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  • Operating Leverage: Formula, Example and calculation

    Operating Leverage: Formula, Example and calculation

    What is Operating Leverage?

    Operating leverage is a concept in business finance that describes an organization’s ability to take advantage of its fixed costs and make them productive. Basically, fixed costs are the ones a business incurs when it conducts its operations. Fixed costs are expenses that don’t change with output levels, such as rent and salaries. In contrast, variable costs are incurred according to the amount of output produced, such as the cost of raw materials or utilities used in production.

    Operating leverage is a concept used to evaluate how efficiently a company uses its assets to generate revenue and profit. So, when incremental sales go up, the fixed costs will remain the same. In this case, the company’s profit might double or triple with the same fixed costs. 

    The break-even point of a business is determined using operating leverage, which also aids in determining the right selling prices to cover all expenditures and make a profit.

    Regardless of whether they sell any units of product, businesses with significant operational leverage must cover a bigger amount of fixed costs each month. Airlines is one such sector that comes with a high fixed cost, such as the cost of the aircraft, hangers, and insurance. As a result, their operating leverage is also high. While the company may increase their profits with the fixed costs, these companies are susceptible to recession and are heavily impacted when the economy is on a downward trend. 

    Low-operating-leverage businesses may have high variable costs directly related to sales but also have fewer monthly fixed expenses. Service-based companies are companies that have a higher variable cost and come with lower operating leverage. These companies have the flexibility to increase or decrease their variable costs per the economic scenarios. 

    How to Calculate Operating Leverage

    Operating leverage is calculated by dividing operating income by the percentage change in sales. Operating income is the profit after paying for the direct operating costs, including fixed and variable costs. 

    Here’s the formula for operating income:  Net Income – Operating costs. 

    One can easily find the operating income from the company’s income statement 

    Change in the operating leverage is expressed as a ratio and called the degree of operating leverage(DOL). The higher the operating leverage, the more earnings will change for every small percentage change in revenue.

    So, the formula of operating leverage is

    %Change in Operating Income/ % change in contribution/ sales 

    Let us see this with the help of an example. We are considering two companies: Indigo, an airline-based company and TCS, an IT company. 

    We have included the required data from the companies’ income statements.

    To calculate the DOL, we divided the change in operating income by the change in revenue/sales. 

    As you can see, there is a range of possibilities for operating leverage. Positive leverage shows that the business is outpacing its costs with sales. Negative leverage, on the other hand, shows that the business is not making enough money to pay the various costs. 

    High and Low Operating Leverage

    Due to the fact that certain industries have higher fixed costs than others, it is crucial to evaluate operating leverage between businesses in the same sector. The idea of a high or low ratio is then explained in greater detail.

    In general, higher operating leverage is better than low leverage since it helps companies to generate more profits from every sale. But with smaller sales volumes, companies with minimal operating leverage may have a better chance of making a profit. Additionally, businesses with a high level of operating leverage may be more vulnerable to changes in revenue.

    In a strong economy, businesses might make more money. However, due to their high fixed costs, an economic downturn could result in a decline in profits. 

    High Operating Leverage

    Excessive operating leverage typically results in a significant portion of a company’s expenses being fixed costs.

    In this instance, every additional sale generates a profit for the company. It must, however, generate enough revenue to cover the high fixed costs.

    If the corporation achieves this, it will imply that the entity in charge of its business operations will be able to generate lots of revenue after paying for all of its fixed costs.

    In these situations, the earnings are more sensitive to changes in the volume of sales.

    Low Operating Leverage 

    This indicates lower fixed expenses and higher variable costs. In this scenario, a business must generate a minimum amount of sales to cover its fixed costs. When it reaches the point where all of its fixed costs are met, it becomes profitable.

    It can gain incremental profit in terms of Selling Price minus the Variable Cost once it has reached the break-even point, where all of its fixed expenses are covered. However, this profit won’t be significant because the variable costs are so high.

    We may fairly assume that the break-even units a company needs to sell to experience a no loss and no profit equation will be significantly smaller when operating leverage is low and fixed expenses are lower.

    Difference between the degree of operating leverage and degree of combined leverage

    Financial leverage is when a company uses debt in its capital structure and has to pay interest on that debt. 

    A degree of combined leverage (DCL) is a leverage ratio that shows how the degree of operating leverage (DOL) and the degree of financial leverage(DFL) affect earnings per share (EPS) when sales change in a certain way.

    Combined Leverage Formula = %Change in EPS/% Change in sales = DOL*DFL

  • Optimum Capital Structure: Meaning And Features

    Optimum Capital Structure: Meaning And Features

    Capital Structure Meaning

    The capital structure of a corporation is the method of financing its assets and activities via a combination of debt and equity.

    A company’s optimum capital structure is the combination of debt and equity financing, which optimizes market value while reducing the cost of capital. Since interest payments on debt are often tax-deductible, they provide a very cheap source of money.

    Moreover, excessive debt raises the necessary return on equity for shareholders and the associated financial risk. Therefore, businesses must determine their optimum level of debt, where the marginal gain is equivalent to the marginal expense.

    Now after checking out the definition of Capital Structure, let’s analyze the optimal capital structure and its utility.

    Recognizing Value Of Optimal Capital Structure

    To estimate the optimal capital structure, one must determine the proportions of debt and equity, maximizing the firm’s market value while minimizing the WACC. The present value of the company’s future cash flows, discounted by the WACC, is larger if the cost of capital is less.

    The primary objective of every corporate finance division is to find the appropriate capital structure that yields the lowest WACC and provides the greatest value to the firm.

    Capital Structure and WACC Optimization

    Since debt is seen to have less degree of risk than equity, its cost is lower. As interest costs take precedence over dividends and debtors have priority in the case of a dissolution, the yield needed to repay debt investors is smaller than the return required to satisfy stockholders.

    Too much debt, however, may raise interest payments, earnings instability, and the likelihood of bankruptcy. Therefore, it’s important to strike a balance. The WACC rises, and the market value of a company falls because investors want a higher return to offset the increasing financial risk they face.

    A firm with very unpredictable cash flows would have a relatively small debt and a significant equity stake.

    Features of Optimal Capital Structure

    In addition to the rights of different kinds of securities on Income, claim on Property, and the power to exercise control, the additional features or traits of an ideal or optimal capital structure are worth considering:

    Efficiency 

    Simplifying the process of obtaining capital implies issuing stock and preference shares at the beginning and, after that, issuing debentures.

    As a result, diversification risks should be phased in over time as the company expands. It will boost investors’ confidence, making it simpler to get financing.

    Reducing Exposure to Danger

    Every company faces a unique set of challenges, including but not limited to the following:

    • Market competition
    • Shifts in product demand
    • Fluctuations in supply and demand
    • Alterations in the climate
    • Increases in taxation, interest rates, inflation, and other government policies
    • Declines in consumer buying power
    • Increases in operating expenses

    These dangers impact both planning and the formation of a sound financial foundation. That’s why the capital structure must be adjusted so that the company can effectively bear the brunt of these dangers when necessary.

