Chapter 1- Introduction to Accounting

Accounting is aptly called the language of business. This designation is applied to accounting because it
is the method of communicating business information. The basic function of any language is to serve as a
means of communication. Accounting duly serves this function. The task of learning accounting is
essentially the same as the task of learning a new language. But the acceleration of change in business
organization has contributed to increase the complexities in this language. Like other languages, it is
undergoing continuous change in an attempt to discover better means of communications. To enable the
accounting language to convey the same meaning to all stakeholders, it should be made standard. To
make it a standard language certain accounting principles, concepts and standards have been developed
over a period of time. This lesson dwells upon the different dimensions of accounting, accounting
concepts, accounting principles and the accounting standards.
A person carrying out business is interested in knowing basically two facts about his business.

Whether the business has resulted into the profit or loss?

What are the assets and liabilities of the business?
Hence a Business organization has to maintain the accounts to find the answer to these questions

Evolution of Accounting
Accounting is as old as money itself. It has evolved, as have medicine, law and most other fields of
human activity in response to the social and economic needs of society. People in all civilizations have
maintained various types of records of business activities. The oldest known are clay tablet records of the
payment of wages in Babylonia around 600 b.c. accounting was practiced in India twenty-four centuries
ago as is clear from Kautilya’s book ‘Arthshastra’ which clearly indicates the existence and need of proper
accounting and audit.

For the most part, early accounting dealt only with limited aspects of the financial operations of private or
governmental enterprises. Complete accounting system for an enterprise which came to be called as
“double entry system” was developed in Italy in the 15th century. The first known description of the
system was published there in 1494 by a Franciscan monk by the name Luca Pacioli.

The expanded business operations initiated by the industrial revolution required increasingly large
amounts of money which in turn resulted in the development of the corporation form of organizations. As
corporations became larger, an increasing number of individuals and institutions looked to accountants to
provide economic information about these enterprises.

For example: Prospective investors and creditors sought information about a corporation’s financial
status. Government agencies required financial information for purposes of taxation and regulation.

Thus accounting began to expand its function of meeting the needs of relatively few owners to a public
role of meeting the needs of a variety of interested parties.

Definition and Meaning of

Accounting
 Book-keeping is that branch of knowledge which tells us how to keep a record of

business transactions. It is considered as an art of recording systematically the

various types of transactions that occur in a business concern in the books of

accounts.

According to Spicer and Pegler, “book-keeping is the art of recording all money

transactions, so that the financial position of an undertaking and its relationship to

both its proprietors and to outside persons can be readily ascertained”. Accounting is

a term which refers to a systematic study of the principles and methods of keeping

accounts. Accountancy and book-keeping are related terms; the former relates to the

theoretical study and the latter refers to the practical work.

According to American Institute of Certified Public Accountants, “Accounting is on

art of recording, classifying and summarizing in a significant manner and in terms of

money, transactions and events which are of a financial character and interpreting the

results thereof.”

Accounting is a sum of the following functions:

1-Recording a monetary transaction in a primary book in a systematic manner.

2-Classifying the transactions account wise to know the transactions of a particular
account.
3-Summarizing the transactions to know the over all position of balances.
4-Interpreting the transactions in terms of profit and loss.
5-Interpreting the transactions in terms of assets and liabilities.

Another popular definition on accounting was given by American accounting

principles board in 1970, which defined it as: “accounting is a service society. Its

function is to provide quantitative information, primarily financial in nature, about

economic entities that is useful in making economic decision, in making reasoned

choices among alternative courses of action”.

Importance and scope of

Accounting
Individuals engaged in such areas of business as finance, production, marketing,

personnel and general management need not be expert accountants but their

effectiveness is no doubt increased if they have a good understanding of accounting

principles. Everyone engaged in business activity, from the bottom level employee

to the chief executive and owner, comes into contact with accounting. The higher the

level of authority and responsibility, the greater is the need for an understanding of

accounting concepts and terminology.

A study conducted in United States revealed that the most common background of

chief executive officers in united states corporations was finance and accounting.

Interviews with several corporate executives drew the following comments:

“…… my training in accounting and auditing practice has been extremely valuable to

me throughout”.

“A knowledge of accounting carried with it understanding of the establishment and

maintenance of sound financial controls- is an area which is absolutely essential to a

Chief Executive Officer”.

 Though accounting is generally associated with business, it is not only business

people who make use of accounting but also many individuals in non-business areas

that make use of accounting data and need to understand accounting principles and

terminology.

For example: An engineer responsible for selecting the most desirable solution to a

technical manufacturing problem may consider cost accounting data to be the

decisive factor. Lawyers want accounting data in tax cases and damages from breach

of contract.

Governmental agencies rely on an accounting data in evaluating the efficiency of

government operations and for approving the feasibility of proposed taxation and

spending programs. Accounting thus plays an important role in modern society and

broadly speaking all citizens are affected by accounting in some way or the other.

Functions of Accounting

Accounting which is so important to all, discharges the following vital functions:

 Keeping Systematic Records: This is the fundamental function of accounting. The

transactions of the business are properly recorded, classified and summarized into final
financial statements - income statement and the balance sheet.
 Protecting the Business Properties: Accounting helps to protect the properties of the
business by maintaining proper record of various assets and thus enabling the
management to exercise proper control over them.
 Communicating the Results: Accounting has been designated as the language of
business. It communicates financial information in respect of net profits, assets,
liabilities, etc., to the interested parties.
 Meeting Legal Requirements: Accounting devises such a system as will meet the legal
requirements. The provisions of various laws such as the companies act, income tax act,
etc., require the submission of various statements like income tax returns, annual
accounts and so on. Accounting system aims at fulfilling this requirement of law.
 Providing information to make judgments about the organization: Accounting is the
system that provides such information as resources and the results achieved through using
them.
Any system has three features, viz., input, processes and output.
Accounting as a social science can be viewed as an information system,
since it has all the three features i.e., inputs (raw data), processes (men and
equipment) and outputs (reports and information). Accounting information
is composed principally of financial data about business transactions. The
mere records of transactions are of little use in making “informed
judgments and decisions”.

The recorded data must be sorted and summarized before significant

analysis can be prepared. Some of the reports to the enterprise manager
and to others who need economic information may be made frequently;
other reports are issued only at longer intervals. The usefulness of reports
is often enhanced by various types of percentage and trend analyses. The
“basic raw materials” of accounting are composed of business transactions
data. Its “primary end products” are composed of various summaries,
analyses and reports.

Accounting is important due to the following reasons:

 Systematic Records
 Preparation of Financial Statements
 Assessment of Progress
 Aid to Decision Making
 Statutory Requirements
 Information to Interested Groups
 Evidence in Courts
 Taxation Problems
 Merger of Firms
 Evaluating the performance in terms of profit or loss
 Future reference
 Fixation of selling price based on the cost of production

OBJECTIVES OF ACCOUNTING

The following are the important objectives of Accounting:

 Maintenance of Accounting Records
 Ascertainment of Profit and Loss
 Depiction of Financial Position
 Providing Information to the stake holders
 Maintaining Control over Assets
 Planning in Respect of Cash
 Ascertainment of cost of production
 SCOPE OF ACCOUNTING

 Accounting is concerned with the transactions and events which are of

financial character.

 Identified and measured transactions are recorded in a book called journal or

book of the prime entry.

 The recorded transactions have to be classified according to nature of

transactions. This work is done in a separate book called Ledger.

 Preparing profit and loss account and a Balance Sheet.

LIMITATIONS OF ACCOUNTING

 It cannot measure the qualitative aspects of the products

 Accounting relies on estimates and forecasts
 Accountants rely on historical cost for recording the fixed assets
 Accounting ignores the price level changes

Methods of Accounting
Basically there are two Methods/Systems of Accounting viz:

 Cash or Realization System of Accounting

 Mercantile or Accrual System of Accounting

Cash or Realisation System of Accounting

Expenses are considered to be expenses only when they are paid for, and the incomes are

considered to be incomes only when they are actually received.

Realization Concept:

Realization refers to inflows of cash or claims to cash like bills receivables, debtors etc. Arising

from the sale of assets or rendering of services.

According to realization concept, revenues are usually recognized in the period in which goods

were sold to customers or in which services were rendered. Sale is considered to be made at the

point when the property in goods passes to the buyer and he becomes legally liable to pay.

To illustrate this point, let us consider the case of a, a manufacturer who produces goods on

receipt of orders.

When an order is received from X, Y starts the process of production and delivers the goods to X

when the production is complete. X makes payment on receipt of goods. In this example, the sale

will be presumed to have been made not at the time when goods are delivered to X.

A second aspect of the realization concept is that the amount recognized as revenue is the

amount that is reasonably certain to be realized. However, lot of reasoning has to be applied to

ascertain as to how certain ‘reasonably certain’ is … yet, one thing is clear, that is, the amount of

revenue to be recorded may be less than the sales value of the goods sold and services rendered.

For example: When goods are sold at a discount, revenue is recorded not at the list price but at

the amount at which sale is made. Similarly, it is on account of this aspect of the concept that

when sales are made on credit, though entry is made for the full amount of sales, the estimated
amount of bad debts is treated as an expense and the effect on net income is the same as if the

revenue were reported as the amount of sales minus the estimated amount of bad debts.

Mercantile or Accrual System of Accounting

Expenses are considered as expenses during the period to which they pertain. Similarly, incomes

are considered to be incomes during the period to which they pertain. When the expenses are

actually paid for or when the incomes are actually received is not significant in case of

Mercantile or Accrual System of Accounting.

As per the provisions of Section 209 of the Companies Act, 1956, all the company form of

organizations are legally required to follow Mercantile or Accrual System of Accounting. Other

organizations have a choice to select either of the systems of accounting.

Periodic matching of Costs and Revenues

This concept is based on the accounting period concept. It is widely accepted that

desire of making profit is the most important motivation to keep the proprietors

engaged in business activities. Hence a major share of attention of the accountant is

being devoted towards evolving appropriate techniques of measuring profits. One

such technique is periodic matching of costs and revenues.

In order to ascertain the profits made by the business during a period, the accountant

should match the revenues of the period with the costs of that period. By ‘matching’

we mean appropriate association of related revenues and expenses pertaining to a

particular accounting period. To put it in other words, profits made by a business in a

particular accounting period can be ascertained only when the revenues earned
 during that period are compared with the expenses incurred for earning that revenue.

The question as to when the payment was actually received or made is irrelevant.

For example: In a business enterprise which adopts calendar year as accounting year,

if rent for March 2017 was paid in April 2018, the rent so paid should be taken as the

expenditure of the year 2016-17, revenues of that year should be matched with the

costs incurred for earning that revenue including the rent for March 2017, though

paid in April 2018. It is on account of this concept that adjustments are made for

outstanding expenses, accrued incomes, prepaid expenses etc. while preparing

financial statements at the end of the accounting period. The system of accounting

which follows this concept is called as mercantile system. In contrast to this there is

another system of accounting called as cash system of accounting where entries are

made only when cash is received or paid, no entry being made when a payment or

receipt is merely due.

Types of Accounting

1 - Single Entry
2 - Double Entry

Advantages of Double Entry System

1. Complete Record
2. Ascertainment of Profit
3. Knowledge of Financial Position
4. A Check on the Accuracy of Accounts
5. No Scope of Fraud
6. Tax Authorities

Glossary of Important Accounting Terms

Assets - All the properties owned by the business.
Account - Account is the record of all the transactions pertaining to a person, asset,

liability,

income or expenditure,

Balance Sheet: Balance Sheet is the summarized statement of what the business

owns

i.e. assets and what the business owes i.e. liabilities.

Bills Payable: Bills Payable indicates the amount payable to the suppliers.

Bills Receivable: Bills Receivable indicates the amount receivable from the

customers.

Capital - Capital indicates the amount of funds invested by the owner in the

business.

Creditor - A creditor is a supplier to whom the business owes money for the goods

bought on credit.

Debtor - A debtor is a customer who owes money to the business for the goods

supplied on credit.

Depreciation - Reduction in the value of fixed assets, which arise either due to time

factor or use factor or both.

Drawings - The amount of funds or goods withdrawn by the owner of the business

for his personal use.

Folio - Folio refers to the page number of the book of original entry or the ledger.

Journal - The Book of Original Entry where the financial transactions are recorded

in the chronological order.

Ledger - The book where the transactions of the similar nature are pooled together

under one Account.

Liabilities - All the amounts owed by the business to various providers of funds or

services are collectively referred to as liabilities.

Branches of Accounting
There are three Branches of Accounting viz:

 1
 1
 Financial Accounting
 2
 2
 Cost Accounting and
 3
 3
 Management Accounting

1. Financial Accounting
Financial Accounting is the process of systematic recording of the business

transactions in the various books of accounts maintained by the organization with the

ultimate intention of preparing the financial statements there from.

Characteristic features of Financial Accounting:

 Financial Accounting considers those transactions, which can be

expressed in terms of money.
 Financial Accounting is referred to as the historical form of
accounting.
 Financial accounting is more or less a legal requirement.
 Financial Accounting is meant for those people who are external to the
organization. This class of people may consist of the people like
investors, customers, suppliers, banks, financial institutions etc.
 Financial Accounting discloses the financial performance and financial
status of the business as a whole.

Financial accounting information is intended both for owners and managers and also

for the use of individuals and agencies external to the business. This accounting is

concerned with the recording of transactions for a business enterprise and the

periodic preparation of various reports from such records.

The records may be for general purpose or for a special purpose. A detailed account

of the function of financial accounting has been given earlier in this lesson.

2. Cost Accounting
Cost accounting developed as an advanced phase of accounting science and is trying

to make up the deficiencies of financial accounts. It is essentially a creation of the

twentieth century. Cost accounting accounts for the costs of a product, a service or an

operation. It is concerned with actual costs incurred and the estimation of future

costs.

Cost accounting is a conscious and rational procedure used by accountants for

accumulating costs and relating such costs to specific products or departments for

effective management action. Cost accounting through its marginal costing technique

helps the management in profit planning and through its another technique i.e.

Standard costing facilitates cost control. In short, cost accounting is a management

information system which analyses past, present and future data to provide the basis

for managerial decision making.

Features of Cost Accounting

+

Utility of Cost Accounting

+

Distinction between Costing and Cost Accounting

+

Distinction Between Financial Accounting And Cost Accounting

+

3. Management Accounting
Management Accounting is the process of analysis and interpretation of financial

data collected with the help of financial accounting and cost accounting, with the

ultimate intention to draw certain conclusions there from, in order to assist the

management in the process of decision-making.

Definition of Management Accounting:

The Institute of Chartered Accountants of England and Wales has defined

management accounting as “any form of accounting which enables a business to be

conducted more efficiently” Management accounting employs both historical and

estimated data in assisting management in daily operations and in planning for future

operations. It deals with specific problems that confront enterprise managers at

various organizational levels. The management accountant is frequently concerned

with identifying alternative courses of action and then helping to select the best one.

For Example: The accountant may help the finance manager in preparing plans for

future financing or may help the sales manager in determining the selling price to be

fixed on a new product by providing suitable data.

Generally management accounting information is used in three important

management functions:

 Control
 Co-ordination
 Planning

Marginal costing is an important technique of management accounting which

provides multi dimensional information that facilitates decision making.

Accounting Concepts
The rules and conventions of accounting are commonly referred to as principles. The

American Institute of certified public accountants has defined the accounting

principle as, “a general law or rule adopted or professed as a guide to action; a settled

ground or basis of conduct or practice”.

It may be noted that the definition describes the accounting principle as a general law

or rule that is to be used as a guide to action.

The Canadian Institute of chartered accountants has defined accounting principles as,

“the body of doctrines commonly associated with the theory and procedure of

accounting, serving as explanation of current practices and as a guide for the

selection of conventions or procedures where alternatives exist”. This definition also

makes it clear that accounting principles serve as a guide to action.

The peculiar nature of accounting principles is that they are manmade unlike the

principles of physics, chemistry etc. They were not deducted from basic axiom.

Instead they have evolved. This has been clearly brought out by the Canadian

Institute of chartered accountants in the second part of their definition on accounting

principles: “rules governing the foundation of accounting actions and the principles

derived from them have arisen from common experiences, historical precedent,

statements by individuals and professional bodies and regulation of governmental

agencies”.

Since the accounting principles are manmade they cannot be static and are bound to

change in response to the changing needs of the society. It may be stated that

accounting principles are changing but the change in them is permanent.

Accounting principles are judged on their general acceptability to the makers and

users of financial statements and reports. They present a generally accepted and

uniform view of the accounting profession in relation to good accounting practice

and procedures. Hence the name generally accepted accounting principles.

Accounting principles, rules of conduct and action are described by various terms

such as concepts, conventions, doctrines, tenets, assumptions, axioms, postulates, etc.

But for our purpose we shall use all these terms synonymously except for a little

difference between the two terms – concepts and conventions.

The term “concept” is used to connote accounting postulates i.e. Necessary

assumptions or conditions upon which accounting is based. The term convention is

used to signify customs or traditions as a guide to the preparation of accounting

statements.

In order to bring uniformity to the recording of business transactions, the accountants

follow certain basic procedures universally. These are referred to as the Accounting

Principles.

The Accounting Principles can be classified in two categories:

 Accounting Concepts
 Accounting Conventions

Accounting Concepts
Accounting Concepts indicate those basic assumptions upon which the basic process

of accounting is based. The important accounting concepts are discussed here under:

Business Entity Concept

–

It is generally accepted that the moment a business enterprise is started it

attains a separate entity as distinct from the persons who own it. In
recording the transactions of a business, the important question is: How
do these transactions affect the business enterprise?
The question as to how these transactions affect the proprietors is quite
irrelevant. This concept is extremely useful in keeping business affairs
strictly free from the effect of private affairs of the proprietors.

In the absence of this concept the private affairs and business affairs are
mingled together in such a way that the true profit or loss of the business
enterprise cannot be ascertained nor its financial position. To quote an
example, if a proprietor has taken Rs.5000/- from the business for paying
house tax for his residence, the amount should be deducted from the
capital contributed by him.

Instead if it is added to the other business expenses then the profit will be
reduced by Rs.5000/- and also his capital more by the same amount. This
affects the results of the business and also its financial position. Not only
this, since the profit is lowered, the consequential tax payment also will be
less which is against the provisions of the income-tax act.

The business is assumed to be a distinct entity than the person who owns
the business. The accounting process is carried out for the business and
not for the person who owns the business. If there is a company carrying
on the business in the name of M/s. XYZ private Ltd., where Mr. A and Mr.
B are the share holders, M/s. XYZ private Ltd. is supposed to be a separate
entity from Mr. A and Mr. B.
Going Concern Concept
–

This concept assumes that the business enterprise will continue to operate
for a fairly long period in the future. The significance of this concept is that
the accountant while valuing the assets of the enterprise does not take into
account their current resale values as there is no immediate expectation of
selling it. Moreover, depreciation on fixed assets is charged on the basis of
their expected life rather than on their market values. When there is
conclusive evidence that the business enterprise has a limited life, the
accounting procedures should be appropriate to the expected terminal
date of the enterprise.
In such cases, the financial statements could clearly disclose the limited
life of the enterprise and should be prepared from the ‘quitting concern’
point of view rather than from a ‘going concern’ point of view. The
business organization is going to be in existence for an indefinitely longer
period of time and is not likely to close down the business in the shorter
period of time.
Money Measurement Concept
–

Accounting records only those transactions which can be expressed in

monetary terms. This feature is well emphasized in the two definitions on
accounting as given by the American Institute of Certified Public
Accountants and the American Accounting Principles Board.

The importance of this concept is that money provides a common

denomination by means of which heterogeneous facts about a business
enterprise can be expressed and measured in a much better way.

For example: When it is stated that a business owns Rs.1,00,000 cash, 500
tons of raw material, 10 machinery items, 3000 square meters of land and
building etc., these amounts cannot be added together to produce a
meaningful total of what the business owns.

However, by expressing these items in monetary terms such as

Rs.1,00,000 cash, Rs.5,00,000 worth raw materials, Rs.10,00,000 worth
machinery items and Rs.30,00,000 worth land and building – such an
addition is possible. Only those transactions and facts find the place in
accounting, which can be expressed in terms of money.

A serious limitation of this concept is that accounting does not take into
account pertinent non-monetary items which may significantly affect the
enterprise. For instance, accounting does not give information about the
poor health of the chairman, serious misunderstanding between the
production and sales manager etc., which have serious bearing on the
prospects of the enterprise.

Another limitation of this concept is that money is expressed in terms of

its value at the time a transaction is recorded in the accounts. Subsequent
changes in the purchasing power of money are not taken into account.
Cost Concept
–

This concept is yet another fundamental concept of accounting which is

closely related to the going-concern concept. As per this concept:
 An asset is ordinarily entered in the accounting records at the price
paid to acquire it i.e., at its cost, and
 This cost is the basis for all subsequent accounting for the asset
The implication of this concept is that the purchase of an asset is recorded
in the books at the price actually paid for it irrespective of its market
value.

For example: If a business buys a building for Rs.3,00,000, the asset would
be recorded in the books as Rs.3,00,000 even if its market value at that
time happens to be Rs.4,00,000. However, this concept does not mean that
the asset will always be shown at cost. This cost becomes the basis for all
future accounting of the asset. It means that the asset may systematically
be reduced in its value by changing depreciation.

The significant advantage of this concept is that it brings in objectivity in

the preparations and presentation of financial statements. But like the
money measurement concept, this concept also does not take into account
subsequent changes in the purchasing power of money due to inflationary
pressures. This is the reason for the growing importance of inflation
accounting.

The assets acquired by the organization are recorded at their cost of

acquisition and this cost is considered for all the subsequent accounting
purposes say charging of depreciation. This concept does not take into
consideration current market prices of the various assets.
Dual Aspect Concept (Double Entry System)
–

This concept is the core of accounting. According to this concept every

business transaction has a dual aspect. This concept proposes that every
business transaction has two aspects. Every debit has corresponding
credit. This concept is explained in detail below:

The properties owned by a business enterprise are referred to as assets

and the rights or claims to the various parties against the assets are
referred to as equities. The relationship between the two may be expressed
in the form of an equation as follows:
Equities = Assets
Equities may be subdivided into two principal types: the rights of creditors
and the rights of owners. The rights of creditors represent debts of the
business and are called liabilities. The rights of the owners are called
capital.

Expansion of the equation to give recognition to the two types of equities

results in the following which is known as the accounting equation:
Liabilities + Capital = Assets
It is customary to place ‘liabilities’ before ‘capital’ because creditors have
priority in the repayment of their claims as compared to that of owners.

Sometimes greater emphasis is given to the residual claim of the owners

by transferring liabilities to the other side of the equation as:
Capital = Assets – Liabilities
All business transactions, however simple or complex they are, result in a
change in the three basic elements of the equation.
This is well explained with the help of the following series of examples:

(i) Mr. Prakash commenced business with a capital of Rs.3,000: the result of this

transaction is that the business, being a separate entity, gets cash-asset of Rs.30,000

and has to pay to Mr. Prakash Rs.30,000, his capital. This transaction can be

expressed in the form of the equation as follows:

(ii) Purchased furniture for Rs.5,000: the effect of this transaction is that cash is

reduced by Rs.5,000 and a new asset viz. Furniture worth Rs.5,000 comes in,

thereby, rendering no change in the total assets of the business. The equation after

this transaction will be:

(iii) Borrowed Rs.20,000 from Bank: as a result of this transaction both the sides of

the equation increase by Rs.20,000; cash balance is increased and a liability to Bank

is created. The equation will appear as follows:

(iv) Purchased goods for cash Rs.30,000: this transaction does not affect the

liabilities side total nor the asset side total. Only the composition of the total assets

changes i.e. Cash is reduced by Rs.30,000 and a new asset viz. Stock worth

Rs.30,000 comes in. The equation after this transaction will be as follows:

(v) Goods worth Rs.10,000 are sold on credit to Vishal for Rs.12,000. The result is

that stock is reduced by Rs.10,000 a new asset namely debtor (Mr. Vishal) for
Rs.12,000 comes into picture and the capital of Mr. Prakash increases by Rs.2,000

as the profit on the sale of goods belongs to the owner.

Now the accounting equation will look as under:

(vi) Paid electricity charges Rs.300: this transaction reduces both the cash balance

and Mr. Prakash’s capital by Rs.300. This is so because the expenditure reduces the

business profit which in turn reduces the equity.

 Thus it may be seen that whatever is the nature of transaction, the accounting

equation always tallies and should tally. The system of recording transactions based

on this concept is called double entry system.

Accounting Period Concept

–

In accordance with the going concern concept it is usually assumed that the life
of a business is indefinitely long. But owners and other interested parties cannot
wait until the business has been wound up for obtaining information about its
results and financial position.

For example: If for ten years no accounts have been prepared and if the
business has been consistently incurring losses, there may not be any capital at
all at the end of the tenth year which will be known only at that time. This would
result in the compulsory winding up of the business.

But, if at frequent intervals information are made available as to how things are
going, then corrective measures may be suggested and remedial action may be
taken.

Life span of the business is divided into shorter time segments, each one being
in the form of Accounting Period. Profitability is computed for this accounting
period (by preparing the profitability statement) and the financial position is
assessed at the end of this accounting period (by preparing the balance sheet).
The normal accounting period for most of the firms is a period of 12 months from
1st April to 31st March.
According to this concept accounting measures activities for a specified interval
of time called the accounting period. For the purpose of reporting to various
interested parties one year is the usual accounting period.
Matching Concept
–

While calculating the profit for the accounting period in a correct manner, the
expenses and costs incurred during the period, whether paid or not, should be
matched with the revenues generated during the period.

For example: if the accounting period ends on 31st March, the salaries for the
month of March should be considered as the cost for the year ending on 31st
March, even if they are actually paid for in the month of April.

Convention of Conservatism
Be liberal when estimating expenses and be conservative when estimating income. It is a world
of uncertainty. So it is always better to pursue the policy of playing safe. This is the principle
behind the convention of conservatism. According to this convention the accountant must be
very careful while recognizing increases in an enterprise’s profits rather than recognizing
decreases in profits. For this the accountants have to follow the rule, anticipate no profit, provide
for all possible losses, while recording business transactions. It is on account of this convention
that the inventory is valued at cost or market price whichever is less, i.e. When the market price
of the inventories has fallen below its cost price it is shown at market price i.e. The possible loss
is provided and when it is above the cost price it is shown at cost price i.e. The anticipated profit
is not recorded. It is for the same reason that provision for bad and doubtful debts, provision for
fluctuation in investments, etc., are created. This concept affects principally the current assets.

Convention of Full Disclosure

The emergence of joint stock company form of business organization resulted in the divorce
between ownership and management. This necessitated the full disclosure of accounting
information about the enterprise to the owners and various other interested parties. Thus the
convention of full disclosure became important. By this convention it is implied that accounts
must be honestly prepared and all material information must be adequately disclosed therein.
But it does not mean that all information that someone desires are to be disclosed in the
financial statements. It only implies that there should be adequate disclosure of information
which is of considerable value to owners, investors, creditors, government, etc. In Sachar
committee report (1978), it has been emphasized that openness in company affairs is the best
way to secure responsible behaviour. It is in accordance with this convention that companies
act, banking companies regulation act, insurance act etc., have prescribed proforma of financial
statements to enable the concerned companies to disclose sufficient information. The practice
of appending notes relating to various facts on items which do not find place in financial
statements is also in pursuance to this convention. The following are some examples: 1.
Contingent liabilities appearing as a note 2. Market value of investments appearing as a note 3.
Schedule of advances in case of banking companies

Convention of Consistency
Follow the accounting practice for a considerably long time. Do not change the practice every
now and then. According to this concept it is essential that accounting procedures, practices
and method should remain unchanged from one accounting period to another. This enables
comparison of performance in one accounting period with that in the past. For Example: If
material issues are priced on the basis of fifo method the same basis should be followed year
after year. Similarly, if depreciation is charged on fixed assets according to diminishing balance
method it should be done in subsequent year also. But consistency never implies inflexibility as
not to permit the introduction of improved techniques of accounting. However if introduction of a
new technique results in inflating or deflating the figures of profit as compared to the previous
methods, the fact should be well disclosed in the financial statement.

Convention of Materiality
The amount involving small amounts which do not have material impact the profitability may be
treated as revenue expenditure even though they are capital expenditure. Example, Books, Sign
boards etc. The implication of this convention is that accountant should attach importance to
material details and ignore insignificant ones. In the absence of this distinction, accounting will
unnecessarily be overburdened with minute details. The question as to what is a material detail
and what is not is left to the discretion of the individual accountant. Further, an item should be
regarded as material if there is reason to believe that knowledge of it would influence the
decision of informed investor. Some examples of material financial information are: fall in the
value of stock, loss of markets due to competition, change in the demand pattern due to change
in government regulations, etc. Examples of insignificant financial information are: rounding of
income to nearest ten for tax purposes etc. Sometimes if it is felt that an immaterial item must
be disclosed, the same may be shown as footnote or in parenthesis according to its relative
importance.

Capital and Revenue Receipts and

Payments
Expenditure (Payments) can be grouped into the following categories:

1. Capital Expenditure
2. Revenue Expenditure
3. Deferred Revenue Expenditure

Capital expenditure

Capital expenditure is that expenditure, the benefit of which is not fully consumed in one period

but spread over periods i.e. The benefits are expected to accrue for a long time.

Any expenditure which gives the following outcomes is a capital expenditure:

  Increases the capacity of an existing asset.
 Increases the life of an existing asset.
 Increases the earning capacity of the concern.
 Results in the acquisition of a new asset.
 Decreases the cost of production.

Capital Expenditure indicates the amount of funds paid for acquiring the infrastructural

properties required for doing business, which are technically referred to as Fixed Assets. Fixed

Assets do not give the returns during the same period during which they are paid for. As such,

benefits available from capital expenditure are long-term benefits.

Following are the examples of capital expenditure:

 Expenditure resulting in the acquisition of fixed assets e.g. Land, building, machines, etc.
 Expenditure resulting in extension or improvement of fixed assets e.g. Amount spent on
increasing the seating accommodation in the picture hall.
 Expenditure in connection with installation of a fixed asset.
 Expenditure incurred for acquiring the right to carry on a business e.g. Patents,
copyright, etc.
 Major repairs and replacements of parts resulting in increased efficiency of a fixed asset.

An expenditure cannot be said to be a capital expenditure only because:

 The amount is large.

 The amount is paid in lump sum.
 The amount is paid out of that fund which has been received out of the sale of fixed asset.
 The receiver of the amount is going to treat it for the purchase of fixed asset.

Revenue Expenditure

An expenditure which is consumed during the current period and which affects the income of the

current period is called revenue expenditure. Also an expenditure which merely seeks to

maintain the business of high assets in good working conditions is revenue expenditure.
Revenue Expenditure indicates the amount of funds paid during a certain period with the

intention to receive the return during the same period. The entire amount of revenue expenditure

affects the Profitability Statement.

Following are the examples of revenue expenditure:

 Expenses of administration, expenses incurred in manufacturing and selling products.

 Replacements for maintaining the existing permanent assets.
 Costs of goods purchased for resale.
 Depreciation on fixed assets, interest on loans for business, etc.

Distinction Between Capital And Revenue Expenditure:

The proper distinction between capital and revenue as regard to expenditure, payments, profits,

receipts and losses is one of the fundamental principles of correct accounting. It is very essential

that in all cases this distinction should be rigidly observed and amounts rightly allocated between

capital and revenue. Failure or neglect to discriminate between the two will falsify the whole of

the results of accounting. However, the distinction is not always easy. In actual practice there is a

good deal of difference of opinion as to whether a particular item is capital or revenue

expenditure. However, the rules mentioned above may serve as a guide for making distinction

between capital and revenue expenditure.

Deferred Revenue Expenditure

Deferred Revenue Expenditure indicates the amount of funds paid, which does not result into the

acquisition of any fixed asset. However, at the same time benefits from this expenditure are not

received during the same period during which they are paid for. Revenue expenditure treated like

capital expenditure.

The examples of Deferred Revenue Expenditure are:

  Initial Advertisement Expenditure.
 Research and Development Expenditure.
 In case of company form of organization, Preliminary Expenses or Company Formation
Expenses.

A heavy expenditure of revenue nature incurred for getting benefit over a number of years is

classified as deferred revenue expenditure. In some cases the benefit of revenue expenditure may

be available for a period of two or three or even more years. Such expenditure is to be written

off over a period of two or three years and not wholly in the year in which it is incurred. For

example a new firm may advertise very heavily in the beginning to capture a position in the

market. The benefit of this advertisement campaign will last quite a few years. It will be better

to write off the expenditure in three or four years and not only in the first year.

Some other examples of deferred revenue expenditure are preliminary expenses, brokerage on

issue of shares and debentures, exceptional repairs, discount on issue of shares or debentures,

expenses incurred in removing the business to more convenient premises and so on.

Capital Receipts and Revenue Receipts

The distinction between capital receipts and revenue receipts is also important.

Money obtained from the sale of fixed assets of investments, issue of shares,

debentures, money obtained by way of loans are examples of capital receipts. On the

other hand, revenue receipts are cash from sales, commission received, interest on

investments, transfer fees, etc. Capital receipts are shown in the balance sheet and

revenue receipts in the profit and loss account.

Capital Receipts

Capital Receipts refer to the funds received by the organization in the form of

capital i.e. Debt or equity.

It is a financing activity.

It is shown on the liability side of the balance sheet.

It needs to be repaid over a period of time.

It is a non recurring activity.

Examples: Loans taken from Banks. Share issued to share holde Rs. Sale of fixed

assets.

Revenue Receipts
Revenue Receipts refer to the funds received by the organization in the form of sale

of their goods and services.

It is shown on the Income (Credit) side of the Trading account of Profit and Loss

statement.

It need not be repaid since it is the income of the firm.

It is a recurring activity.

Examples: Sale of finished products, Rent Received, Interest received.

Capital and revenue profits

Capital profit is a profit made on the sale of a fixed asset or a profit earned on getting

capital for the business. For example, if the original cost of a fixed asset is

Rs50,00,000 and if it is sold for Rs.60,00,000 then Rs.10,00,000 is capital profit.

Similarly if the shares having an original cost of Rs.4,000 are sold for Rs.5,000, the

profit of Rs.1,000 thus made is capital profit. Capital profits should not be transferred

to the profit and loss account but should be transferred to capital reserve which would
 appear as a liability in the balance sheet. Revenue profit, on the other hand, is a profit

by trading, e.g. Profit on sale of goods, income from investments, discount received,

commission earned, rent received, interest earned etc. Such profits are taken to profit

and loss account.

Capital and Revenue Losses

Capital losses are those losses which occur at selling fixed assets or raising share

capital. For e.g., if investments having an original cost of Rs.20,000 are sold for

Rs.16,000, there will be a capital loss of Rs.4,000. Similarly when the shares of the

face value of Rs.100 are issued for Rs.90, the amount of discount i.e. Rs.10 per share

will be a capital loss. Capital losses should not be debited to profit and loss account

but may be shown on the asset side of balance sheet. As and when capital profits

arise, losses are met against them. Revenue losses are those losses which arise during

the normal course of business i.e. In trading operations such as losses on the sale of

goods. Such losses are debited to profit and loss account.

Illustration 1
State which of the following expenditures are capital in nature and which are revenue
in nature:
Freight and cartage on the new machine Rs.150; erection charges Rs.200.
A sum of Rs.10,000 on painting the new factory. Fixtures of the book value of
Rs.1,500 was sold off at Rs.600 and new fixtures of the value of Rs.1,000 were
acquired, cartage on purchase Rs.50. Rs.1,000 spent on repairs before using a
second hand car purchased recently.

Solution
Capital expenditure to be debited to machinery account. Painting charges of new or
old factory are maintenance charges and be charged to revenue. However, if felt
proper, painting charges of new factory may be treated as deferred revenue
expenditure. However, some say painting of new factory is capital expenditure.

Loss of Rs.900 on the sale of fixtures be treated as revenue expense but the cost of
new fixture Rs.1,000 together with cartage Rs.50 be debited to fixture account as
these are capital expenditure. Rs.1,000 being expense to bring the asset in usable
condition is a capital expenditure.

Illustration 2
The sum of Rs.30,000 has been spent on a machine as follows:
Rs.20,000 for additions to increase the output; Rs.12,000 for repairs necessitated by
negligence and Rs.8,000 for replacement of worn-out parts. The sum of Rs.17,200
was spent on dismantling, removing and reinstalling in order to remove their works
to more suitable premises. Classify these expenses into capital and revenue.
Solution
Rs.20,000 spent on additions is to be capitalized but Rs.12,000 and Rs.8,000 spent on
repairs and replacement of worn-out parts respectively are to be charged to revenue.
Rs.17,200 spent for removing to a more suitable premises is to be charged to
revenue as it does not increase efficiency and income. It, may, however be treated as
deferred revenue at the most.

Capital profit is also called as Non operating income is an income which is earned
due to Profit on sale of fixed assets or an income which is earned at the time of issue
of shares and debentures with a Premium

Example: Book value of a Machinery is Rs.45,000 and it is sold for Rs.50,000. Here,
Non operating income is Rs.5,000.

Capital loss is also called as Non operating loss is a loss which is incurred due to
loss on sale of fixed assets or any cost incurred at the time of promotion of business
like discount on issue of shares and debentures.
Example: Book value of a Machinery is Rs.45,000 and it is sold for Rs.40,000. Here,
Non operating loss is Rs.5,000.

Forms of Business Organisations

The finance function of the organization is greatly affected by the forms of organization.
The form of business organization means the basic constitution of the organization in
which it is set. It is generally defined by its ownership. The owners are persons who own
the business organization and they are major source of finance for the organization. The
various laws applicable to business entities as well as the mode of conducting business
depend upon the form of business organization In practical circumstances, we come
across basically three forms of business organizations.
 Proprietary Firms
 Partnership Firms
 Joint Stock Companies
Proprietary Firms

In this case, only one person is the owner of the business who is called as the “Proprietor”

and the same person is the manager. All the profits earned by the business belong to the

proprietor and he is liable for the losses and liabilities of the business.

ADVANTAGES

 Proprietary Firm is the easiest and most economical form of business

organization to form and operate. Not many of the government regulations are
applicable to the Proprietary Firms.
 This form of organization is very suitable where the size of the business is
small and the complexities involved in the business are comparatively less.
However, if the size of the business increases or the complexities in the
business operations grow, this form may prove to be insufficient.

DISADVANTAGES

 This form of organization does not have any legal status. The proprietary firms

exist due to the existence of the proprietor. If the proprietor ceases to be in

existence, the firm ceases to be in existence.

 As only one person is the owner and the manager, the capacity of the

business to raise funds and to cope up with complex business operations is

comparatively limited.

 Proprietary firm is always an unlimited liability organization. In the sense, if the

assets of the firm are insufficient to meet its liabilities, personal property of the

proprietor is always at stake.

 The income of the proprietary firm is clubbed with the individual income of the

proprietor. As such, effective rate of income tax which the proprietor may be

required to pay is likely to be higher.

  It is not possible to transfer the ownership of the business to somebody else

without affecting the basic constitution of the business.

Partnership Firms

In this case, more than two persons but less than twenty persons come together

and form a partnership firm. Each of these partners is the owner of the business

in the proportion decided among themselves. Partnership is a contract among the

partners and the relationship among the partners is governed on the basis of

terms and conditions laid down in an official and written document called as

“Partnership Deed” or “Partnership Agreement”.

ADVANTAGES

 This form of organization is also reasonably easy and economical to form and

operate.

 As resources of more than one person are pooled together, capacity of the

business to handle more complex business operations or operations requiring

more amounts of funds is better as compared to the proprietary firms.

 The tax structure applicable to the partnership firms is fairly reasonable.

While calculating the profit of the partnership firm, following amounts can be

claimed by the firm as the allowable expenditure.

o The firm can pay interest on capital to the partners on the amount of

capital introduced by them in the business.

 o The firm can remunerate the partners in the form of salary, bonus,

commission etc. provided that the partners are “working partners”.

 Not many of the government regulations are applicable to the partnership

firms.

DISADVANTAGES

 This form of organization also does not have any legal status. The partnership

firms exist due to the existence of the partne Rs. If the partners cease to be in

existence, the firm ceases to be in existence. The retirement or death of a

partner leads to the dissolution of the partnership firm.

 The capacity of the business to raise the funds and to cope up with the

complex business operations is comparatively limited though it is more than

that of the proprietary firms.

 Partnership firm is also an unlimited liability organization. In the sense, if the

assets of the firm are insufficient to meet its liabilities, personal property of the

partners is always at stake.

 It is not possible to transfer the ownership of the business to somebody else

without affecting the basic constitution of the business.

Joint Stock Companies

Joint stock companies have become a major form of organization in the recent past.

This form of organization can raise large amount of funds as the resources of larger

number of people can be pooled together. In this case, the total requirement of funds of
the organization is split into smaller units, each of such units being called as a ‘share’.

Each such share carries a denomination value which is called as ‘face value’ or

‘nominal value’.

An individual can participate in the capital requirement of an organization by purchasing

the shares of the company and he becomes the part owner of the company to the

extent of his shareholding in the overall amount of capital of the company. Such

shareholder can exercise his ownership rights through the voting rights offered to him.

The joint stock companies have the following characteristic features:

 All the joint stock companies have a legal entity separate from their owner viz.

shareholders. They gain the legal status by being registered under Companies

Act, 1956, which governs and regulates the operations of all joint stock

companies in India. As legal entities, the joint stock companies can own assets,

incur liabilities, enter into contracts, sue and be sued. The shareholders of the

company cannot be held liable for the actions of the company.

 Generally all joint stock companies are limited liability organizations and the

liability of the shareholders is limited to the extent of amount of shares they

undertake to purchase. For example, If Mr. A undertakes to purchase 100

shares of a company of Rs.100 each, his liability ceases once he pays Rs.10,000

to the company. His personal property is never in danger despite the losses and

liabilities incurred by the company.

 Segregation of ownership and management is a typical feature of joint stock

companies. In case of the companies, shareholders are the owners. However,

 due to large number of shareholders and their wide geographical spread, it may

not be possible for the shareholders to exercise their ownership rights by

participating in the day-to-day affairs of the company. As such, the shareholders

appoint their representatives (viz. directors) to manage the day-to-day affairs of

the company. In case of joint stock companies, shareholders are the owners

while directors/board of directors are the managers.

 Transferability of shares is a feature of a joint stock company. A shareholder can

transfer his ownership rights in the company by transferring his shares to some

other person. In case of public limited companies, shares are freely transferable

and such transfer can be greatly facilitated if the shares are listed on the stock

exchange. In case of private limited companies, there may be some restrictions

on the transfer of shares.

 Being an artificial legal person, the company enjoys a perpetual existence. The

company can die only a legal death, after complying with the prescribed legal

formalities. There is a very famous case under the Companies Act, where during

the war, all the members of a private company, while in meeting, were killed by a

bomb, but the company survived.

 A company is an artificial legal person which does not have a body like a natural

person and hence it cannot sign any documents. However, being a legal

personality, it is bound only by those documents which bear its signature. Hence,

as a substitute to the signature, the law provides for the use of common seal.

Any document having the common seal and witnessed by at least two directors is

binding on the company legally.

 ADVANTAGES

 The capacity of the corporate organizations to raise the funds is comparatively

high. As the number of persons contributing to the requirement of funds is

large, it is possible to raise large amount of funds.

 As the company has a separate legal entity, apart from its owners viz.

shareholders, the personal property of the shareholders is generally not in

danger.

 Transferability of shares is a facility available to the shareholders. If the

shareholders want to release their investment in shares, they can transfer their

shares to any other person. However, it should be remembered that in case of

private limited companies, the shares are not freely transferable.

DISADVANTAGES

The company form of organization is subjected to elaborate legal and procedural

formalities to be complied with, not only for the purpose of formation but also for the

regular operation. The basic applicable law in this connection is in the form of

Companies Act, 1956. However, it should be noted that in case of private limited

companies, these formalities are less rigorous in nature.

Groups Interested In Accounting

Information
 There are several groups of people who are interested in the accounting

information relating to the business enterprise. Following are some of them:

Shareholders

Shareholders as owners are interested in knowing the profitability of the business

transactions and the distribution of capital in the form of assets and liabilities. In fact,

accounting developed several centuries ago to supply information to those who had

invested their funds in business enterprise.

Management

With the advent of joint stock company form of organization the gap between ownership

and management widened. In most cases the shareholders act merely as renders of capital

and the management of the company passes into the hands of professional managers. The

accounting disclosures greatly help them in knowing about what has happened and what

should be done to improve the profitability and financial position of the enterprise.

Potential Investors

An individual who is planning to make an investment in a business would like to know

about its profitability and financial position. An analysis of the financial statements would

help him in this respect.

Creditors

As creditors have extended credit to the company, they are much worried about the

repaying capacity of the company. For this purpose they require its financial statements,

an analysis of which will tell about the solvency position of the company.

Government
Any popular government has to keep a watch on big businesses regarding the manner in

which they build business empires without regard to the interests of the community.

Restricting monopolies is something that is common even in capitalist countries. For this, it

is necessary that proper accounts are made available to the government. Also, accounting

data are required for collection of sale-tax, income-tax, excise duty etc.

Employees

Like creditors, employees are interested in the financial statements in view of various profit

sharing and bonus schemes. Their interest may further increase when they hold shares of

the companies in which they are employed.

Researchers

Researchers are interested in interpreting the financial statements of the concern for a

given objective.

Citizens

Any citizen may be interested in the accounting records of business enterprises including

public utilities and government companies as a voter and tax payer.

The Profession of Accounting

Accountancy can very well be viewed as a profession with stature
comparable to that of law or medicine or engineering. The rapid
development of accounting theory and techniques especially after the
late thirties of 20th century has been accompanied by an expansion of
the career opportunities in accounting and an increasing number of
professionally trained accountants. Among the factors contributing to
this growth has been the increase in number, size and complexity of
business enterprises, the imposition of new and increasingly complex
taxes and other governmental restrictions on business operations.

Coming to the nature of accounting function, it is no doubt a service

function. The chief of accounting department holds a staff position
which is quite in contra - distinction to the roles played by production
or marketing executives who hold line authority. The role of the
accountant is advisory in character. Although accounting is a staff
function performed by professionals within an organization, the
ultimate responsibility for the generation of accounting information,
whether financial or managerial, rests with management. That is why
one of the top officers of many businesses is the financial controller.
The controller is the person responsible for satisfying other managers’
demands for management accounting information and for complying
with the regulatory demands of financial reporting. With these ends
in view, the controller employs accounting professionals in both
management and financial accounting.

These accounting professionals employed in a particular business firm

are said to be engaged in private accounting. Besides these, there are
also accountants who render accounting services on a fee basis
through staff accountants employed by them. These accountants are
said to be engaged in public accounting.
Specialized Accounting Fields
As in many other areas of human activity, a number of specialized fields in

accounting also have evolved besides financial accounting. Management

accounting and cost accounting are the result of rapid technological advances

and accelerated economic growth.

The most important among them are explained here:

Tax Accounting
–

Tax accounting covers the preparation of tax returns and the consideration

of the tax implications of proposed business transactions or alternative

courses of action. Accountants specializing in this branch of accounting

are familiar with the tax laws affecting their employer or clients and are up

to date on administrative regulations and court decisions on tax cases.

International Accounting
–

This accounting is concerned with the special problems associated with

the international trade of multinational business organizations.

Accountants specializing in this area must be familiar with the influences

that custom, law and taxation of various countries bring to bear on

international operations and accounting principles.

Social Responsibility Accounting

–

This branch is the newest field of accounting and is the most difficult to

describe concisely. It owes its birth to increasing social awareness which

has been particularly noticeable over the last three decades or so. Social

responsibility accounting is so called because it not only measures the

economic effects of business decisions but also their social effects, which

have previously been considered to be immeasurable. Social

responsibilities of business can no longer remain as a passive chapter in

the text books of commerce but are increasingly coming under greater

scrutiny. Social workers and people’s welfare organizations are drawing

the attention of all concerned towards the social effects of business

decisions.

The management is being held responsible not only for the efficient

conduct of business as reflected by increased profitability but also for

what it contributes to social well-being and progress.

Inflation Accounting
–
Inflation has now become a world-wide phenomenon. The consequences

of inflation are dire in case of developing and underdeveloped countries.

At this juncture when financial statements or reports are based on

historical costs, they would fail to reflect the effect of changes in

purchasing power or the financial position and profitability of the firm.

Thus, the utility of the accounting records, not taking care of price level

changes is seriously lost. This imposes a demand on the accountants for

adjusting financial accounting for inflation to know the real financial

position and profitability of a concern. Thus a future branch of accounting

called inflation accounting or accounting for price level changes emerged.

It is a system of accounting which regularly records all items in financial

statements at their current values.

Human Resources Accounting

–

Human resources accounting is yet another new field of accounting which

seeks to report and emphasize the importance of human resources in a

company’s earning process and total assets. It is based on the general

agreement that the only real long lasting asset which an organization

possesses is the quality and caliber of the people working in it. This

system of accounting is concerned with, “the process of identifying and

measuring data about human resources and communicating this

information to interested parties”.

Summary
Accounting is rightly called the language of business. It is as old as money itself.

It is concerned with the collecting, recording, evaluating and communicating the

results of business transactions. Initially meant to meet the needs of a relatively

few owners, it gradually expanded its functions to a public role of meeting the

needs of a variety of interested parties. Broadly speaking all citizens are affected

by accounting in some way. Accounting as an information system possesses with

accountants engaged in private and public accounting. As in many other areas

of human activity a number of specialized fields in accounting also have evolved

as a result of rapid changes in business and social needs.

Accounting information should be made standard to convey the same meaning

to all interested parties. To make it standard, certain accounting principles,

concepts, conventions and standards have been developed over a period of time.

These accounting principles, by whatever name they are called, serve as a

general law or rule that is to be used as a guide to action. Without accounting

principles, accounting information becomes incomparable, inconsistent and

unreliable. An accounting principle to become generally accepted should satisfy

the criteria of relevance, objectivity and feasibility.

The FASB (Financial Accounting Standards Board) is currently the dominant

body in the development of accounting principles. The IASC is another

professional body which is engaged in the development of the accounting

standards. The ICAI is an associate member of the IASC and the ASB started
 by the ICAI is formulating accounting standards in our country. Both the IASC

and ICAI consider going concern, accrual and consistency as fundamental

accounting assumptions.

Key Words
Accounting Accounting postulates i.e. Necessary assumptions or

Concept conditions upon which accounting is based.

Accounting Convention signifies the customs or traditions which serve

Conventions as a guide to the preparation of accounting statements.

Accounting The body of doctrines commonly associated with the theory

Principle and procedure of accounting.

Accounting Standards to be observed in the presentation of financial

Standard statements.

Accounting Language of business.

Cost Accounting Accounting for determination and control of costs.

Concerned with the recording of transactions for a business

Financial
enterprise and the periodic preparation of various reports
Accounting
from such records.
 Management
Accounting for internal management needs.
Accounting

Chapter 2- Process of Accounting

Introduction:

During the accounting period the accountant records transactions as and when they occur. At
the end of each accounting period the accountant summarizes the information recorded and
prepares the trial balance to ensure that the double entry system has been maintained. This is
often followed by certain adjusting entries which are to be made to account the changes that
have taken place since the transactions were recorded. When the recording aspect has been
made as complete and upto-date as possible the accountant prepares financial statements
reflecting the financial position and the results of business operations. Thus, the accounting
process consists of three major parts:
1. The recording of business transactions during that period;
2. The summarizing of information at the end of the period, and
3. The reporting and interpreting of the summary information.
A transaction involving receipt or payment of
A Financial Transaction.
money

Journalising Recording

Ledger Posting Classifying

Trial Balance Summarising

Balance Sheet and Profit and loss

Reporting
Account

Ratios and cash flow statement Analysing

Types of Accounts
The Account
The transactions that take place in a business enterprise during a specific period may result in

increases and decreases in assets, liabilities, capital, revenue and expense items. To make up to-

date information available when needed and to be able to prepare timely periodic financial

statements, it is necessary to maintain a separate record for each item. For e.g. It is necessary to

have a separate record devoted exclusively to record increases and decreases in cash, another one

to record increases and decreases in supplies, a third one on machinery, etc. The type of record

that is traditionally used for this purpose is called an account. Thus an account is a statement

wherein information relating to an item or a group of similar items is accumulated. The simplest

form of an account has three parts:

1. A title which gives the name of the item recorded in the account,
2. A space for recording increases in the amount of the item, and
3. A space for recording decreases in the amount of the item. This form of an account is
known as a ‘t’ account because of its similarity to the letter ‘t’ as illustrated below:

Types of Accounts

There are three types of accounts viz. Personal Accounts, Real Accounts and

Nominal Accounts

Personal accounts - The accounts of persons with whom the organization deals in various
capacities.
Examples:
 Accounts of the suppliers
 Accounts of the customers
 Accounts of Bank
 Capital Account
Your account with the Bank is an example of Personal Account.

