Professional Documents
Culture Documents
Faculty: Ms. Luvnica Rastogi Email id: lrastogi@amity.edu Imp Website: www.investorwords.com
Learning Objectives
To understand the meaning of accounting To understand the scope and objectives of financial accounting
Learning Objectives
To understand the recording of transactions To know what are the advantages of journal To learn about the classification of accounts and its rules To learn about compound entries To learn about opening and closing entries To understand the term ledger To know how to do ledger postings To understand the rules of posting To know the meaning of trial balance
Learning Objectives
To learn more about trial balance
To understand the objectives of preparing trial balance To learn how errors are disclosed by trial balance To learn how errors are not disclosed by trial balance
Learning Objectives
To understand the meaning of balance sheet
Introduction
Accounting is the language of the business, the basic function of which is to serve as a means of communication. If you ask to whom does it communicate the results of business operations, the various interested parties are owners, creditors, investors, governments and other agencies .
Definition:
The definition given by the American Institute of Certified Public Accountants clearly brings out the meaning and functions of accounting. According to it, accounting is the art of recording, classifying and summarizing in a significant manner and in terms of money, transactions and events which are, in part at least, of a financial character and interpreting the result thereof.
Meaning of Accounting
Accounting is an Art
Accounting classifies as an art as it helps in attaining the goal of ascertaining the financial results. Analysis and interpretation of the financial data is the art of accounting, requiring special knowledge, experience and judgment.
Contd.
Involves Recording, Classifying and Summarizing
Recording means systematically writing down the transactions and events in account books soon after their occurrence. Classifying is the process of grouping transactions or entries of similar nature at a place. This is done by opening accounts in a book called ledger. Summarizing involves the preparation of reports and statements from the classified data (ledger), understandable and useful to management and other interested parties. This involves preparation of final accounts.
Interpretation
Interpretation is the art of interpreting the results of operations to determine the financial position of an enterprise, the progress it has made and how well it is getting along.
Contd
Facilitates in decision-making with regard to the changes in the manner of acquisition, utilization, preservation and distribution of scarce resources Facilitates in decision-making with regard to the replacement of fixed assets and expansion of the firm Provides necessary data to the government to enable it to take proper decisions concerning to duties, taxes, price control etc. Devices remedial measures for the deviations of the actual from the budgeted performance Provides necessary data and information to managers for internal reporting and formulation of overall policies
Branches of Accounting
Financial Accounting
Accounting deals with recording, classifying and summarizing the business events that have already occurred. It is, therefore, historical in nature. That is why it is called historical accounting or post-mortem accounting or more popularly financial accounting. Its aim is to collate the information about income and financial position on the basis of business events that have taken place during a particular period of time.
Cost Accounting
Cost accounting deals with the detailed study of cost pertaining to cost ascertainment, cost reduction and cost control. The emphasis is on historical costs as well as future decisionmaking costs.
Management Accounting
Management accounting provides information to management not only about cost but also about revenue, profits, investments etc. to enable managers to discharge their duties more efficiently and effectively. Thus, it provides required database to managers to plan and control the activities of business.
Social responsibility accounting involves accounting of social costs incurred by an enterprise and reporting of social benefits created by it.
Contd.
(2)Managers
For managing business profitably, management requires adequate information about financial results and financial position. By providing this information, accounting helps managers in efficient and smooth running of the business.
(3). Investors
Prospective investors would be keen to know about the past performance of business before making investment in that concern. By analyzing historical information provided by accounting records, they can arrive at a decision about the expected return and the risk involved in investing in a particular business.
Contd.
(5). Employees
Employees are concerned about job security and future prospects. Both of these are intimately related with the performance of business. Thus, by analyzing the financial statements, they can draw conclusions about their job security and future prospects.
Contd.
(6). Government
Government policies relating to taxation, providing subsidies etc. are guided by the relevance of industries in the economic development of the country. The policies also consider the past performance of industries. Information about past performance is provided by the accounting system. Collection of taxes is also based on accounting records.
(7).Researchers
Researchers need financial information for testing hypothesis and development of theories and models. The required information is provided by accounting system.
Contd.
(8). Customers
The customers who have developed loyalties toward a business are those who are certainly interested in the continuance of the business. They certainly want to know about the future directions of the enterprise with which they are associating themselves. The way to information about the enterprise is through their financial statements.
(9).Public
Public at large is always interested in knowing the future directions of an enterprise and the only window to peep inside an enterprise is through their financial statements.
Advantages Of Accounting
1. Facilitates to Replace Memory
Accounting facilitates to replace human memory by maintaining a complete record of financial transactions. Human memory is limited by its very nature. Accounting helps to overcome this limitation.
2. Facilitates to Comply with Legal Requirements 3. Facilitates to Ascertain Net Result of Operations 4. Facilitates to Ascertain Financial Position 5.Facilitates the Users to take Decisions
Contd.
6. Facilitates a Comparative Study 7. Assist Management 8. Facilitates Control over Assets 9. Facilitates the Settlement of Tax Liability 10. Facilitates the Ascertainment of Value of Business 11. Facilitates Raising Loans
Sundry Creditor Sundry creditor is the amount owed by an enterprise on account of goods purchased or services received, or in respect of contractual obligations. It is also termed as trade creditor or account payable.
Sundry Debtor Sundry debtors are persons from whom amounts are due for goods sold or services rendered, or in respect of contractual obligations. These are also termed as debtor, trade debtor and account receivable.
Contingent Asset Contingent asset is an asset, the existence, ownership or value of which may be known or determined only on the occurrence or nonoccurrence of one or more uncertain future events.
Contingent Liability Contingent liability is an obligation relating to an existing condition or situation which may arise in future depending on the occurrence or nonoccurrence of one or more uncertain future events.
Accounting Cycle
Collecting and analyzing data from transactions and events. Putting transactions into the general journal. Posting entries to the general ledger. Preparing an unadjusted trial balance. Adjusting entries appropriately. Preparing an adjusted trial balance. Organizing the accounts into the financial statements. Closing the books. Preparing a post-closing trial balance to check the accounts.
ACCOUNTING CONCEPTS
The Business Entity Concept:
Entity concept is an assumption that for an accounting purposes, the business is separate and different from that of its owners. The entity concept is also known as the concept of an Enterprise and is one of the central concepts in accounting. The entity concept may be applied to the whole organization or even to the part of the organization. Thus according to these concepts the business is treated as separate unit from that of its owners, creditors, managers, employees and others.
3. The Money Measurement Concept: The money measurement a concept is an assumption that any accounting transaction is to be measured in money or moneys worth. It is only when a transaction is measured that it can be recorded in the books of an enterprise and the result of the business is determined. Thus the measurement of a transaction also has to be in a common denomination (medium). Money is this common denominations in which transaction are recorded in the books of account.
