Afm U Iii.1

2018
Unit – III – Analysis of

Financial Statement
BA5103 – ACCOUNTING FOR MANAGEMENT

MS. JEBAKERUPA ROSLIN AMIRTHARAJAN, AP
ST. JOSEPH’S COLLEGE OF ENGINEERING | OMR, Chennai

Unit – III – Analysis of Financial Statement Page 2 of 70
TABLE OF CONTENTS
Meaning of Management Accounting 5
Analysis of Financial Statements 5
Meaning 6
Methods 6
Financial Statement 7
Nature of Financial Statement 7
Tools of Analysis of Financial Statements 14
Comparative Statements 14
Common Size Statements 14
Trend Analysis 15
Ratio Analysis 15
Fund flow Analysis 15
Cash Flow Analysis 15
Comparative Financial Statement 16
Comparative Balance Sheet 16
Current financial position and Liquidity position 16
Long-term financial position 16
Profitability of the concern 16
Comparative Income Statement 19
Common Size Statement 21
Common Size Balance Sheet 21
Common Size Income Statement 23
Trend Analysis 25
Ratio Analysis 26
Meaning of Ratios 26
Expression of Ratios 26
Financial Ratios 27
Classification of Ratios 27
Liquidity Ratios 28
Profitability Ratio 29
Activity Ratios 29
Capital Structure or Leverage Ratios 30
Liquidity Ratios 30
Current Ratio 30
Liquid Ratio 33
Cash Position Ratio 35
Profitability Ratios 38
Profit Margin Ratios 38
Rate of Return Ratio 45
Turnover Ratio 48
Fixed Assets Turnover Ratio 48
Working Capital Turnover Ratio 49
Debtor Turnover Ratio 49
Creditors Turnover Ratio 51
Stock Turnover Ratio 52
Capital Structure and Leverage Ratio 55
Proprietary Ratio 55
Capital Gearing Ratio 55
Debt Equity Ratio 56
Fund Flow Statement 56
Meaning of Fund 56
Meaning of Flow of Funds 57
No Flow of Funds 57
Current and Non-Current Assets 57

Current and Non-current Liabilities 58
Fund Flow Statement 59
Methods of Preparing Fund Flow Statement 59
Cash Flow Statement 65
Objectives of Cash Flow Statement 65
Benefits of Cash Flow Statement 66
Cash and Cash Equivalents 66
Cash Flows 67
Difference between Fund Flow and Cash Flow Statement 67
LIST OF FIGURES
Figure 1 Methods of Financial Analysis 6
Figure 2 Classification of Balance Sheet 10
Figure 3 Examples of Fixed Assets 10
Figure 4 Examples of Current Assets 11
Figure 5 Calculation of Common Size Statement 21
Figure 6 Classification of Ratios by Purpose 28
Figure 7 Contents of Current Assets and Current Liabilities 31
Figure 8 Flow of Funds 57
Figure 9 Current and Non-Current Assets 58
Figure 10 Current and Non-Current Liabilities 58
Figure 11 Steps in und Flow Statement 59
LIST OF TABLES
Table 1 Statement form of Profit and Loss Account 8
Table 2 Format of Schedule of Changes in Working Capital 60
Table 3 Calculation of Fund from Operations 61
Table 4 Fund Flow Statement Format 62
Table 5 Difference between fund flow and Cash Flow 67
UNIT – 3 – ANALYSIS OF FINANCIAL STATEMENT

MEANING OF MANAGEMENT ACCOUNTING
Management accounting is the presentation of accounting information in such a way
as to assist management in the creation of policy and in the day-to-day operation of
undertaking.
According to The American Accounting Association, “Management

accounting includes the methods and concepts necessary for effective
planning, for choosing among alternative business actions and for control
through the evaluation and interpretation of performances.”
Management accounting can be viewed as Management-oriented Accounting.
Basically it is the study of managerial aspect of financial accounting, "accounting in
relation to management function". It shows how the accounting function can be re-
oriented so as to fit it within the framework of management activity. The primary task of
management accounting is, therefore, to redesign the entire accounting system so that
it may serve the operational needs of the firm. If furnishes definite accounting
information, past, present or future, which may be used as a basis for management
action. The financial data are so devised and systematically development that they
become a unique tool for management decision.
ANALYSIS OF FINANCIAL STATEMENTS

Financial statement analysis involves gaining an understanding of an organization's
financial situation by reviewing its financial statements. This review involves identifying
the following items for a company's financial statements over a series of reporting
periods:
 Trends. Create trend lines for key items in the financial statements over multiple
time periods, to see how the company is performing. Typical trend lines are for
revenues, the gross margin, net profits, cash, accounts receivable, and debt.
 Proportion analysis. Arrays of ratios are available for discerning the relationship
between the sizes of various accounts in the financial statements. For example,
one can calculate a company's quick ratio to estimate its ability to pay its
immediate liabilities, or its debt to equity ratio to see if it has taken on too much
debt. These analyses are frequently between the revenues and expenses listed
on the income statement and the assets, liabilities, and equity accounts listed on
the balance sheet.
Financial statement analysis is an exceptionally powerful tool for a variety of users of
financial statements, each having different objectives in learning about the financial
circumstances of the entity.
MEANING
The term ‘financial analysis’ includes both ‘analysis’ and ‘interpretation’. The term
analysis means simplification of financial data by methodical classification given in the
financial statements. Interpretation means explaining the meaning and significance of
the data. These two are complimentary to each other. Analysis is useless without
interpretation, and interpretation without analysis is difficult or even impossible.
METHODS
These financial data do not indicate whether the company is performing well or poorly.
Specifically, neither the balance sheet alone nor the income statement alone provides
sufficient information to answer the following questions about Great Deal’s
performance and risk:
 How does the company’s recent profitability compare to its prior profitability, and
to its competitors’ profitability?
 What is the source of the company’s profitability? Does it derive from selling
products and services at substantially higher prices than it costs to obtain those
products and services? Or does it derive from selling large volumes of products
and services? Or from a combination of the two?
 What risks does the company face? For example, is The Company able to pay its
debts as they come due?
Prepare
Understand the Identify Identify Analyse
projected,
Financial Economic Company profitability Value the firm.
financial
Statements Characteristics Strategy and risk
statements.
F IGURE 1 METHODS OF FINANCIAL ANALYSIS

Answering these questions requires analysis of The Company’s financial statements and
related information provided in the notes to the financial statements. The following
Figure presents the typical steps in financial statement analysis and valuation.
FINANCIAL STATEMENT
A financial statement is a collection of data organized according to logical and
consistent accounting procedures. A firm communicates financial information to the
users through financial statements and reports. The financial statement contains
summarized information of the firm’s financial affairs, organized systematically. They are
means to present the firm’s financial situation to users. The preparation of the financial
statements is the responsibility of top management. Thus, two financial statement
prepared generally refers to:
(i) The position statement or the balance sheet; and
(ii) The income statement or the profit and loss account.
According to John N. Myer, “the financial statements are composed of data

which are the result of combinations of (i) recorded facts concerning the
business transactions, (ii) conventions adopted to facilitate the accounting
technique, (iii) postulates, or assumptions made to and (iv) personal
judgments used in the application of the conventions and postulates.”
As these statements are used by investors and financial analyst to examine the firm’s
performance in order to make investment decisions, they should be prepared very
carefully and contain as much information as possible.
NATURE OF FINANCIAL STATEMENT

The financial statements are prepared from the accounting records maintained by the
firm. The generally accepted accounting principles and procedures are followed to
prepare these statements. It seems quite desirable to discuss the nature of each of the
financial statements.
INCOME STATEMENT / PROFIT AND LOSS ACCOUNT

The earning capacity and potential of the firm are reflected by the Income statement
i.e., Profit and Loss Account. The Profit and Loss Account is the “Score-board” of the
firm’s performance during a particular period of time.
The Profit and Loss Account presents the summary of revenues, expenses and net
income or net loss of a firm for a period of time. It serves as a measure of the firm’s
profitability.
COMPONENTS
Profit and Loss Account in the statement form can be prepared as shown in the Table
1. The various components in the Profit and Loss Account can be classified under the
following heads:
1. REVENUE
TABLE 1 STATEMENT FORM OF P ROFIT AND L OSS A CCOUNT
Operating Income Statement for the period ending….
` `
Gross Sales XXX
Less: Sales Returns / Return Inwards XXX
Net Sales for the year (A) XXX
Less: Cost of Sales : (B)
Raw Materials consumed XXX
Direct Wages XXX
Manufacturing Expenses XXX
Finished Goods etc. XXX XXX
XXX
Less: Closing Stock (C ) XXX
Gross Profit (D) = A – (B + C) XXX
Less: Operating Expenses (E )
Administration Expenses XXX
Selling and Distribution Expenses XXX XXX
Net Operating Profit (F) = D – E XXX
Add: Non-Trading Income:
Interest Received XXX
Dividend Received XXX XXX
XXX
Less: Non-Trading Expenses:
Discount Allowed XXX
Interest Paid XXX XXX
Earnings Before Interest and Tax (G) XXX
Less: Interest on Debentures etc. XXX
Earnings Before Tax (H) XXX
Less: Tax XXX
Net Profit after Interest Tax ( I ) XXX
Revenue is the money an entity receives from the sale of goods or services. Other terms
frequently used for revenue are sales, net sales, or sale revenue. It is also referred to as
the “top line” because revenues are reported at the top of the income statement.
2. COST OF GOODS SOLD
Cost of goods sold are the direct costs of producing the goods being offered by the
entity. This would include the materials, labor, and other resources required for
production.
3. GROSS PROFIT
Gross profit is the difference between the revenue received for the product less the cost
of goods sold.
4. OPERATING EXPENSES
Operating expenses are the amount an entity expends to maintain and operate the
general business. Operating expenses include research and development, marketing,
general and administrative, amortization of intangible assets (i.e. patents, good will,
etc.), etc.
In addition, when an entity purchases a capital asset, such as a building or equipment,
they expense a portion of the asset over a number of years; this is called depreciation.
Depreciation expense is an accounting expense that is deducted from net income.
5. OPERATING INCOME
Operating income is equal to revenues minus cost of goods sold and operating
expenses. In other words, it measures the profits or losses of the day to day operations
of the business. Another name for Operating Income is Earnings before Interest and
Taxes (EBIT).
BALANCE SHEETS
The Balance Sheet comprises of a list of assets, liabilities and capital at a given date. It
is static in character because it tells about the financial position of a business as on a
certain date. At the same time, business is dynamic while Balance Sheet in static. It
records only periodic changes rather than continuous ones. More specifically, Balance
Sheet contains information about resources and obligations of a business entity and
about owners’ interests in the business at a particular point of time. Thus, the Balance
Sheet of a firm prepared on 31st December reveals the firm’s financial position on this
specific date.
COMPONENTS
A brief discussion regarding the meaning, nature and contents of various groups of
Balance Sheet is given below:
BALANCE SHEET
LIABILITIES ASSETS
SHARE CAPITAL FIXED ASSETS
RESERVES AND SURPLUS INVESTMENTS
SECURED LOANS CURRENT ASSETS
UNSECURED LOANS MISCELLANEOUS EXPENDITURE
CURRENT LIABILITIES AND PROVISIONS
F IGURE 2 CLASSIFICATION OF BALANCE SHEET
1. FIXED ASSETS
A fixed asset is an item with a useful life greater than one reporting period, and which
exceeds an entity's minimum capitalization limit. A fixed asset is not purchased with the
intent of immediate resale, but rather for productive use within the entity. An inventory
item cannot be considered a fixed asset, since it is purchased with the intent of either
reselling it directly or incorporating it into a product that is then sold. The following are
examples of general categories of fixed assets:
Machinery
Intangible
Land
assets
Furniture
and
fixtures
Buildings Vehicles
F IGURE 3 EXAMPLES OF FIXED A SSETS

2. CURRENT ASSETS
A current asset, also called a current account, is either cash or a resource that are
expected to be converted into cash within one year.
These resources are often referred to as liquid assets because they are so easily
converted into cash in a short period of time. Take inventory for example. Inventory can
easily be sold for cash in the next 12 months. Contrast that with a piece of equipment
that is much more difficult to sell. Also, inventory is expected to be sold in the normal
course of business for retailers. Equipment, on the other hand, is not.
This concept is extremely important to management in the daily operations of a
business. As monthly bills and loans become due, management must convert enough
current resources into cash to pay its obligations.
Management isn’t the only one interested in this category of assets, however. Investors
and creditors use several different liquidity ratios to analyze the liquidity of the company
before they invest in or lend to it. Investors want to know that their invest will continue to
grow and the company will be able to pay returns in the future. Creditors, on the other
hand, simply want to know that their principle will be repaid with interest.
There are many different assets that can be included in this category, but take a look a
few examples of current assets.
F IGURE 4 EXAMPLES OF CURRENT ASSETS
a. CASH
Cash is all coin and currency a company owns. This includes all of the money in a
company’s bank account, cash registers, petty cash drawer, and any other depository.
This can include domestic or foreign currencies, but investments are not included.
b. CASH EQUIVALENTS
Cash equivalents are investments that are so closely related to cash and so easily
converted into cash, they might as well be currency. An example of an equivalent is a
US Treasury Bill. T-bills can be exchanged for cash at any point with no risk of losing their
value.
c. ACCOUNTS RECEIVABLE
Accounts receivable is essentially a short-term loan to customers and vendors who
purchase goods on account. Typically, customers can purchase goods and pay for
them in 30 to 90 days. Accounts receivable keeps track of these loans.
d. INVENTORY
Inventory is the merchandise that a company purchases or makes to sell to customers
for a profit. This could be anything from pencils to cars to houses. It depends on the
business. For example, a car dealership is in the business of reselling cars. Thus, their cars
are considered inventory, even though they have plenty of pencils in their offices.
e. PREPAID EXPENSES
Prepaid expenses are exactly what they sound like—expenses that have been paid
before they were consumed. Insurance is a good example. A six-month insurance policy
is usually paid for up front even though the insurance isn’t used for another six months.
Even though these assets will not actually be converted into cash, they will be
consumed in the current period.
f. SHORT-TERM INVESTMENTS
Investments that are short-term in nature and expected to be sold in the current period
are also included in this category. These typically include investments in stock called
available for sale securities.
g. NOTES RECEIVABLE
Notes that mature within a year or the current period are often grouped in the current
assets section of the balance sheet.
h. DUE FROM OFFICER NOTES

