ng unsold at the - ..-mM*LU-T""I ,.. ..

d of next day at a
hasker (thereafter
have ranged from
Ifollowing is the
1 days:
-
'..:at::.
.,. .... :
:

Concept of Financial Statement

EARNING OBJECTIVES
rhis chapter, you will learn about:
Preparar:ion of financial staternent Balance !SheedInco
. Sources of financial informati Type o f :assets
Profit ar~dLoss ACI:aunt Type of ....-.....-.
Ii,hili&c
.. . ,,~ " ...-+ ~ ., .--." ..-,

7 Introduction
:.<storevaluates investment alternatives based on risks and rewards and selects those alternatives that
.: isiher objectives. An investment decision is based on the projections of the future benefits from the
Exment. This requires a study of the past, present and future performances of the economy. industry
: frocks being considered for investment. For a quick analysis and intelligent decision, investors collect
mation from various sources which are mostly secondary in nature as primary data is rime-consuming
: costly. There are certain information providers who analyze the data for an easy understanding and
:- information providers form an important source of information.

Sources of Company Information

-1ndamenta1 analysis and valuation of a company's stocks calls for gathering and examination of the
--.any's specific data. This data can be obtained from the following sources:
Company's annual reports and prospectuses: These are the main sources of company data. The
annual report contains the company chairman's speech, Balance Sheet and Profit and Loss Account
with explanatory notes, and a review ofthe company's working over the last 5-10 years. The chairman's
speech outlines the events that occurred in the previous year having a bearing on the company's perfor-
mance and how the company responded to those events. It also outlines what the company proposes to
do in the next year.
Z Stock exchange official directory: It is another importarit source covering all the companies whose
shares are listed on the stock exchange. It gives brief history, progress, Balance Sheet and Profit and Loss
.kccount of a company for a period of 10 years. The stock exchange directory also provides valuable
information on important financial ratios, their trend over the last 10 years and yearly high and low
prices quoted for the company's shares.
. Kothari's Economic and Investment Guide of India: This yearly publicarion of rhe Kothari and
Sons is yet another important source of company data. This guide contains a lot of data on individual
companies, their progress and management besides good write-ups on industry scenes.
302 . CHAPTER I S I C O N C E P T OF F I N A N C I A L STATEh45' -

4. Other sources: Other sources of infomation are regular feature columns such as investors' y: 1
company profile reports, company news and comments and business notes in the print media ;..
as The Economic Times, Financial Express, Business Standard, Commerce and Business India. r.
Business Today.

Sources of International Economic Data

In today's interdependent world, the international economic, political, marker, business and techn~..,
developmentshave a considerablebearing on theconditions and prospectsofacountry's economy and rnz. I
and on individual firms' performance. Some important sources of international data include the folloxvir:
1. International Financial Statistics, a monthly IMF publication: It provides each country's !-r-
quarterly and monthly data on major economic indicators such as GNP, money supply, cons.-- -
price index, stock market indices, currency exchange rate expressed in the US dollars and b a r
of payments condition. The International Monetary Fund (IMF) also brings out occasional sc;r
mentaN documents on economic indicators such as prices, production, balance of paymenr. . -
exchange rates, covering a long historical period.
2. Capital International Perspective: This Geneva-based publication reports on the various nax--
stock market indices, world capital market, international interest rates and capital flows.
3. Other International Sources: These sources include The Financial Times of London, The Econc-
a UK weekly. The \Val1 Street Journal, a US daily, Baron's National Business and Financial Wee-:
the USA, International Business Week, Fortune International and the Far Eastern Economic R r - -

Financial Analysis
'l'hc rcrln financial analysis is also known as analysis and interpretation of financial statements. It re+
establishing meaningful relationships benveen various items of the two fin'ancial statements, that is, ifi:r -
statement and position statement. It determines the financial strengths and weaknesses of a firm.
The analysis and interpretation of financial statements is essential to measure the efficiency, profitab. -
financial soundness and future prospects of an enterprise. Financial analysis serves the following purp: :
1. Measures the profitability.
2. Indicates the trend of achievements.
3. Assesses the growth potential of the business.
4. Compares the position of a firm in relation to other firms.
5. Assesses the overall financial strength of a firm.
6. Assesses the solvency of a firm.

Financial Statement
A financial statement is a formal record of the financial activities of a business, a person or an!- .--
enriry. For a business enterprise, all the relevant financial information, presented in a structured mz-- .
and in an easy-to-understand form, is termed as financial statements. Typically, there are four basic fin:- :
statements:
1. Balance Sheet: Also referred to as statement of financial position or condition, Balance Sheet rtp--
on a company's assets, liabilities and ownership equity at a given point in time.
 4 N C l A L STATE'.': i : -RADING ACCOUNT .303
:h as investors' ,m;: 2. Income statement o r Profit and Loss Account: Also referred to as "P&L", it reports on a company's
the print media i income, expenses and profits over a period of time. PtrL account presents information on the oper-
~d Business India. L ations of the enterprise. In some cases, a P&I. is required to be segregated in three sections, such
as, Trading Account, Profit and Loss Account and Profit and Loss Appropriation. These operations
may be production of goods/se~ices,purchasing of raw materials, selling of finished goods etc. These
iilclude sales and various expenses incurred during the processing stage of the operations.
3. Statement of retained earnings: This explains changes in a company's retained earnings over the
reporting period.
ness and rechnol%-.
t. Statement of cash flows: It reports on a company's cash flow activities, particularly its operating,
economy andmar- :-
d u d e the followinr investing and financing actions.

each country's yti Limitations of Financial Statements

1nev supply, consu-.- -
!S dollan and balr-
out occasional sup;
dnce of paymenrs 1-
In the various nari: -
ital flows.
~ n d o nThe
, Ecooo~~~
nd Financial Week&
rern Economic Re+-.
I statements. It refcn --
cements, that is, in~:
sses of a firm.
efficiency, profitabili-
Ile following purpose:
-e financial statements are subject to certain limitations as given below:
1. Financial statements are essentially interim reports: The profit exhibited by the Profit and Loss
Account and the financial position revcalcd by the Balance Sheer may not be exact figures. The
instances of contingent liabilities, deferred revenue expenditure. etc. make them more imprecise.
2. Accounting concepts and conventions serve as basis: The preparation of thr finncial staremenrs
is based on certain accounting concepts and conventions. Oa,ing to this. the financial position, as
disclosed by these statements, may nor be realistic. Due to convention of conservatism, the income
statement may not disclose true income o f a business. Probable losses are raken inro considerauon t~hile
probable incomes arc ignored
3. Personal judgment affects financial statements: Analysis of several items of a financial statement is
left ro the personal judgment of the accountant. Examples include rhe method of depreciation, mode
of amortization of fixed assets and treatment of deferred revenue expenditure. All of these depend
upon the personal judgment of the accountant. The competency of the accountant's opinion relies on
hislher experience and integrity.
4. Important non-monetary aspects are ignored: Financial statements do not portray the qualita-
rive facts that cannot he expressed in terms of money. For example, development of a team of loyal
and efficient workers, enlightened management, and the reputation and prestige of management in
rhe eyes of public are matters of considerable importance for the business hut out of the confines of
financial statements. Therefore, financial statements do not reflect such non-monetaly aspects.

