TEFI Distance Learning Program BUSINESS FINANCE - 1 BUSINESS FINANCE - 1 Prof. R. Balachandran
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1. TEFI Distance Learning Program BUSINESS FINANCE - 1 BUSINESS
FINANCE - 1 Prof. R. Balachandran
2. ChapterNo.1 FinancialAccounting&AccountsFunction
Contents ObjectivesofFinancialAccountingandAccountsFunction
Financial Accounting Process Steps involved till final accounts
Differences among proprietorship firm, partnership firm and a
limited company in terms of FinancialAccounting
Differentfinancialstatementsandtheirpurposesinbusiness Figures What
they mean to a business, Understanding financial statements for
decision-makinginbusiness Financial Accounting as different from
Management Accounting and Cost Accounting Formats of Financial
statements for business Profit & Loss statement, Balance
Sheet,CashflowstatementandFundsflowstatement
Attheendofthechapterthestudentwillbeableto: Understand the
Financial Accounting process and prepare simple statements of
Profit & Loss & Balance Sheet Map the differences between
Accounts and Finance functions in an enterprise Understand numbers
contained in financial statements in the context of
business&usethemindecisionmakinginbusiness
Prepareothertwofinancialstatements,CashflowandFundsflow Map the
differences among Financial Accounting, Management Accounting
andCostAccounting TEFI Distance Learning ProgramTEFI Distance
Learning Program 32 FINANCIAL ACCOUNTING & ACCOUNTS FUNCTION
BUSINESS FINANCE - 1
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Introduction Financial Accounting is done on the basis of certain
Accounting Principles thatareuniversalinnature It is based on a
specific accounting system and has to follow certain basic rules
thatareagainuniversalinnature It also involves specific standards
called Accounting standards and practices called Generally Accepted
Accounting Practices (GAAP), which are different from country to
country. Indian Accounting standards are known as AS and Generally
Accepted Accounting Practices are known as GAAP, India At present,
readily available application software has simplified maintenance
of financial accounts and generation of required financial
statements Why Financial Accounting Running a business, as we may
recall, involves financially, certain amount of money coming in and
certain amount of money going out. The money coming in could be
from the owners of the business enterprise, loans from banks and
others or due to the operations of the business enterprise.
Similarly, the money going out could be for purchasing of assets
required by the business or for meeting expenses of the business
enterprise or for paying off loans earlier taken. Whatever be the
purpose of money coming in and money going out, these financial
transactions are required to be recorded on a day-to-day basis so
that atanygiventime,theownerswillbeinapositiontoknow: How much
money has come into the business and what the source of this money
is How much money has gone out of business and the purposes for
which the moneyhasbeenspent This is called Financial Accounting. In
short, Financial Accounting faithfully records all the transactions
in a business enterprise that involve money and these transactions
are referred to as Financial or Accounting transactions. Let us
examine the following examples to understand the
purposeofFinancialAccounting. Exampleno.1
IhavepurchasedgoodsforsaleworthRs.20,000/-againstcash I need to
record the details to know the value of goods purchased by me and
against what like cash or credit and in case it is a credit
transaction, from whom as I will be required to pay the supplier
later, what is the quantum of goods purchased so that I can know
any given time how much unsold items I have on hand (called stocks)
Similarly I have taken a loan of Rs. 1,00,000/- from a bank to run
my business. I need to record the details to know who has given me
money so that I can 54 return the same to the lender as and when
required and as stipulated at the time oftakingtheloan. Another
example I am selling goods worth Rs.50,000/- on credit. The buyer
is going to pay me after some time. I need to record the details to
know who my customer to whom I have sold goods on credit is, so
that I can follow-up for getting the payment. If we carefully go
through the above examples, we will notice that Financial
Accounting transactions could involve: Cash or credit (the manner
of payment, now or later respectively) Income or Expense (revenue
coming in due to sale of goods or services and revenue going out
due to purchase of goods or services respectively) Asset (what the
business enterprise owns, purchased out of capital, owners'
contribution and/or loans from others) and Liability (what the
business enterprise owes to an outsider who has given it financial
resourcesforpurchaseofassets)
ThustheobjectiveofFinancialAccountingis: To know the financial
position of the business enterprise in terms of: How much revenue
has come in (Income) and how much revenue has gone out (Expense) At
the end of a given period, say one year, whether the business is in
profit (Income > Expenses and difference between Income &
Expenses) or Loss (Expense > Income and difference between
Expense & Income) What the sources of money coming into the
business enterprise (Liabilities) are and where they have been used
(Assets) How much money did the owners bring into the business
enterprise at the beginning and what its current value is (owners'
funds original investment as enhanced by profits
retainedinthebusiness)
Relatedtermsinconnectionwiththeaboveobjectiveare:
Accountingprinciples These are common for the entire globe. For
example, the owner of the business enterprise and the business
enterprise are different from each other from Accounting angle.
Proof of this principle the owner's contribution called capital to
the business enterprise is reflected as Liability in the Accounts
of the enterprise, while the owner accounts for it as an Asset as
it is an investment. FINANCIAL ACCOUNTING & ACCOUNTS FUNCTION
BUSINESS FINANCE - 1
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AccountingRules&Regulations These are again common for the
entire globe. These rules and regulations essentially tell us which
account is to be credited or which account is to be debited. For
example I sell goods against cash Goods account is credited and
cash account is debited is an Accounting Transaction. Accounting
system Cash system that can be followed by a proprietorship firm or
partnership firm this follows cash coming in or going out for
accounting for an item of income (that could result cash coming in)
or expense (that could result cash going out). This system does not
consider credit transactions. Hence accounting is not done of
outstanding transactions. There is noreceivableorpayableinthiscase
Accountingstandards (AS) Given by the Institute of Chartered
Accountants ofIndia (ICAI)alongwithGenerally AcceptedAccounting
Practices (GAAP), India.Operating income (coming from the main
operationsofthe enterprise like trading, manufacturing or services)
and non- operating income (coming from investments made outside the
business in some other business could be share capital or debt
instrumentslikedebenture,bondetc.) Accountingperiod This would
depend upon the country in which the business enterprise operates.
For instance in India, the accounting st st period is from 1 April
to 31 March this is also called Uniform Accounting Period (as all
kinds of business organizations like Proprietorship firm or
Partnership firm or Limited company have to follow this uniformly
in India) or Financial Year Profit and Loss statement Statement
prepared at the end of the Accounting period as above showing the
summary of all income items and expense items besides the result of
performance, namely Profit or Loss fortheperiod. BalanceSheet
Statement of Assets and Liabilities as at the end of the Accounting
period as above, i.e., the sources of funds (term indicating money)
Liabilities and uses of funds Assets Other Accounting Terms have
been explained in the Chapter GlossaryofTerms Fund This represents
financial resource taken or given by the business enterprise
depending upon whether money comes in or goes out. This is a macro
term and includes both cash and credit. For example, a supplier
giving goods on credit does not give cash but gives goods that are
worth certain specified value. The above information will be useful
to the following users of financialstatements:
OwnersoftheBusinessEnterprise
LenderswhohavegivenmoneytotheBusinessEnterprise Other stakeholders
of the Business Enterprise like employees,suppliersetc. Government
agencies like Income Tax authorities and others who are interested
in investing in the business enterprise in
Sharecapitalorloan,likedebentureorbond
FunctionsofAccountsDepartmentthatdoesFinancialAccounting 1.
Maintenance of Accounts strictly in accordance with the Accounting
Principles, following Accounting Rules as per prescribed Accounting
system and observing Accounting standards as well GAAP depending
upon the country of operations. 2. Control over amounts receivable,
amounts payable, bank accounts, cash on hand etc. 3. Preparation of
budgets, both revenue and capital, with the objectives of
allocation of resources, control and monitoring of expenses 4.
Compliance with payment of Advance Tax as per the Rules and
Regulations in this behalf 5. Effective Tax planning thorough
understanding of Income Tax Rules and Regulations with a view to
minimize tax payable by the enterprise 6. Maintenance of Financial
Management Information System (popularly known as MIS) that is a
review of performance of key financial parameters vis--vis the
estimates this is an important tool in taking corrective action in
time and hence forms an integral part of decision-makingprocess 7.
Being responsible for the process of Audits of various kinds
Internal Audit, Statutory Audit, Tax Audit etc. 6 7 FINANCIAL
ACCOUNTING & ACCOUNTS FUNCTION BUSINESS FINANCE - 1
5. Differences among proprietorship and partnership firms on
one hand and limited companies on the other hand in respect of
Financial Accounting process/system Parameter Sale proprietorship
Parternship Limited Firms Firms Companies TEFI Distance Learning
ProgramTEFI Distance Learning Program Accounting Process 8 9
Financial transaction takes place in the Enterprise it could be
cash or on credit if it is Cash, it could result in cash inflow or
outflow Decide on which Account To be debited or credited In
accordance with Accounting principles, the Relevant Rules &
Regulations & prescribed Accounting system Transactions are
maintained in ledgers Creditors, debtors etc. and Registers Sales,
Purchases etc. on individual transaction basis Transactions are
consolidated in a control book of accounts named General Ledger
this contains a single consolidated account for each item of
income, expense, asset and liability example, one account for
operating income, one debtors account, one creditors account etc.
