,05,000.
st
Trial Balance As on 31 August, 2006
Dr. Cr.
Sl. No. Particulars L.F Amount (Rs) Amount (Rs)
1 Capital A/c 1,05,000
2 Purchase A/c 57,21,500
3 Sales A/c 49,64,500
4 Return Outward A/c 50,500
5 Return Inward A/c 45,000
6 Total Debtors A/c 31,29,500
7 Total creditors A.c 26,59,000
8 Bills Receivable A/c 10,75,000
9 Bills payable A/c 25,70,000
10 Furniture A/c 1,25,000
11 Salary A/c 2,34,000
12 Stationery A/c 75,500
13 Ram Kumar & Sons A/c 1,25,000
14 Cash in hand 68,500
1,04,74,000 1,04,74,000
You have to follow the debit-credit rule to prepare the Trial Balance. For
example, purchases account, being expenses, shows a debit balance and,
hence, the balance is shown in the column for debits. It can be seen that
except item No. 14, all other balances are taken from the General Ledger
only the cash balance is taken from the cash book. The tallied Trial Balance
tells that the ledger balances are properly drawn i.e., there is no casting
error. But a tallied Trial Balance does not necessarily mean that there are
no errors in the books of account. There can be a host of errors in spite of
an agreed Trial Balance. This will be discussed later.
Let us see another Trial Balance.
The following Trial Balance has been drafted by a book keeper for the
preparation of final accounts of a trader. Re-draft the same.
st
Trial Balance for the year ended 31 December, 2006
Dr. Cr.
Sl.No. Particulars L.F Amount (Rs) Amount (Rs)
st
1 Stock on 31 December, 2006 1,92,100
2 Capital A/c 13,450
4 Bank overdraft 9,320
5 Sales 2,36,400
6 Purchases 1,06,400
7 Returns inward 13,400
8 Returns outward 2,960
9 Carriage outward 2,360
10 Carriage inward 14,260
11 Salaries 9,600
12 Wages 3,660
13 Sundry Debtors 16,300
14 Sundry creditors 37,360
st
15 Stock on 1 January 2006 94,120
16 Land & buildings 15,000
17 Plant & Machinery 20,900
18 Trade Expenses 2,090
3,95,540 3,95,540
The above Trial Balance, although tallied, has not been prepared carefully.
For example, the closing stock (as on 31st December) does not normally

figure in the Trial Balance because the closing stock is physically

determined first and then valued. Again, the Trial Balance is prepared as on
a particular date and not for a period.
Let us prepare the Trial Balance properly.
st
Trial Balance for the year ended 31 December 2006
Dr. Cr.
Sl. No. Particulars L.F Amount (Rs) Amount (Rs)
1 Capital A/c 13,450
3 Bank overdraft 9,320
4 Sales 2,36,400
5 Purchases 1,06,400
6 Returns inward 13,400
7 Returns outward 2,960
8 Carriage outward 2,360
9 Carriage inward 14,260
10 Salaries 9,600
11 Wages 3,660
12 Sundry Debtors 16,300
13 Sundry creditors 37,360
st
14 Stock on 1 January 2006 94,120
15 Land & buildings 15,000
16 Plant & Machinery 20,900
17 Trade Expenses 2,090
2,99,490 2,99,490
4.3 Errors and their Rectification

There are certain errors which will disturb the Trial Balance in the sense that
the Trial Balance will not agree. These errors are easy to detect and their
rectification is also simple. For example, if the debit column total of the Trial
Balance exceeds the credit column total, the possibilities may be a casting
error in any account, posting of a wrong amount and a balancing error.
These errors are easy to detect and you can, within a short time, arrive at an

agreed Trial Balance. In the era of advanced information technology, when

you will be using software packages for accounting purposes, the possibility
of these types of errors and consequently, a disagreed Trial Balance is nil.
However, there are certain errors which are not detected through a Trial
Balance. In other words, a Trial Balance would agree in spite of these
errors. These errors are very difficult to detect because you will not be
aware of such errors. The examples of such errors are errors of principle,
errors of omission, errors of commission, compensating errors, etc. An error
committed because of lack of knowledge of the basic accounting principles
is called an error of principle. For example, wages paid for installation of
machinery is debited to Wages Account instead of Machinery Account. If a
transaction is not recorded in the journal, it will not be reflected in the ledger
and subsequently, in the Trial Balance. This is an error of omission. If the
amount received from Mr. X is wrongly posted in the account of Mr. Y, an
error of commission has occurred. Finally, if the effect of one error is set off
by another error, then it is a case of a compensating error. For example, if
the Sales Account is undercast by Rs.10,000 and say, the salary account is
also undercast by the same amount, these errors get cancelled and hence
will not affect the Trial Balance.
Rectification of Errors
Rectification of errors depends on the stage at which the errors are
detected. There are mainly two stages in the accounting process when
errors can be detected:
Stage 1: Before preparation of the Trial Balance.
Stage 2: After the Trial Balance but before preparation of the final accounts.
Stage 1: Before preparation of the Trial Balance
As the Trial Balance is not prepared it implies that the ledger balances are
not drawn, i.e., account is not closed. So, it becomes easy to rectify errors
detected at this stage. There can be two types of errors.
(a) An error affecting only one account or more than one account in such a
way that no journal entry is possible for its rectification;
(b) An error affecting two or more accounts in such a way that a complete
journal entry can be passed for its rectification.

In case of type (a) errors, we have to go to the relevant account(s) and put
the figure on the right side of the account. No journal entry is necessary.
Example:
1. The Sales Account is undercast by Rs.15,000
To rectify this error we have to go to the Sales Account in the General
Ledger and make the rectification as below:
Sales Account
Dr. Cr.
(Rs.) (Rs.)
By Rectification 15,000
2. Goods returned by the customer Mr. X of R 5,650 has been posted in

the Return Inward Account as Rs.5,560 and in Mr. X A/c. as Rs.6,550.
Mr. Xs Account
Dr. Cr.
(Rs.) (Rs.)
To Rectification 900
(6,550 5,650)
Return Inward Account

Dr. Cr.
(Rs.) (Rs.)
To Rectification 90
(5,650- 5,560)
In case of type (b) errors rectifications will be done with the help of a journal
entry. Here, please note that rectification entries are passed in the Journal
Proper.
Example
1. Cash received from Ram posted to Shyam account Rs.7,000. Here both
Rams and Shyams accounts are affected by an equal amount. The
rectification entry to be passed will be:

Shyams Account Dr. 7,000

To Rams Account 7,000
(Cash received from Ram wrongly
Credited to Shyam, now rectified)
2. Salary paid Rs.6,000 has been posted to Rent account
The rectification entry will be:
Salary Account Dr. 6,000
To Rent Account 6,000
(Salary paid wrongly debited to
Rent Account, now rectified)
3. Cash received from Jadu Rs.8,640 has been posted to the debit of
Madhus Account.
Here although both Jadus and Madhus accounts are affected, a journal
entry is not possible for rectification because the error is on the same side of
both the accounts. In order to rectify the error both Jadus and Madhus
accounts are to be credited. So, to rectify the error we have to straightway
open the ledger accounts:
Jadus Account
Dr. Cr.
(Rs.) (Rs.)
Madhus Account
Dr. Cr.
(Rs.) (Rs.)
Truly speaking, this is a type (a) error.

Stage 2: After the trial but before the final accounts
Once the Trial Balance is prepared, all ledger balances are drawn. In that
case, to rectify any error, it should be done in such a way that the Trial
Balance agrees. In other words, if an account is to be debited for
rectification, another account has to be credited by the same amount.

Otherwise, the Trial Balance will not tally. This is possible only if the
rectification is done with the help of journal entries.
So far as type (b) errors of stage 1 are concerned, the process of rectifying
the errors is exactly the same in stage 2 as well. The same journal entries
are to be passed. The difficulty arises with type (a) errors of stage 1. This is
because type (a) errors do not have necessary information to complete a
journal entry. You may note here that type (a) errors are of such a nature
that the Trial Balance will not agree if there exist such errors. Thus, if you
are in a hurry and your Trial Balance is not tallying, you can put the
difference to an artificial account created temporarily and make the Trial
Balance tally. Such an artificial account is called the Suspense Account.
The existence of the Suspense Account in the Trial Balance implies that
there exist type (a) errors.
Once type (a) errors are detected, these are to be rectified by passing
journal entries and, upon rectification of all such errors, the Suspense
Account will be automatically eliminated from the Trial Balance. The
technique for passing journal entries in these cases is to put the Suspense
Account to fill in the unknown side or the difference in amount.
Example
1. Purchase Account undercast by Rs.1,500
Here we have only one account, i.e., purchases account. But to
complete the journal entry, we need at least two accounts. The unknown
side will be taken care of by the Suspense Account. Thus, the
rectification entry will be:
Purchases Account Dr. 1,500
To Suspense Account 1,500
2. Cash received from Ram Rs.650 was debited in his account.
Here, Rams account should have been credited. But erroneously, his
account has been debited. To rectify the error, his account should be
credited by double the amount one for setting off the error and the
other for making the correct entry. Thus, the rectification entry will be:
Suspense Account Dr.1,300
To Rams Account 1,300


a) Rectification entries are passed in the Journal Proper.
b) A journal entry is not possible for rectification when the error is on
the same side of two separate accounts.
c) If you are in a hurry and your Trial Balance is not tallying, you can
put the difference to an artificial account created temporarily and
make the Trial Balance tally. Such an artificial account is called the
Rectification Account.
d) If an account is to be debited for rectification, another account has to
be credited by the same amount. Or else, the Trial Balance will not
tally.
4.4 Final Accounts

Popularly, the Profit and Loss Account and the Balance Sheet are together
called the Final Accounts. This is because these are the last or the final step
in the accounting trail. The Profit and Loss Account is prepared to show the
financial results of a business profit or loss during an accounting period;
and the Balance Sheet is prepared to show the financial position position
of assets and liabilities of a business as on a particular date. The Profit
and Loss Account consists of elements of income and expenses. It has two
sides debit and credit. The debit side reflects all expenses and losses, and
the credit side all incomes and gains. The excess of credit over debit is
known as net profit, and the excess of debit side total over the credit side
total in the Profit and Loss Account is known as net loss for the period.
It is worthwhile to note here that for a corporate entity, Profit and Loss
Account and the Balance Sheet are its final accounts. A non-corporate
entity, however, may prepare an additional account (called the trading
account) to show the gross profit earned or gross loss incurred during a
particular period.
Gross profit is arrived at by deducting the direct cost of goods sold from
sales proceeds. If the difference is positive, there is gross profit; and if the
difference is negative, there is gross loss. From gross profit, if we deduct
indirect administration and selling expenses and add other income, we get
net profit.

From the Trial Balance given in section 4.2 of unit 4, let us prepare the final
accounts of the trader:
In the Books of the Trader
st
Trading Account for the year ended 31 December 2006
Dr. Cr.
Particulars Amount Particulars Amount
Rs. Rs.
To opening stock 94,120 By sales 2,36,400
Less Return Inward 13,400
2,23,000
To purchases 1,06,400 By closing stock 1,92,100
Less Return 2,960 1,03,440
Outward
To carriage Inward 14,260
To Wages* 3,660
To profit and Loss 1,99,620
A/c (Gross profit
transferred)
4,15,100 4,15,100
* It is assumed that wages are for handling purchases and hence direct
expenses.
st
Profit and Loss Account for the year ended 31 December, 2006
Dr. Cr.
Particulars Amount Particulars Amount (Rs)
(Rs)
To Salaries 9,600 By Trading Account 1,99,620
(Gross profit transferred)
To Carriage Outward 2,360
To Trade Expenses 2,090
To capital Account 1,85,570
(Net profit transferred)
1,99,620 1,99, 620

st
Balance Sheet for the year ended 31 December, 2006
Dr. Cr.
Amount Amount
Liabilities Assets
(Rs) (Rs)
Capital Account]
Balance: 13,450 Land and Buildings 15,000
Add Net Profit 1,85,570 1,99,020 Plant and Machinery 20,900
Sundry Creditors 37,360 Stock-in-trade 1,92,100
Bank overdraft 9,320 Sundry Debtors 16,300
Cash in hand 1,400
2,45,700 2,45,700
It may be noted here by way of a general rule that if an item appears in the
Trial Balance, it will find its place only once in any final accounts, i.e,
Trading Account or Profit and Loss Account or the Balance Sheet. On the
other hand, if an item is considered from outside the Trial Balance, the same
will find its place twice in the final accounts. For example, the opening stock
figure appears in the Trial Balance, and hence it is shown only once in the
Trading Account; whereas closing stock, which is taken from outside the
Trial Balance, has found its place twice once in the credit side of the
Trading Account and then in the asset side of the Balance Sheet.
However, the closing stock can, in exceptional cases, form part of the Trial
Balance e.g., if it is adjusted against purchases or if the Trial Balance is
prepared after the profit and loss account. In that situation, the closing stock
will appear only as an asset in the Balance Sheet.
We have shown above how to prepare final accounts of a sole proprietor.
But as a student of the Management Course, you should be mainly dealing
with corporate entities. In the next two chapters, we shall discuss corporate
financial statements in greater detail.
Let us look at another example of preparation of final accounts of a sole
proprietor.

Mr. Gupta runs a general store. His Trial Balance as on 31st March 2007
was as follows:
Particulars Dr. (Rs.) Cr. (Rs.)

Capital 12,50,000
Drawings 1,25,000
Purchases 19,62,000
Sales 25,90,000
Opening stock 2,20,000
Returns Outward 22,000
Freights Inward 55,000
Discount Received 25,000
Salaries 2,95,000
Commission 57,500
Discount allowed 25,000
Dividend Received 32,000
Bad Debts 19,500
Provision for Doubtful Debts 15,000
Sundry Debtors 2,65,000
Purchase Subsidies 64,500
Returns Inward 26,000
Investment 2,05,000
Furniture 2,20,000
Sundry Creditors 2,00,000
Salesmens Commission 15,000
Office expenses 72,500
Sales Tax 1,22,000
Cash in Hand and at Bank 6,29,000
42,56,000 42,56,000
Additional Information
(a) Mr. Gupta purchased a running business of Mr. Gour for Rs.6,00,000 on
31st March 2007. He took over stock of Rs.3,25,000, Debtors
Rs.2,65,000, Furniture Rs,75,000 and Creditors Rs.75,000. No entry
was passed for this transaction.

(b) Closing stock as on 31st March 2007 was not valued. Mr. Gupta earned
a uniform rate of gross profit of 25% on net sales.
(c) Provision for doubtful debts is to be maintained at 7% on debtors.
(d) Purchases include purchases of furniture on 1st January 2007 worth
Rs.45,000
(e) Sales include sale of old furniture for Rs.16,000 on 1st October, 2006
(WDV of such furniture on 1st April 2006 was Rs.26,000)
(f) Furniture was to be deposited by 10% p.a.
You are required to prepare the Trading Account and the Profit and Loss
Account of Mr. Gupta for the year ended 31st March 2007 and also a
Balance Sheet as on the same date.
Solution
In the Books of Mr. Gupta Trading Account for the year ended 31st March,
2007
Dr. Cr.
Particulars Rs. Amount Particulars Rs. Amount
To opening stock 2,20,000 By sales 25,90,000
To Purchases 19,62,000 Less: Returns (26,000)
Add: Freights 55,000 Sales of (16,000)
furniture
20,17,000 Sales tax (1,22,000) 24,26,000
Less: Returns (22,000)
Subsidies (64,500) Closing Stock
(balancing figure) 2,86,000
Purchase of
furniture (45,000) 18,85,500
Profit & Loss 6,06,500
A/c (Gross Profit
Transferred)
(-25% of
Rs.24,26,000)
27,12,000 27,12,000

st
Profit and Loss Account for the year ended 31 March 2007
Dr. Cr.
Particulars Amount Particulars Amount
(Rs.) (Rs.)
To salaries 2,95,000 By Trading A/c
(Gross Profit Transferred) 6,06,500
Office Expenses 72,500 Discount 25,000
Discount 25,000 Commission 57,500
Salesmens Commission 15,000 Dividend 32,000
Bad Debts 19,500
Provision for Doubtful debts 24,750
Loss on Sale of Furniture 8,700
Depreciation on Furniture 21,825
Capital A/c
(Net Profit Transferred) 2,38,725
7,21,000 7,21,000
Balance Sheet as on 31st March 2007

Amount Amount
Liabilities Rs. Assets Rs.
Rs. Rs.
Capital 12,50,000 Goodwill 2,20,000 10,000
Add: Net Profit 2,38,725 Furniture 75,000
Add: Taken over 45,000
Less: Drawing 14,88,725 Add: Purchases 3,40,000
Less: Sold 26,000
13,63,725 3,14,000
Sundry Creditors 1,25,000 2,75,000
(2,00,000+75,000) Less: Depreciation 20,525
(21,825 1,300) 2,93,475
Investments 2,05,000
Stock 6,11,000
(2,86,000+3,25,000)
Debtors 2,65,000
Add: Taken over 2,65,000
5,30,000
Less: Provision
@ 7 % 39,750 4,90,250
Cash & Bank balance 6,29,000
Less: Paid to Mr. Gour
6,00,000 29,000
16,38,725 16,38,725

Working Notes
1. Provision for doubtful Debts:
Debtors as per the Trial Balance 2,65,000
Add: Debtors taken over 2,65,000
5,30,000
Provision for doubtful debts
@ 7 % on Rs. 5,30,000 39,750
Less: Provision already made 15,000
Provision to be created 24,750
2. Loss on Sale of Furniture: Rs.
WDV of furniture sold on 1.4.95 26,000
Less: Depreciation for six months 1,300
24,700
Less: Sale proceeds 16,000
Loss on sale 8,700
3. Depreciation on Furniture:
On Rs.26,000 for 6 months 1,300
On Rs.1,94,000 (Rs.2,20,000-Rs.26,000) for one year 19,400
On Rs.45,000 for 3 months 1,125
21,825
4. Goodwill on Purchase of Business:
A. Net Assets taken over Rs.
Furniture 75,000
Stock 3,25,000
Debtors 2,65,000
Less: Creditors (75,000)
5,90,000
B. Payments made 6,00,000
C. Goodwill (B-A) 10,000

2. The Profit and Loss Account and the Balance Sheet are together called
the _____________ .
3. The Profit and Loss Account is prepared to show the ______ of a
business during an accounting period.
4. The Profit and Loss Account consists of elements of __________.

5. In the Profit and Loss Account, the _________ reflects all expenses and
losses while the shows all incomes and gains.
6. __________ is arrived at by deducting the direct cost of goods sold from
sales proceeds.
4.5 Summary
The Trial Balance puts the ledger balances on trial. It not only checks
the arithmetical accuracy of ledger balances but also helps to have an
overview of the operations of the business.
There are certain accounting errors which affect the agreement of the
Trial Balance. These are easy to detect.
Some accounting errors exist in spite of an agreed Trial Balance
(e.g., errors of principle, errors of omission, compensating errors, etc.).
These are difficult to detect.
Rectification of accounting errors depends on the stage at which they
are detected.
Final accounts in case of a sole proprietorship firm consist normally of
the Trading Account, Profit and Loss Account and the Balance Sheet. A
partnership firm has one additional account after Profit and Loss
Account, namely Profit and Loss Appropriation Account. A corporate
entity prepares only two statements of final accounts a Profit and Loss
Account and a Balance Sheet.
Error of Principle: An error committed because of lack of proper
knowledge of accounting principles or concepts.
Error of Omission: Omission of recording a transaction in the primary
books.
Error of Commission: Error of posting the amount in one account
instead of another account.
Compensation Error: One error compensates the other error by an
identical amount.
Trading Account: It shows the gross profit or loss earned or incurred by
a business entity during an accounting period.
Profit and Loss Account: It shows the net profit or loss earned or
incurred by a business entity during an accounting period.
Profit and Loss Appropriation Account: It shows the distribution of
partnership profits among partners.
Balance Sheet: It shows the position of assets and liabilities of a

business entity as on a particular date.
Suspense Account: It is an artificial account which appears in the Trial
Balance to account for undetected errors. Once the errors are detected
and rectified, the Suspense Account stands eliminated.
Gross Profit: It is arrived at by deducting the direct cost of goods sold
from sales proceeds.
Net Profit: It is the residual of gross profit after setting off indirect
expenses and, of course, it includes other income.

1. Study the process of Trial Balance preparation of a manufacturing
company.
2. Why is Trial Balance prepared?
3. Describe the process of rectification of errors.
4. What is a Suspense Account? How is it squared off?
5. You are presented with a Trial Balance showing a difference which has
been carried to the Suspense Account and the following errors are
discovered:
(a) Rs.650 paid for a type-writer was charged to Office Expenses
Account.
(b) Goods worth Rs.7,600 sold to Tumla were posted to his account as
Rs.6,700
(c) A cash sale of Rs,2,000 to Taimmi was posted to the credit of his
account.
(d) Goods worth Rs.2,500 returned by Thakur was posted to the Sales
Account.
(e) Sales return book was overcast by Rs.2,500
(f) Bills receivable from Tripathy Rs.12,000 posted to the credit of bills
payable account and credited to Tripathys account.
Journalise the above corrections and ascertain the amount of
difference in the Trial Balance.

6. From the under mentioned Trial Balance of Mitra & Co., prepare a
Trading Account, a Profit and Loss Account and a Balance Sheet:
Trial Balance As on 31.03.2007
Particulars Dr. Cr.
Rs. Rs.
Opening Stock 45,000
Capital A/c 90,000
Plant and Machinery 85,000
Sundry Creditors 40,000
Fixtures & Fittings 7,500
Discount Received 3,500
Freehold Premises 75,000
Bank overdraft 20,000
Purchases 1,50,000
Provision for Bad Debts 3,000
Salaries 14,000
Purchase Returns 1,500
Sundry Debtors 55,000
Sales (net) 3,37,070
Manufacturing Expenses 15,000
Manufacturing Wages 30,000
Carriage Inwards 2,000
Carriage Outwards 2,100
Administrative Expenses 10,000
Bad Debts 750
Interest and Bank Charges 625
Discount Allowed 750
Insurance 1,500
Cash at Bank 695
Cash in Hand 150
4,95,070 4,95,070
The following adjustments are required:
(a) Closing stock as on 31st March, 2007 was Rs.57,000
(b) Depreciation on Plant and Machinery @ 10%, Fixtures & Fittings @ 5%
(c) Prepaid Insurance Rs.500
(d) Prepaid salary Rs.600
(e) Outstanding interest on overdraft Rs.2,500
(f) Provision for bad debts is to be maintained at 5% of sundry debtors
4.7 Answers
1. a) True b) True c) False d)True
2. Final Accounts
3. Financial results
4. Income and expenses
5. Debit side; Credit side
6. Gross profit
Terminal Questions
1. Refer to 4.2
2. Refer to 4.1
3. Refer to 4.3
4. Refer to 4.3
5. Refer to 4.3
6. Refer to 4.4

Unit 5 An Introduction to
Financial Management
Structure:
5.1 Introduction
Objectives
5.2 Finance Functions
Investment Decision
Financing Decision
Dividend Policy decision
Liquidity Decision
5.3 Interface between Finances and other Functions
Marketing-Finance Interface
Production-Finance Interface
Top Management-Finance Interface
5.4 Financial Goals
Profit Maximization
Wealth Maximization
Other Objectives
5.5 Summary
5.7 Answers
5.1 Introduction
Financial management is a managerial activity concerned with planning and
controlling a firms financial resources. Finance is the lifeblood of any
organization. Any business activity treats finance management as a very
important management function. There is a common thread running through
all departments of any firm production, marketing, materials, research and
development, etc. The R & D Manager requires finance to carry on research
activities to come out with new products or new designs to meet the ever-
changing needs of customers. He may be assigned the task of discovering a
new process which will help in cost reduction leading to an increase in the
firms revenue. Likewise, the Materials Manager should keep a proper stock
of all inventories. Any shortfall in inventory availability in stores leads to
production rundowns sending a spiraling effect on the whole company
system. Sales promotion activities like advertisement, free gifts etc. requires

heavy cash outlays affecting the companys financial resources. Thus, we

find that finance binds together all the different functions of an organization.
Corporates decide their strategies, be it production, marketing, R & D or any
other, based on their financial constraints.
Objectives:
Explain the meaning of business finance.
State the objectives of financial management.
Explain various interfaces between finance and other functions.
5.2 Finance functions

We have just learnt that finance runs through all departments, yet the major
functions coming under the purview of the Finance Department are
mobilizing funds, investing them in proper assets and distributing the profits
earned from such investments to the shareholders. These may be identified
as financing decision, investment decision and dividend decision
respectively. The activities of a Finance Manager can include the following:
Investment or long term asset mix structure
Financing or capital mix structure
Dividend or profit allocation
Liquidity or short term asset mix structure
A Finance Manager should perform all these functions simultaneously and
continuously in the normal course of business. These functions do not
necessarily occur in a sequence. All these functions require skilful planning,
control and execution.
5.2.1 Investment Decision
Investment or capital budgeting decision involves the allocation of capital to
long term funds. A capital budgeting decision may be defined as the firms
decision to invest its current funds in long term assets in anticipation of an
expected flow of benefits over a number of years. Long term assets are
those which affect a firms operations beyond one-year period. Such
decisions generally include expansion, acquisition, modernization and
replacement of long term assets. Investment in these assets requires huge
cash outlays and most of the long term asset financing decisions are
irreversible in nature. The uncertain future puts long term investment

decisions in a precarious state. Expected benefits of investments are difficult

to measure with certainty. Such decisions should therefore be evaluated in
terms of both expected return and risk. Measurement of returns with a cut-
off rate against the prospective return of new investments should be
compared. Cut off rate is also known as hurdle rate, required rate and
minimum rate of return.
In most organizations an Investment Committee is constituted to study the
various investment proposals in line with the technical, marketing and
financial dimensions. The proposal is deliberated on its worthiness and the
decision taken. Deciding on such plans becomes one of the core activities of
Finance Manager.
5.2.2 Financing Decision
Being the second most important function to be performed by the Finance
Manager, he must plan and mobilize the required funds from alternative
sources as and when they are required and at a reasonable cost. He must
be aware of the various sources of funds available in the market, the time
required to procure these funds, the rates applicable and the securities to be
mortgaged to avail these funds. He should determine the correct proportion
of debt (fixed interest source of financing) and equity (variable dividend
securities). The mix of debt and capital is known as the firms capital
structure. The Finance Manager should strive hard to obtain the best
financing mix or the optimum capital structure. A proper balance between
debt and equity to ensure a trade-off between risk and return is necessary.
The use of debt increases the return to equity holders but the risk is also
very high in this proposition. One of the objectives of the Finance Manager
is to maximize the shareholders return with minimum risk, thereby, the
market value per share is maximized and ultimately the shareholders
benefit. In practice, the firm considers many other factors such as control,
flexibility, loan covenants, legal aspects, etc. in deciding the capital
structure.
5.2.3 Dividend Policy Decision
Dividends are the pay-outs to the shareholders. Two alternatives are
available in dealing with dividend decision: they can be distributed to
shareholders or they can be retained in the business itself. Payment of
dividend is required to keep the shareholders happy and increase their

share value. Pay-out or retention depends on the growth prospects of the

firm. High pay-out is well-taken by shareholders and this is reflected in their
share value going up in the market. A growing firm requires large capital
investments and it may have to borrow which comes with a huge interest
payment on a regular basis. The firm may therefore prefer to retain the
earnings and invest them in further investments and the in the newer
opportunities available. Thus the Finance Manager has to strike a balance
between maximization of shareholders wealth and organizations growth.
5.2.4 Liquidity Decision
Liquidity decisions are concerned with the current assets management.
Managing current assets is an integral part of financial management.
Current assets should be managed efficiently in order to safeguard the
firms profitability and liquidity. It also requires a trade-off between
profitability and risk (liquidity). There is always a conflict in the managers
mind as to these two aspects. A firm holding too much cash giving
importance to the liquidity element loses on the profitability aspect. Likewise,
by not investing sufficient funds in current assets, the firm may become
illiquid and not have the ability to meet its current obligations inviting the risk
of bankruptcy. The Finance Manager should ensure sound techniques of
managing current assets to ensure that neither insufficient not unnecessary
funds are invested in current assets. He should be capable of assessing the
right requirements and make sure that funds are available at the time they
are required most.
1. Payment of dividend is required to keep the shareholders happy and
increase their share value. _______________ depends on the growth
prospects of the firm.
2. The mix of debt and capital is known as the firms ________________.
3. Financing decisions should be evaluated in terms of __________ and
___________.
4. Current Assets Management is a trade-off between __________ and
___________.

5.3 Interface between Finance and other Functions

A common bond running through all departmental heads is that they use
resources and since resources are obtained in exchange for money, they
are effectively making investment decision and in the process ensuring that
the investment is effectively used.
5.3.1 Marketing-Finance Interface
The Marketing Manager decides on a number of factors which have a
bearing on the profitability of the firm. For example, he should have a clear
idea about the credit terms extended to customers. Liberal credit terms will
have an impact on the firms profits while a restrictive policy will not bring in
the desired amount of sales. Product promotion and advertisement policies
should also be very clear. In these days of cut-throat competition, a firm
spends enormously on sales promotion activities to keep their product sales
going, to build brand image and to continue with the customers brand
preferences. The moneys so spent will have an implication on the firms
resources.
5.3.2 Production-Finance Interface
The Production Manager is responsible for the production related activities,
be it materials, men or machines. He should organize his work in such a
way that the equipment are put to use most productively and keep track of
all required inventory for smooth production of goods and see that the idle
time is minimized.
5.3.3 Top Management-Finance Interface
The top management is interested in ensuring that the firms long-term goals
are met and there is overall effectiveness of the organization. Strategic
planning and management control are two important functions of the top
management. Finance function provides the basic inputs needed to
undertake these activities.
5.4 Financial Goals

The firms investment rationale and financing decisions are continuous. It is
generally agreed that the financial goal of the firm should be the
maximization of the owners economic welfare. The owners economic
welfare can be maximized by maximizing the shareholders wealth as

reflected in the market value of shares. Profit maximization and wealth

maximization are two important aspects.
5.4.1 Profit Maximization
Profit maximization means increasing the rupee income of firms. Pricing of
goods is a very important function and is determined by the type of economy
in which the firm is functioning. This may be done by market competitive
forces if the economy is a market economy and by Government in a
Government -controlled economy. Firms in a market economy can function
the best only if they produce goods and services desired by the customers
and prices are as competitive as possible for the customers to have a wide
choice of products available at very competitive prices. It is generally held
that under conditions of free competition, businessmen pursuing their own
self-interests also serve the interest of society. When individual firms pursue
the interest of maximizing the profits, societys resources are efficiently
used.
The profit maximization objective has been criticized in recent years. This
objective developed in the early 19th century when private property, self-
financing and single entrepreneurship were the order of the day. With the
passage of time, businesses have had a complete change-over and now
there is a divorce between ownership and management. Todays corporates
are financed by shareholders and lenders but are run by professional
managers. In reality, the objectives of these two constituents owners and
managers may conflict with each other. In the present circumstances, profit
maximization is regarded as unrealistic and difficult.
An alternative to profit maximization is the objective of wealth maximization
which is discussed below.
5.4.2 Wealth Maximization
This is also known as value maximization and net present worth
maximization. Shareholders Wealth Maximization (SWM) is an appropriate
an operationally feasible criterion to choose among the alternative financial
actions. SWM is the maximization of the net present value or wealth of a
course of action to shareholders. A financial action that creates wealth for
shareholders is desirable. The benefits are measured in terms of cash flows.
In investment and financing decisions the flow of cash is important and not
the accounting profits.

Increasing the shareholders economic welfare is equal to increasing the

utility of their consumption over time. The wealth created by the company is
echoed in the market value of companys shares which in other words is a
reflection of the firms financial decisions.
5.4.3 Other Objectives
Besides the above objectives, there are other objectives of financial
management. These include:
i) Ensuring operational efficiency by efficient and effective utilization of
finances and other resources.
ii) Ensuring financial discipline in the management.
iii) Building reserves for growth and expansion.
5. ______________ will have an impact on the firms profits while a
__________________will not bring in the desired amount of sales.
6. _____________ and _____________are two important functions of the
top management.
7. ______________ and _____________ are two important aspects of
financial goal.
8. Ensuring__________, ____________ and __________are other
objectives of financial management.
5.5 Summary
The goal of a company will be to maximize the wealth of the shareholders.
The Finance Manager should take necessary actions in this direction.
He must make proper investment or capital budgeting decisions. He must
plan and mobilize the required funds from alternative sources as and when
they are required and at a reasonable cost. He has to strike a balance
between maximization of shareholders wealth and organizations growth.