Trading Account
-
.rading means buying and selling of goods. Trading A/c shows the result of buying and selling of goods.
This account is prepared to find out d ~ diffcrence
e between the selling prices and cost. If the selling price
srceeds the cost, it will bring gross profit. For example, ifthe cost of Rs. 20,000 worth ofgoods are sold for
Rs. 30,000 that will bring in Gross profit of Rs. 10,000. If h e cost exceeds the selling price, the result will
be gross loss. For example, if thc cost Rs. 30,000 worth of goods are sold for RS. 20,000 that will result in
a person or any o t h r gross loss of Rs. 10,000. Thus the gross profit or gross loss is indicated in Trading Account.
in a structured mannr
:are four basic financiz Items Appearing in the Debit Side of Trading Account
1. Opening Stock: Stock on hand at the commencement of the year or period is termed as the Openine
I, Balance Sheet repom Stock.
2. Purchases: It indicates total purchases both cash and credit made during the year.
,C)4 . CHAPTER 15/CONCEPT OF F I N A N C I A L STATEMENT -

3. ?i;rchases Returns or Returns out words: Purchases Returns must be subtracted from the total
:urchases to get the net purchases. Net purchases will he shown in the trading account.
+. Direct Expenses on Purchases: Some of the Direct Expenses are wages (it is also known as Productive
xages or Manufacturing wages), carriage, octroi duty (duty paid on goods for bringing them within
municipal limits), customs duty, dock dues, Clearing charges, Import duty, fuel, power, lighting
charges related to production, oil, grease and waste, packing charges etc.

Items Appearing on the Credit Side of Trading Account

1. Sales: Total sales (Including both cash and credit) made during the year.
2. Sales Returns or Return Inwards: Sales Returns must be subtracted from the toral sales to get net sales.
Net Sales will be shown.
3. Closing stock: Generally, Closing stockdoes not appear in the trial balance. It appears outside the trial
balance. It represents the value of goods at the end of the trading period.
4. Specimen Form of a trading N c .

Advantages of Trading Account

1. The result of Purchases and Sales can he clearly ascertained
2. Gross profit ratio to sales could also be easily ascertained. It helps to determine Price.
3. Gross profit ratio to direct expenses could also be easily ascertained. And so, unnecessary expenses
could be eliminated.
4. Comparison of trading account details with previous years details help to draw better administrative
policies.

Profit and Loss Account

&

7'hc requirements of the Profit and 1.0s Account can be divided into two categories:
1. General requirements.
2. Special requirements.

Seneral Requirements
General requirements are related to the following three matters:
1. Heading: In case of companies, it is not essential to segregate the Profit and Loss Account into three
sections, viz. Trading Account, Profit and Loss Account and Profit and Loss Appropriation. It must
- 27:

also be noted that dividing the P&L account into three sections is not prohibited in any other case and
should be done to give a better idea with regard to the profit earned and distributed by the cornpan!-
during a particular period.
P&L account can be prepared under the following two headings:
Profit and Loss Account giving details regarding the gross profit and the net profit earned hy thr
company during a particular period.
Profit and Loss Appropriation Account giving details regarding the balance of Profit and Loss
Account brought fotward from the last year, the net profit (or loss) trend (or made) during the
year and appropriations made during the year. Items shown in the Profit and Loss Account are
commonly termed as items appearing "above the line," whereas the items shown in the Profit anc
Loss Appropriation Account are commonly termed as items appearing "belour the line."
 - = 3 F l T AND L O S S ACCOUNT 305

?revision for taxation: Compznies are liable to pay income tax a t a high rate. Usually, the tax
from the total
-ire is about 40% or more of the taxable profit. Although provision for taxation is an appropria-
unt.
- 2 n of profits, the common practice is to show it "above the line," that is, in the Profit and Loss
n as Productive
+?:tion and not in the Profit and Loss Appropriation Section. In other words, profit after tax is
ng them within
:ken from the Profit and Loss Account to the Profit and Loss Appropriation account. However,
power, lightins
-:.Y for a previous period, now provided or refunded for, is charged or credited to the Profit and
1.s~ Account.
~iccountingyear: Although the Companies Act permits a company to select any period of 12 months
u irs accounting year, tax laws have made it almost obligatory for every company to close its hooks of
i'zounts on 31 March every year.
j to get net sales.
~ i a Requirements
l as per Schedule VI, Part 11
.outside the trial - -ofit and Loss Account of a company must be prepared in accordance with the requirements of Part I1
:-rdule VI of the Companies Act, 1956. These requirements are summarized as follows:
-
--
Profir and Loss Account should clearly reveal the result of the working of the company during the
-
1 covered by the account. It should reveal separately the incomes and expenses of non-recurring nature
3;epnonal transactions. The Profit and Loss Account should panicularly disclose informarlon with
--: to the following items:
-
h e turn-over of the company.
ecessary expenses Iommission paid to sole-selling agents.
Iommission paid to other selling agents.
rer administrative 3rokerage and discount on sales other than the usual trade discouor.
Jpeniog and rlosing of goods, purchases made or cost of goods manufamured or value of'senices
rendered during the period covered by the account.
:,rerest on company's debentures and other fixed loans.
-
'mount charged as income tax.
a
Gmuneration payable to the managerial personnel.
'-mount paid to the auditor for services rendered as auditor and as advisor in any other capacity viz.
rxation matters, company law matters and management services.
-he details of licensed, installed and actual capacity utilized.
..
.due of imports, earnings in foreign exchange and amounts remitted during the year in foreign
.-irrencies on account of dividends

\ccount into three -+.-s
ropriation. It must
any other case and
rd by the company
)tofit earned by the
of Profit and Loss
;made) during the
d LOSSAccount are
vn in the Profit and
rhe line."
Appearing on Debit Side of the Profit & Loss A/C
zipenses incurred in a business is divided in two parts: (i) Direct expenses are recorded in trading Alc.
i indirect expenses, which are recorded on the debit side of Profit & Loss Mc. Indirect Expenses are
.-d under four heads:
!-lling Expenses: All expenses relating to sales such as carriage outwards, travelling expenses,
idvertising etc.
?%ce Expenses: Expenses incurred on running an office such as office salaries, rent, tax, postage,
~auoneryetc.
'.laintenance Expenses: Maintenance expenses of assets. It includes repairs and renewals, depre-
::ation etc.
-~
::nancial Expenses: Interest paid on loan, discount allowed, etc., are few examples of financial
ti-penses.
306 CHAPTER 151CONCEPT OF F I N A N C I A L STATEN!' -
-
Items Appearing on Credit Side of Profit and Loss A/c
Gross profit is appeared on the credit side of P & L. Mc. Also other gains and incomes of the businm r-
shown on the credit side. Typical of such gains are items such as Interest received, Rent received, Disco.- -
earned, Commission earned.

