Financial Statement Analysis III

Financial Statement Analysis III 207
UNIT 8 FINANCIAL STATEMENT ANALYSIS III
Structure:
8.0 Learning Objectives
8.1 Introduction
8.2 Advantages of Ratios
8.3 Classification of Ratios
8.4 Concept
8.5 Definitions in Ind AS-7 ‘Statement of Cash Flow’
8.6 Presentation of Cash Flow Statement
8.7 Steps in Preparing the Cash Flow Statement
8.8 Summary
8.9 Key Words/Abbreviations
8.10 Learning Activity
8.11 Unit End Questions (MCQ and Descriptive)
8.12 References
8.0 Learning Objectives

After studying this unit, you will be able to:
 Calculate profitability, liquidity, turnover and solvency ratios
 Critically discuss the strength and weakness of ratio analysis
 Distinguish investing activities that affect a company’s cash flow statement from the business’s
other transactions
CU IDOL SELF LEARNING MATERIAL (SLM)

208 Financial Reporting and Analysis
 Distinguish financing activities that affect a company’s cash flow statement from the business’s
other transactions
 Explain the significance of each component of the cash flow statement
8.1 Introduction
Absolute figures expressed in monetary terms in financial statements by themselves are
meaningless. These figures often do not convey much meaning unless expresses in relation to other
figures.
Ratio analysis is a financial statement analysis tool based on accounting data. It ascertains
numerical relationship between various accounting terms to analyse financial performance with
respect to different parameters like profitability, solvency (long-term and short-term), turnover, etc.
It facilitates both intra- and inter-firm comparison and allows the stakeholders to take informed
decisions. They cover key performance areas for any business enterprise.
8.2 Advantages of Ratios

Ratio analysis offers the following advantages:
 It aids financial statement analysis.

 It facilitates intra-firm comparison and help chart trends.
 Ratios are relative concepts and therefore support inter-firm comparison.
 Ratios help in simplifying accounting terms by providing answers in percentages and times.
It is the simplest tool of financial analysis for a layman.
 It checks and highlights the performance of an enterprise on key parameters of liquidity,
profitability and growth.
 It identifies the points of concern for management and aids in decision making.
 It can be used as a forecasting tool.

8.3 Classification of Ratios

The classification of ratios is as follows:
1. Liquidity Ratios
(a) Current ratio (b) Acid test ratio
(c) Cash ratio
2. Activity Ratios
(a) Capital turnover ratio (b) Asset turnover ratio
(c) Net working capital turnover ratio (d) Inventory turnover ratio
(e) Debtors turnover ratio
3. Profitability Ratios
(a) Related to investments
(i) Earnings margin (ii) Return on capital employed
(iii) Return on equity shareholders’ fund (iv) Return on total assets
(b) Related to sales
(i) Gross profit ratio (ii) Net profit ratio
(iii) Operating ratio (iv) Operating profit ratio
4. Capital Structure/Gearing Analysis/Solvency Ratios
(a) Debt-equity ratio

(b) Interest coverage ratio
(c) Proprietary ratio
5. Market Strength Analysis
(a) Earnings per share (b) Dividend per share
(c) Gross dividend yield (d) Dividend cover
(e) Payout ratio (f) Dividends to cash flow
(g) Price earnings ratio (h) Net asset value per share
(i) Cash flow per share

LIQUIDITY RATIOS
Liquidity or short-term solvency analysis aims to determine the ability of a business to meet
its financial obligations during the short-term and to maintain its short-term debt-paying ability.
The aim of liquidity analysis for a company is to have adequate funds on hand to pay bills when
they are due and to meet unexpected needs for cash. If a business enterprise cannot maintain
its short-term debt paying ability, obviously it cannot maintain a long-term debt-paying ability or
long-term solvency. Shareholders will not be satisfied with such a state of affairs of the company.
Even a business enterprise on a very profitable course will find itself bankrupt it if fails to meet
its obligations to short-term creditors.
Liquidity analysis mainly focuses on balance sheet relationships that indicate the ability of
a business to liquidate current and non-current liabilities. The ratios that evaluate liquidity relate
to working capital or some part of it, because it is out of working capital that debts are paid as
they mature. The comparisons and ratios that evaluate liquidity relate to working capital or some
part of it, because it is out of working capital that debts are paid as they mature. The comparisons
and ratios related to evaluating liquidity or short-term solvency are as follows:
Current Ratio
It is also referred to as working capital ratio and banker’s ratio. Current ratio expresses the
relationship of current assets and current liabilities. It is widely used as a broad indicator of a
company’s liquidity and short-term debt-paying ability. The current ratio formula is as follows:
Current Assets
Current Ratio =
Current Liabilities
Current ratio is more dependable indicator of solvency than is working capital. For many
years, the guideline for the minimum current ratio has been 2 : 1. The assumption is even if the
value of current assets declines 50%, the firm can still pay its current liabilities. But nowadays
there has been a decline in the liquidity of many firms. It can be said that in some industries, a
current ratio substantially below 2 is adequate, while some other industries may require a ratio
much larger than 2. In general, the shorter the operating cycle, the lower the normal current ratio.
The longer the operating cycle, higher the normal current ratio. A higher current ratio enables a
firm to pay-off current obligations and provides adequate margin of safety to the creditors.
A company’s current ratio can be compared with the company’s past current ratios and with
the industry average as well. Such comparisons can help in determining if the current ratio is high
or low, at this period of time. However, the comparisons do not indicate why the current ratio
is high or low. Possible reasons for unsatisfactory current ratio can be found from an analysis
of the individual accounts and items that make up the current assets and current liabilities.
Example: The following are the current assets and current liabilities in respect of the two
companies, Company X and Company Y.

Company X (`) Company Y (`)
Current Assets 4,50,000 1,60,000
Current Liabilities 1,50,000 80,000
The current ratio will be as follows:

Current Assets
Current Ratio =
Current Liabilities
Company X (`) Company Y (`)
Current ratio 4,50,000/1,50,000 = 3.1 1,60,000/80,000 = 2.1
Acid Test Ratio or Quick Ratio

The current ratio is generally used to evaluate an enterprise’s overall short-term solvency or
liquidity position. The current ratio does not take into account the makeup or composition of
current assets. For example, a rupee of cash or debtor is considered more readily available to
meet obligations than the amount stuck in the form of inventory. The quick ratio addresses this
issue and segregates near liquid assets from total current assets. Cash, marketable securities or
short-term investments, receivables and prepaids are included within the meaning of most liquid
assets; inventory is excluded. The acid test ratio is as follows:
Current Assets – Inventory
Acid Test Ratio =
Current Liabilities
It may be preferable to have a better view of liquidity by excluding some other items in
current assets that may not represent relatively current cash flow. Examples of items to be
excluded are prepaids and miscellaneous items such as assets held for sale. This is considered
as a more conservative manner of computing the acid test ratio and the formula of acid test ratio
in this situation will be as follows:
Cash Marketable Securities Net receivables and Debtors

Acid Test Ratio =
Current LIabilities
Inventory should be removed from current assets when computing the acid test ratio due
to the reasons that inventory may be slow moving or possibly obsolete and parts of the inventory
may have been pledged to specific creditors. For example, a winery has inventory that requires
considerable time for aging and therefore a considerable time before sale. To include the wine
inventory in the test computation would overstate the liquidity. There is also a valuation problem
with inventory, because it is stated as a cost figure that is likely to be materially different from
a fair current valuation. In summary, inventory should be left out of the computation because of
possible misleading liquidity indications.
The usual benchmark for acid test ratio is 1.00. However, some industries may find that a
ratio less than 1.00 is adequate, while other need a ratio greater than 1.00. For example, a typical
grocery store sells only for cash and therefore does not have receivables. This type of business
can have an acid test substantially below the 1.00 guideline and still have adequate liquidity.
Example: A firm has the following current assets and current liabilities.
`
Debtors 5,000
Inventory 20,000
Cash 5,000
Total Current Assets 30,000
Total Current Liabilities 20,000
Quick Assets
Acid Test Ratio =
Current Liabilities
10,000
= = 0.5 : 1
20,000
Cash Ratio
Liquidity of a firm can be viewed from an extremely conservative point of view and the
short-term liquidity of a company may be measured through cash ratio. The cash ratio relates
cash and marketable securities to current liabilities. The cash ratio is computed as follows:
Cash Marketable Securities

Cash Ratio =
Current LIabilities
Cash ratio is not given much importance unless a firm is in deep financial trouble. It is not
considered pragmatic to expect a business enterprise to have enough cash and marketable
securities to cover current liabilities. However, in the case of very slow moving inventories and
receivables and highly speculative companies, cash ratio is of great importance. A high cash ratio
indicates that a business enterprise is not using its cash resources to best advantage. A low cash
ratio reflects an immediate problem with paying bills.
Activity Ratios
Activity ratios, also known as turnover ratios, indicate the efficiency with which an enterprise’s
resources are utilised. Liquidity or short-term analysis (current ratio and acid test ratio) will show
misleading results if debtors are too high because of slow collection. Similarly, the current ratio
will be misleading if inventory is not sold and thus remains at high levels. Since liquidity ratios
(i.e., current ratio and acid test ratio) ignore the movement of current assets, it is necessary for
short-term creditors to make an analysis of how fast the debtors and stock are turned in to cash
so that their claim can be met timely. Moreover, the overall profitability of the business depends
upon:
1. The rate of return of capital employed
2. The turnover, i.e., the speed at which the capital employed in the business rotates.
Hence, in order to find out which part of capital (i.e., assets) is efficiently employed and
which part not, different activity or turnover ratios are calculated. Mainly activity ratios include:
1. Capital turnover ratio
2. Asset turnover ratio
3. Net working capital turnover ratio
4. Inventory turnover ratio
5. Debtors turnover ratio
Capital Turnover Ratio

This ratio measures the effectiveness with which a firm uses its financial resources. It
indicates the number of times the capital has been rotated in the process of doing business. The
ratio is computed as follows:
Net Sales (or Cost of goods sold)

Capital Turnover Ratio =
Capital Empoyed or Owner ' sequity
Net Sales = Total Sales – Returns (if any)
Cost of Goods Sold = Opening Stock + Purchases + Direct Expenses –

Closing Stock
Or
= Sales – Gross Profit
Example: A firm has opening and closing stock of ` 30,000 and ` 20,000 respectively. Its
administrative and selling expenses are ` 10,000; Purchases are ` 3,10,000; Sales ` 5,00,000;
Debentures ` 50,000 (representing 1/3rd of owner’s equity).
Cost of goods sold

Capital Turnover Ratio =
Owner ' s equity
Opening stock purchases clo sin g stock

=
Owner 's sequity

30,000
3,10,000 – 20,000
Capital Turnover Ratio = =
3
50000
1
3,20,000
Fixed Asset Turnover Ratio = = 2.133 times
1,50,000
This ratio reveals the number of times net fixed assets (i.e., fixed assets less depreciation)
are turned during the year. Strictly speaking, average net fixed assets should be used in calculating
this ratio. But, invariably, net fixed assets at the end of the year are used.
Turnover (Net Sales)

Fixed Assets Turnover Ratio =
Net Fixed Asset
An improvement in assets turnover ratio as compared to the previous year indicates that
the turnover of the company has improved. In cases where assets are not revalued or replaced,
its magnitude will be the decreasing over the years due to depreciation. Then obviously, the ratio
will be higher as the turnover figures for the future will reflect an increasing trend. This ratio
indicates the extent to which the investment in fixed assets has contributed to sales. If compared
with a previous period, it indicates whether investment in fixed assets has been judicious or not.
The higher the ratio, the better it is because it indicates higher efficiency with respect to utilisation
of fixed assets. A lower ratio may point to the underutilisation of certain assets.
Example: Calculation of fixed asset turnover ratio with the following details:
Particulars 2015-16 (3) 2016-17 (3)

Fixed Assets at written
down value 30,00,000 60,00,000
Sales less returns 1,20,00,000 1,60,00,000
Fixed Asset Turnover = Net Sales/Net Fixed Assets = Net Sales/Net Fixed Assets
Ratio = 1,20,00,000/30,00,000 = 1,60,00,000/60,00,000
= 4 times = 2.67 times
Comment: There has been a decline in fixed asset turnover ratio though the absolute
figures of sales have gone up. It indicates that the increase in fixed assets over the year did not
bring proportionate gains. Hence, the newly acquired assets seem to be underutilised. However,
all the fixed assets do not yield gains in quick turnaround period. The gestation period also needs
to be considered along with standard operating cycle. A reliable conclusion for fixed assets may
be based on a minimum of three years.

Net Working Capital Turnover Ratio

This ratio indicates whether or not the working capital has been effectively utilised in making
sales. This ratio is computed by dividing net sales or cost of goods sold by net working capital.
Net working capital signifies the excess of current assets over current liabilities. The ratio is
calculated as follows:
Turnover (Net Sales)
Net Working Capital Turnover Ratio =
Net Fixed asset
A high net working capital ratio (if it is expressed in percentage) indicates efficient use of
working capital and quick turnover of current assets like stock and debtors. A low ratio indicates
low turnover on these assets.
Inventory Turnover Ratio

Inventory turnover ratio measures the relative size of inventory and influences the amount
of cash available to pay liabilities. A smaller, faster-moving inventory means that the company has
less cash tied up in inventory. On the contrary, a buildup in inventory means that a recession or
some other factor is preventing sales from keeping pace with purchasing and production. Ideally,
inventory should be maintained at an optimum level to support production and sales. Inventory
turnover ratio is calculated by using the following formula:
Cost of goods sold

Inventory Turnover Ratio =
Average inventory
Average inventory is obtained by using a simple average by dividing opening and closing
inventory by two. Cost of goods sold is obtained by deducting gross profit from sales.
Example: Calculate Inventory Turnover Ratio from following data:
Opening Stock ` 56,000
Closing stock ` 44,000
Sales ` 5,00,000
Gross profit margin on sales 20%
Cost of goods sold = (Sales – Gross profit)
= 5,00,000 – 20% (5,00,000)
= 4,00,000
Average inventory = (Opening Stock + Closing Stock)/2
= (56,000 + 44,000)/2
= 50,000

Cost of goods sold

Inventory Turnover Ratio =
Average inventory
= 4,00,000 / 50,000
= 8 times per year
Receivables Turnover Ratio

The ability of a company to collect money from credit sales timely affects the company’s
liquidity. The relationship between credit sales and accounts receivables may be stated as the
receivables turnover. Receivables or debtors turnover determines the liquidity of one item of
current assets and funds out how fast debts are being collected. The formula for computing
Receivables Turnover is as follows:
Net Credit Sales
Receivables Turnover =
Average Accounts Re ceivables or Debtors
Receivables Turnover shows how many times, on average, the receivables were turned into
cash during the period. A higher Debtors Turnover Ratio indicates shorter time span between
occurrence and collection of money from credit sales. This ratio requires calculation on yearly
basis. In case, credit sales are not given in the question, total sales may used for computational
purposes. The presumption is that all the sales are carried out on credit basis.
Example: Calculate Debtors Turnover Ratio and Average Collection Period from the
following data:
Amount `
Opening Debtors 40,000
Closing Debtors 75,000
Credit Sales 3,45,000
Net Credit Sales
Debtors Turnover Ratio =
Average Accounts Re ceivables or Debtors
3,45,000
= 40,000 75,000
2
= 6 times per year
12 months
Average Collection Period =
Debtors Turnover Ratio
12 months
=
6 times
= 2 months
PROFITABILITY RATIOS
The long-term survival of our business enterprise depends on satisfactory income earned by
it. An evaluation of a company’s past profits may give the investors, creditors and others a better
understanding for decision making. The profitability positioned also affects the liquidity position
that is vital to creditors as well. These ratios are:
Return on Capital Employed or Return on Investment

This ratio measures the profitability in relation to the total capital employed in a business
enterprise. The terms invested capital; capital funds and total capital may be used interchangeably.
It is a useful ratio when comparing the overall performances of companies, particularly where
they have different proportions of debt in their capital structure. This ratio would also show
whether the company’s borrowings policy is economically wise and whether the capital had been
employed judiciously. For instance, assume that the funds have been borrowed at 7.5% and return
on capital employed is 7%, it would be better not to borrow unless it is essential. It would also
show that the firm had not been employing the funds efficiently. The business can survive only
when the return on capital is more than the cost of capital employed in the business.
According to some analysts, short-term borrowings, such as bank loans, commercial paper,
deferred tax liability, should be included under capital. Current accrued payables, which are not
interest bearing, should be excluded because their interest component is not observable.
Example: Calculate Return on Capital Employed with the following information:
Particulars Amount (`)
Equity Share Capital 20,00,000
Reserves and surplus (including current year profit of ` 5,00,000) 9,00,000
10% Debentures 10,00,000
Current Liabilities 16,00,000
Fixed Assets 30,00,000
Current Assets 25,00,000
Solution:
Profit Before Interest = Current Year’s Profit + Interest on Debentures
= 5,00,000 + 10%(10,00,000)
= 6,00,000
Total Capital Employed = Fixed Assets + Current Assets – Current Liabilities
= 30,00,000 + 25,00,000 – 16,00,000
= 39,00,000

OR
= Equity Share Capital + Reserves and Surplus +
Long-term Debt
= 20,00,000 + 9,00,000 + 10,00,000
= 39,00,000
Pr ofit before Interest and tax

Return on Capital Employed/ = × 100%
Total Capital Employed
ROI
6,00,000
= × 100%
39,00,000
= 15.4%
Return on Equity Shareholders’ Funds

Taking net income and dividing it by shareholders’ equity give return on equity. This indicates
the returns which the management is realising from the shareholders’ equity and shows how
effectively ordinary shareholders’ funds are being utilised by the management. As long as it is
above the current interest ratio, a company is considered to be doing fairly well.
Pr ofit after tax – Pr eference Dividends

