Accounting and Financial Management (204)

Unit 1

Definition of Management Accounting -

Management accounting is the presentation of accounting information in such a way to assist
management in creation of policy and day to day operation of an undertaking."

Management accounting or managerial accounting is concerned with the provisions and use of
accounting information to managers within organizations, to provide them with the basis to make informed
business decisions that will allow them to be better equipped in their management and control functions.
In contrast to financial accountancy information, management accounting information is:primarily forward-
looking, instead of historical model based with a degree of abstraction to support decision making
generically, instead of case based,designed and intended for use by managers within the organization,
instead of being intended for use by shareholders, creditors, and public regulators;usually confidential
and used by management, instead of publicly reported;computed by reference to the needs of managers,
often using management information systems, instead of by reference to general financial accounting
standards.

Nature of Management Accounting :

Following are main points which shows the nature of management accounting:

1. No Fixed Norms Followed

In financial accounting, we follow different norms and rules for creating ledgers and other account books.
But there is no need to follow fixed norms in management accounting. Management accounting tool may
be different from one organization to other organization. Using of different tools of management
accounting is fully dependent on the persons who are using it. So, business policy of each organization
affects rules and regulation of applying management accounting.

2. Increase in Efficiency

It is the nature of management accounting that it is used for increasing in the efficiency of organization. It
scans the points of inefficiency through analysis of accounting information. By taking action for improving,
organization can increase the efficiency.

3. Supplies Information not Decisions

Management accountant supplies accounting facts and information and also provides interpretation, but
decision making is fully dependent on higher authorities. Management accounting is just guide.

4. Concerned with Forecasting

It is the temperament of management accounting that it is fully concerned with forecasting. In

management accounting, historical accounting information is analyzed through common size financial
statement, ratio analysis, fund flow analysis and accounting data tendency for knowing the probability of
next fact. So, all these things are especially useful for forecasting.

These forecasting may be related with following things

a) sales forecasting
b) production forecasting
c) earning forecasting
d) cost forecasting
Scope of Management Accounting :

Management accounting is concerned with presentation of accounting information in the most useful way
for the management. Its scope is, therefore, quite vast and includes within its fold almost all aspects of
business operations. However, the following areas can rightly be identified as falling within the ambit of
management accounting:
(i) Financial Accounting: Management accounting is mainly concerned with the rearrangement of the
information provided by financial accounting. Hence, management cannot obtain full control and
coordination of operations without a properly designed financial accounting system.
(ii) Cost Accounting: Standard costing, marginal costing, opportunity cost analysis, differential costing
and other cost techniques play a useful role in operation and control of the business undertaking.
(iii) Revaluation Accounting: This is concerned with ensuring that capital is maintained intact in real terms
and profit is calculated with this fact in mind.
(iv) Budgetary Control: This includes framing of budgets, comparison of actual performance with the
budgeted performance, computation of variances, finding of their causes, etc.
(v) Inventory Control: It includes control over inventory from the time it is acquired till its final disposal.
(vi) Statistical Methods: Graphs, charts, pictorial presentation, index numbers and other statistical
methods make the information more impressive and intelligible.
(vii) Interim Reporting: This includes preparation of monthly, quarterly, half-yearly income statements and
the related reports, cash flow and funds flow statements, scrap reports, etc.
(viii) Taxation: This includes computation of income in accordance with the tax laws, filing of returns and
making tax payments.
(ix) Office Services: This includes maintenance of proper data processing and other office management
services, reporting on best use of mechanical and electronic devices.
(x) Internal Audit: Development of a suitable internal audit system for internal control.

Differences between financial accounting and management accounting -

Management accounting is presented internally, whereas financial accounting is meant for external
stakeholders. Although financial management is of great importance to current and potential investors,
management accounting is necessary for managers to make current and future financial decisions.
Financial accounting is precise and must adhere to Generally Accepted Accounting Principles (GAAP),
but management accounting is often more of a guess or estimate, since most managers do not have time
for exact numbers when a decision needs to be made.

