Category: Commerce Notes PPT

Depreciation of Fixed Assets

In bookkeeping terms, depreciation of fixed assets is characterized as the decrease of the recorded expense of a fixed resource in a deliberate way until the estimation of the asset gets zero or unimportant. 

Some examples of fixed assets are buildings, furniture, office hardware, machinery and so on. The land is the main special case which cannot be depreciated as the estimation of land acknowledges with time. 

Depreciation of fixed assets permits a segment of the expense of a fixed asset for the income created by the fixed resource. This is compulsory under the coordinating guideline as incomes are recorded with their related costs in the bookkeeping time frame when the asset is being used. This helps in getting a total image of the income generation transaction.

Concept of Depreciation

The concept of depreciation is the part of a fixed resource’s cost recorded as a cost during the current bookkeeping time frame. Depreciation concept in accounting means that a fixed asset has a helpful life longer than one bookkeeping period and depreciation signifies the value of its worth spent during the current time frame. 

Concept of Depreciation can be determined in numerous ways. We must decide reasonable depreciation for the current bookkeeping time frame as per a fixed asset’s valuable life, unique cost, depreciation method and neighbourhood guidelines. After that, the manager will monitor how much depreciation has been amassed for the fixed asset.

Depreciating assets examples include straight-line depreciation which is the least difficult strategy, partitioning the fixed asset’s expense by the quantity of bookkeeping periods it is relied upon to last. Different techniques can yield more noteworthy depreciation charges in early bookkeeping periods to perceive fast obsolescence or consider the rescue or scrap estimation of the fixed asset after it is completely depreciated. Duty guidelines may likewise permit quickened deterioration to support business venture or disentangle documenting. Further, laws may indicate which depreciation charge techniques must be utilized or cannot be utilized.

Depreciation Entry Example

The journal entry for depreciation can be a basic entry intended to oblige a wide range of fixed assets, or it might be partitioned into discrete entries for each kind of fixed asset. 

The essential depreciation entry example is to charge the Depreciation Expense account (which shows up in the income articulation) and credit the Accumulated Depreciation account (which shows up in the balance sheet as a contra account that lessens the measure of fixed assets). After some time, the balance of accumulated depreciation will keep on expanding as more depreciation is added to it until a time when it rises to the original expense of the asset. Around then, we need to quit recording any depreciation cost, since the expense of the asset has now been decreased to zero. 

Concept of Depreciation in Economics

Depreciation is viewed as a cost, yet not at all like most costs. There is no money surge related. This is because an organization has net money outpouring in the whole measure of the advantage when the benefit was initially bought, so there is no further money-related action. 

Lastly, depreciation is not planned to lessen the expense of a fixed resource for its fairly estimated worth. Market worth might be generously unique and may even increase after some time. Rather depreciation is only planned to charge the expense of a fixed asset for cost over its valuable life step by step. 

Depreciation charge and various other bookkeeping errands make it wasteful for the bookkeeping division to appropriately track and record fixed assets. They lessen this work by utilizing a capitalization breaking point to confine the number of consumptions that are named fixed assets. Any consumption to which the expense is equivalent or more than that, and which has a valuable life traversing more than one bookkeeping period (normally at any rate a year) is delegated to a fixed asset and is then depreciated. This is the depreciation math definition.

What are Adjustment Entries?

Adjusting entries are the entries that are made on the last day of an accounting period. This is done so that a company’s financial statements go in accordance with the accrual method of accounting. In simple words, the adjusting entries are needed in a company for the following reasons:

• Income statement records the revenues which were earned during the accounting period.

• Balance sheet reports the receivables who has a right to receive at the end of the accounting period.

• Income statement reports the expenses and losses to incur during the accounting period. 

• Balance sheet records the liabilities which has incurred as of a particular accounting period.