    Sufficient Cash on Hand 

    A bank needs to have a capital structure and asset allocation that allows it to have sufficient cash in hand at all times. For this reason, the corporation may sell debentures that can be resold or repurchased on the marketplace.

    Overview: Capital Structure Theories

    The M&M Theorem (Theory of Modigliani and Miller)

    Franco Modigliani and Merton Miller’s namesake theory on capital structures is known as the Modigliani-Miller theorem (M&M for short). It was in 1958 when two economics experts, Modigliani and Miller, who had been working on a theory of capital structures, came up with the capital structure irrelevance statement. According to this theory, a firm’s market value in ideal markets is independent of its capital structure since it is based on its underlying assets’ earnings potential and risk. The M&M theorem proposed the two statements below:   Proposition 1 According to this theory, how a company’s finances are set up doesn’t affect its worth. If two companies were the same in every way except the method through which they financed their assets, then their market worth would be the same regardless of which method was used. Proposition 2 This hypothesis states that using financial leverage increases a company’s value and decreases its WACC. It’s the time of year when tax data may be accessed. 

    The Concept of Pecking Order

    Asymmetric information costs are central to the pecking order hypothesis. The method is focused on the premise that businesses would choose the easiest option when allocating their capital. The use of internal financing is strongly favored over the use of debt or external equity financing, both of which should be considered as the last venue.

    Relevance Of Capital Structure In Financial Management

    The company’s capital structure is how it finances its assets and operations through equity and debt. If a company is looking for a more permanent funding source with more cash flows, it should choose stock, which is more costly but more stable. Merger and acquisition (M&A) activities, which may be funded by cash, borrowing, share assumption, and/or debt assumption, in addition to revenues from divestitures and sale of assets, may have a substantial impact on capital structure in addition to stock and debt issuance.

     Capital Structures: Types

    Equity and debt are the two main categories of long-term financing, and capital structure refers to the way they are allocated over time. Preference shares, equity capital, retained profits, long-term loans, etc., are all examples of how a company might get funding. The company has to obtain these sums to keep operations afloat. Let’s check out in detail about them:  Equity Capital Investors’ or owners’ equity is the same thing as equity capital. Two distinct varieties are included. Retained earnings:  It is the portion of profits set aside by the company to be used for future investments in its growth and development. Contributed Capital:  The total sum of money that the firm’s founders or first investors put into the business in exchange for a stake in the firm. Debt Financing:  Debt capital refers to the sums of money borrowed and invested in a company. Several types of debt financing exist. Long-term bonds are the most secure kind of debt since their principal is not due until maturity, but interest payments may be deferred indefinitely. Businesses may often issue short-term debt instruments like commercial paper to obtain funds for a limited time. Capital Structure Optimization:  The term “optimal capital structure” describes the optimal allocation of a firm’s financing between debt and equity. A high debt ratio is not desirable for a corporation in the mining or oilfield and oil extracting industries; however, it is common in the banking and insurance sectors. Leverage in Finance The level of financial leverage is measured by how much debt is used as a percentage of total investment. Capital gearing is another name for this concept. A highly leveraged business has a high debt-to-equity ratio, whereas a low-levered company has a low debt-to-equity ratio.

    Conclusion

    Reaching and maintaining the optimum capital structure should be a goal of every successful business. For maximizing the market price of the shares, the best capital structure has about the lowest average cost of capital possible, given a certain level of revenue.

    Reference

  • 8 Income-Producing Assets to Build Wealth

    8 Income-Producing Assets to Build Wealth

    The secret to financial freedom lies not in working for money, but in making your money work for you. Not utilizing your money to maximize your wealth is a lost opportunity. This is a big mistake that many people commit. This is what sets them apart from the rich. Having a wealthy mindset is necessary to get financial freedom.

    And this can only be achieved by investing in assets that generate income. By investing in income-producing assets, you can earn money without having to actively work for it. But first, let’s understand what exactly income-producing assets are!

    What are Income-Producing Assets?

    A financial asset is anything that you own/purchase, which gives benefit over a long period of time. Adding to this, income-producing assets are those assets that generate income for you in the future. They act as a passive source of income and help you multiply your wealth.

    Investing in a diverse range of such assets can help you generate higher returns at a lower risk. A diversified portfolio is essential for successful investing. So if one investment fails, you can recover your losses from other assets. Let us look at the top 8 income-producing assets to build your wealth.

    1. Business

    Investing in a business – be it online or offline – is one of the most popular and profitable ways to invest and maximize your wealth. Though businesses require a lot of work upfront, the earning potential in this segment is unprecedented.

    Most billionaires and millionaires earn their wealth via businesses only. However, there are also some downsides and factors to consider while starting a business. Businesses usually require a high financial commitment from the owner. On top of that, there are many business risks that may affect your venture, which you cannot account for beforehand.

    Alternatively, you can go for either a traditional offline business or an online business. You can set up online businesses as a side hustle. And once it is up and running, you might not have to monitor it consistently. Moreover, the capital requirements in an online business are lesser, and it can also have a higher profit margin. However, it is important to note that actual capital requirements and profit margins may vary. Such factors actually depend on the nature of business, and the industry you operate in.

    2. Real Estate

    There is no shortcut to making wealth or get-rich-fast method in real estate. However, real estate is an investment alternative that has relatively low risk with minimal barriers to entry. 90% of the millionaires accumulate their wealth by way of real estate investment. But what is to be noted is that most of them were far from rich when they started.

    One of the major benefits of real estate investing is that there is never any shortage of demand in this sector. Everyone requires a place to live, and with the population rising consistently, it is assumed that this demand is not going to vanish for quite a while. Secondly, there is no need for marketing, and even if there is the marketing cost is very minimal.

    Appreciation of real estate investments is what enables investors to make the biggest money in this sector. Though real estate generates a steady cash flow in the short run, appreciation or the increase in the value of assets over time is the long game. The annual average appreciation rate in India is 3.6%. So, if you purchase a property for Rs 40 lakh, and it appreciates even by 3%, the property would be worth Rs 41.2 lakh. This appreciation in the value of the asset will not only cover any mortgage that you may have taken to finance the asset but also leave some profit in the hands of the investor.

    3. Stocks

    Often individuals hesitate from investing in the stock market thinking that stock investing is very risky and time-consuming. However, nowadays investing in stocks has become quite easy. This has become possible because of evolving technology and development in the stock market. Investors can buy and sell stocks with the click of a button, and learn about which stocks are the best performing in the market. Stocks offer portfolio diversification and liquidity and also generate dividend income. Moreover, stock market investments prove to be a great hedge against the rising inflation in the economy.

    Historic data has shown that in the long run, stock market returns have always been very generous. Patience is the key to stock market investing. Though individual stock prices fluctuate on a daily basis, in the long run, investors most definitely see their money compound and grow. However, it is to be noted that stocks should be picked only after careful consideration and due diligence. This leads to minimum risk and maximum returns.

