18 Jan 08

Prof RS Sardesai

Financial Management

Syllabus

1. Ratio Analysis 2. Mgmt of working Capital 3. Fund flow statement 4. Capital Budgeting 5. Other Theory topics

Financial statements are used by analysts to assess the financial state of a

company. However, the available figures in the financial statement in isolation give

only a macro view. It is well known that Statistics hide more than they reveal. It is

basically an art of coloring the truth without being accused of falsehood. In order to

pierce through the faade which management of the company may have put in the

balance sheet using accounting biases so generously permitted by the law, it is

necessary to get the raw data and work on them. It is here that financial ratios come

handy. Ratios are arithmetical relationship between two figures. Financial Ratio

analysis is a study of ratios between various items or group of items in financial

statements. But even Financial Ratios are useful to certain extent only unless inside

information is available.

There are five kind of Financial Ratios: -

(a) Liquidity Ratios (b) Leverage Ratios (c) Turnover Ratios (d) Profitability Ratios (e) Valuation Ratios

Ratio Analysis

Ratio = Numerator/Denominator

2000 2001

Gross Profit 2 Cr 3 Cr

Sales 10 Cr 20 Cr

% Profit 20% 15%

Balance Sheet

Liability

1. Share Capital 2. Reserves & Surplus 3. Contingent Liabilities 4. Secured Loans 5. Unsecured Loans 6. Current Liabilities and

provisions

Assets

1. Fixed Assets 2. Investments 3. Currents Assets and Loans and

Advances

4. Misc Expenditures (to the extent not adjusted)

5. Debit Balance in P&L statement

Fixed Assets Fixed Assets are those, which are acquired with intention not to sell.

Current Assets Current assets are those, which are acquired with the intention to

sell them, or those, which are intended to be sold after conversion into assets meant

for sale.

An asset, which may be Current Asset for one company, may be Fixed Asset for

another since that company may be dealing in that product (asset) and hence this asset

becomes his trading goods/current assets. Even for the same company, out of two

pieces of the same asset, one may be classified as Fixed Asset since the same is

acquired for use by the company where as the other one may be classified as Current

Asset, if the trader is dealing in that asset. For example, a real estate developer, who

purchases land at different locations and sells them after developing

them/constructing buildings, may have acquired a particular plot of land for its office

building. While this plot would be categorized as Fixed Asset, other plots would be

termed as current asset.

Investment of surplus money outside business is called as Investment and is not

counted towards current asset.

There are two types of Share Capitals: -

(a) Equity Share Capital This capital has not been defined by Company Law. Only preferential Capital has been defined. So this is that capital

which is not preferential Share Capital.

(b) Preferential Share Capital Preferential Share Capital more like a loan than Equity Capital where is risk on the capital is limited. This capital

enjoys two basic preference rights. The preferential share capital has first

right on the profits to the extent of committed dividend. It also has first

servicing right over funds on liquidation of the company. Also, in case

there is no distribution of dividend in any year due to poor profits, etc, the

dividend does not lapse like in case of Equity Share Capital. The unpaid

dividend is carried forward and same would be paid from profits in the

subsequent years. Then are additional rights like Participating

Preferential Share where in they participate in case there is surplus cash

available on liquidation of the company, but they do not share any

additional losses.

Reserves.

Types : -

1. Capital Reserves Created out of profits generated from sale of capital

(fixed assets).

2. Revenue Reserves Created out of revenue (business activity) profits.

Free Reserves

Non Free Reserves

Secret Reserves

Non Free Reserves- Like Debenture Redemption Fund (the money is already

committed to a specified purpose. So this reserve is not free for use for any other

purpose)

Secret Reserves Are those the existence of which is known only to the

management.

Creation of Secret Reserves

(a) Excess Provision for liabilities (b) High depreciation (c) Conservative valuation of stock (d) Appreciation of fixed assets like land etc which are always to be

valued at purchase cost irrespective of current market valuation.

(e) Hypothetical provisions (f) High provisions for debtors (g) High provisions for bad debts

Unsecured Loans General loans have only general security against companys

assets and no specific security, ie, no mortgage of any specific assets of company.

Current liabilities - are outstanding payments arising out of business transactions.

Like payment due to suppliers of raw materials/services, electricity/telephone bills,

taxes etc.

Loans Loans are the owings to and from where it is due to exchange of cash only.

No services or material transactions are involved in this case.

Liability When all the related events have already occurred (activity fully

completed)

Vs

Provisions When all the related events have not completed, like in case of announce

of dividend by the board of directors. Unless the proposal of the board is ratified by

the general body meeting, the funds earmarked for the purpose would be treated as

provisions. Once the proposal is ratified by the GBM, it converts into liability.

All provisions will become current liability one day and only then are they paid off.

Financial Ratios

1. Balance Sheet Ratio Both Numerator and denominator are derived form Balance Sheet figures only.

2. Profit and Loss Ratios - Both Numerator and denominator are derived form Profit and Loss statement figures only.

3. Mixed Ratios In this case one of the figure is taken Profit and Loss A/c and other is taken from Balance Sheet.

Balance Sheet Ratios

(a) Solvency Ratios

(i) Current Ratio Current Assets (Standard Ratio = 2)

Current Liability

If ratio is < 2, solvency is affected. Short Term Solvency = 1 year

(ii) Quick Ratio Quick Assets Quick liabilities

This ratio is also called Acid Test Ratio and Liquid Ratio because it

indicates immediate solvency.