4. The concept of Accounting Periodicity: The determination of the income of the enterprise cannot be postponed till the end of the enterprise. Since, according to Going-concern concept there is no limit for the life of the enterprises. Hence the economic activities of the business must be recorded periodically. These period is called as Accounting period & these Accounting period is normally called as Accounting Year or Financial Year or Fiscal Year.
It is, within this Accounting Year, that the income & expenses (i.e.) costs & revenues are matched with reasonable accuracy to provide significant results.
5. The Historical Cost Concept: According to Historical cost concept, all the transactions are recorded in the books at cost and not at its market value. Thus the underlying ideas of this concept are two forms. a. An asset is recorded at the price paid to acquire it i.e. at cost and b. This cost is the basis of all the subsequent treatment of the assets. e.g. depreciation, stock valuation, etc.,
Matching of Expired cost (i.e., expenses) and revenues for the periods determination of income, is one of the most important concept and procedures of accounting. This concept follows the accounting period concept i.e. once an accounting period is determined, within that period, the revenues and its related costs are matched. This concepts is one of the most important concept of accounting and has received major attention of accountants. Matching of costs and revenue is the Test reading of the results and the success of the business activity. At the same time, it is one of the most difficult accounting problems.
CONVENTIONS
Consistency: This concept states that once the organisation has decided on a method, it should use the same method subsequently unless there is a valid reason for a change of method. If frequent changes are made it is not possible to carry out comparisons on an inter-period or interfirm basis. If a change is necessary it has to be highlighted. e.g. if depreciation is charged on diminishing balance method, it should be done year after year.
Disclosure
All significant information should be disclosed. The disclosure concept states that all significant information should be disclosed and all insignificant information should be disregarded. However, there are no definite rules to separate the two. For recording purposes also only significant events are recorded in detail taking into consideration the cost of detailed record keeping
Materiality :
The accountant should attach importance to material details and ignore insignificant details. The question what constitutes a material detail is left to the discretion of the accountant. An item is material if there is reason to believe that knowledge of it would influence the decision of the informed investor. a) Materiality of information b) Materiality of amount c ) Materiality of procedure.
Conservatism
This convention means a caution approach or policy of "play safe". This convention ensures that uncertainties and risks inherent in business transactions should be given a proper consideration. If there is a possibility of loss, it should be taken into account at the earliest. On the other hand, a prospect of profit should be ignored up to the time it does not materialise. On account of this reason, the accountants follow the rule 'anticipate no profit but provide for all possible losses'.
Contd
For example, we buy machinery for Rs. 300,000. It has brought two changes, machinery increases by Rs 300,000 and cash decreases by an equal amount. While recording this transaction in the books of accounts, both the changes must be recorded. In accounting language these two changes are termed "as a debit change" & "a credit change".
Contd
Thus we see that for every transaction there will be two entries, one debit entry and another credit entry. For each debit there will be a corresponding credit entry of an equal amount. Conversely, for every credit entry there will be a corresponding debit entry of an equal amount. So, the system under which both the changes in a transaction are recorded together, one change is debited, while the other change is credited with an equal amount, is known as double entry system.
ACCOUNTING EQUATION
The equation that is the foundation of double entry accounting. The accounting equation displays that all assets are either financed by borrowing money or paying with the money of the companys shareholders. Thus, the accounting equation is
Contd
The balance sheet is a complex display of this equation, showing that the total assets of a company are equal to the total of liabilities and shareholder equity. Any purchase or sale has an equal effect on both sides of the equation, or offsetting effects on the same side of the equation. The accounting equation is also written as
Examples
Transact ion Assets Number
1 2 3 4 5 + + + + 6,000 10,00 + 0 900 1,000 + 700 10,00 0 900 400 + + 600 Shareholder's Explanation Equity + 6,000 Issuing stocks for cash or other assets Buying assets by borrowing money (taking a loan from a bank or simply buying on credit) Selling assets for cash to pay off liabilities: both assets and liabilities are reduced Buying assets by paying cash by shareholder's money (600) and by borrowing money (400)
Liabilities
Liabilities
Shareholder' s Explanation Equity Paying expenses (e.g. rent or professional fees) or dividends Recording expenses, but not paying them at the moment Paying a debt that you owe Receiving cash for sale of an asset: one asset 0 is exchanged for another; no change in assets or liabilities
200
7 8
+ 500
100 500
100
Journal
Introduction:Accounting is the art of recording, classifying and summarizing the financial transactions and interpreting the results thereof. Thus, the accounting cycle involves the following four major phases:
1. Recording of transactions-- This is done in a book called journal. 2. Classifying the transactions-- This is done in a book called ledger. 3. Summarizing the transactions-- This includes preparation of trial balance, profit and loss account and balance sheet of the business. 4. Interpreting the results-- This involves computation of various accounting ratios etc. to know about the liquidity, solvency and profitability of the business.
Journal
A journal records all daily transactions of a business in the order of their occurrence. A journal may, therefore, be defined as a book containing a chronological record of transactions.
ii. Transactions relating to properties and assets iii. Transactions relating to incomes and expenses
Contd..
On the basis of above rules, it is necessary to keep the accounts in respect of the following: i. Each person with whom it deals (customer, suppliers) ii. Each property or asset which it owns (building, machinery etc.) iii. Each item of income and expense (commission, rent, salary etc.)
Classification of Accounts
Personal Accounts
Real Accounts
Nominal Accounts
Personal Accounts
Personal accounts include the accounts of persons with whom the business deals. These accounts can be further classified into three categories:
Real Accounts
Real accounts may be of the following types: a. Tangible Real Account
Tangible real accounts are those which relate to such things that can be touched, felt and measured. For example, cash a/c, building a/c, furniture a/c etc.
Nominal Accounts
Nominal accounts are opened in the books of accounts to simply explain the nature of the transactions. They do not really exist. For example, salary paid to employee, rent paid to landlord etc. Nominal accounts mainly include accounts of expense, losses, income and gains.
RULES OF ACCOUNTING
OPENING ENTRY
In the case of a running business, the assets and liabilities appearing in the pervious years balance sheet will have to be brought forward to the next year. This is done by the means of a journal entry which is known as opening entry. All assets are debited while all liabilities are credited. The excess of assets over liabilities is the proprietors capital and is credited to his capital account
Example:Pass the opening entry on 1.1.2001 on the basis of the following information taken from the business of Mr. Shubham. 1. Cash in hand-- Rs. 20,000 2. Sundry Debtors-- Rs. 60,000 3. Stock in Trade-- Rs. 40,000 4. Plant and Machinery-- Rs. 50,000 5. Land and Building-- Rs. 1,00,000 6. Sundry Creditors-- Rs. 1,00,000
Solution:-
Discount
Cash Discount
An incentive that a seller offers to a buyer in return for paying a bill owed before the scheduled due date. The seller will usually reduce the amount owed by the buyer by a small percentage or a set dollar amount. If used properly, cash discounts improve the days-sales-outstanding aspect of a business's cash conversion cycle. For example, a typical cash discount would be if the seller offered a 2% discount on an invoice due in 30 days if the buyer were to pay within the first 10 days of receiving the invoice. Providing a small cash discount would be beneficial for the seller as it would allow him to have access to the cash sooner. The sooner a seller receives the cash, the earlier he can put the money back into the business to buy more supplies and/or grow the company further.
