Professional Documents
Culture Documents
FINANCIAL
MANAGEMENT
SECTION - D
Unit 8
Understanding Financial Statements
Unit 9
Financial Statement Analysis: Ratio Analysis
Unit 10
Break-Even Analysis
UNIT 8
UNDERSTANDING FINANCIAL
STATEMENTS
Objectives
This unit is designed to:
Develop understanding of Financial Statements
Inculcate understanding of different items of Balance Sheet
Explain concept of Income Statements and various types of
accounts prepared for income measurement.
Develop understanding about various cost classifications and
earning measurement.
Structure
8.1
Introduction
8.2
Concept of Financial Statements
8.3
Balance Sheet
8.4
Items of Balance Sheet
8.5
Income Statements
8.6
Manufacturing Account
8.7
Trading Account
8.8
Profit and Loss Account
8.9
Summary
8.10 Key Words
8.11 Self Assessment Questions
8.12 Suggested Readings
8.1
INTRODUCTION
8.2
CONCEPT OF FINANCIAL
STATEMENTS
8.3
BALANCE SHEET
8.4
i.
iii.
8.4.2
Current Liabilities:
Exhibit: 8.1
Horizontal Form of Balance Sheet
The Balance sheet of . as on
(Name of the Company)
(Date of preparation)
LIABILITIES
Yearly
ASSETS
Yearly
Figures
Figures
X1 X2
X1
X2
Share Capital
Fixed Assets
Authorized shares
Intangible Assets
of Rs. each
Goodwill
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Issued:
shares of Rs.
. each
Subscribed
shares of Rs.
. each
Rs. per share
Called up
Less: unpaid calls
Add: Forfeited
shares
Reserves and
Surplus
Capital Reserve
Capital Redemption
Reserve
Share Premium
Account
Other Reserves
Sinking Fund
Secured Loans
Secured Loans
Debentures
Loans and advances
from banks
Loans and advances
from subsidiaries
Other loans and
advances
Unsecured loans
Fixed Deposits
Unsecured Loans &
advances from banks
or subsidiaries
Current Liabilities
and Provisions
Current Liabilities
Bills Payables
Sundry creditors
Unclaimed dividends
Outstanding
liabilities
Advance income
Provisions
Provision for
Taxation
Proposed Dividends
Provision for
contingencies
Provident fund
schemes
Patents
Trade mark
Copyright
Tangible Assets
Land
Buildings
Leaseholds
Railway sidings
Plant and
Machinery
Furniture and
fittings
Livestocks
Vehicles
Investments
Investment in
Government or
Trust securities
Investments in
shares and
debentures or
bonds
Immovable
properties
Capital of
partnership firms
Current Assets,
Loans and
Advances
Current Assets
Interest Accrued
on Investments
Stores and spare
parts
Loose tools
Stock in trade
Sundry debtors
Bank balance
Cash balance
Loans and
Advances
Advance and loans
to subsidiaries
Bills of Exchange
Balances with
custom, port trust
Miscellaneous
Expenditure
Preliminary
expenses
Expenses or
commission or
brokerage on issue
of shares and
debentures
Discount allowed
on the issue of
shares and
debentures
Other similar
nature items
Profit and Loss
a/c (Loss Balance)
Exhibit: 8.2
Vertical Form of Balance Sheet
The Balance sheet of . ...as on ..
(Name of the Company)
(Date of preparation)
Particulars
Schedule
Yearly Figures
Previous
Current
SOURCES OF FUNDS
Shareholders Fund
Share Capital
A
.
.
Reserves and Surplus
B
.
.
Loan Funds
Secured loans
C
.
.
Unsecured Loans
D
.
.
APPLICATION OF
FUNDS
Fixed Assets
Investments
Currents Assets, Loans
and Advances
Less : Current Liabilities
and provisions
Net Current Assets
Miscellaneous
Expenditure
E
F
G
H
I
.
.
.
.
.
.
___________
.
.
.
.
.
.
___________
Activity 8.2
Do you remember the items of current assets and current liabilities
nature? List them:
Current Assets
Current Liabilities
.
..
.
..
.
..
.
..
