Unit 2: Financial management - Subjective Questions

Business funds refer to the money or financial resources required to establish, operate, and expand a business.

Sources of business funds

1. Internal sources

• Owner's capital: Money contributed by the entrepreneur or partners.
• Retained earnings: Profits retained in the business rather than distributed to owners.
• Sale of assets: Funds generated by selling obsolete or surplus assets.
• Better working-capital management: Faster collection from debtors and reduction of unnecessary inventory can release funds.

2. External sources

• Equity shares: Capital raised by issuing ownership shares.
• Preference shares: Shares carrying a preferential right to dividend and repayment of capital.
• Debentures or bonds: Long-term borrowed funds carrying a fixed rate of interest.
• Bank loans: Short-term or long-term loans obtained from banks.
• Trade credit: Credit allowed by suppliers for purchasing goods or materials.
• Government assistance: Subsidies, grants, seed capital, and concessional loans provided under entrepreneurship schemes.
• Venture capital and angel investment: Investment provided to enterprises with high growth potential.

An entrepreneur should select a source after considering its cost, risk, repayment period, control implications, and purpose.

Fixed capital and working capital can be distinguished as follows:

Thus, fixed capital creates business capacity, whereas working capital keeps that capacity functioning.

The fixed-capital requirement of an enterprise depends on the following factors:

• Nature of business: Manufacturing enterprises generally require more fixed capital than trading or service enterprises.
• Scale of operations: Large-scale businesses need larger premises, machinery, and infrastructure.
• Choice of technology: Capital-intensive technology requires more investment than labour-intensive technology.
• Type of production: Continuous and automated production usually involves a higher investment in machinery.
• Growth plans: Enterprises planning expansion, diversification, or modernization require additional fixed assets.
• Purchase or lease decision: Leasing assets reduces the immediate requirement for fixed capital.
• Availability of second-hand assets: Purchasing reliable used equipment may reduce initial investment.
• Government policy: Tax incentives, subsidies, environmental rules, and licensing requirements can affect asset investment.
• Location: Land, construction, transport, and utility costs differ across locations.
• Degree of collaboration: Outsourcing production or sharing facilities may reduce the need for fixed assets.

Fixed-capital planning should avoid both underinvestment, which limits capacity, and overinvestment, which locks money into idle assets.

Working capital represents the funds required for routine business operations. It may be expressed as:

Gross working capital means total investment in current assets, while net working capital is the excess of current assets over current liabilities.

Operating cycle

The operating cycle is the time taken to convert cash into inventory, inventory into sales, and receivables back into cash:

Cash → Raw materials → Work-in-progress → Finished goods → Sales → Debtors → Cash

A longer operating cycle generally creates a greater working-capital requirement.

Factors affecting working capital

• Nature and size of business
• Length of the production process
• Inventory-holding period
• Credit given to customers
• Credit received from suppliers
• Seasonal fluctuations in demand
• Growth and expansion plans
• Efficiency of inventory and receivables management
• Inflation and changes in input prices
• Availability of bank credit

Estimation approach

An approximate requirement may be calculated as:

A safety margin should be maintained for unexpected expenses, but excessive working capital should be avoided because it reduces profitability.

Business costs may be classified in several ways:

1. By element

• Material cost: Cost of raw materials and components.
• Labour cost: Wages and salaries paid to employees.
• Expenses: Other costs such as rent, power, insurance, and transport.

2. By traceability

• Direct costs: Costs directly identifiable with a product, such as direct materials and direct wages.
• Indirect costs: Common costs that cannot be conveniently traced to one product, such as factory rent.

3. By behaviour

• Fixed costs: Remain constant within a relevant range, such as monthly rent.
• Variable costs: Change with output, such as raw-material cost.
• Semi-variable costs: Contain fixed and variable components, such as certain electricity charges.

4. By function

• Production, administration, selling, and distribution costs.

Importance

Cost classification helps management to:

• Prepare budgets and cost sheets.
• Fix appropriate selling prices.
• Control waste and inefficiency.
• Calculate contribution and break-even output.
• Make decisions regarding outsourcing, product mix, and expansion.
• Compare actual costs with planned costs.