 

Types of Adjustment Entries

Primarily the types of the adjusting entries are discussed in the given sections:

These entries help a business in reporting all the revenues, which it had earned during the accounting period. There might arise a case when a company has already provided a service, but did not receive the payment yet. So, the accrual type of adjusting entries are shown in the financial statements to account for such as these revenues.

Like the accrued income or the revenue, a company only should record the expenses which it incurs. A business should also report an expense even if it does not incur its expenses. For example, a company assigns a worker on a contract basis. The company is expecting to get an invoice on January 3rd and remit the payment on January 8th. However, the services of the worker were availed in the month of December itself. Therefore, the company needs to account the expenses and liability as of December 31st.

Deferred expenses are the payment paid in the present for the future expenses. One must also refer these payments as the deferred expense until the expenses expire or the company avails the service. Like, a company pays Rs.10000 on December 25 towards a machine insurance for the six-month period starting January 1. This means the insurance is actually prepaid for a period between the December 25th and December 31.

It is in relation to the use of the fixed asset in the business, a company depreciates an asset at a certain rate which has a useful life for more than a year. Through the depreciation period, the company allocates this cost of the asset as an expense in the accounting periods where the company uses the asset. Example, a machine costing Rs.50000 with no salvage value and useful life of 20 years will result in a monthly depreciation expense of Rs.50000/240 (20*12).

If the company receives any amount in advance before earning, the company should mention the same as a liability in the current accounting period. Like, a company gets an advance of Rs.5000 for offering a service which will offer at a later date. As on December 31st, the company should analyse the portion of the service which it has already delivered. The portion will come as income, and the balance will be the deferred revenue.

Importance of Adjustment Entries 

Adjusting Entries helps in the following cases:

• The income statement of the company only records the revenues which the company earns during the accounting period.

• Receivables in the balance sheet reflects the accurate amount which the company has the right to receive at the end of an accounting period.

• Income statement encompasses the expenses and losses which a company incurs during the accounting period.

• Balance sheet also consists of the liabilities which the company incurs as of the end of the accounting period.

• This also helps in calculating the exact revenues and expenses.

• Updating the financial statements can be done through these entries.

• To fix an error, adjustment entries are passed easily.

What are Financial Statements?

Financial statements are used by investors and business analysts to evaluate the earning potential and growth of a company. This consists of three major components of a business. They are the Profit and Loss A/c, Income and Expenditure A/c, and Balance Sheet. These three reports together are analyzed to find out the overall financial health of a business. 

The basic analysis of financial statements depends on the information extracted from the financial statements to calculate other ratios. 

Financial Ratios Analysis 

The fundamental financial ratios required for the analysis of financial statements are listed below:

1. Working Capital Ratio – This is an important measure of financial health that reveals the company’s capacity to pay its liabilities with its current assets. The calculation of this ratio is made by dividing current assets by current liabilities.

2. Quick Ratio – This shows how far current liabilities could be covered by cash and by materials with cash value.

3. Earnings per Share (EPS) – This measures the net income earned from every share of the company’s common stock. 

4. Price-Earnings (P/E) Ratio – This shows the investors’ assessments of future earnings. This is obtained by dividing the share price of the company’s stock by EPS.

5. Debt-Equity Ratio – This has to be analyzed with respect to industry norms and company-specific requirements

6. Return on Equity (ROE) – This has to be calculated by subtracting preferred dividends from the company’s net earnings and divide by common equity dollars in the company.

When these ratios are properly applied, using any one of them can help improve the company’s investing performance. The financial ratios analysis helps to pick stocks for investment portfolios.

The Objective of Financial Statement Analysis

The main objective is to give a clear picture of the financial position, performance, and further changes that are useful in making economic decisions. The statements should be clear, relevant, reliable, good and comparable

Financial Ratio Analysis and Interpretation

Analysing and interpreting financial ratios is rather logical while we don’t need to look at the numbers. This analysis is performed by comparing items in the financial statements. And then the interpretation is done with the result of the analyses rather than depending on the items separately.