Often times the officers or owners loan money to the company on a short-term basis.
These 90-180 day loans are typically considered current.
3. INVESTMENTS
Investments are assets which represent a company’s right to receive cash from its stake
in another company, government, etc. Investments are made through purchase of
bonds or shares or other financial instruments of the investee. The intent behind making
such investments is to generate investment income (interest and dividend) and to
benefit from expected capital gain.
4. MISCELLANEOUS EXPENDITURE
Miscellaneous expense could also be a line on the income statement that reports the
amounts from many general ledger accounts whose balances are not significant. For
example, the balances in Cash Short and Over, Bank Service Charges, and Donations
might be combined into one amount and presented on the income statement as
Miscellaneous Expense.
5. SHARE CAPITAL
Share capital (shareholder’s capital, equity capital, contributed capital or paid-in
capital) is the amount invested by a company’s shareholders for use in the business.
When a company is created, if its only asset is cash invested by the shareholder’s, the
balance sheet is balanced on the right side through share capital, an equity account.
Share capital is a major line item but is sometimes broken out by some firms into the
different forms of equity issued. This can represent common stock and preferred stock,
the latter including the par value of the stock.
Share capital is separate from other equity generated by the business. As the name
“paid-in capital” dictates, this equity account refers only to the amount paid-in by
investors and shareholders, as opposed to the amounts generated by the business itself
which flows into the retained earnings account.
6. RESERVES AND SURPLUS

Reserves & surplus fund is created out of profits that are to be shared between the
partners or shareholders. Therefore fund created out of profit is a liability to the
company. Reserves & Surplus fund is created to meet future contingencies. If the
contingency does not arise as expected this fund can be distributed among partners or
distributed as dividends among shareholders. It can be used for issuing bonus shares.
The decision how to make use of the funds will be done by the partners or in the case
of a company in the AGM.
7. SECURED AND UNSECURED LOANS

Loans can either be secured or unsecured. A loan is secured when a borrower is asked
to pledge assets to the lender as security or collateral for the loan. If the value of the
collateral falls below a certain proportion of the loan amount, the lender may ask you
to top up the collateral (by pledging more assets). If you cannot repay your loan, the
lender can sell off these assets to recover the money owed. If the money from the sale
is not enough to recover what you owe, you have to make up the amount (shortfall) still
outstanding. For unsecured loans, the borrower does not provide any assets to the
lender as security for the loan. Interest rates for such loans tend to be higher.
8. CURRENT LIABILITIES
Current (or short-term) liabilities are liabilities that a company is required to settle within
the next twelve months or which it expects to settle within its normal operating cycle.
Accounts payable, salaries payable, accrued expenses and current tax payable are
classified as current liabilities because they are expected to be paid off within a normal
operating cycle. These liabilities are reported as current even if the company expects
them to be paid after 12 months. Short-term debt payable, short-term notes payable
and current lease liability represent that portion of the relevant long-term liability which
is due within next 12 months. Interest payable is normally a current liability because it is
due with 12 months. Dividends payable is a current liability because corporate laws
normally require them to be paid within a certain period after declaration date.
TOOLS OF ANALYSIS OF FINANCIAL STATEMENTS

The most commonly used techniques of financial analysis are as follows:
COMPARATIVE STATEMENTS
These are the statements showing the profitability and financial position of a firm for
different periods of time in a comparative form to give an idea about the position of
two or more periods. It usually applies to the two important financial statements, namely,
balance sheet and statement of profit and loss prepared in a comparative form. The
financial data will be comparative only when same accounting principles are used in
preparing these statements. If this is not the case, the deviation in the use of accounting
principles should be mentioned as a footnote. Comparative figures indicate the trend
and direction of financial position and operating results. This analysis is also known as
“horizontal analysis”.
COMMON SIZE STATEMENTS

These are the statements which indicate the relationship of different items of a financial
statement with a common item by expressing each item as a percentage of that
common item. The percentage thus calculated can be easily compared with the results
of corresponding percentages of the previous year or of some other firms, as the
numbers are brought to common base. Such statements also allow an analyst to
compare the operating and financing characteristics of two companies of different
sizes in the same industry. Thus, common size statements are useful, both, in intra-firm
comparisons over different years and also in making inter-firm comparisons for the same
year or for several years. This analysis is also known as “Vertical analysis”.
TREND ANALYSIS
It is a technique of studying the operational results and financial position over a series
of years. Using the previous years’ data of a business enterprise, trend analysis can be
done to observe the percentage changes over time in the selected data. The trend
percentage is the percentage relationship, in which each item of different years bear
to the same item in the base year. Trend analysis is important because, with its long run
view, it may point to basic changes in the nature of the business. By looking at a trend
in a particular ratio, one may find whether the ratio is falling, rising or remaining relatively
constant. From this observation, a problem is detected or the sign of good or poor
management is detected.
RATIO ANALYSIS
It describes the significant relationship which exists between various items of a balance
sheet and a statement of profit and loss of a firm. As a technique of financial analysis,
accounting ratios measure the comparative significance of the individual items of the
income and position statements. It is possible to assess the profitability, solvency and
efficiency of an enterprise through the technique of ratio analysis.
FUND FLOW ANALYSIS

Fund flow is the net of all fund inflows and outflows in and out of various financial assets.
Fund flow is usually measured on a monthly or quarterly basis; the performance of an
asset or fund is not taken into account, only share redemptions, or outflows, and share
purchases, or inflows.
CASH FLOW ANALYSIS

It refers to the analysis of actual movement of cash into and out of an organization. The
flow of cash into the business is called as cash inflow or positive cash flow and the flow
of cash out of the firm is called as cash outflow or a negative cash flow. The difference
between the inflow and outflow of cash is the net cash flow. Cash flow statement is
prepared to project the manner in which the cash has been received and has been
utilized during an accounting year as it shows the sources of cash receipts and also the
purposes for which payments are made. Thus, it summarizes the causes for the changes
in cash position of a business enterprise between dates of two balance sheets.
COMPARATIVE FINANCIAL STATEMENT

In brief, comparative study of financial statements is the comparison of the financial
statements of the business with the previous year’s financial statements. It enables
identification of weak points and applying corrective measures. Practically, two
financial statements (balance sheet and income statement) are prepared in
comparative form for analysis purposes.
A comparative statement is a document that compares a particular financial

statement with prior period statements or with the same financial report
generated by another company. Analyst and business managers use the
income statement, balance sheet and cash flow statement for comparative
purposes.
COMPARATIVE BALANCE SHEET

The comparative balance sheet shows the different assets and liabilities of the firm on
different dates to make comparison of balances from one date to another. The
comparative balance sheet has two columns for the data of original balance sheets. A
third column is used to show change (increase/decrease) in figures. The fourth column
may be added for giving percentages of increase or decrease. While interpreting
comparative Balance sheet the interpreter is expected to study the following aspects:
CURRENT FINANCIAL POSITION AND LIQUIDITY POSITION

For studying current financial position or liquidity position of a concern one should
examine the working capital in both the years. Working capital is the excess of current
assets over current liabilities.
LONG-TERM FINANCIAL POSITION

For studying the long-term financial position of the concern, one should examine the
changes in fixed assets, long-term liabilities and capital.
PROFITABILITY OF THE CONCERN

The study of increase or decrease in profit will help the interpreter to observe whether
the profitability has improved or not.
After studying various assets and liabilities, an opinion should be formed about the
financial position of the concern.
ILLUSTRATION 1
The following is the Balance Sheets of MS Gupta for the years 2006 and 2007. Prepare
the comparative Balance Sheet and study the financial position of the concern.
Balance Sheet as on 31st December
2006 2007 2006 2007
Liabilities Assets
Rs. Rs. Rs. Rs.
Equity share capital 5,00,000 700,000 Land and Building 2,70,000 1,70,000
Plant and
Reserves and surplus 3,30,000 2,22,000 4,00,000 6,00,000
Machinery
Debentures 2,00,000 3,00,000 Furniture 20,000 25,000
Long term loan on
1,00,000 1,50,000 Other fixed assets 25,000 30,000
mortgage
Bill Payables 50,000 45,000 Cash in hand 20,000 40,000
Sundry creditors 1,00,000 1,20,000 Bill Receivables 1,00,000 80,000
Other current liabilities 5,000 10,000 Sundry debtors 2,00,000 2,50,000
Stock 2,50,000 3,50,000
Prepaid Expenses --- 2,000
12,85,000 15,47,000 12,85,000 15,47,000
Solution:
Comparative Balance Sheet of MS Gupta for the year ending December 2006 & 2007
Year ending 31st Dec Increase / Decrease
2006 2007 Amount Percentage
Rs. Rs. Rs. %
Assets
I. Current Assets
Cash in hand 20,000 40,000 20,000 100.00%
Bill Receivables 1,00,000 80,000 -20,000 -20.00%
Sundry debtors 2,00,000 2,50,000 50,000 25.00%
Stock 2,50,000 3,50,000 1,00,000 40.00%
Prepaid Expenses ___ 2,000 2,000 100.00%
Total Current Assets (A) 5,70,000 7,22,000 1,52,000 26.67%
II. Fixed Assets
Land and Building 2,70,000 1,70,000 -100,000 -37.04%
Plant and Machinery 4,00,000 6,00,000 2,00,000 50.00%
Furniture 20,000 25,000 5,000 25.00%
Other fixed assets 25,000 30,000 5,000 20.00%
Total Fixed Assets (B) 7,15,000 8,25,000 1,10,000 15.38%
Total Assets (A + B) 12,85,000 15,47,000 2,62,000 20.39%
Liabilities & Capital
I. Current Liabilities
Bill Payables 50,000 45,000 -5,000 -10.00%
Sundry creditors 1,00,000 1,20,000 20,000 20.00%
Other current liabilities 5,000 10,000 5,000 100.00%
Total Current Liabilities ( C) 1,55,000 1,75,000 20,000 12.90%
II. Long-term Liabilities
Debentures 2,00,000 3,00,000 1,00,000 50.00%
Long term loan on mortgage 1,00,000 1,50,000 50,000 50.00%
Total Long-term Liabilities (D) 3,00,000 4,50,000 1,50,000 50.00%
Total Liabilities (E = C + D) 4,55,000 6,25,000 1,70,000 37.36%
III. Owned Equities
Equity share capital 5,00,000 7,00,000 2,00,000 40.00%
Reserves and surplus 3,30,000 2,22,000 -1,08,000 -32.73%
Total Owned Equities (F) 8,30,000 9,22,000 92,000 11.08%
Total Capital & Liabilities (E + F) 12,85,000 15,47,000 2,62,000 20.39%
Interpretation
(i) The comparative balance sheet of the company reveals that during 2007 there has
been an increase in fixed assets of 110,000 i.e. 13.49%. Long term liabilities to outsiders
have relatively increased by Rs 150,000 and equity share capital has increased by Rs
200000. This fact indicates that the policy of the company is to purchase fixed assets
from the long-term sources of finance.
(ii) The current assets have increased by Rs 152000 i.e. 26.67% and cash has increased
by Rs 20,000. The current liabilities have increased only by Rs 20000 i.e. 12.9%. This
further confirms that the company has used long-term finances even for the current
assets resulting into an improvement in the liquidity position of the company.
(iii) Reserves and surplus have decreased from Rs 330,000 to Rs 222,000 i.e. 32.73% which
shows that the company has utilized reserves and surplus for the payment of
dividends to shareholders either in cash or by way of bonus.
(iv)The overall financial position of the company is satisfactory.
COMPARATIVE INCOME STATEMENT

