COST ANALYSIS Profit is the ultimate aim of any business and the long-run prosperity of a firm depends upon

its ability to earn sustained profits. Profits are the difference between selling price and cost of production. In general the selling price is not within the control of a firm but many costs are under its control. The firm should therefore aim at controlling and minimizing cost. Since every business decision involves cost consideration, it is necessary to understand the meaning of various concepts for clear business thinking and application of right kind of costs. COST CONCEPTS: A managerial economist must have a clear understanding of the different cost concepts for clear business thinking and proper application. The several alternative bases of classifying cost and the relevance of each for different kinds of problems are to be studied. 2. Explicit and implicit costs: Explicit costs are those expenses that involve cash payments. These are the actual or business costs that appear in the books of accounts. These costs include payment of wages and salaries, payment for raw-materials, interest on borrowed capital funds, rent on hired land, Taxes paid etc. Implicit costs are the costs of the factor units that are owned by the employer himself. These costs are not actually incurred but would have been incurred in the absence of employment of self owned factors. The two normal implicit costs are depreciation, interest on capital etc. A decision maker must consider implicit costs too to find out appropriate profitability of alternatives. 5. Out-of pocket and books costs: Out-of pocket costs also known as explicit costs are those costs that involve current cash payment. Book costs also called implicit costs do not require current cash payments. Depreciation, unpaid interest, salary of the owner is examples of back costs. But the book costs are taken into account in determining the level dividend payable during a period. Both book costs and out-of-pocket costs are considered for all decisions. Book cost is the cost of self-owned factors of production. 6. Fixed and variable costs: Fixed cost is that cost which remains constant for a certain level to output. It is not affected by the changes in the volume of production. But fixed cost per unit decrease, when the production is increased. Fixed cost includes salaries, Rent, Administrative expenses depreciations etc. Variable is that which varies directly with the variation is output. An increase in total output results in an increase in total variable costs and decrease in total output results in a proportionate decline in the total variables costs. The variable cost per unit will be constant. Ex: Raw materials, labour, direct expenses, etc. BREAKEVEN ANALYSIS The study of cost-volume-profit relationship is often referred as BEA. The term BEA is interpreted in two senses. In its narrow sense, it is concerned with finding out BEP; BEP is the point at which total revenue is equal to total cost. It is the point of no profit, no loss. In its broad determine the probable profit at any level of production. Assumptions: 1. 2. 3. 4. All costs are classified into two fixed and variable. Fixed costs remain constant at all levels of output. Variable costs vary proportionally with the volume of output. Selling price per unit remains constant in spite of competition or change in the volume of production.

5. 6. 7. 8. 9. Merits:

There will be no change in operating efficiency. There will be no change in the general price level. Volume of production is the only factor affecting the cost. Volume of sales and volume of production are equal. Hence there is no unsold stock. There is only one product or in the case of multiple products. Sales mix remains constant.

1. Information provided by the Break Even Chart can be understood more easily then those contained in the profit and Loss Account and the cost statement. 2. Break Even Chart discloses the relationship between cost, volume and profit. It reveals how changes in profit. So, it helps management in decision-making. 3. It is very useful for forecasting costs and profits long term planning and growth 4. The chart discloses profits at various levels of production. 5. It serves as a useful tool for cost control. 6. It can also be used to study the comparative plant efficiencies of the industry. 7. Analytical Break-even chart present the different elements, in the costs direct material, direct labour, fixed and variable overheads. Demerits: 1. Break-even chart presents only cost volume profits. It ignores other considerations such as capital amount, marketing aspects and effect of government policy etc., which are necessary in decision making. 2. It is assumed that sales, total cost and fixed cost can be represented as straight lines. In actual practice, this may not be so. 3. It assumes that profit is a function of output. This is not always true. The firm may increase the profit without increasing its output. 4. A major draw back of BEC is its inability to handle production and sale of multiple products. 5. It is difficult to handle selling costs such as advertisement and sale promotion in BEC. 6. It ignores economics of scale in production. 7. Fixed costs do not remain constant in the long run. 8. Semi-variable costs are completely ignored. 9. It assumes production is equal to sale. It is not always true because generally there may be opening stock. 10. When production increases variable cost per unit may not remain constant but may reduce on account of bulk buying etc. 11. The assumption of static nature of business and economic activities is a well-known defect of BEC.

1. 2. 3. 4. 5. 6. 7.

Fixed cost Variable cost Contribution Margin of safety Angle of incidence Profit volume ratio Break-Even-Point

1. Fixed cost: Expenses that do not vary with the volume of production are known as fixed expenses. Eg. Managers salary, rent and taxes, insurance etc. It should be noted that fixed changes are fixed only within a certain range of plant capacity. The concept of fixed overhead is most useful in formulating a price fixing policy. Fixed cost per unit is not fixed. 2. Variable Cost: Expenses that vary almost in direct proportion to the volume of production of sales are called variable expenses. Eg. Electric power and fuel, packing materials consumable stores. It should be noted that variable cost per unit is fixed.

3. Contribution: Contribution is the difference between sales and variable costs and it contributed towards fixed costs and profit. It helps in sales and pricing policies and measuring the profitability of different proposals. Contribution is a sure test to decide whether a product is worthwhile to be continued among different products. Contribution = Sales Variable cost Contribution = Fixed Cost + Profit. 4. Margin of safety: Margin of safety is the excess of sales over the break even sales. It can be expressed in absolute sales amount or in percentage. It indicates the extent to which the sales can be reduced without resulting in loss. A large margin of safety indicates the soundness of the business. The formula for the margin of safety is: Present sales Break even sales or

