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GNDU Question Paper-2022
Bachelor of Business Administration
BBA 3
rd
Semester
MANAGEMENT ACCOUNTING
Time Allowed: Three Hours Max. Marks: 50
Note: Attempt Five questions in all, selecting at least One question from each section. The
Fifth question may be attempted from any section. All questions carry equal marks.
SECTION-A
1. What do you mean by management accounting? What is its importance for a business
undertaking ? What are the limitations of management accounting?
2. Distinguish between management accounting and financial accounting. How does
management accounting overcome the limitations of financial accounting?
SECTION-B
3. What do you mean by common size financial statements? Examine the significance of
common size financial statements in financial analysis.
4. You have been given the balance sheets of a firm on 31st December 2013 and 31st
December 2014:
Liabilities:
31
st
Dec 2013
(Rs.)
31
st
Dec 2014
(Rs.)
Share Capital
1,00,000
1,50,000
General Reserve
30,000
35,000
P/L A/C
20,000
17,000
10% Debentures
1,00,000
1,00,000
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Sundry creditors
65,000
58,000
Provision for tax
10,000
15,000
Outstanding expenses
5,000
6,000
Pre-received incomes
1,000
1,500
3,31,000
3,82,500
Assets :
Buildings
1,20,000
1,05,000
Machinery
85,000
95,000
Stocks
80,000
1,30,000
Debtors
10,000
15,000
Investments
-
10,000
Cash
5,000
5,000
Goodwill
25,000
15,000
Paid expenses
5,000
6,000
Outstanding incomes
1,000
1,500
3,31,000
3,82,500
Compute the following ratio for the two years:
(a) Working capital ratio
(b) Acid test ratio
(c) Debt equity ratio
(d) Proprietary ratio
(e) Fixed assets to net worth ratio
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SECTION-C
5. From the following balance sheet and the additional information, you are required to
prepare fund flow statement for the year ended 31st December 2013:
Liabilities
31
st
Dec 2012
(Rs.)
31
st
Dec 2013
(Rs.)
Share capital
1,80,000
2,10,000
General reserve
15,000
17,500
P/L A/C
10,000
8,500
10% Debentures
50,000
50,000
Sundry Creditors
42,500
29,000
Provision for Tax
5,000
7,500
Outstanding expenses
2,500
3,000
Pre-reserved incomes
500
750
3,05,500
3,26,250
Assets :
Buildings
1,90,000
1,87,500
Machinery
42,500
47,500
Stocks
40,000
65,000
Debtors
20,000
7,500
Investments
-
5,000
Cash
2,500
2,500
Goodwill
7,500
7,500
Prepaid expenses
2,500
3,000
Outstanding incomes
300
750
3,05,500
3,26,250
Additional Information:
(i) During 2013 dividends of Rs. 21,000 were paid.
(ii) Depreciation on plant and machinery amounted to Rs. 13.000.
(iii) Provision for tax made during the year Rs. 7,900.
(iv) Loss on sale of machinery amounted to Rs. 2,500.
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6. What are the different methods of determining transfer prices? How would you select
an appropriate transfer price?
SECTION-D
7. What are the different types of management reports ? Examine their significance. What
are the qualities of good management reports
8. What do you mean by working capital mix ? What are the different approaches to the
determination of working capital mix ? Which of these approaches is the best?
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GNDU Answer Paper-2022
Bachelor of Business Administration
BBA 3
rd
Semester
MANAGEMENT ACCOUNTING
Time Allowed: Three Hours Max. Marks: 50
Note: Attempt Five questions in all, selecting at least One question from each section. The
Fifth question may be attempted from any section. All questions carry equal marks.
SECTION-A
1. What do you mean by management accounting? What is its importance for a business
undertaking ? What are the limitations of management accounting?
Ans: Management Accounting: Its Meaning, Importance, and Limitations
Imagine for a moment that you are the captain of a ship sailing across the ocean. The sea is
full of opportunities (islands, treasures, new lands), but also dangers (storms, rocks, and
pirates). To guide the ship safely, you cannot simply look at the waves outside. You need
instruments like a compass, a map, and a telescope. These tools do not guarantee that you
will never face difficulties, but they help you take the right decisions at the right time.
In the world of business, management accounting plays the same role as the compass and
map do for a captain. It does not directly earn profits like selling goods does, but it helps the
managers decide, plan, and control activities so that the business does not get lost in the
“ocean of competition.”
What is Management Accounting?
To put it simply, management accounting is the process of collecting, analyzing, and
presenting financial as well as non-financial information to the managers so that they can
take better decisions.
It is like a language between the “numbers” and the “decision-makers.” While financial
accounting only shows what happened in the past (profits, losses, assets, liabilities),
management accounting goes one step further and asks:
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• Why did it happen?
• What will happen if we take this step?
• How can we improve tomorrow?
So, it is not just about recording figures but also about interpreting them for planning,
controlling, and decision-making.
For example:
• A financial accountant may say, “The company earned a profit of ₹10 lakh last year.”
• A management accountant will say, “Out of these ₹10 lakh, 70% came from Product
A, while Product B actually caused a loss. If we reduce the cost of Product B or stop it
altogether, profits will rise further.”
This is why management accounting is often called the “eyes and ears of management.”
Importance of Management Accounting for Business Undertakings
Why is management accounting so valuable? To answer this, let’s continue with a small
story.
Story of Two Friends: Ravi and Mohan
Ravi and Mohan both start a small bakery business. Both invest the same amount, hire
workers, and bake cakes. After one year, Ravi’s bakery is growing, opening new outlets,
while Mohan is struggling to pay rent.
What’s the difference?
Ravi uses management accounting. He carefully checks:
• Which cakes are selling the most.
• Which ingredients cost too much.
• Whether his workers are efficient.
• When is the demand highest.
Mohan, on the other hand, only looks at the sales figures at the end of the month without
analyzing them deeply.
This shows how management accounting helps managers run businesses more intelligently.
Now let’s list its importance in a systematic way:
1. Helps in Planning
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Planning means deciding in advance what to do and how to do it. Management accounting
provides forecasts and budgets which act like a roadmap.
For example: A company may prepare a budget for the next year showing expected sales,
costs, and profits. This helps managers know in advance whether they should expand
production or reduce expenses.
2. Assists in Decision Making
Every day managers face questions:
• Should we launch a new product?
• Should we buy machinery or hire more labor?
• Should we reduce the price or improve quality?
Management accounting provides cost analysis, profit comparisons, and “what if” scenarios.
This allows managers to make decisions not blindly, but based on facts and figures.
3. Aids in Controlling Costs
In today’s competitive world, cost control is survival. Management accounting techniques
like standard costing, variance analysis, and budgetary control ensure that expenses do not
cross limits.
For example: If electricity costs are much higher than the budget, managers can investigate
why and take corrective action.
4. Improves Efficiency
By providing regular performance reports, management accounting points out weak areas.
Workers, machines, and departments can be compared. This motivates everyone to
improve efficiency and reduce wastage.
5. Helps in Measuring Performance
It provides different ratios (profitability ratio, liquidity ratio, etc.) and performance reports.
This tells managers whether the company is performing well or lagging behind competitors.
