Accounts & Finance 15 Units NOTES

UNIT
Introduction to Financial Accounting
Names of Sub-Units
Introduction to Financial Accounting, Concept of Conceptual Framework of Financial Accounting,

Concept of Basic Terminology in Accounting, Users of Accounting Information.
Overview
This unit begins by meaning of financial accounting. It discusses the conceptual framework of financial
accounting. The unit explains the users of financial accounting, which are internal users and external
users. It also discusses the introduction to Indian GAAP, Ind AS and IFRS
Learning Objectives
In this unit, you will learn to:
Explain financial accounting
State the users of financial accounting
Identify the basic terminology in accounting
Classify the different accounting concepts
Learning Outcomes
At the end of this unit, you would:
Assess the importance of financial accounting
Examine the conceptual framework of financial accounting
Analyse the users of financial accounting
Evaluate the different accounting concepts
JGI JAIN
DEEMED-T O-BE UNI VE R SI TY
Accounting and Finance
Pre-Unit Preparatory Material
http://www.ddegjust.ac.in/studymaterial/bba/bba-104.pdf
1.1 INTRODUCTION
Accounting is a business language which elucidates the various kinds of transactions during a given
period of time. Accounting is broadly classified into three different functions:
1. Recording
2. Classifying
3. Summarising
The American Institute of Certified Public Accountants defines accounting as process of

documenting, classifying, summarising in a meaningful manner financial transaction and eventually
interpreting the
A well-known author of accounting, [Prof. R.R. Gupta, Principal, Poddar College, Nawalgarh
(Rajasthan)] wrote in First write/record before one deliver goods or renders the services and if there is
any disagreement in future, use the writing or record as an evidence to resolve the misunderstanding
or rectifying the error.
Business transactions must be recorded for the benefit of the owners and other interested parties. The
second group of people includes those who provide resources, products, and services to businesses,
governments, and society at large. The creditors (suppliers who are ready to wait for payment) want to
know if the firm will be able to pay them later (solvency of the business), whereas the government wants
to know if the business has paid all taxes, fees, and other obligations.
1.2 CONCEPTUAL FRAMEWORK OF FINANCIAL ACCOUNTING

Accounting looks to many of us to be a systematic and procedural process. The visible part of
accounting record keeping and financial statement production all too frequently connotes the use
of a low-level talent in a job devoted to prosaic goals and devoid of challenge and inspiration. However,
there is a vast body of theory (conceptual framework) in accounting. Philosophical goals, normative
theories, interconnected concepts, exact definitions, and underlying assumptions, principles, and
restrictions are all part of it. Many individuals are unaware of this theoretical background, but it assists
to justify accounting as a true professional discipline. Thus, accountants philosophize, theorize, judge,
create, and deliberate as a significant part of their professional activity. The principles of accounting
are unlike the principles of the natural sciences and mathematics because
They be derived from or proved by the laws of nature
They are not viewed as fundamental truths or axioms
An accounting theory is not something that is discovered rather, it is created, developed or decreed on the
basis of environmental factors, intuition, authority, and acceptability because the theoretical framework
accounting is difficult to substantiate objectively or by experimentation, arguments concerning it can
degenerate into quasi - religious dogmatism. As a result, the credibility of accounting rests upon its
general recognition and acceptance by preparers, auditors, and users of financial statements. Given
2
UNIT 01: Introduction to Financial Accounting JGI JAIN
this, the purpose of this chapter is to examine the nature and usefulness of a conceptual framework for
financial accounting, and discuss its components.
1.2.1 Basic Terminology in Accounting

The terms, which are generally used in the day-to-day business, are called accounting terminology. So,
it is very much necessary to know all the terms properly. Some of the terms that are frequently used are:
Capital: It is the capital that the business owner has put into the company. It is also known as net
worth or equity. the sum of your assets minus your liabilities. In other terms, capital
is the difference between assets and liabilities. Because a business is treated as a separate entity,
the capital invested by the owner is treated as a liability for the company. This can be shown in an
algebraic way as follows:
Capital = Total Assets Total Liabilities
Assets: Assets are valuable items or properties that a company uses in its operations. In other
terms, an asset is everything that provides a benefit to the company. are future economic
accordingto Finny & Miller, whereas Kohler defines an asset as owned physical property
(tangible) or right (intangible) having economic value to the Assets are defined as
goods or intangible rights controlled by an enterprise and having anticipated future
accordingto the Institute of Chartered Accountants of India. Thus, it is clear from the
above definitions that an asset must have future economic benefit which must be controlled by an
enterprise. The assets may be broadly classified as fixed assets and current assets:
(i) Fixed assets are the assets which are purchased for the purpose of operating the business and
not for resale such as land and building, plant and machinery and furniture, etc.
(ii) Current assets are the assets which are kept for short-term for converting into cash or for resale
such as unsold goods, debtors, bills receivable, bank balance, etc.
Liability: It can be described as current commitments that a commercial enterprise must meet
at some point in the future. are debts, they are amounts owed to according
to Finny and Miller. In other words, liabilities refer to obligations that are not capital-related
gains stemming from present commitments of a particular entity to transfer assets or perform
services to other entities in the futu
to F.A.S.B. Stanford, 1980. According to Accounting Principles Board (APB), liabilities are defined
as, obligations of an enterprise that are recognized and measured in conformity with
a legal obligation to pay for the transaction that has already taken place. Liabilities may be classified
into three types namely:
1. Short-term liabilities are such obligations which are payable within one year. Examples are
creditors, Bills payable, overdraft from a bank, etc.
2. Long-term liabilities are such obligations which are payable after a period of one year such as
debentures, bonds issued by the company, etc.
3. Contingent liability is a liability which arises only on the happening of an uncertain event. If it
happens, the contingent liability is there. If it does not happen, there is no liability. Such liabilities
are not shown in the balance sheet, but are given as a foot note. Example of such liabilities are (i)
Liability on account of bills discounted (ii) Claims against the fi rm not acknowledged as debts.
3
JGI JAIN
Debtors: Debtors are those who owe money to a company after getting products or services on
credit. In an balance sheet, the entire balance outstanding at the end of a specific date
is shown as an asset. receivables are another term for debtors.
Creditors: The creditors are the persons to whom the fi rm owes for providing goods or services.
Revenue: Revenue is the amount of money earned by a company by selling a product or providing
services to clients. Sales, commissions, interest, dividends, rent, and royalties are just a few examples.
It is the amount that is added to the capital as a result of the operations of the firm.
Equity: Equity is, normally, ownership or percentage of ownership in a company or items of value.
Bills of Exchange: A written order from one person (the payor) to another, signed by the person
giving it, instructing the person to whom it is addressed to pay a specified sum of money on demand
or at a specified future date to either the payee or any person presenting the bill of exchange.
Income: The financial gain (earned or unearned) accruing over a given period of time.
Expenditure: A payment or incurrence of an obligation to make a future payment for an asset or
service rendered.
Profit and Loss A/c: The second section of Trading and Profit & Loss Account is Profit & Loss
Account. The gross profit, which is the difference between sales and cost of sale, is shown in the
trading account. As a result, gross profit cannot be treated as net profit when a businessperson
wants to determine how much net profit, he made from operating operations during a certain time
operational and non-operating profits and losses. All expenses and losses are declared on the debit
(left hand side), and all incomes are disclosed on the credit (right hand side). The excess of credit
side over debit side is called net profit while the excess of debit side over credit side shows net loss.
Goods: It is a general term used for the articles in which the business deals; that is, only those articles
which are bought for resale for profit are known as Goods.
Drawings: It is the amount of money or the value of goods which the proprietor takes for his domestic
or personal use. It is usually subtracted from capital.
1.2.2 Users of Accounting Information

There are two types of persons interested in financial statements:
1. Internal users: These are:
Shareholders are interested to know the welfare of the business. They can know the operational
results through such financial statements and the financial position of the business.
Management is interested to take important decisions relating to fixing up the selling prices and
making future policies.
Trade unions and employees are interested to know the operational results because their bonus
etc. is dependent on the profit earned by the business. Financial statements also help in their
negotiations for wages/salaries.
2. External users: The following are most important external users of financial statements:
Investors: They want to know about a earning capacity, which may be determined
financial viability.
4
Creditors, Lenders of Money: The creditors and lenders of money etc. can also know the financial
soundness through financial statement. They have to see two things (i) Regularity of income and
(ii) solvency of the business so that their investment is risk free.
Government: The government is interested in drafting laws to regulate corporate activity, as
well as taxation and other laws. Financial statements aid in the computation of national income
figures, among other things.
Taxation authorities: Financial statements contain information about a operating
results as well as its financial situation. The amount of tax is determined by the tax authorities
based on the financial statement. Other taxing authorities, such as sales tax, will find it quite
useful.
Consumers: These groups are interested in getting the goods at reduced price. Therefore, they
wish to know the establishment of a proper accounting control, which in turn will reduce to cost
of production, in turn less price to be paid by the consumers. Researchers are also interested in
accounting for interpretation.
Research Scholars: Accounting information, as a reflection of a financial success, is
research int
information on purchases, sales, expenses, cost of materials used, current assets, current
liabilities, fixed assets, long-term liabilities, and share-holders funds, all of which can be found
in the accounting records.
1.3 DIFFERENT ACCOUNTING CONCEPTS

The following are the most important concepts of accounting:
1. Money measurement concept
2. Business entity concept
3. Going concern concept
4. Matching concept
5. Accounting period concept
6. Duality or double entry concept
7. Cost concept
8. Revenue recognition concept
9. Full disclosure concept
10. Objectivity Concept
Let us understand each them one by one.
Money Measurement Concept

This concept tunes the accounting system to be effective in capturing the transactions and occurrences
of the business solely in terms of money. Money is employed as a denominator as well as a numerator
in business events and transactions. Transactions that are not expressed in monetary terms are not
allowed to be recorded in the books of accounts.
5
JGI JAIN
Business Entity Concept
firm by the owner at the start of the

firm is referred to as capital. The amount of capital that was initially contributed should be returned to
the owner as a debt owed to the owner, who was nothing more than a contributor to the capital.
Going Concern Concept

-term viability, regardless of
whether the owner is alive or not. The fixed assets are purchased with the purpose of profiting during
the business season. Even if assets that a
use, the fact that those assets are typically sold out by the firm shortly after their utility means that they
are not fixed assets but traded assets..
Matching Concept
This idea merely serves to make the overall accounting system more useful in determining the volume
enues, which are mostly derived

from sales volume, with the expenses at every level.
Accounting Period Concept

The life span is long, and it is divided into operating periods of varying lengths. The accounting
period might be either a calendar year (January to December) or a financial year (April to March).
variances in operating periods of diverse traders.
Duality or Double Entry Accounting Concept

It is the only idea that depicts both sides of a single transaction. The entire law of company is based
solely on the mutual agreement sharing policy. What method is used to get a mutual agreement?
The entire business principle is based on mutual agreement between the parties from one occasion to
the next. Wages are paid solely through the services of labourers by the company. Is there any form
of mutual benefit sharing arrangement in place? The labourers services are obtained by the firm by
paying wages to them. Similarly, the workers are paid on a monthly basis for their contributions to the
company.
Cost Concept
It is a concept that is closely related to the concept of a running business. The transactions are exclusively
recorded in terms of cost rather than market value under this idea. Fixed assets are solely recorded
in terms of their purchase price, which represents
Depreciation is subtracted from the original value, which is the initial purchase price, to arrive
6
Revenue Reorganisation Concept

The principle is also known as the revenue realisation principle. According to this principle, revenue is
recorded in accounting when sales are made. If a given transaction is expected to occur in the future,
it is not documented in accounting. When title to goods goes from the seller to the buyer and the buyer
becomes legally responsible to pay, revenue/sales is considered made.
Full Disclosure Concept

According to this principle, financial statements should present a true and fair picture so that users of
financial statements can get accurate and sufficient information (the statements which includes the
financial data for a particular time period). The disclosure concept states that the owner, creditors,
and investors should be giv
commercial organisations are administered as limited firms, this principle is becoming increasingly
important. The profit and loss account and the balance sheet of a company must offer a genuine and
fair view of the company, according to the Companies Act of 1956.Therefore, companies are showing
foot notes for some items as investments, contingent liabilities etc. along with the balance sheet.
Objectivity Concept
It is also known as the concept of objective evidence. The transactions that are recorded in accounting
must be objective and factual, according to this principle. Each accounting entry should be accompanied
by a voucher or documentary documentation. Personal prejudice must be avoided, and the entry
must be based on a rational approach. If the entries are made without supporting documentation, the
for the auditing of financial statements.
1.4 ASSUMPTIONS AND CONVENTIONS OF ACCOUNTING

The owner and business are treated as two distinct entities and we record those viewpoint of business:
Separate Business Entity: According to this concept, a company is regarded a different entity from
its owner (s). This assumption aids in keeping commercial transactions free of the impact of the
amount raises the cash balance at the point of business, while the owner is classified as a liability
and is shown as capital on the liability side of the balance sheet. For this transaction, this
journal entry is passed:
Cash A/c Dr. 2,00,000
To capita A/c 2,00,000
This concept is becoming more popular because in one sense capital itself may be regarded as a
liability the amount due from the business to the owner. This concept is applicable to the all forms
of business organisations whether it is a limited company, partnership firm or a sole trader.
Going Concern Concept: It is a fundamental accounting assumption underlying the creation of
seen as a going concern, that is, as continuing in operation for the foreseeable according
to this assumption. To compute true profit, all assets are shown at cost price rather than market
pricing, and depreciation is reported on cost price. The firm is assumed to have neither the intention
nor the need to liquidate or drastically reduce the sale of its Under this assumption
7
JGI JAIN
the assets of the business are valued by the accountants on the basis of going concern concept,
historical cost and expected life of the assets.
Money Measurement Concept: Money is medium to value quantities. As per this assumption, only
those transactions of the business are recorded in the accounting which can be measured in money.
recorded in accounting.
Accounting Period Assumption: The income of a firm might be measured at the time of liquidation
or when the business is sold, according to the going concern principle. However, it is really difficult
to wait for such a long period of time that is also uncertain. As a result, accountants have agreed
that the economic life of a business is separated into several segments for the purpose of generating
financial statements and calculating earnings. This period of time is usually one year, either a
calendar year or a financial year. It may be less than a year at times, such as quarterly, half-yearly,
or annually. Reports made for less than twelve months are called interim reports and are less reliable
than annual reports. At the end of each segment (period) profit and loss account and balance sheet
are prepared.
The various rules for preparing financial statements are based on basic accounting assumptions
and principles. If these financial statements are accurate and relevant, they will provide a wealth
of information to the various users of financial statements. Accounting assumptions and principles
must be changed in order to prepare honest and fair financial statements. These modified accounting
principles are as follows:
Conservation (Prudence): According to the law of conservatism, while creating financial statements,
all potential losses must be considered but all anticipated profits/gains must be excluded. In other
words, the accounts must adhere to the it guideline. Similarly, stock-in-trade is valued
fixed assets, and other items are kept. This notion is currently being attacked since it contradicts the
principle of disclosure. The provision of bad and dubious debts, depreciation, and stock valuation
are all used by accountants to construct a secret reserve. The genuine and unbiased view of the
financial statements is lost. The profit and loss statement reflects lesser earnings, but the balance
sheet
Prudence has supplanted conservatism as the law of the day. It suggests that conservatism is
only used when there are unavoidable doubts and uncertainties. Accountants should also provide
justifications for using specific accounting procedures, methods, and rules without being overly
conservative.
Consistency: In order to enable the management to do the comparison of the results of the several
years of the business, whatever accounting policy is adopted in a year, must be adopted in the coming
years. There should be uniformity in accounting process, rules & methods. As a result, biasness of
accountant is removed.
According to Kohlar, there are three forms of consistency:
(a) Vertical consistency is used in the different financial statements of the business on the same
date. For instance, depreciation on fixed assets is used in the income statement and the balance
sheet on the same date.
(b) Horizontal consistency enables the comparison of the profit or performance of a business in a
year with the performance of another year for example the depreciation methods.
(c) Third Dimensional consistency refers to the same principles or practices of accounting adopted
by the different firms in an industry.
8
Timeliness: Accounting information given in the financial statements must be reliable and relevant.
In order to be relevant, this information must be supplied in time. If late and obsolete information
is provided, it will hamper the management and the users of the financial statements to take
appropriate, timely and rational decision.
Materiality: The term
and attached to financial statements that has an impact on the decisions of shareholders, investors,
and creditors, and that all other details should be ignored. Furthermore, an item of knowledge
may be relevant for one purpose but irrelevant for another. This is a matter of opinion. The cost
of a component, for example, may be very important to a small businessman but trivial to a large
businessman. In one more example, the Companies Act permits to ignore the paise at the time of
preparation of financial statements while for the income tax purpose the income is rounded off to
the nearest ten.
Cost-Benefit Principle: As per this principle, the cost of using an accounting principle should not
exceed its benefits. It does not mean that to curtail the costs, no information or a little information
should be given to the users of the financial statements.
Industry Practice: In different industries, different accounting principles/practices are used. The
current accounting procedures in a given industry should be kept in mind while generating financial
reports and presenting accounting information. Disclosing investments and stock at cost or market
price, whichever is lower, is an example. As a result, we can observe that the accounting techniques
that are currently in use in a certain industry have a significant impact on the accounting methods
that are adopted.
1.5 ACCOUNTING EQUATIONS

The accounting equation is regarded as the bedrock of the double-entry accounting system. The total
shown on its balance sheet.

The accounting equation assures that the balance -entry
approach, and that each entry made on the debit side has a corresponding entry (or coverage) on the
credit side.
The accounting equation aids in determining if a business operations are accurately reflected
in its books and accounts. The following are some examples of items found on a balance sheet:
Assets
Cash and cash equivalents, as well as liquid assets such as Treasury bills and certificates of deposit,
are examples of assets. The amount of money owing to the company by its consumers for the sale of
its product and service is known as account receivables. Inventory is likewise seen as a valuable asset.
Liabilities
Liabilities are the amounts that a firm owes or must pay in order to stay in business. Rent, taxes, utilities,
salaries, wages, and dividends payable are all liabilities, including long-term debt.
Equity
A entire assets minus its total liabilities equals its equity. The amount of money
was paid off is known as equity.
9
JGI JAIN
The sum of total earnings that were not paid to shareholders as dividends is known as retained earnings,
represent a total of profits that have been preserved, set aside, or kept for future use.
Accounting Equation Formula and Calculation
Assets = (Liabilities + Equity)
The balance sheet holds the basis of the accounting equation:

Locate the total assets on the balance sheet for the period.
Total all liabilities, which should be a separate listing on the balance sheet.
Locate total equity and add the number to total liabilities.
Total assets will equal the sum of liabilities and total equity.
1.6 INTRODUCTION TO INDIAN GAAP, IND AS AND IFRS
GAAP
Over time, businesses would like to know how they are performing in contrast to their peers. In the same
way, there would be common owners of numerous businesses. Accounting principles are the rules of
action that are used to record, classify, and summarise the transactions of a corporation. If financial
statements are not made using these standards, they will have a poor acceptability and will be difficult
to comprehend, making comparison impossible and untrustworthy. As a result, accountants urge that
common accounting ideas and standards be established so that the aforementioned challenges and
problems do not arise; they are referred to as Generally Accepted Accounting Principles (GAAP).
Ind AS
Financial statements are used by a variety of people, including investors, creditors, the government,
consumers, and business owners. They base a lot of their economic judgments on financial statements. If
financial statements are not adequately regulated, there is a risk that they will mislead and present a skewed
view of the firm instead of a genuine and fair picture of the business. It is critical to regulate the accounting
process so that these statements are transparent, properly disclosed, consistent, and reliable. In addition,
adequate accounting disclosure is necessary. Accounting standards are developed on a national and
worldwide level for this purpose. Accounting standards, in fact, codify the commonly accepted accounting
concepts. Accounting standards provide the rules and procedures that must be followed while preparing
financial statements and annual reports. The International Accounting Standard Committee (IASC) has
issued the International Standards on a global scale. Leading professional bodies from the United Kingdom,
the United States, Australia, France, and Canada are represented on this committee. India is also a member
of this committee. India has also prepared its own accounting standards, which are prepared by the Institute
of Chartered Accountant of India (ICAI).
IFRS
The International Financial Reporting Standards (IFRS) are a set of principles that ensure financial
statements are consistent, transparent, and comparable all throughout the world. The International
Accounting Standards Board (IASB) publishes the International Financial Reporting Standards
(IFRS) (IASB). They define how businesses must keep and report their accounts, as well as the sorts of
10
transactions and other financial events that must be reported. The International Financial Reporting
Standards (IFRS) were created to develop a common accounting language so that businesses and their
financial statements could be consistent and dependable from one company to the next and from one
country to the next.
Conclusion 1.7 CONCLUSION
Accounting is a business language which elucidates the various kinds of transactions during the
given period of time.
For many of us, accounting appears to be methodical and procedural in nature. The visible portion
of accounting record keeping and preparation of financial statements
The terms, which are generally used in the day-to-day business, are called accounting terminology.
The accounting equation is considered to be the foundation of the double-entry accounting system.
Based on this double-entry system, the accounting equation ensures that the balance sheet remains
on the credit side.
were not paid to shareholders as dividends.

In course of time business enterprises would like to know how they are performing in comparison to
each other. Similarly, there would be common owners of several enterprises.
There are many users of financial statements as investors, creditors, government, consumers,
owners, etc. They take many economic decisions on the basis of financial statements.
International Financial Reporting Standards (IFRS) set common rules so that financial statements
can be consistent, transparent, and comparable around the world.
1.8 GLOSSARY
Accounting Conventions: Customs and traditions that guide the accountants to record the financial
transactions.
Accounting Process: It includes the recording of financial transactions, ledger posting, preparation
of financial statements and analysing and interpretation of them
Cost Accounting: Accounting relating to the ascertainment of cost of the product
Management Accounting: Presenting of accounting information in such a way as to assist the
management in taking the important decisions and making the policies
1.9 CASE STUDY: ICAI TOLD TO HASTEN PROCESS FOR DOUBLE-ENTRY

ACCOUNTING SYSTEM
Case Objective
This case study highlights the importance of double-entry accounting system.
A special committee should be formed to transition the single-entry accounting system to the double-
entry accounting system. The procedure takes a long time. It should be says the author.
11
JGI JAIN
Mr. K. Rahman Khan, member of the Institute of Chartered Accountants of India (ICAI) and Honorary
Deputy Chairman of the Rajya Sabha, stated.
Mr. Khan stated that the accounting system in local bodies has already been converted to double entry,
and that the institute should play an important role in monitoring government expenditure.
he owes to society. The institute, as well as the Comptroller and Auditor General of India, the custodian
of government expenditure, have already decided to carry out the conversion. Various Notes The double
to transition to double entry as soon as po
We must ensure that there is more transparency. The double entry accounting system would allow us to
track cost increases, look into the specifics of total government spending, and so
Mr. G. Ramasamy, the Vice-President, stated that the outlay for the Mahatma
Gandhi National Rural Employment Guarantee Act Scheme totalled over 42,000 crores, and that over
6 lakh panchayats across the country were completing their spending statements. He stated,
institute is assisting the panchayats in preparing
He stated that all permissions for the implementation of the International Financial Reporting Standards
(IFRS) would be in place by July 31. The institute has begun programmes to educate professionals and
firms with a turnover of over 1,000 crores in the first phase.

According to him, the institute has signed memorandums of understanding with a number of overseas
peers in order to strengthen bilateral ties. recently met with professional groups in West Asia to
discuss the importance of strengthening networking relationships between members and professionals
from both nations. He said, others, we are looking to get into mutual recognition agreements
with professional associations in Canada, Singapore, and New
Questions
1. What is a double-entry accounting system?
(Hint: Accounting concept whereby assets = liabilities + equity)
2. What is the need to set up a separate committee for converting the single-entry accounting system
to double entry?
(Hint: This process is rather slow)
3. What is the need of double entry accounting system?
(Hint: The double entry accounting system would help measure cost escalation, go into the details of
total public expenditure and so
4. Do you think double-entry accounting system work?
(Hint: Yes, it works)
5. What is the aim of double-entry accounting system?
(Hint: Reduce the time of accounting)
12
1.10 SELF-ASSESSMENT QUESTIONS
A. Essay Type Questions

1. What do you understand by the term capital?
2. What are assets?
3. Write a short note on fixed assets.
4. List accounting principles.
5. Explain Ind AS.
1.11 ANSWERS AND HINTS FOR SELF-ASSESSMENT QUESTIONS
A. Hints for Essay Type Questions

1. Capital is the amount that the business owner has put into the company. It is also known as net worth
liabilities. Refer to Section Conceptual
Framework of Financial Accounting
2. Assets are valuable items or properties that a company uses in its operations. In other terms, an
asset is everything that provides a benefit to the company. Refer to Section Conceptual Framework
of Financial Accounting
3. Fixed assets are the assets which are purchased for the purpose of operating the business and
not for resale such as land and building, plant and machinery and furniture, etc. Refer to Section
Conceptual Framework of Financial Accounting
4. Various rules for preparing financial statements are based on basic accounting assumptions and
principles. If these financial statements are accurate and relevant, they will provide a wealth of
information to the various users of financial statements. Accounting assumptions and principles
must be changed in order to prepare honest and fair financial statements. Refer to Section
Assumptions and Conventions of Accounting
5. The International Accounting Standard Committee (IASC) has issued the International Standards on
a global scale. Leading professional bodies from the United Kingdom, the United States, Australia,
France, and Canada are represented on this committee. India is also a member of this committee.
India has also prepared its own accounting standards, which are prepared by the Institute of
Chartered Accountant of India (ICAI). Refer to Section Introduction to Indian GAAP, IND AS and IFRS
@ 1.12 POST-UNIT READING MATERIAL
ht tp://vc mdrp .tu ms .a c .ir/fi l es/fin an ci al/i stgahe_ ma li /mot on _eng lis h/fin anci a l_
management_%5Bwww.accfile.com%5D.pdf
https://jyotinivas.org/pdf/e_content/bcom/bba_financial_management.pdf
https://mdu.ac.in/UpFiles/UpPdfFiles/2020/Jan/FinancialManagement.pdf
13
JGI JAIN
1.13 TOPICS FOR DISCUSSION FORUMS
Discuss with your friends how financial accounting is useful for nowadays.
14
UNIT
Accounting Cycle
Names of Sub-Units
Introduction to Accounting Cycle, Concept of Accounting Process, Concept of Preparation of Trial

Balance.
Overview
This unit begins by explaining the meaning of accounting cycle. It discusses the concept of accounting
process. The unit explains the preparation of trial balance.
Learning Objectives

Explain the meaning of accounting cycle
State the concept of accounting process
Classify the preparation of trial balance
Learning Outcomes
Assess the importance of the accounting cycle
Examine the concept of the accounting process and analyse the users of financial accounting
Evaluate the preparation of trial balance
JGI JAIN
2.1 INTRODUCTION
The accounting cycle starts from recording individual transactions in the books of accounts and ends
at the preparation of financial statements and closing process. The financial accounting cycle is the
process of recording business transactions and processing accounting data to generate useful financial
information i.e., financial statements including income statement, balance sheet, cash flow statement
and statement of shareholders equity. The time period principle requires that a business should prepare
its financial statements after a specified period of time, say a year, a quarter or on a monthly basis. This
is achieved by following the accounting cycle during each period. Figure 1 shows the accounting cycle:
Post
Journal
Closing Trial
Entries
Balance
Closing Ledger
Entries Accounts
Unadjusted
Financial Trial
Statements Balance
Adjusted
Adjusting
Trial
Entries
Balance
Figure 1: Accounting Cycle

The accounting cycle is a basic, eight-step process for completing a bookkeeping tasks. It provides
a clear guide for the recording, analysis, and final reporting of a financial activities.
The accounting cycle is comprehensively used through one full reporting period. Thus, staying
efficiency. Accounting cycle periods will vary by reporting needs. Most companies seek to analyze their
performance on a monthly basis, though some may focus more heavily on quarterly or annual results.
Regardless, most bookkeepers will have an awareness of the financial position from day-
to-day. Overall, determining the amount of time for each accounting cycle is important because it sets
specific dates for opening and closing. Once an accounting cycle closes, a new cycle begins, restarting
the eight-step accounting process all over again.
2.2 ACCOUNTING PROCESS

Accounting cycle refers to the specific tasks involved in completing an accounting process. The length of
an accounting cycle can be monthly, quarterly, half-yearly, or annually. It may vary from organisation
to organisation but the process remains the same.
18
UNIT 02: Accounting Cycle JGI JAIN
Figure 2 shows the steps in the accounting process:
Collecting
& Analysing
Documents
Post Closing Posting in
Trial Balance Journal
Post Ledger
Closing Entries Account
Accounting
Process
Preparation
of Financial Trial Balance
Statements
Adjusted Trial Adjustment

Balance Entries
Figure 2: Accounting Process
1. Collecting and Analyzing Accounting Documents: It is a very important step in which you examine
the source documents and analyse them. For example, cash, bank, sales, and purchase-related
documents. This is a continuous process throughout the accounting period.
2. Posting in Journal: On the basis of the above documents, you pass journal entries using double
entry system in which debit and credit balance remains equal. This process is repeated throughout
the accounting period.
3. Posting in Ledger Accounts: Debit and credit balance of all the above accounts affected through
journal entries are posted in ledger accounts. A ledger is simply a collection of all accounts. Usually,
this is also a continuous process for the whole accounting period.
4. Preparation of Trial Balance: As the name suggests, trial balance is a summary of all the balances
of ledger accounts, irrespective of whether they carry debit balance or credit balance. Since we
follow double entry system of accounts, the total of all the debit and credit balance as appearing
in the trial balance remains equal. Usually, you need to prepare trial balance at the end of the said
accounting period.
5. Posting of Adjustment Entries: In this step, the adjustment entries are first passed through the
journal, followed by posting in ledger accounts, and finally in the trial balance. Since in most of the
cases, we used accrual basis of accounting to find out the correct value of revenue, expenses, assets
and liabilities accounts, we need to do these adjustment entries. This process is performed at the end
of each accounting period.
19
JGI JAIN
6. Adjusted Trial Balance: Taking into account the above adjustment entries, we create the adjusted
trial balance. The adjusted trial balance is a platform to prepare the financial statements of a
company.
7. Preparation of Financial Statements: Financial statements are the set of statements like the income
and expenditure account or trading and profit and loss account, cash flow statement, fund flow
statement, balance sheet or statement of affairs Account. With the help of the trial balance, we put
all the information into the financial statements. Financial statements clearly show the financial
health of a firm by depicting its profits or losses.
8. Post-Closing Entries: All the different accounts of revenue and expenditure of the firm are
transferred to the Trading and Profit and Loss account. With the result of these entries, the balance
of all the accounts of income and expenditure accounts come to nil. The net balance of these entries
capital.
9. Post-Closing Trial Balance: Post-closing trial balance represents the balances of assets, liabilities
and capital account. These balances are transferred to next financial year as an opening balance.
2.2.1 Books of Accounts

There are two main books of accounts journal and ledger. The journal is used to record economic
transactions chronologically. The ledger is used to classify economic activities according to nature.
Books of Account
Journal Ledger
Purchase Sales Return Return General Cash

Day Book Day Book Inward Book Outward Book Journal Book
Cash General Debtor Creditor

Book Ledger Ledger Ledger
2.2.2 Journal
A journal is a detailed account that records all the financial transactions of a business, to be used for the
future reconciling of accounts and the transfer of information to other official accounting records, such
20
as the general ledger. A journal states the date of a transaction, which accounts were affected, and the
amounts, usually in a double-entry bookkeeping method.
2.2.3 Ledger
A general ledger represents the record-
credit account records validated by a trial balance. It provides a record of each financial transaction
that takes place during the life of an operating company and holds account information that is needed
for assets, liabilities, owner equity, revenues and expenses.
2.2.4 Cash Book

A cash book is a financial journal that contains all cash receipts and disbursements, including bank
deposits and withdrawals. Entries in the cash book are then posted into the general ledger.
2.3 PREPARATION OF TRIAL BALANCE

A trial balance is a bookkeeping worksheet in which the balance of all ledgers is compiled into debit
and credit account column totals that are equal. The general purpose of producing a trial balance is to
ensure the entries in a bookkeeping system are mathematically correct.
Steps in Preparation of Trial Balance

1. Calculate the balances of each of the ledger accounts.
2. Record the debit or credit balances in the trial balance.
3. Calculate the total of the debit column.
4. Calculate total of the credit column.
5. Check if debit is equal to credit.
The accounting cycle starts from recording individual transactions in the books of accounting and
ends at the preparation of financial statements and closing process.
The time period principle requires that a business should prepare its financial statements after a
specified period of time, say a year, a quarter or on a monthly basis.
The accounting cycle is a basic, eight-step process for completing a bookkeeping tasks.
It provides a clear guide for the recording, analysis, and final reporting of a financial
activities.
The accounting cycle is comprehensively used through one full reporting period.
The accounting cycle refers to the specific tasks involved in completing an accounting process.
Debit and credit balance of all the above accounts affected through journal entries are posted in
ledger accounts.
Financial statements are the set of statements like income and expenditure account or trading and
profit and loss account, cash flow statement, fund flow statement, balance sheet or statement of
affairs account.
21
JGI JAIN
All the different accounts of revenue and expenditure of the firm are transferred to the trading and
profit and loss account.
A trial balance is a bookkeeping worksheet in which the balance of all ledgers is compiled into debit
and credit account column totals that are equal.
2.5 GLOSSARY
Transactions: A completed agreement between a buyer and a seller to exchange goods, services, or
financial assets.
Financial Statements: Details of the financial information.
Income Statement: A financial statement that shows and expenditure.
Cash Flow: The net amount of cash and cash equivalent being transferred into and out of a business.
2.6 CASE STUDY: ACCOUNTS SYSTEM IMPROVEMENT
Case Objective
This case study was done in a medium-sized IT consultancy working across the UK and Europe.
The issue with the accounting business process was that the reports lagged behind the true financial
situation. The management team developed their own ad hoc systems and spreadsheets to assess
their departmental profit and loss status. The system was thought to contain errors missing records,
incorrect filing, incorrect data entry, and issues with accounts reconciliation. The improvement process
involved the robust collection and analysis of data to identify the root cause of issues, which could
then be appropriately solved. The improvement project demonstrated to the management team the
importance of identifying the real root causes of an issue and not making a leap to the most obvious
solutions. The root cause was the way that the accounts data flowed into and out of the accounts
process and this was only identified through robust data collection and analysis. The project was clearly
a success and delivered all tangible and intangible benefits. Fundamental to this success was the change
in behaviour at every level in the organization. No matter how small a project, there is value in using
appropriate project management tools and techniques to structure delivery, manage uncertainty, and
deliver benefits.
Questions
1. What was the issue with the accounting business process?
(Hint: The issue with the accounting business process was that the reports lagged behind the true
financial situation.)
2. Why did the management team develop their own ad hoc systems and spreadsheets?
(Hint: to assess their departmental profit and loss status.)
3. What are the improvement processes involved?
(Hint: the robust collection and analysis of data to identify the root cause of issues, which could then
be appropriately solved.)
22

1. What is accounting cycle?
2. What do you understand by the term journal?
3. What is trial balance?

1. Accounting cycle refers to the specific tasks involved in completing an accounting process.Refer to
Section Accounting Process
2. A journal is a detailed account that records all the financial transactions of a business, to be used
for the future reconciling of accounts and the transfer of information to other official accounting
records, such as the general ledger. Refer to Section Accounting Process
3. A trial balance is a bookkeeping worksheet in which the balance of all ledgers is compiled into debit
and credit account column totals that are equal. The general purpose of producing a trial balance
is to ensure the entries in a bookkeeping system are mathematically correct. Refer to
Section Preparation of Trial Balance
https://www.investopedia.com/terms/a/accounting-cycle.asp
https://scalefactor.com/ask-the-experts/the-accounting-cycle/
https://scalefactor.com/ask-the-experts/the-accounting-cycle/
https://xplaind.com/794246/accounting-cycle
Discuss with your friends how to prepare trial balance.
23
UNIT
Depreciation
Names of Sub-Units
Introduction to Financial Accounting, Concept of Depreciation, Need for Calculating Depreciation,

Methods of Calculating Depreciation, Accounting Treatment of Depreciation.
Overview
This unit begins by explaining the meaning of depreciation and discusses the concept of depreciation.
The unit explains the accounting treatment of depreciation. It also discusses the methods of calculating
depreciation.
Learning Objectives

Describe the meaning of depreciation
State the methods of depreciation
Classify the accounting treatment of depreciation
Learning Outcomes
Assess the meaning of depreciation
Examine the methods of depreciation
Analyse the uses of depreciation
JGI JAIN
DEEMED-T O-BE UNIVERSI TY
Pre-Unit Preparatory Material
http://accioneduca.org/admin/archivos/clases/material/depreciation_1564412042.pdf
3.1 INTRODUCTION
Depreciation accounting is mainly based on the concept of income. The matching of revenues and
expenses is the idea of income. Frequently, the goods purchased are matched either immediately or
within a year. The essence of the income notion is that expenses must be matched against earnings.
The ultimate goal of matching is to figure out how much profit or loss the transaction will generate. If
the assets are all long-term assets acquired by the company, they should be matched to the revenues
generated by the company. The fundamental objective of the firm is to match the expenditure of the
assets incurred by the firm at the time of purchase against the revenues. To have an effective matching
against the revenues on every year, the amount of purchase has to be stretched. The stretching of
expenses into many years is known as depreciation.
Depreciation, according to Dickens, is the permanent and ongoin
quantity, and value. Depreciation is the term used to describe the gradual loss in the value of fixed assets.
It is a match between the fixed charge expense and the revenue for the current year. The unrecovered
component of the remaining/left should be carried forward to future years to match against the relevant
revenues. The ultimate goal of depreciation is to replace fixed assets only when they are no longer useful
using current revenues.
3.2 CONCEPT OF DEPRECIATION

Depreciation is an accounting concept that allows a corporation to write off the value of an asset over
than recognizing the entire cost of an asset in the first year, depreciation allows businesses to spread
out that cost and create revenue.
Depreciation is a method of accounting for changes in the carrying value of a property over time. The
gap between the original cost and the cumulative depreciation over the years is known as carrying
value.
Each corporation may decide when to start depreciating a fixed asset, also known as property, plant,
and equipment. A small business, for example, might set a $500 threshold for depreciating an asset.
A larger corporation, on the other hand, may set a $10,000 threshold below which all purchases are
expensed immediately.
3.2.1 Need for Calculating Depreciation