The income statement provides the results of the operations of a business. This statement
traditionally is known as trading and profit and loss A/c. Important components of
income statement are net sales, cost of goods sold, selling expenses, office expenses
etc. The figures of the above components are matched with their corresponding figures
of previous years individually and changes are noted. The comparative income
statement gives an idea of the progress of a business over a period of time. The changes
in money value and percentage can be determined to analyze the profitability of the
business. Like comparative balance sheet, income statement also has four columns. The
first two columns are shown figures of various items for two years. Third and fourth
columns are used to show increase or decrease in figures in absolute amount and
percentages respectively.
The analysis and interpretation of income statement will involve the following:
 The increase or decrease in sales should be compared with the increase or
decrease in cost of goods sold.
 To study the operating profits.
 The increase or decrease in net profit is calculated that will give an idea about
the overall profitability of the concern.
ILLUSTRATION 2
The income statements of a concern are given for the year ending 31st December 2006
and 2007. Rearrange the figures in a comparative form and study the profitability of the
concern.
2006 2007
Details
Rs. Rs.
Net Sales 7,85,000 9,00,000
Cost of Goods Sold 4,50,000 5,00,000
Operating Expenses:
General and Administrative Expenses 70,000 72,000
Selling Expenses 80,000 90,000
Non-Operating Expenses:
Interest Paid 25,000 30,000
Income Tax 70,000 80,000
Solution:
Comparative Income Statement for the year ended 31st Dec 2006 and 2007
Year ending 31st
Increase / Decrease
Dec
2006 2007 Amount Percentage
Rs. Rs. Rs. %
Net Sales 7,85,000 9,00,000 1,15,000 14.65%
Less: Cost of Goods Sold 4,50,000 5,00,000 50,000 11.11%
Gross Profit (A) 3,35,000 4,00,000 65,000 19.40%
Less: Operating Expenses
General and Administrative Expenses 70,000 72,000 2,000 2.86%
Selling Expenses 80,000 90,000 10,000 12.50%
Total Operating Expenses (B) 1,50,000 1,62,000 12,000 8.00%
Operating Profit (C = A + B) 1,85,000 2,38,000 53,000 28.65%
Less: Other Deductions (D)
Interest Paid 25,000 30,000 5,000 20.00%
Net Profit before Tax (E = C - D) 1,60,000 2,08,000 48,000 30.00%
Less: Income Tax (F)
Income Tax 70,000 80,000 10,000 14.29%
Net Profit after Tax (G) 90,000 1,28,000 38,000 42.22%
Interpretation
(i) The comparative income statement given above shows that there is an increase
in net sales of 14.65%. The cost of goods sold has increased by 11%. This has
resulted in increase of gross profit by 19.4%.
(ii) Operating expenses have increased by 8%. The increase in gross profit is sufficient
to cover the operating expenses. There is also an increase in net profit after tax of
Rs 38000 i.e. 42.22%.
(iii) It is concluded from the above analysis that there is sufficient progress in the
performance of the company and the overall profitability of the company is
good.
COMMON SIZE STATEMENT

The common size statements (Balance Sheet and Income Statement) are shown in
analytical percentages. The figures of these statements are shown as percentages of
total assets, total liabilities and total sales respectively. Take the example of Balance
Sheet. The total assets are taken as 100 and different assets are expressed as a
percentage of the total. Similarly, various liabilities are taken as a part of total liabilities.
COMMON SIZE BALANCE SHEET

A statement where balance sheet items are expressed in the ratio of each asset to total
assets and the ratio of each liability is expressed in the ratio of total liabilities is called
common size balance sheet. Thus the common size statement may be prepared in the
following way.
The individual assets

are expressed as a
percentage of total
The total assets
assets i.e. 100 and
or liabilities are
different liabilities
taken as 100
are calculated in
relation to total
liabilities.
F IGURE 5 CALCULATION OF C OMMON SIZE S TATEMENT

For example, if total assets are Rs10 lakhs and value of inventory is Rs 100,000, then
inventory will be 10% of total assets
10000
X 100
100000
ILLUSTRATION 3
The balance sheet of Mr. Anoop Private (Pvt.) Limited (Ltd) and Bansal Private Limited
are given below:
Balance Sheet as on 31 December, 2007
st
Anoop Pvt Bansal Pvt Anoop Pvt Bansal Pvt

Liabilities Ltd Ltd Assets Ltd Ltd
Rs. Rs. Rs. Rs.
Preference share
1,20,000 1,50,000 Land and Building 80,000 1,23,000
capital
Equity share Plant and
1,40,000 4,10,000 3,34,000 6,00,000
capital Machinery
Reserves and Temporary
24,000 28,000 5,000 40,000
surpluses Investments
Long-term loans 1,10,000 1,20,000 Investment 6,000 20,000
Bill Payables 7,000 1,000 Sundry Debtors 4,000 13,000
Sundry creditors 12,000 3,000 Prepaid expenses 1,000 2,000
Outstanding Cash and Bank
15,000 6,000 8,000 10,000
Expenses balance
Proposed
10,000 90,000
Dividend
4,38,000 8,08,000 4,38,000 8,08,000
Compare the financial position of two companies with the help of common size
balance sheet.
Solution:
Common size Balance Sheet as on 31st December 2007
Anoop Pvt Ltd Bansal Pvt Ltd
Amount Amount
% %
Rs. Rs.
Assets:
Fixed Assets:
Land and Building 80,000 18.26% 123,000 15.22%
Plant and Machinery 3,34,000 76.26% 6,00,000 74.26%
Total Fixed Assets (A) 4,14,000 94.52% 7,23,000 89.48%
Current Asset:
Temporary Investments 5,000 1.14% 40,000 4.95%
Investment 6,000 1.37% 20,000 2.48%
Sundry Debtors 4,000 0.91% 13,000 1.61%
Prepaid expenses 1,000 0.23% 2,000 0.25%
Cash and Bank balance 8,000 1.83% 10,000 1.24%
Total Current Assets (B) 24,000 5.48% 85,000 10.52%
Total Assets ( C = A + B) 4,38,000 100.00% 8,08,000 100.00%
Liabilities
Share Capital and Reserves
Preference share capital 1,20,000 27.40% 1,50,000 18.56%
Equity share capital 1,40,000 31.96% 4,10,000 50.74%
Reserves and surpluses 24,000 5.48% 28,000 3.47%
Total Capital and Reserves (D) 2,84,000 64.84% 5,88,000 72.77%
Long-term Liabilities
Long-term loans 1,10,000 25.11% 1,20,000 14.85%
Total Long-term Liabilities (E ) 1,10,000 25.11% 1,20,000 14.85%
Current Liabilities
Bill Payables 7,000 1.60% 1,000 0.12%
Sundry creditors 12,000 2.74% 3,000 0.37%
Outstanding Expenses 15,000 3.42% 6,000 0.74%
Proposed Dividend 10,000 2.28% 90,000 11.14%
Total Current Liabilities (F) 44,000 10.05% 1,00,000 12.38%
Total Liabilities (G = D + E + F) 4,38,000 100.00% 8,08,000 100.00%
Interpretation
(i) An analysis of pattern of financing of both the companies shows that Bansal Ltd is
more traditionally financed as compared to Anoop Ltd. The former company has
depended more on its own funds as is shown by balance sheet. Out of total
investment, 74.01% of the funds are proprietary funds and outsiders funds account
only for 25.9%. In Anoop Ltd proprietors’ fund are 64.83% while the share of out-siders
funds is 34.17% which shows that this company has depended more upon outsiders
funds.
(ii) Both the companies are suffering from shortage of working capital. The percentage
of current liabilities is more than the percentage of current assets in both the
companies.
(iii) A close look at the balance sheet shows that investments in fixed assets have been
from working capital in both the companies. In Anoop Ltd. fixed assets account for
94.52% of total assets while in Bansal Ltd fixed assets account for 89.48%.
(iv)Thus, both the companies face working capital problem and immediate steps should
be taken to issue more capital or raise long term loans to improve working capital
position.
COMMON SIZE INCOME STATEMENT

The items in income statement can be shown as percentages of sales to show the
relations of each item to sales.
ILLUSTRATION 4
Following are the income statements of a company for the year ending 31st December
2006 and 2007.
2006 2007
Rs. Rs.
Sales 5,00,000 7,00,000
Miscellaneous income 20,000 15,000
5,20,000 7,15,000
Expenses
Cost of sales 3,30,000 5,10,000
Office expenses 20,000 30,000
Interest 25000 30,000
Selling expenses 30,000 40,000
4,05,000 6,10,000
Net profit 1,15,000 1,05,000
5,20,000 7,15,000
Solution:
Common size Income Statement for the year ending 31st December 2006 and 2007.
2006 2007
Amount Amount
% %
Rs. Rs.
Sales 5,00,000 100.00% 7,00,000 100.00%
Less: Cost of Sales 3,30,000 66.00% 5,10,000 72.86%
Gross Profit 1,70,000 34.00% 1,90,000 27.14%
Operating Expenses:
Office expenses 20,000 4.00% 30,000 4.29%
Selling expenses 30,000 6.00% 40,000 5.71%
Total Operating Expenses 50,000 10.00% 70,000 10.00%
Operating Profit 1,20,000 24.00% 1,20,000 17.14%
Less: Miscellaneous Income 20,000 4.00% 15,000 2.14%
Total income 1,40,000 28.00% 1,35,000 19.29%
Less: Non-Operating Expenses
25,000 5.00% 30,000 4.29%
(Interest)
Net Profit 1,15,000 23.00% 1,05,000 15.00%
Interpretation
(i) The sale and gross profit have increased in absolute figures in 2007 as compared to
2006. But the percentage of gross profit to sales has gone down in 2007.
(ii) The increase in cost of sales as a percentage of sales has brought the profitability
from 34% to 27.14%.
(iii) Operating expenses have remained the same in both the years.
(iv)Net profit has decreased both in absolute figures and as a percentage in 2007 as
compared to 2006.
TREND ANALYSIS
The trend analysis is a technique of studying several financial statements over a series of
years. In this analysis the trend percentages are calculated for each item by taking the
figure of that item for the base year taken as 100. Generally the first year is taken as a
base year. The analyst is able to see the trend of figures, whether moving upward or
downward. In brief, the procedure for calculating trends is as:
 One year is taken as a base year which is generally is the first year or last year.
 Trend percentages are calculated in relation to base year.
The Trend Analysis is of two types “Trend Percentage” and “Trend Ratios”. They are
calculated as follows:
Trend Percentage Trend Ratios
= Current Year Value – Base Year Value X 100 = Current Year Value X 100
Base Year Value Base Year Value
ILLUSTRATION 5
From the following data relating to the purchase of a firm, prepare Trend Percentages
and Trend Ratios.
Year 1994 1995 1996 1997 1998 1999
Purchases (’00,000)
1,672 1,789 1,873 1,923 2,123 1,463
Rs.
Solution:
Calculation of Trend Percentage and Trend Ratios
Purchases
Trend Trend
Year (’00,000)
Percentage Ratios
Rs.
1994 1,672 - 100.00%
1995 1,789 7.00% 107.00%
1996 1,873 12.02% 112.02%
1997 1,923 15.01% 115.01%
1998 2,123 26.97% 126.97%
1999 1,463 -12.50% 87.50%
Interpretation
It is inferred that the purchase value increase year by till the year 1998 and it has
decreased in the year 1999 this may be due to decrease in the production or decrease
in the raw material price. I might be also be due to increased purchase done in previous
year.
RATIO ANALYSIS
Ratio analysis is one of the techniques of financial analysis where ratios are used as a
yardstick for evaluating the financial condition and performance of a firm. Analysis and
interpretation of various accounting ratios gives a skilled and experienced analyst a
better understanding of the financial condition and performance of the firm than what
he could have obtained only through a perusal of financial statements.
Ratio analysis is a technique of analysis and interpretation of financial

statements. It is the process of establishing and interpreting various ratios for
helping in making certain decisions.
MEANING OF RATIOS
Ratios are relationships expressed in mathematical terms between figures which are
connected with each other in some manner. Obviously, no purpose will be served by
comparing two sets of figures which are not at all connected with each other.
Moreover, absolute figures are also unfit for comparison.
EXPRESSION OF RATIOS
Ratios can be expressed in three ways:
TIMES
When one value is divided by another, the unit used to express the quotient is termed
as “Times”. For example, if out of 100 students in a class, 80 are present, the attendance
ratio can be expressed as follows:
80
= = 0.8 Times
100
PERCENTAGE
If the quotient obtained is multiplied by 100, the unit of expression is termed as
“Percentage”. For instance, in the above example, the attendance ratio as a
percentage of the total number of students is as follows:
= 0.8 X 100 = 80 %
PROPORTIONATE / PURE
This is original form of ratios. Where, one value is mentioned in proportionate to another
value. If the same quotient is expressed as relationship to other value it is termed as
“Pure” ratio. For instance, in the above example, the attendance is mentioned in
proportion with total number of students is as follows:
= 80 : 100 = 0.8 : 1
FINANCIAL RATIOS
Financial ratio is the relationship between two accounting figures expressed
mathematically.
CLASSIFICATION OF RATIOS
Ratios can be classified into different categories depending upon the basis of
classification.
The traditional classification has been on the basis of financial statement to which the
determinants of a ratio belong. On this basis the ratios could be classified as:
1. Profit and Loss Account Ratios, i.e., ratios calculated on the basis of the item of the
Profit and Loss account only, e.g., gross profit ratio, stock turnover ratio, etc.
2. Balance Sheet Ratios, i.e., ratios calculated on the basis of the figures of Balance
Sheets only, e.g., current ratio, debt-equity ratio, etc.
3. Composite Ratios or inter-statement ratios, i.e., ratio based on figures of profit and
loss account as well as balance sheet, e.g., fixed assets turnover ratio, overall
profitability ratios, etc.
However, the above basis of classification has been found to be crude and unsuitable
because analysis of Balance Sheet and Income Statement cannot be done in isolation.
They have to be studied together in order to determine the profitability and solvency of
the business. In order that ratios serve as a tool for financial analysis, they are now
classified as shown in figure 6:
Classification of Ratios by Purpose
Capital Structure
Liquidity Profitability Activity
and Leverage
Profit Margin Rate of Return Fixed Assets Proprietory