Return Equity = × 100
Equity Shareholders' Funds
It is obvious that both the ratios – returns on capital and return on equity – will be influenced
when a company has raised new capital during the course of the year, i.e., in other words, the
ratio will be artificially low. Also, the ratios do not take into account the effect of financial
leverage which undesirably tends to increase the variability of earnings for the ordinary shares.
In fact, ordinary shareholders of a company having higher dose of borrowings expect large
returns to compensate for the high level of risk. Financial analysts, sometimes in such cases, find
out the tradeoff between higher earnings and increased variability of earnings to determine
whether the management has chosen the optimum amount of financial leverage.
Example: Calculate Return of Equity (ROE) from the following information:
`
10% Preference Share Capital (fully paid up) 10,00,000
1,60,000 Equity Shares of `10 each fully paid 16,00,000
Reserves and Surplus 64,00,000
Net Profit after Tax 23,75,000

Solution:
Returns on Equity = Net Profit – Preference Dividend
Preference Dividend = 10% on ` 10,00,000 = ` 1,00,0000
Equity Shareholders’ Funds: `
Paid-up Equity Share Capital 16,00,000
+ Reserves as Surplus 64,00,000
80,00,000
23,75,000 – 1,000,000
Return on Equity = × 100
80,00,000
= 22,75,000/80,00,000 × 100 = 28.44%
Return on Total Assets (ROTA)

This ratio measures the effectiveness of assets invested in the business. It is based on
Earnings before Interest and Tax (EBIT) and Total Assets Invested. It is expressed in percentage
or decimal. ROTA follows ‘the higher, the better’ principle however no universal standardised
metric is defined as ideal ROTA. It is based on book value of Total assets.
Return on Total Assets = EBIT / Total Net Assets × 100
This ratio might be affected by depreciation expense as the total assets value may change.
A simple average of opening and closing total assets may be used instead of closing figure only
due to the assumption of uniformity in earning profits. It is a useful ratio for competing firms
within the same industry.
It may then be referred to as Return on Average Assets.
Example: Calculate Return on Total Assets (ROTA) from the following information:
`
Net Income 1,00,000
Interest Expenses 12,000
Taxes 28,000
Total Assets 40,00,000
Solution:
Return on Total Assets = EBIT / Total Assets × 100

= Net Income + Interest + Taxes on Total Assets × 100
= 1,00,000 + 12,000 – 28,000/40,00,000 × 100 = 3.5%

PROFITABILITY RATIOS RELATED TO SALES

Gross Profit Ratio
It is a profitability ratio that captures the relationship between Gross Profit and Net Sales.
It is expressed in percentage terms. It helps in evaluating operational performance of the company.
Gross Profit = Gross Profit / Net Sales × 100
where, Net Sales = Gross Sales – Sales Returns
As gross profit reports profits left after deducting direct expenses, a gross profit ratio
indicates quantum of profits left to meet indirect expense, financing expenses and remaining
return. A steady gross profit may indicate stable profitability position of the company.
Example:
`
Gross Sales 20,00,000
Sales Returns 1,80,000
Opening Stock 4,00,000
Purchases 11,80,000
Purchase Returns 1,40,000
Closing Stock 90,000
Solution:
Gross Profit = Gross Sales – Sales Returns + Closing Stock – Opening Stock
– (Purchases – Purchase Returns)
= 20,00,000 – 1,80,0000 + 90,0000 – 4,00,0000 – (11,80,0000 –
1,40,0000)
= 4,70,000
Net Sales = Gross Sales – Sales Returns
= 20,00,000 – 1,80,000
= 8,20,000
Gross Profit Ratio = Gross Profit / Net Sales × 100
= 4,70,000 / 18,20,000 × 100
= 25.82%

Net Profit Ratio

It is the ratio of profits after tax with net sales. Net profits indicate the profits left after
deducting selling, administration and financing expenses and taxes. It is a popular measure to
capture overall profitability of the firm. ‘Net profit’ is an absolute term but “Net Profit Ratio”
aids comparison amongst firms being a relative term. This ratio is expressed as percentage. It
signifies the quantum of profits left for dividend distribution and retained earnings. A healthy net
profit ratio does not necessarily indicate healthy cash flows because net profit is an accounting
term calculated after deducting non-cash expenses too.
Net Profit Ratio = Net Profit After Tax/Net Sales × 100
Example: Calculate Net Profit Ratio with the following, information:
`
Sales 20,00,000
Sales return 80,000
Cost of goods sold 11,00,000
Selling and administration expenses 7,20,000
Tax rate 35%
Solution:
Profit before Tax = Sales – Sales return – Cost of goods sold
– Selling and administration expenses
= 20,00,000 – 80,000 – 11,00,000 – 7,20,000
= 1,00,000
Net Profit after tax = Profit Before Tax – Tax
= 1,00,000 – 35% (1,00,000)
= 65,000
Net Sales = Sales – Sales Return
= 20,00,000 – 80,000
= 19,20,000
Net Profit Ratio = Net Profit After Tax/Net Sales × 100
= 65,000/ 19,20,000 × 100
= 3.385%

Operating Ratio
It is calculated as a percentage of operating profit by net sales. This ratio determines the
operational efficiency of the firm. It indicates the profits of the company after meeting operational
expenses.
Operating Profit Ratio = Operating Profit / Net Sales × 100
Example: Calculate Operating Profit Ratio with the following information:
`
Net sales = 8,00,000
Gross profit = 2,80,000
Income from investment = 2,000
Selling expenses = 70,000
Administration expenses = 50,000
Loss on sale of asset = 4,000
Solution:
Operating Profit = Gross Profit – Selling Expenses – Administration Expenses
= 2,80,000 – 70,000 – 50,000
= 1,60,000
Operating Profit Ratio = Operating Profit / Net Sales × 100
= 1,60,000 / 8,00,000 × 100
= 20%
Operating Ratio
It is an expense ratio calculated to capture the relationship between operating cost and net
sales. Non-operating expenses like interest received or paid, taxes, etc. are excluded from the
calculations.
Operating Ratio = Operating Expenses / Net Sales × 100
Example: Calculate Operating Ratio with the following information:
`
Net sales 4,00,000
Cost of goods gold 2,40,000
Selling expenses 40,000
Administration expenses 40,000

Solution:
Operating Cost = Cost of Goods Sold + Selling Expenses + Administration Expenses

= 2,40,000 + 40,000 + 40,000
= 3,20,000
Operating Ratio = Operating Expenses / Net Sales × 100
= 3,20,000 / 4,00,000 × 100
= 80%
SOLVENCY RATIOS
Gearing ratio, i.e., the relationship of long-term debt to total capital is considered the most
important by many investors and financial analysts. Popularly known as debt-equity ratio, this
ratio has the utility to many shareholders, creditors, business managers, suppliers and other user
groups. Gearing ratios are used to indicate:
 The cushion of assets/profits available to holders of fixed income capital, should assets/
profits decline.
 The gearing advantage of potentially higher assets/profits attributable to ordinary shareholders
and the correspondingly higher risk that is incurred.
 The scope for raising additional fixed-income capital at reasonable costs, from the point of
view of the company.
Debt-Equity Ratio
The Debt-Equity Ratio is computed as follows:
Loan Capital Pr eference Share Capital

Debt-Equity Ratio = Net Tangible Assets
× 100
Net tangible assets (or total capital) are obtained by subtracting the intangible assets and
the current assets from total assets. Loan capital plus preference capital constitutes the amount
of long-term debt. Alternatively, subtracting current liabilities from total liabilities can derive long-
term debt. Other variants of Deb-Equity Ratio are as follows:
Long term Liabilities

 × 100
Equity (or Net Worth)
External Equities
 × 100
Internal Equities

Long term debts

 × 100
Owners' Equities
Long term Debts
 × 100
Shareholder 's funds Long term Debt
Sometimes, capital gearing is calculated in terms of debt-equity ratio and not total capital.
Capital gearing ratios, calculated in these two manners, provide essentially the same information.
It is advisable that the investors select a standard method and follow it consistently throughout.
It is said that as a rule of thumb, one should not opt for a company whose long-term debt exceeds
two-thirds of its total capitalisation. Debt-equity ratio is very helpful in assessing a company –
whether the company is marching steadily into or out of debt. In younger and aggressive companies,
comparatively speaking the long-term debts may at times exceed the shareholders’ equity that
means a company will not be able to get out of the difficult situation easily. A company depending
on large amounts of debt should manage and perform well to avoid any worse contingencies.
Debt-equity ratios should be analysed not for one but for many years to determine a trend. If
it is found that equity component is continuously increasing than the long-term debt, there may
not be any cause for concern.
Example: Calculate Debt-Equity Ratio with the following information:
`
Equity Share Capital: 10,000 equity shares of ` 100 each 10,00,000
General Reserve 4,50,000
Surplus 3,00,000
Debentures 7,50,000
Sundry Trade Creditors 4,00,000
Outstanding Expenses 1,00,000
Solution:
External Equities
Debt-Equity Ratio = Internal Equities
Debentures Trade Creditors Outstanding Expenses

= Equity Share Capital General Reserve Surplus
= (7,50,000 + 4,00,000 + l,00,000)/(10,00,000 + 4,50,000 + 3,00,000)

= 12,50,000 / 17,50,000 = 0.71 : 1

Long –term Debt

Debt-Equity Ratio =
Owner's Equity
Debentures
=
Equity Share Capital General reserve Surplus
= (7,50,000) / (10,00,000 + 4,50,000 + 3,00,000)
= 7,50,000 / 17,50,000
= 0.43 : 1
Long term Debt
Debt-Equity Ratio =
Shareholders' Funds Long– term Debt .
Debentures
=
Equity Share Capital General Reserve Surplus Long term Debt
= (7,50,000) / (10,00,000 + 4,50,000 + 3,00,000 + 7,50,000)
= 7,50,000 / 25,00,000
= 0.3 : 1
Interest Coverage Ratio

Interest coverage ratio determines the debt servicing capacity of a business enterprise keeping
in view fixed interest on long-term debt. The formula for this ratio is:
Earnings Before Interest and Tax (EBIT)

Interest Coverage Ratio =
Interest
If a business enterprise is able to earn a return on the assets higher than the rate of interest
on long-term debt, the enterprise makes an overall profit. However, the enterprise runs the risk
of not earning a return on assets equal to the interest cost of the long-term loan, the enterprise
makes an overall loss. The interest coverage ratio measures the degree of protection of creditors
has from default on the payment of interest by the company.
Example: PQR Ltd. has earned a net profit of ` 7,00,000 during the year 2016-17. It has
paid an income tax of ` 2,20,000 and interest on debentures as ` 2,30,000.
The interest coverage ratio may be calculated as follows:
EBIT
Interest Coverage Ratio =
Interest
Pr ofits after Tax Tax Paid Interest Ch arg ed to Pr ofit and Loss Account
=
Interest

= (7,00,000 + 2,20,000 + 2,30,000) / 2,30,000

= 11,50,000 / 2,30,000
= 5 times
Net Worth to Total Assets (Proprietary) Ratio

It indicates the proportion of investors fund in total assets of the business. It is of particular
interest to shareholders as it signals stability of the firm and hints at long-term solvency too. A
healthy proprietary ratio indicates less risk of default on firm’s part.
Total Shareholders Fund
Proprietary Ratio = × 100
Total Assets
Example: Calculate Proprietary Ratio from the following information:
`
Debentures 2,50,000
Total Non-current Assets 7,00,000
Total Current Assets 3,50,000
Cash at Bank 50,000
Solution:
Total Shareholders Funds
Proprietary Ratio =
Total Assets
(5,00,000 1,65,000)
=
7,00,000 3,50,000)
= 63.33%
Note: Cash at Bank is a part of total current assets.
Market Strength Analysis or Investor Analysis

The market analysis or investor analysis are especially important for investors while analysing
information about a company. This analysis helps the investors to decide about a company as an
investment opportunity at a point of time. These ratios are also known as stock market ratios,
investment ratios or market test ratios. The ratios under this category are as follows:

1. Earnings Per Share

Dividing the profits of a company by the total number of shares outstanding derives earnings
per share. Earnings here mean the net profit, net income or the net earnings. This is the amount
by which the total revenues exceed the total expenses for the years.
Earnings after Tax – Pr eference Dividends
Earnings per Share =
Number of Ordinary Shares
The net earnings figure is the amount, which is completely free from any obligations and
the company can plough it back into the company, pay to the ordinary shareholders as dividends
or as a combination of both. This amount is also known as the earnings available for ordinary
shareholders.
Example:
Net Profit before tax ` 100,000
Tax Rate 40% of Net Profit
10% Preferences Share Capital (` 10 each) ` 1,00,000
Equity Share Capital (` 10 Shares) ` 1,00,000

Earnings after Tax – Pr eference Dividends
Number of Ordinary Shares
= [1,00,000 – 40,000 (Tax) – 10,000 (Preference Dividend)] / 10,000
= 50,000 / 10,000
= ` 5 per share
Earnings per share can either be primary or diluted. Primary earnings per share are the
earnings per share for the number of ordinary shares outstanding as on the beginning of the
reports period. Diluted earnings per share, on the other hand, is calculated after considering
convertible debentures, bonds, etc. (which have been converted into ordinary shares) during the
year. It is computed in the same manner as primary earnings per share except that it assumes
that all investments with the convertibility clause were converted at the beginning of the year.
In case a company have bonds and debentures, which are convertible into ordinary shares; it is
always useful to compute fully diluted earnings pel share (assuming full conversion) as well as
earnings per share on a normal basis. This implies adding back the interest aid on the convertibles,
recalculating the numerator and then dividing, by the total number of ordinary shares on the
assumption that conversions has taken place.

Dividend Per Share

The dividend per share can be net or gross. Net dividend per share is the dividend declared
on a single ordinary share for the year, the net of basic rate tax.
Ordinary dividends paid to ordinary shareholders
Net Dividend Per Share = Number of ordinary shares
Gross dividend per share is net dividend per share together with the associated tax credit.
Net dividend per share
Gross Dividend per Share = 1 Basic rate of tax
Alternatively,
Gross Dividend Per Share = Net Divined Per Share + Associated Tax Credit
Gross Dividend Yield

The gross dividend yield is the gross dividend per share dividend by the ordinary share price,
expressed as a percentage.
Gross dividend per share
Gross Dividend Yield = Ordinary share price
× 100%
For example, if a company declares dividend at 20% on its shares, each having a paid-up
value of ` 8 and market prices of ` 25, the dividend yield ratio will be calculated as follows:
20
Dividend Per Share = × 8 = ` 1.60
100
Dividend per share
Dividend Yield Ratio = Market Price per share
= 1.6/25 × 100
= 6.4%
The gross dividend yield indicates the current level of income from a share. Dividend yields
are normally calculated using gross dividend rather that net dividends because it helps in better
analysis and comparison with other types of investment. Also, investors pay income tax at rates
other that the basic rate. If the dividend yield is calculated on a net basis, the level of tax rate
which has been deducted should be made clear.
Besides indicating the general level of the market, dividend, and yield reflects the market
estimates of future dividend growth and risk. The higher the dividend growth expectations for a
given share, the lower the current yield; the higher the market’s estimate of risk, the higher the
current yield.

Dividend Cover
Dividend cover denotes the number of times the dividend per share is covered by earnings
per share.
Earnings per share
Dividend Cover =
Dividend per share
Dividend cover helps in assessing the prospects for dividend increases. Or, alternatively, the
possibility of a dividend cut, should profit decline. For the purpose of dividend cover, full distribution
of earnings per share is normally taken into account. In other words, it is assumed that all profits
are distributed as dividends. The gross dividend per share should be taken to ensure consistency
in the resulting, figure of dividend cover.
Payout Ratio
Payout ratio measures the proportion of earnings per share which are paid out as dividends
Payout Patio = Net earnings per share × 100%
The percentage of available earnings paid out as ordinary dividends has a vital influence on
the market’s behaviour towards those shares that are not in the growth category. For these
companies, which have paid dividends in the form of stock dividends and cash, only the cash
dividend should be included in calculating, the payout ratio. In the case of dividends paid out as
stock dividends, the investor receives nothing that was not already owned and the company gives
up nothing, of value.
Example: Compute the Payout Ratio and Retained Earnings Ratio from the following data:
Amount (`)
Profit 20,000
Number of Equity Shares 3,000
Provision for Tax 10,000
Dividends per Equity Shares 0.80
Preference Dividend 4000
Solution:

Payout Ratio = × 100%
Net earnings per share

Profit available to equity shareholders

No. of equity shares
= 20,000 – 10,000 – 4,000 / 3,000
= 6,000 / 3,000
= ` 2 per share
` 0.80
Dividend Payout Ratio = × 100 = 40%
2
Re tained Earnings
Retained Earnings Ratio = × 100
Total Earnings (after Tax and Pr ef . Divid.)
Retained Earnings = Profit Available for Equity Shareholders – Dividends Paid
= 6,000 – 2,400
= ` 3,600
3,600
Retained Earnings Ratio = × 100 = 60%.
6,000
Dividends to Cash Flow

‘Dividends to cash flow’ is more useful ratio than the payout ratio. It helps in understanding
the past trend in this regard and is greatly helpful in estimating, future dividends than the
conventional payout ratio.
Dividend paid on ordinary shares
Dividend to Cash Flow =
Net earnings available for ordinary shares
Price/Earnings (P/E) Ratio
It is the market price of shares expressed as a multiple of earnings per share.