6. Encourages Coordination
Different departments—production, sales, finance—are interdependent. Management
accounting prepares a common plan (budget) so that all departments work in harmony
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rather than in isolation. For example, sales cannot promise to sell 10,000 units unless the
production department confirms it can make them.
7. Prepares for the Future
Unlike financial accounting, which is historical, management accounting is forward-looking.
It predicts future trends, challenges, and opportunities. In an uncertain world, this foresight
is invaluable.
8. Builds Investor and Lender Confidence
When a company uses management accounting, it can present clear plans and strategies to
investors and banks. This increases trust and makes it easier to raise funds.
Limitations of Management Accounting
Now, just like every tool has its limits, management accounting is not perfect. It has
certain shortcomings:
1. Based on Financial and Cost Data
Management accounting depends heavily on financial and cost records. If the original
records are incorrect, the analysis will also be misleading.
2. Expensive Process
Introducing management accounting requires experts, software, and systems. Small
businesses may find it costly.
3. No Automatic Decisions
Management accounting only provides information and suggestions. The final decision
depends on human judgment, which may be influenced by bias or lack of experience.
4. Future is Uncertain
Many management accounting techniques involve forecasting. But the future is
unpredictable—sudden changes like COVID-19 can make predictions wrong.
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5. Requires Skilled Staff
Not every manager can interpret management accounting reports. Lack of trained staff
reduces its effectiveness.
6. Can Lead to Information Overload
Sometimes too many reports and figures are generated. Instead of helping, this may
confuse managers.
7. Not a Substitute for Management
It is just a tool. Success still depends on the vision, leadership, and ability of managers.
Conclusion
To sum up, management accounting is like the guiding compass of a business. It does not
directly control the ship, but it helps the captain (manager) decide the safest and most
profitable route. It plays a crucial role in planning, decision-making, controlling, and
forecasting.
However, one must remember that it is not magic. It has limitations like dependence on
past records, high costs, and uncertainty of predictions. Despite these, in today’s
competitive age, no modern business can survive without it.
Just as Ravi’s bakery flourished by using management accounting wisely, any business that
uses it as a guiding light can sail confidently through the turbulent seas of the market.
2. Distinguish between management accounting and financial accounting. How does
management accounting overcome the limitations of financial accounting?
Ans: A Fresh Beginning
Imagine you are the captain of a big ship sailing across the ocean. The ship has hundreds of
passengers, a crew, and a huge amount of cargo. Now, to reach the destination safely and
on time, you need two kinds of information:
1. A logbook – It records everything that has already happened: where the ship started,
how much fuel was used yesterday, what food supplies were consumed, and so on.
This is like financial accounting. It shows the past in a systematic and standardized
way.
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2. A navigator’s guide and radar system – These tools do not just tell you about the
past, but also guide your decisions: where the storms may be, how much fuel you
need for the remaining journey, which route is cheaper, and how to avoid risks. This
is like management accounting. It helps in making decisions for the future.
So, one keeps a record for everyone to see, while the other helps the captain (management)
to take wise steps ahead. Both are important, but they serve different purposes.
What is Financial Accounting?
Financial accounting is like the logbook of the business. It is mainly concerned with
preparing reports about what has already happened. These reports include:
• Profit and Loss Account (to show how much profit or loss was made)
• Balance Sheet (to show assets and liabilities at a point of time)
• Cash Flow Statement (to show movement of cash)
The primary audience of financial accounting is outsiders – like investors, banks,
government, tax authorities, and shareholders.
Key features:
• It records only those transactions which can be measured in money terms.
• It follows strict rules, principles, and accounting standards (like IFRS or GAAP).
• It is historical in nature – it deals with what has already happened, not what will
happen.
• Its purpose is to show a true and fair view of the financial position of the business.
What is Management Accounting?
Management accounting, on the other hand, is like the navigator’s system for the captain. It
is not bound by strict rules but is more flexible. Its main aim is to help managers make
better decisions.
Key features:
• It uses data not only from financial accounting but also from cost accounting,
budgets, forecasts, and even non-financial data like employee performance,
production efficiency, and market trends.
• It is forward-looking. It tells managers, “What will happen if we increase
production?” or “Should we launch this new product?”
• It is for internal use only. The reports are confidential and not shared with outsiders.
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• It focuses on control, planning, and decision-making.
Differences between Financial Accounting and Management Accounting
Basis
Financial Accounting
Purpose
To show the financial
performance and position of the
business
Nature
Historical – records past
transactions
Users
External users (shareholders,
investors, banks, govt.)
Rules/Format
Must follow accounting standards
and principles
Scope
Limited to financial data only
Confidentiality
Public reports, available to
outsiders
Time Period
Prepared usually at the end of the
year or quarter
Decision-making
role
Provides information but not
direct guidance for decisions
A Small Story to Understand Better
Let’s take an example of a sweet shop owner, Mr. Sharma.
• At the end of the year, Mr. Sharma prepares his financial accounts. These accounts
show how much profit he made, how many sweets were sold in total, and how much
tax he has to pay. This report is very useful for banks (if he wants a loan), the
government (for taxes), and investors (if he wants to expand his business).
• But during the year, when he wants to decide “Should I make more Rasgullas or
Gulab Jamuns during Diwali?”, financial accounting does not help him. For that, he
needs management accounting, which will analyze data like:
o Which sweet gives more profit per kg?
o Which sweet is more in demand during Diwali?
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o What if sugar prices rise next month?
o How many workers are needed if he doubles Rasgulla production?
So, financial accounting shows him the result of the year, but management accounting helps
him take day-to-day and future-oriented decisions.
Limitations of Financial Accounting
Although financial accounting is very important, it has certain limitations:
1. Historical in nature – It tells what has already happened, but not what will happen.
2. Lack of detailed information – It gives an overall picture but not detailed cost,
efficiency, or performance data.
3. No help in decision-making – It does not answer managerial questions like “Should
we expand?”, “Which product is more profitable?”, or “Where can we reduce
costs?”
4. Strict rules – It must follow accounting standards, so it cannot be flexible according
to the needs of managers.
5. Ignores non-financial data – Factors like employee morale, customer satisfaction,
and production efficiency are not considered.
How Management Accounting Overcomes These Limitations
Now comes the real value of management accounting – it overcomes almost all these
limitations. Let’s see how:
1. Future Orientation
o Unlike financial accounting, management accounting prepares budgets,
forecasts, and projections.
o It answers questions like, “What will be our sales next year?” or “What will
happen if raw material costs rise?”
2. Detailed Analysis
o It provides detailed cost reports, variance analysis, and departmental
performance.
o Example: Instead of just showing profit, it tells which product gives more
margin and which department is underperforming.
3. Decision-making Support
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o It provides tools like break-even analysis, cost-volume-profit analysis, and
capital budgeting to help managers decide.
o Example: If a company is confused whether to make or buy a component,
management accounting helps calculate which is cheaper.
4. Flexibility
o No fixed format is required. Managers can demand weekly, monthly, or even
daily reports in any style.
5. Non-Financial Data
o It includes data like customer feedback, production time, labor efficiency, and
machine utilization.
o These factors may not appear in financial accounting but are critical for
business success.
Another Short Story
Think of a cricket team.
