COST & MANAGEMENT ACCOUNTING

MARATHA MANDIRS BABASAHEB GAWDE INSTITUTE OF MANAGEMENT STUDIES MMS-I DIV-B SEMESTER-2 SUBJECT: COST & MANAGEMENT ACCOUNTING SUBMITTED TO: Prof. M.A.GANACHARI SUBMITTED BY: NAME ROHIT PADALKAR NIKITA PAILKAR RAVI PALVE SHASHANK PAMUL OMKAR PANDY ROLL NO. 91 92 93 94 95

A REPORT ON FOLLOWING TERMS:

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Explain the following terms: I) Profitability Ratios:Profitability ratios are the financial ratios which talk about the profitability of a business with respect to its sales or investments. Since the ratios measure the efficiency of operations of a business with the help of profits, they are called profitability ratios. They are quite useful tools to understand the efficiencies / inefficiencies of a business and thereby assist management and owners to take corrective actions. Profitability ratios are the tools for financial analysis which communicate about the final goal of a business. For all the profit oriented businesses, the final goal is none other than the profits. Profits are the life blood of any business without which a business cannot remain a going concern. Since, the profitability ratios deal with the profits, they are as important as the profits. The purpose behind calculating the profitability ratios is to measure the operating efficiency of a business and returns which the business generates. The different stakeholders of a business are interested in the profitability ratios for different purposes. The stakeholders of a business include owners, management, creditors, lenders etc. A large number of ratios may be used for measuring profitability. The following ratios are, however discussed briefly: a. Gross Profit ratio b. Net Profit ratio c. P/V Ratio d. Operating ratio e. Return on capital employed

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a. Gross Profit Ratio:This ratio shows the amount of gross profit made out of the total net sales. The relation between gross profit and sales is expressed in percentage. The higher the gross profit ratio, the greater is the profitability of the firm, other factors remaining constant. Gross profit ratio shows the margin of profit. A high gross profit ratio is a great satisfaction to the management. It represents the low cost of goods sold. Higher the rate of gross profit, lower the cost of goods sold. Where there are several products, the ratio should preferably be found out for each product separately. Otherwise, the loss arising in one product may be concealed by the high profit made in another. Formula for Gross Profit Margin: Gross profit margin= Gross Profit X 100 Net Sales Gross profit = Net sales Cost of goods sold ILLUSTRATIONS:From the following detail of a business concern ascertain the gross profit ratio: Particulars Sales Gross profit Solution: 2005 Gross profit ratio = Rs 40,000 X 100 Rs 120,000 =26 67%. 2005 120000 40000 2006 160000 60000

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2006 Gross profit ratio = Rs 60,000 X 100 Rs 160,000 =37.5%

b. Net Profit Ratio:This ratio indicates the portion of the sales that is left to the firm after all costs, charges and expenses have been deducted. It is thus; extremely useful to the firm as it is an indication of cost control and sales promotion. This ratio is a guide to the efficiency or otherwise of operating the firm. A ratio of net profit to sales is called Net profit ratio. It indicates sales margin on sales. This is expressed as a percentage. The main objective of calculating this ratio is to determine the overall profitability. Net profit ratio determines overall efficiency of the business. It indicates the extent to which management has been effective in reducing the operational expenses. Higher the net profit ratio, better it is for the business. Calculation of net profit ratio: Net profit Ratio = Net profit X 100 Net sales Net sales = Sales Sales returns

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ILLUSTRATION: Calculate Net profit ratio from the following: Net profit Sales Sales Return SOLUTION: Net profit Ratio = Net profit X 100 Net sales Net sales = Sales Sales returns = Rs 640,000 Rs 40,000 = Rs 600,000 Rs 45,000 Rs 640,000 Rs 40,000

Net profit ratio = Rs 45,000 X 100 Rs 600,000 = 7.5%

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c. Operating Ratio:This is the ratio of the cost of goods sold plus the operating expenses to net sales. Operating profit is an indicator of operational efficiencies. It reveals only overall efficiency. It establishes relationship between operating profit and net sales. This ratio is expressed as a percentage. It helps in examining the overall efficiency of the business. It measures profitability and soundness of the business. Higher the ratio, the better is the profitability of the business. This ratio is also helpful in controlling cash. CALCULATION OF RATIO: Operating profit = Operating profit X 100 Net sales Operating Profit = Gross Profit (Administration expenses + selling expenses) ILLUSTRATION: Calculate operating profit ratio from the following data: Sales Gross profit Administration expenses Selling and distribution expenses Income on investment Loss by fire 3,00,000 1,20,000 35,000 25,000 15,000 9,000

