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Accounts & Finance 15 Units NOTES
Accounts & Finance 15 Units NOTES
Names of Sub-Units
Overview
This unit begins by meaning of financial accounting. It discusses the conceptual framework of financial
accounting. The unit explains the users of financial accounting, which are internal users and external
users. It also discusses the introduction to Indian GAAP, Ind AS and IFRS
Learning Objectives
In this unit, you will learn to:
Explain financial accounting
State the users of financial accounting
Identify the basic terminology in accounting
Classify the different accounting concepts
Learning Outcomes
At the end of this unit, you would:
Assess the importance of financial accounting
Examine the conceptual framework of financial accounting
Analyse the users of financial accounting
Evaluate the different accounting concepts
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Accounting and Finance
http://www.ddegjust.ac.in/studymaterial/bba/bba-104.pdf
1.1 INTRODUCTION
Accounting is a business language which elucidates the various kinds of transactions during a given
period of time. Accounting is broadly classified into three different functions:
1. Recording
2. Classifying
3. Summarising
An accounting theory is not something that is discovered rather, it is created, developed or decreed on the
basis of environmental factors, intuition, authority, and acceptability because the theoretical framework
accounting is difficult to substantiate objectively or by experimentation, arguments concerning it can
degenerate into quasi - religious dogmatism. As a result, the credibility of accounting rests upon its
general recognition and acceptance by preparers, auditors, and users of financial statements. Given
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this, the purpose of this chapter is to examine the nature and usefulness of a conceptual framework for
financial accounting, and discuss its components.
accordingto Finny & Miller, whereas Kohler defines an asset as owned physical property
(tangible) or right (intangible) having economic value to the Assets are defined as
goods or intangible rights controlled by an enterprise and having anticipated future
accordingto the Institute of Chartered Accountants of India. Thus, it is clear from the
above definitions that an asset must have future economic benefit which must be controlled by an
enterprise. The assets may be broadly classified as fixed assets and current assets:
(i) Fixed assets are the assets which are purchased for the purpose of operating the business and
not for resale such as land and building, plant and machinery and furniture, etc.
(ii) Current assets are the assets which are kept for short-term for converting into cash or for resale
such as unsold goods, debtors, bills receivable, bank balance, etc.
Liability: It can be described as current commitments that a commercial enterprise must meet
at some point in the future. are debts, they are amounts owed to according
to Finny and Miller. In other words, liabilities refer to obligations that are not capital-related
gains stemming from present commitments of a particular entity to transfer assets or perform
services to other entities in the futu
to F.A.S.B. Stanford, 1980. According to Accounting Principles Board (APB), liabilities are defined
as, obligations of an enterprise that are recognized and measured in conformity with
a legal obligation to pay for the transaction that has already taken place. Liabilities may be classified
into three types namely:
1. Short-term liabilities are such obligations which are payable within one year. Examples are
creditors, Bills payable, overdraft from a bank, etc.
2. Long-term liabilities are such obligations which are payable after a period of one year such as
debentures, bonds issued by the company, etc.
3. Contingent liability is a liability which arises only on the happening of an uncertain event. If it
happens, the contingent liability is there. If it does not happen, there is no liability. Such liabilities
are not shown in the balance sheet, but are given as a foot note. Example of such liabilities are (i)
Liability on account of bills discounted (ii) Claims against the fi rm not acknowledged as debts.
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Accounting and Finance
Debtors: Debtors are those who owe money to a company after getting products or services on
credit. In an balance sheet, the entire balance outstanding at the end of a specific date
is shown as an asset. receivables are another term for debtors.
Creditors: The creditors are the persons to whom the fi rm owes for providing goods or services.
Revenue: Revenue is the amount of money earned by a company by selling a product or providing
services to clients. Sales, commissions, interest, dividends, rent, and royalties are just a few examples.
It is the amount that is added to the capital as a result of the operations of the firm.
Equity: Equity is, normally, ownership or percentage of ownership in a company or items of value.
Bills of Exchange: A written order from one person (the payor) to another, signed by the person
giving it, instructing the person to whom it is addressed to pay a specified sum of money on demand
or at a specified future date to either the payee or any person presenting the bill of exchange.
Income: The financial gain (earned or unearned) accruing over a given period of time.
Expenditure: A payment or incurrence of an obligation to make a future payment for an asset or
service rendered.
Profit and Loss A/c: The second section of Trading and Profit & Loss Account is Profit & Loss
Account. The gross profit, which is the difference between sales and cost of sale, is shown in the
trading account. As a result, gross profit cannot be treated as net profit when a businessperson
wants to determine how much net profit, he made from operating operations during a certain time
operational and non-operating profits and losses. All expenses and losses are declared on the debit
(left hand side), and all incomes are disclosed on the credit (right hand side). The excess of credit
side over debit side is called net profit while the excess of debit side over credit side shows net loss.
Goods: It is a general term used for the articles in which the business deals; that is, only those articles
which are bought for resale for profit are known as Goods.
Drawings: It is the amount of money or the value of goods which the proprietor takes for his domestic
or personal use. It is usually subtracted from capital.
financial viability.
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Creditors, Lenders of Money: The creditors and lenders of money etc. can also know the financial
soundness through financial statement. They have to see two things (i) Regularity of income and
(ii) solvency of the business so that their investment is risk free.
Government: The government is interested in drafting laws to regulate corporate activity, as
well as taxation and other laws. Financial statements aid in the computation of national income
figures, among other things.
Taxation authorities: Financial statements contain information about a operating
results as well as its financial situation. The amount of tax is determined by the tax authorities
based on the financial statement. Other taxing authorities, such as sales tax, will find it quite
useful.
Consumers: These groups are interested in getting the goods at reduced price. Therefore, they
wish to know the establishment of a proper accounting control, which in turn will reduce to cost
of production, in turn less price to be paid by the consumers. Researchers are also interested in
accounting for interpretation.
Research Scholars: Accounting information, as a reflection of a financial success, is
research int
information on purchases, sales, expenses, cost of materials used, current assets, current
liabilities, fixed assets, long-term liabilities, and share-holders funds, all of which can be found
in the accounting records.
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Accounting and Finance
Matching Concept
This idea merely serves to make the overall accounting system more useful in determining the volume
Cost Concept
It is a concept that is closely related to the concept of a running business. The transactions are exclusively
recorded in terms of cost rather than market value under this idea. Fixed assets are solely recorded
in terms of their purchase price, which represents
Depreciation is subtracted from the original value, which is the initial purchase price, to arrive
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Objectivity Concept
It is also known as the concept of objective evidence. The transactions that are recorded in accounting
must be objective and factual, according to this principle. Each accounting entry should be accompanied
by a voucher or documentary documentation. Personal prejudice must be avoided, and the entry
must be based on a rational approach. If the entries are made without supporting documentation, the
amount raises the cash balance at the point of business, while the owner is classified as a liability
and is shown as capital on the liability side of the balance sheet. For this transaction, this
journal entry is passed:
Cash A/c Dr. 2,00,000
To capita A/c 2,00,000
This concept is becoming more popular because in one sense capital itself may be regarded as a
liability the amount due from the business to the owner. This concept is applicable to the all forms
of business organisations whether it is a limited company, partnership firm or a sole trader.
Going Concern Concept: It is a fundamental accounting assumption underlying the creation of
seen as a going concern, that is, as continuing in operation for the foreseeable according
to this assumption. To compute true profit, all assets are shown at cost price rather than market
pricing, and depreciation is reported on cost price. The firm is assumed to have neither the intention
nor the need to liquidate or drastically reduce the sale of its Under this assumption
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Accounting and Finance
the assets of the business are valued by the accountants on the basis of going concern concept,
historical cost and expected life of the assets.
Money Measurement Concept: Money is medium to value quantities. As per this assumption, only
those transactions of the business are recorded in the accounting which can be measured in money.
recorded in accounting.
Accounting Period Assumption: The income of a firm might be measured at the time of liquidation
or when the business is sold, according to the going concern principle. However, it is really difficult
to wait for such a long period of time that is also uncertain. As a result, accountants have agreed
that the economic life of a business is separated into several segments for the purpose of generating
financial statements and calculating earnings. This period of time is usually one year, either a
calendar year or a financial year. It may be less than a year at times, such as quarterly, half-yearly,
or annually. Reports made for less than twelve months are called interim reports and are less reliable
than annual reports. At the end of each segment (period) profit and loss account and balance sheet
are prepared.
The various rules for preparing financial statements are based on basic accounting assumptions
and principles. If these financial statements are accurate and relevant, they will provide a wealth
of information to the various users of financial statements. Accounting assumptions and principles
must be changed in order to prepare honest and fair financial statements. These modified accounting
principles are as follows:
Conservation (Prudence): According to the law of conservatism, while creating financial statements,
all potential losses must be considered but all anticipated profits/gains must be excluded. In other
words, the accounts must adhere to the it guideline. Similarly, stock-in-trade is valued
fixed assets, and other items are kept. This notion is currently being attacked since it contradicts the
principle of disclosure. The provision of bad and dubious debts, depreciation, and stock valuation
are all used by accountants to construct a secret reserve. The genuine and unbiased view of the
financial statements is lost. The profit and loss statement reflects lesser earnings, but the balance
sheet
Prudence has supplanted conservatism as the law of the day. It suggests that conservatism is
only used when there are unavoidable doubts and uncertainties. Accountants should also provide
justifications for using specific accounting procedures, methods, and rules without being overly
conservative.
Consistency: In order to enable the management to do the comparison of the results of the several
years of the business, whatever accounting policy is adopted in a year, must be adopted in the coming
years. There should be uniformity in accounting process, rules & methods. As a result, biasness of
accountant is removed.
According to Kohlar, there are three forms of consistency:
(a) Vertical consistency is used in the different financial statements of the business on the same
date. For instance, depreciation on fixed assets is used in the income statement and the balance
sheet on the same date.
(b) Horizontal consistency enables the comparison of the profit or performance of a business in a
year with the performance of another year for example the depreciation methods.
(c) Third Dimensional consistency refers to the same principles or practices of accounting adopted
by the different firms in an industry.
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Timeliness: Accounting information given in the financial statements must be reliable and relevant.
In order to be relevant, this information must be supplied in time. If late and obsolete information
is provided, it will hamper the management and the users of the financial statements to take
appropriate, timely and rational decision.
Materiality: The term
and attached to financial statements that has an impact on the decisions of shareholders, investors,
and creditors, and that all other details should be ignored. Furthermore, an item of knowledge
may be relevant for one purpose but irrelevant for another. This is a matter of opinion. The cost
of a component, for example, may be very important to a small businessman but trivial to a large
businessman. In one more example, the Companies Act permits to ignore the paise at the time of
preparation of financial statements while for the income tax purpose the income is rounded off to
the nearest ten.
Cost-Benefit Principle: As per this principle, the cost of using an accounting principle should not
exceed its benefits. It does not mean that to curtail the costs, no information or a little information
should be given to the users of the financial statements.
Industry Practice: In different industries, different accounting principles/practices are used. The
current accounting procedures in a given industry should be kept in mind while generating financial
reports and presenting accounting information. Disclosing investments and stock at cost or market
price, whichever is lower, is an example. As a result, we can observe that the accounting techniques
that are currently in use in a certain industry have a significant impact on the accounting methods
that are adopted.
Assets
Cash and cash equivalents, as well as liquid assets such as Treasury bills and certificates of deposit,
are examples of assets. The amount of money owing to the company by its consumers for the sale of
its product and service is known as account receivables. Inventory is likewise seen as a valuable asset.
Liabilities
Liabilities are the amounts that a firm owes or must pay in order to stay in business. Rent, taxes, utilities,
salaries, wages, and dividends payable are all liabilities, including long-term debt.
Equity
A entire assets minus its total liabilities equals its equity. The amount of money
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Accounting and Finance
The sum of total earnings that were not paid to shareholders as dividends is known as retained earnings,
represent a total of profits that have been preserved, set aside, or kept for future use.
Accounting Equation Formula and Calculation
Assets = (Liabilities + Equity)
GAAP
Over time, businesses would like to know how they are performing in contrast to their peers. In the same
way, there would be common owners of numerous businesses. Accounting principles are the rules of
action that are used to record, classify, and summarise the transactions of a corporation. If financial
statements are not made using these standards, they will have a poor acceptability and will be difficult
to comprehend, making comparison impossible and untrustworthy. As a result, accountants urge that
common accounting ideas and standards be established so that the aforementioned challenges and
problems do not arise; they are referred to as Generally Accepted Accounting Principles (GAAP).
Ind AS
Financial statements are used by a variety of people, including investors, creditors, the government,
consumers, and business owners. They base a lot of their economic judgments on financial statements. If
financial statements are not adequately regulated, there is a risk that they will mislead and present a skewed
view of the firm instead of a genuine and fair picture of the business. It is critical to regulate the accounting
process so that these statements are transparent, properly disclosed, consistent, and reliable. In addition,
adequate accounting disclosure is necessary. Accounting standards are developed on a national and
worldwide level for this purpose. Accounting standards, in fact, codify the commonly accepted accounting
concepts. Accounting standards provide the rules and procedures that must be followed while preparing
financial statements and annual reports. The International Accounting Standard Committee (IASC) has
issued the International Standards on a global scale. Leading professional bodies from the United Kingdom,
the United States, Australia, France, and Canada are represented on this committee. India is also a member
of this committee. India has also prepared its own accounting standards, which are prepared by the Institute
of Chartered Accountant of India (ICAI).
IFRS
The International Financial Reporting Standards (IFRS) are a set of principles that ensure financial
statements are consistent, transparent, and comparable all throughout the world. The International
Accounting Standards Board (IASB) publishes the International Financial Reporting Standards
(IFRS) (IASB). They define how businesses must keep and report their accounts, as well as the sorts of
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transactions and other financial events that must be reported. The International Financial Reporting
Standards (IFRS) were created to develop a common accounting language so that businesses and their
financial statements could be consistent and dependable from one company to the next and from one
country to the next.
Accounting is a business language which elucidates the various kinds of transactions during the
given period of time.
For many of us, accounting appears to be methodical and procedural in nature. The visible portion
of accounting record keeping and preparation of financial statements
The terms, which are generally used in the day-to-day business, are called accounting terminology.
The accounting equation is considered to be the foundation of the double-entry accounting system.
Based on this double-entry system, the accounting equation ensures that the balance sheet remains
1.8 GLOSSARY
Accounting Conventions: Customs and traditions that guide the accountants to record the financial
transactions.
Accounting Process: It includes the recording of financial transactions, ledger posting, preparation
of financial statements and analysing and interpretation of them
Cost Accounting: Accounting relating to the ascertainment of cost of the product
Management Accounting: Presenting of accounting information in such a way as to assist the
management in taking the important decisions and making the policies
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Accounting and Finance
Mr. K. Rahman Khan, member of the Institute of Chartered Accountants of India (ICAI) and Honorary
Deputy Chairman of the Rajya Sabha, stated.
Mr. Khan stated that the accounting system in local bodies has already been converted to double entry,
and that the institute should play an important role in monitoring government expenditure.
he owes to society. The institute, as well as the Comptroller and Auditor General of India, the custodian
of government expenditure, have already decided to carry out the conversion. Various Notes The double
We must ensure that there is more transparency. The double entry accounting system would allow us to
track cost increases, look into the specifics of total government spending, and so
Mr. G. Ramasamy, the Vice-President, stated that the outlay for the Mahatma
Gandhi National Rural Employment Guarantee Act Scheme totalled over 42,000 crores, and that over
6 lakh panchayats across the country were completing their spending statements. He stated,
institute is assisting the panchayats in preparing
He stated that all permissions for the implementation of the International Financial Reporting Standards
(IFRS) would be in place by July 31. The institute has begun programmes to educate professionals and
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UNIT 01: Introduction to Financial Accounting JGI JAIN
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ht tp://vc mdrp .tu ms .a c .ir/fi l es/fin an ci al/i stgahe_ ma li /mot on _eng lis h/fin anci a l_
management_%5Bwww.accfile.com%5D.pdf
https://jyotinivas.org/pdf/e_content/bcom/bba_financial_management.pdf
https://mdu.ac.in/UpFiles/UpPdfFiles/2020/Jan/FinancialManagement.pdf
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Accounting and Finance
Discuss with your friends how financial accounting is useful for nowadays.
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UNIT
Accounting Cycle
Names of Sub-Units
Overview
This unit begins by explaining the meaning of accounting cycle. It discusses the concept of accounting
process. The unit explains the preparation of trial balance.
Learning Objectives
Learning Outcomes
At the end of this unit, you would:
Assess the importance of the accounting cycle
Examine the concept of the accounting process and analyse the users of financial accounting
Evaluate the preparation of trial balance
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Accounting and Finance
2.1 INTRODUCTION
The accounting cycle starts from recording individual transactions in the books of accounts and ends
at the preparation of financial statements and closing process. The financial accounting cycle is the
process of recording business transactions and processing accounting data to generate useful financial
information i.e., financial statements including income statement, balance sheet, cash flow statement
and statement of shareholders equity. The time period principle requires that a business should prepare
its financial statements after a specified period of time, say a year, a quarter or on a monthly basis. This
is achieved by following the accounting cycle during each period. Figure 1 shows the accounting cycle:
Post
Journal
Closing Trial
Entries
Balance
Closing Ledger
Entries Accounts
Unadjusted
Financial Trial
Statements Balance
Adjusted
Adjusting
Trial
Entries
Balance
efficiency. Accounting cycle periods will vary by reporting needs. Most companies seek to analyze their
performance on a monthly basis, though some may focus more heavily on quarterly or annual results.
Regardless, most bookkeepers will have an awareness of the financial position from day-
to-day. Overall, determining the amount of time for each accounting cycle is important because it sets
specific dates for opening and closing. Once an accounting cycle closes, a new cycle begins, restarting
the eight-step accounting process all over again.
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Collecting
& Analysing
Documents
Post Closing Posting in
Trial Balance Journal
Post Ledger
Closing Entries Account
Accounting
Process
Preparation
of Financial Trial Balance
Statements
1. Collecting and Analyzing Accounting Documents: It is a very important step in which you examine
the source documents and analyse them. For example, cash, bank, sales, and purchase-related
documents. This is a continuous process throughout the accounting period.
2. Posting in Journal: On the basis of the above documents, you pass journal entries using double
entry system in which debit and credit balance remains equal. This process is repeated throughout
the accounting period.
3. Posting in Ledger Accounts: Debit and credit balance of all the above accounts affected through
journal entries are posted in ledger accounts. A ledger is simply a collection of all accounts. Usually,
this is also a continuous process for the whole accounting period.
4. Preparation of Trial Balance: As the name suggests, trial balance is a summary of all the balances
of ledger accounts, irrespective of whether they carry debit balance or credit balance. Since we
follow double entry system of accounts, the total of all the debit and credit balance as appearing
in the trial balance remains equal. Usually, you need to prepare trial balance at the end of the said
accounting period.
5. Posting of Adjustment Entries: In this step, the adjustment entries are first passed through the
journal, followed by posting in ledger accounts, and finally in the trial balance. Since in most of the
cases, we used accrual basis of accounting to find out the correct value of revenue, expenses, assets
and liabilities accounts, we need to do these adjustment entries. This process is performed at the end
of each accounting period.
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Accounting and Finance
6. Adjusted Trial Balance: Taking into account the above adjustment entries, we create the adjusted
trial balance. The adjusted trial balance is a platform to prepare the financial statements of a
company.
7. Preparation of Financial Statements: Financial statements are the set of statements like the income
and expenditure account or trading and profit and loss account, cash flow statement, fund flow
statement, balance sheet or statement of affairs Account. With the help of the trial balance, we put
all the information into the financial statements. Financial statements clearly show the financial
health of a firm by depicting its profits or losses.
8. Post-Closing Entries: All the different accounts of revenue and expenditure of the firm are
transferred to the Trading and Profit and Loss account. With the result of these entries, the balance
of all the accounts of income and expenditure accounts come to nil. The net balance of these entries
capital.
9. Post-Closing Trial Balance: Post-closing trial balance represents the balances of assets, liabilities
and capital account. These balances are transferred to next financial year as an opening balance.
Books of Account
Journal Ledger
2.2.2 Journal
A journal is a detailed account that records all the financial transactions of a business, to be used for the
future reconciling of accounts and the transfer of information to other official accounting records, such
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as the general ledger. A journal states the date of a transaction, which accounts were affected, and the
amounts, usually in a double-entry bookkeeping method.
2.2.3 Ledger
A general ledger represents the record-
credit account records validated by a trial balance. It provides a record of each financial transaction
that takes place during the life of an operating company and holds account information that is needed
The accounting cycle starts from recording individual transactions in the books of accounting and
ends at the preparation of financial statements and closing process.
The time period principle requires that a business should prepare its financial statements after a
specified period of time, say a year, a quarter or on a monthly basis.
The accounting cycle is a basic, eight-step process for completing a bookkeeping tasks.
It provides a clear guide for the recording, analysis, and final reporting of a financial
activities.
The accounting cycle is comprehensively used through one full reporting period.
The accounting cycle refers to the specific tasks involved in completing an accounting process.
Debit and credit balance of all the above accounts affected through journal entries are posted in
ledger accounts.
Financial statements are the set of statements like income and expenditure account or trading and
profit and loss account, cash flow statement, fund flow statement, balance sheet or statement of
affairs account.
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Accounting and Finance
All the different accounts of revenue and expenditure of the firm are transferred to the trading and
profit and loss account.
A trial balance is a bookkeeping worksheet in which the balance of all ledgers is compiled into debit
and credit account column totals that are equal.
2.5 GLOSSARY
Transactions: A completed agreement between a buyer and a seller to exchange goods, services, or
financial assets.
Financial Statements: Details of the financial information.