A cost sheet is a statement showing the total cost and cost per unit of producing and selling a product during a specified period.

Stages of cost calculation

1. Prime cost

2. Factory or works cost

3. Cost of production

4. Cost of goods sold

5. Cost of sales

6. Sales and profit

The cost per unit is:

A cost sheet helps in cost control, price determination, comparison across periods, tender preparation, and profit planning.

Principal pricing methods

• Cost-plus pricing: A desired profit margin is added to total cost.
  
• Markup pricing: Price is fixed by adding a percentage markup, usually to purchase cost.
• Target-return pricing: Price is set to earn a predetermined return on investment.
• Competition-based pricing: Price is based on competitors' prices.
• Value-based pricing: Price is based on the value perceived by customers rather than only on cost.
• Penetration pricing: A low introductory price is used to gain market share.
• Skimming pricing: A high initial price is charged for an innovative or differentiated product.
• Marginal-cost pricing: Decisions are based mainly on variable or incremental cost, generally for special orders or spare capacity.

Internal factors

• Production and operating costs
• Desired profit and return on investment
• Product quality and brand position
• Business objectives and available capacity
• Stage of the product life cycle

External factors

• Customer demand and purchasing power
• Competitors' prices and market structure
• Taxes and government regulation
• Distribution-channel margins
• Economic conditions and inflation
• Availability of substitutes

No single method is suitable in every situation. A sound price should cover relevant costs, provide a reasonable return, remain acceptable to customers, and support the firm's long-term strategy.

Break-even analysis identifies the level of sales at which total revenue equals total cost, resulting in neither profit nor loss.

Let:

• = total fixed cost
• = selling price per unit
• = variable cost per unit
• = contribution per unit

Contribution per unit is:

At break-even point:

Therefore:

The profit-volume ratio is:

Thus:

The margin of safety is:

Uses

• Determining minimum required sales
• Estimating profit at different output levels
• Evaluating price or cost changes
• Measuring operating risk
• Supporting capacity and product decisions

Limitations

• Assumes constant selling price and variable cost.
• Assumes fixed costs remain unchanged within the relevant range.
• May assume that all units produced are sold.
• Becomes difficult for a multi-product enterprise with a changing sales mix.
• Ignores uncertainty and qualitative factors.

The two forms of planning are interdependent. Long-term investment decisions create short-term cash requirements, while effective short-term planning supports the implementation of long-term plans.

An integrated financial plan connects the entrepreneur's objectives, investment requirements, financing choices, operations, and expected financial results.

Steps in preparation

1. Define objectives: Specify targets relating to sales, market share, capacity, profit, and growth.
2. Forecast sales: Estimate expected units, selling prices, seasonal variations, and credit sales.
3. Prepare the production or service plan: Determine capacity, materials, labour, and operating resources required.
4. Estimate fixed-capital needs: Calculate investment in land, building, machinery, technology, furniture, and vehicles.
5. Estimate working-capital needs: Forecast inventory, receivables, cash, and current liabilities.
6. Prepare operating budgets: Develop purchase, labour, overhead, selling, and administration budgets.
7. Prepare a cash budget: Estimate cash inflows, outflows, surpluses, and shortages period by period.
8. Select financing sources: Decide the appropriate mix of owner's funds, equity, term loans, and short-term credit.
9. Prepare projected statements: Develop projected income statements, balance sheets, and cash-flow statements.
10. Evaluate feasibility: Examine profitability, liquidity, solvency, break-even point, and debt-servicing capacity.
11. Conduct sensitivity analysis: Test the effects of lower sales, higher costs, delayed collections, or increased interest rates.
12. Monitor and revise: Compare actual performance with budgets and take corrective action.

The final plan must balance profitability, liquidity, risk, cost of finance, and control of the enterprise.

Book keeping is the systematic and chronological recording of financial transactions in the books of an enterprise, supported by relevant documents.