Financial ratios of business are classified into ratios that measure the profitability, liquidity, management efficiency, leverage, and valuation & growth.

Analysis and interpretation of financial statements can also be defined as an experiment to reveal the significance of the financial statement so that the prospects for earnings, ability to pay liabilities, and profitability of the business in the future.

Financial Reporting and Analysis of Financial Statements

Financial Analysis and reporting is a major part of financial analysis carried out by various business enterprises in India and across the world. It reveals the financial health of any business and helps them to strengthen their financial resources and management of generated funds effectively.

There are so many techniques that are commonly used for financial statement analysis namely Vertical, Horizontal, Leverage, Growth, Profitability, Liquidity, Efficiency, Cash Flow, Rates of Return, Valuation, Variance, and Scenario & Sensitivity

But the three major techniques used are horizontal analysis, vertical analysis, and ratio analysis.

Horizontal Balance Sheet

A horizontal balance sheet shows assets on the right column, and the liabilities are shown on the left. The assets of a company include both tangible and intangible or either of them. The assets that are physically seen are referred to as tangible assets. The horizontal analysis of financial statements is represented in the following figure:

Methods of Financial Statement Analysis

The various techniques of financial statement analysis are listed below:

1. Comparative Statement or Comparative Financial and Operating Statements.

2. Common Size Statements.

3. Trend Ratios or Trend Analysis.

4. Average Analysis.

5. Statement of Changes in Working Capital.

6. Fund Flow Analysis.

7. Cash Flow Analysis.

8. Ratio Analysis.

9. Cost Volume Profit Analysis

Financial Statement Analysis Project

Project on financial statement analysis ratios is prepared by students to improve their technical, analytical, and communication skills to forecast the economic decisions and discuss the company’s ability to perform and be successful.

A financial statement that showcases the net worth of an organization by listing the assets and liabilities of the organization, along with shareholder’s equity for a particular period, usually a year, is what a Balance Sheet means.

 

Importance and Purpose of Balance Sheet

1. A Balance Sheet shows the financial position of an organization during a particular time frame

2. The growth of a company is evaluated by comparing the balance sheet of the previous years.

3. iii) A Balance Sheet displays what an organization owns and what the organization owes.

4. With the help of the Balance Sheet, potential shareholders and investors can get an insight into an entity’s liquidity position before buying any shares or before investing.

5. Balance Sheet helps the shareholders and investors to check whether the company will be able to pay dividends.

6. Balance Sheet provides information regarding the short-term financial position of a firm. subtracting the current liabilities from the current assets will show results of the networking capital, which is the funds required to meet the regular activities (rent, wages, utility bills, etc.) of a company.

7. Another feature of a balance sheet is that it acts as a crucial document when applying for credit with a bank or other types of financial institutions.  

 

Shareholder’s equity is a crucial part of a balance sheet, which comprises the common shares, the preference shares, and the retained earnings. The Shareholder’s capital can be calculated by subtracting the liabilities from the assets. 

According to the Schedule III of the Companies Act, 2013, certain amendments were given and also laid down the format for the preparation of the profit & loss account and balance sheet, which all companies need to follow. 

 

An example of the new structure :

Equity and liabilities.

I) Shareholder’s Funds

Money received against shares reserved and surplus share capital 

II) Share Application Money After Allotment

III) Non-current Liabilities

a)Long-term provisions

b)Long-term borrowings

c)Deferred tax liabilities

IV) Current Liabilities

a)Short-term borrowings

b)Short-term provisions

Assets

I)Non-current assets

 a)Fixed assets

b)Other non-current assets

c)Intangible assets

 d)Tangible assets

ii) Current Assets.

a) Short-term loans

b)Inventory

c)Current investments

d) Trade receivables

e)  Other current assets.

 

The general balance sheet definition is – a financial statement that showcases the net worth of an organization by listing its assets and liabilities along with shareholder’s equity for a particular period, usually a year. 