Quick assets are part of current assets which can be converted into cash

fast. Like, Cash and Bank, Debtors, loans etc.

There are certain current assets which can not be converted to cash at all. Like

Prepaid Expenses (Insurance premium), Advances to suppliers, etc.

Then, there are current assets which, if converted to cash, will seriously jeopardise the

business interests of the company. Like, raw material. If sold in the market, will send

wrong signals about the company. Finished goods are also not considered to be part of

the quick assets as the same cannot be sold at short notice and most of the sales are

not in cash but in credit.

Cash Cycle

Debtors

Quick Liabilities Part of the current liabilities which are to be paid in cash, like

(a) Sundry Creditors (b) Outstanding Expenses (c) Taxes Payable (d) Dividend, etc

Advances from customers and Income received in advance are not part of the

quick liabilities as they are not required to be settled in cash and only

services/goods are to be supplied against them.

Standard Ratio = 1

Current Ratio = Current Assets

Current Liability

CR = CA/CL

CR 1 = CA/CL - 1

= CA CL

CL

= Working Capital

CL

CR = CA/CL

QR = QA/QL

QL CL if advances from customers is not there or negligible

Then QR = QA/CL

CR QR = CA/CL - QA/CL

= CA QA

Cash

Raw

Material

WIP

Finished

Goods

Cash Sales

CL

closing Stock + Prepaid Exp CL

Proprietary Ratio = Shareholders Funds

(long term solvency) Total Assets

Higher the ratio, better it is for long term solvency.

--- 7

--- 8

Lecture Date: 23 Jan. 08 Subject: Financial Mgmt

Professor: Mr RS Sardesai

Other Balance Sheet Ratios:

4. Debt Equity Ratio = Loan funds (Indicates Financing Pattern of Co) Share holders funds

= Secured + Unsecured Loans

ESC + PSC + Reserves Losses

Where ESC = Equity Share Capital

PSC = Preferential Share Capital This ratio is used by Financial Institutions to determine loan eligibility and health of the company.

These institutions fix different bench marks for different kind of industries depending

on capital requirement of particular kind of industry, profitability etc.

They permit higher D/E ratio in case of

(a) Import substitution product industries (b) Prime Health Care Products (c) Entrepreneur Projects

They permit lower D/E ratio in case of existing companies as they are expected to

have generated reserves from past operation.

5. Capital Gearing Ratio = Funds bearing fixed rate of return

Funds not bearing fixed rate of return

= Secured + Unsecured loans + PSC

ESC + Reserves - Losses

Gearing of the funds for improving the return to equity share holders

Suppose total funds required for an starting an industry is Rs 400 Cr and provided for

as follows: -

Source Case I Case II Equity Share Capital (ESC) 80 Cr 320 Cr

Loans @ 10% PA 320 Cr 80 Cr

Total 400 Cr 400 Cr

Operating Figures of the company Case I

2003 2004 2005 Sales 150 200 100

--- 9

Mfg Exp @ 40% 60 80 40

Gross Profit (GP) 90 120 60

Adm & Sales (incl Dep) 20 30 18

Profit before int and tax (PBIT) 70 90 42

Interest @ 10% 32 32 32

Profit before Tax 38 58 10

Income Tax @ 40% 15.2 23.2 4.0

Profit after tax 22.8 34.8 6.0

ESC 80.0 80.0 80.0

Return on ESC 28.5 43.5 7.5

Operating Figures of the company Case II

2003 2004 2005 Sales 150 200 100

Mfg Exp @ 40% 60 80 40

Gross Profit (GP) 90 120 60

Adm & Sales (incl Dep) 20 30 18

Profit before int and tax (PBIT) 70 90 42

Interest @ 10% 8 8 8

Profit before Tax 62 82 34

Income Tax @ 40% 24.8 32.8 13.6

Profit after tax 37.2 49.2 20.4

ESC 320 320 320

Return on ESC 11.63% 15.8% 6.38%

Profit & Loss A/c Ratios

1. Gross Profit Ratio = GP

Sales/cost of sales

Sales Cost of sales = GP

Case I GP Ratio = 20% of sales

Sales = 4 lacs . Given

Therefore, GP = 80,000

Cost of sales = 3,20,000

Case II GP Ratio = 20% of sales

GP = 3 lacs . Given

Therefore, Sales = 15 lacs

Cost of sales = 12 lacs

Case III GP Ratio = 20% of sales

Cost of Sales = 8 lacs . Given

Cost + GP = Sales

(80) (20) (100)

GP = 20 x cost of sales = Rs 2 lacs

--- 10

80

Sales = cost + profit = 10 lacs

Higher the GP, better the product for the company. In case of choice of prefernce for

production, a product with higher GP potential should be given preference.

2. Net Profit Ratio = NP x 100

Sales (Gross Income)

Higher the ratio, better the performance.

3. Expenditure Ratio = Raw Material Consumed

(There are many varieties) Sales

Any reduction is better. It increases the profits.

