MASTER OF BUSINESS
ADMINISTRATION (MBA)
III YEAR (FINANCE)
PAPER III
CORPORATE FINANCIAL
ACCOUNTING
BLOCK 3
INTERNATIONAL ACCOUNTING
STANDARDS AND FINANCIAL ANALYSES
WRITTEN BY
SEHBA HUSSAIN
EDITTED BY
PROF. SHAKOOR KHAN
PAPER III
CORPORATE FINANCIAL ACCOUNTING
BLOCK 3
INTERNATIONAL ACCOUNTING STANDARDS AND
FINANCIAL ANALYSES
CONTENTS
Page number
Unit 1 International Accounting Standards and Accounting
For Contractors, Solicitors and Underwriters
4
Unit 2 Financial Analysis
35
Unit 3 Analysis of Financial Statements
82
2
BLOCK 3 INTERNATIONAL ACCOUNTING
STANDARDS AND FINANCIAL ANALYSES
This block highlights international accounting standards and various types of financial
analyses which help finance managers to ascertain actual position of their business and
take fruitful decisions.
Unit 1 basically discusses the significance and scope of international Accounting
standards. Consequently it throws light on accounting for contractors, solicitors and
underwriters. Various examples will be given to discuss the areas in an effective way
Unit 2 deals with financial analysis and its various types. Unit covers important topics
such as ratio analysis; trend analysis; time series; univariate time series models ;
multivariate time series models; project analysis; project analysis through CPM and
Program evaluation and review technique (PERT)
Third unit focuses on typical types of financial analysis such as fund flows, consolidated
financial statements. It also discusses the methods and techniques of projecting working
capital requirements of the organisation.
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UNIT 1
INTERNATIONAL ACCOUNTING STANDARDS AND
ACCOUNTING FOR CONTRACTORS, UNDERWRITERS
AND SOLICITORS
Objectives
After reading this unit, you should be able to:
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Understand the concept International Accounting Standards
Explain the accounting for contractors
Identify the approaches to solicitor’s accounting
Know the principles and practices for accounting of underwriters
Structure
1.1 Introduction to International Accounting standards
1.2 International Accounting standards overview
1.3 Accounts of contractors
1.4 Solicitor’s accounting
1.5 Accounting for underwriting
1.6 Summary
1.7 Further readings
1.1 INTRODUCTION TO INTERNATIONAL ACCOUNTING
STANDARDS
Accounting provides useful information to decision makers, thus as the business
environment has changed so have the accounting standards that govern the presentation
and disclosure of information. International Accounting Standards are central to this
concept.
International standards were first developed in the late 1960’s but they have reached their
zenith of importance in today’s economic and business environment. In light of the
interests and activities of companies and users of financial information becoming global,
the Securities Exchange Commission (SEC) released a statement declaring its
involvement and support to develop a globally accepted, high quality financial reporting
framework. The benefits of international accounting standards can be financial, economic
and political.
Preliminary evidence suggests that companies, lenders, and investors would prefer a
convergence of domestic accounting standards with international accounting standards to
create a quality financial reporting framework. Although there are significant benefits to
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implementing international accounting standards and it is increasing in importance there
are still many challenges to further development and authoritative implementation. To
best understand these challenges one must look at the factors that influence the
development of accounting regulations.
Such factors can include, social and cultural values; political and legal systems; business
activities and economic conditions; standard setting processes; capital markets and forms
of ownership; and finally cooperative efforts by nations. These factors if properly
understood can mitigate or even eliminate the challenges to international accounting
standards. International accounting standards are important today and will most certainly
become more important for the future as they are further developed.
1.2 INTERNATIONAL ACCOUNTING STANDARDS OVERVIEW
Financial reporting has long been guided by the dictates of national standards. The
accounting community has always been in agreement as to the importance of official
standards to ensure the reliability and relevance of financial information. In addition to
each country’s national standards; accounting officials and educators sought the
development of international standards. However the international standards have taken
nearly 20 years to reach their zenith in the financial world. Only in the past seven years
have international standards reached prominence with some countries adopting the
international standards in place of their own standards. Historically, the United States has
been most adamant about maintaining its own U.S.
Generally Accepted Accounting Principles (GAAP), however recently the SEC has
agreed to the use of International Financial Reporting Standards (IFRS) and International
Accounting Standards (IAS). To best appreciate this momentous decision and its
implications one must first understand the differences in how standards developed in
various countries, the history behind the development of International Standards, the
benefits of international standards, and challenges of implementing international
standards within the US, due to major differences between U.S. GAAP and IFRS.
1.2.1 International Standards
Different countries with different accounting practices is an accepted situation, however
it is not without its disadvantages. As the idea of global corporations and markets without
borders began to become a reality, members of the accounting profession realized the
need for international standards. In 1971, the International Accounting Standards
Committee (IASC) was formed. It was a loosely formed committee at the behest of
accounting boards from Australia, Canada, France, Germany, Japan, Mexico,
Netherlands, and U.K. It had a similar framework to that of the US Financial Accounting
Standards Board (FASB) as well as the British and Australian frameworks. At about the
same time the international professional activities of accountancy bodies from different
countries organized under the International Federation of Accountants (IFAC). The IASC
and IFAC operated tangent to each other. However IFAC members were automatically
members of IASC. With this structure, IASC would have autonomy in setting
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international accounting standards and publishing discussion documents relating to
international accounting issues. From the 1970’s the IASC issued roughly forty
standards; that went largely unused by most large corporations and countries with already
established accounting systems. Its greatest progress was in Europe and with developing
or newly industrialized countries. For example in the 1990’s Italy, Belgium, France and
Germany all allowed large corporations to use International Accounting Standards (IAS)
for domestic financial reporting. Yet in large part, the IASC found itself in a situation
where it issued standards but had no power of enforcement, thus no real authority. (Nobes
1999)
In light of its progress in Europe, the IASC focused its efforts at gaining authoritative
powers over accounting regulation in European markets. European multinational
companies, having long suffered the financial burden of filing under national standards
and filing under U.S. GAAP for listing on U.S. exchanges were interested in working
towards authoritative international standards that would phase out the use of U.S. GAAP.
With this incentive, in early 2000, the IASC terminated its link with the IFAC as the first
step in restructuring itself. In 2001, the IASC reorganized as the International Accounting
Standards Board (IASB) and began developing International Financial Reporting
Standards (IFRS) in addition to the existing IAS.
The IASB defined itself as “an independent standard-setting board, appointed and
overseen by a geographically and professionally diverse group of Trustees of the IASC
Foundation who are accountable to the public interest.” To that end the IASB has
fourteen board members from 9 different countries and different academic or professional
backgrounds. Its main goal is to “co-operate with national accounting standard-setters to
achieve convergence in accounting standards around the world.” It is important to note,
that its mission is purposefully stated to work toward convergence not absolute
replacement of national standards.
This means that the IASB wanted agreement between its standards and the national
standards of a country. To that end the IASB began its convergence efforts within
Europe. This made sense because the EU presents a strong capital market and EU
ministers had expressed an interest in IFRS. Indeed by 2005, all European multinational
companies were using IFRS for their financial reporting needs. This was a great
achievement for the IASB and provided the necessary drive for U.S. GAAP convergence
with IFRS. Due to pressure from EU officials and corporations in 2008 the SEC
eliminated the rule requiring European companies to restate their financial statements to
U.S. GAAP for listing on US exchanges. This provided IFRS a foothold in the US
financial reporting. With these rapid changes, the SEC began to seriously look at IFRS
and the benefits it provides. (SEC Release 2008)
1.2.2 Benefits of International Standards
Most of the various national financial regulatory and standards setting bodies agree that
there are numerous concrete benefits to implementing international standards. The SEC
explicitly stated this as far back as 1988, in a policy statement that reads “all securities
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regulators should work together diligently to create sound international regulatory
frameworks that will enhance the vitality of capital markets”(p2). Capital markets are one
area that can benefit greatly from uniform standards. Currently companies desiring to
issue stock via capital markets in different countries must follow the different rules of
each country. This creates significant barriers to entry because meeting the varied
financial reporting requirements leads to considerable increased costs.
For example, in 1993 Daimler-Benz spent Rs. 60 million to prepare financial statements
adhering to U.S. GAAP, and expected to pay between Rs.15 and Rs.20 million each
subsequent year to meet U.S. GAAP (Doupnik 2007). Moreover divergent standards also
create inefficiencies in cross-border capital flows. Uniform reporting standards will lead
to decreased cost of capital because internationally accepted standards will expand the
base of global funding without the penalty of additional reporting costs. This will
eliminate cost as a barrier to entry and encourage investors to pursue access to foreign
markets; which will lead to increased efficiency in cross-border capital flows.
In addition to eliminating excess cost, another benefit of global standards is that they will
eliminate duplication of effort formulating accounting standards. Global standards
facilitate a concentration of accounting experts committed to formulating standards to
meet information users’ needs; standards that have a global approach instead of a narrow
national focus. Also international standards could lead to greater agreement between
accounting and economic measures.
One aspect central to the benefits of using global standards is harmonization. Standard
setting officials and accounting researchers stress the importance of differentiating
‘standardization’ of the rules from harmonization. An easily understood definition of
harmonization provided by Wilson(1969) is:
The term harmonization as opposed to standardization implies a reconciliation of
different points of view. This is a more practical and conciliatory approach than
standardization, particularly when standardization means the procedures of one country
should be adopted by all others. Harmonization becomes a matter of better
communication of information in a form that can be interpreted and understood
internationally (p.40).
An intrinsic benefit of harmonization is that it does not force the elimination of national
standards, which could be met with significant nationalistic opposition. Harmonization
through the use of global standards will enhance the comparability of financial statements
across borders; thus providing a better quality of information for investors and creditors.
However, some developing countries are hesitant to embrace harmonization for fear that
accounting standards will be dominated by standards from developed countries
specifically U.S. GAAP(Nobes 2006).
The adoption of global or international accounting standards is an idea that has patiently
waited in the wings for decades. The increasingly global nature of the business
environment coupled with the complexity of financial dealings propelled global
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accounting standards into the limelight. The EU nations and many other nations have
adopted IFRS; at the same time others are working towards such a goal. Yet this climate
of progress and camaraderie does not mean opposition in nonexistent.
The greatest opposition to IFRS is largely political but many proponents of IFRS see this
obstacle as easily diffused. Indeed, leaders from the G20 countries have established their
support for developing a single set of high-quality global accounting standards. The
FASB/IASB convergence plan has been one of the greatest advantages in helping IFRS
gain a foothold. U.S. GAAP and IFRS are the prominent and most widely used
accounting standards. If the convergence project leads to future agreement between these
two standards sets, global financial reporting will be based on one set of standards. Thus
the ultimate goal of international reporting will be achieved, and international standard
will be an idea whose time has finally arrived.
1.2.3 Structure of IFRS
IFRS are considered a "principles based" set of standards in that they establish broad
rules as well as dictating specific treatments.
International Financial Reporting Standards comprise:
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International Financial Reporting Standards (IFRS)—standards issued after 2001
International Accounting Standards (IAS)—standards issued before 2001
Interpretations originated from the International Financial Reporting
Interpretations Committee (IFRIC)—issued after 2001
Standing Interpretations Committee (SIC)—issued before 2001
Framework for the Preparation and Presentation of Financial Statements
IAS 8 Par. 11
"In making the judgement described in paragraph 10, management shall refer to, and
consider the applicability of, the following sources in descending order:
(a) the requirements and guidance in Standards and Interpretations dealing with similar
and related issues; and
(b) the definitions, recognition criteria and measurement concepts for assets, liabilities,
income and expenses in the Framework."
1.2.4 Framework
The Framework for the Preparation and Presentation of Financial Statements states basic
principles for IFRS.
The IASB Framework—with the exception of the Concepts of Capital and Capital
Maintenance (see below)—is in the process of being updated. The Joint Conceptual
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Framework project aims to update and refine the existing concepts to reflect the changes
in markets, business practices and the economic environment that have occurred in the
two or more decades since the concepts were first developed.
Its overall objective is to create a sound foundation for future accounting standards that
are principles-based, internally consistent and internationally converged. Therefore the
IASB and the US FASB (the boards) are undertaking the project jointly.
1. Role of Framework
Deloitte states:
In the absence of a Standard or an Interpretation that specifically applies to a
transaction, management must use its judgement in developing and applying an
accounting policy that results in information that is relevant and reliable. In making that
judgement, IAS 8.11 requires management to consider the definitions, recognition
criteria, and measurement concepts for assets, liabilities, income, and expenses in the
Framework. This elevation of the importance of the Framework was added in the 2003
revisions to IAS 8.
2. Objective of financial statements
A financial statement should reflect true and fair view of the business affairs of the
organization. As these statements are used by various constituents of the society /
regulators, they need to reflect true view of the financial position of the organization.
3. Underlying assumptions
The underlying assumptions used in IFRS are:

Accrual basis: the effect of transactions and other events are recognized when
they occur, not as cash is gained or paid.
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Going concern: an entity will continue for the foreseeable future.
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Stable measuring unit assumption: financial capital maintenance in nominal
monetary units; i.e., accountants consider changes in the purchasing power of the
functional currency up to but excluding 26% per annum for three years in a row
(which would be 100% cumulative inflation over three years or hyperinflation as
defined in IFRS) as immaterial or not sufficiently important for them to choose
financial capital maintenance in units of constant purchasing power during low
inflation and deflation as authorized in IFRS in the Framework, Par 104 (a).
4. Qualitative characteristics of financial statements
Qualitative characteristics of financial statements include:
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Understandability
Reliability
Comparability
Relevance
True and Fair View/Fair Presentation
5. Elements of financial statements
The financial position of an enterprise is primarily provided in the Statement of Financial
Position. The elements include:
1. Asset: An asset is a resource controlled by the enterprise as a result of past events from
which future economic benefits are expected to flow to the enterprise.
2. Liability: A liability is a present obligation of the enterprise arising from the past
events, the settlement of which is expected to result in an outflow from the enterprise'
resources, i.e., assets.
3. Equity: Equity is the residual interest in the assets of the enterprise after deducting all
the liabilities. Equity is also known as owner's equity.
The financial performance of an enterprise is primarily provided in an income statement
or profit and loss account. The elements of an income statement or the elements that
measure the financial performance are as follows:
4. Revenues: increases in economic benefit during an accounting period in the form of
inflows or enhancements of assets, or decrease of liabilities that result in increases in
equity. However, it does not include the contributions made by the equity participants,
i.e., proprietor, partners and shareholders.
5. Expenses: decreases in economic benefits during an accounting period in the form of
outflows, or depletions of assets or incurrences of liabilities that result in decreases in
equity.
6. Recognition of elements of financial statements
An item is recognized in the financial statements when:
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it is probable future economic benefit will flow to or from an entity.
7. Measurement of the Elements of Financial Statements
Par. 99. Measurement is the process of determining the monetary amounts at which the
elements of the financial statements are to be recognised and carried in the balance sheet
and income statement. This involves the selection of the particular basis of measurement.
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Par. 100. A number of different measurement bases are employed to different degrees
and in varying combinations in financial statements. They include the following:
(a) Historical cost. Assets are recorded at the amount of cash or cash equivalents paid or
the fair value of the consideration given to acquire them at the time of their acquisition.
Liabilities are recorded at the amount of proceeds received in exchange for the obligation,
or in some circumstances (for example, income taxes), at the amounts of cash or cash
equivalents expected to be paid to satisfy the liability in the normal course of business.
(b) Current cost. Assets are carried at the amount of cash or cash equivalents that would
have to be paid if the same or an equivalent asset was acquired currently. Liabilities are
carried at the undiscounted amount of cash or cash equivalents that would be required to
settle the obligation currently.
(c) Realisable (settlement) value. Assets are carried at the amount of cash or cash
equivalents that could currently be obtained by selling the asset in an orderly disposal.
Assets are carried at the present discounted value of the future net cash inflows that the
item is expected to generate in the normal course of business. Liabilities are carried at the
present discounted value of the future net cash outflows that are expected to be required
to settle the liabilities in the normal course of business.
Par. 101. The measurement basis most commonly adopted by entities in preparing their
financial statements is historical cost. This is usually combined with other measurement
bases. For example, inventories are usually carried at the lower of cost and net realisable
value, marketable securities may be carried at market value and pension liabilities are
carried at their present value. Furthermore, some entities use the current cost basis as a
response to the inability of the historical cost accounting model to deal with the effects of
changing prices of non-monetary assets.
8. Concepts of Capital and Capital Maintenance
The Concepts of Capital and Capital Maintenance are not included in the phases to be
updated in the Joint Conceptual Framework Project.
Kevin McBeth, FASB Conceptual Framework Project Manager (Phase C Measurement)
stated: "In the measurement phase the staff suggested that capital and capital
maintenance be discussed in the measurement phase, as it was in the original FASB
Conceptual Framework. However, to date the Boards have not taken a decision on
where, or even whether, those topics will be included in the converged framework.”
It is thus not clear where, or even whether the Concepts of Capital and Capital
Maintenance as stated in the current Framework, Paragraphs 102 to 110 will be included
in the new Conceptual Framework. According to Kevin McBeth, the Concepts of Capital
and Capital Maintenance may even be excluded from the future converged Conceptual
Framework.
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Concepts of Capital
Par. 102: A financial concept of capital is adopted by most entities in preparing their
financial statements. Under a financial concept of capital, such as invested money or
invested purchasing power, capital is synonymous with the net assets or equity of the
entity. Under a physical concept of capital, such as operating capability, capital is
regarded as the productive capacity of the entity based on, for example, units of output
per day.
Par. 103: The selection of the appropriate concept of capital by an entity should be based
on the needs of the users of its financial statements. Thus, a financial concept of capital
should be adopted if the users of financial statements are primarily concerned with the
maintenance of nominal invested capital or the purchasing power of invested capital. If,
however, the main concern of users is with the operating capability of the entity, a
physical concept of capital should be used. The concept chosen indicates the goal to be
attained in determining profit, even though there may be some measurement difficulties
in making the concept operational.
Concepts of Capital Maintenance and the Determination of Profit
Par. 104: The concepts of capital in paragraph 102 give rise to the following concepts of
capital maintenance:
(a) Financial capital maintenance. Under this concept a profit is earned only if the
financial (or money) amount of the net assets at the end of the period exceeds the
financial (or money) amount of net assets at the beginning of the period, after excluding
any distributions to, and contributions from, owners during the period. Financial capital
maintenance can be measured in either nominal monetary units or units of constant
purchasing power.
(b) Physical capital maintenance. Under this concept a profit is earned only if the
physical productive capacity (or operating capability) of the entity (or the resources or
funds needed to achieve that capacity) at the end of the period exceeds the physical
productive capacity at the beginning of the period, after excluding any distributions to,
and contributions from, owners during the period.
The three concepts of capital defined in IFRS during low inflation and deflation are:
(A) Physical capital. See paragraph 102.
(B) Nominal financial capital. See paragraph 104.
(C) Constant purchasing power financial capital. See paragraph 104.
The three concepts of capital maintenance authorized in IFRS during low inflation and
deflation is:
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Physical capital maintenance: optional during low inflation and deflation.
Current Cost Accounting model prescribed by IFRS. See Par 106.
Financial capital maintenance in nominal monetary units (Historical cost
accounting): authorized by IFRS but not prescribed—optional during low
inflation and deflation. See Par 104 (a)Historical cost accounting. Financial
capital maintenance in nominal monetary units per se during inflation and
deflation is a fallacy: it is impossible to maintain the real value of financial capital
constant with measurement in nominal monetary units per se during inflation and
deflation.
Financial capital maintenance in units of constant purchasing power:
authorized by IFRS but not prescribed—optional during low inflation and
deflation. See Par 104(a). Prescribed in IAS 29 during hyperinflation. Constant
Purchasing Power Accounting Only financial capital maintenance in units of
constant purchasing power per se can maintain the real value of financial capital
constant during inflation and deflation in all entities that at least break even—
ceteris paribus—for an indefinite period of time. This would happen whether
these entities own revaluable fixed assets or not and without the requirement of
more capital or additional retained profits to simply maintain the existing constant
real value of existing shareholders´ equity constant.
Par. 105: The concept of capital maintenance is concerned with how an entity defines the
capital that it seeks to maintain. It provides the linkage between the concepts of capital
and the concepts of profit because it provides the point of reference by which profit is
measured; it is a prerequisite for distinguishing between an entity’s return on capital and
its return of capital; only inflows of assets in excess of amounts needed to maintain
capital may be regarded as profit and therefore as a return on capital. Hence, profit is the
residual amount that remains after expenses (including capital maintenance adjustments,
where appropriate) have been deducted from income. If expenses exceed income the
residual amount is a loss.
Par. 106: The physical capital maintenance concept requires the adoption of the current
cost basis of measurement. The financial capital maintenance concept, however, does not
require the use of a particular basis of measurement. Selection of the basis under this
concept is dependent on the type of financial capital that the entity is seeking to maintain.
Par. 107: The principal difference between the two concepts of capital maintenance is the
treatment of the effects of changes in the prices of assets and liabilities of the entity. In
general terms, an entity has maintained its capital if it has as much capital at the end of
the period as it had at the beginning of the period. Any amount over and above that
required to maintain the capital at the beginning of the period is profit.
Par. 108: Under the concept of financial capital maintenance where capital is defined in
terms of nominal monetary units, profit represents the increase in nominal money capital
over the period. Thus, increases in the prices of assets held over the period,
conventionally referred to as holding gains, are, conceptually, profits. They may not be
recognised as such, however, until the assets are disposed of in an exchange transaction.
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When the concept of financial capital maintenance is defined in terms of constant
purchasing power units, profit represents the increase in invested purchasing power over
the period. Thus, only that part of the increase in the prices of assets that exceeds the
increase in the general level of prices is regarded as profit. The rest of the increase is
treated as a capital maintenance adjustment and, hence, as part of equity.
Par. 109: Under the concept of physical capital maintenance when capital is defined in
terms of the physical productive capacity, profit represents the increase in that capital
over the period. All price changes affecting the assets and liabilities of the entity are
viewed as changes in the measurement of the physical productive capacity of the entity;
hence, they are treated as capital maintenance adjustments that are part of equity and not
as profit.
Par. 110: The selection of the measurement bases and concept of capital maintenance will
determine the accounting model used in the preparation of the financial statements.
Different accounting models exhibit different degrees of relevance and reliability and, as
in other areas, management must seek a balance between relevance and reliability. This
Framework is applicable to a range of accounting models and provides guidance on
preparing and presenting the financial statements constructed under the chosen model. At
the present time, it is not the intention of the Board of IASC to prescribe a particular
model other than in exceptional circumstances, such as for those entities reporting in the
currency of a hyperinflationary economy. This intention will, however, be reviewed in
the light of world developments.
1.2.5 Requirements of IFRS
IFRS financial statements consist of (IAS1.8)
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a Statement of Financial Position
a Statement of comprehensive income or two separate statements comprising an
Income Statement and separately a Statement of comprehensive income, which
reconciles Profit or Loss on the Income statement to total comprehensive income
a statement of changes in equity (SOCE)
a cash flow statement or statement of cash flows
notes, including a summary of the significant accounting policies
Comparative information is required for the prior reporting period (IAS 1.36). An entity
preparing IFRS accounts for the first time must apply IFRS in full for the current and
comparative period although there are transitional exemptions (IFRS1.7).
On 6 September 2007, the IASB issued a revised IAS 1 Presentation of Financial
Statements. The main changes from the previous version are to require that an entity
must:

