Chapter 10. Construction Accounts Management – Construction Project Management: Theory and Practice

10

Construction Accounts Management

General, principles of accounting, accounting process, construction contract revenue recognition, construction contract status report, limitations of accounting, balance sheet, profit and loss account, working capital, ratio analysis, funds flow statement

10.1 GENERAL

As has been mentioned at several places, construction projects involve consumption of resources in terms of manpower, equipment, materials and, of course, time. Now, money could serve as a common denominator to reduce all these components to a level-playing field and compare costs of projects, profits (or loss) to the contractor, and so on. In the case of construction projects, which often take several years to complete, issues related to the time value of money, proper planning for cash flow, etc., also acquire tremendous significance. It needs to be borne in mind that transactions are taking place at different times, and it stands to reason that the financial position is viewed as on a certain cut-off date.

Given the uncertainties and the nature of the transactions, certain basic procedures and conventions have evolved in the field of accounting. This chapter aims at introducing basic concepts of accounting and equips a construction engineer to handle day-to-day accounting issues. Effort has been made to avoid details of accounting procedure and complexities, which are beyond the scope of the present text.

In principle, accounting can be defined as a system of recording, collecting, summarizing, analysing and presenting information about an organization or a project in monetary terms. The findings of this exercise are usually presented in the following forms:

  1. balance sheet,
  2. profit and loss account,
  3. a statement of changes in financial position.

When drawing up these statements, it should be borne in mind that they often become the basis for crucial decision-making. In fact, financial statements are of interest to owners and management of companies, potential investors, financial institutions, credit-rating agencies, employees, statutory and regulatory authorities, and competitors. Thus, effort is made to present various facts in an organized manner and at times the analysis is left to the user, who may like to better understand different aspects of the report. For example, whereas the investor would be primarily interested in knowing the prospects of his investment in the company, the tax authorities would be interested in knowing the tax liabilities of the company; the employees in the company may like to know about the stability and profitability of the company, while the creditors may be interested to know whether the amount owing to them would be paid when due; further, an analyst may be interested to know the extent of reliance on external source (debt) in relation to internal source (equity), and the management may be more keen to measure the firm’s liquidity, financial flexibility, profit-generation ability and debt-payment ability.

10.2 PRINCIPLES OF ACCOUNTING

In a manner of speaking, accounting can be called the language of business, and like any language, it aims at effective communication of business transactions. To that extent, it is very important for any accountant, who is an exponent of the accounting language, to keep a true and accurate record of transactions as and when they take place. It is important to note that the accounts should be maintained in a manner that the financial position of a company, project, etc., on a particular date can be easily and accurately ascertained. Now, if this exercise is carried out with sufficient rigour, it should not be difficult to determine the ‘profit’ or ‘loss’ during a particular period.

Though a purely theoretical treatment has been avoided, this section presents a simple treatment of basic issues related to accounting, profit and loss account, and balance sheet, and other relevant information required to analyse this information and make logical conclusions.

Here, it is important to keep in mind that accounting is largely based on the following assumptions:

  1. Transactions is recorded from the viewpoint of the person for whom the accounts are maintained. Consider a transaction involving transfer of, say, X tonnes of cement worth Rs. Y lakh from a cement supplier’s godown to a contractor’s batching plant. Now, the books of the cement supplier should reflect the ‘receipt’ of Rs. Y lakh and the ‘depletion’ of the available stock of cement by X tonnes. On the other hand, as far as the books of the contractor are concerned, they should show an increase (augmentation) of cement stock by X tonnes and an ‘expense’ of Rs. Y lakh.
  2. The establishment is going to exist forever.
  3. Provide for all prospective losses, but do not account for prospective profits.
  4. Sum of debits is always equal to the sum of credits. In other words, the total funds owned are equal to the total funds owed.
  5. Costs and revenues are taken into account or accrued as and when they are incurred or earned, rather than when they are paid or received. This is also known as the principle of accruals.
  6. It is very important that identical or very similar items are treated in the same way in different accounting periods and in different sets of account. This is known as the principle of consistency.

While a detailed treatment of the legal and regulatory framework for accounting is out of the scope of the present text, it may be noted that in India, accounting procedures are governed by the provisions of The Companies Act (1956), Income Tax Act (1961), accounting standards and guidance notes issued by the Institute of Chartered Accountants of India (ICAI), and the Securities and Exchange Board of India (SEBI) listing agreement.

10.3 ACCOUNTING PROCESS

The profit and loss account and the balance sheet are two important financial documents. This section is aimed at understanding the process of preparation of these two documents. The entire exercise of preparation of profit and loss account and balance sheet is carried out involving the following seven steps.

Step 1   Initiation of transaction

A construction company enters into a number of transactions (in a broad sense, a transaction is an event involving money) on a daily basis. The accountants come into action when transactions take place. However, no transaction is recorded unless there is documentary evidence of the same. The documents could be in the form of an invoice, a cash voucher, etc. The documents need to be preserved for crosschecking the accounts as well as for auditing purposes.

Step 2   Keeping records of transactions in a chronological manner

The transactions mentioned above could be cash transactions or non-cash transactions. For cash transactions a cashbook is maintained, while non-cash transactions are recorded in journals chronologically. The term ‘journal’ derives from the fact that this is the book of first entry. A cashbook, on the other hand, keeps record of all cash transactions in chronological manner and shows the cash balance at any point of time. Depending on the nature of cash transactions, entries in cashbook are recorded on either debit or credit side. The explanation of entering some transactions on debit side and some on credit side is given later in the text. Entries in cashbook have serial numbers C1, C2, C3,…and so on, which are used as cross-reference in the T-accounts, also called ledgers.

The journal records both the debit and credit sides of non-cash transactions. It is mandatory these days to record transactions following double-entry procedures. The principle of double entry is that for every debit there is an equal and corresponding credit. In this system (double entry), the bookkeeping convention requires debits to be defined as resource flowing into the accounts (i.e., the account received), credits being resource flowing out (i.e., the account given).

Conventionally, the debit side is written first, followed by the credit side. For reference purpose, the journal has a provision for writing ledger folio (LF). By convention, the entries in the journal are recorded as J1, J2, etc., instead of simply 1, 2, etc. A typical ledger is shown in Table 10.1.

 

Table 10.1 A typical journal

Table 10.2a and Table 10.2b give a summary of the conventions usually adopted to record transactions in a cashbook and a journal. It may be noted from the tables that in cases where there is an increase (or decrease) in the assets, the entry is recorded as debit (or credit). Similarly, an increase in liability or in income is recorded on the credit side, and an increase in expense is recorded on the debit side.

Step 3   Making adjustment entries

Some transactions such as wages paid to labourers and depreciation in the fixed asset (owned by a company) are not recorded on a daily basis, and an appropriate entry is made only at the time of preparing financial statements such as balance sheet and profit and loss account. Such entries are known as adjustment entries, and made in the journal only at the time of closing the accounts.

 

Table 10.2a Conventions used for recording debit transactions

Item description Recorded under

Increase in asset

Debit

Decrease in liability

Debit

Increase in expense

Debit

Decrease in income

Debit

Table 10.2b Conventions used for recording credit transactions

Item description Recorded under

Decrease in asset

Credit

Increase in liability

Credit

Decrease in expense

Credit

Increase in income

Credit

Step 4   Recording transactions in T-account or ledger

As and when the entries in cashbook and journal become substantial in number, they are posted in relevant
T-accounts (so-called due to their T-shape) or ledgers. For some organizations, posting may be done on a daily basis, while for others it may be on a weekly basis. In a ledger, the debit entries are recorded on the left-hand side and the credit entries on the right-hand side. A typical T-account is shown in Table 10.3.

 

Table 10.3 A typical T-account

Step 5   Preparing initial trial balance

Each of the T-account or ledger mentioned earlier is closed at the time of preparing the initial trial balance, which is a prerequisite for preparing the financial statements of profit and loss account and balance sheet. For this, the debit or credit balances from the T-accounts are carried over in the initial trial balance.

