Accounting Rate of Return (ARR) Method Various proposals are ranked in order to rate of earnings on the investment in the projects concerned. The project which shows highest rate of return is selected and others are ruled out. The Accounting Rate of Return is found out by dividing the average income after taxed by the average investment, i.e., average net value after depreciation. The accounting rate of return, thus, is an average rate and can be determined by the following equation. Accounting Rate of Return (ARR) = Average income / Average investment There are two variants of the accounting rate of return; Original Investment Method, and Average Investment Method. 1. Original Investment Method. Under this method average annual earnings or profits over the life of the project are divided by the total outlay of capital project, i.e., the original investment. Thus ARR under this method is the ratio between average Continue reading
Financial Management Tools
Credit Default Swaps (CDS)
The credit default swap (CDS) is the cornerstone of credit derivatives market. A credit default swap is a swap contract in which protection buyer (buyer of CDS) makes a series of payments over the maturity of CDS to the protection seller & in exchange receives a payment which is contingent on the happening of default by third party (reference entity). In short, it is a credit derivative contract between two parties in order to exchange the credit risk of an issuer (reference entity). The underlying (reference) asset can be bond or loan of any corporation known as reference entity. The reference entity is not a party to the contract. Reference entity refers to the party on which protection is written. The protection buyer makes quarterly premium payments (spreads) to the protection seller. This premium is usually some percent of notional value of CDS contract, expressed in basis points. If the Continue reading
What is Activity Based Costing (ABC)?
Changing external business environment has resulted in further developments in the tools and techniques used for management accounting. Traditional management accounting techniques had certain limitations associated with them, for instance, absorption costing methods have been found to be inappropriate in the modern environment. Similarly, standard costing’ suitability with respect to its general philosophy and detailed operations has come under severe criticism. It is believed that traditional management accounting performance measures can produce the wrong type of response. As a response to the limitations of traditional accounting techniques, activity based approaches has gained significant repute. In the case of activity based approaches, the focus is on the activities that the business carries out as opposed to how the activities have traditionally been organised into separate functions. Activity based costing was thus developed because it was realized that older methods like absorption costing, which used labor hours as the basis for absorbing Continue reading
Financial Analysis with the DuPont Model
The dynamic environment of the world today suggests that one should be apt enough to apply his skills immanent to a system and also external with respect to credit management function. These functions include financial planning, plausibility of a defined business strategy or whether a particular merger or acquisition is feasible or not. This has to be done in a rapid yet meaningful way so as to be of immediate need to a particular firm or investor. There are basically four major reasons for an effective financial statement analysis. These have been mentioned as follows: It is useful for long-run business viability so as to determine whether a firm would be able to provide adequate business return when compared to the amount of risks taken. This is essential for outside investors. It is also used by creditors so as to find out whether a potential buyer has the capability to Continue reading
Most Important Types of Budgets in Managerial Accounting
Definitively, a budget refers to forecast of company’s incomes and expenses anticipated for a given period of time. With a budget, an organization is able to analyze how much money they are making and spending, and they are able to figure the best way to channel it among various categories and departments. Budgeting depicts the entire process of analyzing and planning using a budget. Since budgets are vital tools for management and planning, the process of budgeting generally affects all types of organizations regardless of their size and composition. Many organizations participate in budgeting process with the view of determining the most cost effective and efficient strategies of making profits and intensifying its capital and asset base. In management, budgeting guides an organization to use its scarce resources in a way that exploits the existing business opportunities well. Good budgeting concepts integrate efficient business judgment and help the management to Continue reading
Limitations of Ratio Analysis
Ratio analysis is useful, but analysts should be aware of these problems and make adjustments as necessary. Ratios analysis conducted in a mechanical, unthinking manner is dangerous, but if used intelligently and with good judgement, it can provide useful insights into the firm’s operations. Limitations of Ratio Analysis 1. Accounting Information Different Accounting Policies The choices of accounting policies may distort inter company comparisons. Example IAS 16 allows valuation of assets to be based on either revalued amount or at depreciated historical cost. The business may opt not to revalue its asset because by doing so the depreciation charge is going to be high and will result in lower profit. Creative accounting The businesses apply creative accounting in trying to show the better financial performance or position which can be misleading to the users of financial accounting. Like the IAS 16 mentioned above, requires that if an asset is Continue reading