Verification step whether the sum of all credits is equal to sum of
all debits as it should be in case the business enterprise is
following double-entry book-keeping system also known as Accrual
Accounting System This is done by extracting all the balances of
General Ledger in a statement known as Trial Balances. In this
statement, the income and liabilities will appear under Credit side
while assets and expenses will appear under Debit side. This
statement will however disclose errors of some types like wrong
head of accounting, error of omission or commission on both the
sides to the same extent. Example customer debited for credit sale
by Rs.10,000/- more and sales also credited by Rs.10,000/- more.
Process of rectification of errors pointed out by the Trial Balance
statement. Further where the errors are not shown by the Trial
Balance, the process of reconciliation is initiated especially in
the case of creditors, debtors and bank accounts. This is done by
asking for statements of our accounts with them so that we can go
through entry by entry and verify whether the entries are correct
or not. If there is a mistake correction is carried out Closing
entries are then made depreciation on fixed assets, provision for
bad and doubtful debts, provision for outstanding expenses,
outstanding income, adjustment for pre-paid expenses and income
received in advance etc. are made before preparation of final
financial statements for the accounting year, namely Profit &
Loss statement & Balance Sheet Profit & Loss statement and
Balance sheet are prepared in the case of proprietorship firms and
partnership firms, the two statements can be prepared in any format
whereas in the case of limited companies, the business enterprise
has to prepare in accordance with the formats provided for in
Schedule VI of The Companies Act FINANCIAL ACCOUNTING &
ACCOUNTS FUNCTION BUSINESS FINANCE - 1 Step no. 1 Accounting
transaction analysis and deciding which Account to be debited and
which account to be credited Step no. 2 Entering the various
transactions in the basic books of Accounts Registers and ledgers
excluding General Ledger Stepno.3
Postingtheconsolidatedfigureseachaccount-wiseinthe
ControlbookcalledGeneralLedger Stepno.4
Verificationofthedouble-entrybookkeepingprocessthrough TrialBalance
Stepno.5 RectificationoferrorspointedoutbyTrialBalance Step no. 6
Closing and adjustment entries at the end of the Accounting period
Step no. 7 Preparation of Profit & Loss Statement and Balance
Sheet as per prescribed formats in the case of limited companies as
per Schedule VI of the Companies' Act No compulsion. The firm can
choose either of them but once decided, will have to stick with it
If cash system is adopted, credit transactions will be ignored No
specific formats Trading and Profit & Loss Accounts Transferred
to the capital of the owner thereby increasing the investment of
the owner in the firm No compulsion under the partnership Act. The
firm can choose either of them but once decided, will have to stick
with it If cash system is adopted, credit transaction will be
ignored No specific formats Trading and Profit & Loss Accounts
Transferred to the capital accounts of the owners thereby
increasing their investment in the firm in accordance with the
basis of Profit shearing in the partnership Deed Under the
provision of The Companies Act. it is compulsory to adopt the
Accrual basis of Accounting. No choice The enterprise has to
account for both cash and credit transactions Specific formats as
per Schedule VI of the Companies Act. Profit & Loss and Profit
& loss Appropriation Account Transferred to Reserves &
surplus as share capital of the owners cannot be altered by
retained profits in business Accounting system Accrual or cash Cash
transaction and credit transactions Final audited statements
presentation in specific formats Componants of P & L Statement
Retained profit in business (Profit after Tax as reduced by profit
with drawn from business or distributed in the form of
dividend)
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Difference between finance function and accounts function Finance
and accounts functions may be integrated in an organisation. This
means that one department handles both. In most of the small and
medium size units in India, the functions will be integrated. A
business enterprise will require a full-fledged finance department
only when the functions listed above are predominant functions
impacting business in a big way. If the finance functions are not
predominant functions, Accounts department looks after Finance
also. Constant requirement of funds, surplus for investment etc,
could be some of the factors influencing the need for a
full-fledged Finance department. Different financial statements in
a business enterprise and their purposes understanding the meaning
of the figures contained in the financial statements Statement no.
1 Profit&Lossstatement Denotes profit or loss for the
enterprise for the year. Usually prepared for a year that is
referred to as Financial year. This is also called Uniform
Accounting Period. Can be prepared on a monthly basis too. The
result will not be accurate as some of the figures like
depreciation will be more accurate only on an annual basis. The
same thing goes for provision for outstanding income or expenses
too. Profit and Loss statement indicates the financial
performanceoftheyearjustgoneby. 10 Pointers in Profit & Loss
statement: 1. Whether the business earns operating profit? That is
operating income (-) operating expenses (operations being trading,
manufacturing or services) and this excludes income from investment
made in some other enterprise or other activity not connected with
the main operations of the enterprise. Example, sale of fixed
asset, rent income, sale of scrap generated during the process of
manufacturing. 2. Is it that the business is in profit only due to
non-operating income as described above? If it is so, it means that
the main operations of the enterprise are in loss and the firm is
able to keep its head above waters only due to profit coming
fromotherthanmainoperations. 3. How do operating expenses behave?
Are they increasing in proportion to the increase in revenue or
disproportionately to the increase in revenue? If they increase
disproportionately, it means that stricter control over expenses is
indicated. 4. In case operating expenses have gone up, which group
of operating expenses gone up? Is it manufacturing/operations or
administrative or selling/marketing or finance expense that is
going up disproportionately? What is the level of closing stock in
the Profit and Loss statement? Has the level gone up
disproportionately to the increase in revenue? This is important,
as increase in levels of inventory is going to involve carrying
cost like return on investment made in it and this will surely
reduce the profits of the enterprise. The above list is only
suggestive and not exhaustive Statement no. 2Balance Sheet Denotes
position of Assets and Liabilities as on a particular date. It is
useful for a business enterprise for knowing the sources of funds
for the business enterprise and their uses. Further, any user of
this statement will come to know how the original investment in
share capital by the owners has grown due to profits retained in
business, also known as Reserves & Surplus, especially in the
case of a reputed company. In short, capital shareholders' funds =
Total assets (-) External funds invested in business, both
short-term (not exceeding 12 months duration) and term liabilities
(exceeding 12 months duration). This usually indicates the
financial performance of the past including the year just gone by.
Example no. 2: Suppose the sum total of all assets = Rs. 120 lacs
and the external funds invested in business = Rs. 80 lacs. The
shareholders' funds are = Rs. 120 lacs 11 Financial Accounting
Functions Corresponding Finance Functions Maintenance of Accounts
strict compliance with statutory provisions as per ICAI guidelines,
Accounting Standards, GAAP (India) provisions, Income Tax Act
provisions etc. Financial planning and Resources mobilization.
Adequate resources in time and in a cost-effective way. More of
market orientation than statute-orientation Responsible for budgets
both revenue and capital Cash management stand-by arrangements,
both in case of excess and deficit Tax compliance and tax planning
besides audit Responsible for treasury management largely,
liquidity management, risk management and investment management
Management Information System & Reports for Finance Strategic
Financial Management initiatives like expansion, diversification
etc. FINANCIAL ACCOUNTING & ACCOUNTS FUNCTION BUSINESS FINANCE
- 1
7. under review. Pointers in the Cash flow statement 1. Has the
month just gone by generated any surplus of cash or has it resulted
in deficit? 2. If there is a surplus, how to utilize the same and
if there is a deficit,
whatisthealternativesourcethatcangivecashtofillthegap? 3. Whether
the cash flow statement is useful to the business enterprise as a
tool in financial planning? This can happen only if the estimate is
realistic and the actual at the end of the month does not differ
fromtheestimatebyawidemargin Statementno.4Fundsflowstatement
Denotes movement of funds (please refer to fund under terms at the
beginning) during a period under review. Generation of funds and
its use can be explained in terms of assets and liabilities in
simple terms as under: Inliabilitiesor inassets =Sourceoffunds
Inliabilitiesor inassets =Use of funds From the above, the reader
can understand the linkage between Funds flow statement and the
balance sheet of the enterprise. Usually this period is one year.
Funds flow statement can be prepared on an Estimation or Actuals
basis this entirely depends upon the purpose for which funds flow
statement is being prepared. If it is for Financial Planning and
Resources Mobilization, it is done on Estimation basis say for the
next one to two years; on the other hand, if it is prepared for
review purposes, it is done on Actuals basis. Having seen that this
statement is closely linked to balance sheet, let us see the
difference between the two statements. While funds flow statement
tells you about the movement of funds (proposed or actual), balance
sheet gives the impact on Assets and Liabilities due to movement of
funds during a given period. Funds are divided into Resources
(funds coming into business) and Uses (funds going out of
business). Resources are presented in three broad heads
whileusesarepresentedintwobroadheadsasunder: Resources: Long-term
accruals from business = Funds generated from operations Long-term
funds (external) = Fresh capital coming into business like share
capital or loans + sale of fixed assets + sale of investment etc.
Short-term funds (external) = Fresh short-term borrowing from banks
for working capital + any increase in other short-term funds like
TEFI Distance Learning ProgramTEFI Distance Learning Program12 13
(-) Rs. 80 lacs = Rs. 40 lacs. Suppose the starting point for this
business enterprise is Rs. 20 lacs from the owners towards capital,
this means that at present the original investment of Rs. 20 lacs
has grown to Rs. 40 lacs over a period of time. Pointers in the
balance sheet: 1. What is the level of funds employed in business?
Is it increasing disproportionately to the level of revenue? 2.
