Accounting

Working Capital Ratios

2011-12-22T02:31:00.001-08:00

To calculate the length of working capital cycle there needs to be some ratios that sould find out first these ratios are called working capital ratios.
These ratios are the one that are involved in working capital cycle i:e inventory, WIP, finished goods, receivables, payables. These ratios also helps to appraise the performance of a company in a particular period or compare with previous years. Besides this there are some LIMITATIONS of the ratios as well i:e these are based on historic data do not take account of future, there may be element of inflation that will not be consider, there may be some manipulation in the ratios that distorted the actual results
The some specific ratios that are involved in working capital cycle i:e inventory, WIP, finished goods, receivables, payables are as follows.

Inventory holding days: It is the time b/w inventory purchased and being used in production. Calculated as:

Average inventory held Material usage × 365
To calculate average inventory held: Opening inventory + Closing inventory ÷ 2
Where material usage is not given purchases or cost of goods sold will be replace by this.

WIP holding days: It is the time in which goods remain in production. Calculated as:

Average WIP ÷ Production cost × 365
To calculate average WIP: Opening WIP + Closing WIP
Where Production cost is not given purchases or cost of goods sold will be replace by this.

Finished goods period: It the length of time when goods are completed and ready for sale. Calculated as:
Average finished goods in inventory ÷ Cost of goods sold × 365
Where cost of goods sold is not given purchases will be replace by this.

Receivable days: The spam of time during which the debtors or customers pay. Calculated as:
Average receivables ÷ Credit sales × 365

Payable days: The time in which customers are being paid. Calculated as:
Average payables ÷ Credit purchases × 365
Further there are two more ratios that assists in evaluating performance that are as follows:

Inventory turnover(in times): Cost ÷ Average inventory held

Working capital turnover: Sales revenue ÷ Net working capital

Description: To calculate the length of working capital cycle there needs to be some ratios that sould find out first these ratios are called working capital ratios.

Accounting Concepts...

2011-12-21T02:42:00.000-08:00

While making accounting statements a clear objective is that accounts reflect true and fair view. The true and fair view is applied to ensuring business activites are carring out properly. to ensure this application there are certain concepts and conventions which helps that accounts are maintained accurately. Different accounting concepts are as follows:

The Separate Entity concept: This means that the business is treated as a separate entity.i:e The business transactions are recorded separately and distinct from the personal transactions of the owner.

Matching concept: Income and expenses are properly matched with a given accounting period i:e to which they relate.

Historical cost concept: According to the historical cost concept assets and liabilities are recorded at their historical cost. Historical cost means the cost that was initially paid for the acquisition of an asset, e.g. cost of an asset.

Going concern concept: An entity is a going concern if it has an intention to cease trading or shut off its operations nor The circumstances that may lead to the shutting off of the entity’s operations.
An entity should prepare its financial statements on going concern basis if it is to continue its operations in the near future.

Prudence concept: The prudence concept reveals that assets and incomes are not overstated, and liabilities and expenses are not understated.

Materiality concept: This implies that an information is material if its omission or misstatement in the financial statements may affect the decisions of the users of the financial statements.

Consistency concept: This means that accounting principles and policies shall be applied on a consistency basis from one period to another period.

DEPRECIATION

2011-01-10T05:31:00.000-08:00

It is reduction in the value of fixed asset with the passage of time. As an asset is used, its value decreases which is due to wear and tear of that asset. This amount is charged as an expense and represents the benefit use during the period.Depreciation is a non cash expense. This decrease in value of asset is called depreciable value.

DEPRECIABLE VALUE:
Cost/ revalued amount of asset – residual value

RESIDUAL VALUE:
Scrape value of an asset at the end of its useful life. It is also known as N.R.V. (Net Realizable Value)
DOUBLE ENTRY:
Dr Depreciation a/c
Cr Provision for depreciation a/c

METHODS OF DEPRECIATION:
There are two methods of depreciation.
1. Straight Line Method
2. Reducing Balance Method

STRAIGTH LINE METHOD:
This is a method according to which a constant amount of depreciation is charged over the useful life of an asset.
It is calculated as follow:
Annual Charge=Cost – residual value /expected useful life

REDUCING BALANCE METHOD:
This is a method according to which the annual charge decreases over assets useful life there is a percentage given to charge depreciation.
It is calculated as follow:
Net book value = (Cost –Accumulated depreciation) * % of charge

Bad Debts

2011-01-08T09:19:00.000-08:00

Accounts receivable that will remain noncollectable and will be written off are known as irrecoverable or bad debts. They are shown as an expense in trading profit and loss account i:e income statement.

