UNIT-I

MANAGEMENT ACCOUNTING (MA)

According to Association of Certified and Corporate Accountants, “Management accounting is the
application of accounting and statistical techniques to the specified purpose of producing and
interpreting information designed to assist management in its functions of promoting maximum
efficiency and in envisaging, formulating and coordinating their execution.”
Chartered Institute of Management Accountants, London, defines Management accounting is the
application of professional; knowledge and skill in the preparation of accounting information in such a
way as to assist management in the formation of policies and in the formation of policies and in the
planning and control of the operations in the undertaking.
The aims of management accounting are as follows,
 Formulating strategies
 Planning and constructing business activities
 Helps in making decision
 Optimal use of Resource (economics)
 Supporting financial reports preparation
 Safeguarding asset

NATURE OF MANAGEMENT ACCOUNTING (MA)

Managerial personnel are entrusted with authority and responsibility of operating business activities.
Management accounting provides information to the personnel are entrusted with authority and
responsibility of operating business activities. Management accounting provides information to the
managerial personnel at three levels of management viz., top, middle and lower levels of management.
It provides the management with the tools for an analysis of its administrative action that can lay
suitable emphasis on the possible alternatives in terms of costs, prices and profits. The decisions made
by management are based on quantitative information and common sense, foresight, knowledge and
experience. Management accounting includes financial accounting information and raw material from
several other disciplines such as costing, statistics, mathematics, political science, sociology,
psychology, management economics, law etc. With all these data he can ensure optimum utilization of
all the resources including employees by maintaining sound morale of the employees, maximization of
output and minimization of inputs, analyze the managerial questions in terms of costs, revenues, profits
and growth.
The natures of management accounting are as follows:
1) It is a tool for decision making: Management is required to take necessary decisions regarding the
growth and prosperity of the business. MA through its various tools assists the management in decision
making.
2) It is a technique of planning and control: MA lays down systematic plans and control procedures.
Appropriate planning and controlling are essential for taking logical decisions and their effective
implementation.
3) It relates to future: The primary nature of MA is that it focuses on the future.

SCOPE OF MANAGEMENT ACCOUNTING

1) Financial accounting: Financial accounting provides the basic information for analysis by
management. The historical data, records and accounting details helps management to plan for the
future.

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2) Cost accounting: Management accounting techniques are primarily cost accounting technique. The
techniques of marginal costing, budgetary control and standard costing which are important tools of
control in the hands of management. The concepts of controllable and uncontrollable costs, relevant
and irrelevant costs, opportunity costs, differential costs are used in MA.
3) Forecasting and budgeting: Forecasts provided the basis for budgets. Predetermined targets help
people in business to perform tasks accordingly and if there are variations corrective steps are taken by
the management.
4) Management reporting: Reports are prepared at lower managerial levels and submitted to middle
level management and by middle level to top level. Both routine and special reports are maintained.
5) Statistical tools: Graphs charts, diagrams, tables, accounts, narratives etc. are used to present the
accounting information to make it more meaningful.
6) Financial analysis and interpretation: Analysis of financial statements and their interpretation
helps to find out their profitability, solvency and liquidity positions of an enterprise.
7) Control: The basic objective is to use various resources available in the most economical, effective
and efficient manner and this can be fulfilled when different techniques of control are adopted.
8) Tax accounting: Tax has become an important part in business life. Proper tax planning and tax
management save funds for the business.
9) Internal audit: Internal audit has become so important these days that management relies heavily
on it for fixing responsibilities and taking action against individuals. The system is used as a basis for
performance appraisal.
10) Office services: Office routines are controlled through management accounting. Utility of the
alternative office procedures and accounting system may be evaluated and reported by management
accountant.