Mixed Ratios: -

(a) Asset Turnover Ratios (b) Profitability ratios

Asset Turnover Ratio = Turnover

Avg Value of asset

1. Stock Turnover Ratio = Cost of sales

(Utilisation of stock) Avg Value of stock

= Cost of Sales

Opening Stock + Closing Stock

2

Ideally, to work out this ratio, monthly average of closing stock should be

available to arrive at any meaningful analysis. However, in the real life

situation, even both opening and closing stock figures may not be

available in the balance sheet and there may be need to calculate the ratio.

In such cases which ever figure is available is used as average stock

holding and ratio is worked out. However, not much meaning should be

read into such analysis, as it could be highly deceptive due to seasonal

variations of demand and hence production and stock.

2. Debtors Turnover Ratio = Credit Sales

Avg Receivables

Assuming that most of sales are on credit and very little on cash basis,

= Total Sales (= Credit sales)

Opn + Cl receivables

2

In case opening receivables are not available, assume that closing receivables are

avg receivables = Total Sales

--- 11

Cl receivables

3. Debtors Collection Period Ratio = Average Receivables

Credit sales/day

= Closing Receivables

Total sales/day

4. Fixed Asset Turnover Ratio = Cost of Sales

Avg Fixed Assets

A Ltd B Ltd

Cost of Sales 12 Cr 15 Cr

Fixed Assets 5 Cr 10 Cr

FA/TO Ratio 2.4 Cr 1.5 Cr

Preference I II

Age of Company 15 Yrs 5 Yrs

This ratio can give meaningful comparison when

(a) Two companies are in same age group as the difference in age will lead to one company having depreciated asset thereby distorting the ratio.

(b) Related to same industry and have similar product as some industries are capital intensive and others labour intensive.

Profitability Ratios (From owners point of view)

1. Return on Investment = Profit before Interest and Tax

(Very Long Term View) Share Holders funds + Loans

2. Return on ESH Funds = Profit after Int, tax & Pref Dividend

(Long term view) ESC + Reserves Losses

3. Retrun on ESC = Profit after tax, int & Pref dividend

(Medium Term View) ESC

4. Dividend on ESC = Dividend declared

(Short Term) ESC

Practice Sums

Q 1. Given

Current Ratio = 1.5

GP Ratio = 25 % of sales

Stock Turnover Ratio = 5 times

NP Ratio = 8 %

--- 12

Return on Equity Share Capital = 80 %

Debt/Equity Ratio = 3 times

Debtors Collection Period = 73 days

Current Assets = 9 lacs

Long Term Loans = 12 lacs

Closing Stock = 3 lacs

Investments are 25 % of fixsed assets

Calculate

1. Fixed Assets 2. Debtors 3. Current Liabilities 4. NP 5. GP 6. Sales 7. Cost of sales 8. Investments 9. ESC 10. Reserves

Solution.

Current Ratio = 1.5

= Current Assets = 1.5

Current Liabilities

Current Liabilities = Current Assets = 9

Current Ratio 1.5

= 6 lacs

Debt Equity Ratio = Long Term Loans = 3

ESH funds

= 12

ESH Funds

ESH Funds = 4 lacs

Gross Profit Rartio = 25 % of sales

= Cost + Profit = Sales

75 25 100

--- 13

Profit = 1/3 cost

GP = 15/3

= 5 lacs

Sales = Cost + GP

= 15 + 5

= 20 lacs

Net Profit Ratio = Net profit = 8 %

Sales

= NP

20

NP = 8 x 20,00,000

100

= 1,60,000

Debtors Collection Period = Avg Sales x 365 = 73 Days

Credit Sales

Credit Sales = 73 x 20,00,000

365

= 4 lacs

Return on ESC = NP = 0.8

ESC

ESC = 1,60,000

0.8

= 2 lacs

Equity Share Holders Funds = ESC + Reserves

4 lacs = 2 lacs + Reserves

Reserves = 2 lacs

Balance Sheet

ESC 2

Reserves 2

Loans 12

Closing Stock 6

22

FA 10.4

Investments 13 2.6

Current Assets 9

--- 14

Stock 3.0

Debt 4.0

Other Assets 2.0

22.0

Investments = 1

FA 4

1 + Investments = 1 + 1

FA 4

Investments + FA = 5

FA 4

13 = 5

FA 4

FA = 10,40,000

Profit and Loss Account

Cost of Sales 15

GP 5

20

Expenditure find 3.4

NP (known) 1.6

5.0

Sales 20

GP 5.0

5.0

Q 2.

Given

Current Ratio = 1.75

Quick Ratio = 1.25

FA . = 0.80

Share Funds

GP Ratio = 0.25

NP Ratio = 10 %

Current Liabilities = 1,00,000

Stock Turnover Ratio = 6 times

Debtors Collection Period= 3 months

Return on Share Capital = 10 %

There are no long term loans, pre paid expenditure and losses or investments.