Income Statement: A financial statement that shows and expenditure.
Cash Flow: The net amount of cash and cash equivalent being transferred into and out of a business.
Case Objective
This case study was done in a medium-sized IT consultancy working across the UK and Europe.
The issue with the accounting business process was that the reports lagged behind the true financial
situation. The management team developed their own ad hoc systems and spreadsheets to assess
their departmental profit and loss status. The system was thought to contain errors missing records,
incorrect filing, incorrect data entry, and issues with accounts reconciliation. The improvement process
involved the robust collection and analysis of data to identify the root cause of issues, which could
then be appropriately solved. The improvement project demonstrated to the management team the
importance of identifying the real root causes of an issue and not making a leap to the most obvious
solutions. The root cause was the way that the accounts data flowed into and out of the accounts
process and this was only identified through robust data collection and analysis. The project was clearly
a success and delivered all tangible and intangible benefits. Fundamental to this success was the change
in behaviour at every level in the organization. No matter how small a project, there is value in using
appropriate project management tools and techniques to structure delivery, manage uncertainty, and
deliver benefits.
Questions
1. What was the issue with the accounting business process?
(Hint: The issue with the accounting business process was that the reports lagged behind the true
financial situation.)
2. Why did the management team develop their own ad hoc systems and spreadsheets?
(Hint: to assess their departmental profit and loss status.)
3. What are the improvement processes involved?
(Hint: the robust collection and analysis of data to identify the root cause of issues, which could then
be appropriately solved.)
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https://www.investopedia.com/terms/a/accounting-cycle.asp
https://scalefactor.com/ask-the-experts/the-accounting-cycle/
https://scalefactor.com/ask-the-experts/the-accounting-cycle/
https://xplaind.com/794246/accounting-cycle
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UNIT
Depreciation
Names of Sub-Units
Overview
This unit begins by explaining the meaning of depreciation and discusses the concept of depreciation.
The unit explains the accounting treatment of depreciation. It also discusses the methods of calculating
depreciation.
Learning Objectives
Learning Outcomes
At the end of this unit, you would:
Assess the meaning of depreciation
Examine the methods of depreciation
Analyse the uses of depreciation
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Accounting and Finance
http://accioneduca.org/admin/archivos/clases/material/depreciation_1564412042.pdf
3.1 INTRODUCTION
Depreciation accounting is mainly based on the concept of income. The matching of revenues and
expenses is the idea of income. Frequently, the goods purchased are matched either immediately or
within a year. The essence of the income notion is that expenses must be matched against earnings.
The ultimate goal of matching is to figure out how much profit or loss the transaction will generate. If
the assets are all long-term assets acquired by the company, they should be matched to the revenues
generated by the company. The fundamental objective of the firm is to match the expenditure of the
assets incurred by the firm at the time of purchase against the revenues. To have an effective matching
against the revenues on every year, the amount of purchase has to be stretched. The stretching of
expenses into many years is known as depreciation.
Depreciation, according to Dickens, is the permanent and ongoin
quantity, and value. Depreciation is the term used to describe the gradual loss in the value of fixed assets.
It is a match between the fixed charge expense and the revenue for the current year. The unrecovered
component of the remaining/left should be carried forward to future years to match against the relevant
revenues. The ultimate goal of depreciation is to replace fixed assets only when they are no longer useful
using current revenues.
than recognizing the entire cost of an asset in the first year, depreciation allows businesses to spread
out that cost and create revenue.
Depreciation is a method of accounting for changes in the carrying value of a property over time. The
gap between the original cost and the cumulative depreciation over the years is known as carrying
value.
Each corporation may decide when to start depreciating a fixed asset, also known as property, plant,
and equipment. A small business, for example, might set a $500 threshold for depreciating an asset.
A larger corporation, on the other hand, may set a $10,000 threshold below which all purchases are
expensed immediately.
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For its business activities, a corporation is free to select the most appropriate depreciation method.
According to accounting theory, organisations should select a depreciation method that accurately
matches their economic situation. As a result, businesses can select a strategy for allocating asset costs
to accounting periods based on the benefits derived from the use.
For financial reporting, most corporations utilise the straight-line technique, but they may use different
methods for different assets. Use a depreciation method that assigns asset cost to accounting periods in
a systematic and sensible manner is the most crucial criteria to follow.
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Where, N stands for number of years of useful life of the asset, S for scrap value, C for cost of asset, and
R for rate of depreciation.
Annuity Method
as well as interest. The annuity method is a compounded interest method that calculates depreciation
based on the premise that depreciation plus the normal cost of capital to finance the assets will remain
nt of depreciation, this approach takes into
account interest as well as the cost of the assets. Every year, the amount of interest is debited from
the assets account, and the amount of depreciation is credited. The opening balance of the asset is
used to calculate interest. So, it (interest) decreases every year but the amount of depreciation remains
constant which is taken from the annuity tables for depreciation. This amount of depreciation is that
much by which the value of asset becomes zero.
used to purchase new assets. As a result, the funds are safer and more liquid with this strategy.
Depletion Method
It is also known as production method. This method is useful for natural assets such as coal mines,
oil wells, etc. These are taken for excavation for a definite period on the contact basis. In this case, the
depreciation is computed on the basis of production. First, the total production of the contract period is
estimated, then total depreciable cost is divided by the total production and multiplied by annual output
to determine the annual amount of depreciation. In the form of formula:
Annual Output
Annual Depreciation
Total Estimated Output
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= 20,000
To understand the above calculation, the following table is important:
Value of the asset (Begin in Depreciation ( in Value of the asset (End) (in
Col. 1 Col. 2 Col 3 = Col.1 Col.2
1st year 1,00,000 20,000 80,000
2nd year 80,000 20,000 60,000
3rd year 60,000 20,000 40,000
4th year 40,000 20,000 20,000
5th year 20,000 20,000
From the above table, 20,000 is charged on every year to recover 1,00,000 during its life period i.e.,
5 years.
Example 2: Original value of the investment 1,00,000 Scrap value 10,000
Life of the asset 5 years
Depreciation = (1,00,000 10,000)/5
= 18,000
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To understand the methodology of straight-line depreciation, the following table will illustrate the
process.
Value of the asset (Begin) (in Depreciation (in Value of the asset (End) (in
The scrap value of the asset is expected to realize only at the end of the life period of the asset i.e.,
5 years.
Depreciation accounting is mainly based on the concept of income. The concept of income is
matching of revenues with expenses.
The goods purchased are frequently matched through immediate sale or within a year.
According to Dickens, depreciation is the permanent and continuous diminution in the quality/
quantity/value of the asset.
Depreciation is an accounting convention that allows a company to write off an value over a
period of time, commonly the useful life.
Depreciation is used to account for decline in the carrying value over time.
Depreciation needs to be provided because an asset is bound to undergo wear and tear over a period
of time.
Moreover, in order to comply with the matching principle of accounts, it is ideal to provide
depreciation.
A company is free to make use of the most appropriate depreciation method for its business
operations.
There are various methods of allocating depreciation over the useful life of the assets.
According to the concept of depreciation, the value of the asset is dispersed throughout the life of
the period in order to match the respective earnings of the year after year.
3.6 GLOSSARY
Book Value of the Asset: The value of the asset after deducting the depreciation from the value of
the asset at the beginning
Depreciation: Continuous reduction/decrease/diminution in the value of the asset
Depreciation Accounting: Recording the entries of depreciation through journal, ledger accounts of
depreciation, fixed asset and profit and loss account
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Original Value of the Asset: The value of the asset at the time of purchase or acquisition
Scrap Value of the Asset: The value at the end of the life period of the asset; when the asset cannot
be put for further usage
Case Objective
Tata Steel Ltd. wants to establish its EOU in the state of Orissa through exploration of iron ore.
Tata Steel Ltd wants to establish its EOU in the state of Orissa through exploration of iron ore. It identified
that the state of Orissa is one of the ideal states having greater potential of iron ore than any other state
in India. The firm has reached lease contract with the Government of Orissa for the amount of 200
crore towards the extraction of 40,00,000 tonnes iron ore from fields for 10 years. The firm would like
to establish a processing plant which amounts to 50 crore to produce the quality carbon steel for the
foreign industrial buyers. The life period of the machine is denominated in terms of 2,50,000 working
hours. The firm is required to extract the iron ore.
Year 1 2 3 4 5 6 7 8 9 10
Expected Extraction Per Year 8 7 6 5 4 3 3 2 1 1
in Lakh
Hrs. Working 1,00,000 75,000 25,000 12,500 6,250 6,250 6,250 6,250 6,250 6,250
1. Tata Steel Ltd wants to establish its EOU in the state of Orissa.
(Hint: Tata Steel Ltd identified that the state of Orissa is one of the ideal states having greater
potential of iron ore than any other state in India.)
2. To go for further replacement after 10 years, how much should the firm charge depreciation in the
case of iron ore field? Which method should be applied?
(Hint: written down value method)
3. To replace the machinery recently bought after 10 years, how much should be charged as depreciation
in accordance with the working hours given?
(Hint: 6,250)
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1.
period of time, commonly the useful life. Refer to Section Concept of Depreciation
2. Depreciation needs to be provided because an asset is bound to undergo wear and tear over a period
of time. This reduces the working capacity and effectiveness of the asset. Hence, this should reflect
the value of the asset, at which it is carried in the books of accounts. Refer to Section Methods of
Calculating Depreciation
3. Under this method, depreciation on assets is calculated, keeping in account the cost of assets along
with interest thereon. Refer to Section Accounting Treatment of Depreciation
https://bench.co/blog/tax-tips/depreciation/
https://economictimes.indiatimes.com/definition/depreciation
https://corporatefinanceinstitute.com/resources/knowledge/accounting/types-depreciation-
methods/
https://cleartax.in/g/terms/depreciation
34
UNIT
Financial Statements
Names of Sub-Units
Introduction to Financial Statements, the Concept of Different Financial Statements, the Concept of
Outstanding Expenses, Treatment of Closing Stock, Tax Provision, Dividend and Reserves, Finding
Earning per Share (EPS).
Overview
This unit begins by meaning of financial statements, it discusses the different financial statements.
The unit explains the treatment of closing stock. It also discusses the dividend and reserves, finding
Earning per Share (EPS).
Learning Objectives
Learning Outcomes
4.1 INTRODUCTION
A financial statement refers to a formal and written record of all the financial activities and conditions of
an organisation, entity or a person. Financial statements contain a structured, organised, and detailed
summary of all the business processes. These determine the financial condition (whether organisation
is profitable or not) and the strengths and weaknesses of a business at the end of an accounting period.
Financial statements are prepared with the help of the trial balance that is prepared with the help of
ledgers.
There are three major types of financial statements Profit & Loss (P&L) Account, Balance Sheet and
Cash Flow Statement.
The profit and loss account or the income statement shows the r evenues and expenses of a company
during a particular period. It indicates how revenues are transferred into net income. The main objective
of the profit and loss statement is to show managers and investors whether the company has made
money or lost money during a reported period.
The balance sheet refers to the summary of the fiscal balances of a business organisation. In the balance
sheet, the assets, liabilities and equity are listed as of a specific date, such as the end of a fiscal
year. Very often financial accounts describe the balance sheet as a of a financial
The balance sheet is the only financial statement that applies to a single point in time in the
calendar year. Financial statement analysis provides a pathway to measure this element of
risk and it is a technique that features past performance of the organisation and can be measured in
terms of liquidity, profitability, growth potential, efficiency, etc. It focuses on the significant relations hip
between financial statements.
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cash flow statement for the financial year; the statement of changes in equity; and any explanatory
notes annexed to, or forming part of, any document referred to in the above -mentioned financial
statements. However, the financial statement with respect to a One Person Company, a small company
and a dormant company may not include the cash flow statement.
A business owner would be interested in knowing whether his/her business is running at a profit or
incurring loss, the actual financial position of the business, etc. The main aim of financial statements is
to inform the owner about the progress of his/her business and the financial position at the right time
and in the right manner.
Apart from these three financial statements, a fourth statement is the statement of changes in
equity. In a business, the sole purpose of investing money is earning profits. The financial position of
an organisation is determined by evaluating the profit earned or loss suffered by an organisation. In
addition, different users of accounting need different accounting information. Financial statements are
created to fulfil these requirements. Financial statements provide information regarding total profit
earned or loss suffered, i.e., the net income and the distribution of income. The preparation of financial
statements is the final step in the accounting cycle.
produced on a monthly, quarterly, bi-annually or annual basis. In most cases, it is produced on an annual
basis along with other financial statements. The profit and loss account is a statement that reflects the
financial performance to its investors, management and other interested parties.
In simple words, the profit and loss account is the explanation of the
particular period. Let us now discuss the components of the profit and loss account which are given as
follows:
Revenue: Revenue is the total amount of money received by a business entity after selling its products
or services. Generally, revenue is also known as sales revenue or net sales, and it can be calculated
by deducting sales return, discounts and allowances from total sales. It is recorded at the top of the
income statement and because of this it is also known as
Cost of Goods Sold (COGS): The COGS includes all direct costs involved in the process of production.
For example, the costs raw material, labour, factory overheads, depreciation on plant and machinery,
etc.
Gross profit or gross loss: It is the difference between the revenue received and the cost of goods
sold for a particular period.
Operating expenses: Operating expenses are the expenses that a business entity has to bear in day-
to-day business operations. For example, amortisation of intangible assets, advertising and sales
expenses, research and development, rent of building, etc.
Administrative expenses: Administrative expenses are those expenses that are not directly related
with the process of production. These expenses are related to management and supporting activities
of a business organisation. For example, depreciation on corporate office building, salary of top-level
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managers, legal charges, functional cost of the HR department, functional cost of IT department,
functional cost of the finance department, etc.
Operating income: The operating income can be calculated by deducting operating and
administrative expenses from gross profit. It is also known as Earnings before Interest and Taxes
(EBIT).
Other income: The other income is the income that is non-operational in nature and is not generated
on the basis of core operations of a business. For example, the rent received from the in -house
canteen contractor of a factory.
Other expenses: Other expenses are those expenses that are not related to the core operations of a
business enterprise and these expenses do not contribute anything to the process of production. For
example, income tax paid to the government, interest paid for borrowings, etc.
Net profit or net loss: It can be calculated by deducting all expenses from revenue. It is recorded at
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all nominal accounts in the trial balance to the trading and profit and loss account. Next, the personal
accounts of customers are grouped under the heading of sundry debtors, the entities from whom the
amounts of sold goods and services are due.
Similarly, we need to group all balances of suppliers under the single heading of sundry creditors, the
entities to whom the organisation owes money or payment. In the end, the real and personal accounts
are grouped as assets and liabilities and are arranged in a proper way. The resultant statement obtained
is called the balance sheet. The American Institute of Certified Public Accountants defines the balance
carried forward after an
actual constructive closing of books of account and kept according to the principles of
In the balance sheet, assets are represented on the right side and liabilities are shown on the left side.
It is also known as the statement of sources of funds and application of funds. The financial position
of the organisation includes its economic resources (assets), economic obligations (liabilities), and the
equity. As discussed in the previous chapters, a balance sheet is the detailed summary of the
basic accounting equation
Assets = Liabilities + Equity
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Accounting and Finance
However, if the value of the adjusted purchase (the cost of goods sold) is given then, the trial balance will
show figures of both adjusted purchases account and Closing Stock Account.
and temporary differences. The deferred tax calculation, which focuses on the effects of temporary
differences and other tax attributes over time, is the more complicated part of the provision.
Dividend
A dividend is a distribution of profits by a corporation to its shareholders. When a corporation earns a
profit or surplus, it is able to pay a proportion of the profit as a dividend to shareholders. Dividends can
provide stable income and raise morale among shareholders.
Dividends must be approved by the shareholders through their voting rights. Although cash dividends
are the most common, dividends can also be issued as shares of stock or other property. Along with
companies, various mutual funds and Exchange-Traded Funds (ETF) also pay dividends.
A dividend is a token reward paid to the shareholders for their investment in a equity, and it
usually originates from the net profits. While the major portion of the profits is kept within
the company as retained earnings which represent the money to be used for the ongoing
and future business activities the remainder can be allocated to the shareholders as a dividend. At
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times, companies may still make dividend payments even when they make suitable profits. They
may do so to maintain their established track record of making regular dividend payments.
Reserves
A reserve is retained earnings secured by a company to strengthen a financial position, clear
debt & credits, buy fixed assets, company expansion, legal requirements, investment and other plans.
These are usually done to save the cash from being used for other purposes. Reserve funds do not have
any legal restrictions so that the company can use them for any purpose.
Reserves are divided into two types:
1. Revenue Reserves
2. Capital Reserves
A financial statement refers to a formal and written record of all the financial activities and conditions
of an organisation, entity or a person. Financial statements contain a structured, organised, and
detailed summary of all the business processes.
The profit and loss account or the income statement shows the revenues and expenses of a company
during a particular period.
The balance sheet refers to the summary of the fiscal balances of a business organisation. In the
balance sheet, the assets, liabilities and
end of a fiscal year.
The primary aim of investing money in a business is to earn profit. An organisation needs to
periodically evaluate profits earned and losses incurred and its financial standing on a given date.
The profit and loss account is prepared so as to ascertain the net profit earned and the net loss
suffered by a business over a given accounting period.
In simple words, a balance sheet refers to a statement that summarises and pr esents the financial
position of an organisation on any given date.
During the usual course of a business, there are expenses that will be incurred during the current
accounting period.
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The closing stock implies inventory held at the end of the year.
A prepaid expense is a type of asset on the balance sheet that results from a business making
advanced payments for goods or services to be received in the future.
A tax provision is comprised of two parts: current income tax expense and deferred income tax
expense.
A dividend is a distribution of profits by a corporation to its shareholders.
Earnings per share (EPS) is calculated by determining a net profit and allocating that to
each outstanding share of common stock
4.10 GLOSSARY
Accounting Standards Board: The board consisting of accounting professionals to develop and
implement various accounting guidelines.
Bottom Line: The net profit of an organisation.
Carriage outward: The shipping and handling costs incurred by a company that is shipping goods
to a customer.
Depreciation: The reduction in the value of an asset over time due to wear and tear.
Sales commission: The amount of commission received by a person depending on the level of sales
obtained by him/her.
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and had been involved in overstating its income almost every quarter over the course of several years
in order to meet the expectations of the critics. Satyam overstated quarterly revenues by 75 per cent and
profits by 97 per cent on October 17, 2009. It was also found out that bank accounts were falsified for
inflating the balance sheet with balances that actually never existed. In addition, the income statement
was exaggerated by declaring interest income from fake bank accounts. It was also exposed that the
company owner made 6000 fake salary accounts over the past several years and withdrew the money
after the company deposited it.
The result of the
Questions
1. Suppose you are the finance manager at an MNC. What measures will you take to avoid financial
frauds?
(Hint: Periodically tally the books of accounts, check for the bank balance, investigate the unexpected
cash inflows and outflows and check the unbalanced accounts for small and big changes alike.)
2. Briefly explain the Satyam scam and the role played by the board.
(Hint: Prepare a summary by analysing various loopholes in the scandal.)
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https://corporatefinanceinstitute.com/resources/knowledge/accounting/thr ee -financial-
statements/
https://www.accountingtools.com/articles/2017/5/10/financial-statements
www.accountingtools.com/articles/2017/5/10/financial
https://www.wikiaccounting.com/five-types-of-financial-statements-ifrs/
www.wikiaccounting.com/five
www.wikiaccounting.com/five-
https://courses.lumenlearning.com/boundless-finance/chapter/introducing-financial-statements/
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50
UNIT
Names of Sub-Units
Overview
This unit begins with the meaning of bank reconciliation statement, it discusses the need for a
reconciliation statement. The unit explains the preparation of a bank reconciliation statement.
Learning Objectives
Learning Outcomes
5.1 INTRODUCTION
Business organisations record all the cash and bank transactions in the cash book of the company.
The Bank also maintains an account for each customer in its book. A copy of this account is regularly
sent to the customer
as shown by the cash book and that shown by the bank statement do not match. If the balance shown
by the passbook is different from the balance shown by bank column of the cash book, the business
firm will identify the causes for such difference. It becomes necessary to reconcile them. To reconcile
the balances of Cash Book and Pass Book a statement is prepared. This statement is called the
Reconciliation
Bank Reconciliation Statement is a record book of the transactions of a bank account. This statement
helps the account holders to check and keep track of their funds and update the transaction record that
they have made.
The balance mentioned in the bank passbook of the statement must tally with the balance mentioned
in the cash book. In the statement, all the deposits will be shown in the credit column and withdrawals
will be shown in the debit column. However, if the withdrawal exceeds the deposit, it will show a debit
balance (overdraft).
other activities affecting a bank account for a specific period. A bank reconciliation statement is a useful
financial internal control tool used to thwart fraud.
Bank reconciliation statements ensure payments have been processed and cash collections have been
deposited into the bank. The reconciliation statement helps identify differences between the bank
balance and book balance, in order to process necessary adjustments or corrections. An accountant
typically processes reconciliation statements once a month.
The accountant adjusts the ending balance of the bank statement to reflect outstanding checks or
withdrawals. These are transactions in which payment is route but the cash has not yet been accepted
by the recipient. An example is a check mailed on Oct. 30. When preparing the Oct. 31 bank reconciliation
statement, the check mailed the previous day is unlikely to have been cashed, so the accountant deducts
the amount from the bank balance. There may also be collected payments that have not yet been
processed by the bank, which requires a positive adjustment.
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on a particular date. The need and importance of the bank reconciliation statement may be given as
follows:
1. The reconciliation process helps in bringing out the errors committed either in Cash Book or Pass
Book.
