VI SEM BCOM STUDY MATERIAL MANAGEMENT ACCOUNTING. Prepared By SREEJA NAIR PADMA NANDANAN

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1 NEW HORIZON COLLEGE MARATHALLI, BANGALORE (Affiliated to Bangalore University) A Recipient of Prestigious Rajyotsava State Award 2012 conferred by the Government of Karnataka VI SEM BCOM STUDY MATERIAL MANAGEMENT ACCOUNTING Prepared By SREEJA NAIR PADMA NANDANAN Ring Road, Bellandur Post, Near Marathalli, Bangalore Tel : Fax : principalnhc.edu@gmail.com Web :

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3 INDEX SR.NO TITLE` PG.NO 1 Management accounting and analysis of financial statements Ratio analysis Funds flow statement Cash flow statement Budgetary control Management reporting Question paper Books for reference 71 2

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5 CHAPTER -1 MANAGEMENT ACCOUNTING AND ANALYSIS OF FINANCIAL STATEMENTS Management Accounting- management accounting is comprised of two words Management and Accounting. It is the study of managerial aspect of accounting. The emphasis of management accounting is to redesign accounting in such a way that it is helpful to the management in formation of policy, control of execution and appreciation of effectiveness. MEANING AND CONCEPT OF FINANCIAL ANALYSIS. The term financial analysis also known as analysis and interpretation of financial statements. It is a process of determining financial strengths and weaknesses of the firm by establishing strategic relationship between the items of the balancesheet and profit and loss account. TYPES OF FINACIAL ANALYSIS On the basis of material used on the basis of methods of Operation External internal horizontal vertical Analysis analysis analysis analysis 1. On the basis of material used : According to material used, financial analysis can be of two types: (a) External analysis : This analysis is done by outsiders who do not have access to the detailed internal accounting records of the business firm, these outsiders include investors creditors and government agenciesand the general public.for financial analysis these external parties depend on the published financial statements. (b)internal Analysis: this analysis is conducted by persons who have access to internal accounting records of a business firm is known as internal analysis. Such an analysis can therefore,be performed by executives and employees of the organization. 2. On the basis of methods of operation: According to this method financial analysis can be of two types 4

6 (a) Horizontal analysis: it refers to the comparison of financial data of a company for several years. The figures of this type of analysis are presented horizontally over a number of columns. This type of analysis is also known as Dynamic analysis as it is based on the data from year to year rather than data of any one year. Comparative statements and trend percentages are two tools employed in horizontal analysis. (b)vertical analysis: It refers to the study of relationship of the various items in the financial statements of one accounting period. It is also known as Static Analysis. Common size and financial ratios are the two tools employed in vertical analysis. COMPARATIVE STATEMENTS: The comparative financial statements are statements of the financial position at different periods.the elements of financial position are shown in a comparative form so as to give an idea of financial position of two or more periods. COMMON SIZE STATEMENTS: The common size statements, balance sheet and income statement are shown in analytical percentages. The figures are shown as percentages of total assets, total liabilities and total sales. the total assets are taken as 100 and different assets are expressed as percentage of total. TREND ANALYSIS: The financial statements may be analysed by computing trends of series of information. Here one year is taken as base year. Generally, the first or the last is taken as base year and figures of the base year are taken as 100. Formulae = current year/ base year x

7 PROBLEMS: Q.1 prepare comparative statements from the following data: Income statement 2002( in lakhs) 2003(lakhs) Net sales Cost of goods sold Administration exps Selling exps Net profit Balance sheets 2002( in lakhs) 2003(lakhs) Equity capital % preference share capital Reserves % debentures Bills payable Creditors Tax payable total

8 Comparative income statement for the year ended 2002 and 2003 Particulars 2002(lakhs) 2003(lakhs) Increase or decrease Percentage increase or decrease Net sales Less: COGS Gross profit (a) Operating expenses: Admin exps Selling exps Total operating expenses (b) Operating profit (a-b) Net profit

9 Comparative balance sheet statement for the year ended 2002 and 2003 Assets 2002(lakhs) 2003(lakhs) Increase or decrease Current Assets Percentage increase or decrease Cash Stock Total current assets Fixed assets Land Buildings Plant Furniture Total fixed assets Total assets Liabilities and capital Current liability Bills payable Creditors Tax payable Total current liability Debentures Total liability Equity share capital % preference share capital Reserves Total

10 Interpretation: 1. the comparative income statement reveals that there has been increase in net sales of 25% while the cost of goods sold has increased disproportionately by 50% thereby resulting in decrease of gross profit of 25%. Although the operating expenses have remained constant, there has been decrease in net profit of 29.41%. The needs to look into causes of increase in cost of goods sold and control the same. 2. the comparative balance sheet of the company reveals that during 2003 there has been decrease in fixed assets of 20 lakhs i.e 2.5% while long term liabilities to outsiders have increased by 50 lakhs. i.e. 50%. There has also been increase of 45 lakhs. i.e. 22.5% in reserves of the company. The company has used long term resources to finance additional working capital. 240 lakhs in 2003i.e 48%. There has been sufficient increase in balance of cash as well as stock. On the other hand current liabilities have increased by only 125lahks, i.e 41.67%. This further confirms that the company has raised long term finances even for current assets resulting in to a improvement in liquidity position of the company. Q.2 The balance sheet of S and K Co. are given as follows: Liabilities S & Co K &Co. Preference share capital Equity share capital Reserves and surplus Long term loans Bills payable Creditors Outstanding expenses Proposed dividend Total Assets Land and building Plant and machinery Temporary investment Inventories