present all non-owner changes in equity (that is, 'comprehensive income' ) either
in one statement of comprehensive income or in two statements (a separate
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
income statement and a statement of comprehensive income). Components of
comprehensive income can not be presented in the statement of changes in equity.
present a statement of financial position (balance sheet) as at the beginning of the
earliest comparative period in a complete set of financial statements when the
entity applies an accounting
'income statement' is replace by two alternative presentations, either a Statement
of comprehensive income or two separate statements comprising an Income
Statement and separately a Statement of comprehensive income, which reconciles
Profit or Loss on the Income statement to total comprehensive income
The revised IAS 1 is effective for annual periods beginning on or after 1 January 2009.
Early adoption is permitted.
1.3 ACCOUNTS OF CONTRACTORS
Contractors operating under a limited company payment structure need to prepare
financial accounts. Most contractors use a specialist firm of chartered accountants for all
their accounting services including the production of the annual accounts.
Accounting for contractors is somewhat different to regular accounting services as a
result of specific legislation such as IR35, which has created a variety of issues that
require specialist advice. In addition there has been significant growth in accounting
providers and a myriad of schemes all offering the best results for contractors – for
example: umbrella companies, managed service companies , composite schemes,
offshore arrangements etc.
Ultimately, any expert in accounting for contractors will be looking to maximise income
whilst minimising tax. It is essential that any arrangements put in place, and the ultimate
legal structure of your enterprise, keep on the right side of the law. This is why you are
always best advised to seek a specialist who is used to accounting for contractors rather
than a “general practitioner” accountant who may not fully understand the full
implications of working with contractors.
1.3.1 Accounting for contractors – a checklist
1. Is the company you are using comprised of qualified professionals? Are they
Chartered Accountants or are they PCG accredited?
2. Are they part of an established accounting firm ? – Or just a company set up to
benefit from the confusion surrounding accounting for contractors?
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3. Can you visit them? It’s reassuring to be able to drop in and discuss tax concerns
and many companies offering accounting for contractors may only have a
‘virtual’ office location.
1.3.2 Umbrella Company
An umbrella company is a company that acts as an employer to Agency contractors who
work under a fixed term contract assignment, usually through a Recruitment Employment
Agency in the United Kingdom. Recruitment agencies issue contracts to a limited
company as the agency liability would be reduced. It issues invoices to the recruitment
agency (or client) and, when payment of the invoice is made, will typically pay the
contractor through PAYE with the added benefit of offsetting some of the income
through claiming expenses such as Travel, Meals, and Accommodation.
Umbrella companies have become more prevalent since the British government
introduced so-called "IR35" legislation that creates tests to determine employment status
and ability to make use of small company tax relieves.
Managed Service Companies (MSC) and Umbrella
Managed Service Companies (MSCs) are composite company structures. In these
structures, individual contractors will be the shareholders of the company but do not
participate in the management of the company. Company will be managed by service
provider. But the contractors would receive salary and the dividends.
An umbrella company is often confused with a Managed service company (MSC).
Umbrella companies will not fall under the definition of MSC. For a company to be a
Managed Service Company it must fulfil all four conditions of Section 61B (1), Chapter
9, Part 2 ITEPA. Umbrella companies do not satisfy the third condition.
i.e.,
“The payments received by the worker are greater than they would have received if all of
the payments were treated as employment income of the worker relating to an
employment with the service company.”
As umbrella companies do not pay dividends and consider whole income as employment
income, they are not Managed service companies.
In the view of HM Revenue & Customs (HMRC), MSCs existed due to the lack of
application of "IR35" in this sector. Also, it was identified as the cause of lack of
compliance. In December 2006, the UK Treasury introduced draft legislation called
"Tackling Managed Service Legislation," which seeks to address the use of "composite"
structures to avoid income tax and National Insurance on forms of trading that the
Treasury deems as being akin to being "employed." After a period of consultation and redraft, the new legislation became law in April 2007, with additional aspects coming into
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force in August and fully January 2008. PAYE umbrella companies are effectively
exempted from the legislation, which also seeks to pass the possible burden of unpaid
debt (should a provider "collapse" a structure) to interested parties, e.g., a recruitment
agency that has been deemed to encourage or facilitate the scheme. Since the introduction
of the Managed Service Company (MSC) legislation in the 2007 budget, umbrella
companies have become prominent in the UK market. Another viable option for
contractors is to start their own limited company. Starting a limited company involves
paperwork and additional responsibilities.
Accounting for contractors – advantages of using an umbrella company
Changes to legislation in recent years mean contractors have been forced to review the
way in which they operate. By operating under an umbrella company, freelance
contractors benefit from the simplicity of being salaried employees whilst enjoying some
of the financial advantages of a limited company, yet without the hassle and legal
implications
of
setting
up
and
running
a
business.
A good provider will take on all that boring but necessary administration to do with legal
and accounting issues, taxation, insurance, invoicing, VAT - in fact every aspect of
getting you paid - leaving you to concentrate on your contract!
An expert in accounting for contractors will give great customer service and a real
understanding of what contractors need. Combined with a really cost-effective, compliant
and comprehensive service. They can save hundreds, possibly thousands, of rupees each
year.
1.3.3 Cost Accounting Standards for contractors
Cost Accounting Standards (popularly known as CAS) are a set of 19 standards and rules
promulgated by the United States Government for use in determining costs on negotiated
procurements. CAS differs from the Federal Acquisition Regulation (FAR) in that FAR
applies to substantially all contractors, whereas CAS applies primarily to the larger ones.
In 1970, Congress established the original Cost Accounting Standards Board (CASB) to
1) promulgate cost accounting standards designed to achieve uniformity and consistency
in the cost accounting principles followed by defense contractors and subcontractors
under Federal contracts in excess of Rs.100,000 and 2) establish regulations to require
defense contractors and subcontractors, as a condition of contracting, to disclose in
writing their cost accounting practices, to follow the disclosed practices consistently and
to comply with promulgated cost accounting standards. After adopting 19 standards, the
original CASB was dissolved on September 30, 1980; the standards, though, remained
active.
However, CASB was revived in 1988 within the Office of Federal Procurement Policy
(OFPP). The current CASB consists of five members: the OFPP Administrator (who
serves as Chairman) and one member from the United States Department of Defense (this
17
position is held by the Director of the Defense Contract Audit Agency), the General
Services Administration, industry, and the private sector.
The Standards
The original CASB adopted 19 standards, numbered 401 through 420 (419 was never
assigned). The new CASB readopted the original 19 standards with only minor
modifications, and has yet to adopt any new standards.
Standard Title
401
Consistency in Estimating, Accumulating and Reporting Costs
402
Consistency in Allocating Costs Incurred for the Same Purpose
403
Allocation of Home Office Expenses to Segments
404
Capitalization of Tangible Assets
405
Accounting for Unallowable Costs
406
Cost Accounting Period
407
Use of Standard Costs for Direct Material and Direct Labor
408
Accounting for Costs of Compensated Personal Absence
409
Depreciation of Tangible Capital Assets
Allocation of Business Unit General and Administrative Expenses to Final
410
Cost Objectives
411
Accounting for Acquisition Costs of Material
412
Composition and Measurement of Pension Costs
413
Adjustment and Allocation of Pension Cost
414
Cost of Money as an Element of the Cost of Facilities Capital
415
Accounting for the Cost of Deferred Compensation
416
Accounting for Insurance Cost
417
Cost of Money as an Element of the Cost of Capital Assets Under Construction
418
Allocation of Direct and Indirect Costs
419
unused
Accounting for Independent Research and Development Costs and Bid and
420
Proposal Costs (IR&D and B&P)
CAS Applicability
A company may be subject to "full" CAS coverage (required to follow all 19 standards),
"modified" CAS coverage (required to follow only Standards 401, 402, 405, and 406), or
be exempt from coverage. However, a company under "full" coverage is not subject to a
standard where it does not apply (e.g., a company which does not use standard costing
does not have to comply with CAS 407).
18
"Full" coverage applies only when a company receives either one CAS-covered contract
of USRs.50 million or more, or a number of smaller CAS-covered contracts totalling
USRs.50 million. In addition to complying with all 19 standards (where applicable), the
company must also file a CAS Disclosure Statement, which spells out the company's
accounting practices (such as if certain costs are treated as direct contract charges or as
part of overhead expense). There are two versions of the CAS Disclosure Statement: DS1 applies to commercial companies while DS-2 applies to educational institutions.
"Modified" coverage applies when a company receives a single CAS-covered contract of
USRs.7.5 million or more.
In some instances, a contract may be exempt from CAS standards:







Contracts awarded to small businesses are exempt from CAS, regardless of
contract size
Any contract less than USRs.7.5 million is exempt, provided the company has not
been awarded a contract greater than USRs.7.5 million, and also any contract less
than USRs.650,000 is always exempt
Contracts for commercial items
Contracts awarded under sealed bid procedures, or where "adequate price
competition" was available (the latter meaning where at least two companies had
the ability to bid and perform on a contract, even if only one bid was later
received)
Contracts where the price is set by law or regulation
Contracts awarded to foreign governments
Contracts where performance will be performed entirely outside the United States
(including territories and possessions)
Furthermore, in some instances even where a company is subject to a standard, different
rules may apply within the standard itself as to what a company is required to do. As an
example, under CAS 403, if Company A's "residual expenses" (defined as those expenses
incurred by the home office – usually the corporate office – which cannot be identified to
a specific contract, group of contracts, or company segment) exceed a specified
percentage of revenue, Company A must follow a dictated "three-factor" formula to
allocate such expenses, but if Company B's residual expenses do not exceed the
percentage (even if, in Rupees terms, they are greater), Company B may follow the
formula but is not required to do so.
1.4 SOLICITOR’S ACCOUNTING
“Compliance with the Solicitors’ Accounts Rules is the equal responsibility of all
partners in a firm. They should establish policies and systems to ensure that the firm
complies fully with the Rules. Responsibility for day-to-day supervision may be delegated
to one or more partners to enable effective control to be exercised. Delegation of total
responsibility to a clerk or bookkeeper is not acceptable.”
19
1.4.1 Principles
The following principles must be observed. A solicitor must:
(a) Comply with the requirements of practice rule 1 as to the solicitor's integrity, the duty
to act in the client's best interests, and the good repute of the solicitor and the solicitor’s
profession;
(b) Keep other people's money separate from money belonging to the solicitor or the
practice;
(c) Keep other people's money safely in a bank or building society account identifiable as
a client account (except when the rules specifically provide otherwise);
(d) Use each client's money for that client's matters only;
(e) Use controlled trust money for the purposes of that trust only;
(f) Establish and maintain proper accounting systems, and proper internal controls over
those systems, to ensure compliance with the rules;
(g) Keep proper accounting records to show accurately the position with regard to the
money held for each client and each controlled trust;
(h) Account for interest on other people's money in accordance with the rules;
(i) co-operate with the Society in checking compliance with the rules;
And
(j) Deliver annual accountant's reports as required by the rules.
1.4.2 Client Accounting
Client accounting is a simple form of bookkeeping used exclusively for client
transactions. It is the recording by a solicitor of the receipt, payment and transfer of
clients’ money, with all transactions being recorded in individual client ledger accounts
maintained for the person from or on whose behalf the money was received.
PRESERVATION OF RECORDS
According to Rule 10(6) of the Solicitors' Accounts Rules, all books, accounts and
records showing dealings with clients' money, held received or paid by the solicitor and
any other money dealt with by him through a client account must be preserved for at least
6 years from the date of the last entry therein.
20
"The firm should establish policies and systems for the retention of the accounting
records to ensure:
(a) Books of account, reconciliation, bills, bank statements and passbooks are kept for at
least six years;
(b) Paid cheques and other authorities for the withdrawal of money from a client account
are kept for at least two years;
(c) Other vouchers and internal expenditure authorisation documents relating directly to
entries in the client account books are kept for at least two years.”
CLIENT ACCOUNT RECORDS
Regardless of whether a manual or computerized system is used, the various client
account records which a solicitor should keep are as follows:(1) Client receipts;
(2) Client cheque requisitions;
(3) Client cash book;
(4) Client bank statements;
(5) Client journal;
(6) Client ledger;
(7) Reconciliations of client accounts;
(8) Bills records;
(9) Transaction files; and
(10) Direct payments register.
1.4.3 Preparing accounts
It is good practice to prepare monthly management accounts. A sample of a set of
management accounts comprising profit and loss account, appropriation account, balance
sheet and notes to the accounts is as follows:
21
22
23
24
25
1.5 ACCOUNTING FOR UNDERWRITING
Underwriting refers to the process that a large financial service provider (bank, insurer,
investment house) uses to assess the eligibility of a customer to receive their products
(equity capital, insurance, mortgage, or credit). The name derives from the Lloyd's of
London insurance market. Financial bankers, who would accept some of the risk on a
given venture (historically a sea voyage with associated risks of shipwreck) in exchange
for a premium, would literally write their names under the risk information that was
written on a Lloyd's slip created for this purpose.
Companies may enter into commitments to lend money or underwrite securities. In the
current credit environment, some of these commitments to underwrite securities or make
loans may result in the issuance of securities or funding of loans that at the time of
purchase or funding are off-market – that is, not at an interest rate that reflects the current
market rate at the time of purchase or funding absent the commitment.
1.5.1 Issues
1. How should companies with commitments (forward contracts) to underwrite securities
account for any deterioration in the fair value of the commitments prior to purchase of the
underlying securities?
2. How should companies account for any deterioration in the value of the loan
commitments (due to both interest-rate risk and credit risk) prior to funding loans that are
not debt securities?
Accounting Literature
EITF Issue 96-11, Accounting for Forward Contracts and Purchased Options to Acquire
Securities Covered by FAS 115 FAS 5, Accounting for Contingencies SOP 01-06,
Accounting by Certain Entities (Including Entities with Trade Receivables) that Lend to
or Finance the Activities of Others
SFAS 65, Accounting for Certain Mortgage Banking Activities
SFAS 133, Accounting for Derivative Instruments and Hedging Activities (as amended)
SAB 105, Application of Accounting Principles to Loan Commitments
FAS 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities
FAS 159, The Fair Value Option for Financial Assets and Financial Liabilities
AICPA Audit and Accounting Guide, Depository and Lending Institutions
AICPA Audit and Accounting Guide, Brokers and Dealers in Securities
26
Analysis
Issue 1
Commitments to Underwrite Securities Forward contracts to underwrite securities that
will be accounted for by the entity under FAS 115 are covered by EITF Issue 96-11,
Accounting for Forward Contracts and Purchased Options to Acquire Securities Covered
by FAS 115. In EITF Issue 96-11, the Task Force reached a consensus that forward
contracts to purchase securities that will be accounted for under FAS 115 should, at
inception, be designated as held-to-maturity, available-for-sale, or trading and accounted
for in a manner consistent with the accounting prescribed by FAS 115 for that category of
securities.
Held-to-Maturity
Changes in fair value of the forward contract would not be recognized unless a decline in
the fair value of the underlying securities is other than temporary, in which case a loss
would be recognized in earnings.
Available-for-Sale
Changes in the fair value of the forward contract would be recognized in other
comprehensive income. However, if a decline in the fair value is considered other- than
temporary, the decline would be recognized as an impairment charge in earnings. If an
entity does not have the intent and ability to hold the securities until recovery, or if the
entity intends to sell the securities, declines in value would be considered other-than
temporary
.
Trading
Changes in the fair value of the forward contract would be recognized in earnings as they
occur.
Derivatives
Forward contracts that are derivatives subject to FAS 133 should be recognized as assets
or liabilities and measured at fair value. Paragraph 18 of FAS 133 addresses the
accounting for changes in the fair value of a derivative.
Issue 2
Commitments to Fund Loans that Are Not Debt Securities Companies must assess their
loan commitments to fund loans that are not debt securities based on whether, 1) the
commitment would be considered a derivative under FAS 133 and SAB 105, 2) the
company has early adopted FAS 159 and elected to account for loan commitments at fair
value, 3) the company applies industry-specific accounting guidance that requires
27
financial instruments to be accounted for at fair value, 4) the company intends to sell the
loan upon funding the commitment, or 5) the company has the intent and ability to hold
the loan, when funded, for investment in its loan portfolio.
Commitments that are derivatives
Paragraph 10(i) of FAS 133, as amended, indicates that issuers of commitments to
originate (1) mortgage loans that will be held for investment purposes or (2) other types
of loans (i.e., other than mortgage loans) are not subject to the requirements of FAS 133.
However, as discussed in paragraph A33 of FAS 149, the Board concluded that
commitments to originate mortgage loans that will be held for resale should be accounted
for by issuers as derivatives under FAS 133. Accordingly, a lender’s intent with respect
to mortgage loans and the related commitments is important to the accounting analysis
under FAS 133.
Commitments to originate mortgage loans that will be held for resale should be recorded
on the balance sheet at fair value with changes in fair value recorded in earnings.2 Under
FAS 133, both interest-rate risk and credit risk would be considered in recording the
derivative loan commitment at fair value.
Commitments accounted for under the fair value option
Paragraph 7(c) of FAS 159 allows companies to elect the fair value option for written
loan commitments. Thus, an entity could elect to account for those loan commitments
that are not required to be accounted for as derivatives under FAS 133, at fair value with
changes in fair value recorded in earnings. Under FAS 159, both interest-rate risk and
credit risk would be considered in recording the commitment at fair value.
Commitments accounted for under industry-specific accounting guidance
Companies may have industry-specific accounting guidance that indicates financial
instruments, such as loan commitments, should be accounted for at fair value. For
example, a broker-dealer must account for all of its lending commitments at fair value
based on the guidance in the AICPA Audit and Accounting Guide, Brokers and Dealers
in Securities. In applying the guidance in this industry guide, both interest-rate risk and
credit risk would be considered in recording all loan commitments at fair value.
Intention to sell the loan upon funding the commitment
A company’s intent becomes important in determining the appropriate accounting for
loan commitments not specifically addressed by the preceding discussion because the
applicable accounting considerations, whether under broad principles (e.g., FAS 5) or
more specific accounting guidance used by analogy (e.g., EITF Issue No. 96-11), would
require a company to consider its intent to either sell or hold the loan after origination.
There are two acceptable accounting policy alternatives for how a company should
account for loan commitments that (1) are not accounted for at fair value under FAS 133,
28
FAS 159, or industry-specific accounting guidance and (2) relate to loans that the
company intends to hold for sale.
Alternative A
Consistent with the accounting for a funded loan under FAS 65 and SOP 01-06,
companies may account for a loan commitment that meets both of the criteria above
using a lower of cost or fair value model (“LOCOM”) by analogy to EITF Issue No. 9611 if it intends to hold the loan for sale upon its funding. The LOCOM model can also be
supported by analogy to a 1999 speech by Pascal Desroches of the SEC’s Office of the
Chief Accountant. By analogy to the staff’s guidance related to written options, the writer
of the loan commitment would record any declines in fair value through earnings.
Under the LOCOM model, the terms of the committed loan should be compared to
current market terms and, if those terms are below market, a loss should be recorded to
reflect the current fair value of the commitment. Both interest-rate risk and credit risk
would be considered in measuring the fair value (i.e., “exit price”) of the commitment.
The loss would be recorded in the income statement separate from the provision for credit
losses, and a liability would be recorded on the balance sheet separate from the allowance
for credit losses.
Alternative B
Alternatively, companies may account for contingent losses on loan commitments under
FAS 5 if the loss is probable and reasonably estimable. Under the FAS 5 approach, if a
company intends to hold the funded loan for sale, it should consider its intent to sell for
purposes of assessing whether a loss is probable, as well as for measuring the amount of
loss to be recognized.
For example, if it is probable that a loss has been incurred on a loan commitment
(because it is probable that the loan will be funded under the terms of the commitment
and then held for sale at a loss), then companies generally should measure the loss under
FAS 5 based on the current fair value of the commitment. Both interest-rate risk and
credit risk would be considered in measuring the fair value (i.e., “exit price”) of the
commitment.
The loss would be recorded in the income statement separate from the provision for credit
losses, and a liability would be recorded on the balance sheet separate from the allowance
for credit losses. Companies should consider all relevant facts and circumstances to
determine whether a loss is probable, including the probability of funding the loan under
the existing terms of the commitment. The premise under both Alternative A and
Alternative B is that it is inappropriate to delay recognition of a loss related to declines in
the fair value of a loan commitment until the date a loan is funded and classified as held
for sale. If it is probable that a loss has been incurred because it is probable that an
existing loan commitment will be funded and the loan will be sold at a loss, then the loss
on that commitment should be recognized in earnings.
29
Loan to be held for investment
Loan commitments that (1) are not accounted for at fair value under FAS 133, FAS 159,
or industry-specific accounting guidance and (2) relate to loans that a company intends to
hold for investment (i.e., for the foreseeable future) should be evaluated for possible
credit impairment in accordance with FAS 5 and other relevant guidance. Loans that the
company intends to hold only “until the market recovers” would not be considered held
for investment.
Guidance on accounting for credit losses on commitments includes:
• Paragraph 8(e) of SOP 01-06 indicates that an accrual for credit losses on a financial
instrument with off-balance-sheet risk should be recorded separate from a valuation
account related to a recognized financial instrument.
• Paragraph 9.35 of the AICPA Audit and Accounting Guide, Depository and Lending
Institutions, indicates that credit losses related to off-balance-sheet instruments should
also be accrued and reported separately as liabilities if the conditions of FAS 5 are met.
• Page 60 of the November 30, 2006, Current Accounting and Disclosure Issues in the
Division of Corporation Finance indicates that credit loss provisions on other types of
balance sheet and off-balance sheet items that do not affect net interest income should not
be included in the provision for loan losses.
• Questions 1 and 4 in Section 2C of the Office of the Comptroller of the Currency’s
Bank Accounting Advisory Series discuss losses on off-balance sheet commitments and
specifically reference a bank’s estimate of credit losses on such commitments.
If it is probable that a company has incurred a loss, and the amount of loss is reasonably
estimable, the loss should be recorded in the income statement separate from the
provision for credit losses and a liability should be recorded separately from the
allowance for credit losses.
Changes in Intent
If a company enters into a commitment with the intention to hold the funded loan for
sale, it should account for that commitment under Alternative A or Alternative B
(pursuant to a consistently followed accounting policy) described above.
If the company subsequently changes its assertion to an intent to hold a loan for
investment, it should apply its accounting under Alternative A or B through the date that
its intent changed, including recording any loss that would required under Alternative A
or B immediately prior to the change in intent; the company should not reverse any loss
recognized under Alternatives A or B.
1.5.2 Maintenance of proper books of accounts and records
30
(1) Subject to the provisions of any other law, every underwriter shall keep and maintain
the following books of accounts and documents, namely:(a) In relation to underwriter being a body corporate (i) a copy of the balance sheet and profit and loss account as specified in sections 211 and
212 of the Companies Act, 1956 (1 of 1956);
(ii) A copy of the auditor's report referred to in section 227 of the Companies Act, 1956
(1 of 1956).
(b) In relation to an underwriter not being a body corporate (i) records in respect of all sums of money received and expended by them
and the matters in respect of which the receipt and expenditure take place;
and
(ii) Their assets and liabilities.
(2) Without prejudice to sub-regulation (1), every underwriter shall, after the close of
each financial year as soon as possible but not later than six months from the close of the
said period furnish to the Board if so required copies of the balance sheet, profit and loss
account, statement of capital adequacy requirement and such other documents as may be
required by the Board under regulation 16.
(3) Every underwriter shall also maintain the following records with respect to (i) Details of all agreements referred to in clause (b) of rule 4;
(ii) Total amount of securities of each body corporate subscribed to in pursuance of an
agreement referred to in clause (b) of rule 4;
(iii) Statement of capital adequacy requirements as specified in regulation 7;
(iv) Such other records as may be specified by the Board for underwriting.
(4) Every underwriter shall intimate to the Board the place where the books of accounts,
records and documents are maintained.
Period of maintenance of books of accounts, records and other documents
Every underwriter shall preserve the books of account and other records and documents
mentioned under this chapter for a minimum period of five years.
Proforma of balance sheet of underwriters is shown herewith.
31
32
1.5.3 Firm Underwriting
When an underwriter makes a definite commitment to take certain number of shares in
addition to his under writing obligation, it is called 'Firm Underwriting:' He has to take up
shares underwritten firm irrespective of public subscriptions. In such a case liability of
each underwriter excluding firm underwriting and then his liability including firm
underwriting is calculated. There are two methods of calculating the liability of
underwriters. The method to be adopted depends upon the terms of agreement with the
company.
Under one method benefit of firm underwriting is given to individual underwriters for the
share underwritten firm and hence firm application will be included in marked
applications or may be separately deducted from gross liability. But under the second
method, benefit of shares underwritten firm is given to all the underwriters in ratio of
their respective gross liability and therefore, firm applications are included with
unmarked applications.
Activity 1
1. Write an essay on International accounting standards and their need in today’s
business scenario.
2. Discuss various cost accounting principles for contractors. Also give importance
of these principles.
3. write short notes on the following:




clients accounting
accounting for contractors
Solicitors accounting
Firm underwriting
1.6 SUMMARY
IAS was issued between 1973 and 2001 by the Board of the International Accounting
Standards Committee (IASC). On 1 April 2001, the new IASB took over from the IASC
the responsibility for setting International Accounting Standards. During its first meeting
the new Board adopted existing IAS and SICs. The IASB has continued to develop
standards calling the new standards IFRS. This unit basically discusses International
accounting standards. Accounting for contractors was the next area of discussion of this
unit. Solicitor’s accounting was explained with the help of suitable illustrations followed
by accounting for underwriters.
33
1.7 FURTHER READINGS

Tarca, Ann. 2007. International accounting standards. Elsevier

Robert Kirk. 2005. International Financial Reporting Standards in Depth. CIMA
Publishing.

Elliot, Barry & Elliot, Jamie: Financial accounting and reporting, Prentice Hall,
London 2004,

Alan Melville. 2009. International Financial Reporting. Pearson publications
34
UNIT 2
FINANCIAL ANALYSIS
Objectives
On successful completion of this unit, you should be able to:





Appreciate the approach of financial analysis
Identify the ways to analyse various ratios and methods to calculate them
Know the concept of trend analysis and its significance
Recognize the time series analysis and its various techniques including univariate
and multivariate time series models.
Discuss project analysis and evaluation using various techniques like Critical Path
Method (CPM) and Program Evaluation and Review Technique (PERT)
Structure
2.1 Introduction
2.2 Ratio Analysis
2.3 Trend Analysis
2.4 Time series
2.5 Univariate time series models
2.6 Multivariate time series models
2.7 Project analysis
2.8 Project analysis through CPM
2.9 Program evaluation and review technique (PERT)
2.10 Summary
2.11 Further readings
2.1 INTRODUCTION
Financial analysis (also referred to as financial statement analysis or accounting analysis)
refers to an assessment of the viability, stability and profitability of a business, subbusiness or project.
It is performed by professionals who prepare reports using ratios that make use of
information taken from financial statements and other reports. These reports are usually
presented to top management as one of their bases in making business decisions. Based
on these reports, management may:


Continue or discontinue its main operation or part of its business;
Make or purchase certain materials in the manufacture of its product;
35




Acquire or rent/lease certain machineries and equipment in the production of its
goods;
Issue stocks or negotiate for a bank loan to increase its working capital;
Make decisions regarding investing or lending capital;
Other decisions that allow management to make an informed selection on various
alternatives in the conduct of its business.
Financial analysts often assess the firm's:
1. Profitability - its ability to earn income and sustain growth in both short-term and
long-term. A company's degree of profitability is usually based on the income statement,
which reports on the company's results of operations;
2. Solvency - its ability to pay its obligation to creditors and other third parties in the
long-term;
3. Liquidity - its ability to maintain positive cash flow, while satisfying immediate
obligations;
Both 2 and 3 are based on the company's balance sheet, which indicates the financial
condition of a business as of a given point in time.
4. Stability- the firm's ability to remain in business in the long run, without having to
sustain significant losses in the conduct of its business. Assessing a company's stability
requires the use of both the income statement and the balance sheet, as well as other
financial and non-financial indicators.
2.1.1 Methods
Financial analysts often compare financial ratios (of solvency, profitability, growth, etc.):



Past Performance - Across historical time periods for the same firm (the last 5
years for example),
Future Performance - Using historical figures and certain mathematical and
statistical techniques, including present and future values, This extrapolation
method is the main source of errors in financial analysis as past statistics can be
poor predictors of future prospects.
Comparative Performance - Comparison between similar firms.
These ratios are calculated by dividing a (group of) account balance(s), taken from the
balance sheet and / or the income statement, by another, for example :
n / equity = return on equity
Net income / total assets = return on assets
Stock price / earnings per share = P/E-ratio
36
Comparing financial ratios is merely one way of conducting financial analysis. Financial
ratios face several theoretical challenges:

They say little about the firm's prospects in an absolute sense. Their insights about
relative performance require a reference point from other time periods or similar
firms.

One ratio holds little meaning. As indicators, ratios can be logically interpreted in
at least two ways. One can partially overcome this problem by combining several
related ratios to paint a more comprehensive picture of the firm's performance.

Seasonal factors may prevent year-end values from being representative. A ratio's
values may be distorted as account balances change from the beginning to the end
of an accounting period. Use average values for such accounts whenever possible.

Financial ratios are no more objective than the accounting methods employed.
Changes in accounting policies or choices can yield drastically different ratio
values.

They fail to account for exogenous factors like investor behavior that are not
based upon economic fundamentals of the firm or the general economy
(fundamental analysis).
Financial analysts can also use percentage analysis which involves reducing a series of
figures as a percentage of some base amounts. For example, a group of items can be
expressed as a percentage of net income. When proportionate changes in the same figure
over a given time period expressed as a percentage is known as horizontal analysis.
Vertical or common-size analysis reduces all items on a statement to a “common size” as
a percentage of some base value which assists in comparability with other companies of
different sizes.
Another method is comparative analysis. This provides a better way to determine trends.
Comparative analysis presents the same information for two or more time periods and is
presented side-by-side to allow for easy analysis
2.2 RATIO ANALYSIS
Ratio analysis is a tool used by individuals to conduct a quantitative analysis of
information in a company's financial statements. Ratios are calculated from current year
numbers and are then compared to previous years, other companies, the industry, or even
the economy to judge the performance of the company. Ratio analysis is predominately
used by proponents of fundamental analysis.
There are many ratios that can be calculated from the financial statements pertaining to a
company's performance, activity, financing and liquidity. Some common ratios include
37
the price-earnings ratio, debt-equity ratio, earnings per share, asset turnover and working
capital.
Ratios are highly important profit tools in financial analysis that help financial analysts
implement plans that improve profitability, liquidity, financial structure, reordering,
leverage, and interest coverage. Although ratios report mostly on past performances, they
can be predictive too, and provide lead indications of potential problem areas.
Ratio analysis is primarily used to compare a company's financial figures over a period of
time, a method sometimes called trend analysis. Through trend analysis, you can identify
trends, good and bad, and adjust your business practices accordingly. You can also see
how your ratios stack up against other businesses, both in and out of your industry.
There are several considerations you must be aware of when comparing ratios from one
financial period to another or when comparing the financial ratios of two or more
companies.

If you are making a comparative analysis of a company's financial statements
over a certain period of time, make an appropriate allowance for any changes in
accounting policies that occurred during the same time span.

When comparing your business with others in your industry, allow for any
material differences in accounting policies between your company and industry
norms.

When comparing ratios from various fiscal periods or companies, inquire about
the types of accounting policies used. Different accounting methods can result in
a wide variety of reported figures.

Determine whether ratios were calculated before or after adjustments were made
to the balance sheet or income statement, such as non-recurring items and
inventory or pro forma adjustments. In many cases, these adjustments can
significantly affect the ratios.