Balance Sheet Requirements

According to Section 210 of the Companies Act, it is mandatory for a company to prepare a Balance '--
-
at the end ofeach trading period. Section 21 1 requires the Balance Sheet to be set up in the prescribed 6: -
-
This provision is not applicable to banking, insurance, electricity and other companies governed by 5-Y:
Acts. The Central Government also holds the power to exempt any class of companies from comp:r-
witb the requirements of the prescribed form if it appears to be in public interest.
Schedule VI, Part I gives the prescribed form of a company's Balance Sheet. Notes and i n s m c -
regarding various items are given under respective items or sub-items. If the prescribed form cancc-
conveniently given under any item due to lack ofspace, it can be given in a separate schedule or schec_
Such schedules will be annexed to and form part of the Balance Sheet.
The type and nature of assets and liabilities, which are ro be classified and arranged in either of 7
orderly manners, are discussed under following sub-sections.

Classification of Assets
For the purpose of presentation of assets in the Balance Sheet, assets are classified into the following s -
types:
1. Fixed assets: Fixed assets are those assets which are acquired for the purpose of producing ?:,-
or rendering services. These are not held for resale in the normal course of business. Fixed 2:
are used for the purpose of earning revenue and hence these are held for a longer duration. T- 1
are also treated as "Gross Block" and "Net Block" (i.e., fixed assets after depreciation). I n v e s ~ :
in these assets is known as "Sunk Cost." Examples of fixed assets are land and building, plarr . -
machinery, furniture and fixtures, tools and equipment and motor vehicles. All fixed assets are -:-
gible by nature.
2. Intangible assets: Intangible assets are those capital assets which do not have any physical exizrr
Although these assets cannot be seen or touched, they are long lasting and prove to be profita' :
the owners by virtue of the right conferred upon them by mere possession. They also help the
generate income. Goodwill trademarks, copyrights and patents are the examples of intangible as>-
3. Current assets: Current assets include cash and other assets which are converted or realizet - -
cash within a normal operating cycle or, say, within a year. These are acquired for resale, 2 --
ing and helping the process of production, and rendering service or supply of goods. These ;----
constantly keep on changing their form and contribute to routine transactions and operatic:
business. Examples are a s h , bank balance, bills receivables, debtors, stock and prepaid e x F r -
Current assets are also known as floating assets or circulating assets.
4. Liquid or quick assets: Those current assets which can be converted into cash at a very short rr-
or immediately, without incurring much loss or exposure to high risk, are quick assets. Quick 2 .-
can be worked out by deducting stock (raw materials, work-in-progress or finished goods) and p - r
expenses out of total current assets.
5. Fictitious assets: These are the non-existent worthless items which represent unwritten-off losit.
costs incurred in the past and cannot be recovered in future or realized in cash. Examples of such 2
are preliminary expenses (formation expenses), advertisement suspense, underwriting commic
WClAL STATEME' - i i BALANCE SHEET R E Q U I R E M E N T S 307

discount on issue of shares and debentures, loss on issue of debentures and debit balance of Profit and
s of the business - Loss Account. These fictitious assets are written off or wiped out by debiting them to Profit and Loss
t received, Discoc-- .lccount.
i Wasting assets An asset thar has a limited life and therefore dwindles in value over time is a wasting asset.
This type of asset has a limited useful life by nature and depletes over a limited duration. Wasting assets
become worrhless once their utility is over or exhausts fully. During the life of their productive usage, these
=sets produce revenue, but eventually they reach a state where their worth begins to diminish. Such assets
rpare a Balance 5 - 7 are n a n d resources like timber, coal, oil and mineral deposits.
- Contingent assets: Contingent assets are probable assets which may or may not become assets, depend-
1 the prescribed fc-

s governed by sprz
lies from complir-
otes and instruc:
~ h e dform canno- -
ihedule or sched: r
ing on the occurrence or non-occurrence of a specified event or performance or non-performance of a
specified act. For example, a suit is pending in the court of law against the ownership title o f a disputed
property. Subsequently, if the verdict goes in favor of the company, it becomes the company's asset.
However, if the company does not win the lawsuit, it will not have the ownership rights of the p r o p
erty, and it will be of no use to it. Thus, it remains a contingent asset as long as the judgment is not
pronounced by courr.

iged in either of -i
Z'assification of Liabilities
I - ;he purpose of presentation ofliabilities in the Bdance Sheet, they are classified into the following three
...>.

o the following r r r
i of producing $I.-.:
msiness. Fixed t--3-
nger duration. T-:
rciation). Invest-t-
1 building, plant 1-
I1 fixed assets arc 1;-
ny physical exisre-:
we to be profitah t .
i. also help the om-.r
of intangible asv:
erred or realized - -
ired for resale, t--:
~f goods. These t--.r-
,ns and ope ratio:^
ind prepaid expc:::
. Long-term liabilities: These are the obligations that the business enterprise is expected to meet after
a relatively long period. Such liabilities do not become due for payment in the ordinal? course of
business operation or within the normal operating cycle. Debentures, long-term loans from banks or
financial institutions are the examples of long-term liabilities.
1. Current liabilities: Current liabilities are those liabilities thar arc payable within normal operating
cycle, thar is, within a given accounting year. These may arise out of realization tiom current assets
or by creating fresh, current liability (obligation). Trade creditors. bills payable, bank omrdrafr, out-
standing expenses and short-term loan (payable within 12 months or within the accounting year) are
examples of current liabilities.
3. Contingent liabilities: These liabilities may or may not be sustained by an entity depending o n h e
outcome of a Future event such as a courr case. These liabilities are recorded in a company's accounts
and displayed in the Balance Sheet when these are both probable and reasonably estimable. A con-
tingent liability is not an actual liability but an anticipated (probable) liabiliry which may or may not
become payable. It depends upon the occurrence of certain events or performance of certain acts. An
element of uncertainty is always attached to a contingent liability. In other words, it is a potential
liability that may or may not become a sure liability. For example, if a parent guarantees a son's first
car loan, the parent has a contingent liability. If the son makes his car payments and pays off the loan,
the parent will have no liability. If the son fails to make the payments, the parent will have a liability.
Contingent liabilities are shown as footnotes in the Balance Sheet.

at a very short cr-.

:k assets. Quick x --- --nitations of Balance Sheet
-
cd goods) and p r ~ . -,ugh a Balance Sheet is prepared by every organization for disclosing its financial position, it is not free
:mitations. They can be enlisted as follows:
~nwritten-offl o r ~ s . Fixed assets are shown in the Balance Sheet as historical cost less depreciation up to date. A conven-
:ramples of such 2;- tional Balance Sheet cannot reflect the true vdue of these assets. Again, intangible assets are shown in
:writing commiii- - the Balance Sheet at hook values, which may bear no relationship to market values.
308 CHAPTER 1 5 l C O N C E P T OF F I N A N C I A L STATE'.':

2. Sometimes, the Balance Sheer contains some assets that command no market value, such as prelir- -
expenses and debenture discount. T h e inclusion of these fictitious assets unduly inflates the rota -
of assets.
3. A Balance Sheet cannot calculate and show the value of certain qualitative factors like know led^
efficiency of staff members.
4. A conventional Balance Sheet may mislead untrained readers in inflationary situations.