Profit P. V. ratio

Margin of safety can be improved by taking the following steps. 1. Increasing production 2. Increasing selling price 3. Reducing the fixed or the variable costs or both 4. Substituting unprofitable product with profitable one. 5. Angle of incidence: This is the angle between sales line and total cost line at the Break-even point. It indicates the profit earning capacity of the concern. Large angle of incidence indicates a high rate of profit; a small angle indicates a low rate of earnings. To improve this angle, contribution should be increased either by raising the selling price and/or by reducing variable cost. It also indicates as to what extent the output and sales price can be changed to attain a desired amount of profit. 6. Profit Volume Ratio is usually called P. V. ratio. It is one of the most useful ratios for studying the profitability of business. The ratio of contribution to sales is the P/V ratio. It may be expressed in percentage. Therefore, every organization tries to improve the P. V. ratio of each product by reducing the variable cost per unit or by increasing the selling price per unit. The concept of P. V. ratio helps in determining break even-point, a desired amount of profit etc. The formula is,

Contribution X 100 Sales

7. Break Even- Point: If we divide the term into three words, then it does not require further explanation. Break-divide Even-equal Point-place or position Break Even Point refers to the point where total cost is equal to total revenue. It is a point of no profit, no loss. This is also a minimum point of no profit, no loss. This is also a minimum point of production where total costs are recovered. If sales go up beyond the Break Even Point, organization makes a profit. If they come down, a loss is incurred.

Fixed Expenses Contributi on per unit Fixed expenses 2. Break Even point (In Rupees) = X sales Contribution
1. Break Even point (Units) = QUESTIONS 1. What cost concepts are mainly used for management decision making? Illustrate.

2. The PV ratio of matrix books Ltd Rs. 40% and the margin of safety Rs. 30. You are required to work out the BEP and Net Profit. If the sales volume is Rs. 14000/3. A Company reported the following results for two period Period Sales Profit I Rs. 20,00,000 Rs. 2,00,000 II Rs. 25,00,000 Rs. 3,00,000 Ascertain the BEP, PV ratio, fixes cost and Margin of Safety. 4. Write short notes on the following a) Profit Volume ratio b) Margin of Safety 5. Write short notes on: (i) Suck costs (ii) Abandonment costs 6. The information about Raj & Co are given below: PV ratio : 20% Fixed Cost : Rs. 36,000/Selling Price Per Unit: Rs. 150/Calculate (i) BEP in rupees (ii) BEP in Units (iii) Variable cost per unit (iv) Contribution per unit 7. Define opportunity cost. List out its assumptions & Limitation. 8. (a) Explain the utility of BEA in managerial decision making (b) How do you explain break even chart? Explain. 9. Write short motes on: (i) Fixed cost & variable cost (ii) Out of pocket costs & imputed costs (iii) Explicit & implicit Costs (iv) Short rum cost 10. Write short note on the following: (a) PV ratio (b) Margin of Safety (c) Angle of incidence (d) 2. Explain Cost/Output relationship in the short run. 3. Appraise the usefulness of BEA for a multi product organization

4. Describe the BEP with the help of a diagram and its uses in business decision making. 5. If sales in 10000 units and selling price Rs. 20/- per unit. Variable cost is Rs. 10/- per unit and fixed cost is Rs. 80000. Find out BEP in Units and sales revenue what is profit earned? What should be the sales for earning a profit of Rs. 60000/6. How do you determine BEP in terms of physical units and sales value? Explain the concepts of margin of safety & angle of incidence.

7. Sales are 1,10,000 producing a profit of Rs. 4000/- in period I, sales are 150000 producing a profit of Rs. 12000/in period II. Determine BEP & fixed expenses. 8. When a Mc change does Ac changed (a) at the same rate (b) at a higher rate or (c) at a lower rate? Illustrate your answer with a diagram. 9. Explain the relationship between MC, AC and TC assuming a short run non-linear cost function. 10. Sale of a product amounts to 20 units per months at Rs. 10/- per unit. Fixed overheads is Rs. 400/- per month and variable cost is Rs. 6/- per unit. There is a proposal to reduce prices by 107. Calculate present and future P-V ratio. How many units must be sold to earn a target profit of present level? QUIZ 1. The cost of best alternative forgone is_______________ (a) Outlay cost (b) Past cost (c) Opportunity cost (d) Future cost 2. If we add up total fixed cost (TFC) and total variable cost (TVC), we get__ (a) Average cost (b) Marginal cost (c) Total cost (d) Future cost 3. ________ costs are theoretical costs, which are not recognized by the Accounting system. (a) Past (b) Explicit (c) Implicit (d) Historical 4. _____cost is the additional cost to produce an additional unit of output. (a) Incremental (b) Sunk (c) Marginal (d) Total 5. _______ costs are the costs, which are varies with the level of output. (a) Fixed (b) Past (c) Variable (d) Historical 6. _________________ costs are those business costs, which do not Involve any cash payment. ( (a) Past (b) Historical (c) Implicit (d) Explicit 7. The opposite of Past cost is ________________________. (a) Historical (b) Fixed cost (c) Future cost (d) Variable cost 8. _____ is a period during which the existing physical capacity of the Firm can be changed. ( (a) Market period (b) Short period (c) Long period (d) Medium period 9. What is the formula for Profit-Volume Ratio? Sales Variable cost ( ) ( )

(a) --------------- X 100 Contribution Contribution (c) --------------- X 100 Sales

(b) ----------------- X 100 Sales Fixed cost (b) ----------------- X 100 Sales ( )

10. _______ is a point of sales at which there is neither profit nor loss. (a) Maximum sales (b) Minimum sales (c) Break-Even sales (d) Average sales 11. What is the formula for Margin of Safety? (a) Break Even sales Actual sales (b) Maximum sales Actual sales (c) Actual sales Break Even sales (d) Actual sales Minimum sales 12. What is the formula for Break-Even Point in Units? (a) __Contribution_____ (b) __Variable cost____ Selling Price per unit Contribution per unit (c) _ _Fixed cost _____ (d) __Variable cost____ Contribution per unit Selling Price per unit 13. What is the Other Name of Profit Volume Ratio? (a) Cost-Volume-Profit Ratio (b) Margin of safety Ratio (c) Marginal Ratio (d) None 14. What is the break-even sales amount, when selling price per unit is 10/- , Variable cost per unit is 6/- and fixed cost is 40,000/-. (a) Rs. 4, 00,000/(b) Rs. 3, 00,000/(c) Rs. 1, 00,000/(d) Rs. 2, 00,000/15. Contribution is the excess amount of Actual Sales over ______. (a) Fixed cost (b) Sales (c) Variable cost (d) Total cost (

Note: Answer is C for all the above questions.