Double entry:

Dr:     Bad debt expense (I/S)

Cr:     Debtors

When a bad debt becomes good i:e the debt is collectd its entry is:

Dr:     Bank/Cash

Cr:     Bad debts recovered a/c

Provision for doubtful debts:

Companies make a provision for bad debts in advance at the year end which they consider will become bad debts in future. Prudence concept also states that provision is to be made for these doubtful debts. The reason for making provision is that the amount of debtors reported in balance sheet is not overstated.

Double entry:

Dr:     Bad debts (P&L)

Cr:     Provision for bad debts (BS)

When the debt actually becomes bad the entry will be:

Dr:     Provision for bad debts (BS)

Cr:     Debtors a/c

Cash Operating Cycle

2011-01-07T03:47:00.000-08:00

Cash operating cycle is the length of time between company’s outflow of material, wages and other expenditure and inflow of cash from the sales of goods. It reflects a company’s investment in working capital. The faster the cycle, lower is the investment in working capital. The investment increases from raw material to labour, OH, WIP upto final collection of cash from trade receivables.

Calculation of cash operating cycle:

For manufacturing business cash operating cycle is calculated as:

Raw material period                                                             X

Add: WIP period                                                                        X

Add: Finished good period                                                            X

Add: Receivables collection period                                        X

Less: Payables payment period                                               (X)

Cash Operating cycle                                                 X

Note: For retail business there is no raw material and WIP holding period.

The length of cycle depends upon balancing liquidity and profitability. Shortening cash cycle may have an adverse effect on sales because customers buy from that supplier who gives more credit period so there should be an optimum level of cash operating cycle.

STOCK / INVENTORY

2010-12-18T08:02:00.001-08:00

Inventory is a current asset that is held by an entity either to be used in production or to be sold. Inventory that is held at the begining of the financial year is known as opening inventory. The inventory that remains unused or unsold at the end of financial year is known as closing inventory.

There are three forms of inventory.

1. Raw material

2. Work in progress (WIP)

3. Finished goods

Ordering stock

2010-12-18T08:00:00.000-08:00

The store manager will decide that an order needs to be placed and the number or the units to order. The amount to be ordered will be determined by the future plans for production and sales.

It is calculated as follow

Ordering stock = required for sales + closing stock – opening stock

Question:

Hussy Ltd makes a product which requires 2 kg of material X. Hussy Ltd always keep closing inventory of 200 kg of material X each month. As the production of last three months were 500 hundred units. Hussy Ltd is planning to increase its sale to 600 hundred units from the present month.

Required:

How many kg of material X should be ordered?

Solution:

Closing stock                200 kg

Opening stock               200 kg

Requirement for sale     600/2= 300 kg

Now put in formula:

Ordering stock = 300+200-200

Ordering stock = 300 kg of material required.

Cash and Cash Flows

2010-12-17T09:09:00.000-08:00

Money in terms of notes, bills, currency and coins is called cash. Also includes current accounts, deposits etc.

Cash Flows: It is the money that is flowing into the business and out of the business. OR A term which shows the receipt and payments of cash.

It is a measure of a company’s financial health.

Deficit: When cash outflows exceed cash inflows it is called as negative cash flows or deficit.

Surplus: When cash inflows are greater than cash outflows.

Types of Cash flows:

1. Cash flows from operating activities: Amount of cash a company generates from the revenues and expenses e:g cash flows from sales and cash payments to suppliers.

2. Cash flows from investing activities: Is a measure of the total cash generated or lost by a company’s investments it includes buying and selling assets, lending money etc.

3. Cash flows from financing activities: Funds related to the financing of the company. This includes any dividend payments, borrowing money etc.

4. Capital receipts and payments: Related to issue of shares and acquisition of fixed assets.

5. Drawings & Dividends: Cash payments to shareholders as dividends

Sources of Cash: Cash can be obtain from finance activities i:e increase long term debt, equity etc and also from selling assets i:e decrease in current assets and fixed assets.