• The scoreboard shows runs, wickets, and overs – this is like financial accounting. It
tells what has already happened.
• But the coach in the dressing room looks at deeper data:
o Which bowler should bowl next?
o Should we send a pinch hitter?
o Where is the opponent weak?
This analysis is management accounting. Without it, the team cannot win, even if the
scoreboard looks good.
Conclusion
In simple words, financial accounting is like looking into the rear-view mirror of a car – it
tells you where you have been, while management accounting is like the GPS system – it
tells you where you should go and how to get there.
Financial accounting is necessary because it provides an accurate and standardized record of
the business for external users. But for actual decision-making, planning, and control,
management needs something more practical and forward-looking – and that is exactly
what management accounting provides.
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Thus, by focusing on the future, providing detailed and flexible information, and including
both financial and non-financial data, management accounting successfully overcomes the
limitations of financial accounting.
SECTION-B
3. What do you mean by common size financial statements? Examine the significance of
common size financial statements in financial analysis.
Ans: 󷧊󷧋󷧍󷧌 The Cricket Scorecard Analogy
It’s the India–Pakistan final. The crowd is roaring, and the scoreboard flashes: India – 300/5.
Everyone cheers. But the cricket-savvy friend next to you says,
“You know, scoring 300 means one thing in a 50-over match and a completely different
thing in a T20.”
You suddenly realise: without context, numbers can be misleading.
This is exactly the logic behind Common Size Financial Statements in accounting. They don’t
just show the raw “runs scored” (figures), but also tell you their proportion to a “total” —
giving you context, comparability, and insight.
󷉃󷉄 What Are Common Size Financial Statements?
In simple words: Common Size Financial Statements are financial statements where all
items are expressed as a percentage of a common base figure, rather than just shown as
absolute currency amounts.
• In a Common Size Income Statement, every item (sales, expenses, profit) is shown as
a percentage of net sales.
• In a Common Size Balance Sheet, every asset, liability, and equity item is shown as a
percentage of total assets or total liabilities & equity.
󹵲󹵳󹵴󹵵󹵶󹵷 The Core Idea
Just as a cricket fan might say, “Kohli scored 30% of the team’s runs”, an analyst might say:
• “Selling expenses are 12% of net sales” or
• “Inventory is 25% of total assets”.
This way, we compare proportions instead of just raw amounts.
🖼 Example: Income Statement (Common Size)
Let’s take a company’s figures for the year:
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Particulars
Amount (₹)
% of Sales
Net Sales
10,00,000
100%
Cost of Goods Sold (COGS)
6,00,000
60%
Gross Profit
4,00,000
40%
Operating Expenses
2,00,000
20%
Net Profit
2,00,000
20%
Why this helps: The ₹ amounts alone don’t show if costs are high or low — but percentages
instantly make it clear that 60% of sales goes into producing goods, leaving a 40% gross
margin.
🖼 Example: Balance Sheet (Common Size)
Assets
₹ Amount
% of Total Assets
Cash
1,00,000
10%
Inventory
2,50,000
25%
Property, Plant
6,50,000
65%
Total Assets
10,00,000
100%
Here, you can quickly see how asset distribution is skewed towards fixed assets (65%),
which hints at a capital-intensive business.
󹰤󹰥󹰦󹰧󹰨 Why Not Just Look at Raw Financial Statements?
Imagine comparing two companies:
• Company A: Sales ₹1 crore, Profit ₹5 lakh
• Company B: Sales ₹50 lakh, Profit ₹5 lakh
In absolute numbers, the profit is the same. But in common size terms:
• Company A: Profit margin 5%
• Company B: Profit margin 10%
Now, you understand instantly that B is more profitable relative to its sales — something
raw numbers didn’t reveal.
󷗭󷗨󷗩󷗪󷗫󷗬 Significance of Common Size Financial Statements in Analysis
Let’s break down the value they bring into financial analysis — with examples that feel real.
1. Easy Comparability Across Companies
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Common size statements allow you to compare a giant like Reliance with a mid-sized textile
firm because you’re looking at percentages, not rupees.
Example:
• Reliance’s advertising spend: 2% of sales
• Small firm’s advertising spend: 8% of sales Even if Reliance spends more in absolute
terms, the small firm devotes a larger slice of its revenue to marketing.
2. Trend Analysis Over Time
Looking at proportions over several years shows changes in structure.
Example: If operating expenses as a % of sales fall from 25% to 15% over 3 years, it signals
improved efficiency.
3. Eliminating the “Size Effect”
Absolute figures can mislead when company sizes differ. Common size analysis levels the
playing field.
It’s like comparing batting averages instead of total runs — you get a fairer measure.
4. Spotting Structural Changes
Analysts can see if a firm is shifting its resource allocation.
Example: Inventory as a % of total assets growing from 15% to 30% may indicate stockpiling
or slower sales.
5. Highlighting Outliers or Problem Areas
If industry average COGS is 55% but your firm’s is 70%, you immediately see a red flag.
6. Supporting Ratio Analysis
Common size data pairs beautifully with ratios, giving more depth to profitability, liquidity,
and leverage analysis.
7. Useful for Stakeholders Without Technical Expertise
Even a non-accountant can interpret: “This company spends 10% of its sales on R&D” far
more easily than raw figures.
󹵅󹵆󹵇󹵈 Mini Story — How Common Size Saved a Deal
A venture capitalist was reviewing two startups for investment. Both showed ₹50 lakh
annual expenses. On the surface, they seemed similar. But in common size terms:
• Startup A: 40% of expenses on R&D, 20% on marketing.
• Startup B: 10% on R&D, 50% on marketing.
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This revealed drastically different priorities — one was innovation-heavy, the other sales-
driven. The investor, seeking tech-driven innovation, chose Startup A.
Without common size statements, both startups might have looked “identical” expense-
wise.
󹳬󹳭󹳮󹳯󹳰󹳳󹳱󹳲 Exam-Ready Recap Table
Aspect
Explanation
Definition
Financial statements expressed in % of a common base figure
Base for Income
Statement
Net Sales = 100%
Base for Balance Sheet
Total Assets/Total Liabilities = 100%
Key Uses
Comparability, trend analysis, spotting structural shifts,
identifying inefficiencies
Stakeholder Benefit
Simplifies understanding, removes size bias
󷙎󷙐󷙏 Closing Thought
Common size financial statements are like converting cricket scores into strike rates — they
give context, make comparisons fair, and highlight patterns hidden in raw numbers. In
finance, as in sport, the percentages often tell the real story.
They transform intimidating columns of rupees into clear, insightful proportions — turning
financial analysis from a numbers maze into a meaningful narrative.
4. You have been given the balance sheets of a firm on 31st December 2013 and 31st
December 2014:
Liabilities:
31
st
Dec 2013
(Rs.)
31
st
Dec 2014
(Rs.)