 

The balance sheet is one of the three primary financial statements prepared by a firm, the other two being –

1. Profit & loss (P&L) account statement – As the name suggests, the profit & loss account statement shows the net profit or loss of a company during a specific period, which can be a year, quarter, month, etc. It is also known as an income statement.

2. Cash flow statement – The cash flow statement displays the inflow and outflow of cash within an organization during a specific period.

 

What is the Purpose or Importance of a Balance Sheet?

• Shows the financial position of an organization during a specific time frame. 

• Growth of a company can be evaluated by comparing the balance sheet of the previous years.

• Displays what an organization owns and owes.

• Potential shareholders and investors can gain insight into an entity’s liquidity position before buying shares or investing.

• Enables shareholders and investors to check whether the company will be able to pay dividends.

• Provides additional information regarding the short-term financial position of a firm. For example, subtracting the current liabilities from the current assets will show the net working capital, which is the funds required to meet the regular activities (rent, wages, utility bills, etc.) of a company.

• One of the features of a balance sheet is that it acts as a crucial document when applying for credit with a bank or other types of financial institutions.   

 

What is the Balance Sheet Format?

Usually, a balance sheet is created by listing the assets on the left side and liabilities and shareholder’s equity on the right. However, it is also prepared vertically, with the liabilities and shareholder’s equity recorded first and then the assets. 

 

In the case of non-profit organizations, the assets are listed on the right while the liabilities on the left. Additionally, instead of capital, it is a capital fund or general fund. Any surplus or deficit will be added or deducted from this fund before preparing a balance sheet.

 

Test your skills – Now that you know the format, take a problem from your study material and try to prepare a balance sheet by referring to the structure mentioned below.

 

What is the Structure of a Balance Sheet?

The balance sheet structure is discussed in details below – 

1. Assets 

Assets are what an organization owns. These can be converted into cash in the short-run or long-run. Assets can be of the following two types – 

1. Fixed or Non-current Assets – As the name suggests, these are assets that are “fixed” or immovable. Examples of fixed or non-current assets include land, machinery, equipment, building, goodwill, trademarks, etc. Assets can be classified based on their existence type (tangible or intangible) and usage (operating or non-operating).

2. Current Assets – These are assets that can be converted into cash (or cash equivalents) within a short period (usually, a year). Examples of current assets include short-term investments, accounts receivables, cash, etc.

Test your skills – There are several entries under assets other than the ones mentioned here. Refer to your book and try to find those that will go under this head. 

2. Liabilities 

Liabilities are what a firm owes. These are debts or obligations that arise during the course of business. Balance sheet liabilities can be classified into the following –

1. Non-current Liabilities – These are long-term liabilities that are due after one year or even more. Examples of non-current liabilities include mortgage loans, deferred tax liabilities, bonds payable, debentures, pension benefit obligations, etc.

2. Current Liabilities – These are short-term liabilities that are due within a year. Examples of current liabilities include short-term loans, bank overdraft, bills payable, income tax payable, interest payable, payroll tax payable, etc.

3. Contingent Liabilities – As the name suggests, these liabilities arise owing to contingencies. An organization may or may not incur such liabilities, depending on the occurrence of contingent events.Examples of contingent liabilities include product warranties, lawsuits, etc.

Test your skills – Similar to assets, there are also several liabilities not mentioned here. To have a better understanding, try to find all the liabilities from any problems mentioned in your study material. 

3. Shareholder’s equity 

One of the crucial elements of a balance sheet is shareholder’s equity, which constitutes common shares, preference shares, and retained earnings. Shareholder’s capital can be calculated by subtracting liabilities from assets. 

 

The following is a typical balance sheet sample –

 

Test your skills – Prepare a balance sheet in your notebook by referring to any problem in your accountancy book now that you know its format and structure. 

 

Schedule III of the Companies Act, 2013

The amendments made to Schedule III of the Companies Act, 2013 laid down the format for preparation of profit & loss account and balance sheet with which all companies have to comply. 