ADVANTAGES OF MANAGEMENT ACCOUNTING

1) Greater efficiency: Management accounting increases the efficiency of management and
employees as well.
2) Better planning: Planning as is said “look before you leap” is the first and foremost task of
management so that the things can be done in an orderly way. Accounting g information leads to
establishing goals and a suitable course of action for achieving those goals.
3) Better control: Control is the process of comparing the actual with the standard performance and
taking corrective action if deviations are detected.
4) Coordinating: It involves interlinking of different divisions of the business enterprise in a way so as
to achieve the objectives of the organization as a whole. So perfect coordination is required among
production, purchase, finance, personnel and sales departments. In management accounting effective
coordination is achieved through departmental budgets and reports.
5) Organizing: Management accounting also plays a prominent role. The whole organization is
divided into suitable profit or cost centers. A sound system of internal control and internal audit for
each of the cost profit centers helps in organizing and establishing a sound business structure.
6) Motivating: Periodical departmental profit and loss accounts, budgets and reports help the superiors
to find out whom to demote or promote and to reward or penalize.
7) Communicating: It involves transmission of data, results etc.
8) Performance appraisal: The techniques of budgetary control and standard costing help
management in evaluating the performance of different departments, persons, machines, centres etc.
9) Better customer service: The technique of cost control employed in the business result in cost
reduction and thereby price reduction.

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10) Wealth maximisation: The ultimate objective of every business is to maximise the wealth of
shareholders through optimizing profits. This is possible through reduce cost of production and
increase sales.

DIFFERENCE BETWEEN MANAGEMENT ACCOUNTING AND FINANCIAL

ACCOUNTING
Basis of
Financial Accounting Management Accounting
Difference
Accounting designed for outsiders isIt is concerned with the interpretation of
known as financial accounting. It isaccounting information to guide the
concerned with the recording of management for future planning, decision
Definition business transactions and the making and control etc. management
periodic preparation of income accounting provides information to the
statement and balance sheet. insiders e.g., owners, managers and
employees.
Financial accounting is simply Management accounting shows how the
showing how the business has business has to move in future. It
Orientation
moved in the past. It concentrates on concentrates on future and looks forward.
past and looks backward.
To supply information to external It is to supply information for insiders.
Parties involved parties like shareholders, creditors,
banks, investors.
Portrays position of business as a It reports on the profitability, performance
Scope whole. of various divisions or departments.

Financial accounting is an absolute Management accounting is optional.

Compulsion
necessity.
It is meant for outsiders hence it has It is meant for insiders hence it can frame
Principles used to follow accepted principles and and adopt its own principles.
conventions.
It deals with only those events which It deals with monetary as well as non-
Monetary can be described in terms of money. monetary events like technical innovations,
measurement change in value of money.

Financial accounts are usually They are prepared at short intervals as per
Periodicity of
prepared yearly or half yearly the requirements of management.
reporting
Information is precise and most It lays emphasis on precision and
Precision
accurate. approximate figurers are used.
It is more objective, has rigid It is more subjective, has flexible approach.
Nature
approach.
Performance Performance appraisal is not Performance appraisal is applicable.
appraisal applicable.

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DIFFERENCES BETWEEN FINANCIAL, COST AND MANAGEMENT ACCOUNTING
Basis of
Financial Accounting Cost Accounting Management Accounting
Difference
FA is concerned with CA is concerned with MA looks at all situations
Money angle money as an economic money as a measure of from a management view
resource i.e., cash economic performance. point.
CA aims at measuring
Financial aspect of the MA takes help from
the economic
Scope business is dealt with in financial accounting and
performance of cost
FA cost accounting.
centres.
FA takes into
Micro and
consideration micro CA analyses cost
macro- MA takes into consideration
economic factors of centres, products and
economic macro-economic factors.
production and processes.
factors.
revenues.
FA focus attention on CA also focuses
Time factor past and current attention on past and MA concentrates on future.
operations current operations.
Management accountant
Cost accountant works
functions like a technologist
Technician Vs The financial accountant like a technician
using accounting
technologist works like a technician according to the
information for wealth
direction of others.
creation.

DIFFERENCE BETWEEN COST ACCOUNTING AND MANAGEMENT ACCOUNTING

Basis of
Cost Accounting Management Accounting
Difference
Cost accounting is the process of
It is concerned with the interpretation
accounting for costs. It embraces the
of accounting information to guide the
accounting procedure relating to
management for future planning,
recording of all income and
Definition decision making and control etc.
expenditure and the preparation of
management accounting provides
periodical statements and reports with
information to the insiders e.g.,
the object of ascertaining and
owners, managers and employees.
controlling costs.
Cost accounting is only one of the
techniques which is used by Management accounting has a wider
Scope
management accountants in scope as compared to cost accounting.
performance of their jobs.
Organisation MA has a higher status in
Organizational hierarchy is lacking.
structure organizational hierarchy.
Cost accounting uses both past and
Source of It gives more emphasis on future
present information for future decision
information conditions.
making.
It involves both short- and long-range
Planning It involves only short-range planning planning. E.g., capital budgeting
decisions.