Objectives

• To maintain a complete and permanent record of transactions.
• To classify transactions under appropriate accounts.
• To determine amounts receivable from customers and payable to suppliers.
• To provide information for preparing financial statements.
• To support taxation, auditing, and legal compliance.

Advantages

• Provides reliable information about business transactions.
• Helps determine profit or loss and financial position.
• Facilitates comparison between periods.
• Assists in detecting errors and discouraging fraud.
• Supplies evidence in legal and tax matters.
• Supports planning, control, and decision-making.

Limitations

• It records mainly transactions measurable in money.
• Historical records do not automatically predict future performance.
• Incorrect classification or valuation can mislead users.
• Book keeping alone does not interpret financial results.
• Records may still be manipulated if internal controls are weak.

Book keeping is therefore the recording foundation of accounting, while accounting additionally includes summarizing, analysing, interpreting, and communicating financial information.

Under the double-entry system, every transaction affects at least two accounts, and the total amount debited must equal the total amount credited.

The system is based on the accounting equation:

Modern rules of debit and credit

• Assets: Increase by debit and decrease by credit.
• Liabilities: Increase by credit and decrease by debit.
• Capital: Increase by credit and decrease by debit.
• Revenue: Increase by credit.
• Expenses and losses: Increase by debit.
• Drawings: Increase by debit because they reduce capital.

Example

If an owner introduces cash of ₹100,000:

• Cash, an asset, increases and is debited.
• Capital increases and is credited.

Entry:

• Cash A/c Dr. ₹100,000
• To Capital A/c ₹100,000

The accounting equation remains balanced because both assets and owner's equity increase by the same amount. Double entry supports the preparation of a trial balance and improves the completeness and accuracy of records.

The journal is the book of original entry in which transactions are recorded chronologically.

Journal entries

Explanation

• Capital introduced increases both cash and owner's equity.
• Goods purchased for resale are debited to Purchases under the periodic inventory system.
• Furniture is an asset, not a purchase of trading goods.
• The sale records revenue of ₹45,000. Under a perpetual inventory system, a second entry records the cost of ₹30,000.
• Rent is an expense and is therefore debited.

Each entry satisfies the principle that total debit equals total credit.

A ledger is the principal book containing separate accounts for assets, liabilities, capital, revenue, expenses, and personal accounts. It classifies the chronological information recorded in the journal.

Posting process

• Identify the account debited in the journal.
• Enter the amount on the debit side of that ledger account with a reference to the credited account.
• Identify the account credited in the journal.
• Enter the amount on the credit side of that ledger account with a reference to the debited account.
• Record the date and journal folio or reference.
• At the end of the period, total and balance each account.
• Carry forward closing balances where necessary.

Trial balance

A trial balance is a statement listing the debit and credit balances of all ledger accounts on a particular date.

Purposes

• Tests the arithmetic equality of debits and credits.
• Summarizes ledger balances.
• Assists in preparing financial statements.
• Helps locate some posting and totaling errors.

Limitations

A balanced trial balance does not prove complete accuracy. It may not reveal:

• Complete omission of a transaction
• Recording in the wrong account of the same category
• Errors of principle
• Compensating errors
• Recording an incorrect amount on both sides

Thus, the trial balance is an important checking device, but it is not conclusive evidence that the accounts are error-free.

Subsidiary books are special books of original entry used to record large numbers of transactions of a similar nature. They reduce the burden on the general journal.

Principal types

• Purchases book: Credit purchases of goods meant for resale.
• Sales book: Credit sales of goods dealt in by the business.
• Purchases returns book: Goods returned to credit suppliers.
• Sales returns book: Goods returned by credit customers.
• Cash book: Cash and bank receipts and payments.
• Bills receivable book: Bills received from debtors.
• Bills payable book: Bills accepted in favour of creditors.
• Petty cash book: Small routine payments such as postage and local travel.
• Journal proper: Entries not recorded in another subsidiary book, such as opening, closing, adjustment, transfer, and rectification entries.