Calculate

1. Fixed Assets

--- 15

2. Debtors 3. Current Liabilities 4. NP 5. GP 6. Sales 7. Cost of sales 8. Investments 9. ESC 10. Reserves

Solution:

Current Ratio = Current Assets = 1.75

Current Liabilities

= Current Assets

1,00,000

Current Assets = 1,75,000

Quick Ratio = Quick Assets = 1.25

Quick Liabilities

= Current Assets Stock

Current Liabilities

1.25 = 1.75 - Stock

1.00

Stock = 50,000

Stock Turnover Ratio = Cost of Sales = 6

Stock

Cost of Sales = 6 x 50000

= 3,00,000

Debt Equity Ratio = Long Term Loans = 3

ESH Funds

Gross Profit ratio = 25 % of sales

Cost + Profit = Sales

3,00,000 1,00,000 4,00,000

Profit = 1/3 cost

GP = 1,00,000

Sales = 4,00,000

--- 16

NP Ratio = 10 %

= NP .

Turn Over

10 = NP .

100 4,00,000

NP = 40,000

Debtors Collection Period = Avg Sales x 12 = 3 months

Credit Sales

= Avg Sales x 12

4,00,000

Debtors/ Avg Sales = 400000x3

12

= 1,00,000

Return on Share Capital = NP = 10%

ESC

ESC = 4,00,000

Now since no other ratio can be found from the given data, we have to prepare

Balance Sheet to find other ratios.

Equation of Balance Sheet

Total of Asset side = Total of Liability side

FA +CA = SHF + CL

FA + 1,75,000 = SHF + 1,00,000

FA + 75,000 = 1

SHF

0.8 + 75,000 = 1

SHF

SHF = 75,000

0.2

SHF = 3,75,000

Therefore, there are negative reserves (losses) of Rs 25,000

Fixed Assets = 0.8 x 3,75,000

= 3,00,000

--- 17

Profit and Loss A/c

To cost of sales 3,00,000

To GP 1,00,000

4,00,000

To Expenditure 60,000

To Net Profit 40,000

1,00,000

Liability

Share capital 4,00,000

Loans NIL

CL 1,00,000

Sales 4,00,000

4,00,000

By GP 1,00,000

Assets

FA 3,00,000

Investments NIL

CA 1,75,000

Reserves/Losses 25,000

--- 18

Lecture Date:25Jan 08

Subject: Financial Mgmt

Professor: Mr RS Sardesai

Balance Sheet of X Ltd

Liabilities 2003 2004 Assets 2003 2004

Share

Capital 200 250 Fixed

Assets

350 420

Reserves 235 386 Investments 50 50

Secured

Loans

145 64 Current Assets

Sundry

Creditors

72 81 Stock 120 138

O/s

Expenses

38 39 Debtors 230 275

Provision

for Tax

45 36

Proposed

Dividend

50 60

Total 785 916 Total 785 916 Income Statement

Expenditure 2003 2004 Income 2003 2004 To Raw

Material 250 275 By Sales 900 1015

To Wages 188 195 By Misc Income

22 25

To mfg exp 75 78 To Adm Exp 35 32 To Provision

for tax 45 36

To sales exp 102 115 To Net Profit 227 309

Total 922 1040 Total 922 1040 Calculate various ratios.

Sol:

1. Solvency Ratios: -

(a) Current Ratio

= Current Asset 385

Current Liability 205

Current Assets 2003 2004

Stock 120 138

Debtors 230 275

Cash & Bank 35 33

385 446

Current Liabilities 2003

2004

S. Creditors 72 81

O/s Expenses 58 39

Provn for tax 45 36

Proposed Div 50 60

205 216

(b) Quick Ratio

= Quick Assets

385-120 446-138

Quick Liability

205 216

= C/A Stock

1.29 1.43

Current Liability

Assessment: Performance is good

in both years as ratio is more than

standard ratio of 1. However, in the

year 2004, the performance has

further improved.

(c) Profitability Ratio 435 785

= SHF 55 %

Total Assets

SHF 2003 2004

Share Cap 200 250

Reserves 235 386

435 636

(d) Debt Equity Ratio = Long Term Loans 145

SHF 435

33 %

The debt equity of both

years is very low and

--- 19

therefore lenders art

very secure. Further, for

the second year the ratio

has improved from

lenders point of view

2. Profit and Loss Ratios

(a) Expense Ratios (i) RM 250 275

Sales

900 1015

28 % 27 %

(ii) Wages 188 195 Sales

900 1015

21 % 19 %

(iii) Mfg Exp 75 78 Sales

900 1015

8.3 % 7.7 %

(iv) Adm Exp 35 32 Sales

900 1015

4

% 3.1 %

(v) Sales Exp 102 115 Sales

900 1015

11.33 %

11.4 %

All the expense ratios

have been reduced iin

2004 as compared to

2003. Therefore from

point of view of

expenses, 2004 is better

year as compared to

2003.

(b) Gross Profit Ratio

= Gross Profit

387 467

Sales

900 1015

43 % 46 %

Cost of sales 2003

2004

RM 250 275

Wages 188 195

Mfg Exp 75

78

Cost of Sales 513

548

GP 387 467

900 1015

(c) Net Profit Ratio = Net Profit x 100

227

309

Total Income

922

1040

24.6 % 29.7 %

(d) Operating Profit Ratio Operating Profit

227 22

309 25

Sales

900 1015

205 284

900 1015

22.8 % 28 %

The performance for the year

2004 is better than performance

for year 2003.