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DIFFERENCE BETWEEN FINANCIAL ACCOUNTING AND COST ACCOUNTING
Financial Accounting Cost Accounting
It aims at finding out results of accounting year It aims at computing cost of production/ service
in the form of Profit and Loss Account and in a scientific manner and then cost control and
Balance Sheet. cost reduction.
It aims at computing cost of production/ service It is an internal reporting system for an
in a scientific manner and then cost control and organization’s own management for decision
cost reduction. making.
It records historical data. It also records and presents the estimated/
budgeted data. It makes use of both the historical
costs & pre-determined costs.
In financial accounting, the major emphasis is in In cost accounting, classification is basically on
cost classification based on type of transactions, the basis of functions, activities, products,
e.g., salaries, repairs, insurance, stores etc. process and on internal planning and control and
information needs of the organization.
It classifies records, presents and interprets It classifies records, presents and interprets in a
transactions in terms of money. significant manner the material, labour and
overheads cost.
The users of financial accounting statements are The cost accounting information is used by
shareholders, creditors, financial analysts and internal management at different levels.
government and its agencies,
etc.
It aims at presenting ‘true and fair’ view of the It aims at computing ‘true and fair’ view of the
profit and loss position as well as financial cost of production/services offered by the firm.
position.
Financial Statements are prepared for a definite Its reports and statements are prepared as and
period, usually a year. when required.
A set format is used for presenting financial There are not any set formats for presenting cost
information. information.
Financial Accounts are subject to statutory audit Cost accounts are subject to cost audit which
to verify whether they disclose a true and fair verifies whether the cost accounts disclose true
view of the profit and loss as well as financial and fair view of the cost of production of the
position. company.

LIMITATIONS OF MANAGEMENT ACCOUNTING

1) Comparatively a new discipline: Management accounting is of a recent origin and its principles,
rules and conventions are still in evolutionary stage and they are being tried, shaped and reshaped. Still
a lot of research work need to done in this area in order to make this field as a perfect tool in the area of
management.
2) Wide applicability/ wide scope: MA covering so many areas and many disciplines creates
problems, non-monetary factors are also tried to be qualified, future is always quite uncertain.
3) Resistance to change/ opposition to change: Management accounting demands a breakaway from
traditional accounting practices. It calls for a rearrangement of the personnel and their activities which
is generally not liked by the people involved. There is always resistance to change.
4) Too costly: The installation of management accounting system requires heavy costs. Therefore, it
can be adopted only in big concerns.
5) A means not an end: MA simply a means to achieve the desired goal, introduction of the system
does not suffice.
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6) Subjectivity: MA is free to have its own principles, institutional judgments based on sound analysis
provided by accounting information.
7) Immaturity: The management is not equipped with adequate knowledge and understanding of the
different tools and techniques of management accounting and they also lack experience of dealing with
delicate situations.
8) Input limits: The financial accounting and cost accounting information i.e., historical data are the
primary feedback for managerial accounting. The strength and weakness of the management
accounting depends on the strength and weakness of these basic records. So, the limitations are also the
limitations of management accounting.
9) Management accounting is only a tool: Management accounting cannot replace the management.
Management accountant is only an adviser to the management. The decision regarding implementing
his advice is to be taken by the management.
10) Provides only Data: Management Accounting provides only data and not decisions. It only
informs not prescribes. This limitation should also be kept in mind while using the techniques of
Management Accounting.
11) Personal Bias: The interpretation of financial information depends upon the capacity of
interpreter as one has to make a personal judgment. Personal prejudices and bias affect the objectivity
of decisions.