2. Bank reconciliation statement may also show any undue delay in the clearance of cheques.
3. Sometimes, the cashier may have the tendency of cheating, like he makes entries in the Cash Book,
staff may be detected only through bank reconciliation statements. So, the bank reconciliation
statement acts as a control technique too.
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Business organisations record all the cash and bank transactions in cash book of the company.
The Bank also maintains an account for each customer in its book.
A copy of this account is regularly sent to the customer by the bank which is called or
To reconcile the balances of Cash Book and Pass Book a statement is prepared. This statement is
called the Reconciliation
A bank reconciliation statement is a summary of banking and business activity that reconciles an
bank account with its financial records.
Bank reconciliation statements ensure payments have been processed and cash collections have
been deposited into the bank.
The accountant adjusts the ending balance of the bank statement to reflect outstanding checks or
withdrawals.
The reconciliation statement is the most common tool used by organizations for reconciling the
balance as per books of company with the bank statement and is made at the end of every month.
5.4 GLOSSARY
Bank Overdraft: If the bank statement shows a debit balance at a particular point in time, it is
known as an overdraft. It implies that the account is overdrawn, i.e., withdrawals are more than
deposits. Bank
Statement: It gives the details of transactions between the bank and the customer. Every bank
provides bank statements to each customer either weekly or monthly.
Pay-in-Slips: Documents supporting cheques deposited into the bank.
Case Objective
The case study explains the impact of lack of internal controls in an IT giant.
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An independent legal counsel appointed by IT major Wipro has found that lack of internal controls led
to the embezzlement committed by one of the former junior employees between November 2006 and
December 2009.
The legal counsel submitted the probe report last week to the audit committee set up to investigate the
fraud early.
Based on the findings of the legal counsel, Wipro said that if corrections were to be carried out to the
submitted the report this month and measures have already been taken to tighten the he said.
Stating that it has been able to recover most of the embezzled amounts, Wipro, which is listed on the
New York Stock Exchange, in its latest disclosure to the US Securities and Exchange Commission, said
its audit panel has concluded that mistakes were committed in certain accounting entries and that they
were also not supported by any documents. and our independent registered public accounting firm
also identified the lack of internal controls that gave rise to the embezzlement and financial statement
misstatements as material weaknesses in internal control over financial Wipro said in its
disclosure to SEC. The material weaknesses related to sharing of online banking access passwords and
ernal accounting system passwords by certain employees within the finance and accounting
departments including those responsible for external financial reporting.
There was a lack of effective controls over recording of journal entries, including inadequate
documentation which resulted in ineffective controls over bank reconciliation statements, exchange
rate fluctuation accounts and outstanding liabilities accounts and also there was a lack of timely and
adequate reconciliation and review of period and end reinstatement of foreign currency inter-company
and unit balances, including recording of appropriate adjustments. Also, segregation of duties with
respect to recording and initiating banking payments was found insufficient.
Questions
1. Why is BRS important for a firm?
(Hint: Reconciliation helps you identify any unusual transactions that might be caused by fraud or
accounting errors, and the practice can also help you spot inefficiencies.)
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Discuss with your friends how a bank reconciliation statement is useful for a firm.
60
UNIT
Ratio Analysis
Names of Sub-Units
Introduction to the Ratio Analysis, Types of Ratios, the Concept of Liquidity Ratios, Solvency Ratio, the
Concept of Activity Ratio, the Concept of Profitability Ratio, the Concept of Market Test Ratio.
Overview
This unit begins by the meaning of ratio analysis, it discusses the concept of liquidity ratios. The unit
explains the solvency ratio. It also discusses the profitability ratio.
Learning Objectives
Learning Outcomes
At the end of this unit, you would:
Assess the importance of profitability ratio
Examine the profitability ratio
Analyse the solvency ratio
Evaluate the activity ratio
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6.1 INTRODUCTION
The ratio analysis is one of the important tools of financial statement analysis to study the financial
ratio is used to describe significant relationships which exist between figures shown in a balance
sheet, in a profit and loss account, in a budgetary control system or any other part of the accounting
Financial statements contain substantial information (figures) relating to profit or loss
and financial position of the business. If these items in financial statements are considered independently,
they may or may not be of much use. To make a meaningful reading of financial statements, these items
found in financial statements have to be compared with one another. Ratio analysis, as a technique or
analysis of financial statements uses this method of comparing the various items found in financial
statements.
can be used to evaluate the financial strengths and weaknesses of an organisation. Ratio analysis helps in
presenting the information contained within the financial statements in a comparative form. Financial
investors, creditors and management of an organisation. This information helps these stakeholders
in understanding how well a business is performing and what areas of the business need to be
improved.
Liquidity Ratios
Ratios that are used to measure the liquidity position of a business entity are categorised under liquidity
without
by using its current assets. The current liabilities are the short-term obligations to be met within one
year. For example, short-term debt, accounts payable, sundry creditors, etc. Current assets refer to the
short-term assets that can be converted to cash within a year. For example, cash, marketable securities,
short-term investments, accounts receivable, prepaid expenses, inventory, etc. There are three important
liquidity ratios which are as follows:
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Current Ratio
The current ratio is equal to the total current assets divided by total current liabilities. It indicates the
extent to which current assets can be used to pay-off current liabilities. Mathematically, it is expressed
as follows:
Current Assets
Current Ratio
Current Liabilities
Quick Ratio
One of the limitations of the current ratio is that it assumes that all current assets of a business entity
can be easily converted to cash to meet its current liabilities. This assumption may not always be true.
There are current assets such as inventory and pre-paid expenses that cannot be readily converted
into cash. To overcome this limitation, there is another ratio called the quick ratio. The quick ratio is
also referred to as the acid test ratio. Quick ratio is equal to liquid current assets divided by current
liabilities. Mathematically, it can be expressed as follows:
Cash in hand Cash at bank Receivable Marketable securitis
Current Ratio
Current Liabilities
be paid-off using
its liquid current assets such as cash, marketable securities and accounts receivables. Ideally, a quick
ratio of 1:1 is considered financially viable.
Cash Ratio
It is the ratio of cash and cash equivalents of an organisation to its current liabilities. It assesses the
capability of a business entity to repay its current liabilities by using its cash and cash equivalents
only. It is a more restrictive and better measure of liquidity than the current ratio and quick ratio. The
formula of cash ratio is as follows:
Cash Cash Equivalents
Cash Ratio
Current liabilities
Solvency Ratio
Solvency ratios are also called leverage ratios. These are used to measure the ability of an organisation
to service its debt and interest obligations. Solvency ratios are different from liquidity ratios, although
both are used to measure the ability of an organisation to pay-off its obligations. Solvency ratios are a
measure of the long-term sustainability of a business entity, while liquidity ratios are a measure of the
current liabilities of an organisation. Solvency ratios are particularly of interest to long-term creditors
and shareholders as these ratios give a clear picture of the long-term health and survival of business
entity. Solvency ratios are tools to assess if a business entity can pay-off its debt and interest on maturity.
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The ideal solvency ratio varies from one industry to another. However, a solvency ratio higher than 20%
is considered to be satisfactory. A low solvency ratio is indicative of an insufficiency to
repay its debt obligations. Some of the important Solvency Ratios are as follows:
Debt-Equity Ratio
The debt- against its
total equity. In other words, this ratio reveals the relationship between external equities and internal
equities. Therefore, it is also called the external-internal equity ratio. Total equity includes all ordinary
capital, reserves, preferences and minorities. It is an net assets (total assets as reduced
Debt is borrowed capital and includes those funds which a firm owes to external sources of finance.
These funds are obligatory in nature and are sourced from banks, NBFCs, etc. The debt considered is
exclusive of current liabilities.
Equity is the capital owned by an organisation and it can be raised by issuing new shares or equity.
These funds are ownership based in nature and belong to shareholders, proprietors or the owner of the
discounts on the issue of shares, common stock, treasury stock, retained earnings, and the capital
surplus. The debt-equity ratio can also be computed as follows:
Total debt
Debt Equity Ratio
Shareholders' equity
through loans and other financial liabilities. A ratio greater than 1 implies that a significant proportion
of assets are being financed using debt, whereas a ratio below 1 implies that most of the assets are
financed through equity. The debt to total assets ratio can be calculated as follows:
Long Term Debt
Debt to Total Assets Ratio
Total Assets
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Solvency Ratio
-term debt and other obligations. The
cash flows are sufficient to meet its short - and long-
ratio measures the size of a business income after tax plus depreciation expenses against the
total debt obligations of the business entity. Mathematically,
Solvency Ratio = (PAT + Depreciation)/(Total Liabilities)
An insolvent firm cannot pay its debt and would be forced into bankruptcy. It is recommended that
investors should examine all the financial statements of a firm to ensure that it is solvent and profitable.
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Here, fixed cost-bearing funds = Debentures + Preference shares + Other long-term loans
High capital gearing ratio indicates that an organisation has large fund-bearing fixed interest and/
or fixed dividend-bearing funds compared to equity share capital. A lower ratio indicates that the
preference shares capital and other fixed interest-bearing funds in the organisation are less than the
equity share capital. An ideal capital gearing ratio is 2:1.
Activity Ratio
Activity Ratios, also referred to as Operating or Management Ratios, are used to measure an
and fixed assets. The commonly used Activity Ratios are inventory turnover ratio, turnover
ratio and working capital turnover ratio. Before discussing different types of Activity Ratios, let us first
understand the concept of the average collection period. Average collection period refers to the average
number of days between the date that a credit sale is made and the date that receivables are collected
from the customer. It is computed as follows:
365
Average collection period
Average Receivables Turnover Ratio
during a given period. In other words, the inventory turnover ratio measures the number of times an
organisation sold its total average inventory during a financial year. For example, an organisation with
an average inventory and net sales of worth ` 10,00,000 and ` 50,00,000 effectively sold its inventory
over 5 times. Inventory Turnover Ratio is calculated using the following formula:
Cost of Goods Sold
Inventory Turnover Ratio
Average Inventory
365
Average Selling Period :
Inventory Turnover
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of Debtors Turnover Ratio reflects inefficient management of debtors by the organisation. Accounts
Receivable Turnover is calculated by dividing net credit sales by Average Accounts Receivable for that
period. Mathematically, it can be expressed as follows:
Net Credit Sales
Debtors Turnover Ratio
Average Accounts Receivables
Profitability Ratio
to its expenses over a specified time period. Profit includes the income earned after an organisation has
deducted the costs and expenses incurred in the process. The three main types of profitability ratios are
gross profit ratio, net profit ratio and operating profit ratio. Let us discuss various profitability ratios:
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Accounting and Finance
or
Sales Direct Materials Direct Labour Overhead
Sales
When expressed in percentage form, gross profit ratio is known as gross profit margin or gross profit
percentage.
Gross Profit
Gross Profit Margin 100
Net Sales
Higher ratios are considered favourable as they imply that the organisation is selling its products at a
higher profit percentage.
When expressed in percentage form, net profit ratio is known as net profit margin or net profit
percentage
Net Profit after Tax
Net Profit Margin 100
Net Sales
When expressed as a percentage, Operating Profit Ratio is known as operating margin and it can be
expressed as follows:
OperatingIncome
Operating Margin 100
Sales Revenue
Operating income is also referred to as Earnings Before Income and Taxes (EBIT). EBIT includes the
income that remains on the income statement after all operating and overhead costs are deducted.
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with the money. ROE is expressed as a percentage and the formula is as follows:
ROE = Net Equity
ratios are indicators of the performance of the company and also reflects the likely performance of the
company in the near future. If the profitability, solvency and turnover ratios are good then the
market test ratios will be high. The market test ratios are as follows:
Dividend per Share/Earnings per Share
Dividend Payout Ratio: Dividend payout ratio is the dividend per share divided by the earnings per
share. Dividend payout ratio indicates the extent of the net profit distributed to the shareholders by
way of dividend. A higher dividend payout ratio indicates that the company does not require further
funds in the near future or it may also indicate that the cost of borrowing is less than the cost of
equity. A low payout ratio is an indicator of the fact that the company is in requirement of funds.
Dividend Yield: (Dividend per share/Market price)× 100
This ratio reflects the percentage yield earned by investors by investing in share at the
current market price. This measure is especially useful for those investors who are interested in
regular returns rather than capital appreciation.
Book Value: (Equity capital + Reserves Profit loss A/C debit balance)/Total number of equity shares
This ratio indicates the net worth per equity share. Book Value is a function of the past earnings and
distribution policy of the company.
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Accounting and Finance
Ratio analysis is a tool for determining and interpreting the relationships between different
financial statements for providing the understanding of the performance and financial position of
an organisation.
Financial ratios can be divided into liquidity ratios, solvency ratios, profitability ratios and activity
ratios.
to meet its current liabilities using its
current assets. These are the current ratio and quick ratio.
Solvency ratios also referred to as leverage ratios are used to measure the ability of an organisation
to pay its long-term debt and the interest on that debt. For example, debt-equity and debt to total
assets ratios.W
expenses over a specified time period. For example, gross profit, net profit and operating profit
ratios.
Activity ratios also referred to as operating or management ratios are used to measure an
6.4 GLOSSARY
Debt: The amount owed to an individual or organisation for the funds borrowed.
Equity: The value of the shares issued by an organisation.
Debentures: The long-term securities that yield a fixed rate of interest, issued by an organisation
and secured against assets.
Working capital: The capital used by an organisation to perform its day-to-day operations and
obtained by deducting the current liabilities from the current assets.
Case Objective
The case study explains the analysis of financial statements.
Stortford Yachts Ltd. was established in 1983 and provides complete service for cruise holidays in various
destinations of Greece and Turkey. It deals in yacht chartering, yacht management and yacht brokerage
business. The company manages a fully equipped fleet of yachts and has a team of qualified and trained
staff.
In the past, the company has achieved good levels of growth and return on capital which is gradually
changing. The company has failed to introduce new product lines and relies on traditional yachts with
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little investment in research or product development. The Director of Stortford Yachts Ltd., Paul Marriot
decided to address the problem and introduce new ideas with respect to their product lines.
Paul meets the Director of Management Consultants group and stated that he plans to introduce
stronger management control within the company. The Director receives a file containing a summary
of the profit and loss statement, and the balance sheet statements of Stortford Yachts Ltd., for the past
three years, which is as follows:
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Financial ratios of Stortford Yacht Ltd. for the year 2013 were also provided to the consultants: Average
ratios for 2013
Ratio 2013
Return on equity 27.78%
Asset turnover 1.9 times
Net profit margin 5.3%
Current ratio 1.31 times
Quick ratio 0.995 times
Debtors collection period 28 days
Suppose you are the Planning Assistant of the Management Consultants Group and are required to
analyse the financial statement over the last three years.
Questions
1. Prepare a detailed report on the performance in terms of profitability and liquidity.
(Hint: Analyse the other Liquidity and Profitability Ratios for the years 2011 and 2012 of Stortford
Yacht Ltd.)
2. Suggest changes in the financial structure to improve the profitability and liquidity position of the
company.
(Hint: Based on the ratio trends, suggest structural changes to the company. The reduction in overall
performance is highlighted through the reduction of the net profit figures on the profit and loss
statement. The company needs to control costs and analyse the reason behind the sharp fall in the
net profit figures.)
3. The debt-
its total equity. Refer to Section Introduction to Ratios
4. It is the ratio of the cost of goods sold by an organisation to its average inventory during a given
accounting period. Refer to Section Introduction to Ratios
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75
UNIT
Names of Sub-Units
Introduction to Cost-Volume-Profit Analysis (CVP), Calculations for CVP Analysis, Concept of Achieving
a Desired Profit, Break-Even Analysis.
Overview
This unit begins by explaining the meaning of cost-volume-profit analysis (CVP), it discusses the
calculations for CVP analysis. The unit explains achieving a desired profit. It also discusses the break-
even analysis.
Learning Objectives
Learning Outcomes
7.1 INTRODUCTION
The cost-volume-profit (CVP) analysis helps management in finding out the relationship of costs and
revenues to profit. The aim of an undertaking is to earn profit. Profit depends upon a large number of
factors, the most important of which are the costs of the manufacturer and the volume of sales effected.
Both these factors are interdependent the volume of sales depends upon the volume of production,
which, in turn, is related to costs. The cost again is the result of the operation of a number of varying
factors as follows:
1. Volume of production
2. Product mix
3. Internal efficiency
4. Methods of production
5. Size of plant, etc.
Of all these, volume is perhaps the largest single factor which influences costs which can basically be
divided into fixed costs and variable costs. Volume changes in a business are a frequent occurrence,
often necessitated by outside factors over which management has no control and as costs do not
always vary in proportion to changes in levels of output, management control of the factors of
volume presents a peculiar problem. As profits are affected by the interplay of costs and volume,
the management must have, at its disposal, an analysis that can allow for a reasonably accurate
presentation of the effect of a change in any of these factors which would have no profit performance.
Cost-volume-profit analysis furnishes a picture of the profit at various levels of activity. This enables
the management to distinguish between the effect of sales volume fluctuations and the results of price
or cost changes upon profits. This analysis helps in understanding the behaviour of profits in relation
to output and sales. Fixed costs would be the same for any designated period regardless of the volume
of output accomplished during the period (provided the output is within the present limits of capacity).
These costs are prescribed by contract or are incurred in order to ensure the existence of an operating
organisation. Their inflexibility is maintained within the framework of a given combination of resources
and within each capacity stage, such costs remain fixed regardless of the changes in the volume of
actual production. As fixed costs do not change with production, the amount per unit declines as output
rises. Absorption or full costing system seeks to allocate fixed costs to products. It creates the problem
of apportionment and allocation of such costs to various products. By their very nature, fixed costs have
little relation to the volume of production.
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Variable costs are related to the activity itself. The amount per unit remains the same. These costs
expand or contract as the activity rises or falls. Within a given time span, distinction has to be drawn
between costs that are free of ups and downs of production and those that vary directly with these
changes. Study of behaviour of costs and CVP relationship needs proper definition of volume or activity.
Volume is usually expressed in terms of sales capacity expressed as a percentage of maximum sales,
volume of sales, unit of sales, etc.
Production capacity is expressed as a percentage of maximum production, production in revenue
of physical terms, direct labour hours or machine hours. Analysis of cost-volume-profit involves
consideration of the interplay of the following factors: 1. Volume of sales 2. Selling price 3. Product mix
of sales 4. Variable cost per unit 5. Total fixed costs.
The relationship between two or more of these factors may be (a) presented in the form of Notes, reports
and statements (b) shown in charts or graphs, or (c) established in the form of mathematical deduction.
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A simplified contribution margin income statement classifies the line items and ratios as follows:
The equation:
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As the variable costs change in direct proportion (i.e., in %) of revenue, the contribution margin also
changes in direct proportion to revenues, However, the contribution margin percentage remains the
same.
Targeted Profit
The CVP analysis is conducted to determine a revenue level required to achieve a specified profit. The
revenue may be expressed in number of units sold or in dollar amount.
Income Statement
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to break even and the total profits and losses at other sales level. Break even analysis is a method, as
said by Dominick Salnatore, of revenue and total cost functions of the firm. According to Martz, Curry
and Frank, a break-even analysis indicates at what level cost and revenue are in equilibrium. In case of
break-even analysis, the break-even point is of particular importance. Break-even point is that volume
of sales where the firm breaks even i.e., the total costs equal total revenue. It is, therefore, a point where
losses cease to occur while profits have not yet begun. That is, it is the point of zero profit.
Fixed Costs
BEP
Selling price Variable costs per unit
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3. The company considered manufacturing a wide range of products and is operating at various
locations. Hence, to carry out the analysis at company scale is a very complex procedure which
involves sorting of relevant data from a heap of data and then compiling it in the form required by
cost per unit of output (AVC) are constant. Profit is equal to total revenue (P.Q.) less the sum of Total
Variable Costs (Q.TVC) and fixed costs.
Thus, R = PQ [(Q. AVC) + FC] R = TR TC The break-even chart shows the extent of profit or loss to
the firm at different levels of activity. A break-even chart may be defined as an analysis in graphic
form of the relationship of production and sales to profit. The break-even analysis utilises a break-
even chart in which the Total Revenue (TR) and the Total Cost (TC) curves are represented by straight
lines, as shown in Figure 1.
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D Profit
Break-even point TR
TC
Variable cost
Cost,
Revenue TFC
Price (`)
Fixed Cost
O Q1 Quantity (Q)
Figure 1:
In the figure, total revenues and total costs are plotted on the vertical axis whereas output or sales
per time period are plotted on the horizontal axis. The slope of the TR curve refers to the constant
price at which the firm can sell its output.
The TC curve indicates Total Fixed Costs (TFC) (the vertical intercept) and a constant average
variable cost (the slope of the TC curve). This is often the case for many firms for small changes in
output or sales.
The firm breaks even (with TR=TC) at Q1 (point B in the figure) and incurs losses at smaller outputs
while earnings profits at higher levels of output. Both the Total Cost (TC) and Total Revenue (TR)
curves are shown as linear.
TR curve is linear as it is assumed that the price is given, irrespective of the output level. Linearity
of TC curve results from the assumption of constant variable costs. If the assumptions of constant
price and average variable cost are relaxed, break even analysis can still be applied, although the
key relationship (total revenue and total cost) will not be linear functions of output.
Nonlinear total revenue and cost functions are shown in Figure 2. The cost function is conventional
in the sense that at first, costs increase but less than in proportion to output and then increase more
than in proportion to output. There are two break-even points L and M. Note that profit which is
the vertical distance between the total revenue and total cost functions, is maximised at output rate
Q*. Of the two break even points, only the first, corresponding to output rate Q1 is relevant.
When a firm begins production, the management usually expects to incur losses. But it is important
to know at what output rate the firm will go from a loss to a profit situation. In Figure 2, the firm
would want to get to the break-even output rate Q1 as soon as possible and then of course, move to
the profit maximising rate Q*. However, the firm would not expand production beyond Q* because
this would result in a reduction of profit.