Pr ice per ordinary share
Price Earnings (P/E) Ratio =
Earnings per share
Many investors consider P/E ratio as the best indicator of the ongoing performance of a
company. This ratio along with the payout ratio indicates the market estimates of future dividend
growth and risk. High growth shares have high P/E ratio, as investors are willing to pay a greater
multiple of current earnings to achieve a higher future growth. If high risk is found in a share,
it reduces its market price and hence automatically reduces its P/E ratio. Payout ratios can have
a positive influence on P/E Ratio. High P/Es are not always bad. If investors are willing to pay
a high price for a share in relations to its earnings, then they are doing so in the belief that the
company has a brighter future. That it will continue to strengthen and grow in future. Buying,

a share with a high P/E is described as being a security with a high multiple. It should be
understood here that the common share dividends come out of the earnings per share. Drop-in
earnings could mean that dividend is in troubles.
The elements that govern the P/E ratio are:
 Those factors that and fully reflected in the financial data (tangible factors) – Growth of
earnings and sales in the past; profitability or rate of returns on invested capital; stability of
past earnings; dividend rate and record, and financial strength or credit standing.
 Those factors that are reflected to an indefinite limit in the data (intangible factors) –
quality of management; nature and prospects of the industry, and competitive position and
individual prospects of the company.
Net Asset Value Per Share

This ratio is also known as book value per share. Net asset value per share is the value
of net tangible assets attributable to one ordinary share. Net asset value is, simply put, the
shareholders’ equity. Net asset value or book value has nothing, to do with the market value as
shares usually sell in the stock market at several times its net asset or book value.
Net Asset Value Per Share =
Ordinary share capital Re serves – Intan gibles

Number of ordinary shares outs tanding at balance sheet date
Net assets value applies to ordinary shares only. However, it does not mean that investors
can get that amount if the company is liquidated. The amounts attributable to the assets are only
attempts at fair and systematic evaluation, not at guessing what these assets would bring if sold
in the marketplace. Net asset or book value can be considered only as the theoretical value of
ordinary shares if the assets of the company were liquidated at the amounts attributed to them
on the balance sheet It is not usual for a share price to be very different from the net asset value
per share, even where assets in the balance share have recently been revaluated. In general,
earnings and the dividend paying potential of the company will influence the market price of a
share. Share prices will not be significantly influenced by the net asset value per share except
where:
 The company is an investment vehicle for specific types of assets (e.g., investment trusts,
property companies).
 It seems probable that the company will be liquidated.
 A takeover bid of the company seems likely.

The net asset value per share figure is useful while comparing shares of one company with
shares of other companies operating in the same industry. If it is found that a company is selling
shares at a much lower ratio of market price to book value, then other companies in the same
industry. If it is found that a company is selling shares at a much lower ratio of market price to
book value, then other companies in the same industry, it indicates a good investment opportunity.
When a share can be bought for less than its net asset value, it is an indication that share will
have good value in the future. In the stock market, it is often found that a share is selling, five
times, seven times (and more) than its book value. The lower the multiple, the greater will be
probable value of the share.
Cash Flow Per Share

Cash flow per share is useful indicator of a company’s general ability to leverage itself, to
pay dividends, to convert accounting earnings into cash and to enjoy financial flexibility.
Cash flow from operations after taxes
Cash Flow per Share =
Ordinary shares outs tan ding at balance sheet date
The amount of cash flow does not totally belong to ordinary shareholders, as the earnings
belong; it is meant to pay the expenses and claims prior to the payment of dividend.
Growth and Stability Analysis

Growth and stability ratios measure the performance and financial strength of a company
apart from market valuation. Stability ratios are useful in evaluating the quality of bonds, debentures,
preference shares, etc. These ratios are calculated over time and relate to sales, total returns,
and earnings per share. Such ratios are:
Sales in final period

1. Growth in sales =
Sales in base period
Net earned for total capital in final period
2. Growth in total return =
Net earned for total capital in base period
Earnings per share in final period
3. Growth in earnings =
Earnings per share in base period
Worst year (or lowest year)
4. Maximum decline in coverage of interest charges =
Average of previous three years
Normally, interest charges may include any of the following combinations:

 Interest on short and long-term debts, including capital leases
 Interest on expenses plus an interest component for operating leases

 Interest on expenses on short and long-term debts plus rentals on both capital and
operating bases
 Total fixed charges, rentals and preferred dividends.
5. Per cent decline in return on total capital =
6. Per cent decline in return on ordinary capital =
7. Percentage decline in earnings per share =
LIMITATIONS OF FINANCIAL RATIOS

Financial statement analysis through ratios is useful because they highlight relationships
between items in financial statements. However, they have a number of limitations which should
be kept in mind while preparing, or using them.
 Ratios are based on accounting figures given in financial statements. However, accounting
figures are themselves subject to deficiencies, approximations, and diversity in practice or
even manipulation to some extent. Therefore, ratios are not very helpful in drawing, reliable
conclusions.
 Ratios have an inherent problem of comparability. Companies otherwise similar may employ
different accounting methods, which can cause problem, in comparing certain key
relationships. For example, inventory turnover can be different for a company using FIFO
than the other company using, LIFO method of inventory valuation. Similarly, the differences
in accounting methods related to depreciation methods, estimates of the life of assets,
amortisation of intangibles and preliminary expenses, treatment of extraordinary items, etc.
can create the problem of comparability among, the companies even in the same industry.
 Inflation may limit the utility of accounting ratios. Due to inflation, historic cost-based financial
statements and accounting figures do not reflect current value figures, especially in the
case of assets purchased at different dates by the different enterprises. Since financial
statements are not adjusted in terms of inflation effect, accounting ratios calculated (using
varying costs or prices) have distortions and become defective. Sometimes, gains (reflected
through ratios) over time in sales, net income and other key figures disappear when the
accounting data are adjusted for change in price levels.
 Accounting ratios are not totally dependable and they must be used after giving due weightage
to general economic conditions, industry situation, position of firms within the industry,
mode of operations, size of firms, diversity of product which can make the business
enterprises completely dissimilar and thus, affect the computation of accounting ratios.

 The different methods of computation also influence the utility of accounting ratios. The
different concepts used for determining numerator and denominator in a particular accounting
ratio will not help in drawing reliable conclusions even in identical situations.
PRACTICAL PROBLEMS
Problem 1. The working capital of Herald Ltd. has deteriorated in recent years and
currently has the following status:
Current Assets Amount (`)
Inventory 5,60,000
Trade Receivables 3,50,000
Cash at Bank 70,000
9,80,000
Current Liabilities
Trade Payables 4,90,000
Outstanding Liabilities 2,10,000
7,00,000
(a) Compute the current ratio and quick ratio.
(b) An additional short-term bank loan of ` 50,000 is also under consideration. Calculate
revised current ratio and quick ratio assuming the loan is received.
(c) There is also a negotiation going on for discounting the debtors of `
3,50,000 for ` 3,15,000 a collection agency for immediate cash. Also, obsolete stocks
worth ` 1,25,000 are being sold for ` 80,000. Of the cash to be realised by the two
transactions, the current liabilities are to be reduced to ` 1,00,000, Calculate the
current ratio after these transactions are put through.
Solution:
Current Ratio Quick Ratio

Current Assets Liquid Assets (Debtors Cash) Trade Receivables
(a) = =
Current Liabilities Current Liabilities
9,80,000 4,20,000
= =
7,00,000 7,00,000
= 1.4 = 0.6

Current Assets Liquid Assets

(b) = =
Current Liabilities Current Liabilities
9,80,000 4,20,000
= =
7,50,000 7,50,000
= 1.3 = 0.6
(c) Revised Inventory = 5,60,000 – 1,25,000 = 4,35,000
Revised Trade Receivables = 3,50,000 – 3,50,000 = 0
Revised Cash = 70,000 + 3,15,000 + 80,000 – 1,10,000 = 3,55,000
Revised Current Assets = 4,35,000 + 0 + 3,55,000 = 7,90,000
Revised Current Liabilities = 4,90,000 + 1,00,000 = 5,90,000
New Current Ratio = = = 1.34
Problem 2. From the following accounts of New Era Ltd., you are required to calculate
the following ratios and comment on results:
(i) Gross Profit Percentage (ii) Net Profit Percentage
(iii) Return on Total Assets (iv) Quick Assets Ratio
(v) Debtors Collection Period (vi) Stock Turnover Ratio
(vii) Fixed Assets Turnover (viii) Return on Shareholders’ Funds
(ix) Current Ratio (x) Debt Ratio
Balance Sheet as at 31st March, 2017

Particulars (` '000) (` '000)
Equity and Liabilities
Share Capital:
Reserves and Surplus 450
Shareholders’ Funds 240 690
Non-current Liabilities:
Long-term Borrowings (12% Debentures) 700 700
Current Liabilities:
Trade Payables 620
Other Current Liabilities 45 665
Total 2,055

Assets (` '000) (` '000)

Non-current Assets:
Fixed Assets 875 875
Current Assets:
Inventories 310
Trade Receivables 770
Cash at Bank 100 1,180
Total 2,055
Extract from Statement of Profit and Loss:

(` '000)
Sales 31,00,000
Gross Profit 17,25,000
Expenses 8,05,000
Depreciation 2,50,000
Solution:
1725
Gross Profit Percentage = × 100% = 55.60%
3100
670
Net Profit Percentage = × 100% = 21.60%
3100
670
Return on Total Assets = × 100% = 32.60%
2055
870
Quick Assets Ratio = = 1.3 : 1
665
770
Debtors Collection Period = × 365 = 91 Days
3100
3100
Stock Turnover Ratio = = 10 Times
310
3100
Fixed Assets Turnover = = 3.5 Times
875
586
Return on Shareholders’ Funds = × 100% = 84.90%
690
1100
Current Ratio = = 1.8 : 1
665
1365
Debt Ratio = × 100% = 66.40%
2055

Very few ratios have an absolute value but they are used in a relative way in intra- and inter-
firm comparisons. Both gross and net margins are calculated using the profit before tax and interest
to identify the trading profit, irrespective of the capital structure in force. Both these figures seem
satisfactory but knowledge of the industry is necessary. Also, the returns on shareholders’ funds
and on total assets both appear quite satisfactory.
The quick ratio exceeds the 1 : 1 norm and the current ratio is near the 2 : 1 norm, but
this requirement varies widely. On the other hand, the debt ratio seems high, as two-thirds of all
assets are financed by debt.
Assets turnover ratio also need comparisons to make judgement but the debtor collection
period of 91 days would seem too long for most industries, especially if credit is granted on a
net monthly basis.
Problem 3. Angel Company’s financial statements provide the following information:
2015-16 (` ) 2016-17 (` )
Short-term investments 2,00,000 3,20,000
Trade receivables 3,20,000 4,00,000
Cash and cash equivalents 2,00,000 1,60,000
Prepaid expenses 28,000 12,000
Inventories 18,40,000 21,60,000
Total current assets 25,88,000 30,52,000
Total fixed assets 56,00,000 64,00,000
Current liabilities 6,40,000 8,00,000
Long-term borrowings 16,00,000 16,00,000
Share capital 20,00,000 20,00,000
Reserves and surplus 4,68,000 8,12,000
Statement of Profit and Loss for the Current Year
Particulars (` '000)
Revenue from Operations 40,00,000
Total Revenue 40,00,000
Expenses:
Cost of Goods Sold 28,00,000
Finance Costs 1,60,000
Total Expenses 29,60,000

Profit/(Loss) before Tax 10,40,000

Tax Expense @ 50% 5,20,000
Profit/(Loss) from Continuing Operations (After Tax) 2,60,000
From the above information, analyse the company’s position from Liquidity, Profitability and
Activity point of view.
Solution:
Liquidity Ratios
Current Ratio = = = 3.81:1
Quick Assets 30,52,000
Quick Assets Ratio = = = 1.1:1
Activity Ratios
Sales 40,00,000
Debtors Turnover Ratio = = = 11.1 Times
Average Debtors 3,60,000
Stock Turnover Ratio = = = 1.4 Times
Average Stock 20,00,000
Sales 40,00,000
Total Assets Turnover Ratio = = = 0.67 Times
Average Assets 60,00,000
Profitability Ratio
Gross Profit 12,00,000

Gross Profit Ratio = × 100 = × 100 = 30%
Sales 40,00,000
Net Pr ofit 5,20,000

Net Profit Ratio = × 100 = × 100 = 13%
Sales 40,00,000
Pr ofit Before Interest and Tax
Return on Investment = × 100
Capital Employed
12,00,000
= × 100 = 27.20%
100
Pr ofit after Interest and Tax
Return on Shareholders’ Funds = × 100
Shareholders' Funds
5,20,000
= × 100 = 18.50%
28,12,000

On the basis of the above ratios, it can be said that the firm’s position is sound from the
point of view of liquidity and profitability. However, activity ratios do not present a profitable
position. Better position will be reflected after inter-firm comparison.
Problem 4. Financial Statement Extracts of Om Company are given below:
2016-17 (`in lakhs)
Share Capital 250
General Reserve 280
Surplus (Current Year) 10
Long-term Borrowings 300
Short-term Borrowings 360
Trade Payables 150
Other Current Liabilities 30
Fixed Assets 400
Non-current Investments 50
Trade Receivables 460
Cash and Cash Equivalents 460
Additional information:
 From the Surplus Account, ` 90 lakhs were transferred to General Reserve during the
year.
 Interest cost amounted to ` 120 lakhs.
 Taxation @ 50%.
 You are required to calculate:
o Debt-Equity Ratio
o Current Ratio
o Interest Coverage Ratio
Solution:
Long term Debt 300 300

Debt-Equity Ratio = = = = 0.56
Equity Shareholders Funds 250 280 10 540
Current Assets 460 460 10 930
Current Ratio = = = = 1.72
Current Liabilities 360 150 10 540
EBIT[PAT(1 t) Intt] (10 90) / (1 0.5) 120 320
Interest Coverage Ratio = = =
Interest 120 120
= 2.67

Problem 5. Calculate P/E Ratio from following information:

2016-17
Equity share capital @ ` 20 each 50,00,000
General reserve 5,00,000
Secured borrowings @ 15% 25,00,000
Unsecured borrowings @ 12.5% 10,00,000
Fixed assets 30,00,000
Investments 5,00,000
Operating profit 25,00,000
Income tax rate 50%
Market price per share ` 50
Solution:
Operating Profit 25,00,000
Less: Interest
Secured Borrowings @ 15% (25,00,000) (3,75,000)
Unsecured Borrowings @ 12.5% (10,00,000) (1,25,000)
Profit before Tax 20,00,000
Less: Income Tax @ 50% (10,00,000)
Profit after Tax 10,00,000
Number of Equity Shares 2,50,000
EPS = = = ` 4
No. of Equity Shares 2,50,000
Market price per share 50
P/E Ratio = = = 12.50 : 1
EPS 4
Problem 6. Following are the extracts from Balance Sheet of Benny Jay Ltd. as on 31st
March, 2017:
`
Equity share capital (5,00,000 @ ` 10 each) 50,00,000
9% Preference share capital (50,000 @ ` 100 each) 50,00,000
Capital reserve 5,00,000
Debenture redemption fund 15,00,000

Bank overdraft 85,00,000

Trade payables 25,00,000
Other current liabilities 15,00,000
Land 4,00,000
Building 21,00,000
Plant and machinery 1,19,00,000
Furniture and fittings 1,50,000
Office cars 1,50,000
Inventories 1,50,00,000
Trade receivables 6,00,000
Cash and cash equivalents 2,00,000
Compute the following:
(a) Net Worth (b) Total Value of Equity
(c) Shareholders’ Reserves (d) Total Fixed Assets
(e) Total Current Assets (f) Working Capital
(g) Long-term Liabilities
Solution;
(a) Net Worth: It can be calculated from either assets or liabilities side.
Equity share capital (5,00,000 @ ` 10 each) 50,00,000
Net Worth from Liabilities Approach 1,30,00,000
Land 4,00,000
Building 21,00,000


Total Assets 3,05,00,000
Less:
Bank Overdraft 85,00,000
Net Worth from Assets Approach 1,30,00,000
(b) Total Value of Equity
Net Worth 1,30,000
Less:
Total value of Equity 80,00,000
(c) Shareholders’ Reserves
Shareholders’ reserves 30,00,000
(a) Total Fixed Assets
Land 4,00,000
Building 21,00,000
Total Fixed Assets 1,47,00,000
(b) Total Current Assets
Total Current Assets 1,58,00,000

(c) Working Capital

Total Current Assets 1,58,00,000
Less: Current liabilities
Bank overdraft 85,00,000
Working Capital 33,00,000
(d) Long-term Liabilities
Long-term liabilities 50,00,000
Problem 7. Calculate and comment upon the rate of return on total assets from the data
about the following two companies:
X Ltd (`) Y Ltd. (`)
Sales – 2,52,75,000
Total Assets 42,50,000 –
Net Profit in Sales 6% 4%
Turnover of Assets 6 times 6 times
Gross Margin 20,68,000 12%
Solution:
Sales = 42,50,000 × 6
= 2,55,00,000 = 2,52,75,000
Total Assets = 2,52,75,000 ¸ 6
= 42,50,000 = 42,12,500
Net Profit in Sales 6% of 2,55,00,000 4% of 2,52,75,000
= 15,30,000 = 10,11,000
Rate of Return on Total Assets = 15,30,000 ¸ 42,50,000 = 10,11,000 ¸ 42,50,000
= 36% = 24%
Problem 8. The following are the ratios relating to activities of Bentota Ltd.:
Debtors Velocity 3 Months
Stock Velocity 8 Months
Creditors Velocity 2 Months
Gross Profit Ratio 25%

Gross profit for the current year ended 31ST March 2017 amounted to ` 8,00,000. Closing
stock of the year is ` 30,000 above the opening stock. Bills receivables amounted to ` 50,000
and bills payables to ` 10,000 Find out:
 Sales (all credit basis)  Sundry Debtors
 Closing Stock  Sundry Creditors
Solution:
Sales (all credit basis) Gross Profit

(a) = = × 100
Gross Profit Ratio Sales
8,00,000
25 = × 100
Sales
Sales = ` 32,00,000
Sundry Debtors Credit Sales
(b) Debtors Turnover Ratio
=
Closing Debtors Bills Receivables
32,00,000
4 = Closing Debtors 50,000
Closing Debtors = ` 7,50,000

Note: Debtors velocity of 3 months implies that debtor turnover ratio will be 4 (12/3).
(c) Closing Stock

Cost of Goods Sold
Stock Turnover Ratio =
Average Stock
24,00,000 (32,00,000 – 8,00,000)
15 = Average Stock
Average Stock = ` 16,00,000

Opening Stock Clo sing Stock
= 16,00,000
2
Closing Stock + Opening Stock = 32,00,000
Closing Stock – Opening Stock = 30,000
Closing Stock = ` 16,15,000
Opening Stock = ` 15,85,000
Note: Stock velocity of 8 months implies that Stock turnover ratio will be 1.5 (12/8).