Exhibit 8.3
Suzlon Energy Limited
Balance Sheet as at March 31, 2009
Particulars
Schedule
(Rs. In Crores)
As at 31st March
2009
2008
SOURCES OF FUNDS
Shareholders Fund
Share Capital
Employee Stock Options
Outstanding
Reserves and Surplus
A
B
299.66
8.25
299.39
10.22
6177.41
6485.32
6638.05
6947.66
refund
Loan Funds
Secured loans
Unsecured Loans
D
E
95.00
--
4006.23
3323.25
7329.48
672.26
2412.48
3084.74
13,909.80
10,032.40
APPLICATION OF FUNDS
Fixed Assets (including intangible
assets)
Gross Block
Less Depreciation / amortization
Net block
Capital work in progress
915.83
364.33
551.50
286.97
838.47
779.20
266.98
512.22
134.64
646.86
Investments
7127.80
4919.48
175.40
93.64
399.26
H
1383.62
4745.14
212.40
2698.75
9039.91
1483.23
3306.59
875.50
1289.15
6954.47
3301.77
369.27
3671.04
5368.87
13,909.80
1946.39
635.66
2582.05
4372.42
10,032.40
The Schedules referred to above and notes to accounts form an integral part of the balance
sheet.
8.5
INCOME STATEMENTS
8.6
MANUFACTURING ACCOUNT
8.8
TRADING ACCOUNT
8.9
Activity 8.3
Recall at least two examples of following expenses.
Operating Expenses
.
.
Selling & Distribution Exp .
.
Administrative Expenses
.
.
Financial Expenses
.
.
Non Operating Expenses
.
.
Activity 8.4
Find out following things from Suzlons Energy Financial Statements
for the years 2009 and 2008.
Reserves and Surplus
.
.
Net Profit
.
.
Loan Funds
.
.
Financial Charge
.
.
Profits transferred to
Balance sheet
.
.
Dr.
Particulars
Cr.
Amount in
Rs.
Particulars
Amount in
Rs.
Raw Materials
Xx
Work in process
Xx
Xxxx
By Cost of Finished
Goods c/d
By Closing Stock
To Purchases of
Raw Materials
To Manufacturing Wages
Xxxx
Raw Materials
xx
Xxxx
Work in process
xx
To Carriage inwards
Xxxx
Xxxx
To Opening stock
To Balance b/d
To Net Loss b/d
To General Reserve
To Dividends
To Balance c/f
xxxx
xxxx
-------------
Xxxx
By Sales
xxxx
Xxxx
Xxxx
By Closing Stock
By Gross Loss c/d
(If Dr. >Cr)
xxxx
xxxx
------------Xxxx
Xxxx
Xxxx
Xxxx
Xxxx
Xxxx
------------Xxxx
Xxxx
Xxxx
Xxxx
-------------
------------xxxx
xxxx
xxxx
By Balance b/d
------------xxxx
xxxx
-------------
xxxx
xxxx
xxxx
xxxx
xxxx
xxxx
xxxx
xxxx
Particulars
INCOME
Sales [See Schedule O, Note 2]
Other Income
EXPENDITURES
Cost of Goods sold
Operating and other expenses
Employee remuneration and benefits
Financial charges
Depreciation/ Amortization
Schedule
2009
2008
7235.58
177.14
7412.72
6926.01
125.61
7051.62
4543.85
1803.47
199.07
433.97
99.16
7079.52
333.20
4226.99
854.47
139.34
139.61
96.21
5446.62
1605.00
873.16
285.21
(539.96)
---(81.76)
11.07
(469.27)
2268.44
________
1799.17
1319.79
155.00
(89.00)
0.13
(23.49)
11.44
1265.71
1477.86
_______
2743.57
-0.13
(1.05)
149.69
-25.44
-________
1800.09
=======
300.00
________
2268.44
=======
3.13
8.70
3.13
8.47
K
L
M
N
F
APPROPRIATIONS
Proposed dividend on equity shares
Residual dividend of previous
Tax on dividends [see schedule O
Note13(g)]
Transfer to general reserve
Surplus carried to balance sheet
Earnings (loss) per share (in Rs) [see
schedule O, note B]
- Basic [Nominal value of share
Rs. 2/-]
- Diluted [Nominal value of share
Rs. 2/-]
Significant accounting policies and notes to
accounts
The schedules referred to above and the notes to accounts form an integral part of the profit and loss
account.