Depreciation needs to be provided because an asset is bound to undergo wear and tear over a period of
time. This reduces the working capacity and efficacy. As a result, this should represent the
value as recorded in the books of accounts. Furthermore, when new technologies and innovation take
hold, every asset becomes obsolete over time. As a result, the value will depreciate over time, and
this must be factored in. In addition, depreciation is appropriate for complying with the accounting
at
the same time as the revenue. So, an asset which generates income must be depreciated as per
given provisions.
28
UNIT 03: Depreciation JGI JAIN
DEEMED-TO-BE UNIVERSI TY
3.2.2 Factors Affecting Depreciation

The amount of depreciation is impacted by a number of factors. Let us take a look at some of them.
There are four main factors to consider when calculating the depreciation expense are as follows:
The cost of the asset.
The estimated salvage value of the asset. Salvage value (also called residual value) is the amount of
money that the company expects to recover, less the disposal costs, on the date the asset is scrapped,
sold, or traded in.
Estimated useful life of the asset. Useful life refers to the window of time that a company plans to use
an asset. Useful life can be expressed in years, months, working hours, or units produced.
Obsolescence
calculation of depreciation. For example, a machine capable of producing units for 20 years may be
obsolete in six years; therefore, the useful life is six years in this case.
For its business activities, a corporation is free to select the most appropriate depreciation method.
According to accounting theory, organisations should select a depreciation method that accurately
matches their economic situation. As a result, businesses can select a strategy for allocating asset costs
to accounting periods based on the benefits derived from the use.
For financial reporting, most corporations utilise the straight-line technique, but they may use different
methods for different assets. Use a depreciation method that assigns asset cost to accounting periods in
a systematic and sensible manner is the most crucial criteria to follow.
3.3 METHODS OF CALCULATING DEPRECIATION

There are various methods of allocating depreciation over the useful life of assets. The method of
providing depreciation is selected on the basis of various factors such as types of assets, nature of
business, circumstances prevailing in business, etc. These methods are given below:
Straight Line Method

This method is also known as fixed installment method. In this method, depreciation is ascertained on
the original cost by a fixed percentage, keeping in mind the scrap value of the assets. Under this method,
the amount of depreciation remains uniform/fixed and the value of the asset becomes zero at the end
of its life. It may also be calculated by the following formula:
Depreciation = Original Cost (Scrape Value / Life of Assets in Year)
Diminishing Balance Method

The written-down-value method is another name for this method. Depreciation is computed on a
decreasing value in this method, but the rate of depreciation remains constant. Every year, the amount
of depreciation on assets lowers, but the value does not decline to zero. The cost of assets, scrap
value, and useful life of the assets can all be used to calculate the rate of depreciation. The formula to
compute the rate of depreciation is given below:
S
Rate 1 n 100
C
29
JGI JAIN
Where, N stands for number of years of useful life of the asset, S for scrap value, C for cost of asset, and
R for rate of depreciation.
Annuity Method
as well as interest. The annuity method is a compounded interest method that calculates depreciation
based on the premise that depreciation plus the normal cost of capital to finance the assets will remain
nt of depreciation, this approach takes into
account interest as well as the cost of the assets. Every year, the amount of interest is debited from
the assets account, and the amount of depreciation is credited. The opening balance of the asset is
used to calculate interest. So, it (interest) decreases every year but the amount of depreciation remains
constant which is taken from the annuity tables for depreciation. This amount of depreciation is that
much by which the value of asset becomes zero.
Depreciation Fund Method or Sinking Fund Method

This method is set up in such a way that the collected funds are immediately available to replace assets
when their useful lives expire. The amount of depreciation on assets is put into a sinking fund using t his
procedure. Each year, an equivalent amount of depreciation is invested in government or marketable
securities, and the interest earned on these securities is likewise reinvested. When the economic
life expires, the securities are sold in the market, and the proceeds are used to replace the old assets. If
any profit or loss is realised from the sale of these securities, it is credited to the profit and loss account.
Insurance Policy Method

The concept is related to that of a sinking fund. The firm takes out an insurance policy to replace the
assets in this approach. The amount of premium is determined by the annual amount of depreciation,
whereas the sinking fund technique requires the firm to purchase some securities. The sum of the
premium, plus interest, is held by the insurance company. The insurance coverage matures when the
used to purchase new assets. As a result, the funds are safer and more liquid with this strategy.
Revaluation or Appraisal Method

As its name indicates, depreciation is calculated on the basis of revaluation of assets. After some time
or an interval of a year, the assets are revalued by experts. The difference of the valuation of the two
periods is called depreciation or appreciation of that period. Generally, this method is used in the case
of livestock, copyrights and patents.
Depletion Method
It is also known as production method. This method is useful for natural assets such as coal mines,
oil wells, etc. These are taken for excavation for a definite period on the contact basis. In this case, the
depreciation is computed on the basis of production. First, the total production of the contract period is
estimated, then total depreciable cost is divided by the total production and multiplied by annual output
to determine the annual amount of depreciation. In the form of formula:
Annual Output
Annual Depreciation
Total Estimated Output
30
UNIT 03: Depreciation JGI JAIN
Machine Hour Rate Method

When depreciation is calculated on the basis of working hours of the machine or plant, this method is
used. The original cost of plant or machinery is divided by the total number of working hours of the
machine or plant to find the machine hour rate. To compute the depreciation of a year the machine
hour rate is multiplied by the total working hours of the machine/plant in a year. This procedure may
be explained with the following formula:
Original Cost of Machine

Machine Hour Rate
Total Working Hours of the Machine Duringits Life
Annual Depreciation = Machine Hour Rate × Working Hours in a Year
3.4 ACCOUNTING TREATMENT OF DEPRECIATION

According to the concept of depreciation, the value of the asset is dispersed throughout the life of the
period in order to match the respective earnings of the year after year. The purchase value of the asset is
an expenditure to be stretched to many numbers of years in order to equate with the revenues. To equate
the revenues, the scrap value of the asset at the end of the life period is realized should be deducted and
apportioned to the total number of the economic life period of the asset. The aim of deducting the scrap
value of the asset is reducing the original value of the investment.
Example: Cost of Machine - 1,00,000
Estimated life of the machine - 5 years
Scrap value - Nil
Depreciation = (Cost of the machine Scrap value) / Economic Life period of the asset in years
Depreciation = (1,00,000 0) / 5
= 20,000
To understand the above calculation, the following table is important:
Value of the asset (Begin in Depreciation ( in Value of the asset (End) (in
Col. 1 Col. 2 Col 3 = Col.1 Col.2
1st year 1,00,000 20,000 80,000
2nd year 80,000 20,000 60,000
3rd year 60,000 20,000 40,000
4th year 40,000 20,000 20,000
5th year 20,000 20,000
From the above table, 20,000 is charged on every year to recover 1,00,000 during its life period i.e.,
5 years.
Example 2: Original value of the investment 1,00,000 Scrap value 10,000
Life of the asset 5 years
Depreciation = (1,00,000 10,000)/5
= 18,000
31
JGI JAINDEEMED-T O-BE UNIVERSI TY
To understand the methodology of straight-line depreciation, the following table will illustrate the
process.
Value of the asset (Begin) (in Depreciation (in Value of the asset (End) (in
1st year 1,00,000 18,0000 82,000

2nd year 82,000 18,0000 64,000
3rd year 64,000 18,0000 46,000
4th year 46,000 18,0000 28000
5th year 28,000 18,0000 10,000(Scrap value) *
The scrap value of the asset is expected to realize only at the end of the life period of the asset i.e.,
5 years.
Depreciation accounting is mainly based on the concept of income. The concept of income is
matching of revenues with expenses.
The goods purchased are frequently matched through immediate sale or within a year.
According to Dickens, depreciation is the permanent and continuous diminution in the quality/
quantity/value of the asset.
Depreciation is an accounting convention that allows a company to write off an value over a
period of time, commonly the useful life.
Depreciation is used to account for decline in the carrying value over time.
Depreciation needs to be provided because an asset is bound to undergo wear and tear over a period
of time.
Moreover, in order to comply with the matching principle of accounts, it is ideal to provide
depreciation.
A company is free to make use of the most appropriate depreciation method for its business
operations.
There are various methods of allocating depreciation over the useful life of the assets.
According to the concept of depreciation, the value of the asset is dispersed throughout the life of
the period in order to match the respective earnings of the year after year.
3.6 GLOSSARY
Book Value of the Asset: The value of the asset after deducting the depreciation from the value of
the asset at the beginning
Depreciation: Continuous reduction/decrease/diminution in the value of the asset
Depreciation Accounting: Recording the entries of depreciation through journal, ledger accounts of
depreciation, fixed asset and profit and loss account
32
UNIT 03: Depreciation JGI JAIN DEEMED-TO-BE UNIVERSI TY
Original Value of the Asset: The value of the asset at the time of purchase or acquisition
Scrap Value of the Asset: The value at the end of the life period of the asset; when the asset cannot
be put for further usage
3.7 CASE STUDY: FINDING DEPRECIATION
Case Objective
Tata Steel Ltd. wants to establish its EOU in the state of Orissa through exploration of iron ore.
Tata Steel Ltd wants to establish its EOU in the state of Orissa through exploration of iron ore. It identified
that the state of Orissa is one of the ideal states having greater potential of iron ore than any other state
in India. The firm has reached lease contract with the Government of Orissa for the amount of 200
crore towards the extraction of 40,00,000 tonnes iron ore from fields for 10 years. The firm would like
to establish a processing plant which amounts to 50 crore to produce the quality carbon steel for the
foreign industrial buyers. The life period of the machine is denominated in terms of 2,50,000 working
hours. The firm is required to extract the iron ore.
Year 1 2 3 4 5 6 7 8 9 10
Expected Extraction Per Year 8 7 6 5 4 3 3 2 1 1
in Lakh
Hrs. Working 1,00,000 75,000 25,000 12,500 6,250 6,250 6,250 6,250 6,250 6,250
1. Tata Steel Ltd wants to establish its EOU in the state of Orissa.
(Hint: Tata Steel Ltd identified that the state of Orissa is one of the ideal states having greater
potential of iron ore than any other state in India.)
2. To go for further replacement after 10 years, how much should the firm charge depreciation in the
case of iron ore field? Which method should be applied?
(Hint: written down value method)
3. To replace the machinery recently bought after 10 years, how much should be charged as depreciation
in accordance with the working hours given?
(Hint: 6,250)

1. What is depreciation?
2. What is the need for calculating depreciation?
3. How can we calculate depreciation under annuity method?
33
1.
period of time, commonly the useful life. Refer to Section Concept of Depreciation
2. Depreciation needs to be provided because an asset is bound to undergo wear and tear over a period
of time. This reduces the working capacity and effectiveness of the asset. Hence, this should reflect
the value of the asset, at which it is carried in the books of accounts. Refer to Section Methods of
Calculating Depreciation
3. Under this method, depreciation on assets is calculated, keeping in account the cost of assets along
with interest thereon. Refer to Section Accounting Treatment of Depreciation
https://bench.co/blog/tax-tips/depreciation/
https://economictimes.indiatimes.com/definition/depreciation
https://corporatefinanceinstitute.com/resources/knowledge/accounting/types-depreciation-
methods/
https://cleartax.in/g/terms/depreciation
Discuss with your friends if depreciation is useful or harmful for a firm.
34
UNIT
Financial Statements
Names of Sub-Units
Introduction to Financial Statements, the Concept of Different Financial Statements, the Concept of
Outstanding Expenses, Treatment of Closing Stock, Tax Provision, Dividend and Reserves, Finding
Earning per Share (EPS).
Overview
This unit begins by meaning of financial statements, it discusses the different financial statements.
The unit explains the treatment of closing stock. It also discusses the dividend and reserves, finding
Earning per Share (EPS).
Learning Objectives

Explain the meaning of a financial statement
Discuss the major characteristics of financial statements
State the scope of financial statements
Describe the concept of the profit and loss (P&L) account
Detail upon the concept of the balance sheet
JGI JAIN
Learning Outcomes

Assess the meaning of a financial statement
Examine the concept of outstanding expenses
Analyse the treatment of closing stock
Evaluate the outstanding expenses
4.1 INTRODUCTION
A financial statement refers to a formal and written record of all the financial activities and conditions of
an organisation, entity or a person. Financial statements contain a structured, organised, and detailed
summary of all the business processes. These determine the financial condition (whether organisation
is profitable or not) and the strengths and weaknesses of a business at the end of an accounting period.
Financial statements are prepared with the help of the trial balance that is prepared with the help of
ledgers.
There are three major types of financial statements Profit & Loss (P&L) Account, Balance Sheet and
Cash Flow Statement.
The profit and loss account or the income statement shows the r evenues and expenses of a company
during a particular period. It indicates how revenues are transferred into net income. The main objective
of the profit and loss statement is to show managers and investors whether the company has made
money or lost money during a reported period.
The balance sheet refers to the summary of the fiscal balances of a business organisation. In the balance
sheet, the assets, liabilities and equity are listed as of a specific date, such as the end of a fiscal
year. Very often financial accounts describe the balance sheet as a of a financial
The balance sheet is the only financial statement that applies to a single point in time in the
calendar year. Financial statement analysis provides a pathway to measure this element of
risk and it is a technique that features past performance of the organisation and can be measured in
terms of liquidity, profitability, growth potential, efficiency, etc. It focuses on the significant relations hip
between financial statements.
4.2 DIFFERENT FINANCIAL STATEMENTS

The primary aim of investing money in a business is to earn profit. An organisation needs to periodically
evaluate profits earned and losses incurred and its financial standing on a given date. There are
different users of accounting information and all of them have different requirements. The information
requirements of different users can be fulfilled by preparing final accounts or financial statements.
Financial statements provide information regarding the profit earned and the losses suffered by a
business. A financial statement is an official record of all financial transactions of an organisation for
a particular period. It reflects the financial position (or financial health) a nd the performance of the
organisation. Under a financial statement, the profit and loss account reflects the financial performance
of the organisation while the balance sheet reflects the financial position or financial health of the
organisation.
According to Section 2 (40) of the Indian Companies Act, 2013, a financial statement in relation to a
company includes the balance sheet as at the end of the financial year; the profit and loss account; the
40
UNIT 04: Financial Statements JGI JAIN
cash flow statement for the financial year; the statement of changes in equity; and any explanatory
notes annexed to, or forming part of, any document referred to in the above -mentioned financial
statements. However, the financial statement with respect to a One Person Company, a small company
and a dormant company may not include the cash flow statement.
A business owner would be interested in knowing whether his/her business is running at a profit or
incurring loss, the actual financial position of the business, etc. The main aim of financial statements is
to inform the owner about the progress of his/her business and the financial position at the right time
and in the right manner.
Apart from these three financial statements, a fourth statement is the statement of changes in
equity. In a business, the sole purpose of investing money is earning profits. The financial position of
an organisation is determined by evaluating the profit earned or loss suffered by an organisation. In
addition, different users of accounting need different accounting information. Financial statements are
created to fulfil these requirements. Financial statements provide information regarding total profit
earned or loss suffered, i.e., the net income and the distribution of income. The preparation of financial
statements is the final step in the accounting cycle.
4.2.1 Preparation of Statement of Profit and Loss

The profit and loss account is prepared so as to ascertain the net profit earned and the net loss suffered
by a business over a given accounting period. Therefore, this statement depicts the financial position
of the business. In other words, the profit and loss account is a statement that shows expenditures,
ss account is a brief description
produced on a monthly, quarterly, bi-annually or annual basis. In most cases, it is produced on an annual
basis along with other financial statements. The profit and loss account is a statement that reflects the
financial performance to its investors, management and other interested parties.
In simple words, the profit and loss account is the explanation of the
particular period. Let us now discuss the components of the profit and loss account which are given as
follows:
Revenue: Revenue is the total amount of money received by a business entity after selling its products
or services. Generally, revenue is also known as sales revenue or net sales, and it can be calculated
by deducting sales return, discounts and allowances from total sales. It is recorded at the top of the
income statement and because of this it is also known as
Cost of Goods Sold (COGS): The COGS includes all direct costs involved in the process of production.
For example, the costs raw material, labour, factory overheads, depreciation on plant and machinery,
etc.
Gross profit or gross loss: It is the difference between the revenue received and the cost of goods
sold for a particular period.
Operating expenses: Operating expenses are the expenses that a business entity has to bear in day-
to-day business operations. For example, amortisation of intangible assets, advertising and sales
expenses, research and development, rent of building, etc.
Administrative expenses: Administrative expenses are those expenses that are not directly related
with the process of production. These expenses are related to management and supporting activities
of a business organisation. For example, depreciation on corporate office building, salary of top-level
41
JGI JAIN
managers, legal charges, functional cost of the HR department, functional cost of IT department,
functional cost of the finance department, etc.
Operating income: The operating income can be calculated by deducting operating and
administrative expenses from gross profit. It is also known as Earnings before Interest and Taxes
(EBIT).
Other income: The other income is the income that is non-operational in nature and is not generated
on the basis of core operations of a business. For example, the rent received from the in -house
canteen contractor of a factory.
Other expenses: Other expenses are those expenses that are not related to the core operations of a
business enterprise and these expenses do not contribute anything to the process of production. For
example, income tax paid to the government, interest paid for borrowings, etc.
Net profit or net loss: It can be calculated by deducting all expenses from revenue. It is recorded at
is also known as because many non-cash transactions such as amortisation,

depreciation, etc. are included under it. All the above items appear in the debit or credit side of the
profit and loss account. The items that appear on the debit side of the profit and loss account are as
follows:
Expenses incurred in a business: This is divided into two parts:
Direct expenses: These are recorded in the income statement.
Indirect expenses: These are recorded on the debit side. Indirect expenses are further categorised
as follows:
Selling expenses: These include all expenses relating to sales such as carriage outwards, travelling
expenses, advertising, distribution costs, etc.
Office expenses: These include all expenses incurred on running an office such as office salaries,
rent, tax, postage, stationery, etc.
Maintenance expenses: These include all expenses related to the maintenance of assets such as
repairs and renewals, depreciation, etc.
Financial expenses: These include all expenses related to interest paid on loan, discount allowed,
etc. The items that appear on the credit side of the profit and loss account are as follows:
Gross profit
Other gains and incomes of the business such as interest received, rent received, discounts earned
and commission earned.
Particulars Note Figures as at the Figures as at the

No. end of the current end of the previous
reporting period reporting period
I. Revenue from operations XXX XXX
II. Other Income XXX XXX
III. Total Revenue (I+II) XXX XXX
IV. Expenses:
Cost of materials consumed XXX XXX
42

Purchases of Stock-in-Trade
Changes in inventories of finished XXX XXX
goods work-in-progress and
stock-in-trade
Employee benefits expense
Finance costs
Depreciation and amortisation
expense
Other expenses
Total Expenses XXX XXX
V. Profit before exceptional and XXX XXX
extraordinary items and tax (III-
IV)
VI. Exceptional items XXX XXX
VII. Profit before extraordinary items XXX XXX
and tax (V-VI)
VIII. Extraordinary items XXX XXX
IX. Profit before tax (VII-VIII) XXX XXX
X. Tax Expense:
1. Current Tax XXX XXX XXX
2. Deferred Tax XXX XXX XXX
XI. Profit/(Loss) for the period from XXX XXX
continuing operations
XII. Profit/(Loss) from discontinuing XXX XXX
operations
XIII. Tax expense of discontinuing XXX XXX
operations
XIV. Profit/(Loss) from discontinuing XXX XXX
operations (after tax)
XV. Profit/(Loss) for the period XXX XXX
XVI. Earnings per equity share:
1. Basic XXX XXX XXX
2. Diluted XXX XXX XXX
4.2.2 Preparation of Balance Sheet

In simple words, a balance sheet refers to a statement that summarises and presents the financial
position of an organisation on any given date. It shows assets and liabilities of the organisation. The
main aim of preparing a balance sheet is to determine the exact financial position of the organisation.
In a balance sheet, the debit balances are reflected by the assets and credit balances are reflected by
the liabilities. A number of steps are involved in preparing a balance sheet. The first step is transferring
43
JGI JAIN DEEMED-T O-BE UNI VE R SI TY
all nominal accounts in the trial balance to the trading and profit and loss account. Next, the personal
accounts of customers are grouped under the heading of sundry debtors, the entities from whom the
amounts of sold goods and services are due.
Similarly, we need to group all balances of suppliers under the single heading of sundry creditors, the
entities to whom the organisation owes money or payment. In the end, the real and personal accounts
are grouped as assets and liabilities and are arranged in a proper way. The resultant statement obtained
is called the balance sheet. The American Institute of Certified Public Accountants defines the balance
carried forward after an
actual constructive closing of books of account and kept according to the principles of
In the balance sheet, assets are represented on the right side and liabilities are shown on the left side.
It is also known as the statement of sources of funds and application of funds. The financial position
of the organisation includes its economic resources (assets), economic obligations (liabilities), and the
equity. As discussed in the previous chapters, a balance sheet is the detailed summary of the
basic accounting equation
Assets = Liabilities + Equity
and mandatorily from April 01, 2016. As per Schedule

III, the vertical format has now been permitted for the balance sheet. The balance sheet should include
the following items and in the order:
Name ot the Company.........................
Balance Sheet as at...........................
(Rupees in. ....... )

1 2 3 4
I. Equity and liabilities
1. funds
a. Share capital
b. Reserves and surplus
c. Money received against share warrants
2. Share application money pending
allotment
3. Non-current liabilities
a. Long-term borrowings
b. Deferred tax liabilities (Net)
c. Other long-term liabilities
d. Long-term provisions
44

4. Current liabilities
a. Short-term borrowings
b. Trade payables
c. Other current liabilities
d. Short-term provisions
Total:
II. Assets
1. Non-current assets
a. Fixed Assets
i. Tangible assets
ii. Intangible Assets
iii. Capital work-in-progress
iv. Intangible assets under
development
b. Non-current investments
c. Deferred tax assets (net)
d. Long-term Loan and Advances
e. Other Non-current assets
2. Current assets
a. Current investments
b. Inventories
c. Trade receivables
d. Cash and cash equivalents
e. Short-term loans and advances
f. Other current assets
Total:
4.3 OUTSTANDING EXPENSES

During the usual course of a business, there are expenses that will be incurred during the current
accounting period and are not paid or in other words, there are certain expenses that take place during
the current accounting period but payment for the same are not made, such expenses are called
outstanding expenses.
The outstanding expense is a personal account with a credit balance and is treated as a liability for the
business. It is recorded on the liability side of the balance sheet of a business.
For accounting accuracy, these expenses need to be realised whether they are paid or not. Like the other
expenses incurred by a business, it is also charged against the profit that is obtained for the current
year.
45
JGI JAIN
4.4 TREATMENT OF CLOSING STOCK

The closing stock implies inventory held at the end of the year. Thus, to derive information relating to
closing stock we maintain a real account by name Closing Stock. It provides data relating to the value
of stock unsold at the end of the accounting period. The value of closing stock is ascertained by physical
verification of stock and its valuation at cost or market price whichever is lower.
Usually, the closing stock does not appear in the Trial Balance when the accounts are being finalized as
the closing stock is ascertained by physical verification, which takes time in bringing up the value. Thus,
it appears as part of adjustment entry, which has to be passed before the preparation of Final Accounts.
If the closing stock is shown in the trial balance it means the adjustment for the closing stock has
already been done and it will be shown as a current asset on the right side of the balance sheet. From
the accounting point of view, aspects covered while preparing the accounts are:
1. Closing Stocks as shown on the Credit Side of Trading Account
2. Closing Stocks as shown on the Asset Side of Balance Sheet
However, if the value of the adjusted purchase (the cost of goods sold) is given then, the trial balance will
show figures of both adjusted purchases account and Closing Stock Account.
4.5 PREPAID EXPENSES

A prepaid expense is a type of asset on the balance sheet that results from a business making advanced
payments for goods or services to be received in the future. Prepaid expenses are initially recorded as
assets, but their value is expensed over time onto the income statement. Unlike conventional expenses,
the business will receive something of value from the prepaid expense over the course of several
accounting periods.
4.6 TAX PROVISION

A tax provision is comprised of two parts: current income tax expense and deferred income tax expense.
and temporary differences. The deferred tax calculation, which focuses on the effects of temporary
differences and other tax attributes over time, is the more complicated part of the provision.
4.7 DIVIDEND AND RESERVES
Dividend
A dividend is a distribution of profits by a corporation to its shareholders. When a corporation earns a
profit or surplus, it is able to pay a proportion of the profit as a dividend to shareholders. Dividends can
provide stable income and raise morale among shareholders.
Dividends must be approved by the shareholders through their voting rights. Although cash dividends
are the most common, dividends can also be issued as shares of stock or other property. Along with
companies, various mutual funds and Exchange-Traded Funds (ETF) also pay dividends.
A dividend is a token reward paid to the shareholders for their investment in a equity, and it
usually originates from the net profits. While the major portion of the profits is kept within
the company as retained earnings which represent the money to be used for the ongoing
and future business activities the remainder can be allocated to the shareholders as a dividend. At
46
times, companies may still make dividend payments even when they make suitable profits. They
may do so to maintain their established track record of making regular dividend payments.
Reserves
A reserve is retained earnings secured by a company to strengthen a financial position, clear
debt & credits, buy fixed assets, company expansion, legal requirements, investment and other plans.
These are usually done to save the cash from being used for other purposes. Reserve funds do not have
any legal restrictions so that the company can use them for any purpose.
Reserves are divided into two types:
1. Revenue Reserves
2. Capital Reserves
4.8 FINDING EARNING PER SHARE (EPS)
each outstanding share of common stock

Earnings per share value is calculated as net income (also known as profits or earnings) divided by
available shares. A more refined calculation adjusts the numerator and denominator for shares that
could be created through options, convertible debt, or warrants. The numerator of the equation is also
more relevant if it is adjusted for continuing operations.
To calculate a EPS, the balance sheet and income statement are used to find the period-end
number of common shares, dividends paid on preferred stock (if any), and the net income or earnings. It
is more accurate to use a weighted average number of common shares over the reporting term because
the number of shares can change over time.
A financial statement refers to a formal and written record of all the financial activities and conditions
of an organisation, entity or a person. Financial statements contain a structured, organised, and
detailed summary of all the business processes.
The profit and loss account or the income statement shows the revenues and expenses of a company
during a particular period.
The balance sheet refers to the summary of the fiscal balances of a business organisation. In the
balance sheet, the assets, liabilities and
end of a fiscal year.
The primary aim of investing money in a business is to earn profit. An organisation needs to
periodically evaluate profits earned and losses incurred and its financial standing on a given date.
The profit and loss account is prepared so as to ascertain the net profit earned and the net loss
suffered by a business over a given accounting period.
In simple words, a balance sheet refers to a statement that summarises and pr esents the financial
position of an organisation on any given date.
During the usual course of a business, there are expenses that will be incurred during the current
accounting period.
47
JGI JAIN
The closing stock implies inventory held at the end of the year.
A prepaid expense is a type of asset on the balance sheet that results from a business making
advanced payments for goods or services to be received in the future.
A tax provision is comprised of two parts: current income tax expense and deferred income tax
expense.
A dividend is a distribution of profits by a corporation to its shareholders.
Earnings per share (EPS) is calculated by determining a net profit and allocating that to
each outstanding share of common stock
4.10 GLOSSARY
Accounting Standards Board: The board consisting of accounting professionals to develop and
implement various accounting guidelines.
Bottom Line: The net profit of an organisation.
Carriage outward: The shipping and handling costs incurred by a company that is shipping goods
to a customer.
Depreciation: The reduction in the value of an asset over time due to wear and tear.
Sales commission: The amount of commission received by a person depending on the level of sales
obtained by him/her.
4.11 CASE STUDY: SATYAM COMPUTERS LIMITED BUSINESS ACCOUNTING

FRAUD
Case Objective
The case study explains the impact of fradulent financial reporting on an organisation and its
stakeholders.
Satyam Computer Services Limited was among the leading organisations in the outsourced IT services
industry in India. The organisation was established in 1987 in Hyderabad by Ramalinga Raju. Satyam
Computer Services Limited began with 20 employees and developed rapidly as a global IT company.
The company was engaged in providing IT and Business Process Outsourcing services across various
sectors. Between 2003-2008, Satyam Computer grew considerably and generated USD $467 million from
its total sales. By March 2008, Satyam Computer had grown to USD $2.1 billion. It booked an annual
compound growth rate of 35% in that time period.
Satyam was a Level I enterprise as it had a turnover above `50 crores. This implied that it was compulsory
for Satyam to comply all accounting standards. These accounting standards improve the credibility
and reliability of financial statements, determine managerial accountability, assist accountants and
auditors, and enable ease of understanding. However, there have been several frauds in corporate
history due to lack of compliance to these standards and inefficient corporate governance.
On January 7, 2009, Ramalinga Raju revealed in a letter addressed to Satyam Computers Board
g figures for several
years. Ramalinga Raju declared that he had overstated the assets on balance sheet
by $1.47 billion. He revealed that about $1.04 billion worth of bank loans and cash that Satyam claimed
to own did not exist. Besides, Satyam Computers had underreported its liabilities on the balance sheet
48
and had been involved in overstating its income almost every quarter over the course of several years
in order to meet the expectations of the critics. Satyam overstated quarterly revenues by 75 per cent and
profits by 97 per cent on October 17, 2009. It was also found out that bank accounts were falsified for
inflating the balance sheet with balances that actually never existed. In addition, the income statement
was exaggerated by declaring interest income from fake bank accounts. It was also exposed that the
company owner made 6000 fake salary accounts over the past several years and withdrew the money
after the company deposited it.
The result of the
s and pension fund. The

others that were affected were depositors in Satyam Computers, the underwriters, auditors,
attorneys, and insurers and even trustworthy competitors whose reputations suffered owing to their
association with Satyam. Some of the main points that organisations must remember after the Satyam
Scandal are:
Investigation of all inaccuracies: The fraud at Satyam started on a small scale initially and grew
up to $276 million. Most accounting frauds start out small with the offender assuming that minute
changes in the financial statements would go unnoticed. Thus, organisations should be aware when
the accounts do not balance or if something seems inaccurate even if it is insignificant.
Adherence to accounting standards: Organisations should follow a set of guidelines to prepare
and present their financial statements. This helps in bringing consistency in the reporting of
the accounting information. It also ensures transparency, consistency and comparability of the
accounting information by providing uniformity in accounting practices as accountants and
auditors follow the same rules and procedures.
Role division: Dividing responsibilities across a team of individuals would help in detecting
irregularities or misappropriated funds.
Questions
1. Suppose you are the finance manager at an MNC. What measures will you take to avoid financial
frauds?
(Hint: Periodically tally the books of accounts, check for the bank balance, investigate the unexpected
cash inflows and outflows and check the unbalanced accounts for small and big changes alike.)
2. Briefly explain the Satyam scam and the role played by the board.
(Hint: Prepare a summary by analysing various loopholes in the scandal.)

1. What is a financial statement?
2. Why profit and loss account is prepared?
49
JGI JAINDEEMED-T O-BE UNI VE R SI TY
3. What is a balance sheet?

4. What are prepaid expenses?

1. A financial statement refers to a formal and written record of all the financial activities and
conditions of an organisation, entity or person. Financial statements contain a structured, organised
and detailed summary of all the business processes. Refer to Section Different Financial Statements
2. The profit and loss account is prepared so as to ascertain the net profit earned and the net loss
suffered by a business over a given accounting period. Refer to Section Different Financial Statements
3. In simple words, a balance sheet refers to a statement that summarises and presents the financial
position of an organisation on any given date. It shows assets and liabilities of the organisation.
Refer to Section Different Financial Statements
4. A prepaid expense is a type of asset on the balance sheet that results from a business making
advanced payments for goods or services to be received in the future. Refer to Sec tion Prepaid
Expenses
https://corporatefinanceinstitute.com/resources/knowledge/accounting/thr ee -financial-
statements/
https://www.accountingtools.com/articles/2017/5/10/financial-statements
www.accountingtools.com/articles/2017/5/10/financial
https://www.wikiaccounting.com/five-types-of-financial-statements-ifrs/
www.wikiaccounting.com/five
www.wikiaccounting.com/five-
https://courses.lumenlearning.com/boundless-finance/chapter/introducing-financial-statements/
https://courses.lumenlearning.com/boundless
Discuss with your friends how financial statements work in a company.
50
UNIT
Bank Reconciliation Statement
Names of Sub-Units
Introduction to Bank Reconciliation Statement, Need for a Reconciliation Statement, Preparation of a

Bank Reconciliation Statement.
Overview
This unit begins with the meaning of bank reconciliation statement, it discusses the need for a
reconciliation statement. The unit explains the preparation of a bank reconciliation statement.
Learning Objectives

Explain the bank reconciliation statement
State the need for a reconciliation statement
Identify the preparation of a bank reconciliation statement
Learning Outcomes

Examine the need for a reconciliation statement
Analyse the preparation of a bank reconciliation statement
JGI JAIN
5.1 INTRODUCTION
Business organisations record all the cash and bank transactions in the cash book of the company.
The Bank also maintains an account for each customer in its book. A copy of this account is regularly
sent to the customer
as shown by the cash book and that shown by the bank statement do not match. If the balance shown
by the passbook is different from the balance shown by bank column of the cash book, the business
firm will identify the causes for such difference. It becomes necessary to reconcile them. To reconcile
the balances of Cash Book and Pass Book a statement is prepared. This statement is called the
Reconciliation
Bank Reconciliation Statement is a record book of the transactions of a bank account. This statement
helps the account holders to check and keep track of their funds and update the transaction record that
they have made.
The balance mentioned in the bank passbook of the statement must tally with the balance mentioned
in the cash book. In the statement, all the deposits will be shown in the credit column and withdrawals
will be shown in the debit column. However, if the withdrawal exceeds the deposit, it will show a debit
balance (overdraft).
5.2 CONCEPT OF BANK RECONCILIATION STATEMENT

A bank reconciliation statement is a summary of banking and business activity that reconciles an
other activities affecting a bank account for a specific period. A bank reconciliation statement is a useful
financial internal control tool used to thwart fraud.
Bank reconciliation statements ensure payments have been processed and cash collections have been
deposited into the bank. The reconciliation statement helps identify differences between the bank
balance and book balance, in order to process necessary adjustments or corrections. An accountant
typically processes reconciliation statements once a month.
The accountant adjusts the ending balance of the bank statement to reflect outstanding checks or
withdrawals. These are transactions in which payment is route but the cash has not yet been accepted
by the recipient. An example is a check mailed on Oct. 30. When preparing the Oct. 31 bank reconciliation
statement, the check mailed the previous day is unlikely to have been cashed, so the accountant deducts
the amount from the bank balance. There may also be collected payments that have not yet been
processed by the bank, which requires a positive adjustment.
5.2.1 Need for a Reconciliation Statement

The reconciliation statement is the most common tool used by organizations for reconciling the balance
as per books of company with the bank statement and is made at the end of every month. The main
objective of reconciliation is to ascertain if the discrepancy is due to error rather than timing. It is
prepared from time to time to check that all transactions relating to the bank are properly recorded by
the businessman in the bank column of the cash book and by the bank in its ledger account. Thus, it is
prepared to reconcile the bank balances shown by the cash book and by the bank statement. It helps in
detecting, if there is any error in recording the transactions and ascertaining the correct bank balance
56
UNIT 05: Bank Reconciliation Statement JGI JAIN
on a particular date. The need and importance of the bank reconciliation statement may be given as
follows:
1. The reconciliation process helps in bringing out the errors committed either in Cash Book or Pass
Book.
2. Bank reconciliation statement may also show any undue delay in the clearance of cheques.
3. Sometimes, the cashier may have the tendency of cheating, like he makes entries in the Cash Book,
staff may be detected only through bank reconciliation statements. So, the bank reconciliation
statement acts as a control technique too.
5.2.2 Preparation of a Bank Reconciliation Statement

Step 1: Check for Uncleared Dues
First of all, compare the opening balances of both the bank column of the cash book as well as the bank
statement. The two can be different in terms of uncleared dues like un-presented or un-credited cheques
from the previous month.
Step 2: Compare Debit and Credit Sides
Start by comparing the credit side of the bank statement to the debit side of the bank statement. Also,
compare the credit side of the cash book to the debit side of the cash book. The two must be equal in both
documents. Tick the columns if you find any error.
Step 3: Check for Missed Entries
Analyse entries in the bank column of the cash book as well as in checkbook. Look for records that have
been missed to be posted in the bank column of the cash book. Make a separate list of all such items and
list them in the cash book.
Step 4: Correct them
Correct the errors present in the cash book, if any.
Step 5: Revise the Entries
Calculate the balance after revising the updated cash bank column.
Step 6: Make BRS Accordingly
Prepare Bank Reconciliation Statement accordingly. Make sure to add the updated version of records.
Step 7: Add Unpresented Cheques and Deduct Uncredited Cheques
Banks are not aware of Un-
case when the business firm forgets to deliver the signed cheque to the issued name.
This situation leads to the addition of the cheque amount in the bank statement.
On the other hand, cheques which beneficiary has not yet collected are called un -credited cheques.
These must be deducted.
57
Step 8: Make Final Changes

Make all the final adjustments and check for bank errors in the bank statement and the errors
in the cash book. During heavy transaction days, firms or banks may make mistakes in noting entries.
The process removes those errors. Although it consists of fine work, reconciliation becomes a helping
hand at hard times (large transaction days).
Step 9: Left-Hand Side Equal to the Right-Hand Side
The results from both the documents i.e. bank statement and cash book must match with each other.
Business organisations record all the cash and bank transactions in cash book of the company.
The Bank also maintains an account for each customer in its book.
A copy of this account is regularly sent to the customer by the bank which is called or
To reconcile the balances of Cash Book and Pass Book a statement is prepared. This statement is
called the Reconciliation
A bank reconciliation statement is a summary of banking and business activity that reconciles an
bank account with its financial records.
Bank reconciliation statements ensure payments have been processed and cash collections have
been deposited into the bank.
The accountant adjusts the ending balance of the bank statement to reflect outstanding checks or
withdrawals.
The reconciliation statement is the most common tool used by organizations for reconciling the
balance as per books of company with the bank statement and is made at the end of every month.
5.4 GLOSSARY
Bank Overdraft: If the bank statement shows a debit balance at a particular point in time, it is
known as an overdraft. It implies that the account is overdrawn, i.e., withdrawals are more than
deposits. Bank
Statement: It gives the details of transactions between the bank and the customer. Every bank
provides bank statements to each customer either weekly or monthly.
Pay-in-Slips: Documents supporting cheques deposited into the bank.
5.5 CASE STUDY: PROBE BLAMES LACK OF INTERNAL CONTROLS
Case Objective
The case study explains the impact of lack of internal controls in an IT giant.
58
UNIT 05: Bank Reconciliation Statement JGI JAIN
An independent legal counsel appointed by IT major Wipro has found that lack of internal controls led
to the embezzlement committed by one of the former junior employees between November 2006 and
December 2009.
The legal counsel submitted the probe report last week to the audit committee set up to investigate the
fraud early.
Based on the findings of the legal counsel, Wipro said that if corrections were to be carried out to the
-after-tax for 2009-10 would have been

higher by 2.1 per cent (approximately 92 crores). Chief Financial Officer, Mr. Suresh C. Senapaty,
submitted the report this month and measures have already been taken to tighten the he said.
Stating that it has been able to recover most of the embezzled amounts, Wipro, which is listed on the
New York Stock Exchange, in its latest disclosure to the US Securities and Exchange Commission, said
its audit panel has concluded that mistakes were committed in certain accounting entries and that they
were also not supported by any documents. and our independent registered public accounting firm
also identified the lack of internal controls that gave rise to the embezzlement and financial statement
misstatements as material weaknesses in internal control over financial Wipro said in its
disclosure to SEC. The material weaknesses related to sharing of online banking access passwords and
ernal accounting system passwords by certain employees within the finance and accounting
departments including those responsible for external financial reporting.
There was a lack of effective controls over recording of journal entries, including inadequate
documentation which resulted in ineffective controls over bank reconciliation statements, exchange
rate fluctuation accounts and outstanding liabilities accounts and also there was a lack of timely and
adequate reconciliation and review of period and end reinstatement of foreign currency inter-company
and unit balances, including recording of appropriate adjustments. Also, segregation of duties with
respect to recording and initiating banking payments was found insufficient.
Questions
1. Why is BRS important for a firm?
(Hint: Reconciliation helps you identify any unusual transactions that might be caused by fraud or
accounting errors, and the practice can also help you spot inefficiencies.)

