{Page 1} INTRODUCTION Accounting serves the purpose of providing financial information relating a business. such information is provided to people who have interest in the organization , such as shareholders, managers, creditors, debenture holders, bankers, tax authorities and others, broadly speaking, on the basis of type of accounting information and the purpose for which such information is used, accounting may be divided into three categories: 1. Financial accounting (or General accounting), 2. Cost accounting, and 3. Management accounting FINANCIAL ACCOUNTING: Financial accounting is mainly concerned with recording business transaction in the books of account for the purpose presenting financial accounts to management, share holders, creditors, investors and tax authorities, etc. It is defined as “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”. The information supplied by financial accounting is summarized in the following two statements at the end of the accounting period, generally one year. Profit and loss account showing the net profit or loss during the period. Balance Sheet showing the financial position of the firm at the point of time. OBJECTIVE OF FINANCIAL ACCOUNTING: Financial accounting is to present a true and fair view of company’s income and financial position at regular intervals of one year mainly for use by parties who are external to business. COST ACCOUNTING: Cost accounting is a branch of accounting which specializes in providing information about the detailed cost of products or services being supplied by the undertaking. Compared with financial accounting, cost accounting is relatively a recent development. It has primarily developed to meet the needs of management. Profit and loss Account of balance sheet are presented to management by the financial accountant.
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A FINANCIAL STATEMENT USING RATIO ANALYSIS AT MAHINDRA AND MAHINDRA LTD
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INTRODUCTION
Accounting serves the purpose of providing financial information relating a business. such information
is provided to people who have interest in the organization , such as shareholders, managers, creditors,
debenture holders, bankers, tax authorities and others, broadly speaking, on the basis of type of
accounting information and the purpose for which such information is used, accounting may be divided
into three categories:
1. Financial accounting (or General accounting),
2. Cost accounting, and
3. Management accounting
FINANCIAL ACCOUNTING:
Financial accounting is mainly concerned with recording business transaction in the books of account
for the purpose presenting financial accounts to management, share holders, creditors, investors and tax
authorities, etc.
It is defined as “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”.
The information supplied by financial accounting is summarized in the following two statements at the
end of the accounting period, generally one year.
Profit and loss account showing the net profit or loss during the period.
Balance Sheet showing the financial position of the firm at the point of time.
OBJECTIVE OF FINANCIAL ACCOUNTING:
Financial accounting is to present a true and fair view of company’s income and financial position at
regular intervals of one year mainly for use by parties who are external to business.
COST ACCOUNTING:
Cost accounting is a branch of accounting which specializes in providing information about the detailed
cost of products or services being supplied by the undertaking. Compared with financial accounting, cost
accounting is relatively a recent development. It has primarily developed to meet the needs of
management. Profit and loss Account of balance sheet are presented to management by the financial
accountant.
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The terms ‘costing’ and ‘cost accounting’ are often used interchangeably. The chartered institute of
Management Accountants (CIMA) of UK has defined costing as, “the techniques and process of
ascertaining costs”. Thus, costing simply means cost finding by any process or technique. It consists of
principles and rules which are used for determining:
(a) The cost of manufacturing a product; e.g., motor car, furniture, chemical steel, paper etc.
(b) The cost of providing a services; e.g., electricity, transport, education, etc.
Cost accounting information is mainly for internal use i.e. management. It is not to be provided to
external parties such as shareholder, creditors, potential investors, etc. neither do they have any claim on
this information, excepting government, to whom cost information may have to be submitted.
MANAGEMENT ACCOUNTING:
Meaning and Definitions
The terms ‘management accounting’ is the modern concept of accounts as a tool of management.
It is a board term and is concerned with all such accounting information that is useful to management. In
simple words, the term management accounting is applied to the provision of accounting information for
management activities such as planning, controlling and decision making, etc.
According to the Institute of Chartered Accountants of England, “any form of accounting which
enables a business to be conducted more efficiently” may be regarded as management accounting”.