 

A typical example of the new structure is mentioned below –

 

Equity and liabilities:

1. Shareholder’s Funds

1. Money received against shares

2. Reserves and surplus

3. Share capital 

2. Share Application Money After Allotment

3. Non-current Liabilities

1. Long-term provisions

2. Long-term borrowings

3. Deferred tax liabilities

4. Current Liabilities

1. Short-term borrowings

2. Short-term provisions

Assets:

1. Non-current assets 

1. Fixed assets

2. Other non-current assets

3. Intangible assets 

4. Tangible assets 

2. Current assets 

1. Short-term loans

2. Inventory

3. Current investments 

4. Trade receivables

5.  Other current assets

 

Limitations of a Balance Sheet 

• One of the primary limitations of a balance sheet is that it only accounts for assets that are acquired. Assets that cannot be expressed in monetary terms are excluded from the balance sheet.

• A balance sheet does not show the actual market value of a company’s assets, which might hinder proper financial assessment. 

• Sometimes current assets are expressed in the balance sheet based on estimation. This discrepancy might distort liquidity projections of a company.

The above includes balance sheet definition and everything that you need to know about this financial statement. Make sure to keep checking out ’s website for more of these articles and blogs.

Break-even analysis is an essential economic tool that helps to determine the point beyond which a company earns a profit. It helps businesses calculate the volume of products that need to be sold so that a company overcomes all the initial cost of investment. Reaching this break-even point means that a company is no more in a state of loss.

What is the Break-Even Point? 

In a business scenario, the break-even point is a perimeter at which the total expenses of the enterprise equals the total revenue generated. Reaching this point indicates that a business has overcome all the expenses and no more in a state of loss. 

Since this calculation reveals such vital information of a business, it is a necessity to learn and calculate break-even points accurately. 

To understand this further, consider this formula. 

Break-even point = Fixed Cost / (Price per cost – Variable cost) = Fixed Cost / Gross Profit Margin

Where, 

• Fixed cost refers to the cost incurred in a business unit, which doesn’t depend upon the volume of production. For example, rent, loans, insurance premiums, etc. comes under fixed cost. 

• Variable cost is the cost to produce one unit of product. 

Example 

Let us understand this equation by taking a break even analysis example mentioned as follows. 

A factory ABC Enterprises produces a particular kind of good wherein the total fixed costs stands at Rs.50,000 and variable cost to produce a good is Rs.30. The company sold these goods with a sale price per unit of Rs.50. 

In this case, 

Break-even point = 50,000/ (50-30) = 2500 units 

So, from the above break-even analysis, it is evident that BEP (break-even point) for ABC enterprises stands at 2500. This means a company will have to sell at least 2500 units of the product to overcome these fixed and variable costs incurred for production. 

This can further help companies in determining the total sales achieved by the company then. They need to multiply the break-even point with the sale price per unit to do so. In this case, the value of total sales made by the company at their break-even point will be equal to (2500*50) Rs.1,25,000. 

Numerical to Solve 

1. A company produces goods at a variable cost of Rs.12 per unit, and the same is sold at Rs.20 per unit. Fixed cost incurred by a company for a period stands at Rs.40,000. Calculate the number of products a company needs to manufacture to attain a profit target of Rs.10,000. 

2. Check the following table to know about cost analysis for 6 months of a business operation. 

1. Calculate the breakeven quantity 

2. Draw break-even chart for the 6 months of business operation 

3. Determine the profit earned by an organization 

3. Fixed costs of an enterprise is Rs.3,00,000, and the variable cost and selling price of the product is Rs.42 per unit and Rs.72 per unit, respectively. The company expects to sell 15,000 units of the product whereas it has a maximum factory capacity of 20,000 units. Draw a break-even chart depicting the break-even point and determine the profit earned at this current situation. 