Step 6   Preparing profit and loss account and closing of T-accounts

The trial balance as prepared above becomes the source and basis for preparing the profit and loss account for a period and the balance sheet as of any date. For preparing the latter from the trial balance, the items related to revenue and expenditure are extracted. This combined with adjustment entries form the basis of profit and loss account. The adjustment entries now consist of stocks of raw materials, stock of work in progress, and stock of finished goods, besides other entries such as purchases made, interest paid, income taxes paid, depreciation and wages incurred for the period for which profit and loss statement is desired.

Step 7   Preparing the balance sheet

Preparation of a final trial balance sheet precedes the preparation of balance sheet as on a particular date for a company. The final trial balance includes items related to assets and liabilities from the initial trial balance, and also includes the balances from the profit and loss accounts. A detailed discussion on balance sheet is given elsewhere in the book.

10.4 CONSTRUCTION CONTRACT REVENUE RECOGNITION

The construction industry is characterized by the long-term nature of projects, the involvement of several uncertainties, and the frequent change orders observed in projects. This calls for a slightly different approach in accounting processes, especially when it comes to recognizing the revenue. There are different methods used to demarcate revenue recognition. These are

  1. Cash method of revenue recognition
  2. Straight accrual method of revenue recognition
  3. Completed contract method of revenue recognition
  4. Percentage of completion method of revenue recognition

These methods are explained with the help of illustrative examples. Let us begin with the given information about a construction company (see Table 10.4).

 

Table 10.4 Data for illustrating contract revenue

S. No. Description Amount (Rs. lakh)

1

Contract value

500.0

2

Original estimated cost of the contractor to complete the contract

450.0

3

Billed (invoice) to date

350.0

4

Payments received to date

315.0

5

Costs incurred to date

333.0

6

Estimated (forecasted) costs to complete

135.0

7

Costs paid to date

300.0

10.4.1 Cash Method of Revenue Recognition

In this method, the revenue for the project at any point of time is calculated by subtracting costs paid to date from the payments received to date.

 

Revenue = payment received to date − costs paid to date            (10.1)

For the data provided in Table 10.4, revenue to date = Rs. 315.0 lakh – Rs. 300.0 lakh = Rs. 15.0 lakh

10.4.2 Straight Accrual Method of Revenue Recognition

In this method, the revenue for the project at any point of time is calculated by subtracting costs incurred to date (even if the cost is not yet paid) from the billed (invoice) to date (even if the billed amount is not yet realized).

 

Revenue = billed (invoice) to date − costs incurred to date            (10.2)

For the data provided in Table 10.4, revenue to date = Rs. 350.0 lakh – Rs. 333.0 lakh = Rs. 17.0 lakh

10.4.3 Completed Contract Method of Revenue Recognition

In this method, the revenue is recognized only when the project has been completed. For the example project, the revenue would be zero since the project has not yet been completed. In cases where the contracts extend to several years, the company will not be in a position to show any revenue, and thereby profits, during the interim period. Obviously, for a long-duration construction project, this method has drawbacks.

10.4.4 Percentage of Completion Method of Revenue Recognition

In the first step, the percentage completion of the contract is evaluated. This is determined using the following relationship:

In the second step, the revenue for the project is calculated by multiplying the contract value with the percentage completion obtained in the first step.

 

Revenue = Percentage complete × Contract value                    (10.4)

For the example project, the revenue recognized using this method would be Rs. 500.0 lakh × Rs. 333 lakh × 100%/(Rs. 333 lakh + Rs. 135 lakh) = Rs. 500 lakh × 71.15% = Rs. 355.75 lakh. Gross profit to date for this case would then be Rs. 355.75 lakh (revenue recognized) – Rs. 333.0 lakh (cost incurred to date) = Rs. 22.75 lakh.

In view of the high uncertainty that is characteristic of the construction industry, some construction companies do not record profits on projects till the billing reaches 50 per cent of the original contract value. Till such time, the cost is accumulated and the total cost incurred during the year is considered as ‘invoiced sales’ for the year. When the billing crosses 50 per cent of the original contract value, the revenue from the project is recognized but even then, a contingency amount varying from 1 per cent to 5 per cent is kept for unforeseen reasons while calculating the revenue and, thereby, the profit. Obviously, the provision for contingency is lowered towards the advanced completion percentage.

10.5 CONSTRUCTION CONTRACT STATUS REPORT

As discussed elsewhere, a construction company executes a number of construction contracts in a given financial year. Each of these construction contracts may not be getting completed in a given financial year. While some contracts might start and get over in a financial year, some others may be in different stages of completion. For example, some contracts may be completed about 30 per cent; some others may be 50 per cent complete; and the rest may be about 80 per cent complete. Contract status report, also known as work-in-progress schedule, is a summary of each of the contracts being executed by the company which are not yet completed. This report is usually prepared by each of the project managers responsible for the mentioned contract. The report from each of the contract is compiled at head-office level. Table 10.5 illustrates the procedure of preparing contract status report.

 

Table 10.5 Data needed for preparing contract status report

For preparing the contract status report, the data required by the project manager includes contract value, cost to date, estimated cost to complete the balance work, and total amount billed to date. In case the contract value is revised due to change order, the revised contract value is to be noted. The source of ‘cost to date’ is the project cost report discussed in Chapter 12. The estimated total cost of completion is obtained by adding ‘cost to date’ and ‘estimated cost to complete the balance work’. The estimated profit or loss, then, can be obtained by subtracting ‘estimated total cost of completion’ from the ‘contract value’.

The revenue recognized till date can be computed based on any one of the methods explained in the previous section, depending on the accounting norms followed by the company. In most of the cases, the percentage completion method of revenue recognition is adopted. Keeping in mind the accounting principles discussed earlier, the proportional profit (based on the percentage completion) is reported in case of projects showing profit, while for projects showing loss, the entire loss is projected in the status report. Alternatively, the revenue can also be computed by adding cost to date and total profit on pro-rated basis, or total loss, as the case may be. The computations are shown in Table 10.6.

 

Table 10.6 Data needed for preparing contract status report

For completion of the discussion, we introduce the concepts of over-billing and under-billing. These terms are discussed in detail elsewhere.

 

Over billing = Billed to date − Revenue                    (10.6)

 

Under billing = Revenue − Billed to date                    (10.7)

Based on the above two formulaes, columns (11) and (12) have been computed in Table 10.6.

10.6 LIMITATIONS OF ACCOUNTING

Although accounting is a powerful tool to monitor financial transaction and evaluate the financial health of an organization, there are some inherent limitations that should be kept in mind when using the tool and arriving at any conclusion. The first such limitation that can be easily understood is that only transactions with money value can be recorded in the normal accounting procedures. Thus, generation (or loss) of goodwill cannot be kept track of. Similarly, records can be maintained only considering the original value. It is clear that the value of a plot of land, an equipment, or a building can be clearly defined only at the time of purchase (or sale), and it is difficult to assign any value in the intermediate period. In fact, an intermediate valuation of stock in terms of market price or cost price, whichever is lower, always involves the personal judgement of an accountant, which should be avoided in a scientific treatment and is also the bone of contention in a large proportion of disputes involving taxation, etc.

10.7 BALANCE SHEET

The balance sheet is one of the most important and fundamental financial statements of a firm. As the term suggests, the balance sheet provides information about the overall financial standing/position of a firm, giving a clear picture of its assets and liabilities among other things. In other words, a balance sheet presents a summary of what the company owns and what the company owes. Now, given the fact that transactions take place at different times (dates), it is obvious that neither assets nor liabilities are really permanent (though, as stated above, the establishment is assumed to be permanent in drawing up financial statements). Such a picture can at best be a snapshot—relevant for a particular point of time, say March 31, 2005, or December 31, 1990. Obviously, such a financial position is true for only a particular point in time, and bound to be different on the preceding or the following day. It may be mentioned here that the actual selection of the time and date of the balance sheet is more or less a matter of convention and practice, and it is more important to clearly understand the concept of the snapshot view of the overall financial status.