Relationship of Management Accounting to Cost Accounting and Financial Accounting:
The three types of accounting, i.e., financial accounting, cost accounting and management accounting
are closely linked. The management accounting uses the principles and practices not only of cost
accounting but also of financial accounting. Information provided by financial accounting proves
extremely useful for management accounting. For example, profit and loss account and balance sheet
become the basis of ratio analysis and comparative financial statements, etc, which are used by the
management accounting as important tools of planning and control.
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Financial accounting records also become basis of preparing detailed cost computation and reports. Cost
accounting is a more detailed application of financial accounting and provides detailed cost information
about products, services, departments, etc. This information is used by management accounting for
planning, controlling and decision making purposes.
Fig. 1.1 shows the evolution of management accounting and its relationship to cost accounting and
financial accounting.
Fig.1.1. Relationship of financial, cost and management accounting.
PREPARING
PROFIT & LOSS
ACCOUNT AND
BALANCE SHEET
FINANCIAL
ACCOUNTING
ANALYSING
COST FOR
CONTROL AND
MAXIMISING
EFFICIENCY
COST
ACCOUNTING
ASSISTING
MANAGEMENT
FOR PLANNING,
DECISION
MAKING AND
CONTROL
MANAGEMENT
ACCOUNTING
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MANAGEMENT ACCOUNTANT – THE CONTROLLER
Management accountant plays a very important role in an organization. He analyses and interprets
accounting information and meets the informational needs of management at different levels. In an
organization, a management accountant generally performs a staff function i.e. advisory role. But if he is
permitted to participate in planning and decision making, he is a part of the management team and thus
becomes a part of the line function. It is very important that status of the management accountant in the
organization is clearly defined so that the scope of his work and responsibilities are accordingly
determined.
ORIGIN
The first basic principles of management accounting emerged during the period 1400 to 1600 in the
form of standards for materials, employee productivity, job cost system and budgets. But no
standardized management accounting was in practice until 1885 when Henry Metcalf published the
‘cost manufacture’. The real growth of management accounting was in 20 th century in USA due to the
emergence of large and integrated companies such as DuPont and general motors.
In fact the growth of management accounting is because of the need to overcome the limitations of
financial and cost accounting.
LIMITATIONS OF FINANCIAL ACCOUNTING:
Financial accounting is extremely useful to different categories of users. But it also suffers from the
following limitations.
1. Shows only overall performance. Financial accounting provides information about profit, loss,
cost etc., of the collective activities of the business as a whole. It does not give data regarding
costs by departments, products, processes and sales territories, etc.
2. Historical in nature. Financial accounting is historical, since the data are summarized only at
the end of the accounting period. There is no system of computing day to day cost and also
computing pre- determined costs.
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3. No performance appraisal. In financial accounting, there is no system of developing norms and
standards to appraise the efficiency in the use of materials, labour and other costs by comparing
the actual performance with what should have been accomplished during a given period of time.
4. No material control system. Generally, there is no proper system of control of materials losses
which may arise in the form of obsolescence, deterioration, excessive scrap and
misappropriation, etc.
5. No labour cost control. In financial accounting, there is no system of recording loss of labour
time; i.e., idle time. Labour cost is not recorded by jobs, processes or departments and as such no
system of incentives may be easily used to compensate workers for their above – standard
performance.
CHARACTERISTICS OR NATURE OF MANAGEMENT ACCOUNTING:
It is clear from the above definitions that management accounting is concerned with accounting data that
is useful in decision making. The main characteristics of management accounting are as follows:
1. Useful in decision making. The essential aim of management accounting is to assist
management in decision making and control. It is concerned with all such information which can
prove useful to management in decision making.
2. Financial and cost accounting information. Basic accounting information useful for
management accountings derived from cost accounting records.
3. Internal use. Information provided by management accounting is exclusively for use by
management for internal use. Such information is not to be given to parties external to the
business like shareholders, creditors, banks etc.