Advantages

• Promotes division of work and specialization.
• Saves time and permits simultaneous recording.
• Makes posting more efficient.
• Improves internal control and accountability.
• Facilitates detection of errors.
• Provides transaction-wise information for management.

Subsidiary books are especially useful when an enterprise has a high volume of repetitive transactions.

The transactions should be recorded as follows:

Important distinction

The purchases and sales books record only credit transactions involving trading goods. They do not record:

• Cash purchases or cash sales
• Purchase or sale of fixed assets
• Services purchased or provided

Correct classification simplifies ledger posting and reduces accounting errors.

Annual financial statements present the financial performance, position, and cash movements of an enterprise for an accounting year.

Main components

1. Trading account or cost-of-goods-sold section

• Determines gross profit or gross loss.
• Compares net sales with the cost of goods sold.

2. Statement of profit and loss

• Records revenues, operating expenses, finance costs, taxes, and other items.
• Determines net profit or net loss.

3. Balance sheet

• Reports assets, liabilities, and owner's equity on the reporting date.
• Reflects the equation:

4. Cash-flow statement

• Classifies cash flows into operating, investing, and financing activities.

5. Notes to accounts

• Explain accounting policies, classifications, commitments, contingencies, and supporting details.

Relationship among statements

• Net profit from the profit and loss statement increases retained earnings or capital in the balance sheet.
• Closing cash in the cash-flow statement agrees with cash and cash equivalents in the balance sheet.
• Purchase and sale of fixed assets affect both the balance sheet and investing cash flows.
• Borrowings affect liabilities, finance cost, and financing cash flows.

Together, the statements help users evaluate profitability, liquidity, solvency, cash generation, and stewardship of resources.

Step 1: Calculate net sales

Step 2: Calculate net purchases

Step 3: Calculate cost of goods sold

Step 4: Calculate gross profit

Step 5: Calculate net profit

Operating expenses:

Other income is commission received of ₹8,000.

Therefore:

• Gross profit = ₹195,000
• Net profit = ₹139,000

Financial ratios convert accounting figures into relationships that help assess performance and financial position.

Liquidity ratios

Current ratio

It measures the ability to meet short-term obligations. A very low ratio may indicate liquidity difficulty, while an excessively high ratio may indicate idle current assets.

Quick ratio

It provides a stricter test because inventory and prepaid expenses are excluded.

Solvency ratio

Debt-equity ratio

A high ratio indicates greater financial leverage and fixed repayment risk.

Profitability ratios

Gross profit ratio

It reflects production, purchasing, and pricing efficiency.

Net profit ratio

It measures overall profitability after expenses.

Return on capital employed

It evaluates how efficiently long-term funds are used.

Ratios should be compared with past periods, budgets, competitors, and industry norms. No ratio should be interpreted in isolation because accounting policies, seasonality, inflation, and one-time events can affect the results.

Taxation is the compulsory levy imposed by government on income, profits, property, goods, services, or transactions to finance public expenditure and achieve economic and social objectives.

Objectives of taxation

• Raise revenue for public services and infrastructure.
• Redistribute income and reduce economic inequality.
• Influence consumption, saving, and investment.
• Discourage harmful goods or activities.
• Promote selected industries or regions through incentives.
• Support economic stability and development.

Direct and indirect taxes

Responsibilities of an entrepreneur

• Obtain the required tax registrations and identification numbers.
• Maintain invoices, accounts, payroll records, and supporting documents.
• Determine taxable income according to applicable law.
• Collect indirect tax where required and issue valid tax invoices.
• Deposit tax within prescribed time limits.
• Deduct and remit withholding or payroll taxes where applicable.
• File accurate periodic and annual returns.
• Claim deductions and input-tax credits only when legally supported.
• Preserve records for the statutory period.
• Cooperate with assessment, audit, and verification procedures.

Tax rules differ by jurisdiction and may change over time. Entrepreneurs should therefore follow current law and obtain professional advice when necessary. Tax planning means arranging transactions lawfully to use available benefits, whereas tax evasion is illegal concealment or misrepresentation.