What is the relationship between owners' contribution and borrowed
funds? Is it in line with what the lenders usually accept
1.5:1to2:1(excludingshort-termliabilities) 3. Will the enterprise
be able to meet the short-term liabilities from its
short-termassets? 4. Whether the Return on Investment (ROI) for the
business is coming down or going up? This is a combination of
P&L and Balance sheet. Funds employed in business are known
from the balance sheet while the earnings are known from the Profit
and Loss statement. 5. Whether the capacity of the business
enterprise to pay interest and repay loan installments is
satisfactory? This is again a combination of Profit & Loss
statement for earnings and Balance sheet for the repaymentliability
Statementno.3 Cashflowstatement Denotes the position of cash inflow
and cash outflow for a particular period. The period is usually one
month, but can be more frequently done. This is useful to a
business enterprise from the point of view of control and
monitoring the amount of cash available in business, also known as
liquidity. This information is required both for planning, i.e.,
arranging for back up, in case the available cash is less than
required and control, in case the available cash is more than
required. The business enterprise cannot afford to keep more cash
than required, as idle cash does not earn any return and it is
better to save interest by putting the excess cash back into
overdraft etc. The loss incurred by keeping more cash than required
is often referred to as opportunitycost. Exampleno.3: My enterprise
requires Rs.10lacs on an average by way of cash. Suppose my
projected receipts for December 2004 are Rs.250lacs and projected
outflows are Rs.260lacs with opening balance of Rs.10lacs. This
will result in my closingbalanceofcashofRs.20lacs. This is far in
excess of my requirement of Rs.10lacs. What do I do with this
excess cash? I put it back into my bank account so that I can save
some interest especially if my bank account is overdraft like
account in which case, I pay interest on the amount used by me.
Once I prepare the cash flow statement, I compare it with the
actual position at the end of the month so that I can verify as to
how far I have been good in projecting my cash position for the
month FINANCIAL ACCOUNTING & ACCOUNTS FUNCTION BUSINESS FINANCE
- 1
8. TEFI Distance Learning ProgramTEFI Distance Learning
Program14 15 Uses: Long-term uses = Fresh purchase of fixed assets
+ fresh investment made by the business + repayment of loans or
redemption of bonds/debentures etc. Short-term uses = Fresh
purchase of inventory + any increase in level of receivables or any
other short-term (working capital) asset + any reduction in
short-term liabilities like bank overdraft or level of creditors
etc. Example no. 4: Long-term sources (Internal) Rs.20lacs
Long-term sources (External) Rs.30lacs Short-term sources Rs.20lacs
Total funds available Rs.70lacs Long-term use Rs.40lacs Short-term
use Rs.30lacs Total uses Rs.70lacs In the above example, we observe
that short-term funds are deficient in comparison with short-term
use, whereas long-term funds are in excess of long-term use. This
should be the feature of any Funds flow statement, as long-term
sources that include profit retained in business will be available
both for long-term and short-term use. As against this, short-term
funds (otherwise known as working capital funds) are not available
for long-term purposes. The reason is obvious short-term funds are
available for day-to-day operations and hence if they are diverted
to long-term use, the efficiency of the business enterprise will be
drastically affected. It will affect the income as well as increase
the cost by way of interest in case we take additional
borrowingtofillthegapcausedbyreductioninworkingcapitalfunds.
PointersinFundsflowstatement: 1. Whether long-term sources are in
excess of long-term use or isittheotherwayaround? 2. It is
desirable to have long-term sources in excess of long term use and
this excess is available to short-term purposes Differences among
Financial Accounting, Management Accounting and Cost Accounting
Financial Accounting Cost Accounting Management Accounting Function
is to record all the financial transactions in accordance with
certain principles, standards etc. Function is to analyse costs
associated with an activity or a product or a division and
ascertain whether the activity or a division or a product is
profitable or not Function is to make required modifications in the
financial accounting, analyse and present it to the management for
control and managerial decision-making Provides historical data and
is a measure of performance of the business enterprise as a whole
Is concerned more with costs associated with a specific product
etc. to ascertain the profitability of the product or division
provides a tool in the hands of the management to take decision on
product or activity. Works with the data provided by Financial
accounting Financial accounting data modified by regrouping the
items as required for decision-making. Non- financial data like
quantitative data also used in management accounting. Further even
future data considered as required by management Compulsory for all
the business enterprises to follow Not compulsory at least in some
industries. Maintained purely for pricing decisions, control of
costs and planning for profits Not at all compulsory in any
industry. It is purely at the instance of the management for their
purpose and not for any external use Useful more for outsiders as a
pointer to the financial performance of the business enterprise
Useful for managerial decision-making including management. May not
be useful for owners in a professional set-up Useful for owners of
the business enterprise in any set-up. Not much flexibility more or
less standardised Involves detailed study of costs and hence
depends upon the nature of enterprise Thoroughly flexible in
approach depending upon the requirement of control from the
managements point of view. Involves generation of Management
Information System Reports FINANCIAL ACCOUNTING & ACCOUNTS
FUNCTION BUSINESS FINANCE - 1
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Profit & Loss & Balance Sheet Example no. 5 - A sample of
Profit and Loss Account (Rupees in Lacs) Income from operations 100
Operating expenses: Salaries 30 Repairs and maintenance 3
Depreciation 10 Office and general expenses 10 Marketing expenses
including Commission, if any 7 Interest and other Charges 10 Total
expenses 70 Profit before tax 30 Tax at 35% 10.5 Profit after tax
19.5 Dividend 7.5 Profit retained in Business [Retained Earnings]
12 Learningpoints: ! Interest is charged to income before
determining the profit of the organisation. Once the profit of the
organisation is determined, tax is paid at the stipulated rate and
the dividend is paid only after this.
Thus,dividendisprofitallocation. ! This difference between interest
and dividend gives opportunity to business enterprises, to have a
mix of capital of the owners and loans taken from outside, so that
they can save on tax, through the interest charged as expense on
the income. The amount of tax so saved is called tax shield on the
interest. ! In the case of profit distributed among the partners as
well in the case of dividend distributed among the shareholders,
these are not taxed againinthehandsoftheowners.
Linkagebetweenbalancesheetandprofitandlossaccounts The above
statement is known as the Profit and Loss Account. This records the
income and expenditure for a given period and is closed as soon as
the period is over. The residual profit, as it belongs to the
owners, gets transferred to the capital account in another
statement, called Balance Sheet. The balance sheet tells us about
the following: How much money has the business enterprise raised ?
Which are the sources for the money ? What is the use for this
money ? 16 17 Example no. 6 The balance sheet is also known as
Assets and Liability statement. A sample balance sheet is shown
below: (Rupees in lacs) Liabilities Assets Sharecapital: 100
FixedAssets 60 Reserves: 150 Less: Depreciation 30 (Retained
profits Net Fixed Assets: 30 over a period of Investments: 80 time)
Current Assets: Net worth 250 Bills Receivable 100 Bank overdraft
30 Cash and Bank 35 Creditors for expenses 10 Other current assets
60 Other current liabilities 15 Total current assets 195 Total
current liabilities 55 Total Liabilities 305 Total Assets 305
Suppose profit for the year is Rs.30 lacs after paying tax and
dividend. This would be transferred to the balance sheet and the
reserves at the end of the current year would be Rs.150 lacs +
Rs.30 lacs = Rs.180 lacs. Similarly the depreciation claimed on the
fixed assets and shown as an operating expense would also get
transferred to the balance sheet to reduce the value of the fixed
assets. Let us assume that there is no increase in the fixed assets
during the year that there are no other changes and the
depreciation for the year is Rs.10 lacs. We can construct the
balance sheet for the next year without much change, excepting to
accommodate these figures of depreciation and increase in reserves.
The balance sheet as at the end of the next year would look as
under: (Rupees in Lacs) Liabilities Assets Share capital 100 Fixed
assets 60 Reserves and surplus 180 Less: depreciation 40 Net worth
280 Net fixed assets 20 Bank overdraft 30 Investments 100 Current
Assets : Creditors for expenses 10 Bill Receivable 120 Other
current liabilities 15 Cash and Bank 35 Total current liabilities
55 Other current assets 60 Total liabilities 335 Total current
assets 215 Total Assets 335 FINANCIAL ACCOUNTING & ACCOUNTS
FUNCTION BUSINESS FINANCE - 1
10. TEFI Distance Learning ProgramTEFI Distance Learning
Program18 19 Weseethatbetweenthetwobalancesheets,therearetwochanges
InvestmenthasgoneupbyRs.20lacsand
BillreceivablehasgoneupbyRs.20lacs. The total is Rs.40 lacs. Where
have these funds come from? This amount is the total of profit
transferred to balance sheet from the profit and loss account and
depreciation added back, as it does not involve any cash outlay.
The figure is Rs.30 lacs + Rs.10 lacs = Rs.40 lacs. This figure is
referred to as internal accruals. This need not be the case all the
times. Where we use these funds entirely depends upon the business
priority and what we have shown is only a sample. Learning points:
! The business enterprise generates funds from operations, known as
internal accruals comprising depreciation (which is added back,
beingonlyabook-entry)andprofitaftertaxanddividend; ! Where these
funds are used is entirely dependent upon business exigencies;
Depreciation claimed in the books as an expense goes to reduce the
value of the fixed assets in the books, while profit after tax and
dividend is shown as Reserves and increases the net worth of the
company. Exampleno.7 Cashflowstatement OpeningBalanceforPeriod
(+)Receiptsduringtheperiod (-)Expensesduringtheperiod = Closing
Balance for the period (is the same as Opening Balance for the next
period) (Rupees in Lacs) Cash Receipts Revenue Receipts Sales
Receipts 100 Dividend income on shares 5 Rent income 10 Total 115
Capital Receipts Fresh debenture 50 Fresh term loan 100 Sale of
fixed asset 10 Total 160 Non-Revenue Receipt Sale of shares 20
Total 20 Total Receipts 295 Cash Payments Revenue expenditure
Payment to creditors 75 Payment of interest 15 Payment of expenses
25 Total 115 Capital expenditure Purchase of fixed assets 150
Repayment of term loan 25 Total 175 Non-Revenue expenditure
Purchase of UTI Units 2 Total 2 Total Payments 292 Opening balance
of cash 3 Add: Total Receipts 295 Less: Total Payments 292 Closing
balance of cash 6 (Opening balance for the next period) Example no.