4. Purely optional. Management accounting is a purely voluntary technique and there is no
statutory obligation. Its adoption by any firm depends upon its utility and desirability.
5. Concerned with future. As management accounting is concerned with decision making, it is
related with future because decision is taken for future course of action and not the past.
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CHARACTERISTICS OR NATURE OF MANAGEMENT ACCOUNTING:
It is clear from the above definitions that management accounting is accounting is concerned with
accounting data that is useful in decision making. The main characteristics of management accounting as
follows:
* Useful in decision making. The essential aim of management accounting is to assist
management in decision making and control. It is concerned with all such information which can
prove useful to management in decision making.
* Financial and cost accounting information. Basic accounting information useful for
management accountings derived from financial and cost accounting records.
* Internal use. Information provided by management accounting is exclusively for use by
management for internal use. Such information is not to be given to parties external to the
business like shareholders, creditors, banks, etc.
* Purely optional. Management accounting is a purely voluntary technique and there is no
statutory obligation. Its adoption by any firm depends upon its utility and desirability.
* Concerned with future. As management accounting is concerned with decision making, it is
related with future because decisions are taken for future course of action and not the past.
SCOPE OF MANAGEMENT ACCOUNTING:
Management accounting has a very wide scope. It includes not only financial accounting and cost
accounting but all type of internal control, internal audit, tax accounting, office services, cost control and
other methods and control procedures. Thus scope of management accounting inter alia includes the
following:
1. FINANCIAL ACCOUNTING.
Financial accounting provides basic historical data which helps management to forecast and plan
its financial activities for the future period. Thus for an effective and successful management
accounting, there should be a proper and well designed financial accounting system.
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2. COST ACCOUNTING:
Many of the techniques of profit planning and decision-making like marginal costing, CVP
analysis and differential cost analysis are used by the management accounting.
3. BUDGETING AND FORECASTING:
In order to plan business activities for the future, forecasting and budgeting play a very
significant role. Forecasting helps in the preparation of budgets and budgeting helps management
accountant in exercising budgetary control.
4. TAX PLANNING:
In order to take advantage of various provisions of tax laws, management accountant has to
depend upon tax accounting and planning to minimize its tax liabilities and save more funds for
the business.
5. REPORTING TO MANAGEMENT:
For effective and timely decision, there should be a system of prompt and intelligent reporting
into management both routine and special reports are prepared for submission to top
management, middle order management and operating level management depending and their
requirements.
TOOLS AND TECHNIQUES USED IN MANAGEMENT ACCOUNTING
Management accounting uses a number of tools and techniques to help management in achieving
business goals. Some of the important tools and techniques are as follows:
1. Budgeting
2. Standard costing and variance analysis.
3. Marginal costing and costing volume profit analysis.
4. Ratio analysis.
5. Comparative financial statements
6. Differential cost analysis.
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FINANCIAL ACCOUNTING AND MANAGEMENT ACCOUNTING-COMPARISON
Financial accounting and management accounting are two major sub – systems of accounting
information system. Both are concerned with revenues and expenses, assets and liabilities and cash
flows. Both therefore involve financial statements. But the major differences between the two arise
because they serve different audiences. The main points of difference the two are as follows:
Basis Financial Accounting Management Accounting
1. External &
internal users
Financial accounting information is
mainly intended for external users
like investors, shareholders,
creditors, govt. authorities, etc,:
Management accounting
information meant for internal
users, i.e., management.
2. Accounting
method
It is based on double entry system
for recording business transactions.
It is not based on double entry
system.
3. Statement
requirements
Under company law and tax laws,
financial accounting is obligatory to
satisfy various statutory provisions.
Management accounting
provides detailed information
about individual products,
plants, departments or any other
responsibility centre.
4. Analysis of cost
& profit
Financial accounting shows the
profit/loss of the business as a
whole. It does not show the cost &
profit for individual products,
processes or departments are.
