Finance for the non finance managers

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What is Finance

“79 per cent of the top CEOs rate Finance skills as the most required

for the CEO of the future in a KPMG survey.



Companies do not work in a vacuum, they interact and transact with the other entities present in the economic environment. Finance grew out of economics as a special discipline to deal with a special set of common problems.

The reason for the existence of a company is to increase the wealth of its owners. In order for it to be able to do so, there is need for financial management to concern itself with the financial decisions.

And to take financial decisions, there is requirement for information.

Accounting is the system that provides this financial information.

“Accounting is the art of recording, classifying, and summarizing in a significant manner and in terms of money, transactions and events which are, in part at least, of a financial character, and interpreting the results thereof.”

Figure 1.....

FINANCIAL ACCOUNTING is a formalized system designed to record the financial information of the company. Basically, it deals with the past performance of the company. It provides information to the decision makers who are external to the organization.

MANAGERIAL ACCOUNTING provides financial information that might be used for making better decisions regarding the future. This information is usually reserved for internal decision makers.

Goals of Financial Management

What are the goals of financial management?

The goal is to

▪ Maximize Profits or

▪ Maximize Shareholder’s wealth

But this maximization of company’s profit isn’t just the bottom line, since corporate environment has other goals — increase of sales, increase of market shares, increase in growth rate of sales and, of course, rise in salary and perks.

Figure 2......

Profitability

Maximizing profits is the ultimate aim of a company. In maximizing those profits there is always a trade-off with risk. The greater the profit, the greater the risk involved. Given a choice of two equally risky projects, one would normally choose the one with a greater anticipated return.

Figure 3.....

(Audio clip) It is evident from the figure that Project A is a better choice than Project B since anticipated return is better in Project A.

Survival

Companies hardly wish to go bankrupt. So ensuring financial viability is one of the crucial goals of financial management. Figure 4.....

LIQUIDITY is simply a measure of the amount of resources a company has, that are cash or are convertible into cash.

SOLVENCY is simply the same concept from a long-term perspective. The company must plan for adequate solvency well in advance as it takes a long period of planning to generate large amount of cash.

The more profitable the finance manager attempts to make the company by keeping it fully invested, the lower the liquidity and the greater the possibility of a liquidity crisis and even bankruptcy. The more liquid the company is kept the lower the profits. This is a balancing act that the Finance Manager has to perform.

Figure 5 .....

(Audio clip) Profitability and liquidity vary inversely. Profitability normally increases at the expense of liquidity and vice versa.

Generally Accepted Accounting Principles

Generally accepted accounting principles (GAAP) provide firms with a great deal of latitude in the preparation of key financial statements used to measure performance. These are used as a guide in accounting and as a basis of practice.

1.Accounting Entity assumption

Under this assumption, an accounting entity is held to be “separate and distinct from its owners.” In other words, according to this assumption, the business and its owners are considered two separate and distinct entities. All the transactions of the business are recorded in the books from the point of view of the business and not from the point of view of the proprietor.

2. Going Concerns

The underlying assumption is that the undertaking will last for a long time. In other words, it is assumed that the business will exist for an indefinite period of time, and transactions are recorded from this point of view.

Fear of not remaining a going concern requires the auditor to indicate the same in his report. If a company goes bankrupt, its resources may be sold at forced auction, even at a lower value than reported in the financial statements.

Figure 9 .......

3.Conservatism

The essence of this principle is “anticipate no profit, and provide for all possible losses”. This requires that sufficient attention and consideration is given to the risks taken by the company. It takes into consideration all prospective losses and does not consider prospective profits till they are received.

Figure 10 .....

4.Matching

The Matching principle provides the guidelines as to how the expense be matched with revenue. For matching expenses with revenue, first revenues should be identified and then costs associated with these revenues should be identified. Thus, it takes into account the basis of depreciation.

Example: A machine is purchased with an expected 5-year life. Charging the full amount paid for one machine as an expense in the year of purchase itself would make a big dent in the profitability position. This is because the machine should provide service for all 10 years, giving products and profits in each of the years.

Figure 11.....

5.Cost

The cost of an item is what was paid for it, or its ‘historical’ value. Thus, it is an expenditure, which is incurred in acquiring an asset or service. This expenditure is treated as an asset if it is useful in future. It is treated as expense if it has expired.

Figure 12.....

6. Objective evidence

Objectivity principle holds that accounting should be free from personal bias. It means that all accounting transactions should be evidenced and supported by business documents.

Therefore, this rule requires accountants to ensure that financial reports are based on such evidence as reasonable individuals could agree on within narrow bounds.

Figure 13.....

7. Materiality

The principle of materiality emphasizes the fact that accounting records should consist only of such events as are significant from the point of view of income determination. This requires the accountant to correct errors that are “material” in nature. Material means large or significant. Therefore, errors that are material in nature ought to be eliminated.

Figure 14......

8. Consistency

This principle holds that accounting procedures or practices should remain the same from one year to another. If a company changes its accounting methods, the auditor must disclose the change in his or her report. The impact of the change should also be notified.

Figure 15 .......

9. Full disclosure

To protect against unforeseen situations that may arise, there is a generally accepted accounting principle called “full disclosure”. This principle specifies that there should be complete and understandable reporting on the financial statements of all significant information relating to the economic affairs of the entity. Less applicable to India, as in developed countries.

Basic Terms

Assets

Resources owned by the company represent the company’s assets. An asset is anything with economic value, helping the company to provide goods and services to its customers. Money owing by debtors, stock of goods, cash, furniture, machines, buildings etc. are a few examples of assets. Assets are either ‘Fixed assets’ or ‘Current assets’.

Figure 6.....

Liabilities

Liabilities, from the word ‘liable’, represent the company’s obligations to outside creditors. Thus, the claims of those. who are not owners are ‘liabilities’. Liabilities are either ‘long-term’ or ‘current’ liabilities.

Figure 7 .....

Shareholder’s Equity

Equity represents the value of the company to its owners.

The value of a company owned by an individual proprietor is referred to as owner’s equity. The value owned by the partner in the company is known as partner’s equity. For the company, we talk of this value as shareholders’ equity.

Debits and Credits

A debit balance denotes one of the following:

• Money owing to the firm by a person.

• Firm owns property or asset totaling the relevant amount, or

• Firm has incurred loss or expense.

A credit balance will show one of the following:

• Money owing to the person concerned.

• Firm has earned an income.

In accounting, the general tradition followed is as follows:

• Increases in assets are recorded on the left-hand side and decreases in them on the right-hand side; and

• In the case of liabilities and capital, increases are recorded on the right-hand side and decreases on the left-hand side.

When the two sides are put together in T form, the left-hand side is called the ‘debit side’ and the right-hand side is the ‘credit side’. Abbreviations have been introduced for common accounting usage, like Cr. (credit) or Dr. (debit).

The Accounting Equation

| |

|Assets = Liabilities + Shareholders’ Equity |

Example:

If you were to buy a house for Rs 2,00,000 by putting down Rs 40,000 of your own money and borrowing Rs 1,60,000 from a bank, you would say that your equity in the Rs 2,00,000 house is Rs 40,000.

As in the case of above example: FIG…

2,00,000 = 1,60,000 + 40,000

The left side of this equation represents the company’s resources. The right side gives the sources of cash used to buy these resources. After defining the assets and liabilities, the shareholder’s equity is merely the residual value (Audio Clip)

Shareholders’ equity (E) equals equity capital (E), which includes reserves & surplus (R&S).

So, A = L + E

Net income consists of revenue (R) less expense (E).

Revenues (R) make owners better off and expenses makes owners worse off. Therefore their effect would be directly on shareholder’s equity (E) in the above equation.

Recording of Financial Information

Accountants record the day’s events in a journal, referred to as a General Ledger (GL).

To ensure that all elements of a financial event are recorded, accountants use a system called Double-Entry Book Keeping.

