Course Code : MCS-035
Course Title : Accountancy and Financial Management
Assignment Number : MCA (3)/035/Assign/2014-15
Maximum Marks : 100
Weightage : 25%
Last Dates for Submission : 15th October, 2014 (For July 2014 Session)
15th April, 2015 (For January 2015 Session)
Note: This assignment has five questions. Answer all questions. 20 marks are for viva voce. You may use illustrations and diagrams to enhance the explanations. Please go through the guidelines regarding assignments given in the Programme Guide for the format of presentation.
Question 1
Explain the role of Ratio Analysis in the interpretation of financial statements. Examine the limitations of ratio analysis.
A ratio is an arithmetical relation between two figures or variables. Financial ratio analysis is a study of ratios between various items or group of items in financial statements. Financial ratio analysis is an analytical tool for measuring the
performance of an organisation. Ratio analysis is primarily used to analyse past performance and based on this make future projections.
Users of Financial Ratios
Financial ratio analysis is the process of establishing relationship between the variables of the balance sheet and profit and loss account, in order to find out the strength and weakness of the firm. Ratio analysis is undertaken by the various stock holders in the firm viz. trade creditors, suppliers of long-term debt, investors and the management itself. Trade Creditors are interested in the firm’s ability to meet claims in the short run. Their analysis will therefore, be confined to the firm’s liquidity position in the short run. Suppliers of long-term debt, on the other hand are more concerned with long-term solvency and survival. They analyse the firm’s profitability over time, its ability to generate cash, its ability to repay interest and the principle amount. They also analyse the capital structure. Long-term suppliers of credit do analyse the historical financial statements but their main focus is on projected or proforma financial statement to analyse its future solvency and profitability. Investors are interested in the firm’s earnings and how these earnings are used. They concentrate on the firm’s present and future profitability. They are also interested in the firm’s financial structure to the
extent that it influences the firm’s earnings ability and risk. Ratios are used as a bench mark for evaluating the financial position and performance of a firm. Accounting figures presented in the financial statements would convey some meaning only if they are seen in relation to the other variables. Ratios help to other summarise large quantities of financial information (data). Through ratio analysis one can make a qualitative judgment. The ratios basically reflect a quantitative relationship among different variables.
The current and acid test ratios are satisfactory. Since they are above the ideal standards of 2:1 and 1:1 respectively.
1. The debt equity ratio is marginally higher than the ideal standard of 2:1.However, the debt-equity ratio fixed assets ratios reflect a satisfactory position of the company.
2. The Gross Profit Ratio and Net Profit Ratio and Return on Capital Employed is not impressive and effort needs to be made to improve the profitability of the Company.
Question 2
Critically examine the various methods of evaluation of Capital Budgeting Proposals. Discuss their advantages and limitations.
Solution:
Some of the major techniques used in capital budgeting are as follows: 1. Payback period 2. Accounting Rate of Return method 3. Net present value method 4. Internal Rate of Return Method 5. Profitability index.
1. Payback period:
The payback (or payout) period is one of the most popular and widely recognized traditional methods of evaluating investment proposals, it is defined as the number of years required to recover the original cash outlay invested in a project, if the project generates constant annual cash inflows, the payback period can be computed dividing cash outlay by the annual cash inflow.
Payback period = Cash outlay (investment) / Annual cash inflow = C / A
Advantages:
1. A company can have more favourable short-run effects on earnings per share by setting up a shorter payback period.
2. The riskiness of the project can be tackled by having a shorter payback period as it may ensure guarantee against loss.
3. As the emphasis in pay back is on the early recovery of investment, it gives an insight to the liquidity of the project.
Limitations:
1. It fails to take account of the cash inflows earned after the payback period.
2. It is not an appropriate method of measuring the profitability of an investment project, as it does not consider the entire cash inflows yielded by the project.
3. It fails to consider the pattern of cash inflows, i.e., magnitude and timing of cash inflows.
2. Accounting Rate of Return method:
The Accounting rate of return (ARR) method uses accounting information. The accounting rate of return is found out by dividing the average income after taxes by the average investment.
ARR= Average income/Average Investment
Advantages:
1. It is very simple to understand and use.
2. It can be readily calculated using the accounting data.
3. It uses the entire stream of incomes in calculating the accounting rate.
Limitations:
1. It uses accounting, profits, not cash flows in appraising the projects.
2. It ignores the time value of money; profits occurring in different periods are valued equally.
3. It does not consider the lengths of projects lives.
4. It does not allow for the fact that the profit can be reinvested.
3. Net present value method:
The net present value (NPV) method is a process of calculating the present value of cash flows (inflows and outflows) of an investment proposal, using the cost of capital as the appropriate discounting rate, and finding out the net profit value, by subtracting the present value of cash outflows from the present value of cash inflows.
Advantages:
1. It recognizes the time value of money
2. It considers all cash flows over the entire life of the project in its calculations.
3. It is consistent with the objective of maximizing the welfare of the owners.
Limitations:
1. It is difficult to use
2. It presupposes that the discount rate which is usually the firm’s cost of capital is known. But in practice, to understand cost of capital is quite a difficult concept.
3. It may not give satisfactory answer when the projects being compared involve different amounts of investment.
4. Internal Rate of Return Method:
The internal rate of return (IRR) equates the present value cash inflows with the present value of cash outflows of an investment. It is called internal rate because it depends solely on the outlay and proceeds associated with the project and not any rate determined outside the investment.