8 Funds flow statement Financial statements - Funds flow statement
- Format Funds inflow sources Long-termfunds 2003-2004 2004-2005
Profitafterfax 240 265 Less: Dividendpaid 80 80 Netprofit 151 176
Add: Depreciationfor theyear 36 40 Amountamortised 15 15 (A) -
Long-termfunds (internal) 202 231 FINANCIAL ACCOUNTING &
ACCOUNTS FUNCTION BUSINESS FINANCE - 1
11. TEFI Distance Learning Program
Decreaseinoverdraft/cashcredit 0 0 Decreaseintradecreditors 85 0
Decreaseinprovisionsandother Short-termliabilities 0 0
Decreaseinshort-termloans 0 0 (E)-Short-termuses 270 336 Total uses
= D + E 750 854 SummaryofFundsflowstatement Long-termfunds 467 568
Long-termuse 480 518 Surplusor(deficit) (13) 50 Short-termfunds 283
286 Short-termuse 270 336 Surplusor(deficit) 13 (50) Questions and
numerical exercises for practice and reinforcement of learning 1.
What kind of business organization is suitable to begin with
foranentrepreneurandwhy? 2. What is the objective of financial
accounting from the point of view of the owner of an enterprise? 3.
Suppose you want to know the financial performance of your business
for the current year, which statement gives you the relevant
figures? Which statement gives you the financial position of the
enterprise? 4. Trace the advantages of a cash flow statement to a
business enterprise. Can you use this statement for planning for
resources? If no, which statement is available to you for this
purpose ? 5. For you as the owner of a business enterprise, is it
necessary to know in depth the process of financial accounting? In
case your answer is no how can you run the enterprise
withafullcontrolovertheamountinvestedinbusiness? 6. What is the
significance of operating income from business point of view?
Suppose you have operating loss of Rs. 5 lacs and overall profit of
Rs. 2 lacs, what does it
mean?WhatisthesourceoftheoverallprofitofRs.2lacs? 21 FINANCIAL
ACCOUNTING & ACCOUNTS FUNCTION TEFI Distance Learning Program20
BUSINESS FINANCE - 1 Increase in share capital 0 0 Increase in term
loans 150 0 Increase in debentures/bonds 0 250 Increase in fixed
deposits/acceptances and other medium and long-term liabilities 75
50 Decrease in investments 25 15 Sale proceeds of fixed assets 15
22 (B) - Long-term funds (external) 265 337 Total Long-term funds
(A+B) 467 568 Increase in short-term bank borrowing overdraft/cash
credit 133 132 Increaseintradecreditors 0 67
Increaseinshort-termloans 65 22 Increaseinprovisions andother 33 45
Short-termliabilities 0 0 Decreaseincashandbank Decreaseininventory
0 0 Decreaseinreceivables 52 0 Decreaseinothercurrentassetq 0 0 (C)
-Short-termfunds 283 286 Totalfunds generatedduring theyear 750 854
Funds outflow - uses Long-term use 2003-2004 2004-2005
Increaseinfixedassets 175 268 Increaseininvestment 75 50
Decreaseintermloans,redemptionof bondsanddebenturesanddecreasein
othermediumandlong-termliabilities 230 200 (D) Long-termuses 480
518 Short-term use Increaseininventory 122 160
Increaseinreceivables 0 147 Increaseincashandbank 32 14
Increaseinothercurrentassets 31 15
12. TEFI Distance Learning ProgramTEFI Distance Learning
Program ChapterNo.2 CostsinBusiness&RoleofCosting Contents
Whatiscost? Differencebetweencostandexpenseinbusiness
Whatiscosting? RoleofCostinginabusinessenterprise
Marginalcostinganditsuseindeterminingbreak-evenanalysis Possible
activities where costs could be high and measures of containing
them Attheendofthechapterthestudentwillbeableto:
Prepareacostsheetforajob
Determinethebreak-evenpointforagivenbusiness
Planforscaleofbusinessandprofits Examine possible areas of high
cost in one's own business and evolve suitable measures of
controlling them Introduction In Chapter no. 1, we had seen the
role of Accounts and the process of Accounting. We had also
familiarized ourselves with the four financial statements, namely
Profit & Loss statement, Balance Sheet, Cash flow statement
& Funds flow statement and their use in one's business. In this
chapter, we turn our attention to costs in a business enterprise.
All of us have heard expense as well as cost and mostly would have
taken these terms to mean the same. They are not the same. In a new
business in the absence of expense before revenues start flowing
into business from the activity of the enterprise, the costs
associated with an activity are determined based on estimates. For
an existing business, however, cost is derived from business
expenses. This is done by segregating the business expenses into
distinct levels like in the case of a manufacturing unit:
Production/manufacturing Office administration Marketing/selling
& Cost of borrowing Finance cost Further expense is a part of
Profit & Loss statement while cost is a part of Cost
Accounting. The purpose of Cost Accounting is to keep record of all
the costs associated with various products individually, or a group
of products or a business unit or a business division (in case an
enterprise has more than one division), or a branch (in case an
enterprise has more than one branch) etc 22 23 At the very basic
level, we can say that it is used for the following purposes in a
business: ! Determine the price at which a business enterprise
should sellitsproductorservice ! Ascertain the correct
profitability of a product at the end of the year. Suppose a
business enterprise has more than one product, it could be that
overall the business may be in profit while in one product it could
be losing. The loss in one product could be more than made up by
gainsinanotherproductandhenceoveralltheresultisProfit. ! Take
suitable business decisions on increasing the production/sale of a
product or reducing its production/sale depending upon the analysis
as perthesecondstep ! Review the costs on actual basis at the end
of the period and compare the actual profit earned with the
estimated one to know the areas responsible for higher costs if any
so as to evolve suitable corrective measurestocontrolthehighercosts
Etc. Roleofcostinginbusiness Suppose we manufacture a single
product. Then we know all the costs associated with this single
product. Hence it is easy for us to analyze the costs from the
Profit and Loss Account at the end of the Accounting period or even
more frequently. The bifurcation of costs should be into major
heads as describedaboveforamanufacturingunit. However, the
bifurcation of costs into the major 4 heads is not going to be easy
for each product in the case of a multi-product enterprise. The
Profit & Loss statement as seen in Chapter no. 1 represents the
total cost of the organization for all the products and activities
of the enterprise without any bifurcation.
CostAccountingjustdoesthatbasedonfollowingconsiderations. 1.
Whether the cost is incurred directly in producing the product?
Known as direct cost. The direct cost gets absorbed into the total
cost of the product and the Entrepreneur or his /her Accountant
need not employ any specific tool for allocating the costs over
various activities. Example material or wages. Most of the times,
the direct costs vary with the level of production or sales as the
case may be in proportion. 2. If not a direct cost, then it ist an
indirect cost like for example, the salary of factory supervisor.
Unlike direct cost, the indirect cost gets allocated over various
products or activities of the organization. For this the
Entrepreneur or his/her Accountant needs some basis for
bifurcation. For example rent paid for the building that houses all
the plant and machinery. The rent cost can be bifurcated on more
than one basis among the various products coming from the plant and
machinery. At stage 1, the rent is allocated among the plant and
machinery based on the area occupied by each machine to the total
area. At stage 2, the rent allocated to a particular machine gets
allocated among its various products based on the numbers if they
are homogenous in value or based COSTS IN BUSINESS & ROLE OF
COSTING BUSINESS FINANCE - 1
13. TEFI Distance Learning ProgramTEFI Distance Learning
Program on different values and units if their production values
are different. Most of the times, the indirect costs do not vary
with the level of production or sales as the case may be in
proportion; they may vary less
thanproportionately.Hencetheyarecalledfixedcostsalso. Note: There
could be notable exceptions of direct costs being fixed and not
variable with the level of production or sales as the case may be.