FINANCIAL STATEMENT ANALYSIS

Financial statements are the summarized reports of accounting transactions.
The term financial statement generally refers to two statements:
 The balance sheet
 The income statement or profit and loss account.
 The business may also prepare
 A statement of retained earnings
 Statement of changes in financial position
Financial statements

Income statement or Balance sheet Statement of Statement of changes

profit and loss account retained earnings in financial position
i) Income statement: It is also called profit and loss account is generally considered to be the most
useful of all financial [Link] shows the net profit earned or loss suffered during a particular
period.
ii) Balance sheet: It is a statement of financial position of a business at a specified moment of time. It
represents all assets owned by the business at a particular moment of time and the claims (equities) of
the owners and outsiders against those assets at that time.
iii) Statement of retained earnings: It is also known as profit and loss appropriation account in case
of companies. The term retained earnings means the accumulated excess of earnings over losses and
dividends. The balance shown by the income statement is transferred to the balance sheet through this
statement, after making necessary appropriations. It is a connecting link between the balance sheet and
the income statement.
iv) Statement of changes in financial position (SCFP): A better understanding of the affairs of the
business, it is essential to identify the movement of working capital or cash in and out of the business.

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This statement may emphasize any of the following aspects relating to change in financial position of
the business:
a) Change in the firm’s working capital position (fund flow statement) or SCFP working capital basis
b) Change in the firm’s cash position (cash flow statement) or SCFP cash basis
c) Change in overall financial position (statement of changes in financial position) or SCFP.

IMPORTANCE OF FINANCIAL STATEMENT ANALYSIS

1. Holding of Share: Shareholders are the owners of the company. Time and again, they may have to
take decisions whether they have to continue with the holdings of the company's share or sell them out.
The financial statement analysis is important as it provides meaningful information to the shareholders
in taking such decisions.
2. Decisions and Plans: The management of the company is responsible for taking decisions and
formulating plans and policies for the future. They, therefore, always need to evaluate its performance
and effectiveness of their action to realise the company's goal in the past. For that purpose, financial
statement analysis is important to the company's management.
3. Extension of Credit: The creditors are the providers of loan capital to the company. Therefore, they
may have to take decisions as to whether they have to extend their loans to the company and demand
for higher interest rates. The financial statement analysis provides important information to them for
their purpose.
4. Investment Decision: The prospective investors are those who have surplus capital to invest in some
profitable opportunities. Therefore, they often have to decide whether to invest their capital in the
company's share. The financial statement analysis is important to them because they can obtain useful
information for their investment decision making purpose.

LIMITATIONS OF FINANCIAL STATEMENTS

1. Financial analysis is only a means: Financial analysis is a means to an end and not the end itself.
The analysis should be used as a starting point.
2. Ignores price level changes: Financial statements are normally prepared on the concept of
historical costs. They do not reflect values in terms of current costs.
3. Financial statements are essentially interim reports: The profit shown by profit and loss account
and the financial position as depicted by the balance sheet is not exact. The exact position can be
known only when the business is closed down.
4. Accounting concepts and conventions: Financial statements are prepared on the basis of certain
accounting concepts and conventions. On account of convention of conservatism, the income statement
may not disclose true income of the business since probable losses are considered while probable
incomes are ignored.
5. Influence of personal judgement: Many items are left to the personal judgement of the accountant.
The judgement is to be exercised with respect to proper classification of assets, classification of
expenditure into capital and revenue etc.
6. Disclose only monetary facts: Financial statements do not depict those facts which cannot be
expressed in terms of money. Development of a team of loyal and efficient workers, reputation and
prestige of management with public, professional knowledge, skill etc. are ignored in case of financial
statements.

FINANCIAL ANALYSIS
Financial statement analysis is the judgmental process which aims to evaluate the current and past
financial position and the results of operations of an enterprise. The primary objective is to determine
the best possible estimates and predictions about future conditions and performance.
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Financial statement analysis is mainly
 A study of relationship among the various factors in a business, as disclosed by a single set of
statements
 A study of the trend of these factors, as shown in the series of statements.
Financial analysis requires two-fold exercises:
1. Analysis of past performance
2. Prospective analysis to predict the likely future

USES OF ANALYSIS
1. Screening tool: the analysis can be serving as a preliminary screening tool in the selection of
investments.
2. Forecasting tool: the analysis can be used as a forecasting tool of future financial results.
3. Diagnosis tool: managerial, operating and other problems can be analyzed.
4. Evaluation tool: The technique of analysis helps in evaluation of management.