11 Book-debts Prepaid expenses Cash and bank balances Total Compare the financial position of the companies with the help of common size balance sheet. Common size balance as on Dec 31, 2002 Particulars S & Co. K &Co. Fixed assets: Amount % Amount % Land and building Plant and machinery Total fixed assets Current assets : Temporary investment Book debts Inventories Prepaid expenses Cash and bank balance Total current assets Total assets Share capital and reserves Preference share capital Equity capital Reserves and surplus Total capital and reserves Long term loans Current liabilities Bills payable Creditors Outstanding expenses Proposed dividend Total current liability Total liability

12 Interpretation: 1.An analysis pattern of financing both the companies shows that K &Co. is more traditionally financed as compared to S & Co. the former company has depended more on its own funds as shown by balancesheet. Out of the total investments, 71.53% of the funds are proprietor s fund and outsiders fund account only for 28.47%. In S&Co proprietors funds are 64.83% while outsiders share is which shows that this company has depended more on outsiders funds. 2. Both the companies are suffering from inadequacy of working capital. The percentage of current liabilities is more than the percentage of current assets in both the companies. The first company is suffering more from working capital position than the second company because current liabilities are more current assets by 3.44% and this percentage is in the case of second company 3. Both the companies face working capital problem and immediate steps should be taken to issue more capital or raise long term loans to raise working capital position. Q.3 Q.3 calculate the trend percentages from the following figures of X ltd taking 1998 as base. Year Sales Stock Profit before tax Year Sales Trend % Stock Trend % Trend amount amount Profit before tax %

13 Interpretation 1. The sales have increased in all the years upto The percentages in 2002 are 200 as compared to 100 in The increase in sales is satisfactory. 2. The figures of stock has also increased from 1998 to The increase in stocks is more in 2001 and 2002 as compared to earlier years. 3. Profit before tax has substantially increased. In five years time it has increased double. 12

14 CHAPTER 2 RATIO ANALYSIS Meaning of ratio A ratio is a simple arithmetical expression of the relationship of one number to another. Use and significance of ratio analysis Managerial Uses of Ratio Analysis a) Helps in decision-making. Financial statements are prepared primarily for decision-making. But the information provided in financial statements is not an end in itself and no meaningful conclusion can be drawn from these statements alone. Ratio analysis helps in making decisions from the information provided in these financial statements. b) Helps in financial forecasting and planning. Ratio Analysis is of much help in financial forecasting and p1anning.planning is looking ahead and the ratios calculated for a number of years work as a guide for the future. Meaningful conclusions can be drawn for future from these ratios. Thus, ratio analysis helps in forecasting and planning. c) Helps in communicating. The financial strength and weakness of a firm are Communicated in a more easy and understandable manner by the use of ratios. Thus, ratios help in communication and enhance the value of the financial statements. d) Helps in co-ordination. Ratios even help in co-ordination which is of utmost importance in effective business management. Better communication of efficiency and weakness of an enterprise results in better co-ordination in the enterprise. e) Helps in control. Ratio analysis even helps in making effective control of the business. Standard ratios can based upon proforma financial statements and variances or deviations, if any, can be found by comparing the actuals with the standards so as to take a corrective action at the right time. (b) Utility to shareholders An investor in the company will like to assess the financial position of the Concern where he is going to invest. Ratio analysis will be useful to the investor in making up his mind whether present financial position of the concern warrants further investment or not. (c) Utility to creditors. The creditors or suppliers extend short-term credit to the concern. They are interested to know whether financial position of the concern warrants their payments at a specified time or not. Current and acid-test ratios will give an idea about the current financial position of the Concern. 13

15 (d) Utility to Employees The employees are also interested in the financial position of the concern especially profitability. Their wage increases and amount of fringe benefits are related to the volume of profits earned by the concern. Various profitability ratios relating to gross profit, operating profit, net profit, etc. enable employees to put forward their viewpoint for the increase of wages and other benefits. (e)utility to Government Government is interested to know the overall strength of the industry. Various financial statements published by the industrial units are used to calculate ratios for determining short-term, long-term and overall financia1 position of the concerns. Government may base its future policies on the basis of these ratios. Limitations of ratio analysis 1. Limited Use of a Single Ratio. A single ratio, usually, does not convey much of a sense. To make a better interpretation a number of ratios have to be calculated which is likely to confuse the analyst than help 2. Lack of adequate standards. There are no well accepted standards or rules of thumb for all ratios which can be accepted as norms. It renders interpretation of the ratios difficult. 3. Inherent Limitations of accounting. Like financial statements, ratios also suffer from the inherent weakness of accounting records such as their historical nature. Ratios of the past are not necessarily true indicators of the future. 4. Change of Accounting Procedure. Change in accounting procedure by a firm often makes ratio analysis misleading. 5. Window Dressing. Financial statements can easily be window dressed to present a better picture of its financial and profitability position to outsiders. Hence, one has to be very careful in making a decision from ratios calculated from such financial statements. But it may be very difficult for an outsider to know about the window dressing made by a firm. 6. Personal bias. Ratios are only means of financial analysis and not an end in itself. Ratios have to be interpreted and different people may interpret the same ratio in different ways. 14