(d) Sundry Creditors

Credit Purchases
Creditors Turnover Ratio = Closing Creditors Bills Payables
24,30,000
6 = Closing Creditors 10,000
Closing Creditors = ` 3,95,000
Note: Creditors velocity of 2 months implies that Creditors turnover ratio will be 6 (12/2).
Credit Purchases have been calculated as follows:
Cost of Goods Sold = Opening Stock + Purchases (assumed all on credit basis) — Closing
Stock
24,00,000 = 15,85,000 + Purchases – 16,15,000
Purchases = ` 24,30,000
Problem 9. The capital of Era Co. Ltd is as follows:
Equity Share capital (1,60,000 @ ` 10 each) 16,00,000
9% Preference Share capital (6,000 @ ` 100 each) 6,00,000
22,00,000
The accountant has ascertained following information:
Profit (after tax at 30%) ` 5,40,000
Depreciation ` 12,000
Equity Dividend Paid 30%
Market Price of equity share ` 80
You are required to calculate:
(a) Dividend Yield on equity shares
(b) Cover for the preference and equity dividends
(c) Earnings for Equity Shares
(d) Price-earnings ratio
Solution:
Dividend per share 3(30% of 10)

Dividend Yield on equity shares = =
= 3.75

Pr ofit after tax

Cover for preference dividends =
Dividend payable to preference shareholders
5,40,000
= = 10 times
54,000
Pr ofit after tax – Pr eference Dividends
Cover for equity dividends =
Dividend Payable to equity shareholders
5,40,000 – 54,000
= = 1.1025 times
1,60,000 3
Earnings available to equity shareholders
Earnings for equity shares =
Number of equity shares outs tanding
4,86,000
= = ` 3.04 per share
1,60,000
Price-earnings ratio = = = 26.32 times
Earnings per share 3.04
Problem 10. With the help of the following ratios of Indu Films, calculate current liabilities,
inventories, trade receivables, cash, fixed assets and current assets.
Current Ratio 2.5
Liquidity Ratio 1.5
Net Working Capital ` 3,00,000
Stock Turnover Ratio (cost of sales/ closing stock) 6 times
Gross Profit Ratio 20 percent
Fixed Assets Turnover Ratio (on cost of sales) 2 times
Debt Collection Period 2 months
Fixed Assets to Shareholders’ Net Worth 0.80
Solution:
Net Working Capital = Current Assets – Current Liabilities

Current assets
Current Ratio = = 2.5
Current Liabilities
Current Assets = 2.5 Current Liabilities
Hence,
Net Working Capital = 2.5 Current Liabilities – Current Liabilities
3,00,000 = 1.5 Current Liabilities

Current Assets = 2.5 Current Liabilities

= 5,00,000
Liquid assets
Liquid assets ratio = = 1.5
Current Liabilities
Liquid Assets = 3,00,000
Inventories = Current Assets – Liquid Assets
= 5,00,000 – 3,00,000 = ` 2,00,000
Stock turnover ratio = 6 times (cost of sales/closing stock)
Cost of sales = 6 × 2,00,000 = ` 12,00,000
Sales = 12,00,000 + (12,00,000 × 20/80)
= ` 15,00,000
Debtors Turnover = Sales/Closing Debtors
12/12 (Debt Collection Period) = 15,00,000/Closing Debtors
Closing Debtors = ` 2,50,000
Cash = Current Assets – Stock – Debtors
= ` 50,000
Fixed Assets Turnover Ratio (on cost of sales) = 2 times
Cost of Sales/Fixed Assets = 2
Fixed Assets = 12,00,000/2 = ` 6,00,000
Problem 11. Calculate current assets, liquid assets, current liabilities and stock from the
followim information:
Current Ratio 2.6
Liquidity Ratio 1.4
Net Working Capital ` 3,30,000
Solution:
Calculation of Current Assets and Current Liabilities:
Working Capital = Current Assets – Current Liabilities
Current Assets
Current Ratio = = 2.6 : 1
Current Liabilities
Working Capital = Current Assets – Current Liabilities
Working Capital = 2.6 Current Liabilities – Current Liabilities = 1.6 Current Liabilities

Working Capital (Given) = 3,30,000

1.6 Current Liabilities = 3,30,000
Current Liabilities = ` 2,06,250
Current Assets = 2.6 × ` 2,06,250 = ` 5,36,250
Calculation of Liquid Assets:
Liquid Ratio (Given) = 1.4
Liquid Assets
Liquid Ratio =
Current Liabilities
Liquid Assets = 2,06,250 × 1.4 = ` 2,88,750
Liquid Assets = Current Assets – (Stock + Prepaid Expenses)
Stock = Current Assets – Liquid Assets (Assuming nil prepaid expenses)
= ` 2,47,500
Problem 12. From the following information given below, you are required to calculate
Operating Profit Ratio:
`
Gross Sales 11,70,000
Sales Return 90,000
Opening Stock 45,000
Closing Stock 54,000
Purchases 7,38,000
Office and Administrative Expenses 90,000
Selling and Distribution Expenses 72,000
Solution:
Operating Pr ofit
Operating Profit Ratio = × 100
Net Sales
Operating Profit = Net Sales – Total Operating Cost
Net Sales = Gross Sales – Sales Return
= 11,70,000 – 90,000 = ` 10,80,000
Total Operating Cost = Cost of Goods Sold + Office and Administrative
Expenses + Selling and Distribution Expenses

Cost of Goods Sold = Opening Stock + Purchase – Closing Stock

= 45,000 + 7,38,000 – 54,000 = ` 7,29,000
Total Operating Expenses = 7,29,000 + 90,000 + 72,000 = ` 8,91,000
Operating Profit = Net Sales – Total Operating Expenses
= 10,80,000 – 8,91,000 = ` 1,89,000
1,89,000
Operating Profit Ratio = × 100 = 17.5%
10,80,000
Problem 13. Calculate Return on Shareholders’ Investment Ratio from the following
information :
`
5,000 Equity shares @ of ` 100 each 5,00,000
20,000, 15% preference share @ of ` 50 each 10,00,000
Net Profit before Interest and Tax 5,00,000
Interest on Loan 1,00,000
Taxes 15,000
Solution:
Profit after int erest and tax
Return on Shareholders’ Investment = × 100
Capital Employed
Shareholders’ Investment = Equity Share Capital + Preference Share
Capital + Reserves and Surplus –
Accumulated Losses
= 5,00,000 + 10,00,000 + 2,50,000
= ` 17,50,000
Net Profit after Interest and Taxes = Net Profit before Interest and Tax –
Interest on Loan – Taxes
= 5,00,000 – 1,00,000 – 15,000
= 2,50,000
2,50,000
Return on Shareholders' Investment = × 100 = 14.28%
17,50,000

Problem 14. Compute:

(a) Earnings per share
(b) Dividend Yield Ratio (when dividend payout is not given)
(c) Price Earnings Ratio from the following information:
Net profit before tax ` 9,00,000
Market Price Per Equity Share ` 95
Number of Equity Shares 90,000
Provision for Tax ` 1,50,000
Preference Dividend ` 90,000
Solution:
Earnings available to equity shareholders
Earnings for equity shares =
Number of equity shares outs tanding
6,60,000
=
90,000
= ` 7.33 per share

Dividend yield on equity shares = = = 7.716%
Price-earnings ratio = = × 100
= 12.96 times
8.4 Concept
A cash flow statement discloses net increase (or decrease) in cash during an accounting period.
As per AS-3 (Revised), the objective of cash flow statement is to provide information about cash
flows of an enterprise which is useful in providing the users of financial statements a basis to assess
the ability of an enterprise to generate cash and cash equivalents to utilise those cash flows. The
statement deals with the provisions of information about the changes in cash and cash equivalents
during the accounting year. It classifies cash flows into operating, investing and financing activities.
It is significant to note that AS-3 is titled ‘Cash Flow Statement’ whereas Ind AS-7, issued in
February 2015, is titled ‘Statement of Cash Flows’. However, contents of both the standards are
almost identical.

8.5 Definitions in Ind AS-7 ‘Statement of Cash Flow’

The following terms are used in this Statement with the meanings specified:
Cash comprises cash on hand and demand deposits with banks.
Cash equivalents are 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.
Cash flows are inflows and outflows of cash and cash equivalents.
Operating activities are the principal revenue-producing activities of the enterprise and other
activities that are not investing or financing activities.
Investing activities are the acquisition and disposal of long-term assets and other investments
not included in cash equivalents.
Financing activities are activities that result in changes in the size and composition of the
owners’ capital (including preference share capital in the case of a company) and borrowings of the
enterprise.
Cash and Cash Equivalents

1. Cash equivalents are held for the purpose of meeting short-term cash commitments rather
than for investment or other purposes. For an investment to qualify as a cash equivalent, it must be
readily convertible to a known amount of cash and be subject to an insignificant risk of changes in
value. Therefore, an investment normally qualifies as a cash equivalent 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 substance, cash equivalents; for example, preference
shares of a company acquired shortly before their specified redemption date (provided there is only
an insignificant risk of failure of the company to repay the amount at maturity)
2. Cash flows exclude movements between items that constitute cash or cash equivalents
because these components are part of the cash management of an enterprise rather than part of its
operating, investing and financing activities. Cash management includes the investment of excess
cash in cash equivalents.
Classification of Cash Inflows and Outflows

A cash flow statement focuses on various activities and items which bring about changes in the
cash balance between two balance sheet dates. This statement covers all items which increase or
decrease the cash of a business enterprise. For example, this statement includes items like receipts
from debtors and payments to creditors. On the contrary, this statement will not cover items which
have no immediate effect on cash increase or decrease. For instance, goods purchased on credit
and goods sold on credit will not be included in this statement as these transactions have no effect on
inflow and outflow of cash.
A cash flow statement aims to determine the effects on cash of different types of cash inflows
and outflows. In this process, all cash flows, i.e., activities resulting into cash flows are classified
into different categories. The ICAI’s AS-3 ‘Cash Flow Statement’ has classified cash flows into
three categories:
I. Operating Activities (or Flows)
II. Investing Activities (or Flows)
III. Financial Activities (or Flows)
Figure 8.1 displays the classification of cash inflows and cash outflows relating to operating
activities, investing activities and financing activities.
Activities
Cash Inflows
Cash Outflows
Cash payments for goods and services,
Cash received from debtors for goods and
merchandise
services
Cash payments for wages
Interest and dividends on loans and Operating
investment Activities
Cash payments for interest to creditors
Payments to government for taxes
Payments to others for expenses
Cash sales of property, plant, equipment,

other long-term assets, and intangibles Purchase of shares, debentures and
securities of other enterprises
Cash sales of investments in shares,
Investing
debentures and other securities Purchase of property, plant, equipment and
Activities
other long-term assets
Cash collection (loan repayments)
from borrowers
Loans given to other firms
Repayment of loans
Proceeds from issue of shares

Financing Payment to owners, including cash dividend
Activities
Proceeds from short-term and long-term debt
Reacquiring preference or equity shares
Figure 8.1: Classification of Cash Inflows and Outflows Relating to Operating

Activities, Investing Activities and Financing Activities

I. Operating Activities: Operating activities are those transactions which are considered in the
determination of net income. Examples of cash inflows in this category are cash received from
debtors for goods and services, interest and dividend received on loans and investment. Examples of
cash outflows in this category are cash payments for goods and services, merchandise, wages,
interest, taxes, supplies and others.
Classification of Cash Inflows and Cash Outflows:
AS-3 Cash Flow Statement states:
(i) The amount of cash flows arising from operating activities is a key indicator of the extent
to which the operations of the enterprise have generated sufficient cash flows to maintain
the operating capability of the enterprise, pay dividends, repay loans and make new
investments without recourse to external source of financing. Information about the specific
components of historical operating cash flows is useful, in conjunction with other information,
in forecasting future operating cash flows.
(ii) Cash flows from operating activities are primarily derived from the principal revenue
producing activities of the enterprise. Therefore, they generally result from the transactions
and other events that enter into the determination of net profit or loss. Examples of cash
flows from operating activities are:
(a) cash receipts from the sale of goods and the rendering of services;
(b) cash receipts from royalties, fees, commissions and other revenue;
(c) cash payments to suppliers for goods and services;
(d) cash payments to and on behalf of employees;
(e) cash receipts and cash payments of an insurance enterprise for premiums and claims,
annuities and other policy benefits;
(f) cash payments or refunds of income taxes, unless they can be specifically identified
with financing and investing activities; and
(g) cash receipts and payments relating to future contracts, forward contracts, option
contracts and swap contracts when the contracts are held for dealing or trading purposes.
(iii) Some transactions, such as the sale of an item of plant, may give rise to a gain or loss which
is included in the determination of net profit or loss. However, the cash flows relating to
such transactions are cash flows from investing activities.
(iv) Cash flows from operating activities are determined according to the activities relating to the
business in which the enterprise deals in, e.g., interest and dividend received by financial
institutions will be treated as operating cash flow.

Similarly, an enterprise may hold securities and loans for dealing or trading purposes, in which
case they are similar to inventory acquired specifically for resale. Therefore, cash flows arising
from the purchase and sale of dealing or trading securities are classified as operating activities. In
the same manner, cash advances and loans made by finance enterprises are usually classified as
operating activities since they relate to the main revenue-producing activity of that enterprise.
Operating ActiviteisInd AS-7 provides the following on reporting cash flows from operating
activities:
1. An entity shall report cash flows from operating activities using either:
(a) the direct method, whereby major classes of gross cash receipts and gross cash payments
are disclosed; or
(b) the indirect method, whereby profit or loss is adjusted for the effects of transactions of
a non-cash nature, any deferrals or accruals of past or future operating cash receipts
or payments, and items of income or expense associated with investing or financing
cash flows.
2. Entities are encouraged to report cash flows from operating activities using the direct
method. The direct method provides information which may be useful in estimating future
cash flows and which is not available under the indirect method. Under the direct method,
information about major classes of gross cash receipts and gross cash payments may be
obtained either:
(a) from the accounting records of the entity; or
(b) by adjusting sales, cost of sales (interest and similar income and interest expense and
similar charges for a financial institution) and other items in the statement of profit and
loss for:
(i) changes during the period in inventories and operating receivables and payables;
(ii) other non-cash items; and
(iii) other items for which the cash effects are investing or financing cash flows.
3. Under the indirect method, the net cash flow from operating activities is determined by
adjusting profit or loss for the effects of:
(a) changes during the period in inventories and operating receivables and payables;
(b) non-cash items such as depreciation, provisions, deferred taxes, unrealised foreign
currency gains and losses, and undistributed profits of associates; and
(c) all other items for which the cash effects are investing or financing cash flows.

Alternatively, the net cash flow from operating activities may be presented under the indirect
method by showing the revenues and expenses disclosed in the statement of profit and loss and the
changes during the period in inventories and operating receivables and payables.
II. Investing Activities: Investing activities include acquisition of long-term or fixed assets;
disposal of long-term or fixed assets; acquisition and disposal of intangible assets; purchase and sale
of shares, debentures and other securities; lending of money and its subsequent collection. Cash
inflows from investing activities generally include cash sales of property, plant, equipment and
intangible assets, cash sales of investments in shares, debentures and other securities, cash collection
(loan repayments) from borrowers. Cash outflows are purchase of shares, debentures and securities
of other enterprises, purchase of property, plant, equipment and other long-term assets, loan given to
other firms.
According to AS-3 Cash Flow Statement:
(i) The separate disclosure of cash flows arising from investing activities is important because
the cash flows represent the extent to which expenditures have been made for resources
intended to generate future income and cash flows. Examples of cash flows arising from
investing activities are:
(a) Cash payments to acquire fixed assets (including intangibles). These payments include
those relating to capitalised research and development costs and self constructed fixed
assets;
(b) Cash receipts from disposal of fixed assets (including intangibles);
(c) Cash payments to acquire shares warrants or debt instruments of other enterprises
and interests in joint ventures (other than payments for those instruments considered to
be cash equivalents and those held for dealing or trading purposes);
(d) Cash receipts from disposal of shares, warrants or debt instruments of other enterprises
and interests in joint ventures (other than receipts from those instruments considered to
be cash equivalents and those held for dealing or trading purposes);
(e) Cash advances and loans made to third parties (other than advances and loans made
by a financial enterprise);
(f) Cash receipts from the repayment of advances and loans made to third parties (other
than advances and loans of a financial enterprise);
(g) Cash payments from future contracts, forward contracts, option contracts and swap
contracts except when the contracts are held for dealing or trading purposes, or the
payments are classified as financing activities; and

(h) Cash receipts from future contracts, forward contracts, option contracts and swap
contracts except when the contracts are held for dealing or trading purposes, or the
receipts are classified as financing activities.
(ii) When a contract is accounted for as a hedge of an identifiable position, the cash flows of
the contract are classified in the same manner as the cash flow of the position being
hedged.
III. Financing Activities: Financing activities relate to long-term liability and equity capital. A
firm engages in financing activities when it obtains resources from owners, returns resources to
owners, borrows resources from creditors and repays amounts borrowed. Cash inflows include
proceeds from issue of shares and short-term and long-term borrowings. Cash outflows include
repayment of loans and payments to owners, including cash dividends. Repayments of accounts
payable or accrued liabilities are not considered repayment of loans under financing activities but
are classified as cash outflows under operating activities.
AS-3 Cash Flow Statement observes:
The separate disclosure of cash flows arising from financing activities is important because it
is useful in predicting claims on future cash flows by providers of funds (both capital and borrowings)
to the enterprise. Examples of cash flows arising from financing activities are:
(a) cash proceeds from issuing shares or other similar instruments;
(b) cash proceeds from issuing debentures, loans, notes, bonds, and other short- or long-term
borrowings; and
(c) cash repayments of amounts borrowed.
Provisions of AS-3 on Treatment of Certain Items
1. Interest and Dividend
Cash flows from interest and dividends received and paid should be disclosed separately and
classified on the basis of nature of the enterprise as shown below:
For Financial Enterprises
• Interest paid and received, dividend received as operating activities.
• Dividend paid as financing activities.
For Other Enterprises
• Interest and dividend received as investing activities.
• Interest and dividend paid as financing activities.