Advantages:
1. It considers cash flows over the entire life of the project.
2. It satisfies the users in terms of the rate of return on capital.
3. It is compatible with the firm’s maximising owners’ welfare.
Limitations:
1. It involves complicated computation problems.
2. It may not give unique answer in all situations. It may yield negative rate or multiple rates under certain circumstances.
5. Profitability index:
It is the ratio of the present value of future cash benefits, at the required rate of return to the initial cash outflow of the investment. It may be gross or net, net being simply gross minus one.
Advantages:
1. It gives due consideration to the time value of money.
2. It requires more computation than the traditional method but less than the IRR method.
3. It can also be used to choose between mutually exclusive projects by calculating the incremental benefit cost ratio.
Question 3
“Inadequate working capital is disastrous whereas redundant working capital is a criminal waste. Critically examine this statement.” Discuss.
Solution:
The advantages of working capital or adequate working capital may be enumerated as below: -
Cash Discount:
If a proper cash balance is maintained, the business can avail the advantage of cash discount by paying cash for the purchase of raw materials and merchandise. It will result in reducing the cost of production.
It creates a Feeling of Security and Confidence:
The proprietor or officials or management of a concern are quite carefree, if they have proper working capital arrangements because they need not worry for the payment of business expenditure or creditors. Adequate working capital creates a sense of security, confidence and loyalty, not only throughout the business itself, but also among its customers, creditors and business associates.
Sound Goodwill and Debt Capacity:
It is common experience of all prudent businessmen that promptness of payment in business creates goodwill and increases the debt of the capacity of the business. A firm can raise funds from the market, purchase goods on credit and borrow short-term funds from bank, etc. If the investor and borrowers are confident that they will get their due interest and payment of principal in time.
Easy Loans from the Banks:
An adequate working capital i.e. excess of current assets over current liabilities helps the company to borrow unsecured loans from the bank because the excess provides a good security to the unsecured loans, Banks favor in granting seasonal loans, if business has a good credit standing and trade reputation.
Distribution of Dividend:
If company is short of working capital, it cannot distribute the good dividend to its shareholders inspite of sufficient profits. Profits are to be retained in the business to make up the deficiency of working capital. On the other contrary, if working capital is sufficient, ample dividend can be declared and distributed. It increases the market value of shares.
Exploitation of Good Opportunity:
In case of adequacy of capital in a concern, good opportunities can be exploited e.g., company may make off-season purchases resulting in substantial savings or it can fetch big supply orders resulting in good profits.
Meeting Unseen Contingency:
Depression shoots the demand of working capital because sock piling of finished goods become necessary. Certain other unseen contingencies e.g., financial crisis due to heavy losses, business oscillations, etc. can easily be overcome, if company maintains adequate working capital.
High Morale:
The provision of adequate working capital improves the morale of the executive because they have an environment of certainty, security and confidence, which is a great psychological, factor in improving the overall efficiency of the business and of the person who is at the hell of fairs in the company.
Question 4
Differentiate between:
a) Trial Balance and a Balance sheet
Solution:
Trial Balance
Balance Sheet
1.
A Trial Balance is prepared to check the arithmetical accuracy of the books of accounts.
1.
A Balance Sheet is prepared to know the financial position of the business enterprise on a given date.
2.
A Trial Balance can be prepared frequently. It may be prepared at the end of a month or a quarter.
2.
A Balance Sheet is generally prepared at the end of the accounting period.
3.
The heading of the two columns are “Debit Balances” and “Credit Balances”.
3.
The headings of the two sides are “Liabilities” and “Assets”.
4.
All types of accounts find their place in the Trial Balance.
4.
In a Balance Sheet, accounts of assets, liabilities, capital and those accounts which are remained open after the preparation of Trading and Profit and Loss account.
5.
Generally, the opening stock appears in the Trial Balance, whereas the closing stock does not.
5.
In a Balance Sheet, only the closing stock appears on the assets side.
6.
In a Trial Balance, it is not possible to have information about net profit or net loss.
6.
In the Balance Sheet, information about net profit earned or net loss incurred is provided.
7.
A Trial Balance can be prepared without making adjustments regarding prepaid expenses, income received in advance, accrued income, etc.
7.
A Balance Sheet can not be prepared without making adjustments regarding prepaid expenses, outstanding expenses, income received in advance or accrued income, making provisions for possible losses, etc.
b) Profit and Loss Account and a Balance Sheet.
Solution
1. Profit and loss A/c is a Nominal account. It discloses net operational results (Profit or loss) for a particular period will be displayed.
2. Balance sheet is not an account. It is a statement. But it will be prepared with the help of Real and Personal accounts balances as on a specified date (Usually at the end of the year).
3. Balance accounts should be carried forward to the next fiscal year whereas Profit and Loss A/c accounts should not be carried forward to the next fiscal year. These accounts balances should be carried forward to Retained Earnings A/c. Finally the Retained Account shows net results (Profit or Loss). and the Retained Earnings A/c should be transferred to Liabilities side of the Balance Sheet.
4. P&L A/s shows the net results (Profit or Loss) whereas the Balance Sheet shows the Financial Position of a Business as on a particular date.
5. A profit and loss account reports the results of activity over a period of time, usually one year. A balance sheet reports the situation (assets, liabilities and equity) at a point in time.
6. The Profit and Loss Statement reports (Revenue – Expenses) Net Income (Net Profit) and it accumulates throughout one fiscal (business) year and is restarted from zero at the end of the year.
7. The Balance Sheet reports the value of the entity (person or business). Assets = Liabilities + Equity. Its accounts start from zero at the beginning and continue to accumulate until the business closes.