1. What is bank reconciliation statement?
2. What is the need to prepare bank reconciliation statement?
3. What are the steps in the preparation of a bank reconciliation statement?

1. A bank reconciliation statement is a summary of banking and business activity that reconciles an
59
financial records. Refer to Section Concept of Bank Reconciliation
Statement
2. The main objective of reconciliation is to ascertain if the discrepancy is due to error rather than
timing. Refer to Section Concept of Bank Reconciliation Statement
3. There are nine steps in the preparation of a bank reconciliation statement. Refer to Section Concept
of Bank Reconciliation Statement
https://tallysolutions.com/accounting/bank-reconciliation-statement/
https://cleartax.in/s/bank-reconciliation-statement
https://corporatefinanceinstitute.com/resources/knowledge/accounting/bank-reconciliation/
https://corporatefinanceinstitute.com/resources/knowledge/accounting/bank-reconciliation/
Discuss with your friends how a bank reconciliation statement is useful for a firm.
60
UNIT
Ratio Analysis
Names of Sub-Units
Introduction to the Ratio Analysis, Types of Ratios, the Concept of Liquidity Ratios, Solvency Ratio, the
Concept of Activity Ratio, the Concept of Profitability Ratio, the Concept of Market Test Ratio.
Overview
This unit begins by the meaning of ratio analysis, it discusses the concept of liquidity ratios. The unit
explains the solvency ratio. It also discusses the profitability ratio.
Learning Objectives

Explain the profitability ratio
State the solvency ratio
Identify the activity ratio
Classify the profitability ratio
Learning Outcomes
Assess the importance of profitability ratio
Examine the profitability ratio
Analyse the solvency ratio
Evaluate the activity ratio
JGI JAIN
6.1 INTRODUCTION
The ratio analysis is one of the important tools of financial statement analysis to study the financial
ratio is used to describe significant relationships which exist between figures shown in a balance
sheet, in a profit and loss account, in a budgetary control system or any other part of the accounting
Financial statements contain substantial information (figures) relating to profit or loss
and financial position of the business. If these items in financial statements are considered independently,
they may or may not be of much use. To make a meaningful reading of financial statements, these items
found in financial statements have to be compared with one another. Ratio analysis, as a technique or
analysis of financial statements uses this method of comparing the various items found in financial
statements.
6.2 INTRODUCTION TO RATIOS

Accounting ratios, an important sub-set of financial ratios, are a group of metrics used to measure the
efficiency and profitability of a company based on its financial reports. They provide a way of expressing
the relationship between one accounting data point to another and are the basis of ratio analysis.
can be used to evaluate the financial strengths and weaknesses of an organisation. Ratio analysis helps in
presenting the information contained within the financial statements in a comparative form. Financial
investors, creditors and management of an organisation. This information helps these stakeholders
in understanding how well a business is performing and what areas of the business need to be
improved.
6.2.1 Types of Ratios

Financial ratios are categorised into four major types which are based on the five different financial
aspects of a business, namely liquidity, solvency/leverage, profitability, activity and market test. Financial
ratios are analytical tools that help in comparing financial statements of different organisations,
industries or different departments of a single organisation. Also, they can be used to compare financial
data of an organisation at different time periods. While analysing the financial statements of an
organisation, it is advisable to have a complete understanding of the different types of ratios, their
calculation and interpretation.
Liquidity Ratios
Ratios that are used to measure the liquidity position of a business entity are categorised under liquidity
without
by using its current assets. The current liabilities are the short-term obligations to be met within one
year. For example, short-term debt, accounts payable, sundry creditors, etc. Current assets refer to the
short-term assets that can be converted to cash within a year. For example, cash, marketable securities,
short-term investments, accounts receivable, prepaid expenses, inventory, etc. There are three important
liquidity ratios which are as follows:
64
UNIT 06: Ratio Analysis JGI JAIN
Current Ratio
The current ratio is equal to the total current assets divided by total current liabilities. It indicates the
extent to which current assets can be used to pay-off current liabilities. Mathematically, it is expressed
as follows:
Current Assets
Current Ratio
Current Liabilities
Quick Ratio
One of the limitations of the current ratio is that it assumes that all current assets of a business entity
can be easily converted to cash to meet its current liabilities. This assumption may not always be true.
There are current assets such as inventory and pre-paid expenses that cannot be readily converted
into cash. To overcome this limitation, there is another ratio called the quick ratio. The quick ratio is
also referred to as the acid test ratio. Quick ratio is equal to liquid current assets divided by current
liabilities. Mathematically, it can be expressed as follows:
Cash in hand Cash at bank Receivable Marketable securitis
Current Ratio
Current Liabilities
Alternatively, quick ration can also be calculated as follows:

Current Assets Inventory Advances Prepayments
Current Ratio
Current Liabilities
be paid-off using
its liquid current assets such as cash, marketable securities and accounts receivables. Ideally, a quick
ratio of 1:1 is considered financially viable.
Cash Ratio
It is the ratio of cash and cash equivalents of an organisation to its current liabilities. It assesses the
capability of a business entity to repay its current liabilities by using its cash and cash equivalents
only. It is a more restrictive and better measure of liquidity than the current ratio and quick ratio. The
formula of cash ratio is as follows:
Cash Cash Equivalents
Cash Ratio
Current liabilities
Solvency Ratio
Solvency ratios are also called leverage ratios. These are used to measure the ability of an organisation
to service its debt and interest obligations. Solvency ratios are different from liquidity ratios, although
both are used to measure the ability of an organisation to pay-off its obligations. Solvency ratios are a
measure of the long-term sustainability of a business entity, while liquidity ratios are a measure of the
current liabilities of an organisation. Solvency ratios are particularly of interest to long-term creditors
and shareholders as these ratios give a clear picture of the long-term health and survival of business
entity. Solvency ratios are tools to assess if a business entity can pay-off its debt and interest on maturity.
65
JGI JAIN
The ideal solvency ratio varies from one industry to another. However, a solvency ratio higher than 20%
is considered to be satisfactory. A low solvency ratio is indicative of an insufficiency to
repay its debt obligations. Some of the important Solvency Ratios are as follows:
Debt-Equity Ratio
The debt- against its
total equity. In other words, this ratio reveals the relationship between external equities and internal
equities. Therefore, it is also called the external-internal equity ratio. Total equity includes all ordinary
capital, reserves, preferences and minorities. It is an net assets (total assets as reduced
For example, if the debt-equity is 50%, it implies that half

debt and the other half are financed using equity. Solvency ratios help the business owners to predict
the chances of a possible bankruptcy. As the debt-equity ratio increases, the possibility of bankruptcy
increases significantly as the organisation is financed heavily using debt as against equity. The debt-
to-equity ratio debt-equity ratio measures the ratio of long-
Mathematically, it can be expressed as follows:
Total liabilities
Debt Equity Ratio
Shareholders' equity
Debt is borrowed capital and includes those funds which a firm owes to external sources of finance.
These funds are obligatory in nature and are sourced from banks, NBFCs, etc. The debt considered is
exclusive of current liabilities.
Equity is the capital owned by an organisation and it can be raised by issuing new shares or equity.
These funds are ownership based in nature and belong to shareholders, proprietors or the owner of the
discounts on the issue of shares, common stock, treasury stock, retained earnings, and the capital
surplus. The debt-equity ratio can also be computed as follows:
Total debt
Debt Equity Ratio
Shareholders' equity
Therefore, the debt-

words, it is the ratio of the amount invested by outsiders (shareholders) to the amount invested by the
owners of an organisation.
Debt-to-Total Assets Ratio
through loans and other financial liabilities. A ratio greater than 1 implies that a significant proportion
of assets are being financed using debt, whereas a ratio below 1 implies that most of the assets are
financed through equity. The debt to total assets ratio can be calculated as follows:
Long Term Debt
Debt to Total Assets Ratio
Total Assets
66
Interest Coverage Ratio

Interest coverage ratio denotes the relationship between the net profit (earnings) before interest and
tax (EBIT), and the fixed interest charges. It is used by stakeholders to evaluate whether the concerned
organisation would be able to pay its interest periodically.
Interest Coverage Ratio = EBIT/Fixed Interest Expenses
Preferred Dividend Coverage Ratio

This ratio is used to measure the ability of a firm to pay a dividend on preference shares carrying a
specific rate of return. For example, dividend coverage of 3 implies that a firm has sufficient earnings
to pay dividends amounting to 3 times of the present preferred dividend pay-out during a period. The
preferred dividend coverage ratio is expressed as follows:
Preferred dividend coverage ratio = EAT or PAT (earnings/profits after taxes)/ Preference dividend
Preferred Dividend Coverage Ratio = [EAT (or PAT)]/(Annual amount of Preference Dividend)
Solvency Ratio
-term debt and other obligations. The
cash flows are sufficient to meet its short - and long-
ratio measures the size of a business income after tax plus depreciation expenses against the
total debt obligations of the business entity. Mathematically,
Solvency Ratio = (PAT + Depreciation)/(Total Liabilities)
An insolvent firm cannot pay its debt and would be forced into bankruptcy. It is recommended that
investors should examine all the financial statements of a firm to ensure that it is solvent and profitable.
Fixed Assets Ratio
plant and equipment less depreciation. Mathematically:

Fixed assets ratio = (Net sales)/(Average net fixed assets)
A higher fixed assets ratio indicates that the firm has effectively used investments in fixed assets to
generate revenues. On the contrary, a lower ratio indicates that the resources have been underutilised
and there is the presence of idle capacity.
Capital Gearing Ratio

Capital gearing is also known as financial leverage. Capital gearing ratio is the relation of common
-bearing funds. Capital gearing describes the relative share of
fixed interest and/or fixed dividend-
can be calculated as follows:
Capital Gearing Ratio = (Common Equity)/(Fixed Cost-Bearing Funds)
67
JGI JAIN
Here, fixed cost-bearing funds = Debentures + Preference shares + Other long-term loans
High capital gearing ratio indicates that an organisation has large fund-bearing fixed interest and/
or fixed dividend-bearing funds compared to equity share capital. A lower ratio indicates that the
preference shares capital and other fixed interest-bearing funds in the organisation are less than the
equity share capital. An ideal capital gearing ratio is 2:1.
Activity Ratio
Activity Ratios, also referred to as Operating or Management Ratios, are used to measure an
and fixed assets. The commonly used Activity Ratios are inventory turnover ratio, turnover
ratio and working capital turnover ratio. Before discussing different types of Activity Ratios, let us first
understand the concept of the average collection period. Average collection period refers to the average
number of days between the date that a credit sale is made and the date that receivables are collected
from the customer. It is computed as follows:
365
Average collection period
Average Receivables Turnover Ratio
Where, Average Receivables Turnover Ratio = (Annual Sales)/(Accounts Receivables)
Inventory Turnover Ratio

It is the ratio of cost of goods sold by an organisation to its average inventory during a given accounting
during a given period. In other words, the inventory turnover ratio measures the number of times an
organisation sold its total average inventory during a financial year. For example, an organisation with
an average inventory and net sales of worth ` 10,00,000 and ` 50,00,000 effectively sold its inventory
over 5 times. Inventory Turnover Ratio is calculated using the following formula:
Cost of Goods Sold
Inventory Turnover Ratio
Average Inventory
COGS = Opening Inventory + Purchases Closing Inventory

Average inventory refers to the average of beginning and closing inventory:
OpeningInventory ClosingInventory
Average Inventory
2
365
Average Selling Period :
Inventory Turnover
Debtors Turnover Ratio

This ratio measures the number of times average debtors are turned over during a financial year. Debtors
Turnover Ratio is also referred to as accounts receivable turnover ratio. It indicates the frequency with
which the sundry debtors in an organisation are converted into cash. A higher value of Debtors Turnover
Ratio reflects an efficient management of debtors by an organisation. On the other hand, lower value
68
of Debtors Turnover Ratio reflects inefficient management of debtors by the organisation. Accounts
Receivable Turnover is calculated by dividing net credit sales by Average Accounts Receivable for that
period. Mathematically, it can be expressed as follows:
Net Credit Sales
Debtors Turnover Ratio
Average Accounts Receivables
Creditors Turnover Ratio

Creditors turnover ratio is calculated by dividing the net credit purchases by the average accounts
payable during a financial year. It is also called accounts payable turnover ratio. It is computed as
follows:
Creditors Turnover Ratio = (Net Credit Purchases)/(Average Accounts Payable)
Net Credit Purchases = Gross credit purchases Returns to suppliers
Average Accounts Payable = Average of bills payable at the beginning and at the end of the year.
Higher creditor turnover ratio indicates rapid account settlement of creditors.
Working Capital Turnover Ratio

Working capital measures, the operating liquidity available to an organisation. It is current assets
as reduced by current liabilities in a given time period. A high ratio indicates efficient utilisation of
working capital and vice versa. However, a very high Working Capital Turnover Ratio implies that an
organisation does not have enough capital to support its sales. The commonly used formula for the
calculation of Working Capital Turnover Ratio is as follows:
Net Sales
Working Capital Turnover Ratio
Average Working Capital
Profitability Ratio
to its expenses over a specified time period. Profit includes the income earned after an organisation has
deducted the costs and expenses incurred in the process. The three main types of profitability ratios are
gross profit ratio, net profit ratio and operating profit ratio. Let us discuss various profitability ratios:
Gross Profit Ratio

This ratio shows the relationship between an gross profit and total net sales revenue.
This ratio is used to assess the operational performance of the organisation. It is calculated by dividing
gross profit by net sales in a given time period. Mathematically, the gross profit ratio can be expressed
as follows:
Gross profit
Gross Profit Ratio
Net sales
69
JGI JAIN
or
Sales Direct Materials Direct Labour Overhead
Sales
When expressed in percentage form, gross profit ratio is known as gross profit margin or gross profit
percentage.
Gross Profit
Gross Profit Margin 100
Net Sales
Higher ratios are considered favourable as they imply that the organisation is selling its products at a
higher profit percentage.
Net Profit Ratio

Net profit ratio calculation involves use of two values, namely net profit after tax and
net sales. Net profit is determined by adjusting the operating and non-operating incomes and expenses
and loss in the gross profit. It is calculated by dividing the net profit (after tax) figure by the net sales in
a given time period. Net profit after tax is calculated by deducting operating expenses and income tax
from gross profit. Mathematically, Net Profit Ratio can be expressed as follows:
Net Profit after Tax
Net Profit Ratio
Net Sales
When expressed in percentage form, net profit ratio is known as net profit margin or net profit
percentage
Net Profit after Tax
Net Profit Margin 100
Net Sales
Operating Profit Ratio

This ratio indicates the relationship between operating income of an organisation and its sales revenue.
Operating profit ratio shows operating income as a percentage of revenue from sales. It is calculated by
dividing operating income by sales revenue. Mathematically, it can be expressed as follows:
OperatingIncome
Operation Profit Ratio
Sales Revenue
When expressed as a percentage, Operating Profit Ratio is known as operating margin and it can be
expressed as follows:
OperatingIncome
Operating Margin 100
Sales Revenue
Operating income is also referred to as Earnings Before Income and Taxes (EBIT). EBIT includes the
income that remains on the income statement after all operating and overhead costs are deducted.
70
Return On Investment (ROI)

This ratio used to evaluate the competence of an investment or to compare the competence of different
investments. ROI is calculated by dividing the return expected from an investment by the cost of the
investment. ROI is expressed as a percentage and the formula is as follows:
Return from Investment Cost of Investment
ROI
Cost of Investment
Return On Equity (ROE)
with the money. ROE is expressed as a percentage and the formula is as follows:
ROE = Net Equity
Return On Assets (ROA)

Return on Assets measures how profitable an organisation is relative to its total assets. In other words,
ROA indicates how efficiently the management is utilising its assets to generate profits. ROA is expressed
as a percentage and the formula is as follows:
ROA = (Net Income)/(Total Assets)
Market Test Ratio
ratios are indicators of the performance of the company and also reflects the likely performance of the
company in the near future. If the profitability, solvency and turnover ratios are good then the
market test ratios will be high. The market test ratios are as follows:
Dividend per Share/Earnings per Share
Dividend Payout Ratio: Dividend payout ratio is the dividend per share divided by the earnings per
share. Dividend payout ratio indicates the extent of the net profit distributed to the shareholders by
way of dividend. A higher dividend payout ratio indicates that the company does not require further
funds in the near future or it may also indicate that the cost of borrowing is less than the cost of
equity. A low payout ratio is an indicator of the fact that the company is in requirement of funds.
Dividend Yield: (Dividend per share/Market price)× 100
This ratio reflects the percentage yield earned by investors by investing in share at the
current market price. This measure is especially useful for those investors who are interested in
regular returns rather than capital appreciation.
Book Value: (Equity capital + Reserves Profit loss A/C debit balance)/Total number of equity shares
This ratio indicates the net worth per equity share. Book Value is a function of the past earnings and
distribution policy of the company.
71
Ratio analysis is a tool for determining and interpreting the relationships between different
financial statements for providing the understanding of the performance and financial position of
an organisation.
Financial ratios can be divided into liquidity ratios, solvency ratios, profitability ratios and activity
ratios.
to meet its current liabilities using its
current assets. These are the current ratio and quick ratio.
Solvency ratios also referred to as leverage ratios are used to measure the ability of an organisation
to pay its long-term debt and the interest on that debt. For example, debt-equity and debt to total
assets ratios.W
expenses over a specified time period. For example, gross profit, net profit and operating profit
ratios.
Activity ratios also referred to as operating or management ratios are used to measure an
and fixed assets.

The most commonly used activity
turnover ratios.
6.4 GLOSSARY
Debt: The amount owed to an individual or organisation for the funds borrowed.
Equity: The value of the shares issued by an organisation.
Debentures: The long-term securities that yield a fixed rate of interest, issued by an organisation
and secured against assets.
Working capital: The capital used by an organisation to perform its day-to-day operations and
obtained by deducting the current liabilities from the current assets.
6.5 CASE STUDY: STORTFORD YACHTS LIMITED
Case Objective
The case study explains the analysis of financial statements.
Stortford Yachts Ltd. was established in 1983 and provides complete service for cruise holidays in various
destinations of Greece and Turkey. It deals in yacht chartering, yacht management and yacht brokerage
business. The company manages a fully equipped fleet of yachts and has a team of qualified and trained
staff.
In the past, the company has achieved good levels of growth and return on capital which is gradually
changing. The company has failed to introduce new product lines and relies on traditional yachts with
72
little investment in research or product development. The Director of Stortford Yachts Ltd., Paul Marriot
decided to address the problem and introduce new ideas with respect to their product lines.
Paul meets the Director of Management Consultants group and stated that he plans to introduce
stronger management control within the company. The Director receives a file containing a summary
of the profit and loss statement, and the balance sheet statements of Stortford Yachts Ltd., for the past
three years, which is as follows:
Profit and Loss Account summary
Particulars (in lakhs)

2011 2012 2013
Sales turnover 4.90 5.30 6.60
Operating costs 4.17 4.43 5.82
Profit before tax 0.73 0.87 0.78
Taxes 0.24 0.30 0.27
Profit after tax 0.49 0.57 0.51
Dividends 0.12 0.16 0.16
Net profit 0.37 0.41 0.35
Balance Sheet Summary
Particulars (in lakhs)

2011 2012 2013
Fixed assets 2.40 2.77 2.88
Current assets
Stocks:
Raw materials 0.09 0.12 0.15
Finished goods 0.40 0.43 0.45
Debtors 1.14 1.32 1.84
Bank 0.03 0.04 0.05
1.66 1.91 2.49
Less: Current liabilities 1.35 1.56 1.90
Net current assets 0.31 0.35 0.59
2.71 3.12 3.47
Capital find reserves 0.5 0.91 1.26
Bank loans 2.21 2.21
2.71 3.12 3.47
73
JGI JAIN
Financial ratios of Stortford Yacht Ltd. for the year 2013 were also provided to the consultants: Average
ratios for 2013
Ratio 2013
Return on equity 27.78%
Asset turnover 1.9 times
Net profit margin 5.3%
Current ratio 1.31 times
Quick ratio 0.995 times
Debtors collection period 28 days
Suppose you are the Planning Assistant of the Management Consultants Group and are required to
analyse the financial statement over the last three years.
Questions
1. Prepare a detailed report on the performance in terms of profitability and liquidity.
(Hint: Analyse the other Liquidity and Profitability Ratios for the years 2011 and 2012 of Stortford
Yacht Ltd.)
2. Suggest changes in the financial structure to improve the profitability and liquidity position of the
company.
(Hint: Based on the ratio trends, suggest structural changes to the company. The reduction in overall
performance is highlighted through the reduction of the net profit figures on the profit and loss
statement. The company needs to control costs and analyse the reason behind the sharp fall in the
net profit figures.)

1. What is ratio analysis?
2. What is liquidity?
3. What is debt-equity ratio?
4. What is the inventory turnover ratio?

1. The ratio analysis is one of the important tools of financial statement analysis to study the financial
stature of the business fleeces, corporate houses and so on. Refer to Section Introduction to Ratios
2. Liquidity refers to the business ability to convert its assets into cash quickly without reducing
its price. Liquidity ratios help in assessing an ability to meet its current liabilities by
using its current assets. Refer to Section Introduction to Ratios
74
JAIN
3. The debt-
its total equity. Refer to Section Introduction to Ratios
4. It is the ratio of the cost of goods sold by an organisation to its average inventory during a given
accounting period. Refer to Section Introduction to Ratios
https://www.accountingtools.com/articles/ratio-analysis.html
https://corporatefinanceinstitute.com/resources/knowledge/finance/ratio-analysis/
https://corporatefinanceinstitute.com/resources/knowledge/finance/financial-ratios/
https://cleartax.in/s/accounting-ratio
https://www.educba.com/ratio-analysis-types/
Discuss with your friends how ratio analysis is useful nowadays.
75
UNIT
Cost-Volume-Profit Analysis (CVP)
Names of Sub-Units
Introduction to Cost-Volume-Profit Analysis (CVP), Calculations for CVP Analysis, Concept of Achieving
a Desired Profit, Break-Even Analysis.
Overview
This unit begins by explaining the meaning of cost-volume-profit analysis (CVP), it discusses the
calculations for CVP analysis. The unit explains achieving a desired profit. It also discusses the break-
even analysis.
Learning Objectives

Explain the meaning of cost-volume-profit analysis (CVP)
State the calculations for CVP analysis
Identify the achieving a desired profit
Classify the break-even analysis.
JGI JAIN
Learning Outcomes

Assess the meaning of cost-volume-profit analysis (CVP)
Examine the break-even analysis
Analyse the calculations for CVP analysis
Evaluate the achieving a desired profit
7.1 INTRODUCTION
The cost-volume-profit (CVP) analysis helps management in finding out the relationship of costs and
revenues to profit. The aim of an undertaking is to earn profit. Profit depends upon a large number of
factors, the most important of which are the costs of the manufacturer and the volume of sales effected.
Both these factors are interdependent the volume of sales depends upon the volume of production,
which, in turn, is related to costs. The cost again is the result of the operation of a number of varying
factors as follows:
1. Volume of production
2. Product mix
3. Internal efficiency
4. Methods of production
5. Size of plant, etc.
Of all these, volume is perhaps the largest single factor which influences costs which can basically be
divided into fixed costs and variable costs. Volume changes in a business are a frequent occurrence,
often necessitated by outside factors over which management has no control and as costs do not
always vary in proportion to changes in levels of output, management control of the factors of
volume presents a peculiar problem. As profits are affected by the interplay of costs and volume,
the management must have, at its disposal, an analysis that can allow for a reasonably accurate
presentation of the effect of a change in any of these factors which would have no profit performance.
Cost-volume-profit analysis furnishes a picture of the profit at various levels of activity. This enables
the management to distinguish between the effect of sales volume fluctuations and the results of price
or cost changes upon profits. This analysis helps in understanding the behaviour of profits in relation
to output and sales. Fixed costs would be the same for any designated period regardless of the volume
of output accomplished during the period (provided the output is within the present limits of capacity).
These costs are prescribed by contract or are incurred in order to ensure the existence of an operating
organisation. Their inflexibility is maintained within the framework of a given combination of resources
and within each capacity stage, such costs remain fixed regardless of the changes in the volume of
actual production. As fixed costs do not change with production, the amount per unit declines as output
rises. Absorption or full costing system seeks to allocate fixed costs to products. It creates the problem
of apportionment and allocation of such costs to various products. By their very nature, fixed costs have
little relation to the volume of production.
80
UNIT 07: Cost-Volume-Profit Analysis (CVP) JGI JAIN
Variable costs are related to the activity itself. The amount per unit remains the same. These costs
expand or contract as the activity rises or falls. Within a given time span, distinction has to be drawn
between costs that are free of ups and downs of production and those that vary directly with these
changes. Study of behaviour of costs and CVP relationship needs proper definition of volume or activity.
Volume is usually expressed in terms of sales capacity expressed as a percentage of maximum sales,
volume of sales, unit of sales, etc.
Production capacity is expressed as a percentage of maximum production, production in revenue
of physical terms, direct labour hours or machine hours. Analysis of cost-volume-profit involves
consideration of the interplay of the following factors: 1. Volume of sales 2. Selling price 3. Product mix
of sales 4. Variable cost per unit 5. Total fixed costs.
The relationship between two or more of these factors may be (a) presented in the form of Notes, reports
and statements (b) shown in charts or graphs, or (c) established in the form of mathematical deduction.
7.2 INTRODUCTION TO CVP

Cost-volume-profit (CVP) analysis is a method of cost accounting that looks at the impact that varying
levels of costs and volume have on operating profit.
The cost-volume-profit analysis, also commonly known as break-even analysis, looks to determine the
break-even point for different sales volumes and cost structures, which can be useful for managers
making short-term economic decisions. CVP analysis makes several assumptions, including that the
sales price, fixed and variable cost per unit are constant. Running this analysis involves using several
equations for price, cost and other variables, then plotting them out on an economic graph.
The CVP formula can be used to calculate the sales volume needed to cover costs and break even. The
break-even point is the number of units that need to be sold, or the amount of sales revenue that has to
be generated, in order to cover the costs required to make the product.
7.2.1 Calculations for CVP Analysis

The CVP analysis looks at the effect of sales volume variations on costs and operating profit. The analysis
is based on the classification of expenses as variable (expenses that vary in direct proportion to sales
volume) or fixed (expenses that remain unchanged over the long term, irrespective of the sales volume).
Accordingly, operating income is defined as follows:
Operating Income = Sales Variable Costs Fixed Costs
A CVP analysis is used to determine the sales volume required to achieve a specified profit level. Therefore,
the analysis reveals the break-even point where the sales volume yields a net operating income of zero
and the sales cutoff amount that generates the first dollar of profit.
Cost-volume profit analysis is an essential tool used to guide managerial, financial and investment
decisions.
Contribution Margin and Contribution Margin Percentage

The first step required to perform a CVP analysis is to display the revenue and expense line items in a
contribution margin income statement and compute the contribution margin ratio.
81
JGI JAIN
A simplified contribution margin income statement classifies the line items and ratios as follows:
Contribution Margin Income Statement
Statement Item Amount Percent of Income
Sales $100 100%
(Deduction) Variable Costs $60 60%
(Total) Contribution Margin $40 40%
(Deduction) Fixed Costs $30 30%
(Total) Operating Income $10 10%
The method relies on the following assumptions:

Sales price per unit is constant (i.e., each unit is sold at the same price).
Variable costs per unit are constant (i.e., each unit costs the same amount).
Total fixed costs are constant (i.e., costs such as rent, property taxes or insurance do not vary with
sales over the long term).
Everything produced is sold.
Costs are only affected because activity changes.
The equation:
Operating Income = Sales Variable Costs Fixed Costs

Sales = units sold × price per unit
Variable costs = units sold × cost per unit
The first equation above can be expanded to highlight the components of each line item:
Operating Income = (units sold × price per unit) (units sold × cost per unit) Fixed Cost
The contribution margin is defined as Sales Variable Costs. Therefore,
Contribution margin ($) = (units sold × price per unit) (units sold × cost per unit)
Contribution margin percentage (CM%) is computed as follows:
CM% = Contribution Margin (%) / Sales (%)
Accordingly, another way to express the relationship between contribution margin, CM percentage, and
sales is as follows:
Contribution margin % = Sales % × Contribution Margin %
The contribution margin percentage indicates the portion each dollar of sales generates to pay for
fixed expenses (in our example, each dollar of sales generates $.40 that is available to cover the fixed
costs).
82
As the variable costs change in direct proportion (i.e., in %) of revenue, the contribution margin also
changes in direct proportion to revenues, However, the contribution margin percentage remains the
same.
Targeted Profit
The CVP analysis is conducted to determine a revenue level required to achieve a specified profit. The
revenue may be expressed in number of units sold or in dollar amount.
Income Statement
Statement Item Amount Percent of Income
Sales (20 units $5) $100 100%
(Deduction) Variable Costs (20 units $3) ($60) (60%)
(Total) Contribution Margin $40 40%
(Deduction) Fixed Costs ($30) (30%)
(Total) Operating Income $10 10%
7.2.2 Achieving a Desired Profit

The CVP analysis also manages product contribution margin. Contribution margin is the difference
between total sales and total variable costs. For a business to be profitable, the contribution margin must
exceed total fixed costs. The contribution margin may also be calculated per unit. The unit contribution
margin is simply the remainder after the unit variable cost is subtracted from the unit sales price. The
contribution margin ratio is determined by dividing the contribution margin by total sales.
The contribution margin is used in the determination of the break-even point of sales. By dividing the
total fixed costs by the contribution margin ratio, the break-even point of sales in terms of total dollars
may be calculated. For example, a company with $100,000 of fixed costs and a contribution margin of
40% must earn revenue of $250,000 to break even.
Profit may be added to the fixed costs to perform CVP analysis on a desired outcome. For example, if the
previous company desired an accounting profit of $50,000, the total sales revenue is found by dividing
$150,000 (the sum of fixed costs and desired profit) by the contribution margin of 40%. This example
yields a required sales revenue of $375,000.
CVP analysis is only reliable if costs are fixed within a specified production level. All units produced
are assumed to be sold, and all fixed costs must be stable in a CVP analysis. Another assumption is all
changes in expenses occur because of changes in activity level. Semi-variable expenses must be split
between expense classifications using the high-low method, scatter plot or statistical regression.
7.2.3 Break-even Analysis

Break even analysis examines the relationship between the total revenue, total costs and total profits
of the firm at various levels of output. It is used to determine the sales volume required for the firm
83
JGI JAIN
to break even and the total profits and losses at other sales level. Break even analysis is a method, as
said by Dominick Salnatore, of revenue and total cost functions of the firm. According to Martz, Curry
and Frank, a break-even analysis indicates at what level cost and revenue are in equilibrium. In case of
break-even analysis, the break-even point is of particular importance. Break-even point is that volume
of sales where the firm breaks even i.e., the total costs equal total revenue. It is, therefore, a point where
losses cease to occur while profits have not yet begun. That is, it is the point of zero profit.
Fixed Costs
BEP
Selling price Variable costs per unit
Advantages of Break-even Analysis

The main advantages of using break even analysis in managerial decision making can be the following:
1. It helps in determining the optimum level of output below which it would not be profitable for a firm
to produce.
2. It helps in determining the target capacity for a firm to get the benefit of minimum unit cost of
production.
3. With the help of break-even analysis, the firm can determine minimum cost for a given level of
output.
4. It helps firms in deciding which products are to be produced and which are to be bought by the firm.
5. Plant expansion or contraction decisions are often based on the break-even analysis of the perceived
situation.
6. Impact of changes in prices and costs on profits of the firm can also be analysed with the help of
break-even technique.
7. Sometimes, the management has to take decisions regarding dropping or adding a product to the
product line. The break-even analysis comes very handy in such situations.
8. It evaluates the percentage financial yield from a project and thereby helps in the choice between
various alternative projects.
9. The break-even analysis can be used in finding the selling price which would prove most profitable
for the firm.
10. By finding out the break-even point, the break-even analysis helps in establishing the point
wherefrom the firm can start payment of dividend to its shareholders.
Limitations of Break-even Analysis

The following are the key limitations of break-even analysis:
1. Break-even analysis is generally used to find out the output level at which the total fixed cost of a
company is covered up by the contributions. But due to non-availability of separate data for fixed
and variable cost for each product manufactured by the company the analysis had to be carried out
with respect to time.
2. The analysis itself has got some inherent limitations which have been mentioned earlier.
84
3. The company considered manufacturing a wide range of products and is operating at various
locations. Hence, to carry out the analysis at company scale is a very complex procedure which
involves sorting of relevant data from a heap of data and then compiling it in the form required by
the basis of fixed and variable cost.

4. Data needed for the analysis is generally kept secret by the companies otherwise it can indicate
their profit margins per unit.
Application of Break-even Analysis

Break-even analysis is a very generalized approach for dealing with a wide variety of questions
associated with profit planning and forecasting. Some of the important practical applications of break-
even analysis are as follows:
1. What happens to overall profitability when a new product is introduced?
2. What level of sales is needed to cover all costs and earn, say, 1,00,000 profit or a 12% rate of return?
3. What happens to revenues and costs if the price of one of a product is hanged?
4. What happens to overall profitability if a company purchases new capital equipment or incurs
higher or lower fixed or variable costs?
5. Between two alternative investments, which one offers the greater margin of profit (safety)?
6. What are the revenue and cost implications of changing the process of production?
7. Should one make, buy or lease capital equipment?
Methods of Break-even Analysis

The break-even analysis can be performed by the following methods.
1. Break-even Chart
The difference between price and average variable cost (P
That is, revenue on the sale of a unit of output after variable costs are covered represents a
contribution toward profit. At low rates of output, the firm may be losing money because fixed costs
have not yet been covered by the profit contribution.
Thus, at these low rates of output, profit contribution is used to cover fixed costs. After fixed costs are
covered, the firm will be earning a profit. A manager may want to know the output rate necessary
cost per unit of output (AVC) are constant. Profit is equal to total revenue (P.Q.) less the sum of Total
Variable Costs (Q.TVC) and fixed costs.
Thus, R = PQ [(Q. AVC) + FC] R = TR TC The break-even chart shows the extent of profit or loss to
the firm at different levels of activity. A break-even chart may be defined as an analysis in graphic
form of the relationship of production and sales to profit. The break-even analysis utilises a break-
even chart in which the Total Revenue (TR) and the Total Cost (TC) curves are represented by straight
lines, as shown in Figure 1.
85
JGI JAIN
D Profit
Break-even point TR
TC
Variable cost
Cost,
Revenue TFC
Price (`)
Fixed Cost
O Q1 Quantity (Q)
Figure 1:
In the figure, total revenues and total costs are plotted on the vertical axis whereas output or sales
per time period are plotted on the horizontal axis. The slope of the TR curve refers to the constant
price at which the firm can sell its output.
The TC curve indicates Total Fixed Costs (TFC) (the vertical intercept) and a constant average
variable cost (the slope of the TC curve). This is often the case for many firms for small changes in
output or sales.
The firm breaks even (with TR=TC) at Q1 (point B in the figure) and incurs losses at smaller outputs
while earnings profits at higher levels of output. Both the Total Cost (TC) and Total Revenue (TR)
curves are shown as linear.
TR curve is linear as it is assumed that the price is given, irrespective of the output level. Linearity
of TC curve results from the assumption of constant variable costs. If the assumptions of constant
price and average variable cost are relaxed, break even analysis can still be applied, although the
key relationship (total revenue and total cost) will not be linear functions of output.
Nonlinear total revenue and cost functions are shown in Figure 2. The cost function is conventional
in the sense that at first, costs increase but less than in proportion to output and then increase more
than in proportion to output. There are two break-even points L and M. Note that profit which is
the vertical distance between the total revenue and total cost functions, is maximised at output rate
Q*. Of the two break even points, only the first, corresponding to output rate Q1 is relevant.
When a firm begins production, the management usually expects to incur losses. But it is important
to know at what output rate the firm will go from a loss to a profit situation. In Figure 2, the firm
would want to get to the break-even output rate Q1 as soon as possible and then of course, move to
the profit maximising rate Q*. However, the firm would not expand production beyond Q* because
this would result in a reduction of profit.
86
TC
D Total revenue
Profit
M
Loss
L
Revenue TFC
Cost
O Q1 Q2 Rate of Output
(Q)
2. Break-even Models and Planning for Profit

The breakeven point represents the volume of sales at which revenue equals expenses; that is, at
which profit is zero. The break-even volume is arrived at by dividing fixed costs (costs that do not
vary with output) by the contribution margin per unit, i.e., selling price minus variable costs (costs
that vary directly with output). In certain situations, and especially in the consideration of multi-
products, break even volume is measured in terms of rupee sales value rather than units.
This is done by dividing the fixed costs or overheads by the contribution margin ratio (contribution
margin divided by selling price). Generally, in these types of computations, the desired profit is added
to the fixed costs in the numerator in order to ascertain the sales volume necessary for producing
the target profit. If management plans for a certain profit, then revenue needed to cover all costs
plus the desired profit is
P.Q. = TR = TFC + AVC × Q + Profit
TFC+Profit
and QB
P AVC
TFC + TFC +
or Q8 where, p = Profit.
P AVC ACM
TFC +
and SB P QB AVC
1
P
TFC
and %B
P AVC Q cap
87
The Cost-Volume-Profit (CVP) analysis evaluates the change in profit with respect to changes in
sales volume and cost. It is often used as an evaluation tool of cost and business decisions by the
finance managers.
Profit volume ratio represents the proportion of sales revenue available with the business for
covering the fixed costs and profits. P/V ratio is calculated by dividing total contribution by total
sales.
Profit/Volume (P/V ratio) = Total contribution/Total sales
A higher P/V ratio implies that the organisation is making huge profits. Therefore, higher P/V ratio
is always favourable for the organisation.
CVP analysis is based on the assumption that total cost of a product is segregated into two
components, i.e., fixed and variable. The fixed component of cost does not change with the level of
output. However, the variable component of cost varies with changes in the level of output. Semi
variable costs are also classified into fixed and variable elements.
Marginal cost is the change in the total cost of production when an additional unit of product is
produced. Thus, it is the cost incurred in producing an extra unit of product.
refers to the difference between sales and marginal cost. It can also be
expressed as the excess of sales revenue over variable costs.
The break-even analysis is a technique to judge whether or not the given level of production would
be profitable for an organisation.
Break-even Point (BEP) refers to a point where the total cost is equal to the total revenue of an
organisation. In other words, it is a point where there is no profit or no loss for the organisation.
BEP (Units) = Fixed Cost/Contribution per unit BEP (`) = Fixed Cost/P/V Ratio
The cash BEP refers to a production level at which cash inflow would be equal to cash outflow. The
cash break-even point is computed by taking only those fixed costs that are payable in cash.
One of the limitations of break-even analysis is that it is based on an unrealistic assumption that
cost behaviour is linear and variable cost always moves in direct proportion of the cost. However, in
reality, variable costs may move with the level of output, but not necessarily in direct proportions.
7.4 GLOSSARY
Cost-Volume-Profit (CVP) analysis: This is a tool used for analysing business decisions. This tool
helps in analysing the relationship between total cost, volume of sales, and profit.
Break-even analysis: An analysis that helps in determining the equilibrium point of total sales and
total cost.
Margin of Safety (MOS): A margin which expresses the difference between total sales and break-
even sales.
Contribution: The difference between sales revenue and total variable costs.
Cost of production: All costs which are incurred in the manufacturing facilities for the production
of goods and services.
Budgeting: Development of financial and costing plans for the projection of revenue and expenses
so as to control or monitor activities.
88
7.5 CASE STUDY: REDUCTION IN SELLING PRICE OF MEHTA

EXPORTERS LTD.
Case Objective
The case study explains the effect of reduction of selling price.
Mehta Exporters Ltd. produces and markets industrial containers and packing cases. Due to heavy
competition, the organisation proposes to reduce the selling price. The Board of directors planned
to reduce prices in three stages, such as 5%, 10%, and 15%. If the organisation wants to maintain the
present levels of profit, the organisation has to increase its sales. Following information is available of
Mehta Exporters Ltd.:
Particulars Amount (`)

Present sale turnover (3,00,000 units) 30,00,000
Less: Variable cost (3,00,000 units) 18,00,000
Less: Fixed cost 7,00,000
Net profit 5,00,000
Questions
1. Find out increase in sales at various stages of price reduction.
(Hint: The solution to the given problem is as follows:)
Particulars Present Price at Reduction Price at Reduction Price at Reduction

Price of 5% (`) of 10% (`) of 15% (`)
Price 10 9.50 9.00 8.50
Less: Variable cost 6.00 6.00 6.00 6.00
Contribution per unit 4.00 3.50 3.00 2.50
Total contribution required = Fixed cost + Profit

= ` 7,00,000 + ` 5,00,000 = ` 12,00,000
Therefore, units required to meet total contribution are calculated as follows:
Particulars Calculation Units to be Produced
At the present price ` 12,00,000/4.00 3,00,00
When price is reduced by 5% ` 12,00,000/3.50 3,42,860
2. Is it a good decision to cut the price during heavy competition?