Take for example, wages. We can see that wages are direct cost in
terms of contribution to production and hence get absorbed. However
the reader will appreciate that a major portion of the wages is
fixed and a very small portion of it is variable in the form of
production incentive. It is in fact on this very issue, in the
past, there used to be big tussle between the management of
enterprises and the workers' unions. The trade unions would want
the entire portion of wages to be fixed while the management would
like to maximize the portion of variable wages so that they can
easily link the variable portion to
theproductionoutputgivenbytheworker/workers. Thus Cost Accounting
is complementary to Financial Accounting. It exactly tells us as to
whether we are in profit in all the products that we are
manufacturing. It could so happen that while in some products we
are in profit, in some others we could be in loss. For taking a
decision by the Entrepreneur, the costs need to be accounted for
properly and absorbed (in the case of direct costs) or allocated
properly (in the case of indirect costs). In the absence of Cost
Accounting, we continue to sell huge volume of a product in which
we are losing and at the end of the Accounting period, we are in
big loss. Had we checked it up earlier, we could have taken
corrective action of either reducing the production of the product
in which we are losing or if the market can absorb a higher value,
increase its selling price. Concept of cost and bifurcation of cost
into fixed and variable Marginal costing As mentioned earlier,
usually all direct costs are variable costs as they vary with the
level of activity and indirect costs are also fixed costs as they
do not vary with the level of activity and are necessarily incurred
irrespective of level of activity. Here, the reader will be well
advised to keep in mind that considering inflation every year, all
costs vary and hence the basis of bifurcation of costs into fixed
and variable requires relooking at. What we mean by the term
variable costs is that the costs vary with the level of activity,
be it production or sales, in proportion to the increase in that
activity of production or sales. Similarly, fixed costs are those
that do not vary in proportion to the level of activity and most of
the times, they vary less than proportionately to the increase in
the level of activity, be it production or sales. While it is true
that all costs vary if we consider inflation, for a while let us
forget and discuss marginal costing. This principle is based on
incidence of fixed costs in a business those are independent of
production means that they are incurred even before producing the
first unit. This is based on the premises that for a given
business, for a given period, the 24 25 fixed costs do not increase
while the variable costs increase directly with each
unitproducedmore.Thisisexplainedthroughanexampleasunder:
Exampleno.1 Suppose for a manufacturing unit, the fixed costs are
Rs.1lac and the variable
costis65%ofthesalepriceofRs.25/-perunit.Whatdoesthismean? At the
very beginning, the business recovers variable costs from the
customer. The fixed costs are not fully recovered. The difference
between selling price and variable cost is called contribution. At
first the contribution is less than fixed costs and hence the total
costs > total revenue. This results in alosssituation. At stage
no. 2, the contribution = fixed costs; this is the stage of
break-even pointwhenthereisneitherprofitnorloss. Beyond this stage,
the contribution = fixed costs + profits. Thus theoretically,
wecanseethreestagesinanybusinessasunder:
Stage1,wherecontribution
14. TEFI Distance Learning ProgramTEFI Distance Learning
Program26 27 Yes,asunder: Exampleno.3
HowmuchshouldyouselltoregisteraprofitofRs.1lac.? We know that if we
record profits in the enterprise, the contribution = FC + profit In
this case, the contribution to record Rs. 1 lac profit = 1 lac
fixed costs + 1 lac profit = Rs. 2 lacs Hence sales for recording
Rs. 2 lacs contribution = 2,00,000/contribution per unit = 22,858
units and the sales volume will be 22,858 x Rs. 25/- per unit = Rs.
5,71,450/- The question perhaps uppermost in the minds of readers
now will be, whether the BEP can be found out in the case of
multi-product unit. Definitely more complex but not impossible
provided the costing system in the business unit is quite
efficient. We will have to apportion all the fixed costs of the
enterprise among the various products that the unit is
manufacturing and determine the break-even point for each of this
product. This will enable the management to decide on optimal
product mix that will give maximum profits with the least
possiblevolumeofbusiness Cost sheet for a job based on bifurcation
of costs into direct and indirect costs Now let us see an example
as to how we will quote for a job, based on material, labour and
manufacturing expenses, both direct and indirect. This is done
through a cost sheet Example no. 4 Direct materials 1,00,000 Direct
wages: Machineshop: 10,000 hours 80,000 Paintshop: 4,000hours
60,000 1,40,000 Otherdirectmanufacturingexp. 35,000
Indirectmanufacturingexp. Machineshop: 25,000 Paintshop: 12,000
37,000 Administrative overheads 75,000 Selling & distribution
overheads 66,000 Total cost 4,53,000 Add: gross margin 25% 1,13,250
Quotation value to the customer 5,66,250 Cost estimation for a job
is done on the following lines: Prime cost: Material cost Wages
Direct manufacturing expenses (+) Factory overheads = Factory cost
(+) Administrative overheads = Office cost (+) Selling overheads =
Sales cost (+) Distribution overheads = Total cost, on which gross
margin is loaded to get the proper quotation for the customer.
Having seen the costs in totality, it is time now for us to go into
details of eachofthesemajorheadsofcostsinabusiness Costofproduction
Materialsconsumed:Rawmaterialsandpackingmaterials
Consumptionofstoresandsparesincludingmachineryspares Wagesforlabour
Utilityexpenses:Power,waterandfuel Repairsandmaintenance
Depreciationonfactoryassets Manufacturingexpenses Production
over-heads including factory administration, time office
expenses,insuranceonfactoryassetsetc
Administrativeandgeneralexpenses Officesalaries
Depreciationonofficeassets Repairstoofficeassets
Communicationexpenses Travellingandconveyance Printingandstationary
Auditexpenses Legalexpenses Consultancycharges Charityanddonation
Rentratesandtaxesetc. Sellinganddistributionexpenses
Freight,octroiandinsuranceoutward Advertisement Salescommission
Branchofficeexpenses Secondarypackingmaterial Salesincentivesetc.
Particulars Rupees Rupees COSTS IN BUSINESS & ROLE OF COSTING
BUSINESS FINANCE - 1
15. Break Even Point Analysis Picture TEFI Distance Learning
ProgramTEFI Distance Learning Program28 29 Finance and other bank
charges Interest on loans Interest on working capital limits given
by banks Commission on bills collected through banks, guarantees
issued, letters of credit opened by the banks on our behalf etc.
Remittance charges for remittance from one place to another place
etc. Behaviour of Costs While we do have all the above expenses, a
close examination would tell us that all of them do not behave in
the same manner. For example, we have an administrative office and
pay salaries to the employees in the administrative office. We
continue to pay them the salaries, irrespective of whether the
level of sales has come down or increased. Like this, we have a lot
of business expenditure, which is independent of the level of
activity undertaken by the business enterprise. Simultaneously, we
do have certain expenses, like communication expenses and hiring
costs that entirely depend on the level of activity, like, the
scale of a project or the number of projects executed in a given
time and man-hours or machine- hours spent on development of a
product etc. Note: In the above discussion, the effect of inflation
on costs in general has been ignored. This means that due to
inflation, all costs in general, be they fixed or variable,
increase constantly. In that sense, no cost is fixed and all costs
are variable. However, the concept of cost bifurcation into fixed
or variable is based on the assumption that in the short run, fixed
expenses are constant and
short-termcouldmeanupto24monthsinthecaseofamanufacturingit.
Relationshipbetweenfixedexpensesandprofits The difference between
the selling price and the variable costs is known as contribution.
Contribution per unit = Selling price per unit (-)
variableexpensesperunit. Itisveryclearthatthisshouldnotonlybe
sufficienttomeetthefixedcostsbutalsogiveprofits. Sales amount = S
and variable expenses for this sales amount = V, then contribution
would be S (-) V. Let us say this is C and the fixed costs are F.
Then at the point where the contribution is just enough to meet the
fixed expenses, C = F. It is only beyond this point that the sales
would give us profit. This point is called break-even point,
thereby meaning at this point there would be neither loss nor
profit. Once we know our level of fixed expenses and the amount of
variable expenses going into every unit of production, we can plan
for profits more accurately. Variable Costs Sales Amount Fixed
Costs Total Costs Break Even point Units Amount in Rupees COSTS IN
BUSINESS & ROLE OF COSTING BUSINESS FINANCE - 1
16. TEFI Distance Learning ProgramTEFI Distance Learning
Program LearningPoints: ! Costs associated with any business are
bifurcated into direct and indirect, depending upon their
relationship with the level of activity in an organisation. ! Costs
are also bifurcated into variable and fixed costs depending upon
whether they vary with the level of activity of production or sales
as the case may be or they remain fixed irrespective of the level
of activity. Mostlydirectcostsarevariableandindirectcostsarefixed.
! Contribution is the difference between selling price and variable
cost. In the initial stage of sales, contribution goes for meeting
the fixed costs and at the point of break even, the contribution =
fixed costs. It is only beyond this point that the business
enterprise starts earning profit. ! This means that beyond this
point, the contribution is sufficient not only for meeting fixed
expenses but also gives profit. ! The point of break even helps
management in determining the level of operation and the volume of
profits that they would like to target in a given year. ! The
phenomenon of break even is based on this assumption that in the
short run fixed costs do not increase and this short run could be 6
months at the most in the case of a software unit. Visibility of
costs across various levels in an organisation The purpose of cost
bifurcation into fixed and variable is to have a control over the
costs of the enterprise and to achieve the objective of maximising
profits for the enterprise. This objective is achievable only when
all the employees are aware right from the commencement of their
association with the company, that for any operation of the
company, we incur costs; be it production, administration or sales.
For example, production personnel in charge of production may not
appreciate the cost associated with carrying large inventory or
cost of consumption of materials during the process or production
of the cost of material wasted during transfer or carrying it from
one department to another department. Similarly, marketing
personnel may not appreciate the cost associated with inventory
cost of finished goods or receivable carrying costs etc. The
administrative or finance people may not appreciate the cost of
delay in getting the finance in terms of market opportunity lost
for the business enterprise. Thus there are always visible and
invisible costs associated with any operation. We, as managers and
owners would appreciate the fact that even when costs are incurred
by us directly, we take them for granted; we do not make any
conscious efforts to reduce them. Hence it would be unrealistic to
expect that we would be cost conscious in the case of those costs,
which are not visible to us immediately, while at work, as
explained above. Thus from the management's point of view, it is as
much important, if not more, to make all the employees aware of
invisible costs associated with their area of operation, as it is
to have a proper bifurcation of costs intofixed and variable for
the purpose of control over them. This alone would enable the
employees to develop a holistic view of the company and its
operations, instead of being compartmentalized or segmented in
their approach.