Trade Discount
A discount on the list price granted by a manufacturer or wholesaler to buyers in the same trade. Suppose A buys from B $200 worth of goods. He is allowed a discount of 10% from the list price. Then he would have to pay only $180 to B. Suppose the terms had stipulated that he be allowed a discount of 10% and 5% off from the list price. This would not give him a deduction of 15% from the $200
Cash Discount
Trade Discount
Is a reduction granted by supplier from Is a reduction granted by supplier from the list price of goods or services on the invoice price in consideration of business consideration re: buying in bulk immediate or prompt payment for goods and longer period when in terms of services As an incentive in credit management to Allowed to promote the sales encourage prompt payment Not shown in the supplier bill or invoice Shown by way of deduction in the invoice itself
Cash discount account is opened in the Trade discount account is not opened in ledger the ledger Allowed on payment of money Allowed on purchase of goods
It may vary with the quantity of goods It may vary with the time period within purchased or amount of purchases which payment is received made
Ledger
LEDGER is the principal book of accounts which contains various accounts. An account is a summarized record of similar transactions during an accounting period relating to a particular person or thing. Therefore, all the accounts, whether real, nominal or personal, are collected in the ledger.
FORMAT
Dr. Title of the Account Cr
POSTING
Posting means the process of transferring all the debit and credit items from the journal onto the accounts maintained in the ledger. Each amount entered in the debit column of the journal is posted by entering it on the debit side of the account in the ledger with relevant details. Similarly, each amount entered in the credit column is posted by entering it on the credit side of the account in the ledger with relevant details.
TRIAL BALANCE
Trial balance is a list of debit and credit balances extracted from the ledger on a particular date. Since for every debit entry there is a corresponding credit entry of the equivalent amount, the total of the debit and credit balances should agree in equal amount. A trial balance essentially proves the arithmetical accuracy of the entries passed in the books of account and is derived from ledger where all accounts find a place. Trial balance is prepared after striking the balance of various accounts in the ledger.
Note:- A trial balance is not a conclusive proof of the absolute accuracy of the account. It does not indicate the absence of an error. So, a non-tailed trial balance indicates the presence of book keeping error.
purchase of furniture wrongly posted as Rs. 50 in the account Omission of posting, e.g., when a debit entry of Rs. 500 for purchase of furniture has not been posted at all Duplication of posting, e.g., when a debit entry of Rs. 500 for purchase of furniture has been posted twice to the account Wrong side of posting, e.g., when debit entry is posted on the credit side or credit entry is posted on the debit side. That is, when debit entry of Rs. 500 is posted on the credit side and vice-versa
Contd..
Errors in casting the totals of debit or credit side of the trial balance Wrong transfer of balances to the trial balance Omission of entering the balance of account in the trial balance Balance of cash book omitted to be recorded in the trial balance Wrong balancing of account
REVENUE EXPENDITURE
1. Revenue expenditure is the expenditure which benefits in the current accounting year. It is not carried forward to the next year or years. 2. It is the expenditure which is incurred in the normal course of business to run the business and to maintain the fixed assets of business. 3. It is the expenditure which is incurred on purchase of goods meant for resale or to purchase materials which will be used to convert them into final product.
Therefore, revenue expenditure is a recurring expenditure made to maintain the business. The amount spent is generally small and the benefit is for a short period which is not more than a year. All revenue expenditure are charged to trading and profit and loss account.
CAPITAL RECEIPTS
Capital receipts are the receipts which are not received in the ordinary course of business. These are non-recurring receipts. Money obtained from the sale of fixed assets or investments, issue of shares or debentures, loans taken are some of the examples of capital receipts. Capital receipts are shown as liability reduced from assets appearing in the balance sheet.
REVENUE RECEIPTS
Revenue receipts are receipts obtained in the normal course of business. It is a receipt against supply of goods or services. The money obtained from sales, interest, dividend, transfer fees etc. are examples of revenue receipts. Revenue receipts are credited to profit and loss account.
CAPITAL PROFIT
Those profits which are not earned during the regular course of business and which are not earned on account of the dayto-day trading activities of the business are capital profits. For example, profit on sale of asset and premium received on issue of shares. These types of profits are normally not taken to profit and loss account but are shown in the liabilities side of the balance sheet.
CAPITAL LOSSES
The losses which are not suffered during the regular course of business are called capital losses. For example, discount on issue of shares.
INCOME STATEMENTS
Introduction
After the agreement of trial balance, a trader closes ledger accounts with a view to ascertain the following aspects: Gross profit Net profit Financial position of the firm
TRADING ACCOUNT
The goods account is split up and separate accounts are opened as follows: Opening stock account, i.e. stock at commencement Purchase account including both cash and credit purchases Sales account including both cash and credit sales Returns inwards account, i.e. total goods returned by customers Returns outwards account, i.e. total goods returned to vendors Closing stock account, i.e. stock of goods at the end These separate accounts, in total, are ultimately transferred to a common heading called trading account.
Contd..
In order to find out the gross profit or gross loss of a business, a trading account is prepared. This account gives the overall profit of the business relating to an accounting period which is subject to deduction of general administrative, selling and other expenses. Gross profit is the difference between sale proceeds of a particular period and the cost of the goods actually sold during that period.
Contd
The balance of a trading account showing gross profit or gross loss becomes the opening transfer entry of this account on the credit or debit side respectively. All the revenue expenses appear on the debit side including those expenses which do not find a place in the trading account. The losses on sale of capital asset or any abnormal loss also appear on the debit side. The credit side of the account shows the revenue earned including the non-trading income like interest on bank deposit or securities, dividend on shares, rent of let-out property, profit arising from sale of fixed assets etc. after transfer of all the nominal accounts from the trial balance to the profit and loss account. The net result of the profit and loss account is ascertained by balancing it. If the credit side is more than the debit side, it indicates net profit for the period. Conversely, if the debit side is more than the credit side, it indicates net loss for the period.
BALANCE SHEET
The American Institute of Certified Public Accountants defines balance sheet as a tabular statement of summary of balances (debits and credits) carried forward after an actual and constructive closing of books of account and kept according to the principles of accounting.
