Question 1a: Discuss the importance of ratio analysis for inter-firm and intrafirm comparisons including

circumstances responsible for its limitations .If any

Question 1b: Why do you understand by the term 'pay-out ratio'? What factors are taken into
consideration while determining pay-out ratio? Should a company follow a fixed pay-outratio policy?
Discuss fully.

1(a) Ratio analysis is the orderly usage of ratios in order to interpret the financial statements in a way to
determine the strength and weaknesses of a company and its past performance , present financial
position can also be found. From the Ratio analysis conclusions can be found regarding different aspects
such as the health of the firm financially, operating efficiency and profitability of the task. Ratio analysis
is priceless in creating an inter-firm evaluation as it helps to draw a comparison between the units
within the same business or the ones following the same accounting methods. It also offers the required
and important financial information for all the similar firms with a sight to refining their efficiency and
profitability. Ratio analysis also helps in the intrafirm comparisons by giving the data required. An
interfirm comparison provides the relative position of the firms and also provides the pertinent data for
the assessment of the performance of different subdivisions. If the comparison demonstrates a
variance, then the probable reasons of variations can be recognized and if the results are not positive,
then some action will be started to immediately bring them in line with the results. Nevertheless, in
spite of it being such a beneficial tool, it is not completely void of its limitations. A single ratio is of very
limited use, therefore it is important to have a comparative study. The base that is used for ratio
analysis, that is, financial statements have their own limitations. Also, they only consider the
quantitative characteristics of business transactions even though there are numerous other non-
quantitative aspects such as the quality of work force which affects profitability and productivity to a
large extent. The ratio analysis as a tool is also limited by the variations in accounting
procedures/policies.

1(b)Pay-out Ratio refers to the amount of earnings paid out in dividends to shareholders. Investors can
utilize the payout ratio to find out what the companies are doing with their incomes. This can be
considered as; A very little payout ratio shows that a firm is primarily engrossed on retaining its incomes
rather than paying out dividends. The pay-out ratio also specifies how well the wages support the
dividend payment. The lower the ratio, the more protected the dividend since smaller dividends are
easier to payout than larger dividends. One of the major factors to be taken into account in determining
the payout ratio is the dividend policy of the company. A relatively young, quick-growing companies are
usually fixated on reinvesting their earnings in order to grow the business. By itself, they generally show
low (sometimes zero) dividend payout ratios. At the same time, bigger and more established firms can
generally afford to return a higher percentage of their earnings to the stockholders. Yet another factor
to be taken into account is the type of industry in which the firm is operating. As an example, the
banking sector typically pays out a huge amount of its profits. Some other sectors like real estate
investment trusts are required by law to allocate a certain percentage of their earnings. Funds
requirement of the company and its available liquidity is another factor to be taken into account while
determining the pay-out. Some companies chooses to follow a fixed payout ratio policy irrespective of
the incomes made. This is a welcome policy from the standpoint of the investors. But, the firm should
contemplate numerous other significant factors such as its requirement for future investment and
growth, cash requirements and debt obligations.

Q.8. (a) What is Master Budget? How it is different from Cash Budget?

(b) What are the various methods of inventory valuation? Explain the effect of inventory valuation
methods on profit during inflation. What are the provisions of Accounting Standard 2 (AS-2) with regards
to inventory valuation?

ANS.8. The master budget is the combination of all lower-level budgets made by a firms's numerous
functional expanses, and it comprises of budgeted financial statements, a cash forecast, and a financing
plan.

Cash Budget

Cash budget is a financial budget organized to compute the budgeted cash inflows and outflows
throughout a period and the budgeted cash balance at the end of a time period. Cash budget aids the
managers to determine all unnecessary idle cash or cash scarcity that is anticipated during the period.
Such data assistances the managers to plan accordingly. For example, if any cash shortage is predicted in
the future, the managers plan to alternate the credit policy or to borrow cash and if a lot of idle cash is
expected, they plan to finance it or to use it for the settlement of loan.

All businesses have to maintain a small level of cash to allow them to carry on business activities. The
managers of a firm need to find that safe level. The cash budget is then made by taking into account,
that small level of cash. Thus, if a cash scarcity is expected during a period, a plan is made to borrow
money.

Cash budget is a constituent of master budget.

There are three foundational approaches to valuing inventory that are permitted by Generally accepted
accounting principles (GAAP) -
(a) First-in, First-out (FIFO): Under FIFO, the cost of the goods sold is founded upon the cost of material
bought initially in the time period, while the cost of inventory is built upon the cost of material bought
later in the time. This outcomes in inventory being valued close to present replacement cost. During
periods of inflation, the use of FIFO will result in the lowest approximation of cost of goods sold among
the three approaches, and the highest net income.
(b) Last-in, First-out (LIFO): Under LIFO, the cost of goods sold is founded upon the cost of material
bought at the end of a time period, which results in costs that closely estimates current costs. The
inventory, however, is valued based on the cost of the materials bought priorly in the year. During
periods of inflation, the use of LIFO gives an outcome in the uppermost estimate of cost of goods sold
between the three approaches, and the lowest net income.
(c) Weighted Average: In the weighted average approach, the inventory and the cost of goods sold are
founded upon the average cost of every units bought during the time period.

Without inflation, all of the three inventory valuation methods will give similar results. However, the
prices incline to increase over the years, and the business's costing methods affect the valuation ratios.