16 Illustration 1. Calculate Quick Ratio from the information given below LIABILITIES. ASSETS. Bank Loan 1,00,000 Stock-in-trade 1,35,00Ö Sundry 1,50,000 Sundry Debtors 72,000 70,000 Creditors Less provision for doubtful debts 2,000 Bills Payable 20,000 Cash-in-hand 15,000 Creditors for 10,000 Cash at Bank 1,10,000 expenses 6% Debentures 2,00,000 Short-term 1,50,000 Investments Plant and 3,00,000 Machinery Prepaid 5,000 insurance Solution: Quick ratio = Quick assets/current liabilities Quick assets = 70, , ,10, ,50,000 = 3,45,000 Current liabilities = 1,50, , ,000 = 1,80,000 Quick ratio = 3,45,000/1,80,000 = Note: Bank Loan is a long-term liability. However, bank overdraft should be taken as a current liability. For calculating quick assets, stock-in-trade and prepaid insurance are excluded from current assets. Sundry debtors should be taken after deducting provision for bad and doubtful debts. Illustration 2. a) App1e Company Ltd. s Current Ratio is 5.5:1, Quick Ratio is 4 to 1. Inventory is. 30,000, what are its current liabilities? b) If Orange Company Ltd. s inventory is. 60,000, total current liabilities are. 1,20,000, Quick Ratio is 2 to 1, calculate Current Ratio. c) If Banana Company Ltd. s Current Liabilities are. 25,000, Quick Ratio is 1.5 : 1, Inventory is. 12,500, calculate current assets. 15

17 Solution: (a) Let Current Liabilities be x. Current Ratio = Current Assets: Current Liabilities = 5.5x: x Quick Ratio = Quick Assets: Current Liabilities = 4x: x Inventory = Current Assets - Quick Assets. 30,000 = 5.5x -4x.30,000 = 1.5x x =30,000/1.5 =. 20,000 So Current Liabilities are. 20,000 (b) Inventory =. 60,000 Current Liabilities - =. 1,20,000 Quick Ratio = 2 to 1, Quick Ratio = Quick Assets to Current Liabilities As Quick ratio is 2 to 1, so Quick Assets are 2 times the current liabilities. So Quick Assets = 2 x 1,20,000 = 2,40,000 Current Assets = Quick Assets + Inventory = 2,40, ,000 =. 3,00,000 Current Ratio = Current Assets : Current Liabilities = 3,00,000:1,20,000 = 2.5:1 (c) Current Liabilities =. 25,000 Quick Ratio = 1.5:1 16

18 Inventory =. 12,500 Current Assets? Quick Ratio = Quick Assets : Current Liabilities As Quick Ratio is 1.5: 1, Quick Assets should be 1.5 time the current liabilities or Quick Assets = 1.5 x 25,000 =. 37,500 Current Assets = Quick Assets + Inventory =. 37, ,500 =. 50,000 Illustration 3: Following is the Profit and Loss Account to Electro Matrix Ltd. for the year ended 31 December, 2011 To Opening Stock 1,00,000 By Sales 5,60,000 To Purchases 3,50,000 By Closing stock 1,00,000 To Wages 9000 To Gross Profit c/d 2,01,000 6,60,000 6,60,000 To Administrative 20,000 By Gross profit 2,01,000 expenses To S and D expenses 89,000 By interest on 10,000 investments To non-operating 30,000 By profit on sale of 8,000 expenses investments To net profit 80,000 2,19,000 2,19,000 You are required to calculate: 1. Gross Profit Ratio 2. Net Profit Ratio 3. Operating Ratio 4. Operating Profit Ratio 5. Administrative expenses ratio. 17

19 Solution: Gross profit ratio = Gross profit/net sales * 100 = 2,01,00/5,60,000 * 100 = 35.9% Net profit ratio = Net Profit (after tax)/ net sales * 100 = 80,000/5,60,000 * 100 = 14.3% Operating Ratio = Cost of goods sold + operating expense / Net sales Cost of goods sold = Op. Stock + Purchases + Wages Closing Stock = 1,00, ,50, ,000 1,00,000 = 3,59,000 Operating Expenses = Administrative + Selling & Distribution expenses = 20, ,000 = 1,09,000 Operating ratio = 3,59, ,09,000 / 5,60,000 * 100 = 83.6% Operating profit ratio = 100 operating ratio = % = 16.4% Administrative expense ratio = Administrative expenses / net sales * 100 = 20,000 / 5,60,000 * 100 = 3.6% 18

20 Illustration 4:The comparative balance sheets of a Ltd. company are given for the years ending December 31, 2003 and Equity Share Capital Reserve Fund 8% Debentures Mortgage Loan Sundry creditors Bills Payable Bank Overdraft Outstanding expenses Tax Liabilities 3,00,000 4,00,000 Goodwill 2,00,000 2,00,000 1,50,000 2,80,000 Land & Building 3,00,000 4,00,000 2,00,000 3,00,000 Plant & 2,50,000 3,50,000 Machinery 4,00,000 2,58,000 Patents 50,000 50,000 50,000 70,000 Stock 1,50,000 2,00,000 25,000 35,000 Sundry Debtors 40,000 60,000 Bills Receivable 10,000 15,000 Marketable Securities 15,000 20,000 Cash Balance Prepaid Expenses 1,00,000 80,000 80,000 90,000 18,000 20,000 40,000 45,000 2,000 3,000 11,90,000 14,38,000 11,90,000 14,38,000 Sales 5,00,000 6,00,000 Purchases 3,00,000 4,05,000 From the information for two years, calculate: (a) Current Ratio (b) Acid-test Ratio (c) Inventory Turnover Ratio (d) Debtors Turnover Ratio (e) Average Collection Period (f) Creditors Turnover Ratio (g) Average Payment Period (h) Working Capital Turnover Ratio 19