8.11 SUMMARY
In this unit we have discussed financial statements in detail. The
financial statements are logically compiled and consistently
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8.13
UNIT 9
FINANCIAL STATEMENT
ANALYSIS: RATIO ANALYSIS
Objectives
The objective of this unit is to familiarize you with
Concept of financial statement analysis
The techniques of financial analysis
Ratio analysis
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9.1
INTRODUCTION
9.2
iv.
Ratio Analysis
v.
Funds Flow analysis
vi.
Cash Flow Analysis
vii.
Break Even Analysis
viii. Value added Analysis
Ratio analysis is most useful and popularly used among the various
techniques. This will be discussed in detail in the forthcoming
discussion. Whereas another popular technique of financial i.e. break
even analysis will be discussed in the next chapter.
Activity 9.1
Do you know why financial statement analysis is done? List your
arguments below.
9.3
RATIO ANALYSIS
ii.
Types of Ratios
A number of ratios can be calculated from the accounting data. It can
be categorized into various classes according to financial activity or
functions evaluated. Various financial authorities have classified
ratios from different angles. Some classify ratios according to the
statements with which they are related like balance sheet ratios,
income statement ratios and combined ratios. Bombay stock
exchange classifies ratios into two categories i.e. primary and
secondary ratios. The classification according to the requirements of
users of ratios is most commonly used in accounting literatures. As
stated earlier that the users of accounting ratios are short and long
term creditors, investors, management and employees. The short term
creditors are concerned with liquidity of the firm while long term
creditors are interested in profitability and long term solvency. In the
same way management has to protect interest of all concerned. They
also monitor growth and efficiency in business. The investors or
owners are interested in returns and profitability. According to needs
of users, ratios are broadly categorized in four categories:
Liquidity ratios
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9.4
Activity Ratios
Solvency or leverage Ratios
Profitability Ratios
LIQUIDITY RATIOS:
The liquidity of a firm is measured by its ability to meet its short term
obligations as and when they become due. It is referred to the ease
with which a firm can spare cash to pay its bills and dues of short
time. The liquidity ratios are good indicators of cash flow problems
in a business. Quantum and quality of current assets held by business
determines the liquidity position. The quantum here is related with
amount and structure of current assets held by business. The quality
here means its ability to meet cash requirements. The ratios used to
gauge liquidity of firm are known as liquidity ratios.
The important ratios measuring liquidity are current ratio, quick ratio,
absolute liquidity ratio and defensive interval ratio.
i. Current Ratio
It is one of the most widely used ratios. It establishes
relationship between current assets and current liabilities. It
measures firms ability to meet current liabilities from fund
arising out of realization from current assets. This ratio has
great significance in assessing working capital position. Net
working capital is excess of current assets over current
liabilities. This ratio is calculated by dividing current assets
by current liabilities.
Current Ratio =
Current Assets
Current Liabilities
Quick Assets
Current Liabilities
The ideal absolute liquidity ratio is taken as 1:2 or 0.5:1. The ratio
greater than this means idle cash funds lying in the firm.
9.5
ACTIVITY RATIOS
Where,
Cost of goods sold = Net Sales Gross Profit
Average Inventory = Opening Inventory + Closing Inventory
2
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Illustration
9.1
797000
-197000
600000
Gross Profit
Less : Operating Expenses
Selling and Dist Expenses
Administration Expenses
Operating Profit
Add: Non operating Income
Interest on Bonds, Dividends etc
Less : Non operating expenses
Loss on sale of bonds
Net Profit
400000
38000
202000
240000
160000
12000
172000
-4000
168000
350000
254000
604000
428600
243200
185400
368600
50000
604000
Solution
Liquidity Ratios:
Current Ratio =
Current Assets
428600
Current Liabilities
1.8 : 1
243200
Quick Assets
221600
Current Liabilities
243200
=
.91 : 1
To calculate quick ratio, quick assets are to be calculated. Quick
assets are calculated by deducting stock and payments in advance
from the current assets. Only one item of current assets is left after
deducting these two items i.e. receivables. The quick ratio is also near
to ideal ratio thus this ratio also proves good liquidity and supports
the results of current ratio.
It is surprising to note that the firm does not have cash or cash
equivalent assets thus absolute liquidity ratio cannot be calculated.
This is an indication that despite above two favorable liquidity ratios,
the firms ability to meet immediate payments is not good. Thus
serious attention is needed to raise absolute liquidity. A little
deficiency in the both of these ratios may be caused by firms
inability to hold cash balances.