Contd
The balance sheet is one of the important statements depicting the financial strength of the company. On one hand, it shows the properties which were utilized and on the other, the sources of those properties. The balance sheet shows all the assets owned by the company and all the liabilities and claims it owes to owners and outsiders. The balance sheet is prepared on a particular date. The right hand side shows properties and assets. Usually, there is no particular sequence for showing various assets and liabilities.
SECURED LOANS
All those loans against which securities are given are shown under this category. Debentures are shown under this heading. Loans and advances from bank, subsidiary companies etc. should be shown separately and the nature of securities should also be mentioned.
UNSECURED LOANS
These are the loans and advances against which the company has not given any security. The items included here are deposits, loans and advances from subsidiary companies and loans and advances from other sources. Short-term loans from banks and other sources are also shown in this category. Short-term loans include those which are due for not more than one year on the balance sheet.
Provision for taxation Proposed dividends Provision for contingencies Provision for provident fund scheme Provision for insurance, pension and similar staff benefits schemes Other provisions
ASSETS SIDE
1. Fixed Assets
Fixed assets are those which are purchased for use over a long period. These assets are meant to increase production capacity of the business. They are not acquired for sale but are used for a considerable period of time. The balance sheet is prepared to show the financial position of the concern. These assets should be shown in such a way that balance sheet depicts true financial position of the business.
2. Investments
Investments are shown by giving their nature and mode of valuation. Investments under various sub-heads such as investments in government or trust securities, in shares, debentures and bonds, and in immovable properties are given separately in the inner column of the balance sheet.
3. Current Assets
Current assets are such assets as in the ordinary and natural course of business move onward through the various processes of production, distribution and payment of goods, until they become cash or its equivalent by which debts may be readily and immediately paid.
4. Miscellaneous Expenditure
Deferred expenditure is shown under this heading. Miscellaneous expenditure are the expenses which are not debited fully to the profit and loss account of the year in which they have been incurred. These expenses are spread over a number of years and unwritten balance is shown in the balance sheet. The items under this heading are preliminary expenses, discount allowed on issue of shares or debentures, interest paid out of capital during construction
Contd
XYZ Ltd. Trial Balance November 30, 2002 Cash Purchases Land Accounts Payable Amit, Capital Amit, Drawing Fees Earned Wages Expense Rent Expense Commission Supplies Expense Miscellaneous Expense 5,900 550 20,000 400 25,000 2,000 7,500 2,125 800 450 800 275 32,900
32,900
110
XYZ Ltd. Trial Balance November 30, 2002 Cash Purchases Land Accounts Payable Amit, Capital Amit, Drawing Fees Earned Wages Expense Rent Expense Commission Supplies Expense Miscellaneous Expense 5,900 550 20,000 400 25,000 2,000 7,500 2,125 800 450 800 275 32,900
Balance Sheet
32,900
111
XYZ Ltd. Trial Balance November 30, 2002 Cash Purchases Land Accounts Payable Amit, Capital Amit, Drawing Fees Earned Wages Expense Rent Expense Commission Supplies Expense Miscellaneous Expense 5,900 550 20,000 400 25,000 2,000 7,500 2,125 800 450 800 275 32,900
Income Statement
32,900
112
XYZ Ltd.
Balance Sheet
1. 11 12 14 15 17 18 2. 21 23 3. 31 32 Assets Cash Accounts Receivable purchases Prepaid Insurance Land Office Equipment Liabilities Accounts Payable Unearned Rent Owners Equity Amit, Capital Amit, Drawing 4. 41 5. 51 52 54 55 59
Income Statement Revenue Sales Expenses Wages Expense Rent Expense Commission Supplies Expense Miscellaneous Expense
113
Summary
Original evidence records
Accounting records
Financial Statements
Source documents
Journals
Profit and Loss Statement
Ledger
Balance Sheet
Liquidity Analyzing Activity Analyzing Debt Analyzing Profitability A Complete Ratio Analysis
Financial Ratio are used as a relative measure that facilitates the evaluation of efficiency or condition of a particular aspect of a firm's operations and status Ratio Analysis involves methods of calculating and interpreting financial ratios in order to assess a firm's performance and status
Example
(1) (2) (1)/(2)
1994
1995
$550,000 /$500,000
$550,000 /$600,000
1.10
.92
Interested Parties
4
u Creditors
u Management
FLiquidity
FActivity FDebt
FProfitability
Analyzing Liquidity
u
Liquidity refers to the solvency of the firm's overall financial position, i.e. a "liquid firm" is one that can easily meet its shortterm obligations as they come due.
Net Working Capital (NWC) NWC = Current Assets - Current Liabilities Current Ratio (CR) Current Assets CR = Current Liabilities Quick (Acid-Test) Ratio (QR) Current Assets - Inventory QR = Current Liabilities
10
Analyzing Activity
u
Activity is a more sophisticated analysis of a firm's liquidity, evaluating the speed with which certain accounts are converted into sales or cash; also measures a firm's efficiency
IT =
Inventory
Accounts Receivable Annual Sales/360 Accounts Payable Annual Purchases/360 Sales Net Fixed Assets Sales
ACP =
APP=
FAT =
TAT =
Total Assets
12
Analyzing Debt
Debt is a true "double-edged" sword as it allows for the generation of profits with the use of other people's (creditors) money, but creates claims on earnings with a higher priority than those of the firm's owners.
Measures of Debt
13
u There
are Two General Types of Debt Measures Degree of Indebtedness Ability to Service Debts
Debt Ratio (DR) Debt-Equity Ratio (DER) Times Interest Earned Ratio (TIE) Fixed Payment Coverage Ratio (FPC)
DR=
Total Liabilities
Total Assets
Long-Term Debt Stockholders Equity
DER=
FPC=
15
Analyzing Profitability
Profitability Measures assess the firm's ability to operate efficiently and are of concern to owners, creditors, and management A Common-Size Income Statement, which expresses each income statement item as a percentage of sales, allows for easy evaluation of the firms profitability relative to sales.
EPS =
P/E =
An approach that views all aspects of the firm's activities to isolate key areas of concern Comparisons are made to industry standards (crosssectional analysis)
Comparisons to the firm itself over time are also made (timeseries analysis)
Al-Noor Sugar Mills An Introduction, Common Size financial Statements By Shah Zaman
Mission Statement
To gain strength through industry leadership in the manufacturing and marketing of sugar and Lasani Wood and to have a strong presence in these product markets while retaining the options to diversify in other profitable venture. To operate ethically while maximizing profits and satisfying customers needs and stake holder's interests. To assist in the socio economic development of Pakistan especially in the rulra areas through industrial expansion and development.