(Audio clip)

The term double entry signifies that it is not possible to change one number in an equation without changing at least one other number.

Example:

An accounting equation looks like:

A = L + E

2,00,000 = 1,60,000 + 40,000

20,000 = 20,000 (Returned Rs. 20,000 to bank reduces both cash & Liability)

1,80,000 1,40,000 + 40,000

Now if you purchase raw material inventory for Rs. 15,000 and pay cash for it.

You’ll see that the equation does not change.

A = L + E

Rs 1,80,000 = Rs 1,40,000 + Rs 40,000

+ 15,000 Raw Material

- 15,000 Cash (This is because value of one asset is increased and the other asset is decreased)

Valuation of Assets and Liabilities

Example:

Consider you brought a car three years ago for Rs 2,00,000. Today it might cost Rs. 2,40,000

So, Is your car worth Rs. 2,00,000 or Rs. 2,40,000?

Now your old car is no longer new so its value may be lost by 60%.

So it’s worth Rs 80,000.

However, due to inflation, you could sell the car for Rs. 1,40,000.

So is the value of your car Rs. 1,40,000 at present?

How do you value your car or your asset?

Figure…

Valuation of Assets

There are various methods used to value assets such as:

A. Historical Cost: According to this method,

• Assets are valued in relation to the past.

• The information is verifiable.

Drawback:

• Often information is outdated.

• Does not state clearly the present worth of assets.

Example:

Let’s suppose that years ago Indian Railways bought land at a cost of Rs 10 per acre (Believe us, that’s possible for government companies). Suppose that 1,000 acres of that land runs through the downtown of a major city. Today, Indian Railways has to determine the value at which it wishes to show that land on its current financial statements. The historical cost of the land is Rs 10,000 (Rs 10 per acre multiplied by 1,000 acres). Accountants are comfortable with their objective evidence. If the land cost Rs 10,000 and the company says it cost Rs 10,000, then everyone gets a fair picture of what the land cost. However, accountants don’t clearly state that the Rs 10,000 figure appearing on the balance sheet represents the cost rather than the current value of the land. One might well get the impression from the balance sheet that the property is currently worth only Rs 10,000. In fact, today that land might be worth Rs 10,00,000 (or even Rs 1,00,00,000).

B. Net Realizable Value: According to this method,

• Assets are valued in relation to present, value that they can fetch in the market.

• Packing costs and other similar expenses would be reduced in the amount expected, to obtain the net value.

Drawbacks:

• Based on someone else’s estimate of what the asset could be sold for.

• Another problem is that an asset may not have a ready buyer.

• Poses a problem from an accountant’s point of view also, as it does not confirm to GAAP.

Example: In the Indian Railways scenario as above, the Net Realizable Value would be Rs 10,00,000 or Rs 1,00,00,000

C. Future Cash Flows: According to this method,

• Assets are valued in relation to future.

• It requires the expertise of the company’s own management to assess cash flows.

• Unfortunately, none of these methods satisfy the information needs.

D. Replacement Cost: Here,

• Assets are valued in relation to its replacement value as it is hard to know the cost of an asset with its similar performing parameters.

Drawbacks:

• Does not provide objective evidence.

• Difficult to use when determining numbers reported on the financial statements.

Valuation of Liabilities

In general, our liability is simply the amount we expect to pay in the future.

For instance: If we borrow Rs. 7,000 from a bank today and have an obligation to pay Rs.10, 000 to the bank three year’s from today.

Is our current liability Rs. 10,000? No, as the bank charges interest for the use of their money and the interest accumulates over the three years, if it is payable at the end of the three-year period along with the principal amount. Usually, however, banks fix EMIs (Equated Monthly Installments) which amortize the capital + interest over the period of the term loan.

If we are to pay Rs. 10,000 in three years, it implies that Rs 3,000 of interest will, theoretically, be amortized over that three-year period, such as,

7,000 ( liability 3,000 ( Interest 10,000 ( To be paid in three years

Hence our liability would be limited to Rs. 7,000 as of today, but as we make use of the money the interest might accumulate, if so stipulated in the loan Terms & Conditions, so that the liability increases, and at the end of three years, the liability of Rs. 10,000 falls due for payment, i.e. from a deferred liability, it becomes a current liability.

Valuation of Shareholders Equity

Once the value of assets and liabilities has been determined, the shareholders’ equity is whatever it must take to make the equation balance.

Example:

Assets (A) = Liabilities (L) + Shareholder(s) equity (E)

10,000 = 7000 + Shareholders’ equity

Therefore; Shareholders’ Equity = 3000

Quiz: Judge the right valuation

Understanding Cash - Flow Statements

| |

|A cash-flow statement shows where the company’s cash came from (sources of cash) and where it went (uses of cash). |

Figure 1.....

• Cash flows from operating activities are primarily the cash effects of day-to-day revenue and expense transactions that are included in the Profit & Loss A/c.

• Cash flow from the investing activities is the cash effect of purchasing and selling long-term assets such as plant and equipment etc.

• Cash flow from financing activities are cash effects of transactions involving liabilities and shareholders equity.

Understanding the concept of cash flow Statement

• Cash flow starts with profit from operations taken from the Profit & Loss A/c.

• Depreciation and interest expense are added back to generate cash from operation figure.

• Increase and decrease in working capital are part of the operating activities, the net changes are therefore reflected.

Uses of cash flow Statement

• It forecasts the future cash flows, management can use it to predict where cash is most likely to come from and go to next year.

• Shows the company’s owners and creditors, and how much management invested last year in new equipment and facilities.

• Confirms whether a company has enough cash available to pay interest to bondholders, and dividends to stockholders.

Cash flow from operations

• This section shows how much cash came into the company and how much went out during the normal course of business.

• Generally Accepted Accounting Principles (GAAPs), as well as logic, dictate how adjustments are made on the cash flow statements and whether they have increased or decreased the company’s supply of cash.

• *The increase in the ‘notes receivable’ balance also signals a reduction in cash.

• *A decrease in accounts payable balance also decreases cash, because you’ve used funds to settle liabilities, hence reduction in the overall balance in the account.

|Cash flows from operations: | | |

|Net income | |1,509,601 |

|Adjustments to reconcile net income to net cash | | |

|Increase in accounts receivable |(221,275) | |

|Decrease in inventories |940,000 | |

|Increase in notes receivable* |(30,000) | |

|Decrease in accounts payable* |(202,500) | |

|Depreciation on equipment |477,750 | |

|Net cash provided by operations | |2,473,576 |

• Since depreciation on equipment didn’t physically decrease the company’s cash balance, accounting rules call for it to be shown as an inflow of cash from operations.

Cash flows from investing activities

|Cash flows from investing activities: | | |

|Purchase of property and equipment |(20,80,695) | |

|Proceeds from sale of equipment | 1,60,000 | |

|Net cash used for investing activities. | |(19,20,695) |

• Cash may come in or go out because of various investing activities that aren’t connected to business as usual.

• The investment in property and equipment is an investment in the company’s future; it should enhance its competitive position.

• Inflow from ‘equipment sale’ is minimal. It is a good sign, since it shows that unlike some cash strapped companys; this company hasn’t been forced to sell off equipment to cover expenses.

• A company that is forced to sell off equipment to cover expenses is like a sinking ship.

Cash flows from financing activities

|Cash flows from financing activities | | |

|Sale of common stock |25,000 | |

|Sale of bonds |65,750 | |

|Cash dividends paid |(50,000) | |

|Net cash inflow from financing activities | |40,750 |

• A company that has to rely on financing activities to satisfy most of its cash requirement is headed for trouble.

• Healthy companies are able to meet their normal cash requirements through operations.

• Long term financing should be used for long-term use, e.g. for acquiring new machinery, equipment or facilities, never to pay daily business bills.

Points to Remember

1. A negative cash flow from operations means that the company failed to meet its cash needs.

2. The cash flow statement reconciles a company’s cash balance from one year to the next.

3. While depreciation is deducted on the income statement to come up with net income, it doesn’t decrease the company’s cash.