Carefully examine any departures from industry norms.
In analyzing Financial Statements for the purpose of granting credit Ratios can be
broadly classified into three categories.



Liquidity Ratios
Efficiency Ratios
Profitability Ratios
Some other important ratios include:
38





Leverage ratios
Working capital ratios
Bankruptcy ratios
Coverage ratios
Total coverage ratios
2.2.1 Liquidity Ratios
Liquidity Ratios are ratios that come off the the Balance Sheet and hence measure the
liquidity of the company as on a particular day i.e the day that the Balance Sheet was
prepared. These ratios are important in measuring the ability of a company to meet both
its short term and long term obligations.
We will illustrate all the ratios with the help of balance sheet of Charlie Building Supply
company for year ended 1999 which is as follows:
CHARLIE BUILDING SUPPLY CO.
DEC31,1999
Balance Sheet
Cash
Notes receivables
Accounts receivables
Inventory
Rs. 1,896
Rs. 4,876
Rs. 97,456
Rs. 156,822
Notes payable, bank
Notes receivable, discounted
Accounts payable
Accruals
Rs. 14,000
Rs. 4,842
Rs. 152,240
Rs. 5,440
Total Current Assets
Rs. 261,050
Total Current Liabilities
Rs. 176,522
Land and buildings
Equipment and fixtures
Prepaid expenses
Rs. 46,258
Rs. 11,458
Rs. 1,278
Mortgage (Loans)
Rs. 10,000
Total Liabilities
Rs. 186,522
Networth
Rs. 133,522
Total Assets
Rs. 320,044
Total Liabilities and Networth Rs. 320,044
FIRST LIQUIDITY RATIO
Current Ratio: This ratio is obtained by dividing the 'Total Current Assets' of a company
by its 'Total Current Liabilities'. The ratio is regarded as a test of liquidity for a company.
39
It expresses the 'working capital' relationship of current assets available to meet the
company's current obligations.
The formula:
Current Ratio = Total Current Assets/ Total Current Liabilities
An example from our Balance sheet:
Current Ratio = Rs.261,050 / Rs.176,522
Current Ratio = 1.48
The Interpretation:
Charlie Building Supply Company has Rs.1.48 of Current Assets to meet Rs.1.00 of its
Current Liability
Review the Industry Norms and Ratios for this ratio to compare and see if they are above
below or equal to the others in the same industry.
SECOND LIQUIDITY RATIO
Quick Ratio: This ratio is obtained by dividing the 'Total Quick Assets' of a company by
its 'Total Current Liabilities'. Sometimes a company could be carrying heavy inventory as
part of its current assets, which might be obsolete or slow moving. Thus eliminating
inventory from current assets and then doing the liquidity test is measured by this ratio.
The ratio is regarded as an acid test of liquidity for a company. It expresses the true
'working capital' relationship of its cash, accounts receivables, prepaids and notes
receivables available to meet the company's current obligations.
The formula:
Quick Ratio = Total Quick Assets/ Total Current Liabilities
Quick Assets = Total Current Assets (minus) Inventory
An example from our Balance sheet:
Quick Ratio = Rs.261,050- Rs.156,822 / Rs.176,522
Quick Ratio = Rs.104,228 / Rs.176,522
Quick Ratio = 0.59
The Interpretation:
40
Charlie Building Supply Company has Rs.0.59 cents of Quick Assets to meet Rs.1.00 of
its Current Liability
THIRD LIQUIDITY RATIO
Debt to Equity Ratio: This ratio is obtained by dividing the 'Total Liability or Debt ' of a
company by its 'Owners Equity a.k.a Net Worth'. The ratio measures how the company is
leveraging its debt against the capital employed by its owners. If the liabilities exceed the
net worth then in that case the creditors have more stake than the shareowners.
The formula:
Debt to Equity Ratio = Total Liabilities / Owners Equity or Net Worth
An example from our Balance sheet:
Debt to Equity Ratio = Rs.186,522 / Rs.133,522
Debt to Equity Ratio = 1.40
The Interpretation:
Charlie Building Supply Company has Rs.1.40 cents of Debt and only Rs.1.00 in Equity
to meet this obligation.
2.2.2 Efficiency Ratios
Efficiency ratios are ratios that come off the the Balance Sheet and the Income Statement
and therefore incorporate one dynamic statement, the income statement and one static
statement, the balance sheet. These ratios are important in measuring the efficiency of a
company in either turning their inventory, sales, assets, accounts receivables or payables.
It also ties into the ability of a company to meet both its short term and long term
obligations. This is because if they do not get paid on time how will you get paid paid on
time. You may have perhaps heard the excuse 'I will pay you when I get paid' or 'My
customers have not paid me!'
FIRST EFFICIENCY RATIO
DSO (Days Sales Outstanding): The Days Sales Outstanding ratio shows both the
average time it takes to turn the receivables into cash and the age, in terms of days, of a
company's accounts receivable. The ratio is regarded as a test of Efficiency for a
company. The effectiveness with which it converts its receivables into cash. This ratio is
of particular importance to credit and collection associates.
Best Possible DSO yields insight into delinquencies since it uses only the current portion
of receivables. As a measurement, the closer the regular DSO is to the Best Possible
41
DSO,
the
closer
the
receivables
are
to
the
optimal
Best Possible DSO requires three pieces of information for calculation:



level.
Current Receivables
Total credit sales for the period analyzed
The Number of days in the period analyzed
Formula:
Best Possible DSO = Current Receivables/Total Credit Sales X Number of Days
The formula:
Regular DSO = (Total Accounts Receivables/Total Credit Sales) x Number of Days in
the period that is being analyzed
An example from our Balance sheet and Income Statement:
Total Accounts Receivables (from Balance Sheet) = Rs.97,456
Total Credit Sales (from Income Statement) = Rs.727,116
Number of days in the period = 1 year = 360 days ( some take this number as 365 days)
DSO = [ Rs.97,456 / Rs.727,116 ] x 360 = 48.25 days
The Interpretation:
Charlie Building Supply Company takes approximately 48 days to convert its accounts
receivables into cash. Compare this to their Terms of Net 30 days. This means at an
average their customers take 18 days beyond terms to pay.
SECOND EFFICIENCY RATIO
Inventory Turnover ratio: This ratio is obtained by dividing the 'Total Sales' of a
company by its 'Total Inventory'. The ratio is regarded as a test of Efficiency and
indicates the rapiditity with which the company is able to move its merchandise.
The formula:
Inventory Turnover Ratio = Net Sales / Inventory
It could also be calculated as:
Inventory Turnover Ratio = Cost of Goods Sold / Inventory
42
An example from our Balance sheet and Income Statement:
Net Sales = Rs.727,116 (from Income Statement)
Total Inventory = Rs.156,822 (from Balance sheet )
Inventory Turnover Ratio = Rs.727,116/ Rs.156,822
Inventory Turnover = 4.6 times
The Interpretation:
Charlie Building Supply Company is able to rotate its inventory in sales 4.6 times in one
fiscal year.
THIRD EFFICIENCY RATIO
Accounts Payable to Sales (%): This ratio is obtained by dividing the 'Accounts Payables'
of a company by its 'Annual Net Sales'. This ratio gives you an indication as to how much
of their suppliers money does this company use in order to fund its Sales. Higher the ratio
means that the company is using its suppliers as a source of cheap financing. The
working capital of such companies could be funded by their suppliers..
The formula:
Accounts Payables to Sales Ratio = [Accounts Payables / Net Sales ] x 100
An example from our Balance sheet and Income Statement:
Accounts Payables = Rs.152,240 (from Balance sheet )
Net Sales = Rs.727,116 (from Income Statement)
Accounts Payables to Sales Ratio = [Rs.152,240 / Rs.727,116] x 100
Accounts Payables to Sales Ratio = 20.9%
The Interpretation:
21% of Charlie Building Supply Company's Sales is being funded by its suppliers.
2.2.3 Profitability Ratios
Profitability Ratios show how successful a company is in terms of generating returns or
profits on the Investment that it has made in the business. If a business is Liquid and
Efficient it should also be Profitable.
43
FIRST PROFITIBILITY RATIO
Return on Sales or Profit Margin (%): The Profit Margin of a company determines its
ability to withstand competition and adverse conditions like rising costs, falling prices or
declining sales in the future. The ratio measures the percentage of profits earned per
Rupees of sales and thus is a measure of efficiency of the company.
The formula:
Return on Sales or Profit Margin = (Net Profit / Net Sales) x 100
An example from our Balance sheet and Income Statement:
Total Net Profit after Interest and Taxes (from Income Statement) = Rs.5,142
Net Sales (from Income Statement) = Rs.727,116
Return on Sales or Profit Margin = [ Rs.5,142 / Rs.727,116] x 100
Return on Sales or Profit Margin = 0.71%
The Interpretation:
Charlie Building Supply Company makes 0.71 cents on every Rs.1.00 of Sale
SECOND PROFITABILITY RATIO
Return on Assets: The Return on Assets of a company determines its ability to utitize the
Assets employed in the company efficiently and effectively to earn a good return. The
ratio measures the percentage of profits earned per Rupees of Asset and thus is a measure
of efficiency of the company in generating profits on its Assets.
The formula:
Return on Assets = (Net Profit / Total Assets) x 100
An example from our Balance sheet and Income Statement:
Total Net Profit after Interest and Taxes (from Income Statement) = Rs.5,142
Total Assets (from Balance sheet) = Rs.320,044
Return on Assets = [ Rs.5,142 / Rs.320,044] x 100
Return on Assets = 1.60%
44
The Interpretation:
Charlie Building Supply Company generates makes 1.60% return on the Assets that it
employs in its operations.
THIRD PROFITABILITY RATIO
Return on Equity or Net Worth: The Return on Equity of a company measures the ability
of the management of the company to generate adequate returns for the capital invested
by the owners of a company. Generally a return of 10% would be desirable to provide
dividents to owners and have funds for future growth of the company
The formula:
Return on Equity or Net Worth = (Net Profit / Net Worth or Owners Equity) x 100
Net Worth or Owners Equity = Total Assets (minus) Total Liability
An example from our Balance sheet and Income Statement:
Total Net Profit after Interest and Taxes (from Income Statement) = Rs.5,142
Net Worth (from Balance sheet) = Rs.133,522
Return on Net Worth = [ Rs.5,142 / Rs.133,522] x 100
Return on Equity or Return on Net Worth = 3.85%
The Interpretation:
Charlie Building Supply Company generates a 3.85% percent return on the capital
invested by the owners of the company.
2.2.4 Leverage ratios
This group of ratios calculates the proportionate contributions of owners and creditors to
a business, sometimes a point of contention between the two parties. Creditors like
owners to participate to secure their margin of safety, while management enjoys the
greater opportunities for risk shifting and multiplying return on equity that debt offers.
Note: Although leverage can magnify earnings, it exaggerates losses.
45
Equity Ratio
Common Shareholders' Equity
= Equity Ratio
Total Capital Employed
The ratio of common stockholders' equity (including earned surplus) to total capital of the
business shows how much of the total capitalization actually comes from the owners.
Note: Residual owners of the business supply slightly more than one half of the total
capitalization.
Debt to Equity Ratio
Debt + Preferred Long-Term
= Debt to Equity Ratio
Common Stockholders' Equity
A high ratio here means less protection for creditors. A low ratio, on the other hand,
indicates a wider safety cushion (i.e., creditors feel the owner's funds can help absorb
possible losses of income and capital).
Total Debt to Tangible Net Worth
If your business is growing, track this ratio for insight into the distributive source of
funds used to finance expansion.
Debt Ratio
Current + Long-Term Debt
= Debt Ratio
Total Assets
What percentage of total funds are provided by creditors? Although creditors tend to
prefer a lower ratio, management may prefer to lever operations, producing a higher ratio.
2.2.5 Working Capital Ratios
Many believe increased sales can solve any business problem. Often, they are correct.
However, sales must be built upon sound policies concerning other current assets and
should be supported by sufficient working capital.
There are two types of working capital: gross working capital, which is all current assets,
and net working capital, which is current assets less current liabilities.
If you find that you have inadequate working capital, you can correct it by lowering sales
or by increasing current assets through either internal savings (retained earnings) or
46
external savings (sale of stock). Following are ratios you can use to evaluate your
business's net working capital.
Working Capital Ratio
Use "Current Ratio" in the section on "Liquidity Ratios."
This ratio is particularly valuable in determining your business's ability to meet current
liabilities.
Working Capital Turnover
Net Sales
= Working Capital Turnover Ratio
Net Working Capital
This ratio helps you ascertain whether your business is top-heavy in fixed or slow assets,
and complements Net Sales to Tangible Net Worth (see "Income Ratios"). A high ratio
could signal overtrading.
Note: A high ratio may also indicate that your business requires additional funds to
support its financial structure, top-heavy with fixed investments.
Current Debt to Net Worth
Current Liabilities
= Current Debt to Net Worth Ratio
Tangible Net Worth
Your business should not have debt that exceeds your invested capital. This ratio
measures the proportion of funds that current creditors contribute to your operations.
Note: For small businesses a ratio of 60 percent or above usually spells trouble. Larger
firms should start to worry at about 75 percent.
Funded Debt to Net Working Capital
Long-Term Debt
= Funded Debt to Net Working Capital Ratio
Net Working Capital
Funded debt (long-term liabilities) = all obligations due more than one year from the
balance sheet date
Note: Long-term liabilities should not exceed net working capital.
47
2.2.6 Bankruptcy Ratios
Many business owners who have filed for bankruptcy say they wish they had seen some
warning signs earlier on in their company's downward spiral. Ratios can help predict
bankruptcy before it's too late for a business to take corrective action and for creditors to
reduce potential losses. With careful planning, predicted futures can be avoided before
they become reality. The first five bankruptcy ratios in this section can detect potential
financial problems up to three years prior to bankruptcy. The sixth ratio, Cash Flow to
Debt, is known as the best single predictor of failure.
Working Capital to Total Assets
Net Working Capital
= Working Capital to Total Assets Ratio
Total Assets
This liquidity ratio, which records net liquid assets relative to total capitalization, is the
most valuable indicator of a looming business disaster. Consistent operating losses will
cause current assets to shrink relative to total assets.
Note: A negative ratio, resulting from negative net working capital, presages serious
problems.
Retained Earnings to Total Assets
Retained Earnings
= Retained Earnings to Total Assets Ratio
Total Assets
New firms will likely have low figures for this ratio, which designates cumulative
profitability. Indeed, businesses less than three years old fail most frequently.
Note: A negative ratio portends cloudy skies. However, results can be distorted by
manipulated retained earnings (earned surplus) data.
EBIT to Total Assets
EBIT
= EBIT to Total Assets Ratio
Total Assets
How productive are your business's assets? Asset values come from earning power.
Therefore, whether or not liabilities exceed the true value of assets (insolvency) depends
upon earnings generated.
Note: Maximizing rate of return on assets does not mean the same as maximizing return
on equity. Different degrees of leverage affect these separate conclusions.
48
Sales to Total Assets
Total Sales
= Sales to Total Assets Ratio
Total Assets
See "Turnover Ratio" under "Profitability Ratios."
This ratio, which uncovers management's ability to function in competitive situations
while not excluding intangible assets, is inconclusive if studied by itself.
But when viewed alongside Working Capital to Total Assets, Retained Earnings to Total
Assets, and EBIT to Total Assets, it can confirm whether your business is in imminent
danger.
Note: A result of 200 percent is more reassuring than one of 100 percnt.
Equity to Debt
Market Value of Common + Preferred Stock
= Equity to Debt Ratio
Total Current + Long-Term Debt
This ratio shows you by how much your business's assets can decline in value before it
becomes insolvent.
Note: Those businesses with ratios above 200 percent are safest.
Cash Flow to Debt
Cash Flow*
= Cash Flow to Debt Ratio
Total Debt
Also, refer to "Debt Cash Flow Coverage Ratio" in the section on "Coverage Ratios."
Since debt does not materialize as a liquidity problem until its due date, the closer to
maturity, the greater liquidity should be.
Other ratios useful in predicting insolvency include Total Debt to Total Assets (see
"Leverage Ratios" below) and Current Ratio (see "Liquidity Ratios").
*Cash flow = Net Income + Depreciation
Note: Because there are various accounting techniques of determining depreciation, use
this ratio for evaluating your own company and not to compare it to other companies.
49
2.2.7 Long-Term Analysis
Current Assets to Total Debt
Current Assets
= Current Assets to Total Debt Ratio
Current + Long-Term Debt
This ratio determines the degree of protection linked to short- and long-term debt. More
net working capital protects short-term creditors.
Note: A high ratio (significantly above 100 percent) shows that if liquidation losses on
current assets are not excessive, long-range debtors can be paid in full out of working
capital.
Stockholders' Equity Ratio
Stockholders' Equity
= Stockholders' Equity Ratio
Total Assets
Relative financial strength and long-run liquidity are approximated with this calculation.
A low ratio points to trouble, while a high ratio suggests you will have less difficulty
meeting fixed interest charges and maturing debt obligations.
Total Debt to Net Worth
Current + Deferred Debt
= Total Debt to Net Worth Ratio
Tangible Net Worth
Rarely should your business's total liabilities exceed its tangible net worth. If it does,
creditors assume more risk than stockholders. A business handicapped with heavy
interest charges will likely lose out to its better financed competitors.
2.2.8 Coverage Ratios
Times Interest Earned
EBIT
= Times Interest Earned Ratio
I
EBIT = earnings before interest and taxes
I = rupees amount of interest payable on debt
50
The Times Interest Earned Ratio shows how many times earnings will cover fixedinterest payments on long-term debt.
2.2.9 Total Coverage Ratios
EBIT s
+
= Total Coverage Ratio
I
1-h
I = interest payments
s = payment on principal figured on income after taxes (1 - h)
This ratio goes one step further than Times Interest Earned, because debt obliges the
borrower to not only pay interest but make payments on the principal as well.
2.2.10 Common-Size Statement
When performing a ratio analysis of financial statements, it is often helpful to adjust the
figures to common-size numbers. To do this, change each line item on a statement to a
percentage of the total. For example, on a balance sheet, each figure is shown as a
percentage of total assets, and on an income statement, each item is expressed as a
percentage of sales.
This technique is quite useful when you are comparing your business to other businesses
or to averages from an entire industry, because differences in size are neutralized by
reducing all figures to common-size ratios. Industry statistics are frequently published in
common-size form.
When comparing your company with industry figures, make sure that the financial data
for each company reflect comparable price levels, and that it was developed using
comparable accounting methods, classification procedures, and valuation bases.
Such comparisons should be limited to companies engaged in similar business activities.
When the financial policies of two companies differ, these differences should be
recognized in the evaluation of comparative reports.
For example, one company leases its properties while the other purchases such items; one
company finances its operations using long-term borrowing while the other relies
primarily on funds supplied by stockholders and by earnings.
Financial statements for two companies under these circumstances are not wholly
comparable.
51
Example Common-Size Income Statement
2008
2009
2010
Sales
100%
100%
100%
Cost of Sales
65%
68%
70%
Gross Profit
35%
32%
30%
Expenses
27%
27%
26%
Taxes
2%
1%
1%
Profit
6%
4%
3%
2.3 TREND ANALYSIS
Trend analysis is a form of comparative analysis that is often employed to identify
current and future movements of an investment or group of investments. The process may
involve comparing past and current financial ratios as they related to various institutions
in order to project how long the current trend will continue. This type of information is
extremely helpful to investors who wish to make the most from their investments.
The process of a trend analysis begins with identifying the category of the investments
that are under consideration. For example, if the investor wishes to get an idea on the
potential for making a profit with pork bellies, the focus will be on the performance of
pork bellies in a commodities market. The trend analysis will include more than one
supplier for the commodity, in order to get a more accurate picture of the current status of
pork bellies on the market.
Once the focus is established, the investor takes a long at the general performance for the
category over the last couple of years. This helps to identify key factors that led to the
current trend of performance for the investment under consideration. By understanding
how a given investment reached the current level of performance, it is then possible to
determine if all or most of those factors are still exerting an influence.
After identifying past and present factors that are maintaining a current trend in
performance, the investor can analyze each factor and project which factors are likely to
continue exerting influence on the direction of the investment. Assuming that all or most
of the factors will continue to exert an influence for the foreseeable future, the investor
can make an informed decision on whether to buy or sell a given asset.
52
A trend analysis may be used to identify and project upswings in the performance of a
stock or commodity, or to identify the potential for an upcoming downturn in value. By
comparing the financial ratio of the past with the present and identifying key factors that
helped the investment to arrive at the current point, it is possible to use the process of
trend analysis to project future worth and adjust the components of the financial portfolio
accordingly.
The futures field and its methodologies are changing. New methodologies are emerging,
and older ones revitalised. This paper explores trend analysis (TA) as a methodology that
has some underlying sub-methodologies, some of which might be useful in different
types of analysis. This is not an exhaustive survey but serves to give an overview of
different methods.
A trend is evident when some phenomenon is seen to have a specified general direction
or tendency. Some trends, for instance those using population data relatively stable, that
is, not likely to be dramatically affected by other events or phenomena, they are built on
other long-term trends such as birth rate, life expectancy and habitation patterns, which
change slowly over time. Trend Analysis (TA) is also used to predict business, consumer,
and political trends at local to global levels. These are less stable and more likely to be
impacted on by other trends or events. For instance, a trend toward democracy in India
might be indicated by a growing middle class, but this trend could be slowed or
dramatically changed by a rise in religious fundamentalism, the political ups and downs,
prolonged drought, regional instability and so on. One of the keys to TA is to think
broadly and deeply enough about the possible interruptions to a trend.
2.4 TIME SERIES
An ordered sequence of values of a variable at equally spaced time intervals can be
called as time series. It is an effective technique of trend analysis.
The usage of time series models is twofold:


Obtain an understanding of the underlying forces and structure that produced the
observed data
Fit a model and proceed to forecasting, monitoring or even feedback and
feedforward control.
Time Series Analysis is used for many applications such as:







Economic Forecasting
Sales Forecasting
Budgetary Analysis
Stock Market Analysis
Yield Projections
Process and Quality Control
Inventory Studies
53



Workload Projections
Utility Studies
Census Analysis
and many, many more...
Techniques: The fitting of time series models can be an ambitious undertaking. There
are many methods of model fitting including the following:



Box-Jenkins ARIMA models
Box-Jenkins Multivariate Models
Holt-Winters Exponential Smoothing (single, double, triple)
The user's application and preference will decide the selection of the appropriate
technique. It is beyond the realm and intention of the authors of this handbook to cover
all these methods. The overview presented here will start by looking at some basic
smoothing techniques:


Averaging Methods
Exponential Smoothing Techniques.
Later in this section we will discuss the Box-Jenkins modeling methods and Multivariate
Time Series.
2.4.1 Moving Average or Smoothing Techniques
Inherent in the collection of data taken over time is some form of random variation. There
exist methods for reducing of canceling the effect due to random variation. An often-used
technique in industry is "smoothing". This technique, when properly applied, reveals
more clearly the underlying trend, seasonal and cyclic components.
There are two distinct groups of smoothing methods


Averaging Methods
Exponential Smoothing Methods
We will first investigate some averaging methods, such as the "simple" average of all
past data.
A manager of a warehouse wants to know how much a typical supplier delivers in 1000
rupees units. He/she takes a sample of 12 suppliers, at random, obtaining the following
results:
54
Supplier
Amount
Supplier
Amount
1
2
3
4
5
6
9
8
9
12
9
12
7
8
9
10
11
12
11
7
13
9
11
10
The computed mean or average of the data = 10. The manager decides to use this as the
estimate for expenditure of a typical supplier.
Is this a good or bad estimate? We shall compute the "mean squared error":




The "error" = true amount spent minus the estimated amount.
The "error squared" is the error above, squared.
The "SSE" is the sum of the squared errors.
The "MSE" is the mean
The results are:
Error and Squared Errors
The estimate = 10
Supplier Rs.
Error
Error Squared
1
2
3
4
5
6
7
8
9
10
11
12
-1
-2
-1
2
-1
2
1
-3
3
-1
1
0
9
8
9
12
9
12
11
7
13
9
11
10
1
4
1
4
1
4
1
9
9
1
1
0
55
The SSE = 36 and the MSE = 36/12 = 3.
So how good was the estimator for the amount spent for each supplier? Let us compare
the estimate (10) with the following estimates: 7, 9, and 12. That is, we estimate that each
supplier will spend Rs.7, or Rs.9 or Rs.12.
Performing the same calculations we arrive at:
Estimator 7
SSE
MSE
144
12
9
10
12
48
4
36
3
84
7
The estimator with the smallest MSE is the best. It can be shown mathematically that the
estimator that minimizes the MSE for a set of random data is the mean.
Next we will examine the mean to see how well it predicts net income over time.
The next table gives the income before taxes of a PC manufacturer between 1985 and
1994.
Year
Rs.
(millions)
Mean
Error
Squared
Error
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
46.163
46.998
47.816
48.311
48.758
49.164
49.548
48.915
50.315
50.768
48.776
48.776
48.776
48.776
48.776
48.776
48.776
48.776
48.776
48.776
-2.613
-1.778
-0.960
-0.465
-0.018
0.388
0.772
1.139
1.539
1.992
6.828
3.161
0.922
0.216
0.000
0.151
0.596
1.297
2.369
3.968
The MSE = 1.9508.
The question arises: can we use the mean to forecast income if we suspect a trend? A
look at the graph below shows clearly that we should not do this.
56
Figure 1
In summary, we state that
1. The "simple" average or mean of all past observations is only a useful estimate for
forecasting when there are no trends. If there are trends, use different estimates
that take the trend into account.
2. The average "weighs" all past observations equally. For example, the average of
the values 3, 4, 5 is 4. We know, of course, that an average is computed by adding
all the values and dividing the sum by the number of values. Another way of
computing the average is by adding each value divided by the number of values,
or
3/3 + 4/3 + 5/3 = 1 + 1.3333 + 1.6667 = 4.
The multiplier 1/3 is called the weight. In general:
The
are the weights and of course they sum to 1.
2.4.2 Exponential Smoothing
This is a very popular scheme to produce a smoothed Time Series. Whereas in Single
Moving Averages the past observations are weighted equally, Exponential Smoothing
assigns exponentially decreasing weights as the observation get older.
57
In other words, recent observations are given relatively more weight in forecasting than
the older observations.
In the case of moving averages, the weights assigned to the observations are the same and
are equal to 1/N. In exponential smoothing, however, there are one or more smoothing
parameters to be determined (or estimated) and these choices determine the weights
assigned to the observations.
2.5 UNIVARIATE TIME SERIES MODELS
The term "univariate time series" refers to a time series that consists of single (scalar)
observations recorded sequentially over equal time increments. Some examples are
monthly CO2 concentrations and southern oscillations to predict el nino effects.
Although a univariate time series data set is usually given as a single column of numbers,
time is in fact an implicit variable in the time series. If the data are equi-spaced, the time
variable, or index, does not need to be explicitly given. The time variable may sometimes
be explicitly used for plotting the series. However, it is not used in the time series model
itself.
2.5.1 Box-Jenkins Models
The Box-Jenkins ARMA model is a combination of the AR and MA models (described
on the previous page):
where the terms in the equation have the same meaning as given for the AR and MA
model.
A couple of notes on this model are:
1. The Box-Jenkins model assumes that the time series is stationary. Box and
Jenkins recommend differencing non-stationary series one or more times to
achieve stationarity. Doing so produces an ARIMA model, with the "I" standing
for "Integrated".
2. Some formulations transform the series by subtracting the mean of the series from
each data point. This yields a series with a mean of zero. Whether you need to do
this or not is dependent on the software you use to estimate the model.
3. Box-Jenkins models can be extended to include seasonal autoregressive and
seasonal moving average terms. Although this complicates the notation and
mathematics of the model, the underlying concepts for seasonal autoregressive
58
and seasonal moving average terms are similar to the non-seasonal autoregressive
and moving average terms.
4. The most general Box-Jenkins model includes difference operators,
autoregressive terms, moving average terms, seasonal difference operators,
seasonal autoregressive terms, and seasonal moving average terms. As with
modeling in general, however, only necessary terms should be included in the
model. Those interested in the mathematical details can consult Box, Jenkins and
Reisel (1994), Chatfield (1996), or Brockwell and Davis (2002).
There are three primary stages in building a Box-Jenkins time series model.
1. Model Identification
2. Model Estimation
3. Model Validation
The following remarks regarding Box-Jenkins models should be noted.
1. Box-Jenkins models are quite flexible due to the inclusion of both autoregressive
and moving average terms.
2. Based on the Wold decomposition thereom (not discussed in the Handbook), a
stationary process can be approximated by an ARMA model. In practice, finding
that approximation may not be easy.
3. Chatfield (1996) recommends decomposition methods for series in which the
trend and seasonal components are dominant.
4. Building good ARIMA models generally requires more experience than
commonly used statistical methods such as regression.
Typically, effective fitting of Box-Jenkins models requires at least a moderately long
series. Chatfield (1996) recommends at least 50 observations. Many others would
recommend at least 100 observations.
2.6 MULTIVARIATE TIME SERIES MODELS
The multivariate form of the Box-Jenkins univariate models is sometimes called the
ARMAV model, for Autoregressive Moving Average Vector or simply vector ARMA
process.
The ARMAV model for a stationary multivariate time series, with a zero mean vector,
represented by
59
is of the form
where

xt and at are n x 1 column vectors with at representing multivariate white noise

are n x n matrices for autoregressive and moving average parameters

E[at] = 0

where
a
is the dispersion or covariance matrix of at
As an example, for a bivariate series with n = 2, p = 2, and q = 1, the ARMAV(2,1)
model is:
with
The estimation of the matrix parameters and covariance matrix is complicated and very
difficult without computer software. The estimation of the Moving Average matrices is
especially an ordeal. If we opt to ignore the MA component(s) we are left with the ARV
model given by:
where


xt is a vector of observations, x1t, x2t, ... , xnt at time t
at is a vector of white noise, a1t, a2t, ... , ant at time t
60


is a n x n matrix of autoregressive parameters
E[at] = 0

where
a
= E[at,at-k] is the dispersion or covariance matrix
A model with p autoregressive matrix parameters is an ARV(p) model or a vector AR
model.
The parameter matrices may be estimated by multivariate least squares, but there are
other methods such as maximium likelihood estimation.
There are a few interesting properties associated with the phi or AR parameter matrices.
Consider the following example for a bivariate series with n =2, p = 2, and q = 0. The
ARMAV(2,0) model is:
Without loss of generality, assume that the X series is input and the Y series are output
and that the mean vector = (0,0).
Therefore, tranform the observation by subtracting their respective averages.
The diagonal terms of each Phi matrix are the scalar estimates for each series, in this
case:
1.11, 2.11 for the input series X,
1.22, .2.22 for the output series Y.
The lower off-diagonal elements represent the influence of the input on the output.
This is called the "transfer" mechanism or transfer-function model as discussed by Box
and Jenkins in Chapter 11. The terms here correspond to their terms.
The upper off-diagonal terms represent the influence of the output on the input.
This is called "feedback". The presence of feedback can also be seen as a high value for a
coefficient in the correlation matrix of the residuals. A "true" transfer model exists when
there is no feedback.
61
This can be seen by expressing the matrix form into scalar form:
Finally, delay or "dead' time can be measured by studying the lower off-diagonal
elements again.
If, for example, 1.21 is non-significant, the delay is 1 time period.
2.7 PROJECT ANALYSIS
Managing and running organizations is an evolutionary process over the ages. Such
processes have been under going many structural changes. Organizations have shifted
from functional managed structures to project based organizational structures.
Consequently, project management in organizations is becoming increasingly important.
Indeed, it is critical for the success of the company. Most of the above mentioned process
changes have occurred in the last three decades. Irrespective of the type of industry or the
domain, the need for managerial and structural change is being observed.
Decisions on where to invest the company's resources to achieve a technological
innovation have a major impact on the future competitiveness of the company. Therefore,
trying to get involved in the right projects is worth an effort, both to avoid wasting the
company's time and resources in meaningless activities, and to improve the chances of
success.
However, in a continuous improvement context, ideas for change and projects which
need significant resources might be prioritised rather than selected, with a view to all
projects eventually being addressed.
In short, project evaluation aims at analysing research and development projects, or
activities or ideas, for any or all of the following purposes:





Getting an overall understanding of the project.
Making priorities among a set of projects.
Taking a decision about whether or not to proceed with a project.
Monitoring projects, eg by following up the parameters analyzed when the project
was selected.
Terminating projects and evaluating the results obtained.
2.7.1 Specific techniques
Project evaluation methods have evolved in response to changing needs, although 'old'
techniques are still in use today. The earlier methods were based on financial assessment,
and even now this forms the back-bone of most practical methods.
62
One basic classification of all potential techniques might be:



Techniques mainly or uniquely based on a financial assessment.
Techniques mainly based on human judgment.
Learning techniques, which explicitly take account of past experience in order to
improve future decisions.
Most of the techniques in practical use by industry incorporate a mixture of financial
assessment and human judgment. A more detailed list of types of techniques is shown in
table 1.
Table 1-Type of Project Evaluation techniques
Techniques
Short description



Among the longest established, easily-applied methods
Criticised as of limited accuracy
The key is the ratio (financial benefit) /(cost) in which the
estimations of benefits should be agreed by marketing
Cash flow analysis


Requires the estimation of cash outflows and inflows
It can be sofhisticated by considering discounting factors
Score
methods

They generalize the simple Ratio Analysis by considering
the probability for technical and market success
The estimations of probability are usually made by experts
Some of these methods include discount factors: some of the
measures are Internal Rate of Return (IRR) and Return of
Investment (ROI)
Financial
methods
ratio
index


Mathematical
methods



Matrix methods


They are based on the optimisation of allocation of R&D
resources through mathematical programming
The success of the methods depends strongly on how well
the benefit is understood and how well the input data is
converted into variables
The algorithms tend to be customised and they can
incorporate experience through expert systems
They employ subjective considerations for proper
measurement of management information
Matrix methods use correlation techniques in order to
identify relationships that constitute the basis for decisionmaking
63