Balance Sheet
2006
2007
2008
2006
2007
2008
ASSETS Cash Stores and Spares 48,694 131,668 47,597 144,818 86,463 188,578 100% 100% 98% 110% 178% 143%
trade deposits
other receivables
3,638
11,081
5,254
23,271
7,164
417
100%
100%
144%
190%
197%
4%
100%
Fixed Assets
100%
total assets
2072660
2,338,064
3775726
100%
42%
short term liabilities Trade and other payables Interest markup accrued short term borrowings Current portion of long term liab provision for income tax long term financing liabilities against assets subject to finance lease long term deposits deferred liabilities Authorized capital (20,000,000, @Rs. 10 each) Paid up capital General revenue reserve Inappropriate profit 317,484 25,138 397,809 105,139 7,460 67,470 77,568 5,035 344,112 200,000 185,703 190,000 111,468 317,484 14,446 270,955 118,679 2,089 325,000 70,840 4,874 346,074 200,000 185,703 190,000 154,659 526,054 28,416 862,684 123,808 0 237,500 28,261 4,869 492,058 200,000 185,703 190,000 366,139 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 100% 57% 68% 113% 28% 482% 91% 97% 101% 100% 100% 100% 139% 166% 113% 218% 123% 0% 315% 46% 64% 122% 100% 100% 100% 310%
2072660
2,338,04
3775726
Analysis
In reviewing the basic financial ratios, we will examine the ratios of Al-Noor Sugar Mills for the fiscal years ended September 30, 2008 and September 30, 2007. Al-Noor Sugar Mills is a growing company.
Analysis
Note that while Al-Noor Sugar Millss earnings rose from 2007 to 2008, the earnings generated per dollar of assets fell over the period. In 2007, Al-Noor Sugar Mills earned 10.22 cents before financing costs on every dollar of average assets; however, in 2008, AlNoor Sugar Mills earned only 9.63 cents before financing costs on every dollar of average assets. The ratio, return on assets, allows the analyst to compare the earnings generating ability of the company relative to the invested assets.
Profit Margin
Al-Noor Sugar Millss rise in profit margin in 2008 is due to the reduction of cost of sales rather than to the reduction of selling, general and administrative expenses relative to sales.
Analysis- ROA
It appears that Al-Noor Sugar Millss fall in ROA was driven by a fall in ATO, not a fall in PM. The firm had difficulty generating sales from the assets in 2008 relative to 2007. For every Rupee of average assets, Al-Noor Sugar Mills generated only Rs.3.21 in sales in 2008 while Al-Noor Sugar Mills generated Rs.3.92 in sales in 2007.
Analysis
These results suggest that while Al-Noor Sugar Mills did generate greater income and sales in 2008 versus 2007, it generated less income (before financing costs) per dollar of average assets, it took longer to sell its inventory, and it generated fewer sales from each dollar of plant assets.
Analysis-Return on Equity
Al-Noor Sugar Millss ROE has fallen in 2008 but it has not fallen as much as the fall in ROA. Note that Al-Noor Sugar Millss return on equity is higher than its return on assets. This is due to the use of leverage. Financing with debt and preferred stock can increase the return to common shareholders if the return on assets is greater than the cost of debt.
EXERCISE 1 LIABILITES Capital Reserves ASSETS 180 Net Fixed Assets 20 Inventories 400 150
Term Loan
Bank C/C Trade Creditors Provisions
300 Cash
200 Receivables 50 Goodwill 50 800
50
150 50 800
a. b. c. d. e. f.
What is the Net Worth : Capital + Reserve = 200 Tangible Net Worth is : Net Worth - Goodwill = 150 Outside Liabilities : TL + CC + Creditors + Provisions = 600 Net Working Capital : C A - C L = 350 - 250 = 50 Current Ratio : C A / C L = 350 / 300 = 1.17 : 1 Quick Ratio : Quick Assets / C L = 200/300 = 0.66 : 1
EXERCISE 2 LIABILITIES Capital Reserves Bank Term Loan Bank CC (Hyp) Unsec. Long T L 2005-06 300 140 320 490 150 2006-07 350 Net Fixed Assets 160 Security Electricity 280 Investments 580 Raw Materials 170 S I P 2005-06 730 30 110 150 20 2006-07 750 30 110 170 30
Creditors (RM)
Bills Payable Expenses Payable Provisions Total
120
40 20 20 1600
70 Finished Goods
80 Cash 30 Receivables 40 Loans/Advances Goodwill 1760
140
30 310 30 50 1600
170
20 240 190 50 1760
1. Tangible Net Worth for 1st Year : ( 300 + 140) - 50 = 390 2. Current Ratio for 2nd Year : (170 + 30 +170+20+ 240 + 190 ) / (580+70+80+70) 820 /800 = 1.02 3. Debt Equity Ratio for 1st Year : 320+150 / 390 = 1.21
Equity Capital
Preference Capital Term Loan Bank CC (Hyp) Sundry Creditors Total
800
300 150 50 100 1400
= 2:1
2. Tangible Net Worth : Only equity Capital i.e. = 200 3. Total Outside Liabilities / Total Tangible Net Worth : (600+400+100) / 200 = 11 : 2 4. Current Ratio will be : (300 + 150 + 50 ) / (400 + 100 ) = 1 : 1
Exercise 4. LIABILITIES Capital + Reserves P & L Credit Balance Loan From S F C Bank Overdraft Creditors 355 ASSETS Net Fixed Assets 265 1 125 128 1 7 Cash 100 Receivables 38 Stocks 26 Prepaid Expenses
Provision of Tax
Proposed Dividend
9 Intangible Assets
15
30 550
550
Q. What is the Current Ratio ?
Exercise 4. LIABILITIES
contd ASSETS 355 Net Fixed Assets 265 1 125 128 1 7 Cash 100 Receivables 38 Stocks 26 Prepaid Expenses
Capital + Reserves P & L Credit Balance Loan From S F C Bank Overdraft Creditors
Provision of Tax
Proposed Dividend
9 Intangible Assets
15
30 550
550
Q . What is the Proprietary Ratio ? Ans : (T NW / Tangible Assets) x 100 [ (362 - 30 ) / (550 30)] x 100 (332 / 520) x 100 = 64% Q . What is the Net Working Capital ? Ans : C. A - C L. = 255 - 88 = 167 Q . If Net Sales is Rs.15 Lac, then What would be the Stock Turnover Ratio in Times ? Ans : Net Sales / Average Inventories/Stock 1500 / 128 = 12 times approximately
Exercise 4.