2. Extraordinary items
The cash flows associated with extraordinary items should be classified as arising from operating,
investing or financing activities as appropriate. It should be disclosed separately. Few examples of
such items are:
(i) Claim for loss of Stock — Operating activity
(ii) Claims for loss of assets — Investing activity
(iii) Recovery of bad debts — Operating activity
(iv) Damages paid/received for breach of contract — Operating activity
(v) Winnings from lotteries — Investing activity
(vi) Cost of legal action to protect property title — Investing activity.
3. Taxes on Income
Cash flows arising from taxes on income should be separately disclosed and should be classified
as cash flows from operating activities unless they can be specifically identified with financing and
investing activities. For instance:
(i) Provision for taxation for the current year — Non-cash charge under operating activity
(ii) Tax paid — Operating cash outflow
(iii) Income tax refund — Cash inflow from operating activity
(iv) Capital gains tax — Cash outflow from investing activity
(v) Corporate dividend tax — Cash outflow from financing activity.
4. Foreign Currency Cash Flows
Foreign currency cash flows should be converted at the exchange rate of the date of cash
flow. Exchange gain/loss on cash and cash equivalents held in foreign currency will be reported as
part of reconciliation of change in cash and cash equivalents for the period and hence, not reported
in cash flow statement.
5. Non-cash Transactions
Investing and financing transactions that do not require the use of cash or cash equivalents are
not shown in the cash flow statement. Examples of such non cash transactions are:
(i) Issue of shares or debentures for a consideration other than cash, i.e., against building,
machinery, etc.
(ii) Conversion of debentures into equity shares.
(iii) Purchase of business by issue of shares.

AS-3 (Revised) recommends that such transactions may be disclosed under footnote to cash
flow statement.
6. Investments in Subsidiaries, Associates and Joint Venture
Acquisition of interest in any subsidiary, associates or in any joint venture is treated as ‘Investing
Activity”. Similarly, sale or disposal of such interest and receipt of interest or dividends on such
investments is treated as “Investing Activity”.
8.6 Presentation of Cash Flow Statement

A cash flow statement can be presented in either the direct or indirect format. The investing
and financing sections will be the same under either format. However, the operating section will be
different.
ABC Company
for the Year Ended 31st December, 2016
Particulars ` `
(A) Cash Flow from Operating Activities
Cash Receipts from:
Sales
Interest Received
Cash Payments for:
Purchases
Operating Expenses
Interest Payments
Income Taxes
Net Cash Flow from Operating Activities
(B) Cash Flows from Investing Activities:
Sale of Plant Assets
Sale of Investments
Purchase of Plant Assets
Purchase of Investments
Net Cash Flows Used by Investing Activities
(C) Cash Flows from Financing Activities:
Repayment of Bonds and Debentures
Issue of Common Shares
Dividends Paid
Net Cash Flows from Financing Activities
Net Increase (Decrease) in Cash
Figure 8.3: Cash Flow Statement (Direct Method)
ABC Company
for the Year Ended 31st December, 2016
Particulars ` `
(A) Cash Flow from Operating Activities
Net Income
Adjustments to Reconcile Net Income to Net
Cash provided by Operating Activities:
Depreciation
Gain on Sale of Investments
Loss on Sale of Plant Asset
Decrease in Accounts Receivable
Increase in Inventory
Decrease in Prepaid Expenses
Increase in Accounts Payable
Increase in Accrued Liabilities
Decrease in Income Taxes Payable
Net Cash Flow from Operating Activities
(B) Cash Flows from Investing Activities:
Sale of Plant Assets
Sale of Investments
Purchase of Plant Assets
Purchase of Investments
Net Cash Flows Used by Investing Activities
(C) Cash Flows from Financing Activities:
Repayment of Bonds and Debentures
Issue of Common Shares
Dividends Paid
Net Cash Flows from Financing Activities
Net Increase (Decrease) in Cash
Figure 8.4: Cash Flow Statement (Indirect Method)
8.7 Steps in Preparing the Cash Flow Statement

The preparation of the cash flow statement uses data from both the income statement and the
comparative balance sheets.
As noted earlier, companies often only disclose indirect operating cash flow information, whereas
analysts prefer direct—format information. Understanding how cash flow information is put together
will enable you to take an indirect statement apart and reconfigure it in a more useful manner. The
result is an approximation of a direct cash flow statement, which—while not perfectly accurate—
can be helpful to an analyst. The following demonstrates how direct cash flow statement is prepared
using the income statement and the comparative balance sheets for ABC Company, a fictitious
company, shown here in Fig. 8.5 and Fig. 8.6.

ABC Company Income Statement

for the Year Ended 31 December 2016
Particulars ` `
Revenue ` 23,598
Cost of goods sold 11,456
Gross profit 12,142
Salary and wage expense ` 4,123
Depreciation expense 1,052
Other operating expenses 3,577
Total operating expenses 8,752
Operating profit 3,390
Other revenues (expenses):
Gain on sale of equipment 205
Interest expense (246) (41)
Income before tax 3,349
Income tax expense 1,139
Net income ` 2,210
Figure 8.5
ABC Company Comparative Balance Sheets
31 December 2016 and 2015
Particulars 2016 2015 Net Change

Cash ` 1,011 ` 1,163 ` (152)
Accounts receivable 1,012 957 55
Inventory 3,984 3,277 707
Prepaid expenses 155 178 (23)
Total current assets 6,162 5,575 587
Land 510 510 _
Buildings 3,680 3,680 _
Equipment* 8,798 8,555 243
Less: Accumulated depreciation (3,443) (2,891) (552)
Total long-term assets 9,545 9,854 (309)
Total assets ` 15,707 ` 15,429 ` 278
Accounts payable ` 3,588 ` 3,325 ` 263
Salary and wage payable 85 75 10

Interest payable 62 74 (12)

Income tax payable 55 50 5
Other accrued liabilities 1,126 1,104 22
Total current liabilities 4,916 4,628 288
Long-term debt 3,075 3,575 (500)
Common equity 3,750 4,350 (600)
Retained earnings 3,966 2,876 1,090
Total liabilities and equity ` 15,707 ` 15,429 ` 278
Figure 8.6
*During 2016 the company purchased new equipment for a total cost of ` 1,300. No Items
impacted retained earnings other than net income and dividends.
Solution:
The first step in preparing the cash flow statement is to determine the total cash flows from
operating activities. The direct method of presenting cash from operating activities is illustrated
below. Further is given the indirect method of presenting cash flows from operating activities. Cash
flows from investing activities and from financing activities are identical under either method.
Operating Activities: Direct Method
We first determine how much cash ABC received from its customers, followed by how much
cash was paid to suppliers and to employees as well as how much cash was paid for other operating
expenses, interest, and income taxes.
Cash Received from Customers: The income statement reported revenue of ` 23,598 for
the year ended 31st December, 2016. To determine the approximate cash receipts from its customers,
it is necessary to adjust this revenue amount by the net change in accounts receivable for the year.
If accounts receivable increase during the year, revenue on an accrual basis is higher than cash
receipts from customers, and vice versa. For ABC Company, accounts receivable increased by
` 55, so cash received from customers was ` 23,543, as follows:
Revenue ` 23,598
Less: Increase in accounts receivable (55)
Cash received from customers ` 23,543

Cash received from customers affects the accounts receivable account as follows:
Beginning accounts receivable ` 957
Plus revenue 23,598
Minus cash collected from customers (23,543)
Ending accounts receivable ` 1,012
The accounts receivable account information can also be presented as follows:
Beginning accounts receivable ` 957
Plus revenue 23,598
Minus ending accounts receivable (1,012)
Cash collected from customers ` 23,543
Cash received from customers” is sometimes referred to as “cash collections front customers”
or “cash collections.”
Cash Paid to Suppliers: For ABC Co., the cash paid to suppliers was ` 11,900, determined as
follows:
Cost of goods sold ` 11,456
Plus: Increase in inventory 707
Equals purchases from suppliers ` 12,163
Less: Increase in accounts payable (263)
Cash paid to suppliers ` 11,900
There are two pieces to this calculation: the amount of inventory purchased and the amount
paid for it. To determine purchases from suppliers, cost of goods sold is adjusted for the change in
inventory. If inventory increased during the year, then purchases during the year exceeded cost of
goods sold, and vice versa. The company reported cost of goods sold of ` 11,456 for the year ended
31st December 2016. Inventory increased by ` 707. So, purchases from suppliers was ` 12,163.
Purchases from suppliers affect the inventory account, as shown below:
Beginning inventory ` 3,277

Plus purchases 12,163
Minus cost of goods sold (11,456)
Ending inventory ` 3,984

The company purchased ` 12,163 of inventory from suppliers in 2016 but is this the amount of
cash that was paid to its suppliers during the year? Not necessarily. The company may not have yet
paid for all of these purchases and may yet owe for some of the purchases made this year. In other
words, the company may have paid less cash to its suppliers than the amount of this year’s purchases,
in which case liability (accounts payable) will have increased by the difference. Alternatively, the
company may have paid even more to its suppliers than the amount of this year’s purchases, in
which case accounts payable will have decreased.
Therefore, once purchases have been determined, cash paid to suppliers can be calculated by
adjusting purchases for the change in accounts payable. If the company made all purchases with
cash, then accounts payable would not change and cash outflows would equal purchases. If accounts
payable increased during the year, then purchases on an accrual basis would be higher than they
would be on a cash basis, and vice versa. In this example, the company made more purchases than
it paid in cash. So, the balance in accounts payable increased. The cash paid to suppliers was
` 11,900, determined as follows:
Purchases from suppliers ` 12,163

Less: Increase in accounts payable (263)
Cash paid to suppliers ` 11,900
The amount of cash paid to suppliers is reflected in the accounts payable account, as shown
below:
Beginning accounts payable ` 3,325
Plus purchases 12,163
Minus cash paid to suppliers (11,900)
Ending accounts payable ` 3,588
Cash Paid to Employees: To determine the cash paid to employees, it is necessary to adjust
salary and wages expense by the net change in salary and wages payable for the year. If salary and
wages payable increased during the year, then salary and wages expense on an accrual basis would
be higher than the amount of cash paid for this expense, and vice versa. Salary and wages payable
increased by ` 10, so cash paid for salary and wages was ` 4,113, as follows:
Salary and wage expense ` 4,123

Less: Increase, in salary and wage payable (10)
Cash paid to employees ` 4,113

The amount of cash paid to employees is reflected in the salary and wages payable account, as
shown below:
Beginning salary and wages payable ` 75

Plus salary and wage expense 4,123
Minus cash paid to employees (4,113)
Ending salary and wages payable ` 85
Cash Paid for Other Operating Expenses: To determine the cash paid for other operating
expenses, it is necessary to adjust the other operating expenses amount on the income statement by
the net changes in prepaid expenses and accrued expense liabilities for the year. If prepaid expenses
increased during the year, other operating expenses on a cash basis would be higher than on an
accrual basis, and vice versa. Likewise, if accrued expense liabilities increased during the year,
other operating expenses on a cash basis would be lower than on an accrual basis, and vice versa.
For ABC Co., the amount of cash paid for operating expenses in 2016 was ` 3,532, as follows:
Other operating expenses ` 3,577
Less: Decrease in prepaid expenses (23)
Less: Increase in other accrued liabilities (22)
Cash paid for other operating expenses ` 3,532
Cash Paid for Interest: To determine the cash paid for interest, it is necessary to adjust
interest expense by the net change in interest payable for the year. If interest payable increases
during the year, then interest expense on an accrual basis will be higher than the amount of cash paid
for interest, and vice versa. For ABC Co., interest payable decreased by ` 12, and cash paid for
interest was ` 258, as follows:
Interest expense ` 246
Plus: Decrease in interest payable 12
Cash paid for interest ` 258
Alternatively, cash paid for interest may also be determined by an analysis of the interest
payable account, as shown below:
Beginning interest payable ` 74

Plus interest expense 246
Minus cash paid for interest (258)
Ending interest payable ` 62

Cash Paid for Income Taxes: To determine the cash paid for income taxes, it is necessary to
adjust the income tax expense amount on the income statement by the net changes in taxes receivable,
taxes payable, and deferred income taxes for the year. If taxes receivable or deferred tax assets
increase during the year, income taxes on a cash basis will be higher than on an accrual basis, and
vice versa. Likewise, if taxes payable or deferred tax liabilities increase during the year, income tax
expense on a cash basis will be lower than on an accrual basis, and vice versa. For ABC Co., the
amount of cash paid for income taxes in 2016 was ` 1,134, as follows:
Income tax expense ` 1,139
Less: Increase in income tax payable (5)
Cash paid for income taxes ` 1,134
Investing Activities
The second and third steps in preparing the cash flow statement are to determine the total cash
flows from investing activities and from financing activities. The presentation of this information is
identical, regardless of whether the direct or indirect method is used for operating cash flows.
Purchases and sales of equipment were the only investing activities undertaken by ABC Co. in
2016, as evidenced by the fact that the amounts reported for land and buildings were unchanged
during the year. An informational note tells us that ABC Co. purchased new equipment in 2016 for
a total cost of ` 1,300. However, the amount of equipment shown on balance sheet increased by
only ` 243 (ending balance of ` 8,798 minus beginning balance of ` 8,555); therefore, ABC Co.
must have also sold or otherwise disposed of some equipment during the year. To determine the
cash inflow from the sale of equipment, we analyse the equipment and accumulated depreciation
accounts as well as the gain on the sale of equipment. Assuming that the entire accumulated
depreciation is related to equipment, the cash received from sale of equipment is determined as
follows:
The historical cost of the equipment sold was ` 1,057. This amount is determined as follows:
Beginning balance equipment (from balance sheet) ` 8,555
Plus: Equipment purchased (from informational note) 1,300
Minus: Ending balance equipment (from balance sheet) (8,798)
Equals: Historical cost of equipment sold ` 1,057
The accumulated depreciation on the equipment sold was ` 500, determined as follows:
Beginning balance accumulated depreciation (from balance sheet) ` 2,891
Plus: Depreciation expense (from income statement) 1,052
Minus: Ending balance accumulated depreciation (from balance sheet) (3,443)
Equals: Accumulated depreciation on equipment sold ` 500

The historical cost information, accumulated depreciation information, and information from
the income statement about the gain on the sale of equipment can be used to determine the cash
received from the sale.
Historical cost of equipment sold (calculated above) ` 1,057
Less: Accumulated depreciation on equipment sold (calculated above) (500)
Equals: Book value of equipment sold ` 557
Plus: Gain on sale of equipment (from the income statement) 205
Equals: Cash received from sale of equipment ` 762
Financing Activities
As with investing activities, the presentation of financing activities is identical, regardless of
whether the direct or indirect method is used for operating cash flows.
Long-term Debt and Common Equity: The change in long-term debt, based on the beginning
2016 (ending 2015) and ending 2016 balances was a decrease of ` 500. Absent other information,
this indicates that the Company retired ` 500 of long-term debt. Retiring long-term debt is a cash
outflow relating to financing activities.
Similarly, the change in common stock during 2016 was a decrease of ` 600. Absent other
information, this indicates that the Company repurchased ` 600 of its common stock. Repurchase of
common stock is also a cash outflow related to financing activity.
Dividends Recall the following relationship:
Beginning retained earnings + Net income – Dividends = Ending retained earnings
Based on this relationship, the amount of cash dividends paid in 2016 can be determined from
an analysis of retained earnings, as follows:
Beginning balance of retained earnings (from the balance sheet) ` 2,876
Plus: Net income (from the income statement) 2,210
Minus: Ending balance of retained earnings (from the balance sheet) (3,966)
Equals: Dividends paid ` 1,120
Note that dividends paid are presented in the statement of changes in equity.
Overall Statement of Cash Flows Direct Method

Figure 8.7 summarises the information about ABC Co.’s operating, investing, and financing
cash flows in the statement of cash flows. At the bottom of the statement, the total net change in
cash is shown to be a decrease of ` 152 (from ` 1,163 to ` 1,011). This decrease can also be seen
on the comparative balance sheet in Figure 25.8. The cash provided by operating activities of

` 2,606 was adequate to cover the net cash used in investing activities of ` 538; however, the
company’s debt repayments, cash payments for dividends, and repurchase of common stock (i.e.,
its financing activities) of ` 2,220 resulted in an overall decrease in cash of ` 152.
Particulars ` `
Cash flow from operating activities:

Cash received from customers ` 23,543
Cash paid to suppliers (11,900)
Cash paid to employees (4,113)
Cash paid for other operating expenses (3,532)
Cash paid for interest (258)
Cash paid for income tax (1,134)
Net cash provided by operating activities 2,606
Cash flow from investing activities:
Cash received from sale of equipment 762
Cash paid for purchase of equipment (1,300)
Net cash used for investing activities (538)
Cash flow from financing activities:
Cash paid to retire long-term debt (500)
Cash paid to retire common stock (600)
Cash paid for dividends (1,120)
Net cash used for financing activities (2,220)
Net increase (decrease) in cash (152)
Cash balance, 31st December, 2015 1,163
Cash balance, 31st December, 2016 ` 1,011
Figure 8.7: ABC Co.’s Cash Flow Statement (Direct Method) for
Year Ended 31st December, 2016
Overall Statement of Cash Flows: Indirect Method
Using the alternative approach to reporting cash from operating activities, the indirect method,
we will present the same amount of cash provided by operating activities. Under this approach, we
reconcile ABC Company’s net income of ` 2,210 to its operating cash flow of ` 2606.
To perform this reconciliation, net income is adjusted for the following: (a) any non-operating
activities, (b) any non-cash expenses, and (c) changes in operating working capital items.