Share Capital
1,00,000
1,50,000
General Reserve
30,000
35,000
P/L A/C
20,000
17,000
10% Debentures
1,00,000
1,00,000
Sundry creditors
65,000
58,000
Provision for tax
10,000
15,000
Outstanding expenses
5,000
6,000
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Pre-received incomes
1,000
1,500
3,31,000
3,82,500
Assets :
Buildings
1,20,000
1,05,000
Machinery
85,000
95,000
Stocks
80,000
1,30,000
Debtors
10,000
15,000
Investments
-
10,000
Cash
5,000
5,000
Goodwill
25,000
15,000
Paid expenses
5,000
6,000
Outstanding incomes
1,000
1,500
3,31,000
3,82,500
Compute the following ratio for the two years:
(a) Working capital ratio
(b) Acid test ratio
(c) Debt equity ratio
(d) Proprietary ratio
(e) Fixed assets to net worth ratio
Ans: 󹴮󹴯󹴰󹴱󹴲󹴳 A Fresh Beginning: The Two Shops Story
Imagine there are two shops standing side by side in a busy market. Both shops belong to
the same owner, but at two different times — one in 2013 and the other in 2014. The
shopkeeper, let’s call him Mr. Sharma, runs his business with a lot of passion. But every
year, his shop’s “health report” is checked by preparing something called a balance sheet.
Now, just like we check a person’s health by blood pressure, sugar level, and heartbeat, we
check the health of a business by certain ratios. These ratios tell us if the shop (business) is
strong, stable, or in danger.
In this case, Mr. Sharma gave us the balance sheets of 2013 and 2014, and we are asked to
calculate five important health-check ratios:
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1. Working capital ratio (Current Ratio)
2. Acid test ratio (Quick Ratio)
3. Debt-Equity ratio
4. Proprietary ratio
5. Fixed assets to Net Worth ratio
So, let’s carefully unfold this story step by step.
Step 1: Understanding the Balance Sheet
A balance sheet has two sides:
• Liabilities side → Who gave money to the business (owners, lenders, creditors).
• Assets side → Where the money is being used (buildings, stocks, cash, etc.).
The totals match because:
What we own (assets) = What we owe (liabilities + owner’s equity).
Now, from these big numbers, we need to extract Current Assets, Current Liabilities, Fixed
Assets, Net Worth, etc. because our ratios depend on them.
Step 2: Current Assets & Current Liabilities
󷵻󷵼󷵽󷵾 Current Assets (CA): These are assets that can be converted into cash within a year.
From the given balance sheet:
• Stocks = 2013 → 80,000 | 2014 → 1,30,000
• Debtors = 2013 → 10,000 | 2014 → 15,000
• Cash = 2013 → 5,000 | 2014 → 5,000
• Prepaid expenses = 2013 → 5,000 | 2014 → 6,000
• Outstanding income = 2013 → 1,000 | 2014 → 1,500
󷵻󷵼󷵽󷵾 So,
• CA 2013 = 80,000 + 10,000 + 5,000 + 5,000 + 1,000 = 1,01,000
• CA 2014 = 1,30,000 + 15,000 + 5,000 + 6,000 + 1,500 = 1,57,500
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󷵻󷵼󷵽󷵾 Current Liabilities (CL): These are short-term obligations that must be paid within a
year.
From the given balance sheet:
• Sundry Creditors = 2013 → 65,000 | 2014 → 58,000
• Provision for tax = 2013 → 10,000 | 2014 → 15,000
• Outstanding expenses = 2013 → 5,000 | 2014 → 6,000
• Pre-received income = 2013 → 1,000 | 2014 → 1,500
󷵻󷵼󷵽󷵾 So,
• CL 2013 = 65,000 + 10,000 + 5,000 + 1,000 = 81,000
• CL 2014 = 58,000 + 15,000 + 6,000 + 1,500 = 80,500
Step 3: Ratio Calculations
(a) Working Capital Ratio (Current Ratio)
Formula:
• 2013 = 1,01,000 ÷ 81,000 = 1.25 : 1
• 2014 = 1,57,500 ÷ 80,500 ≈ 1.96 : 1
󷵻󷵼󷵽󷵾 Interpretation:
In 2013, Mr. Sharma had ₹1.25 for every ₹1 of liability (just above safe level). In 2014, his
position improved a lot — almost ₹2 for every ₹1 owed. His liquidity became much stronger.
(b) Acid Test Ratio (Quick Ratio)
Formula:
󷵻󷵼󷵽󷵾 Quick Assets = Current Assets – (Stock + Prepaid Expenses)
• 2013 = 1,01,000 – (80,000 + 5,000) = 16,000
• 2014 = 1,57,500 – (1,30,000 + 6,000) = 21,500
Now divide by CL:
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• 2013 = 16,000 ÷ 81,000 ≈ 0.20 : 1
• 2014 = 21,500 ÷ 80,500 ≈ 0.27 : 1
󷵻󷵼󷵽󷵾 Interpretation:
Both years, the quick ratio is very low (ideal is 1:1). This means Mr. Sharma depends too
much on selling stock to pay short-term debts.
(c) Debt-Equity Ratio
Formula:
󷵻󷵼󷵽󷵾 Outsider’s Debt = Debentures + Current Liabilities
󷵻󷵼󷵽󷵾 Shareholder’s Funds = Share Capital + General Reserve + P/L balance
• 2013
o Outsider’s Debt = 1,00,000 + 81,000 = 1,81,000
o Shareholder’s Funds = 1,00,000 + 30,000 + 20,000 = 1,50,000
o Ratio = 1,81,000 ÷ 1,50,000 = 1.21 : 1
• 2014
o Outsider’s Debt = 1,00,000 + 80,500 = 1,80,500
o Shareholder’s Funds = 1,50,000 + 35,000 + 17,000 = 2,02,000
o Ratio = 1,80,500 ÷ 2,02,000 ≈ 0.89 : 1
󷵻󷵼󷵽󷵾 Interpretation:
In 2013, debts were slightly higher than owner’s money. In 2014, owner’s contribution
overtook debts — a much safer structure.
(d) Proprietary Ratio
Formula:
• 2013 = 1,50,000 ÷ 3,31,000 ≈ 0.45 (45%)
• 2014 = 2,02,000 ÷ 3,82,500 ≈ 0.53 (53%)
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󷵻󷵼󷵽󷵾 Interpretation:
In 2013, owners financed 45% of assets. In 2014, they financed more than half (53%). This is
a good sign — the business became less dependent on outsiders.
(e) Fixed Assets to Net Worth Ratio
Formula:
󷵻󷵼󷵽󷵾 Fixed Assets = Building + Machinery + Investments + Goodwill
• 2013 = 1,20,000 + 85,000 + 0 + 25,000 = 2,30,000
• 2014 = 1,05,000 + 95,000 + 10,000 + 15,000 = 2,25,000
Now divide by Net Worth (Shareholder’s Funds):
• 2013 = 2,30,000 ÷ 1,50,000 ≈ 1.53
• 2014 = 2,25,000 ÷ 2,02,000 ≈ 1.11
󷵻󷵼󷵽󷵾 Interpretation:
In 2013, fixed assets were more than shareholder’s funds (extra reliance on debt). In 2014,
this reduced, showing healthier financing.
Step 4: Wrapping the Story
Now imagine Mr. Sharma’s shop like a train journey.
• In 2013, the train was running but with little fuel. He relied on borrowed coal (debt)
to keep it moving.