Cash Flow Statement

A cash flow statement, also known as statement of cash flows is a financial statement that shows how
changes in balance sheet accounts and income affect cash and cash equivalents, and breaks the
analysis down to operating, investing, and financing activities. Essentially, the cash flow statement is
concerned with the flow of cash in and out of the business. The statement captures both the current
operating results and the accompanying changes in the balance sheet. As an analytical tool, the
statement of cash flows is useful in determining the short-term viability of a company, particularly its ability
to pay bills.

Fund Flow Statement

A fund flow statement shows a company's inflows and outflows of funds. It is used to show investors,
stakeholders or owners where the company's money came from and where it went.

Importance

A fund flow statement is an important tool used in evaluating a company's performance. A fund flow
statement is a statement that shows all money coming in to a company and all money leaving a company
during an accounting period. This statement is used by investors when considering investing in a
company. The fund flow statement shows problems a company has if the cash flow is negative.

Main differences between Cash flow and Fund flow statement is given below:

1. Fund flow statement reflects the change in the working capital of a company while cash flow statement
shows the change in the cash position of the company between two balance sheet dates.

2. Funds flow statement deals with all the components of working capital while cash flow statement deals
with cash and cash equivalents.

3. Cash flow statement there is classified into operating activities, investment activities and financing
activities, but funds flow statement there is no such classification.

4. As cash flow statement is easily understood by any person but funds flow statement is little bit
complex.

5. While funds flow statement reveals the change in the working capital of a company between two
balance sheet dates while cash flow statement reveals the change in the cash position of the company
between two balance sheet dates.

6. As funds flow statement shows the change in working capital it deals with all the components of
working capital while cash flow statement deals only with cash and cash equivalents.

7. In case of funds flow statement schedule of changes in working capital is prepared while in case of
cash flow statement no such schedule is prepared.

8. While cash flow statement there is classification of cash flows as cash flow from operating activities,
cash flow from investment activities and cash flow from financing activities, but as far as funds flow
statement is concerned there is no such classification.

9. As cash flow statement is only concerned with cash related transactions it is can be easily understood
by a person who does not have accounting knowledge which is not the case with funds flow statement.

Statement of Cash Flows Explained

A cash flow statement (CFS) is one of a business’s most important financial reports. Unlike the income
statement and balance sheet, which concentrate on accounting profits, a CFS deals with the cash
component of a business. Since cash provides liquidity, it is decisive for the survival of a business.
A CFS records a firm’s all cash-based transactions during a particular accounting period. In other
words, it mirrors the availability and usage of business funds to reveal its current state of liquidity. Thus,
it explains how well a corporate unit manages its resources (cash and cash equivalents) to ensure
uninterrupted business functioning and generate profits.
Further, it is essential for corporate planning in the short run as it gauges a company’s capacity to meet
its short-term obligations. Besides, it is also crucial for business forecasting, determining liquidity status,
dividend decision-making, borrowing in case of monetary shortage, and wisely allocating surplus funds.
Besides, it discloses vital information regarding the solvency of a business. As opposed to other financial
statements, it is more difficult to manipulate and, therefore, more reliable. Hence it is widely sought after
by the stakeholders of a business.
The cash flows in a business from three significant activities: operating, investing, and financing. Thus, a
cash statement presents the cash generated and spent on all these activities individually and collectively.
Following are the basic steps to preparing a CFS:
1. Take the opening balance of cash and bank available at the beginning of the respective
accounting year.
2. Add to it all the incoming cash from various sources like cash sale of goods or services, proceeds
 from the sale of assets or investments, the funds acquired by the issue of shares or through bank
loans, etc.
3. Subtract the cash outflows from payments like salaries, dividends, rent, insurance, loan
repayment, stock repurchase, taxes, etc. Also, deduct the money invested in business projects or
offered as a loan.
Then the net amount so evaluated is the cash in hand remaining with the company.

