110101131

INDEX
S. No Topic Page No.

Week 1
1 Introduction and Scope of Accounting 1
2 Financial Statements 18
3 Balance Sheet 1 27
Week 2
8 Profit and Loss Account 1 101
Week 3
11 Depreciation 1 141
12 Depreciation 2 160
13 Inventory Valuation 181
14 Cash Flow Statement 1 208
Week 4
19 Corporate Governance 294
20 Corporate Governance Global Models 307
Week 5
21 Corporate Governance Enron Case 319
22 Accounting Standards and Principles 350
23 Evolution of Accounting 373
24 Recording of Financial Transactions 392
25 Zee Case Profit & Loss and Balance Sheet 412
Week 6
26 Zee Case Balance Sheet 426
27 Hindalco Case Profit & Loss and Balance Sheet 439
Hindalco Case Balance Sheet and Cash Flow
28 Statement 461
29 Interpretation and Analysis of Financial Statements 487
30 Ratio Analysis and Interpretation 1 508
Week 7
31 Ratio Analysis and Interpretation 2 529
Interpretation and Analysis of Financial Statements
32 Shipping Corp. of India 1 546
Week 8
36 Financial Statement Analysis TCS Case 1 608
37 Financial Statement Analysis TCS Case 2 620
38 Financial Statement Analysis RIL Case 1 633
39 Financial Statement Analysis RIL Case 2 646
40 Revision of Course 655
Financial Accounting
Prof. Varadraj Bapat
School of Management
Indian Institute of Technology, Bombay
Lecture - 01
Introduction and Scope of Accounting
Namaste to all of you, today we are going to start a new course on Financial Accounting.
I am very much excited to meet you all and I am sure at your end also you are excited to
take the new course on financial accounting.
(Refer Slide Time: 00:42)
This is a brief introduction about myself I am Varadraj Bapat, I am a chartered

accountant and cost accountant currently I am a faculty in finance at IIT Mumbai and I
have teaching interest mainly in the area of accounting as well as to an extent in
economics. I also have various research interest including in accounting, bankruptcy
prediction, financial disclosures, financial inclusion, portfolio management, green
accounting and so on.
1
I am also interested in Yog Brahmavidya as well as Bhartiya Sanskriti these are about
my Facebook pages. For a more detailed study I have written a book on Financial
Accounting a Managerial Perspective this mainly caters to those who are interested in the
study of accounting, but tries to consider those students who may not have a commerce
or accounting background, but today are interested in accounting education. Now the
course is mainly going to discuss about financial accounting and financial statements.
2
We also have one more course on cost accounting which will discuss about the
accounting issues related to costs. You will need to submit various assignments in during
the course we will be discussing about as and when the assignment becomes due.
So, now we will start in this PPT discussion on comparison between financial cost
accounting and then we will also learn about financial statements. Now for those who do
not have accounting as their basic background as far as the commerce and accountancy
students are concerned anyway this course is going to be very much relevant. But even
for others assuming that you are engineers or you are pharmacists or for that matter you
are arts students or science students this course is equally going to be important for you
because, when you join your career whether it is a job or whether for doing some
business you are mainly being hired for your functional expertise.
But, as you move up the ladder actually your management and financial expertise
becomes more than more importance; so, accounting will be very much useful to you
because it will help you to build your understanding of finances it will also help you to
analyze the performance of yourself as well as others which is very much important
when you are in a managerial position.
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Now, we will discuss bit a as to what is accounting? In simple terms we can define
accounting as a language of business where the performance is reported and evaluated in
financial terms and if you are doing accounting properly it leads to improvement in the
efficiency which will ultimately maximize the profits. Accounting data is very much
useful for planning, organizing and controlling of all business operations.
And even for non business entities like government or NGO’s. Now the knowledge of
accounting is also useful for personal investment and tax planning decisions. Keep in
mind that this course is not to make you an accountant, those of you who have taken
accounting as your basic area you can learn more detailed accounting and can become
accountants, but this course is for everybody. So, you may or may not be intending to be
an accountant you can be a doctor, you can be a engineer, you can be a manager, you can
be a pharmacists, but what this course enables you to is to understand some basic
accounting and financial concepts these terminologies are going to be helpful to you in
any area.
Because your performance is going to be evaluated in financial terms whoever you are
and this course is mainly to make you understand those terminologies. Now there are
three important streams of accounting.
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So, we will discuss with trying to understand what are these streams? The first one is
financial accounting, then there is cost accounting and there is management accounting.
5
Now, this particular course is on financial accounting. So, we will be going into what is
financial accounting more in details, but right now we are just trying to differentiate the
three main streams. So, what financial accounting deals with is about recording of
financial transactions that is the first step, the next step is summarizing the transactions
and the third step is reporting of the financial position that is usually by preparing
financial statements. Now briefly, every business transaction needs to be recorded, if it
has some financial implication.
Can you think of some business transactions for example, you might purchase raw
material it is a business transaction, then you may do some processing, you may will go
for selling of a finished product, you may incur expenses on travelling, you may be
charged by bank charges by the bank as an expense, you may receive interest all of these
are examples of business transactions and they need to be recorded. Even if you are a
non business entity let us say you are an NGO or you are a government then also these
transactions are there.
So, business or non business, but any transaction which has a financial implication needs
to be recorded. So, the first step in financial accounting is recording of every transaction
next step is about summarizing the transactions. Almost all of you would have your own
bank account, so, you will be entering into various transactions with bank, I think you
would have also seen passbook or a bank statement. Now what does the bank statement
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give you? Bank statement or a passbook is a summary of your transactions with the
bank.
Now, bank is having lakhs of customer and they are having variety of transactions, they
are also having apart from customers various investment and loan related transaction, but
what they are doing is there summarizing only the transactions related to a particular
account holder and then they give you a passbook. So, the second step is summarizing
the related transactions. In this case if as a customer of a bank you get a summary of your
transactions it becomes useful to you, you are not interested in other transactions of the
bank neither bank is authorized to pass you on the information of other customers.
So, they will just summarize the transactions about you that is the second step and in
case of. So, in this example it was a personal transaction for a particular customer same
way bank will summarize the transactions about loans at one place, transactions about
their assets at one place, transactions about their salary expenditure at one place. So, they
would be summarizing the related transactions in the second step. Those of you are
aware of the terminologies used in accounting normally the first step is called as
journalizing or recording the transactions in the journal, the second step is called as
preparation of ledger accounts.
Now I am not using that jargon here, so to make it simple I have just tried to put two
steps; as recording of transactions and the second step as summarizing of transactions.
Now, in the third step reporting is done because, you already have summarized the
transactions now, now at the end of accounting period it can be 1 year or it can be at the
end of the month what we are interested in knowing the final balances. So, you may be
wanting to know your profits, you may be wanting to know how much cash you have,
you maybe wanting to know how much bank deposits you have.
So, you want to have a final summary of the balances which represent your financial
position. So, in the third step reporting is done by preparing various financial statements.
Keep in mind that the whole exercise of financial accounting is mainly for preparation of
financial statements which are intended for external users.
So, financial statements are passed on to outsiders of the business. Now who can be
external users? As you are aware most of the people have to file income tax returns. So,
along with income tax returns if you are a businessman you will need to give your
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financial position. So, one of the users of financial statements are taxation authorities or
government authorities there can be various other user for example, if you approach a
bank for a loan bank will ask you to submit your financial statement or a balance sheet.
So, they are also your external users, in some cases customer ask for some statement,
sometimes for vendor registration that is you want to be a supplier to a particular
company that company ask for your financial statement. So, even your customers or your
suppliers become the; become the parties who are interested in your financial statement,
then employees might be interested. So, a variety of external users are provided financial
statement; in case of many entities like listed companies those financial statements are
put in public domain.
So, they are available for anybody who is interested in those financial statements.
Internal users mind well are equally interested that can be management or that can be
your board of directors or your owners, but in general financial statements are meant to
be available for external user. That is why I have said that financial accounting is
targeted to external users. I hope you are getting over all understanding as to the process
or the steps of financial accounting. Now let us compare with second stream of
accounting that is cost accounting.
Now, when it comes to cost accounting these are the three important steps; the first is
recording of costs. Now, you can see it very well matches with the financial accounting,
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because there are also the first step was recording of financial transactions now it says
recording of costs, the next one is analysis of cost and the third one is preparation of cost
statements. Now you may be wondering that the first step in financial accounting which
is recording of financial transactions appears to be very similar now it is recording of
cost. So, is it the same thing? Many times yes.
Because most of the financial transactions may give you some cost and almost all the
costs are financial transactions. For example, if you go out let us say to a restaurant, then
you will incur some expenditure, it will be a financial transaction, it will also be a cost to
you, you might be paying rent, rent is a financial transaction it is also a cost to you, you
might be paying salaries again it is a financial transaction it is also a cost.
So, many times almost all cost are covered in financial transactions then do you need the
step again? You have already recorded there in financial accounting, then why do you
need to record? Actually the answer is you do to need to record more because in cost
accounting you are recording with lot of more details. For example, in financial
accounting you may be just recording the salary here you are also recording the time
consumed on what work that particular employee is doing, you are also might be
recording more details about the nature of work.
So, the recording of cost is actually more detailed recording, it further leads to analyzing
the costs under different heads; for example, say manufacturing cost, production cost,
marketing cost, admin cost and so on. Based on this analysis finally you come out with
various financial statements like a cost sheet. Keep in mind that cost accounting is
primary targeted to internal user. So, this is the confidential data, it is not given out to
anybody, it’s mainly for internal users.
So, I hope you would have I will just go back a bit. So, now, first we discuss financial
accounting, then we discuss cost accounting. We will not going to too much details of
cost accounting, because we are having a separate course on cost accounting where we
will discuss further details about it. The third step in accounting or at third stream in
accounting is known as management accounting. Now what is done in management
accounting is it is a umbrella concept.
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Now, you are recording both financial as well as other data, you analyze the financial
data with other data that leads to preparation of various statements which are mainly
used for managerial decisions. Now, this data again is a confidential, it is maintained for
decision making of various levels of management it is not given to outsider, so, it is
targeted to primarily internal users.
Now we have restated the streams so on one hand you have got financial accounting
which is published normally in public domain for external user, on the other side your
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have got cost and management accounting many times its together called as managerial
accounting which gives you information on decision making and it is mainly for internal
user.
Now, we will move to the next level I hope you have understood the main streams of
accounting. Now in financial accounting as you we have seen the final target is
preparation of financial statement. Now let us look at these things that what do you mean
by financial statements, which are the important financial statements and what purposes
these statements serve?
Now the first thing what are the important statements? I think many of you might have
heard about them or might have been aware about them do you think of different
financial statements? I think most of you are right there is a balance sheet, there is a
profit and loss account, there is a cash flow statement and there are more statements
which are considered as financial statements. Any statement which gives you financial
information in a summarized form is considered as a financial statement, what purpose
do they serve?
For example if you take balance sheet, what do you get from balance sheet? If you want
to know the financial statement of that entity that how will be that entities is what assets
they have, do they have any payables or liabilities all that information you will get from
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the balance sheet that is the purpose of balance sheet. We are going to discuss in detail in
coming slide as to what does the balance sheet give you.
The next is profit and loss account, as the name suggest it gives you profit or loss at the
end of some year or a month it also gives you what where the major streams of income
or revenue, where have you spent all that money and finally, what you are left with in the
form of profits at various levels? That is what is provided by P and L account we also
have a statement known as cash flow statement.
Because many times you are interested in knowing how much cash the business has
generated and where it has spend, what are the major sources of earning cash, what are
the major sources of spending cash or major sources of making investments and so on.
So, that all is summarized in cash flow statement, apart from that also there are some
more statements like there can be fund flow statement, there are financial statements of
subsidiary books, there are financial statements of a particular cash related transactions
like say cash book.
So, variety of financial statements are prepared and they can be in the category of
financial statements. In this course we will mainly be talking about balance sheet p and l
account and cash flow statement in coming weeks. Now to put it in a very much of a
layman language, if you think of a company or for that matter any organization it need
some resources for doing the business, so, you got resources, resources are provided by
somebody.
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So, there are also providers for resources. So, for any organization these resources and
providers for resources need to always match. Now while doing the operations normally
you follow a basic business model.
So, you start with some money, then you may have to do some procurement of raw
material or procurement of essential items, then these are consumed in your operation,
you get finished goods they are delivered, then you go for billing, collect the money
back, so, you are back to money. So, what circle we have is normally known as a money
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cycle it can also be called as a business cycle or as value addition cycle because what we
are trying is if you are starting with x amount of money it goes through the whole
process you would like to have x plus amount of money.
So, there should be some value addition in the form of generation of some extra cash,
this is a basic business model. Now it is supported by infrastructure and it is operated by
people because there are people who are essentially running the whole system they are
also the part of business model or business cycle.
Now, usually the costs are incurred in the beginning part, when you go for procurement
on consumption of your resources and as you deliver it to the customer you start
recovering money and that generates what is known as revenue. Now a statement is
prepared to compare the cost and revenue.
Now, what that statement will be? I think most of you are guessing it right that is what is
called as profit and loss account; it compares your cost and revenue. Now if you want to
be profitable normally, you will need more revenues than the cost and if you are
consistently profitable the business or the organization will become healthy and strong
and it will also help you to last longer. Now this business model from this business
model we will try to understand what is P and L and what is balance sheet? As we have
just discussed a statement is prepared for comparing revenue and cost that is called as P
and L account, it gives you net result in the form of profit or loss.
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On the other side you make a statement which lists out your resources, those resources
are known as assets and there are providers for resources which are known as liabilities.
Now, your assets are further categorized as fixed assets. So, whatever infrastructure you
have is known as fixed assets because infrastructure is of permanent nature, it is not
getting continuously consumed in your process, it acts as a catalyzed catalyzes catalyst it
supports your process.
Now there are assets which are continuously moving in your business cycle these assets
are known as current assets. So, we have got two major categories fixed assets and
current assets that current those current assets are also sometimes known as working
capital.
Now, can you think of any examples of fixed assets, I think one very easy example
which would have come to your mind is a land or building. So, to run the business you
will need some place in the form of building, you will also thinking you might also have
thought of fixed assets like say vehicles there can be computers within the computer you
will need software. So, hardware as well as software all these are examples of fixed
assets. Now what could be the examples of current assets? Now current assets you can
look at the money cycle and I think you will realize what could be the current assets.
So, when you do procurement you are purchasing raw material, then whatever raw
material remains in your hand as a inventory or as a stock that is one current asset, then
15
you might consume the raw material and generate finished goods, some of the finished
goods will be with you as a stock, again the stock of finished good is a example of
current asset. Thus finished goods or whatever services you are providing are provided to
the customers then customers may not pay you immediately, there might be some
balances which are to be collected from the customers.
So, those receivable balances are also your current assets, whatever cash you have in
hand or whatever cash you have got with banks with in the bank account all these are
examples of your current assets. So, fixed assets current assets these are the major
examples of assets. Can you consider people as in your assets? The answer is both yes
and no because people are human assets are the most important assets for the business,
this is the intellectual capital you have they are the people who are running the business.
Unfortunately, human assets are not permitted to be shown on the balance sheet; can you
think why they are not to be shown in balance sheet?
Because human assets are not owned by the entity or by that business, they are just
working there may be as employees or as partners or owners, but they are not the assets
which are owned. So, it is necessary that an item which is owned by that company or by
that organization that can only be shown as an asset; seen people are not owned human
assets are not shown as a part of balance sheet, that is why in the slide I have shown it,
but I have shown it below the balance sheet ok.
So, these all these assets to together are the resources for the business, along with
resource resources you will need the providers for resources because resources cannot
come for free there would be somebody who have provided. Who have provided those?
Then there are three four examples as you can see from the slide there is capital there are
borrowings and there are current liabilities.
Now what is a capital? Capital refers to the money which owners have put in. What are
borrowings? Borrowing refers to the money which the lenders have given you, for
example, banks or financial institutions they have given you some amount of loan that is
called as a borrowing. And what are current assets or current liabilities? The current
liabilities are the moneys which are been generated from the money cycle. For example,
if you have purchase something, but not paid them then those outstanding balances or
payables are examples of current liabilities.
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So, I think now at the first stage you would have seen: what are the important items on
asset side and on liability side of the balance sheet. So, we will stop here and in the first
session what we have discussed till now first we understood what is accounting, then we
have tried to distinguish between financial accounting and management accounting.
Financial accounting is mainly for external users and we are trying to record the cost and
prepare statements.
In cost accounting it is mainly for internal users we record cost and provide various
financial statements. In the next part we discussed about financial statements, so, we
have discussed what is money cycle or business cycle and from business cycle how do
you get P and L and balance sheet. In the next session we are going to continue this and
go further into what is P and L and balance sheet.
So, I hope you have liked the first session, so please watch the second session as well
Namaste.
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Lecture - 02
Financial Statements
Namaste to all of you, this is our second session on Financial Accounting, I am sure you
would have enjoyed the first session. In the first session it was just an introductory
session so, we had just started with understanding what is accounting, then what is the
distinction between various streams of accounting like financial cost, management
accounting after that we have moved to Financial Statements. So, we have seen how are
financial statements emerging? So, basically they emerge from money cycle.
So, you can have a view at the slide where we have just seen what is a money cycle; I am
trying to go from a very much of a layman who does not know accounting some of you
might be well versed with accounting terms. So, please bear with me, we will go in
details in the coming sessions.
But to begin with this is what is a money cycle, it starts with money procurement and so
on goes back to money. So, at the stage of procurement and consumption the costs are
incurred then delivery collection is a time you get the revenue.
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Now, from this money cycle the basic financial statements emerged so on one hand we
have got a P and L account, it records your revenues it records your costs and it
compares the revenues and the cost the net result is given to you in the form of profit or
loss. On the other side we have got balance sheet, now what does the balance sheet do? It
lists out the resources for the business those resources for the business are known as the
assets, it also list out the providers for resources which are known as the liabilities, in the
last session we had also seen what are the important assets.
So, you can again look at those slides I think you know it all now the first one is fixed
assets which is nothing, but infrastructure needed for the business can you think of any
example. So, it can be land, building, it can be vehicle, it can be software, it can be
patents these are all your fixed assets. What are the current assets? All those assets which
are getting converted or which are moving in money cycle; so, it includes your stocks, it
includes your receivables, it includes your cash balances, it includes any moneys which
you have to receive from let us say from electricity authority as a deposit all these are
included in current assets, human assets are important, but not part of balance sheet.
Then on liability side we have got three important items, we have got capital this is the
money which owners have put in, then we have got borrowings this is the money which
lenders have put in as various types of loans and then we have got current liabilities.
Current liabilities again are coming from money cycle for example, the payables to
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suppliers. So, if we purchase some goods do not pay that money immediately, then that
much balance will be your payable or if you use let us say electricity, but have not paid
the electricity bill then the outstanding electricity bill will become your current liability
ok
So, this was a brief of what we did last time. If you look at the bottom part of the slide it
is sort of trying to tell the purpose of these two statements. So, balance sheet is one
which shows you the financial position of the organisation and P and L account it tells
you about the profitability of the organisation. Now moving ahead again it tells you what
does the balance sheet gives?
So, it shows the cumulative position of resources that is your assets and the sources of
the funds that is your liabilities at the end of the year of course, it can be at the end of the
month or a quarter also, but keep in mind it is a cumulative position.
So, if you purchase your some land 10 years before it will come continue to appear in
balance sheet today unless you have sold it. So, all your assets continue your liabilities
will also continue. So, if you have obtained a loan 4 years back it will appear in the
balance sheet at that time it will even appear in the balance sheet today as long as you
have not yet repaid it. So, you cannot say that this loan was taken four years ago, let us
forget it now that is not possible loan was there then, loan is there now, the outstanding
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balance will be shown in the balance sheet of today also, that is why it has been called as
a cumulative position as on a particular date.
The profit and loss statement essentially gives you revenues and cost performance, but
for a particular quarter or a year. So, if you have made any sales in this month and if you
make profit and loss for this month it will come as a profit and loss of this month, but it
cannot be shown in the next year it can only be shown in the current year ok. So, it is not
accumulative performance it is a performance for that period that is shown in the P and L
account.
Now very important statement is as we have seen in the beginning your resources and
sources match. So, your balance sheet exactly matches, but after doing business for
sometime your business cycle is continuously going on will the balance sheet still match
is it possible? Suppose you are doing well in the business your assets will slowly go on
increasing your liabilities will not increase infact liabilities can go on decreasing then
will the balance sheet still tally or match.
Now I am just going back to the slide so, that you can have a view of the balance sheet.
So, you can just look at the asset side normally what will happen is if your business is
doing well your stocks will go up, then your receivables will go up, your cash will go up
while on liability side you might be repaying your loan so, loan balances will go down. If
you pay your suppliers or employees on time your current liabilities will also go down.
So, your liabilities are falling assets are rising, then will the balance sheet still tally is it
possible that the total of assets and liabilities will match, what do you think? Just have a
thought on this.
Is any item missed out in the given assets or liabilities which should be there. Actually
very important item is known as reserves which was not shown earlier, but I am just
showing it now to highlight it or bring your attention to it. So, what will happen is after
say 1 year you have made some profit in profit and loss account that profit either is taken
away by the owners it is their profit they can take it away, but mostly owners do not take
away the whole of profit they may take some money remaining money is accumulated in
the business in the form of reserves.
So, that reserve goes on increasing, see we have already seen that assets are raising your
external liabilities are not rising in fact, they are falling. So, there is a difference that
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difference will be given in the form of reserves. So, what happens is for a healthy
business profit goes on building up and that accumulates in the balance sheet in the form
of reserve. Now suppose you have no time to study the balance sheet the old balance
sheet of a company just have a look at balance sheet and look at the reserves position, if
the reserves money is high it immediately tells you that companies able to generate profit
on a consistent basis because 1 year’s profit you can get through P and L.
But it is only for that year, but that whole profit is getting added up in reserves, if the
total profit for so many years minus what profit they have taken away is what is shown in
the reserves and if that amount is very high it will mean that company is having a good
financial position for a pretty long time. You would have heard of Blue Chip Companies
most of the top rated companies have a high level of reserves.
Now, what happens is if you have good amount of reserves then company can easily
expand, they do not have to go to bank to borrow new money, they can spend that money
on anything which they want and the company will grow in a very healthy manner. Now
once again I have summarized the financial positions.
So, balance sheet it may be prepared at any time not necessarily at the end of the year,
but it gives you position as on that day and profit and loss account is normally prepared
and presented at the end of a particular period.
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This is once again summarizing the items in the balance sheet for you, so, we have got
liabilities, now the first item I have put it as owners fund. Now what do you understand
by owners fund? If we just go back we had earlier put capital and we had the second item
was reserve. So, these two items taken together capital plus reserves are known as
owners fund. Now how do you define capital? If we remember we have seen that money
which owners put in is a capital here business is generating profits and giving it to
owners in the form of reserves.
So, capital plus reserves together is the first item in the liability side of the balance sheet
that is known as owners fund. The second item is noncurrent liabilities in the earlier
balance sheet we have called it borrowings as an example, but any liability which is of
long term in nature is called as a noncurrent liability mainly it will include borrowings or
loans it can also include any other item which you have not paid in 1 years time. The
third item is current liability so, current liability we had seen that from the money cycle
certain liabilities arise as far as the definition is concerned if that liability is intended to
be paid in 1 years time then it is called as a current liability.
So, we have seen two three examples can you think of any other example. For example,
if you have employees with you should pay salary at the end of the month, but if you do
not pay that salary then the amount of salary which is still unpaid it will be called as a
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current liability. If suppose there are some other expenses let us say office expenses, you
have not yet paid them then that is also current liability.
So, all those liabilities which are due or which are payable within 1 years time they are in
current liabilities all those liabilities which are not intended to be paid in 1 year are
noncurrent liabilities. So, both these noncurrent plus current these are external liabilities
and the top item or the first item was owners funds this is also called as an internal
liability.
Now, go to asset side we have already discussed what is a fixed asset. So, this is a
infrastructure or these are the assets which are long term with the business to be used for
the business, then we have added one more item here that is known as noncurrent
investments and the last item the bottom most item is a current asset which I think we
have already discussed.
So, what we mean by current assets is these are those items which are to be liquidated or
which are to be received within 1 years time or and they are not normally coming from
the money cycle. So, all those items which are likely to last for more than 1 year are
called as noncurrent ok. So, assets broadly are noncurrent current; current is the last item
within noncurrent we have got fixed assets then next is noncurrent investments.
Now what is this non current investment? First of all what is meant by investment? If
you see I will just take you back in the earlier balance sheet we had not mentioned of any
investment we had just seen fixed assets and current asset because that was a balance
sheet which emerges from money cycle, but in case you have invested some money
outside your business then that money is called as an investment.
So, here any money which we have put outside your business and which is to last for
more than 1 year then it is called as a non current investment. So, can you think of any
examples of noncurrent investment may be something like fixed deposit kept in bank for
more than 1 year not in your bank account because, bank account is a current asset, but if
you keep the money in fixed deposit with a bank for 2 years, then that will be an example
of non current investment. Similarly, if you invest in shares of some other company then
that is non-current investment are you getting me.
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So, you can have some examples of those money put outside your business that is the
non current investment apart from these if you have any noncurrent assets then they are
categorized as other noncurrent assets. So, are you getting these are the important items
in balance sheet under liabilities and assets. Now we will come to the next item we are
going to discuss balance sheet and P and L in the next sessions, but right now it is very
important for you to know where from you get all these information.
The best source of information for you is a annual report because every company comes
out with the annual report and that annual report has financial statements.
Whatever financial statement that we have discussed like balance sheet, P and L, cash
flow, they will all be available in the annual reports along with notes to accounts and
some more disclosures. Then there are some other things in annual report also, there will
be chairman’s statements, there will be board of directors analysis, there will be auditor’s
report, there will be report on corporate governance, there will be consolidated financial
statements, then there is a management discussion and analysis.
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There is also a list of employees receiving remuneration more than 60 lakhs maybe some
of you are aspiring for that may be someday even my name should appear among the
employees who are earning more than 60 lakhs per year. So, there is a list given out there
that who are these people what is their qualifications and experience and so on. So, this
annual report is a authenticated document and a very useful document for any learner,
you will get financial statements here I am telling you this right away because I am
expecting each one of you to download the annual report of the company this is freely
available.
So, please choose your company download your annual report read it go through it
because in our course in coming lectures we are going to discuss about balance sheet, P
and L, cash flow some more requirements of preparation of financial statements all these
should not be theoretical. Go through your annual report look at the balance sheet and L
and L of your own company, your own means you do not may not be owning it, but
consider it as your company and start studying it from now, that is why in this situation I
have told you what is annual report in detail we are going to look at various financial
statements in the coming sessions.
I hope you have like the second session also this was bit shorter one, but the third session
onward now we will go into technical details about each of the financial statements.
Thank you so much and Namaste.
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Lecture – 03
Balance Sheet 1
Namaste to all of you. Welcome to the third session of Financial Accounting. In our first
session, we had discussed the distinction between financial cost and management
accounting, and we had also seen the importance of accounting. In the second session,
we started with our discussion on financial statements. If you remember we have
discussed the basic format of Balance Sheet and then we went on to understand what is
annual report. If you remember, balance sheet is a statement which gives the financial
position as on a particular date, it is a cumulative statement.
Today, we are going to discuss further in detail about what is balance sheet and how it is
prepared. We also discussed about annual report. Now, this is a authenticated document
which is published by the company and it is a treasure of lot of data about companies. It
is freely available. So, I had told you to download annual report of one particular
company and go through it in detail. It will give you financial statements, it will give you
consolidated balance sheet, it will also give you various other statements which are very
much relevant to understand the company, the nature of company and so on. I had told
you that there will be a list of employees who are earning more than 60 lakhs per year.
So, if you aspire to go there first of all you should know the list. So, lot of information
will be available.
I hope by now you have decided your company and also downloaded your annual report.
We will be giving you some assignments at the end of the week which you have to do on
your company. But, right now let us move to our session 3, which we will discuss further
about the balance sheet.
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So, introduction to the balance sheet and the elements of balance sheet. Now, you
already know that financial statements records are the provides information for about
financial status; it can be for individual, it can be for organisation, it can be for a
particular business and so on.
There are three important financial statements: balance sheet, profit and loss and cash
flow statement. So, in our course we are going to discuss about how these are prepared
and how they can be read and interpreted.
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Now, coming to specifically what the balance sheet is, it portrays the value of economic
resources which are controlled by the enterprises. So, what they are known as economic
resources controlled by enterprise? The accounting terminology for it is assets and also
how they are financed. They are financed through variety of liabilities. So, either it is
money put in by outsiders which is known as liability or it is money put in by the owners
themselves which is known as owners fund or it is also called as equity. So, balance
sheet is a statement which summarises asset on one side and external and internal
liabilities on the other side.
Now, just to get a feel of the balance sheet this is the format in short. So, you can start
from the asset side, in the last session we are already discussed what are those terms. So,
the first one is fixed assets; this is various infrastructure of the company. The second one
is non-current investments. These are long term investments which are going to last for
more than 1 year outside our business. The third one are current assets. These are assets
which are intended to be held for less than 1 year. So, these three are the major assets or
the resources of the undertaking.
On the other side, we have got liabilities. Liabilities are the providers of funds. The first
item there is owners’ fund. In our last session we have discussed what does it consist of.
Do you remember what is included in an owner fund? There are two items. The first one
is capital and the second one is reserves or accumulated profits. The second item is
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noncurrent liabilities. As the name suggest noncurrent refers to one which is likely to last
for more than 1 year. So, long term liabilities the third one is current liabilities or short
term liabilities or those liabilities which are likely to last for less than 1 year. So, to just
to have a glance, this one is not official format. We are going to it in the next slide. But,
just to understand in short what the balance sheet is I think this format is very much
useful.
So, any balance sheet can be very much longer because of long large number of items. It
can be summarised in this particular short form just to give at a at a first eye view of the
balance sheet. Now, every balance sheet shall give a true and fair view of state of affairs.
This is the terminology which accountants use. They do not show correct they do not say
correct view because there are a lot of assumptions which go into valuation of certain
items in the balance sheet. We will be discussing it later, but any balance sheet is
supposed to give a true and fair view as at the end of financial year or it can also be
prepared in between; it will give you a balance sheet as at the end of that particular day.
Now, let us go for a detailed balance sheet. Now, this is the official format as per the
schedule VI of Companies Act. This particular format was introduced in year 2011, that
is why I have kept there 10 and 11, for a corporate balance sheet two year data is to be
given. So, you can see the columns there one for 2010, the other one is for 2011. Now,
the first item there it is going to start with the equity and liabilities that is I; in that one is
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shareholders funds. If you remember in our earlier balance sheet; I will just go back. See,
here I have shown the first item as owners fund. Now, in this format it uses the term
shareholders fund.
Now, why is this difference why there it was owners fund and why here it is shareholders
fund? Can you think of what is the difference? There is no difference as such.
Shareholders are nothing, but the owners of the company. But, since this is the format
meant for the company they have specifically used the term shareholders. While for
using the short form I had used the term owners fund because every balance sheet is not
a balance sheet of a company. It can be a company it if it is a partnership firm what
whose capital it will be? It will be called as a partners capital. If it is a proprietary
concern with a single owner it will be called as a proprietors capital. In case of NGO or a
non profit organization what it will be called? It is called as a capital fund ok. So, overall
whoever are the owners, it is their capital.
Now, let us go back to company balance sheet. In company balance sheet it is called as
shareholders funds. Inside the shareholders fund item a is share capital. Now, how do
you define share capital? What is the share capital? Yesterday we have discussed in the
last session we had discussed about capital. Do you remember what is the capital?
Capital refers to the money which is put in by the owners. In case of company the
shareholders are the owners. So, money which is put in by the shareholders is known as
share capital. There are three-four specific items under share capital, but we will not go
right now into it. But, whatever the money which they have paid it is known as paid up
capital that will come here in the balance sheet. So, item a is share capital.
Second item is reserves and surplus. Now, what do you understand by reserve and
surplus? Reserves I think in the last session we had discussed. If you remember from the
profit and loss account the profit is generated by the entity or by the company. There are
two choices with the company: either it can distribute profit in to the owners, then it will
not come in the balance. But, most of the good companies do not distribute whole of the
profit. They may give part of the profit to the owner and remaining profit is ploughed
back into the balance sheet; ploughed back means instead of distributing it is kept with
the company and in the balance sheet it appear as a reserve. So, but the full name for it is
reserves and surplus.
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Now, in the last session we are seen that this profit which is ploughed back is a reserve.
Actually for a company there are some other type of reserves also. There can be statutory
reserve, there can be capital reserve or there can be dividend equalisation reserve. These
are of few examples of reserve. The total of reserves and surplus is given as item b in the
balance sheet.
Now, take a look at item c. The item c is money received against share warrants. Now,
the question which will arise in your mind is what is share warrant? I think everybody
knows the share. What is the share? So, in the partnership firm, let us say there are three
partners. Instead of writing total capital we will say as a’s capital, b’s capital, c’s capital.
But, in company what happens there are 1000, 10000, 1 lakh, 10 lakh there are large
number of owners. So, we do not write everybody’s name in the balance sheet. We write
the amount which is contributed by that persons together it form share capital.
So, share refers to the share in the ownership of a particular company. So, for so many
shareholders suppose there are 10000 shareholders in the company everybody would
have put in some capital, that total is item number a share capital. In item number c, it
talks about share warrant. So, you will be wondering what is a warrant? Does anybody
know what is a share warrant? Now, sometime what happens is a few people are entitled
to receive share in future.
So, as of today they have not yet received share, so, we cannot show it in the share
capital. Whoever has received share from a company and has paid the money will be
share capital, item a. But, if that person has paid the money, but still has not been
received has not been issued a share, but has been issued a right to receive share in future
it is called as share warrant. That means, suppose I am a company, there are hundred
people who have paid me some money and I have issued them the warrant which gives
them are right to get share in future. The money which is received by me; I am a
company, so, money which is received by me against those share warrants is that item
number c. The money received against share warrant.
Now, you may be wondering why should company go into this business of issuing
warrants. There are variety of reasons. As I told you one simple way is take money give
them share, then it will go in item a that is known as share capital. But, in certain
instances as a company I do not want to give them share now, but I want to receive
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money and give them share in future, then in such scenario I issue them share warrant.
Can you think of any such scenario where a share warrant is received?
I think some of your guessed it correct. In many cases there are some shares known as a
ESOPs. ESOP that is Employee Stock Option Plan sometimes is also sweat equity. So,
there are managers or executives who are working for the company we want to
incentivise them. We want to give them some benefits because they are working very
well, but we also want them to stay in the company, we do not want them to go out. So,
what we do is we will issue them warrant and attach a condition that if they continue in
the company for next 3 years then that warrant can be converted into share. So, this is
one example of when the share warrant is received.
Can you think of any other example? Sometimes what happens is company wants to
raise loan. Let us say I go to bank and request the bank to give me loan, but what banks
says is that bank wants the share in our profit. Now, we cannot directly give them share.
So, what we do is when we take loan we give them some share warrants and these share
warrants can later on the converted into shares by the bank. They pay some token money
to receive the share warrant and that money is shown in item number c.
Now, you may be wondering that the share warrants is a small amount, why so much
discussion on it? Why so much discussion because later on it is going to be added to a
and keep in mind that a that is share capital is a very important item. These are the
owners of the company. So, today’s investor should know that there are some owners
which are in future going to be included in the list of shares. Now, they can be
employees, they can be bankers, in some cases company get some technology from some
technical experts or some professionals, maybe to compensate them we give them
warrants. So, all these are shown under item number c that is money received against
share warrants.
Obviously, this item c is not there for a proprietary concern or for a partnership concern.
So, in that earlier short balance sheet it was not there, but in a company balance sheet in
a detailed format this item is bound to be disclosed. I hope you are getting what is item
number c. Now, we will go to the next slide.
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Now, item number 2; this is share application money pending allotment. Now, what is
meant by application money? Many of you would be aware that whenever the shares are
issued first of all the shareholder or a prospective share holder has to pay to the
company. So, suppose I am company, I want to issue shares; of course, I am not giving
them for free they are going to pay me. So, I declare that I am willing to issue share to
prospective investors; people who want the shares in my company, they would come
forward and pay me some money. Now, I receive money if I give them shares then no
problem it will go in one a, that is share capital.
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However, what happens is if a company wants to issue shares it declares that is willing to
issue share whoever wants to invest, that is the prospective investors, they would pay
money and they want to issue shares receive shares. Now, if they are issued shares then it
will go in one a no problem.
But, in some cases what happens is the allotment of shares is delayed means I receive the
money now, but till the end of the year the shares are not allotted that is and then where
will you keep that money that that particular amount is kept under this item number 2.
So, I hope you have got it now.
So, share application money pending allotment; that means, suppose I have received 10
lakhs from the shareholders as till not given them shares. So, it is an application money,
but the allotment of shares has not happened; allotment means giving process of giving
the shares that has not yet happened. That is why it is shown as share application money
pending allotment. It is shown as a separate item because later on it is going to be added
to one a that is share capital or the other possibility is I can reject their applications and I
will refund the money.
So, it is not yet clear whether it is a share holders funds or whether it is liability. If I give
them shares it become shareholder fund if I give them back to the prospective investors it
becomes a external liability. That is why there is a second item is a specific item known
as share application money pending allotment ok.
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Now, the third item. The third item is noncurrent liabilities. Now, we have discussed it
earlier in the last session also and also in the beginning of the session. So, what do you
understand by noncurrent? I think by now everybody knows that whatever is intended to
be settled within one year is we call current. If it is likely to last for more than 1 year we
call it noncurrent. So, all these items under are the examples of long term liabilities, they
are going to be for more than 1 year. So, they come under item number 3 noncurrent
liabilities.
In that if you see a, it is long term borrowings. Now, as the name suggests it is for a long
term more than 1 year borrowing. What do you mean borrowing? Borrowing refers to the
loans which are taken by the company. So, company most probably will take loans from
banks, it can also take loan from financial institutions it can take loans from non banking
financial companies or NBFCs are as they are known as. From anybody if they have
taken loan then it will be shown under the head 3 a as long term borrowings.
Now, 3 b, deferred tax liability. Now, what do you mean by deferred? Deferred means
instead of paying now I am going to pay it in future after one year and tax liability. See
normally the tax liabilities are to be paid in the same year then it is known as current tax
liability, but a part of the tax liability instead of paying now is paid after 2 years, 3 years,
4 years then it is called as a deferred tax liability. Of course, this is not as per the wish of
taxpayer otherwise he/she will say I do not want to pay now and I will defer it.
Government decides as to what tax liability you have to pay now and a part of the tax
liability as a incentive they say you do not pay it now you pay after 2-3 years. We will
discuss it later on as to which items are deferred, but in general whichever items which
are not to be paid in next year, but can be paid beyond that then it is called as a deferred
tax liability. Then the item c, 3 c is other noncurrent other long term liabilities non
noncurrent and long term is almost same.
So, we have already seen that a refers to long term loans, b refer to deferred tax liability,
other than these are shown under c as other noncurrent liability. Now, the question in
your mind will be which are such items. Can you think of any such item? I will just give
you one example. Suppose, we have received deposit from somebody it is not the loan,
but the deposit is likely to be paid after 2 years, 3 years, 4 years etcetera then it will fall
in 3 c because it is neither borrowing nor it is a tax liability, but it is a long term in
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nature. It is not a short term deposit. It is to be paid after 2-3 years, then it will be shown
as a other noncurrent liability.
Then the fourth item 3 d, that is long term provisions. Long term means more than 1 year
that you are aware, but what do you understand by provision. Is anybody aware what is a
provision? See, this is the amount which is payable, but how much is payable is not
known to me to the full accuracy with the exact details a few of the details are not yet
known, information is not available. So, what I do is I make the best estimate of a
particular liability and show it as a provision. So, such long term items are shown as long
term provisions.
Can you think of any example of any provision which is long term in nature? Suppose, a
customer has filed a complaint against me and wants to take some compensation
because, of deficiency in service. We are having argument with the customers some case
is on or some discussion is on. We are not going to paid it immediately. After some court
decision or after some authority’s decisions we will pay it. It will take to 2, 3, 4 years in
such case whatever is likely to be payable as a compensation will be shown as a long
term provision.
Or another example I give. We have got lot of employees working in our company.
When they retire they have to be paid with gratuity. At the time of retirement employees
get gratuity amount however we do not know the gratuity amount because it depends on
the salary of that person at the time of retirement. Age of retirement we do not know or
in case of unfortunate death of the person we have to pay it at the time of death. So,
nobody knows the date of death.
So, naturally we do not know the exact amount of gratuity, but we make our best
estimate and that estimated liability of gratuity will be shown as a long term provision.
Later on we are going to discuss a bit more on provision, but right now I think you would
have generally understood that this is the one of the long term liabilities that is why it
shown under item 3, that is noncurrent liabilities.
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Now, the next one is current liabilities. Now, in the last session we have already
discussed what is a current liability; it is less than 1 year period and it comes from the
business cycle. So, mostly it relates to day today transactions of the business. So, 3 a
refers to short term borrowings.
Now, we already know long term borrowings means more than 1 year, the short term
borrowings are loans which are taken for less than 1 year. So, for example, we have
approach bank for a bridge loan; bridge loan is typically sanction for just 2 months, 3
months, 4 months period. That means, we are going to start a new project, but it will start
after 3 months. So, for that 3 months we have obtained some loan that bridge loan which
is 3 month loan so, it is shown as a short term provision. For that matter any loan which
is less than one year accepted from bank or NBFCs will be a short term borrowing.
Next one is trade payables. I think most of you are aware about it that whenever we buy
any item in a B2B transaction it is not across the counter. If you are in business
transaction what happens company places a order, the goods are delivered and payment
is done after 15 days, 1 month, 2 month etcetera. So, from the date of purchase till the
date of payment the amount is a payable it is related to our regular trading activity, that is
why it is shown as a trade payable. Usually trade payables will be for 15 days, 1 month,
2 months and so on. So, that is why they are clubbed under current liabilities.
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The third one are other current liabilities. So, as you know what is not covered in
borrowing or trade payables there can be any other items. Can you think of any
examples? Most of you would have got this in your mind that suppose salaries are there,
so, we are supposed to pay salary on thirty first of the month or thirtieth of the month.
But, if you do not pay then till the time you pay it becomes a outstanding salary. So, it is
an example of other current liabilities. Same way electricity bill, rent, and any other
office expenses which is not paid, but is payable in the short term that will be other
current liability.
And, the last item in this head that is 4 d is short term provision. We have already
discussed the provision. So, a particular liability where amount is not known with
substantial accuracy is a provision, but it is payable in the short term period then it is
called as a short term provision.
So, with this that is right now we have gone through 1, 2, 3 and 4. So, we have finished
the asset side of a detailed format. In the next session, we will discuss about we have
completed the liability side of the format. Now, we will next session we will discuss
about the asset side Namaste.
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Lecture – 04
Balance Sheet 2
Namaste, welcome to the 4th session of our Financial Accounting course; I hope you
have enjoyed first three sessions and first session 1 and 2 where very much introductory.
We had just started what is financial accounting, then we went to understand financial
statements particularly the starting point of balance sheet which we saw how it gets
emerged from business cycle, we also discussed about what is there.
In the annual report in the last session we had started a little detailed discussion of
balance sheet. So, I will just go back to the formats which we have seen, those of who
have first time seen the balance sheet this was the short format at one glance to
understand what is a balance sheet.
On one side we have got assets which provide a list of all the resources with the
enterprise, on the other side we have got liabilities. So, liabilities are giving you the
providers for the resources or there are internal people like owners who have given us
owners funds, there are external people like banks who have given us external liabilities
both are listed under the head liabilities.
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After this we had started discussion on format as per schedule VI, now few of you may
be wondering what is the schedule VI mean. Now, schedule six is a schedule under
companies act. So, for all the companies the balance sheet is to be prepared as per this
format. Now, under schedule VI the first item not the first part is I refers to equity and
liabilities that is what we are discuss in the last session, under that you have got 1 that is
shareholders funds I hope you have understood it. If you have a doubt in anything not
only here, but even of the earlier items please feel free to discuss it on discussion forums.
So, the team from IIT we would like to respond to all your queries please be responsive
discuss a lot on your discussion forum.
As I have told you earlier I hope you have decided about your company, download the
annual report of that company look at the balance sheet; as we are studying a particular
financial statement please look at the balance sheet of your company. And, any doubts
you have you can discuss with your classmates you can also discuss and ask it on to IIT
team we will be responding to each and every question from your side ok. So, under item
number 1 there are three sub items share capital, reserves and surplus and money
received against share warrant.
So, capital share capital is a money which is put in by the owners, reserves and surplus
refers to the profits which are ploughed in; c refers to the money which is collected from
certain people and in future they will receive shares, so far they have not received any
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shares such money is shown as money received against share warrant. In item number 2
share application money pending allotment this is also similar; the prospective investors
have paid me some money, shares are to be issued to them but are not yet issued, till that
time the money is shown under item number 2 that is share application money pending
allotment. Once they are allotted it will go in 1 if they are not allotted it will be refunded
that is the item number 2.
Item number 3 is non-current liabilities again you have got four items a are long term
borrowings. So, these are the loans taken for more than 1 year, b is deferred tax liability.
Now, this is a tax liability the amount which is to be paid as tax, but not in the current
year it will be paid after 2, 3, 4 years due to certain provisions under tax laws. They are
differed tax liabilities later on we are going to discuss how they are calculated, but once
we complete our balance sheet.
c is other long term liabilities, so other than a and b if there are deposits received for
more than 1 year or if there are some salaries which are unpaid for a longer period they
are all shown under other long current long term liabilities, then 3D is long term
provisions. So, provisions are those items in liabilities of which the amount is not known
with substantial accuracy. So, a provision is created and it is shown under 3D especially
if it is for more than 1 year.
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The next one which discussed was item number 4 in item number 4 a, then item number
4 where current liabilities as the name suggest these are for less than 1 year. So, 4 a is
short term borrowings, so loans taken for less than 1 year 4 b we are trade payables. So,
these are various purchases made, but we have not yet paid related to our regular
business, so they are called as trade payables. 4 c are any other current liabilities like do
you remember any examples we are discussed outstanding salaries or outstanding
electricity bills or outstanding office expenses outstanding stationary charges.
So, on any expense which is not yet paid, but is payable in 1 year that is other current
liabilities. 4 d are short term provisions, so again estimated liabilities which are payable
in short term. So, in our last session we had come up to item 4 this was a quick revision I
am taking revision every time especially in the earlier sessions but, I hope you are
attentive and you have understood whatever we have discuss till now.
Now, let us go to the II part of balance sheet that is known as assets. So, these are the
properties or these are the resources which are available with the enterprise in two again
the item number 1 is noncurrent asset as the name suggests noncurrent means it is for
more than 1 year or you can also call it as a long term in that you have got a; a refers to
fixed assets. In a again we have got a small i and ii, so a 1 is tangible assets a 2 is
intangible assets.
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In our second session we are discussed what is a fixed asset I hope you remember. So,
fixed assets refer to the infrastructure of the undertaking, it refers to those assets which
are used for running the business cycle they themselves do not take part in business
cycle, they do not get converted, but they support the money cycle. So, which are such
items?
For example, we have got land, we may have a building, we may have a machinery, we
may have vehicles they are with us for a longer period, they help us in doing business or
they help us in doing our regular activities, but they are themselves or not getting
converted, so it is not a stock ok. So, these are fixed assets they are of two types one is
tangible the other is intangible.
Tangible means that can be touched, that has physically existence. So, all the examples
which we discussed like land building vehicles these are all tangible second one are
intangibles, they have no physical existence and cannot be touched, but they have a
value. So, what are such assets can you think of any example? I think all of you use
computers we can see the computer screen and the other parts that is all your hardware,
but computer also has some software built into it that software you cannot touch or you
cannot feel it but you can see its impact that is an example of intangible asset.
Can you think of any other example? There are patents, there are copyrights, there are
trademarks these all are rights of the company or rights of the owner, but not of physical
in nature it is a intellectual property all these are examples of intangible fixed assets.
This is an era aware intangible assets are becoming more important than tangible assets
say 100 years before tangible assets were very important. So, large companies like ford
or general motors or general electric wire big companies.
Today which are the big company’s? I think all of you know now it is Google, it is
Facebook it is, Microsoft do they have physical assets of course, they have little bit, but
most of their assets are intangible in nature anyway this was just for discussion in general
for any company there will be some tangible assets some intangible assets through be
shown under a 1 and 2, a 3 is capital work in progress.
Now, what is meant by work in progress? That means, some work is going on
something which is under construction, capital because it’s a long term. So, suppose
building is under construction once it is ready then we will call it as a tangible fixed
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asset, right now the building is not ready, but some work is on we have spent some
money and suppose it will take three years to complete. So, as of now I cannot show it is
a building or as a tangible asset neither I can show the money paid just as an advanced
because some work is already happened that is why it is shown as a capital work in
progress.
The fourth one is intangible assets under development. Now, what is this? Just like
capital work in progress lot of intangible assets are being created or being developed, but
still they are not ready like you have applied for patent, but patent is not yet sanctioned,
but you have already spend lot of amount on research, then that will be a intangible asset
under development or for example, you are developing some software development
testing has not happened.
So, it is not in the ready stage for use, but cost has been incurred in the development
process that will be shown as intangible asset under development. Now, when you
studied your company’s balance sheet for last two three years please try to look at item 3
and 4 carefully because, this year suppose it is under construction or under development
next year it will be ready. And, it would have gone into tangible or intangible asset right
because we expect in 1 or 2 years the work will be completed and it will be classified
either as tangible or intangible.
Suppose a particular item is shown as under construction for a long period 2, 3, 4 years,
then we will have a doubt as to why that item is not getting ready, is it a fraud to show
that item or there are genuine problems; if non-completing it of course, we cannot
conclude anything right away. But, I am just saying that you can just look at the details
of item 3 and 4 and say that these items are stagnant or they are getting ready and new
items are by being newly constructed ok.
Now, this a that is fixed assets as 1, 2, 3, 4 the total of that is considered as a total of
fixed assets. Now, the second item that is 1 b is non current investment, in our last to last
session we are discussed a bit about what is an investment, do you remember? So, if you
put in some money outside your business it is called as a investment within your own
business if you construct a building construct or purchase stock purchase that is not an
investment; investment means you have to give it money to some other company or
somewhere else. So, can you give any examples of investments?
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So, for example, shares for example, bank deposits for examples units of mutual fund if
you invest money with some other company or with the bank then it is a investment if
that investment is done for more than 1 year it will be shown under 1 bs non-current
investment. Some of you may be interested in finance in future you might be wanting to
do career in finance you would have heard of terms like portfolio management or stock
market whatever the money you are putting in there that is all under 1 b.
And there is a science of how that is managed, how do you invest, when do you buy,
when do you sell all those things are studied under portfolio management of course, right
now will not going to it, but what portfolio they have your company has you can see
from 1 b. So, when you go to balance sheet of your company have a look at 1 b to
understand what type of investments they are making.
Now, go to 1 c that is deferred tax asset if you remember in the last session and even in
the beginning of today’s session we discussed about deferred tax liability. Now, deferred
means something which is not due today or in the current year which is due in later
years, if it is a liability it will be shown as a deferred tax liability this is a deferred tax
asset.
So, today you will not get the benefit of it you will get it after two three years, then it is
called as a deferred tax asset. Does it mean after three years government will pay you
tax? Of course, no government pays us tax, but government gives you some benefits
which you can use after 2 years, after 3 years benefit of remission of tax or reduction of
tax that is called as a deferred tax asset. Exactly what is this item we will discuss later
on, but if there is any such asset in existence it will be shown under 1 c ok.
Now, the next item is d long term loans and advances. Now, what do you mean by loans
and advances? Loan is of two types; one, the company has taken loan, then it will be
shown as a borrowing under the liabilities we have seen it in the last session, but suppose
company gives loan, then to distinguish it from normal loans we will call it as loan and
advance. So, if company gives loan to somebody or advance to somebody it is
considered as a loans and advances.
So, in future if you see the word loan and advance always keep in mind that it is an asset
item if there is only loan then it is a liability, if it is a loan and advance there is a hint to
you that it is an asset ok. Now, since this is for a longer period we are showing it as a
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long term loans and advance. What can be an example? For example, suppose company
gives advance to employee to purchase new house, now the housing advance will
obviously not be for one year only, it may be for 5 years, ten years, 15 years, then it will
be shown as a long term loan and advance.
It can also be a loan or advance given to some supplier for two three years let us say
supplier wants to buy a new machinery. So, we will give some loan to be repaid after 3
years, then it will be shown as a long term loan and advance. Then 1 e other noncurrent
assets, so apart from abcd if there is any other long term asset then it will be shown as a
other noncurrent asset ok. So, under item 1 we have discussed whole of long term assets.
Now, let us go to second, so in assets we have got one as noncurrent, two as current I
think you all know the definition these are all going to mature or which are going to be
liquidated or converted within a period of 1 year. If you remember in our session 1 we
have seen the business cycle. So, in a business cycle mostly it is a exchange of fixed
assets noncurrent assets we will discuss or we will deal in them only after two three
years, four years, five years, but current assets’ transactions take place every moment,
they are continuously being exchanged.
So, under 2 1 we have got current investments I think you remember what is an
investment. So, we put money outside our business it is called investment, for example,
if we have a three-month bank FD, then it will be shown as a current investment or if we
invest in shares and sell them after two months, then it will be a current investment ok,
then 2 b is inventories.
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Now, what do you understand by inventory? The other name for it is stocks we might
have some raw material that are converted to finished goods or we can purchase finished
goods all this taken together are known as inventories. So, these are items which are
meant to be converted or sold in our normal course of business which will be shown
under 2 b c is trade payables sorry trade receivables we have already seen trade payables
under liability. What is a trade receivable?.
In B2B business normally when we sell the goods across the counter we do not get the
payment immediately, we will sell the goods, we will send the bill after 15 days, 1
month, 2 month customer will make the payment. So, till the time the money is received
it is called as a trade receivable. In other words whenever we make a credit sale till the
time we do not get the payment the sale amount will be shown as a trade receivable, the
world trade shows that it’s a day to day activities, it is a regular business activity relating
to or creating a receivable for me it will be called as a trade receivable 2 c. Now 2 d cash
and cash equivalent I think everybody understand cash, everybody likes cash because it
is very easy to spend. What is the cash equivalent?
There are items which are almost like cash; they can be very easily converted into cash,
so they are called as cash equivalents. Later on we are going to study cash flow statement
if you remember that is a third statement, when we study cash flow we will go into
details about what is cash and cash equivalent, but right now you can just assume it that
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its more or less like a cash. Now e that is short term loans and advances we have just
discussed loans and advance I hope you remember. So, these are the loans given by the
entity, so when we give loan to employee or to other company or advance to somebody,
all that is under the head loans and advances.
So, under that if there for less than 1 year we will call it as a short term loans and
advance, 2 f other current assets. So, a to e if there is a particular item which is of short
term in nature, but we does not fit in a to e it will be shown under f as other current
assets I hope you have got what is an asset. So, it is a total of 1 plus 2 simple if it is more
than 1 year the it is non-current if less than 1 year then it is current. So, we get here the
total of assets some of you might have many queries do not worry we are going to again
discuss the assets taking each asset we will discuss it in detail right now let us go ahead.
So, if you look at the elements of balance sheet there are three parts one is a asset then it
is funded by a liability here I mean a external liability or by the owners which is called as
owners fund. Now, let us go into detail of each item. So, how do you define an asset?
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This is a probable future economic benefit what is owned or controlled. So, there are two
conditions to be satisfied to be called an asset; one, the item should have an economic
value and two, the item should be owned. If you remember on day 1, the first session I
had told you that a particular asset does not come in balance sheet because it does not
satisfy condition number 2 do you remember that item that item is a human asset, the
employee, scientist, managers, executives working with the company actually they are
very important asset to the entity, but that cannot be shown in the balance sheet because
look at the definition it should have a probable economic value which they have, but it
should also be owned or control.
So, employees are not our slaves they are not owned by the company, so they cannot be
shown as owned assets that is why human assets you would not see in the balance sheet.
Now, any other assets first of all you have to see whether it’s a it meets this two
conditions I think examples you are all aware cash, land, building, investment,
machinery think of another 10 examples and I think you can include it in your
assignment.
Now, again the definition is given that it is a resource controlled by the enterprise as a
result of some past event, but it should have a future value. The second point is resources
must have a cost or value that can be measured reliably, if we have an asset that has
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some value but there is no reliable estimation available, then also we cannot value it and
show it in the balance sheet.
Now, the types of assets we have got fixed assets, current assets and investments. I think
with this we will stop here we have already discussed it when we discuss the balance
sheet, but we will take up each item now individually and will explain it in detail. But,
till that time as I have told you please go to the balance sheet of your company and look
at what assets they have, then only you will really have a real type of learning Namaste.
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Lecture – 05
Balance Sheet 3
Namaste we have already discussed format of Balance Sheet. So, you know that amongst
the financial statements balance sheet has a very important role and it shows the financial
position as at a particular date. Now let us do a small case or a problem where we will try
to prepare the balance sheet from given balances, later on we will do it for a company in
a company format, but this is a small exercise which wherein we will not emphasize too
much on format. We will just try to prepare the basic structure of balance sheet you have
a printout of this so, have a look at it and try to solve the case along with me.
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Now, this is a balance sheet they have given list of balances and from this you are
required to prepare a balance sheet. So, how shall we go about? We know there are two
sides of balance sheet one represents liabilities and the other represents assets, liabilities
are the way the money has been sourced and assets are the resources which are required
for the business. So, for each and every item go on marking it as a asset item or a liability
item.
For example capital, where will you capital be recorded, where will you take it? This is a
liability item so, mark it as L like that try to mark each and every item. So, creditors is
what type of item? Creditors represent the payables for our supply somebody has
supplied us good and we have to pay them right now it is a liability so, we will mark it
as. Bank overdraft here the bank has allowed us to draw excess beyond our balance again
it is one more liability so, L cash in hand this is A, furniture A, debtors these are
receivables from customers so, this is A.
Plant and machinery or plant it is A, drawings so, money is put in by the owners that is
capital if they take out the money from the business it is called as a drawing. So, this is
not exactly asset, but we will mark it as minus L. So, it is a L item, but it should be
reduced from L system is not allowing me to mark it that way. Now I think its fine
creditors; creditors also represent, closing stock this is S, bills payable is a liability.
Bills receivables and maybe other assets, but it is an asset and net profit is it an asset or
liability should it be written in the balance sheet, net profit or reserves represents the
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accumulated profit of the undertaking. So, it is one of the liabilities, it belongs to the
owners we will add it to the owners funds, but right now mark it as liability. So, we have
marked all the items now based on this prepare the balance sheet you can do the exercise
on your own you can halt the pause the video here and prepare the balance sheet and then
we will check the solution. So, ready with the solution.
I am just showing you the solution directly I hope you have made it and you are
rechecking it. So, we have listed out all the assets plant, furniture these are part of fix
assets debtors, closing stock, bills receivable and cash in hand these are all current assets.
You can see it is as per the order of permanence, the most permanent asset is put up and
the most liquid asset is put at the last. Capital minus drawings that is why we have put it
as minus L then we have got two creditors here; creditors 100000 again creditors 25000.
Because these are probably long term creditors and these are short term creditors, bank
overdraft and bills payables and this last creditor these are all current assets current
liabilities sorry getting it. So, this is a balance sheet as on that particular date using the
balances which we were we had been given.
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Now, let us go to the next problem this is even more interesting because here based on
the information as it is made available we are trying to prepare the balance sheet. Now
we have been given a few raw transactions and directly from raw transaction we should
make balance sheet on respective date on each date ok. Now, Jala Ram start store on 1st
January 2012 with investment of 200000 from his personal savings he decides to call the
venture as Messrs Hanuman Stores. On 2nd January the stores purchases a shop for
500000.
Paying 100000 rupees in cash and signing a mortgage for 400000. So, a shop is
purchased down payment of 100000 is made in cash and a mortgage is signed; that
means, a loan is obtained for 400000 so, that shop of 500000s can be paid. Now the store
purchases merchandise worth 50000 in cash and one fifth 150000 on credit. So, the
payment for this 150000 will be made latter on, but we will have to record it right now
on the date the transaction is entered it is recorded the payment is made as and when it
becomes due. Now he sells half the merchandise for 150000 in cash.
He sales the remaining inventory for 75000 on credit for 15 days to Mr. Bharat on 7
January inventory of 150 that is the next purchase is made from Laxman on credit of
rupees 30 of 30 days and on 10th Jan another inventory of that inventory of 100000 was
sold for 120 in cash. Now here not only we have to make balance sheet we have to make
balance sheet on the respective dates. You I will request you to take printout of this and
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solve it yourself you can take a pause here solve it and then we are going to check
answer for every transaction. So, you have to make series of balance sheets on 1st Jan,
2nd Jan 3rd Jan 4th Jan and so on.
So you are ready ok. In the interest of time I am immediately showing you the solution I
hope you are ready with the solution by now, so, that you can cross check it.
So, the first transaction was opening of a new business with investment of 200000s from
personal savings that is a capital which Jala Ram has brought in. So, the day 1 that is on
1st January the balance sheet shows capital of 200000s Mr. Jala Ram would have
brought in cash of 200000. So, we are showing cash of 200000 the balance sheet tallies
at 200000. So, total of liabilities matches the total of assets. Now this precondition
should be there on all the days now.
The next transaction; the next transaction is there is a purchase of shop for 500000 down
payment is made for 100000 and remaining is in the form of mortgage loan of 400000.
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So, now the on in the balance sheet on 2nd January we have added a shop of 500000 and
mortgage loan payable is shown as 400000 and the cash balance which was earlier
200000 has been reduced now by 100000 and now it is stands at 100000, getting it the
capital which was 200000 remains unchanged. So, the balance sheet on 2nd January now
has a total of 200000 both of assets and liabilities the balance sheet in tallying.
Are you getting it. Now you will observe one thing that the earlier balance of capital of
200000s which was as on 1st January will be continued in the balance sheet of 2nd
January. This happens because balance sheet is a cumulative statement, it is not a
statement of anyone transaction as on 1st January since it was only one transaction we
made a fresh balance sheet, but on 2nd January we continue earlier balance of capital of
200000 and we continue to write it on 2nd January.
In fact, as long as it is not paid off it will be continued to be shown in the balance sheet
this balance sheet and in the subsequent balance sheets also, are you getting it. These
things are very simple, but since this is a very first problem which we are discussing I am
just going slow. So, it is clear to you. Now let us go to the third transaction; third
transaction now there is a purchase of merchandise that is goods are purchased 50000 in
cash and remaining 150 on credit.
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So, on 3rd January this is how the balance sheet looks like. Now the cash balance has
come down to 50000, see earlier it was 100000 since we have made a payment of 50000
for goods. The cash will come down to 50 shop remains unchanged at 500000
merchandise that is inventory is 200000 now it is also called as goods 150 is purchased
on credit 50000 is purchased on cash so, total goods are 200000.
Capital 200000 payable for mortgage this is continued in the last time on from last time
that is 400000 and payables now these are trade payables that is creditors also sometimes
is called its 150000, total is 750000 sorry you getting it. This is how slowly the balance
sheet will get build and more and more items will get added. Now next transaction on 4h
January half of the merchandise inventory is sold for 150000 in cash.
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Now, on 4th of Jan the cash balance increases from 50000 plus 150 it becomes 200000.
Shop 500000, unchanged merchandise earlier it was 200000, now half of it remains so, it
has become 100000. Capital unchanged 200000, mortgages unchanged at 400000s,
payables unchanged. Now there is a addition here because the transaction was unique
compared to our earlier transactions inventory of 100000 was sold for 150000.
So, we get cash of 200000 I mean 50000 was the earlier cash, new 150 was added I will
just mark write it here for more clarity. So, we got fresh cash of 150 and merchandise or
inventory or goods of 100000 were given to customers. So, inventory of 100000 sold for
150; that means, we got 50000 extra that 50000 represents profit. So, in balance sheet we
will write it as profit and loss account 50000 getting it. Now let us go to next transaction
on 6th January remaining half of the inventory is sold for 75000.
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So, now cash is 200000 shop 500000 no changes here merchandise or inventory which
was 100000 earlier half of it is sold. So, remaining is now 50000 a new asset that is
receivables is added. So, you can see inventory of 50000 is reduced and receivables of 75
are added, we have not yet received any cash, but we are going to receive it in future.
Still we will show 75000 in the balance sheet so, there is a difference of 25000 which is
further profit. So, profit and loss account which was 50000 earlier is now 50 plus 25
become 75. So, capital 200000, mortgages 400000 and payables 150 they are same as in
earlier balance sheet.
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And now the balance sheet total has become 825000. Now 7 January inventory worth
150 was purchased from Laxman on credit of 30 days.
So, this is as on 7 January since the new inventory is purchased, inventory has become
200000 this is a transaction on credit. So, payables will now become 300000 earlier it
was 150, 150 plus 150 it become 300000 all other balances are unchanged.
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So, now the total becomes 975. Now the last transaction on 10th January inventory
costing 100000 was sold for 120 in cash.
So, 10th Jan; now, the cash balance increases by 120, it was 200000 earlier becomes 320,
merchandise or inventory which was 200000 of that 100000 is reduced. So, it becomes
100000, shop and receivables are unchanged because this was a cash transaction. The
profit which was 75 we are going to further add 20000 to profit. Capital payables for
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mortgage and payables that is trade payables remain unchanged the total becomes
107500 are you getting.
This was a very simple exercise we have seen a series of transactions and made a series
of balance sheets for it. In real life it is not necessary to make balance sheet everyday
you can make it at the end of the period at the end of 3 months or at the end month of 1
month. But within the system this is how the balance sheet gets updated or revised. So,
this is only one problem where we are looking at series of balance sheet are you getting it
ok. Let us go to the third case.
Now, in the third case we have been given several balances and from these balances you
are required to make a vertical balance sheet. Latter on for a company we are going to
make a detailed balance sheet this is a very simple exercise where we use only a skeleton
type of pattern or a structure and we will try to make a vertical balance sheet. So, have a
look at these items go through each and every item. As we did in the first case we will
mark every item as asset and liability and then prepare a balance sheet.
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One note is also given that bad debts recovered is not included in cash balance perhaps
they do not know where to write it. So, if you start from sales where will you record it in
the balance sheet? Actually sales is a profit and loss item. So, it should not be recorded
anywhere in the balance sheet it is just given to you as an extra balance. So, we will just
mark it as PL, those of who are interested in preparing profit and loss account you can
make it as extra work, but right now we are going not going to use this.
Because we are only going to focus on the balance sheet return outward this is also a
profit and loss item capital, capital is a balance sheet item we will write it on liability
side discount, discount cr this is the discount which we have received it is a PL item,
creditors a liability item cash at bank credit they have given; that means, this is a bank
overdraft. Normally, cash at bank is if we keep cash in bank it becomes a debit balance it
becomes a asset, but here cash at bank credit; that means, we have drawn excess from the
bank or it is also known as bank overdraft it is a type of loan which bank has given us.
So, we will mark it as, loan credit so, we have got loan. So, again we will mark it as L
bad debts recovered this is a unique item first of all everybody has understood what is
bad debt recovered? When we sell goods it gets converted into receivables or debtors,
you can see here there is a debtors balance, now from those debtors we are supposed to
receive cash. In case a particular debtors becomes non paying or becomes bankrupt, for
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example Vijay Mallya. So, for banks the loan which was given to Mallya became bad
debts.
Now, of course, government very smartly has caught it and is recovering the money from
Mallya, but otherwise the money given to Mallya was more or less like a bad debt. So, in
case of this party Messrs Seetha enterprises they would have given some loan and the
loan is not receivable that is why they consider it as a bad debt earlier. But now that bad
debt they are able to recover they have received that money as a bad debt, but they do not
know where to record it. So, they have not included it in cash balance. So, now, we are
going to do two things we are going to include it in the cash balance outs. So, this is a
special case this is not as such for bad debt recovered this is definitely bad debt
recovered.
But since the money is not shown in the cash we are going to add it in the cash. So, I
have written it plus 2 cash A, A means on asset side outstanding expenses; that means,
we have take we have incurred some expense likes say electricity bill, but we have not
yet paid it so, it becomes a liability. Net loss companies or the enterprise is suffering
loss. So, where should we write this loss will it go to balance sheet yes because if there is
a profit it is added to liability side if there is a loss we will reduce it from liability.
So, we will mark it as minus, salary this is a PL item, samples these are free samples
which are distributed it is a marketing expense. So, we will mark it as PL land and
building this is a asset item, I think most of the items are getting clear to you. Now on
this side also we have got few balances we will not go for marking every item I hope you
will be able to mark it yourself and based on this let us go for preparation of balance
sheet. So, you can pause your video here and I will show you the solution please first
solve it and then check with my solution.
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So let us have a look at the solution this is the balance sheet for Messrs Seetha
enterprises. So, always have a habit of writing it on top either we can write it as a
liability on one side and asset on one side or we are I can write in the vertical form right
now we are making it in vertical form. So, we will start with liabilities.
Have a look at the items as we have marked in the earlier sheet. So, the capital is marked
as L. So, we will start with capital there is a loss which is reduced from capital. So,
capital minus loss the value of capital or the amount of capital is reduced then one
heading called borrowed fund is made we have written loan in that.
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Total capital employed then we have listed all the assets under the heading fixed assets
first of all building, furniture and goodwill please check with the solution which you
have made.
Then in current assets we have got cash, but keep in mind we have the balance of cash
was given as 6000 this bad debt recovered was added to cash balance because it was not
added by them earlier. So, now we will write 6750 then debtors than closing stock. So,
we get total of current assets, from current assets we are reducing the current liabilities
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creditors, outstanding expense, bank overdraft, total current liabilities and we get the net
balance as net current assets 13050.
You can also write these liabilities on liability side, but we are making in a vertical
format. So, we have written it under the assets and reduced it from current assets. So,
total assets is 193 it matches with total liabilities 193050, getting it. This was a simple
balance sheet; latter on we are also going to make balance sheet for companies, but just
to make you understand the fundamentals we are making this simple balance sheet.
So, we will stop here Namaste.
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Lecture - 06
Balance Sheet 4
Namaste In financial accounting, if you remember in our first session, we had tried to
understand what is accounting and then started discussion on financial statements. In the
second session, we discussed what a business cycle is and from that how the main
financial statements that are balance sheet and P and L account emerges. Then in session
3 and 4 we went into what is balance sheet and what are the items in balance sheet.
Today we will continue with our discussion on Balance Sheet, and then we will proceed
to understand the profit and loss account. We will take a quick review of balance sheet.
So, you already know short form format of balance sheet. There are 6 items. Then I will
go ahead, we are going to discuss each of them in detail. We had also seen a detailed
format of balance sheet under schedule III of Companies Act.
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So, we have equities and liabilities, then shareholder’s funds, share capital, reserves and
surplus. I hope you know their meanings. If you really do not know please do not keep
quiet ask them on the discussion forum. Then you have got money received against share
warrant.
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Then we went on to discuss share application money pending allotment and non-current
liabilities, then current liabilities.
Then we discussed on assets, again divided as non-current assets followed by current