(Hint: Yes, it is a good decision for an organisation to cut the price during heavy competition. In this
way, the organisation can retain its position in the market by attracting more customers.)
89

1. What is cost-volume-profit (CVP) analysis?
2. What is the use of CVP analysis?
3. What is the first step required to perform a CVP analysis?
4. What does a break-even analysis examine?

1. Cost-volume-profit (CVP) analysis is a method of cost accounting that looks at the impact that
varying levels of costs and volume have on operating profit. Refer to Section Introduction to CVP
2. A CVP analysis is used to determine the sales volume required to achieve a specified profit level.
Refer to Section Introduction to CVP
3. The first step required to perform a CVP analysis is to display the revenue and expense line items
in a Contribution Margin Income Statement and compute the Contribution Margin Ratio. Refer to
Section Introduction to CVP
4. Break-even analysis examines the relationship between the total revenue, total costs and total
profits of the firm at various levels of output. Refer to Section Introduction to CVP
https://corporatefinanceinstitute.com/resources/knowledge/finance/cvp-analysis-guide/
https://www.cliffsnotes.com/study-guides/accounting/accounting-principles-ii/cost-volume-profit-
relationships/cost-volume-profit-analysis
https://www.wallstreetmojo.com/cost-volume-profit-analysis/
https://www.economicsdiscussion.net/cost-accounting/cost-volume-profit-analysis/32641
https://psu.pb.unizin.org/hmd329/chapter/cvp/
Discuss with friends about the importance of cost-volume-profit analysis (CVP).
90
UNIT
Financial Statement Analysis
Names of Sub-Units
Introduction to Financial Statements Analysis, the Significance of Financial Statements Analysis,

Analysis of Statement of Profit and Loss, Analysis of Balance Sheet, Analysis through Common Size,
Trend and Comparative Statements.
Overview
This unit begins with meaning of financial statements analysis, it discusses the significance of
financial statements analysis. The unit analysis of the balance sheet, analysis through common size,
trend and comparative statements.
Learning Objectives
Explain the meaning of financial statements analysis
Discuss the significance of financial statements analysis
Describe the sources of obtaining financial analysis information
Explain the different types of financial statement analysis
JGI JAIN
DEEMED-TO-BE UNIVERSITY
Learning Outcomes
Assess the meaning of financial statements analysis
Examine the significance of financial statements analysis
Analyse the analysis of balance sheet
Evaluate the analysis through common size, trend and comparative statements
8.1 INTRODUCTION
Financial statements provide detailed information about various items of an organisation such as
assets, liabilities, equity, reserves, expenses, profit and loss, cash flows, funds flows, etc. This information
is not simple to understand for most of the stakeholders and their analysis and interpretation are
required to make them understandable. Hence, financial statement analysis is a crucial process in which
financial information about an organisation is analysed. It is essential to understand this information
for good operational decision making and it provides a path to examine the relationship between
various financial events of financial statements. In other words, financial statements analysis is a
process of interpretation of financial statements to understand the profitability, operational efficiency
and financial health of the organisation. Financial statement analysis involves two activities namely
analysis and then interpretation. The term analysis is related to the mathematical representation
of financial data by applying various techniques and interpretation means explaining the meaning,
importance and consequences of various financial events. Both these activities are very essential to
measure financial soundness and future prospects of the business organisation.
In a business, the sole purpose of investing money is earning profits. The financial position of an
organisation is determined by evaluating the profit earned or loss suffered by an organisation. In
addition, different users of accounting information need other accounting information. Financial
statements are created to fulfil these requirements. Financial statements provide information regarding
total profit earned or loss suffered the net income and the distribution of income. Preparation of the
financial statement is the final step in the accounting cycle.
8.2 ANALYSIS OF STATEMENT OF PROFIT AND LOSS

The gross profit or gross loss calculated in a trading account is taken to the second part of the account
called the profit and loss account. The profit and loss account is prepared to ascertain the net profit
earned or the net loss suffered by the business over an accounting period, depicting the financial
performance of the organisation. In this account, all indirect revenue expenses are shown on the debit
side whereas all the indirect revenue incomes are shown on the credit side. In other words, the profit and
loss account is a statement that shows the expenditures, revenues and net income of an organisation.
According to Carter, A profit and loss account is an account into which all the gains and the losses are
collected to ascertain the excess of the gains over the losses or vice-versa. A profit and loss account
can be prepared by considering the following accounting rules:
Debiting all the expenses
Crediting all the incomes
Considering the balance amount, if any, as profit or loss
94
UNIT 08: Financial Statement Analysis JGI JAIN
The following is the commonly used pro form a of a trading account:

Trading Account for the year ended 31st March
Dr. Cr.
Particulars Amount ` Amount ` Particulars Amount ` Amount `

To Opeining Stock XXX By Sales XXX
Less: Returns XXX XXX
To Purchase XXX Inwards

Less: Returns XXX XXX By Closing Stock XXX
Outwards XXX By Gross Loss (to be transferred XXX
to P&L A/c)
To Wages XXX
To Freight
To Carriage
Inwards XXX
To Clearing
Charges XXX
To Packing charges XXX
To Dock dues XXX

To Power XXX
To Gross Profit (to be transferred XXX
to P&L A/c)
XXX XXX
The general pro form a of the profit and loss account is shown as follows:
Profit & Loss Account for the year ended 31st March
Particulars Amount (`) Particulars Amount (`)

To Trading A/c By Trading A/c
(Gross Loss) (Gross Profit)
To Salaries By Commission earned
To Rent & Taxes By Rent received
To Stationeries By Interest received
To Postage expenses By Discounts received
To Insurance By Net Loss
To Repairs (Capital A/c)
To Trading expenses
To office expenses
To Interest
To Bank charges
To Establishment expenses
95
JGI JAIN
Particulars Amount (`) Particulars Amount (`)

To Sunder expenses
To Commission
To Discount
To Advertisement
To Carriage outwards
To Traveling expenses
To Distribution expenses
To Bad Debt provision
To Net Profit (transferred to Capital A/c)
The profit and loss account plays an important role in the accounting process as it helps in determining
the net results of the business activities. The main objectives of the profit and loss account are as follows:
Determining the net gain or loss of an organisation
Controlling unnecessary expenses by providing information about the effect of individual expense
on the net profit or loss of the organisation
Assisting in analysing the progress of an organisation by comparing the current and previous
net profit
Helping in preparing the balance sheet, which would further indicate the financial position of an
organisation
8.3 ANALYSIS OF BALANCE SHEET

A balance sheet is the statement that summarises, and presents the financial position of an organisation
on a particular date, by showing the assets and liabilities of the organisation. It is prepared with an
aim to know the exact financial position of the business on the last date of the financial year. Assets
in the balance sheet reflect debit balances whereas liabilities reflect credit balances. A balance sheet
can be prepared by performing a series of steps. Firstly, all nominal accounts in the trial balance are
transferred to the trading and profit and loss accounts. After that, personal accounts of customers are
grouped under the heading of sundry debtors. These are the entities from whom the amounts of sold
goods and services are due. Similarly, all balances of the suppliers are grouped under the single heading
of sundry creditors, the entities to whom the organisation owes money or payment. Finally, the balances
of real and personal accounts are grouped as assets and liabilities and are arranged in a proper way.
The resultant statement obtained is called the balance sheet.
The American Institute of Certified Public Accountants defines balances sheet as A tabular statement
of summary of balances (debits and credits) carried forward after an actual constructive closing of
books of account and kept according to the principles of accounting.
In the balance sheet, assets are represented on the right side and liabilities are shown on the left side.
It is also known as the statement of sources of funds and application of funds. The financial position
of the organisation includes its economic resources (assets), economic obligations (liabilities), and
balance sheet is the detailed summary of the basic
accounting equation:
Assets = Liabilities + Equity
96
The pro forma of the balance sheet:

Balance Sheet of As at
Liabilities Amount (`) Assets Amount (`)

Sundry creditors Cash in hand including petty cash
Bills payable Cash at bank
Bank overdraft Bills receivables
Employees provident fund Sundry debtors
Loans (Cr.) Loan (Dr.)
Mortgage Closing stock
Reserves or reserve funds Loose tools
Capital Investment
Add: Interest on capital Furniture and fitting
Add: Net profit Plant and machinery
Less: Drawing Land and building
Less: Income tax Leasehold land
Less: Interest on drawing Business premises
Less: Net loss Patent and trade mark
Goodwill
Total Total
8.3.1 Analysis through Common Size, Trend and Comparative Statements
Common Size
Common size analysis, also referred to as vertical analysis, is a tool that financial managers use to
analyze financial statements. It evaluates financial statements by expressing each line item as a
percentage of the base amount for that period. The analysis helps to understand the impact of each
item in the financial statement and its contribution to the resulting figure.
The technique can be used to analyze the three primary financial statements, i.e., balance sheet, income
statement, and cash flow statement. In the balance sheet, the common base item to which other line
items are expressed is total assets, while in the income statement, it is total revenues.
Common size analysis can be conducted in two ways, i.e., vertical analysis and horizontal analysis.
Vertical analysis refers to the analysis of specific line items in relation to a base item within the same
financial period. For example, in the balance sheet, we can assess the proportion of inventory by dividing
the inventory line using total assets as the base item.
On the other hand, horizontal analysis refers to the analysis of specific line items and comparing them
to a similar line item in the previous or subsequent financial period. Although common-size analysis is
not as detailed as trend analysis using ratios, it does provide a simple way for financial managers to
analyze financial statements.
97
JGI JAINDEEMED-TO-BE UNIVERSITY
Common size financial statement analysis is computed using the following formula:
Amount of Individual item

Percentage of Base = × 100
Amount of Base item
Trend Analysis
time. Periods may be
measured in months, quarters, or years, depending on the circumstances. The goal is to calculate and
analyze the amount change and percent change from one period to the next.
Trend analysis is a financial statement analysis technique that shows changes in the amounts of
corresponding financial statement items over a period of time. It is a useful tool to evaluate the trend
situations.
The statements for two or more periods are used in horizontal analysis. The earliest period is usually
used as the base period and the items on the statements for all later periods are compared with items
on the statements of the base period. The changes are generally shown both in dollars and percentage.
Comparative Statement
A comparative statement is a document used to compare a particular financial statement with
prior period statements. Previous financials are presented alongside the latest figures in side-by-side
and compare it with industry
rivals.
identified and the performance of managers, new lines of business and new products can be evaluated,
without having to flip through individual financial statements.
Comparative statements can also be used to compare different companies, assuming that they follow
the same accounting principles. For example, they can show how different businesses operating in the
same industry react to market conditions. Reporting just the latest dollar amounts makes it hard to
compare the performances of companies of various sizes. Adding prior period figures, complete with
percentage changes, helps to eliminate this problem.
In a business, the sole purpose of investing money is earning profits. The financial position of an
organisation is determined by evaluating the profit earned or loss suffered by an organisation.
Financial statements act as an important source of information as they provide structured and
easy-to-understand information regarding the business activities of an organisation.
The objective of financial statements is to provide information that would convey the performance
details, financial position, and the changes in the financial position of the organisation. These help
users in making decisions.
Stakeholders cannot use financial information which they do not understand. Problems in
understanding financial information may arise out of two reasons: incapability in
understanding information and ambiguity in the information itself.
98
A set of information can only be considered relevant when the information adds value to the
decision-making process.
Information is reliable when it is dependable and this is possible only when it is free from errors
(especially material errors), complete and free from bias.
without comparing the financial information of one period with another or the financial information
of one entity to another.
Some of the main scopes of financial statements are providing information about the financial
position, providing information about the financial performance, providing information about
changes in the financial position, and providing notes and supplementary schedules.
The gross profit or gross loss calculated in a trading account is taken to the second part of the
account called the profit and loss account. The profit and loss account is prepared to ascertain the
net profit earned or the net loss suffered by the business over an accounting period, depicting the
financial performance of the organisation.
The profit and loss account plays an important role in the accounting process as it helps in
determining the net results of the business activities.
The main components of a profit and loss account are expenses and incomes. The expenses are
shown on the debit side and the incomes are shown on the credit side of the P&L account.
A balance sheet is the statement that summarises, and presents the financial position of an
organisation as on a particular date, by showing the assets and liabilities of the organisation.
In the balance sheet, assets are represented on the right side and liabilities are shown on the left
side.
A balance sheet plays a vital role in taking important financial decisions by management and
investors of the organisation.
Trading transactions of a company, such as income, sales and expenditure and the resulting profit
or loss for a given period is summarised in the profit and loss (P&L) account. In comparison, the
balance sheet provides a financial snapshot of a company at a given moment.
8.5 GLOSSARY
Accounting standards board: The board consisting of accounting professionals to develop and
implement various accounting guidelines.
Bad debt: A debt that is not collectible and therefore worthless to the creditor.
Bottom line: The net profit of the organisation.
Carriage outward: The shipping and handling costs incurred by a company that is shipping goods
to a customer.
Depreciation: A reduction in the value of an asset over time due to wear and tear.
Sales commission: The amount of commission received by a person depending on the level of sales
obtained by him/her.
99
JGI JAIN
8.6 CASE STUDY: CASE STUDY: SATYAM COMPUTERS LIMITED BUSINESS

ACCOUNTING FRAUD
Case Objective
The present case discusses the fraudulent financial reporting by Satyam Computer Services Limited
due to weak internal control, non-compliance with accounting standards and poor auditing by the
audit committee.
Fraudulent financial reporting has a significant impact on a company and its stakeholders. It also
confidence in the capital market. Often high-profile fraudulent cases related to deceitful
financial reporting raise apprehensions about the credibility of the financial reporting process in a
nation. Also, concerns the raised about the roles of management, auditors, regulators, analysts, etc., to
check fraudulent financial reporting.
Satyam Computer Services Limited was among the leading organisations in the outsourced IT services
industry in India. The organisation was established in 1987 in Hyderabad by Ramalinga Raju. Satyam
Computer Services Limited began with 20 employees and developed rapidly as a global IT company.
The company was engaged in providing IT and Business Process Outsourcing services across various
sectors. Between 2003 and 2008, Satyam Computer grew considerably and generated USD $467 million
from its total sales. By March 2008, Satyam Computer had grown to USD $2.1 billion. It booked an annual
compound growth rate of 35% in that period.
Satyam was a Level I enterprise as it had a turnover of above `50 crores. This implied that it was
compulsory for Satyam to comply with all accounting standards. These accounting standards improve
the credibility and reliability of financial statements, determine managerial accountability, assist
accountants and auditors, and enable ease of understanding. However, there have been several frauds
governance.
On January 7, 2009, Ramalinga Raju revealed in a letter addressed to Satyam Computers
several years. Ramalinga Raju declared that he had overstated the assets on
balance sheet by $1.47 billion. He revealed that about $1.04 billion worth of bank loans and cash that
Satyam claimed to own did not exist. To meet the expectations of the critics, Satyam Computers had
been included in exaggerating its income almost every quarter over the course of various years. Satyam
overstated quarterly revenues by 75 per cent and profits by 97 per cent on October 17, 2009. It was also
found out that bank accounts were falsified for inflating the balance sheet with balances that actually
never existed. In addition, the income statement was exaggerated by declaring interest income from
fake bank accounts. It was also exposed that the company owner made 6000 fake salary accounts over
the past several years and withdrew the money after the company deposited it.
considerably. The fraud

also had an adverse impact on employees who lost their jobs and pension fund. The others that
and insurers, and even competitors whose reputations suffered owing to their association with Satyam.
Some of the main points that companies must remember after the Satyam Scandal are:
Investigation of all inaccuracies: The fraud at Satyam started on a small scale initially and grew
up to $276 million Most accounting frauds start out small with the offender assuming that minute
100
changes in the financial statements would go unnoticed. Thus, companies should be aware when
the accounts do not balance or if something seems inaccurate even if it is insignificant.
Adherence to accounting standards: Companies should follow a set of guidelines to prepare
and present their financial statements. This helps in bringing consistency in the reporting of
the accounting information. It also ensures transparency, consistency and comparability of the
accounting information by providing uniformity in accounting practices as accountants and
auditors follow the same rules and procedures.
Role division: Dividing responsibilities across a team of individuals would help in detecting
irregularities or misappropriated funds.
Questions
1. Suppose you are the finance manager at an MNC. What measures will you take to avoid financial
frauds?
(Hint: Periodically tally the books of accounts, check for the bank balance, investigate the unexpected
cash inflows and outflows and check the unbalanced accounts for small and big changes alike.)
2. Briefly explain the Satyam scam and the role played by the board.
(Hint: Prepare a summary by analysing various loopholes in the scandal.)
1. What do you mean by financial statements? Discuss.

2. What are profit and loss accounts? Explain.
3. Explain the relationship between a balance sheet and profit and loss account

1. Financial statements provide information regarding total profit earned or loss suffered in the net
income and the distribution of income. Preparation of the financial statement is the last step in the
accounting cycle. Refer to Section Analysis of Statement of Profit and Loss
2. Profit and loss account is prepared to ascertain the net profit earned or the net loss suffered by the
business over an accounting period. Refer to Section Analysis of Statement of Profit and Loss
3. Trading transactions of a company, such as income, sales and expenditure and the resulting profit
or loss for a given period is summarised in the profit and loss (P&L) account. In comparison, the
balance sheet provides a financial snapshot of a company at a given moment. Refer to Section
Analysis of Balance Sheet
101
JGI JAINDEEMED-TO-BE UNIVERSITY
https://corporatefinanceinstitute.com/resources/knowledge/finance/analysis-of-financial-
statements/
https://www.aafmindia.co.in/financial-statement-analysis-tools-limitation-uses-process
https://online.hbs.edu/blog/post/financial-statement-analysis
https://cleartax.in/s/financial-statement-analysis
Discuss with your friends, what is the need of financial statement analysis.
102
UNIT
09 Introduction to Corporate Finance
Names of Sub-Units
Introduction to corporate finance, concept of financial decisions of a firm, introduction to financial

management, objectives of financial management, concept of finance function.
Overview
This unit begins by explaining the meaning of corporate finance, it discusses the concept of financial
decisions of a firm. The unit explains the introduction to financial management. It also discusses the
objectives of financial management.
Learning Objectives

Explain the corporate finance
State the financial decisions of a firm
Identify financial management
Classify the objectives of financial management
Learning Outcomes
Assess the meaning of corporate finance
Examine the financial decisions of a firm
Analyse the objectives of financial management
Evaluate the finance function
JGI JAIN
9.1 INTRODUCTION
Corporate finance is the division of finance that deals with how corporations deal with funding sources,
capital structuring, and investment decisions. Corporate finance is primarily concerned with maximizing
shareholder value through long and short-term financial planning and the implementation of various
strategies. Corporate finance activities range from capital investment decisions to investment banking.
Corporate finance departments are charged with governing and overseeing their financial
activities and capital investment decisions. Such decisions include whether to pursue a proposed
investment and whether to pay for the investment with equity, debt, or both.
It also includes whether shareholders should receive dividends. Additionally, the finance department
manages current assets, current liabilities, and inventory control.
9.2 FINANCIAL DECISIONS OF A FIRM

Financial decisions refer to decisions concerning financial matters of a business firm. There are many
kinds of financial management decisions that the firm makers in pursuit of maximising
can classify these decisions into three major groups:

1. Investment Decisions / Capital Budgeting Decisions
Investment decision relates to the determination of total amount of assets to be held in the firm,
the composition of these assets and the business risk complexities of the firm as perceived by the
investors. It is the most important financial decision. Since funds involve cost and are available in a
limited quantity, its proper utilisation is very necessary to achieve the goal of wealth maximasation.
The investment decisions can be classified under two broad groups;
(i) Long-term investment decision
(ii) Short-term investment decision
The long-term investment decision is referred to as capital budgeting and the short-term investment
decision as working capital management.
Capital budgeting is the process of making investment decisions in capital expenditure. These are
expenditures, the benefits of which are expected to be received over a long period of time exceeding
one year. The finance manager has to assess the profitability of various projects before committing
the funds. The investment proposals should be evaluated in terms of expected profitability, costs
involved and the risks associated with the projects.
The investment decision is important not only for the setting up of new units but also for the
expansion of present units, replacement of permanent assets, research and development project
costs, and reallocation of funds, in case, investments made earlier, do not fetch result as anticipated
earlier.
2. Financing Decisions / Capital Structure Decisions
Once the firm has taken the investment decision and committed itself to new investment, it must
decide the best means of financing these commitments. Since, firms regularly make new investments;
the needs for financing and financial decisions are ongoing, hence, a firm will be continuously
planning for new financial needs. The financing decision is not only concerned with how best to
finance new asset, but also concerned with the best overall mix of financing for the firm.
108
UNIT 09: Introduction to Corporate Finance JGI JAIN
A finance manager has to select such sources of funds which will make optimum capital structure.
The important thing to be decided here is the proportion of various sources in the overall capital
mix of the firm. The debt-equity ratio should be fixed in such a way that it helps in maximising
the profitability of the concern. The raising of more debts will involve fixed interest liability and
dependence upon outsiders.
It may help in increasing the return on equity but will also enhance the risk. The raising of funds
through equity will bring permanent funds to the business but the shareholders will expect higher
rates of earnings. The financial manager has to strike a balance between anxious sources so that
the overall profitability of the concern improves. If the capital structure is able to minimise the risk
and raise the profitability, then the market prices of the shares will go up maximising the wealth of
shareholders.
3. Dividend Decision
The third major financial decision relates to the disbursement of profits back to investors who
supplied capital to the firm. The term dividend refers to that part of profits of a company which is
distributed by it among its shareholders. It is the reward of shareholders for investments made by
them in the share capital of the company. The dividend decision is concerned with the quantum of
profits to be distributed among shareholders.
A decision has to be taken whether all the profits are to be distributed, to retain all the profits in
business or to keep a part of profits in the business and distribute others among shareholders.
The higher rate of dividend may raise the market price of shares and thus, maximise the wealth of
shareholders. The firm should also consider the question of dividend stability, stock dividend (bonus
shares) and cash dividend.
4. Liquidity Decisions
Liquidity and profitability are closely related. Obviously, liquidity and profitability goals conflict in
most of the decisions. The finance manager always perceives / faces the task of balancing liquidity
and profitability. The term li
reserves to meet emergencies whereas profitability aims to achieve the goal of higher returns. As said
earlier, striking a proper balance between liquidity and profitability is a difficult task. Profitability
will be affected when all the bills are to be settled in advance. Similarly, liquidity will be affected if the
funds are invested in short term or long-term securities. That is the funds are inadequate to pay-off
its creditors. Lack of liquidity in extreme situations can lead insolvency.
9.3 INTRODUCTION TO FINANCIAL MANAGEMENT
any business, it is important that the finance it procures is invested in a manner that the returns from
the investment are higher than the cost of finance. In a nutshell, financial management
Endeavors to reduce the cost of finance
Ensures sufficient availability of funds
Deals with the planning, organizing, and controlling of financial activities like the procurement and
utilisation of funds
Some Definitions
management is the activity concerned with planning, raising, controlling and
administering of funds used in the Guthman and Dougal
109
JGI JAIN
management is that area of business management devoted to a judicious use of capital

and a careful selection of the source of capital in order to enable a spending unit to move in the
direction of reaching the J.F. Brandley
management is the operational activity of a business that is responsible for obtaining
and effectively utilizing the funds necessary for efficient Massie
9.3.1 Objectives of Financial Management

Financial management is generally concerned with procurement, allocation and control of financial
resources of a concern. The objectives can be as follows:To ensure regular and adequate supply of funds
to the concern.
1. To ensure adequate returns to the shareholders which will depend upon the earning capacity, market
price of the share, expectations of the shareholders.
2. To ensure optimum funds utilisation. Once the funds are procured, they should be utilised in
maximum possible way at least cost.
3. To ensure safety on investment, i. e, funds should be invested in safe ventures so that adequate rate
of return can be achieved.
4. To plan a sound capital structure-There should be sound and fair composition of capital so that a
balance is maintained between debt and equity capital.
Profit maximisation
Profit maximisation is the capability of a business or company to earn the maximum profit with low
cost which is considered as the chief target of any business and also one of the objectives of financial
management. According to financial management, profit maximisation is the approach or process which
increases the profit or Earnings per Share (EPS) of the business. More specifically, profit maximisation
to optimum levels is the focal point of investment or financing decisions.
maximisation may be the but the means to achieve this end, is what matters, and that
distinguishes a company in the corporate world and the Henrietta Newton Martin
Profit Maximisation Theory: Assumptions and Criticisms!
In the neoclassical theory of the firm, the main objective of a business firm is profit maximisation. The
firm maximises its profits when it satisfies the two rules:
(i) MC = MR and,
(ii) MC curve cuts the MR curve from below.
Maximum profits refer to pure profits which are a surplus above the average cost of production. It is the
amount left with the entrepreneur after he has made payments to all factors of production, including
his wages of management. In other words, it is a residual income over and above his normal profits.
The profit maximisation condition of the firm can be expressed as:
Maximise (Q)
Where (Q)=R (Q)-C (Q)
Where (Q) is profit,
R (Q) is revenue,
110
C (Q) are costs, and

Q are the units of output sold.
The two marginal rules and the profit maximisation condition stated above are applicable both to a
perfectly competitive firm and to a monopoly firm.
Assumptions:
The profit maximisation theory is based on the following assumptions:
1. The objective of the firm is to maximise its profits where profits are the difference between the
revenue and costs.
2. The entrepreneur is the sole owner of the firm.
3. Tastes and habits of consumers are given and constant.
4. Techniques of production are given.
5. The firm produces a single, perfectly divisible and standardised commodity.
6. The firm has complete knowledge about the amount of output which can be sold at each price.
7. The own demand and costs are known with certainty.
8. New firms can enter the industry only in the long run. Entry of firms in the short run is not possible.
9. The firm maximises its profits over some time-horizon.
10. Profits are maximised both in the short run and the long run.
Given these assumptions, the profit maximising model of firm can be shown under perfect competition
and monopoly.
1. Profit Maximisation under Perfect Competition Firm:
Under perfect competition, the firm is one among a large number of producers. It cannot influence
the market price of the product. It is the price-taker and quantity-adjuster. It can only decide about
the output to be sold at the market price. Therefore, under conditions of perfect competition, the MR
curve of a firm coincides with its AR curve.
The MR curve is horizontal to the X-axis because the price is set by the market and the firm sells its
output at that price. The firm is thus in equilibrium when MC= MR= AR (Price). The equilibrium of
the profit maximisation firm under perfect competition is shown in Figure 1 where the MC curve
cuts the MR curve first at point A.
MC
A B
AR
= MR
O M M
Output
Figure 1
111
JGI JAIN
It satisfies the condition of MC = MR, but it is not a point of maximum profits because after point A,
the MC curve is below the MR curve. It does not pay the firm to produce the minimum output when
it can earn larger profits by producing beyond
2. Profit Maximisation under Monopoly Firm:
There being one seller of the product under monopoly, the monopoly firm is the industry itself.
Therefore, the demand curve for its product is downward sloping to the right, given the tastes and
incomes of its customers. It is a price-maker which can set the price to its maximum advantage. But
it does not mean that the firm can set both price and output. It can do either of the two things.
If the firm selects its output level, its price is determined by the market demand for its product. Or,
if it sets the price for its product, its output is determined by what the consumers will take at that
price. In any situation, the ultimate aim of the monopoly firm is to maximise its profits.
The conditions for equilibrium of the monopoly firm are:
(1) MC = MR<AR (Price), and
(2) The MC curve cuts the MR curve from below.
In Figure 2, the profit maximising level of output is OQ and the profit-maximisation price is OP. If
more than OQ output is produced, MC will be higher than MR, and the level of profit will fall. If cost
and demand conditions remain the same, the firm has no incentive to change its price and output.
The firm is said to be in equilibrium.
A MC
P
B
D (AR)
MR
O Q
Output
Figure 2
Wealth maximisation
Wealth maximisation is the concept of increasing the value of a business in order to increase the
value of the shares held by its stockholders. The concept requires a management team to
continually search for the highest possible returns on funds invested in the business, while mitigating
any associated risk of loss. This calls for a detailed analysis of the cash flows associated with each
prospective investment, as well as constant attention to the strategic direction of the organisation.
example, if a company spends funds to develop valuable new intellectual property, the investment
community is likely to recognize the future positive cash flows associated with this new property
tions may occur if a business reports
continuing increases in cash flow or profits.
112
9.4 FINANCE FUNCTION

The finance function is a part of financial management. Financial management is the activity concerned
with the control and planning of financial resources.
In business, the finance function involves the acquiring and utilisation of funds necessary for efficient
source to run any organisation, it provides the money, and it acquires the money.
The finance function has been classified into three:
Long-term Finance: This includes finance of investment of three years or more. Sources of long-term
finance include owner capital, share capital, long-term loans, debentures, internal funds and so on.
Medium-term Finance: This is financing done between 1 to 3 years, and this can be sourced from
bank loans and financial institutions.
Short-term Finance: This is finance needed below one year. Funds may be acquired from bank
overdrafts, commercial paper, advances from customers, trade credit etc.
9.4.1 Role of Chief Financial Officer (CFO)

A chief financial officer (CFO) is the senior executive responsible for managing the financial actions of
financial strengths and weaknesses and proposing corrective actions.

The role of a CFO is similar to a treasurer or controller because they are responsible for managing the
finance and accounting divisions and for ensuring that the financial reports are accurate
and completed in a timely manner. Many have a CMA designation.
The CFO reports to the chief executive officer (CEO) but has significant input in the
investments, capital structure, and how the company manages its income and expenses. The CFO works
run.
For example, when the marketing department wants to launch a new campaign, the CFO may help to
ensure the campaign is feasible or give input on the funds available for the campaign.
The CFO may assist the CEO with forecasting, cost-benefit analysis, and obtaining funding for various
initiatives. In the financial industry, a CFO is the highest-ranking position, and in other industries, it is
usually the third-highest position in a company. A CFO can become a CEO, chief operating officer, or
president of a company.
9.4.2 Role of Treasury and Controller

Treasurers and controllers are both financial managers, but they have different roles. Controllers
usually concentrate on what has already happened inside a company. They prepare financial
statements and other reports based on past activity. Treasurers focus outward and interact with the
bankers, shareholders and potential investors who provide capital. In some small businesses, the owner,
a controller and an outside accountant might share the financial duties.
Education and Qualifications: Treasurers and controllers should be graduates, with several years of
experience working in accounting or finance positions, who have completed courses in accounting,
finance or economics. Both positions call for candidates who pay attention to detail, are analytically
minded and possess organisational skills. They should be comfortable working with Microsoft Excel
113
JGI JAIN
Employers often require that controllers be certified public accountants.