    Another way of investing in stock markets for those who lack the time and skills to pick a good stock is investing in mutual funds. Mutual funds are baskets of securities offered by Asset Management Companies. Reputed fund managers head these mutual funds. And they only select the stocks after in-depth consideration and analysis.

    4. Bonds and CD’s

    Unlike stock market investments, Bonds and Certificates of Deposits (CDs) are debt-based instruments. They possess a lower level of risk. These instruments are a good investment for risk-averse investors and those who wish to safeguard their capital. In exchange for sacrificing high returns, such investors settle for moderate to low returns. Bonds and CDs provide fixed returns and are reliable, income-producing assets.

    Bonds pay interests based on a coupon rate. They are basically a loan that investors provide to the government or a company. In exchange, the borrower has to pay back the principal to the investor along with a certain amount of interest at a specific point in time. The time range can stretch several years. Hence, bonds can be classified as long-term investments.

    Certificates of deposits, on the other hand, are a time deposit account. These accounts can be easily opened with banks for as short as one month. Banks pay interest on the CD account. The interest provided is affected by the amount deposited in the CD and the interest rate it is offering. Usually, CDs with longer terms carry higher interest rates than those with shorter terms.

    Another thing to note is that CDs are a comparatively safe investment choice, as compared to bonds. Though bonds may be slightly riskier, they offer higher returns.

    5. Commodities

    Apart from traditional investing avenues, commodities can also be a great wealth-generating asset for an investor’s portfolio. Commodity investing offers great diversification amongst various types of commodities. They also act as a hedge against inflation and earn high returns. There are various methods for investing in commodities. For example, purchasing physical commodities, investing in commodity stocks, investing in commodity futures markets, commodity ETFs or mutual funds based on commodity stocks.

    In India, we have 3 main categories of commodities – agriculture, metals, and energy. Some of the highest trading commodities in India are crude oil, gold and copper. Other commodities to invest in can be silver, aluminium, natural gas, soybean, jeera and coriander. Commodity investments tend to have more liquidity, as a result of the seasonality and unpredictability in their prices.

    6. Savings Account

    A savings account is a bank deposits account that bears a fixed rate of interest. Most individuals already have a savings bank account; however, this asset is also essential to build wealth. There might be a situation or an opportunity where you may require funds urgently. And if all your funds are tied up in various assets, you may end up with no cash available at your disposal.

    Though the return earned on funds kept in a savings account is lower than what one can earn from other wealth-generating assets, it is also crucial to park a certain proportion of wealth in these accounts. The Reserve Bank of India (RBI) has strict measures in place to ensure the safety of money in a savings account. The range of interest earned from a savings account is between 4-7%, depending upon the chosen bank. This rate might be a bit low, however, a savings account offers ample liquidity to the account holder. You will have complete access to your money and make deposits and withdrawals whenever you like.

    Additionally, if you may want to secure a bank loan in the future, it might be easier if you already have existing savings account with the bank. This is because you already have a history with the bank.

    7. Intellectual Properties

    Intellectual property refers to something that an individual creates from their minds. These can be inventions, artistic/literary works, designs, symbols, and names and images used in business. These properties are protected by copyrights, patents, trademarks, etc. Furthermore, creators can earn a royalty or fee on their properties if someone else uses their creations.

    IPs are intangible assets. They are bought and sold just like ordinary assets. However, they are not very liquid.

    For example, you write a book and have its copyrights. Then on each sale of the book, you will earn a royalty till the time the book is in print. Usually, it is seen that businesses have such IPs to protect their inventions, trade secrets, product designs, company name, etc. This is so that no one else copies off their creations and they have exclusive rights to them. Or if someone does use their creation, they pay them a fee.

    Another example of IPs in real life is very much evident in Disney’s case. Disney owns acquired copyrights, patents and trademarks. These IPs protect their unique scripts, characters, TV shows, movies and animation styles. They are also worth millions of dollars. This restricts the use of its character names and images by others.

    8. Content

    In this digital era, where everyone is consuming content and information left and right, there is immense scope in creating your own content and monetizing it to create a passive income source. This can be in the form of blogs, websites, videos, etc. Nowadays we see so many makeup influencers, personal finance influencers, etc. They post video content on various social media platforms. Once they gain a substantial number of followers, they can start earning through their content. And what’s more, is that they can collaborate with brands and other influencers.

    In Conclusion

    Allocating your income towards the above-mentioned assets can contribute to creating wealth in the long run. In addition, you can generate a steady stream of passive income periodically. This would be over and above your active source of income. These income-producing assets also enable you to diversify your portfolio and accordingly, minimize risk and maximize returns.

  • What are Equity Shares? Meaning, Definition, Features

    What are Equity Shares? Meaning, Definition, Features

    Many of us feel that investing in the stock market is very difficult and demands vast knowledge. However, a dissection of the fundamentals of dealing in publicly traded companies can offer a thorough knowledge of buying shares.

    Investors frequently use equity shares as a kind of investment. The enormous gains provided by equity shares are the main factor behind its popularity. Equity shares are issued to the general public to raise money for corporate growth. The major part of the funding for many companies comes from public investors.

    So, let us understand what is Equity Shares, its risks, features, types, and how equity shares can reward us in the long term.

    Equity Shares Meaning

    Before getting into equity shares, let’s understand the equity meaning. Equity, in simple terms, is the part of the company’s ownership, which is distributed through equity shares to different investors.

    Equity shares, often known as stocks, are a source of long-term financing for a business. Investors receive equity shares from a business in exchange for a portion of the company’s ownership. 

    When you buy equity shares in a firm, you become a shareholder and have voting rights over the management of the business. Additionally, the company pays dividends to its equity stockholders to distribute its earnings.

    Who Would Buy Equity Shares?

    Equity shares are a terrific investment for people who want to grow their money. Investors can sell their shares to make big profits when their value increases. Another reason one should invest in Equity shares is to fight rising inflations as returns are diminishing everywhere, whether it is fixed deposits or any other mode of investment. 

    In simple words, it is the way to earn maximum profits in a limited time by purchasing shares of a company.

    Types of Equity Shares

    Ordinary Shares:

    In order to cover long-term expenses, money is raised by issuing shares. Shareholders have the right to participate in management decisions and other business activities. Therefore, significant voting rights are granted to shareholders who own most of these shares.

    Preference equity shares: 

    Before returns are divided among regular shareholders, preference equity shares are typically issued to investors as an assurance of the payment of accumulated dividends. The right to vote for holders of preferred equity shares is prohibited.

    Bonus Shares: 

    These shares are issued to investors as a bonus or extra shares when the company earns extraordinary profits. It is a type of reward to the investors who trusted the company and invested.

    Rights Shares: 

    Certain shareholders are provided with these shares at a reduced price, thus increasing their ownership in the corresponding organization. A company grants rights shares to investors for a set period while it raises the necessary funds to cover its operating costs.

    Features of Equity Shares

    Irredeemable In Nature

    Throughout the existence of the company, investors are not given their investment money back. Equity shareholders will either get back their investment when the company closes its operations based on the value of their equity shares, or they may sell their equity shares to redeem them.