Cash Flow Statement Format

The CFS is subdivided into three categories:

#1 – Cash flow from Operating Activities

Cash Flow from Operating Activities includes cash used in or generated from the daily core business
activities. The operational activities are the principal revenue-generating or expense-incurring activities of
the company. It includes selling goods or services and payment towards expenses like salaries, taxes,
etc.
Some operating activities that result in cash inflows and outflows are listed below.
Cash flow from Operating Activities

Cash Inflows Cash Outflows

Sales revenue received from customers Rent paid

The commission, brokerage, royalty, and other

Cash payment to suppliers and vendors
fees received

Receipts from debtors Salary, wages, and commission paid

Taxes paid

Purchase of stock in cash

Freight and other expenses paid

#2 – Cash flow from Investing Activities

Cash flow from Investing Activities represents the outgoing or incoming cash from acquiring or
disposing of a company’s long-term assets and holdings. Assets include land, property, plant &
equipment, investments in other companies, etc.
Listed below are some of the cash flows through investing activities:
Cash flow from Investing Activities

Cash Inflows Cash Outflows

Proceeds from the sale of fixed asset Purchase of fixed assets

Cash is received from selling investments in Buying of shares, debentures, and other long-
other companies like bonds, fixed assets, term or short-term investment instruments
equity, debentures, etc. issued by other companies

Money received on maturity of shares,

debentures, and bonds.
Dividends and interest received on
investments.

#3 – Cash flow from financing activities

Cash Flow from financing activities shows the capital receipts and payments marked by the
transactions with the corporate finance providers like banks, shareholders, and promoters.
Given below are some the examples of cash flows from financing activities:
Cash flow from Financing Activities

Cash Inflows Cash Outflows

Proceeds from borrowings from banks and

Repayment of borrowings or loan installments
other financial institutions

Proceeds from issuance of the shares and

Buyback of debentures and shares
debentures

Interest paid on loans and borrowings.

Dividend paid on shares issued.

Preparing Cash Flow Statement

As discussed, the CFS is a sum of all operating, investing, and financing activities. Thus, it reflects the net
increase or decrease in cash flows of a business.
There are two methods for calculating cash flows: direct and indirect. Note that the difference between
the two methods lies in computing cash flows from operating activities. In contrast, the cash flows from
investing and financing activities are treated similarly in direct and indirect methods.

#1 – Direct Method
Only the cash operating items are recorded under the direct method of preparing CFS. This method is
relatively easy to understand as it considers the actual cash transactions.
The cash from operating activities can be straightaway computed by adding all the cash receipts and
deducting all the cash payments. Later the cash from all the three activities, i.e., operating, investing, and
financing, can be summed up to get the closing balance of cash and cash equivalents.
Cash Flow Statement – Direct Method

Particulars Amount Total amount

Opening Cash Balance XXXX

Cash flow from operating activities:

Receipts from sale of goods and services, royalties, etc. XXXX

Payment to employees, taxes, suppliers, etc. (XXXX)

Net cash from operating activities (A) XXXX

Cash flow from investing activities:

Sale of investments, vehicles, property, etc. XXXX

Purchase of machinery, plant, equipment, etc. (XXXX)

Net cash from investing activities (B) (XXXX)

Cash flow from financing activities:

Proceeds from issuing shares, borrowings from banks, etc. XXXXX

Repayment of loan (XXXX)

Payment of dividends to shareholders (XXX)

Net cash from financing activities (C) XXXX

Add: Net cash flow during the year (A + B + C) XXXX

Ending Cash Balance XXXXX

The Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB)
suggest that companies record their cash flows through the direct method. But it is not a handy method
for the organizations since various accrual incomes and outstanding expenses are equally significant in
accounting.