asset.
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If you look at the format it is as per the permanence. So, what is permanent comes first.
For example, in balance sheet share capital has the longest renewal that comes first, then
non-current liabilities, then current liabilities. In assets first we have got non-current
liabilities because they are going to be with us for more than 1 year, within that also
fixed assets are likely to be more with the company for a longer tenure, so first we have
got fixed asset then we have got other non-current assets then we have got current assets.
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So, in the format of balance sheet if you look at the elements which we are going to
discuss in detail now, there are 3 elements one is assets, next liabilities; here I mean
external liabilities followed by owner’s funds.
In the last session we are just started our discussion on assets. So, we will just start again
from that. In the assets we are already seen the major examples of assets. So, we have
got land building, patents, investments, cash and so on. As a definition something which
is a property of the company which has a probable economic value that is called as a
asset.
And the second condition is it must be owned or controlled by the entity. We also saw in
our earlier sessions we had seen that business cycle you need human power, you need
people to manage the business, they are invaluable assets of the enterprise, their skills are
important, how they behave is important. However, they cannot be shown in the balance
sheet because human beings are not owned by the company.
In assets essentially there are the items which are owned by the company and which are
going to have economic value in future. Usually, assets will not be made available to
company for free, so there will be some cost for the asset and we are assuming that there
is a economic value which can be measured and if exact value is not known at least it can
be estimated.
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Now, coming to the types of assets; as we know there are major two types of assets one
are non-current then other ones are current. Non-current means those which are likely to
last for more than 1 year, which again the major examples of fixed assets and current
assets.
Do you remember what is meant by fixed assets? Because when we discussed money
cycle, we had started with the first asset which is fixed asset. Do you remember what it
is? Yes, many of you are correct I think. It is a kind of infrastructure using which
company does its business. Whatever operations are happening fixed assets themselves
do not get converted, but they act as catalysts, they support the whole process.
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Now, what are the types of fixed assets? There are two types, one is tangible the other is
intangible. Tangible means something which you can touch, which you can feel, which
has physical existence. They are called as tangible assets. I think the examples are very
very easy everybody knows what are the examples of tangible assets. We have got land,
machinery, furniture, vehicles, large number of say computers, cameras, mobile, phones,
large number of assets which you can touch, feel are all called as tangible fixed assets.
The other type is intangible. Now, this is something which you cannot touch or feel, but
still they have a value. They are going to be with the company for a long time. So, what
are the examples of intangible assets? Can you think of any examples?
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Earlier I had taken one example if you remember. We had seen that we have a computer
is it a fixed asset the answer is yes, there are two things in computer there is a hardware,
there will be a mouse, there will be a keyboard, there will be all other parts, now
whatever you can touch whatever you can see these are all tangible parts, but there is
also intangible part which is software, which is loaded in the computer.
And many of you use mobile phone, so in mobile phone more frequently whole day I
think most of you would be on mobile phone. So, you can see your instrument, but in
that instrument, there are apps there are various other things which are loaded on
instrument which do not have physical existence which are but which are of very much
used to you. Those things are an example of intangible assets.
Ok, any other examples of intangible asset do you think of? Let us see you are doing
some scientific research and you get a new formula or you develop a new product then
you will apply for a patent. If you get a patent it has a very important economic value
and patent will be an example of intangible asset. Those of who are good in art or those
who have got creative attitude, you might have a new drawing or you may might come
out with the new size or a design that also can be registered. It is registered as a
copyright then a copyright or a trade mark is also an example of intangible asset, ok. Are
you seeing the example?
So, you have got patents, we have got trademarks, we have got goodwill. Now, what is
goodwill? As the name suggests it is a good name of the concern. If you are say running
a shop for many years 2 years, 3 years, 5 years, 10 years several people in the locality or
even from faraway places we will know your shop they would prefer your shop over
other shops, because of the trust factor, because of reliability and so on, that will be what
is known as goodwill.
There are several brands of international and national importance, they can be considered
to be valuable, that brand name itself is valuable. Can you name of or think of a few
brands? I think everybody would have heard of Tata which is highly reputed brand all
over India, there are several companies under Tatas like TCS or Tata motors or Tata
steel, but the brand name is Tata. So, that Tata name is attached with lot of goodwill.
Similarly, nowadays most of you know Jio. So, Jio is a brand name which is owned by
reliance industries that is also brand name. I do not want to advertise too many
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companies but I am just giving you examples. For example, relatively new, but which
has taken a big name is Patanjali. So, Patanjali is a big brand name today not only in
yoga, but also in ayurved. Like that there are also several international brands. So, all of
these are backed by some goodwill of that company. It is sometimes copyrighted, then
the copyright is a intangible assets, sometimes it is not copyrighted then it can be called
as a goodwill.
Now, valuation of intangible assets is bit difficult. Relatively valuation of tangible assets
is easy, anyway we will go into it later on, but right now on your screen you have got
variety of both tangible and intangible fixed assets.
Now, the next one is current assets. Now, what is the definition of current asset? I think
we have seen it earlier, we have got a money cycle or a cycle of operations and in the
operation cycle or in the money cycle or in the value addition cycle many assets are
getting continuously exchanged, those assets are typically what are known as current
assets. Normally, the life of these assets is not very long, they are likely to be with you
for a relatively shorter time maybe 15 days, 1 month, 2 months, 3 months and so on;
these assets are known as current assets.
Now, current assets can be classified into two types, one is a monetary one, the other one
is non-monetary. Now, can you give examples of monetary current assets or non-
monetary current asset? Is anyone of you able to think? Something which can be
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expressed in money terms is monetary, I think most of you would be thinking of it, but in
fact every value in the financial statement can be expressed in monetary terms. Then can
you call everything as a monetary, then what will come as non-monetary, ok. I will try to
respond to your question.
So, see monetary assets are debtors and bank. So, they represent something which you
are going to receive from bank or something which you are going to receive from your
customers or debtors. Their value does not change. So, they are called as monetary fixed
assets, monetary current assets. Then, what are non-monetary current assets? Can you
think of any examples? Non-monetary current assets are variety of stocks or inventory
with you.
So, if you have purchased raw material, it is a fixed, it is a inventory of raw material you
will converted into finished goods it becomes inventory of finished goods. Some of the
companies only deal trading business, they purchase finished goods, they sell finished
goods, in that case the stock of finished goods in their hand is a non-monetary current
asset.
As I was just saying even non-monetary assets have a monetary value, then why do you
call them non-monetary? The reason is because their value goes on changing with the
changes in the market value in the market. So, for example, the value of inventory of
finished goods may go up and down, value of investment sometimes go up and down.
So, such assets are known as non-monetary current assets, ok. Now, I think you would
have understood what are the important assets. Now, let us go to the next part that is
liability.
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Now, what is meant by a liability? I think you are able to see it on the screen, that it is a
present obligation of the enterprise that arise from the past events. So, in the past suppose
we have got purchase we have purchased raw material from somebody, if you pay in
cash you get raw material you pay cash then there is no liability. But, if you purchase
raw material but you are yet to pay, let us say you are going to pay at the end of one
month, but as of today you are not paid then it will be shown as a liability in your books.
It will be what type of liability in the example which I am saying.
I have purchased raw material I have not yet paid I am going to pay within a month, what
type of raw liability it is? I think most of you are guessing it correctly it will be a current
liability, because it is going to be settled in just 1 month. Anyways, types we will see
later on. Now, it is an existing obligation there should be some evidence available on the
balance sheet date and it is expected that there will be some outflow which can be
anticipated and value also can be measured. So, suppose we have purchased raw material
of 1 lakh, we will pay after 1 month rupees 1 lakh.
So, you know that expected outflow is 1 lakh that is why it is called as a liability.
Sometimes you do not know exact value, but you can estimate the value, still it will be
called as a liability. Can you think of any examples of liability other than what example I
gave you? I think most of you are guessing it rightly. Suppose I take a loan from bank I
will have to repay it, so bank loan also is an example of a liability. Now, what are the
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types of liabilities? Nowadays, your life is very simple. If you remember current, one
type is current the other type is non-current.
So, non-current is something which will be settled after 1 year, which has a life of more
than 1 year. So, can you think of any examples of non-current liability. I think bank loan
which we discussed was one, because it is mostly for more than 1 year. But other than
bank loan, are there any other liabilities any other non-current liabilities, ok.
These are long term or non-current liabilities. They are likely to be repaid or perform
beyond 1 year. Usually, they represent sources of funds because that is how the
enterprise or company is raising it funds. Now, example one is bank loan you already
know if it is more than 1 year it can be loan from NBFCs. Do you know what is NBFC?
Full form is Non-Banking Financial Companies. So, other than banks there are
companies which give you variety of loans that is also a non-current liability for us.
One more possible liability is debenture. Now, what do you understand by debentures?
Debenture also is a type of loan. So, many companies come out with a debenture issue,
they inform the investors that we will issue a debentures, investors pay them money and
they issue a certificate for debenture. So, it is a loan, but which can be traded in the debt
market. In any case as for as the balance sheet is concerned it is an example: of a long-
term loan.
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One more possible liability is deferred tax liability. Earlier we had discussed a bit on it
when we discuss the format. So, normally the tax liability should be paid within 1 year,
but under special circumstances or because of some specific provision in the law if it can
be paid after more than 1 year it will be called as a before tax liability. Now, the other
exam the other type is current liability I think you all know the examples, but just have a
look.
So, these are the obligations which are likely to be repaid or performed within 1 year and
normally they come from day to day business transactions or from the money cycle or
from the business cycle as we were see. I think you know most of the examples, one is
creditors also known as accounts payable, then outstanding expenses. Now, what do you
mean by outstanding expenses?
So, for example, if you have got 100 employees normally the salary should be paid on
the last day of the month, say on 30th or 31st. If we do not pay salary on that day and we
pay salary on let us say salary of April should be paid by 30th of April, but if you do not
pay, if we pay it in May, on 10th of May then on 30th of April up to 9th of May if you
make a daily balance sheet in each balance sheet it will be shown as a outstanding
expense or it can be also called as an outstanding liability. Like that any expense which
is unpaid will be considered as an outstanding expense.
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Then one more example is interest accrued, but not a due. Now, what is the meaning?
So, suppose you have taken loan from bank let us say you have taken loan of 1 lakh at 10
percent per annum that means, every year you have to pay 10 percent. So, on 1 lakh you
have to pay 10,000, but at the end of the year; now at the end of the year if you do not
pay 10,000 it will be an example of an outstanding expense which we have already
discussed.
But even during the year let us say 3 months are over and you are preparing a balance
sheet, so you have to pay 10,000 at the end of the year, that means at the end of 3 months
you have to pay one-fourth of 10,000 or say 2500, but you do not have to pay it now you
will pay it at the end of the year. But at the end of 3 months you have already created an
obligation it is called as an accrued interest; it is accrued but not due. When will it
become due? After 1 year, but after 3 months since you have used the funds you will
need to show 2500 as an accrued interest. It is one more example of current liability.
The next example is provision for tax. Now, what is the meaning? As we were discussing
whatever profit we earn we have to pay income tax on it. The calculation is done by us.
Finally, it is to be approved by income tax department until it is approved by department
we will show as per hour calculation we will calculate the profit, as per our calculation
we will also calculate the taxes payable. Till the time we pay it, it will be shown as
provision for tax under the head current liabilities.
The next is bank overdraft. Now, what is the meaning of bank overdraft? Now, bank
gives a facility to the account holder that account holder can withdraw some money that
is called as a bank overdraft. So, suppose we have deposited 10,000 in bank normally we
can withdraw only 10,000 balance will be 0, but in case of current accounts you can
deposit 10,000 but you can withdraw 15,000, that 5000 which we have taken more the
balance in the bank account will be appearing as minus 5000, that minus 5000 is called
as a bank overdraft.
Of course, there will be a limit that a particular company can draw how much from the
bank, but it is payable in the short term. So, it is considered as a current liability. Are you
getting? Just think of some more examples of current liabilities. Now, we have
understood both non-current assets, current assets, then current non-current liabilities,
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current liabilities. Think of the examples and they will be discussed on the discussion
forum, ok.
Now, let us go to one special type of liability that is called as a provision. If you have
marked when we discuss the current liability, we had shown one item known as
provision for tax. Now, did you think why it is called as a provision? Why I did not call
it as outstanding tax? If I pay tax on time, no problem, no liability is created. If I do not
pay tax on time it should have been shown as a outstanding tax, but instead of calling it
out standing we are calling it provision for tax. Now, what is the reason? Ok.
Now, have a look at it. So, provision are those amounts which are retained by way of
providing for a known liability for which amount cannot be determined with substantial
accuracy. That means, I know there is a obligation, I know there is a liability, but I do
not know exactly how much should be payable, in such scenarios you create a special
item it is also a type of liability, but it has a special name as provision. So, provision
refers to amount which is set aside for meeting claims which are admissible, but amount
is not yet confirmed.
Examples are also in front of you. One example is provision for electricity charges. Now,
let us say we prepare accounts or balance sheet at the end of 31st of March and every
month we get the bill for electricity on the 10th of next month; that means, February bill
will occur on 10th of March, March bill will occur on 10th of April. That means, on 31st
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March I do not know the amount of bill, but I know that I have consumed electricity, that
means some amount is payable on account of electricity charges. I did not pay the bill till
date if fact I did not received the bill which will me on 10th of April. So, as on 31st
March when I am making a balance sheet I am unaware of the amount which I have to
pay, but I am very much aware that electricity has been consumed, that means some
amount needs to be provided for. So, we will create a provision.
Now, the question which will come in your mind is, so far we have not received any bill,
so how will we know the charges for electricity bill for the month of March. Now, there
are various ways of estimating. For example, I can do one thing I know the charges for
last 11 months, right from April to February I have all the bills, only March bill is
pending. So, I can take average of 11 months or I can even take a last March electricity
bill and add a 5 or 10 percent and treat it as a provision for this March. So, there are
various ways of estimating but there will be some estimation done and a provision is
created. I hope you are getting what is a provision.
Another example which we are already discussed was provision for taxes. Now, as far as
the provision is concerned, we do not know how much taxes will be finally payable,
because those decisions are taken by tax authorities. But what I do is based on my
understanding I calculate profit; I also calculate the taxes payable and make a provision
in the balance sheet. For estimated amount of taxes likely to be paid that is called as a
provision for tax.
Same way to the employees, normally bonus is paid at the end of the year based on their
performance, exact amount is not known because that will be known after performance
evaluation. So, as on 31st March some estimated provision is made for bonus that is
called as provision for bonus. There is a possibility that there will be some bad debts. We
are having debtors or accounts receivable in the balance sheet, there could be some bad
debts may be half percent, may be 1 percent, may be 2 percent, may be 5 percent,
according to the type of business I will make an estimate and create a provision that is
known as provision for bad debts.
So, today we have discussed both current, non-current assets, then current, non-current
liabilities and we have come up to some specific liability which is called as provision. In
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our next session we will go ahead and going to further some more types of liabilities and
then into profit and loss account Namaste.
Thank you so much.
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Lecture – 07
Balance Sheet 5
Namaste. I hope you have enjoyed the last week sessions, and you are also able to
comfortably complete the assignment. So, we were discussing financial statements;
particularly we were discussing balance sheet, we also seen the format of balance sheet,
and now we are discussing each element of balance sheet. So, already on the screen you
are seeing three major elements assets, liabilities and owners funds.
Within that we have already discussed asset and almost completed the liability. Today
will going to owners fund, then we will see the process how the balance sheet emerges,
and then we will go to discuss what is a profit and loss account.
Right now, let us briefly revise asset and liabilities.
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So, these are assets. I think you all know this is something which is a property or a
resource of a company which has a value, and it is likely to give some probable future
cash flow. There are variety of examples which are in front of you, so I am not repeating
them.
Then two major types of assets noncurrent current, within noncurrent you have got fixed
and fix assets and investment. Now, what do you mean by fixed assets? This is a
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infrastructure or a property which is going to last for more than 1 year it acts as a catalyst
in our operations.
There are two types: tangible fixed assets, intangible fixed assets. Tangible example are:
land, building, plant, machinery, variety of things which we see in front of us, which are
going to have a longer life; these are all tangible. Intangible: we cannot see or we cannot
as such touch it, but they have a value, they are very important to us. They can include
software, they can include apps on your mobiles, they can include patterns and so on. So,
these are the examples.
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Then the next type is current assets. Current assets have a life of less than 1 year. There
are two major types monetary and non-monetary so, within monetary what are the
example; debtors and bank balances, as we saw last time. And in non-monetary category
you have got variety of inventory or stock; like raw material or like finished goods, there
is also one more type known as work-in-progress stock. That is also an example of non-
monetary asset.
Then we went to discuss the liabilities, these are the present obligation. These are the
dues which company or an enterprise has to pay and you can reasonably estimate the
amounts and they would result in outflow in future.
Now, what are the types and what are the examples of the liabilities. So, again you got
long-term liabilities short-term liabilities. So, what are the examples of long-term?
Mostly bank loans or loans from NBFC or deferred tax obligations. These are all long-
term liabilities.
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The other one is current or a short-term liability. What are the examples? They include
bank overdraft, they include payables or creditors, they include variety of outstanding
expenses. Can you give an example of outstanding expense? Last time we discussed
about salary, but do you think of any other expense which is not paid on time. Suppose
we have purchased stationery, but we do not pay the stationary bill immediately, we will
pay after some time till the time is paid it becomes outstanding expense. Any expense
you can think of if not paid on the date you got the service or the product, it becomes an
outstanding expenses, ok.
Now provisions; now, this is a specific type of liability, wherein the amount is not known
with substantial accuracy. We know the existence of liability, but not the amount. So
example, can you think of any example? The four examples are in front of you, but apart
from that is there any other example of a provision, just think over it.
Suppose some repair work is done in our factory or in office, we do not know exactly
what was done in the repairs; the particular party who has done repair as not yet send the
bill. So, we do not know the charges, but we know the repairs has been done and we are
required to prepare balance sheet on say 31st of March, then we will make a provision
for repair.
There is another possible case: we have sold products for which we have given a
guarantee because of guarantee clause, now for 1 year we will have to provide a free
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service. Suppose there is any damage in the product we will have to repair it for free or
we may you have to replace it. Then for 1 year there is an existence of an obligation, but
we do not know the amount. We may have to pay more or less, but we will calculate
some estimation; based on our past record or based on whatever is likelihood of the
repair and replacement cost. Let us say 2 percent or 3 percent maybe set aside for
provision for repairs.
Can you think of any other example? One more example is gratuity; I think most of you
know that whenever an employee retires or in case of unfortunate death of employee, we
have to pay gratuity to the employee. The gratuity is calculated on the basis of number of
years of service, that service can be 5 years, 6 years, 10 years, 40 years whatever.
According to the tenure of that employee and the retirement salary of that employee
company has to pay gratuity. Now, as on the day of balance sheet we are not sure about
the gratuity amount payable, but the liability exists.
So, in such case we will calculate provision for gratuity, ok. And plus, four more
examples given here I hope the concept of provision is clear to you.
Now, there is one more special type of liability, where neither we know the amount nor
we know the existence of asset.
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Now, you question might come in your mind that neither the amount is known nor its
existence is certain, whether the liability would be created or no is also not known. Is it
necessary to show such a liability in the balance sheet? What do you think? The answer
is yes. Even if there is a very small likelihood of getting an obligation; there is no
certainty of obligation, but there is a very small chance that we make an obligation. In
such scenario also we will have to show that liability; that liability is called as
Contingent Liability.
As the name suggest contingent liability is a possible obligation that this obligation may
arise. Since it is not a present obligation if you remember when we discussed or defined
the liability, we had said that it is a present obligation arising from the past event.
Now, contingent liability is a possible obligation, since it is just a possible obligation it is

not actually shown as a part of balance sheet, but it is required to be shown as a footnote.
So, below the balance sheet we have to give a note for all the contingent liabilities; are
you getting me? Now, can you think of any examples? I think you are seeing what is a
meaning that, it may or may not arise as for occurrence of some events. In which
everything is uncertain, but liability or obligation can be there and enterprise or a
company has no control over that event. Can you think of any example?
One of the best example are court cases. Suppose one of our customer feels that
whatever service we have given is not a satisfactory service, we have say given a wrong
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product or sold wrong product to a customer which is of a poor quality. Customer files a
complaint against us to a consumer court or even files a case against us in the court;
saying that this product was faulty and we will have to give compensation to the
customer.
Now there are two possibilities: in possibility one, we accept that there was a fault on our
part and we agree to pay some compensation, but amount is not yet known. Some
discussion is going with customer; customer is asking for 10 lakh compensation, we say
no 10 lakh is too much we will pay you 1 lakh. Then there will be a negotiation between
them and then the amount will be decided. In such case it will be called as the provision,
because we have accepted our obligation.
Now, the liabilities there is certain, but the amount is still being decided, but in a case
where we refuse our obligation. That means, we say that nothing is payable as a damages
or as a compensation our product is of good quality. But still customer says no product is
of bad quality, claims a compensation of 10 lakhs, we are saying nothing is payable.
Customer files a case in the court. now court decision is unknown. If court gives decision
against us we may have to pay, if court decision in our favour we may not have to pay.
Now, this is a proper example of contingent liability. I hope you are getting it. Any other
example can you think of, of a contingent liability.
Now, suppose fire occurs, and because of fire lot of damages have occurred and some of
the curtains are closed, they are sealed curtains we do not know whether they are
damaged or not, and they do not belong to us they belong to some customer or somebody
else. Now, if inside the package there damage we have to pay compensation, if they are
not damage me do not have to pay a compensation. That we will be only when it reaches
the customer, customer opens and ask for or not ask for compensation, that can also be a
case of contingent liability, ok. I hope you are getting me.
Now, this is a rare case. However, for big companies since they are into lakhs of
transactions, there are bound to be some or other cases where there would be court cases
for such things, they are required to be properly disclosed as per company law. So, they
will come in notes to account.
I am hoping that you are properly reading the balance sheet of your company; I have
already told you to select one company and read the annual report of that company. Go
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to the balance sheet of your company not in the main balance sheet, but below the
balance sheet there are notes. In the notes there will be one of the items known as
contingent liability, where they will have to discuss full details as to the nature of case
filed by the customer or filed by any other person, what is a legal advice to the company
on the likely charges and so on.
Now, suppose company accepts the obligation it will get converted into what provision.
If court gives decision against us it becomes a contingent, it becomes our regular current
liability. But as long as nothing of that sort happens it remains in the balance sheet as a
contingent liability; I hope you getting me. Now, this was our last item in balance sheet
liability side. Now, we will go to the next item that is known as owners fund.
Now, we have already seen this item when we are seen the format earlier. Now, this is a
residual interest of the enterprise or this is the amount which enterprise or company has
to pay to the owners. Now why it is called residual; because these are your assets from
their assets first you have to pay external liabilities. So, you have to pay your both
current as well as noncurrent liabilities, it any amount remain after paying that amount,
then owners will get it. That is why owners fund is considered as a residual interest.
If you remember the format of balance sheet earlier it has two components: there is a
capital, owners have put in some money that is the capital plus the profits which
enterprise gives to the owner that is called as reserves. That capital plus reserves together
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is known as Owners Fund. We can also put it in this way this is the total of assets minus
total of all external liabilities, the balance is called as Owner Fund.
There are two more names to owners funds which are often quoted in phrase or if you
read various information on reports, sometime they call that net worth of a particular
company is 100 crore, that net worth is another name given to owners fund. Sometimes it
is referred to as equity; so, it is said that equity of company is 500 crore, that equity
refers to owners fund. Keep in mind this is rather tricky word; there is a type of capital
known as equity capital, that equity capital is different and is a type of capital; now, only
equity means owners fund, so it includes capital plus reserves.
Now, in the American terminology they call it equity, whereas in UK it is called as net
worth, in India it is called as owners fund; this terms are used interchangeably. Since in a
company shareholders are the owners, instead of owners fund it is also called as
shareholders funds. Please go to your balance sheet in it may be shown as shareholder
fund or owners fund in your balance sheet.
Now, many of you might be investing in mutual funds, if you do not invest then you can
start investing. Now, if you invest in mutual fund for that scheme everyday NAV is
announced; NAV, you can search for NAV on Google, they would give lot of NAVs.
Because every day as per the requirements of SEBI, NAV is required to be published,
now this NAV that is also actually owners fund of that particular scheme.
Do you know what is the full form of NAV? Full form is Net Asset Value; here net asset
refers to total assets minus total liabilities that means, it is nothing but the owners fund
for that scheme. So, it is the total owners fund divided by number of units they calculate
per unit in NAV and they publish it anyway. Since that the particular term is often used I
felt that you should know that NAV is also nothing, but the owners fund.
Now, let us go in to all the three components; now, as you know the balance sheet is
required to tally or balance sheet is required to match.
Assets = Liabilities + Owners Fund
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Now, you know that owners fund itself is capital plus retained earnings or reserves. So,
owners fund can be calculated by two ways:
Owners Fund = Assets – Liabilities
Owners Fund = Capital + Retained Earnings
Now, let us go to balance sheet equation. Now, you all know that A that is assets is equal
to L plus O.
A=L+O
Where, A= Assets, L= Liability and O= owner’s fund
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Now, if you want to understand how the balance sheet is prepared; we will take 5 simple
transactions and for that transactions try to understand impact on A, L and O.
Now, let us say a company is newly formed and it issue shares. Now, can you think of
what will be the impact on A, L and O? Issue shares means what happens the prospective
shareholders or investors approach the company they pay money, company will give
them shares for that money, so company receives cash give shares. Now, can you think
of what has happened to A L O? So, there is a plus in A; assets go up no change in
liability owners fund go up. So, A plus O plus, are you getting and if you see in detail we
have said plus bank, because bank balance of the company goes up and equity share
balance also goes up. So, add to bank add to equity shares.
Now, those of who were commerce students you would have already studied journal
entries. Now, what I am showing you is nothing but the journal entries, but just for the
benefit of non-commerce people I am not using the terminology journal entry, but in the
same way actually journal entries are derived. For every transaction some item of A L O
changes and those items actually match there are equal number of debits and credits.
So, we are just trying to make it very simple for five sample transactions which are very
easy transactions, but very basic. Most of the transaction of companies are based on
these transactions. We are trying to understand the impact of A, L and O. Aare you
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getting the first one? Issue of share by the company, ok; now, the company is formed
shareholders have already given the money and they have received the shares.
Now, next what company has done is; company borrows from bank. Now, what will be
the impact on A L O? I think most of you have guessed it correct, because when
company approaches bank, bank sanctions and pays the loan, the bank balance goes up
companygot the money, bank balance goes up and a new liability kwon as bank loan is
created. So, plus in bank and plus in bank loan payable; so, A is plus L is plus.
Remember if company get rs. 10 Lakh loan then loan is added with 10 lakhs same
amount is added in bank, that is why the balance sheet is always balances or matches.
Are you getting the second one also?
Now, let us go to the third one. First look at 3 a: cash purchase of equipment. Now,
company received a lot of cash from equity shares plus loans also. So, they have decided
to use that cash and purchase machinery or equipment. Now, what will be the impact on
balance sheet? How will you reflect it in terms of A L O? Company pays cash, so bank
balance reduce, but they will receive machinery. So, it is plus in A minus also in A, if
you go to explanation plus in equipment minus in bank.
There is another example which is in 3 b: that is collection of debtors, company has

already sold some money some goods to the customers, money is yet to be collected that
is called as debtors. Now, if the money is collected company’s bank balance increase and
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debtors or receivables balance decrease: so, plus in bank minus in debtors. Actually
transaction 3 a and 3 b appears to be opposite, because 3 a is a payment 3 b is a receipt.
But here we are not looking at payment or receipt both are exchange of assets. So, if you
look carefully neither L is affected nor O is affected within A only one asset is reduced
other asset is added, ok. So, are you getting it?
Now, let us get to 4. Now, have a look at 4 a: company repays bank loan and 4 b is
payment of creditors or suppliers. Now, company repays bank loan, what will be the
effect? We repay lone which we have borrowed earlier, so bank balance will come down,
bank loan payable will also come down. If you remember entry number 2, entry number
2 exactly reversing earlier it was plus now minus, minus in bank minus in bank loan
payable. And what about 4 b? 4 b is payment of creditors. That means, we have already
purchased some goods. Now, we have to pay those vendors or supplier or creditors. That
means our bank balance will be reduced, we are repaying, so minus in bank and minus in
creditors, ok. So, A is minus L is also minus, no change in O. Are you getting it?
See these are very easy entries for those who have already learnt commerce, but for those
who are doing it for the first time please look at them carefully. Because, based on the
simple entries actually you can calculate or you can write down any entry, because the
same entries are going to happen they may happen ten thousand times with slight
changes, but the base remains same.
Now, go to the fifth entry. Now, company pays dividend to shareholders. Now, how it
will be reflected? I hope you know what is a dividend: dividend means what happens is
company earns profit, now company distributes this profit to the shareholders or to the
owners that is called as Dividend. If you remember we saw business cycle, in business
cycle your revenue minus expense you get profit that profit is either paid to owners or is
plowed back or kept transferred back to balance sheet.
Now, we are assuming that that profit is paid to the owner or to the shareholders. Now,
what will be the entry? We are making payment, so bank balance will come down, and
what else will change? Are the assets changing? Because of bank yes, but no other asset
is changing, are the liability changing? No, but O that is from the owner’s fund there is a
reserve that reserve balance is coming down, ok.
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So, minus in A and minus in O or you can say minus in bank minus in reserves, are you
getting. These were just the simple transactions we can look at hundreds of transactions,
but once the basic logic is clear I hope you will be able to understand more and more
transactions.
So, with this we are completing our session on balance sheet and in our next class we
will start with profit and loss account. Namaste
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Lecture – 08
Profit and Loss Account 1
Namaste. Welcome everybody to our sessions on Financial Accounting. We have already

discussed what is accounting, then we started with financial statements. And in our last
sessions we have discussed one of the most important financial statement that is balance
sheet. We have also seen the format of balance sheet a short form then in detail as per
schedule III of Companies Act.
So, can you tell me what does the balance sheet give you? The balance sheet is a
statement which shows the financial position of the entity as on a particular day.
Normally it is prepared at the end of the year, you have a list of assets, you have a list of
liabilities and you also have a balancing figure as owners fund or equity shareholders
money that is there in the balance sheet. Today we are going to start with the next
financial statement which is profit and loss account; sometimes it is called as income
statement.
So, for business entities in India we call it P and L account, in some countries like us it is
called income statement. For non-profit organizations like trusts and societies it is called
as income and expenditure account, but the basic concept is that of profit and loss
account. So, today in the session we will discuss what is P and L account? And try to
understand what are the elements of P and L account. Now P and L account discloses the
results of operations of the entity.
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If you are a company; obviously, you would be looking for the profit. So, P and L
account will show you the profit during a particular year or during a particular month. If
you are a nonprofit organization then you will prepare income and expenditure account
and it will give you the surplus.
Now for every entity to calculate the profit, you will need to know the incomes and
expenses. Now in our first session we had a look at the money cycle or at the business
cycle; from the business cycle you will come to know what are the incomes, you will
also come to know what are the expenses and they would be listed out and the difference
between them would be the surplus or would be the profit of the entity.
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So, the major components of P and L account are incomes and expenses.
And this is a simple format or a short form of P and L account; so, it starts with sales
most of the entity’s income is the sales. Then less cost of goods sold gives you gross
profit, then you deduct other expenses or operating expenses taxes that is the net profit;
this is a very simple format of P and L.
Now let us look at the Company Act format as per the schedule III of Company Act; now
instead of sales the word uses revenue from operations.
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Now, what do you mean by revenue from operations? For a simple understanding in the
earlier slide I had used the word sales; which is more or less same as revenue, but now
the term revenue because entity might not be selling the goods it can also be providing
variety of services.
So, the revenue it generates from services plus the revenue it generates from sales both
together; it is called as revenue from operations. Operations indicate that this relates to
day-to-day functioning of the entity; that is why any money or any income which is
generated from the normal course of business would be shown as revenue from
operations.
Next to that there is other income; now what is other income? As the name suggests it is
other than revenue if any incoming generated; it is shown separately. Now you can add
both of them, so in step number III; you get total revenue which is I plus II, but now the
users of that P and L account want to know how much is a revenue generated from
operations and how much is other income? That is why it has to be classified; in item I,
you only show the revenue from operations in item II; you show other incomes and in
item III; it is a total of I plus II.
Now, what is an example of other income? Can somebody think of the example. Suppose
we have deposited some money in the bank, we have a surplus cash we deposit in a bank
at the end of the quarter or at the end of the 6 months; bank gives us some interest, that
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interest is an example of other income. It is not a income from our regular business, it is
not a sale of goods or it is not a supply of services done by us. But from our surplus
money we invested, we got some income from that investment in the form of interest
then it is an example of other income.
Same way sometimes, if we sell our fixed asset at profit then the profit which you
generate will be an example of other income. The loss which you incur by selling asset is
also other income ok. So, search items which are not in the normal course of business,
but they are also revenue in nature they would be shown as other income; now both
together forms the total revenue for that entity. Now item number IV is expenses; now
all expenses of the concern in that particular year or that for that period are listed out.
Company Act has specified certain headings, so you just like in balance sheet there were
certain headings; there are certain headings in P and L account all your expenses you are
to fit in those headings.
So, the first item is cost of material consumed; now what do you understand here by
material consumed? Suppose you are a manufacturing entity, you would purchase raw
material, you may also purchase some components, some spare parts; now the cost of all
these items is considered as material consumed.
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If it is in stock; you will not take it here what is actually consumed in the period is shown
as cost of material consumed. Next is purchase of stock in trade; now, what do you
understand by stock in trade? Now, if you are a trading entity you will buy goods and
sell them as it is as finished goods that will be an example of stock in trade.
Sometimes even manufacturing companies buy finished goods sell finished goods. So,
whatever you purchased as a ready item; what raw material you consume will be in item
number I, but what your purchased and sold as it is to the customer that will be shown as
purchases of stock in trade. Now next item is very interesting changes in inventory of
finished goods, work in progress and stock in trade; keep in mind all these are different
types of inventories or stocks in your hand.
Now, if there is any change in those stocks that will be shown. Do you think of any other
type of inventory? Actually there is one more type are you remembering it? There is also
a raw material inventory, but that is not shown here because you remember in item
number I, we have considered raw material consumed. So, we have not considered
opening and closing stock; what is actually consumed is taken to P and L. But in case of
stock in trade or in case of finished goods, we have considered purchase of stock in trade
not consumed actual purchase.
So, out of that purchase some of the amount of stock in trade is not sold out; remains
with the entity as a closing stock, there might be some amount of stock in the beginning
which is known as opening stock. Now opening stock minus closing stock is your change
in stock; now that change in the stock in trade will have to be included here. Same way
whatever finished goods you have or whatever work in progress you have any change
there on will be shown as changes in the inventories. Now this is a very important item
and you have to be very careful about the sign of these changes.
Because see first item that is cost of material consume; whatever you consume is a
expense; purchase whatever your purchase is an expense. But in case of change if there
is decrease in the inventory earlier you have more inventory, now you have less
inventory there is a decrease; that shows that you have consumed that in inventory it
becomes your expense it has a positive sign.
But suppose there is a increase in the inventory, then there will be a negative sign getting
it? So, earlier you have got less inventory; now you have got more inventory; that means,
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there is a increase in the inventory that will be shown in the expenses with the negative
sign because it is a like your income it reduces your expense ok. So, look at the balance
sheet or of your own company; you be careful because this change in my inventory will
be small item, but it can have a positive sign it can also have a negative sign ok.
The next item is employee benefit expenses, so in simple terms you can say it is a salary
expense. But it may include some other employee benefits like overtime, like bonuses,
like work visits, like the cost of any other facilities given to employees, the cost of
recruitment of those employees; all that items would be clubbed together in the heading
employee benefit expense. The next item is also very interesting it is called as finance
cost.
Now, what do you mean by finance cost? You are using money, if you are paying any
cost for raising those finances that will be called as a finance cost. What will be an
example of finance costs? The best and simple example is payment of interest. Suppose
you have obtained loan from the bank; at the end of every quarter normally you will have
to pay interest that interest will be considered as finance cost.
If you pay interest on your debentures, interest on lease all this will be considered and
included in finance cost. In fact, even the cost of raising the debentures; some charges
which you incur as one time charges, they would also be amortized that is a part of that
will be included in the finance cost ok.
The next item is also a different type of item; that is depreciation and amortization
expense. Now what is meant by this item? After this session we are going to discuss; we
are going to have a separate session on depreciation, but as of now you can understand
that depreciation is a fall in the value of fixed assets. Now fixed assets are there in the
balance sheet, if their value falls. Because as you use the asset suppose you own a car;
when you use your own car, you do not have to pay any rent, but the value of your car is
falling that fall in the value is called as a depreciation and that depreciation is considered
as a expense in the balance sheet.
Any fixed asset which you are using will lose value; at the end of the year its value will
be less than the value in the beginning. There are various methods of calculating
depreciation that we are going to discuss later. But as per the method which is used by
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your company whatever is a fall in the value that will be shown separately as a
depreciation in the profit and loss account.
Keep in mind that this is a unique expense because it is a non-cash expense. All the
expenses starting from cost of raw material consumed to finance cost; we were paying in
cash. Suppose you hire somebody you pay salary, suppose you take loan, you pay
interest; suppose you purchase raw material, you pay for the raw material. Like that there
will be a cash cost involved in other items, but in depreciation, there is no cash cost.
We have purchased say a car or we have purchased some machinery at that time you
have paid in cash. But now that car is being used for 5 years; let us assume, there will be
no cash to be paid every year. I think you are getting me, If we hire that asset on rent
then we can pay rent but if it is our own asset then no cash cost will involve. But even if
you are not paying in cash, the value of your asset is falling and that value fall in the
value is to be estimated and calculated and to be shown in P and L account as a
depreciation. Now what do you understand by amortization? Because there are two items
depreciation and amortization; I think most of you are able to judge it. Because there are
two types of fixed assets there are tangible assets when they lose value it is called as
being depreciated, there are intangible assets when they lose value it is called as
amortized.
So, suppose you have got software, you have purchased software and the license is for 3
years; that means, every year; one third of the cost will be reduced in the beginning if
you pay 3 lakhs for 3 years, then you can calculate that for each year 1 lakh rupees is a
fall in the value of that software; at the end of three years it will become 0; that 1 lakh
which is calculated each year is called as amortization. So, like that for any intangible
asset, there is a reduction in the value that will be calculated it is just like depreciation;
only thing is it is on intangible assets. So, there is a separate name for it known as
amortization.
So, all the expenses for any company are to be put under six heads; keep in mind you can
have more expenses also, but you would put them under the most appropriate head and at
the end of the six items you calculate the total expenses.
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Now, we have got next heading; heading V that is profit before exceptional and
extraordinary items and tax. So, it is III minus IV; earlier we have seen this III was
referring to the total revenue minus total expenses; this gives you profit, very simple.
Whatever is the Total revenue you minus total expense from that, what you get is a is
profit; only thing is you are yet to calculate or take into consideration some other items
which are exceptional extraordinary and taxes. That is why it is called as profit before
exceptional and extraordinary items and taxes; what these items are? We will just take
into account.
But right now we are at item number V which you can say is a profit calculated as a
initial profit. Now from that you are going to deduct two items; item number VI is
exceptional item, item number VIII is extraordinary item. Now what is an exceptional
item? As the name suggests, if certain item is not likely to recur every year it is not in the
normal course of business, it is required to be separately shown and it will be categorized
as an exceptional item.
Can you think of any example of exceptional item? Let us see there is a major flood in
the factory and because of flood your stocks are damaged, your machinery is damaged,
you will have to incur lot of repairs after the flood to restore your machinery and make
your factory in proper order. So, the loss of stock, damage to the machinery and
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repairing cost all these taken together; if the amount is significant keep in mind I am
talking of major flood.
Normal flood like every year water logging, then it is not an exceptional item; if it is a
significant loss because of a major flood, then that will be separately shown as a
extraordinary item. Same way you can also say about fire, any such eventualities which
is not in the normal course; it is not likely to recur every year, you will need to classify it.
Now here the judgment is given to the management whether a particular item is to be
classified exceptional or to be shown as a normal item. If they would have treated it as a
normal item it would have come in the normal expenses. For example, your raw material
is destroyed in flood; if it is a minor amount you would any way including cost of raw
material consumed, you do not have to separately show.
But if it is a sizable amount; we will show it as exceptional item because it is not going
to happen every year. Same way, there are extraordinary items; if the happening is even
more exceptional than exceptional then it will be called as extraordinary. For example,
flood is so much devastating that it has completely destroyed our factory then it can be
considered as a extraordinary item.
Keep in mind this is a rarest of a rare case; normal if flooding happens then either it is
exceptional nor extraordinary. If there is a major flood which might occur somewhere in
10, 20 years once then it is exceptional. If flood is so large that it has totally destroyed
our factory something which you expect once in 100 years perhaps and it may have
impact in the existence of your entity itself, then you will characterized it as a
extraordinary item.
Now, the discretion is given to management to categorize is that either exceptional or

extraordinary. Now why these items are shown separately? Because the users of financial
statement; that is those who are reading the P and L should know whether a particular
item is going to happen every year or no. Normally we assume that the items which are
categorized as expenses are in the normal course of business; so they will happen
repeatedly regularly we have already defined P and L it is a statement which shows
normal incomes and expenses.
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So, it is assumed that they are going to be recurring in nature; however, if there is a
major loss which is not going to recur; you will go categorize it as a exceptional or
extraordinary. Keep in mind that this cannot be recorded in the balance sheet because
that is also a revenue item; it is not creating any new asset that I can write it in the
balance sheet. In fact, it is destroying my existing assets; that is why it has to be removed
from balance sheet and those losses how to be booked somewhere in P and L; so, special
headings are created to show it as exceptional and extraordinary.
Now when somebody is reading P and L and they look at a exceptional or extraordinary
expense, they would understand that this is not a normal expense. So, next year we can
expect to have more profits because there will not be exceptional and extraordinary
losses in the next year when I am referring to losses it can also be profits sometimes.
Can you think of an exceptional item of profit? Just think over; suppose we own a piece
of land. We have purchased land for 5 lakhs in 1950, today in 2019 or in 2020; after 70
years the land which was purchased for 5 lakhs, perhaps today might have a value of 5
crores. So, 5 lakh rupees land if we sell in 5 crore we will make a profit of 4 crore 95
lakhs.
Now all profits are shown in P and L; so that profit is also shown in P and L, can we
show it in our revenue? Obviously, no because it is not our business to sale land, neither
can we show it as other income; though it is other income it is not going to recur every
year because if we sell land this year then, next year no land available for sale. It is not
like sale of our normal goods; that is why this 4 crore 95 lakhs is an example of
extraordinary item. Remember here that we said extraordinary item, they have not said
extraordinary expense it can be income as well as expense.
So, you will have to careful about the sign here; this is not always a negative sign, it can
be negative sometimes it can be positive also. In addition to that management will have
to write a note below explaining what is a extra exceptional extraordinary item and why
they have categorized that item as exceptional or extraordinary. So, I will advise you
now you go back to your balance sheet for your own company, check if there are any
exceptional or extraordinary items and write a note as to why they are classified so; fine.
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So, I hope you have got this; so now we were at V, profit before exceptional
extraordinary then we will deduct exceptional items, we will deduct extraordinary items;
so you get IX which is profit before tax.
Now from that item X is tax expense; so we will deduct current taxes and deferred taxes
to get profit or loss for the year from continuing operations. Now what is a current tax
and what is a deferred tax? I think we have discussed it earlier I will just repeat again.
So, on the profits which you have earned in IX, you will have to pay some money to
government that is a taxes. If those taxes are due in the current year, they would be called
as current taxes; if they are allowed to be paid and after 2 years, 3 years, 4 years
something like that they would be called as deferred tax; still we this show them in the
today’s P and L.
Because they are on the profits of this year, but they can be paid afterwards they will go
to balance sheet. So, tax expense is categorized as current differed; so you get profit from
continuing operations.
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Then separately you have to show profit from discontinuing operations; that means if
some business is stopped, then those profits will have to be profits or losses will have to
be shown separately the taxes on those discontinuing operations. Like some factory
which is closed, but you get some profit or loss from there; so, profit before tax and
profit after tax from ex discontinuing operation is shown in item number XIV.
And finally, item number XV is profit or loss for the year which is total of XI; that is
profit or loss from continuing operation plus XIV. So, continuing plus discontinuing both
the profit after taxes are added and you get the final result, it is like a final scorecard for
that business as profit or loss for the year. Now this was the format as per schedule III of
Companies Act.
So, we stop here and in next session we will continue the profit and loss account.
Namaste.
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Lecture – 09
Namaste. We have already discussed the basics of financial statements, then we have
seen balance sheet both the basic format and the company format and we have also seen
income statement or profit and loss account formats.
Now, let us try to prepare some basic financial statement in the form of Profit and Loss
Account. This is not in the full fledged company format; this is for us to understand the
basic format of income statement or P and L and to calculate the profit.
So, the first case for that Atal limited, now a list of balances related to incomes and
expenses are given and from that we have to make income statement. So, raw materials,
taxes, power and fuel, employee cost you know all of these are various expenses,
manufacturing expense is another expense. So, all these are being marked as a expense
category right; total turnover is our revenue or our income. So, I will just mark it as a
income and selling and admin expense, interest and depreciation are expenses.
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So, in P and L it is very simple we will note income and we will reduce the expense from
the same, we will break it down into two parts trading part and P and L part. So, please
prepare the solution first and then check it with the solution which I am going to show.
You can pause your video complete the work and then only look have a look at the
solution.
So, in the interest of time we are immediately showing you the solution I hope you have
made it yourself. So, the total turnover is the first item; here only one income item we
have in the form of turnover this is also known as top line for the business from this
certain expenses are deducted.
That is raw material, power, employee expense, manufacturing expense, selling expense
and depreciation. What we have not reduced is or charged is interest because the items
which are charged here are known as operating expenses. So, we will deduct first the
operating expense which gives us a figure of operating profit it is also known as EBIT or
PBIT; PBIT or EBIT refers to Earning Before Interest and Tax or Profit Before Interest
and Tax; then less interest we get EBT or profit before tax. Now why is interest deducted
separately in a separate step can somebody tell me the answer, can you think of it?
Because interest is not a regular expense related to the business; if you look at other
items like raw material, power, employee, manufacturing etcetera they were essential
part to run that business; whereas interest is a repayment made to bank or to some party
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for loan which we have taken. So, it is not integral part to the operations of business; it is
considered as a finance cost. If we have invested our own money of capital; we do not
have to pay interest, interest is being paid because we have borrowed money, it does not
necessarily have to do with the operations of business.
So, we have not kept it in operating expense we have reduced it separately. So, we get
two levels of profit; first we have calculated EBIT and then we have calculated EBT. We
have also deducted taxes separately whereas, where we will finally, get profit figure
known as EAT or PAT. Now why is profit deducted separately; because profit as nothing
to do with our policies. As per the prevailing law as per the taxation policy of the
government the taxes have been calculated and they have been deducted to know the
final profits available after taxes.
But we would also like to get one level before that to calculate profit before tax. So, that
we know that from our own business we have got operating profit, we also deduct
interest. So, we need to know how much profit we have made it our self that is profit
before tax and then finally, what profit remains with us is a profit after tax. So, I hope
you are all able to make it yourself; now let us go to the next case.
Next case here the balances of Shiva are given; certain items have been given and from
this you have to make profit and loss account. But now we are going to make in two
levels first the trading account and next the P and L account. The trading account is the
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upper part of P and L, where we will record those items which are directly related to
trading or manufacturing ok. This is a horizontal form of P and L we will make; in the
last case we have made a vertical form now we are going to make a horizontal form ok.
Now, have a look at these balances mark the items of income and expense and then
prepare trading and P and L account. So, cash what will you mark it as? Is it an income
or expense? The answer is no actually you know it is a balance sheet item it is an asset in
the balance sheet. So, it is not required as far as the P and L is concerned, but right now
we will just mark it as BS. So, BS is balance sheet; so that you know that it is a balance
sheet item those of you want to make balance sheet also you can even mark A after that
because it is an asset item. But right now I am not going to give much time on it because
we are going to focus on preparation of P and L.
Trade debtors; again a balance sheet item, rent again a balance sheet item? No; rent is an
expense; so you should mark as E; salary again an expense, trade creditors balance sheet
item; you know it is a liability you can mark it as L; if you are keen. Insurance, it is an
expense petty expenses of course, are expenses; opening stock this is the last year stock
which we are going to use it now; so, it becomes an expense item for us. Sales; sales is
an income item, purchases; expense item, capital neither income neither expense it is a
balance sheet item.
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Drawings, again a balance sheet item; motor vehicles balance sheet item, machinery is a
balance sheet item, office expense is an expense machinery expenses mark well these are
maintains or such expenses on machinery they are not for purchase or for acquisition of
machine. So, machinery is a balance sheet, but machinery expense is a expense item.
Fuel and lubricant another expense and last item closing stock; this is an income item we
are this is the remaining stock which we will use it in the next period.
So, for this period it becomes an income item; got it? Now only pick up E and I items
prepare a profit and loss account in the horizontal format; upper part is known as trading
lower part is known as P and L. So, please make your solution; I will halt here please
pause the video and then after you are ready see the remaining part of video.
So, here we are now this is a solution of trading account. So, you can see the sales and
closing stock are shown on credit side, this side is known as credit side where we show
incomes this side is known as debit side.
I am not going to jargons of why debit, why credit, but normally this is called as credit. I
will just mark it; CR normally stands for credit and DR stands for debit. On debit side or
on expense side we start with opening stock then record the items which are related to
the core operations; so we have recorded purchases and fuel.
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Whereas those which are general nature of expenses like rent etcetera are recorded in P
and L account. So, rent, salary, insurance, petty expense, office expense and machinery
expenses have been recorded in P and L; of course, this classification is not very strict.
Some items like for example, machinery expenses if it is in a factory it can be written in
a trading account, but we have assume that this is a small business which is not a
manufacturing per say these are like more of a maintenance of machinery for day to day
use. So, we have kept it in general expense category in the P and L account ok.
So, now based on your sales and closing stock we have charged first two items that is
opening stock, purchases and fuel and the balance is called as gross profit. Are you able
to calculate the gross profit? I will just show you the process; take the sum, the same
amount will be carried over here since this is total I will make it bold.
Now, calculate the balance on the debit side that is 46225 that represents the profit from
trading account, which is known as gross profit. Now this gross profit, we are caring it
over on the credit side and then we will charge all the expense. Again following the same
process take a total, take total on debit side also you will get a balance of 30000, this
30000 represents your final profit; generally known as net profit. Are you getting it? Net
profit is the most important figure, so I am just making it bold.
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So, for this particular period we have recorded all incomes and expenses and got a profit
of 30000; this is the traditional way of writing it in a horizontal form all debit on one side
and credit on one other side. More modern format is making a income statement in the
vertical form which we had already seen in the last case; got it? Now let us go to the next
one.
Now, this is more of a interesting item from the books of Amar limited, we are going to
prepare trial balance, P and L account and balance sheet. So, far in the earlier cases we
have seen how to prepare balance sheet, we have also seen how to prepare P and L; now
we are going to next step where for the same case we will prepare P and L as well as
balance sheet. In fact, we will also prepare one more statement known as trial balance.
So, here there are list of balances; these balances would have been extracted from their
ledger.
Now what is ledger they have made list of balances list of accounts if they calculate the
balance of each account; they get the final balance as on 31st March 2020; they will
make a list and this is what the list is. Now, what is a trial balance? Trial balance means
this particular list will be categorized into debit balances and credit balances and we will
check the total of debits and credits. Why do we check this? Because we want to check
arithmetic accuracy of the accounts, this does not mean that 100 percent accuracy is
ensured. But at the first stage trail balance helps us to know whether arithmetic accuracy
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is there, whether we have missed any balance, whether any particular account has any
issues. So, we will make a list of balances, prepare the trial balance and then make P and
L and balance sheet ok.
So, for this list of balance now; please take a printout. For all the cases I have been
telling you that based on this print out; prepare the solution yourself and then check with
my solution there is a small error here.
Because we are given balance is on 31st March 2020. So, this opening stock must be on
1st April 2019, by typo error it was shown as 18; so I have now corrected it. Now please
correct it in your sheet also and with these balances first make a trial balance. Now let us
go to the solution I hope you have also made a trial balance.
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Now, what I have done here is first I have marked every item as C and D. What is C and
D? Credit and debit; like capital account this is the money which investors have put in
our business; so, this has credit balance this is the amount which is repayable.
Drawings represents the money which we have paid to the owner mister A. So, we will
mark it as D debit; purchase is an expense item, so we have mark it as D. Freight is a
expense item we have marked it as D like that all the items first have been listed as C or
D ok. C items can either become a liability in the balance sheet or can become an income
item in the income statement. But right now we are not going for that we are just listing
out items as C or D and let us prepare the trial balance from same.
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So, here now all C items have been taken together and we have one taken one total of all
C items ok. So, this is like a trial balance, but we will prepare exact trial balance from
this. We were given list of balances as on 31st March 2020 then we have mark this items
as C and D and now we are going to make a trial balance as on 31st March 2020.
So, what we have done is; all the items which we were marked as C, we have kept under
the column C and all items which are marked as D have been kept in the column D.
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And then we will take totals of credit column and debit column. Are you getting it? This
simple statement is known as a trial balance; now this becomes a starting point for
preparation of P and L and balance sheet. Now based on this let us go for preparation of
P and L and balance sheet; I hope you are ready with the solution. Are you ready to see
the solution? Since we have done it before; I hope you know the process for example,
A’s capital, where will you take it as?
You know it is a liability item in the balance sheet. If you want you can go on marking it
like this; results again a liability item in the balance sheet. Sales less returns, this is a
profit and loss income item.
See now your work is very simple because we have separated credit balances and debit
balances. If you go to let us say purchases; it is a profit and loss expense item almost all
debits are going to be profit and loss expense few would be balance sheet assets. Only
one for example, drawing will be reduced from the balance sheet liability side ok.
So, now your job will be simple; using this data let us go to income statement and the
balance sheet. So, if you are ready we will go to the solution.
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So, here is a solution for P and L account; are you getting it? So, trading account we
have got two credit items sales and closing stock; the total is 3350000 and there are four
debit items, opening stock, purchase, freight inward and wages. So, we get gross profit of
880000; I hope it is matching with you.
This 880 is then carried to the lower part of P and L known as profit and loss account.
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And then we will list out all the expenses to get a net profit of 149000 have you got this?
This is the profit and loss account; let us go to balance sheet now. Now, based on the
items which are given in the trial balance; prepare the balance sheet; I am deliberately
not showing you the solution, I hope you are able to make it yourself now.
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So, balance sheet on 31st March 2020; if you have made it yourself earlier, check it if not
make it now along with me. Now, from the trial balance those items which were; those
items which were marked as balance sheet items, now carry them to balance sheet. Then
from debit side there are many assets item, carry them to asset side. After that; take total
of assets and liabilities it should match; is it matching? If not what is a problem? Which
item is missing?
You have to go back to trial balance and find out whether item is missing and also check
whether your carried profit from profit and loss account because, it must be added in the
balance sheet. So, we have not yet added profit; so this net profit let us add, now is it
matching? Still there is a difference we need to find out which item has been wrongly
added; so there is a difference of 20000.
If you look carefully, we have excluded this drawing of 20000 that also needs to be
considered. So, it is reduced from capital, it is going to be a minus figure and once you
consider this it is going to tally. Is it matching? Are you getting it? This is how trial
balance helps you to find out the errors. Trial balance helps you to find out which item
was missing and which item was wrongly added or which item the amount is wrong and
from trial balance you can make P and L and balance sheet.
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In coming sessions we will do it for company, but this is based on a proprietary concern
type of a simple transaction and the balance sheets from the simple transactions.
Namaste
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Lecture – 10
Namaste. Welcome to Financial Accounting. We have discussed about balance sheet

which is one of the most important statements of financial nature. In the last statement or
in the last session, we had started with discussion on Profit and Loss Account.
We had almost done, we will just have some more discussion today. So, as you all know
profit and loss account is a statement which gives you profit or loss and in case of
nonprofit entities it is called as a surplus for a particular period. It has to list all incomes
and all expenses.
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So, it has two parts; income part and expense part and this is our short form a very
simple form of P and L and we are also seen in detailed form as per the schedule III of
companies act. So, its starts from revenue; revenue or the income of the entity, then other
income; you get total revenue.
Then in item number IV, you consider the expenses. There are six categories of
expenses, starting from cost of material to depreciation. I had told you that change in
inventory is slightly confusing item because it is not a direct expense as such. What
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happens is you have got opening inventory you have got closing inventory, if there is a
reduction in the inventory. So, more opening inventory less closing inventory, there will
be a decrease in inventory which is an expense.
So, in the it is in the under the head expenses will have a positive sign. But if you have
got less inventory in the beginning more inventory in the end so, increase in the
inventory is mean actually conveys that there is less expenditure in the period; you are
keeping more inventory for future that is since it is an under the expense head. Increase
in the inventory would you have a negative sign.
So, I had told you that go to your balance sheet of your company and see the sign of this
item, it can be positive, it can also be negative. While for all other items it will be
positive; positive means it is added to expense. Then employee benefits, then financial
cost; financial cost is slightly unique type of expense because it is related to your
business, but it is specifically for raising of funds.
So, if you have taken loan, you will have to pay interest; if you have issued debenture,
you will have to pay interest; if you have leased an asset that is you are taking somebody
else’s asset for use, then you will have to pay financial cost for the lease that is also
finance cost. So, all these items are added in finance cost and the last item of expense is
also unique in nature that is depreciation and amortization. Do you remember what is
depreciation? There is a reduction in the value of fixed asset. If it is for tangible fixed
asset, we call it depreciation; if it is for intangible fixed asset, it is called as amortization.
Now, how the depreciation is calculated, we will see in the next session. But as of now
whatever is a depreciation as calculated represents an expense of the entity for that
period. Suppose you have purchased a machinery for 5 lakhs and the life of the
machinery is let us say, 5 years. You cannot charge the whole 5 lakhs in year 1, but you
also cannot say that nothing is a cost throughout the 5 years. At the end of 5 years, we
will consider 5 lakhs.
So, this 5 lakh rupees, you will credit over its useful life which is 5 years may be you can
take 1 lakh each year that 1 lakh represents the depreciation for that year. I hope you are
getting it. More methods of depreciation we will see later on, but depreciation is one of
the expense it is unique because it is non cash in nature; you do not pay any cash for it,
but there is a fall in the value of assets, so you record it ok.
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So, after taking these six items, you get total expense. Now 3 minus 4 gives you profit
this is your initial profit. Now, a few more items are considered there, they are known as
exceptional and extraordinary. Do you remember what these items are? These items are
non recurring in nature. Normal course of business, we do not expect them every year
like say fire, like some major accident I am not talking of a very small fire or a very
small accident, that is in normal course, that will be in item IV.
But some big happening which causes major losses or major incomes, they would be
categorized as exceptional incomes or expenses the losses because of them would be
under this item. In rare cases, there can be also exceptional incomes. What is an
example? Last time we said sale of asset; asset like a land not your normal goods, then it
is your revenue. But if you sell land maybe once in 10 years, 15 years, 50 years like that
it can happen, it will be categorized as a exceptional and extraordinary item; it is shown
either in 6 or 8.
It needs to be separately categorized because readers of P and L account should know