21 Solution Current Ratio = Current Assets/ Current Liabi1ities Current Assets (2003) =. 1,50, ,00, , , , ,000 =. 3,90,000 Current Assets (2004) =. 2,00, , , , , ,000 =. 4,38,000 Current Liabilities (2003) =. 50, , , , ,000 =. 1,40,000 Current Liabilities (2004) =. 70, , , , ,000 =. 2,00,000 Current Ratio (2003) = 3,90,000 / 1,40,000 = 2.78 Current Ratio (2004) = 4,38,000 / 2,00,000 = 2.19 Acid-Test Ratio = Liquid Assets / Current liabilities Liquid Assets (2003) =. 1,00, , , ,000 =. 2,38,000 Liquid Assets (2004) =. 80, , , ,000 =. 2,35,000 Acid-test Ratio(2003) 2,38,000 / 1,40,000 = 1.7 Acid-test Ratio (2004) 2,35,000 / 2,00,000 = Inventory Turnover Ratio = Sales / average inventory Inventory Turnover Ratio (2003 = 5,00,000 / 1,50,000 = 3.33 times Inventory Turnover Ratio (2004) = 6,00,000 / (1,50, ,00,000)/2 = 6,00,000 / 1,75,000 = 3.43 times (d) Debtors Turnover Ratio = Annual Credit Sales / Average Trade Debtors Debtors Turnover Ratio (2003) = 5,00,000 / 1,80,000 = 2.78 times 20

22 Debtors Turnover Ratio (2004) = 6,00,000 / (1,80, ,70,000)/2 = 6,00,000 / 1,75,000 = 3.43 times (e) Average Collection Period = Average trade debtors * number of working days / net sales Average Collection Period (2003) = 1,80,000 / 5,00,000 * 365 = 131 days Average Collection Period (2004) = 1,75,000 / 6,00,000 * 365 = 106 days (f) Creditors Turnover Ratio = Annual Credit Sales / Average Trade Creditors Creditors Turnover Ratio (2003) = 3,00,000 / (50, ,000) = 3,00,000 / 75,000 = 4 times Creditors Turnover Ratio (2004) = 4,05,000 / (75, ,05,000)/2 = 4,05,000 / 90,000 = 4.5 times (g) Average Payment Period = Average Trade Creditors X No. of Working Days / Annual Credit Purchases Average Payment Period (2003) = 75,000 / 3,00,000 * 365 = 91 days Average Payment Period (2004) = 90,000 / 4,05,000 * 365 = 81 days (h) Working Capital Turnover Ratio = Cost of Sales / Average Working Capital Working capital = Current Assets Current Liabilities Working Capital(2003) =. 3,90,000. 1,40,000 =. 2,50,000 Working Capital(2004) =. 4,38,000. 2,00,000 =. 2,38,000 Working Capital Turnover (2003) =. 5,00,000/. 2,50,000 = 2 times Working Capital Turnover (2004) =. 6,00,000 /(2,50,00 + 2,38,000)/2 =. 6,00,000 /2,44,000 = 2.46 times 21

23 Illustration 5: From the following information, make out a statement of proprietors funds with as many details at possible (j) Current Ratio 2.5 (ii) Liquid ratio 1.5 (iii) Proprietary Ratio (Fixed Assets / Proprietors Funds) 0.75 (iv) Working Capital 60,000 (y) Reserves and Surplus 40,000 (vi) Bank Overdraft 10,000 (vii) There is no long-term loan or fictitious assets. Solution: Calculation of Current Assets and Current Liabilities Current Ratio = 2.5 (given) Current Ratio = Current Assets / Current Liabilities Suppose, Current Liabilities are X So, Current Assets will be 2.5 X Working Capital = Current Assets Current Liabilities 60,000 = 2.5X X (as working capital =. 60,000) 60,000 = 1.5 x X = 60,000 / 1.5 = 40,000 Therefore, Current Liabilities And Current Assets = 2.5 x 40,000 =. 1,00,000 are. 40,000 Calculation of stock Liquid Ratio = Liquid assets / current liabilities = 1.5 (given) 1.5 = Quick assets / 40,000 Quick assets = 60,000 Quick assets = Current assets stock 60,000 = 1,00,000 stock Stock = 1,00,000 60,000 = 40,000 22

24 Calculation of Proprietors Funds and Fixed Assets Proprietary Ratio = 0.75:1 Fixed Assets : Proprietors funds = 0.75 : 1 If Proprietors funds are X, Fixed Assets would be 0.75 X Since, Proprietors funds + Long-term Loans + Current Liabilities = Fixed Assets + Current Assets + Fictitious Assets So, X ,000 = 0.75X + 1,00, (as long-term loans and fictitious assets are nil) or X -.75X = 1,00,000-40,000.25X = 60,000 X =. 2,40,000 Calculation of Capital Proprietors funds = Share Capital + Reserves Or. 2,40,000 = Share Capital +. 40,000 Or Share Capital =. 2,00,000 Statement of Proprietors funds Proprietors funds Share capital 2,00,000 Reserves and surplus 40,000 2,40,000 Investment of funds Fixed Assets 1,80,000 Current Assets Stock 40,000 Others 60,000 2,80,000 Less current liabilities 40,000 2,40,000 23

25 Illustration 6:From the following details, make out the balance sheet with as details as possible: 1. Stock velocity = 6 2. Capital turnover ratio = 2 3. Fixed asset turnover ratio = 4 4. Gross profit turnover ratio = 20% 5. Debtors velocity = 2 months 6. Creditors velocity = 73 days The gross profit is 60,000. Reserves and surplus is 20,000. Closing stock is 5000 more than opening stock Solution: Calculation of sales Gross profit ratio = gross profit / sales * 100 Since gross profit ratio is 20% and Gross Profit is. 60,000, Sales are: 20/100 = 60,000 / sales 20 * sales = 60,000 * 100 sales = 60,000 * 100 / 20 = 3,00,000 Calculation of Purchases Purchases = cost of goods sold + CL. Stock opening stock As gross profit ratio is 20%, cost of goods sold is 80% Cost of goods sold = 3,00,000 * 80% = 2,40,000 Purchases = 2,40, ,000 = 2,45,000 Calculation of Stocks Stock-turnover ratio = Cost of goods sold / Average stock 6 = 2,40,000 / Average stock 6 * Average stock = 2,40,000 Average stock = 40,000 Average stock = (Opening stock + closing stock)/2 40,000 = Opening stock + (Opening stock ) / 2 40,000 = (2 Opening stock )/2 24