Activity Ratios:
Inventory Turnover Ratio:
Collection period
Sales
Debtors
=
1000000
221600
=
4.5 times
=
12 months in a Year
Debtors Turnover ratio
= Aprox. 2.67 months
12
3.5
12
4.5
Both of these turnover ratios are towards higher range. In the absence
of ideal ratios the holding of inventories approximately for 3 to 4
months is not considered optimal. However it depends on the nature
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Creditors
=
200000
=
Payment period
Purchases
Creditors
=
638500
200000
=
3.19 times
Creditors +bills payables
180000+20000
=
12 months in a Year
Creditors Turnover ratio
= Aprrox 3.75 months
12
3.19
9.6
SOLVENCY RATIOS:
Debt
Equity
It is a ratio between long term debt and net worth. A ratio of
2:1 is considered good as it is the norm accepted by financial
institutions.
Ratio based on External Equities =
External Equities
Internal Equities
This ratio is another variant of debt equity. It is a relationship
between total outsiders fund and insiders fund. Outsiders
fund or external equities include both short term and long
term debt i.e. debt plus current liabilities. A ratio of 1:1 may
be taken as good.
In calculating all the above ratios, confusions may arise for
inclusion of preference shares in equity or debt. In fact it
depends on the purpose for which this ratio is calculated. If it
is calculated for showing impact of debt on magnification of
equity share holders earnings, preference shares are included
in debt. While if it is calculated to show firms riskiness
(financial risk), it is included in equity. This diverse treatment
may pose problems for external analysts thus normally
preference shares are included in equity if it is issued for more
than 12 years periods other wise included in debt.
Interpretation:
The acceptable levels of ratios have already been discussed
along with variants of ratios. But these norms cannot be
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Proprietary Ratio:
This ratio is also known as net worth to total assets.
Proprietors fund is also known as owners equity or net worth.
It establishes relationship between net worth and total assets
and shows the proportion of total assets financed by owners
fund.
Proprietary Ratio=
Owners Equity
Total Tangible Assets
Interpretation:
This ratio indicates the strength of financial foundation of a
concern and used to study the capitalization of a business
concern. If this ratio is higher, the long term solvency of a
business concern is treated as good and it indicates that the
external fund providers have got enough support from
owners. If the ratio is low, the external fund providers may
not feel safe with regards to solvency.
iii. Fixed Assets to Long Term Funds Ratio:
This ratio is calculated to find the proportion of long term
funds used to finance the fixed assets. An organization may
finance its assets i.e. Fixed Assets and Current Assets either
by short term funds or long term funds popularly known as
current and non current liabilities. Normally it is said to be
risky if fixed assets are invested by using short term funds. As
short term funds or currents liabilities become due for
payment within an operating cycle. Their use for financing
fixed assets may result in default in payment of current
liabilities. Therefore this ratio is used to examine firms risk
caused by financing strategy. This ratio is calculated by
applying this formula:
FA to LF =
Fixed Assets
Long Term Funds
Interpretation:
If this ratio is greater than one, this means that firm is risky as
fixed assets are financed by short term funds and firm is
following aggressive financing policy. On the same time firm
is able to attain advantages of aggressive financing in the
form of increased returns. If the ratio is lower than one, it is
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EBITDA
Annual Interest Charges
If annual obligations caused by debt include interest and
principal installments, the fixed charge coverage ratio is
calculated by applying the following formula
Fixed charge coverage:
EBITDA
Interest+ Principal Repayment
1 - Tax Rate
Interpretation:
As discussed earlier that these ratios measures how many
times, fixed charges have been covered by earnings available
for their payment. A higher ratio is desirable and is an
indication of a good debt serving ability of the firm. But a
very high ratio may not be good as it may be due to
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Illustration 9.2
Following is the balance sheet of Delta company as on 31st
December,09
Figures in Lacs
Liabilities
Equity Share Capital @100 each
7% Pref. Sh. Capital @100 each
General Reserves
P&L A/c (Current Year)
6% Mortgage loan
Sundry Creditors
Rs.
10
2
2
2
8
2
Assets
Land &Building
Plant & Machinery
Furniture
Investments
Stock
Debtors
Bills receivable
Cash and Bank
Preliminary Expenses
26
Examine the firms long term solvency.
Solution:
Debt Equity Ratio:
Rs.