Real Accounts

The accounts of assets Physically seen.

Examples:
  Land Account

 Building Account

 Machinery Account

 Furniture Account

 Vehicles Account

 Stock account

 Cash Account

 Computer Account

Real Accounts may also consist of the accounts of some intangible assets like - Goodwill

Account and Patents and Trade Marks Account.

Nominal Accounts

The accounts of incomes or expenses.

Examples:

 Sales Account

 Purchases Account

 Salary Account

 Wages Account

 Printing and Stationary Account

 Insurance Account

 Telephone Expenses Account

 Interest paid /Received Account

 Commission paid or Received Account

Golden Rules of Accounting
Debit and Credit

The left-hand side of any account is called the debit side and the right-hand side is

called the credit side. Amounts entered on the left hand side of an account, regardless

of the title of the account are called debits and the amounts entered on the right hand

side of an account are called credits. To debit (Dr) an account means to make an

entry on the left-hand side of an account and to credit (Cr) an account means to make

an entry on the right-hand side. The words debit and credit have no other meaning in

accounting, though in common parlance; debit has a negative connotation, while

credit has a positive connotation.

Double entry system of recording business transactions is universally followed. In

this system for each transaction the debit amount must equal the credit amount. If

not, the recording of transactions is incorrect. The equality of debits and credits is

maintained in accounting simply by specifying that the left side of asset accounts is

to be used for recording increases and the right side to be used for recording

decreases; the right side of a liability and capital accounts is to be used to record

increases and the left side to be used for recording decreases. The account balances

when they are totaled, will then conform to the two equations:
 1. Assets = liabilities + owners’ equity

2. Total Debits = Total Credits

From the above arrangement we can state that the rules of debits and credits are as follows:

Debit Signifies

1. Increase in asset accounts

2. Decrease in liability accounts

3. Decrease in owners’ equity accounts

Credit Signifies

1. Decrease in asset accounts

2. Increase in liability accounts

3. Increase in owners’ equity accounts

From the rule that credit signifies increase in owners’ equity and debit signifies decrease in it, the

rules of revenue accounts and expense accounts can be derived. While explaining the dual aspect

of the concept in the preceding lesson, we have seen that revenues increase the owners’ equity as

they belong to the owners. Since owners’ equity accounts increase on the credit side, revenue

must be credits.
So, if the revenue accounts are to be increased they must be credited and if they are to be

decreased they must be debited. Similarly we have seen that expenses decrease the owners’

equity. As owners’ equity account decreases on the debit side expenses must be debits. Hence to

increase the expense accounts, they must be debited and to decrease it, they must be credited.

From the above we can arrive at the rules for revenues and expenses as follows:

1. Debit Signifies Increase in expenses and Decrease in revenues

2. Credit Signifies Increase in revenues Decrease in expenses

Golden Rules of Accounting

1. Personal accounts – debit the receiver, credit the giver

2. Real accounts – debit what comes in, credit what goes out

3. Nominal accounts - debit all the expenses, credit all the incomes

Personal A/c

Debit The receiver Credit The giver

For e.g. : Anil paid Rs.1000 to Mukesh on 31-8-2017

In the books of Anil,

 L
D Cr
Dat .
Particulars eb edi
e F
it t
.

201 Mukesh A/c 1,

1,0
7 Dr. 00
00
Au To Cash A/c 0

gus (Being cash

t 31 paid)

In the books of Mukesh,

L D
Cr
Da . e
Particulars ed
te F bi
it
. t

20 1,
Cash A/c 1,0
17 0
Dr. 00
Au 0
To Anil A/c
gu 0
(Being cash
st
received )
31
Real A/c

Debit(Dr) What comes in Credit(Cr) What goes out.

For e.g. : Purchased Furniture worth Rs.2000 on 31-8-2017

L D
Cr
Da . e
Particulars ed
te F bi
it
. t

20 2,
Furniture A/c 2,0
17 0
Dr. 00
Au 0
To Cash A/c
gu 0
(Being furniture
st
purchased)
31

Nominal A/c

Debit The expenses & losses Credit The incomes & gains.
 For e.g. : Paid Electricity Bill of Rs.3000 on 31-8-2017

L
Cr
Dat . De
Particulars edi
e F bit
t
.

201 Electricity A/c 3,

3,0
7 Dr. 00
00
Aug To Cash 0

ust A/c

31 (Being

Electricity Bill

paid)

Journalizing
Journal

The French work ‘Jour’ means ‘day’ Journal, therefore means a daily record of business

transactions. Journal is known as the book of primary entry’ or ‘original entry’. Transactions are

entered in this book date wise.

Debit entry is entered first and then credit entry is entered. The debit total of every transaction is

equal to credit total of that transaction. Every debit has corresponding credit.
When a business transaction takes place, the first record of it is done in a book called journal.

The journal records all the transactions of a business in the order in which they occur.

The journal may therefore be defined as a chronological record of accounting transactions. It

shows names of accounts that are to be debited or credited, the amounts of the debits and credits

and any other additional but useful information about the transaction. A journal does not replace

but precedes the ledger.

The Journal may be subdivided in the following five columns:

 Date - It refers to the date on which a particular transaction has taken

place.

 Particulars - It refers to titles of the account to be debited or credited.

Title of the account to be debited starts from the extreme left and the

abbreviation “Dr.” is written to the extreme right of the same column on

the same line. Title of the account to be credited is entered on the next

line preceded by the words “To” leaving some space from the extreme

left. In the same column on the next line, brief description of the

transaction is written which is referred to as “Narration”. The narration

conventionally starts with the wording “Being”.

 L.F. - This is the abbreviation of Ledger Folio. This column refers to

the page number of the ledger.

 Amount Debited - The amount to be debited is stated in this column.

  Amount Credited - The amount to be credited is stated in this

column.

Specimen Journal

A proforma of a journal is given below.

D C
L
D e r
Particular .
at b e
s F
e i d
.
t it

2 Electricity 3 3

0 A/c , ,

1 Dr. 0 0

7 To Cash 0 0

A A/c 0 0

u (Being

g Electricity

u Bill paid)

st

1
 L
D Cr
Da .
Particulars eb ed
te F
it it
.

20 3 30 30
Cash A/C
17 9 ,0 ,0
Dr.
Au 00 00
To sales A/C
gu
(Being cash
st
sales)
31

The debit entry is listed first and the debit amount appears in the left-hand amount

column; the account to be credited appears below the debit entry and the credit

amount appears in the right hand amount column. The data in the journal entry are

transferred to the appropriate accounts in the ledger by a process known as posting.

Any entry in any account can be made only on the basis of a journal entry.

The column l.f. which stands for ledger folio gives the page number of accounts in

the ledger wherein posting for the journal entry has been made. After all the journal

entries are posted in the respective ledger accounts, each ledger account is balanced

by subtracting the smaller total from the bigger total. The resultant figure may be

either debit or credit balance and vice-versa.

Thus the transactions are recorded first of all in the journal and then they are posted

to the ledger. Hence the journal is called the book of original or prime entry and the
 ledger is the book of second entry. While the journal records transactions in a

chronological order, the ledger records transactions in an analytical order.

Journalizing

Journalizing refers to the process of recording the business transaction in the Journal that is

referred to as the Book of Original Entry or the Book of Prime Entry. The various transactions

are entered in the journal in the chronological order, as and when the transactions take place.

Format of a journal entries: Paid Electricity Bill of Rs.700 on 10/10/2017

Dat Particulars L D Cr

e . e ed

F bi it
 . t

201 7 70
Electricity A/c
7 0 0
Dr.
Oct 0
To Cash A/c
obe
(Being Electricity
r
paid in cash)
10

Illustrations of Journalizing

Illustration 1

1. January 1 - started business with Rs.3,000

2. January 2 - bought goods worth Rs.2,000

3. January 9 - received order for half of the goods from ‘g’

4. January 12 - delivered the goods, g invoiced Rs.1,300

5. January 15 - received order for remaining half of the total goods purchased

6. January 21 - delivered goods and received cash Rs.1,200

7. January 30 - g makes payment

8. January 31 - paid salaries Rs.210 and - received interest Rs.50

Let us now analyze the transactions one by one.

January 1 - Started Business With Rs.3,000:

The two accounts involved are cash and owners’ equity. Cash, an asset increases and hence it has

to be debited. Owners’ equity, a liability also increases and hence it has to be credited.

January 2 - Bought Goods Worth Rs.2,000:

The two accounts affected by this transaction are cash and goods (purchases). Cash balance

decreases and hence it is credited and goods on hand, an asset, increases and hence it is to be

debited.

January 9 - Received Order For Half Of The Goods From ‘G’:

No entry is required as realization of revenue will take place only when goods are delivered

(realization concept).

January 12 - Delivered The Goods, `G’ Invoiced Rs.1,300:

This transaction affects two accounts – goods (sales) a/c and receivables a/c.

Since it is a credit transaction, receivables increase (asset) and hence it is to be debited.

Sales decreases goods on hand and hence goods (sales) a/c is to be credited. Since the term

‘goods’ is used to mean purchase of goods and sale of goods, to avoid confusion, purchase of

goods is simply shown as purchases a/c and sale of goods as sales a/c.

January 15 – Received Order For Remaining Half Of Goods: No entry.

January 21 - Delivered Goods And Received Cash Rs.1,200:

This transaction affects cash a/c.

Since cash is realized, the cash balance will increase and hence cash account is to be debited.

Since the stock of goods becomes nil due to sale, sales a/c is to be credited (as asset in the form

of goods on hand has reduced due to sales).

January 30 - `G’ Makes Payment:

Both the accounts affected by this transaction are asset accounts – cash and receivables.

Cash balance increases and hence it is to be debited. Receivables balance decreases and hence it

is to be credited.

January 31 - Paid Salaries Rs.210:

Because of payment of salaries cash balance decreases and hence cash account is to be credited.

Salary is an expense and since expense has the effect of reducing owners’ equity and as owners’

equity account decreases on the debit side, expenses account is to be debited.

January 31 - Received Interest Rs.50:

The receipt of interest increases cash balance and hence cash a/c is to be debited. Interest being

revenue which has the effect of increasing the owners’ equity, it has to be credited as owners’

equity account increases on the credit side.

When journal entries for the above transactions are passed, they would be as follows:

D Particulars L D C

a . e r

t b e
 i d
e F
t it

J 3
3
a Cash A/C ,
,
n Dr. 0
0
. To Capital A/C 0
0
(Being Business Started) 0
0
1

J 2
2
a Purchases A/C ,
,
n Dr. 0
0
. To Cash 0
0
(Being Goods Purchased) 0
0
2

J 1
1
a Receivables A/C ,
,
n Dr. 3
3
. To Sales A/C 0
0
(Being Goods Sold On 0
0
1 Credit)

J Cash A/C 1
a , 1

n Dr. 2 ,

. To Sales A/C 0 2

(Being Goods Sold For 0 0

2 Cash) 0

J 1
1
a Cash A/C ,
,
n Dr. 3
3
. To Receivables A/C 0
0
(Being Cash Received For 0
0
3 Sale Of Goods)

J 2
2
a 1
Salaries A/C 1
n 0
Dr. 0
.
To Cash A/C

(Being Salaries Paid)

3

J Cash A/C 5
5
a Dr. 0
 n 0

.
To Interest A/C

(Being Interest Received)

3

Illustration 2

Journalize the following transactions in the books of Mr. Shantilal Hajeri.

1. Mr. Hajeri commenced business with cash Rs.10,000, Machinery Rs.10,000, Buildings

Rs.30,000 and Furniture Rs.15,000.

2. Installed and paid for Neon Sign Board at a cost of Rs.1,000.

3. Mr. Hajeri borrowed Rs.25,000 from his wife and the same were deposited by him in

bank to open an account.

4. Mr. Hajeri purchased goods for Rs.7,000 for cash.

5. Mr. Hajeri purchased goods worth Rs.10,000 from Mr. Vishal Singh on credit @2% Cash

Discount.

6. Sold goods to Vithal worth Rs.15,000 against cash after allowing 5% Trade Discount.

7. Paid Rs.1,995 to Mr. Ramesh for purchases of goods after allowing 5% Cash Discount

on the invoice.

8. Sent a cheque of Rs.1,000 to Chief Minister’s Fund as his personal contribution.

9. Placed an order for goods worth Rs.2,000 with M/s Sangeeta Trade Rs.
10. A personal table fan worth Rs.450 brought in the office for office use. Solution In the

Books of Mr. Shantilal Haje

Compound Journal Entry

If similar transactions take place on the same day and the same account is either

debited or credited, instead of passing different journal entries, it can be accounted

for by passing a compound journal entry. It avoids duplication and makes the journal

less bulky.

Illustration: First entry in the above example.

Thumb Rules for journal entries are:

1. Purchase of goods is always debit to “Purchases Account”

2. Sale of goods is always credit to “Sales Account”

3. Cash Received Debit to “Cash Account”

4. Cash Paid Credit to “Cash account”

5. Cheque Received Debit to “Bank A/c”

6. Cheque issued Credit to “Bank a/c”

7. Credit Purchases always credit “Supplier’s account”

8. Credit Sales always debit “Purchaser’s account”

9. Return of Purchased goods (Return outwards) always credit to this account

10. Return of sold goods (Return inwards) always debit to this account

Ledger Posting
Ledger
The Ledger is the book where transactions pertaining to one account are pooled

together under one Ledger Account. A ledger account can be defined as the record of

all the transactions pertaining to a person, asset, liability, income or expenditure

which have taken place during a specified period and shows the net effect of all these

transactions at the end. Ledger is known as the principle book of accounts. For each

account a separate page is kept. All entries made in Journal are recorded in Ledger.
The entries made in the Journal are recorded in the Ledger in their respective

accounts. Ledger helps in knowing the transactions account wise.

As such, the transactions are first entered into the Journal or Subsidiary Book when

they take place and from there they are transferred to Ledger and this process is

called as Ledger Posting.

A ledger is a set of accounts. It contains all the accounts of a specific business

enterprise. It may be kept in any of the following two forms: (i) Bound ledger and (ii)

Loose leaf ledger

A bound ledger is kept in the form of book which contains all the accounts. These

days it is common to keep the ledger in the form of loose- leaf cards. This helps in

posting transactions particularly when mechanized system of accounting is used.

Specimen of a Ledger Account

The Ledger Account may be maintained in two ways

Type I

Cash Account

Debit Rs Credit Rs

To Capital 3,000 By 2,000

A/C Purchases
 A/C

By Salaries
To Sales A/C 1,200 210
A/C

To Receivables By Balance 3,340

1,300
A/C C/D
50
To Interest A/C

5,550
5,550

Debits are on left side and Credits are on right side. There is no balance column.

Balance is calculated as the difference between the debit totals and credit totals.

If debit totals are more than the credit totals, the balance is shown in credit side and If

debit totals are less than the credit totals, the balance is shown in debit side. This is

called Balancing of account.

Type II

This format is sale like a journal but there is an additional column to record the

balance. In this format there is a balance columns and the balance is calculated after
every transaction. This format is used by Banks and in accounting software packages

like Tally. The entries in type 1 format will appear as under in type 2 format.

D C De
D
Parti L e r bit
a
cular . b e Bal
t
s F i d an
e
t it ce

To ,
3,0
Capit 0
00
al A/C 0

To ,
4,2
Sales 2
00
A/C 0

To 1 5,5

Recei , 00

vable 3

s A/C 0
 0

To
5 5,5
Intere
0 50
st A/C

By 2,

Purch 0 3,5

ases 0 50

A/C 0

By
2
Salari 3,3
1
es 40
0
A/C

The journal entries of Illustration 1 are posted into respective ledger accounts which

in turn are balanced. They will appear as under after ledger posting.

Cash Account

Debit Rs Credit Rs

3,000 2,000
To Capital By
 Purchases
A/C
A/C

By Salaries
To Sales A/C 1,200 210
A/C

To Receivables By Balance 3,340

1,300
A/C C/D
50
To Interest A/C

5,550

Capital Account

Debit Rs Credit Rs

To Balance By Cash
3,000 3,000
C/D A/C

3,000 3,000

Purchases Account
 Debit Rs Credit Rs

To Cash By Balance
2,000 2,000
A/C C/D

2,000 2,000

Receivables Account

Debit Rs Credit Rs

To Credit By Balance
1,300 1,300
Sales C/D

To Balance
0
C/D

1,300 1,300

Sales Account
 Debit Rs Credit Rs

By
To Balance
2,500 Receivables 1,300
C/D
A/c

By Cash A/C 1,200

2,500 2,500

Subsidiary Books
If the volume of transactions is very large, recording all the transactions in the Journal may prove to be a
voluminous job. Hence, the transactions of the similar nature may be entered into a separate Subsidiary
Book and the net effect of the similar transactions may be transferred into the main records. In many
cases there are innumerable transactions of a similar nature. Instead of entering each and every entry in
journal they are maintained in a separate register/book and the total of all transactions at the end of the
day is entered in the journal. Such separate books are called as Subsidiary books.

Illustrative list of Subsidiary books:

1. Purchases book to record credit purchases of goods.

2. Sales book to record credit sales of goods.
3. Purchase returns book to record returns to suppliers.
4. Sales returns book to record returns from customers.
 5. Cash book to record cash transactions.
6. Bills receivable book to record bills received.
7. Bills payable book to record bills payable accepted.
8. General journal or journal proper to record any other transactions which cannot be entered in
the above specialized subsidiary books.

Cash Book

This records all the cash transactions i.e., Cash Receipts and Cash Payments. In some cases, Cash and
Bank Book may be maintained which records Cash as well Bank Receipts and Cash as well as Bank
Payments. The Cash and Bank Book may look as below:

Date Particulars L.F. Cash Bank

Purchases Register or Purchases Day Book

This records all the credit purchases transactions.

Date Name of the Supplier L.F. Invoice No. Amount

Sales Register or Sales Day Book

This records all the credit sales transactions. The Sales Register may look as stated below:

Date Name of the Customer L.F. Invoice No. Amount

Purchases Returns Register

This records the transactions of return of goods to the suppliers from whom purchases were made on
credit basis. The Purchases Return Register may look as stated below:

Date Name of the Supplier L.F. Debit Note No. Amount

Sales Returns Register

This records all the transactions of return of goods by the customers to whom sales were made on credit
basis. The Sales Return Register may look as stated below:

Date Name of the Customer L.F. Credit Note No. Amount

Journal Proper

This records all the residual transaction, which cannot be entered into any other subsidiary book.

The transactions, which can be entered in the Journal proper are,

 Opening Entries
 Closing Entries
 Rectification Entries
 Adjustment Entries

Trial Balance
The trial balance is simply a list of the account names and their balance as of a given moment of
time with debit balances in one column and credit balances in another column. It is prepared to
ensure that the mechanics of the recording and posting of the transaction have been carried out
accurately. If the recording and posting have been accurate then the debit total and credit total in
the trial balance must tally thereby evidencing that an equality of debits and credits has been
maintained. In this connection it is but proper to caution that mere agreement of the debt and
credit total in the trial balance is not conclusive proof of correct recording and posting. There are
many errors which may not affect the agreement of trial balance like total omission of a
transaction, posting the right amount on the right side but of a wrong account etc.
Trial Balance is the summary of all the balances in all the accounts listed in the General Ledger
and Cash / Bank Book of an organization at any given date. Tallying of Trial Balance generally
ensures the arithmetical accuracy of the process of Ledger Posing.
Format of Trial Balance
Trial Balance as on 31st March 2017

Name of the Account Debit Credit

When we show up to the present moment with all of our senses, we invite the world to fill us
with joy. The pains of the past are behind us. The future has yet to unfold. But the now is full of
beauty simply waiting for our attention.
Trial Balance of the entries of Illustration 1 would appear as follows:

Debit
Rs Credit Rs

Cash 3,340 Capital 3,000

Purchase 2,000 Sales 2,500
Salaries 210 Interest 50

5,550
5,550

Summary

The following steps are involved in the accounting process:

1. The first and the most important part of the accounting process is the analysis of the
transactions to decide which account is to be debited and which account is to be credited.
2. Next comes journalizing the transactions i.e. Recording the transactions in the journal.
3. The journal entries are posted into respective accounts in the ledger and the ledger accounts are
balanced.
4. At the end of the accounting period, a trial balance is prepared to ensure quality of debits and
credits.
5. Adjustment and closing entries are made to enable the preparation of financial statements.
6. As a last step financial statements are prepared.

These six steps taken sequentially complete the accounting process during an accounting period and are
repeated in each subsequent period.

Key Words
Account A statement wherein information relating to all items are accumulated.

Credit Signifies decrease in asset accounts, increase in liability accounts and increase in
owners’ equity accounts.
Debit Signifies increase in asset accounts, decrease in liability accounts and decrease in
owners’ equity accounts.
Journal A book of prime entry.

Ledger A set of accounts of a specific business enterprise.

Trial Balance
A list of balances of accounts to ensure arithmetical accuracy.
Chapter 3- Closing Adjustment Entries

Introduction
While preparing the final accounts, we have to make certain closing adjustment entries such as
providing depreciation on fixed assets, providing for bad and doubtful debts, rectify the errors
that might have taken place, and reconcile the bank balance. We have to also make provisions
for the expenses incurred but not paid, income accrued but not received, prepaid expenses etc.
The purpose of these entries is to match the transactions pertaining to the period and to arrive at a
true and correct position of assets and liabilities and profit and loss statement.

Depreciation Accounting
With the passage of time, all fixed assets lose their capacity to render services, the exceptions
being land and antics. Accordingly, a fraction of the cost of the asset is chargeable as an expense
in each of the accounting periods in which the asset renders services. The accounting process for
this gradual conversion of capitalized cost of fixed assets into expense is called depreciation.

Depreciation can be defined as a permanent, continuous and gradual reduction in the book value
of a fixed asset. In common parlance depreciation means a fall in the quality or value of an asset.
But in accounting terminology, the concept of depreciation refers to the process of allocating the
initial or restated input valuation of fixed assets to the several periods expected to benefit from
their acquisitions and use. Depreciation accounting is a system of accounting which aims to
distribute the cost or other basic value of tangible capital assets, less salvage (if any), over the
estimated useful life of the unit (which may be a group of assets) in a systematic and rational
manner. It is a process of allocation and not of valuation.
The international accounting standards committee (IASC) (now international accounting
standards board) defines depreciation as follows:
Depreciation is the allocation of the depreciable amount of an asset over the estimated useful life.
The useful life is in turn defined as the period over which a depreciable asset is expected to be
used by the enterprise.
The depreciable amount of a depreciable asset is its historical cost in the financial statements,
less the estimated residual value. Residual value or salvage value is the expected recovery or
sales value of the asset at the end of its useful life.
Causes of Depreciation
The causes of depreciation are:
1. Use factor
2. Time factor
3. Obsolescence
Among other factors, the two main factors that contribute to the decline in the usefulness of fixed
assets are deterioration and obsolescence.

Deterioration is the physical process wearing out whereas obsolescence refers to loss of
usefulness due to the development of improved equipment or processes, changes in style or other
causes not related to the physical conditions of the asset.
The other causes of depreciation are:
1. Efflux of time – mere passage of time will cause a fall in the value of an asset even if it is
not used.
2. Accidents – an asset may reduce in value because of meeting with an accident.
3. Fall in market price – a sudden fall in the market price of the asset reduces its value even
if it remains brand new.

Need For Depreciation Accounting

It is necessary to distribute the cost of a fixed asset in such a way so as to allocate it as equitably
as possible to the periods during which the benefits are received from the use of fixed assets.
This system or procedure is called depreciation accounting.

The need for depreciation accounting arises on three grounds:

To calculate proper profit

–

 According to matching concept of accounting, profit of any year can be calculated only
when all costs of earning revenues have been properly charged against them. Asset is an
important tool in earning revenues.

 The fall in the book value of assets reflects the cost of earning revenues from the use of
assets in the current year and hence like other costs like wages, salary, etc., it must also
be provided for proper matching of revenues with expenses.

To show true financial position

–

 The second ground for providing depreciation is that it should result in carrying
forward only that part of asset which represents the unexpired cost of expected future
service.
 If the depreciation is not provided then the asset will appear in the balance sheet at the
overstated value.

To make provision for replacement of assets

–
  If no changes were made for depreciation, profits of the concern would be more to that
extent.
 By making an annual charge for depreciation, a concern would be accumulating
resources enough to enable it to replace an asset when necessary.
 Replacement, thus, does not disturb the financial position of the concern.

Methods of Depreciation
The amount of depreciation of a fixed asset is determined taking into account the following
three factors: its original cost, its recoverable cost at the time it is retired from service and
the length of its life. Out of these three factors the only factor which is accurately known is
the original cost of the asset. The other two factors cannot be accurately determined until
the asset is retired. They must be estimated at the time the asset is placed in service. The
excess of cost over the estimated residual value is the amount that is to be recorded as
depreciation expense during the assets’ life-time.
There are no hard and fast rules for estimating either the period of usefulness of an asset or
its residual value at the end of such period. Hence these two factors, which are inter-related
are affected to a considerable extent by management policies.
In this lesson three such methods are discussed.viz.

1. Straight line method

2. Diminishing balance method
3. Annuity method

1. Straight Line Method (SLM) Of Depreciation

This method which is also known as ‘fixed installment system’, provides for equal amount of
depreciation every year. Under this method, the cost of acquisition plus the installation charges,
minus the scrap value, is spread over the estimated life of the asset to arrive at the annual charge.

In other words, this method writes off a fixed percentage, say 20%, of the original cost of the
asset every year in such a way that the asset is reduced to nil or scrap value at the end of its life.
Evaluation
The chief merit of this method is that it is easy to calculate depreciation, and hence, it is simple.
Depreciation charge is constant from year to year, regardless of the extent of use of the asset.
This method can be employed in the case of assets like furniture and fixtures, short leases, etc.,
which involve little capital outlay, or which have no residual value. This method is criticized on
the ground that the depreciation charge remaining the same every year, cost of repairs and
maintenance would be increasing as the asset becomes older. With the efficiency of the asset
declining, it is unfair to charge the same amount of depreciation every year.
Depreciation = Cost of asset - Estimated scrap value / Estimated life in
years
Illustration 1
On 1-4-2017, machinery was purchased for Rs.10,000. Depreciation at the rate of 10% has to be
written off assuming the life of asset as 10 years. Write up the machinery account for three years
under Straight line method (SLM). Assume the scrap value as nil.

Solution
Machinery Account

In reality new machines are purchased and old machines are sold. Hence the companies maintain
a detailed depreciation schedule to account for purchases and sales of machinery.
Detailed format is as under
Illustration 2
On 1-4-2017, machinery was purchased for Rs.15,000. Depreciation at the rate of 10% has to be
written off. On 1-4-2019 a new machinery for Rs.25,000 was purchased Write up the machinery
account for three years under Straight line method (SLM). Assume the scrap value as nil.

Solution
Machinery Account
Illustration 3
On 1-4-2017, machinery was purchased for Rs.20,000. Depreciation at the rate of 10% has to be
written off. On 1-4-2018 a new machinery for Rs.35,000 was purchased On 1-4-2019 old
machinery was sold for Rs.15,000. Write up the machinery account for three years under Straight
line method (SLM). Assume the scrap value as nil.

Solution
Machinery Account
Notes

1. Even though machinery is sold for 15,000, it will not reflect in Machinery account. Original cost
of machinery sold is deducted from the cost.
2. A depreciation of Rs.2,000 per year was made for two years on the sold machinery. Hence,
Rs.4,000 is deducted from the Depreciation
3. Only one machinery of 35,000 is left and the depreciation for two years on the same is 7,000.
Hence written down value is 28,000.
4. Written Down Value of Machinery sold was Rs.16,000 but it was sold for Rs.15,000. Hence there
will be a loss of Rs.1000 on Loss on sale of asset which will be reflected in Profit and Loss
account.

2. Diminishing Balance Method

The depreciation is provided at a predetermined percentage, on the balance of cost of asset after
deducting the depreciation previously charged (usually termed as written down value).
This method which is also known as the, `reducing installment system’, or `written down value
method’, applies depreciation as a fixed percentage to the balance of the net cost of the asset not
yet allocated at the end of the previous accounting period. The percentage of depreciation is so
fixed that, theoretically, the balance of the unallocated cost at the end of the estimated useful life
of the asset should be equal to the estimated residual value.
Evaluation
Unlike the fixed installment system, depreciation under this method is not fixed, but gradually
decreasing. As such, in the initial periods, the amount will be much higher, but negligible in the
later period of the asset.
Thus, this method tends to offset the amount of depreciation on the one hand and repairs and
maintenance on the other. This method is also simple, although the calculation of depreciation is
a bit complicated. Further, as and when additions are made to the asset, fresh calculations do not
become necessary. This method is best suited to assets such as plant and machinery which have a
long life.
Entries Required
The entry to be made on writing off depreciation under any method is:
Depreciation a/c ……. Dr
To asset a/c
The depreciation account goes to the debit of the profit and loss account.
The entry for this is:
Profit and loss a/c …… Dr
To depreciation a/c
The asset appears at its reduced value in the balance sheet.
Illustration 4
On 1-4-2017, machinery was purchased for Rs.10,000. Depreciation at the rate of 10% has to be
written off. Write up the machinery account for three years under Written down value method
(WDV). Assume the scrap value as nil.

Solution
Machinery Account

In reality new machines are purchased and old machines are sold. Hence the companies maintain
a detailed depreciation schedule to account for purchases and sales of machinery.
Detailed format is as under
3. Annuity Method Of Depreciation
Under the first two methods of depreciation the interest aspect has been ignored. Under this
method, the amount spent on the acquisition of an asset is regarded as investment which is
assumed to earn interest at a certain rate. Every year the asset is debited with the amount of
interest and credited with the amount of depreciation. This interest is calculated on the debit
balance of the asset account at the beginning of the year.
The amount to be written off as depreciation is calculated from the annuity table an extract of
which is given below:
5%
Years 3% 3.5% 4% 4.5%

3 0.353530 0.359634 0.360349 0.363773 0.367209

4 0.269027 0.272251 0.275490 0.278744 0.282012

5 0.218355 0.221481 0.224627 0.227792 0.230975

The amount to be written off as depreciation is ascertained from the annuity table and the same
depends upon the rate of interest and the period over which the asset is to be written off. The rate
of interest and the amount of depreciation would be adjusted in such a way that at the end of its
working life, the value of the asset would be reduced to nil or its scrap value.
Evaluation
This method has the merit of treating purchase of an asset as an investment within the business,
and the same is supposed to earn interest. However, calculations become difficult when additions
are made to the asset. The method is suitable only for long leases and other assets to which
additions are not usually made and as such in case of machinery, this method is not found
suitable.
Illustration 5
A lease is purchased for a term of 4 years by payment of Rs.1,00,000. It is proposed to depreciate
the lease by annuity method charging 4% interest. If annuity of re.1 for 4 years at 4% is
0.275490, show the lease account for the full period.

Amount of annual depreciation= Rs.1,00,000 x re.0.275490= Rs. 27,549

Assets purchased during the year.

If assets are purchased during the year we can make depreciation on proportionate period.
It can be done as under Proportionate depreciation = Depreciation for the year X No of days
from the date of purchase/365.
Example:

Since the companies have different categories of fixed assets carrying different rates of
depreciation, they maintain a detailed Depreciation Schedule as under.
Illustrative Depreciation Schedule

Exercises on Depreciation Accounting

Since Written Down Value method is compulsory under Companies Act we will solve them
only by Written Down Value method.
Exercise 1
Prepare a depreciation schedule up to 31-3-2020 based on the following information.

Solution
Statement of Fixed assets and depreciation
Adjustment Entries
Closing Entries

Periodically, usually at the end of the accounting period, all revenue and expense account

balances are transferred to an account called income summary or profit and loss account and are

then said to be closed.

The balance in the profit and loss account, which is the net income or net loss for the period, is

then transferred to the capital account and thus the profit and loss account is also closed.

In the case of corporation the net income or net loss is transferred to retained earnings account

which is a part of owners’ equity.

The entries which are passed for transferring these accounts are called as closing entries.
Because of this periodic closing of revenue and expense accounts, they are called as temporary
or nominal accounts.
On the other hand, the assets, liabilities and owners’ equity accounts, the balances of which are
shown on the balance sheet and are carried forward from year to year are called as permanent or
real accounts.

The principle of framing a closing entry is very simple. If an account is having a debit balance,
then it is credited and the profit and loss account is debited. Similarly if a particular account is
having a credit balance, it is closed by debiting it and crediting the profit and loss account.

In our example sales account and interest account are revenues, and purchases account and
salaries account are expenses. Purchases account is an expense because the entire goods have
been sold out in the accounting period itself and hence they become cost of goods sold out. This
aspect would become more clear when the reader proceeds to the lessons on profit and loss
account.
The closing entries would appear as follows:

Adjustment Entries
Because of the adopting of accrual accounting, after the preparation of trial balance, adjustments
relating to the accounting period have to be made in order to make the financial statements
complete. These adjustments are needed for transactions which have not been recorded but
which affect the financial position and operating results of the business.

A concern is required to pass certain entries at the end of the year to adjust the various items of
Incomes and expenses, such entries are called as adjustment entries.
Rectification of Errors

Identification of Errors
Errors occur when some transactions are incorrectly entered in the account books. Identification
and rectification of the errors is necessary to ensure the correctness of final accounts.
Need of Rectification

 1

1
 For the preparation of correct Accounting Records.

 2

2
Preparation of P & L A/c with corrected figures to ascertain correct Profit or Loss.
 3
3
To find out the true financial position of the firm by preparing Balance Sheet with
corrected figures.
Classification of Errors
Type of Error with Meaning Sub-Types with Examples

1. Error of Omission (a) Error of Complete Omission

This error occurs when a Goods sold to X on Credit but not recorded in Sales Book.
transaction is not recorded in the
Journal. This type of error is *(b) Partial Omission
difficult to locate because it is not Goods sold to X on Credit recorded in Sales Book but not posted to the A/c
reflected in the Trial Balance as of X, thus sales A/c is credited but X is not debited creating short debit. This
both debit and credit entries error will affect Trial Balance.
related to a transaction are
missing.
2. Error of Commission (a) Error of Recording in the Book Of Original Entry
Goods purchased from Vishal for Rs. 459, recorded as Rs. 549, in the
(These errors are caused due to Purchase Book. (This error will not affect Trial Balance as same amount will
wrong recording of transactions, be posted in both the A/cs, Purchase A/c as well as Ravi.)
wrong totalling of subsidiary *(b) Wrong Totalling of Subsidiary Book
books or Ledger A/cs, Wrong Example: Purchase Book has been under cast (short totalled) by Rs. 100,
posting and wrong carry forward) Purchase A/c will be debited short by Rs. 100, decreasing the debit side of
This error occurs while posting Trial Balance by Rs. 100.
and balancing of accounts in (c) Error in Totalling or Balancing of Ledger A/cs*
Ledger. Example: Creditors A/c has been balanced short by Rs. 500, then Trial
Balance will Rs. 500 short in Credit side.
(d) Error of Posting

*(i) Posting to the wrong side but correct account. Goods sold to X for Rs.
500, entered to the credit of X's A/c instead of posting to the debit side of his
account.
*(ii) Posting with wrong amount.
*(iii) Posting twice in an A/c.
(iv) Errors in posting to the wrong A/c but correct side don't affect Trial
Balance.
*(e) Error in carrying forward
Total of purchase book Rs. 2,500 is carried forward as Rs. 2050 Creating
short debit of Rs. 450, in Purchase A/c and in turn short debit in Trial
Balance.
Type of Error with Meaning Sub-Types with Examples

3. Errors of Principle (a) Treating capital items as revenue item

Example: Wages paid for the installation of a new machinery charged to
(These errors are caused due to Wages A/c instead of Machinery A/c.
the violation of accounting (b) Treating Revenue Items as Capital Item
principles i.e. allocation between Example: Rs. 200 paid for the repairs of an old Machinery but debited to
Capital and Revenue Items. Machinery A/c instead of Repairs A/c.

4. Compensating Errors Example: On July, 1st 2017 a sum of Rs. 2,000 paid to Vishal is posted as Rs. 200
to the Debit of his A/c and on July 20th, 2071 a sum of Rs. 200 paid to Vikasl has
(Two or more errors committed in been posted as Rs. 2,000 to the Debit of his A/c. Net Effect will be zero.
such a way that the net effect of
these errors of the debit and
credits of A/cs is nil).
This error occurs when the entries
corresponding to two or more
transactions, which are incorrectly
entered in the account books,
compensate each other.

From Rectification point of view, errors are classified into the following two categories
only:
Case I: Errors which don't affect the Trial Balance or Two Sided Errors.
Case II: Errors which affect the Trial Balance or one Sided Errors.
Errors not Affecting Trial Balance
–

 Errors of complete omission.

 Wrong recording in the books of original entry.
 Complete omission from posting to the A/cs.
 Errors of posting to the wrong A/c but on the correct side.
 Compensating errors.
 Errors of principle.

Errors Affecting Trial Balance

–

 Errors in totalling of Subsidiary books or ledger A/cs - i.e. overcast or undercast.

 Error in the Balancing of Ledger A/cs.
 Error in posting to the correct A/c but with the wrong amount or to the wrong side or
both.
 Errors of Paitial ommission.
 Omitting to show an A/c in the Trial Balance.
Location of Error
The omission, commission and compensating errors cannot be located from the Trial Balance.
Location of such errors can only be determined when

 Statements of accounts are received from the suppliers, customers and other business associates
 Statements of accounts are sent to the customers
 Internal and external audits are performed

Errors like principle errors are easily located when there is a mismatch between the debit and
credit totals of the Trial Balance.
To locate such errors, an accountant performs any of the following tasks:

 Computes the difference between debit and credit totals in Trial Balance and performs various
operations on it to determine the error entry
 Checks the schedules of sundry creditors and debtors
 Checks the total of all the subsidiary books such as Sales Book and Purchase Book
 Checks all the entries in Journal and their posting in Ledger

Suspense Account

 It is a temporary account to which the difference in the Trial Balance is transferred.

 If the total of credit side is more than the debit side a Suspense Account with Debit balance equal
to the amount of difference is opened and shown on the debit side there by tallying the trial
balance.
 If the total of credit side is less than the debit side a Suspense Account with Credit balance equal
to the amount of difference is opened and shown on the credit side there by tallying the trial
balance.
 It should be opened only when the accountant fails to determine the location of errors.
 It is closed when the accounting entries are passed to rectify the errors that resulted in the
difference in the Trial Balance.
 When in spite of the effects, the Trial Balance does not tally, the difference is put to a newly
opened account named Suspense A/c.
 Suspense A/c is an imaginary account, opened temporarily for the purpoes of reconciling a Trial
Balance.
 Later on when the errors affecting the Trial Balance are located, rectification entries are passed
through the Suspense A/c.
 When all the errors are located and rectified, the Suspense A/c will be automatically closed i.e. it
will show zero balance.
 But if suspense A/c still shows a balance it will indicate that certain errors are still to be
discovered and rectified.

Rectification of Errors

When the errors are detected, these have to be rectified in the books of accounts. Rectification of
errors depends upon The type of error and The time of depiction of an error.
A) Rectification of Two Sided Errors
Two sided errors are those errors which affect two sides of Accounts. These errors don't affect
Trial Balance as discussed earlier. These Errors are rectified by passing a Journal entry
irrespective of the time of rectification. In other words their rectifying entry will be same
whether (a) the error is depicted before preparing Trial Balance or (b) after the preparation of
Trial Balance but before the Final A/cs are prepared.

Steps for Rectification

1. Locate the Effect of Error on Different Accounts.
2. The Account Showing Excess credit should be Debited.
3. The Account Showing Excess Debit should be Credited.
4. The Account Showing short Debit should be Debited.
5. The Account Showing short Credit should be Credited.

Examples (with Explanation)

(I) when an account has wrongly been debited in place of another A/c.
Rectification will be done by debiting the correct account and Crediting the A/c which was
wrongly debited.
Example: Machinery purchased for Rs. 10,000 has been debited to Purchases A/c.
Solution: Here two A/cs are affected.

 Machinery A/c is not debited its debit side is short by Rs.10,000, where as purchases A/c is
debited by mislake purchases A/c debit side is in excess by Rs.10,000. While rectifying this
mistake machinery A/c will be debited by Rs.10,000.
 because it w as not debited earlier and purchases A/c will be credited be cause it was wrongly
debited Hence.

Rectifying Entry is:

(II) When an account has wrongly been Credited in place of another account.
Example: Rs.5,000 received from the sale of old furniture has been Credited to Sales A/c.
Solution: This errors also affects the two A/cs

 Furniture A/c is not Credited its credit side is short by Rs.5,000.

 Sales A/c is credited by mistake its credit side is in excess or Rs.5,000.
 Therefore for rectifying this mistake Sales A/c will be debited because it was wrongly Credited
and Furniture A/c which was not Credited earlier will now be credited by Rs.5,000.

Hence Rectifying entry is:

(III) When there is a short debit in one A/c and a short Credit in another A/c.
Example: Goods sold to Seema for Rs.540 was entered in the Sales Book as Rs.450.
Solution: This errors also affects the two A/cs

 Here Seema's A/c is debited by Rs.90 short and Sales A/c is credited by Rs.90 short. (Instead of
Rs.540 by Rs.450).
 Therefore rectification will be done by Debiting Seema's A/c and Crediting Sales A/c. Hence
Rectifying entry is:

(IV) When there is an Excess Debit in one A/c and Excess Credit in another a/c.
Example: Goods purchased from Mohan for Rs.300, was recorded in Purchase Book as
Rs.3000.
Solution:

 Here Purchases A/c is Debited by Rs.3000, instead of Rs.300, ie. Rs.2700, more.
 Mohan's A/c is also Credited by Rs.2700 more.
 Rectification will be done by debiting Mohan's A/c and Crediting purchases A/c by Rs.2700, ie.
the entry in the reverse direction.

Rectifying Entry:

Problem
Rectify the following errors:

 Credit purchases from Amit not recorded for Rs.8,000 (Error of Complete omission).
 Wages paid Rs.500 for the installation of a new Machinery were recorded in wages A/c. (Error of
Principle).
 Credit sales to Anil for Rs.5,000 were posted to Amit's A/c (Error of Commission).
  Goods purchased from Ram for Rs.900 were recorded in Sales Book (Error of Commission).
 Goods returned to Amit for Rs.1,000 entered as Rs.100 (Error of Commission).
 Rent paid Rs.400 wrongly debited to Landlord's A/c (Error of Principle).
 Rs.500, paid for the proprietor's medical bill were debited to "Sundry Expenses A/c" [Error of
Principle].
 Rs.2,500, received from Anil were recorded in the Cash Book as Rs.5,200 [Error of
Commission].

Solution
Note that In Error No. 4. more than two Account are affected.

Now the Rectifying entry will be Entry (b) + Entry (c) ie.

B) Rectification of One Sided Errors

These errors affect only one side of an Account either debit or credit. Therefore these errors
affect the Trial Balance. Rectification of these errors is done difference in the two cases i.e.

1. Before preparing the Trial Balance

2. After preparing the Trial Balance
Case I: Rectification of one sided errors before preparing Trial Balance.
When there errors are rectified before preparing Trial Balance, rectification is done directly by
debiting or crediting the concerned ledger account.

 For short Debit → Concerned A/c is Debited

 For Excess Credit → Concerned A/c is Debited
 For Short Credit → Concerned A/c is Credited
 For Excess Debit → Concerned A/c is Credited

Example 1
–

Purchase Book undercast by Rs.150

Analysis:
 It means that the total of the Purchase Book is Rs.150 short.
 This total is posted to purchase A/c - Debit side.
 Hence purchase A/c is debited short by Rs.150.
 No effect on any other A/c.
 Therefore purchase A/c will be debited by Rs.150 to rectify this error as given below.

Example 2
–

Purchase Book is overcast by Rs.300

Analysis:
 Means total of the purchase Book is in excess by Rs.300 which is posted to the debit side
of purchase A/c.
 Hence purchase A/c is debited in excess by Rs.300.
 No effect on any other A/c.
 Therefore to rectify this error Rs.300 will be credited to purchase A/c (ie. opposite side).
Case II: Rectification of one Sided Error after Preparing Trial Balance
When the errors are detected after the preparation of Trial Balance then every single sided error
is rectified by passing a Journal entry through the Suspense Account.

 For short Debit in one Account → Debit that Account and Credit the Suspense A/c
 Excess Credit in one Account → Debit that Account and Credit the Suspense A/c
 Short Credit in one Account → Credit that A/c and Debit the Suspense A/c
 Excess Debit in one Account → Credit that A/c and Debit the Suspense A/c

Example 3
–

Hence for the same error as given in example No in case I, the following Journal Entry will be
passed.

Example 4
–

Sales Book was undercast by Rs.200

Analysis:
 Sales book totalled short by Rs.200 which is posted to the credit side of sales A/c.
 Therefore sales A/c credit side is short by Rs.200.
 Hence rectification will be done by crediting the sales A/c and Debiting the Suspense A/c
by Rs.200.
Note
When nothing is mentioned in the question about the time of detection of an error, the students
are advised to rectify one sided errors through Suspense A/c.

Exercises on Rectification of Errors

Rectify the following errors
1. Without opening a Suspense A/c
2. By passing Journal entries through Suspense A/c

 Rs.400 Paid to X were entered in the Cash Book but omitted to be posted to the Ledger.
 Rs.400 Paid to X were debited to his A/c as Rs.40.
 Rs.400 paid to X were debited to his A/c as Rs.4000 (for Thousand).
 Rs.400 Paid To X were Credited to his A/c.
 Rs.400 Paid To X were Credited to his A/c as Rs.40.
 Sales Book was overcast by Rs.200.
 Sales Return Book undercast by Rs.400.
 Purchase Return Book undercast by Rs.500.

Solution
Without opening a Suspense A/c, if the errors (single side) are detected before preparing
Trial Balance then these are rectified by directly the amount in the concerned Ledger
Accounts.

 X’s A/c will be debited by Rs.400 as it is a case of partial ommission.

 X’s A/c was debited show by Rs.360 (400-40) there for the rectification will be done by debiting
X’s A/c by Rs.360.
 X’s A/c was debited in excess by Rs.3600 (4000-400) therefore rectifica - tion will be done by
Crediting the X’s A/c by Rs.3,600.
 X’s A/c was Credited by Rs.400 instead of debiting by Rs.400, therefore rectification will be
done by debiting the X’s A/c by Rs.400+400 ie. Rs.800 (Rs.400 to cancel the effect of wrong
credit and Rs.400 for actually debiting the A/c).
 X’s is wrongly Credited by Rs.40 instead of Debiting it by Rs.400. Hence rectification will be
done by Debiting the X’s A/c by Rs.440.
 Sales Book overcast means Sales A/c is Credited is excess by Rs.200 where as customer’s have
been debited by the correct amount.
Hence rectificaion will be done by debiting - Sales A/c by Rs.200.
 Sales Return Book total Undrcast by Rs.400 means Sales Return A/c is debited short by Rs. 400.
Hence Rectification will be done by debiting the Sales Return A/c by Rs.400.
 Purchase Return Book undercast by Rs.500 means Purchase Return A/c is credited short by
Rs.500.

Hence rectification will be done by Crediting the Purchase Return A/c by Rs.500.
Exact Solution
In this example the rectification in X’s A/c from Error No. 1 to 4 will be shown as follows:
X's Account
By opening Suspense A/c only Rectifying Journal Entries are done.

Problem: An accountant of a trading concern could not agree the Trial Balance.
There was an excess credit of Rs.100 which he transferred to the suspense A/c.
The following errors were then subsequently discovered:

 Received Rs.550 from X, were posted to the debit of his account.

 Rs.100 being purchase return were posted to the debit of purchases A/c.
 Discount received Rs.200 Correctly entered in the Cash Book but posted to the debit of the
discount A/c.
 Salary paid Rs.3,500 to x were posted to the salary A/c as Rs.2,500.
 A purchase of Rs.400 has been passed through Sales Book. However the customer's account has
been correctly credited.

Give Rectifying entries and Suspense A/c

Rectifying Journal Entries
Suspense A/c

Since the Balance of the suspense A/c is nil, it indicates that all the errors have been rectified.

Bank Reconciliation Statement

Usually all the firms open a current account with the bank as there are so many transactions
and record these transactions in the Bank column of the Cash Book. Bank also maintains a
separate ledger account of each firm (customer) and periodically supplies a copy of the account
to the firm for information. This copy of the firm's Account supplied by the bank is known as
Bank Statement or Bank Pass Book. Since all the transactions with the bank are entered in
both the books Cash Book and Pass Book, the balances of the two books should tally with each
other. But usually the two balances don't tally. Bank Reconciliation Statement is prepared to
reconcile the difference between the Bank Balance shown by the Cash Book and Bank Pass
Book.

DEFINITION
A schedule showing the items of difference between the bank statement and the bank
column of Cash Book is known as Bank Reconciliation Statement.
Causes for Difference in Balances
Causes of Differences in Cash Book and Pass Book
The differences may be caused by either

1. Time gap in recording transactions or

2. Errors Committed in recording transactions.

Differences Caused by the time gap

–

Reasons for the time gap in recording the transactions in the two books (Cash Book and Pass
Book) are as given below –
 Cheques issued but not yet presented for payment in the bank.
 Cheques deposited or paid into the bank for collection but not yet credited by the bank.
 Cheques deposited but dishonored by the bank.
 Interest allowed by the bank.
 Interest on overdraft, bank charges, commission etc. charged by the bank.
 Direct Deposit by the customers into the bank.
 Interest, Dividend etc. collected by the bank.
 Direct payments made by the bank on behalf of customer as per standing instruction.

Differences caused by Errors Committed

–

Such errors may be of two types

(1) Errors committed by the firm
 Cheques issued to some creditors but omitted to be recorded in the Cash Book or
recorded twice.
 Cheques deposited into the bank omitted to be entered in the Cash Book or recorded
twice.
 Error in totalling or balancing the bank column of the Cash Book.

(2) Errors committed by the bank

Something bank records a wrong entry in the customer's account which causes a difference in
the two balances.
Need and Importance:
 It helps in locating and rectifying the errors or omissions committed either by the firm
or by the bank.
 Customer becomes sure of the correctness of the bank balance shown by the cash book.
 Facilitates the preparation of amended or revised Cash Book.
 Reduces the chances of fraud by the staff of the firm or bank.
 Helps in keeping a track of the cheques deposited for collection.
Procedure of Preparing Bank Reconciliation Statement
A Bank Reconciliation Statement is prepared when we get the duly completed Pass Book from
the Bank. On receiving the Cash Book,

1. First of all tally the Debit side entries of the cash book with the Credit side entries of the Pass
Book and vice versa.
2. Tick the items appearing in both the book.
3. Unticked items will be the points of differences.
4. A BRS is then prepared by taking either the balance as per Cash Book or Pass Book as a starting
point.

Important Points
1. If the Starting point is Cash Book Balance then the ending point will be Pass Book
Balance.
2. If the starting point is Pass Book Balance then the ending point will be the Balance as per
Cash Book.
3. Debit Balance as per Cash Book or Credit Balance as per Pass Book, means that the firm
has that much amount of deposited at the bank also called favorable balance write the
amount under + item.
4. Credit Balance as per Cash Book or Debit Balance as per Pass Book, means that this
much amount has been withdrawn in excess of deposit also called overdraft or
unfavorable balance write the amount under - item.

Method of Preparing BRS Starting with by the Balance/overdraft as per Bank Column of Cash
Book.

Note
To get more from less means something is to be added therefore + item & To get less from more,
something is to be deducted therefore _ item.
1. First of all write
Under Plus Item – If the Cash Book Balance is debit or favourable or simple balance.
Under Minus Item – If the Credit Balance or overdraft as per Cash Book is given.
2. Now study the point of difference
(a) If the entry is done in the Cash Book and not in the Pass Book then.

 If it is done on the debit side of Cash Book, Balance in the Cash Book will be more as compared
to Pass Book and hence the item will be – item as shown in the box above.
 Where as if the entry is done on the Credit side of Cash Book, the Balance in the Cash Book will
be less as compared to Pass Book and hence the item will be + item.

(b) If the entry is done in the Pass Book and not in the Cash Book then.
  If done on the Credit side of Pass Book– Pass Book Balance is more as compared to Cash Book –
item.
 It it is done on the Debit side of Pass Book– Pass Book Balance is less as compared to Cash Book
(–) item.

3. At the end + items and - items are totalled

(a) If total of Plus Items is more than the total of (-) items Difference is Cr Balance or favourable
balance as per Pass Book.