that this is not a profit in the normal course of business. So, it is separately shown, so
item V is your normal profit to that you adjust for VI and VIII. First you take VI, then
you get profit before extraordinary item and tax then you take VIII; you get profit before
tax. So, by after you deduct VIII in IX you have considered all items exceptional and
extraordinary, you have only not considered the taxes.
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Now, from IX we will reduce the taxes, so you have a tax expense. Now, what do you
mean by tax expense? There are variety of taxes for example, GST. Will you include
GST here? The answer is no because GST is a indirect tax. They indirect taxes which are
incurred are part of your cost. So, it will be already included in these expenses.
So, what you are considering here in tax expense is only taxes on your profits which is
nothing, but income tax. So, profit before tax; here the word tax refers to income tax
only. Now from that you are deducting two types of taxes, it is both are income tax only,
but under the provision of income tax certain taxes are allowed to be deferred; that
means, you can pay them after 2 years, 3 years, 4 years etcetera. Most of the taxes you
have to pay now; they are called as current taxes. If you are allowed to defer the amount
of tax, it will be called as a defer tax.
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So, from IX, you will this is profit before tax you will deduct the tax expense, then you
will get XI. Now this is a profit from your normal business. So, it is a profit for the
period from continuing operations. Now, some part of the business, you might have
stopped that business. For example, certain factory is closed now or certain line of
business is closed then again the readers of P and L should know that this is a profit or
loss coming from a closed business. So, it is to be separately categorized in XII as profit
from discontinuing operations ok.
So, at XI, you have calculated all the profit from continuing operation, then profit from
discontinuing operation, you reduce any tax expense on discontinuing operation. So in
XIV, you get profit or loss from discontinuing operation. Now, this XII sorry this XI plus
XIV together gives you profit or loss for the period.
Now, they have written loss in bracket because suppose this figure is negative, it will be
shown in bracket which indicates that you have incurred the loss for the period. It says
for the period, I think you all know that profit and loss account itself is paid for a
particular period may be a year or a quarter or for a month. So, unlike a balance sheet,
suppose last year sales or last year’s expenses cannot be shown in P and L account
whatever profit you have incurred is a profit for the particular period.
I hope you understood P and L, if you have any queries please discuss them on our
discussion forum. Now, we will just consider one or two important concepts. One
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important concept is income because there we had said revenue here; we had said
revenue from operations.
So, first of all we should be clear as to what is a income. Now, income is defined as
increased in economic benefit during a particular accounting period. Normally it reflects
in inflows or enhancement of asset either you get cash or some of your assets are
enhanced or your liabilities are reduced, then it is called as a income.
Every income is not revenue, income is of two types. It can be revenues or it can be
gains. Income which you get from a normal business activity or from a day to day
business activity is called as revenue and income which occurs because of an occasional
activity because of a onetime activity is called as a gain.
So, we had already seen one example that we have a piece of land you sale it after 10, 15
or 20 years. This is not your normal business, you are not into a developer or as a
builder. For a builder buying and selling of land will be normal course that will be a
revenue, but for any other company sale of land or a sale of fixed asset would be a
onetime activity; it is not a nor normal or a ordinary activity. So, any gains from sale of
fixed asset would be categorized as a gain.
So, all the incomes are into revenue and gains keep in mind in P and L account the item
number I is revenue, so you do not write any gain there. Are you getting me? So,
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whatever is your normal operations; if there is any sale or any revenue from provision of
services that will be one that is your normal business. Other than that is categorized as
other incomes, so you would have wondered here it is called revenue, but here it is called
income. Because here you can show revenue as well as gains which are not from normal
businesses ok.
So, for example, if you have purchase shares, you will get some dividend on it or if you
make profit by selling, then dividend as well as the gain from sale both together would
be shown as other incomes. Same way, there are other gains which we had categorized as
exceptional or extraordinary items like from sale of a big land. Are you getting me?
So, here just a conceptual understanding as to what is a income. The other one is
expense. Now almost everybody knows expense because every now and then we keep on
incurring some expense. So, expense happens means what for a normal persons if his
cash reduce then that person calls as a expense because there is a outflow of cash.
Sometime there is a reduction in the value of asset like depletion in the asset or sometime
suddenly a new liabilities created. All this put together lead to decrease in economic
benefit which is called as an expense.
Now, expenses are also of two type. When it is in the normal course, then we just call it
as an expense. For example, if you pay salary if you pay rent, if you pay electricity
charges, if you pay travelling expenses; all this is a example of are examples of expenses.
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There is also a peculiar type of expense which is known as loss, so it is not in a normal
course.
So, if you have purchase machinery life is expected to be 5 years, then every year you
will depreciate; depreciation is your expense. But suddenly the machinery proves to be a
bad machinery, it is not serving your purpose either it is of a outdated technology or
there are some problems with running of machinery, so you will have to dispose of the
machinery in the second year for zero value. So, the whole amount is lost, then we will
not call it as a day to day expense, we will call it as a loss on sale of machinery and it
will be categorized as loss. Are you getting?
So, any expense of such type which is not day to day or normal, can you give any other
example of any such loss? So, suppose you have purchased a patent; patent has a life of 4
years, you were expecting that that technologies usable for 4 years, but within next year a
better technology has come; I think we are all in knowledge era. So, you are aware that
last year you purchased a new mobile, but this year now you there is a better mobile
available, so you feel the old mobile is outdated.
So, whatever expense which is incurred in buying that particular patent is not of any use
you might have to write it off, then that is also an example of a loss. So, as you got
expenses, we divide into two types. If you go back to P and L, you can see here in item
IV the term used is expenses. So, from the revenue we deduct only those items which are
normal in nature. Those which were not normal we are categorizing them mostly as
exceptional or sometimes as extraordinary and in some cases as relating to discontinuing
operations, but normally the item in IV, items in this IV are day to day types of expenses.
Are you getting? So, this was like the P and L is essentially a list of incomes and
expense.
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Now, in the last part, we will look at an at a important concept known as matching
concept. Now, why there is a need to list incomes and expense? There is a need because
of an accounting principle which is known as matching. So, at the end of the year as per
the accounting norms or as per the accounting requirement, you have to make a list of all
incomes and all expense. Why there is such a requirement? Because unless you do that
you will not be able know profit or loss that is why accountants have made it a rule that
incomes and expenses should be listed at the end of the period and that net result should
be available in P and L account.
Now, matching concept avoids misstatements in earnings. So, what happens is suppose
you have generated revenue in the current period, the expense which is related to that
should also be recognized in the same period. If you record revenue now, you will show
lot of profits in this year; expense will come in the next year, but that year in revenue is
not there because you will again show lot of losses in the next year, so that leads to a
misstatement.
So, matching concept says that whenever you recognize the revenue also recognize the
expense related to that. So, neither there is a excessive profit in earlier year and sudden
losses in the next year that is avoided. Similarly, it should not happen that now you
record expense, but you suddenly record revenue in the next year which is also a
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misstatement. Can you give an example of such a happening that revenue is recorded
now, but expense suddenly comes later?
Let us say you are selling some item and you give the customer guarantee for 5 years,
you record revenue now, show the profit also now, but the guarantee is for next 5 years;
that means, in the next 5 years whatever is a repair etcetera on the item sold, we will
have to be incurred by the business in year 2, 3, 4 and 5. But in year 1 you are recorded
all the revenue. So, how will you avoid that?
If you remember in our earlier class, we had discuss that we create a provision exactly
how much will be incurred because of guarantee nobody knows, but we will create a
reasonable provision for year 2, 3, 4 and 5 and record it write in year 1. This is due to
matching concept. Can you think of any other example? I think you have heard about
depreciation in last two classes, little bit discussion on happen on depreciation happen.
For example, if you purchase machinery of 5 lakhs having a life of 5 years. Now, you
have paid entire 5 lakhs in year 1, but you will use the machinery write up to year 5. Is it
right full that the whole expense shown in year 1 only? The answer is no because you are
going to use that machinery in year 1, 2, 3, 4 and 5. So, revenue which is generated by
using that machinery is spread over 5 years, so what we do is the expenses there on are
also spread over 5 years.
So, what we do is we create different types of provisions. If you remember we had

discussed in the balance sheet a concept called provision what is the need of provision is
because of the matching concept. Same way why you have to provide for depreciation is
also because of the matching concept; I am just discussing matching concept because this
is a base for P and L.
Why was P and L account prepared? It was because of the matching concept like that
actually there are several principles and concepts in accounting. So, I am going to
discuss as and when the relevant statement comes into picture, so that you are not
suddenly board and you can relate the concept to the relevant statement I hope you are
getting a.
So, with this discussion we have completed the discussion on P and, we already had
discuss balance sheet, so you have understood the basics statements now. I know we
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have not done any cases or problems we will do them in later sessions, but overall
understanding of statements have happened you can read this statements and once again
remind you that you have to download annual report of your company whichever
company you choose start reading their P and L account and balance sheet along with my
lectures.
So, that you also see the actual statement instead of just theoretical discussion, in coming
sessions we will discuss some relevant concepts. For example, what is depreciation, how
do you calculate and value inventory, what are important accounting rules. We will
discuss a few concepts like this and then we will go for actual preparation of P and L and
balance sheet. Till that time keep refreshing yourself by reading those P and L and
balance sheets. So, with this we will stop here. Namaste.
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Prof. Varadraj Bhat
Lecture – 11
Depreciation 1
Namaste to all of you, we are starting with the 3rd module. In the first two modules, we
have discussed the basics of financial statements. In module 1 if you remember we
started with introduction, then we discussed what is balance sheet, what is the format of
balance sheet, what are the assets, liabilities, equity. We also saw how are the major
entries entered into; so, we had briefly discussed five important entries.
In module 2, we had started with discussion on balance sheet and P and L little more in
detail. So, we have also discussed what is P and L and the format of P and L. I am once
again reminding you that right from second session, I have been telling you that you
need to identify your company, download the financial statements of a listed company
and study the balance sheet P and L and all the statements as we are discussing in the
class.
Because it is not just theory also read, observe what you are seeing in the financial
statement of your company. And if you find any derivation, then what we are teaching or
if you feel that there is something more to discuss, please put it on our discussion forum
and you will be getting answers, you can also discuss with other members of the class.
So, today we are going to start with the module 3, as you can see it is on Depreciation. If
you have minutely read the P and L account, there is one item in P and L known as
depreciation and amortization; that is something we are going to discuss today. It also
appears in the balance sheet especially with reference to fixed assets.
Now, in our module 3, we are going to discuss two important things; one is depreciation
and the other is valuation of inventory because these two are very important items in
both P and L and balance sheet; so, right now let us start with depreciation. Now what do
you understand by depreciation? Many of you might already know and we have also
discussed what is depreciation earlier.
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Now, while beginning this module, we are going to also discuss one very important
concept that is known as concept of conservatism and then we will continue with the
discussion on depreciation. Now what do you mean by concept of conservatism? Do you
know what it is? As the name suggest, it is about not showing profit unless it is
extremely confirmed, but showing on losses whenever there is a slight likelihood of a
loss. To put it in specific terms, it states that accountant should not anticipate any
income, but shall provide for all possible losses.
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So, as per this concept it is not prudent to count unrealised gain, but it is desired to guard
for all possible losses.
So, when the alternative values of assets are available accountants need to choose the one
which leads to lesser value. So, there is a possibility that a particular asset can have two
values. As per one method the value is 50000, as per the other method it is 45000. Now
to be on safer side as per the concept of conservatism, we will say that let us value the
asset at 45000. Because instead of showing excessive value, it is better to be on a safer
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side or on the conservative side because, we do not want the value in the balance sheet to
be inflated. We are if it is slightly on a lower side ok.
Now, for conservatism there are three important qualitative characteristics; the first one
is prudence. So, the judgement about the losses which are to be guarded as well as the
gains which are uncertain. So, even if there is a slight possibility of a loss, we account
for it.
If you remember we have discussed provisions when we discuss the balance sheet. So,
whenever there is a likelihood of a loss, there is no certainty that loss will arise, but there
is a chance that there will be a loss, what we do is we estimate the likely loss and make a
provision and show it in the balance sheet as a liability. But when it comes to gains that
there may be some gain then we do not account for it. So, this is the first qualitative
characteristic known as prudence.
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The second one is neutrality. Unbiased outlook is required to identify and record such
possible losses and to exclude all uncertain gain. Now when you are sitting in the chair
of managing director or assembly who is manager, there is likelihood that you would like
to show better results. So, you would like to show more profits, but accountant is
supposed to be neutral. Accountant needs to have an unbiased view and ensure that any
slight chance of loss should be identified and recorded while whatever the profits or
gains we are recording, they should have hundred percent certainty. Any possible
uncertain gain should be excluded.
And the third one is faithful representation of alternate values. So, when accountant is
recording or showing an item in the balance sheet, first of all faithfully identify all
possible values and then while recording the asset take the lower value. When it comes
to balance sheet liability side, we would record and we would create provision for all
possible losses.
When it is for preparing of P and L when a loss is being accounted in the balance sheet
automatically it will also be recorded in a profit and loss statement. So, to an extent the
profit will be understated and we will ensure that because of any uncertain gain the profit
is not over stated. Are you getting me; now, this concept of conservatism is very
important and it is at a root of several accounting treatments.
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Two important examples are there on the screen. The first one is the closing stock is
valued at cost or market value whichever is lower. So, in the balance sheet while
showing the inventory, a particular item of stock or inventory will have a cost. If its
market value is more than the cost which is more a likelihood that the cost is 10000, the
market value is 12000. In such scenario, we will not record unrealised profit of two 2000
because we have not yet sold the item. It has a market value of 12, but its cost is only 10
so, we will continue to show it at 10.
However, suppose the cost is 10, but market value falls to 9000, then there is a
possibility of loss of 1000. We have not yet sold the particular item at 9000, but its
market value has come down to 9000. In such scenario that item of stock, we will record
at 9000.
So, we will already record a loss which is likely to happen. That is why, any item of
closing stock should be valued at cost or market value whichever is less. Now after
today’s session, we will look into details of valuation of inventory, but right now just
keep it as an example of conservatism; are you getting me?
Now the next one; the next one is the topic which we are going to discuss today that is
about depreciation. Now, most of you know that depreciation refers to fall in the value of
fixed asset. Now such fall might not have happened in a particular period, but still
because of conservatism, we take the cost of asset, we look at the life of the asset and
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spread that cost over its life. So, we will go on reducing the balance sheet value of the
asset every year, we will not wait till the asset is fully exhausted.
So, suppose you purchase the machinery at 1000, it has a value a life of 5 years. We will
not wait for 5 years to for it to lose its value; every year this 10000 rupees will be spread
over the period of 5 years. So, value is 10000, the life which is estimated is 5 years so,
we will distribute 10000 by 5 that is 2000 each year and make a provision for
depreciation every year.
So, the concept of conservatism is at the root of the need to provide depreciation ok.
There are some more examples also, but these two are very prominent one hence, we are
also going to discuss them in this course. Now can you think of any other example? Are
you able to feel think that there is any other possibility where we use conservatism; I
think some of you are guessing correct.
Suppose we make a credit sale, the amount is yet to be collected from the customer. So,
we show it in the balance sheet as a debtor or a receivable. Now there is a likelihood that
few of our customers do not pay their dues on time and eventually they do not pay at all.
So, there will be a need to create a provision for this. This is normally is known as RDD
or Reserve for Doubtful Debts. So, any customer any debtor, if is likely to not pay; we
will immediately make a provision ok. So, like that we can have some more examples
also, but right now let us go ahead.
Now, we will discuss about depreciation.
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Now, depreciation especially it is for fixed assets which are used in business either for
production or for supply of services. Now, typically they lose value as we use a
particular asset, the value of asset is likely to fall because of its use. Even if you do not
use the asset just by a passage of time also, the asset value is gradually reduced.
Now, that portion of value of asset which slowly reduces its value, it is necessary that
that loss of value it charged to profit and loss account because we are using that asset to
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generate revenue. So, against current revenue, there is a necessary to charge expense for
loss of value of fixed asset.
Now, the portion of cost which is a loss of value for the current period is called as a
depreciation for that particular period.
What it means is, it is a reduction in the value of fixed asset or it is reduction in the
utility of that particular asset due to variety of reasons. It can be due to passage of time, it
can be due to natural wear and tear, it can be due to obsolescence or it can be due to
exhaustion of subject matter. But there is a gradual and continuous fall in the value that
we are recording as depreciation. So, we have just discussed the major causes of
depreciation.
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The first one; that is, lapse of time. Now if you purchase a brand new car, do not use it.
Suppose you purchase say a vehicle at 15 lakhs, do not use it for 2 years. After 2 years,
will it have a value of 15 lakhs? The answer is no, because just by lapse of time even if
you do not use it because it has become older vehicle, it loses its value.
So, one important cause which is irrespective of uses lapse of time, the other is wear and
tear because most of the assets we are buying to use them. So, as we use them, there is
some wear and tear there is some value loss because of utilisation; so, that is accountant.
The third one is obsolescence of technology because new technologies are coming up
that is why the older assets would soon become outdated.
In today's era, the biggest reason for depreciation is obsolescence because much better
products, much better technology, much better services are available every now and then.
So, even before the useful life is lost by wear and tear, it gets lost due to obsolescence. I
think the best example is our mobile phones, I know everybody wants to change mobile
phones within say 6 months or 1 year.
The old phone might not be still unusable, but newer phone might give much better
utilities. That is why with better availability of either hardware or software, one tends to
replace the assets faster that is mainly because of obsolescence. If you as observe
carefully, many of the apps either on our mobile or on computer, they need to be deleted
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or updated continuously because the older versions are no longer, the best versions and
the newer versions are available that is also because of obsolescence.
The fourth reason is exhaustion; the exhaustion of subject matter. Can you think of it is
related to which asset? Anyone has a clue because most of the assets which we normally
use like say mobile phones, computers, machinery or furniture; they are subject to first
three reasons, but not much to exhaustion. So, which are the assets which are subject to
exhaustion? I think some of you are guessing it correctly, it is asset like a mine.
So, in mine what happens is as we are extracting a particular mineral, the value of the
mine falls not by time loss or not by obsolescence, but mainly because whatever is
mineral in that mine goes down; the stock of that mineral goes down. So, for a specific
assets like mines or like oil wells, the exhaustion is a major reason for depreciation ok. I
hope, you are getting all the causes correct. So, these are the objectives of providing
depreciation.
Now, we are generating revenue to know the correct profits we should also account for
costs in that period. I think we have seen in P and L account that matching concept is a
important concept of P and L. So, it is necessary that though we are not paying for
depreciation in cash, we should account for this loss which is not a cash loss, but it is a
loss of value of asset which is for generating this revenue. So, to ascertain the correct
results in P and L account, it is necessary to make a provision for depreciation. It is
equally true to present the true and fair value of fixed assets.
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Because if a particular let us say, example of mobile phone if a mobile phone is

purchased for 20000, it has a life for 2 years; that means, at the end of year 1, its value is
down from 20000 to 10000. If in the balance sheet, we continue to show 20000, it will be
a wrong representation. That is why we need to make a provision; I am here assuming
that 20000 is a depreciation is a value each year the depression is 10000; first year
10000, second year 10000. So, we will make a provision for 10000 in year 1 so, valuable
reduced from 20000 to 10000 which will be a true and fair value ok.
Now, the third one is to accumulate the funds for replacement. So, suppose after 2 years
we want to buy another mobile for 20000, we need to set aside that much of money.
Because if we do not do anything for 2 years, after 2 years suddenly we will realize that
the old phone is now no longer usable. So, what we do is every year let us say, we keep
aside 10000 10000 so, that at the end of 2 years we have got enough money for
replacement of earlier assets ok.
Now, how do you calculate? Now it is very difficult to calculate the exact amount, but
what we do is, we make an estimate. So, that we get the closest possible amount, what
are the important factors for estimation?
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The first one is of course, the cost of asset; keep in mind that the cost should include
expenses like installation. So, if you have purchased a machinery, it will need some
installation. That installation cost should also be added to the cost of asset then we try to
estimate the useful life of the asset.
So, suppose if a machine is likely to be used for 4 years in a productive and an efficient
manner, it may have a total life of 5 years, but in the 5th year it may face with lot of
accidents or possibility of more repairs. So, we may not want to use it in 5th year, we
may want to use it in the most profitable manner for 4 years in which case the useful life;
see the total life is 5, but the useful life can be considered as 4.
Now, we look at the estimates provided by the manufacturers and also our own
experience to calculate the useful life of a particular item. The third one is scrap value at
the time of useful life. So, suppose we are going to use the machine only for 4 years, at
the end of fourth year we may sell it as a second hand asset to someone else or we may
scarp it and it will give you some scrap value.
So, whatever is a value which is a sellable value at the end of that useful life that will be
also considered. So, these three factors are first estimated and based on that the
depreciation is calculated.
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Now, there are variety of methods for providing for depreciation, four methods are
particularly popular. The first one is straight line method, the next as you can see is
Reducing Balance of RBM, machine hour and production units.
Now, let us see or discuss them one by one.
Now, straight line method is very simple; we estimate the useful life and spread over the
entire depreciable cost over its useful life. So, suppose a particular machine is purchased
for 10000, it has a total life of 5 years, but useful life is 4 years. So, 4 will be our
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denominator, 10000 is a cost. Let us say, it is likely to have a scrap value of 2000 so, 10
minus 2; that means, 8000 is a depreciable amount to be written off over a period of 4
years so, 8000 by 4 so, each year depreciation will be 2000. Now this remains constant
for all the 4 years, that is why it is called as a straight line method ok.
Now, this is a formula; cost of asset minus the scrap value at the end of useful life
divided by useful life. So, you get annual depreciation which remains fixed throughout
its life.
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So, here is an example. I think it is very simple so, all of you can calculate it orally. So,
cost of machinery is 18000, installation charges are 2000, useful life is 5 years, we are
assumed that scrap value is 0. So, how much is a depreciation 18 plus 2 so, total cost is
20 to be written off over a period of 5 years.
So, 20 upon 5; that means, 4000 per annum is a depreciation. I think very simple
everybody is able to calculate. Are you getting?
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Now, let us make go to the next method. The second method is known as reducing
balance method. Now here what we do is instead of calculating a fixed annual amount,
we calculate a fixed percentage or a fixed rate. Now every year whatever is a value of
machinery at the beginning, we charge it at a particular rate and calculate the
depreciation for that year.
So, depreciation is calculated as,
Depreciation = WDV * depreciation rate.
Now what is WDV?
Written Down Value = acquisition cost - depreciation.
So, in year 1; if you go by our earlier example, our machineries cost was 18000, suppose
the rate of depreciation is 10 percent 18000 into 10 percent; that means, 1800 will be the
depreciation for year 1.
But in year 2, we will not charge 10 percent on 18000, what we will do is first we will
say 18000 minus 1800; that means, the cost of machine or the value of machine known
as WDV is itself reduced which has come to now 16200 on that we charge 10 percent.
So, we will get 1620 as a depreciation for year 2; let us look.
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Now, the main advantage of this method is that the total charge of depreciation is now
not uniform, over a period of time it falls. Because in the later years your repair expense
is high, it is good to charge more depreciation in the earlier year and charge lesser
depreciation in the later years. So, this is the formula, depreciation is WDV into
depreciation rate.
Let us take one very simple example. The cost of machinery is 50000, the scrap value is
5000 useful life is 10 years and depreciation rate is calculated at 15 percent.
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So, we will try to calculate depreciation for first 2 years. In the first year, it simple 50000
into 15 percent that is 7500. Now in the second year, we will not charge 15 percent on
50000 first we take 50000 minus 7500. So, 42500 is a WDV on that we will charge 15
percent. So, year 1, depreciation is 7500; year 2, it is 6350; year 3, it will be further
reduced. Each year the depreciation is reduced that is why it is known as written down
value method.
So, I hope you have understood first two methods. Just compare them; straight line and
written down. In the next session we will discuss a little more about them. Namaste.
Thank you.
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Lecture – 12
Depreciation 2
Namaste. If you remember in the last session, we had started our discussion on the
concept of conservatism. Can somebody tell what is conservatism very briefly? By
conservatism what we mean is, any possible loss we need to provide for; possible I am
saying not certain even if there is a chance of a loss, we should provide. But if there is a
possible game, but it is not certain then we will not account for it. So, accountants follow
a very prudent path or a conservative path and normally assign a lower value when two
values are available. We had seen two examples of this.
One is because of the application of the concept of conservatism; the closing stock is to
be valued at cost or market value whichever is lower. The second one was depreciation is
required to be provided every year.
Now, most of you would have read your annual report. Just look at the financial
statements. After the financial statement, in the note number 1 company would have
given important accounting policies. Please go through those accounting policies.
Several of those accounting policies are based on the concept of conservatism. Please try
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to identify them. We have just given two examples of valuation of stock and
depreciation, but some more examples you can find if you read carefully ok.
So, let us go ahead with today's session. Then in the last session, we had started
discussion on depreciation. First of all how do you define depreciation?
See depreciation is a loss in value as the name suggest, but it is a continuous and gradual
loss in value of fixed assets. In case of other assets like inventory or like investment,
values can go up and down. But for fixed asset from the date of purchase, till the date it
is scrapped out the value of asset continuously falls and that fall is what is known as
depreciation. So, it is a gradual and continuous fall in the value of asset mainly because
of four reasons. Do you remember those four reasons? I think most of you are
remembering.
So, lapse of time, wear and tear, obsolescence and exhaustion. Particularly the first three
are important for most of the assets and exhaustion; the fourth one is for which asset? It
is only for assets like a mine ok. Now, we went into the discussion on the methods of
depreciation. Now to calculate any depreciation, we need three important estimates. First
one is mostly actual that is a cost of asset, then estimate of the useful life and the
estimate of the scrap value.
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Based on these three we try to calculate annual depreciation for each and every tangible
and intangible asset. Now, to calculate them, there are four methods there are several
methods, but four methods we are going to discuss in these this.
The first two are very important; the straight line and reducing balance. Last time we had
discussed straight line. Do you remember what is straight line method?.
I will just give you a very simple example. Suppose we have purchased one asset say,
machinery for 1 lakh. It is useful life is 4 years, scrap value is let us say 10000. What
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will be the depreciation every year? 1 lakh minus 10000; that means, 90000 is to be
distributed over a period of 4 years. So, we will simply divide 90 by 4. So, 90000 upon 4
is a depreciation per annum. Getting it? So, it will be 22500 and this is known as straight
line method. You can see the formula ok; cost of asset minus scrap value upon useful
life.
Now, what will happens due to this is the depreciation remains constant throughout the
useful life. The second method is known as reducing balance method. Now in reducing
balance method what happens is instead of annual depreciation which is fixed, we
calculate a we arrived at a depreciation rate. So, suppose the same machine; let us say is
having a value of 1 lakh in the beginning. And, suppose the rate of depreciation is taken
as 25 percent, then in year 1; it will be 1 lakh into 25percent that is 25000. In year 2, we
will not apply 25000 on 1 lakh. We will take 1 lakh minus the first year’s depreciation
that is 25000. So, 75000; the 75000 is known as written down value.
See acquisition cost minus depreciation. Now on 75000, 75000 into 25 percent is a
second years depreciation; in third year it is 75 minus the second years depreciation that
is 22500 and so, we will get a further reduced value, on that we will charge the same rate
that is 25 percent. So, effectively the amount of depreciation will go on reducing every
year that is why it is known as reducing balance method.
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Last time we had stopped our discussion with the comparison of the two methods;
straight line and reducing. Now, between the two methods, which method is better in
your opinion? I think those who like simplicity, we will say that straight line is simple.
So, it is good. There are some advantages of straight line, but there are a lot of
advantages with reducing balance Now in reducing balance, what happens is the value of
depreciation falls over a period of its useful life. In the earlier year, the depreciation is
higher; in the later year, the depreciation is lesser.
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Now, this is a very good thing because every year the cost of repair is likely to increase
because the machine is becoming older. So, it is good to charge more depreciation in the
initial years and lesser depreciation in the later years. Because initial years repair will be
less, but depreciation is high; later year let us skip depreciation less. So, that repair more
of repair can be born that is one approach, that is also another advantage is reducing
balance. Because in the initial year there is significant loss in the value that gets better
reflected in the balance sheet; if we charge more depreciation in the earlier years which
happens in reducing balance.
That is why income tax act allows only one method that is reducing balance method in
companies act both the methods are allowed; straight line as well as reducing balance.
If you are reading the balance sheet of your company which you have chosen, please
read their depreciation schedule. In the depreciation schedule, then we have mention the
method as well as the rate at which they are charging depreciation. I hope you getting it.
Now let us go.
So, this is a formula once again you can have a look at it. Last time we had done these
calculations.
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Now, let us go to the third method that is known as machine hour method. Now what
happens is in case of certain machines, the life depends on how many hours you use the
machine.
So, the depreciation is also calculated as per the likely life which is calculated in terms of
its working hours.
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So, this is an example. If the cost of machine is 5 lakhs and estimated working hours are
40000 scrap value is 10000.
Now, there given the pattern of effective working hours. Let us say in year 1-2, it is
5000; 3-5 it 7000 and 6-7, it is 3000. Now how do you compute depreciation? Now, what
we will do is we know the cost and we also know that the estimated working hours are
40000; scrap value is 10000; so, instead of charging straight line depreciation which will
be uniform or instead of charging depreciation at a certain rate. We will calculate it on
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per hour basis and then based on the hours in that particular year, we will compute the
depreciation.
For example, firstly, we will we know that the total depreciation total number of working
hours are 40000. Now the cost of machine is 5 lakhs minus 10000; that means, basically
we have to depreciate 490000 over its useful life. In year 1 and 2, it is a new machine yet
to settle. So, useful hours or useful hours are only 5000; so, 5000 upon 40000 into
490000. So, the cost is the depreciation is 61250 in year 1 and 2. Are you getting?
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Now, in year 3, 3 to 5; now the amount to be depreciated is same 5 lakh minus 10000
that is 490000. In year 3 to 5, the estimated number of hours are 7000. So, 7000 divided
by the total hour that is 40000. So, each year we are getting 85750 as depreciation from
year 3 to 5, fine.
And for year 6 to 8, now the machine as rather become older. So, the useful hours per
year are only 3000; so, 3000 upon 40000 in to 5 lakh minus 10000 which is constant. So,
in year 6 to 8, the annual depreciation is only 36750. Are you getting?
So, here instead of reducing it over a period, we are going by its utilization. So, in a year
how many hours you use, accordingly the depreciation is charged. Are you getting? This
is known as machine hour method and fourth one which we are going to discuss is
production unit method.
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Now, in production unit method, what we are doing is we are looking at the annual
production and the depreciation will be charged based on the production in that year.
Now, this is the formula we use. So, what we do is, total depreciable amount will be
divided by the estimated total production. Out of the total production whatever is a
production units for that particular period that much portion will be depreciated in that
period.
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Let us check this example. So, cost is 30000, estimated total production is 4000; it is in
terms of unit, the scrap value is 2000. So, basically you will see that 30 minus 2; that
means, 28000 is a depreciable amount which is mainly for the production of 4000.
Now, this 4000 is spread over three years in this manner. In year 1, estimated is 2000,
year 2, 1500 and year 3, 500. So, what we will do is the depreciation is for 4000 units,
we will spread it over as per the estimates of units.
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So, in year 1, 30 minus 2 that is 28000 is to be basically depreciated and here we take
2000 divided by 4000; that means, for year 1, the depreciation is estimated to be 14000.
In year 2, the formula is same it is 1500 upon 4000; that means, we are calculating it
based on 10000; we are calculating it to be 10500. Now can you do it year 3? Just have a
look once again.
So, 30 minus 2; that means, basically 28000 upon 4000 and in year 3, the estimated units
are just 500. So, you can do it orally also; 500 into 28000 divided by 4000.
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Are you getting it? This is the calculation. So, you are getting 3500 per year. Are you
getting? There are some more methods, but they do not have much of practical utility.
The first two methods that is straight line and reducing balance are the most important
methods and almost all companies use any one of the two, particularly the second
method that is reducing balance is most important. Most of the companies using and as
per income tax act, it is mandatory to use reducing balance method.
The third and fourth method are not use normal in financial accounting, but they will be
useful for managerial or for cost accounting. That is why, I have covered it in this
particular session ok. So, with this our discussion on depreciation is over. I will once
again remind you to look at the depreciation schedule as per your own company and that
will give you some more inputs. So, with this now having discussed about depreciation,
let us have a look at how it appears in the annual report. I have been telling you in every
session that you decide a company, go to the annual report of that company and as we
discuss have a look at the statements which are as published by a particular company.
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Now, here I am showing you extracts from Tata motors annual report so, that you will
actually have a feel of how it looks like. So, right now, we are in the section of balance
sheet; within balance sheet, you can have a look at assets. I hope it is visible; though the
font is little small, but this is how actually it is in the annual report of Tata motors. So,
you can see item a is property plant and equipment. This is something which we were
discussing about when we were discussing depreciation. Over all within noncurrent
assets, a list of asset is provided and then the description of each asset is given. So,
property plant and equipment is described.
Now, in the end if you look there is a table which is showing the type of the asset and
estimated useful life. I think this is very interesting because for calculation of
depreciation, we have seen we want to estimate useful life of a particular asset and that
will be the basis for calculation of depreciation. So, here you can see the types, building,
then roads, bridges and culverts. For that the life is reasonably wrong. So, it is 4 to 6
years. Then plant machinery equipment, it is 3 to 30 years. Computers and it related
assets is 3 to 6 years, vehicles 3 to 11 years, furniture fixtures 3 to 21 years.
So, reasonably long range, but for a particular class of assets, they have defined some
estimated useful life Now for a particular asset within that range, they would decide the
useful life.
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Now, next they have given definitions of some of the terms like depreciation, then the
terms in the box have also been defined like accumulated depreciation. So, I hope you
remember, what is depreciation. This is a loss or reduction in the value of asset in a
particular year. Now for that asset, the depreciation for year 1 is say 10000; year 2, 8000;
year 3, 4000; then what we do is we accumulate or collect the depreciation. So, in year 1,
it will be 10, in year 2, it will be 10 plus 8, 18; in year 3, it will be ten 8 and 4, 22.
Like that the total depreciation or accumulated depreciation is calculated and it is to be

disclosed in the balance sheet. After that, there is a item called as depreciation expense.
Depreciation expense refers to the depreciation for that particular year and the last item
given over here is salvage value; salvage value or scrap value. This is at the time of
disposal, what value you have is called as a salvage value ok.
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Now this is a very important. Note: I know it is little difficult to read, but I have given it
here because as it is as what is in the annual report. So, it starts with the assets which are
owned by the company. So, it says owned assets, then the category of assets are given
starting with land, building, then plant and equipment, furniture and fixtures and so on.
Now, the cost as at April 1, 2016 that is the opening balances are given, then additions,
then currency translation differences, then disposal. Now the total of all this will be the
cost as on March thirty first, 2017; that is the closing cost. So, just to give the cost of the
asset; the original cost, there are four items disposal will of course, be reduced, but the
total will be the cost at the end. Now the next is accumulated depreciation as on April
first 2016. So, at the beginning of the year, what is the depreciation than the depreciation
which is added, depreciation which is written off, the depreciation on disposal. Then at
the end, you are got accumulated depreciation as at the end of the year.
So, we considered all the cost, then all the accumulated depreciation cost minus
accumulated depreciation is a net carrying amount. We were discussing about WDV
written down value. It is same as the net carrying account amount has been discussed.
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Now, a few more things; now this is related to intangible assets. Now this is about the
goodwill. One of the important intangible assets is goodwill. Now, what happens is when
company acquires other assets, it may pay more than what amount is a fair value of that
asset. So, suppose you are acquiring assets worth 15 crore, but you are paying 18 crore
let us say. So, you are paying 3 crore more 18 minus 15, 3 crore which you are paid will
be considered as goodwill.
There is another category of goodwill which is known as self generated goodwill, but it
is not disclosed in the balance sheet. What is disclosed in the balance sheet is called as a
purchased goodwill which is classified as intangible asset in the balance sheet. So, here
we are looking at a purchase goodwill. So, first the definition of goodwill is given and
then the value of goodwill as is disclosed in the balance sheet, you can have a look.
Under the assets non-current assets, there is items c called as goodwill ok.
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Now, if you go little ahead, there is a working table which is given in the for the
goodwill. It is similar to that for a tangible asset, but slight different; first balance at the
beginning, then it is called as impairment. That means if asset loses its value, it is called
as impairment. So, some amount is provided as impairment. There is currency translation
differences because though that goodwill is in foreign currency and the balance at the
end. You can just have a look at what is impairment. Now cash generating units to which
goodwill is located are tested for impairment annually.
So, what it means is, you have paid for certain amount as a goodwill assuming that that
particular unit or that particular part of the business would be able to generate cash. If
that business does not have that capacity any longer; that means, the depreciation is no
longer applicable. In such cases, the depreciation is written off or its value is removed
from the balance sheet that process is called as an impairment.
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Now, further we will go to other tangible assets. So, other intangible assets I am sorry.
So, here in the assets after goodwill which you see item like other intangible assets are
given. I think, we are already discussed intangible asset. Intangible assets are those assets
which you cannot touch or feel. Now these assets are also required to be amortized. So,
they are to be depreciated, but here since they are intangible that is called as they are to
be amortized. Now you can see here type of the asset and estimated useful life. So, for
patents, it is 2 to 12 years; for computer software, it is 1 to 8 years, then for dealer
network, it is 20 years and for intellectual property rights, it is 3 to 10 years. So, I hope
you are getting the difference.
For goodwill, there is no particular estimated useful life. It can remain perpetually, only
thing is you test it for impairment. If that particular business or product has lost its value,
then we will write off goodwill. We will call it as an impairment, but for other intangible
assets, we will charge depreciation that is known as amortization. The calculation is
same like for depreciation.
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So, you will need an estimated life. So, that estimated life is given ok. Now there is one
more working table again the font is small, but just you can have a look. It says working
table for other intangible assets. So, just like for tangible assets, it starts with opening
balances additions and so on and then accumulated depreciation is calculated and then
you get the final value.
There is one more exhibit a. These are excerpt from the annual report page 155. Now
here, the final disclosure is given. So, property plant and equipment that is the tangible
assets total and goodwill and other intangible assets total which gives you the total of
total ok. If this is not so, clearly visible I would request you to download the annual
report of Tata motors and see it yourself, I am sure you are also looking at annual report
of your own company.
But, I am just showing you because when actually you see it, you will have the feel of it.
Then some term boxes are given like amortization, expense and total accumulated
amortization. This is just like depreciation; amortization expense refers to amortization
during the year and there is accumulated amortization just like accumulated depreciation.
So, this was the actual extract of the annual report of Tata motors of 2016-2017 ok.
Please have a look at it and I hope your, the concept of depreciation are more clear to
you now. Namaste.
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Lecture – 13
Inventory Valuation
Namaste. Let us start our next module 3.2 which is on Inventory Valuation. I hope you
remember our earlier modules, earlier we have discussed about balance sheet, we have
also discussed about profit and loss account and in the last two sessions we have
discussed about depreciation, its calculation and various methods of depreciation as well.
Today we are going to start with another important item in both P and L balance sheet
which is known as inventory. So, we will specifically look at inventory valuation. Now
what do you understand by inventory? It is also called as stock.
So, this is referring to tangible property which is held for sale in the normal course of
business. So, there are variety of inventories you can have, normally you start with
purchasing of raw material. So, if there is any unused raw material which is lying at the
end of a period or say year, then that will be called as stock of raw material or inventory
of raw material; then the raw material is processed to make finished goods.
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Now, in the course of processing if it is not completed. So, it is not finished goods
neither it is raw material, then we will call it as a work in progress. There will be also
goods which are ready for dispatch, but not yet sold so, you will have stock of finished
goods. So, these are the three major items of stock RM stock, then WIP stock and FG
stock this is in case of a manufacturing concern. For a trading concern, they may only
have stock of finished goods sometimes it can be also called as a stock of purchased
items which are meant for resale.
Now, apart from this, there could be some items which are retained for retained with us
for maintenance purposes. They would also be forming part of spare parts, part of
inventory of spare parts or such type of stocks. So, this is what is inventory. Now for
example, if you are holding some land will it be an inventory? Can we classify it as an
inventory? Mostly the answer is no because land is a fixed asset land is not meant for
reset. You buy land generally you use it for construction purposes or you may use it for
factory or you may use it for your shop.
So, land becomes a fixed asset to be used and not to be resold. So, land would normally
not be a part of inventory; now I am using the word normally. So, in which cases it will
be a part of inventory can somebody tell? I think yes some of you are giving correct
answers for a company which is into construction, for builders, developers for such
companies land is an inventory. So, they buy land, either they sell land or they buy land
then they construct a some flats or shops or godowns then they sell it as finished
products.
So, for them land becomes an inventory, but other than them then the land should be
classified should not be classified as inventory because, we are defining it as items which
are for sale in the normal course of business. Now one more example for example: cars,
can you treat cars as an inventory? Again mostly the answer is no car are cars are meant
for own use so, they are classified as vehicles and put it as tangible fixed assets.
Only for certain companies car is an inventory for which company? For example, Tata
motors they are manufacturers of car or Maruti they are manufacturers of car so
obviously, for them car is an inventory; even for car dealers they are in to buying and
selling of cars so, for them car is an inventory, but for all others it is not. So, I hope the
point is clear any item which is normally bought and sold or you buy a raw material
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process it and sell, then these items which are raw material, work in progress and
finished goods these are the ones which you call them as inventory.
Now, apart from these very small items like lose tools or maintenance supplies, they are
also part of inventory because they would be also absorbed into the product. However, if
you are keeping men machinery spares, then such items should be classified as fixed
assets because they are not into for the purpose of selling ok.
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Now, the valuation of inventory is very important because inventory is one of the items
of your assets in the balance sheet. So, any overvaluation will mean that you are showing
excess value of the asset. If you are under valuing inventory then also it is wrong because
you are showing less value of your assets and this is very important item because on one
side it affects our balance sheet, it also affects our P and L account because inventory is a
item in P and L as well.
So, change in the inventory if you remember is a profit and loss item. So, it will impact
our profit or loss for the period as well that so, for this reason it is very important to
apply proper principles to arrive at a correct valuation of inventory. So, now we will look
at what goes into the cost of inventory ok.
So, cost of inventory one obvious part is the cost at which we have purchased or the cost
of acquisition ok. So, if you have purchased raw material for 20,000, then the 20,000
which will come as a bill from our vendor that will be the cost of inventory, but apart
from that we add a few more items. So, suppose we are bringing it in we are paying
some carriage involved on it or some freight on it to bring it to our factory or to our
storage godown, then the cost which is spent on carrying it inward will also be added to
the cost of inventory because it is not just the purchase cost, but we are also looking at
the change of location.
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If you are changing the location then it is added to the cost of inventory, if the condition
of inventory change then those costs are also added. So, for example, we have purchased
raw material for 20,000, we have spent 1,000 for the carriage. So, 20 plus 1 now the cost
is 21, then we spend some 5,000 rupees to convert the raw material into finished goods.
Then when we are valuing finished goods inventory, we will take 20 plus 1 that is 21
plus 5. So, inventory will be valued at 26,000 ok. So, any amount which is spent for
change of location or change of condition then that can be added for calculating the cost
of inventory. In change of condition there can be some other things like we provided
some finishing, we have added some extra items on it or we have changed the packing all
these things can be added to the cost of inventory.
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Now, there is an accounting standard 2 and in the new series there is IndAS 2 that
defines how the valuation of inventory is to be done. So, as per AS 2 inventory should be
valued at cost or net realisable value whichever is lower. I hope you remember that while
discussing depreciation we had discussed some concept and that concept has direct
bearing on the valuation of inventory, which was that concept do you remember? That
was concept of conservatism.
Because of conservatism if inventory is say having cost of 26,000 as we discuss, but its
market value has gone down to say 22,000; we will not take 26,000 in the balance sheet
we will record it at only 22,000, but if the cost is 26, but its market value is 29. So, we
have 3,000 rupees of profit, but the profit is still unrealized. So, we will not value it at 29
we will keep it at 26 only ok.
So, for the purpose of valuation it is the cost or net realizable value whichever is lower.
So, you have understood what is meant by cost, but what do you understand by net
realizable value can somebody tell what it is? It is very close to market value, but there is
slight adjustment to the market value for calculating net realizable value so, it is the
estimated selling price of that item in the normal course of business.
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So, if you value the item at selling price we take that, but you may have to incur some
cost for selling the item. So, the estimated selling price minus the cost which is required
to complete the sale that will be reduced; now that can be selling expenses, it can be
commission, it can be some packing which is required on it because we are not going to
realise that much, but we will have to spend it, we will reduce it from the cost we will
reduce it from the market value to arrive at net realizable value.
So, net realizable value refers to the amount which you will recover if you happen to sell
that particular item of inventory in the normal course of business are you getting? Ok.
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Now, let us take a very simple case for calculation of net realizable value. Now suppose
for the year end 19-20 now the cost of semi finished product is 70,000, we will have to
spend further 10,000 rupees for finishing it and then the product can be sold at 60,000.
But again we will have to pay commission of 5 percent on the selling price. Now what
will be the value of inventory in the balance sheet for year ended 19 and 20 just have a
relook.
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So, how much will be the value will you pay 70 or will you pay 60 or something else
because the cost is 70 as you can see but its selling price is unfortunately only 60.
So, will you take 60? Actually you will have to calculate NRV or Net Realizable Value I
will just show you the calculation.
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Now, see in any case the cost which is 70 we will not be able to consider because the
market value is less than 70. So, we have started with the selling price which is 60, from
that since this is a semi finished items some more cost is required to complete the item
which is 10,000. So, estimated cost of completion which is 10 so, 60 minus 10 and we
will have to pay commission of 5 percent on sales. So, 60,000 into 5 percent so, 3,000 is
a commission, 60 minus 10 minus 3; that means, if you sell that item if you complete and
sell that item you will realize 47,000, but the cost which you have incurred is 70.
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But in the balance sheet we are going to record only 47,000 are you getting? Cost or
NRV whichever is lower that will be the value of inventory for balance sheet purposes.
Now suppose just for discussion, if the cost of this item would have been 47,000 what
we would have done? We would have still calculated this 60 minus 10 minus 3 net
realisable value 47, but its purchase cost is 40.
So, 47 or 40 in which case we will consider it at cost that is at 4000 are you getting? Ok.
So, this was one important basic rule for valuation that always go for lower of cost or
NRV. Now, there are some techniques or some methods for valuation of inventory we
will also discuss about them.
Now, see there are five methods we have already seen how to calculate the cost, but
when it comes to calculating the market value, we have to go into further technicalities.
So, we are going to discuss five important methods that is specific identification FIFO,
LIFO, weighted average and adjusted selling price.
Now, what happens is when the item is identifiable it becomes very simple we know
how much is the cost for it. So, suppose you are making a painting or you are making a
something like customized product like say tailor made garment or if you are selling a
car, but it is not a normal car it is a designer cost car which is extremely costly in such
cases you know that item that item can be identified and you can know the cost of that
item.
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But in many cases what happens you are into a bulk production scenario. So, you are
making thousands of or in some cases lacks of units continuously, and it becomes
impracticable. And, it is impossible for us to know the cost of a particular item in such
cases what we do is, if we can identify always go for specific identification, but where
we cannot identify, we will have to go for other methods one of the very popular
methods and acceptable method is first in first out.
Now, in first in first out what happens is, suppose we have got 50 items which are the
older items, new 200 items are coming and you have issued 30 items in a particular week
or a month. So, 50 items are there, new 200 items have come in and 30 items are going
out we will assume that since the 50 items are already there in the opening inventory, the
30 items which are issued must have been issued from the opening inventory.
So, this is a simple queuing system like we are in a queue, whoever has come first will
get the ticket first, then second, then third, then forth. So, as per the chronology of the
receipts whenever an item has come in the inventory, we will issue it in the same
sequence. Keep in mind actually the issues may be random because all the units are alive
and this is a scenario of mass production.
So, you exactly do not know which item is newer and which item is older, but for
valuation purposes we will assume that the older items are issued out first, they will be
valued at that cost and the remaining items which are comparatively new will remain in
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the inventory and they will be valued at their purchase cost are you getting me? We will
take a look at a simple example.
Now, let us say in a particular month this is the data, now the date of receipt is known to
you these are various purchases the units purchased is known and the price is also
known.
So, we have purchased 5 units on date 5th we have purchased 5000 units at 7, then 12th
3000 units at 9 and then on 20th 6900 units at 9.
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After that on 22nd 8000 units at 11 and 27, 2000 units at 13 so, in a month totally there
are five different purchases and we know the units and the prices
Now, 20,000 units were issued during the month and we have to determine the value of
closing stock. Now you understand that since 20,000 units are issued in the month they
can be from any of the lots, but for valuation purposes we must know or we must
estimate or assume that from which lots they are issued.
Since there are five items, I would assume based on first in first out that the most old
items or those which were received early date they would be issued first. So, we will first
issue 5000, then 3000, then 6000, 9000 and so, on.
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Till 20,000 units are issued and then the remaining items that is a newer items they
would remain in the stock.
Now, let us have a look now the closing stock is 4900. So, what we have done is, we
have taken total purchases which is 5 plus 3 plus 6900 plus 8 and plus 2 from which
20000 are issued.
So, total 24900 items are available and 20 are issued. So, 4900 is in the stock the older
ones, that is those which were received on 5th 12th and 20th they have been issued
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completely the newer ones will remain in the stock. So, which are the most latest items?
27 2000 13 is a latest item and since we have a stock of 2009 4900 of which 2000 is a
purchased on 27 the remaining 2900 is purchased on 22nd ok. So, are you getting? So,
2000 units at 27th and 2900 purchased on 22nd.
Now, we will go for valuation 2000 into 13 and 2900 at 11 this is the value of closing
stock are you getting? Now if we would have been using LIFO what would have
happened? In LIFO method the third method last in first out.
So, in LIFO method what is assumed is the last items are issued first. So, we would have
assumed that all the earlier items or all the later items are issued and the oldest purchase
that is on 5th at 5000 is what is there in stock. So, 5000 rupee units were purchased at 7
rupees.
So, I would have valued my stock as 5000; 4900 into 7 instead of 57900 the cost would
have been much lesser. So, the value of stock changes by the use of methods either FIFO
or LIFO are you getting.
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Now, we will just it have a look at the LIFO method. So, as I have just explained you in
LIFO method the assumption is the latest goods are issued out first.
Now, example now the various dates are given and again the units of units and prices are
known to you.
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Now, 22000 units are issued during the month.
So, what we will do is, first we will have a look at the total purchases from that deduct
22000. So, we come to know that 5500 units are available in the stock; are you getting?
So, orally tried to take total 3 plus 6 plus 2500 plus 7000 plus 9000 these are the total
purchases from which 22000 units have been issued ok.
So, total purchases were 27500 minus 22. So, I am having a stock of 5500 units. Now
question is stock consists of which items the older items or newer items? In FIFO
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method we had assumed that the older items are issued out and the newer item is in stock
where as in LIFO it is assumed that the latest items have already been issued and the
oldest items are in stock.
Since our stock is now 5500 we assume that these four purchases are already issued, but
the oldest item which is purchased on 2nd at 3000 at 16 is still in stock and there are
another 2500 from 10th purchase at 20 that is also in stock. So, now, you can have a
look. So, 3000 units purchased on 2nd and 2500 units purchased on 10th.
So, the stock is now 3000 into 16 and 2500 into 20. So, value of closing stock is 98000
are you getting? So, now if you have understood LIFO and FIFO method which method
will give you more value of closing stock? Generally since the prices are rising; you can
have a look here the prices are slowly rising in most cases as you can see here, in FIFO
what happens is the older items are issued out and the newer items remain in stocks. So,
normally the stock value will be slightly on higher side and this stock value is closer to
the market value that is why FIFO method is normally preferred over LIFO.
In LIFO method it will be assumed that the latest units are already issued and older units
will be there in the stock. Now between LIFO and FIFO which method will give you
more profit? In the scenario of rising prices which normal is a case, in FIFO the stock
value is high. So, assets value will be high the profits will also be higher, in LIFO asset
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value will be lower and profit will be lower. Now most of the cases companies have to
pay tax on profits. So, they want to show lesser profit. So, they would prefer LIFO.
However income tax authorities are equally smart income tax authorities do not allow the
use of LIFO method normally FIFO method only is allowed by most of the regulatory
authorities ok; but it is interesting to understand and compare the two methods. Now I
have taken two different cases one for FIFO and one for LIFO, I will request you to
calculate now the stock as per LIFO and FIFO for both the examples, then you can get
comparative figure of stock under LIFO and under FIFO are you getting me? Ok.
Now, LIFO is one extreme FIFO is another extreme. In FIFO the value of stock is
normally higher in LIFO it is lesser there is one more method which acts as a via media
its a midway.
In that method what is done is, here we go for a weighted average. Instead of only using
older or newer prices we go on calculating the weighted average. So, under this method
the value of inventory slowly changes.
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So, the weighted average you can see the formula the total cost of goods available for
sale upon the units.
So, we will get the average price. So, you can just have a look at the example we know
the quantity, price and the amount.
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And we are given that 3200 units are issued in the period.
So, what we do is since total quantities 3200 the total cost is 43, we can calculate 43
upon 32. So, 13.44 is a weighted average price and the stock is 200. So, 200 into 13.44
you get 2688 as a weighted average price I hope you have got it.
The issue price weighted average is better because once you calculate the issue price,
you can show it as a issue price and you can also take that value. So, you can just have a
look here, the old cost was ten and at the end it was 12 and there were fluctuations in
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between, but we have calculated a weighted average 13.44 and that is taken as a issue
price and it is also taken as a closing stock. So, the stock price is changed here, but does
not change suddenly that is the advantage of weighted average most of the regulatory
authorities either used allow use of FIFO or use weighted average ok.
Now, let us go to the next method that is adjusted selling price. Now what happens is in
many cases there are no much records available, there are hundreds of items which are
traded or which are sold if you think of a kirana shop there are so, many types of items
100 or 500 items are kept and lot of items are purchased and sold every time. So, the
stock keeper or the shopkeeper does not know exact price and the date.
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So, here we were looking at the quantity and prices such information may not be
available, but at the end of the period let us say on 31st March they can calculate the
actual items which are available. So, we will know the number of units, but we will not
know the cost. However, they will know the selling price you know that most of the
retail items the selling price is required to be written on the package. So, it is very easy to
know the selling price.
So, what is done is, first the selling price of the stock is calculated, but we know that the
stock cannot be shown at a selling prices. So, we reduce the profit margin on it, there
will be estimates of profit margin on different types of products. So, they will calculate
the value of stock list the margin you will get the cost of stock, it is an estimate it is not a
exact value, but it will be close to the correct value ok. So, let us have a look.
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So, here date wise information is not known, but during a particular month they know the
goods purchased, transport cost and storage cost.
Now, they also know the sales and selling price of closing stock because they do not
know exact cost of closing stock.
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Now, what is first one is you will add sales and the selling price of stock. So, the total
value is 60,000.
Then we will deduct various types of expenses. So, less purchase cost, transport cost and
storage cost; that means, there is a gross profit of 28000
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Now, 28000 is on a total of 60. So, 28 upon 60 the gross margin is 46.67 percent. So, for
each type of product line a gross margin is calculated which is 46.67 percent. So, the
selling price of closing stock is 10000 minus 46.67 percent that is 4667 you get the value
of inventory as 5333 are you getting? This is the cost estimated cost of the inventory they
do not know the exact value.
Suppose the profit margin is negative; that means, the cost is more than the selling price
then we will simply show it as the selling price. But here since the cost estimated cost is
5333 and selling price is 10000 the stock will now be valued at 5333.
Now, the last method that is adjusted selling price is not very suitable method, but if the
records are not available in such cases this method is used. So, with this we complete this
topic on inventory valuation of course, we are going in a hurry those who want to learn
more I would request you to discuss more on discussion forum, create different cases and
try to understand in different scenarios what are the evaluations of FIFO under LIFO
under weighted average and under adjusted selling price.
So, that we realise as to what method is suitable another important thing you should do
is, go to your own annual report and check which method the company is using. They
would write a note on the inventory and we will also give the method which they are
using for inventory valuation and that will give you more insights into valuation of
inventory, I hope you have all like the sessions. Namaste.
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Lecture – 14
Cash Flow Statement 1
Dear students, Namaste, today we are going to start one very exciting and new topic that
is titled as Cash Flow Statement. If you remember there are three important statements in
an annual report which are mandatory for all the companies and in fact, they are required
for almost all the undertakings. Do you remember what are the three statements? The
first one going by how we have learnt it is balance sheet, then profit and loss account and
the third one is cash flow statement. In the first session, we had seen the purposes of each
of these statements. So, can you tell what does the balance sheet tell you?
Balance sheet is a statement of financial position. So, it lists the assets and liabilities as
on a particular date. A profit or loss account is a statement showing incomes and
expenses, the net result is profit or loss for a particular period. Traditionally, these two
statements were considered as the final statements showing the results of any entity.
Entity can be of any type it may be profit making or non-profit making or it can be a
partnership firm or say proprietary concern or a corporate; almost every undertaking had
to prepared these two statements.
Gradually, it was realized that these two statements though are very important; they do
not give all the information which is required by the stakeholders because stakeholders
are equally interested in knowing about the movement of cash in the entity. So, a third
statement was made mandatory in 90’s and that is known as cash flow statement. So,
today we are going to discuss the cash flow statement and we will also take a look at a
few cases involving cash flow statement ok.
So, these are the contents.
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And we are going to discuss various topics as are listed in the index.
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I have just inform you that the traditional financial statements, they fail to give
information about generation and utilization of cash, and users of the statement usually
want to know what are the ways an enterprise is able to generate the cash and they also
want to know how that cash is utilized in a particular period.
So, there is a need to give a summary of movement of cash in a period and there comes
the importance of cash flow statement.
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Now, the meaning of cash flow statement is it is a summary of cash flows both receipts
as well as payments during an accounting period. Further it categorizes the flows under
the three heads that is operating, investing and financing. If you want to read more
details, these are the accounting standards on the basis of which cash flows are made.
The current one which normally companies are using is called as IndAS-7, it is similar to
international accounting standard that is IAS-7 and the old set of standard for this is AS-
7; AS-3 which deals with preparation of cash flow statement.
Now, you already know balance sheet you also know P and L account. Now can you
think cash flow statement is similar to which of these two statements? Is anyone of you
able to think now based on whatever we are discussed now? I think some of you are able
to guess it. This is somewhat similar to P and L because P and L is also for a particular
accounting period; cash flow statement is also for a particular accounting period unlike a
balance sheet. Balance sheet is not for a period, it is prepared at the end of the period, but
it is a cumulative statement.
So, if the balance sheet is for 31st March 2020, it will give the assets and liabilities
which are purchased or which are acquired in all the earlier years, not just this year; right
from the starting of the business till 31st March 2020, if any asset is purchased and not
yet sold it will be shown in the balance sheet.
But if you consider a profit and loss account for year ended March 2020, it will only
show profits or sales or expenses from first April 19 to 31st March 2020. Are you getting
so, it is a period statement; profit and loss is a period statement, similarly cash flow is
also a period statement. Now the balance sheet gives you all assets and liabilities. This is
not the case with cash flow; cash flow is giving you summary of receipts and summary
of expenses. In that sense, some of the items would be similar to profit and loss account,
but mind well there are several items in the balance sheet which do not come in P and L,
but which are directly reflected in cash flow statement.
Can you think of any such example that a particular item is in balance sheet and because
it is in balance sheet, it will come in cash flow without coming in P and L? Just think a
bit. Suppose, company purchases machinery and pays cash for it; will it go in cash flow
statement? Answer is yes, because company has paid cash for it; will it go in P and L?
Answer is no, because it is neither income nor expense. Will it go in balance sheet? Yes
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because it is a asset so, machinery is a new asset which is purchased. So, it is reflected in
balance sheet and because it comes in balance sheet and there is a payment of cash
involved, it will also come in cash flow.
So, mind well though I am saying it is somewhat similar to P and L, it is not that it is
giving same information as in P and L because there are several items which would be
coming from balance sheet to cash flow statement. Any item where cash movement is
involved will be shown in the cash flow. We will just have a look at the categorization
now because that is very important every flow has to be categorized into three heads as
we can see here which are operating, investing and financing.
Now to begin with what do you mean first of all by cash? Because we are saying that it is
a cash flow statement. Always keep in mind that when we say cash it refers to cash and
cash equivalents. Now, what is cash is cash in hand.
But of course, cash which you keep in your pocket; in the form of currency notes is not
the only cash; it is cash in hands and demand deposits. Now, demand deposits are
normally kept with bank. So, in financial statements many times we call it as bank
balance so, cash balance plus bank balance both are considered. Bank balance in which
type of accounts, if it is in a savings account, yes; if it is in current account, yes; if it is in
fixed deposit, no. Because as per our definition, it should be a demand deposit; that
means, it should be possible for the company or an enterprise to withdraw it or use it
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whenever it wants. That is why bank balance is in saving and current accounts will be
considered not in the FD account; are you getting? Ok.
Now, other term here used is cash and cash equivalent. Now, what is at cash equivalent?
Cash equivalent refers to short term highly liquid investments, we are saying it is cash
equivalent. So, it is just like cash; anytime you want you should be able to convert it into
cash that is why, those which are ultra short term something which is convertible in less
than 48 hours is considered as cash equivalent. There is one more condition attached that
it should not be subject to changes in the value. So, can you think of any examples of
cash equivalent now? Suppose there is a fixed deposit in bank, will you consider it as a
cash equivalent? If the time period is short and there are no conditions attached for its
conversion into cash, then you can consider it as a cash equivalent.
What other items? You can sell shares easily in the stock market; can you consider
shares balance as the cash equivalent? The answer is no because though you can sell it, it
is highly liquid investment, but the second condition is not fulfilled because it is not
subject to in significant risk of change. There is a sizeable chances of change in the value
so, you know all know that stock prices keep on changing, not only every day, every
minute; so, stocks are not considered as cash equivalent. What else can be considered as
cash equivalence? There are debt instruments like debentures; will you consider them as
cash equivalent? Even then, the answer is no because debenture prices do not change as
frequently as share prices, but never the less they can also change that is why debentures
are also not considered as cash equivalent.
Any other marketable security like one which is bonds corporate bonds will not be
considered; however, if there are government securities or treasury securities which you
can sell without a loss in the price, without a loss of or change of price; then, such
investments can be considered as cash equivalence. Normally, banks accept deposits
which are called as deposits which are for extremely short period like money at call or
money at short notice, they are considered as correct example of cash equivalent ok. So,
whenever in cash flow statement, hence forth we will use the term cash, it includes
balances of cash plus cash equivalence; are you getting me?
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Now, let us go ahead. Now what do you understand by cash flow? Now it is a common
sense, any cash flows in the form of inflow that is receipt of cash or bank out flows that
is payments of cash and cash equivalent, these are all included in cash flow.
Nevertheless, movement inside the cash and cash equivalent is not considered as cash
flow. Now what is a moment in cash and cash equivalent; can you give any example.
Suppose, we are having 3 lakh rupees in bank balance and we withdraw it and we
received cash from bank, will you consider it as a cash flow? The answer is no, because
though you are receiving cash, you are just converting bank balance into cash. So, bank
balance is any way an example of cash or if you sell your short term security and
converted it into bank balance, there again it is a movement between cash equivalent to
cash.
So, we will not consider such movements as a part of cash; got it. So, these are not
considered as movement is cash and hence, they are not considered as cash flows. Now,
let us go to the types of cash slow.
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Now the cash flows which are generated through various activities are actually required
to be classified, we have already discussed it. There are three heads operating investing
and financing. I think these heads are very much self explanatory, but there are some
specific meanings attached, but right now at the outset, what do you feel would be
considered as an operating cash flow. Just think of what items should be included; are
you able to make any judgment?
As the name suggest something which is to do with operations; operation means our day
to day business activities. We generate several items of cash coming in and going out.
Now they are all considered as operating; this is also a residuary head. So, whatever
cannot be considered as investing or financing will also be included in operating and
now think of the examples of operating flows, but I would just show it here for your
clarity.
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So, now, in the form of figure your all the cash flow activities are divided into operating,
investing, financing. Operating means something related to day today activities, I have
deliberately not given any example because you can easily think of 30-40 examples
related to day to day activities.
Next are investing; now what example you can think of? Obviously, on the screen you
can see that very easy example is purchase of land. So, when you purchase land, you pay
cash, you receive land. Land is a fixed asset or a property, plant and equipment kind of
item; that is why it is an investing activity. Financing, example is loan taken. So, we
have obtained loan from bank so, we receive; our bank balance increases and a new
liability in the form of bank loan is created. This is an example of financing activity. So,
are you getting all the three activities?
Now, let us look at operating activities little more in detail.
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So, these are defined as principal revenue generating activities of the enterprise ok. So,
this is the technical term for normal activities or day-to-day activities and any other
activity which cannot be defined as of investing and financing will also fall in it. Now, I
have given very easy example that obviously, the most important activity for generating
cash will be cash received from customers, against either sale of goods or provision of
services.
So, suppose you are a taxi operating agency and you provide taxi customers pay you
either cash or through credit card or through bank then, you are generating revenue. In
which statement will you show the revenue? Obviously, you will show it in P and L
account, but you will also show in cash flow statement. Because you are also generating
or you are receiving cash in the process. So, this is a very clear cut and very simple
example of cash in flow from operating activities.
Now, think of another 5-6 examples. These are very easy as I said you can even list 30
examples. Can you think of some more examples? Suppose you go to some restaurant to
have say some lunch so, what will happen? You will have lunch make payment, Now
make payment means cash outflow will happen, either in the form of cash or through
credit card or by cheque or by some means, means of payment, but in any case since the
cash is moving out, we will consider it as a operating cash flow because it is a day-to-day
activity it is not an investing or financing activity.
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Any other example, lot of expenses I think you might be thinking of like salaries, like a
rent paid, they all will fall in the operating activities.
So, these are the examples, I am listing. You can receive some money apart from sales in
the form of royalties, fees, commissions, their cash equivalents, cash paid to suppliers or
cash which is paid to employees as salaries, allowances, (Refer Time: 18:43) for their
expenses all these examples of operating activities. Now, let us go to next one; next is
which a head, that is investing activities. Now how will you define investing activities
and what are the examples?
Just think of investing activities, now here you are making investment as the name
suggest. So, if you are purchasing shares of some entity, it will be an investing activity.
If you are putting a deposit in a bank, it will be an investing activity. If you are
withdrawing the money from bank deposit and converting it into cash, it is an investing
activity. If you are selling your shares or debentures converting into cash, again it is a
investing activity. If you are purchasing any fixed asset as say land or building, again it
is an investing activity. So, these are variety of examples of investing activity.
Now before going to investing activities, we also would like to understand how are the
operating activities reported. Now, there are two methods of reporting of operating
activities; one is a direct method, other is a indirect method.
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In the direct method, gross sales and gross payments of cash are reported.
Now, this is a format of direct method, I hope just by observing it will be clear to you
that cash received from customers or cash paid to suppliers, to employees etcetera all are
shown as a total amount of cash which is either received or paid. The net amount is
considered as cash generated from operations before taxes minus income tax paid, you
will get the net cash from operating activities. Are you getting; this is a direct method
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because the total amount of cash received and paid is shown. There is another method
which is known as indirect method.
In indirect method, what happens is you start with profit as a starting point from P and L
account and then, you make certain adjustments to calculate the cash which is generated
from operating activities. In the beginning of the session, we had discussed that cash
flow as lot of similarities with P and L.
Actually, this part of cash flow that is operating activities part is very much similar to P
and L. So, we assume that whatever is cash generated is in the form of profit; it is not
true, but just start with whatever is your profit is assumed to be cash from operating
activities and those items which are differing.
So, in P and L account there are some non-cash items they would be adjusted, there
would be a few non-operating items they would also be adjusted. That is why from your
profit, you work back to calculate the cash generated from operating. Just have a look at
the format, I think that would make many things clear to you.
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So, you can start with retained earnings, these are the reserves which are accumulated in
the year add the dividend paid because dividend is going out for financing reasons. We
will look at it later on, then you also add the income taxes paid. So, you get net profit
before tax; then you add depreciation. Why do you add depreciation? Can somebody
think of because we have already discussed depreciation in last two sessions. We will
add depreciation because if you remember it is a non cash expense, it is debited to P and
L or it is charged to P and L, but no cash out flow was involved.
So, we will add depreciation, we will add a few non-operating items like loss on sale of
assets or interest paid, provisions for bad debts. So, we will deduct again non-operating
items like interest dividend or profit on sale of assets and after making all adjustments
related to P and L account. Keep in mind these adjustments are under two heads; one is if
you find any item which is non-profit in nature sorry non-cash in nature, we are going to
account for it. If there is any item which is non-operating in nature, but it is in P and L.
So, we will adjust for it.
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Now, after making both types of adjustments, we get fund from operations. Now, front
fund from operations, funds here refers to working capital. So, it is not just cash it
includes the current assets and liabilities. So, we will remove the effect of current assets
and liabilities. So, from funds from operations we add and reduce all decreases and
increases of current assets and liabilities. Here we get cash generated from operations,
but before tax. From that we will reduce income tax paid to finally get net cash flow
from operating activities.
Are you getting it, I know it is bit complicated because this is a indirect method, this is a
reverse method. I will just show the last slide again. So, if you remember once again, I
am just making you remember the P and L account. Please have a look at your P and L
once again and if you have not understood P and L I think, first you will have to study P
and L topic properly before coming to this.
But in P and L account there was a list of incomes list all the expenses giving you net
profit. Now here what we are doing is we are starting with net profit, adding all those
items which are non-cash or non-operating, they were deducted for calculating the profit
for example, depreciation. So, we add depreciation, we add income tax provided, we add
loss on sale of asset etcetera; then, we deduct those items which are non-operating, but
are added for calculating a profits like profit from sale of asset etcetera. And after
making this adjustment you use to get funds from operations.
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There we make adjustment for current assets and liabilities. Now, why do we make that
adjustment? Because every time you are made profit does not mean you have made cash.
Suppose, you are there are credit sales; credit sales will give you profit, but it will not
generate any cash for you because the cash is still locked up in debtors, cash may be
locked up in stock or your you have not yet received profit, but you have already got
money from creditors. All such scenarios need to be adjusted because here our focus is
for calculating the cash from operations. Are you getting me?
So, we will stop here. What we have covered today is we have started with cash flow
statement, the importance of cash flow statement, the three categories operating,
investing and financing. Particularly today, we have discussed operating activities. If it is
bit difficult for you to understand, do not worry in next session we are going to revise
operating and also look at investing and financing which will make the operating
activities once again more clear. Namaste.
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Lecture – 15
Namaste to all of you, we have started with a new statement that is Cash Flow Statement.
I hope you all liked it and you are excited about it. So, can you tell: now what is a cash
flow statement? It is a statement which lists the cash inflows and outflows. Now
naturally with the question comes is why do you need this statement. Now why is it
required, what are your two other important statements? The first statement was balance
sheet the second statement was P and L account.
Balance sheet gives you what? It gives you the financial position of the enterprise; P and
L gives you the income and expenditure. But both these statements are not able to tell
you how much is cash generated or spent that is why third important statement was
introduced around in 1995 that is known as cash flow statement. It gives you inflows and
outflows of cash not only that, it gives you those flows under the three heads what are
the three heads? One is operating, next is investing, third is financing.
In our last session we have discussed what is operating, today we will go into investing
and financing. Now before that what do you mean by cash that is a first question,
because we are talking about cash flow. So, what is a cash? So, cash includes cash plus
cash equivalent, particularly in cash you are having cash and bank balances in cash
equivalent what do you cover in cash equivalent? You include extremely short term
investments which are highly liquid and are not exposed to loss of value because of
market forces.
So, something like money at call with banks or money in certain securities, but no
change of value is expected there only few restricted securities can be included in cash
equivalent. Now any moment of cash is considered as a cash flow, but there is an
exception if there is a movement within cash and cash equivalent items do not consider
them as cash flow. So, what is such example? So, if you deposit money in bank, you
withdraw money from bank this is a change within the cash and cash equivalent; one
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cash item is coming down other cash item is increasing. So, we will not consider as a
cash flow and we will not show it in cash flow statement.
So, here you are got cash and cash equivalent items taken together and there are several
other items. If because of any transaction cash and cash equivalent either reduces or
increases we will call it as a cash flow and we will be shown in the cash flow statement
this much is what we had discuss and how will hope it is clear to you, but you can just
glands to the slides once again.
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So, this is a index we are slowly going to next items today. IndAS 7 is a new set of
standard which we are following for this calculation.
This is the definition of cash and cash equivalent, the meaning of cash, then the types of
cash flows.
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Now, particularly we were discussing what is operating cash flow. So, operating as this
name suggest means day to day activities or principal revenue generating activities of the
enterprise.
So, any item which is related to either generation of cash or expenditure of cash on day
to day business, which is considered as operating activity. Any activity which cannot fall
in financing or investing, but there is a cash movement is also included because it is a
residuary head known as operating activity. We have seen a few examples in the last
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session, but today going by the nature of business can you tell what will be the operating
activity?
For example suppose you are a web developer, you develop websites for various
companies what will be the operating activity for you? What are the incomes for you?
Probably are charging some fees to your clients for generating new web content, you
may be charging fees for hosting their websites; all these would be incomes for you
which will go in P and L, they would also be cash generated for you. Whenever the
customer pays you, you are generating cash and that cash is from operating activity. So,
it falls in the first example, that is cash received from sale of goods or rendering services.
If you are Tata motors; in the last session we had taken example of Tata motors. For Tata
motors what is a principal revenue generating activity, I think most of you know the
company they sale cars. So, selling cars, trucks, vehicles is there business. So, money
with they generate in cash by sale of car or by sale of a truck will be there principal
revenue generating activity. And what are the expenses? I think their common company
rent, taxes, salaries, travelling expenses all of them are considered as for running of
business. So, there your operating activity related outflows ok.
Suppose you are a web developer company you purchase a car, will it be an operating
activity outflow? Answer is no because car is a fixed asset for you, it is not your day to
day activity I do not think you will buy car and sell cars everyday who will buy and sell
cars regularly? For a car dealer car is a stock item. So, purchase and sale of cars is a day
to day activity it will be a operating activity, but for most other enterprises car is a part of
fixed asset.
So, for them purchase of car will fall in will go in fixed assets in the balance sheet; in
cash flow statement where will it go? It will go in investing activity not in the operating
activity; are you getting me? Some more examples are already listed here I think we have
seen it in the last session.
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Now, there are two methods of preparing cash flow of which the first method is very
simple it is known as direct method.
So, please have a look at the format I think it does not need any much of explanation it is
very similar to P and L actual. In P and L you start with sales reduce all the expenses you
get profit. Same way only exception is there we show actual payments plus outstanding
expenses here you are only concentrating on actual receipts and payments.
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So, receipts from customers plus cash sales, that is your cash receipt minus payments to
employees, payments of rent, payments of payments to creditors not a purchases keep in
mind P and L account we show purchases whether you pay or not it is considered as a
expense, here only that much amount which you have paid to creditors. In case of cash
purchase the amount will be same, but for credit purchase your purchasing now paying
later whenever you are paying it will go in cash flow statement ok. So, but this is
relatively simple only one thing you have to keep in mind is almost like a P and L, but it
should be on cash basis are you getting me. So, you are listing all cash receipts minus all
cash payments from operating activities, they would be net cash from operating
activities.
Now, the second method is slightly complex because here we are going from P and L to
calculating cash from operating activities. So, in P and L account we get profit or loss for
the period. We start from back or we start from transfer to reserve sometimes then we
add back of few items to begin with we assume that profit is very close to cash from
operations only those items which require adjustment. Suppose there are 40 items in P
and L all of them will not need adjustment, few of them which are of two types they
would need adjustments, only those two types of items we will either add or reduced. So,
what are these two types of items? One is if it is non-cash I will just show you the
format.
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So, we are starting with retained earnings plus dividend plus taxes, that is net profit
before tax then we add noncash items; best example of it is depreciation because we are
already discuss depreciation earlier, that it is not a cash expense it is charged to P and L,
but does not involve cash so, be added back. Similarly if there are any non operating
items. So, what are the non operating items? Keep in mind most of the items in P and L
are operating, but a few items like sale of machinery and there is some loss on sale of
that machinery that loss, but we will be shown in P and L.
But, we do not want to have it here in cash flow that is why we add it back. So, add loss
on sale of some something like a machinery. Similarly, if there is a profit on sale of land
that is already shown in P and L so, we reduce it from there because its not operating
item, we make a adjustment for it and after adjusting these items we get funds from
operations.
After this also there is a third adjustment that is related to your current assets and current
liabilities. So, what happens is, from your current assets if there is a increasing current
asset, it leads to less cash in the hands of company. So, suppose there are receivables. So,
you have sent sold a goods, but you do not get cash your data. So, receivables are
increasing your cash is falling.
So, any increasing current asset there is a fall in cash keep in mind there is a competition
between current assets and cash; cash is also one of the current asset. So, other than cash
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if any other current asset is increasing, it leads to decrease in cash. You can have a look
here there is a less increase of current asset similarly if current asset decreases like you
have credit you have debtors, debtors pay more cash to you their balance will go down
and you have more cash that is my add decrease in current assets.
So, from the balance sheet we will get balances of current assets and liabilities, we would
have a look at increase and decrease make the adjustments in the funds from operations
that will give you cash generated from operations are you getting me? So, fund is a
amount of profit generated, but it is not cash. So, we are making adjustment and
calculating cash generated from operation, we will have to deduct the income taxes
which are paid that gives you cash flow from operating activities is it clear? This much
we are discuss last time, but since it is little more complex we have just revised it again
we are now going to next two heads, the next head is investing activities.
These also bit of we have discuss last time so, all those activities which are related to
long term assets like fixed assets or investments, they would be included here in
investment investing activities. So, what are the examples? Either purchase or sale of
fixed asset; so, purchase of land sale of land, purchase of machinery, sale of machinery
these are all investing activities or related to investments like keeping FD or withdrawing
FD with bank, purchasing some shares or selling some shares all this is included as
investing activities.
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So, these are few of the examples just have a look at them. If you put FD in bank you
will receive interest there on, that interest is also and investing related flow. If you
purchase shares you will received dividend there on, that dividend is received because of
your investment that is why it is considered as a investing activity that is also an example
of investing activity are you getting?
So, in operating activities there were two methods what were the two methods? Direct
and indirect; luckily there are no two methods in investing activity you have to directly
show whatever is you have received or paid that is why calculation of investing activities
very simple there is nothing to be afraid, whatever is a amount which is paid either on
fixed assets or investments or received because of them that will be directly show. Keep
in mind we are not talking of profit or loss on sale of machinery that is for P and L. In
fact, now we are only concerned with the total amount which is either received or paid
for fixed assets getting it.
Now, the third type of activity is known as financing activity. Now here in the first
session if you remember we had seen that business needs resources, those resources are
assets now these assets are financed by somebody. So, somebody makes you payment
you get some money from that money you have purchased the assets. Now from where
you have raised the money or from where you have generated those finances they are
categorized as financing activities.
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There are two important types in it one is known as equity, the other is known as
borrowings. Do you remember, when we discuss balance sheet we had discussed is I
would request you to go back and have a look at balance sheet format. So, what does it
fall what does falls under equity? These are the owners funds these are the moneys of the
shareholders like share capital or preference share capital that will be shown and what
are the borrowings? Borrowings are various types of loans taken by you. So, either loan
taken or loan prepaid or interest paid on that loan they are all falling under financing
activities.
So, here some examples are given like issue of shares or debentures borrowings and so,
on what do you mean by debenture do you remember? So, debenture is also like a loan
company obtains a loan and gives a certificate to the lender in the form of debenture
certificate, that is called as a debenture. But, it is just like a loan for the company so, that
is also a financing activity.
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So, here there are some specific examples when you issue shares exactly reverse of it is
called as buyback of shares; that means, company takes back the shares from shareholder
and gives them money that is called as buyback of shares so, that also a financing. Same
way issue or redemption of preference shares or debentures; in issue what happens?
Company receives money gives preference shares. Buyback or redemption is exactly
opposite company takes back shares give them cash both the cases the cash is involved
and it is related to financing of the business. So, it will fall in the financing category of
cash flows are you getting?
Now, whenever you raise funds, you have to compensate your investors in the form of
interest or dividend. If you take loan you will pay interest that is also financing activity if
you raise money by way of shares you will pay them dividend that is also a financing
activity; are you getting all the examples? Now, let us consider some specific items in
the cash flow of which the first one is interest. We have just discussed it already, but this
will be reinforcing in your mind interest can be received or paid.
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Now, to begin with how do you account for interest received? We have already discussed
this that you receive interest mainly because you are made investment. So, if you are
made investment in bank like FD or if you are maid investment in debenture of some
other company, you will receive interest from them that will be categorized as investing
flow, but there are some exceptions to it which have noted please keep in keep them in
mind.
Suppose the investment is in cash equivalent for example, investment is in ultra short
term deposit which you have categorized as cash equivalent, then it is not an investment.
As far as cash flow is concerned it is not an investment that is why interest received on
cash equivalent type of investment will be considered not as an investing activity, we
will categorize is an operating activity because it is a day to day item similarly
sometimes we receive interest from trade advances getting me?
So, suppose we have put some money as an advance to our suppliers and they give us
interest on that amount it is rare it does not happen every now and then, but suppose it is
there we have received some interest from it or suppose there is a bill receivable and on
bill receivable we have received interest then it is not related to any investment it is not a
long term activity. Because typically it is for one month two months three months four
months like less than one year, that is why those investments and interest there on would
be categorized as operating activities.
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And the third example which is for specific type of undertakings or company is known as
finance enterprises. What are the examples of finance enterprises? For example, of bank
a non banking finance companies for them finance is there business. So, giving loan is
their business. So, they are bound to receive interest from their customers, that is there
day to day business activity or principal revenue generating activity. So, we will
categorize it as operating flows for all finance related companies are you getting. So, this
is about interest received.
Now, about interest paid. Now interest paid as you all know by default we will treated as
a financing activity, but there are a few exceptions.
Suppose the loan is obtained as a working capital loan, I hope you know what is working
capital. Working capital means current assets minus current liabilities this is a capital
which is used for day to day activities or if you remember our session 1 and 2 we had
seen a business cycle. Now whatever is money blocked up in business cycle you can get
some loan from bank for specifically for working capital.
Now, if you pay interest on a working capital loan, it should be categorized as an