Example 1

Consider the transactions given in Table 10.7.

The balance sheet for the above transactions as on March 31, 2004, is shown in Table 10.8.

The balance sheet shown in Table 10.8 as on March 31, 2004, reflects a liability of Rs. 500,000 (which
M/s ABC owes to Mr M) and assets in the form of a bank balance of Rs. 300,000 (the balance after funds for the equipment were transferred out), as well as equipment worth Rs. 200,000 that M/s ABC now owns. It may be pointed out that in any balance sheet, the sum of assets and liabilities should always match—this, in fact, is a cardinal principle of accounting. It may be noted that in this illustrative example, the dates for transfer of funds and installation of equipment have been kept identical to avoid the complication of an ‘apparent mismatch’ in the intervening period when the funds would have been transferred out and the equipment is not yet in place.

 

Table 10.7 Transaction details for example problem

Date Detail Remarks

19-03-04

A company ABC is created and a bank account for the firm opened

 

20-03-04

Mr M transfers an amount of Rs. 500,000 to the company account

 

25-03-04

An expense of Rs. 200,000 is made to M/s XYZ for purchase of equipment E1

Balance in bank reduced to Rs 300,000

25-03-04

Equipment E1 is delivered and installed in the premises of ABC

 

Table 10.8 Balance sheet as on 31 March 2004

Traditionally, the liabilities comprised the left-hand side of the balance sheet and the assets comprised the right-hand side. The modern layout of balance sheet is linear and it gives details of liabilities beneath assets.

Figure 10.1 shows a typical balance sheet, and it can be seen, even without completely understanding the nuances or the strict definitions of the words used, that the information contained is critical from the point of view of understanding the financial health of the organization.

A close look at the balance sheet would reveal that assets and liabilities are arranged in the order of their liquidity. As far as listing the assets in the balance sheet is concerned, they can be listed in order of either liquidity promptness or fixity. Liquidity promptness refers to the ease with which an asset can be converted into cash (to repay a liability, etc.). In other words, the more liquid assets occupy the bottom position under asset heading. On the other hand, the amounts falling due within one year, such as bank loans, creditors and debentures, occupy the top position under liabilities heading.

It should also be noted that while a balance sheet is a very terse, matter-of-fact statement, which should in itself be complete, additional information is appended to better explain some of the features and facilitate better understanding. Such additional documents could be auditors’ and/or director’s report, other schedules forming part of accounts, (one such schedule referred to as schedule ‘G’ giving details of current assets is given in Figure 10.2) notes explaining significant accounting policies, related parties’ disclosure, etc.

Some of the common terms appearing in a typical balance sheet are discussed in the following sections. These are discussed under two broad sections—liabilities and assets.

Figure 10.1 Balance sheet

10.7.1 Liabilities

Technically, liabilities represent the funds made available (to the company) by an external agency—be it owner(s), shareholders, or financial institutions. In other words, liabilities represent the funds owed (by the organization) to someone, and arise on account of borrowings by the company. Obviously, all liabilities need to be repaid at some point of time or the other, and depending upon the duration over which the funds are available, liabilities are often classified as (a) long term and (b) current. Usually, a period of one year is used as a benchmark to differentiate these liabilities, as briefly discussed below.

SCHEDULE G

Figure 10.2 Schedule G

Long-term Liabilities

These liabilities arise in cases when the funds are available for more than one year. Debentures, bonds, mortgages and loans secured from financial institutions and commercial banks may be regarded as the source of long-term borrowings (or liabilities). Such liabilities are to be repaid (to the creditors) either as a single lump-sum payment at the time of maturity of the deposit, loan, or debenture, or in instalments over the life of the loan.

Current Liabilities

As against long-term liabilities, current liabilities are obligations payable in a short period, usually within the accounting period. It may be noted that liabilities due during the operating cycle (discussed elsewhere) of the organization are also deemed current liabilities. Such liabilities include accounts payable, taxes payable, accrued expenses, deferred income and short-term bank credit. It should be borne in mind that in some cases existing current liabilities can be cleared (liquidated) through the creation of additional current liabilities. Taking a short-term loan from one source to pay off a loan of another creditor is an example of such a transaction.

10.7.2 Assets

Although the term ‘asset’ is widely understood and used in common exchange of ideas, in business accounting for a resource to be considered as an asset of a company, it needs to satisfy the following conditions:

  1. it must be valuable—a resource is valuable in the event that it is either cash or it is convertible into cash, or it can provide future benefits to the operations of the firm
  2. it should be owned by the company in the legal sense, and merely possession or control is not sufficient for the resource to be considered as an asset
  3. it must be acquired at a measurable money cost. In the event that an asset is not acquired for cash/promise to pay cash, the test is what the asset would have cost, had cash been paid for it

Fixed Assets

As the name suggests, such assets are fixed and cannot be easily physically moved. They are usually acquired to be retained in business on long-term basis to produce goods and services, and not to be sold off easily. To that extent, fixed assets can also be looked upon as long-term assets, and are expected to remain with the company for periods longer than one accounting period. Very often, a viewer may use the extent and nature of these assets to judge the financial soundness of a company in terms of its future earnings, revenue, or profits. Fixed assets can be further classified into tangible and intangible fixed assets.

Tangible fixed assets   Tangible fixed assets are those that have physical existence and contribute directly to generate goods and services. Land, buildings, plant, machinery, furniture, etc., are examples of tangible fixed assets. Such assets are shown at the cost they were acquired in the balance sheet, and this cost is distributed or spread over their useful life. Now, this yearly charge is referred to as depreciation. Thus, the amount of the tangible fixed assets shown in the balance sheet every year declines to the extent of the amount of depreciation charged in that year, and by the end of the useful life of the asset, it equals only to the salvage value, if any. It may be noted that the salvage value signifies the amount realized by the sale of the asset at the end of its useful life. The subject of different models for depreciation is very important to construction companies, in view of the large amounts of equipment often owned by them, and is taken up for a more detailed discussion elsewhere in the text.

Intangible fixed assets   These assets do not directly generate goods and services, and in a manner of speaking, reflect the ‘rights’ of the firm. Such assets include patents, copyrights, trademarks and goodwill. Just as patents confer exclusive rights to use an invention, copyrights relate to production and sale of literary, musical and artistic works, and trademarks represent exclusive rights to use certain names, symbols, labels, designs, etc. It may be noted that intangible fixed assets are also written off over a period of time.

Current assets

Current assets comprise liquid assets of short duration. These assets are used in the operating cycle of the firm. Some examples of current assets are cash and bank balances, debtors, stock, etc. These assets will usually change their forms, time and time again, during the course of a year. Such assets in the ordinary and natural course of business move onward through the various processes of production, distribution and payment of goods until they become cash or equivalent, by which debts may be readily and immediately paid. Money used to purchase these assets is called floating or circulating capital.

Out of the given examples of current assets, cash is the most basic current asset. Bank balances are deposits made in the banks. Debtors are amount due to an entity or firm from customers buying on credit. In case of a construction company, debtors represent money that clients owe to the construction firm for construction services rendered by the company. Stocks consist of construction material for use in construction projects in case of construction companies. A more general definition of stock would be the value of inventory consisting of raw materials, work in progress, and finished goods.

10.8 PROFIT AND LOSS ACCOUNT

The profit and loss account is also known as the income and expenditure statement, the statement of earnings, and the statement of operations. This is a statement of the incomes and expenditures (or revenues and expenses) of the company during an accounting period, usually a year. Information on the following heads is commonly found in a profit and loss account:

  • Gross profit
  • Details of costs incurred
  • Income from other investments of the company
  • Interest details
  • Outstanding expenses
  • Prepaid expenses
  • Income received in advance
  • Outstanding income
  • Depreciation
  • Provision for bad and doubtful debt, etc.