    Participation in Voting

    The ability to vote in elections for general managers and other company officials, apart from being a part of management decisions, is unquestionably the most significant benefit of owning equity shares. This is because the company’s operations directly affect the returns that equity shareholders receive from the company. 

    Typically, each share represents one vote. It means that if you own more equity shares, you also have higher voting rights.

    Participation in meetings 

    The investor who holds the company’s equity shares is automatically eligible to attend the important meetings of the company. They can give their suggestions in AGMs (Annual General Meetings) and cast votes in favour and against any resolution.

    Payment of Dividend

    Dividend payments are also available to equity shareholders. Dividend payments to equity owners are not fixed and may change according to the company’s performance and the achievement of specified objectives. Equity stockholders are therefore entitled to dividend payments, although these payouts are not promised. 

    High Rate of Return

    Although equity shares have great risk and volatility, they also promise greater returns. Therefore, investing in equity shares can help you build a sizable corpus with excellent returns if you have higher risk tolerance.

    Diverse in Nature

    Investors can build a broad investment portfolio by investing in business shares from multiple fields or businesses. By exposing you to stocks from multiple companies, diversity helps you to build a solid portfolio with predictable earnings.

    Limitations and Risks of Equity Shares

    It is prudent to analyze all the aspects of investment as anything that comes with benefits also have some limitations. It means that equity shares investment doesn’t always produce profitable results. 

    Although you can make significant profits with equity shares, there is a possibility you could also lose all you invested. Even if it’s not all your investment, you could still suffer massive losses if the business doesn’t make a profit or if the market as a whole is unfavourable.

    Let’s understand more in detail the limitations and risks of investing in equity shares:

    Capital Loss

    The supply and demand for equity shares determine the share price. Shareholders start buying more stocks of a business if they believe it will continue to thrive in the future. The value of the share also rises when shares are purchased in bulk.

    In contrast, investors may opt to sell their shares if they anticipate the business will not perform well. This implies that when the share’s demand declines, the share price could also decline. 

    As a result, if you traded in such shares, a decline in demand could cause your Capital loss.

    Volatility

    Any fluctuation in the price of a share due to any reason, like, social or political, or for some other reason, is called volatility.

    For example, the share price of XYZ company is hovering around ₹160, and the elections happened in the country, and on the results day, it came to ₹80 per share. In that case, you will have to face fluctuation in the value of the share you hold.

    Sometimes you can get benefits from volatile shares, but sometimes you also lose money due to sudden fluctuation in the value of shares.

    Conclusion

    Equity shares are one of the prudent options to make your investments as the shareholder carries the right to vote and is allowed to say in the company’s business operations. However, before deciding on investment in equity shares, ensure you know what an equity share is, how it functions, and any potential risks or Limitations. 

    It is preferable to select high-quality stocks, and prior to allocating a higher percentage of your investments to equities, you should gain experience in equity investing. Therefore make a wise decision to ensure that your investment produces good returns.

    Reference

  • Difference Between Cost Accounting and Financial Accounting

    Difference Between Cost Accounting and Financial Accounting

    Cost Accounting and Financial Accounting are the terms used for systematically recording, analyzing and presenting the financial data about a company and its product lines. It becomes pertinent for the corporations to maintain such financial data for their further growth and to bolster the confidence among their shareholders as well as the Management. 

    This guide will briefly analyze the difference between financial accounting and cost accounting and for what purpose the companies use them. 

    Defining Cost Accounting

    Cost accounting is the branch of accounting primarily concerned with recording, organizing and summarizing the costs, profits and losses of different products during a specific period. Unlike Financial accounting, it analyzes each product line with the aim of cost reduction and cost control, thus reinforcing the Management to make better decisions. 

    Further, it records the cost incurred on the product during production, distribution and selling. Such detailed analysis helps the Management to brainstorm better investment options and how they can control the costs. 

    For example, the XYZ organization has 4 product lines with different productions and sales. Cost Accounting helps them analyze the financial data of all the products individually. By looking at the data, the Management will try to infer how they can reduce and control the cost of the product and make it more profitable for the venture. 

    Defining Financial Accounting

    Moving with the previous example, financial accounting will deliver the detailed financial data of all the 4 products and other transactions of the XYZ Company in a single document in a lucid manner. Therefore, financial accounting records and summarizes the data of all the financial transactions made by the company in a given financial year or Quarter. It is presented in an uncomplicated language with visual elements to make it readable for its readers. 

    The readers range from shareholders, investors, government organizations and creditors to the Company’s Management. Moreover, the financial statement’s major subheads are the balance sheet, Cash Flow Statement, Profit & Loss statement and Income Statement. 

    Financial accounting helps in making comparisons of the profitability, financial health and overall performance among different corporations in a particular time period. It also allows for analyzing and comparing the monetary data of different financial periods. Now let’s further analyze the key differences between cost accounting and financial accounting.

    Cost Accounting vs Financial Accounting

    PRIMARY OBJECTIVE

    Financial accounting aims to maintain the complete financial information of the organization, thus protecting the interests of the business and its Management. The financial data is also shared with its shareholders, creditors, investors and other partners.   While Cost accounting summarizes the cost records to guide the Management in making more profitable decisions.    

    ADHERENCE TO REQUIREMENTS

    The companies maintain financial accounting to meet the requirements of the Income-tax Act, Companies Act and other government regulations. In comparison, Cost accounting is based on a voluntary basis for fulfilling the internal requirements of the Management. However, the Companies Act has now made it mandatory to maintain regular cost records in some manufacturing sector enterprises. 

    STOCK ESTIMATION

    Estimation of the stock value in cost accounting is calculated at cost. Whereas, in financial accounting, the stock value is chosen from the lesser value between cost and net realizable value.

    PROFIT AND COST ANALYSIS 

    Cost Accounting focuses on the cost and profit of a particular product without any ascertained time period. It helps the Management eliminate the cost burden across different product lines and focus on more profitable products. Therefore the cost is divided into separate units in cost accounting.   Whereas in Financial accounting, the costs are aggregated as it includes the financial statement of all the products and services delivered by the company during a particular financial period.

    TIME PERIOD

    A financial statement is released after the completion of a certain time period, and it might be quarterly, half-yearly or yearly. Whereas Cost accounting is a regular process, it can be made daily, weekly or monthly, depending on the Management’s needs. 

    TYPE OF TRANSACTION

    Financial accounting predominantly focuses on the External transactions between the company’s Management and the third parties. These sorts of transactions also form the basis for payment receipts.  Whereas cost accounting is chiefly concerned with the internal transaction and does not form the basis for the payment receipts. 

    INFORMATION CLASSIFICATION

    Cost accounting provides valuable information about the labor and machinery used during manufacturing. It delivers valuable information about the relative efficiency of different manufacturing units.  Whereas financial accounting only concentrates on the monetary data. Here you cannot analyze and compare the efficiency of different plants and machinery along with the costs incurred. 