Where They Work: There are positions for treasurers and controllers in all sizes of companies except
for the smallest, where owners and external accountants often perform the necessary financial
functions. Treasurers and controllers work in non-profit organisations and government agencies
as well as private sector businesses, especially banks and other financial businesses. Their day-to-
day functions include accounting oversight this mainly falls within the functions of a controller
analysis and reporting. A treasurer tends to specialize in cash management and risk management.
Controller vs Treasurer Focus: Controllers focus on the internal workings of organisations. They
prepare budgets and supervise accounting and auditing work. They also generate the tax returns
and financial statements required by regulators. Controllers monitor whether operational units are
meeting deadlines and complying with regulations. Treasurers obtain loans and other credit from
outside sources, maintain relationships with banks, raise equity capital, invest company funds and
communicate with shareholders. In general, they manage the cash and ensure that the
company meets the financial goals expressed in the budget.
Job Outlook and Salary: The US Bureau of Labor Statistics has predicted a 15 percent growth rate
in jobs for financial managers, a category that includes controllers and treasurers, through 2029.
degrees, certifications and an understanding of international finance
will have the best prospects for employment. The median annual salary for financial managers was
$129,890 in 2019, with $208,000 for the highest 10 percent.
9.4.3 Emerging Role of Financial Manager in India

Reflecting the emerging economic and financial environment in the post-liberalisation era, the role/ job
of financial managers in India has become more important, complex and demanding, the key challenges
are, intern in the areas specified below:
(a) Financial structure
(b) Foreign exchange management
(c) Treasury operations
(d) Investor communication
(e) Management control (f) Investment planning
The main elements of the changed economic and financial environment, inter alia, are the following:
Considerable relaxation in industrial licensing framework in terms of the modifications in the
Industries Development (Regulations) Act;
Abolition of the Monopolies and Restrictive and Trade Practices Act and its replacement by the
Competition Act;
Repeal of Foreign Exchange Regulation Act (FERA) and enactment of a liberalised Foreign Exchange
Management Act (FEMA);
Abolition of Capital Issues (Control) Act and the setting-up of the Securities and Exchange Board of
India (SEBI) under the SEBI. Act for the regulation and development of the securities market and the
protection of investors;
Enactment of the Insurance Regulatory and Development Authority (IRDA) Act and the setting-up of
the IRDA for the regulation of the insurance sector and the consequent dismantling of the monopoly
of UC and GIC and its subsidiaries;
114
Emergence of the capital market at the center-stage of the financing system and the disappearance
of the erstwhile development/public financial/term lending ~institutions from the Indian financial
scene;
Emergence of highly articulate and. sophisticated money
Globalisation, convertibility of rupee, liberalised foreign resentments in India, Indian foreign
investment abroad;
Market-determined interest rate, emergence of highly innovative financial instruments:
Growth of mutual funds; credit rating, other financial services;
Rigorous prudential, credit risk management framework for banks and financial institutions;
Access 10 Euro-issues, American Depository Receipts (ADRs);
Privatization/Disinvestment of public sector undertakings.
Corporate finance is the division of finance that deals with how corporations deal with funding
sources, capital structuring, and investment decisions.
Corporate finance is primarily concerned with maximizing shareholder value through long and
short-term financial planning and the implementation of various strategies.
Corporate finance departments are charged with governing and overseeing their financial
activities and capital investment decisions.
Financial decisions refer to decisions concerning financial matters of a business firm.
There are many kinds of financial management decisions that the firm makers go in pursuit of
wealth, viz., kind of assets to be acquired, pattern of capitalisation,
distribution of income etc.
Investment decision relates to the determination of the total amount of assets to be held in the firm,
investors.
Capital budgeting is the process of making investment decisions in capital expenditure.
A finance manager has to select such sources of funds which will make optimum capital structure.
Liquidity and profitability are closely related. Obviously, liquidity and profitability goals conflict in
most of the decisions.
The financial management is generally concerned with procurement, allocation and control of
financial resources of a concern.
Profit maximisation is the capability of a business or company to earn the maximum profit with low
management.
Under perfect competition, the firm is one among a large number of producers.
There being one seller of the product under monopoly, the monopoly firm is the industry itself.
Therefore, the demand curve for its product is downward sloping to the right, given the tastes and
incomes of its customers.
115
JGI JAIN
Wealth maximisation is the concept of increasing the value of a business in order to increase the
value of the shares held by its stockholders.
The finance function is a part of financial management. Financial management is the activity
concerned with the control and planning of financial resources.
A chief financial officer (CFO) is the senior executive responsible for managing the financial actions
of a company.
9.6 GLOSSARY
Corporate finance: The area of finance that deals with sources of funding
Financial decisions: A crucial decision that is to be made by the financial manager
Investment Decision: A decision regarding whether or not to purchase, sell, exchange, tender, or
pledge any trust property
Financing Decisions: Financing decision means from where a business wants to get financed (it
includes banks, financial institutions, shares, debentures etc)
9.7 CASE STUDY: ASSET ALLOCATION AND INVESTMENT MANAGEMENT

STRATEGIES
Case Objective
The case study explains how effect asset allocation and investment management help a company.
The client is one of the prominent investment companies in Kuwait which operates a wide range of
investment and financial activities, including direct investments, asset management, and corporate
finance services. The client had a strong foothold in the Kuwaiti market with an asset base of KD 289.38
million as of Sep 30, 2009. The asset base was skewed heavily towards Kuwait and other G.C.C countries,
with minimal investments spread across U.S, Asia, North Africa and European Market. Additionally,
significant amount of the assets was in privately held companies.
The Challenge
Economic downturn impacted the asset prices, and the liquidity of the company. Over a period of time,
felt the need for an optimal allocation of its portfolio which would reduce the risk levels, meet target
returns, and provide sufficient liquidity. The client was also looking for developing effective and suitable
portfolio management strategies and in developing performance measurement standards.
Our Approach
We analysed the existing portfolio of the client, the strengths and weaknesses of the company, and the
current investment environment regionally, and globally. Further, AB sat with individual departmental
heads and asset managers, circulated questionnaires and assessed the feedback in terms of suitability
of the asset
After assessing the investment environment, returns expectations, risk capacity, liquidity requirements,
expertise, and other advantages and constraints, AB developed a framework for strategic and tactical
optimal asset allocation of its portfolio, and periodical rebalancing. In the strategic asset allocation,
116
recommendations were made to increase its investment in Fixed Income Assets in order to meet the
liquidity of the company and also recommendations were made for the inclusion of additional asset
classes like commodities which would enhance the risk return tradeoff, and diversification of the
portfolio. The tactical asset allocation aimed at an optimal allocation amongst sectors across different
regions.
Conclusion
We assisted the client by developing portfolio management strategies and guidelines spanning from
investment screening, monitoring to exiting its investments. We also advised on adopting a synthetic
credit scoring mechanism for arriving at the appropriate fixed income asset pricing since a majority of
its fixed income assets were priced arbitrarily. Further, AB suggested appropriate benchmark against
which the investment performance should be analysed, and developed a mechanism for measurement
and attribution analysis of its investments and performance.
Questions
1. What is the importance of corporate finance?
(Hint: The main aim of corporate finance is to increase the shareholder values that help the managers
to be able to balance capital funding between investments in projects that increase the long-term
profitability and sustainability of a company.)
2. What are the major areas of finance?
(Hint: Finance consists of three interrelated areas: (1) money and credit markets, which deals with
the securities markets and financial institutions; (2) investments, which focuses on the decisions
made by both individuals and institutional investors)
3. What are the sources of finance?
(Hint: Sources of finance for business are equity, debt, debentures, retained earnings, term loans,
working capital loans, letter of credit, euro issue, venture funding etc. These sources of funds are
used in different situations.)
A. Essay-type Questions
1. What do you understand by corporate finance?
2. What are financial decisions?
3. Explain investment decision.
4. What do you understand by profit maximisation?
5. What is wealth maximisation?
A. Hints for Essay-Type Questions

1. Corporate finance is the division of finance that deals with how corporations deal with funding
sources, capital structuring, and investment decisions. Refer to Section Introduction to Financial
117
Management
2. Financial decisions refer to decisions concerning financial matters of a business firm. There are
many kinds of financial management decisions that the firm makers in pursuit of maximising
income etc. Refer to Section Financial Decisions of a Firm

3. Investment decision relates to the determination of total amount of assets to be held in the firm,
investors. Refer to Section Financial Decisions of a Firm
4. Profit maximisation is the capability of a business or company to earn the maximum profit with low
management. Refer to Section Introduction to Financial Management
5. Wealth maximisation is the concept of increasing the value of a business in order to increase the
value of the shares held by its stockholders. Refer to Section Introduction to Financial Management
https://www.coursera.org/learn/wharton-finance
https://courses.corporatefinanceinstitute.com/courses/introduction-to-corporate-finance
https://www.edx.org/course/introduction-to-corporate-finance
https://www.edx.org/learn/corporate-finance
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/background/cfin.htm
Discuss about the advantages of corporate finance with your team.
118
UNIT
Time Value of Money
Names of Sub-Units
Introduction to time value of money, concept of time value of money, concept of time lines and notation,
types of time value of money, present value of a perpetuity, intra-year compounding and discounting.
Overview
This unit begins by explaining the time value of money, it discusses the concept of time lines and
notation. The unit explains the types of time value of money. It also discusses the intra -year
compounding and discounting.
Learning Objectives

Explain the concept of time value of money
Describe the relationship between present value and future value of cash flows
Interpret as to how interest rate is used for adjusting the value of cash flows
Discuss the procedure for discounting and compounding of values
Understand the calculation of present value and future value of an annuity
JGI JAIN
DEEMED-TO-BE UN IV E RSI TY
Learning Outcomes

Evaluate the concept and importance of worth today as compared to in the future
Identify how to use interest factor tables in order to calculate the present or future values
Justify the significance of opportunity cost and time value of money
10.1 INTRODUCTION
This chapter throws light on the concept of time value of money, which is the foundation of all financial
concepts related to money and its worth. It draws the importance of worth today as compared
to that in the future. It deals with the present value and the future value of an investment. The manner
of computation of time value of money enables one to distinguish between the worth of different
investments that yield returns to an investor at different points of time. The concepts detailed in this
chapter are of utmost importance because all other chapters of finance will expand on these basic
concepts. For instance, the time value of money forms the basis for all tools and techniques laid down
under capital budgeting decisions, such as net present value, profitability index, internal rate of return,
and so on. The chapter begins with an introduction to the concept of time value of money.
Thereafter, it discusses the procedure for computation of future values and present values of both single
cash flows and an annuity. Moreover, the concept of net present value is also described at the end of the
chapter.
10.2 INTRODUCTION TO TIME VALUE OF MONEY

Let us begin the discussion of time value of money by analysing a simple scenario. When an investor is
given a choice between deriving ` 20,000 today or deriving ` 20,000 at a future date, he would generally
prefer to have ` 20,000 today. Similarly, if he is given a choice between making payment of ` 20,000 today
or making the payment of the same ` 20,000 at a future date, he would generally prefer to pay ` 20,000
later. This is so because, in the first scenario, by having ` 20,000 early, the investor can simply keep such
money in the bank and earn interest. Similarly, in the second scenario, by deferring the payment to a
later date, the investor could earn some interest by holding the money longer in the bank.
This allowability of time gap helps us make money and the incremental gain is called the time value of
money. The interest plays a significant role in determining the time value of money. Interest rate is the
rate at which investors earn income on their investments, usually at a yearly percentage. Some of the
reasons as to why money in the future is worth less than the same money derived now are as follows:
Usually, individuals hold a preference for present consumption in comparison to future consumption.
If the current preference is very high, then a very high incentive is to be offered to him to
forego the same, such as a higher rate of interest.
In case of inflation, the value of currency declines over a period of time. If there is more inflation,
then the gap between the worth of money today and the worth of money in future is higher. Thus,
the higher the inflation, the higher is the gap and vice versa.
The risk of future uncertainty also lowers the value. For instance, some future contingencies,
like non-receipt of payment, uncertainty of life, etc., may result in the reduction in payment
or non-payment altogether.
124
UNIT 10: Time Value of Money JGI JAIN
DEEMED-T O-BE UN IV E RSI TY
10.3 TIME LINES AND NOTATION
Cash Flows
$100 $100 $100 $100
0 1 2 3 4
Year
Figure 1: A Time Line for Cash Flows : $100 in Cash Flows Received
at the End of Each Year of Next 4 years
In the figure, 0 refers to right now. A cash flow that occurs at time 0 is therefore already in present
value terms and does not need to be adjusted for time value. A distinction must be made here between
a period of time and a point in time. The portion of the time line between 0 and 1 refers to period 1,
which, in this example, is the first year. The cash flow that occurs at the point in time 1 refers to the cash
flow that occurs at the end of period 1. Finally, the discount rate, which is 10 percent in this example, is
specified for each period on the time line and may be different for each period.
Had the cash flows been at the beginning of each year instead of at the end of each year, the time line
would have been redrawn as it appears in Figure 2.
Cash Flows
$100 $100 $100 $100
0 1 2 3 4
Year
Figure 2: A Time Line for Cash Flows : $100 in Cash Flows Received
at the Beginning of Each Year of Next 4 years
Note that in present value terms, a cash flow that occurs at the beginning of year two is the equivalent
of a cash flow that occurs at the end of year one. Cash flows can be either positive or negative; positive
cash flows are called cash inflows and negative cash flows are called cash outflows. For notati onal
purposes, we will assume the following for the chapter that follows:
Notation Stands For

PV Present value
FV Future value
CF t Cash flow at the end of period t
A Annuity: constant cash flows over several periods
r Discount rate
g Expected growth rate in cash flows
n Number of years over which cash flows are received or paid
125
JGI JAIN
The Intuitive Basis for Present Value

There are three reasons why a cash flow in the future is worth less than a similar cash flow today.
1. Individuals prefer present consumption to future consumption. People would have to be offered
more in the future to give up present consumption. If the preference for current consumption is
strong, individuals will have to be offered much more in terms of future consu mption to give up
current consumption, a trade-
Conversely, when the preference for current consumption is weaker, individuals will settle for much
less in terms of future consumption and, by extension, a low real rate of return or discount rate.
2. When there is monetary inflation, the value of currency decreases over time. The greater the
inflation, the greater the difference in value between a nominal cash flow today and the same cash
flow in the future.
3. A promised cash flow might not be delivered for a number of reasons: The promisor might default
on the payment, the promisee might not be around to receive payment, or some other contingency
might intervene to prevent the promised payment or to reduce it. Any uncertainty (risk) associated
with the cash flow in the future reduces the value of the cash flow.
The process by which future cash flows are adjusted to reflect these factors is called discounting, and
the magnitude of these factors is reflected in the discount rate. The discount rate can be viewed as
a composite of the expected real return (reflecting consumption preferences in the aggregate over
the investing population), the expected inflation rate (to capture the deterioration in the purchasing
power of the cash flow), and the uncertainty associated with the cash flow.
10.4 TYPES OF TIME VALUE OF MONEY

The time value of money is the widely accepted conjecture that there is greater benefit to receiving a
sum of money now rather than an identical sum later. It may be seen as an implication of the later -
developed concept of time preference.
The time value of money is among the factors considered when weighing the opportunity costs of
spending rather than saving or investing money. As such, it is among the reasons why interest is paid
or earned: interest, whether it is on a bank deposit or debt, compensates the depositor or lender for the
loss of their use of their money.
10.4.1 Future Value of a Single Account

The future value of a lump sum amount or single cash flow means the value of such amount after
a particular period of time at the given interest rate. The accrued amount/future value (FVn) on a
principal amount (P0) at an interest rate per payment period (i) after a number of payment periods (n)
is given by the following formula:
FVn P0(1 i)n
Here,
FVn = Future value
P0 = Principal amount
i = Interest rate per payment period =
126
Annual rate of interest (r) / Number of payment periods per year (k)
n = Number of payment periods
(1 + i)n = Future value factor or compound value factor = FVIFi,n = Future value interest factor at i%
for n periods
Thus, FVn = P0 (1 + r/k)n
when compounding is done k times a year at an annual interest rate r.
FVn = P0(FVIFi,n)
The financial tables for computing the values of (1 + i)n at various rates of interest
for n number of periods is available in Appendix A (The Compound Sum of One
Rupee) Future value interest factor of ` 1 per period at i% for n periods, FVIFi,n.
Let us understand the concept of future value of cash flows with the help of some illustrations.
Illustration: Determine the amount of compound interest for an investment made with ` 15,000 at 6%
interest p.a. compounded half-yearly for a period of 6 years.
FVn P0(1 i)n
(1 + i)n = FVIFi, n = Future value interest factor at i% for n periods

I = r/k
= 0.06/2
= 3%
n = 6 × 2 = 12
Using financial tables, the future value interest factor of ` 1 per period at 3% for 12 periods, FVIF3,
12 = 1.426
Future value = 15,000 (1.426) = 2,13,90
Compound interest = Future value Present value
= 2,13,90 15,000 = ` 6,390
10.4.2 Future Value of an Annuity

An annuity is referred to as a stream of regular and periodic payments that are made or received for a
specific period of time. Generally, receipts or payments occur at the end of every period in an ordinary
annuity. Algebraically, the future value of an annuity is given by the following formula:
n 1 n 2 1 0
FVAn R 1 i R 1 i ....... R 1 i R 1 i
127
JGI JAIN
Here,
FVAn = Future value of an annuity
R = Each periodic receipt or payment
N = Length of the annuity
We can say that the future value of an annuity is equal to the periodic receipt (R) times the total of
the future value interest factors at i% rate of interest for time periods ranging from 0 to n A shortcut
formula is as follows:
(1 i)n 1
FVAn R
i
Or
FVAn = R (FVIFAi, n )
where FVIFAi, n = Future value interest factor of an annuity at i% for n periods The financial tables for
computing the values of (1 + i)n -1 / i at various rates of interest for n number of periods is available
in Appendix C (The Compound Value of an Annuity of One Rupee) Future value interest factor of an
ordinary annuity of ` 1 per period at i% for n periods, FVIFAi, n. Let us understand this with the help of
a few illustrations.
Illustration: What would be the future amount of an annuity if the payment of ` 1,000 is made annually
for a period of 7 years at the rate of interest of 14% compounded annually?
Here, R = 1,000, n = 7, and i = 0.14
(1 i)n 1
FVAn R
i
FVAn = R (FVIFA 0.14,7)

Using financial tables, we get = 1,000 (10.730) = ` 10,730.
10.4.3 Present Value of a Single Account

The process of finding the present value (PV) of cash flows is exactly the reverse of finding the future
value (FV). Also, the formula for computation of future value can be readily transformed into the
formula for present value as:
FVn
P0
(1 i)n
Or
P0 = FVn (1 + i) -n
Here,
FVn = Future value n years hence from now
128
P0 = Present value today

i = Interest rate per payment period =
Annual rate of interest (r) / Number of payment periods per year (k)
n = Number of payment periods for which discounting is done
(1 + i) n = Present value factor = PVIFi, n = Present value interest factor at i% for n Periods
Thus, P0 = FVn (1 +r/k) -n
when compounding is done k times a year at an annual interest rate r.
P0 = FVn (PVIFi, n)
The financial tables for discounting the values of (1 + i) n at various rates of interest for n number of
periods is available in Appendix B Present value interest factor of ` 1 per period at i% for n periods,
PVIFi, n.
Let us understand the concept of the present value of cash flows with the help of illustrations.
Illustration: What is the present value of ` 2 expected to be received after 2 years compounded annually
at the rate of 10%?
Given that i = 0.10, n = 2, FVn = 2
P0 = FVn (PVIFi, n)
= 2(PVIF0.10,2)
= 2(0.826) = ` 1.652
Hence, ` 1.652 shall grow to ` 2 after 2 years if compounded @ 10% annually.
10.4.4 Present value of an Annuity

Present value of an annuity comes into picture when instead of a single cash flow, the cash flows of the
same amount are received over a specific number of years. Just as we may require to compute the future
value of a stream of periodic and regular cash flows, we may also be sometimes required to compute the
present value of a stream of equal cash flows. Algebraically, the present value of an annuity is given by
the following formula:
R R R R
PVAn 1 2
....... n 1 n
1 i 1 i 1 i 1 i
1 1 1 1
R .......
(1 i)1 (1 i) 2 (1 i)n 1
(1 i)n
R PVIFi, 1 PVIFi, 2 PVIFi, 3 ..... PVIFi, n
R PVIFA i, n
129
JGI JAIN
Here,
n PVA = Present value of an annuity
R = Each periodic receipt or payment
N = Length of the annuity
We can say that the present value of an
formula for PVAn is as follows:
1
1 n
PVA n R 1 i
i
Or
PVAn = R (PVIFAi, n)
Where, PVIFAi,n = Present value interest factor of an annuity at i% for n periods.
1
1
1 i n
The financial tables for computing the values of at various rates of interest for n
i
number of periods is available in Appendix D Present value interest factor of an (ordinary)
annuity of ` 1 per period at i% for n periods, PVIFAi,n. Let us understand this with the help of
an illustration.
Illustration: You are required to calculate the present value of a 4-year annuity of ` 40,000
(periodically) which is discounted at the rate of 10 percent annually.
Solution: Here, i = 0.10, n = 4, R = ` 40,000
PVAn = R (PVIFAi, n)
By using financial tables, we get PVIFA0.10,4 = 3.170
Thus, PVA4 = 40,000(3.170)
= ` 1,26,800
10.5 PRESENT VALUE OF A PERPETUITY

Perpetuity is defined as an annuity wherein the cash payments or cash receipts start on a determined
date and continue on a periodic basis indefinitely or perpetually. Some examples include fixed interest
payments on permanently deposited money which is irredeemable. While computing the present value
of perpetuity, the following points must be considered:
The value of the perpetuity is definite since payments or receipts which are likely to be expected too
far in the future entail very minimal present value.
As the principal amount is not to be redeemed, the principal carries no present value.
130
The value of perpetuity simply means the interest amount over the suitable discount rate. For
determining the present value of multi-period perpetuity, the following formula can be used:
R R R R
PVA .......
(1 i) (1 i)2
1
(1 i) 3
(1 i)
R R
n
n 1 (1 i) i
Where
R = the payment or receipt each period
i = the interest rate per payment or receipt period
Similarly, when perpetuity is characterised by a stream of cash flows which grows at a constant rate
forever, it is referred to as the growing perpetuity. For determining the present value of the growing
perpetuity, the following formula can be used:
R R(1 g)1 R(1 g)2 R(1 g)

PVA .......
(1 i) 1 (1 i)2 (1 i) 3 (1 i)
R(1 g)n 1 R
n 1
(1 i)n i g
Where
R = the payment or receipt each period
i = the interest rate per payment or receipt period
g = growth rate
Let us understand the computation of perpetuity value with the help of an illustration.
Mr Ram intends to retire and receive a sum of ` 6,000 per month. After his death, he wishes to render his
monthly payments to future generations. If an interest of 10% compounded annually is earned by him,
then compute the amount which he needs to apportion to achieve his perpetuity aim.
Here,
R = ` 6,000 and i = 0.10/12 = 0.00833
Substituting these values in the perpetuity formula, we get PVA = ` 6,000 ÷ 0.00833 = ` 7,20,288
10.6 INTRA-YEAR COMPOUNDING AND DISCOUNTING

The time value of money says that the worth of a unit of money is going to be changed in future. Put
simply, the value of one rupee today will be decreased in the future. The whole concept is about the
present value and future value of money. There are two methods used for ascertaining the worth of
money at different points of time, namely, compounding and discounting. Compounding method is used
131
JGI JAIN
to know the future value of present money. Conversely, discounting is a way to compute the present
value of future money.
Present Future
Value Value
Intra-year Compounding
Up to this point, we generally have assumed that interest was calculated at the end of each year, based
on the principal balance at the beginning of the year and the annual interest rate. That is, we have
assumed that interest was compounded (or discounted) on an annual basis, and in solving problems, we
have used the annual compounding pages in AH 505.
Compounding interest more -
compounded on a semi-annual, quarterly, monthly, daily, or even continuous basis. When interest is
compounded more than once a year, this affects both future and present-value calculations.
With intra-year compounding, the periodic interest rate, instead of being the stated annual rate,
becomes the stated annual rate divided by the number of compounding periods per year. The number
of periods, instead of being the number of years, becomes the number of compounding periods per year
multiplied by the number of years.
Refer to the following table.
Compounding Frequency Number of Periods, n Periodic Rate, i

Annual years i = annual interest rate
Quarterly quarters (years × 4) i = annual interest rate ÷ 4
Monthly months (years × 12) i = annual interest rate ÷ 12
Daily days (years × 365) i = annual interest rate ÷ 365
With monthly compounding, for example, the stated annual interest rate is divided by 12 to find the
periodic (monthly) rate, and the number of years is multiplied by 12 to determine the number of
(monthly) periods.
The major differences between compounding and discounting techniques in time value of money are as
follows:
Compounding technique
It is a process of calculating future value using the present investment.
It determines money gained by an investment.
132
It is also called as present value.

Compound interest rate.
Uses future value/compounding factor.
Its formula is Fv= Pv(1+r)^n
Amount increases in this method.
Right side to left (time line).
If the rate is low then, future value will decrease and if the rate is high then, future value will increase.
Discounting technique
It calculates future cash flows using the present value.
It determines the amount to be invested to get maximum future gains.
It is also called future value.
Discount rate.
It uses the present value/discounting factor.
Its formula is Pv=Fv/((1+r)^n).
Amount decreases in this method.
Left to right side (time line).
If the rate is low, then the present value will increase; if the rate is high, then the present value will
decrease.
The factors as to why money in the future is worth less than the same money derived now include
preference for present consumption, inflation and risk of uncertainty.
While compounding is the process of computing future values of cash flows, discounting is concerned
with finding out the present values of cash flows.
When compounding is done for more than once in a year, the effective interest rate or the actual
annualised interest rate shall be higher than the nominal or real rate of interest.
The future value of a lump sum amount or single cash flow means the value of such amount after a
particular period of time at the given interest rate.
An annuity is referred to as a stream of regular and periodic payments that are made or received
for a specific period of time.
value (FV).
The difference between the present value of cash inflows and the present value of cash outflows
gives the net present value of a financial decision.
The time value of money is the widely accepted conjecture that there is greater benefit to receiving
a sum of money now rather than an identical sum later.
It may be seen as an implication of the later-developed concept of time preference.
133
JGI JAIN
The future value of a lump sum amount or single cash flow means the value of such amount after a
particular period of time at the given interest rate.
An annuity is referred to as a stream of regular and periodic payments that are made or received
for a specific period of time.
value (FV).
The present value of an annuity comes into picture when instead of a single cash flow, the cash flows
of the same amount are received over a specific number of years.
10.8 GLOSSARY
Cash flow: A movement of money, whether receipt or payment of amount, from one source to
another. It is generally used to determine a value or rate of return.
Financial decisions: A number of decisions concerning borrowing, investment and allocation of
funds in relation to the financial mix of a business firm.
Inflation: A quantitative measure of rise in the general level of prices, whereby a unit of currency
purchases less than it was capable of buying in the prior periods.
Annuity:A series of equal payments which occurs atequal intervals of time. Its specific characteristics
are that the payments equal each other as well as the interval between each one of them is the same.
Interest: The return available to those who supply funds to a firm. It is the price that is paid for the
use of loanable funds over a period of time.
10.9 CASE STUDY: ASSESSMENT OF FUTURE VALUE OF DEPOSITS
Case Objective
The case study explains how to assess future value of deposits.
Mr Sahil, a salaried person, opened a bank account on 1st April, 2013, by making a deposit of ` 1,600.
He is considering evaluation of his investments and deposits to assess the worth of money invested
by him and interest earned thereon. The deposit account yielded him an interest @ 6% compounded
quarterly. In anticipation of making more investments, Mr Sahil closed his account in the bank on 1st
October, 2013. Besides, the proceeds of his earlier account, he added enough additional money required
to invest in a time deposit of a six-month period for ` 2,000. The time deposit earned him an interest @
6% compounded monthly. To make his investments fruitful, he approached a financial advisor to assist
him to find out the financial particulars concerning the present value and future value of deposits.
For this purpose, the financial advisor evaluated the additional amount that Mr Sahil invested on 1st
October, 2013, the maturity value of his time deposit as on April 1, 2014, and the total amount of interest
earned by him.
Given (1 + i)n = 1.03022500 where i = 1 (1/2) % and n = 2
Also, (1 + i )n = 1.03037751 where I = ½ % and n = 6
Questions
1. How much of additional amount did Mr Sahil invest on 1st October, 2013?
(Hint: Mr initial investment yielded interest for April-June and July-
134
September quarters, i.e., 2 quarters.)

i = 6/4 = 1(1/2)% and n = 2
n
1
Compounded amount = 1,600 1 1 %
2
= 1,600 × 1.03022500 = 1,648.36)

The additional amount = ` (2,000 1,648.36) = ` 351.64
2. How much was the maturity value of Mr time deposit on 1st April, 2014?
(Hint: In this case, the time deposit yielded interest for 2 quarters compounded monthly.)
i = 6/12
= ½ and n = 6%
6
1
Required maturity value = 2,000 1 %
2
= 2,000 × 1.03037751 = ` 2,060.75)

3. What is the amount of total interest earned?
(Hint: Total interest earned = (48.36 + 60.75) = ` 109.11)

1. What is the time value of money?
2. What is the future value of a lump sum amount or single cash flow?
3. What is perpetuity?

1. The time value of money is the widely accepted conjecture that there is greater benefit
to receiving a sum of money now rather than an identical sum later. Refer to Section
Introduction to Time Value of Money
2. The future value of a lump sum amount or single cash flow means the value of such amount
after a particular period of time at the given interest rate. Refer to Section Types of Time
Value of Money
3. Perpetuity is defined as an annuity wherein the cash payments or cash receipts start on
a determined date and continue on a periodic basis indefinitely or perpetually. Refer to
Section Present Value of Perpetuity
135
JGI JAINDEEMED-TO-BE UN IV E RSI TY
https://psu.instructure.com/courses/1806581/pages/introduction -what-is-time-value-of-money
https://www.siptolumpsum.net/2019/09/time-value-of-money.html
https://cleartax.in/s/time-value-money-tvm
https://www.fool.com/investing/how-to-invest/time-value-money/
https://khatabook.com/blog/what-is-time-value-of-money/
Discuss the usefulness of time value of money with your friends.
136
UNIT
Long Term Investment Decisions
Names of Sub-Units
Introduction to long-term investment decisions, concept of capital budgeting, importance of capital

budgeting, process of capital budgeting, techniques of evaluating projects, concept of different cash
flows.
Overview
This unit begins by explaining the meaning of long-term investment decisions, it discusses the, concept
of capital budgeting. Further, the unit explains the importance of capital budgeting. It also discusses
the process of capital budgeting.
Learning Objectives

Explain the long-term investment decisions
State the concept of capital budgeting
Identify the importance of capital budgeting
Classify the techniques of evaluating projects
JGI JAIN
Learning Outcomes
Assess the long-term investment decisions
Examine the importance of capital budgeting
Analyse the techniques of evaluating projects
Evaluate the concept of capital budgeting
11.1 INTRODUCTION
Long-term investment decision is referred to as the capital budgeting decision. It relates to the
investment in fixed assets, for example, buying a new machine. Before making the final decision, the
finance manager makes a comparative study of various alternatives available in the market based on
their cost and profitability.
These decisions are very important as they affect the earnings of the business in the long-run.
Factors affecting long-term investment decisions are:
Cash flow of the project: Cash flow of the project during the life of investment affects the long-term
investment decision. Series of cash receipts and payments over the life of investment have to be
carefully analysed before making a capital budgeting decision.
Rate of return of the project: The most important criterion is the rate of return of the project.
Investment yields return in the future. Thus, the calculation of returns is necessary to analyse the
best project.
Risk involved: With every investment proposal, there is some degree of risk involved. The company
must try to calculate the risk involved in every proposal and select a proposal with a moderate
degree of risk only.
11.2 CONCEPT OF CAPITAL BUDGETING

As part of long-range planning process decision is taken on the programme, the organisation will
undertake and the appropriate resources that will be allocated to each programme over the next few
ges from the exercise of strategic
planning. The techniques of capital budgeting are used to take such decisions.
Capital budgeting is the art of locating assets that are worth more than they cost to accomplish a
predetermined target, such as maximising a
outflow shortly in exchange for future returns. A capital investment decision entails a mostly permanent
commitment
of money, which is usually fraught with risk. Such decisions have long-term implications for an
-
and can potentially lead to bankruptcy.
Capital budgeting can be described as the mechanism by which businesses determine the purchasing of
major fixed assets, such as machinery, equipment, buildings as well as the acquisition of other businesses,
either through the purchase of equity shares or a group of assets, to conduct ongoing operations.
Capital budgeting is a structured preparation mechanism for the acquisition and investment of capital
142
UNIT 11: Long Term Investment Decisions JGI JAIN
acquisition.
11.2.1 Importance of Capital Budgeting

Long-term Goals: For the growth & prosperity of the business, long-term goals are very important
for any organisation. A wrong decision can be disastrous for the long-term survival of the firm.
Capital budgeting has its effect in a long-time span. It also affects future cost & growth.
Involvement of a Large Number of Funds: Capital Investment requires a large number of funds.
As the companies have limited resources, the company has to make a wise & correct investment
decision. The wrong decision would harm the sustainability of the business. The large investment
includes the purchase of an asset, rebuilding or replacing existing equipment.
Irreversible Decision: The capital Investment decisions are generally irreversible as it requires
large amounts of funds. It is difficult to find the market for that asset. The only way remains with
the company is to scrap the asset & incur heavy losses.
Monitoring & Controlling the Expenditure: Capital budget carefully identifies the necessary
expenditure and R&D required for an investment project. Since a good project can turn bad if
budgeting process.
Transfer of Information: The time that a project starts as an idea, it is accepted or rejected;
numerous decisions have to be made at various levels of authority. The capital budgeting process
facilitates the transfer of information to appropriate decision-makers within a company.
Difficulties of Investment Decision: The long-term investment decisions are difficult because it
extends several years beyond the current period. Uncertainty indicates a higher degree of risk.
Management loses its flexibility and liquidity of funds in making investment decisions so it must
consider each proposal very thoroughly.
Maximisation of Wealth: Long-term investment decision of the organisation helps in safeguarding
the interest of the shareholder in the organisation. If the organisation has invested in a planned
manner, the shareholder would also be keen to invest in that organisation. This helps in the
maximisation of wealth of the organisation. Any expansion is fundamentally related to further sales
and future profitability of the firm and assets acquisition decisions are based on capital budgeting.
11.2.2 Process of Capital Budgeting

Capital budgeting is a decision-making mechanism by which businesses assess the acquisition of
large fixed assets, such as buildings, machinery and equipment. It also includes decisions to buy other
companies, either through the acquisition of their common stock or a collection of assets that can be
used to run a company.
The capital budgeting process consists of five steps:
1. Proposal for project: Proposals for new investment programmes are made at all levels of a company
and reviewed by finance personnel and key management bodies.
2. Review and analysis of projects: Financial administrators, including main management bodies,
conduct formal reviews and analyses to evaluate investment demerits.
3. Decision making about proposals: Capital expenditure decision-making is usually dependent on
capital availability and limits.
143
JGI JAIN
4. Selection and implementation: Expenditures are made and programmes are initiated after
identification, analysis, selection and approval.
5. Follow-up and review process: Outcomes are tracked and real costs and benefits are compared to
what was predicted. If actual results vary from those predicted, action may be taken.
11.3 TECHNIQUES OF EVALUATING PROJECTS

When a firm is presented with a capital budgeting decision, one of its first tasks is to determine whether
or not the project will prove to be profitable. The payback period (PB), internal rate of return (IRR) and
net present value (NPV) methods are the most common approaches to project selection.
Although an ideal capital budgeting solution is such that all three metrics will indicate the same decision,
and selection criteria, more emphasis will be put on one approach over another. Nonetheless, there are
common advantages and disadvantages associated with these widely used valuation methods.
11.3.1 Net Present Value (PV)

cash
outflows is known as the net present value or NPV. The cash flow forecasts are based on a market-based
discount rate, also known as a hurdle rate, that takes into account the time value of money. In dollar
terms, net present value (NPV) expresses the effect of an investment on wealth creation. Allow capital
investments with positive cash flows and dismiss those with negative cash flows as a rule of thumb.
be
adequate to cover its expenses, borrowing costs and underlying cash flow risks.
Acceptance Criteria:
(a) In case of single project, accept project if NPV 0, and reject if NPV < 0.
(b) In case of multiple projects, select the project with the highest NPV.
11.3.2 Internal Rate of Return (IRR)

The internal rate of return, or IRR, is the average rate of return on investment throughout its useful life.
The IRR is the discount rate that causes the NPV to become zero. This is the discount rate at which the
current value of cash outflows equals the present value of cash inflows, or anything similar. Accept a
capital expenditure if the IRR exceeds the cost of capital; deny it if the IRR falls below the cost of capital.
This IRR is then compared with the rate of return that the management wishes to generate from the
project. The decision is taken after comparing the IRR with this rate of return.
Steps to Calculate IRR:
(a) Form an equation, with PV of cash outflows on left-hand side and PV of cash inflows on right-hand
side as follows:
C1 C2 C3 C2
Co 2 3 .........
1 1 r 1 r n
1 r 1 r
144
Where,
Co = PV of Cash outflow
C1, C2, C3.............. Cn = Cash Inflow
1, 2, .....n = Number of Years
r = Expected Rate of Return
(b) Substitute the value for r on the right-hand side, and calculate the value of the right-hand side
(c) If the value on the right-hand side is higher than the value on the left-hand side, then substitute a
higher value for r.
(d) If the value of the right-hand side is lower than the value on the left-hand side, then substitute a
lower value for r.
(e) Continue this till the value of the right-hand side is equal to the value of the left-hand side or arrive
at two values of r which will give a slightly higher value than the left-hand side and a slightly lower
value than the left-hand side.
(f) Put these two values of r in the following formula of interpolation and get the value of IRR:
NP Vat Lower Rate
IRR Lower Rate Higher Rate Lower Rate
NP Vat Lower Rate
(a) Accept Project if IRR > Cut off rate
(b) Reject Project if IRR < Cut off rate
11.3.3 Modified Internal Rate of Return (MIRR)

Due to the limitations attached with IRR, MIRR is used. It overcomes some of the deficiencies of IRR, such
as it eliminates
produces a result that is consistent with NPV.
Steps to Calculate MIRR:
(a) Under this method, all cash flows apart from the initial investment are brought to the terminal
value using an appropriate rate of return (cost of capital).
(b) This results in a single stream of cash inflow in the terminal year.
(c) This single terminal value in the last year is then discounted to PV (in year 0) using an appropriate
discounting factor.
(d) The rate of return which equates the PV of the terminal cash inflows with the PV of cash inflows, is
called MIRR.
11.3.4 Profitability Index (PI)
present value of cash inflows divided by the present value of cash outflows is shown. It is the ratio of the
present value of the earnings to the amount of investment. It is the variation of the NPV method. In case
145
JGI JAIN
of projects with different investment sizes, the NPV method cannot be used. It is necessary to relate the
flows of investment in case of different investment sizes. This is done in PI Method.
Discounted Cash Inflow
Profitability Index
Discounted Cash Outflow
Discounted Cash Inflow
Payback period 100
Discounted Cash Outflow
(a) Accept Project if PI 0 and reject the project if PI < 0
(b) In case of many projects, accept the project with the highest PI.
11.3.5 Payback Period

It refers to that period within which the project will generate the necessary cash to recoup the initial
investment.
In case of even cash flows, payback period can be calculated as follows:
Initial Investment
Payback period
Annual Cash Flow
In case of uneven cash flows, the payback period can be found out by adding up the cash inflows until
the total is equal to the initial cash outlay.
Acceptance Rule:
(a) The project would be accepted, if its payback period is less than the maximum or standard payback
period set by the management.
(b) In case of selection from several projects, the project with the shortest period will be selected.
11.3.6 Discounted Payback Period

The discounted payback period is a capital budgeting procedure used to determine the profitability of a
project. A discounted payback period gives the number of years it takes to break even from undertaking
the initial expenditure, by discounting future cash flows and recognising the time value of money. The
metric is used to evaluate the feasibility and profitability of a given project.
The more simplified payback period formula, which simply divides the total cash outlay for the project
or not to take on a project because it assumes only one, upfront investment, and does not factor in the
time value of money.
Discounted Payback Period = Year Before the Discounted Payback Period Occurs + (Cumulative Cash
Flow in Year Before Recovery / Discounted Cash Flow in Year After Recovery)
11.3.7 Accounting Rate of Return (ARR)

As per this method, the capital investment proposals are judged based on their relative profitability. It
is a ratio of the average after tax profit divided by the average investment.
146
Average Annual Net Earnings

Average rate of return = 100
Average Investment
Original Investment Scrap Value

Average rateof return=
2
(a) A project with ARR above the expected level will be accepted
(b) In case of more than two projects, a project with Highest ARR will be ranked first, and so on.
11.4 CONCEPT OF DIFFERENT CASH FLOWS