operating flow not as a financing flow. And the third example or a second exception you
can say is for a finance enterprise. Now, naturally for a finance enterprise paying of
interest is a part of their day to day activity they receive interest they pay interest so, far
them interest paid is categorized as a operating flow are you getting. So, this was about
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interest; now based on these can you imagine what will happen for dividend? Because
dividend also you get both the categories like dividend interest and dividend received
and dividend paid.
Now, if it is dividend paid what will happen? Whom do you pay dividend? We raise
money by way of shares. So, share holders pay us as a company their money to
compensate them we give them part of share of our profit that is known as dividend. So,
it should fall in which category? Is it operating is it investing or is it financing? I think
most of you are guessing it correct this is related to raising of funds.
So, it is a financing activity, we have raised funds by way of shares we give dividend to
shareholders. So, it will be considered as a financing outflow are there any exceptions
like for interest? Now this is a peculiar item there are no exceptions even if it is a finance
company, even if it is a operating item or whatever you will never consider it has
operating or investing dividend paid is always considered as a financing item.
What about dividend received? Where will dividend received go? Dividend received is
very similar to interest received actually by default it will be considered as an investing
flow.
You will just go to that slide. So, dividend received what happens is for a non financial
enterprises, we will always categorize it as a investing flow because we have made
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investment in shares we get dividend. But for a finance company or for a bank we will
categorize it as a operating flow because for them it is a day to day activity and dividend
paid we have already discuss is always categories as a financing.
So, you are getting me. So, we have discuss now today few peculiar items, first we
discuss the investing operating, then investing, financing and two peculiar item that is
interest and dividend. In the next session we will take a few more items and then we will
start looking at the problems, Namaste.
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Lecture – 16
Namaste. In last two sessions we have been discussing one of the very important
statements that is in the form of Cash Flow Statement. We already revised it last time but
I will just give a brief revision, so cash flow statement had three categories, operating,
investing and financing. Now, what do you mean by operating do you remember? So,
these were principal revenue generating activities; now the challenge in operating
activities was it can be by direct method.
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So, have a look at this format or it can be also calculated by indirect method that is
starting from P and L, we have to list out certain activities which are non-operating or
non-cash.
And then we also list out working capital items to get cash flow from operating
activities.
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Then we discussed the second head which is investing activity, any moment because of
fixed assets or investments either buying or selling which was all categorized as
investing activities.
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We have also discussed financing activity.
So, these are the examples of financing activities, now these are the movements in equity
or in borrowings. Any issue of shares, or purchase of shares, or any issue of debentures,
or purchase of debentures, or taking of loan, or repayment of loan paying installment of
loan is all considered as financing.
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There are two unique items in it which were also discussed that is interest, by default I
think you all know that any interest received will be generally considered as an investing
flow. Because, you make investment you get interest, but there are exceptions which are
equally important. So, keep in mind three exceptions if the investment is of cash
equivalent nature, or the interest is received on trade advances, or operating receivables
the interest will be an operating inflow. And, if all the interest received is for a finance
enterprise like a bank then it is a operating flow.
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Then interest paid normally it is a financing activity, but interest on a working capital
loan will be a operating activity, and for a finance enterprise we will categorize this as a
operating flow.
As far as the dividend is concerned mostly dividend received is an investing flow, but for
a finance company it is a operating flow. And for dividend paid it is very simple for any
type of enterprise without exception we will categorize it as a financing is it clear are
there any queries. As I have told earlier also I remind you about two things all your
queries and questions please discuss them on the discussion forum. So, ask to TA’s, ask
to me or ask to all other colleagues who are also studying with you.
Second important thing is download your annual report and read the statement which we
are discussing for your own company. So, for last two sessions we have discussed cash
flow, I hope you have seen you have start reading the cash flow of your own company. If
you observe any special things, you can of course discuss in the discussion forum are
you clear, we will look at some more peculiar items now that is foreign currency
transactions.
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Now, all the transactions may not be in the domestic currency, if it is a foreign currency
item then it needs that is also shown in the same cash flow, but it is reported as a separate
part of reconciliation of cash and cash equivalent. Because, suppose we are an Indian
company we hold some balances in dollars, the value of rupee to dollar will change in
the beginning as well as in the end though changes in the value are not as such any cash
flow. So, they would be shown as a reconciliation in the cash and cash equivalent.
Now, suppose there are any unrealized gains in the foreign due to foreign exchange rate
changes like, we are holding dollars the value of dollar increases, but we are not yet sold
those dollars then it is a unrealized gain. So, these are not known as cash flows they
would be reconciled in cash and cash equivalent. Now there is, so this is about foreign
currency items the second is above the next one is about extraordinary items, I hope you
remember the extraordinary items which we had discussed.
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Now, if the cash flows are associated with extraordinary items they should be shown
under the respective heads, but to be separately disclose. So, for example, if there is a
loss by fire you know extraordinary means some major loss it is a mega loss by fire.
Then under what head will you categorize as a operating or as investing or as finance.
What do you feel?
Now here we have to look at what we have lost, suppose stock is lost by fire, then that
loss will you show it in cash flow and if yes under which head. First of all this being a
non cash item it will not flow in coming cash flow, but if you receive insurance claim for
loss of stock where will you show? That insurance claim will be treated since, it is a loss
of stock which is a operating item, insurance claim received because of loss of stock or
because of loss of profit policy it will be considered as a operating item.
Will it go as investing item anytime? In some cases suppose, it is a claim for loss of
machinery because of fire stock and machinery both might be lost. Whatever is a portion
related to loss of machinery that will be considered as a cash inflow due to investing
activity that is what is known by as whatever is a associated item it will be late ok, so are
you getting now I am showing it on screen.
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So, whatever is a relevant item normally it is either operating or investing.
Now, next is about treatment of taxes, normally taxes are an operating item; so whatever
is a tax paid we will show it as a operating expense.
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If there are some specific taxes on investing or financing related items we will show it
under the respective head. So, example is dividend tax whenever we pay dividend we
have to pay tax on that dividend, so taxes on dividend will be categorized as a financing
flow. I hope you remember that dividend first of all is financing, so tax there on is also
financing. Now, next one is about cash flow related to subsidiaries.
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Now, for subsidiary companies or associate companies since this is a cash flow statement
only the cash flow related to enterprise and the investee would be reported, so cash flow
related to dividend and advances will be shown.
Now, the next one is a case about acquisition and disposal of various businesses. Now,
suppose we acquire another company and make payment there off then it is considered
as an investing activity. But, within investing activity it will be separately shown as a
investing activity and total amount which is purchased or dispose will be separately
shown under the respective activity. Now, if the payment is made by means of cash and
cash equivalent, that should be separately shown ok.
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Now, the next is about non-cash transactions, there are certain transactions which are to
be excluded from cash flow and they should not be shown because, it is non-cash in
nature. Can you think of any examples of such items that there is a transaction, but it is
non cash in nature, so should not come in cash flow. Do you think of any such examples?
I think some of you are guessing it correctly.
Suppose, you purchase new assets normally we purchase fixed asset and pay for it, so it
will come as a investing outflow. But, suppose new assets are purchased, but we do not
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pay cash instead of paying cash we are assuming liability against the asset, so we are
taking over asset and also taking over liability in exchange. So, no cash payment or
receipt is involved, so it will not be shown in the cash flow.
Similarly, sometimes we purchase another company, but do not pay cash make the
payment in the form of shares; so we get that business of the enterprise in lieu of that we
issue our shares. So, our assets increase, liabilities increase and our share capital
increases, no movement of cash then again it is a non cash transaction, another example
is conversion of debt into equity.
Now, there are certain types of debentures which are known as convertible debentures.
So, those debentures are debt they are converted into equity shares no cash payment or
there is a loan taken from bank and we are unable to make repayment. So, bank
emphasizes or forces us to convert it into equity, again no cash is involved, so it is also
an example of non cash transaction. So, keep in mind that in most cases any movement
or asset of liability will lead to cash flow, but we also have to be careful in the nodes to
see whether there are any non cash flow items then they should not be considered in the
cash flow.
Now, in the end you are required to make disclosure of cash and cash equivalent, so you
should show the total cash, cash equivalent in the beginning and in the end and a
reconciliation. Because, in the cash flow statement you have listed all inflows and
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outflows, the net total of that should match with the movement of cash and cash
equivalent and it should match with your balance sheet ok. There are also some more
disclosures which are mandated by the accounting standards, one is that enterprise has
cash and cash equivalent, but that much of balance is not available for use, then it needs
to be separately disclosed.
Now when such case will arise can you think of any such item, suppose we are having a
branch in Afghanistan we have some cash there, but lot of terrorist activities are on, so
we are unable to use it, we will have to separately disclose it. So, any such cash or bank
balances not available for business will be separately disclosed, there are also some
undrawn borrowing facilities I hope you know about bank overdraft.
So, by bank overdraft bank has sanctioned us loan anytime we can withdraw it, it is
almost equivalent to cash for us, but right now we have not withdrawn it, then such these
are like balances available. So, they should also be shown by way of note, but if there are
any restrictions on use of them they should also be discussed. Are you getting this?
Now, after this we will move to we will have a look at certain formats and then we will
move to the actual cases of calculation for cash flow. First let us look at certain formats,
now whenever we discuss the operating, investing, and financing items we have looked
at examples, but let us look at the actual format how it will be disclose in the cash flow
item.
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So, this is a format for cash generated from operations I think you have already seen it,
but this is more detail. So, have a look at it, it starts with retained earnings, add dividend
you get net profit after tax; keep in mind normally in P and L account your incomes
minus expenses the last item is profit. Here we start with profit and go to cash from
operations, add the tax expenses for the year you get net profit before tax then add non-
cash items.
So, depreciation or amortization like goodwill written off, then adjust for non operating
items. So, loss on sale of assets or interest expenses are added interest dividend income
or profit is reduced that is why you can see it is in bracket.
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You get fund from operations then adjust for working capital items, so any decrease in
current asset or increase in current liabilities added and reverse that is increase in current
assets. See cash is also a current assets, so it is in competition with other current asset, if
other current assets goes up the cash false; that is why increase in current asset is
reduced, if there is a decrease in current liability then the cash falls.
So, cash and current liabilities go together any increase in current liability you can see
here is leading to increase in cash decrease in current liability reduces our cash. Now,
these items will be adjusted and you get cash generated from operations of course, you
will have to now reduce the income tax. So, you get cash flow from operating activities
this is the end of the first part of cash flow statement then.
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The second and third are very simple, now cash from investing activity you have to just
list the items.
Next is cash from financing activity.
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I think you know the examples, so though there is no direct or indirect directly those
items you can add in the cash flow statement.
So, at this stage you have got first second and third type of activities, so you get net
increase or decrease of cash which is a total of 1 plus 2 plus 3. Then you add cash and
cash equivalents at the beginning, so you get cash and cash equivalent at the end ok.
Now, here it should match the total increase plus beginning should be what is there in the
end.
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Now, apart from this you have to also show reconciliation of the balances, so in the
balance sheet you will have the value or the balances of cash and cash equivalent they
are restated in the cash flow statement both at the beginning and the end. So, the closing
cash flow statement will show balances in the beginning as well as end of cash, bank,
and short term investments which you are treating as cash equivalent are you getting.
So, with this we have discussed the format, now we will go into actual case the cases will
be available to you on the Google link, but right now I am showing them here I would
request you to read it carefully and we will also try to solve those that is the solution of
them.
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So, have a look at the case we are given a profit and loss account.
So, sales and interests are given that is a total income of 215000, then various expenses
are given like purchases, wages, interest, depreciation, office expense, goodwill, tax,
dividend, so you get net profit.
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Then opening and closing balance sheet is given ok, so, liability side is given to you,
then the asset side is given to you.
So, you have got P and L at the end of year, then opening balance sheet and closing
balance sheet with this much information we have been asked to prepare cash flow
statement. Now, how will you proceed, now as per as the operating cash flow is
concerned, I am just going back this P and L statement is what is going to give you
operating cash flow.
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So, we will start with net profit make adjustments here add and less they will give you
operating cash flow, balance sheet items are mostly related to investing or financing. So,
any change in the balance sheet item you should note carefully that is going into
investing and financing; of course, there will be few items in the balance sheet which
will have impact on operating also, so be careful about them ok.
So, let us start with balance sheet one by one look at the change and take a notebook and
note whether that particular change is investing or financing. Once you have done that
rest of the job is very simple it just clerical work you have to note it in the format as a
cash flow statement are you getting me. So, please try to solve with me, now the first
item share capital, there is a increase from 160000 to 190000.
You do not have to write the full balance sheet, but just write ac or something in short
form and note whether what type of item it is, so is it operating item or investing item or
financing item. So, I recommend that you just write ac write o or i or f whatever you feel
it is, so can you guess what type of flow it is? See there is a movement from 160 it has
increased to 190.
So, it is some type of cash flow, is it an operating? I think answer is no, because share
capital has nothing to do with day to day business, is it investing? Again the answer is
no, because we are not making investments here. Some of the shareholders have made
investment in our company and we have issued them shares, that is why our share capital
balance has increased. So, it is not o not i it is a f type of item that is financing item,
please note it as f, so share capital in front of this you write f, is it an inflow or outflow?
Better we write as inflow or outflow what it is see the share capital balance has
increased.
So, we have received money and we have given them shares it is a cash flow statement,
so cash has coming or has gone out, cash as actually come in. So, for the sake of working
note write it as f inflow; that means, finance inflow, like that we will categorize each
item I think the rest of the work is very simple. The next is general reserve, which type
of item it is actually there is no change, so there is nothing has happened just take it or
say dash or something like that, next is P and L account. Now, this is not profit and loss
account this is a balance of P and L account which as increase from 9000 to 2200.
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So, it is which type of item, actually if you do 22 minus 9 there is a increase of 13000
you can see here net profit, actually this is not even net profit this is a profit which is
transferred to balance sheet ok. So, 13000 is added to the balance of P and L in the
balance sheet, so it is what type of item? This is increases because of the profit
generated, so it is a o type of item. So, right now you just mark it as o we will when we
solve our operating we will take it into account, but right now let us mark it as o.
Next is debentures, debenture balance has reduced from 80000 to 51000, now you will
categorize it as which type of item; see some movement has happened there is a decrease
in the balance. So, we must have redeem the debentures; that means, we have paid
money and cancelled part of the debentures of how much amount, 29000 which is a
difference. So, it is which type of item is it o or i or f, it is not o its not day to day item it
is neither I it is not our investment it is f item we had raised money by way of debentures
now we are repaying it. So, mark it as f is it inflow or outflow it is basically an outflow
we are making payment, so mark it as f outflow.
Next one is creditors from 20 they have increased to 40, so it is what type of item? If you
remember it is required for a calculating our operating flows this is a working capital
item. So, mark it as o if want you can also say its working capital w cap or something
can write, but basically it is a o item, it is not a direct inflow or outflow. Next is proposed
dividend, now this is a tricky item it has increased from 2 to 3 it is what type of item? Is
it o? No, is it i? No, it is f, I think you remember we have discussed that payment of
dividend is always f, how much amount? 2000 or 3000 or 1000.
Mostly the difference is the cash flow, but here it is not difference the whole of last
year’s amount would have been paid just have a look at P and L also, in profit and loss
you can see dividend 3000. So, what has happened is at the end of the current year we
have made a proposed dividend of 3 it is this amount, and last year’s 2000 last year
means on 31st march 2019 200 would have been provided they would have already paid
it, and for this year new 3000 has been provided.
So, the entire amount of 2000 this is a special item please mark it carefully, so this 2000
is f outflow, it is a financing item it is a outflow, 3000 is not outflow it is basically a P
and L item. So, you can write it as a o see dividend is a very special item it is going to
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come two times this is f outflow and 3000 is o we will consider it when we look at P and
L account.
Now, let us I hope you have understood the liability items we are going to see the answer
also, but better you note it and we will solve it together. Now, we will go to assets in
assets the first item is land, land there is no change so dash, fixed assets there is a fall in
fixed asset from 140 to 190 1. So, what is happened there could be sale, but it can be
wrong also because please look there is a depreciation ok.
So, depreciation of 9000 it matches here, so there is a reduction in the value of fixed
asset no purchase or no sale, so probably it is dash. We will look at it once again,
investment 59000 increasing to 1 1 1. So, what type of item it is, there is a increasing
investment we have made payment and investment has increased, so it is a investing type
of flow first time investing flow is coming, so mark it as I outflow are you getting.
Next is sundry debtors, 12 to 17 what type of item? It is a working capital item or o item,
so mark it as o and we will adjust it in the operating flow. Next is bank, what type of
item it is? Actually it is a tricky item is not an item it is a cash equivalent. So, write its c,
c for cash; goodwill, goodwill you can see it has fallen from 30 to 19 normally goodwill
falls because of amortization.
So, we will have to look in P and L account, you can see here goodwill written off
11000, so 30 to 19 the difference is because of goodwill return of right now you can
mark it as a o item, so I hope you have understood all the markings of balance sheet.
Now, as far as the P and L account is concerned I am once again taking you to P and L
start with net profit and go back adjusting these items as per our format they can be plus
or minus for few items which are non operating or non profit.
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So, we will now go to the solution only the first part is be tricky, now here we are
starting with operating flows. So, please have a look at P and L we are go in the reverse
order we start with profit add dividend, add tax, add goodwill, like that we go on adding
the items which are these two are added because their financing item this is a financing
item tax is the tax which is provided goodwill is written off depreciation is written off
they are non operate non-cash items I will just show you the solution.
So, retained earnings plus dividend give you profit as per P and L account which is
16000, add depreciation, add goodwill, add interest expense, add income tax, add and
reduce interest income. See here in P and L we had a interest income of 15000 which
was added for P and L now we will reduce it; I know it is bit complicated, but just keep
in mind as per format we are going these gives us funds from operations.
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Now, in funds from operations we are going to adjust to working capital items, so add
increasing debtors and less sorry add increase in creditors and less increase in debtors
this gives me cash generated from operations, now income tax will come twice because
here income tax provided was added.
Now, this one this amount 37000 same amount of tax is also paid that is why I will pay
out the income tax income, tax paid I get net cash flow from operating activities are you
getting operating is only bit complicated investing is very simple I think you already
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noted two items, one is purchase of investment, so it is less and interest income is our
income, so you add it getting it.
So, 37000 negative is a investing activity the next is financing activity say very simple
again four items issue of share is a receipt, dividend, redemption and interest is a
payment. So, financing activities negative 15000, now the total of three all the three
items, so we had taken 50000 as a operating activities and minus 37 as a flow from
investing and minus 15 as a flow from financing. If you add these 3 there is a net
reduction of 2000, so net decrease in cash. Then go to balance sheet balance sheet has a
opening bank balance of 5000 and closing bank balance of 3000. So, if you take minus 2
plus 5 you will get 3000, so here the cash flow statement tallies.
We will also make a reconciliation in the beginning and end there is only one item, so
beginning is 5000 end is 3000. So, we already knew that there is a fall of 2000 from
balance sheet in the bank balance, now we have explained it through cash flow
statement. I hope you have understood it, once again have a look at both the problem and
the solution this is a starting and a simple problem and it will give you proper insights
into cash flow statement ok.
So with this we will stop Namaste.
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Lecture – 17
Namaste. Welcome everybody we have been discussing about Cash Flow Statement. I
hope you have gone through the given notes and understood what is a cash flow
statement; please also have a look at cash flow statement for your own company. Today
we will do second case on cash flow statement which will cover various aspects related
to preparation of the statement, a small revision before that.
If you remember in the cash flow statement there are three sections, one is cash from
operations cash flows from operations, second is cash flows from investing activities and
third is cash flows from financing activity. In the first part we calculate the cash
generated from day to day activities of the business and normally it is done using indirect
method. So, we start with profit, then add back noncash items or non operating items, we
make adjustment for some of the items which need to be deducted.
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So, in short we can say that the depreciation should be added or items like loss or interest
expenses are added, while items like interest income or profit on sale of investments are
reduced.
That gives you funds from operations, then we also have to make adjustment for working
capital items, we need to make adjustment for income tax that gives you cash flow from
operating activities.
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Next one is pretty simple all those items which are related to investment both inflows
and outflows like purchase or sale of assets or interest received, they are all shown under
the head investing activities.
Third one is financing activities, where we show all those items related to raising of
funds by the business like issue of shares or issue of debentures or taking loan and the
reverse of this, that is redemption of share or redemption of debenture or repayment of
loan interest or dividend paid there on.
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So, these are the three headings, then we take the total of the three and that we match
with the increase or decrease of cash during that particular period. We have already done
one case now we will go for the second case.
So, with this introduction now we prepare for the second case, it will be better if you take
the printout of this particular case so, that you can actually solve as I am also solving it
ok. Now look at the given data, we have been given profit and loss account for year 31st
March 2020.
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So, sales profit on sale of investment and revenue from services total is 98000.
Now, from these there are deductions like consumption of material, manufacturing
expenses, wages, depreciation, general expenses, discount on issue of debentures, tax,
interim dividend and we have got profit retained which is 17600. We have also been
given 2 years figures of balance sheet for March 19 and March 2020.
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So, again you can see certain items of liabilities and certain items of assets. Now using
this information you are required to prepare cash flow statement ok. So, how shall we go
about? You all know that if there is a change in the balance sheet between the 2 years
that should be considered as most likely item of impact on cash. So, let us start with
balance sheet, take every item of balance sheet and we will mark it as inflow or outflow
and also as either as O, I or F if we feel that some moment has happened.
So, let us start with share capital share; capital you can see there is no moment, general
reserve again no moment for profit and loss account we do see increased from 8000 to
25600. Now, this change is more slightly to have some impact on cash flow.
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Now, it is what type of item? I will just take you to the solution. So, normally make five
columns like this particular than 2 years figures change and OIF. Now, is there a change
here in case of cash flow? Yes now we want to mark it as O,I or F. Now you all know
that the change in the profit and loss account is due to the profit accumulated during the
year and it is mainly the operating related item. So, we have marked it as O; now this is
our working, this does not mean exact amount will go in cash flow statement, but to start
with we are going to mark every change. We will also have a look at P and L items and
then after considering both we will go for preparation of cash flow.
Now, the next one is debentures; you can see debentures there is a increase from 10000
to 27000. So, it is what type of item? You know that debenture is for raising of funds and
from 10000 it has increased to 27. So, 17000 increase; that means, new debentures are
issued. So, we will consider it as a what type of item? O or I or F, it is a F type of item
that is financing item.
Next one is creditors. Creditors you can see 16 to 10. So, it is a fall of 6000. Now it is
what type of item? Is it operating, investing or financing or none of the above? Actually
only three categories so, none of the above does not exists, but it is not investment, it is
not finance also and this is a item which is related to normal activities of the business.
So, we will mark it as O particularly it is a working capital item ok. So, you can see here
16 to 10. So, minus 6 and this is I have marked it as CA or CL; that means, I know it is a
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current liability, but I have marked it as CACL because it is something to do with current
assets and liabilities; actually how to treat it we will go in the next step.
Next is differ tax liability it is gone up from 7 to 12. So, plus 5000 and taxation is a
operating item. So, I have marked it as O. Are you clear? So, like this for every item in
balance sheet assigned O, I or F or CACL; CACL is a part of O actually now this will
help us for preparation of cash flow let us go to assets.
Now, in assets again there are changes. So, land there is no change equipment it has gone
up from 21 to 55600. Now, it is what type of item? Is it F? Is it? I? I think the answer is
yes we have made investment in the equipment new equipments have been purchased.
So, write the change here and mark that change as I item ok 34600 I. Next is investment
long term you can see investment has gone down from 5000 to 3000. So, minus 2000 it
is investment so; obviously, it is a investing item; so, I category of item: sundry debtors.
Sundry debtors you can see has gone down from 15000 to 14300.
So, it is minus 700, what type of item it is? You know it is a current asset. So, it is
marked as CACL, next one is bank. Bank has gone up from 5000 to 6700. So, 1700 what
type of item it is? O, I or F I think many would have marked it as O because it is a
current asset or you can mark it as CACL, but in reality it is not be caution because bank
balance is a part of your cash balance. So, we are making a cash flow statement any
change in the cash balance is not to be shown in the cash flow.
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We will take it in the last part of cash flow statement as a reconciliation ok. So, what I
have done is for convenience, you can see here sundry debtors are marked as CACL and
bank is marked as C; C means cash. So, it is cash and cash equivalent kind of item
goodwill there is no change so 0. I hope you are getting, once again I am taking you to
balance sheet liabilities, have a look at all the items you will realize that normally in the
liability side there are F type of items or O type of items.
And normally in assets there will be I type of items because there will be investments
like fixed assets or investments and there would be O type of items or CACL type of
items are you getting? Now let us go back to P and L from profit or loss account have a
look at those items which will have impact on cash flow. So, suppose sales is 90000 will
it have impact on cash flow? So, we would have received 90000 is it O I or F type of
received?
Again many of you would have marked it as O, but keep in mind that is a not the correct
answer then what type of item it is? Is it I or f the answer is no because it is an normal
day to day item and in the indirect method we do not show normal items related to
operations I will just take you to the actual calculation.
So, this is how I have made the format, first is sales very tricky item because many times
peoples feel that sales means cash has come in keep in mind we do not follow a direct
method. So, we are going to take profit and loss as a starting point and only we are going
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to mark three category of items. Items like depreciation which are non-cash, items like
profit on sale of investments which are related to not operation something else, that is
non operating items and CACL type of items are you getting me? So, in the sales the first
item sales I have written it has no adjustment.
The next is profit on sale of investments which is 2000. You all know that since this is a
profit on sale of investment it is a investing flow. So, I have marked it as I it will have
one impact on operating flow as well because we have already considered it in P and L
account, we have already added it in profit. So, we will have to reduce it from profit that
is why it is a marked as both I and O. Remember balance sheet items have only one
impact P and L items are going to have two impacts because balance sheet is already
balance P and L accounts are coming from outside in the cash flow statements.
So, they will have two impacts on cash flow. So, they have been marked as 2; either it
will not have any impact no adjustment or it will have two impacts. So, I and O in I it is
plus, plus means cash is coming in and in O it is minus. This is just a working note for
our understanding, but it will ease our actual making of cash flow are you getting me?
Next is revenue from services you know that any revenue earn is a day to day item it is
just like sales is from sale of goods. They might have also provided some services, for
which they have earned 6000 this is not a cash flow item so, I have marked it as no
adjustment ok.
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Let us go to the next one. So now, consumption of material 40000: where we need go
OIF? I will request you to mark all the items; manufacturing, wages, depreciation,
general expenses and so, on are you able to make up your mind? Even if it go goes
wrong no problem mark it and then we will go to the next step just mark whatever you
feel.
So, consumption of raw material materials will go as a O item. Maybe few of you have
made mistake it is not a O item it is a no adjustment item. So, ignore it put a dash or
write no adjustment; manufacturing expenses again same thing it is a normal day to day
item. So, no adjustment; wages no adjustment: depreciation again no adjustment? No it
has. Because it is a non-cash item though it is reduced from P and [laugher], it is not
involving any cash outflow. So, we will mark it as O it will also have some impact on the
equipment or the machinery account. So, in O that is in the operating flows it is going to
be added.
So, I have marked it as plus and in I that is in the machinery we will mark it as minus.
So, depreciation OI plus and minus getting? This will be true for all non cash items they
will be added in the cash flow statement. General expenses no adjustment; discount on
issue of debentures will it involve any cash flow? Indirectly yes because when we issue
debentures we should have got cash, but to the extent of discount we will not receive
cash its a F type of item, it will also have impact on operating flows because it is one of
our expenses, but it does not involve any cash ok.
So, I have marked it as OF getting it? In operations its plus and in F it will have minus.
Tax 6000 I think most of you are judged it correct it is a O type of item, but this 6000
does not mean it is cash tax paid, this much of tax has been charged for the year do you
will have to look at the balance sheet item and then finally, decide how much tax is paid
ok. So, right now I have marked it as O, O because it will come two times in the
operating flows and marked it as plus and minus.
Because again it comes two times, exact amount we will determine later on. Interim
dividend do you remember what is interim dividend? Dividend represents the share of
profit which is paid to the shareholders. If it is paid during the year it is called as interim
dividend. Now interim dividend is a F type of item it is a financing outflow, but it will
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have an impact on O because it is rooted through P and L. So, I have marked it as FO
minus and plus.
Minus because it is an outflow in financing we will add it in O. So, I have written it as

plus last item profit retained again it is O, because it comes from day to day activities
and we will mark it as plus. If you remember the second effect of profit written is there
in the balance sheet. So, now, we have marked all items of P and L we have also marked
all items of balance sheet. I hope you have understood it is very important for you to
properly understand all these items.
Once this is clear making of cash flow statement is really very simple. Are you getting
all the items? I will request you to practice a lot. Take 2 years balance sheet for any
company, calculate the cash flow statement and check it with their actual cash flow
statement ok. So, now, look at the answer now actual answer is very simple if you have
really understood all these items, you can easily write down the final answer.
Now, this is in front of you in final short, but I request you to properly solve it yourself.
Now, I will try to explain every item it start you know there is a particular format. So, we
are starting with retained earnings 17600 from where we did you got this item? Actually
it came from 2 sources: first it was given in P and L it also I had a some impact on
balance sheet. Because balance sheet we had transferred the balance of P and L which is
a increase of 17600 it is only one item, but it comes at two places ok. So, here retain
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earnings it is a inflow see if it is a outflow you should write in bracket if it is a inflow;
that means, a positive figure.
So, retained earnings 17600 to that add interim dividend paid. Now you know here we
had written interim dividend 5000 as F and O. So, it is a financing item we are also going
to add it for calculation of P and L. So, remember it is paid actually it is a outflow, but in
P and L we add it because right now we are not showing it as a outflow, we are
calculating it using it for calculation of profit. So, 17600 plus 5000 I get NPAT or Net
Profit After Tax which is 22600 then tax provided.
See in P and L we had got 6000 OO of which the first effect is this the tax was reduced
from profit and loss account we will add it back, we are going to take this item again, but
we will look at it later on. Right now just add a back the tax we will get net profit before
tax, which is 28600. Please try to solve with me so, that you also get the practice. Next is
depreciation you know here in P and L we add a item of 5000 O plus. So, we are this is a
non cash expense.
So, we will add back 5000 same way there was a item discount on issue of debenture in
P and L we had marked it as OF in any case this 3000 is to be added in O. So, discount
on issue of debenture is added. See this is only one effect the second effect we will see
later on the effect related to operating activities we are looking right now. Next is profit
on sale of investments. If you remember in P and L we had added these 2000 to calculate
the profit now, we are going to reverse it.
So, we will reduce 2000 because it is a negative figure we will write in bracket are you
getting? So, NPBT 28600 add 5000 add 3000 minus 2000. So, we are getting 34600 this
is called as funds from operations. This is the money which we have generated from our
operations or from our normal business that is why we have started with profit, we have
removed non operating type of items now which items are yet to be shown in operating
activities. Do you remember?
Items which we are related to CA or CL or related to working capital they are yet to be
treated. So, we start with funds from operations, then make adjustment for debtor and
creditor there are only two adjustments let us go to balance sheet to have a look at it. So,
you know that in the liabilities there was a item creditors. From 16000 it has reduced to
10000 minus 6000. So, I hope you understand that we have paid 6000 getting it? That is
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why the creditors balance have come down we are going to reduce it from the cash flow
as minus 6000 getting it?
But for debtors it is exactly opposite; in the assets the debtors have gone down now
debtors are going down means, these are the balances with customers they have paid us
we have got more money that is why their balance has gone down. So, this minus 7000 is
going to be plus in the cash flow statement getting it? I know its slightly tricky keep in
mind that it will be exactly opposite for debtors and creditors.
For creditor it is minus 6 for debtor there the figure was minus so, we converted into plus
or you can also remember it this way that whatever is a direction of movement in a
current liability same will be for cash ok. So, current liability went down. So, cash also
went down, but for a debtor which is a current asset it competes with cash. So, debtors
have gone down so, cash has gone up ok. So, it is a plus 700. So, at this stage we get
cash generated from operations which is 29300.
So, we will stop here, we will continue the same assignment or the same case in the next
session. Namaste.
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Lecture – 18
Namaste. In the last session, we were discussing case number 2 of Cash Flow Statement.
Those of who have missed it, I will request you to see the session, also take the printout
of the case which we where solving. We were half way through so, we will continue
from there, but just we will look at the case once again.
So, this is a we are asked to prepare cash flow statement for Keshav Limited. Now, profit
or loss account for March 2020 was given ok.
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Then, the balance sheet was given for last year and this year or opening balances and
closing balances ok. So, this is liabilities, assets.
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And, now based on this figure information we were asked to prepare cash flow
statement. Now, as a process of preparing it as a working note what I had ask you to do
was take every item of balance sheet then P and L mark the change and mark it as O, I or
F.
Once that marking is done the rest of the work is very simple; actual preparation of cash
flow. So, we have done marking last time just have a look once again.
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So, we started with balance sheet liabilities, these were the markings. So, profit and loss
account was marked as O, debenture being a financing item F, creditors CACL, differed
tax liability O.
Assets, equipment and long term investments were I and sundry debtors CACL bank
balance, this is a cash and cash equivalent item. So, it should be marked as C. It will not
be shown as a flow in the cash flow statement.
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Now, P and L; P and L items like sales or revenue from services are not to be shown in
cash flow. So, I have written here as no adjustment or you can say no item of cash flow.
For items like profit on sale of investment there will be two adjustments.
Now, this is related to investment so, it is I, profit is there so, money is coming in so, it is
plus. But, it has a second effect in O, keep in mind. O because it is already added in P
and L we want to remove it from P and L. It is not regular day to day activity. So, we
will reduce it from O that is why I have marked it as I and O and plus and minus ok. This
plus and minus etcetera is not to be written in cash flow, but it will help us in making the
cash flow, getting it?
Now, all these are expense items in P and L. So, day-to-day items like consumption,
manufacturing, wages, general expenses are NA, but depreciation it is a non cash
expense, so, O plus. Discount on issue of debentures OF plus taxation OO, because it
will come under operating items twice plus and minus interim dividend FO plus and
minus. If you have still not understood it please read it two three times. It is very
important; once that is done remaining job is simple.
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Now, based on this we went for preparation of cash flow statement. The first part is
operating activities. There is a specific format. So, please go through the format two
three times. We calculate net profit after tax, net profit before tax and then do
adjustments for certain items. Now to calculate NPAT we started with retained earnings,
add interim, dividend, add taxes provided, we got NPBT, then depreciation and discount
and debentures was added. Keep in mind, these are non-cash items they do not bring in
cash, but because we do not pay cash for it we are adding it because it is a indirect
method, then profit on sale of investment is to be reduced.
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So, we get fund from operations 34600, to these we will make adjustment for working
capital items or CA and CL items. Now, sundry debtors had gone down reduction of
sundry debtor means they have paid us money so, it is added. Creditors have also gone
down. Now, to creditors for them to go down we pay them money. So, reduction in
creditors is in bracket so, it is a outflow ok.
So, CA and CL is be tricky, keep track of it, I will once again just remind what I told you
last time. For CL it is simple; addition to CL that is current liabilities also addition to
cash reduction of CL is reduction of cash I think you keep that in mind ok. For even
more simple you can remember that cash and CL have affection with each other, they
will go together whereas, cash and CA are competing, they would go opposite just
remember CL and its opposite movement is for current assets ok.
Now, after adjusting debtors and creditors we get cash generated from operations, but
before tax. So, I am marked it as BT which is 29300. Now, the income tax paid is to be
reduced that is 1000. Now, from where you got 1000? 1000 was not given anywhere, but
we had two figures we will go to P and L. You can see here in P and L that taxes
provided was 6000. Weather Actual payment has done or not, we do not know, but that
much of tax were charged in P and L.
Of that we had to go to balance sheet now. If you see balance sheet in the liability there
is a item called differed tax liability and it has increased from 7 to 12; that means, there
is a increase of 5000 these are taxes provided, but not paid. Do you remember what is
differed tax? As the name suggests differed means this is this times item, but to be paid
later on any tax which is not to be paid in the current year if it is to be paid in current
year it is called current tax. If it is not to be paid in current year, but can be paid after 2,
3, 4 years it is called as a differed tax.
Now, the differed tax liability has gone up by 5000 we have marked it has O. So, out of
the total taxes of 6000 for the year as you can see from P and L, 5000 are differed; that
means they would be paid later on. They are not to be paid now. So, 6 minus 5 remaining
1000 is paid in the current year. Are you getting me? Here I have shown in bracket 6
minus 5 or you can say 6000 minus 5000 so, it is 1000, getting it.
So, tax you have to keep in mind always it will come two times. First, tax provided will
add on net profit after tax because this is charged in the year and what is actually paid is
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to be deducted. That is why taxes are to be shown twice in the cash flow because what is
provided is not paid it is to be added and what is actually paid is to be deducted because
it represents outflow ok. And, government also wants to keep track on at provisions and
actual payments; that is also one reason why in the format specifically these items are to
be shown twice. You cannot show net effect, you have to add 6 and reduce 1. Getting it?
So, this was the last item this gives us net cash flow from operating activities which is
28300 positive; that means, that much cash we have got from our normal business
activities.
Now, this was bit complicated remaining is very simple. Next is cash flow from
investing activities. Now, go to balance sheet, we had marked many items as I. So, just
take those items I means investing and put them here. So, now we will go back to
balance sheet. Balance sheet if you remember there was investment long term. It was
marked as I minus 2000 minus means from 5000 it has gone down to 3000.
So, we have sold investment and we have received 2000, but we cannot directly write
this 2000 in cash flow because there will be some profit or loss on sale of investment;
getting it? So, these 2000 plus in P and L there was one item called as profit on sale of
investment 2000; we had marketed it as I O plus minus. See, in I it is plus so, 2000
rupees is the cost of investment plus 2000 rupees of profit, total sale value is 4000. You
were not given the sale value; we have to calculate the sale value. So, sale of investment
2000 plus 2000, 4000 is the inflow for the year. Getting it? Ok.
Next is purchase of equipment. If you go to balance sheet there was equipment 21000
increasing to 55600 so, 34600 of increase. We had marked it as I. This represents
purchase; getting it? But, this may not be the actual amount of purchase. increased means
there is which have been purchase but it is reducing because of depreciation. So, we have
to consider both the effect of purchase and that is the addition and reduction due to
depreciation and the net effect will be this 34600.
So, let us calculate the purchase amount, getting it? I have worked out 39600. How it is
worked out, can you guess? See, the net effect is 34600 and if you go to P and L there
was a depreciation of 5. So, 34 plus 5 you get 39600.
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I have also shown equipment account here. Those of who are familiar with ledger
accounts have a look at the account. The opening balance was 21, closing balance was
55, reduction due to depreciation is 5. We don’t know how much is a purchase. We only
knows that there is a reduction overall increase of 34600 plus 5000; that means, there is a
cash bank for purchase of 39600. So, either you make a account like I have made it here
or you can make a working note, but arrive at this amount of 39600. It is in bracket
because it is a minus, it is a reduction in cash flow; are you getting?
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So, two item in investing plus 4000 and minus 39600 net cash flow from investing
activities 35600, are you getting? So, from operating there was a addition or positive
figure of 28300 that is cash generated from operating activities. This is the cash invested
in investing activities 35600 in minus.
Now, the third heading is financing activity. So, go to balance sheet look at F type of
items ok. Balance sheet normally you have to go to liabilities because that is where you
will get F items you can see there is only one item debenture 10000 was opening, 27 was
closing, increase of 17 F. So, it represents what? A financing inflow, We issue
debentures. So, we have got cash and we have given debentures; getting it? So, inflow is
17, but do not write 17 directly in cash flow because there could be some item in P and
L.
If you remember in P and L there was one item called as discount on issue of debentures.
We had marked it as OF plus, getting it? It is F because it is a financing item of 3000 it is
related to issue of debenture; that means debentures of the face value of 17 are issued at
discount. Company did not received 17. Company received 17 minus 3 that is 14, that is
your inflow of from debentures; getting it? So, I have written it here as issue of
debentures 17 minus 3, 14000, got it?
So, only one item was there in the balance sheet, but there was one item in P and L, that
is this interim dividend we had marked is as FO minus plus. What is F? Because
dividend is always a financing activity. We have issued shares and we are giving
dividend to the shareholders during the same here it is given. So, it is called interim; that
means, it is declared and paid. See the amount is 5000, that 5000 we added here in P
operating and we will reduce it in financing, got it? So, in financing there are only two
items issue of debentures and interim dividend paid plus 14 minus 5. So, net cash flow
from financing activities 9.
So, you have got all the three headings now, 28300 plus minus 35600 plus 9000. So, net
increase in cash this is a total of O plus I plus F that is 1700, are you getting it? Now, this
can be cross checked with the balances in the balance sheet. So, to this we add cash and
cash equivalents at the beginning which is 5000 cash and cash equivalents at the end are
6700. So, has it has it tallied?
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Now, from where we got this 5 and 6700, we will go back to balance sheet. See there is a
item in balance sheet, bank, which we had marked as C and we had discussed that this
1700 is not inflow or outflow. This is the change of balance; in fact, we are calculating
whole cash flow statement to see whether our total matches with the changes in the cash
flow statement in the cash and cash equivalent. So, all other changes together was 1700.
It matches with the change in the bank; that means our statement is correct. It is tallying;
are you getting? So, 1700 plus 5000 you get 6700.
Now, there is something more also. Now, go to cash and cash equivalent we have to
make a reconciliation statement. Show the cash and cash equivalent at the beginning and
at the end. Here we have only one. This problem only has one item, but sometime there
can be two, three items of cash and cash equivalent. So, show them take the total; so,
bank opening 5, closing 6700 the total is same 5 and 6700 and equipment was a working
note.
So, for the whole cash flow statement as for the format start with operating item, show
them here, then go for investing, go for financing, add opening, less closing and also
show the reconciliation of cashless of cash and cash equivalent then our cash flow
statement is over; is it clear?
Now, also we would discuss just a bit from the financing angle. What are your
comments? Is it a good cash flow statement for the company? Does it represent sound
and well running company? What do you feel from these three totals? Operating
activities is a positive figure, is it a good sign? Of course, yes, we are getting cash, what
is bad in it. We are able to generate 28300 from our normal business. You can see here.
This is a very good sign. This shows the strength of business. Now, we have a negative
cash flow in investing; is it a good sign? We are giving cash. cash is going out, is it a
good sign? Some may fail it is not good sign our cash is going outside, but actually it is a
positive sign because unless we make investment how will business grow.
So, you can see here company is generating cash 28300 and they are investing in
purchase of new equipment. So, if you want a healthy growth of the company, company
has to continuously make investments in new equipment, new software, new technology
or at least in new investments. So, you can see here they have sold some of the old
investments at profit which is also good sign and all that money they have put in the new
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equipments that would give them coming years it will be good for generating more
profits and more cash flows.
So, keep in mind negative cash flow of investing activities not bad. In fact, that should be
negative if it is positive; that means, you are selling your existing asset which may not be
good. It is good if new assets are getting created. So, negative cash flow in investing
activities healthy. Next is financing. Financing is plus 9000, is it good? Should be
Positive negative? Actually both is fine in financing because sometimes it will be
negative because of payments of dividend like here they have paid 5000 shareholder
should get some money. So, is it is a positive sign, but company has to grow.
So, you can see here they have raised some new money by the way of debentures. That
14000 is used to finance the purchase of investment partly. Partly it has come from the
operating flows and partly from this. So, no problem this 9000 can be either or positive
or negative it is a healthy sign, overall looking at the and also look at the cash and cash
equivalents at the beginning and end it also shows a good sign. If you have too much of
cash it is not good, if you have too little cash not even the money to pay regular activities
that is also not sound. So, you can see here company has slightly increased their
balances, but not too much of cash not too less of cash.
So, overall from the cash flow statement I am not looking at P and L and balance sheet.
We will later on discuss the ratios and how to analyze the segments, but just by looking
at the cash flow which we have made overall comments if you make we can say that it is
a healthy sign. They have generated a positive cash flow from operations, they have
invested during the year so, negative cash flow from investing and a small positive from
financing. So, company as a healthy cash policy they are able to have a good cash flow
from operations. So, I hope you have over all understood cash flow statement.
Now, we have already discussed balance sheet first, then we discussed P and L, today we
have also discuss cash flow. I hope now the basic financial statements are clear to you. In
coming sessions we will discuss some conceptual and theoretical aspects, like corporate
governance, like ethical part of accounting or like how was the accounting evolved, how
are the entries recorded. And, in last part of our course, in last 4-5 sessions we will again
go back to financial statements wherein we will go for preparation of balance sheet, P
and L and cash flow and we will also try to analyze them by way of ratios.
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But, to do all that you need to do a lot of homework. Now, that you have understood all
the three statements please read the statements of various companies, at least of your
company and also try to prepare simple P and Ls and balance sheets and maybe after one
or two weeks we will go for preparation of some more statements ok.
Thank you so much. Namaste.
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Department of School of Management
Lecture - 19
Corporate Governance
Namaste. We have already discussed Financial Statements now. I hope you are
practicing on the same on balance sheet, then P and L and in last two sessions or last 3, 4
sessions rather we have been discussing on cash flow statement. So, now, we are going
to go for some conceptual and theoretical aspects. I am hoping that you will continue
your practice on the financial statements while for a week we will discuss on certain
conceptual aspects. Keep in mind this conceptual aspects are equally important so that
you get overall idea of various aspects related to accounting and they are very much
important for the corporate or business world.
Now, one of the hot topics or hot areas which are discussed is known as Corporate
Governance. I hope most of you have heard this term. It is often in news often for non
wrong reasons that lack of corporate governance has led to some fraud as has led to some
problems. So, what is Corporate Governance? This will be discussed in the current ppt.
Now what do you understand by it? Can somebody think of it what it is? As the name
suggest there are two name parts of it; one is corporate the other is governance.
Corporate refers to companies or the corporations; governance refers to the rules for
managing the company or operating the company.
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So, these are the norms for managing the company. These are some of the explanations
as to what is Governance. Now Governance consists of various mechanisms, processes
and relationships by which the company is controlled and managed. We want that
company should be ruled properly, should be managed properly, should be operated
properly. So, various processes are formed.
Now Governance structures and principles identify the distribution of rights and
responsibilities because there are various stakeholders in the company. You all know that
the owners of company are the shareholders, but shareholders are large in number, they
are spread everywhere. They are not at one place. For a private company may be the
number of shareholders are less 2, 3, 4, 5, 10; but for a public company there are lacks of
share holders and they are located at different locations, in different cities for bigger
companies; they are all over the globe.
So, they cannot manage day to day affairs. So, they appoint their representatives which
are known as board of directors which are elected every year. So, we have got two
parties now. We have got shareholders as the owners, then there are Board of Directors,
there are other stakeholders as well. There are managers who are doing day to day
management or regular functioning, who will be the employees of the company, there
will and other employees as well.
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Now company cannot operate without money. Shareholder is one source, but you know
there are lenders in the form of bankers, in the form of institutions, in the form of
debenture holders. They are also stakeholder. Apart from that there are creditors,
government, auditors. All these stakeholder have different rights and responsibilities.
Sometimes there are conflicts, they fight with each other. So, Corporate Governance
seeks to form certain rules. We tell them that do not fight with each other, do your
responsibility properly, get your rights and see that you do not encroach on other persons
rights. That is covered in the governance structure which is integral part of Corporate
Governance. Getting it?
Now, why it is necessary? It is necessary because of the possibility of conflict between

different stakeholders. There are natural conflicts of interest. I hope you know the
different forms of business, like a proprietary concern, partnership and company. In
proprietary concern what happens? There is only one person owner; mostly the same
person is a manager. So, there is no conflict of interest. He is the owner and same person
is manager. In company that is not the case. Shareholders are the owners, board of
directors are their top management. So, there is a conflict. Shareholders want more
profit, Board of Directors want more remuneration. So, it is necessary that to avoid their
fights and have well defined rights and responsibilities, we need Corporate Governance.
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So, what these do is Corporate Governance practices is an attempt to align the interest of
each other to tell them that do not fight, have such a mechanism or arrangement or
process where all the stakeholders benefit and naturally in the process the company
keeps on growing healthily. Getting it?
Now, these are the main principles of Corporate Governance. Transparency,