Figure 10.3 Profit and loss account

A typical profit and loss account for a major construction company is shown in Figure 10.3.

As can be noticed, profit and loss account is an important financial statement that helps to ascertain the profit/loss of any particular business during a particular period of time. The statement, in essence, is the scoreboard of the performance of the organization in terms of profitability.

Some of the common terms appearing in a typical profit and loss account are discussed in the following paragraphs:

Revenues

Revenues are incomes accrued by sale of goods/services/assets or by the supply of the organization’s resources to others. In other words, revenue refers to the overall value received from its customers or users. Interest, dividend, rent, etc., from the investments of the organization in other organizations, banks, etc., are also sources of revenue.

Expenses

As against revenue, which can be considered as the inflow of funds into an organization, expenses cause an outflow of funds. Indeed, expenses should be made with the object of generating revenues! For example, in a construction company, expenses need to be made towards procuring materials, payment to workers and staff, procuring and installing plant and machinery (either through purchase or hire), and so on. To facilitate proper monitoring and control, expenses are classified under material cost, labour cost, plant and equipment cost, other costs such as cost toward fuel and power, insurance, etc. General and administrative expenses comprise salary of staff, rent of the organization premises, welfare, etc.

Net income/profit

Quite simply, the difference between the total revenues and the total expenses is termed as net income or profit. Now, a part of this net profit is retained to augment the reserves and surplus (retained earnings), and the remaining is used for paying dividends to shareholders.

10.9 WORKING CAPITAL

There has been considerable growth in the construction industry in the recent past, which has led to proliferation of small, medium and large construction companies. This has introduced stiff competition amongst all types of companies with different financial structures to win contracts for lesser profit margins. Companies with different financial structures have different working capital requirements; however, it is important that a company has sufficient working capital or access to funds to meet its short-term obligations. Too little may result in avoidable consequences such as cash-flow problems and failure to pay suppliers, labour, subcontractors, etc., on time. Ultimately, a business with insufficient working capital may be forced to cease trading even if it continues to report profit. Similarly, too much of working capital would make the funds idle, thereby hitting the profitability of the company. Working capital management, thus, seeks to arrive at a balance between liquidity and profitability, which are inversely related and, hence, lead towards opposite directions. Further, it aims at ascertaining the optimum level of cash and inventory that can be maintained and the optimum credit that should be allowed.

Stated simply, working capital or gross working capital refers to the current assets. When the term ‘net capital’ is used, it basically refers to the difference in current asset and current liability. It is said that working capital is to business what blood is to the body. This explains why it is important to manage the working capital effectively.

Moreover, working capital is costly and by suitably managing it, the profitability of business can be improved. Management of working capital means management of its key components, i.e., cash, debtors, inventory and creditors. The various factors that affect working capital include the nature of the business, the nature of raw materials used, the process technology used in the business, the nature of finished goods, the degree of competition in the market, and the paying habits of customers.

10.9.1 Need for Working Capital

The objective of financial decision-making is to maximize the shareholders’ wealth. To achieve this, it is necessary to generate sufficient profits. The extent to which profits can be earned will naturally depend upon the magnitude of sales, among other things. A successful sales programme is, in other words, necessary for earning profits by any business enterprise. However, sales do not convert into cash instantly; there is invariably a time lag between the sale of goods and the receipt of cash. There is, therefore, a need for working capital in the form of current assets to deal with the problem arising out of the lack of immediate realization of cash against goods sold. Therefore, sufficient working capital is necessary to sustain sales activity. Technically, this is referred to as the operating or cash cycle and is explained in detail in the following section.

10.9.2 Operating Cycle

The operating cycle can be said to be at the heart of the need for working capital. The continuing flow from cash to suppliers, to inventory, to accounts receivable, and back into cash is what is called the operating cycle, which in fact is a continuous process. In other words, the term ‘operating cycle’ refers to the length of time necessary to complete the process of movement from cash to inventory (raw materials, consumables, other stocks), to finished goods, to receivables, and to cash again. A typical operating cycle is shown in Figure 10.4 and is explained in the context of a construction company.

A construction company is awarded a contract. The company may or may not receive mobilization advance. However, the company gets monthly payment for the work done during a particular month, and thus, cash is realized. The cash so obtained is spent in procuring inventory (materials, consumables and other stocks). The inventory is utilized in the production process of some construction activities of the contract. The inventories may be procured either in cash or on credit. In the later case, the supplier of inventory is treated as creditors of the company. The cash is also utilized in paying labour wages and equipment supplier, and in meeting overhead expenses. Upon completion of billing cycle, the company raises the bill for different activities carried out (it is equivalent to finished goods in case of manufacturing) during the billing period. Till the time payment is received against the bill, it is understood as credit sales and the client is regarded as debtor to the company. The retention and the other deductions from the certified bill are considered as outstanding and are treated as debtors. Further, the receipt of payment against the bill completes the operating cycle.

Figure 10.4 Working-capital cycle or operating cycle

The provision for taxes, bad debts and expenses towards general overheads also needs to be considered in the cycle. A company operating profitably is generally cash-surplus. Failure to do so makes the company short of cash and eventually leads to its downfall.

If it were possible to complete the above cycle instantaneously, there would be no need for current assets (working capital). But since it is not possible, the firm is forced to have current assets. Since cash inflows and cash outflows do not match, firms have to necessarily keep cash or invest in short-term liquid securities so that they will be in a position to meet obligations when they become due.

Business activity does not come to an end after the realization of cash from customers. For a company the process is continuous, and hence the need for a regular supply of working capital. The magnitude of working capital required will not be constant, but will fluctuate. The changes in the level of working capital occur for three basic reasons—(1) changes in the level of sales and/or operating expenses, (2) policy changes and (3) changes in technology. To carry on with the business, a certain minimum level of working capital is necessary on a continuous and uninterrupted basis. For all practical purposes, this requirement will have to be met permanently as is the case with other fixed assets. This requirement is referred to as permanent or fixed working capital.

Any amount over and above the permanent level of working capital is temporary, fluctuating, or variable working capital. This portion of the required working capital is needed to meet fluctuations in demand consequent upon changes in production and sales as a result of seasonal changes.

10.9.3 Components of Working Capital

There are several components of working capital, as shown in Figure 10.5. As can be observed, these are broadly classified under current assets and current liabilities.

Current assets include cash/bank balances, inventories, sundry debtors, and loans and advances. These assets will usually change their forms, time and time again, during the course of a year. Such assets in the ordinary and natural course of business move onward through the various processes of production, distribution and payment of goods, until they become cash or equivalent, by which debts may be readily and immediately paid.

Figure 10.5 Components of working capital

Current liabilities are all those liabilities that are falling due within a period of 12 months. The liabilities consist of sundry creditors, advances received from customers, overdraft facilities (unsecured) and provisions. The provisions are mainly proposed dividends, corporate taxes, miscellaneous owings by the company, etc. In order to minimize the requirement of working capital, contracting organizations attempt to avail the maximum credit facility extended by suppliers. However, contracting organizations should meet the payment commitments made to suppliers on the due date.

The components of working capital in the context of a construction company are given below.