A Cash Flow Statement is a statement that is prepared by acquiring Cash from different sources and the
application of the same for different payments throughout the year.
It is prepared from analysis of cash transactions, or it converts the financial transactions prepared
under accrual basis to cash basis.
The information about the number of resources provided by operational activities or net income after
the adjustment of certain other charges can also be obtained from it. The changes in Cash both at the
beginning and at the end can also be known with the help of this statement and that is why it is called
the Cash Flow Statement.
Thus, cash flows are classified into three main categories:
1. Cash Flows from Operating Activities: Operating activities are the principal revenue-producing
activities of the enterprise and other activities that are not investing or financing activities. The
amount of cash flows arising from operating activities is a key indicator of the extent to which
the operations of the enterprise have generated sufficient cash flows to maintain the operating
capability of the enterprise, pay dividends, repay loans and make new investments without recourse
to external sources of financing. Information about the specific components of historical operating
cash flows is useful, in conjunction with other information, in forecasting future operating cash
flows.
Cash flows from operating activities are primarily derived from the principal revenue-producing
activities of the enterprise. Therefore, they generally result from the transactions and other events
that enter into the determination of net profit or loss.
Examples of cash flows from operating activities are:
a. Cash receipts from the sale of goods and the rendering of services;
b. Cash receipts from royalties, fees, commissions and other revenue;
c. Cash payments to suppliers of goods and services;
d. Cash payments to and on behalf of employees;
e. Cash receipts and cash payments of an insurance enterprise for premiums and claims, annuities
and other policy benefits;
f. Cash payments or refunds of income taxes unless they can be specifically identified with
financing and investing activities; and
g. Cash receipts and payments relating to futures contracts, forward contracts, option contracts
and swap contracts when the contracts are held for dealing or trading purposes.
147
Some transactions, such as the sale of an item of plant, may give rise to a gain or loss which is included
in the determination of net profit or loss. However, the cash flows relating to such transactions are
cash flows from investing activities.
2. Cash Flows from Investing Activities: Investing activities are the acquisition and disposal of long-
term assets and other investments not included in cash equivalents. The separate disclosure of cash
flows arising from investing activities is important because the cash flows represent the extent to
which expenditures have been made for resources intended to generate future income and cash
flows.
Examples of cash flows arising from investing activities are:
a. Cash payments to acquire fixed assets (including intangibles). These payments include those
relating to capitalised research & development costs and self-constructed fixed assets;
b. Cash receipts from disposal of fixed assets (including intangibles);
c. Cash payments to acquire shares, warrants or debt instruments of other enterprises and
interests in joint ventures (other than payments for those instruments considered to be cash
equivalents and those held for dealing or trading purposes);
d. Cash receipts from disposal of shares, warrants, or debt instruments of other enterprises and
interests in the joint venture (other than receipts from those instruments considered to be cash
equivalents1 and those held for dealing or trading purposes);
e. Cash advances and loans made to third parties (other than advances and loans made by a
financial enterprise);
f. Cash receipts from the repayment of advances and loans made to third parties (other than
advances and loans of a financial enterprise);
g. Cash payments for future contracts, forward contracts, option contracts and swap contracts
except when the contracts are held for dealing or trading purposes or the payments are classified
as financing activities; and
h. Cash receipts from futures contracts, forward contracts, option contracts and swap contracts
except when the contracts are held for dealing or trading purposes or the receipts are classified
as financing activities.
3. Cash Flows from Financing Activities: Financing activities are activities that result in changes in
the size and composition of the capital (including preference share capital in the case of
a company) and borrowings of the enterprise. The separate disclosure of cash flows arising from
financing activities is important because it is useful in predicting claims on future cash flows by
providers of funds (both capital and borrowings) to the enterprise.
Examples of cash flows arising from financing activities are:
(a) Cash proceeds from issuing shares or other similar instruments:
(b) Cash proceeds from issuing debentures, loans, notes, bonds and other short-or long-term
borrowings; and
(c) Cash repayments of amounts borrowed, such as redemption of debentures, bonds preference
shares.
148
Capital Budgeting is the art of locating assets that are worth more than they cost to accomplish a
predetermined target, such as maximising a wealth.
A capital investment decision entails a mostly permanent commitment of money, which is usually
fraught with danger.
Capital budgeting is a decision-making mechanism by which businesses assess the acquisition of
large fixed assets, such as buildings, machinery and equipment.
Time and effort are needed for project analysis. The costs of this exercise must be justified by the
advantages that it provides.
These investments aim to increase capacity and/or expand the distribution network.
Any group of projects that are mutually exclusive means that choosing one eliminates the possibility
of the others.
When we have mutually exclusive projects, our decision rules must not only determine whether a
project is good or bad but also rate which project is the better.
Capital budgeting is the process of assessing and selecting long-term assets based on their costs and
expected returns.
The long-term investment decision is referred to as the capital budgeting decision. It relates to the
investment in fixed assets, for example, buying a new machine.
As part of the long-range planning, process decision is taken on the programme, the organisation
will undertake and the appropriate resources that will be allocated to each programme over the
next few years.
Capital budgeting is the art of locating assets that are worth more than they cost to accomplish a
predetermined target, such as maximising a wealth.
When a firm is presented with a capital budgeting decision, one of its first tasks is to determine
whether or not the project will prove to be profitable.
The payback period (PB), internal rate of return (IRR) and net present value (NPV) methods are the
most common approaches to project selection.
cash inflows and the present value of cash
outflows is known as the net present value or NPV.
The internal rate of return, or IRR, is the average rate of return on investment throughout its useful
life.
The profitability index, or PI, is the ratio of an in net present value to its cost of capital.
A Cash Flow Statement is a statement that is prepared by acquiring Cash from different sources and
the application of the same for different payments throughout the year.
11.6 GLOSSARY
Capital budgeting: Planning and deployment of available capital to maximise long-term profitability
of the firm
149
JGI JAIN
Capital rationing: The allocation of the limited funds available for financing the capital projects
to only some of the profitable projects in such a manner that the long-term returns are maximised
Risk-free rate: The rate at which the future cash flows of a project which is not subjected to risk are
discounted
Risky investment: Variability that is likely to occur between the estimated returns and the actual
returns
11.7 CASE STUDY: LONG TERM EFFECTS OF CAPITAL BUDGETING
Case Objective
This Case Study discusses how the long-term effects of capital budgeting helped to decide Mr. Amit to
buy Mrida Motors or not.
Amit, who holds an ITI diploma, has worked for Mrida Motor and Supreme Garage for the past ten
number of clients picked Amit to fix their vehicles. After three years, he was promoted to supervisor. Amit
and would assist Supreme owner, Mr. Gupta, in keeping a record of the accounts.
Mr. Gupta admired him greatly, and Amit was elevated to manager of Mrida Motors and Supreme
Garage two years ago. When Gupta retired from the Indian Army owing to a leg injury 18 years ago, he
started this firm. Mrida Motors and Supreme Garage had a solid reputation and was known as the top
motor garage in the district due to good customer relations and quality service.
A large number of customers from the surrounding area would bring their vehicles to Supreme Garage.
The shop specialised in engine overhauling. There was an electrical department for auto electrical and
an Exide battery agency. Mrida Motors specialised in denting and painting and had good insurance
relations. It has its tow vehicle and did well in the event of accidents or breakdowns. It presently
employed ten full-time mechanics, one supervisor besides Amit and Gupta who were manager and the
owner, respectively. Workers worked overtime during peak season and extra casual labour was brought
in to meet delivery requirements. Mrs. Gupta has been in poor health for the past year. Six months ago,
she had a minor heart attack. Mrs. and Mr. Gupta decided to go to the United States to be closer to their
daughter, a Cardiologist in Los Angeles. Gupta opted to sell the company because he had no one to
succeed him.
He wishe
image. He contacted Amit and offered to purchase his business. The initial offer was for 57.50 lakh
rupees. He also suggested supporting Amit with the finance of the acquisition. Gupta provided him with
five-
profit and loss records as of March 31, 2000, were also sent to him. He phoned Amit and told him that
based on the business flow, he valued the goodwill at 15 lakh rupees. Amit was excited about the offer.
He was well aware that the business was incredibly prosperous, with profits constantly increasing over
time. It has never been in a bad position before. He sought advice from a friend who was both a banker
and a Chartered Accountant. He advised him otherwise. He knew there was a scope of negotiation over
the price of the business. Now, Mrida Motors needs assistance.
150
Sales and Profit of Previous Years
Net sales 81,95,000 90,34,000

PBT 7,37,500 7,56,600
PAT 5,25,000 6,23,200
Summary of Projected sales and earnings
Year 2001 2002 2003 2004 2005

Net Sales 11,00,000 120,00,000 125,00,000 130,00,000 135,00,000
PBT 8,65,000 9,50,000 10,50,000 12,00,000 12,50,000
PAT 7,00,000 7,80,000 8,60,000 9,30,000 9,75,000
ANNEXURE 1
RNS MOTORS
Balance sheet (As on 31.03.2000)
Liabilities `
Capital 16,00,000
Retained profits 18,10,880
Building loan 26,99,200
Term loan 12,16,000
Current liabilities 8,14,400
Total liabilities 81,40,480
Assets
Gross block 66,56,000
Depreciation 14,22,720
Net blocks (at the end) 52,33,280
Current assets
Stocks 6,65,600
Receivables 13,31,200
Cash in hand 9,10,400
Total current assets 29,07,200
Total assets 81,40,440
Depreciation Schedule
Asset Gross Block Depreciation Net Block

Land Building 38,40,000 6,16,000 32,24,000
Plant Eqpt. 26,24,000 7,34,720 18,89,280
Other Assets 1,92,000 72,000 1,20,000
Total 66,56,000 14,22,726 55,33,280
151
JGI JAIN
RNS MOTORS
Profit & Loss Account (for the year ending 31.03.2000)
Net Sales 99,64,800

Direct Wages 30,78,400
Contract Materials 18,83,200
Supplies 2,36,800
Mix Costs 4,24,000
Cost of Sales 56,22,400
Gross Profit from Operation 43,42,400
Operating Expenses 26,35,200
Total Depreciation for the Year 3,76,272
Net Income before Interest and Taxes 13,30,928
Interest 4,97,440
Profit Before tax 8,33,488
Income tax 1,58,240
Net Profit after tax 6,75,248
Questions
1. If you were the banker, will you finance?
(Hint: yes, after comparing P&L account and balance sheet of RNS Motors)
2. How would you evaluate the goodwill of RNS Motors.
(Hint: evaluate all assets and liabilities of RNS Motors)

1. What do you understand by long-term investment decision?
2. What is capital budgeting?
3. What is the process of capital budgeting?
4. What do you understand by profitability index?

1. The long-term investment decision is referred to as the capital budgeting decision. It relates to the
investment in fixed assets, for example, buying a new machine. Before making the final decision, the
finance manager makes a comparative study of various alternatives available in the market based
on their cost and profitability. Refer to Section Concept of Capital Budgeting
152
2. Capital budgeting is the art of locating assets that are worth more than they cost to accomplish a
Budgeting
3. The capital budgeting process is a decision-making mechanism by which businesses assess the
acquisition of large fixed assets, such as buildings, machinery and equipment. It also includes
decisions to buy other companies, either through the acquisition of their common stock or a
collection of assets that can be used to run a company. Refer to Section Concept of Capital Budgeting
4.
The present value of cash inflows divided by the present value of cash outflows is shown. Refer to
Section Techniques of Evaluating Projects
https://www.investopedia.com/articles/financial-theory/11/corporate-project-valuation-methods.
asp
https://cleartax.in/s/capital-budgeting
https://www.accountingtools.com/articles/what-is-capital-budgeting.html
https://corporatefinanceinstitute.com/resources/knowledge/finance/capital-budgeting-best-
practices/
https://ift.world/booklets/corporate-finance-capital-budgeting-part1/
Discuss the usefulness of capital budgeting with your friends.
153
UNIT
Cost of Capital
Names of Sub-Units
Introduction to Cost of Capital, Concept of Cost of Capital, Concept of Measurement of Cost of Capital,
Computation of Overall Cost of Capital, Cost of Capital Practices in India.
Overview
This unit begins by explaining the meaning of cost of capital, it discusses the concept of cost of capital.
The unit explains the measurement of cost of capital. It also discusses the computation of overall cost
of capital.
Learning Objectives

Explain the meaning and importance of cost of capital
Discuss the various classifications of cost of capital
Describe the concept of cost of cost of capital
Explain the measurement of cost of capital
Outline the cost of capital practices in India
JGI JAIN
Learning Outcomes

Assess the importance of cost of capital
Examine the measurement of cost of capital
Analyse the computation of overall cost of capital
Evaluate the cost of capital practices in India
12.1 INTRODUCTION
The cost of capital is the cost incurred to an organisation when it raises capital from different sources.
Capital is raised for different purposes. For example, for building a factory, paying off an old debt,
expansion of business, etc. The overall cost of capital for an organisation is usually calculated by finding
cost of capital is also used by firms internally to analyse the capital structuring and reduce the costs or
project the targeted revenues to be earned to cover the cost. Cost of capital depends on the source of the
finance used. Capital can be raised by issuing equity shares or preference shares or by taking debts or
issuing debentures.
Mostly, organisations use a combination of equity, preference and debts to finance their capital
requirements. They do not depend only on one source of finance. Therefore, the overall cost of capital
is calculated using the weighted average cost of all the capital sources which is also known as WACC.
12.2 CONCEPT OF COST OF CAPITAL

Cost of capital is expressed in terms of the return expected by the providers of long-term capital to a
business firm (such as shareholders, debenture holders or lenders) as a token of compensation in lieu
of their contribution to the total capital. When business firms procure finances from different sources,
then they have to pay back some additional amount of money besides the principal amount, usually in
the form of periodic interest payments. Such amount payable by the firm is known as the cost of capital.
The cost of capital is useful to the management or investors to arrive at an appropriate decision. For
example, to evaluate different investment options, it is very important to use the relevant cost of capital
with the help of which the estimated future cash flows from available investment projects are converted
into the present value of benefits by discounting them. Similarly, the cost of capital acts as the cut-off
rate for appraising and comparing the performance of a particular business project against the hurdle
debt policies and
for evaluating the capital budgeting decisions. It is used to discount or compound the cashflows or a
stream of cashflows.
The cost of capital can be described in two ways, i.e., the explicit cost of capital and the implicit cost of
capital. The explicit cost of capital pertains to the clear and obvious cash outflows of a firm towards the
utilisation of capital such as in the form of interest payment to debenture holders, dividend payment
to shareholders, repayment of the principal loan amount to financial institutions, etc. Conversely,
the implicit cost of capital pertains to the opportunity loss of foregoing a better investment option by
choosing an alternative course and it is not actually a cash outflow.
158
UNIT 12: Cost of Capital JGI JAIN
For instance, when a firm uses its bank deposit for business purposes which earn an interest of 9.5% p.a.,
it forgoes the interest earnings from the bank on this deposit. The implicit cost of capital, in this case,
shall be 9.5% interest that could have been earned by not using the deposit for business purposes.
Cost of capital for each source of finance can be determined separately, such as cost of equity, cost of
preference share capital, cost of long-term debt and cost of retained earnings. In the following sections,
we will discuss the cost of each source of capital.
12.2.1 Measurement of Cost of Capital

Cost of capital is measured for different sources of capital structure of a firm. It includes cost of
debenture, cost of loan capital, cost of equity share capital, cost of preference share capital, cost of
retained earnings etc.
The measurement of cost of capital of different sources of capital structure is discussed here.
Cost of Debentures
The capital structure of a firm normally includes debt capital. Debt may be in the form of debentures
bonds, term loans from financial institutions and banks etc. The amount of interest payable for issuing
debentures is considered to be the cost of debenture or debt capital (Kd). The cost of debt capital is much
cheaper than the cost of capital raised from other sources, because interest paid on debt capital is tax
deductible.
The cost of debenture is calculated in the following ways:
(i) When the debentures are issued and redeemable at par: Kd = r (1 t)
where Kd = Cost of debenture
r = Fixed interest rate
t = Tax rate
(ii) When the debentures are issued at a premium or discount but redeemable at par
Kd = I/NP (1 t)
where, Kd = Cost of debenture
I = Annual interest payment
t = Tax rate
Np = Net proceeds from the issue of debenture.
(iii) When the debentures are redeemable at a premium or discount and are redeemable after period:
Kd
I(1-t)+1/N(Rv NP) / ½ (RV NP)
where Kd = Cost of debenture.
I = Annual interest payment
t = Tax rate
NP = Net proceeds from the issue of debentures
Ry = Redeemable value of debenture at the time of maturity
159
Cost of Preference Share Capital

For preference shares, the dividend rate can be considered as its cost, since it is this amount which
the company wants to pay against the preference shares. Like debentures, the issue expenses or the
discount/premium on issue/redemption are also to be taken into account.
(i) The cost of preference shares (KP) = DP / NP
Where, DP = Preference dividend per share
NP = Net proceeds from the issue of preference shares.
(ii) If the preference shares are redeemable after a period of the cost of preference shares (KP) will be:
1
Dp Rv NP
Kp n
1
Rv NP
2
where NP = Net proceeds from the issue of preference shares

RV = Net amount required for redemption of preference shares
DP = Annual dividend amount.
There is no tax advantage for cost of preference shares, as its dividend is not allowed deduction
from income for income tax purposes. The students should note that both in the case of debt and
preference shares, the cost of capital is computed with reference to the obligations incurred and
proceeds received. The net proceeds received must be taken into account while computing cost of
capital.
Cost of Equity or Ordinary Shares

The funds required for a project may be raised by the issue of equity shares which are of permanent
nature. These funds need not be repayable during the lifetime of the organisation. The calculation of the
cost of equity shares is complicated because, unlike debt and preference shares, there is no fixed rate of
interest or dividend payment.
The cost of equity share is calculated by considering the earnings of the company, market value of the
shares, dividend per share and the growth rate of dividend or earnings.
(i) Dividend/Price Ratio Method: An investor buys equity shares of a particular company as he expects
a certain return (i.e., dividend). The expected rate of dividend per share on the current market price
per share is the cost of equity share capital. Thus, the cost of equity share capital is computed on the
basis of the present value of the expected future stream of dividends.
Thus, the cost of equity share capital (Ke) is measured by:
Ke = where D = Dividend per share
P = Current market price per share.
If dividends are expected to grow at a constant rate of cost of equity share capital
(Ke) will be Ke = D/P + g.
This method is suitable for those entities where growth rate in dividend is relatively stable. But this
method ignores the capital appreciation in the value of shares. A company which declares a higher
amount of dividend out of given quantum of earnings will be placed at a premium as compared to
a company which earns the same amount of profits but utilizes a major part of it in financing its
expansion programme.
160
(ii) Earnings/Price Ratio Method: This method takes into consideration the Earnings per Share (EPS)
and the market price of share. Thus, the cost of equity share capital will be based upon the expected
rate of earnings of a company. The argument is that each investor expects a certain amount of
earnings whether distributed or not, from the company in whose shares he invests.
If the earnings are not distributed as dividends, it is kept in the retained earnings and it causes
future growth in the earnings of the company as well as the increase in market price of the share.
Thus, the cost of equity capital (Ke) is measured by:
Ke = E/P where E = Current earnings per share
P = Market price per share.
If the future earnings per share will grow at a constant rate then cost of equity share capital (Ke)
will be
Ke = E/P+ g.
This method is similar to dividend/price method. But it ignores the factor of capital appreciation
or depreciation in the market value of shares. Adjustment of Floatation Cost There are costs of
floating shares in market and include brokerage, underwriting commission etc. paid to brokers,
underwriters etc.
These costs are to be adjusted with the current market price of the share at the time of computing
cost of equity share capital since the full market value per share cannot be realised. So, the market
price per share will be adjusted by (1 f) where stands for the rate of floatation cost.
Thus, using the earnings growth model the cost of equity share capital will be:
Ke = E / P (1 f) + g
Cost of Retained Earnings

The profits retained by a company for using in the expansion of the business also entail cost. When
earnings are retained in the business, shareholders are forced to forego dividends. The dividends
forgone by the equity shareholders are, in fact, an opportunity cost. Thus, retained earnings involve
opportunity cost.
If earnings are not retained, they are passed on to the equity shareholders who, in turn, invest the same
in new equity shares and earn a return on it. In such a case, the cost of retained earnings (Kr) would be
adjusted by the personal tax rate and applicable brokerage, commission etc. if any.
D
Therefore, Ke = Ke (1 t) (1 f), where Ke g
P
t = Shareholders personal tax rate.

f = rate of floatation cost.
Many accountants consider the cost of retained earnings as the same as that of the cost of equity share
capital. However, if the cost of equity share capital i9 computed on the basis of dividend growth model
(i.e., D/P + g), a separate cost of retained earnings need not be computed since the cost of retained
earnings is automatically included in the cost of equity share capital.
Therefore, Kr = Ke = D/P + g.
161
JGI JAIN
Overall or Weighted Average Cost of Capital

A firm may procure long-term funds from various sources like equity share capital, preference share
capital, debentures, term loans, retained earnings etc. at different costs depending on the risk perceived
by the investors.
When all these costs of different forms of long-term funds are weighted by their relative proportions to
get overall cost of capital it is termed as weighted average cost of capital. It is also known as composite
cost of capital. While taking financial decisions, the weighted or composite cost of capital is considered.
12.3 MEASUREMENT OF SPECIFIC COSTS

The cost of additional capital needed by the company to finance investment ideas is known as the
marginal cost of capital. It is derived by first calculating the cost of each capital source depending on
the market value. Following that, which type of capital would be the best for financing a project
is determined. The marginal cost of capital is calculated by factoring in the impact of higher capital
costs on the overall earnings. To put it another way, the marginal cost of capital is computed in the same
way that the weighted average cost of capital is obtained: by simply adding more capital to the total cost
of capital.
The following formula can be used to calculate the marginal cost of capital:
Marginal Cost of Capital = E + D+ P+ R = KE + KD + KP + KR
Example: Following is the capital structure of Ego ltd. Find which is considered to be optimum as on 31st
March, 2018
Particular (`)
14% Debentures 30,000
11% Preference shares 10,000
Equity Shares (10,000 shares) 1,60,000
2,00,000
The company share has a market price of ` 23.60. Next year dividend per share is 50% of year 2017 EPS.
The following is the trend of EPS for the preceding 10 years which is expected to continue in future.
Year EPS (`) Year EPS (`)

2008 1.00 2013 1.61
2009 1.10 2014 1.77
2010 1.21 2015 1.95
2011 1.33 2016 2.15
2012 1.46 2017 2.36
The company issued new debentures carrying 16% rate of interest and the current market price of
debenture is ` 96.
Preference shares ` 9.20 (with annual dividend of ` 1.1 per share) were also issued. The company is in
50% tax bracket.
162
UNIT 12: Cost of Capital JGI JAINDEEMED-T O-BE UNI VE R SI TY
(A) Calculate after tax:

(i) Cost of new debt
(ii) Cost of new preference shares
(iii) New equity share (assuming new equity from retained earnings)
(B) Calculate the marginal cost of capital when no new shares are issued.
(C) Calculate the amount that can be spent for capital investment before new ordinary shares must be
sold. Assume that retained earnings for next investment is 50 percent of 2017.
(D) Calculate the marginal cost of capital when the fund exceeds the amount calculated in (C), assuming
new equity is issued at ` 20 per share.
Solution:
(A) (i) Cost of new debt
I 1 t
Kd =
P0
16 1 0.5
=
96
= 0.0833
(ii) Cost of new preference shares
PD
=K =
p P0
1.1
=
9.2
= 0.12
(iii) Cost of new equity shares
D1
=K = +g
e
P0
1.18
= 0.10
23.60
= 0.05 + 0.10 = 0.15

Calculation of D1
D1 = 50% of 2017 EPS = 50% of 2.36 = `1.18
(B) Calculation of marginal cost of capital
Type of Capital Proportion Specific Cost Product
(1) (2) (3) (2) × (3) = (4)
Debenture 0.15 0.0833 0.0125
Preference share 0.05 0.12 0.0060
163
JGI JAIN

Equity share 0.80 0.15 0.1200
Marginal cost of capital 0.1385
(C) The company can spend the following amount without increasing marginal cost of capital and
without selling the new shares:
Retained earnings = (0.50) (2.36 × 10,000) = ` 11,800
The ordinary equity (Retained earnings in this case) is 80% of total capital
11,800 = 80% of Total Capital
11,800
Capital investment before issuing equity = = ` 14,750
0.80
(D) If the company spends in excess of ` 14,750 it will have to issue new shares.
1.18
Capital investment before issuing equity= 0.10 = 0.159
20
The marginal cost of capital will be:

(1) (2) (3) (2) × (3) = (4)

Debentures 0.15 0.0833 0.0125
Preference shares 0.05 0.1200 0.0060
Equity shares (New) 0.80 0.1590 0.1272
0.1457
12.4 COMPUTATION OF OVERALL COST OF CAPITAL
each category of capital weighted in different proportions. In the calculation of WACC, all the sources of
capital such as common stock, preferred stock, bonds, other long-term debt, etc. are included. To arrive
at the WACC, the cost of each source of capital is multiplied by its proportion in the total capital. Let us
now consider an example to understand the concept of WACC.
Assume that a company generates funds by issuing debentures and equity shares. On loan capital,
it pays interest, and on equity capital, it pays a dividend. The WACC is calculated by adding the total
interest paid on debt capital to the total dividend paid on equity capital.
The WACC is calculated using the following formula:
Weighted average cost of capital = (KE × E) + (KP × P) + (KD × D) × (1-T) + (KR × R)
Where
E = Proportion of equity capital in the capital structure
P = Preference capital proportion in capital structure
D = Debt capital proportion in capital structure
164
R = Retained earnings proportion in capital structure

KE = Cost of equity
KP = Cost of preference shares
KD = Cost of debt
KR = Cost of retained earnings
Example: Barco Ltd. has the following capital structure on 31st March 2010
Equity shares (20,000 shares issued) = `20,00,000
10% preference shares = ` 4,00,000
10% debentures = ` 12,00,000
` 200 each and Barco projects to pay dividend of ` 20 per share and will rise
at 10% every year indefinitely. Calculate the WACC on the capital structure given using a 50% corporate
tax rate.
Solution:
Cost of debt after tax = [(1 T) × R] × 100
KD = [(1 0.50) × 10%] × 100 = 5%
Cost of equity capital when growth rate is given = [(D/MP) + g] × 100
KE = [(10/100) + 10%] × 100 = 10%
The weighted average cost of capital is calculated by using the below formula:
Source of Capital Amount (`) Weight (W) Specific cost of capital W*CC
Equity Shares 20,00,000 1.10 0.20 0.110
10% Preference Share 4,00,000 0.22 0.20 0.022
10% Debentures 12,00,000 0.66 0.10 0.0230
Total 36,00,000 0.1550
Therefore, weighted average cost of capital = 0.1550 = 15.5%

Example: Acorpus Ltd, a tube light manufacturing company, is in the process of analysing its capital
budgeting projects and wants to calculate weighted average cost of capital. You are given the following
information:
Balance Sheet

Equity shares 20,00,000 Fixed Assets 30,00,000
Preference shares 10,00,000 Current Assets 28,00,000
Retained earnings 4,00,000
Debentures 16,00,000
165
JGI JAIN

Current liabilities 8,00,000
58,00,000 58,00,000
1. 10% debentures of 2000 face value for 10 years redeemable at 10% premium is sold at par, 5%
floatation costs.
2. 10% preference shares of selling prices `2,000 per share and 5% floatation costs
3. Equity shares of selling price `200 per share with `10 floatation cost per share.
The expected growth in equity dividend is 20% per year and the corporate tax is 50%. In the current
financial year, the expected dividend is 20% per share.
Calculate the weighted average cost of capital.
Solution:
Cost of Debt Capital = [{I (1-T) + (P NP/N) (1-T)}/ (P + NP/2)] × 100
1 200 1 0.50 2,200 1,900 / 10 1 0.50

KD 100
2, 200 1,900 / 2 1
= 11.2%
Cost of preference share = (D/NP) × 100
KP = {10/ (2000 100)} × 100
= 2.10%
Cost of equity capital = [(D/MP) + G] × 100
KE = 1(10/200) + 0.20) × 100
= 60%
Source of Capital Amount ` Weight (W) Specific cost of capital W*CC

Equity Shares 20,00,000 0.86 0.60 0.129
10% Preference Share 10,00,000 0.42 0.0210 0.0022
10% Debentures 16,00,000 0.68 0.112 0.0190
Total 46,00,000 0.30048
The weighted average cost of capital therefore is 30.048%.

Example: The capital structure of the company is as follows:
(`)
Debentures (` 100 per debenture) 5,00,000
Preference shares (` 100 per share) 5,00,000
Equity shares (` 10 per share) 10,00,000
20,00,000
166
The market prices of these securities are as follows:

Debentures ` 105 per debenture
Preference shares ` 110 per preference share
Equity shares ` 24 each.
Additional information:
(1) ` 100 per debenture redeemable at par, 10% coupon rate, 4% floatation costs, 10-year maturity.
(2) ` 100 per preference share redeemable at par, 5% coupon rate, 2% floatation cost and 10-year
maturity.
(3) Equity shares has ` 4 floatation cost and market price ` 24 per share.
The next year expected dividend is ` 1 with annual growth of 5%. The firm has practice of paying all
earnings in the form of dividend.
Corporate tax rate is 30%. Use YTM method to calculate cost of debentures and preference shares.
You are required to calculate the WACC using the above information by using:
(a) Book value weights
(b) Market value weights
Solution:
(i) Cost of Equity (Ke)
D1
= g
P0 F
1
= 0.05
24 4
= .01 or 10%
(ii) Cost of Debt (Kd)
Current market price (P0) floatation cost = I(1-t) × PVAF(r,10) + RV × PVIF(r,10)
` 105 4% of ` 105 = ` 10(1-0.3) × PVAF (r,10) + ` 100 × PVIF (r,10)
Calculation of NPV at discount rate of 5% and 7%
Year Cash flows (`) Discount factor @ 5% Present Value Discount factor @ 7% Present Value (`)
0 100.8 1.000 (100.8) 1.000 (100.8)
1 to 10 7 7.722 54.05 7.024 49.17
10 100 0.614 61.40 0.508 50.80
NPV +14.65 -0.83
Calculation of IRR
14.65
IRR = 5 % + (7% 5%)
14.65 0.83
167
14.65
5%+ (7% 5%)
15.48
Cost of debt (Kd) = 6.89%

Cost of preference shares (Kp)
Current market price (P0) floatation cost = PD × PVAF (r,10) + RV × PVIF (r,10)
` 110 2% of ` 110 = ` 5×PVAF (r,10) + ` 100 × PVIF (r,10)
Calculation of NPV at discount rate of 3% and 5%
Year Cash flows (`) Discount factor @ 3% Present Value Discount factor @ 5% Present Value (`)
0 107.8 1.000 (107.8) 1.000 (107.8)
1 to 10 5 8.530 42.65 7.722 38.61
10 100 0.744 74.40 0.614 61.40
NPV +9.25 -7.79
Calculation of IRR
9.25
IRR = 3% + (5% 3%)
9.25 7.79
9.25
3%+ (5% 3%)
17.04
= 4.08%
(a) Calculation of WACC using book value weights
Source of capital Book Value Weights After tax cost of capital WACC (Ko)
(`) (a) (b) (c) = (a)×(b)
10% Debentures 5,00,000 0.25 0.0689 0.01723
5% Preference shares Equity shares 5,00,000 0.25 0.0408 0.01020
10,00,000 0.50 0.10 0.05000
20,00,000 1.00 0.07743
WACC (Ko) = 0.07743 or 7.74%

(b) Calculation of WACC using market value weights
Source of capital Market Value Weights After tax cost of capital WACC (Ko)
(`) (a) (b) (c) = (a)×(b)
10% Debentures (`105 × 5,000) 5,25,000 0.151 0.0689 0.0104
5% Preference shares (`110 × 5,000) 5,50,000 0.158 0.0408 0.0064
Equity shares (`24 × 1,00,000) 24,00,000 0.691 0.10 0.0691
34,75,000 1.000 0.0859
WACC (Ko) = 0.0859 or 8.59%
168
12.5 COST OF CAPITAL PRACTICES IN INDIA

The purpose of this study is to gain an insight into current capital budgeting practices in the Indian
corporate sector, especially in an era where companies are increasingly exposed to various types of
risks, both in the local and the global markets. A questionnaire survey was conducted on 77 Indian
companies listed on the Bombay Stock Exchange in India.
The findings reveal that an uptrend towards usage of sophisticated capital budgeting techniques
continues in India with use of multiple methods. The traditional payback period and the Discounted
Cash Flow (DCF) Techniques of Internal Rate of Return (IRR) and Net Present Value (NPV) are the ones
most preferred. The degree of sophistication is apparently high in larger, younger companies and those
with highly qualified CEOs, even with a trend for usage of the new specialised technique of real options.
Discount rate/cost of capital based on Weighted Average Cost of Capital (WACC) is the most favoured
and cost of equity capital based on Capital Asset Pricing Mode (CAPM) or dividend yield model is the
most popular. Sensitivity analysis technique is the most popular for consideration of risk. Linkage with
corporate objectives and strategy, Customer market /demand analysis and technical considerations
such as availability of raw material, power, technology, manpower and suitable project location emerge
as the most important non-financial considerations in investment appraisal.
The findings of the study are in conformance with the academic theory in many respects. Indian
corporate sector gives high preference to theoretically superior DCF techniques of NPV and IRR. There
is an increased consideration of risk by companies with higher use of sensitivity analysis. However,
theory-practice gap remains in adoption of theoretically sound techniques of real options, Adjusted
Present Value (APV), Modified Internal Rate of Return (MIRR) or simulation analysis, as these techniques
are found to be adopted by only a handful of companies.
The cost of capital is defined as the cut-off rate or the minimum rate of return that is required from
an investment.
For an investor, it is relevant to note that an investment can bring-in gains only when the rate of
return on investment is greater than the cut-off rate or the cost of capital.
The cost of capital forms the basis of fixing discount rate which is the rate at which future cash flows
are discounted to determine the present values of future cash flows.
Some of the important factors that affect capital cost of capital are market opportunity, capital
preferences, risk and inflation.
The cost of capital is usually categorised into four types including cost of equity, cost of debt, cost of
preference shares and cost of retained earnings.
The cost of equity capital refers to the cost of using the capital of equity shareholders in the business.
In other words, the rate of return a corporation pays to shareholders is known as the cost of equity.
The cost of equity can be determined using various methods such as dividend price approach, price
approach, growth approach, realised yield approach and the Capital Asset Pricing Model (CAPM)
Approach.
According to the CAPM, the cost of equity is calculated as:
Ke = Rf + (E(Rm) Rf )
169
JGI JAIN
Where,
Ke = Cost of Equity
Rf = Risk free rate
= Beta of stock/company
E (Rm) Rf = Equity Risk premium
An investment beta is a reflection of its return volatility in comparison to the total industry.
Retained earnings are profit reserves held by companies that are not distributed as dividends. These
are preserved to fund a long-term and short-term activities.
The cost of preference capital is the amount of dividend payable on them and expenses incurred for
raising preference shares.
The entire cost or rate of interest paid by an organisation when raising debt capital is referred to as
cost of debt capital.
The Weighted Average Cost of Capital (WACC) refers to an overall cost of capital in
which each category of capital weighted in different proportions. To arrive at the Weighted Average
Cost of Capital (WACC), the cost of each source of capital is multiplied by its proportion in the total
capital.
12.7 GLOSSARY
Debentures: A type of debt instrument used by organisations to raise money for medium to long
term at a fixed rate of interest
Expected growth rate: The rate at which a particular investment is expected to grow during a
particular period of time.
Specific cost of capital: The cost of capital of each component of capital using in the overall financing
of a company
Weighted average: The type of average that is calculated by summing the products of each
observation by its assigned weight
12.8 CASE STUDY: SECTOR-WISE ANALYSIS OF COST OF CAPITAL IN INDIA
Case Objective
This Case Study highlights how researchers collected data and carried out an analysis of the cost of
debt, cost of equity and the Weighted Average Cost of Capital (WACC) of 13 major sectors in India.
In December 2020, the RBSA Advisors conducted a study related to sectoral analysis of the cost of capital
in India. They studied the following 13 sectors:
1. Automobile & Ancillaries 7. Infrastructure
2. Capital Goods 8. Metals & Mining
3. Cement 9. Oil & Gas
4. Chemicals 10. Pharmaceuticals
5. Consumer Durables 11. Power
6. FMCG 12. Realty
170
13. Telecom
For the purpose of this study and to find out the cost of capital, the researchers took a sample size of 135
companies listed on NSE. 42 sectors were identified but only 13 sectors were selected. These 13 sectors
represent approximately 56.0% of the total market capitalisation. These sectors so not include the BFSI
and IT sectors which constitute approximately 22.0% and 14.3% of Market capitalisation.
For all the 13 sectors, the researchers selected the top 10 companies (and 15 companies in case of
pharmaceuticals sector) of every sector which represents 67% to 99% of the market Cap of the overall
sector.
Source: https://rbsa.in/archives_of_research_reports/RBSA-Advisors-Cost-of-Capital-in-India-4th-Edition-December2020.pdf
For conducting the sectoral analysis, the researchers adopted the following methodology:
The researchers list all the companies as per the criterion mentioned.
The researchers obtained data related to debt, interest costs, beta and market cap from Capital IQ.
Kd is used for analysis is pre-tax Kd (Pre-tax Kd = Cost of Debt before tax)
The Kd is determined by dividing the Interest Cost of Last Twelve Months (LTM) with the average of
the outstanding debt of the respective companies as on Sep 30, 2020 and Sep 30, 2019.
The post-tax Kd is arrived at by reducing the tax impact from the pre-tax Kd. For the purpose of
analysis, a tax rate of 34.94% was assumed (Post-tax Kd = Cost of Debt after tax)
Ke is calculated using CAPM. The beta is regressed over three years i.e., Oct 1, 2017 - Sep 30, 2020. (Ke
= Cost of Equity)
171
The researchers considered an annualized yield of 10-year zero coupon bond as on Sep 30, 2020
issued by the GOI to be the risk-free rate.
The researchers used the equity risk premium at 7%
Weighted Average Cost of Capital (WACC) was calculated by assigning weights to Debt and equity
The pre-tax Kd, Ke and WACC across the 13 sectors were recorded as:
Particulars Rate Sector

KD (Pre Tax) Min 6.2% FMCG
Max 11.7% Automobile & Ancillaries
Ke Min 9.8% FMCG
Max 16.1% Infrastructure
WACC Min 7.9% Power
Max 12.8% Realty
The weighted average Kd, Ke and WACC across the 13 sectors are shown as:
18.0%
16.0%
14.0%
12.0%
10.0%
8.0%
6.0%
4.0%
2.0%
0.0%
Automobile Capital Cement Chemicals Consumer FMCG Infrastructure Metals Oil & Pharmaceuticals Power Realty Telecom Median
& Ancillaries Goods Durables & Gas
Mining
Kd Pre Tax Ke WACC
Source: https://rbsa.in/archives_of_research_reports/RBSA-Advisors-Cost-of-Capital-in-India-4th-Edition-December2020.pdf
After a thorough analysis, the researchers represented all the major 13 sectors using pie charts. For
each sector, the pie charts show the total number of companies analysed for different ranges of Kd, Ke
and WACC. For example, for automobiles and ancillaries,
2
3
2
3
<2% 6% 12% >12%
Pre-tax Kd
172
1
3
3
3
<12% 14% 16% >16%
Ke
1
1
3
<12% 14% 15% >15%
WACC
An analysis of the top 10 companies revealed that the range of WACC for top 10 firms is 11.7% to 15.4%.
Similar pie charts were drawn for all the 12 other sectors.
Some of the important research findings are as follows:
The median Kd (pre-tax), Ke and WACC for these 13 sectors is 8.3%, 12.2%, and 10.8% respectively.
The cost of equity, and consequently the overall cost of capital has reduced due to the surge in
market.
Questions
1. Which sector has the minimum K d?
(Hint: FMCG sector Kd = 6.2%)
2. Which sector has the minimum WACC?
(Hint: Power sector WACC = 7.9%)
A. Essay-type Questions
1. What is cost of capital?
2. Write a short note on cost of retained earnings.
173
3. What is WACC?
4. Write a short note on cost of capital practices in India.