6
8
2
2
3
1
1
2
1
26
DSCR
EBIT*/Interest Charges
476000/48000 = 9.91 times
*See calculation done in illustration 9.4.
It can be seen from above ratios that firm has sound solvency position
and sufficient earnings to meet annual obligations of debt though
degree of leverages used by organization are too less. It is advised
that firm may plan to invest additional opportunities by employing
debt.
9.7
PROFITABILITY RATIOS:
Gross Profit
Sales
Operating profits
Sales
OR
EBIT
Sales
Operating Costs
Sales
=
GP/Sales *100
=
400000/1000000*100 =40%
Net Profit Ratio
=
NP/Sales *100
=
168000/1000000*100=16.8%
Operating Profit Ratio =
Operating Profit/Sales *100
=
160000/1000000*100=16%
Operating Cost Ratio =
OC/Sales *100
=
840000/1000000*100=84%
Operating Cost= Cost of Goods sold+ Selling& Dist.+
Administration
840000
=600000+38000+202000
Expenses Ratios:
Cost of Goods Sold =600000/1000000*100
Selling and Dist. Exp. =38000/1000000*100
Administrative Exp. =202000/1000000*100
=60%
=3.8%
=20.2%
is known as net assets. The long term liabilities include long term
debts and net worth. The net worth is also known as shareholders
fund or equity. The funds of long term debt providers and share
holders are their investments in firm. A relationship between profit
figures available for distribution to them and their investment is
established in profitability ratios related to investment.
i. Return on Investment (ROI):
This ratio measures profits earned on each rupee of
investment. Traditionally, this ratio was calculated by
dividing net profits after tax by total assets. For inter firm
comparison use of net profits after tax may give misleading
results as it is affected by capital structure. Two firms with
equal earnings before interests and taxes (EBIT) but having
different debt equity proportion (capital structure) may
possibly have different profit after taxes. It will be possible
as interests are deducted before charging taxes on income.
Thus firm gets advantage of tax shield. The difference in
amount of interest of two firms results in difference in tax
shield which ultimately creates difference in profit after tax
(PAT). Therefore use of PAT for inter firm comparison is
not advisable. The following example will make it more
clear.
Firm A
Firm B
Capital Structure (total 10 lacs)
All Equity
3:7
EBIT
100000
100000
Less Interest
No Interest
30000
(Debt is available on 10% interest)
Taxable income
100000
70000
Less Tax 50%
50000
35000
Profit after tax (PAT)
50000
35000
In this example firm A and B both are having equal earnings
but capital structure of both the firm is different. Firm A is
all equity firm and has no debt capital. While firm B has Rs.
300000 debt raised at 10% rate of interest and remaining Rs.
700000 through equity. The PAT of both the firms is
different. If this PAT is used as numerator and investment
of 10 lacs as denominator to calculate ROI, it will
conceptually be unsound. On the one hand numerator of
firm Bs ROI does not takes into account tax saving of Rs.
15000 (Tax A-B Firm) on the other it includes debt
investment amount of rupees 3 lacs in denominator, the
required return (interest) which has already being paid and
deducted. Moreover the capital structure decision depends
on acumen of financial manager of the firm. It has nothing
to do with the firms operating efficiency. Similarly taxes
are non controllable and firms opportunities for availing tax
incentives differ. Thus use of EBIT for calculating ROI
would be more prudence.
ROI =
EBIT
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Total Assets*
*Total assets include total tangible assets but if something
has been paid to acquire intangible assets then those may
also be included.
ii. Return on Net Capital Employed:
It is also known as return on net assets. It is calculated by
dividing EBIT by net capital employed. It is calculated to
see return available on long term capital (equity and debt).
ROCE=
EBIT
Net Capital Employed*
*Net Capital employed is sum of long term debts and net
worth. Alternatively, it can be calculated as fixed assets plus
current assets minus current liabilities.
iii. Return on Equity:
It is also known as return on net worth. It measures
profitability of owners investment. The profit available to
equity share holders will be after payment to debt,
preference share and taxes are earnings of. An organization
not having preference share capital, the profit after taxes
will be available as earnings to equity share holders.
ROE = Profit after Interest Tax and Pref. Share Dividend
Equity Shareholders Fund
The equity shareholders fund is also known as net worth or
proprietors fund. It includes paid up value of equity share
capital, share premium and reserves and surplus less
accumulated losses.