The only non-operating activity in ABC Co.’s income statement, the sale of equipment, resulted
in a gain of ` 205. This amount is removed from the operating cash flow section; the cash effects of
the sale are shown in the investing section.
The Company’s only non-cash expense was depreciation expense of ` 1,052. Under the indirect
method, depreciation expense must be added back to net income because it was a non-cash deduction
in the calculation of net income.
Changes in working capital accounts include increases and decreases in the current operating
asset and liability accounts. The changes in these accounts arise from applying accrual accounting;
i.e., recognising revenues when they are earned and expenses when they are incurred instead of
when the cash is received or paid. To make the working capital adjustments under the indirect
method, any increase in a current operating asset account is subtracted from net income and a net
decrease is added to net income. As described above, the increase in accounts receivable, for
example, resulted from recording income statement revenue higher than the amount of cash received
from customers; therefore, to reconcile back to operating cash flow, that increase in accounts
receivable must be deducted from net income. For current operating liabilities, a net increase is
added to net income and a net decrease is subtracted from net income. As described above, the
increase in wages payable, for example, resulted from recording income statement expenses higher
than the amount of cash paid to employees.
Figure 8.8 presents a tabulation of the most common types of adjustments that are made to net
income when using the indirect method to determine net cash flow from operating activities.
Additions  Non-cash items

— Depreciation expense of tangible assets
— Amortisation expense of intangible assets
— Depletion expense of natural resources
— Amortisation of bond discount
 Non-operating losses
— Loss on sale or write-down of assets
— Loss on retirement of debt
— Loss on investments accounted for under the equity method
 Increase in deferred income tax liability
 Changes in working capital resulting from accruing higher amounts for expenses
than the amounts of cash payments or lower amounts for revenues than the
amounts of cash receipts
— Decrease in current operating assets (e.g., accounts receivable, inventory
and prepaid expenses)
— Increase in current operating liabilities (e.g., accounts payable and accrued
expense liabilities)

Subtractions  Non-cash items (e.g., amortisation of bond premium)

 Non-operating items
— Gain on sale of assets
— Gain on retirement of debt
— Income on investments accounted for under the equity method
 Decrease in deferred income tax liability
 Changes in working capital resulting from accruing lower amounts for
expenses than for cash payments or higher amounts for revenues than for
cash receipts
— Increase in current operating assets (e.g., accounts receivable, inventory,
and prepaid expenses)
— Decrease in current operating liabilities (e.g., accounts payable and
accrued expense liabilities)
Figure 8.8: Adjustments to Net Income using the Indirect Method

Accordingly, the ` 55 increase in accounts receivable and the ` 707 increase in inventory are
subtracted from net income and the ` 23 decrease in prepaid expenses is added to net income. For
current liabilities, the increases in accounts payable, salary and wage payable, income tax payable,
and other accrued liabilities ` 263, ` 10, ` 5, and ` 22, respectively) are added to net income and the
` 12 decrease in interest payable is subtracted from net income. Figure 8.9 presents the cash flow
statement for under the indirect method by using the information that we have determined from our
analysis of the income statement and the comparative balance sheets. Note that the investing and
financing sections are identical to the statement of cash flows prepared using the direct method.
Cash flow from operating activities:

Net income ` 2,210
Depreciation expense 1,052
Gain on sale of equipment (205)
Increase in accounts receivable (55)
Increase in inventory (707)
Decrease in prepaid expenses 23
Increase in accounts payable 263
Increase in salary and wage payable 10
Decrease in interest payable (12)
Increase in income tax payable 5
Increase in other accrued liabilities 22
Net cash provided by operating activities 2,606

Cash flow from investing activities:

Cash received from sale of equipment 762
Cash paid for purchase of equipment (1,300)
Net cash used for investing activities (538)
Cash flow from financing activities:
Cash paid to retire long-term debt (500)
Cash paid to retire common stock (600)
Cash paid for dividends (1,120)
Net cash used for financing activities (2,220)
Net decrease in cash (152)
Cash balance, 31st December, 2015 1,163
Cash balance, 31st December, 2016 ` 1,011
Figure 8.9: ABC Co.’s Cash Flow Statement (Indirect Method)

Year Ended 31st December, 2016
Illustrative Problems
Illustrative Problem 1. From the following Profit and Loss Account and additional information
of M/s Anurag Enterprises, compute cash flow from operations.
Profit and Loss Account
for the Year Ended 31st March, 2017
Particulars ` Particulars `
To Opening Stock 1,60,000 By Sale
To Purchases Cash 6,00,000
Cash 2,00,000 Credit 10,00,000
Credit 6,00,000 8,00,000 By Closing Stock 2,08,000
To Wages 48,000 By Commission 1,12,000
To Office Expenses 1,76,000 By Royalties 80,000
To Selling Expenses 96,000 By Discount Received 40,000
To Bad debts 16,000
To Discount Allowed 32,000
To Depreciation 1,20,000
To Provision for Tax 2,40,000
To Net Profit 3,52,000
20,40,000 20,40,000

Additional Information:
Particulars March 31, 2016 March 31, 2017
` `
Debtors 1,20,000 1,44,000
Creditors 1,12,000 80,000
O/s Selling Expenses 24,000 32,000
Prepaid Office Expenses 16,000 24,000
Accrued Royalties 96,000 88,000
Advance Commission 72,000 64,000
Provision for Tax 3,20,000 4,80,000
Solution:
Cash Flow from Operations
Particulars ` `
(A) Receipts from Operations:
Cash Sales 6,00,000
Cash Received from Debtors*1 9,76,000
Cash from Royalties*2 88,000
Cash from Commission*3 1,04,000
17,68,000
Less:
(B) Operating Cash Payments
Cash Purchases 2,00,000
Cash paid to Creditors*4 6,32,000
Cash Selling Expenses 88,000
Cash Office Expenses 1,92,000 11,12,000
Cash inflow from operations before tax 6,56,000
Less: Income Tax paid (on operating incomes) 80,000
Net Cash flow from operations 5,76,000
*1. Cash Received from debtors (Prepare Debtors A/c)

Debtors A/c
To Balance b/d 1,20,000 By Cash Received (Bal. (Fig.) 9,76,000
To Sales (Credit) 10,00,000 By Balance c/d 1,44,000
11,20,000 11,20,000
*2 Cash from Royalties

Opening Balance + Royalties as per P & L A/c — Closing Balance = Cash from Royalties
96,000 + 80,000 – 88,000 = ` 88,000
*3 Cash from Commission
Closing Balance + Commission as per P & L A/c — Opening Balance = Cash from Commission
64,000 + 1,12,000 – 72,000 = ` 1,04,000
*4 Cash
Opening Balance + Purchases – Cl. Balance = Cash Paid to Creditors
80,000 + 6,00,000 – 1,12,000 = ` 6,32,000
Illustrative Problem 2. The net income reported on the income statement for the year was `
1,10,000 and depreciation of fixed assets for the year was ` 44,000. The balances of the current
asset and current liability accounts at the beginning and end of the year are as follows:
End of the Year Beginning of the year
` `
Cash 1,30,000 1,40,000
Debtors 2,00,000 1,80,000
Inventories 2,90,000 3,00,000
Prepaid Expenses 15,000 16,000
Accounts Payable 1,02,000 1,16,000
Calculate total cash from operating activities.
Solution:
Cash from Operating Activities
Particulars ` `
Net Income 1,10,000
Add: Depreciation 44,000
Operating Profit before working capital changes 1,54,000
Add: Decrease in Inventories 10,000
Decrease in prepaid expenses 1,000 11,000
1,65,000
Deduct: Increase in Debtors 20,000
Decrease in Accounts Payable 14,000 34,000
Net Cash Flow from Operating Activities 1,31,000

Illustrative Problem 3. From the following, calculate cash from operation by Indirect Method.
Particulars ` ` Particulars `
To Opening Stock 2,00,000 By Sales 45,00,000
To Purchases 36,40,000 By Closing Stock 2,40,000
To Wages 2,25,000
To Outstanding 25,000 2,50,000
To Manufacturing Expenses 75,000
To Gross Profit c/d 5,75,000
47,40,000 47,40,000
To Salaries 1,37,500 By Gross Profit b/d 5,75,000
Add: Outstanding 62,500 2,00,000 By Rent Received 37,500
To Insurance 30,000 By Commission Accrued 17,500
Less: Prepaid 7,500 22,500 By Net Loss 55,000
To Office Expenses 1,17,500
To Selling Expenses 1,45,000
To Share Issue Expenses w/o 75,000
6,85,000 6,85,000
Solution:
Calculation of Cash from Operating Activities
(Indirect Method)
Particulars ` `
Net Loss as per Profit and Loss Account (Before tax and extraordinary item) (55,000)
Adjustments for Non-cash Charges and Non-operating Items
Add: Depreciation 1,25,000
Add: Share Issue Expenses w/o 75,000 2,00,000
1,45,000
Less: Rent Received (Non-operating) (37,500)
Operating Profit before Working Capital Charges 1,07,500
Adjustment for Current Assets/Liabilities:
Add: Increase in Current liabilities
Wages O/s 25,000
Salaries 62,500 87,500
1,95,000

Less: Increase in Current Assets

Stock 40,000
Prepaid Insurance 7,5000
Accrued Commission 17,500 (65,000)
Net Cash from operating Activities 1,30,000
Illustrative Problem 4. X Ltd. has the following balance on 1st January, 2016:
` `
Fixed Assets 15,00,000
Less: Depreciation (5,00,000) 10,00,000
Bank 87,500
Other Current Assets 6,25,000
Net year’s estimate are:
(i) The company will acquire fixed assets costing ` 2,50,000 after selling one machine for
` 70,000, costing ` 1,50,000 on which depreciation provided will amount to ` 90,000.
(ii) The net profits will be ` 1,75,000 after providing for depreciation of ` 1,50,000.
(iii) Current assets and current liabilities (other than bank balance) at 31.12.2016 are estimated
to be ` 7,50,000 and ` 4,00,000 respectively.
At the end of the accounting year, the company deposits all the cash into the bank. Calculate
the cash flows from operations and investing activities for the year 2016.
Solution:
Cash Flow from Operating Activities
Particulars ` `
Net Profit after depreciation 1,75,000
Add: Depreciation provided 1,50,000
Less: Profit on sale of machinery (10,000)
Operating profit before working capital changes 3,15,000
Less: Increase in assets (1,25,000)
Add: Increase in current liabilities 1,50,000
Net cash from operating activities 3,40,000

Cash Flow from Investing Activities
Particulars ` `
Purchase of Machine 70,000
Purchase of Machine (2,50,000)
Net cash used in investing activities (1,80,000)
Working Note:
Calculation of Profit on sale of machinery: 70,000 – (1,50,000 – 90,000) = ` 10,000.
Illustrative Problem 5. From the following information, calculate cash from operations.
for the year ended 31st March ,2016
To Opening Stock 1,50,000 By Sales 32,75,000
To Purchases 14,50,000 By Closing Stock 3,25,000
To Wages 70,000
To Gross Profit c/d 19,30,000
36,00,000 36,00,000
To Operating Expenses 11,10,000 By Gross Profit b/d 19,30,000
To Interest on Debentures 18,000 By Interest on Investments 15,000
To Depreciation 1,20,000 By Dividend Received 18,000
To Loss on Sale on Plant 40,000 By Profit on Sale of Land 20,000
To Discount on Issue of Shares 10,000 By Rent Received 12,000
To Goodwill w/o 15,000 By Refund of Tax 8,000
To Provision for Tax 30,000 By Insurance Claims for
To General Reserve 25,000 Loss of Stock 1,25,000
To Proposed, Dividend 1,80,000
To Interim Dividend 70,000
To Net Profit 5,10,000
21,28,000 21,28,000
31.03.15 31.03.16
` `
Stock 1,40,000 1,00,000
Debtors 25,000 1,00,000
Creditors 15,000 50,000
Provision for Tax 50,000 60,000

Outstanding Salaries 20,000 25,000

Accrued Commission 15,000 15,000
Solution:
Cash Flow from Operating Activities
Particulars ` `
Net Profit before Tax and Extraordinary items (1) 6,82,000
Adjustment for: Non-cash Charges and Non-operating Items
Add: Depreciation 1,20,000
Goodwill 15,000
Discount on Issue of Shares 10,000
Loss on Sale of Plant 40,000
Interest on Debentures (2) 18,000 2,03,000
Less: Profit on Sale of Land (3) 20,000 8,85,000
Interest Received (3) 15,000
Dividend Received (3) 18,000 (53,000)
Operating Profit before Working Capital Changes 8,32,000
Adjustment for Working Capital:
Add: Decrease in Current Assets and Increase in Current Liabilities:
Stock 40,000
Debtors 35,000
O/s Salaries 5,000 80,000
9,12,000
Less: Increase in Current Assets and Decrease in Current Liabilities:
Debtors 75,000
Accrued Commission 15,000
Prepaid Expenses 2,000 (92,000)
8,20,000
Less: Tax Paid (12,000)
Cash flow before Extraordinary Items 8,08,000
Add: Cash from Extraordinary Items
(Insurance Claims for Loss of Stock (4)) 1,25,000
Net Cash Flow from Operations 9,33,000

Working Notes:
` `
(1) Net Profit as per P and L A/c 5,10,000
Add: Tax and Appropriations:
Provision for Tax 30,000
Proposed Dividend 1,80,000
Interim Dividend 70,000
General Reserve 25,000 3,05,000
8,15,000
Less: Tax Refund and Extra Ordinary Receipts (8,000 + 1,25,000) 1,33,000
6,82,000
(2) Interest on Debentures to be adjusted against Financing Activities.
(3) Interest Received, Dividend Received, Profit on sale of Fixed Assets are covered by Investing
Activities.
(4) Insurance claims for loss of Stock is treated under Operating Activities while loss of assets
under “Investing Activities’.
Illustrative Problem 6. The following data are provided for ABC Ltd.:
Income Statement Data for 2016
Particulars `
Revenues 84,000
Cost of goods sold (48,000)
Depreciation expense (4,000)
Interest expense (6,000)
Other expenses (22,000)
Net Income 4,000
Comparative Balance Sheets Data

Particulars 2016 2015
` `
Assets
Current Assets
Cash 20,000 16,000
Debtors (Net) 12,000 7,000
Stock in Hand 16,000 14,000

Non-current Assets
Plant and Machinery 24,000 20,000
Less: Accumulated Depreciation (8,000) (4,000)
Total Assets 64,000 63,000
Liabilities
Creditors 12,000 14,000
Non-current Note Payable 20,000 20,000
Less: Discount on Note (1,600) (2,000)
30,400 32,000
Owner’s Equity
Equity Share Capital 24,000 14,000
Retained Earnings 9,600 7,000
33,600 21,000
Total Liabilities 64,000 63,000
Required: Prepare statement of cash flows using the Indirect Method as per [AS-3 (Revised)]
Solution:
ABC Ltd.
Cash Flow Statement for the year Ended 31st December, 2016
[AS-3 (Revised)] (Indirect Method)
Particulars ` `
(A) Cash Flows from Operating Activities
Net Income before tax 4,000
Adjustments for:
Depreciation 4,000
Amortisation of discount on note payable 400
Interest expenses 6,000
Operating Profit before Working Capital Changes 14,400
Increase in Debtors (5,000)
Increase in Inventories (2,000)
Decrease in Creditors (2,000)
Net Cash Provided by Operating Activities 5,400
(B) Cash Flows from Investing Activities
Purchase of Plant and Machinery (4,000)
Net Cash Used in Investing Activities (4,000)

(C) Cash Flows from Financing Activities

Issues of Share Capital 10,000
Interest Paid (6,000)
Dividends Paid (1,400)
Net cash from financing activities 2,600
Net increase in cash and cash equivalent (A + B + C) 4,000
Cash and cash equivalents at the beginning of the period 16,000
Cash and cash equivalents at the end of the period 20,000
Note:
Dividends paid have been calculated as under:
`
Retained earnings at the beginning 7,000
Add: Net Income 4,000
11,000
Less: Retained earnings at the end 9,600
Dividend paid 1,400
Illustrative Problem 7. From the following particulars, prepare Cash Flow Statement for the
year ended 31st March, 2016 using:
(a) Direct Method
(b) Indirect Method
Income Statement for the year ended 31st March, 2016
Particulars ` `
Turnover 12,80,000
Less: Cost of Goods sold 8,00,000
Add: Other Receipts: 4,80,000
Insurance Claims for loss of Stock due to fire 20,000
5,00,000
Less: Operating Expenses 3,16,000
Interest on Debentures 6,000
Depreciation 84,000
Discount on Debentures w/o 400 4,06,400
Profit before Tax 93,600
Less: Provision for Tax 36,800
Profit after Tax 56,800

The assets and liabilities as on 31st March, 2015 and 31st March, 2016 were as under:
Particulars 31.03.2015 31.03.2016
` `
Stock 72,000
88,000
Debtors 16,000 15,200
Bills Receivable 12,000 22,000
Cash and Bank Balance 44,800 99,200
Creditors 31,200 38,000
Bills Payable 8,000 6,000
O/s Expenses 12,400 17,600
(i) Fully paid Equity shares of the face value of ` 80,000 were allotted at a premium of @
20%.
(ii) Fired assets were acquired for ` 60,000 and the payment was made in 6% convertible
debentures at par.
(iii) Income Tax paid during the year amounted to ` 38,000.
(iv) Company paid a dividend and corporate dividend tax thereon for the year ended 31st
March, 2006 amounting to ` 44,000.
(v) 9% Debentures for ` 1,20,000 were redeemed at a premium of 2%.
Solution:
(a) Cash Flow Statement (Direct Method)
Particulars ` `
Cash Flow from Operating Activities:
(a) Operating Cash Receipts:
Cash from Customers (1) 12,70,800
(b) Operating Cash Payments (2) 11,22,000
Cash Flow from Operations (a – b) 1,48,800
Income Tax Paid (38,000)
1,10,800
Cash Flow from Extraordinary Items:
Add: Claims Received 20,000
Net Cash Flow from Operating Activities 1,30,800