Current Ratio
Ratio Ratio Turnover Ratio Ratio
Return on Working
Gross Profit Capital
Liquid Ratio Capital Capital
Ratio Gearing Ratio
Employed Turnover Ratio
Cash Position Operating Return on Total Debtors Debt-Equity

Ratio Ratio Assets Turnover Ratio Ratio
Return on
Operating Creditors
Shareholders
Profit Ratio Turnover Ratio
Fund
Stock Turnover
Net Profit Ratio
Ratio
F IGURE 6 CLASSIFICATION OF RATIOS BY P URPOSE

LIQUIDITY RATIOS
Liquidity Ratios indicate about the financial position of the company. A company is
deemed to be financially sound if it is in a position to carry on its business smoothly and
meet its obligations, both short-term and as well as long-term without strain. It is a sound
principle of finance that the short-term requirements of funds should be met out of short-
term funds and long-term requirements should be met out with long-term funds. For
example, if the payment of raw materials purchases is made through issue of
debentures it will create a permanent interest burden on the enterprise. Similarly, if fixed
assets are purchased out of funds provided by the bank overdraft, the firm will come to
grief because such assets cannot be sold away when payment will be demanded by
the bank.
Liquidity includes three ratios:
 Current Ratio
 Liquid / Quick Ratio
 Cash Position Ratio
PROFITABILITY RATIO
Profitability is an indication of the efficiency with which the operations of the business
are carried on. Poor operational performance may indicate poor sales and hence poor
profits. A lower profitability may arise due to the lack of control over the expenses. The
Profitability Ratios are further classified as Profit Margin Ratios and Rate of Return Ratios.
PROFIT MARGIN RATIOS

These ratios shows the relationship between the profit and sales. It also gives an
indication about the expenses spent at various levels and how it is under the control of
the company’s performance. The Profit Margin Ratios include:
 Gross Profit Ratio
 Operating Ratio
 Operating Profit Ratio
 Net Profit Ratio
RATE OF RETURN RATIOS

This ratio shows the relationship between the profit and the investment. It gives a clear
state of long-term investment in earning returns. The Rate of Return Ratios includes:
 Return on Capital Employed
 Return on Total Assets
 Return on Shareholders Fund
Generally, the profitability ratios with higher value are favorable as it indicates that the
company is doing well.
ACTIVITY RATIOS
These ratios are calculated on the basis of 'cost of sales' or ‘sales’; therefore, these ratios
are also called as 'Turnover Ratios'. Turnover indicates the speed or number of times the
capital employed has been rotated in the process of doing business. In other words,
these ratios indicate how efficiently the capital is being used to obtain sales; how
efficiently the fixed assets are being used to obtain sales; and how efficiently the working
capital and stock is being used to obtain sales. Higher turnover ratios indicate the better
use of capital or resources and in turn lead to higher profitability. Turnover ratios include
the following ratios:
 Fixed Assets Turnover Ratio
 Working Capital Turnover Ratio
 Debtors Turnover Ratio
 Creditors Turnover Ratio
 Stock Turnover Ratio
CAPITAL STRUCTURE OR LEVERAGE RATIOS

The Capital structure or Leverage ratios are also known as Stability Ratios. This ratio helps
in ascertaining the long-term solvency of a firm which depends basically on three
factors:
1. Whether the firm has adequate resources to meet its long-term funds
requirements;
2. Whether the firm has used an appropriate debt-equity mix to raise long-term funds;
3. Whether the firm earns enough to pay interest and instalment of long-term loans
in time.
To identify the above requirements, the following ratios can be calculated.
 Proprietary Ratio
 Capital Gearing Ratio
 Debt-Equity Ratio
LIQUIDITY RATIOS
"Liquidity" refers to the ability of the firm to meet its current liabilities. These ratios,
therefore, are also called 'Short-term Solvency Ratios.' These ratios are used to assess
the short-term financial position of the concern. They indicate the firm's ability to meet
its current obligations out of current resources.
Short-term creditors of the firm are primarily interested in the liquidity ratios of the firm as
they want to know how promptly or readily the term can meet its current liabilities. If the
term wants to take a short-term loan from the bank, the bankers also study the liquidity
ratios of the firm in order to assess the margin between current assets and current
liabilities.
CURRENT RATIO
This ratio is an indicator of firm’s commitment to meet its short-term liabilities. It is
expressed as follows:
Current Assets
=
Current Liabilities
Current Assets mean assets that will either be used up or converted into cash within a
year’s of time or during the normal operating cycle of the business, whichever is longer.
Current Liabilities mean liabilities payable within a year or during the operating cycle,
whichever is longer.
Current Liabilities Current Assets

• Creditors • Cash in hand
• Bills Payable • Cash at Bank
• Bank Overdraft • Stock or Inventory
• Shirt-term Loans • Debtors
• Unclaimed dividend • Bills Receivable
• Provision for Taxation • Prepaid Expenses
• Proposed Dividend • Investments readily
convertible into cash or Short-
term Investments
• Marketable Securities
F IGURE 7 CONTENTS OF CURRENT ASSETS AND CURRENT LIABILITIES

It is generally believe that 2:1 ratio shows a comfortable working capital position.
However this rule should not be taken as a hard and fast rule, because ratio that is
satisfactory for one company may not be satisfactory for other. It means that current
assets of a business should, at least be twice of its current liabilities. The reason of
assuming 2 : 1 as the ideal ratio is that the current assets includes such assets as stock,
debtors etc., from which full amount cannot be realized in case of need. Hence, even
if half the amount is realized from the current assets on time, the firm can still meet its
current liabilities in full.
ILLUSTRATION 6
From the following information compute the ‘Current Ratio’:
`
Sundry Debtors 40,000
Sundry Creditors 20,000
Prepaid Expenses 20,000
Debentures 1,00,000
Short-term Investments 10,000
Inventories 20,000
Loose tools 5,000
Outstanding Expenses 20,000
Bills Payable 10,000
Bank Overdraft 10,000
Solution:
Calculation of Current Assets:
`
Inventories 20,000
Total Current Assets 90,000
Calculation of Current Liabilities:

`
Total Current Liabilities 60,000
Current Ratio
= Current Assets
Current Liabilities
` 90,000
=> = 1.5 : 1
` 60,000
Inference:
An ideal current ratio is 2:1 and the safety zone is 1:1. The current ratio of the firm is 1.5:1.
This indicates the firm liquidity position is exactly between the ideal current ratio and
safety zone. The firm should take effort to either increase its current assets or reduce its
current liabilities to maintain a sound liquidity position.
LIQUID RATIO
Liquid or Quick or Acid Test indicates whether the firm is in a position to pay its current
liabilities within a month or immediately. This ratio is ascertained by comparing liquid
assets to liquid liability. It is expressed as follows:
Liquid Assets
=
Liquid Liabilities
Liquid Assets are obtained by deducting stock-in-trade and prepaid expenses from
current assets. Stock is not treated as a liquid asset because it cannot be readily
converted into cash as and when required.
Liquid liabilities are obtained by deducting bank overdraft from current liabilities. Bank
overdraft is not included in liquid liabilities because bank overdraft is not likely to be
called on demand and is treated as a sort of permanent mode of financing. Hence, it
is not treated as a quick liability.
An ideal acid test ratio is said to be 1:1. The idea is that for every rupee or current
liabilities, there should at least be one rupee of liquid assets. This ratio is better test for
short-term financial position of the company than the current ratio.
The current ratio of a business does not reflect the true liquid position, if its current assets
consist largely of stock-in-trade. If the liquid assets are equal to or more than liquid
liabilities, the condition may be considered as satisfactory.
ILLUSTRATION 7
From the following information compute the ‘Current Ratio’ and ‘Liquid Ratio’:
`
Cash in hand 10,000
Inventories 30,000
Cash at Bank 25,000
Solution:
Calculation of Current Assets:
Calculation of Current Assets: aaaaaa Calculation of Current Liabilities:
` `
Sundry Debtors 45,000 Sundry Creditors 25,000
Prepaid Expenses 20,000 Outstanding Expenses 20,000
Cash in hand 10,000 Bills Payable 10,000
Short-term Investments 10,000 Bank Overdraft 15,000
Inventories 30,000
Cash at Bank 25,000
Total Current Assets 1,40,000 Total Current Liabilities 70,000
Current Ratio
= Current Assets
Current Liabilities
1,40,000
=> = 2 : 1
70,000
Liquid Assets = Current Assets – (Stock + Prepaid Expenses)

= 1,40,000 – (30,000 + 20,000)
= 1,40,000 – 50,000
= ` 90,000
Liquid Liabilities = Current Liabilities – Bank Overdraft
= 70,000 – 15,000
= ` 55,000
Liquid Ratio
= Liquid Assets
Liquid Liabilities
90,000
=> = 1.64 : 1
55,000
Inference:
The current ratio 2:1 of the firm is good and it is exactly equal to the ideal ratio. Whereas,
the liquid ratio 1.64:1 is very much higher than the ideal ratio 1:1. This indicates that, the
company is not properly utilizing its working capital for the business.
CASH POSITION RATIO

This ratio is also known as near cash ratio and cash ratio. These ratio shows how quickly
the firm can pay off its liabilities relative to cash, bank balances, marketable securities
since these are considered as the most liquid component of the current assets. Simply,
this ratio measures the ability of a firm to meet its current obligations with the cash or
cash equivalents.
It is the most stringent liquidity ratio and is considered as an important decision factor
for the creditors regarding how much amount is to be lent to the asking firm. The high
value of cash position ratio shows sufficient cash balance with the firm and is capable
of paying the current debts. The formula for calculating the Cash Position Ratio is:
Cash + Marketable Securities
=
Current Liabilities
The recommended value of Cash Position Ratio is 0.20:1 to 0.50:1.
ILLUSTRATION 8
Calculate Cash Position Ratio with the following information:
`
Cash in hand 10,000
Marketable Securities 10,000
Inventories 30,000
Cash at Bank 25,000
Solution
Calculation of Current Liabilities:
``
Total Current Liabilities 95,000
Cash Position Ratio
Cash + Marketable Securities

=
Current Liabilities
=> 10,000 + 25,000 + 10,000

95,000
= 45,000 = 0.47 : 1
95,000
The cash position ratio 0.47:1 of the company is good as it lies between the ideal cash
position ratio 0.20:1 to 0.50:1.
ILLUSTRATION 9
From the following details, find out
a. Current Assets
b. Current Liabilities
c. Liquid Assets
d. Stock
Given
Current Ratio 2.5
Liquid Ratio 1.5
Working Capital ` 60,000
Solution
1. Current Assets:
Given:
Working Capital = ` 60,000
Current Assets – Current Liabilities = ` 60,000
And Current Ratio = 2.5
Current Assets 2.5
=
Current Liabilities 1
Hence, if
Current Assets = 2.5
Current Liability = 1
Working Capital = 2.5 – 1 = 1.5
If 1.5 proportion of Working Capital
= ` 60,000
Then
2.5 proportion of Current Assets
= `60,000 X 2.5 = ` 1,00,000

1.5
2. Current Liability
If 1.5 proportion of Working Capital = ` 60,000
Then
1 proportion of Current Liability
= `60,000 X 1 = ` 40,000
1.5
3. Liquid Assets
Given:
Liquid Ratio = 1.5
Liquid Assets
= 1.5
Current Liabilities
Liquid Assets
= = 1.5
`40,000
Hence, Liquid Assets = 1.5 X ` 40,000 = ` 60,000

4. Stock
W.k.t. Liquid Assets = Current Assets – Stock
` 60,000 = ` 1,00,000 – Stock
 ` 1,00,000 - ` 60,000 = Stock
 Stock = ` 40,000
Summary of Answer
Current Asset = ` 1,00,000
Current Liability = ` 40,000
Liquid Assets = ` 60,000
Stock = `40,000
PROFITABILITY RATIOS
The Profitability Ratios measures the overall performance of the company in terms of the
total revenue generated from its operations. In other words, the ratios that measure the
capacity of a firm to generate profits out of expenses and the other cost incurred over
a period are called the period are called the profitability ratios.
Ultimately, these ratios are nothing but a simple comparison of various levels of profits
with either SALES or INVESTMENT. Profit Margin Ratios and the Rate of Return Ratios are
the two types of Profitability Ratios.
PROFIT MARGIN RATIOS

The profit margin ratio is a sales based ratio. These ratios are further classified as:
GROSS PROFIT RATIO