2. Mixed Ratios

(a) Asset Turnover Ratio

--- 20

= Cost of Sales

513 548

Closing Stock

120 138

(Assuming Avg Stock =

Cl Stock) 4.27 Times

3.97 Times

The stock turnover ratio is

lesser for year 2004 which

means that the stock has not

been effectively utilised as

compared to year 2003.

(b) Debtors Collection Period

= Avg Debtors x 365

230 x 365

265 x 365

Total Sales

900 1015

(Assuming avg debtors

are closing 93 days

99 days

debtors and all sales are

on credit)

From the above, the avg credit

period allowed to lenders has

gone up form 93 days to 99

days in case of year 32004 as

against year 2003.

(c) Credit Payment Period Cl Creditors x 365

72 x 365

81 x 365

RM Consumed

250

275

105 days

108 days

The creditors payment period

has increased by 3 days which

means that company could

convince the creditors for

higher credit period which is

good sign.

(d) Fixed Asset Turnover Ratio

= Cost of Sales

513

548

Cl Fixed Assets

340

420

1.46 times

1.3 times

The fixed asset utilisation for

year 2003 is better than that for

year 2004.

3. Profitability Ratios

(a) Return on Investments = Profit before tax & int

227 + 45

309 + 36

Total funds employed

435 + 145

636 + 64

272 335

580 700

47 % 49 %

Return on investment is better

for 2004 than 2003 (Minor

improvement)

(b) Return on SHF = Net Profit after tax

227 309

SHF

435 636

52 % 49 %

Return on SHF has decreased

mainly due to increase in SH

capital and increase in reserves.

(c) Return on ESC ( = EPS) = Net Profit after tax

227 309

--- 21

Share Capital

200 250

114 % 124 %

(d) Dividend on Share Capital

= Dividend

Declared 50

60

Share Capital

200 250

25 % 24 %

(e) Dividend payout Ratio = Dividend

Declared 50

60

Net Profit

227 309

22 % 20 %

Year 2004 shows conservative

mgmt outlook towards

declaration and payment of

dividend.

(f) Sales to Working Capital Ratio 900 1015

CA 385 446

180 230

-CL 205 216 5

times 4.4 times

WC 180 230

Working capital mgmt

worsened in year 2004. Credit

period could have been

increased to improve sales.

Overall Assessment: -

1. The mgmt could reduce all types of expenses

theref#by improving net

profit.

2. the return on investments and to

shareholders have

increased in 2004 but

mgmt has not increased

the payout of dividend.

3. The solvency of company is very good.

Improved slightly in

2004.

4. The gross profit and net profit ratios have

improved in year 2004.

5. Utilisation of various assets and working

capital was better in

year 2003 as compared

to 2004.

--- 22

A short Note :

(This note is to serve as a

guiding factor and is not to be

considered as an exhaustive

one. Please refer to

recommended books on the

said subject for a detailed

reading on the topic)

Financial Accounting

Capital v/s Revenue Expenditure / Receipts

Final accounts prepared at the end of the year consist of Trading and Profit & Loss Account as well as Balance Sheet. Closing balances of all ledger accounts appearing in the Trial Balance are taken to be either in the trading and profit and loss account or balance sheet. In order to understand how to make such decision i.e. to decide as to which item will be taken to which place, the following accounting principle is applied :

(a) All revenue expenditure and incomes are taken to trading and profit and loss account and

(b) all items of assets and liabilities are taken to balance sheet.

It is, therefore, necessary to realise the importance of distinction between capital and revenue items inasmuch as any error committed on this account will lead to mistake in preparing final accounts.

What is Revenue expenditure ? It is an expenditure which organisation incurs to enable it to carry on its day to day activities. It is basically intended to benefit the organisation in its normal operation in a short period, basically a years time. Thus basically any expenditure which benefits the organisation only for current period (and not for long period) is termed as revenue expenditure. Examples of revenue expenses are :

i. Expenses incurred for manufacturing operation like buying of raw material, spare parts, components, accessories, utilities, spares, fuels, etc.

ii. Expenses incurred to maintain the economic life of the assets with the help of which activities are undertaken by the organisation e.g., normal repairs & maintenance, consumables like

--- 23

greese, oil, insurance premium paid for safety of such assets etc.

iii. Expenses incurred for the operation of the factory like its rent, rates & taxes, security charges, maintenance charges, wages to workers & other staff, license fee etc.

iv. Cost of goods purchased for resale.

v. Depreciation on fixed asset, interests on loan for business etc.

vi. Expenses of administration like office rent, rates, taxes, salary to staff, travelling exp, Printing & Stationery etc.

vii. Sales expenses like commission on sale, distribution cost, freight on goods sold etc.

What is Capital expenditure ? Capital expenditure is an expenditure which is expected to benefit the organisation for a long period of time in carrying out its activities. It means it is incurred to get benefit for future periods, in contrast to a revenue expenditure, which benefits only current period. From the above definition it follows that normally capital expenditure refers to expenditure on those items which last for a long period and business avails its utility over future years. This is possible when money is spent in buying those goods and services which are of long term in nature. One

look at the balance sheet shows that such item could only be fixed assets utilized by the business for a number of years to earn revenue. Thus we can infer that capital expenditure means an expenditure which :

I) Increases the quantum of fixed assets

II) Helps in replacement of worn out assets and

III) Improves the quality of fixed assets

Increase in Quantum: I] Addition to fixed

assets like purchase of land, construction of building, purchase of plant etc. increases the quantity of fixed assets. Hence amount spent on the purchase of such fixed asset is treated as capital expenditure. Note :It is to be noted

that all expenditure like custom duty, octroi, freight, loading/unloading charges, expenses on erection etc. incurred in connection with the purchase, receipt or erection of a fixed asset are to be aggregated and added to the purchase price

--- 24

of the assets to ascertain its total cost. For this purpose it is immaterial whether company spends actual sum on such expenses or utilizes its own resources (like labour) for it.