Cash Flow from Financing Activities:

• Issue of Shares at Premium (3) 96,000
• Redemption of Debentures (1,22,400)
• Interest on Debentures (6,000)
• Dividend and Corporate Dividend Tax (44,000)
Net Cash Used in Financing Activities (76,400)
Net Increase in Cash and Cash Equivalents 54,400
Cash and Cash Equivalents in the Beginning 44,800
Cash and Cash Equivalents at the End 99,200
Financing and Investing Activities not affecting cash flow
— Issue of debentures against acquisition of land 60,000
Working Notes:
(1) Receivables A/c (Debtors + Bills Receivables)
To Balance b/d 28,000 By Cash Received (B.F.) 12,70,800
To Sales (credit) 12,80,000 By Balance c/d 37,200
13,08,000 13,08,000
(2) Payables A/c (Creditors + Bills Payable)
To Cash Paid 8,11,200 By Balance b/d 39,200
To Balance c/d 44,000 By Purchases* 8,16,000
8,55,200 8,55,000
Operating Expenses A/c
To Cash Paid (Bal. Figure) 3,10,800 By Balance b/d 12,400
To Balance c/d 17,600 By Profit and Loss A/c 3,16,000
3,28,400 3,28,400
*Purchases = Closing Stock + Cost of Goods Sold – Opening Stock

Purchases = 88,000 + 8,00,000 – 72,000 = 8,16,000
This operating cash payment = 8,11,200 (To creditors)
and operating expenses paid 3,10,800
11,22,000

`
(3) Face Value of Shares issued 80,000
Add: Premium @ 20% 16,000
96,000
(b) Cash Flow Statement as per AS-3 (Revised)

(Indirect Method)
Particulars ` `
I. Cash Flow from Operating Activities:
Net Profit before Tax and Extraordinary Item 73,600
Adjustment for Non-cash and Non-operating items: Depreciation 84,000
Discount on Issue of Debentures 400
Interest on Debentures 6,000
Operating Profit before Working Capital Changes 1,64,000
Adjustment for current items:
Less: Increase in Stock (16,000)
Less: Increase in Bills Receivable (10,000)
Less: Decrease in Bills Payable (2,000)
Add: Decrease in Debtors 800
Add: Increase in Creditors 6,800
Add: Increase in O/s Expenses 5,200
Cash Generated from Operation 1,48,800
Less: Income Tax paid 38,000
Cash Flow from Operation before Extraordinary Item 1,10,800
Add:Insurance Claim for Loss of Stock 20,000
Net Cash Generated from Operation 1,30,.800
II. Cash Flow from Investing Activities —
III. Cash flow from Financing Activities — —
Issue of Shares at Premium 96,000
Redemption of Debentures (1,22,400)
Interest on Debentures (6,000)
Dividend and Corporate Dividend Tax (44,000)
Net Increase in Cash and Cash Equivalents 54,400
Cash and Cash Equivalents in the Beginning 44,800
Cash and Cash Equivalents at the End 99,200

Illustrative Problem 9. Presented below is the comparative balance sheets for Jyoti Ltd. at
31st March:

` `
Cash 40,000 57,000
Accounts Receivable 77,000 64,000
Inventory 1,32,000 1,40,000
Prepaid expenses 12,140 16,540
Land 1,25,000 1,50,000
Equipment 2,00,000 1,75,000
Accumulated Depreciation-Equipment (60,000) (42,000)
Building 2,50,000 2,50,000
Accumulated Depreciation-Building (75,000) (50,000)
7,01,140 7,60,540
Accounts Payable 33,000 45,000
Bonds Payable 2,35,000 2,65,000
Equity Share Capital (` 10 per share) 2,80,000 2,50,000
Retained Earnings 1,53,140 2,00,540
7,01,140 7,60,540
(i) Operating expenses include depreciation expense of ` 70,000 and amortisation of prepaid
expenses of ` 4,400.
(ii) Land was sold for cash at book value.
(iii) Cash dividends of ` 74,290 were paid.
(iv) Net income for 2007 was ` 26,890.
(v) Equipment was purchased for ` 65,000 cash. In addition equipment costing ` 40,000 with
a book value of ` 13,000 was sold for ` 15,000 cash.
(vi) Bonds were redeemed at face value by issuing 3,000 equity shares of ` 10 at par.
Prepare a statement of cash flow for 2016 using the indirect method [AS-3 (Revised)].

Solution:
Jyoti Ltd.
Cash Flows Statement for the Year Ended 31st December, 2016
[AS-3 (Revised)] (Indirect Method)
Particulars ` `
(A) Cash Flows from Operating Activities
Net Income 26,890
Adjustments for:
Depreciation 70,000
Amortisation of Prepaid Expenses 4,400
Gain on Sale of Equipment (2,000)
Operating Profit before Working Capital Changes 99,290
Increase in Accounts Receivable (13,000)
Decrease in Inventories 8,000
Decrease in Accounts Payable (12,000)
Net Cash from Operating Activities 82,290
(B) Cash Flow from Investing Activities:
Sale of Land 25,000
Sale of Equipment 15,000
Purchase of Equipment (65,000)
Net Cash Used in Investing Activities (25,000)
(C) Cash Flows from Financing Activities
Dividends Paid (74,290)
Net Decrease in Cash and Cash Equivalents (A + B + C) (17,000)
Cash and Cash Equivalents at the Beginning of the Period 57,000
Cash and Cash Equivalents at the End of the Period 40,000
Significant Non-cash Transaction
Redemption of Bonds in exchange for Equity Share Capital ` 30,000
Working Notes:
Equity Share Capital Account
To Balance c/d 2,80,000 By Balance b/d 2,50,000
By Bond Payable A/c 30,000
2,80,000 2,80,000
Bonds Payable Account

To Equity Share Capital Account 2,35,000 By Balance b/d 2,65,000
To Balance c/d 30,000
2,65,000 2,65,000
Illustrative Problem 10. ABC Limited has collected the following information for the preparation
of cash flow statement for the year ended 31st March, 2016.
(` in lakhs)
Net Profit 25,000
Dividend (including dividend tax) paid 8,535
Provision for income tax 5,000
Income tax paid during the year 4,248
Loss on sale of assets (net) 40
Book value of the assets sold 185
Depreciation charged to Profit and Loss Account 20,000
Amortisation of capital grant 6
Profit on sale of investments 100
Carrying amount of investment sold 27,765
Interest income received on investments 2,506
Interest paid during the year 10,520
Increase in working capital (excluding cash and bank balance) 56,075
Purchase of fixed assets 14,560
Investment in joint venture 3,850
Expenditure on construction work-in-progress 34,740
Proceeds from calls in arrear 2
Receipt of grant for capital projects 12
Proceeds from long-term borrowings 25,980
Proceeds from short-term borrowings 20,575
Opening cash and bank balance 5,003
Closing cash and bank balance 6,988
Prepare the Cash Flow Statement for the year ended 31st March, 2016 in accordance with AS-
3 ‘Cash Flow Statement’.

Solution:
ABC Limited
Cash Flow Statement for the Year Ended 31st March, 2016
Particulars ` in lakhs
Cash Flows from Operating Activities
Net profit before taxation (25,000 + 5,000) 30,000
Adjustments for:
Depreciation 20,000
Loss on sale of assets (Net) 40
Amortisation of capital grant (6)
Profit on sale of investments (100)
Interest income on investments (2,506)
Operating profit before working capital changes 57,428
Changes in working capital (Excluding cash and bank balance) (56,075)
Cash generated from operations 1,353
Income taxes paid (4,248)
Net cash used in operating activities (2,895)
Cash Flows from Investing Activities
Sale of assets (185 – 40) 145
Sale of investments (27,765 + 100) 27,865
Interest income on investments 2,506
Purchase of fixed assets (14,560)
Investment in joint venture (3,850)
Expenditure on construction work-in progress (34,740)
Net cash used in investing activities (22,634)
Cash Flows from Financing Activities
Proceeds from calls in arrear 2
Receipts of grant for capital projects 12
Proceeds from long-term borrowings 25,980
Proceed from short-term borrowings 20,575
Interest paid (10,520)
Dividend (including dividend tax) paid (8,535)
27,514
Net increase in cash and cash equivalents (27,514 – 22,634 – 2,895) 1,985
Cash and cash equivalents at the beginning of the period 5,003
Cash and cash equivalents at the end of the period 6,988
Illustrative Problem 11. The summarised Balance Sheet of XYZ Ltd. for the years ended 31st
March, 2015 and 2016 are as follows:
Liabilities 31.3.2015 31.3.2016 Assets 31.3.2015 31.3.2016
(`) (`) (`) (`)
Equity share capital 11,20,000 15,60,000 Fixed Assets 32,00,000 38,00,000
10% Preference share capital 4,00,000 2,80,000 Less: Depreciation 9,20,000 11,60,000
Capital Reserve — 40,000 22,80,000 26,40,000
General Reserve 6,80,000 8,00,000 Investment 4,00,000 3,20,000
Profit and Loss A/c 2,40,000 3,00,000 Cash 10,000 10,000
9% Debentures 4,00,000 2,80,000 Other Current Assets 11,10,000 13,10,000
Current liabilities 4,80,000 5,36,000
Proposed dividend 1,20,000 1,44,000
Provision for tax 3,60,000 3,40,000
38,00,000 42,80, 000 38,00,000 42,80,000
(i) The company sold one fixed asset for ` 1,00,000, the cost of which was ` 2,00,000 and the
depreciation provided on it was ` 80, 000.
(ii) The company also decided to write off another fixed asset costing ` 56, 000 on which
depreciation amounting to ` 40, 000 has been provided.
(iii) Depreciation on fixed assets provided ` 3,60,000.
(iv) Company sold some investment at a profit of ` 40, 000, which was credited to capital
reserve.
(v) Debentures and preference share capital redeemed at 5% premium.
(vi) Company decided to value inventory at cost, whereas previously the practice was to value
inventory at cost less 10%. The inventory according to books on 31.3.2015 was ` 2,16,000.
The inventory on 31.3.2016 was correctly valued at ` 3,00,000.
Prepare Cash Flow Statement as per revised AS-3 by indirect method.

Solution:
Cash Flow Statement for the year ended 31st March, 2016
Particulars ` `
A. Cash Flow from Operating Activities
Profit after appropriation
Increase in Profit & Loss A/c after inventory adjustment
[` 3,00,000 – (` 2,40,000 + ` 24,000)] 36,000
Transfer to general reserve 1,20,000
Proposed dividend 1,44,000
Provision for tax 3,40,000
Net profit before taxation and extraordinary item 6,40,000
Adjustments for:
Depreciation 3,60,000
Loss on sale of fixed assets 20,000
Decrease in value of fixed assets 16,000
Premium on redemption of preference share capital 6,000
Premium on redemption of debentures 6,000
Operating profit before working capital changes 10,48,000
Increase in current liabilities (` 5,36,000 – ` 4,80,000) 56,000
Increase in other current assets
[` 13,10,000 – (` 11,10,000 + ` 24,000)] (W.N.1) (1,76,000)
Cash generated from operations 9,28,000
Income taxes paid (3,60,000)
Net cash from operating activities 5,68,000
B. Cash Flow from Investing Activities
Purchase of fixed assets (W.N.3) (8,56,000)
Proceeds from sale of fixed assets 1,00,000
Proceeds from sale of investments (W.N.2) 1,20,000
Net cash from investing activities (6,36,000)
C. Cash Flow from Financing Activities
Proceeds from issuance of share capital 4,40,000
Redemption of preference share capital (` 1,20,000 + ` 6,000) (1,26,000)
Redemption of debentures (` 1,20,000 + ` 6,000) (1,26,000)
Dividend paid (1,20,000)
Net Cash from financing activities 68,000
Net increase/decrease in cash and cash equivalent during the year Nil
Cash and cash equivalent at the beginning of the year 10,000
Cash and cash equivalent at the end of the year 10,000

Working Notes:
1. Revaluation of inventory will increase opening inventory by ` 24,000.
2,16, 000
 10 = ` 24,000
90
Therefore, opening balance of other current assets would be as follows:
` 11,10,000 + ` 24,000 = ` 11,34,000
Due to under valuation of inventory, the opening balance of profit and loss account be increased
by ` 24,000.
The opening balance of profit and loss account after revaluation of inventory will be
` 2,40,000 + ` 24,000 = ` 2,64,000.
2. Investment Account
To Balance b/d 4,00,000 By Bank A/c 1,20,000
To Capital reserve A/c (balancing figure being
(Profit on sale of investment) investment sold)
40,000 By Balance c/d 3,20,000
4,40000 4,40,000
3. Fixed Assets Account
Particulars ` Particulars ` `
To Balance b/d 32,00,000 By Bank A/c (sale of assets) 1,00,000
To Bank A/c 8,56,000 By Accumulated Depreciation A/c 80,000
(Balancing figure being assets By Profit and loss A/c 20,000 2,00,000
purchased) (Loss on sale of assets)
By Accumulated Depreciation A/c 40,000
By Profit and loss A/c
(Assets written off) 16,000 56,000
By Balance c/d 38,00,000
40,56,000 40,56,000
4. Accumulated Depreciation Account

To Fixed Assets A/c 80,000 By Balance b/d 9,20,000
To Fixed Assets A/c 40,000 By Profit and loss A/c
To Balance c/d 11,60,000 (Depreciation for the period) 3,60,000
12,80,000 12,80,000

8.8 Summary
The analysis of a ratio gives the relationship between two variables at a point of time and over a
period of time. Ratio analysis offers following advantages: (1) It aids financial statement analysis. (2)
It facilitates intra-firm comparison and help chart trends. (3) Ratios are relative concepts and therefore
support inter-firm comparison. (4) Ratios help in simplifying accounting terms by providing answers
in percentages and times. (5) It checks and highlights the performance of an enterprise on key
parameters of liquidity, profitability and growth. (6) It identifies the points of concern for management
and aids in decision making. (7) It can be used as a forecasting tool.
There are mainly four types of ratios profitability, liquidity, turnover and solvency ratios. Liquidity
ratio measures the short-term liquidity of the firm with the help of ratios like current ratios, quick
ratios, etc. Profitability ratios measure the operational efficiency of the firm. They give the details of
how efficient the firm is in applying its resources to get the maximum returns.
Current Ratio (page no. 5)
Acid Test Ratio (page no. 6)
Cash Ratio (page no. 7)
Capital Turnover Ratio (page no. 8)
Fixed Assets Turnover Ratio (page no. 9)
Net Working Capital Turnover Ratio (page no. 10)
Inventory Turnover Ratio (page no. 10)
Receivables Turnover (page no. 11)
Return on Capital Employed/ROI (page no. 13)
Return Equity (page no. 14)
Return on Total Assets (page no. 15)
Gross Profit Ratio (page no. 16)
Net Profit Ratio (page no. 17)
Operating Profit Ratio (page no. 18)
Operating Ratio (page no. 19)
Debt-equity Ratio (page no. 20)
Interest Coverage Ratio (page no. 22)

Proprietary Ratio (page no. 22)

Earning per Share (page no. 23)
Net Dividend Per Share (page no. 25)
Gross Dividend Per Share (page no. 25)
Gross Dividend Yield (page no. 25)
Dividend Yield Ratio (page no. 25)
Dividend Cover (page no. 26)
Payout Ratio (page no. 26)
Dividend to Cash Flow (page no. 27)
Price Earnings (P/E) Ratio (page no. 27)
Net Asset Value Per Share (page no. 28)
Limitations of ratio: (1) False results, (2) qualitative factors are ignored, (3) lack of standard
ratio, (4) may not be comparable, (5) price level changes are not considered, (6) window dressing
and (7) personal bias.
The cash flow statement reflects a firm’s liquidity. The balance sheet is a snapshot of the
firm’s financial resources. The cash flow statement includes only inflows and outflows of cash and
cash equivalents; it excludes transactions that do not directly affect cash receipts and payments.
These non-cash transactions include depreciation or write-offs on bad debts or credit losses to name
a few. The CFS is a cash basis report on three types of activities these are operating activity,
investing activity and financing activity.
Operating activities are those transactions which are considered in the determination of net
income. Examples of cash inflows in this category are cash received from debtors for goods and
services, interest and dividend received on loans and investment. Examples of cash outflows in this
category are cash payments for goods and services; merchandise; wages; interest; taxes; supplies
and others.
Investing activities include acquisition of long-term or fixed assets; disposal of long-term or
fixed assets; acquisition and disposal of intangible assets; purchase and sale of shares, debentures and
other securities; lending of money and its subsequent collection. Cash inflows from investing activities
generally include cash sales of property, plant, equipment and intangible assets, cash sales of investments
in shares, debentures and other securities, cash collection (loan repayments) from borrowers. Cash
outflows are purchase of shares, debentures and securities of other enterprises, purchase of property,
plant, equipment and other long-term assets, loan given to other firms.

Financing activities relate to long-term liability and equity capital. A firm engages in financing
activities when it obtains resources from owners, returns resources to owners, borrows resources
from creditors and repays amounts borrowed. Cash inflows include proceeds from issue of shares
and short-term and long-term borrowings. Cash outflows include repayment of loans and payments
to owners, including cash dividends. Repayments of accounts payable or accrued liabilities are not
considered repayment of loans under financing activities but are classified as cash outflows under
operating activities.
Provisions of AS-3 on Treatment of Certain Items: (1) Interest and Dividend (For Financial
enterprises): interest paid and received, dividend received as operating activities; and dividend paid
as financing activities and (For Other Enterprises): interest and dividend received as investing activities;
and interest and dividend paid as financing activities. (2) Extraordinary items: The cash flows associated
with extraordinary items should be classified as arising from operating, investing or financing activities
as appropriate. It should be disclosed separately. Few examples of such items are: (i) Claim for loss
of stock – Operating activity, (ii) Claims for loss of assets – Investing activity, (iii) Recovery of bad
debts – Operating activity, (iv) Damages paid/received for breach of contract – Operating activity,
(v) Winnings from lotteries – Investing activity and (vi) Cost of legal action to protect property title
– Investing activity. (3) Taxes on Income: Cash flows arising from taxes on income should be
separately disclosed and should be classified as cash flows from operating activities unless they can
be specifically identified with financing and investing activities. For instance, Provision for taxation
for the current year – Non-cash charge under operating activity, (ii) Tax paid – Operating cash
outflow, (iii) Income tax refund – Cash inflow from operating activity, (iv) Capital gains tax – Cash
outflow from investing activity and (v) Corporate dividend tax – Cash outflow from financing activity.
8.9 Key Words/Abbreviations

 LIFO: Last in First Out.
 FIFO: First in First Out.
 P/E Ratio: Price earning ratio.
 EPS: Earning per share.
 EBIT: Earning before interest and tax.
 PAT: Profit after tax.
 CFS: Cash Flow Statement.
 IFRS: International Financial Reporting Standard.
 GAAP: Generally Accepted Accounting Principles.
 ICAI: The Institute of Chartered Accountants of India.