Check-lists


Relevance
and
decision trees



Multicriteria
table methods
&





QFD

Experience
methods
based



Vision



Method that includes the reminders of the factors which are
important in decision-making
Simple and rapid way to assess a project with little effort
Can be considered as starting point for more sophisticated
methods as SWOT analysis
It is an approach for structured thinking
It requires a very clear objective or long term goal,
establishing a clear differentiation between goals and means
for achieving them
Critical path analysis and decision trees are examples of
these methods
Scoring procedures to incorporate judgments based on a
number of criteria
Various criteria may be used such as economic and financial
factors and concepts or decision theory
The scoring of criteria is usually complemented with the use
of weight factors in order do distinguish the importance of
each criteria
It is used in many fields of design and engineering
It is based on the identification of customer requirements and
the means for achieving those requirements
Includes a scoring procedure with weighting of the factors
They are based on the analysis of conditions that are usually
related to the success or failure of a project (quality of
execution, synergies, etc.)
Success or failure is predicted according to the answers to
questions on those mentioned factors
The inputs for those factors should come from members in
different departments
The vision is that of an individual (a Chief Executive or a
product champion) defying conventional wisdom and
bringing about a breakthrough
It is common when information is scarce and it can be
sustained by irrational methods
When it works it has many virtues: speedy, incisive and
changing the scene
64
Many techniques used today are totally or partially software based, which have some
additional benefits in automating the process. In any case, the most important issue, for
any method, is the managers' interpretation of the direct outcomes.
There is no best technique. The extent to which different techniques for project
evaluation can be used will depend upon the nature of the project, the information
availability, the company's culture and several other factors. This is clear from the variety
of techniques which are theoretically available and the extent to which they have been
used in practice. In any case, no matter which technique is selected by a company, it
should be implemented, and probably adapted, according to the particular needs of that
company.
2.8 PROJECT ANALYSIS THROUGH CPM (CRITICAL PATH
METHOD)
CPM as a management methodology has been used from the mid 50s. The main objective
of the CPM implementation was to determine how best to reduce the time required to
perform routine and repetitive tasks that are needed to support an organization. Initially
this methodology was identified to conduct routine tasks such as plant overhaul,
maintenance and construction.
Critical path analysis is an extension of the bar chart. The CPM uses a work breakdown
structure where all projects are divided into individual tasks or activities. For any project
there is a sequence of events that have to be undertaken. Some tasks might be dependent
on the completion of the previous tasks while other might be independent of the tasks
ahead and can be undertaken at any given time.
Job durations and completion times also differ significantly. CP analysis helps decision
makers and project execution members to identify the best estimates (based on accurate
information) of the time that is needed to complete the project.
The CP analysis is also a helpful way of identifying if there are alternate paths or plans
that can be undertaken to reduce the interruption and hurdles that can arise during the
execution of any task. Critical path analysis consists of three phases—Planning, Analysis,
and Scheduling and Controlling. All three activities are interdependent. But they require
individual attention at all different stages of the project. When the constraints in the
project are of a purely technical nature the “critical tasks form a path (tasks linked by
technological constraints) extending from the project start to the project completion,
denominated critical path.” (Rivera and Duran, 2004) When the projects experience
resource constraints critical tasks form a critical sequence.
While CPM methods are ideal to identify the nature of the tasks and the time and money
that is involved at every stage of the process, it should be customized to suit the needs
and goals of the organization and the project. Communication and information transfer
issues are critical for successful completion of any project. By defining and creating
standard operating procedures (SOP)
65
for similar tasks performed at more frequent interval any organization can evaluate the
progress and/or success of a project team with reference to these metrics. SOPs are not
static entities; but rather, change and evolve based on the environment, the culture and
norms and the type of product marketed in the region. It is important when using CPM
that the project team has some historical information of the processes and the task and are
able to reference this information during the planning and decision making process.
Control mechanisms in projects with respect to the alignment of the project outcomes
with the plan initially proposed is important. As the person at the helm of a project, the
project manager is responsible for the success or failure of the project as a whole.
(Globerson and Zwikael, 2002) It is the responsibility of the project manager to look into
the root cause of a problem if one exists and to identify the potential solutions that can be
implemented. If the project manager himself or herself is the cause of the problem
however, then arriving at an honest and appropriate solution might be impossible.
Realistically determining the sequence of events needed in the critical path is important.
Nabors in the article ‘Considerations in planning and scheduling,’ identified that often in
construction jobs the sequence of events are not always dependent. For example, the
“electrical drawings did not have to be complete before foundations could be constructed,
that all engineering did not have to be complete before construction could start.” (Nabors,
1994)
There are two methods by which the Critical Path can be identified. They are;
The forward pass
Here, CPM calculates 1. the earliest time within which a project can be completed. “The
date each activity is scheduled to begin is know as the “early start,” and the date that each
activity is scheduled to end is called “early finish.” (Winter, 2003) In this method of
critical path determination, the earliest possible date for starting of the project is
identified and then the activities are lined up to identify the completion date.
The backward pass
Here, selecting the date 2. when the organization wishes to complete the project or the
last activity identifies CP. Time requirements are based on working backward from the
final date desired for the last activity to the initial first activity. The dates identified in
this method of CPM are called late start dates (for the starting of the first activity) and the
late finish dates (for the last activity in the project.
Important for the CPM using either the forward pass or the backward pass is that the total
time needed for completion of the project does not change but the dates when the project
can be started might differ based on the approach used in the two methods. The selection
of either the forward or the backward pass depends on the final desired results and the
available documents and accurate data needed to determine the time for every activity on
the network diagram. (Baram, 1994) Slack or float is defined as the time between the
earliest starting time (using the forward pass method) and the latest starting time (using
66
the backward pass method) used for identifying the critical path. “Total float (float) is the
amount of time an activity can be delayed without delaying the overall project
completion time.” (Winter, 2003)
Typically, the critical path has little or no slack or float built into the activities. Therefore,
it can be stated that the activities on the critical path if subjected to extensive delays will
make the project take longer to complete. If the earliest time that any activity can be
started is the same as the latest time that the activity can be started then the timing of
starting that activity is very important for the project. In addition, ensuring that the
activity has all the necessary resources as and when required is paramount. CPM also
connects the different functional factors of planning and scheduling with that of cost
accounting and finance. In many situations, schedules are often created without
considering the resource needed (the availability of the resources at the time it is
required) and cost that is incurred in case these resources are not available. (Just and
Murphy, 1994) Often, during
the scheduling process in CPM it is assumed that the resources of labor, equipment and
capital are unlimited when in reality this is not very true. The factor of resources can get
even more complicated due to the interdependencies of the various resources on each
other throughout the entire duration of the project.
It is important to note that every activity time identified in determining the critical path
are done using a work calendar that is appropriate and relevant for the task at hand. In
addition, with many projects the supply chain that spans the activities can lie on more
than one continent complicating the task of identifying accurate start and finish dates that
are appropriate for all the activities. The constraints in the system can also impact the
float that is identified in the process. Resource constraints are often the most difficult to
identify and evaluate especially if the same resource is required for more than one
project. Projects are often managed very cost consciously during the initial stages of the
project. As the project progresses, and if delays occur at various stages of the project, the
cost of the project might be compromised to satisfy the time of completion of the project.
CPM identifies the two important variables of any project the time and the cost of the
project. When CPM was initially introduced the techniques were best suited for welldefined projects with relatively small uncertainties in the execution of the project. During
this time of CPM initial introduction markets were also very regional and localized and
there were few dominant players in any given market. CPM was also well suited for
activity-type network. PERT on the other hand was well suited for projects that had high
degrees of uncertainty in the time and cost variables and was suited for projects that were
dependent on activities that had to be conducted at various locations around the world.
Scheduling is an important part of the planning of any project. However, it is first
necessary to develop a list of all the activities required, as listed in the work breakdown
structure. Activities require both time and the use of resources. Typically, the list of
activities is compiled with duration estimates and immediate predecessors.
67
To illustrate the use of CPM, we can imagine a simple cookie-baking project: the recipe
provides the complete statement of work, from which the work breakdown structure can
be developed. The resources available for this project are two cooks and one oven with
limited capacity; the raw materials are the ingredients to be used in preparing the cookie
dough. As listed in Table 1, the activities take a total of 80 minutes of resource time.
Because some activities can run parallel, the cooks should complete the project in less
than 80 minutes.
Table 2 displays some of the planning that will save time in the project. For example,
once the oven is turned on, it heats itself, freeing the cooks to perform other activities.
After the dough is mixed, both batches of cookies can be shaped; the shaping of the
second batch does not have to wait until the first batch is complete. If both cooks are
available, they can divide the dough in half and each cook can shape one batch in the
same four-minute period. However, if the second cook is not available at this time, the
project is not delayed because shaping of the second batch need not be completed until
the first batch exits the oven.
Table 2
Description of Activity
Duration
(minutes)
Immediate
Predecessor(s)
15 minutes
—
8 minutes
—
C. Mix dough
2 minutes
B
D. Shape first batch
4 minutes
C
E. Bake first batch
12 minutes
A, D
F. Cool first batch
10 minutes
E
G. Shape second batch
4 minutes
C
H. Bake second batch
12 minutes
E, G
A. Preheat oven
B.
Assemble,
ingredients
measure
68
Description of Activity
Duration
(minutes)
Immediate
Predecessor(s)
I. Cool second batch
10 minutes
H
J. Store cookies
3 minutes
F, I
Total time
80 minutes
Some expertise is required in the planning stage, as inexperienced cooks may not
recognize the independence of the oven in heating or the divisibility of the dough for
shaping. The concept of concurrent engineering makes the planning stage even more
important, as enhanced expertise is needed to address which stages of the project can
overlap, and how far this overlap can extend.
After beginning the project at 8:00 A.M., the first batch of dough is ready to go into the
oven at 8:14, but the project cannot proceed until the oven is fully heated—at 8:15. The
cooks actually have a one-minute cushion, called slack time. If measuring, mixing, or
shaping actually take one additional minute, this will not delay the completion time of the
overall project.
The set of paths through the system traces every possible route from each beginning
activity to each ending activity. In this simple project, one can explicitly define all the
paths through the system in minutes as follows:
A-E-F-J = 15 + 12 + 10 + 3 = 40
A-E-H-I-J = 15 + 12 + 12 + 10 + 3 = 52
B-C-D-E-F-J = 8 + 2 + 4 + 12 + 10 + 3 = 39
B-C-D-E-H-I-J = 8 + 2 + 4 + 12 + 12 + 10 + 3 = 51
B-C-G-H-I-J = 8 + 2 + 4 + 12 + 10 + 3 = 39
The critical path is the longest path through the system, defining the minimum
completion time for the overall project. The critical path in this project is A-E-H-I-J,
determining that the project can be completed in 52 minutes (less than the 80-minute total
of resource-usage time). These five activities must be done in sequence, and there is
apparently no way to shorten these times. Note that this critical path is not dependent on
the number of activities, but is rather dependent on the total time for a specific sequence
of activities.
The managerial importance of this critical path is that any delay to the activities on this
path will delay the project completion time, currently anticipated as 8:52 A.M. It is
important to monitor this critical set of activities to prevent the missed due-date of the
69
project. If the oven takes 16 minutes to heat (instead of the predicted 15 minutes), the
project manager needs to anticipate how to get the project back on schedule. One
suggestion is to bring in a fan (another resource) to speed the cooling process of the
second batch of cookies; another is to split the storage process into first- and secondbatch components.
Other paths tend to require less monitoring, as these sets of activities have slack, or a
cushion, in which activities may be accelerated or delayed without penalty. Total slack
for a given path is defined as the difference in the critical path time and the time for the
given path. For example, the total slack for B-C-G-H-I-J is 13 minutes (52–39 minutes).
And the slack for B-C-D-E-H-I-J is only one minute (52–51), making this path near
critical. Since these paths share some of the critical path activities, it is obvious that the
manager should look at the slack available to individual activities.
Table 3 illustrates the calculation of slack for individual activities. For projects more
complex than the simplistic cookie project, this is the method used to identify the critical
path, as those activities with zero slack time are critical path activities. The determination
of early-start and early-finish times use a forward pass through the system to investigate
how early in the project each activity could start and end, given the dependency on other
activities.
Table 3
Activity
Early Start
Early Finish
Late Start
Late Finish
Slack
A
8:00
8:15
8:00
8:15
0
B
8:00
8:08
8:01
8:09
1
C
8:08
8:10
8:09
8:11
1
D
8:10
8:14
8:11
8:15
1
E
8:15
8:27
8:15
8:27
0
F
8:27
8:37
8:39
8:49
12
G
8:10
8:14
8:23
8:27
13
H
8:27
8:39
8:27
8:39
0
70
Activity
Early Start
Early Finish
Late Start
Late Finish
Slack
I
8:39
8:49
8:39
8:49
0
J
8:49
8:52
8:49
8:52
0
The late-time calculations use the finish time from the forward pass (8:52 A.M.) and
employ a backward pass to determine at what time each activity must start to provide
each subsequent activity with sufficient time to stay on track.
Slack for the individual activities is calculated by taking the difference between the latestart and early-start times (or, alternatively, between the late-finish and early-finish times)
for each activity. If the difference is zero, then there is no slack; the activity is totally
defined as to its time-position in the project and must therefore be a critical path activity.
For other activities, the slack defines the flexibility in start times, but only assuming that
no other activity on the path is delayed.
CPM was designed to address time-cost trade-offs, such as the use of the fan to speed the
cooling process. Such crashing of a project requires that the project manager perform
contingency planning early in the project to identify potential problems and solutions and
the costs associated with employing extra resources. Cost-benefit analysis should be used
to compare the missed due-date penalty, the availability and cost of the fan, and the effect
of the fan on the required quality of the cookies.
This project ends with the successful delivery of the cookies to storage, which brings two
questions to mind: First, should the oven be turned off? The answer to this depends on
the scheduling of the oven resource at the end of this project. It might be impractical to
cool the oven at this point if a following project is depending on the heating process to
have been maintained. Second, who cleans up the kitchen? Project due dates are often
frustrated by failure to take the closeout stages into account.
Example 1
In order to construct a house, there are many jobs that need to be done at the same time.
Certain parts of the construction must be done before others can be started. We can not
start wiring the house if the walls have not been put up, and we can not put the walls up
till the foundation had been set. Before the foundation is set, you must choose a good plot
to dig the foundation hole. However, there are certain jobs which can be done
simultaneously. While you are wiring the outlets, you can have someone do the heating
and air conditioning ducts or can have the landscaper working on the outside layout. The
partial order diagram will allow one to see how long the whole process will take.
71
Below, we show each task that needs to be done, and the amount of time required for that
task. The amount of time is estimated.
1. Find Plot
2 days
2. Excavate land
5 days
3. Dig for foundation
3 days
4. Lay concrete foundation
5 days
5. Exterior firework
2 days
6. Exterior electrical
2 days
7. Exterior gasline
5 days
8. Supports for walls/ceiling/floor/stairs
5 days
9. Siding/Roof
3 days
10. Windows
1 day
11. Interior wiring
2 days
12. Interior plumbing
2 days
13. Heating/AC ducts
2 days
14. Insulation
1 day
15. Dry wall
2 days
16. Landscaping
14 days
17. Painting
2 days
18. Light Fixtures/Switches
7 hours
19. Floor Ring
2 day
20. Doors/Cabinets
1 day
21. Clean-up
1 day
72
The next table shows what task precedes each task. This allows us to see what tasks can
be done at the same time. If one task does not depend on the other, then those two tasks
can be done at the same time.
Table 4
Partial Order formula: x R y x = y or x precedes y
We read the following Hasse diagram from left to right to find the minimum time for the
whole process of constructing the house.
The critical path time can be reduced if we do certain tasks differently. The time for
landscaping right now is 14 days. But if more workers are used, then the time will be less.
If pre-fabricated materials are used, then it will take less time, because less people are
needed, and less time is used in making the material. Also depending on the design of the
house, the time can be reduced or even increased. If fewer rooms are needed by the
family that is living there, then it will take less time, then designing at large size home
with many rooms, and closets inside each room.
What can also reduce the time is experience of the construction workers. If the workers
are new, then they will be a bit slower, and making more mistakes which increases the
time for each task.
73
Figure 2 partial Order Diagram: Construction of a House
Critical Path Method (CPM): 1,2,3,4,816,21 which is 35 days
2.9 PROGRAM EVALUATION AND REVIEW TECHNIQUE (PERT)
This is a project management technique that shows the time taken by each component of
a project, and the total time required for its completion. PERT breaks down the project
into events and activities, and lays down their proper sequence, relationships, and
duration in the form of a network. Lines connecting the events are called paths, and the
longest path resulting from connecting all events is called the critical path. The length
(duration) of the critical path is the duration of the project, and any delay occurring along
it delays the whole project. PERT is a scheduling tool, and does not help in finding the
best or the shortest way to complete a project
PERT method (Program Evaluation and Review Technique) is developed by the Ministry
of Defense of the USA in 1958 in the framework of the project Polaris. PERT diagram is
one of the tools for project management. With its help it is possible to analyze the time
which is necessary for project execution and the consequence of tasks which involved
into the project. The main advantage of such diagram type over the other diagram types is
74
the possibility of calculation of the project fulfillment critical path that is the consequence
of tasks which has the minimal float for execution and on which the total time for the
whole project execution depends. If the task on the critical path is delayed than the
execution of the whole project is delayed. There for it is important to calculate the critical
path of the whole project execution and pay the most attention to tasks which appear on
this way.
2.9.1 Network Diagrams
According to Stevenson, the main feature of PERT analysis is a network diagram that
provides a visual depiction of the major project activities and the sequence in which they
should be completed. Activities are defined as distinct steps toward completion of the
project that consume either time or resources. The network diagram consists of arrows
and nodes and can be organized using one of two different conventions. The arrows
represent activities in the activity-on-arrow convention, while the nodes represent
activities in the activity-on-node convention. For each activity, managers provide an
estimate of the time required to complete it.
The sequence of activities leading from the starting point of the diagram to the finishing
point of the diagram is called a path. The amount of time required to complete the work
involved in any path can be figured by adding up the estimated times of all activities
along that path. The path with the longest total time is known as the critical path.
As Stevenson noted, the critical path is the most important part of the diagram for
managers since it determines the completion date of the project. Delays in completing
activities along the critical path will necessitate an extension of the final deadline for the
project. If a manager hopes to shorten the time required to complete the project, he or she
must focus on finding ways to reduce the time involved in activities along the critical
path.
The time estimates managers provide for the various activities comprising a project
involve different degrees of certainty. When time estimates can be made with a high
degree of certainty, they are called deterministic estimates. When they are subject to
variation, they are called probabilistic estimates. In using the probabilistic approach,
managers provide three estimates for each activity: an optimistic or best case estimate; a
pessimistic or worst case estimate; and the most likely estimate. A beta distribution can
be used to describe the extent of variability in these estimates, and thus the degree of
uncertainty in the time provided for each activity. Computing the standard deviation of
each path provides a probabilistic estimate of the time required to complete the overall
project.
useful management tool for planning, coordinating, and controlling large, complex
projects such as formulation of a master (COMPREHENSIVE) budget , construction of
buildings, installation of computers, and scheduling of the closing of books. The
development and initial application of PERT dates to the construction of the Polaris
submarine by the U.S. Navy in the late 1950s. The PERT technique involves the
75
diagrammatical representation of the sequence of activities comprising a project by
means of a network consisting of arrows and circles (nodes), as shown in Figure 1.
Arrows represent tasks" or "activities," which are distinct segments of the project
requiring time and resources. Nodes (circles) symbolize "events," or milestone points in
the project representing the completion of one or more activities and/or the initiation of
one or more subsequent activities. An event is a point in time and does not consume any
time in itself as does an activity.
An important aspect of PERT is the Critical Path Method (CPM) . A path is a sequence of
connected activities. In Figure 3, 2-3-4-6 is an example of a path. The critical path for a
project is the path that takes the greatest amount of time. This is the minimum amount of
time needed for the completion of the project. Thus, activities along this path must be
shortened in order to speed up the project. To compute this, calculate the time (ET) and
the latest time (LT) for each event.
Figure 3
The earliest time is the time an event will occur if all preceding activities are started as
early as possible. Thus, for event 4 in Figure 4, the earliest time is 19.3 (i.e., 13 + 6.3).
The latest time is the time an event can occur without delaying the project beyond the
deadline. The earliest time for the entire project is 49.5. Working backward from event 6
(finish) it is seen that the latest time for event 4 is 35.5.
The slack for an event is the difference between the latest time and earliest time. For
event 4 the slack is 35.5 - 19.3 = 16.2. This is the amount of time event 4 can be delayed
without delaying the entire project beyond its due date. Finally, the critical path the
network is the path leading to the terminal event so that all events on the path have zero
path. Figure 4 shows the earliest and latest times for each event.
76
Figure 4
Event Earliest Time Latest Time Slack
1
0
6.3
6.3
2
0
0
0
3
13
13
0
4
19.3
35.5
16.2
5
37
37
0
6
49.5
49.5
0
The path 2-3-5-6 is the critical path.
In a real-world application of PERT to a complex project, the estimates of completion
time for activities will seldom be certain. To cope with the uncertainty in activity time
estimates, proceed with three time estimates: an optimistic time (labeled a), a most likely
time (m), and a pessimistic time (b). A weighted average of these three time estimates is
then calculated to establish the expected time for the activity. The formula is: ( a + 4m +
b )/6. For example, given three time estimates, a = 1, m = 3, and b = 5, the expected time
is [1 + 4(3) + 5]/6 = 3.
77
It should be considered that PERT diagram does not give you ready concrete decisions
but it helps you to find these decisions.
PERT diagram is constructed by definite rules. It represents the set of tasks, connected
between each other in the consecution of their execution.
Activity 2
1. What are various uses of trend analysis? Differentiate univariate time series
models with multivariate time series models.
2. Write a note on financial analysis. What are different types of financial analysis?
3. From the following financial statements calculate:
1.
2.
3.
4.
5.
6.
Current ratio
Acid test or quick ratio
Debt to equity ratio
Asset turnover
Return on assets
Return on Equity (ROE)
XYZ and Co. ltd. Balance Sheet for the period12/31/2000---------12/31/2001
ASSETS:
Cash-------------------------- ----4000------------------ 14000
Marketable securities---------------0--------------------2000
Account receivable--------------5000------------------- 3000
Inventories------------------------5000------------------ 10000
TOTAL CURRENT ASSETS-------24000-----------------29000
Property and equipment-----------------3000-------------------6000
Less depreciation---------------------------0-------------------1000
Net property and equipment-------3000--------------------5000
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land and intangible-------------------0--------------------6000
TOTAL ASSETS------------------27000-----------------40000
LIABILITIES:
Account payable-------------------3000-------------------9000
Note payable--------------------------0-------------------6000
Current portion of long term debt--0-------------------2000
TOTAL CURRENT LIABILITIES------3000-----------------17000
Long term debt---------------------7000-------------------5000
TOTAL LIABILITIES---------10000-----------------22000
OWNER EQUITY--------------17000----------------18000
TOTAL LIABILITIES AND EQUITY--27000-----------------40000
Income statement
-------------------------------12/31/2000------12/31/2001
Sales to customers-----------------10000-------------15000
Cost of goods sold-----------------3000----------------6000
GROSS INCOME---------------7000-----------------9000
General and adminis. expenses----0-------------------5000
depreciation--------------------------0-------------------1000
OPERATING INCOME-------7000-----------------3000
income taxes------------------------0--------------------2000
NET INCOME. ----------------7000-------------------1000
4. In the following table, the Project manager knows the succession of the project
activities and the optimistic, pessimistic and most likely time (in weeks) for the
following activities:
79
Draw a network diagram using pert technique and find out earliest start time, earliest
finish time, latest start time and latest finish time and slack for each activity.
80
2.10 SUMMARY
This unit highlights various types of financial analyses and techniques. Financial analysis
refers to an assessment of the viability, stability and profitability of a business, sub
business or project. After an introduction to financial analysis concepts of ratio analysis
were discussed. Certain important ratios including liquidity Ratios; efficiency Ratios;
profitability Ratios; leverage ratios; working capital ratios; bankruptcy ratios; coverage
ratios and total coverage ratios. In the next section trend analysis was explained. Trend
analysis is a form of comparative analysis that is often employed to identify current and
future movements of an investment or group of investments. Time series is a technique of
trend analysis which was discussed with its various techniques and methods. Project
analysis and evaluation was described with two important techniques called Critical Path
Method (CPM) and Program Evaluation and Review Technique (PERT). Various
examples were illustrated to probe into the areas of discussion.
2.11 FURTHER READING