#2 – Indirect Method
The CFS prepared through an indirect method requires adjustment of the non-cash items which are
earned but not yet received. These changes are made to the net profit or loss of the company in the
particular accounting year.
The non-cash and non-operating expenses are added back to the net profit/loss, while all the non-
operating and accrued incomes are subtracted. Thus, it is the reverse treatment of the income
statement and provides the operating profit before the working capital changes.
Cash Flow Statement – Indirect Method

Particulars Amount Total amount

Cash flow from operating activities:

Profits before tax XXXX

Add: Non-operating expenses

Depreciation, accounts payable, accrued expenses, etc. XXXX

Less: Non-operating income

Accounts receivable, prepaid expenses, unearned revenue, etc. (XXXX)

Operating profits before working capital changes XXXX

Add: Decrease in current assets and increase in current liability XXXX

Less: Decrease in current liability and increase in current

(XXXX)
assets

Net Cash from operating activities (A) XXXX

Cash flow from investing activities:

Proceeds from sale of fixed assets XXXX

Purchase of fixed assets (XXXX)

Net cash from investing activities (B) XXXX

Cash flow from financing activities:

Proceeds from issuing shares, borrowings from banks, etc. XXXX

Payment of borrowings, dividends, etc. (XXXX)

Net cash from financing activities (C) XXXX

Net cash flow during the year (A + B + C) XXXX

Add: Opening cash balance XXXX

Ending Cash Balance XXXX

The corporates widely use the indirect method since the books of accounts are on an accrual basis, thus
making it a more practical approach.

Example 1:
From the following information, calculate cash flow from operating activities using direct method.
Solution:
Cash flow from operating Activities
Working Notes:

1. Cash Receipts from Customers is calculated as under:

Cash Receipts from Customers = Revenue from Operations + Trade Receivables in the
beginning − Trade Receivables in the end
= Rs 2, 20,000 + Rs 33,000 − Rs 36,000
= Rs 2, 17,000

2. Purchases = Cost of Revenue from Operations − Opening Inventory + Closing Inventory

= Rs 1, 20,000 − Rs 22,000 + Rs 27,000 = Rs 1,25,000
3. Cash payment to suppliers = Purchases + Trade Payables in the beginning − Trade
Payables in the end
= Rs 1,25,000 + Rs 17,000 − Rs 15,000 = Rs 1,27,000
4. Cash Paid to Employees = Rs 30,000 + Rs 2,000 − Rs 3,000 = Rs 29,000
5. Cash Paid for Insurance Premium = Rs 8,000 − Rs 5,000 + Rs 5,500 = Rs 8,500
6. Income Tax Paid = Rs 10,000 + Rs 3,000 − Rs 2,000 = Rs 11,000

What is Fund Flow Statement Format?

The fund flow statement summarizes the source of funds and the application of funds, compares the
balance sheets of two different dates, and analyzes where the company has earned money and where
the company has spent money.

Three Parts of Fund Flow Statement Format

1. Statement of Changes in Working Capital: Working capital means the difference between
the current assets and current liabilities. If there is an increase in working capital, then it will be an
application of funds, and if there is a decrease in working capital, it will be a source of funds.
2. Funds from Operations: If the company earns a profit, it will be a source of funds, and if there is a
loss, it will be an application of funds.
3. Fund Flow Statement: After ensuring the above two requirements, the firm will prepare the fund
flow statement, which will comprise all outflow and inflow of funds.
1. Source of Fund: It is used to know where funds have been arranged for investment. The
source of the fund can be in the form of the issue of shares, debentures, profit from
operations, dividends received on investments, proceeds from borrowings, etc.
2. Application of Fund: It is used to know where the arranged funds have been invested.
Application of funds can be in the purchase of fixed assets, increased working capital,
purchase of investments, the dividend paid, repayment of borrowings, interest paid, etc.
How to Prepare a Fund Flow Statement? (Examples)