Students can solve these numerical quickly and accurately after they have a thorough understanding of the concept of break-even analysis. To understand why we need to calculate this, look at its importance in detail.

Significance of Break-Even Analysis 

As per the break even analysis definition, its calculation can help companies determine the minimum number of goods to be sold so that the total fixed and variable cost of production is met. Therefore, a company already has an exact figure about the number of units to be sold to overcome losses. 

Since break-even analysis gives businesses an idea about the operational scenario, it helps plan the budget for various business operations. Besides, they can set objectives to accelerate the production speed and achieve them positively. 

Fixed and variable costs may have an impact on an organization’s profit margin. But, with break-even analysis of the business operations, they will be able to evaluate if any effects are changing the value of cost. In such scenarios, controlling cost becomes a necessity to ensure they earn profit from business operations. 

Pricing of products has a huge impact on the calculation of break-even points. For instance, if the price of goods increases, then understandably their break-even point will be reduced. For example, if earlier an organization needed to sell 50 units of this product to reach breakeven, it will be attained at only 45 units if the selling price is increased. 

Sales of goods can significantly decline in a situation of financial crisis or breakdown. In such scenarios, managing margin of safety becomes easier with concepts like break even analysis. That’s because the company will have an idea on the minimum number of products they need to sell to ensure their organization doesn’t undergo any loss.

The margin of safety can be calculated by the following formula, 

Margin of safety = (current sales level – Break-even point)/ Current sales level 

Or, Margin of safety = (current sales level – Break-even point)/ Selling price per unit  

These are a few pointers which briefly discuss why it is important to calculate break-even points and study them in a business environment. 

Components of Break-even Analysis 

The two components that help define break-even analysis are mentioned as follows 

1. Fixed Cost 

Costs incurred in running a business that doesn’t vary with the volume of the production are known as a fixed cost. Also known as an overhead cost, examples of fixed costs are salaries, rent, premiums, loans, bills, etc. 

2. Variable Cost 

This is the cost that varies as the number of manufactured products fluctuates. Cost of fuel, raw material, packaging, etc. comes under this.

Applications of Break-Even Analysis 

New businesses have a lot to plan before they introduce a facility and start manufacturing goods for sale. To ensure the plans regarding cost and pricing of goods are done right, break even analysis is a necessity. One will be able to analyze and state if the new business idea is productive or not. 

For cases, a company wishes to introduce the production of new products in its business unit; the study of break-evens can emerge very significant. Before they start producing the goods, analyzing break-even will help them understand the cost and pricing strategy. 

Change in a business model may have an impact on your businesses productivity. The change of model doesn’t necessarily mean it will affect the costs and expenses, but if that’s the case, it will help you change your selling price accordingly. Hence, analyzing break-even in this scenario is both feasible and important. 

Further, while discussing, the term marginal costing and break even analysis may appear frequently. Marginal cost is the extra cost incurred in producing one extra unit of a good. This can help determine how variable costs can affect the volume of production in a business unit. 

Understanding break even analysis meaning will help students get an in-depth idea about this economic concept. Students looking for comprehensive study material can browse to ’s official website or download the app to access the study notes. All our study materials are prepared by experienced and qualified teachers and are guaranteed to help students learn the nuances of the subject intricately. 

Break-even analysis is an essential economic tool that is used to determine the cost structure of a company or the number of units or services that need to be sold in order to cover the expenditure done by it. Break-even is a condition in which the company makes no profit nor suffers any loss, it just recovers all the money spent on the development of a  product.

The break-even analysis is used to examine the relation between the fixed cost, variable cost, and revenue generated by a company. Usually, a company with a low fixed cost will have a low break-even point of sale.

Importance of Break-Even Analysis

• Determines the Size of Units to be Sold: Break-even analysis helps a company in determining the number of units that needs to be sold in order to cover the cost. Variable cost and selling price of an individual product along with the total cost, are required to evaluate the break-even analysis.