4. Note the figure of company’s investment in its operations.

For preparing a statement remember that:

• If there is an increase in assets, cash must have gone out

• An increase in liability will also mean that, to that extent cash must have come in;

• A reduction in assets should mean, that part of the asset was realized in cash;

• A reduction in liability means that, to that extent cash has been utilized.

Format- Have a glance

Super Industries

Cash Flow Statement

For Year Ended December 31, 1999

|Cash flows from operations: | | |

|Net income | |15,09,601 |

|Adjustments to reconcile net income to net cash | | |

|Increase in accounts receivable |(2,21,275) | |

|Decrease in inventories |9,40,000 | |

|Increase in notes receivable |(30,000) | |

|Decrease in accounts payable |(2,02,500) | |

|Depreciation on equipment |4,77,750 | |

|Net cash provided by operations | |24,73,576 |

|Cash flows from investing activities | | |

|Purchase of property and equipment |(20,80,695) | |

|Proceeds from sale of equipment |1,60,000 | |

|Net cash used for investing activities | |(19,20,695) |

|Cash flows from financing activities | | |

|Sale of common stock |25,000 | |

|Sale of bonds |65,750 | |

|Cash dividends paid |(50,000) | |

|Net cash inflow from financing activities | |40,750 |

|Net increase (decrease) in cash | |5,93,631 |

|Cash balance, December 31, 1998 (last year) | |6,77,600 |

|Cash balance, December 31, 1999 (this year) | |12,71,231 |

Understanding Income Statement

An income statement is an accounting statement that summarizes a company’s sales, the cost of goods sold, expenses, and profit or loss. This is often called a “consolidated earnings statement.

Figure 1.....

Income statements are also produced for a month or a quarter. The quarterly statements keep the stockholders updated about company’s performance between two annual reports.

Figure 2.........(Audio clip to explain the flow-chart)

(Audio clip)

“So it looks like:

(i)Net Sales- Cost of goods sold= Gross Profit

(ii)Gross Profit- Operating expenses=Earnings before income tax

(iii)Earnings before income tax- Income tax= Net Income (or Net loss)”

For a detailed income statement, accounting department and management information systems would compile detailed information in categories like:

• Gross sales, sales returns and allowances, and sales discounts that went to produce net sales.

• Information about the methods that were used to value inventory and depreciation on machinery and equipment.

• Individual balances for each of the selling and general-and-administrative expense accounts.

What does Accounting Mean?

Accountants use jargon that you can understand by referring to the following points:

• ‘Revenues’ and ‘sales’ are synonymous. (Accountants prefer ‘Revenue’ as it sounds more impressive).

• ‘Profit’, ‘net income’, and ‘earnings’ all refer to how much money the company made.

• ‘Inventory’, ‘merchandise’, and ‘good’s are material the company bought, and which it intends to sell to customers for profit.

• For accountants, an income statement is a ‘profit and loss’ statement, as it shows whether the company has made profit or loss.

• Lists or summaries of things like expenses or equipment are typically referred to as ‘statements’ or ‘schedules.’

• (Audio clip)” Thus, Accounting is the art of recording, classifying and summarizing in a significant manner and in terms of money, transactions and events which are, in part at least, of a financial character, and interpreting the results thereof”.

Understanding the concept of Income Statement

The following Income statement would explain the concept.

Super Industries

Consolidated Income Statement

For Year Ended December 31, 1999

|Net Sales | | |3,80,28,500 |

|Cost of goods sold: | | | |

|Inventory, January 1 | |41,90,000 | |

|Purchases (net) | |2,54,18,500 | |

|Goods available for sale | |2,96,08,500 | |

|Less inventory, December 31 | |32,50,000 | |

|Cost of goods sold: | | |2,63,58,500 |

|Gross profit | | |1,16,70,000 |

|Operating expenses | | | |

|Selling: | | | |

|Sales salaries expense |19,91,360 | | |

|Advertising expense | |35,27,650 | |

|Sales promotion expense |9,87,745 | | |

|Depreciation expense — selling equipment |4,03,850 |69,10,605 | |

|General and administrative: Office salaries expense |11,24,650 | | |

|Repairs expense |1,12,655 | | |

|Utilities expense |39,700 | | |

|Insurance expense |48,780 | | |

|Equipment expense |63,750 | | |

|Interest expense |2,11,020 | | |

|Misc. expenses |6,50,100 | | |

|Depreciation expense — office equipment |73,900 |23,24,555 | |

|Total operating expenses | | |92,35,160 |

|Earnings before income tax | | |24,34,840 |

|Income tax | | |9,25,239 |

|Net Income | | |15,09,601 |

|Common stock shares outstanding: | | |25,00,000 |

|Earnings per share of common stock: | | |0.60 |

Net sales: This is what was really sold after customers’ ‘returns’, sales discounts, and other allowances were taken away from gross sales. Companies usually just show the net sales amount on their income statements and don’t bother to show ‘returns’.

Cost of goods sold: On January 1 there were goods the company started the year with, but bought lots more to resell during the year. The details such as purchases, returns and allowances may be omitted, so just the net amount of purchases shows up on the statements.

New purchases are added to beginning inventory to get the amount of goods available for sale. But it has inventory of goods still on the shelves on December 31. When that ending inventory is subtracted from goods available for sale, you get the cost of goods sold.

Gross Profit: This is the profit made by the company before expenses and taxes are taken away.

Operating expenses: This section of the income statement adds up how much money was spent to run the company in the given year.

• Selling Expenses includes everything spent to run the sales end of the business, like travel, meals and lodging for salespeople, and advertising etc.

• General- and-administrative expenses are the total amount spent to run, the non-sales part of the company. These expenses included rent, office salaries, interest on loans, and depreciation etc.

Figure 4..........

Earnings before income tax: This is the profit of the company before it pays income tax.

Income Tax: This is what the company pays the Income Tax Department, if it wants to stay in business.

Net Income: Is the profit made by the company after all the dust settles. Losing money would be a ‘Net loss’.

Earnings per share: This shows the income available for distribution to the shareholders. It is derived by dividing the net income after tax and other provisions, by the number of shares subscribed by the investors in the company.

Points to Remember

• Don’t look for details on an income statement, account balances are often condensed and summarized.

• It is of paramount importance to read the ‘Notes’ in an annual report.

• An income statement covers a period of time. By subtracting various operating expenses from sales, the ‘bottom line’, or Profit, is revealed.

• ‘Revenue’ and ‘Sales’ are synonymous. So are ‘net income’, ‘Profit’ and ‘earnings’.

• Gross profit is sales minus cost of goods sold.

• Net profit is gross profit minus expenses and taxes.

Now about notes

Every annual report has several pages of notes at the end. Here is what the notes reveal:

1. Notes reveal information about lease contracts for facilities or office equipment that the company has agreed to pay for the next few years.

2. Notes even disclose if the company has been named as a defendant in any product liability, environmental pollution or patent infringement law suits.

3. These notes even discuss what amount of the potential loss is covered by insurance, and whether losing any outstanding insurance claims case would have a “material adverse affect” on the company’s financial condition.

Understanding Balance Sheets

The Balance Sheet indicates the financial position of a company at a particular point of time. Basically, it illustrates the accounting equation on a specific date; that date being the end of the accounting period. In other words, a balance sheet shows assets (what the company owns) and sets them equal to its liabilities (what the company owes) plus the owner’s equity in the business.

A balance sheet confirms to what accountants call the “basic accounting equation”. (Hyperlink to first chapter ‘Accounting equation’).

Why do we need a balance Sheet?

As mentioned, a balance sheet measures the ‘true’ financial position of a business concern at a particular point of time. (‘True’ is given in inverted commas because no balance sheet ever shows, or can ever show, the exact financial picture—due to various constraints/strategies, e.g. method of depreciation adopted, LIFO/FIFO system of inventory valuation etc.—of a company, and even the firm of Chartered Accountants who prepare the balance sheet/ who are the Auditors to the company admit in the notes that the picture portrayed is but a true and fair representation of the actual financial affairs of the company).