Interpretation
The above three ratios shows how efficiently the internal as
well as external resources of internal as well as external
fund providers have been utilized. It is desired that firm
should attain satisfactory return on all kinds of investments.
The ROE represents the extent to which earnings
expectations of shareholders have been met. The dividends
to be distributed to the equity shareholders are not fixed; but
earnings of the firm after distribution to all outside parties
are considered to be earnings of equity shareholders it may
fully or partially be distributed or retained. Each firm has
main objective to maximize the return of equity
shareholders.
Illustration 9.4
Using the data of Delta company find the Profitability ratios related
to Investment.
Solution
The data set of Delta Company gives only information about profits
transferred to balance sheet in the current year i.e. Rs. 200000.
The EBIT may be derived by taking certain assumptions.
Like firms corporate tax rate is say 50% and the net profits shown in
balance sheet are after preference share dividends.
The EBIT figure may be calculated
Balance sheet figure of profit (current year)
200000
Dividends distributed on Pref. Shares
14000
Net profit after tax before Pref. Div. 214000
Adjusting tax effect of 50%
+214000
Profits before taxes
428000
Add Interest Charges 6% of 8 Lacks
48000
EBIT
476000
Return on Investments:
EBIT/Total Tangible Assets
476000/2500000=.19
Return on Net Capital Employed:
Return on Equity:
Activity 9.4
Identify the current assets and current liabilities of Delta Ltd. Also
calculate liquidity ratios of Delta Ltd.
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9.8
DuPont Chart
OR
Illustration 9.5
You have been asked by the management of the Y. M Ltd. To project
a trading and profit and loss account and the Balance Sheet on the
basis of the following estimated figures and ratios for the next
financial year ending on March 31, 1995.
Ratio of Gross Profit
20%
Stock Turnover Ratio
5 times
Average Debt Collection Period
3 months
Creditors velocity
3 months
Current Ratio
2
Proprietary Ratio(FA to Capital Employed)
75%
Capital Gearing Ratio
30%
(Pref. Shares &Debentures to CE)
Net profit to Issued Capital (Equity)
10%
General Reserve and P&L to issued capital (equity) 25%
Preference share capital to Debentures
2
Cost of goods sold consists of 50% for materials
Gross Profit Rs. 6,25,000.
Show working notes clearly and also comment on financial
position of Y. M. Ltd.
Solution
Sales : Gross Profit ratio
=
`
20% =
20 Sales=
Sales =
Sales =
Cost of goods sold
=
=
=
Materials
=
=
Direct Expenses
=
(GP/Sales) *100
(625000/Sales) *100
625000
625000/20
3125000
Sales Gross Profit
3125000-625000
2500000
50% of 2500000
1250000
Cost of Goods Sold Materials
=
Current Assets
Stock
Stock Turnover ratio
5
Stock
Stock
Debtors
Debtors collection
3
Debtors
Current Assets
2500000-1250000 = 1250000
=
=
=
=
=
=
=
=
=
Current Liabilities
Current Ratio =
2
=
Current Liab. =
=
Creditors
Creditors velocity
=
3
=
Creditors
=
Bank overdraft
=
=
=
Fixed Assets FA to LF
As long term fund employed
FA/LF= 75/100
=
Working Capital
=
640625
=
Fixed Assets =
Capital Employed (LF)=
=
=
Capital gearing 30% =
30% =
Pref. Sh Cap. +Debenture
Equity Shareholder Fund
CA/CL
1281250/CL
1281250/2
640625
(Creditors/Credit purchases)*12
(creditors/1250000 (material)*12
312500
Current Liabilities-Creditors
640625-312500
328125
=
75%
=
FA+WC (Working Capital)
WC/LF=25/100
CA-CL
1281250-640625
(640625/25)*100
FA+CA-CL
1921875+1281250-640625
2562500
Pref. Sh. Cap. +Debenture/ CE
Pref. Sh. Cap. +Deb./ 2562500
=
30%*2562500
=
768750
=CE-(Pref. Sh . Cap. + Debenture)
=
2562500-768750
=
1793750
=
768750 *2/3 = 512500
=
768750 *1/3 = 256250
9.9
SUMMARY
This unit has explained the analysis of financial statement for the
purpose of drawing significant conclusions by establishing
relationship between various data given in financial reports i.e.
balance sheet and the profit and loss account. Financial analysis is
used to identify the financial strengths and weaknesses of the firm.