Suggestedcostreductionmeasuresforsomeofthetypicalproblemsfaced
inamanufacturingunit Problem Suggested solution 3130 Better
material handling facilities even by incurring capital expenditure,
if needed. Better quality suppliers by increasing the quantum of
indent at a time. Promoting skills of workers by periodic feedback
and training inputs. Linkage and long-term contracts with quality
suppliers to ensure consistency in supply. A close examination
about product- wise consumption and whether we are producing
certain varieties wherein the consumption is very high, just to
keep certain customers happy as we have all along been producing
them, even though the contribution from such product/s is less. Is
it because of high consumption of machinery spares? Is high
consumption of machinery spares because of old machinery? A study
should be made about the recurring cost of spares and the
advisability of replacing the machinery one after another in a
phased manner the replacement programme is different from
modernization programme. Do we have a regular maintenance programme
of machinery, depending upon their usage? Is it possible for us to
develop indigenous spares in the place of imported spares, in case
the spares are imported just now so that lead- time can be less and
over all cost will also reduce over a period of time? Material
consumption high Repairs and maintenance high COSTS IN BUSINESS
& ROLE OF COSTING BUSINESS FINANCE - 1
17. TEFI Distance Learning ProgramTEFI Distance Learning
Program Bifurcationofoperatingexpensesintofixedandvariableexpenses:
32 33 By having an effective means of communication and promoting
awareness among all concerned regarding cost associated with
communication. Printing and stationary wherever possible, to
specify the quality of stationary for taking out draft printouts
and final printouts, so that first class stationary need not
beusedfortakingdraftprintouts. How does it compare with other units
in the same industry? Can we promote consciousness among the
production employees regarding power conservation? Can we also
promote cost consciousness among administrative staff? Simple
measures of switching off lights and fans and air-coolers when not
needed will save 10/15%electricitycharges. How do we compare with
others in this area? Try and introduce a part of the pay package as
incentive based on performance, attendance etc. rather than by way
of monthly emoluments. Wherever possible, try and introduce
superannuation and personal accident insurance schemes and reduce
pro-rata, the increase in emoluments with its incidental increase
in terminal and annual benefits. The organisation should have a
need based and effective incentive scheme for most of the
categories of employees so that reward is not in the form of
increments only, that in turn, increases the cost to the
organisation by way ofterminalandannualbenefits To make the branch
office/development centre/strategic business unit, a profit centre
and making the unit-in-charge responsible for the performance of
the unit. Control through budgets, excluding specific inputs, which
are considered on merits, i.e., on request being justifiedetc.
Toning up receivable management by having a systematic follow-up.
Try and obtain bill finance by making the customers accept the
bills drawn on them. Try and get advance
whereverpossible,evenagainstbankguarantee Preferable to enter into
annual maintenance contracts with the vendors so as to avoid last
minute hitch in the operations due to break down, unless the
company has its own machine maintenancedepartment. Communication
& Printing and stationary costs alarming Power bill is high/
consumption of electricity is also high. Employee costs Branch
office/Development centre/Strategic Business Units etc. High
receivable carrying cost because of delay in realisation
Maintenance cost being very high Nature of expense Variable Fixed
Materials Yes ------ Power/electricity Major portion Minor portion
Consumables Yes ------ Stores Major portion Minor portion Wages to
labour Minor portion Major portion Repairs & maintenance Major
portion Minor portion in view of annual maintenance contract.
Factory administration Expenses Minor in the form of incentives
Major portion fixed by way of salaries, security contract charges,
insurance on factory assets etc. Depreciation on all assets -------
By and large fixed Processing charges or vendor charges paid to
outside contractors to whom a part of the job is given for
execution By and large variable -------- Staff welfare expense
-------- Fixed Insurance charges for all assets -------- Fixed Rent
rates and taxes for the business premises -------- Fixed General
and Administrative expenses (All) -------- Fixed Selling expenses:
Incentives to marketing personnel Variable -------- Advertisement
expenses Variable if for specific product/s Fixed for a major
portion. Product launch exp. Variable if for specific product/s
-------- Branch office exp. -------- By and large fixed FINANCIAL
CHARGES: Interest on working capital Variable -------- Interest on
term loans -------- Fixed Interest on debenture -------- Fixed
Interest on fixed dep. -------- Fixed Interest on unsecured loans
-------- Fixed Interest on bonds -------- Fixed COSTS IN BUSINESS
& ROLE OF COSTING BUSINESS FINANCE - 1
18. TEFI Distance Learning ProgramTEFI Distance Learning
Program34 35 Questionsforrevisionandreinforcementoflearning 1. What
is the difference between financial accounting and cost accounting
from an entrepreneur's point of view? Describe with an example. 2.
What are the major groups of costs in a manufacturing unit and
whatarethesub-headsofcostsunderthesemajorgroupsofcosts? 3. Can you
plan for profits of your organization based on marginal costing?
Illustrate with an example. You may assume suitable figures of
variable cost, selling price per unit and fixed costs for the
enterprise. 4. What is the concept of cost sheet for a job? Assume
suitably costs under all the major heads and prepare a cost sheet
for a job manufacturing 1200 unitsofAluminumtanks. 5. Suppose you
are always cost conscious as an Entrepreneur. You do not allow
costs to increase. Are you practising cost reduction or cost
control? Chapter No. 3 Introduction to Financial Management
Contents Details of Finance Function listed in Chapter no. 1
Sensitizing to FinancialAccounting
ObjectivesofFinancialManagementShort-termandLong-term Financial
system and markets in India : Government of India, Ministry of
Finance at the helm, statutes, statutory authorities, financial
intermediaries, other financial institutions, agents who operate in
the markets etc. Brief introduction to Financial Instruments At the
end of the chapter the student will be able to: Link the short-term
and long-term objectives of Financial Management to profitability
and wealth maximization respectively Map the role of Financial
markets in India and how they work Evaluate the merits of different
financial instruments & Take decision on how much Capital and
how much Debt for one's business Introduction Financial Management
is an integral part of Business Management. Finance is one of the
key functions in an organisation. The other key functions in an
organisation are: Production Human Resources Marketing Each of the
above function has got sub-divisions for example Production has
maintenance, Administration has purchases etc. Finance deals with
financial resources. Financial management as a corollary would deal
with management of financial resources and related areas. Some of
the key finance functions as seen in Chapter no. 1 are: Financial
planning and estimation of finance required for the organisation
Mobilization of financial resources required as above Ensuring that
the funds are available in adequate quantity at appropriate time
BUSINESS FINANCE - 1 INTRODUCTION TO FINANCIAL MANAGEMENT
19. TEFI Distance Learning ProgramTEFI Distance Learning
Program36 37 andatanaffordablecost
Managementofcashintheorganisationthroughcashflowstatement
Management of investment outside the business enterprise in other
organizations Management of risk in dealing with foreign exchange
for imports and exports Let us examine briefly the above functions
with some examples. Financial planning and estimation of finance
required for the organisation Any activity in a business enterprise
requires planning for proper execution in time. Finance is required
for any activity at least in the beginning and hence financial
planning is the prime function of Finance. This involves detailed
study of any activity from understanding the total funds
requirement for that activity, when the funds will be required and
how much funds will be required at different stages. For a new
enterprise the entire resources have to come from outside
(externally); for an existing enterprise, a part of the resources
at least will be available from the profits made in the past and
retained in business after declaring dividend. Example No. 1: We
require Rs.10lacs for an activity. Let us see how it affects an
existing enterprise. Let us assume the profits available to be
Rs.5lacs. Then we require further resources of Rs.5lacs only. This
is the difference between an existing enterprise and a new one.
Financial planning will take this into account. Mobilization of
financial resources Having ascertained in the above example that we
require Rs.10lacs for a set activity, for a new enterprise we
require the entire amount to be mobilized. For an existing
enterprise with available profits of Rs.5lacs, we require only
Rs.5lacs. The Financial manager will then assess all the
alternative resources available to him (for details please refer to
Chapter 7 Financial Planning and
Analysis)keepinginmindthefollowingrequisites:
Adequacy(availabilityinadequatequantity)
Timeliness(availabilityintime)and Cost(atanaffordablecost) Adequate
supply in time etc. This has been explained in the above point. For
reinforcement the student's attention is drawn to one of the
objectives of financial management at least in the short run, the
objective of maximizing profits of the organisation. The profits so
maximized in turn enhance the Earning Per Share (Please refer to
Chapter7 FinancialPlanningandAnalysis) Management of cash in the
organisation Thisinvolvesthefollowingsteps:
Ascertainingtheaveragecashrequirementbylookingatthepast
figuresandforanewenterprise,estimatingthisfigure. Preparing the
cash flow statement for a given period, taking all the cash inflows
and cash outflows during the period to determine whether there is a
surplus or deficit at the end of the period (For format of cash
flow statement please refer to Chapter 1 Sensitizing to
FinancialAccounting) Arranging for funds from outside especially
through a bank with whom the enterprise has loan facilities in case
of deficit in the cash flow statement; if on the contrary, the cash
flow statement reveals a surplus, dealing with this surplus in a
suitable manner (For further details, please refer to chapter 8 -
Working Capital Management) Management of investment outside the
organisation Over a period of time the enterprise reinvests a part
of the profits for future growth of the organisation in business.
The Finance manager can invest such funds outside the business in
other enterprises also provided the parent enterprise does not
require them immediately. Short-term surplus as revealed by the
Cash flow statement is also invested for short duration. Thus
investment outside one's own business becomes the responsibility of
the Finance Manager Management of risk in foreign exchange etc. A
business enterprise may require imports and do exports also.