Factors determining the working capital requirements There are a large number of factors such as the nature and size of business, the character of their operations, the length of production cycle, the rate of stock turnover and the state of economic situation etc. that decode requirement of working capital. These factors have different importance and influence on firm differently. In general following factors generally influence the working capital requirements. 1. Nature or character of business: The working capital requirements of a firm basically depend upon the nature of its business. Public utility undertakings like electricity, water supply and railways need very limited working capital as their sales are on cash and are engaged in provision of services only. On the other hand, trading firms require more investment in inventories, receivables and cash and such they need large amount of working capital. The manufacturing undertakings also require sizable working capital.

2. Size of business or scale of operations: The working capital requirements of a concern are directly influenced by the size of its business, which may be measured in terms of scale of operations. Greater the size of a business unit, generally, larger will be the requirements of working capital. However, in some cases, even a smaller concern may need more working capital due to high overhead charges, inefficient use of available resources and other economic disadvantages of small size. 3. Production policy: If the demand for a given product is subject to wide fluctuations due to seasonal variations, the requirements of working capital, in such cases, depend upon the production policy. The production could be kept either steady by accumulating inventories during stack periods with a view to meet high demand during the peck season or the production could be curtailed during the slack season and increased during the peak season. If the policy is to keep the production steady by accumulating inventories it will require higher working capital. 4. Manufacturing process/Length of production cycle: In manufacturing business, the requirements of working capital will be in direct proportion to the length of manufacturing process. Longer the process period of manufacture, larger is the amount of working capital required, as the raw materials and other supplies have to be carried for a longer period. 5. Seasonal variations: If the raw material availability is seasonal, they have to be bought in bulk during the season to ensure an uninterrupted material for the production. A huge amount is, thus, blocked in the form of material, inventories during such season, which give rise to more working capital requirements. Generally, during the busy season, a firm requires larger working capital then in the slack season. 6. Working capital cycle: In a manufacturing concern, the working capital cycle starts with the purchase of raw material and ends with the realization of cash from the sale of finished products. This cycle involves purchase of raw materials and stores, its conversion into stocks of finished goods through workin progress with progressive increment of labour and service costs, conversion of finished stock into sales, debtors and receivables and ultimately realization of cash. This cycle continues again from cash to purchase of raw materials and so on. In general the longer the operating cycle, the larger the requirement of working capital. 7. Credit policy: The credit policy of a concern in its dealings with debtors and creditors influences considerably the requirements of working capital. A concern that purchases its requirements on credit requires lesser amount of working capital compared to the firm, which buys on cash. On the other hand, a concern allowing credit to its customers shall need larger amount of working capital compared to a firm selling only on cash. 8. Business cycles: Business cycle refers to alternate expansion and contraction in general business activity. In a period of boom, i.e., when the business is prosperous, there is a need for larger amount of working capital due to increase in sales. On the contrary, in the times of depression, i.e., when there is a down swing of the cycle, the business contracts, sales decline, difficulties are faced in collection from debtors and firms may have to hold large amount of working capital. 9. Rate of growth of business: The working capital requirements of a concern increase with the growth and expansion of its business activities. The retained profits may provide for a part of working capital but the fast growing concerns need larger amount of working capital than the amount of undistributed profits. SOURCE OF FINANCE Incase of proprietorship business, the individual proprietor generally invests his own savings to start with, and may borrow money on his personal security or the security of his assets from others. Similarly, the capital of a partnership from consists partly of funds contributed by the partners and partly of borrowed funds. But the company from of organization enables the promoters to raise necessary funds from the public who may contribute capital and become members (share holders) of the company. In course of its business, the company can raise loans directly from banks and financial institutions or by issue of securities (debentures) to the public. Besides, profits earned may also be reinvested instead of being distributed as dividend to the shareholders. Thus for any business enterprise, there are two sources of finance, viz, funds contributed by owners and funds available from loans and credits. In other words the financial resources of a business may be own funds and borrowed funds. Owner funds or ownership capital:

The ownership capital is also known as risk capital because every business runs the risk of loss or low profits, and it is the owner who bears this risk. In the event of low profits they do not have adequate return on their investment. If losses continue the owners may be unable to recover even their original investment. However, in times of prosperity and in the case of a flourishing business the high level of profits earned accrues entirely to the owners of the business. Thus, after paying interest on loans at a fixed rate, the owners may enjoy a much higher rate of return on their investment. Owners contribute risk capital also in the hope that the value of the firm will appreciate as a result of higher earnings and growth in the size of the firm. The second characteristic of this source of finance is that ownership capital remains permanently invested in the business. It is not refundable like loans or borrowed capital. Hence a large part of it is generally used for a acquiring long lived fixed assets and to finance a part of the working capital which is permanently required to hold a minimum level of stock of raw materials, a minimum amount of cash, etc. Another characteristic of ownership capital related to the management of business. It is on the basis of their contribution to equity capital that owners can exercise their right of control over the management of the firm. Managers cannot ignore the owners in the conduct of business affairs. The sole proprietor directly controls his own business. In a partnership firm, the active partner will take part in the management of business. A company is managed by directors who are elected by the members (shareholders). Merits: Arising out of its characteristics, the advantages of ownership capital may be briefly stated as follows: 1. 2. 3. 4. It provides risk capital It is a source of permanent capital It is the basis on which owners acquire their right of control over management It does not require security of assets to be offered to raise ownership capital