There are various techniques which can be used for the purpose of
financial analysis. The ratio analysis is one of the most widely used
techniques of financial analysis. This technique is used to examine an
organization from the angle of liquidity, solvency, activity and
profitability. Liquidity and solvency position of business exhibits
firms ability to meet its short term and long term obligations. While
the activity and profitability ratio exhibits firms efficiency in
operations. The firms earning power can also be examined by using
DuPont chart.
9.12
2007
700000
800000
220000
1720000
2008
700000
680000
240000
1620000
900000
920000
1100000
520000
1620000
1120000
400000
1520000
260000
540000
800000
820000
1720000
300000
520000
820000
700000
1620000
2400000
960000
500000
24000
Hint: CR: 2.02 and 1.85, QR: .65 and.49 , Debt Equity=D/E .14 and
.17, EAT=EBIT-Int*(1-Tax Rate) =208900 and 248800, EPS= 2.98
and 3.55
Answers of activities:
(9.3)
(9.4)
CL
= S. Creditors = 2
CR
=CA/CL =7/2 =3.5
QR
=QA/CL 4/2 =2
ALR =Cash/CL 1/2 =.5
(9.5) CA-100000, CL-40000
10.1
10.2
10.3
10.4
10.5
10.6
10.7
10.8
10.9
10.10
Introduction
Marginal Costing
Behavior of Costs
Cost Volume Profit Analysis
Break Even Analysis
Break Even Chart
Summary
Key Words
Self Assessment Questions
Suggested Readings
10.1 INTRODUCTION
As we know that profit is one of the most important factors to
measure performance of a business firm. Thus the profit planning is a
fundamental part of management function. This will be possible
when information about cost i.e. fixed and variable both and selling
prices are available in the hands of management. The profit planning
is possible by establishing relationship between cost, volume and
profit (CVP) in break even analysis through marginal costing
concepts. The CVP relationship studies impact of change in volume
and cost based on behavior of cost on profit. The marginal costing is
a technique of costing which classifies costs according to their
behavior and enables establishing CVP relationships. Therefore it is
essential to understand the concept of marginal costing and the
behavior of various types of costs used therein.
Marginal Cost
Economists define marginal cost as costs incurred to produce an
additional unit of a product. But from cost accountants point of view
total costs obtained by adding prime cost and variable costs is
marginal cost. Since costs can be divided into fixed costs and variable
costs and fixed costs remain the same, hence, marginal cost tends to
be equal to total variable expenses and sometimes marginal cost is
described as variable cost.
Total cost = variable cost per unit quantity + fixed cost.
According to ICMA (London), Marginal cost is the amount, at any
given volume of output by which aggregate costs are changed, if the
volume output is increased or decreased by one unit. In simple
words, addition or changes in the total cost due to change in output
by one unit is known as marginal cost. For example, for producing
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400 units the total cost is Rs. 4000. If production is increased to 401
units, total cost is Rs. 4009. Thus, marginal cost = Rs. 4009 4000 =
Rs. 9
Marginal Costing
As it has been defined that marginal costing provides sound basis of
profit planning and decision making. The marginal costing
framework is based on cost behavior of various elements of cost. It
classifies total costs of production into two broad categories i.e. fixed
cost and variable cost on the basis of their variability. It may be
defined as ascertainment of marginal cost and of the effect on profit
of changes in volume or type or output by differentiating between
fixed and variable costs. In other words, it is a technique of
differentiating between variable and fixed costs primarily concerns
with (i) ascertainment of marginal costs; and (ii) determination of
cost volume profit relationships.
Features of Marginal Costing
Level of output
Level of output
constant and variable costs that vary in direct proportion are total
variable costs.
C
o
s
t
s
Output
Concave
Convex
Level of output
Semi variable cost contains feature of fixed and variable cost. This
cost is a combination of fixed and variable costs. It remains fixed up
to a particular point and then changes with the change in production
or consumption. It changes with the change in the volume of
production or sales but may not be in direct proportion to the change
in output. The examples of semi variable cost include light,
telephone, maintenance etc.
C
o
s
t
s
Variable portion
Fixed portion
Level of output
Illustration 10.1
The following particulars are presented by ABC limited.
Sales
Rs. 40,000
Fixed Cost
Rs. 12,000
Variable Cost
Rs. 20,000
If production volume is 4000 units, find contribution, P.V. Ratio,
Break Even Volume and Margin of Safety.