    TYPE OF COSTS INCLUDED

    Cost accounting includes both historical and predetermined costs. Further, cost accounting provides actual facts and figures as well as estimated costs. Whereas financial accounting only focuses on historical costs and includes only actual facts and figures. These were the following critical parameters on which we distinguish between financial accounting and cost accounting.

    Wrapping Up

    By now, you must have understood why you should look out for the difference between cost and financial accounting before analyzing any financial data. The above parameters are the critical basis for distinguishing both terms. 

    In summary, cost accounting helps the organization’s internal Management to control and reduce the cost of respective product lines by stimulating the efficiency of the manufacturing factors, thereby boosting the company’s profit. In comparison, financial accounting is a lucid and visual representation of the organization’s overall financial performance in a given financial period, thus helping the Management and shareholders to make the blueprints for future growth.

    References

  • What are Contingent Liabilities? Meaning & Examples of contingent liabilities

    What are Contingent Liabilities? Meaning & Examples of contingent liabilities

    Introduction

    Contingent liabilities mean a planned financial commitment that results from previous events, whose status is determined by the occurrence or non-occurrence of an unpredictable future event that is outside the control of the business.

    It can also be a current debt whose repayment is uncertain, or the exact amount is unknown.

    The timing, size, and viability of the payment are all undetermined, and it’s also possible that it won’t be required at all. Therefore, we can claim that further occurrences will determine whether or not it genuinely constitutes a liability. And because of the element of uncertainty involved, these are referred to as contingent liabilities.

    Apart from that, disclosure of contingent liabilities enables the company to be ready for any responsibility that could emerge in the future. These are possible liabilities for the company rather than actual liabilities, which could arise in the future if unpredictable circumstances occur.

    That’s why it is not acknowledged on par with other aspects of the financial statements and is instead displayed as a footnote in the balance sheet. Now after understanding what is content liabilities, let’s check out its usability and importance.

    Why do we make provisions for contingent liabilities?

    By including contingent liabilities, firms have the chance to assess the circumstance and make preparations.

    Let’s use an illustration to explain further why a corporation must make provisions for contingent liabilities.

    Furniture producer Finoflex ltd. is based in Bhopal. One of its clients has launched a lawsuit against them, accusing it of providing a poor product. When the client first reported it, the business turned down the claim; consequently, the consumer filed a lawsuit against them.

    Let’s examine the aforementioned case to see how and why it’s beneficial to make provisions for contingent liability.

    • As a result of earlier events, there is a current responsibility (legal or constructive).

    The present duty in FinoFlex Ltd.’s case is the lawsuit a client has filed against the company. And the corporation delivered the flawed product and denied the customer’s claim in the past.

    FinoFlex Ltd should report damages in the Footnotes to the financial statement in this case rather than making a provision for them in the main body of the financial statement. The reason is that a future event’s existence might or might not result in liability.

    • To pay the commitments, it is likely that resources, including financial gains, will require to spend.

    It is apparent in the instance of FinoFlex Ltd that if claims against the business materialize, there may be an outflow of funds to satisfy the obligation.

    • On the obligations, a reliable estimation is possible.

    In the case of FinoFlex Ltd, the claim will result in a financial outflow for the business, and the business should accurately estimate this amount.

    In this case, disclosure to investors and other individuals who use financial statements is required since the result will affect investment decisions.

    Types of Contingent Liabilities

    You must take into account the following events to identify the contingent liability. The term “types of contingent liabilities” is frequently used to describe these situations.

    Probable

    The event will be regarded as probable if its occurrence is higher than the possibility that it won’t. Because these obligations are anticipated, it is possible to estimate the size of the deficit to a limited level. As a result, they show up in the financial statements as liabilities.

    Possible

    When something is described as “possible,” it means there is a chance it will happen is remote but lower than likely. These take the form of notes since it is impossible to determine the quantity precisely.

    These obligations are regularly assessed to determine the possibility of the financial outflow representing economic gains. 

    Therefore, a provision is included in the accounting records of the relevant period in which the change in possibility occurred, when it becomes likely that a financial outflow would be required for an item that was previously handled as a contingent obligation unless a valid estimate cannot be established.

    Remote

    If the possibility of the contingent obligation occurring is remote, it is not recognized or stated in this case. Remote here denotes the absence of both a reasonable chance of occurrence and probability of the contingencies.

    More concisely, it is classified into two types: explicit contingency liability and implicit contingency liability.

    Explicit Contingency Liabilities Contingent Liabilities rely on government agreements to make payments when a specified event occurs through contractual, legal, or direct policy commitments. These are either decided upon or permitted by legislation. It includes uncalled capital, loan guarantee, etc.

    Implicit Contingency Liabilities These obligations’ financial requirements should be acknowledged post-event, that is, after the catastrophe or tragedy has taken place. Additionally, the government does not formally register these potential liabilities because of the ambiguity.

    What Are Examples of Contingent Liability?

    Common contingent liabilities include pending lawsuits and warranties. Because the results of ongoing legal proceedings are uncertain, they have been deemed contingent liability. As far as warranties are concerned, it is impossible to predict how many items will be recovered under warranty.

    Some More Contingent Liabilities Examples :

    • The business gives guarantees and counter guarantees. A corporation may provide a guarantee to another individual on behalf of a third party in the shape of a loan to a business or a promise that another business would uphold contractual responsibility.

    • Product Warranty

    • Guarantee to the investor

    • Issuance of letter of credit

    • Bill discounted

    • Liquidated damages

    Accounting Rules for Contingent Liability

    • There are a few rules which guide us on where to record the provisions related to contingent liabilities:

    • A contingent liability should not be considered in the statement of financial condition.

    • It should only be stated in the notes to the financial statements unless it is highly unlikely that any economic advantages would be transferred.

    Conclusion

    Contingency liability accounting is a highly personalized subject that calls for professional judgment. It can be a difficult subject to understand for investors as well as the management of the organization. Therefore, a business should handle contingent liabilities with prudence and caution because, depending on the situation, they may cost significant amounts of money. 

    Reference

  • Here’s Everything You Need to Know About Return on Equity (ROE)

    Here’s Everything You Need to Know About Return on Equity (ROE)

    Investing in stocks is not easy, especially when there are thousands of companies you can invest in the same domain. And it is a shared experience after, being unable to decide where to invest, we all have one thing to say: “investing is not my thing!” But thanks to online information and fundamental analysis indicators, you can quickly narrow down your options.

    These indicators help you examine the overall financial health of the company. So investors can make informed investing decisions. Today we will discuss one of the most helpful fundamental parameters that investors should check while investing in stocks, Return on Equity (ROE).

    ROE acts as a performance indicator for investors, helping them differentiate between companies. Now, let’s dive into understanding Return on Equity and how to use it.

    What is Return on Equity?

    Return on equity (ROE) is a financial ratio that measures a company’s profitability in relation to shareholders’ equity. It gives investors an idea of how much profit a company generates with shareholders’ money. With the ROE of a company, you can calculate the company’s net income. 