1. Cost of capital is expressed in terms of the return expected by the providers of long-term capital to
a business firm (such as shareholders, debenture holders or lenders) as a token of compensation in
lieu of their contribution to the total capital. Refer to Section Concept of Cost of Capital
2. The profits retained by a company for using in the expansion of the business also entail cost. When
earnings are retained in the business, shareholders are forced to forego dividends. Refer to Section
Concept of Cost of Capital
3. The weighted average cost of capital (WACC) refers to an overall cost of capital in
which each category of capital weighted in different proportions. Refer to Section Computation of
Overall Cost of Capital
4. The findings reveal that an uptrend towards usage of sophisticated capital budgeting techniques
continues in India with use of multiple methods. The traditional payback period and the Discounted
Cash Flow (DCF) Techniques of Internal Rate of Return (IRR) and Net Present Value (NPV) are the
ones most preferred. Refer to Section Cost of Capital Practices in India
https://tallysolutions.com/accounting/cost-of-capital/
https://tallysolutions.com/accounting/cost of-capital/
https://corporatefinanceinstitute.com/resources/knowledge/finance/cost-of-capital/
https://corporatefinanceinstitute.com/resources/knowledge/finance/cost
https://hbr.org/2015/04/a-refresher-on-cost-of-capital
refresher-
https://dducollegedu.ac.in/Datafiles/cms/ecourse%20content/BMS-%20Cost%20of%20Capital.pdf
https://dducollegedu.ac.in/
https://dducollegedu.ac.in/Datafiles/cms/ecourse%20content/BMS
Datafiles/cms/ecourse%20content/BMS
Explain the advantages and disadvantages of cost of capital.
174
UNIT
Working Capital Management
Names of Sub-Units
Introduction to working capital management, concept of working capital management, concept of

factors influencing working capital management, working capital estimation, meaning of working
capital financing, concept of inventory management.
Overview
This unit begins by explaining the meaning of working capital management, it discusses the concept
of working capital management. The unit explains the concept of factors influencing working capital
management. It also discusses the meaning of working capital financing and concept of inventory
management.
Learning Objectives

Explain the working capital management
State the concept of working capital management
Identify the inventory management
Classify the working capital financing
JGI JAIN
Learning Outcomes

Assess the working capital management
Examine the working capital financing
Analyse the inventory management
Evaluate the concept of working capital management
13.1 INTRODUCTION
Working capital management is significant in financial management due to the fact that it plays a
vital role in keeping the wheel of the business running. Every business requires capital, without which
it cannot be promoted. Investment decision is concerned with investment in current assets and fixed
assets. There are two assets required to be financed by fixed capital and working capital. In other words,
the required capital can be divided into two categories, such as fixed capital and working capital. Fixed
capital required for establishment of a business, whereas working capital required to utilise fixed assets.
Fixed assets cannot be utilised without current assets. It is just like a blood in the human body, without
which there is no body.
13.2 OVERVIEW OF WORKING CAPITAL MANAGEMENT

Working capital refers to the funds invested in current assets, i.e., investment in sundry debtors, cash and
other current assets. Current assets are essential to utilise facilities provided by plant and machinery,
land and buildings. In case of the manufacturing organisation, a machine cannot be used without raw
material. The investment in the purchase of raw materials is identified as working capital. It is obvious
that a certain amount of funds is tied up in raw material inventories, work in progress, finished goods,
consumable stores, sundry debtors and day-to-day cash requirements. However, the organisation
also enjoys credit facilities from its suppliers by way of credit. Similarly, the organisation need not
pay immediately for various expenses, etc., the workers are paid only periodically. Therefore, a certain
amount of funds automatically become available to finance the current assets requirement. However,
the requirement of current assets is usually greater than the amount of funds provided through current
liabilities in such a way that a satisfactory level of working capital is maintained.

From the point of view of concept, the term, working capital, can be used in two different ways:
1. Gross working capital: The gross working capital refers to investment in all the current assets taken
together. The total of investments in all current assets is known as gross working capital.
2. Net working capital: Net working capital refers to the excess of total current assets over total
current liabilities. Current liabilities are those liabilities that are intended to be paid in the
From the point of view of time, the term, working capital, can be divided into two categories:
1. Permanent: It is also referred as hard-core working capital. It is the minimum level of investment
in the current assets that is carried by the business at all times to carry out maximum level of its
activities. It should be financed by long-term sources.
2. Temporary working capital: It refers to that part of working capital, which is required by the
business over and above permanent working capital. It is also called variable working capital. Since
180
UNIT 13: Working Capital Management JGI JAIN
the quantum of temporary working capital keeps on fluctuating from time-to-time depending on
the business activities, at may be financed from short-term sources.
13.2.1 Factors Influencing Working Capital Management

The important factors are:
General Nature of Business: In some organisations, the sales are mostly in cash basis and the
operating cycle (explained) later is also short. In these concerns, the working capital requirement
is comparatively low. Mostly, service companies come under this category. In manufacturing
companies, usually the operating cycle is very long and a firm is also required to give credit to
customers to boost sales. In such cases, working capital requirement is high. Similarly, a trading
concern requires lower working capital than a manufacturing concern.
Production Policy: Working capital requirements also fluctuate according to production policy
adopted by the company. Example: In case of products having seasonal demand, a steady production
can be planned throughout the year in which case finished goods are to be kept for a longer period.
The other alternative is to produce only during the season in which case raw materials have to be
accumulated throughout the year.
Credit Policy: A company, which allows liberal credit to its customers, may have higher sales, but
consequently will have larger amount of funds tied up in sundry debtors. Similarly, a company,
which has very efficient debt collection machinery and offers strict credit terms, may require lesser
amount of working capital that the one where debt collection system is not so efficient where the
credit terms are liberal. The creditability of a company in the market also has an effect on the
working capital requirement. Reputed and established concern can purchase raw material on credit
and enjoy many other services like door delivery after sales service This would mean that they could
easily have large current liabilities.
Inventory Policy: The inventory policy of a company also has an impact on the working capital
requirements. An efficient firm may stock raw material for a smaller period and may, therefore,
require lesser amount of working capital.
Abnormal Factors: Abnormal factors like strikes and lockouts require additional working capital.
Recessionary conditions necessitate a higher amount of stock of finished goods remaining in stock.
Similarly, inflationary conditions necessitate more funds, to maintain the same amount of current
assets.
Market Conditions: In case of competitive pressure, large inventory is essential, as delivery has to
be off the shelf or credit has to be extended on liberal terms.
Conditions of Supply: If prompt and adequate supply of raw materials, spares, stores, etc., is
available it is possible to manage with small investments in inventory or work on Just-In-Time (JIT)
inventory principles. However, if supply is erratic, scant, seasonal, channelised through government
agencies, etc., it is essential to keep larger stocks increasing working capital requirements.
Business Cycle: Business fluctuations lead to cyclical and seasonal changes in the production and
sales and affect the working capital requirements.
Growth and Expansion Activities: The working capital of the firm increases as it grows in terms of
sale or fixed assets.
Level of Taxes: The amount of taxes to be paid is determined by the prevailing tax regulations. Very
often taxes have to be paid in advance on the basis of the profit of the preceding year. Management
has no discretion in regard to payment of taxes; in some Notes cases non-payment may invite penal
action. There is, however, wide scope to reduce the tax liability through proper tax planning.
181
JGI JAIN
Dividend Policy: Payment of dividend utilises cash while retaining profit acts as a source of working
capital. Thus, working capital gets affected by dividend policies.
Operating Efficiency: Efficient and coordinated utilisation of capital reduces the amount required
to be invested in working capital.
Price Level Charges: Inflationary trends in the economy necessitate more working capital to
maintain the same level of activity.
Depreciation Policy: Depreciation charges do not involve any cash outflow. The effect of depreciation
policy on working capital is, therefore, indirect. In the first place, depreciation affects the tax liability
and retention of profits and on dividend.
13.3 WORKING CAPITAL ESTIMATION

The following points highlight the top five methods for estimating working capital requirements:
1. Percentage of Sales Method: This method of estimating working capital requirements is based on
the assumption that the level of working capital for any firm is directly related to its sales value. If
past experience indicates a stable relationship between the amount of sales and working capital,
then this basis may be used to determine the requirements of working capital for future period.
2. Regression Analysis Method (Average Relationship between Sales and Working Capital): This
method of forecasting working capital requirements is based upon the statistical technique of
estimating or predicting the unknown value of a dependent variable from the known value of an
independent variable. It is the measure of the average relationship between two or more variables,
i.e.; sales and working capital, in terms of the original units of the data.
3. Cash Forecasting Method: This method of estimating working capital requirements involves
forecasting of cash receipts and disbursements during a future period of time. Cash forecast will
include all possible sources from which cash will be received and the channels in which payments
are to be made so that a consolidated cash position is determined.
This method is similar to the preparation of a cash budget. The excess of receipts over payments
represents surplus of cash and the excess of payments over receipts causes deficit of cash or the
amount of working capital required.
4. Operating Cycle Method: This method of estimating working capital requirements is based upon
the operating cycle concept of working capital. The cycle starts with the purchase of raw material
and other resources and ends with the realisation of cash from the sale of finished goods.
It involves purchase of raw materials and stores, its conversion into stock of finished goods through
work-in-process with progressive increment of labour and service costs, conversion of finished
stock into sales, debtors and receivables, realisation of cash and this cycle continues again from
cash to purchase of raw material and so on. The speed/time duration required to complete one cycle
determines the requirement of working capital longer the period of cycle, larger is the requirement
of working capital and vice-versa.
5. Projected Balance Sheet Method: Under this method, projected balance sheet for future date is
prepared by forecasting of assets and liabilities by following any of the methods mentioned here. The
excess of estimated total current assets over estimated current liabilities, as shown in the projected
balance sheet, is computed to indicate the estimated amount of working capital required.
182
13.4 WORKING CAPITAL FINANCING

-term assets such as
accounts receivable and inventory, and to provide liquidity so that your company can fund its day- to-
day operations including payroll, overhead and other expenses. There are many types of working
capital financing. The best fit for your company will depend on its industry, business model, stage of
development and the current assets on its balance sheet.
Types of Working Capital Finance

Working capital financing includes loans, sales, assignments, guarantees and favorable terms from
customers and vendors. We have organised the types of working capital financing into categories as
follows:.
Working Capital Revolver: A working capital revolver is a line of credit in which the maximum
amount available for borrowing is tied to the amount of accounts receivable and inventory on
the balance sheet. This secured credit line is described as a revolver since funds can
be borrowed, repaid and then reborrowed over and over again. Working capital loans secured by
accounts receivable and/or inventory are a form of asset-based lending (ABL). A working capital
revolver is also known as a:
working capital line of credit,
working capital credit facility,
working capital facility,
revolving credit facility, or
revolving loan facility.
Some lenders offer unsecured lines of credit, often referred to as a business line of credit. These
unsecured lines are usually targeted toward small businesses (with the owner providing a personal
guarantee) or very large businesses (with strong credit histories).
Accounts Receivable Factoring: Accounts receivable factoring is the sale of accounts receivable to
a third-party at a discount to accelerate the receipt of cash. The discount is the fee charged by the
third-party buyer (or factor) for its service. The factor primarily relies on the creditworthiness of the
about the sale and the factor is responsible for collection. Receivables may be sold on a recourse
or non-recourse basis. Spot factoring is the sale of a single invoice rather than all of a
receivables. Accounts receivable factoring is also referred to as invoice factoring.
Invoice Discounting: Invoice discounting is the assignment of accounts receivable to a third-party
as collateral for a loan. The customer is not usually notified about the assignment and the company
remains responsible for collection. The company receives a loan similar to the way it would with a
revolving line of credit.
Purchase Order Financing: Purchase order financing or PO financing, is an advance given to your
supplier by a lender for goods your company needs to fulfill a customer order. The customer then
makes its payment directly to the lender. After deducting the amount of its loan and fees, the lender
sends the remainder to your company. PO financing provides capital to fulfill large orders that you
might not be able to finance otherwise.
Trade Finance: Trade finance facilitates international trade by transferring to a third-party the risk
that an exporter will not receive payment, or an importer will not receive its goods. There are many
183
JGI JAIN
forms of trade finance including letters of credit, bank guarantees, asset-based loans, accounts
receivable factoring and purchase order financing.
Customer Advances: Customer advances are cash payments received before a company provide
goods or services to its customer. These advances provide an important source of - working
capital financing. Of course, the company incurs an obligation to provide the goods or services to
the customer in the future, which is usually recognised as a deferred revenue liability on its balance
sheet.
Vendor Credit: Vendor credit enables you to wait a specified period of time before paying for goods
or services provided by a supplier or vendor. Payment terms may offer a discount for paying early
or a penalty for paying late. Some vendors offer extended terms to select customers, which provide
a longer than normal period before payment is due.
MRR Line of Credit: An MRR line of credit is a loan facility in which the amount available for
-as-a-service (SaaS)
companies have minimal accounts receivable because customers pay up front and no inventory
because they sell a service rather than the product. However, SaaS companies have recurring
revenue that lenders view as an asset that, in effect, can provide a collateral base for a loan.
Merchant Cash Advances: Merchant cash advances (MCA) are upfront payments that you receive
in exchange for a percentage of your future daily credit/debit card receipts. An MCA is not a loan
but a sale of future revenue. This is expensive financing but might be the best bet for a business with
limited or poor credit history that also processes a lot of credit card transactions.
13.5 OPERATING CYCLE AND CASH CYCLE
Operating Cycle
Raw material >>> Work-in-Process >>> Finished Goods >>> Accounts Receivable >>> Cash
This cycle of raw material conversion to cash is called operating or working capital cycle. In terms of
time, it is the time taken after the purchases of raw material till its translation into cash. The total of
inventory holding period and a receivable collection period of a firm is the operating cycle time of that
firm.
Operating cycle and cash operating cycle are used interchangeably but a misconception. They are
different by a small margin but that makes a big difference.
Cash Operating Cycle

Like working capital, operating cycle can also be gross operating cycle (operating cycle) and net
collection period. It is the time period for which the working capital is required.
How to Calculate using Formula?

The time of operating cycle can be broken as follows:
1. Inventory Holding Period
Raw Material Holding Period
Work-in-process Period
Finished Goods Holding Period
2. Receivables Collection Period
184
Formula for Operating Cycle
Operating Cycle = Inventory Holding Period + Receivable Collection Period
Or, Operating Cycle = Raw Material Holding Period + Work-in-process Period + Finished Goods Holding
Period + Receivable Collection Period
Formula for Cash Operating Cycle
Cash Operating Cycle = Inventory Holding Period + Receivable Collection Period

Period
Or, Cash Operating Cycle = Raw Material Holding Period + Work-in-process Period + Finished Goods
Holding Period + Receivable Collection Period Payment Period
Operating Cycle Example
Suppose $500 Dollar worth of inventory is purchased from a supplier on 20 days credit and it was sold
after 40 days of purchasing it. The credit of 40 days is given to the buyer. The buyer paid on completion
of the credit period.
Here,
The Operating Cycle = Inventory Holding Period + Receivable Collection Period

= 40 + 40
= 80 Days.
Cash Operating Cycle = 80 Days 20 Days Credit)

= 60 Days
OPERATING vs. CASH OPERATING

CYCLE
This cycle of raw material conversion

to cash
Inventory Holding Period +

Receivable Collection Period
Operating cycle less

collection period
Inventory Holding Period +

Receivable Collection Period
Payment Period
185
JGI JAIN
Analysis of Operating and Cash Cycle

Operating cycle is extremely important because business is all about the running the operating cycle
smoothly. If it is running smoothly, almost everything will be smooth. If any part of the operating cycle
is stuck, the whole business gets disturbed. For a manager to effectively manage the business, he should
have a deep understanding of his business cycle and potential threats and risks to it. Proactively, he
should have ways and means to mitigate those threats and risks.
In this example, operating cycle is 80 days. The entrepreneur should always focus to reduce it as more
as possible and that will ensure better utilisation of their fixed assets. In turn, they will gain the higher
return on their investment.
On the other hand, cash operating cycle is the base for working capital estimations. In our example,
working capital requirement is $500 for 60 days. Banks take this as a base for funding their client. A
manager handling finance should focus on reducing the cash cycle as that will save him the interest
payment period. Other than norma -in-

inventory holding time practically zero. Bigger companies are trying to adopt JIT with the help of tools,
like supplier system integration.
The continuing flow from cash to suppliers, to inventory, to accounts receivables and back into cash is
what is called the operating cycle. The operating cycle involves the following procedure:
1. Conversion of cash into raw materials.
2. Conversion of raw materials into work-in-process.
3. Conversion of work-in-process into finished goods.
4. Conversion of finished goods into sales [debtors and cash]
5. Conversion of debtors into cash
The following Figure shows the operating cycle:
Debtor
Sales
Cash
Finished Goods
Raw Materials
Work-in-Process
Cash Conversion Cycle

The amount of time a resources is tied up calculate by subtracting the average payment period
from the operating cycle.
186
In other words, the time period between the dates from when pays it suppliers to the date till it receives
the cash from its customers.
Calculation of Cash Conversion Cycle (CCC)
CCC = OC APP
where, OC = Operating Cycle
APP = Accounts Payable Period
OC = AAI + ARP. AAI = Average Age of Inventory
ARP = Account Receivables Period.
From the financial statements, it can be determined as the constituents of Cash Conversion Cycle, i.e.,
AAI, ACP, APP:
Average Inventory
AAI
Cost of Gold Sold/365
Average Accounts Receivable
ARP
Annual Sales/365
Average Accounts Payables
APP
Cost of good sold/365
13.6 CONCEPT OF INVENTORY MANAGEMENT

Working capital refers to short-term funds to meet operating expenses. It refers to the funds, which a
company must possess to finance its day-to-day operations. It is concerned with the management of
manage the current assets, current liabilities and their inter-relationship that exists between them. If
a firm cannot maintain a satisfactory level of working capital, it is likely to become insolvent and may
even be forced into bankruptcy.
The concept of working capital has been a matter of great controversy, among the financial wizards
and they view it differently. There is no universally accepted definition of working capital. Broadly, there
are two concepts of working capital commonly found in the existing literature of finance such as:
1. Gross Working Capital (Quantitative Concept) and
2. Net Working Capital (Qualitative Concept).
Both these concepts of working capital have operational significance. The two concepts are not to be
regarded as mutually exclusive. Each has its relevance in specific situations from the management
point of view.
Each concept of working capital has its own significance
the the an integration of both these concepts is necessary to understand working
capital management in the context of risk, return and uncertainty.
Gross Working Capital Concept: According to this concept, the total current assets are termed
as the gross working capital or circulating capital. Total current assets include; cash, marketable
securities, accounts receivables, inventory, prepaid expense, advance payment of tax, etc. This
concept also called as or broader To quote Weston and Brigham,
187
JGI JAIN
securities,
assets and their financing. According to Walker, of this concept is helpful in providing for the
current amount of working capital at the right time so that the firm is able to realise the greatest
return on The supporters of this concept, like Mead, Field, and Baker and Malott, argue
that the management is very much concerned with the total current assets as they constitute the
total funds available for operating process.
Net Working Capital Concept: As per this concept, the excess of current assets over current liabilities
represents net working capital. Similar view is expressed by Guthmann and Dougall, Gerstenberg,
Goel, Park
Stevens, fully supported this concept and viewed that the net working capital helps creditors and
investors to judge the financial soundness of a firm.
Net Working Capital Concept represents the amount of the current assets, which would remain after
all the current liabilities were paid. It may be either positive or negative. It will be positive, if current
assets exceed the current liabilities and negative, if the current liabilities are in excess of current assets.
which financed with long-term funds.

Net Working Capital Concept indicates or measures the liquidity and also suggests the extent to which
working capital needs may be financed by the permanent source of funds. To quote Roy Chowdary,
Working Capital indicates the liquidity of the business whilst gross working capital denotes the
quantum of working capital with which business has to
Net working capital = Current Assets Current Liabilities
13.7 LEVELS OF INVENTORY

Inventory accounting deals with valuing and accounting for changes in assets. Inventory involves goods
in three stages of production: raw goods, in-progress goods, and finished goods. An accurate inventory
accounting system keeps track of changes to inventory at all three stages and adjusts asset values and
costs accordingly.
13.7.1 EOQ
Economic order quantity (EOQ) is the ideal order quantity a company should purchase to minimise
inventory costs such as holding costs, shortage costs, and order costs. This production-scheduling
model was developed in 1913 by Ford W. Harris and has been refined over time. The formula assumes
that demand, ordering and holding costs all remain constant. The formula for EOQ is:
188
2DS
Q
H
where:
Q = EOQ units
D = Demand in units (typically on an annual basis)
S = Order cost (per purchase order)
H = Holding costs (per unit, per year)
13.7.2 JIT
Just In Time inventory is the reduced amount of inventory owned by a business after it installs a just- in-
time manufacturing system. The intent of a JIT system is to ensure that the components and sub-
assemblies used to create finished goods are delivered to the production area exactly on time. Doing
so eliminates a considerable investment in inventory, thereby reducing the working capital needs of a
by the following means:

Reduced production runs: Fast equipment setup times make it economical to create very short
production runs, which reduces the investment in finished goods inventory.
Production cells: Employees walk individual parts through the processing steps in a work cell,
thereby reducing scrap levels. Doing so also eliminates the work-in-process queues that typically
build up in front of a more specialised work station.
Compressed operations: Production cells are arranged close together, so there is less work-in-
process inventory being moved between cells.
Delivery quantities: Deliveries are made with the smallest possible quantities, possibly more than
once a day, which nearly eliminates raw material inventories.
Certification: Supplier quality is certified in advance, so their deliveries can be sent straight to the
production area, rather than piling up in the receiving area to await inspection.
Local sourcing:
shortened distances make it much more likely that deliveries will be made on time, which reduces
the need for safety stock.
Working capital management is significant in financial management due to the fact that it plays a
vital role in keeping the wheel of the business running.
Every business requires capital, without which it cannot be promoted.
Investment decision is concerned with investment in current assets and fixed assets.
Working capital refers to the funds invested in current assets, i.e., investment in sundry debtors,
cash and other current assets.
Current assets are essential to utilise facilities provided by plant and machinery, land and buildings.
The gross working capital refers to investment in all the current assets taken together.
189
JGI JAIN
In some organisations, the sales are mostly in cash basis and the operating cycle (explained) later
is also short.
Working capital requirements also fluctuate according to production policy adopted by the company.
A company, which allows liberal credit to its customers, may have higher sales, but consequently
will have larger amount of funds tied up in sundry debtors.
Working capital financing is used to fund your investment in short-term assets.
Invoice discounting is the assignment of accounts receivable to a third-party as collateral for a loan.
Trade finance facilitates international trade by transferring to a third-party the risk that an exporter
will not receive payment, or an importer will not receive its goods.
Merchant cash advances (MCA) are upfront payments that you receive in exchange for a percentage
of your future daily credit/debit card receipts.
Operating cycle is extremely important because business is all about the running the operating
cycle smoothly.
The amount of time a resources is tied up calculate by subtracting the average payment
period from the operating cycle.
Working capital refers to short-term funds to meet operating expenses. It refers to the funds, which
a company must possess to finance its day-to-day operations.
Inventory accounting deals with valuing and accounting for changes in assets.
Economic order quantity (EOQ) is the ideal order quantity a company should purchase to minimise
inventory costs such as holding costs, shortage costs and order costs.
Just in time inventory is the reduced amount of inventory owned by a business after it installs a
Just-In-Time manufacturing system.
13.9 GLOSSARY
Working capital management: Business tool that helps companies effectively make use of current
assets, helping companies to maintain sufficient cash
Financial management: Planning, organising, directing and controlling the financial activities
such as procurement and utilisation of funds
Investment decision: The decision made by the investors or the top-level management with respect
to the amount of funds
Gross working capital: The sum of a current assets
Net working capital: The difference between a total current assets and current liabilities.
13.10 CASE STUDY: MYSORE LAMPS LIMITED
Case Objective
The case study explains the need for working capital.
Mysore Lamps Limited is a company specialising in the production of fluorescent lamps. The company
has been maintaining the quality of its products and due to the efforts of its marketing manager, the
190
company has been able to capture a sizeable share of the product market in the recent past. The company
is planning to expand in the same product line. Mr. Mysore, the Managing Director of the company, is
confronted with the problem of increasing working capital due to the expansion plans of the company.
Mysore Lamps Limited was set up in 1991 with an authorised capital of ` 110 crore and faced heavy
competition in the initial years of commencement of business. During 2006, the company could make a
dent in the fluorescent lamps market and its position as on December 31, 2006, was as shown in Exhibit 1
Liabilities Rs. Assets Rs.
Capital 1500 Fixed assets 1000
Reserves 762 Current assets 1862
Long-term loan 400 Raw materials 200
Current liabilities 200 Work-in-progress 287
Finished goods 450 receivables 675
Bank overdraft 962 Cash 250
Total 4274 Total 4274
During the year 2006, the company was able to sell 50 lakh pieces of fluorescent lamps a ` 60 with a
profit margin of 10 per cent. The raw material comprised about 50 per cent of the selling price; while
wages and overheads accounted for 12 and 18 per cent, respectively. As a policy, the company keeps
raw material stock for two months of its requirements. To make prompt supply to customers on orders
received, finished goods stock for two months requirements are maintained, and sales credit of 3 months
is given to customers. Due to the standing of the company in the market, the company is able to enjoy 2
months from its suppliers. The production process is of 30 days duration.
Mr. Mysore is seriously considering the proposal for expansion by installing an automatic plant costing
` 30 crores. The expansion will bring in an additional capacity of 100 lakh units per annum. Mr. Mysore
is not worried about the financing of this plant as the same would be done for the retained earnings
able to increase its sale from 50 lakh pieces after the expansion scheme.
Questions
1. As a manager, what steps would you take to effectively manage the working capital in an inflationary
situation?
(Hint: After observing balance sheet)
2. What is the need for working capital?
(Hint: Your working capital is used to pay short-term obligations, such as your accounts payable
and buying inventory.)
3. What is permanent working capital?
(Hint: Permanent working capital refers to the minimum amount of working capital, i.e., the amount
of current assets over current liabilities which is needed to conduct a business even during the
dullest period.)
191

1. What do you understand by working capital management?
2. What is gross working capital?
3. What is net working capital?
4. What do you understand by MRR line of credit?

1. Working capital management is significant in financial management due to the fact that it plays a
vital role in keeping the wheel of the business running. Refer to Section Overview of Working Capital
Management
2. The gross working capital refers to investment in all the current assets taken together. The total of
investments in all current assets is known as gross working capital. Refer to Section Overview of
Working Capital Management
3. Net working capital refers to the excess of total current assets over total current liabilities. Refer to
Section Overview of Working Capital Management
4. An MRR line of credit is a loan facility in which the amount available for borrowing is tied directly
Refer to Section Working Capital Financing
https://www.bajajfinserv.in/what-is-working-capital-management
www.bajajfinserv.in/what
https://corporatefinanceinstitute.com/resources/knowledge/finance/working -capital-
management/
https://www.accaglobal.com/an/en/student/exam-support-resources/fundamentals-exams-study-
www.accaglobal.com/an/en/student/exam
resources/f9/technical-articles/wcm.html
resources/f9/technical
https://efinancemanagement.com/working-capital-financing/working-capital-management
https://efinancemanagement.com/working
https://cleartax.in/s/working-capital-management-formula-ratio
https://cleartax.in/s/working
Discuss with your friends about the practical application of working capital management
192
UNIT
Financing Decisions
Names of Sub-Units
Introduction to financing decisions, concept of financing alternatives, concept of capital structure,

concept of leverages.
Overview
This unit begins by explaining the meaning of financing decisions, it discusses the concept of financing
alternatives. The unit explains the capital structure. It also discusses the concept of leverages.
Learning Objectives
Explain the financing decisions
State the financing alternatives
Identify the capital structure
Classify the concept of leverages
Learning Outcomes
Assess the meaning of financing decisions
Examine the financing alternatives
Analyse the capital structure
Evaluate theconcept of leverages
JGI JAIN
14.1 INTRODUCTION
Financing decision is a crucial decision that is to be made by the financial manager, the decision is about
the financing-mix of an organization. Financing Decision is focused on the borrowing and allocation
of funds required for the investment decisions of the firm. We will learn in detail about these various
financing decisions in the upcoming section.
The financing decision comes from two sources from where the funds can be raised the first is from
borrowing funds from the outside the corporate in the form debenture, loan, bond, etc. The objective of
the financial decision is to balance an optimum capital structure.
The basic financial decisions that financial managers need to take are as follows:
Investment Decision
These are also known as capital budgeting decisions. A
and thus must be put to use with much analysis. A firm should pick those investments where he can
gain the highest conceivable returns. Investment decision involves careful selection of the assets where
funds will be invested by the corporates.
Financing Decision
Financial decision is the utmost important decision which is to be made by business individuals. These
are wise decisions indeed that are to be chalked out with proper analysis. The person decides when,
of development for the firm but also to boost
Dividend Decision
Dividend decisions relate to the distribution of profit that are earned by the organization. The main
criteria in this decision are whether to distribute to the shareholders or to retain the earnings. Dividend
decisions are affected by the earnings of the business and dependency on earnings.
14.2 FINANCING ALTERNATIVES

This financing alternative primer contains an overview of the different ways that an entrepreneur can
raise capital to fund their new business. Raising capital to fund a business is one of the most important
steps in setting up a new business for success. It is important for entrepreneurs to understand their
different options and the pros and cons of each alternative.
14.2.1 Equity
represents the
acquisition, it is the value of company sale minus any liabilities owed by the company not transferred
with the sale.
In addition, shareholder equity can represent the book value of a company. Equity can sometimes be
offered as payment-in-kind. It also represents the pro-rata ownership of a shares.
198
UNIT 14: Financing Decisions JGI JAIN
one of the most common pieces of data

employed by analysts to assess the financial health of a company
14.2.2 Preferences
dividends that are paid out to shareholders before common stock dividends are issued. If the company
enters bankruptcy, preferred stockholders are entitled to be paid from company assets before common
stockholders. Most preference shares have a fixed dividend, while common stocks generally do not.
Preferred stock shareholders also typically do not hold any voting rights, but common shareholders
usually do.
14.2.3 Debentures
A debenture is a type of bond or other debt instrument that is unsecured by collateral. Since debentures
have no collateral backing, they must rely on the creditworthiness and reputation of the issuer for
support. Both corporations and governments frequently issue debentures to raise capital or funds.
14.3 CAPITAL STRUCTURE

Organizations need funds to run and maintain their businesses. The requisite funds may be raised from
short-term sources or long-term sources or a combination both the sources of funds, so as to equip itself
with an appropriate combination of fixed assets and current assets. Current assets, to a considerable
extent, are financed with the help of short-term sources. Normally, firms are expected to follow a prudent
financial policy, as revealed in the maintenance of net current assets. This net positive current asset
must be financed by long-term sources. Hence, long-term sources of funds are required to finance for
long-term assets (fixed assets) and
networking capital (positive current assets).
The long-term financial strength as well as profitability of a firm is influenced by its financial structure.
-
consisting of current liabilities, long-term debt, preference share and equity share capital.
The financial structure, therefore, includes both short-term and long-term sources of funds.
Meaning of Capital Structure
financial decisions in any firm should be taken in the light of this objective. Whenever a company is
required to raise long-term funds, the finance manager is required to select such a mix of sources
of finance that overall cost of capital is minimum (i.e., value of the firm/wealth of shareholders is
maximum). A mix of long-term sources of finance is referred as
Capital structure refers to the kinds of securities and the proportionate amounts that make up
capitalization. It is the mix of different sources of long-term sources such as equity shares, preference
shares, debentures, long-term loans and retained earnings.
The term capital structure refers to the relationship between the various long-term source financing
such as equity capital, preference share capital and debt capital. Deciding the suitable capital structure
is the important decision of the financial management because it is closely related to the value of the
199
JGI JAIN
firm. Capital structure is the permanent financing of the company represented primarily by long-term
debt and equity.
Definition of Capital Structure

The following definitions clearly initiate the meaning and objective of the capital structures.
According to the definition of Gerestenbeg, structure of a company refers to the composition
or make up of its capitalization and it includes all long-term capital
According to the definition of James C. Van mix of a permanent long-term financing
represented by debt, preferred stock, and common stock
According to the definition of Presana Chandra, composition of a financing consists of
equity, preference, and
Optimum Capital Structure

The capital structure is said to be optimum when the firm has selected such a combination of equity and
debt so that the wealth of firm (shareholder) is maximum. At this capital structure, the cost of capital is
minimum and market price per share is maximum.
It is very difficult to find out optimum debt and equity mix where capital structure would be optimum
because it is difficult to measure a fall in the market value of an equity shares on account of Increase in
more realistic expression than um capital

Features of an Appropriate Capital Structure
Profitability: The most profitable capital structure is one that tends to minimize cost of financing
and maximise earning per equity share.
Flexibility: The capital structure should be such that company can raise funds whenever needed.
Conservation: The debt content in the capital structure should not exceed the limit, which the
company can bear.
Solvency: The capital structure should be such that firm does not run the risk of becoming insolvent.
Control: The capital structure should be so devised that it involves minimum risk of loss of control
of the company.
Optimum capital structure is the capital structure at which the weighted average cost of capital is
minimum and thereby the value of the firm is maximum.
Optimum capital structure may be defined as the capital structure or combination of debt and equity,
that leads to the maximum value of the firm.
Objectives of Capital Structure

Decision of capital structure aims at the following two important objectives:
1. Maximize the value of the firm.
2. Minimize the overall cost of capital.
200
Forms of Capital Structure

Capital structure pattern varies from company to company and the availability of finance.
Normally, the following forms of capital structure are popular in practice.
Equity shares only.
Equity and preference share only.
Equity and debentures only.
Equity shares, preference shares and debentures.
10.4 THEORY OF CAPITAL STRUCTURE

Capital structure is the major part of the financial decision which affects the value of the firm
and it leads to change EBIT and market value of the shares. There is a relationship among the capital
structure, cost of capital and value of the firm. The aim of effective capital structure is to maximize
the value of the firm and to reduce the cost of capital. In this thesis will investigate whether the type
understands t
chooses debt rather than equity to finance its operations. These theories are presented below
10.4.1 Net Income Approach (NI)

According to this approach, the cost of debt capital, Kd and the cost of equity capital Ke remains
unchanged when D/S, the degree of leverage, varies. Here, S stands for total capital employed = D+E).
The constancy of Kd and Ke with respect to the degree of leverage means that Ko, the average cost of
capital, measured by the following formula declines as the degree of leverage increases.
D E
K =k × +k ×
o d
(D+E) e (D+E)
This happens because when the degree of leverage increases, Kd which is lower than
Ke, receives a higher weight in the calculation of Ko.
This can also be illustrated by a graph shown in Figure
Ke
Ko
Kd
Degree of Leverage D/S
As our assumption is that the cost of debt and equity capital would not change with the change in the
level of leverage, Ko is seen to go down with the increasing proportion of debt in the capital. Note that
201
JGI JAIN
we are talking about the market value of debt and the market value of equity. Many times, we confuse it
with the book values of debt and equity, a measure that always leads to problems in measuring the true
costs of debt and equity.
10.4.2 Net Operating Income Approach

Taking an opposite view from the view taken in the net income approach, this approach states that the
cost of capital for the whole firm remains constant, irrespective of the leverage employed in the firm.
With the cost of debt and the cost of capital constant, we can say that the cost of equity capital changes
with the leverage to compensate for the additional level of risk.
Putting it simply, according to the net operating income approach, for all degrees of leverage,
Overall capitalisation rate remains constant
The cost of debt remains same
Given this, and manipulating the equation of the total cost of capital, we can express the cost of
equity as:
(Ko kd )×D
K e =K o +
(D+E)
Ke
Ko
Kd
Degree of Leverage D/S
Modigliani-Miller (MM) Approach

In 1958, Franco Modigliani and Merton Miller (MM) published one of the most surprising theories of the
modern financial management. They concluded that the value of a firm depends solely on its future
earnings stream, and hence its value is unaffected by its debt/equity mix. In short, they concluded that a
ems from its assets, regardless of how those assets are financed. In other words, a variant
of the net operating income approach discussed above. This finding had such widespread implications
that the article was judged by the members of the Financial Management Association to have had more
impact on financial management than any other published work.
MM began with a very restrictive set of assumptions, including perfect capital markets (which implies
zero taxes). And then they used an arbitrage proof to demonstrate that capital structure is irrelevant.
Under their assumptions, if debt financing resulted in a higher value for the firm than equity financing,
then investors who owned shares in a leveraged (debt-financed) firm could increase their income by
202
selling those shares and using the proceeds, plus borrowed funds, to buy shares in an unleveraged (all
equity-financed) firm. The simultaneous selling of shares in the leveraged firm and buying of shares in
the unleveraged firm would drive the prices of the stocks to the point where the values of the two firms
would be identical. Thus, according to MM
hypothesis: a stock price is not related to its mix of debt and equity financing.
Modigliani and Miller have restated and amplified the net operating income position in terms of three
basic propositions. These are as follows:
Proposition I
The total market value of a firm is equal to its expected operating income (EBIT when
Tax = 0) divided by the discount rate appropriate to its risk class. It is independent of the degree of
leverage.
EBIT EBIT
VL = VU = =
ko,L ke,L
Here, the subscript L is used to denote Leveraged firm and subscript U is used to denote unleveraged
firm. Since the V (Value of the firm) as established by the above equation is a constant, under the MM
model, when there are no taxes, the value of the firm is independent of its leverage. This implies that the
weighted average cost of capital to any firm is completely independent of its capital structure and the
WACC foror any firm, regardless of the amount of debt it uses, is equal to the cost of equity of unleveraged
firm employing no debt.
Proposition II
The expected yield on equity, Ke, is equal to Ko plus a premium. This premium is equal to the debt-equity
ratio times the difference between Ko and the yield on debt, Kd. This means that as the use of debt
increases, its cost of equity also rises, and in a mathematically precise manner.
Proposition III
The cut-off rate for investment decision making for a firm in a given risk class is not affected by the
manner in which the investment is financed. It emphasises the point that investment and financing
decisions are independent because the average cost of capital is not affected by the financing decision.
14.4 LEVERAGES
Generally, increase in leverage results in increased returns and risk; and decrease in leverage results in
decrease in returns and risk. The amount of leverage in the capital structure (the mix of long-term
debt and equity) can significantly affect its value by affecting returns and risks.
-related variables. In financial
analysis, it represents the influence of one financial variable over some other related financial variable.
The three basic types of leverage can be defined with reference to income statement as follows:
1. Operating leverage is concerned
earnings before interest and taxes, or EBIT (EBIT is descriptive label for operating profits).
203
JGI JAIN
2. Financial leverage is concerned with the relationship between the firms EBIT and its common share
charges to magnify the effects of charge in EBIT/operating profit on earnings per share.
3. Total leverage is concerned with the relationship between the sales revenue and EPS.
The dictionary meaning of the term leverage refers to an increased means for accomplishing some
It helps us in lifting heavy objects by the magnification of force when a lever is applied to a
function.
James Horne has defined leverage as the employment of an asset or funds for which the firm pays a
fixed cost or fixed return.
Christy and Roder defines leverage as the tendency for profits to change at a faster rate than sales.
Operating Leverage
It takes place when a change in revenue produces a greater change in EBIT. It is related to fixed costs. A
firm with relatively high fixed costs uses much of its marginal contribution to cover fixed costs.
It refers to heavy usage of fixed assets. A few definitions are as follows:
use of fixed operating costs to magnify a change in profits relative to a given change in
Walker & Petty
degree of
operating leverage. E F Brigham
It is a function of three factors:
1. Fixed costs
2. Contribution
3. Volume of sales
A few specific characteristics of operating leverage are as follows:

It affects the assets side of the Balance sheet.
It is related to the composition of fixed assets.
It is related in fluctuations in business risk.
It affects the capital structure and return on total assets.
Degree of Operating Leverage (DOL)

The behaviour of operating leverage may be measured by the degree of operating leverage.
The degree of operating leverage is the percentage change in the profits resulting from a percentage
change in the sales. It may be put in the form of the following formula:
Percentage change in EBIT
Degree of operating leverage =
Percentage change in Sale
204
The degree of operating leverage (DOL) is defined as the percentage change in the earnings before
interest and taxes relative to a given percentage change in sales.
% Change in EBIT
DOL=
% Change in Sales
EBIT / EBIT
DOL=
Sales / Sales
Break-Even Analysis and Operating Leverage

Break-even analysis is used by the firm.
1. To determine the level of operations necessary to cost all operating costs and,
2. To evaluate the profitability associated with various levels of sales.
-even point is the level of sales necessary to give all operating costs. At that
point, earnings before interest and taxes equal zero.
The operating breakeven point is sensitive to a number of variables. Fixed operating cost, the
sales price per unit and the variable cost per unit. The effects of increase or decrease in these variables
can be analysed as under:
Increase in variable Effect on operating break-even

Fixed operating costs Increase
Sales price per unit Decrease
Variable operating cost per unit Increase
Changes in fixed operating costs affect operating leverage. Significantly, the higher the fixed operating
costs, higher are the firms, operating leverage and its operating risks. High operating leverage is good
when revenues are rising and bad when they are falling.
Margin of Safety and Operating Leverage

-even sales. The
margin of safety tells the company how much they could lose in sales before the company begins to lose
money, or, in other words, before the company falls below the break-even point. The higher the margin
of safety is, the lower the risk is of not breaking even or incurring a loss. In order to calculate margin of
safety, we use the following formula:
Margin of safety = Total budgeted (or actual sales) Break-even-sales
Financial Leverage
have magnifying impact on the EPS due to any change in EBIT (Earnings before Interest and Taxes). In
other words, financial leverage is a process of using debt capital to increase the return on equity.
ty of the firm to use fixed financial changes to
magnify the effect of changes in EBIT on the firms
205
The following are the essentials of financial leverage:

(1) It relates to liabilities side of the balance sheet.
(2) It is related to capital structure.
(3) It is related to financial risk.
(4) It affects earning after tax and earnings per share.
(5) It may be favourable or unfavourable. Unfavourable leverage occurs when the firm does not earn
as much as the funds cost.
Degree of Financial Leverage (DFL)

The degree of financial leverage is a financial ratio that measures the sensitivity in fluctuations of a
structure. The degree of financial l

risk (the risk associated with how the company finances its operations).
There are several ways to calculate the degree of financial leverage. The choice of the calculation
method depends
wants to decide whether it should or should not issue more debt. In such a case, net income would be an
appropriate measure of profitability.
% Change in Net Income
Degreeof Financial Leverage=
% Change in EBIT
relationship with share price.