contd
LIABILITIES
Capital + Reserves 355
ASSETS
Net Fixed Assets 265
7 Cash
100 Receivables
1
125
Bank Overdraft
Creditors
38 Stocks
26 Prepaid Expenses
128
1
Provision of Tax
Proposed Dividend
9 Intangible Assets
15 550
30
550
Q. What is the Debtors Velocity Ratio ? If the sales are Rs. 15 Lac. Ans : ( Average Debtors / Net Sales) x 12 = (125 / 1500) x 12 = 1 month Q. What is the Creditors Velocity Ratio if Purchases are Rs.10.5 Lac ? Ans : (Average Creditors / Purchases ) x 12 = (26 / 1050) x 12 = 0.3 months
Exercise 5. : Profit to sales is 2% and amount of profit is say Rs.5 Lac. Then What is the amount of Sales ? Answer : Net Profit Ratio = (Net Profit / Sales ) x 100 2 = (5 x100) /Sales Therefore Sales = 500/2 = Rs.250 Lac Exercise 6. A Company has Net Worth of Rs.5 Lac, Term Liabilities of Rs.10 Lac. Fixed Assets worth RS.16 Lac and Current Assets are Rs.25 Lac. There is no intangible Assets or other Non Current Assets. Calculate its Net Working Capital. Answer Total Assets = 16 + 25 = Rs. 41 Lac Total Liabilities = NW + LTL + CL = 5 + 10+ CL = 41 Lac Current Liabilities = 41 15 = 26 Lac Therefore Net Working Capital = C. A C.L = 25 26 = (- )1 Lac
Exercise 7 : Current Ratio of a concern is 1 : 1. What will be the Net Working Capital ?
Answer : It suggest that the Current Assets is equal to Current Liabilities hence the NWC would be NIL ( since NWC = C.A - C.L ) Exercise 8 : Suppose Current Ratio is 4 : 1. NWC is Rs.30,000/-. What is the amount of Current Assets ? Answer : 4a - 1a = 30,000 Therefore a = 10,000 i.e. Current Liabilities is Rs.10,000 Hence Current Assets would be 4a = 4 x 10,000 = Rs.40,000/-
Exercise 9. The amount of Term Loan installment is Rs.10000/ per month, monthly average interest on TL is Rs.5000/-. If the amount of Depreciation is Rs.30,000/- p.a. and PAT is Rs.2,70,000/-. What would be the DSCR ? DSCR = (PAT + Depr + Annual Intt.) / Annual Intt + Annual Installment = (270000 + 30000 + 60000 ) / 60000 + 120000 = 360000 / 180000 = 2
Exercise 10 : Total Liabilities of a firm is Rs.100 Lac and Current Ratio is 1.5 : 1. If Fixed Assets and Other Non Current Assets are to the tune of Rs. 70 Lac and Debt Equity Ratio being 3 : 1. What would be the Long Term Liabilities? Ans : We can easily arrive at the amount of Current Asset being Rs. 30 Lac i.e. ( Rs. 100 L - Rs. 70 L ). If the Current Ratio is 1.5 : 1, then Current Liabilities works out to be Rs. 20 Lac. That means the aggregate of Net Worth and Long Term Liabilities would be Rs. 80 Lacs. If the Debt Equity Ratio is 3 : 1 then Debt works out to be Rs. 60 Lacs and equity Rs. 20 Lacs. Therefore the Long Term Liabilities would be Rs.60 Lac.
Exercise 11 : Current Ratio is say 1.2 : 1 . Total of balance sheet being Rs.22 Lac. The amount of Fixed Assets + Non Current Assets is Rs. 10 Lac. What would be the Current Liabilities?
Ans : When Total Assets is Rs.22 Lac then Current Assets would be 22 10 i.e Rs. 12 Lac. Thus we can easily arrive at the Current Liabilities figure which should be Rs. 10 Lac
EXERCISE 12. A firm sold its stocks in CASH, in order to meet its liquidity needs. Which of the following Ratio would be affected by this? 1. 2. 3. 4. Debt Equity Ratio Current Ratio Debt Service Coverage Ratio Quick Ratio
EXERCISE 13. A company is found to be carrying a high DEBT EQUITY Ratio. To improve this, a bank may suggest the company to :
1. 2. 3. 4.
Raise long term interest free loans from friends and relatives Raise long term loans from Institutions Increase the Equity by way of Bonus Issue Issue Rights share to existing share holders.
EXERCISE 15. Under which of the following methods of depreciation on Fixed Assets, the annual amount of depreciation decreases? 1. 2. 3. 4. Written Down Value method Straight Line method Annuity method Insurance policy method
EXERCISE 16 Debt Service Coverage Ratio (DSCR) shows : 1. Excess of current assets over current liabilities 2. Number of times the value of fixed assets covers the amount of loan 3. Number of times the companys earnings cover the payment of interest and repayment of principal of long term debt 4. Effective utilisation of assets
Exercise 18. From the following financial statement calculate (i) Current Ratio (ii) Acid test Ratio (iii) Inventory Turnover (iv) Average Debt Collection Period (v) Average Creditors payment period. C.Assets Sales 1500 Inventories 125 Cost of sales 1000 Debtors 250 Gross profit 500 Cash 225 C. Liabilities Trade Creditors 200
(i) Current Ratio : 600/200 = 3 : 1 (ii) Acid Test Ratio : Debtors+Cash /Trade creditors = 475/200 = 2.4 : 1 (iii) Inventory Turnover Ratio : Cost of sales / Inventories = 1000/125 = 8 times (iv) Average Debt collection period : (Debtors/sales) x 365 = (250/1500)x365 = 61 days (v) Average Creditors payment period : (Trade Creditors/Cost of sales) x 365 (200/100) x 365 = 73 days
Q. Why this Fund Flow Statement is studied for ? 1. 2. 3. 4. It indicates the quantum of finance required It is the indicator of utilisation of Bank funds by the concern It shows the money available for repayment of loan It will indicate the provisions against various expenses
Q . In Fund Flow Statements the Liabilities are represented by ? 1. 2. 3. 4. Sources of Funds Use of Funds Deficit of sources over application All of the above.
Q . When the long term sources are more than long term uses, in the fund flow statement, it would suggest ? 1. 2. 3. 4. Increase in Current Liabilities Decrease in Working Capital Increase in NWC Decrease in NWC
Q . When the long term uses in a fund flow statement are more than the long term sources, then it would mean ? 1. 2. 3. 4. Reduction in the NWC Reduction in the Working Capital Gap Reduction in Working Capital All of the above
Q. How many broader categories are there for the Sources of funds, in the Fund Flow Statement ?
1. 2. 3. 4. Only One, Source of Funds Two, Long Term and Short Term Sources Three , Long, Medium and Short term sources None of the above.
Cost accounting
Introduction
COST - MEANING
Cost means the amount of expenditure ( actual or notional) incurred on, or attributable to, a given thing.