Following are the ycar-end Balance Sheets of Prerna Put. Ltdfir 2008 and 2009. Prepare the comp--
Balance Sheet and study thefinancialposition of the concern.
- a , .,._
d i.a% 2008 W Liab 2008 2Mc
(Rr. 001 006 Rs. 000) (Rs. i.5
- -
- ~

Land and building 270 170 Equity share capital 500

Plant and machinery 400 600 Resewes and surplus 330 ,-:
--
Furniture 20 25 Debentures 200 -
:is'

Other fixed assets 40 30 Long-term loan on mortgage 100 1;

Cash in hand 20 40 Bill payables 50 . .
Bill receivable 100 80 Sundry creditors 100 1:
Sundry debtors 200 250 Other current liabilities 20
Stock 250 350
Prepaid ex~enses - 5
Total assets 1300 1550 Total liabilities 1300

Solution
Table 1 Comparative Balance Sheet of Prerna Pvt. Ltd. for the years ending December
2008 and 2009

December 31, bmeIL

20'09 fa0
Assets
Current Assets
Cash in hand 20 40 t20 +lo0
Bill receivable 100 80 -20 -20
Sundry debton 200 250 +50 +25
(Con! .:
.ZAL STk-i' i
. 5 . 8 B A L A N C E SHEET REQUIREMENTS . 309

Table 1 (Cont~nued)
such as ptell- --
Hates rhe roc; December. ember 31, e/Demme Inrrem
2008 2009 i OW) (per
like knowl&x - - -
I Stock 250 350 +lo0 + 40
) Prepaid expenses - 5 - -
/ Total current assets 570 725 +I52 126.67

pare the conz.?.:--

' Fired Assets
, Land and building 270 170 -100 -37.03
' Plant and machinery 400 600 +200 +50
' Furniture 20 25 +5 +25
-
-~ ~
' Other fixed assets 40 30 1 0 -25
500
j Total fixed assets 730 825 +95 +13
.330 -- 7-<

Total assets 1300 1550 250 +19.23

LOO .?r.-
-
Liabilities and Capital
100 1'~

i Bill payable 50 45 -5 -10

I
1 Sundry creditors 100 120 + 20 + 20
!I Other current liabilities 20 10 -10 -50
i
/ Total current liabilities 170 175 l5 +2.94
!
1
Long-term Liabiiitzes
1300 155C
!I Debenr+res 200 300 +lo0
Long-term oan on 100 150 +50 +50
mortgages
I December Total long-term 300 450 +I50 +50
liabilities

Inerease/Derrm Total liabilities 470 625 +I55 +32.97

(Percentage) Capital
Equity share Capitzl 500 700 +200 140
II Reserve & surplus 330 225 -105 -31.81
i Total owned equities 830 925 +95 +11.44
i
i ~ o t capital
a ~ and 1300 1550 +250 +19.23
1 Liabilities
+25 6
(Continuec
310 CHAPTER ISICONCEPT OF F I N A N C I A L STATEME'.-
- -

C
/ Thc income rtatementr .fKishu Automotive Ltd. awgivenfir theyean ending31 December 2009 and20:
Rearrange theffgurer in a comparativeform and study theprojtabilizy ofthe concern.

Sales Rs. 785,000 Rs. 900,000

Cost ofgoodr sold
Materials
Operating expenses
Selling expenses 80,000 90,000
Genera and administrarive expenses 70,000 72,000
Interest expense 25,000 30,000
Taxes 70,000 80,000

f Solution
Table 2 Comparative income statement of Kishu Automotive Ltd. for the years ending
31 December 2009 and 2010.

- - - - - -
Sales Rs.785,OOO Rs. 9,00,000 +1,15,0OO +14.64
Cost ofgoods sold
Materials 450,000 500,000 +50,000 11.1!
Gross profit 335,000 400,000 +65,000 +16.4
Operating expenses
Selling expenses 80,000 90,000 +lO,O00 +12.5
General and administrative expenses 70,000 72,000 +2,000 +2.85
Earnings before interest and taxes (EBIT) 185,000 238,000 +53,000 +28.64
Interesr expense 25,000 30,000 +5,000 +20
Earnings before taxes (EBT) 160,000 208,000 +48,000 +30
Taxes 70,000 80,000 +10,000 +14.2?
Net income 90,000 128,000 +38,000 +42.22
. C I A L STATE!.': - ::.ANCE SHEET REQUIREMENTS 311

her 2009 and:. . a 7jzding and h j i t and Loss Account and Balance Sheet of a company XYZ wing thefollowing trial
7;. taken on 31st March, 2011.
- :. ialunce ofa CompanyX E o n 31" March 2011

Dr. h cr. Rc.

Plant and Machinery
Opening stock
Purchases
Building
Carriage inward
Carriage outward
Wages
Sundry debtors
Salaries
Furniture
rs ending Trade expense
Discount on sales
Advertisement
Bad debts
Drawings
Bills receivable
Insurance
Bank balances
Sales
Interest received 2,000
Sundry creditors 40,000
Bank loan 100,000
Discount on purchases 2,000
Capital 171,500
795,500 795,500
Closinx stock on 31': March 201 1 was RF. 90,000
312 CHAPTER 151CONCEPT O F FINANCIAL STATEME'.-

j Solution
I
, Trading a n d Profit a n d Loss Account for t h e year ended o n 3lS',March 2011

Opening Stock 60,000 Saks 480,000

Purchases 160,000 Less discount -1,900 478.1'-

Less discount , -2,000 158,000
Closing stock 90.0;"
3,400
Wages 32,000
Gross profit (transferred to P&L) 314,700
568,100 568.1 .''
1 Carriage ourward 5,000 Gross profit 314,--,
1 (rranshrred to P&L)

I1 Salaries
Trade expenses
24,000
12,000
Interest received

f Adverrisement
1 Bad debts
[ insurance 4,400
I Net profit (transferred to capital) 264,500
316,700 31Y.

Discount on purchases and discount on sales are deducted from purchases and sales respectively. T--
may be shown on the credit and debit side of Profit and Loss Account, respectively, and it will not r%:
i the net profit of the business. The gross
. profit will he affected if discount is treated so.
.-=---:?
Balance Sheet for the year ended o n 31", March 2011 . -
-. .
.... - -
-.
. -- - .. ..
Assets Rs. ~iabil&es Rs.
m
Current Assets: Current Liabilities:
Bank balance 20,000 Sundry creditors 40,OO.
Bills receivable 50,000 Bank loan lOO,OCI<
Sundry debtors 100,000 Fixed and Long Term:
Closing stock 90,000 Capid 171,500
Fixed Assets: Ner profit 264,500
Furniture 36,000
Plant and Machinery 100,000 -Drawings -10,000 426,OP.:
Building 170,000
566,000 566J
 - 3 NTS TO R E M E M B E R 313

.. Distinction between Profit and Loss Account and Balance Sheet

- ..
~zrcncesbetween Profit and Loss Account and Balance Sheet are shown in Table 3.
'able 3 Difference between Profit and Loss Account and Balance Sheet .

Profit and Loss Account Balance Shea

Profit and Loss Account is an account.
1. Profit and Loss Account shows the profit or
losses during the accounting period.
I. It is prepared for the accounting period
which has ended.
-. Accounts appearing in Profit and Loss
Account are completely closed.
1. Balance Sheet is a statement of assets and liabilities.
2. Balance Sheet shows the financial position
of the business.
3. It is prepared as on the last date of the
accounting period.
4. Accounts appearing in Balance Sheet carry fonvard balance
which becomes the opening balance for the next period.