TYPES OF ANALYSIS:
On the basis of materials used the analysis may be of two types:
1) Internal analysis: Analysis of managerial use is internal analysis. It is meant for internal
management and control purposes. With the help of the books of accounts and complete information
about the business the analysis is made. The analyst is connected with the enterprise.
2) External analysis: The analyst is not connected with the enterprise. The analysis for credit
extinction and investment commitments is external analysis. The conclusion on the external analysis is
based on the published data.
On the basis of modus Operandi, it may be classified into two types:
1) Horizontal analysis: This technique is also known as comparative analysis/dynamic analysis.
It is conducted by setting consecutive balance sheet, income statement or statement of cash flow side-
by-side and reviewing changes in individual categories on a year-to-year or multiyear basis. The most
important item revealed by comparative financial statement analysis is trend.
A comparison of statements over several years reveals direction, speed and extent of a trend(s). The
horizontal financial statements analysis is done by restating amount of each item or group of items as a
percentage. The horizontal analysis consists of a study of the behaviour of each of the items in the
financial statements i.e., increases and decreases of passage of time. It is also known as dynamic type
of analysis since it shows the changes which have taken place.
2) Vertical analysis: Vertical analysis is the study of the quantitative relationships existing among the
items at a particular date. It is static type of analysis or a study of position. Eye look at the comparative
analysis is on a vertical analysis; hence the analysis is termed as vertical analysis. Mainly, this type of
analysis is used to study through ratios and the quantitative relationship of the various items of the
financial statement on a particular data or for one accounting period. This type of analysis is useful to
understand the performance of several companies in the same group or many divisions or departments
in the same company.

TOOLS OF FINANCIAL STATEMENT ANALYSIS

1. Comparative Financial Statements
2. Common Size Financial Statements
3. Trend Percentages
4. Ratio Analysis
5. Cash Flow Statements
6. Fund Flow Statements
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Comparative Financial Statements: Financial statements of two or more periods are compared by
setting up side by side and reviewing the changes which have occurred in individual items therein from
year to year. The comparison shall reveal not only the trend but the direction, velocity and the
amplitude of trend.
Comparative financial statements may be of two types:
1. Comparative balance sheet
2. Comparative income statements
Comparative balance sheet: The comparative balance sheet shows increases or decreases in absolute
terms as well as in percentages, in the various assets and liabilities and in capital. Comparative analysis
of the balance sheet at the beginning and end of the period helps to find out the progress of the
company.
If two comparative balance sheets are presented in a statement form, four columns of amounts can be
drawn
 Two for amounts relating to two years
 Third for absolute increase or decrease
 Fourth for percentages of increase or decrease.
It shows the effect of operations on assets and liabilities.
Comparative income statements: Comparative income statements provide information about the
progress of the business. The absolute changes as well as relative changes of various items taking the
previous year’s figure as the basis may be depicted along with the actual data for the relevant periods.

Common Size Financial Statements: The proportion which a single item represents within a total
group or sub group. The total group figure is the base and can be taken as 100. Since all other
component items are expressed as a percentage of the total, which has a common size i.e., 100, the
financial statements are known as common size financial statements.
In a balance sheet, the ratio of each asset to total assets and the ratio of each liability and capital item to
total liabilities are computed. The figure of total assets or the total liabilities and capital is taken as 100
in the income statement, net sales (i.e., sales less returns) are set at 100 percent and every other item in
the statements expressed as a per cent of total sales.

Trend Percentages: The figures of the initial year, for which data are available, can be taken as 100
and the figures of all later years can be converted into index numbers i.e., as a percentage of the initial
figure. This process sets a longer-term trend comparison. The year which is to be chosen as a base year
should be as typical or normal. the trend analysis conveys a better understanding of managements
philosophies, policies and motivations, which have brought about the changes revealed over the years.
Uses of trend percentages: Progress of business over a period can be assessed by computing trend
percentages of sales, cost of sales/production, profit, capital employed etc.
Comparative figures of trend percentages give a useful data to assess the strength and weaknesses of
the business.
Limitations of trend percentages: Since the data used in analysis is influenced by inflationary factors,
it becomes difficult. Selection of a normal base year for trend analysis is difficult.

Ratio Analysis: A ratio expresses the mathematical relationship between one quantity and another.
Ratios of the company can be compared with
 Past ratios of the same company
 Ratios of other companies in the industry.
 Established standards.
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Funds And Cash Flow Statement: The sources of working capital and the uses to which these funds
have been put to are presented in this statement. Fund flow statement helps to know how the working
capital has been affected by various items in the. It is also referred as statement of sources and
application of funds. The statement can be prepared on the basis of cash basis is known as cash flow
statement.