26 80,000 = 2 Opening stock Opening stock = 75,000 Opening stock = 75,000 / 2 37,500 Closing stock = Opening stock = 37, = 42,500 Calculation of debtors Calculation of creditors Debtors velocity = debtors / credit sales * no of months 2 = debtors / 3,00,000 * 12 (sales taken as credit sales) Debtors * 12 = 3,00,000 * 2 Debtors = 3,00,000 * 2 / 12 = 50,000 Creditors velocity = Creditors / credit purchases * no of days 73 = Creditors / 2,45,000 * 365 Creditors * 365 = 2,45,000 * 73 Creditors = 2,45,000 * 73 / 365 = 49,000 Calculation of fixed assets Fixed asset turnover ratio = cost of goods sold / fixed assets 4 * fixed assets = 2,40,000 Fixed assets = 2,40,000 / 4 = 60,000 Calculation of capital Capital turnover ratio = cost of goods sold / capital 2 = 2,40,000 / capital 2 * capital = 2,40,000 capital = 2,40,000 / 2 = 1,20,000 Capital = net worth Net worth = share capital + reserves i.e. share capital + reserves = 1,20,000 Share capital = 1,20,000 reserves = 1,20,000 20,000 = 1,00,000 Balance sheet Liabilities Assets Capital 1,00,000 Fixed assets 60,000 Reserves & Surplus 20,000 Stock 42,500 25

27 Creditors 49,000 Debtors 50,000 Cash (balancing 16,500 figure) 1,69,000 1,69,000 Questions 2 Marks 1. Define the term Ratio 2. What is debt-equity ratio? 3. What is return on capital employed? 4. How do you calculate debtor s turnover ratio? 5. What is the significance of fixed interest coverage ratio? 6. What is meant by short term solvency of a company? 7. State the features of profit volume ratio? 8. State the significance of stock turnover ratio? 9. Give the meaning of leverage ratio? 10. Write a note on creditor s turnover ratio? 11. Name liquidity ratio? 12. Current ratio is 2.6:1 and a current liability is find out current assets? 13. What is P/V ratio? 8 marks:- 1. State the meaning and importance of turnover ratios? 2. What are the limitations of ratio analysis? 3. State any four accounting ratios and tell their utility? 4. Analyze the relationship between liquidity, solvency and profitability? 5. Ratios are mechanical and incomplete explain? 6. What are turnover ratios? Analyze their utilities? 15 marks:- 1. Give an explanatory note on various aspects of occurring ratios? 26

28 CHAPTER 3 FUNDS FLOW ANALYSIS The Funds Flow Statement is a statement which shows the movement of funds and is a report of the financial operations of the business undertaking. It indicates various means by which funds were obtained during a particular period and the ways in which these funds are employed. In simple words, it is a statement of sources and applications of funds. Meaning of funds Funds in a popular sense mean working capital, i.e., the excess of current assets over current liabilities. The working capital concept of funds has emerged due to the fact that total resources of business are invested partly in fixed assets in the form of fixed capital and partly kept in form of liquid or near liquid form as working capital. Meaning and concept of flow of funds The flow of funds occurs when a transaction changes on the one hand a non-current account and on the other a current account and vice-versa. Current accounts and Non- Current accounts:- Current Accounts can either be a current assets or current liabilities. Current assets are those assets which in the ordinary course of business can be or will be converted into cash with a short period of normally one accounting year. Current liabilities are those liabilities which are intended to be paid in the ordinary course of business within a short period to normally one accounting year out of the current assets or the income of the business Procedure for knowing whether a transaction results in the flow of funds or not:- 1) Analyze the transaction and find out the two accounts involved. 2) Make a journal Entry of the transaction. 3) Determine whether the accounts involved in the transaction are current or noncurrent. 4) If both the accounts involved are current i.e., either permanent assets or permanent liabilities, it still does not result in the flow of funds. 5) If the accounts involved are such that one is a current account while the other is a non-current account. i.e., current asset and permanent liability or current asset and fixed asset, or current liability and fixed asset or current liability and permanent liability then it results in the flow of funds. 27

29 Transactions showing no flow of funds:- Transactions which involve only the current accounts and hence do not result in the flow of funds: 1) Cash collected from debtors. 2) Bills receivables realized. 3) Cash paid to creditors. 4) Payment or discharge of bills payable. 5) Issued bills payable to trade creditors. 6) Received acceptances from customers. 7) Raising of short-term loans. 8) Sale of temporary or marketable investments. 9) Goods purchased for cash or credit. Transactions which involve only non-current accounts and hence do not result in the flow of funds: 1) Purchase of one new machine in exchange of two old machines 2) Purchase of building or furniture in exchange of land. 3) Conversion of debentures into shares. 4) Redemption of preference shares in exchange of debentures. 5) Transfers to general reserves, etc., 6) Payment of bonus in the form of shares. 7) Purchase of fixed assets in exchange of shares, debentures, bonus, long term loans. 8) Writing of fictitious assets. 9) Writing off of accumulated losses or discount on issue of shares, etc., Transactions which result in flow of funds:- Transactions which involve both current and non-current accounts and hence results in the flow of funds:- 1) Issue of Shares for cash at premium. 2) Issue of debentures for cash. 3) Raising of long-term loans. 4) Sale of fixed assets on cash or credit. 5) Sale of trade investments. 6) Redemption of preference shares. 7) Redemption of debentures. 28