?elationships between Profit and Loss Account and Balance Sheet

-.?e Profit and Loss Account provides a link between the Balance Sheet at the beginning of a period and the
:dance Sheet at the end of that period. The Profir and Loss Account deals with the costs incurred during the
.-zrrent period for the purpose of earning the related revenue. The impact of the cost incurred in that period is
~ s l o s e dby the Balance Sheet. The Balance Sheet exhibits expenditure which is either outstanding or paid in
ri-ance, that is, the unexpired benefits (i.e. the benefits to be achieved due to prior investment). It also serves
5 a means of carrying forward unexpired acquisition costs of assets. The amount of net profit or loss reported
:-- the Profit and Loss Account is carried forward in the Balance Sheer showing its impact on various other
-5ms disclosed in the Balance Sheet. The Profit and Loss Account explains the changes in the owner's capital or
.s respectively. 7-- ~ u i r between
y the opening and dosing Balance Sheet ofthe accounting period. Thus, the Balance Sheet shows
.- ynsactions remaining for execution as a result of the revenue transactions of the Profit and Loss Account.
.--
ind it will not F-
-
The preparation of the Profit and Loss Account precedes the working of the Balance Sheet and the Balance
i-eet cannot be prepared without the preparation ofthe Profit and Loss Account. The Profit andLoss Account can
u prepared without the Balance Sheet. However, the absence of the Balance Sheer will l a d to non-disclosure of
7: impact of the revenue terms on the Balance Sheet which is the final resulting financial position of the business.

- chis chapter, the concept of financial statement has
- e n introduced at basic level. Mainly, the income
xtement (Profit and Loss Account) and the Balance
,tee[ have bepn explained in derail. The Profit and Loss
lccount and the Balance Sheet are together known as
final accounts. These are the final steps in the acwunt-
ing process. The Profit and Loss Account is prepared to
show the financial results of an enterprise. The Balance
Sheet shows the position of assets and liabilities of a
business entity as on a particular date.

Points t o Remember

1. A financial statement is a formal record of the structured manner and in an easy-to-understand

financial activities of a businchs, a person or any form, is termed as financial statements.
other entity. For a business enterprise, all the 2. Fixed assets are used for the purpose of earningreve-
relevant financial information, presented in a nue and hence these are held for a longer dwtion.
314 CHAPTER 1 5 l C O N C E P T OF F I N A N C I A L STATENF'
3. Intangible assets are those capital assets which
do not have any physical existence. They help
the owners generate income. Goodwill trade-
marks, copyrights and patents are the examples
of intan9ble assets.
4. Current assets include cash and other assets
which are converted or realized into cash within
a normal operating cycle or, say, within a year.
5. Those current assets which can be converted
into cash at a very short notice or immediately,
without incurring much loss or exposure to
high risk, are quick assets.
6. The non-existent worthless items which repre-
sent unwritten-off losses or costs incurred in the
past and cannot be recovered in future or realized
in cash are factitious assets.
...~ Multiple-choice Questions
1. In the annual report, where would a financial
statement reader find our if the company's
financial statements give a fair depiction of its
financial position and operating results?
(a) Notes to the financial statements
(b) Management discussion a n d analysis
section
(c) Balance sheet
(d) Auditor's report
2. Which accounting assumption assumes that an
enterprise will continue in operation long
enoush to carry out its existing objectives and
commitments?
(a) Monetary unit assumption
(b) Economic entity assumption
(c) Time period ass~unption
(d) Going concern assumption
3. T h e purchase of an office building by issuing
long-term notes payable should be reported as a
(a) cash outflow in the financing section of
the statement of cash flows.
(b) cash outflow in the investing section ofthe
statement of cash Rows.
(c) cash outflow in the operating secrion of
the statement of cash flows.
(d) noncash investing and financing activity.
4. The deferred income tax liability:
(a) Represenn incomc ?ax paymeno that
are deferred until future years because of
-
7. An asset that has a limited life and there'--
dwindles in value over time is a wasting zssr
8. Contingent assets are probable assets u~%:-
may or may not become assets, dependin; - ~
the occurrence or non-occurrence of a spec'r
event or performance or non-performance :
specified act.
9. Long-term liabilities are the obligations r.
the business enterprise is expected to meet - -
a relatively long period.
10. Current liabilities are those liabilities thar ;-
payable within normal operating cycle, t k r
within a given accounting year.
11. Contingent liabilities may or may not be 7 -
tained by an entity depending on the outcr-
of a future event such as a court case.
temporary differences between G 1 -
rules and tax accounting rules.
(b) Is a contingent liability, which can r 5 -
in a deferred income tax asset.
(c) IS never recorded.
(d) Ismrded&etherornotthe&rencebr
taxable inmmeand financial accoundng
5. A company normally sells its produrn
Rs. 20 per unit, which includes a c r -
margin of25%. However, the selling pricr
fallen to Rs. 15 per unit. This company'.; :-
rent inventory consists 200 units purchav:
Rs. 16 per unit. Replacement cost has -
fallen to Rs. 13 per unit. Calculate theva'::
inventory a t the lower of cost or market.
(a) Rs. 2,550.
(b) Rs. 2,600.
(c) Rs. 2,700.
(d) Rs. 3,000.
6. A measure of profitabiliry is the
(a) current ratio.
(b) debt to total assets ratio.
(c) return on assets ratio.
(d) working capital.
7. Working capital is a measure of
(a) consistency.
(b) liquidity.
(c) profitability.
(d) solvency.
 '......
...,,.,, ,....
.'...

s~-.. Financial Ratios

...
ir.
".. *.
Rs. 3,45,00:
Rs. I,oo,on:
LEARNING OBJECTIVES
Rs. 1,40,00- ,,, .-
Rs. 50,OW In this chapter, you will learn about:
- -
Rs. 1.10,OO: Liquidity ratios Profin:bility ratios
Rs. 5,00,00( Asset turnover r: rtios Valuat ion ratios
Financial leveras;e ratios

YTU,Dec. 20': i

- Introduction
::io ai~alysiscompares one figure in one financial statement with another figure in the same financial state-
?rnt or in another financial statement of the company. A ratio is expressed in the numerator-denominator
5rmat. Thus, the numerator and denominator can he either from the profit and loss account or the halance
iieet of the same company. In another word, a financial ratio is a comparison between one parameter of a
nancial statement with another parameter. For example, current ratio is the ratio of current assets and cur-
icnt liabilities. Current assets are the assets that can he readily turned into cash and current liabilities are the
sbligations that are due in near future. If the current ratio is 3, it means we have the assets three times of the
~bligationsto be paid in near future.
n d profit and 1 0 s Financial ratios are useful to indicate a firm's performance and financial situation. Most ratios can be
calculated from the information provided by the financial statements. Financial ratios can he used to analyze
trends and compare the firm's finandals with those of other firms. In some cases, ratio analysis can predict
tuture bankruptcy.