Limitations: There are also certain limitations of ownership capital as a source of finance. These are: The amount of capital, which may be raised as owners fund depends on the number of persons, prepared to take the risks involved. In a partnership confer, a few persons cannot provide ownership capital beyond a certain limit and this limitation is more so in case of proprietary form of organization. A joint stock company can raise large amount by issuing shares to the public. Bus it leads to an increased number of people having ownership interest and right of control over management. This may reduce the original investors power of control over management. Being a permanent source of capital, ownership funds are not refundable as long as the company is in existence, even when the funds remain idle. A company may find it difficult to raise additional ownership capital unless it has high profit-earning capacity or growth prospects. Issue of additional shares is also subject to so many legal and procedural restrictions. Borrowed funds and borrowed capital: It includes all funds available by way of loans or credit. Business firms raise loans for specified periods at fixed rates of interest. Thus borrowed funds may serve the purpose of long-term, medium-term or short-term finance. The borrowing is generally at against the security of assets from banks and financial institutions. A company to borrow the funds can also issue various types of debentures. Interest on such borrowed funds is payable at half yearly or yearly but the principal amount is being repaid only at the end of the period of loan. These interest and principal payments have to be met even if the earnings are low or there is loss. Lenders and creditors do not have any right of control over the management of the borrowing firm. But they can sue the firm in a law court if there is default in payment, interest or principal back.

Merits: From the business point of view, borrowed capital has several merits. 1. It does not affect the owners control over management. 2. Interest is treated as an expense, so it can be charged against income and amount of tax payable thereby reduced. 3. The amount of borrowing and its timing can be adjusted according to convenience and needs, and 4. It involves a fixed rate of interest to be paid even when profits are very high, thus owners may enjoy a much higher rate of return on investment then the lenders. Limitations: There are certain limitations, too in case of borrowed capacity. Payment of interest and repayment of loans cannot be avoided even if there is a loss. Default in meeting these obligations may create problems for the business and result in decline of its credit worthiness. Continuing default may even lead to insolvency of firm. Secondly, it requires adequate security to be offered against loans. Moreover, high rates of interest may be charged if the firms ability to repay the loan in uncertain. Source of Company Finance Based upon the time, the financial resources may be classified into (1) sources of long term (2) sources of short term finance. Some of these sources also serve the purpose of medium term finance. I. The source of long term finance are: 1. 2. 3. 4. 5. Issue of shares Issue debentures Loan from financial institutions Retained profits and Public deposits

II. Sources of Short-term Finance are: 1. Trade credit 2. Bank loans and advances and 3. Short-term loans from finance companies. Sources of Long Term Finance 1. Issue of Shares: The amount of capital decided to be raised from members of the public is divided into units of equal value. These units are known as share and the aggregate values of shares are known as share capital of the company. Those who subscribe to the share capital become members of the company and are called shareholders. They are the owners of the company. Hence shares are also described as ownership securities. 2. Issue of Preference Shares: Preference share have three distinct characteristics. Preference shareholders have the right to claim dividend at a fixed rate, which is decided according to the terms of issue of shares. Moreover, the preference dividend is to be paid first out of the net profit. The balance, it any, can be distributed among other shareholders that is, equity shareholders. However, payment of dividend is not legally compulsory. Only when dividend is declared, preference shareholders have a prior claim over equity shareholders.

Preference shareholders also have the preferential right of claiming repayment of capital in the event of winding up of the company. Preference capital has to be repaid out of assets after meeting the loan obligations and claims of creditors but before any amount is repaid to equity shareholders. Holders of preference shares enjoy certain privileges, which cannot be claimed by the equity shareholders. That is why; they cannot directly take part in matters, which may be discussed at the general meeting of shareholders, or in the election of directors. Depending upon the terms of conditions of issue, different types of preference shares may be issued by a company to raises funds. Preference shares may be issued as: 1. 2. 3. 4. Cumulative or Non-cumulative Participating or Non-participating Redeemable or Non-redeemable, or as Convertible or non-convertible preference shares.

In the case of cumulative preference shares, the dividend unpaid if any in previous years gets accumulated until that is paid. No cumulative preference shares have any such provision. Participatory shareholders are entitled to a further share in the surplus profits after a reasonable divided has been paid to equity shareholders. Non-participating preference shares do not enjoy such right. Redeemable preference shares are those, which are repaid after a specified period, where as the irredeemable preference shares are not repaid. However, the company can also redeem these shares after a specified period by giving notice as per the terms of issue. Convertible preference shows are those, which are entitled to be converted into equity shares after a specified period. Merits: Many companies due to the following reasons prefer issue of preference shares as a source of finance. 1. It helps to enlarge the sources of funds. 2. Some financial institutions and individuals prefer to invest in preference shares due to the assurance of a fixed return. 3. Dividend is payable only when there are profits. 4. If does not affect the equity shareholders control over management Limitations: The limitations of preference shares relates to some of its main features: 1. Dividend paid cannot be charged to the companys income as an expense; hence there is no tax saving as in the case of interest on loans. 2. Even through payment of dividend is not legally compulsory, if it is not paid or arrears accumulate there is an adverse effect on the companys credit. 3. Issue of preference share does not attract many investors, as the return is generally limited and not exceed the rates of interest on loan. On the other than, there is a risk of no dividend being paid in the event of falling income. 1. Issue of Equity Shares: The most important source of raising long-term capital for a company is the issue of equity shares. In the case of equity shares there is no promise to shareholders a fixed dividend. But if the company is successful and the level profits are high, equity shareholders enjoy very high returns on their investment. This feature is very attractive to many investors even through they run the risk of having no return if the profits are inadequate or there is

loss. They have the right of control over the management of the company and their liability is limited to the value of shares held by them. From the above it can be said that equity shares have three distinct characteristics: 1. The holders of equity shares are the primary risk bearers. It is the issue of equity shares that mainly provides risk capital, unlike borrowed capital. Even compared with preference capital, equity shareholders are to bear ultimate risk. 2. Equity shares enable much higher return sot be earned by shareholders during prosperity because after meeting the preference dividend and interest on borrowed capital at a fixed rate, the entire surplus of profit goes to equity shareholders only. 3. Holders of equity shares have the right of control over the company. Directors are elected on the vote of equity shareholders. Merits: From the company point of view; there are several merits of issuing equity shares to raise long-term finance. 1. It is a source of permanent capital without any commitment of a fixed return to the shareholders. The return on capital depends ultimately on the profitability of business. 2. It facilities a higher rate of return to be earned with the help borrowed funds. This is possible due to two reasons. Loans carry a relatively lower rate of interest than the average rate of return on total capital. Secondly, there is tax saving as interest paid can be charged to income as a expense before tax calculation. 3. Assets are not required to give as security for raising equity capital. Thus additional funds can be raised as loan against the security of assets. Limitations: Although there are several advantages of issuing equity shares to raise long-term capital. 1. The risks of fluctuating returns due to changes in the level of earnings of the company do not attract many people to subscribe to equity capital. 2. The value of shares in the market also fluctuate with changes in business conditions, this is another risk, which many investors want to avoid.