(b) Where as if the - items total is more than the + items total Difference is Dr Balance or
overdraft as per Pass Book. Balance or overdraft as per Pass Book.
Ready Reference
+ Items (Items which increases the Pass Book Balances or decreases the Cash Book Balance)

 Cheques issued but not yet presented.

 Credits made by the bank for Interest.
 Amount directly deposited by the customers in our bank A/c.
 Interest and dividend collected by the bank.
 Cheques paid into the bank but omitted to be recorded in the Cash Book.

– Items (Items which, decreases the Pass Book Balance or increase the Cash Book Balance)

 Cheques sent to the bank for collection but not yet credited by the bank.
 Cheques paid into the bank but dishonored.
 Direct payments made by the bank.
 Bank charges, commission etc. debited by the bank.
 Cheques issued but omitted to be recorded in the Cash Book.

Exercises on Bank Reconciliation Statement

Example 1: Balance as per Cash Book is given
Prepare BRS as on 31st July 2011

 Balance as per Cash Book is Rs.25,000 as on 31st July 2011.

 Cheques for Rs.15,000 were deposited into the Bank in the month of July but only cheques for
Rs.11,000 were credited by the bank till 31st July 2011.
 Cheues issued for Rs. 13,000 in July, out of which a cheque for Rs.3,800 was presented for
payment on 3rd August.
 Bank charged Rs. 50 as Bank charges and credited interest of Rs.370.
 A customer directly deposited Rs. 1,550 in tirm's bank A/c.
 Bank paid the Insurance Premium of Rs.1,200 as per standing instructions on 25.07.2011.

Solution
Explanation

 Balance per Cash Book means favourable Balance, hence + item. If nothing (i.e. Debit or Credit)
is written with the Balance given, it is treated as favourable.
 Cheques were deposited into the bank for Rs.15,000 but credited by the bank for Rs.11,000 in the
month of July, implies that cheques for Rs.4,000 (15,000– 11,000) are entered in the Cash Book
but not in the Pass Book increasing the Cash Book Balance by Rs.4,000 as compared to Pass
Book. Hence to get Pass Book Balance from the Cash Book Balance Rs.4,000 will have to be
deducted.
 Cheque issued but not presented for payment till 31st July is for Rs.3800 entered more on the
credit side of Cash Book as compared to Pass Book Cash book Balance is less by Rs. 3800 as
compared to Pass Book + item.
 (a) Bank charges of Rs.50 entered in the Pass Book decreases the Balance of Pass Book.To reach
Pass Book Balance from Cash Book Balance, this item has to be deducted i.e. – item.
(b) Interest credited by the Bank Rs.370 entered in Pass Book increases the, balance of Pass
Book, hence to seach the Balance from cash book and this item is to be added + item.
 Direct deposit by a customer Rs.1,550 increases the Pass Book Balance + item.
 Payment made by the bank for insurance premium decreases the Pass Book Balance – item.
 + items total Rs. 30,720 is more than – item total Rs.5250 by Rs.25,470. Hence the difference of
Rs.25,470 will be + item i.e. Favaurable Balance or Cr Balance as per Pass Book.

Example 2: When overdraft as per Cash Book is given

 Overdraft as per Cash Book is Rs.10,500 on 30th June 2011.

 Cheques deposited but not yet collected Rs.2,000.
 Chequs issued but not yet presented for payment of Rs.2,800.
 Bank charges of Rs.50 and Interest on overdraft of Rs.250 are. charged by the bank.
  A customer directly deposited Rs.1,200 into the Bank.
 Insurance Premium of Rs.1,500 is paid by the bank as per standing instructions.
 Prepare Bank Reconcilliation Statement for the month of June 2011.

Solution

Overdraft means unfavaurable balance or Negative Balance

Hence put it under – item. Explanation for all other items is similar as example 1 except the
following.

 Item No. 4 (b) - Interest on overdraft decreases the Pass Book Balance hence it is to be deducted
from Cash Book Balance to reach at Pass Book Balance item.
 This time the total of (-) items Rs.14,300 is more to the total of + item is Rs.4,000 by Rs.10,300.

Hence this is a (–) item or in other words overdraft as per Pass Book.
Case II – Starting with Pass Book Balance/overdraft.

 First of all write under

+ Item – If Cr Balance, favaurable balance or Simply Balance as per Pass Book is given. [60]
(–) Item - If Debit Balance or overdraft as per Pass Book is given.
 Now study the point of difference between the Cash Book and Pass Book.
 1. If the entry is done in the Cash Book and not in the Pass Book then.
If is done on the Debit side of Cash Book Balance in the Cash will be more as compared
to Pass Book and hence the item is to be added in the Pass Book Balance to get the Cash
Book Balance i.e. + item.

Where as if the entry is done on the Credit side of Cash Book Cash Book Balance will be
less as compared to Pass Book hence (–) item.
2. If the entry is done in the Pass Book and not in the Cash Book then.
If it is done on the Debit side of Pass Book Pass Book Balance is less as compared to
Cash Book item is to be added in Pass Book Balance to get the Cash Book Balance +
item.
If is done on the Credit side of Pass Book Pass Book Balance is more as compare to Cash
Book item. (-) item.
 At the end + item and – item are totalled.

Ready Reference
+ Items [items which increases the Cash Book Balances or decreases the Pass Book Balance]

 Cheques sent for collection to the bank but not yet credited/collected by the bank.
 Cheques deposited into the bank but dishonoured.
 Direct Payments made by the bank.
 Bank charge, commmission etc. debited by the bank.
 Cheques issued but omitted to be recorded in the Cash Book.

- Items [Items which decreases the Cash Book Balance or increases the Pass Book Balance]

 Cheques issued but not yet presented.

 Credits made by the bank for interest.
 Amount directly deposited by the customers into the Bank.
 Interest and dividend collected by the Bank.
 Cheques paid into the bank but omitted to be recorded in the Cash Book.

Example 3: Balance as per Pass Book is given

Given (1) Balance as per Pass Book is Rs.25,470 Point No. (2) to (6) are same as given in
example (1) Prepare B.R. Statement for the month of July 2011. [ 61 ]

Solution
Important Points

 Starting and Ending Points are reversed as compared to Example No. 1, Hence + items and (–)
items are interechanged.
 Favourable balance whether of Cash Book or Pass Book is always a + item.
 If + items total is more than the – items total then the difference in the two totals is always a
favourable balance.
 where as if + items total is less than the – items total then the difference in the two totals is
overdraft.

Example 4: Overdraft as per Pass Book is given

Given that (1) Overdraft as per Pass Book is Rs.10,300 Rest of the contents (points 2 to 6) are
same as given in example No. 2
Prepare B.R. Statement for the month of June 2011

Solution
Important Points

 Overdraft whether as per Cash Book or Pass Book is always a (–) items.
 Starting and Ending points are interchanged as compared to Example No. 2, hence + items and
(–) are also interchanged.
 Here (–) items total is more as compared to (+) items total, therefore the difference in the two
balance is a negative items i.e. overdraft as per Cash Book.

Amended Cash Book Method

Introduction
So far we have studied the preparation Bank Reconcilliation Statement simply by reconciling the
causes of differences between the Cash Book and Pass Book. In actual practice adjustments are
done in the Cash Book by comparing the Bank column of Cash Book with the Bank Statement
and after that B.R. Statement is prepared. It is called Amended Cash Book Method.

Procedure

1. Adjusted Cash Book is prepared starting with the Balance of the Cash Book given in the question.
2. All errors that have been committed in the Cash Book will have to be rectified by passing
adjusting entries in the Cash Book.
Usual or General Errors are:
1. Overcasting or Undrcasting of Debit/Credit Column of Cash Book.
2. Cheques deposited or Issued but omitted to be entered in the Cash Book.
3. Incorrect amount (if any) entered in the Cash Book.
4. Entries on the incorrect side or in the wrong column of Cash Book.
5. Any amount recorded twice in the Cash Book.
 3. Certain amounts for which Bank has debited our A/c will be recorded on the Credit side
of Cash Book. Such items are:
1. Interest charged by the bank on overdraft etc.
2. Debits made by the bank for the bank charges, commission etc.
3. Direct payments made by the Bank on behalf of the A/c holder.
4. Cheques sent for collection but dishonoured by the bank.
5. Any amount recorded twice in the Cash Book.
4. Cash Book is then balanced and the new Balance of the Cash Book is taken as the
Starting point for preparing the B.R. Statement.
Important:
1. It should be noted that the following items must not be recorded in the Amended
Cash Book.
2. Cheques deposited into the Bank but not yet credited by the bank.
3. Cheques Issued but yet not presented for payment.
4. Any wrong entry in the Pass Book.
Example 5: Overdraft as per Pass Book is given
The Cash Book of Mr. Sharma showed a balance of Rs.3,560 as on 31st Dec. 2010 at the Bank
where as Pass Book showed a balance of Rs.4,230.
Comparison of the Cash Book and Pass Book revealed the following.

1. The Bank has debited Mr. Sharma with Rs.460, the annual premum of his life policy according to
his standing instructions and Rs 20 as Bank charges.
2. Mr. Sharma paid into the Bank cheques totalling Rs.3,100 on Dec. 26th 2010 of which those for
Rs.2,500 were collected in December. One cheque for Rs.200 was returnced deshonoured on 2nd
Jan. 2011.
3. The Bank has credited Mr. Sharma by Rs.1,600, the preceeds of a bill.
4. Cash collected on 31st Dec. 2010 totalling Rs.850 was entered in the Cash Book in the Bank
column on the same date but banked on 2.1.2011.
5. Mr. Sharma issued cheques totalling Rs.2,300 in the month of Dec. out of which cheques for
Rs.1000 have not been presented for payment till 31st Dec.

Solution
Points to Remember

 Amended or adjusted Cash Book is started with the given balance of bank as per Cash Book.
 Closing Balance of the adjusted Cash Book is the opening balance of Bank Reconciliation
statement.
 Entry for the dishouner of the cheques of Rs.200 is not done.

1. In the Cash Book as its was dishonoured after 31st Dec.

2. In Bank Reconciliation Statement it is included in the adjustment (Rs.3100–2500)

Example 6
Prepare a Bank Reconciliation Statement on the basis of the following information:
Solution

Summary
Depreciation can be defined as a permanent, continuous and gradual reduction in the book value
of a fixed asset.

The causes of depreciation are 1) Use factor 2) Time factor 3) Obsolescence.

Methods of depreciation are 1) Straight line method 2) Diminishing balance method and 3)
Annuity method.

Straight Line Method (SLM) Of Depreciation: This method which is also known as ‘fixed
installment system’, provides for equal amount of depreciation every year. Under this method,
the cost of acquisition plus the installation charges, minus the scrap value, is spread over the
estimated life of the asset to arrive at the annual charge.

Diminishing Balance Method: The depreciation is provided at a predetermined percentage, on

the balance of cost of asset after deducting the depreciation previously charged (usually termed
as written down value).

Periodically, usually at the end of the accounting period, all revenue and expense account
balances are transferred to an account called income summary or profit and loss account and are
then said to be closed.

Because of the adopting of accrual accounting, after the preparation of trial balance, adjustments
relating to the accounting period have to be made in order to make the financial statements
complete. These adjustments are needed for transactions which have not been recorded but
which affect the financial position and operating results of the business.

Errors occur when some transactions are incorrectly entered in the account books. Identification
and rectification of the errors is necessary to ensure the correctness of final accounts.

 Error of Omission: This error occurs when a transaction is not recorded in the Journal.
 Error of Commission: These errors are caused due to wrong recording of transactions, wrong
totaling of subsidiary books or Ledger A/cs, Wrong posting and wrong carry forward.
 Errors of Principles: These errors are caused due to the violation of accounting principles.
 Compensating Errors: Two or more errors committed in such a way that the net effect of these
errors of the debit and credits of A/cs is nil.
 Suspense Account: It is a temporary account to which the difference in the Trial Balance is
transferred
A schedule showing the items of difference between the bank statement and the bank column of
Cash Book is known as Bank Reconciliation Statement.

The differences may be caused by either

1. Time gap in recording transactions or

2. Errors Committed in recording transactions

3. Key Words
Accumulated
The total periodic depreciation charged on depreciable assets.
Depreciation
Bank Reconciliation A schedule showing the items of difference between the bank statement and the
Statement bank column of Cash Book.
Two or more errors committed in such a way that the net effect of these errors of
Compensating Errors
the debit and credits of Accounts is nil.

Depreciable Amount The historical cost less the estimated residual value.

Asset which is expected to be used during more than one accounting period nd is
Depreciable Asset
held for long term use to generate income.

The depreciation is provided at a predetermined percentage, on the balance of

Diminishing Balance
cost of asset after deducting the depreciation previously charged (usually termed
Method
as written down value.

These errors are caused due to wrong recording of transactions, wrong totaling of
Error of Commission
subsidiary books or Ledger Accounts, Wrong posting and wrong carry forward.

Error of Omission This error occurs when a transaction is not recorded in the Journal.

Errors of Principles These errors are caused due to the violation of accounting principles.

Fixed installment system’, which provides for equal amount of depreciation every
Straight Line Method
year spread over the estimated life of the asset.

It is a temporary account to which the difference in the Trial Balance is

Suspense Account
transferred.

Written Down Value Cost less Accumulated Depreciation.

Accumulated
Depreciation The total periodic depreciation charged on depreciable assets.

Chapter 4- Preparation of Financial Statement

The primary objective of any business concern is to earn income. Ascertainment of the periodic
income of a business enterprise is perhaps the important objective of the accounting process.
This objective is achieved by the preparation of profit and loss account or the income statement.
Profit and loss account is generally considered to be of greatest interest and importance to end
users of accounting information. The profit and loss account enables all concerned to find out
whether the business operations have been profitable or not during a particular period. Usually
the profit and loss account is accompanied by the balance sheet as on the last date of the
accounting period for which the profit and loss account is prepared.

A balance sheet shows the financial position of a business enterprise as of a specified moment of
time. It contains a list of the assets, the liabilities and the capital of a business entity as of a
specified date, usually at the close of the last day of a month or a year. While the profit and loss
account is categorized as a flow report (for a particular period), the balance sheet is categorized
as a status report (as on a particular date).

Profitability Statement

Profit and loss account consists of two elements: one element is the inflows that result from the
sale of goods and services to customers which are called as revenues. The other element reports
the outflows that were made in order to generate those revenues; these are called as expenses.
Income is the amount by which revenues exceed expenses. The term ‘net income’ is used to
indicate the excess of all the revenues over all the expenses.
The basic equation is: Revenue – Expenses = Net Income

This is in accordance with the matching concept.This financial statement is referred to as “Profit
and Loss Account” in more technical language. The purpose of this financial statement is to
disclose the result of operations of the business transactions during a given period of time. As
such, by nature, profit & loss account is a period statement which relates to a specific duration of
time. Hence, profit and loss account is always referred to as “Profit and Loss Account for the
year ended on 31st March 2017.”
Profit and loss account may have the following four components –
MANUFACTURING ACCOUNTTRADING ACCOUNTPROFIT AND LOSS
ACCOUNT

This part of Profit and Loss Account discloses the result of manufacturing operations carried
out by the organization. The final result disclosed by the Manufacturing Account is the Cost of
Production incurred by the organization.

Following is the specimen of Manufacturing Account:

Manufacturing Account for the year ended 31st March 2017.

Format of Trading & Profit & Loss Account

Expenditure Income

200 By sales 2,200

To opening stock

To purchases 1,000 By closing stock 225

500
To direct mfg expenses

To gross profit
725

2,425 2,425

To gross profit By gross profit

150 725

To gross profit 75 By interest 5

Format of Trading & Profit & Loss Account

To telephone By other income

50 10

To travelling
15

To rent 50

To bad debts
2

To taxes & insurance

10

To professional fees 4

To interest
50

To depreciation
31

To other expenses
40

To net profit 263

740 740

Trading and Profit and Loss Account

Expenditure Income

To opening stock By sales 2,200

200

To purchases By closing stock

1,000 225

To direct mfg expenses

500
Format of Trading & Profit & Loss Account

To direct mfg expenses

725

2,425 2,200

To salary 150 By gross profit

725

To electricity By interest
75 5

To telephone 50 By other income

10

To travelling
15

To rent 50

To bad debts
2

To taxes & insurance

10

To professional fees
4

To interest 50

To depreciation
31

To other expenses
40

To net profit 263

740
740

The structure of the profitability statement can be drafted as below:

Sales
Less : Factory Cost
Gross Profit
Less : Administrative and Selling Overheads
Operating Profits
Less : Non-Operating Expenses
Add : Non-Operating Incomes
Profit Before Tax
Less : Taxes
Profit After Tax
Less : Dividend Paid
Retained Profit
Format of an Operating Statement
3/31/201
3/31/2016

Sales 36.64 20.30

1

2 Other income
0.00 0.01

Total 36.64 20.31

-
-

Opening stock of RM 0.00

3 0.00

Purchase of RM 7.41
12.94

Closing stock of RM 0.00

0.00

Raw Material consumed 7.41

12.94

Direct labour 2.59

2.03

Power & fuel 3.12

4.33

Other manufacturing exp 7.82

0.49

Change in finished goods

0.22 0.00
 Cost of goods sold 27.90 13.05

4 To gross profit
8.74 7.26

Gross profit margin 23.85% 35.71%

Selling & admni. expenses 4.02

2.54

Profit Before DIT (PBDIT) 6.20

5 3.24

Depreciation 1.72
2.05

Profit before interest & tax 4.15

6 1.52

Interest on loan a/cs

0.80 1.02

Interest on cash credit

0.00 0.00

7 Total interest 0.80

1.02

8 Profit Before Tax (PBT) 0.50

3.35

9 Provision for tax 0.00

0.00

10 Profit After Tax (PAT) 0.50

3.35

Net Profit Margin 9.14% 2.46%

Income And Owner’s Equity

+

Income Vs. Receipts

+
Expenses
An expense is an item of cost applicable to an accounting period. It represents economic
resources consumed during the current period. When expenditure is incurred the cost involved is
either an asset or an expense.
If the benefits of the expenditure relate to further periods, it is an asset. If not, it is an expense of
the current period. Over the entire life of an enterprise, most expenditure becomes expenses. But
according to accounting period concept, accounts are prepared for each accounting period.
Hence, we get the following four types of transactions relating to expenditure and expenses:
Multiple-step form of income statement:
Gross Sales
Less: Sales Returns
Net Sales
Less: Cost Of Goods Sold
Raw Materials Cost
Opening Stock Of Raw Material
Add Purchase Of Raw Material
Freight
Raw Materials Available
Less Closing Stock Of Raw Material
Raw Materials Consumed
Direct Labour Cost
Manufacturing Expenses
Total Production Cost
Add Opening Work-In-Progress
Total
Less Closing Work-In-Progress
Cost Of Goods Manufactured
Add Opening Finished Goods
Cost Of Goods Available For Sale
Less Closing Finished Goods
Cost Of Goods Sold
Gross Profit
Less Operating Expenses
Administrative Expenses
Selling And Distribution Expenses
Operating Profit
Add Non-Operating Income
(Such As Dividend Received Profit On Sale Of Assets Etc.)
Less Non-Operating Expenses
(Such As Discount On Issue Of Shares Written Off, Loss On Sale Of Assets, Etc.)
Profit (Or) Earnings Before Interest & Tax (EBIT)
Less Interest
Profit (Or) Earnings Before Tax (EBT)
Less Provision For Income-Tax
Net Profit (Or) Earnings After Tax (EAT)
Earnings Per Share Of Common Stock
The advantage of multiple-step form of income statement over single step form and the “t”
shaped profit and loss account is that there are a number of significant sub totals on the road to
net income which lend themselves for significant analysis.
 Operating Statement of TCS Ltd.
Consolidated
(amount in crores)

2014-15 2013-14

94,648.41 81,809.36
Revenue from operations

Operating expenditure 70,166.70 56,656.57

Earnings Before Interest, Tax,

Depreciation and Amortisation 24,481.71 25,152.79
(EBITDA)

Other income (net) 3,229.91 1,636.74

Finance costs 104.19 38.52

Depreciation and amortisation expense 1,798.69 1,349.15

Profit before exceptional item and tax 25,808.74 25,401.86

Exceptional item 489.75

-

Profit before tax (PBT) 26,298.49 25,401.86

Tax expense 6,238.79 6,069.99

Profit for the year before minority

20,059.70 19,331.87
interest

Minority interest 207.52 168

Profit for the year (PAT) 19,852.18 19,163.87

Adjustment for amalgamation of -

-
acquired subsidiaries
 Operating Statement of TCS Ltd.
Consolidated
(amount in crores)

Balance brought forward from previous

39,504.51 29,529.97
year

Amount available for appropriation 59,356.69 48,693.84

Appropriations - -

Interim dividends on equity shares

10,772.92 2,349.87
(excluding tax)

Proposed dividend on equity shares

4,700.95 3,917.46
(excluding tax)

Dividend on redeemable preference

28.76
shares (excluding tax)

Tax on dividends (interim and proposed) 2,635.69 795.68

Write back of tax on dividends of prior

-20.97
year -

Capital redemption reserve 157.12

255.57

General reserve 1,953.64 1,883.41

Statutory reserve 46.24 57.03

Balance carried to balance sheet 39,012.65 39,504.51

Observations on Operating statements:

REVENUESEBITDAPROFIT BEFORE TAX (PBT)PROFIT AFTER TAX
(PAT)EARNINGS PER SHARE (EPS)DIVIDEND

The revenue of the Company aggregated 94,648.41 crores in fiscal 2015 (81,809.36 crores in
fiscal 2014), registering a growth of 15.69%. In terms of US Dollars, the revenue in fiscal 2015
was $15.45 billion ($13.44 billion in fiscal 2014) registering a growth of 14.96%.

In fiscal 2015, there was a special, one-time reward to eligible employees, which increased the
employee expenses by 2,627.91 crores.
Explanation of Items on the Income Statement:
The heading of the income statement must show:

 The business enterprise to which it relates

 The name of the statement (income statement)
 The time period covered (year ended 31st march of the relevant year)

The income statement is generally followed by various schedules that give detailed account of
the items, listed on them. Information about these schedules are given against each item in the
financial statements.
One important objective in reporting revenue on an income statement is to disclose the major
source of revenue and to separate it from miscellaneous sources. For most companies the major
source of revenue is the sale of goods and services.

Sales Revenue
An income statement often reports several separate items in the sales revenue section, the net of
which is the net sales figure. Gross sales is the total invoice price of the goods sold or services
rendered during the period. It should not include sales taxes or excise duties that may be charged
to the customers.

Such taxes are not revenues but rather represent collections that the business makes on behalf of
the government and are liabilities to the government until paid. Similarly, postage, freight or
other items billed to the customers at cost are not revenues. These items do not appear in the
sales figure but instead are an offset to the costs the company incurs for them. Sales returns and
allowances represent the sales values of goods that were returned by customers or allowance
made to customers because the goods were defective.

The amount can be subtracted from the sales figure directly without showing it as a separate item
on the income statement. But it is always better to show them separately.

Cash discount Vs. Trade discount

Sometimes called as cash discounts, sales discounts are the amount of discounts allowed to
customers for prompt payment. For example: If a business offers a 3% discount and if sales are
Rs.10,000 the business receives only Rs.9,700 in cash and records the balance Rs.300 as sales
discount.

There is another kind of discount called as trade discount which is given by the wholesaler or
manufacturer to the retailers to enable them to sell at catalogue price and make a profit: example
List less 30 percent. Trade discount does not appear in the accounting records at all.

Miscellaneous or Secondary Sources Of Revenues

These are revenues earned from activities not associated with the sale of the enterprise’s goods
and services. Interest or dividends earned on marketable securities, royalties, rents and gains on
disposal of assets are examples of this type of revenues.

For example: In the case of its operating loss has been converted into net profit only because of
other income, other than sales revenue.
Cost of Goods Sold
When income is increased by the sale value of goods or services sold, it is also decreased by the
cost of these goods or services. The cost of goods or services sold is called the cost of sales. In
manufacturing firms and retailing business it is often called the cost of goods sold.

The complexity of calculation of cost of goods sold varies depending upon the nature of the
business. In the case of a trading concern which deals in commodities it is very simple to
calculate the most of goods sold and it is done as follows:

Opening stock xxx

Add: purchase xxx
Freight xxx
Goods available for sale xxx
Less: closing stock xxx
Cost of goods sold xxx

The calculation becomes a complicated process in the case of manufacturing concern, especially
when a number of products are manufactured because it involves the calculation of the work in
progress and valuation of inventory. The cost of goods sold in the case of would have been
calculated as given in illustration `e’.

Illustration: Cost Of Goods Sold

Gross Profit
The excess of sales revenue over cost of goods sold is gross margin or gross profit. In the case of
multiple-step income statement it is shown as a separate item. Significant managerial decisions
can be taken by calculating the percentage of gross profit on sale.

This percentage indicates the average mark up obtained on products sold. The percentage varies
widely among industries, but healthy companies in the same industry tend to have similar gross
profit percentages.

Operating Expenses
Expenses which are incurred for running the business and which are not directly related to the
company’s production or trading are collectively called as operating expenses. Usually operating
expenses include administration expenses, finance expenses, depreciation and selling and
distribution expenses. Administration expenses generally include personnel expenses also.
However sometimes personnel expenses may be shown separately under the heading
establishment expenses.

Until recently most companies included expenses on research and development as part of general
and administrative expenses. But now-a-days the financial accounting standards board (fasb)
requires that this amount should be shown separately. This is so because the expenditure on
research and development could provide an important clue as to how cautious the company is in
keeping its products and services up to date.

Operating Profit
Operating profit is obtained when operating expenses are deducted from gross profit.

Non-Operating Expenses
These are expenses which are not related to the activities of the business example. Loss on sale
of asset, discount on shares written off etc.

These expenses are deducted from the income obtained after adding other incomes to the
operating profit. Other incomes or miscellaneous receipts have already been explained. The
resultant profit is called as profit (or) earning before interest and tax (EBIT).

Interest Expenses
Interest expense arises when part of the expenses are met from borrowed funds. The FASB
requires separate disclosure of interest expense. This item of expense is deducted from income or
earnings before interest and tax. The resultant figure is profit (or) earnings before tax (EBT).

Income Tax
The provision for tax is estimated based on the quantum of profit before tax. As per the corporate
tax laws, the amount of tax payable is determined not on the basis of reported net profit but the
net profit arrived at has to be recomputed and adjusted for determining the tax liability. That is
why the liability is always shown as a provision.

Net Profit
This is the amount of profit finally available to the enterprise for Appropriation. Net profit is
reported not only in total but also per share of stock. This per share amount is obtained by
dividing the total amount of net profit by the number of shares outstanding.

The net profit is usually referred to as profit or earnings after tax. This profit could either be
distributed as dividends to shareholders or retained in the business. Just like gross profit
percentage, net profit percentage on sales can also be calculated which will be of great use for
managerial analysis.
Profit and Loss Appropriation Account
This part of Profit and Loss Account, which is mainly applicable to company form of
organization, discloses the manner in which the PAT earned by the organization is appropriated.
The amount of profit not appropriated or retained is transferred to Reserves and Surplus in the
Balance Sheet. Following is the specimen of Profit and Loss Appropriation Account.

Profit & Loss Appropriation Account for the year ended on 31st March 2017

Particulars Amount Particulars Amount

By opening balance

Dividend paid Profit After Tax b/fd

Transferred to reserves Amount withdrawn from reserves

Balance transferred to balance sheet

Total Total

Illustration – Vishal Pvt. Ltd.

For The Year Ended 31st March 2012
For The Year Ended 31st March 2012

Retained Earnings At The

700
Beginning Of The Year
5,625

Add: Net Income 6,325

Less: Dividends
5,600

General Reserve 625

6,225

Retained Earnings At The End 100

Of The Year
Balance Sheet

The purpose of this financial statement is to disclose the financial status of the organization in
terms of its assets and liabilities at any given point of time. Thus, in simple language, Balance
Sheet is a listing of the assets and liabilities of an organization at any given point of time.
Whichever sources are used by an organization for raising the required amount of funds, create
an obligation or liability for the organization and whichever ways the funds are used or applied
by an organization create the properties or assets for the organization.
Hence, in practical circumstances, the liabilities are referred to as “Sources of Funds” and the
assets are referred to as “Application of Funds”. As such, by nature, the Balance Sheet is a
positive statement in the sense that it relates to a specific point of time or date. Hence, the
Balance Sheet is always referred to as “Balance Sheet as on 31st March 2017.”

Balance sheet is a statement of Liabilities and Assets as on a given date.

The balance sheet is basically a historical report showing the cumulative effect of past
transactions. It is often described as a detailed expression of the following fundamental
accounting equation:
Assets = Liabilities + OwnersEquity (Capital)
Assets are costs which represent expected future economic benefits to the business enterprise.
However, the rights to assets have been acquired by the Enterprise as a result of past
transactions.

Liabilities also result from past transactions. They represent obligations which require settlement
in the future either by conveying assets or by performing services. Implicit in these concepts of
the nature of assets and liabilities is the meaning of ownersequity as the residual interest in the
assets of the enterprise.

Liabilities= Amount owed to others.

They represent a source of funds. Liabilities have credit balances.

Assets= Amount owed to you by others. Assets have debit balances.

Every credit has corresponding debit and vice versa. Hence, the balance sheet should always
tally.
Overview of a balance sheet
Liabilities:

1. Owned Funds
2. Term Liabilities
3. Current Liabilities

Assets:

1. Fixed Assets
2. Non Current Assets
3. Current Assets

Components of liabilities
–

There are three groups of sources of funds.

 Net Owned Funds (NOF) = Money owned by the owner. Also called as
TANGIBLE NET WORTH.
 Term Liabilities. Amount payable after one year. Also called as Non
Current Liabilities.
 Current Liabilities. Amount payable within one year.

Classification of Sources
–

All the liabilities are classified into two sources.

 Long Term Source. LTS = a) Owned Funds + b) Term Liabilities.
 Short Term Source. STS = Current Liabilities.
Components of Owned Funds
–

Paid up Capital + Free Reserves + Profit - Loss - Drawings.

It is also called as Equity or Tangible Net Worth, More the equity better the financial health of
a firm. It is expected to be one third of total debts.
Glossary of Capital
–

 Authorised Capital: The Maximum capital that a company can raise.

 Issued Capital: Capital offered to the public for subscription.
 Subscribed Capital: Capital for which the public has submitted their
applications.
 Called up Capital: Capital which has been called by a company for
payment.
 Paid up Capital: Amount paid by share holders.

Components of Term Liabilities

–

 Borrowings from Friends & Relatives

 Borrowings from Term Lending Institutions. DFIs
 Borrowings (Term Loans) from Banks
 Deferred Tax Liability
 Debentures
 Public Deposits
 Other liabilities payable after one year

Components of Current Liabilities

–

 Cash Credit (overdraft) from Bank

 Instalments of Term Loans payable within 12 months
 Outstanding liabilities towards Credit Purchases (Creditors)
 Provision for Expenses
 Provision for Dividend/Tax
 Income Received in Advance
 Other Liabilities payable within one year

Components of Assets
–

 Fixed Assets. (FA) = Assets in the form of land & building, Plant &
machinery, furniture, vehicles etc.
 Non Current Assets. (NCA) Assets receivable after one year.
1+2 = Long Term Uses
  Current Assets (CA)= Assets Receivable within one year.
3 = Short Term Uses

Components of Fixed Assets

 Land & Building
 Plant & machinery
 Furniture & Fixtures
 Vehicles
 Electrical Equipments

 Computers & Electronic Equipments

 Capital Work in Progress
 Other Fixed Assets

Components of Non Current Assets

–

Investments. Earnest Money, Security Deposit.

Intagible Asset: An asset which appears in the balance sheet but may not reflect a real asset.

Examples: Loss, Drawings, Goodwill, Patents, Deferred Revenue Expenditure, Preliminary

expenses not written off.

Components of Current Assets

 Cash on Hand
 Balance in Bank a/cs
 Raw materials
 Work in Process
 Finished Goods/Stock
 Debtors/Receivables
 Advances paid
 Prepaid Expenses
 Accrued Income
 Other Current Assets

Classification of Uses
–

Use of funds has two major groups.

 Long Term Uses (LTU) = a) Fixed Assets. (FA) + b) Non Current Assets.
(NCA)
 Short Term Uses (STU) = Current Assets (CA)

Long Term Sources should be more than Long Term uses. Then it is called Long Term
Surplus.
Form and Presentation of a Balance Sheet
Two objectives are dominant in presenting information in a balance sheet. One is clarity and
readability; the other is disclosure of significant facts within the framework of the basic
assumptions of accounting. Balance sheet classification, terminology and the general form of
presentation should be studied with these objectives in mind.

Conventions of Preparing the Balance Sheet

There are two conventions of preparing the balance sheet, the American and the English.
According to the American convention, assets are shown on the left hand side and the liabilities
and the owners’ equity on the right hand side. Under the English convention just the opposite is
followed i.e. Assets are shown on the right hand side and the liabilities and owners’ equity are
shown on the left hand side. In the illustration `a’, the American convention has been followed.

There are two forms of presenting the balance sheet

 Horizontal format: When the liabilities and owners’ equity are listed on the
left hand side and assets on the right hand side, we get the account form of
balance sheet.
 Vertical format: An alternative practice is the report form of balance sheet
where the liabilities and owners’ equity are listed at the top of the page and
the assets are listed below them.

Formats of Balance Sheet

 Horizontal format
Assets
Liabilities
31-3-2009 31-3-2009 31-3-2010
31-3-2010
Share Capital 700,000 800,000 Land & Building 450,000 480,000

Share Capital Plant & Machinery 300,000 440,000

0 40,000
P & L A/c 120,000 Furniture 100,000 180,000
1,50,000
15% Debentures 200,000 300,000 Bills Receivables 60,000
50,000
Mortgage Loan 250,000 200,000 Stock in Trade 200,000 218,000

Creditors 128,000 160,000 Sundry Debtors 170,000 222,000

Bills Payables 102,000 Cash at Bank 220,000 228,000

168,000
Total 1,500,000 1,818,000 Total 1,500,000 1,818,000

 Vertical Format
Liabilities Actual Actua
 As on 3/31/2016 3/31/20

Sources of Funds - -
1 Share Capital 7.25 7.25
Reserves & Surplus 0.00 1.43

Profit & Loss Account 3.35 0.50

Sub Total 10.60 9.18

2 Term Liabilities

Unsecured Loans 2.15 2.50

Term Loan 1.70 1.51

Total Term Liabilities 3.85 4.01
3 Current Liabilities

Cash Credit 4.18 4.13

Creditors 10.81 6.05

Provisions for Taxation 0.00

0.00
Provision for Expenses 1.19 0.52

Total Current Liabilities 16.18 10.70

4 Total Liabilities 30.63 23.89
Assets 3/31/2016 3/31/2017
1 Fixed Assets - -
Gross Block 15.55 15.92

Less Accumulated Depreciation 2.05 3.77

Net Block as per Schedule 13.50 12.15

2 Current Assets

Inventory 0.35 0.35

Debtors 10.05 8.36
 Cash and Bank Balance 3.57 1.38

Current Investments 1.40 1.65

Other Current Assets 0.76 0.00

Total Current Assets 16.13 11.74

3 Long Term Investments 1.00 0.00
4 Total Assets 30.63 23.89

The following is the typical summarized balance sheet of a company

Balance Sheet of XYZ Co Rs. Crores

March '13 March '12

12 months
12 months
Sources Of Funds

Total Share Capital 289.37 289.37

Equity Share Capital 289.37 289.37

Share Application Money 0 0

Preference Share Capital 0 0

Reserves 7,612.58 5,751.70

Revaluation Reserves 0 0

Net worth 7,901.95 6,041.07

Secured Loans
0 0
Unsecured Loans 71.27 97.48

Total Debt 71.27 97.48

Total Liabilities 7,973.22 6,138.55

Application Of Funds
Gross Block 3,828.85 3,425.94

Less: Accumulated Depreciation 2,024.42

1,914.33
Net Block 1,804.43 1,511.61

Capital Work in Progress 293.55 343.15

Investments 6,430.48 4,882.81

Inventories 636.28 678.53

Sundry Debtors 423.2

0
Cash and Bank Balance 446.49
558.86
Total Current Assets 1,195.14 1,548.22

Loans and Advances 1,987.44 1,744.82

Fixed Deposits 0 1,208.36

Total CA, Loans & Advances 3,182.58 4,501.40

Deffered Credit
0 0
Current Liabilities 668.22 2,925.53

Provisions 1,742.47 2,174.89

Total CL & Provisions 2,410.69 5,100.42

Net Current Assets 771.89 -599.02

Miscellaneous Expenses
0 0
Total Assets 9,300.35 6,138.55

Contingent Liabilities 1,252.99 1,445.67

Book Value (Rs) 273.08 208.77

Notes on the Accounts

Notes on the Accounts are stated in the final accounts with the help of Schedules referred to in
the financial statements and they form an integral part of the balance sheet.

From the above balance sheet it would have been found that previous years figures are also
given. As per the companies act, 1956 it is mandatory for the companies to give figures for the
previous year also. The schedules attached to the balance sheet give details of the respective
items.
Listing of Items on the Balance Sheet
Assets in balance sheet are generally listed in two ways:

1. In the order of liquidity or according to time i.e. In the order of the degree of ease with
which they can be converted into cash or,
2. In the order of permanence or according to purpose i.e., in the order of the desire to keep
them in use. Some assets cannot be easily classified.

For example: Investments can be easily sold but the desire may be to keep them. Investments
may therefore be both liquid and semi-permanent that is why they are shown as a separate item
in the balance sheet.

Liabilities can also be grouped in two ways; either in the order of urgency of payment or in the
reverse order. The various assets and liabilities grouped in the two orders will appear as follows:
Order of Liquidity
Click to flip
Click to flip
Order of Permanence
Classification of Items in the Balance Sheet
Although each individual asset or liability can be listed separately on the balance sheet, it is more
practicable and more informative to summarize and group related items into categories called as
account classifications. The classifications or group headings will vary considerably depending
on the size of the business, the form of ownership, the nature of its operations and the users of
the financial statements.

For example, While listing assets, the order of liquidity is generally used by sole traders,
partnership firms and banks, whereas joint stock companies by law follow the order of
permanence. As a generalization which is subject to many exceptions, the following
classification of balance sheet items is suggested as representative.

Assets: Current assets, Investments, Fixed assets, Intangible assets and Other assets
Liabilities: Current liabilities and Long term liabilities
Owners’ Equity: Capital and Retained earnings
Current Assets
Current assets are those which are reasonably expected to be realized in cash or sold or
consumed during the normal operating cycle of the business enterprise or within one year,
whichever is longer. By operating cycle we mean the average period of time between the
purchase of goods or raw materials and the realization of cash from the sale of goods or the sale
of products produced with the help of raw materials. Current assets generally consist of cash,
marketable securities, bills receivables, debtors, inventory and prepaid expenses.

 1

Cash: Cash consists of funds that are readily available for disbursement. It
includes cash kept in the cash chest of the enterprise as also cash deposited
on call or current accounts with banks.

 2

Marketable Securities: These consist of investments that are both readily

marketable and are expected to be converted into cash within a year. These
investments are made with a view to earn some return on cash that otherwise
would be temporarily idle.

 3

Accounts Receivable: Accounts receivable consist of amounts owed to the

enterprise by its consumers. This represents amounts usually arising out of
normal commercial transactions. These amounts are listed in the balance
sheet at the amount due less a provision for portion that may not be collected.
This provision is called as provision for doubtful debts. Amounts due to the
enterprise by someone other than a consumer would appear under the
heading `other receivables’ rather than `accounts receivables’.
If the amounts due are evidenced by written promises to pay, they are listed
as bills receivables. Accounts receivables are expected to be realized in cash.

 4

Inventory: Inventory consists of,

i) Goods that are held in stock for sale in the ordinary course of business.
ii) work-in-progress that are to be currently consumed in the production of
goods or services to be available for sale. Inventory is expected to be sold
either for cash or on credit to customers to be converted into cash. It may be
noted in this connection that inventory relates to goods that will be sold in
the ordinary course of business.
A van offered for sale by a van dealer is inventory. A van used by the dealer
 to make service calls is not inventory but an item of equipment which is a
fixed asset.
 5
5
Prepaid Expenses: These items represent expenses which are usually paid
in advance such as rent, taxes, subscriptions and insurance.
For example, If rent for three months for the building is paid in advance then
the business acquires a right to occupy the building for three months. This
right to occupy is an asset. Since this right will expire within a fairly short
period of time it is a current asset.
Long Term Investments
The distinction between a marketable security shown under current asset and as an investment is
entirely based on time factor. Those investments like investments in shares, debentures, bonds
etc. That will be retained for more than one year or one operating cycle will appear under this
classification.
Fixed Assets
Tangible assets used in the business that are of a permanent or relatively fixed nature are called
plant assets or fixed assets. Fixed assets include furniture, equipment, machinery, building and
land. Although there is no standard criterion as to the minimum length of life necessary for
classification as fixed assets, they must be capable of repeated use and are ordinarily expected to
last more than a year. However the asset need not actually be used continuously or even
frequently. Items of spare equipments held for use in the event of breakdown of regular
equipment or for use only during peak periods of activity are also included in fixed assets.
With the passage of time, all fixed assets with the exception of land lose their capacity to render
services. Accordingly the cost of such assets should be transferred to the related expense
amounts in a systematic manner during their expected useful life. This periodic cost expiration is
called depreciation. While showing the fixed assets in the balance sheet the accumulated
depreciation as on the date of balance sheet, is deducted from the respective assets.
Intangible Assets
While tangible assets are concrete items which have physical existence such as buildings,
machinery etc., intangible assets are those which have no physical existence. They cannot be
touched and felt. They derive their value from the right conferred upon their owner by
possession.
Examples are: goodwill, patents, copyrights and trademarks.
Fictitious Assets
These items are not assets. Yet they appear in the asset side simply because of a debit balance in
a particular account not yet written off – example Debit balance in current account of partners,
profit and loss account, etc.
Classification of Liabilities

 1

Current Liabilities
When the liabilities of a business enterprise are due within an accounting
 period or the operating cycle of the business, they are classified as current
liabilities. Most of the current liabilities are incurred in the acquisition of
materials or services forming part of the current assets.
These liabilities are expected to be satisfied either by the use of current assets
or by the creation of other current liabilities. The one year time interval or
current operating cycle criterion applies to classifying current liabilities also.
Current liabilities generally consists of bills payable, creditors, outstanding
expenses, income received in advance, provision for income-tax etc.

Accounts Payable: These amounts represent the claims of suppliers related

to goods supplied or services rendered by them to the business enterprise for
which they have not yet been paid. Usually these claims are unsecured and
are not evidenced by any formal written acceptance or promise to pay.
When the enterprise gives a written promise to pay money to a creditor for
the purchase of goods or services used in the business or the money
borrowed, then the written promise is called as bills payable or notes
payable. Amounts due to financial institutions which are suppliers of funds,
rather than of goods or services are termed as short-term loans or by some
other name that describes the nature of the debt instrument, rather than
accounts payable.

Outstanding Expenses: These are expenses or obligations incurred in the

previous accounting period but the payment for which will be made in the
next accounting period. A typical example is wages or rent for the last month
of the accounting period remaining unpaid. It is usually paid in the first
month of the next accounting period and hence it is an outstanding expense.

Income Received In Advance: These amounts relate to the next accounting

period but received in the previous accounting period. This item of liability is
frequently found in the balance sheet of enterprises dealing in the publication
of newspapers and magazines.

Provision For Taxes: This is the amount owed by the business enterprise to
the government for taxes. It is shown separately from other current liabilities
both because of the size and because the amount owed may not be known
exactly as on the date of balance sheet. The only thing known is the existence
of liability and not the amount.
 2
2
Long Term Liabilities
All liabilities which do not become due for payment in one year and which
do not require current assets for their payment are classified as long-term
liabilities or fixed liabilities. Long term liabilities may be classified as
secured loans or unsecured loans.
When the long-term loans are obtained against the security of fixed assets
owned by the enterprise, they are called as secured or mortgaged loans.
 When any asset is not attached to these loans they are called as unsecured
loans. Usually long-term liabilities include debentures and bonds, borrowings
from financial institutions and banks, public debts, etc. Interest accrued on a
particular secured long term loan, should be shown under the appropriate
sub-heading.

Contingent Liabilities: Contingent liabilities are those liabilities which may

or may not result in liability. They become liabilities only on the happening
of a certain event. Until then both the amount and the liability are uncertain.
If the event happens there is a liability; otherwise there is no liability at all. A
very good example for contingent liability is a legal suit pending against the
business enterprise for compensation.
If the case is decided against the enterprise the liability arises and in the case
of favorable decision there is no liability at all. Contingent liabilities are not
taken into account for the purpose of totaling of balance sheet.

Capital or Owners’ Equit

As mentioned earlier, owners’ equity is the residual interest in the assets of the enterprise.
Therefore the owners’ equity section of the balance sheet shows the amount the owners have
invested in the entity. However, the terminology owners' equity, varies with different forms of
organizations depending upon whether the enterprise is a joint stock company or sole
proprietorship / partnership concern.

Sole Proprietorship/Partnership Concern

The ownership equity in a sole Proprietorship or partnership is usually reported in the balance
sheet as a single amount for each owner rather than distinction between the owners initial
investment and the accumulated earnings retained in the business.
For example, In a sole-proprietor’s balance sheet for the year 2011, the capital account of the
owner may appear as follows:

Rs.
Owner’s capital as on 1-4-2016 2,50,000

Add: 2015-16 – profit 30,000

2,80,000

Less: Drawings 15,000

Owner’s capital as on 31-3-2017 2,65,000

Joint Stock Companies

In the case of joint stock companies, according to the legal requirements, owners’ equity is
divided into two main categories. The first category called share capital or contributed capital is
the amount the owners have invested directly in the business. The second category of owners’
equity is called retained earnings.

Share capital is the capital stock per-determined by the company by the time of registration. It
may consist of ordinary share capital or preference share capital or both. The capital stock is
divided into units called as shares and that is why the capital is called as share capital. The entire
predetermined share capital called as authorized capital need not be raised at a time. That portion
of authorized capital which has been issued for subscription as on a date is referred to as issued
capital.

“Retained earnings” is the difference between the total earning to date and the amount of
dividends paid out to the shareholders to date. That is, the difference represents that part of the
total earnings that have been retained for use in the business. It may be noted that the amount of
retained earnings on a given date is the accumulated amount that has been retained in the
business from the beginning of the company’s existence up to that date. The owners’ equity
increases through retained earnings and decreases when retained earnings are paid out in the
form of dividends.

Guidelines for Preparation of Financial

Statements
New Schedule III (Section 129)
The Schedule III has been revised by Ministry of Company Affairs (MCA) and is applicable for
all Balance Sheet made after 31st March, 2011. The Format has done away with earlier two
options of format of Balance Sheet, now only Vertical format has been permitted. This schedule
explains the format and contents of Balance Sheet and Profit and Loss Account.

General Instructions for Preparation of Balance Sheet

The disclosure requirements specified in Part I and Part II of this Schedule are in addition to the
disclosure requirements specified in the Accounting Standards. Each item on the face of the
Balance Sheet and Statement of Profit and Loss shall be cross-referenced to any related
information in the notes to accounts.

Rounding off
Depending upon the turnover of the Company, the figures appearing in the Financial Statements
may be rounded as below:
Turnover Rounding off
 1. Less than one hundred crore rupees: To the nearest hundreds, thousands,
lakhs or millions, or decimals thereof.
2. One hundred crore rupees or more: To the nearest lakhs or millions or
crores, or decimals thereof.

Once a unit of measurement is used, it should be used uniformly in the Financial Statements.
The corresponding amounts (comparatives) for the immediately preceding reporting period for
all items shown in the Financial Statements:
Part I - Form of Balance Sheet
Name of the company………………………
Balance Sheet as at……………………….
(Rupees in……………)
Part I - Form of Balance Sheet
Equity and Liabilities

1. Shareholders’ Funds
1. Share capital
2. Reserves and surplus
3. Money received against share warrants
2. Share Application money pending allotment
3. Non-current liabilities
1. Long-term borrowings
2. Deferred tax liabilities (Net)
3. Other long term liabilities
4. Long-term provisions
4. Current liabilities
1. Short term borrowings
2. Trade payables
3. Other current liabilities
4. Short-term provisions

TOTAL
Part I — Form of Balance Sheet
Assets

1. Non-current assets
1. Fixed Assets
o Tangible assets
o Intangible Assets
o Capital work-in-progress
o Intangible assets under development
2. Non-current Investments
3. Deferred tax assets (net)
4. Long-term Loan and Advances
5. Other Non-current assets
2. Current assets
 1. Current investments
2. Inventories
3. Trade receivables
4. Cash and cash equivalents
5. Short-term loans and advances
6. Other current assets

Criteria for Current Assets

–

An asset shall be classified as current when it satisfies any of the following criteria:
 It is expected to be realized in, or is intended for sale or consumption in, the
company’s normal operating cycle;
 It is held primarily for the purpose of being traded;
 It is expected to be realized within twelve months after the reporting date;
or
 It is cash or cash equivalent unless it is restricted from being exchanged or
used to settle a liability for at least twelve months after the reporting date;

All other assets shall be classified as non-current.

Criteria for Current Liability
–

A liability shall be classified as current when it satisfies any of the following criteria:
 It is expected to be settled in the company’s normal operating cycle;
 It is held primarily for the purpose of being traded;
 It is due to be settled within twelve months after the reporting date; or
 The company does not have an unconditional right to defer settlement of
the liability for at least twelve months after the reporting date;

All other liabilities shall be classified as non-current.

Operating cycle
–

An operating cycle is the time between the acquisition of assets for processing and their
realization in cash or cash equivalents. Where the normal operating cycle cannot be identified,
it is assumed to have a duration of 12 months.
Trade Receivable and Payable
–

A receivable shall be classified as a ‘trade receivable’ if it is in respect of the amount due on

account of goods sold or services rendered in the normal course of business.

A payable shall be classified as a ‘trade payable’ if it is in respect of the amount due on account
of goods purchased or services received in the normal course of business.
Mandatory Disclosures
A. Share Capital for each class of share capital
(different classes of preference shares to be treated separately) :

1. The number and amount of shares authorized;

2. The number of shares issued, subscribed and fully paid, and subscribed but not fully paid;
3. Par value per share;
4. A reconciliation of the number of shares outstanding at the beginning and at the end of
the period;
5. The rights, preferences and restrictions attaching to that class including restrictions on the
distribution of dividends and the repayment of capital;
6. Shares in the company held by its holding company or its ultimate holding company or
by its subsidiaries or associates;
7. Shares in the company held by any shareholder holding more than 5 percent shares;
8. Shares reserved for issue under options and contracts/commitments for the sale of
shares/disinvestment, including the terms and amounts;
9. Separate particulars for a period of five years following the year in which the shares have
been allotted/bought back, in respect of:
Aggregate number and class of shares allotted as fully paid up pursuant to contract(s)
without payment being received in cash.
Aggregate number and class of shares allotted as fully paid up by way of bonus shares
(Specify the source from which bonus shares are issued).
Aggregate number and class of shares bought back
10. Terms of any security issued along with the earliest date of conversion in descending
order starting from the farthest such date;

B. Reserves and Surplus

1. Reserves and Surplus shall be classified as:
1. Capital Reserves;
2. Capital Redemption Reserves;
3. Securities Premium Reserve;
4. Debenture Redemption Reserve;
5. Revaluation Reserve;
6. Other Reserves – (specify the nature of each reserve and the amount
in respect thereof);
7. Surplus i.e. balance in statement of Profit & Loss disclosing
allocations and appropriations such as dividend paid, bonus shares
and transfer to/from reserves;
8. Surplus i.e. balance in Statement of Profit & Loss disclosing
allocations and appropriations such as dividend, bonus shares and
transfer to/from reserves etc.(Additions and deductions since last
balance sheet to be shown under each of the specified heads)
2. A reserve specifically represented by earmarked investments shall be termed
as a ‘fund’.
 3. Debit balance of Statement of Profit and Loss shall be shown as a negative
figure under the head ‘Surplus’ Similarly, the balance of ‘Reserves and
Surplus’, after adjusting negative balance of surplus, if any, shall be shown
under the head ‘Reserves and Surplus’ even if the resulting figure is in the
negative.

C. Long-term Borrowings
1. Long-term borrowings shall be classified as:

1. Bonds/debentures.
2. Term loans:
1. from banks and
2. from other parties
3. Deferred payment liabilities.
4. Deposits.
5. Loans and advances from related parties.
6. Long-term maturities of finance lease obligations.
7. Other loans and advances (specify nature).
2. Borrowings shall further be sub-classified as secured and unsecured. Nature
of security shall be specified separately in each case.
3. Where loans have been guaranteed by directors or others, a mention thereof
shall be made and also the aggregate amount of such loans under each head.
4. Bonds/debentures (along with the rate of interest and particulars of
redemption or conversion, as the case may be) stated in descending order of
maturity or conversion, starting from farthest redemption or conversion date,
as the case may be. Where bonds/debentures are redeemable by installments,
the date of maturity for this purpose must be reckoned as the date on which
the first installment becomes due.
5. Particulars of any redeemed bonds/debentures which the company has power
to reissue.
6. Terms of repayment of term loans and other loans.
7. Period and amount of default in repayment of dues, providing break-up of
principal and interest shall be specified separately in each case.