II] Replacement means

acquiring new assets or parts thereof on account of decreased utility of existing assets [or parts thereof ]. This could also happen due to modernization of or change in the production process.

The note of para [I] above equally applies to replacement of fixed assets.

III]Improvement in quality

of fixed assets takes place when expenditure is incurred :

(a) To increase the useful life of the fixed asset ; e.g. Old dilapidated factory building is restored / renovated by undertaking heavy repairs exp

(b) To increase the production /

service capacity of the fixed asset ; e.g. by installing some balancing equipment, overall capacity of the plant is increased.

(c) To increase the efficiency of the fixed asset; e.g. here the rated production capacity of the plant increases. Say earlier plant was producing 100 pieces of bathing soap in one minute, but after expenditure is incurred, the rate of production increases to 120 pieces per minute.

(d) To improve the operating economy of the asset; e.g. here the rated production capacity of the plant remains the same but cost of production decreases due to reduction in the rate of consumption of raw material or increase in the production speed so that the same amount of overheads are spread over larger quantum of production.

--- 25

It is to be further noted that whether an expenditure is revenue or capital expenditure should be decided purely on the basis of benefit which is likely to accrue there from. It means benefit should accrue for a long period. It is not dependent upon :

1. the amount of expenditure (i.e. quantum)

2. the time of payment of such expenditure

3. the mode of payment, whether paid in lump sum or in instalment.

4. the amount is paid out of sale of fixed assets or out of funds raised from long term sources like share capital, term loan, debentures etc.

However, keeping principle of materiality in mind, normally any expenditure of say less then Rs.5000/- may be treated as revenue expenditure although benefit may accrue for a long period out of such expenditure. Even under the Income Tax Act. 1962, such expenditure are tax deductible

Capital and revenue

receipts:

As it is necessary to distinguish between capital and revenue expenditure, in the same way it is necessary to make a proper distinction between capital and revenue receipts. Capital receipts are shown in the Balance Sheet as liabilities whereas revenue receipts are shown in the Profit & Loss account as income of the current period. Money received from the sale of fixed asset, or money raised by issue of shares, debentures or obtained by way of term loan are example of capital receipts. Moneys obtained in the course of business are revenue receipts. Examples are: money obtained from sale of goods, interest on deposits, dividends or investments. However, some of the items of receipt like subsidies or grants received from government or such other authorities (which are non-refundable) should be carefully classified either as

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capital receipt or revenue receipt depending upon the terms and conditions of such receipt and/or benefit going to accrue out of such income.

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A short Note : (This note is to serve as a

guiding factor and is not to be

considered as an exhaustive

one. Please refer to recommended books on the

said subject for a detailed

reading on the topic)

Revenue Recognition

Revenue recognition is fundamentally based on the three assumption of accounting concept: 1. Accrual 2. Going concern 3. Consistency Revenue of an organisation originates from : ( A) 1. Sale of goods _( TV,

Garment, furniture etc) 2. Rendering of services

(hotels, telephone, laundry etc)

3. others income like (a) interest

(b)Dividend

(c) Royalty

(d) Copy right etc.

4. Revenue from Hire Purchase, Lease agreement.

5. Revenue from government grant and subsidies.

6. Revenue from insurance contracts.

7. Revenue from construction contracts.

(B) other types of revenue

arises: [1] Appreciation in the

value of Fixed assets [land and building)

(2) Appreciation in the value of Current assets (Animals, Forest products, agriculture produce)

(3) Changes in foreign exchange rate [ say depreciation of rupee ] when goods have been exported in the past but payment is received after such devaluation.

(4) Paying less than for an obligation amount [ when rupee appreciates and loan is repayable in foreign currency ]

When revenue should be recognised? (1) In Case Sale Of Goods

(a) Sale of goods:

[i] Revenue is recognised when transfer of property in goods takes place between seller and buyer. Usually such transfer of property coincides with transfer of significant risk and reward of ownership from seller to the buyer. Some time transfer of property does not coincide with transfer of reward and risk. It may arise when either buyer or seller

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commits default in respect of delivery of goods as per terms of contract. In such a situation risk remains with the party (either buyer or seller) which commits default. Some time party may agree that risk will be transferred at some different time.

e.g.: Insurance for overseas journey. Here risk starts only when outward journey starts although customer might have paid premium in advance and contract is entered into.

(ii) All term of contracts are

agreed upon by both parties who also agree to honour their commitments of agreed time.

(iii) Time and mode of

payment / delivery of goods is immaterial.