Accountability, Trusteeship and Ethics. I think you understand all these terms.
Transparency because shareholders are far away, lenders at one place, customers are at
other place, they all want to know about the company. So, company should run its affairs
in such a way that necessary information is available to all. Board of director should not
do partiality that they will have some information or their relatives will have some more
information, while other stakeholders are keep kept in dark. That will give a wrong
signal to the people. So, one of the essential principle is transparent operations or
transparent governance system.
The second is accountability. Now those who are running the company either as board or
as employees, they should be accountable. They are taking remuneration, they should be
accountable for their decisions. So, accountability.
Next is trusteeship. It is very important that board and the managers consider themselves
as trustees. That does not mean they should not take remuneration. They should take
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remuneration in a legal way, but should not be fraud of the company, should not enter
into such transactions which are against the interest of the company for their selfish
motive. That is why trusteeship is a very important principle.
And the last, but perhaps the most important is ethics. There is a need for high moral
values. We know its business, everybody wants to make money, but they should make it
following the moral principles. So, if the board of directors try to cheat shareholders, or a
managers try to cheat the technology give to someone else, or those who are in charge
tell our strategies to our competitors. It is lack of ethics and that would bring loss to the
company, it would also bring loss to the stakeholders. So, it is very important to
emphasize and to make all stakeholders realize that they should make money, but in
ethical manner. In Hindi, we can call it as a “SHUBH LABH” (GOOD-PROFIT). They
should have SHUBH (GOOD), they should have profits, they should have remuneration
they should have dividends, but in a ethical manner.
So, these are necessary principles of Corporate Governance.
Now, we are already discussed it, but now you can just see it in a form of a figure. There
is a large body known as share holders. I have put it in the red because they are at a risk.
They have put in the money, but they do not have control and you have another body
called as senior managers. I have put the general term it includes the board and also
many other managers who have day to day control over the company. So, ownership and
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control is separated. The relationship should not be ownership versus control that
managers are trying to cheat the share holders. They should go hand in hand for the
benefit of both.
So, senior managers always try to get more remuneration and they want more discretion
that they should have all the freedom to take any decision they want. That is where the
control is needed. They should get remuneration, but in a proper manner. They should
have discretion, but the decisions which they are taking should have some control
mechanism, that is why you have a Corporate Governance System.
Now, separation of ownership and control is the main reason for need of governance.
Now, controlling owners have their own interest. What happens is in the earlier figure
we have seen that there are two groups share holders and senior managers, but within
share holders also there are many groups. You may have a promoter group or a
controlling group. Now they have the controlling stake. They are able to take all the
decisions. There are lacks of small shareholders who will be scattered and who do not
have any control. So, it is not just a conflict between shareholder and mangers. Between
the shareholders also there are many groups. Major group is a controlling owner. This is
often a long term owner and they have got lot of financial strength.
Often we call about talk about business groups. You know for example, there is a Birla
group, there is a Tata group; there is a Reliance group. Now this groups means they have
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controlling stake in their companies and then there are lot of other shareholders who do
not have controlling stake. Within other shareholders also sometime there are strategic
shareholders who may have big chunks of shares like 5 percent, 10 percent, 15 percent
like financial institutions or like foreign institutional investors. So, they are also having
though not full control, but the partial control. Now often conflict of interest between
controlling and small shareholders lead to certain investor protection issues.
Because regulators, government. In India, you know there is a regulator called SEBI
Securities and Exchange Board of India. In US, there is a regulator called SEC S, E, C
Securities and Exchange Commission. They try to intervene to ensure that small holders,
shareholders are not cheated by the controlling shareholders or by managers. All these
issues are very important for governance.
Now how is this executed?
So, you know the owners are shareholders. What rights they have? The most important is
they have got voting right. They have a voting right to appoint the Board of Directors for
managing the company. So, in the annual general meeting, elections are held and board
is appointed. That’s their main right. Apart from that they have got voting right for doing
several things like appointing Auditors, like taking major business decisions for mergers
(Refer time: 13:19) or for making fresh issue, for coming out with right issue, or for
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taking a very large quantum of loan. So, any matters need to go to general meeting for
getting the shareholder approval where shareholders above voting right.
So, these are the main rights of shareholders. Of course, many time these are on paper
because lacks of shareholders are there, but they don’t have time and money to actually
come and exercise their right. So, often the rights are in the hands of controlling
shareholder groups, but in any case as a shareholder as a body they have these rights.
Next are Non-Executive directors. So, within directors there are two groups, Executive
and Non-Executive. Executive are Full-time managers. They take day to day business
decisions. They are at the helm of affairs of company. There are also other type of
directors who do not come everyday, they are on the board. So, they attend board
meetings, they are part of important decisions, but they are not in the process of
execution of decisions. Executive directors are there in taking decisions and also
executing them. Okay, so where share holder is one group second is Non-Executive and
third is Executive Directors. Now within Non-Executive Directors also there are 2 types
Independent and Non-Independent Directors. Now Non-Independent Directors belong to
the promoter groups.
For example, I think most of you know Reliance industries. Now who are the promoter
groups in Reliance? The promoter group is Mukesh Ambani group because Mukesh
Ambani and family owns major stake in the company and Mukesh Ambani is Chairman
and Managing Director. So, belongs to the Executive Director position. He is able to take
the decision and he is also in charge of actual running of the company. Now in the Non-
Executive Director we have go to wife of Mukesh Ambani, Neeta Ambani. She is not
day to day manager or Executive Director, but she cannot be considered as Independent,
but she belongs to Ambani family. That’s why she is a Non-Independent, but Non-
Executive Director. Getting it? Then there are Independent Directors.
So, these are professionals like Charted Accountants or Cost Accountants or lawyers or
professors who are many times invited on the board, they should not be from the owner
family, but there is seat on board for giving a independent view of strategy. These people
are called as Non-Executive Independent Directors. So, are you getting? So, these are the
major groups. Independent directors are supposed to also maintain the standard of
conduct. So, if something is wrong in the happening in the company, this seat on the
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board they are attending Board of Directors meeting. So, they are able to take major
decisions and they should have some check on how the company is functioning.
At least they should see that wrong things do not happen. This is expected from
Independent Non-Executive Directors. Getting it? So, this is the major structure.
Now, here in the graphical form. So, you can see here shareholders they appoint board.
Board intern appoint Senior Managers for regular running of company. Senior Managers
intern appoint employees of the company. So, this is as per as the operation is concerned
now to keep check you know there are Auditors. Who are Auditors? Auditors are
independent professionals who certify the financial statements of the company.
In India, Chartered Accountants are the Auditors. Now whom will Auditors report.
Suppose there is a fraud in company. When they are doing audit they realize that there is
some fraud. Now Board of Directors are engaging in fraud or Senior Managers engaged
in fraud then whom will the report? Will they again go and tell the board because they
cannot go and tell all the shareholders, shareholders are scattered. So, within the board,
Audit Committee is formed and that Audit Committee should have majority of Non-
Executive Directors. So, that Auditors are able to report their findings to Audit
Committee.
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So, Audit Committee though is a part of board is supposed to overlook the functioning of
the board to whom the Auditors make interim reporting, this is interim reporting. The
final reporting Auditors will make directly to the shareholders, but that’s in the AGM.
Are you getting? During the year as and when the things are happening, the Auditors will
provide their reports to Audit Committee who are overlooking the functioning of the
board. Now within the board as we have already discussed there are 2 types of directors
Executive and Non-Executive. Non-Executive Directors are meant to do monitoring
function on the Executive Directors who are running the company.
So, Executive Directors are supposed to report to Non-Executive Directors. This is the
overall structure. Are you waiting it? Now my request is you have already downloaded
the annual report of your company. Go to the Board of Directors section. They would
have given the list of the board. In that list, there will be a category of Executive and
Non-Executive Directors. So, go through that. Look at various types of directors.
Now, further into the structure, we already know there is a board that some major body
accountable for governance and that is a elected body by the shareholders. Then there is
CEO and team which is an implementing body and there is Annual Shareholders
Meeting. So, shareholders cannot meet every now and then, they meet only once a year
and that is where they review the conduct of the board. Okay.
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Now, a few more issues in Corporate Governance. One important issue is Board
Diversity. Now if all the members of board belong to the same family, they would think
in the same way that decision making of the company may not be that good. That’s why
on the board you need different type of people. So, over last many years these principles
are getting evolved that you need more diverse board. That’s why out of family or out of
the promoter you need some Independent Directors. There is also now a requirement of
having women directors. So, all boards for long where all male dominated.
Now, more and more women are being inducted into the board. There are also other
ways to bring in diversity like employee representatives or representatives of some more
groups. Now there are 2 important positions in the company Chairperson and CEO.
Chairperson is the person who heads the shareholders body and also heads the Board of
Directors and CEO or the Chief Executive Director Chief Executive Officer is in charge
of regular day to day activities. Now same person may be Chairman and CEO. Like in
case of Reliance, Mukesh Ambani is Chairman, he is also CEO of the company. Some of
the groups have done a separation that have a separate person as Chairperson to overlook
the activities, CEO for regular conduct of activities.
For example, most of the banks, Chairman is different, CEO is different. In Tata group
you know Ratan Tata is Chairman of all Tata group companies, but he is not CEO of any
company. There are professional CEOs. Nowadays for some of the companies like TCS
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even the Chairman is not from Tata family, but there are 2 different persons acting as
Chairman and CEO. There are some advantages of the separation, though it is not
necessary these are some of the issues. Next is Audit Committee. I think we have already
discussed that Audit Committee is here to monitor the activities. So, Audit Committee
consists of Non- Executive Director and a Finance Director because Finance Director is
suppose to help them in understanding the financial statements, but the Finance Director
does not have any voting right in the Audit Committee.
The role of CFO is also becoming important. CFO is Chief Executive Officer because
CFO is will be accountable for proper preparation of financial statements. CEO may not
have time of course, CEO is overall in charge of everything, but CFO is has a particular
importance for heading the finance team of the company. Then we have already seen
there are independence of Director, but the independence of Auditors are also very
important. So, here we have got Auditors which are appointed technically by
shareholders, but if Auditors listen to everything of the board then the independence is
lost. That’s why some principles have been brought in like Auditor should not provide
other services to the company. So, that Auditor is independent. Same Auditor if auditing
for so many years they become too much familiar
So, you need rotation of Auditors. So, like this various principles, new principles are
coming in the Corporate Governance. There is one more type of control known as
Market Corporate Control.
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Now, if the company is not doing properly. Now there is a market for voting shares and
that gives the ultimate control. So, what will happen is if company is not transfer run, if
there are frauds, if there is improper governance that message goes to stock market and
in the stock market the demand for company shares may drop. So, the price of the
company may drop. That brings in some check on the directors. That is possible if you
have got a active secondary market, there will be some check because that will prevent
managers from becoming lazy or pursuing selfish or unethical practices. Getting it?
Because, their share prices will drop, but that is not the only thing.
Further if share price is dropped too much, other groups will try to take over the
company that is through mergers and amalgamation because now it will become a
cheaper company from them for them to take over. So, if there is a active market for
mergers it becomes further check on promoters because they have some fear factor that if
they are not working properly other companies may take over and may remove them and
put their own managers. Getting it? So, this is one important and powerful mechanism of
Corporate Governance. So, we have tried to summarize somewhat is Corporate
Governance, what are the important principles and what is a structure of Corporate
Governance. So, I hope you have understood it we will stop here. Namaste.
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Department of School of Management
Lecture - 20
Corporate Governance: Global Models
Namaste. In the last session we had discussed Corporate Governance, the structure, the
need for governance and what will happen if there is a lack of governance. I hope you
have understood remembered it, I had also asked you to check in your annual report who
are the directors of your company; I hope you have done this also look at the AGM
notice that is Annual General Meeting there will be some information about board
meetings as well. So, that was about the basics of governance.
Today we look at the global models, although the corporate governance principles are
global in nature different give things are given emphasis in different parts of world. So,
today’s discussion will be on that and as we have seen last time ethics is very important
part of governance which is very much there in Indian culture. So, we will discuss about
the same.
Now, by far the most popular model is Anglo-US model one which evolved in US or in
UK mainly in English speaking countries, it has spread all over the world because major
MNCs from there operate everywhere in the world and many of the regulator have
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adopted this model. Now, here CEO plays pivotal role, so chief executive officer is one
who is looking after the operations is also responsible for reporting to the board is also
responsible for reporting to the shareholders. Now, the capital markets are very active in
US especially, so if CEO performance declines it has a impact on the stock market
performance of the company, the stock prices typically drop and that is a control
mechanism on the CEO functioning.
Now, the short term actions are very important because the appointment of CEO itself is
for 2 years, 3 years or sometimes even 1 year. So, the profit in that year many times in
that quarter plays a very important role because you know stock markets are very
sensitive. The profits or the performance will have immediate impact on the stock prices
not even at the end of the quarter, it happens every minute.
So, the positive side or negative side in the short term becomes very important, it is very
much necessary in the model that there should be active market for corporate takeovers.
So, if the management team is not doing well the stock prices will fall that will bring in
bad name to the company, but it does not have immediate effect on the controlling group.
Because if they have reasonably high number of shares they can continue to be in charge
of the company, but because of the falling prices the company becomes a prey for
somebody wanting to takeover.
So, other groups may take over the company and the current management gets exposed
because of takeover threat that is how the Anglo US model operates, that a negative
performance is penalized by reduction in prices. And. if the negative performance
continuous for a longer time the whole company will be taken over by somebody else.
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Now, there is a agency theory which is very important for understand this model. This is
a study of how to align the interest between shareholders and management these are
considered to be the most important stakeholders and you can go in there is a lot of
research which has happened in agency theory. Now, the major solutions given are in the
form of big pay cheque.
So, CEO is given substantially high salary a very high salary and also lot of perks. Now,
the idea is that keeps CEO on toe. If the performance falls the person will lose out on
sizeable financial benefit that keeps person motivated, not only the CEO it is also true for
senior management team they are also given other benefits in the form of stock options I
hope you know stock options. So, they are issued lot of shares often free of cost or at a
discounted price which are converted after some days. So, they have an incentive that if
they are performing well the prices of the company will the stock of the company will be
high. Since they are getting stock at a negligible price they would be able to make a lot
of money.
And, the third is a market for takeover which we already seen that in case of bad
performance fall in the prices company becoming a easy target for take over and of
course, the new group will kick off the current team. So, that becomes a it is a carrot and
threat of carrot of a big pay cheque threat because a poor performance will mean loss of
job and loss of control on the company.
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Now, here is an example of how big the pay cheque is this was a recent news a may be
one year old news item we know the largest bank in India is state bank of India at that
time that is in year 16 -17 it was headed by Arundhati Bhattacharya. Now, Arundhati is
managing a bank as big as SBI which has a market share of 23 percent in deposit and 21
percent in advance.
So, you can imagine how big the state bank is in if you look at the Indian banking
industry, her salary was 28 lakhs per annum which is even less than 5 percent of salary
of ICICI bank CEO at that time Chanda Kochhar was CEO of ICICI Bank her
compensation was 6 crores versus compensation for Arundhati is only 28 lakhs. I am just
trying to bring the difference is SBI is a PSU under the public sector the salary is 28
lakhs even for the chairman and MD and for CEO in private sector it is 6 crore. This is
not including other perks which the CEO of private sector banks get, this is not only for
ICICI I have shown you the salaries of other private sector banks.
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So, Aditya Puri who is incharge of or CEO of HDFC Bank we can see the salary for
2016 was 9.3 then 10 crore now 9.67 crore. Remember this is excluding the perks, this is
the cash salary for Chanda Kochhar it was 4.79, then 6 and now you know that she is
held up in a fraud, so she has been removed. In Shikha Sharma who heads Axis bank it is
3.73 4 crore 4 crore for Rana Kapoor Yes Bank again something like 5 to 6 crore for
Uday Kotak for Kotak Mahindra bank it is about 3 crore.
So, do you feel now wanting to join the bank as CEO that is true for CEOs of many
private companies and this is mainly because of US model where the top management
team gets a very high salary are you getting this was just as an example. Now, there is
also Japanese and German model keep in mind that these are advanced countries, but the
capital markets are not as active as in US.
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So, the market control as envisaged in a US model or Anglo US model is not very active.
Now, here instead of short term goals long term goals are given more importance and
shareholders have a more dominating roll, the chances of mergers and takeovers are
relatively less because there is no active market and regulators have more control they do
not encourage takeovers that easily.
There is a restriction on non banking finance, so banks play a very major role in Japanese
and German companies even their corporate governance because banks are major
stakeholders there would be a lot of control of banks or the important institutions on the
functioning instead of market control its more of a bank dominated economy ok.
Now, we will go to Chinese model we know that for last ten fifteen years China is lot in
news and china has acquired major market share in various types of commodities lot of
production or manufacturing activity has shifted to China.
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Now, in china it is a dominance of government companies now the companies which are
partly privatized they have got tradings stocks and there are also standards of
governance, but in many cases there is a duel board and it’s truly insider company
insider dominated system.
So, for day to day operations there will be one board there will be one senior board
consisting of government party leaders etcetera who have the final say in the decision
making. So, it is a dominance of a state and the minority shareholders rights are not
protected they do not have much rights and such that is a Chinese model.
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Now, we look at the corporate governance model in India, here by India in ancient India
because the current model which is being practiced is mostly Anglo US model. But, from
a very long time in the history we have got a model with a ethical foundation we know
that Vedic period is perhaps more than 1 lakh years old and lot of ethical foundations or
moral foundations have been laid down.
So, even in prehistoric times we do observe certain government related norms and
mechanisms from various Rigvedic hymns or in Upanishads various norms for regulation
are provided for more well documented norm if we go to Kautilya’s Arthshastra a
detailed treatise has been written about statecraft. So, though the name is Arthshastra
actually it is about governance. So, lot of governance principle not only for government
even for corporates or businesses have been laid down.
Now, if you look at the history records of Pataliputra which was the capital of Mauryan
Empire we have very well administered city and there were properly laid down
principles of governance.
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Now, four important principles which are known as fourfold duties or dharma’s for the
king or any other leader even for corporate leader. One is Raksha or protection, second is
Vriddhi it is enhancement not just growth also enhancement, Palana having a
maintenance and Yogakshema which is safeguard having controls.
So, there were fourfold duties for the leaders there are various salient ideas or thoughts
which are there in the ancient scriptures which are very much relevant to governance. So,
I have tried to list a few of them.
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The first one is Atmano Mokshartham, Jagat hitaya cha, so all work is an opportunity for
doing good for the world Jagat hitaya cha for the good of the world and gaining both
materially and spiritually. So, materially because you will get reward in this world you
will also get reward in the form of Moksha or in other world that is a basic principle of
life.
Then Atmana Vindyate Viryam, Atmana means self. So strength and inspiration for
excellence in work comes from within, so divine or lord is within. So, it is not based on
rewards from outside you will see in the western or in the Anglo US model its mostly the
back pay cheque or some threat, but here from within Vindyate Viryam means from
within you feel like doing good or doing selfish work that is the driving principle.
Tesham sukhm tesham shanti shaswati I hope you understand sukhm refers to happiness,
shanti refers to peace, shaswati means infinite; infinite happiness and peace is possible
from the taking care of others or all well beings because if we only try to get happiness
keeping others unhappy that would not be a shaswati sukhm because at some other point
of time we get hit. So, here the message is that for shaswat sukh or for infinite happiness
we have to take care of others also. Now, Yogah karmashu Kaushalam or Samatvam
yoga uchyate these are two definitions of yoga that, he who works with calm and even
mind achieves the most.
So, Kaushalya or the efficiency of karma depends on how much calm we are if we are
able to work without getting distracted then we can perform very good our level of
achieving will be very high Yadishi bhavana yasya siddhi bhavati tadrishi, bhavana
means feelings whatever feelings you keep same way you get. So, if you have bad
feelings for others you get bad things, but if you keep good feelings for others you get
good feel good things back. So, for achieving better performance or for having a fair
corporate governance people in charge need to have fair and good feelings not just
outcome even the means are important.
Parasparam bhavayantah shreyah param bhavapsyathah, so here parasparam bhavayantah

parasparam means mutual cooperation has been given very much of importance it is not
just a feeling of competition western model mostly emphasizes on competition one who
is the best will be made CEO. So, managers would essentially fight with each other
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because they want to prove that they are better than others, but in Indian model lot of
emphasizes has been given for mutual cooperation.
So, nowadays world is slowly moving towards team spirit that as a team we need to
perform better because if company has to be good then as a team we need to be good. So,
that particular thing comes from this principle like that we can have lot of principles
have, but I have just tried to list a few of them. Now, these are basic values of Indian
principles of governance.
Human beings are given lot of importance because an individual has a immense
potential, energy and talent for perfection there is no limitation for how well the human
being can achieve. There is a holistic approach because unity of individual and universe
is a starting point in the Indian concept. So, it is not a fight if we try to disturb others we
also get disturbed that is a holistic approach this is useful within the team also and
between the corporates and other entities or stakeholders as well.
Now, the subtle and intangible subjects are extremely important as much as tangible
objects now if you look at the balance sheets of the companies all over the world say 100
years before that tangible assets where most important. Now a days the intangible assets
are becoming more important because, of the knowledge society actually our ancient
scriptures or Shasta’s had emphasized it thousands of or perhaps lakhs of year before that
one needs to develop third eye or gyaanachakshu one needs to develop wisdom the inner
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resources are as much important perhaps more important like than outer resources. Outer
resources are in the form of capital or land of plant and machinery, but to use them
effectively you need inner resources if you have got inner talent the outer resources can
be raised.
And the last point which we already discussed is about cooperation, that cooperation is a
powerful instrument for teamwork and the success of any team or any enterprise very
much depends on the collective work that does not mean individual achievement is not
important. But, it should be supported by teamwork then one can perform consistently
for a long period of time are you getting. So, these are the important principles we have
tried to compare various global models, we have a US model or Anglo US model which
emphasizes on CEOs role lot of perks and salary is to CEO.
The second is German or Japanese model which is more of a bank based, the third is
Chinese model which is more straight driven, the fourth one which we discuss is a Indian
model which is more of ethics and moral driven that it is not a regulator from outside,
but it is from within you feel that you should perform in a fair manner. So, emphasis on
self regulation nowadays the world is slowly coming to understand importance of these
concepts like self regulation or team spirit or having the need of fairness within and so
on.
So, with this will stop here. Namaste.
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Lecture – 21
Corporate Governance: Enron Case
Namaste. In our last two sessions, we have discussed on Corporate Governance. If you
remember, first we discussed about what is governance; what are the major principles
and what is a governance structure. In the last session, we had discussed on various
global models of governance. The dominant model is Anglo-US model, then we also
have a German-Japanese model, Chinese model and we discussed the salient features of
ancient Indian model.
Today, we will discuss about a very interesting case which is known as case of Enron.
This happened in 2001, one of the biggest corporate frauds and one of the very striking
case of failure of governance. A company, which was shown to be extraordinarily good
company, highly successful, following all norms but, was completely a fraud. So, we
will just see what it was. After this case major changes were made in the governance
mechanism all over the world.
So, we will try to discuss both the things first on the Enron case. Now, we will just see
what is a background and what was the story of the bankruptcy of Enron.
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Now, Enron was a energy giant. It was mainly involved in the supply of power in USA,
later on it went into manufacturing and it also started power plants all over the world or
many of the plants were in progress when the company collapsed.
Now, this was a professionally managed company. So, no shareholder had more than 21
percent stake 20 percent stake and normally, it is argued that professionally managed
companies are better than those which are under some group.
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So, the major shareholders were various institutions, corporations, banks, charities, small
investors and so on. It was an American company on paper a very good team of
management was in charge of the company.
It was based in Houston, mainly into energy trading and distribution and they had also
started energy manufacturing. And, it was very famous for advocacy of energy
deregulation. So, they wanted lot of freedom for distribution and they had spent a lot of
energy on advocacy for their costs. In just 15 years of its existence, it became a very
important company it became the seventh largest company with 21000 employees,
seventh largest in US and sixteenth largest in the world that was the clout of Enron. And,
in 2000, the stock price reached a level of 90 dollar.
So, within 8 to 9 months time stock price grows strong 40 dollar to 90 dollar and the
market capitalization was 80 billion. Remember, it is a big amount especially in 2001
and the revenue was 139 billion. So, it was one of the large and very highly successful
US companies.
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Their auditors were Arthur Andersen. They also used to be consultants. The board had
14 members of which only 2 were insiders which were also executive directors. All other
board members were from different families and different groups, they were all
professionals. Most of the directors also had some stock in the company and planning
that at the time of retirement they were given lot of stock options.
So, that not only during their period of company’s employment; in future also they will
make a lot of money from the company stocks that is how the arrangement was. On
paper it was a very strong on solid arrangement.
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But, in reality there were many bad practices happening. So, Andrew Fastow who was a
CFO, Chief Financial Officer of the company had created certain partnerships which
were condor and raptors. So, the major employees of the company have created some
partnership firms and the main company Enron was allowed to invest in those firms. So,
they were making private business wherein only they were the owners.
Now, in year 2000, Kenneth Lay who was the chairman of the company three times met
with Dick Cheney. Keep in mind, Dick Cheney was a very important politician. He was
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the secretary of the state of US and the meetings were mainly for discussion on energy
policy and the energy policy which was declared in may 2001, was very much in favor of
energy sector particularly favoring Enron.
So, Enron had a huge political clout and they could manage the policies of US
government for the benefit of their company.
On August 14, 2001 see within just 1 year this Jeff Skilling resigned as a CEO and
Kenneth Lay again became the CEO. Now, here the stock market treated it as a wrong
news because the CEO has resigned; that means, something is wrong with the company.
The stock prices began to fall because now investors were worried about the stability of
the company.
Immediately there was a chain reaction. There was a hedging done by Enron against its
own stock and as the stock prices declined the hedging led to more and more lost to
Enron. Already they were suffering losses in operations, further losses because of
stocking prices that led to bankruptcy of company within a very short period of time.
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You can just see in December 2001 they became bankrupt. This is a movement of stock
price. In Jan; this is 2000 actually, Jan 2000 the stock price was 40, it reached to 70
eventually by the end of 2000 it reached 90 and by the end of 2001, it just crashed to 1
dollar from 95 to 1 dollar and company became bankrupt and had to be closed. So, you
can see such as a short period of time very large company can totally collapse because of
failure of governance, because of corrupt people who were in charge they were duping
the company, they were duping each other, but ultimately it lead to fall of the company.
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Now, this is the process of their bankruptcy or how it happened. Now, it was a very
much prosperous business as they were reporting till July. Now, till their earlier quarter it
was a profit making but the July quarter was the first time they reported a huge loss third
quarter October end there was a loss of more than 600 million which was extremely
surprising the stock prices fell from 30 to 20 and it November it came to be known that
they were overstating their profits for so many years and in just one month in December
Enron became bankrupt.
Now, this is their governance structure very complicated ah. Of course, there are
shareholders and there is a board. So, board consists of Ken Lay was the chair. There
were audit and compensation committees. Management had skilling lay was the CEO,
Fastow was CFO, then Causey was CEO and there were other people in the team.
Company’s policies and code of conduct were in place which was supposed to regulate
both the board and management, but proper guidance was not there.
The auditors who are supposed to be overlooking everything they had multiple
relationships. Apart from being auditors they were also consultants and making huge
amount of money and in a way allowing the company to manipulate their accounts.
There were also outside law firms who were part of the consultants, they were getting lot
of financial rewards from the company. So, they were also not doing a proper function as
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an independent professionals. Other functional like internal auditors and whistleblowers
also proved to be failures ok.
There were CPs, SPs that is partnerships made by the managing team who were making
profit at the cost of company.
Now, Sherron Watkins she became very famous as a whistleblower. She noticed the
fuzzy accounting of the company. She is an outsider, she found out that these partnership
condor and raptor were being misused by the company. She rose to the rose and written
to the both the chairman Kenneth Lay and auditors Arthur Andersen about the unstability
and within very short period market came to know about this and company collapsed.
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Now, he is the person in charge Kenneth Lay. Throughout this, he was in charge of the
company in different capacities and was making lot of political contributions. He had
donated more than 1 lakh dollars to President Bush and in 2001; Bush had invited him to
become advisor of his transition team.
So, many people who might feel that there is a lot of corruption in India keep in mind
there is much more political corruption in US and Enron is a very striking case because
Enron was a very big donor to both the major parties in US and indirectly their
malpractices were getting a cover up.
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Now, what were the reasons? What was the accounting fraud? See, the actual profit was
much less, but the reported profit was very high and this was not just in 2000, this was
happening in last four years from 96 to 2000 continuous accounting manipulations were
done and thus profits were overstated.
Now, these are some of the accounting malpractices. One is we have seen an
overstatement of profit, bad accounting policies in the form of lower depreciation, not
making provisions where it was necessary, not stating various possible risks which could
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be contingent liabilities requiring provisions, then there were large number of global
subsidiaries. So, at several places in the world they had started so called power
manufacturing plants and lot of money was being invested there on paper and these
plants were nothing much, but they were giving a lot of royalty to Enron. So, there was
an internal income.
In the books of Enron, they would report it as a profit and in the books of subsidiaries;
they will show it as a capital expenditure. When the company busted it came to be
known that most of the plants had nothing in that, they were all going to be perpetually
in loss. But, for 3 to 4 years they were showing these expenditures as capital work in
progress because see power is the nature of industry is such that it takes a long time of a
gestation before you invest and the power production starts that gestation period was
used to play with the accounting there.
If you remember, the plant of Enron was has had also started in India at Dabhol near
Ratnagiri and there was very big fraud both corporate fraud as well as political fraud
done by Enron in India as well under one of it is subsidiaries such a practice was done by
several of it is global subsidiaries. But, in US books it was reported as a profit mainly
coming from internal income.
So, in short time trying to summarize there was conflict of interest with auditors the most
reputed auditors in the world at that time were Arthur Andersen. The biggest audit firm
today you might have heard of Big Four the major audit firms even bigger than that was
Enron had a of very high respect, but they were into multiple conflicting roles. They
were auditors, they were also consultants they were getting automatic renewals and they
were party to the fraud. So, this relationship was affecting the independence of auditor.
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Now, there were also accounting and staff policy failure. Independent directors failed to
detect malpractices. We have just discussed that on the board you have got executive
directors, non-executive directors and there are also independent directors. In Enron
there is a professionally managed company. So, there was nothing like promoting group.
Several respectable people like accountants, lawyers or corporate professionals were on
the board, but they failed to detect the malpractices.
Company had a big retirement fund. It was invested in their own stock, that money was
also used to play with the stock prices. It caused disastrous loss to employees retirement
fund because when the company collapse the employees lost job, their retirement money
was also affected, but the ex CEO was smart enough here already in cashed in his own
stock before. So, people at the helm knew that there are malpractices and they had made
money while the employees and small shareholders were losing substantially.
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There was a political confusion as well. There was a very strong relationship with Enron
and political parties. So, government, US government failed in proper monitoring.
There was what is known as managerialism. So, managers had built up their own
empires. They were making lot of profit officially from the company as remuneration
and also from their partnerships.
There was conflict in the board. So, Enron’s board failed to control and oversee it. The
board was also benefiting from various other relationships. Board members are supposed
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to be independent, but they were taking money from Enron in the form of consultancy
and other fees. So, there was lack of independence of board.
There were stock options schemes. So, CEOs, managers, employees they were very
happy because they were making a lot of money from stock options. So, they had every
on paper this is a good incentive that they should perform well for better profit, but it
was being misused to manipulate profit, show higher book profit which will in turn book
boost the stock price of company in the short term, but for a short period they used to get
a lot of money.
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Control and management was overlapping. We have already seen that there were
corporate partnerships. There so, there was no independence. Private firms partnership
firms were valid investment for Enron. So, Enron was making investment in those firms
and they were making profits from both the ways. We have already seen this.
Now, there was also failure of financial management. CFO had done a very poor job.
The financial reports, their balance sheet and P and L were extremely complicated. So,
even experts in finance could not understand what they have written there, there were no
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proper notes, there were no proper details. So, deliberately the accounts were made in a
confused in a confusing manner. Now, special team of reviewing the reports also failed
to perform their job.
We have also already seen this that more than 50 percent of their retirement money was
invested in their own stock. So, the common goal have become to boost stock prices
rather than really to boost the performance of the company.
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Now, after this many reforms were suggested. One of it was auditors should not be
allowed to perform other services because it compromises on their independence.
Then government and stock exchanges need to be very cautious and they need to tighten
their rules to avoid insider trading because people at the helm of Enron were also
involved in insider trading in their stock prices. And, the percentage of assets of
retirement funds what can be invested in their own stock also need to be checked.
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Need for a better accounting reporting financial reporting system. I think we have
discussed the formats of P and L and balance sheet. Indian formats are much better,
much more transparent compared to US formats. Now, the US also has changed their
format, but overall there is need to be less complicated reporting so that the balance sheet
P and L cash flow are easy to read. So, these were the reforms which were suggested.
Now, we look at the laws which were changed and some new changes in the law some
new changes in the law brought particularly because of Enron problem. But, also because
there were several other companies in US facing such things that law popularly known as
SOX or Sarbanes-Oxley Act. It is a very big act, it is an American law, but it has affected
regulation in other countries also.
So, I have tried to just in summary tell it has significantly affected the way the audits are
done, the way the corporate governance is done not only in US, but also in other
countries.
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Now, this is a brief history. So, Sarbanes and Oxley are the names of the two
congressmen who are brought in this law and this is about the public company
accounting reform and investor protection act. The other name for it is Corporate and
Auditing Accountability and Responsibility and Transparency Act. I just named the rate
read the names because now, you will understand what is the content of the act.
So, the major objective was to restore public confidence because after Enron the
confidence was lost and assure ethical business practices because of too much of greed
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the morals were forgotten so, they are somewhat emphasized. The major fraud of Enron
we have also seen. There was also major fraud in world com one other big US chain.
Now, here are some of the major provisions of law are discussed, but we will just go
through them. So, a new board known as Public Company Accounting Oversight Board
was created. This is in a way regulator on auditors created as a nonprofit organization
under the authority of SEC. So, the professional body like AICPA equivalent to Indians
ICAI. They do not have much say now; it is a public accounting oversight board which is
mainly to as an oversight on auditors.
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Now, the auditors independence. Now, it prohibits auditors from taking other services
like consultancy and also necessitates rotation of audit partners.
Any conflict of interest should be avoided. So, same person who has say resigned as
CEO or CFO should not get audit engagements.
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Then, the corporate responsibility; it establishes minimum independence standards for

audit committees. Then CEOs and CFO must certify the periodic reports for truthfulness
and accuracy.
Enhanced financial disclosure; so, new accounting standards were brought in for
disclosure of off-balance sheet transactions and the real time disclosure became
necessary.
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Now, analyst conflict of interest; analysts operate in stock market. They also have
conflict of interest with the company. So, improvement of objectivity of research and
providing investors with useful and reliable information was one of the objectives.
Commission resources and authority; so, SEC created a commission to properly oversee
the functioning under the law.
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Studies and reports; the Comptroller General of US which is a public body they
conducted a study on consolidation of public accounting firms. So, lot of accounting
firms like Price Waterhouse Coopers and they created a kind of monopoly. So, the
studies were done on the impact of that.
Corporate and criminal fraud accountability; now, generally the white crimes go
unaccounted, they do not get much of penalty, but their penalties were increased.
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So, white collar crime penalty enhancement was done.
Corporate tax return must be filed by CEO to make the CEO more accountable.
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Corporate fraud accountability was also enhanced.
There was also an amendment later on known as JOBS Act to make SOX Act kind of
diluted and kind of symbols for small companies.
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This is applicable to US and also to all international companies who have listed any
equity or debt in US that is why it has become a kind of global act. It also is applicable to
all audit firms.
There were also some criticisms that it is bringing in too much of control.
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But, overall it is liked and it is praised for better investment confidence and also for more
accurate and reliable statements.
So, the whole purpose was to nurture ethical culture. We also already seen how in Indian
system we emphasize on ethics and moral. Under the act in US also emphasize was on
ethical culture.
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Now, the similar acts were introduced by many countries in the world for example, C-
SOX. Then in Germany, in Japan, South Africa and several countries similar laws have
been introduced.
Including some changes were also made in India and corporate governance laws and
rules today have been made much more stricter.
So, with this we will stop our discussion on corporate governance we have discussed
what the governance is, we have also seen the various global models, then we discussed
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Enron case as a striking example of governance failure and we have seen the reforms
mainly through SOX and such other loss.
So, with this we will stop. Namaste.
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Lecture – 22
Accounting Standards and Principles
Namaste. In our last module, we had discussed corporate governance. Today we are
going to discuss about very important concept of Accounting Principles, Accounting
Standards, IAS, GAAP and so on. Now you have learnt already learnt what are the
financial statements. Now we are going to look into the assumptions which go into
preparation of these statements.
So, this will be discussed in the current session: Accounting Principles, Concepts,
Standards, IAS and GAAP.
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First the accounting principles: now we know that accounting seeks to disseminate
information. We record transactions, prepare statements and they are provided to the
users. It is very much necessary that such communication is based on certain uniform
and scientifically laid down principles; so that it is understood by everybody in the same
sense.
Now, accounting principle means those rules of conduct or procedures which are adopted
by accountants universally for both recording as well as for disseminating.
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Now, these are the important accounting concepts. Now these are the basic assumptions
or conditions upon which the accounting is based. The first one is business entity
concept. Now many times for a proprietary concern, the owner and the business look
together for the outsider they appear as one thing, but in accounting we always keep in
mind that owner is separate from the entity and the accounts are being prepared for a
particular entity.
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Next is dual aspect. We know that for every transaction there are two effects. Sometimes
those are called as debit or credit because of two effects the balance sheet always tally.
We have already seen the balance sheet equation that
Equities + Liabilities = Assets.
The next one is known as cost concept. Now assets are normally to be recorded that
historical cost that is at the acquisition cost. We ignore market value unless there is some
specific condition for taking it into account otherwise both the asset valuation as well as
recording of expenses happen on actual cost.
Going concern: this is a very important assumption that it is anticipated that business will
continue for long foreseeable future and is not likely to be liquidated in a short period.
The accounting is always done with the assumption of continuity of the business
concern.
Next one is accounting period concept. We all know that the business is a continuous
process. It keeps on happening transactions keep on coming, but as far as the accounting
is concerned, the whole of business life is divided into certain periods which are known
as accounting periods. Normally there is a 1 year accounting period. Within 1 year, you
can have a quarter or a month, but we cannot have some system where accounts are not
closed at any point of time.
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Normally in India the, are you aware of the accounting period in India? Normally it is
from first April to thirty first March. So, at the end of every thirty first March, profit and
loss and balance sheet and cash flow and all other statements are prepared books are
considered to be closed and then the new books are opened from first April or from the
first day of the next financial year that is as per accounting period concept.
Next one is money measurement concept. Now, all transactions which are expressed in
money terms alone are recorded. There could be some other transactions like good will
or like good contacts or relations which or emotions which cannot be measured in money
and such things cannot be recorded in accounting.
Next is realisation concept. Now revenue is recognized only when, a particular

agreement is reached. So, only in case of realization of a transaction, the transaction is
recorded.
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Constant Value Concept: so, there is an assumption of constant value of currency; for
example, rupee. We do not assume that the value of rupee though is changing vis-a-vis
the foreign currency we do not record the changes in the value of currency. The value of
currency also changes because of inflation, but those are not the business transactions.
We record the transaction only when some transactions happens with third party,
otherwise the value of currency is considered to be constant.
Next is Accrual Concept. This is one very important concept because transactions may
happen, but payment may not come. So, receipt of cash or payment of cash could be
delayed or it could be advanced, but the transaction date is a date when the agreement or
a particular contract is reached. This is called as a accrual Concept. So, transactions are
recorded as and when they accrue or as and when they occur; not as and when the cash is
received or paid.
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The next one is Consistency. Now the accounting policies or assumptions are the base
for making the entries or for preparation of statements. Now once you decided to use a
particular assumption or use a particular accounting concept that should not be changed
from period to period because accounting statements should be comparable from
different period.
Now, in order to achieve the comparability, it is necessary that the accounting principles
and policies are followed from one period to another in a consistent manner. If for some
special reason, the change in the accounting policy is necessary; it needs to be separately
disclosed and the effect of such changes also required to be disclosed.
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Now, here the accounting conventions are given in short. One of the convention, we have
already seen that is known as consistency. That method or a principle once adopted
should be followed for a longer period of time. Disclosure – all relevant information and
fact concerning the financial position must be made available to the users, it should be
communicated, it should be disclosed properly. Materiality – many times some
transactions are too small, they are insignificant. It is necessary that significant
information is shared, it is recorded that is why materiality of transaction is also taken
into account.
Objectivity- now, whenever a particular choice is to be made or whenever a particular

assumption is to be chosen, unbiased and objective view is to be taken. Next is Stable
Monetary Unit. We have already seen it like the way we have Indian rupee or whatever
currency we are recording it is considered to be of a stable value. The last one is very
important Conservatism or Prudence. We have discussed it earlier also that if there are
two choices either you can use valuation method a or b, use that method which shows
lower value because accountants avoid any overstatement of income or overstatement of
asset, we go for a more conservative approach or a prudent approach where the value
recorded is as low as possible and not on a higher side.
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As per AS1, AS1 refers to Accounting Standard 1. There are three assumptions which
are considered as fundamental accounting assumptions which is going concern,
consistency and accrual. Now it is always assumed that any accounting statements which
are prepared are on the basis of these three assumptions. That is why they are called as
Fundamental Accounting Assumption.
If these any of this assumption is not true it is required to be disclosed, but there is no
need to disclose these three because it is assumed that they are always followed.
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Now, a very small exercise; now consider the following data pertaining to L limited. The
cost of land purchased on first April 2020 is 125 lakhs and registration charges are 15
lakhs.
Now, there are three possible market values as on thirty first March, 2021 that is the year
ending on March thirty first 2021. Rs.150 Lakhs is a value possibility A or B 120 Lakhs
or C 130 Lakhs. Now what company did was while finalizing the annual accounts, it has
considered the value of land as 125 Lakhs. Now is it correct? What will be the value in
your opinion in each of the scenario A, B and C and which of the accounting assumption
is violated by company L? Just think over.
Now, if you take scenario A where the market value is 150, how much is a cost of land?
Will we consider 125 or we will add registration charges also? We are not going for cost
of purchase, we call it cost of acquisition which includes cost of purchase plus any
incidental expense one time expenses like registration fee. So, 125 plus 15, the cost of
land to the company is 140. In scenario A, the market value is 150. So, what should we
consider as a cost as a value in the balance sheet?
We take lower of the 2, 140 or 150. So, in scenario A, the valuation will be made at 140
Lakhs. Now company has made it at 125. So, they have violated a principle called as cost
principle or cost concept because the cost of acquisition of land is 140, they have
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wrongly calculated it as 125. Got it? Now in scenario B; in scenario b, the cost remains
same which is 140, the market value has gone down it is only 120.
So, what should we consider it as? Should they value at 140 or they should value at 120?
This is not stock. If it is a stock or inventory, we take cost or market value whichever is
less that is 140 or 120 we would have taken 120, but this is a land. So, it is a long term
asset. So, we will not go by the market value, we will still value it at 140.
In case of B or in case of C any of the cases, we will value it at 140 and the concept
which the company has violated is Cost Concept. They are not violated conservatism
concept. Are you getting? If they happen to value it at 150, they would violate
Conservatism Concept because land is a fixed asset it should always be recorded at cost
when we say cost at the acquisition costs. Are you getting? Ok.
Now, go to let us go to accounting standards. Now accounting policies and principles are
used for a very long period of time perhaps for hundreds of years and different countries
and different areas have different accounting standard policies. Although most of the
policies are common, there are different conventions in different areas. Now to
standardize these policies accounting standards were introduced. So, these are written
policy documents which are issued by some expert accounting body or by regulatory
body or by government. And they give certain guidelines about recognition, treatment,
measurement, presentation, disclosure and so on. And they are standardized that is why
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they are called standard and they should be uniformly followed within that territory
maybe that country or that region or so on.
Now accounting standards provide framework and standard policies so that if you
compare the financial statements of different entities, they are very much comparable.
Now, Accounting Standards seek to ensure that financial statements of an enterprise give
a true and fair view of it is financial position and working results.
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Now, Accounting Standards not only prescribe appropriate treatment, but they faster
greater transparency and market discipline.
In general, Accounting Standards promote uniformity, rationalization, comparability and

transparency. Sometimes these accounting standards are also called as Financial
Reporting Standards. They have the same meaning.
Now, different countries have different accounting standards. As far as India is

concerned, what standards we use, we will discuss about it. I think you all would have
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heard about Institute of Chartered Accountants of India or ICAI. This is apex accounting
body in India which constituted ASB or Accounting Standard Board in 1977 in order to
harmonize various accounting policies and principles.
While harmonizing or while coming out with the standards, they do give consideration to
law, customs, usage and business environment in the country.
Now, ASB gives due consideration to International Standards also. There are 2 sets of
International Standards. One is International Financial Reporting Standard or IFRS as
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they are known as or the other one are International Accounting Standards or IAS. Now
an effort has been made right from 1977 to harmonize Indian Standards with the global
standards.
Now, we will come to IND AS. Now the earlier set of standards which were being used
in India were called as AS.
So, we had a series of standards like AS1, AS2, AS3, AS4 and so on. Now in accordance
with the policy of convergence, here by convergence we mean the convergence of global
standards. Different countries have different standards. An effort has been made all over
the globe to harmonize to bring these standards together. Now because of this policy,
Ministry of Corporate Affairs has issued a press release on 21 February 2011 and they
have notified a new series of standards which are called as IND AS that is a new series
of Indian Accounting Standards.
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Now, several requirements of Ind AS are considerably dissimilar from policies and
practices followed by Indian companies because many of the Indian companies for years
were following Ind AS that is the old state of standards.
Now, International Standard which is IFRS has been examined an effort has been made
to bring down the differences and as far as possible harmonize the same.
Now, this is the new set of standards which have been notified. So, Ind AS 101 is First-
time Adoption of Indian Accounting Standards. Ind AS 2 is about Share based Payment.
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Ind AS 3 is Business Combination then Insurance Contracts, Non current Assets Held for
Sale, Exploration of Minerals, type of items. So, then AS 107 is Financial Instruments
and 108 is Operating Segments.
So, these are special standards from 107 to 108. And then again a series starts from Ind
AS 1 which is the presentation of Accounting Standards.
Then we have got Ind AS 2, 7, 8, 10, 11, 12. I am not reading out all the standards, but
all these are available for downloading. I will request you to download these standards. If
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you are interested you can go through them in detail and if you do not want to go in so
much of details, you at least try to understand various terminologies. So, that whenever a
reference is made to a standard; you should be able to at least refer to it and read about it.
So, this is the list of all the standards.
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Now, it is not within the purview of the course to really go through every standard, it is
not necessary. We have already seen how financial statements are prepared. They are
already prepared based on various standards. Now let us look at what are the
International Standards.
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Now, there is a body known as IASC International Accounting Standards Committee

which was formed in 1973. Now most of the countries started adopting those standards
except Canada, Japan and US.
Now, to give proper direction and interpretations Standard Interpretation Committee was
made in 1997. Now a new board known as IASB was created in 2001 to prescribe the
non for norms for treatment of various items on preparation and presentation of Financial
Standards.
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Now, IASB has adopted 41 standards of IASC. Now as I told you the American Standard
sorry US Standards are not in harmony. In US, there is a body called as FASB, Financial
Accounting Standard Board. FASB and IASB are in the process of eliminating the
differences and bring those standards nearer.
Now, IASB purchases or publishes its standards in a series of pronouncements which are
called as IFRS, International Financial Reporting Standard. It has also adopted the body
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of standards issued by Board of International Accounting Standard, IASC and these
pronouncements are called as International Accounting Standards or IAS.
Now, I have given here, a list of IAS. Again I would request you to download these IAS
if you have interest and then go through them in detail. So, for example, IAS 1 is about
Preparation of Financial Statements, IAS 2 is on Inventory, IAS 7 is on Cash Flow
Statements, IAS 8 is on Accounting Policy Changes in the Financial Estimates and
Errors. If you observe carefully the news in different countries there are different gaps
and they together are called as GAAP.
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Now GAAP is a backbone of accounting information system, without which system

cannot even stand correctly. Now GAAPs and Accounting Standards as considered as a
theory base for all the accounting. So, are you getting me? So, here we have discussed
today various information about various types of standards. In future, these standards are
these standards are applicable in all the statements which we made. We are not going
into too much details of it, but I will request you to download them and go through in as
for your own interest. Namaste.
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Lecture – 23
Evolution of Accounting
Namaste. In today’s session we will discuss about Evolution or history of Accounting, in

the last session we have understood various concepts and principles of accounting which
have been standardized as accounting standard. Today let us look at how the accounting
evolved.
Now, do you know any Hindu or Indian festival which is associated with accounting or
bookkeeping? Are you able to recognize or remember any of festivals which you would
be celebrating, but it has a very strong relationship with accounting anybody is able to
guess? I will give you a hint, it is something to do with the concept of accounting period.
In the last session we have discussed accounting period concept, it means that infinite
periods are divided into a specific one year period when we close the books we reopen
new books and we prepare P and L and balance sheet at the end of the period that is the
accounting period concept. Now, do you know or do you remember any festival which is
associated with that period?
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Now, governments and merchants have been using the accounting for keeping records
since almost time immemorial and India had a very long tradition of preparing chopadis.
Chopadis refer to the books of accounts and every year the old chopadis were closed and
new set of chopadis were opened.
I think many of you have judged it or remember remembered it correctly that is called as
Lakshmi pooja and that is very important reason why Diwali is celebrated.
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Now, Lakshmi pooja is an auspicious day on which the old books are closed new books
or chopadis are worshiped and then they are opened on the next day. Now, you can here
understand how the concept of accounting period is very firmly rooted in Indian
tradition.
This is a traditional photo how the chopadis used to be worshiped and then the new
chopadis will be started during Diwali.
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This is a photograph of some records of how the accounting was made in the old period.
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We also see mention of several financial instruments particularly hundis which are
mentioned in many of the Indian scriptures and they were used extensively for transfer of
money, here there are some photographs of some of the hundis.
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Many of you would have heard about Kautilya Arthshastra; Kautilya Arthshastra has
well documented rules about accounting. Chanakya or Vishnugupta or Kautilya, he was
a statesman, economist and also a spiritual guru his period is around 4th century BC.
And Kautilya prescribed the accounting theory that included bookkeeping, preparation of
financial statements, auditing, fraud risk management and so on.
He considered accounting to be integral part of economics and various kingdoms in

India used his work until the 15th century before the advent of colonial rule.
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He recognized the importance of accounting in economic enterprises and he realized that

proper measurement of economic performance is extremely essential for efficient
allocation of resources. Now, he has specified broad scope of accounting and considered
the explanation and prediction at its proper objective.
Now, the accounting rules are given for recording and classifying economic data also it
was emphasized the critical role of audit which needs to be independent and should be
carried out in a periodic manner, there were two important offices treasurer and
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comptroller general they were deliberately separated to ensure that there is audit
independence.
So, accounting the accountability was increased, specialization was brought in and the
scope of conflict was reduced considerably because of separation of these two office.
Clarity, consistency and completeness of rules is key to such enforcement, these
measures were necessary, but not sufficient to eliminate fraudulent accounting.
Now, according to Kautilya Arthshastra maintenance of accounts, now the financial year
was fixed and a full process for closure of accounts and audit of the same was also
mentioned. It covers the method of consolidation of accounts of various departments
because under government you have got so many departments and to get a complete
picture for the kingdom or for the state it is necessary to consolidate them properly. Now,
accountants were required to furnish the completed accounts to the head office.
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Now, Kautilya says that receipts maybe for the current period for the last period and
accidental, so the receipts have been classified and the differentiation has been made
between cash receipts, debtors, currents and accrued in current and accrued income,
income from other sources, windfall gains and recovery of bad debts and so on.
He has recognized the concept of risk and suggested that different rate of interest for
loans be charged. Foreign trade loan attracted the highest rate of interest because the
returns are uncertain. So, to take care of risk; risk premium can be charged on such types
of loans.
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Now, the expenditure on classification the expenditure classification was also done
similar to classification of receipts. So, differentiation of capital expenditure and revenue
expenditure was made an expenditure is of two kinds; daily expenditure and profitable
expenditure. The expenditure between income and the difference between income and
expense was termed as a net balance. He insisted on making long term investments
especially in construction that would generate profit over a period. It has also entailed
keeping track of the work in progress.
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Now, the role and responsibility of a accountant has been quite well defined. In a
hierarchical organization structure of senior to junior accountants existed in the
kingdoms treasury function, the accountants maintain the books of accounts on annual
basis according to prescribe standards and the same were furnished for audit at the end of
the year. Kautilya suggested good salaries be paid to accountants as well as auditor as
higher income would keep them ethical.
Because if they are not given good salary there are more chances that they commit the
fraud, I think most of you who are looking forward to be accountants would be very
happy to know that salary of accountants were at a very high level accountants as well as
auditors as per Kautilya’s principles.
Now, one very important and fascinating part was segregation of two offices treasury
and audit, this is necessary for avoiding the conflict of interest between finance function
and audit function. Kautilya’s categorically stated that the head of finance and the head
of audit should independently and separately report to the king, he consider recognized
the possibility of collision between the two.
In India, the government has now current government has comptroller general of audit
and ministry of finance these are two separate functions. However, in the corporate
world many times these functions may not be that much separate because audit
executives may still report to CFO rather than directly to CEO. But it is necessary
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theoretically to have complete separation and have a independent position for auditors,
so that they can directly report to CEO or to the board.
Kautilya significantly emphasized building of ethical culture because whatever rules you
may unless there is a morality within it is likely that people will find out ways and means
to somehow do various types of frauds. Now, Kautilya believed that character reflected
personal values of individuals and ethical value learning must commence right from
childhood even as at as an adult ethical conduct was as important as professional skill.
Because skill alone is not at all enough to ensure that frauds do not happen or improper
conduct does not happen.
He proposed measures to build ethical climate in the kingdom. However, he was

practical and recognized the potential of corruption. In accounting he talked about
misstating financial statements due to abuse of power and fraudulent reporting. He
devised a system of reward and punishment to ensure compliance of rules and
regulations.
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Now, verification and auditing of accounts; now, a concept of continuous monitoring,

periodical auditing, verification of vouching existed even in ancient times. Checks were
done daily and periodically five nights, pakshas, months, four months and year these
were the periods when the periodical checks were done.
Now, the attributes used in the present day for verifying income and payment vouchers
were also used in those times. Interestingly, each department had species to pro had had
spies to provide information and report wrongdoing to the seniors. So, what is happening
at a lower level was to be directly reported to seniors through spies. There was a full
process for discovering fraudulent transactions and punishing the accountants for
misstating financial statements.
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This is about the ancient India, where the accounting was really well developed. Now, as
far as the western countries are developed western countries are concerned the
accounting developed much later. So, in 1445 we have Luca patchouli Pacioli who is
considered as a father of modern accounting because he published the first modern
textbook of accounting, he is from Italy.
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Now, governments and merchants has been using the system of transactions, recording
for a very long time. However, the system became a standard for merchants especially in
Europe only after Pacioli structured and organized it in his book getting it.
So, now the question which may arise is in the ancient India is it possible that we have
such a detailed system of accounting as you can see in Arthshastra because system of
accounting should be supported by that must level of developed commerce. So, we do
see that business, trade, commerce and industry all were highly developed in ancient
India.
There was a very high BoP surplus that is Balance of Payments surplus which can be
cross checked by the movement of gold because a lot of gold used to used to be
transferred to India there are records available about that movement. And, there are also
records available about navigation because trade was happening through sea routes, that
is also available.
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Now, Indian business in the ancient time, the examination reveals that business people
on the Indian subcontinent use the corporate form from a very ancient time and that
corporate form used to be known as sreni. Now, the records are available around 800 BC
and from there more or less continuously it was used until the advent of Islamic invasion
in 1000 AD. Now, this provides the evidence for the use of corporate form for a very
long time much before the roman proto corporations.
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In fact, the use of sreni in ancient India was widespread including virtually every kind of
business, political and municipal activity. Moreover, when we examine how these
entities were structured, governed and regulated we find that they bear many similarities
to modern day corporations. This has there has been a detailed book by Professor
Vikramaditya Khanna on economic history of the corporate form in India, so we have
taken this slides from that.
We also have some other records particularly about world economic history. So, Paul
Bairoch was a great post war economic historian, he has specifically documented the
history of industry and also the urban history where a lot has been stated about the share
of India because India was a highly industrialized country before the arrival of British
and a more detailed record is available from the work of Angus Maddison.
So, Angus Maddison was in charge of one very important project about world economic
history which was instituted by OECD development center studies.
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Now, the economic history as has been brought in is really very interesting if we look at
the share of world GDP in the work of Angus Maddison it is documented from 00 to
1998, the same has been reproduced here in the slide. So, you can see here that India had
a very high share in 00 it was as high as 32.9 percent up to year 1000 also it was 28.9
percent of the global GDP and as much as 1700 it was as high as 24 percent. So, you can
easily see that India and China were the dominant economies in the world; other
countries like Western Europe and US has have arrived much later.
So, the point I am trying to make is considering that a very high share of GDP for India
there is every possibility that we had a good system of accounting. So, the accounting
system which is documented by Kautilya and other authors do have support from other
various others collaborative record. So, with this we will stop here you can see the details
about this on internet, so I have given you the source as well.
Now, here you can also see it in the form of a graph and with this we will stop. Namaste.
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Lecture – 24
Recording Financial Transactions
Namaste. In our earlier modules we have discussed about financial statements, then we
have discussed various conceptual aspects like corporate governance like evolution of
accounting. Today we are going to go back to the very first step of accounting, if you
remember the accounting has three steps, one is recoding of transactions, summarizing
and preparation of financial statements.
Normally, the students are first taught about recording and then they go to financial
statements; we have followed a reverse path. We have first understood what is a final
output in the form of balance sheet, then P and L then cash flow and now we are going to
understand what is a recording part of it
The main purpose of changing this sequence because this course is mainly for non-
accounting students like engineers or management students who are less interested in
recording they are more interested in reading and analysing the statements. So, we have
tried to understand the balance sheet P and L and cash flow. Now, we will discuss what
are the basic transactions using those transactions you get a summary and from that
summary you have made the P and L and balance sheet.
So, this is popularly known as journal entries or ledger entries, we will not go into too
much of details of it, I will just give an overview as to what is journal, what is ledger and
so on. And in the next PPT of this module, we will see how basic P and L and balance
sheet is prepared, so that in next sessions we can talk about preparation of corporate P
and L and balance sheet ok. To first begin with the Recording of Financial Transactions.
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So, we are going to discuss about journal, ledger and subsidiary books, these are the
major books of accounts, these are not final accounts, but from here the recording aspect
starts.
Now, first one is journal now this is called as a book of original entry because all the
transactions are first recorded in journal and the effects are decided here in journal.
Recording of transaction is many times called as journalizing of entries.
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Entries are recorded normally in a chronological manner; these are very important in
earlier days we used to have physical books where people will actually write the journal
entries, now most of the accounting is computerized. So, journal entries happen within
the system, within the system ledgers are created and within the computer system the
final accounts are created, but keep in mind the correctness of journal entries has not
gone down in fact, it has increased.
If there is a any kind of mistake in the journal entry it is going to be carried in the ledger
and it is going to be carried in the final account. So, either an entry in the amount or
entry a mistake in the very conceptual understanding of the entry is going to distort the
final accounts completely. So, keep in mind that journal entries have not lost relevance,
only thing is instead of from the book today they are made in some, so computer
software, but understanding of this entries is very important.
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Now, this is a specimen of traditional journal where you write date, particular, ledger
folio, debit amount and credit amount. Even in computerized system a similar type of
entry is to be made
Now, here what we have tried to do is give a list of simple transactions and the entries
for those transactions. So, that you understand that for a particular transaction how an
entry is passed, so goods sold for cash 5000, cash deposited in bank 3000.
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Now, if you take these two simple entries, the journal entries for them is like this the
goods are sold for cash. So, cash comes in we get more cash that is why cash account is
debited and our sales are increasing, so sales account is credited. Keep in mind that cash
is an asset, so by debiting it the cash increases sales is an income, so by crediting it the
sales increases.
So, cash account to sales account this is how the entries written the debit amount for cash
is 5000, the credit amount for sales is 5000. It is necessary that total of debit and credit
should match for every entry, then only the final balance sheet will be tallied. Are you
getting it, for those who do not have any commerce or such type of accounting
background this maybe very new, but this forms the basis of all other entry of various
entries or various accounting which is done in future
The next entry was cash deposited in bank. So, remember here what is done is the bank
balance is increasing and the cash balance is decreasing, so we say bank account debit
3000 to cash account 3000; that means, the cash account is credited by 3000 and here the
date is written, are you getting me. Now, we can take hundreds of transactions and go on
writing more and more entries as I told you we are not going into too much details this is
just to make you understand what a journal is I hope that much is clear to you. The next
one is ledger.
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Now, from the journal the entries are classified and grouped for a particular account and
they are written under a particular account in what is known as a ledger. In the old days
physically the ledgers used to be written and they were called as principle books of
entries, journal is a primary book where the entries first made from there it is transferred
to ledger and ledger is a main book that is why is called as a principle book of accounts.
This is a specimen of ledger, you can see here this side is for debit, this side is for credit,
date particular J F; J F is a journal folio and the amount same way date, particular, J F
and amount; we will write here D r for debit, C r for credit and ABC account is the
heading of a particular account.
So, getting it has two sides and for every account a separate ledger account is required to
be opened in the ledger book. Normally, to and by is written on debit and credit side.
Now, a simple case is given, so that we can prepare ledger accounts for the given
transactions.
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Prepare ledger accounts for Ram and Company, opening balances are given cash,
debtors, creditors and capital.
And some simple transactions are given purchase of goods on credit, cash sales, goods
sold on credit and paid cash for expenses.
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Further cash received from debtors, cash paid to creditors. Now, I will request you to
take print out of this particular case, the case has been shared with you and now try to
look, try to solve it and then check with the solution ok.
Now, this is how in the books of Ram and Company the ledger will appear. First account
prepared is cash account it follows like this, to balance brought down 1500 you can see
here the opening balance of cash was given, it was not given whether it is debit or credit.
But since you know that cash is an asset it is going to have a debit balance of 1500, then
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there was a cash transaction on 4th April cash sales of 2400. So, we have sold goods and
we have got cash, so this will go on debit side in the ledger.
On f15th April again there is a cash transaction paid cash for rupees 250 for expenses.
So, you have paid cash; cash will go down it will appear as a credit transaction you can
just see this transactions here are you getting me. So, opening balance 1500 on this is a
debit side, on 4th April to sales 2400, on 15th April by expenses 250 we will go back
again. Next cash transaction 18th April cash received from debtors 1200 and on 22 April
paid cash to creditors 800. You can see here, cash received from debtors will appear on
debit side because the money has come in. So, to debtors 1200 and amount paid to
creditors is by creditors on 22nd April 800.
So, we have recorded all the transactions in the period related to cash and the last day
that is on 30th of April we will calculate the balance; are you getting it. So, we will take
total here which is 5100 and deduct this two amounts we get a balance of 4050; that
means, the cash in hand at the end of the month that is on 30th April is 4050, are you
getting it.
So, what you would have realized is we have summarized, we have categorized and
summarized the transactions, we were given the raw transactions since we want to
prepare a cash account we have classified only those transactions which are related to
cash. So, first one was opening balance of cash, then cash sales, then cash expenses, cash
received from debtor and cash paid to creditor. Only those items or those entries related
to cash will come in the ledger account known as cash account this is very much of
commonsense, but I am just repeating it for those who are perhaps doing it for the first
time are you getting it.
This is how a separate ledger account is created for every asset or a liability or a income
or expense and transactions related to that account are recorded in the ledger. So, this is
cash account, the balance will be carried here so that in the next month that is from May,
1st May it says two balance brought down now below this we can make the account for
May.
So, you can see accounting period concept the accounts are being closed at the end of a
particular month. So, at the end of April we get the balance it becomes the opening
balance for the next month.
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Now, similarly we have prepared purchase account; purchase account there was only one
entry to creditors there was a cash purchase of goods for 3000 and that much is balance
carried down. For sales; sales are on credit side there were two sales, one for cash sale
the other one was credit sale, this is the total sales for the month balance brought down is
3650, are you getting it.
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Next is debtors; debtors are the customer balances or receivables from customers, there
is only one transaction of sale, on 7th April 12500 the amount is received by cash 1200
and the balance is 1250.
So, if you see carefully you will realize that the opening balance of 1200 is received on
18th April and a fresh sale the amount of 1250 is yet to be received till 1st May, getting
it; perhaps they were credit period of 1 month. So, last month’s balance is received this
month’s balance is due it is carried to the next month.
Creditors there was only one credit purchase on 2nd April for 3000, the balance is still
pending we have already paid the opening balance of 800 on 22nd of April. So, these are
the accounts of receivables and payables this is a very small company very less number
of transactions, but that will give you one idea as to how a particular account can be
prepared for even for a larger company.
Then the expense account there was only one entry for expense for cash expense this 250
rupees is a balance of expenses. Capital account there is no entry, normally the capital
will not change every month, so opening balance of 1900 is carried as a closing balance,
so are you getting me.
Now, there is one more topic known as subsidiary books we have just seen that journal
entries are passed then ledger accounts are prepared, but what happens is in most of the
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businesses similar type of entries come in very large number like purchases, sales and
cash. So, there is no point in making journal entry every time instead of that we will
prepare a register and record all the purchases in one register, all the sales in one register,
all cash transactions are recorded in a special book known as cash book where the
cashier will record only the cash transactions.
So, in subsidiary books instead of having one journal for a similar type of transaction
number of books are prepared which are called as subsidiary books these are the books
of original entry from there the transactions are transferred to ledger are you getting it.
So, this easiest procedure in the olden days, physical maintenance was required. So,
different books could be maintained at different point of time like in sales depot there
will be sales book, in the hands of cashier there will be cash book etcetera. Nowadays
everything is done by computer system, but even in computer system subsidiary books
are maintained and authority of making certain type of transactions will lie in certain
type of people.
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So, typical subsidiary books are cash book for all cash transactions, purchase book for
purchases, sales book for credit sales, purchase return books sales return book then bill
receivable book for recording transactions of promissory notes and so on. Bills payable
book and there is one journal proper.
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Now, all the similar transactions will go in sale, purchase, cash book etcetera, but the
transactions which do not get recorded in any of the subsidiary books will be recorded in
the journal proper. If there are any rectification of mistakes to be done they will also be
recorded in journal proper. So, this was a very short summary of important books like
journal, ledger and subsidiary books as I told we are not going into details of it, but those
who are more interested in the topic perhaps can go to some book of accounting and go
for more details about the books of accounts.
Now, we will continue this discussion and try to prepare take a very simple case and
prepare P and L and balance sheet from trial balance.
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Now, first we will discuss about cash system and mercantile system, we have already
discussed about one of the concepts known as accrual concept.
In cash system of accounting what happens is only those transactions which are related
to cash are recorded. So, suppose you have a very small let us say a small-time
shopkeeper whenever sale happens the person records it as a cash sale, if there is a
purchase the person records it as a cash purchase.
Suppose any sales are made on credit, it will be recorded in a separate diary, but if the
sales will be recorded only when the cash is received this is called as a cash system of
accounting, earlier government system used to be mostly on cash basis.
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Example is this, suppose the December salary is paid on 5th of January, then in the cash
system it is recorded in January because the payment has made in January though it is a
expense of December it is not recorded in December, this is called a cash system.
Now, in general cash system has lot of lacunae it is not a full proof system. So, we need
a mercantile system where all entries are made irrespective of cash received or not as and
when a particular transaction is due it needs to be recorded and afterwards its payment or
receipt is recorded.
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So, transaction occurs when a particular contract is entered when a understanding is
reached about sale or purchase or about incurring expense it needs to be recorded, that is
also called as a accrual system. That is why I told you that in our concepts you have read
about the accrual concept, using the accrual concept the system of accounting which is
followed is called as a mercantile system.
Cash basis of accounting has lot of lacunae that is why most of the businesses have
converted their accounting system to mercantile system, except for very small businesses
now the cash system is not much in use, are you getting it.
Now, let us go to a small case where perhaps you will understand how to make a small P
and L and balance sheet this is not for a company, so not in a particular format just to
understand from the trial balance how to make P and L and balance sheet. First of all
what do you understand by trial balance? We have just discussed what is a ledger; in
ledger there are various accounts and at the end of the period the balances are calculated
for each account.
Now, those balances are listed in a list which is called as a trial balance. Now, trial
balance has many advantages because it gives you the list of all the accounts it also helps
us to ensure to find out if there are any mistakes, if there are any errors in the ledger the
trial balance will not tally. So, that the total of debit should match with total of credit in a
trial balance which gives a initially we feel that most of the things are correct of course,
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it’s not a full proof method there could be still some errors, but largely it helps us in
finding out many of the errors.
Now, a small trial balance is given, you can see here and using this trial balance you are
required to make P and L account and balance sheet. This is not for in the company
format you can use any format, but just try to make a P and L and balance sheet. So, first
of all read the items of the trial balance, mark whether a particular item is a P and L item
or a balance sheet item and then take them to P and L or balance sheet.
I hope you have got the print out if you are not you can stop the video here take the print
out and then go for the next step. So, we will discuss a few of them first is cash. Now,
cash is what type of item? It is a asset right, so it should go under the assets. Trade
debtors again asset in the balance sheet, rent is a expense in P and L salary, expense in P
and L please note this items. Trade creditors liabilities in balance sheet, insurance
expense in P and L; in the same manner try to note all other items in the trial balance I
think it is very simple, opening stock this goes in P and L account as a expense, is it
done. So, please complete the exercise and then I will show you the solution So, P and L
account is now to be made in two parts, the first part is known as trading account.
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So, we have recorded sales, opening stock, purchases the balance is called as gross profit
which is 65000. Since, there is no closing stock you do not find here closing stock, if
there would have been closing stock it would have come here.
Then there is a listing of all other expenses, so gross profit is 65000, you list out all the
expenses and you get net profit of 30300. As the name suggest as I told you it is not for
any company, so it’s not in a particular format, but it is just given for you to understand
how to make a simple P and L.
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Then we go to balance sheet; balance sheet you know has to two side’s assets and
liabilities. On asset side we have recorded motor vehicle, machinery, debtors and cash,
capital and trade creditors. The net profit 30300 from P and L is to be carried in the
balance sheet, we have already discussed that profit represents the owners funds, this
amount belongs to the owners that is why it is shown below the capital.
I hope it is now clear to you how to prepare a very starting point; a simple P and L and
balance sheet, in coming sessions we are going to make P and L and balance sheet for
various types of companies taking the actual data from the balance sheets of companies.
This was basically a starting point for you to understand how a simple P and L and
balance sheet can be made from the trial balance. I hope it is clear to you, so we will stop
here. Namaste. Thank you.
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Lecture – 25
Zee Case: Profit & Loss and Balance Sheet
Namaste. In last few sessions, we have been discussing about various conceptual and
theoretical aspects. So, we have already discussed about corporate governance,
accounting standards, evolution of accounting and so on. Now let us go back to the
problem solving. The way earlier we have introduced ourselves to balance sheet P and L
and cash flow, now let us take the actual cases and try to prepare both balance sheet and
P and L.
So, today we are going to take case of Zee TV Zee entertainment television and I think it
will be interesting for you all. So, all I have already shared with you the case I will
request you to take a print out in front of you and solve the problem along with me so,
that you can actually prepare the balance sheet as well as P and L.
So, as we discusses in the video, you are expected to do it with you. If you do not have a
print out right now, you can stop the video, take the print out, be ready and then see this
video; then it will be more useful to you. Are you getting me?
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The link has already been shared with you that will help you to actually work on this
particular case live. Now there are two parts, both the jumbled balance sheet and P and L
has been given to you. So, the sequence is not as per the formal or the official sequence.
You are suppose to put it in the official sequence calculate the profit and prepare
complete the preparation of P and L.
3 year data is given to you for March 17, 16 and 15. So, that you can have a
understanding of comparison; how the trends have happened in the last 3 years.
Gradually this will help us to move to analysis because in coming sessions, we will
calculate various ratios and discuss about analysis of financial statements. But as of
today we will not go into analysis, but just keep on looking at figures for 3 years so, that
you can understand the trend.
So, are you prepared? Take the sheet in front of you. We will start with the P and L
account, you can have a look at P and L. This is the depreciation and amortisation is a
first item. This column is specially kept for writing where a particular item will go. If
you do not remember what are the items in P and L, just have a look at the format. It is a
very simple format, we start with the income, we reduce various expenses, then we get
profit before tax, then we will record various items related to tax. There are few more
items as per the format and finally, you get the profit ok.
So, for each item read the item; if there are any queries, you can discuss it in the
discussion forum. I will try to solve their query your queries right away and based on that
based on the understanding of what that item is try to put it in a format in a at a particular
place. So, P and L account for Zee TV for last 3 years, the first item is depreciation and
amortisation expenses.
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As you all know, it is a very simple item; already it is given that it is expense. So, we
will put it under the head of expenses like that we will go on putting for every item. Next
is other income as the name suggests basically it is a income. So, I will put I am putting
it as I, tax for earlier years; this is the item related to taxation.
So, what could have happened is some item of tax is related to earlier year, but the
assessment of tax has been made in the current year that is why it is coming in the
transactions today. You can have a look at the amount; the amounts are relatively small
5.40 in the March 17 00 in 16 and minus 1.88 in March 15. Why it is minus? Perhaps
they have received some credit for extra amount paid earlier as a tax ok. So, taxation is a
under the expense head that is why the amount has come as negative.
Other expenses as the name suggests it is an expense. So, mark it as E finance costs
again it is an expense, deferred tax this is a tax related item. So, we are marking it as T.
What do you mean by deferred tax? I think you all remember that there are two types of
taxes; current tax and deferred tax. When the tax is required to be paid in the same year,
we call it current tax. If deferment is allowed; that means, tax relates to this period, but it
is to be paid in 2nd 3rd or 4th year or later, we call it a deferred tax, but both are charged
to P and L. So, under P and L we will just mark it as T. Other operating revenues this is a
revenue item so, it is a income.
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So, I am marking it as I, imported raw material this is a tricky item it is to be given as a