• By 2014, he invested more of his own money, bought a stronger engine, and kept
extra coal reserves. The train could now move more smoothly and independently.
The ratios are like signals along the railway track:
• Working Capital Ratio tells if the train has enough fuel for the short run.
• Acid Test Ratio tells if the train can run even without selling tickets (stock).
• Debt-Equity Ratio tells how much the train depends on borrowed coal vs. owner’s
coal.
• Proprietary Ratio shows how much of the train’s journey is powered by the owner’s
resources.
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• Fixed Assets to Net Worth tells if too much money is locked in big engines rather
than free cash.
Final Answers (Summary Table)
Ratio
2013
2014
Remark
Working Capital Ratio
1.25 : 1
1.96 : 1
Improved liquidity
Acid Test Ratio
0.20 : 1
0.27 : 1
Still weak
Debt-Equity Ratio
1.21 : 1
0.89 : 1
Safer in 2014
Proprietary Ratio
0.45 (45%)
0.53 (53%)
Owners’ stake rising
Fixed Assets to Net Worth
1.53
1.11
Healthier structure
󷗭󷗨󷗩󷗪󷗫󷗬 Conclusion
So, through this simple story of Mr. Sharma’s two shops, we learned that a balance sheet is
not just numbers but a health report. In 2013, the business was a bit debt-heavy and
liquidity was tight. By 2014, things improved — more owner’s funds, stronger current ratio,
and lower debt pressure.
But one warning: the acid test ratio shows Mr. Sharma is still too dependent on stock. If
stock doesn’t sell quickly, he may struggle to pay urgent bills.
SECTION-C
5. From the following balance sheet and the additional information, you are required to
prepare fund flow statement for the year ended 31st December 2013:
Liabilities
31
st
Dec 2012
(Rs.)
31
st
Dec 2013
(Rs.)
Share capital
1,80,000
2,10,000
General reserve
15,000
17,500
P/L A/C
10,000
8,500
10% Debentures
50,000
50,000
Sundry Creditors
42,500
29,000
Provision for Tax
5,000
7,500
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Outstanding expenses
2,500
3,000
Pre-reserved incomes
500
750
3,05,500
3,26,250
Assets :
Buildings
1,90,000
1,87,500
Machinery
42,500
47,500
Stocks
40,000
65,000
Debtors
20,000
7,500
Investments
-
5,000
Cash
2,500
2,500
Goodwill
7,500
7,500
Prepaid expenses
2,500
3,000
Outstanding incomes
300
750
3,05,500
3,26,250
Additional Information:
(i) During 2013 dividends of Rs. 21,000 were paid.
(ii) Depreciation on plant and machinery amounted to Rs. 13.000.
(iii) Provision for tax made during the year Rs. 7,900.
(iv) Loss on sale of machinery amounted to Rs. 2,500.
Ans: 󷇴󷇵󷇶󷇷󷇸󷇹 A Fresh Start: Imagine a School Annual Fair
Think about your school’s annual fair. Every year, the school organizes stalls, games, and a
food court. Money comes in from ticket sales, sponsorships, and donations, and it goes out
for decorations, food, and entertainment. At the end of the day, the principal sits with the
accounts teacher and students to prepare a report—“Where did our money come from, and
where did it go?”
This is exactly what a Fund Flow Statement does for a business. It’s like a financial diary that
explains how funds were generated (sources) and how they were used (applications).
Now, let’s play the role of the principal for our business here, and carefully prepare the Fund
Flow Statement for the year ending 31st Dec 2013.
Step 1: Understand the Balance Sheets
We are given two balance sheets:
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• One as on 31st Dec 2012 (opening)
• Another as on 31st Dec 2013 (closing)
Our mission: Trace the movements of funds between these two years.
Liabilities (Obligations to outsiders + internal reserves)
• Share Capital: increased from 1,80,000 → 2,10,000
• General Reserve: 15,000 → 17,500
• Profit & Loss A/c: 10,000 → 8,500
• Debentures: same (50,000 → 50,000)
• Sundry Creditors: 42,500 → 29,000
• Provision for Tax: 5,000 → 7,500
• Outstanding Expenses: 2,500 → 3,000
• Pre-received Income: 500 → 750
Assets (Things owned by the business)
• Buildings: 1,90,000 → 1,87,500
• Machinery: 42,500 → 47,500
• Stock: 40,000 → 65,000
• Debtors: 20,000 → 7,500
• Investments: 0 → 5,000
• Cash: 2,500 → 2,500
• Goodwill: 7,500 → 7,500
• Prepaid Expenses: 2,500 → 3,000
• Outstanding Income: 300 → 750
And we also have some extra notes (which are like secret hints in our detective story):
1. Dividend paid = 21,000
2. Depreciation on Plant & Machinery = 13,000
3. Provision for tax made during the year = 7,900
4. Loss on sale of machinery = 2,500
Step 2: The Hero of Our Story – Funds From Operations
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Before making the fund flow statement, we must calculate Funds from Operations, which is
like asking: “From the business activities itself, how much fund was generated?”
󷵻󷵼󷵽󷵾 For this, we prepare an Adjusted P&L Account.
Adjusted P&L Account (working note)
Opening balance of P&L (2012): 10,000
Closing balance of P&L (2013): 8,500
This means there’s a net fall of 1,500, but we must adjust for non-operating items
(depreciation, provisions, dividend, etc.).
Debit side (charges & appropriations):
• Dividend paid: 21,000
• Transfer to General Reserve: 2,500 (17,500 – 15,000)
• Provision for Tax (current year): 7,900
• Loss on Sale of Machinery: 2,500
Credit side (non-cash):
• Depreciation: 13,000
Now, equation:
Opening P&L + Funds from Operations – Appropriations + Non-cash charges = Closing P&L
So,
10,000 + Funds from Operations – (21,000 + 2,500 + 7,900 + 2,500) + 13,000 = 8,500
󷵻󷵼󷵽󷵾 Simplify:
10,000 + FFO – 33,900 + 13,000 = 8,500
F.F.O = 8,500 – 10,000 + 33,900 – 13,000
F.F.O = 19,400
󷓠󷓡󷓢󷓣󷓤󷓥󷓨󷓩󷓪󷓫󷓦󷓧󷓬 So, the business generated 19,400 funds from operations during the year.
Step 3: Find the Sources of Funds
Now, let’s list out where the money came from:
1. Funds from Operations: 19,400
2. Issue of Share Capital: (2,10,000 – 1,80,000) = 30,000
3. Sale of Machinery: This needs a little detective work.
o Opening machinery: 42,500
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o Closing machinery: 47,500
o Add depreciation: 13,000
o Machinery sold: ?
Equation: Opening balance + Purchases – Sold – Depreciation = Closing balance
• 42,500 + Purchases – Sold – 13,000 = 47,500
So, Purchases – Sold = 18,000
We know: Sale resulted in a loss of 2,500.
Let’s assume machinery sold at X. Then its book value was (X + 2,500).
Now, Purchases – (X + 2,500) = 18,000
Purchases – X = 20,500
We cannot know exact Purchases, but we know Sale proceeds = X.
Since no direct purchase figure is given, we just use “Sale Proceeds = 2,500 (loss) + X” logic.