D. Other Long-term Liabilities

Other Long-term Liabilities shall be classified as:

1. Trade payables
2. Others

E. Long-term provisions
The amounts shall be classified as:
 1. Provision for employee benefits.
2. Others (specify nature).

F. Short-term borrowings
1. Short-term borrowings shall be classified as:
1. Loans repayable on demand
• from banks and
• from other parties.
2. Loans and advances from subsidiaries/holding
company/associates/business ventures.
3. Deposits.
4. Other loans and advances (specify nature).
2. Borrowings shall further be sub-classified as secured and unsecured. Nature
of security shall be specified separately in each case.
3. Where loans have been guaranteed by directors or others, a mention thereof
shall be made and also the aggregate amount of loans under each head.
4. Period and amount of default in repayment of dues, providing break-up of
principal and interest shall be specified separately in each case.

G. Other current liabilities

The amounts shall be classified as:

1. Current maturities of long-term debt;

2. Current maturities of finance lease obligations;
3. Income received in Advance;
4. Interest accrued but not due on borrowings;
5. Interest accrued and due on borrowings;
6. Unpaid Dividends;
7. Application money received for allotment of securities and due for refund
and interest accrued thereon. Share application money includes advances
towards allotment of share capital;
8. Unpaid matured deposits and interest accrued thereon;
9. Unpaid matured debentures and interest accrued thereon;
10. Other payables (specify nature);

H. Short-term provisions
The amounts shall be classified as: a. Provision for employee benefits. b. Others (specify nature).
Tangible assets

1. Classification shall be given as:

1. Land
2. Buildings
3. Plant and Equipment
 4. Furniture and Fixtures
5. Vehicles
6. Office equipment
7. Others (specify nature)
2. Assets under lease shall be separately specified under each class of asset.
3. A reconciliation of the gross and net carrying amounts of each class of assets
at the beginning and end of the reporting period showing additions,
disposals, acquisitions and other movements and the related depreciation and
impairment losses/reversals shall be disclosed separately.
4. Where sums have been written off on a reduction of capital or revaluation of
assets or where sums have been added on revaluation of assets, every balance
sheet subsequent to date of such write-off, or addition shall show the reduced
or increased figures as applicable and shall by way of a note also show the
amount of the reduction or increase as applicable together with the date
therefore for the first five years subsequent to the date of such reduction or
increase.

J. Intangible assets
1. Classification shall be given as:
1. Goodwill
2. Brands /trademarks
3. Computer software
4. Mastheads and publishing titles
5. Mining rights
6. Copyrights, and patents and other intellectual property rights, services
and operating rights
7. Recipes, formulae, models, designs and prototypes
8. Licences and franchise
2. Others (specify nature)

K. Non-current investments
Non-current investments shall be classified as trade investments and other investments and
further classified as:

1. Investment property;
2. Investments in Equity Instruments;
3. Investments in Preference shares;
4. Investments in Government or trust securities;
5. Investments in units, debentures or bonds;
6. Investments in Mutual Funds;
7. Investments in partnership firm;
8. Other non-current investments (specify nature);

L. Long-term loans and advances

 1. Long-term loans and advances shall be classified as:
1. Capital Advances;
2. Security Deposits;
3. Loans and Advances to related parties (giving details thereof);
4. Other Loans and Advances (specify nature);
2. The above shall also be separately sub-classified as:
1. To the extent secured, considered good;
2. Others, considered good;
3. Doubtful;
3. Allowance for bad and doubtful loans and advances shall be disclosed under
the relevant heads separately.
4. Loans and Advances due by directors or other officers of the company or any
of them either severally or jointly with any other persons or amounts due by
firms or private companies respectively in which any director is a partner or
a director or a member should be separately stated.

M. Other non-current assets

Other non-current assets shall be classified as:

1. Long-term Trade Receivables (including trade receivables on deferred credit

terms);
2. Others (specify nature);
3. Long-term Trade Receivables, shall be sub-classified as:
1. secured, considered good;
2. unsecured, considered good;
3. Doubtful;
4. Allowance for bad and doubtful debts shall be disclosed under the relevant
heads separately.
5. Debts due by directors or other officers of the company or any of them either
severally or jointly with any other person debts due by firms or private
companies respectively in which any director is a partner or a director or a
member should be separately stated.

Summary
A balance sheet shows the financial position of a business enterprise as of a specified moment of
time.
Profit and loss account consists of two elements: one element is the inflows that result from the
sale of goods and services to customers which are called as revenues. The other element reports
the outflows that were made in order to generate those revenues; these are called as expenses.
Manufacturing Account is a part of Profit and Loss Account that discloses the result of
manufacturing operations carried out by the organization. The final result disclosed by the
Manufacturing Account is the Cost of Production incurred by the organization. Trading Account
is a part of Profit and Loss Account that discloses the result of trading operations carried out by
the organization. The final result disclosed by the Trading Account is the Gross Profit earned by
the organization.
Profit and Loss Account is a part of Profit and Loss Account that discloses the final result of
business transactions of the organization. The final result disclosed by the Profit and Loss
Account is the Profit After Tax (PAT) earned by the organization.
Profit and Loss Appropriation Account is a part of Profit and Loss Account, which is mainly
applicable to company form of organization, discloses the manner in which the PAT earned by
the organization is appropriated i.e. how much is disbursed as dividend and how much is retained
in the business.
The structure of the profitability statement can be drafted as below:
Sales
Less : Factory Cost
Gross Profit
Less : Administrative and Selling Overheads
Operating Profits
Less : Non-Operating Expenses
Add : Non-Operating Incomes
Profit Before Tax
Less : Taxes
Profit After Tax
Less : Dividend Paid
Retained Profit
Trade discount is given by the wholesaler or manufacturer to the retailers to enable them to sell
at catalogue price and make a profit. Trade discount does not appear in the accounting records at
all. Cash discount is given on case to case basis for prompt payment. Cash discount is treated as
an expense and it appears in the accounting records.
The liabilities are referred to as “Sources of Funds” and the assets are referred to as “Application
of Funds”.
Liabilities = Amount owed to others.
They represent a source of funds. Liabilities have credit balances.

Asset = Amount owed to you by others.

Assets have debit balances.
Overview of a balance sheet:
Liabilities:

1. Owned Funds
2. Term Liabilities
3. Current Liabilities

Assets:

1. Fixed Assets
 2. Non Current Assets
3. Current Assets

There are two forms of presenting the balance sheet:

Horizontal format
When the liabilities and owners’ equity are listed on the left hand side and assets on the right
hand side, we get the account form of balance sheet.
Vertical Format
An alternative practice is the report form of balance sheet where the liabilities and owners’
equity are listed at the top of the page and the assets are listed below them.
Notes on the Accounts are stated in the final accounts with the help of Schedules referred to in
the financial statements and they form an integral part of the balance sheet.

The Schedule III of the Companies” Act has been revised by Ministry of Company Affairs
(MCA) and is applicable for all Balance Sheet made after 31st March, 2011. The Format has
done away with earlier two options of format of Balance Sheet, now only Vertical format has
been permitted. This schedule explains the format and contents of Balance Sheet and Profit
and Loss Account.

Credit Balances of Trial Balance in respect of Personal and Real Accounts go to the liability
side of the Balance Sheet. Debit Balances of Trial Balance in respect of Personal and Real
Accounts go to the asset side of the Balance Sheet.

Credit Balances of Trial Balance in respect of Nominal Accounts go to the income side of the
Profit and Loss Account and Debit Balances of Trial Balance in respect of Nominal Accounts
go to the Expenses side of the Profit and Loss Account.

Key Words
Balance Sheet is the summarized statement of what the business owns i.e.
Balance Sheet
assets and what the business owes i.e. liabilities.

Bills Payable Bills Payable indicates the amount payable to the suppliers.

Bills Receivable It indicates the amount receivable from the customers.

Capital Capital indicates the amount of funds invested by the owner in the business.

A creditor is a supplier to whom the business owes money for the goods
Creditor
bought on credit.

A debtor is a customer who owes money to the business for the goods
Debtor
supplied on credit.

Depreciation Reduction in the value of fixed assets, which arise either due to time factor
 or use factor or both.

The amount of funds or goods withdrawn by the owner of the business for
Drawings
his personal use.

Liabilities All the amounts owed by the business to various providers of funds or
services are collectively referred to as liabilities.

1. Explain the format of Profit and Loss Account.

2. Explain the format of Trading Account.
3. Explain the format of Manufacturing and Trading
Account.
4. Explain the format of Operating Statement.
5. Explain the format of Profit and Loss Appropriation
Account.
6. Explain the format of Horizontal Balance Sheet.
7. Explain the format of Vertical Balance Sheet.
8. What are the components of Own Funds (Equity)?
9. What are the components of Term Liabilities (Debt)?
10. What are the components of Current Liabilities?
11. What are the components of Current Assets?
12. What are the components of Fixed Assets?
13. What are the components of Intangible Assets?
14. What are the components of Non-Current
Assets?
15. Explain the Guidelines for Preparation of
financial statements as per Companies Act.
hapter 5- Cost Accounting

Introduction
The industrial revolution in England posed a challenge to the development of accounting as a
tool of industrial management. This necessitated the development of costing techniques as guides
to management action. Cost accounting emphasizes the determination and the control of costs. It
is concerned primarily with the cost of manufacturing processes.

Accounting can no longer be considered a mere language of business. The need for maintaining
the financial chastity of business operations, ensuring the reliability of recorded experience
resulting from these operations and conducting a frank appraisal of such experiences has made
accounting a prime activity along with such other activities as marketing, production and
finance. Cost accounting is primarily concerned with providing information relating to the
conduct of the various aspects of a business like cost or profit associated with some portions of
business operations to the internal parties viz., management.

The Institute of Cost and Management Accountants, London, has defined Cost Accounting as
“the application of costing and cost accounting principles, methods and techniques to the
science, art and practice of cost control and the ascertainment of profitability as well as the
presentation of information for the purpose of managerial decision-making.”

One of the principal functions of cost accounting is to assemble and interpret cost data, both
actual and prospective, for the use of management in controlling current operations and in
planning for the future.

All goods and services are meant for sale. So the organization has to fix selling price. The
normal formula of selling price is as shown below,
Selling Price = Cost Price + Profit.
To decide the selling price a firm has to know its cost price. Hence, the computation of the cost
of production is very important. If the selling price is fixed arbitrarily without the computation of
the cost of production, it may result in over pricing or under pricing. In case of over pricing you
will lose your customers and In case of under pricing you will lose your profit. Selling Price acts
as a balancing factor between the customers and profit. Hence, one should compute the cost of
production as accurately as possible. For this purpose one should know what are the different
types of costs and how to prepare a cost sheet.

Types of Cost
In the process of cost accounting, costs are arranged and rearranged in various classifications.
The term 'classification’ refers to the process of grouping costs according to their common
characteristics.
The different bases of cost classification are:

 1

1
By nature or elements (materials, labour and overheads)

 2

2
By time (historical, pre-determined)

 3

3
By traceability to the product (direct, indirect)

 4

4
By association with the product (product, period)

 5

5
By changes in activity or volume (fixed, variable, semi-variable)

 6

6
 By function (manufacturing, administrative, selling, research and development, pre-
production)

 7

7
By relationship with the accounting period (capital, revenue)

 8

8
By controllability (controllable, non-controllable)

 9

9
By analytical/decision-making purpose (opportunity, sunk, differential, joint, common,
imputed, out-of-pocket, marginal, uniform, replacement)
 10
10
By other reasons (conversion, traceable, normal, avoidable, unavoidable, total)
Opportunity Cost
opportunity cost of a commodity is forgoing the opportunity to produce alternative goods and
services. It is also called as Economic cost. In view of scarcity of resources, every producer has
to make a choice among several alternatives. The second alternative use of a resource has to be
sacrificed for using it in a particular way. Opportunity Cost can be also defined as the benefit
forgone on the second best alternative.

If you have a building, you can give it on rent. If you are using it for the own business, the rent
that you would have received is sacrificed by you and that is the opportunity cost of Building. If
you were not working in your own business, you would have done a job and earned salary. The
salary that you would have received is sacrificed by you and that is the opportunity cost of your
services.
Examples
Rent on own land and building used for business.
Salary on the own efforts of owners/proprietor.
Interest on the own capital invested by owners.
For example, Mr. A has Rs.1,00,000 to invest. He has two options open.

1. Keep the same with some bank in a fixed deposit and get the interest of 10% p.a.
2. Invest the money in the business and get the return on investment of 12%.

If Mr. A decides to invest the money in business, he cannot get the interest on the fixed deposit
from the bank. So the opportunity cost of investing the money in the business is in the form of
lost interest on fixed deposits with the bank. It should be noted that the opportunity cost itself
finds no place in the accounting process. However, it is required to be considered in the decision
making process, for the comparison purpose. The returns available from a proposal should be
more than the cost of opportunity lost, then and then only the proposal can be accepted.
Implicit cost
–

Implicit cost includes the opportunity costs of those factors of production which are already
owned by the businessman. These costs are not explicitly incurred by the producer for buying
factors. Implicit cost is also called opportunity cost.

Explicit cost
–

Explicit cost includes these payments which are made by the employer to those factors of
production which do not belong to the employer himself. Direct Contractual Monetary
Payments.

These costs are explicitly incurred by the producer for buying factors from others on contract.
For example, the payments made for raw materials, power, fuel, wages and salaries, the rent on
land and interest on capital are all contractual payments made by the employer. Explicit cost is
also called accounting cost.

Accounting Cost
–

All those expenses incurred by a producer that enter the accounts are known as accounting
cost. Land : Rent, Labour: Wages, Capital: Interest and Enterprise: Profit.

Money Cost
–

The sum of money spent for producing a particular quantity of commodity is called its money
cost.

Real Cost
–

According to Marshall the real cost of production of a commodity is expressed not in money
but in efforts and sacrifices undergone in the making of a commodity.
Direct and Indirect Cost
–

Direct Cost indicates that cost which can be identified with the individual cost center. It
consists of direct material cost, direct labour cost and direct expenses. It is also termed as
Prime Cost.

Indirect Cost indicates that cost which cannot be identified with the individual cost center. It
consists of indirect material cost, indirect labour cost and indirect expenses. It is also termed as
overheads. As it is not possible to identify these costs with individual cost centers, such
identification is done in the indirect way by following the process of allocation, apportionment
and absorption.

Sunk Cost
–

The historical cost which has been incurred in the past is called as “Sunk Cost”. This type of
cost is normally not relevant in the decision making process. This is also called as the Historical
Cost.
Example: Cost of acquiring a machinery for the business.

The Relevant Cost

–

It the realisable Market Value of an asset. This type of cost is relevant in the decision making
process.

Controllable and Uncontrollable Costs

–

The costs which can be Controlled by the management are called Controllable Costs.
Example: Advertising expenses, Pay packages.

The costs which cannot be Controlled by the management are called Uncontrollable Costs.
Example: Cost of Interest, Depreciation, Taxes, Dearness Allowances, raw material prices,
electricity charges, water charges etc.

Normal and abnormal Costs

–
The costs which are incurred in the normal course of the business are called as Normal Costs.
Example: Rent, Material Cost, Wages.

The costs which are incurred due to the reasons beyond the control of the management such as
Floods, earthquake, Tsunami, fire etc are called as abnormal Costs.
Example: Dacoit/loot of the goods, Loss of goods due to fire/flood/earthquake.

Fixed, Variable and Semi-Variable/Semi-Fixed Cost

Fixed cost indicates that portion of total cost which remains constant at all the levels of
production, irrespective of any change in the later. As the volume of production increases, per
unit fixed cost may reduce, but not the total fixed cost.
Examples of Fixed Cost: Depreciation, Interest on Loans, Rent, Salary of office staff etc

Variable cost indicates that portion of the total cost which varies directly with the level of
production. The higher the volume of production, the higher the variable cost and vice versa,
though per unit variable cost remains constant at all the levels of production.
Examples of Variable cost: Raw Material, Wages of labour law, Repairs and maintenance etc

Semi-variable or semi-fixed cost indicates that portion of the total cost which is partly fixed and
partly variable in relation to the volume of production.

Marginal cost
In Economics and Finance marginal cost is the change in Total Cost that arises when the quantity
produced changes by one unit. It is the cost of producing one more unit of a commodity.

The marginal cost of production is the increase in Total cost as a result of producing one extra
unit. It is the variable costs associated with the production of one more units.

Opportunity Cost
In very simple language, opportunity cost is the cost of opportunity foregone. Opportunity cost is
the return on the second best alternative foregone. The resource like men, material, machine,
money etc. may be having various alternative uses each one having some specific yield or return.
However, if they are used in one particular way, they cannot be used in any other way.
Opportunity cost refers to the return or yield which is not available if the resources are used in
any specific manner.
Elements Of Cost
The elements of costs are the essential part of the cost. There are broadly three elements of cost,
as explained below:
MATERIAL

The substance from which the produce is made is called material. It can be direct as well as
indirect.
Direct Material: It refers to those materials which become an integral part of the final product
and can be easily traceable to specific physical units. Direct materials, thus, include:

 All materials specifically purchased for a particular job or process.

 Components purchased or produced.
 Primary packing materials (e.g., carton, wrapping, card-board boxes etc.).
 Material passing from one process to another.

Indirect Material: All materials which are used for purpose ancillary to the business and which
cannot conveniently be assigned to specific physical units are known as `indirect materials’.
Oil, grease, consumable stores, printing and stationery material etc. Are a few examples of
indirect materials.

LABOUR

In order to convert materials into finished products, human effort is required. Such human
effort is known as labour. Labour can be direct as well as indirect.

Direct Labour: It is defined as the wages paid to workers who are engaged in the production
process and whose time can be conveniently and economically traceable to specific physical
units. When a concern does not produce but instead renders a service, the term direct labour
or wages refers to the cost of wages paid to those who directly carry out the service, e.g., wages
paid to driver, conductor of a bus in transport service.

Indirect Labour: Labour employed for the purpose of carrying out tasks incidental to goods
produced or services provided is called indirect labour or indirect wages. In short, wages which
cannot be directly identified with a job, process or operation, are generally treated as indirect
wages.
Examples of indirect labour are: wages of store-keepers, foremen, supervisors, inspectors,
internal transport men etc.
EXPENSES

Manufacturing Expenses other than Material and Labour costs. Expenses may be direct or
indirect.

Direct Expenses: These are expenses which can be directly, conveniently and wholly
identifiable with a job, process or operation. Direct expenses are also known as chargeable
expenses or productive expenses.
Examples of such expenses are: cost of special layout, design or drawings, hire of special
machinery required for a particular contract, maintenance cost of special tools needed for a
contract job, etc.

Indirect Expenses: Expenses which cannot be charged to production directly and which are
neither indirect materials nor indirect wages are known as indirect expenses.
Examples are rent, rates and taxes, insurance, depreciation, repairs and maintenance, power,
lighting and heating etc.

Cost Centre
Cost Center is defined as a location, person, or item of equipment (or a group of these) in or
connected with an undertaking, in relation to which costs may be ascertained and used for the
purpose of cost control. Correct identification of a cost center is a pre-requisite for the successful
implementation of the cost accounting process as the costs are ascertained and controlled with
respect to the cost centers. Similarly, correct identification of cost center facilitates the fixation of
responsibility in a correct manner.

Material Cost
Material cost is the first and probably the most important element of cost. In the case of specific
types of industries, say cement, sugar, chemicals, iron and steel etc., the materials cost forms a
very significant portion of the overall cost of production. The term material refers to all
commodities which are consumed in the production process. The materials which can be
consumed in the production process can be basically classified as:
  1

Direct Materials
 2
2
Indirect Materials
Stages in the movement of material
The movement of material may involve the following stages.

 Procurement of materials.
 Storing the material till it is required for consumption.
 Issue of the material for consumption.

Procurement of Materials
Though the practices may differ from organisation to organisation, normally, the process of
purchasing the materials involves the following stages.
Purchase Requisition:

 Material to be purchased
 When it is required
 How much to be purchased

Before deciding the quantity to be purchased, consideration will have to be given to the
following factors also:

 Quantity already ordered.

 Quantity reserved. This quantity is such, as if it is not in stock.
 Funds availability: Amounts which are kept aside for drawing up purchase budget should
be considered.

If proper planning is not done regarding material management it may result in over stocking or
under stocking. Both these situations have their advantages and disadvantages
Over stocking
Advantages:

 Ordering cost is low

 No fear of shortage of material for production chain
 If the price increases in future benefit

Disadvantages:

 Carrying cost is High

 If the price decreases in future Loss
 Blocking of working capital
  Risk of deterioration of quality and obsolescence.
 More storage facilities
 Additional Insurance Cost
 More material handling and upkeeping
 Risk of breakage/pilferage etc

Under stocking
Advantages:

 Ordering Carrying cost is low

 If the price decreases in future benefit

Disadvantages:

 Ordering cost is High.

 Fear of shortage of material for production chain.
 Production holdups, resulting into disturbed delivery schedules.
 Frantic eleventh hour purchases which may result into unfavourable prices and quality.
 Payment for idle time to workers.
 Increase in Ordering Cost.
 If the price increases in future Loss.

To have more advantages and to minimize the disadvantages, an organization should maintain
optimum stock of materials.

Meaning of Inventory
Inventory means all the materials, parts, suppliers, expenses and in process or finished products
recorded on the books by an organization and kept in its stocks, warehouses or plant for some
period of time.
Types of Inventory

 Raw Materials
 Finished Components
 Work- in- Progress (WIP)
 Finished Goods
 Goods in Transit
 Tools
 Auxiliary Materials
 Machine Spares

Need for Inventory

 To gain economies in Purchasing /Manufacturing.

 Safety Stocks to avoid stock outs.
 To satisfy the demand during the period of replenishment.
  To level out Production.
 To prevent loss of Sales.
 To create buffer against uncertainty in Supplier’s Plant.
 To take advantage of lower transportation cost.
 Supplier’s condition of minimum quantity.
 Govt. Regulations.

Inventory control
Inventory control is the technique of maintaining the size of the inventory at some desired level
keeping in view the best economic interest of an organization.

Objectives of inventory control

 Protection against fluctuations in demand

 Better use of men, machines and material
 Protection against fluctuations in output
 Control of stock volume
 Control of stock distribution
 Deciding optimum order size
 Deciding Reorder point

Major activities of inventory control

 Planning the inventories

 Procurement of inventories
 Receiving and inspection of inventories
 Storing and issuing the inventories
 Recording the receipt and issues of inventories
 Physical verification of inventories
 Follow-up function
 Material standardization and substitution

Inventory Decisions
Executive decide two basic issues while dealing with inventories:

 How much of an item to order when the inventory of that item is to be replenished.
 When to replenish the inventory of that item.

Inventory decisions facilitate production or satisfy customer demands. Inventory system is a set
of policies and controls which monitors and determines the levels of inventory.
Perpetual Inventory System
It is a method of recording stores balances after every receipt and issue, to facilitate regular
checking and obviate closing down for stock taking. –Wheldon
Factors which help helpful to make system successful:
  Stores ledger, stores control, cards or bin cards are properly maintained.
 Quantity balance store shown in the store ledger; stock control and bin cards are
reconciled.
 Exploring the cause of discrepancies if any physical balances and book balances.

Steps in Inventory control

 Deciding the maximum- minimum limits of inventory

 Determination of Reorder point
 Determination of reorder quantity
 Perpetual inventory control
 ABC analysis

Method of control through turn over

Inventory Turnover method.
It means how many times a company’s inventory is sold and replaced (finished product).
Inventory Turnover Ratio. Illustration
Opening Stock 100 Closing stock 200
Cost of goods sold 1500
Calculate Inventory Turnover Ratio.
ITR = COGS/Average Stock = 1500/150 = 10 times
It can also be calculated as stock holding period
(Average Stock*365)/COGS = 150*365/1500= 36 days
It can also be calculated as Percentage
(Average Stock*100)/COGS = 150*100/1500= 10%

Labour Cost
Labour Cost is another important element of cost in the manufacturing cost.
Methods to ascertain labour cost.
The starting point for ascertaining the labour cost is in the form of Time Keeping and Time
Booking.

Time Keeping
This is the process of recording the attendance time of the workers. The recording of time
attended may be necessary from the following angles.

 To maintain discipline.
 Though the regular wages may not depend upon the time attended, in some
cases, the other payments like overtime wages, dearness allowance etc. may
be linked with the attendance.
 The fringe benefits like Pension, Gratuity on retirement. Provident Fund etc.
may depend on the continuity of service which will be available only if time
attended is recorded properly.
  Attendance records may be required for research and other purposes.

Methods of Time Keeping

Hand-Written Method
Under this method, the names of the workers are recorded in the attendance register with
provision of various columns for various days.

Token or Disc Method

Under this method, each worker is allotted an identification number and a disc or token bearing
that number. Immediately before the scheduled opening time, all the tokens/discs will be placed
at the factory gate. Every incoming worker will take out his token and drop it in a separate box or
hang it on a separate board. The tokens/discs not removed will indicate that the said worker is
absent.

Time Recording Clock Method

Under this method, every worker is allotted an individual ticket number and a clock card which
bears that ticket number. The cards are placed on two racks on either side of the time recording
clock denoting separately ‘In’ rack and ‘Out’ rack. At opening time, all the cards are placed in
the ‘Out’ rack.

On arrival, the worker takes out his own card, puts it in the slot available on the time clock
recorder which punches the time on that card, and places the card in the ‘In’ rack. All the cards,
left in the ‘Out’ rack indicate absent workers. At the time of departure, he removes the card
from the In’ rack, gets it punched and places it in the ‘Out’ rack.
It is clean, safe and quick and has printed records to avoid disputes. Chances of fraudulent entries
being made can be avoided.

Time Booking
The ultimate aim of costing is to decide the cost of each cost center. Equally important is to
record the time spent for individual cost centers. This process is in the form of time booking.
The methods followed for this purpose, may be considered as below:

Daily time sheets

Under this method, each worker is provided with a daily time sheet on which the time spent by
him on various jobs/work orders is expected to be mentioned.

Weekly Time Sheets

Under this method too, one sheet is allotted to each worker but instead of recording the work
done for only a day, a record of time for all the jobs during the week is made. These types of
time sheets are useful for intermittent types of jobs like building or construction work. It involves
a comparatively less amount of paper work.

Job Card
Under this method, the details of time are recorded with reference to the jobs or production/work
orders undertaken by the workers rather than with reference to individual workers, and this
facilitates the computation of labour cost with reference to jobs or production/ work ordeRs.
There may be two ways in which job card may be maintained.

Reconciliation of the time attended and the time booked

Overhead Expenses
Overhead Expenses: The term overheads includes, indirect material, indirect labour and
indirect expenses. Overheads may be incurred in the factory, office or selling and distribution
departments/divisions in an undertaking. Thus overheads may be of three types: factory
overheads, office and administrative overheads and selling and distribution overheads. This
classification of overheads may be shown thus:

Classification Of Overheads
Factory Overheads = Indirect Material + Indirect Labour + Indirect Expenses
Office Overheads = Indirect Material + Indirect Labour + Indirect Expenses
Selling and distribution Overheads = Indirect Material + Indirect Labour + Indirect Expenses
Factory Overheads
–

 Indirect Material such as consumable stores, cotton waste, oil and

lubricants etc.
 Indirect Labour Cost such as wages paid to the foreman/storekeeper, works
manager’s salary etc.
 Indirect Expenses such as carriage inward cost, cost of factory
lighting/power expenses, rent/insurance/repairs for factory
building/machinery, depreciation on factory building or machinery etc.

Office and Administration Overheads

–

 Indirect Material such as stationery items, office supplies etc.

 Indirect Labour cost such as salaries paid to Accounts and Administration
staff, Directors’ remuneration etc.
 Indirect Expenses such as postage/telephone,
rent/insurance/repairs/depreciation on office building, general lighting,
legal/audit charges, bank charges etc.

Selling and Distribution Overheads

–

 Indirect Material such as packing material, samples etc.

 Indirect Labour like salaries paid to sales personnel, commission paid to
sales manager etc.
  Indirect Expenses like carriage outwards, warehouse charges,
advertisement, bad debts, repairs and running of distribution van, discount
offered to customers etc.

Preparation of Cost Sheet

The various elements/components of the cost as discussed above can be presented in the form of
a statement, popularly known as ‘Cost Sheet’ or ‘Cost Statement’. The cost sheet may be
prepared separately for each cost center and may have the columns like, cost per unit or cost of
previous period etc.

Costs of production are the most important force governing the supply of a product. A firm
chooses a combination of factors which minimizes its cost of production for a given level of
output. Production of a commodity involves expenses to be incurred on different factors viz.
Land, Labour, Capital and Enterprise. It is the sum total of expenses incurred by the producer to
pay for the factors of production. Costs of production have different meanings.

Importance of cost sheet in pricing decisions

Selling Price = Cost Price + Profit.
Every thing that a firm produces has to be sold. The firm has to fix Selling Price. As per the
formula above, Selling Price depends on Cost Price.

Hence Cost price should be known to decide the correct Selling price after adding profit margin.
If the correct price is not calculated, it may lead to a situation of over pricing or under pricing.
Hence, the computation of the cost of production is very important. Cost Sheet helps in
calculating the per unit cost of production.

A Proforma cost sheet is shown below:

Particulars
S.N Amount Amount

1 Material cost
- -

Material consumed=
- -

Opening stock+ purchases-closing stock

- -

Carriage inward
- -

Total material cost

- -

Labour cost
2 - -
 Particulars
S.N Amount Amount

Payment made to labours

- -

Contribution to EPF/gratuity/perquisites
- -

Total labour cost

- -

Prime cost (3=1+2)

3 - -

Other direct manufacturing expenses

4 - -

Power & fuel

- -

Repairs & maintenance

- -

Factory rent
- -

Depreciation of machinery
- -

Spare parts & accessories

- -

Lubricants
- -

Others
- -

Total other cost

- -

Factory cost (5=3+4)

5 - -

Factory over heads (Indirect Cost)

6 - -

Indirect material
- -

Indirect labour cost - -

 Particulars
S.N Amount Amount

Indirect other cost

- -

Total over head costs

- -

Cost of goods sold (7= 5+6)

7 - -

Administrative expenses
8 - -

Salary
- -

Depreciation of furnitures of office

- -

Insurances of office assets

- -

Licence fees/taxes
- -

Stationery - -

Telephone
- -

Postage
- -

Electricity of office
- -

Rent of Office
- -

Miscellaneous expenses
- -

Total Administrative expenses

- -

9 Total cost of production (9=7+8) - -

 Particulars
S.N Amount Amount

Selling expenses
10 - -

Travelling expenses
- -

Advertisement & publicity

- -

Discount given
- -

Bad debts
- -

Packing
- -

Carriage outward
- -

Any others
- -

Total Selling expenses

- -

Cost of sales (11=9+10)

11 - -

Profit Margin % of col 11

12 - -

Sale price (13=11+12)

13 - -

No. of units to be sold

14 - -

Sale price per unit (15= 13/14)

15 - -

Illustration:
Prepare a cost sheet on the basis of the following information. Calculate selling price per unit if
total no. of units is 1000 and Profit margin is 20%.
Opening stock 4,000

Purchases of raw material 39,000

Opening stock 4,000

Closing stock 5,000

2,000
Carriage inward

Payment made to labours 12,000

Contribution to EPF/gratuity/perquisites 3,000

Power & fuel

1,100

Repairs & maintenance

900

Factory rent 1,300

Depreciation of machinery 1,400

Spare parts & accessories 400

300
Lubricants

Other manufacturing expenses 100

Indirect material 450

Indirect labour cost 550

Indirect other cost 150

Salary 5,500

Depreciation of furnitures of office 2,500

Insurances of office assets 750

Opening stock 4,000

Licence fees/taxes 125

Stationery
75

Telephone 123

Postage 251

Electricity of office 352

654
Rent of office

Miscellaneous expenses 259

Travelling expenses 459

Advertisement & publicity 126

Discount given
25

Bad debts
43

Packing
12

Carriage outward
71

Other selling expenses

19

Answer:
S.N Particulars Amount Amount

1
Material cost
S.N Particulars Amount Amount

Material consumed= 38,000

opening stock+ purchases-closing stock

4000+39000-5000

Carriage inward 2,000

Total material cost 40,000

Labour cost
2

Payment made to labours 12,000

Contribution to EPF/gratuity/perquisites 3,000

Total labour cost 15,000

Prime cost (3=1+2) 55,000

3

Other direct manufacturing expenses

4

Power & fuel 1,100

Repairs & maintenance 900

Factory rent 1,300

Depreciation of machinery 1,400

Spare parts & accessories

400

Lubricants 300
S.N Particulars Amount Amount

Others
100

Total other cost 5,500

Factory cost (5=3+4) 60,500

5

6 Factory over heads (Indirect Cost)

Indirect material
450

Indirect labour cost

550

Indirect other cost

150

Total over head costs 700

Cost of goods sold (7= 5+6) 61,200

7

Administrative expenses
8

Salary 5,500

Depreciation of furnitures of office 2,500

Insurances of office assets

750

Licence fees/taxes
125

Stationery
75

Telephone
123
S.N Particulars Amount Amount

Postage
251

Electricity of office 352

654
Rent of office

Miscellaneous expenses 259

Total administrative expenses 10,589

Total cost of production (9=7+8) 71,789

9

Selling expenses
10

Travelling expenses 459

Advertisement & publicity 126

Discount given
25

Bad debts
43

Packing
12

Carriage outward
71

Any others
19

Total selling expenses 755

Cost of sales (11=9+10) 72,544

11

12 Profit margin % of col 11 20% 14,509

S.N Particulars Amount Amount

Sale price (13=11+12) 87,053

13

No. of units to be sold 1,000

14

Sale price per unit (15= 13/14)

15 87

Summary
The Institute of Cost and Management Accountants, London, has defined Cost Accounting as
“the application of costing and cost accounting principles, methods and techniques to the
science, art and practice of cost control and the ascertainment of profitability as well as the
presentation of information for the purpose of managerial decision-making.”

Direct Cost indicates that cost which can be identified with the individual cost center. It consists
of direct material cost, direct labour cost and direct expenses. It is also termed as Prime Cost.

Indirect Cost indicates that cost which cannot be identified with the individual cost center.
Fixed cost indicates that portion of total cost which remains constant at all the levels of
production, irrespective of any change in the later.

Variable cost indicates that portion of the total cost which varies directly with the level of
production.
Opportunity cost is the return on the second best alternative foregone.

Element of cost
Material Cost = Direct Material + Indirect Material
Labour Cost = Direct Labour + Indirect Labour
Other Expenses = Direct Expenses + Indirect Expenses
Total Factory Cost = Total Direct Cost + Total Indirect Cost

Cost Center is defined as a location, person, or item of equipment (or a group of these) in or
connected with an undertaking, in relation to which costs may be ascertained and used for the
purpose of cost control.
The movement of material may involve the following stages:

 Procurement of materials.
 Storing the material till it is required for consumption.
  Issue of the material for consumption.

If proper planning is not done regarding material management it may result in over stocking or
under stocking. Both these situations have their advantages and disadvantages.

Inventory means all the materials, parts, suppliers, expenses and in process or finished products
recorded on the books by an organization and kept in its stocks, warehouses or plant for some
period of time.
Inventory control is the technique of maintaining the size of the inventory at some desired level
keeping in view the best economic interest of an organization.
Steps in Inventory control are fixation of inventory levels, Determination of Reorder point;
Determination of reorder quantity and ABC analysis.
The starting point for ascertaining the labour cost is in the form of Time Keeping and Time
Booking. Time Keeping is the process of recording the attendance time of the workers. Time
booking is the time spent by him on various jobs/work orders.
The term “overheads” means indirect costs.

Classification Of Overheads
Factory Overheads = Indirect Material + Indirect Labour + Indirect Expenses
Office Overheads = Indirect Material + Indirect Labour + Indirect Expenses
Selling and distribution Overheads = Indirect Material + Indirect Labour +Indirect Expenses

The various elements/components of the cost as discussed above can be presented in the form of
a statement, popularly known as ‘Cost Sheet’ or ‘Cost Statement’.
Selling Price = Cost Price + Profit. To decide the selling price a firm has to know its cost price.
Hence, the computation of the cost of production is very important. Cost Sheet helps in
calculating the per unit cost of production.

Key Words
The amount of expenditure incurred on or attributable to a
Cost
specified article, product or activity.

“The application of costing and cost accounting principles,

methods and techniques to the science, art and practice of
Cost Accounting cost control and the ascertainment of profitability as well as
the presentation of information for the purpose of
managerial decision-making".
 A location, person, or item of equipment (or a group of
these) in or connected with an undertaking, in relation to
Cost Center which costs may be ascertained and used for the purpose of
cost control.

It includes:
Cost of Goods Sold (i) Cost of materials.
(ii) Labour and factory overheads.

Cost of Sales Cost of goods sold plus selling and administrative expenses.

The various elements/components of the cost presented in

Cost Sheet
the form of a statement, for ascertaining the cost per unit.

That cost which can be identified with the individual cost

Direct Cost
center.

That portion of total cost which remains constant at all the

Fixed Cost
levels of production, irrespective of any change in the later.

That cost which cannot be identified with the individual

Indirect Cost
cost center.

All the materials, parts, suppliers, expenses and in process

or finished products recorded on the books by an
Inventory
organization and kept in its stocks, warehouses or plant for
some period of time.

The technique of maintaining the size of the inventory at

Inventory Control some desired level keeping in view the best economic
interest of an organization.

Opportunity Cost The return on the second best alternative foregone.

Overheads Indirect costs.

Time Booking The time spent by him on various jobs/work orders.

The process of recording the attendance time of the

Time Keeping
workers.

Variable Cost That portion of the total cost which varies directly with the
level of production.

Self Assessment Questions

 1

1
Explain the importance of Cost Accounting.

 2

2
Explain the features of Cost Accounting.

 3

3
Discuss the relationship between Financial Accounting & Cost Accounting.

 4

4
Explain the different Types of costs.

 5

5
What is a cost centre?

 6

6
 Explain the format of a Cost Sheet with hypothetical example.

 7

7
Explain the components of overhead costs.

 8

8
What are the elements of cost?

 9

9
Explain the movement of material in a manufacturing company.

 10

10
State the advantages and disadvantages of Over stocking.

 11

11
State the advantages and disadvantages of Under stocking.

 12

12
Describe the methods of recording attendance of Labour.

 13

13
Give examples of Fixed Cost and Variable Cost.
 14
14
Explain the Opportunity Cost with examples.

Accounting & Financial Management

Chapter 6- Cost, Volume & Profit Relationship
Introduction
There is a definite relationship between Cost, Volume and Profit. As the volume increases, the
average fixed cost decreases, average cost also decreases and the profit increases. Cost-volume-
profit (CVP) analysis focuses on the way cost and profit change when volume changes. It is,
broadly speaking, that system of analysis which determines the probable profit at any level of
activity. This technique is generally used to analyse the incremental effect of volume on costs,
revenues and profits. At what volume of operations are costs and revenues equal? What volume
of output or sales would be necessary to earn a profit of say Rs.2 lakhs? How much profit will be
earned at a volume of, say 10,000 units? What will happen if there is a reduction of 10 percent in
the selling price? Questions like these are sought to be answered through CVP analysis. This
detailed analysis will help the management to know the profit levels at different activity levels of
production and sales and various types of costs involved in it.

Formulas for Various Cost Calculations

Average Fixed cost
Calculation of average cost is important to fix the selling price per unit.

 Average Fixed Cost = Total Fixed Cost / Total No. Of Units

Total Fixed Cost remains constant but Average Fixed Cost goes on decreasing as the level of
production increases. If the production is very high, the average fixed cost may become
negligible. This is called Economy of Scale. It means if the scale of business is high, the average
fixed cost becomes negligible and average cost becomes equal to variable cost.

Average Variable cost

 Average Variable Cost = Total Variable Cost / Total No. Of Units

Average Variable Cost remains constant but Total Variable Cost goes on increasing as the level
of production increases.
Average Total cost

 Average Total Cost = Total Fixed + Variable Cost / Total No. Of Units

Average Total Cost goes on decreasing as the level of production increases. But, Total Cost goes
on increasing as the level of production increases.

 Total Cost = Total Fixed Cost + Total Variable Cost

Formulas

 Average Fixed Cost = Total Fixed Cost / Total No. of Units

 Average Variable Cost = Total Variable Cost / Total No. of Units
 Average Total Cost = Total Cost / Total No. of Units
 Total Cost = Total Fixed Cost + Total Variable Cost
 Total Variable Cost = Total No. of Units X Variable Cost Per Unit
 Marginal Cost = Change in Total Cost / Change in Output = ΔTC / Δ Q
 Total Revenue = Total No. of Units X Selling Price Per Unit
 Average Revenue = Total Revenue / Total No. of Units
 Marginal Revenue = Change in Total Revenue / Change in No. of Units
 Total Profit = Total Revenue - Total Cost
 Average Profit = Total Profit / Total No. of Units
 Marginal Profit = Change in Total Profit / Change in No. of Units
 Marginal Profit = Marginal Revenue - Marginal Cost

Abbreviations used in Costing

 TFC = Total Fixed Cost

 AFC = Average Fixed Cost
 TVC = Total Variable Cost
 AVC = Average Variable Cost
  ATC = Average Total Cost (AC= Average Cost)
 TC = Total Cost
 TR = Total Revenue
 AR = Average Revenue
 TP = Total Profit
 AP = Average Profit
 MR = Marginal Revenue
 MC = Marginal Cost
 MP = Marginal Profit

Illustration

Observations on Cost Behavior

1. Total fixed cost is constant

2. Average Fixed Cost is decreasing gradually
3. Total Variable Cost is increasing gradually
4. Average Variable Cost is constant
5. Total Cost is increasing gradually
6. Aver Total Cost is decreasing gradually

Cost, Volume and Profit Relationship

There is a definite relationship between Cost, Volume and Profit. As the volume increases,
the average fixed cost decreases, average cost also decreases and the profit increases. Cost-
volume-profit (CVP) analysis focuses on the way cost and profit change when volume
changes. It is, broadly speaking, that system of analysis which determines the probable
profit at any level of activity. This technique is generally used to analyse the incremental
effect of volume on costs, revenues and profits.

The following are the three important aspects of a business.

1. Selling price per unit and total sales amount

2. Total cost which in its turn may be in the form of variable cost or fixed cost
3. Volume of sales
Cost-Volume-Profit Analysis aims at studying the relationships existing among these factors and
its impact on the amount of profits.

Let us study the following examples.

Calculating Cost, Volume and Profit at different levels of production
Illustration 1

Illustration 2

You can observe from the above table that as the sales (Volume) increases Average Cost
decreases and Total Profit increases. This shows that there is a relationship between Cost,
Volume and Profit.

Application of Cost-Volume-Profit Analysis

CVP analysis helps in:

1. Forecasting the profit in an accurate manner

 2. Preparing the flexible budgets at different levels of activity
3. Fixing prices for products

Economy of Scale
Scale means scale of production or level of production. As you increase the scale of production
Average fixed cost goes on decreasing and it becomes negligible. Total cost also goes on
decreasing and it almost becomes equal to variable cost. So a big organization can increase the
scale of production to reduce its average cost of production and it can sell at a lower price than
the competitors or small firms. This is called economy of scale. Small firms have higher average
cost of production and hence they cannot compete with big firms. It can be explained as “Big
fish eating Small Fish”.

Marginal Costing
The marginal cost of production is the increase in Total cost as a result of producing one extra
unit. It is the variable costs associated with the production of one more units.
Many firms follow the pricing policy of Marginal Cost + Profit. They don’t consider the average
cost. Average cost includes partly the average fixed cost. As long as your selling price is more
than your marginal cost you can make profit even though the selling price is less than average
cost.

Example:
Bus with a capacity of 40 seats is going from Pune to Solapur. The ticket price is fixed as Rs.400
per person. Average Cost is Rs.200 per person. Suppose a bus has 20 passengers who have paid
Rs.400 each and it has left Pune. At the outskirts of Pune there are 10 passengers who want to go
to Solapur. They bargain with the bus operator and request for a fare of Rs.200 each. Since the
marginal cost of additional passenger is nil, the bus operator will make a profit of Rs.2,000 (200
X 10) by accepting their request. Normally we feel that the bus operator made a loss of Rs.2,000
i.e (400-200) per person for 10 persons.

A five start hotel as a tarrif of Rs.10,000 per day and the marginal cost of one room per day is
Rs.500/-. Now even if the lodge gives a discount of 80% and charges Rs.2,000 per day per room,
the lodge will make a profit of Rs.1,500 per day per room compared to keeping the rooms
vacant.

Marginal costing is a technique of costing. This technique of costing uses the concept `marginal
cost’. Marginal cost is the change in the total cost of production as a result of change in the
production by one unit. Thus marginal cost is nothing but variable cost. In marginal costing
technique only variable costs are considered while calculating the cost of the product, while
fixed costs are charged against the revenue of the period. The revenue arising from the excess of
sales over variable costs is known as `contribution’. Using contribution as a vital tool, marginal
costing helps to a great extent in the managerial decision making process. This unit deals with
the various aspects of marginal costing.

According to the Institute of cost and management accountants (icma), london, marginal cost is
`the amount at any given volume of output by which aggregate costs are changed if the volume
of output is increased or decreased by one unit’. Thus marginal cost is the added cost of an extra
unit of output.

MC = Direct Material + Direct Labour + Other Variable Costs = Total Cost – Fixed Cost.
Illustration
A concern manufacturing product x has provided the following information:
Sales 75,000
Direct materials 30,000
Direct labour 10,000
Variable overhead 10,000
Fixed overhead 15,000

In order to increase its sales by Rs. 25,000, the concern wants to introduce the product y, and
estimates the costs in connection therewith as under:
Direct materials 10,000
Direct labour 8,000
Variable overhead 5,000
Fixed overhead Nil
Advise whether the product Y will be profitable or not.
Solution

Commentary: if product Y is introduced, the profitability of product X is not affected in any

manner. On the other hand, product Y provides a contribution of Rs.2,000 Towards fixed cost
and profit. Therefore, Y should be introduced.
Benefits of Marginal Costing
The technique of marginal costing is of immense use to the management in taking various
decisions, as explained below:
1. How Much To Produce?
–
Marginal costing helps in finding out the level of output which is most profitable for running a
concern. This, in turn, helps in utilizing plant capacity in full, and realise maximum profits. By
determining the most profitable relationships between cost, price and volume, marginal costing
helps a business determine most competitive prices for its products.
2. What To Produce?
–

By applying marginal costing techniques, the most suitable production line could be
determined. The profitability of various products can be compared and those products which
languish behind and which do not seem to be feasible (in view of their inability to recover
marginal costs), may be eliminated from the production line by using marginal costing. It, thus,
helps in selecting an optimum mix of products, keeping the capacity and resource constraints in
mind. It will also serve as a guide in arriving at the price for new products.
3. Whether To Produce Or Procure?
–

The marginal cost of producing an article inside the factory serves as a useful guide while
arriving at make or buy decisions. The costs of manufacturing can be compared with the costs
of buying outside and a suitable decision can be arrived at easily.

4. How To Produce?
–

In case a particular product can be produced by two or more methods, ascertaining the
marginal cost of producing the product by each method will help in deciding as to which
method should be allowed. The same is true in case of decisions to use machine power in place
of manual labour.
5. When To Produce?
–

In periods of trade depression, marginal costing helps in deciding whether production in the
plants should be suspended temporarily or continued in spite of low demand for the firm’s
products.

6. At What Cost To Produce?

–

Marginal costing helps in determining the no profit- no-loss point. The efficiency and economy
of various products, plants, departments can also be determined. This helps in profit planning
as well as cost control.
Limitations Of Marginal Costing
Marginal costing has the following limitations:
Difficulty in classification
–

In marginal costing, costs are segregated into Fixed and variable. In actual practice, this
classification scheme proves to be Superfluous in that, certain costs may be partly fixed and
partly variable and Certain other costs may have no relation to volume of output or even with
the time. In short, the categorization of costs into fixed and variable elements is a difficult and
tedious job.
Difficulty In Application
–

The marginal costing technique cannot be applied in industries where large stocks in the form
of work-in-progress (job and contracting firms) are maintained.
Defective Inventory Valuation
–

Under marginal costing, fixed costs are not included in the value of finished goods and work in
progress. As fixed costs are also incurred, these should form part of the cost of the product. By
eliminating fixed costs from finished stock and work-in-progress, marginal costing techniques
present stocks at less than their true value. Valuing stocks at marginal cost is objectionable
because of other reasons also:
 In case of loss by fire, full loss cannot be recovered from the insurance
company.
 Profits will be lower than that shown under absorption costing and hence
may be objected to by tax authorities.
 Circulating assets will be understated in the balance sheet.

Wrong Basis For Pricing

–

In marginal costing, sales prices are arrived at on the basis of contribution alone. This is an
objectionable practice. For example, in the long run, the selling price should not be fixed on the
basis of contribution alone as it may result in losses or low profits. Other important factors
such as fixed costs, capital employed should also be taken into account while fixing selling
prices. Further, it is also not correct to lay more stress on selling function, as is done in
marginal costing, and relegate production function to the background.
Limited Scope
–

The utility of marginal costing is limited to short-run profit planning and decision-making. For
decisions of far-reaching importance, one is interested in special purpose cost rather than
variable cost. Important decisions on several occasions, depend on non-cost considerations also,
which are thoroughly discounted in marginal costing.
In view of these limitations, marginal costing needs to be applied with necessary care and
caution. Fruitful results will emerge only when management tries to apply the technique in
combination with other useful techniques such as budgetary control and standard costing.
Marginal Revenue
The concept of Marginal Revenue is same as Marginal Cost.
The marginal Revenue is the increase in Total Revenue as a result of selling one extra unit. It is
the variable revenues associated with the selling of one more units.
Example

Marginal Profit
The concept of Marginal Profit is same as Marginal Cost.
The marginal Profit is the increase in Total Profit as a result of selling one extra unit. It is the
variable Profit associated with the selling of one more units.

Example

Break Even Analysis

Break Even Point (BEP)
This is a situation of no profit no loss. It means that at this stage, contribution is just enough to
cover the fixed costs i.e. Contribution = Fixed Cost. It also means that contribution generated by
all sales beyond Break Even Point will directly result into profits. As such, it will be intention of
every business to reach the Break Even Point, as early as possible. The Break Even Point may be
expressed in two ways.
  In terms of quantity – Fixed Costs/ Contribution per unit
 In term of amount – Fixed Costs/P/V Ratio

The break-even point can also be shown graphically through the break-even chart. The break-
even chart `shows the profitability or otherwise of an undertaking at various levels of activity
and as a result indicates the point at which neither profit nor loss is made’. It shows the
relationship, through a graph, between cost, volume and profit. The break-even point lies at the
point of intersection between the total cost line and the total sales line in the chart. In order to
construct the breakeven chart, the following assumptions are made:
Profit Graph
This graph (called profit graph) gives a pictorial representation of cost-volume profit
relationship. In this graph x axis represents sales. However, the sales line bisects the graph
horizontally to form two areas. The ordinate above the zero sales line, shows the profit area, and
the ordinate below the zero sales line indicates the loss or the fixed cost area. The profit-volume-
ratio line is drawn from the fixed cost point through the break-even point to the point of
maximum profit. In order to construct this graph, therefore, data on profit at a given level of
activity, the break-even point and the fixed costs are required.

Assumptions Of Break-Even Chart

1. Fixed costs will remain constant and do not change with the level of activity.
2. Costs are bifurcated into fixed and variable costs. Variable costs change
according to the volume of production.
 3. Prices of variable cost factors (wage rates, price of materials, suppliers etc.)
Will remain unchanged so that variable costs are truly variable.
4. Product specifications and methods of manufacturing and selling will not
undergo a change.
5. Operating efficiency will not increase or decrease.
6. Selling price remains the same at different levels of activity.
7. Product mix will remain unchanged.
8. The number of units of sales will coincide with the units produced, and
hence, there is no closing or opening stock.