foot note. It is not a part of P and L, it is an additional information Zee TV being a into
the services luckily there are no raw material inputs. So, item is 000, but still I have put it
here and we are putting it as NA. So, that you understand that this item should not come
in the normal course.
Next is exceptional items credit. So, we are putting it as exceptional items because if you
remember after the regular items, we have to separately show exceptional and extra
ordinary items. So, I have marked it as EXC to differentiate it from normal expenses. So,
exceptional items are of credit nature 47 in the current year, 00 in the earlier years,. Are
you getting?
Next is MAT entitlement credit. Now what is this MAT credit entitlement, first of all
what is MAT? Full form of MAT is Minimum Alternate Tax. As per the Indian tax laws
under income tax, suppose the tax is as calculated are less than the book profit by a
certain percentage. See there are two sets of profits; one is the profits which we normally
calculate that is called as a book profit. For the tax purpose, we calculate separate profit.
Now, if the taxation the taxable profit is much lesser than the normal profit government
says that you at least pay some minimum tax that is normally calculated at 18 percent of
the book profit. Are you getting me? Suppose book profit is 100 that is from P and L
account the profit is 100, but for tax purposes the profit is only 10. Can this happen?
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Answer is yes because depreciation may be higher some expenses may be higher in
taxation and certain incomes may be exempt for tax purposes that is why as per as P and
L is concerned, the net profit may be 100, but the taxable income may be only 10.
That means, you will pay tax only on the income of 10. That is in such scenario
government says that based on whatever tax whatever profit you have calculated, at least
18 percent of that should be paid as a tax and that tax is called as Minimum Alternate
Tax. The amount which you are paying, you can get credit later on.
Suppose in some other year let us say that now your profit is 20, but for income tax
purpose the profit is higher; let us say 50. So, for book purpose or for P and L account it
is 20, but income tax is higher in that year you will be paying tax on 50. You have
already paid extra tax as MAT Minimum Alternate Tax that tax you can get credit now
that is why here you can see an item known as MAT credit entitlement. So, 0 in the
current year, 0 in earlier year, but in 3 years before it was minus 148 because it is a credit
entitlement. Are you getting me?
Now this will fall in the taxation type of item so, right now I am putting it as T. Next is
equity share dividend. So, you can see all the 3 years consistently the company is paying
dividend of 216, it will be in which type; is it a income or a expense? Actually it is
neither it is neither income nor expense. This is called as appropriation of profit after the
profit is calculated it is distributed to the owners, so, it is called as appropriation of
profit. So, I am just putting it as APP.
This particular categorization I E T etcetera is for our own calculation; it is not under any
law just for understanding. So, APP stands for appropriation of profit operating and
direct expense this is an expense head. So, we are putting it as E, tax on dividend. Now
what is a meaning of tax on dividend? Whenever company pays any dividend, they have
to pay tax on the amount of dividend paid.
Keep in mind this is different from the income tax. On the profit earned, you have to pay
some tax that is a income tax. Now profit before tax minus tax, you get profit after tax,
on from that PAT you pay dividend, on that dividend you have to pay some extra tax that
is called as tax on dividend. So, this does not form part of the normal taxation. This is a
part of appropriation of profit ok. So, it goes along with dividend so, you put it as APP.
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Next is preference share dividend where will it go? Again it is a type of dividend. So, we
are putting it as APP, you can see in the current year it is 0, last 2 years it is 121, 121.
Are you getting me? Any doubts? Once again, I am repeating please solve it with me
take a sheet in your hand and go on marking the items, later on you can prepare P and L
account. You can pause the video and actually prepare the P and L, I will show you the
solution; you can cross check the solution getting it.,
Next is employee benefit expense, this is one of the expenses. So, let us mark it as E.
Current tax, we have seen there are two types of tax. Here we have we had seen deferred
tax; now this is a current tax. So, this is a T type of tax type of items. Indigenous raw
material actually this is not an item to be shown. So, we are here imported raw material
and now indigenous raw material. This is just a extra disclosure. So, we are just putting it
as NA it is to come as a foot note.
Revenue from operations, this is the main income for the company. See this is a TV
company. So, for a manufacturing or a selling company the main income is sales, but for
a service company the main income is revenue from operations; you can see this 3 years
income is given. You can also calculate the trend, you can calculate various ratios, but
right now we are just marking it as I. So, we have now marked all the items.
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Now, based on this items, you are required to calculate the following total operating
revenues, total revenue, total expense, PBDIT the full form is Profit Before Depreciation
Interest and Tax, then PBT, PAT, earning per share and equity dividend percent. Are you
getting?
So, now we have noted everything before I go to the solution I will request all of you to
solve it, prepare P and L account also calculate this items and then we will see the
solution. You can pause the video for the time being so, that you can complete and verify
the solution. Now let us go to the solution, I hope you are able to solve it.
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Now, cross check it. This is the actual published financial statement for Zee TV, its starts
with revenue from operations, then other operating revenue, you get total operating
revenues.
If you remember this was one of the items which was asked, then other income. What is
a difference in other income and operating revenue? Operating revenue comes from your
day to day business, from your profits, from your regular business. What is coming from
regular operations is revenue from operations. Apart from that, but related to operations
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is other operating revenue and other income is something like investment income, money
which is received on investment made outside the business. So, there is a classification
between other operating revenue and other income.
Now, the total will be called as total revenue. Is it matching with what you have
calculated? Just see that trends in the revenue also then expenses.
Normally, you should write it in this sequence there is a stated format as per the law
operating and direct expense, employee benefit, financial cost, depreciation, other
expense, total expense. Are you getting this figure? You can also have a look at that
trends, how there is a increase in income. See the employee benefit expenses have
dropped perhaps they have removed some of the employees. So, this is revenue trend,
this is expense trend.
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Now, when you compare these two, you get profit before exceptional and extraordinary
items, see the profit has gradually increased. Then there was one item called exceptional
item this 47, it is to be shown at this stage before calculating the tax taxable profit. Now,
you get profit before tax, then the tax section comes. So, you have got tax expenses on
continuing operation which includes current tax, MAT credit entitlement deferred tax,
tax for earlier years. So, total tax. This is called as total tax expenses.
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Then you get this was a profit before tax 1695, now at this stage you get profit after tax.
This is the profit or loss from continuing operation because there are no discontinued
operations for this company. So, same amount is a profit or loss for the year less. Now
you calculate the appropriations. Appropriations is dividend and tax on dividend. You
can see here equity dividend is constant, the preference dividend was constant for first 2
years, but is 0 in the current year.
Now, at this stage, we get the retained earnings for the current year which is 801.
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Now, you have to show other information. In the other information, first they have to
show basic EPS and diluted EPS. Now what is meant by EPS? This is one of the ratios,
but very important ratio earning per share. Now here you can see that the profit for the
year is 1034; this is the total profit for the company, but what shareholder say is how
much profit we like get or one share that is nothing, but earning per share.
So, the formula for earning per share is PAT divided by number of shares, I will write it
down for you. Now you will say that number of shares are not known to you, you are
right because we are just going to balance sheet. If you look at the balance sheet; in case,
you have taken a print out you can get this figure, but we will calculate it once we do the
balance sheet. So, based on this ratio, you can calculate the basic EPS and diluted EPS.
Now, what is a difference in basic and diluted EPS? See the numerator is same PAT, but
the denominator can change. In the basic EPS, we calculate PAT upon current number of
shares. For diluted EPS in the denominator we add some shares which might be issued in
future. For example, there could be some share warrants issued which will get converted
into shares at a later date. So, they are also going to be shares in future.
So, we calculate PAT plus those number of shares that is why it that amount will be
slightly less than the basic PAT so, it basic EPS. So, it is called as a diluted EPS. For this
company there is no difference in that so, both the amounts are same.
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After this companies required to report the value of imported and indigenous raw
material so, this two items are shown; imported raw material, indigenous raw material.
Then we have to show that dividend and dividend percentage. We have already shown
the dividend which is 216; you can convert it into percentage which comes to 225
percent. Now, how will you calculate the dividend percent? Has any one of you done it?
So, get the equity dividend, take the figure of equity dividend and divide it by the
number of equity shares that will give you dividend per share the way we had got
earning per share, but here it is of interest to know what is a percentage of dividend.
So, we should calculate it by the total amount of capital. So, say a dividend of 216 is
given on a capital of 1000 so, 216 upon 1000. So, here we will calculate, we will take
into account paid up capital. Are you getting? So, equity dividend you divide it by paid
up capital you will get the percentage of equity dividend as a rate so, that is 225 percent.
Are you getting it?
Now, let us go to balance sheet. Now similar to P and [laughter], 3 years figures of
balance sheet are given. Using this data, you are required to prepare the balance sheet for
Zee TV. Take a look at these items and we will go on marking each item. If you
remember the format of balance sheet, there are various sections in that like under assets,
you have got noncurrent assets, then current assets; under liability, we have got equity
followed by noncurrent liabilities and then back current liabilities.
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So, each of the item try to understand it and give some mark as to under what heading
will it fall. So, that it will become easier for you to prepare the balance sheet. Shall we go
ahead now? So, capital work in progress, now what do you understand by this? So, if you
have got some building under construction; once they are ready they will become fixed
asset, but as long as they are getting constructed, they are a part of capital WIP.
So, this is under fixed assets under noncurrent assets. So, we will mark it as NCA; NCA
refers to Non Current Assets see this marking is for our internal purposes. Next is
preference share capital, now under what will it fall? This is a type of owners fund. So,
we will put it as E stands for equity not equity share this is a preference share, but this is
under owners funds. Other noncurrent assets as the name suggests, it is a noncurrent
asset. So, we will mark it as NCA, I hope you are getting it.
So, now the time for this session is up. We will continue in the next session, but we have
just started. So, that you can take the sheet and continue it and then compare with the
answer which we will discuss in the next session.
So, we will stop here. Namaste. Thank you.
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Lecture – 26
Zee Case: Balance Sheet
Namaste. In our last session we were trying to solve a case from Zee TV. We have
already prepared the profit and loss account and now we were in the process of preparing
the balance sheet. Last time also I had told, but once again I am reminding here, it is
expected that you sit with the print out take that particular sheet and try to solve the case
along with me, then prepare the balance sheet in your own notebook and check with the
balance sheet as shown in the video.
Just to take you back we will look at the profit and loss account, we started with this P
and L, we put it in a proper format like this. This was our answer for profit and loss
account and various questions which were asked which include total operating revenue
total revenue and so on; they were calculated in the solution.
Today we are going to continue with our solution of balance sheet and we will try to
calculate debt equity ratio based on our calculations ok, so let us continue. So, we had
only done three items the first item was capital WIP marked as NCA, preference share
capital is E that is equity and other noncurrent assets is NCA that is Non Current Asset.
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Long term borrowings, this is NCL or Non Current Liability because it is long term it is
noncurrent, tangible fixed asset NCA, trade payables; this is ACL current liability.
Other current liabilities as the name suggest, they are under the head CL, short term
provisions we have discussed provisions earlier since they are short term in nature they
are also a part of CL. Contingent liabilities they should not be part of balance sheet, they
will only come as a foot note; so we will put it as NA. Reserves and surplus, this is a part
of equity, so E this is a very tricky item; I will just show you in full.
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Current investment quoted market value, where should we show it? Actually we do not
value the investment at market value; we value it at cost, but it is just given as a extra
information. So, it should not come anywhere in the balance sheet, so we will just put it
as NA; these are the tricky items you should be very careful.
Contingent assets, again NA it is not regular item in the balance sheet. Other fixed assets
NCA Noncurrent investments, NCA deferred tax assets as the name suggest it is related
to tax, but it is deferred tax, so it is a noncurrent in nature, so NCA. Other current assets
that is CA, long term provisions noncurrent liability, current investments CA, inventory
CA, trade receivables CA.
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Cash and cash equivalent CA, short term loans and advances; it is short term so current
and these are not loans give these are not loans taken. These are loans given you can get
the hint from loan and advance. So, it is an asset it will be a CA.
I will show this item in full expenditure in foreign currency this is a expense item this is
not a balance sheet item, but it is given as a foot note to balance sheet. So, right now let
us put it as NA it is not a regular balance sheet item, so not applicable. FOB value of
goods exported. What is FOB? Free On Board; board here means ship. So, for the goods
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which are exported what is a value of exports this is not a balance sheet item it is just
comes as a foot note.
Long term loans and advances NCA, dividend remittance in foreign currency; that
means, the dividend which is paid abroad in foreign currency. This is not regular balance
sheet item; it is a foot note item. So, NA see I have not added any extra items as the
items are there in the actual published balance sheet of Zee entertainment TV are
reproduced here. So try to understand, try to compare with balance sheet of your own
company. Because as I have said this is not a theoretical course, it should have an
application for the actual companies.
Next is noncurrent investment unquoted book value, so noncurrent investments are

classified into quoted and unquoted. Quoted means listed; for listed they have given
market value, for unquoted they have given book value, but this is a extra information
this is not a part of balance sheet, so NA.
Other earnings again they are earnings, so not a part of balance sheet give it as NA,
bonus equity share capital again NA it’s not a part of balance sheet, but to be given as a
foot note. Intangible fixed assets, it is a part of balance sheet it is NCA. Current
investment unquoted book value extra information NA, equity share capital face value
rupee 1 basically this is a E, this has one more use also they have given a face value.
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So we can use it for calculating number of shares. See 96 is a total value of capital each
share is of 1 rupee; that means, the number of shares are also 96 crores. When we will
calculate the EPS earning per share in P and L account, this number of share is an
important information which we need, we can get it from this. Right now you can mark it
as E because it is a part of equity.
Noncurrent investment quoted market value; quoted means listed, but this is a extra
information, so let us put NA.
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Now, all items are over. Based on these items you have to use all the information,
prepare a proper balance sheet and calculate the following. We are going to have a same
thing for our assignment as well as for the examination. So, I hope you solve it with me
and similar way it will be for your assignments and final examination as well.
So, total share capital, shareholders funds, noncurrent liabilities, current liabilities and so
on can be calculated. So, at this stage, I will request you to stop the video prepare the
complete balance sheet, calculate these items and then continue and see in the video; I
will be showing you the solution soon ok. I hope you have solved it. Now let us go to the
solution.
(Refer Slide Time: 10: 01)
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So, first part is shareholders funds which we have marked it as E under that there are two
items equity share capital and preference share capital. So, we get the total share capital
1622; if you look at the amounts, you will realize that equity share capital is constant.
So, no new issue or buy back of shares, but preference share capital has come down.
Why has it come down? There must be redemption of preference shares; that means,
company has repaid that capital and cancelled the shares; you can see this difference
right. Then reserves and surplus, you know this is accumulated profit.
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So, you get the total shareholders funds, then long term borrowings are negligible. What
does it show? This is called as it zero debt company; that means, the long term debt for
the company is almost 0, it is almost fully funded by shareholders funds. There is very
important ratio called as debt equity ratio which we will be calculating soon. This
information is useful to understand the stability of the company. Now, this for this
company, it is a very good sign that they do not have any.
Loans long term provisions is a small amount, then you get current liabilities total, then
total capital and liabilities.
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Now, let us go to assets, tangible, intangible assets, working capital, work in progress
other assets. Now here we calculate a sub total known as fixed assets, you can see there
is a raise of fixed assets in the period mainly because of other assets.
Then we have got noncurrent investments, deferred tax assets, long term loans and
advances have significantly gone down. So, they would have given advance to somebody
either that advance has been repaid most probably; it is converted into other noncurrent
assets. You can see there is a matching raise in other noncurrent asset you can see almost
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19 plus 402 more or less you are going to get this amount. Are you getting? So, some
amount given as advance is now getting converted into other noncurrent asset.
So, total noncurrent assets which include fixed assets and other noncurrent assets, then
current assets, you can see sharp price in the current investment; that means, company
has made almost an investment of 1100 crores fresh investment which is short term in
nature. There is a sharp fall in short term loans and advances as well.
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So, you get the total of current assets and then total assets which is total of CA NCA plus
CA, at this stage contingent liabilities are given immediately below the assets.
Now, you get other information which includes again contingent liabilities, CIF value of
imports, foreign exchange earning, remittances in foreign currency, earnings in foreign
exchange, the details of bonus.
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Now, this details of bonus 47 shows that out of the capital of 97 roughly half of it 47 is
coming by way of bonus which shows that the company is steadily profit making
company and they have given lot of bonuses to their shareholders. Then the information
is given about current and noncurrent investment their market values and book values
respectively. Are you getting it? So, with this we have more or less discussed this case, I
will request you to verify and once again compare the balance sheet and P and L of your
company with Zee TV.
Zee TV as I told you in the beginning is a services company, yours maybe a

manufacturing company. This comparison will be interesting and you can get lot of
insights and I will request you to get data about various companies and try to prepare
balance sheets of various types because then you can easily understand various
terminologies and also start analysing the balance sheet. So, with this, we will stop here.
Namaste.
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Lecture - 27
Hindalco Case: Profit & Loss and Balance Sheet
Nmaste To all of you. So, far we have covered detailed discussion on financial
statements, balance sheet P and L as well as cash flow. We have also considered some
cases where we have tried to prepare each of the three statements. Today, we are going
to discuss a very interesting case where for the same company we are going to prepare
all the three financial statements.
The data is already given to you, you are expected to understand each and every part of it
that is understand the terminology and then put it in the proper sequence based on the
format.
So, this is the cased of Hindalco limited, this is the leading aluminium and copper
manufacturer belonging to Aditya Birla group headquartered at Mumbai and it is the
flagship company in the metal business.
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It has the annual turnover, I will request you to open your sheet which is already shared
with you. So, please ensure that you are sitting with the printout of the given case. In
case you do not have it, you can stop the video, take the printout and then we will start
the discussion ok.
So, this is a leading company in metal business, the annual turnover is over US dollar 15
billion and employs around 20,000 people, This is the world largest aluminium rolling
company and one of the biggest producers of primary aluminium in Asia.
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With this information, now we will go to question 1 which is related to preparation of P
and L. 10 marks I have given tentatively because similar questions can be asked in the
exam or in the assignment.
Now, this is the balance sheet sorry this is the information from P and L, take this
information and start preparing P and L account. We will take one by one the item and
just try to put it in the proper section of P and L. The first one is deferred tax. Now where
will you put it? I think you all know the meaning that the taxes which are to be paid in
the current period are called current tax, but taxes on the current income, but which can
be prepared later is called as deferred tax. But in the P and L it is under the taxation
section. So, we will mark it as T right like that try to mark each and every item.
Next is other comprehensive income for the year. Where will it go? This is perhaps a
new item for a you. After calculating all other items, we have to separately show it below
the P and L. So, I will show it later on, then cost of material consumed. This is one of the
expenses in fact, this is the first item under the expense head you can just look at the
amount, since it is a leading manufacturing company. It is more than 25000 crore, it is
one of the biggest amount in the P and L account.
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Then purchases of stock in trade, what do you mean by purchase of stock in trade? See
companies mainly manufacturing, but very few item it purchases and re sales. You can
see the amount is very small, but anyway it is one of the expense items; employee benefit
expense again an expense. So, mark it as E, this is you can see amount is relatively less
because it is a large scale manufacturer 1800 highly mechanised operations. So,
employee cost is kept relatively at a lower level; power and fuel cost again an expense, it
is four it is 6000 crore.
Next one is equity shares, share capital. Where will you put it? Is it required in P and L?
Actually it is not required in P and L, this is a balance sheet item; it is just given because
we can use it for a calculation of number of shares. So, 222.89 crore is the share capital
paid up face value is rupee 1; that means, number of shares are also 2221 222.89, we will
require it for calculation of the earning per share. Right now it is not required so, we are
ignoring it or we can even say NA because this is not a part of P and L account.
Finance cost; this is an expense, depreciation and amortisation one more expense other
expenses are of course, expenses.
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Profit or loss before exceptional or extraordinary item; now this is the profit which is
calculated actually it need not be given to you, but it is given because you can recheck it
whatever calculations you have done it. So, this is the profit as calculated. So, I am
marking it as P.
Increase in the inventories now, where will you put it? It is one of the expense items, but
it is tricky item because should it be plus or minus. It can be either increasing the
expense or it can be reducing the expense. So, increase in the inventory, will it increase
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the expense or reduce the expense? Just think over it because many times mistakes
happen.
See what is happening is, we have incur the cost in the current period, but it will be used
in the next period. So, it will lead to reduction in the expense in the current period. Now
to just remind you, I am just putting it as negative; keep it in mind.
Next is exceptional item; this is going to be reported, but not with the normal expense it
will come after the normal calculation of tax. So, I have just put it putting it as
exceptional sorry exc; I will put it as. Current axis this is the part of tax segment so, I am
putting it as T.
Revenue from operations, this is the income other income is of course, then income.
Excise duty on sales, where will it come? This is one tricky item either excise duty or
GST. Now this is a part of our income though it does not actually belong to us, but since
the expenses include their indirect tax portion even the income needs to include. So, we
will put it as I.
Now, using this much of information, you are supposed to calculate the profit or loss
after tax for the year then profit or loss before tax and also EPS.
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Other things I think are simple to you. Keep in mind that after you calculate the profits,
you will also have to consider this other comprehensive income for the year ok. So, I will
wait for a moment, you can stop this video, do the calculation and then we will discuss
the solution.
So, are you ready to discuss the solution? Now we will go to the solution segment. Here
we are looking at the revenue from operations, you can see this is the standalone P and L
account; that means, it does not include subsidiaries its only for this company.
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So, first one is revenue from operations, this is in the income section of P and L, add
other income, you get the total income. What is this note number? This note numbers are
the notes numbers for the detailed note on the item. Those who are more interested, you
can go to the annual report of Hindalco and read the note that will give more details as to
how this revenue has been calculated.
Next is the expense section. In expense section, we will first take the cost of material
consume which is the biggest amount. You can see here, now I have included 2 years
figures. Though for calculation you will know only one year figure the prior years
figures are also given because you can start comparing and start understanding the trend.
You can see in two years there is about 10 percent increase in their sales revenue from
operations from 39 crore to 43 crore, the cost of material consumed has also gone up
from 21 to 25.
In fact, there is substantial increase in the cost of material. Next is purchase of stock in
trade, then next is increase in the inventory, then the next is duty on sales. Now this is a
tricky item excise duty we have included here in the expenses, though earlier I told you
that it can be in the income as well, but since this is specifically given on sales, it needs
to be included in the expense.
Then employee benefit expense, power and fuel, finance cost, depreciation and
amortisation and other expenses. So, you get total expense of 38 and 41 respectively.
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Now you can calculate the profit or loss before exceptional items and before tax. Now at
this stage we consider the exceptional item which is 325, now you get profit before tax,
then the tax expenses current tax and deferred tax.
Now, you get the profit or loss for the year. At this stage I think, you would be doing it
for the first time, we need to calculate other comprehensive income for the year. This is
not from the regular business of the company, but from some other sources it has come
that comes to 957. We have to add it after profit or loss for the year even after a
calculating the taxation related items. That gives us the total comprehensive income for
the year, and then we have to go for calculation of earning per share.
Now, how will you calculate this? I think we have not discuss the formula, but I will just
write it down right now. So, we have to take profit after tax that is the profit as we have
calculated here and divided by number of shares. In the last session, we just discussed on
it, see shareholders want to know the profit earned per share earning means profit
earning per equity share that is why the profit as is available to the owners, we divided
by number of shares. So, number of shares is known to you, which is 222. So, 2393
divided by 222, you will get this earning per share basic and diluted. So, the current
number of shares if we consider it is called basic and if we consider future shares it will
be called as diluted ok. So, this is about P and L now, we will continue with the balance
sheet.
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So, we need to calculate EPS at this stage, the total comprehensive income is 2393, but
the formula if EPS is PAT upon number of shares that is profit for the year for this
company only. So, we will take 1436 divided by 222, we have calculated the number of
shares and then we will get the basic EPS as 6.45 which is same as diluted EPS. In basic
EPS, the current number of shares are calculated and in diluted EPS in the denominator
we take what are the prospective number of shares on EPS ok.
So, we have completed now the discussion on P and L let us go to understand the
balance sheet.
Now, on the basis of information given below, you have to calculate and prepare the
balance sheet.
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Now, this is the figures in balance sheet. Once again take the sheet in front of you and
each and every item we will discuss first and then we will actually prepare the balance
sheet.
The first one is authorised share capital. Now what do you understand by authorised
share capital and where should it go? Shall we consider it as an equity or shareholders
funds? This is the tricky item often students feel that it is a shareholders fund, but
actually it is not. Authorised capital is the maximum capital which companies permitted
to raise it is not to be taken in the balance sheet as one of the items; it can be just written
as a note if required, but not to be taken in the total. So, we will put it is NA and do not
include it for the total purposes.
Other investments short term; obviously, as the name suggest it is investment, but should
I put it as NCA or as CA? It is very specifically given as short term. So, it is should be a
part of current asset and not a part of investment section in NCA. So, we will put it as
CA in other noncurrent assets it is of course, NCA noncurrent assets.
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Other noncurrent liabilities, NCL.
Bank balance other than cash and cash equivalents, where will it go? You know normally
bank balances are part of cash and cash equivalent, but here this is specifically given that
these balances are not that liquid may be because of some reason,we have a balance in
bank, but it cannot be withdrawn. So, it is not a part of cash and cash equivalent, it
should be treated as a current asset. I think this is the new item for most of you just keep
in mind.
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Borrowings; borrowings are various loans. So, it is a non current height borrowings there
are two types of borrowings given one is borrowings long term and one is only
borrowings. So, we will treat long term borrowings as NCL and other borrowings as CL.
Now cash and cash equivalents this is of course, a current asset; contingent assets shall
we treat it as NCL NCA? Will it go in NCA? The answer is no because contingent assets
cannot be shown in the balance sheet this should not be considered at all. So, I am just
marking it as NA.
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Contingent liability also the same thing these are contingent items their occurrence
depends on some uncertain event, as on today this liability does not exists. So, we will
mark it as NA do not included it in the main balance sheet they will come as a footnote
after the total is calculated.
Current tax liability made this is a current tax liability. So, it is a part of CL; deferred tax
liability not to be paid in the current year. So, this is NCL.
Disposal group assets classified as held for sale or as held for distribution to owners;
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again a slightly tricky item where will it go? So, these are some fixed assets which are to
be disposed. Say old machinery which has been scrapped which is kept in the factory,
but we want to sell it out that is why it is classified as held for sale or held for giving
back to the owners. So, though it is it could be a fix asset, right now since it is held for
sale it should be marked as a CA it is also a slightly tricky item.
Equity share capital paid up it is a equity capital. So, we will put it as E. Just compare it
with the authorised capital. See authorised capital is 235 that is the maximum amount
company can raise. But company has actually raised only 222 which we will consider as
owners fund or as equity.
Intangible assets these are fixed assets intangible in nature. So, we will mark it as NCA.
Capital work in progress this is the construction work in progress again an NCA part of
fixed asset. Intangible asset under development this is also like capital WIP, but these are
intangible assets like patent some research work may be going on right. Now it is not
ready, but it is still a part of fixed asset. So, we will considered it as NCA.
Other current liabilities; obviously, its a CL.
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Inventory CA, investment in subsidiaries where will it go? See investment in subsidiaries
not a short term investment it is a long term investment. So, we will treat it as NCA, you
can just have a look at the amount it is a substantial amount 16,000 crore because this
company is a big company in Birla group, they must be having lot of subsidiaries and
have held shares in that subsidiaries. So, it is NCA.
Investment property, I think one of the; we have not dealt with this item earlier, they
have purchased some land or some properties intended to be an investment. So, it is an
NCA, but its not a fixed asset, it will be shown under investments.
Investments in associates again NCA; what is meant by associate? The company where
we hold more than 51 percent share is a subsidiary. If you hold less than fifty one, but
have a dominating interest in that it will be considered as an associate company, but right
now you just mark it as NCA.
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Liabilities associated with noncurrent assets or disposal group classified as held for sale
or as held for distribution. Again these are the liabilities, but these are related to some
assets which are held for sale. So, we will not classify them as NCL, they are also short
term in nature. So, we will classified as CL.
Current tax assets as the name suggest its the current item. So, let us mark it as CA,
something like advance tax paid to be settled in 1 year. Loans given long term so, it is
NCA; loans given short term short term as so, in mark it as CA. Long term provisions is
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a long term in nature. So, it is a liability, but a noncurrent liability NCL.
Noncurrent tax assets net so, it is a tax asset, but noncurrent in nature so, NCA.
Other current assets; obviously, CA, other current financial liabilities they are current in
nature. So, we will mark it as CL, they are financial in nature. So, they are not like trade
creditors, they could be some loans raised or some finance is less, but for a short term
period. So, we will mark it as CL.
Other equity as the name suggests its an equity. So, we will mark it as E. Now what is
this other equity mean? We already have been given share capital which is 222 and this
is the substantial amount 49000 crore. So, what it can be? These refers to the reserves
that is why they have marked it as other equity. So, we will put it as E. Other financial
assets; as they are financial in nature they are likely to be long term. So, we will call it as
NCA.
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But there is a trick there are two items given here, again we get one more item as other
financial asset long term; that means, this particular item is long term and this item is
short term. So, let us mark this as NCA because its long term whereas this will be
marked as CA.
Other financial liabilities long term; since this is a financial liability, but long term in
nature we will call mark it as NCL.
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Now, perhaps you have to check whether there are any other financial liabilities, but
which are short term. So, let us go back and check, here you can see here there were
some other current financial liabilities which we are correctly mark them as CL and here
we have got other financial liabilities long term. So, we have marking it as NCL. Other
investments; since these are investments; these are not current investments they already
have given some current investments which we had marked earlier if you remember.
There were some current investments see other investment short term which were
marked as CA and this one is other investments short it is not given its short term. So,
most probably it is long term. So, we will mark it as NCA.
Now, property plant and equipment these are referring to fix assets, its NCA. Trade
payables as the name sorry provisions; now have we already considered long term
provisions? If you go back, you will realise that there were long term provisions given
earlier marked as NCL.
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So, this provisions are likely to be short term we will mark it as CL. Trade payables;
obviously, these are related to trade. So, CL trade payables long term. So, this is NCL.
You can see most of the trade payables 5000 crore is short term only a small amount is
long term which is 24. And trade receivables it is a regular current assets so, CA.
So, we have marked all the balance sheet items, now based on this you are required to
calculate current assets, current liabilities, NCA, NCL, total equity and calculate debt
equity ratio. So, we will stop here and in the next session I will be showing you the
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solution, I hope you are able to complete it till that time Namaste.
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Lecture - 28
Hindalco Case: Balance Sheet and Cash Flow Statement
Namaste. In our last session we had started a detailed case on Hindalco limited, we have
already prepared their profit and loss account. And, if you remember in the last session
we had done a discussion on balance sheet and you were to prepare a complete balance
sheet and we were to discuss the solution today. Those of who have missed the session,
once again I will request you to download that case take that problem try to complete it,
and then have a look at the solution because today we will be discussing the solution of
balance sheet. Are you prepared let us go there? Ok.
So, now the marks items which were marked under NCA or CA you have to put in the
proper format and have a look at the solution.
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So, under assets NCA noncurrent assets, first fixed assets are shown. So, we always
follow the order of permanence. So, most permanent asset is perhaps property, plant and
equipment and this is the note number those of who really want to know more details,
you can go to Hindalco annual report shake the note number 2 for more details. The total
amount is also very big, it is 39,999 crore.
Next is capital work in progress they have not given any note for it, the total amount is
also relatively small it is 736. Investment property perhaps in our earlier balance sheets
this was not there that is 9. Then intangible assets there are also intangible assets under
development. So, these items together actually formed the fixed assets of the company.
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Then under NCA the next category is financial assets. So, these are long term financial
assets mainly the investments. So, investment in subsidiary you can say see is the biggest
amount 16,000 crores investment in associates other investments. Then loans given and
other financial asset; this is more refined and more latest terminology used in by the
bigger companies.
So, have a look at this balance sheet carefully; then non-current tax assets. So, these are
mainly deferred tax assets for which they have not given any note, but the total amount is
given and then other non-current assets which is 861. So, at this stage you get the total of
total NCAs.
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Now, let us go to current assets, inventory after inventory other assets have been
nomenclature use for them is financial assets. So, you have got other investments short
term which is also a substantial amount 3700 crores, trade receivables, cash and cash
equivalent, bank balances other than cash and cash equivalent see this is also a current
asset this is also a current asset then why it is classified separately?
It is classified because it will make difference in the cash flow statement, that is why you
have to note that all bank balances may not be C and CEs. Normally, we say that bank
balance is the cash equivalent which is true, but if there is some exception it needs be to
separately shown that is how they have shown it.
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Then loans given short term other financial assets. So, this is the total of financial assets
from 7 from this item to this item. Then next you get current tax assets and other current
assets.
So, this is the total of CAs and 8,2000 crore is a total of both 60 plus 21 that is non-
current plus current getting it.
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So, this is the asset side now, let us go to the liability side. In liability side the first item
return is authorised share capital although keep in mind that this is not to be taken in the
total. It is just written their by way of a note, do not mistake it to take it in the total; it is
the breakup of it is given like this. Share capital which is paid up 222.89 which should be
taken in total and other equity which is 49.227. So, you get 49450 as the total of equity.
So, other equity the note is given which mainly consists of reserves and surplus, but they
have used a different nomenclature.
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The next is liabilities, within liabilities you have got non-current liabilities in that again
financial liabilities. So, financial liabilities you can see the liabilities how they are
separated here, within NCL financial liabilities are given separately and provisions and
tax liabilities are given separately. Because they arise from business whereas, financial
liabilities are in the nature of raising of funds now we have learned cash flow statement.
So, something coming from financial liability will go in the cash flow statement as a
which item? As not as a operating item it will be treated as a financing item that is how it
has been properly classified. For smaller companies often you may not see this
classification, but since is a very big company it has used more latest format.
So, borrowings that is the loans is the biggest amount note number 18A, trade payables
which is relatively very small; that means, they do not have much of credit purchases got
it because their purchases are big, but trade payables are very small. If you go for
comparison with assets, they have got substantial amount of trade receivables, but trade
payables are very small. Are you getting it? Please note this because these are non-
current in nature that is very small. Regular trade payables are is a very big amount ok,
but we will come to it.
But so, this is a non-current trade payables which is a small amount, then other financial
liabilities, then we go to long term provisions deferred tax liabilities and other current
other noncurrent liabilities. So, total NCL is 2328.
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Then we will go to current liabilities borrowings current liabilities in that financial
liabilities; borrowings trade payables and other current financial liabilities; now
provisions and other current liabilities current tax liabilities.
So, total CLs are 12 whereas, total NCL was 20 plus equity.
So, both the liabilities taken together first is taken total and then the total is 82728, at this
stage they are disclosing the current liabilities contingent liabilities as well as contingent
asset. Note number 1 is a note for contingent liabilities are you getting me? Ok. So, this
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is about the balance sheet, it looks very simple here, but compare it with the answer
which you have made if you are able to solve it correctly that is very good.
Now, let us go to the third part of the case, that is for preparation of cash flow statement
ok. So, take your sheet once again and we will go for discussion of cash flow statement.
It is a very long statement so, be very attentive, we know that there are three sections in
cash flow what are the three sections? First is operating, investing and financing in that
also operating is complicated because we have to go in a; how why because we have to
go in which method do we use direct or indirect?
We use indirect method starting from profit we do adjustments. Anyway right now the
figures are given to you, you have to just arrange them properly. And there are several
items which do not form part of cash flow they also you have to be careful. Then
unrealised loss on derivative transactions where will it go? Next is unrealised for its loss.
These are unrealised items. So, they have no impact. So, we will not consider them short
term liquid investment in mutual fund its already given that it is cash equivalent. So, we
will mark it as C; C is the marking we make here for cash equivalent.
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Sale of shares in subsidiaries for this here it is dash, but where will it go? Sale of shares;
so, it is an investment which have been sold. So, we will write it as I. Sale of property
plant equipment and intangible assets again it is I, return of capital from subsidiary it is I
its dash, but earlier years there was some figure. So, what is meant by this return of
capital? We have invested in capital in subsidiary, the subsidiary company might have
return the same, but it is a investment coming back.
Repayment of non-current borrowings; so, loans we have taken and we have repaid. So,
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it is a F type of transaction. Repayment of loans and deposits: where will it go? So,
perhaps we have taken loans and deposits and we are repaying it. So, we will treat it as F.
Repayment of financial lease liability; financial lease is one of the its a type of loan, its
one of the way of financing the company. So, it is F. Realised gain of cash flow on
hedges in OCI, this is other comprehensive income related item and it is related to cash
flow hedges so, we will not consider it right now.
Sale of investment others as the name suggests it is related to sale of investments. So, I
you can see here the amount is substantial 5000 crores.
Purchase of property plant equipment and intangible assets, this is the purchase of
investments. So, it is I. Profit before tax do we require it? Yes because in cash flow
statement we are going to start with PBT and making the adjustments. So, we will go it
and mark it as O.
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Payment of current borrowings, repayment of current borrowings; normally borrowings

we treat as F, but since these are current borrowings we will treat it as O. Then proceeds
from issue of equity shares, it is F type of transaction it is a financing transaction tree
you can just read it full including share application money. So, share application money
received or return both will be also part of financing transaction.
Pre payment of noncurrent borrowings, this is a big amount company had taken some
loan, but it is noncurrent in nature it has been prepaid; that means, if the loan is taken
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for 10 years they have repaid it within 8 years. Still since it is noncurrent in nature it is
for raising of funds. So, we will mark it as F. Payment of direct taxes net of refund this is
O because taxes is treated as a operating item. If you remember the format we will
calculate first all items and at the end we write the payment of taxes.
Non other non-operating income or expenses where will it go? Since it is non-operating
many times we feel that it may not be O, but since it is income or expense it should be
treated as O right now since it is dash we can ignore it.
Novation and restructuring of long term borrowings: where will it go? What is meant by
novation first of all? That means, existing loans the terms of loan are changed. Suppose
the loan is taken for 5 years maybe it is changed to 8 years, some type of obligation or
some mortgage under it might have change, the loan terms have changed that is called as
novation and restructuring of long term loans where will it be marked as? Should it be an
F item? There is neither any repayment nor any new loan taken. So, this is a non-cash
item it should not come in the cash flow statement. So, we will mark it as NC.
Loans and deposits given we have given loans, we are not sure whether as investment or
as a borrowing, but since the word given is used we will treat it as I. Liabilities no longer
required written back; that means, some liabilities existed those liabilities have exhausted
now. So, we will have to write it back; that means, they would be taken back to P and L
account they are no longer existing as a liability. So, under which head we will put it as?
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It is a non- cash item. So, we will put it as NC.
See we have not repaid the loan it is just written back. Investment in subsidiary it is I,
interest received its a simple it is when we make in investment we receive income as in.
So, we will put it as I, interest income that is also I.
Increase in non- financial liabilities, this is only increase in liability. So, should we
ignore it or we should take it? Increase in trade and other payables increase in inventory
should we take it? We should because it is a part of operating item we know we start
with PBT do adjustments for non-operating items then do adjustments for working
capital items.
So, working capital items like trade, debtors and creditors they should be considered
under O either you mark it as working capital or you can mark it as O right now I am just
marking it as O. Increase in inventory also is O increase in financial liabilities also is O
finance costs.
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Finance costs is of course, F item, but this is again tricky; you can see finance costs
finance cost paid. So, we will consider basically the finance cost paid not just the finance
cost. Now, fair value gain on modification of borrowings; so, they have obtained some
loans, those loans have been restructured and there is some fair value go gain on it, it is a
non-cash transaction. So, we will not take it we will just mark it as NC.
Employee share option expenses what is employee share option? Employs are issued
shares either as free or at a discount which they can convert into equity shares. This is to
incentivise the employees, but for us right now it is a finance item or it is a O type of
item it can go either way, but we will mark it as O. Dividend received we have received
dividend. So, it is a investment income we will mark it as I.
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Dividend paid including dividend distribution taxes, this is a F. Dividend income we

have received the dividend. So, we will mark it as I, you can see the amount is coming
two types dividend received dividend income. So, do not take it twice we should only
take the amount which is actually received. So, I will just cut it to avoid the confusion.
Same way here we had interest income and interest received. So, we should go for
interest received. So, I will just cut it otherwise later on there will be a confusion then
dividend income. So, we have then depreciation and amortisation should it be
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considered? Yes because it is a non-cash expense we add it to PBT. So, mark it as O.
Deposit with bank with less than 3 months of initial maturity this is a deposit with bank.
So, insignificant risk the maturity is also very small so, we can consider it as a cash
equivalent. So, we have marking it as C.
Decrease in trade and other receivables, this is a working capital item let us mark it as O.
Decrease in non-financial assets again let us mark it as O.
Decrease in financial assets this is also O, cheques and drafts in hand. Cheques and drafts
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being a day to day item as a part of bank balance this is a cash and cash equivalent. So,
we will mark it as C. Cash on hand again it is C balances with current accounts in banks
again it is C. Bad debts and provisions for doubtful debts should we consider it?
It is a non-cash item, but it will have impact on P and L. So, we will mark it as O.
Acquisition of property plant and equipment by means of a non-cash government grant.
This is the acquisition of property so, it looks like I, but it is since it is by means of non-
cash government grants, we will not consider it as a cash flow item we are marking it as
NC.
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Acquisition of property by means of financial lease; acquisition is being made by lease,

but still it is a acquisition in cash terms so, we will mark it as I. Loss of PPE; PPE refers
to property plant and equipment and intangible sold or discarded; that means, old fixed
assets are being sold or discarded we have received some small amount of cash. So, it is
a I.
Gain on investments measured at FVTPL that is by fear value calculation the investment
show some gain, but not a cash can transaction because it is not a sale of investment. So,
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we will ignore it. Cash on assets held for sale sorry loss on assets held for sale shall we
consider or ignore it? We will need to consider it because we are following indirect
method. So, this is a non-operating type of losses. So, we will mark it as O we will add it
to PBT.
Now, cash and cash equivalents as at the beginning net cash generated or used in
operation. So, you are required to calculate all this figures, opening cash, the cash
generated from operating activities, then cash generated from investing activities, cash
generated from financing activities, total decrease of cash operating profit before
working capital changes and cash and cash equivalent at the end of the year.
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Now, how will you do all the things? It is possible because cash at the end of the year is
you can take it from balance sheet, then do all other calculations and by reverse working
you can calculate the cash at the beginning of the year. So, are you ready now to prepare
the cash flow statement? So, you can pause the video here complete the calculation and
right away we will discuss, talk about the solution.
(Refer Time: 25:24).
I hope you are ready with the solution. So, I will show the solution to you.
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Just try to understand each and every term it is a very long cash flow statement. So, we
start with PBT then adjust for lot of items.
Remember we are going to adjust for non- cash and non-operating both types of items.
So, we are adjusting for finance cost, depreciation, employee share option expenses mark
this is a very peculiar item because its a share related item, but since it is a employee
related item we show it under O not under F. Then bad debts, long term provisions no
longer required written back see mark the sign also its a negative because it is a profit to
us we are now reducing it.
Then unrealised FOREX losses, unrealised gains these are not directly cash flow items,
but since they have an impact on P and L we are considering them here. Then fair value
gain on modification of borrowings again it is a non-cash item, but since that gain was
included in P and L we have included it here as a negative item Gain or loss on assets
held for sale gain or loss on PPE interest income, dividend income, mark it the items
were given two times earlier.
There was interest received which will be an investment item, but interest income it is a
operating item. Then dividend income non-operating income or expenses realised gain
on cash flow hedges in OCI. Now, this is again not directly impacting our cash, but it has
a impact on our P and L and it is a gain. So, right now we are showing it here, then loss
on investment held at FVTPL that is also in a way a non-cash item, but has an impact on
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P and L. So, we are considering it under O.
Now, after all these we get operating profit before working capital changes, then we will
consider all the working capital changes like increasing inventory, trade another
receivable, financial assets, non-financial assets increase in trade and other payables
financial liabilities non-financial liabilities.
So, we at this stage get cash generation from operations, then payment of direct taxes net
of refund. This is the actual tax paid, we get net cash generated or used in operating
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activities. I know its bit longish, but read it 2-3 times so, that you understand how it is for
a large company, if your own company is also large one compare it with the cash flow of
your own company.
Next one is very simple now cash flow from investing activities but bit longish.
Purchase of plant, sale of plant, investment in subsidiaries, sale of shares in subsidiary,

return of capital from subsidiary, purchase on investments, purchase or sale of
investment repayment of loan and deposits, loan and deposits given, interest and
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received and dividend received mark here the term received here there it was interest
income now it is interest actually received. So, we get net cash generated or used in
investing activity. Next is financing activities proceeds from issue of shares pre payment
of noncurrent borrowing this is the biggest amount.
Since company had lot of cash you can see here there good cash generation, they have
used it for repaying their loans. Then repayment of noncurrent borrowings, repayment
of finance lease, proceeds from current borrowings which is also negative because they
have repaid it, then dividend paid finance cost paid. So, you get net cash generated or
used in financial activities which is a substantial amount, it is a negative amount this
company has repaid there old liabilities, a net increase in cash and cash equivalent which
is 2490.
Then you get net cash and cash flow as deported which is 1809, there is some
supplementary information also regarding non- cash transactions. So, just noted
acquisition of property by means of financial lease, acquisition of property of by means
of non-cash government grants, novation and restructuring. So, these three are treated as
non-cash transactions.
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Then you get the reconciliation of cash and cash equivalent, which is cash in hand, cash
and drafts in bank under bank there are two items, current account balances and short
term deposits and short term investments in mutual funds. So, here you get total. So, are
you getting it? It is big longish, but the study will be very much useful to you to
understand the terminology particularly the cash flow statement.
So, we will stop here Namaste.
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Lecture - 29
Namaste. In last many sessions we have been discussing about preparation of financial
statements, P and L, balance sheet, cash flow and so on. In this and the next few sessions
we will discuss about interpretation and analysis of the statements.
Now, there are large number of users of the financial statement, they mainly include the
owners, the prospective owners that is investors who want to invest in the company, they
also include employees, managers who are insiders may want to use the statements for
decision making, it will also include government, regulators, suppliers customers. So,
there are large number of users, and different users use the statements for different
purposes. So, they may not be interested in all information in the statements, statements
will give you assets, liabilities, income expenses, cash flows and so on.
But a particular user is interested in a particular thing in the statement, and to understand
that particular aspect you will have to analyse the information given in the statement.
The information will be just taken as a raw data, it will be analysed not only for this year
for earlier years, it can be compared with the statements of other companies or other
entities or of industry average, then the information in the statement becomes much more
useful and enriched. For that it is necessary to understand various techniques used for
analysis and interpretation of the statements.
I have been telling you right from first session that for your company download the
annual report, read the whole report, read the financial statements. So, now though it is
mainly analysis of statements, we are also going to use other information. So, if you have
still not read the whole report please read your report once again your annual report once
again so, that you know other information and we will try to understand how that
information can be analysed.
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So, we will be discussing about financial statement analysis, we have already just seen
that the information is raw data.
It needs to be reorganised and converted into relevant information as per the needs of the
user.
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There are two major types of analysis, one is known as horizontal analysis and other is
vertical analysis. Now as the name suggests in horizontal analysis we compare. So, we
take 2, 3, 4, 5 years of financial statements and convert it into a comparative statement.
So, instead of just taking the raw figure, we want to convert it into a comparative
statement and then compare it over a period of time.
So, every item is to be compared with the previous year and the change is calculated as a
absolute amount as a percentage to that base. So, what could be the base in P and L
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account, what is the base? The total revenue which be normally a base and every amount
is considered as a percentage of that total and we will compare it with last year or last to
last year over a period of time, that is called as a horizontal analysis.
In vertical analysis, this involves finding out the relationship between two items in
respect of the same year.
So, here we prepare a common size statement.
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Now, it compares each item, the base of the total is considered as 100 and then we find
each item as a percentage to the base.
In common size statement on income statement, each item is expressed as a percentage

of net sales or the total revenue. For balance sheet we take the total of balance sheet and
common size statements become very much useful not only for comparison of items
within the same company that is just the last year of the same company, but it is also
useful across the industry.
So, for example, suppose there is a small cement company and there is a large cement
company their absolute figures will be different. So, you cannot compare them in
absolute figures, but you convert them as a percentage of sales if you are comparing P
and L and then it will be compared across different companies. We are going to see a
few cases like that, so this is called as a vertical analysis. In both the cases there is a
comparison, but in horizontal analysis it is comparing for the same company with earlier
periods earlier years or quarters, and in vertical analysis we first convert it into a
comparative statement and we can compare with other companies or also with the
industry ok.
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Here also we can compare with earlier years of the same company as well.
Other method could be benchmarking. We can also convert the whole statement into a
pie chart as you can see here for company A and B, total sales as a percentage is
calculated. So, you can understand see here this part is cost of goods sold for company A
is 51 percent, for company B its 43 percent. So, A is spending much more on cost of
goods sold like that we will be able to make comparisons. Operating expenses if you
compare for A it is 28 percent, but for B it is higher.
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So, A is using more of cost of goods sold so, that is more raw material, but has relatively
lesser operating expenses while B has lesser percentage on the raw material on the cost
of goods sold, but has more percentage of operating expenses like that the structure of
the two companies is different. Keep in mind that this comparison should normally make
be made with the same industry and in reasonably similar sizes.
If you are comparing with very small company with very large company sometimes the
comparison may not be meaningful. I think you would have read segmental statements
because for large companies they are having businesses of different types. So, the whole
P and L and balance sheet is converted and is reported for each business segment and if
you want to study a particular industry instead of taking the total P and L, just take the
segmental revenue statement for the relevant segment; are you getting me? So, these are
some of the techniques used for comparison; now, we will go to the most important
technique that is called as ratio analysis.
There are large number of ratios which can be calculated. In fact, any figure can be
compared with any other figure and we can get more and more ratios, but we are going
to discuss some important ratios and how these ratios can be interpreted.
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First of all what is a ratio? This is relationship between two or more items in financial
statements example is net profit ratio. So, everybody is interested in profitability so, we
can calculate the profit in P and L account. In fact, P and L account is meant for that, but
to understand the profitability only calculating the profit is not enough.
For example if we get this information that profit of company A is 65, company B is 45;
so, which company is more profitable? Only on the basis of these perhaps most will say
that A looks profitable because their profit is much more than that of B. If we get the
information of sales also, now what do you get? You realise that A is able to make a
profit of 65 on sales of 650, B is able to make profit of 45 on sale of only 300; that
means, if you just take a percentage here you will realise that, profitability of A is 10
percent while profitability of B is 15 percent. So, B’s business is actually more profitable
than that of A. This is the insight which ratios give; absolute figure like these often can
give you a kind of information which may be misleading.
So, any figure in the financial statement needs to be seen in relation to others, that is why
ratio analysis is a very very important technique we have seen variety of stakeholders, all
the stakeholders find ratios very much useful and variety of ratios can be calculated ok.
So, we have just discussed this.
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Now, this is not just comparing the financial statements, the different numbers in
statement we can also do variety of comparisons. Because see absolute figure cannot be
compared, but a relative figure can be compared that is why once you calculate ratio you
can compare it with previous years, you can compared with peers with industry averages
and so on, that is why much more insights can be drawn from ratios then what can be
drawn from raw statements.
We have just discussed these that number of stakeholders have interest in variety of
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information; particularly for example, performance. So, people want to know not only
present performance, past performance and likely future performance for that ratios are
very much useful. Because financial statements only give you the information about the
current state; you calculate the ratio compare it with the past. So, that we know the past
and present performance, beyond that we can use the ratios for doing projections because
using ratios, we can calculate the probable position in future; of course, based on some
assumptions that is why for performance evaluation of future also this is useful.
We also to come to know about strengths and weaknesses of the company because we
can compare with peers and with industry average. So, we know that compared to other
company our profitability is good or compared to other company our operating costs are
less or compared to other company we can see that our advertising costs are less.
So, we can take a decision there that is there a necessity to advertise more spend more on
advertising increase our sales? We can see that in a particular segment our market share
is less. So, is there a possibility to push more in that market segment? So, like that
variety of decisions also can be taken. Sometimes if we collect information about
operations, let us say that our transportation costs are less that is a strength, but our
packing costs are more. So, is there a scope for going for a alternate packing like that
number of decisions can be taken if we have information for if we calculate the ratios
carefully.
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Now, ratios can be classified in variety of ways as I told you hundreds of ratios can be
calculated for different purposes, but here we are going to discuss mainly the ratios
which are calculated from financial statements. But when we come to solving the case
we will consider other ratios as well, let us in the beginning understand the ratios which
are calculated from financial statements. So, first one is liquidity ratios.
Now, what do you understand by liquidity? As the name suggests, this is about
availability of cash or liquid money with the company. So, we will calculate certain
ratios wherein we can comment on liquidity. Then we have got capital structure, leverage
activity, profitability, return and so on let us look at each type of ratio.
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Now, one of the most important ratio of liquidity is current ratio. This is extensively used
not only by shareholders, but by managers, also by bankers by suppliers and so on. This
is a simple ratio current assets divided by current liabilities. So, all the current assets are
total, all the current liabilities are total and you get a relationship which is known as
current ratio.
where,
Current Asset (CA) = Inventories + Sundry Debtors + Cash & Bank balances +
Receivables / Accruals + Loans & Advances + Disposable Investments
Current Liabilities (CL) = Creditors + Short term Loans + Bank Overdraft + Cash Credit
+Outstanding Expenses + Provision for Taxation + Proposed Dividend + Unclaimed
Dividend
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This tries to answer this question that whether business has enough current assets to meet
its current debts. So, what should be the ratio? What is what how much ratio is required?
It becomes obvious that your current assets should be at least equal to current liabilities.
But normally based on conservatism, the acceptable ratio is considered as 2 is to 1.
But it may change significantly from the nature of business and also from the
characteristics of CA and CL.
So, for example, if company A has current ratio of 2.5 and company B has current ratio
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of 1.5, can we say A is better? Normally yes, because they are able to have current assets
of more than 2 is to 1, but sometimes it changes by the nature of business which
businesses would need more current asset and which need less current assets; can you
just give a thought.
Suppose one company is a manufacturing company, the other company is a service

company which will have more current ratio? Normally manufacturing company will
need much more current ratio, because they have raw material stock, work in progress,
finish good stock, many times they also have more of finish good, they have raw
material, working progress, finish goods and even large quantity of debtors. Because
when they sale they do not realise the cash immediately whereas, a service company may
have less current ratio.
For example if you think of railways, what will be the current ratio of railways? The
current ratio will be very less because they do not have to give any they do not have to
have any daters they are not giving any credit. In fact, passengers book the money put
the money book the tickets in advance. So, perhaps there current assets can be negative
so, their current ratio will be very less. So, it changes from the nature of business, it also
depends on characteristics of CA, CL like we were talking that company A may have 2.5
company, B may have 1.5.
But if company A has very large quantum of inventories, which have become old
inventories they have out dated inventories and they cannot be traded easily or sold
easily then the quality of their CA is in question. Or if they have large quantum of
receivables which are not being it is not possible to collect them easily. Suppose they
have given some they have sold goods to let us say to Malya, and Malya is absconding
can you collect that money? It is very difficult the company would have become
bankrupt, but still if the amounts were shown in their current assets, then the quality of
current assets become questionable that is why it is said that it depends also on the
characteristics of current assets.
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So, to go more in deep another ratio is calculated that ratio is known as quick ratio or
sometimes it is called as acid test ratio; now the formula is quick asset upon quick
liabilities. So, in current ratio it was current assets upon current liabilities, in quick ratio
we have adjusted the current assets by reducing inventories and we have adjusted current
liabilities by reducing bank overdraft.
Where,
Quick Asset= CAs - Inventories