Uses of Cash: Uses of cash are vice versa of sources of cash. Paying payables that decrease in long term debt. equity. Buying assets that results increase in current assets, fixed assets.

Cash Accounting: A method in which receipts and expenses are recorded in the period in which they are actually receive and paid.

Cash Forecast: Cash forecasting is a method that forecasts cash position in future it ensures that sufficient funds will be available when they are needed. It provides an early warning of liquidity problems. Enables management to plan strategies to deficits and surpluses.

Objectives of Cash Budget: The main objectives of cash budget is:

To help management what to do with surpluses and deficits i:e where to invest the surpluses and for deficits where to get finance.

For working capital management.

To set borrowing limits and minimize cost of funds.

To compare actual cash flows with budgeted cash flows which allows business to decide whether it will have enough cash or new sources of borrowing will be necessary.

Types of Forecast:

1. Balance sheet base forecast

2. Financial statement base forecast

3. Receipt and payments base forecast

Working Capital Management

2010-12-17T09:08:00.001-08:00

Working capital is the capital available for day to day transactions/operations of an organization. It ensures that a company has sufficient cash flow in order to meet its short-term debt obligations and operating expenses. Working capital management involves management of cash, stock, amount receivables from debtors, amount payable to creditors.

Working capital= Current assets-Current liabilities

Current assets include cash, stock, debtors etc.
Current liabilities include creditors, loan payable, dividend payable etc.
Main objectives of working capital management is to:

minimize the investment in working capital
minimize cost of investment
minimize working capital cycle

Financial management:

2010-12-17T09:07:00.000-08:00

Financial Management can be defined as the management of the finance of a business in order to achieve financial objectives.

The key point of financial management of a business are:

• Create wealth

• Generate cash

• Provide an adequate return on investment

There are 3 key elements in the process of financial managment

1) Financial Planning: Management need to ensure that enough resources are available at the right time to meet the needs of the business. In the short term, to invest in equipment and stocks etc. In the medium and long term, funding may be required for significant additions to the productive capacity of the business

2) Financial Control:Financial control is a important activity to help the business ensure that the business is meeting its objectives.

• Are assets being used efficiently?

• Are the businesses assets secure?

• Do management act in the best interest of shareholders and in accordance with business rules?

3) Financial Decision-making: The key aspects of financial decision-making relate to:

• Investments must be financed in some way there are always financing alternatives that can be considered. For example it is possible to raise finance from selling new shares, borrowing from banks.

• Financing and dividends decision is whether profits earned by the business should be retained after distributed dividends to shareholders. If dividends are too high, the business may be run out of funding to reinvest in growing revenues.

Accruals & Prepayments

2010-12-17T02:04:00.001-08:00

Accrual:
Accruals concept states that income and expenses must be recorded in the accounting records and reported in the financial statements of the period to which they relate.

Accruals are accrued expenses, they have not yet been paid for. Accruals are current liabilities.

Prepayment:
The payment of a debt in full before it is due. OR Payments which have been made in one accounting period, but should not be charged against profit until a later period because they relate to that later period.

If we pay for something that relates to next accounting period, we use a prepayment to transfer that charge forward to the next period. Prepayments are current assets.

KEY TERMS:

Accrued expenses:Expenses that has been incurred but not yet paid.

Accrued income:Income that is earned but not yet received.

Prepaid expense:Expenses that has not been incurred but has been paid in advance.

Pre-received income:Income that is not earned but received in advance.

Safety/Buffer Stock

2010-12-17T01:49:00.001-08:00

Minimum level of stock required to meet emergencies. Safety stock should be quite enough to cover problems i:e break in supply,shortage of material. In Justin in time(JIT) system the purpose is to eliminate the buffer stock.

Buffer stock=2 x average stock – reorder quantity

Free Stock

2010-12-17T01:44:00.000-08:00

Free stock represents what is really available for future use.

The free stock balances give better picture to the manager that how much stock needed for the current situation. So he can take decisions regarding the inventory.

Free stock is calculated as:-

Materials in stock                                      X

Materials on order from suppliers               X

Materials requisitioned, not yet issued       (X)

Free stock balance                                X

Question: – Mick Ltd, a wholesaler has 8,500 units outstanding for material on existing customers orders; there are 4,000 units in stock. Order from supplier is 5,500.