• It shows the snapshot picture of financial position in a systematic standard form.

• At one glance, the position of the business at a particular point of time, can be understood.

• the balance sheet snows whether the firm is solvent or not.

• If assets exceed liabilities it is solvent; otherwise, it is insolvent.

Features of a Balance Sheet

• A balance sheet is basically a “snapshot” statement.

• It does not summarize information for certain accounts as the income statement does.

• The balance sheet has a striking resemblance to the final financial position that is made by using the accounting equation.

• The balances of the accounts on the balance sheet change a little bit with every passing day, because of business activities occurring after the date of the balance sheet. Remember, it only shows the company’s financial position as on one particular day. Hypothetically, the very next day, a company’s directors could liquidate its entire assets, wind up the company and depart.

• The balances in a company’s balance sheet accounts run ‘perpetually’. In contrast, the balances in the income statement accounts are reset to zero (or closed out) at the beginning of the new financial year.

Understanding the concept of Balance sheet

Study the example given below, for better understanding.

Super Industries

Balance Sheet

December 31, 1999

Assets

|Current Assets | | | |

|Cash and cash equivalents | |12,71,231 | |

|Accounts receivable |10,32,409 | | |

|Less allowance for doubtful accounts |38,000 |9,94,409 | |

|Notes receivable | |3,50,000 | |

|Merchandise inventories | |32,50,000 | |

|Total current assets | | |58,65,640 |

|Property and equipment | |1,78,41,980 | |

|Less accumulated depreciation | |41,73,130 | |

|Net property and equipment | | |1,36,68,850 |

|Total Assets | | |1,95,34,490 |

Liabilities

|Current liabilities | | | |

|Accounts payable |12,75,300 | | |

|Salaries payable |3,30,000 | | |

|Income taxes payable |9,25,239 | | |

|Other accrued expenses |8,000 | | |

|Total current liabilities | |25,38,539 | |

|Long-term liabilities | | | |

|Mortgage payable |5,00,000 | | |

|Bonds payable |24,00,000 | | |

|Total long-term liabilities | |2,90,000 | |

|Total Liabilities | | |54,38,539 |

Stockholders’ Equity

|Common stock, 25,00,000 shares at Re.1 par value per share | |25,00,000 | |

|Capital in excess of par value | |17,50,000 | |

|Retained earnings, January 1, |83,86,350 | | |

|Net income for year |15,09,601 | | |

|Less dividends |(50,000) | | |

|Retained earnings, December 31, 19xx | |98,45,951 | |

|Total Stockholders’ Equity | | |1,40,95,951 |

|Stockholders’ Equity | | |1,95,34,490 |

Assets

These are anything of value that the company owns. That includes cash, accounts receivable from customers credit on sales, etc. They are either current assets or fixed assets.

Figure 1......

Current Assets: These are those assets of the business, which are kept for short-term for converting into cash or for resale.

• Cash and Cash equivalents: This is the balance in the company’s current account(s), plus highly liquid short-term or temporary investments.

Figure 2.......

• Accounts receivable and notes receivable: customers to whom it sold goods or services on credit owe these to the company. The total accounts receivable balance is reduced by an allowance for doubtful accounts. The accountants usually estimate what percentage of the company’s receivables will turn sour and thus subtract that amount. The result is a realistic net amount that the company expects to collect.

• Merchandise inventories: If a company is a retailing or wholesaling business, this is the value of products that the company has bought and intends to resell for a profit.

Figure 3.......

Fixed Assets: These are those, which are purchased for the purpose of operating the business but not for resale. They are shown at the cost, the company paid to buy or bill them (including such expenses as installation costs and taxes) minus the amount that they’ve depreciated.

• Depreciation can be plain old wear-and-tear, technological obsolescence – the kind that makes the computer you paid Rs. 40,000 for last year worth Rs. 10,000 today.

Liabilities

Shows the debts, the company owes to creditors of every kind. Even the employees are creditors of the company on the balance sheet date, because it owes them salaries that won’t be paid until payday.

Figure 4.......(Audio clip) for the definitions within the flow-chart.

|Current Liabilities | | | |

|Accounts payable |12,75,300 | | |

|Salaries payable |3,30,000 | | |

|Income taxes payable |9,25,239 | | |

|Other accrued expenses |8,000 | | |

|Total current liabilities | |25,38,539 | |

|Long-term liabilities | | | |

|Mortgage payable |5,00,000 | | |

|Bonds payable |24,00,000 | | |

|Total long-term liabilities | |29,00,000 | |

|Total Liabilities | | |54,38,539 |

Current Liabilities: are bills, the company must pay within the next twelve months.

Long-term Liabilities: are bills that will be due in more than one year.

Shareholders’ Equity

This section shows what the company is worth to its owners.

Figure 6...........

|Equity Shares, 25,00,000 shares at Re1 par value per share | |25,00,000 | |

|Capital in excess of par value | |17,50,000 | |

|Retained earnings, January 1, |83,86,350 | | |

|Net income for year |15,09,601 | | |

|Less dividends |(50,000) | | |

|Retained earnings, December 31, 1999 | |98,45,951 | |

|Total Shareholders’ Equity | | |1,40,95,951 |

Securities regulations nonetheless still require par value to be accounted for, separately from other types of additional paid-in, capital.

Last January’s retained earnings, plus the net-income or profit that the company made this year, minus dividends, equal the retained earnings on the balance sheet dated December 31.

When you add in the par value of its common stock and the capital received in excess of par, you have the total shareholders’ equity.

Points to Remember

1. The balance sheet freezes the company’s account balances at a single point in time. Next days figures could be very different.

2. Liabilities and shareholders’ equity represent claims against a company’s assets. That’s why the balance sheet balances.

3. Theoretically, shareholders’ equity is what the shareholders should be able to collect if the company’s assets were sold on the balance sheet date at their mentioned value & liabilities are paid.

4. To sum it up, a balance sheet is a one-day “snapshot” of the company’s assets, debts and owners’ equity.

Ratio Analysis

Ratio analysis is the process of determining and interpreting numerical relationship between figures of the financial statements.

Financial Ratios

Financial ratios, which use data from a firm’s balance sheet, income statement, statement of cash flows, (and certain market data for cross-verification), are often used when evaluating the financial performance of the firm.

(Hyperlink of headings to same)

• Liquidity ratios indicate a firm’s ability to meet its short-term financial obligations.

• Asset management ratios indicate how efficiently a firm is using its assets to generate sales.

• Financial leverage ratios indicate a firm’s capacity to meet short and long-term debt obligations.

• Profitability ratios measure how effectively a firm’s management generates profits.

(Audio clip) The various types of ratios, such as liquidity, solvency, efficiency and profitability ratios, when compared and benchmarked, are important decision-making tools for management or investors.

Liquidity Ratios

These involve the following:

Current Ratio: This ratio is used to assess the short-term financial position of the business concern.

Current Ratio = Current Assets

Current Liabilities

Fig. 1....

However, many Current Assets e.g. rent paid in advance, cannot be readily encashed, whereas Current Liabilities must be paid when they fall due. Therefore, another ratio, called the Quick Ratio, is more representative in portraying the liquidity situation.

Quick Ratio: Liquidity ratio/ ‘acid test’ ratio is worked out to realistically portray the short-term liquidity position of the firm.

Quick ratio = Current Assets – Inventory – Prepaid Expenses

Current liabilities

(Audio clip) It is only when non-encashable items, such as ‘inventory’ and ‘pre-paid’ expenses are deducted from current assets, that a true picture of our ability to meet current liabilities, emerges.

Fig. 2….

Efficiency Ratios/Asset Management Ratios

A number of ratios exist that can:

• Help a company assess its efficiency of operations

• Allow for Comparison between:

▪ Other Companies

▪ Other periods of time, and

• Measure efficient handling of receivables and inventory.