Management accounting
provides detailed information
about individual products,
plants, departments or any other
responsibility centre.
5. Past and future
data.
It is concerned with recording
transitions which have already taken
place, i.e., it represents past or
historical records.
It is future oriented and
concentrates on what is likely to
happen in future though it may
use past data for future
projections.
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COST ACCOUNTING AND MANAGENT ACCOUNTING:
An examination of the meaning and definitions of cost accounting and management accounting indicates
that the distinction between the two is quit vague. Some writers even consider these two areas as
synonymous while others distinguish between the two. horngren, a renowned author on the subject, has
gone to the extent of saying, “modern cost accounting is often called management accounting. Why?
Because cost accountings look at their organization through manager’s eyes”. Thus managerial aspects
of cost accounting are inseparable from management accounting. One point on which all agree is that
these two types of accounting do not have clear cut territorial boundaries. However, distinction between
cost accounting and management accounting may be made on the following point:
BASIS COST ACCOUNTING MANAGEMENT ACCOUNTING
1. Scope Scope of cost accounting is limited
to providing cost information for
managerial uses.
Scope of management accounting is
broader than that of cost accounting
as it provides all types of
information, i.e...Cost accounting
information for managerial uses.
2. Emphasis Main emphasis is on cost
ascertainment and cost control to
ensure maximum profit.
Main emphasis is on planning
controlling and decision-making to
maximize profit.
3. Technique
employed
Various technique used by cost
accounting include standard
costing and variance analysis,
marginal costing and cost volume
profit analysis, budgetary control,
uniform costing and inter-firm
comparison, etc.
Management accounting also uses
all these techniques used in cost
accounting but in addition it also
uses techniques like ratio analysis,
funds flow statement, statistical
analysis, operations research and
certain techniques from various
branches of knowledge like
mathematics, economics, etc.,
which so ever can help
management in its tasks.
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LIMITATION ON MANAGEMENT ACCOUNTING
Management accounting is very useful tool of management. However, it suffers from certain limitations
as stated below:
1) Based on historical data:
Management accounting helps management in making decisions for the future but it is mainly
based on the historical data supplied by financial accounting and cost accounting. This implies
that historical data is used for making future decisions. The accuracy and dependability of such
data will leave their mark on the quality of managerial decisions.
2) Lack of wide knowledge:
The management accountant should have knowledge of not only financial and cost accounting
but also many allied subjects like economics, management, taxation, statistical and mathematical
techniques etc. lack of knowledge of these subjects on the part of management accountant limits
the quality of management accounting.
3) Complicated approach:
Management accounting provides mass of data using various accounting and non-accounting
subjects for decision making purpose. But sometimes management avoided this complicated and
lengthy course of decision making and makes decisions based on intuition. This leads to
unscientific approach to decision making.
4) Not a substitute of management:
Management accounting only provides information to management for decision making but it is
not a substitute of management and administration.
5) Costly system:
The installation of management accounting system in an organization is costly affair as it
requires a wide net-work of management information system, rules and regulations. All this
requires heavy investment and small concerns may not be able to afford it.
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RATIO ANALYSIS
MEANING OF FINANCIAL STATEMENT:
The term financial statements refer to two basic statements which an accounting prepares at the end of
an accounting period for a business enterprise. These are:
1. Balance sheet (or Income statement of financial position ) which reflects the assets, Liabilities
and capital as on a certain date, and
2. Profit and Loss Account (or Income Statement) which shows the results of operations i.e. profit
or loss during a certain period.
RATIO ANALYSIS:
Ratio analysis is the process of determining and interpreting numerical relationship based on financial
statements. It is the technique of interpretation of financial statements with the help of accounting ratios
derived from the balance sheet and profit and loss account.
Ratio analysis is a very important tool of financial analysis. It is the process of establishing the
significant relationship between the items of financial statement to provide a meaningful understanding
of the performance and financial position of a firm. Ratio when calculated on the Basis of accounting
information are called ‘Accounting Ratio’.