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TC
D Total revenue
Profit
M
Loss
L
Revenue TFC
Cost
O Q1 Q2 Rate of Output
(Q)
TFC + TFC +
or Q8 where, p = Profit.
P AVC ACM
TFC +
and SB P QB AVC
1
P
TFC
and %B
P AVC Q cap
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Accounting and Finance
The Cost-Volume-Profit (CVP) analysis evaluates the change in profit with respect to changes in
sales volume and cost. It is often used as an evaluation tool of cost and business decisions by the
finance managers.
Profit volume ratio represents the proportion of sales revenue available with the business for
covering the fixed costs and profits. P/V ratio is calculated by dividing total contribution by total
sales.
Profit/Volume (P/V ratio) = Total contribution/Total sales
A higher P/V ratio implies that the organisation is making huge profits. Therefore, higher P/V ratio
is always favourable for the organisation.
CVP analysis is based on the assumption that total cost of a product is segregated into two
components, i.e., fixed and variable. The fixed component of cost does not change with the level of
output. However, the variable component of cost varies with changes in the level of output. Semi
variable costs are also classified into fixed and variable elements.
Marginal cost is the change in the total cost of production when an additional unit of product is
produced. Thus, it is the cost incurred in producing an extra unit of product.
refers to the difference between sales and marginal cost. It can also be
expressed as the excess of sales revenue over variable costs.
The break-even analysis is a technique to judge whether or not the given level of production would
be profitable for an organisation.
Break-even Point (BEP) refers to a point where the total cost is equal to the total revenue of an
organisation. In other words, it is a point where there is no profit or no loss for the organisation.
BEP (Units) = Fixed Cost/Contribution per unit BEP (`) = Fixed Cost/P/V Ratio
The cash BEP refers to a production level at which cash inflow would be equal to cash outflow. The
cash break-even point is computed by taking only those fixed costs that are payable in cash.
One of the limitations of break-even analysis is that it is based on an unrealistic assumption that
cost behaviour is linear and variable cost always moves in direct proportion of the cost. However, in
reality, variable costs may move with the level of output, but not necessarily in direct proportions.
7.4 GLOSSARY
Cost-Volume-Profit (CVP) analysis: This is a tool used for analysing business decisions. This tool
helps in analysing the relationship between total cost, volume of sales, and profit.
Break-even analysis: An analysis that helps in determining the equilibrium point of total sales and
total cost.
Margin of Safety (MOS): A margin which expresses the difference between total sales and break-
even sales.
Contribution: The difference between sales revenue and total variable costs.
Cost of production: All costs which are incurred in the manufacturing facilities for the production
of goods and services.
Budgeting: Development of financial and costing plans for the projection of revenue and expenses
so as to control or monitor activities.
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Questions
1. Find out increase in sales at various stages of price reduction.
(Hint: The solution to the given problem is as follows:)
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relationships/cost-volume-profit-analysis
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90
UNIT
Names of Sub-Units
Overview
This unit begins with meaning of financial statements analysis, it discusses the significance of
financial statements analysis. The unit analysis of the balance sheet, analysis through common size,
trend and comparative statements.
Learning Objectives
In this unit, you will learn to:
Explain the meaning of financial statements analysis
Discuss the significance of financial statements analysis
Describe the sources of obtaining financial analysis information
Explain the different types of financial statement analysis
JGI JAIN
DEEMED-TO-BE UNIVERSITY
Accounting and Finance
Learning Outcomes
At the end of this unit, you would:
Assess the meaning of financial statements analysis
Examine the significance of financial statements analysis
Analyse the analysis of balance sheet
Evaluate the analysis through common size, trend and comparative statements
8.1 INTRODUCTION
Financial statements provide detailed information about various items of an organisation such as
assets, liabilities, equity, reserves, expenses, profit and loss, cash flows, funds flows, etc. This information
is not simple to understand for most of the stakeholders and their analysis and interpretation are
required to make them understandable. Hence, financial statement analysis is a crucial process in which
financial information about an organisation is analysed. It is essential to understand this information
for good operational decision making and it provides a path to examine the relationship between
various financial events of financial statements. In other words, financial statements analysis is a
process of interpretation of financial statements to understand the profitability, operational efficiency
and financial health of the organisation. Financial statement analysis involves two activities namely
analysis and then interpretation. The term analysis is related to the mathematical representation
of financial data by applying various techniques and interpretation means explaining the meaning,
importance and consequences of various financial events. Both these activities are very essential to
measure financial soundness and future prospects of the business organisation.
In a business, the sole purpose of investing money is earning profits. The financial position of an
organisation is determined by evaluating the profit earned or loss suffered by an organisation. In
addition, different users of accounting information need other accounting information. Financial
statements are created to fulfil these requirements. Financial statements provide information regarding
total profit earned or loss suffered the net income and the distribution of income. Preparation of the
financial statement is the final step in the accounting cycle.
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To Freight
To Carriage
Inwards XXX
To Clearing
Charges XXX
To Packing charges XXX
XXX XXX
The general pro form a of the profit and loss account is shown as follows:
Profit & Loss Account for the year ended 31st March
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The profit and loss account plays an important role in the accounting process as it helps in determining
the net results of the business activities. The main objectives of the profit and loss account are as follows:
Determining the net gain or loss of an organisation
Controlling unnecessary expenses by providing information about the effect of individual expense
on the net profit or loss of the organisation
Assisting in analysing the progress of an organisation by comparing the current and previous
net profit
Helping in preparing the balance sheet, which would further indicate the financial position of an
organisation
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Total Total
Common Size
Common size analysis, also referred to as vertical analysis, is a tool that financial managers use to
analyze financial statements. It evaluates financial statements by expressing each line item as a
percentage of the base amount for that period. The analysis helps to understand the impact of each
item in the financial statement and its contribution to the resulting figure.
The technique can be used to analyze the three primary financial statements, i.e., balance sheet, income
statement, and cash flow statement. In the balance sheet, the common base item to which other line
items are expressed is total assets, while in the income statement, it is total revenues.
Common size analysis can be conducted in two ways, i.e., vertical analysis and horizontal analysis.
Vertical analysis refers to the analysis of specific line items in relation to a base item within the same
financial period. For example, in the balance sheet, we can assess the proportion of inventory by dividing
the inventory line using total assets as the base item.
On the other hand, horizontal analysis refers to the analysis of specific line items and comparing them
to a similar line item in the previous or subsequent financial period. Although common-size analysis is
not as detailed as trend analysis using ratios, it does provide a simple way for financial managers to
analyze financial statements.
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Common size financial statement analysis is computed using the following formula:
Trend Analysis
time. Periods may be
measured in months, quarters, or years, depending on the circumstances. The goal is to calculate and
analyze the amount change and percent change from one period to the next.
Trend analysis is a financial statement analysis technique that shows changes in the amounts of
corresponding financial statement items over a period of time. It is a useful tool to evaluate the trend
situations.
The statements for two or more periods are used in horizontal analysis. The earliest period is usually
used as the base period and the items on the statements for all later periods are compared with items
on the statements of the base period. The changes are generally shown both in dollars and percentage.
Comparative Statement
A comparative statement is a document used to compare a particular financial statement with
prior period statements. Previous financials are presented alongside the latest figures in side-by-side
and compare it with industry
rivals.
identified and the performance of managers, new lines of business and new products can be evaluated,
without having to flip through individual financial statements.
Comparative statements can also be used to compare different companies, assuming that they follow
the same accounting principles. For example, they can show how different businesses operating in the
same industry react to market conditions. Reporting just the latest dollar amounts makes it hard to
compare the performances of companies of various sizes. Adding prior period figures, complete with
percentage changes, helps to eliminate this problem.
In a business, the sole purpose of investing money is earning profits. The financial position of an
organisation is determined by evaluating the profit earned or loss suffered by an organisation.
Financial statements act as an important source of information as they provide structured and
easy-to-understand information regarding the business activities of an organisation.
The objective of financial statements is to provide information that would convey the performance
details, financial position, and the changes in the financial position of the organisation. These help
users in making decisions.
Stakeholders cannot use financial information which they do not understand. Problems in
understanding financial information may arise out of two reasons: incapability in
understanding information and ambiguity in the information itself.
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A set of information can only be considered relevant when the information adds value to the
decision-making process.
Information is reliable when it is dependable and this is possible only when it is free from errors
(especially material errors), complete and free from bias.
without comparing the financial information of one period with another or the financial information
of one entity to another.
Some of the main scopes of financial statements are providing information about the financial
position, providing information about the financial performance, providing information about
changes in the financial position, and providing notes and supplementary schedules.
The gross profit or gross loss calculated in a trading account is taken to the second part of the
account called the profit and loss account. The profit and loss account is prepared to ascertain the
net profit earned or the net loss suffered by the business over an accounting period, depicting the
financial performance of the organisation.
The profit and loss account plays an important role in the accounting process as it helps in
determining the net results of the business activities.
The main components of a profit and loss account are expenses and incomes. The expenses are
shown on the debit side and the incomes are shown on the credit side of the P&L account.
A balance sheet is the statement that summarises, and presents the financial position of an
organisation as on a particular date, by showing the assets and liabilities of the organisation.
In the balance sheet, assets are represented on the right side and liabilities are shown on the left
side.
A balance sheet plays a vital role in taking important financial decisions by management and
investors of the organisation.
Trading transactions of a company, such as income, sales and expenditure and the resulting profit
or loss for a given period is summarised in the profit and loss (P&L) account. In comparison, the
balance sheet provides a financial snapshot of a company at a given moment.
8.5 GLOSSARY
Accounting standards board: The board consisting of accounting professionals to develop and
implement various accounting guidelines.
Bad debt: A debt that is not collectible and therefore worthless to the creditor.
Bottom line: The net profit of the organisation.
Carriage outward: The shipping and handling costs incurred by a company that is shipping goods
to a customer.
Depreciation: A reduction in the value of an asset over time due to wear and tear.
Sales commission: The amount of commission received by a person depending on the level of sales
obtained by him/her.
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governance.
On January 7, 2009, Ramalinga Raju revealed in a letter addressed to Satyam Computers
several years. Ramalinga Raju declared that he had overstated the assets on
balance sheet by $1.47 billion. He revealed that about $1.04 billion worth of bank loans and cash that
Satyam claimed to own did not exist. To meet the expectations of the critics, Satyam Computers had
been included in exaggerating its income almost every quarter over the course of various years. Satyam
overstated quarterly revenues by 75 per cent and profits by 97 per cent on October 17, 2009. It was also
found out that bank accounts were falsified for inflating the balance sheet with balances that actually
never existed. In addition, the income statement was exaggerated by declaring interest income from
fake bank accounts. It was also exposed that the company owner made 6000 fake salary accounts over
the past several years and withdrew the money after the company deposited it.
and insurers, and even competitors whose reputations suffered owing to their association with Satyam.
Some of the main points that companies must remember after the Satyam Scandal are:
Investigation of all inaccuracies: The fraud at Satyam started on a small scale initially and grew
up to $276 million Most accounting frauds start out small with the offender assuming that minute
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changes in the financial statements would go unnoticed. Thus, companies should be aware when
the accounts do not balance or if something seems inaccurate even if it is insignificant.
Adherence to accounting standards: Companies should follow a set of guidelines to prepare
and present their financial statements. This helps in bringing consistency in the reporting of
the accounting information. It also ensures transparency, consistency and comparability of the
accounting information by providing uniformity in accounting practices as accountants and
auditors follow the same rules and procedures.
Role division: Dividing responsibilities across a team of individuals would help in detecting
irregularities or misappropriated funds.
Questions
1. Suppose you are the finance manager at an MNC. What measures will you take to avoid financial
frauds?
(Hint: Periodically tally the books of accounts, check for the bank balance, investigate the unexpected
cash inflows and outflows and check the unbalanced accounts for small and big changes alike.)
2. Briefly explain the Satyam scam and the role played by the board.
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https://corporatefinanceinstitute.com/resources/knowledge/finance/analysis-of-financial-
statements/
https://www.aafmindia.co.in/financial-statement-analysis-tools-limitation-uses-process
https://online.hbs.edu/blog/post/financial-statement-analysis
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Discuss with your friends, what is the need of financial statement analysis.
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UNIT
Names of Sub-Units
Overview
This unit begins by explaining the meaning of corporate finance, it discusses the concept of financial
decisions of a firm. The unit explains the introduction to financial management. It also discusses the
objectives of financial management.
Learning Objectives
Learning Outcomes
At the end of this unit, you would:
Assess the meaning of corporate finance
Examine the financial decisions of a firm
Analyse the objectives of financial management
Evaluate the finance function
JGI JAIN
DEEMED-T O-BE UNI VE R SI TY
Accounting and Finance
9.1 INTRODUCTION
Corporate finance is the division of finance that deals with how corporations deal with funding sources,
capital structuring, and investment decisions. Corporate finance is primarily concerned with maximizing
shareholder value through long and short-term financial planning and the implementation of various
strategies. Corporate finance activities range from capital investment decisions to investment banking.
Corporate finance departments are charged with governing and overseeing their financial
activities and capital investment decisions. Such decisions include whether to pursue a proposed
investment and whether to pay for the investment with equity, debt, or both.
It also includes whether shareholders should receive dividends. Additionally, the finance department
manages current assets, current liabilities, and inventory control.
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A finance manager has to select such sources of funds which will make optimum capital structure.
The important thing to be decided here is the proportion of various sources in the overall capital
mix of the firm. The debt-equity ratio should be fixed in such a way that it helps in maximising
the profitability of the concern. The raising of more debts will involve fixed interest liability and
dependence upon outsiders.
It may help in increasing the return on equity but will also enhance the risk. The raising of funds
through equity will bring permanent funds to the business but the shareholders will expect higher
rates of earnings. The financial manager has to strike a balance between anxious sources so that
the overall profitability of the concern improves. If the capital structure is able to minimise the risk
and raise the profitability, then the market prices of the shares will go up maximising the wealth of
shareholders.
3. Dividend Decision
The third major financial decision relates to the disbursement of profits back to investors who
supplied capital to the firm. The term dividend refers to that part of profits of a company which is
distributed by it among its shareholders. It is the reward of shareholders for investments made by
them in the share capital of the company. The dividend decision is concerned with the quantum of
profits to be distributed among shareholders.
A decision has to be taken whether all the profits are to be distributed, to retain all the profits in
business or to keep a part of profits in the business and distribute others among shareholders.
The higher rate of dividend may raise the market price of shares and thus, maximise the wealth of
shareholders. The firm should also consider the question of dividend stability, stock dividend (bonus
shares) and cash dividend.
4. Liquidity Decisions
Liquidity and profitability are closely related. Obviously, liquidity and profitability goals conflict in
most of the decisions. The finance manager always perceives / faces the task of balancing liquidity
and profitability. The term li
reserves to meet emergencies whereas profitability aims to achieve the goal of higher returns. As said
earlier, striking a proper balance between liquidity and profitability is a difficult task. Profitability
will be affected when all the bills are to be settled in advance. Similarly, liquidity will be affected if the
funds are invested in short term or long-term securities. That is the funds are inadequate to pay-off
its creditors. Lack of liquidity in extreme situations can lead insolvency.
any business, it is important that the finance it procures is invested in a manner that the returns from
the investment are higher than the cost of finance. In a nutshell, financial management
Endeavors to reduce the cost of finance
Ensures sufficient availability of funds
Deals with the planning, organizing, and controlling of financial activities like the procurement and
utilisation of funds
Some Definitions
management is the activity concerned with planning, raising, controlling and
administering of funds used in the Guthman and Dougal
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Profit maximisation
Profit maximisation is the capability of a business or company to earn the maximum profit with low
cost which is considered as the chief target of any business and also one of the objectives of financial
management. According to financial management, profit maximisation is the approach or process which
increases the profit or Earnings per Share (EPS) of the business. More specifically, profit maximisation
to optimum levels is the focal point of investment or financing decisions.
maximisation may be the but the means to achieve this end, is what matters, and that
distinguishes a company in the corporate world and the Henrietta Newton Martin
Profit Maximisation Theory: Assumptions and Criticisms!
In the neoclassical theory of the firm, the main objective of a business firm is profit maximisation. The
firm maximises its profits when it satisfies the two rules:
(i) MC = MR and,
(ii) MC curve cuts the MR curve from below.
Maximum profits refer to pure profits which are a surplus above the average cost of production. It is the
amount left with the entrepreneur after he has made payments to all factors of production, including
his wages of management. In other words, it is a residual income over and above his normal profits.
The profit maximisation condition of the firm can be expressed as:
Maximise (Q)
Where (Q)=R (Q)-C (Q)
Where (Q) is profit,
R (Q) is revenue,
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Given these assumptions, the profit maximising model of firm can be shown under perfect competition
and monopoly.
1. Profit Maximisation under Perfect Competition Firm:
Under perfect competition, the firm is one among a large number of producers. It cannot influence
the market price of the product. It is the price-taker and quantity-adjuster. It can only decide about
the output to be sold at the market price. Therefore, under conditions of perfect competition, the MR
curve of a firm coincides with its AR curve.
The MR curve is horizontal to the X-axis because the price is set by the market and the firm sells its
output at that price. The firm is thus in equilibrium when MC= MR= AR (Price). The equilibrium of
the profit maximisation firm under perfect competition is shown in Figure 1 where the MC curve
cuts the MR curve first at point A.
MC
A B
AR
= MR
O M M
Output
Figure 1
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It satisfies the condition of MC = MR, but it is not a point of maximum profits because after point A,
the MC curve is below the MR curve. It does not pay the firm to produce the minimum output when
it can earn larger profits by producing beyond
2. Profit Maximisation under Monopoly Firm:
There being one seller of the product under monopoly, the monopoly firm is the industry itself.
Therefore, the demand curve for its product is downward sloping to the right, given the tastes and
incomes of its customers. It is a price-maker which can set the price to its maximum advantage. But
it does not mean that the firm can set both price and output. It can do either of the two things.
If the firm selects its output level, its price is determined by the market demand for its product. Or,
if it sets the price for its product, its output is determined by what the consumers will take at that
price. In any situation, the ultimate aim of the monopoly firm is to maximise its profits.
The conditions for equilibrium of the monopoly firm are:
(1) MC = MR<AR (Price), and
(2) The MC curve cuts the MR curve from below.
In Figure 2, the profit maximising level of output is OQ and the profit-maximisation price is OP. If
more than OQ output is produced, MC will be higher than MR, and the level of profit will fall. If cost
and demand conditions remain the same, the firm has no incentive to change its price and output.
The firm is said to be in equilibrium.
A MC
P
B
D (AR)
MR
O Q
Output
Figure 2
Wealth maximisation
Wealth maximisation is the concept of increasing the value of a business in order to increase the
value of the shares held by its stockholders. The concept requires a management team to
continually search for the highest possible returns on funds invested in the business, while mitigating
any associated risk of loss. This calls for a detailed analysis of the cash flows associated with each
prospective investment, as well as constant attention to the strategic direction of the organisation.
example, if a company spends funds to develop valuable new intellectual property, the investment
community is likely to recognize the future positive cash flows associated with this new property
tions may occur if a business reports
continuing increases in cash flow or profits.
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source to run any organisation, it provides the money, and it acquires the money.
The finance function has been classified into three:
Long-term Finance: This includes finance of investment of three years or more. Sources of long-term
finance include owner capital, share capital, long-term loans, debentures, internal funds and so on.
Medium-term Finance: This is financing done between 1 to 3 years, and this can be sourced from
bank loans and financial institutions.
Short-term Finance: This is finance needed below one year. Funds may be acquired from bank
overdrafts, commercial paper, advances from customers, trade credit etc.
run.
For example, when the marketing department wants to launch a new campaign, the CFO may help to
ensure the campaign is feasible or give input on the funds available for the campaign.
The CFO may assist the CEO with forecasting, cost-benefit analysis, and obtaining funding for various
initiatives. In the financial industry, a CFO is the highest-ranking position, and in other industries, it is
usually the third-highest position in a company. A CFO can become a CEO, chief operating officer, or
president of a company.
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Emergence of the capital market at the center-stage of the financing system and the disappearance
of the erstwhile development/public financial/term lending ~institutions from the Indian financial
scene;
Emergence of highly articulate and. sophisticated money
Globalisation, convertibility of rupee, liberalised foreign resentments in India, Indian foreign
investment abroad;
Market-determined interest rate, emergence of highly innovative financial instruments:
Growth of mutual funds; credit rating, other financial services;
Rigorous prudential, credit risk management framework for banks and financial institutions;
Access 10 Euro-issues, American Depository Receipts (ADRs);
Privatization/Disinvestment of public sector undertakings.
Corporate finance is the division of finance that deals with how corporations deal with funding
sources, capital structuring, and investment decisions.
Corporate finance is primarily concerned with maximizing shareholder value through long and
short-term financial planning and the implementation of various strategies.
Corporate finance departments are charged with governing and overseeing their financial
activities and capital investment decisions.
Financial decisions refer to decisions concerning financial matters of a business firm.
There are many kinds of financial management decisions that the firm makers go in pursuit of
wealth, viz., kind of assets to be acquired, pattern of capitalisation,
distribution of income etc.
Investment decision relates to the determination of the total amount of assets to be held in the firm,
the composition of these assets and the business risk complexities of the firm as perceived by the
investors.
Capital budgeting is the process of making investment decisions in capital expenditure.
A finance manager has to select such sources of funds which will make optimum capital structure.
Liquidity and profitability are closely related. Obviously, liquidity and profitability goals conflict in
most of the decisions.
The financial management is generally concerned with procurement, allocation and control of
financial resources of a concern.