-
.
. of Financial Ratios
Tvwes
hire are five broad categories of financial ratios as listed below:
1. Liquidity ratios (e.g., current ratio and acid-test or quick ratio).
2. Asser turnover ratios (e.g., inventory turnover, average collection period, receivable turnover, fixed
assets turnover and total assets turnover).
3. Financial leverage ratios (e.g., debt-equity ratio, debt ratio, interest coverage ratio, fixed char,wes cover-
age ratio and deht service coverage ratio).
4. Profitability ratios (e.g., profit margin ratio and rate of return ratio).
5. Valuation ratios (e.g., price-earnitigs ratio, yield and market value to bookvalue ratio).
In the following sub-sections we will discuss each one of them
318 . CHAPTER 16lFINANCIAL RA- T

Liquidity Ratios
Liquidity ratios provide information about a firm's ability to meet its short-term financial obligations. 7
important liquidity ratios are: current ratio, acid-test or quick ratio and bankfinance to working capitalgap r r
1. Currpnt ratio: It is the ratio of current assets to current liabilities:
Current assets
Current ratio =
Current liabilities
Short-term creditors prefer a high current ratio since it reduces their risk. Shareholders may pre+
lower current ratio so that more of the firm's assets are working to grow the business. The main L?
hack of the current ratio is that it also takes into account the inventory which may include many ir=-
that are difficult to liquidate quickly and that have uncertain liquidation values.
2. Acid-tcrt or quick ratio: It is an alternative measure of liquidity that does not include inventory k -
current assets. The quick ratio is defined as follows:
Current assets - Inventory
Quick ratio =
Current liabilities
The current assets used in the quick ratio are cash, accounts receivable and notes receivable. Tx~
assets essentially are current assets less inventory.
3. Bank finance to working capital gap ratio: It is ratio of short-tm bank borrowing and working c a r :
gap, Where working capital gap is equal to current assets less current liabilities other than bank 3-.-
rowings. This ratio shows us the degree of the firm's reliance on short-term bank finance for financ-:
the working capital gap.
Short-term bank borrowing:
Bank finance to working capital gap ratio =
Working capitalgap

Asset Turnover Ratios -

Asset turnover ratios include fixed asset turnover and total asset turnover. Asset turnover ratios indicate hon r
ciendy the firm utilizes its assets. They sometimes are referred to as efficiency ratios, asset utilization ratios or s.r
management ratios. Two commonly used asset turnover ratios are invmtoy turner and receivabler t u r n
1. Inventory turnouer: It is the cost of goods sold in a time period divided by the average inventoy !7-
during that period:
Cost of goods sold
Inventory turnover =
Average inventory
The inventory turnover is often reported as the inventoryperiod, which is the number of days w a d
inventory on hand. It is calculated by dividing the inventory by the average daily cost of goods so!:
Average inventory annual
Inventory period =
Cost of goods sold1365

Inventory turnover
2. Receivables turnover: It is an indication of how quickly the firm collects its accounts receivables. !:
defined as follows:
Annual credit sales
Receivables turnover =
Accounts receivable
I N A N C I A L RAT C ~2 T Y P E S OF FINANCIAL RATIOS
cial obligations. '7-c
krngcapitalgap m.7
~oldersmay prefc- :
ess. The main d r p -
include many iter:
ude inventory in 1-1
es receivable. The;:
and working capir:
ther than bank bo--
inance for financir;
rios indicate how eF-
lization ratios or ass-
eceiuabler turnover.
.-rage inventory lev=
ber of days worth c-
cost of goods sold:
lnts receivables. It L;
319
The receivables turnover is often reported in terms of the number of days for which credit sales remain
in accounts receivable before they are collected. This number is known as the collectionperiod. It is the
accounts receivable balance divided by the average daily credit sales, calculated as follows:
Accounts receivable
Average collection period =
Annual credit sales1365
- 365
Receivable turnover
Financial Leverage Ratios
-
-:nancial leverage ratios provide an indication of the long-term solvency of the firm. Unlike liquidity
xtios that are concerned with short-term assets and liabilities, financial leverage ratios measure the
scent to which the firm is using its long-term debt. Described below are three important financial
zrerage ratios:
1 . Debt ratio: I t is defined as total debt divided by total assets:
Total debt
Debt ratio =
Total assers
2. Debt-equiy ratio: It is total debt divided by total equity:
Total debt
Debt-equity ratio =
Total equity
Debt ratios depend on che classification of long-term leases and on the classification of some items as
long-term debt or equity.
3. lnterest coverage ratio: It indicates bow well the firm's earnings can cover the interest payments on its
debt. It is calculated as follows:
EBIT
Interest coverage =
Interest charges
where EBIT means earnings before interest and taxes.
Profitability Ratios
?rotitability ratios offer several different measures of h e firm's success in generating profits. Described below
rre three important profitability ratios:
1. Grossprofir margin: It is a measure of the gross profit earned on sales. The gross profit margin considers
the firm's cost of goods sold but does not include ocher costs. It is defined as follows:
Sales - Cost of goods sold
Gross profit margin =
Sales
-
Gross profit
Net sales
2. Return on mets: It is a measure of how effectively the firm's assets are being used to generate profits. It
is defined as follows:
Net income
Return on assets =
Total assers
320 . CHAPTER 1A/FINANCIAL RATiC:

3. Remm on equity: It is the bottom line measure for the shareholders, measuring the profits earned &
each rupee invested in the firm's stock. Return on equity is defined as follows:
Net income
Return on equity, ROE =
Shareholder equity
= Profit margin x Total assets turnover x Equity multiplier

- Netincome Totd sales Totalassets

- X X
Total sales Total assets Common equity

Extended Du Pont Equation

In the 1920s the DuPont corporation created a method of analysis that fills this need by breaking dov-
ROE into a more complex equation. DuPont analysis shows the causes of shifts in the number. There 2-:
rwo variants of DuPont analysis, the original three-step equation, and an extended five-step equation. T-t
three-step equation breaks up ROE into three very important components:
ROE = (Net ~ r o f i margin)
t x (Asset turnover) x (Equity multiplier)
These components include:
1. Operating efficiency as measured by profit margin.
2. Asset use efficiency as measured by total asset turnover.
3. Financial leverage as measured by the equity multiplier.

Three-step DuPont calculation

Taking the ROE equation:
ROE = net incomelshareholdeis equity and multiplying the equation by (saleslsales), we get:
ROE = (net incomdsales) X (saleslshareholder's equity)
We now have ROE broken into two components, the first is net profit margin, and the seconc'
the equity turnover ratio. Now by multiplying in (assetslassets), we end up with the three-srr
DuPont identity:
ROE = (net incumelsales) x (salesIassets) x (assetsishareholder's equity!
This equation for ROE breaks ir into three widely used and studied components:
ROE = (Net profit margin) x (Asset turnover) x (Equity multiplier)
The three-step equation breaks up ROE into three very important components:
Net profit
ROE=
Equity
- Netprofit x-x-EBT EBIT x-x-Sales Assets
EBT EBIT Sales Assets Equity

where
Net profit = net profit after taxes
Equity = shareholders' equity
EBIT = Earnings before interest and taxes
Sales = N e t sales
 : ->VANTAGES AND LIMITATIONS OF RATIO ANALYSIS 321

Ir profits earne6 '.- ,a'vation Ratios

.~rionratios indicate how the equity stock of the company is assessed in the capital market. Since the
- I-ctr value of equiry reflects the combined influence of risk and return, valuation ratios are the most
-~-rehensive measures of a firm's performance. Described below are two valuation ratios:
. Price-eaning~ratio: It can be defined as