Whenever this is done the invoice is in foreign currency imports,
the business enterprise. For requires foreign exchange while in
exports, it gets foreign exchange. There is a risk involved while
doing imports or exports. The risk is that the exchange rate of the
foreign currency in terms of Indian Rupees can keep changing. We
will explain this through an example. Example no. 2 We have
exported goods worth US Dollars 1000. The money is to be received
in a month's time. Presently the exchange rate is 1 US Dollar =
Rs.44/-. By the time the money is received after a month, in case
the rate is less than Rs. 44/-, we will lose money. On the contrary
if the exchange rate is more than Rs. 44/-, we will gain. Exactly
opposite will be the effect in the case of imports. The importer
will pay less if the exchange rate decreases and more if the
exchange rate increases. There are ways and means of minimizing the
risk of foreign
exchange.Financemanagerisexpectedtotakecareofsuchrisks. Short-term
and long-term objectives of Financial Management Short-term
objective The short-term objective of Financial Management is to
procure financial resources at an affordable cost thereby
increasing the return to the owners of the business in the form of
Profit After Tax (PAT). This objective is often times referred to
as profit maximization. This is known as the short-term BUSINESS
FINANCE - 1 INTRODUCTION TO FINANCIAL MANAGEMENT
20. TEFI Distance Learning ProgramTEFI Distance Learning
Program38 39 objective as it is done on a continuous, year-to-year
basis. One or more of the followingmeasurescanachievethis:
Monitoringofcostsonacontinuousbasisthroughbudgets Suitable cost
reduction techniques wherever the costs are high, especially in the
case of direct costs like material cost for a manufacturing unit
Minimization of cost of borrowed capital from outside by observing
financialdiscipline Proper mix of Capital and debt (known as
financial leverage for further details please refer to Chapter no.
6 Risk associated with business) Control over liquidity available
in the organisation so as to minimize the cost of carrying too much
cash etc. Long-term objective The long-term objective of Financial
Management is to increase the wealth of the owners of the business.
The term wealth refers to various business assets of the enterprise
that are free of debt. This means that this wealth belongs to the
business owners. This is reflected in the balance sheet as = Total
Assets of the business (-) Funds borrowed from outside, both
short-term and long-term This can be explained through an example.
Example no. 3 Capital in business of the owners = Rs.10lacs Profit
retained in business = Rs.20lacs Owners' capital in business =
Rs.30lacs Addition to wealth of the enterprise = Rs.20lacs This
means that at the starting point the wealth of the enterprise was
Rs.10lacs and this has gone up to Rs. 30lacs due to the prudent
policy of the management of retaining profits within the
organisation. Thus the short-term objective of earning profits is
also a contributory factor to realizing the long-term
objectiveofwealthmaximization
Someofthemeasuresthroughwhichweachievethelong-termobjectiveare:
Strategic financial management decisions relating to expansion or
diversification, joint venture etc. Thus while profitability
reflects the Operating Efficiency, Wealth Maximization reflects the
managerial/entrepreneurialcompetency. To sum up, both short-term
objective and long-term objective need to be put in place for
sustained growth of a business enterprise. To an extent at least,
the long-term objective is dependent upon the short-term objective
of profit maximization. FinancialsysteminIndia In order to
understand financial management better, we need to understand the
Financial System that exists in India. Any country needs a system
to regulate, supervise, monitor and control the players,
intermediaries, the investors etc. who take part in the financial
markets in the system. Further an efficient system alone can ensure
that the national objective on Economy of the country is met by
aligning the developments in the system with the national
priorities. An example of the national priority deciding the
development in the financial markets is infrastructure development
and need for longer duration financial resources and development of
deep discounted 1 bonds to meet this requirement. (For further
details, please refer to Chapter 5 FinancialResources) The
Financial System is one of the most important inventions of the
modern society. It is well known that certain sectors in any
society have surplus funds, which are available for investment,
while certain other sectors demand funds or have use for these
funds in their activity. This fundamental forms the basis
forthefinancialsystemanywhereintheworld. For example, there are
always in any economy, seekers of funds, mainly,
businessfirmsandgovernmentandsuppliers offunds,mainlyhouseholds.
TheFinancial System TheFinancialMarkets: A Financial Market can be
defined as the market in which financial assets are created or
transferred. Financial assets represent claims to payment of a sum
of money sometime in the future and/or periodic payment in the form
of dividendorinterest. Financial markets can be classified as
primary and secondary markets. More often, they are also classified
as money markets and capital markets. In fact, primary and
secondary markets are integral part of capital markets, as money
marketshaveaverylimitedsecondarymarket. Primary market: The market
for raising funds through share capital, debenture, bonds etc.
wherein the funds directly flow from the households and other
saving units in the economy to the users of these funds, namely,
GovernmentandBusinessEnterprisesintheformofLimitedCompanies.
Secondary market: The market for disposing of the claims in the
forms of shares, debentures of the investors to other investors
without surrendering the Seekers of Funds (Mainly Business, Firms
and Government) Suppliers of Funds (Mainly Households) BUSINESS
FINANCE - 1 INTRODUCTION TO FINANCIAL MANAGEMENT
21. TEFI Distance Learning ProgramTEFI Distance Learning
Program40 41 claim directly to the principal users of these funds,
namely, business enterprises or Government. This market enables
selling off investment in business enterprises by public at large
either through stock exchanges or directlytootherinvestors.
ConstituentsoftheIndianFinancialSystem The Government of India,
Ministry of Finance, heads the Indian financial system. The
ministry in turn is bifurcated into various departments like the
Department of Economic Affairs, the Department of Company Affairs
etc. The Indian financial system consists of: The financial markets
The statutes governing the various segments of the financial
markets The statutory authorities responsible for regulating,
supervising, monitoring and controlling the markets and its
components The financial intermediaries Special organizations
Agents operating in different segments of the financial markets and
Financial instruments/securities issued in the markets to raise
resources The financial markets The financial markets consist of:
Money markets maximum duration of 12 months Capital markets Minimum
duration 12 months and maximum durationcouldbeeven20-25years
Foreignexchangemarkets FinancialServicesmarket: Insuranceservices
Banking Non-BankingFinancialCompanies Mutualfunds VentureCapital
ETC. The money markets and capital markets in turn do have Primary
market and Secondary market. Primary market means issue of
financial instruments by companies and others that want to raise
financial resources from the market. Secondary market refers to
that market wherein the financial instruments issued in the Primary
market change hands from one investor to another for financial
consideration. SEGMENTS OF MONEY MARKETS: Call money market
Exclusively for banks to be borrowers inter-bank operations for a
very short period. One day to fourteen days. Fourteen day borrowing
is in the notice money market that is also a part of the Call Money
Market. Only scheduled commercial banks are permitted to be
borrowers in this market. While some banks will be borrowers, some
others will be lenders. There is no specific market place. Deals
are done over the phone. Commercial paper Issued by companies and
Public Sector Undertakings as part of working capital requirement.
This is a promissory note issued by companies requiring short-term
funds (say from 15 days to 180 days or six months). Maximum period
is twelve months. The six- month commercial paper can be extended
for a further period of six months, making a total of 12 months.
Commercial bills Discounted by banks and Non-banking Financial
Institutions. These are short-term bills usually not exceeding
90-120 days covering commercial transactions in the private sector.
Treasury bills Issued by Government of India through the RBI for
meeting budgetary deficits. These are for fixed maturity periods of
91 days and 364 days. The Reserve Bank of India controls the money
markets in India. It is known as money market regulator, but
without any supporting statute unlike the capital
marketsegmentthathasspecificstatutes. Primarymarket Primary market
in the money market is the market in which RBI requiring funds for
Government of India issue securities like treasury bills and get
finance and there is no specific market place excepting in the case
of treasury bills. RBI conducts auction of treasury bills after due
notice in national dailies and hence this can be construed as the
market place. Secondary market The secondary market is provided by
Discount and Finance House of India Limited (DFHI) a subsidiary of
RBI. It provides a two-way quotation, one for purchasing money
market instruments and another for selling money market
instruments. For example, a holder of Treasury bill of Government
of India can sell it to DFHI and anyone wants to purchase treasury
bills, he can approach DFHI who can sell it to him. There is no
secondary market for call money or notice money market. BUSINESS
FINANCE - 1 INTRODUCTION TO FINANCIAL MANAGEMENT
22. TEFI Distance Learning ProgramTEFI Distance Learning
Program42 43
InsuranceInsuranceRegulatoryandDevelopmentAct(IRDA)controlled by
the Insurance Regulatory and Development Authority coming under
GOI, Ministry of Finance Banking Banking Regulations Act controlled
by RBI Non-banking Financial Companies (NBFCs example Kotak
Mahindra Finance Company Limited) Non-Banking Financial Companies
Act of RBI Functioning of limited companies registered in India The
Companies' Act controlled by the Company Law Board (CLB) coming
under GOI, Ministry of Finance. The principal officer is known as
The Registrar of Companies (ROC). Company Law Board is primarily
responsible for conduct of the affairs of limited companies
registered in India under the Companies' Act. The difference in
roles of CLB and SEBI is that the latter is mainly concerned with
issue of securities in the capital market protecting the interest
of the invests who invest in Foreign Exchange market seametries
SEBI is not the companies Act while CLB is not the SCRA. They play
complementary roles. Foreign Exchange Management Act and Exchange
Control Regulations Act both coming under the RBI Note : Indian
companies accessing international markets come directly under the
GOI, Ministry of Finance The financial intermediaries A financial
intermediary means an institution like a bank mobilising resources
from saving units in the economy and deploying these resources by
giving loans to or by investment in users of these financial
resources for creating economicwealth. Bankingcompanies
FinancialInstitutions(FIs) Mutual Funds (MFs) in a limited sense,
whenever they invest in securities in the primary market
Non-banking Financial Companies (NBFCs) & Venture Capital
Funding Agencies Special organisations/Boards These come under one
of the financial market regulators or directly under GOI Ministry
of Finance All-India Financial Institutions GOI - MOF National Bank
for Agriculture and Rural Development NABARD) Export Import Bank of
India (EXIM Bank)ETC. Central Board of Direct Taxes - CBDT - GOI -
MOF Stock Exchanges - SEBI BUSINESS FINANCE - 1 SEGMENTS OF
CAPITALMARKETS: GOI bonds Various state government bonds Bonds
issued by Public Sector undertakings likeBHELetc. Bonds issued by
private sector companies, banks and financial institutions
Debentures issued by private sector companies Share Capital issued
by private sector companies Preference share capital issued by
private sectorcompanies In the case of public issues by private
sector companies, banks, financial institutions and mutual funds,
Securities Exchange Board of India (SEBI) is the controlling
authority. It is referred to as the capital market regulator.