The Gross Profit Ratio is used to understand how much cost incurred to manufacture a
product. It also helps in understanding the efficiency of the company and how it is using
its resources to produce the product and then make a profit by passing the cost incurred
to the consumers of the product.
Gross profit is the margin of profit left after deducting manufacturing or trading expenses
from the net sales. It is a very important ratio because it evaluates both the efficiency
and pricing policy of a business. It is computed as follows:
Gross Profit
= X 100
Net Sales
Where, Gross Profit
= Total Revenue – Operating Expenses
Significance: It indicates gross profit on products sold. It also indicates the profit
available to cover operating expenses, non-operating expenses, etc. Change in gross
profit ratio may be due to change in selling price or cost of revenue from operations or
a combination of both. A low ratio may indicate unfavourable purchase and sales
policy. Higher gross profit ratio is always a good sign. A ratio of 25% to 30% may be
considered as good.
ILLUSTRATION 10
From the following detail of a business concern ascertain the gross profit ratio:
Details 2005 2006
Sales ` 1,20,000 ` 1,60,000
Gross Profit ` 40,000 ` 60,000
Solution:
Gross Profit
= X 100
Net Sales
Hence
2005 2006
40,000 A a a aaaa 60,000
= X 100 = 33.33% = X 100 =37.5%
1,20,000 1,60,000
Inference
The company Gross Profit Ratio is high and it is increasing. It also indicates that the
company is having good control over its expenses.
ILLUSTRATION 11
Following information is available for the year 2014-15, calculate gross profit ratio:
`
Revenue from Operations:
Cash 25,000
Credit 75,000
Purchases:
Cash 15,000
Credit 60,000
Carriage Inwards 2,000
Salaries 25,000
Decrease in Inventory 10,000
Return Outwards 2,000
Wages 5,000
Solution:
Revenue Statement for the year 2014-15
` `
Sales:
Cash Sales 25,000
Credit Sales 75,000 1,00,000
Less:
1. Purchases
Cash 15,000
Credit 60,000
75,000
Less: Return Outwards 2,000 73,000
2. Carriage Inwards 2,000
3. Decrease in Inventory 10,000
4. Wages 5,000 90,000
Gross Profit 10,000
Note: Salaries is not included in calculation because it is an administrative expense.
Gross Profit
Gross Profit Ratio = X 100
Net Sales
` 10,000
= X 100
` 1,00,000
= 10%
Inference
The company Gross Profit Ratio 10% is poor, as it is below the expected level of 25% to
30%. From the given information we can also infer that the administrative expenses
Salary is above the Gross Profit, so the company will not have net profit instead it will
face net loss. The company should concentrate either on increasing the selling price or
reducing cost of goods sold.
OPERATING RATIO
The operating ratio compares production and administrative expenses to net sales. The
ratio reveals the cost per sales dollar of operating a business. A lower operating ratio is
a good indicator of operational efficiency, especially when the ratio is low in
comparison to the same ratio for competitors and benchmark firms.
The operating ratio is only useful for seeing if the core business is able to generate a
profit. Since several potentially significant expenses are not included, it is not a good
indicator of the overall performance of a business, and so can be misleading when used
without any other performance metrics. For example, a company may be highly
leveraged and must therefore make massive interest payments that are not considered
part of the operating ratio.
To calculate the operating ratio, add together all production costs (i.e., the cost of
goods sold) and administrative expenses (which includes general, administrative, and
selling expenses) and divide by net sales (which is gross sales, less sales discounts, returns,
and allowances). The measure excludes financing costs, non-operating expenses, and
taxes. The calculation is:
Cost of Goods Sold + Operating Expenses
Operating Ratio = X 100
Net Sales
Where,
Cost of Goods Sold = Opening Stock + Purchases – Closing Stock
Operating Expenses = Administrative Expenses + Financial Expenses + Selling Expenses
Significance: This ratio is a test of the efficiency of the management in their business
operation. It is a means of operating efficiency. In normal conditions, the operating ratio
should be low enough so as to leave portion of the sales sufficient to give a fair return
to the investors.
Operating ratio plus operating profit ratio is 100. The two ratios are obviously interrelated.
For example, if the operating profit ratio is 20%, it means that the operating ratio is 80%.
A rise in the operating ratio indicates a decline in the efficiency.
Lower the operating ratio, the better is the position because greater is the profitability
and management efficiency of the concern. The higher the ratio, the less favorable is
the situation, because there will be smaller margin of profit available for the purpose of
payment of dividend and creation of reserves.
OPERATING PROFIT RATIO

Operating net profit ratio is calculated by dividing the operating net profit by sales. This
ratio helps in determining the ability of the management in running the business.
In other words, the operating profit ratio demonstrates how much revenues are left over
after all the variable or operating costs have been paid. Conversely, this ratio shows
what proportion of revenues is available to cover non-operating costs like interest
expense.
This ratio is important to both creditors and investors because it helps show how strong
and profitable a company’s operations are. For instance, a company that receives 30
percent of its revenue from its operations means that it is running its operations smoothly
and this income supports the company. It also means this company depends on the
income from operations. If operations start to decline, the company will have to find a
new way to generate income.
Operating Profit
Operating Profit Ratio = X 100
Net Sales
Where,
Operating profit = Gross profit - Operating Expenses (or)
Net sales - Operating cost (or)
Net sales - (Cost of goods sold + Administrative and office expenses
+ Selling and distribution expenses) (or)
(Net profit + Non-operating expenses) - (Non-operating incomes)
The operating profit margin ratio is a key indicator for investors and creditors to see how
businesses are supporting their operations. If companies can make enough money from
their operations to support the business, the company is usually considered more stable.
On the other hand, if a company requires both operating and non-operating income
to cover the operation expenses, it shows that the business’ operating activities are not
sustainable.
A higher operating margin is more favorable compared with a lower ratio because this
shows that the company is making enough money from its ongoing operations to pay
for its variable costs as well as its fixed costs.
ILLUSTRATION 12
From the following information given below, you are required to calculate Operating
Profit Ratio:
` `
Gross Sales 6,50,000 Purchases 4,10,000
Sales Return 50,000 Office and Administrative Expenses 50,000
Opening Stock 25,000 Selling and Distribution Expenses 40,000
Closing Stock 30,000
43 Unit – III – Analysis of Financial Statement Page 43 of 70
Solution:
Revenue Statement
` `
Gross Sales 6,50,000
Credit Sales 50,000
Net Sales 6,00,000
Less: Cost of Goods Sold
Opening Stock 25,000
Add: Purchases 4,10,000
4,32,000
Less: Closing Stock 30,000 4,05,000
Gross Profit 1,95,000
Less: Operating Expenses
Office and Administrative Expenses 50,000
Selling and Distribution Expenses 40,000 90,000
Operating Profit 1,05,000
Operating Profit Ratio = Operating Profit X 100 = ` 1,05,000 X 100 =17.5 %

Net Sales ` 6,00,000
INFERENCE
The company operating profit 17.5% is good as it is near the expected level.
NET PROFIT RATIO

Net Profit Ratio is based on all-inclusive concept of profit. It relates revenue from
operations to net profit after operational as well as nonoperational expenses and
incomes. It is calculated as under:
Net Profit
Net Profit Ratio = X 100
Net Sales
Net profit includes non-operating incomes and profits. Non-Operating Incomes such as
dividend received, interest on investment, profit on sales of fixed assets, commission
received, discount received etc. Profit or Sales Margin indicates margin available after
deduction cost of production, other operating expenses, and income tax from the sales
Ms. Jebakerupa Roslin Amirtharajan, AP | ST. JOSEPH’S COLLEGE OF ENGINEERING

revenue. Higher Net Profit Ratio indicates the standard performance of the business
concern.
ADVANTAGES
1. This is the best measure of profitability and liquidity.
2. It helps to measure overall operational efficiency of the business concern.
3. It facilitates to make or buy decisions.
4. It helps to determine the managerial efficiency to use a firm's resources to
generate income on its invested capital.
5. Net profit Ratio is very much useful as a tool of investments evaluation.
ILLUSTRATION 13
From the following, calculate Profitability ratios.
Dr. Trading & Profit and Loss of Ambika & Co. for the year ending 31.3.2004 Cr.
Particulars ` Particulars `
To Opening stock 1,99,000 By Sales 17,00,000
To Purchases 11,19,000 By Closing Stock 2,98,000
To Gross Profit 6,80,000
19,98,000 19,98,000
To Administrative Expenses 3,00,000 By Gross Profit 6,80,000
To Selling Expenses 60,000 By Interest 18,000
To Financial Expenses 30,000
To Loss on sale of Plant 8,000
To Net Profit 3,00,000
6,98,000 6,98,000
Solution
` 6,80,000
1. Gross Profit Ratio = Gross Profit X 100 = X 100 =40 %
Net Sales ` 17,00,000
2. Operating Ratio
Cost of Goods Sold = Opening Stock + Purchases – Closing Stock
= ` 1,99,000 + ` 11,19,000 – ` 2,98,000 => ` 10,20,000
Operating Expenses = Administrative Expenses + Selling Expenses
+ Financial Expenses
= ` 3,00,000 + ` 60,000 + ` 30,000 => ` 3,90,000

Cost of Goods Sold + Operating Expenses

= X 100
Net Sales
= ` 10,20,000 + ` 3,90,000 X 100 = ` 14,10,000
X 100
` 17,00,000 ` 17,00,000
= 82.94 %
3. Operating Profit Ratio
Operating Profit = Gross Profit – Operating Expenses = `6,80,000 – ` 3,90,000
= ` 2,90,000
Operating Profit X 100 ` 2,90,000 X 100

= = =17.06 %
Net Sales ` 17,00,000
` 3,00,000
4. Net Profit Ratio = Net Profit X 100 = X 100 =17.65 %
Net Sales ` 17,00,000
INFERENCE
Gross Profit Ratio 40% Operating Profit Ratio 17.06%
Operating Ratio 82.94% Net Profit Ratio 17.65%
It is inferred that, though the company’s Gross Profit Ratio is good, the high operating
expenses ratio leads to poor operating profit ratio.
RATE OF RETURN RATIO

The profitability of the firm is also measured in relation to investments. The term
investment may refer to total assets, capital employed or the owners’ equity. The
efficiency of an enterprise is judged by the amount of profits. But sometimes the
conclusion drawn on the basis of profit-to-sales ratio may be misleading. Because it is
possible that profit in terms of sales is sufficient but sales regard to capital may be
inadequate. Therefore, the state of efficiency cannot be judged by the volume of profits
alone: along with profit the size of investment should also be considered.
RETURN ON TOTAL ASSETS

Profitability can be measured in terms of relationship between net profit and assets. The
ratio is also known as Profit-to-assets ratio. It measures the profitability of investments. The
overall profitability can be known.
Net Profit
Return on Total Assets = X 100
Total Assets

There are various approaches possible to define net profit and assets, according to the
purpose and intent of the calculation of ratios.
ADVANTAGES
1. This ratio highlights the success of the business from the owner's point of view.
2. It helps to measure an income on the shareholders' or proprietor's investments.
3. This ratio helps to the management for important decisions making.
4. It facilitates in determining efficiently handling of owner's investment.
RETURN ON CAPITAL EMPLOYED

Return on Capital Employed Ratio measures a relationship between profit and capital
employed. This ratio is also called as Return on Investment Ratio. The term return means
Profits or Net Profits. The term Capital Employed refers to total investments made in the
business. It is computed as
Operating Profit
Return on Capital Employed = X 100
Capital Employed
Where, Capital Employed = Total Assets - Current Liabilities
Significance: It measures return on capital employed in the business. It reveals the
efficiency of the business in utilization of funds entrusted to it by shareholders,
debenture-holders and long-term loans. For inter-firm comparison, return on capital
employed funds is considered good measure of profitability. It also helps in assessing
whether the firm is earning a higher return on capital employed as compared to the
interest rate paid. The use of net profit ratio in conjunction with the assets turnover ratio
helps in ascertaining how profitably the assets have been used during the period.
RETURN ON SHAREHOLDERS FUND

This ratio is very important from shareholders’ point of view in assessing whether their
investment in the firm generates a reasonable return or not. It should be higher than the
return on investment otherwise it would imply that company’s funds have not been
employed profitably.
A better measure of profitability from shareholders point of view is obtained by
determining return on total shareholders’ funds, it is also termed as Return on Net worth
(RONW) and is calculated as under:
Return on Shareholders Fund = Net Profit X 100

Shareholders Fund

Where, Shareholders Fund = Equity Share Capital + Preference Share Capital

+ Reserves and Surplus – Accumulated Losses
The term Net Profit as used here, means net income after payment of interest and tax
including non-operating income.
ILLUSTRATION 14
From the above Balance Sheet and additional information, you are required to
calculate:
a. Return on Total Assets
b. Return on Capital Employed
c. Return on Shareholder’ Fund
Liabilities ` Assets `
Share Capital (` 10) 10,00,000 Fixed Assets 13,00,000
Reserves 3,00,000 Current Assets 3,60,000
8% Debentures 2,00,000
Creditors 1,60,000
16,60,000 16,60,000
Net operating profit before tax is ` 3,20,000. Assume tax rate at 50%. Dividend declared
amounts to `1,80,000.
Solution
` 1,60,000
a. Return on Total Assets = Profit after Tax X 100 = X 100 =9.64 %
Total Assets ` 16,60,000
b. Return on Capital Employed
Profit before Tax and Interest = Net Operating Profit before tax
+8% dividend on debentures
= ` 3,20,000 + (8% on ` 2,00,000)
= ` 3,20,000 + ` 16,000 = ` 3,36,000
Capital Employed =Total Assets – Current Liabilities =` 16,60,000 – ` 1,60,000 = ` 15,00,000
Profit before Tax and Interest X 100 ` 3,36,000