(2) In Case of Sale of Services:

In case of contract for services, revenue is recognised under two distinct method : (a) Completed service

contract method : It is a method of accounting under which revenue is recognised only when contract is completed.

e.g. :Painting of portrait. Services rendered by hotel or by STD booth

(b)Proportionate Completion

method:

Under this method of accounting , revenue is recognised proportionately with the degree of completion of services.

e.g. : An artist working in a movie. (3)Forward contract:

Forward contract, as opposed to existing or current contract, are those contracts in which both seller and buyer agree to do something in future time as per the terms and conditions agreed now. This is so because it takes time to produce goods as per the specification of the buyer. e.g. in industries like mining or agriculture crops, forward contracts are entered into for supply of such goods at future dates. In such cases when these items are substantially ready, and there is negligible risk of non performance of sale contract then revenue may be recognised say by way of closing stock. Otherwise revenue should be recognised when goods are ready as per the requirement of buyers, they are in deliverable conditions and buyer has shown his intention to take the delivery of the same.

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Revenue Recognition in respect of Other Income: (a) Interest: it accrues on time

basis, hence interest income is recognised on time basis irrespective of agreed date of payment.

(b) Dividends: it should be

recognised only when right to receive it is established e.g.: when dividend is approved in AGM & not when it is declared by the board. However interim dividend, the income should be recorded on receipt basis .

(c) Royalty: In accordance

with terms of agreement when any of the above income is receivable from foreign country then sometimes you need to take exchange permission from government . in such cases revenue should be recognised only when such permission are received.

Effects of uncertainty in respect of revenue recognition : Revenue should be recognised only when there is certainty about its receipt irrespective of the fact whether exact quantum thereof is known or not. When uncertainty exist about amount only, then reasonable estimates may be made about such amount provided there is certainly about its receipt. But

when there is uncertainty about its receipt itself, then revenue should be recognised only when such uncertainty is removed . e.g. subsidies & grants from government authorities may be recognised only when our claim is accepted by the authorities. When uncertainty about realisation of revenue arises at a stage subsequent to making of sale we should not reverse the Revenue Entry rather we should make a provision of loss on the basis of such uncertainty Revenue which is not recorded at first stage due to uncertainty about its receipt, should be recorded subsequently when uncertainty about its receipt is eliminated. Some Illustration: [ as to when ownership passes / revenue

should be recognised ] (1)Delivery is delayed at buyers request but bill is accepted:

by buyers and goods are ready for delivery and they are identifiable. Here delivery should be recognised irrespective of the fact that delivery is delayed at the request of the buyer.

(2)Goods are to be delivered subject to some condition:

sometimes goods are sold subjected to inspection, testing, etc .here revenue should be recognised only

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when customers has inspected /tested the goods and accepted the delivery.

(3)Goods Sold on Approval:

Revenue should be recognised only when approval of the buyer is received.

(4)Subscriptions for Magazines

Revenue should be recognised on time basis, that is revenue with respect to issues not delivered should not be recognised

(5)Sale on Instalment Basis

In case of sale on instalment basis, revenue includes sale price of the goods sold plus interest for credit granted. Therefore revenue in respect of sale of goods should be recognised on the date of sale. However, revenue related to interest, income should be recognised when they become due and payable by the customers

(6) Commission & Brokerage:

Commission and brokerage are recognised as revenue when the parties (from whom they are earned/receivable) enters into legal contract and services are fully rendered to earn such revenue. Time of receipt of payment is immaterial.

[7] Advertising commission

It should be recognised when the advertisement prepared is released for public view and media confirms about the same. However, revenue in respect of preparation of such advertisement may be recognised when the production is completed and preview of the same is approved by the client.

[8]Insurance Income:

It should be recognised when full premium as per agreed terms are received and the risk commences.

[9] Entrance & Membership fee

Normally entrance fee (say of club or association) is normally considered as Capital Receipt (although they are received by the organisation frequently]. Membership fee is however normally considered as revenue receipt They should be recognised when they are due for payment by the member. However, exact time of revenue recognition will depend upon the services which are to be rendered to the members and the degree of their realisation from members..

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1 Short Notes:

(i) Return on Investment, (ii) Debt - Equity Ratio and (iii) Stock Turnover Ratio. (Marks 5) (i) Return on Investment : The overall performance of a business is judged by this ratio which is a measure of relationship between profit earned and capital employed. It ascertains how much income the use of Rs. 100 of capital generates. The ratio is expressed as %. It is calculated as: Profit before interest and tax x 100 Capital employed Where capital employed = Share capital + Reserve + Long term loan - Fictitious assets and non-operating assets. ROI is a fair measure of the profitability of any concern which also helps in comparing performance efficiency of different industries. (ii) Debt Equity Ratio : This ratio indicates the relationship between shareholders funds and long term liabilities. Shareholders funds include equity and preference share capital, reserves less fictitious assets. It is computed as : Long term debts Shareholders funds The ratio is calculated to ascertain the long term financial soundness of business. It indicates the extent to which business depends upon outsiders. It discloses the firms ability to meet its long term obligations. The lower the ratio, the better for the firm. (iii) Stock Turnover Ratio : This ratio gives the relationship between cost of goods sold during a given period and the average amount of inventory during that period : Cost of Goods Sold

Average stock where, cost of goods sold = Opg stock + Purchase + Direct Exp. - Cl. stock The ratio indicates whether stock has been efficiently used or not. The purpose is to keep only the required minimum invested in stock. Higher the ratio the better as it indicates that more sales are produced by a rupee of Invest in stock. In directs the management attention to control excess investment in stock and helps reduce storage cost.