1. What are the objectives of financial management?
2. How is the optimum mix of capital structure achieved by a Finance
Manager?
3. How do the financing, investment and dividend decision help a Finance
Manager to achieve the objective of wealth maximization?
5.7 Answers
1. Pay-out or retention
2. Capital structure
3. Return; risk
4. Profitability; risk
5. Liberal credit terms; restrictive policy
6. Strategic planning; management control
7. Profit maximization; wealth maximization
8. Operational efficiency; financial discipline; building reserves for growth
and expansion
Terminal Questions
1. Refer to 5.4
2. Refer to 5.2.2
3. Refer to 5.4.2

Unit 6 Financial Planning

Structure:
6.1 Introduction
Objectives
6.2 Steps in Financial Planning
6.3 Factors Affecting Financial Plan
6.4 Estimation of Financial Requirements of a Firm
Capitalization
6.5 Summary
6.7 Answers
6.1 Introduction
The Finance Manager has to estimate the financial requirements of the
company. He should determine the sources from which capital can be
raised and determine how effectively and judiciously these funds are put into
use so that repayments can be done in time. Financial planning is deciding
in advance the course of action for future. It includes the following:
Estimation of the amount of funds to be raised.
Finding out the various sources of capital and the securities offered
against the money so received.
Laying down policies to administer the usage of funds in the most
appropriate way.
Objectives:
After studying this unit, you will be able to:
Explain the steps involved in Financial Planning.
Explain the factors affecting Financial Plan.
List the causes for over-capitalization.
Explain the effects of under-capitalization.
6.2 Steps in Financial Planning

Estimate capital requirements: This is the first step in financial
planning. The following factors may be used to determine the capital:
o Requirement of fixed assets.
o Investment intangible assets like patents, copyrights, etc.

o Amount required for current assets like stocks, cash, bank balances,
etc.
o Cost of set-up and likely expenses to be incurred on the new issue of
shares and debentures.
Determine the type of sources to be acquired and their proportion:
The Finance Manager has to decide on the form in which the money is
to be sourced, that is, debt, equity, preference shares, loans from banks
and the proportion in which these are to be procured.
Steps in Financial Planning:
The financial planning process involves the following steps:
1. Projection of financial statements: Financial statements are the
companys profit and loss account and the balance sheet. These two
statements can be prepared for a certain period of future time and they
help the manager to determine the amount of fund requirements.
2. Determination of funds needed: Once the projections are drawn in
terms of sales of products, the cost of production, marketing activities,
etc., the Finance Manager can draw up a plan as to the fund
requirement based on the time factor. He can know whether the funds
are to be procured on a short term basis or on a long term basis.
3. Forecast the availability of funds: A company will have a steady flow
of funds. If the manager is able to forecast these amounts properly, then
the moneys to be borrowed can be reduced, thus saving on the interest
payments.
4. Establish and maintain control system: Control system is ineffective
without adequate planning and the adequacy of planning can be gauged
only through proper control measures. Both these activities are essential
for effective utilization of funds.
5. Develop procedures: Procedures should be developed for basic plans
how they should be achieved.
Long term strategic plan
Long term plans generally range over a period of 2-5 years. These plans
reflect the impact of long term investment and financing decisions of the
company. Generally, these plans focus on acquiring capital assets, R & D
expenditure, new market penetration strategies, process engineering

techniques, new and innovative product development strategies, etc. The

long term plans are supported by the annual plans.
Short term operating plans
These plans cover a period of 1-2 years. They deal with the implication of
short term decisions. These plans are generally called budgeting and
include planning and controlling activities in the short run. The short term
plans consist of aspects such as sales, production, levels of inventories to
be maintained, number of men (labour) to be used, cash flows etc.
6.3 Factors Affecting Financial Plan

o Nature of industry: The nature of the industry in which the company is
performing is a major factor which affects financial plans. A labour-
intensive industry requires less capital than a capital-intensive industry.
o Status of the company in the industry: The status of the company is a
factor which has to be considered while drawing a financial plan. If the
company is a well-recognized and a reputed one, it will have no
problems in raising finance at short notices. But on the other hand, if the
company is a new entrant into the field, it will need time to establish itself
and therefore raising money is slightly difficult, especially so if the
company wants to go public. New firms may find it easier and better to
take loans and function rather than going public.
o Alternative sources of finance: The Finance Manager will assess the
alternative sources of funds and get the cheapest source of funds. He
should also verify the conditions attached to the funds he procures, that
are the contractual restrictions placed by the lenders.
o Attitude of management towards control: If the management wants to
have control over the firm, it may not go in for the equity form of finance
for control vests with equity shareholders and it gets diluted with every
new issue of equity shares. Such companies prefer to raise additional
amounts by debenture issue or bond issue.
o Extent of working capital requirements: The Finance Manager
formulates his plan considering the short and long term financial needs
of the firm. Short term funds required to finance working capital needs
are to be procured through short term sources only. It is always a
prudent policy to use short term avenues for short term requirements

and long term needs can be funded by the issue of shares and
debentures.
o Capital structure: Capital of a firm has two components debt and
equity. The proportion of these should be so decided that the company
gets the advantage of leverage. Running the company with loans and
debentures will certainly help equity shareholders to get more income
but the company is also functioning under a great risk.
o Flexibility: This is one important factor that should be kept in mind while
planning. The financial plan should be flexible enough to adjust to the
needs of the changing conditions. There should be flexibility to raise the
amount from any source and similarly the repayments may be done any
time the company has excess funds. The firm should also have the
flexibility of substituting one form of financing with another if the need
arises.
o Government policy with regard to financial controls, statutory
provisions and controls should be considered. The SEBI guidelines
should be strictly adhered to wherever applicable and necessary
permissions from concerned authorities should be taken if necessary.

1. ________________________ is the first step in financial planning.
2. __________ generally range over a period of 2-5 years and
___________ cover a period of 1-2 years.
3. A labour-intensive industry requires less capital than a ______________
industry.
4. Capital of a firm has two components, namely, ________ and
_________
6.4 Estimation of Financial Requirements of a Firm

Estimating the capital requirements of a firm is a very complex and
complicated process. The estimate should be correct, for wrong estimates
will adversely affect the company. Capital requirements of a company
broadly fall under two categories fixed capital and working capital. Fixed
capital refers to the capital to meet the long term requirements of the
business. Working capital is cash required for day-to-day activities.

6.4.1 Capitalization
Capitalization is the determination of the amount of capital to be raised, the
types of securities that will be offered, the proportion in which they will be
issued and the administration of capital. The components of capitalization
are:
Par value of share capital paid up value of both equity and preference
share capital.
Reserves and surplus all types of capital and revenue reserves.
Long-term borrowed funds debentures issued and other long term
borrowings.
Capitalization includes both own funds and borrowed funds. There are two
approaches, that is, the theories for the determination of the amount of
capitalization. They are:
Cost Approach: Under this approach, the capitalization of a company is
based on the cost of acquisition of fixed assets, setting up a company and
the amount of working capital requirement. The amount of capitalization is
arrived at by adding the following items:
1. Cost of acquisition of fixed assets, such as, land and building, plant and
machinery, furniture and fixtures, etc.
2. Cost of establishing the company preliminary expenses incurred,
underwriting commission, expenses on issue of shares, debentures, etc.
3. Working capital requirements.
The cost approach is not a preferred method of capitalization as the
companys earning capacity should be taken into consideration rather than
the total value of the assets the company holds.
Earnings Approach:
Under the Earnings Approach, the capitalization of the company is
determined on the basis of its earnings. This approach advocates that the
value of the company is equal to the value of its earnings. For example, if a
company earns Rs. 100000 and the rate of capitalization is 12%, the
companys capitalization would be calculated as: (Average profits*100) / rate
of return, that is, (100000*100) / 12 which is equal to Rs. 833333.
The Earnings Approach provides a good basis for determining the
capitalization of the existing company.

Over-capitalization
Over-capitalization arises when the present capital of the company is not
effectively or properly used. There is excess capital available in the
company than the actual requirement. A firm is said to be over-capitalized
when its earnings are not sufficient to pay dividends to the investors. For
example, if the companys rate of return is 12% and it earns a profit of Rs.
100000 on an investment of Rs. 1200000, we get the fair rate of return to be
less than the profits earned. Fair rate of return is 1200000*12% which is Rs.
144000. The company is earning less than the fair return in the industry.
The company is said to be over-capitalized because the earning of the
company is (100000/1200000)*100 which is 8.33% and this is less than the
fair rate return of the industry.
How do we know over-capitalization has occurred?
Actual capitalization of the company exceeds the capitalization
warranted by the activity levels.
Earnings are lower than the expected returns.
There is a fall in the rate of dividends declaration.
There is a fall in the market value or the market price of the shares of
the company.
Causes of over-capitalization:
If a company acquires assets at inflated prices than the book values,
over-capitalization occurs.
Acquiring unproductive assets, mostly intangible in nature like goodwill,
patents, etc.
High initial costs by way of preliminary expenses.
A company being set up in boom time pays more on acquisition of
assets. Once the boom time subsides, it will find the capital over
capitalized.
Raising more capital than the required amount.
Company borrows money at high rates of interest than the moneys
could be put into profitable use.
A company postponing plant repairs and maintenance will find itself
over-capitalized as the efficiency of the plant stands reduced.

Excessive taxation by government leaves very little money with the

company. The money may be insufficient to meet its daily requirements
and the company may resort to borrowings. Borrowing beyond a certain
limit leads to over-capitalization
Effects of over-capitalization
Fall in profits
Fall in dividend rates
Loss of investors confidence
Fall in market prices of shares.
Under-capitalization
Under-capitalization is the reverse to over-capitalization. It is a situation
where the actual capitalization is much less than the proper capitalization.
For example, if the companys average profits are Rs. 75000 and the actual
capitalization is Rs. 500000 with an ROI of 12%,
(75000*100)/12 which is Rs. 625000. In case of under-capitalization the
actual rate of earnings is higher than the fair rate of return, in our case 12%.
How do we know if under-capitalization has occurred?
Actual capitalization is less than real ROI.
Actual rate of earnings is higher than the ROI
Dividends of the company are higher than companies in similar industry.
Market price of share is very high.
Causes for under-capitalization
Underestimation or wrong estimation of companys earning capacity.
Acquiring assets during recession phase of the business cycle.
Maintaining high standards of efficiency in companys workings.
Conservative dividend policy.
Effects of under-capitalization
Encourages competition and new competitors appear in the scene.
Encourages management to manipulate share prices.
High profits will attract high tax rates.
High profits will make the workers demand higher wages.

A feeling of exploitation sets in the minds of consumers that they are

paying high prices to the companys products and the company may
lose the goodwill of customers.
5. _____________ is the determination of the amount of capital to be
raised.
6. ________________arises when the present capital of the company is
not effectively or properly used.
7. A company has _____________ if its actual capitalization is less than
real ROI.
8. Conservative dividend policy results in _________.
6.5 Summary
Financial planning is deciding in advance the course of action for future.
The financial planning process involves the following six steps:
Projection of financial statements
Determination of funds needed
Forecast the availability of funds
Establish and maintain control system
Develop procedures
Long term plans generally range over a period of 2-5 years. Short term
plans cover a period of 1-2 years.
Capitalization is the determination of the amount of capital to be raised,
the types of securities that will be offered, the proportion in which they
will be issued and the administration of capital.
Under Cost Approach, the capitalization of a company is based on the
cost of acquisition of fixed assets, setting up a company and the amount
of working capital requirement.
Under the Earnings Approach, the capitalization of the company is
determined on the basis of its earnings.
Over-capitalization arises when the present capital of the company is not
effectively or properly used.
Under-capitalization is a situation where the actual capitalization is much
less than the proper capitalization.


1. Explain the steps involved in Financial Planning
2. Explain the factors affecting Financial Plan.
3. List the causes of over-capitalization.
4. Explain the effects of under-capitalization.
6.7 Answers
1. Estimation of capital requirements
2. Long term plans; short-term plans
3. Capital intensive industry
4. Debt; equity
5. Capitalization
6. Over-capitalization
7. Under-capitalization
8. Under-capitalization
Terminal Questions
1. Refer to 6.2
2. Refer to 6.3
3. Refer to 6.4.1.3
4. Refer to 6.4.1.4

Unit 7 Working Capital Management I

Structure:
7.1 Introduction
Objectives
7.2 Components of Current Assets and Current Liabilities
Current Assets
Current Liabilities
7.3 Concepts of Working Capital
7.4 Objective of Working Capital Management
7.5 Need for Working Capital
7.6 Operating Cycle
7.7 Determinants of Working Capital
7.8 Estimation of Working Capital
Estimation of Current Assets
Estimation of Current Liabilities
7.9 Cash Management
Motives of Holding Cash
Objectives of Cash Management
Determining the Cash Needs Models for Determining Optimal
Cash
7.10 Summary
7.12 Answers
7.1 Introduction
Assets and liabilities of a company can be classified as follows:
Assets Fixed Assets and Current Assets.
Liabilities Long-term liabilities and short-term (Current) liabilities.
Assets are possessions/items of economic value owned by an individual or
company which can be expressed monetarily or can be converted to cash
like land, building, plant, etc. They can be tangible (land, building, plant) and
intangible (goodwill, patents). Assets help in generating future revenues to
the company. Fixed assets are those assets which are permanent in nature
and are held to be used in creating income and wealth. They are not
ordinarily for sale. Current assets are those assets which can be easily

liquidated and encashed at a short notice usually within a year. Examples of

current assets are debtors, short-term investments, cash and bank balances
etc.
Liabilities are economic obligation that legally binds a company to settle a
debt. Long term liabilities are those which are repayable over a period
greater than the accounting period, example, debentures, term loans, etc.
Short tem liabilities or current liabilities have to be paid within the accounting
period. For example, creditors, bills payable, outstanding expenses etc.
Managing current assets assumes importance because of the fact that the
liquidity position of a firm is dependent on the amount of investment in CA
and the time value of money is less significant for CA than FA.
Objectives:
Explain the meaning, definition and concepts of working capital.
State the objectives of working capital management.
Bring out the importance of working capital management.
Explain the process of estimation of working capital.
Explain the factors determining cash requirements.
Explain the process of cash forecasting.
7.2 Components of Current Assets and Current Liabilities

7.2.1 Current Assets
Inventories
Sundry Debtors
Bills Receivables
Cash and Bank Balances
Short-term Loans and Advances
Short-term Investments
7.2.2 Current Liabilities
Sundry Creditors
Bills Payable
Outstanding Expenses
Tax Provision

Working capital management involves managing the different components

of current assets and current liabilities. It is an effort to try to maintain a
healthy relationship between these two so that a satisfactory level of
working capital is maintained. It is very important for a firm to maintain a
satisfactory level of working capital, otherwise there are chances of the firm
becoming insolvent and going bankrupt. The interface between CA and CL
is therefore very important and forms the main subject under working capital
management.
7.3 Concepts of Working Capital

There are two concepts of working capita gross and net.
Gross working capital refers to the firms investment in total current
assets.
Net working capital refers to the difference between current assets and
current liabilities. Net working capital is positive when CA exceeds CL and
negative when CL exceeds CA.
A Finance Manager should ensure there is sufficient liquidity in the firms
operations. This is possible only when the CA and CL are managed
efficiently. Liquidity of the firm is defined as the firms ability to meet its
short-term obligations as and when payable.
7.4 Objective of Working Capital Management

Liquidity V. Profitability
The basic objective of working capital management is to maintain the
smooth functioning of the normal business operations of a firm. The
company has to decide on the sufficient quantity of working capital to be
maintained. A company following a conservative approach will have more
current assets at its disposal. Holding large amount of CA is not very
advisable as the firms lose on the profitability aspect. They can earn more
by putting these resources to alternative uses or by investing CA into short
term investment avenues. This approach is dynamic in nature wherein only
small amounts of cash are held by companies and the rest put to alternative
uses. A firm following a conservative policy will tend to lose on profits and
those following an aggressive policy will invest everything available and in

the bargain lose on the liquidity element. A trade-off between these two
variables is required for the smooth running of the company.
7.5 Need for Working Capital

We all have understood by now the importance of working capital in the day-
to-day running of operations. Different firms have different requirements of
working capital. One of the objectives of a firm is to maximize shareholders
wealth. To achieve this objective, the firm should earn good returns from its
operations which mean that earning a steady amount of profit requires good
amount of sales. The firm should invest adequately in current assets to
enable it to generate sales continuously without any break. Sales do not
convert into cash instantaneously and there is always an operating cycle
involved in the conversion of sales into cash.
7.6 Operating Cycle

It is the length of time required to convert sales into cash. This involves
three phases:
Acquisition of resources procuring raw materials, labour, fuel, etc.
Manufacture of the product conversion of raw material into
inventory.
Sale of the product conversion of sales into cash or credit in which
case the firm has accounts receivable.
These three phases occur on a continuous basis and there is no
synchronization. If it were possible to bring together the three phases there
is no need for working capital management. Cash outflows occur before
inflows and cash inflows are not certain because of the difficulty in
forecasting sales accurately. Outflows, on the other hand are certain. Since
these two do not match, firms should keep sufficient cash or invest in short-
term liquid securities to enable them to meet obligations as and when they
become due. Likewise, there should be sufficient stock of finished goods to
meet unexpected demand from customers. Customers are known to change
loyalty when they do not find products available as every product in the
market is known to have a number of substitutes. Further, the firms should
give sell goods on credit if they have to be competitive. To facilitate these,
firms should have an adequate level of working capital.

How is the length of the operating cycle determined? The length of OC is

the sum total of:
Raw Material storage period
Conversion period
Finished goods storage period
Average collection period
This total is referred to as Gross Operating Cycle (GOC). From this, the
firm has to make payables which are the Average Payment Period.
Subtracting payables deferrals from GOC, we get Net Operating Cycle or
the Cash Conversion Cycle.
Permanent and Temporary Working Capital:
Permanent working capital is the minimum investment in the form of
inventory of raw materials, work-in-progress, finished goods, stores and
book debts to facilitate uninterrupted operations in a firm. This minimum
level is called the permanent or fixed working capital. It is permanent like
the firms fixed assets are. Over and above this, the firms working capital
requirements fluctuate depending upon the cyclicality and seasonality of
product demands. This is referred to as the variable or fluctuating or
temporary working capital. These two aspects can be graphically shown
as follows:
Working capital (Rs.)
Temporary working capital
Permanent working capital
Time

For a growing firm, the requirements can be depicted as follows:
Temporary working capital

Working capital (Rs.)
Permanent working capital
Time

1. _____________ refers to the firms investment in total current assets.
2. Net working capital is ___________ when CA exceeds CL and
__________ when CL exceeds CA.
3. A trade-off between these __________ and ____________ is required
for the smooth running of the routine affairs of the company.
4. ______________ is called as conversion of sales into cash.
5. The length of the operating cycle determined by ________,
__________, ______________ and ___________.
7.7 Determinants of Working Capital

A firm should plan its operations in such a way that there is neither too much
nor too little working capital. Investing heavily on current assets will affect
the firms earning potential and having too little has an effect on the firms
credibility. Hence, as we have discussed earlier, it should strike a balance
between liquidity and profitability elements. The requirements vary time to
time and from firm to firm. The following factors are identified as significant
factors affecting the composition of working capital or current assets:

Nature of Business: Working capital requirements are basically

influenced by the nature of business. Trading organizations invest little
on fixed assets and are have a large stock of finished goods, accounts
receivable (arising out of credit sales) and accounts payables (due to
credit purchases). In contrast, public utilities do not have large stocks of
current assets and they invest heavily on fixed assets. On an average,
the percentage of current assets to total assets are found to be lowest in
hotels, restaurants and travel agents offices (10%-20%) while it is in the
range of 20%-30% in electricity generation companies and railways and
they are in the range of 80%-90% in trading companies.
Nature of raw material used: The nature of raw materials also
influences the quantum of inventory. For example, if the raw material is
based on the agricultural produce, the seasonality of production affects
the raw material requirements. Consequently, the percentage of raw
material inventory to total current assets will be very high. Some
companies may depend on raw materials to be imported or which may
have to be procured from other places. These companies will therefore
hold large quantities of raw materials so that there are no production
hold-ups.
Sales and demand conditions/Business Cycle: Companies which are
growing will have large quantities of finished good inventory. Sales
depend on the demand conditions which vary depending on the
seasonality and cyclicality of product demand. The upward swing in the
economy, that is, during boom phase, sales rise rapidly bringing in new
accounts receivables. An increase in sales will also necessitate
additional investment in fixed assets aiding production activities. This will
in turn lead to an increase in creditors and accounts payable. Thus a
boom phase has an all-round effect of steady production, high sales,
increased accounts receivables and payables. On the other hand, during
a slack period, there is depression everywhere. A company with
seasonal sales may follow a policy of steady production and utilize its
production resources to the fullest extent possible. This policy can lead
to accumulation of inventories during off season and disposal during
peak periods.
Processing technology: The manufacturing cycle comprises the
purchase and use of raw materials and production of finished goods.
Longer the manufacturing cycle, larger is the firms requirement of

working capital. This will also lead to an extended manufacturing time
span and larger tie-up of funds in inventory. In case the raw material has
to go through several stages during the production process, the work-in-
progress inventory is likely to be higher than any other item of current
assets.
Production policy: The quantity of working capital is also determined
by the production policy in force. The seasonality of goods demanded
and availability affects the finished goods inventory. A firm can have two
options either they confine to production only if demand is there or raw
materials are available or they can follow a steady production policy
throughout the year. The former is called variable production policy and
has serious drawbacks like non-availability of skilled workforce to
execute the orders in time or lack of physical facilities availability like
power, transportation and infrastructure at the right time, etc. Following a
steady production policy is a better alternative, but the shortcoming here
is that there is a huge pile of finished goods inventories. Each product
has a shelf-life after which it is not saleable in market. Steps should be
therefore be taken to dispose them off quickly or otherwise the firm runs
into possibilities of they become outdated or deteriorating in quality
which again is a drain on companys profits.
Credit policy: The Credit policy of the firm affects the working capital.
The credit terms to be granted to customers depend on the industry
norms. If the industry standard is 45 days and the firm restricts its credit
terms to 20 days, it works heavily on the companys sales. On the other
hand, if the company follows the industry standard and grants credit of
45 days, extra efforts are to be put in towards collection. Incidence of
bad debts is higher in such cases. Credit sales result in higher book
debts. Higher book debts mean more working capital. In contrast, if
liberal credit terms are available from suppliers, the working capital
requirement is less.
In order to ensure that unnecessary funds are not tied up in debtors, the
firm should follow a rationalized credit policy based on the credit
standing of customers and other relevant factors.

Operational Efficiency: The operating efficiency of the firm relates to

the optimum utilization of resources at minimum costs. Investment in
working capital will be low if a firm controls its operating costs and
utilizes its assets in the most optimum way. Use of working capital is
improved and the velocity of cash conversion cycle is stepped up. Better
utilization of resources improves profitability and helps in reducing the
pressure on working capital.
6. Trading organizations invest little on _______ and invest more on
______.
7. Growing companies have large quantities of __________.
8. Longer the____________, larger is the firm requirement of working
capital.
9. The seasonality of goods demanded and availability affects the
_____________ inventory.
10. The working capital requirements are __________ if liberal credit terms
are available from suppliers.
11. Better utilization of resources improves _________ and helps in
reducing the pressure on working capital.
7.8 Estimation of Working Capital

The two components of WC are CA and CL which have a bearing on the
Operating Cycle. To compute the WC needs, we should find the holding
period of various types of inventories, credit collection period and credit
payment period. WC is calculated on the assumption that production/sales
are a continuous process and all costs accrue similarly. The steps involved
in estimating various items of CA and CL are as follows:
7.8.1 Estimation of Current Assets
Raw Materials Inventory: The investment in raw material inventory is
estimated as:
o [Budgeted production(units)*cost of raw material per unit*Average
inventory holding period (months or days)] / [12 months or 365 days]
Work-in-progress inventory: [Budgeted production(units)*Estimated
WIP cost per unit*Average time span of WIP inventory months or (days)]
/ [12 months or 365 days]
Finished Goods inventory: [Budgeted production(units)*cost of goods

produced per unit excluding depreciation*finished goods holding period
(months or days)] / [12 months or 365 days]
Debtors: [Budgeted credit sales (units)*cost of sales per unit excluding
depreciation *Average debt collection period (months or days)] / [12
months or 365 days]
Cash and Bank balances: Apart from the WC needs for financing
inventories and debtors, firms should also have some minimum cash
balances with them. This amount will depend on the firms attitude
towards risk, access to borrowing sources, past experience, etc.
7.8.2 Estimation of Current Liabilities
Trade Creditors: [Budgeted yearly production(units)*raw material cost
per unit*credit period allowed by creditors(months or days)] / [12
months/365days]
Direct Wages: [Budgeted yearly production(units)*Direct labour cost per
unit*Average time-lag in payment of wages(months or days)] / [12
months/365days]
Overheads: [Budgeted yearly production(units)*overhead cost per unit*
Average time-lag in payment of overheads (months or days)] / [12
months/365days]
Example:
You are the Financial Consultant for Zen Enterprises. The company wants
you to advise them on the average amount of working capital required for
the year 2007-08. The following estimates are made based on the previous
years working. You may add 15% to the computed amount for contingency
purposes.

Amount Rs.
Average stock of finished goods 50000
Average stock of raw materials goods 80000
Average credit given to customers (sales) (4 weeks) 1000000
Average time lag in payment of wages 2 weeks 1000000
Average time lag in payment of materials 3 weeks 100000
Average time lag in payment of rent 3 months 60000
Average time lag in payment of salaries of clerks 2 weeks 80000
Average time lag in payment of salary of manager 2 weeks 20000
Average time lag in payment of sundry expenses 6 weeks 40000
Advance payment of sundry expenses (paid quarterly in advance) 25000
Solution
Statement showing working capital needs of Zen Enterprises
Current Assets Amount Rs.
Stock of finished goods 10000
Stock of raw materials goods 20000
Debtors Credit sales/debtors turnover=(1000000*4 weeks) / 52 76923
weeks
Advance payment of sundry expenses (25000*3 months) / 12 6250
months
Total investment in CA 113173
Current Liabilities
Wages (1000000*2) / 52 38462
Materials (100000*3) / 52 5769
Rent (60000*3) / 12 3462
Salaries of clerks (80000*2) / 52 3077
Salary of manager (20000*2) / 52 769
Sundry expenses (40000*6) / 52 4615
Total investment in CL 56154
Net working capital CACL 57019
Add 15% contingency allowance (15% of 57019) 8553
Average WC 65572

Example:
Anu Foundries sells goods on a gross profit of 25%. Depreciation is taken
into account as a part of cost of production. The following are the annual
figures available to you.
Amount Rs.
Sales 2 months credit 1000000
Materials consumed 1 month credit 200000
Wages paid 1 month lag 250000
Cash manufacturing expenses 1 month lag 180000
Administration expenses 1 month lag 80000
Sales expenses prepaid quarterly 40000
Advance Income tax payable 100000
The company maintains one month stock of raw materials and finished
goods. It also has the practice of keeping Rs. 50000 as cash balance at all
times. Estimate working capital requirements keeping 15% of the estimate
as contingency reserve.
Solution
Current Assets Amount Rs.
Debtors (cash cost of goods sold) (750000*2) / 12 125000
Prepaid sales expenses (40000*3) / 12 10000
Stock of raw materials (200000*1) / 12 16667
Stock of finished goods (630000*1) / 12 52500
Cash in hand given 50000
Total current assets 254167
Current liabilities
Creditors (200000*1) / 12 16667
Manufacturing expenses (180000*1) / 12 15000
Administration expenses ( 80000*1) / 12 6667
Tax provision 100000/4 25000
Wages (250000*1) / 12 20833
Total Current liabilities 84167
Net working capital 170000
Add 15% for contingency reserve 25500
Average working capital needed 195500

Working notes:
Manufacturing expenses calculation
Sales 1000000
Less Gross profit 25% on sales 250000
Total cost of manufacture 750000
Less cost of materials 200000
Cost of wages 250000
Manufacturing expenses 300000
Depreciation calculation:
Manufacturing expenses 300000
Less cash manufacturing expenses 180000
Depreciation 120000
Calculation of total cash cost
Total cost of manufacture 750000
Less depreciation 120000
630000
Add administration cost 80000
Add sales expenses 40000
Cost of goods sold 750000
7.9 Cash Management

Cash is the most important current asset for a business operation. It is the
force that drives business activities and also the ultimate output expected by
the owners. The firm should keep sufficient cash at all times. Excessive
cash will not contribute to the firms profits and shortage of cash will disrupt
its manufacturing operations. The term cash can be used in two senses
in a narrow sense it means the currency and other cash equivalents such as
cheques, drafts and demand deposits in banks. In a broader sense, it
includes near-cash assets like marketable securities and time deposits in
banks. The distinguishing nature of this kind of asset is that they can be
converted into cash very quickly. Cash in its own form is an idle asset.
Unless employed in some form or another, it does not earn any revenue.
Cash management is concerned with (a) management of cash flows into
and out of the firm, (b) cash management within the firm and
(c) management of cash balances held by the firm deficit financing or
investing surplus cash. Cash management tries to accomplish at a minimum

cost the various tasks of cash collection, payment of outstandings and
arranging for deficit funding or surplus investment. It is very difficult to
predict cash flows accurately. Generally, there is no correlation between
inflows and outflows. At some points of time, cash inflows may be lower
than outflows because of the seasonal nature of product sale thus
prompting the firm to resort to borrowings and sometimes outflows may be
lesser than inflows resulting in surplus cash. There is always an element of
uncertainty about the inflows and outflows. The firm should therefore evolve
strategies to manage cash in the best possible way. These can be broadly
summarized as:
Cash planning: Cash flows should be appropriately planned to avoid
excessive or shortage of cash. Cash budgets can be prepared to aid this
activity
Managing cash flows: The flow of cash should be properly managed.
Steps to speed up cash collection and inflows should be implemented
while cash outflows should be slowed down.
Optimum cash level: The firm should decide on the appropriate level of
cash balance. Balance should be struck between excess cash and cash
deficient stage.
Investing surplus cash: The surplus cash should be properly invested
to earn profits. Many investment avenues to invest surplus cash are
available in the market such as, bank short term deposits, T-Bills, inter
corporate lending etc.
The ideal cash management system will depend on a number of issues like,
firms product, competition, collection program, delay in payments,
availability of cash at low rates of interests and investment opportunities
available.
7.9.1 Motives of Holding Cash
There are four motives of holding cash. They are:
Transaction motive: This refers to a firm holding cash to meet its routine
expenses which are incurred in the ordinary course of business. A firm will
need finances to meet a plethora of payments like wages, salaries, rent,
selling expenses, taxes, interests, etc. The necessity to hold cash will not

arise if there were a perfect co-ordination between the inflows and outflows.
These two never coincide. At times, receipts may exceed outflows and at
other times, payments outrun inflows. For such periods when payments
exceed inflows the firm should maintain sufficient balances to be able to
make the required payments. For transactions motive, a firm may invest its
cash in marketable securities. Generally, they purchase such securities
whose maturity will coincide with payment obligations.
Precautionary motive: This refers to the need to hold cash to meet some
exigencies which cannot be foreseen. Such unexpected needs may arise
due to sudden slow-down in collection of accounts receivable, cancellation
of an order by a customer, sharp increase in prices of raw materials and
skilled labour etc. The moneys held to meet such unforeseen fluctuations in
cash flows are called precautionary balances. The amount of precautionary
balance also depends on the firms ability to raise additional money at a
short notice. The greater the creditworthiness of the firm in the market, the
lesser is the need for such balances. Generally, such cash balances are
invested in highly liquid and low risk marketable securities.
Speculative motive: This relates to holding cash to take advantage of
unexpected changes in business scenario which are not normal in the usual
course of firms dealings. It may also result in investing in profit-backed
opportunities as the firm comes across. The firm may hold cash to benefit
from a falling price scenario or getting a quantity discount when paid in cash
or delay purchases of raw materials in anticipation of decline in prices. By
and large, business firms do not hold cash for speculative purposes and
even if it is done, it is done only with small amounts of cash. Speculation
may sometimes also boomerang in which case the firms lose a lot.
Compensating motive: This is yet another motive to hold cash to
compensate banks for providing certain services and loans. Banks provide a
variety of services like cheque collection, transfer of funds through DD, MT,
etc. To avail all these purposes, the customers need to maintain a minimum
balance in their account at all times. The balance so maintained cannot be
utilized for any other purpose. Such balances are called compensating
balances. Compensating balances can take any of the following two forms
(a) maintaining an absolute minimum, say for example, a minimum of Rs.
25000 in current account or (b) maintaining an average minimum balance of

Rs. 25000 over the month. A firm is more affected by the first restriction than
the second restriction.
7.9.2 Objectives of Cash Management
This can be studied under two heads: (a) meeting payments schedule and
(b) minimize funds committed to cash balances.
Meeting payments schedule: In the normal course of functioning, a firm
will have to make many payments by cash to its employees, suppliers,
infrastructure bills, etc. It will also receive cash through sales of its products
and collection of receivables. Both these do not happen simultaneously. A
basic objective of cash management is therefore to meet the payment
schedule in time. Timely payments will help the firm to maintain its
creditworthiness in the market and to foster good and cordial relationships
with creditors and suppliers. Creditors give a cash discount if payments are
made in time and the firm can avail this discount as well. Trade credit refers
to the credit extended by the supplier of goods and services in the normal
course of business transactions. Generally, cash is not paid immediately for
purchases but after an agreed period of time. There is deferral of payment
and is a source of finance. Trade credit does not involve explicit interest
charges, but there is an implicit cost involved. If the credit terms are, say,
2/10, net 30, it means the company will get a cash discount of 2% for
prompt payment made within 10 days or else the entire payment is to be
made within 30 days. Since the net amount is due within 30 days, not
availing discount means paying an extra 2% for 20-day period.
The other advantage of meeting the payments in time is that it prevents
bankruptcy that arises out of the firms inability to honour its commitments.
At the same time, care should be taken not to keep large cash reserves as it
involves high cost.
Minimize funds committed to cash balances: Trying to achieve the
second objective is very difficult. A high level of cash balances will help the
firm to meet its first objective discussed above, but keeping excess reserves
is also not desirable as funds in its original form is idle cash and a non-
earning asset. It is not profitable for firms to keep huge balances. A low level
of cash balances may mean failure to meet the payment schedule. The aim
of cash management is therefore to have an optimal level of cash by
bringing about a proper synchronization of inflows and outflows and check

the spells of cash deficits and cash surpluses. Seasonal industries are
classic examples of mismatches between inflows and outflows.
Factors for efficient cash management
The efficiency of cash management can be augmented by controlling a few
important factors described below:
Prompt billing and mailing: There is a time lag between the dispatch of
goods and preparation of invoice. Reduction of this gap will bring in early
remittances.
Collection of cheques and remittances of cash: It is generally found that
there is a delay in the receipt of cheques and their deposits into banks. The
delay can be reduced by speeding up the process of collection and
depositing cash or other instruments from customers. The concept of float
helps firms to a certain extent in cash management. Float arises because of
the practice of banks not crediting firms account in its books when a cheque
is deposited by it and not debit firms account in its books when a cheque is
issued by it until the cheque is cleared and cash is realized or paid
respectively. A firm issues and receives cheques on a regular basis. It can
take advantage of the concept of float. Whenever cheques are deposited
with the bank, credit balance increases in the firms books but not in banks
books until the cheque is cleared and money realized. This refers to
collection float, that is, the amount of cheques deposited into a bank and
clearance awaited. Likewise the firm may take benefit of payment float.
The difference between payment float and collection float is called as net
float. When net float is positive, the balance in the firms books is less
than the banks books; when net float is negative; the firms book balance
is higher than in the banks books.
7.9.3 Determining the Cash Needs Models for Determining Optimal