Construction of Break-Even Chart

The following steps are required to be taken while constructing the Break-even chart:

1. Sales volume is plotted on the x-axis. Sales volume can be shown in the form
of rupees, units or as a percentage of capacity. A horizontal line is drawn
spacing equal distances showing sales at various activity levels.
2. Y axis represents revenues, fixed and variable costs. A vertical line is also
spaced in equal parts.
3. Draw the sales line from point o onwards. Cost lines may be drawn in two
ways (i) fixed cost line is drawn parallel to x axis and above it variable cost
line is drawn from zero point of fixed cost line. This line is called the total
cost line
4. The point at which the total cost cuts across the sales line is the break-even
point and volume at this point is break-even volume.
5. The angle of incidence is the angle between sales and the total cost line. It is
formed at the intersection of the sales and the total cost line, indicating the
profit earning capacity of a firm. The wider the angle the greater is the profit
and vice versa. Usually, the angle of incidence and the margin of safety are
considered together to show that a wider angle of incidence coupled with a
high margin of safety would indicate the most suitable conditions.
Margin of Safety
These are the sales beyond Break Even Point. A business will like to have a high margin of
safety because this is the amount of sales which generates profits. As such, the soundness of the
business is indicated by the margin of safety.

Margin of safety may be expressed as a ratio or as a percentage. E.g. If actual sales are Rs.
l,00,000 and Break Even Sales are Rs. 60,000, Margin of Safety will be
(Sales - Break Even Sales)X 100/Sales
i.e.

Advantages And Limitations Of Break-Even Analysis

The break-even analysis is a simple tool employed to graphically represent accounting data. The
data revealed by financial statements and reports are difficult to understand and interpret. But
when the same are presented through break-even charts, it becomes easy to understand them.
Break-even charts help in:

1. Determining total cost, variable cost and fixed cost at a given level of
activity.
2. Finding out break-even output or sales.
3. Understanding the cost, volume, profit relationship.
4. Making inter-firm comparisons.
5. Forecasting profits.
6. Selecting the best product mix.
7. Enforcing cost control.

On the negative side, break-even analysis suffers from the following limitations:
  1

It is very difficult if not impossible to segregate costs into fixed and variable
components. Further, fixed costs do not always remain constant. They have a
tendency to rise to some extent after production reaches a certain level.
Likewise, variable costs do not always vary proportionately. Another false
assumption is regarding the sales revenue, which does not always change
proportionately. As we all know selling prices are often lowered down with
increased production in an attempt to boost up sales revenue. The break even
analysis also does not take into account the changes in the stock position (it
is assumed, erroneously though, that stock changes do not affect the income)
and the conditions of growth and expansion in an organisation.

 2

The application of break-even analysis to a multi-product firm is very

difficult. A lot of complicated calculations are involved.

 3

The break-even point has only limited importance. At best it would help
management to indulge in cost reduction in times of dull business. Normally,
it is not the objective of business to break-even, because no business is
carried on in order to break-even. Further the term BEP indicates precision or
mathematical accuracy of the point. However, in actual practice, the precise
break-even volume cannot be determined and it can only be in the nature of a
rough estimate. Therefore, critics have pointed out that the term `break-even
area’ should be used in place of BEP.
 4
4
Break-even analysis is a short-run concept, and it has a limited application in
the long range planning.
Despite these limitations, break-even analysis has some practical utility in that it helps
management in profit planning. According to wheldon, `if the limitations are accepted, and the
chart is considered as being an instantaneous photograph of the present position and possible
trends, there are some very important conclusions to be drawn from such a chart’.
Cash Break-Even Chart
This chart is prepared to show the cash need of a concern. Fixed expenses are to be classified as
those involving cash payments and those not involving cash payments like depreciation. As the
cash break-even chart is designed to include only actual payments and not expenses incurred,
any time lag in the payment of items included under variable costs must be taken into account.
Equal care must be shown on the period of credit allowed to the debtors for the purpose of
calculating the amount of cash to be received from them, during a particular period.

Formulas for Break Even Analysis

Margin of Safety
Total sales minus the sales at break-even point is known as the margin of safety. Lower break-
even point means a higher margin of safety. Margin of safety can also be expressed as a
percentage of total sales.
Composite Break-Even Point
Where a firm is dealing with several products, a composite breakeven point can be calculated
using the following formula:Break-Even Point (Of Sales) = (Fixed Costs/ Contribution Per
Unit)X Selling Price Per Unit

1. Break-Even Point (Of Sales) = Fixed Costs/ P/V Ratio

2. B.E.P. (Sales) = (Fixed Cost X Selling Price per Unit)/ (Selling Price per Unit – Variable Cost per
Unit)
3. B.E.P. (Sales) = (Fixed Cost X Selling Price per Unit)/ Contribution Per Unit
4. B.E.P. (Sales) = (Fixed Cost X Total Sales)/ Total Contribution
5. B.E.P. (Sales) = Total Contribution/ PV Ratio
6. Break-Even Point ( of Units) = Fixed Costs/ Contribution Per Unit
7. B.E.P. (In Units) = Fixed Cost/ (Selling Price per Unit – Marginal Cost per Unit)
8. Sales Needed For a Desired Profit = (Fixed Cost + Desired Profit)/ P/V Ratio
9. Total Contribution = Sales – Total Variable Cost
10. Total Contribution = Fixed Costs + Profit
11. Total Contribution = Sales X P/V Ratio
12. Total Contribution = Fixed Costs – Loss
13. Contribution Per Unit = Sales/No of Units sold
14. Contribution Per Unit = Selling Price Per Unit - Variable Cost Per Unit
15. Contribution Per Unit = Selling Price Per Unit X P/V Ratio
16. Total Variable Cost =Total Cost – Fixed Costs
17. Total Variable Cost = Sales – Total Contribution
18. Total Variable Cost = No of Units sold X Variable Cost Per Unit
19. Profit = Total Contribution – Fixed Costs
20. Profit = Sales X P/V Ratio– Fixed Costs
21. Profit = Sales – Total Cost
22. Profit = Sales – ( Fixed Costs +Total Variable Cost)
23. P/V Ratio = Total Contribution/ Sales
24. P/V Ratio = Contribution Per Unit/ Selling Price Per Unit
25. P/V Ratio =Change in Profit/ Change in Sales
26. P/V Ratio =Change in Contribution Change in Sales
27. P/V Ratio = (Fixed Costs + Profit)/ Sales
28. Fixed Cost = Total Cost – Total Variable Cost
29. Total Cost = Fixed Costs +Total Variable Cost
30. Margin Of Safety = Total Sales – Sales At B.E.P.
31. Margin Of Safety = Profit/ P/V Ratio
 32. Margin of Safety %= {(Actual Sales –BEP Sales)/ BEP Sales}X100
33. Margin Of Safety (As A Percentage) = Margin Of Safety X 100/ Total Sales
34. Selling Price Per Unit = Total Sales/ No of Units sold
35. Increasing in Selling Price to maintain BEP = Increase in Variable Cost per unit
36. Cash Break-Even Point (Of Output) = Cash Fixed Costs/Cash Contribution Per Unit
37. Composite Break-Even Point (Sales) = Cash Fixed Costs/ Composite P/V Ratio
38. Composite Break-Even Point (Sales) = (Total Fixed Costs X Total Sales)/ Total Contribution
39. Composite Break-Even Point (Sales) = Total Contribution X 100/ Total Sales

Summary
Observations on Cost Behavior

 1

1
Total fixed cost is constant

 2

2
Average Fixed Cost is decreasing gradually

 3

3
Total Variable Cost is increasing gradually

 4

4
Average Variable Cost is constant

 5

5
Total Cost is increasing gradually
 6
6
Aver Total Cost is decreasing gradually
A big organization can increase the scale of production to reduce its average cost of production
and it can sell at a lower price than the competitors or small firms. This is called economy of
scale.

The marginal cost of production is the increase in Total cost as a result of producing one extra
unit. It is the variable costs associated with the production of one more units.
Cost-volume-profit analysis is a technique of analysis to study the effects of cost and volume
variations on profit. It determines the probable profit at any level of activity. It helps in profit
planning, preparation of flexible budgets, fixation of selling prices for products, etc. As the
volume increases, the average fixed cost decreases, average cost also decreases and the profit
increases.

Break Even Point is a situation of no profit no loss. It means that at this stage, contribution is just
enough to cover the fixed costs. The Break Even Point may be expressed in two ways.

 In terms of quantity – Fixed Costs/ Contribution per unit

 In term of amount – Fixed Costs/P/V Ratio

The break-even point is generally depicted through the break-even chart. The chart shows the
profitability of an undertaking at various levels of activity. It brings out the relationship between
cost, volume and profit clearly. On the negative side, the limitations of break-even analysis are:
difficulty in segregating costs into fixed and variable components, difficulty in applying the
technique to multi-product firms, short-term orientation of the concept etc.

Key Words
Break Even Point A situation of no profit no loss.
Cost-volume-profit A technique of analysis to study the effects of cost and volume variations
analysis on profit.
Economy of scale Increasing the scale of production to reduce average cost of production.

Margin of Safety Sales beyond Break Even Point.

Marginal cost The increase in Total cost as a result of producing one extra unit.

Marginal Profit The increase in Total Profit as a result of selling one extra unit.

Marginal Revenue The increase in Total Revenue as a result of selling one extra unit.

Profit Volume (P/V)

This ratio indicates the contribution earned with respect to one rupee of
Ratio
sales.
Self Assessment Questions
 1

1
How to calculate Average Cost, Average Revenue and Average Profit? Give examples.

 2

2
How to calculate Marginal Cost, Marginal Revenue and Marginal Profit? Give examples.

 3

3
How to calculate Total Cost, Total Revenue and Total Profit? Give examples.

 4

4
What is Marginal Cost? What is the utility of Marginal Cost?

 5

5
Explain the concept of Marginal Revenue and Marginal Profit.

 6

6
Explain the concept of Cost, Volume and Profit relationship with example.

 7

7
Explain the concept of Economy of Scale.

 8

8
What is Break Even Point? How is it calculated?
  9

9
What is Margin of Safety? How is it calculated?

 10

10
What is Profit Volume Ratio? How is it calculated?

 11

11
Explain the concept of Break Even Point with a graph and example.
 12
12
Construct a Break Even Point graph for the following information. The fixed cost of a
firm is Rs. 10,00,000/-. The variable cost is Rs.6/- per unit. Sale price per unit is
Rs.10/-.

Chapter 7- Introduction to Financial Management

Introduction
A business is an activity which is carried on with the intention of earning profits. production,
marketing and finance are the key operational areas in case are of a manufacturing organisation,
out of which finance, is the most crucial one. This is so, as the functions of production and
marketing are related with the function of finance. If the decisions relating to money or funds
fail, it may result into the failure of the business organisation as a whole. Hence, it is utmost
important to take the proper financial decisions and that too at a proper point of time.
The reasons for finance function being a highly centralized function are very obvious.

1. Financial decisions are the most crucial ones on which survival or failure of the
organisation depends.
2. Financial decisions affect the solvency position of the organisation and a wrong decision
in this area may land the organisation into crisis.
3. The organisation may gain economies of centralization in the form of reduced cost of
raising the funds, acquisition of fixed assets at the competitive prices etc.

Profit Maximization
As a basic principle, any business activity aims at earning the profits. According to this principle,
all the functions of the business will have the profit as the main objective. Similarly, the finance
function will also have the profits as the main objective.
Wealth Maximization
Due to the limitations attached with the profit maximization as an objective of the finance
function, it is no more accepted as the basic objective. As against it, it is now accepted that the
objective of the business should be to maximize its wealth and value of the shares of the
company.
The value of an asset is judged not in terms of its cost but in terms of the benefit it produces.
Similarly the value of a course of action is judged in terms of the benefits it produces less the
cost of undertaking it.

Meaning and Importance of Financial

Management
R.C. Osborn: The finance function is the process of acquiring and utilising funds of a business.
Bonneville and Dewey: Financing consists of the raising, providing, managing of all the money,
capital or funds of any kind to be used in connection with the business.
Prather and Wert: Business finance deals primarily with raising, administering and disbursing
funds by privately owned business units operating in non-financial fields of industry.
Financial Management is the function of Assessment, Acquisition, Allocation of capital and
Appropriation of profit and Analysis of performance.
According to the modern approach, the function of finance is concerned with the following three
types of decisions:

1. Financing Decisions
2. Investment Decisions
3. Dividend Policy Decisions

Financing Decisions
Financing decisions are the decisions regarding the process of raising the funds. This function of
finance is concerned with providing the answers to the various questions like:

 1

1
What should be the amount of funds to be raised? In simple words, the amount of funds
to be raised by the organization should not be more or less than what is required as both
the situations involve the adverse consequences.

 2

2
 What are the various sources available to the organization for raising the required amount
of funds? For the purpose of raising the funds, the organization can go for internal
sources as well as external sources.

 3

3
What should be the proportion in which the internal and external sources should be used
by the organization?

 4

4
If the organization, particularly the corporate form of organization, wants to raise the
funds from different sources, it is required to comply with various legal and procedural
formalities. Earlier, these legal and procedural formalities were prescribed and regulated
by Controller of Capital Issues (CCI). Since 1992, after the abolition of the office of CCI,
these formalities are prescribed and regulated by Securities and Exchange Board of India
(SEBI). Though the intention of this subject is not to consider the SEBI regulations and
guidelines in details, relevant SEBI guidelines are discussed at the appropriate places.
 5
5
During the last decade of the twentieth century, lots of changes have taken place in the
capital market, which refers to the market available to the companies to raise the long
term requirement of funds. The question arises what is the nature of capital market
operations? What kinds of changes have taken place recently affecting the capital market
in the country?
Investment Decisions
Investment Decisions are the decisions regarding the application of funds raised by the
organization. The investment decisions relate to the selection of the assets in which the funds
should be invested.
The assets in which the funds can be invested are basically of two types:
Fixed Assets - Fixed Assets indicate the infrastructural facilities and properties required by the
organization. Fixed Assets are the assets which bring the returns to the organization over a longer
span of time. The investment decisions in these types of assets are technically referred to as
“Capital Budgeting Decisions.” Capital Budgeting decisions are concerned with the answers to
the questions like:

 1

1
How the fixed assets or proposals or projects should be selected to make the investment
in? What are the various methods available to evaluate the investment proposals in the
fixed assets?
 2
2
 How the decisions regarding the investment in fixed assets or proposals or projects
should be made in the situations of risk and uncertainty?
Current Assets - Current Assets are the assets which get generated during the course of
operations and are capable of getting converted in the form of cash or getting utilized within a
short span of time of one year. Current Assets keep on changing the form and shape very
frequently. The investment decisions in these types of assets are technically referred to as
“Working Capital Management.” Working Capital Management decisions are concerned with
the answers to the questions like:

 1

1
What is the meaning of working capital management? What are the objectives of working
capital management?

 2

2
Why the need for working capital arises?

 3

3
What are the factors affecting the requirement of working capital?

 4

4
How to quantify the requirement of working capital?

 5

5
What are the sources available for financing the requirement of working capital?
 6
6
Working capital management is concerned with the management of current assets on
overall basis as well as on individual basis. In practical situations, current assets may be
found in the form of cash and bank balances, receivables and inventory. Working capital
management is concerned with the management of these individual components of
current assets as well.
Dividend Policy Decisions
Profits earned by the organization belong to the owners of the organization. In case of the
corporate form of organization, shareholders are the owners and they are entitled to receive the
profits in the form of dividend. However, there is no specific law or statute which specifies as to
how much amount of profits should be distributed by way of dividend and how much amount of
profits should be retained in the business. The alternatives available to the organization to
distribute the profits in the form of dividend on one hand and retention of profits in the business
have reciprocal relationship with each other.
If the dividends paid are higher, retained profits are less and vice versa. If the organization pays
higher dividends, shareholders are very happy as they get more recurring income and the
company may be able to gain the confidence of the shareholders. However, the organization can
be in financial problems as payment of dividend results into the withdrawal of profits from the
business. On the other hand, if the organization pays less dividend, the organization may be in a
favourable situation.
However, the shareholders are likely to be offended. As such, the organization is required to take
the decisions regarding the payment of dividend in such a way that neither the shareholders are
offended nor the organization is in financial problems. As such, dividend policy decisions are the
strategic financial decisions and are concerned with the answers to the questions like:
1. What are the forms in which the dividends can be paid to the shareholders?
2. What are the legal and procedural formalities to be completed while paying the
dividend in different forms?

Duties and Responsibilities of Finance

Officer
On the basis of the scope of the finance function, which has already been discussed, the various
duties and responsibilities which a finance executive has to fulfil can be classified as below:
1. Recurring Duties
2. Non-recurring Duties
Recurring Duties

Deciding the Financial Needs: In case of a newly started or growing concern, the basic duty of
the finance executive is to prepare the financial plan for the company. Financial plan decides in
advance the quantum of funds required, their duration, etc. The funds may be needed by the
company for initial promotional expenditure, fixed capital, working capital or for dividend
distribution. The finance executive should assess this need of funds properly.
Raising the Funds Required: The finance executive has to choose the sources of funds to fulfill
financial needs. The sources may be in the form of issue of shares, debentures, borrowing from
financial institutions or general public, lease financing etc. The finance executive has also to
decide the proportion in which the various sources should be raised. For this, he may have to
keep in mind basic three principles of cost, risk and control. If the company decides to go in for
issue of securities say in the form of shares or debentures, he has to arrange for the underwriting
or listing of the same. If the company decides to go in for borrowed capital, he has to negotiate
with the lenders of the funds.
Allocation of funds: The financial executive has to ensure proper allocation of funds. He can
allocate the funds basically for two purposes.

 Fixed Assets Management: He has to decide in which fixed assets the company should invest
the funds. He has to ensure that the fixed assets acquired or to be acquired satisfy the present as
well as future needs of the company. He has to ensure that the funds invested in the fixed assets
justify the investments in terms of the expected cash flows generated by them in future. If there
 are more than one proposals for making the investments in fixed assets, the finance executive has
to decide in which proposal, the company should invest the funds. For this purpose, he may be
required to take the help of various techniques of capital budgeting to evaluate the various
proposals.
 Working Capital Management: The finance executive has to ensure that sufficient funds are
made available for investing in current assets as it is the life-blood of the business activity. Non-
availability of funds to invest in current assets in the form of say cash, receivable, inventory etc.
may halt the business operations.

Allocation of Income: Allocation of the income of the company is the exclusive responsibility
of the finance executive. For this purpose, basically the income may be distributed among the
shareholders by way of dividend or it may be retained in the business for future purpose like
expansion.
Control of Funds: The finance executive is responsible to control the use of funds committed in
the business so as to ensure that cash is flowing as per the plan and if there is any deviation
between estimates and plans, proper corrective action may be taken in the light of financial
position of the company.
Evaluation of Performance: The financial executive may be required to evaluate and interpret
the financial statements, financial position and operations of the company. For this purpose, he
may be required to ensure that proper books and records are maintained in proper way so that
whatever data is required of this purpose is available in time.
Corporate Taxation: As the company is a separate legal entity, it is subjected to the various
direct and indirect taxes like income tax, wealth tax, excise and customs duty, sales tax etc. The
finance executive may be expected to deal with the various tax planning and tax saving devices
in order to minimize the tax liability.
Other Duties: In addition to all the above duties the financial executive may be required to
prepare annual accounts, prepare and present financial reports to top management, carrying out
internal audit, get done statutory and tax audit, safeguarding securities and assets of company by
properly insuring them etc.
Non-Recurring Duties

The non-recurring duties of the finance executive may involve preparation of financial plan at
the time of company promotion, financial readjustments in times of liquidity crisis, valuation of
the enterprise at the time of acquisition and merger thereof etc.

Theories of Capitalization
The assessment of the funds needed by the company should be done in such a way that the total
amount of funds available should be neither too large nor too less. As such, one of the most
important financial decisions becomes the determination of the amount which the company
should have at its disposal. This is capitalization.
Thus the term capitalization means total amount of long term funds available to the company. In
the words of Dewing “Capitalization includes capital stock and debt”. Therefore capitalization
includes shares and debentures issued by the company and also the long term loans taken from
the financial institutions. The question arises regarding the inclusion of non-distributed profit in
the capitalization.
There are two important theories which act as guidelines for determining the amount of
capitalization.
Cost Theory
–

Cost theory of capitalization considers the amount of capitalization on the basis of cost of
various assets required to set up the organisation. It gives more stress on current outlays than
on the requirements which are necessary to accommodate the investment on a going concern
basis.

The company may need the funds to invest in fixed and current assets and also to meet
promotional and organisational expenses. The total sum required for all these purposes gives
the amount of capitalization. The cost theory of capitalization seems to be ideal as it considers
the actual funds to acquire various assets, but it does not consider the earnings capacity of
these assets.

If the amount of capitalization arrived at on this basis includes the cost of assets acquired at
inflated costs or the cost of idle and obsolete assets, the earnings are bound to be low which will
not be able to pay favourable return on the cost of assets and this will result into over-
capitalization. Similarly, cost theory of capitalization may not be useful in case of company
with irregular earnings.

Earnings Theory
–

Earnings theory of capitalization considers the amount of capitalization on the basis of

expected future earnings of the company, by capitalizing the future earnings at the appropriate
capitalization rate. Thus, for determining the amount of capitalization, it is necessary to take
the following steps:

To decide future earnings

Estimations of future earnings may be comparatively an easy task in case of established
concerns as there can be some basis of past data. In case of new concerns, estimating the
future earnings is a difficult task. While estimating future earnings, following factors should
be kept in mind.

 Smaller the period, more accurate will be the estimations of future earnings. While
estimating future earnings on the basis of past earnings, weighted average of past
earnings may be considered giving maximum weightage to recent earnings.
 While considering future earnings on the basis of past earning, care should be taken to
adjust the earnings on account of non-recurring factors. Moreover, adjustments should
be made for known factors in future.
  In case of new concerns, the estimations of future earnings depend upon correct
estimation of future sales (which in turn should be based upon proper sale forecast) and
future costs. Allowance should be made for contingencies.

To determine Capitalization rate

This is the most tricky and delicate issue and is entirely a subjective concept. The concepts
of capitalization rate may take any of the following forms:
 It is the rate of return that is required to attract investors to the particular
organization.
 It is the cost of capital.
 It is the rate of earnings of the similar organizations in the same industry.

To capitalize the future earnings at the decided rate of Capitalization.

Following example will illustrate the working of earnings theory of capitalization.

Illustration:
Expected future earnings of A Ltd. are Rs.3,00,000. Find out the amount of capitalization if
rate of return earned by similar types of companies is 15%.
Amount of capitalization = Rs.3,00,000 x 100/15 = Rs.20,00,000.
Expected future Profit after Tax of a company is Rs.2.5 lacs. Capitalization Rate is 10%. The
ideal capitalization of the company will be, Rs.2,50,000 x 100/10 = Rs.25,00,000.
The earnings theory of capitalization is ideal in the sense that it considers earnings capacity of
the organization. But it has limitations in the sense that it involves the estimation of two
variables i.e. future earnings and capitalization rate, which are too difficult to ascertain.
As such, in case of established concerns, earnings theory may be useful, whereas new concerns
may prefer cost theory to decide the amount of capitalization.
Overcapitalization
In simple terms, over-capitalization means existence of excess capital as compared to the level of
activity and requirements. For example, if a company is earning a profit of Rs.50,000 and the
normal rate of return applicable for the same industry is 10%, it means that the amount of shares
and debentures should be Rs.5,00,000. If the amount of shares and debentures issued by the
company is more than Rs.500,000, then the company will be said to be overcapitalized.
The term over-capitalization should not be taken to mean excess funds. There can be situation of
over-capitalization; still the company may not be having sufficient funds. Similarly, the company
may be having more funds and still may be having a low earning capacity thus resulting into
over-capitalization.

Causes of Overcapitalization

The situation of over-capitalization may arise due to various reasons as stated below:

1. The assets might have been purchased during the inflationary situations. As such the real value of
the assets is less than the book value of the assets.
2. Adequate provision might not have been made for depreciation on the assets. As such, the real
value of the assets is less than the book value of the assets.
 3. The company might have spent huge amounts during its formation stage or might have spent
huge amounts for the purchase of intangible assets like goodwill, patents, trademarks, copyrights
and designs etc. As a result, the earning capacity of the company may be adversely affected.
4. The requirement of funds might not have been properly planned by the company. As a result, the
company may have shortage of capital and to overcome the situation of shortage of capital, the
company may borrow the funds at unremunerative rates of interest, which in its turn will reduce
the earnings of the company.
5. The company might have followed the lenient dividend policy without bothering much about
building up the reserves. As a result, the retained profits of the company may be adversely
affected.
6. If there is a very high rate of taxation for companies, the company may not be having sufficient
funds left with it for modernization or renovation programmes. As such, the real value and the
earning capacity of the assets will be lower.
7. There may be many instances, where the management of the company may raise large amounts
by issuing securities, irrespective of the fact whether they are really required or not, in order to
take benefit of favourable capital market conditions. As a result, only the liability of the company
increases but not the earning capacity.
8. According to the earnings theory of capitalization, the capitalization is the amount of earnings
capitalized at a representative rate of return. As such, if the capitalization rate is wrong, the
amount of capitalization will be wrong, in such a way that lower the rate of capitalization, higher
will be amount of capitalization.

Effects of Overcapitalization
On Company
The real value of the business and its earning capacity reduces with the adverse affect on market
value of shares. Credit standing of the company in the market falls down and it is difficult to
raise further capital. The temporary means like lower amount of depreciation and maintenance
charges are followed to improve the earnings which aggravates the situation further.
On Shareholders
This is the worst affected class. The shares held by them are not having any backing of tangible
assets. Due to the reduced market values, the shares become non-transferable or are required to
be transferred at extremely low prices.
On Consumers
To overcome the situation of overcapitalization and to improve the earnings, the company may
be tempted of increase the selling price, more particularly in monopoly conditions. Due to this,
the quality of the products may also be affected.
On Society at Large
The increasing selling prices and reducing quality can’t be continued for a very long time due to
the competition existing in the market. The situation like this means loosing the backing of the
shareholders as well as the consume Rs. As a result, the company is dragged towards the winding
up which ultimately affects the society at large in the adverse way in terms of lost industrial
production, unemployment generated, unrest among the workers as a part of society etc.
Remedies Available
In order to overcome the situation of overcapitalization, the company may resort to any of the
following remedial measures:

 1
 1
To reduce the debts by repaying them. But the debts should be repaid out of the own
earnings of the company. There is no point in repaying the debts out of the fresh issue of
shares or debentures, as it does not reduce the amount of capitalization.

 2

2
To redeem the preference shares if they carry too high rate of dividend.

 3

3
The persons holding the debentures may be persuaded to accept new debentures which
carry lower rate of interest.

 4

4
The par value of the equity shares may be reduced but this also will have to be done only
after taking the shareholders into confidence.
 5
5
The number of equity shares may be reduced but this also will have to be done only after
taking the shareholders into confidence.

Undercapitalization

As against the indication of overcapitalization, the situation of undercapitalization indicates the

excess of real worth of the assets over the aggregate of shares and debentures outstanding. Thus,

if a company succeeds in earning abnormally high income continuously for a very long period of

time, it indicates symptoms of undercapitalization. As such, undercapitalization is an indication

of effective and proper utilization of funds employed in the business. It also indicates sound

financial position and good management of the company. Hence it is said that

“undercapitalization is not an economic problem but a problem in adjusting capital structure”.

Causes of Undercapitalisation

The situation of undercapitalization may arise due to various reasons as stated below:
 1. Sometimes, it may so happen that while deciding the amount of shares and debentures to be
issued, the future earnings may be underestimated. As a result, if the actual earnings turn out to
be higher, capitalization of these earnings may result into undercapitalization. Similarly, use of
low rate of capitalization for capitalizing the future earnings may also result in
undercapitalization.
2. There may be cases where the earnings of the business come as a windfall. This may arise during
transition from depression to boom. Thus, while recovering from depression, the companies may
find their earnings too high to result into the state of undercapitalization.
3. Sometimes, the company may follow too conservative policy for paying the dividends keeping
aside more and more profit for making further additions and investments. As a result, the
company may find itself to be in too high profits and thus undercapitalization.
4. The company may be in the position to improve its efficiency through constant modernization
programmes financed out of its own savings. As such the earnings capacity of the company may
increase to such an extent that the real value of the assets is much more than the book value
which results into the state of undercapitalization.

Effects of Undercapitalization
On Company
Financial stability and solvency of the company is not affected due to undercapitalization, but it
still affects the company adversely.

1. As earnings per share ratio is very high, it increases the competition unduly by creating a feeling
that the line of business is very lucrative.
Increasing amounts of profits increases the tax liability of the company.
2. Marketability of the shares of the company gets restricted due to very high market prices of
shares.

3. Very high profitability of the company induces the employees to demand increase in wages,
reduced working hours, more welfare schemes and more social amenities.
4. Very high profitability of the company creates a feeling among the customers that the company is
charging very high prices for its products. They try to bring pressure on the company for reducing
the prices of the product.
5. Increasing profitability coupled with unrest among the employees as well as consumers increases
the possibility of Government control and intervention over such companies. This proves to be
quite embarrassing for the company.

On Shareholders
Generally, the shareholders of an undercapitalized concerns are benefited. Firstly, they get a very
high dividend income regularly. Due to the increasing share prices, the investment of
shareholders in the company appreciates considerably which can be encashed at any time.
Secondly, in times of need, the shareholders may get loans on the security of these shares on
easy terms due to high credit standing of the company in market. However, the shareholders of
the undercapitalized concerns may suffer in the sense that the market for the shares is limited due
to very high market prices of the shares.
On Society
The effects of undercapitalization on the society as a whole may not necessarily be adverse ones.
It may encourage new entrepreneurs to start new ventures or existing ones to expand. This may
increase the industrial production and reduce the unemployment problems. The consumers may
get variety of products at the competitive prices.
However, society may not be benefited if the state of undercapitalization is not taken into right
spirit. If the feeling is developed among the workers and consumers that they are being exploited
due to ever-increasing profitability of the undercapitalized company, it may disturb not only the
company itself but also the society as a whole. Possibility of Government intervention and
introduction of various control measures (say in the form of price control, dividend ceiling and
dividend freeze) increases.
Remedies Available
The main indications about existence of the situation of undercapitalization is the ever-increasing
amount of earnings per share. If the situation of undercapitalization is to be resolved, the
company can take any of the following two measures in order to reduce the amount of earnings
per share.
Issue of Bonus Shares
If the company has sufficient amount of reserves and surplus in hand, whole or a part of reserves
and surplus may be capitalized by way of bonus shares. As a result, number of shares as well as
amount of share capital will increase and amount of reserves and surplus will be reduced. It
should be noted that it will affect neither the amount of capitalization nor the total income of the
shareholders. But it will reduce the amount of earnings per share.
For example, Suppose that the present capitalization of the company comprise of Equity Share
Capital of Rs.1,00,000 (divided into 1000 Equity Shares of Rs.100/- each) and reserves of
Rs.75,000. If the present earnings are Rs.50,000, the present earnings per share will Rs.50 i.e.
Rs.50,000/1000 equity shares. The company decides to issue 500 equity shares of Rs.100/- each
as bonus shares. As such, the equity share capital will increase to Rs.150,000 and reserves will
reduce to Rs.25,000. The earnings of the company will be considered against total of 1500 equity
shares and as such, earnings per share will reduce to Rs.33.33 i.e. Rs.50,000/1500 Equity Shares.
Splitting the Shares
To overcome the situation of undercapitalization, the company may decide to split the shares in
order to spread the earnings over a greater number of shares so that the earnings per share may
be reduced.
Watered Stock/Watered Capital
When share capital is not represented by the assets of equal value, the situation may mean
introduction of water in the capital or watered capital.
This situation may arise due to following reasons:
1. The services of the promoters are valued highly and they are paid usually in the
form of shares of the company. As such, share capital is increased but no assets
are created.
2. Sometimes, the company pays higher price to the vendors of the assets transferred
i.e., the price which is more than the worth of the assets.

Sources of Finance
The various sources from which a company may meet its long term and medium term
requirement of funds are discussed under the following headings:
1. Shares
2. Debentures
3. Term Loans
4. Public Deposits
 5. Leasing and Hire Purchase
6. Retained Earnings

Share Capital
A share indicates the smallest unit into which the overall requirement of capital of a company is
subdivided. For example, If the capital required by a company is Rs.10 Crores, it can be
subdivided into 1 crore smaller units called as “Shares”, each one of the units having the value of
Rs.10 each, which in technical words is referred to as “Face Value” or “Nominal Value”. In the
Indian circumstances, the Face Value or Nominal Value can be decided by the company on its
own. Generally found face value or nominal value is Rs.10 or Rs.100 each share.
Indian circumstances, a company can raise the long term funds by issuing two types of
shares.

 Equity Shares
 Preference Shares

Equity Shares
These are the corner stones of the financial structure of the company. On the strength of these
shares, the company procures other sources of capital. Equity Shares as a source of long term
funds for the company has the following characteristic features:

 1

1
Investors in the equity shares are the real owners of the company. As such, the investors
in equity shares are entitled to the profits earned by the company or the losses incurred by
the company.

 2

2
Funds raised by the company by way of equity shares are available on permanent basis.
In other words, funds raised by the company by way of equity shares are not required to
be repaid by the company during the lifetime of the company. They are required to be
repaid only at the time of closing down of the company i.e. winding up of the company.

 3

3
Funds raised by the company by way of equity shares are available to the company on
unsecured basis i.e. the company does not offer any of its assets by way of security to the
investors in equity shares.
  4

4
Return which the company pays on equity shares is in the form of dividend. The rate of
dividend is not fixed. It generally depends upon the profits earned by the company.
However, a profit making company is under no obligation to pay dividend on equity
shares.

 5

5
Equity shares as a source of raising the long term funds is a risk free source for the
company, as the company does not commit anything on equity shares.

 6

6
Equity shares as an investment is very risky for the investors. As such, the investors are
granted the voting rights. By exercising the voting rights, the investors can participate in
the affairs regarding the business of the company. These voting rights are generally
proportionate voting rights, in the sense the voting rights of the investors are in
proportion to their investment on the overall capital of the company. However, it should
be noted that due to some recent amendments to the companies Act, 1956, it may be
possible for the companies to issue the equity shares with disproportionate voting rights.

 7

7
Equity shareholders may not be able to compel the company to pay the dividend, but they
enjoy the right to maintain the proportionate interest in profits, assets and control of the
company. As such, if the company wants to issue additional equity shares, it is under
legal obligation to offer these equity shares to the existing shareholders first, before going
to the open market as a general offer. This right of equity shareholders is called “Pre-
emptive Right”.
 8
8
In financial terms, equity shares as a source of raising the funds is a costly source
available to the company. The reasons for this will be discussed in the following
paragraphs.

Preference Shares
These are the shares which enjoy preferential treatment as compared to the equity shares in
respect of the following factors:
 bullet
Unlike in case of equity shares, the preference shares carry the dividend at a fixed rate
which is payable even before any dividend is paid on equity shares.
  bullet
In the case of winding up of the company, preference shareholders are paid back their
investment even before the investment of equity shareholders is paid off.
Preference Shares as a source of funds for the company involves the following characteristic
features:

 1

1
Investors in preference shares are not the absolute owners of the company.

 2

2
Funds raised by the company by way of preference shares are required to be repaid
during the existence of the company. As per the provisions of Section 80 of the
Companies Act, the company can issue the preference shares maximum for the duration
of 20 years. As such, unlike equity shares, preference share is not a permanent capital
available for the company.

 3

3
Like in case of equity shares, funds raised by the company by way of preference shares
are available to the company on unsecured basis i.e. the company does not offer any of its
assets by way of security to the investors in preference shares.

 4

4
Return which the company pays on preference shares is also in the form of dividend
which is payable by the company out of the profits earned. However, unlike in case of
equity shares, the rate of dividend is prefixed and precommunicated to the investors.

 5

5
As compared to equity shares, risk on the part of company is more in case of preference
shares.
 6


6
Preference shares as an investment is comparatively less risky for the investors. As such,
generally, preference shares do not carry any voting rights and hence they do not have
any say in controlling the affairs of the company. However, Companies Act, 1956
 provides for voting rights to preference shareholders in the following circumstances.

 If any resolution directly affecting the rights of the preference shareholders is

discussed by the equity shareholders (For example, winding up of the company or
reduction of share capital etc.), the preference shareholders can vote on such
resolutions.
 If the dividend has not been paid on the preference shares, in case of cumulative
preference shares for an aggregate period of two years and in case of non-
cumulative preference shares, either for a period of two consecutive years or for
an aggregate period of three years out of the six preceding years, then the
preference shareholders can vote on all the matters placed before the company in
the meeting of the equity shareholders.
Types of Preference Shares

If the company wants to issue the preference shares, they can be of different varieties.
Convertible Vs. Non-convertible
Convertible Preference Shares are those which can be converted in the equity shares at a later
date, the terms of conversion (i.e. when the conversion will take place, at what rate it will take
place etc.) being known to the investors in the beginning only.
Non-convertible Preference Shares are those which can not be converted in the form of equity
shares. They are issued as preference shares and they remain the preference shares.
Cumulative Vs. Non-cumulative
Preference Shares are to be paid dividend at a fixed rate. However, dividend is payable only if
there are profits. The question arises as to what happens if the company is unable to pay dividend
as there are no profits earned by the company. It depends upon the types of preference shares.
If the preference shares are cumulative preference shares and the company is unable to pay the
dividend in a certain year due to non-availability of profits, the arrears of dividend go on
accumulating till the company earns the profits and once the company earns the profits, the
arrears of preference dividend are required to be paid first, then only the dividend can be paid on
equity shares.
If the preference shares are non-cumulative preference shares and the company is unable to pay
the dividend in a certain year due to non-availability of profits, the arrears of preference dividend
do not accumulate. The dividend lapses in the year of loss.
Retained Earnings
Retained earnings or ploughed back profits is one of the best source of raising long term funds
for the company. Retained earnings are ploughed back profits which are retained in the business
after distributing dividends. It indicates that whatever profits are earned by the company are not
distributed by it by way of dividend but are kept aside for being used in future for expansion or
other purposes. If the company follows a regular policy of ploughing back of profits i.e. keeping
aside profits without distributing them, the shareholders may resent this policy. As such, while
deciding the amount of profits to be retained, the company has to be very careful, about its
consequences on the expectations of shareholders and also on the prices of the shares.

Debt Capital
Debt Capital

Debt Capital means the long term loans taken from Banks or other institutions or general public

repayable after one year. They carry fixed rate of interest.

Important sources of Debt Capital are Debentures, Loans from Banks, Public Deposits, Inter

corporate borrowings, deferred tax liabilities, Leasing finance, Hire Purchase etc.

Debentures
In simple words, Debenture means a document containing an acknowledgement of indebtedness
issued by a company and giving an undertaking to repay the debt at a specified date or at the
option of the company and in the meantime to pay the interest at a fixed rate and at the intervals
stated in the debenture Deed.

The above description of debentures indicates the following characteristic features of debentures.

 1

1
Investors who invest in the debentures of the company are not the owners of the
company. They are the creditors of the company or in other words, the company borrows
the money from them.

 2

2
Funds raised by the company by way of debentures are required to be repaid during the
life time of the company at the time stipulated by the company. As such, debentures are
not a source of permanent capital. Debentures can be considered to be a long term source.

 3

3
In practical circumstances, debentures are generally secured i.e. the company offers some
of the assets as security to the investors in debentures.

 4

4
Return paid by the company is in the form of interest. Rate of interest is predetermined,
but the same can be freely decided by the company. The interest on debenture is payable
even if the company does not earn the profits.
  5

5
Debentures as a source of raising long term funds are very risky from company’s point of
view. The risk accepted by the company in case of debentures is twofold. First, to pay the
interest at the predefined rate and at predefined time intervals irrespective of non-
availability of profits and second, to repay the principal amount of debentures during the
life time of the company.

 6

6
Risk on the part of investors is very less in case of debentures. The investors in
debentures being the creditors of the company, they can not control the affairs of the
company. As such, the debentures do not carry any voting rights. However, in the event
of non-payment of interest or principal amount, they can interfere in the operations of the
company by taking legal action.
 7
7
In financial terms, debentures prove to be a cheap source of funds from the company’s
point of view. The reasons for this will be discussed in the following paragraphs.
Types of Debentures
A Company can issue debentures of different varieties as described below:
Registered Vs. Bearer

Registered Debentures are those the holders of which are registered in the company as debenture
holders and those can be transferred to another person only through the company. Holders of
bearer debentures are not registered with the company and can be transferred to anybody by
mere delivery.
Convertible Vs. Non-Convertible

Convertible Debentures are the debentures which have the right to get converted into the equity
shares of the company. Non-Convertible Debentures do not enjoy such right.
Based upon the conversion criteria, debentures can be classified as below:

1. Fully Convertible Debentures (FCD)

2. Partly Convertible Debentures (PCD)
3. Non-Convertible Debentures (NCD)
4. Optionally Convertible Debentures

FCDs are the debentures which are entirely convertible in the form of equity shares of the
company. For example, the terms of issue may provide that the face value of the debenture is
Rs.100. At the end of 5 years, the investors will get 1 equity share of the company. This is the
case of FCD.
PCDs are the debentures which are partly convertible in the form of equity shares of the
company. For example, the terms of issue may provide that the face value of the debenture is
Rs.200. At the end of 5 years, the investors will get one equity share of Rs.100 each while the
remaining amount of Rs.100 will be repaid at the end of 7 years. This is the case of PCD.
NCDs are the debentures which are not convertible in the equity shares of the company. They are
issued as debentures, they are repaid as debentures.
In case of optionally convertible debentures, the investors are given the option to convert their
investment in the form of equity shares of the company.

ADVANTAGES OF DEBENTURES
To the Company

1.
2.
3.
4.

To the investors

1.

DISADVANTAGES OF DEBENTURES

1.
2.

Protection of interests of Debenture holders

Recent amendments to Companies Act, 1956 have made some provisions with the intention to
protect the interests of the debenture holders.

1. A Company accepting the funds from debenture holders shall appoint one or more debenture
trustees and in Prospectus or the Letter of Offer, the company should state that the debenture
trustee or trustees have given their consent to the company to act in the same capacity. The
debenture trustee will be primarily responsible to ensure that the interests of the debenture
holders are protected (including the creation of security) and the grievances of the debenture
holders are effectively redressed. To be more specific, the debenture trustee should take following
effective steps:

1. To ensure that the assets of the company and of the guarantors are sufficient to discharge
the principal amount at all times. If it is concluded that the assets of the company are
insufficient to discharge the principal amount, the trustees may file a petition before the
Company Law Board who, after hearing both the parties, may impose restrictions on the
incurring of any further liabilities by the company.
2. To satisfy himself that the prospectus or the letter of offer does not contain any matter
inconsistent with the terms of debentures or with the trust deed.
3. To ensure that the company does not commit any breach of the provisions of the trust
deed.
4. To take steps to remedy any breach of the provisions of trust deed or terms of issue of
debentures.
 5. To take steps to call meeting of the debenture holders as and when required.

2. The trust deed for securing the issue of debentures should be executed in the prescribed form and
within stipulated period. This trust deed shall be open for inspection by any member or debenture
holder of the company and he can take the copies of the same on the payment of prescribed fees.
3. A company issuing debentures is required to create debenture redemption reserve for the
redemption of debentures and every year adequate amount should be credited to this reserve out
of the profits until such debentures are redeemed. The amount standing to the credit of debenture
redemption reserve shall be available only for the redemption of debentures.

Term Loans

Term Loans indicate liabilities accepted by the company which are for the purpose of purchasing
the fixed assets and are repayable over a period of 3 to 10 years. The term loans may be granted
by the Banks (nationalized, cooperative, rural etc.) or the Financial Institutions like Industrial
Development Bank of India (IDBI), Industrial Credit and Investment Corporation of India
(ICICI), Industrial Finance Corporation of India (IFCI) etc.
Features of Term Loans

 1

1
Banks or Financial Institutions granting the term loans are not at all the owners of the
company. They are creditors of the company. They lend the funds to the company.

 2

2
Term Loans are required to be repaid during the life time of the company at the
predecided intervals say monthly, quarterly, yearly etc. The initial gap after which the
repayment of term loan starts (technically referred to as the moratorium period) also
depends upon the agreement between the borrowing company and the lending bank or
financial institution.

 3

3
The term loans may be secured or unsecured, though normally all the term loans are
secured. The security which is offered for the term loans is the hypothecation or
mortgage of the fixed assets purchased with the help of term loans.

 4

4
 Return payable by the company on term loans is in the form of interest which may be
calculated on monthly or quarterly or half yearly basis at a predecided rate on the
outstanding balance of the term loan. The interest on term loan is payable despite the
non-availability of profits.

 5

5
Term Loans as a source of raising long term funds is very risky from company’s point of
view. The risk accepted by the company in case of term loans is twofold. One, to pay the
interest at the predecided rate and at predecided time intervals irrespective of non-
availability of profits and Second, to repay the principal amount of term loans.

 6

6
Risk on the part of lending bank or financial institution is very less in case of term loans.
The banks or financial institutions being the creditors of the company, they can not
control the affairs of the company. As such, they do not have any voting rights. However,
in the event of non-payment of interest or principal amount, they can interfere in the
operations of the company by taking legal action.
 7
7
In financial terms, as in case of debentures, term loans also prove to be a cheap source of
funds from the company’s point of view. The reasons for this will be discussed in the
following paragraphs.
Public Deposits

In the recent past, Public Deposits has become one of the most important sources available to the
companies for meeting the medium term requirement of funds. The companies find public
deposits as an attractive source mainly due to following reasons:

1. Raising the funds in the form of public deposits is more convenient than borrowing the funds
from banks and financial institutions. Borrowing the funds from banks or financial institutions is
a tedious job involving the compliance with many procedural requirements like margin money
stipulations, security requirements, submission of periodical statements etc. None of these
procedural requirements are required to be complied with in case of public deposits.
2. The rate of interest which the company is required to pay on public deposits is comparatively less
than the rate of interest payable on the funds borrowed from banks or financial institutions.
3. Public Deposits are unsecured borrowings for the company.
4. The company can raise the funds in the form of public deposits which can be used for any
purposes. The end use of the funds raised in the form of public deposits is not committed by the
company.
5. In the situations of credit squeeze introduced by the banks, public deposits plays a very important
role.
Lease Financing

Under the leasing agreements, the company acquires the right to use the asset without holding

the title to it. Thus, it is the written agreement between the owner of the assets, called “the

lessor”, and the user of the assets, called “the lessee” whereby the lessor permits the lessee to

economically use the asset for a specified period of time but the title of the asset is retained by

the lessor. This economical use of the asset is permitted by the lessor on the payment of

periodical amount which is in the form of “lease rent”.

Advantages of Leasing for the lessee

 bullet
Risks of ownership: Leasing facilitates lessee to avoid the risks attached with the
ownership of the equipments, say risk of obsolescence in the area of everchanging ver
changing technologies. technologies.
 bullet
Saving of capital outlay: Leasing enables lessee to make full use of the asset without
making immediate payments of the purchase price which otherwise would be payable by
him. Some lessors may also finance to the extent of 100% of the cost of the equipment
where lessee is not required to make any provision for asset acquisition.
 bullet
Tax advantages: Under the leasing propositions, the payment of lease rents is the tax
deductible expenditure. On the other hand, if the company decides to own the same asset
by resorting to the borrowing, the expenses which are available for deduction for tax
purposes are in the form of depreciation and interest on borrowing.
 bullet
Structuring of lease rents: Lessor may structure the payments of lease rents in such a
way that it matches the revenue expectations of the lessee from the equipments, which
may not be possible if lessee resorts to borrowing for owning the asset.
 bullet
No effect on borrowing power: As the obligations accepted by the lessee under the lease
deed appear nowhere on the balance sheet as debt, the borrowing power of the lessee still
remains unaffected. The lessee may still resort to debt capital provided equity base of the
company permits further borrowing.
 bullet
Convenience : Leasing is the quickest method of financing the requirements of long term
capital and lessee is relieved from the rigid and time consuming procedures and terms
and conditions involved in other forms of term borrowings say term loans.
Types of Leases
Financial Lease
In this type of lease, the lessor acts as a financier. Lessee selects the asset and bears the cost of
repairs, maintenance and insurance of the asset. Lessor reserves the right to confiscate the asset
in the event of any default on the part of lessee. The lessor recovers a major part of the cost of
asset by way of lease rent during the lease period; the lessor agrees to transfer the ownership of
the asset to the lessee by paying a nominal price which is referred to as “repurchase Price”. This
type of lease is also referred to as “capital lease”.
Operating Lease
In this type of lease, the lessee gets a limited right to use the asset. Lessor selects and purchases
the asset and leases the same to the lessee. Lessor bears the cost of repairs, maintenance and
insurance of the asset. Operating lease is for a smaller duration of time and imposes no long term
obligation either on the lessor or on the lessee. The lease rent paid by the lessee does not contain
any part towards the cost of the asset. After the lease period is over, the possession of the asset
reverts back to the lessor who can lease out the asset to another party. The lease deed is
cancellable at the option of the lessor or the lessee after giving specific notice.
Sale and Lease Back
In this type of lease, the lessee purchases the asset of his own choice and then sells the same to
the lessor. On the sale of asset to the lessor, the ownership of the asset gets transferred to the
lessor. Lessor then leases out the same asset to the lessee. After this stage, it becomes a routine
lease transaction both for the lessor as well as for the lessee. In practical circumstances, this type
of lease is very regularly found in case of some old asset which is used by an organization for a
certain duration of time.
Hire Purchasing

Hire Purchasing is also emerging as a popular source of long term financing whereby the
company can acquire long term infrastructural facilities, say fixed assets. It will be pertinent to
note here the relationship between lease financing and hire purchasing.
Hire purchase indicates an agreement between the owner of goods, called as “the hiree” and the
user of the goods, called as “the hirer” whereby the hiree deliver the goods to the hirer but the
ownership of the goods remains with the hiree. In return, the hirer makes the periodical payments
of hire charges which are partly against the capital repayment and partly against the interest
payable. For accounting and tax purposes, only the interest is treated as revenue expenditure and
is considered to be a tax deductible expenditure.
The hirer capitalizes the asset purchased under the hire purchase agreement though he is not the
owner of the assets. Depreciation is considered by the hirer as an expenditure, debiting the same
to profit and loss account and hence becomes the tax deductible expenditure. The further hire
purchase installments towards capital which are not yet due are shown as liability on the Balance
Sheet.
After the hire charges are paid by the hirer in full, he gets an option of purchasing the asset
entirely in which case the installments paid earlier are converted into the purchase price and the
ownership of the asset is transferred to the hirer.
If the hirer fails to pay any installment, hire can take the possession of the asset without
refunding any installment paid earlier. It is the duty of the hirer to keep the asset in good
condition. As such, the hire may stipulate that the assets should be properly insured, the premium
being paid by the hirer. Further, it may also be stipulated that the hirer will not sell or exchange
the asset till he becomes the owner of the asset. The hirer has a right to put an end to the
agreement before the last installment is paid, but the installments paid by him previously are not
refunded to him.
Summary
Profit Maximization and Wealth Maximization are the two main objectives of Financial
Management. Finance function is the process of acquiring and utilizing funds of a business. The
function of finance is concerned with the financing Investment and Dividend Policy Decisions.
Financial Management is the function of Assessment, Acquisition, Allocation of capital and
Appropriation of profit and Analysis of performance.
Functions of CFO include Assessment, Acquisition, Allocation of capital and Appropriation of
profit and Analysis of performance. Other functions are funds management, tax planning and
returns, management of audit, relationship with Creditors, Debtors etc.

Capitalization means the determination of the amount which the company should have at its
disposal.
Cost theory of capitalization considers the amount of capitalization on the basis of cost of
various assets required to set up the organization.

Earnings theory of capitalization considers the amount of capitalization on the basis of expected
future earnings of the company, by capitalizing the future earnings at the appropriate
capitalization rate.

Overcapitalization means existence of excess capital as compared to the level of activity and
requirements.
Undercapitalization means existence of excess assets as compared to the level of capital.

The various sources of long term finance are Shares, Debentures, Term Loans, Public Deposits,
Leasing, Hire Purchase and Retained Earnings.

A share indicates the smallest unit into which the overall requirement of capital of a company is
subdivided.
Retained earnings are ploughed back profits which are retained in the business after distributing
dividends.
Debt Capital means the long term loans taken from Banks or other institutions or general public
repayable after one year, carrying fixed rate of interest.

Debenture means a document containing an acknowledgement of indebtedness issued by a

company and giving an undertaking to repay the debt at a specified date.

Term Loans indicate liabilities accepted by the company which are for the purpose of purchasing
the fixed assets and are repayable over a period of 3 to 10 years.

Lease is the written agreement between the owner of the assets, called “the lessor”, and the user
of the assets, called “the lessee” whereby the lessor permits the lessee to economically use the
asset for a specified period of time against a payment called rent but the title of the asset is
retained by the lessor.
Hire purchase indicates an agreement between the owner of goods, called as “the hire” and the
user of the goods, called as “the hirer” whereby the hire deliver the goods to the hirer against a
payment called hiring charges but the ownership of the goods remains with the hire.