Figure 3.......

These are the following:

Average Receivables Ratio/Receivable turnover Ratio

To maximize profits and operate efficiently, early collection of receivables is a must, and is shown by the Receivables Turnover Ratio:

Receivables Turnover Ratio = Credit Sales

Average Receivables Balance

Where, Average Receivables = Receivables year start + Year end

2

Days Sales in Receivables = 365

Receivables Turnover

Days sales in receivables are the average age of receivables, or how long it takes to collect them.

We could directly compare the turnover to:

• Other companies or,

• Own company, in prior years.

Suppose “Days sales in receivables” is 32 days, is it a good figure, when we compare with other companies, or with the industry average? If industry average is 40, it is fine. But if industry average is 20 days, we need to accelerate our own collections.

Inventory Ratios

Inventory held too long can:

• Result in spoilage/warehousing costs.

• Waste money due to interest costs/opportunity costs (i.e. interest which could have been earned by investing the money elsewhere).

Inventory turnover is calculated to ascertain this aspect, preferably separately for:

• Raw materials

• Semi-finished goods (goods in process)

• Finished goods.

Ratios thus revealed should be analyzed keeping in mind seasonal considerations, shortages and peculiarities of each industry:

Inventory Turnover Ratio

Inventory Turnover Ratio = Cost of goods sold

Average Inventory Balance

Days sales in Inventory = 365

Inventory Turnover

Solvency Ratios/Financial Leverage Ratios

• Takes a long-term view.

• Assess whether Company has over-reached itself through excessive leverage i.e. can it pay principal/interest on loans/debentures etc. on a sustained basis?

Two of the most common solvency ratios are:

Figure 4......

Interest Coverage Ratio

This ratio indicates how many times the profit covers fixed interest. It measures the margin of safety for the lenders. The higher the ratio, more secure the lender is in respect to his periodical interest income.

Interest Coverage Ratio = Profit before Interest & Taxes

Interest Expense

Debt-Equity Ratio

The purpose of debt-equity ratio is to derive an idea of the amount of capital supplied to the concern by the proprietor and of ‘asset cushion’ or cover available to its creditors on liquidation.

Debt to Equity = Total Debt

Shareholders’ Equity

Interest has to be paid by the Company out of profits. So long as profits exceed interest payment obligations, the company’s creditors can breathe easily. However, shareholders expect higher profits thereafter (dividends), so comparison over past years can show trends e.g.

Year Operating Income (Rs.) Interest (Rs.) Interest Coverage ratio

2001 28,000 10,000 (28,000/1,000 = 2.8

2002 44,000 12,000 ( 44,000/12,000 = 3.7

(A better performance

than last year).

From Creditors point of view, the higher ratio brings relief.

Whether the promoters consider it an improvement or not depends on how they look at profits:

• a need for high returns/risk i.e. high financial leverage may make them feel that more liabilities could have been raised, to boost turnover further/pay higher dividends or even leverage expansion.

It would have increased promoters’ rate of return (on investment) at cost of greater risk exposure.

Profitability Ratios

• Profitability ratios attempt to show how well the Company did, given the Level of risk.

• Again, profitability ratios have to be read with other ratios to get a more accurate picture of the Company’s performance.

• Net income by itself, cannot be meaningfully compared with that of competitors, or industry averages.

• Levels of investment, share prices may be higher than ours: no two companies can be compared in performance without taking various parameters into account.

Margin Ratios

Margin ratios are one common class of profitability ratios:

Gross Margin Ratio = Gross margin x 100%

Sales

This is calculated to determine the selling price so that there is adequate gross profit to cover the operating expenses, fixed charges, dividends etc.

Operating Margin Ratio = Operating margin x 100%

Sales

This is calculated to test the operational efficiency of the business.

Net Profit Margin Ratio = Net profit margin x 100%

Sales

This is worked out to determine whether operating cost is within desired parameters or not. An increase in this ratio over the previous period shows improvement in the operational efficiency.

Margins are closely watched: The potato wafers or supermarket businesses operate on about 2% margins. A small slip can wipe out their profits.

Return on Investment Ratios

• ROI ratios are another broad category of profitability ratios.

• Definitions of ROI vary from company to company.

• Understand pros and cons of whatever ROI ratio your company uses.

• Basically, Return on Assets (ROA) is an ROI measure that evaluates returns generated by an asset base.

• Dividing profits earned, by assets used to generate these profits = ROI (return on Investment).

• Good for evaluating performance of Sub-Divisions/Profit Centres.

• Shareholders are interested in return on equity i.e. ROE.

Return On Assets (ROA) = Profit before Interest & Tax

Total Assets

Return On Equity (ROE) = Net Profit

Shareholders’ equity

This ratio is used to compare the performance of a company’s equity capital with that of other companies, which are alike in quality. The company with higher ROE will be favoured by the investors.

Benchmarking (Common to all ratios)

• Ratios, by themselves, are unreliable as sole basis for decision-making.

• They need to be ‘read’ in a series of at least two or three ratios, to gauge a Company’s financial position.

• Further, they need to be ‘benchmarked’, to decide whether the ratio is a healthy one or not.

A benchmark is a basis for comparison:

• Benchmarks are of three types:

-The Company’s history, trends.

-Comparison of the Company with specific industry competitors.

-Industry wide comparison.

Common Size Statements

• Apart from benchmarking, common size statements are another way of rationalizing readings from ratio analysis.

It basically involves comparing factors (with either a competitor or industry average). Cash e.g. should be seen as a:

-Fraction of Equity, for both Companies, (or Industry average) before comparing.

-Variable input, depending on terms of business. XYZ Co. may be more cash oriented, ABC Co. may be more credit oriented.

-Calculate ratio of cash to Total Assets

- Calculate ratio of cash to Total Equities.

(Audio clip) Ratios by themselves are only guideposts. Their relevance is enhanced when we add ‘balancing factors’ like benchmarking and common sizing, which puts ratios into correct perspective.

Quiz

Quiz will come

Depreciation

The word ‘depreciation’ originates from the word ‘deprecate’ — indicating physical wearing out. Depreciation is how a Company recovers the cost of its more costly assets gradually, over the years they’ll be used in business.

Types of Depreciation

- Physical Depreciation: A machine wears out over a period of time in use, while generating revenues over that period, which cannot be expensed (entire cash shown as an expense) in the first year itself. It would distort the actual situation (make a huge dent in ‘Profits’ figures), whereas it earns revenues over its full useful life.

- Technological Depreciation: Introduction of better, faster (even cheaper) technology is regularly sending current designs of almost anything, to the trashcan.

- Accidents/ Major breakdowns may also prematurely age an asset.

Thus, we allocate a portion of original cost as an expense each year, and balance cost v/s depreciation. Revenue received out of sales of the machine’s output each year is matched with some portion of its cost.

Accidents or major breakdowns may also render a machine redundant, e.g. a car that has a burst engine cylinder block and damaged crankshaft/ gearbox.

Over a 10 year period, a machine may depreciate disproportionately e.g. a car; more in the first two years of its life, less and less as it gets older, till it plateaus out.

How much do we Amortize or Depreciate?

Figure 1.....

Cost of Machine + Installation + Directly Associated Costs = Total Cost - Salvage Value (At end of 10 yr. Period) = Depreciable base

Asset Value of Depreciation

- Historical Cost is what we originally paid for the machine.

- Cost of putting it into service e.g. wiring, plant modifications, special staff support (proportionate to salary /wages applicable depending on time spent by him in maintaining only that machine).

- Money spent on putting the machine into service has to be added to the cost of the machine.

- Taking An Income Tax Deduction in the first year itself is tantamount to taking an interest-free loan from the Govt., showing full amount as a deductible expense

- Depreciation/tax payments are deferred (annually) to the future.