8.10 Learning Activity

1. Calculate Current and Quick Ratio:
S. No. Items Amount
1 Current Investments 40,000
2 Inventories 5,000
3 Trade Receivables 2,000
4 Short-term Borrowings 20,000
5 Trade Payables 2,500
6 Prepaid Expenses 2,000
7 Short-term Provisions 3,000
8 Other Current Liabilities 5,000
9 Short-term Loans and Advances 4,000
10 Tangible Fixed Assets 1,00,000
11 Cash and Cash Equivalents 10,000
12 Advance Tax 8,000
_________________________________________________________________
_________________________________________________________________
2. Calculate following ratios from the above particulars:
(i) Debt-Equity ratio
(ii) Total Assets to Debt ratio
(iii) Proprietary ratio
Particulars Amount
Preference Share Capital 1,00,000
General Reserve 60,000
Profit & Loss Balance 40,000
12% Mortgage Loan 1,80,000
Non-current Assets 4,50,000

What conclusions do you draw from the above ratios?

_________________________________________________________________
_________________________________________________________________
8.11 Unit End Questions (MCQ and Descriptive)
A. Descriptive Type Questions

1. What is ratio analysis?
2. What is liquid ratio?
3. What is Inventory turnover ratio?
4. What are operating expenses?
5. What is operating profit? How is it calculated? What is its significance?
6. What are non-operating expenses?
7. What are the items included in Shareholders’ Fund?
8. What does too low ‘Trade Receivables Turnover Ratio’ indicate?
9. What does too high ‘Trade Receivables Turnover Ratio’ indicate?
10. Discuss the computation and significance of the following financial ratios:
(a) Current Ratio
(b) Quick Ratio
(c) Inventory Turnover Ratio
(d) Debt-equity Ratio
(e) Accounts Receivables Ratio
(e) Earnings Margin
(f) Earnings per Share

11. Following information has been extracted from financial statements of Nia Manufacturing:
Balance Sheet as at 31 March, 2017
Particulars Amount (`)

Equity and Liabilities
Shareholders’ Funds
(a) Share Capital 3,00,000
Non-current Liabilities
(a) Long-term Borrowings 1,00,000
Current Liabilities
(a) Short-term Borrowings —
(b) Trade Payables 80,000
(c) Other Current Liabilities 20,000
5,00,000
Assets
Non-current Assets
(a) Fixed Assets
(i) Tangible Assets 3,50,000
Current Assets
(a) Inventories 65,000
(b) Trade Receivables 60,000
(c) Cash and Cash Equivalents 25,000
5,00,000
Extract from Income Statement:
Revenue from Operations Expenses 9,00,000

Selling and Administration Expenses 1,00,000
Other Expenses (including tax) 2,50,000
Profit/(Loss) from Continuing Operations (after tax) 1,50,000

You are required to determine the following:

o Current Ratio
o Working Capital
o Current Assets to Total Assets Ratio
o Current Liabilities to Total Assets Ratio
o Cash Conversion Cycle
o Market price of share if P/E ratio is 8.

12. Calculate absolute liquid ratio from the following information:
Amount (`)
Share capital 1,00,000
Bank overdraft 25,000
Trade payables 20,000
Bills payable 30,000
Goodwill 2,00,000
Plant and machinery 2,00,000
Inventories 50,000
Trade receivables 50,000
Cash in hand 30,000
Bills receivable 75,000
Marketable securities 10,000
Cash at bank 20,000
13. Calculate current ratio, liquid ratio and absolute liquid ratio from the following information:
Amount (`)
Inventories 1,80,000
Cash in hand 30,000
Bills receivable 90,000
Cash at bank 45,000
Bills payable 75,000


Outstanding expenses 1,05,000
Prepaid expenses 30,000
Land and building 6,00,000
Goodwill 1,50,000
14. Find out Operating Ratio:
Cost of goods sold ` 6,00,000
Office and administrative expenses ` 45,000
Selling and distribution expenses ` 30,000
Sales ` 9,00,000
Sales return ` 30,000
15. You are required to find out:
(a) Dividend Yield Ratio
(b) Dividend Payout Ratio and
(c) Earning Per Share Ratio with below details:
`
10% Preference Shares of `10 each 15,00,000
1,80,000 Equity Shares of ` 10 each 18,00,000
Tax Rate 50%
Equity Dividend Rate 30%
Market Price of Equity Share ` 40
16. What is a cash flow statement? List the classifications of cash flow.
17. Explain the meaning of ‘cash and cash equivalents’ as per AS-3 (Revised).
18. Explain operating activities.
19. What are the items of operating activities?
20. Prepare a format of ‘Cash Flow Statement’ under Indirect Method.
21. What are the advantages of preparing Cash Flow Statement?

22. From the following Profit and Loss Account of ABC Ltd. for the year ended 31st March
2017 calculate Cash generated from “Operating Activities” by Direct Method.
Particulars ` ` Particulars `
To Opening Stock 1,60,000 By Sale (Cash) 42,50,000
To Purchases (Cash) 31,00,000 By Commission accrued 40,000
To Wages 4,40,000 By Dividend received 60,000
Add: Outstanding 60,000 5,00,000 By Profit on sale of Plant 2,40,000
To Salaries 2,20,000 (Sale proceeds ` 22,40,000
Add: Outstanding 20,000 — Book value ` 20,00,000)
2,40,000 By Closing Stock 2,20,000
Less: Prepaid 10,000 2,30,000
To Office Expenses 80,000
To Selling Expenses 1,20,000
To Income Tax paid 20,000
To Goodwill written off 44,000
To Preliminary Expenses written off 20,000
To Net profit 4,26,000
48,10,000 48,10,000
23. From the following details relating to the accounts of Grow More Ltd., prepare Cash Flow
Statement:
Particulars 31.03.2016 31.03.2015
` `
Liabilities
Share Capital 10,00,000 8,00,000
Reserve 2,00,000 1,50,000
Profit and Loss Account 1,00,000 60,000
Debentures 2,00,000 —
Provision for Taxation 1,00,000 70,000
Proposed Dividend 2,00,000 1,00,000
Sundry Creditors 7,00,000 8,20,000
25,00,000 20,00,000

Assets
Plant and Machinery 7,00,000 5,00,000
Land and Building 6,00,000 4,00,000
Investments 1,00,000 —
Sundry Debtors 5,00,000 7,00,000
Stock 4,00,000 2,00,000
Cash on Hand/Bank 2,00,000 2,00,000
25,00,000 20,00,000
(i) Depreciation @ 25% was charged on the opening value of Plant and Machinery.
(ii) During the year one, old machine costing ` 50,000 (WDV ` 20,000) was sold for
` 35,000.
(iii) ` 50,000 was paid towards income tax during the year.
(iv) Building under construction was not subject to any depreciation.
Prepare Cash flow Statement.
24. Following are the Balance Sheets of Suhani Ltd. as on 31st March, 2015 and 2016.
Particulars 31.03.2016 31.03.2015
` `
Liabilities
Share Capital 4,00,000 3,00,000
General Reserve 1,00,000 3,00,000
Profit & Loss A/c 50,000 30,000
Debentures 1,00,000 1,50,000
Provision for Taxation 40,000 50,000
Proposed Dividend 40,000 30,000
Trade Creditors 70,000 90,000
8,00,000 7,30,000
Assets
Goodwill 90,000 1,00,000
Plant and Machinery 4,29,250 2,98,000
Investment 60,000 1,00,000
Sundry Debtors 1,10,000 1,60,000
Stock 80,000 50,000

Cash and Bank Balance 20,000 10,000

Discount on Debentures 5,000 8,000
8,00,000 7,30,000
(i) Depreciation on Plant and Machinery has been charged @ 15%.
(ii) A machine costing ` 10,000 (W.D.V. ` 3,000) has been discarded. An old machine
costing ` 50,000 (W.D.V. ` 20,000) has been sold for ` 35,000.
(iii) A profit of ` 10,000 has been earned by sale of investments.
(iv) Debentures have been redeemed at 5% premium.
(v) ` 45,000 income tax has been paid and adjusted against provision for taxation.
Prepare Statement of Changes in Financial Position on cash basis.
25. From the following, prepare a cash flow statement for XYZ Ltd. for the year 2016.
XYZ Ltd.
Balance Sheet as at March 31, 2015 (` ’000)
Liabilities & Equity ` Assets `
Paid-up Capital 50 Gross Fixed Assets 1,000
Retained Earnings 350 Less: Accumulated Depreciation 100 900
Long-term Debt 500 Inventory 100
Notes Payable 80 Account Receivables 50
Accounts Payable 80 Cash 10
1,060 1,060
Balance Sheet as at March 31, 2016 (` ’000)

Liabilities & Equity ` Assets `
Paid up Capital 50 Gross Fixed Assets 1,125
Retained Earnings 415 Less: Accumulated Depreciation 175 950
Long-term Debt 550 Inventory 110
Notes Payable 100 Account Receivables 60
Accounts Payable 90 Cash 85
1,205 1,205

Income Statement, March 31, 2016

Particulars ` (‘000)
Sales 1,200
Less: Cost of goods sold – 800
Gross Profit 400
Less: Selling, general, administration, expenses – 150
EBIT 250
Less: Interest expenses – 50
EBT 200
Less: Taxes (50%) – 100
Net Income 100
(i) Dividend paid : 35
(ii) Additions to retained earnings : 65
(iii) Depreciation : 75
26. Financial information of ABC Ltd. for the year ended 31st March, 2015 and 2016 are as
follows:
Summarised Balance Sheet
as on 31st March, 2016 and 2015
` `
Assets
Cash and cash equivalents 4,500 1,500
Trade receivables 7,500 3,750
Inventory 3,000 2,250
Intangible asset (net) 1,500 2,250
Due from associates 28,500 28,500
Property, plant and equipment at cost 18,000 33,750
Accumulated depreciation (7,500) (9,000)
Property, plant and equipment (net) 10,500 24,750
Total assets 55,500 63,000
Liabilities
Accounts payable 7,500 18,750
Provision for taxation 7,500 4,500
Total liabilities 15,000 23,250

Shareholders’ equity
Share capital 9,750 9,750
Retained earnings 30,750 30,000
Total shareholders’ equity 40,500 39,750
Total liabilities and shareholders’ equity 55,500 63,000
Summarised Statement of Profit and Loss for the year ended 31st March, 2016
Particulars `
Sales 45,000
Cost of sales (15,000)
Gross operating profit 30,000
Administrative and selling expenses (3,000)
Interest expenses (3,000)
Depreciation of property, plant and equipment (3,000)
Amortisation of intangible asset (750)
Investment income 4,500
Net profit before taxation 24,750
Taxes on profit (6,000)
Net profit 18,750
1. All sales made are credit sales. All purchases are also credit purchases.
2. Interest expense for the year 2015-2016 was ` 3,000 which was fully paid during the
year.
3. The company pays salaries and other employee dues before the end of each month. All
administration and selling expenses incurred were paid before 31st March, 2016.
4. Investment income comprised dividend income from investments in shares of blue chip
companies. This was received before 31st March, 2016.
5. Equipment with a net book value of ` 11,250 and original cost of ` 15,750 was sold for
` 11,250.
6. The company declared and paid dividends of ` 18,000 to its shareholders during 2015-
2016.
7. Income tax expense for the year 2015-2016 was ` 6,000, against which the company
paid ` 3,000 during 2015-2016 as an estimate.
Using all the given financial information of ABC Ltd., prepare the cash flows statement as per
AS-3 under indirect method.

B. Multiple Choice/Objective Type Questions

1. Net working capital is defined as:
(a) Total assets minus current assets
(b) The excess of current assets over current liabilities
(c) Current liabilities less current assets
(d) Marketable securities and cash
2. The __________ is a measure of liquidity which excludes __________ generally the least
liquid asset.
(a) Current ratio, account receivable
(b) Liquid ratio, inventory
(c) Gross profit margin and operating ratio
(d) Current ratio and average collection period
3. The __________ indicates the percentage of each sales rupee remaining after the firm has
paid for its goods.
(a) Net profit margin (b) Operating profit margin
(c) Gross profit margin (d) Earnings available to equity shareholders
4. Higher gearing means __________
(a) Capital structure is high geared (b) Capital structure is optimum
(c) Capital structure is low geared (d) None of the above
5. Return on Proprietor’s fund indicates __________
(a) Utilisation of capital employed (b) Utilisation of assets
(c) Utilisation of proprietor’s fund (d) Utilisation of total resources
6. Which among the following is useful in evaluating credit and collection policies:
(a) Average payment period (b) Average collection period
(c) current ratio (d) Inventory turnover ratio

7. Which among the following ratio provide the information critical to the long-run operation
of the firm:
(a) Liquidity (b) Activity
(c) Solvency (d) Profitability
8. Which among the following analysis involves the comparison of different firms financial
ratio at the same point of time:
(a) Time-series (b) Cross-sectional
(c) Marginal (d) None of the above
9. Time-series analysis is often used to:
(a) Assess developing trends (b) Standardize result
(c) Correct errors of judgement (d) None of above
10. Which among the following is the name of ‘Return on Investment’:
(a) Rate of return (b) Return on capital employed
(c) Yield on capital (d) All the above
Answers:
1. (b), 2. (b), 3. (c), 4. (a), 5. (c), 6. (b), 7. (c), 8. (b), 9. (a), 10. (d)
8.12 References
1. Williams, Jan R., Susan F. Haka, Mark S. Bettner and Joseph V. Carcello (2008), Financial
and Managerial Accounting. McGraw-Hill Irwin, p. 266, ISBN 978-0-07-299650-0.
2. W.H. Beaver, “Financial Ratios as Predictors of Failure”, Empirical Research in
Accounting Selected Studies, 1996, p. 71.
3. Helfert, Erich A., “The Nature of Financial Statements: The Cash Flow Statement”, Financial
Analysis – Tools and Techniques: A Guide for Managers.
4. “Operating Activity on Dividends in GAAP”, chron.com, Retrieved 16th March, 2018.

Financial Statement Analysis III

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Financial Statement Analysis III 207

UNIT 8 FINANCIAL STATEMENT ANALYSIS III

8.0 Learning Objectives

CU IDOL SELF LEARNING MATERIAL (SLM)

8.2 Advantages of Ratios

 It aids financial statement analysis.

CU IDOL SELF LEARNING MATERIAL (SLM)

8.3 Classification of Ratios

(a) Debt-equity ratio

CU IDOL SELF LEARNING MATERIAL (SLM)

CU IDOL SELF LEARNING MATERIAL (SLM)

Company X (`) Company Y (`)

Current Assets 4,50,000 1,60,000

Current Liabilities 1,50,000 80,000

The current ratio will be as follows:

Current ratio 4,50,000/1,50,000 = 3.1 1,60,000/80,000 = 2.1

Acid Test Ratio or Quick Ratio

Cash Marketable Securities Net receivables and Debtors

Total Current Liabilities 20,000

Cash Marketable Securities

Capital Turnover Ratio

Net Sales (or Cost of goods sold)

Net Sales = Total Sales – Returns (if any)

Cost of Goods Sold = Opening Stock + Purchases + Direct Expenses –

Cost of goods sold

Opening stock purchases clo sin g stock

CU IDOL SELF LEARNING MATERIAL (SLM)

Turnover (Net Sales)

Particulars 2015-16 (3) 2016-17 (3)

CU IDOL SELF LEARNING MATERIAL (SLM)

Net Working Capital Turnover Ratio

Inventory Turnover Ratio

Cost of goods sold

CU IDOL SELF LEARNING MATERIAL (SLM)

Cost of goods sold

Receivables Turnover Ratio

Return on Capital Employed or Return on Investment

CU IDOL SELF LEARNING MATERIAL (SLM)

Pr ofit before Interest and tax

Return on Equity Shareholders’ Funds

Pr ofit after tax – Pr eference Dividends

CU IDOL SELF LEARNING MATERIAL (SLM)

Return on Total Assets (ROTA)

Return on Total Assets = EBIT / Total Assets × 100

CU IDOL SELF LEARNING MATERIAL (SLM)

PROFITABILITY RATIOS RELATED TO SALES

= 4,70,000 / 18,20,000 × 100

CU IDOL SELF LEARNING MATERIAL (SLM)

Net Profit Ratio

CU IDOL SELF LEARNING MATERIAL (SLM)

CU IDOL SELF LEARNING MATERIAL (SLM)

Operating Cost = Cost of Goods Sold + Selling Expenses + Administration Expenses

The Debt-Equity Ratio is computed as follows:

Loan Capital Pr eference Share Capital

Long term Liabilities

CU IDOL SELF LEARNING MATERIAL (SLM)

Long term debts

Debentures Trade Creditors Outstanding Expenses

= (7,50,000 + 4,00,000 + l,00,000)/(10,00,000 + 4,50,000 + 3,00,000)

CU IDOL SELF LEARNING MATERIAL (SLM)

Long –term Debt

Interest Coverage Ratio

Earnings Before Interest and Tax (EBIT)