• Budgeting and Setting Targets: It allows a company to set a budget and fix a goal and work accordingly since the owner knows at which point their company can break even. It also helps the company in setting an achievable target.

• Organizing the Margin of Safety: In times of a financial breakdown, when the company is not performing well, it helps in deciding the minimum number of sales the company requires to make a profit. With the margin of safety reports, the management of the company can take its business decisions accordingly.

• Monitors and Controls Cost: The fixed and variable cost of a product can affect the profit margins of a company. Therefore, the break-even analysis can help the management detect if any effects are changing the cost.

• Helps to Design Pricing Strategy: If the selling price of a product is increased then the quantity of product to be sold for break-even will be reduced. And like that, if the selling price is reduced, then a company needs to sell extra to break even. So it also helps in designing the pricing strategy of a product.

Components of Break-Even Analysis

• Fixed Costs: These costs are also known as overhead costs. These costs come into existence once the financial activity of a business starts. The fixed costs include taxes, salaries, rents, depreciation cost, labor cost, interests, energy cost, etc.

• Variable Costs: These costs are called variable costs because they decrease or increase according to the volume of the production. Variable costs include packaging cost, cost of raw material, fuel, and other materials related to production.

Applications of Break-Even Analysis

• New Business: This guides the company regarding the productivity of a new business so for a new venture, a break-even analysis is essential. It helps the management in formulating the pricing strategy and is practical about the cost.

• Manufacture New Products: Before launching a new product the company needs to check the break-even analysis before starting its production and see if the product adds necessary expenditure to the company.

• Change in Business Model: The break-even analysis helps a company in determining whether they need to change the selling price of a product if there is any change in any business model like shifting from retail business to wholesale business. 

Break-Even Analysis Formula

Break-even point = Fixed cost/-Price per cost – Variable cost

Example of Break-Even Analysis

Suppose a company is selling a pen. The company first determines the fixed costs (lease, property tax, and salaries) which sums up to  ₹1,00,000. The variable cost determined by the company for one pen is  ₹2 per unit. And , the pen is sold at a price of ₹10.

Therefore, to determine the break-even point of Company, the pen will be:

Break-even point = Fixed cost/Price per cost – Variable cost

= ₹1,00,000/(₹12 – ₹2)

= 1,00,000/10

= 10,000

Therefore, with the given variable costs, fixed costs, and selling price of the pen, the company  would need to sell 10,000 units of pens to break-even.

The primary element of a valid partnership contract is the capability or eligibility of partners to form a business agreement. The capacity to contract here means the legal ability of an individual or an entity to enter into a partnership. According to business law, the partner must be competent and fulfill the specified criteria before signing a contract.

Section 11 of the Indian Contract Act, 1972 details the capacity in contract law. It defines the ability to form contracts based on three aspects. They are as follows.

Apart from contractual capacity, partnership contracts must also include the following.

• Offer

• Consideration

• Intent

• Legality

• Acceptance

The meaning of contractual capacity can be understood in detail through norms and examples.

Refer to the official website of for a detailed explanation.

Detailed Explanation of Capacity to Contract in a Business

Given below is a thorough explanation of the contractual norms to judge an individual’s capacity to enter into a contract.

1. Attaining the Age of 18

A minor does not hold the capacity of holding a contract in business. Any agreement made with a minor in business is void ab-initio, which means ‘from the beginning’. If any person aged below 18 years enters into a contract, he cannot ratify the agreement even when he turns 18. This means that an invalid agreement can never be ratified.

Even though a minor is prohibited from entering a contract, he can register himself as a beneficiary of an agreement. Section 30 of the Indian Partnership Act, 1932 mentions that a minor cannot participate as a partner in the business, but he can enjoy the benefits earned by the firm.

A minor gets to enjoy some extra benefits in business. This contractual benefit needs to be explained in terms of the capacity to contract with examples. For instance, if a minor pretends to be a major and enters into a contract, he can later plead the minority through some simple formalities. The rule of estoppel is not applicable to a minor.