Key Words
The determination of the amount which the company should have at its
Capitalization
disposal.

The amount of capitalization on the basis of cost of various assets

Cost theory of capitalization
required to set up the organization.

A document containing an acknowledgement of indebtedness issued by

Debenture a company and giving an undertaking to repay the debt at a specified
date.

The long term loans taken from Banks or other institutions or general
Debt Capital
public repayable after one year, carrying fixed rate of interest.

The amount of capitalization on the basis of expected future earnings of

Earnings theory of
the company, by capitalizing the future earnings at the appropriate
capitalization
capitalization rate.

Finance function The process of acquiring and utilizing funds of a business.

The function of Assessment, Acquisition, Allocation of capital and

Financial Management
Appropriation of profit and Analysis of performance.

An agreement between the owner of goods, called as “the hirer” and the
user of the goods, called as “the hirer” whereby the hirer deliver the
Hire purchase
goods to the hirer against a payment called hiring charges but the
ownership of the goods remains with the hirer.

The written agreement between the owner of the assets, called “the
lessor”, and the user of the assets, called “the lessee” whereby the lessor
Lease permits the lessee to economically use the asset for a specified period of
time against a payment called rent but the title of the asset is retained by
the lessor.
 Existence of excess capital as compared to the level of activity and
Overcapitalization
requirements.

Ploughed back profits which are retained in the business after

Retained earnings
distributing dividends.

The smallest unit into which the overall requirement of capital of a

Share
company is subdivided.

Liability accepted by the company which are for the purpose of

Term Loan purchasing the fixed assets and are repayable over a period of 3 to 10
years.

Undercapitalization
Existence of excess assets as compared to the level of capital.

 1

1
Explain the Meaning and Importance of Financial Management.

 2

2
What are the Duties of Finance Officer?

 3

3
Explain the Theories of Capitalization.

 4

4
What is Over Capitalization? What are the causes? What are the remedies?

 5

5
What is Under Capitalization? What are the causes? What are the remedies?

 6
 6
List out the Sources of finance.

 7

7
State the features of Share Capital.

 8

8
State the features of Preference Shares. Explain the advantages and disadvantages of
Preference Shares.

 9

9
State the features of Ordinary Shares. Explain the advantages and disadvantages of
Ordinary Shares.

 10

10
State the features Debt Capital.

 11

11
Differentiate between Share Capital and Debt Capital.

 12

12
State the features of Debentures. Explain the advantages and disadvantages of
Debentures.

 13

13
State the features of Public Deposits. Explain the advantages and disadvantages of Public
Deposits.

 14

14
 State the features of Term loans from Banks. Explain the advantages and disadvantages
of Term loans from Banks.

 15

15
State the features Leasing Finance. Explain the advantages and disadvantages of Leasing
Finance.

 16

16
Explain the types of Leasing Finance.
 17
17
State the features of Hire Purchase. Explain the advantages and disadvantages of Hire
Purchase.

Chapter 8- Capital Structure, Cost of Capital & Leverages

Introduction
For undertaking any business activity capital is required. Capital can be own capital (equity) or
borrowed capital (debt).

A firm has to decide what should be the proportion of equity and debt. Also, a firm has to
calculate the cost of capital so that they can compare it with the return on capital employed. If a
firm depends upon borrowed capital it is called as leveraging.

Capital Structure
Capital structure refers to the mix of sources from which the long-term funds required by a

business are raised, i.e., what should be the proportion of equity share capital, preference share

capital, internal sources, debentures and other sources of funds in the total amount of capital

which an undertaking may raise for establishing its business.

Principles of Capital structure

Cost Principle
–
According to this principle, the ideal capital structure should minimize cost of financing and
maximize earnings per share. Debt capital is a cheaper form of capital due to two reasons.
First, the expectations of returns of debt capital holders are less than those of equity
shareholders. Secondly, interest is a deductible expenditure for tax purposes whereas dividend
is an appropriation of profits.
Risk Principle
–

According to this principle, ideal capital structure should not accept unduly high risk. Debt
capital is a risky form of capital, as it involves contractual obligations as to the payment of
interest and repayment of principal sum, irrespective of profits or losses of the business.

If the organization issues a large amount of preference shares, out of the earnings of the
organization, less amount will be left for equity shareholders as dividend on preference shares
are required to be paid before any dividend is paid to equity shareholders. Raising the capital
through equity shares involves least risk as there is no obligation as to the payment of dividend.
Control Principle
–

According to this principle, the ideal capital structure should keep controlling the position of
owners intact. As preference shareholders and holders of debt capital carry limited or no
voting rights, they hardly disturb the controlling position of residual owners. The Issue of
equity shares disturbs the controlling position directly as the control of the residual owners is
likely to get diluted.
Flexibility Principle
–

According to this principle, the ideal capital structure should be able to cater to additional
requirements of funds in the future, if any. E.g. If a company has already raised too heavy debt
capital, by mortgaging all the assets, it will be difficult for it to get further loans in spite of good
market conditions for debt capital and it will have to depend on equity shares only for raising
further capital. Moreover, organization should avoid capital on such terms and conditions
which limit company's ability to procure additional funds.

Example
If the company accepts debt capital on the condition that it will not accept further loan capital
or dividend on equity shares will not be paid beyond a certain limit, then it loses flexibility.
Timing Principle
–

According to this principle, the ideal capital structure should be able to seize market
opportunities, should minimize the cost of raising funds and obtain substantial savings.
Accordingly, during the days of boom and prosperity, the company can issue equity shares to
get the benefit of investors' desire to invest and take the risk. During the days of depression,
debt capital may be used to raise capital as the investors are afraid to take any risk.

Factors Affecting Capital Structure

Before deciding the mix of various long-term sources of funds, it is necessary for the company to

take into consideration various factors which can be broadly classified as below:

 Internal Factors
 External Factors
 General Factors

Internal Factors
1. Cost Factor
Cost Factor as the factor affecting the capital structure decisions refers to the cost associated with
the process of raising the various long-term sources of funds which is referred to as Cost of
Capital. While deciding the capital structure, it should be ensured that the use of capital is
capable of earning enough revenue to justify the cost of capital associated with it.
It should be noted that the borrowed capital is a cheaper form of capital for the company and this
is due to the following reasons.

 1

1
The expectations of the lenders of borrowed funds (viz. debentures, term loans etc.) are
less than the expectations of the investors who invest in the own capital of the company
(viz. shares). This is due to the fact that the risk on the part of lenders of borrowed funds
is comparatively less than the risk on the part of investors in own funds.

 2
2
The return which the company pays on borrowed funds (i.e. interest) is an income tax
deductible expenditure for the company whereas the return paid on own capital (i.e.
dividend) is not an income tax deductible expenditure for the company. As such, when
the company pays the interest on borrowed capital, its tax liability gets reduced, whereas
payment of dividend does not affect the tax liability of the company as the same is paid
out of profit after taxes.
2. Risk Factor
In financial terms, risk and return always go hand in hand. Whichever capital is cheap for the
company is risky for the company. Cost associated with the borrowed funds may be less, but the
borrowed capital is more risky for the company.
This is due to the following reasons.
  1

1
Payment of interest at the predetermined rate of interest at the predetermined time
intervals irrespective of non-availability of profits is a contractual obligation for the
company.

 2

2
The company is required to repay the principal amount of borrowed capital at the
predetermined maturity date.
 3
3
Borrowed capital is usually secured capital. If the company fails to meet its contractual
obligations, the lenders of borrowed funds may enforce the sale of assets offered to them
as security.
Cost associated with the own funds may be more for the company, but the risk associated with
them is less. This is due to the following reasons.

 1

1
As the return paid on own capital i.e. dividend is the appropriation of profits, the
company is not bound to pay any dividend unless there are profits. There are many
companies who have not paid any dividend on equity shares for years together due to
non-availability of profits.

 2

2
The company is not expected to repay the own capital during the lifetime of the company.
 3
3
Own capital is an unsecured capital. As such, none of the assets of the company are
offered as the security to the investors in own funds.
3. Control Factor
While planning the capital structure and more particularly while raising the additional funds
required by the company, the control factor essentially becomes an important factor to be
considered, specifically for the closely held private limited companies. Control factor refers to
the capacity of the existing owners of the company to retain control over operations of the
company. If the company decides to meet the additional requirements of funds by issuing the
equity shares or preference shares, the controlling interest of the existing owners is likely to get
diluted as the investors in equity shares enjoy the absolute voting rights while investors in
preference shares enjoy limited voting rights.

If the company decides to meet the additional requirement of funds by way of borrowed capital,
the controlling interest of the existing owners remains intact as the lenders of borrowed funds do
not enjoy any voting rights. However, it should be remembered here that if the existing owners
contribute to the rights shares which indicate the additional shares offered to the existing owners
in the existing proportion, their controlling interest may not get affected. Similarly, while raising
the additional requirements of funds by way of borrowed capital, the existing owners of the
company need to remember that their controlling interests may be indirectly affected if the
lending Bank or Financial Institutions appoint their representatives as Nominee Directors on the
Board of Directors of the borrowing company.
External Factors
1. General Economic Conditions
While planning the capital structure, the company needs to consider the general conditions
existing in the economy. If the economy is in the boom and the interest rates are likely to decline,
the company will like to raise equity capital immediately, leaving the borrowed capital to be
considered in the future. It may also be possible to raise more equity capital in boom as the
investors may be ready to take risk and to invest. If the economy is in depression, the company
will like to go for equity capital as it involves less amount of risk. However, it may not be
possible to raise the capital by way of equity during the period of depression as the investors may
not be willing to take the risk. Under such circumstances, the company may be required to go for
borrowed capital.
2. Behavior of Interest Rates
While planning the capital structure, the company may be required to take into consideration the
likely behavior of interest rates in the economy. If the interest rates in the economy are likely to
decline, depending more upon the long-term sources carrying a fixed rate of return (viz.
debentures, preference shares) will prove to be dangerous for the company. If the interest rates in
the economy are likely to increase, the company will get benefited by issuing the long-term
securities carrying a fixed rate of return.
3. Policy of the Lending Institutions
If the policy of the lending banks or financial institutions is too harsh or rigid, it will be advisable
not to go for borrowed funds. Instead, the company will like to go for more convenient sources
like leasing or hire purchase, though they are more costly propositions.
4. Taxation Policy
Taxation policy as a factor affecting the capital structure decisions needs to be viewed from the
angle of the company as well as the investor. As far as interest is concerned, from the company’s
point of view, the return paid on the borrowed capital i.e. interest is a tax-deductible expenditure.
From the investor’s point of view, the return received by him on the funds lent to the company is
a taxable income. Further, if the interest on debentures/bonds exceeds Rs.2,500, the paying
company is required to deduct the tax at source and pay the same to the Central Government. As
such, income received by the investors in their hands gets reduced to the extent of tax deducted
at source.
5. Statutory Restrictions
The statutory restrictions prescribed by the Government and various other statutes are required to
be taken into consideration before the capital structure is planned by the company. The company
has to decide the capital structure within the overall framework prescribed by the Government or
various other statutes.
General Factors
 bullet
Constitution of the Company
While deciding the capital structures, the constitution of the company plays a very
important role. If the company is a private limited company or a closely held company,
the control factor may play a dominant role. If the company is a public limited company
or a widely held company, the cost factor may play a dominant role.
 bullet
Characteristics of the Company
Characteristics of the company in terms of its size, age and credit standing play a very
important role in the capital structure decisions. Very small companies and the companies
in their early stage of life have to depend more upon the equity capital, as they have
limited bargaining capacity and they do not enjoy the confidence of the investors.
 bullet
Stability of Earnings
If sales and earnings of the company are stable and predictable in the future, the company
does not mind taking the risk and it can borrow the funds, as cost factor and control factor
will play more important role. However, if the sales and earnings are not likely to be
stable and predictable over a period of time and are likely to be subject to wide
fluctuations, the risk factor plays an important role and the company will not like to have
more borrowed capital in its capital structure.
 bullet
Attitude of the Management
If the management attitude is conservative, the control factor and risk factor may play
important role in the capital structure decisions. If the management attitude is aggressive,
the cost factor may play an important role.
Objects of the Capital Structure Planning

While planning the capital structure, the following objects of the capital structure planning come
into play.

1. To maximize the profits available to the owners of the company. This can be ensured by issuing
the securities carrying less cost of capital.
2. To issue the securities which are easily transferable. This can be ensured by listing the securities
on the stock exchange.
3. To issue further securities in such a way that the value of shareholding of present owners is not
adversely affected.
4. To issue the securities which are understandable by the investors.
5. To issue the securities which are acceptable to the lenders or investors.

Theories of Capital Structure

Theories of capital structure are as under:

 Net Income Approach

 Net Operating Income Approach
 Traditional Approach
 Modigliani - Miller Approach

For this purpose, the following assumptions have been made.

1. Firms use only long-term debt capital or equity share capital to raise funds.
2. Corporate Income Tax does not exist.
3. Firms follow the policy of paying 100% of its earnings by way of dividend.
4. Operating earnings are not expected to grow.

The following definitions and symbols are also used.

S = Market Value of equity shares
B = Market Value of debt
V = Total Market Value of the firm
NOI = Net Operating Income i.e. EBIT
I = Total Interest Payments
NI = Net Income available to equity shareholders. i.e. EBIT - I
Overall cost of capital = EBIT/V

1. Net Income Approach

According to this approach as proposed by Durand, there exists a direct relationship between the
capital structure and valuation of the firm and the cost of capital. By the introduction of
additional debt capital in the capital structure, the valuation of the firm can be increased and cost
of capital can be reduced and vice versa.

To explain the approach more precisely, we will consider the following example:

It can be seen from above, that by the increase in debentures, the total value of the firm increases
and cost of capital reduces and vice versa. However, this will hold good only if the cost of
debentures i.e. rate of interest is less than the equity capitalization rate.
2. Net Operating Income Approach
According to this approach, also proposed by Durand, the valuation of the firm and its cost of
capital is independent of its capital structure. Any change in the capital structure does not affect
the value of the firm or cost of capital, though the further introduction of debt capital may
increase the equity capitalization rate and vice versa.
To explain the approach, more precisely, we will consider the following example:

It can be seen from the above that the market value of the firm remains unaffected by change in
the capital structure. However, the introduction of additional debentures increases the equity
capitalization rate and vice versa.
3. Traditional Approach
This is the mean between two extreme approaches of net income approach on one hand and net
operating income on another. It believes the existence of what may be called 'Optimal Capital
Structure'. It believes that up to a certain point, additional introduction of debt capital, in spite of
increase in cost of debt capital and equity capitalization rate individually, the overall cost of
capital will reduce and the total value of the firm will increase. Beyond the point, the overall cost
of capital will tend to rise and the total value of the firm will tend to reduce. Thus, for the
judicious mix of debt and equity capital, it is possible for the firm to minimize the overall cost of
capital and maximize total value of the firm. Such a capital structure where overall cost of capital
is minimum and total value of the firm is maximum is called: Optimal Capital Structure".

To explain this approach, more precisely, we will consider the following example:
It can be seen from the above neither the no-debentures position nor the position where
debentures are issued to the extent of Rs.6,00,000 minimize the overall cost of capital or
maximize the total value of the firm. It is when debentures are issued to the extent of Rs.3,00,000
that the overall cost of capital is minimum and the total value of the firm is maximum, hence that
is the Optimal Capital Structure.
5. Modigliani - Miller (M and M) Approach
This approach closely resembles net operating income approach. According to this
approach, the value of the firm and its cost of capital are independent of its capital
structure. It argues, that overall cost of capital is the weighted average of cost of debt
capital and cost of equity capital. The cost of equity capital depends upon shareholders'
expectations. Now, if shareholders expect 10% from a certain company, they already take
into consideration debt capital in the capital structure. For every increase in debt capital
the expectations of the shareholders also increase as in the eyes of shareholders, risk in
the company also increases. Thus, each change in the mix of debt capital and equity
capital is automatically offset by change in the expectations of the shareholders which in
turn is attributable to change in risk element. As such, they argue that, leverage i.e. mix in
debt capital and equity capital, has nothing to do with the overall cost of capital and the
overall cost of capital is equal to the capitalization rate of pure equity stream of a risk
class. Hence, leverage has no impact on share market prices or cost of capital.

Cost of Capital
The cost of raising funds to finance a project includes Interest/Dividend and other miscellaneous
expenses like stamp duty, processing fees, consultant’s fees and Opportunity cost of the funds of the
company. The return on capital employed should be more than the cost of capital. Otherwise, the
company will be in loss.

We discussed about the various sources from which the long-term requirement of the capital can be
met. Each of these sources involves some cost. The cost of capital can be defined as "the rate at which
an organization must pay to the suppliers of capital for the use of their funds".
In economic terms, the cost of capital is viewed from two different angles.
1. The cost of raising funds to finance a project. This cost may be in the form of the interest
which the company may be required to pay to the suppliers of funds. This may be the
explicit cost attached with the various sources of capital.
2. The cost of capital may be in the form of opportunity cost of the funds of company i.e.
rate of return which the company would have earned if the funds are not invested.
E.g. Suppose that a company has an amount of Rs.100,000 which may either be utilized
for purchasing a machine or maybe invested with a bank as a fixed deposit carrying the
interest 10% p.a. If the company decides to use the amount for purchasing the machine,
obviously it will have to forgo the interest which it would have earned by investing the
same in fixed deposit with the bank. Thus, the cost of capital of this capital of
Rs.1,00,000 is 10%.
CONCEPTS OF COST OF CAPITAL
Besides the general concept of cost of capital, the following concepts are also used frequently.

 Component Cost and Composite Cost

Component cost refers to the cost of individual components of capital viz. equity
shares, preference shares, debentures and so on. Composite cost of capital refers
to the combined or weighted average cost of capital of the various individual
components. For capital budgeting decisions, it is the composite cost of capital
which is considered.
 Average Cost and Marginal Cost
The average cost refers to the weighted average cost of capital.
Marginal cost refers to the incremental cost attached with new funds raised by
the company.
 Explicit Cost and Implicit Cost
Explicit cost is the one which is attached with the source of capital explicitly or
apparently. Implicit cost is the hidden cost which is not incurred directly.

Example:
In the case of debt capital, the interest which the company is required to pay on
the same is explicit cost of capital. However, if the company introduces more
and more doses of debt capital in the overall capital structure, it makes the
investment in the company a risky proposition. As such, the expectations of the
investors in terms of return on their investment may increase and share prices of
the company may decrease. These increased expectations of the investors or the
decreased share prices may be considered to be implicit cost of debt capital.

 IMPORTANCE OF COST OF CAPITAL

The term cost of capital is important for a company basically for the following purposes:

 The concept of cost of capital is used as a tool for screening the investment proposals.
Example: In the case of the net present value method, the cost of capital is used as the
 discounting rate for discounting the future inflow of funds. Any project resulting into positive
net present value only will be accepted. All other projects will be rejected. Similarly, in case
of Internal Rate of Return Method (IRR), the resultant IRR is compared with the cost of
capital. It is expected, that if a project is to be accepted, IRR resulting from the same should
be more than cost of capital. If project generates IRR which is less than cost of capital, the
project will be rejected.
 The cost of capital is used as the capitalization rate to decide the amount of capitalization in
case of a new concern.
 The concept of cost of capital provides useful guidelines for determining the optimal capital
structure (This concept is discussed in detail in the following pages). Optimal capital
structure is the one where the overall cost of capital is minimum and the overall valuation of
the firm is maximum.

Cost of Equity
The computation of the cost of equity shares is the most complex procedure. It is due to the fact that
unlike preference shares or debentures, equity shares do not have either the interest or dividend to be paid
at a fixed rate. The cost of equity shares basically depends upon the expectations of the equity
shareholders. The following are the approaches to compute the cost of equity shares.

DIVIDEND/PRICE (D/P) APPROACH

According to this approach, before an investor pays a certain price for purchasing equity shares of the
company, he expects a certain return on the investment which is in the form of the dividend. The
expected rate of dividend is the cost of equity shares. This means, that the investor calculates the
market price of the shares by capitalizing the present dividend rate which is expected to be same for
all times to come at a given level. E.g. If the market price of Equity shares of a company (Face value
Rs.10) is Rs. 15 and if the company at present is paying the dividend @ 20% which is expected to be
continued in the future also, the cost of Equity Shares will be, 20% x 10/15 = 13.3%

Example
Market Price of a share is Rs.25/- Face Value is Rs.10/- Dividend paid is 50%. Earnings per share is
Rs.10. Calculate the Cost of Equity

Answer
Cost of Equity as per Dividend/Price method is
Cost of Equity = Dividend Per Share/ Market Price, = 5 X100/25 = 20.00%

This approach is objected on certain grounds. Firstly, this presupposes that an investor looks forward
only to receive dividend on equity shares. This may not always be correct. He may also look forward
to capital appreciation in the value of his shares. Secondly, this approach assumes that the company
will not earn on its retained earnings and that the retained earnings will not result in either
appreciation of the market price or increase in dividends. This assumption can be a wrong
assumption which may lead to wrong conclusions.
EARNINGS/PRICE (E/P) APPROACH

According to this approach, the cost of equity shares is based upon the stream of unchanged earnings
earned by a company. This approach holds that each investor expects a certain amount of earnings
whether distributed by way of dividend or not, from the company in whose shares he invests.
Objections to the Earnings/Price Approach to compute cost of equity shares are,

 Assumption that the Company will exist in the future.

 Assumption that EPS remains constant in future.
 Assumption that Market Price of the share remains constant in future.
 All the earnings may not be distributed as dividends.

Example
Market Price of a share is Rs.25/- Face Value is Rs.10/- Dividend paid is 50%. Earnings per share is
Rs.10. Calculate the Cost of Equity

Answer
Cost of Equity as per Dividend/Price method is
Cost of Equity = Earnings Per Share/ Market Price, = 10 X100/25 = 40.00%

D/P + G APPROACH

According to this approach, the investor is prepared to pay the market price of the shares as he
expects not only the payment of the dividend but also expects a growth in the dividend rate at a
uniform rate perpetually. Thus, the cost of equity shares can be calculated as,
(D/P) + G
where
D = Expected dividend per share
P = Market price per share
G = Growth in expected dividends.

Example
If the dividend per share is Rs. 1 per share with the expected growth of 6% per year perpetually, the
cost of equity shares, with the assumed market price of the share of Rs. 25, will be
1 /25 + 0.06 = 0.04 + 0.06 = 0.10 = 10%
This approach involves the difficulty of determining the growth rate.
SBI has given a dividend of Rs.10 per share. The dividend is expected to grow at 15%. Purchase
price of the share is Rs.1,000/- The cost of equity capital based on Dividend / Price Plus Growth
Method will be
10 /1,000 + 0.15 = 0.01 + 0.15 = 0.16 =16%

Example
The market Price of a share is Rs.15/- Face Value is Rs.10/- Dividend paid is 20%. The Expected
growth in Dividend is 10%. Calculate the Cost of Equity by Dividend/Price Plus Growth Method
Cost of Equity as per this method is
Dividend Per Share/Market Price + (Growth Rate) = 2 X100/15 = 13.33% + 10% = 23.33%

REALISED YIELD APPROACH

According to this approach, the cost of equity shares may be decided on the basis of yields actually
realized over the period of past few years which may be expected to be continued in future also. This
approach basically considers D/P + G approach, but instead of considering the future expectations of
dividends and growth factor, the actual yields in past are considered.

Cost of Retained Earnings:

Many times, it is argued that the retained earnings do not cost anything to the company. This is
argued like this as there is no obligation, either formal or implied, to pay return on retained earnings
even though they constitute one of the major sources of funds for the company. In case of debt, the
company has a fixed obligation to pay interest on it. Almost similar obligation exists in case of
preference share also. In case of equity shares, though there is no legal obligation, the expectations of
the shareholders at least provide a starting point for computing the cost of equity shares. The retained
earnings do not involve any of such obligations, either, formal or implied. As such, it may be felt that
retained earnings involve no cost as they are not raised from outside source. But this contention is not
correct. Retained earnings involve cost and this cost is in the form of the opportunity cost in terms of
dividend foregone by or withheld from the equity shareholders.

Example
Assuming that the profits earned by the company are not retained but are distributed among
shareholders by way of dividend. These amounts of dividends which would have been received by
the shareholders, after due adjustments for tax deducted at source, could have been invested by the
shareholders elsewhere to earn some return. The company, by retaining the profits, prohibits the
shareholder from earnings these returns. As such, the company is required to earn on the retained
earnings at least equal to the rate which would have been earned by the shareholders if they were
distributed to them. This is the cost of retained earnings.

Cost of Preference Shares

The cost of capital preference shares is the dividend rate payable on them. As in case of
debentures, the cost capital is adjusted for the amount excess or less received on the issue of
preference shares.
Cost of Preference Share = Dividend paid/Net amount collected.

Example
Suppose, a company issues 1,000 preference shares of Rs.100 each at the value of Rs.105 each.
Rate of dividend is 10% and the expenses involved with the issue of preference shares amount to
Rs.10,000. Thus the net amount received works out to Rs.95,000 where as the amount of the
dividend is Rs.10,000.
Here, the cost of capital works out to
(10,000/95,000) x 100 = 10.52%
As the amount of dividend payable on preference shares is not a tax deductible expenditure, there
is no question of further adjustment for the tax benefit.
Illustration
A company issues 1000 Preference Shares of Rs.100 each at a premium of Rs.5 each bearing a
dividend of @8% p.a. Company incurs the expenses in connection with the issue of Preference
Shares to the extent of Rs. 10,000. The tax rate applicable is 30%. Calculate the Cost of
Preference Shares.
Solution
-

Market Price of a preference share is Rs.110/- . Rate of Dividend is 11%, Period till maturity is
10 Years.
Face Value of the share is Rs.100/-. The cost of Preference Share is,
Cost of Preference Share = {D+(FV-MP)/N}/MP
Where D = Dividend per share, FV = Face Value, MP + Market Price, N = Number of years till
maturity
Cost of Preference Share = {11+(100-110)/10}/110 = (11-1)/110 = 9.09%

A company raised preference share capital of Rs.1,00,000 by issue of 10% preference shares of
Rs. 10 each. Company incurs the expenses in connection with the issue of Preference Shares to
the extent of Rs. 5,000. The tax rate applicable is 30%. Calculate the Cost of Preference
Shares .when they are issued at 10% premium will be,

Solution
–
Cost of Debt
The debts may be either short term debts or long-term debts. Very naturally, the cost of capital in
the form of debt is the interest which the company has to pay. In addition to interest a borrower
also incurs expenditure for raising debt in the form of stamp duty, documentation charges,
consultancy fees etc. But this is not the real cost attached with debt capital. The real cost is
something less than the rate of interest which the company has to pay. This is due to the fact that
the interest on debt is a tax deductible expenditure. If the amount of interest is considered as a
part of expenses, the tax liability of the company reduces proportionately. As such, while
computing the cost of debt, adjustments are required to be made for its tax impact.
Example: Suppose a company issues the debentures having the face value of Rs.100 and bearing
the rate of interest of 10% p.a. If the tax rate applicable to the company is 50%, the cost of
debentures is not 10% which is the rate of interest, but it is to be duly reduced by the tax benefit
available for this interest. The tax benefit is 50% of 10%, hence the cost of debentures is only
5%. Further, the interest payable on the debentures has to be viewed from the angle of the
amount actually received on their issue.
Example: A company issues 1000 debentures of Rs.100 each bearing interest @8% p.a.
Company incurs the expenses in connection with the issue of debentures to the extent of
Rs.10,000 (These expenses may be in the form of discount allowed, underwriting commission,
advertisement etc.) Thus, the company will have to pay the annual interest of Rs.8,000 on the net
amount received to the extent of only Rs.90,000 (i.e. Rs.1,00,000 minus Rs.10,000). Cost of
debentures in this case works out to around 8.89% and assuming that the tax rate applicable is
50%, the tax benefit makes the cost of debentures equal to 4.45%. However, the debt capital has
a hidden cost also. If the debt content in the capital structure of a company exceeds the optimum
level, the investors start considering company as too risky and their expectations from equity
shares increase.
The real cost is something less than the rate of interest due to the fact that the interest on debt is a
tax deductible expenditure. The tax liability of the company reduces proportionately.

Post tax cost = Pre Tax Cost X (1- Tax Rate).

If a company has taken a loan at 12% and the income tax rate is 30%.,
the effective cost of debt = (12X (1-0.30)) = 8.4%.

Weighted Average Cost of Capital

Composite Cost of Capital
After ascertaining the cost of each source of the capital constituting the capital structure, the next
step is to compute the composite cost of capital which is defined as the weighted average of the
cost of each specific type of capital. The reason behind considering weighted average and not the
simple average is to give consideration to the proportion of various sources of funds in the
capital structure of the company. Thus, the process of computing the composite cost of capital is
carried on by following the steps stated below.

1. Assign weights to various sources of funds. It may be stated here that the
weights may be in the form of book value of funds or market value of funds.
2. Multiply the cost of each source of funds by the weights assigned.
3. Calculate the composite cost by dividing total weighted cost by the total
weights.

The above process can be explained with the help of following illustrations.
ILLUSTRATION I

The capital structure of a company and the cost of specific sources of funds is as below :
 Solution

In considering the most desirable capital for a company, the following estimates of the cost of

debt and equity capital (after tax) have been made at various levels of debt-equity mix.

ILLUSTRATION II
From the information given below, calculate the weighted cost of capital (before tax) for Z Ltd.

 Normal yield on Equity shareholders' fund anticipated at 15%.

 Dividend rate on preference shares - 12%.
 Tax rate for Z Ltd. - 60%.
 Interest on secured loans - 16.25%.
 Interest on unsecured loans - 20%.

You are required to determine the optimal debt equity mix for the company by calculating

composite cost of capital.

Solution
It can be seen from the above that composite cost of capital is minimum i.e. 13.40% when capital

structure is as below,

40% debt 60% equity 100%

Following items have been extracted from the liabilities side of XYZ company as at 31st

December 1986.

Paid-up Capital Rs.

4,00,000 Equity shares of Rs. 10 each 40,00,000

Reserves and Surplus 60,00,000

Loans

15% Non-convertible Debentures 20,00,000

14% Institutional Loans 60,00,000

Other information about the company as relevant is given below :

You are required to calculate the weighted average cost of capital, using book values as the

weights and Earnings/Price (E/P) ratio as the basis of cost of equity.

 Solution

Working Notes :

 It is assumed that the company is subjected to tax rate of 50%.

 Cost of equity shares is calculated on Earning /Price basis.

Average cost of equity = Average EPS / Average Market Price = 6/40 = 0.15 =15%

Composite Cost of Capital is also called as Weighted Average Cost of Capital (WACC).
A company raises capital from different sources at different costs. WACC is the combined cost
of total capital.

WACC = (KeX E + Kd X D) / (E + D)
where, Ke= Cost of Equity. Kd= Cost of Debt, E = Amount of Equity, D = Amount of Debt

Example
Cost of Debt 10%. Amount of Debt. 100 Lacs. Cost of Equity 12% Amount of Equity 50 Lacs.
Calculate the Composite cost of capital.

Answer
WACC = (KeX E + Kd X D) / (E + D) = (50 X 12% + 100 X 10 %) / (50+100) =0.10667=
10.67%
Valuation of Firm
We can calculate the value of a firm based o cost of capital.
Value of Firm = Value of Equity + Value of Debt
Value of Equity = Profit Before Tax/Capitalization rate %
Value of Debt = Cost of Debt amount/Cost of Debt %

Example
PBIT 10 Lacs Interest 2 Lacs, Cost of Debt = 10%, Capitalization rate = 20%. Calculate Value
of Firm.

Answer
Value of Equity = Profit Before Tax / Capitalization rate % = 8,00,000/0.20 = 40,00,000
Value of Debt = Cost of Debt amount / Cost of Debt % = 2,00,000/0.10 = 20,00,000
Value of Firm = Value of Equity + Value of Debt = 40,00,000 + 20,00,000 = Rs.60,00,000

Another formula:
Value of Firm = PBIT / Weighted Average Cost of Capital

Example
PBIT 15 Lacs Interest 2 Lacs, Weighted Average Cost of Capital 15%. Calculate Value of Firm.

Answer
Value of Firm = PBIT / Weighted Average Cost of Capital = 15,00,000 / 0.15 = Rs.1,00,00,000

Concept of Leverages
Let us assume that there are two companies A and B which are exactly similar to each other in
terms of nature of business, size, extent of turnover etc. As such, the amount of capitalization is
also the same for both the companies which is assumed to be Rs.10,000. However, strategies for
raising the capital are different from each other. Assuming that the required capital can be raised
either by way of equity or debt, following particulars are available:
Company A Company B

Sales 20,000 18,000 20,000 18,000

Less: Variable Cost 10,000 9,000 10,000 9,000

Contribution 10,000 9,000 10,000 9,000

Less: Fixed Cost 5,000 5,000 5,000 5,000

PBIT 5,000 4,000 5,000 4,000

Less: Interest 900 900 100 100

PBT 4,100 3,100 4,900 3,900

Less: Income Tax

2,050 1,550 2,450 1,950
@50%

PAT 2,050 1,550 2,450 1,950

Number of Equity
100 100 900 900
Shares

Earning per share 20.5 15.5 2.72 2.16

It can be noted from the above example that A Ltd. is able to earn more amount per equity share
because in its capital structure, the amount of debentures is more and also because the interest
paid on debentures is tax deductible expenditure and amount of tax is less in case of A Ltd.
It can also be noted from the above example that a 10% reduction in sales in case of A Ltd.
reduces the earnings per share by around 24% while the same percentage of reduction in sales in
case of B Ltd. reduces the earnings per share by around 20%. It happens so because the risk of
reduction in sales and earnings gets distributed among less number of equity shares in case of
company A Ltd., while the said risk gets distributed among more number of equity shares in case
of company B Ltd.
Explanations -
The profitability statement of a company takes the following form -
Profit before Interest & Taxes (PBIT)
Less : Interest on long-term borrowings
Profit before Taxes (PBT)
Less : Taxes
Profit after Taxes (PAT)
Less : Preference Dividend
Distributable Profits for Equity
If both the calculations are merged together, following relationship emerges.
Sales Revenue
Less : Variable Operating Cost
Contribution
Less : Fixed Operating Cost
Profit before Interest & Taxes (PBIT)
Less : Interest on Long-term borrowings
Profit before Taxes (PBT)
Less : Taxes
Profit after Taxes (PAT)
Less : Preference Dividend
Distributable Profits for Equity
In very simple words, the term leverage measures relationship between two variables. In
financial analysis, the term leverage represents the influence of one financial variable over some
other financial variable. In financial analysis generally three types of leverages may be
computed.

1. Operating Leverage
2. Financial Leverage
3. Combined Leverage

Operating Leverage

It measures the effect of change in sales quantity on Earnings Before Interest and Taxes (EBIT)
It is computed as:
Operating Leverage = Sales - Variable Cost (i.e. Contribution)/Earnings before interest and tax

Indications:
A high degree of operating leverage means that the component of fixed cost is too high in the
overall cost structure. A low degree of operating average means that the component of fixed cost
is less in the overall cost structure. In other words, operating leverage measures the impact of
percentage increase or decrease in sales on earnings before interest and taxes.
E.g. In the example cited above, when sales are Rs.20,000 contribution is Rs.10,000 and earnings
before interest and taxes are Rs.5,000. As such operating leverage can be calculated as :
Operating Leverage = Contribution/ EBIT = 10,000 / 5,000 = 2
It means that every 1% increase in contribution will increase the EBIT by 2% and vice versa. As
such, when contribution is Rs.9,000 instead of Rs.10,000 i.e. the contribution is reduced by 10%,
the EBIT is reduced by 20% i.e. the EBIT has become Rs.4,000 instead of Rs.5,000.
Financial Leverage

It indicates the firm's ability to use fixed financial charges to magnify the effects of changes in
EBIT on the firm's EPS. It indicates the extent to which the Earnings Per Share (EPS) will be
affected with the change in Earnings Before Interest and Tax (EBIT). It is computed as :
Financial Leverage = EBIT/(EBIT – Interest)

Indications:
A high degree of financial leverage indicates high use of fixed income bearings securities in the
capital structure of the company. A low degree of financial leverage indicates less use of fixed
income bearing securities in the capital structure of the company.
E.g. In the example cited above, in case of A Ltd., the EBIT is Rs.5,000 and interest on
debentures is Rs.900, when sales are Rs.20,000 whereas in case of B Ltd., the EBIT is Rs.5,000
and interest on debentures is Rs.100 when sales are Rs.20,000. As such, the degree of financial
leverage can be computed as
Financial leverage =EBIT /(EBIT – Interest)
High degree of financial leverage is supported by the knowledge of the fact that in the capital
structure of A Ltd, 90% is the debt capital component, whereas in case of B Ltd, 10% is the debt
capital component.
It means that in case of A Ltd. every 1% increase in EBIT will increase EPS by 1.22% and vice
versa.
As such, when EBIT is reduced from Rs.5,000 to Rs.4,000 (i.e. 20% reduction), EPS of A Ltd.
gets reduced from Rs. 20.50 to Rs.15.50 (i.e. 24.40% reduction) and EPS of B Ltd. gets reduced
from Rs. 2.72 to Rs. 2.16 (i.e. 20.40% reduction).

Uses of Financial Leverage:

The degree of financial leverage gives an indication regarding the extent to which EPS may be
affected due to every change in EBIT. As the use of debt capital in the capital structure increases
the EPS, the company may like to use more and more debt capital in its capital structure by using
the financial leverage.
As explained in the example cited above, EPS in case of A Ltd. is Rs.20.50 when sales are
Rs.20,000, as 90% of its capital is debt capital. But in case of B Ltd. EPS is only Rs.2.72 when
sales are Rs.20,000, as only 10% of its total capital is debt capital. As such, the phrase is often
used that financial leverage magnifies both profits and losses'.
However, though financial leverage magnifies the profits as well as EPS, the use of debt capital
beyond a certain limit will not necessarily give a favourable impact. Use of financial leverage is
useful as long as debt capital costs less than what it earns. It reduces profits or EPS if it costs
more than what it earns. As such, financial leverage also acts as a guideline in setting maximum
limit upto which the company should use the debt capital.
However, the technique of financial leverage suffers from some limitations.

Limitations :

1. It ignores implicit cost of debt. It assumes that the use of debt capital may be useful so long as the
company is able to earn more than the cost of debt, i.e. interest. But it is not always correct.
Increasing use of debt capital makes the investment in the company a risky proposition, as such
the market price of the shares may decline, which may not be maximizing the shareholders'
wealth. Before considering the capital structure, the implicit cost of debt should be considered.
2. It assumes that cost of debt remains constant regardless of degree of leverage which is not true.
With every increase in debt capital, the interest rate goes on increasing due to the increased risk
involved with the same.

Combined Leverage
The combined effect of operating leverage and financial leverage measures the impact of charge
in contribution on EPS.
Combined Leverage = Operating Leverage x Financial Leverage
{Sales - Variable Cost/Earnings before interest and tax)} X {EBIT/(EBIT – Interest)} = (Sales -
Variable Cost)/(EBIT – Interest)
EG. In the example cited above, in case of both A Ltd. and B Ltd., when sales are Rs.20,000,
contribution is Rs.10,000 but earnings after interest and before tax are Rs.4,100 and
Rs.4,900 respectively. As such combined leverage can be computed as:

It means that in case of A Ltd. every 1% increase in contribution will increase EPS by 2.44% and
vice versa, while in case of B Ltd. every 1% increase in contribution, will increase EPS by
2.04%. As such when contribution gets reduced from Rs. 10,000 to Rs. 9,000 i.e. 10%
reduction, EPS of A Ltd. gets reduced from Rs. 20.50 to Rs.15.50 (i.e. 24.4% reduction) and
EPS of B Ltd. gets reduced from Rs.2.72 to Rs. 2.16 (i.e. 20.4 reduction).

Indications :
The indications given by the combined effect of operating and financial leverages may be studied
under the following possible situations.

1. High Operating Leverage, High Financial Leverage:

It indicates very very risky situation as a slight decrease in sales and/or contribution may affect
the EPS to a very great extent. As far as possible, this situation should be avoided.
2. High Operating Leverage, Low Financial Leverage:
It indicates that a slight decrease in sales and/or contribution may affect EBIT to a very great
extent due to existence of high fixed cost but this possibility is already taken care of by low
proportion of debt capital in the overall capital structure.
3. Low Operating Leverage, High Financial Leverage:
It indicates that the decrease in sales/contribution will not affect EBIT to a very great extent as
the component of fixed cost is negligible in the overall cost structure. As such, the company has
accepted the risk of borrowing more debt capital in order to increase EPS to the maximum
possible extent. This may be considered to be an ideal situation.
4. Low Operating Leverage, Low Financial Leverage:
It indicates that the decrease in sales/contribution will not affect EBIT to a very great extent as
the component of fixed cost is negligible in the overall cost structure. But still, the company has
not accepted the risk of having large component of debt capital in its capital structure. It may
indicate very very cautious policy followed by the management which need not be necessary, as it
will not maximize the shareholders' wealth. At the same time, it may also indicate that the
company is not utilizing its borrowing capacity properly and fully.
Summary
Capital structure refers to the mix of sources from which the long-term funds required by a
business are raised. Principles of Capital structure are Cost Principle, Risk Principle, Control
Principle, Flexibility Principle and Timing Principle.

Theories of capital structure are

1. Net Income Approach
2. Net Operating Income Approach
3. Traditional Approach and
4. Modigliani - Miller Approach
Net Income Approach:
By the introduction of additional debt capital in the capital structure, the valuation of the firm
can be increased and cost of capital can be reduced and vice versa.

Traditional Approach:
It believes the existence of what may be called 'Optimal Capital Structure'.

Net Operating Income Approach:

Any change in the capital structure does not affect the value of the firm or cost of capital.

Modigliani - Miller Approach:

Value of the firm and its cost of capital are independent of its capital structure.

The cost of capital can be defined as "the rate at which an organisation must pay to the suppliers
of capital for the use of their funds".
The cost of equity shares basically depends upon the expectations of the equity shareholders.

Dividend/Price (D/P) Approach:

Cost of Equity = Dividend Per Share/ Market Price

Earnings/Price (E/P) Approach:

Cost of Equity = Earning Per Share/ Market Price

Dividend/Price + Growth (D/P + G) Approach:

Cost of Equity = Dividend Per Share/ Market Price+ Growth.
Cost of Preference Share = Dividend paid/Net amount collected
Cost of Preference Share = {D+(FV-MP)/N}/MP, Where D = Dividend per share, FV = Face
Value, MP + Market Price, N = Number of years till maturity
Cost of Debt = Interest paid/Net amount collected
Composite cost of capital is the weighted average of the cost of each specific type of capital
Composite Cost of Capital is also called as Weighted Average Cost of Capital. (WACC).
WACC = (KeX E + Kd X D)/ (E + D) where, Ke= Cost of Equity. Kd= Cost of Debt,
E = Amount of Equity, D = Amount of Debt

Value of Firm = Value of Equity + Value of Debt

Value of Equity = Profit Before Tax/Capitalization rate %
Value of Debt = Cost of Debt amount/ Cost of Debt %
Value of Firm = PBIT/ Weighted Average Cost of Capital

Leverage represents the influence of one financial variable over some other financial variable.
In financial analysis generally three types of leverages.

1. Operating Leverage
2. Financial Leverage
3. Combined Leverage

Operating Leverage = Sales - Variable Cost (i.e. Contribution)/Earnings before interest and tax
Financial leverage = EBIT /(EBIT – Interest)
Combined Leverage = Operating Leverage x Financial Leverage
Combined Leverage = Contribution/ EBT

Key Words
The mix of sources from which the long-term funds required by a business
Capital structure
are raised

Combined Leverage Relation between Contribution and Earning before tax

Composite cost of capital The weighted average of the cost of each specific type of capital

Cost of capital The rate at which an organization must pay to the suppliers of capital for
the use of their funds and other incidental expenses

Cost of Debt Interest paid/Net amount collected

Cost of equity shares The expectations of the equity shareholders

Cost of Preference Share Dividend paid/Net amount collected

Dividend/Price (D/P) Cost of Equity = Dividend Per Share/ Market Price

Approach

Dividend/Price + Growth Cost of Equity = Dividend Per Share/ Market Price+ Growth
(D/P + G) Approach

Earnings/Price (E/P) Cost of Equity = Earning Per Share/ Market Price

Approach

Financial leverage Relation between Earnings before interest and tax and Earnings before tax

Leverage The influence of one financial variable over some other financial variable.

Net Income Earning Before Tax (EBT)

Net Operating Income Earning Before Intrest and Tax (EBIT)

Operating Leverage Relation between Contribution and Earnings before interest and tax

Optimal Capital Structure Where the Composite Cost of Capital is lowest.

Value of Firm Value of Equity + Value of Debt

Self Assessment Questions

 1

1
Explain the meaning of Capital Structure.

 2

2
State the important principles of Capital Structure.

 3

3
State the factors affecting Capital Structure.

 4
 4
State the objects of the Capital Structure Planning.

 5

5
State the different Theories of Capital Structure.

 6

6
Explain the meaning of the Cost of Capital.

 7

7
Describe the meaning of Cost of Equity.

 8

8
Explain the meaning of Cost of Debt.

 9

9
Explain the meaning of Cost of Preference Shares.

 10

10
Explain the meaning of the Weighted Average Cost of Capital.

 11

11
How is the value of a firm calculated?

 12

12
Explain the Concept of Leverages.

 13
 13
Explain the meaning of Operating Leverage.

 14

14
Explain the meaning of Financial Leverage.
 15
15
Explain the meaning of Combined Leverage.
Numerical Problems
1. A company issues 5000 debentures of Rs.1000 each bearing interest @9% p.a.
Company incurred the expenses in connection with the issue of debentures to the
extent of Rs.11,000. The tax rate applicable is 35%. Calculate the Cost of debentures.
2. A company issues 8000 Preference Shares of Rs.5000 each bearing interest @11%
p.a. Company incurred the expenses in connection with the issue of debentures to the
extent of Rs.15,000. The tax rate applicable is 35%. Calculate the Cost of
Preference Shares.
3. A company issues 6000 Preference Shares of Rs.1000 each at a premium of 10%
bearing interest @12% p.a. Company incurred the expenses in connection with the
issue of debentures to the extent of Rs.18,000. The tax rate applicable is 35%.
Calculate the Cost of Preference Shares.
4. A company issues 6000 Preference Shares of Rs.1000 each at a discount of 10%
bearing interest @ 9% p.a. Company incurred the expenses in connection with the
issue of debentures to the extent of Rs.8,000. The tax rate applicable is 35%.
Calculate the Cost of Preference Shares.
5. Market Price of a preference share is Rs.1,010/-. Rate of Dividend is 10%, Period till
maturity is 2 Years. Face Value of the share is Rs.100/- Calculate the Cost of
Preference Shares.
6. Market Price of a share is Rs.250/- Face Value is Rs.200/- Dividend paid is 20%.
Earning per share is Rs.100.
Calculate the Cost of Equity by the following methods,
1. Dividend/Price method
2. Dividend/Price + Growth method
3. Earning/Price method
7. Cost of Debt 9%. Amount of Debt. 110 Lacs. Cost of Equity 14% Amount of Equity
40 Lacs. Calculate the Composite cost of capital.
8. Sales of a company are Rs.17.00 lacs. Variable cost is 9.00 lacs. Fixed cost
(Excluding interest on debt) is Rs.3.00 lacs. Interest on debt is Rs.2.00 lacs.
Calculated all the three leverages.

Chapter 9- Working Capital Assessment

Introduction
In the previous chapters we have seen that whatever funds are raised by a company, can be
applied basically for two purposes:

1. To acquire fixed assets, the technical terminology used to be Capital

Budgeting.
2. To invest in the current assets, technical terminology used to be Working
Capital Management.

Working capital management is considered to be one of the most important functions of finance, as a very
large amount of funds are blocked in current assets in practical circumstances. Unless working capital is
managed properly, it may lead to the failure of business.

Meaning and Importance of Working Capital

The term “Working Capital” may mean Gross Working Capital or Net Working Capital. Gross
Working Capital means Current Assets. Net Working Capital means Current Assets less Current
Liabilities. Unless otherwise specified, Working Capital means Net Working Capital. As such,
Working Capital Management refers to proper management of Current Assets and Current
Liabilities.

The term current assets refer to those assets held by a business which can be converted in the
form of cash or used during the course of normal operations within a short span of time say one
year, without any reduction in value. Current assets change the shape very frequently. The
current assets ensure smooth and fluent business operations and are considered to be life-blood
of the business. In case of a manufacturing organization, current assets may be found in the form
of stocks, receivables, cash and bank balances and sundry loans and advances.
The term current liabilities refer to those liabilities which are to be paid off during the course of
business, within a short span of time say one year. They are expected to be paid out of current
assets or the earnings of the business. Current liabilities consist of sundry creditors, bills payable,
bank overdraft or cash credit, outstanding expenses etc.
Working Capital refers to that part of the firm’s capital, which is required for financing short-
term or current assets such a cash marketable securities, debtors and inventories.
The term working capital needs to be viewed from one more angle.

 Fixed or Permanent Working Capital

 Variable or Temporary Working Capital

Fixed Working Capital is the minimum working capital required to be maintained in the business
on permanent or uninterrupted basis. The requirement for this type of working capital is
unaffected due to the changes in the level of activity.
Variable working capital is the working capital required over and above the fixed or permanent
working capital and changes with the fluctuations in the level of activity as a result of changes in
production and sales.
The relationship between fixed and variable working capital can be shown with the help of
following diagram.
Difference between Permanent and Temporary Working Capital

Factors Affecting Working Capital

Requirement
Nature of Business
–

Some businesses are such that due to their very nature, their requirement of fixed capital is
more rather than working capital. These businesses may sell services and not the commodities
and that too on cash basis. As such, no funds are blocked in piling the inventories and no funds
are blocked in receivables.

Example:
Public utility services like railways, electricity boards, infrastructure oriented projects etc.
Their requirement of working capital is less. Whereas if the organization is a trading
organization, the requirement of working capital will be on the higher side, as huge amount of
funds get blocked in mainly two types of current assets, stock and receivables.
Size of the Organization
–
In small scale organizations, requirement of working capital is quite high due to high amount
of overheads, high buying costs and high selling costs. As such, medium sized organizations
have an edge over the small scale organizations.

However, if the business grows beyond a certain limit, the requirement of working capital may
be adversely affected by the increasing size.
Phase of Trade Cycles
–

During the inflationary conditions, the working capital requirement will be on the higher side
as the company may like to buy more raw material, may increase the production to take the
advantage of favourable market conditions and due to increased sales more funds are blocked
in stocks and receivables.

During the depression, the requirement of working capital will be on the lower side due to
reduced operations but more working capital may be required due to piling up of inventories
and due to non-payment of dues by customers in time. As such, in both the extreme situations
of trade cycles, requirement of working capital may be high.
Trading Terms
–

The terms on which the organization makes the purchases and sales affect the requirement of
working capital in a big way. If the purchases are required to be made on cash basis and sales
are to be made on credit basis to cope with competition existing in the market, it will result into
high requirement of working capital.

Whereas, if the purchases can be made on credit basis and sales can be made on cash basis, it
will reduce the requirement of working capital, as a part of working capital requirement can
be financed out of credit offered by the suppliers.
Length of Production Cycle
–

The term production cycle refers to the time duration from the stage raw material is acquired
till the stage finished product is manufactured. The principle will be “longer the duration of
production cycle, higher the requirement of working capital.” In some businesses like machine
tool industry, the time gap between the acquisition of raw material till the completion of
production is quite high.

As such, more amount is blocked in raw materials or work in progress or finished goods and
even in receivables. Requirement of working capital is always very high in this case. Whereas
in case of the industries like paper industry or sugar industry, the production cycle is very
short. As such, the requirement of working capital, at least for stocks, may be very less.
Profitability
–
High profitability reduces the strain on working capital as the profit to the extent they are
earned in cash can be used for financing the requirement of working capital.

However, the profit which reduces the strain on working capital is the post-tax profit (i.e. the
profit earned after paying off the tax liability) and post-dividend profit (i.e. the profit
remaining in the business after paying the dividend on the shares.)

Working Capital Cycle

Generally, it will not be possible for any organization to operate without the working capital. Let
us assume that a manufacturing organization commences its business with a certain amount of
cash. This cash will be invested to buy the raw material.

The raw material purchased will be processed with the help of various infrastructural facilities
like labour, machinery etc. to convert the same in the form of finished products. These finished
products will be sold in the market on credit basis whereby the receivables get created. And
when receivables make the payment to the organization, cash is generated again.