30 8) Purchase of fixed assets on cash or credit. 9) Purchase of long-term/trade investments. 10) Payment of bonus in cash. 11) Repayment of long-term loans. 12) Issue of shares against purchase of stock-in-trade Definition of funds flow statement According to Anthony The funds flow statement describes the sources from which additional funds were derived and the use to which these sources were put. I.C.W.A defines Funds flow Statement as a Statement either prospective or retrospective, setting out the sources and applications of the funds of an enterprise. The purpose of the statement is to indicate clearly the requirement of funds and how they are proposed to be raised and efficient utilization and application for the same Advantages of funds flow statement The basic purpose of funds flow statement is to reveal the changes in the working capital on the two balance sheet dates. It also describes the sources from which additional working capital has been financed and the uses to which working capital has been applied. The significance or importance of funds flow statement can be well followed from its various used given below: 1. management of various companies are able to review their cash budget with the aid of fund flow statements 2. Helps in the evaluation of alternative finance and investments plan 3. Investors are able to measure as to how the company has utilized the funds supplied by them and its financial strengths with the aid of funds statements. 4. It serves as an effective tool to the management of economic analysis 5. It explains the relationship between the changes in the working capital and net profits. 6. Help in the planning process of a company 7. It is an effective tool in the allocation of resources 29

31 8. Helps provide explicit answers to the questions regarding liquid and solvency position of the company, distribution of dividend and whether the working capital is effectively used or not. 9. Helps the management of companies to forecast in advance the requirements of additional capital and plan its capital issue accordingly. 10. Helps in determining how the profits of a company have been invested: whether invested in fixed assets or in inventories or ploughed back. Limitations of funds flow statement Funds flow statement has many advantages; however it has some disadvantages or limitations also. Let s look at some of the limitations of funds flow statement 1. Funds flow statement has to be used along with balance sheet and profit and loss account, it cannot be used alone. 2. It does not reveal the cash position of the company, and that is why company has to prepare cash flow statement in addition to funds flow statement. 3. Funds flow statement merely rearranges the data which is there in the books of account and therefore it lacks originality. In simple words it presents the data in the financial statements in systematic way and therefore many companies tend to avoid preparing funds flow statements. 4. Funds flow statement is basically historic in nature, that is it indicates what happened in the past and it does not communicate anything about the future, only estimates can be made based on the past data and therefore it cannot be used the management for taking decision related to future. 5. Procedure for preparing funds flow statement:- Funds Flow statement is prepared by comparing two balance sheets and with the help of such other information derived from the accounts as may be needed. The preparation of funds flow statement consists of two parts: 1. Statement or Schedule of Changes in Working Capital 2. Statement of Sources and Application of Funds Statement of schedule of changes in working capital 30

32 Working Capital means the excess of current assets over current liabilities. This statement is prepared with the help of current assets and current liabilities derived from the two balance sheets. WORKING CAPITAL = CURRENT ASSETS CURRENT LIABILITIES 1. An increase in current assets increases working capital. 2. A decrease in current assets decreases working capital. 3. An increase in current liabilities decreases working capital and 4. A decrease in current liabilities increases working capital. 31

33 A typical form of statement or schedule of changes in working capital is as follows: PARTICULARS Previous Current Effect on working Capital year year Increase Decrease Current Assets: Cash in hand Cash at bank Bills Receivable Sundry Debtors Temporary Investments Stocks/Inventories Prepaid Expenses Accrued Incomes Total Current Assets Current Liabilities Bills Payable Sundry Creditors Outstanding Expenses Bank Overdraft Short-term advances Dividends Payable Proposed dividends* Provision for taxation* Total Current Liabilities Working Capital (CA- CL) Net Increase or Decrease in Working Capital *May or May not be a current liability. 32

34 Example:- Prepare a statement of changes in working capital from the following balance sheets of ABC and company limited. Liabilities Assets a) CURRENT ASSETS 1) Cash Balance 2) Bills Receivable 3) Sundry Debtors 4) Stocks/Inventories 5) Prepaid Expenses 56,000 5,75,000 9,15,000 9,48,000 3,24,000 78,000 8,25,000 12,25,000 12,00,000 2,84,000 b) CURRENT LIABILITIES 1) Sundry Creditors 2) Bills Payable 3) Bank Overdraft 4) Outstanding Expenses 5) Provision for Taxation 6) Provision for Dividends 7) Reserve for Bad Debts 7,40,000 2,20,000 2,81,000 1,23,000 2,38,000 1,98,000 18,000 11,00,000 4,00,000 2,50,000 1,00,000 3,00,000 2,50,000 12,000 Balance Sheet as on December 31 33

35 Solution Statement of schedule of changes in working capital Particular Effect on working capital Increase Decrease a) CURRENT ASSETS 1) Cash Balance 2) Bills Receivable 3) Sundry Debtors 4) Stocks/Inventories 5) Prepaid Expenses 56,000 5,75,000 9,15,000 9,48,000 3,24,000 78,000 8,25,000 12,25,000 12,00,000 2,84,000 22,000 2,50,000 3,10,000 2,52,000 40,000 TOTAL 28,18,000 36,12,000 8,34,000 40,000 b) CURRENT LIABILITIES 1) Sundry Creditors 2) Bills Payable 3) Bank Overdraft 4) Outstanding Expenses 5) Provision for Taxation 6) Provision for Dividends 7) Reserve for Bad Debts 7,40,000 2,20,000 2,81,000 1,23,000 2,38,000 1,98,000 18,000 11,00,000 4,00,000 2,50,000 1,00,000 3,00,000 2,50,000 12,000 31,000 23,000 6,000 3,60,000 1,80,000 62,000 52,000 TOTAL 18,18,000 24,12,000 60,000 6,72,000 Working Capital(CA-CL) 10,00,000 12,00,000 Net increase in working capital 2,00,000 2,00,000 total 12,00,000 12,00,000 8,94,000 8,94,000 34