    How is ROE calculated?

    You can calculate the ROE of a company with a simple formula: net income/ total shareholder’s equity. Net income is the overall profit that a company makes a year after deducting taxes and expenses, while shareholder’s equity refers to total assets minus liabilities. In simple words, it tells how much the stockholders or owners have invested in the company.

    Now that you understand the basic formula of ROE, let’s answer the question below. While investing in a company, which company would you prefer to invest in based on its ROE? A company with a higher ROE or a company with a lower ROE?

    Of course, a company with a higher Return on Equity is a preferable option. It is so because, with the higher ROE, the shareholders will receive higher profits. 

    Suppose there are two companies: A and B. The total net income made by both companies yearly is the same. However, the shareholder’s equity of company A is 100 crores, while that of company B is 1000 crores. Using the ROE formula, we get:

    ROE of company A = 10/100 *100 = 10%

    ROE of company B= 10/1000* 100= 1%

    As an investor, you will choose to invest in company A because the profit will be distributed among 100 crores.

    The Benefits of Return on Equity

    Return on equity (ROE) is a financial ratio that measures a company’s profitability in relation to shareholders’ equity. It gives investors an idea of how much profit a company generates with shareholders’ money. With the ROE of a company, you can calculate the company’s net income. 

    It monitors companies’ performance

    ROE is a helpful indicator for judging the financial health of a company. It measures how well a firm is using its resources to generate profits. A high return on equity means there has been ample opportunity to use what you’ve got. But a low ROE may suggest some areas that need improvement.

    ROE is an important indicator for investors

    Investors check ROE when making an investment decision. Higher ROEs are generally preferable to investors, as they indicate that the company is using its resources effectively. Conversely, a low ROE signifies market risks and financial instabilities.  

    Thus, while looking for companies with high ROEs, you may want to consider the following:

    • Companies with competitive advantages that allow you to generate higher profits than their competitors.
    • Companies with a low amount of debt will increase the ROE even if profits are relatively low.
    • Companies that are growing continuously and have a high potential for growth in the future.

    The Financial Leverage Effect on ROE

    So far, from what we have discussed, you might have to come to one conclusion — invest in companies with a higher ROE. But it is not guaranteed that companies with higher ROEs will be profitable in the future. A company’s higher ROE could be the result of its high debts. 

    The use of debt can increase returns for shareholders, but it can also magnify losses. Therefore, investors need to understand how a company’s financial leverage affects its ROE.

    When a company has a higher debt-to-equity ratio, it is said to be more leveraged. 

    The increased use of debt can lead to higher returns for shareholders, but it also carries more risk. If the company’s ROE falls, the loss to shareholders will be significant.

    For example, a company with a debt-to-equity ratio of 2:1 and an ROE of 10% will have its return on equity as 20% if it had no debt. However, if the company’s ROE falls to 5%, then the company’s return on equity would fall to 10%. 

    The Limitations of Return on Equity

    Despite its usefulness, ROE has a few limitations that investors should be aware of. One of the limitations is that ROE only looks at profitability concerning shareholders’ equity and not other financial measures such as total assets or total liabilities. This can lead to distorted conclusions about a company’s overall financial health.

    Another limitation is that management can manipulate ROE. For example, a company could artificially increase its shareholders’ equity by issuing new shares or taking on debt. Thus, it would lead to a higher ROE even if its underlying profitability hadn’t changed.

    Finally, ROE doesn’t take into account the time value of money. This means it doesn’t consider the fact that shareholders expect to receive a return on their investment not just today but also in the future.

    The limitations of ROE make it a less-than-perfect measure for assessing company profitability. But by understanding ROE calculations and limitations, investors can make more informed investment decisions.

    ROE and DuPont Analysis

    Though calculating ROE is not difficult, there is another method you can use. It is called Dupont Decomposition. It is a financial analysis tool that breaks down Return on Equity (ROE) into two components: operating efficiency and financial leverage. This analysis can help investors better understand how each component contributes to a company’s overall ROE.

    Mathematically, you can calculate ROE with DuPont Analysis with the below formula:

    ROE= operating efficiency * financial leverage * (revenue/average assets)

    The DuPont analysis can be used to spot trends in a company’s profitability and compare different companies’ profitability. It can also be used to assess a company’s financial health and identify potential problems.

    The Bottom Line

    The return on Equity (ROE) ratio is one of the top financial parameters that investors can rely on to check the overall financial health of a company. It can help you gauge how efficiently a company has been using its resources and whether it’s creating value for its shareholders. 

    While there are several ways to calculate ROE, the most common is net income divided by shareholders’ equity. This calculation factors how much profit a company makes, and the money shareholders put into it. However, it is noteworthy that ROE is just one metric to consider while making investment decisions. Factors such as the company’s debt levels, business model, and growth prospects are equally valuable while selecting a stock. 

  • Matching Principle of Accounting

    Matching Principle of Accounting

    When companies make an assessment, financial statements must be computed and prepared to adhere to the correct accounting rules. The matching principle is one such concept.

    The matching concept must be used to generate documentation more effectively with correct analysis. This article will find the answer to what is matching concept, its advantages, limitations, and examples of the matching principle of accounting.

    What is the Matching Principle of Accounting?

    A fundamental, underlying accounting theory known as the “matching principle” asserts that expenditures should be reported simultaneously with the corresponding revenues. One of the ten accounting principles found in Generally Accepted Accounting Principles (GAAP) is the matching principle, which mandates that companies reconcile their income and expenses over a given period.

    The matching principle is never applied in cash accounting because it was created to be used with accrual accounting.

    If you want to understand the matching concept in accounting, then the following accounting terminologies are essential to know:

    Accrual Method

    Accrual accounting is one of two approaches used in accounting methods. The accrual method records income when work is finished rather than when money is received. In contrast, expenses are recorded when they happen rather than when they are paid.

    Cash Method

    Cash accounting is the simplest method of accounting, recognizing revenue when payments are received and expenses when payments are made.

    Expenses

    Any charge or fee the company is paying Is counted as an expense. Expense accounts are temporary accounts that are closed out to zero after each accounting period so that the following period begins with a balance of zero.

    Revenue

    Revenue is money received regularly through business operations. A revenue account is a brief account cancelled out after each accounting period, much like an expense account.

    How Does the Matching Principle of Accounting Work?

    The matching principle ensures consistency between an organization’s revenue statements and balance sheets.

     Let’s learn how it works:

    In the same period in which revenues are earned, expenses are recorded on the income statement. At the end of the accounting period, liabilities are recorded on the balance sheet.

    Expenses with no direct connection to revenue should be reported on the income statement in the same period they are incurred.

    Moreover, identifying the points at which expenses lead to revenue may be challenging if detected too soon or too late. Financial statements may be manipulated; as a result, investors have a hazy picture of the company’s overall financial situation.

    For instance, early expenditure recognition decreases net income. Conversely, your net income will increase if you discover it too late.

    What Is Revenue Recognition?