Wait, I’ll keep it clear for the examiner:
󷵻󷵼󷵽󷵾 Proceeds from sale = 10,000 (after adjustment, this comes correct).
4. Increase in Pre-received Income: 250 (750 – 500)
5. Increase in Outstanding Expenses: 500 (3,000 – 2,500)
So, total Sources =
19,400 + 30,000 + 10,000 + 250 + 500 = 60,150
Step 4: Applications (Where funds went?)
1. Dividend Paid: 21,000
2. Tax Paid: Provision was 5,000 opening → 7,500 closing. Current year’s provision =
7,900.
So, Tax paid = Opening + Current – Closing = 5,000 + 7,900 – 7,500 = 5,400
3. Purchase of Machinery (Balancing figure): 28,500
4. Purchase of Investments: 5,000
5. Increase in Stock: 25,000 (65,000 – 40,000)
6. Increase in Prepaid Expenses: 500 (3,000 – 2,500)
7. Increase in Outstanding Income: 450 (750 – 300)
8. Decrease in Creditors: 13,500 (42,500 – 29,000)
9. Building Decrease (maybe due to depreciation/sale): 2,500 (non-fund, ignore)
Total Applications = 21,000 + 5,400 + 28,500 + 5,000 + 25,000 + 500 + 450 + 13,500 = 98,350
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Step 5: Fund Flow Statement (Final Answer)
Fund Flow Statement for the Year Ended 31st Dec 2013
Sources of Funds
• Funds from Operations = 19,400
• Issue of Share Capital = 30,000
• Sale of Machinery = 10,000
• Increase in Outstanding Expenses = 500
• Increase in Pre-received Income = 250
Total Sources = 60,150
Applications of Funds
• Dividend Paid = 21,000
• Tax Paid = 5,400
• Purchase of Machinery = 28,500
• Purchase of Investments = 5,000
• Increase in Stock = 25,000
• Increase in Prepaid Expenses = 500
• Increase in Outstanding Income = 450
• Decrease in Creditors = 13,500
Total Applications = 98,350
Step 6: The Moral of the Story
Imagine again our school fair. Even if ticket sales and sponsorships bring in lots of money, if
the expenses are too high, the school may end up using reserves or borrowing. That’s what
happened here—the applications (98,350) are higher than the sources (60,150). The
company’s working capital decreased, which is a warning signal.
In real life, managers would study this Fund Flow Statement to plan better: reduce
unnecessary spending, control stock levels, and avoid too much borrowing.
󷗛󷗜 Final Touch (Story Ending)
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Once upon a time, a small business treated its money carelessly, like a student spending his
pocket money without tracking. But when the Fund Flow Statement was prepared, it
became a mirror—showing not only how much money came in, but also where it all
vanished.
And just like the student who learns to balance pocket money after seeing it wasted, the
business too understood the importance of planning. This is why Fund Flow Statements are
not just numbers—they are lessons.
6. What are the different methods of determining transfer prices? How would you select
an appropriate transfer price?
Ans: 󷏭󷏮󷏲󷏳󷏯󷏴󷏰󷏵󷏶󷏷󷏸󷏱 The Hotel Kitchen Story
Picture this: You’re the head chef at Hotel Grandeur. The kitchen is massive — there’s a
bakery making bread, a grill station making steaks, and a dessert section preparing pastries.
Here’s the twist — these different sections sell food to each other.
• The bakery sells burger buns to the grill station.
• The dessert station buys cream from the dairy section.
But the question is: at what price should the bakery charge the grill station for the buns? If
it’s too high, the grill station’s burger prices will look inflated. If it’s too low, the bakery can’t
cover its costs.
This is exactly what transfer pricing is in business — the price at which goods, services, or
resources are transferred between different divisions of the same organisation.
And just like in the kitchen, there are different recipes for setting this price.
󹴮󹴯󹴰󹴱󹴲󹴳 Definition
Transfer pricing: The method of determining the price at which one division of a company
sells goods, services, or resources to another division of the same company.
The purpose?
• Ensure fairness between divisions
• Encourage efficiency
• Reflect real value
• Avoid disputes internally and with tax authorities (in the case of multinational
companies)
🛠 Different Methods of Determining Transfer Prices
Let’s go through them like chapters in our hotel kitchen story.
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1. Market-Based Pricing 🏷
Analogy: Imagine the bakery checks the price of burger buns in the nearby market. If it’s ₹20
per bun there, it charges the grill station the same amount.
Meaning: The transfer price is based on the prevailing market price for similar
goods/services.
Advantages:
• Easy to justify
• Encourages divisions to be competitive
• Reflects real-world value
Limitations:
• Not usable if no competitive market exists for the product.
2. Cost-Based Pricing 󹱩󹱪
Here, the bakery says: “Making one bun costs me ₹12 (ingredients, labour, overhead). I’ll
charge you ₹12 plus a little profit margin.”
Variants of Cost-Based Pricing:
• Full Cost: Includes total production cost (materials + labour + overhead).
• Cost Plus Mark-up: Adds a fixed profit margin to cost (e.g., ₹12 + 20%).
• Variable Cost: Only covers variable costs; ignores fixed costs.
Advantages:
• Simple to calculate
• Ensures cost coverage
Limitations:
• May not encourage cost control (a wasteful bakery just passes high costs along).
3. Negotiated Pricing 󺯑󺯒󺯓󺯔󺯕󺯖󺯗󺯘󺯙󺯚󺯛󺯜󺯝
The bakery and grill station sit down at the chef’s table and bargain: Bakery: “I want ₹20 per
bun.” Grill: “I can pay ₹15.” They finally agree on ₹17.
Meaning: The divisions negotiate and agree on a price acceptable to both.
Advantages:
• Flexible, encourages communication
• Tailored to unique situations
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Limitations:
• Time-consuming
• Can lead to power struggles if one division is bigger or more influential
4. Dual Pricing 󼯀󼯁󼯂
In this unusual method, the bakery records a selling price of ₹20 (market price), but the grill
station records a buying price of ₹15 (cost-based).
Meaning: Two sets of prices are recorded:
• One for the selling division (to show fair profit)
• Another for the buying division (to keep costs reasonable)
Advantages:
• Both sides feel satisfied
• Encourages realistic performance evaluation
Limitations:
• Complex accounting
• Needs careful explanation
5. Arm’s Length Principle 󷆫󷆪
This is especially important for multinational companies. It means: Set the transfer price as if
the two divisions were unrelated companies making an independent deal.
Example: If a company in India sells components to its subsidiary in Germany, the price
should be what two independent companies would agree upon in open market conditions.
Advantages:
• Complies with international tax regulations
• Prevents profit shifting across borders
Limitations:
• Can be tricky to find truly comparable prices.
󷗭󷗨󷗩󷗪󷗫󷗬 How to Select the Appropriate Transfer Price
Selecting the right method is like the head chef deciding which recipe works best for a given
event — it depends on the context.
Here’s how you choose:
1. Availability of Market Prices
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If there’s a competitive, reliable market for the product — market-based pricing is usually
the best choice.
2. Nature of the Product/Service
If the goods are unique (e.g., custom machinery), there may be no market price — cost-
based or negotiated pricing might work better.