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SOLUTION: Operating profit = Operating profit X 100 Net sales =Rs60, 000 X 100 Rs 3, 00,000 = 20% Note: Operating profit = Gross profit (Administration expenses + Selling expenses) = 1, 20,000 (35,000 + 25,000) = 1, 20,000 60,000 = 60,000

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d. Return on investment ratio (ROI):ROI is the basic profitability ratio. This ratio establishes relationship between net profit (before interest, tax and dividend) and capital employed. It is expressed as a percentage on investment. The term investment here refers to long-term funds invested in business. This investment is called capital employed. Where Capital employed = Equity share capital + preference share capital+ Reserve and surplus + long term liabilities fictitious assets Non trading investment Or Capital employed = (Fixed asset depreciation) + (Current Asset Current liabilities) Or Capital employed = (Fixed Assets Depreciation) + (Working capital) This ratio is also known as Return on capital employed ratio. It is calculated as under ROI = Net profit before interest, tax and dividend X 100 Capital employed Note: If net profit after interest, tax and dividend is given, the amount of interest, tax and dividend should be added back to calculate the net profit before interest, tax and dividend. Significance: ROI ratio judges the overall performance of the concern. It measures how efficiently the sources of the business are being used. In other words, it tells what is the earning capacity of the net assets of the business. Higher the ratio the more efficient is the management and utilization of capital employed. ILLUSTRATION: From the following data, calculate the return on capital employed: Net fixed assets Rs 100,000 current assets Rs 50,000, current liabilities Rs 25,000, Gross profit Rs 32,500, Interest on longterm debt Rs 7500 tax Rs 8750, office and administrative expenses Rs 2500, selling and distribution expenses Rs 5000. There were no long term investments.

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Solution: Calculation of return on capital employed: Net profit before interest = Gross profit office and Administrative and tax expenses selling and distribution expenses = Rs 32,500 Rs 2500 Rs 5000 = Rs 25000 Capital employed = Net fixed Assets + Current Assets Current liabilities = Rs 100,000 + 50,000 25,000 = 1, 25,000 Return on capital employed = Net profit before interest and tax X 100 Capital employed =Rs 25,000 X 100 Rs 125,000 = 20%

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e. Profit-Volume ratio:Profit volume ratio is the relation between contribution and sales expressed as a percentage indicating the intrinsic strength of a product which denotes as to what is the contribution from sales revenue of each rupee. This ratio is different from gross profit ratio and net profit ratio. The gross profit ratio shows the margin left after meeting the manufacturing costs and it measures the efficiency of production as well as pricing. The net profit ratio shows the earnings left for the shareholders as a percentage of net sales. It measures the overall efficiency of production, administration, selling, financing, pricing and tax management. The gross profit ratio and the net profit ratio provide a valuable understanding of the cost and profit structure of the firm and enable the financial analyst to identify the sources of business efficiency/inefficiency. The profit-volume ratio is very useful especially when the business is dealing with a range of products and break even has to be found out for each product to decide upon the selling price and a most suitable product mix. When the contribution from sales is expressed as a sales value percentage, then it is known as profit/volume ratio (or P/V ratio). The relationship between the contribution & sales is expressed by it. Sound financial health of a companys product is indicated by better P/V ratio. The change in profit due to change in volume is reflected by this is reflected by this ratio. If expressed on equal footing with sales, it will show how large the contribution will appear. If size of sales is $ 100, then P/V ratio of 60% will mean that contribution is $ 60. One important characteristic of P/V ratio is that at all levels of output it will remain constant because at various levels, variable cost as a proportion of sales remains constant. When P/V ratio is considered in conjunction with margin of safety, it becomes particularly useful. P/V ratio can be referred by other terms like: (a) Marginal income ratio, (b) Contribution to sales ratio, &
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(c) Variable profit ratio.

P/V ratio may be expressed as: P/V ratio= Contribution Sales = Sales Variable cost Sales = 1- Variable cost Sales Or, P/V ratio = Fixed Cost + Profit Sales

Return on assets (ROA):This ratio measures the profitability of the total funds of a firm. It measures the relationship between net profits and total assets. The objective is to find out how efficiently the total assets have been used by the management. Return on assets = net profit after taxes plus interest x 100 Total assets

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Total assets exclude fictitious assets. As the total assets at the beginning of the year and end of the year may not be the same, average total assets may be used as the denominator.

Return on capital employed (ROCE):This ratio measures the relationship between net profit and capital employed. It indicates how efficiently the long-term funds of owners and creditors are being used. Return on capital employed = Net profit after taxes plus interest x 100 Capital employed CAPITAL EMPLOYED denotes shareholders funds and long-term borrowings. To have a fair representation of the capital employed, average capital employed may be used as the denominator. Return on shareholders equity:This ratio measures the relationship of profits to owners funds. Shareholders fall into two groups i.e. preference shareholders and equity shareholders. So the variants of return on shareholders equity are Return on total shareholders equity = Net profits after taxes x 100 Total shareholders equity .