Market price per share

Price-earnings ratio =
Earnings pershare

1. Dividendpolicy ratios: Dividend policy ratios provide insight into the dividend policy of the firm and
J by breaking do-&- the prospects of its future growth. Two commonly used dividend policy ratios are: dividendyield and
1 number. There z payout ratio.
:-step equation. F: The dividend yield is defined as follows:

Dividends per share

Dividend yield =
Share price
A high dividend yield does not necessarily translate into a high future rate of return. It is important
to consider the prospects of continuing and increasing the dividend in future.
The dividend payout ratio is helpful in this regard, and is defined as follows:

Dividends per share

Payout ratio =
Earnings per share
es), we get:

Advantages and Limitations of Ratio Analysis

n, and the second is
with the three-ster iancial ratio analysis is a useful tool for users of financial statement. It has following advantages:
1. It simplifies the financial statements.
eholder's equity) 2. It helps in comparing companies of different size with each other.
3 It helps in trend analysis which involves comparing a single company over a period.
4. It highlights important information in simple form quickly. A user can judge a company by just
v multiplier) looking at few numbers instead of reading the whole financial statements.
3espite usefulness, financial ratio analysis has some disadvantages. Some key disadvantap of financial ratio
lnalysis are:
\
1. Diierent companies operate in different environmental conditions such as regulation, market struc-
ture, etc. These factors are so significant that a comparison of two companies from different industries
might be misleading.
2. Financial accounting information is affected by estimates and assumptions. Accounting standards
allow different accounting policies, which impairs comparabiliry and hence ratio analysis is less useful
in such situations.
3. Ratio analysis explains relationships between past information while users are more concerned about
current and future information.
4. Most ratios by themselves are not highly meaningFul. They should be viewed as indicators, with several
of them combined, to only highlight the firm's situation.
 322 . CHAPTER I b l F I N A N C I A L -
:
5 -

1% balance sheet and income statement ofa company. Ashrr & Co., at the end of theyear 201 I aregiven 6
I
Table 1 Ashu & Co. Balance S h e e t o n December 31,201 1

Assets Amount (2s. 000) LiabiIib Amount (Rs. W

Cash Us. 220 Accounts payable Rs. 210

1 Receivables 255 Notes payable 420
1 ~nvenmty 630
- Other current liabilities 125
-
/ T o d current asset. 1105 Total current liabilities 755
Net fixed assets 1250 Long-term debt
Common equiry
Total assets 2355 Total liabilities and equity 2355

Table 2 Ashu & Co. Income S t a t e m e n t o n December 31,2011

ZF. 000 Rs. 000

Sales
Cost ofgoods sold: 2,500
I Materials 1,000
I
Labor 600
Heat, light, and power
Indirect labor
Depreciation
i
Gross profit 660
i
1I Selling expenses 180

I General and administrative expenses 220

Earnings before interest and taxes (EBIT) 260

I Interesr expense 40
Earnings before taxes (EBT)
Taxes
Net income 160
Calculate (a) current ratio, (b) asset management ratios [inventory turnover, fixed assets rurnover, tomi e
Nrnover, and days sales outstanding (DSO),assume a 365-day year], (c) debt and times-interest-earned CT:E
ratios, (d) profitability ratios [the profit margin on sales, return on mral assers (ROA), return on comrnc-
equity (ROE), basic earning power (BEP) of assets, and earnings per share (EPS)], (e) market value rari r.
(pricelearnings ratio, pricelcash flow ratio, and marketlbook value ratio). Ashu & Co. had an a v e r s
 r 1 ADVANTAGES AND LIMITATIONS OF RATIO ANALYSIS 323

'10,000shares outstanding during 201 1, and the stock price on December 31,201 1 was Rs. 40.00. Use
- - c Extended D u Pont Equation to determine company's return on equity.

Solution
2, We have
mount (Ilr Current assets
Current ratio =
Rs. 210 Current liabilities
420 - Rs. 1,105,000
Rs. 755,000
125
= Rs. 1.46
755
490 b) Asset management ratios
Sales
1110 Inventory turnover =
Inventory
2355
- Rs. 2,500,000
-
Rs. 630,000
= Rs. 3.96
Sales
Fixed assets turnover =
Net fixed assets
-
Rs. 2,500,000
Rs. 1,250,000
= Rs. 2.00
Sales
Total assets turnover =
Total assets
- Rs. 2,500,000
Rs. 2,355,000
= Rs. 1.06
! Accounts receivable
I DSO=
1 Sales1365
Rs. 255,000
! -
-
Rs. 2,500,0001365
I = 37.23 days
iI
i (c) Debt ratio = Total debtlTota1 assets
= (Total liability - Common equity)/Total assets
= Rs. 1,245,0001Rs. 2,355,000
turnover, coral assea = 0.5286
,nterest-earned (TIE)
return on common = 52.86%
I market value ratios
Co, had an average
I 324 . CHAPTER 16lFINANCIAL RA- 1:

I
TIE ratio = EBITIInterest
= Rs. 260,OOOlRs. 40,000
= 6.50
(d) Profitability ratios
Net income
Profit margin =
Sales
Rs. 160,000
-
-
Rs. 2,500,000
= 0.064
= 6.40%
Net income
ROA =
Total assets
-
-
Rs. 160,000
Rs. 2,355,000
=0.067
= 6.70%
EBIT
BEP =
Total assets
- Rs. 260,000
Rs. 2,355,000
=0.11

Net income
EPS =
Number of shares outstanding
-
-
Rs. 160,000
10,000
=&.I6
(e) Market value ratios
Price
NE ratio =-
EPS
--Rs. 40
Rs. 16
= 2.5
Net income + Depreciation
Cash flowlshare =
Number of shares outstanding
- Rs. 1,60,000 + Rs. 80,000
10,000
= Rs. 24
 i -?VANTAGES AND LIMITATIONS OF RATIO ANALYSIS 325

Rs. 40
?rice/cash flow =--
Rs. 24

Market price
Iarketlbook value =
Book value
- 40(10,000)
- Rs.
Rs.11,10,000
= 3.63
ROE= Profit margin x Total assets turnover x Equity multiplier
- Rs. 1,60,000 Rs. 25,00,000 Rs. 23,55,000
- X
Rs. 25,00,000 Rs.23,55,000 Rs.ll,lO,OOO

33e balance rheet and income sratement of a company, Kishu Automotive Ltd., ut the end of theyear 2009 are
:;t,en below:

Table 3 Kishu Automotive Ltd. Balance Sheet on December 31, 2009

-
Assets Amount Liabifiities Ammt
-
,-..__^.
bunsnt Assets: Current Liabilities
Cash in hand Rs. 20,000 Bill payables Rs. 50,000
Bill receivable 100,000 Sundry credirors 100,000
Sundry debtors 200,000 Orher current liabilities 5,000
Stock (Inventory) 250,000 Total current liabilities 155,000
Prepaid expenses Nil
Total current assets 570,000
Fixed Assets Long term liabilities:
Land and building 270,000 Debentures 200,000
Plant and machinery 400,000 Long-term loan on mortgages 300,000
Furniture 20,000 Common equity 630,000
Other fixed assets 25,000 Total long-term IiabiIities 1,130,000
I
Totuljixed ussets 715,000 Total liabilities 1,285,000
TotalAssets 1,285,000
326 CHAPTER 16lFINANClAL R A T l r I
-
Table 4 Kishu Automotive Ltd. Income Statement on December 31,2009