= = X 100 = 22.4 %
Capital Employed ` 15,00,000
c. Return on Shareholders’ Fund
Shareholders’ Fund = Share Capital + Reserves
= ` 10,00,000 + ` 3,00,000 = ` 13,00,000

Profit after Tax ` 1,60,000

= X 100 = X 100 = 12.31 %
Shareholders’ Fund ` 13,00,000
TURNOVER RATIO
The Turnover Ratios measure the efficiency of investments made by the firm in the form
of revenues and the cost of sale generated during a period of time. These ratios show
the relationship between the revenues or cost of sales generated due to the investment
activities undertaken.
Some of the turnover ratios are also categorized as liquidity ratios, operating ratios,
activity ratios, efficiency ratios, and asset utilization ratios.
If the turnover ratio is high it is good for the company. For instance, a large amount of
credit sales in relationship to a small amount of accounts receivable indicates that the
company was efficient and effective in collecting its accounts receivable.
Turnover ratios are more accurate when they use the asset's average balances for the
year (as opposed to one balance at the final instant of the accounting year). The
reason is that an income statement amount reflects the total activity during the entire
year.
FIXED ASSETS TURNOVER RATIO

The Fixed Assets Turnover Ratio shows, how efficiently the fixed assets are used to
generate sales. Simply, this ratio shows the efficiency of a firm in generating profits
relative to the investments in the fixed assets.
The fixed assets turnover ratio is suitable for the heavy industries where huge capital is
employed in the investments such as manufacturing. Thus, the ratio should be
compared with the companies within the specific industries.
Also, the companies should keep in mind; that accelerated depreciation can inflate
the value of the ratio, due to the reduced value of the denominator. To overcome this
problem, the company should reinvest in other investments to compensate the older
assets. The formula to compute this ratio is:
Net Sales
Fixed Assets Turnover Ratio =
Net Fixed Assets
Where, Net Fixed Assets = Value of Assets – Depreciation
Higher the ratio, the better is the utilization of fixed assets. This means a firm is able to
generate sales with the limited amount of fixed assets without raising any additional
capital.

WORKING CAPITAL TURNOVER RATIO

The working capital turnover ratio measures how well a company is utilizing its working
capital to support a given level of sales. Working capital is current assets minus current
liabilities. A high turnover ratio indicates that management is being extremely efficient
in using a firm's short-term assets and liabilities to support sales. Conversely, a low ratio
indicates that a business is investing in too many accounts receivable and inventory
assets to support its sales, which could eventually lead to an excessive amount of bad
debts and obsolete inventory.
Cost of Sales
Working Capital Turnover Ratio =
Net Working Capital
Where, Net Working Capital = Current Assets – Current Liabilities
An extremely high working capital turnover ratio can indicate that a company does not
have enough capital to support its sales growth; collapse of the company may be
imminent. This is a particularly strong indicator when the accounts payable component
of working capital is very high, since it indicates that management cannot pay its bills
as they come due for payment.
An excessively high turnover ratio can be spotted by comparing the ratio for a particular
business to those reported elsewhere in its industry, to see if the business is reporting
outlier results.
DEBTOR TURNOVER RATIO

The Debtors Turnover Ratio also called as Receivables Turnover Ratio shows how quickly
the credit sales are converted into the cash. This ratio measures the efficiency of a firm
in managing and collecting the credit issued to the customers.
One important thing that needs to be taken care of is, generally the companies use
total sales in the place of net sales, which gives an inflated turnover ratio. Thus, while
calculating this ratio, only the net credit sale is to be taken into consideration.
Ideally, a company compares its debtor’s turnover ratio with the companies that have
similar business operations and revenue and lay within the same industry the formula to
compute Debtors Turnover Ratio is:
Net Credit Sales
Debtor Turnover Ratio =
Average Debtors
Opening Debtor + Closing Debtor
Where, Average Debtor =
2

ILLUSTRATION 15
A firm has total sales of ` 5,00,00 out of which the credit sales are ` 2,50,000. The opening
balance of account receivables is ` 2,00,000 and the closing balance at the end of
financial year is ` 1,00,000. Calculate Debtor Turnover Ratio.
Solution
Average Debtor
Opening Debtor + Closing Debtor ` 2,00,000 + ` 1,00,000
= = = ` 1,50,000
2 2
Credit Sales ` 2,50,000

Debtor Turnover = Average Debtor = ` 1,50,000 = 1.67 times
AVERAGE COLLECTION PERIOD

The Average Collection Period, also called as Debt Collection Period, shows how much
time business takes to realize the credit sales. Simply, how long will it take to recover
payments from the debtors against the credit sales? This period encompasses the
duration when the credit was given to the customer or client and the date when the
cash was realized against it. The formula to compute this ratio is:
Days in a Year
Average Collection Period =
Debtors Turnover Ratio
Note: Generally, 365 Days are considered
The efficiency of the collection period can be assessed by comparing the average
against the credit period allowed to the customers.
ILLUSTRATION 16
A firm has a credit sales of ` 5,00,000 and the average account receivables is ` 1,00,000,
Calculate Average Collection Period.
Solution
Credit Sales ` 5,00,000
Debtor Turnover = Average Debtor = ` 1,00,000 = 5 times
Days in a year 365

Average Collection Period = Debtor Turnover Ratio = 5 = 73 days

CREDITORS TURNOVER RATIO

It is a ratio of net credit purchases to average trade creditors. Creditors’ turnover ratio is
also known as payables turnover ratio.
It is on the pattern of debtors’ turnover ratio. It indicates the speed with which the
payments are made to the trade creditors. It establishes relationship between net credit
annual purchases and average accounts payables. Accounts payables include trade
creditors and bills payables. Average means opening plus closing balance divided by
two. In this case also accounts payables' figure should be considered at gross value i.e.
before deducting provision for discount on creditors (if any).
Net Credit Purchase
Creditors Turnover Ratio =
Average Accounts Payable
Where, Average Debtor = Trade Creditors + Bills Payable
The above ratio is usually complemented with AVERAGE PAYMENT PERIOD which may
be calculated as follows:
Days in a Year
Average Payment Period =
Creditors Turnover Ratio
Shorter average payment period or higher payable turnover ratio may indicate less
period of credit enjoyed by the business it may be due to the fact that either business
has better liquidity position; believe in availing cash discount and consequently enjoys
better credit standing in the market or business credit rating among suppliers is not good
and therefore they do not allow reasonable period of credit. The above two alternative
conclusions are contradictory of each other therefore the ratio should be interpreted
with caution.
ILLUSTRATION 12
From the following figures calculate average age of creditors and creditor turnover
ratio:
`
Creditor (closing) 54200
Bills payable (closing) 5800
Total purchases 338000
Cash purchases 28500
Purchases returns 9500
Days of year 365

Solution:
Net Credit Purchase = Total Purchase – Cash Purchase – Purchases Return
= ` 3,38,000 – ` 28,500 – ` 9,500 = ` 3,00,000
Average accounts Payable = Creditors + Bills Payable
= ` 54,200 + ` 5,800 = ` 60,000
Net Credit Purchase ` 3,00,000
Creditor Turnover = Average Accounts Payable = ` 60,000 = 5 times
Days in a year 365

Average Payment Period = Creditor Turnover Ratio = 5 = 73 days
STOCK TURNOVER RATIO

Inventory turnover ratio or Stock turnover ratio indicates the velocity with which stock of
finished goods is sold i.e. replaced. Generally it is expressed as number of times the
average stock has been “turned over” or rotates of during the year.
A slow inventory movement has the following disadvantages:
 Blocking of scarce funds which could be gainfully employed elsewhere;
 Requiring more strong space resulting in higher maintenance and handling costs;
 Chances of product being outdated or out of fashion especially in case of
consumer goods;
 During storage for excessive period quality may deteriorate due to inherent
factors like rusting loss of potency etc.
Similarly insufficient level of inventory is also dangerous because it may be responsible
for the loss of business opportunity. Thus for each item of stock minimum average and
maximum levels should be fixed carefully. Following formula is used to calculate this
ratio:
Cost of Goods Sold
Stock Turnover Ratio =
Average Inventory Cost
However in the absence of required information any one of the following formula may
be substituted as:
Net Sales Net Sales Net Sales
= Or Or
Average Inventory Cost Average Inventory at Selling Price Inventory
High turnover suggests efficient inventory control, sound sales policies, trading in quality
goods, reputation in the market, better competitive capacity and so on.
Low turnover suggests the possibility of stock comprising of obsolete items, slow moving
products, poor selling policy, over investment in stock etc.

ILLUSTRATION 13
From the following information, find out:
a. Sales c. Sundry Debtors
b. Closing stock d. Sundry Creditors
Gross Profit Ratio 25 %
Debtors Collection Period 4 Months
Stock Turnover Ratio 4 Times
Creditors Collection Period 6 Months
Closing Stock is ` 10,000 more than the opening stock. Bills Receivable amount to `
65,000 and Bills Payable to ` 80,000. Cost of goods sold for the year is ` 9,00,000
Solution
a. Sales
Given: Gross Profit Ratio is 25% and Cost of Goods Sold ` 9,00,000
w.k.t. Sales = Cost of Goods Sold + Gross Profit
But, both the information are available in different units.
We also know that, Gross Profit is 25% it means it is 25% of Sales.
Hence, 100% Sales = 75% of Cost of Goods sold + 25% of Gross Profit
If 75% of Cost of Goods Sold is ` 9,00,000 then, 100% of sales
` 9,00,000
= X 100% = ` 12,00,000
75%
b. Closing Stock
Given: Stock Turnover Ratio is 4 times
Cost of Goods Sold ` 9,00,000

= = 4 times = = 4 times
Average Stock Average Stock
` 9,00,000
 Average Stock = = ` 2,25,000
4 times
We also known that Average Stock
Opening Stock + Closing Stock
=
2
Opening Stock + (Opening Stock + ` 10,000)
=
2
2 Opening Stock + ` 10,000
=
2
 2 X Average Stock = 2 Opening Stock + ` 10,000

 2 X ` 2,25,000 = 2 Opening Stock + ` 10,000

 ` 4,50,000 = 2 Opening Stock + ` 10,000
 ` 4,50,000 – ` 10,000 = 2 Opening Stock
 ` 4,40,000 = 2 Opening Stock
 Opening Stock = (` 4,40,000 / 2) => ` 2,20,000
 Closing Stock = Opening Stock + ` 10,000 => ` 2,20,000 + ` 10,000 => ` 2,30,000
c. Sundry Debtors
Given: Debtors Collection Period = 4 Months
Months in a year 12
= = 4 Months => = 4 Months
Debtors Turnover Ratio Debtors Turnover Ratio
12
 Debtors Turnover Ratio =  3 times
4 Months
With that we can calculate
Total Sales ` 12,00,000
= = 3 times => = 3 times
Closing Debtors Closing Debtors
` 12,00,000
 Closing Debtors =  ` 4,00,000
3 times
 Sundry Debtors + Bills Receivable = ` 4,00,000
 Sundry Debtors + ` 65,000 = ` 4,00,000
 Sundry Debtors = ` 4,00,000 - ` 65,000
 Sundry Debtors = ` 3,35,000
d. Sundry Creditor
w.k.t. Cost of Goods sold = Opening Stock + Purchases – Closing Stock
 ` 9,00,000 = ` 2,20,000 + Purchases – ` 2,30,000
 Purchase = ` 9,00,000 – ` 2,20,000 + ` 2,30,000
 Purchase = ` 9,10,000
Given: Creditor Collection Period = 6 Months
Months in a year 12
= = 6 Months => = 6 Months
Creditor Turnover Ratio Creditor Turnover Ratio
12
 Creditors Turnover Ratio =  2 times
6 Months
With that we can calculate
Total Purchase ` 6,90,000
= = 2 times => = 2 times
Closing Creditor Closing Creditors

 Closing Creditors = ` 9,10,000  ` 4,55,000

2 times
 Sundry Creditor + Bills Payable = ` 4,55,000
 Sundry Creditor + ` 80,000 = ` 4,55,000
 Sundry Creditor = ` 4,55,000 - ` 80,000
 Sundry Creditor = ` 3,75,000
CAPITAL STRUCTURE AND LEVERAGE RATIO