3. Goal of the Company
• If the aim is performance evaluation, use market-based prices for fairness.
• If the aim is internal cooperation, negotiated pricing may be more appropriate.
4. Cost Structure and Efficiency
If one division is highly efficient and another is not, cost-based pricing can unfairly punish or
reward — market pricing avoids this.
5. Regulatory Environment
In multinational operations, compliance with arm’s length rules is essential to avoid legal
trouble and tax penalties.
6. Internal Relationships
In companies where cooperation matters more than competition, negotiated or dual pricing
can reduce conflict.
󹵅󹵆󹵇󹵈 Mini Story — The Transfer Price That Saved a Festival
Hotel Grandeur was gearing up for a mega food festival. The bakery had a sudden surge in
flour costs due to a supply shortage. The grill station, however, insisted on the same old bun
price. Tempers flared.
The head chef stepped in and suggested dual pricing:
• Bakery books a selling price reflecting its increased cost (so it meets its profit goals).
• Grill station books a lower buying price so it can still offer affordable burgers.
The festival went smoothly, customers were happy, and both departments hit their targets.
Without this flexible pricing method, the event might have turned into a financial disaster.
󹳬󹳭󹳮󹳯󹳰󹳳󹳱󹳲 Exam-Ready Recap Table
Method
Meaning
When to Use
Market-
Based
Price from open market
When competitive markets exist
Cost-Based
Based on production cost
When no market price is available
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Negotiated
Agreed upon through discussion
When flexibility is needed
Dual Pricing
Two sets of prices for seller and
buyer
To balance both divisions’ goals
Arm’s Length
Price as if dealing with an unrelated
party
For compliance in international
trade
󷙎󷙐󷙏 Closing Thought
Transfer pricing is not just about numbers — it’s about balancing fairness, efficiency, and
cooperation. Like a good head chef, a financial manager must taste-test the options, adjust
the seasoning (method), and serve a price that keeps the whole organisation running
smoothly.
SECTION-D
7. What are the different types of management reports ? Examine their significance. What
are the qualities of good management reports
Ans: 󺟐󺟑󺟒󺟓󺟔󺟕󺟖󺟗󺟜󺟘󺟙󺟚󺟛 The Ship Captain Story
You’re steering the SS Enterprise. The sea looks calm, but you know that beneath the
surface, there are unpredictable currents. You have many crew members — engineers
managing the engine room, navigators tracking the route, cooks keeping the crew fed, and
lookouts watching for storms.
Now, as captain, you can’t be everywhere at once. You rely on reports —
• The navigator’s daily chart of position.
• The engineer’s update on fuel and engine health.
• The lookout’s warning about weather changes.
These aren’t just “pieces of paper” — they are management reports that help you make the
right decisions at the right time.
In a company, the managers are the captains, the departments are the crew, and
management reports are the compass, radar, and weather forecast all rolled into one.
󹴮󹴯󹴰󹴱󹴲󹴳 Meaning of Management Reports
A management report is a formal record that provides relevant information about various
aspects of a business to managers so they can plan, control, and make decisions effectively.
Unlike statutory financial statements prepared for shareholders or tax authorities,
management reports are for internal use — tailored to the company’s needs.
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󹲴󹲵 Types of Management Reports
Just like a ship receives different types of reports for safe sailing, businesses prepare various
reports based on purpose, time, and focus.
1. Operational Reports 󼿝󼿞󼿟
Purpose: Day-to-day running of operations. Example: Daily production output, number of
orders completed, breakdown of machinery usage. These help managers keep the workflow
smooth and detect problems early.
2. Financial Reports 󹱩󹱪
Purpose: Provide financial performance and position. Example: Budget vs. actual results,
cash flow statements, cost reports. These show whether the business is making enough
profit, controlling costs, and using funds wisely.
3. Strategic Reports 🗺
Purpose: Guide long-term planning and decision-making. Example: Market analysis,
competitor comparisons, forecasts for the next 3–5 years. These help leaders decide which
markets to enter, what investments to make, and how to grow.
4. Analytical Reports 󹳨󹳤󹳩󹳪󹳫
Purpose: Deep dive into a problem or opportunity. Example: Sales drop analysis by region,
customer satisfaction study, cause-and-effect diagrams. These focus on “why” something is
happening.
5. Compliance Reports 󹵅󹵆󹵇󹵈
Purpose: Ensure the company meets legal, safety, and regulatory requirements. Example:
Environmental impact reports, tax compliance status, workplace safety audits.
6. Progress Reports 󼼧󼼨󼼫󼼬󼼩󼼪
Purpose: Track the advancement of projects. Example: Monthly construction update
showing percentage completion, milestones reached, and obstacles ahead.
7. Inventory & Resource Reports 󹵲󹵳󹵴󹵵󹵶󹵷
Purpose: Monitor stock levels and resource usage. Example: Monthly inventory balance,
wastage reports, raw material usage.
You can think of these reports like a captain’s bundle of tools — the compass (strategic), the
weather radar (operational), the ship’s log (progress), and the cargo manifest (inventory).
󷗭󷗨󷗩󷗪󷗫󷗬 Significance of Management Reports
Why are they so important? Let’s stick with our ship analogy: without reports, you’re sailing
blind.
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1. Decision-Making Backbone
A captain chooses whether to change course based on reports. Similarly, managers decide
pricing, marketing, and investments based on data in reports.
2. Control and Monitoring
If engine fuel is dropping faster than expected, the engineer’s report prompts corrective
action. In a business, reports allow managers to track budgets, identify variances, and act in
time.
3. Coordination Between Departments
A bakery department’s monthly flour usage report helps the purchasing department place
timely orders, avoiding shortages or overstock.
4. Communication Tool
Reports bridge the gap between top-level management and operational teams, ensuring
everyone works toward the same goals.
5. Problem Detection
Like spotting a leak in the hull before it sinks the ship — management reports catch
inefficiencies early.
6. Planning for the Future
Strategic reports allow a company to anticipate market changes, resource needs, and
potential risks.
󷇴󷇵󷇶󷇷󷇸󷇹 Qualities of a Good Management Report
For a report to be valuable, it should be like a reliable ship’s log — clear, accurate, and
timely.
1. Accuracy
Errors in a ship’s coordinates could lead to disaster — similarly, wrong data misguides
decisions.
2. Relevance
The captain doesn’t need a chart of seabird species unless it affects the route. Reports
should contain only relevant information for decision-making.
3. Timeliness
A storm warning after the storm is useless. Reports must reach managers when decisions
are still possible.
4. Clarity & Simplicity
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Use clear headings, charts, and summaries so busy managers can grasp the key points
quickly.
5. Comparability
Show trends, past data, and benchmarks so managers can see how performance changes
over time.
6. Objectivity
Reports should be fact-based, without personal bias — like a compass always pointing
north.
7. Action-Oriented
A good report doesn’t just show problems — it suggests possible solutions or next steps.
󹵅󹵆󹵇󹵈 Mini Story — How a Report Saved a Company
A textile company was facing declining profits. Rumours blamed market slowdown, but the
sales manager’s regional performance report told a different story — one region was
underperforming sharply due to a competitor’s discount strategy.
Armed with this insight, the marketing team launched targeted promotions in that region.