Solution
Contribution
=
Sales Variable costs
=
40,000-20,000 =20,000
Contribution per Unit = Selling price per unit Variable Cost per unit
= (40,000/4,000)-(20,000/4,000)
= 10-5 = 5 per unit
P/V ratio
= Contribution /Sales
= 20,000/40,000 or 5/10
= .50 or 50%
Fixed cost
Breakeven in units =
Contribution per unit
Breakeven in units
12,000
5
= 2400 units
ii.
iii.
Illustration 10.3
A company producing a single article sells it at Rs.10 each. The
marginal cost of production is Rs.6 each and fixed cost is Rs.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 Rs. 500
Profit at sales of Rs.3,000
New breakeven point if sales price is reduced by 10%
Margin of safety at sales of 400 units
Solution
Marginal Cost Statement
Particulars
Amount Amount Amount
Units produced
1
50
100
Sales (units * 10)
10
500
1000
Variable cost
6
300
600
Contribution (sales- VC)
4
200
400
Fixed cost
400
400
400
Profit (Contribution FC) -396
-200
0
Amount
400
4000
2400
1600
400
1200
In real life, most of the firms turn out many products. However, the
assumption has to be made that the sales mix remains constant. This
is defined as the relative proportion of each products sale to total
sales. It could be expressed as a ratio such as 2:4:6, or as a percentage
as 20%, 40%, 60%. The calculation of breakeven point in a multiproduct firm follows the same pattern as in a single product firm. The
numerator will be the same fixed costs but the denominator now will
be weighted average contribution margin. The following formula may
be used for calculating BEP in case of multiple products.
Fixed costs
Breakeven point
(in units)
=
Weighted average contribution margin per unit
One should always remember that weights are assigned in proportion
to the relative sales of all products. Here, it will be the contribution
margin of each product multiplied by its quantity.
Breakeven Point in Sales Revenue
Here also, numerator is the same fixed costs. The denominator now
will be weighted average contribution margin ratio which is also
called weighted average P/V ratio. The modified formula is as
follows:
Fixed cost
B.E. point (in revenue) =
Weighted average P/V ratio
Illustration 10.4
Budget of Prima limited includes following data for the year 2009.
Fixed Overhears
3,00,000
Contribution Per Unit
Product A
Rs. 6/Product B
Rs. 2.5/Product C
Rs. 4/Sales forecasts
Product A
24,000 Units @Rs. 12.5/Product B
1,00,000 Units @Rs. 7/Product C
50,000Units @ Rs. 10/Calculate Composite Breakeven Point.
Solution
Profit Volume Ratio
Product A
=
6/12.5 = .48
Product B
=
2.5/7 = .357
Product C
=
4/10 =.4
Composite PV
Sales in Rs. Sales Mix PVR Composite PVR
Product A
3,00,000
.20
*.48 .96
Product B
7,00,000
.467 *.357 .1667
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Product C
5,00,000
.333
*.4
.1333
.396
Fixed cost
B.E. point (in revenue) =
Weighted average P/V ratio
30,000
B.E. point (in revenue) =
.369
=7,57,575
Activity 10.3
Find out P/V ratio and profit if sales are Rs. 20,000, fixed costs are
Rs. 4,000 and Break even sale is Rs. 10,000.
TR LINE
C
O
S
T
S
R
E
V
E
N
U
E
S
Profit Zone
Loss Zone
TC LINE
BEP
T
F
C
T
V
C
Angle of
Incidence
OUTPUT
Figure 10.7 Contribution Break Even Chart
Profit
Profit
in Rs.
BEP
F
Loss
I
X
E
D
C
O
S
Limitations ofT Breakeven Chart
Sales Line
10.7 SUMMARY
This chapter has explained about cost volume profit analysis (CVP).
CVP facilitates management in profit planning. Marginal costing
provides sound basis for profit planning and break even analysis is
most popular version of CVP analysis. Break even is a benchmark
point. Operations below it are loss making. If a firm operates above
this benchmark level it earns profit. But at this benchmark firm
neither earns profit nor incurs loss. Graphical presentation of break
Dr. Hanuman Praasd, Associate Professor, FMS, MLSU, Udaipur,
Email: drhanu73@yahoo.com
Page 78
10.9
10.10
SUGGESTED READINGS