Cash
One of the prime responsibilities of a Finance Manager is to maintain an
appropriate balance between cash and marketable securities. The amount
of cash balance will depend on risk-return trade-off. A firm with less cash
balances has a weak liquidity position but may be earning profits by
investing its surplus cash and on the other hand it loses on the profits by
holding too much cash. A balance has to be maintained between these
aspects at all times. So how much is optimum cash? This section explains
the models for determining the appropriate balance. Two important models
are studied here Baumol model and Miller-Orr model.
Baumol Model
The Baumol model helps in determining the minimum cost amount of cash
that a manager can obtain by converting securities into cash. It is an
approach to establish a firms optimum cash balance under certainty. As
such, firms attempt to minimize the sum of the cost of holding cash and the
cost of converting marketable securities to cash. The Baumol model is
based on the following assumptions:
The firm is able to forecast its cash requirements in an accurate way.
The firms pay-outs are uniform over a period of time.
The opportunity cost of holding cash is known and does not change with
time.
The firm will incur the same transaction cost for all conversions of
securities into cash.
A company will sell securities and realizes cash and this cash is used to
make payments. As the cash balance comes down and reaches a point, the
Finance Manager replenishes its cash balance by selling marketable
securities available with it and this pattern continues. Cash balances are
refilled and brought back to normal levels by the acts of sale of securities.
The average cash balance is C/2. The firm buys securities as and when
they have above-normal cash balances. This pattern is explained below:
C
Cash balance
C/2 Average
0 T1 T2 T3
Time

Baumols Model
The total cost associated with cash management has two elements
(a) cost of conversion of marketable securities into cash and (b) the
opportunity cost.
The firm incurs a holding cost for keeping cash balance which is the
opportunity cost. Opportunity cost is the benefit foregone on the next best
alternative for the current action. Holding cost is k(C/2).
The firm also incurs a transaction cost whenever it converts its marketable
securities into cash. Total number of transactions during the year will be the
total funds requirement, T, divided by the cash balance, C, i.e. T/C. If per
transaction cost is c, then the total transaction cost is c(T/C).
The total annual cost of the demand for cash is k(C/2) + c(T/C).
Total cost
Holding cost
Cost
Transaction cost
Cash balance C*
Baumols Cut-off Model
The optimum cash balance C* is obtained when the total cost is minimum
which is expressed as C* = 2cT/k where C* is the optimum cash balance, c
is the cost per transaction, T is the total cash needed during the year and k
is the opportunity cost of holding cash balance. The optimum cash balance
will increase with increase in the per transaction cost and total funds
required and decrease with the opportunity cost.
Example:
A firms annual cost requirement is Rs. 20000000. The opportunity cost of
capital is 15% per annum. Rs. 150 is the per transaction cost for the firm

when it converts is short-term securities to cash. Find out the optimum cash
balance. What is the annual cost of the demand for the optimum cash
balance?
Solution
C* = 2cT/k = [2(150)(20000000)] / 0.15 = Rs. 200000
The annual cost is 150(20000000/200000) + 0.15 (200000/2) = Rs. 30000.
Example:
Mysore Lamps Ltd. requires Rs. 30 lakhs to meet its quarterly cash
requirements. The annual return on its marketable securities which are of
the tune of Rs. 30 lakhs is 20%. The conversion of the securities into cash
necessitates a fixed cost of Rs. 3000 per transaction. Compute the optimum
conversion amount.
Solution
C* = 2cT/k = [2*3000*3000000] / 0.05@ = Rs. 600000
@ is 20% / 4 as 20% is annual return and fund requirement is done on a
quarterly basis.
Miller-Orr model
Miller-Orr came out with another model due to the limitation of the Baumol
model. Baumol model assumes that cash flow does not fluctuate. In the real
world, rarely do we come across firms which have their cash needs as
constant. Keeping other factors such as expansion, modernization,
diversification constant, firms face situations wherein they need additional
cash to maintain their present position because of the effect of inflationary
pressures. The firms therefore cannot forecast their fund requirements
accurately. The Miller-Orr model overcomes this shortcoming and considers
daily cash fluctuations. The MO model assumes that cash balances
randomly fluctuate between an upper bound (upper control limit) and a lower
bound (lower control limit). When cash balances hit the upper limit, the firm
has too much cash and it is time to buy enough marketable securities to
bring back to the optimal bound. When cash balances touch zero level, the
level is brought up by selling securities into cash. Return point lies between
the upper and lower limits. Symbolically, this can be expressed as
Z = 33/4*(c2/i) where Z is the optimal cash balance, c is the transaction
cost, 2 is the standard deviation of the net cash flows and i is the interest
rate. MO model also suggests the optimum upper boundary b as three times
the optimal cash balance and lower limit, i.e. upper limit b=lower limit + 3Z
and return point=lower limit + Z. This is shown graphically as follows:
Upper limit
Cash balance
Return point
Lower limit
Time
Miller-Orr Model
Example:
Mehta industries have a policy of maintaining Rs. 500000 minimum cash
balance. The standard deviation of the companys daily cash flows is
Rs. 200000. The interest rate is 14%. The company has to spend Rs. 150
per transaction. Calculate the upper and lower limits and the return point as
per MO model.
Solution
Z = 33/4*(c2/i)
33/4*(150*2000002) / 0.14/365 = Rs. 227226
The Upper control limit = lower limit + 3Z = 500000 + 3*227226 =
Rs. 1181678
Return point = lower limit + Z = 500000 + 227226 = Rs. 727226
Average cash balance = lower limit + 4/3Z = 500000 + 4/3*227226 =
Rs. 802968

Cash Planning
Cash planning is a technique to plan and control the use of cash. It helps in
developing a projected cash statement from the expected inflows and
outflows of cash. Forecasts are based on the past performance and future
anticipation of events. Cash planning can be done a daily, weekly or on a
monthly basis. Generally, monthly forecasts are commonly prepared by
firms.
Cash Forecasting and Budgeting
Cash budget is a device to plan for and control cash receipts and payments.
It gives a summary of cash flows over a period of time. The Finance
Manager can plan the future cash requirements of a firm based on the cash
budgets. The first element of a cash budget is the selection of the time
period which is referred to as the planning horizon. Selecting the
appropriate time period is based on the factors exclusive to the firms. Some
firms may prefer to prepare weekly budget while others may work out
monthly estimates while some others may be preparing quarterly or yearly
budgets. Firms should keep in mind that the period selected should be
neither too long nor too short. Too long a period, estimates will not be
accurate and too short a period requires periodic changes. Yearly budgets
can be prepared by such companies whose business is very stable and they
do not expect major changes affecting the companys flow of cash.
The second element that has a bearing on cash budget preparation is the
selection of factors that have a bearing on cash flows. Only items of cash
nature are to be selected while non-cash items such as depreciation and
amortization are excluded.
Cash budgets are prepared under three methods:
1. Receipts and Payments method
2. Income and Expenditure method
3. Balance Sheet method
We shall be discussing only the receipts and payments method of preparing
cash budgets.
Example:
Given below is the prepared a cash budget of M/s. Panduranga Sheet
Metals Ltd. for the 6 months ending 30th June 2007. It has an opening cash
balance of Rs. 60000 on 1st Jan 2007.
Month Sales Purchases Wages Production Selling

overheads overheads
Jan 60000 24000 10000 6000 5000
Feb 70000 27000 11000 6300 5500
March 82000 32000 10000 6400 6200
April 85000 35000 10500 6600 6500
May 96000 38800 11000 6400 7200
June 110000 41600 12500 6500 7500
The company has a policy of selling its goods 50% on cash basis and the
rest on credit terms. Debtors are given a months time period to pay their
dues. Purchases are to be paid off two months from the date of purchase.
The company has a time lag in the payment of wages of a month and the
overheads are paid after a month. The company is also planning to invest in
a machine which will be useful for packing purposes, the cost being
Rs. 45000, payable in 3 equal installments starting bi-monthly from April. It
also expects to make a loan application to a bank for Rs. 50000 and the
loan will be granted in the month of July. The company has to pay advance
income tax of Rs. 20000 in the month of April. Salesmen are eligible for a
commission of 4% on total sales effected by them and this is payable one
month after the date of sale.
Solution
Jan Feb March April May June
Opening cash balance 60000 85000 126100 153000 118850 150100
Cash receipts:
Cash sales 30000 35000 41000 42500 48000 55000
Credit sales 30000 35000 41000 42500 48000
Total cash available 90000 150000 202100 236500 209350 253100
Cash payments
Materials 24000 27000 32000 35000
Wages 5000 10500 10500 10250 10750 11750
Production overheads 6000 6300 6400 6600 6400
Selling overheads 5000 5500 6200 6500 7200
Sales commission 2400 2800 3280 3400 3840
Purchase of asset 15000 15000
Payment of advance IT 20000
Total cash payments 5000 23900 49100 117650 59250 79190
Closing cash balances 85000 126100 153000 118850 150100 173930

Working note:
Wages calculation
Jan Feb Mar Apr May Jun

10000 11000 10000 10500 11000 12500
5000 5500-feb 5000-mar 5250-apr 5500-may 6250-jun
5000-mar 5500-feb 5000-mar 5250-apr 5500-may
5000 10500 10500 10250 10750 11750

12. Management of cash balances can be done by ____________ and
_________.
13. The four motives for holding cash are ___________,
_______________ , ____________ and ____________.
14. The greater the creditworthiness of the firm in the market lesser is the
need for ___________ balances.
15. __________ refers to the credit extended by the supplier of goods and
services in the normal course of business transactions.
16. When cheques are deposited in a bank, credit balance increases in the
firms books but not in banks books until the cheque is cleared and
money realized. This is called as ________________.
17. According to Baumol model, the total cost associated with cash
management has two elements ______________ and ____________.
18. The MO model assumes that cash balances randomly fluctuate
between a ____________ and a __________________.
7.10 Summary
All companies are required to maintain a minimum level of current assets at
all points of time. This level is the core or permanent working capital of the
company. Over this level, working capital varies with the level of activities.
Working capital management is concerned with determination of relevant
levels of current assets and their efficient use. The dangers of holding
excess current assets are unnecessary accumulation of stocks and
inadequate working capital which stagnates growth.

The need for holding cash arises due to a variety of reasons transaction
motive, speculation motive, precautionary motive and compensating motive.
The objective of cash management is to make short-term forecasts of cash
position, investing surplus cash and finding means to arrange for cash
deficits. Cash budgets help Finance Manager to forecast the cash position.

1. Miraj Engineering Co. has forecast its sales for the 3 months ending
Dec. as follows:
Oct. Rs. 500000 Nov Rs. 600000 Dec. Rs. 650000
The goods are sold on cash and credit basis 50% each. Credit sales are
realized in the month following the sale. Purchases amount to 50% of
the months sales and are paid in the following month. Wages and
administrative expenses per month amount to Rs. 150000 and Rs.
80000 respectively and are paid in the following month. On 1st Dec. the
company has purchased a testing equipment worth Rs. 20000 payable
on 15th Nov. On 31st Dec. a cash deposit with a bank will mature for
Rs. 150000. The opening cash balance on 1st Nov. is Rs. 100000. What
is the closing balance in Nov. and Dec.?
2. The following data is available in respect of a company. A condition is
laid by suppliers that the orders must be placed in multiples of 500 units
only.
Annual requirements 300000 units
Purchase price per unit Rs. 3
Cararying cost 25% of purchase price
Cost per order placed Rs. 20
Find EOQ.
3. Nisha Ltd. wants to calculate EOQ. You are requested to help them. The
following are the required data available.
Annual demand 480 units
Price per unit Rs. 4
Carrying cost 40 Paise per unit
Cost per order Rs. 5 per unit.
Also calculate the number of order per year and frequency of purchases.

7.12 Answers
1. Gross working capital
2. Positive, negative
3. Liquidity and profitability
4. Operating cycle
5. Raw Material storage period, Conversion period, Finished goods
storage period and Average collection period
6. Fixed assets and current assets
7. Finished good inventory
8. Manufacturing cycle
9. Finished goods
10. Less
11. Profitability
12. Deficit financing or investing surplus cash
13. Transaction, speculative, precautionary and compensating
14. Precautionary
15. Trade credit
16. Collection float
17. Cost of conversion of marketable securities into cash and opportunity
cost.
18. Upper bound (upper control limit) and lower bound (lower control limit).
Terminal Questions
1.2, 3: Hint: Apply EOQ formula of EOQ = 2AS / C

Unit 8 Working Capital Management II

Structure:
8.1 Introduction
Objectives
8.2 Inventory Management
Role of Inventory in Working Capital
Purpose of Inventories
Costs Associated with Inventories
Inventory Management Techniques
Re-order Point
Pricing of Inventories
8.3 Receivables Management
Objectives
Costs Associated with Maintaining Receivables
Credit Policy
Credit Standards
Credit Period
Cash Discounts
Collection Program
8.4 Summary
8.6 Answers
8.1 Introduction
Inventory management is the process of efficiently overseeing the constant
flow of units into and out of an existing inventory. This process usually
involves controlling the transfer in of units in order to prevent the inventory
from becoming too high, or too slow. Receivables are a direct result of credit
sales. Credit sale is resorted to by a firm to push up its sales which
ultimately result in pushing up the profits earned by the firm. At the same
time, selling goods on credit results in blocking of funds in accounts
receivable. Additional funds are, therefore, required for the operational
needs of the business which involve extra coasts in terms of interest.
Moreover, increase in receivables also increases chances of bad debts.

Objectives
State the purpose of inventory.
Discuss the techniques of inventory control.
State the objectives of receivables management.
List out the costs associated with receivables management.
8.2 Inventory Management

The term inventory refers to the stockpile of products. Inventory comprises
of those assets which will be sold off in the near future and moneys
recovered. Inventory consists of three types of assets raw materials, semi
-finished goods (work in progress) and finished goods. Raw material
inventory consists of those items which are purchased by the firm to be
converted into finished goods. Work in progress inventory consists of
partially complete goods, that is, items currently being used in the
production process. Finished goods stock represent completed products
ready to be sold.
Inventory management is the control of all above-mentioned assets to
obtain the goal of minimizing total costs direct and indirect that are
associated with holding inventories. Stocks constitute a very significant part
of current assets. A rough estimate says, out of the total current assets with
Indian public companies, more than 60% account for inventories. The sheer
size of this asset tells us the amount of funds required. It, therefore,
becomes necessary to manage inventories in a very efficient way and avoid
unnecessary hold-ups.
The chief responsibility of a Finance Manager of a firm is to see to it that the
actions of the firm ultimately lead to wealth maximization of shareholders.
We have already discussed in the previous section that in order to minimize
cash requirements, inventories should be turned over as quickly as possible.
Stock hold-ups lead to cash block-ups percolating down to other areas. Also
he should ensure availability of sufficient raw materials for smooth
production and sufficient finished goods stock to satisfy sales demands.
These two conflicting situations must be balanced properly. The optimum
level of inventory determined is a basis of trade-off between costs and
benefits associated with the inventory levels.

8.2.1 Role of Inventory in Working Capital

Inventories form an important part of a firms working capital. Some
characteristic features about inventory are as follows:
1. Current asset: Inventories will be converted to cash within a year.
2. Level of liquidity: Inventories are looked at as next to cash. A firm
having fast-moving goods in its stock can convert the products quickly to
cash. Such stocks are called as highly liquid stocks. Firms having large
stocks of goods not demanded by customers or which are outdated in
style and fashion or which have deteriorated in quality due to external
conditions like weather, have huge liquidity problems. Such firms do
show the goods as current assets but these cannot be sold in the market
and therefore do not bring any profits to the firm.
3. Liquidity lags: Inventories have three types of lags:
a. Creation lag: Raw materials are purchased on credit (creation of
accounts payable) and used to produce finished goods. Production
entails many types of payments like labour, electricity charges, rent
of building, etc. All the payments are made after a small time lag,
generally after 30 days. Similarly, goods purchased for resale
(trading companies) are also held for a period of 30 days or so
before payment is made for them. There is always a lag in payment
whether goods are purchased or manufactured. This liquidity lag
offers a benefit to the firm.
b. Storage lag: The goods held for sale cannot be converted into cash
immediately. Whether the goods are fast-moving or slow-moving, the
firm realizes its cash after a certain period. The firm, on the other
hand, pays off its suppliers, labourers and meets overhead expenses
before the goods are actually sold and cash realized. This lag is a
cost to the firm.
c. Sale lag: Instant cash is realized when goods are sold on cash basis
but in competitive situations, firms should give some credit period to
their customers to enhance their sales volumes. This results in
accounts receivable and this lag is a cost to the firm.
4. Circulating Activity: Stocks are in a circulating pattern with other
current assets. Raw materials get converted into semi-finished goods
which in turn are processed and sold as finished goods. Finished goods

take the accounts receivable form and then become cash. Cash is
again re-invested in inventory to continue the operating cycle.
8.2.2 Purpose of Inventories
The goal of inventory holding is to achieve efficiency through cost reduction
and to increase sales volume. The following are the other benefits accruing
from holding inventories:
Sales: Customers purchase goods only when the need arises. On the
other hand, firms should always have a ready stock of finished goods to
maintain customers loyalty. If the goods they want are not available
most of them look at other substitutes (in present day market scenario,
plenty of alternatives with similar features and prices are available).
Avail quantity discounts: Suppliers give discounts for bulk purchases.
Such discounts increase the firms profits. Firms may go in for large
orders to benefit from discounts offered by dealers.
Reducing ordering costs and time: Every time a firm places an order,
it incurs certain administrative expenses and some time is lost in
processing these forms to get necessary approvals. Each of these
varies with the number of orders placed. To save on time and costs, the
firms may think about placing big orders.
Reduce risk of production shortages: Manufacturing firms require a
whole lot of raw materials and spares and tools to help the production
process and in machine maintenance. Even if one item is missing or is
not available immediately, the entire production process goes for a toss
and the firm incurs heavy losses. To avoid such situations, firms
maintain the required stores and inventories in sufficient quantities.
These benefits arise because stocks provide a buffer between purchasing,
producing and marketing goods.
8.2.3 Costs Associated with Inventories
Successful inventory management is a trade off between high and low
levels of inventory. The inventory cost can be classified as under:
Material costs: These are the costs of purchasing the goods and the
related cost such as transportation and handling costs associated with it.
Ordering costs: The expenses incurred to place orders with suppliers
and replenish inventory of raw materials are known as ordering cots.

Ordering costs include requisitioning, purchase ordering, transporting,

receiving, inspecting and handling at the warehouse. These costs go up
with the number of orders placed; the more frequently inventory is
required, higher is the firms ordering costs. In contrast, a firm with high
levels of inventory will have less ordering costs, that is, the ordering
costs and volume ordered have an indirect ratio.
Carrying costs: These are the expenses incurred in connection with
maintaining a given level of inventory, that is, storage of goods. They
include storage, insurance, taxes, deterioration, spoilage, obsolescence,
salaries of warehouse-keeper, maintenance of buildings etc. Carrying
costs generally are to the tune of 25% of the value of inventory in
storage. The greater the inventory, the greater is the carrying cost.
Contrary to the ordering cost, these costs decline with increase in
inventory size.
Cost of funds tied up in inventory: Whenever a firm commits its
resources to inventory, it is using funds that otherwise might have been
available for other activities. The firm is losing on the opportunity cost. If
the funds were not locked up in inventory, they would have earned a
return.
Cost of running out of goods: These are the costs associated with the
inability to provide materials to the production department when they ask
for or not providing finished goods to the marketing department when
demand is there. Both these types of lapses have a cost on the profits of
the firm. Loss in production takes place due to non-availability of raw
materials and customers are lost due to non-availability of finished
goods in the market. Erosion of customers is not a good sign and the
companys goodwill is lost in the market.
8.4.4 Inventory Management Techniques
We have just studied the objectives of inventory management and the
importance of the optimum level of inventory. Many mathematical models
are available to handle inventory management problems. Some of the
methods of efficient inventory control system are discussed here:
ABC System
Monitoring a large number and types of inventory becomes very difficult in a
big company given the amount involved. In such cases, ABC analysis

enables the management to monitor the stocks in a proper manner. It is

neither required nor desirable for firms to keep the same degree of control
on all the items in stock. Items of high value command maximum attention
while low value items do not require much control. The firm therefore
classifies inventories into three different categories A group items with
high-value come under this classification and they involve the largest
investment and high attention. Rigorous, sophisticated and intensive control
measures are used for such item monitoring. Items under the C group
represent least value items needing simple control techniques and less
attention although the number of items in this group is fairly large. The B
group stands midway. They are neither too expensive nor very cheap.
These items require reasonable attention. The ABC analysis concentrates
on important items and is therefore known as Control by Importance and
Exception. It is also known as Proportional Value Analysis as items are
classified according to the importance of their value.
Advantages of ABC analysis:
It ensures closer control on costly items in which lies the greater part of
companys resources.
Clerical costs are greatly reduced as stocks are maintained at optimum
level.
It helps in achieving the main objective of inventory control at minimum
cost.
Economic Order Quantity (EOQ)

EOQ refers to the optimal order size that will result in the lowest ordering
and carrying costs for an item of inventory based on its expected usage.
Answers to questions such as: What should be the quantity ordered for each
replenishment of stock, how many orders should be placed to get the raw
materials or should the entire requirement be procured once or in
installments and if installments, how many of them these are sought to be
explained by the EOQ model. The optimum level of inventory is referred to
as the Economic Order Quantity. It is the economic lot size. EOQ is defined
as that level of inventory order that minimizes the total cost associated with
the inventory management. It is that level one unit beyond which is
additional cost to the firm and one unit below may hamper production

process. The model is based on the following assumptions; nevertheless, it

is the most widely used technique in inventory control.
Constant or uniform demand: The firm knows with certainty the annual
consumption of a particular item of inventory.
Constant unit price: The EOQ model is based on the assumption that
the per unit price of material does not change and is constant
irrespective of the order size.
Constant carrying costs: Unit carrying costs are known to vary
substantially as the size of inventory increases or decreases. Firms
derive economies of scale by increasing order size. However, the EOQ
model assumes the carrying costs to be constant.
Constant ordering costs: Ordering costs are assumed to be constant
whatever the number of orders are and whatever the size is.
Total cost Carrying cost

Costs
Ordering cost
Q* Ordering size
Economic Order Quantity:

Optimum Production Quantity
The formula for EOQ model is 2AS / C
Where A refers to the annual usage,
S refers to ordering cost,
C refers to cost of carrying inventory per unit per annum.

Example:
The following details are available. Calculate EOQ.
Annual consumption of raw material M 40000 units.
Cost per unit Rs. 16
Carrying cost is 15% p.a
Cost of placing an order Rs. 480
Solution
EOQ = 2AS / C = 2*40000*480) / 2.4 = 16000000 = 4000 units
C = 16*15% = 2.4
Example:
Bangalore Industries is a pioneer in manufacturing perfumes. It has
estimated that the annual requirement of a particular type of perfume which
is used as raw material is 50000 units. The carrying cost is estimated as
15% and the ordering cost is estimated to be Rs. 10 per order. The unit cost
of raw material is Rs. 8. What is the most economical order?
Solution
EOQ = 2AS / C = 2*50000*10} / 1.2 = 833333 = 913 units
C = 8*15% = 1.2
8.2.5 Re-order Point
In the EOQ model, it was assumed that there is no time lag between
ordering and procuring of materials. Therefore the re-order point for
replenishing the stocks occurs at that level when the inventory level drops to
zero and because of instant delivery by suppliers, the stock levels bounce
back. But rarely do we come across such situations in real life. There is
always a lead time between ordering date and receipt of materials. Due to
this, the reorder level is always higher than zero. The firm places a fresh
order before the stocks go down to zero and by the time they hit the zero
levels, new stocks would have arrived and the business is smooth. The
question now is what should be the level of inventory before fresh orders are
placed? Factors such as the time required to re-stock and the usage rate of
the said material are to be considered to decide on this issue.
Re-order Point = Normal Consumption during lead time + Safety stock
Reorder level = Average usage *Lead time

Safety stock
In order to avoid a stock-out situation, the firms should maintain a safety
stock which will act as a buffer or a cushion against a possible shortage of
inventory. Safety stock may be defined as the minimum additional inventory
to meet an unanticipated increase in usage resulting from an unusual high
demand.
8.2.6 Pricing of Inventories
There are different ways of valuing inventories. Firms should choose that
system which gives them the maximum benefit.
First In First Out (FIFO): A firm adopting this method prices the raw
material at that rate at which the materials were received. The goods
received first are issued first and once the first set of consignment is
completely exhausted, the second set is not utilized. This is a logical
method of issues which is used by almost all companies.
Last In First Out (LIFO): In the LIFO method, the consignment last
received is first issued and if this is not sufficient, only then the previous
set in the warehouse is utilized. This system is useful when the
companies want to price their product on the basis of total cost incurred
plus a percentage of profit. Under this method, the goods manufactured
will be having a higher value and therefore the company can derive a
higher profit on their goods. This method defies logic in the sense
companies issuing materials for production activities under this system
find that they have ended up with the initial sets procured and they have
deteriorated in quality after a point of time.
Weighted Average Method: The pricing of materials is done on
weighted average method wherein weights are assigned to the
quantities held and accordingly priced. This is one of the most widely
used methods as it gives importance to the balances in stores in their
proportion of availability.
Standard price method: Under this method, the material is priced at a
standard cost which is predetermined. When the material is purchased,
the stock account will be debited with the standard price. The difference
between the purchase price and the standard price will be carried to a
variance account. This is again not a widely used system as the pre-

determined prices may be very less and not consistent with the
prevailing situations.
Replacement or Current price method: This method prices the issues
at the value that is realizable at the time of issue.

1. Inventory consists of three types of assets _____________,
____________ and __________________.
2. The optimum level of inventory is a trade-off between ____________
with the inventory levels.
3. Liquidity lags are of three types. They are _________, ____________
and ___________.
4. The goal of inventory holding is to achieve efficiency through
____________.
5. Loss in production takes place due to non-availability of raw materials
is ________ type of inventory cost.
6. ABC technique classifies high-value goods under ___________- group
and places least value goods under ______ group.
7. The ABC analysis is also known as ____________.
8. ___________refers to the optimal order size that will result in the
lowest ordering and carrying costs for an item of inventory based on its
expected usage.
9. ___________is the minimum additional inventory to meet an
unanticipated increase in usage resulting from an unusual high
demand.
10. The price of the material which is predetermined is _________.
8.3 Receivables Management

Businesses sell goods on credit to increase the volume of sales. In the
present era of intense competition, one way to improve sale deals is to offer
relaxed payment conditions to customers. Finished goods get converted to
receivables when sold on credit terms. Trade credit is a marketing tool that
tries to bridge the gap between production and distribution of companys
products. Trade credit creates receivables or book debts which the firm
hopes to realize in the near future. The receivables are a very important
component of current assets. A study has recently concluded that

receivables constitute a third of a firms current assets. As this is a huge

amount in the composition of current assets, the Finance Manager must
know how to exercise proper control on this item. The purpose of this
section is to explain the various facets of receivables, their importance in a
company and their efficient management.
8.3.1 Objectives
The term receivables is defined as debt owed to the firm by customers
arising from the sale of goods or services in the ordinary course of
business. The main objective of having receivables in the current assets is
to promote and encourage sales which will lead to increased profits. In
competitive situations, the firms will be forced to offer goods on credit
keeping in line with competitors strategies. Customers will always prefer to
postpone payments and they will constantly be in search of that supplier
who gives credit. The company may lose customers by following a no
credit policy which in turn means fewer sales and lesser profits. All firms
therefore grant credit to increase sales, profits and to meet competition.
8.3.2 Costs Associated with Maintaining Receivables
The following are the different costs incurred with the extension of credit and
accounts receivable:
Capital cost: A firm offering goods on credit can surely expect higher
sales but some of the firms resources remain blocked in them as there
is a time lag between a credit sale and cash receipt from customers. The
increase in the accounts receivables is an investment in assets to the
company. To the extent the moneys are blocked in its book debts, the
firm has to arrange additional funds to meet its obligations for payments
to its suppliers, employees, etc. The cost of the use of additional capital
to maintain its obligations will definitely have an effect on the firms
profits.
Collection cost: These are the costs incurred in collecting receivables.
They are administrative in nature and these costs include (a) additional
expenses on the creation and maintenance of staff, stationery, postage,
registers etc.
Delinquency Cost: This cost arises out of the failure of customers to
meet their obligations when payment on credit sales becomes due after

the expiry of credit period. Additional costs in the form of reminders,

legal charges etc. will be incurred.
Default cost: The firm may not be able to recover its dues because of
its customers inability to pay off their debts. Such dues are bad debts
and go on to reduce the profits of the company.
The size of the receivables is determined by the firms credit policy and the
level of its sales.
8.3.3 Credit Policy

The credit policy of a company can be regarded as a trade-off between
increased credit sales leading to higher profits and the cost of having large
cash locked up in receivables. The credit policy to be adopted in businesses
largely depends upon the competitors strategies. If the competitors are
grating a 15 day credit period and if the firm decides to extend the credit
period to 30 days, the firm will be flooded with customers demand for
companys products. Sometimes, it may not be able to cope up with the
fresh demand. In the long run, other companies may also have to extend
their time line failing which they will be driven out of the scene by
competition. The firm which started the scheme will become a market leader
and other firms will look upon it for further leads.
The credit policy is a framework to determine (a) credit standards, (b) period
of credit, (c) cash discounts to be offered and (d) collection program. All
these variables listed influence the amount of sales, the amounts locked up
in receivables and the bad debts incidence.
8.3.4 Credit Standards

The term credit standard represents the criteria for extending credit to
customers. The quantitative basis for setting credit standards are credit
rating, references, average payment period and ratio analysis. There is
always a benefit to the company with extension of credit to its customers,
but with the benefit come the risks of delayed payment or non-payment,
funds blocked in receivables, etc. Non-extension of credit leads to loss of
customers and indiscriminate extension come with their own problems. The
firm should therefore evaluate the trade-off between cost and benefit as a
whole. Professional credit rating agencies help may be sought to rate a
customers creditworthiness. After rating, the customers are rated as

excellent, very good, good, average, poor, etc. If the company has a
policy of granting credit only to excellent and very good rated customers
and the companys profits are not increasing because of such a policy, the
question the company faces now is Should credit policy be liberalized so as
to grant credit to good and average customers, to have increased sales?
The answer to this question lies in making a cost benefit analysis of tight
credit policy and liberalized credit policy. The overall credit standards can be
divided into (a) tight or restrictive and (b) liberal or easy-going. In general,
the implication of the above factors should be considered.
8.3.5 Credit Period

This refers to the time given to customers to pay for their purchase. It is
generally expressed in days like 15 days or 30 days. Generally, firms give a
discount if payments are made within a said period beyond which they will
not lose on the benefit that can be availed. Increasing the credit period will
bring in new sales and new customers. Reducing the period will lower sales
as customers decrease, which is not desirable.
8.3.6 Cash Discounts
Firms offer cash discounts to induce prompt payments. Cash discounts
have implications on sales volume, average collection period, investment in
receivables, incidence of bad debt losses and profits. Change in discount
rate will bring in additional sales granting discounts implies reduced prices
and this factor brings in new sales. The customers will also want to take
advantage of discounts and therefore they pay their dues promptly. The
negative effect of higher discount on sales is that the per unit profits will
reduce.
8.3.7 Collection Program
The success of a collection program will be dependent on the collection
policy. The objective of a collection policy is to achieve timely collection of
receivables, thereby releasing funds locked up in receivables and minimize
bad debts occurrence. The collection program consists of the following:
Monitoring receivables.
Informing customers about the due date for payment.
Initiating legal action to overdue customers after sending repeated
notices.

Collection policy should be so formulated that it is not too rigorous as it acts

as an irritant to customers, leading to bad relationship with them. Laxity in
the rigour of collection effort will increase sales but bad debt losses will also
increase.

11. Trade credit is a tool that bridges the gap between ___________of
companys products.
12. The main objective of having receivables in the current assets is to
_______________ which lead to increased profits.
13. All firms grant credit to _________, _________ and _________.
14. __________ refers to the failure of customers to meet their obligations
when payment on credit sales becomes due after the expiry of credit
period.
15. ___________ are bad debts to the company.
16. The credit policy to be adopted in businesses largely depends upon the
_____________.
8.4 Summary
Inventory forms a major part of the current assets. The objective of inventory
management is to minimize total costs both direct and indirect. When
usage of inventory and availability is uncertain, the Finance Manager should
be able to get stocks at the least possible time. EOQ will help the Finance
Manager to arrive at the correct amount of inventory level.
All business firms generally sell goods on credit. Goods sold on credit
become receivables which constitute a very important part of current assets.
The level of receivables depend on a number of factors like the volume of
credit sales, credit policy of the firm, credit period extended to customers
and cash discount policy of the company. Liberal credit policy increases the
volume of sales but also brings with it problems of liquidity and bad debts.