DEFINITIONS:
Kennedy and Mc Mullah. “The relationship of one to another, expressed in simple term of
mathematical is known as ratio”
According to Accountant’s Handbook by Wixom, kell and Bedford, a ratio “is an expression of the
quantitative relationship between two numbers”.
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Ratio analysis is very powerful and most commonly used tool of analysis and interpretation of financial
statements. It concentrates on the inter-relation among the figures appearing in the financial statements.
Ratio analysis helps to analyze the part performance of a company and to make future projections. It
allows various interested parties like management, shareholders, potential investors, creditors,
government and other analysts to make an evaluation of the various aspects of company’s performance
from their own point of view and interest. For example, management and shareholders may be interested
in the company’s profitability while creditors and debenture holders may be interested in solvency of the
company.
BASIS OF COMPARISON:
Trend Analysis involves comparison of a firm over a period of time, that is, present ratios are compared
with past ratios for the same firm. It indicates the direction of change in the performance –
improvement, deterioration or constancy – over the years.
Inter-firm Comparison involves comparing the ratios of a firm with those of others in the same lines of
business or for the industry as a whole. It reflects the firm’s performance in relation to its competitors.
WAYS TO INTERPRET ACCOUNTING RATIOS:
Single absolute ratio.
Group ratio.
Historical comparison.
Inter-firm comparison.
Projected ratios.
CLASSIFICATION OF RATIOS:
Analysis of Short Term Financial Position or Test of Liquidity.
Analysis of Long Term Financial Position or Test of Solvency.
Activity Ratios.
Profitability Ratios.
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TEST OF LIQUIDITY:
The liquidity ratios are used to test the short term solvency or liquidity position of the business.
It enables to know whether short term liabilities can be paid out of short term assets.
It indicates whether a firm has adequate working capital to carry out routine business activity.
It is a valuable aid to management in checking the efficiency with which working capital is being
employed.
It is also of importance to shareholders and long term creditors in determining to some extent the
prospects of dividend and interest payment.
IMPORTANT RATIOS IN TEST OF LIQUIDITY:
1. Current ratio.
2. Quick ratio.
3. Absolute liquid ratio.
CURRENT RATIO
It is the most widely used of all analytical devices based on the balance sheet. It establishes relationship
between total current assets and current liabilities.
Current assets
Current ratio =
Current liabilities
IDEAL RATIO: 2:1
High ratio indicates under trading and over capitalization.
Low ratio indicates over trading and under capitalization.
ABSOLUTE LIQUIDITY RATIO
This ratio establishes a relationship between absolute liquid assets to quick liabilities.
Absolute liquid assets
Absolute liquid ratio=
Quick liabilities
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IDEAL RATIO: 1:2
It means that if the ratio is 1:2 or more than this the concern can be taken as liquid. If the ratio is less
than the standard of 1:2, it means the concern is not liquid.
Notes: - {Quick assets = Current asset-(inventories + prepaid expenses)
Quick Liabilities = Current liabilities – Bank overdraft
Absolute liquid assets include cash in hand, cash at bank, marketable securities, Temporary
investments.}
II. TEST OF SOLVENCY
Solvency indicates that position of an enterprise where it is capable of meeting long term
obligations.
When an organization's assets are more than its liabilities is known as solvent organization.
Long term solvency ratios denote the ability of the organization to repay the loan and interest.
IMPORTANT RATIOS IN TEST OF SOLVENCY:
Debt-equity ratio.
Proprietary ratio.
Solvency ratio.
Fixed assets to net worth ratio.
Current assets to net worth ratio.
Current liabilities to net worth ratio.
Capital gearing ratio.
Fixed assets ratio
Debt servicing ratio.
Dividend coverage ratio.
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DEBT EQUITY RATIO:
It is calculated to measure the relative claims of outsiders and the owners against the firm’s assets. This
ratio indicates the relationship between the outsider’s funds and the shareholders’ funds.