Methods Of Depreciation

The Straight line method first calculates the depreciable base (cost less salvage) before dividing it by number of years (life of machine) to arrive at annual rate of depreciation. The straight-line method is the most straightforward method of Asset Value Depreciation. But:

▪ Not all equipment deteriorates equally e.g. a car, over its useful life.

▪ Methods based on actual usage: total life are too cumbersome to be practicable

For Example: Say a machine costs Rs. 10,000 and Rs. 1,000 (as additional set-up/installation/maintenance expenses) = Rs 11,000 but we anticipate/guess its Kabari (Scrap Value) at Rs. 3,000 at the end of its useful life, of say, 10 yrs,

we get:

Cost of Machine + Installation + Directly Associated Costs = Total Cost

Total Cost - Salvage Value (At end of 10 yr. Period) = Depreciable base

10,000 + 1,000 =11000 (Total cost)

11000 – 3,000 = 8,000 as the Depreciable Base

Depreciable Base = Rs. 8,000, Spread out over 10 yrs = Rs. 8000/10(Yrs) = Rs 800/- depreciation per year.

This happens when we accurately assess asset life, but:

• If the machine outlasts its estimated life, we stop depreciation thereafter.

• If it fetches more salvage value, we book a Gain. If salvage value is 5000, against 3000 (Book Value at end of 10 yrs), we show a Gain of Rs. 2000.

• If the machine becomes obsolete after a mere 3 years, depreciation is 3(yrs) x 800 (p.a.) = 2400/-, less scrap value Rs. 500/-, we have a net loss of

11,000 – 2400 = Rs. 8600 (book value) – 500 (salvage returns) = Rs 8,100 (loss).

Cost = 11000

Annual Depreciation = 800 x 3= 2400 = 8600 (Book value)

(Book value) 8600 – 500 (salvage value) = 8100 (Net loss)

Proportionate Annual Depreciation of Rs. 800 (8000 ( 10) is an example of the Straight Line Method of Depreciation.

The written down value method:

• Written down value, applicable to machines that have high rates of depreciation in the initial year or two, and later taper it e.g. a car, is a usable method.

Figure 2...

• Under this method, depreciation is charged at a fixed rate every year, ON THE REDUCING BALANCE. A certain percentage is applied to the previous year’s book value, to arrive at the current year’s depreciation/ book value, WHICH SHOWS A DECLINING BALANCE, WEIGHTED FOR EARLIER YEARS, AND LOWER AND LOWER FOR LATER YEARS, as the machine grows older.

• Accelerates depreciation taken in early years. Reduces the amount taken in later years. Ignores salvage value; starts with depreciable base = asset cost.

Declining balance can be of many types: For example,

• 200 per cent declining balance, OR

• Double declining balance, is one popular method

EXAMPLE OF DOUBLE DECLINING BALANCE METHOD:

[The Double Declining Method takes an amount (usually double, i.e. 200% of the amount that we take in the Straight Line Method) and applies it to the book value of an asset each year]:

Suppose the asset costing Rs.16,000 has AN ESTIMATED USEFUL LIFE OF 5 YEARS, the depreciation would be calculated as follows:

YEAR DEPRECIABLE BASE PERCENTAGE (FIXED) DEPRECIATION

1 16000-0 x0.40 6,400

2 16000-0-6400 x0.40 3,840

3 16000-6400-3840=5750 x0.40 2,304

4 16000-6400-3840-2304 x0.40 1,382

5 Depreciation in the 5th year is only Rs. 74 to finally write off the entire machine depreciable base (Rs. 16000/-) less scrap value (Rs. 2000).

This example also shows accelerated, i.e. realistic, depreciation in early years of the machine’s life, when its productivity/ book value is higher, as opposed to its fall in value in later years, and commensurate retarded depreciation.

Comparison of Methods of Depreciation:

FIG. 2….

• Many companies choose straight-line method for reporting depreciation to shareholders because net income is higher in early year.

• Because net income is lower in early years, some companies prefer the written down value method, especially for Income Tax purposes.

(Audio clip) Depreciation, therefore serves multiple functions such as a tax-incentive for capital investment, a provision for replacement as well a tax-adjustment resource.

Quiz

Quiz to come…

Inventory Valuation

(Where is the Real Value?)

Inventory consists of Stocks of raw material, semi-finished and finished goods.

|The Inventory equation = Opening Stock + Purchases – Sales = Closing Stock |

Where, opening stock is the last year’s closing stock and closing stock will be the next year’s opening stock.

Since manufacturing units have three types of inventories (raw0materials, stock in process, and finished goods), we will, for purposes of easy comprehension, treat inventory as only of one type e.g. finished goods, as in a supermarket.

Periodic v/s Perpetual Inventory Methods:

In the inventory equation, the problem centres around

• Cost of goods sold, and

• Closing Inventory.

Figure 1...

Keeping track of sales receipts does not necessarily mean accounting for each and every outgoing item from inventory. A hardware merchant cannot physically account for each of thousands of items in stock, which he sells. Doing so would leave him little time to make sales!

Periodic Method of Inventory means a periodic physical count of inventory at yearly, or shorter intervals.

• Weaknesses are:

-No control; no idea, at given point of time, what is in stock, (how much sold, how much left).

-If not in inventory, no way of determining whether item is lost, spoilt in storage, broken or stolen.

-If treated as sold, their costs end up as ‘cost of goods sold’ expense.

-Very unreliable and haphazard approach to inventory control.

The Perpetual Method:

• Alternative to ‘Periodic’ method.

• Here each transaction of sale/item recorded.

• Only possible where unit cost is high, range of items is limited, and units sold are limited in number.

Figure 2...

Yet Computers and Bar Codes have solved the problems to a maximum extent and, provided computerized systems are well maintained, on-line inventory control in Real Time Has Arrived.

The Problem of Inflation:

Because items bought later may be costlier (on account of inflation) than those bought earlier, it becomes important to know which items were sold, and which still remain in inventory.

If we have ten machines, bought from Jan. To Oct., each Rs. 1000 costlier, and two from previous year, we have 12 machines costing different amounts.

Why is this so important? Because of:

Figure3.....

Monetary restrictions — inventory has to be given monetary value.

If 5 units were shown as sold, how do we know which ones were sold, and which ones remain, for assigning them rupee values.

Rupee values are necessary for the balance sheet.

Arbitrary values, arrived at by guess work could severely,

- Overstate net income, resulting in higher tax, or

- Understate inventory and expense / cost of goods sold.

So inflation (resulting in different batches of same stocks costing differently), monetary restriction and accounting principles, make it important to ascertain which ones were sold, and which ones are left.

Cost Flow Assumptions:

The methods of determining which units were sold and which are on hand are referred to as Cost Flow Assumptions.

There are four major alternative cost flow assumptions:

Specific Identification: Each item is ‘tagged’ in some way and accounted for.

First in First Out (FIFO): i.e. oldest goods are sold first, obviating old, tattered inventory. Akin to flow of goods on a conveyor belt. Quite practical and makes sense.

Weighted Average: Used where bulk or liquid goods mix in storage e.g. petrol/ coal. So older stock @25/litre and later ones at 26/- which get mixed in the common storage tank, are averaged at Rs. 25.50 per litre.

Last in First Out (LIFO): It assumes that last goods received, are nearest the hatch and are sold first, like goods piled up and sold off the top of the pile eg. coal. It is logical and is becoming increasingly popular, with a shift from FIFO to LIFO.

Figure 4, 5, 6.....

Comparison of LIFO and FIFO

FIFO

• Inflationary situations create distortion in reporting inventory in financial statements. For instance, two units bought at different periods of time and sold for same price, earn different profit margins.

• Thus during periods of rising prices, the FIFO method does not give users of financial statements a current picture of profit-future of the company.

LIFO

• In LIFO, we sell a unit bought recently (say, @20) for Rs. 30 per unit), while the unit bought for Rs. 10/- is still in stock! So the inventory shows that item (now costing Rs 20 in open market) at Rs 10 each, meaning gross under valuation of inventory.