1. What is inventory management? Explain its role in working capital
2. Explain the inventory management techniques
3. Explain the costs associated with the maintaining receivables

8.6 Answers to SAQs and TQs

1. Raw materials, semi finished goods and finished goods
2. Costs and benefits associated
3. Creation lag, storage lag and sale lag
4. Cost reduction and increase sales volume
5. Cost of running out of goods
6. A and C
7. Control by Importance and Exception
8. EOQ
9. Safety stock
10. Standard price
11. Production and distribution
12. Encourage sales
13. Increase sales, profits and to meet competition.
14. Delinquency Cost:
15. Default cost
16. Competitors strategies
Terminal Questions
1. Inventories form an important part of a firms working capital. For more
details refer section 8.2
2. Many mathematical models are available to handle inventory
management problems. For more details refer section 8.2
3. The term receivables is defined as debt owed to the firm by customers
arising from the sale of goods or services in the ordinary course of
business. For more details refer section 8.3

Unit 9 Financial Statement Analysis
Structure:
9.1 Introduction
Objectives
9.2 Meaning of Ratio Analysis
Steps in Ratio Analysis
9.3 Classification of Ratios
Balance Sheet Ratio Analysis
Profit and Loss Account Ratio Analysis
Combined Ratio Analysis
9.4 Advantages of Ratio Analysis
9.5 Limitations of Ratio Analysis
9.6 Computation of Ratios (Problems)
9.7 Summary
9.9 Answers
9.1 Introduction
Ratio analysis helps to interpret the information in such a way that it can be
understood by even those people who are not much familiar with financial
figures and statistics. However, all the problems of a business cant be
solved by ratio analysis. It will merely give a general indication of a trend, at
the same time spotlighting any divergence from normality. This knowledge,
however, should enable management to correct whatever may be going
wrong in business. This unit deals with meaning, classification, advantages
and calculation of ratios.
Objectives:
Explain the meaning of Ratio Analysis
Explain the steps in Ratio Analysis
Explain the classification of Ratios
Explain the merits and demerits of Ratio Analysis
Compute the different Ratios

9.2 Meaning of Ratio Analysis

The most important task of a financial manager is to interpret the financial
information in such a manner, that it can be well-understood by the people,
who are not well-versed in financial information figures. The technique by
which it is so done is known as Ratio Analysis.
Ratio is a relationship between two or more variable expressed in,
(i) Percentage, (ii) Rate and (iii) Proportion
Ratio Analysis is an important technique of financial analysis. It depicts the
efficiency or short-fall of the organisation in the form of trend analysis.
Different ratios appeal to different people. Management, having the task of
running a business efficiently, will be interested in all ratios. A supplier of
goods on credit will be particularly interested in liquidity ratios, which
indicate the ability of the business to pay its bills. Existing and future
shareholders will be interested in investment ratios, which indicate the level
of return that can be expected on an investment in the business. Major
customers, intent on having a continuing source of supply, will be interested
in the financial stability, as revealed by the capital structure, liquidity and
profitability ratios. Debenture and loan stock holders will be interested in the
ability of a business to pay interest, and ultimately to repay the capital. A
banker, giving only short-term loans, will be interested mainly in the liquidity
of the business, and its ability to repay those loans.
The overall advantages of ratios are that they enable valid comparisons to
be made between business of varying size and in different industries.
9.2.1 Steps in Ratio Analysis
Step 1 : Collection of information, which are relevant from the financial
statements and then to calculate different ratios accordingly.
Step 2 : Comparison of computed ratios of the same organisation or with
the industry ratios.
Step 3 : Interpretation, drawing of inference and report-writing.

9.3 Classification of Ratios

Profit and Loss A/c Combined Ratios Balance Sheet
Ratios Ratios
Examples: Examples: Examples:

Gross Profit Ratio Return on Capital Liquidity Ratio
Employed
Net Profit Ratio Return on Share- Current Ratio
holders Fund
Expense Ratio Turnover of Proprietary Ratio
Working Capital
Operating Profit etc. Debtors Turnover Debt-Equity Ratio
Ratio etc. Capital Gearing etc.
Chart Showing Application of Different Ratios

For Testing Ratio Concerned Interested Parties
A. Profitability 1. Gross Profit Ratio Shareholders

2. Net Profit Ratio Creditors (Long Term)
3. Operating Ratio Government
4. Return on Capital Employed Purchasers of Enterprise
Employees
5. Dividend Ratio
6. Earning per Share
7. Dividend per Share
B. Liquidity and 1. Current Ratio Creditors (Short Term)

Solvency 2. Liquid Ratio Investors
3. Absolute Liquid Ratio Money lenders
4. Proprietary Ratio
5. Assets to Proprietorship Ratio
6. Debt.-Equity Ratio
7. Capital Gearing Ratio
C. Capital 1. Capital Gearing Ratio Shareholders and outsiders

Structure 2. Equity Capital Ratio
3. Long-term Loans to Networth

D. Activity 1. Debtors Turnover Ratio Management

2. Creditors Turnover Ratio Shareholders
3. Stock Turnover Ratio Creditors (Long and Short Term)
4. Fixed Asset Turnover Ratio Customers
5. Current Asset Turnover
6. Total Asset Turnover Ratio
7. Working Capital Turnover Ratio
E. Management All concerned ratios Management

Efficiency
9.3.1 Balance Sheet Ratio Analysis

1. Current Ratio
Current Assets
Current Ratio =
Current Liabilitie
s
Current ratio indicates the firms ability to pay its current liabilities.
It indicates the strength of the working capital.
Higher ratio, i.e., more than 2:1 indicates sound solvency position.
Lower ratio i.e., less than 2:1 indicates inadequate working capital.
2. Quick Ratio
Quick ratio is also known as liquid ratio or acid test ratio.
Quick or Liquid Assets
Liquid Ratio
Liquid/Cur rent Liabilitie s
Current Assets - (Stock and Prepaid Expenses)

Current Liabilitie s - Bank Overdraft
Higher ratio i.e., more than 1:1 indicates sound financial position.
Lower ratio, i.e., less than 1:1 indicates financial difficulty.
3. Net Working Capital Ratio
It is a measure of companys liquidity position.
Net Working Capital
Net Working Capital Ratio
Net Assets

4. Proprietary Ratio
Shareholde r ' s Funds

Proprietary Ratio
Total Assets or Total Resources
Higher ratio, say more than 75% shows lesser dependence on
external sources.
Lower ratio, say less than 60% shows more dependence on external
sources.
Determine the extent of trading on equity.
5. Capital Gearing Ratio
Fixed Interest Bearing Funds
Capital Gearing
Equity Share Capital
The capital gearing ratio shows the mix of finance employed in the
business.
Few Concepts
Equity Capital = Loan Capital = Even Gear
Equity Capital > Loan Capital = Low Gear = Over Capitalisation
Equity Capital < Loan Capital = Higher Gear = Under Capitalisation
It is useful to ascertain whether a company is practicing trading on
equity and if so, to what extent is done.
6. Debt Equity Ratio
Debt-equity ratio is calculated as follows:
(i) Debt Equity Ratio External Equities
Internal Equities
(ii) Debt Equity Ratio Outsiders ' Funds

Shareholde rs' Funds
As a long-term financial ratio it may be calculated as follows:
(i) Debt Equity Ratio Total Long Term Debts

Total Long Term Funds
Total Long Term Debts
(ii) Debt Equity Ratio
Shareholde rs' Funds
As acceptable norm for this ratio is considered to be 2:1 a higher debt-

equity ratio is allowed in the case of capital-intensive industries.
9.3.2 Profit and Loss Account Ratio Analysis

1. Gross Profit Ratio
Gross Pr ofit
Gross Pr ofit Ratio 100
Net Sales
Sales Cost of Goods Sold
= 100
Net Sales
A ratio of 25 % 30% may be considered good.
2. Operating Ratio
Cost of Goods Sold Operating Expenses
Operating Ratio =
Net Sales
Cost of Goods Sold = Opening Stock + Purchase Closing Stock
Operating Expenses = Administrative Expenses + Financial Expenses +

Selling Expenses
For manufacturing concern an operating ratio between 75% and 80% is
expected.
3. Net Profit Ratio
Higher the ratio of net operating profit to sales, better is the operational
efficiency of the concern.
Net Pr ofit
Net Profit Ratio 100
Net Sales
This ratio is used to measure the overall profitability and hence it is very
useful to proprietors.
4. Return on Capital Employed
This is considered as Du-point control i.e.,
Net Profit Sales
or
Sales Capital Employed
Operating Profit
Return on Capital Employed 100
Capital Employed
The higher the ratio, the more efficient use of the capital employed and
better is the financial position.

5. Return on Shareholders Fund

This ratio establishes the profitability from the shareholders point of
view.
Net Pr ofit
Re turn on Shareholde rs' Fund 100
Shareholde rs' Fund
Net Profit = Net operation Income Interest non-operating expenses
Shareholders Fund = Share Capital + Reserves Surplus
P & L A/c (Dr. Balance)
Misc. Expenditure to the extent not written-off.
9.3.3 Combined Ratio Analysis
1. Stock Turnover
It is also known as Stock Velocity. This ratio helps the financial manager
to evaluate an inventory policy. The ratio reveals the number of times
finished stock is turned over during a given accounting period.
Cost of Goods Sold Sales
Stock Turnover Ratio = or
Average Inventory at Cost Closing Stock
This ratio indicates whether investment in inventory is within proper limit
or not.
It is a test of efficient inventory management. To judge whether the ratio
of a firm is satisfactory or not, it should be compared over a time on the
basis of trend analysis.
No. of days in a year/month Operating Profit
Age of Inventory =
Inventory Turnover Ratio
2. Debtors Turnover Ratio
Credit Sales
Debtors Turnover Ratio =
Average Debtors
Credit Sales
Debtors Turnover =
Closing Debtors
Debt collection period is calculated by any of the following ratios:
Month / Days in a year

i)
Debtors Turnover

Average Debtors Months / Days

ii)
Net Credit Sales for the Year
Accounts Re ceivable
iii)
Average Monthly or Daily Credit Sales
The higher the Turnover Ratio and the shorter the average collection
period, the better the trade credit management and the better the
liquidity of debtors.
3. Creditors Turnover Ratio
Also termed as Creditors Velocity
Net Credit Purchase

Creditors Turnover Ratio =
Average Accounts Payable
Accounts Payable
=
Net Credit Purchase
Accounts Payable
Average Payment Period = No. of Days in a year
Net Credit Purchase
A higher ratio shows that the creditors are not paid in time. A lower ratio
shows that the business is not taking the full advantage of credit period
allowed by the creditors.
4. Working Capital Turnover Ratio
A Higher Working Capital Turnover Ratio shows that there is low
investment in working capital and vice-versa. A higher ratio will indicate
effective utilisation and more profit.
Credit of Sales Sales

Working Capital = or
Net Working Capital Net Working Capital
Turnover Ratio
5. Fixed Assets Turnover Ratio

Higher the ratio, greater is the intensive utilization of fixed assets. Lower
ratio means underutilizations of fixed assets.
Fixed Asset = Cost of Sales or Sales
Turnover Ratio Net Fixed Assets Net Fixed Assets

6. Capital Turnover Ratio

Sales
Lower Capital = Cost of Sales or
Total Capital Employed
Turnover Ratio Total Capital Employed
Lower ratio shows lower profit and higher ratio shows higher profit.
7. Interest Coverage
EBIT
Interest Coverage =
Fixed Interest Ch arg es
[EBIT = Earning before Interest and Tax]
The ratio shows how many times the interest charges are covered by
EBIT out of which they will be paid. The coverage ratio may be
interpreted with reference to its degree. Higher the ratio, better is the
position of long-term creditors. It also highlights the ability of the firm to raise
additional funds in future.
8. Dividend Coverage
It measures the ability of a firm to pay dividend on preference shares
which carry a stated rate of return. Higher the coverage, better is the
position. Dividend coverage on equity share also calculated.
Dividend Coverage = Net Profit after Tax and Interest

(For Preference) Preference Dividend
Dividend Coverage = EBIT Preference Dividend

Equity Dividend
(For Equity)
(Where I = Interest on Debt-Capital, T = Tax]
Other Important Ratios on which the Management is interested.

1. Dividend Pay = Dividend per share
Earning per share
out Ratio
Total Dividend to Equity Sheholders (Cash Dividend)
= Total Net Profit available to Equity Shareholde rs
Dividend paid to Equity Shareholde rs
2. Earning per =
Equity Share No. of Equity Shares

Profit available for Equity Shreholdes

3. Dividend per share =
No. of Equity Shares
Operating Income
4. Fixed Interest Cover =
Annual Interest Expense
Market Pr ice of a Share

5. Price Earning Ratio =
Earning per Share
Dividend per Share
6. Dividend Yield =
Market Price per Share
Earning per Share

7. Earning Yield =
Market Price per Share
Functional Classification of Ratios: All the ratios discussed previously

can be classified on the basis of their functions as follows:
1. Liquidity Ratios: 2. Solvency Ratios:
a) Current ratio a) Current ratio
b) Acid test ratio b) Acid test ratio
c) Equity ratio
d) Debt ratio
e) Debt-equity ratio
f) Net income to debt service ratio
3. Profitability Ratios: 4. Activity Ratios:
a) Gross profit ratio a) Inventory turnover
b) Net profit ratio b) Debtors turnover
c) Return on equity c) Fixed assets turnover
d) Return on investment d) Working capital turnover
e) Return on networth
5. Leverage Ratios: 6. Financial ratios:
a) Debt ratio a) Fixed assets ratio
b) Net income to debt service ratio b) Capital gearing ratio
c) Debt equity ratio c) Debt-equity ratio
d) Proprietary ratio d) Current ratio
e) Liquidity ratio
The classification given above would help students to work out problems
which do not specify the individual ratios to be worked out but the student is

asked to calculate a particular group such as solvency ratios, leverage

ratios, etc.
The table given below would also help students to calculate the required
ratios in a given problem:
Objectives of Analysis Ratios to be Computed
1. Short-term financial solvency a) Current ratio
b) Liquidity ratio
2. Long-term financial solvency a) Equity or proprietary ratio
b) Debt ratio
c) Debt-equity ratio
d) Shareholders equity to total equity ratio
3. Immediate solvency a) Liquidity ratio
4. Overall efficiency a) Return on investment
b) Operating ratio
c) Assets turnover and other turnover ratios
d) Return on proprietors equity
e) Earnings per share
5. Profitability in relation to sales a) Gross profit ratio

b) Net profit ratio
6. Profitability in relation to a) Return on investment
investment b) Return on proprietors equity
c) Earnings per share
7. Over-trading or under-trading a) Proprietary ratio
b) Current ratio
c) Stock turnover ratio
8. Trading on equity a) Capital gearing ratio
9. Over-capitalisation and a) Proprietary ratio
under-capitalisation b) Current ratio
c) Return on equity capital
10. Operating efficiency a) Operating ratio
b) Expense ratios
An absolute figure does not convey anything unless it is related with the
other relevant figure. Magnitude of current liabilities of a company does not
tell anything about solvency position of the company. It is only when it is

related with current assets figures of the same company an idea about the
solvency position of the company can be had. Ratios make a humble
attempt in this direction.
Ratios are significant both in vertical and horizontal analysis. In vertical
analysis ratios help the analyst to form a judgement whether performance of
the Corporation at a point of time is good, questionable or poor. Likewise,
use of ratios in horizontal analysis indicates whether the financial condition
of the corporation is improving or deteriorating and whether the cost,
profitability or efficiency is showing an upward or downward trend.
Financial ratios are meaningful in judging the financial condition and
profitability performance of the corporation only when there is a comparison.
In fact, analysis of ratio involves two types of comparison. First, a
comparison of present ratio with past and expected future ratios for the
same corporation. When financial ratios for several preceding years are
computed, the analyst can determine the composition of change and
whether there has been an improvement or deterioration in the financial
position of the corporation over the period of time. The second method of
comparison involves comparing the ratios of the company with those of
similar type of company or with industry averages at the same point of time.
Such a comparison would provide considerable insight into the relative
financial condition and performance of the company.
1. __________ is the technique of interpreting the financial information in
such a manner, that it can be well-understood by the people, who are
not well-versed in financial information figures.
2. _____________ iss a relationship between two or more variable
expressed in Percentage, Rate and Proportion.
3. Existing and future shareholders of a company will be interested in
___________ which indicate the level of return that can be expected on
an investment in the business.
4. Higher Current Ratio indicates __________ while Lower Current Ratio
indicates ____________ .
5. ___________ is also known as liquid ratio or acid test ratio.
6. __________ is a measure of companys liquidity position.

9.4 Advantages of Ratio Analysis

Ratio analysis is a very important and useful tool for financial analysis. It
serves many purposes and is helpful not only for internal management but
also for prospective investors, creditors and other outsiders. The following
are the important uses (advantages) of ratio analysis.
1. It is an important and useful tool to check upon the efficiency with
which the working capital is being used (managed) in a business
enterprise. Ensures efficient management of working capital.
2. It helps the management of business concern in evaluating its financial
position and efficiency of performance.
3. It serves as a sort of health test of a business firm, because with the
help of this analysis financial managers can determine whether the firm
is financially healthy or not.
4. A ratio analysis covering a number of past accounting (financial)
periods clearly shows the trend of changes in the business position
(i.e., whether the trend in financial position, income position etc. is
upward, or downward or static). The progress or downfall of a business
concern is clearly indicated by this analysis. Use to measure the trend
of the Business.
5. It helps in making financial estimates for the future (i.e., in financial
forecasting).
6. It helps the task of managerial control to a great extent.
7. It helps the credit suppliers and investors in evaluating a business firm
as a desirable debtor or as a potential investment outlet.
8. With the help of this analysis ideal (standard) ratios can be established
and these can be used for the purpose of comparison of a firms
progress and performance.
9. This analysis communicates important information regarding financial
strength and standing, earning capacity, debt (borrowing) capacity,
liquidity position, capacity to meet fixed commitments (charges,
solvency, capital gearing, working capital management, future
prospects etc. of a business concern.
10. This analysis may be employed for the purpose of comparing the
working result and efficiency of performance of a business enterprise
with that of other enterprises engaged in the same industry (Inter-firm-
comparison).

11. It helps the management or a business concern to discharge their basic

functions of planning, co-ordinating, controlling, etc.,
12. It serves as an instrument for testing management efficiency.
13. It sometimes provides a useful tool for decisions on certain policy
matters.

1. Ratio analysis helps in making financial forecasting.
2. The progress or downfall of a business concern is not clearly
indicated by ratio analysis.
3. Ratio analysis is an important and useful tool to check upon the
efficiency with which the working capital is being managed in a
business enterprise.
9.5 Limitations of Ratio Analysis

1. Accounting ratios (calculated under the system of ratio analysis) will be
correct only if the accounting data (figures), on which they are based,
are correct.
2. It is mainly a historical analysis or an analysis of the past financial data.
3. In regard to profits of a business concern, ratio analysis may, in certain
circumstances be misleading.
4. Continuous changes in price levels (or, purchasing power of money)
seriously affect the validity or comparison of accounting ratios
calculated for different accounting (financial) periods, and make such
comparisons very difficult.
5. Comparisons become difficult also on account of difference in the
definition of several financial (accounting) terms like gross profit,
operating profit, net profit etc., and on account of a considerable
diversity in practice as regards their measurement.
6. The validity of comparison is also seriously affected by window
dressing in the basic financial statements and by differences in
accounting methods used by different business concerns.
7. A single ratio will not be able to convey much information.
8. This analysis gives only a part of the total information required for
proper decision-making.

9. Ratio analysis should not be taken as substitute for sound judgement.

10. It should not be overlooked that business problems cannot be solved
simply mechanically through ratio analysis or other types of financial
analysis.
9.6 Computation & Ratios (Problems)

Illustration 1: The following is the trading and profit and loss account of
Ram Sons (Pvt.) Ltd. For the year ended June 30, 2007.
Rs. Rs.
To Stock-in-hand 76,250 By Sales 5,00,000
To Purchases 3,15,250 By Stock in hand 98,500
To Carriage and freight 2,000
To Wages 5,000
To Gross profit 2,00,000
Rs. 5,98,500 Rs. 5,98,500
To Administrative expenses1,01,000 By Gross profit 2,00,000
To Finance expenses: By Non-operating incomes:
Interest 1,200 Interest on security 1,500
Discount 2,400 Dividend on shares 3,750
Bad debts 3,400 Profit on sale of shares 750
7,000 6,000
To Selling and distribution
Expenses 12,000
To Non-operating expenses:
Loss on sale of
Securities 350
Provision for legal suit 1,650 2,000

To Net Profit 84,000
Rs. 2,06,000 Rs. 2,06,000
You are required to calculate: (a) Expense ratio, (b) Gross profit ratio,
(c) Net profit ratio, (d) Operating net profit ratio, (e) Operating ratio, and
(f) Stock turnover.

Solution:
a) Expense ratios
Administra tion expenses Rs. 1,01,000

i) 100 20.2%
Sales Rs. 5,00,000
Finance expenses Rs. 7,000
ii) 100 1.40%
Sales Rs. 5,00,000
Selling and distributi on expenses Rs. 12,000
iii) 100 2.40%
Sales Rs. 5,00,000
Non - operating expenses Rs. 2,000
iv) 100 0.4%
Sales Rs. 5,00,000
b) Gross Profit ratio
Gross Profit 2,000

100 40%
Sales 5,00,000
c) Net Profit ratio
Net Profit 84,000

100 16.80%
Sales 5,00,000
d) Operating Net Profit Ratio

Operating net profit = Net profit + Non-operating expenses Non-
operating incomes
= Rs. 84,000 + Rs. 2,000 Rs. 6,000 = Rs. 80,000
Operating net profit Rs. 80,000

Ratio 100 16% *
Sales Rs. 5,00,000
* It may be noted that operating ratio together with the operating net profit
ratio will be equal to 100%.

e) Operating ratio
This is an expression of the cost of goods sold plus all other operating
expenses to net sales. This is calculated as follows:
Stock in the beginning Rs. 76,250
Add: Purchases 3,15,250
Add: Direct expenses (Rs. 2,000 + Rs. 5,000) 7,000
3,98,500
Less: Stock in hand at the end 98,500
Cost of goods sold 3,00,000
Add: All operating expenses:
Administration expenses 1,01,000
Finance expenses 7,000
Selling and distribution expenses 12,000
1,20,000
Total cost of operation Rs. 4,20,000
Rs. 4,20,000
The operating ratio = 100 84% * .
Rs. 5,00,000
f) Stock turnover
Stock at the beginning Rs. 76,250
Add: Stock at the end 98,500
Total Stock Rs. 1,74,750
Rs.1,74,750
Average stock 87,375
2
Cost of gods sold Rs. 3,00,000

Stock turnover = 3.43 times
Average stock Rs. 87,375
* It may be noted that operating ratio together with the operating net
profit ratio will be equal to 100%.

Illustration 2: M/s Raj and Sons Ltd. present you the following:
BALANCE SHEET
As at 31st December, 2006
Rs. Rs.
Equity Share Capital 50,000 Fixed assets 87,500
8% Preference Share Capital 10,000 Investments 25,000
Reserve Fund 40,000 Stock 30,000
6% Debentures 20,000 Sundry Debtors 13,500
Sundry Creditors 30,000 Bank Balance 7,000
Profit and Loss Account Preliminary expenses 8,000
2005 1,000
2006 20,000
21,000
Rs. 1,71,000 Rs. 1,71,000
The directors intend to transfer a sum of Rs. 5,000 out of the current year
profits to provision for tax.
You are required to calculate the following ratios:
a) Return on capital employed ratio
b) Current ratio
c) Fixed assets to networth
d) Debt to equity capital
e) Return on owners capital

Solution:
Raja & Sons Limited
Working Capital:
Current Assets:
Bank Balance Rs. 7,000
Sundry Debtors 13,500
Stock 30,000
Investments* 25,000
75,500
Less: Current Liabilities
Sundry Creditors 30,000
Provision for taxation 5,000
35,000
Working Capital 40,500
Fixed Assets 87,500
Total Funds (Capital) Employed 1,28,000
Less: 6% Debentures 20,000
Shareholders Equity 1,08,000
Represented by:
Equity Share Capital 50,000
Preference Share Capital 10,000
Reserves 40,000
Profit and Loss A/c Balance 8,000
Rs. 1,08,000
(a) Return on capital employed ratio
Net profit for 2000 Rs. 20,000
Add: Interest on debentures 1,200
Total 21,200
Less: Provision for tax 5,000
Adjusted profits after tax Rs. 16,200
16 , 200
Return = 100 12.7%
1, 28 , 000
Note: It is presumed that the provision for taxation is sufficient to discharge
tax liability.
* Presumed to be temporary investments.
P & L A/c balance less preliminary expenses provision for taxation.

(b) Current ratio
Current Asset 75,500

2.16 : 1
Current Liabilitie s 35,000
Company is having current assets of Rs. 2.16 for every Re. 1 of current
liabilities. As the ideal ratio is 2:1, the current ratio is very satisfactory.
(c) Fixed assets to networth
Fixed assets Rs. 87,500
81 : 1
Netw orth Rs.1,08,000
The ratio is less than 1 and it indicates that net worth is more than the
fixed assets and that a portion of net worth is used for financing working
capital. The proper ratio is 0.67, where the whole of long-term funds are
considered. In this case as we have taken only net worth the situation is
very satisfactory.
(d) Debt to equity capital

Debt 20,000
2:5
Equity Capital 50,000
This ratio indicates very low gearing. If one substitutes equity for equity
capital in the denominator, the ratio will be further lower than it is now.
(e) Return on owners capital
Pr ofits available for ow ners 20,000 5,000 15,000
100 25%
Ow ner' s Capital 50,000 10,000 60,000
The return is high even without trading on equity. It would have been
much more had there been high gearing.

Illustration 3: Following is the Balance Sheet of X Company Ltd.:

Balance Sheet as on 31st December 2006
Rs. Rs.
Equity Share Capital 1,00,000 Cash in Hand 2,000
6% Preference Share Capital 1,00,000 Cash at Bank 10,000
7% Debentures 40,000 Bills Receivable 30,000
8% Public Debt 20,000 Investments 20,000
Bank Overdraft 40,000 Debtors 70,000
Creditors 60,000 Stock 40,000
Outstandings Creditors 7,000 Furniture 30,000
Proposed Dividend 10,000 Machinery 1,00,000
Reserves 1,50,000 Land and Building 2,20,000
Provision for Taxation 20,000 Goodwill 35,000
Profit and Loss Account 20,000 Preliminary Expenses 10,000
Rs. 5,67,000 Rs. 5,67,000
During the year provision for taxation was Rs. 20,000. Debentures are
repayable in 2019 and public debt in 2013. Sales during the year were
Rs. 3,00,000. Dividend proposed was Rs. 10,000. Profit carried forward
from the last year Rs. 15,000.
You are required to calculate: (a) Short-term solvency ratios, (b) Long-term
solvency ratios, and (c) Sales ratios.
Solution:
(a) Short-term solvency ratios
1. Current ratio
Current assets
Current ratio
Current liabilitie s
Rs. (2,000 10,000 30,000 20,000 * 70,000 40,000 )

Rs. ( 40,000 60,000 7,000 10,000 20,000 )
Rs. 1,72,000 172

Rs. 1,37,000 137
Company is having current assets of Rs. 172 as against current
liabilities of Rs. 137. There is small margin of safety against fall in
price and financial position is not very sound.

2. Quick ratio:
Quick assets
Quick ratio
Current liabilities
Rs. (2,000 10,000 30,000 20,000 70,000 )

Rs. 1,37,000
Rs. 1,32,000 132

Rs. 1,37,000 137
Companys immediate resources for meeting current liabilities are a

little less than obligations. Its financial position cannot be said to be
very strong. This fact was supported by current ratio also.
* Presumed to be temporary investment.
(b) Long-term solvency ratios
1. Equity ratio:
This is also called shareholders equities to total equities ratio, or net
worth to total assets ratio.
Total ow ned capital including accumulate d profits
Equity ratio
Total Capital
Rs. (1,00,000 1,00,000 1,50,000 20,000 ) Rs. 3,70,000 370

Rs. 5,67,000 Rs. 5,67,000 567
It means that out of every investment of Rs. 567 in the firm,
shareholders contribution is only Rs. 370, i.e., the cushion against
fall in price of assets in the case of liquidation of the company is only
Rs. 197. This margin is not very satisfactory.
2. Net Income to debt service ratio:
Net income before charging interest and income tax

Periodic interest on long term debts
Rs . 35 , 000 ( 1) Rs . 4 , 400 Rs . 39 , 400

9 times .
Rs . 4 , 400 Rs . 4 , 400
Earning of the company from this angle is very sound.

Note:
i) Profit for the year has been calculated as under:
Profit and Loss Account as per B/S Rs. 20,000
Add: Transfer to proposed dividend 10,000
Add: Transfer to taxation reserve 20,000
50,000
Less: Carried forward from last year 15,000
Profit for the year Rs. 35,000
Sales ratios
1. Sales to fixed assets = Sales : Fixed assets
= Rs. 3,00,000 : Rs. 3,85,000 = 60:77
Whether this ratio is satisfactory or not will be determined by comparing
it either with standard ratio or with some ratio prevalent in that industry.
Goodwill is included in fixed assets.
2. Sales to working capital = Sales : Working Capital
= Sales: (Current assets Current liabilities)
= Rs. 3,00,000 : (Rs. 1,72,000 Rs. 1,37,000)
= 3,00,000 : 35,000 = 60 : 7
Again, comment on suitability of ratio can be made only after comparing
this ratio with other standard ratio.
Illustration 4: A Ltd. has a current ratio of 4.5 to 1 and liquidity ratio of 3 to
1. If its merchandise inventory is Rs. 24,000, find out the total current
liabilities.
Solution:
Current ratio 4.5:1
Liquidity ratio 3.0:1
Inventory to current liabilities 1.5:1
24 , 000
Current Liabilitie s 1 Rs . 16 , 000
1.5

Illustration 5: B Ltd. Has a liquidity ratio of 2 to 1. If its merchandise

inventory is Rs. 15,000 and total current liabilities are Rs. 30,000, ascertain
the current ratio.
Solution: As per the liquidity ratio for every Re. 1 of liability, there are Rs. 2
of liquid assets.
Liquid assets (Rs. 30,000 x 2) Rs. 60,000
Add: Merchandise inventory 15,000
Total of current assets Rs. 75,000
Rs . 75 , 000
Current ratio 2.5 : 1
Rs . 30 , 000
Illustration 6: Following are the ratios relating to the trading activities of
National Traders Ltd.:
Debtors velocity 3 months
Stock velocity 8 months
Creditors velocity 2 months
Gross profit ratio 25 per cent
Gross profit for the year ended 31st December, 2006 amounts to
Rs. 4,00,000. Closing stock of the year is Rs. 10,000 above the opening
stock. Bills receivable amount of Rs. 25,000 and bills payable to Rs.
10,000. Find out: (a) Sales, (b) Sundry debtors, (c) Closing stock and (d)
Sundry creditors.
Solution:
Gross profit
a) G . P . Ratio
Sales
Gross profit
Sales
G . P . ratio
Rs . 4 , 00 , 000
100
25
Rs .16 , 00 , 000

b) Debtors velocity Debtors 12

Sales
Sales Debtors velocity

Debtors
12
16 , 00 , 000 3

12
Rs . 4 , 00 , 000
As debtors for this ratio include bills receivable, the book debts amount
to Rs. 4,00,000 Rs. 25,000 = Rs. 3,75,000.
Cost of goods sold
c) Stock velocity 12
Average stock
Cost of goods sold Stock velocity

Average stock
12
Cost of goods sold = Sales GP.
= Rs. 16,00,000 Rs. 4,00,000 = Rs. 12,00,000
12 , 00 , 000 8
Average stock Rs . 8 , 00 , 000
12
If x is assumed to be the opening stock, x + Rs. 10,000 would be the
closing stock.
x x 10 , 000
Average stock
2
Average stock 2 10 , 000

Opening stock ( x )
2
8 , 00 , 000 2 10 , 000
Rs . 7 , 95 , 000
2
Closing stock = Rs. 7,95,000 + Rs. 10,000 = Rs. 8,05,000
Total creditors
d) Creditor ' s velocity 12
Purchases
Purchases Creditors velocity

Creditors
12
Purchases = Cost of goods sold + Closing stock Opening stock

= Rs. 12,00,000 + 8,05,000 7,95,000 = Rs. 12,10,000
12 ,10 , 000 2
Creditors Rs . 2 , 01, 667
12
As creditors for this ratio include bills payable.

Trade creditors = Rs. 2,01,667 Rs. 10,000 = Rs. 1,91,667
Illustration 7: Following is the Balance Sheet of X Ltd. on 31st December,
2006.
Equity Share Capital 20,000 Goodwill 12,000
Capital Reserves 4,000 Fixed Assets 28,000
8% Loan on Mortgage 16,000 Stocks 6,000
Trade Creditors 8,000 Debtors 6,000
Bank Overdraft 2,000 Investments 2,000
Taxation: Current 2,000 Cash in Hand 6,000
Future 2,000
Profit and Loss Account:
Profit 2006 after taxation
and interest on fixed
deposits 12,000
Less: Transfer to:
Reserves 4,000
Dividend 2,000
6,000
6,000
Rs. 60,000 Rs. 60,000
Sales amounted to Rs. 1,20,000. Calculate ratios for: (a) testing liquidity,
(b) testing solvency , and (c) testing profitability.