Mantel, Samuel J., Jr., Jack R. Meredith, Scott M. Shafer, and Margaret M.
Sutton. Core Concepts: Project Management in Practice. New York, NY: John
Wiley & Sons, Inc., July 2004.

Meredith, Jack R., and Samuel J. Mantel, Jr. Project Management: A Managerial
Approach. New York, NY: John Wiley & Sons, Inc., 2002.

Martin Mellman et. al., "Accounting for Effective Decision Making" (Irwin
Professional Press, 1994)

Eric Press, "Analyzing Financial Statements" (Lebahar-Friedman, 1999)
UNIT 3
81
ANALYSIS OF FINANCIAL STATEMENTS
Objectives
Upon successful completion of this unit, you should be able to:






Understand various methods of inventory valuation
Absorb the approach balancing inventory and costs
Know the classic economic order quantity model for inventory control
Discuss ABC analysis for inventory control
Appreciate the approaches to short term financing
Have understanding of the future of inventory management
Structure
3.1 Introduction to fund flow statements
3.2 Process of preparing fund flow statements
3.3 Comparative financial statements
3.4 Projecting working capital requirements
3.5 Techniques for assessment of working capital requirements
3.6 Summary
3.7 Further readings
3.1 INTRODUCTION TO FUND FLOW STATEMENTS
The fund flow statement reports the flow of funds through the firm during the year. In
order to prepare fund flow statement proper understanding of working capital and sources
and applications is necessary. The fund flow statement is a record, a post-mortem of
where the funds came from and how these were utilized during the year. The fund flow
statement attempts to explain the change in financial position from one balance sheet to
the subsequent balance sheet in terms of change in the funds or the working capital
position of the firm.
According to R.N. Anthony, “Fund flow is a statement prepared to indicate increase in
cash resources and the utilisation of such resources of a business during the accounting
period.”
According to Smith Brown, “Fund flow is prepared in summary form to indicate changes
occurring in terms of financial conditions between two different balance sheet dates.”
3.1.1 Objectives of Fund Flow Statement
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The major objectives of fund flow statement are:
1. To help to understand the changes in assets.
2. To point out the financial strength and weaknesses of the business.
3. To inform as to how the funds of the business have been used.
4. It evaluates the firm’s financing capacity.
5. Fund flow statement helps in estimating the amount of finance required for completing
its various projects.
6. This statement gives an insight into the evolution of the present financial position.
3.1.2 Uses of Fund Flow Statement
1. The users of fund flow statement, such as investors, creditors, bankers, government,
etc., can understand the managerial decisions regarding dividend distribution, utilization
of funds and earning capacity with the help of fund flow statement.
2. The quantum of working capital is revealed by the schedule of working capital
changes, which is a part of fund flow statement.
3. The fund flow statement is the best and first source for judging the repaying capacity
of an enterprise.
4. The management will be able to detect surplus/shortage of fund balance.
5. The fund from operation is not mentioned in the profit and loss account and balance
sheet but it is separately calculated for the purpose of fund flow statement.
3.1.3 Limitations of Fund Flow Statement
The fund flow statement suffers from the following limitations:
1. The fund flow statement is prepared with the help of balance sheet and profit and loss
account of the current period and these statements are based on historical cost. So a
realistic comparison of profitability and the funds position is not possible as the current
cost is not considered for the purpose of preparation of fund flow statement.
2. The cash position of the firm is not revealed by fund flow statement. To know the cash
position a cash flow statement has to be prepared.
83
3. The various activities are not classified as operating activities, investing activities and
financing activities while preparing fund flow statement.
3.2 PROCESS OF PREPARING A FUND FLOW STATEMENT
Funds Flow Statements is prepared in two parts - The first one is sources of Funds and
the other is Uses of Funds or Application of funds. The difference of these two parts is
change in working capital. When sources of funds exceed the application of funds, it is
increase in working capital and when application of funds exceeds the sources, it is
decrease in working capital. Funds Flow Statement presents those items only which
affect the working capital.
If any transaction does not affect the working capital at all i.e., if it results in increase or
decrease in both current assets and current liabilities (such as payment to creditors) or it
affects only fixed assets and fixed liabilities (such as conversion of debentures into
shares, or shares into stocks or vice versa, issue of bonus shares, purchase of fixed assets
like building or machinery by issue of shares or debentures etc.), it is not to be shown in
funds Flow Statement.
Problem
From the following information prepare
i) A Schedule of Changes in Working Capital
ii) A Funds Flow Statement
Balance Sheet of M/s Kohinoor & Co. as on
Liabilities
Capital
Profit/Loss
Appropriation
Bank Loan
Bills Payable
Sundry Creditors
Reserve for Taxation
31stMarch
2006
2007
18,50,000
14,78,000
12,00,000
4,00,000
14,00,000
2,00,000
21,00,000
17,64,000
9,00,0000
6,80,000
12,20,000
1,80,000
65,28,000 68,44,000
Assets
Goodwill (at Cost)
Land and Buildings
Plant and
Machinery
Furniture and
Fittings
Stock/Inventories
Sundry Debtors
Bills Receivable
Bank
Cash
31stMarch
2006
2007
6,00,000
18,50,000
4,74,000
1,94,000
8,26,000
12,00,000
8,00,000
5,00,000
84,000
6,00,000
22,00,000
5,24,000
1,94,000
7,24,000
12,80,000
7,21,000
4,83,000
1,18,000
65,28,000 68,44,000
84
Solution: Schedule of Changes in Working Capital
Schedule/Statement of Changes in Working Capital for the period from the year
2006 to 2007
Particulars/Account
Previous
Period
Current
Period
Working Capital
Change
Increase
A. CURRENT ASSETS
1) Stock/Inventories
2) Sundry Debtors
3) Bills Receivable
4) Bank
5) Cash
B. CURRENT
LIABILITIES/PROVISIONS
1) Bills Payable
2) Sundry Creditors
3) Provision for Taxation
Working Capital (A − B)
Change in Working Capital
8,26,000
12,00,000
8,00,000
5,00,000
84,000
7,24,000
12,80,000
7,21,000
4,83,000
1,18,000
34,10,000
33,26,000
1,14,000
4,00,000
14,00,000
2,00,000
6,80,000
12,20,000
1,80,000
1,80,000
20,000
20,00,000
20,80,000
3,14,000
14,10,000
12,46,000
(12,46,000 − 14,10,000)
(Or) (3,14,000 −
4,78,000)
Decrease
1,02,000
80,000
79,000
17,000
34,000
1,98,000
2,80,000
4,78,000
1,64,000
Working Notes
To be able to work out all the problems on preparation of Funds Flow Statement in a
similar manner, it would be convenient to adopt the procedure of preparation of altered
fund (ledger) accounts.
85
Altered Fund Accounts
Make up all those ledger accounts within the Fund Area where there is a change in
values. These are accounts which have been influenced on account of transactions during
the period for which the flow is being analysed.
In this problem, we need to prepare





Capital a/c
Profit and Loss Appropriation a/c
Bank Loan a/c
Land and Buildings a/c
Plant and Machinery a/c
Each Ledger account should be prepared so as to reveal all the information relating to
that account and for that period
Dr Capital a/c Cr
Date
Particulars
J/F
31-03-07 To Balance c/d –
Total
Amount
(in Rs)
Date
Particulars
J/F
21,00,000 01-04-06 By Balance b/d –
–
By Bank a/c (?) –
18,50,000
2,50,000
21,00,000
21,00,000
Total
01-04-07 By Balance b/d –


Amount
(in Rs)
21,00,000
The higher closing balance indicates additional capital raised during the period.
Capital has been raised in exchange for cash
Dr Bank Loan a/c Cr
Date
Particulars
J/F
–
To Bank a/c (?) –
31-03-07 To Balance c/d –
Total
Amount
(in Rs)
Date
Particulars
J/F
3,00,000 01-04-06 By Balance b/d –
9,00,000
12,00,000
12,00,000
12,00,000
Total
01-04-07 By Balance b/d –


Amount
(in Rs)
9,00,000
The lower closing balance indicates repayment of loan during the period.
Loan has been repaid by paying out cash
86
Dr Land and Buildings a/c Cr
Date
Particulars
J/F
01-04-06 To Balance b/d –
–
To Bank a/c (?) –
Total
22,00,000
01-04-07 To Balance b/d –


Amount
Amount
Date
Particulars J/F
(in Rs)
(in Rs)
18,50,000 31-03-07 By Balance c/d – 22,00,000
3,50,000
Total
22,00,000
9,00,000
The higher closing balance indicates additional purchase/acquisition during the
period.
Additional Assets have been purchased for cash
Dr Plant and Machinery a/c Cr
Date
Particulars
J/F
01-04-06 To Balance b/d –
–
To Bank a/c (?) –
Total
01-04-07 To Balance b/d –


Amount
(in Rs)
Date
Particulars
J/F
Amount
(in Rs)
4,74,000 31-03-07 By Balance c/d –
50,000
5,24,000
5,24,000
5,24,000
Total
5,24,000
The higher closing balance indicates additional purchase/acquisition during the
period.
Additional Assets have been purchased for cash
Making up the Funds Flow Statement
Every posting read as "By Cash/Bank a/c" indicates a source of fund and as "To
Cash/Bank a/c" indicates an application of Fund. Filling the details with the Ledger
account head as the identifier in the Funds Flow Statement is all that you need to do.
Dr Profit and Loss Appropriation a/c Cr
Date
Particulars
J/F
31-03-07 To Balance c/d –
Total
Amount
Amount
Date
Particulars
J/F
(in Rs)
(in Rs)
17,64,000 01-04-06 By Balance b/d – 14,78,000
31-03-07 By P/L (FFO) a/c – 2,86,000
17,64,000
Total
01-04-07 By Balance b/d
17,64,000
–
17,64,000
87


