Objectives of Managerial Accounting Activity:

1. Providing information for decision making and planning, and participating as part of the
management team in the decision making and planning process
2. Assisting managers in the operational activities
3. Motivating managers toward the organization’s goals
4. Measuring the performance activities, subunits, managers, and other employee within
organization.
5. Assessing the organizations competitive position.

Managerial Accounting vs. Financial Accounting

Managerial Accounting Financial Accounting

S.no
1 Internally accepted
2 No mandatory rules
3 Financial and non- financial
4 Emphasis on the future
5 Internal evaluation and decisions
based on very detailed information
6 Report information for the
business entity, such as a division,
product, project, or territory
S.no
1 Externally accepted
2 Must follow externally imposed rules
3 Objective financial information
4 Historical orientation
5 Information about the firm as whole
6 Report information for the business entity
only

Common size statement:

Financial statements in which all amounts are expressed in percentage for the purpose of analysis
are called common size statements.
Uses:-
It is useful in comparing the current period with prior periods, individual businesses or one
business with industry percentages.

SOLVENCY RATIOS

 SHORT-TERM FINANCIAL POSITION

Liquidity refers to the ability of a concern to meet its current obligations as and when these
become due. The short-term obligations are met by realizing amounts from current, floating or
circulating assets. The current assets should either be liquid or near liquidity. These should be
convertible into cash for paying obligations of short-term nature. The sufficiency or insufficiency
of current assets should be assessed by comparing them with short-term (current) liabilities. The
bankers, suppliers of goods and other short-term creditors are interested in the liquidity of the
concern. They will extend credit only if they are sure that current assets are enough to pay out
the obligations.

 ANALYSIS OF LONG-TERM FINANCIAL POSITION

 The ability of a business to meet its financial obligations (debts) is called solvency.
The term ‘solvency’ refers to the ability of a concern to meet its long term obligations. The long-
term indebtedness of a firm includes debenture holders, financial institutions providing medium
and long-term loans and other creditors selling goods on installment basis. The long-term
creditors’ of a firm are primarily interested in knowing the firm’s ability to pay regularly interest
on long-term borrowings, repayment of the principal amount at the maturity and the security of
their loans. Accordingly, long-term solvency ratios indicate a firm’s ability to meet the fixed
interest and costs and repayment schedules associated with its long-term borrowings.

 CURRENT RATIO
Current ratio may be defined as the relationship between current assets and current liabilities.
This ratio is a measure of general liquidity and is most widely used to make the analysis of a
short-term financial position or liquidity of a firm. It is calculated by dividing the total of current
assets by total of the current liabilities. Thus,
Current Ratio = Current Assets
Current Liabilities
A relatively high current ratio is an indication that the firm is liquid and has the ability to pay its
current obligations in time as and when they become due. On the other hand, a relatively low
current ratio represents that the liquidity position of the firm is not good and the firm shall not be
able to pay its current liabilities in time without facing difficulties. A ratio equal or near to the
rule of thumb of 2: 1 i.e., current assets double the current liabilities is considered to be
satisfactory. The idea of having double the current assets as compared to current liabilities is to
provide for delays and losses in the realization of current assets.

 QUICK OR LIQUID RATIO

Quick Ratio, also known as Acid Test or Liquid Ratio, measures the firm’s capacity to pay off
current obligations immediately and is a more rigorous test of liquidity than the current ratio. It is
used as a complementary ratio to the current ratio.
Quick ratio may be defined as the relationship between quick/liquid assets and current or liquid
liabilities. An asset is said liquid if it can be converted into cash within a short period without
loss of value. The assets which can be included in the liquid assets are cash, bills receivable,
sundry debtors, marketable securities and short-term or temporary investments.
Inventories cannot be termed to be liquid asset because they cannot be converted into cash
immediately without a sufficient loss of value. In the same manner, prepaid expenses are
also excluded from the list of quick/liquid assets because they are not expected to be
converted into cash.
Quick Ratio = Quick Assets
Current Liabilities
Usually, a high acid test ratio is an indication that the firm is liquid and has the ability to meet its
current or liquid liabilities in time and on the other hand a low quick ratio represents that the
firm’s liquidity position is not good. As a convention quick ratio of 1: 1 is considered
satisfactory.
A firm having a high quick ratio may not have a satisfactory liquidity position if it has slow-
paying debtors. On the other hand, a firm having a low quick ratio may have a good liquidity
position if it has fast moving inventories.
A similitude of this ratio is the Absolute Liquid ratio.
Acid-test ratio. The acid-test ratio is also called the quick ratio. Quick assets are defined
as cash, marketable (or short-term) securities, and accounts receivable and notes receivable,
net of the allowances for doubtful accounts. These assets are considered to be very liquid
(easy to obtain cash from the assets) and therefore, available for immediate use to pay
obligations. The acid-test ratio is calculated by dividing quick assets by current liabilities.

Inventory turnover. The inventory turnover ratio measures the number of times the
company sells its inventory during the period. It is calculated by dividing the cost of goods
sold by average inventory. Average inventory is calculated by adding beginning inventory
and ending inventory and dividing by 2. If the company is cyclical, an average calculated on
a reasonable basis for the company's operations should be used such as monthly or
quarterly.