Current Assets

A  Stock at sites/main depot

B  Outstanding (including retention)

C  Work in progress (WIP)

D  Other current assets

E  Excess cost over invoicing

F  Work done unbilled

G  Cash and bank balance

Current Liabilities

H  Unadjusted advance (material, mobilization and plant)

 I  Vendor credit

 J  Other current liabilities

 

Net working capital = A + B + C + D + E + F + G − H − I − J    (10.8)

10.9.4 Determination of Working Capital

It is evident from Figure 10.5 that there are a number of components of working capital and monitoring all of them is no easy task. Hence, some construction companies monitor only a few important components such as stock of materials, as well as customer outstanding from among current assets and advances provided by the customer or owner from among current liabilities. A budgetary norm is fixed for each of these three components and they are monitored accordingly. In order to calculate the net working capital, the revised formula then becomes:

 

Net working capital = A + B − H                    (10.9)

The proportion of current asset to fixed asset depends on the psyche of the manager dealing with the working capital. An aggressive manager would prefer less of current assets than fixed assets. On the other hand, a conservative manager would stress more on the current assets than the fixed assets. An average manager would follow the intermediate path. The proportion of current asset to fixed asset impacts the return on assets employed and is evident from the given example (see Table 10.9). The example shows that for the same sale amount of Rs. 150 lakh, the variation in the ratio of current to fixed asset (from 1.2:1 to 0.8:1) results into the return on asset varying from 13.6 per cent to 16.7 per cent depending on the approach of the manager.

 

Table 10.9 Data to illustrate different approaches in managing working capital

10.9.5 Financing Sources of Working Capital

One important issue in working capital management is to decide on the sources of finances for the working capital. The finances may be arranged from short-term sources or long-term sources. Arranging short-term finances are less costly compared to long-term finances. Here also, the proportion in which short-term finances and long-term finances are arranged is dependent on the manager’s approach.

The three common approaches adopted in working capital finance are—matching approach, aggressive approach and conservative approach. In the matching approach, the permanent part of working capital is financed through long-term funds and the variable part through short-term funds. In the conservative approach, the permanent part of working capital as well as part of the variable working capital is financed through long-term funds, thereby avoiding risk but at the cost of profitability.

In the aggressive approach, the variable part of the working capital as well as part of the permanent working capital are financed through short-term funds, thereby involving a relatively high degree of risk. In summary, in conservative approach the major sources of finances are long-term, while in aggressive approach the major sources of finances are short-term.

Depending on the approach, the mix of short-term and long-term finance has a bearing on the return. This is illustrated through an example (see Table 10.10).

It is evident from Table 10.10 that the interest liability changes depending on the approach of the manager. For example, interest in aggressive approach works out to be Rs. 5,200, while it is Rs. 5,800 for the conservative approach. This is hitting the return on equity. In aggressive approach, the return on equity works out to be 13.72 per cent, while it is 12.88 per cent in case of conservative approach. This difference could be even more pronounced if the difference in interest rates of short-term loan and long-term loan widens. This is the reason the determination of proportion of short-term and long-term finances demands appropriate attention. Having understood the importance of this, we now see the various options available for short-term and long-term finances of working capital. The common sources of finance are shown in Figure 10.6 and are described briefly in the following two sections.

 

Table 10.10 Different approaches in financing working capital

Figure 10.6 Sources of finance

Sources of Short-term Finance

The sources for short-term finance could be broadly classified in two categories—spontaneous and negotiated. While the first type does not require any formal arrangement on the part of the company availing them and come up automatically in the normal course of business, the negotiated category requires formal arrangements and is largely obtained from commercial banks. While trade credit comes under the spontaneous type, bank finances and some other sources such as commercial papers fall under the negotiated category. The sources of short-term finance are discussed briefly in the following paragraphs.

Trade credit   Trade credit is very common in construction industry as it comes with fewer restrictions and is known for its simplicity and flexibility. Suppliers, vendors and subcontractors extend credit to the construction company. This form of financing does have benefits, but at the same time, it involves certain implicit and explicit costs. The cost of paying late in the form of reduced credit standing of the company is an example of implicit cost, while the cost of foregoing discount is an example of explicit cost.

Bank finance   Banks are one of the important sources of finance. Bank finances could be of different types—overdraft facility, cash credit, purchase or discounting of bills, letter of credit, working capital loan, etc. Credits extended by banks could be either unsecured or against some collateral. The collaterals could be in the form of hypothecation, pledge, mortgage, or lien. The interest rate depends on whether interest is paid upfront or at maturity.

Other sources   The other sources of short-term funds include commercial papers, forfaiting, factoring and inter-corporate deposits.

Commercial paper (CP)   The concept of commercial paper (CP) originated in the USA on the pattern of short-term notes. Blue-chip companies in need of short-term funds could issue CP. In India, it came into existence in 1987. The maturity of CP lies between 15 days and less than one year.

Factoring   Factoring is a process whereby a firm sells its receivables for cash to another firm known as the factor, which specializes in their collection and administration. In a broader sense, factoring is a type of bill discounting. The factor buys the client’s receivables and controls the credits, and collects the same at maturity. In factoring, the seller of the goods informs the factor about an order received by the seller. The factor, in turn, evaluates the customer’s (buyer of the goods) credit worthiness and approves the deal. The approval means that the factor has purchased the accounts receivables and now it is his responsibility to provide coverage for any bad debt loss. Of course, the factor offers this service for a certain commission.

Forfaiting   This is an extension of factoring in the area of international trade. In forfaiting, an exporter discounts the bill with an agency known as the forfaitor. Once the export deal is finalized, the exporter intimates the forfaitor. The forfaitor then scrutinizes the deal. Once the forfaitor is satisfied, it quotes the discount rate and if it is agreeable to the exporter, the deal is signed.

Sources of Long-term Finance

The period involved in long-term finance is between 5 years and 10 years. Such finances are usually arranged to start a new business or to expand the existing business. The interest rates are usually high in view of the larger risks involved. Also, it is difficult to get finance on long-term basis, especially for construction companies. Some typical sources of long-term finance are:

  1. Retained earnings
  2. Clearing bank loan facility
  3. Shares
  4. Merchant bank
  5. Industrial and commercial finance corporation
  6. Debentures
  7. Government grants

Retained earnings   Retained earnings are those portions of earnings (usually between 30 per cent and 80 per cent of earnings after tax) of a company which are ploughed back (reinvested) into the business. These are also sometimes referred to as internal equity. The retained earnings are an important source of long-term finance.

Debentures   Debentures are loans made to the company at fixed interest rates repayable at a set time. A company’s reputation plays an important role in raising this type of loan. Debentures can be secured by mortgage on the firm’s property as well. In case of liquidation or bankruptcy of the firm, those holding debentures can exercise their right almost ahead of all creditors.

Shares   Equity shares are issued to the promoters of a company at the formation stage of the company. Subsequently, the company issues shares privately to the promoters’ relatives, friends, business partners, employees, etc. Once the company grows, it raises capital from the public in the form of issue of equity shares.

Rights issue   In rights issue, existing shareholders are offered new shares in exchange for their present shares, at some discount. The left-out shares (those not taken by existing shareholders) are put up for sale.

Merchant bank   Merchant banks also provide loan at some fixed interest charges, which are negotiable. They usually attract higher interest charges. The loan is flexible in the sense that capital and interest repayment can be arranged to suit the company’s (the borrower) future cash-flow position.

Loans   Long-term loans are difficult to raise by construction companies, especially for new entrants in the business. This is because of the high risk involved in such loans for long terms. However, companies are able to raise long-term loans on higher interest rates. The new entrants first have to develop a good market reputation before realizing such loans.

Financial instruments   Financial instruments such as bonds, floating-rate notes, bills of exchange, and promissory notes are also increasingly used for raising long-term finance for a company.

Venture capital   These funds are an important source of finance for new companies. However, venture capital investors are specific to a business and they are very small in number.

10.10 RATIO ANALYSIS

Mathematically, ratio is the representation of one quantity (say, X) as a proportion of another (say, Y), and expressed as X/Y. To calculate the ratio, X is divided by Y, and the quotient (Z) multiplied by 100, in case the result is to be expressed as a percentage. Now, in obtaining Z some of the absolute value of X is lost, and the quotient is representative of the value only in relation to the value of Y.