RATIO ANALYSIS
Ratio analysis is the process of determining and presenting the relationship of items and group of items
in the statements. Ratios play triple role in an enterprise- historical, contemporal and astrological.
Analysis of data leads to comments over past performances, present position and future trends.
Interpretation forms the core part of ratio analysis. The usefulness of ratios is wholly dependent on
their intelligent and judicious interpretation.

ADVANTAGES OF RATIO ANALYSIS

1. Assessment of financial health and operational efficiency: Ratios reveal useful trends for the
assessment of financial strength and operational efficiency of an enterprise.
2. Facilitates inter firm comparison: Ratio analysis helps in Interfirm comparison. Suitable
relationships can be established between various relevant factors in the concern and these are compared
with others in the industry.
3. Intra firm comparison possible: The performance of different divisions or departments can be
analyzed with the help of ratio analysis.
4. Planning and forecasting: Ratios serve as barometers for future. They are also help in forecasting
and planning the business activities for a future period. The ratios are used to find out which area has
problems. The cause of the problem and the solution for it are steps ahead.
5. Simplifies financial statements and accounting figures: Ratio analysis simplifies the
comprehension of financial statements. Ratios tell the whole story of changes in the financial condition
of the business.
6. Help in locating weak points of the firm: Ratio analysis would pin point the deficiency of various
departments or branches of a business unit even though the overall performance is satisfactory.

LIMITATIONS OF RATIO ANALYSIS

a) Only indicators: ratios are simply indicators. Too much reliance should not be put on figures.
b) Dependence on financial statements: The base of ratio analysis is financial statements. Whatever
limitations financial statements have, automatically apply to ratio analysis. Where may be different
accounting policies for different years and in different firms?
c) No precise terminology or fixed standards. Accounting ratios and the terms used in calculation of
ratio have no standard, e.g., net profit ratio is calculated on the basis of operating profit, net profit after
tax, net profit before tax.
d) Problems of price level changes: Financial analysis based on accounting ratios will give
misleading results if the effects of changes in price level are not taken into account. The financial
statements of the companies should, therefore, be adjusted keeping in view the price level changes if a
meaningful comparison is to be made through accounting ratios.
e) Accuracy of accounts: If the accounts have not been correctly prepared the ratio cannot be correctly
computed.
f) Window Dressing: The term window dressing means manipulation of accounts in a way so as to
conceal vital facts and present the financial statements in a way to show a better position than what it
actually is.
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g) Correct interpretation not possible: Only after studying the realities behind the financial
statements, the ratios can be correctly interpreted.
h) Ratios ignore qualitative factors: The ratios are obtained from the figures expressed in money.
Qualitative factors, which may be important, are ignored.
i) Single ratio not sufficient: It is very necessary to take into account the combined effect of the
various ratios so that the results are correctly interpreted regarding the financial condition and earning
performance of the business.
j) Ratios only a first step: Ratios only a first step for analysis and interpretation of financial statements
and must be supplemented by thorough investigation before conclusions can be drawn from them.

INTERPRETATION OF RATIOS
1) Adjustments for changes in accounting policies, inflation, window dressing, inaccuracy of accounts
etc. should be made before calculating the ratios.
2) Absolute figures must also be studied along with the ratios.
3) A single ratio can’t give any conclusion. A group of ratios will give some idea about the aspect.
4) Ratios must be compared either on the basis of time or with the standard, which may be industry
standard, general standard or predetermined company standard.
5) Interfirm comparison is essential.
6) Interpretation should be with reference to both conceptual and contextual bases.
7) The qualitative phenomenon and characteristics of components used for ratio analysis should also be
kept in mind.

DU PONT ANALYSIS CHART

This analysis has been presented by Du Pont Company of USA through a chart popularly known as Du
Pont chart. The earning power of an enterprise is gauged by return on capital employed. Return on
investment (ROI) represents the earning power of the company.
The return on investment is a combination of two major factors:
1) Profit margin
2) Capital employed turnover
Return on capital employed= Profit on sales X Capital employed turnover
OR
= Net profit margin X Investment turnover.
= Operating profit X Sales
Sales Capital employed
= Operating profit
Capital employed
To know the net return on capital employed, net profit may be taken instead of operating profit.