Profit maximisation is the capability of a business or company to earn the maximum profit with low
cost which is considered as the chief target of any business and also one of the objectives of financial
management.
Under perfect competition, the firm is one among a large number of producers.
There being one seller of the product under monopoly, the monopoly firm is the industry itself.
Therefore, the demand curve for its product is downward sloping to the right, given the tastes and
incomes of its customers.
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Wealth maximisation is the concept of increasing the value of a business in order to increase the
value of the shares held by its stockholders.
The finance function is a part of financial management. Financial management is the activity
concerned with the control and planning of financial resources.
A chief financial officer (CFO) is the senior executive responsible for managing the financial actions
of a company.
9.6 GLOSSARY
Corporate finance: The area of finance that deals with sources of funding
Financial decisions: A crucial decision that is to be made by the financial manager
Investment Decision: A decision regarding whether or not to purchase, sell, exchange, tender, or
pledge any trust property
Financing Decisions: Financing decision means from where a business wants to get financed (it
includes banks, financial institutions, shares, debentures etc)
The Challenge
Economic downturn impacted the asset prices, and the liquidity of the company. Over a period of time,
felt the need for an optimal allocation of its portfolio which would reduce the risk levels, meet target
returns, and provide sufficient liquidity. The client was also looking for developing effective and suitable
portfolio management strategies and in developing performance measurement standards.
Our Approach
We analysed the existing portfolio of the client, the strengths and weaknesses of the company, and the
current investment environment regionally, and globally. Further, AB sat with individual departmental
heads and asset managers, circulated questionnaires and assessed the feedback in terms of suitability
of the asset
After assessing the investment environment, returns expectations, risk capacity, liquidity requirements,
expertise, and other advantages and constraints, AB developed a framework for strategic and tactical
optimal asset allocation of its portfolio, and periodical rebalancing. In the strategic asset allocation,
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recommendations were made to increase its investment in Fixed Income Assets in order to meet the
liquidity of the company and also recommendations were made for the inclusion of additional asset
classes like commodities which would enhance the risk return tradeoff, and diversification of the
portfolio. The tactical asset allocation aimed at an optimal allocation amongst sectors across different
regions.
Conclusion
We assisted the client by developing portfolio management strategies and guidelines spanning from
investment screening, monitoring to exiting its investments. We also advised on adopting a synthetic
credit scoring mechanism for arriving at the appropriate fixed income asset pricing since a majority of
its fixed income assets were priced arbitrarily. Further, AB suggested appropriate benchmark against
which the investment performance should be analysed, and developed a mechanism for measurement
and attribution analysis of its investments and performance.
Questions
1. What is the importance of corporate finance?
(Hint: The main aim of corporate finance is to increase the shareholder values that help the managers
to be able to balance capital funding between investments in projects that increase the long-term
profitability and sustainability of a company.)
2. What are the major areas of finance?
(Hint: Finance consists of three interrelated areas: (1) money and credit markets, which deals with
the securities markets and financial institutions; (2) investments, which focuses on the decisions
made by both individuals and institutional investors)
3. What are the sources of finance?
(Hint: Sources of finance for business are equity, debt, debentures, retained earnings, term loans,
working capital loans, letter of credit, euro issue, venture funding etc. These sources of funds are
used in different situations.)
A. Essay-type Questions
1. What do you understand by corporate finance?
2. What are financial decisions?
3. Explain investment decision.
4. What do you understand by profit maximisation?
5. What is wealth maximisation?
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UNIT
Names of Sub-Units
Introduction to time value of money, concept of time value of money, concept of time lines and notation,
types of time value of money, present value of a perpetuity, intra-year compounding and discounting.
Overview
This unit begins by explaining the time value of money, it discusses the concept of time lines and
notation. The unit explains the types of time value of money. It also discusses the intra -year
compounding and discounting.
Learning Objectives
Learning Outcomes
10.1 INTRODUCTION
This chapter throws light on the concept of time value of money, which is the foundation of all financial
concepts related to money and its worth. It draws the importance of worth today as compared
to that in the future. It deals with the present value and the future value of an investment. The manner
of computation of time value of money enables one to distinguish between the worth of different
investments that yield returns to an investor at different points of time. The concepts detailed in this
chapter are of utmost importance because all other chapters of finance will expand on these basic
concepts. For instance, the time value of money forms the basis for all tools and techniques laid down
under capital budgeting decisions, such as net present value, profitability index, internal rate of return,
and so on. The chapter begins with an introduction to the concept of time value of money.
Thereafter, it discusses the procedure for computation of future values and present values of both single
cash flows and an annuity. Moreover, the concept of net present value is also described at the end of the
chapter.
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Cash Flows
0 1 2 3 4
Year
Figure 1: A Time Line for Cash Flows : $100 in Cash Flows Received
at the End of Each Year of Next 4 years
In the figure, 0 refers to right now. A cash flow that occurs at time 0 is therefore already in present
value terms and does not need to be adjusted for time value. A distinction must be made here between
a period of time and a point in time. The portion of the time line between 0 and 1 refers to period 1,
which, in this example, is the first year. The cash flow that occurs at the point in time 1 refers to the cash
flow that occurs at the end of period 1. Finally, the discount rate, which is 10 percent in this example, is
specified for each period on the time line and may be different for each period.
Had the cash flows been at the beginning of each year instead of at the end of each year, the time line
would have been redrawn as it appears in Figure 2.
Cash Flows
0 1 2 3 4
Year
Figure 2: A Time Line for Cash Flows : $100 in Cash Flows Received
at the Beginning of Each Year of Next 4 years
Note that in present value terms, a cash flow that occurs at the beginning of year two is the equivalent
of a cash flow that occurs at the end of year one. Cash flows can be either positive or negative; positive
cash flows are called cash inflows and negative cash flows are called cash outflows. For notati onal
purposes, we will assume the following for the chapter that follows:
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Here,
FVn = Future value
P0 = Principal amount
i = Interest rate per payment period =
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Annual rate of interest (r) / Number of payment periods per year (k)
n = Number of payment periods
(1 + i)n = Future value factor or compound value factor = FVIFi,n = Future value interest factor at i%
for n periods
Thus, FVn = P0 (1 + r/k)n
when compounding is done k times a year at an annual interest rate r.
FVn = P0(FVIFi,n)
The financial tables for computing the values of (1 + i)n at various rates of interest
for n number of periods is available in Appendix A (The Compound Sum of One
Rupee) Future value interest factor of ` 1 per period at i% for n periods, FVIFi,n.
Let us understand the concept of future value of cash flows with the help of some illustrations.
Illustration: Determine the amount of compound interest for an investment made with ` 15,000 at 6%
interest p.a. compounded half-yearly for a period of 6 years.
n 1 n 2 1 0
FVAn R 1 i R 1 i ....... R 1 i R 1 i
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Here,
FVAn = Future value of an annuity
R = Each periodic receipt or payment
N = Length of the annuity
We can say that the future value of an annuity is equal to the periodic receipt (R) times the total of
the future value interest factors at i% rate of interest for time periods ranging from 0 to n A shortcut
formula is as follows:
(1 i)n 1
FVAn R
i
Or
FVAn = R (FVIFAi, n )
where FVIFAi, n = Future value interest factor of an annuity at i% for n periods The financial tables for
computing the values of (1 + i)n -1 / i at various rates of interest for n number of periods is available
in Appendix C (The Compound Value of an Annuity of One Rupee) Future value interest factor of an
ordinary annuity of ` 1 per period at i% for n periods, FVIFAi, n. Let us understand this with the help of
a few illustrations.
Illustration: What would be the future amount of an annuity if the payment of ` 1,000 is made annually
for a period of 7 years at the rate of interest of 14% compounded annually?
Here, R = 1,000, n = 7, and i = 0.14
(1 i)n 1
FVAn R
i
FVn
P0
(1 i)n
Or
P0 = FVn (1 + i) -n
Here,
FVn = Future value n years hence from now
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R R R R
PVAn 1 2
....... n 1 n
1 i 1 i 1 i 1 i
1 1 1 1
R .......
(1 i)1 (1 i) 2 (1 i)n 1
(1 i)n
R PVIFi, 1 PVIFi, 2 PVIFi, 3 ..... PVIFi, n
R PVIFA i, n
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Here,
n PVA = Present value of an annuity
R = Each periodic receipt or payment
N = Length of the annuity
We can say that the present value of an
1
1 n
PVA n R 1 i
i
Or
PVAn = R (PVIFAi, n)
Where, PVIFAi,n = Present value interest factor of an annuity at i% for n periods.
1
1
1 i n
The financial tables for computing the values of at various rates of interest for n
i
number of periods is available in Appendix D Present value interest factor of an (ordinary)
annuity of ` 1 per period at i% for n periods, PVIFAi,n. Let us understand this with the help of
an illustration.
Illustration: You are required to calculate the present value of a 4-year annuity of ` 40,000
(periodically) which is discounted at the rate of 10 percent annually.
Solution: Here, i = 0.10, n = 4, R = ` 40,000
PVAn = R (PVIFAi, n)
By using financial tables, we get PVIFA0.10,4 = 3.170
Thus, PVA4 = 40,000(3.170)
= ` 1,26,800
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The value of perpetuity simply means the interest amount over the suitable discount rate. For
determining the present value of multi-period perpetuity, the following formula can be used:
R R R R
PVA .......
(1 i) (1 i)2
1
(1 i) 3
(1 i)
R R
n
n 1 (1 i) i
Where
R = the payment or receipt each period
i = the interest rate per payment or receipt period
Similarly, when perpetuity is characterised by a stream of cash flows which grows at a constant rate
forever, it is referred to as the growing perpetuity. For determining the present value of the growing
perpetuity, the following formula can be used:
Where
R = the payment or receipt each period
i = the interest rate per payment or receipt period
g = growth rate
Let us understand the computation of perpetuity value with the help of an illustration.
Mr Ram intends to retire and receive a sum of ` 6,000 per month. After his death, he wishes to render his
monthly payments to future generations. If an interest of 10% compounded annually is earned by him,
then compute the amount which he needs to apportion to achieve his perpetuity aim.
Here,
R = ` 6,000 and i = 0.10/12 = 0.00833
Substituting these values in the perpetuity formula, we get PVA = ` 6,000 ÷ 0.00833 = ` 7,20,288
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to know the future value of present money. Conversely, discounting is a way to compute the present
value of future money.
Present Future
Value Value
Intra-year Compounding
Up to this point, we generally have assumed that interest was calculated at the end of each year, based
on the principal balance at the beginning of the year and the annual interest rate. That is, we have
assumed that interest was compounded (or discounted) on an annual basis, and in solving problems, we
have used the annual compounding pages in AH 505.
Compounding interest more -
compounded on a semi-annual, quarterly, monthly, daily, or even continuous basis. When interest is
compounded more than once a year, this affects both future and present-value calculations.
With intra-year compounding, the periodic interest rate, instead of being the stated annual rate,
becomes the stated annual rate divided by the number of compounding periods per year. The number
of periods, instead of being the number of years, becomes the number of compounding periods per year
multiplied by the number of years.
Refer to the following table.
With monthly compounding, for example, the stated annual interest rate is divided by 12 to find the
periodic (monthly) rate, and the number of years is multiplied by 12 to determine the number of
(monthly) periods.
The major differences between compounding and discounting techniques in time value of money are as
follows:
Compounding technique
It is a process of calculating future value using the present investment.
It determines money gained by an investment.
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Discounting technique
It calculates future cash flows using the present value.
It determines the amount to be invested to get maximum future gains.
It is also called future value.
Discount rate.
It uses the present value/discounting factor.
Its formula is Pv=Fv/((1+r)^n).
Amount decreases in this method.
Left to right side (time line).
If the rate is low, then the present value will increase; if the rate is high, then the present value will
decrease.
The factors as to why money in the future is worth less than the same money derived now include
preference for present consumption, inflation and risk of uncertainty.
While compounding is the process of computing future values of cash flows, discounting is concerned
with finding out the present values of cash flows.
When compounding is done for more than once in a year, the effective interest rate or the actual
annualised interest rate shall be higher than the nominal or real rate of interest.
The future value of a lump sum amount or single cash flow means the value of such amount after a
particular period of time at the given interest rate.
An annuity is referred to as a stream of regular and periodic payments that are made or received
for a specific period of time.
The process of finding the present value (PV) of cash flows is exactly the reverse of finding the future
value (FV).
The difference between the present value of cash inflows and the present value of cash outflows
gives the net present value of a financial decision.
The time value of money is the widely accepted conjecture that there is greater benefit to receiving
a sum of money now rather than an identical sum later.
It may be seen as an implication of the later-developed concept of time preference.
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The future value of a lump sum amount or single cash flow means the value of such amount after a
particular period of time at the given interest rate.
An annuity is referred to as a stream of regular and periodic payments that are made or received
for a specific period of time.
The process of finding the present value (PV) of cash flows is exactly the reverse of finding the future
value (FV).
The present value of an annuity comes into picture when instead of a single cash flow, the cash flows
of the same amount are received over a specific number of years.
10.8 GLOSSARY
Cash flow: A movement of money, whether receipt or payment of amount, from one source to
another. It is generally used to determine a value or rate of return.
Financial decisions: A number of decisions concerning borrowing, investment and allocation of
funds in relation to the financial mix of a business firm.
Inflation: A quantitative measure of rise in the general level of prices, whereby a unit of currency
purchases less than it was capable of buying in the prior periods.
Annuity:A series of equal payments which occurs atequal intervals of time. Its specific characteristics
are that the payments equal each other as well as the interval between each one of them is the same.
Interest: The return available to those who supply funds to a firm. It is the price that is paid for the
use of loanable funds over a period of time.
Case Objective
The case study explains how to assess future value of deposits.
Mr Sahil, a salaried person, opened a bank account on 1st April, 2013, by making a deposit of ` 1,600.
He is considering evaluation of his investments and deposits to assess the worth of money invested
by him and interest earned thereon. The deposit account yielded him an interest @ 6% compounded
quarterly. In anticipation of making more investments, Mr Sahil closed his account in the bank on 1st
October, 2013. Besides, the proceeds of his earlier account, he added enough additional money required
to invest in a time deposit of a six-month period for ` 2,000. The time deposit earned him an interest @
6% compounded monthly. To make his investments fruitful, he approached a financial advisor to assist
him to find out the financial particulars concerning the present value and future value of deposits.
For this purpose, the financial advisor evaluated the additional amount that Mr Sahil invested on 1st
October, 2013, the maturity value of his time deposit as on April 1, 2014, and the total amount of interest
earned by him.
Given (1 + i)n = 1.03022500 where i = 1 (1/2) % and n = 2
Also, (1 + i )n = 1.03037751 where I = ½ % and n = 6
Questions
1. How much of additional amount did Mr Sahil invest on 1st October, 2013?
(Hint: Mr initial investment yielded interest for April-June and July-
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https://psu.instructure.com/courses/1806581/pages/introduction -what-is-time-value-of-money
https://www.siptolumpsum.net/2019/09/time-value-of-money.html
https://cleartax.in/s/time-value-money-tvm
https://www.fool.com/investing/how-to-invest/time-value-money/
https://khatabook.com/blog/what-is-time-value-of-money/
136
UNIT
Names of Sub-Units
Overview
This unit begins by explaining the meaning of long-term investment decisions, it discusses the, concept
of capital budgeting. Further, the unit explains the importance of capital budgeting. It also discusses
the process of capital budgeting.
Learning Objectives
Learning Outcomes
At the end of this unit, you would:
Assess the long-term investment decisions
Examine the importance of capital budgeting
Analyse the techniques of evaluating projects
Evaluate the concept of capital budgeting
11.1 INTRODUCTION
Long-term investment decision is referred to as the capital budgeting decision. It relates to the
investment in fixed assets, for example, buying a new machine. Before making the final decision, the
finance manager makes a comparative study of various alternatives available in the market based on
their cost and profitability.
These decisions are very important as they affect the earnings of the business in the long-run.
Factors affecting long-term investment decisions are:
Cash flow of the project: Cash flow of the project during the life of investment affects the long-term
investment decision. Series of cash receipts and payments over the life of investment have to be
carefully analysed before making a capital budgeting decision.
Rate of return of the project: The most important criterion is the rate of return of the project.
Investment yields return in the future. Thus, the calculation of returns is necessary to analyse the
best project.
Risk involved: With every investment proposal, there is some degree of risk involved. The company
must try to calculate the risk involved in every proposal and select a proposal with a moderate
degree of risk only.
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acquisition.
budgeting process.
Transfer of Information: The time that a project starts as an idea, it is accepted or rejected;
numerous decisions have to be made at various levels of authority. The capital budgeting process
facilitates the transfer of information to appropriate decision-makers within a company.
Difficulties of Investment Decision: The long-term investment decisions are difficult because it
extends several years beyond the current period. Uncertainty indicates a higher degree of risk.
Management loses its flexibility and liquidity of funds in making investment decisions so it must
consider each proposal very thoroughly.
Maximisation of Wealth: Long-term investment decision of the organisation helps in safeguarding
the interest of the shareholder in the organisation. If the organisation has invested in a planned
manner, the shareholder would also be keen to invest in that organisation. This helps in the
maximisation of wealth of the organisation. Any expansion is fundamentally related to further sales
and future profitability of the firm and assets acquisition decisions are based on capital budgeting.
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4. Selection and implementation: Expenditures are made and programmes are initiated after
identification, analysis, selection and approval.
5. Follow-up and review process: Outcomes are tracked and real costs and benefits are compared to
what was predicted. If actual results vary from those predicted, action may be taken.
and selection criteria, more emphasis will be put on one approach over another. Nonetheless, there are
common advantages and disadvantages associated with these widely used valuation methods.
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Where,
Co = PV of Cash outflow
C1, C2, C3.............. Cn = Cash Inflow
1, 2, .....n = Number of Years
r = Expected Rate of Return
(b) Substitute the value for r on the right-hand side, and calculate the value of the right-hand side
(c) If the value on the right-hand side is higher than the value on the left-hand side, then substitute a
higher value for r.
(d) If the value of the right-hand side is lower than the value on the left-hand side, then substitute a
lower value for r.
(e) Continue this till the value of the right-hand side is equal to the value of the left-hand side or arrive
at two values of r which will give a slightly higher value than the left-hand side and a slightly lower
value than the left-hand side.
(f) Put these two values of r in the following formula of interpolation and get the value of IRR:
NP Vat Lower Rate
IRR Lower Rate Higher Rate Lower Rate
NP Vat Lower Rate
Acceptance Criteria:
(a) Accept Project if IRR > Cut off rate
(b) Reject Project if IRR < Cut off rate
present value of cash inflows divided by the present value of cash outflows is shown. It is the ratio of the
present value of the earnings to the amount of investment. It is the variation of the NPV method. In case
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of projects with different investment sizes, the NPV method cannot be used. It is necessary to relate the
flows of investment in case of different investment sizes. This is done in PI Method.
Discounted Cash Inflow
Profitability Index
Discounted Cash Outflow
Discounted Cash Inflow
Payback period 100
Discounted Cash Outflow
Acceptance Criteria:
(a) Accept Project if PI 0 and reject the project if PI < 0
(b) In case of many projects, accept the project with the highest PI.
In case of uneven cash flows, the payback period can be found out by adding up the cash inflows until
the total is equal to the initial cash outlay.
Acceptance Rule:
(a) The project would be accepted, if its payback period is less than the maximum or standard payback
period set by the management.
(b) In case of selection from several projects, the project with the shortest period will be selected.
or not to take on a project because it assumes only one, upfront investment, and does not factor in the
time value of money.
Discounted Payback Period = Year Before the Discounted Payback Period Occurs + (Cumulative Cash
Flow in Year Before Recovery / Discounted Cash Flow in Year After Recovery)
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Acceptance Criteria:
(a) A project with ARR above the expected level will be accepted
(b) In case of more than two projects, a project with Highest ARR will be ranked first, and so on.
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Some transactions, such as the sale of an item of plant, may give rise to a gain or loss which is included
in the determination of net profit or loss. However, the cash flows relating to such transactions are
cash flows from investing activities.
2. Cash Flows from Investing Activities: Investing activities are the acquisition and disposal of long-
term assets and other investments not included in cash equivalents. The separate disclosure of cash
flows arising from investing activities is important because the cash flows represent the extent to
which expenditures have been made for resources intended to generate future income and cash
flows.
Examples of cash flows arising from investing activities are:
a. Cash payments to acquire fixed assets (including intangibles). These payments include those
relating to capitalised research & development costs and self-constructed fixed assets;
b. Cash receipts from disposal of fixed assets (including intangibles);
c. Cash payments to acquire shares, warrants or debt instruments of other enterprises and
interests in joint ventures (other than payments for those instruments considered to be cash
equivalents and those held for dealing or trading purposes);
d. Cash receipts from disposal of shares, warrants, or debt instruments of other enterprises and
interests in the joint venture (other than receipts from those instruments considered to be cash
equivalents1 and those held for dealing or trading purposes);
e. Cash advances and loans made to third parties (other than advances and loans made by a
financial enterprise);
f. Cash receipts from the repayment of advances and loans made to third parties (other than
advances and loans of a financial enterprise);
g. Cash payments for future contracts, forward contracts, option contracts and swap contracts
except when the contracts are held for dealing or trading purposes or the payments are classified
as financing activities; and
h. Cash receipts from futures contracts, forward contracts, option contracts and swap contracts
except when the contracts are held for dealing or trading purposes or the receipts are classified
as financing activities.
3. Cash Flows from Financing Activities: Financing activities are activities that result in changes in
the size and composition of the capital (including preference share capital in the case of
a company) and borrowings of the enterprise. The separate disclosure of cash flows arising from
financing activities is important because it is useful in predicting claims on future cash flows by
providers of funds (both capital and borrowings) to the enterprise.