2. Issue of Debentures: When a company decides to raise loans from the public, the amount of loan is dividend into units of equal. These units are known as debentures. A debenture is the instrument or certificate issued by a company to acknowledge its debt. Those who invest money in debentures are known as debenture holders. They are creditors of the company. Debentures are therefore called creditor ship securities. The value of each debentures is generally fixed in multiplies of 10 like Rs. 100 or Rs. 500, or Rs. 1000. Debentures carry a fixed rate of interest, and generally are repayable after a certain period, which is specified at the time of issue. Depending upon the terms and conditions of issue there are different types of debentures. There are: a. Secured or unsecured Debentures and b. Convertible of Non convertible Debentures.

It debentures are issued on the security of all or some specific assets of the company, they are known as secured debentures. The assets are mortgaged in favor of the debenture holders. Debentures, which are not secured by a charge or mortgage of any assets, are called unsecured debentures. The holders of these debentures are treated as ordinary creditors. Sometimes under the terms of issue debenture holders are given an option to covert their debentures into equity shares after a specified period. Or the terms of issue may lay down that the whole or part of the debentures will be automatically converted into equity shares of a specified price after a certain period. Such debentures are known as convertible debentures. If there is no mention of conversion at the time of issue, the debentures are regarded as nonconvertible debentures. Merits: Debentures issue is a widely used method of raising long-term finance by companies, due to the following reasons. 1. Interest payable on Debentures can be fixed at low rates than rate of return on equity shares. Thus Debentures issue is a cheaper source of finance. 2. Interest paid can be deducted from income tax purpose; there by the amount of tax payable is reduced. 3. Funds raised for the issue of debentures may be used in business to earn a much higher rate of return then the rate of interest. As a result the equity shareholders earn more. 4. Another advantage of debenture issue is that funds are available from investors who are not entitled to have any control over the management of the company. 5. Companies often find it convenient to raise debenture capital from financial institutions, which prefer to invest in debentures rather than in shares. This is due to the assurance of a fixed return and repayment after a specified period. Limitations: Debenture issue as a source of finance has certain limitations too. 1. It involves a fixed commitment to pay interest regularly even when the company has low earnings or incurring losses. 2. Debentures issue may not be possible beyond a certain limit due to the inadequacy of assets to be offered as security. Methods of Issuing Securities: The firm after deciding the amount to be raised and the type of securities to be issued, must adopt suitable methods to offer the securities to potential investors. There are for common methods followed by companies for the purpose. When securities are offered to the general public a document known as Prospectus, or a notice, circular or advertisement is issued inviting the public to subscribe to the securities offered thereby all particulars about the company and the securities offered are made to the public. Brokers are appointed and one or more banks are authorized to collect subscription. Some times the entire issue is subscribed by an organization known as Issue House, which in turn sells the securities to the public at a suitable time. The company may negotiate with large investors of financial institutions who agree to take over the securities. This is known as Private Placement of securities. When an exiting company decides to raise funds by issue of equity shares, it is required under law to offer the new shares to the existing shareholders. This is described as right issue of equity shares. But if the existing shareholders decline, the new shares can be offered to the public. 3. Loans from financial Institutions:

Government with the main object of promoting industrial development has set up a number of financial institutions. These institutions play an important role as sources of company finance. Besides they also assist companies to raise funds from other sources. These institutions provide medium and long-term finance to industrial enterprises at a reason able rate of interest. Thus companies may obtain direct loan from the financial institutions for expansion or modernization of existing manufacturing units or for starting a new unit. Often, the financial institutions subscribe to the industrial debenture issue of companies some of the institutions (ICICI) and (IDBI) also subscribe to the share issued by companies. All such institutions also underwrite the public issue of shares and debentures by companies. Underwriting is an agreement to take over the securities to the extent there is no public response to the issue. They may guarantee loans, which may be raised by companies from other sources. Loans in foreign currency may also be granted for the import of machinery and equipment wherever necessary from these institutions, which stand guarantee for re-payments. Apart from the national level institutions mentioned above, there are a number of similar institutions set up in different states of India. The state-level financial institutions are known as State Financial Corporation, State Industrial Development Corporations, State Industrial Investment Corporation and the like. The objectives of these institutions are similar to those of the national-level institutions. But they are mainly concerned with the development of medium and small-scale industrial units. Thus, smaller companies depend on state level institutions as a source of medium and long-term finance for the expansion and modernization of their enterprise. 4. Retained Profits: Successful companies do not distribute the whole of their profits as dividend to shareholders but reinvest a part of the profits. The amount of profit reinvested in the business of a company is known as retained profit. It is shown as reserve in the accounts. The surplus profits retained and reinvested may be regarded as an internal source of finance. Hence, this method of financing is known as self-financing. It is also called sloughing back of profits. Since profits belong to the shareholders, the amount of retained profit is treated as ownership fund. It serves the purpose of medium and long-term finance. The total amount of ownership capital of a company can be determined by adding the share capital and accumulated reserves. Merits: This source of finance is considered to be better than other sources for the following reasons. 1. As an internal source, it is more dependable than external sources. It is not necessary to consider investors preference. 2. Use of retained profit does not involve any cost to be incurred for raising the funds. Expenses on prospectus, advertising, etc, can be avoided. 3. There is no fixed commitment to pay dividend on the profits reinvested. It is a part of risk capital like equity share capital. 4. Control over the management of the company remains unaffected, as there is no addition to the number of shareholder. 5. It does not require the security of assets, which can be used for raising additional funds in the form of loan. Limitations: However, there are certain limitations on the part of retained profit.