Solution:
Test of Liquidity
1. Current ratio
Current assets
Current ratio
Stock Debtors Investment s Cash

Creditors Bank overdraft * Pr ovision for current taxation
Rs. 20,000
5 : 3
Rs.12,000
Current ratio is reasonably good because current assets are almost
double the current liabilities.
2. Quick ratio
Quick assets
Quick ratio
Debtors Investment s Cash i n hand

Creditors Bank overdraft Pr ovision for current taxation
Rs .14 , 000
7 : 6 1. 2 : 1
Rs .12 , 000
* Many accountants do not include bank overdraft in the current liability on
the ground that arrangement with the bank regarding the bank overdraft is
permanent. Though this argument is substantially true yet the fact remains
that this facility can be concerned by the bank at any time and in keeping
with convention of conservation, the inclusion of bank overdraft in current
liability seems to be reasonable.
If quick ratio is 1:1 then position is said to be satisfactory. In this case it is
more than one and hence liquidity of the company is sound.
TEST OF SOLVENCY
Although test of liquidity is the test of solvency, yet solvency normally stands
for the ability to meet all outside liabilities out of all assets. Therefore:
Total assets Rs . 60 , 000 15
Solvency ratio
Total outside liabilitie s Rs . 28 , 000 7
15 : 7 2.2 : 1
Total liabilities are covered more than twice and, hence, solvency of the
company is certain. In liabilities provision for future taxation is not included

and in total assets goodwill is included only on the presumption that, if sold,
it will realise that much of the amount. Goodwill appears in the Balance
Sheet only when company has paid for it. In emergency it can also find
market for it.
TEST FOR PROFITABILITY
The following tests have been carried out: (a) Return on total assets,
(b) Return on total investment employed, (e) Return on shareholders funds.
Other profitability ratios based on sales have not been calculated because
of lack of information.
(a) Return on total assets:
Income before tax & interest on fixed liability
Return on total assets 100
Total assets
Rs. (6,000 2,000 2,000 1,280)

100
Rs . 60 , 000
Rs. 11,280
100 18.8%
Rs. 60,000
This return can be compared with general return in the market and
accordingly conclusions can be drawn.
(b) Return on gross capital, employed:
Return on gross Capital
Income before tax & int erest on fixedliabi lities
Employed = 100
Shareholde rs' funds fixed liabilitie s
Rs. 11,280
= 100
Rs. (20,000 4,000 2,000 6,000 16,000 )
Rs. 11,280
= 100 23.5%
Rs. 48,000
Company seems to have very sound financial policy because after
earning at the rate of 23.5%, they are paying only 8% on fixed loans.
(c) Return on shareholders funds:
Income after taxation
Return on shareholde rs' funds 100
Shareholde rs' funds
Rs. 6,000 Rs. 2,000
100
Rs. (20,000 4,000 2,000 6,000 )
Rs. 8,000
100 25%
Rs. 32,000
Provision for taxation for future has been included in income. Since transfer
to capital reserve is not available to shareholders it has been excluded from
the income.
Illustration 8: Define any three of the following accounting ratios:
(i) Liquid ratio; (ii) Proprietary ratio; (iii) Operating ratio; (iv) Net profit ratio;
(v) Return on proprietors funds.
From the following financial statements of Rimzim Ltd., calculate any three
of the above accounting ratios and comment on the significance thereof.
XYZ Ltd.
Manufacturing, Trading and Profit and Loss Account
for the year ended 31st March, 2007
Rs. Rs.
To Opening Stock 5,00,000 By Sales: Cash 3,00,000
To Purchases 11,00,000 Credit 17,00,000
To Wages 3,00,000 20,00,000
To Factory Overheads 2,00,000 By Closing Stock 6,00,000
To Gross Profit 5,00,000
Rs. 26,00,000 Rs. 26,00,000
To Administrative Expenses 75,000 By Gross Profit 5,00,000
To Selling and Distribution 50,0000 By Dividend on
Expenses Investments 10,000
To Debenture Interest 20,000 By Profit on Sale of
To Depreciation 60,000 Furniture 20,000
To Loss on Sale of Motor Car 5,000
To Net Profit 3,20,000
Rs. 5,30,000 Rs. 5,30,000
To Preference Dividend By Balance b/d 2,71,000
(net) interim 15,000 By Net Profit 3,20,000
To Provision for Taxation 1,76,000
To Balance c/d 4,00,000
Rs. 5,91,000 Rs. 5,91,000

Balance Sheet as at 31st March, 2007

Equity Share Capital 10,00,000 Goodwill (at cost) 5,00,000
6% Preference Share Capital 5,00,000 Plant & Machinery 6,00,000
General Reserve 1,00,000 Land and Building 7,00,000
Profit and Loss Account 4,00,000 Furniture and Fixtures 1,00,000
Provision for Taxation 1,76,000 Stock-in-trade 6,00,000
Bills Payable 1,24,000 Bills Receivable 30,000
Bank Overdraft 1,20,000 Debtors 1,50,000
Creditors 4,80,000 Bank 2,20,000
Rs. 29,00,000 Rs. 29,00,000
Solution:
(i) Liquid ratio: This is also known as acid test ratio or quick ratio. It is a
ratio between cash and bank balances, readily saleable securities and
book debts against current liabilities and is calculated as under:
Quick assets
CurrentLiabilities
Bills receivable Debtors Bank
Tax provision Bills payable Creditors Bank overdraft

Rs. 30,000 1,50,000 2,20,000 4,00,000
0.44
Rs.1,76,00 0 1,24,000 4,80,000 1,20,000 9,00,000
Thus against the current-payable liability of Re. 1, the readily available liquid
assets for payment is Re. 0.44.
(ii) Proprietary ratio: It is the ratio of total shareholders fund to the total
assets employed in the business. In the given problem, it is
Equity capital Pref.capit al General reserve Profit and Loss A/c

Total assets
Rs.10,000 5,00,000 1,00,000 4,00,000 20,00,000
0.69
Rs. 29,00,000 29,00,000
Thus, out of every Re. 1 employed in the business, shareholders
contribution is Re. 0.69 whereas the creditors have contributed the
remaining Re. 0.31.

(iii) Operating ratio: Operating ratio is the ratio between cost of sales to the
total net sales and is found as under:
Cost of goods sold Other operating ex penses closing stock
100
Total net sales
Opening stock Purchases Wages Ov erheads
100
Total net sales
Rs.5,00,000 11,00,000 3,00,000 2,00,000 6,00,000 75,000 50,000 60,000
100
20,00,000
5,85,000
100
20,00,000
This ratio indicates the ratio of total expenses to sales and deducting it from
100, we get profit margin on sales. However, in calculating this ratio non-
operating income and expenses (like profit or loss on sale of assets and
dividends and purely financial expenses like interest) are excluded.
(iv) Net profit ratio: It is the ratio between net profit (excluding non-
operating income and expenses) to total sales.
Net profit Loss on sale of motor car Debentureinterest (Dividend Profit on sale of furniture)
100
Total sales
Rs.3,20,000 5,000 20,000 (10,000 20,000) 3,15,000

100 5.75
20,00,000 20,00,000
Thus, on a sale of Rs. 100 a net profit of Rs. 15.75 is made before taxes.*
* Operating ratio together with net profit ratio when expressed as percentage will
equal 100.
(v) Return on proprietors fund: It is a ratio between net operating profit to

total shareholders equity. In the given problem. It is
Net operating profit [as per (iv) above]

100
Shareholde rs equity [as per (ii) above]
2,95,000
100 14.75%
20,00,000

Illustration 9:
Gross profit Rs. 80,000
Gross profit to cost of goods sold ratio 1/3
Stock velocity 6 times
Opening stock Rs. 36,000
Accounts receivable velocity (year of 360 days) 72 days
Accounts payable velocity 90 days
Current assets Rs. 1,50,000
Bills receivable 20,000
Bills payable 5,000
Fixed assets turnover ratio 8 times
Prepare balance sheet with as many details as possible.
Solution:
A) Working Notes
1) Cost of goods sold = Gross profit 3 times
= 80,000 3 = Rs. 2,40,000
2) Sales = Cost of goods sold + Gross profit
= Rs. 2,40,000 + Rs. 80,000 = Rs. 3,20,000
3) Average stock:
Cost of gods sold
Stock velocity
Average stock
Cost of gods sold 2 , 40 , 000
Average stock Rs . 40 , 000
Stock velocity 6
4) Closing Stock:
Opening Stock Closing Stock
Average stock
2
or Closing stock = Average stock 2 Opening stock
= 40,000 2 Rs. 36,000 = Rs. 80,000 Rs. 36,000 = Rs. 44,000

5) Accounts receivable:
Credit sales
Accountsreceivable turnover
Average debtors
360
Collection period
Accountsreceivable turnover
360 Averag debtors

Credit sales
Collection period Credit sales
or Average debtors
360
72 3,20,000
Rs. 64,000
360
Note: All sales have been assumed to be credit sales.
6) Debtors = Accounts receivable Bills receivable

= Rs. 64,000 Rs. 20,000 = Rs. 44,000
7) Accounts payable:
Credit purchases
Accounts payable turnover
Average creditors
360
Payment period
Accounts Payable turnover
360
or Payment period
Credit Purchases
Average Creditors
360 AveragDebtors

Credit purchases
Payment period Credit Purchases

Average Creditors
360
90 Rs. 2,48,000 *
Rs. 62,000
360

8) Creditors = Accounts payable Bills receivable

= Rs. 62,000 Rs. 5,000 = Rs. 57,000
9) Fixed assets
Cost of goods sold
Fixed assets turnover
Fixed assets
Cost of goods sold 2 , 40 , 000
or Fixed assets
Fixed assets turnover 8
Rs . 30 , 000
Note: For the calculation of fixed assets turnover ratio it is cost of

goods sold (not sales) which is taken into consideration.
(B) Balance Sheet as on ..
Shareholdsers Fund Fixed Assets Rs. 30,000
(balancing figure) Rs. 1,18,000 Current Assets
Creditors 57,000 Stock 44,000
Bills Payable 5,000 Debtors 44,000
Bills Receivable 20,000
Cash 42,000
Rs. 1,80,000 Rs. 1,80,000
Note: In the absence of information average debtors and average creditors

have been taken as debtors and creditors at the end respectively.
Illustration 10: From the following particulars, prepare the Balance Sheet
of X Ltd., which has only one class of share capital:
i) Sales for the year Rs. 20,00,000.
ii) G.P. ratio 25%.
iii) Current assets ratio 1.50.
iv) Quick assets (cash and debtors) ratio 1.25.
v) Stock turnover ratio 15.
vi) Debts collection period 1 months.
vii) Turnover to fixed assets 1.5.
viii) Ratio of reserves to share capital 0.33 (i.e. 1/3).
ix) Fixed assets to net worth 0.83 (i.e. 5/6).
(The term turnover refers to cost of sales and the term stock to closing
stock).

Solution:
(A) Working Notes:
(1) Closing Stock:
Sales Rs. 20,00,000
Less: Gross Profit 25% on sales Rs. 5,00,000
Cost of goods sold Rs. 15,00,000
Cost of sales
Stock velocity
Average stock
Cost of sales Rs. 15,00,000
Average stock
Stock velocity 15
Rs. 1,00,000
As the term stock relates to closing stock, Rs. 1,00,000 is the closing
stock
(2) Fixed assets:
As the term turnover refers to cost of sales
Cost of sales
Fixed assets
Turnover to fixed assets
Rs.15,00,0 00

1.5
Rs.10,00,0 00
(3) Share capital and reserves:
Fixed assets
Fixed assets to net w orth
Net w orth
Fixed assets
Net w orth
Fixed assets to net w orth ratio
Rs.10,00,0 00

5/6
Rs.12,00,0 00
As the ratio of reserves to share capital is 1:3 out of net worth
Rs.3,00,000 are reserves and the rest share capital (i.e.,
Rs.9,00,000).

(4) Book Debts:
Debt collection period in terms of months

Debtors
12
Net sales
Net sales Collection period
Debtors
12
Rs. 20,00,000 1.5

12
Rs. 2,50,000
(5) Current Liabilities:
Current assets ratio = 1.5
Quick assets ratio = 1.25
Stock to current liabilities 0.25
Current liabilities will be 4 times the stock = Rs. 4,00,000.
(6) Cash:
Current assets ratio = 1.5.
As the current liabilities are Rs. 4,00,000, the total of current assets
would be Rs. 6,00,000.
Cash = Current assets (Stock and debtors)
= Rs. 6,00,000 (1,00,000 + 2,50,000)
= Rs. 2,50,000
X Ltd.
(B) Balance Sheet as on ..
Share Capital Rs. 9,00,000 Fixed Assets Rs. 10,00,000
Reserves 3,00,000 Current Assets:
Current Liabilities 4,00,000 Cash 2,50,000
Debtors 2,50,000
Stock 1,00,000 6,00,000
Rs. 16,00,000 Rs. 16,00,000


1. Equity ratio is also called shareholders equities to total equities
ratio, or net worth to total assets ratio.
2. Solvency normally stands for the ability to meet all outside liabilities
out of all assets.
3. Goodwill appears in the Balance Sheet only when company has paid
for it.
4. Operating ratio is the ratio of total shareholders fund to the total
assets employed in the business.
9.7 Summary
Ratio is a relationship between two or more variable expressed in
Percentage, Rate and Proportion.
Ratio Analysis is an important technique of financial analysis.
Current ratio indicates the firms ability to pay its current liabilities.
Quick ratio is also known as liquid ratio or acid test ratio.
Net Profit Ratio is used to measure the overall profitability and hence it
is very useful to proprietors.
A Higher Working Capital Turnover Ratio shows that there is low
investment in working capital and vice-versa.
Ratio analysis is a very important and useful tool for financial analysis.
It helps the management of business concern in evaluating its financial
position and efficiency of performance.

1. Explain the steps in Ratio Analysis.
2. Following is the Balance Sheet of Spraylac Paints Limited as on 31st
December, 2006:

Rs. Rs.
Creditors 6,000 Cash 5,000
Bills Payable 10,000 Investments (Govt. Securities) 15,000
Outstanding Expenses 1,000 Sundry Debtors 20,000
Taxation Provision 13,000 Stock 30,000
Total Current Liabilities 30,000 Total Current Assets 70,000
6% Mortgage Debentures 70,000 Fixed Assets 1,80,000
7% Preference Shares 10,000 Less: Depreciation
Equity Shares 50,000 provision 50,000
Reserves and Surplus 40,000 1,30,000
Rs. 2,00,000 Rs. 2,00,000
Additional information:
a) Net sales 3,00,000
b) Cost of goods sold 2,58,000
c) Net income before tax 20,000
d) Net income after tax 10,000
Calculate solvency ratios.
3. The following are the summarized Profit and Loss Account of Vidarbha
Limited for the year ending 31st December, 2006, and the Balance Sheet
as on that date:
Profit and Loss Account
Rs. Rs.
To Opening Stock 99,500 By Sales 8,50,000
To Purchases 5,45,250 By Closing Stock 1,49,000
To Incidental Expenses 14,250
To Gross Profit 3,40,000
9,99,000 9,99,000
To Operating Expenses: By Gross Profit 3,40,000
Selling and Distribution 30,000 By Non-operating Income
Administrative Expenses 1,50,000 Interest 3,000
Finance 15,000 By Profit on Sale of Shares 6,000
To Non-operating Expenses:
Loss on Sales of Assets 4,000
To Net Profit 1,50,000
3,49,000 3,49,000

Balance Sheet
Rs. Rs.
Issued Capital: Land & Buildings 1,50,000
2,000 Equity Shares of Plant & Machinery 80,000
Rs. 100/- each 2,00,000 Stock-in-trade 1,49,000
Reserves 90,000 Sundry Debtors 71,000
Current Liabilities 1,30,000 Cash and Bank Balance 30,000
Profit and Loss Account 60,000
Rs. 4,80,000 Rs. 4,80,000
From the above statement you are required to calculate the following ratios:
i) Current ratio
ii) Operating rato
iii) Stock turnover
iv) Return on total resources
v) Turnover of fixed assets.
4. The following are the extracts from the financial statements of M/s
Efficient and Experts Ltd., as on 1-3-2006 and 2007 respectively:
31-3-2006 31-3-2007
Rs. Rs.
Stock 10,000 25,000
Debtors 20,000 20,000
Bills receivable 10,000 5,000
Advance (recoverable in cash or kind) 2,000
Cash on hand 18,000 15,000
Creditors 25,000 30,000
Bills payable 15,000 20,000
Bank overdraft 2,000
9% Debentures 2022 2,00,000 2,00,000
Sales for the year 3,50,000 3,00,000
Gross profit 70,000 50,000
Your are required to compute for both these years:
(1) Current ratio; (2) Liquid ratio; (3) Stock turnover rate, (4) Number of
days outstanding of debtors; (5) Stock-working capital ratio.

9.9 Answers
1. Ratio Analysis
2. Ratio
3. Investment ratios
4. Sound solvency position; inadequate working capital
5. Quick ratio
6. Net Working Capital Ratio
7. 1-True; 2- False; 3- True
8. 1- True; 2- True; 3- True; 4- False
Terminal Questions
1. Refer to 9.2.1
2. Refer to 9.6
3. Refer to 9.6
4. Refer to 9.6

Unit 10 Funds Flow Analysis

Structure:
10.1 Introduction
Objectives
10.2 Meaning of Fund Flow Statement
10.3 Objectives of Fund Flow Statement
10.4 Steps in Preparation of Fund Flow Statement
10.5 Computation of changes in Working Capital and Fund from Operation
10.6 Summary
10.8 Answers
10.1 Introduction
For the purpose of fund flow statement the term fund means net working
capital. The flow of fund will occur in a business, when a transaction results
in a change i.e., increase or decrease in the amount of fund. It is a technical
device designed to highlight the changes in the financial condition of a
business enterprise between two balance sheets.
Objectives:
After standing this unit you will be able to:
Explain the meaning of Fund Flow Statement.
Explain the objectives of Fund Flow Statement.
Compute Fund from Operations.
10.2 Meaning of Fund Flow Statement

Fund may be interpreted in various ways as (a) Cash, (b) Total current
assets, (c) Net working capital, (d) Net current assets. For the purpose of
fund flow statement the term fund means net working capital. The flow of
fund will occur in a business, when a transaction results in a change
i.e., increase or decrease in the amount of fund.
According to Robert Anthony, the Fund Flow Statement describes the
sources from which additional funds were derived and the uses to which
these funds were put.

Different Names of Fund-flow Statement

A Funds Statement
A statement of sources and uses of fund
A statement of sources and application of fund
Where got and where gone statement
Inflow and outflow of fund statement
10.3 Objectives of Fund Flow Statement

The main purposes of Fund Flow Statement are:
1. To help to understand the changes in assets and asset sources which
are not readily evident in the income statement or financial statement.
2. To inform as to how the loans to the business have been used.
3. To point out the financial strengths and weaknesses of the business.
Format of Fund Flow Statement
Sources Applications
Fund from operation Fund lost in operations
Non-trading incomes Non-operating expenses
Issue of shares Redemption of redeemable preference share
Issue of debentures Redemption of debentures
Borrowing of loans Repayment of loans
Acceptance of deposits Repayment of deposits
Sale of fixed assets Purchase of fixed assets
Sale of Investments Purchase of long term Instruments
(Long Term)
Decrease in working capital Increase in working capital
10.4 Steps in Preparation of Fund Flow Statement

1. Preparation of schedule changes in working capital (taking current items
only).
2. Preparation of adjusted profit and loss account (to know fund from [or]
fund lost in operations).
3. Preparation of accounts for non-current items (Ascertain the hidden
information).
4. Preparation of the fund flow statement.

Format of Schedule of Changes in Working Capital

Particulars Previous Year Current year Increase in Decrease in
W/c W/c
Current Assets
Cash in hand
Cash at bank
Bills receivable
Debtors
Inventory
Prepaid expenses
Short-term investment
(A) Total
Current Liability
Bills payable
Creditors
Outstanding expenses
Accrued expenses
Income received in advance
Bank overdraft
Cash credit from banks
Short-term loan
Short-term deposit
Provision for taxation
Proposed dividend
Provision against current assets
(B) Total
Working Capital (C)
(C = A B)
Increase in W/C
Decrease in W/C
Fund from operation can be ascertained by preparing adjusted profit and
loss account. It may be prepared in statement form or account form.

Format of Adjusted Profit and Loss Account

To Bal. B/d (P&L Account Dr. Bal.) By Bal. B/d (P&L Account Cr. Bal.)
To Non-operating Exp. By Non-operating Incomes
To Depreciation on Fixed Assets By Profit on sale of Investment
To Goodwill written-off By profit on sale of fixed asset
To Patent & trademark off By Dividend on Investment
To Preliminary expenditure By Interest on Investment
To Discount on issue of shares & By Rent received, gift received
Debentures By Damages received under law
To Loss on sale of investment By Transfer from general reserve
To Loss on sale of Fixed Assets
To damages paid under law
To Premium on redemption of profit
Share and debentures
To Interim dividend
To Dividend declared
(A) Total
To ascertain the hidden information, we have to prepare accounts for all

non-current items of assets and liabilities (whether adjustment is given or
not) then only easier to find the inflow and outflow of funds.
I. Self Assessment Questions
1. The term fund means _______________
2. The flow of fund will occur in a business, when a transaction results in
____________
3. According to _____________ the Fund Flow Statement describes the
4. The main purposes of Fund Flow Statement are:
A) To help to understand the changes in assets and asset sources
which are not readily evident in the income statement or financial
statement.
B) To inform as to how the loans to the business have been used.
C) To point out the financial strengths and weaknesses of the business.
D) All the above

10.5 Computation of changes in Working Capital and Fund from

Operations
Illustration 1
From the following balance sheets of Mr. M. prepare the statement of
schedule of changes in working capital.
Balance Sheet as at December 31
Liabilities 2005 2006 Assets 2005 2006
Equity Capital 5,00,000 5,00,000 F. assets 6,00,000 7,00,000
Debentures 3,70,000 4,50,000 Long-term 2,00,000 1,00,000
Investment
Tax payable 77,000 43,000 Working progress 80,000 90,000
Accounts Payable 96,000 1,92,000 Stock-in-trade 1,50,000 2,25,000
Interest payable 37,000 45,000 Account receivable 70,000 1,40,000
Dividend payable 50,000 35,000 Cash 30,000 10,000
11,30,000 12,65,000 11,30,000 12,65,000
Solution:
Statement of changes in Working Capital
Particulars 2005 2006 Effect on working capital
Rs. Rs. Increase Rs. Decrease Rs.
Current Assets:
Cash 30,000 10,000 20,000
Accounts Receivable 70,000 1,40,000 70,000
Stock-in-trade 1,50,000 2,25,000 75,000
Work-in-progress 80,000 90,000 10,000
Total Current Assets 3,30,000 4,65,000
Tax payable 77,000 43,000 34,000
Accounts payable 96,000 1,92,000 96,000
Interest payable 37,000 45,000 8,000
Dividend payable 50,000 35,000 15,000
Total Current Liabilities 2,60,000 3,15,000
Working Capital (CA-CL) 70,000 1,50,000
Net increase in
Working capital (B/f) 80,000 80,000
Total 1,50,000 1,50,000 2,04,000 2,04,000

Illustration 2
Calculate the fund from operation from the following details as on 31st
March, 2007.
1. Net profit for the year ended 31st March, 2007 Rs. 6,50,000.
2. Gain on sale of building Rs. 35,500.
3. Written of Goodwill 10% from the book value of Rs. 1,80,000.
4. Old machine sold for Rs. 6,500 worth Rs. 8,000.
5. Rs. 1,25,000 have been transferred to the general reserve fund.
6. Rs. 1,30,000 is provided for Depreciation.
Solution:
Adjusted Profit and Loss Account
Rs. Rs.
To Goodwill 18,000 By sale of building (gain) 35,500
To loss on sale 1,500 By balance c/d 8,89,000
of machinery (Fund from operation)
To general reserve 1,25,000
To depreciation 1,30,000
To closing balance 6,50,000
9,24,500 9,24,500
Fund from operational can be calculated alternatively in a statement form.

Net profit of the year 6,50,000
Add: Non-operating expenditure
Goodwill written-off 18,000
Loss on sale of machinery 1,500
General reserve 1,25,000
Depreciation 1,30,000 2,74,500
9,24,500
Less: Non-operating incomes
Gain on sale of buildings 35,500
Fund from operation 8,89,000

Illustration 3
From the following details calculate fund from operations:
Rs.
Opening balance of Profit & Loss A/c 25,000
Salaries 5,000
Discount on issue of debentures 2,000
Rent 3,000
Provision for bad debts 1,000
Transfer to G. Reserve 1,000
Refund of Tax 3,000
Profit on sale of building 5,000
Depreciation on plant 5,000
Preliminary exp. written-off 2,000
Loss on sale of plant 2,000
Provision for tax 4,000
Dividend received 5,000
Closing balance of Profit & Loss A/c 60,000
Proposed Dividend 6,000
Solution:
Adjusted Profit and Loss Account
To balance b/d 60,000 By profit on sale of building 5,000
To depreciation on plant 5,000 By refund of tax 3,000
To provision for tax 4,000 By dividend value 5,000
To loss on sale of plant 2,000 By Balance b/d 25,000
To discount on issue of 2,000 By Balance c/d 48,000
debentures (fund from operation)
To provision for bad debts 1,000
To G. reserve (transfer) 1,000
To Prel. Exp. written-off 2,000
To Goodwill written-off 3,000
To proposed dividend 6,000
86,000 86,000

Alternatively,
Net Profit (difference between opening and closing balance) 35,000
Add : Provision for bad debts 1,000
G. Reserve (transfer) 1,000
Depreciation 5,000
Prel. Exp. written-off 2,000
Proposed dividend 6,000
Loss on sale of plant 2,000 26,000
61,000
Refund of Tax 3,000
Dividend received 5,000
Profit on sale of building 5,000 13,000
Fund from operation 48,000
Illustration 4
A company reported current profit of Rs. 70,000 after incorporating the
following:
Loss on sale of equipment 10,000 Gain from sale of
non-current assets 4,000
Premium on redemption of 1,500 Excess provision of taxation 22,000
Debentures
Discount on issue of debentures 2,000 Dividend income 4,000
Depreciation on machinery and 20,000 General Reserve 5,000
Building
Depletion of natural resources 10,000 Preliminary expenses 1,000
Amortization of goodwill 30,000 Profit on revaluation of 2,500
Investment
Interim dividend 25,000
Derive the net inflow of funds from the operation.

Solution
Net profit 70,000
Add : Non-Operation Expenses:
Loss on sale of equipment 10,000
Depreciation of natural resources 10,000
Depreciation on machinery 20,000
Amortization of goodwill 30,000
Interim dividend 25,000
G. Reserve 5,000
Prel. Exp. 1,000
1,25,000
1,95,000
Less : Non-operating income:
Dividend Income 4,000
Gain from sale of non-current assets 4,000 8,000
Net fund from operation 1,87,000
Illustration 5
From the following balance sheets of ABC Ltd., on 31-12-2005 and 2006
prepare a schedule of changes in working capital and fund flow statement.
Liabilities Assets
2005 2006 2005 2006
Rs. Rs. Rs. Rs.
Share Capital 1,00,000 1,00,000 Goodwill 12,000 12,000
General Reserve 14,000 18,000 Buildings 40,000 36,000
P & L A/c 16,000 13,000 Plant 37,000 36,000
Sundry Creditors 8,000 5,400 Investment 10,000 11,000
Bills payable 1,200 800 Stock 30,000 23,400
Provision for tax 16,000 18,000 Bills receivable 2,000 3,200
Provision for 400 600 Debtors 18,000 19,000
Doubtful debts Cash at bank 6,600 15,200
1,55,600 1,55,800 1,55,600 1,55,800
Adjustments
1. Depreciation charges on plant and buildings Rs. 4,000 each.
2. Provision for taxation of Rs. 19,000 was made during the year 2006.
3. Interim dividend of Rs. 8,000 was paid during the year 2006.
Solution
Step-I
Schedule of Changes in Working Capital
Particulars 2005 2006 Effect on working capital
+
Current Assets
Stock 30,000 23,400 6,600
B/R 2,000 3,200 1,200
Drs. 18,000 19,000 1,000
Cash 6,600 15,200 8,600
Total 56,600 60,800
Current Liabilities
Crs. 8,000 5,400 2,600
B/P 1,200 800 400
Total CL 9,200 6,200
W/C (CA CL) 47,400 54,600
W/C (+) 7,200 7,200
54,600 54,600 13,800 13,800
Increase in working capital Rs. 7,200
Step-II
Plant A/c
Rs. Rs.
To bal. b/d 37,000 By Dep. (Ad P & L A/c) 4,000
To cash purchase (Bal.) 3,000 By Bal. c/d 36,000
40,000 40,000
Buildings A/c
Rs. Rs.
To bal. b/d 40,000 By Dep. (Ad P&L a/c) 4,000
By Bal. c/d 36,000
40,000 40,000
Investments A/c
Rs. Rs.
To bal. b/d 10,000
To Cash Purchase (Bal.) 1,000 By Bal. c/d 11,000
11,000 11,000

Provision for Taxation A/c

Rs. Rs.
To bal. (tax paid) 17,000 By bal. b/d 16,000
To bal. c/d 18,000 By Ad P&L a/c (Provision) 19,000
35,000 35,000
Provision for Doubtful A/c
Rs. Rs.
To bal. c/d 600 By bal. b/d 400
By Ad P&L a/c (Bal.) 200
600 600
General Reserve A/c
Rs. Rs.
To bal. c/d 18,000 By bal. b/d 14,000
By Ad P&L a/c (Bal.) 4,000
18,000 18,000
Adjusted P&L A/c
Rs. Rs.
To dep. on plant 4,000 By bal. b/d 16,000
To dep. on building 4,000 By FFO (Bal.) (1) 36,200
To prov. for tax 19,000
To General Reserve 4,000
To provision for doubtful debts 200
To interim dividend 8,000
To bal c/d 13,000
52,200 52,200
Step-IV
Fund Flow Statement
Fund Inflow Rs. Fund Outflow Rs.
FFO (1) 36,200 Purchase of plant (2) 3,000
Purchase of investment (3) 1,000
Payment of tax (4) 17,000
Payment of dividend (5) 8,000
Working capital 7,200
36,200 36,200

Note: a) (5) is given in the adjustment.

b) Provision for doubtful debts may be reduced from Drs.
Alternatively.
c) Account for General Reserve may or may not prepared. We can
take the difference directly.
d) FFO means Fund From Operation
10.6 Summary
For the purpose of fund flow statement the term fund means net working
capital.
The flow of fund will occur in a business, when a transaction results in a
change i.e., increase or decrease in the amount of fund.
According to Robert Anthony, the Fund Flow Statement describes the
The main purposes of Fund Flow Statement are:
1. To help to understand the changes in assets and asset sources
which are not readily evident in the income statement or financial
statement.
2. To inform as to how the loans to the business have been used.
3. To point out the financial strengths and weaknesses of the business.
The steps involved in the preparation of Fund Flow Statement are:
1. Preparation of schedule changes in working capital.
2. Preparation of adjusted profit and loss account.
3. Preparation of accounts for non-current items.
4. Preparation of the fund flow statement.

1. What are the objectives of Fund Flow Statement?
2. Explain the different steps involved in preparation of Fund Flow
Statements.
3. Give the Format of Adjusted Profit and Loss Account.

10.8 Answers
1. Net working capital
2. Increase or decrease in the amount of fund
3. Robert Anthony
4. All the above
Terminal Questions
1. Refer to 10.3
2. Refer to 10.4
3. Refer to 10.5

Unit 11 Cash Flow Analysis

Structure:
11.1 Introduction
Objectives
11.2 Meaning of Cash Flow Statement
11.3 Objectives of Cash Flow Statement
11.4 Uses of Cash Flow Statement
11.5 Steps in Preparing Cash Flow Statement
11.6 Difference between Cash and Fund Flow Statement
11.7 Computation of Cash from Operations (Problems)
11.8 Summary
11.10 Answers
11.1 Introduction
Cash is the lifeblood of business. A firm receives cash from various sources
like sales, debtors, sale of assets, investments etc. Likewise, the firm needs
cash to make payment to salaries, rent dividend, interest etc. Cash flow
statement reveals the inflow and outflow of cash during a particular period.
Objectives:
Explain the meaning of Cash Flow Statement
Explain the uses of Cash Flow Statement
Explain the steps in preparing Cash Flow Statement
Distinguish between Cash & Fund Flow Statement
Compute the Cash from Operations.
11.2 Meaning of Cash Flow Statement

Cash flow statement reveals the inflow and outflow of cash during a
particular period. It is prepared on the basis of historical data showing the
inflow and outflow of cash. It is an important tool of cash planning and
control.

11.3 Objectives of Cash Flow Statement

1. To show the causes of changes in cash balance between the balance
sheet dates.
2. To show the factors contributing to the reduction of cash balance in spite
of increasing profit or decreasing profit.
11.4 Uses of Cash Flow Statement

1. It explains the reasons for low cash balance.
2. It shows the major sources and uses of cash.
3. It helps in short term financial decisions relating to liquidity.
4. From the past year statements projections can be made for the future.
5. It helps the management in planning the repayment of loans, credit
arrangements etc.
11.5 Steps in Preparing Cash Flow Statement

1. Opening of accounts for non-current items (to find out the hidden
information).
2. Preparation of adjusted P & L Account (to find out cash from operation
or profit, and cash lot in operation or loss).
3. Comparison of current items (to find out inflow or outflow of cash).
4. Preparation of Cash Flow Statement.
To prepare Account for all non-current items is easier for preparing Cash
Flow Statement.
Cash from operation can be prepared by this formula also.
Decrease in Current Assets Increase in Current Assets
Net Profit + Increase in Current Decrease in
Liabilities Current Liabilities
Cash Flow Statement can be prepared in statement form or account form.
A specimen cash flow statement
Account form of cash flow statement is normally followed by all.

Cash Flow Statement

Inflow of Cash Outflow of Cash
Opening Cash Balance xxx Redemption of Pref. Shares xxx
Cash from Operation xxx Redemption of Debentures xxx
Sales of Assets xxx Repayment of Loans xxx
Issue of Debentures xxx Payment of Dividends xxx
Raising of Loans xxx Pay of Tax xxx
Collection from Debentures xxx Cash Lost in Operations xxx
Refund of Tax xxx
xxx xxx
Cash from operation can be calculated in two ways

1. Cash Sales Method
Cash Sales (Cash Purchases + Cash Operation Expenses)
2. Net Profit Method
It can be prepared in statement form or by Adjusted Profit and Loss
Account.

State whether the following statements are True or False:
1. Cash flow statement reveals the inflow and outflow of cash during a
particular period.
2. Cash Flow Statement is always prepared in statement form.
3. Cash Flow Statement explains the reasons for low cash balance.
4. Cash Flow Statement helps in short term financial decisions relating to
liquidity.

11.6 Difference between Cash and Fund Flow Statement

Cash Flow Statement Fund Flow Statement
01 Cash flow statement takes into Fund flow statement is
consideration only the changes in cash concerned with changes in
position between two Balance Sheet working capital, position
between two balance sheet
dates.
02 Cash from operation is calculated Fund from operation is
only by actual receipt and payment calculated by Adjusted Profit
and Loss Account
03 It is more useful to management It is not more useful than
as a tool of financial analysis cash flow statement
04 Whether there is inflow of cash there Sound fund position does not
will be definitely be inflow of funds necessarily mean sound cash
position
05 Increase in current liabilities or Increase in current liabilities or
decrease in current assets will decrease in current assets will
increase in cash and vice versa mean decrease in working
capital
11.7 Computation of Cash from Operations (Problems)

Illustration 1
From the following balances you are required to calculate cash from
operations
December 31
2005 2006
Rs. Rs.
Debtors 50,000 47,000
Bills Receivable 10,000 12,500
Creditors 20,000 25,000
Bills Payable 8,000 6,000
Outstanding Expenses 1,000 1,200
Prepaid Expenses 800 700
Accrued Income 600 750
Income received in advance 300 250
Profit made during the year 1,30,000

Solution:
Cash from Operation
Profit made during the year 1,30,000
Add: Decrease in Debtors 3,000
Increase in Creditors 5,000
Increase in Outstanding Expenses 200
Decrease in Prepaid Expenses 100 8,300
1,38,300
Less: Increase in Bills Receivable 2,500
Decrease in Bills Payable 2,000
Increase in Accrued Income 150
Decrease in Income received in advance 50 4,700
Cash from Operation 1,33,600
Illustration 2
Following are the summarized balance sheets of Thomson as on 31st
December 2005 and 2006:

Share Capital 1,00,000 1,30,000 Land 1,00,000 95,000
General Reserve 25,000 30,000 Machinery 75,000 84,500
P & L A/c 15,200 15,400 Stock 50,000 37,000
Bank Loan 35,000 Debtors 40,000 32,100
(Long term)
Creditors 75,000 67,500 Cash 200 300
Provision for Tax 15,000 17,500 Bank 4,000
Goodwill 7,500
Total 2,65,200 2,60,400 2,65,200 2,60,400
Adjustments
1. Dividend of Rs. 11,500 was paid.
2. Assets of another Company were purchased for a consideration of
Rs. 30,000 payable in shares. The following assets were purchased
(a) stock Rs. 10,000, (b) Machinery Rs. 12,500.