The term 'Solvency' generally refers to the capacity of the business to meet its short-term
and long-term obligations. Short-term obligations include creditors, bank loans and bills
payable etc. Long-term obligations consists of debenture, long-term loans and long-
term creditors etc. Solvency Ratio or capital structure indicates the sound financial
position of a concern to carry on its business smoothly and meet its all obligations.
Liquidity Ratios and Turnover Ratios concentrate on evaluating the short-term solvency
of the concern have already been explained. Now under this part of the chapter only
the long-term solvency ratios are dealt with. Some of the important ratios which are
given below in order to determine the solvency of the concern:
PROPRIETARY RATIO
Proprietary Ratio is also known as Capital Ratio or Net Worth to Total Asset Ratio. This is
one of the variant of Debt-Equity Ratio. The term proprietary fund is called Net Worth.
This ratio shows the relationship between shareholders' fund and total assets. It may be
calculated as:
Shareholders’ Fund
Proprietary Ratio =
Total Assets
Significance: This ratio used to determine the financial stability of the concern in general.
Proprietary Ratio indicates the share of owners in the total assets of the company. It
serves as an indicator to the creditors who can find out the proportion of shareholders'
funds in the total assets employed in the business. A higher proprietary ratio indicates
relatively little secure position in the event of solvency of a concern. A lower ratio
indicates greater risk to the creditors. A ratio below 0.5 is alarming for the creditors.
CAPITAL GEARING RATIO

This ratio also called as Capitalization or Leverage Ratio. This is one of the Solvency
Ratios. The term capital gearing refers to describe the relationship between fixed interest

and/or fixed dividend bearing securities and the equity shareholders' fund. It can be
calculated as shown below:
Equity Share Capital
Capital Gearing Ratio =
Fixed Interest Bearing Funds
Where, Equity Share Capital = Equity Share Capital + Reserves and Surplus
Fixed Interest Bearing Funds = Debentures + Preference Share Capital
+ Other Long-Term Loans
A high capital gearing ratio indicates a company is having large funds bearing fixed
interest and/or fixed dividend as compared to equity share capital. A low capital
gearing ratio represents preference share capital and other fixed interest bearing loans
are less than equity share capital.
DEBT EQUITY RATIO

This ratio also termed as External - Internal Equity Ratio. This ratio is calculated to
ascertain the firm's obligations to creditors in relation to funds invested by the owners.
The ideal Debt Equity Ratio is 1: 1. This ratio also indicates all external liabilities to owner
recorded claims. It may be calculated as:
Outsider's Funds
Debt Equity Ratio =
Shareholders' Funds
The term Total Long-Term Debt refers to outside debt including debenture and long-
term loans raised from banks.
FUND FLOW STATEMENT

In view of recognized importance of capital inflows and outflows, which often involve
large amounts of money should be reported to the stakeholders; the funds flow
statement is devised.
MEANING OF FUND
The term "Fund" refers to Cash, to Cash Equivalents or to Working Capital and all financial
resources which are used in business. These total resources of a concern are in the form
of men, materials, money, plant and equipment and others.
In a narrow sense the word "Fund" denotes cash or cash equivalents.
In a broader meaning the word "Fund" refers to Working Capital. The Working Capital
indicates the difference between current assets and current liabilities. The term working
capital may be:
 Gross Working Capital: Represents total of all Current Assets.

 Net Working Capital: Excess of Current Assets over Current Liabilities.

MEANING OF FLOW OF FUNDS
The term "FLOW OF FUNDS" refers to changes or movement of funds or changes in
working capital in the normal course of business transactions. The changes in working
capital may be in the form of inflow of working capital or outflow of working capital. If
the components of working capital results in increase of the fund, it is known as Inflow
of Fund or Sources of Fund. Similarly, if the components of working capital effects in
decreasing the financial position it is treated as Outflow of Fund. For example, if the fund
rose by way of issue of shares will be taken as a source of fund or inflow of fund. This
transaction results in increase of the financial position. Like this, the fund used for the
purchase of machinery will be taken as application or use of fund or outflow of fund.
The following chart shows the movement of funds:
INFLOW
Fund coming Inside the Business Example: Sale of Assets
BUISNESS TRANSACTIONS
OUTFLOW
Fund going out of Business Example: Purchase of Assets
F IGURE 8 FLOW OF FUNDS
NO FLOW OF FUNDS
Some transactions may not make any movement or changes in the fund position. Such
transactions are involved within the business concern. Like the transaction which
involves both between current assets and current liabilities and between non-current
assets and non-current liabilities and hence do not result in the flow of funds. For
example, conversion of shares in to debenture, such transaction involves between non-
current account only and this activity does not effect in increase or decrease of the
working capital position.
CURRENT AND NON-CURRENT ASSETS

Assets are resources a company owns. They consist of both current and noncurrent
resources. Current assets are ones the company expects to convert to cash or use in
the business within one year of the balance sheet date. Noncurrent assets are ones the
company reckons it will hold for at least one year.

•Cash in hand •Tangible

•Cash at Bank •Land
•Bills Receivable •Building
•Sundry Debtors •Plant and Machinery
•Short-term loans and advances •Furniture and Fittings
•Marketable Investments •Long-term Investment
•Inventories •Intangible
•Prepaid Expenses •Goodwill
•Accrued Incomes •Trade Mark
•Patent Right
Current Non-Current
assets Assets
F IGURE 9 CURRENT AND NON-CURRENT ASSETS

CURRENT AND NON-CURRENT LIABILITIES
Current and non-current liabilities both are the parts of total liabilities of business. Both
are shown in the liability side of balance sheet. Current liabilities are paid within one
financial year or beginning of second financial year. Non-current liabilities are taken for
long period. These liabilities are not settled within one financial year. Now we explain
the examples of Current and Non-current liabilities.
Current Liabilities
•Bills Payable
•Sundry Creditors
•Expenses Outstanding
•Dividends Payable
•Bank Overdraft
•Short-term Loans
•Provisions against Current Assets
•Provisions for Taxation
Non-Current Liabilities
•Equity Share Capital
•Preference Share Capital
•Debentures
•Long-term Loans
•Profit and Loss (Balance of Profit)
F IGURE 10 CURRENT AND N ON-C URRENT LIABILITIES

FUND FLOW STATEMENT

It’s a statement prepared to analyze reasons for changes in two balance sheet periods
in the financial position of the company. It presents the inflow and outflow of funds in
an understandable manner. In short, it a fund flow statements is prepared to explain
changes between the working capital of the company from one balance sheet date
to another.
According Foulke “A statement of source and application of funds is a

technical device designed to analyze the changes to the financial condition of
a business enterprise in between two dates”
If the long term requirements of the firm are fulfilled just by an issue of shares or other
securities, then funds generated operations will reflect the increase in working capital
during the period. However, if funds from operations are not sufficient to fund the
working capital requirements, there will be a decrease in working capital.
METHODS OF PREPARING FUND FLOW STATEMENT

Generally speaking, the fund flow analysis requires the preparation of two statements
a. Statement of changes in Working Capital
b. Fund from Operation and
c. Fund Flow Statement
For preparing the two statements, the following steps have to be done:
Preparation
of fund flow
Calculation statement
of Fund from
Preparation Operation
of Non-
Prepare the Current A/c
statement of items
changes in
working
capital
F IGURE 11 S TEPS IN UND F LOW S TATEMENT
SCHEDULE OF CHANGES IN WORKING CAPITAL:

Many business enterprises prefer to prepare another statement, known as schedule of
changes in working capital, while preparing a funds flow statement, on a working
capital basis. This schedule of changes in working capital provides information

concerning the changes in each individual current assets and current liabilities
accounts (items).
This schedule is a part of the funds flow statement and increase (decrease) in working
capital indicated by the schedule of changes in working capital will be equal to the
amount of changes in working capital as found by funds flow statement. The schedule
of changes in working capital can be prepared by comparing the current assets and
current liabilities at two periods.
The format of schedule of changes in working capital is as follows:
TABLE 2 F ORMAT OF S CHEDULE OF CHANGES IN WORKING CAPITAL
Previous Current Effect on Working Capital
Particulars Year Year Increase Decrease
` ` ` `
Current Assets:
1. Cash in hand XXX XXX
2. Cash at Bank XXX XXX
3. Bills Receivable XXX XXX
If current year value is higher
4. Sundry Debtors XXX XXX
than the previous year value
5. Short-term loans and advances XXX XXX enter the increased value in
6. Marketable Investments XXX XXX increase column else enter the
value in the decrease column.
7. Inventories XXX XXX
8. Prepaid Expenses XXX XXX
9. Accrued Incomes XXX XXX
Total Current Assets (A): XXXX XXXX
Current Liabilities:
1. Bills Payable XXX XXX
2. Sundry Creditors XXX XXX
3. Expenses Outstanding XXX XXX If current year value is higher
4. Dividends Payable XXX XXX than the previous year value
enter the increased value in
5. Bank Overdraft XXX XXX
decrease column else enter the
6. Short-term Loans XXX XXX value in the increase column.
7. Provisions against Current Assets XXX XXX
8. Provisions for Taxation XXX XXX
Total Current Liabilities (B): XXXX XXXX
Working Capital (A – B) XXXX XXXX
Net Increase / Decrease in Working Capital XXXX XXXX
XXXXX XXXXX XXXXX XXXX
FUND FROM OPERATIONS

Fund from Operation is to be determined on the basis of Profit and Loss Account. The
operating profit revealed by Profit and Loss Account represents the excess of sales
revenue over cost of goods sold. In the true sense, it does not reflect the exact flow of

funds caused by business operations. Because the revenue earned and expenses
incurred are not in conformity with the flow of funds. For example, depreciation charges
on fixed assets, write up of fixed assets or fictious assets, any appropriations etc. do not
cause actual flow of funds. Because they have already been charged to such profits.
Hence, fund from operation is prepared to find out exact inflow or outflow of funds from
the regular operations on the basis of items which have readjusted to the current profit
or loss. The balancing amount of adjusted profit and loss account is described as fund
from operations.
CALCULATION OF FUND FROM OPERATIONS
Fund from operations is calculated with the help of following adjustments. The
adjustments may be shown in the specimen proforma of profit and loss account as
given below:
TABLE 3 CALCULATION OF FUND FROM OPERATIONS
Amount Amount
Particulars
` `
Net profit before tax and extraordinary expenses
XXXX
(Current Year P&L – Previous Year P&L in the Balance Sheet)
Add: Non-Fund and Non-Operating items which have already
been debited to P&L a/c:
1. Depreciation and Depletion XXX
2. Amortization of Fictious and Intangible Assets etc.
a. Goodwill, Patent and Trademark written off XXX
b. Preliminary expenses written off XXX
3. Appropriation of Retained earnings:
a. Transfer to General Reserve XXX
b. Provision for Taxation XXX
c. Provision for Proposed Dividend XXX
d. Loss on Sale of Fixed Assets XXX XXXX
XXXX
Less: Non-Fund and Non-Operating items which have already
been credited to P & L a/c:
1. Profit on sale of Fixed Assets XXX
2. Appreciation or Revaluation of fixed assets XXX XXXX
Fund from Operation XXXX
FUND FLOW STATEMENT:

After preparing the schedule of changes in working capital, the next step is to prepare
the Fund Flow Statement to find out the different sources and applications of funds.

While preparing this statement the emphasis is given on the changes in the fixed assets
and fixed liabilities. The statement may be prepared either in ‘T form’ or in ‘Vertical form’.
TABLE 4 F UND F LOW S TATEMENT FORMAT
Sources of Funds ` Application of Funds `
Fund from Operations XXX Fund Lost in Operation XXX
Issue of Share Capital XXX Redemption of Preference Shares XXX
Issue of Debentures XXX Redemption of Debentures XXX
Raising of Long-term Loans XXX Repayment of Lon-term Loans XXX
Sale of Fixed Assets XXX Purchase of Fixed Assets XXX
Sale of Investments XXX Purchase of Investments XXX
Payment of Dividend XXX
Payment of Tax XXX
Net Decrease in Working Capital XXX Net Increase in Working Capital XXX
XXXX XXXX
ILLUSTRATION 14
Prepare Fund flow Statement
2009 2010 2009 2010
Capital & Liabilities Assets
` ` ` `
Share Capital 200000 250000 Cash in hand 30000 47000
5% Debentures 130000 125000 Cash at Bank 50000 45000
Creditors 70000 45000 Debtors 120000 115000
Bills Payable 10000 23000 Stock 80000 90000
Machinery 60000 80000
Land 70000 66000
410000 443000 410000 443000
Solution:
Schedule of Changes in Working Capital
Changes in Working Capital
2009 2010
Particulars Increase Decrease
` `
` `
Current Assets:
Cash in hand 30000 47000 17000
Cash at Bank 50000 45000 5000
Debtors 120000 115000 5000

Stock 80000 90000 10000

Total Current Assets (A) 280000 297000
Creditors 70000 45000 25000
Bills Payable 10000 23000 13000
Total Current Liabilities (B) 80000 68000
Working Capital (A-B) 200000 229000
Increase in Working Capital 29000 29000
229000 229000 52000 52000
Fund Flow Statements

Sources / Inflow ` Application / Outflow `
Sale of Land 4000 Increase in Working Capital 29000
Issue of Shares 50000 Purchase of Machinery 20000
Redemption of Debentures 5000
54000 54000
ILLUSTRATION 15
Prepare Fund flow Statement
2009 2010 2009 2010
Capital & Liabilities Assets
` ` ` `
Equity Share Capital 300000 400000 Goodwill 115000 90000
Redeemable Pref. Share Capital 150000 100000 Land & Building 200000 170000
General Reserve 40000 70000 Plant 80000 200000
Profit & Loss A/C 30000 48000 Debtors 160000 200000
Proposed Dividend 42000 50000 Stock 77000 109000
Creditors 55000 83000 Bills Receivable 20000 30000
Bills Payable 20000 16000 Cash 15000 10000
Provision for Tax 40000 50000 Bank 10000 8000
677000 817000 677000 817000
Additional information
1. Depreciation on Plant ` 10000 and Land and Building ` 20000.
2. Dividend of ` 20000 has been paid in 2010.
3. Income tax of ` 35000 has been paid in 2010.