The underlying principle of ratio analysis lies in the fact that it makes related information comparable. For instance, the fact that the net profits of an organization are, say, Rs. 10 lakh, provide very little basis for evaluation of the information in terms of performance. It is only when viewed against a target profit, profit achieved in previous years, percentage of profit in terms of the total sales, total assets, etc., that the figure of Rs. 10 lakh begins to make sense, and helps the management make strategic decisions. Now, in the context of business accounting, ratios acquire special significance as interest focuses not only on absolute values of parameters such as revenue, sales, etc., but also on their value in relation to others, as clearly brought out in the given example. The example clearly highlights the importance of ratios as an aide to business analysis, and the effort in this section is focused on providing an overview of some of the commonly used ratios in normal business accounting.

Table 10.11 shows the data for two organizations over a two-year period.

The following are some of the observations that can be made on the basis of the data presented in Table 10.11:

  1. Whereas the sales for both A and B were identical in the first year, they grew at different levels for the two companies. The sales of A grew by 50 per cent, while B recorded a growth of only 25 per cent.
  2. In the first year, profits of A and B are 25 per cent and 10 per cent of the respective sales values, and these numbers became 33 per cent and 20 per cent in the next year.

     

    Table 10.11 Data for sales and profit for organizations A and B

  3. Whereas the profit of A doubled in the second year, B managed a two and a half times growth in profits.

In the above example, since both sales and profits were in the same units (rupees), it was possible to express the results in terms of percentages.

While the example highlights the importance and power of using ratios in analysis of business data, it should be remembered that computing ratios does not really add any new information, and only reveals a relationship in a more meaningful way. At the same time, pure ratios (or percentages) are also quite meaningless. For example, a statement that a company invests one per cent of its revenue in research and development does not communicate anything about the actual investments in research and development. Thus, in a manner of speaking, ratios and absolute numbers serve to complement each other as ways of presenting information, and ratio analysis should only be considered as an important tool in business analysis and decision-making.

It is clear from the above discussion that ratio analysis is basically useful when a comparison is involved—that of a number with another number, or that of a ratio with another ratio. Generally, three types of comparisons are commonly used in business—trend ratios, inter-firm comparison, and comparison with standards or plans. Trend ratios involve a comparison of ratios of a firm over time—that is, present ratios are compared with past ratios (for the same firm). A comparison of the profitability of a firm over a period, say, 1981 through 1985, is an illustration of trend ratio. Trend ratios are indicative of a general direction of change years. In inter-firm comparison, the subject of investigation is comparison of ratios of a firm with those of others in a similar line of business at the same time, or for the industry as a whole. A comparison of the market share or revenues of Hutch and Airtel would be an inter-firm comparison in the telecommunication sector. A comparison of investment in research and development by the telecommunication and construction industries could be looked upon as another example of inter-firm comparison. Finally, the comparison of ratios of a typical organization in a particular sector such as construction with that of a leading construction organization could be an example of comparison with standards. Also, if the comparison is carried out for different ratios against a target value set by management of an organization, it would be an example of ‘comparison with plan’.

In the following paragraphs, discussion will be largely confined to different aspects of the ratios that are commonly used in the industry to study financial performance and integrity—liquidity ratio, capital structure ratio, profitability ratio, activity ratio and supplementary ratio.

10.10.1 Liquidity Ratios

Liquidity in financial terms refers to the ease with which assets can be converted to cash to pay off debts, meet an expense, etc. To that extent, cash in hand has the highest liquidity, followed by, say, bank deposits in savings account, fixed deposits, etc. Naturally, then, given the time and complexities involved in selling land, or such other assets, they have the lesser liquidity. The liquidity ratio, therefore, is a measure of the ability of a firm to meet its short-term obligations and reflects its short-term financial strength. Depending on how the parameters involved are calculated, the following variants of liquidity ratios are commonly used:

  1. Current ratio
  2. Acid test/quick/liquid ratio

Current Ratio

Current ratio is a measure of short-term financial liquidity and indicates the ability of the firm to meet its short-term liabilities. A current ratio in excess of 1.3:1 is generally considered satisfactory for construction organizations (Schexnayder and Mayo 2004). A current ratio of less than 1:1 would certainly be undesirable in any industry, as some safety margin is required to protect the creditors’ interest at least.

Acid Test of Liquidity or Quick Ratio

The ‘quick assets’ include only the cash and bank balances, short-term marketable securities, and receivables. The acid ratio test is a more rigorous measure of a firm’s ability to service short-term liabilities. The ratio is also widely accepted as the best available measure of the liquidity position of a firm. The recommended value of acid test ratio is in excess of 1.1:1 for a construction organization (Schexnayder and Mayo 2004).

10.10.2 Capital Structure Ratios

When a firm wishes to make a long-term borrowing, it needs to commit to

  • pay the interest regularly, and
  • repay the principal when it is due [in instalment(s) at due dates, or in a single payment at the time of maturity].

Now, for long-term creditors, both the criteria are important and they often base their judgement on the (long-term) financial soundness on the capital structure ratios, which reflect the long-term solvency of a firm. It is quite evident that the above two criteria are quite different but mutually dependent, and are examined using slightly different capital structure ratios. It may be borne in mind that usually two types of capital structure ratios are used—leverage ratios and coverage ratios.

Leverage Ratio

The source document for computing leverage ratio is the balance sheet. Some of the important leverage ratios are given below.

Debt equity ratio   This ratio is computed to better understand the financial structure and integrity of a firm, as it reflects the relative contribution of creditors and owners of business in its financing. Now, depending on the relationship between creditor’s claims and owner’s capital, there can be several variants of the debt equity ratio as given below.

  1. In the above expression, long-term debt excludes the current liabilities and shareholders’ equity includes both ordinary and preference capital, besides past accumulated profits (reserves and credit balance of the profit and loss account). The shareholders’ equity so defined is also referred to as the ‘net worth’, and the debt equity ratio computed on this basis may also be called debt to net worth ratio.

  2. In the above expression, the total debt is the sum of the short-term and long-term debts.

Neither a very high nor a very low debt equity ratio is desirable, and each firm needs to determine an optimum level where the debt and equity are properly balanced.

Debt asset ratio   This ratio relates the total debt to the total assets of the firm, and is defined as follows:

In the above, the total debt comprises long-term debt and current liabilities, whereas the total assets consist of all assets minus fictitious assets (i.e., total debt plus shareholders’ equity).

Coverage Ratio

This ratio is calculated from the profit and loss account. Coverage ratio measures the relation between what is ‘normally’ available from operations of the firms and the outsiders’ claims. Some of the important leverage ratios are given below.

Interest coverage ratio

This ratio measures the debt-servicing capacity of a firm. It shows how large the EBIT is, compared to the interest charges. The ratio, like the interest coverage ratio, reveals the safety margin available to the preference shareholders, and, in principle, a higher value of the ratio is considered better from the point of view of shareholders.

Dividend coverage ratio

This ratio is a measure of the ability of a firm to pay dividend on preference shares that carry a stated rate of return.

10.10.3 Profitability Ratios

The importance of profits to any commercial firm cannot be overstressed—the entire exercise of proper management is directed to maximize profitability without compromising on other parameters such as quality and safety. In a certain manner, profitability is also a measure of efficiency and indicates public acceptance of the product. Moreover, profits provide funds for repaying debts incurred while financing the project and mobilizing resources. The profitability ratios have been defined to establish quantitative measures of the profitability of a firm, and are of interest to owners, management, creditors and regulatory bodies. These ratios can be determined on the basis of either sales or investments. In the former class, the ratios commonly used are the (gross or net) profit margin and the expenses (or operating) ratio. On the other hand, ratios such as those defined in terms of return on assets, capital employed, and equity of shareholders are based on investment. Some of these ratios are discussed below.

Profit Ratios

These ratios are a measure of the relation between profits and sales of a firm. Now, accounting procedures differentiate between gross, net and operating profits, and the profitability ratios based on sales could be defined as gross profit ratio, operating profit ratio and net profit ratio.