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TOTAL SHAREHOLDERS EQUITY includes preference share capital plus equity share capital plus reserves and surplus less accumulated losses and fictitious assets. To have a fair representation of the total shareholders funds, average total shareholders funds may be used as the denominator Return on ordinary shareholders equity = net profit after taxes pref. dividend x 100 Ordinary shareholders equity or net worth ORDINARY SHAREHOLDERS EQUITY OR NET WORTH includes equity share capital plus reserves and surplus minus fictitious assets. Earnings per share (EPS)This ratio measures the profit available to the equity shareholders on a per share basis. This ratio is calculated by dividing net profit available to equity shareholders by the number of equity shares. Earnings per share = net profit after tax preference dividend Number of equity shares

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Dividend per share (DPS):This ratio shows the dividend paid to the shareholder on a per share basis. This is a better indicator than the EPS as it shows the amount of dividend received by the ordinary shareholders, while EPS merely shows theoretically how much belongs to the ordinary shareholders Dividend per share = Dividend paid to ordinary shareholders Number of equity shares Dividend payout ratio (D/P):This ratio measures the relationship between the earnings belonging to the ordinary shareholders and the dividend paid to them. Dividend pay out ratio = total dividend paid to ordinary shareholders x 100 Net profit after tax preference dividend OR Dividend pay out ratio = Dividend per share x 100 Earnings per share

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Price earning ratio (P/E):This ratio is computed by dividing the market price of the shares by the earnings per share. It measures the expectations of the investors and market appraisal of the performance of the firm. Price earning ratio = market price per share Earnings per share CURRENT RATIO The current ratio is a financial ratio that measures whether or not a firm has enough resources to pay its debts over the next 12 months. It compares a firm's current assets to its current liabilities. It is expressed as follows:

The current ratio is an indication of a firm's market liquidity and ability to meet creditor's demands. Acceptable current ratios vary from industry to industry and are generally between 1.5 and 3 for healthy businesses. If a company's current ratio is in this range, then it generally indicates good short-term financial strength. If current liabilities exceed current assets (the current ratio is below 1), then the company may have problems meeting its short-term obligations. If the current ratio is too high, then the company may not be efficiently using its current assets or its short-term financing facilities. This may also indicate problems in working capital management. Low values for the current or quick ratios (values less than 1) indicate that a firm may have difficulty meeting current obligations. Low values, however, do not indicate a critical problem. If an organization has good long-term prospects, it may be able to borrow against those prospects to meet current obligations. Some types of businesses usually operate with a current ratio less than one. For example, if inventory turns over much more rapidly than the accounts payable become due, then the current ratio will be less than one. This can allow a firm to operate with a low current ratio. sets include those

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Note that Inventory is excluded from the sum of assets in the Quick Ratio, but included in the Current Ratio. Ratios are tests of viability for business entities but do not give a complete picture of the business' health. If a business has large amounts in Accounts Receivable which are due for payment after a long period (say 120 days), and essential business expenses and Accounts Payable due for immediate payment, the Quick Ratio may look healthy when the business is actually about to run out of cash. In contrast, if the business has negotiated fast payment or cash from customers, and long terms from suppliers, it may have a very low Quick Ratio and yet be very healthy. Generally, the acid test ratio should be 1:1 or higher, however this varies widely by industry. [1] In general, the higher the ratio, the greater the company's liquidity (i.e., the better able to meet current obligations using liquid asset) Notice that very often "Acid test" refers to Cash ratio, instead of Quick ratio:

The debt-to-equity

ratio

(D/E) is

a financial

ratio indicating

the

relative

proportion

of shareholders' equity and debt used to finance a company's assets.

Closely related

to leveraging, the ratio is also known as Risk, Gearing or Leverage. The two components are often taken from the firm's balance sheet or statement of financial position (so-called book value), but the ratio may also be calculated using market values for both, if the company's debt and equity are publicly traded, or using a combination of book value for debt and market value for equity financially.

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COMBINED RATIO:

A measure of profitability used by an insurance company to indicate how well it is performing in its daily operations. A ratio below 100% indicates that the company is making underwriting profit while a ratio above 100% means that it is paying out more money in claims that it is receiving from premiums. The combined ratio is comprised of the claims ratio and the expense ratio. The claims ratio is claims owed as a percentage of revenue earned from premiums. The expense ratio is operating costs as a percentage of revenue earned from premiums. The combined ratio is calculated by taking the sum of incurred losses and expenses and then dividing them by earned premium.

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