Examples of cash flows arising from financing activities are:
(a) Cash proceeds from issuing shares or other similar instruments:
(b) Cash proceeds from issuing debentures, loans, notes, bonds and other short-or long-term
borrowings; and
(c) Cash repayments of amounts borrowed, such as redemption of debentures, bonds preference
shares.
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Capital Budgeting is the art of locating assets that are worth more than they cost to accomplish a
predetermined target, such as maximising a wealth.
A capital investment decision entails a mostly permanent commitment of money, which is usually
fraught with danger.
Capital budgeting is a decision-making mechanism by which businesses assess the acquisition of
large fixed assets, such as buildings, machinery and equipment.
Time and effort are needed for project analysis. The costs of this exercise must be justified by the
advantages that it provides.
These investments aim to increase capacity and/or expand the distribution network.
Any group of projects that are mutually exclusive means that choosing one eliminates the possibility
of the others.
When we have mutually exclusive projects, our decision rules must not only determine whether a
project is good or bad but also rate which project is the better.
Capital budgeting is the process of assessing and selecting long-term assets based on their costs and
expected returns.
The long-term investment decision is referred to as the capital budgeting decision. It relates to the
investment in fixed assets, for example, buying a new machine.
As part of the long-range planning, process decision is taken on the programme, the organisation
will undertake and the appropriate resources that will be allocated to each programme over the
next few years.
Capital budgeting is the art of locating assets that are worth more than they cost to accomplish a
predetermined target, such as maximising a wealth.
When a firm is presented with a capital budgeting decision, one of its first tasks is to determine
whether or not the project will prove to be profitable.
The payback period (PB), internal rate of return (IRR) and net present value (NPV) methods are the
most common approaches to project selection.
cash inflows and the present value of cash
outflows is known as the net present value or NPV.
The internal rate of return, or IRR, is the average rate of return on investment throughout its useful
life.
The profitability index, or PI, is the ratio of an in net present value to its cost of capital.
A Cash Flow Statement is a statement that is prepared by acquiring Cash from different sources and
the application of the same for different payments throughout the year.
11.6 GLOSSARY
Capital budgeting: Planning and deployment of available capital to maximise long-term profitability
of the firm
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Capital rationing: The allocation of the limited funds available for financing the capital projects
to only some of the profitable projects in such a manner that the long-term returns are maximised
Risk-free rate: The rate at which the future cash flows of a project which is not subjected to risk are
discounted
Risky investment: Variability that is likely to occur between the estimated returns and the actual
returns
Case Objective
This Case Study discusses how the long-term effects of capital budgeting helped to decide Mr. Amit to
buy Mrida Motors or not.
Amit, who holds an ITI diploma, has worked for Mrida Motor and Supreme Garage for the past ten
number of clients picked Amit to fix their vehicles. After three years, he was promoted to supervisor. Amit
and would assist Supreme owner, Mr. Gupta, in keeping a record of the accounts.
Mr. Gupta admired him greatly, and Amit was elevated to manager of Mrida Motors and Supreme
Garage two years ago. When Gupta retired from the Indian Army owing to a leg injury 18 years ago, he
started this firm. Mrida Motors and Supreme Garage had a solid reputation and was known as the top
motor garage in the district due to good customer relations and quality service.
A large number of customers from the surrounding area would bring their vehicles to Supreme Garage.
The shop specialised in engine overhauling. There was an electrical department for auto electrical and
an Exide battery agency. Mrida Motors specialised in denting and painting and had good insurance
relations. It has its tow vehicle and did well in the event of accidents or breakdowns. It presently
employed ten full-time mechanics, one supervisor besides Amit and Gupta who were manager and the
owner, respectively. Workers worked overtime during peak season and extra casual labour was brought
in to meet delivery requirements. Mrs. Gupta has been in poor health for the past year. Six months ago,
she had a minor heart attack. Mrs. and Mr. Gupta decided to go to the United States to be closer to their
daughter, a Cardiologist in Los Angeles. Gupta opted to sell the company because he had no one to
succeed him.
He wishe
image. He contacted Amit and offered to purchase his business. The initial offer was for 57.50 lakh
rupees. He also suggested supporting Amit with the finance of the acquisition. Gupta provided him with
five-
profit and loss records as of March 31, 2000, were also sent to him. He phoned Amit and told him that
based on the business flow, he valued the goodwill at 15 lakh rupees. Amit was excited about the offer.
He was well aware that the business was incredibly prosperous, with profits constantly increasing over
time. It has never been in a bad position before. He sought advice from a friend who was both a banker
and a Chartered Accountant. He advised him otherwise. He knew there was a scope of negotiation over
the price of the business. Now, Mrida Motors needs assistance.
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ANNEXURE 1
RNS MOTORS
Balance sheet (As on 31.03.2000)
Liabilities `
Capital 16,00,000
Retained profits 18,10,880
Building loan 26,99,200
Term loan 12,16,000
Current liabilities 8,14,400
Total liabilities 81,40,480
Assets
Gross block 66,56,000
Depreciation 14,22,720
Net blocks (at the end) 52,33,280
Current assets
Stocks 6,65,600
Receivables 13,31,200
Cash in hand 9,10,400
Total current assets 29,07,200
Total assets 81,40,440
Depreciation Schedule
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RNS MOTORS
Profit & Loss Account (for the year ending 31.03.2000)
Questions
1. If you were the banker, will you finance?
(Hint: yes, after comparing P&L account and balance sheet of RNS Motors)
2. How would you evaluate the goodwill of RNS Motors.
(Hint: evaluate all assets and liabilities of RNS Motors)
2. Capital budgeting is the art of locating assets that are worth more than they cost to accomplish a
Budgeting
3. The capital budgeting process is a decision-making mechanism by which businesses assess the
acquisition of large fixed assets, such as buildings, machinery and equipment. It also includes
decisions to buy other companies, either through the acquisition of their common stock or a
collection of assets that can be used to run a company. Refer to Section Concept of Capital Budgeting
4.
The present value of cash inflows divided by the present value of cash outflows is shown. Refer to
Section Techniques of Evaluating Projects
https://www.investopedia.com/articles/financial-theory/11/corporate-project-valuation-methods.
asp
https://cleartax.in/s/capital-budgeting
https://www.accountingtools.com/articles/what-is-capital-budgeting.html
https://corporatefinanceinstitute.com/resources/knowledge/finance/capital-budgeting-best-
practices/
https://ift.world/booklets/corporate-finance-capital-budgeting-part1/
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UNIT
Cost of Capital
Names of Sub-Units
Introduction to Cost of Capital, Concept of Cost of Capital, Concept of Measurement of Cost of Capital,
Computation of Overall Cost of Capital, Cost of Capital Practices in India.
Overview
This unit begins by explaining the meaning of cost of capital, it discusses the concept of cost of capital.
The unit explains the measurement of cost of capital. It also discusses the computation of overall cost
of capital.
Learning Objectives
Learning Outcomes
12.1 INTRODUCTION
The cost of capital is the cost incurred to an organisation when it raises capital from different sources.
Capital is raised for different purposes. For example, for building a factory, paying off an old debt,
expansion of business, etc. The overall cost of capital for an organisation is usually calculated by finding
cost of capital is also used by firms internally to analyse the capital structuring and reduce the costs or
project the targeted revenues to be earned to cover the cost. Cost of capital depends on the source of the
finance used. Capital can be raised by issuing equity shares or preference shares or by taking debts or
issuing debentures.
Mostly, organisations use a combination of equity, preference and debts to finance their capital
requirements. They do not depend only on one source of finance. Therefore, the overall cost of capital
is calculated using the weighted average cost of all the capital sources which is also known as WACC.
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For instance, when a firm uses its bank deposit for business purposes which earn an interest of 9.5% p.a.,
it forgoes the interest earnings from the bank on this deposit. The implicit cost of capital, in this case,
shall be 9.5% interest that could have been earned by not using the deposit for business purposes.
Cost of capital for each source of finance can be determined separately, such as cost of equity, cost of
preference share capital, cost of long-term debt and cost of retained earnings. In the following sections,
we will discuss the cost of each source of capital.
Cost of Debentures
The capital structure of a firm normally includes debt capital. Debt may be in the form of debentures
bonds, term loans from financial institutions and banks etc. The amount of interest payable for issuing
debentures is considered to be the cost of debenture or debt capital (Kd). The cost of debt capital is much
cheaper than the cost of capital raised from other sources, because interest paid on debt capital is tax
deductible.
The cost of debenture is calculated in the following ways:
(i) When the debentures are issued and redeemable at par: Kd = r (1 t)
where Kd = Cost of debenture
r = Fixed interest rate
t = Tax rate
(ii) When the debentures are issued at a premium or discount but redeemable at par
Kd = I/NP (1 t)
where, Kd = Cost of debenture
I = Annual interest payment
t = Tax rate
Np = Net proceeds from the issue of debenture.
(iii) When the debentures are redeemable at a premium or discount and are redeemable after period:
Kd
I(1-t)+1/N(Rv NP) / ½ (RV NP)
where Kd = Cost of debenture.
I = Annual interest payment
t = Tax rate
NP = Net proceeds from the issue of debentures
Ry = Redeemable value of debenture at the time of maturity
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(ii) Earnings/Price Ratio Method: This method takes into consideration the Earnings per Share (EPS)
and the market price of share. Thus, the cost of equity share capital will be based upon the expected
rate of earnings of a company. The argument is that each investor expects a certain amount of
earnings whether distributed or not, from the company in whose shares he invests.
If the earnings are not distributed as dividends, it is kept in the retained earnings and it causes
future growth in the earnings of the company as well as the increase in market price of the share.
Thus, the cost of equity capital (Ke) is measured by:
Ke = E/P where E = Current earnings per share
P = Market price per share.
If the future earnings per share will grow at a constant rate then cost of equity share capital (Ke)
will be
Ke = E/P+ g.
This method is similar to dividend/price method. But it ignores the factor of capital appreciation
or depreciation in the market value of shares. Adjustment of Floatation Cost There are costs of
floating shares in market and include brokerage, underwriting commission etc. paid to brokers,
underwriters etc.
These costs are to be adjusted with the current market price of the share at the time of computing
cost of equity share capital since the full market value per share cannot be realised. So, the market
price per share will be adjusted by (1 f) where stands for the rate of floatation cost.
Thus, using the earnings growth model the cost of equity share capital will be:
Ke = E / P (1 f) + g
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Particular (`)
14% Debentures 30,000
11% Preference shares 10,000
Equity Shares (10,000 shares) 1,60,000
2,00,000
The company share has a market price of ` 23.60. Next year dividend per share is 50% of year 2017 EPS.
The following is the trend of EPS for the preceding 10 years which is expected to continue in future.
The company issued new debentures carrying 16% rate of interest and the current market price of
debenture is ` 96.
Preference shares ` 9.20 (with annual dividend of ` 1.1 per share) were also issued. The company is in
50% tax bracket.
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Solution:
(A) (i) Cost of new debt
I 1 t
Kd =
P0
16 1 0.5
=
96
= 0.0833
(ii) Cost of new preference shares
PD
=K =
p P0
1.1
=
9.2
= 0.12
(iii) Cost of new equity shares
D1
=K = +g
e
P0
1.18
= 0.10
23.60
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(C) The company can spend the following amount without increasing marginal cost of capital and
without selling the new shares:
Retained earnings = (0.50) (2.36 × 10,000) = ` 11,800
The ordinary equity (Retained earnings in this case) is 80% of total capital
11,800 = 80% of Total Capital
11,800
Capital investment before issuing equity = = ` 14,750
0.80
(D) If the company spends in excess of ` 14,750 it will have to issue new shares.
1.18
Capital investment before issuing equity= 0.10 = 0.159
20
each category of capital weighted in different proportions. In the calculation of WACC, all the sources of
capital such as common stock, preferred stock, bonds, other long-term debt, etc. are included. To arrive
at the WACC, the cost of each source of capital is multiplied by its proportion in the total capital. Let us
now consider an example to understand the concept of WACC.
Assume that a company generates funds by issuing debentures and equity shares. On loan capital,
it pays interest, and on equity capital, it pays a dividend. The WACC is calculated by adding the total
interest paid on debt capital to the total dividend paid on equity capital.
The WACC is calculated using the following formula:
Weighted average cost of capital = (KE × E) + (KP × P) + (KD × D) × (1-T) + (KR × R)
Where
E = Proportion of equity capital in the capital structure
P = Preference capital proportion in capital structure
D = Debt capital proportion in capital structure
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Source of Capital Amount (`) Weight (W) Specific cost of capital W*CC
Equity Shares 20,00,000 1.10 0.20 0.110
10% Preference Share 4,00,000 0.22 0.20 0.022
10% Debentures 12,00,000 0.66 0.10 0.0230
Total 36,00,000 0.1550
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= 11.2%
Cost of preference share = (D/NP) × 100
KP = {10/ (2000 100)} × 100
= 2.10%
Cost of equity capital = [(D/MP) + G] × 100
KE = 1(10/200) + 0.20) × 100
= 60%
(`)
Debentures (` 100 per debenture) 5,00,000
Preference shares (` 100 per share) 5,00,000
Equity shares (` 10 per share) 10,00,000
20,00,000
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The next year expected dividend is ` 1 with annual growth of 5%. The firm has practice of paying all
earnings in the form of dividend.
Corporate tax rate is 30%. Use YTM method to calculate cost of debentures and preference shares.
You are required to calculate the WACC using the above information by using:
(a) Book value weights
(b) Market value weights
Solution:
(i) Cost of Equity (Ke)
D1
= g
P0 F
1
= 0.05
24 4
= .01 or 10%
(ii) Cost of Debt (Kd)
Current market price (P0) floatation cost = I(1-t) × PVAF(r,10) + RV × PVIF(r,10)
` 105 4% of ` 105 = ` 10(1-0.3) × PVAF (r,10) + ` 100 × PVIF (r,10)
Year Cash flows (`) Discount factor @ 5% Present Value Discount factor @ 7% Present Value (`)
0 100.8 1.000 (100.8) 1.000 (100.8)
1 to 10 7 7.722 54.05 7.024 49.17
10 100 0.614 61.40 0.508 50.80
NPV +14.65 -0.83
Calculation of IRR
14.65
IRR = 5 % + (7% 5%)
14.65 0.83
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14.65
5%+ (7% 5%)
15.48
Year Cash flows (`) Discount factor @ 3% Present Value Discount factor @ 5% Present Value (`)
0 107.8 1.000 (107.8) 1.000 (107.8)
1 to 10 5 8.530 42.65 7.722 38.61
10 100 0.744 74.40 0.614 61.40
NPV +9.25 -7.79
Calculation of IRR
9.25
IRR = 3% + (5% 3%)
9.25 7.79
9.25
3%+ (5% 3%)
17.04
= 4.08%
(a) Calculation of WACC using book value weights
Source of capital Book Value Weights After tax cost of capital WACC (Ko)
(`) (a) (b) (c) = (a)×(b)
10% Debentures 5,00,000 0.25 0.0689 0.01723
5% Preference shares Equity shares 5,00,000 0.25 0.0408 0.01020
10,00,000 0.50 0.10 0.05000
20,00,000 1.00 0.07743
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The cost of capital is defined as the cut-off rate or the minimum rate of return that is required from
an investment.
For an investor, it is relevant to note that an investment can bring-in gains only when the rate of
return on investment is greater than the cut-off rate or the cost of capital.
The cost of capital forms the basis of fixing discount rate which is the rate at which future cash flows
are discounted to determine the present values of future cash flows.
Some of the important factors that affect capital cost of capital are market opportunity, capital
preferences, risk and inflation.
The cost of capital is usually categorised into four types including cost of equity, cost of debt, cost of
preference shares and cost of retained earnings.
The cost of equity capital refers to the cost of using the capital of equity shareholders in the business.
In other words, the rate of return a corporation pays to shareholders is known as the cost of equity.
The cost of equity can be determined using various methods such as dividend price approach, price
approach, growth approach, realised yield approach and the Capital Asset Pricing Model (CAPM)
Approach.
According to the CAPM, the cost of equity is calculated as:
Ke = Rf + (E(Rm) Rf )
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Where,
Ke = Cost of Equity
Rf = Risk free rate
= Beta of stock/company
E (Rm) Rf = Equity Risk premium
An investment beta is a reflection of its return volatility in comparison to the total industry.
Retained earnings are profit reserves held by companies that are not distributed as dividends. These
are preserved to fund a long-term and short-term activities.
The cost of preference capital is the amount of dividend payable on them and expenses incurred for
raising preference shares.
The entire cost or rate of interest paid by an organisation when raising debt capital is referred to as
cost of debt capital.
The Weighted Average Cost of Capital (WACC) refers to an overall cost of capital in
which each category of capital weighted in different proportions. To arrive at the Weighted Average
Cost of Capital (WACC), the cost of each source of capital is multiplied by its proportion in the total
capital.
12.7 GLOSSARY
Debentures: A type of debt instrument used by organisations to raise money for medium to long
term at a fixed rate of interest
Expected growth rate: The rate at which a particular investment is expected to grow during a
particular period of time.
Specific cost of capital: The cost of capital of each component of capital using in the overall financing
of a company
Weighted average: The type of average that is calculated by summing the products of each
observation by its assigned weight
Case Objective
This Case Study highlights how researchers collected data and carried out an analysis of the cost of
debt, cost of equity and the Weighted Average Cost of Capital (WACC) of 13 major sectors in India.
In December 2020, the RBSA Advisors conducted a study related to sectoral analysis of the cost of capital
in India. They studied the following 13 sectors:
1. Automobile & Ancillaries 7. Infrastructure
2. Capital Goods 8. Metals & Mining
3. Cement 9. Oil & Gas
4. Chemicals 10. Pharmaceuticals
5. Consumer Durables 11. Power
6. FMCG 12. Realty
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13. Telecom
For the purpose of this study and to find out the cost of capital, the researchers took a sample size of 135
companies listed on NSE. 42 sectors were identified but only 13 sectors were selected. These 13 sectors
represent approximately 56.0% of the total market capitalisation. These sectors so not include the BFSI
and IT sectors which constitute approximately 22.0% and 14.3% of Market capitalisation.
For all the 13 sectors, the researchers selected the top 10 companies (and 15 companies in case of
pharmaceuticals sector) of every sector which represents 67% to 99% of the market Cap of the overall
sector.
Source: https://rbsa.in/archives_of_research_reports/RBSA-Advisors-Cost-of-Capital-in-India-4th-Edition-December2020.pdf
For conducting the sectoral analysis, the researchers adopted the following methodology:
The researchers list all the companies as per the criterion mentioned.
The researchers obtained data related to debt, interest costs, beta and market cap from Capital IQ.
Kd is used for analysis is pre-tax Kd (Pre-tax Kd = Cost of Debt before tax)
The Kd is determined by dividing the Interest Cost of Last Twelve Months (LTM) with the average of
the outstanding debt of the respective companies as on Sep 30, 2020 and Sep 30, 2019.
The post-tax Kd is arrived at by reducing the tax impact from the pre-tax Kd. For the purpose of
analysis, a tax rate of 34.94% was assumed (Post-tax Kd = Cost of Debt after tax)
Ke is calculated using CAPM. The beta is regressed over three years i.e., Oct 1, 2017 - Sep 30, 2020. (Ke
= Cost of Equity)
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The researchers considered an annualized yield of 10-year zero coupon bond as on Sep 30, 2020
issued by the GOI to be the risk-free rate.
The researchers used the equity risk premium at 7%
Weighted Average Cost of Capital (WACC) was calculated by assigning weights to Debt and equity
The pre-tax Kd, Ke and WACC across the 13 sectors were recorded as:
The weighted average Kd, Ke and WACC across the 13 sectors are shown as:
18.0%
16.0%
14.0%
12.0%
10.0%
8.0%
6.0%
4.0%
2.0%
0.0%
Automobile Capital Cement Chemicals Consumer FMCG Infrastructure Metals Oil & Pharmaceuticals Power Realty Telecom Median
& Ancillaries Goods Durables & Gas
Mining
Source: https://rbsa.in/archives_of_research_reports/RBSA-Advisors-Cost-of-Capital-in-India-4th-Edition-December2020.pdf
After a thorough analysis, the researchers represented all the major 13 sectors using pie charts. For
each sector, the pie charts show the total number of companies analysed for different ranges of Kd, Ke
and WACC. For example, for automobiles and ancillaries,
2
3
2
3
Pre-tax Kd
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1
3
3
3
Ke
1
1
3
WACC
An analysis of the top 10 companies revealed that the range of WACC for top 10 firms is 11.7% to 15.4%.
Similar pie charts were drawn for all the 12 other sectors.
Some of the important research findings are as follows:
The median Kd (pre-tax), Ke and WACC for these 13 sectors is 8.3%, 12.2%, and 10.8% respectively.
The cost of equity, and consequently the overall cost of capital has reduced due to the surge in
market.
Questions
1. Which sector has the minimum K d?
(Hint: FMCG sector Kd = 6.2%)
2. Which sector has the minimum WACC?
(Hint: Power sector WACC = 7.9%)
A. Essay-type Questions
1. What is cost of capital?
2. Write a short note on cost of retained earnings.
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3. What is WACC?
4. Write a short note on cost of capital practices in India.
https://tallysolutions.com/accounting/cost-of-capital/
https://tallysolutions.com/accounting/cost of-capital/
https://corporatefinanceinstitute.com/resources/knowledge/finance/cost-of-capital/
https://corporatefinanceinstitute.com/resources/knowledge/finance/cost
https://hbr.org/2015/04/a-refresher-on-cost-of-capital
refresher-
https://dducollegedu.ac.in/Datafiles/cms/ecourse%20content/BMS-%20Cost%20of%20Capital.pdf
https://dducollegedu.ac.in/
https://dducollegedu.ac.in/Datafiles/cms/ecourse%20content/BMS
Datafiles/cms/ecourse%20content/BMS
174
UNIT
Names of Sub-Units
Overview
This unit begins by explaining the meaning of working capital management, it discusses the concept
of working capital management. The unit explains the concept of factors influencing working capital
management. It also discusses the meaning of working capital financing and concept of inventory
management.