Required:-

Calculate free stock for Mick Ltd?

Solution:-

Materials in stock                                     4000

Materials on order from suppliers              5500

Materials requisitioned, not yet issued       (8500)

Free stock balance                                    1000

Overheads

2010-12-17T01:42:00.001-08:00

Resources consumed or lost in completing a process and which cannot be traced directly to the cost of the product.

Overheads are indirect costs. Overheads are total of:

1) Indirect materials (e:g nails in a chair, gum used in table )

2) Indirect labour (e:g supervisor, storekeeper)

3) Indirect expenses (e:g rent, machine running expense)

Overheads can be categorized into:

Production Overheads
Non-production overheads
Production overheads are those, that are directly related to production e:g machine insurance, machine greases etc.

Non-production overheads are not directly related to production e:g selling and distribution cost, research cost etc.

The production and non-production overheads are further categorized into:

Variable overheads
Fixed overheads
Variable overheads are those indirect cost which varies with the level of output but constant for unit cost e:g salesman commission, electricity charges etc.

Fixed overheads are that cost which remain the same for a given level of output during the period e:g rent and rates, factory managers salary etc.

Cost Volume Profit (CVP) Analysis

2010-12-17T01:40:00.000-08:00

It is a method to determine the relationship between change in activity level, total sales revenue, expenses and profit. OR a method that deals with how profits and costs change with a change in volume.

Objective of CVP analysis:

Establish the financial results when specified level of activity or volume changes. To establish this management need to know

Break-even point
Margin of safety
Break-even point: The level of activity where there is no profit or loss i:e the point at which cost or expenses and revenue are equal.

It can be calculated in units or in value, and can be calculated as follows:

Break-even point (in units) = Fixed cost ÷ Contribution per unit

Contribution per unit = Selling price per unit – Variable cost per unit

Break-even point (in value) = Fixed cost ÷ Contribution to sales ratio

Contribution to sales ratio = Total contribution ÷ Total Sales revenue

Margin of Safety: It is the difference between budgeted sales volume/revenue and break-even sales volume/revenue. It shows the amount by which actual sales can fall without a loss being incurred.

It can be calculated also in units or in value, and can be calculated as follows:

Margin of safety (in value/units) = Budgeted Sales revenue/unit – Break-even Sales revenue/unit

Margin of Safety (in % value) = Budgeted Sales revenue – Break-even Sales revenue × 100% ÷ Budgeted Sales revenue

Margin of Safety (in % units) = Budgeted Sales units – Break-even Sales units × 100% ÷ Budgeted Sales units

Surplus & Investment of Surplus

2010-12-17T01:37:00.000-08:00

Surplus is, when a business have excess of cash inflows over cash outflows because of large amount of cash generated from operations or sale of fixed assets

Business have to invest surplus funds but it should be kept in mind that the surplus is temporary or permanent. Temporary surplus may be invested until it is ensure that it need not be used in current operations. Permanent surplus should be invested. It should be kept in mind that investment should be profitable and secure.

Objectives of investment of surplus:

As they are assets of company so need to be look after like any other assets.

In time of inflation, value of money effectively fall.

There are some factors that should be consider before investment of surplus

Risk
Liquidity
Maturity
Return
Risk: There is a strong link between risk and return the higher the risk the higher the return and vice versa. High risk can lead to permanent losses that can collapse the company. Shares traded in stock market are consider to be most high risk type of investment

Liquidity: It involves the ability to turn investment into cash immediately. There is also a close link between liquidity and return. A less liquid investment generally provide a higher return and a high liquid investment generally provide a lower return. It is important to consider investments liquidity before investing. If the amount and duration of cash surplus are to be change then highly liquid investment should be taken, if not then less liquid investment should be taken.

Maturity: The length and duration of investment. The longer the maturity the higher the return. A company’s investment should be mature so that surplus cash is available when business needs it.

Return: Income generated by an investment, expressed usually as percentage of amount invested. The whole purpose of investment is to receive a return the rate of return is also an important factor when investing cash surpluses.

Types of Investment:

Shares
Bonds
Debenture stocks
Certificates of deposit (CDS)
Gilt-edged securities
Bills of exchange etc…….