3. Machinery was further purchased for Rs. 4,000.

4. Income tax paid Rs. 16,500 for the year.
5. Depreciation written-off in Machinery Rs. 6,000.
6. Loss on sale of machine Rs. 100 was written-off to General Reserve.
Prepare Cash flow statement.
Solution:
Step 1: Account for Non-Current Items
Share Capital A/c
To Balance C/d 1,30,000 By Balance b/d 1,00,000
By Stock 10,000
By Machinery 12,500
By Goodwill 7,500
1,30,000 1,30,000
General Reserve A/c

To Machinery A/c 100 By Balance b/d 25,000
To Balance C/d 30,000 By Ad P & L A/c (Bal.) 5,100
30,100 30,100
Provision for Tax A/c

To Bank (Tax Paid) (8) 16,500 By Balance b/d 15,000
To Balance C/d 17,500 By Ad P & L A/c (Bal.) 19,000
34,000 34,000
Bank Loan A/c
To Balance (Paid) (11) 35,000 By Balance b/d 35,000

35,000 35,000

Machinery A/c
To Balance b/d 75,000 By Depreciation 6,000
(Ad P & L)
To Share Capital 12,500 By General Reserve 100
(Loss on Sales)
To Cash Purchases 4,000 By Cash (Sale of 900
(7) Machinery)
91,500 91,500
Land A/c
To Balance c/d 1,00,000 By Ad P L A/c 5,000
(Balance)
By Balance b/d 95,000
1,00,000 1,00,000
Adjusted P & L A/c
To Dep. of Machinery 6,000 By Balance b/d 15,200
To Dep. of Land 5,000 By Cash from 46,800
operation (Bal.) (2)
To Prov. For Tax 19,000
To Div. Paid 11,500
To Balance c/d 15,400
62,000 62,000
Step III: Comparison of Current Items

Stock 50,000 37,000 = 13,000 .. (5)
Debtors 40,000 32,100 = 7,900 .. (6)
Creditors 75,000 67,500 = 7,500 .. (10)
Payment of Dividend Rs. 11,500 given in adjustment .. (9)
Sale of Machinery Rs. 900 .. (4)
Opening Cash Balance Rs. 200 .. (2)
Closing Cash & Bank Balance Rs. 4,300 .. (12)

Step IV
Cash Flow Statement
Opening Cash (1) 200 Purchase of Machinery (7) 4,000
Cash from Operation (2) 46,800 Payment of Tax (8) 16,500
Issue of Shares (Stock) (3) 10,000 Payment of Dividend (9) 11,500
Sales of Machinery (4) 900 Decrease in Creditors (10) 7,500
Decrease in Stock (5) 13,000 Repayment of Loan (11) 35,000
Decrease in Debtors (6) 7,900 Closing balance of Cash & 4,300
Bank (12)
78,800 78,800
Illustration 3
The following details are available for a Company prepare, cash flow
statement.
Assets Previous Year Current Year
Cash 9,000 7,800
Debtors 14,900 17,700
Stock 49,200 42,700
Land 20,000 30,000
Goodwill 10,000 5,000
1,03,100 1,03,200
Liabilities
Share Capital 70,000 74,000
Debentures 12,000 6,000
Reserve for Bad & Doubtful Debts 700 800
Trade Creditors 10,360 11,840
P & L A/c 10,040 10,560
1,03,100 1,03,200

Additional Information
Dividend paid Rs. 3,500. Debentures paid-off Rs. 6,000, Land was
purchased for Rs. 10,0000. Amount provided for Goodwill written-off
Rs. 5,000.
Solution
Step 1: A/c for Non-current Items
Land A/c
To Balance b/d 20,000 By Balance c/d 30,000
To Cash Paid 10,000
(Balance) (1)
30,000 30,000
Share Capital
To Balance b/d 74,000 By Issue of Shares 4,000
(Balance) (2)
74,000 74,000
Debentures A/c
To Cash (Balance) (3) 6,000 By Balance b/d 12,000

12,000 12,000
Goodwill A/c
By Adj P & L 5,000
(Written-off)
10,000 10,000

Adjusted P & L A/c

To Dividend Paid 3,500 By Balance b/d 10,040
To Goodwill written off 5,000 By CFO (Balance) (5) 9,120
To Reserve for bad debts 100
19,160 19,160
Cash Flow Statement for the Current Year

Inflow Outflow
Opening Cash 9,000 Purchase of land (1) 10,000
Issue of Share Capital (2) 4,000 Increase in Drs. (8) 2,800
Increasing Crs. (6) 1,480 Debentures Redemption (3) 6,000
Decrease in Stock (7) 6,500 Dividend Paid (4) 3,500
Cash from operation (5) 9,120 Closing Cash 7,800
30,100 30,100
(4) Given in adjustment

(6, 7, 8) Comparison of current items.
Illustration 4
From the following balance sheets of Joy Ltd., prepare cash flow statement:
Liabilities
Particulars Previous Year Current Year
Equity Share Capital 3,00,000 4,00,000
8% Redeemable Pref. Share Capital 1,50,000 1,00,000
General Reserve 40,000 70,000
P & L A/c 30,000 48,000
Proposed Dividend 42,000 50,000
Creditors 55,000 83,000
Bills Payable 20,000 16,000
Provision for Taxation 40,000 50,000
6,77,000 8,17,000

Assets
Particulars Previous Year Current Year
Goodwill 1,15,000 90,000
Building 2,00,000 1,70,000
Plant 80,000 2,00,000
Debtors 1,60,000 2,00,000
Stock 77,000 1,09,000
Bills Receivable 20,000 30,000
Cash 15,000 10,000
Bank 10,000 8,000
6,77,000 8,17,000
Additional information:
(A) Depreciation of Rs. 10,000 and Rs. 20,000 have been changed on Plant
and buildings during the current year.
(B) An interim dividend of Rs. 20,000 has been paid during the current year.
(C) Rs. 35,000 was paid during the current year for income tax.
Solution
Step I: A/c for Non-current Items
Buildings A/c
Rs. Rs.
To Balance b/d 2,00,000 By Depreciation (Ad P & L) 20,000
By Cash (Sales) (Bal.) (4) 10,000
By Balance c/d 1,70,000
2,00,000 2,00,000
Plant A/c
Rs. Rs.
To Balance b/d 80,000 By Depreciation (Ad P & L) 10,000
To Cash (Purchase) (7) 1,30,000 By Balance c/d 2,00,000
2,10,000 2,10,000

Equity Share Capital A/c

Rs. Rs.
To Balance c/d 4,00,000 By Balance b/d 3,00,000
By Issue of Shares (2) 1,00,000
4,00,000 4,00,000
Pref. Share Capital A/c
Rs. Rs.
To Redemption (Bal) (6) 50,000 By Balance b/d 1,50,000
To Balance c/d 1,00,000
1,50,000 1,50,000
Provision for Taxation A/c
Rs. Rs.
To Cash (Tax paid) (10) 35,000 By Balance b/d 40,000
To Balance c/d 50,000 By Balance 45,000
(Ad. P & L A/c)
85,000 85,000
Adjusted P & L A/c

Rs. Rs.
To Depreciation on Plant 10,000 By Balance b/d 30,000
To Depreciation on Buildings 20,000 By CFO (Balance) (3) 2,18,000
To Goodwill write-off 25,000
To Provision for Tax 45,000
To Interim Dividend 20,000
To proposed Dividend 50,000
(Current Year)
To Balance C/d 48,000
2,48,000 2,48,000

Step III
Comparison of Current Items
Debtors 1,60,000 2,00,000 = + 40,000 (11)
Stock 77,000 1,09,000 = + 32,000 (12)
Bills Receivable 20,000 30,000 = 10,000 (13)
Opening Cash & Bank 15,000 + 10,000 = 25,000 (1)
Closing Cash 10,000 + 8,000 = 18,000 (15)
Creditors 55,000 83,000 = 28,000 (5)
Bills Payable 20,000 16,000 = + 4,000 (14)
Interim dividend paid = 20,000 (8)
Previous year dividend paid = 42,000 (9)
Step IV
Cash Flow Statement
Inflow Rs. Outflow Rs.
Opening Cash & Bank (1) 25,000 Redemption of Pr. Shares (6) 50,000
Issue of Equity Share 1,00,000 Purchase of Plant (7) 1,30,000
Capital (2) Payment of Interim Dividend (8) 20,000
Cash from Operation (3) 2,18,000 Payment of Proposed Dividend 42,000
Sale of Buildings (4) 10,000 (Previous Year) (9)
Increase in Creditors (5) 28,000 Payment of Tax (10) 35,000
Increase in Debtors (11) 40,000
Increase in Stock (12) 32,000
Increase in B/R (13) 10,000
Decrease in B/P (14) 4,000
Closing Cash & Bank (15) 18,000
3,81,000 3,81,000

Illustration 5
Statement of the financial position of Mr. Kumar are given below:
1-7-2006 31-12-2006
Liabilities
Accounts Payable 2,900 2,500
Capital 73,900 61,500
76,800 64,000
Assets:
Cash 4,000 3,000
Debtors 2,000 1,700
Stock 800 1,300
Buildings 10,000 8,000
Other Fixed Assets 60,000 50,000
76,800 64,000
(a) There were no drawings.
(b) There were no purchases or sales of either buildings or other fixed
Assets. Prepare Cash Flow Statement.
Buildings Account
Rs. Rs.
To Balance b/d 10,000 By Depreciation
(Ad P & L A/c) 2,000
10,000 10,000
Fixed Assets A/c
Rs. Rs.
By Depreciation 10,000
(Ad P & L A/c)
60,000 60,000

Capital A/c
Rs. Rs.
To Net Loss (Bal) (Ad P&L) 12,400 By Balance b/d 73,900
73,900 73,900
Adjusted Profit & Loss A/c

Rs. Rs.
To Depreciation on 2,000 By Net Loss 12,400
Buildings (Capital A/c)
To Depreciation on 10,000
other Fixed Assets
To cash Trading Loss 400
12,400 12,400
Cash Flow Statement

Opening Cash 4,000 Decrease in A/c/s 400
Decrease in Debtors 300 Increase in Stock 500
Cash Trading Loss 400
Closing Cash 3,000
4,300 4,300
(1) and (6) given in the sum: Comparison of current items:

Debtors 2,000 1,700 = 300 Decrease Inflow
Stock 8,000 13,000 = 500 Increase Outflow
A/c Payable 2,000 2,500 = 400 Decrease Outflow

Illustration 6
From the following particulars prepare Cash Flow Statements.
Liabilities: 1st Jan. 31st Dec.
Creditors 36,000 41,000
Mr. As Loan 20,000
Capital 1,48,000 1,49,000
Bank Loan 30,000 25,000
2,14,000 2,35,000
Assets:
Cash 4,000 3,600
Debtors 35,000 38,400
Stock 25,000 22,000
Land 20,000 30,000
Buildings 50,000 55,000
Machinery 80,000 86,000
2,14,000 2,35,000
During the year Mr. A (Proprietor) had drawn Rs. 26,000 for personal use.
The provision for depreciation against machinery as on 1st January was
Rs. 27,000 and as on 31st December Rs. 36,000.
Step I
A/c for Non-current Items
Land A/c
Rs. Rs.
To Balance b/d 20,000 By Balance b/d 30,000
To Cash Purchase
(Balance) (7) 10,000
30,000 30,000

Building A/c
Rs. Rs.
To Balance b/d 50,000 By Balance b/d 55,000
To Cash Purchases 5,000
(Balance) (8)
55,000 55,000
Machinery A/c
Rs. Rs.
To Balance b/d 1,07,000 By Balance b/d 1,22,000
(80,000 + 27,000) (86,000 + 36,000)
To Cash Purchases 15,000
(Balance) (9)
1,22,000 1,22,000
Capital A/c
Rs. Rs.
To Drawings (10) 26,000 By Balance b/d 1,48,000
To Balance c/d 1,49,000 By Net Profit (Bal.)27,000
(Transferred to Ad).
P & L A/c)
1,75,000 1,75,000
Step II
Adjusted P & L A/c
Rs. Rs.
To Provision for Depreciation 9,000 By CFO (3) 36,000
(36,000 27,000)
To Net Profit (Capital A/c) 27,000
36,000 36,000

Step III
Comparison of Current Items
Creditors 36,000 41,000 = 5,000 Increase (4)
As Loan 20,000 = 20,000 Increase (2)
Bank Loan 30,000 25,000 = 5,000 Decrease (1)
Debtors 35,000 38,400 = 3,400 Increase (11)
Stock 25,000 22,000 = 3,000 Decrease (5)
Step IV
Capital A/c
Opening Cash (1) 4,000 Repayment of Bank Loan (6) 5,000
Loan from A (2) 20,000 Purchase of Land (7) 10,000
Cash from Operation (3) 36,000 Purchase of Building (8) 5,000
Increase in Creditors (4) 5,000 Purchase of Machinery (9) 15,000
Decrease in Stock (5) 3,000 Drawing (10) 26,000
Increase in Debtors (11) 3,400
Closing Cash (12) 3,600
68,000 68,000
Note: 10, 11 and 12 are given in problem.
11.8 Summary
Cash flow statement reveals the inflow and outflow of cash during a
particular period.
It is prepared on the basis of historical data showing the inflow and
outflow of cash.
It is an important tool of cash planning and control.
Cash from operation can be calculated in two ways
1. Cash Sales Method:
Cash Sales (Cash Purchases + Cash Operation Expenses)

2. Net Profit Method:

It can be prepared in statement form or by Adjusted Profit and Loss
Account.
Uses of CFS:
It explains the reasons for low cash balance.
It shows the major sources and uses of cash.
It helps in short term financial decisions relating to liquidity.
It helps the management in planning the repayment of loans, credit
arrangements etc.

1. What are the objectives of a Cash Flow Statement?
2. Mention the steps involved in the preparation of a Cash Flow Statement.
3. Distinguish between Cash Flow Statement and Fund Flow Statement.
4. The following are the summarized Balance Sheet of M/s. NIDHI Ltd. as
on 31st December, 2005 and 2006.
2005 2006
Rs. Rs.
Liabilities
Share Capital 2,00,000 2,50,000
General Reserve 50,000 60,000
Profit and Loss A/c 30,500 30,600
Bank Loan (Long-term) 70,000
Sundry Creditors 1,50,000 1,35,200
Provision for Taxation 30,000 35,000
5,30,500 5,10,800
Assets
Land and Building 2,00,000 1,90,000
Machinery 1,50,000 1,69,000
Stock 1,00,000 74,000
Sundry Debtors 80,000 64,200
Cash 500 500
Bank 8,000
Goodwill 5,000
5,30,500 5,10,800
Additional Information:
1) Loss on sale on machinery Rs. 200 was written-off to General Reserve.
2) Income-tax provided during the year Rs. 33,000.
3) Depreciation written-off on machinery Rs. 12,000.
4) Machinery was further purchased for Rs. 8,000.
5) Assets of another Company were purchased for a consideration of
Rs. 50,000 payable in shares. The following assets were purchased
were purchased. Stock Rs. 20,000, Machinery Rs. 25,000.
6) Dividend of Rs. 23,000 was paid.
Prepare the Cash Flow Statement.
5. The following is the summary of annual accounts of Meet Computers
Ltd., for the two years 2005 and 2006.
Comparative Balance Sheets

Rs. Rs. Rs. Rs.
Notes
Payable 20,000 Marketable 5,000 3,000
Bills Payable 5,000 8,000 Securities 5,000 7,000
Accrued Taxes 3,000 5,000 Cash 10,000 15,000
Accrued Wages 2,000 2,000 Bills Receivables
Long-term Loan 15,000 Inventory 12,000 15,000
Shareholders Fund 60,000 70,000 Fixed Assets 50,000 55,000
Other Assets 8,000 5,000
90,000 1,00,000 90,000 1,00,000

Profit and Loss Account for the year ending Dec. 31, 2006
Rs. Rs.
Net Sales
Expenses 50,000
Cost of Goods Sold 25,000
Selling and Admn. Expenses 5,000
Depreciation 5,000
Interest 1,000
36,000
Net profit before tax 14,000
Less: Income Tax (50%) 7,000
Net profit after tax 7,000
Add: Profit and Loss A/c on 1-1-2006 40,000
47,000
Less: Dividend 3,000
Profit and Loss Balance as on 31-12-2006 44,000
Prepare the Cash Flow Statement.

6. Parimala has submitted the following Balance Sheets on 31st March,
2006 and 2007.

Rs. Rs. Rs. Rs.
Share Capital in 2,99,000 3,36,000 Goodwill 50,000 25,000
Equity Shares of
Rs. 100 each
Debentures 60,000 30,000 Land & Build. 1,00,000 1,50,000
Creditors 52,500 55,000 Stock 2,00,000 1,75,000
Reserve for 3,500 4,000 Sundry Debtors 70,000 90,000
Doubtful Debts
Profit & Loss A/c 50,000 55,000 Cash 45,000 40,000
4,65,000 4,80,000 4,65,000 4,80,000

Additional Information:
(1) No depreciation is charged on Land and Buildings.
(2) Dividend was paid Rs. 15,000 and Tax Paid amounted to Rs. 10,000
Prepare a Cash Flow Statement.
7. From the following Balance Sheet of DRINKS Ltd. Make out a Cash
Flow Statement.
Rs. Rs. Rs. Rs.
Equity Share Capital 3,00,000 40,00,000 Goodwill 1,00,000 80,000
8% Redeemable Land & Buildg. 2,00,000 1,70,000
Preference Shares 1,50,000 1,00,000 Plant 80,000 2,00,000
Capital Reserve Sundry Debtors 1,40,000 1,70,000
Profit & Loss A/c 20,000 Stock 77,000 1,09,000
General Reserve 30,000 48,000 Bills Receivable 20.000 30,000
Sundry Creditors 40,000 50,000 Investments 20,000 30,000
Bills Payable 25,000 47,000 Cash in Hand 15,000 10,000
Proposed Dividend 20,000 16,000 Cash at Bank 10,000 8,000
Liability for 42,000 50,000 Preliminary 15,000 10,000
Expenses Expenses
Provision for 30,000 36,000
Taxation 40,000 50,000
6,77,000 8,17,000 6,77,000 8,17,000
Additional Information is as follows:

a) A piece of land had been sold out in 2007 and the profit on sale has
been credited to Capital Reserve.
b) A machine has been sold for Rs. 10,000. The WDV of the machine was
Rs. 12,000. Depreciation of Rs. 10,000 is charged on Plant Account in
2007.
c) The investments are Trade Investments. Rs. 3,000 by way of dividend is
received including Rs. 1,000 from pre-acquisition profit which has been
credited to Investment Account.
d) An interim dividend of Rs. 20,000 has been paid in 2007.
e) Proposed dividend for 2006 was paid in 2007.

11.10 Answers
Answers to SAQs:
1. True
2. False
3. True
4. True
Terminal Questions
1. Refer to 11.3
2. Refer to 11.5
3. Refer to 11.6
4. Refer to 11.7
5. Refer to 11.7
6. Refer to 11.7
7. Refer to 11.7

Unit 12 Understanding Cost

Structure:
12.1 Introduction
Objectives
12.2 Classification of Cost
On the basis of behaviour of cost
On the basis of elements of the cost
12.3 Overheads and Non-cost Items
Overheads
Classification of Overheads
Non cost items
12.4 Determination of total cost
12.5 Cost sheet
Proforma of cost sheet
12.6 Estimation of Cost
12.7 Summary
12.9 Answers
12.1 Introduction
In the previous Units we have studied basics of accounting and tools for
financial statement analysis. However, managers require different kinds of
information for decision making. Accounting records and financial
statements prepared on the basis of accounting records do not provide all
the information required by managers of a business. Organizations have to
maintain many other types of records. One such record is cost record. Cost
records provide cost data to managers. What is the meaning of cost, how
costs are classified and determined has been discussed in this Unit.
Objectives:
After studying this chapter, you should be able to:
Understand Classification of costs based on their behaviour or elements
of cost
Know Determination of Total Cost
Prepare of Cost sheet
Prepare of Estimated Cost Sheet
12.2 Classification of cost

Cost classification is the process of grouping costs according to their
common features. Costs are to be classified in such a manner that they are
identified with cost center or cost unit. Cost is classified as follows:
1. On the basis of behaviour of cost
2. On the basis of elements of cost
12.2.1 On the basis of behaviour of cost
Behaviour means change in cost due to change in output. On the basis of
behaviour cost is classified into following categories:
Fixed Cost
It is that portion of the total cost which remains constant irrespective of
output up to the capacity limit. It is called as a period cost as it is
concerned with period. It depends upon the passage of time. It is also
referred to as non-variable cost or stand by cost or capacity cost. It
tends to be unaffected by variations in output. These costs provide
conditions for production rather than costs of production. They are created
by contractual obligations and managerial decisions. Rent of premises,
Taxes and insurance, staff salaries are examples for fixed cost.
Variable Cost
This cost varies according to the output. In other words, it is a cost which
changes according to the changes in output. It tends to vary in direct
proportion to output. If the output is decreased, variable cost will also
decrease. It is concerned with output of product. Therefore, it is called as a
product cost. If the output is doubled, variable cost will also be doubled.
For example, direct material, direct labour, direct expenses and variable
overheads are variable costs.
Characteristics of Variable Cost:
1. Total cost changes in direct proportion to change in total output.
2. Variable cost per unit remains constant.
3. It is quite divisible.
4. Per unit variable cost is smaller value.
5. It is identifiable with the individual cost unit.
6. Functional managers can exercise control over variable cost.

Semi-Variable Cost
This is also referred to as semi-fixed or partly variable cost. It remains
constant up to a certain level and registers change afterwards. These costs
vary in some degree with volume but not in direct or same proportion. Such
costs are fixed only in relation to specified constant conditions. For example,
repairs and maintenance of machinery, telephone charges, maintenance of
building, supervision, professional tax etc. are semi-variable costs.
12.2.2 On the basis of elements of cost
Elements mean nature of items. A cost is composed of three elements:
material, labour and expenses. Each of these three elements can be direct
and indirect as shown below.
Figure 12.1

1) Direct Cost:
It is the cost which is directly chargeable to the product manufactured. It is
easily identifiable. Direct cost consists of three elements which are as
follows:
a) Direct Material:
It is the cost of basic raw material used for manufacturing a product. It
becomes a part of the product. No finished product can be manufactured
without basic raw materials. It is easily identifiable and chargeable to the
product. For example, leather in leather ware, pulp in paper, steel in steel
furniture, sugarcane in sugar manufacturing or production etc. What is raw
material for one manufacturer might be finished product for another. Direct
material includes the following:
1. All materials specially purchased for production or the process.

2. All components purchased for production or the process.
3. Material transferred from one cost centre to another or one process to
another.
4. Primary packing materials, wrappings, cardboard boxes etc., necessary
for preservation or protection of product.
Some of the items like nails or thread in the store are part of finished
product. They are not treated as direct materials in view of negligible cost.
b) Direct Labour or Direct Wages:
It is the amount of wages paid to those workers who are engaged on the
manufacturing line for conversion of raw materials into finished goods. The
amount of wages can be easily identified and directly charged to the product.
These workers directly handle raw materials, work-in-progress and finished
goods on the production line. Wages paid to workers operating lathes,
drilling, cutting machines etc. are direct wages. Direct wages are also known
as productive labour, process labour or prime cost labour.
Direct wages include the payment made to the following group of workers:
1. Labour engaged on the actual production of product.
2. Labour engaged in aiding the operations viz. Supervisor, Foreman,
Shop clerks and workers on internal transport.
3. Inspectors, Analysts needed for such production.

c) Direct Expenses or Chargeable Expenses:

It is the amount of expense which is directly chargeable to the product
manufactured or which may be allocated to product directly. It can be easily
identified with the product. For example, hire charges of a special machine
used for manufacturing a product, cost of designing the product, cost of
patterns, architects fees / surveyors fees, or job cost of experimental work
carried out specially for a job etc. Cost of special drawings, cost of special
layout designs, patents, patterns, cost of models, surveyors fees, Excise
duty, Royalty on production, cost of rectifying defective work, and license
fees for a product. Utility of such expenses is exhausted on completion of
the job.
2) Indirect Cost:
It is that portion of the total cost which cannot be identified and charged
direct to the product. It has to be allocated, apportioned and absorbed over
the units manufactured on a suitable basis. It consists of the following three
elements:
a) Indirect Material:
It is the cost of material other than direct material which cannot be charged
to the product directly. It can not be treated as part of the product. It is also
known as expenses materials. It is the material which cannot be allocated
to the product but which can be apportioned to the cost units; Examples are
as follows:
1. Lubricants, cotton waste, Grease, Oil, stationery etc.
2. Small tools for general use.
3. Some minor items such as thread in dress making, cost of nails in shoe
making etc.
b) Indirect Labour:
It is the amount of wages paid to those workers who are not engaged on the
manufacturing line, for example, wages of workers in administration
department, watch and ward department, sales department, and general
supervision.
c) Indirect Expenses:
It is the amount of expenses which is not chargeable to the product directly.
It is the cost of giving service to the production department. It includes

factory expenses, administrative expenses, selling and distribution

expenses etc.
1. _________________ means change in cost due to change in output.
2. ________________ cost varies according to the output
3. Indirect material are also called as ___________________.
12.3 Overheads and Non-cost Items

12.3.1 Overheads
Aggregate of indirect cost is referred to as overheads. It is also called as on
cost or Supplementary Cost. It arises as a result of overall operation of a
business. According to Weldon overhead means the cost of indirect
material, indirect labour and such other expenses, including services as
cannot conveniently be charged to direct specific cost units. It includes all
manufacturing and non-manufacturing supplies and services.
These costs cannot be associated with a particular product. The principal
feature of overheads is the lack off direct traceability to individual product. It
remains relatively constant from period to period. The amount of overheads
is not directly chargeable i.e. it has to be properly allocated apportioned and
absorbed on some equitable basis.
12.3.2 Classification of Overheads
We have studied that overheads are indirect costs which can be classified
based on elements as shown in 12.2. Another way to classify them is based
on functions as follows.
1. Factory Overheads: It is the aggregate of all the factory expenses
incurred in connection with manufacture of a product. These are incurred
in connection with running of factory. They include the items of expenses
viz., factory salary, work managers salary, factory repairs, rent of factory
premises, factory lighting, lubricants, factory power, drawing office salary,
haulage (cost of internal transport) depreciation of plant and machinery
unproductive wages, estimation expenses, royalties, loose tools written
off, material handling charges, time office salaries, counting house
salaries etc.
2. Administrative Overheads or Office Overheads: It is the aggregate
of all the expenses as regards administration. It is the cost of office
service or decision making. It consists of the following expenses: Staff

salaries, printing and stationery, postage and telegram, telephone
charges, rent of office premises, office conveyance, printing and
stationery and repairs and depreciation of office premises and furniture
etc.
3. Selling and Distribution Overheads: It is the aggregate of all the
expense incurred in connection with the sales and distribution of finished
product and services. It is the cost of sales and distribution services.
Selling expenses are such expenses which are incurred in acquired and
retaining customers. They include, the following expenses;
(a) Advertisement (b) Show room expenses (c) Traveling expenses
(d) Commission to agents (e) Salaries of Sales office (f) cost of catalogues
(g) Discount allowed (h) Bad debts written off (i) Commission on sales
(j) Rent of Sales Room (k) Samples and Free gifts (l) After sales service
expenses (m) Expenses on demonstration and technical advice to
prospective customers (n) Free repairs and servicing expenses
(o) Expenses on market research (p) fancy packing and demonstration.
Distribution expenses include all those expenses which are incurred in
connection with making the goods available to customers. These expenses
include the following:
(a) Packing charges (b) Loading charges (c) Carriage on sales (d) Rent of
warehouse (e) Insurance and lighting of warehouse (f) Insurance of delivery
van (g) Expenses on delivery van (h) Salaries of Godown keeper, drivers
and packing staff.
12.3.3 Non-cost items
Non-cost items are those items which do not form part of cost of a product.
Such items should not be considered while ascertaining cost of a product.
These are items included in profit and loss A/c as per principles of Financial
Accountancy but not related to product. For examples, Income-tax paid,
provision for Income-tax, interest on capital, interest on loan, profit on sale
of fixed assets, loss on sale of fixed assets, transfer fees received, transfer
to reserves, any other appropriation of profit, commission to Managing
Director or Partners, capital loss, donations, capital expenditure, discount on
shares and debentures Goodwill written off, Preliminary expenses written

off, brokerage, pure financial expenses or losses and expenses not related
to the business, wealth tax, bonus to directors and employees (if it is based
on profit), expenses of raising capital, penalties and fines.
12.4 Determination of Total Cost

Cost of product is determined as per cost attach concept studied already.
Total cost of a product consists of various elements of cost which have the
quality of coherence. All the elements of cost can be grouped and
regrouped. Grouping and re-grouping of the various elements of costs leads
to significant divisions of costs. The logical process of determination of cost
by groping and re-grouping various elements is illustrated as follows:
Fig. 12.2
Division of Cost
As shown in Fig. 12.2 Total cost is divided into various sub groups each of
which has been explained here.

Prime Cost:
It comprises of all direct materials, direct labour and direct expenses. It is
also know as flat cost.
Prime Cost = Direct Materials + Direct Labour + Direct Expenses.
Works Cost:
It is also known as factory cost or cost of manufacture. It is the cost of
manufacturing an article. It includes prime cost and factory overheads.
Works Cost = Prime Cost + Factory Overheads
Cost of Production
It represents factory cost plus administrative overheads.
Cost of Production = Factory Cost + Administrative overheads.
Total Cost
It represents cost of production plus selling & distribution overheads.
Total Cost = Cost of Production + Selling & Distribution overheads.
Selling Price
It is the price which includes total cost plus margin of profit ( or minus loss) if
any.
Selling Price = Total Cost + Profit (-Loss)
How these divisions of costs are comprised in selling price is shown in in

fig. 12.3.

Composition of Selling Price:

Profit
Selling &
Distribution
Overheads
Office
Overheads
Factory
Overheads
Direct
Cost of Production
Expenses
Direct
Factory Cost
Selling Price
Prime Cost
Total Cost
Labour
Direct
Materials
Fig. 12.3
12.5 Cost Sheet

For determination of total cost of production a statement showing the
various elements of cost is prepared. This statement is called as a
statement of cost or cost sheet. Cost sheet is a statement which provides
for the assembly of the detailed cost of entire or most units. It is a statement
showing the details of the total cost of job, operation or order. It brings out
the composition of total cost in a logical order, under proper classification
and sub-divisions. The period covered by the cost sheet may be a week, a
month or so. Separate columns are provided to show the total cost and cost
per unit. A cost sheet is prepared under output or unit costing method.
Features of Cost Sheet
Cost sheet has the following features:
1. It relates to a particular product.
2. It relates to cost incurred during a particular period.
3. It may show total cost as well as per unit cost.
4. It may be based on actual data or estimated data.