(Audio clip) Under LIFO, Profit also shows a declining curve under inflationary conditions.

Figure 7......

Graphical Comparison

-Companies under FIFO system pay more taxes (because they ‘show’ more profit).

-Those opting for LIFO ‘show’ less profit pay less tax and have more cash.

-Otherwise, everything is exactly the same.

• Companies whose inventories costs (values) are rising, (inflation) benefit from LIFO.

• These whose stock values plummet (e.g. computer chips) had better opt for FIFO.

• Commodities dealers should go for ‘Weighted Average’ method.

How Profitability Changes, in Inventory & Depreciation Methods

• Let us take an example of a company, say ABC:

Opening position in 2000 is: (LIFO method chosen)

Opening Inventory = Rs. 40,000

Purchases = Rs. 1,71,000

Cost of goods sold = Rs. 1,62,000

Opening Inventory + Purchases – Cost of goods sold = Closing Inventory

40,000 +1,71,000 – 1,62,000 = 49,000 (closing Inventory)

• But, since the LIFO/FIFO choice focuses on which goods were sold (& not on how much was spent on purchases), the balance sheets under FIFO would differ from B/S under LIFO.

- What would happen to Profit & loss account under the two choices?

- We need to ascertain the effect of these differences or cost of goods sold, in order to answer that question.

Example

Comparative Profit & Loss Accounts (LIFO/Weighted Average/FIFO)

Year Ended June 30, 2000

|Item |LIFO |Weighted Average |FIFO |

|Sales |297,000 |297,000 |297,000 |

|Less Cost of Goods Sold |162,000 |160,000 |158,000 |

|Gross Profit |135,000 |137,000 |139,000 |

|Less Operating Expenses |91,000 |91,000 |91,000 |

|Operating Income |44,000 |46,000 |48,000 |

|Less Interest Expense |12,000 |12,000 |12,000 |

|Income Before Taxes |32,000 |34,000 |36,000 |

|Income Taxes |13,000 |14,000 |15,000 |

|Net Income |19,000 |20,000 |21,000 |

• Depreciation choices are mandated by law.

• But we have latitude in Financial Reporting!

In the above Profit & Loss A/c example, the ‘Straight-Line’ (ST.L) Method has been used for reporting depreciation.

(Audio clip) The relationship between depreciation and inventory control are best highlighted by comparing various combinations of the two.

But what would have the effect of using:

• Double declining balance depreciation method? (DDB)

• On all the Inventory systems, (LIFO, W.A., & FIFO)?

Operating costs included Rs. 10,000 of depreciation on Straight Line basis.

The following figures illustrate impact of using DDB method:

(Rs. In Thousands)

| |A |B |C |D |E |F |

|Item |LIFO |W.A. |FIFO |LIFO |W.A. |FIFO |

| |ST.L. |ST.L |ST.L |DDB |DDB |DDB |

|Sales |297 |297 |297 |297 |297 |297 |

|Less Cost of Goods Sold |162 |160 |158 |162 |160 |158 |

|Gross Profit |135 |137 |139 |135 |137 |139 |

|Less Operating Expenses |91 |91 |91 |99 |99 |99 |

|Operating Income |44 |46 |48 |36 |38 |40 |

|Less Interest Expenses |12 |12 |12 |12 |12 |12 |

|Income before Taxes |32 |34 |36 |24 |26 |28 |

|Income Taxes |13 |14 |15 |9 |10 |11 |

|Net Income |19 |20 |21* |15* |16 |17 |

There are six possible Net Incomes!

Each of the three inventory methods can be matched with both of the depreciation methods.

The company’s reported net income can be greatly affected by the choice of accounting methods!

In this example, we can presume that two companies with identical operations, each report the incomes of (a) 15,000* (for a LIFO/DDB Company) (b) 21,000* (for a FIFO/ST.L. Company).

A difference of 40%!! can be obtained.

Figure 8.....

Who says Accounts/Finance People Aren’t Creative?!

Quiz

Quiz is awaited…

Budgeting

Budgeting: The Means is not the end.

A budget is simply a plan; your household budget is also a plan. They have two main features.

Figure 1…..

4 Key reasons for having a budget:

— Goals: A map for the future.

— Effective Evaluation: goals, broken into objectives/time blocks, allow one to assess performance.

— Compel Managers to think and plan ahead.

— Communication & Unity in the organization; goals have to be conveyed, people convinced and performance quantified.

(Audio Clip): Budgetory Systems enable us to plan, monitor, adjust and achieve, organizational goals.

Structure

The organization’s Master Budget projects key financial statements:

Figure 2….

Difference between 'Budget' and 'Budgeting'

|Sl. |Budget |Sl. |Budgeting |

|No. | |No. | |

|1. |A Business Plan |1. |Incorporates system of using budget + Monitoring + Correction |

| | | |system |

|2. |Financial Budget only one part |2. |Enables management to steer the company to the goals. |

|3. |Forces confrontation with, and need to control|3. |Manages the future by ‘on-line’ course corrections, as |

| |the future. | |dictated by analyses of data revealed by monitoring MIS. |

Types of Budgets

Figure 3.

(Audio Clip)

While budgeting helps to plan, monitor and achieve, the two types of budgetory systems (static and flexible) are both relevant, depending on the type of industry.

Budget Preparation

There are generally 4 basic steps involved in a budget formulation exercise:

Figure 4.

Forecasting

While budgets are primarily based on past trends i.e. follow Historical Pattern,

environmental changes which have appreciable impact, viz:

— Technology upgrades

— Initiatives by competitors

— Changes in laws/tax laws

have to be suitably accommodated/ ANTICIPATED.

Besides,

— Sophisticated financial package for computerized applications can take the drudgery and uncertainty out of budgeting to some extent.

— Yet all conjecture about the future is guesswork.

— Experience and judgement of managers are very important in partially eliminating the 'guess' part of 'work'.

— Once Sales and Production costs have been finalized, budgets can be prepared.

The 4 stages of formulation. (see 'Budgetory Formulation') Hyperlink to budget formulation are now gone through by cost centre/unit/segment/departmental/section heads.

Basically, it is a play-off between costs, resources, business strategies and profitability goals.

The budgetory exercise, broken down into the smallest individual unit of the organization, is now recompiled by adding up all the separate elements, to form the company budget (with necessary alterations).

(Audio Clip) Through interplay between capital and operating budgets, tempered by constraints and prompted by market forces, the Budget takes final shape.

Monitoring

Figure 5…

Monitoring

• To take timely action in cases where negative variances are cause for concern, periodic reviews of actual performance (in quantifiable e.g., ‘rupee’ terms) compared to budgeted figures needs to be done.

• Concerned departments should submit, whenever possible, back-up notes, to support/ explain the variances. For example: If a production manager has to achieve the production of 3000 pistons in December 2000, and achieves only 1800, it represents a negative variance of @ of 1200 in numerical terms, and 40 %!

- Management will want to know why; if there are acceptable reasons, like supplier’s strike, sudden change in orders position (cancellations), generator breakdown etc. Then,

• Steps will be taken to obviate/anticipate these in future.

- If reasons are vague, a deeper probe will be called for till root cause is identified. Either way, production plans will need, now, to be dovetailed into sales/cash flow/profitability budgets.

Budgetory Control

The essence of budgetory control is comparing budgeted figures with performance.

— If performance is below the budgeted figure, it is known as a negative variance.

— If performance exceeds budgeted figure, it is known as positive variance.

Since budgetory factors are of two types-

(a) Resources (including men, money, machines, markets)

(b) Goals (sales, inventory, expenditure, production),

it is obvious that a negative variance in expenditure matched by a positive variance in production is a sign to Monitoring Authority that cost control measures are being efficiently implemented.

Negative achievement data with respect to production, sales, collections etc. matched by zero variance in consumption of resources can mean that such resources are not being deployed in an optimum manner.