Learning Objectives
Learning Outcomes
13.1 INTRODUCTION
Working capital management is significant in financial management due to the fact that it plays a
vital role in keeping the wheel of the business running. Every business requires capital, without which
it cannot be promoted. Investment decision is concerned with investment in current assets and fixed
assets. There are two assets required to be financed by fixed capital and working capital. In other words,
the required capital can be divided into two categories, such as fixed capital and working capital. Fixed
capital required for establishment of a business, whereas working capital required to utilise fixed assets.
Fixed assets cannot be utilised without current assets. It is just like a blood in the human body, without
which there is no body.
From the point of view of time, the term, working capital, can be divided into two categories:
1. Permanent: It is also referred as hard-core working capital. It is the minimum level of investment
in the current assets that is carried by the business at all times to carry out maximum level of its
activities. It should be financed by long-term sources.
2. Temporary working capital: It refers to that part of working capital, which is required by the
business over and above permanent working capital. It is also called variable working capital. Since
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the quantum of temporary working capital keeps on fluctuating from time-to-time depending on
the business activities, at may be financed from short-term sources.
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Dividend Policy: Payment of dividend utilises cash while retaining profit acts as a source of working
capital. Thus, working capital gets affected by dividend policies.
Operating Efficiency: Efficient and coordinated utilisation of capital reduces the amount required
to be invested in working capital.
Price Level Charges: Inflationary trends in the economy necessitate more working capital to
maintain the same level of activity.
Depreciation Policy: Depreciation charges do not involve any cash outflow. The effect of depreciation
policy on working capital is, therefore, indirect. In the first place, depreciation affects the tax liability
and retention of profits and on dividend.
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about the sale and the factor is responsible for collection. Receivables may be sold on a recourse
or non-recourse basis. Spot factoring is the sale of a single invoice rather than all of a
receivables. Accounts receivable factoring is also referred to as invoice factoring.
Invoice Discounting: Invoice discounting is the assignment of accounts receivable to a third-party
as collateral for a loan. The customer is not usually notified about the assignment and the company
remains responsible for collection. The company receives a loan similar to the way it would with a
revolving line of credit.
Purchase Order Financing: Purchase order financing or PO financing, is an advance given to your
supplier by a lender for goods your company needs to fulfill a customer order. The customer then
makes its payment directly to the lender. After deducting the amount of its loan and fees, the lender
sends the remainder to your company. PO financing provides capital to fulfill large orders that you
might not be able to finance otherwise.
Trade Finance: Trade finance facilitates international trade by transferring to a third-party the risk
that an exporter will not receive payment, or an importer will not receive its goods. There are many
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forms of trade finance including letters of credit, bank guarantees, asset-based loans, accounts
receivable factoring and purchase order financing.
Customer Advances: Customer advances are cash payments received before a company provide
goods or services to its customer. These advances provide an important source of - working
capital financing. Of course, the company incurs an obligation to provide the goods or services to
the customer in the future, which is usually recognised as a deferred revenue liability on its balance
sheet.
Vendor Credit: Vendor credit enables you to wait a specified period of time before paying for goods
or services provided by a supplier or vendor. Payment terms may offer a discount for paying early
or a penalty for paying late. Some vendors offer extended terms to select customers, which provide
a longer than normal period before payment is due.
MRR Line of Credit: An MRR line of credit is a loan facility in which the amount available for
-as-a-service (SaaS)
companies have minimal accounts receivable because customers pay up front and no inventory
because they sell a service rather than the product. However, SaaS companies have recurring
revenue that lenders view as an asset that, in effect, can provide a collateral base for a loan.
Merchant Cash Advances: Merchant cash advances (MCA) are upfront payments that you receive
in exchange for a percentage of your future daily credit/debit card receipts. An MCA is not a loan
but a sale of future revenue. This is expensive financing but might be the best bet for a business with
limited or poor credit history that also processes a lot of credit card transactions.
Operating Cycle
Raw material >>> Work-in-Process >>> Finished Goods >>> Accounts Receivable >>> Cash
This cycle of raw material conversion to cash is called operating or working capital cycle. In terms of
time, it is the time taken after the purchases of raw material till its translation into cash. The total of
inventory holding period and a receivable collection period of a firm is the operating cycle time of that
firm.
Operating cycle and cash operating cycle are used interchangeably but a misconception. They are
different by a small margin but that makes a big difference.
collection period. It is the time period for which the working capital is required.
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Or, Operating Cycle = Raw Material Holding Period + Work-in-process Period + Finished Goods Holding
Period + Receivable Collection Period
Or, Cash Operating Cycle = Raw Material Holding Period + Work-in-process Period + Finished Goods
Holding Period + Receivable Collection Period Payment Period
Suppose $500 Dollar worth of inventory is purchased from a supplier on 20 days credit and it was sold
after 40 days of purchasing it. The credit of 40 days is given to the buyer. The buyer paid on completion
of the credit period.
Here,
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Debtor
Sales
Cash
Finished Goods
Raw Materials
Work-in-Process
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In other words, the time period between the dates from when pays it suppliers to the date till it receives
the cash from its customers.
Calculation of Cash Conversion Cycle (CCC)
CCC = OC APP
where, OC = Operating Cycle
APP = Accounts Payable Period
OC = AAI + ARP. AAI = Average Age of Inventory
ARP = Account Receivables Period.
From the financial statements, it can be determined as the constituents of Cash Conversion Cycle, i.e.,
AAI, ACP, APP:
Average Inventory
AAI
Cost of Gold Sold/365
Average Accounts Receivable
ARP
Annual Sales/365
Average Accounts Payables
APP
Cost of good sold/365
manage the current assets, current liabilities and their inter-relationship that exists between them. If
a firm cannot maintain a satisfactory level of working capital, it is likely to become insolvent and may
even be forced into bankruptcy.
The concept of working capital has been a matter of great controversy, among the financial wizards
and they view it differently. There is no universally accepted definition of working capital. Broadly, there
are two concepts of working capital commonly found in the existing literature of finance such as:
1. Gross Working Capital (Quantitative Concept) and
2. Net Working Capital (Qualitative Concept).
Both these concepts of working capital have operational significance. The two concepts are not to be
regarded as mutually exclusive. Each has its relevance in specific situations from the management
point of view.
Each concept of working capital has its own significance
the the an integration of both these concepts is necessary to understand working
capital management in the context of risk, return and uncertainty.
Gross Working Capital Concept: According to this concept, the total current assets are termed
as the gross working capital or circulating capital. Total current assets include; cash, marketable
securities, accounts receivables, inventory, prepaid expense, advance payment of tax, etc. This
concept also called as or broader To quote Weston and Brigham,
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securities,
assets and their financing. According to Walker, of this concept is helpful in providing for the
current amount of working capital at the right time so that the firm is able to realise the greatest
return on The supporters of this concept, like Mead, Field, and Baker and Malott, argue
that the management is very much concerned with the total current assets as they constitute the
total funds available for operating process.
Net Working Capital Concept: As per this concept, the excess of current assets over current liabilities
represents net working capital. Similar view is expressed by Guthmann and Dougall, Gerstenberg,
Goel, Park
Stevens, fully supported this concept and viewed that the net working capital helps creditors and
investors to judge the financial soundness of a firm.
Net Working Capital Concept represents the amount of the current assets, which would remain after
all the current liabilities were paid. It may be either positive or negative. It will be positive, if current
assets exceed the current liabilities and negative, if the current liabilities are in excess of current assets.
13.7.1 EOQ
Economic order quantity (EOQ) is the ideal order quantity a company should purchase to minimise
inventory costs such as holding costs, shortage costs, and order costs. This production-scheduling
model was developed in 1913 by Ford W. Harris and has been refined over time. The formula assumes
that demand, ordering and holding costs all remain constant. The formula for EOQ is:
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2DS
Q
H
where:
Q = EOQ units
D = Demand in units (typically on an annual basis)
S = Order cost (per purchase order)
H = Holding costs (per unit, per year)
13.7.2 JIT
Just In Time inventory is the reduced amount of inventory owned by a business after it installs a just- in-
time manufacturing system. The intent of a JIT system is to ensure that the components and sub-
assemblies used to create finished goods are delivered to the production area exactly on time. Doing
so eliminates a considerable investment in inventory, thereby reducing the working capital needs of a
Working capital management is significant in financial management due to the fact that it plays a
vital role in keeping the wheel of the business running.
Every business requires capital, without which it cannot be promoted.
Investment decision is concerned with investment in current assets and fixed assets.
Working capital refers to the funds invested in current assets, i.e., investment in sundry debtors,
cash and other current assets.
Current assets are essential to utilise facilities provided by plant and machinery, land and buildings.
The gross working capital refers to investment in all the current assets taken together.
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In some organisations, the sales are mostly in cash basis and the operating cycle (explained) later
is also short.
Working capital requirements also fluctuate according to production policy adopted by the company.
A company, which allows liberal credit to its customers, may have higher sales, but consequently
will have larger amount of funds tied up in sundry debtors.
Working capital financing is used to fund your investment in short-term assets.
Invoice discounting is the assignment of accounts receivable to a third-party as collateral for a loan.
Trade finance facilitates international trade by transferring to a third-party the risk that an exporter
will not receive payment, or an importer will not receive its goods.
Merchant cash advances (MCA) are upfront payments that you receive in exchange for a percentage
of your future daily credit/debit card receipts.
Operating cycle is extremely important because business is all about the running the operating
cycle smoothly.
The amount of time a resources is tied up calculate by subtracting the average payment
period from the operating cycle.
Working capital refers to short-term funds to meet operating expenses. It refers to the funds, which
a company must possess to finance its day-to-day operations.
Inventory accounting deals with valuing and accounting for changes in assets.
Economic order quantity (EOQ) is the ideal order quantity a company should purchase to minimise
inventory costs such as holding costs, shortage costs and order costs.
Just in time inventory is the reduced amount of inventory owned by a business after it installs a
Just-In-Time manufacturing system.
13.9 GLOSSARY
Working capital management: Business tool that helps companies effectively make use of current
assets, helping companies to maintain sufficient cash
Financial management: Planning, organising, directing and controlling the financial activities
such as procurement and utilisation of funds
Investment decision: The decision made by the investors or the top-level management with respect
to the amount of funds
Gross working capital: The sum of a current assets
Net working capital: The difference between a total current assets and current liabilities.
Case Objective
The case study explains the need for working capital.
Mysore Lamps Limited is a company specialising in the production of fluorescent lamps. The company
has been maintaining the quality of its products and due to the efforts of its marketing manager, the
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company has been able to capture a sizeable share of the product market in the recent past. The company
is planning to expand in the same product line. Mr. Mysore, the Managing Director of the company, is
confronted with the problem of increasing working capital due to the expansion plans of the company.
Mysore Lamps Limited was set up in 1991 with an authorised capital of ` 110 crore and faced heavy
competition in the initial years of commencement of business. During 2006, the company could make a
dent in the fluorescent lamps market and its position as on December 31, 2006, was as shown in Exhibit 1
During the year 2006, the company was able to sell 50 lakh pieces of fluorescent lamps a ` 60 with a
profit margin of 10 per cent. The raw material comprised about 50 per cent of the selling price; while
wages and overheads accounted for 12 and 18 per cent, respectively. As a policy, the company keeps
raw material stock for two months of its requirements. To make prompt supply to customers on orders
received, finished goods stock for two months requirements are maintained, and sales credit of 3 months
is given to customers. Due to the standing of the company in the market, the company is able to enjoy 2
months from its suppliers. The production process is of 30 days duration.
Mr. Mysore is seriously considering the proposal for expansion by installing an automatic plant costing
` 30 crores. The expansion will bring in an additional capacity of 100 lakh units per annum. Mr. Mysore
is not worried about the financing of this plant as the same would be done for the retained earnings
able to increase its sale from 50 lakh pieces after the expansion scheme.
Questions
1. As a manager, what steps would you take to effectively manage the working capital in an inflationary
situation?
(Hint: After observing balance sheet)
2. What is the need for working capital?
(Hint: Your working capital is used to pay short-term obligations, such as your accounts payable
and buying inventory.)
3. What is permanent working capital?
(Hint: Permanent working capital refers to the minimum amount of working capital, i.e., the amount
of current assets over current liabilities which is needed to conduct a business even during the
dullest period.)
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Discuss with your friends about the practical application of working capital management
192
UNIT
Financing Decisions
Names of Sub-Units
Overview
This unit begins by explaining the meaning of financing decisions, it discusses the concept of financing
alternatives. The unit explains the capital structure. It also discusses the concept of leverages.
Learning Objectives
In this unit, you will learn to:
Explain the financing decisions
State the financing alternatives
Identify the capital structure
Classify the concept of leverages
Learning Outcomes
At the end of this unit, you would:
Assess the meaning of financing decisions
Examine the financing alternatives
Analyse the capital structure
Evaluate theconcept of leverages
JGI JAIN
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14.1 INTRODUCTION
Financing decision is a crucial decision that is to be made by the financial manager, the decision is about
the financing-mix of an organization. Financing Decision is focused on the borrowing and allocation
of funds required for the investment decisions of the firm. We will learn in detail about these various
financing decisions in the upcoming section.
The financing decision comes from two sources from where the funds can be raised the first is from
borrowing funds from the outside the corporate in the form debenture, loan, bond, etc. The objective of
the financial decision is to balance an optimum capital structure.
The basic financial decisions that financial managers need to take are as follows:
Investment Decision
These are also known as capital budgeting decisions. A
and thus must be put to use with much analysis. A firm should pick those investments where he can
gain the highest conceivable returns. Investment decision involves careful selection of the assets where
funds will be invested by the corporates.
Financing Decision
Financial decision is the utmost important decision which is to be made by business individuals. These
are wise decisions indeed that are to be chalked out with proper analysis. The person decides when,
Dividend Decision
Dividend decisions relate to the distribution of profit that are earned by the organization. The main
criteria in this decision are whether to distribute to the shareholders or to retain the earnings. Dividend
decisions are affected by the earnings of the business and dependency on earnings.
14.2.1 Equity
represents the
acquisition, it is the value of company sale minus any liabilities owed by the company not transferred
with the sale.
In addition, shareholder equity can represent the book value of a company. Equity can sometimes be
offered as payment-in-kind. It also represents the pro-rata ownership of a shares.
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14.2.2 Preferences
dividends that are paid out to shareholders before common stock dividends are issued. If the company
enters bankruptcy, preferred stockholders are entitled to be paid from company assets before common
stockholders. Most preference shares have a fixed dividend, while common stocks generally do not.
Preferred stock shareholders also typically do not hold any voting rights, but common shareholders
usually do.
14.2.3 Debentures
A debenture is a type of bond or other debt instrument that is unsecured by collateral. Since debentures
have no collateral backing, they must rely on the creditworthiness and reputation of the issuer for
support. Both corporations and governments frequently issue debentures to raise capital or funds.
The long-term financial strength as well as profitability of a firm is influenced by its financial structure.
-
consisting of current liabilities, long-term debt, preference share and equity share capital.
The financial structure, therefore, includes both short-term and long-term sources of funds.
financial decisions in any firm should be taken in the light of this objective. Whenever a company is
required to raise long-term funds, the finance manager is required to select such a mix of sources
of finance that overall cost of capital is minimum (i.e., value of the firm/wealth of shareholders is
maximum). A mix of long-term sources of finance is referred as
Capital structure refers to the kinds of securities and the proportionate amounts that make up
capitalization. It is the mix of different sources of long-term sources such as equity shares, preference
shares, debentures, long-term loans and retained earnings.
The term capital structure refers to the relationship between the various long-term source financing
such as equity capital, preference share capital and debt capital. Deciding the suitable capital structure
is the important decision of the financial management because it is closely related to the value of the
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firm. Capital structure is the permanent financing of the company represented primarily by long-term
debt and equity.
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understands t
chooses debt rather than equity to finance its operations. These theories are presented below
This happens because when the degree of leverage increases, Kd which is lower than
Ke, receives a higher weight in the calculation of Ko.
This can also be illustrated by a graph shown in Figure
Ke
Ko
Kd
As our assumption is that the cost of debt and equity capital would not change with the change in the
level of leverage, Ko is seen to go down with the increasing proportion of debt in the capital. Note that
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we are talking about the market value of debt and the market value of equity. Many times, we confuse it
with the book values of debt and equity, a measure that always leads to problems in measuring the true
costs of debt and equity.
Given this, and manipulating the equation of the total cost of capital, we can express the cost of
equity as:
(Ko kd )×D
K e =K o +
(D+E)
Ke
Ko
Kd
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selling those shares and using the proceeds, plus borrowed funds, to buy shares in an unleveraged (all
equity-financed) firm. The simultaneous selling of shares in the leveraged firm and buying of shares in
the unleveraged firm would drive the prices of the stocks to the point where the values of the two firms
would be identical. Thus, according to MM
hypothesis: a stock price is not related to its mix of debt and equity financing.
Modigliani and Miller have restated and amplified the net operating income position in terms of three
basic propositions. These are as follows:
Proposition I
The total market value of a firm is equal to its expected operating income (EBIT when
Tax = 0) divided by the discount rate appropriate to its risk class. It is independent of the degree of
leverage.
EBIT EBIT
VL = VU = =
ko,L ke,L
Here, the subscript L is used to denote Leveraged firm and subscript U is used to denote unleveraged
firm. Since the V (Value of the firm) as established by the above equation is a constant, under the MM
model, when there are no taxes, the value of the firm is independent of its leverage. This implies that the
weighted average cost of capital to any firm is completely independent of its capital structure and the
WACC foror any firm, regardless of the amount of debt it uses, is equal to the cost of equity of unleveraged
firm employing no debt.
Proposition II
The expected yield on equity, Ke, is equal to Ko plus a premium. This premium is equal to the debt-equity
ratio times the difference between Ko and the yield on debt, Kd. This means that as the use of debt
increases, its cost of equity also rises, and in a mathematically precise manner.
Proposition III
The cut-off rate for investment decision making for a firm in a given risk class is not affected by the
manner in which the investment is financed. It emphasises the point that investment and financing
decisions are independent because the average cost of capital is not affected by the financing decision.
14.4 LEVERAGES
Generally, increase in leverage results in increased returns and risk; and decrease in leverage results in
decrease in returns and risk. The amount of leverage in the capital structure (the mix of long-term
debt and equity) can significantly affect its value by affecting returns and risks.
-related variables. In financial
analysis, it represents the influence of one financial variable over some other related financial variable.
The three basic types of leverage can be defined with reference to income statement as follows:
1. Operating leverage is concerned
earnings before interest and taxes, or EBIT (EBIT is descriptive label for operating profits).
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2. Financial leverage is concerned with the relationship between the firms EBIT and its common share
charges to magnify the effects of charge in EBIT/operating profit on earnings per share.
3. Total leverage is concerned with the relationship between the sales revenue and EPS.
The dictionary meaning of the term leverage refers to an increased means for accomplishing some
It helps us in lifting heavy objects by the magnification of force when a lever is applied to a
function.
James Horne has defined leverage as the employment of an asset or funds for which the firm pays a
fixed cost or fixed return.
Christy and Roder defines leverage as the tendency for profits to change at a faster rate than sales.
Operating Leverage
It takes place when a change in revenue produces a greater change in EBIT. It is related to fixed costs. A
firm with relatively high fixed costs uses much of its marginal contribution to cover fixed costs.
It refers to heavy usage of fixed assets. A few definitions are as follows:
use of fixed operating costs to magnify a change in profits relative to a given change in
Walker & Petty
degree of
operating leverage. E F Brigham
It is a function of three factors:
1. Fixed costs
2. Contribution
3. Volume of sales
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The degree of operating leverage (DOL) is defined as the percentage change in the earnings before
interest and taxes relative to a given percentage change in sales.
% Change in EBIT
DOL=
% Change in Sales
EBIT / EBIT
DOL=
Sales / Sales
Changes in fixed operating costs affect operating leverage. Significantly, the higher the fixed operating
costs, higher are the firms, operating leverage and its operating risks. High operating leverage is good
when revenues are rising and bad when they are falling.
Financial Leverage
have magnifying impact on the EPS due to any change in EBIT (Earnings before Interest and Taxes). In
other words, financial leverage is a process of using debt capital to increase the return on equity.
ty of the firm to use fixed financial changes to
magnify the effect of changes in EBIT on the firms
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Finally, there is a formula that allows calculating the degree of financial leverage in a particular time
period:
EBIT
Degreeof Financial Leverage=
EBIT Interest
Combined leverage or total leverage can be defined as potential use of fixed costs, both operating and
financial, to magnify the effect of changes in sales on the firms, earnings per share. Total leverage or
combined leverage can therefore be viewed as the total impact of the fixed cost in the firms operating
and financial structure.
Combined leverage = operating leverage × financial leverage
% change inEBIT % change inEPS
= ×
% change in sales % change in EBIT
% change in EPS
=
% change in Sales
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A high operating leverage and a high financial leverage combination is very risky. If the company is
producing and selling at a high level it will make extremely high profit for its shareholders.
But, even a small fall in the level of operations would result in tremendous fall in earnings per share. A
company must, therefore, maintain a proper balance between these two leverages.
A combination of high operating level and a low financial leverage indicates that the management
is careful since the higher amount of risk involved in high operating leverage has been sought to be
balanced by low financial leverage. However, a more preferable option would be to have a low operating
leverage and a high financial leverage. A low operating leverage implies that the company reaches its
breakeven point at a low level of sales.