Purpose of Cost Sheet

Cost sheet serves the following purposes:
1. It gives the break up of total cost under different elements.
2. It shows total cost as well as cost per unit.
3. It helps comparison of current years costs with previous years costs.
4. It facilitates preparation of tender or quotations.
5. It enables the management to fix selling price.
6. It controls cost.
12.5.1 Proforma of Cost Sheet
Cost sheet for the period .. Production Units
Unit Cost
Rs. Rs. Rs.
Direct Materials Cost

Opening Stock of Materials xx
+ Purchases xx
+ Carriage Inwards xx
+ Custom Duty and Octroi xx
Dock Charges xx
Freight Inwards xx
xx
Less: Closing Stock of Materials xx xx
Direct Wages xx
Direct Expenses / Chargeable Expenses xx
Prime Cost xx
Factory Overheads
Factory Rent, Rate, Insurance xx
Factory Lighting xx
Factory Supervision xx
Motive Power xx
Fuel & Oil xx
Grease, Water etc. xx
Steam xx
Welfare Expenses xx

Laboratory Expenses xx
Depreciation of Plant & Machinery xx
Depreciation of Factory Building xx
Repairs & Maintenance of Factory xx
Indirect Wages xx
Estimation Expenses xx
Technical Director's Fees xx
Haulage xx
Royalty xx
Loose tools W/off xx
Material handling Charges xx
Factory Stationary xx
Works Manager's Salary xx
Works Clerical Staff's Salary xx
Supervisor's Salary xx
Store Keeper's Salary xx
Service Department Expenses xx
Factory Clearing xx
All other Factory Expenses xx
Less: Scrap Sales xx xx
Add: Opening Work in Progress xx
xx
Less: Closing Work in Progress xx
Factory Cost
Office & Administrations Overheads
Office Rent Rate & Taxes xx
Staff Salaries xx
Office Lighting xx
Office Cleaning xx
Printing & Stationery xx
Postage & Telegram xx
Office Conveyance xx
Depreciation on Office Building & Furniture xx

Office Equipments
Office Repairs xx
Sundry Expenses xx
General Expenses xx
Legal Expenses xx
Audit Fees xx xx
Cost of Production xx
Add: Opening Stock of Finished Goods xx
xx
Less: Closing Stock of Finished Goods xx
Cost of Finished Goods sold xx
Selling & Distribution Overheads
Selling:
Advertisement xx
Show Room Expenses xx
Travelling Expenses xx
Commission on Sales xx
Sales Salaries xx
Discount allowed xx
Bad Debts xx
Samples & Gifts xx
After Sales
Service Expenses xx
Demonstration Expenses xx
Packing Expenses xx
Loading Charges xx
Carriage on Sales xx
Rent of Warehouse xx
Insurance & Lighting of Warehouse xx
Expenses of Delivery Van xx
Salaries of Packing Department xx xx
Collection Charges xx
Cost of Catalogues xx

Cost of mailing literature xx

Cost of tender xx
Total Cost or Cost of Sale xx
Profit xx
Sales xx
Treatment of Certain Items of cost sheet:

i) Raw Materials:
For calculation of raw materials consumed, following formula may be used:
Rs.
Opening Stock of Raw Materials xx
Add: Purchases xx
xx
Less: Closing Stock of Raw Materials xx
Cost of Material Consumed xx
ii) Work in Progress:

It represents incomplete units at the end of a given period. The work in
progress is valued at prime cost or at factory cost.
At Prime Cost:
In such a case opening and closing work in progress is taken into
consideration in cost sheet while calculating prime cost.
Rs.
Direct Materials xx
Add: Direct Wages xx
Add: Other Direct Expenses xx
xx


Prime Cost xx
At Factory Cost:
Direct Materials xx
Direct Labour xx
Other Direct Expenses xx
Prime Cost xx
Add: Factory Overheads xx
xx
Factory Cost xx
iii) Carriage Inward:

It is the carriage on purchase of materials it should be added to the cost of
material purchased.
iv) Carriage Outward:
It is the carriage on sales it should be treated as selling and distribution
overhead.
v) Defective Material:
If defective material is returned to supplier, the cost of material consumed
should be reduced by the value of such material. If it is sold, it should be
reduced.
vi) Scrap:
If wastage or residual of material scrap or defective product is sold as scrap,
the value realized should be deducted from factory overheads. However,
realisable value of scarp of materials should be deducted from cost of
materials consumed.
vii) By-Product:
Realisable value of by-product is deducted from factory overheads.

viii) Defective Product

If defective product is rectified by incurring extra expenditure, it should be
included in factory cost, if it is caused by normal reasons. If it is caused by
abnormal reasons, the rectifying cost is transferred to costing P & L A/c.
ix) Normal Loss of Raw Materials:
It should be ignored. It will get automatically charged to output.
x) Abnormal Loss of Raw Materials:
Cost of material abnormally lost such as loss of materials due to fire,
accidents, water seepage etc. should be deducted from the value of material
purchased.
xi) Special Stores:
Cost of special stores and consumables identified with specific products
should be taken as a part of prime cost.
xii) Packing Charges:
Treatment depends on the nature of packing:
a) Cost of essential packing is included as part of direct material cost.
b) Cost of temporary packing which is required for movement of semi-
finished goods for further processing should be taken as a part of factory
overheads.
c) Packing of finished goods for transportation to consumers place should
be treated as selling and distribution overheads.
d) Fancy packing to promote sale should be treated as publicity cost.
xiii) Trade discount:
It should be deducted from sales.
xiv) Octroi and Custom Duty:
It is incurred in connection with purchase of materials. It should be included
in cost of material consumed.
Illustration (Treatment or Allocation of Expenses):
The account of X Manufacturing Company for the year ended December.
2001 showing the following:

Rs. Rs.
Drawing Office Salaries 6,500 Materials Purchased 1,85000
Counting House Salaries 1,2,600 Travelling Expenses 2,100
Carriage Outwards 4,300 Travellers Salaries & 7,700
Commission
Carriage on Purchases 7,150 Productive Wages 1,26,000
Bad Debts written of 6,500 Depreciation :
Repairs of Plant, 4,450 - Plant & Machinery 6500
Machinery & Tools & Tools
- Furniture 300
Rent, Rates, Taxes & Directors Fees 6000
Insurance
- Factory 8,500 Gas and Water:
- Office 2,000 - Factory 1200
Sales 4,61,10 - Office 400
0
Stock of Materials Managers Salary
th
(3/4 Factory
th
- 31st Dec. 2000 62,800 And 1/4 Office) 10000
- 31st Dec. 2001 48,000 General Expenses 3400
Prepare statement giving the following information:

a) Material Consumed;
b) Prime cost;
c) Factory overhead and percentage of wages;
d) Factory Cost
e) General overhead and the processing on factory cost;
f) Total Cost;
g) Net profit.

Solution:
Statement of Cost and Profit for the year ended 31st December 2001.
Rs. Rs.
Stock of Raw Materials 1.1.2001 62,800
Add: Purchases 1,85,000
Add: Carriage on Purchases 7,150
2,54,950
Less: Stock of Raw Materials 31.12.2001 48,000
a) Value of Materials Consumed 2,06,950
Productive Wages 1,26,000
b) Prime Cost 3,32,950
Factory Overheads:
Drawing Office Salaries 6,500
Repairs to Plant and Machinery 4,450
Factory Rent, Rates, Taxes & Insurance 8,500
Depreciation of Plant, Machinery, Tools 6,500
Factory Gas, and Water 1,200
Managers' Salary (3/4) of Rs. 10,000 7,500 34,650
Percentage of Factory Overheads

34,650 x 100 55
On Wages = = = 27.5%
1,26,000 2
c) Factory Cost 3,67,600

General Overheads:
Counting House Salaries 12600
Carriage 4300
Bad Debts 6500
Office Rent, Rates, Taxes & Insurance 2000
Travelling Expenses 2100
Travellers Salaries and Commission 7700
Depreciation on Furniture 300
Directors Fees 6000
Office Gas and Water 400
Manager's Salary 2500

General Expenses 3400 47,800

d) Total Cost 415,400
e) Net Profit 45,700
Sales 461,100
Note: Percentage of General Overheads on Factory Cost:
47,800 (Approximately)
100 13%
3,67,600
12.6 Estimation of Cost

Very often, the management desires to know, what will be the cost? even
before the production starts. The purpose to know the cost before it is
incurred might be different. It may be to keep the cost within control or it
may be used for profit planning. Many times, it is required to submit tenders,
to give quotations, to prepare the price lists etc. For this purpose the
estimation of probable cost of production is essential. This requires the
past cost data to be analyzed, present circumstances are taken into
consideration and future is to be projected. This involves the study of each
and every element of cost and their nature of behaviour. Keeping in view the
nature of behaviour of elements of cost, it can be classified into following
three categories:
a) Fixed Cost.
b) Variable Cost.
c) Semi Variable Cost.
We will study in detail the nature of behaviour of cost hereinafter:
a) Fixed Cost:
Fixed cost is that cost which remains unaffected even though there is
change in the level of output. It remains constant at all the levels of output
for a given period of time. Examples of such costs are rent, rates and taxes
of factory premises, salary of General Manager, Foreman, Watchman,
Insurance, Depreciation etc. These expenses are incured according to the
unit of time and not according to level of production. Hence, sometimes they
are called as periodic cost. For example, such fixed cost is ascertained in

a particular concern Rs. 12,000/- per month. Assume the capacity of this
concern is to produce 1000 units per month. If the concern produces 100
units or 500 units or 700 units or 1000 units this fixed cost will remain
constant at all these levels of output.
This fixed cost remains fixed/constant at all the levels of output, but the cost
per unit changes if there is change in the level of output. We will study this
principle with the help of the above data at different levels or output.
Level of Output Fixed Cost Cost per Unit

(Units) Rs. Rs.
100 12,000 120
300 12,000 40
500 12,000 24
800 12,000 15
1000 12,000 12
Conclusion:
Fixed cost remains fixed at all the levels of output (If within capacity) and
does not get affected even though there is change in the level of output.
However, fixed cost per unit changes, if there is change in the level of output.
Fixed cost also changes in the long run sometimes. For example, municipal
tax in respect of factory premises in the year 1991 may not be the same as
it was in the 1981.
b) Variable Cost:
It is the cost which tends to vary directly with the volume of output. If there is
increase in output this cost increases and if there is decrease in level of
output this cost decreases. The change in the variable cost takes place in
the same direction in which the level of output changes. This cost consists
of Direct Wages, Direct Expenses and some part of indirect expenses which
varies according to the level of output. Normally this cost changes in the
same proportion in which proportion the output changes. Hence, these
expenses are called as variable expenses. Say for example, if standard unit
of expenses on direct materials will change if level of output changes. For
100 units it will be Rs. 2,000/-. For 300 units it will be Rs. 6,000/-. For 500
units it will be Rs. 10,000/- Etc. However, variable cost per units will remain

unchanged provided price level does not change. We will study this principle
with the help of the above data at different levels of output:
Level of Output Variable Expenses Cost

(Units) (Direct Materials) Per Unit
Rs.
100 2,000 20
300 6,000 20
500 10,000 20
800 16,000 20
1000 20,000 20
Conclusion:
Variable expenses change directly in relation to change in level of output on
the same proportion in which proportion the level of output changes.
However, variable expenses per unit will remain the same. Here we have
assumed the price level remains unchanged.
c) Semi Variable Cost:
This is the third category of the nature of behaviour of the expenses. These
expenses are neither fixed nor variable. These expenses change in the
same direction in which the level of output changes. Thus these expenses
are partly fixed and partly variable in nature. Example of such expenses is
Depreciation of Plant and Machinery, maintenance of factory building etc.
These expenses will increase if factory is run from single shift to double shift
or triple shifts. Depreciation and maintenance will increase but not in the
same ratio the output increases. Thus, these expenses are neither fixed nor
variable cent percent. Hence, they are called as semi-variable expenses.
The expenses on electricity or telephones, you will find upto a certain level
of consumption is charged, at a fixed specified level and again change takes
place after that specified level is crossed.
Conclusion:
The expenses change in the same direction but not in the same proportion,
in which proportion, the output changes. The change in expenses largely
depends on the nature of expenses. No hard and fast rule can be
established in relation to semi variable cost. The management is specifically
required to study the trend of expenses which are semi variable in nature.

When management decides to ascertain the probable cost for the purpose
of submitting tender or to give quotations or preparing price list, it is normally
prepared in the form of Cost Sheet taking all the forecasted figures on
estimation basis. However the estimation should not be prepared blindly. It
should be done on the basis of our discussion in the earlier paras in respect
of nature of expenses. We will be studying the same in the following
illustrations:
Illustration
M/s. Godan and Sons manufactured and sold 2000 Typewriters in the year
2004. Its summarised Trading and Profit and Loss Account for the year
2004 is as below:
Rs. Rs.
To Cost of Material 1,20,000 By Sales 6,00,000
consumed
To Direct Wages 1,80,000
To Manufacturing Charges 75,000
To Gross Profit C/d 2,25,000
Total 6,00,000 6,00,000
To Management Expenses 90,000 By Gross 2,25,000
Profit B/d
To General Expenses 30,000
To Rent Rates & Taxes 15,000
To Selling Expenses 45,000
To Net Profit 45,000
Total 2,25,000 2,25,000
For the year 2005 it is estimated that:

1. The output and sale will be 3,000 typewriters.
2. Price of material will rise by 25% on the previous year level.
3. Wages per unit will rise by 10%
4. Manufacturing charges will increase in proportion to the combined cost
of material and wages.
5. Selling cost per unit will remain unchanged.
6. Other expenses will remain unaffected by the rise in output.

Prepare a statement showing the cost at which typewriters will be

manufactured in 2005 and give price at which it should be marked so as to
show profit of 10% on selling price.
Solution:
Total Cost Per
Particulars Cost Unit
Rs. Rs.
I Direct Materials 1,20,000 60.00
II. Direct Labour 1,80,000 90.00
(A) Prime Cost 3,00,000 150.00
III. Factory Overheads 75,000 37.50
(B) Factory Cost 3,75,000 187.50
IV. Office Overheads:
(Rs. 90,000 + Rs. 30,000 + 15,000) 1,35,000 67.50
(C) Cost of Production 5,10,000 255.00
V. Selling & Distribution Expense 45,000 22.50
(D) Cost of Sale 5,55,000 277.50
Profit 45,000 22.50
6,00,000 300.00
Estimates of the year 2005:

1. Material cost per unit Rs. 60
Add: Expected Increase of price of material in 2000
25% over that of 2004 i.e. Rs. 15
Expected price of material (per unit) Rs. 75
2. Wages per unit Rs. 90
Add: Expected increase @10% Rs. 9
Expected Wages per unit Rs. 99
3. Manufacturing charges are Rs. 75,000
Percentage of manufacturing expenses to combined cost of materials
and wages.
Manufacturing Expenses
= 100
Materials Cost Labour Cost

37.50
= 100 25%
150
Manufacturing expenses are 25% of combined cost of materials & wages.
To ascertain the selling price to be quoted in the year 2005 we will prepare
estimated cost sheet for 2005 as follows:
Estimated Cost Sheet for the year 2005

Production 3000 Units
Cost Per
Total Cost
Particulars Unit
Rs.
Rs.
I. Direct Materials (1) 2,25,000 75.00
II. Direct Labour (2) 2,97,000 99.00
(A) Prime Cost 5,22,000 174.00
III. Factory Overheads (3)
(25% of Combined Cost of Materials & Wages) 1,30,500 43.50
(B) Factory Cost 6,52,500 217.50
IV. Office Overheads: 1,35,000 45.00
(C) Cost of Production 7,87,500 262.50
V. Selling & Distribution Expense 67,500 22.50
(D) Cost of Sale 8,55,000 285.00
Profit 95,000 31.67
(E) Selling Price 9,50,000 316.67

4. ____________________ are those items which do not form part of cost
of a product.
5. ___________________ is a statement which provides for the assembly
of the detailed cost of entire units
6. Cost sheet shows total cost as well as cost per unit. State True/False.
7. ____________ tends to vary directly with the volume of output
12.7 Summary
Cost is the amount of expenditure incurred on a given thing. Cost is
classified on the basis of behaviour, elements and function. On the basis of
behaviour it has been divided into fixed variable and semi variable cost. On
the basis of elements it has been divided in to direct and indirect costs. On
the basis of function it has been divided into Administration, Selling and
Distribution etc.
For determination of total cost of production a statement showing the
various elements of cost is prepared. This statement is called as a
statement of cost or cost sheet. Very often, the management desires to
know, what will be the cost? even before the production starts. The
purpose to know the cost before it is incurred might be different. For this
purpose the estimation of probable cost of production is essential.

1. What is cost? How would you classify cost?
2. Give examples of each of factory overheads and office overheads.
3. Distinguish between Fixed cost and variable cost.
4. What is a cost sheet? What are the purposes of cost sheet ?
5. Discuss in details the elements of the total cost.
6. Mr. Rajendra furnishes the following data relating to the manufacture of
X standard product during the month of April, 2005:
Raw Materials consumed Rs.15, 000
Direct labour charges Rs. 9,000
Machine hours worked 900
Machine hour rate Rs. 5
Administrative overheads 20% on works cost
Selling overheads Rs.0.50 per unit
Units produced 17,100
Units sold 16,000 at Rs. 4 per unit
You are required to prepare a Cost Sheet from the above, showing:
a) the cost per unit.
b) Profit per unit sold and profit for the period.
7. During the calendar year 2005 the accounts of Air Cool Services Ltd.
Charai, Thane, manufacturers of AIR COOLERS revealed the following
data:
Materials used Rs. 9, 99,999
Direct Wages Rs. 4, 44,444
Factory Overheads Rs. 1, 11,111

Office Overheads Rs. 15,556
It is estimated that in 2002:
1. Each Air cooler will require materials worth Rs. 990 /-
2. Expenditure on Direct wages will be Rs. 888/-
3. The factory overheads will bear the same ratio to works cost as in 2005
4. The office overheads will bear the same ratio to works cost as in 2005.
5. The company desired to earn profit 50% on selling price.
Prepare the statement showing the price at which the Air cooler should be
sold during the year 2006.
12.9 Answers
1. Behaviour
2. Variable
3. Expense material
4. Non-cost items
5. Cost sheet
6. True
7. Variable cost
Answers to TQs
1. Ref. 12.2
2. Ref. 12.3.2
3. Ref. 12.6
4. Ref. 12.5
5. Ref. 12.2.2

6.
Statement of Cost of Production for the month of April 2005
Unit Produced = 17,100
Per unit
Rs. Rs.
Raw Materials Consumed 15,000
Direct Labour Charges 9,000
Prime Cost 24,000
Factory Expenses (900 hrs @ 5 per hr.) 4,500
Works Cost 28,500
Administrative Overheads
(20% on Works Cost) 5,700
Cost of Production 34,200 2.00
Statement of Profit
Rs...
Cost of Production of 16,000 @ Rs. 2 per unit 32,000
Selling Overheads 50 Paise for 16,000 units 8,000
Cost of Sales 40,000
Profit for the period 24,000
Sales (16,000 units @ Rs. 4 per unit) 64,000
24,000
Profit per unit sold Rs.1.50
16,000
Note: Factory overheads should be calculated on the basis of machine

hours and the machine hour rate.

7
Cost Sheet of M/s. Air Coolers Ltd. Thane for the year ended
31st December, 2005
Particulars
Rs.
I. Direct Materials Consumed
9,99,999
II. Direct Wages
4,44,444
(A) Prime Cost
14,44,443
III. Factory Overheads
1,11,111
(B) Works Cost
15,55,554
IV. Office Overheads
15,556
(C) Cost of Production
15,71,110
Working Notes:
1. Ratio of factory overheads to wages :
1.11.111
100 25%
4,44,444
2. Ratio of office overheads to works cost:

15,556
100 1%
15,55,554
3. Profit is 50% on selling price:

If selling price is 100 then profit is 50. If Cost is 50 then % of profit to
cost is,
50
100 100%
50
Thus, profit is 100% of cost of production.

Estimated Cost Sheet for the year 2006

Particulars Cost Per Unit
Rs.
I. Direct Material 990

II. Direct Wages 888
(A) Prime Cost 1,878
III. Factory Overheads
(25% of Direct Labour) 222
(B) Works Cost 2,100
IV. Office Overheads
(1% of Works Cost) 21
(C) Cost of Production 2,121
Profit @100% of Cost 2,121
(D) Selling Price 4,242

Unit 13 Marginal Costing & Break-even Analysis

Structure:
13.1 Introduction
Objectives
13.2 Basic concept of marginal costing
Meaning and Features of Marginal costing
Advantages of Marginal Costing
Limitations of Marginal Costing
13.3 Concept of Profit and Contribution
13.4 Concept of Profit/Volume Ratio
13.5 Break Even Point (B.E.P.)
Methods of calculating Break Even Point
Assumptions, Uses and Limitations of Break Even Analysis
Factors affecting Break Even Point and Margin of safety
Break-Even Chart
13.6 Summary
13.8 Answers
13.1 Introduction
We have studied in the earlier chapter that cost can be classified into two
groups viz. fixed cost and variable cost. Variable cost varies with the
changes in the volume of output or level of activity. As against this, fixed
cost relates to time and does not vary with the changes in the level of
activity, Because of inclusion of fixed cost in determination of total cost of a
product, the cost per unit or process varies from period to period according
to the volume. This has given rise to the concept of marginal costing. We
shall study more regarding this Unit.
Learning Objectives:
After studying this chapter, you should be able to understand:
Concept of marginal costing.
Understand difference between profit and Contribution.
Understand the concept and use of break even point

13.2 Basic Concept of Marginal costing

Marginal costing is concerned with determination of product cost which
consists of direct material, direct labour, direct expenses and variable
overheads. It should be kept in mind that variable costs per unit are fixed
and fixed costs per unit are variable. This method of costing is generally
known as marginal costing. Marginal costing is also known as direct costing,
contributory costing and incremental costing.
13.2.1 Meaning and Features of Marginal costing
Meaning: The ICMA has defined marginal cost as the amount at any given
volume of output by which aggregate costs are changed if the volume of
output is increased or decreased or decreased by one unit. From the
analysis of this definition it is clear that increase/decrease in one unit of
output increases/reduces the total cost from the existing level to the new
level. This increase/decrease in variable cost from existing level to the new
level. is called as marginal cost.
Suppose the cost of producing 100 units is Rs. 200. If 101 units are
manufactured the cost goes up by Rs. 2 and becomes Rs. 202. If 99 units
are manufactured, the cost is reduced by Rs. 21 i.e. to Rs. 198. with the
increase or decrease in the volume the cost is increased or decreased by
Rs. 2 respectively. Thus Rs. 2 will be called as the marginal cost.
Marginal costing means the ascertainment of marginal costs and of the
effect on profit of changes in volume or type of output by differentiating
between fixe and variable costs.
Marginal costing is not a method of costing. It is a technique of controlling by
bringing out relationship between profit and volume.
Features of Marginal Costing:
1. The elements of cost are differentiated between fixed costs and variable
costs.
2. Only the variable or marginal cost is considered while calculating
product costs.
3. Stock of finished products and work-in-progress are valued at variable
cost.
4. Contribution is the difference between sales and marginal cost.
5. Fixed costs do not find place in the product cost.

6. Prices are based on marginal cost plus contribution.

7. It is a technique of cost recording and cost reporting.
8. Profitability of various products is determined in terms of marginal
contribution.
9. Presentation of data is oriented to highlight the total contribution and
contribution from each product.
13.2.2 Advantages of Marginal Costing
Fig. 13.1

1. Constant in nature :
Marginal cost remains the same per unit of output whether there is increase
or decrease in production.
2. Realistic :
It is realistic as fixed cost is eliminated. Inventory is valued at marginal cost.
Therefore, it is more realistic and uniform. No fictitious profit arises.
3. Simplified overhead Treatment :
There is no complication of over-absorption and under-absorption of
overheads.
4. Facilitates control :
Classification of cost as fixed and variable helps to have greater control over
costs.
5. Meaningful Reporting :
The reporting made to management is more meaningful as the reports are
based on sales figures rather than production. Comparison of efficiency can
be done in a better way.
6. Relative Profitability :
In case a number of products are manufactured, marginal costing helps
management in the determination of relative profitability of each product.
7. Aid to Profit Planning :
The technique of marginal costing helps management in profit planning. The
management can plan the volume of sales for earning a required profit.
8. Break-even point :
Break Even Point can be determined only on the basis of marginal costing.
9. Pricing decisions :
These decisions can be based on contribution levels of individual products.
10. Responsibility Accounting :
It becomes more effective when based on marginal costing. Managers can
identify their responsibilities clearly.

13.2.3 Limitations of Marginal Costing
Fig. 13.2
1. Analysis of overheads :
In marginal costing, costs are to be classified into fixed and variable costs.
Considerable difficulties are experienced in analysing overheads into fixed
and variable categories. Therefore, segregation of costs into fixed and
variable is rather difficult and cannot be done with precision.
2. Greater emphasis on Sales :
Marginal costing technique lays greater emphasis on sales rather than
production. In fact, efficiency of business is to be judged by considering both
sales and production.
3. Difficulty in Application :
Marginal costing is not applicable in those concerns where large stocks
have to be carried by way of work-in-progress.

4. Improper basis for fixation of selling price :

In marginal costing selling price is fixed on the basis of contribution alone
which is not proper.
5. Less effective in Capital Intensive Industry :
Marginal costing technique is less effective in capital intensive industry
where fixed cost is huge.
6. Lack of standard for control :
Marginal costing does not provide any standard for control purpose. In fact,
budgetary control and standard costing are more effective tools in
controlling costs.
7. Elimination of Fixed Cost :
In marginal costing technique fixed costs are not included in the value of
finished goods and work-in-progress. Since fixed costs are incurred, these
should also form part of the costs of the product. Elimination of fixed costs
from finished stock and work-in-progress results into the under statement of
the stocks. The statement of the stocks affects the profit and loss account
and the balance sheet, which leads to deflation of profits.
8. Incomplete Information :
Marginal cost does not give complete information. For example, increase in
production and sales may be due to so many factors such as extensive use
of machinery, expansion of resources and by automation. The exact cause
is not disclosed by marginal costing.
9. Useful only for short term assessment :
Marginal costing is useful for short-term assessment of profitability.
However, long-term assessment of profit can be correctly determined on full
costs basis only.
10. Not acceptable for tax :
Income tax authorities do not recognise marginal costing for inventory
valuation.
1. In marginal costing, costs are to be classified into fixed and variable
costs. State True/False
2. _________________ is useful for short-term assessment of profitability

13.3 Concept of Profit and Contribution

Concept of Profit
Profit is known as Net Margin calculated after deducting fixed cost from
total contribution or gross margin. Profit is an excess of contribution over
fixed cost.
Profit = Contribution Fixed Cost
Or
P=CF
Contribution
Contribution is the excess of selling price over variable costs. It is known as
contribution because it contributes towards recovery of the fixed costs and
profits. Contribution is a pool of amount from which total fixed costs will be
deducted to arrive at the profit or loss. By equation the concept of
contribution can be stated as follows :
C = SV
C = Contribution
S = Sales
V = Variable Cost
Distinction between Contribution and Profit
Contribution Profit
1. It includes fixed cost and profit. It does not include fixed cost.
2. This concept is used by This concept decides profit or loss of a
marginal costing. business organisation.
3. It is equal to fixed cost at Break- It is the result of excess of sales over
even-point. break-even-point.
4. It is used in managerial decision It is used in deciding profitability of an
making. organisation.
Illustration 1
Rs.
Sales 12,000
Variable Cost 7,000
Fixed Cost 4,000
Calculate contribution and Profit.

Solution
C = S V
= 12,000 7,000
= 5,000
P = CF
= 5,000 4,000
= 1,000
Contribution is not profit. It covers fixed cost and the balance left out is
profit. Contribution plays a very important role in decision making. It is the
criteria of deciding profitability of various alternatives. The alternative which
gives maximum contribution is considered as most profitable.
Marginal Cost Equation
We have seen in the earlier paragraphs that contribution is the difference
between sales and variable cost. In other words, products sold provide fund
to meet fixed costs and profits. Therefore, contribution is equal to fixed cost
plus profit. From this the following equation has been derived :
SV = F+P
i.e. C = F+P Contribution (c)
where S = Sales
V = Variable Cost;
F = Fixed Costs,
P = Profit
If any three factors are given, the fourth can be ascertained. This equation is
also used for ascertainment of Break-Even-Point (B.E.P.) i.e. the point or
level where there is no profit or no loss.
3. ________________ is the excess of selling price over variable costs
4. BEP stands for ____________________________
13.4 Concept of Profit/Volume Ratio

This is popularly known as P/V Ratio. It expresses the relationship between
contribution and sales. It is expressed in percentage. P/V ratio can be
calculated in either of the following ways.
SV C
P/V ratio = x 100 x 100
S
S
where C = Contribution (being the difference between sales and

variable costs)
S = Sales
V = Variable Costs
P/V ratio can be determined by expressing change in profit or loss in
relation to change in sales. P/V ratio indicates the relative profitability of
different products, processes and departments.
If information about two periods is given, P/V ratio is calculated as follows :
Change of Profit
P/V Ratio = x 100
Change in Sales
Illustration 2
Rs.
Sales 20,000
Variable cost 16,000
Calculate P/V Ratio

Solution
Contribution
P/V Ratio =
Sales x 100
4,000
= x 100
20,000
= 20%
P/V ratio is most important to watch in business. It is the indicator of the rate
at which the organisation is earning profit. A high ratio indicates high
profitability and a low ratio indicates low profitability. It is useful for
calculating Break Even Point, and at a given level of sales, what sales are
required to earn a certain amount of profit etc.

Higher P/V Ratio is an index of sound financial health of company. P/V Ratio
can be improved by improving contribution which can be improved by taking
the following steps :
a) Increase in sales
b) Reduction in marginal cost
c) Concentration on sale of profitable product.
Limitations of P/V Ratio
Following limitations should be kept in mind while using P/V Ratio.
a) It heavily depends on contribution.
b) It fails to consider the capital outlays required by additional productive
capacity.
c) It indicates only relative profitability.
d) Over simplification may lead to erroneous conclusion.
e) Higher ratio will show the most profitable item, only when other
conditions are constant.
Factors Influencing P/V Ratio
Factors P/V Ratio
A. Fixed Cost
i) Increase No Impact
ii) Decrease No Impact
B. Sales Volume
i) Increase No Impact
ii) Decrease No Impact
C. Selling Price
i) Increase Increase
ii) Decrease Decrease
D. Variable Cost / Unit
i) Increase Decrease
ii) Decrease Increase

13.5 Break Even Point (B.E.P.)

Break-even-point is the point at which total revenue is equal to total cost. It
is that level of output (or sale) where there is no profit or no loss. At this
stage contribution is just sufficient to absorb fixed cost. The organisation
starts earning profit when the output or sales activity crosses this point.
Output or sales below this point results in a loss. Calculation of Break Even
Point for different levels of output or profit is called Break Even Analysis.
13.5.1 Methods of calculating Break Even Point
There are two ways of calculating break even point :
Contribution Approach :
Following formulae are used in this approach :
Fixed cost
B.E.P. (units) =
Selling Price Variable Cost
per unit per unit
Fixed cost
OR =
Contribution per unit
Break Even Sales (Rs.)

OR =
Selling price per unit
Fixed cost x Sales

B.E.P (in value) =
Sales Variable Cost
Fixed cost x Selling price per unit
OR =
Fixed Cost
OR =
P/V ratio
OR = B.E.P. Units x Selling price per unit
Equation Approach :
We know that
Sales Fixed Cost Variable Cost = Net Profit
Sales Total Cost = Net Profit
Sales = Fixed Cost + Variable Cost + Net Profit

Sales Variable cost = Fixed Cost + Net Profit

Contribution = Fixed Cost + Net Profit
Therefore
At Break Point
Contribution = Fixed Cost
Contribution Fixed Cost = 0
Fixed Cost Expected Profit
Required Sales =
P. V. Ratio
Relationship between Contribution and BEP
Contribution = Fixed Cost
A. At BEP Profit / Loss = Contribution Fixed Cost
= Nil
Contribution > Fixed Cost
B. At above BEP Profit = Contribution Fixed Cost
Contribution < Fixed Cost

C. At below BEP Loss = Fixed Cost Contribution
Illustration 3
Total Fixed Cost Rs. 12,000
Selling Price 12 per unit
Variable cost 9 per unit
Calculate Break Even Point.

Solution
Contribution = S V
= 12 9
= 3
Contribution
P/V Ratio = x 100
Sales
3
= x 100 = 25%
12

Total Fixed Cost

B.E.P. =
P/V Ratio
12,000
= = Rs. 45,000
25%
13.5.2 Assumptions, Uses and Limitations of Break Even Analysis

Assumptions:
Break Even Analysis is based on the following assumptions :
i) Costs can be classified into fixed and variable categories.
ii) Fixed Costs remain fixed for the entire volume.
iii) Variable costs change according to the changes in output.
iv) Selling price per unit remains the same for the entire volume.
v) Market is sufficient to absorb the entire output.
Uses of Break even analysis:
It facilitates determination of selling price which will give the desired profits.
i) It makes it possible to divide the sales volume to cover a given rate of
return on capital employed.
ii) The management can forecast profit and volume at levels of activity.
iii) It suggests to make a change in sales mix.
iv) It helps management to do inter-firm comparison of profitability.
v) It shows the impact of changes in costs on profits.
vi) It enables the management to plan for the optimum utilisation of
capacity.
Limitations:
Break Even Analysis is subject to certain limitations which are as follows :
i) B.E. Analysis is based on the assumption that costs can be
classified into fixed and variable categories. In practice it is very
difficult to have such a clear cut distinction.
ii) It assumes that fixed cost remains constant. However, in practice it
may change.
iii) Variable costs may not vary in direct proportion to the volume.
iv) Selling price may not remain constant.
v) The assumption that only one product is produced does not hold true
in practice.

vi) The assumption regarding production and sales does not realise in
practice.
vii) The analysis is static. However, circumstances are dynamic. Break
Even Analysis becomes complicated when all these changes are to
be incorporated.
viii) It does not consider capital employed in business. It presents only
one fact of profit planning.
13.5.3 Factors affecting Break Even Point and Margin of safety:
There are three factors viz. fixed cost, variable cost and selling price which
affect Break Even as follows:
Factors Effect on BEP

A. Fixed Cost
i) Increase i) BEP will go up
ii) Decrease ii) BEP will come down
B. Variable Cost
i) Increase per unit i) BEP will go up
ii) Decrease per unit ii) BEP will come down
C. Selling Price
i) Increase per unit i) BEP will come down
ii) Decrease per unit ii) BEP will go up
Margin of safety:
Margin Of Safety (MOS) is the difference between actual sales and Break
Even sales. It is given by formula
MOS = Actual Sales B.E.P. Sales
Or
Profit
MOS =
P/V Ratio

Illustration 4
Rs.
Sales 1,00,000
Fixed Cost 20,000
Variable Cost 60,000
Solution
S V
1. P/V = x 100
S
1,00,000 60,000
= x 100
80 60
= 40%
Fixed Cost
2. B.E.P. =
P/V Ratio
20,000
=
40%
100
= 20,000 x
40
= 50,000
3. MOS = Actual Sales B.E.P. Sales

= 1,00,000 50,000
= 50,000
OR
Profit
MOS =
P/V Ratio
20,000
=
40%
= 50,000

13.5.4 Break-Even Chart

The break-even chart is a graphical representation of marginal costing. It
indicates the graphic relationship between costs, volume and profits. It
shows not only the BEP but also the costs and revenue at varying levels of
sales. Therefore, it can be more appropriately called as the cost-volume-
profit graph (CVP graph). Thus the Break-even chart indicates the following
information:
i) Fixed Cost.
ii) Variable Costs.
iii) Total Cost
iv) Sales Value.
v) Profit or Loss.
vi) Break-even point.
vii) Margin of safety.
Assumptions of Break Even Chart
However, the construction of Break-Even chart is based on certain important
assumptions. These assumptions are as listed below:
i) Fixed cost will remain constant.
ii) Prices of variable cost factors will remain unchanged.
iii) Semi-variable cost is segregated into variable and fixed costs.
iv) Method of production will not change.
v) Operating efficiency will remain unchanged.
vi) There will be no changes in pricing policy.
vii) Sales equal production.
viii) Product-mix will remain constant.
Graphical chart can help to do Break Even analysis. Break-Even chart
indicates profit or loss at different levels of sales volume. It shows fixed
cost, variable cost, sales revenue and profit or loss at a given level of
production.
Steps to draw Break Even Chart:
1. Select a scale for sales on horizontal axis.
2. Select a scale for cost and revenue on vertical axis.
3. Draw fixed cost line parallel to horizontal axis.
4. Draw total cost line.