Either way, it reveals opportunities for improvement, one by identifying successful patterns of operation (for application throughout the organization) and two, identifying inefficient patterns, for applying corrective measures.

(Audio Clip) Identifying negative and positive budgetory variances aid accountants and managers to pinpoint areas of excellence or otherwise, for further investigation and analysis.

Quiz

Quiz…

Taking Financial Decisions

Question Yourself?

1. Which inventory or depreciation method is best for our company?

2. Is a project going to yield an acceptable rate of return?

3. Will a merger be profitable?

4. How much leverage should a company employ?

A fundamental decision made by any business is the degree to which it incurs fixed costs. A fixed cost is one that remains the same, regardless of the level of operations. As sales increase, fixed costs don’t increase at all till a particular point. Profits can rise faster during good times. And since fixed costs don’t decline even during, unfortunately, hard times, profits are harder hit than sales.

The degree to which a firm locks profits into fixed costs is referred to as its LEVERAGE POSITION.

• The more highly leveraged a firm, the riskier it is because of the obligations related to fixed costs.

• The more highly leveraged the greater the profits during good times.

• This presents a classic problem of making a decision where there is a trade-off between risks and return.

Figure 1.....

Financial Leverage is specifically the extent to which a firm gets its cash resources from borrowing (debt) as opposed to issuance of additional shares of (equity).

Operating Leverage is concerned with the extent to which a firm commits itself to high levels of fixed costs other than interest payments, e.g. long-term non-cancelable rent leases.

In the cases of both financial and operating leverage, the crucial question is how much leverage is appropriate.

Financial Leverage

Figure 1…..

Let’s start our discussion of financial leverage with an example.

Assume you were to buy a small building as a piece of investment property. You buy the building for Rs. 100,000 and pay the full amount in cash.

Suppose, that a year later you sell the building for Rs. 130,000. Your pre-tax profit is Rs 30,000. This is a 30 percent pre-tax return on your original investment of Rs. 100,000.

As an alternative to paying the full Rs. 100,000 cash for the investment, you might have to put Rs. 10,000 cash down and borrow Rs 90,000 from the bank at 15 percent interest. This time when you sell the property for Rs. 130,000 you repay the Rs. 90,000 to the bank, along with Rs. 13,500 interest. After deducting your original Rs. 10,000 investment, Rs. 16,500 is left as a pre-tax profit. This is a pre-tax return of 165 percent on your Rs. 10,000 investment. Compare the 30 percent we calculated earlier to this rate of return of 165 percent. That’s financial leverage for you!

Note that we had a net profit of Rs. 30,000 without leverage, but only Rs. 16,500 in the leveraged case. Although we earned a higher return, we had less profit. That’s because in the unleveraged case we had invested Rs. 100,000 of our money, but in the leveraged case we had invested only Rs. 10,000. If we have additional investment opportunities available to us, we could have invested our full Rs. 100,000 borrowed Rs. 900,000, and had a pre-tax profit of Rs. 165,000 on the same investment that yields Rs. 30,000 in the unleveraged situation. Financial leverage cannot only increase your yield from investments, but can also allow you to consider projects that are much larger than what would be feasible without borrowing.

Suppose, however, that the property were sold after one year for Rs. 70,000 rather than Rs. 130,000. On Rs. 100,000 unleveraged investment, the loss would be Rs. 30,000 before taxes. This would be a 30 percent loss on our original Rs. 100,000 investment.

In the leveraged case, the loss will be magnified. We would have to repay the bank the Rs. 90,000 loan plus Rs. 13,500 of interest. These payments total to Rs. 103,500, which is Rs. 33,500 greater than the Rs. 70,000 proceeds from the sale. Further, we’ve lost our initial Rs. 10,000 investment. The total loss is Rs. 43,500 before taxes. On our initial investment of Rs. 10,000, this constitutes a loss of 435 percent. That’s financial leverage too!

Let us put that into a table so as to see the effect of financial leverage more clearly.

|Original investment |Amount Borrowed |Profit/(Loss) |Profit/(Loss) as percentage of |

| | | |original investment |

|1,00,000 |— |30,000 |30% |

| 10,000 |90,000 |30,000 |165% |

|1,00,000 |— |(30,000) |(30%) |

| 10,000 |90,000 |(30,000) |435% |

Clearly when the firm is going to accept this level of leverage, it must decide if the 165 percent possible gain is worth the risk of a 435 percent loss.

• A person dependent on a steady level of income from share dividends might prefer to buy the share of a firm that shuns leverage and prefers a steady, if lesser income.

• A person looking for large potential appreciation in share price might prefer the share of a firm that is highly leveraged.

How much financial leverage is enough

Leverage decision is based on firm’s policy.

1. Some firms raise almost all of their funds from issuing shares to shareholders and from earnings retained in the firm.

2. Other firms borrow as much as they possibly can and raise additional money from shareholders.

3. Most firms are sometimes in the middle.

4. Some firms maintain one-fourth as much as equity.

5. Some firms equal amounts of debt and equity.

6. Some firms more debt than equity.

The choice of DEBT or EQUITY?

In making a decision, regarding whether additional funds should be raised from issuing debt or equity, there are several factors to be considered.

1. The first rule of financial leverage is that it only pays to borrow if the interest rate is less than the rate of return on the money borrowed.

2. The amount that lenders let you borrow depends largely on your available collateral.

3. The desired leverage position depends on the degree to which sales and profits fluctuate.

4. The greater the fluctuation in sales and profit, the less leverage you can afford.

5. A decision must be made regarding the level of extra risk you are willing to take to achieve a higher potential rate of return on shareholder’s investments.

Operating Leverage

The decisions about operating leverage are an issue that directly affects the line managers of the firm.

Figure 2…

Let’s assume that you could lease a slower, older technology copy machine for Rs. 10,000 per year, or a faster, newer technology copy machine for Rs. 15,000 per year. Both produce photocopies of equal quality. Both use the same quantities of paper and ink toner, but the faster machine requires less operating time. Therefore, our cost is much lower for the faster machine. As a result, the variable cost of copies on the slow machine is 30 paise each, while the variable cost of copies from the fast machine is only 25 paise each. Is the faster machine the better bet?

The newer technology has a higher fixed cost and lower variable cost than the older technology. Variable costs are those that vary directly with volume. One of the principle functions of new technology is to reduce the variable costs of production. Much will depend on ability to optimize machine usage, by ensuring higher demand/ orders.

Breakeven Analysis

1. Break-even analysis requires dividing the fixed costs by the contribution margin per unit.

Break-even point = Fixed Costs

Contribution margin/unit

This is equivalent to saying, “How many times do we have to get a contribution of 20 paise before we have covered our fixed cost of Rs 10,000?” For the slower machine, Rs. 10,000 divided by 20 paise equals 50,000. We need to make and sell 50,000 copies to break-even.

2. If we sell more copies than the break-even point for the machine we have, we make a profit. If we sell fewer copies than the break-even point, we lose money.

3. At 100,000 copies, the two machines produce an equal pre-tax profit of Rs. 100,000. Above that point, the faster machine generates a higher profit because every extra copy yields 25 paise profit as compared to the 20 paise profit from the slower machine. On the other hand, for each copy less than 100,000, the slower machine has a higher profit, because its profits go down only 20 paise per copy, while the faster machine’s profits fall off at a rate of 25 paise per copy.

Figure (Break-even)

The less the variability in our production volume, the lower the risk associated with incurring the larger fixed costs in order to achieve a higher profit.

(Audio clip) The higher the level of a company’s sustained sales and profits, and availability of adequate collateral security, the better its chances of sustaining higher leverages, especially through optimization of asset utilization and lower break-even point.

The decision falls into management’s lap. A decision has to be made as to whether the risks associated with the fixed costs of financial and operating leverage are worth the higher potential return.

Financial leverage is concerned with where the money comes from — lenders or owners, but not with what we do with the money. That’s Management’s prerogative. And such decisions can have vital competitive/ survival implications.

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