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 DU PONT CHART

The interaction of profitability and activity (turnover) ratios is shown by the Du Pont chart. The overall
performance or efficiency of a firm is a result of its working and operations which are reflected in the
margin.
The overall performance can be improved either by improving the profit margin or by accelerating the
pace of rotation of funds for business activity leading to more sales per rupee of investment. The profit
margin can be raised by controlling costs and increasing sales. The investment turnover can be raised
by limiting the investment in fixed assets or working capital without adversely affecting the sales.
The analysis presents a clear picture of the spheres which need more attention to be paid by the
management to have better performance.

FUNDS FLOW STATEMENT

Fund flow statement is a statement is a financial statement which summarises, for the period covered
by it, the changes in the financial position including the sources from which the funds were obtained by
the enterprise and the uses to which such funds were applied.
The statement which analyses the flow of funds, i.e., the reasons for changes in working capital is the
fund flow statement. Fund flow statement shows the movement of funds into the firm from such
sources as shareholders (e.g., capital), creditors (e.g., long term borrowings), sale of fixed assets etc. It
also shows the movement of the funds out of firm to pay dividends, repay long term loans, purchase of
fixed assets etc. Thus, FFS shows changes which have taken place in the financial structure.

DIFFERENCES BETWEEN FUND FLOW STATEMENT AND INCOME STATEMENT

(PROFIT AND LOSS ACCOUNT)
Basis of difference Fund flow statement Income statement
Nature It is a statement of changes in It shows profit or loss for a
financial position. given accounting period.
Objective It is prepared to find out the funds It is prepared to show how the

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 from operations and how they are income was earned during the
utilised. accounting period.
Scope This statement presents information It presents the results of all
only about working capital. business transactions on the
income of the business
enterprise for a year.
Sources of funds This statement presents many sources Income statement presents
of funds such as issue of share capital funds only from operations
and debentures, sale of fixed assets in after charging depreciation,
addition to funds from operations in write off goodwill etc.
calculating funds from operations
adjustments are made for non-fund
items such as depreciation, write off
goodwill, preliminary expenses, loss
on sale of fixed assets etc.
Matching This statement matches the funds This statement matches cost of
obtained with the funds used without goods sold and other items of
making any distinction between expenses with the sales and
capital and revenue items. other revenues to know the
profit or loss.
Timing FFS is prepared after the income Income statement is not
statement of the current year has been prepared from FFS.
prepared.
Treatment of The difference between the two sides The difference may be profit
difference in two may be increase in working capital (excess of revenues over
sides. (excess of sources over uses) or expenses) or loss (excess of
decrease in working capital (excess of expense over revenues).
uses over sources).
Basic data It is prepared from two comparative It is prepared from nominal
balance sheets, income statement and accounts and additional
additional information. information in the form of
adjustments.
Accuracy FFS shows the true amount of funds It does not provide true
from operations. information because it
includes non-cash and non-
operating items.

DIFFERENCE BETWEEN FUND FLOW STATEMENT AND POSITION STATEMENT

(BALANCE SHEET)
Basis of difference Balance sheet Fund flow statement
Nature It is a statement of financial It is a change statement
position of the business explaining the reasons for
enterprise on a particular date. change in the assets and
liabilities between two balance
sheet dates.
Components It shows the assets, liabilities It shows the items causing
and owners’ capital changes in the working capital
and the reasons thereof.
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 Objective It is prepared to find out the It helps to find out the capacity
financial position of an of the firm to meet its
enterprise on a particular date. obligations. It is an important
tool of financial analysis.
Legal aspects A limited company has to There is no legal obligation to
prepare its balance sheet in prepare this statement.
accordance with details and
prescribed Performa given in
schedule VI part II of the
companies act.

Basic data It is prepared with the help of

It is prepared with the help of
trial balance and adjustments
comparative balance sheets of
thereof. Retained earnings are
two years, income statements
considered as a source of funds.
and additional information.
Relevance Since it shows the financialIt is more useful for internal
position, it is more relevant for
managements it helps in
external reporting. financial analysis and decision
making.
Timing It is prepared at the end of the It is prepared after the balance
account ting period. sheet has been prepared.
Schedule of changes in No schedule of changes in Schedule of changes in working
working capital working capital is needed to capital is necessary to prepare
prepare balance sheet. fund flow statement. This
schedule highlights the amount
of change in working capital.