36 Adjusted profit and loss account Under this method, we make up an account by name Adjusted Profit and Loss a/c posting the Net Profit along with all the postings representing losses, gains, appropriations and adjustments. This account is the same as the second part of the account prepared in the direct method. We start with posting the net profit and obtain the funds from operations as a balancing figure. Whereas in the direct method we start with the funds from operations and obtain the net profit as the balancing figure. Format ADJUSTED PROFIT AND LOSS ACCOUNT Particulars Particulars To Depreciation and Depletion or amortization of fictitious and intangible assets such as Goodwill, Patents, Trade Marks, Preliminary Expenses etc. To Appropriation of Retained Earnings, such as Transfers to General Reserve, Dividend Equalisation Fund, Sinking Fund etc. To loss on sales of any non-current or fixed asset To Dividends(including interim dividend) To proposed Dividend(if not taken as current liability) To provision for taxation(if not taken as a current liability) To Closing balance(of P&L A/c) To Funds lost in Operations(balancing figure, in case credit side exceeds the debit side) By Opening Balance (of P & L A/c) By Transfers from excess provisions By Appreciation in the value of fixed assets By Dividends received By Interest on investments By Profit on sale of fixed of noncurrent assets By Funds from Operations(balancing figure in case debit side exceeds credit side) 35

37 *payment of dividend and tax will appear as an application of funds only when these items are appropriations of profits and not current liabilities. Problem From the information provided in the following profit and loss account, find out the Funds from Operations Particulars Amount Particulars Amount To Salaries and Wages To Rent and Rates To Interest To Provision for Taxes To Depreciation on Machinery To Depreciation on Furniture To Loss on Sale of Motor Car To Reserve for Bad Debts To General Reserve To Special Reserve To Goodwill Written off To Discounts on issue of Shares To Net Profit 3,42,000 1,24,000 76,000 1,32,000 87,000 39,000 91,000 42,000 1,25,000 75,000 50,000 40,000 5,25,000 By Gross Profit By Commission By Miscellaneous Income By Profit on Sale of Asset 12,50,000 2,80,000 1,54,000 64,000 16,84,000 16,84,000 36

38 Calculating Funds from Operations Particulars Amount Particulars To Provision for Taxes To Depreciation on Machinery To Depreciation on Furniture To Loss on Sale of Motor Car To General Reserve To Special Reserve To Goodwill Written off To Discounts on issue of Shares To Net Profit 1,32,000 87,000 39,000 91,000 1,25,000 75,000 50,000 40,000 5,25,000 By Funds from Operations By Profit on Sale of Asset 11,00,000 64,000 11,64,000 11,64,000 Why call it Adjusted Profit and Loss a/c method? Since we arrive at funds from operations by adjusting all the losses, incomes, appropriations and adjustments that have affected the net profit as revealed by the profit and loss account we call this the adjusted profit and loss account method. Funds flow statement: Preparation of funds flow statement While preparing the Funds Flow Statement, the Sources and Uses of Funds are to be disclosed clearly so as to highlight the Sources from where the Funds have been generated the Uses to which these Funds have been applied. This Statement is also sometimes referred to as the Sources and Applications of Funds Statement or Statement of Changes in Financial Position. Sources of Funds Items to be shown under the head Sources of Funds are as follows:- 37

39 1. Issue of Shares and Debentures for Cash: The total amount received from the Issue of Shares or Debentures is to shown under this head. But, the Issue of bonus Shares or Conversion of Debentures into Equity Shares or Shares issued to vendors shall not be shown here as there is no inflow of Cash 2. Long Term Loans: The Amount received on raising Long Term Loans is shown under this head. Short Term Loans are not to be shown here as their treatment has already been done while preparing the Statement of Changes in Working Capital. 3. Sale of Investments and other Fixed Assets: The Total Amount received on the sale of Investments and other Fixed Assets is to be shown under this head. 4. Funds from Operations: The Funds generated from Operations as computed in Step II are also required to be shown here. 5. Decrease in Working Capital: This would be the Balancing Figure of the Statement and will come from change in Working Capital Statement Application of Funds Items to be shown under Application of Funds are as follows:- 1. Purchase of Fixed Assets and Investments: The Cash Payment made for purchase of Fixed Assets and Investments is an application of Funds. But if the purchase if made by issue of shares or debentures, such a transaction will not constitute application of funds. Similarly, if the purchases are on credit, these will not constitute fund applications. 2. Redemption of Debentures, Preference Shares and Repayment of Loan:- Payment made including Premium (less: Discount) is to be taken as fund application 3. Payment of Dividend & Tax: Payment of Dividend and Tax are to be taken as applications of fund if the provisions are excluded from Current Liabilities and Current Provisions are added back to profit to determine the Funds from Operations 4. Increase in Working Capital: This would be the Balancing Figure of the Statement and will come from change in Working Capital Statement 38

40 Format Funds flow statement (for the year ended.) Sources Applications Funds from operations Issue of share capital Issue of Debentures Raising of long-term loans Receipts from partly paid shares, called up Sale of non-current(fixed) assets trading receipts such as dividends Sale of long-term investments Net Decrease in Working Capital Non Funds lost in Operations Redemption of Preference share capital Redemption of Debentures Repayment of long-term loans Purchase of non-current(fixed) assets Purchase of long-term investments Non-trading payments Payment of dividends* Payment of tax* Net Increase in working capital *payment of dividend and tax will appear as an application of funds only when these items are appropriations of profits and not current liabilities. PROBLEMS AND SOLUTIONS ON FUNDS FLOW STATEMENT:- Q 1) The following schedule shows the balance sheets in condensed form of machinery manufacturing company ltd., at the end of the year 2013:- Assets Cash and bank balance Sundry Debtors Temporary investments Prepaid Expenses Stock in trade Land and Buildings Machinery