1. Only well established companies can be avail of this sources of finance. Even for such companies retained profits cannot be used to an unlimited extent. 2. Accumulation of reserves often attract competition in the market, 3. With the increased earnings, shareholders expect a high rate of dividend to be paid. 4. Growth of companies through internal financing may attract government restrictions as it leads to concentration of economic power. 5. Public Deposits: An important source of medium term finance which companies make use of is public deposits. This requires advertisement to be issued inviting the general public of deposits. This requires advertisement to be issued inviting the general public to deposit their savings with the company. The period of deposit may extend up to three yeas. The rate of interest offered is generally higher than the interest on bank deposits. Against the deposit, the company mentioning the amount, rate of interest, time of repayment and such other information issues a receipt. Since the public deposits are unsecured loans, profitable companies enjoying public confidence only can be able to attract public deposits. Even for such companies there are rules prescribed by government limited its use. Sources of Short Term Finance The major sources of short-term finance are discussed below: 1. Trade credit: Trade credit is a common source of short-term finance available to all companies. It refers to the amount payable to the suppliers of raw materials, goods etc. after an agreed period, which is generally less than a year. It is customary for all business firms to allow credit facility to their customers in trade business. Thus, it is an automatic source of finance. With the increase in production and corresponding purchases, the amount due to the creditors also increases. Thereby part of the funds required for increased production is financed by the creditors. The more important advantages of trade credit as a source of short-term finance are the following: It is readily available according to the prevailing customs. There are no special efforts to be made to avail of it. Trade credit is a flexible source of finance. It can be easily adjusted to the changing needs for purchases. Where there is an open account for any creditor failure to pay the amounts on time due to temporary difficulties does not involve any serious consequence Creditors often adjust the time of payment in view of continued dealings. It is an economical source of finance. However, the liability on account of trade credit cannot be neglected. Payment has to be made regularly. If the company is required to accept a bill of exchange or to issue a promissory note against the credit, payment must be made on the maturity of the bill or note. It is a legal commitment and must be honored; otherwise legal action will follow to recover the dues. 2. Bank loans and advances: Money advanced or granted as loan by commercial banks is known as bank credit. Companies generally secure bank credit to meet their current operating expenses. The most common forms are cash credit and overdraft facilities. Under the cash credit arrangement the maximum limit of credit is fixed in advance on the security of goods and materials in stock or against the personal security of directors. The total amount drawn is not to exceed the limit fixed. Interest is charged on the amount actually drawn and outstanding. During the period of credit, the company can draw, repay and again draw amounts with in the maximum limit. In the case of overdraft, the company is allowed to overdraw its current account up to the sanctioned limit. This facility is also allowed either against personal security or the security of assets. Interest is charged on the amount actually overdrawn, not on the sanctioned limit.

The advantage of bank credit as a source of short-term finance is that the amount can be adjusted according to the changing needs of finance. The rate of interest on bank credit is fairly high. But the burden is no excessive because it is used for short periods and is compensated by profitable use of the funds. Commercial banks also advance money by discounting bills of exchange. A company having sold goods on credit may draw bills of exchange on the customers for their acceptance. A bill is an order in writing requiring the customer to pay the specified amount after a certain period (say 60 days or 90 days). After acceptance of the bill, the company can drawn the amount as an advance from many commercial banks on payment of a discount. The amount of discount, which is equal to the interest for the period of the bill, and the balance, is available to the company. Bill discounting is thus another source of short-term finance available from the commercial banks. 3. Short term loans from finance companies: Short-term funds may be available from finance companies on the security of assets. Some finance companies also provide funds according to the value of bills receivable or amount due from the customers of the borrowing company, which they take over. UNIT - VIII FINANCIAL ANALYSIS THROUGH RATIOS Ratio Analysis Absolute figures are valuable but they standing alone convey no meaning unless compared with another. Accounting ratio show inter-relationships which exist among various accounting data. When relationships among various accounting data supplied by financial statements are worked out, they are known as accounting ratios. Accounting ratios can be expressed in various ways such as: 1. a pure ratio says ratio of current assets to current liabilities is 2:1 or 2. a rate say current assets are two times of current liabilities or 3. a percentage say current assets are 200% of current liabilities. Each method of expression has a distinct advantage over the other the analyst will selected that mode which will best suit his convenience and purpose. Uses or Advantages or Importance of Ratio Analysis Ratio Analysis stands for the process of determining and presenting the relationship of items and groups of items in the financial statements. It is an important technique of financial analysis. It is a way by which financial stability and health of a concern can be judged. The following are the main uses of Ratio analysis: (a) Useful in financial position analysis: Accounting reveals the financial position of the concern. This helps banks, insurance companies and other financial institution in lending and making investment decisions. (ii) Useful in simplifying accounting figures: Accounting ratios simplify, summaries and systematic the accounting figures in order to make them more understandable and in lucid form. (iii) Useful in assessing the operational efficiency: Accounting ratios helps to have an idea of the working of a concern. The efficiency of the firm becomes evident when analysis is based on accounting ratio. This helps the management to assess financial requirements and the capabilities of various business units. (iv) Useful in forecasting purposes: If accounting ratios are calculated for number of years, then a trend is established. This trend helps in setting up future plans and forecasting. (v) Useful in locating the weak spots of the business: Accounting ratios are of great assistance in locating the weak spots in the business even through the overall performance may be efficient.