Earnings per share. Earnings per share (EPS) represents the net income earned for each
share of outstanding common stock. In a simple capital structure, it is calculated by dividing
net income by the number of weighted average common shares outstanding.

Dividend yield. Another indicator of how a corporation performed is the dividend yield. It
measures the return in cash dividends earned by an investor on one share of the company's
stock. It is calculated by dividing dividends paid per share by the market price of one
common share at the end of the period.
 Cash flow statement
Definition: A financial statement that reflects the inflow of revenue vs. the outflow of expenses
resulting from operating, investing and financing activities during a specific time.

Operating Activities
Operating activities shows the cash effects of revenue and expense transactions. Stated another
way, the operating activities of the statement of cash flows includes the cash effects of those
transactions reported in the income statement.

The operating profit adjusted for depreciation, profit and or losses on sale of non-current assets,
interest paid and working capital changes i.e. increases or decreases in inventories, receivables
and payables. It also includes outflows as interest paid, dividends paid and tax paid.
Some of the examples include:
Cash Inflows Cash Outflows
Collections from customers for sales of goods Payments to suppliers of merchandise and
and services services, including payments to employees

Interest received Payments of interest

Dividends received Payments of income taxes
Other receipts from operations Other expenditures relating to operations

Cost behavior refers to the manner in which a cost changes as a related activity changes.
Variable costs are costs that are vary in proportion to changes in the level of activity.
Fixed costs are costs that remain in the same in total dollar amount as the level of activity
changes.
Mixed Costs has characteristics of both a variable and a fixed cost. It is sometime called semi
variable or semi fixed costs.
Variable Cost Behavior

When activity Increases Decreases

Total Variable cost Increase Decrease proportionately
proportionately
Variable cost per unit Remains constant Remains constant

Fixed Cost Behavior

When activity Increases Decreases

Total Fixed cost Remains constant Remains constant
Fixed cost per unit Decreases Increases
Graphically, the total fixed cost looks like a straight horizontal line while the total variable
cost line slopes upward.

The graphs for the fixed cost per unit and variable cost per unit look exactly opposite the
total fixed costs and total variable costs graphs. Although total fixed costs are constant, the
fixed cost per unit changes with the number of units. The variable cost per unit is constant.

When cost behavior is discussed, an assumption must be made about operating levels. At
certain levels of activity, new machines might be needed, which results in more
depreciation, or overtime may be required of existing employees, resulting in higher per
hour direct labor costs. The definition of fixed cost and variable cost assumes the company
is operating or selling within the relevant range (the shaded area in the graphs) so additional
costs will not be incurred.
Mixed costs

Some costs, called mixed costs, have characteristics of both fixed and variable costs. For
example, a company pays a fee of $1,000 for the first 800 local phone calls in a month and
$0.10 per local call made above 800. During March, a company made 2,000 local calls. Its
phone bill will be $1,120 ($1,000 + (1,200 × $0.10)).

To analyze cost behavior when costs are mixed, the cost must be split into its fixed and
variable components. Several methods, including scatter diagrams, the high-low method,
and least-square regression, are used to identify the variable and fixed portions of a mixed
cost, which are based on the experience of the company.

Margin of Safety

In break-even analysis, margin of safety is how much output or sales level can fall before a
business reaches its break-even point (BEP). The margin of safety is the amount by which the
company's current sales exceed break-even sales.
Margin of safety = ((Budgeted sales - break-even sales) /Budgeted sales) x 100%

The margin of safety is a tool to help management understand how far sales could change
before the company would have a net loss. It is computed by subtracting break-even sales
from budgeted or forecasted sales. To state the margin of safety as a percent, the difference
is divided by budgeted sales. If the Three M's, Inc., has budgeted sales of $800,000, its
margin of safety is $50,000 ($800,000 budgeted sales – $750,000 break-even sales) or 6.7%
($50,000 ÷ $750,000), a rather low margin of safety. If, however, its budgeted sales are
$900,000, its margin of safety is $150,000 ($900,000 budgeted sales – $750,000 break-even
sales) or 20% ($150,000 ÷ $750,000). The competition, economy, and assumptions in the
sales budget must be reviewed by management to assess whether 20% is a comfortable
margin of safety.

Payback technique

The payback measures the length of time it takes a company to recover in cash its initial

investment. This concept can also be explained as the length of time it takes the project to

generate cash equal to the investment and pay the company back. It is calculated by dividing the

capital investment by the net annual cash flow. If the net annual cash flow is not expected to be

the same, the average of the net annual cash flows may be used.

The shorter the payback period, the sooner the company recovers its cash investment. Whether

a cash payback period is good or poor depends on the company's criteria for evaluating projects.

Some companies have specific guidelines for number of years, such as two years, while others

simply require the payback period to be less than the asset's useful life.

Annual rate of return method

The three previous capital budgeting methods were based on cash flows. The annual rate of

return uses accrual-based net income to calculate a project's expected profitability. The annual

rate of return is compared to the company's required rate of return. If the annual rate of return

is greater than the required rate of return, the project may be accepted. The higher the rate of

return, the higher the project would be ranked.

The annual rate of return is a percentage calculated by dividing the expected annual net income

by the average investment. Average investment is usually calculated by adding the beginning

and ending project book values and dividing by two.

Manufacturing overhead. The manufacturing overhead budget identifies the expected

variable and fixed overhead costs for the year (or other period) being budgeted.