Uses of Fund Flow Statement

A fund flow statement is a powerful tool of financial analysis and it has helped the management and
external users of accounting information in solving a number of difficult problems.
The uses are:
1. Informative value: the financial consequences of business operations are clearly explained in detail
by a fund flow statement
2. Forecasting value: a projected fund flow statement can be prepared and resources can be properly
allocated after an analysis of the proper state of affairs.
3. Testing value: FFS helps to test whether the working capital has been effectively utilised or not.
4. Decision making value: the sources of raising funds and their application help the shareholders to
decide whether the management of the business is an enlightened one. It helps in decision making.
5. Helps in financial analysis: An FFS provides complete information about the changes in the
financial position of a business enterprise.
6. Helps in borrowing funds from banks and financial institutions: the banks and financial
institutions provide loans to the business enterprises after taking into consideration the following facts
 Purpose of loan
 Capacity to repay loan
 Working capital position

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7. Helps in formulation of a proper dividend policy: A fund flow statement helps to frame a realistic
dividend policy since it provides a clear picture of the liquidity position of the business enterprise.
8. Helps in proper allocation of resources: with the help of past FFS and projected FFS the
management can find out the availability of different sources of funds (e.g., from operations, issue of
share capital, raising of loans etc.)
9. Helps in management of working capital: it is a part of the sound financial policy to ensure that
the working capital is neither excessive nor inadequate. With the help of schedule of changes in
working capital and the fund flow statement the management can determine the adequacy of working
capital.

CASH FLOW STATEMENT: A cash flow statement is a statement showing inflows and outflows of
cash i.e., sources and application of cash
DIFFERENCE BETWEEN CASH FLOW STATEMENT AND FUND FLOW STATEMENT
Basis of difference Fund flow statement Cash flow statement
Basis of analysis The statement is regarding the The statement is regarding the
change in working capital change in cash position
position between two balance between two balance sheet
sheet dates. dates.
Content The statement explains/analyses The statement
the reasons for change in explains/analyses the reasons
balances or working capital for change in cash and bank
between two dates. balances between two dates.
Basis of preparation Increase in current liability or Increase inn current liability
decrease in current assets result in or decrease in current assets
decrease in working capital and (other than cash) result in
vice versa. increase in cash and vice
versa.
Effect of working The effect of transaction on The effect of transaction on
capital/cash working capital is seen while cash is seen while preparing
preparing FFS. FFS.
Interpretation Sound funds position doesn’t Sound cash position implies
imply that sound cash position that sound cash position as
since inflow of funds doesn’t inflow of cash necessarily
necessarily involve inflow of involves inflow of cash.
cash.
Usefulness FFS is more useful for a long- FFS is more useful for short
term analysis term analysis
Principles of accounting FFS is based on accrual basis of CFS is prepared by converting
accounting data on accrual basis into cash
basis.
Revelation It shows sources and application It reveals inflows and
of funds outflows of cash.
Analysis results It examines effective utilization It examines the generating
of working capital efficiency of cash and
smoothness of cash flow.

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IMPORTANCE OF CASH FLOW STATEMENT:
 Evaluation of cash forecasting: with the help of projected cash flow statement and its comparison
with the actual cash flow statement, the success or failure of cash forecasting can be evaluated.
 Easy financing decision making: the management can find convenience in making decisions as to
financing the business in future by appraising the cash flow statement.
 Helps in investment decisions: cash flow statement helps management in arriving at sound
investment decisions in future.
 Proper allocation of available cash resources: According to priorities the cash resources are
allocated. Steps are taken to recover the debts. Collection of cash and credit policies are also be
designed after a careful study of cash flow statement.
 Explains the deviations from earnings: Cash flow statement explains the reasons for change in the
cash position.
 Ability to generate cash flows: the cash flow statement makes it possible to predict the amounts,
timing and uncertainty of future cash flows on the basis of what has happened in the past.
 Investing and financing transactions during the period: By analyzing the company’s investing
activities and financing activities the users of financial statements can judge why assets and liabilities
increased or decreased during the period.
 Ability to pay dividends and meet commitments: Employees, creditors, investors and others can
easily get a summarized view of flow of cash in the business and therefore assess the ability to pay
dividends and meet its commitments as to repayment of loans on due dates.

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