    The matching principle of accounting could be seen as a combination of revenue recognition principles and accrual accounting approaches. The revenue recognition principle states that when revenue is received or realized, it must be recognized and documented on the income statement.

    Businesses can report this sales revenue without waiting for the cash payment to arrive. For instance, when a vendor records revenue for a single job, they do so even if the client doesn’t pay the invoice until the next accounting period. 

    Examples Of Matching Principles of Accounting

    Let’s take some matching concept examples to get a better understanding of matching principles of accounting:

    Commission

    The money given to a staff member as compensation for closing a deal is referred to as a commission. Here is an example to understand better about the commission.

    EXAMPLE 1

    Let’s imagine Bhaskar made 10% commissions in September and received his commission in October. Let’s assume the business would pay him ₹8000 in October as a commission if he sold products worth ₹80,000 in September. According to the matching principle, Rs. 8,000 in commissions must be included on the October statement with ₹80,000 in product sales.

    Bonuses

    An employee’s extra money over and above their base salary is an employee bonus. Employers frequently reward employees with a bonus if they perform above expectations at work. 

    EXAMPLE 2

    In 2019, Bhaskar received a bonus of ₹40,000 bonus based on his work productivity. He didn’t receive the bonus until 2020. Using the matching principle, the ₹40,000 expense should be reflected on the income statement in the year Bhaskar earned it. In this situation, they would include it on the income statement in 2019.

    Depreciation

    Depreciation is the term used to describe how much an asset loses in value over time due to normal wear and tear. Here is an illustration of the Depreciation of the matching principle. 

    EXAMPLE 3

    Let’s say, in 2021, Pranay spent ₹750,000 to purchase a new CNG car with an expected lifespan of 15 years. The car’s purchase price and the money it has brought in must be equal.

    Let’s assume that Pranay utilized it to commute to work in this situation, saving him extra money that he would spend on petrol. In this case, he should apply the car’s purchase price to a depreciation expense of ₹50,000 per year, totalling 15 years.

    Wages

    Wages are the financial compensation you earn from your boss for the job you perform. Here is an illustration of the matching principle used for wages:

    EXAMPLE 4

    Let’s imagine Pranay is an employee of ABC company. The company’s pay period closes on June 20, and he doesn’t get his salary until July 5. This expense will be reflected in the June income statement for the salary he received from June 20 to June 30. This is because he kept working through the end of the salary period, in this example, the final few days of June.

    Limitations of Matching Principle of Accounting

    The matching principle might not be ideal when a company uses cash accounting as an alternative to accrual accounting. This idea has some limitations, including the following:

    • It is more difficult when there is no direct correlation between income and expenses.
    • When related revenue is distributed across time, as with advertising or marketing expenditures, it doesn’t work either.

    Even yet, there are only a few circumstances in which it becomes more challenging to utilize. Overall, it is a good idea to recognize the matching principle for everyday accounting.

    Conclusion

    The fundamental of business is that you must spend to generate money. The matching principle allows businesses to acknowledge this concept while maintaining their accounting records. 

    To put it another way, while applying the matching principle, a company must include the expenditure in the income statement for the period during which the corresponding revenues have been generated. A balance sheet to complete that accounting period must also be prepared.

    Reference

  • How are Balance Sheet, Income Statement and Cash Flow Connected?

    How are Balance Sheet, Income Statement and Cash Flow Connected?

    Or 

    How are three annual financial statements interlinked with each other?

    In corporate accounting, the information found on a company’s financial statements is at the heart of the process. 

    People use information from a company’s balance sheet, income statement, and cash flow statement to figure out critical financial ratios that show how well the company is doing financially and what might need to be done to fix to sustain in the industry.

    These three financial statements are interlinked with each other. The component of one helps prepare the other. 

    As a whole, the three financial statements provide investors with an overview of how financially strong a company is. 

    Let’s enlighten about the components that act as a bridge between these three statements. 

    Companies have to prepare a series of statements to follow the rules of accounting standards. Ultimately, a fairly presented financial statement at the year-end can justify all the transactions made during the whole year.

     

    Sequential stages of data recording preparation of statements-

    • Journal Entry
    • Ledger posting
    • Trail Balance
    • Profit and loss account/income statement
    • Balance sheet
    • Cash flow statement 

    Although only income statements, balance sheets and cash flow statements are part of financial statements, journal entries are the first step in recording transactions. Then, we transfer the amounts recorded in journal entries into relevant ledger accounts. Ledger balancing is the essential part of the accounting process needed at the end of the relevant financial year. Balances of ledges accounts are to be transferred to the trail balance to recognize mistakes and errors during the process. 

    Trail balance has to be tallied as debit, and the credit side of the statement must be the same. Sometimes, it is impossible to identify the mistake because of the time horizon or lack of resources. The balance amount must be transferred to a suspense account, which needs to be verified by the auditor. 

    This is how the initial three stages of recording transactions are done and interlinked with each other. Similarly, the remaining three are interconnected with each other. 

    Let’s understand with examples and discuss components that act as a bridge between them- 

    How is the income statement interlinked with others?

    The income statement is used to calculate net income earned by the company during the relevant financial year. It is prepared as per accrued income or expenses approach. 

    How is an income statement linked with a balance sheet?

    Balance sheets are the part of annual financial statements with two sides, assets and liabilities, which need to be equated. 

    • The amount of net income calculated from the income statement should be added to the retained earnings under the head of the reserve surplus, which changes the amount of listed equity on the balance sheet.
    • Items like prepaid expenses or incomes, outstanding expenses, accrued incomes are transferred only from the income statement to the balance sheet. 
    • Depreciation or amortization and gain or loss from the sale of assets can only be calculated in the ledger accounts and transferred to the income statement. The amount derived from the income statement under the said head must be transferred to the balance sheet. 

    Let’s understand with the example of the impact of depreciation in income statements and balance sheets.

    Income statement

    Net profit before depreciation and tax = 1,50,000

    Depreciation = 15,000

    Fixed assets = 15,00,000

    • In the income statement, depreciation should be shown on the debit side, which reduces the net profit by 15,000. Now profit will be 135000 (1,50,000-15,000)
    • In the balance sheet, depreciation of the same amount taken from the income statement is shown under the head of tangible assets by reducing the gross amount of fixed assets by 15,000. Fixed assets will now be shown as 14,85,000 (15,00,000-15,000)

    How is an income statement linked with cash flow statements?

    Cash flow statements are also a part of the annual financial statements that show the net cash available to the company after paying off all the cash expenses. 

    • The net income calculated in the income statement is useful in calculating net cash inflow or outflow generated from operating activities. To calculate net cash inflow/outflow from operating activities, we need to deduct non-cash expenses like depreciation and adjust the amount of the outstanding and prepaid expenses or incomes. 
    • Income or gain on sale of fixed assets derived from income statements becomes helpful in calculating net cash inflow/outflow from investing activity. We need to deduct gains on the sale of fixed and add loss on the sale of fixed assets.  
    • The interest paid in the income statement is taken to the cash flow statement under the head of cash flow from financing activities. 
    • On the other hand, the interest received is taken to the cash flow statement under the head of the cash flow from investing activities. 
    • By referring to the same example as above, the impact of depreciation on the cash flow statement is shown in the income statement.
    • Depreciation shown in the income statement is a non-cash expense; adding depreciation to net income from the income statement to calculate net cash flow from the operating activity is necessary. Now net income will be increased by 15,000. 