As such, there is a cycle in which cash available to the organization is converted back in the form
of cash. This cycle is referred to as Working Capital Cycle. Working Capital Cycle is also called
as Operating cycle.
Operating Cycle Concept
The time taken to convert raw material into cash is known as operating cycle.

 bullet

Conversion of cash into raw material.

 bullet

Conversion of raw material into work in progress.

 bullet

Conversion of Work in progress into finished goods.

 bullet

Conversion of finished goods into Credit Sales (Debtors).

 bullet
Recovery from Debtors.
In between each of these stages, there is some time gap involved. The entire requirement of
working capital arises due to this time gap. As this time gap is unavoidable, requirement of
working capital is unavoidable. The finance professional is interested in reducing this time gap to
the minimum possible extent in order to manage the working capital properly.

Sources of Working Capital

The basic principle of finance states that the permanent requirement of working capital should be
financed out of long term or permanent sources viz. own generation of funds, cash profits, shares
or debentures etc.

For financing temporary requirement of working capital, the organization can go for various
sources which can be discussed as below:

1. Spontaneous Sources
2. Inter-corporate Deposits
3. Commercial Papers
4. Factoring
5. Forfaiting
6. Facility from Banks

a. Spontaneous Sources
Spontaneous Sources for financing the working capital requirement arise during the course of
normal business operations. During the course of business operations, the company may be able
to buy certain goods or services for which the payment is to be made after a certain time gap. As
such, the company is able to buy goods or services without making payment for the same.
These spontaneous sources are unsecured in nature and vary with the level of sales. These
spontaneous sources do not have any explicit cost attached to the same. They are generally
known as “Current Liabilities.” Following forms of current liabilities may be used as
spontaneous sources for financing the working capital requirement.
TRADE CREDIT
If the company buys the raw material from the suppliers on credit basis, it gets the raw material for
utilization immediately with the facility to make the payment at a delayed time. By accepting the
delayed payment, the suppliers of raw material finance the requirement of working capital. For using
this source, certain factors may play an important role:

 Trends in the industry.

 Liquidity position of the company.
 Earnings of the company over a period of time.
 Record of payment by the company to the suppliers over a period of time.
 Relationship of the company with the suppliers.

OUTSTANDING EXPENSES

All the services enjoyed by the company are not required to be paid for immediately. They are paid
for after a certain time gap.

As such, the company is able to get the benefit of these services without paying for the same
immediately, thus getting the finance for working capital purposes. These are called “outstanding
expenses”. This may apply to salaries, wages, telephone expenses, electricity expenses, water charges
etc.

b. Inter Corporate Deposits (ICD)

Inter Corporate Deposits indicate the amount of funds borrowed by one company from another
company, usually both the companies being under the same management but not necessarily so.
Point to be noted here is that ICDs are not considered to be deposits as per the provisions of
Section 58-A of the Companies Act, 1956 and as such the regulations applicable to the public
deposits do not apply to ICDs.
c. Commercial Papers

Commercial Paper is an unsecured promissory note issued at a discount. The rate of discount is
required to be decided by the issuer and is not regulated.

Example:
A CP of Rs. 100 may be issued at Rs. 98, indicating that the investor has to pay Rs. 98 while at
the time of maturity, he will get Rs. 100. It means that difference between Rs. 98 and Rs. 100
i.e. Rs. 2 is in the form of interest on investment made by the investor.

1. Factoring
2. Forfaiting
3. Facility from Banks

d. Fund based lending

In case of Fund Based Lending, the lending bank commits the physical outflow of funds. As
such, the funds position of the lending bank does get affected. The Fund Based Lending can be
made by the banks in the following forms:
Loan
–

In this case, the entire amount of assistance is disbursed at one time only, either in cash or by transfer
to the company’s account. It is a single advance. The loan may be repaid in installments, the interest
will be charged on outstanding balance.
Overdraft
–

In this case, the company is allowed to withdraw in excess of the balance standing in its Bank
account. However, a fixed limit is stipulated by the Bank beyond which the company will not be able
to overdraw the account.

Granting of the assistance in the form of overdraft presupposes the opening of a formal current
account. Legally, overdraft is a demand assistance given by the bank i.e. bank can ask for the
repayment at any point of time.

Overdraft is given by the bank for a very short period of time, at the end of which the company is
supposed to repay the same. Interest is payable on the actual amount drawn and is calculated on daily
product basis.
Cash Credit
–

In practice, the operations in cash credit facility are similar to those of overdraft facility except the
fact that the company need not have a formal current account.

Here also a fixed limit is stipulated beyond which the company is not able to withdraw the amount.
Legally, cash credit also is a demand facility, but in practice, it is on continuous basis. Here also, the
interest is payable on actual amount drawn and is calculated on daily product basis.
Bills Purchased/Discounted
–

This form of assistance is comparatively of recent origin. This facility enables the company to get the
immediate payment against the credit bills/invoices raised by the company. The bank holds the bills
as a security till the payment is made by the customer.

The entire amount of bill is not paid to the company. The company gets only the present worth of the
amount of the bill, the difference between the face value of the bill and the amount of assistance
being in the form of discount charges. However, on maturity, bank collects the full amount of bill
from the customer.

While granting this facility to the company, the bank inevitably satisfies itself about the credit
worthiness of the customer and the genuineness of the bill. A fixed limit is stipulated in case of the
company, beyond which the bills are not purchased or discounted by the bank.
Working Capital Term Loans
–

To meet the working capital needs of the company, banks may grant the working capital term loans
for a period of 3 to 7 years, payable in yearly or half yearly installments.
Export Credit
–

This type of assistance may be considered by the bank to take care of specific needs of the company
when it receives some export order. Packing credit is a facility given by the bank to enable the
company to buy/manufacture the goods to be exported.

If the company holds a confirmed export order placed by the overseas buyer or an irrevocable letter
of credit in its favour, it can approach the bank for packing credit facility. Basically, packing credit
facility may take two forms:
 Pre-shipment Packing Credit
To take care of needs of the company before the goods are shipped to the
overseas buyer.
 Post-shipment Packing Credit
To take care of needs of the company from the shipment of goods to the
overseas buyer till the date of collection of dues from him.

Necessarily, both these facilities are short-term facilities. The company may be required to repay
the same within a predecided span or out of the export proceeds of the goods exported.

Various Committees on Working Capital

It can be seen from the preceding discussions that the commercial banks play a very significant
role in financing working capital needs. These working capital needs used to be met mainly in
the form of cash credit facilities and these advances used to be totally security oriented rather
than end-use oriented. As such, the units which were able to provide securities to the banks were
able to get main chunk of the finances provided by the banks whereas others experienced
shortage of inputs, lower capacity utilization, high cost of production and ultimately threat of
closure. Reserve Bank of India has attempted to identify major weakness in the system of
financing of working capital needs by Banks in order to control the same properly.

These attempts were mainly in the form of appointment of following committees:

 Dahejia committee
 Tandon committee
 Chhore Committee
 Marathe Committee
 Nayak Committee and Vaz Committee

Dahejia Committee
This committee was appointed in October 1968 to examine the extent to which credit needs of
industry and trade are likely to be inflated and how such trends could be checked.
FINDINGS
The committee found out that there was a tendency of industry to avail of short-term credit
from Banks in excess of growth rate in production for inventories in value terms. Secondly, it
found out that there was a diversion of short-term bank credit for the acquisition of long-term
assets.

The reason for this is that generally banks granted working capital finance in the form of cash
credit, as it was easy to operate. Banks took into consideration security offered by the client
rather than assessing financial position of the borrowers. As such, cash credit facilities granted
by the banks was not utilized necessarily for short-term purposes.
It also suggested that hard core part in case of financially sound companies should be put on a
term loan basis subject to repayment schedule. In other cases, borrowers should be asked to
arrange for long term funds to replace bank borrowings.
In practice, recommendations of the committee had only a marginal effect on the pattern and
form of banking.

RECOMMENDATIONS

The committee, firstly, recommended that the banks should not only be security oriented, but they
should take into consideration total financial position of the client. Secondly, it recommended that all
cash credit accounts with banks should be bifurcated in two categories.

 Hard core which would represent the minimum level of raw materials, finished goods and
stores which any industrial concern is required to hold for maintaining certain level of
production and
 Short-term component which would represent of funds for temporary purposes i.e. Short-
term increase in inventories, tax, dividend and bonus payments etc.

Tandon Committee
Tandon Committee Recommendations
In August 1975, Reserve Bank of India appointed a study group under the Chairmanship of Mr.
P. L. Tandon, to make the study and recommendations on the following issues:

 1

1
Can the norms be evolved for current assets and for debt equity ratio to ensure minimum
dependence on bank finance?

 2

2
How the quantum of bank advances may be determined?
  3

3
Can the present manner and style of lending be improved?
 4
4
Can an adequate planning, assessment and information system be evolved to ensure a
disciplined flow of credit to meet genuine production needs and its proper supervision?
The observations and recommendations made by the committee can be considered as below:
Methods of Borrowings
The committee recommended that the amount of bank credit should not be decided by the
capacity of the borrower to offer security to the banks but it should be decided in such a way to
supplement the borrower’s resources in carrying a reasonable level of current assets in relation to
his production requirement. For this purpose, it introduced the concept of working capital gap i.e.
the excess of current assets over current liabilities other than bank borrowings. It further
suggested three progressive methods to decide the maximum limits according to which banks
should provide the finance.

METHOD I

Under this method, the committee suggested that the Banks should finance maximum to the extent of
75% of working capital gap, remaining 25% should come from long term funds i.e. own funds and
term borrowings.
To explain these methods in further details, let us consider the following data:

It can be observed from above that the gradual implementation of these methods will reduce the
dependence of borrowers on bank finance and improve their current ratio. The committee
suggested that the borrowers should be gradually subjected to these methods of borrowings from
first to third.
However, if the borrower is already in second or third method of lending, he should not be
allowed to slip back to first or second method of lending respectively. It was further suggested
that if the actual bank borrowings are more than the maximum permissible bank borrowings, the
excess should be converted into a term loan to be amortized over a suitable period depending
upon the cash generating capacity.
Tandon Committee
Maximum Permissible Bank Finance (MPBF)
1st Method: 0.75 X (CA - CL)
2nd Method: (0.75 X CA) - CL
3rd Method: (0.75 X (CA - CCA) - CL)

Example:
Current Assets Rs.100. Current Liabilities Rs.60 Lacs. Core Current Assets Rs.8
1st Method: 0.75 X (100-60) = 30 Lacs
2 Method: (0.75 X100) - 60
nd
= 15 Lacs
3rd Method: (0.75 X (100-8) - 60) = 9 Lacs

METHOD II

Under this method, the committee suggested, that the borrower should finance 25% of current assets
out of long term funds and the banks provide the remaining finance.
To explain these methods in further details, let us consider the following data:
It can be observed from above that the gradual implementation of these methods will reduce the
dependence of borrowers on bank finance and improve their current ratio. The committee
suggested that the borrowers should be gradually subjected to these methods of borrowings from
first to third.
However, if the borrower is already in second or third method of lending, he should not be
allowed to slip back to first or second method of lending respectively. It was further suggested
that if the actual bank borrowings are more than the maximum permissible bank borrowings, the
excess should be converted into a term loan to be amortized over a suitable period depending
upon the cash generating capacity.
Tandon Committee
Maximum Permissible Bank Finance (MPBF)
1st Method: 0.75 X (CA - CL)
2nd Method: (0.75 X CA) - CL
3rd Method: (0.75 X (CA - CCA) - CL)

Example:
Current Assets Rs.100. Current Liabilities Rs.60 Lacs. Core Current Assets Rs.8
1st Method: 0.75 X (100-60) = 30 Lacs
2 Method: (0.75 X100) - 60
nd
= 15 Lacs
3rd Method: (0.75 X (100-8) - 60) = 9 Lacs

METHOD III

Under this method, the committee introduced the concept of core current assets to indicate permanent
portion of current assets and suggested that the borrower should finance the entire amount of core
current assets and 25% of the balance current assets out of long term funds and the banks may
provide the remaining finance.
To explain these methods in further details, let us consider the following data:
It can be observed from above that the gradual implementation of these methods will reduce the
dependence of borrowers on bank finance and improve their current ratio. The committee
suggested that the borrowers should be gradually subjected to these methods of borrowings from
first to third.
However, if the borrower is already in second or third method of lending, he should not be
allowed to slip back to first or second method of lending respectively. It was further suggested
that if the actual bank borrowings are more than the maximum permissible bank borrowings, the
excess should be converted into a term loan to be amortized over a suitable period depending
upon the cash generating capacity.
Tandon Committee
Maximum Permissible Bank Finance (MPBF)
1st Method: 0.75 X (CA - CL)
2nd Method: (0.75 X CA) - CL
3rd Method: (0.75 X (CA - CCA) - CL)

Example:
Current Assets Rs.100. Current Liabilities Rs.60 Lacs. Core Current Assets Rs.8
1st Method: 0.75 X (100-60) = 30 Lacs
2 Method: (0.75 X100) - 60
nd
= 15 Lacs
3rd Method: (0.75 X (100-8) - 60) = 9 Lacs

Chhore Committee
In April 1979, Reserve Bank of India appointed a study group under the chairmanship of Mr.
K.B. Chhore to review mainly the system of cash credit management policy by banks.

The observations and recommendations made by the committee can be discussed as below:
1. The committee has recommended increasing role of short-term loans and bill finance and
curbing the role of cash credit limits.
2. The committee has suggested that the borrowers should be required to enhance their own
contribution in working capital. As such, they should be placed in Second Method of
lending as suggested by Tandon Committee.
If the actual borrowings are in excess of maximum permissible borrowings as permitted
by Method II, the excess portion should be transferred to Working Capital Term Loan
(WCTL) to be repaid by the borrower by half yearly installments maximum within a
period of 5 years. Interest on WCTL should normally be more than interest on cash credit
facility.
3. The committee has suggested that there should be the attempts to inculcate more
discipline and planning consciousness among the borrowers, their needs should be met on
the basis of quarterly projections submitted by them. Excess or under-utilization beyond
tolerance limit 10% should be treated as irregularity and corrective action should be
taken.
4. The committee has suggested that the banks should appraise and fix separate limits for
normal non-peak levels and also peak levels. It should be done in respect of all borrowers
enjoying the banking credit limits of more than Rs. 10 Lakhs.
5. The committee suggested that the borrowers should be discouraged from approaching the
banks frequently for ad hoc and temporary limits in excess of limits to meet unforeseen
contingencies. Requests for such limits should be considered very carefully and should be
sanctioned in the form of demand loans or non-operating cash credit limits. Additional
interest of 1% p.a. should be charged for such limits.

Marathe Committee
In 1982, Reserve Bank of India appointed a study group known as Marathe Committee to review
the Credit Authorization Scheme (CAS) which was in existence since 1965. Under CAS, the
banks were required to take the prior approval of RBI for sanctioning the working capital limits
to the borrowers.

As per Marathe Committee recommendations, in the year 1988, CAS was replaced by Credit
Monitoring Arrangement (CMA) according to which the banks were supposed to report to RBI,
sanctions or renewals of the credit limits beyond the prescribed amounts for the post-sanction
scrutiny.

Nayak Committee
Recently, RBI has accepted the recommendations made by Nayak Committee. This was with the
intention to recognize the contribution made by the SSI Sector to the economy.
According to Nayak Committee recommendations, for evaluating working capital requirements
of village industries, tiny industries and other SSI units having the total fund based working
capital limits up to Rs.50 Lakhs, the norms for inventory and receivables as suggested by Tandon
Committee will not apply. The working capital requirement of these units will be considered to
be 25% of their projected turnover (for both new as well as existing units), out of which 20% is
supposed to be introduced by the units as their margin money requirements and remaining 80%
can be financed by the bank. In other words, there are 4 working capital cycles assumed in every
year.
Vaz Committee has extended the recommendations of Nayak Committee to all the business
organizations. This has also been accepted by RBI.
As a result of Nayak Committee and Vaz Committee recommendations, projected turnover of the
borrowers is the basis for evaluating the working capital requirement. Out of the projected
turnover, 5% is supposed to be introduced by the borrower in the form of own contribution and
remaining 20% can be financed by the bank. The requirement of working capital has nothing to
do with the level of current assets and current liabilities, which was the basis of Tandon
Committee and Chore Committee recommendations.
The working capital requirement of SSI units will be considered to be 25% of their projected
turnover. Out of which 20% of Working Capital (It means 5% of turnover) is supposed to be
introduced by the units as their margin money requirements and remaining 80% of Working
Capital (It means 20% of turnover) can be financed by the bank.
Example

Evaluation of working capital requirements by the banks relaxed

With the intention to give greater autonomy to the banks while evaluating working capital
requirement, RBI has officially withdrawn the concept of MBPF with effect from 15th April,
1997. As a result of this, now the banks are free to have their own methods for evaluating the
working capital requirement of the borrowers.

Assessment of Working Capital Requirement

First you have to estimate the figures for various components of Current Assets and take the total
of the same.

1. Then you have to estimate the figures for various components of Current
Liabilities and take the total of the same.
2. The difference between the Current Assets and Current Liabilities will be
Net Working Capital Required.
3. Add Contingency of about 10% to meet the unforeseen expenses or rise in
prices.
4. You will get Working Capital Required.

Format for Calculating WC Requirements

Illustration:
Elements of cost Amount per unit
Raw material 80
Direct Labour 30
Overheads 60
Raw materials are in stock for one month. Credit allowed by suppliers is one month.
Credit allowed to customers is two months. 25% sales in cash.
Lag in payment of wages and overheads one month.
Materials are in process for an average of half month.
Finished Goods are in stock for an average of one month.
Cash in hand and at bank is expected to be Rs. 25,000.
You are requested to calculate working capital needed to finance a level of activity of 96,000
units.
Answer:

Working Capital Ratios

The term ‘ratio’ implies arithmetical relationship between two related figures. The ‘Ratio
Analysis’ is a technique for interpretation of financial statements based on computation of
various ratios.

The following are the important ratios:

1. Current Ratio
2. Quick Ratio (Acid Test Ratio)
3. Working Capital Turnover Ratio
4. Inventory/Stock Turnover Ratio
5. Debtors Turnover Ratio
6. Current Assets Turnover Ratio

Current Ratio
+

Liquid Ratio or Acid Test Ratio or Quick Ratio

–

It is an improved version of current ratio.

It is calculated as, Liquid Assets/Liquid Liabilities or (Current Assets-Inventory-Prepaid
Expenses)/(Current Liabilities-Bank Overdraft/cash credit).

Liquid Assets include all current assets except inventories and prepaid expenses.
Liquid Liabilities include all current liabilities except bank overdraft or cash credit.
Bench Mark for Quick Ratio is 1:1. Higher ratio is preferable. It should not be too high.
Working Capital Turnover Ratio
–
It is calculated as Net sales/Working capital.

A high working capital turnover ratio indicates the capability of the organization to achieve
maximum sales with the minimum investment in working capital. It indicates that working
capital is turned over in the form of sales a greater number of times. As such, higher this ratio,
better will be the situation.
Inventory/Stock Turnover Ratio
–

It is calculated as Net Sales/Average inventory.

Average inventory may be computed as (Opening inventory + inventory at the end of every
month)/13
For convenience inventory may be computed as under,
(Opening inventory + closing inventory)/2

There can be no standard inventory turnover ratio which may be considered to be ideal. It may
depend on nature of industry. Bench Mark can be taken as 4.

A high inventory turnover ratio indicates that maximum sales turnover is achieved with the
minimum investment in inventory. As such, as a general rule, high inventory turnover ratio is
desirable. On the other hand, a low inventory turnover ratio may indicate over investment in
inventory, existence of excessive or obsolete/non-moving inventory, improper inventory
management, accumulation of inventories at the year end in anticipation of increased prices or
sales volume in near future and so on.
Debtors Turnover Ratio
–

It is calculated as Net Credit Sales/ Average Sundry Debtors.

This ratio indicates the speed at which the sundry debtors are converted in the form of cash.
However, this intention is not correctly achieved by making the calculations in this way.
As such, this ratio is normally supported by the calculations of Average Collection Period,
which is calculated as below:
 Calculation of daily sales: Net Credit Sales/No. of working days
 Calculation of average collection period = Average Sundry debtors/Daily
sales

Credit sales should be considered normally. Total sales may be considered if break up of cash
sales and credit sales is not available.
The average collection period as computed above should be compared with the normal credit
period extended to the customers. If the average collection period is more than normal credit
period allowed to the customers, it may indicate over investment in debtors which may be the
result of over-extension of credit period, liberalization of credit terms, ineffective collection
procedures and so on.
Example:
Net credit sales: Rs.1,80,000/-. Average sundry debtors: Rs.36,000/-
The computation of average collection period will be made as below:
(a) Calculation of daily sales:
Net credit sales/No. of working days
= Rs. 1,80,000/360
= Rs. 500/ per day
(b) Calculation of average collection period:
Average sundry debtors/Daily sales
= Rs. 36,000/Rs. 500
= 72 days.
The average collection period thus calculated may then be compared with the normal credit
period allowed to the customers i.e., 60 days and the conclusion may be drawn that there is a
delay in collecting the due.
Current Assets Turnover Ratio
–

It is calculated as Net Sales/Current Assets.

A high current assets turnover ratio indicates the capability of the organization to achieve
maximum sales with the minimum investment in current assets. Higher the current assets
turnover ratio better will be the profitability.

Exercises on Working Capital Requirement

Illustrative Problems
1

Vishal Private Limited sells goods on a gross profit of 25%. Depreciation is considered in cost of
production. The following are the annual figures given to you.

The company keeps one month’s stock each of raw materials and finished goods. It also keeps
Rs.1,00,000 in cash. You are required to estimate the working capital requirements of the
company on cash basis assuming 15% safety margin.
Solution

Estimated Working Capital Requirements of Raju Brothers Pvt. Ltd.

Working Notes
(a) Manufacturing Expenses

(b) Total Cash Cost

(c) Income Tax liability of the company will not be considered as a part of the
cost.

The management of Vishal Industries has called for a statement showing the working capital
needs to finance a level of activity of 1,80,000 units of output for the year. The cost structure for
the company’s product for the above-mentioned activity level is detailed below.

Additional Information:

1. Minimum desired cash balance is Rs.20,000.

2. Raw materials are held in stock on an average for two months.
3. Work in progress (assume 50% completion stage) will approximate to half a month’s production.
4. Finished goods remain in warehouse on an average for a month.
5. Suppliers of materials extend a month’s credit and debtors are provided two month’s credit. Cash
sales are 25% of total sales.
6. There is a time-lag in payment of wages of a month and half and a month in case of overheads.

From the above facts, you are required to

 Prepare a statement showing working capital needs.

 Determine the maximum working capital finance available under first two methods suggested by
Tandon Committee.

Solution :

Estimated Requirement of Working Capital

Calculation of Maximum Permissible Bank Borrowing

Means of Finance

Working Notes
It is assumed that the year consists of 360 days and that sales are evenly distributed throughout
the year. As such, monthly sales will be 15000 units.

Summary
Working capital refers to the funds invested in current assets i.e. investment in stocks, sundry
debtors, cash and other current asset. The objective of working capital management is to ensure
Optimum Investment in current assets. There are certain factors affecting working capital
requirement such as nature of business, size of organization, trading terms, length of production
cycle, profitability etc.

Gross Working Capital means Current Assets. Net Working Capital means Current Assets less
Current Liabilities. Unless otherwise specified, Working Capital means Net Working Capital.

Fixed Working Capital is the minimum working capital required to be maintained in the business
on permanent or uninterrupted basis. Variable working capital is the working capital required
over and above the fixed or permanent working capital.

Factors affecting Working Capital Requirement are Nature of business, size of the organization,
length of the operating cycle, credit purchases and sales, lag of payment for expenses.

The sources of working capital can be,

 Spontaneous sources: These sources arise during the course of normal

business operations such as the company is able to buy goods or services on
credit for example: trade creditors and outstanding expenses.
 Inter corporate deposits: Inter corporate Deposits indicate the amount of
funds borrowed by one company from another company.
 Commercial Papers: A Commercial Paper is an unsecured promissory note
issued at a discount.
 Banks: Working Capital cycle is a cycle in which cash available to the
organization is converted back in the form of cash after manufacturing and
sale of goods.

Reserve Bank of India has attempted to identify major weakness in the system of financing of
working capital needs by Banks in order to control the same properly. These attempts were
mainly in the form of appointment of various committees namely Dahejia committee, Tandon
committee, Chhore Committee, Marathe Committee, Nayak Committee and Vaz Committee.
These committees have suggested various norms for Working Capital Finance.

Working Capital Cycle is a cycle in which cash available to the organization is converted back in
the form of cash through the process of raw material, work in process, finished goods, debtors.
Sources of Working Capital are Share capital, creditors, Cash credit from banks, factoring,
forfeiting, Inter-corporate Deposits, Commercial Papers, etc.

Tandon Committee. Methods of calculating Maximum Permissible Bank Finance (MPBF).

1st Method: 0.75 X (CA-CL)
2nd Method: (0.75X CA)-CL
3 Method:
rd
(0.75 X(CA-CCA)-CL)

Nayak Committee: The working capital requirement of SSI units will be considered to be 25%
of their projected turnover. Out of which 20% of Working Capital (It means 5% of turnover) is
supposed to be introduced by the units as their margin money requirements and remaining 80%
of Working Capital (It means 20% of turnover) can be financed by the bank.
Assessment of Working Capital Requirement

First you have to estimate the figures for various components of Current Assets and Current
Liabilities. The difference between them will be Net Working Capital Required. Add
Contingency to it.
The term ‘ratio’ implies arithmetical relationship between two related figures. The ‘Ratio
Analysis’ is a technique for interpretation of financial statements based on computation of
various ratios.

The following are the important ratios:

1. Current Ratio
2. Quick Ratio (Acid Test Ratio)
3. Working Capital Turnover Ratio
4. Inventory/Stock Turnover Ratio
5. Debtors Turnover Ratio
6. Current Assets Turnover Ratio

Current Ratio = Current Assets/Current Liabilities

Quick Ratio (Acid Test Ratio) = (Current Assets-Inventory-Prepaid Expenses)/(Current

Liabilities-Bank Overdraft/cash credit)
Working Capital Turnover Ratio = Net sales/Working capital
Inventory/Stock Turnover Ratio = Net Sales/Average inventory
Debtors Turnover Ratio Net Credit Sales/Average Sundry Debtors
Current Assets Turnover Ratio = Net Sales/Current Assets

Key Words
The minimum working capital required to be maintained in the business
Fixed Working Capital
on permanent or uninterrupted basis

Gross Working Capital Current Assets

Net Working Capital Current Assets less Current Liabilities

Ratio An arithmetical relationship between two related figures

A technique for interpretation of financial statements based on

Ratio Analysis
computation of various ratios

Variable working capital Is the working capital required over and above the fixed or permanent
working capital
Working Capital cycle A cycle in which cash available to the organization is converted back in
the form of cash after manufacturing and sale of goods

Chapter 10- Working Capital Management

Introduction
Working capital in general practice refers to the excess of Current Assets over Current Liabilities.
Management of working capital therefore is concerned with the problems that arise in attempting to
manage the Current Assets, the Current Liabilities and the inter-relationship that exists between them.
The basic goal of Working Capital Management is to manage the Current Assets and Current Liabilities
of a firm in such a way that a satisfactory level of Working Capital is maintained. Working Capital
Management Policies of a firm have a great effect on its profitability, liquidity and structural health of
the organization.

Meaning and Importance of Working Capital

Management
Working Capital Management means efficient management of components of Current Assets
and Current Liabilities. The basic objective of Working Capital Management is to avoid over
investment or under investment in Current Assets, as both the extremes involve the adverse
consequences. Over investment in Current Assets may lead to the reduced profitability due to
cost of funds blocked, extra storing space required, extra efforts for follow up and recovery
required, possibility of malpractice etc. The objective of Working Capital Management is to
ensure Optimum Investment in Current Assets. In other words, Working Capital Management
intends to ensure that the investment in Current Assets is reduced to the minimum possible
extent. However, the normal operations of the organization should not be affected adversely.

Components of Current Assets

 Cash on Hand
 Balance in Bank a/c
 Raw materials
 Work in Process
 Finished Goods/Stock
 Debtors/Receivables
 Advances paid
 Prepaid Expenses
 Accrued Income
 Other Current Assets
 Components of Current Liabilities

 Cash Credit from Bank

 Instalments of Term Loans payable within 12 months
 Outstanding liabilities towards Credit Purchases (Creditors)
 Provision for Expenses
 Provision for Dividend/Tax
 Income Received in Advance
 Other Liabilities payable within one year.

Current assets mainly comprises of Inventory, Debtors (Receivables) and Cash. Hence, working
capital management can be said to be management of Cash, Debtors (Receivables) and Inventory
(Material).





Cash Management
Management of cash is one of the most important areas of overall working capital management.
This is due to the fact that cash is the most liquid type of current assets. As such, it is the
responsibility of the finance function to see that the various functional areas of the business have
sufficient cash whenever they require the same.

At the same time, it has also to be ensured that the funds are not blocked in the form of idle cash,
as the cash remaining idle also involves cost in the form of interest cost and opportunity cost. As
such, the management of cash has to find a mean between these two extremes of shortage of cash
as well as idle cash.
A company may hold the cash with the various motives as stated below:
TRANSACTION MOTIVE

The company may be required to make various regular payments like purchases,
wages/salaries, various expenses, interest, taxes, dividends etc. for which the company may hold
the cash. Similarly, the company may receive the cash basically from its sales operations.

However, receipts of the cash and the payments by cash may not always match with each other.
In such situations, the company will like to hold the cash to honour the commitments whenever
they become due. This requirement of cash balances to meet routine needs is known as
transaction motive.

PRECAUTIONARY MOTIVE
In addition to the requirement of cash for routine transactions, the company may also require
the cash for such purposes which cannot be estimated or foreseen.
Example
There may be a sudden decline in the collection from the customers, there may be a sharp
increase in the prices of the raw materials etc. The company may like to hold the cash balance
to take care of such contingencies and unforeseen circumstances. This need of cash is known as
precautionary motive.

SPECULATIVE MOTIVE

The company may like to hold some reserve kind of cash balance to take the benefit of
favorable market conditions of some specific nature.

Example
Purchases of raw material available at low prices on the immediate payment of cash, purchase
of securities if interest rates are expected to increase etc. This need to hold the cash for such
purposes is known as speculative motive.

Estimating the Cash Requirements

As has been discussed in the preceding paragraphs, the company should hold adequate cash
balance but should necessarily avoid the excessive balances. For this purpose, basically the
company is required to assess its need for cash properly. For this purposes, one of the best tools
available with the company is to prepare the cash budget. A cash budget is the statement
showing the various estimated sources of cash receipts on one hand and the various applications
of cash on another hand.

Thus, by preparing the cash budget, the company may predict whether at any point of time there
is likely to be excess or shortage of cash. If the shortage of cash is estimated, the company has to
arrange the cash from some other source. If the excess of cash is estimated, the company may
explore the possibility of investing the cash balance profitably.
Before preparing the cash budget, following principles must be kept in mind.

 1

1
The period for which the cash budget is to be prepared should be selected very carefully.
There is no fixed rule as to the period to be covered by the cash budget. It depends on
company and individual circumstances.
As a general rule, the period to be covered by cash budget should neither be too long nor
too short. If it is too long, it is possible that the estimates will be inaccurate. If it is short,
the areas which are beyond the control of the company will not be given due
consideration.
 2


2
 The items which should appear in the cash budget should be carefully decided. Naturally,
all those items which do not have bearing on the cash flows will not be considered while
preparing the cash budget. Eg. As the cost in the form of depreciation does not involve
any cash outflow, it does not affect the cash budget, though the amount of depreciation
affects the determination of the tax liability which involves cash outflow.
While preparing the cash budget, the various items appearing in the same may be
classified under the following two categories:
 Operating Cash Flows: These are the items of cash flow which arise as the result
of regular operations of the business.
 Non-Operating Cash Flows: These are the items of cash flow which arise as the
result of other operations of the business.
The standard items which may appear on a standard cash budget may be stated as below.

Principles of Cash Management

The basic objective of cash management is to reduce the operating cash requirement to the
minimum possible extent without affecting the routine transactions. In particular, the objectives
of cash management can be stated as below:

 1

1
Accelerate the cash collections.

 2

2
Delay the cash payments to the extent possible.

 3

3
Maintenance of optimum cash balance.
 4
4
 Investment of excess cash available.
Accelerate Cash Collections

This can be done with the help of following techniques.

 As far as possible insist upon the payment from the customer in the safe modes like demand
drafts, letters of credit, preaccepted hundies/bills of exchange etc. This may reduce the bank float.
 In order to ensure the prompt payment from customers, self-addressed envelope can be sent along
with the bill/invoice itself. Allowing the cash discounts is the best possible way to induce the
customer to make prompt payments.
 In case of the outstation customers, faster means of communications can be used so as to reduce
the postal float to the minimum possible extent. Eg. Courier Services, Speed Post etc.
 Decentralised Collection: In case of the company which has the branches at different places, the
company can establish the decentralised collection centres. The customers in a certain area are
required to make the payment at the local collection centre and the cheques collected by the local
collection centre are deposited in the local bank account. The balance in the local bank account
beyond a predetermined level may be transferred to the central or head office bank account at
periodic intervals. The decentralised collections may be useful for reducing the postal float as
well as bank float.
 Lock Box System: Under this arrangement, the company hires a post office box at important
collection centres. The customers are instructed to make the payment directly to the lock box. The
local bankers of the company are authorised to pick up the cheques from the lock box. After
crediting the cheques to the company’s account, the bank informs the company about the details
of cheques credited. The lock box systems reduces the postal float as well as bank float. The
clerical work of handling the cheques before deposits is performed by the banker and the process
of collection of cheques can be started immediately on the receipt of cheque from the customer.

It should be noted in this connection that both the above systems of decentralised collections as
well as lock box system, help to reduce deposit float but at the same it involves cost. Before
taking any decision in this connection, it is necessary to carry out a cost-benefit analysis to
ensure that the funds released due to speedy collections justify the additional costs.
Delay Cash Payments

This can be done with the help of following techniques.

 Payments can be made from a bank which is distant from the bank of the company to which
payment is to be made. This may increase the postal float and bank float.
 Attempts should be made by the company to get the maximum credit for the goods or service
supplied to it. Eg. In case of wages payable to the workers, the company gets the services in
advance which are to be paid for later. Thus, they provide the credit to the company for the period
after which they are paid, say a week or a month. As such, if the company can make monthly
payment of wages rather than weekly payment of wages, it can enjoy extended credit, slow down
the payments and reduce the requirement of operating cash balance.
 Avoid Early Payments: If according to the terms of credit available to the company, it is
required to make the payment within the stipulated period, it should not make the payment before
the specified date unless the company is entitled to cash discounts. The delay in making the
payment beyond the stipulated time may affect the credit standing of company.
 Centralised Disbursements: Under this methods, the payments are made by the Head Office of
company from its central bank account. This involves the benefits mainly in three respects as
 compared to decentralised payments. Firstly, it increases the transit time.
Example: If the creditor at Madras is to be paid out of the Central bank account of the company
in Delhi, it increases the postal float as well as the bank float, which is ultimately beneficial for
the company. Secondly if the company decides to make decentralised payments by maintaining
various bank accounts at various branches, it will be necessary for it to maintain minimum cash
balance at all these bank accounts, whereas in case of centralised disbursement system, the
problem of maintaining minimum cash balance will be only in case of central bank account.
Thirdly, to maintain the bank accounts at different branches may prove to be administratively
difficult.In case of a company operating on decentralised basis, the arrangements can be made in
such a way that the local branches are authorised to deposit the cheques in the local bank
accounts but are not authorised to withdraw the amounts from there. This facilitates speedy
collections as well as ensures proper control over the disbursements from the bank accounts.
 It may not be necessary for the company to arrange for the funds immediately after it issues the
cheque. If it is possible to analyse the time lag in the issue of cheque and their presentation for
payment, which is possible on the basis of past experience, the company may make arrangements
for funds only on the expected date of presentation of cheque for payment.

Maintenance of Optimum Cash Balance

As stated earlier, maintenance of cash balance which is more than requirement as well as less
than requirement involves the consequences. As such, one of the basic objectives of cash
management is to maintain the optimum cash balance. One of the tools available to the company
to ensure the maintenance of optimum cash balance is to prepare the cash budget. By preparing
the cash budget in a proper way, the company can have an idea in advance of the timing and
quantum of excess availability of cash or shortage of cash.

Accordingly, the company can take the decision of investment of excess cash on short term basis
(in case of excess cash available) or to meet the shortfall (in case of shortage of cash).

Investment of Excess Cash Balance

As stated earlier, one of the basic objectives of cash management is to optimise the investment in
cash. The company cannot afford to keep the excess cash balance idle as it involves the
opportunity cost. As such, one of the basic objectives of cash management requires the company
to think about the possibility of investing the excess cash balance on short term basis.
The avenues available to the company to invest the excess cash balance on short term basis may
be in various forms. Eg. Inter-corporate loans/deposits, inter-corporate bills discounting, stock
market operations, commercial paper, bank deposits etc. However, the final selection of the
avenue for investing the cash balance may depend upon various factors.

 Return - The basic factor affecting any investment decision is essentially in the form of return on
investment. Higher the return, better the investment.
 Risk - Risk and return always go hand in hand. High return investments may involve high risk.
While selecting the investment yielding high return, the company should take into consideration
the risk involved with the proposition.
 Liquidity - In some cases, due to unexpected cash needs, it may be necessary to sell the
investment before maturity. Under these circumstances, liquidity associated with the investment
becomes an important criteria to formulate the investment policy.
  Legal requirements - Some organisations may be subjected to certain legal requirements before
they can select their investment portfolio.
Example: Public charitable trusts, co-operative societies etc. These organisations are required to
invest their funds in certain specified forms.

Exercises on Cash Management

Illustrative Problems
1. A Private Limited Company is formed to take over a running business. It has decided to raise
Rs.55 lakhs by issue of Equity Shares and the balance of the capital required in the first six
months is to be financed by a financial institution against an issue for Rs.5 lakhs, 8% Debentures
(Interest payable annually) in its favour.
Initial outlay consists of:
Freehold premises Rs. 25 Lakhs

Plant & Machinery Rs. 10 Lakhs

Stock Rs. 6

Vehicle & Other items Rs. 5 Lakhs

Payments on the above items are to be made in the month of incorporation. Sales during the first
6 months ending on 30th June are estimated as under:
January Rs. 14 Lakhs April Rs. 25 Lakhs
February Rs. 15 Lakhs May Rs. 26.50 Lakhs

March Rs. 18.50 Lakhs

June Rs. 28 Lakhs

- Debtors 2 Months
Lag in payment
- Creditors 1 Month

Other Information:
1. Preliminary expenses Rs.50,000 (Payable in February)
2. General Expenses Rs.50,000 p.m. (Payable at the end of each month).
3. Monthly wages (Payable on 1st day of next month) Rs.80,000 p.m. for first 3 months and
Rs.95,000 p.m. thereafter.
4. Gross profit rate is expected to be 20% on sales.
5. The shares and debentures are to be issued on 1st January.
6. The stock levels throughout is to be the same as the outlay.

Prepare cash budget for the 6 months ended 30th June.

Solution: Cash Budget (For 6 months ending 30th June) Rs. In Lakhs
Working Notes:

 It is assumed that the company is incorporated in January.

 Assuming that the company is carrying on manufacturing operations, the purchases say for the
month of January are computed as below:

3. A newly started company ‘Green Co. Ltd.’ wishes to prepare cash budget from January.
Prepare a cash budget for the first 6 months from the following estimated revenue and
expenditure.
Cash balance on 1st January was Rs.10,000
A new machine is to be installed at Rs.30,000 on credit, to be repaid by two equal installments in
March and April.
Sales Commission @ 5% on total sales is to be paid within the month following actual sales.
Rs.10,000 being the amount of second call may be received in March. Share premium amounting
to Rs.2,000 is also obtainable with 2nd call.
Period of credit allowed by suppliers 2 months

Period of credit allowed to customers 1 month

Delay in payment of overheads1

Delay in payment of wages ½ month

Assume cash sales to be 50% of total sales.

Solution: Cash Budget of Green Co. Ltd.
Prepare a cash budget for the quarter ended 30th September, 1987 based on the following
information.
Cash at bank on 1st July, 1987 Rs.25,000
Salaries and Wages estimated monthly Rs.10,000
Interest Payable – August 1987 Rs.5,000

Credit sales are collected 50% in the month of sales made and 50% in the month following.
Collection from credit sales are subject to 5% discount if payment is received in the month of
sales and 2.5% if payment is received in the following month.
Creditors are paid either on a prompt or 30 days basis. It is estimated that 10% of the creditors
are in the prompt category.

Solution:
Cash Budget (For Quarter ending September 1987)
Working Notes:

It is assumed that salaries and wages are paid in the same month.
5. ABC Co. Ltd. wishes to arrange overdraft facilities with its bankers during the period April to
June 1987 when it will be manufacturing mostly for stock. Prepare a cash budget for the above
period from the following data, indicating the extent of the bank facility the company will
require at the end of each month.

Additional Information:

 All sales are credit sales, 50% of credit sales are realized in the month following the sales and the
remaining 50% in the second month following.
 Creditors are paid in the month following the month of purchases.
  Cash at Bank on 1.4.87 (Estimated) Rs.25,000.

Solution:
Cash Budget of ABC Co. Ltd.

Note:
It can be seen that the company will be required to arrange for the bank finance of
Rs.47,000 at the end of May 1987 and an additional amount of Rs.1,20,000 at the end of
June 1987.

Receivables Management
Receivables or Debtors as Current Assets get created on account of the credit sales made by the
company i.e. the company makes the sales to the customers but the customers do not make the
payment immediately. Even if the customers do not pay the cash immediately, the company has
to make credit sales to the customers in order to face the competition and also to attract the new
and potential customers to buy the goods or services from the company.
Objects of Management of Receivables
As in case of general objective of working capital management, the receivables management is
also to achieve a trade off between the risk and profitability. The aim of receivables management
is to ensure optimum investment in receivables i.e. the investment in receivables should be
neither less nor more.
If the objective of the company is to reduce the investment in receivables to the minimum extent,
the company will not make any credit sales at all, as receivables is the result of credit sales made
by the company. This will reduce the investment in receivables, but the company will suffer in
terms of profitability as the customers will not buy from the company, particularly if the
competitors offer the credit to the customers.
On the other hand, if the company makes credit sales to the customers in order to increase the
sales and profitability, the company may be accepting the risk of bad debts, more collection
efforts etc. As such, the objective of receivables management is to increase the credit sales to
such an extent that the risk of non-recoverable dues is reasonable and within control.
As in case of any other financial decisions, decisions regarding the receivables management also
involve the cost benefit analysis. Costs associated with the receivables management may be in
the form of credit administration costs, cost of bad debts and opportunity cost of funds blocked
in receivables. Benefits associated with the receivable management are naturally in the form of
profits from the sales made on credit basis. An effective receivables management policy tries to
increase the credit sales to such an extent that the profits arising therefrom are more than the
costs attached to it.
Receivables Management may be concerned with the following aspects:

1. Credit Analysis.
2. Credit Terms.
3. Financing of Receivables.
4. Credit Collection.
5. Monitoring of Receivables.

1
Credit Analysis

Even though the intention of the company will be to increase the profits by increasing the sales,
the company will not like to sell its products to any customer who comes its way. For this
purpose the company has to decide the customers to whom it should sell its products on credit.
The credit should be extended only to those customers whose creditworthiness is established. For
deciding the credit worthiness of the customers, the company may consider various factors viz.
analysis of the financial status of the customer, reputation of the customer, record of previous
dealing of the customer with the company, quality and character of the management running the
business of the customer etc. For deciding the credit worthiness of the customer, the company
may need information which may be available from the following sources.
Trade References
–

The company can ask the prospective customer to give trade references. The company may
insist that the references should be given of those names who are currently dealing with the
company. The company in turn can obtain the information from these references, either by
personal interview or by sending short questionnaires. While doing this, honesty, seriousness
and integrity of the references should be examined.
Bank Reference
–

The company can ask the prospective customer to instruct its banker to give the relevant
information to the company. In this case, there may be two problems. Firstly, the banker of the
prospective customer may not give clear answers to the enquiries made by the company.
Secondly, even though the Bank of prospective customer certifies the proper conduct of the
account, it may not mean that he will settle his dues of the company in time. As such, along
with Bank reference, other ways of obtaining the information should also be used.
Credit Bureau Reports
–

The sources of trade references and bank references may be biased in some cases. In such
cases, the credit bureau reports may be considered. In some cases, the associations for some
specific industries maintain credit bureau that may give useful and authentic information
about their members.
Financial Statements
–

This is one of the easiest ways to obtain the information about the creditworthiness of the
prospective customer. If the prospective customer is a public limited company, there may not
be any difficulty in getting the financial statements in the form of Profit and Loss Account and
Balance Sheet. However, getting the financial statements, may be difficult in case of private
limited companies or partnership firms.
Past Experience
–

This can be considered to be the most reliable source of getting the information about the
creditworthiness of the customer who is dealing with the company presently. If there is the
question of extending further credit to the existing customer, the company should inevitably
consider the past experience while dealing with that customer.
Salesmen’s Interviews and Reports
–

Many a times, companies may depend upon the reports given by the sales personnel for
evaluating the creditworthiness of the customers.
After the creditworthiness of the customer is ascertained, the next question is to decide the limit
on the credit to be allowed to them, both in terms of amount and duration. The decision depends
upon the amount of anticipated sales, increased cost of monitoring and servicing the receivables
and the financial strength of the customer.
If the customer is a frequent buyer of the goods of the company, a line of credit for selling may
be established which means the maximum amount of credit which the company may extend. In
such case, the company need not investigate every order of the customer so long as it is within
the limit of line of credit. The line of credit granted for the customer should be reviewed
periodically in the light of the collection of the previous dues, specific requirements of the
customer for the future and so on.
2
Credit Terms
Credit terms indicate the terms on which the company should extend the credit to the customer.
This involves the consideration of following aspects,
– Credit Period
– Credit Limit
– Discount Policy
Credit Period

Credit period is the time allowed by the company to the customers to pay their dues. The
duration of this credit period may depend upon various factors.
One, in case of the products having inelastic demand, the credit period may be small, however if
the demand is elastic, small credit period may affect quantum of sales.
Two, credit period may depend upon the nature of industry. In the buyer’s market, the company
may be required to offer more credit period. In the seller’s market, the company may afford to
offer smaller credit period. Further, it also depends upon the policies followed by the
competitors.
Three, decisions regarding the credit period may be affected by the management attitudes. If the
management attitude is aggressive, it may offer more credit period to increase sales and profits.
However, if management attitude is conservative, it will like to restrict the credit period.

Lastly, the credit period may depend upon the amount of funds available and also upon possible
bad debts losses. Naturally, the company will like to have credit period as short as possible,
whereas the customers will like to have longer credit period. As such, by liberalizing its credit
period, the company can attract new customers.
However, the proposition of liberalizing the credit period may involve the consequences in the
form of more investment in receivables, possibility of bad debts losses, increased cost of
monitoring and servicing the receivables etc. As such, policy to liberalize the credit period
should be viewed from this angle.
3
Financing the Receivables

Whichever sources are available to the company for financing the working capital requirement,
are equally the sources available for financing the receivables. This is due to the fact that
receivables is a part of working capital. However, following sources may be identified as the
sources available for financing the receivables particularly.

1. Bills Discounting
2. Cash Credit against hypothecation of book debts as the security.
3. Factoring.

4
Credit Collection
This indicates the steps taken by the company to collect the dues from the customer. For this
purpose, the company may follow the standard practices of reminding the customer just before
the due date. This can be done by sending the reminder letters, or making telephone calls or by
paying the personal visits.
The customers who are slow paying ones should be handled property. If they are permanent
customers, they may object to harsh collection procedure and the company may loose them
ultimately. If the slow paying customer is facing some temporary funds problem, the company
should understand the same.
If there are some defaulting customers, the company should decide as how many reminders
should be sent and how each of them should be drafted. If these measures fail, the next step taken
may be the personal call to these customers or the personal visit by the company’s representative.
If all these above courses of action fail, the company may decide to take the legal action against
the defaulting customer as a last resort.
It is a very regular practice to offer cash discounts to the customers in order to speed up the
credit collection process.
While designing the credit collection policy, following propositions should be remembered.

 Before deciding collection policies and procedures, it is essential to make a cost benefit analysis.
The costs are the administrative expenses associated with the collection policies and the benefits
are the reduced bad debts losses and interest on released investment in debtors. As a financial
management proposition, it is necessary that the cost should be justified by the benefits.
 Before deciding collection policies and procedures, provisions of the Indian Limitation Act
should be kept in mind. In spite of the repeated reminders, if the customer fails to pay the amount
due from him, the legal action should be initiated against the customer before the limitation
period is over.

5
Monitoring the Receivables

It may be necessary to ensure that the outstanding receivables are within the framework of the
credit policy decided by the company. For this, the company may be required to apply regular
checks and have a regular system to monitor the receivables property. For this, the company may
use the following techniques.
Techniques available on Macro Basis:

One of the most common methods to monitor the receivables on macro basis is to calculate the
Average Collection Period (ACP) which effectively indicates the period taken by the customers
to make payment to the company or the average period of credit allowed by the company to the
customers.
Average Collection Period may be calculated in two stages described below :

 Calculation of daily or monthly sales –

Credit Sales during the year
No. of days / No. of months
  Calculation of Average Collection Period –
Sundry Debtors in Balance Sheet
Daily/Monthly Sales

For the purpose of proper interpretation of ACP, it needs to be compared with the NCP, i.e. the
Normal Credit Period offered by the company to customers for making the payment. If ACP
works out to be more than the NCP, it indicates inefficiency on the part of marketing department
or sales department or collection department of the company in collecting the dues from the
customers.
If ACP works out to be less than the NCP, it indicates efficiency on the part of marketing
department or sales department or collection department of the company in collecting the dues
from the customers. However, calculation of ACP as a tool to monitor the receivables involves
some limitations:

1. Calculation of ACP assumes that the credit sales are evenly spread throughout the year. In
practical circumstances, credit sales are not evenly spread throughout the year. In such situations,
ACP may give wrong indications.
2. Calculation and interpretation of ACP as a tool to judge the efficiency or inefficiency of the
company in collecting the dues from the customers is not possible based upon the published
financial statements of the company due to non-availability of sufficient data for the same. Eg.
The amount of credit sales made by company or the normal credit period offered by the company
are not available in the published financial statements.

Techniques available on Micro Basis

Considering the limitations associated with the calculation of ACP, it may not be a tool available
to monitor the receivables on micro basis. For this, the calculation of age-wise analysis of
receivables may be made. Age-wise analysis of the receivables involves the classification of
outstanding receivables at any given point of time (say at the end of every month) into the
different age groups (age of the receivables indicating the number of days since the date
receivables become outstanding). Percentage of receivables falling under each age group may
also be calculated. For example,
Age Group Amount %
(No. of days) Rs.
Less than 30 days
31-60 days
60-90 days
More than 90 days
Now, if the normal credit period offered by the company to the customers is 30 days, any amount
which is outstanding for more than 30 days is definitely indicating the inefficiency on the part of
collection department of the company in collecting the receivables. Thus age-wise analysis of the
receivables may provide superior information about the quality of receivables and the company
can concentrate its collection efforts on those receivables which are outstanding for a longer
period of time.
Factoring
In the recent past, factoring has emerged as one of the major financial service in the Receivables
Management area.
What is Factoring?
Factoring indicates the relationship between a financial institution (called as the “factor”) and a
business organisation (called as the “client”) who in turn sells the goods/services to its customers
(called as the “customer”), whereby the factor purchases book debts of the client, either with
recourse or without recourse, and in relation thereto controls the credit extended to the customers
and administers the sales ledger of the client. In non-technical language, the financial service in
the form of factoring tries to provide the services which the marketing department of an
organisation will be undertaking.
Example:
The factor may provide the following services to the client:

 1

1
Factor may undertake the credit analysis of the customers of the client. Factor may also
help the client in deciding the credit limit upon each customer and the other credit terms
like period of credit, discount to be allowed etc. It should be noted that the factor need
not factor all the debts of the client. He may have his own assessment of the customers of
the client and accordingly, he will factor the debts of the client.

 2

2
Factor will undertake the various bookkeeping and accounting activities in relation to the
receivables management. This will consist of maintenance of debtors’ ledger and
generation of the various periodical reports on behalf of the client (like outstanding from
the customers, age wise analysis of the outstandings etc.)

 3

3
The factor undertakes the responsibility of following up with the customers for the
purpose of making the collection from the customers. For this it will be necessary that
the client informs its customers about the fact that the debts have been factored by the
factor and that the customers should make the payments to the factor directly.