ELEMENTS OF
COST
COST
MATERIALS
OTHER
LABOUR EXPENSES
INDIRECT
DIRECT
INDIRECT DIRECT
INDIRECT
DIRECT
OVERHEADS
DOH
FOH
AOH
SOH
MATERIAL: The substance from which the finished product is made is known as material. Direct material is one which can be directly or easily identified in the product Eg: Timber in furniture, Cloth in dress, etc. Indirect material is one which cannot be easily identified in the product.
LABOUR: The human effort required to convert the materials into finished product is called labour.
DIRECT LABOUR is one which can be conveniently identified or attributed wholly to a particular job, product or process. Eg:wages paid to carpenter, fees paid to tailor,etc. INDIRECT LABOUR is one which cannot be conveniently identified or attributed wholly to a particular job, product or process.
OTHER EXPENSES are those expenses other than materials and labour.
DIRECT EXPENSES are those expenses which can be directly allocated to particular job, process or product. Eg : Excise duty, royalty, special hire charges,etc.
INDIRECT EXPENSES are those expenses which cannot be directly allocated to particular job, process or product.
COST SHEET
DIRECT MATERIAL DIRECT LABOUR DIRECT EXPENSES
SALES
FACTORY COST +ADMINISTRATIVE OVERHEADS COST OF PRODUCTION +OPENING STOCK OF FINISHED GOODS -CLOSING STOCK OF FINISHED GOODS COST OF GOODS SOLD +SELL. & DIST. OVERHEADS COST OF SALES +PROFIT
SALES
METHODS OF COSTING
JOB COSTING CONTRACT COSTING BATCH COSTING PROCESS COSTING UNIT COSTING OPERATING COSTING OPERATION COSTING MULTIPLE COSTING
TYPES OF COSTING
UNIFORM COSTING MARGINAL COSTING STANDARD COSTING HISTORICAL COSTING DIRECT COSTING ABSORBTION COSTING
Learning Objectives
To describe as to how the concepts of fixed and variable costs are used in C-V-P analysis To segregate semi-variable expenses in C-V-P analysis To identify the limiting assumptions of C-V-P analysis To work out the breakeven analysis, contribution analysis and margin of safety To understand how to draw a breakeven chart To compute breakeven point
To assist planning and decision making, management should know not only the budgeted profit, but also:
the output and sales level at which there would neither profit nor loss (break-even point) the amount by which actual sales can fall below the budgeted sales level, without a loss being incurred (the margin of safety)
Contribution is a term meaning making a contribution towards covering fixed costs and making a profit
Before a firm can make a profit in any period, it must first of all cover its fixed costs. Breakeven is where total sales revenue for a period just covers fixed costs, leaving neither profit nor loss. For every unit sold in excess of the breakeven point, profit will increase by the amount of the contribution per unit.
Cost-volume- profit analysis can answer a number of analytical questions. Some of the questions are as follows: 1. What is the breakeven revenue of an organization? 2. How much revenue does an organization need to achieve a budgeted profit? 3. What level of price change affects the achievement of budgeted profit? 4. What is the effect of cost changes on the profitability of an operation?
Revenue required at $. 200 Selling Price per unit to earn Operating Income of Variable Fixed cost cost per unit 2,000 100 120 140 2,500 100 120 140 3,000 100 120 140 0 4,000 5,000 6,667 5,000 6,250 8,333 6,000 7,500 10,000 1,000 6,000 7,500 10,000 7,000 8,750 11,667 8,000 10,000 13,333 1,500 7,000 8,750 11,667 8,000 10,000 13,333 9,000 11,250 15,000 2,000 8,000 10,000 13,333 9,000 11,250 15,000 10,000 12,500 16,667
From the above example, one can immediately see the revenue that needs to be generated to reach a particular operating income level, given alternative levels of fixed costs and variable costs per unit. For example, revenue of $. 6,000 (30 units @ $. 200 each) is required to earn an operating income of $. 1,000 if fixed cost is $. 2,000 and variable cost per unit is $. 100. You can also use this to assess what revenue the company needs to breakeven (earn operating income of Re. 0) if, for example, one of the following changes takes place: The booth rental at the ABC convention raises to $. 3,000 (thus increasing fixed cost to $. 3,000) The software suppliers raise their price to $. 140 per unit (thus increasing variable costs to $. 140)
The margin of safety is sales quantity minus breakeven quantity. It is expressed in units. The margin of safety answers the what if questions, e.g., if budgeted revenue are above breakeven and start dropping, how far can they fall below budget before the breakeven point is reached? Such a fall could be due to competitors better product, poorly executed marketing programs and so on
This fundamental marginal cost equation plays a vital role in profit projection and has a wider application in managerial decision-making problems.
The difference between sales and marginal cost, i.e. contribution, will bear a relation to sales and the ratio of contribution to sales remains constant at all levels. This is profit volume or P/V ratio. Thus, P/V Ratio (or C/S Ratio) =Contribution (c) (4) Sales (s) It is expressed in terms of percentage, i.e. P/V ratio is equal to (C/S) x 100.
1. Contribution
Contribution is the difference between sales and marginal or variable costs. It contributes toward fixed cost and profit. The concept of contribution helps in deciding breakeven point, profitability of products, departments etc. to perform the following activities: Selecting product mix or sales mix for profit maximization
Fixing selling prices under different circumstances such as trade depression, export sales, price discrimination etc.