5. Draw the sales line starting from the point of origin and finishing at
point of maximum sales.
6. The point of intersection of two lines i.e. sales line and total cost line is
the Break Even Point.
7. Draw the line from intersection to vertical axis and horizontal axis to get
sales value and number of units produced at break-even point.
8. Show the loss area when production is less than the break-even point
and profit area when production is more than the break-even point.
9. Show margin of safety by deducting break even sales from total sales.
10. Show the angel of incidence.
Specimen of break-even-chart is as given below:
Production (Volume)

Use and Limitations of Break even point

Advantages of Break-Even Chart:
1. It is simple to construct and understand. Facts are represented
graphically are understood well.
2. It helps management in studying the relationship between cost, volume
and profits. This enables the management in taking decisions on sales.
3. It helps management in understanding the strength and profit earning
capacity of a business concern. Many important decisions can be taken
on the basis of margin of safety, break-even point etc.
4. It indicates the impact of different product mixes on profits. This helps
management in selecting the most profitable product-mix.
Limitations of Break-Even-Chart
5. Break-even chart indicates a static picture. It becomes out of date if
there is a change in the assumptions or conditions.
6. A company manufacturing variety of products cannot represent the fact
of each product in the chart.
7. Break-even chart does not consider the amount of capital employed
which is very vital in many decisions.
5. Profit/Volume ratio is popularly known as __________________.
6. P/V ratio heavily depends on contribution is considered as one of the
benefit aspect. True/False.
7. B.E. Analysis is based on the assumption that costs can be classified
into ______________ and ____________________.
8. The break-even chart is a graphical representation of
____________________.
13.6 Summary
Increase/decrease in one unit of output increases/reduces the total cost
from the existing level to the new level. This increase/decrease in variable
cost from existing level to the new level. is called as marginal cost. So
Marginal costing means the ascertainment of marginal costs and of the
effect on profit of changes in volume or type of output by differentiating
between fixed and variable costs.

Contribution is the excess of selling price over variable costs. It is known as

contribution because it contributes towards recovery of the fixed costs and
profits. Contribution is not profit. It covers fixed cost and the balance left out
is profit. Contribution plays a very important role in decision making. It is the
criteria of deciding profitability of various alternatives. The alternative which
gives maximum contribution is considered as most profitable.
Profit is known as Net Margin calculated after deducting fixed cost from
total contribution or gross margin. Profit is an excess of contribution over
fixed cost.
P/V Ratio expresses the relationship between contribution and sales. It is
expressed in percentage. It is the indicator of the rate at which the
organistion is earning profit. A high ratio indicates high profitability and a low
ratio indicates low profitability. It is useful for calculating Break Even Point,
at a given level of sales, sales required to earn a certain amount of profit
etc.
Higher P.V. Ratio is an index of sound financial health of companys
product. P/V Ratio can be improved by improving contribution.
Break-even-point is the point at which total revenue is equal to total cost. It
is that level of output (or sale) where there is no profit or no loss. At this
stage contribution is just sufficient to absorb fixed cost. Break Even Analysis
is finding out break even points for different levels of output variable costs
and profits required. Break Even analysis can be done through Break Even
chart.

1. State merits and demerits of Marginal Costing.
2. Distinguish between Profit and Contribution.
3. From the following particulars of X Ltd., calculate the break-even point :
Rs.
Variable cost per unit 12
Fixed Cost 60,000
Selling price per unit 18

4. A company estimates that next year it will earn a profit of Rs. 50,000.
The budgeted fixed costs and sales are Rs. 2,50,000 and Rs. 9,93,000
respectively. Find out the break-even point for the company.
5. From the following particulars, find out the selling price per unit if B. E. P.
be brought down to 9,000 units.
Rs.
Variable cost per unit 75
Fixed expenses 2,70,000
Selling price per unit 100
6. Total sales turnover and profits during two periods are as under:
Period I : Sales Rs. 20 lakhs; Profit Rs. 2 lakhs
Period II : Sales Rs. 30 lakhs; Profit Rs. 4 lakhs
Calculate P/V Ratio
7. You are required to calculate the break-even-point in the following case:
The fixed cost for the year is Rs. 80,000; variable cost per unit for the
single product being made is Rs. 4.
Estimated sales for the period are valued at Rs. 2,00,000. The number
of units involved coincides with the expected volume of output. Each
unit sells at Rs. 20.
Calculate break-even point.
8. What do you mean by Break Even Point? Explain this with the help of
graph.
13.8 Answers
1. True
2. Marginal costing
3. Contribution
4. Break Even Point
5. P/V ratio
6. False
7. fixed and variable categories
8. marginal costing

Terminal Questions
1. Ref. 13.2.2 and 13.2.3
2. Ref. 13.3
3. Contribution = Sales V. Cost
= 18 12
= 6
Fixed cost
B.E.P. (in units) =
60,000
=
6
= 10,000 Units
Fixed Cost
B.E.P. (Rs.) =
P/V Ratio
C
P/V Ratio = x 100
S
6
= x 100
18
= 33.33%
60,000
=
33.33%
= Rs. 1,80,000
Fixed Cost
4. B.E.P. =
P/V Ratio
Contribution = SV=F+P
C
P/V Ratio = x 100
S
C = F+P
= 2,50,000 + 50,000
= 3,00,000
3,00,000
P/V Ratio = x 100
9,93,000

= 30.21%
2,50,000
B.E.P. =
30.21%
= 8,27,500
5. Let us assume that the contribution per unit at B.E. sales of 9,000 is x.
Fixed cost
B.E.P. =
Contribution per unit is not known. Therefore,
2,70,000
9,000 units =
x
9,000 x = 2,70,000
x = 30
The contribution at present is 100 75 = 25
New Contribution is Rs. 30 per unit, in place of Rs. 25. Therefore, the
selling price should be Rs. 105, i.e., Rs. 75 + 30 as variable cost per unit will
not change.
Change of profit
6. P/V Ratio = x 100
Change in sales
2,00,000
= x 100
10,00,000
= 20%
7.
Per Unit Total
Rs. Rs.
Sales (No. of units sold 1,00,00) 20 2,00,000
Less: Variable cost (100 unit x 4) 4 40,000
Contribution 16 1,60,000
Less: Fixed Cost 80,000
Profit 80,000

Sales of B.E.P.
Fixed Cost
B.E.P. =
P/V Ratio
C
P/V Ratio = x 100
S
16
= x 100
20
= 80%
(or)
80,000
B.E.P. (Rs.) =
80%
= Rs. 1,00,000
8. Ref. 13.4

Unit 14 Budgetary Control

Structure:
14.1 Introduction
Objectives
14.2 Meaning of Budget
14.3 Meaning, Essentials and Objectives of Budgetary Control
14.4 Steps in Budgetary Control
14.5 Types of Budgets
14.6 Preparation of Flexible Budget
14.7 Merits and Demerits of Budgetary Control
14.8 Summary
14.10 Answers
14.1 Introduction
Every Organisation makes plans. Some plans are more formal than other
and some organisations plan more formally than other but all make same
attempt to consider the risk and opportunities which lie ahead and how to
confront them. In most businesses this process is formalised at least in
short-term, with considerable effort put into preparing annual budgets and
monitoring performance against those budgets. In this Unit we shall study
more about budgets.
Learning Objectives:
After studying this chapter, you should be able to:
Differentiate between Forecast and Budgeting
Understand different types of budgets
Prepare Flexible budgets
Know the merits and demerits of budgetary control
14.2 Meaning of Budget

A budget is prepared to have effective utilisation of funds and for the
realisation of objectives as efficiently as possible.

Definition of Budget:
A financial or quantitative statement prepared and approved prior to a
defined period of time, of the policy to be pursued during that period for the
purpose of attaining a given objective.
Forecast v. Budget
A forecast is a predication of the future state of world, in connection with
those aspects of world which are relevant to and likely to affect on future
activities. Forecast is calculation of probable events. Both forecasting and
planning involve recognition of the relevant factors in a given situation and
understanding of what each factor has contributed to it and how each is
likely to affect the future. Any organised business cannot avoid anticipating
or calculating future conditions and trends for the framing of its future policy
and decision. Forecast is concerned with probable events and the
budgeting relates to planned events. Budgeting should be preceded by
forecasting, but forecasts may be made for purpose other than budgeting.
A forecast is an assessment of probable future events. Budget is an
operating and financial plan to a business enterprise. At planning stage it is
necessary to prepare forecast of probable course of action for the business
in future. Budget is a sort of commitment or a target which the management
seems to attain on the basis of the forecasts made. Forecasts are made
regarding sales, production, cost and financial requirements at the business.
A forecast denotes some degree of flexibility while a budget denotes a
definite target. The following points of difference can be noted between
forecast and budget as shown in Table 14.1.
Table 14.1
Forecast Budget
1. Forecast is merely an estimate of 1. Budget shows the policy and
what is likely to happen. It is a programme to be followed in a
statement of problem events period under planned conditions.
which are likely to happen under
anticipated conditions during a
specified period of time.
2. Forecasts, being statements of 2. A budget is a tool of control since
future events, do not connote any it represents actions which can
sense of control. be shaped according to will so
that it can be suited to the
conditions which may or may not
happen.

3. Forecasting is a preliminary step 3. It begins when forecasting ends.

for budgeting. It ends with the Forecasts are converted into
forecast of likely events. budgets.
4. Forecasts are wider in scope and 4. Budgets have limited scope. It
it can be made in those sphere can be made of phenomenon
also where budgets cannot capable of being expressed
interfere. quantitatively.
Essential of Budget:
1) A budget is prepared prior to a defined period of time.
2) It is prepared for the definite future period.
3) The policy to be followed to attain the given objectives must be laid
before the budget is prepared.
4) The budget is a monetary or quantitative statement of that policy.
Thus a budget fixes a target in terms of rupees or quantities against which
the actual performance is measured.
1. __________________ is calculation of probable events.
2. Budget denotes a definite target. State True/False
14.3 Meaning, Essentials and Objectives of Budgetary Control

Definition of Budgetary Control:
The establishment of budgets relating the responsibilities of executives to
the requirements of a policy, and the continuous comparison of actual with
budgeted results, either to secure by individual action the objectives of that
policy or to provide a firm basis for its revision.
Or in simple words, budgetary control is implementing budgets and making
managers responsible for implementing it.
Essentials of budgetary control:
1) Establishment of budgets for each function and section of the
organisation.
2) Continuous comparison of the actual performance with that of the
budget so as to know the variations from budget and placing the
responsibility of executives for failure to achieve the desires results as
given in the budget.

3) Taking suitable remedial action to achieve the desired objective if there

is a variation of the actual performance from the budgeted performance.
4) Revision of budgets in the light of changed circumstances.
Objectives of Budgetary Control
1) Planning:
A budget is a plan of the policy to be pursued during the defined period of
time to attain a given objective. The budgetary control will force
management of all levels to plan in time all the activities to be done during
the future periods.
2) Co-ordination:
The budgetary control coordinates the various activities of the firm and
secures Co-operation of all concerned so that the common objective of the
firm may be successfully achieved.
3) Control:
Control consists of the action necessary to ensure that the performance of
the organisation conforms to the plans and objectives. Budgetary control
makes control possible by continuous comparison of actual performance
with that of the budget so as to report the variations from the budget to the
management for corrective action.
14.4 Steps in Budgetary Control

1) Organisation Chart:
Before successful installation of a budgetary control, it is necessary that the
concern should have a definite plan of organisation. The chief executive
who is the head of the budgetary control system delegates his authority to
the budget officer who sees that all budgets are co-ordinated.
2) Budget Centre:
A budget center is a section of the organisation of an undertaking defined
for the purpose of budgetary control. Budget Centres will disclose the
sections of the organisation where planned performance is not achieved.
3) Budget Manual:
It is a document which sets out, the responsibilities of the persons and the
forms and records required for budgetary control. It is a written document
which guides the executives in preparing various budgets.

4) Budget Controller or Budget Officer:

Chief executive appoints some persons known as budget controller who are
given the specific duty of administering the budget. The budget officer
should see that the actual performance is met in line with the budgeted
performance and should issue timely warning when the actual performance
differs substantially.
5) Budget Committee:
The Budget Controller is assisted by the Budget Committee. The Budget
Committee will include all the department heads. These heads will prepare
the budgets and submit to the committee for approval. It is the duty of the
Budget Committee to make necessary adjustments in the budgets,
co-ordinate all the budgets and finally approve the budgets.
6) Budget Period:
It is the period for which a budget is prepared and employed. The budget
period will depend upon the following two factors:
i) The type of business and
ii) The control aspect.
In the case of seasonal industries, the budget period should be short one
and should cover one season. From control point of view, the budget period
should be a short one. So that the actual results may be compared with
the budget each week end or month. Long term budgets should be
supplemented by short-term budgets to make budgetary control successful.
7) Key factor:
Key factor is defined as the factor which limits production. It is also known
as principal budget factor, limiting factor and governing factor. The key
factor will differ from concern to concern and might be sales, plant capacity,
raw materials, labour etc. The budget relating to the key factor should be
prepared first and the other budgets should be prepared based as the
principal budget factor. The key factors are temporary in nature and may be
overcome by suitable management actions. Generally, sales is the key
factor in any business. This can be overcome by taking proper sales
promotion steps

14.5 Types of Budgets

Budgets can be classified based on by the following factors:
1) The coverage they encompass.
2) The capacity to which they are related.
3) The conditions on which they are based.
4) The periods which they cover.
The classification based on the above factors is shown in Fig. 14.1.
Figure 14.1
Functional Budget:
It is a budget which relates to any of the functions of an undertaking for e.g.
Sales, Purchase, Research and development, etc. The following are
functional budgets which are commonly used.
1) Sales Budget including Selling & Distribution Cost Budget.
2) Production Budget consisting of Materials Budget, Labour Budget, Plant
utilisation Budget etc.
3) Purchase Budget.
4) Capital Expenditure Budget.
5) Administrative Cost Budget.
6) Research and Development Cost Budget.
7) Cash Budget.
Master Budget:
It is a consolidated summary of the various functional budgets. It is defined
as a summary budget incorporating its components functional budgets and
which is finally approved, adopted and employed. It is prepared by the

Budget Committee by co-ordinating the various functional budgets. It is used

to prepare the Budgeted Profit and Loss Account and a Budgeted Balance
Sheet.
Fixed Budget:
It is a budget prepared for a given level of activity. It does not take into
consideration any change in expenditure arising out of changes in the level
of activity. These budgets are useful when the actual level of activity
corresponds to budgeted level of activity.
Flexible Budget:
It is a budget designed to change in accordance with the level of activity
actually attained. It gives different budgeted costs for different levels of
activity. It is prepared after classifying the expenses into fixed, variable and
semi-variable, because the usefulness such a budget depends upon the
accuracy with which the expenses are classified. Such a budget is desirable
in the following cases:
1) Where the level of activity varies from period to period, due to the
seasonal nature of the industry or the variation in demand.
2) Where the business is a new one and it is difficult to anticipate the
demand.
3) Where an industry is suffering from the shortage of a factor of production
such as materials, labour, plant capacity etc. the level of activity
depends upon the availability of such a factor of production.
Basic Budget:
It is a budget which is prepared for use, unaltered over a long period of time.
This does not take into consideration the current conditions.
Current Budget:
It is a budget which is related to the current conditions and is prepared for
use over a short period of time. This is more useful than the basic budget.
Long Term Budget:
It is budget prepared for period longer than a year. These budgets help in
business forecasting and forward planning. The examples of long-term
budgets are Capital Expenditure Budget and Research and Development
budget.

Short Term Budget:

A budget which is prepared for periods less than a year and is very useful
to lower levels of management for control purposes. Such budgets are
prepared for these activities for whom the trend is difficult to foresee over
longer periods. Cash Budgets and Materials budgets are examples of long
term budgets.
Some important functional budgets:
1) Sales Budget:
Sales budget is a plain for coordinating the marketing operations, both in
financial and quantitative or physical terms. It is an important budget
because the ultimate object of all efforts is towards sales. The forecasted
quantities of sales and values of sales are presented in this budget. Sales is
one of the limiting factor. Hence, this budget should be prepared accurately
because preparation of all other budgets is based on sales budget. It is
prepared by the sales manager. The important factors to be taken into
consideration in its preparation are present sales, trends, salesmens is
assessments, estimated production capacity, availability of raw materials,
trade prospects, competition, financial resources, orders on hand
fluctuations, etc.
2) Production Budgets:
There is a close relationship between the sales and the production budget.
It is plan of forecast of the output of the business divided into various
products according to periods. There should be a relation between
production and sales budget; whatever is produced should be sold. As such,
it should be prepared keeping in view the sales budget, and as such it
cannot be prepared independently. Production budget can be prepared both
in quantitative or physical terms and financial terms, i.e. in rupees. The
works manager is responsible for its preparation. There are a number of
factors to be considered in the preparation of a production budget. These
are production planning, time gaps, capacity of plant, forecast of closing
finished stock, seasonal fluctuations, an availability of the raw materials, etc.
3) Cost of production budget:
The quantity produced or the number of units converted into in monetary
terms is called as cost of production budget. The number of units or quantity
to be produced is to be determined, without which cost of production budget

cannot be prepared. This budget estimates the cost of output planned. This
budget reflects the amount to be spent on producing a particular quantity as
stated in the production budget. A cost of production budget is composed of
the cost of materials, labour and overheads.
4) Materials budget:
Materials budget is a detailed statement of the forecast of the quantity of
raw materials required for production. In its preparation, it classifies both the
direct and indirect material requirements. This material budget mainly deals
with determining the quantity of raw materials required for production. It
should include the forecast of different types of raw materials, and should be
compatible to budgeted output, time lag, seasonal nature, fluctuations in
prices, market conditions, changing tastes and habits of the consumers,
government policy, etc. While preparing it, one should ensure and, enable
the fixing of the minimum stock level and their re-order level.
5) Direct labour budget:
Direct labour budget is concerned with determining the requirements of
direct labour for production. It has two forms like labour requirements budget
and labour cost budget. The labour is to be recruited as per the
requirements of production department. It should reflect the labour
requirements in different departments classifying labour into various trades.
Basically, labour is divided into direct and indirect labour and accordingly
two types of budgets can be prepared. Direct labour is involved in
manufacturing and indirect labour is involved and form part of the works
overheads. In preparing the labour budget, piece rate, time rate, overtime,
outworkers etc. should be considered.
6) Cash budget:
Cash budget is defined as an analysis of flow of cash in a business over a
future, short or long period. It is a forecast of expected cash intake and
outtake. It is a plan of estimate cash receipts and disbursements during a
given period of time. Cash is the nucleus or lifeblood in the working capital
management. It reflects the estimated cash receipts on account of cash
sales, credit collections and miscellaneous receipts. The other part of the
budget shows the estimated disbursements on account of cash purchases,
sums payable to creditors, wages, tax payment, dividends, etc. This budget
takes into account the flow of every item of cash, either receipts or
payments. A minimum cash balance is maintained always to meet the

contingencies. The Chief finance officer or accountant is responsible for the

preparation of the cash budget. If the cash budget is deficit, necessary
arrangements may be made with a bank to procure the required money to
meet the current cash transactions.
7) Capital Expenditure Budget:
This budget gives an estimate of the amount of capital that may be needed
for acquiring the fixed assets required for fulfilling production requirement as
in the production budget. Separate budgets may be prepared for different
items of fixed assets such as plant and machinery budget, building budget
etc. The capital expenditure budget takes into account the following factors.
a] Replacement of existing assets.
b] Purchase of additional assets to meet a proposed increase in production
due to increase in demand.
c] Purchase of additional assets to start new lines of production.
d] Installation of an improved type of machinery so as to reduce cost of
production.
8) Research and Development Budget:
A good business concern should conduct research to fund new products
and to find new ways so as to make improvement in quality of old products.
For this purpose, some amount of revenue is kept aside every year and a
research and development budget is prepared taking into consideration the
research projects in hand and the new projects to be taken up. Thus, this
budget provides an estimate of the expenditure to be incurred on research
during the budget period.
14.6 Preparation of Flexible Budgets

Illustration1
1. Flexible Budget:
The expenses budget for production of 10,000 units in a factory are
furnished below:
Per units (Rs.)

Materials 70
Labour 25
Variable overheads 20

Fixed overheads (Rs. 1,00,000) 10

Variable Expenses (Direct) 5
Selling Expenses (10% fixed) 13
Distribution Expenses (20% fixed) 7
Administration Expenses (Rs. 50000) 5
155
Prepare a budget for production of 6000 and 8000 units. Administrative

Expenses are fixed for all levels of production.
6000 units 8000 units 10000 units
Cost
Per unit Total Per unit Total Per unit Total
Materials 70 4,20,000 70 5,60,000 70 7,00,000
Labour 25 1,50,000 25 2,00,000 25 2,50,000
Direct Exp. 5 30,000 5 40,000 5 50,000
Prime Cost 100 6,00,000 100 8,00,000 100 10,00,000
Factory overheads
Fixed 16.67 1,00,000 12.50 1,00,000 10 1,00,000

Variable 20 1,20,000 20 1,60,000 20 2,00,000
Factory Cost 136.67 8,20,000 132.50 10,60,000 130 13,00,000
Administrative 8.33 50,000 6.25 50,000 5 50,000
Expenses 145.00 8,70,000 138.75 11,10,000 135 13,50,000
Selling & Distribution Expenses
Selling 13.87 83,200 13.32 1,06,600 13 1,30,000

Distribution 7.93 47,600 7.35 58,800 7 70,000
Total Cost 166.80 10,00,800 159.35 12,75,400 155 15,50,000
Working Note:
1) Materials, Labour, Direct Expenses and Variable overheads are variable
costs.
Therefore the cost per unit will be the same at all levels of production.
2) Fixed overheads (both factory and administration) will be the constant
for all levels of production.

3) Selling and Distribution expenses are partly fixed and partly variable.
The variable part per unit will be the same for all levels whereas the
fixed part in total will be constant for all levels.
For e.g. At 10,000 units, selling expenses per unit is 13 out of which
10% is fixed.
10
The fixed part is 13 = 1.3 per unit
100
Total fixed cost = 1.3 x 10,000 = Rs. 13000
90
Variable Cost per unit = 13 = Rs. 11.70
100
The variable for 10000 units = 11.70 x 10,000
= 1, 17,000
Total selling expenses for 10,000 units

= 1, 17,000 + 13,000 = 1, 30,000
Similarly at 6000 level, the selling expenses will be as follows.

Variable = 6,000 x 11.7 = 70,200
Fixed 13,000
Total 83,000
In similar procedure distribution expenses are also calculated

Illustration 2
Production Budget
From the following data, prepare a production budget for the ABC Co. Ltd.
Stocks for the budgeted period (units).
Product As on 1st Jan. As on 30th June

A 8000 10000
B 9000 8000
C 12000 14000

Requirements to fulfill sales schedule

A 60000 units
B 50000 units
C 80000 units
Normal loss in production

A 4%
B 2%
C 6%
Solution:
Production Budget
(For six months ending 30th June)
Products (in units)
A B C
Budgeted Sales 60000 50000 80000
+ Desired Cl. stock 10000 8000 14000
70000 58000 94000
(-) Opening Stock 8000 9000 12000
62000 49000 82000
+ Normal loss 2600 1000 5000
Units to be produced 64600 50000 87000
Working Note:
Calculation of Normal loss
62000
A 100 = 64600 (Approx)
96
Loss is 64,000 62,000 = 2600
49000
B 100 = 50000
98
Loss is 50000 49000 = 1000 units
82000
C 100 = 87000 (Approx.)
94
Loss = 87000 82000 = 5000

14.7 Merits and Demerits of Budgetary Control

Merits:
Budgetary control establishes a basis for internal audit by regularly
evaluating departmental results.
By reporting information which has not gone according to plan, it
economises on managerial time and maximises efficiency. This is called
Management by exception reporting.
Scarce resources would be allocated in an optimal way, thus controlling
expenditure.
It forces management to plan ahead so that long-term goals are
achieved.
Communication is increased throughout the firm and coordination is
improved.
An effective budgetary control system will allow people to participate in
the setting of budgets, and thereby have a motivational impact on the
work force. Individual and corporate goal are aligned.
Areas of efficiency and inefficiency are identified. Variance analysis will
prompt remedial action where necessary.
The budget provides a yardstick against which the performance of the
firm can be evaluated. It is better to compare actual with budget rather
than with the past, since the latter may no longer be suitable for current
and expected conditions.
People are made responsible for items of cost and revenue, i.e., areas
of responsibility are clearly delineated.
Demerits:
Budgets are perceived by the work force as pressure devices imposed
by top management. This can have an adverse effect on labour relations.
It can be difficult to motivate an apathetic work force.
The pressure in the budgeting system may result in inaccurate record
keeping.
Manager may over-estimate costs in order that they will not be held
responsible in the future for over spending. The difference between the
minimum necessary costs and the costs built into the budget is called
slack.
Departmental conflict arises because of competition for resource

allocation. Departments blame each other if targets are not achieved.
Uncertainties can occur in the system, e.g. uncertainly over demand,
inflation, technological change, competition, weather etc.
It may be difficult to align individual and corporate goal. Individual goals
often may contradict the firms goals.
It is important to match responsibilities with control, otherwise a manager
will be demotivated. Costs can only be controlled by a manager if they
occur within a certain time span and can be influenced by that manager.
A problem arises when a cost can be influenced by more than one
person.
Managers are often accused of wasting expenditure when they either:
a. demand a grater budget allowance than is really needed, or
b. unnecessary spend in order to fully utilise their allowance through
fear of future cutbacks. Zero base budgeting can overcome this
problem.
Sub-optimal decisions may arise when a manager tries to enhance his
short-run performance in a way which is detrimental to the organisation
as a whole, e.g. delaying expenditure on urgently needed repairs.
They are based on assumed conditions (e.g. rates of interest) and
relationship (e.g. product-wise held constant) that are not varied to
reflect the actual circumstances that come about.
They make allowance for tasks to be performed only in relation to
volume rather than on time.
They compare current costs with estimates based only on historical
analysis.
Their short-term horizon limits the perspective, so short-term results may
be sought at the expenses of longer term stability or success.
They have a built-in bias that tends to perpetuate inefficiencies. For
example, next years budget is determined by increasing last years by
15 per cent, irrespective of the efficiency factor in the last year.
As with all types of budgets the game of beating the system may take
more energy than is being devoted to running the business.

The fragile internal logic of static budget will be destroyed if top

management reacts to draft budgets by requiring changes to be made to
particular items which are then not reflected through the whole budget.
3. The Budget Controller is assisted by the team called ______________.
4. _____________ is otherwise called as limiting factor.
5. ________________ budget prepared for a longer period of time.
6. Scarce resources would be allocated in an optimal way, thus controlling
expenditure. State True/False
14.8 Summary
Budget is a plan of managements intentions of attaining specified
objectives.
Though Budgeting and forecasting sounds to be similar there is
difference between them. Forecast is concerned with probable events
and the budgeting relates to planned events.
The main objectives of budgetary control are Planning, Co-ordination
and control. Based upon the capacity, budget can be fixed or flexible.
Fixed budget is a budget prepared for a given level of activity. Flexible
budget is a budget designed to change in accordance with the level of
activity actually attained.
Based upon the functions in an organisation the budget can be classified
as
1) Sales Budget including Selling & Distribution Cost Budget.
2) Production Budget consisting of Materials Budget, Labour Budget,
Plant utilization Budget etc.
3) Purchase Budget.
4) Capital Expenditure Budget.
5) Administrative Cost Budget.
6) Cash Budget.
7) Research and Development Cost Budget


1) Distinguish between Forecast and Budget.
2) Distinguish between Flexible Budget and Fixed Budget.
3) Every coin has two sides. Explain this statement with respect to
Budgeting.
4) Explain various functional budgets.
5) Mr. Johnson who is C.A. believes that Production Budget can be
prepared only after Sales Budget. Is Mr. Johnson right in his
assumption ? If Yes, Why?
6) Mr. Ambani assumes that for production of 10,000 units the total
material cost will be 1,00,00,000. But because he is not sure about the
demand of the product, he believes that the production could be 7,000
units or 9,000 units. Please help Mr. Ambani in calculating the total
material cost under following situations:
a) If the production is 7,000 units
b) If the production is 9,000 units
c) Calculate the material cost per unit
7) For the following particulars prepare a flexible budget for the three
months ending 30th September 2006 showing the estimated sales,
costs and profits for 60%, 80% and 100% activity. Assume that all items
are produced are sold.
Fixed Expenses: Rs.
Management Salaries 4, 20,000
Rent and Rates 2, 80,000
Depreciation on Machinery 3, 50,000
Sundry Office Cost 4, 45,000
14, 95,000
Semi-variable expenses at 50% activity
Rs.
Plant Maintenance 1, 25,000
Indirect Labour 4, 95,000
Salesmens Salaries & Expenses 1, 45,000
Sundry expenses 1, 30,000
8, 95,000

Variable expenses at 50% activity:

Rs.
Materials 12, 00,000
Labour 12, 80,000
Salesmens Commission 1, 90,000
26, 70,000
Semi-variable expenses remain constant between 40% and 70% activity,
increase by 10% of the above figures between 70% and 80% activity and
increase by 15% of the above figures between 80% and 100% activity.
Fixed expenses remain constant whatever may be the level of activity.
Sales at 60% activity are Rs. 51, 00,000, at 80% activity are Rs. 68, 00,000,
at 100% activity are Rs. 85, 00,000.
14.10 Answers
1. Forecast
2. True
3. Budget Committee
4. Key factor
5. Long term budget
6. True
Terminal Questions
1. Ref. 14.2
2. Ref. 14.5
3. Ref. 14.7
4. Ref. 14.5
5. Ref. 14.5
6. Ans: a) 70, 00.000 b) 90, 00,000 c) 1,000
Solution:
Flexible Budget For 3 Months ended 30th Sept. 2006
Hint:
Here every thing is mentioned w.r.t. 50% activity so its better to calculate all
cost at 100% activity and then start calculation 60%, 80%, 100% capacities.

For example
At 50% activity material costs is 12,00,000 so at 100% it will be 24,00,000
So now at 60% it will be 60% of 24, 00,000 which is 14, 40,000. Similarly at
80% it will be 80% of 24, 00,000 which is 19, 20,000. In similar way all costs
are to be calculated.
Particulars 60% 80% 100%
Variable costs:
Materials 14,40,000 19,20,000 24,00,000
Labour 15,36,000 20,48,000 25,60,000
Salesmens Comm. 2,28,000 3,04,000 3,80,000
32,04,000 42,72,000 53,40,000
Semi-variable costs:
Plant Maintenance 1,25,000 137,500 1,43,750
Indirect Labour 4,95,000 5,44,500 5,69,250
Salesmens salary 1,45,000 1,59,500 1,66,750
Sundry Exp. 1,30,000 1,43,000 1,49,500
8,95,000 9,84,500 10,29,250
Fixed Costs:
Management salaries 4,20,000 4,20,000 4,20,000
Rent and Rates 2,80,000 2,80,000 2,80,000
Depreciation 3,50,000 3,50,000 3,50,000
Sundry office cost 4,45,000 4,45,000 4,45,000
14,95,000 14,95,000 14,95,000
Total Cost 55,94,000 67,51,500 78,64,250
Sales 51,00,000 68,00,000 85,00,000
Profit / Loss (4,94,000) 48,500 6,35,750
Working Notes:
Fixed Expenses are constant for all levels of activity.
Variable expenses change proportionately to the level of activity.

Semi-variable expenses are the same for levels between 40%-70%. At 80%
the semi-variable expenses increase by 10%.
For e.g. Plant Maintenance at 60% = 1, 25,000
+ 10% (at 80% level) 12,500
At 70% level = 1, 37,500
Similarly they increases by 15% at 100% level.

References:
Cost and Management Accounting Duncan Williamson
Management Accounting I. M. Pandey
Fundamentals of Management Accounting T. P. Ghosh
Management Accounting B. S. Raman
Cost Accounting Jawaharlal
Cost and Management Accounting Taxman
Financial Management by Khan Jain
Financial Management by I. M. Pandey
Financial Management by Prasanna Chandra
Financial Management by Shashi Gupta and Neeti Gupta
Financial Management by Rustagi
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Principles of Financial Accounting and Management Unit 1

Unit 1 Financial Accounting An Introduction

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2. Internal routine reporting to managers on the profitability of products,

1.2 Basic Accounting Concepts

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partnership, or a corporate entity. In case of a sole proprietary form of

Sikkim Manipal University Page No.: 3

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Examples of accrual concept:

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others of enterprise resources yielding interest, royalties and dividends

1.3 Double Entry Accounting

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1.4 The Accounting Trail

Recording in the Primary Books

Posting in the Secondary Books

Preparation of Trial Balance

Preparation and Presentation of Financial Statements

Transactions and Events

preparation of financial statements. The human intervention normally ends

1.5 Financial Statements and their nature

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provide information about the financial position, performance and changes

Sikkim Manipal University Page No.: 9

The amount at which equity is shown in the balance sheet is dependent on

1.6 The Accounting Equation

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be maintained or a new equality be achieved. This is possible because of

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The Accounting trail shows the process of accounting. Accounting

1.8 Terminal Questions

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1.9 Answers to SAQs and TQs

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Unit 2 Primary Books

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2.2 Ground Rules of Journalisation

Transaction No. 1: Jan 1, Capital introduced into the business by the

Transaction No. 2: Jan. 2, Purchased furniture worth Rs.20,000

Voucher Ledger Dr. Cr.

The transaction has resulted in an increase in expense (debit), a decrease

Voucher Ledger Dr.Cr.

To cash Account 15,000

Transaction No. 4: Jan. 4, sold goods for cash Rs.25,000

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Transaction No. 6: Jan 10. Purchased stationery worth Rs.2,500

Transaction No. 7: Jan. 15 Sold goods on credit Rs.1,20,000

Transaction No. 8: Jan. 20. Amount received from a customer Rs.19,500

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(debit), an increase in expenses i.e., discount allowed (debit), and a

Transaction No. 9: Jan 21, Advertisement expenses incurred Rs.2,500

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Self Assessment Questions

2.3 Types of Journals

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Sales Day Book

c) Return Outward Book

d) Return Inward Book