#1 – Statement of Change in Working Capital

Now we will see the format of the “statement of change in working capital.”
 In this format, there are two parts – current assets and current liabilities. We will take existing
assets and current liabilities from the balance sheet on March 31, 2019, and March 31, 2018.
Then calculate net working capital (after deduction of current liabilities from current assets). After
that, compare the networking capital of both years and find out changes in working capital.
 In the below example, net working capital as of March 31, 2019, and March 31, 2018, is $12,000
and $5,500. Therefore for the current year, i.e., March 2019, the increase in working capital is
$6,500.
#2 – Prepare a Statement of Fund From Operations
After preparing the statement of change in working capital, now we need to prepare a report of funds from
operations:
 In this statement, we will take the profit/loss from the profit & loss a/c. But then, we need to adjust
profit/loss.
 We prepare profit & loss accounts on an accrual basis. However, in this non-cash
expenses like depreciation, bad debt, and any expenses written off are also considered for
getting the actual profit or loss.
 We will add back or less, as the case may be, those non-cash expenses, and we will get the cash
profit/loss.
 In the below format, we have assumed the current year’s profit is $20,000. Then we have
identified non-cash items which have been deducted in profit & loss a/c, which is $3,230, which is
now added back to the current year’s profit. As a result, a non-operating item added in the profit &
loss account of $120 has been reduced from the current profit.
 After adding and deducting non-cash or non-operating items, we will reach the position in which
fund flow from operations can be derived, i.e., $23,110.

#3 – Prepare the Fund Flow Statement

Last, we will prepare the fund flow statement.
 This statement will find out the sources and applications of funds.
 In the above example, we have seen that increases in working capital are $6,500 (considered as
applications of funds), and the fund from an operation is $23,110 (considered a source of funds).
 Suppose we have issued share capital in the market amounting to $5,000 (considered a source
of funds). Arranged source of the funds is used to enhance working capital and purchase fixed
assets.
Statement of Sources and Application of Funds Current Year

Sources of Fund

Fund Generated from Operating Activities 23,110.00

Proceeds from issue of Share Capital 5,000.00

Total Source of Funds 28,110.00

Application of Fund

Purchase of Fixed Assets 21,610.00

Increase in Working Capital 6,500.00

Total Application of Funds 28,110.00

Financial Analysis
An example of Financial analysis is analyzing a company’s performance and trend by calculating financial
ratios like profitability ratios, including net profit ratio, which is calculated by net profit divided by sales. It
indicates the company’s profitability by which we can assess the company’s profitability and trend of
profit. There are more liquidity ratios, turnover ratios, and solvency ratios.
Financial Statement Analysis is considered one of the best ways to analyze the fundamental aspects. It
helps us understand the company’s financial performance derived from its financial statements. It is an
important metric to analyze its operating profitability, liquidity, leverage, etc. The following financial
analysis example outlines the most common financial analysis used by professionals.

Example #1 – Liquidity Ratios

Liquidity ratios measure the ability of a company to pay off its current obligations. The most common
types are:
Current Ratio
The Current Ratio measures the number of current assets to current liabilities. Generally, the ratio of 1 is
considered ideal for depicting that the company has sufficient current assets to repay its current liabilities.
Current Ratio = Current Assets / Current Liabilities

ABC’s Current Ratio is better than XYZ, which shows ABC is in a better position to repay its current
obligations.
Quick Ratio
The Quick ratio helps analyze the company’s instant paying ability of its current obligations.
Quick Ratio Formula = (Current Assets – Inventory)/Current Liabilities.

ABC is better positioned than XYZ to cover its current obligations instantly.
Example #2 – Profitability Ratios
Profitability ratios analyze the earning ability of the company. It also helps in understanding the
company’s operating efficiency of the business. A few important profitability ratios are as follows:
Operating Profitability Ratio
Measures the Operating efficiency of the company;
Operating Profit Ratio Formula = Earnings Before Interest & Tax/Sales

Both companies have a similar operating ratio.

Net Profit Ratio
Measures the overall profitability of the company;
Net Profit Ratio Formula = Net Profit/Sales.

XYZ has better profitability compared to ABC.

Return on Equity (ROE)
Return on Equity measures the return realized from shareholders’ equity of the company.
Return on Equity Formula = Net Profit/Shareholders’ Equity

XYZ provides a better return to its equity holders as compared to ABC.