In some cases, a guardian can enter into a valid business contract on behalf of a minor individual. Here, the guardian has no right to bind a minor to buy any immovable property under the contract. However, with proper certification and approval, the minor’s property can be sold when required. 

According to business law, a minor cannot be declared insolvent at any point in time. Even if the minor owes some dues to the firm, he will not be held personally liable for it.

When a joint contract is signed between a minor and major, it has to be done in the presence of the minor’s guardian. In such contracts, the liability of the contract is held by the adult.

2. An individual has to be of Sound Mind

Section 12 of the Indian Contract Act (1872) necessitates a person to be of sound mind, have a complete understanding of the contract terms and conditions, and hold the ability to judge its impact on his interests.

Here, the capacity of parties to the contract also applies to an individual who is usually of unsound mind and occasionally in sound mind. However, in this case, the contract has to be signed when he is in a state of complete soundness. A contract made by an individual of unsound mind shall be considered as null and void according to capacity law definition.

A person under the influence of any sort of intoxication is considered incapable of entering into a contract. Such individuals can make a contract only when they are sober and have a complete understanding of the contractual terms.

3. People Disqualified under Law

Other than minors and people of unsound mind, some individuals might be restricted from entering into any contract as well. Such individuals do not hold the capacity to contract under valid business laws. Disqualification under contractual laws could include reasons related to politics, legal status, etc. This could also happen when a person is a foreign sovereign, national enemy, convict, or insolvent.

• Alien enemies: people who are having citizenship in countries who don’t have cordial relationships with India or in a war situation are called Alien enemies. People signing the contract during a war situation is not encouraged and a contract during a peace situation is valid.

• Married women: married women are not allowed to enter a contract regarding their husband’s property.

• Pardanashin Women: Pardanashin women who will be under influence are not eligible to be involved in the contract as they cannot understand the contract.

• State Ambassadors: The ambassadors are incompetent to contract.

• Convict Serving Sentence: People who are on Bail or serving their sentence are not allowed to sign a contract.

• Patent Officers: People having patent rights are issued by their owners to them. A patent is a monopoly right given to its owner. Hence patent officers are not allowed to sign the contract.

• Legal professionals: People who work as judges, advocates, public prosecutors are not allowed to sign a contract related to their connections.

For example, Advocate has taken a case from a Y person, the legal proceedings are going on. So advocates cannot sign a contract with that person in buying that property.

• Insolvent: The insolvent person is allowed to purchase the property but cannot sell his own property.

• Company: The company is formed under the law. Different companies are bound by different laws. Here, the company is considered as an artificial person. The company cannot sign contracts outside its limits.

4.Capacity contract limited due to Mental Illness

Persons with mental illness or disorders are also having limited capacity to contract irrespective of age. Some of the instances related to campsity  are listed below-

1. Intellectual disability: People with intellectual disability are having an exception for capacity to contract, it also includes the severity of the disorder.

2. Advanced dementia: People suffering from dementia are exempted from involving or signing the contract.

3. Hallucinations and visions: People who are in hallucination and visualize things without any reference are exempted from signing the contract.

4. Affective disorders: People having depressions or bipolar disorder will have frequent mood changes. So people with these problems are not allowed to be involved in any contract.

Contracts signed by people with disabilities are considered to be null. Court will determine whether the contract is legal or illegal. To determine, as a part of the process, individuals’ mental health is determined. People with stress and are mentally challenged are not allowed to be involved in any contract, if they are involved then it is invalid.

Based on legal capacity, affected people are categorized into different types. They are –

• Partial legal incapacity: If a mental disorder or disability is restricted to a certain area and is normal in day-to-day life, then it is partial legal incapacity. For example, hallucinations.

• Relative legal incapacity: Relative legal incapacity contradicts Partial legal incapacity. People who can perform normal activities like shopping, reading and cannot do long-term contracts are referred to this.