(vi) Useful in comparison of performance: Managers are usually interested to know which department performance is good and for that he compare one department with the another department of the same firm. Ratios also help him to make any change in the organisation structure. Limitations of Ratio Analysis: These limitations should be kept in mind while making use of ratio analyses for interpreting the financial statements. The following are the main limitations of ratio analysis. 1. False results if based on incorrect accounting data: Accounting ratios can be correct only if the data (on which they are based) is correct. Sometimes, the information given in the financial statements is affected by window dressing, i. e. showing position better than what actually is. 2. No idea of probable happenings in future: Ratios are an attempt to make an analysis of the past financial statements; so they are historical documents. Now-a-days keeping in view the complexities of the business, it is important to have an idea of the probable happenings in future. 3. Variation in accounting methods: The two firms results are comparable with the help of accounting ratios only if they follow the some accounting methods or bases. Comparison will become difficult if the two concerns follow the different methods of providing depreciation or valuing stock. 4. Price level change: Change in price levels make comparison for various years difficult. 5. Only one method of analysis: Ratio analysis is only a beginning and gives just a fraction of information needed for decision-making so, to have a comprehensive analysis of financial statements, ratios should be used along with other methods of analysis. 6. No common standards: It is very difficult to by down a common standard for comparison because circumstances differ from concern to concern and the nature of each industry is different. 7. Different meanings assigned to the some term: Different firms, in order to calculate ratio may assign different meanings. This may affect the calculation of ratio in different firms and such ratio when used for comparison may lead to wrong conclusions. 8. Ignores qualitative factors: Accounting ratios are tools of quantitative analysis only. But sometimes qualitative factors may surmount the quantitative aspects. The calculations derived from the ratio analysis under such circumstances may get distorted. 9. No use if ratios are worked out for insignificant and unrelated figure: Accounting ratios should be calculated on the basis of cause and effect relationship. One should be clear as to what cause is and what effect is before calculating a ratio between two figures. Ratio Analysis: Ratio is an expression of one number is relation to another. It is one of the methods of analyzing financial statement. Ratio analysis facilities the presentation of the information of the financial statements in simplified and summarized from. Ratio is a measuring of two numerical positions. It expresses the relation between two numeric figures. It can be found by dividing one figure by another ratios are expressed in three ways. 1. Jines method 2. Ratio Method 3. Percentage Method Classification of ratios: All the ratios broadly classified into four types due to the interest of different parties for different purposes. They are: 1. 2. 3. 4. Profitability ratios Turn over ratios Financial ratios Leverage ratios

1. Profitability ratios: These ratios are calculated to understand the profit positions of the business. These ratios measure the profit earning capacity of an enterprise. These ratios can be related its save or capital to a certain margin on sales or profitability of capital employ. These ratios are of interest to management. Who are responsible for success and growth of enterprise? Owners as well as financiers are interested in profitability

ratios as these reflect ability of enterprises to generate return on capital employ important profitability ratios are: Profitability ratios in relation to sales: Profitability ratios are almost importance of concern. These ratios are calculated is focus the end results of the business activities which are the sole eritesiour of overall efficiency of organisation. 1. Gross profit ratio: x gross profit 100

Nest sales
Note: Higher the ratio the better it is 2. Net profit ratio: X Net profit after interest & Tax 100

Net sales
Note: Higher the ratio the better it is 3. Operating ratio (Operating expenses ratio)

Cost of goods sold operating exenses X 100 Net sales

Operating profit operating ratio X 100 = 100 Net sales

Note: Higher the ratio the better it is cost of goods sold= opening stock + purchase + wages + other direct expensesclosing stock (or) sales gross profit. Operating expenses: = administration expenses + setting, distribution expenses operating profit= gross profit operating expense. Expenses ratio =

concernexpense X 100 Net sales

Note: Lower the ratio the better it is Profitability ratios in relation to investments: 1. Return on investments:

Net profit after tax & latest depreciation X 100 share holders funds

Share holders funds = equity share capital + preference share capital + receives & surpluses +undistributed profits. Note: Higher the ratio the better it is 2. Return on equity capital:

Net Profit after tax & interestX- 100 preference divident equity share capital

Note: Higher the ratio the better it is

Net profit after tax - preferecne divident No. of equity shares operating profit 4. Return on capital employed = x 100 capital employed N. P. after tax and interest 5. Return on total assets = Total Assets
3. Earnings per share=

Here, capital employed = equity share capital + preference share capital + reserves & surpluses + undistributed profits + debentures+ public deposit + securities + long term loan + other long term liability factious assets (preliminary expressed & profit & loss account debt balance) II. Turn over ratios or activity ratios: These ratios measure how efficiency the enterprise employees the resources of assets at its command. They indicate the performance of the business. The performance if an enterprise is judged with its save. It means ratios are also laced efficiency ratios. These ratios are used to know the turn over position of various things in the ___________. The turnover ratios are measured to help the management in taking the decisions regarding the levels maintained in the assets, and raw materials and in the funds. These ratio s are measured in ratio method. 1. Stock turnover ratio = Here, Average stock=

cost of goods sold average stock

opening stock closing stock 2

Note: Higher the ratio, the better it is 2. Working capital turnover ratio =

sales working capital

Note: Higher the ratio the better it is working 3. Fixed assets turnover ratio = Note: Higher the ratio the better it is. 3 (i) Total assets turnover ratio is : Note: Higher the ratio the better it is. 4. Capital turnover ratio= Note: Higher the ratio the better it 5. Debtors turnover ratio= 5(i)= Debtors collection period=

sales fixed assets sales total assets

Sales Capital employed

credits sales or sales average debtors 365 (or)12 Turnoveratio

Here, Average debtors =

opening debitors closing bebtors 2

Debtors = debtors + bills receivable Note: Higher the ratio the better it is. 6. Creditors turnover ratio =

credit purchasers or purchases average credetors

6 (i) creditors collection period= Here, Average creditor=

365 (or)12 Creditor turnover ratio

opening closing credetors 2

Creditors = creditors + bills payable. Note: lower the ratio the better it is. 3. Financial ratios or liquidity ratios: Liquidity refers to ability of organisation to meet its current obligation. These ratios are used to measure the financial status of an organisation. These ratios help to the management to make the decisions about the maintained level of current assets & current libraries of the business. The main purpose to calculate these ratios is to know the short terms solvency of the concern. These ratios are useful to various parties having interest in the enterprise over a short period such parties include banks. Lenders, suppliers, employees and other. The liquidity ratios assess the capacity of the company to repay its short term liabilities. These ratios are calculated in ratio method. Current ratio =