Return on Capital Employed (ROCE)
Return on Capital Employed measures the return realized from the total capital employed in the business.
ROCE Formula = Earnings before Interest & Tax/Capital Employed

Both companies have a similar return ratio to be provided to all the owners of capital.
Example #3 – Turnover Ratios
Turnover ratios analyze how efficiently the company has utilized its assets.
Some important turnover ratios are as follows:
Inventory Turnover Ratio
Inventory Turnover Ratio measures evaluating the effective level of managing the business’s inventory.
Inventory Turnover Ratio Formula = Cost of Goods Sold/Average Inventory.

A higher ratio means a company is selling goods quickly and managing its inventory level effectively.
Receivable Turnover Ratios
Receivable Turnover Ratios help measure a company’s effectiveness in collecting its receivables or
debts.
Receivable Turnover Ratio Formula = Credit Sales/Average Receivables.

A higher ratio means the company is collecting its debt more quickly and managing its account
receivables effectively.
Payable Turnover Ratios
The payable Turnover Ratio helps quantify the rate at which a company can pay off its suppliers.
Payable Turnover Ratio Formula = Total Purchases/Average Payables

Higher the ratio means a company is paying its bills more quickly and managing its payables more
effectively.
Example #4 – Solvency Ratios
Solvency ratios measure the extent of the number of assets owned by the company to cover its future
obligations. Some important solvency ratios are as follows:
Debt Equity Ratio
The Debt to Equity Ratio measures the amount of equity available with the company to pay off its debt
obligations. A higher ratio represents the company’s unwillingness to pay off its obligations. Therefore it is
better to maintain the right debt-equity ratio to manage the company’s solvency.
Debt Equity Ratio Formula = Total Debt/Total Equity

A higher ratio means higher leverage. XYZ is in a better solvency position as compared to ABC.
Financial Leverage
Financial leverage measures the number of assets available to equity holders of the company. The higher
the ratio, the higher the financial risk in terms of debt position to finance the company’s assets.
Financial Leverage Formula = Total Assets/Equity

Higher the ratio of ABC implies that the company is highly leveraged and could face difficulty paying off its
debt compared to XYZ.

What Is Earnings Power?

Earnings power is a figure that telegraphs a business's ability to generate profits over the long haul,
assuming all current operational conditions generally remain constant. Equity analysts ritually assess a
company’s earning power when issuing buy and sell recommendations to best determine if a company’s
stock is worth investing in.

Understanding Earnings Power

Earnings power factors in several elements, including a company’s total assets, plus recent growth or
loss trends. Earning power likewise considers metrics such as a company's return on assets (ROA),
which is the ability to generate profit from its assets, as well as the return on equity (ROE), which is a
measurement of a stock’s financial performance. Furthermore, some companies determine earnings
power based on dividend yields associated with specific securities.

Earnings Power Metrics for Determining Current Business Health

A company can cultivate a keen insight into its earnings power by examining earnings before interest and
tax (EBIT). This calculation examines a company’s earnings power based on continuous operations, as
well as cash flow. By generally excluding any and all irregular income or expenses, EBIT provides a
reliable snapshot of a company’s liquidity profile, its ability to meet debt obligations, and its overall health.
Some individual sectors and/or industries place greater importance on particular metrics for calculating
earnings than others. Case in point: dividend yield carries more weight with well-established blue-chip
companies than it does with rapidly growing startups, which are more apt to reinvest profits back into their
operations during development stages.

Limits of Earnings Power Metrics

Earnings power assumes that ideal conditions will continue to surround the business. It does not account
for any internal or external fluctuations that may negatively affect rates of production. Therefore, there is
an ever-present risk that general market volatility, regulatory restrictions, or other unforeseen events may
affect business flows in ways that earnings power cannot anticipate.

The Basics Earning Power Formula

The basic earning power (BEP) formula, which is also referred to as the basic earning power ratio, is as
follows:
Basic Earning Power = Earnings Before Interest and Taxes (EBIT)/Total Assets