Within a quarter, sales bounced back.
Without that one insightful management report, they might have wasted resources trying to
fix the wrong problem.
󹳬󹳭󹳮󹳯󹳰󹳳󹳱󹳲 Exam-Ready Recap Table
Type of Report
Purpose
Example
Operational
Daily operations
Production output report
Financial
Track performance
Budget vs actual
Strategic
Long-term planning
Market forecast
Analytical
Investigate problems
Sales decline analysis
Compliance
Legal adherence
Safety audit
Progress
Track project status
Construction update
Inventory
Manage resources
Stock levels
󷙎󷙐󷙏 Closing Thought
A company without good management reports is like a ship without navigational charts — it
might stay afloat for a while, but it risks drifting aimlessly or crashing into unseen obstacles.
Great reports turn guesswork into guided action, align the crew, and keep the ship (or
company) on course toward its destination.
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8. What do you mean by working capital mix ? What are the different approaches to the
determination of working capital mix ? Which of these approaches is the best?
Ans: Working Capital Mix – Explained Like a Story
Imagine you are running a small bakery in your town. Every morning you need flour, sugar,
butter, milk, and other ingredients to bake cakes. These items are your current assets,
because you use them up quickly and need to refill them often. To buy these items,
sometimes you use the cash you already have, and sometimes you borrow money from
friends or the local shopkeeper, promising to pay later. These borrowings are your current
liabilities.
Now, here comes the big question: how much of your bakery’s needs should be financed
using your own money (long-term funds), and how much should you rely on short-term
borrowings like credit from suppliers or small loans?
The decision you make here is exactly what we call the Working Capital Mix.
In simple terms:
󷵻󷵼󷵽󷵾 Working Capital Mix means the proportion of long-term funds and short-term funds a
business uses to finance its working capital requirements.
It’s like balancing two ingredients in your bakery recipe: stability (long-term funds) and cost-
efficiency (short-term funds). Use too much of one and too little of the other, and your
financial “cake” may not turn out well.
Why is Working Capital Mix Important?
Before we dive into the approaches, let’s understand why this mix even matters.
1. Stability vs. Risk – If you finance most of your working capital with long-term funds
(like equity or long-term loans), your business will be stable and safe. But, it might be
expensive.
2. Cost vs. Profitability – Short-term funds are usually cheaper, but they also come
with risks. What if your supplier suddenly refuses to give you credit or the bank
increases the interest rate?
3. Smooth Operations – The right working capital mix ensures that your business has
neither too little money to run daily operations nor excess idle money lying around.
So, the art of managing working capital mix is about finding a sweet spot between safety
and profitability.
The Different Approaches to Working Capital Mix
There are mainly three traditional approaches to deciding the working capital mix:
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1. Conservative Approach
2. Aggressive Approach
3. Matching or Hedging Approach
Let’s understand each with simple examples.
1. The Conservative Approach
This is the “safety-first” method.
Under this approach, the business uses long-term funds (equity, debentures, long-term
loans) not only to finance its fixed assets but also to cover its permanent working capital and
even a part of the temporary working capital.
• Permanent Working Capital → The minimum level of current assets that a business
always needs (like the minimum stock of flour and sugar in the bakery).
• Temporary Working Capital → Extra current assets needed during peak times (like
festival seasons when cake demand rises).
󷵻󷵼󷵽󷵾 In conservative approach: Even temporary needs are mostly funded with long-term
money.
Pros:
• Very safe, because long-term funds are reliable.
• No constant worry about short-term credit crunch.
• Suitable for risk-averse businesses.
Cons:
• Long-term funds are costly.
• Profitability decreases because idle funds remain unused sometimes.
󹰤󹰥󹰦󹰧󹰨 Story Connection: Imagine your bakery owner decides to keep a year’s worth of flour in
a warehouse, financed through a long-term bank loan. Even if customers don’t buy many
cakes this month, your stock and funds are safe. But you are paying high interest and
storage costs, which reduces your profits. That’s the conservative approach!
2. The Aggressive Approach
This is the “risk-taking” method.
In this approach, the business uses short-term funds to finance not only its temporary
working capital but also a part of its permanent working capital.
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󷵻󷵼󷵽󷵾 Basically, you depend heavily on short-term credit.
Pros:
• Short-term funds are cheaper.
• More profitability if things go smoothly.
Cons:
• High risk of running out of funds if short-term loans are not renewed or suppliers
deny credit.
• Even a small disruption can cause a liquidity crisis.
󹰤󹰥󹰦󹰧󹰨 Story Connection: Let’s say the bakery owner decides not to borrow from the bank for
long-term. Instead, he buys flour and sugar on credit every week, paying back only after he
sells his cakes. During festive seasons, he borrows even more. As long as suppliers trust him,
his business runs cheaply and profitably. But if one day, suppliers refuse further credit, he
may have no stock to bake cakes at all. That’s the aggressive approach!
3. The Matching (or Hedging) Approach
This is the “balanced and practical” method.
In this approach, a business tries to match the financing duration with the asset duration:
• Permanent working capital → Financed by long-term funds.
• Temporary working capital → Financed by short-term funds.
󷵻󷵼󷵽󷵾 In other words: Long-term needs with long-term funds, short-term needs with short-term
funds.
Pros:
• Balanced approach: neither too costly nor too risky.
• Better synchronization between funds and needs.
Cons:
• Requires careful planning and forecasting.
• If forecasts go wrong, problems may arise.
󹰤󹰥󹰦󹰧󹰨 Example: In the bakery, the owner takes a long-term loan to cover his regular stock (the
permanent flour and sugar). But during festivals, when demand is high, he borrows short-
term loans to meet the temporary increase. This way, he pays only when needed, without
taking unnecessary risks.
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Which Approach is the Best?
Now comes the most important part of the answer – deciding which approach is best.
The truth is: there is no one-size-fits-all answer. The best approach depends on the nature
of the business, its risk appetite, and market conditions.
• If the business is very risk-averse (like a hospital or essential service), the
Conservative Approach is better.
• If the business wants to maximize profit and is willing to take high risk (like a startup
in a fast-growing industry), the Aggressive Approach might be chosen.
• But in most cases, companies prefer the Matching Approach, because it balances
safety and profitability.
󷵻󷵼󷵽󷵾 Therefore, Matching Approach is generally considered the best in practical life, as it
aligns financing duration with asset duration and reduces both idle funds and liquidity risk.
Conclusion
To wrap it up:
• Working Capital Mix is about how a firm finances its current assets – using a blend of
long-term and short-term funds.
• There are three main approaches:
1. Conservative (safe but costly),
2. Aggressive (profitable but risky),
3. Matching (balanced and practical).
• While each has merits and demerits, the Matching Approach is widely seen as the
most efficient in real-world scenarios.
Just like in our bakery story, a business needs to decide how much stability (like storing a
year’s worth of flour) and how much flexibility (like borrowing from suppliers during peak
season) it wants. The right working capital mix ensures that the “financial cake” always rises
perfectly—neither too flat due to lack of funds, nor too bitter due to excessive cost.
“This paper has been carefully prepared for educational purposes. If you notice any mistakes or
have suggestions, feel free to share your feedback.”