% Change in EPS
% Change in EBIT
Finally, there is a formula that allows calculating the degree of financial leverage in a particular time
period:
EBIT
EBIT Interest
Combined leverage or total leverage can be defined as potential use of fixed costs, both operating and
financial, to magnify the effect of changes in sales on the firms, earnings per share. Total leverage or
combined leverage can therefore be viewed as the total impact of the fixed cost in the firms operating
and financial structure.
Combined leverage = operating leverage × financial leverage
% change inEBIT % change inEPS
= ×
% change in sales % change in EBIT
% change in EPS
=
% change in Sales
206
A high operating leverage and a high financial leverage combination is very risky. If the company is
producing and selling at a high level it will make extremely high profit for its shareholders.
But, even a small fall in the level of operations would result in tremendous fall in earnings per share. A
company must, therefore, maintain a proper balance between these two leverages.
A combination of high operating level and a low financial leverage indicates that the management
is careful since the higher amount of risk involved in high operating leverage has been sought to be
balanced by low financial leverage. However, a more preferable option would be to have a low operating
leverage and a high financial leverage. A low operating leverage implies that the company reaches its
breakeven point at a low level of sales.
Therefore, risk is diminished. A highly cautious and conservative manager will keep both its operating
and financial leverage at a very low level, but the approach may, however, mean that the company is
losing profitable opportunities.
Degree of Combined Leverage (DCL)

The Degree of Combined Leverage (DCL) is the leverage ratio that sums up the combined effect of the
Degree of Operating Leverage (DOL) and the Degree of Financial Leverage (DFL) has on the Earning
per share or EPS given a particular change in shares. This ratio helps in ascertaining the best possible
financial and operational leverage that is to be used in any firm or business.
Formula for Degree of Combined Leverage (DCL)
The formula used for ascertaining the Degree of Combined Leverage is:
DCL = %Change in EPS / %Change in Sales = DOL * DFL
This ratio has been known to be very useful to a company or firm as it helps a firm understand the
effects of combining financial and operating leverage on the total earnings of the company. A high
level of combined leverage shows the risk involved in the company as there are more fixed costs in the
company, while a low combined leverage would mean better for the company.
The financing decision is a crucial decision that is to be made by the financial manager, the decision
is about the financing-mix of an organization.
Financing decision is focused on the borrowing and allocation of funds required for the investment
decisions of the firm.
Financial decision is the utmost important decision which is to be made by business individuals.
Dividend decisions relate to the distribution of profit that are earned by the organization.
A debenture is a type of bond or other debt instrument that is unsecured by collateral.
t of capital is lowest and the market price

per share is highest with this capital structure.
The proportional proportions of various forms of funds must be determined when deciding on a
capital structure.
In financial management, capital structure theory refers to a systematic approach to financing
business activities through a combination of equities and liabilities.
207
JGI JAIN
According to net income approach, the cost of debt and the cost of equity do not change with a
change in the leverage ratio.
In contrast to the net income approach, the NOI approach states that the cost of capital for the
whole firm remains constant, irrespective of the leverage employed in the firm
The use of fixed-cost assets or capital to amplify returns to the owners is known as leverage.
The percentage change in earnings as a result of a percentage change in sales is the degree of
operating leverage.
Operating leverage is affected by changes in fixed operating costs. Significantly, the operating
leverage and operating risks increase as fixed operating costs rise.
The difference between current sales and break-even sales is a margin of safety.
Financial leverage is defined as a capacity to employ fixed financial costs in such a way
that every change in EBIT has a magnifying effect on EPS.
The degree of financial leverage is a financial measurement that gauges a overall
sensitivity to operating income volatility induced by changes in its capital structure.
The possible use of fixed costs, both operating and financial, to magnify the effect of fluctuations in
sales on the earnings per share is known as combined leverage or total leverage.
The Degree of Combined Leverage (DCL) is a leverage ratio that averages the combined effect of the
DOL and the Degree of Financial Leverage (DFL) on EPS for a given change in sales.
14.6 GLOSSARY
Leverage: Strategy that companies use to increase assets

Influence: The power or capacity of causing an effect in indirect or intangible ways.
Magnify: To make something appear larger than it really.
Earnings per Share: A financial measure that shows any profitability
Capital structure: The particular combination of debt and equity used by a company to finance its
overall operations and growth
Debt capital: The capital that a business raises by taking out a loan
Income approach: A real estate valuation method that uses the income the property generates to
estimate fair value
14.7 CASE STUDY: CAPITAL STRUCTURE OF HIMALAYAN PAINT
Case Objective
The case study explains the capital structure of a company.
On 28th March 2001, the Himalayan Paint Private Limited was incorporated. The Himalayan Paint is a
listed private limited company located in New Delhi. The authorised share capital of Himalayan Paint
is ` -up capital is ` 8.33 lac. The current status of the private company
Himalayan Paint is
208
record, the Annual General Meeting (AGM) was conducted on 30th October,
Paint Private Limited has two directors, Mr. Kesav Arora and Mr. Sumit Arora.
Mr. Anand Dixit was the President of Himalayan Cements. In 2001, the company became largest seller of
cement in India. In the same year, Mr. Dixit decided to enter the paint industry under the brand name of
Himalayan Paint. He presented his proposal in board meeting and the proposal was accepted. However,
the long-term and medium-term financing was needed for the new project.
Mr. Rajiv Pandey was the finance manager of the organisation. Mr. Pandey prepared the capital
structure for the new investment and explained to Mr. Dixit. According to the capital structure, 40% of
capital was earned from issuing debentures, 30% of capital was raised from term loans, 20% of capital
was raised from public deposits and remaining 10% of capital was from retained earnings of the parent
organisation.
Mr. Pandey was not in favour of raising capital by issuing shares because he did not want interference
of shareholders in the internal decisions of the organisation. A product was launched in the market in
2004 by the team effort of Himalayan Paint and Himalayan Cements. The new product received good
start in market.
After the end of two financial years, Himalayan Paint found that it is making loss. There were several
reasons for the loss, such as the paint market being filled with MNCs which were selling low-price better-
quality paints and extensive advertising by competitors.
Himalayan Paint started promoting their product extensively. Initially, Himalayan Paint was making
moderate profit, which went towards payment of interests of loans and meeting other expenses. In 2007,
public deposits matured and Himalayan Paint paid their liability out of the profits made by Himalayan
Cements. Mr. Pandey was forced to resign and Mr. Alok Mukherjee was appointed as Finance Manager
by Mr. Dixit.
Questions
1. What were the mains issues in front of Himalayan Paint?
(Hint: Interest on loans, competitors, MNCs)
2. What are the present sources of finance for Himalayan Paints?
(Hint: Debentures, term loans, public deposits and retained earnings)

1. What do you understand by leverage?
2. Explain operating leverage.
3. What is financial leverage?
4. What do you understand by capital structure?
209
1.
variable on another related financial variable is referred to as leverage in financial analysis. Costs,
output, sales revenue, EBIT, EPS and other financial factors may be included. Refer to Section
Leverages
2. It occurs when a change in revenue results in a larger change in EBIT. It has something to do with
fixed costs. A company with high fixed costs utilises a large portion of its marginal contribution to
cover those costs. It alludes to the extensive use of fixed assets. Refer to Section Leverages
3. capacity to employ fixed financial costs in such a way
that every change in EBIT has a magnifying effect on EPS. In other words, financial leverage is the
process of increasing the return on equity through the use of loan capital. Refer to Section Leverages
4. Financial management aims at maximising the wealth of shareholders. All financial choices in any
company should be made keeping this goal in mind. When a corporation has to raise long-term
money, the finance manager must choose a combination of sources of capital with the lowest overall
cost of capital (i.e., the value/shareholder wealth is at its highest). The word
refers to the combination of long-term financing sources. Refer to Section Capital Structure
https://www.economicsdiscussion.net/financial-management/types-of-financial-decisions-in-
financial-management/31652
https://businessjargons.com/financing-decision.html
https://www.toppr.com/guides/business-studies/financial-management/financing-decision/
www.toppr.com/guides/business-studies/financial
http://www.its.caltech.edu/~rosentha/courses/BEM103/Readings/JWCh16.pdf
http://www.its.caltech.edu/~rosentha/courses/BEM103/Readings/JWCh16
https://efinancemanagement.com/financial-management/types-of-financial-decisions
https://efinancemanagement.com/financial
Discuss with your friends about the uses of capital structure.
210
UNIT
15 Dividend Decision
Names of Sub-Units
Introduction to dividend decision, concept of dividends, forms of dividends, dimensions of dividend

policy, bonus shares and stock split.
Overview
This unit begins by explaining the meaning of dividend decision, it discusses the concept of dividends.
The unit explains the dimensions of dividend policy. It also discusses the bonus shares and stock split.
Learning Objectives

Explain the dividend decision
State the forms of dividends
Identify the bonus shares and stock split
Classify the dimensions of dividend policy
Learning Outcomes
Assess the meaning of dividend decision
Examine the forms of dividends
Analyse the bonus shares and stock split
Evaluate the dimensions of dividend policy
JGI JAIN
15.1 INTRODUCTION
The term dividend refers to that part of the profits of a company that is distributed by the company
among its shareholders. It is the reward of the shareholders for investments made by them in the shares
of the company. Investors are interested in earning the maximum return on their investments and
maximising their wealth. A company, on the other hand, needs to provide funds to finance its long-term
growth.
If a company pays out as dividend most of what it earns, then for business requirements and further
expansion it will have to depend upon outside resources, such as the issue of debt or new shares. The
dividend policy of a firm thus affects both the long-term financing and the wealth of shareholders. As a
result, the f
distributed profits and retained earnings.
Since the dividend is a right of shareholders to participate in the profits and surplus of the company for
their investment in the share capital of the company, they should receive a fair amount of the profits.
The company should, therefore, distribute a reasonable amount as dividends (which should include a
normal rate of interest plus a return for the risks assumed) to its members and retain the rest for its
growth and survival.
15.2 CONCEPT OF DIVIDENDS

Dividend refers to the business concerns net profits distributed among the shareholders. It may also
be termed as the part of the profit of a business concern, which is distributed among its shareholders.
According to the Institute of Chartered Accountants of India, the dividend is defined as distribution
to shareholders out of profits or reserves
The dividend is the payment by a company to its shareholders out of its distributable profit. In other
words, the dividend is paid to the shareholders out of the revenue profits earned by it in the ordinary
course of business.
The dividend represents that part of the profit of a firm that is distributed to the shareholders. The
in proportion to their shareholding in the company. The dividend may be in the form of cash or non -
cash, i.e., bonus shares.
15.2.1 Forms of Dividends

A dividend is generally considered to be a cash payment issued to the holders of company stock. However,
there are several types of dividends, some of which do not involve the payment of cash to shareholders.
These dividend types are noted as follows:
Cash Dividend
The cash dividend is by far the most common of the dividend types used. On the date of declaration,
the board of directors resolves to pay a certain dividend amount in cash to those investors holding the
holders of the stock. On the date of payment, the company issues dividend payments.
Stock Dividend
A stock dividend is an issuance by a company of its common stock to its common shareholders without any
consideration. If the company issues less than 25 percent of the total number of previously outstanding
216
UNIT 15: Dividend Decision JGI JAIN
shares, then treat the transaction as a stock dividend. If the transaction is for a greater proportion of
the previously outstanding shares, then treat the transaction as a stock split. To record a stock dividend,
transfer from retained earnings to the capital stock and additional paid-in capital accounts an amount
equal to the fair value of the additional shares issued. The fair value of the additional shares issued is
based on their fair market value when the dividend is declared.
Property Dividend
A company may issue a non-monetary dividend to investors, rather than making a cash or stock payment.
Record this distribution at the fair market value of the assets distributed. Since the fair market value is
likely to vary somewhat from the book value of the assets, the company will likely record the variance
as a gain or loss. This accounting rule can sometimes lead a business to deliberately issue property
dividends to alter their taxable and/or reported income.
Scrip Dividend
A company may not have sufficient funds to issue dividends shortly, so instead, it issues a scrip dividend,
which is essentially a promissory note (which may or may not include interest) to pay shareholders at a
later date. This dividend creates a note payable.
Liquidating Dividend
When the board of directors wishes to return the capital originally contributed by shareholders as a
dividend, it is called a liquidating dividend and maybe a precursor to shutting down the business. The
accounting for a liquidating dividend is similar to the entries for a cash dividend, except that the funds
are considered to come from the additional paid-in capital account.
Cash Dividend Example
2,000,000 outstanding shares, to be paid on June 1 to all shareholders of record on April 1. On

February 1, the company records this entry:
Debit Credit
Dividends payable 1,000,000
On June 1, ABC pays the dividends, and records the transaction with this entry:
Debit Credit
Cash 1,000,000
Stock Dividend Example

ABC International declares a stock dividend to its shareholders of 10,000 shares. The fair value of the
stock is $5.00, and its par value is $1. ABC records the following entry:
217
JGI JAIN
Debit Credit
Retained earnings 50,000
Common stock, $1 par value 10,000
Additional paid-in capital 40,000
Property Dividend Example
by Pablo Picasso, which the company has stored in a vault for several years. The company originally
acquired the prints for $500,000, and they have a fair market value as of the date of dividend declaration
of $4,000,000. ABC records the following entry as of the date of the declaration to record the change in
the value of the assets, as well as the liability to pay the dividends:
Debit Credit
Long-term investments - artwork 3,500,000
Gain on appreciation of artwork 3,500,000
Debit Credit
On the dividend payment date, ABC records the following entry to record the payment transaction:
Debit Credit
Long-term investments - artwork 4,000,000
Scrip Dividend Example

ABC International declares a $250,000 scrip dividend to its shareholders that has a 10 percent interest
rate. At the dividend declaration date, it records the following entry:
Debit Credit
Retained earnings 250,000
Notes payable 250,000
The date of payment is one year later so that ABC has accrued $25,000 in interest expense on the notes
payable. On the payment date (assuming no prior accrual of the interest expense), ABC records the
payment transaction with this entry:
Debit Credit
Notes payable 250,000
Interest expense 25,000
Cash 275,000
218
Liquidating Dividend Example
dividend declaration with this entry:
Debit Credit
Additional paid-in capital 1,600,000
On the dividend payment date, ABC records the following entry to record the payment transaction:
Debit Credit
Cash 1,600,000
15.3 DIMENSIONS OF DIVIDEND POLICY

The following are various factors that have a bearing on the dividend policy:
Nature of Business: The nature of business has an important bearing on the dividend policy.
Example: The industrial units that are having the stability of earnings may formulate (adopt) stable
or a more consistent dividend policy than others that are having unstable earnings because they can
predict easily their earnings. Firms that are involved in necessities suffer less from stable incomes
than the firms that are involved in luxury goods.
Age of Company: The age of a company has more impact on the distribution of profits as dividends.
A newly started and growing company may require much of its earnings for financing expansion
programs or growth requirements and it may follow a rigid dividend policy.
Liquidity Position of Company: Generally, dividends are paid in the form of cash, hence, it entails,
cash. Although a firm may have sufficient profits to declare dividends, it may not have sufficient
cash to pay dividends. Thus, the availability of cash and the sound financial position of the firm is
an important factor in making dividend decisions.
Equity Shareholders Preference for Current Income: Legally, the Board of Directors has the
discretion to decide the distribution of the earnings of a firm. The shareholders who are legal owners
of the firm appoint the Hence, directors have to take into consideration preferences,
while deciding dividend payment.
Legal Rules: Legal rules restrictions are significant as they provide the framework within which
dividend policy is formulated. In other words, the dividend policy of a firm has to be evolved within
the legal framework and rules and regulations. The legal rules have to do with the capital impairment
rule, net profits and insolvency rule. Example: The dividend can be paid from earnings either from
the current earnings or from past earnings and be reflected in the earned surplus.
Financial Needs of the Company: This is one of the key factors, which influence the dividend policy
of a firm. Financial needs mean funds required for foreseeable future investment.
Access to the Capital Market (External Sources):
ability to raise funds from the capital market. A company, which has easy access to the capital
market provides that flexibility in deciding dividend policy. Easy access is possible only to the
companies that are well established and hence here a profit track record.
219
JGI JAIN
Control Objective: Control over the company is also an important factor, which influences dividend
policy. When a firm distributes more earning as dividends in the form of cash it reduces its cash
position. As a result, the firm will have to issue shares to the public to raise funds required to finance
investment opportunities that lead to loss of control, since, the existing shareholders will have to
share control with new owners. Financing investment projects by way of internal source avoids, loss
of control.
Inflation: Inflation is the state of the economy in which the prices of products or goods have been
increasing. Inflation is a factor that influences dividend policy indirectly. The Indian accounting
system is based on historical costs. The funds accumulated from depreciation may not be sufficient
to replace the absolute asset or equipment, since depreciation is provided based on historical costs.
Consequently, to replace assets and equipment, the firm has to depend upon retained earnings, this
leads to the payment of low dividends, during the inflation period.
Dividend Policy of Competitors: Keeping one eye on dividend policy is very important. If
the firm wants to retain the existing shareholders or it wants to maintain share price in the market,
and if it is planning to raise funds from the public for expansion programs, it has to pay dividends
at par with its competitors. Hence, it is one of the factors that influence the dividend policy of a firm.
15.3.1 Dividend Policy Formulation

Formulation of dividend policy for a business enterprise calls for careful consideration of a myriad of
factors which may be categorised into external and internal considerations.
A. External Considerations:
General state of Economy: The level of business activity of an enterprise and so also its earnings
is subject to general economic and business conditions of the country.
Uncertainty about future economic and business conditions may lead 0 to the retention of all
or part of the profits in the company. During periods of prosperity, the management may not
always be liberal in dividend payment although earning power of the company warrants it.
State of capital market: If the state of the capital market is relatively comfortable and raising
funds from different sources, the management may tempt to declare high dividends. In case of
a slump in the capital market, the situation will be completely different.
State regulation: The management must formulate the dividend policy within the overall
legal framework which may prescribe rules to regulate the pattern and mode of the income
distribution.
Tax policy: Dividend policy is also affected in part by the tax policy of the Government. Tax
incentives may lead to a liberal dividend policy.
B. Internal Considerations:
investment opportunities and preferences: The appropriate
preferences. The company has to give importance to the preferences.

The nature of the business activity of the company influences
largely the level of income. A company with fluctuating earnings must retain a larger share of
income during boom periods to ensure that dividend policy is not affected by the business cycle.
Access to capital market: A company which is access to the capital market can raise funds and
earn reasonable profits and can formulate a liberal dividend policy.
220
Age of company: An old and established company having reached saturation point may follow
a high payout policy, whereas young and growing concerns cannot follow, as it requires a large
number of funds to finance its growth requirements.
Growth rate of the company: A rapidly growing concern requires long-term funds. Hence, its
dividend must be kept at a minimum.
Liquidity position of the company and its funds requirements: A company with high profitability
and large reserves may not necessarily have sufficient cash balances to pay cash dividends
particularly when most of the sales have been affected through credit, in such a situation it
would be unwise to drain off additional cash by paying dividends.
15.3.2 Factors Influencing Dividend Decisions

The corporate, institutional and legal factors that influence the dividend decision of a firm include the
growth and profitability of the firm its liquidity position, the cost and availability of alternative forms
of financing concerns about the managerial control of the firm, the existence of external (largely legal)
restriction and the impact of inflation of cash flow.
Growth and Profitability

The amount of growth a firm can sustain and its profitability is related to its dividend decisions, so long
as the firm (because of managerially imposed external market constraints) cannot issue additional
equity.
Firms with strong growth prospects maintain low target payout ratios. All the firms that experience
above-average growth rates are expected to have low dividend payout ratios since, in line with the
residual theory of dividends, a greater number of profitable investment opportunities should result
(other things being equal in a greater need for earnings retention.
This interrelationship among the growth, its profitability and its investment, financing and
dividend decisions cannot be overemphasised.
Liquidity
The liquidity position of a firm is often an important consideration in dividend decisions. Since dividends
represent a cash outflow, it follows that the better the cash position and overall liquidity of the firm, the
to pay (and maintain) a cash dividend.
A growing, profitable firm may not be liquid, since it needs funds for new capital expenditures and to
build up its permanent working capital position.
Likewise, firms in cyclical industries may experience times when they lack liquidity due to general
economic conditions. Hence, the degree of liquidity is a variable of concern when a dividend policy
is being assessed.
Cost and Availability of Alternative Forms of financing

The ability of a firm to raise money externally will have a direct bearing on the level of dividends paid
to shareholders. A company that has easy access to the capital markets, and that can conveniently
and economically raise funds in several alternative ways, will have greater latitude in setting dividend
policy than a firm that has to rely heavily on earnings retention as a source of financing.
221
JGI JAIN
In essence, the key question is whether or not a firm can (if the need arises) finance its dividend payments
externally. Those that can are likely to set higher dividend levels than those that cannot.
Two aspects that tend to work against this approach to dividend payments are the cost of financing
and issue expenses. Financing dividends externally may have merit so long as the cost of financing is
relatively low.
However, when interest rates rise, the idea of financing dividends begins to lose its appeal. Moreover,
issue expenses and other flotation costs will lower desired payout ratios, since they raise the cost of
financing.
This is particularly true when the amount of external financing involved is fairly small, for flotation
costs are inversely related to the size of the issue and tend to rise rapidly as the size of an issue declines.
Managerial Control
In some cases, control of the firm may be a factor to consider when establishing a dividend policy.
Suppose a fairly substantial proportion of the firm is owned by a controlling group, and the remainder
of the stock is publicly held. Under these circumstances, the higher the payout ratio, the more likely it is
that a subsequent issue of equity may be needed to finance capital expenditures.
Those in control might prefer to minimise the likelihood of an offering of equity to avoid any dilution in
their ownership position.
Hence, they would prefer a low payout policy. On the other hand, a firm may establish a relatively high
dividend payout ratio (if it believes that is what shareholders desire) as a way to keep the firm from
being acquired in a merger or acquisition.
Legal constraints
The legal rules act as boundaries within which a company can declare dividends. In general, cash
dividends must be paid from current earnings or from previous earnings that have been retained by the
corporations after providing for depreciation. However, a company may be permitted to pay a dividend
in any financial year out of the profits of the company without providing for depreciation.
Though the dividends should be paid
or reserves (retained earnings) to issue fully paid bonus shares (stock dividend).
Access to the Capital Market

Another matter for consideration by management in setting an appropriate dividend policy is the
negotiating for a bank overdraft limit or having access to other short-term sources of funds.
new issue of shares or to issue debt is restricted, it will likely
retain a higher proportion of its profits than a company that has ready access to funds from the capital
market. Companies that are likely to have difficulties raising funds on the capital market include small
companies, new companies and companies in what may be termed venture capital fields.
Inflation
Inflation must be taken into account when a firm establishes its dividend policy. On the one hand,
investors would like to receive larger cash dividends because of inflation.
222
equipment, finance new capital expenditures and meet permanent working capital needs. Thus, in
inflationary times, there may be a tendency to hold down cash dividends.
External Restrictions
The protective covenants in a bond indenture or loan agreement often include a restriction on the
payment of cash dividends. This restriction is imposed to preserve the ability to service its debt.
These restrictions may be in the form of coverage ratio, sinking fund, etc. The presence of these
restrictions forces a company to retain earnings and follow a low payout.
15.4 BONUS SHARES AND STOCK SPLIT
Bonus Shares
A bonus issue, also known as a scrip issue or a capitalisation issue, is an offer of free additional shares to
existing shareholders. A company may decide to distribute further shares as an alternative to increasing
the dividend payout. For example, a company may give one bonus share for every five shares held.
Bonus issues are given to shareholders when companies are short of cash and shareholders expect a
regular income. Shareholders may sell the bonus shares and meet their liquidity needs. Bonus shares
may also be issued to restructure company reserves. Issuing bonus shares does not involve cash flow. It
net assets.
Bonus shares are issued according to each stake in the company. Bonus issues do not dilute
relative equity of each shareholder the same as before the issue. For example, a three-for-two bonus
issue entitles each shareholder three shares for every two they hold before the issue. A shareholder with
1,000 shares receives 1,500 bonus shares (1000 x 3 / 2 = 1500).
Stock Split
Stock split means splitting one share into many, say, one share of ` 500 into 5 shares of `100. Stock splits
are a tool used by the companies to regulate the prices of shares, i.e., if a share price increases beyond a
limit, it may become less tradable, for example, suppose a share price increases from `50 to
`1000 over the years, it is possible that it might goes out of range of many investors.
A stock split is when a company divides the existing shares of its stock into multiple new shares to boost
the liquidity. Although the number of shares outstanding increases by a specific multiple, the
total dollar value of the shares remains the same compared to pre-split amounts, because the split does
not add any real value.
The most common split ratios are 2-for-1 or 3-for-1 (sometimes denoted as 2:1 or 3:1), which means that
the stockholder will have two or three shares after the split takes place, respectively, for every share held
before the split.
The term dividend refers to that part of the profits of a company that is distributed by the company
among its shareholders.
223
JGI JAIN
It is the reward of the shareholders for investments made by them in the shares of the company.
If a company pays out as dividend most of what it earns, then for business requirements and further
expansion it will have to depend upon outside resources, such as the issue of debt or new shares.
Dividend refers to the business concerns net profits distributed among the shareholders.
The dividend is the payment by a company to its shareholders out of its distributable profit.
A dividend is generally considered to be a cash payment issued to the holders of company stock.
The cash dividend is by far the most common of the dividend types used.
A stock dividend is an issuance by a company of its common stock to its common shareholders
without any consideration.
A company may issue a non-monetary dividend to investors, rather than making a cash or stock
payment.
When the board of directors wishes to return the capital originally contributed by shareholders as a
dividend, it is called a liquidating dividend
The ability of a firm to raise money externally will have a direct bearing on the level of dividends
paid to shareholders.
In some cases, control of the firm may be a factor to consider when establishing a dividend policy.
The legal rules act as boundaries within which a company can declare dividends.
A bonus issue, also known as a scrip issue or a capitalisation issue, is an offer of free additional
shares to existing shareholders.
15.6 GLOSSARY
Dividends: It refers to that portion of the net earnings that is paid out to the equity
shareholders.
Dividend Policy: It decides the portion of earnings to be paid as dividends to ordinary shareholders
and what portion is ploughed back into the firm for investment purposes.
Pay-out Ratio: The ratio of dividend to earnings is known as the pay-out ratio.
Stability: It refers to the consistency or lack of variability in the stream of dividend payments.
15.7 CASE STUDY: RAJART AND ASSOCIATES FINANCIAL ALTERNATIVES
Case Objective
This case study familiarises with different types of securities as per the requirements of different
companies.
George Thomas was finishing some weekend reports on a Friday afternoon in the downtown office
of Wishart and Associates, an investment-banking firm. Since Monday, Meenda, a partner with the
business, had not been in the New York office. He was travelling through Pennsylvania, meeting with five
potential clients who were exploring a securitie
George was anticipating the arrival of the cable.
224
Meenda would be recommending different types of assets to each of the five clients to fulfil their specific
demands, George understood. He also knew Meenda wanted him to phone each of the clients over the
weekend to discuss the recommendations. As soon as the cable came, George was ready to make these
calls. The secretary handed George the following telegram at 4:00 p.m. George Thomas, Wishart and
Associates STOP Taking advantage of the offer to go skiing on Poconos STOP Recommendations as
follows:
1. common stock,
2. preferred stock,
3. debt with warrants,
4. convertible bonds, and
5. callable debentures are the five types of securities available.
George understood as he picked up the phone to make the first call that the potential clients were not
matched with the investment options. George discovered folders on each of the five firms seeking funding
they were in the front of each folder. George went over each of the notes one by one.
API, Inc.
API, Inc. currently requires $8 million and will require $4 million in four years. In the tri-state area, a
packaging company with a high growth rate. Over-the-counter (OTC) trading is how common stocks
are traded. The stock is currently low, but it is expected to rise in the next 12 to 18 months. Any sort
of security is acceptable to me. Good leadership and growth are expected to be mild. Profits should
skyrocket as a result of the new machinery. The debt of $7 million was recently paid off. Except for short-
term responsibilities, he has essentially no debt left.
Sandford Enterprises
$16 million is required. The stock price has dropped, but it is predicted to rise. In the following two
years, excellent growth and profitability are expected. Low debt-to-
history of paying off debt before it matures. The majority of earnings are retained, while dividends are
paid in small amounts. Management is adamant about not handing over voting power to outsiders.
Money will be utilised to purchase plumbing materials and machinery.
Sharma Brothers., Inc.

To expand its cabinet and woodworking operations, it will need $20 million. Originally a family firm, it
now employs 1,200 people, generates $50 million in revenue, and is traded over the counter. He is looking
for a new shareholder, but he is not willing to stock at a discount. Straight debt cannot raise more than
$12 million.
There are good growth opportunities. Earnings are excellent. Should pique the curiosity of investors.
Banks may be prepared to lend money to meet long-term requirements.
Sacheetee Energy Systems

The liberal investment community in the Boston area holds the firm in high regard. A good firm with a
lot of potential. The stock is currently trading for $16 per share. Management would prefer to raise $28
225
JGI JAIN
million by selling common shares at $21 or higher, but this is a distant second choice. Those who are
likely to invest in this company will be attracted by the financing gimmicks and the opportunity to make
a quick profit on their investment.
Ranbaxy Industry
A total of $25 million is required. The company makes boat canvas covers and needs money to expand.
Money for the long future is required. Ownership that has been tightly maintained for a long time is
reluctant to relinquish control. Without the authorisation of bondholders and the First National Bank of
Philadelphia, it is impossible to issue debt. The debt-to-equity ratio is relatively low. Profits are relatively
high. Growth prospects are favourable. Strong management, with slight flaws in the areas of sales and
promotion.
secretary entered the office as George was going over the folders. Meenda leave any
other stuff here on Monday other than these
think those notes will come in
Meenda called early this morning to say he had double-checked the information in the folders. He also
stated that he had learned nothing new on the trip and that he had essentially squandered his week,
except for the fact that he had been invited to go skiing at the business lodge up there.
George studied the situation for a while. He could always wait until the next week when he would be
certain that he had the proper advice and that he had taken into account some of the factors that
the initial deadline if he could figure out which firm fit each recommendation. George returned to his
office and began matching each company with the proper financing.
Questions
1. Which type of financing is appropriate for each firm?
(Hint: EBIT-EPS (Approach) Analysis)
2. What types of securities must be issued by a firm that is on the growing stage to meet the financial
requirements?
(Hint: Trading on equity)

1. What do you understand by dividend?
2. Define dividend according to ICAI.
3. What is a stock dividend?
4. What do you understand by inflation in dividend decisions?
226
DEEMED
EEMED-T O-BE U
UNI VE R SI TY
1. Dividend refers to the business concerns net profits distributed among the shareholders. It may also
be termed as the part of the profit of a business concern, which is distributed among its shareholders.
Refer to Section Concept of Dividends
2.
Refer to Section Concept of Dividends
3. A stock dividend is an issuance by a company of its common stock to its common shareholders
without any consideration. Refer to Section Concept of Dividends
4. Inflation is the state of the economy in which the prices of products or goods have been increasing.
Inflation is a factor that influences dividend policy indirectly. Refer to Section Dimensions of Dividend
Policy
https://efinancemanagement.com/dividend-decisions
https://businessjargons.com/dividend-decision.html
https://www.mbaknol.com/financial-management/dividend-decision/
http://oer2go.org/mods/en-boundless/www.boundless.com/finance/definition/dividend-decision/
index.html
https://cbpbu.ac.in/userfiles/file/2020/STUDY_MAT/COMMERCE/COM%20406%20F%20(AFM)_
DIVIDEND%20DECISION%201.pdf
https://www.mbaknol.com/financial-management/dividend-decision/
Discuss with your friends about the disadvantages of dividend decision
227

Accounts &amp; Finance 15 Units NOTES

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Accounts &amp; Finance 15 Units NOTES

Uploaded by

Copyright:

Available Formats

UNIT

Introduction to Financial Accounting

Introduction to Financial Accounting, Concept of Conceptual Framework of Financial Accounting,

Pre-Unit Preparatory Material

The American Institute of Certified Public Accountants defines accounting as process of

1.2 CONCEPTUAL FRAMEWORK OF FINANCIAL ACCOUNTING

1.2.1 Basic Terminology in Accounting

1.2.2 Users of Accounting Information

1.3 DIFFERENT ACCOUNTING CONCEPTS

Let us understand each them one by one.

Money Measurement Concept

Business Entity Concept

firm by the owner at the start of the

Going Concern Concept

enues, which are mostly derived

Accounting Period Concept

variances in operating periods of diverse traders.

Duality or Double Entry Accounting Concept

Revenue Reorganisation Concept

Full Disclosure Concept

for the auditing of financial statements.

1.4 ASSUMPTIONS AND CONVENTIONS OF ACCOUNTING

1.5 ACCOUNTING EQUATIONS

shown on its balance sheet.

was paid off is known as equity.

The balance sheet holds the basis of the accounting equation:

1.6 INTRODUCTION TO INDIAN GAAP, IND AS AND IFRS

Conclusion 1.7 CONCLUSION

on the credit side.

were not paid to shareholders as dividends.

1.9 CASE STUDY: ICAI TOLD TO HASTEN PROCESS FOR DOUBLE-ENTRY

to transition to double entry as soon as po

firms with a turnover of over 1,000 crores in the first phase.

1.10 SELF-ASSESSMENT QUESTIONS

A. Essay Type Questions

1.11 ANSWERS AND HINTS FOR SELF-ASSESSMENT QUESTIONS

A. Hints for Essay Type Questions

@ 1.12 POST-UNIT READING MATERIAL

1.13 TOPICS FOR DISCUSSION FORUMS

Introduction to Accounting Cycle, Concept of Accounting Process, Concept of Preparation of Trial

In this unit, you will learn to:

Figure 1: Accounting Cycle

2.2 ACCOUNTING PROCESS

Figure 2 shows the steps in the accounting process:

Adjusted Trial Adjustment

Figure 2: Accounting Process

2.2.1 Books of Accounts

Purchase Sales Return Return General Cash

Cash General Debtor Creditor

for assets, liabilities, owner equity, revenues and expenses.

2.2.4 Cash Book

2.3 PREPARATION OF TRIAL BALANCE

Steps in Preparation of Trial Balance

Conclusion 2.4 CONCLUSION

2.6 CASE STUDY: ACCOUNTS SYSTEM IMPROVEMENT

2.7 SELF-ASSESSMENT QUESTIONS

A. Essay Type Questions

2.8 ANSWERS AND HINTS FOR SELF-ASSESSMENT QUESTIONS

A. Hints for Essay Type Questions

@ 2.9 POST-UNIT READING MATERIAL

2.10 TOPICS FOR DISCUSSION FORUMS

Discuss with your friends how to prepare trial balance.

Introduction to Financial Accounting, Concept of Depreciation, Need for Calculating Depreciation,

In this unit, you will learn to:

Accounts & Finance 15 Units NOTES

Accounts & Finance 15 Units NOTES