Therefore, risk is diminished. A highly cautious and conservative manager will keep both its operating
and financial leverage at a very low level, but the approach may, however, mean that the company is
losing profitable opportunities.
The financing decision is a crucial decision that is to be made by the financial manager, the decision
is about the financing-mix of an organization.
Financing decision is focused on the borrowing and allocation of funds required for the investment
decisions of the firm.
Financial decision is the utmost important decision which is to be made by business individuals.
Dividend decisions relate to the distribution of profit that are earned by the organization.
A debenture is a type of bond or other debt instrument that is unsecured by collateral.
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According to net income approach, the cost of debt and the cost of equity do not change with a
change in the leverage ratio.
In contrast to the net income approach, the NOI approach states that the cost of capital for the
whole firm remains constant, irrespective of the leverage employed in the firm
The use of fixed-cost assets or capital to amplify returns to the owners is known as leverage.
The percentage change in earnings as a result of a percentage change in sales is the degree of
operating leverage.
Operating leverage is affected by changes in fixed operating costs. Significantly, the operating
leverage and operating risks increase as fixed operating costs rise.
The difference between current sales and break-even sales is a margin of safety.
Financial leverage is defined as a capacity to employ fixed financial costs in such a way
that every change in EBIT has a magnifying effect on EPS.
The degree of financial leverage is a financial measurement that gauges a overall
sensitivity to operating income volatility induced by changes in its capital structure.
The possible use of fixed costs, both operating and financial, to magnify the effect of fluctuations in
sales on the earnings per share is known as combined leverage or total leverage.
The Degree of Combined Leverage (DCL) is a leverage ratio that averages the combined effect of the
DOL and the Degree of Financial Leverage (DFL) on EPS for a given change in sales.
14.6 GLOSSARY
Case Objective
The case study explains the capital structure of a company.
On 28th March 2001, the Himalayan Paint Private Limited was incorporated. The Himalayan Paint is a
listed private limited company located in New Delhi. The authorised share capital of Himalayan Paint
is ` -up capital is ` 8.33 lac. The current status of the private company
Himalayan Paint is
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record, the Annual General Meeting (AGM) was conducted on 30th October,
Paint Private Limited has two directors, Mr. Kesav Arora and Mr. Sumit Arora.
Mr. Anand Dixit was the President of Himalayan Cements. In 2001, the company became largest seller of
cement in India. In the same year, Mr. Dixit decided to enter the paint industry under the brand name of
Himalayan Paint. He presented his proposal in board meeting and the proposal was accepted. However,
the long-term and medium-term financing was needed for the new project.
Mr. Rajiv Pandey was the finance manager of the organisation. Mr. Pandey prepared the capital
structure for the new investment and explained to Mr. Dixit. According to the capital structure, 40% of
capital was earned from issuing debentures, 30% of capital was raised from term loans, 20% of capital
was raised from public deposits and remaining 10% of capital was from retained earnings of the parent
organisation.
Mr. Pandey was not in favour of raising capital by issuing shares because he did not want interference
of shareholders in the internal decisions of the organisation. A product was launched in the market in
2004 by the team effort of Himalayan Paint and Himalayan Cements. The new product received good
start in market.
After the end of two financial years, Himalayan Paint found that it is making loss. There were several
reasons for the loss, such as the paint market being filled with MNCs which were selling low-price better-
quality paints and extensive advertising by competitors.
Himalayan Paint started promoting their product extensively. Initially, Himalayan Paint was making
moderate profit, which went towards payment of interests of loans and meeting other expenses. In 2007,
public deposits matured and Himalayan Paint paid their liability out of the profits made by Himalayan
Cements. Mr. Pandey was forced to resign and Mr. Alok Mukherjee was appointed as Finance Manager
by Mr. Dixit.
Questions
1. What were the mains issues in front of Himalayan Paint?
(Hint: Interest on loans, competitors, MNCs)
2. What are the present sources of finance for Himalayan Paints?
(Hint: Debentures, term loans, public deposits and retained earnings)
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A. Hints for Essay-Type Questions
1.
variable on another related financial variable is referred to as leverage in financial analysis. Costs,
output, sales revenue, EBIT, EPS and other financial factors may be included. Refer to Section
Leverages
2. It occurs when a change in revenue results in a larger change in EBIT. It has something to do with
fixed costs. A company with high fixed costs utilises a large portion of its marginal contribution to
cover those costs. It alludes to the extensive use of fixed assets. Refer to Section Leverages
3. capacity to employ fixed financial costs in such a way
that every change in EBIT has a magnifying effect on EPS. In other words, financial leverage is the
process of increasing the return on equity through the use of loan capital. Refer to Section Leverages
4. Financial management aims at maximising the wealth of shareholders. All financial choices in any
company should be made keeping this goal in mind. When a corporation has to raise long-term
money, the finance manager must choose a combination of sources of capital with the lowest overall
cost of capital (i.e., the value/shareholder wealth is at its highest). The word
refers to the combination of long-term financing sources. Refer to Section Capital Structure
https://www.economicsdiscussion.net/financial-management/types-of-financial-decisions-in-
financial-management/31652
https://businessjargons.com/financing-decision.html
https://www.toppr.com/guides/business-studies/financial-management/financing-decision/
www.toppr.com/guides/business-studies/financial
http://www.its.caltech.edu/~rosentha/courses/BEM103/Readings/JWCh16.pdf
http://www.its.caltech.edu/~rosentha/courses/BEM103/Readings/JWCh16
https://efinancemanagement.com/financial-management/types-of-financial-decisions
https://efinancemanagement.com/financial
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UNIT
15 Dividend Decision
Names of Sub-Units
Overview
This unit begins by explaining the meaning of dividend decision, it discusses the concept of dividends.
The unit explains the dimensions of dividend policy. It also discusses the bonus shares and stock split.
Learning Objectives
Learning Outcomes
At the end of this unit, you would:
Assess the meaning of dividend decision
Examine the forms of dividends
Analyse the bonus shares and stock split
Evaluate the dimensions of dividend policy
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15.1 INTRODUCTION
The term dividend refers to that part of the profits of a company that is distributed by the company
among its shareholders. It is the reward of the shareholders for investments made by them in the shares
of the company. Investors are interested in earning the maximum return on their investments and
maximising their wealth. A company, on the other hand, needs to provide funds to finance its long-term
growth.
If a company pays out as dividend most of what it earns, then for business requirements and further
expansion it will have to depend upon outside resources, such as the issue of debt or new shares. The
dividend policy of a firm thus affects both the long-term financing and the wealth of shareholders. As a
result, the f
distributed profits and retained earnings.
Since the dividend is a right of shareholders to participate in the profits and surplus of the company for
their investment in the share capital of the company, they should receive a fair amount of the profits.
The company should, therefore, distribute a reasonable amount as dividends (which should include a
normal rate of interest plus a return for the risks assumed) to its members and retain the rest for its
growth and survival.
in proportion to their shareholding in the company. The dividend may be in the form of cash or non -
cash, i.e., bonus shares.
Cash Dividend
The cash dividend is by far the most common of the dividend types used. On the date of declaration,
the board of directors resolves to pay a certain dividend amount in cash to those investors holding the
holders of the stock. On the date of payment, the company issues dividend payments.
Stock Dividend
A stock dividend is an issuance by a company of its common stock to its common shareholders without any
consideration. If the company issues less than 25 percent of the total number of previously outstanding
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shares, then treat the transaction as a stock dividend. If the transaction is for a greater proportion of
the previously outstanding shares, then treat the transaction as a stock split. To record a stock dividend,
transfer from retained earnings to the capital stock and additional paid-in capital accounts an amount
equal to the fair value of the additional shares issued. The fair value of the additional shares issued is
based on their fair market value when the dividend is declared.
Property Dividend
A company may issue a non-monetary dividend to investors, rather than making a cash or stock payment.
Record this distribution at the fair market value of the assets distributed. Since the fair market value is
likely to vary somewhat from the book value of the assets, the company will likely record the variance
as a gain or loss. This accounting rule can sometimes lead a business to deliberately issue property
dividends to alter their taxable and/or reported income.
Scrip Dividend
A company may not have sufficient funds to issue dividends shortly, so instead, it issues a scrip dividend,
which is essentially a promissory note (which may or may not include interest) to pay shareholders at a
later date. This dividend creates a note payable.
Liquidating Dividend
When the board of directors wishes to return the capital originally contributed by shareholders as a
dividend, it is called a liquidating dividend and maybe a precursor to shutting down the business. The
accounting for a liquidating dividend is similar to the entries for a cash dividend, except that the funds
are considered to come from the additional paid-in capital account.
Debit Credit
Retained earnings 1,000,000
Dividends payable 1,000,000
On June 1, ABC pays the dividends, and records the transaction with this entry:
Debit Credit
Dividends payable 1,000,000
Cash 1,000,000
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Debit Credit
Retained earnings 50,000
Common stock, $1 par value 10,000
Additional paid-in capital 40,000
by Pablo Picasso, which the company has stored in a vault for several years. The company originally
acquired the prints for $500,000, and they have a fair market value as of the date of dividend declaration
of $4,000,000. ABC records the following entry as of the date of the declaration to record the change in
the value of the assets, as well as the liability to pay the dividends:
Debit Credit
Long-term investments - artwork 3,500,000
Gain on appreciation of artwork 3,500,000
Debit Credit
Retained earnings 4,000,000
Dividends payable 4,000,000
On the dividend payment date, ABC records the following entry to record the payment transaction:
Debit Credit
Dividends payable 4,000,000
Long-term investments - artwork 4,000,000
Debit Credit
Retained earnings 250,000
Notes payable 250,000
The date of payment is one year later so that ABC has accrued $25,000 in interest expense on the notes
payable. On the payment date (assuming no prior accrual of the interest expense), ABC records the
payment transaction with this entry:
Debit Credit
Notes payable 250,000
Interest expense 25,000
Cash 275,000
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Debit Credit
Additional paid-in capital 1,600,000
Dividends payable 1,600,000
On the dividend payment date, ABC records the following entry to record the payment transaction:
Debit Credit
Dividends payable 1,600,000
Cash 1,600,000
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Control Objective: Control over the company is also an important factor, which influences dividend
policy. When a firm distributes more earning as dividends in the form of cash it reduces its cash
position. As a result, the firm will have to issue shares to the public to raise funds required to finance
investment opportunities that lead to loss of control, since, the existing shareholders will have to
share control with new owners. Financing investment projects by way of internal source avoids, loss
of control.
Inflation: Inflation is the state of the economy in which the prices of products or goods have been
increasing. Inflation is a factor that influences dividend policy indirectly. The Indian accounting
system is based on historical costs. The funds accumulated from depreciation may not be sufficient
to replace the absolute asset or equipment, since depreciation is provided based on historical costs.
Consequently, to replace assets and equipment, the firm has to depend upon retained earnings, this
leads to the payment of low dividends, during the inflation period.
Dividend Policy of Competitors: Keeping one eye on dividend policy is very important. If
the firm wants to retain the existing shareholders or it wants to maintain share price in the market,
and if it is planning to raise funds from the public for expansion programs, it has to pay dividends
at par with its competitors. Hence, it is one of the factors that influence the dividend policy of a firm.
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Age of company: An old and established company having reached saturation point may follow
a high payout policy, whereas young and growing concerns cannot follow, as it requires a large
number of funds to finance its growth requirements.
Growth rate of the company: A rapidly growing concern requires long-term funds. Hence, its
dividend must be kept at a minimum.
Liquidity position of the company and its funds requirements: A company with high profitability
and large reserves may not necessarily have sufficient cash balances to pay cash dividends
particularly when most of the sales have been affected through credit, in such a situation it
would be unwise to drain off additional cash by paying dividends.
Liquidity
The liquidity position of a firm is often an important consideration in dividend decisions. Since dividends
represent a cash outflow, it follows that the better the cash position and overall liquidity of the firm, the
to pay (and maintain) a cash dividend.
A growing, profitable firm may not be liquid, since it needs funds for new capital expenditures and to
build up its permanent working capital position.
Likewise, firms in cyclical industries may experience times when they lack liquidity due to general
economic conditions. Hence, the degree of liquidity is a variable of concern when a dividend policy
is being assessed.
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In essence, the key question is whether or not a firm can (if the need arises) finance its dividend payments
externally. Those that can are likely to set higher dividend levels than those that cannot.
Two aspects that tend to work against this approach to dividend payments are the cost of financing
and issue expenses. Financing dividends externally may have merit so long as the cost of financing is
relatively low.
However, when interest rates rise, the idea of financing dividends begins to lose its appeal. Moreover,
issue expenses and other flotation costs will lower desired payout ratios, since they raise the cost of
financing.
This is particularly true when the amount of external financing involved is fairly small, for flotation
costs are inversely related to the size of the issue and tend to rise rapidly as the size of an issue declines.
Managerial Control
In some cases, control of the firm may be a factor to consider when establishing a dividend policy.
Suppose a fairly substantial proportion of the firm is owned by a controlling group, and the remainder
of the stock is publicly held. Under these circumstances, the higher the payout ratio, the more likely it is
that a subsequent issue of equity may be needed to finance capital expenditures.
Those in control might prefer to minimise the likelihood of an offering of equity to avoid any dilution in
their ownership position.
Hence, they would prefer a low payout policy. On the other hand, a firm may establish a relatively high
dividend payout ratio (if it believes that is what shareholders desire) as a way to keep the firm from
being acquired in a merger or acquisition.
Legal constraints
The legal rules act as boundaries within which a company can declare dividends. In general, cash
dividends must be paid from current earnings or from previous earnings that have been retained by the
corporations after providing for depreciation. However, a company may be permitted to pay a dividend
in any financial year out of the profits of the company without providing for depreciation.
Though the dividends should be paid
or reserves (retained earnings) to issue fully paid bonus shares (stock dividend).
negotiating for a bank overdraft limit or having access to other short-term sources of funds.
new issue of shares or to issue debt is restricted, it will likely
retain a higher proportion of its profits than a company that has ready access to funds from the capital
market. Companies that are likely to have difficulties raising funds on the capital market include small
companies, new companies and companies in what may be termed venture capital fields.
Inflation
Inflation must be taken into account when a firm establishes its dividend policy. On the one hand,
investors would like to receive larger cash dividends because of inflation.
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equipment, finance new capital expenditures and meet permanent working capital needs. Thus, in
inflationary times, there may be a tendency to hold down cash dividends.
External Restrictions
The protective covenants in a bond indenture or loan agreement often include a restriction on the
payment of cash dividends. This restriction is imposed to preserve the ability to service its debt.
These restrictions may be in the form of coverage ratio, sinking fund, etc. The presence of these
restrictions forces a company to retain earnings and follow a low payout.
Bonus Shares
A bonus issue, also known as a scrip issue or a capitalisation issue, is an offer of free additional shares to
existing shareholders. A company may decide to distribute further shares as an alternative to increasing
the dividend payout. For example, a company may give one bonus share for every five shares held.
Bonus issues are given to shareholders when companies are short of cash and shareholders expect a
regular income. Shareholders may sell the bonus shares and meet their liquidity needs. Bonus shares
may also be issued to restructure company reserves. Issuing bonus shares does not involve cash flow. It
net assets.
Bonus shares are issued according to each stake in the company. Bonus issues do not dilute
relative equity of each shareholder the same as before the issue. For example, a three-for-two bonus
issue entitles each shareholder three shares for every two they hold before the issue. A shareholder with
1,000 shares receives 1,500 bonus shares (1000 x 3 / 2 = 1500).
Stock Split
Stock split means splitting one share into many, say, one share of ` 500 into 5 shares of `100. Stock splits
are a tool used by the companies to regulate the prices of shares, i.e., if a share price increases beyond a
limit, it may become less tradable, for example, suppose a share price increases from `50 to
`1000 over the years, it is possible that it might goes out of range of many investors.
A stock split is when a company divides the existing shares of its stock into multiple new shares to boost
the liquidity. Although the number of shares outstanding increases by a specific multiple, the
total dollar value of the shares remains the same compared to pre-split amounts, because the split does
not add any real value.
The most common split ratios are 2-for-1 or 3-for-1 (sometimes denoted as 2:1 or 3:1), which means that
the stockholder will have two or three shares after the split takes place, respectively, for every share held
before the split.
The term dividend refers to that part of the profits of a company that is distributed by the company
among its shareholders.
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It is the reward of the shareholders for investments made by them in the shares of the company.
If a company pays out as dividend most of what it earns, then for business requirements and further
expansion it will have to depend upon outside resources, such as the issue of debt or new shares.
Dividend refers to the business concerns net profits distributed among the shareholders.
The dividend is the payment by a company to its shareholders out of its distributable profit.
A dividend is generally considered to be a cash payment issued to the holders of company stock.
The cash dividend is by far the most common of the dividend types used.
A stock dividend is an issuance by a company of its common stock to its common shareholders
without any consideration.
A company may issue a non-monetary dividend to investors, rather than making a cash or stock
payment.
When the board of directors wishes to return the capital originally contributed by shareholders as a
dividend, it is called a liquidating dividend
The ability of a firm to raise money externally will have a direct bearing on the level of dividends
paid to shareholders.
In some cases, control of the firm may be a factor to consider when establishing a dividend policy.
The legal rules act as boundaries within which a company can declare dividends.
A bonus issue, also known as a scrip issue or a capitalisation issue, is an offer of free additional
shares to existing shareholders.
15.6 GLOSSARY
Dividends: It refers to that portion of the net earnings that is paid out to the equity
shareholders.
Dividend Policy: It decides the portion of earnings to be paid as dividends to ordinary shareholders
and what portion is ploughed back into the firm for investment purposes.
Pay-out Ratio: The ratio of dividend to earnings is known as the pay-out ratio.
Stability: It refers to the consistency or lack of variability in the stream of dividend payments.
Case Objective
This case study familiarises with different types of securities as per the requirements of different
companies.
George Thomas was finishing some weekend reports on a Friday afternoon in the downtown office
of Wishart and Associates, an investment-banking firm. Since Monday, Meenda, a partner with the
business, had not been in the New York office. He was travelling through Pennsylvania, meeting with five
potential clients who were exploring a securitie
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Meenda would be recommending different types of assets to each of the five clients to fulfil their specific
demands, George understood. He also knew Meenda wanted him to phone each of the clients over the
weekend to discuss the recommendations. As soon as the cable came, George was ready to make these
calls. The secretary handed George the following telegram at 4:00 p.m. George Thomas, Wishart and
Associates STOP Taking advantage of the offer to go skiing on Poconos STOP Recommendations as
follows:
1. common stock,
2. preferred stock,
3. debt with warrants,
4. convertible bonds, and
5. callable debentures are the five types of securities available.
George understood as he picked up the phone to make the first call that the potential clients were not
matched with the investment options. George discovered folders on each of the five firms seeking funding
they were in the front of each folder. George went over each of the notes one by one.
API, Inc.
API, Inc. currently requires $8 million and will require $4 million in four years. In the tri-state area, a
packaging company with a high growth rate. Over-the-counter (OTC) trading is how common stocks
are traded. The stock is currently low, but it is expected to rise in the next 12 to 18 months. Any sort
of security is acceptable to me. Good leadership and growth are expected to be mild. Profits should
skyrocket as a result of the new machinery. The debt of $7 million was recently paid off. Except for short-
term responsibilities, he has essentially no debt left.
Sandford Enterprises
$16 million is required. The stock price has dropped, but it is predicted to rise. In the following two
years, excellent growth and profitability are expected. Low debt-to-
history of paying off debt before it matures. The majority of earnings are retained, while dividends are
paid in small amounts. Management is adamant about not handing over voting power to outsiders.
Money will be utilised to purchase plumbing materials and machinery.
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JGI JAIN
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Accounting and Finance
million by selling common shares at $21 or higher, but this is a distant second choice. Those who are
likely to invest in this company will be attracted by the financing gimmicks and the opportunity to make
a quick profit on their investment.
Ranbaxy Industry
A total of $25 million is required. The company makes boat canvas covers and needs money to expand.
Money for the long future is required. Ownership that has been tightly maintained for a long time is
reluctant to relinquish control. Without the authorisation of bondholders and the First National Bank of
Philadelphia, it is impossible to issue debt. The debt-to-equity ratio is relatively low. Profits are relatively
high. Growth prospects are favourable. Strong management, with slight flaws in the areas of sales and
promotion.
secretary entered the office as George was going over the folders. Meenda leave any
other stuff here on Monday other than these
think those notes will come in
Meenda called early this morning to say he had double-checked the information in the folders. He also
stated that he had learned nothing new on the trip and that he had essentially squandered his week,
except for the fact that he had been invited to go skiing at the business lodge up there.
George studied the situation for a while. He could always wait until the next week when he would be
certain that he had the proper advice and that he had taken into account some of the factors that
the initial deadline if he could figure out which firm fit each recommendation. George returned to his
office and began matching each company with the proper financing.
Questions
1. Which type of financing is appropriate for each firm?
(Hint: EBIT-EPS (Approach) Analysis)
2. What types of securities must be issued by a firm that is on the growing stage to meet the financial
requirements?
(Hint: Trading on equity)
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UNIT 15: Dividend Decision JGI JAIN
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1. Dividend refers to the business concerns net profits distributed among the shareholders. It may also
be termed as the part of the profit of a business concern, which is distributed among its shareholders.
Refer to Section Concept of Dividends
2.
Refer to Section Concept of Dividends
3. A stock dividend is an issuance by a company of its common stock to its common shareholders
without any consideration. Refer to Section Concept of Dividends
4. Inflation is the state of the economy in which the prices of products or goods have been increasing.
Inflation is a factor that influences dividend policy indirectly. Refer to Section Dimensions of Dividend
Policy
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