41 Liabilities and Capital Sundry Creditors Outstanding Expenses 8% Debenture Depreciation Fund Reserve for Contingencies Profit and Loss Account Capital The following information concerning the transactions if available: % Dividend was paid in cash. 2. New machinery for was purchased but old machinery costing was sold for. 4000, accumulated depreciation was % Debentures were redeemed by purchase from open 96 for a debentures of investments were sold at book value. You are required to prepare a schedule of changes in working capital and statement showing sources and application of funds. SOLUTION:- SCHEDULE OF CHANGES IN WORKING CAPITAL Increase in working capital Decrease in working capital Current Assets: Cash and Bank Sundry Debtors Temporary Investments Prepaid Expenses Stock in trade Current liabilities: Sundry Creditors Outstanding Expenses

42 Working Capital Net Decrease in W.C FUNDS STATEMENT OF SOURCES AND APPLICATION FO SOURCES RS APPLICATIONS RS Sale of Machinery Funds from operations Net Decrease in Working Capital 4000 Redemption of Debentures Purchase of Machinery Dividend Paid Note: Investments are given to temporary so it will be taken as current assets and not sources of funds. WORKING NOTES:- 1) Machinery Account To Balance b/d To Cash (Purchase) By Cash (sale) By Accumulated depreciation (on sold machine) By Adjusted P/L A/c(loss on sale) By balance c/d Depreciation Fund A/c To Machinery A/c To Balance c/d By Balance b/d By Adjusted P/L A/c(Dep charged during the year)

43 Adjusted Profit and Loss A/c To Depreciation To Loss on sale of machinery To Dividend To Balance c/d By Balance b/d By Profit on redemption of debentures By Funds from operations Q 2) From the following condensed balance sheets of A Ltd, for the year ending 31 st December 2012 and 31 st December 2013, draw out a funds flow statement and a statement of changes in working capital for 2013 Liabilities Balance Sheet of A Ltd, 31 st 31 st Assets Dec Dec st Dec st Dec 2013 Equity Share Capital 6% Redeemable Preference share capital Capital Reserve General Reserve Profit and Loss A/c Sundry Creditors Bills payable Outstanding Expenses Proposed Dividend Provision for Taxation Nil Goodwill Land and Building Plant and Machinery Furniture Trade Investments Sundry Debtors Stocks Bills Receivable Cash in hand Cash at bank Preliminary Expenses Additional information: 42

44 Solution:- 1) A piece of land has been sold out in 2013 and the balance has been revalued, profits on sale and revaluation being transferred to capital reserve account. 2) Depreciation on Plant and Machinery has been written off in 2013 and no depreciation has been charged on land and buildings 3) A machinery was sold for (w.d.v. being ) and no furniture has been sold during the year. 4) An interim dividend of has been paid in ) 3000 have been received as Dividend on Trade investments. The proposed dividend and provision for taxation are considered as current liabilities. STATEMENT OF CHANGES IN WORKING CAPITAL Effect on working capital Increase Decrease Current Assets: Cash in hand Cash at Bank Bills Receivable Stocks Sundry Debtors Current Liabilities: Outstanding Expenses Bills payable Sundry Creditors Proposed Dividend Provision for Taxation Working Capital Net Increase in Working Capital

45 STATEMENT OF SOURCES AND APPLICATION OF FUNDS Sources Applications Issue of Share Capital Sale of Land and Building Sales of Machinery Dividend Received Funds from Operations Redemption of Preference share capital Purchase of Plant and Machinery Purchase of Trade investment Interim Dividend Paid Net increase in W.C LAND AND BUILDING A/c Balance b/d Balance Capital Reserve (profit on sale and revaluation) By cash(sale) (balancing figure) By Balance c/d PLANT AND MACHINERY A/c To Balance b/d To cash(purchase) By Cash (sale) By Adjusted P/L A/c (Loss on sale of machinery) By Depreciation By Balance c/d

46 FURNITURE A/c To Balance b/d By Depreciation(balancing figure) By balance c/d TRADE INVESTMENTS A/c To Balance b/d To Purchases(Balancing figure) By Balance c/d ADJUSTED PROFIT AND LOSS A/c Transfer to General Reserve To Depreciation on plant and machinery To Depreciation on furniture To loss on sale of machinery To Goodwill written off To preliminary expenses written off To Interim Dividend To Balance c/d By Balance b/d By Dividend on Trade Investment By funds from operations

47 Questions 2 marks:- 1. What is funds flow statement? 2. Write any two limitations of funds flow statement? 3. Name any four transactions which result in the flow of funds? 4. Write any two differences between cash flow statement and funds flow statement? 5. Indicate with reason, whether flow of funds takes place when cash is received from debtors? 6. Why do you prepare funds flow statement? 7. What do you prepare in a funds flow statement? 8. List any two advantages of funds flow statement? 8 marks:- 1. Explain the funds from operations? How it is computed? 2. Distinguish between cash flow statement and funds flow statement? 3. Is depreciation a source of funds? Explain? 4. Analyze some of the transactions that will either increase or decrease the amount of working capital? 5. How do you construct funds flow statement? 6. Explain the managerial uses of the funds flow statement? 15 marks:- 1. Give and explanatory note of sources and application of funds? 2. A funds flow statement is a better substitute for an income statement? Elucidate. 46