Solution:
Schedule of Changes in Working Capital
Changes in Working Capital
1999 2000
Particulars Increase Decrease
` `
` `
Current Assets:
Debtors 160000 200000 40000
Stock 77000 109000 32000
Bills Receivable 20000 30000 10000
Cash 15000 10000 5000
Bank 10000 8000 2000
Total Current Assets (A) 282000 357000
Creditors 55000 83000 28000
Bills Payable 20000 16000 4000
Total Current Liabilities (B) 75000 99000
Working Capital (A-B) 207000 258000
Increase in Working Capital 51000 51000
258000 258000 86000 86000
Preparation of Ledger account for additional information
Plant Account
To Balance b/d 80000 By P&L a/c (Depreciation) 10000
To Bank a/c (Balancing Figure -Purchase) 130000 By Balance c/d 200000
210000 210000
Land & Buildings Account
To Balance b/d 200000 By P&L a/c (Depreciation) 20000
By Bank a/c(Balancing Figure– Sales) 10000
By Balance c/d 170000
200000 200000
Proposed Dividend Account
To Bank (Payment) 20000 By Balance b/c 42000
To Balance c/d 50000 By P&L a/c (Proposed Dividend) 28000
70000 70000
Provision for Taxation Account
To Bank (Payment) 35000 By Balance b/c 40000
To Balance c/d 50000 By P&L a/c (Provision for Taxation) 45000
85000 85000

Calculation of Fund From Operation

Particulars ` `
Net Profit after Extraordinary Items 18000
Add: Non-fund and Non-trading expenses
Depreciation on Plant 10000
Depreciation on Land and Building 20000
Proposed Dividend 28000
Provision for Taxation 45000
Goodwill Written off 25000
Transfer to General Reserve 30000 158000
Fund From Operation 176000
Fund Flow Statements

Sources / Inflow ` Application / Outflow `
Fund From Operation 176000 Increase in Working Capital 51000
Issue of Shares 100000 Redemption of Preference Shares 50000
Sale of Building 10000 Tax Paid 35000
Dividend Paid 20000
Purchase of Plant 130000
286000 286000
CASH FLOW STATEMENT

A cash flow statement, when used in conjunction with the other financial statements,
provides information that enables users to evaluate the changes in net assets of an
enterprise, its financial structure (including its liquidity and solvency) and its ability to
affect the amounts and timing of cash flows in order to adapt to changing
circumstances and opportunities. Cash flow information is useful in assessing the ability
of the enterprise to generate cash and cash equivalents and enables users to develop
models to assess and compare the present value of the future cash flows of different
enterprises. It also enhances the comparability of the reporting of operating
performance by different enterprises because it eliminates the effects of using different
accounting treatments for the same transactions and events.
OBJECTIVES OF CASH FLOW STATEMENT

A Cash flow statement shows inflow and outflow of cash and cash equivalents from
various activities of a company during a specific period. The primary objective of cash
flow statement is to provide useful information about cash flows (inflows and outflows)
of an enterprise during a particular period under various heads, i.e., operating activities,
investing activities and financing activities. This information is useful in providing users of

financial statements with a basis to assess the ability of the enterprise to generate cash
and cash equivalents and the needs of the enterprise to utilize those cash flows. The
economic decisions that are taken by users require an evaluation of the ability of an
enterprise to generate cash and cash equivalents and the timing and certainty of their
generation.
BENEFITS OF CASH FLOW STATEMENT

Cash flow statement provides the following benefits:
 A cash flow statement when used along with other financial statements provides
information that enables users to evaluate changes in net assets of an enterprise,
its financial structure (including its liquidity and solvency) and its ability to affect
the amounts and timings of cash flows in order to adapt to changing
circumstances and opportunities.
 Cash flow information is useful in assessing the ability of the enterprise to generate
cash and cash equivalents and enables users to develop models to assess and
compare the present value of the future cash flows of different enterprises.
 It also enhances the comparability of the reporting of operating performance by
different enterprises because it eliminates the effects of using different
accounting treatments for the same transactions and events.
 It also helps in balancing its cash inflow and cash outflow, keeping in response to
changing condition. It is also helpful in checking the accuracy of past assessments
of future cash flows and in examining the relationship between profitability and
net cash flow and impact of changing prices.
CASH AND CASH EQUIVALENTS

As stated earlier, cash flow statement shows inflows and outflows of cash and cash
equivalents from various activities of an enterprise during a particular period. As per AS-
3, ‘Cash’ comprises cash in hand and demand deposits with banks, and ‘Cash
equivalents’ means short-term highly liquid investments that are readily convertible into
known amounts of cash and which are subject to an insignificant risk of changes in
value. An investment normally qualifies as cash equivalents only when it has a short
maturity, of say, three months or less from the date of acquisition. Investments in shares
are excluded from cash equivalents unless they are in substantial cash equivalents. For
example, preference shares of a company acquired shortly before their specific
redemption date provided there is only insignificant risk of failure of the company to
repay the amount at maturity. Similarly, short-term marketable securities which can be

readily converted into cash are treated as cash equivalents and is liquidable
immediately without considerable change in value.
CASH FLOWS
‘Cash Flows’ implies movement of cash in and out due to some non-cash items. Receipt
of cash from a non-cash item is termed as cash inflow while cash payment in respect of
such items as cash outflow. For example, purchase of machinery by paying cash is cash
outflow while sale proceeds received from sale of machinery is cash inflow. Other
examples of cash flows include collection of cash from trade receivables, payment to
trade payables, payment to employees, receipt of dividend, interest payments, etc.
Cash management includes the investment of excess cash in cash equivalents. Hence,
purchase of marketable securities or short-term investment which constitutes cash
equivalents is not considered while preparing cash flow statement.
DIFFERENCE BETWEEN FUND FLOW AND CASH FLOW STATEMENT

TABLE 5 DIFFERENCE BETWEEN FUND FLOW AND CASH F LOW
Basis For Cash Flow Fund Flow
Comparison
A cash flow statement is a A fund flow statement is a
statement showing the inflows statement showing the changes in
Meaning
and outflows of cash and cash the financial position of the entity in
equivalents over a period. different accounting years.
To show the reasons for To show the reasons for the changes
Purpose of movements in the cash at the in the financial position, with respect
Preparation beginning and at the end of the to previous year and current
accounting period. accounting year.
Basis Cash Basis of Accounting. Accrual Basis of Accounting.
Short Term Analysis of cash Long Term Analysis of financial
Analysis
planning. planning
Discloses Inflows and Outflows of Cash Sources and applications of funds
Opening and Contains opening and closing
Does not contains opening balance
closing balance of cash and cash
of cash and cash equivalents.
balance equivalents.
Part of Financial
Yes No
Statement

ILLUSTRATION NO. 16
Prepare Cash flow statement with the following balance sheets:
1999 2000 1999 2000
Liabilities Assets
` ` ` `
Share Capital 100000 150000 Cash 45000 39000
Debentures 50000 40000 Book Debts 17450 20850
Creditors 10000 11000 Stocks 40600 35350
Bills Payable 5000 4500 Machinery 20650 17200
Provision for Doubtful Debts 3500 4000 Land 80000 137000
Profit and Loss 50200 52800 Goodwill 15000 12900
218700 262300 218700 262300
Solution:
Preparation of Cash from Operations
` `
Net profit before tax and other extraordinary items 2600
Add: Non-Cash Expenses and Non-Operating Expenses
Goodwill Written-Off 2100
Fund from Operation 4700
Add: Decrease in Assets & Increase in Liabilities
Decrease in Stock 5250
Increase in Creditors 1000
Increase in Provision for Doubtful Debts 500 6750
11450
Less: Increase in Assets & Decrease in Liabilities
Increase in Book Debts 3400
Decrease in Bills Payable 500 3900
Cash from Operation 7550
Cash Flow Statement
Sources ` Application `
Opening Balance 45000 Redeemable Debenture 10000
Issue of Shares 50000 Purchase of Land 57000
Sale of Machinery 3450 Closing Balance 39000
106000 106000

ILLUSTRATION NO. 17
Following are the comparative balance sheets of M/s. Geetha & Co. as on 31st
December 2014 and 2015
2014 2015 2014 2015
Liabilities Assets
` ` ` `
Share capital 70,000 74,000 Cash 9,000 7,800
Debentures 12,000 6,000 Trade Debtors 14,900 17,700
Creditors 10,360 11,840 Stock 49,200 42,700
Provision for Doubtful Debts 700 800 Land 20,000 30,000
Profit and Loss 10,040 10,560 Goodwill 10,000 5,000
1,03,100 1,03,200 1,03,100 1,03,200
Additional Information:
1. Dividends were paid totaling ` 3,500
2. Land was purchased for ` 10,000 and amount provided for the amortization of
goodwill totaled ` 5,000
3. Debenture loan was repaid ` 6,000
Prepare Cash Flow Statement.
Solution
Preparation of Ledger account for additional information
Land Account
To Balance b/d 20000
To Bank a/c (Purchase) 10000 By Balance c/d 30000
30000 30000
Goodwill Account
To Balance b/d 10000 By P&L a/c (Amortization) 5000
By Balance c/d 5000
10000 10000
Proposed Dividend Account
To Bank (Payment) 3500 By P&L a/c (Proposed Dividend) 3500
3500 3500
Debenture Account
To Bank (Redemption) 6000 By Balance b/c 12000
To Balance c/d 6000
12000 12000

Preparation of Cash from Operations

` `
Net profit before tax and other extraordinary items 520
Add: Non-Cash Expenses and Non-Operating Expenses
Proposed Dividend 3500
Goodwill Written-Off 5000 8500
Fund from Operation 9020
Add: Decrease in Assets & Increase in Liabilities
Decrease in Stock 6500
Increase in Creditors 1480
Increase in Provision for Doubtful Debts 100 8080
17100
Less: Increase in Assets & Decrease in Liabilities
Increase in Trade Debtors 2800 2800
Cash Flow Statement
Sources ` Application `
Opening Balance 9000 Redeemable Debenture 6000
Issue of Shares 4000 Purchase of Land 10000
Cash from Operation 14300 Dividend Paid 3500
Closing Balance 7800
27300 27300

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2018

Unit – III – Analysis of

BA5103 – ACCOUNTING FOR MANAGEMENT

ST. JOSEPH’S COLLEGE OF ENGINEERING | OMR, Chennai

Analysis of Financial Statements 5

Nature of Financial Statement 7

Tools of Analysis of Financial Statements 14

Common Size Statements 14

Fund flow Analysis 15

Cash Flow Analysis 15

Comparative Financial Statement 16

Comparative Balance Sheet 16

Current financial position and Liquidity position 16

Long-term financial position 16

Profitability of the concern 16

Comparative Income Statement 19

Common Size Statement 21

Common Size Balance Sheet 21

Common Size Income Statement 23

Capital Structure or Leverage Ratios 30

Cash Position Ratio 35

Profit Margin Ratios 38

Rate of Return Ratio 45

Fixed Assets Turnover Ratio 48

Working Capital Turnover Ratio 49

Debtor Turnover Ratio 49

Creditors Turnover Ratio 51

Stock Turnover Ratio 52

Capital Structure and Leverage Ratio 55

Capital Gearing Ratio 55

Debt Equity Ratio 56

Fund Flow Statement 56

Meaning of Flow of Funds 57

Current and Non-Current Assets 57

Fund Flow Statement 59

Methods of Preparing Fund Flow Statement 59

Cash Flow Statement 65

Objectives of Cash Flow Statement 65

Benefits of Cash Flow Statement 66

Cash and Cash Equivalents 66

Difference between Fund Flow and Cash Flow Statement 67

UNIT – 3 – ANALYSIS OF FINANCIAL STATEMENT

According to The American Accounting Association, “Management

ANALYSIS OF FINANCIAL STATEMENTS

F IGURE 1 METHODS OF FINANCIAL ANALYSIS

According to John N. Myer, “the financial statements are composed of data

NATURE OF FINANCIAL STATEMENT

INCOME STATEMENT / PROFIT AND LOSS ACCOUNT

SHARE CAPITAL FIXED ASSETS

RESERVES AND SURPLUS INVESTMENTS

SECURED LOANS CURRENT ASSETS

UNSECURED LOANS MISCELLANEOUS EXPENDITURE

CURRENT LIABILITIES AND PROVISIONS

F IGURE 2 CLASSIFICATION OF BALANCE SHEET

F IGURE 3 EXAMPLES OF FIXED A SSETS

F IGURE 4 EXAMPLES OF CURRENT ASSETS

h. DUE FROM OFFICER NOTES

6. RESERVES AND SURPLUS

7. SECURED AND UNSECURED LOANS

TOOLS OF ANALYSIS OF FINANCIAL STATEMENTS

COMMON SIZE STATEMENTS

FUND FLOW ANALYSIS