Contributio n
Changes in contribution
Changes in sales
Change in profit
Sales
Change in sales
A fundamental property of marginal costing system is that P/V ratio remains constant at different levels of activity. A change in fixed cost does not affect P/V ratio. The concept of P/V ratio helps in determining the following: Breakeven point Profit at any volume of sales Sales volume required to earn a desired quantum of profit Profitability of products
The contribution can be increased by increasing the sales price or by reduction of variable costs. Thus, P/V ratio can be improved by the following:
Increasing selling price Reducing marginal costs by effectively utilizing men, machines, materials and other services Selling more profitable products, thereby increasing the overall P/V ratio
3. Breakeven Point
Contribution = Fixed cost a. Using Marginal Costing Equation S (sales) V (variable cost) = F (fixed cost) + P (profit) At BEP P = 0, BEP S V = F By multiplying both the sides by S and rearranging them, one gets the following equation: S BEP = F.S/S-V
Fixed cost
Thus, if sales is $. 2,000, marginal cost $. 1,200 and fixed cost $. 400, then: 400 x 2000
Breakeven point =
2000 - 1200
= $. 1000
Breakeven point =
Margin of safety Margin of safety is also (sales) x 100 % presented in ratio or percentage as follows: Sales at selected activity
A company producing a single article sells it at $. 10 each. The marginal cost of production is $. 6 each and fixed cost is $. 400 per annum. You are required to calculate the following: Profits for annual sales of 1 unit, 50 units, 100 units and 400 units P/V ratio Breakeven sales Sales to earn a profit of $. 500 Profit at sales of $. 3,000 New breakeven point if sales price is reduced by 10%
Particulars Units produced Sales (units * 10) Variable cost Contribution (sales- VC) Fixed cost Profit (Contribution FC)
Profit Volume Ratio (PVR) = Contribution/Sales * 100 = 0.4 or 40% Breakeven sales ($.) = Fixed cost / PVR = 400/ 40 * 100 = $. 1,000 Sales at BEP = Contribution at BEP/ PVR = 100 units Sales at profit $. 500 Contribution at profit $. 500 = Fixed cost + Profit = $. 900 Sales = Contribution/PVR = 900/.4 = $. 2,250 (or 225 units) Profit at sales $. 3,000 Contribution at sale $. 3,000 = Sales x P/V ratio = 3000 x 0.4 = $. 1,200 Profit = Contribution Fixed cost = $. 1200 $. 400 = $. 800 New P/V ratio = $. 9 $. 6/$. 9 = 1/3
$. 400
= $. 1,200 1/3
Rationale
Capital budgeting is based upon identifying opportunities and threats in the environment, as well as internal weaknesses, setting long term goals, formulating action plans and strategies and implementing them with online continuous monitoring and feedback from the systems.
These decisions have to fulfil the criteria of creating net positive present value for the organization.
Rationale (contd)
Thus the organization should tap and hold on to every opportunity in the next environment (both external and internal), which creates positive net present value for the shareholders. In a competitive environment, every organization has to attract, reward, and retain its shareholders and potential investors.
The Concept
Capital budgeting decisions are made when a firm is interested in acquisition and investment in long-lived or fixed assets.
For such purposes, the firm has to draw up long-range plans where realistic and flexible plans are made, taking into account the financing, production, marketing, research etc. components of the project.
Less: Depreciation = Earning before interest and tax (EBIT) Less: Interest (external debt) = Earning before tax (EBT) Less: Tax = Profit or earning after tax (PAT/EAT) Net Cash Flow to equity owners = Profit or earning after tax (PAT/EAT) + Depreciation + CAPEX (Capital expenditure)
Example:
A project will generate INR 10,000, INR 20,000, and INR 30,000 p.a. for three years after initial investment of INR 8,000. Discount rate is 10%. determine the value of net cash flows for the firms at the end of three years? Solution: value of initial investment cash outflow (0 yr.) = INR 8,000 Value of cash inflow for the 1st yr. = 10 ,000 1 10 % 1 Value of cash inflow for the 2nd yr. = 20 ,000 Value of cash inflow for the 3rd yr. = 30 ,000 Total value of cash inflows = INR 48140 1 10 % 3 Value of net cash flow = INR 48140 8000 = INR 40140
1 10 % 2
Project Categories
The two main categories are dependent and independent projects. Dependent projects: Projects are said to be dependent when acceptance/rejection of one project affects the acceptance/rejection of the other project (s). These are also called contingent projects. Contingent projects can be classified as complimentary or substitute projects. Dependent projects, as the name suggests, represent investments that cannot be accepted unless one or more projects are also accepted. For example, we may not be able to purchase and install a new piece of equipment unless we also expand the floor space of our facility. For proper evaluation, dependent projects must be lumped together as a single investment.
2. Non-discounting techniques like payback and the accounting rate of return method. 3. Discounting techniques like the net present value (NPV) method, internal rate of return (IRR) method, profitability index method and discounted payback method. 4. The concept and rationale for calculating modified NPV and modified IRR. 5. The concept of capital rationing and understand the selection of projects under capital rationing.
2. Discounting methods:
net present value (NPV) profitability index (PI) internal rate of return (IRR) discounted payback period (DBP) terminal value (TV)
A project requires a machine. The cost of the machine is INR 10,000. Its useful life is five years. Depreciation is charged annually according to the straight-line depreciation method. Determine the ARR for the machine. Solution The depreciation as per the straight-line method comes out to be 10,000/5 = INR 2,000 p.a. We find the income from the machine for each year. The income generated by the machine in five years is INR 10,000, INR 12,000, INR 15000, INR 20,000 and INR 10,000, respectively.
The firm presents aRule standard orthe a target The PB Accept/Reject for PBPB. Method of the projects is compared with the target PB. If projects PB period > target PB, then the project is rejected. If the projects PB period < target PB, then the project is accepted.
Calculation of NPV
Here, PVIF is present value interest factor of INR 1 at 10% for Year 1 through 5.
Modified NPV
The modified NPV method is also called the terminal value method. The modified NPV considers the reinvestment of cash flows generated during the project.
The above table shows the future value of reinvested cash inflows. Now, we will calculate the present value of the cumulative future value of all the cash inflows. The discount rate is the cost of capital, i.e., 10 per cent.
Here, the present value of cash inflows is INR 18,956 after reinvestment and the cash outflow is INR 10,000. This results in net present value of INR 9,726; hence, we should take up the project.
IRR for Project B is 13.28. We see that IRR is greater than the firms cost of capital of 10 per cent. In this case, we can say that both the projects can be selected. Thus, if Projects A and B are independent of each other, then both the projects should be accepted because their IRRs are greater than the cost of capital. However, if both the projects are mutually exclusive projects, then Project A should be selected since it has the greater IRR.
Capital Rationing
When firms have to take investment decisions under the constrain of fund availability it is termed as Capital rationing. Capital budgeting decision taken when amount of funds available with the firm are limited are termed as capital rationing decisions. Thus lesser the funds available with the firm, lesser will be the number of profitable investment projects accepted by the firm. Under capital rationing the usual capital budgeting decisions have to be restructured in order to maintain the profitability and value addition of the firm.
An Example
A given company has four possible feasible, profitable capital investment proposals. W, X, Y and Z require INR 90,000, INR 63,000, INR 1,35,000 and INR 53,000 of initial investment having present value of benefits as1,41,000, 97,000, 1,61,000 and 61,000, respectively. All the four projects seem lucrative enough for the company to invest. However, the company has only INR 3,00,000 available for investment purpose. How should the company go about investing this amount of INR 3,00,000?
An Example (Contd)
Solution
The table below shows the present value and the profitability index of the four projects:
An Example (Contd)
Now, we rank the given projects in descending order of PI and then decide where to allocate the money. As evident from the table, Project X has the highest PI, followed by Projects W, Y and Z in that order. The company has only INR 3,00,000 available. Projects X, W and Y occupy the top three places on the ranking and the total funds required by these projects comes out to be INR 2,88,000. Hence, Projects W, X, Y will be accepted while Project Z will be rejected.
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