Gross profit ratio

A relatively low gross profit ratio can obviously be seen as a signal requiring careful and detailed analysis of the factors involved. On the other hand, a high gross profit ratio is often regarded as a sign of good management, though in this case, too, the factors responsible should be carefully analysed.

Net profit ratio

The net profit is calculated after deducting all operating and non-operating expenses, including taxes and interest. A high net profit margin ensures adequate return to the owners and is also indicative of the ability of a firm to withstand adverse conditions on account of a decline in sales, increase in cost of production, or fall in demand, at least for some time. Obviously, a low net profit margin has quite the opposite implications.

Expenses Ratios

These ratios constitute another methodology of representing profitability ratios, and are based basically on the expenses, rather than the profits. Simply speaking, the expenses ratio is the complementary component of the profit ratio, gross as well as net. For instance, if the profit ratio is deducted from 100 per cent, the resultant is nothing but the expense ratio. Of course, alternatively, the profit ratio can be obtained by subtracting the expenses ratio from 100 per cent. In principle, expense ratios are computed by dividing the expenses by the sales. Like in the case of profit-based ratios discussed above, there are different variants of expenses ratios. Some of these are discussed below.

Operating ratio

The operating ratio is an indicator of the total operating cost incurred for every hundred rupees of sales, and reflects the efficiency of cost management in controlling the operational cost. The total operating cost is usually taken as the sum of the cost of the goods sold and the operating expenses. A high operating cost alerts the management to the necessity of adopting appropriate measures to reduce cost.

Cost of goods sold ratio

The cost of goods sold ratio shows the percentage share of sales consumed by cost of goods sold (and, therefore, what proportion is available for expenses involved in selling and distribution, as well as financial expenses consisting of interest and dividends).

Profitability Ratios Based on Investment

So far, the discussion has been confined to understanding the profit generated in terms of sales, whether from the point of view of profit generated or from the standpoint of expense incurred. The following paragraphs discuss profitability from yet another perspective, namely, that of investment. It may be noted at this stage that, generally speaking, three kinds of investments are often referred to, namely, assets, capital employed and shareholders’ equity. Based on each of these, three broad categories of returns on investment (commonly referred to as ROIs) have been identified—return on assets, return on capital employed, and return on shareholders’ equity.

Return on assets (ROA)

The assets may be defined as total assets or simply the tangible assets (i.e., total assets minus intangible assets like goodwill, patents and trademarks, as well as fictitious assets).

Return on capital employed (ROCE)

 

 

This ratio indicates how efficiently the long-term funds are being used. The term ‘net capital’ refers to total assets minus current liabilities, or alternatively, it is the sum of the long-term liabilities and the owner’s equity.

Return on shareholders’ equity

 

 

The ratio measures the return on the owners’ funds (investments) in a firm. Sometimes, the shareholders’ equity is also referred to as ‘net worth’. The ratio is indicative of how profitably the owners’ funds have been utilized by the firm.

10.10.4 Activity Ratios

This set of ratios used in business accounting is concerned with measurement of efficiency in asset management. These ratios, at times also called efficiency ratios, measure the efficient employment of assets by relating the assets to sales and/or cost of goods sold. An activity ratio may, therefore, be defined as a test of the relationship between sales and/or cost of goods sold and the various assets of a firm. Depending upon the various types of assets, different types of activity ratios can be defined. Some of the important and commonly used activity or efficiency ratios are discussed in greater detail in the following paragraphs.

Inventory (or Stock) Turnover Ratio

In the above expression, the cost of goods sold is taken as the sum of the opening stock and the manufacturing stock, including purchases less the closing stock (inventory). Average inventory is the average of the opening and the closing inventory. A high inventory turnover ratio is generally considered better than a lower ratio since it implies good inventory management, but a very high ratio calls for a careful analysis.

Receivables (Debtors) Turnover Ratio

In the above expression, the term ‘average debtor’ is the average of the opening and closing balance of debtors. The ratio is an indirect indication of the rapidity with which receivables or debtors can be converted into cash.

Assets Turnover Ratio

There are many variants of this ratio. The expressions for computing some of these ratios are given below:

It may be noted that the numerator in all the cases is the same (total cost of goods sold), though the denominator is different depending upon the definition of the ‘assets’ used. It may be further noted that in the discussion here, the total and fixed assets are not inclusive of depreciation. The higher the above ratio, the more efficient is the management and utilization of the assets, and vice versa.

10.10.5 Supplementary Ratios

Besides the four broad heads of ratios discussed, there are numerous other ratios that could be useful for analyses of firms. It is not the intention to cover all of them here. However, some useful ratios related to productivity and ratios related to periods of credit offered by the firm and periods of credit enjoyed by the firm are described briefly under supplementary ratios.

Periods of Credit

The period of credit offered by the firm is defined as:

For the value in weeks and days, the 12 in the expression should be replaced by 52 and 365, respectively.

The period of credit enjoyed by the firm is defined as:

For the value in weeks and days, the 12 in the expression should be replaced by 52 and 365, respectively.

The above ratios indicate credit control of the firms. The ratios indicate whether the firm is applying a sensible policy with respect to both its creditors and debtors.

Productivity Ratios

Many variants of productivity ratios are possible depending on the types of numerator and denominator considered. The productivity ratios are essentially the ratio of output to a given input. Some of the commonly used productivity ratios are listed below and these are self-explanatory.

  • Turnover to number of employees
  • Turnover to subcontractors
  • Turnover to plant and equipments
  • Profit to number of employees
  • Plant and equipments value to number of employees

The summary of ratios discussed in the preceding sections is given in pictorial form in Figure 10.7.

10.11 FUNDS FLOW STATEMENT

The funds flow statement of a company is a useful financial statement that summarizes changes in the availability of funds over a period of time, and thus also serves as a very important supporting document to the balance sheet, or the profit and loss statement. In general, ‘funds’ in this context are simply taken as the financial resources (working capital) available at a certain point in time—and are, therefore, taken as the excess of current assets over current liabilities, and represented as follows:

Working capital (WC) = Current assets (CA) − Current liabilities (CL)                    (10.32)

Changes in funds are described as flow of funds—an increase as inflow and decrease as outflow. Being so, increase/inflow in funds would be considered as source and decrease/outflow as use. Therefore, funds flow statement depicts factors responsible for changes in working capital during a given period. In other words, its purpose is to show wherefrom working capital originates and whereto the same goes during an accounting period. Accordingly, it portrays the sources and applications of working capital and highlights the basic changes in the resources and financial structure of a firm between its two consecutive balance-sheet dates. When funds are identified with working capital, the funds flow statement records the reasons for changes in working capital. Thus, funds flow statement may be defined as a statement that records sources from which funds have been obtained and uses to which they have been applied. If a transaction causes an increase in working capital, it is termed as a source of funds, and if it causes a decrease in working capital, it is termed as application or use of funds. Obviously, in the preparation of this statement, transactions affecting working capital are to be traced out. For this purpose, let us formulate some general rules so as to ascertain which transactions give rise to a source or use of working capital and which do not.

Figure 10.7 The summary of the ratios

10.11.1 Changes in Working Capital or Funds

It has been emphasised elsewhere that any transaction causes some ‘movement’ of funds—and given the definition of working capital, it should be clear that a transaction affects working capital if it results in an increase (or decrease) in CA without a corresponding increase (or decrease) in the CL. Similarly, a transaction that causes increase (or decrease) in CL without a corresponding increase (or decrease) in the CA also affects the working capital.

As a corollary to this, a transaction does not affect working capital if it results in an increase (or decrease) in the CA followed by a corresponding increase (or decrease) in the amount of CL, or an increase (or decrease) in the amount of CL followed by a corresponding increase (or decrease) in the amount of CA. Besides these more or less arithmetical conditions, it should be noted that as discussed elsewhere in greater detail, the aggregate current assets and current liabilities of a company are essentially a sum total of several components. Thus, the working capital is not affected if there is only a change in the composition of current assets (or liabilities), i.e., an increase in one component of CA (or CL) accompanied by a decrease in the other component of CA (or CL). Similarly, any change in the liabilities also does not affect the working capital.