The higher closing balance indicates additional funds generated through profits
during the period.
FFO = Funds From Operations.
These are the Funds flowing in on account of profits made from regular
operations during the period.
Funds from Operations
One additional detail/item that is to be gathered is the Funds From Operation. This
information is derived from the Profit and Loss Appropriation account. Where the
posting in the appropriation account reads "By Funds From Operations" it indicates a
source of fund and where it reads "To Funds From Operations" it indicates an application
of fund
Filling the detail relating to FFO in the Funds Flow Statement and deriving the difference
between the total sources and total applications would complete its preparation.
Changes in Fund Accounts
Just for solving this problem and similar other ones, you may not need to prepare the
above notes and you can just manage with a simple comparison of figures as below.
This can be done orally showing the calculation in the Funds Flow Statement itself.
Item
Capital
Profit/Loss
Appropriation
Bank Loan
Land and Building
Plant and
Machinery
Amount
Previous
Period
18,50,000
14,78,000
12,00,000
18,50,000
3,70,000
Amount
Current
Period
Change
Nature
21,00,000
17,64,000
9,00,000
22,00,000
4,74,000
2,50,000
2,86,000
3,00,000
3,50,000
50,000
Liability Inflow
Increase
Inflow
Liability Inflow
Increase
Inflow
Liability - Outflow
Increase
Liability Increase
Asset Increase
Result
88
3.2.1 Funds Flow Statement
Statement Form
Funds Flow Statement for the period from the year 2006 to 2007
Particulars
Amount
SOURCES (INFLOW) of FUNDS :
1) Capital
2) Profit/Loss Appropriation
Amount
2,50,000
2,86,000 5,36,000
Less: APPLICATIONS (OUTFLOW) of FUNDS
1) Land and Buildings
3,50,000
2) Plant and Machinery
50,000
3) Bank Loan
3,00,000 7,00,000
Change in Working Capital
−
1,64,000
There is a decrease in Net Working Capital to the extent of Rs. 1,64,000
T Form
Statement of Sources and Applications of Funds for the period from the year 2006
to 2007
Sources (Inflow)
of Funds
1) Capital
2) Profit/Loss Appropriation
Amount
2,50,000
2,86,000
Applications (Outflow)
of Funds
1) Land and Buildings
2) Plant and Machinery
3) Bank Loan
5,36,000
Amount
3,50,000
50,000
3,00,000
7,00,000
Change in Working Capital
1,64,000
(Sources/Inflow of Funds) < (Applications/Outflow of Funds)
There is a decrease in Net Working Capital to the extent of Rs. 1, 64,000
3.3 COMPARATIVE FINANCIAL STATEMENT
Comparative Financial Statement analysis provides information to assess the direction of
change in the business. Financial statements are presented as on a particular date for a
particular period. The financial statement Balance Sheet indicates the financial position
89
as at the end of an accounting period and the financial statement Income Statement shows
the operating and non-operating results for a period. But financial managers and top
management are also interested in knowing whether the business is moving in a favorable
or an unfavorable direction. For this purpose, figures of current year have to be compared
with those of the previous years. In analyzing this way, comparative financial statements
are prepared.
Comparative Financial Statement Analysis is also called as Horizontal analysis. The
Comparative Financial Statement provides information about two or more years' figures
as well as any increase or decrease from the previous year's figure and it's percentage of
increase or decrease. This kind of analysis helps in identifying the major improvements
and weaknesses. For example, if net income of a particular year has decreased from its
previous year, despite an increase in sales during the year, is a matter of serious concern.
Comparative financial statement analysis in such situations helps to find out where costs
have increased which has resulted in lower net income than the previous year.
Example
Comparative Income Statement for the years ended 31st Dec 2008 & 31st Dec 2009
% of
31st Dec 31st Dec Increase/
increase /
2008
2009 (Decrease)
(decrease)
Rs.7,000 Rs.9,000 Rs.2,000 28.57%
Rs.5,000 Rs.6,400 Rs.1,400 28.00%
Rs.2,000 Rs.2,600
Rs.600 30.00%
Sales
Less: Cost of goods sold
Gross profit
Less: Operating expenses
General & administrative
Rs.200 Rs.300
expenses
Selling & distribution
Rs.400 Rs.500
expenses
Other operating expenses
Rs.100 Rs.150
Operating profit Rs.1,300 Rs.1,650
Less: Interest expenses
Rs.300 Rs.400
Net income before
Rs.1,000 Rs.1,250
taxes
Less: Taxes at 30%
Rs.300 Rs.375
Net Income after
Rs.700 Rs.875
taxes
Rs.100
50.00%
Rs.100
25.00%
Rs.50
Rs.350
Rs.100
50.00%
26.92%
33.33%
Rs.250
25.00%
Rs.75
25.00%
Rs.175
25.00%
Comparative Balance Sheets as on 31st Dec 2008 & 31st Dec 2009
90
% of
31st Dec 31st Dec Increase /
increase /
2008
2009 (Decrease)
(decrease)
Current Assets:
Cash
Rs.500 Rs.600
Accounts
Rs.2,000 Rs.3,000
Receivables
Inventory
Rs.1,500 Rs.2,500
Total Current
Rs.4,000 Rs.6,100
Assets
Fixed Assets:
Buildings
Rs.3,000 Rs.4,000
Furnitures & office
Rs.1,000 Rs.1,500
equipments
Total Fixed
Rs.4,000 Rs.5,500
Assets
Total Assets
Rs.8,000Rs.11,600
Liabilities:
Current Liabilities:
Accounts Payable
Rs.1,000 Rs.1,200
Notes Payable
Rs.500 Rs.500
Interest Payable
Rs.100 Rs.120
Total Current
Rs.1,600 Rs.1,820
Liabilities
Shareholder's Equity:
Common Stock
Rs.5,000 Rs.7,500
Retained earnings
Rs.1,400 Rs.2,280
Total
Stockholder's Rs.6,400 Rs.9,780
equity
Total Liabilities &
Stockholder's
Rs.8,000Rs.11,600
equity
Rs.100
20.00%
Rs.1,000
50.00%
Rs.1,000
66.67%
Rs.2,100
52.50%
Rs.1,000
33.33%
Rs.500
50.00%
Rs.1,500
37.50%
Rs.3,600
45.00%
Rs.200
Rs.0
Rs.20
20.00%
0.00%
20.00%
Rs.220
13.75%
Rs.2,500
Rs.880
50.00%
62.86%
Rs.3,380
52.81%
Rs.3,600
45.00%
Comparative balance sheet is designed to show financial differences between several
accounting periods. A balance sheet is a detailed account of everything lost and gained
financially during a certain time, containing both physical and abstract data. A
comparative balance sheet is useful because a business can instantly compare profits and
losses between different time periods. Most businesses use comparative balance sheets to
help
increase
profits
and
functionality
of
a
company.
Features
A comparative balance sheet will include several different types of accounting data. First
there will be the income received and money spent. There will also be a list of credits and
91
debits to the company. A list of assets and liabilities is also included. All of these factors
are necessary to see what the total worth of the company is through the balance sheet.
The comparative balance sheet allows the company or business to see at a glance how its
profits differ from one year to another. These comparative balance sheets are aligned so
that business people can see at a glance the financial differences from year to year.
Function
A balance sheet is designed to help keep a business or company aware of every expense
and profit that it is receiving. It also allows the company to see which times of the year
are most profitable, and which years they did the best. This knowledge is important so
that the company can adapt to the information to build the best business possible. If the
business did better three years ago, they can look at that data and try to decide what it
was that made them do so well that year. Then they can change what they are doing in the
present to help boost current profits.
Benefits
The main benefit of a comparative balance sheet is that profits and losses can be seen at a
glance. It is also possible to see the increase or decrease of assets that the business has.
The company will be able to tell what the biggest money suckers in the business are, and
try to think of ways to cut down losses in that area.
Significance
Without a comparative balance sheet, businesses would not know how to change their
strategy from year to year. All they would have to go on would their current balance
statements. This would be detrimental to most businesses. It is very important to be able
to look at past profit information to judge how to act for the future.
3.4 PROJECTING WORKING CAPITAL REQUIREMENTS
As we all know that finance is the lifeblood of the Organization. Marketing is the food of
the Organization. Human resource is the internal linkage of the Organization. All the
function will contribute as per their role assign to them and finance is the most important
among
all.
Working capital management involves the relationship between a firm's short-term assets
and its short-term liabilities. The goal of working capital management is to ensure that a
firm is able to continue its operations and that it has sufficient ability to satisfy both
maturing short-term debt and upcoming operational expenses. The management of
working capital involves managing inventories, accounts receivable and payable, and
cash. Working capital is also known as “Liquid Capital” or “Watered Capital”.
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Working capital management deals with the most dynamic field in Finance which needed
constant interaction between Finance and other functional managers. The finance
manager acting along cannot improve a company’s working capital situation. At most
best he may persuade the bankers to be a little more liberal and worst he may succeed in
hoodwinking
them
once
in
a
way.
The objective of working capital management is to maintain the optimum balance of each
of the working capital components. This includes making sure that funds are held as cash
in bank deposits for as long as and in the largest amounts possible, thereby maximizing
the interest earned. However, such cash may more appropriately be "invested" in other
assets
or
in
reducing
other
liabilities.
For example, an organization may be faced with an uncertainty regarding availability of
sufficient quantity of crucial inputs in future at reasonable price. This may necessitate the
Holding of inventory i.e., current assets. Similarly an organization may be faced with an
uncertainty regarding the level of its future cash inflows and insufficient amount of cash
may incur substantial costs. This may necessitate the holding of a reserve of short – term
marketable securities, again a short term capital asset. The unpredictable and uncertain
global market plays a vital role in working capital. Though the globalization of economy
and free trading of products envisages the continuous availability of products but how
much its cost effective and quality based varies concern to concerns.
When you make projections for income in the coming year, you should have two sets of
numbers. One set will be your financial goals, and this can be the figure you share with
your sales team, employees or even investors. The fiscal goals can be aggressive, and
there is little risk to setting these goals high.
However, when it comes to budgeting your working capital, you should set the
projections slightly lower to account for unforeseen problems. For example, if you are
aiming for a Rs.20,000 income next month, you may think taking on Rs.6,000 in debt
payments is safe. But, you may find a piece of equipment breaks or one of your
employees quits. In this case, the Rs.6,000 could be too much debt to reasonably allow
you to make repairs or cover the cost of hiring a new employee. Adjust for the possibility
a certain amount of profits are outside of your control, and budget for a Rs.15,000 profit
instead.
If you want to go into business for yourself or get additional funding for your business,
you will want to learn how to create monthly income or cash projections as this is the
level of detail your banker(s) and investor(s) will need to have in order to understand
where and how their funds are being spent. This is especially important for start-ups or
working capital (inventory) loans.
While monthly projections can be tedious, they can also help to work through certain
financial roadblocks before they start. Additionally, the process will help to better
understand how cash flows through your organization.
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3.4.1 Instructions to project working capital requirements
1.
Step 1
Estimate what all sales will be for the month. Back up your assumptions with reasons
that explain your growth rate (or lack of one). Look at other start-ups in the same
industry or estimate yourself based on past experience. Start with a weekly projection
and then multiply by 4 for a monthly projection.
2.
Step 2
Subtract all costs associated with the service or production for the month. This
includes wages (include paid vacations, paid sick leave, health insurance and
unemployment insurance). This is your Gross Profit.
3.
Step 3
Subtract out a charge for administrative support and supplies. This includes all shared
or fixed costs such as the building rents, utilities, telephone, insurance, advertising
and administrative payroll.
4.
Step 4
Sum for Operating Profit. Deduct interest and taxes for the Net Projected Monthly
Income.
There are no rules or formulae to determine the working capital requirements of firms. A
large numbers of factors, each having a different importance, influence working capital
needs of a firm.
Also the importance of factors changes for a firm over time. There for an analysis of
relevant factors should be made to determine total investment in working capital. The
following is description of factors which generally influence the working capital
requirements
of
firms.
a) Nature of Business
In some business organization, the scales are mostly on a cash basis and the operating
cycle is also very short. In the concerns the working capital requirement is comparatively
less. Mostly services giving companies come in this category. In manufacturing concerns,
usually
the
operating cycle is very long and a firm has to give credit to customers for improving
scales. In such a case, the working capital requirement is more.
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b) Production Policy
Working capital requirement is also fluctuate according to production policy. Some
products have seasonal demands but in order to eliminate the fluctuation in the working
capital, the manufacture plans the production in steady flow throughout the year. This
policy
will
even
out
the
fluctuation
in
the
working
capital.
c) Market Conditions
Due to consumption in the market the demands for working capital fluctuate. In a
comparatively environment, a business firm has to give liberal credit to customers.
Similarly it will have to maintain a large inventory of finished goods to service the
customers promptly. In this situation the large amount of working capital will require.
On other hand when, a firm will on seller’s market, it can manage with smaller amount of
working capital because sales can be made on cash basis and there will be no need to
maintain a large inventory on finished goods because the customers can be serviced with
delay.
d) Seasonal Fluctuation
A firm who is producing the products with seasonal demands requires more working
capital during peak seasons while the demand for working capital will go down during
slack seasons.
e) Growth and expansion Activities
The working capital needs of the firm increase as it grows in terms of sales or fixed
assets. A growing fund may need to invest funds in fixed assets in order to sustain its
growth production and sales. This will in turn increase investments in current assets,
which
will
result
in
increase
working
capital
needs.
f) Operating efficiency
The operating efficiency of the firm relates to optimum utilization of resources at
minimum cost. The firm will be effectively contributing to its working capital if it is
efficient in controlling operating costs the working capital is better utilized and cash
cycle
is
reduce
which
working
capital
needs.
g) Credit Policy
The working capital requirement of a firm is depend a great extend on the credit policy
followed by a firm for its debtors. A liberal credit policy will result in huge funds blocked
in debtors which will enhance the need for working capital. If the creditors are ready to
supply.
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3.4.2 Factors requiring consideration while estimating working capital

The average credit period expected to be allowed by suppliers.

Total costs incurred on material, wages.

The length of time for which raw material are to remain in stores before they are
issued for production.

The length of the production cycle (or) work in process.

The length of sales cycle during which finished goods are to be kept waiting for
sales.

The average period of credit allowed to customers
 The amount of cash required to make advance payment
Estimating working capital needs is critical when starting up a new business, and when
going through a period of growth and expansion. By understanding the cycles a business
goes through, and assigning some numbers to them, it is possible to come up with a
realistic estimate of how much working capital you should have on hand. And, when a
business is experiencing financial difficulties, an analysis of these cycles and the impact
they have on cash flow and resources enables taking the necessary steps to turn the
situation around.
3.5 TECHNIQUE FOR ASSESSMENT OF WORKING CAPITAL
REQUIREMENT
1. Estimation of Component of working capital Method
Since working capital is the excess of current assets over current liabilities, an assessment
of the working capital requirements can be made by estimating the amounts of different
constituents of working capital e.g., inventories, accounts receivable, cash, accounts
payable, etc.
2. Percent of sales Approach
This is a traditional and simple method of estimating working capital
Requirements. According to this method, on the basis of past experience between sales
and working capital requirements, a ratio can be determined for estimating the working
capital requirements in future.
3. Operating Cycle Approach
According to this approach, the requirements of working capital depend upon the
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operating cycle of the business. The operating cycle begins with the acquisition of raw
materials and ends with the collection of receivables.
It may be broadly classified into the following four stages viz.
• Raw materials and stores storage stage.
• Work-in-progress stage.
• Finished goods inventory stage.
• Receivables collection stage.
The duration of the operating cycle for the purpose of estimating working capital
requirements is equivalent to the sum of the durations of each of these stages less the
credit period allowed by the suppliers of the firm.
Symbolically the duration of the working capital cycle can be put as follows: O=R+W+F+D-C
Where,
O = Duration of operating cycle;
R = Raw materials and stores storage period;
W = Work-in-progress period;
F = Finished stock storage period;
D = Debtors collection period;
C = Creditors payment period.
Each of the components of the operating cycle can be calculated as follows:R = Average stock of raw materials and stores/
Average raw materials and stores consumptions per day
W = Average work-in-progress inventory/
Average cost of production per day
D = Average book debts/
Average credit sales per day
C = Average trade creditors/
Average credit purchases per day
After computing the period of one operating cycle, the total number of operating cycles
that can be computed during a year can be computed by dividing 365 days with number
of operating days in a cycle. The total expenditure in the year when year when divided by
the number of operating cycles in a year will give the average amount of the working
capital requirement.
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To estimate the Working Capital Requirements of an organization, we need to estimate
the following:1.
2.
Estimation of Current Assets
Estimation of Current Liabilities
3.5.1 Estimation of current assets
1. Raw Material Inventory
The Investment in Raw Material can be computed with the help of the following
formula:Budgeted Production
Inventory Holding
X
(In Units)
(months/days)
12months / 365 days
Cost of Raw Material(s)
Average
X
per unit
Period
2. Work-in-Progress Inventory
The Investment in Work-in-Progress Inventory can be computed with the help of the
following formula:Budgeted Production
time span of Work-inX
(In Units)
(months/days)
12months / 365 days
Estimated Work-in-Progress
cost per unit
X
Average
Progress Inventory
3. Finished Goods Inventory
The Investment in Finished Goods Inventory can be computed with the help of the
following formula:Budgeted Production
Cost of Goods
Holding
X
X
(In Units)
Produced per unit
12months / 365 days
Finished Goods
Period (months/days)
4. Debtors
The Investment in Debtors can be computed with the help of the following formula:Budgeted Credit Sales
X
(In Units)
per unit
Cost of Sales
X
Average Debt Collection
Period (months/days)
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12months / 365 days
5. Cash and Bank Balances
Apart from Working Capital needs for Financing Inventories and Debtors, Firms also
find it useful to have such minimum cash Balances with them. It is difficult to lay down
the exact procedure of determining such an amount. This would primarily be based on the
motives of holding cash balances of the business firm, attitude of management towards
risk, the access to the borrowing sources in times of need and past experience.
3.5.2 Estimation of Current Liabilities
The Working Capital needs of business firms are lower to the extent that such needs are
met through the Current Liabilities(other than Bank Credit) arising in the ordinary course
of business. The Important Current Liabilities in this context are Trade-Creditors, Wages
and Overheads:1. Trade Creditors
The Funding of Working Capital from Trade Creditors can be computed with the help of
the following formula:Budgeted Yearly Production
Cost of Raw Material(s)
Credit Period
allowed by
X
X
(In Units)
____________ per unit
Creditors
(months/days)
12months / 365 days
Note:-Proportional adjustment should be made to cash purchases of Raw Materials
2. Direct Wages
The Funding of Working Capital from Direct Wages can be computed with the help of
the following formula:Budgeted Yearly Production
Direct Labor Cost
Lag in Payment
X
X
(In Units)
per unit
12months / 365 days
Average Time
of Wages (months/days)
Note:-The average Credit Period for the payment of wages approximates to half-a-month
in the case of monthly wage payment. The first days monthly wages are paid on the 30 th,
extending credit for 29 days, the second days wages are, again , paid on the 30th day,
extending credit for 28 days, and so on. Average credit period approximates to half-amonth.
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3. Overheads (other than Depreciation and Amortization)
The Funding of Working Capital from Overheads can be computed with the help of the
following formula:Budgeted Yearly Production
Overhead Cost
Payment
X
X
(In Units)
per unit
12months / 365 days
Average Time Lag in
of Overheads (months/days)
Note:-The amount of Overheads may be separately calculated for different types of
Overheads. In the case of Selling Overheads, the relevant item would be sales volume
instead of Production Volume.
Projections of working capital also need some ratios to be considered:
The following, easily calculated, ratios are important measures of working capital
utilization.
Ratio
Stock
Turnover
(in days)
Formulae
Average Stock
* 365/
Cost of Goods
Sold
Receivables
Debtors * 365/
Ratio
Sales
(in days)
Payables
Ratio
(in days)
Creditors * 365/
Cost of Sales
(or Purchases)
Result
Interpretation
On average, you turn over the value of your
entire stock every x days. You may need to
break this down into product groups for
= x effective stock management.
days Obsolete stock, slow moving lines will extend
overall stock turnover days. Faster
production, fewer product lines, just in time
ordering will reduce average days.
It take you on average x days to collect
monies due to you. If your official credit
terms are 45 day and it takes you 65 days...
=x
why ?
days
One or more large or slow debts can drag out
the average days. Effective debtor
management will minimize the days.
On average, you pay your suppliers every x
days. If you negotiate better credit terms this
will increase. If you pay earlier, say, to get a
discount this will decline. If you simply defer
= x paying your suppliers (without agreement)
days this will also increase - but your reputation,
the quality of service and any flexibility
provided by your suppliers may suffer.
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Current
Ratio
Total Current
Assets/
Total Current
Liabilities
(Total Current
Assets Quick Ratio Inventory)/
Total Current
Liabilities
(Inventory +
Working
Receivables Capital
Payables)/
Ratio
Sales
Current Assets are assets that you can readily
turn in to cash or will do so within 12 months
in the course of business. Current Liabilities
are amount you are due to pay within the
coming 12 months. For example, 1.5 times
=x
means that you should be able to lay your
times
hands on Rs.1.50 for every Rs.1.00 you owe.
Less than 1 times e.g. 0.75 means that you
could have liquidity problems and be under
pressure to generate sufficient cash to meet
oncoming demands.
Similar to the Current Ratio but takes account
=x
of the fact that it may take time to convert
times
inventory into cash.
As % A high percentage means that working capital
Sales needs are high relative to your sales.
Other working capital measures include the following:
Bad debts expressed as a percentage of sales.
Cost of bank loans, lines of credit, invoice discounting etc.
Debtor concentration - degree of dependency on a limited number of
customers.
Once ratios have been established for your business, it is important to track them over
time and to compare them with ratios for other comparable businesses or industry sectors.
Activity 3
1. Discuss the need and relevance of fund flow statements. What is the T form fund
flow statement? Explain with the help of suitable example.
2. Describe why consolidated financial statements are prepared. What are the main
features of consolidated balance sheet?
3. Explain various techniques of working capital projections. What are various
factors to be considered while projecting these requirements?
4. Discuss various ratios to be considered in working capital projections and
estimations.
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3.6 SUMMARY
Analysis of financial statements and their preparation is the crucial task of finance
managers of firms. This unit discusses analysis of various financial statements. First unit
introduces the analysis of fund flows in the organisation. The fund flow statement reports
the flow of funds through the firm during the year. In order to prepare fund flow
statement proper understanding of working capital and sources and applications is
necessary. Second area of discussion was the process of preparing fund flow statements
which was explained with help of most suitable illustrations. Comparative financial
statements were focused in the next section including comparative income statement and
balance sheet. Further, projection of working capital requirements was described and
various techniques were discussed including relevant ratios and calculations.
3.7 FURTHER READINGS

Smith. Keith V and George W. Gallinger. Readings on short term financial
management. 3rd edition West Publishing company 1988

Peter Atrill and Eddie McLaney, "Accounting and Finance for Non-Specialists"
(Prentice Hall, 1997)

Leopold Bernstein, John Wild, "Analysis of Financial Statements" (McGraw-Hill,
2000)

Daniel L. Jensen, "Advanced Accounting" (McGraw-Hill College Publishing,
1997)
SOLUTIONS TO THE ACTIVITIES
Activity 2
Solution 3
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1. Current ratio = 1.7
2. Acid test or quick ratio = 1.1
3. Debt to equity ratio = 1.2
4. Asset turnover = .38%
5. Return on assets = 2.5%
6. Return on Equity (ROE)= 5.5%
Solution 4
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