currentassets currentliabilitie s

Note: The ideal ratio is 2:1 i. e., current assets should be twice. The current liabilities. Quick ratio or liquid ratio or acid test ratio:

quick assets currentliabilitie s

Quick assets = cash in hand + cash at bank + short term investments + debtors + bills receivables short term investments are also known as marketable securities. Here the ideal ratio is 1:1 is, quick assets should be equal to the current liabilities. Absolute liquid ratio=

absolute liquid assets currentliabilitie s

Here, Absolute liquid assets=cash in hand + cash at bank + short term investments + marketable securities. Here, the ideal ratio is 0,0:1 or 1:2 it, absolute liquid assets must be half of current liabilities. Leverage ratio of solvency ratios: Solvency refers to the ability of a business to honour long item obligations like interest and installments associated with long term debts. Solvency ratios indicate long term stability of an enterprise. These ratios are used to understand the yield rate if the organisation. Lenders like financial institutions, debenture, holders, banks are interested in ascertaining solvency of the enterprise. The important solvency ratios are: 1. Debt equity ratio= =
outsiders funds share holders funds

Debt Equity

Here, Outsiders funds = Debentures, public deposits, securities, long term bank loans + other long term liabilities. Share holders funds = equity share capital + preference share capital + reserves & surpluses + undistributed projects.

The ideal ratio is 2:1 2. Preprimary ratio or equity ratio= The ideal ratio is 1:3 or 0.33:1 3. Capital greasing ratio: = Here,

share holder funds total assets

(equity share capital reserves & surplusses undistributed projects) (Outsiders funds preference share capital )

higher gearing ratio is not good for a new company or the company in which future earnings are uncertain. 11. Debt to total fund ratio= Capital employed= outsiders funds + The ideal ratio is 0.6.7 :1 or 2:3

outsiders funds capital employed

1. A companys return on investment indicates its ____. (a) Solvency (b) Stock turnover (c) Profitability (d) Debtors collection 2. Which would a business be most likely to use its solvency (a) Gross profit ratio (b) Debtors collection period (c) Debt Equity ratio (d) Current ratio 3. Higher Assets turnover ratio explains ____. (a) More profitability (b) Higher sales turnover (c) Better utilization of assets (d) large liability base 4. Which of the following measures companys liquidity position (a) Stock Turnover ratio (b) Debtors collection period (c) Current ratio (d) Net profit ratio 5. The difference between current assets and current liabilities is called___. (a) Cost of goods sold (b) Outsiders funds (c) Working capital (d) Shareholders funds 6. Debtors is a current asset, where as creditors is ________. (a) Fixed Asset (b) Fixed Liability (c) Current Liability (d) Long-term Liability 7. What is the Desirable current Ratio ______? (a) 1:2 (b) 3:2 (c) 2:1 (d) 1:1 8. Long-term stability of an enterprise indicates by ____ ratios. (a) Liquidity (b) Profitability (c) Solvency (d) Turnover 9. The Liquidity ratios assess the capacity of the company to repay Its_____________ Liability. ( ( ( (

(a) Long-term (c) Solvency

(b) Profitability (d) Turnover

10. In which Book-keeping system, business transactions are recorded as two separate accounts at the same time? ( (a) Single entry (b) Triple entry (c) Double entry (d) None 11. In which Concept Business is treated separate from the Proprietor? (a) Cost concept (b) Dual aspect concept (c) Business entity concept (d) Matching concept 12. When a deduction allowed from the gross or catalogue price to traders; then it is called as ____. ( ) (a) Cash discount (b) Credit discount (c) Trade discount (d) None 13. Out standing wages is treated as _________. (a) Asset (b) Expense (c) Liability (d) Income 14. How many types of accounts are maintained to record all types of business transactions? ( ) (a) Five (b) four (c) Three (d) Two 15. Which connects the link between Journal and Trial Balance? (a) Trading Account (b) Profit & Loss account (c) Ledger (d) Balance sheet 16. Which assets can be converted into cash in short period? (a) Fixed Assets (b) Intangible Assets (c) Current Assets (d) Fictious Assets 17. Bank over draft is a ________. (a) Asset (b) Expense (c) Liability (d) Income 18. Profit and Loss account is prepared to find out the business ____. (a) Gross result (b) Financial position (c) Net result (d) Liquidity position 19. The statement of Debit and credit balances of Ledger accounts is called as _________. ( (a) Journal (b) Ledger (c) Trial balance (d) Balance sheet 20. _____ is a person who owes money to the firm. (a) Creditor (b) Owner (c) Debtor (d) Share holder 21. The statement reveals the financial positions of a business at any given date is called __________. ( (a) Trading account (b) Profit and loss account (c) Balance sheet (d) Trial balance ( ( (

22. ______ is called as Book of Original Entry. (a) Ledger (b) Trial Balance (c) Journal (d) Trading account 23. Debit what comes in; Credit what goes out is ____ account principle? (a) Nominal (b) Personal (c) Real (d) None

24. The process of entering transactions in to Ledge accounts known as __. (a) Journal entry (b) First entry (c) Posting (d) None

25. Debit Expenses and Losses; Credit Incomes and Gains is ___ account Principle ( ) (a) Personal (b) Real (c) Nominal (d) None 26. Prepaid Insurance Premium is treated as _________. (a) Gain (b) Income (c) Asset (d) Liability 27. Acid Test Ratio is also called as ________. (a) Current Ratio (b) Absolute Liquid Ratio (c) Quick Ratio (d) Debt-Equity Ratio 28. The relationship between two numerical values is called as ____. (a) Account (b) Ledger (c) Ratio (d) Discount 29. Gross Profit can be found out by preparing _______. (a) Profit and Loss account (b) Balance sheet (c) Trading account (d) Trial balance 30. Net Profit can be found out by preparing _______. (a) Trading account (b) Trial balance (c) Profit and Loss account (d) Balance sheet ( ( ( )

Note: Answer is C for all the above questions.