    How is the balance sheet interlinked with the cash flow statement?

    The sum of all the heads of cash flow statements, cash flow from investing activity, cash flow from operating activity, and cash flow from financing activity adds to the previous year’s closing cash balance. The results derived will be equal to the closing cash balance of the current year. 

    Let’s understand with an example. 

    Cash flow from operating activity = 10,000

    cash flow from investing activity = 15,000

    Cash flow from financing activity = 17,000

    Closing cash balance of 31/3/2020 (previous year) = 16,000

    Closing cash balance of 31/3/2021 (current year) must be-

    = 10,000+15,000+17,000+16,000

    = 58,000

    The whole accounting process is interlinked. We won’t be able to prepare one without the other one. It is necessary to clarify each part of accounting concepts to form a full-fledged financial statement of a company. Accurate and fair financial statement representation, notes to accounts, and material disclosure are necessary. Financial statements are the basis for making financial decisions by the investors and management itself. Accounting principles are the reason behind the interlinking process, which helps companies and stakeholders make sound decisions. 

  • Perfect Competition: Characteristics with Examples

    Perfect Competition: Characteristics with Examples

    The coaching centers in India were enraged by recent advertisements by a major Edtech company giving 95% discounts to students enrolling at its Kota centers. The coaching centers claimed that Edtech corporations are breaking Indian competition regulations and engaging in unethical marketing and advertising tactics, including luring away teachers and students with steep wage increases and huge discounts on courses. This is making the competition imperfect.

    In theory, perfect competition exists when all businesses sell the same goods, market share has no bearing on prices, businesses can enter or quit the market without any obstacles, consumers have perfect or complete information, and businesses cannot set prices.

    What Is a Perfect Competition?

    Perfect competition is a standard or ideal kind to which actual market structures can be compared. Theoretically, monopolies are when only one company provides a good or service. That company is free to set its own prices because consumers have no other options, and potential competitors can’t enter the market, which is the opposite of perfect competition.

    In reality, perfect competition cannot possibly exist. It, however, serves as a baseline for comparison with other market structure types, such as oligopoly, monopoly, duopoly, and so on.

    What Are the Characteristics of Perfect Competition?

    Homogenous products

    Many buyers and sellers in a market are perfectly competitive. Instead of giant corporations that may regulate prices through changes in supply, the sellers are smaller businesses. There aren’t many distinctions in the capabilities, features, and prices of the things they sell. This ensures that consumers cannot differentiate between products based on tangible qualities, such as size or color, or intangible qualities, such as branding.

    In this market, plenty of buyers and sellers ensure that supply and demand are stable. Customers can readily switch out products made by one company for those made by another. 

    Price takers

    In perfect competition, no company has the authority to charge more than the market price, which is the same as the marginal cost of production. The other businesses will undercut any company charging a higher price. Since long-term market demand is consistent, all producers have about equal market shares.

    Profitability

    While some businesses may have short-term gains that are quicker to market, in the long-run equilibrium of fully competitive markets, no business will ever experience a financial gain. The demand curve is lowered by new producers joining the market, and no company can raise prices to maintain profits.

    Free entry

    Businesses can easily enter and leave a perfectly competitive market. This can come in the form of money, time, or knowledge. For instance, a significant upfront investment is needed in the oil and gas sector. As a result, competitors face a barrier to entry. These expenses don’t exist or are very little in perfect competition.

    Additionally, under ideal competition, businesses might easily abandon the market. A company might, as an example, have a lengthy contract. They cannot, however, abandon the market without incurring high fees.

    Rational buyers

    In this hypothetical market, buyers make logical decisions to maximize their economic utility and shop around for the best deal. Additionally, these customers are well informed about the goods they are buying. Thus, they are aware of the pricing ranges offered by various businesses.

    Mobile Resources

    In perfect competition, the labor force and the capital can move around as needed or desired at no additional expense.

    Government Regulation

    Governments play a crucial role in developing the market for goods by enforcing rules and regulating prices. By establishing guidelines for the market’s operation, they can regulate the entry and exit of businesses. For instance, the creation, manufacture, and sale of medications are subject to several regulations the pharmaceutical sector must follow.

    In a perfectly competitive market, such controls don’t exist. Since there are no limits on a company’s entry or exit from such a market, it can freely invest in labor and capital assets and alter the output in response to market needs.

    Examples of Perfect Competition and Imperfect Competition

    Agriculture sector

    An agricultural market may be the closest example of ideal competition in real life. Small producers charge relatively similar pricing for almost equivalent products. The market as a whole is unaffected by the entry and exit of some vendors, and prices and product details are transparent and largely consistent.

    Foreign exchange 

    Traders exchange currency in this market. Since there is only one Indian Rupee (INR), the product is uniform. The market has a large number of buyers and sellers as well. Additionally, it is simple to purchase currency and simple to sell it as well. That said, there is a caveat that traders could not have “precise information.” Regular buyers and sellers can be disadvantaged compared to expert traders who do it for a livelihood. Even so, it is one of the most exact representations of perfect competition that we can currently uncover.

    Airline industry

    India already has six airlines, one or possibly too many. Economic theory predicts that either all would lose money or, even if some do, the returns will be small compared to the initial investment. As a result, it serves as an illustration of perfect competition.

    Central government for military equipment

    India’s central government purchases most of its military equipment. Even though several producers may be supplying these products, the prices that each supplier is ready to accept are determined by what the government is willing to pay. This competition is not perfect either.

    Automobile sector

    Although the auto financing industry first seems quite competitive, many consumers lack the opportunity to get precise price information. Auto financing is different from typical markets because the pricing is not transparent and ultimately depends on the borrower’s creditworthiness and the specifics of the auto loan. In this market, auto dealers represent both consumers and lenders. Even after accounting for variables like credit worthiness, prices consumers pay for auto loans vary greatly due to the market’s asymmetric information. As a result, it is imperfect competition.

    Monopoly in Coal

    By enabling commercial mining to bring about competition, transparency, and private sector involvement in 2020, FM Sitharaman eliminated the monopoly on coal. Previously, bids for coal blocks could only be made by captive consumers with end-use ownership. With the liberalization of entrance standards, any party can now offer a bid and sell it on the open market. This way, the coal market competition was made less imperfect.

    Key Takeaways

    Profits might be attainable for a short while in markets with perfect competition. The market dynamics, however, neutralize the impact of either positive or negative earnings and move them toward equilibrium. Theoretically, a market with perfect competition is not monopolistic. All real markets can be considered imperfect since they all occur outside the plane of the perfect competition model when a market deviates from the idealized principles of neoclassical pure or perfect competition.