Increase in working capital can be brought about in a variety of ways. The most straightforward contribution could come from profits from ongoing business operations. Then, there could be other sources of ‘income’, such as sale of fixed assets, raising long-term borrowings, or raising share capital. All these become source of funds for the company.

Similarly, losses in business operations, purchase of fixed assets, payment of dividends, etc., result in a decrease in the working capital and need to be shown under ‘use’, ‘application’, or ‘outflow’ of funds.

10.11.2 Determining Funds Generated/Used by Business Operations

As mentioned earlier, the profit and loss account of a company provides a summary of the transactions related to expenses incurred and revenues earned during a particular period. This information needs to be appropriately analysed using the principles outlined above to understand the implications as far as the working capital is concerned. Table 10.12 gives an illustrative example of such a classification. In fact, to that extent, the funds flow statement is only a summary of some of the transactions already presented in the profit and loss statement, prepared with a view to highlight the sources and application of funds along with increase/decrease in working capital for a particular period.

10.11.3 Application of Funds Flow Statement

A funds flow statement can be used for analysis of facts during a given period and also for effective financial planning for the future. An increase in working capital clearly involves higher interest costs, besides risks of inventory accumulations, receivables being locked up, maintaining more (idle) cash than required, and so on. The information provided by funds flow statement is crucial to the analysts of the firm, both internal and external, besides being useful to the creditors.

The analysts can get appropriate answers to several important financial questions. For example, analysis of the funds flow statement yields valuable information on subjects such as how the profits for a period were used, why the dividends (to the shareholders) were paid only at a certain rate, how dividends could still be given despite losses encountered in a period, and so on.

 

Table 10.12 Sources and applications of funds statement

  (Rs. lakh) (Rs. lakh)

Sources of funds

 

 

Profit before taxes

 

2000

Add for depreciation1

 

800

Total generated from operations

 

2800

Sale of fixed assets

 

30

 

 

2830

Applications of funds

 

 

Dividends paid

500

 

Taxes paid

350

 

Purchases of fixed assets

1320
2170

 

 

660

Increase/decrease in working capital

 

 

Decrease in stocks

60

 

Decrease in work in progress

60

 

Increase in debtors

370

 

Increase in creditors

–50

 

Increase in cash balances

220

 

 

 

660

1It may be recalled that depreciation does not involve movement of fund.

External analysts can also find a lot of important facts and figures in the funds statement of a company. For example, the statement clearly shows the extent of reliance on external sources (debt) in relation to internal (equity) sources, the major sources used to finance major non-current asset expansion like plant and equipment, the major source of funds used for repayment of long-term debentures or preference shares, and so on. Indeed, such disclosures to a trained reader reveal the financing and investment activities of a company. In fact, creditors can also use a funds flow statement to examine the mechanics of how the funds for activities such as expansion are being raised.

The funds flow statement also helps to better understand the effect of various financing and investment decisions on working capital in future. For example, in case the implementation of a certain decision results in excessive or inadequate working capital, steps need to be taken to improve the situation or review the decision itself. Consider a situation where the working capital position is expected to deteriorate—a decision can be made to raise funds by borrowing or by issuing new equity shares.

REFERENCES

 

1. Agrawal, R. and Sriniwasan, R., 2005, Accounting Made Easy, New Delhi: Tata McGraw-Hill.

2. Schexnayder, C.J. and Mayo, R.E., 2004, Construction Management Fundamentals, Singapore: McGraw-Hill.

3. Sharan, V., 2005, Fundamentals of Financial Management, New Delhi: Pearson Education.

REVIEW QUESTIONS
    1. Net working capital means
      1. Current assets—current liabilities
      2. Fixed assets—fixed liabilities
      3. Current assets—non-tangible assets
    2. An aggressive approach to current asset financing leads to
      1. Greater profitability
      2. Lower profitability
      3. No impact on profitability
    3. The longer the operating cycle—
      1. The larger the size of current assets
      2. The smaller the size of current assets
      3. The size of current assets remain unchanged
    4. Mortgage involves
      1. Moveables as collateral
      2. Immovables as collateral
      3. No collateral
    5. Commercial paper is issued by
      1. Any company
      2. Only blue-chip companies
      3. Only government companies
    6. Retained earning is liability. (True or False)
    7. Goodwill is tangible asset. (True or False)
    8. Factoring and forfaiting are sources of long-term finance. (True or False)
    9. T-account is also called ledger. (True or False)
    10. Outstanding is part of current liability. (True or False)
  1. Discuss the principles of accounting.

     

  2. What is meant by initial trial balance? Why is it important to prepare an initial trial balance?

     

  3. What are the different entries in a balance sheet?

     

  4. What is meant by assets and liabilities? Give examples of assets and liabilities in the context of a construction organization.

     

  5. Write short notes on T-account, cashbook, and profit and loss account.

     

  6. What do you mean by working capital? Why is working capital management important?

     

  7. What is operating cycle?

     

  8. Differentiate between short-term and long-term finance.

     

  9. Discuss different ratios and their relevance.

     

  10. For the set of data given in Table Q11.1, calculate the revenue using the following methods of revenue recognition—(1) cash method of revenue recognition, (2) straight accrual method of revenue recognition, (3) completed contract method of revenue recognition, and (4) percentage of completion method of revenue recognition.

     

    Table Q11.1 Data for Question 11

    S. No. Description Amount (Rs.)

    1

    Contract amount

    2,000,000

    2

    Original estimated cost

    1,800,000

    3

    Billed to date

    1,500,000

    4

    Payments received to date

    1,300,000

    5

    Costs incurred to date

    900,000

    6

    Forecasted costs to complete

    850,000

    7

    Costs paid to date

    800,000
  11. Table Q12.1 shows inter-firm comparison of construction companies. Calculate the current ratio and the net working capital for each of the companies and comment on them.

     

    Table Q12.1 Inter-firm comparison

  12. From the transaction details of a construction company, M/s New Construction Limited, given in Table Q13.1, prepare the profit and loss account and the balance sheet. Assume all transactions to be cash transactions. Also, assume depreciation of machinery to be zero in this financial year.

     

    Table Q13.1 Transaction details of M/s New Construction Company

    Transaction Reference Description

    1

    T1

    Purchased materials for Rs. 6,566

    2

    T2

    Paid salaries Rs. 668

    3

    T3

    Paid for telephone charges Rs. 1,691

    4

    T4

    Interest on loan paid Rs. 177

    5

    T5

    Tax paid Rs. 77

    6

    T6

    Sold goods for Rs. 9,614

    7

    T7

    Borrowed loan from Citibank Rs. 3,176

    8

    T8

    Purchased machinery for Rs. 3,176

  13. Determine the working capital required for the business from the given data.

     

    Table Q14.1 Data for Question 14

    Particulars Rs. (lakh)

    General reserves

    50

    Cum depreciation

    20

    Short term loans

    30

    Work in progress

    40

    Finished goods

    10

    Debtors

    30

    Sales

    100

    Commercial papers

    15

    Rental deposits

    5

    Other advances made

    15

    Equity capital

    200

    Fixed assets

    150

    Raw materials

    25

    Creditors

    30

    Advance received

    10

    Overdraft

    50

    Provision for tax

    5

    Cash in bank

    5

    Advance tax

    10
  14. Write short notes on (a) Percentage of completion method, and (b) Completed contract method of project accounting.

     

  15. What are the basic concepts and features behind preparing profit and loss account and balance sheet?

     

  16. Working capital management assumes considerable significance in construction management. What are the concepts and strategies behind effective working capital management?