2. What is meant by analysis of financial statements? Briefly explain vertical analysis.? Analysis of financial statement is a systematic process of evaluating and establishing relationships between different components of financial statements to better understand the performance of the firm. It determines the meaning of the information disclosed in the financial statement of have complete results regarding profitability and financial position of the firm. Vertical analysis is the analysis of financial statements of an enterprise for one particular period. Thus, the interpretation of balance sheet at the end of the accounting period is vertical analysis.

3. What are the alternatives available to a company for the allotment of debentures when there is over-subscription of debentures? (Marks 3) Ans. In case of over-subscription of shares : (i) The company may reject same applications, i.e the application money received is returned back. (ii) It may not allot any share to some applicants, whereas it may make pro-rata allotment to other applicants. (iii) It may not allot any share to some applicants, full allotment may be made to some other applicants and pro-rata allotment may be made to the rest.

4. Briefly explain the meaning and significance of any two of the following ratios : (i) Debt to total funds ratio; (ii) Debtor's turnover ratio and (iii) Net profit ratio. (Marks 5) (i)Debtors Turnover Ratio : This ratio indicates the relationship between net credit sales and average trade debtors = Net credit sales Average Trade Debtors

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The debtors are gross, i.e. before adjusting for provision for bad debts. The ratio helps to evaluate efficiency in management regarding collection of amount from debtors. Higher the ratio, the more prompt is collection from debtors. (ii)Net Profit Ratio : It is a measure of relationship between net profit and net sales. It is calculated as : Net Profit x 100 Net sales The term net profit means net profit before tax or after tax. It is a measure of operational efficiency of the enterprise. It also indicates proportion of sales available to management for payment of dividend and creating reserves for future growth. Higher the ratio, the better is the firms capacity to withstand economic risks and adverse conditions. (iii) Debt. to total funds Ratio = Long term debts/(Long term funds + Shareholders funds) Long term funds + Shareholders funds = 600000 + 500000 + 300000 + 100000 = 1500000 ... Debt to total funds ratio = 600000/1500000 = 2 : 5

5 Intro to Fundamental Analysis The massive amount of numbers in a company's financial statement can be bewildering and intimidating to many investors. On the other hand, if you know how to read them, the financial statements are a gold mine of information. Financial statement analysis is the biggest part of fundamental analysis. Also known as quantitative analysis, it involves looking at historical performance data to estimate the future performance. Followers of quantitative analysis want as much data as they can find on revenue, expenses, assets, liabilities, and all the other financial aspects of a company. Fundamental analysts look at this information for insight into the performance of in the future. They don't ignore the company's stock price; they just avoid focusing exclusively on it.

Before we learn different ways to estimate future performance, it is important to understand the basics of the financial statements (both quarterly and annual

reports).

6 Explain briefly the factors which a company should consider while

planning its capital structure. Ans. A brief explanation of factors taken into consideration while planning the capital structure :- (any seven)

1. Trading on equity 2. Stability of sales 3. Cost of capital 4. Cash flow ability 5. Control 6. Flexibility 7. Size of the company 8. Market condition

(1/2 mark for each point + 1/2, mark for

7 Explain briefly the steps involved in the process of financial planning. Ans. Process of financial planning includes the following steps : (a brief explanation of each point) 1. Estimating the amount of capital to be raised. 2. Determining the form and proportionate amount of securities to be issued. 3. Formulating policies for the administration of capital. (If an examinee conveys suitable meaning in any format, full credit should be given.)

8 State any three advantages of debenture issue as a source of finance. Ans. Any three advantages of debentures issued as a source of finance :- 1. The cost of servicing the debenture is lowest. 2. It is a tax deductible expense. 3. No risk of loss of control due to absence of voting right. 4. It leads to trading on equity/flexibility in financial operations. 5. Fixed rate of interest even if rate of earning is high.

9 Explain any three effects of under-capitalisation on a company. (1*3=3 marks) Ans.Any three effects of under capitalisation on a company :- 1. The market value of shares goes up since earnings are high. 2. Secrets reserves are built up. 3. Government interventions in the form of higher taxes.

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4. The high rate of earning may encourage outsiders to enter the field and increase competition. 5. The employees demand higher salaries and wages and this leads to dissatisfaction and labour tension.

10 What is financial planning? Explain, in brief, the role of financial planning in the management of finance. 6 marks Ans. Financial planning : Its meaning should include the following points : 1. Estimating the amount of capital. 2. Determining the composition of capital. 3. Determining the objectives, procedures, programmes and budgets to deal with the financial activities. 4. Formulating policies for the administration of capital.

Role of Financial Planning in Management of Finance The following points should be explained in brief : 1. Optimum availability of funds. 2. Ensuring co-ordination between different functional areas of business. 3. Effective financial control.

11 What are the principal sources of long-term finance for a business enterprise? Explain Ans. Principal sources of long-term finance. Any three of the following sources with explanation : 1. Equity share capital 2. Preference share capital 3. Retained earnings 4. Debenture capital 5. Term loans 6. Public deposits