The FIFO method assumes that the first component in inventory is the first until its sold. FIFO provides a
more precise value for ending inventory on the balance sheet. But at the same time, FIFO increases
net income and increased net income can create a surge in the taxes owed.

The LIFO method tells that the last item entering inventory is the first sold. During periods of inflation
LIFO displays ending inventory on the balance sheet much lesser than what the inventory is actually
worth at present prices, this means lower net income due to a higher cost of goods sold.

The average cost method gives a weighted average of all components available for sale during
the accounting period and then uses that average cost to find the value of COGS and ending inventory.

Provisions of Accounting Standard 2 (AS-2) in regards to inventory valuation are as follows: -

1.Inventory

As per the description of inventory or closing stock it includes the following things;

1. Items that are there for sale in the normal flow of business I.e finished stock of goods.

2. Work-in-progress (WIP) for any such sale. Goods that are not yet ended or ready to sale.

3. Raw material that are not even issued for production while evaluation of closing stock or
inventory. It also includes consumable stores item.

2.Applicability

AS-2 is not applicable in the following cases.

1. Work in process in the construction contract business including, directly connected to service
contract.

2. Any financial instruments that as stock in trade which includes shares, debentures, bonds etc.

3. Other inventories like livestock, agricultural product and forest product, natural gases and
mineral oils etc.

4. Work in progress in the business of banking, consulting and service business. That means it
includes incomplete consulting service, merchant banking service and medical service in
process.

4. All of above are not cover under the definition of inventory/ closing stock that's why this
accounting standard if not become applicable to above cases or in the course of business.

3.Cost of inventory
Valuation of inventory is made at cost or market/ net realizable value whichever is lower There are three
types of cost that are included in the inventory which are given below

Purchase cost

Invoice price at which goods are purchased

Duties and taxes paid

Freight inward

Any other expenditure directly relating to acquiring goods

Above cost should be reduced by following

Duties and taxes received or receivable back from the tax authority

Trade discount

Rebate

Duty drawback

Cost of conversion
After the purchase the raw materials or goods during the production time whatever cost is paid or
payable will be regarded as conversion cost. That includes direct labour, material and other direct
expense and allocation of fixed and variable production overhead incurred for conversion or raw
material in to finished goods. These are the things that should be considered for conversion cost of the
inventory.

Fixed production overhead this includes indirect cost of production that remains constant without
linking to numbers of elements produced.

Variable overhead indirect cost of production that depends on the number of elements which are
made .

Other cost
This includes all other expenditure acquired to bring inventory or stock in the current location and
condition.

Methods of valuation of inventory

There are number of method for the evaluation of the inventory in the standard course of business
which includes FIFO, LIFO, weighted average cost, standard cost and retail method. But essentially the
following two methods are usually used

1. FIFO (first in first out)

2. Weighted average
Net realisable value
Net realisable value implies the typical selling price of the goods less estimated expenditure to sale such
goods. It is projected value based on consistent evidence at time of evaluation. Approximation of net
realisable value can be done on the following basis.

1. If the completed goods in which raw material and supply is used is sold at their cost or
above their cost, then the estimated realisable value of raw material and supplies is
considered more than cost.

2. If the completed goods in which raw material and supply are used is sold at below cost then
the estimated realisable value of raw material or supply is equal to replacement price of raw
material or supply.

Disclosure in financial statement

Evaluation of inventory is completed on assessment of cost and net realisable value whichever is lesser.
This value must be revealed in the financial statements. The rest of the things relating to inventory to be
unveiled in accordance with Accounting Standard-1 are accounting policies accepted in calculating
inventory, cost formula and classification of inventory such as finished goods, raw material & WIP and
stores and spares etc.

Ques:

Trading and Profit and Loss Account for the year ended 31st Mar 2004
Particulars (Dr) Amount Particulars (Cr) Amount
To opening stock 150000 By cash sales 61000
To purchases 369000 By credit sales 780000
To wages 180000
To salaries 150000 By closing stock 140000
To Sunday office expenses 108750
To Gross Profit c/d 23250

Total 981000 Total 981000

To Discount allowed 7000 By Gross Profit b/d 23250

To Bad debts w/o 8000 By Discount received 4000
To Depreciation By misc income 2000

Furniture @5% 2000 By net loss c/d 26750

Machinery@10% 34500 36500
To interest on loan from 4500
Dass

Total 58500 Total 58500

 Balance Sheet as at 31st Mar 2004
Liabilities Amount Assets Amount
OWNERS CAPITAL FIXED ASSETS
Opening balance 516000 Machinery 345000
Less drawings 40000 Less depreciation 34500
Less loss 26750 449250 Net block 310500
Furniture 40000
UNSECURED LOAN Less depreciation 2000
Dass @9% 100000 Net block 38000 348500
INVESTMENTS
CURRENT LIABLITIES AND CURRENT ASSETS, LOANS AND
PROVISIONS ADVANCES
Sundry Creditors 125000 Stock 140000
Wages outstanding 20000 Sundry debtors 193000
Interest on loan 4500 Bank 16000
Unexpired insurance 1250

TOTAL 698750 TOTAL 698750

Notes: Opening balance of owners capital= stock+debtors+bank+machinery+furniture-sundry creditors

=150000+181000+5000+250000+40000-11000

=516000