However SEBI does not control Government bonds or securities issued
by Public Sector Undertakings. GOI bonds and state government bonds
are handled and controlled by RBI. Public sector undertaking like
Bharat Heavy ElectricalsLimited(BHEL)comedirectlyunderGOIMOF.
Primarymarket There is no specific market place for this. This
again, like in the case of money market, facilitates issue of
securities by those who require funds in the medium to long-term.
The public issue process is supervised and controlled by the lead
merchant banker/bankers in the case of all public issues. Primary
market ends with the listing of securities on stock exchanges by
the Registrar to the Issue. Details of operators in the primary
market have been given under Agentsoperatinginfinancialmarkets.
Secondarymarket The secondary market begins with the listing of
securities on the stock exchanges by the Registrar to the issue. It
has a market place in the form of stock exchanges. Its operations
are through share brokers who are registered with respective stock
exchanges. The stock exchanges in turn are controlled and regulated
by SEBI. Details of operators in the secondary market have also
beengivenunderAgentsoperatinginthefinancialmarkets. Statutes
governing the various segments of the financial markets and the
statutoryauthorities
StatutemeansanActpassedeitherbytheParliamentorStatelegislature.
MoneymarketNospecificstatutecontrolledbyRBI Capital market
Securities Contracts Regulations Act and Rules as well as SEBI
regulations for the various operators in the Capital market
controlled bySEBI.MutualFundsalsocomeundertheRegulationsofSEBI.
INTRODUCTION TO FINANCIAL MANAGEMENT
23. TEFI Distance Learning ProgramTEFI Distance Learning
Program44 45 Depositories National level special organisations
coming under the national stock exchanges and assume responsibility
for collating details of ownership of shares issued by a limited
company controlled by SEBI Depository participants Retail level
operators who maintain Electronic Share Accounts of various owners
of securities Financial instruments Already referred to under
financial markets above. For further details, please refer to
chapter 5 - Financial Resources Questions for reinforcement of
learning 1. What do you think is the primary objective of this
chapter from the point of view of an Entrepreneur? 2. What are the
instruments in the money market and capital market? 3. What is
wealth of a business enterprise? Are profit and wealth linked to
each other? Illustrate with an example. 4. What do you understand
by the term strategic financial management from the point of view
of the owner of the business enterprise? When
willyouthinkofsuchastrategy? 5. For a new business enterprise,
which financial instruments in your opinionareavailabletoyou?
BUSINESS FINANCE - 1
InstituteofCharteredAccountantsofIndia(ICAI)-GOI-MOF
InstituteofCostandWorksAccountantsofIndia(ICWAI)- GOI-MOF
InstituteofCompanySecretariesofIndia(ICSI)-GOI-MOF
InstituteofCharteredFinancialAnalystsofIndia(ICFAI) GOI-MOF
ForeignInvestmentPromotionBoard(FIPB)GOI-MOF ETC.
Agentsoperatingindifferentsegmentsofthefinancialmarkets The agents
operating in the capital market are more. Hence we examine them
briefly here. In respect of other segments of the financial markets
from a study of the above it will be clear to the students as to
who the operators are in the respectivesegments.
PrimarymarketcontrolledandmonitoredbySEBI
Merchantbanker(theprincipaloperator) Merchant banker controls the
Primary market and is fully responsible for the issue of public
securities like Capital, debentures, bonds etc. the capital market
instruments. He is the principal operator and controls and monitors
all the other operators in the capital market. He is fully
accountable to SEBI for the smooth conduct of the operations in the
capital markets. He has to ensure 100% conformity with SCRA rules
and regulations as well as SEBI rules and regulations.
Sharebrokerswhounderwritebesidesmarketingtheissue Underwriting in
the capital market means giving an undertaking to invest money in
securities issued to public should the issue fail to collect the
required amounts as per SEBI rules and regulations. Underwriting as
such does not involve any funds and hence is referred to as fee
based activity. However once the issue fails to collect the
required amount, the underwriter is expected to make good the
deficit amount to the extent undertaken by him. Bankers to the
issue who collect the share application money along with the share
application forms Advertisement companies and publicity companies
Printers for printing the stationery required for the issue
Registrars to the Issue who take the responsibility of issuing the
securities to successful investors (in case the issue collects more
money than the issue size), refund excess money together with
interest and getting the securities listedonaStockExchange
Secondary market controlled and monitored by SEBI Stock Exchanges
controlled and regulated by SEBI Share brokers controlled by
respective stock exchanges as well as SEBI INTRODUCTION TO
FINANCIAL MANAGEMENT
24. TEFI Distance Learning ProgramTEFI Distance Learning
Program46 47 Wholesale price and not the retail price The prices of
the selected commodities for determining the rate of inflation over
a period of one year could be on the wholesale or retail. The
latter one is mostly referred to as consumer price. Thus we have a
wholesale price index and consumer price index for expressing rates
of inflation. Conventionally in India the rate of inflation has
always been expressed in wholesale price index basis rather than
consumer price index basis although the consumer price index
increase is also published regularly. At present the wholesale
price index inflation is around 6%. We will explain this concept
through an example. Example no. 1 I had spent Rs. 100/- in getting
a basket of commodities one year ago. If the rate of inflation is
say 7%, now I will be required to spend Rs. 107/- to get the same
basket of commodities. How do we get Rs.107/-? Rs. 100/- x 1.07 =
Rs. 107/-. This means that due to inflation, the purchasing power
of the local currency decreases with the passage of time. This is
exactly the concept of time value of money. In simple words, time
value of money means that with the passage of time, money loses its
value. Is there a situation in which the prices decrease over a
period of time and opposite of inflation takes place? Usually in a
developing country, such a situation does not arise, as the demand
is always greater than supply. However currently Japan was fill
recently experiencing deflation in which current prices would be
less than the past prices. This is harmful to a developing economy,
as units that save money would get very low interest or no
interest. Hence there will be no incentive for the units to invest
money in bonds, fixed deposits etc. Concept of Interest as
compensation for loss of purchasing power due to inflation: You
keep money in a deposit with a bank. It could be a Savings Bank or
a Fixed Deposit. What does the bank pay to you? Interest. This is
the return on your investment. Why should the bank pay interest to
you? Let us enumeratethepossiblereasonsforthebank'saction. ! The
bank does the business of lending. For this, it requires funds
through deposits. It earns interest on loans and pays
interestondeposits; ! With the passage of time, the purchasing
power of money reduces. The same thing will happen to your deposit
with the bank. The bank gives compensation to you for this loss in
value ofmoney; ! In case the bank does not pay interest, it will
not get funds for lending. You will not keep deposits with it. You
will choose other willing banks or avenues of investment. While all
of them are correct, we are more interested in the second reason.
Value of money erodes due to inflation as we have seen in the
earlier paragraph. The rates of inflation would be different for
different countries. Further, it could be different for the same
country at different times. Sometimes it could be high while at
some other times, it could be low. BUSINESS FINANCE - 1 Chapter No.
4 - Time Value of Money Contents ! Introduction to the concept of
inflation Wholesale PriceIndexandConsumerPriceIndex !
Moneylosingvalueduetoreductioninpurchasingpower ! Concept of
interest as compensation in purchasing power of money !
Fourtierstructureforratesofinterestinanyeconomy !
Compoundinganddiscountingprocesses !
Applicationoftimevalueofmoneytobusinessdecisions !
Numericalexercisesforpractice
Attheendofthechapterthestudentwillbeableto: !
Determine-Futurevalueofapresentsumbycompounding !
Determine-Presentvalueofafuturesumby discounting !
Determine-Presentvalueofabondinvestment ! Explain - the different
tiers of interest structure in an economy ` ! Choose
thebestprojectbasedonitsNetPresentValue Concept of Inflation
Wholesale Price Index and Consumer Price Index Inflation means to
increase. In this context, it means increase in prices of
commodities. The price increase is due to the difference between
supply and demand for a given commodity. If the supply is more than
demand, prices decline and if the demand is more, prices increase.
In a developing country like India, the demand for most of the
commodities will always be more than the supply. Hence inflation
will always be experienced in developingmarkets. The increase is
constantly measured in all the countries. The items included for
determining the prices would be different from country to country.
For example, in India, essential commodi