Rs. 785,000

Cost of Gooh Sokf:

Materials Rs. 4,50,000
Gross profit 335,000
Operating Eupmcs:
Selling expenses
General and administrative expenses
Earnings before interest and tpes (EBIT)
Interest expense
Earnings before taxes (EBT)
Taxes
Net income

Calculate (a) current ratio, (b) asset management ratios (inventory turnover, fixed assets turnover, to=
assets turnover, and days sales outstanding, assume a 365-day year), (c) debt and times-interest-earne:
ratios, (d) profitability ratios (profit margin on sales, return on total assets, return on common equlr
and basic earning power of assets), (e) market value ratios (pricelearnings ratio, pricelcash flow ratio, ar:
marketlbook value ratio). Kishu Automotive Ltd. had an average of 10,000 shares outstanding durkr
2009, and the stock price on December 31,2009, was Rs. 50.00. Use the Extended Du Pant Equation r'
determine the company's return on equity.
Solution
(a) We have
Current assets
Current ratio =
Current liabilities
- Rs. 570,000
Rs. 155,000
= 3.67

(b) Asset management ratios

Sales
Inventory turnover =
Inventory
- Rs. 785,000
Rs. 250,000
=3.14
 3 ADVANTAGES A N D LIMITATIONS OF RATIO ANALYSIS
-: . 327
Sales
Fixed assets turnover =
Net fixed assets
-
-
Rs. 785,000
Rs. 715,000
=1.09

Sales
Total assets turnover =
Total assets

Accounts receivable
DSO =
Sales1365
- Rs. 100,000
60,000
70,000 Rs. 785,0001365
90,000 = 46.49 days

ssets turnover, rot2 (c)We have

mes-interest-earn?: Total debt
Debt ratio =
.
,n common equin~ . Total assets
a s h flow ratio, a~: - Total liability - Common equity
outstanding durin: Total assets
)u Pont Equation tc
- Rs. 6,55,000
Rs. 1,285,000

EBIT
TIE ratio = --
Interest
-
-
Rs. 185,000
Rs. 25,000
= 7.4

(d) Profitability ratios

Net income
Profit margin =
Sales
- Rs. 90,000
Rs. 785,000
=0.114
=11.46%
328 . CHAPTER 161FINANCIAL RAT I:

Net income
ROA=
Total assets
i -
-
Rs. 90,000
II Rs.1,285,000
Ii = 0.07
1
!
= 7%

i Net income -
- Rs. 90,000
2 ROE=
i Common equity Rs. 630,000
= 0.142
i = 14.2%
EBIT -
-
Rs. 185,000
BEP =
i Total assets Rs. 1,285,000

I Net income
1 EPS=
i Number of shares outstanding
1
I
- Rs. 90,000
i 10,000
I = Rs. 9.00
:
1 (e) Market value ratios
!
j PIE ratio =-Price
EPS
i
Rs. 50.00
1
I
-
Rs. 9.00
!
i Net income + Depreciation
Cash flowlshare =
Number of shares outstanding
i -
-
Rs.90,000 +0
I
i 10,000
I
!
= Rs. 9.0

1
i
Pricdcash flow=
Rs. 50.00
Rs. 9.00
FINANCIAL R i - : - 3 l N T S TO REMEMBER . 329

Market price
Market /Book value =
Book value
Rs.
- 50(10,000)
Rs. 630,000
= 0.79

ROE = Profit margin x Total assets turnover x Equiry multiplier

- Rs. 90,000 X Rs. 785,000
- Rs. 1,285,000
Rs.785,000 Rs. 1,285,000 Rs. 630,000

:: this chapter, various financial ratios have been
rxplained. These ratios are frequently used for
Yssurement of financial performance of an orga-
-.hation. Broadly, these ratios can be categorized
s liquidity ratios (e.g., currenr ratio and acid-test
-:quick ratio), asset turnover ratios (e.g., inven-
nry turnover, average collection period, receivable
turnover, fixed assets turnover and toral assets turn-
over), financial leverage ratios (e.g., debt-equiw
ratio, debt ratio, interest coverage ratio, fixed charges
coverage ratio and debr senice coverage rario), prof-
itabiliry ratios 1c.3.. profit marsin ratio and rate of
return ratio); and valuation rarios.

Points to Remember
Current assets Average inventory annual
1. Current ratio = 5. Inventory period =
Current liabilities Cost of goods sold I365

- 365
Current assets - Inventory
2. Quick ratio = Inventory turnover
Current liabilities
Annual credit sales
3. Bank Finance to working capital gap ratio 6. Receivables turnover =
Accounts receivable
-
- Short-term bank borrowings
7. Average collection period
Working capital gap
Accounts receivable
Cost of goods sold Annual credit sales1365
4. Inventory turnover = 365
Average
0
inventorv -
Receivable turnover
330 CHAPTER 1 6 l F I N A N C I A L RAT':

Total debt 14. ROE= (net incomeisales) X (saleslassets)

8. Debt ratio =
Total assets x (assetsishareholder's equiry)
Total debt = (Net profit margin) x (Asset turnovs:
9. Debt-equity ratio =
Total equity x (Equity multiplier)
EBIT
10. Interest coverage = Netprofit Netprofit EBT
Interest charges 15. R O E = -
- x-
Equity EBT EBIT
11. Gross profit margin
EBIT Sales Assets
Sales - Cost of goods sold X - X - X y
-
- Sales Assets Equ~ty
Sales
-
- Gross profit Market price per share
16. Price-earnings ratio =
Net sales Earnings per share
Net income
12. Return on assets = Dividends per share
Total assets 17. Dividend yield =
Share price
13. Return on equity, ROE
Net income Dividends per share
-
- 18. Payout ratio =
Shareholder equity Earnings per share
= Profit margin x Total assets turnover
xEquity nolultiplier
- Netincome Total sales
- X
Totalsales Total assets
Totalassets
X
Common equity

, Multiple-Choice Questions
I . Orher things held constant, which of the fol- 3. A Company has Rs. 5 million in total a s s
lowing will not affect the current ratio, assum- The company's assets are financed ,,--.
ing an initial current ratio greater than 1.0 Rs. 1 million of debt, and Rs. 4 millior
(a) Fixed assets are sold for cash common equity. The company's income srr-I
(b) Long-term debt is issued to pay off current ment is summarized below:
liabilities Operating Income (EBIT) Rs. 1 .OOO,OCF
(c) Accounts receivable are collected. Interest Expense 100,W'
id) Cash is used to pay off accounts payable.
Earnings before tax (EBT) Rs. 900,OC.
2. Other things held constant, which of the fol-
Taxes (40%) 360.0'~
lowing will not affect the quick ratio? (Assume
that current assets equal current liabilities.) Net Income Rs. 540,OP~
(a) Fked assets are sold for cash. The company wants to increase i n asseri -
(b) Cash is used to purchase inventories. Rs.1 million, and it plans to finance r -
ic) Cash is used to pay off accounts payable. increase by issuing Rs.1 million in new ct--
(d) Accounts receivable are collected. This action will double the company's i n t e - r