Quick Liabilities= CLs - Bank Overdraft
Now, what is the logic why is inventory is reduced? Because normally inventories are
not quick in nature, it takes a long time to convert them into cash. Because first of all we
will have to make sales, then if it is a credit sale it will get converted into debtors and
after the cash debtors are collected we will get cash. That is why, any in liquid asset in
the current assets; all current assets are supposed to be liquid within 1 year period, but of
that those which cannot be easily converted there should be reduced. That is why
something like inventories reduced, part of your debtors are slow moving debtors, they
should also be reduced then we get quick assets. And for quick liabilities we consider
almost all current liabilities except those which do not have to be repaid immediately.
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In case of bank overdraft it is a facility which is sanction for 1 year and normally
company may not have to repay it in a shorter period of time that is why quick liabilities
generally are considered as CL minus bank ODE. I am saying generally again and again
because this depends on the users. Keep in mind all ratios these are not calculated as per
any accounting standard this is not prepared by our own company other people are
judging our company. So, as per the needs of the user they calculate ratio so, we have got
hundreds of different ratios and people can use different formulas. But the formulas
which are normally used are being discussed in the class.
Now, quick ratio is a quiet conservative measure than current ratio so, what we are
calculating here is a immediate solvency of the company. In current assets we were
calculating overall solvency or ability to meet current debt, in quick ratio we are looking
and trying to check their ability to repay the immediate debt. So, the ideal current ratio is
1 is to 1, normally this is irrespective of nature of business because for any business you
would need enough quick assets to meet at least quick liabilities ok.
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So, first two ratios where mainly for short term stability of the business, now let us look
at the long term stability, which is also known as capital structure or leverage. If you all
know that if we analyse the sources of funds, there are two major sources of funds one it
comes from owners, other it comes from lenders. It can be in the form of equity or it
second one is normally in the form of loans or debentures.
So, if company has to raise 100 rupees, they can either raise 100 of equity no debt maybe
80 of equity 20 debt, 50 of equity 50 debt. So, these three companies have a different
capital structure. Now we calculate variety of ratios to know the capital structure of the
company now is it good to have more equity or more debt? Which one will be lasting
with the company for a longer time, you will realise that equity need not be repaid
immediately whereas, debt has to be repaid as on a due date that is why having more
debt is relatively more risky. So, from a stability view point higher equity is better.
Now, we will calculate different ratios we seek to measure the percentage of equity at the
same time if we have too much of equity and no debt it negatively impacts profitability.
So, company has to seek a balance between fair amount of equity and debt, let us look at
the ratios.
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So, from the capital structure angle these are the ratios which gives insight into long term
solvency position of the company.
The first one is equity ratio. As the name suggests the total capital employed is the
denominator and we see what percentage of capital employed is being funded by the
equity or by the owners fund. So, it is popularly known as equity ratio.
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Now, complementary to this is a debt ratio. So, debt ratio seeks to find total debt as a
percentage of capital employed. So, see denominator is same for both, the money which
is either equity or debt is taken in the as a capital employed, in the first ratio it was a ratio
of equity, the second ratio is the equity of the ratio of debt. So, we are consider the
various types of borrowings or deferred payment arrangements.
Where,
Total debt includes short and long term borrowing from financial institution, debentures/
bonds deferred payment arrangements
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The third ratio is known as debt equity ratio perhaps it is much more popular than the
first two, because here we are finding debt as a percentage of equity. So, numerator we
have got the moneys which we have to repay and denominator has got money which we
do not have to repay, moneys which we have taken from debt lenders upon moneys
which we have taken from owners.
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Now, here preference capital though is a part of equity or the owners fund is taken in the
numerator, because it is required to be repaid at a certain debt. So, higher ratio will mean
more risk and a lower ratio indicates more stability. This is a very important ratio which
is seen by bankers and many other stakeholders, including suppliers and also the owners
of the company ok. So, we will stop here, in the next session we will continue our
discussion on ratios and then we will go for solving certain cases on ratio analysis.
Namaste.
507
Lecture - 30
Ratio Analysis and Interpretation 1
Namaste. In our last station we had started discussion on analysis of financial statement
and its interpretation. So, financial statements give vast amount of data, different users
can extract the relevant information. So, they may either go for horizontal statement,
vertical statement or benchmarking. The most important technique for analysis is Ratio
Analysis where variety of ratios are calculated.
So, last time we had seen these example that if you want to know about profitability only
comparing the profits does not give a fair picture. We want to know the profit as a
percentage of sales then we will have to calculate the ratio known as net profit ratio. So,
we will know that company B has more profitability than that of A as a percentage of
sales. There are variety of ratios which are calculated because different stakeholders
want different type of information.
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Now, the ratios are useful for knowing the strengths and weaknesses of the company,
they are also useful for taking decisions, they are also useful for knowing the
performance. Now, the importance of ratios is that the financial statements tell you about
the present and the past, but the ratios can be used even to project the future. So, we can
make certain assumptions, look for the past trends and make the projections for the
future that is an advantage of the ratios.
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Now, in our last session we had started discussion on first two type of ratios that is
liquidity and capital structure.
Within liquidity current ratio is the most important ratio which is used extensively, here
me want to know whether company has enough current assets to pay for its current
liabilities.
where,
Current Asset (CA) = Inventories + Sundry Debtors + Cash & Bank balances +
Receivables / Accruals + Loans & Advances + Disposable Investments
Current Liabilities (CL) = Creditors + Short term Loans + Bank Overdraft + Cash Credit
+Outstanding Expenses + Provision for Taxation + Proposed Dividend + Unclaimed
Dividend
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So, ratio normally is considered to be 2 is to 1 to be acceptable, but it can considerably

change from industry to industry. General idea is we should have enough of current
assets to meet the current liabilities and avoid any default or bankruptcy. Now, a more
conservative measure of this ratio is quick ratio, where we calculate quick assets to quick
liabilities. Then we had started looking at the long term liquidity of the company for that
we calculate the capital structure ratios.
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So, we know that there are two important funding sources one is a equity other is a debt.
So, equity ratio we seek to calculate equity as a percentage of capital employed.
In debt, debt as a percentage of capital employed.
Where,
Total debt includes short and long term borrowing from financial institution, debentures/
bonds deferred payment arrangements
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And, the debt equity ratio which is perhaps is the most common and extensively used;
debt is calculated as a percentage of equity. But, while calculating the ratio in the
numerator we take debt plus preference share capital. Keep in mind actually normally
shareholders equity includes preferential capital, but for the purpose of this ratio we
deduct it from the denominator and add it to the numerator because, though it is a
shareholders funds it is repayable within 5 to 10 years. So, it has acquired a nature like
debt. So, we add debt plus preference capital and divide it by shareholders equity minus
the preference capital got it.
So, debt equity ratio is a very important ratio where the bankers are extensively
interested. In fact, no loan is granted by any bank unless they calculate debt equity ratio.
How much debt equity ratio is acceptable? Suppose you want to buy a vehicle of 10
lakhs, how much loan bank will give any idea normally, how much loan banks give?
Banks normally say that we will finance 75 percent of vehicle; that means, what debt
equity ratio they are looking for? From 10 lakhs they will give 7.5 lakhs and owner has
to put in 2.5 lakhs.
So, what is the debt equity ratio? 7.5 by 2.5; that means, acceptable debt equity ratio is 3
like that Reserve Bank of India and the regulators fix the maximum debt equity ratio
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which bank can give and individual banks also decide the maximum. And, again from
case to case basis they can vary it a bit normally they bring it down. Suppose, the
borrower is not very sound as does not have a very strong position they can also say that
out of 10 lakhs we will finance only 6 lakhs. Then what will be the debt equity? 6 by 4;
that means, it becomes 1.5. So, norm is 3, but they can bring down maximum financing
as per the requirement.
So, debt equity ratio is a very important ratio which is looked by banker while
sanctioning any loan proposal. Other lenders also see it like non-banking companies or
leasing companies many times if a company wants to make a credit sale, they check the
customers debt equity ratio. Because, will the customer be able to repay that loan for that
both current ratio is also important, debt equity ratio is also important. In a short term
transaction current ratio is given more weight, for a long term debt equity is given more
weight.
This debt equity ratio also changes from the nature of project or the asset financed. For
example, as I told you for a vehicle normally bank gives 75 percent loan. So, the debt
equity ratio is how much? 75 by 25 means 3 is to 1. For a housing loan, let us suppose
you are buying a house of 1 crore, how much loan bank will give? Normally, bankers
finance 80 percent of house or even more sometimes, but if they finance 80 percent; that
means, 80 lakhs banks will give 20 lakh the borrower will give.
So, what is the debt equity ratio? 80 by 20 means it is 4 is to 1, many times bankers even
finance 85 percent; that means, 85 by 15. So, it is almost the ratio of 5.5 or 6. So, house
is considered to be much more safer as it than vehicle. So, they are willing to go for
higher debt equity ratio, are you getting me? Suppose some infrastructure project to be to
be started like construction of road or construction of railways, will the debt equity ratio
be higher or lower?
The debt equity ratio for such long term projects is much higher, it can be 6, 10, 15 also
sometimes for railways because, the returns from these assets are going to come over a
longer period of time. And these are much more safer and stable assets, bankers do give
much more debt equity ratio. Have you heard of subprime problem in U.S.? There was
very big crisis in 2008 known as subprime crisis.
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In subprime crisis bankers gave lot of loans to those borrowers which were subprime,
subprime means of lower quality. Bankers went on giving more and more debt equity
ratio that created very big problems of non-performing assets that is known as subprime
crisis. Those who are interested you can type subprime crisis in Google, lot of articles
will come and you will get more information right now we will not discuss more about it,
but what I am trying to tell is debt equity ratio is very important. If the debt equity ratio
is violated by bank, bank start giving more debt equity ratio it going it gives a problem to
the bank in the long run.
It also creates problem to the company, if the debt equity ratio is high because you are
taking more and more risk when you are going for more and more debt. The company’s
which has stable assets like more land and building can have more debt equity ratio. But,
if companies are like service sector companies or it companies they must have lower
debt equity ratio. For example, many it company like Infosys in fact, are called as 0 debt
company, they have no debt at also. So, 0 debt equity ratio is a basis they go for later on
we will see some cases of the companies. Now, the next type of ratios are known as
coverage ratios.
We were discussing about the bankers so, bankers want to decide on maximum debt
equity ratio, but they also look at whether the interest which is going to be repaid is
covered by the income or earnings of the company.
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Now, the fixed claims are like interest on loan or preference dividend or the repayment
of instalments. So, important ratio which is mainly considered by bankers is debt service
coverage ratio.
So, the numerator is earnings available for debt service upon interest plus instalment. So,
normally net profit is available plus some non-cash expenses like depreciation are added
and some adjustments may be made for loss on sale of assets and interest on debts. So,
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this much is a money available is kept as a numerator and the instalment to be paid and
including the interest is to be kept as a denominator.
Where,
Earnings for debt service= Net Profit + Non cash operating expenses like depreciation
and other amortisation
So, bankers here we know that how many times the earning is available for repaying
their instalment whether the company has capacity to make the repayment on time ok,
that is a debt service coverage ratio. Same way one can also calculate interest coverage
ratio. So, whether the company will be able to at least repay interest for that normally the
numerator is a bit or profit before interest and tax divided by interest good.
Where,
EBIT= Earnings before interest and tax
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So, higher ratio both the debt service and interest coverage if the ratio is higher; that
means, there is a good coverage available for repayment of interest or instalment; that
means, the chances of default are less. So, bankers normally insist on at least the
minimum debt coverage ratio which they want to emphasize on.
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Where,
EAT= Earnings after tax
Same way, preference shareholders will be interested to know the coverage for their
dividend that is why preference dividend coverage ratio; now the preference dividend
can be paid only after paying interest and taxes. So, numerator now we have taken EAT
or you can also call it PAT: Earning After Tax or Profit After Tax divided by preference
dividend liability.
So, if the profit after tax is sufficient, the company will be able to pay the dividend as per
the contracted terms. So, the coverage is seen in this ratio. Now, there is one important
ratio known as capital gearing ratio.
This is very similar to debt equity ratio which we discussed earlier. So, in the numerator
we consider the preference capital plus debt and the denominator we see the owners fund
that is equity capital plus reserves minus any possible losses. So, here also if the ratio is
higher the company is considered to be more risky or it can also be calculated for a
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particular project, if the ratio is higher the project is considered to be risky; you need to a
balance too high ratio is to be avoided.
Now, the next type of ratios are known as activity ratios. They are sometimes also called
as efficiency or performance or turnover ratios because, here we calculate how better or
how efficiently the company is able to utilise their assets.
Now, the assets are being used mainly for generating sales. So, a comprehensive ratio for
this is capital turnover ratio.
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Now, we employ the capital in business to generate the sales. So, we are calculating sales
upon capital employed. A company which is efficient will be able to sell more and more
using lesser capital right. So, higher the ratio is preferable, higher ratio means they are
able to generate more turnover and most likely their profits also will be high ok. So, to
do it over all for all the assets taken together we calculate capital turnover ratio. Other
popular ratio is fixed asset turnover ratio.
So, sales again in the numerator, the denominator we are taking fixed assets or capital
assets. So, what are the long term assets used by the company and how much sales they
are able to generate. This shows the efficiency in utilisation of fixed assets, this can be
also calculated for individual asset, either it can be calculated for the whole company, it
can be calculated for a particular project or a plant, it can even be calculated for a single
asset.
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If that asset is able to generate the revenue just see how efficiently you are using the
asset. Let we consider a simple example, suppose there is a auto rickshaw driver, he or
she as a auto rickshaw let us say the cost of rickshaw is 4 lakhs. He is able to generate a
daily turnover of say 1000 rupees, what will be the fixed asset turnover ratio? Just
calculate daily turnover of 1000 rupees, normally rickshaw cannot be used for the whole
year; let us say it is used for 300 days in a year.
What will be the turnover? 300 in to 1000; that means, 3 lakhs is a turnover and the value
of fixed asset was 4 lakhs. So, 3 by 4; that means, in the year the ratio is less than 1;
assuming that this rickshaw is operated in a single shift of 8 hours turnover generated
was 1000. The ratio is 3 lakhs upon 4 lakhs or 3 by 4, now if the same rickshaw is
operated in 2 shifts so, 1000 in the morning 1000 in afternoon.
So, now the turnover has doubled, what will be the ratio? So, 1000 plus 1000 means
2000 in a day into 300 days so, 6 lakhs divided by 4 lakhs. So now, you can see earlier
the ratio as 0.75, now it has become 6 by 4 that is 1.5. So, the efficiency of use of asset
has improved, I am just giving a simple example that it can also be calculated for one
single auto rickshaw because, one asset is able to generate the turnover, same way it can
be done at various levels.
Now, generation of turnover is very important for success of company because, that is
what is going to give you profits, that is why this ratio is very important for the ability of
the business to generate the sales. Now, just like fixed asset we can also see how
efficiently business is using working capital. So now, it is sales upon working capital that
is current asset minus current liability. So, are they effectively using their working
capital, higher the ratio will be good because that shows a more or a bad more efficiency
of the company.
Now, this ratio is very interesting because if you want to study the working capital
management of the company these ratio is now subdivided into inventory turnover,
debtors turnover and creditors turnover.
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Where,
Now, this is about the inventory turnover because, there will be different units or
departments in the company looking after the stock management, debtors management,
creditors management. So, we can know the efficiency of each part of the business. The
first one here we are looking for is inventory turnover over. Now, either we can take
sales upon inventory, but more sophisticated would be cost of sales because you know
inventory is recorded at cost. So, numerator also will take at cost of sales instead of just
taking the closing inventory it will be better if we take average inventory because, we
know that on an average how much is a stock and how much is a sales generated.
So, cost of sales upon average inventory is the better or improved formula getting it.
Now, the same formula can be also converted to number of days to make it more
meaningful. Suppose, a company has let us say a turnover of 4 lakhs and has debtors of
40,000 what will be the ratio; sorry, as an inventory of 40,000 and turn over of 4 lakhs
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so, 4 lakhs upon 40,000. So, ratio is 10; inventory turnover ratio is 10, but it can be also
calculated in terms of number of days. Now, can you calculate it in number of days?
How much was inventory? 40,000, sales was 4 lakhs; now 40,000 upon 4 lakhs instead
of doing 4 lakh upon 40 which was 10 we are doing 40,000 upon 4 lakhs; that means, 1
by 10 multiplied by 365 days. So, you will get 36.5, now this is in terms of days, now
you can I think understand it better. So, company on an average holds inventory of 36.5
days.
Now, we can compare it with their inventory policy, If there policy is to keep one month
stock; that means, stocks should have been 30 days, but actually they are having 36.5
days. So, we can compare their policy with the actual and accordingly take the decisions
for improving the efficiency. Now, the same ratio can be calculated for debtors.
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For debtors what will be the formula? It is sales upon debtors or accounts receivables,
but since accounts receivables are only applicable to credit sales we can improvise it by
taking the numerator as credit sales and divide it by average accounts receivable.
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Same ratio like stock we can convert it into terms of number of days that is also known
as debtors velocity. So, instead of having debtors turnover in number of times it is better
understood if we go for number of days. Suppose the sales of the company is 10 lakhs
and they have receivables of 2 lakhs, now what will be their ratio 10 lakh by 2 lakhs so,
how much is the ratio? 5. Now, in terms of days how much it is? 2 lakhs by 10 lakhs;
that means, we get 1 by 5 into 365. So, how much it will be?
If it is more than 70 days, around 70 to 75 days roughly 72 days we can say is the
debtors, now you can really understand the gravity of the situation. Suppose, their policy
is to have credit for 30 days, they must have collected in 30 days at least in 30 to 35
days. But, here they have debtors for 72 days means almost more than a double their
policy; that means, their debtors management system is not efficient. So, for managers
they would continuously calculate this ratio and try to improve their performance. Will it
be useful to investors also or the shareholders also or the auditors also?
Answer is yes, because auditors or shareholders will also calculate this ratio when they
come to know that the policy of the company is 30 days, but the ratio is 72 days what
does it mean? There is every possibility that the debtors which the company as shown
has lot of wrong entries or false entries or there is a windowing dressing, there is a over
statement of debtors. So, we would try to investigate to find out the nature of debtors.
There are more ratios also like aging statements. So, we will try to find out that how
many days that debtors are still there with the company; like that lot of hints can be there
further investigation in that. Now, the next ratio is creditors turnover ratio.
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So, normally we take sales upon that item, but since creditors are related to purchases,
we take purchases particularly we will take credit purchases. So, credit purchase upon
average accounts payable.
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So, here also we can convert it into number of days and know within how many days we
are repaying. Suppose our normal policy is to have a credit of 30 days, but we are
repaying in only 20 days; we will have to check whether we are getting any discount for
early repayment or where our people are unnecessarily paying before time. Or, if it is too
long, investors will be interested in knowing whether there is any problem with the
company; That they don’t have cash on time therefore they are not repaying or whether
their purchases are dummy, they are showing some wrong figures in purchase, but do not
pay in time. So, this ratio is also important.
So, we have now covered the liquidity ratios, then we have also discussed the ratios like
debt equity which were about stability and now we have discussed the ratios on
efficiency. In the next session we will go for next round of ratios. Namaste.
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Lecture - 31
Ratio Analysis and Interpretation 2
Namaste. In last two sessions we have been discussing about Analysis and Interpretation
of financial statements. We have already discussed that raw data in itself is not much
useful it needs to be analysed from the view point of a particular stakeholder, then it
becomes far more useful it becomes comparable and it can be also used for projections.
We have also discussed that we can do horizontal as well as vertical analysis, but the
most important type of analysis is ratio analysis and large number of ratios can be
calculated serving variety of purposes.
In our early sessions we had started the discussion on liquidity ratios, then capital
structure as well as you have also discussed the activity ratios. Do you remember: what
is liquidity ratios stand for? These are also known as working capital ratios because they
tell you about availability of funds for day to day management of the business.
So, which are the important ratios in the category? The first one is current ratio perhaps
the most important ratio and very often used by variety of users where we compare the
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relationship of current assets to current liabilities. So, for day to day transactions this is
very important, so for taking a decision of giving credit often suppliers will look at the
current ratio of the customer to see whether customer will be able to repay the debt in the
repay that particular debt in time.
It is also seen by bankers, it is also useful for internal management to see how is the
working capital management of the company. The other liquidity ratio was quick ratio
which is more conservative way of calculating current ratio. Then going to capital
structure or leverage ratios we had seen that long term funds can be obtained from two
ways: one is equity that is owners fund, the other is debt.
Now, capital structure is a mixture of in what percentage you debt equity versus what
percentage you can debt you have you can raise the debt, it can be 100 versus 0 that will
be called as no debt or all equity company. In such a scenario the risk is less, the stability
of the company is more because debt leads to possibility of liquidation because firm has
to pay interest and instalment on certain due date. But, having less debt affects our
returns or profitability to some extent that is why a good mix is required between debt
and equity.
One of the most important ratios in this segment is debt equity ratio which is extensively
used by lenders or bankers. They decide as to what debt equity ratio is acceptable, it is
also useful and is used by long term investors; in case of M and A or such deals also this
ratio plays an important role. The next type of ratios are known as activity ratios they are
also known as turnover or efficiency ratios.
So, here we see how efficiently an asset being used for example, if you have fixed assets
of let us say 1 crore how much revenue we are able to generate from them. Suppose, we
can generate a revenue of 4 crore it will mean turnover of 4 crore divided by fixed assets
of 1 crore giving a ratio of 4; 4 is to 1 that is known as fixed asset turnover ratio, very
important ratio to know the utilisation of fixed asset. This ratio is also useful and similar
ratio is also calculated for working capital turnover.
Now, within working capital you can know the efficiency in management of each of the
current assets. So, what ratio do you calculate for it do you remember? We calculate
debtors turnover ratio which is sales upon debtors, but we need to refine it a bit because
debtors or receivables are mainly from credit sales. So, we can refine it a bit and say it
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call it as credit sales upon average debtors; same way it can be cost of sales upon average
stock or average inventory for inventory turnover ratio. Now, both these ratios I will just
show you the ratios for more clarity.
So, we were here working capital turnover ratio which is sales upon working capital. For
inventory turnover we take cost of sales because, the inventory is at cost instead of sales
generally better ratio would be cost of sales divided by average inventory.
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Now, this ratio can also be represented in terms of number of days, then it is called as a
stock holding period. So, we take average inventory divide it by cost of sales and
multiplied by 365 or multiply it by 12; if you want to know it in terms of months.
So, this is the stock holding period, same way for debtors we can calculate debtors
turnover ratio we can also calculate debtors velocity that is number of days of debtors.
Now, this is useful for knowing how well the company is managing inventory or debtors,
we can compare it with their standard credit policy that for how many days they are
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giving credit; let us say as per policy they give credit for 30 days, but the ratio is 33 it
will mean that they are slightly slow in collection.
If the ratio is much more let us say the ratio is 50 versus standard of 30 it will mean that
they are very slow in collection, it can also mean from audit angle or from investigation
angle that there is a possibility of some over statement of debtors. Then we will go for
aging schedule or some more techniques to know the components in the debtors or how
long those receivables are pending to be collected; like that these ratios are of more used
for the management of the company.
We also have creditor’s turnover ratio that is credit purchase upon average accounts
payable.
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We can also calculate creditor’s velocity that is company takes how many days to make
the credit a make the payment. We also know that how many days the company is
getting credit. So, in a way we know what is the reputation of the company in the market,
are they getting any credit. So, that if we want to take a credit decision we can know the
credit period for the customer which other people are giving that particular party. Now,
let us go with this I think a turnover ratios is clear to you.
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Now, we will go to the next type of ratios they are known as profitability ratios. In fact,
our discussion on the ratio itself we had started with this ratio that is known as net profit
ratios. These ratios are also known as P and L ratios because both numerator and
denominator we are getting from P and L and as the name suggest we know about the
profitability of the business in relation to the turnover generated or in relation to sales ok.
So, one of the important ratios is net profit ratio, net profit upon sales you can also take
net profit before tax, but more common is the final profit that is net profit after tax
divided by sales. If you want to know the gross ratio, then we go for gross profit ratio
which is gross profit upon sales this is also known as gross margin. Now, both this now
this particular ratio instead of finding for the whole company it can be calculated for a
particular division or particular range of products or sometimes on a single product.
So, that we know that from that product how much is a gross profit generated, see gross
profit is more linked to sales because for calculating net profit we charge various other
things which could be fixed charges. But, gross profit is mainly related to sales that is
why gross margin or GP ratio is very much useful to know the profitability of a
particular segment.
We can compare this ratio with other players in the market, so that we know are our
prices being fixed a properly do we have in a profitability, do we have more profitability
are we overcharging is there a scope for reducing the price to increase the sales or are we
undercharging that is our margins are too thin as like that various calculations can be
done using gross profit margin or gross profit ratio. It can also be calculated at a
operating profit level where in it is operating profit upon sales. So, we will know the
profitability of our operations from the sale.
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Now, within profitability ratios there are other ratios which are known as return ratios
this is profitability in the context of capital employed or resources used by the
undertaking. The earlier profitability ratios they were profitability in relation to sales, but
for the investor what is more important will be the money put by him or her and what
return the company is able to generate those ratios are profitability.
So, one of the important ratios is return on equity as the name suggests this is the most
important ratio from the owners view point because owners want to know how much
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money they have put and what return they are able to get from the company for that
profit after tax upon net worth is a usual formula, net worth you know is also known as
equity. So, we can also say profit after tax upon equity or we can say profit after tax
upon owner’s fund.
Now, this ratio is very important because owners will know the return from a particular
company, they can compare this ROE across different companies or for the whole
market, so as to choose which company they can invest in. Now, the other important
ratio even more important I would say is known as ROI Return on Investment, it can also
be called as return on capital employed.
Now, in the in the numerator we write return and in the denominator we write capital
employed; that means, capital which is invested sometimes it is also known as return on
invested capital. Now, what is a written here? Written refers to profit, but it may not be
profit after tax we may often take profit before tax and add back interest.
Because remember in the denominator we are writing total capital employed in the first
ratio that is ratio a we had taken only owners fund in the denominator. But, in ratio b the
denominator capital employed includes equity plus debt that is all first used since the
denominator has debt numerator also we need to add interest.
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So, we take profit after tax, add back tax, add interest many times we make adjustment
for non trading or non operating income because we were using this ratio to know the
returns from that particular business activity or that particular company. So, if there are
any non operating items they can be removed and we will calculate the return related to
that particular business. Now, this ratio can be calculated for the whole company, but it
can also be calculated for a particular segment of business.
Like for example, one factory or one plant, it can be calculated for one project. Now, this
is used by investors to know the return it is also a very much used in project
management. In fact, most of the project decisions are driven by ROI, before deciding
any project you have to make projection and find out how much is the return expected
from that project.
So, if company wants to invest 50 crore in some project it must know how much return it
is likely to get suppose that return let us say is 10 percent. So, we will invest 50 crore and
we are likely to get 50 lakhs it is 50 lakhs by 50 crore which is just 1 percent, then
definitely we will not be interested. If we are getting 5 crore on a return on investment of
50 crore it becomes a return of 10 percent perhaps steel company may not be interested if
their cost of funds is say 12 percent and the project is giving only 10 percent then it is not
worth to enter that particular business
So, viability of a project very much depends on ROI generated by the project. Now, this
ratio not only for the company even in the individual life it is useful. Suppose you are
taking the decision to purchase some asset or if you are taking a decision to go for higher
education it will be good for you to know the ROI on your investment because you are
investing money you are investing your time.
So, how much return it is likely to generate becomes useful. So, this ratio is extensively
used in different types by different types of users from the investors at to the company as
they themselves want to start a new project ok.
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Now, the next one here the definition of capital employed also you see. Now, this is a
broad base all the money used, so we are adding equity that is owners fund plus
preference capital plus reserves and surplus plus debentures or any long term debts, if
there are any miscellaneous expenses or non trade investments they are usually removed.
Because if you are putting some money outside business return on that investment can be
separately calculated, here it is good to remove it from the denominator. And, in the
numerator also you can see that is why we have reduced non trade adjustment are you
getting ok.
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Now, let us go to another formula of calculating ROI, we have already seen turnover
ratios we have already seen profitability ratios. Now, one way of calculating TOI is by
multiplying the profitability into capital turnover,
If you remember capital turnover had sales in the numerator divided by capital employed
and profitability had PAT upon sales. So, if you multiply both you will get profit upon
capital employed which is precisely what is ROI are you getting. Now, there can be some
variations like one can take operating profit ratio or one can take net profit before tax
ratio and so on.
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Now, the next ratio in the return ratios is return on assets. Now, we are using fixed assets
or some any asset, so we can take that particular asset in the denominator and find out
the profit generated by that asset. So, net profit after tax here it need not be the net profit
of the whole company, it can be the profit from that particular plant or that particular
activity divided by average fixed assets this is bit of improved one because instead of
taking yearend figures we have taken average figures.
See in the in the numerator the profit is calculated for the whole year, so it makes sense
to instead of taking the closing take the average fixed assets. Now, this can be calculated
for different assets you can instead of fixed assets you can also take average total assets
if you want to know the return on total assets.
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So, now, from return ratios we will go to next ratio which is in a way a return ratio, but
this is extremely important from stock market angle known as earning per share. We can
calculate the net profit from net profit, if there are any payments to be made to
preference shareholders extra they removed. So, that we know the profit available for the
equity owners and we will divide it by number of shares. Now, this is very important
because if you tell somebody that total net profit of our company is let us say 1300
crores.
Now, shareholder does not know what exactly he or she gets on his or her own shares.
So, instead of telling 1300 crores, if you divide it by number of shares you will get a
more understandable figure. Let us say it comes to 150 rupees per share, then it becomes
very simple to understand that is why in stock market parlance EPS plays a very
important role. Whenever any data is reported about the share like market price it is
immediately compared with earning per share as to what that share is able to earn for the
shareholders or for the owners.
Now, from this EPS some market related ratios like PE ratio are calculated where we
compare the market price with earning per share are you getting. So, this is very
important ratio in the stock market from the investor’s angle especially from small
investor’s angle.
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Now, from EPS as I told you we are able to calculate PE ratio price earning ratio. Now,
in the numerator we have taken market price per share and divided it by earning per
share. Now, what will this ratio tell you? Suppose earning per share of a particular
company is 10 rupees and it has a market price of 150 rupees, so 150 upon 10 it means
15 times it is earning is the market price. Now, what does it tell you, is it good to have
high or PE ratio or low PE ratio? As of now PE ratio of Indian market now instead of
taking one company average PE is calculated for the whole capital market. Currently
capital market has a average PE of around 25.
Now, suppose company has a PE ratio of 15 is it a good or bad sign? Perhaps for a new
investor it is a good sign because while other shares are putting at 25 PE we are getting
this particular share at a 15 PE. That means, it is comparatively available at a lesser price
it could be a good bye of course, such decisions should not be taken only by PE I am just
giving an example because we will have to study other aspects.
But as far as the PE is concerned for a fresh investors it shows that the price of the share
is relatively low which is a good sign from a buying angle, but from the company's angle
it reflects upon the goodwill of the company when other companies in the market are
able to command a PE of 25, if our company has a PE of only 15; that means, this
company is not much respected by the market either its earnings are not considered very
reliable or market feel that the future is not very good that is why PE ratio could be low.
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Whereas for some company if PE ratio is high let us say company b has a PE ratio of 50
while the market PE is 25; that means, this company has a higher recognition in the
market. So, in stock market parlance PE ratio is very important whenever a price is
quoted normally PE is also quoted for that share. Now, will this ratio change every year
or will it change every day? Now, this is one ratio which will change every day not only
everyday it will change every minute.
Because numerator that is market price changes every minute denominator may change
only on yearly basis, suppose the results are balance sheet P and L etcetera prepared at
the end of the year you will get EPS only at the end of the year or all earlier ratios which
we calculated they would be yearly most of the companies declared their results
quarterly. So, you will be able to calculate the ratios for each quarter, but as far as PE is
concerned you can calculate these ratio every minute as the market is moving the PE
ratio will also keep improving itself.
These two ratios are very important, so we devoted little more time I will request you
have already have a company and if you have seen the annual report go to some stock
market website look at the market price of the share and calculate the PE ratio mostly in
the side PE ratio will also be given that will give you market flavour. All earlier ratios
where only financial statement ratios, this is related to what is happening in the market.
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There are one or two more ratios which are useful for stock market or for investors that is
known as dividend per share. Now, in the numerator we take dividend, so that we know
how much is a dividend paid by the company on per share basis. So, dividend distributed
upon number of shares. Now, we have seen variety of ratios either for liquidity or for
profitability or for return then from stock market angle.
Now, many of these ratios can be used in combination and that will give you good
insight about the performance or stability of the company, it can also be used for other
purposes by various stakeholders. In the next session, we will be calculating the ratios
and try to interpret them taking real data from the actual company. So, I will request you
to revise whatever ratios we have done right.
Now let us stop. Namaste. Thank you.
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Lecture – 32
Interpretation and Analysis of Financial Statements: Shipping Corp. of India case 1
Namaste. In last three sessions, we have discussed a lot about Financial Statement
Analysis and its Interpretations. We have seen variety of ratios and to which stakeholders
which ratios are important. Now, let us start actual playing with numbers.
So, today we are going to actually work on certain company’s data so that you get the
feel to calculate those things. As I have told you earlier, these sheets are shared with you.
So, please take a printout. If you have still not taken take it right now. You can hold the
video take the printout.
Now, we are going to discuss about Shipping Corporation of India and we will be
calculating comparative as well as common size statement which is horizontal and
vertical analysis as we discussed in the first session. So, let us do it on the actual data.
Now, this is a profit and loss account of Shipping Corporation of India. I hope you know
about this company. This is a public sector undertaking Government Company which is
a one of the leading shipping companies in India and in we have got date of March, 16
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and 17. This is not a very good year for the company you can see here revenue from
operations has dropped from 4000 to 3400. We will look at various expenses.
So, first we are going to start with what is known as horizontal analysis. So, in horizontal
analysis what we do is we compare the 2 years. We want to study this year March 17. So,
we collect the data of last year that is March 16 and each of the figures will compare
with earlier year. So, what we prepare is known as a comparative statement. Now, it is
very easy to make it is very much common sense. So, I request you to make it along with
you.
So, we will give a title, this is a comparative statement. Now, what is done in
comparative statement is we have got 2 year data. So, we will calculate the difference,
the increase or decrease in the year. So, if you take the first figure, normally we expect
an increase I have deliberately taken a company where there is a decrease. So, you can
see that the revenue from operations gross has fallen from 4078 to 3407. So, minus 671
is a difference or increase in the current year; not increase, it is a decrease so, it is a
minus increase.
Now, even this absolute figure does not tell you about what is relatively relative change,
relative increase or decrease. So, what we will do is we will calculate this as a percentage
to the base that is to the last year. So, we get minus 0.16; that means, 16 percent fall in
the revenue. Are you getting? So, each of the figures now we are going to compare, first
find the difference and then find the percentage change.
Now, calculating all these figures is very simple of course, when you calculate on calci
you will have to calculate every figure, but overall we will be able to do the same thing
for all the figures. So, we will see now one by one figures. So, revenue from operations
gross and net both are same. They have fallen by 16 percent. Then other non operating
revenue; I do not know why this showing the same thing ok. Again it is a 16 percent. So,
I got a bit confuse it is correct, but it is a increase of 16 percent from 34 it became 39.
So, here the third figure that is other operating revenue has increased by 16 percent,
coincidently both figures came 16. Then the total operating revenue shows a fall of 16
percent because the anyway other operating revenue was negligible. The major
component was the revenue from operations. Other income you can see has also fallen
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by 19 percent 19000 crores, but sorry 19 crores which comes to 12 percent fall. So, total
revenue again as a 16 percent fall. This figure is not required; it is just a total.
Operating and direct expenses, there are more or less same from 2339; they have fallen
to 2149 that is a fall of 0.08 percent, negligible change. Employee benefits are almost
same, salaries have almost not changed more or less it is the same figure. Finance cost
has again almost remained constant, marginal increase of 0.7 percent; depreciation is
also more or less constant.
Other expenses it is very slight fall. So, you can see that total expenses more or less are
same. They have only decrease by minus 0.11 percent. Naturally you can now see the
impact of profitability of all this while the revenue has come down by 16 percent
revenues are expenses are more or less constant.
If you think of shipping industry, you will realise that they have same number of ships,
same number of crew. So, depreciation cost is more or less same, maintenance cost is
same, the salary cost is same, operating expenses are almost same. So, only the fall is in
the revenue which led to significant fall in the profits. So, profits have come down by
244 which comes to 0.50 percent fall. So, you can see from 421 to 177; that means, less
than half the profit ok. So, more than 50 percent fall in the profit.
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If you look at the absolute amounts, you can understand 660 crore loss of revenue of
which 440 was made up by reduction in expenses, but overall reduction in profit by 244
crore. That is why nearly 50 percent fall of profit because there other expenses came
down by 240 at least they were saved otherwise they would have more or less gone into
losses. Net profit before tax is same. Current tax again is more or less constant.
Now, if you think a bit you will be surprised as to why the current tax has not changed
because normally profits fall, the income tax on that also should have come down. But,
what happens is if shipping is a unique industry where income tax is charged on the
freight carried by them that is why there is no major fall in income tax; they have got
some mat credit entitlement. Do you remember, what is this? We had discussed in one of
the cases earlier. This is known as Minimum Alternate Tax.
So, in the earlier year they have paid more tax as a MAT. They are now getting credit for
it that last year they have got credit of 24, this year they have got credit of 11; no major
change. Deferred taxes, anyway is a very small amount. So, there is no significant
change in it, there is no tax of earlier years.
So, total tax expenses are more or less constant slight fall in the tax expenses. So, overall
profit after tax, you can see is a major fall from 275 to 135. So, 65 percent more or less
fall in the profit. Then there is a small prior period item. What is meant by prior period
item? These are items of earlier year, but now you have got some extra information’s.
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So, you are doing the kind of rectification, then no extraordinary item. So, final profit
from continuing operations has come down by 241. So, a fall of 64 percent and that is
reported as a profit for the period. Are you getting everything?
This is a very simple starting point of analysis known as comparative statement where
we take last year’s figure and compare it with this year’s figures and do comparison both
in absolute value and also in percentage. This is a very useful simple statement for the
performance analysis.
Now, we will go for the balance sheet.
Same way like earlier we will try to calculate comparative balance sheet and analyse it.
So, either you can call it difference or you can call it change and we will also calculate
percentage change. So, please calculate it along with me. So, current year figure minus
last year figure and take it as a percentage to the base, percentage to last year’s figure.
Equity capital of course, has not changed. So, have a look at it, there is no change in
equity capital so, zero change.
Reserves and surplus has slightly gone down. Why it would have gone down? There are
some prior period item and a few changes companies profits have gone down, but
company had paid dividend. That is why their reserves available with them have slightly
gone down. You can see company as substantial reserves on a capital of 461, they have
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reserves of 6444. In current year, it is now 6400. So, it is a negligible fall only one
percent fall in the reserves. Total share holders funds are also more or less same; it is
again a 1 percent fall.
Now, look at the long term borrowings. From 4598, there is a substantial reduction in
long term borrowing; almost one third of their debt they have paid. So, minus 1520, it is
a reduction of 33 percent of their debt. Why they would have done that? Maybe their
loans there was a due date of loan and they have repaid the loan. There is another
possibility that these loans were costly in nature, paying high interest. So, they decided to
repay it, but they have done a major repayment. If you look at the deferred tax liability, it
has increased from 0 to 343. So, you cannot calculate percentage, but it is a sizeable
increase.
Other long term liabilities are anyway negligible. Long term provisions have gone down.
So, if you take the total noncurrent liability there is a major fall, 26 percent fall; mainly
this fall is because of repayment of long term borrowings.
Now, let us go to their current liabilities. They had no short term borrowing they have
increased the short term borrowing from 0 to 974. Now, if you read this together you will
understand that part of their long term borrowings which where this are now converted
into short term borrowing. Why this would have happened? Maybe because this is their
last year of repayment, ok. Suppose they have issued a 10 year debenture, 9 years are
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over this is the last year. This is the year in which repayment would be due. That is why
you can see here total reduction is 1520 of that 974 is now a short term borrowing.
In the always keep in mind that long term means one which is repayable for more than 1
year. So, if you take a loan say for 8 years; for 7 years it will be shown as a long term in
the eighth year it will be shown as a short term or if you are repaying in instalment which
is more common whatever are the instalments due in the current year that would be
called as a short term borrowing ok. So, not that all the long term borrowings were
completely paid, partly they were paid remaining are due in the current year. So, now
they are reflected as short term borrowing.
Trade payables, there is a significant increase from 989 to 2900. So, you can see it is
more than 100 percent 190 almost 200 percent increase you can say. They are more or
less doubled or they are rather they are tripled from 1000 to or nearly 3000. We do not
know the reasons. There is one possibility that company has having some cash crunch.
So, they are delaying their trade payables. So, one needs to investigate more. Now, we
will look at cash flow statement that time we will get to know little more about it, but
you can see here clearly that the trade payables have increased three times and the
quantum is also very big it is 3000 crore. It is almost now more or less equal to their long
term borrowings.
Now, the current payables have substantially reduced. Perhaps maybe some of their other
current payables are now converted into trade payables. We will have to study their
finances more to understand it, but as of now you can see that other current payables
have substantially gone down. It is a 90 percent fall in that figure. Then, short term
provisions; they have also gone down almost by 86 percent. Current liabilities, total you
can see has increased now because of the major increase in the trade payables. Although
other current liabilities and trade payables are more or less upsetting each other, but still
overall you can see rise in 1242 as a current liability which is mainly contributed by rise
in the short term borrowings.
Now, in the last session we have discussed the current ratio. If you now calculate current
ratio you will realise that the ratio would have fallen. We will do later on, but as of now
we will see that we can see that nearly 50 percent rise in the total current liabilities.
Now, let us go to assets.
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Assets you can see are more or less same. So, no major ship they have acquired. It is
almost same base of asset only 2 percent change that to fall mainly because of
depreciation. Intangible assets are anyway almost nil, negligible. Work in progress, there
is a small work in progress. Other assets – a sets is for sale or sold are not there for sale
are not there.
Total fixed assets have marginally fallen by 1 percent. Noncurrent investments have
slightly increased. It is not a very it is not a major amount though in terms of percentage
it is a 173 percent increase. Long term loans and advances, you can see there is a fall,
maybe they have recovered some of their long term advances. So, total noncurrent assets
are not much change in it. It is a 3 percent change.
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Now, let us go to current ones. They had a very small amount in current investments
which we have disposed off now, 37 crores. Inventory – it is a shipping company, not
very large inventory they need. There is a slight increase in inventory. There is a slight
decrease in trade payables which is understandable because their revenue has fallen.
Cash and cash equivalents are more or less constant from 1200 to 1300 crore. Short term
loans and advances have slightly increased; as a percentage it is a major increased 100
and 14 percent but amount wise it is not a big increase and other current assets is anyway
has small amount.
So, if you look at total current assets there is a increase of 323. So, around 13 percent
increase in current assets. So, are you getting? This is known as comparative balance
sheet. I hope it is very simple, so, you would have understood the calculation. I am just
tempted to calculate current ratio though in detail we will solve the cases later on, but
just for one calculation let us do it now. I hope you remember the formula. It is current
asset divided by current liabilities.
So, in the last year in the current year it is 2727, total current assets divided by total
current liability of 4000. So, current ratio is 0.67. In the last year it was 0.84. So, you can
see here because of the rise in current liabilities rise of about 44 percent there is a fall in
the ratio. Are you getting it? Now, traditionally speaking this is not a comfortable
position because they have much more current liabilities than their current assets. But,
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because it is the shipping company and it is a government company it may not come in
trouble, but otherwise these are troublesome figures. Are you getting me?
Now, let us go to cash flow.
This is the summary of their cash flow statement in two years March 16 and 17. Let us
do the calculation of comparative figures. Now, you know current year minus last year.
So, major fall in net profit which we had already calculated and as a percentage it is a 60
percent fall in net profit before tax. Now, what do you see from cash from operating
activities? It is a major fall nearly 50 percent fall from 1327 to 682. So, significant fall in
cash generated from operating activities. Cash generated from investing where negative
202 they are now negative 85. So, it is 116 and cash from financing activity is also
substantially negative from minus 1000 to minus 500.
So, it is a increase of 582 about 50 percent decrease, but since the figure was negative
now here in the change it appears like an increase. Overall there are no much changes in
the cash and cash equivalent. Though yes, if you look from the compare the opening and
closing in the last year it was relatively higher now it has come down ok. So, particularly
if you look at these three figures, you will realise that there has been a major fall in
operating cash flows which are somehow made good by reducing to some extent
reducing investment and to some extent reducing their repayment of loan. Are you
getting me?
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So, what we did now for all the three statements was calculation of comparative
statement. This is known as horizontal analysis. Now, for the same company let us go for
vertical analysis. Now, this is a P and L account. Now, in vertical analysis what we did in
the horizontal analysis was comparing the two years, but it was comparison of absolute
values and then we converted as a percentage. Now, in common size statement we will
compare everything with the base and convert them into percentages. I think it is a
simple job. So, you try to do it yourself. We will be actually calculating it in the next
session. Till that time. Namaste. Thank you.
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Lecture – 33
Namaste. In last few sessions we are discussing financial statement analysis, so we

discussed about horizontal vertical analysis then variety of ratios. In the last session we
had seen how to do horizontal analysis where in we have calculated and prepared a
comparative statement. I hope it is clear to all, today we are going to go for a common
size statement.
I will just show comparative statement once more.
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So, what we are done was we have calculated the change and the percentage change for
both P and L balance sheet.
And then for summarized cash flow, this was a common size P and L and common size
balance sheet.
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Now, what we will do is what is known as vertical analysis and for vertical as the name
suggests it is vertical because to a common base we compare and calculate the figures
and then if you want we can compare the 2 years figures, but first we will compare it
within the year. So, a statement which we make is known as common size statement, I
had requested to make it I had requested you to make it on your own, so this is common
size ok. So, let us make common size statement please make it along with me it is very
simple, so take the print out of the given sheet that is P and L balance sheet and cash
flow which is for 2 years.
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Now, if you take P and L we can compare these two values, but instead of comparing
actual values we want to first convert them into percentage. For converting into
percentage we will take the base as the total revenue or sometimes we take base as
revenue from operations. So, for any individual figure let us say we want to calculate
operating and direct expenses which is 2141, so 2141 divided by revenue from
operations.
So, 62 percent is the operating expenses, so total revenue if is 100 62 percent is spent on,
now what we can do here is let us make it B dollar 8, so that we can drag it now. So, all
the figures we have got it as a relationship of the total, you can also do it for the total
even for the revenue items got it. Gross and net revenue is of course 1 and other figures
are as a percentage to total, for better understanding if you like you can even converted
into percentage, this looks bit better.
So, operating expenses you can see are now 63 percent of the revenue, now same thing
do it for the; so now, are you able to see them as a common size statement the total is
100 and every item that is safe operating expense is 63 percent in March 17 whereas, it is
57 percentage in March 16. So, you can easily see that operating expenses as a
percentage have gone up.
Actually, if you look at the amount they have not increased much, but because of the fall
in the revenue they could not reduced their expenses like the fall in the revenue that is
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why as a percentage they have gone up. So, this is one way of interpreting it, employee
benefit as a percentage as slightly gone up, depreciation as a percentage as slightly gone
up.
So, various figures now you can get it as a percent, profit if you want to see profit before
tax has gone down from 10 percent to 5 percent, profit after tax has gone down from 9
percent to 4 percent.
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In a way we are now calculating variety of ratios, you have seen net profit profitability
ratios which were profit upon sales. You can also calculate various expense ratios like;
say operating expenses to sales to know the operating expense percent or employee
benefit expense percent. So, all figures are now represented as a percentage and then we
are able to compare them across the years because, comparing absolute figures was not
that much sensible although since it is for the same company still it was possible.
But, if you want to compare with other companies in the industry it was senseless to
compare it, but now we can compare it across different companies or with the industry
average also to know our expenses versus others. This is known as a common size P and
L or a common size statement of revenue, now let us do it for balance sheet.
Now, balance sheet also we have got figures for 2 years, so I have pasted that formula
here. But this could be slightly wrong because we have to take total; this particular figure
that is share capital is taken to the base of what earlier we took it as a base of total
revenue because it was in P and L.
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In balance sheet it will be taken as a base of total of capital and liabilities which is same
as total of assets. So, you can see here total of capital and liabilities which is 22, so here I
have to take base as 22, so it is 3 percent of the total for both the years are you getting it,
it is very simple, but it gives you lot of insights if you read carefully. Now you can see
that out of 100 of total liabilities only 3 comes from share capital is it a good or bad sign,
it is good sign because you can see lot of reserves are accumulated over the period.
So, only 3 is the money put in by the owners on that 44 percent was generated by way of
reserves, so the total shareholder’s funds where 48 percent now it is 47 percent. Because
of reduction in profit there is a slight fall, long term borrowings where 32 percent and
now they have gone down to 21 percent total non-current liabilities have of course, fallen
in line from 33 to 24.
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Short term borrowings are actually going up which is a matter of concern from 0 to 7
trade payables increased from 7 to 20 percent, although there was a fall in other current
liabilities. So, overall total current liabilities which were earlier 20 percent have now
become 28 percent.
If you look at assets tangible assets are 80 percent of the total assets is it a good sign
normally yes, because it is a shipping company they have to invest huge amounts in
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purchasing the ships they have their own ships that is why this percentage is very high as
much as 80 percent.
Most other figures are very small except that cash equivalents which are around 10
percent we have to check whether they need that much of cash maybe they have got
excess cash also. And current assets in general earlier where 17 percent have become
now 19 percent, but which mainly comprise of cash other items are very small other
items of current assets.
So, this is a comparative balance sheet, now this comparative balance sheet sorry this is a
common size balance sheet it can be across the industry compared. In coming case we
are going to compare with other peers in the industry, but right now is this clear to you
this is a comparative balance sheet, now let us go to cash flow statement.
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Now, we have got cash flow statement for 2 years, now in cash flow the denominator is
going to be the total cash generated I think total is not given here. So, first we will have
to calculate the total, this total you can take as a base it does not become that much
sensible for cash flow statement, but I am just showing how it can be it calculated, so
because there are only 3 figures. So, this is a large amount in from operations though it
has come down whereas, the financing activities it is a negative amount are you getting
it.
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Now, let us go to the next calculation, now is it visible, so here we have taken of
financial statements of 5 leading shipping companies in India we were just talking about
comparison across the industry peers. Now, this is for shipping corporation of India the
company which we were discussing, then there is Gujarat Pipavav, GE shipping,
Reliance Naval, and Shreyas shipping. So, now, all the figures are given you can see
shipping corporation is a industry leader they have much more turnover than other
companies other companies are relatively small, but we would try to calculate their
profitability now as a percentage.
If you look at their profits, profit after tax you will see that the reported net profit of
shipping companies shipping corporation is only 135 versus relatively much higher
profits for GE shipping whereas Reliance naval has a huge loss, but absolute figures are
difficult to compare because the base is different. So, what we will do now is we will
convert each of these figures into percentage then it will make much better understanding
for us. So, all the figures we will divided by the sales turnover.
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And, let us converted into percentages I will also copy the heading and I will hide now
the actual figures instead of looking at the actual figures it becomes far better and
sensible to compare it as a common size statements.
Now, let us see one by one, so here we see that the net sales and if you take different
items raw material anyway is negligible, but you have a high raw material for I think one
of the figures is not compared. So, here now we are taking all the 5 figures as common
size statements and I think they become much better comparable.
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So, let us take raw material, raw material cost is negligible, but for reliance naval their
nature of business is different. So, they have got significant raw material cost they also
are spending large quantum in other manufacturing expenses. Whereas, for shipping
corporation the major amount is in other manufacturing instead of other expenses, but
there can be slide different way of classifying it.
Now, if you go to profits you will realize that operating profit is 22 percent for Shipping
Corporation, but for other peers like Gujarat Pipavav and for GE shipping it is much
higher 61 percent and 43 percent. It is only 4 percent for reliance and 14 percent for
Shreyas shipping, if we go for PBDIT that is cash profit or Profit Before Depreciation
Interest and Tax.
Again we get a similar figure, interest expenses are very high for Reliance 110 percent of
the revenue that is why at PBDT Profit Before Depreciation and Tax Reliance becomes
minus 97 percent while for others the figures are more or less same. Then the
depreciation is 16 percent, but very high for Reliance because they have got very costly
ships and interest burden is also very high on them, you can see here Reliance has
acquired very high cost ships at paying high level of interest.
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Now, the profit before tax only 5 percent, but very good profit both for Gujarat Pipavav
and GE shipping and for Reliance Naval it is significant negative. Of course you should
keep in mind that though all 5 are shipping companies, nature of operation slightly differ
because some are operating some pores like; Gujarat Pipavav, so they are making more
profits.
Now, profit before tax these are the figures, profit after tax again the two companies
Gujarat Pipavav and GE shipping are showing very good profitability and the calculation
has been done right up to p ratio and book value is it clear, this is how comparative
statement helps us to compare the balance sheets and P and L.
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We will also do it for balance sheet, see different companies are different way of
financing that can be compared and understood from balance sheet analysis.
Now, as you know for balance sheet every figure will be compared with the total of
assets and liabilities, we have already done for GE shipping sorry for a shipping
corporation which now we will also do it for all other peers.
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Let us hide the actual figures I think will unhide it, because for some time also see the
actual figure then we will go to the percentages. So, you can see the share capital for
Shreyas is very small for others is more or less in the range though for GE it is less it is
only 150 crore. If you compare reserves Shipping Corporation has huge reserves as well
as GE shipping has large reserves, in Reliance the reserves are very less company is
continuously earning losses.
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See I am not referring to Reliance industries is this Reliance Naval this is a Anil Ambani
group company. In net worth net worth is very high for shipping corporation pretty high
for GE for other companies it is comparatively less. Secured loans are very high for
shipping corporation 0 0 for I think this is Gujarat Pipavav.
These shows different way of financing it is a equity finance company you can see no
debt whereas, for GE shipping they have a reasonable quantum of debt, for Reliance the
debt is very high. On a capital of something like 1000 100 of net worth they have 8 times
that as a debt and anyway Shreyas is relatively small less debt.
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You can also look at their gross block, gross block is very high for Shipping Corporation
because, they own lot of ships somewhat less for GE and other companies have lesser.
So, you can understand that other companies are more efficient in utilizing there asset
which is mainly the ship. Now, I think we will hide the figures and go for comparison
with percentage.
Let us convert it into percentage terms.
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So now, you can see this is a shipping corporation they have only 4 percent of the total as
share capital because they have got substantial reserves, Gujarat Pipavav has even higher
reserves, but they have no debt. So, it is mainly financed by share capital plus reserves,
now their net worth is 100 percent of the total for shipping corporation its 63 of net
worth versus 33 of secured loans, for GE shipping it is 53 versus 43.
So, if you remember we had discussed about debt equity ratio, debt equity ratio will be
37 by 60 by 63 for Gujarat Pipavav it is 0, for GE shipping it is 43 by 53, for Reliance it
is 88 by 8 because of huge debt and for the last company it is that is Shreyas it is 39 is to
64.
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Now, if you go to the gross block you will realize that very high gross block 146 percent
for GE shipping, but their ships are relatively older that is why they have lot of
accumulated depreciation net block is 105. Now, if you look at total fixed assets I think it
is same amount more or less because only Reliance Naval has some capital work in
progress; total current assets are 20 percent more or less in the same range.
Current liabilities are very high for Shipping Corporation maybe because of the loans
which they have to repay now. And the total the miscellaneous expenses anyway are 0,
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net current assets are more or less same for all the companies, in case of reliance you can
see that because of huge losses continuously their net worth is relatively low. So,
comparative balance sheet can be compared across industry peer and it helps us for better
analysis.
So, we will continue the analysis of few more companies in coming sessions till now
Namaste. Thank you.
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Lecture – 34
Namaste. In last few sessions, we are discussing the case of Shipping Corporation of
India we have seen how to do horizontal analysis by preparing a comparative statement
where we compare the current figures with last year. Then we have also seen how to
prepare a common size statement to go for vertical analysis where we convert all figures
into percentages of 100 and then we can compare either with the same company in
earlier years or we can compare across different players in the pair group.
So, within the same industry, who are the competitors and how their balance sheet or P
and L looks like. It can also be compared with industry average or with the particular
segment in case of a broader companies ok. So, I am requesting you to study your own
company once again and compare it with their other pairs. You can go to websites like
money control where they will give you all the data in the balance sheet in the excel
format ok. Now, let us go to one more analysis in today session.
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So, here again we have got the data for shipping corporation, but now it is a long term
data, it is a 5 year data. In earlier sessions, we only compare 16 and 17. Today we will
compare 5 years figures. So, what we are going to calculate is known as trend analysis.
So, we will take March 13 figure as 100 and compare other figures as a percentage that
to that base. So, we will know over the period how is the movement? This is known as
trend analysis we can also calculate CAGR cumulative growth rates, but right now we
will just do the trend. So, we have just seen how to calculate it we have taken the base as
100. So, that is a figure for March 17, so for sorry March 13. So, March 14 figure is
calculated as E7 upon F7. Now for March 15 it is D7 upon F7. Are you getting me?
So, March 16 C7 upon F7 and for the March 17, we will compare the current figure that
is March 17 figure with March 13 figure. So, if you look at the revenue trends you will
realize that March 17 what was 100 is more or less up and down and it is at the same
position. It slightly went down and now it has slightly increased the sorry this is for
reserves and surplus.
Now, I will just hide this ok. So, we can also do it for share capital although it would not
make much sense because share capital is unchanged converting into percentage.
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So, share capital is same 100 percent in each year for other figures like reserves have
also not changed much. In the first 2 years, the company that is in earlier years the
company was in loss. I think this also got converted into percentage; it is not changing,
but we leave it.
So, are you getting me? So, company was reducing its reserves. Now its reserves have
slightly increased and again they are slightly decreasing look at trends in borrowings.
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You will realize that borrowings are slowly going down from 100, company is
systematically repaying its long term borrowings and becoming relatively debt free.
Short term borrowings earlier it went up, then it went down. Now they have again gone
up.
Trade payables where slowly going up down again they have increased substantially. If
you look at the trends of total current liabilities it shows slightly rising trend which is
very some because their revenue is more or less constant. So, no reason for that to go up,
tangible assets are again more or less constant.
Capital WIPs you can see in one of the years the capital WIP was high maybe they were
in the process of building new ship now again it has gone down. Total noncurrent assets
have shown a significant rise in the current year. If you look at current assets, you will
realize that current investments are slowly going down perhaps they are disposing of
their investments. Inventory is anyway have very small amount, but the trade receivables
are slowly going down because their business is also shrinking. Cash and cash equivalent
is more or less constant, it had gone down in one of the years, short term loans and
advances had shot up in between, they went down that again they have bit increased.
So, this needs to be investigated and if you look at total assets there is somewhat stinking
of total assets over the period of time. So, like this in trend what is done is for the earliest
year we take as 100 and over the years we go for the comparison. Now let us do it for P
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and L items, it might make more sense for P and L items to you. So, we have already
seen the P and L earlier.
So, let us hide the figures or maybe I will keep 1 year figures. Now if you look at the
revenue, you will realize that first 3 years it was constant, but in last 2 years; there is a
fall. Other income anyway it is a small amount, but it is slowly going down because their
investments are also getting disposed of perhaps.
Operating and direct expenses they are going down because the revenue itself is going
down. There is a fall in the operating and other expenses; it is a positive sign because
you can see more fall than the fall in the revenue.
Employee expenses are more or less constant, finance cost is also not changed much
actually it should have substantially reduced because they are repaying their loans
compared to earlier years. Depreciation figures are going down perhaps because their
assets are becoming older; other expenses anyway negligible about. If you look at the
profit; now there is a significant fall in the profit over the period of time. Tax total taxes
earlier went up, now they have gone down and the final figure reported net profit is also
showing reduction which is not a very positive sign.
So this is how the trend is calculated the purpose of trend is having a long term
perspective instead of just looking at 2 or 3 years, we little bit take a long term
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perspective, but we have to keep in mind that industry should be reasonably stable for a
long term perspective and that for that company also there should not be major changes.
So, for a company like shipping corporation, it is good because there has not been major
changes either in their assets or in their revenue model. Getting it? Now with this, we
will go to major form of analysis that is known as ratio analysis.
Now, this is the data for Havells Limited. This is the consumer goods manufacturing
company. I will request you to keep your ratio sheet ready because we will be calculating
various ratios. I will just show you the sheet which has been shared with you.
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But if you are not having it we will just have a look kind of revision for you. Please keep
that sheet ready because we can readily calculate the ratios. Now for liquidity ratio, we
have discussed earlier cash, current and quick ratio that is current assets by current
liabilities and quick assets by quick liabilities. This ratio, in this sheet has been slightly
tweaked. Here we have gone for quick ratio upon current liabilities which is a more
conservative measure. There can also be a ratio called as cash ratio where we are
calculating cash plus cash equivalent as a percentage of current liabilities.
Now, this is even more conservative, we want to know how much cash we have for
repayment of current liabilities. One more ratio related to liquidity is inventory to net
working capital, inventory upon working capital; working capital is CA minus CL. Now
is it good to have higher ratio or lower ratio for inventory to net working capital? Higher
ratio will mean that their working capital is relatively illiquid because inventory is not so
liquid asset.
For other as ratios like current and quick ratio higher ratio is normally good from
liquidity viewpoint although it will have a negative impact on profitability if you have
two higher ratio. Next ratios are profitability ratios very simple to understand.
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Because denominator is always total operating revenue and we take the respective profit
in the numerator. Right now EBIDTA has been taken. I hope you have heard about this
term EBIDTA, this is Earning Before Interest Depreciation and Amortization. This term
is very much popular in US and often used by analysis to know the cash profit generated
by the business.
So, here we have calculated it as a percentage of sales then EBIT or PBIT. This is the
operating revenue or profit as a percentage of sales before interest and taxes the net profit
margin. We have also discussed about return ratios of them ROI is perhaps the most
important that is EBIT upon capital employed, it can be done at a company level or at a
project level also.
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Then ROTA that is Return On Total Assets ROE EPS which is very important for
shareholders. This particular ratio, we had not discussed earlier that is known as EVA
Economic Value Added. In EVA, we take no PAT or net profit net operating profit, but
we reduce taxes. So, net operating after tax and we reduce the charge for the capital. So,
capital into cost of capital because you will have to compensate the capital in the form of
interest or dividend we calculate a weighted average rate of cost of cal capital and apply
it on all the capital.
Here the capital does not refer only to equity, but the total capital employed. So, no pat
minus capital into cost of capital gives you another major of profitability known as EVA
ok. So, we will not necessarily go for all the ratios, but keep the sheet ready.
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Now, the next type of ratios are activity ratios. We have discussed them extensively. So,
I will not repeat, but these are the formulas in short, it is also given where to find these
items. You remember return ratios and turnover ratios are composite; one figure is from
P and L other figure is from balance sheet.
Next are leverage ratios the most popular being debt to equity or debt equity ratio. You
can also go for debt to asset ratio, interest coverage ratio.
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And the last three ratios are particularly useful for shareholders which are in the form of
PE ratio dividend yield and so on. I think dividend yield we have not discussed. So,
dividend yield refers to DPS or Dividend Per Share divided by market price. Now from
investor angle, it seeks to find out what percentage of return does the dividend give that
is why it is called as Dividend Yield.
Dividend Payout Ratio is DPS upon EPS. So, we will come to know what percentage of
their earning is being distributed by way of dividend. Higher is good or lower is good?
Not necessarily higher will mean that companies share holders are getting more cash
dividend; lower we will mean that company is investing that amount and is more of a
growth oriented company. So, according to stage of comp industry and company,
companies have to decide the payout ratio many times companies try to keep it constant
ok.
So, this was a summary sheet for various ratios, now let us go to actual figures for
Havells and try to calculate the important ratios.
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Now, we have got balance sheet and P and L both so, that we can calculate the composite
ratios as well first try to have a view in the balance sheet.
So, you can see the capital is constant; there is a gradual rise in reserves. So, company
was be a profit making company. Their long term borrowings they have repaid and have
become a zero debt company now.
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Short term borrowings are also repaid completely, trade payables are nearly constant,
current liabilities other current liabilities are somewhat increasing.
Tangible assets have slightly gone up. So, company is investing something; their
noncurrent investments had doubled earlier it has gone down.
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Now, cash and cash equivalents has gone up. Now you do not have to look at every
figure, but we just had a overall look at the balance sheet.
Now, let us try to calculate a few important ratios. So, if we start with liquidity in
liquidity, what ratio you would like to calculate? Can somebody suggest what is a
important ratio in liquidity? I think most of you know current ratio is the most important
ratio and the formula is CA that is total current assets upon current liabilities.
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So, let us try to calculate the current ratio this is CA divided. So, we are taking total
current assets divided by total current liabilities.
So, we get 1.88 I am just reducing the unwanted decimals. So, over a period of 3 years,
you can see there is a gradual rise in current asset is it a good sign? Normally yes
because we know standard ratio is to 2 is to 1 and slight increase in the ratio in their case
and we are trying to go to the standard ratio. Any other important liquidity ratio?
Sometimes you know that we calculate quick ratio now how will you calculate quick
ratio sorry this was CR current ratio now we will go for quick ratio what is the formula?
We take trade receivables, cash equivalent, short term loans and advances and other
current assets. In other words normally we can say its total current assets minus
inventories in the numerator. So, please try to calculate along with me we will put this in
bracket. Current assets minus inventory people can use variety of ratios and there can be
slight difference in the formulas and divided by quick liabilities; quick liabilities are
more or less same as current liabilities except we deduct bank over draft. Right now, you
can see there is no short term borrowing as such. So, we will take total current liabilities.
So, we are getting 1.2. So, it has improved from 0.81 then to 0.6 and now 1.26 is it a
good sign? I think yes we have seen that normally the standard ratio is 1 is to 1. So, they
are somewhere around it the liquidity position seems to be comfortable ok. So, these
where the ratios which we have calculated only based on balance sheet. So, they are also
known as balance sheet ratios.
Now, what is, what are the other balance sheet ratios? We can also comment on their
capital structure or it is known as gearing or leverage. So, the most popular ratio is debt
equity ratio. What is the formula of debt equity ratio do you remember? It is the long
term borrowings divided by the shareholders fund debt upon equity. So, ratio was 0.06
and it has become 0 now is it good sign ?
Yes from a stability viewpoint because they are slowly repaying there debt anyway even
earlier the debts were not very high they were only 6 percent, but now even with their
repaid. Some people instead of long term borrowing take long term plus short term
borrowing that is total borrowing in the numerator even in that case the amount is 0 ok.
So, this is known as debt equity ratio. Now let us go to their profit and loss account.
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So, in P and L what ratios can be calculated? One typical ratios one typical ratio which
we calculate is net profit ratio or variety of profitability ratios.
So, let us go to their net profit or profit for the period which is 715. So, NP ratio profit
upon sales now always the question is which figures to take. Because you have got
revenue from operation less excise, revenue from operations net, other operating
revenue, total operating revenue and total revenue. Normally since it is a net profit after
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tax, after everything it does make sense to take either total revenue or total operating
revenue any of the figures are reasonable, but total revenue makes more sense.
So, you are getting 0.12 we will converted into percent so, around 13 percent.
So, you can see there was a rise in net profit as a percentage also it has increased from 10
percent to 13 percent is it a good sign? Definitely because higher profitability is always
advantageous, we can also calculate the profitability at different level particularly profit
before tax this is known as NPBT ratio.
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So, from 12 percent to 17 percent CNP 80 which is found to be less because this is
before tax and we will take one more that is known as operating profit.
Now, you see your revenue and you have got total expenses. They have not calculated
any operating profit, but usually if we add back depreciation and finance cost, we will
get PBIT Profit Before Interest and Tax or we can also calculate PBDIT to know the
cash profits.
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So, what we will do here is, we will calculate this is profit before depreciation and tax;
this is also the cash profit for the business this is also popularly known as EBIDTA. Now
we are comparing with operating revenue. So, you can see they have a very stable
EBIDTA around 15 percent because their sales have increased their profits have
increased the bit, but otherwise as a percentage it remains constant. So, we have now
calculated both balance sheet and profitability P and L ratios. Now, we will also go for
calculation of return ratios etc., but in the next session. Namaste. Thank you.
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Indian institute of Technology, Bombay
Lecture – 35
Namaste. In last few sessions, we are studying the Analysis of Statements. So, we have
in details studying the Shipping Corporation case; calculating the comparative, common
size as well as trend and then we went for calculation of ratios. So, for Havells Limited
we have calculated first the balance sheet ratios. Three important ratios one was current
ratio, quick ratio and the third one was debt equity ratio.
Then for P and [laughter], we have calculated profitability as net profit after tax
popularly known as NP ratio, net profit before tax ratio and also EBIDTA or cash
operating profit ratio. Is it clear to you? Now, we will continue the case and try to
calculate return and activity related ratios which pick up one figure from P and L and one
figure from balance sheet. So, you have to keep both the sheets ready now.
Now, first of all this profitability which is calculated as a percentage to sales naturally
we would be interested in knowing profitability on their investment which is called as
return ratios.
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So, we would try to calculate return on equity popularly known as ROE. Do you
remember the formula? Just check from the sheet. So, this is the return meant for the
equity shareholders which is profit after tax. So, we will take the final profit and divided
by from the balance sheet, we take the total shareholders’ funds. I will just do it again.
So, profit after tax divided by shareholders funds.
So, you get 0.27 as a percentage it is better understood, it means 27 percent is the
profitability with respect to owners or shareholders. There has been a good change from
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22 it has improved to 27 you can easily compare with normal returns which you get from
bank FD which is 8 or 9 percent. So, definitely it is a good return, but there can be scope
for even higher return.
Now, the other measure is ROI also known as Return On Invested or investment or
Return On Invested capital. So, what is a formula? Instead of taking profit after tax we
will take profit before tax. And to this we are going to add the interest income if any
sorry, interest expense if any. Now, here again should we take PBT or should we take
profit before exceptional items? Actually it makes more sense to take profit before
exceptional item because you are trying to calculate profitability of the business;
exceptional items are not regularly going to recover, you can see it is a big amount 202.
So, we will go for 711 which is in the numerator, we will put it in bracket because this is
the profit before tax and before exceptional items. To this add finance cost which is
interest and such types of costs. This is the numerator and divide it from the balance
sheet. We have to take shareholders funds plus borrowings ok.
So, what we are doing is in the numerator we are going to take profit before exceptional
items before taxes, add finance costs and in the denominator we have taken owners plant
first debt. So, we got 27 percent and in all the three years it is more or less constant at 27
percent. You can see here mainly it is only because of effects of taxes that there was a
slight change. So, this was ROE and ROI.
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Now, let us try to calculate activity ratios. So, to know how efficiently the company is
using its assets. So, we will go to balance sheet.
In balance sheet, you are having fixed assets. We will compare them with sales; maybe
from P and L it is easier because we have got a sales figure here.
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This is fixed asset turnover ratio as it is known as. So, normally we will go for operating
revenue total operating revenue and divide it by total fixed assets. So, you are getting it
5.02. Shall we convert it into percent? Actually no, it does not make sense because this is
number of times; that means, you are using your assets to generate revenue 5 times in the
year. Over the period of time, you will find it is more or less constant. Although their
profits the revenues are increasing slowly the fixed assets are also increasing slowly so,
more or less steady fixed asset turnover ratio.
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Now, we can also calculate other type of turnover ratios. I will just keep them here; one
is TAT that is Total Asset Turnover ratio. So, let us compare the total revenue and divide
it by total of all the assets. Now, naturally the ratio has gone down because in the first
ratio that is FAT, we had taken in the denominator only fixed assets. Now, we have taken
all the assets.
So, you can see there is a compare it to fat this is lesser ratio. It is slightly going down,
but it is more or less constant. So, this is how now going for little bit of working type
capital types of assets. We can calculate inventory turnover ratio. So, for inventory
turnover total operating revenues divided by the value of inventory which is 6.93 or point
0.70 7.5 and 6.91. So, it is more or less constant. The efficiency of use of inventory had
increased the bit now it has fallen.
Now, would you like to convert it into number of days? It is known as inventory
velocity. Let us try to do that. What is the formula? We can just transpose this take 1
upon the given inventory turnover and then multiply it by 365. So, this is in terms of
days. So, it was 52 days, then it came down to 42 days; now, again it is 52 days. So, that
means, any inventory which comes in the remains with the company for 52 days. Same
way it can also be done for debtors and for other assets.
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Now, we can calculate more ratios, but we will not go into the debt, we are going to
consider two more cases of different companies where we will calculate much more
variety of ratios.
Right now let us understand two other important ratios which are already calculated; one
is EPS. What is the formula? We have discussed it earlier, do you remember? That is
earning per share. So, we take profit or loss for the period and divide it by number of
shares.
So, here you can see there was a fall in EPS from 38 to 7 and then it has increased now
to 11.45. You can check the share capital which is more or less constant. So, you can see
here that this is the EPS as calculated by the company. There are no pending warrants
etcetera. So, diluted EPS and basic EPS is more or less same. Equity share dividend for
first two years was constant. In the current year they have increased the dividend to 374
and this is the tax on dividend. So, they have also calculated equity dividend as a
percentage; as a percentage to their nominal value of capital. So, earlier it was 300
percent now they have increased it to 600 percent.
We can also calculate their dividend their EPS which is already given and we can go for
their payout ratio; dividend payout ratio. Now, there are two ways of doing it; either we
can go for DPS by EPS, but right now we do not have the figure of DPS, but we know
the total dividend. So, what we can do is take the total dividend and divide it by the
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available profits which is equity dividend of the company divided by the profit for the
period.
So, you are getting 52 converted into percentage. So, you can see earlier company was
distributing 40 percent of their profit. Now, since the profits have increased, but they
have doubled the dividend, so, the percentage of distribution has gone to 52 percent. Is it
good to have higher or lower ratio? There is nothing good or bad, but higher ratio
signifies that company is able to company has decided to distribute more profits. A lower
ratio we will mean that companies distributing less, but retaining the profit for own
growth. So, it depends on the strategy of the company and on the opportunities which
they have ok. So, we have just calculated few important ratios here.
Now, in the next problem we will go for more detailed ratio taking out a particular
company and looking for variety of aspects of that company. In the mean tile I will
request you to go through the ratio sheets which are given to you and also variety of
problems which we have already discussed.
Having calculated variety of ratios of profitability, return, as well as the activity, let us
have a look at expense ratios. So, this is our profit and loss account. We have got number
of expenses particularly the larger expense is cost of material consumed. So, it will be of
interest for us to know cost of material consumed is what percentage of the revenue. So,
the formula for expense ratio is that particular expense ratio divided by sales. In this case
since we know the revenue from operations and we have also been given other operating
revenue we can also take total operating revenue in the denominator.
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So, let us find the cost of material consumed as a percentage of total operating revenue.
We are calling it Cost of Material Consumed Ratio; like that you can give it any suitable
name. So, it is 0.52. It is better understood if we convert it into percentage. So, you can
see it is more or less stagnant 52.89, then 53.15 and 53.95.
There is no other major expense item in the P and L. The largest expense was material
consumed. So, that is what is required that is the way we can also link other items, but
still let us link one more item that is employee benefit expense ratio.
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So, you can see over the period of three years it has increased. It is almost 7 percent; now
earlier it was 5.28 percent. So, these were important expense ratios.
Now, let us go to cash flow statement. In cash flow we have got cash flows categorized
into three. So, the most important of that is cash from operating activities. Let us see
what percentage of revenue it is.
So, cash from operating activities as a percentage of revenue. Now, it is logical for us to
take revenue from operations or total operating revenue. So, let us take total operating
revenue. We get 0.09. So, total operating revenue was 5436 and the cash from that
revenue of course, we have incurred variety of expenses. The final cash which came into
hand of business was 0.09 as a percentage it becomes 9.64.
So, you can see slightly very some figure here. What was 13 percent in March 14
become 11 percent and now it is about 9.6 percent. So, there is a fall in the ratio of cash
from operations as a percentage of operating revenue. One can also link the net cash
from operating revenues to the operating profits. So, if you go to P and L, we have got
profit before exceptional and extraordinary items to that if we add finance costs we will
get profit before interest and taxes. So, we get 72 percent.
So, out of the profits which we are reporting 72 percentage available as cash from
operations for the business. There also you see a drop. Earlier it was more than 100
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percent, then it became 90 and now it is 72, which means that lesser amount is now
getting realized as a cash which is not a very positive of value for the business. Like that
you can calculate a few cash flow ratios. Of course, most of the important ratios are on
the side of P and L where a different type of ratios can be calculated on P and L.
So, we will stop here. Namaste. Thank you.
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Lecture – 36
Financial Statement Analysis: TCS Case 1
Namaste. In last few sessions, we have been discussing about Analysis of Financial
Statements. We have seen horizontal and vertical analysis and we have also discussed
variety of ratios. If you remember, we had discussed that one can have any number of
ratios linking any particular data to some other data and those relationships are much
more valuable to the users of financial statements. So, variety of stakeholders according
to their requirement calculate variety of ratios. There can be also slight variations in the
formulas they use although most of the ratios to have a standard formula.
So, we have discussed cases of a few companies. Today we will discuss a very important
company known as TCS Limited. This is one of the largest companies in India in terms
of employment. Perhaps the largest private sector employer and has a very high market
capitalization and it is one good example of a service sector company. So, let us look at
their financials and try to calculate different ratios and then comment on the financial
statements going for the interpretation of those ratios. We have also taken here apart
from financial some other type of data because ratios do use or can be used can use
variety of data apart from financial statements.
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Now, let us look at the TCS. This is their basic information the registered office, their
address, name of the directors, name of the auditors and so on. I hope you have done it
for your company as a part of the assignment.
Now, this is a price and share holding data for the company; so, calculated up to May,
2019. Now, this is the latest price, the percentage change in price; the number of shares
number of shares are calculated in millions then the market cap. Do you know what is
market cap?
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Student: No.
We have not seen this ratio, but this differs to number of shares into market price. Full
form is market capitalization; popularly known as m cap or market cap. This is a very
good proxy for the size of the company or you can say the value of the company valued
at stock market prices because here we are taking stock market price into number of
shares. Then the volume, do you know what is volume referring to? Here the volume is
referring to the number of shares traded.
So, when you look it from a stock market angle, high volume indicates more liquidity for
the company stocks and normally shareholders or prospective investors prefer to invest
in a company which has more volumes. So, some basic data which is given we are just
looking at. Then PE; we have discussed PE. Do you remember what is it? Price earning
ratio according to market prices it will keep on changing. Denominator which is EPS
which will change on a quarterly basis, but the numerator which is market price keeps on
changing every now and then. This is the current PE for the company.
Then earning per share, percentage change for 1 month, 12 months etcetera are the
changes of the market price and 52 week high or low is the low and high market price for
the company. So, 273 is a high price 2730 and I think it is only showing part of it. So, I
will click here and that will be visible; you can see here 2273 (Refer Time: 05:09) 3273
is the highest price and 17, 2273 is the highest price and 1712 is the lowest price.
So, this is generally known as price and share holding data. It is already given, but I am
just those who are more interested in stock markets, you can easily download this data
and study more about the company from stock market angle. Now, the share holding data
this is a Indian company this belonging to Tata group. So, Indian promoters have 72
percentage holding. Foreign collaborators, there is no collaboration so, 0 percent.
Indian Institutions and mutual fund have just 2 percent holding FIIs or Foreign
Institutional Investors have 16 percent holding there is no ADR or GDR. Are you aware
what is ADR or GDR? This is American Depository Receipt or Global Depository
Receipt. So, company can issue it shares in foreign market using these instruments, but
since TCS has not done. This is 0 percent free float that is the stock which is freely
available in the market, it is 28 percent.
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Shareholders percentage is 616. This is the number of shareholders and pledged