Outsider’s funds Debt equity ratio=
Shareholders’ funds
IDEAL RATIO: 2:1;
It means for every 2 shares there is 1 debt. If the debt is less than 2 times the equity, it means the
creditors are relatively less and the financial structure is sound. If the debt is more than 2 times the
equity, the state of long term creditors are more and indicate weak financial structure.
Notes: - {Components of Debt Equity Ratio Outsider’s funds include all debts/liabilities to outsiders,
whether long term or short term or whether in the form of debentures, bonds, mortgages or bills.
Shareholders’ funds consists of equity share capital, preference share capital, capital
reserves, revenue reserves and reserves representing accumulated profits and surpluses like
reserve for contingencies sinking funds. The accumulated losses and deferred expenses, if any
should be deducted from the total to find out shareholders’ funds, it is called net worth and the
ratio may be termed as debt to net worth ratio. }
PROPRIETARY RATIO OR NET WORTH RATIO:
It establishes relationship between the proprietors fund or shareholders funds and the total assets
Proprietary funds Capital employed
Proprietary ratio = or
Total assets Total liabilities
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IDEAL RATIO: 0.5:1
Higher the ratio betters the long term solvency (financial) position of the company. This ratio indicates
the extent to which the assets of the company can be lost without affecting the interest of the creditors of
the company
Notes:-
{Components of Proprietary Ratio: Shareholders’ funds or Proprietary funds are equity share
capital, preference share capital, undistributed profits, reserves and surpluses. Out of this amount
accumulated losses should be deducted. Total assets on other hand denote total resources of the
concern.}
SOLVENCY RATIO:
It expresses the relationship between total assets and total liabilities of a business. This ratio is a small
variant of equity ratio and can be simply calculated as 100-equity ratio
Total assets
Solvency ratio=
Total liabilities
No standard ratio is fixed in this regard. It may be compared with similar, such organizations to evaluate
the solvency position. Higher the solvency ratio, the stronger is its financial position and vice-versa.
FIXED ASSETS TO NET WORTH:
It is obtained by dividing the depreciated book value of fixed assets by the amount of proprietor’s funds.
Net fixed assets
Fixed assets to net worth ratio=
Net worth
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IDEAL RATIO: 0.75:1
A higher ratio, say, 100% means that there are no outside liabilities and all the funds employed are those
of shareholders. In such a case the return to shareholders would be lower rate of dividend and this is also
a sign of over capitalization.
This ratio shows the extent to which ownership funds are sunk into assets with relatively low turnover.
When the amount of proprietor's funds exceed the value of fixed assets, a part of the net working capital
is provided by the shareholders, provided there are no other non-current assets, and when proprietor’s
funds are less than the fixed assets, creditors obligation have been used to finance a part of fixed assets.
The Yardstick for this measure is 65% for industrial undertakings.
CURRENT ASSETS TO NET WORTH RATIO:
It is obtained by dividing the value of current assets by the amount of proprietor’s funds. The purpose of
this ratio is to show the percentage of proprietor’s fund investment in current assets.
Current assets
Current assets to net worth ratio=
Proprietor’s fund
A higher proportion of current assets to proprietor’s fund, as compared with the proportion of fixed
assets to proprietor’s funds are advocated, as it is an indicator of the financial strength of the business,
depending on the nature of the business there may be different ratios for different firms. This ratio must
be read along with the results of fixed assets to proprietor’s funds ratio.
CURRENT LIABILITIES TO NET WORTH:
It is expressed as a proportion and is obtained by dividing current liabilities by proprietor's fund.
Current liabilities
Current liabilities to net worth ratio = Net worth
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IDEAL RATIO: 1:3
This ratio indicates the relative contribution of short term creditors and owners to the capital of an
enterprise. If the ratio is high, it means it is difficult to obtain long term funds by the business.
CAPITAL GEARING RATIO:
It expresses the relationship between equity capital and fixed interest bearing securities and fixed