 4

4
Factor can purchase the debts of the client making the immediate payment of these debts
to the client after maintaining about 20% to 30% margin. This reduces the strain on the
working capital requirements of the client and the client can concentrate on the
manufacturing and other activities. After the customer makes the payment to the factor on
the due date, the factor passes on the funds to the client after adjusting the funds
advanced by him to the client. If the factor purchases the debt of the client, it will be
involving the cost and the cost is slightly higher than the interest which the client would
 have paid had he borrowed the funds from the bank. If some of the debts are not
purchased by the factor, the client can borrow from the bank against these debts.

 5
5
Factor can assume the risk of non-payment by the customers if the factoring is without
recourse factoring and in such cases, the factor is not able to recover the money from the
client. If the factoring is with recourse factoring, the risk of non-payment by the
customers is assumed by the client and not by the factor. As such, the factor is entitled to
recover the funds advanced by him to the client.

Types of Factoring :
On the basis of above features of factoring, factoring can be classified in the following ways :
Without Recourses Factoring
+

With Recourse Factoring

+

Advantages of Factoring :
 bullet
Factoring is the way in which the company can finance its requirement of working capital
in respect of receivables. Immediate availability of cash reduces the strain on working
capital of the company. As the financing in the form of factoring moves with the level of
receivables directly, the company need not worry about financing the additional
requirement of working capital due to the increased amount of sales.
 bullet
Factoring orgainsation is a professional specializing in the various fields. The company
can take the advantage of the expertise of the factor in the areas of credit evaluation,
credit analysis, deciding the credit limits upon the customers etc.
 bullet
With the help of factoring as a financial service, the company can be relieved of the
administrative responsibilities of maintaining the debtors’ ledger, periodical report
generations and following up with the customers for collecting the dues etc. This not only
results in the cost saving for the company, but the company is able to concentrate its
efforts on business development.
Disadvantages of Factoring :
 bullet
As the amount charged by the factoring organisation, consists of the components towards
the administrative services rendered by the factor as well as the cost of finance provided
by the factor, the effective financial burden on the company increases.
 bullet
The Indian circumstances, Factoring is mainly with-recourse factoring. This means that
the risk of non-payment on the part of customer is not borne by the factor. It is borne by
 the selling firm. This has restricted the popularity of factoring services in the Indian
circumstances.
 bullet
While making the credit evaluation, if the factor adopts a very conservative approach
with the intention to minimize the risk of delay and default, it may restrict the sales
growth of the selling company.
 bullet
Factoring may be considered to be a symptom of financial weakness on the part of the
selling company. It may indicate that the selling company is not able to manage its
receivables effectively on its own and is required to take the help of an outside agency in
the form of factor.

Management of Inventory
Management of inventory assumes importance due to the fact that investment in inventory
constitutes one of the major investments in current assets.
Meaning and Types of Inventory
Inventory means all the materials, parts, suppliers, expenses and in process or finished products
recorded on the books by an organization and kept in its stocks, warehouses or plant for some
period of time.
Types of Inventory

1. Raw Materials
2. Finished Components
3. Work- in- Progress(WIP)
4. Finished Goods
5. Goods in Transit
6. Tools
7. Auxiliary Materials
8. Machine Spares

Need for Inventory

1. To Gain economies in Purchasing /Manufacturing.

2. Safety Stocks to avoid stock outs.
3. To satisfy the demand during the period of replenishment.
4. To level out Production.
5. To prevent loss of Sales.
6. To create buffer against uncertainty in Supplier’s Plant.
7. To take advantage of lower transportation cost.
8. Supplier’s condition of minimum quantity.
9. Govt. Regulations.

Objectives of inventory control

1. Protection against fluctuations in demand

2. Better use of men, machines and material
3. Protection against fluctuations in output
 4. Control of stock volume
5. Control of stock distribution
6. Deciding optimum order size
7. Deciding Reorder point

Inventory control
Inventory control is the technique of maintaining the size of the inventory at some desired level
keeping in view the best economic interest of an organization.
Major activities of inventory control

1. Planning the inventories.

2. Procurement of inventories.
3. Receiving and inspection of inventories.
4. Storing and issuing the inventories.
5. Recording the receipt and issues of inventories.
6. Physical verification of inventories.
7. Follow-up function .
8. Material standardization and substitution.

Inventory Decisions
Executive decide two basic issues while dealing with inventories;

 How much of an item to order when the inventory of that item is to be replenished.
 When to replenish the inventory of that item.

Inventory decisions facilitate production or satisfy customer demands.

Inventory system is a set of policies and controls which monitors and determines the levels of
inventory. Inventory conventionally includes raw materials, work-in-progress, components parts,
supplies and finished goods. Operations is a transformation process in which the inputs are raw
materials and output is the finished goods.
Suppliers Raw materials Work in Process Finished good Customers.
Perpetual Inventory System
It is a method of recording stores balances after every receipt and issue, to facilitate regular
checking and obviate closing down for stock taking. – Wheldon
Factors which help helpful to make system successful
Stores ledger, stores control, cards or bin cards are properly maintained;
Quantity balance store shown in the store ledger; stock control and bin cards are reconciled;
Exploring the cause of discrepancies if any physical balances and book balances.
Steps in Inventory control
Deciding the maximum- minimum limits of inventory;
Determination of Reorder point;
Determination of reorder quantity;
Perpetual inventory control;
ABC analysis;
Method of control through turn over.

Inventory Turnover method

It means how many times a company’s inventory is sold and replaced (finished product)
Inventory Turnover Ratio. Illustration
Opening Stock 100 Closing stock 200
Cost of goods sold 1500.
Calculate Inventory Turnover Ratio

ITR = COGS/Average Stock = 1500/150 = 10 times.

It can also be calculated as stock holding period.

(Average Stock*365)/COGS = 150*365/1500 = 36 days

It can also be calculated as Percentage.

(Average Stock*100)/COGS = 150*100/1500 = 10%
Costs associated with Inventory

 1

1
Material Cost: Price per Unit * No of Units plus any other direct costs associated with
getting the item to the plant.

 2

2
Procurement Cost (Ordering Cost) in case of Purchase or Setting Cost in case of
Manufactured Item.

 3

3
Inventory Carrying Cost.
 4
4
Loss of customer goodwill, back order handling, and lost sales.
Procurement Cost (Ordering Cost)

 1

1
Cost of Paper work, Typing, Dispatching an Order etc.

 2

2
Cost of effective communication like Cost of follow up i.e. Telephone, Travel etc.
  3

3
Salaries and Wages of Purchase Dept.

 4

4
Carriage inwards i.e Incoming Goods freight.

 5

5
Transportation Cost.

 6

6
Transit Insurance.

 7

7
Cost of receiving goods, inspection and transferring to stores.

 8

8
Cost of Purchase Returns.
 9
9
Damages during transit.
Set up Cost for Manufactured Items

 1

1
Cost of Changing Set up of M/C Tools and Equipment for next job .

 2

2
Cost of issue of materials for new job.

 3
 3
Cost of inspection of first few pieces from new Setting.

 4

4
Cost of Scrap.

 5

5
Cost of idle time of machine and labor.
 6
6
Cost of paper work.
Inventory Carrying Cost or Holding Cost

 Cost of borrowing Capital. On the funds blocked in the inventory.

 Opportunity Cost.
 Deterioration and Obsolescence.
 Insurance Cost.
 Storage cost.
 Storage Cost includes.
1. Salaries and Wages of the stores personnel.
2. Rent if space is rented.
3. If own building then Depreciation, Repair and Maintenance cost deemed rent.
4. Depreciation cost of Material Handling equipment and its Repair and Maintenance cost.

Inventory Control
Inventory Control is a set of Techniques to provide the organization with optimum inventory
investment and maintaining continuity of material flow throughout the Chain.
Objectives of Inventory control
Provide acceptable level of customer service (on-time delivery)
Allow cost-efficient operations
Minimize inventory investment
Inventory control comprises of

1. Selective Control (Which items to be Controlled ?).ABC Analysis

2. EOQ (How much to Order?) (Size of the Order)
3. Replenishment System(When to Order ?) (Reorder Level)

Over stocking
Advantages

1. Ordering cost is low

2. No fear of shortage of material for production chain.
 3. If the price increases in future benefit

Disdvantages

1. Carrying cost is High

2. If the price decreases in future Loss

Under stocking
Advantages

1. Ordering Carrying cost is low

2. If the price decreases in future benefit

Disdvantages

1. Ordering cost is High

2. Fear of shortage of material for production chain.
3. If the price increases in future Loss

Selective Inventory Control Types

1. ABC Analysis
2. VED Analysis
3. XYZ Analysis
4. FSN Analysis
5. GOLF Analysis
6. SOS Analysis
7. HML Analysis
8. SDE Analysis
9. VEIN Analysis
10. GUS Analysis

ABC Analysis
This technique assumes the basic principle of “Vital Few Trivial Many” known as “Always
Better Control”. It is an analytical method of inventory control which aims at concentrating
efforts in those areas where attention is required most.
80/20 Analysis. Statistics reveal that just a few handful items account for bulk of the annual
expenditure on materials. These handful few items need very close watch and are called “A”
Items. Other items are many but the annual expenditure on the same is comparatively less.
Category
Value Quantity

A High Low

B Medium Medium

C Low High
 Category
Value Quantity

Item
Quantity Quantity Order Checking

Regular system to see that there is no overstocking as well a

there is no danger of production being interrupted for unwa
A Costlier Less
material

Order may be on review Position being viewed in each month

B Less Costlier
basis

Order in large quantity so that cost can be avoided

C Economical Larger

Class % of Total Va
No. of items % of total Value/Consumption

5,60,000
A 300 6 70

1,60,000
B 1,500 30 20

80,000
C 3,200 64 10

Steps for ABC Analysis

 1

1
Prepare the List of Items.

 2

2
Estimate their annual usage in quantities.

 3

3
Determine unit cost of each item.

 4
 4
Multiply annual usage quantity by unit cost to arrive at annual usage value in Rs.

 5

5
Arrange items in descending order of their annual usage value ie. Starting with highest
annual usage value.

 6

6
Calculate cumulative annual usage value.

 7

7
Express no of items and cumulative usage value as percentage of respective totals.
 8
8
Plot cumulative usage value % age against % age of cumulative no of items
A: 1.53% items account for 54% of Value
B: 6.51% items account for 35% of Value

ABC illustration

ABC in shapes

Order Quantity Strategies

Lot-for-lot: Order exactly what is needed for the next period
Fixed-order quantity: Order a predetermined amount each time an order is placed
Min-max system: When on-hand inventory falls below a predetermined minimum level, order
enough to refill up to maximum level
Order n periods: Order enough to satisfy demand for the next n periods
Economic Order Quantity
It is also known as standard order quantity, optimum quantity or economic lot size.
By definition economic order quantity is that size of order for which the total cost is minimum.
Economic Order Quantity:
How Much to Order?
Determining order quantity is the basic decision in Inventory Control.
Ordering large Lots infrequently reduces administrative work but increases inventory.
Ordering small Lots frequently increases administrative work but keeps low inventory
One has to order optimum size.
Economic Order Quantity
EOQ indicates that quantity where the total variable cost is minimum.
Such cost basically consists of two parts.
Annual Procurement Cost (Ordering Cost)
–

Annual procurement cost is product of cost per order and the number of orders.
This cost will be high if the item is procured in small lots frequently but annual Inventory cost
will be low.
Annual Inventory Carrying Cost
–

Annual Inventory Carrying Cost is the product of average inventory investment and the
carrying Cost.
This cost falls if the item is procured in small lots but annual procurement cost will be high.
Behavior of both the cost is diametrically opposite.
When the total cost is minimum both the costs are balanced and resulting quantity is Economic
Order Quantity.
A balance is to be struck between these two factors and it is possible at Economic Quantity
where the total variable cost of managing the inventory is minimum.
Example:
Annual Demand 2400 Units
Ordering Cost Rs.100 per Order
Price Per Unit Rs.100
Inventory Carrying Cost 12% on average inventory
Example

Fill in the Blanks

EOQ formula
Symbols
Annual Consumption = A
Ordering Cost = O
Price/unit = Cu
Inv. Carrying Cost of AVG Investment = i
Order quantity. = Q
In some books Annual Consumption is denoted by S or D
Carrying Cost is denoted by H
EOQ formula
Annual Ordering Cost: = A/Q *O
Annual Inv. Carrying cost = Q/2 * Cu.i
Total Cost = A/Q *O + Q/2 * Cu.i
When Total cost = Min
A/Q *O = Q/2 * Cu.i
2AO = Q^2 * Cu.i
Q^2 = 2AO/ Cu.i
Q = Sqr Root of (2A*O/Cu*i)
Hence EOQ = Sqr Root of (2A*O/Cu*i)
EOQ = √2xAxO / C
Where EOQ = Economic Order Quantity
A = Annual Requirement in Units
O = Cost of Placing an Order
C = Cost of Carrying One Unit Per Year
Illustration

A manufacturer uses 200 units of a component every month and he buys them entirely from
outside supplier. The order placing cost is Rs. 100 per order and annual carrying cost per unit is
Rs. 12. From this set of data, calculate Economic Order Quantity
Annual Demand 2400 Units

Ordering Cost Rs. 100 per Order

Price Per UnitRs.

Inventory Carrying Cost12% on average inv

EOQ = Sq Root of 2AO/C

Sq Root of 2 X 5000 X 60/ 100 X 15%
= Sq Root of 6,00,000/15
= Sq Root of 40,000
= 200 units
If a Discount is offered
Discount is normally offered for the bulk purchase. Order size is more than EOQ.
If you accept the proposal there will be reduction in ordering cost and material cost but there will
be increase in carrying cost.
Compare the benefit with the cost. If benefit to cost ratio is more than 1 you can accept the
proposal.
Calculate EOQ after considering the price after discount. If the EOQ you get is more than the
quantity for which the discount is offered, you can accept the discount proposal.
Illustration on discount offer

Customer gives you 5% discount if you buy 500 units. Will you accept the offer?
Total Cost with EOQ i.e 200 units without discount
Material Cost = 5000 X 100
= 5,00,000
Ordering Cost = Ordering Cost X No. of Orders
= 60 X 25
= 1,500
Carrying Cost = Q/2 * Price * cost %
= 200/2* 100 * 15/100
=1,500
Total Cost without discount = 5,03,000
Total Cost with discount offer i.e 500 units
Material Cost = 5000 X 95
 = 4,75,000
Ordering Cost = Ordering Cost X No. of Orders
= 60 X 10
= 600
Carrying Cost = Q/2 * Price * cost %
= 500/2* 95 * 15/100
= 3562.50
Total Cost without discount = 4,79,162.50
Total cost with discount offer is less than without discount. Hence we will accept the offer.

Exercise on discount offer

Customer gives you 5% discount if you buy 400 units.

Will you accept the offer?
Fixation of Inventory Levels
MAXIMUM LEVEL

It indicates the level above which the actual stock should not exceed. If it exceeds, it may
involve unnecessary blocking of funds in inventory.

MINIMUM LEVEL

It indicates the level below which the actual stock should not reduce. If it reduces, it may
involve the risk of non-availability of material whenever it is required.

RE-ORDER LEVEL

It indicates that level of material stock at which it is necessary to take the steps for
procurement of further lots of material.

DANGER LEVEL

This is the level fixed below minimum level. If the stock reaches this level, it indicates the need
to take urgent action in respect of getting the supply.

Calculation of various levels. Formulas

  1

1
Re-order Level: Maximum Lead Time x Maximum Usage.

 2

2
Maximum Level: Re-order Level + Re-order Quantity - (Minimum Usage x Minimum
Lead Time)

 3

3
Minimum Level: Reorder Level - (Normal Usage + Normal Lead Time)

 4

4
Average Level: (Minimum Level + Minimum Level)/ 2
 5
5
Danger Level: Normal Usage x Lead time for emergency purchases
Maximum stock level
Quantity of inventory above which should not be allowed to be kept.
This quantity is fixed keeping in view the disadvantages of overstocking;
Factors to be considered
Amount of capital available.
Godown space available.
Possibility of loss.
Cost of maintaining stores;
Likely fluctuation in prices;
Seasonal nature of supply of material;
Restriction imposed by Govt.;
Possibility of change in fashion and habit.
Minimum stock level

 This represents the quantity below which stocks should not be allowed to fall .
 The level is fixed for all items of stores and the following factors are taken into account:

1. Lead time-
2. Rate of consumption of the material during the lead time.

Re-ordering level
It is the point at which if stock of the material in store approaches, the store keeper should
initiate the purchase requisition for fresh supply of material.
This level is fixed some where between maximum and minimum level.
Re-order Level without safety stock = Maximum Lead Time (L) x Maximum Usage (D)
ROL = L * D
Re-order Level with safety stock = Maximum Lead Time (L) x Maximum Usage (D) + Safety
Stock (SS).
ROL = L * D + SS
Re-order Level
Re-order Level without safety stock = Maximum Lead Time (L) x Maximum Usage (D)
ROL = L * D
Re-order Level with safety stock = Maximum Lead Time (L) x Maximum Usage (D) + Safety
Stock (SS)
ROL = L * D + SS
Re-order Level without safety stock

Normal usage – 50 units per week

Minimum usage – 25 units per week
Maximum usage – 75 units per week
Re-order quantity – 400 units
Re-order period – 4 to 6 weeks
Answer:

1. Re-order Level: Maximum Lead Time x Maximum Usage = 6 weeks x 75 units = 450 units.
2. Minimum Level: Re-order Level - (Normal Usage x Normal Lead Time) = 450 units - (50
units x 5 weeks) = 200 units.
3. Maximum Level: Re-order Level + Re-order Quantity - (Minimum Usage x Minimum Lead
time)450 units + 400 units - (25 units x 4 weeks) = 750 units

Summary
Working Capital Management means efficient management of components of Current Assets
and Current Liabilities. The basic goal of Working Capital Management is to manage the Current
Assets & Current Liabilities of a firm in such a way that a satisfactory level of Working Capital
is maintained. The objective of Working Capital Management is to avoid over investment or
under investment in Current Assets, as both the extremes involve the adverse consequences.

The hedging approach suggests that the permanent working capital requirement should be
financed with fund from long term sources while the temporary working capital requirement
should be financed with short term funds

The motives of holding cash may be the transaction motive, precautionary motive or speculative
motive. By preparing the cash budget, the company may predict any likely excess or shortage of
cash and thereby the company may appropriate take action. The basic objective of cash
management is to reduce the operating cash requirement to the minimum possible extent without
affecting the routine transactions.

The basic objective of management of receivables is to optimize the return on investment in

receivables. And it also has to achieve a trade off between the risk and profitability. Receivables
management has the following aspects; credit analysis, setting of credit terms, financing of
receivables, credit collection and monitoring of receivables. Factoring indicates the relationship
between a financial institution (called as factor) and a business organization (called as client)
who in turns sells the goods/services to its customers, whereby the factor purchases book debts
of the client, either with recourse or without recourse, and in relation thereto controls the credit
extended to the customers and administers the sales ledger of the client.
Inventory includes raw material, stores and supplies ,work in progress and finished goods,. The
basic objective of inventory management is to optimize the returns of investment in inventory by
stocking enough inventory to ensure sooth uninterrupted production and at the same time
avoiding unnecessary blocking of funds.

The various techniques of inventory management include

1. Economic Order Quantity

2. Fixation of Inventory levels
3. Computation of Inventory turnover
4. ABC analysis
5. Preparation of Bill of Materials
6. Perpetual Inventory System

Self-Assessment Questions
1. Explain the various motives for holding the cash.
2. Explain the various principles to be followed for managing the cash in a very big size
organization having the branches all over the country.
3. Define the concept of float and illustrate this concept with an example.
4. Write short notes on-
i) Estimation of cash requirements
ii) Cash management
5. What is meant by a firm’s credit terms? What are the expected effects of (a) A decrease in the
firm’s cash discounts and (b) A decrease in credit period.
6. What are the important dimensions of a firm’s credit policy? Discuss the consequences of a
liberal credit policy.
7. Write a detailed note on “factoring”.
8. State the advantages and disadvantages of factoring.
9. What are the objects of inventory management?
10. How do you fix various levels of inventory?
11. Explain the concept of ABC Analysis with example
12. Explain the concept of Economic Order Quantity with example
13. Explain the concept of Reorder Point with example
14. State the advantages and disadvantages of Overstocking and Under stocking
15. How do you control Inventory through Inventory turnover method?

From the following budgeted data of ABC Ltd. prepare cash budget for the quarter ending 31st
December, 2017.
Additional Information

Cash on hand on 1.10.17 : Rs.5,000

Sales : 20% realized in the month of sale, discount allowed 2%, balance realized in 2
subsequent months.
Purchases : These are paid in the following month of supply.
Wages : 25% in arrears paid in the following month
Misc. expenses : paid a month in arrears
Rent : Rs.1000 per month paid quarterly in advance due to October.
Income Tax : Installments of Rs.25,000 due on or before 15.12.17
Income from investment : Rs.5,000 received quarterly April, July, Oct. etc.
Insurance claim : Rs.72,936 receivable in December.
2

A firm expects to have Rs. 30,000 in Bank on 1.10.2017 and requires you to prepare an estimate
of cash position during the three months October 2017 to December 2017. The following
information is supplied to you.

Other information

1. 25% of the sales are for cash, remaining amount in the month following that of sale.
2. Suppliers supply goods at 2 months’ credit.
3. Delay in the payment of wages and all other expenses is one month.
4. Income Tax of Rs.10,000 is due to be paid in December.
5. Preference shares dividend of 10% on Rs.1,00,000 is to be paid in October.
3

The credit manager of ABC Company had to decide on a proposal for liberal extension of credit
which will result in a slowing process of average collection period from one month to two
months. The company’s product was sold for Rs.20 per unit of which Rs.15 represented variable
cost (including credit department cost). The current actual sales amounted to Rs.24 Lakhs,
represented entirely by credit sales. The average total costs was Rs.18. The extension in credit
policy was expected to result in a 25% increase in sales i.e. Rs.30 Lakhs annually. The corporate
management aimed at a return of 25% on additional investment. You are required to make
relevant calculations to help the credit manager in examining the financial implications of
liberalizing the credit policy.
4

XYZ Ltd. requires 20,000 units of product A per annum. The purchase price is Rs.4 per unit. The
inventory carrying cost is 20% per annum and the cost of ordering is Rs. 100 per order. Advise
the company, on how many times they should order in a year, so as to minimize the cost of
product A?
5

A manufacturer buys certain essential spares from outside suppliers at Rs.40 per set. Total annual
requirements are 45000 sets. The annual cost of investment in inventory is 10% and costs like
rent, stationery, insurance, taxes etc. per unit per year work to Rs.1, cost of placing an order is
Rs.5. Calculate the Economic Order Quantity.
6

From the particulars given below, your are required to compute.

1. Economic Order Quantity.

2. Maximum Level.
3. Minimum Level.
4. Re-ordering Level.
5. Average stock level.

 Quantity required annually 4,000 units @Rs.10 per unit.

 Interest and cost of carrying one unit - 10%
 Cost of placing an order at Rs.1000 per order.
 Consumption per week Maximum 80 units. Minimum 40 units.
 Lead time (in weeks) Maximum 7 Minimum 3

A publishing house purchases 200 units of a particular item per year at a unit cost of Rs.20, the
ordering cost per order is Rs.50 and the inventory carrying cost is 25%. Find the optimal order
quantity and minimum total cost including purchase cost. If a 2% discount is offered by the
supplier for purchase in lots of 1000 or more, should the publishing house accept the proposal?
Chapter 11- Profit Management

Introduction
The Finance Manager has to decide the dividend policy very carefully. A wrong dividend policy may put
the company into financial troubles and the capital structure of the company may get unbalanced. The
growth of the company may get hampered if sufficient resources are not available to implement growth
programmes.
The Finance Manager has to formulate the dividend policy in such a way which coincides with the
ultimate object of the finance function of maximizing the wealth of shareholders and value of the firm.

Meaning and Importance of Profit

Management
Profits earned by a company may be handled by it basically in two ways.

 1

To distribute the profits among the shareholders by way of dividend.

 2
2
To retain the profits in the business to be used in future.

There are no strict rules and guidelines available to decide as to what portion of the profits
should be distributed by way of dividend and what portion should be retained in the business. As
such, to decide the dividend policy may be one of the trickiest and delicate decisions which the
management of the company may be required to take.

If the management decides to retain a large portion of the profits in the business, funds required
for future expansion and modernization needs of the company may be available to it on long
term basis, without any obligations to repay the same. The expansion or modernization
programmes may improve the earning capacity of the company in future which may carry
forward the growth of the company.

The company may be able to absorb the shocks of business fluctuations and adverse situations
boldly. A strong and stable company may earn the confidence of the investors and creditors and
funds may be available to it at reasonable rates conveniently. As a result, the share prices and the
value of the company will increase. Thus, though the shareholders are required to forego the
dividends in the short run, they get benefit in the long run.

On the other hand, if the management decides to distribute a large portion of profits by way of
dividend, the company may be able to earn the confidence of the shareholders and may be able to
attract the prospective investors to invest in the securities of the company.

Shareholders are necessarily interested in getting larger dividends immediately due to the time
value of money and also due to uncertainty regarding the future. Shareholders are thus attracted
to the companies paying high dividends, due to which prices of the shares and value of the
company increases.

Thus, it can be seen that both high retention's and high dividends may be desirable, but there is
necessarily a reciprocal relationship between the retention's and dividends – Higher the
retention's, lower the dividends, Lower the retention's, higher the dividends. The skill of the
Finance Manager lies in striking the balance between these two extremes.

Profitability Ratios
As the name itself suggests, the intention for calculating these ratios is to know the profitability
of the organization.
Following ratios may be computed under this group.
Gross Profit Ratio
–

It is calculated as Gross Profit X 100/Net Sales

The Gross Profit ratio indicates the relation between production cost and sales and the
efficiency with which the goods are produced or purchased. A high gross profit ratio may
indicate that the organization is able to produce or purchase at a relatively lower cost. As such,
a high gross profit ratio will be desirable. Gross profit ratio may be increased by any of the
following methods:
 Increase sales price, production cost remaining the same
 Reduce production cost, sales price remaining the same
 Increase sales price, reduce production cost

Net Profit Ratio

–

It is calculated as Net Profit after taxes X 100/Net sales

The Net Profit Ratio indicates that portion of sales available to the owners after the
consideration of all types of expenses and costs – either operating or non-operating or normal
or abnormal. A high net profit ratio indicates higher profitability of the business. As such a
high net profit ratio will be desirable.
Operating Profit Ratio
–
It is calculated as (Manufacturing cost of goods sold + Operating Expenses) x 100/Net Sales

The numerator includes the various operating cost which a business has to incur in order to
earn the profits. Following types of non-operating expenses are excluded from the numerator
viz., Interest, Dividend (On equity as well as preference shares), loss on the sale and
assets/investments.

This ratio indicates the percentage of net sales which is absorbed by the operating costs.
A high operating ratio indicates that only a small margin of sales is available to meet the
expenses in the form of interest, Dividend and other non operating expenses. As such, a low
operating ratio will always be desirable.
Return On Investment (ROI)
–

Investments mean, equity or Capital or Assets. Hence, there are three different ratios under
this category.
 Return On Asset (ROA):
It is calculated as Net Profit x 100/Assets, A high ROA indicates a good
performance.
 Return On Capital Employed (ROCE):
It is calculated as (Net Profit + Interest on Long Term Sources) X
100/Capital Employed.
A high ROCE indicates a good performance. It should be higher than the
Cost of Capital.
 Return on Shareholders’ Funds (Return on Equity):
This ratio indicates the profitability of a firm in relation to the funds
supplied by the shareholders or owners. It is calculated as (Net Profit after
taxes – preference Dividend) x 100/Shareholders’ Funds A high ROE
indicates a good performance. It should be about double the Risk free
Return.

Earnings Per Share (EPS)

–

It is calculated as (Net Profit after taxes - Preference Dividend)/Number of Equity Shares

It is only used ratio to measure the profits available to the equity shareholders on a per share
basis.
Retained Profit Ratio
–

Retained profit ratio shows the profit transferred to reserve. This is called plough back of
profit.
Retained Profit = PAT (1-Payout ratio)
Retained Profit Ratio = Retained Profit/PAT
Lenders expect that the companies should retain maximum profit till they pay the outside
liabilities.
Dividend Related Ratios
  1

Dividend Payout Ratio

 2

Dividend Yield
 3
3
Dividend Per Share
DIVIDEND PAYMENT RATIO (D/P)
It is calculated as, Dividend Per Share x 100/Earnings Per Share

It is also calculated as, Dividend paid x 100/Profit After Tax

It measures the relationship between the earnings belonging to the equity shareholders and the
amount finally paid to them by way of Dividend. It indicates the policy of management to pay
cash Dividend. D/P Ratio when subtracted from 100, gives the indications about the policy of
the management to retain the profits in the business with the intention to reinvest the same
which is likely to have an effect on future market price of the share. India has a record of low
Dividend Pay out Ratio compared to other major countries.
Dividend Payout measures the percentage of earnings that the company pays in dividends .

DPR = Dividends paid X 100/Earnings (PAT) Or DPR = (DPS X 100)/EPS

Example:
Suppose the PAT of a limited company is Rs.100 lacs. If it pays Rs.40 lacs as dividend, the DPO
ratio is 40%. The higher the DPO ratio, the less the retention ratio and vice-versa.

DIVIDEND PER SHARE

It is calculated as Dividend Paid/No of Equity Shares.
This formula shows the Dividend distributed per share. This ratio is in turn used for
calculating Dividend Pay Out Ratio and Dividend yield.

Example:
Suppose the PAT of a limited company is Rs.100 lacs. If it pays Rs.50 lacs as dividend, and if
the no. of shares is 25 lacs .
DPS = Dividends paid/ no. of shares DPS = 50 lacs/25 lacs = Rs.2 per share

DIVIDEND YIELD
It is calculated as Dividend Per Share x 100/Market Price Per Share
This ratio shows the income to the share holders in the form of Dividend. India has a record of
low Dividend yield = (Dividend Per Share X 100)/Market Price Stock

Dividend yield measures the return that an investor can make from dividends alone. It is
related to the market price for the share.

Example:
The market price of a stock is Rs.400/- and the dividend is Rs.5/-. Then the dividend yield is
1.25%, which is very poor in Indian conditions. Thus while dividend rate for the above stock
assuming Rs.10/- as the face value would be 50%, the dividend yield is just Rs.1.25%

Dividend Policy
Dividend policy refers to the policy of the management regarding distribution of profit to share
holders and retention of profit for the needs of the organization. There are conflicting opinions
regarding the impact of dividend policy on the valuation of the firm. According to one school of
thought, dividends are irrelevant, so the dividends have no impact on value of the firm.
According to second school of thought, dividends are relevant to the value of the firm measured
in terms of market prices of the shares.
Factors Determining Dividend Policy
Before formulating the dividend policy of the company, the Finance Manager is required to take
into consideration various factors which may be classified as below:

 1

1
External Factors
 2
2
Internal Factors
External Factors:
Phase of Trade Cycles
–
The company’s dividend policy depends upon the phase of trade cycles through which the
company may be moving. During the phase of boom and prosperity, the company may not like
to distribute huge amount of profits by way of dividends though the earning capacity of the
company may permit it to do so. The company will like to retain more profits which can be
used during the depression which is likely to follow.

Further, the company will like to take the benefits of investment opportunities prevailing
during the period of boom. Similarly, during the period of depression, the company will like to
withhold the dividend payments to retain the profits in the business in order to preserve its
liquidity position. At all the times, though it may be necessary to declare higher dividends to
increase marketability of its shares.
Legal Restrictions
–

The Company can formulate its dividend policy within the overall legal framework. If the
company wants to pay the dividend in cash, relevant provisions of Companies Act, 1956 are
required to be followed by the company.

If the company wants to issue the bonus shares with the intention to capitalise its reserves,
relevant SEBI guidelines are required to be followed by the company. The relevant provisions
of Companies Act, 1956 and SEBI guidelines are discussed later.
Tax Policy
–

Tax policy as a factor affecting the dividend policy of the company needs to be considered from
the point of view of company as well as from the shareholders. As far as the company is
considered, dividend can be paid out of profit after tax.

As such, the company does not get any tax advantage by paying the dividend. On the other
hand, as per the provisions to Section 115-O of the Income Tax Act, 1961, it increases the tax
burden for the company as the company paying the dividend is required to pay “tax on
distributable profits” which in common language is referred to as “dividend tax”. The rate at
which the company is required to pay the dividend tax is 12.5% of the amount of dividend paid
and the said basic rate is further increased by the surcharge of 10% and the education cess of
2%.

As such, the effective rate of dividend tax works out as 14.025%. As far as shareholders are
concerned, as per the provisions of Section 10(34) of the Income Tax Act, 1961, dividend
received by the, whether interim or final, is a tax free income. As such, they are not required to
pay the tax on dividend received by them.
Investment Opportunities
–

Formulation of dividend policy of the company depends upon the investment opportunities
available to the company. If the investment opportunities involve a higher rate of return than
the cost of capital of the company, the company will like to retain the profits to be invested in
these projects.
Restrictions imposed by the lending institutions
–

In practical circumstances, the lending banks or financial institutions impose certain

restrictions on the company preventing the payment of dividend entirely or limiting the
amount of dividend or disallowing the payment of dividend if certain conditions are not
fulfilled.

This is due to the fact that the payment of dividend amounts to the withdrawal of profits from
the business and company paying the dividend may be against the interest of the lending banks
or financial institutions so long as the loans are still unpaid to them.
Internal Factors:
Attitude of the Management
–

If the attitude of the management is aggressive, it may decide to pay more dividend as the
management be interested in increasing the recurring income of the shareholders. Whereas if
the attitude of the management is conservative, the company will like to retain more profits in
the business to take care of the contingencies.
Composition of Shareholding
–

The composition of the shareholding may play an important role in the dividend policy
formulation of the company. If the company is a private limited company having less number
of shareholders, the company will like to retain more profits and restrict the payment of
dividend in order to reduce the tax liability of the individual shareholders, as the dividend
received by the shareholders is a taxable income in their hands. If the company is a public
limited company, tax brackets of the individual shareholders may not have a significant impact
on the dividend policy of the company.
Age of the Company
–

A young and growing concern will like to retain maximum profits in the business in order to
finance its growth and expansion needs as it may be difficult for it to raise the funds from the
open market whenever the need arises. On the other hand, an old or established company
having reached the saturation point, may follow a high dividend policy.
Nature of Business/Earnings
–

The nature of business of the company inevitably affects its dividend policy. A company having
stability of earnings may be able to formulate long term dividend policy and may even follow a
high dividend policy if the earnings so permit. On the other hand, a company having unstable
income may like to retain its profits during boom to ensure that dividend policy is not affected
by cyclical variations.
Growth Rate of Company
–

The growth rate of the company closely affects its dividend policies. A rapidly growing
company may like to retain majority of its profits in order to take care of its expansion needs.
However, care should be taken by the management to invest only in those projects which yield
more returns than its cost of capital.
Liquidity Position
–

Profitability and Liquidity are separated from each other. In spite of existence of high
profitability or huge reserves, the company may not have sufficient funds to pay cash
dividends. As such, before formulating the dividend policy, due considerations should be given
to the liquidity positions of the company. At the same time, future commitments affecting the
liquidity should also be considered.

Example: At present, company’s cash position may be comfortable, but it may need cash
within a short time to pay instalments of term loans or to pay creditors for materials. In such
case, Finance Manager may not like to impair its liquidity for making dividend payment.
Customs and Traditions
–

In some cases, the customs and traditions built by the company may affect its dividend policy.
E.g. If the company is following the stable dividend policy for 20 years, it may like to maintain
the trend in 21st year also, in spite of adverse profitability or liquidity situations.
Types of Dividend Policy
As discussed above, a most of factors are required to be considered by the company before
formulating its dividend policy. The selection of ultimate dividend policy varies from industry to
industry. There may be various pattern in which a company may pay dividends.
Stable Dividend Policy

According to this policy, the company pays a fixed amount of dividend irrespective of the
fluctuations in income. During the periods of prosperity, the company withholds extra income to
be used for paying dividends in lean years.
Stable dividend policy does not indicate stagnation in dividend payout. If the company is assured
about permanent increase in earnings, amount of dividend per share may be increased.

Stable dividend policy helps the company in following respects :

1. The credit standing of the company in market increases. The investors are assured of a stable
income and the company can raise as much funds as required in the market.
 2. The share prices of the company increase. The marketability of the shares increase and the
investors are ready to pay high premium for these shares.
3. The management of the company enjoys confidence of the shareholders. This may enable the
company to raise the funds whenever required and it also improves the morale of management.
4. The company following stable dividend policy can formulate financial plan on long term basis as
future demand and supply of capital can be correctly estimated.

While formulating stable dividend policy, care should be taken not to fix the dividend payout
ratio at a very high level which can not be maintained in lean period. For this purpose, correct
estimations of earnings capacity and future earnings of the company should be made.
No Immediate Dividend Policy

According to this policy, the company does not pay any dividend despite the huge earnings. The
company retains the earnings to be used in future for its growth and expansion programmes if it
is feared that the access to capital market will be difficult or costly in future.
The main drawback with this policy is that the shareholders do not get immediate cash income
by way of dividend and hence shareholders who invest in the shares with the view to get regular
income may not be in favour of this policy.
However, this policy may attract the shareholders who are willing to devote short term dividend
income for long term capital gains and share in the increased prosperity of the company.
Regular and Extra Dividend Policy

This policy may be used as supplement to stable dividend policy. In case of a stable dividend
policy, the dividend pay out its maintained at a constant rate. However, if in a particular year, the
earnings of the company increase abnormally, the additional earnings may be distributed by way
of extra dividends rather than increasing the dividend payout rate itself.
The advantage attached with the policy is that the shareholders are aware of the fact the extra
dividends are solely due to the abnormal earnings which may be dropped if there are no
abnormal earning in a particular year.
However, if a company follows a policy of regular and extra dividends for years together, a
wrong impression may be created in the minds of shareholders who may treat the extra dividends
as a part of regular dividends and the omission to pay extra dividend in some year may result into
loss of confidence of the shareholders with the adverse effect on share prices and credit standing
of the company.
Regular Stock Dividend Policy

According to this policy, the company may decide to pay dividends in the form of stock rather
than in the form of cash i.e. by issuing bonus shares. This policy may be useful to the company
as it does not involve the effect on liquidity position of the company.
However, following its policy on a regular basis may prove to be disadvantages due to two
reasons.

 Firstly, if the company is not in the position to increase future earnings on a permanent basis,
issue of Bonus shares may reduce the earnings per share which may adversely affect the share
prices and credit standing of the company.
 Secondly, the shareholders who are interested in getting cash income on regular basis may not
approve of this policy on a permanent basis and may demand cash dividends.
Irregular Dividend Policy

According to this policy, the dividend payout rate is not fixed by the company. The dividend per
share varies according to the level of earnings. As such, high earnings may result into high
dividends whereas less earnings may result into less or no dividends.

As such, this policy believes that the shareholders are entitled to dividends only when the
earnings and liquidity position of the company justify the payment of dividends. This policy may
be followed by the companies having unstable income.
This policy may be advantageous for the company as it does not commit itself to any fixed and
regular payment of dividend. However, it may not be approved by the shareholders as it does not
assure any fixed or regular dividend income.

Types of Dividend Payment

If a company wants to distribute the profits among the shareholders by way of dividend, it can do
so in two forms:

 1

Payment of Dividend in Cash

 2
2
Issue of Bonus Shares
Cash Dividend
–

If the company wants to distribute the dividend by way of cash i.e. by issuing the dividend
warrants, the company is required to fulfill various procedural and legal formalities.
 The rate of dividend to be paid needs to be decided by the Board of
Directors. However, the capacity of the Board of Directors is only the
recommendary capacity. The dividend is declared by the shareholders in
their meeting i.e. Annual General Meeting. However, the shareholders can
not increase the rate of dividend recommended by Board of Directors.
According to the provisions of Section 205-1(B) of the Companies Act, 1956,
the Board of Directors can declare the interim dividend. The term interim
dividend refers to the dividend declared in between two Annual General
Meetings.
 The dividend is payable out of the current year’s profit after providing for
sufficient amount of depreciation as per the provisions of Schedule XIV of
the Companies Act, 1956.
 Before any dividend is paid in cash, the company is required to transfer a
certain minimum amount to reserves from the profits earned in the current
 year. This provision is made to ensure that the company does not withdraw
the entire amount of profits from the business.
 Any amount of dividend declared including interim dividend shall be
deposited in a separate bank account within five days from the date of
declaration of such dividend and the amount so deposited shall be used for
the payment of interim dividend.
If the dividend has been declared but has not been paid or the dividend
warrants are not posted within 30 days from the declaration of dividend to
any shareholder entitled to the payment of dividend, every director of the
company who is knowingly a party to the default, shall be punishable with
simple imprisonment upto three years and also to a fine of Rs.1000 for
every day during which the default continues.
Further, the company shall be liable to pay simple interest at prescribed
rate linked to State Bank of India Rates during the period for which the
default continues.
 Any dividend which has been declared by the company but which remains
to be paid or claimed within 30 days from its declaration, the company
shall, within 7 days from the expiry of such 30 days, transfer this amount of
unpaid or unclaimed dividend to a separate account opened with a
scheduled bank. If any amount remains pending in this account for a period
of 7 years, such amount will be transferred by the company to a fund
established by the Central Government as “Investor Education and
Protection Fund” which is supposed to be used for promotion of investors’
awareness and protection of the interests of the investors.

Bonus Shares
–

 Bonus Shares indicate the payment of dividend in the form of shares of the
same company in proportion to their existing shareholding.
 This form of paying the dividend does not involve any outflow of cash, but
involves only transfer of retained earnings to share capital. Profits earned
by a company in the previous years effectively belong to the equity
shareholders as they are the ultimate owners of the company.
 However, so long as the reserves appear on the balance sheet of the
company, the legal ownership of the reserves remain with the company. By
issuing the bonus shares, the company transfers ownership of reserves to
the shareholders legally.
 As such, issue of bonus shares is technically referred to as the capitalization
of reserves. When a company issues bonus shares, reserves of the company
get reduced and share capital of the company increases.

Dividend Theories
 1


 
1
Irrelevance Approach
This approach is suggested mainly by Modigliani and Miller. According to this approach,
the value of the company remains unaffected by the dividend policy of the company.
It is the earnings potential and the investment opportunities available to the company
which affects its value and not the dividend policy.
Suppose, that a company wants to invest in a project, it has the two options open before
it.
 Pay the earnings and raise the funds from market.
 Retain the earnings to be used to finance the project.
If the company pays the dividend, it will have to go to the market for raising the funds.
Acquisition of the funds from the market will dilute the shareholding which results in
reduced share values. As such, whatever the shareholders receive by way of cash
dividends, they loose in terms of reduced share values.
As such, they are not concerned with the fact whether the earnings are retained or are
distributed by way of dividend. The market price of the shares and as such value of the
company remains the same in both the situations.
It is worth recollecting here the Modigliani Miller approach in relation to capital structure
which suggests that the value of firm and its cost of capital are independent of its capital
structure.
As such, in relation to dividend policy also, the source from which the funds required to
finance the investment programme are raised does not affect the value of the company.
 2
2
Relevance Approach
This approach is suggested mainly by Walter and Gordon. They hold that there is a direct
relationship between the dividend policy of the company and its value in terms of market
price of its shares.
The propositions of the above approach can be stated, in most simple words as below.
The investors prefer current dividend income to future dividend income as it does not
involve any risk.
As such, increasing payout ratio increases the share prices under normal circumstances.
However, if the company has the investment opportunities open before it where expected
rate of return is more than cost of capital, the share prices may increase even with the
declining payout ratio which is due to the anticipated and future dividend income.
There are three different theories:

 Dividend Irrelevance Theory: Miller and Modigliani

 Dividend Relevance Theory: These are theories whose propagators argue that the dividend
policy of a firm affects the value of the firm. There are two main theorists:
1. James E. Walter (Walter’s model) Long-term capital gains preferred to dividend
2. Myron Gordon (Gordon’s model): “ a bird in the hand” theory

1. Miller and Modigliani

The propagators of this school of thought were France Modigliani and Merton Miller (1961).
They state that the dividend policy employed by a firm does not affect the value of the firm.
They argue that the value of the firm is dependent on the firm’s earnings.
Preposition - Dividends do not affect the value of a limited company.

Underlying assumptions
There are not tax differences between dividends and capital gains for shares.
Under the assumptions the rate of return, r, will be equal to the discount rate, k. As a result the
price of each share must adjust so that the rate of return, which is composed of the rate of
dividends and capital gains on every share, will be equal to the discount rate and be identical for
all shares.
The return is computed as follows:
r = (Dividends + Capital gains or loss)/Share price
r = DIV1 + (P1 – P0)/P0
2. Walter’s Theory

Shows relationship between a firm’s rate of return r and its cost of capital k.
Long-term capital gains are less than tax on dividends.
The higher the rate of dividend, the less the amount available for retention and growth and vice-
versa. Hence the less the value of the firm.
The market value of the firm is not due to dividends paid but funds retained in business
Growth rate = (1 – DPO) x Return on equity
Walter’s formula for determining Market Price of a Share is as follows:
P = (DPS/k) + [r (EPS – DPS)/k]/k
Where:
P = market price per share
DPS = dividend per share
EPS = earnings per share
r = firm’s average rate of return
k = firm’s cost of capital

The market value is determined as the present value of two sources of income:
PV of constant stream of dividend (DPS/k)
PV of infinite stream of capital gains: r(EPS-DPS)/k
Hence the formula can be rewritten as P = {DPS + (r/k) (EPS – DPS)}/k

Three types of scenarios of firms:

Growth Firm: There are several investment opportunities (r > k) and the firm can reinvest
earnings at a higher rate r than that which is expected by shareholders k. thus they will
maximize value per share if they reinvest all earnings.

 Market Price of share will increase in this case

Normal Firm: There aren’t any investments available for the firm that are yielding higher
rates of return (r = k) thus the dividend policy has no effect on market price.
  Market Price of share will not be affected in this case

Declining Firm: There aren’t any profitable investments for the firm to reinvest its earnings,
i.e. any investments would earn the firm a rate less than its cost of capital (r < k). The firm
will therefore maximize its value per share if it pays out all its earnings as dividend. If they
retain the earnings market price of share will decrease.

Walter’s Theory: Example

Suppose the PAT of a limited company is Rs.100 lacs. If it pays Rs.50 lacs as dividend, and if
the no. of shares is 25 lacs. Return on Equity is 20%. Cost of Capital is 10% . What is the Market
Price of the Share?
Price for a given share = D + r (E - D)/ke
ke ke
(2+).2(4-2)/0.1)/0.1 = Rs.24
If DPS 1, MP = Rs.26.
If DPS 3, MP = Rs.22.
It means the Dividend affects value of company.
3. Gordon’s Model

If a company has continuous good showing, it will be reflected in the growth of dividends. This
in turn will turn the sentiments of investors in favor of the firm. More and more demand for the
shares of the company in the secondary market will be made. This will increase the market value
of the firm. Thus the market value of the firm is dependent upon the dividends declared.

It is called as “ a bird in the hand” theory. as dividend is more certain than the unknown
appreciation in market price in the future.

Proverb: “A bird in hand is worth two in the bush”

The Bird-in-the-hand theory

Put forth by Kirshman (1969) in the following terms:
“Of two stocks with identical earnings record and prospects but the one paying higher dividend
than the other, the former will undoubtedly command higher dividend than the latter merely
because stockholders prefer present to future values….stockholders normally act on the premise
that a bird in the hand is worth two in the bush and for this reason are willing to pay a premium
price for the stock with the higher dividend rate just as they discount the one with the lower
rate”.
The Bird-in-the-hand theory
Even when r = k, the dividend policy does affect the value of the share based on the view that:
under conditions of uncertainty, investors tend to discount distant dividends (capital gains) at a
higher rate than they discount near dividends.
Investors behave rationally, are risk-averse and therefore have a preference for near dividends to
future dividends.

As per Gordon’s theory, the cost of equity, ke = (D1/P0) + g.

 D1 = dividend at T1,
 P0 = market value of the share at T0 and
 g = growth rate in decimals.
 g = ke – (D1/P0), P0 = D1/(ke – g) D1 = P0 x (ke – g)

The growth rate, cost of equity and return on equity have to be expressed in decimals always.

Summary
Profits earned by a company may be handled by it basically in two ways.

 1

To distribute the profits among the shareholders by way of dividend.

 2
2
To retain the profits in the business to be used in future.

The Finance Manager has to formulate the dividend policy in such a way which coincides with
the ultimate object of the finance function of maximizing the wealth of shareholders and value of
the firm.

Dividend policy refers to the policy of the management regarding distribution of profit to share
holders and retention of profit for the needs of the orgnisation, age of the company, attitude of
the management, cost of distribution of dividend etc.

Before formulating the dividend policy of the company, the Finance Manager is required to take
into consideration various factors such as statutory restrictions, tax policy, shar holders’
expectations, needs of the organization.
Irrelevance Approach: According to Modigliani and Miller, the value of the company remains
unaffected by the dividend policy of the company.

Relevance Approach: According to Walter and Gordon. They hold that there is a direct
relationship between the dividend policy of the company and its value in terms of market price of
its shares. There are different types of Dividend Policy such as Stable policy, Regular policy,
Irregular policy, fixed dividend policy etc.

If a company can distribute the profits among the shareholders by way of Payment of dividend
in cash or Issue of Bonus Shares. Bonus Shares indicate the payment of dividend in the form of
shares of the same company in proportion to their existing shareholding. This form of paying the
dividend does not involve any outflow of cash. Net worth of the company remains same after
issue of bonus shares.

Miller and Modigliani state that the dividend policy employed by a firm does not affect the value
of the firm.
Return on investment = (Dividends + Capital gains or loss)/ Share price
Walter’s formula for determining Market Price of a Share: P = (DPS/k) + [r (EPS – DPS)/k]/k
This formula can be rewritten as P = {DPS + (r/k) (EPS – DPS) }/k
As per Gordon’s theory, the cost of equity, ke = (D1/P0) + g.

The intention for calculating ratios is to know the profitability of the organisation The formulas
of the important Ratios are as under,

 Gross Profit Ratio = GP/sales

 Net Profit Ratio = NP/sales
 Operating Profit Ratio = OP/sales
 Earning Per Share = Profit/No. of shares
 Dividend Per Share = Dividend/No. of shares
 Dividend Payout Ratio = DPS/EPS or Dividend Payout Ratio =
Dividend/Profit
 Dividend Yield = DPS/MP
 Return on Equity = Profit/ Net Owned Funds
 Return on Capital = Profit/ Capital
 Retained Profit Ratio = 1-Payout ratio or Retained Profit Ratio = Retained
Profit/PAT

Self Assessment Questions

 1

1
Explain the Meaning and Importance of Profit Management.

 2
 2
Explain the important Profitability Ratios.

 3

3
Explain the important Dividend Ratios.

 4

4
Explain the need for Dividend Policy.

 5

5
What are the factors affecting Dividend Policy?

 6

6
What are the different types of Dividend?

 7

7
What are the different Dividend Theories?

 8

8
Explain the Miller and Modigliani Theory with example.

 9

9
Explain the Walter’s Theory with example.

 10

10
Explain the Gordon’s Theory with example.

 11

11
 Explain the concept of Bonus Shares.

 12

12
How is the valuation of shares done under Gordon’s Theory?
 13
13
How is the valuation of shares done under Walter’s Theory?
Numerical Problems
1
Calculate DPS, Dividend Payout Ratio, Dividend Yield and Retained Profit Ratio
on the basis of the following information:

Paid up Capital: 400 Lacs

Face Value: Rs.10/-
PAT: 150 Lacs
Divided Paid: 60 lacs
Market Price of Share: Rs.30/-
Calculate DPS, Dividend Payout Ratio, Dividend Yield and Retained Profit Ratio.
2
Calculate various profitability and dividend ratios on the basis of the following
information:

Share Capital Rs.2,000 Lacs

Face value of the Share Rs.10/-
Market Price of share Rs.50/-
Profit after Tax: Rs.500 Lacs
Dividend Distributed: Rs.40Lacs
Sales Rs.5,000Lacs
Cost of Goods Sold Rs.3,400 Lacs
Operating Profit: Rs.750 Lacs
Net Owned Funds: Rs.5,000 Lacs
Long Term: Liabilities = Rs.4,000 Lacs
3
Show the effect of dividend policy on the market price of its shares as per
Walter’s Theory on the basis of the following information:

Cost of equity = 12%

Earnings per share = Rs.8
Assumed return on equity under three different scenarios:
 r = 15%
r = 10%
r = 12%
Assume DPO ratio to be 50%

nnnn