promoters holding. So, whether promoters have pledged their holding and taken loan that
is just 2 percent which shows more stability for the company. If it is higher it means that
promoters have taken lot of loans using their stake ok. So, this is some share holding
data.
Now, let us go to financials. So, we have got financial data for last 5 years. Again in that
there is a equity share data. So, first of all you have got price data. You can see over last
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5 years, the market prices have been this. This is the higher market prices and this is the
low market price ok. Now, the average market cap this is one of the high M cap
company. So, current average market cap is 5232.
Number of employees I have told you, it is one of the largest employers in India in
thousands is 300 that is 3 lakhs; this 300,000 is the and the current is 395,000. So, around
4 lakh is a number of employees. Total wages or salary which is also given in rupees
millions it is. So, it is 663960 millions. This is the total salary. Then bonus rights or
conversions some code is given for the same. Then shares outstanding, this is the number
of shares which are outstanding it is 1914.
So, those shares which are issued and have not yet been cancelled these are shares
outstanding. Above also we had been given number of shares data.
Now, let us go to income data which is mainly extracted from their profit and loss
account. So, this is the sales for last 5 years; current sales is 1231. You can do a trend
analysis because the information is made available for last 5 years. Then, other income
which is not much so, you get total revenue which is currently 1267 then, gross profit
which is 325. The balance is of course, their cost of providing services because it is
mainly a service company. Depreciation which is not much of amount which is 20000
millions since this is a manufacturing company their depreciation is relatively low.
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Interest cost you can see is very low. Why it is low? Because the debt must have been
very low. We will go to balance sheet now.
Then profit before tax, you can see reasonably consistent increase in profit although in
the current year the profit has stagnated. Minority interest is given in last 2 years; right
now there is no minority interest. Now, what is meant by minority interest? This is the
data for the whole group. So, group will have various subsidiaries and there might be
some shareholders who have shares in the subsidiary. Although our company that is TCS
has majority holding there might be some small shareholders in those subsidiary
companies. Their holding or their share in the owners fund is called as minority interest
which will come whenever any consolidated balance sheet is given.
Now, currently there is no minority interest those companies might have been merged
with TCS. Then prior period items, what is a prior period item? These items are last
years mistakes or errors; if they are rectified in a particular year they are required to be
separately shown as a prior period item which is not the case, so, it is 0.
Extraordinary items into bracket expense. So, in most of the years it is 0 except in 1 year
where it is 4898. Then tax and the last figure over here is profit after tax.
So, the whole P and L will would have been very long. So, a kind of summary of P and L
is given and we have been asked to calculate certain ratios.
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So, one is a gross margin ratio, then effective tax rate and net margin ratio. Now, how
will you calculate gross margin? What is a formula? Do you remember the formula?
Very simple, we are trying to link gross profit to sales. So, compute the gross margin
ratio. So, this is equal to gross profit divided by net sales. So, you get 0.30 you can
convert it into percentage for better understanding. So, 31 percent is a gross margin or
gross profit percent.
So, if you compare 5 years, what do you get? It is 31, 26, 28, 27 and 26 which shows that
margins are in pressure. In 2014, their margins were pretty high 31 percent; now it is
only 26 percent. Gradual fall in the margin is seen. Getting it?
Next is effective tax rate. Please calculate with me. So, we have got tax amount. Now,
this is what percentage if you want to know it as a percentage. So, what is a formula?
This tax is to be divided by what? It is charge on which amount? Actually it is charge on
profit before tax. So, this shows 23 percent. In terms of percentages, it has come to 24.
So, you can see in all the years it has remained stagnant; it is 24 percent.
Now, what is the actual rate of tax for the companies? The maximum marginal rate is 30
percent or 33 percent including surcharge. Most of the companies do some investment
and their effective rate of tax is low and they might also get some benefits because of
export or because of some investment at certain places. That is why we need to calculate
effective tax rate which you can see here is 24 percent, Getting it?
Next is net profit margin. Net profit margin is nothing, but net profit ratio. So, we will
calculate the net profit after tax as a percentage of which figure, you will get?
Student: Net sales.
Net sales or other income or total revenue. Normally here total revenue is more relevant.
See, in case of gross profit we had taken it as a percentage of net sales, but for net profit
we are normally going for total revenue because net profit includes all profits including
other income, but yes if you want to calculate it as a percentage of net sales then that can
also be done. So, it comes to 23 percent. Over the period it has also fallen from 23, it has
slowly gone down and it is now 20 percent.
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Why there is a fall in net profit? Mainly because of fall in the gross profit. In fact, other
income has increased especially from 2015 and that would have help to slightly take up
net profit ratio, otherwise all other calculations are more or less same. Are you getting
me? So, we have calculates calculated some of the important profit related ratios.
Now, we can also go for balance sheet and try to calculate sum of the balance sheet
related ratios. Before that if you want to have some idea about the cost, you can be asked
about calculating how much their how much is their cost of sales as a percentage of
profits. So, can you calculate it? You can calculate you can take the gross margin and
100 minus gross margin, you will get the percentage of their cost of sales ok.
So, let us also try to calculate that ratio. You can also call it cost of providing service
because it is mainly a service company. One easy way of doing, it is just finding it from
the gross margin; otherwise we can calculate the cost of sales here and then divided by
net sales; cost of sales upon net sales or one minus the gross margin either way you can
get it. You can see here the cost of sales is slowly going up and that increase has put
pressure on the gross margin which in turn has also brought down the net margin. Are
you getting it?.
Let us go to now the balance sheet data. Have a look at the balance sheet first. The
current assets are slowly going up same way their current liabilities are also going up,
but at a slower rate. You can see their current liabilities are much lesser than current
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asset. Then net fix assets also show slow raise although the major raise was in 2015 after
that it is more or less stagnant. Then free reserves sorry share capital. Share capital is
more or less same although it has been reduced now in terms of rupees millions.
Then the free reserves- free reserves are steadily going up net worth also is steadily
going up the company has been in profit for a very long time that is why they are able to
build up their free reserves. What is a net worth? Net worth is nothing, but the owners
fund. The net worth also has been slowly increasing and as you know share capital plus
free reserves give us the net worth. Then you get long term although net worth may not
be exactly that amount because there could be some other reserves also in some cases.
See this is not the full balance sheet we have just been given some extracted and
important figures.
Now, long term debt it is very low it is just 1273 and now it is 540. So, company is
mainly relying on the owner’s fund. They hardly have any debt and whatever little debt
they have that also they are slowly repaying. Total assets, this is the figure of their total
assets which has been steadily rising especially if you see last year March this is I think
March 17. There was a major increase in the total assets ok.
Now, let us try to calculate these two ratios; debt to equity ratio and current ratio. Now,
what is the formula of debt to equity? Normally we take long term debt as a percentage
or of or divided by net worth or we can also say borrowed fund upon owners’ fund. If
you go for a percentage it will be 0 percent I will just increase the decimal it becomes
0.26 percent which is very low. Sometimes it is calculated as number of times, but since
this amount is so small that number of times will be just 0.2.
Now, is it good to have such a low debt equity ratio if you remember we had discussed
about debt equity ratio of 1, 2, 3, 4 also sometimes; that means, debt was much more
than the debt by than the equity maybe 2 times or 3 times. Now, is it good to have low
debt equity? Answer is yes. We have discussed that higher debt equity leads to un
stability whereas, a lower debt equity is a stable position; that means, from risk
perspective lower debt equity is always good, but it may impact profitability adversely.
But, what happens is in case of companies like IT companies, they do not require very
high quantity of capital. For a manufacturing or for an infrastructure company there is a
need of a huge capital. So, they can justify more debt equity ratio their income streams
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are also more stable. But, for a IT company or for a service sector company their main
capital is human capital or their main capital is their brain. It is not in the tangible form
so, does not need too much of fixed asset, so, does not need too much of capital.
So, they do not have normally have high level of debt equity ratio. So, it is good that they
have low debt equity ratio. In fact, they have further brought it down. There are
companies like Infosys which most of zero debt company because they are completely
financed by equity. Now, this was about their long term stability. Now, let us look at
their liquidity for which we will calculate current ratio.
Now, what is the formula of current ratio? Do you remember? It is current assets divided
by current liabilities. So, please calculate along with me CA divided by CL. So, you get
2.73. Normally, it is not calculated as a percentage. So, we will drag it over a period of
time it has consistently increased. So, from 2.73 now it is 4.55. Of course, in the last year
it had come down a bit. So, is it a good sign? Normally yes because we have discuss that
debt equity ratio of 2 is to 1 is considered as standard although that standard can change
from company to company.
So, here we see that company has much higher debt equity ratio than the minimum
required which is a positive sign from liquidity angle. Although one can raise a question
as to why current assets are though that high compared to current liability? For further
analysis we may require more data like their aging schedule or like their debt like their
debtors collection period, to see whether their collection period is too high. But, as of
now based on available data this is a good sign as for as liquidity is concerned.
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Now, next are cash flow related information. So, all the three types of cash flows are
given; cash from operations, investments and financial activity. So, you can see here
cash from operations is consistently rising, although in the last year it has become
somewhat stagnant. Cash from investments was negative; high quantum negative. Last
year also it was negative in the current year it is positive.
Now, it is a good sign that it is it a good sign that it is positive now? Not necessarily,
although normally we feel positive is good, but if investment side cash flow is positive it
means that there is no much of fresh investment. So, having a negative cash flow from
investment is in fact, good. Of course, just by one year we cannot conclude because over
4 year period they have got a negative cash flow there. Cash from financing activity has
been most years negative because they have been paying good amount as a dividend and
do not have a to really raise a much of the funds since they are getting good amount of
cash flows from operations.
So, overall you can see that net cash flow was has been maintained well. In fact, it was
much higher positive figure in 2016, then negative figure one year and again it has
become positive. So, overall their cash flow position looks fine. So, we have just have a
look at all the three statements.
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Now, in the coming session we are going to continue with calculation of various ratios.
So, I will request you all to sit with that sheet and try to calculate the ratios along with
me. Till that time let us break. Namaste.
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Lecture – 37
Financial Statement Analysis: TCS Case 2
Namaste. In last few sessions, we are discussing Analysis of Financial Statements and in
the last session we had taken up case of TCS limited. So, TCS Limited, you all know is a
leading Indian MNC which is one of the largest private sector employer in India.
And, we had discussed their market data, equity market data, then income data, balance
sheet data and cash flow. And, we had also calculated some basic ratios related to P and
L and related to balance sheet.
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Now, let us go for their combined ratios. By combined what I mean is one figure is
picked up from one statement, the other one is picked from the other statement. Some of
the ratio has have also been calculated on the extra information which is provided by the
company ok. So, first one, now the formulas for the ratios are pretty simple almost
common sense, but let us try to calculate the important ratios and observe the trends in it.
Now, first one is Exports to Sales. So, what is a formula here? We are trying to look at
the export as a percentage of total sales. So, exports are given only for first 2 years and
we will divide it by their net sales which comes to about 3 percent. I am sorry not 3
percent, it is just 0.32 percent in March 14, and was 0.5 percent and in more current
years it in the figure has not been given. So, it is just 0 amount.
The next one is net working capital to sales. Now which is the important ratio for
working capital? We have seen that for liquidity we normally calculate current ratio,
which we have already calculated.
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But, here we just compare between current assets and liabilities between two balance
sheet items. But if we know working capital is mainly required to finance the operations,
which is required to finance the day to day business activities.
So, one way to know the adequacy of working capital is to link it to the revenue which
we generate or the sales which we generate using that working capital. So, the ratio
which is calculated is net working capital to sales.
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So, now the working capital figure is not given although we have been given current
assets and current liabilities. So, compute CA minus CL which will be working capital
for the numerator and divided by sales.
So, CA minus CL this is the working capital divided by shall we take total revenue or net
sales both the figures are possible, but since working capital is mainly for our own
business operations, not for other income it will be more authentic to take net sales.
So, it comes to 0.33 you can see gradually it is going up from 0.33, then 0.36, it went to
0.55 and in last year it has slightly come down to 0.51. So, what does it mean that
company is now keeping more and more working capital. So, for one rupee of sales they
had 0.33, now it is almost 0.5.
Now is it a good sign? Not necessarily they are from liquidity angle it is good, but they
are keeping too much of too much of working capital. They are having slightly higher
working capital than required as I said we need to check from audit angle the
composition of their debtors, because they do not have any inventory.
So, their major current assets are the receivables from customers. So, they need to be
checked. Do you remember any other ratio which is similar to this ratio? We had discuss
that ratio earlier, that ratio would be sales to working capital, which is known as working
capital turnover ratio, which is just a transposition of this ratio though it is not required in
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the case, I will just try to calculate it. So, I am writing it down here. You know that there
are turnover ratios which we calculate to know the efficiency in use of that particular
asset.
So, to know the efficiency in use of working capital, we can calculate working capital
turnover ratio. What is the formula sales upon working capital? So, let us take net sales
and divide it by working capital. So, again in bracket, we have to take sorry there is some
confusion in bracket we have to take CA minus CL.
So, you can see the working capital turnover ratio is slowly going down; it has gone
down from 3 to 1.94. What does it show; it means the efficiency of use of working
capital has been falling. Actually net working capital to sales and working capital
turnover ratio is showing the same thing. I have just calculated it again to make you
understand that different ratios can be used actually to calculate the same thing.
Now, the same thing can you calculate one more ratio for it, do you remember we have
discussed that ratio. We can express this working capital turnover ratio in terms of
number of sales number of days of sales, let us do that also. So, that you get even more
clarity this we will call it as working capital in terms of days the formula is already with
you. So, try to calculate it. So, working capital days we will use the transposition now.
So, it will be 1 divided by the turnover ratio, it is 1 upon I do not know why it is not
taking 1 upon C. So, you will get the ratio into if you want to do it in terms of number of
days we will multiplied by 365.
So, you get 121 days. So, from 121 it has gone up to 187. So, in a year of 365 days if a
particular amount is locked up in the form of working capital earlier it was 121 it has
now gone up to 187 days, which is you can understand is a very high amount; that
means, almost for half the period of the year their working capital is locked up. It is
normally suppose you sell some item you can give a credit for 2 months, 3 months, 4
months, which we will mean a 90 days or 120 days period, but here it is very high it is
187. So, all these 3 ratios actually were essentially same conveying the same meaning,
but in a different way. Are you getting it?
Now, next one is sale to assets ratio. Now this is similar to this working capital turnover,
but it refers to the total assets. So, now, the total assets are used to generate sales. So, we
will take the total revenue here. Because, we are going to divide it by total assets and we
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will divide it from the balance sheet we get total assets, we will divide it by that. So, we
get 1.24.
So, you can see there is more or less stagnancy in this ratio although it ratio increased in
2015. It has now fallen to 1 point fallen a bit, but still better than slightly less than March
14 1.19; that means, 1 rupee of assets are converted into sale of 1.19 still norm compared
to other industries it is a ratio on a lower side ok. So, this is showing efficiency in
utilization of total assets.
Now, next is ROTA, Return On Total Assets or Return on, Assets as it has been called
here. So, in the denominator as the name suggest, we will take the total assets, here
return signifies profitability. So, the final profits which you earned or profit after tax
divided by total assets give you return ratio on total assets. So, take profit after tax in the
numerator and from balance sheet take total assets, we get 0.28 normally we will express
it as a percentage.
So, here you see that the ratio has been falling earlier they were able to generate 28
percent return on the assets, which has now come down to 24 percent. So, more assets
are getting locked up relatively giving lesser profitability. Now, from the equity
shareholders angle what could be interesting to them is return on equity or return on
owner’s fund. So, what is a formula return is profit. So, PAT, Property after Tax divided
by equity or owners funds.
So, let us calculate it PAT divided by net worth 0.38 let us express it as a percentage. So,
38.96 percent was return in March 14 slowly the return has been falling. Mainly because
of lower profitability they are able to generate lesser return than equity. Now, the next
one similar ratio, but very important ratio is return on capital.
Now, what is the difference in return on equity and return on capital? Return on equity is
a return only on equity shareholders money, return on capital is a total capital employed.
Although this company does not have much debt, but normally it is capital that is owners
fund plus debt, taken together what is the long term capital. And, what do you take in the
numerator; numerator also we will not just take PAT we will take PAT plus tax plus
finance cost ok.
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So, I will put this in bracket return on capital is equal to we have been given profit after
tax add taxes or we could have also taken PBT directly and to this we can add interest or
the finance cost, divided by in the denominator. We are going to take total long term
capital. So, we will take again put it in bracket net worth sorry it got closed net worth
plus so, net worth plus long term debt.
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So, now you got 0.51 this is for the March 14 debtors. So, 0.51 slowly it has come down
to 40 percent, sorry not 0.51 51 percent in as a percentage and it has gone down to 40
percent.
So, because of the falling margins the return on the capital employed has also fallen.
Why is it higher than return on equity? Because, now you are taking profit before taxes,
since this company is more or less 0 debt company; there was no much effect of interest.
Because of addition of taxes the return on capital or long term capital is much better, and
if you compare with return on say bank, bank might give you 8 or 9 percent return
whereas, TCS is able to earn as much as 51 percent return on their capital and on owners
funds it is 38 percent.
So, for most of the healthy companies it should be on a higher side are you getting it. So,
these return ratios are very important for owners as well as for anybody who wanting to
take over the company or who wants to study the company from a long term angle.
Now, next is sales per share, now this is one of the hybrid ratio, this is not a financial
ratio per say, because denominator is number of shares, but shareholders might be
interested to know that how much sale is generated for one share. So, it is sales. So, we
will take the data of net sales and let us divide it by number of shares. They have given
this share outstanding data e o y means at the end of the year. So, we get 417 since all the
data is in rupees million, this is also in rupees million.
So, for one share I will copy it here. So, for one share they are able to generate 417
millions of sales you can see there is a gradual rise. So, company is able to increase, it is
revenue. Although it is profitability is in sort of pressure. Now the next is earning per
share this refers to as you know profit available per share. So, what is a formula which
profit will you take, operating profit, profit before tax or after tax you will take profit
after tax. In fact, if there is a preference dividend we will deduct preference dividend
also.
So, PAT or profit available to the owners should be in the numerator right now let us
take PAT, profit after tax divided by number of shares. So, you can see earning per share
has been increasing gradually. Because company’s total profit is going up although
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profitability is falling a bit total profits are rising. So, earning per share is also slowly
going up.
Next is cash flow per share. Now some shareholders may not be happy just by knowing
the earning, they would probably be interested in knowing the cash generated per share,
again we do not know whether they want total cash flow or whether they want operating
cash flow per share, probably they are looking for operating cash flow.
So, let us go for this is a new formula. So, note the formula cash flow per share operating
cash generated from operating activities divided by number of shares. So, you can see
there is a good rise from 75 to 130 more or less consistent rise in the cash flow from
operating activity per share basis, next is dividend per share. So, how much money is
company distributing as a dividend, which will be received on a per share basis.
So, it is simple now we will take total dividend and divide it by number of shares. I think
here dividend data is not available. So, you will not be able to calculate dividend per
share. Let us check once again no dividend data is not available.
Now, the next one is dividend yield. Now, what do you mean by dividend yield; that
means, as a percentage what return you are getting based on dividend. So, it is dividend
upon will you take number of shares no. If you take dividend upon share capital, you will
get the rate of dividend declared, but they are talking about market yield.
So, we will take dividend upon market price of the share or DPS upon market price since
we do not have dividend data, we are not able to calculate dividend yield also, but it is
already given on in as a share information above I will just show you.
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So, they have given here dividend yield which is 0.7 percent this is the current dividend
yield we do not have 5 year data, but the current yield is known to you. The next one is
book value per share. Now, this is a very interesting and a important information. So, net
worth is the value which shareholders will get we divided by number of shares to know
that if the company is closed today, how much money will each shareholder get per share
basis.
So, please take net worth and divide it by number of shares. So, from 251, you can see
consistent rise to 443; that means, company is slowly earning profits and adding
reserves. So, their book value is going up.
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Now, price upon sales ratio this is referring to market prices. Now, I think market price
information is not available for all the years yeah it is there. So, average market cap is
given, but we are not been given number of we have not been given average market
price, let us check again high and low market price is given, but average is not given. So,
we will not be able to calculate price per share ratio average PE ratio that is price upon
EPS, again we need average price and we divide it by earnings. So, we cannot calculate
this also.
Next is price to book value ratio again in absence of market price we do not know, but
this is a important ratio which links market prices to book value, we have just calculated
book value.
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Next is dividend payout. So, this is based on the dividend; dividend upon the current
market price sorry dividend payout is a percentage of amount which is distributed as a
dividend from the profits. So, it is dividend upon profit or d p s upon e p s. So, we do not
know dividend data. So, we do not know this.
Now, there are 3 last ratios which are interesting, because they are related to number of
employees. Average sales per employee, average wages per employee and average net
profit plus per employee, this we can calculate because we know the number of
employee data.
So, let us go for it. Sales divided by number of employees. So, it was 2722 in rupees
million and it has slowly increase to 3116, this is the revenue generated by one single
employee. Now, let us see what employees get for it that is their wages. Now, total
salaries and wages are given and divide it by number of employees. So, you may want to
be employee of TCS perhaps, because 993 million was that time and today it is 1680
million for every employee single employ and net profit.
So, we will take net profit after tax and divide it by number of employees. So, 637 per
employee and now it is 655. You can see it is more or less kind of stagnated because
profitability is under pressure although the salaries of employees has increased quite
healthily ok. So, this was an attempt to do to show you how a detail analysis is done by
especially the analyst who are trying to study a particular company in detail.
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So, in next session, we will try to take another company till that time study this carefully
Namaste thank you.
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Lecture – 38
Financial Statement Analysis: RIL Case 1
Namaste. In last few sessions, we are discussing Financial Statement Analysis,

particularly in the last session we have discussed a case of TCS we are we have little bit
gone beyond financial analysis, we have also taken other information and have
calculated the ratios for TCS. In the current session and in the next session, we are going
to take up Reliance Industries Limited, we know it is a premier listed company. It is a
biggest listed company in India in terms of its market capitalization. So, we will try to
analyze the company on different basis. The type of analysis which we are doing in
portfolio management parlance, this is known as fundamental analysis. There are two
types of analysis one is fundamental, other is technical.
In technical analysis; the price data of the company, the volume, the movements of
prices, the charts all these things are studied whereas, in fundamental analysis the
fundamentals of the company are studied which will mainly involve the financial
statements and other data about the company. This part of fundamental analysis is known
as company analysis, then there is a study of industry or the sector in which the company
is operating that is known as industry analysis and the third part is known as economy
analysis, where the whole of the country or whole of the economy is studied.
Now, all this three factors impact the performance of the company. Of course, we will
not be able to go into details of industry or economy analysis, but we would try to look at
how to do company analysis mainly based on the ratios…
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So, let us now, look at the reliance, you know that the MD, CEO and the chairman is
Mukesh Ambani and the Company Secretary is K Sethuraman, the auditors are
Chaturvedi and Shah. This is some details face value of the company is rupees 10.
The price is rupees 1255, this is in May 2019; the percentage change during the week
etcetera is given. The market cap is 3161428 in terms of rupees millions, the volume you
can see is fairly high which shows that the company shares are very liquid, the number of
shares are 6503 millions ok.
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Now, let us go to the share holding pattern, again it is a Indian company. The percentage
of shareholding of promoters is 45 percent. It belongs to Mukesh Ambani group. Indian
institutions have about 12 percent foreign institutional investors 18 percent. They have
issued securities abroad that is why ADR or GDR is 3.2 percent, free float is 20 percent.
What is a free float? That means, these are the shares which are freely traded in the
market which is about 20 percent. The number of shareholders are given. I think this is
the largest number for any company in India 27,90,000 the percentage of shares pledged
by promoters is 0 percent.
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Now, let us look at the stock market data, this is the high and low prices for last 5 years.
Average price is also given for last 5 years. The shares outstanding at the end of year in
terms of millions is given.Ddo you see any movement in the number of shares? Yes if
you look at the last 2 years there is a major rise from 2958 to 5921 and that is because of
the fresh issue of bonus shares. So, they have given bonus ESOS conversion etcetera.
So, every year some slight amount of ESOS are given and this year it looks like major
rise in the share because of the bonus. Average market capitalization over the period is
also given. The number of employees are pretty high in terms of thousands so, its 23000
employees and now it is 187000 employees. Now the total salary over a period of time is
given, I think this needs a bit of correction the number of employees. So, we will do the
correction in the number of employees.
Now, the net sales, the net sales data over the period you can see that right from March
14 in fact, the net sales have slightly gone down and in the last year again the net sales
have increased the other income is pretty stable.
The total revenue went down in first 3 years and then again it has gone up understand
that they are in oil business. So, oil prices fluctuate their sales are also fluctuating. The
gross profits surprisingly show a pretty stable sign. The gross profit have more or less
increased in all the years except in last year they decreased a bit and again they have
jumped up to 544. Depreciation is a substantial amount. Why it is high compared to that
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in TCS? Mainly because its a manufacturing company, they have got vast amount of
fixed assets.
So, depreciation is 112 now it has increased to 167. Interest cost is also high and it has
gone up substantially. Profit before tax is increasing steadily, minority interest is also
pretty high and this minority interest is because of the shareholding of other people in
their subsidiaries. There is a extraordinary income in March 14, there is no extraordinary
income in any other year taxes you can see last 2 years the taxes have increased.
And the profit after tax has also increased more or less consistently; the dividend figures
are given over last some years some ok.
So, profit after tax and we have taken estimated figures of dividend for all the years just
for our calculation sake. So, this is their income data, now using this we can calculate
certain important ratios the first one is gross margin ratio. So, what is the formula, do
you remember? It is gross profit divided by sales. So, it is 8 percent for March 14 please
calculate it with me for all the years. So, it becomes 8, then 9 then 17, 15 and 13. So, you
can see that in March 16, they were sorry in March yeah March 16 they were able to
significantly increase their gross profit margin. Overall they have a good margin
although it is changing over a period of time they are into several businesses, but mainly
in oil refining. So, may be the changes in the oil prices could be responsible for changes
in the gross margin.
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The next is EBDITA. Now what is a full form of EBDITA? Earning Before Depreciation
Interest Tax and Amortization; this is a cash operating profit. Now we have been given
gross profit which is almost like a operating profit and we have also been given profit
before tax. So, in profit before tax, let us add interest and depreciation to get EBDITA.
PBT add interest add depreciation this is the EBDITA, we will divide it by net sales.
So, it is about 10 percent in March 14 over a period of time, it has increased slowly from
9 to 20 and then it is more or less stagnant slightly it has gone down.
Now, this is a very important figure to know the cash generated from their operating
profits. Now the next one is net profit margin you all know the formula net profit upon
sales. But here instead of sales we would take the total revenues. So, net profit was 5
percent went up to 10 percent is now 8.71 percent as we know mainly because of gross
margins, but it also takes into account other income and other figures.
Now, let us go to balance sheet data.
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Now, last time we had studied TCS, but this is important and more interesting because
this is a manufacturing company which is which has more figures because it invest in
variety of types of assets. Now you can see that their current assets which actually went
down and again have gone up current liabilities are pretty high. If you look at the ratio
you will realize that their current liabilities are much higher than current assets in March
18. Inventory as a days because being a manufacturing company has to maintain lot of
inventory, it has increased from 48 to 64 and again it went down to 56.
Debtors are very low 8, 5, 6, 10 and 16 this is in number of days. So, you will realize that
their credit policies are very strict, they are selling almost on cash basis or with a very
minimum credit, but slightly it has gone up to 16 days now.
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Net fixed assets they are having vast quantum of fixed assets and there is a consistent
increase in the fixed assets which is 5909 now. Share capital has been constant more or
less, but in the last year it has gone up. Free reserves are pretty high amount free reserves
are high because consistently they are making good amount of profits. Net worth is also
reasonably high. Long term debt being a manufacturing company it is not a zero debt
company like TCS, they have a high long term debt although the debt equity ratio is not
very high, we will just calculate the ratio now..
Total assets they are nearly doubled over a period of 5 years. Now let us calculate two
important ratios that is debt equity and current ratio. So, you know the formula in debt
equity it is debt upon equity. So, long term debt divided by net worth 0.50; either it can
be expressed as a percent or just as a fraction this time. Let us just keep it as a fraction.
So, its 0.51, signifying that for one rupee of equity 50 paise is an amount of long term
debt. If you compare all the 5 years, then debt equity ratio increase the bit to 0.61 it has
again gone down now till March 18.
Now, current ratio you know it is current assets divided by current liabilities.
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It was pretty high 1.31 and now has decrease substantially to 0.59. Particularly you will
see that because of rise in the current liabilities, the current ratio is falling. Now if you
remember we had discussed of standard ratio of 2 is to 1 reliance industry has much
lesser current ratio than the standard ratio. This could be a bit of problematic as far as the
liquidity is concerned although it is a very big company with a high credit rating. So,
they are able to manage even with lesser current assets.
Particularly in the last years there is last 2 years, there is a remarkable increase in current
liabilities maybe that needs to be further studied.
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Now, in the third part cash flow is given, you can see in the last year there is a significant
increase in the cash from operations, cash from investments is more or less maintained
although in the March 15. It was significantly negative which is a positive sign, but in
most of the years a RI has been able to make some or other investment. Financial activity
related cash flow also has been more or less constant though there are few fluctuations,
but compared to the total size. It is not very high and the net cash flow was minus 160,
then it became minus 220 and in the last year it is 12660.
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Now, let us calculate some of the combined ratios. The first one is interest coverage ratio
now what is a formula do you remember? We see how better the interest is covered. So,
how many times they have earning to pay interest? Interest in the denominator and
profits in the numerator. So, you will take which profit in the numerator? Will you take
PAT? No because we have to take profit before interest and taxes from that amount we
can pay interest.
So, let us calculate PBIT, we have been given PBT add interest to that we will get PBIT;
this is the profit available for paying interest divided by interest. So, you get 8.28. So,
there is a fair coverage although they have got lot of interest payments since their
profitability is very high, it is covered 8 times the coverage increased now it has slightly
gone down.
The next one are the efficiency related ratios? We have just considered one ratio here
that is sales to fixed assets ratio. So, it shows how efficiently you are utilizing your fixed
assets to generate sales. So, sales divided by fixed assets. Since this is operating related
we are mainly considering only net sales and not taking total revenue. So, what do you
see here? There is a serious fall in the ratio. It was 1.81 the ratio has fallen particularly
from March 16 and then it has become stagnant, its 0.66. If you look carefully their fixed
assets have increased substantially without much increase in the sales in fact, sales went
down and now the sales are steadily rising.
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But its a very complex company. So, we cannot directly know anything, they might be
constructing new fixed assets, but the current data as of available right now shows that
the efficiency of utilization has somewhat gone down. Now return on assets popularly
known as rota r o t a where we will try to calculate how the total assets are used to
generate profits. So, we will take PAT upon total assets. PAT divided by total assets. So,
you get 0.52. So, you can see 0.05 and if you convert it in percentage then it is more
meaningful.
So, 5 percent was the return it has gone down to 4.42, it is not a much of a fall, but slight
fall in the return on total assets the next one is return on equity. So, equity means owners
funds and what profits they are able to generate? So, PAT upon net worth. So, 11.32
percent was the return and now it has more or less stagnant it has become 12.29. So, if
you remember TCS this return on equity is somewhat lower for reliance.
Now, the next one is return on capital popularly known as ROCE or sometimes called as
ROI where we will take the total return and in the denominator take the total funds debt
plus equity. So, do you remember formula? In the numerator we will take PBT add back
interest divide it by long term debt plus equity. So, 10.61 percent; in case of TCS it was
almost zero debt company very low debt, but reliance being a manufacturing company
has a reasonable quantum of debt. So, you can see the return on capital is slightly lower
and now over a period of time the return has gone up to 13 percent. Keep in mind that it
is interesting to study manufacturing because you get debt plus equity and we have
discussed about capital structure. If you know your capital structure there is a higher
quantum of debt the return tends to increase which is known as trading on equity.
Now, you can see here that company has somewhat been able to improve their return on
capital by going for some level of debt ok, but in case of TCS if you remember, the
return on capital was much higher because of the effect of tax. Now the next is net
working capital to total sales. So, working capital is CA minus CL divided by sales 0.08,
you can also take it as a percentage; that means, about 8 percent of the capital of the sales
is the net working capital..
You can see this is very interesting it has moved from 8 percent to minus 32 percent now
what could be the reason? Because their current liabilities have increased substantially.
So, look at the current assets and liabilities, now the current liabilities are much more
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than current assets. So, they are into a negative working capital scenario, that is a reason
why the ratio has turned negative in last 3 years.
So, really interesting ratio it was 8 percent then became less than 1 percent and its
negative in last 3 years. If you look at current ratio you will see it was from 1.31 to 0.59
the same impact was in terms of sales if you look at, you can get it from this ratio getting
it?
So, we will stop here in the next session. We will continue with the calculation of the
remaining ratios. Namaste.
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Prof. Varadaraj Bapat
Lecture – 39
Financial Statement Analysis : RIL Case 2
Namaste. In the last session we were discussing the financials of Reliance industries, we
have considered their P and L, balance sheet, cash flow and have also calculated few of
the ratios. So, what we are doing is the company analysis for the company taking 5 year
data, let us continue with the same.
So, we had come up to this net working capital to sales ratio and we had seen that the
movement is really very interesting from plus 8 percent to minus 32 percent. So, much is
a negative working capital now as a percentage of sales. Next one is sales per share, so,
take the sales and divide it by number of shares.
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So, 14477.98 and if you drag it over a period of time you can see there is a slow fall in
the sale per share because the sale performance has dropped while the number of shares
have gone up.
So, there is a fall in sale per share the next is very important figure from financial stock
market angle that is EPS or Earning Per Share.
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So, numerator I think you all know we take PAT this is the total profit of the company
divided by number of shares to know the profit available per share. So, 76 the earning
per share has increased in March 17 because, the profit have gone the up, but now it has
significantly decreased because number of shares have also increased now. Dividend per
share here we have just taken one hypothetical amount for dividend and we divide it by
number of shares to get dividend per share.
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So, dividend divided by number of shares, I think there is some confusion we will do it
again.
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So, 34.02 it has more or less remain constant over the period.
The next one is dividend yield, now this is important ratio and slightly a different ratio
because it is trying to leak dividend to market prices, we will try to calculate it on
average basis because we know the average market price. So, dividend is a return to the
shareholder which we have calculated on per share basis divide it by average market
price during the year; 0.04 let us do it as a percentage. So, 4.20 percent over the years it
has fallen because market prices have increased dividend has not increased much fine.
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Now, book value per share this we know from balance sheet that what is the net worth
and calculate it on per share basis. This is going to be a pretty high amount it represents
the total value of the company if the whole of the company is sold off today on per share
basis. So, it is 83133 in terms of millions of rupees and it has now gone up to 105959.
The next ratios are price related ratios PE ratio. So, price per earning it can be done at a
particular point of time, but right now we will do on average. So, average price during
the year divided by earning per share. So, its 10.59 for 1 for the shares sorry it is not for
1 share it is 10.59 times and you can see it has gone up now it is substantially high it is
23 what does it show higher is good or lower is good?
Normally, from the company’s reputation view point higher is good; that means, market
is giving more importance to this particular company’s earnings, but from investors
viewpoint many times lower may be good because that could be a good time to buy the
shares. Of course, there are other market related factors also which go into the PE
because the price of the share also depends on vast market and economic related factors.
The next is price to book value ratio we have just calculated book value per share. Now
we will try to link it to the prices. Now let us go to dividend payout ratio. So, we have
already calculated dividend per share we will divide it by the, we will take the market
price. So, dividend per share upon market price this is the percentage of earning the
shareholders are getting usually calculated as a percentage.
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So, I am sorry there is some confusion, earlier we have already calculated dividend yield
which is market dividend per share upon market price currently we have been asked to
find dividend payout, what dividend payout means is from 100 rupees of earning how
much money is being paid out as a dividend. So, it is DPS upon EPS. So, DPS divided
by EPS. So, 44.46 percent is a dividend payout, you can see it has slightly gone up which
shows that more percentage is being now paid as a dividend out of the available profits
to the equity owners.
Now, the three next three ratios are related to performance of employees. So, this is a
semi financial ratio you can say because the denominator will be now number of
employees and we will try to link the sales average wages and average net profit to the
number of employees.
So, first one is sales upon number of employees. So, it is 181782 millions per employee
and you can see there is a fall because there has not been much increase in the sales. In
fact, there was a decrease in the sales and only in the last year there is a slight rise.
Average wages per employee. So, total wage data is available divided by number of
employees. So, 2331 millions there is some confusion in this data because number of
employees are in per 1000 that is why we are getting very high figure. So, do not worry
they are not getting that much of amount we will have to what we are doing is we are
taking the total amount in million and take dividing by number of employees in terms of
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1000. So, further we need to divide by 1000 to get the correct figure, so then we will get
just 2.
Same way even for average sales per employees then it was necessary to divide it by
1000, remember this is in millions of rupees the next is average net profit per employee.
So, we are taking profit after tax and dividing it by number of employees and further
dividing by 1000 because number of employees are in 1000’s. So, 9.41 it has gone up
now because recent years the profitability is bit improved.
Now the last two ratios are net sales to operating cash flow ratios, we have not done
many ratios on cash flow. So, we know the cash generated from operations is a operating
cash flow and we have got net sales figures. So, we are trying to link our sales to
operating cash flow. You can see that there is a slow fall in the ratio. So, the higher
figure we will mean that the in relation to sales the operating cash flows have been low,
right now it is a bitter sign that slowly the ratio is going down.
And the last one we will try to know the profits as a percentage of operating cash flow.
So, since they have asked for net profit we are calculating profit after tax and dividing it
by cash flow from operations it will be better understood as a percentage. So, profits are
about 52 percent and now they have they have more or less remain constant they are now
50 percent. It will actually make better sense if we link PBDIT because that is a profit
cash profit from operations. So, let us link that as well. So, we are linking our cash profit
to cash from operating activities.
So, let us take profit before tax add interest, add depreciation which is our PBDIT and
divide it first by cash from operations. So, you are getting 0.99 1.31 the amount is close
to 1 is it correct it is correct because both are showing the cash generated one is a profit
generated on cash basis the other is cash generated from operations, that is why the
amounts are fairly close its 0.99 1.33 etcetera. So, we have tried to calculate variety of
ratios there here. As I told you one can calculate 100s of ratios, but each ratio from each
stakeholder’s angle is very important.
So, here we have tried to calculate number of important ratios and try to understand the
significance of the major ratios and try to work them out for different companies
because, that will give you insight about the performance or financial position or cash
flow of that particular company.
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So, let us stop here, Namaste.
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Prof. Varadaraj Bapat
Lecture – 40
Revision of Course
Namaste. To all of you, I am very happy that we have reached the last 40th lecture of this
course. So, we were meeting regularly for last 2 months, I am hoping that you would
have found the lectures as well as the assignments very much useful for your learning
process. Now, this being a last lecture we will take a brief recap of whatever we have
discussed whatever you have learnt in the course, we would also think of what can be
done further for strengthening the learning and also what are the avenues for future
learning.
I know it is a mix of variety of students or participants of different type, because this

course has registration of students from different faculties; there are engineering
students, there are management students, there are non-commerce students like art or
sciences, there are also few commerce students, there are some entrepreneurs or
housewives and so on. So, it is going to be useful for almost everybody in the society if
you have a basic knowledge of accounting, which we have tried to discuss in the class.
So, we started with discussion on what is meant by accounting.
If you remember we discussed that accounting is a language of business. So, we come

out with financial statements based on transactions. First we record transactions then we
summarize and the reports which are available are known as financial transactions giving
us the financial reports. It is not only restricted to business entities it is equally useful for
non-profit organizations, for government organizations. In fact, they are also useful for
households. Just to know the expenses and income of a household also if proper financial
statements are prepared then that that becomes advantageous. Then we went on to
discuss three important financial statements we started with balance sheet.
So, balance sheet is a statement which gives the financial position as at a particular date.
We can make balance sheet as on any date, but normally it is prepared at the end of the
quarter may be at the end of 3 months or sometimes at the end of 1 year. There is a
specific format for the balance sheet. So, you have got assets and liabilities; assets
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represents the resources which we use for business like cash, like land and building, like
patents like software or hardware and so, on they are required to be funded by somebody
those are the sources of funds which we call them as liabilities.
There are two major types of liabilities in the category of NCL that is noncurrent
liabilities or long term liabilities and then there are current liabilities. The non-current
liabilities in turn can be of two types you have owners funds which is also known as
equity or net worth and then you will have variety of other non-current liabilities which
mainly consist of borrowings of debt. So, we discussed about the balance sheet.
Now, analysis of balance sheet is very much useful because we come to know the
strengths and the weaknesses of the business in the form of assets and liabilities. Though
I am using the term business it is not just for business entities, if you study the balance
sheet for a new organization say a trust or a school or for government organizations also,
you come to know: what are the resources which are being used for running those
activities and who are funding those resources. So, we have seen first the basic formats,
we have also seen the format of balance sheet as per company law.
Next we moved to profit and loss account. We all know profit and loss account or
income statement is an important statement because it list out all the incomes. So, the
revenues generated from where the money is coming and then we relate it with the
expenses; in the expenses all category of expenses will be listed. So, first you will have
operating expenses like purchases, like manufacturing expenses, then you may have
something like rent, advertising, marketing expenses, you will also have finance cost,
then non-cash cost like depreciation, that give you the first level of profit which can be
called as a operating profit.
If you do not consider finance cost, then from operating profit you deduct finance cost
then what operating profit you is also known as PBIT. After you deduct finance cost you
get PBT. From PBT or Profit Before Tax you deduct taxes to get PAT, this is the profit
available to the owners from that some profit may be distributed to the owners in the
form of dividends and then the remaining profits are called as retained earnings which
are transferred to balance sheet. Because they get added to the owners funds normally we
show it under the category as reserves and surplus in the balance sheet.
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Then we move to the third important statement that is known as cash flow statement.
Cash flow statement as the name suggest talks about the flows of cash. Now the cash
flow statement evolved because though profit and loss account makes us to understand
the profitability of the business, it may not tell us what is the cash coming in and in what
way the cash is being utilized that is why a cash flow statement was developed. And, all
the cash flows are categorized under three heads so, that users of the statement
understand purposes for which the cash is being raised and is being utilized.
So, there are three headings. Do you remember the headings? The first one is operating
cash flows. So, this is the normal business activity of the entity or the day to day
activities of the entity. All the money is coming in and out for normal course of activities
are listed under the cash flow from operating activities, usually we use indirect method
for the same. So, we start with profit before tax and we make adjustments for those items
which are non-cash in nature. So, what are those non-cash items? We will add
depreciation, we will add any particular amounts which are written off which are non
cash in nature. Now why do we add depreciation? I think you all know, but I am just
revising because here is where many get confused.
On one hand when we prepare P and L account we deduct depreciation, but in cash flow
we add depreciation. What is the reason? Because it is a non cash expense and we have
not paid any cash for the same, but it has been deducted for calculating profits or PBT.
So, here what we do is, we take PBT we add depreciation, we also make adjustment for
non operating items. For example, if there is any profit on sale of shares we will take in
cash flow statement, will we add this profit or deduct the profit? Just think over most of
you are right we will deduct the profit. Again a point of confusion because many times
when the word profit comes we feel it should be added, but in reality it should be
deducted because it has already been considered for calculation of profit and it is not an
operating item. So, we need to remove it that is why we deduct it.
So, we deduct profit from operation something like profit from sale of shares, if there is
any loss due to some non operating item let us say loss on sale of old machinery, then
because it is a loss we will add it. So, we after making the adjustments for non-cash and
non operating items, we get a figure which is known as funds from operations. Now in
funds from operations we will make adjustment for working capital items.
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So, any moment in inventory, any moment in debtors, any moment in creditors will be
adjusted in cash flow statement because, it affects the availability of cash to me. For
example, if the amount of debtors or receivables has gone down during the year, it means
that our collection efforts were good and debtors have paid more amount from their last
years outstanding they have reduced their outstanding, they have paid that amount to us.
So, decreasing debtors is a plus item in the cash flow statement ok. So, I think keep only
this in mind that decrease in debtor is a addition to cash, automatically the same rule will
be applicable to inventory. When it comes to creditors it will be exactly opposite
because, for a current asset decrease is going to be added, but for a current liability
decrease will be deducted getting it. So, we will adjust working capital items at this stage
we will get cash flow from operating activities before tax, then we will deduct the taxes
paid, then we will get the cash flow from operating activities. This is the first part of cash
flow statement which is comparatively complicated to calculate and it is a lengthier part.
After that there are two more headings; the second one is cash from investing activities
as the name suggests it includes long term investments, it also includes any other NCA
like fixed assets. So, if you have purchased or sold these items, any cash going out or
coming in would be shown under cash from investing activities. The third one is cash
from financing activities; so, any money which we have raised for the business or if you
have gone for repayment, then that will be included under this. For example, issue of
shares or buy back of shares, issue of debentures or redemption of debenture, taking loan
returning or repaying loan all these transactions would be in the financing item.
There is some special need to note about interest and dividend. Whenever interest is
received because it is received from investments, it will be categorized as investing item
same thing is true for dividend received. Whenever interest is paid or dividend it paid it
will be categorized as a financing item. So, we will make total of operating plus
investing plus financing, that will be the total cash generated by the company or entity
during the year, we will add opening balance and that will be matching with the closing
balance of cash.
In the note we will show any non cash transactions which we have not included in the
cash flow statement. What are such non-cash transactions? For example, if there is a
share swap. Now what is a share swap? Suppose we have acquired other company, for
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acquiring other company we have issued our shares and in return we have got shares of
that company from that their shareholders, then it is called as a share swap deal; no cash
payment is involved. So, it is not coming in the cash flow statement it will be shown as a
note or as a footnote.
Like that there can be more transactions for example, if we have some outstanding loan
which is payable to the bank, but instead of paying the loan amount we issued shares. So,
our capital balance has increased and the loan balance has decreased without
involvement of any cash, then again it becomes a non cash transaction. So, we will not
show it in the cash flow, but we will show it as a footnote. So, have you got it? I have
just gone a little in detail because cash flow statement is one important statement and
many times the participants get confused in that.
So, we discussed about all the three financial statements. At this point of time I had told
you in the sessions earlier and again I am repeating that it is very important for you to
have a hands on view of the actual statements, just what we discussed in the class is not
enough. So, you were asked in the first 2-3 sessions itself, that you need to choose your
company, download the annual report read the annual report carefully particularly the
financial statement part of it.
I hope you have completed that assignment and you have submitted the required details,
but going beyond required details I will request you to many times read their P and L,
balance sheet, cash flows. And, you can also check with the other companies financial
statements so, that you know the peculiarities how different financial statements are
prepared by different companies.
Apart from financial statements there will be many other useful information in the annual
report, that also we have discussed in the class and by now you would have seen it in the
annual report do you remember what else is there? There will be corporate governance
report, there will be sustainability report, there will be list of employees which are who
are getting high level of salary, there would be directors report, there will be auditor’s
report like that a variety of information about that company and sometimes about that
industry is available. So, please go through that information also. In the class particularly
after discussing the financial statements, we have gone into some of the conceptual parts.
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Now, many times in the traditional system the accounting its taught from journal entries
then we go to ledger account. From ledger we come to trial balance, from trial balance
students are taught to prepare P and L and balance sheet. But I have gone in a reverse
way first we have learnt: what is the output in the form of balance sheet, then income
statement, then cash flow and then you have been introduced to the steps which are taken
for preparation of those statements. Because this is not a hard core class meant for
accounting students, this is mainly meant for non accounting professionals who have
lesser time.
So, we have tried to cover the whole course in 20 hours to discuss important part of
accounting ok. Now, at this stage we had discussed two important topics one was
depreciation, methods of depreciation, how the depreciation is provided, next was
inventory methods like FIFO or method like weighted average we had discussed, then
we went to some conceptual discussion in conceptual discussion we have learnt about
corporate governance; what is corporate governance, what are the important principles of
governance, what happens due to failure of governance it leads to variety of frauds
malpractices.
So, we discussed an example of Enron which is one of the biggest global fraud, then we
also discussed global models of corporate governance the Anglo US model which is very
much dependent on CEO and on the capital markets, then the banking dominated model
of Japan and Germany, government dominated model in China and ethical model in
India.
We have also discussed various ethical aspects or moral aspects which we get from
indian culture (bharateeya sanskriti) and which are very important for proper functioning
of any organization. Then from corporate governance we have also discussed about
evolution of accounting, how accounting is related to Deevali, how various shreni types
of organizations existed in ancient India. So, we have learnt about the history of
accounting, then again we went to statements because by now I had hope that you would
have familiarize yourself about the financial statements. So, we have may we have then
gone for 2-3 exercises or cases taking real life companies and we had made in the class
various financial statements like P and L balance sheet and cash flow.
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From that if you remember we had done a case of Hindalco and in detail all the three
statements were made after that we went to analysis of financial statements in the
analysis we take ready statements sometimes we take some extra data and study the
statements so, that we can analyze it and we can draw some interpretations from the
statement. We saw that from a portfolio management angle this is a part of fundamental
analysis.
In fundamental analysis there are three components company analysis, economy analysis
and industry analysis we had focused on company analysis which is related to what we
are learning that is financial statements. So, varieties of ratios were calculated. Do you
remember important categories of ratios? From the balance sheet we started with
liquidity ratios like current ratio then financial statement stability related ratios like debt
equity or capital gearing ratio, then from income statement we can calculate profitability
ratio like net profit or operating profit ratio, we can also calculate expense ratios like cost
of good sales, to sales or material consumed to revenue these types of ratios.
Then we can calculate variety of return ratios. So, in return ratios we link the profitability
to amount invested. The most important return ratio is ROI Return On Investment or
sometimes it is called as return on invested capital; it can be calculated for the whole
company, it can also be calculated for a particular project or for a particular SBU or
division of the company it becomes a very important criteria for evaluation of projects.
There can also be return on equity share holders funds known as ROE or return on
owners fund, then there can be other type of ratios which are known as turnover or
activity ratios or efficiency ratios. For example, total asset turnover or inventory turnover
or debtors turnover or fixed asset turnover these ratios measure the efficiency in use of
that asset, we have also seen that inventory turnover you can convert it into number of
days. So, we know that how many days of inventory or how many days of receivables
are in the balance sheet.
So, we these were the ratios related to financial statements there can be other ratios
which are useful for stock market like earning per share or dividend yield or for example,
PE ratio this becomes very important for stock market investors. You can also have other
ratios for example, for employees important ratio can be revenue per employee or profit
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per employee. So, like that you can also take some outside data and link it to financial
statements to calculate other types of ratios.
So, this was the almost the last part of our discussion. Now going ahead there can be a
few concepts which we have not discussed, but those who have developed interest now
in accounting or in finance, I would request you to study them further. One of them is
environmental accounting or green accounting at is as it is known as where we try to
measure the environmental impact for a particular project or for a company.
So, you can have environment accounting, there is another concept called as inflation
accounting which tries to measure the impact of inflation, another important aspect of
accounting is human resources accounting. We have seen that human resources are one
of the most important assets for the business, but we cannot show it in the balance sheet
because they are not owned by the organization.
But now there are concepts like HRA or Human Resource Accounting where some
efforts are made to evaluate and value the human resources and put them in the form of a
particular figure. So, there are variety of contemporary or new concepts which are
coming in accounting. In our major discussion we have also discussed about accounting
standards or GAAP, but we have discussed it in short you can go more in detail about
various financial standards or accounting standards which are issued by various bodies
why they are issued and how they are applied by variety of companies.
So, there are number of aspects which can be studied in accounting. I hope you have
developed now more and more interest. There are a few more concepts like investment
accounting, departmental accounting, branch accounting. So, what I would request you
is, now if you have developed some basic understanding go for a detail accounting book
or some other web courses in accounting, wherein more aspects would be detailed would
be discussed and you can learn more and more aspects of accounting.
As far as our course is concerned various sheets have been shared with you they include
first was about our assignment on annual report, there are variety of cases, there are also
some conceptual aspects which have been shared with you. If you have not downloaded
a few of them I would request you to download go through them and for any queries
which you have, our discussion forums are always active and research scholars and
professors from IIT are also participating in it to respond to your queries. So, keep on
662
raising the queries discuss it amongst the peer group also discuss it with our research
scholars and that will help continuous learning for you and we are also of course, going
to have a proctored exam.
And, I hope you are preparing well for the exam, and best wishes to all of you not only
for the exam, but also for grasping the learning which would have happen. You would
have learned many things and I hope they would be very much useful for your day to day
life. It can be for your corporate life, for your career because you will be evaluated on
financial performance, it will be also useful for entrepreneurs. If you are doing business
the knowledge of finance is very important; if you are wanting to study further let us say
wanting to do MBA or PhD or wanting to learn further some more aspects of accounting
or finance for that also this course is very going to be very much useful.
So, all the best for exam as well as for further learning keep in touch. Namaste.
663
THIS BOOK IS NOT FOR SALE
NOR COMMERCIAL USE
(044) 2257 5905/08 nptel.ac.in swayam.gov.in

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INDEX

S. No Topic Page No.

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This is a brief introduction about myself I am Varadraj Bapat, I am a chartered

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Thank you so much and Namaste.

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So, we will stop here Namaste.

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Then we discussed on assets, again divided as non-current assets followed by current

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Thank you so much.

(Refer Slide Time: 00:47)

Right now, let us briefly revise asset and liabilities.

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Now, contingent liability is a possible obligation, since it is just a possible obligation it is

(Refer Slide Time: 14:23)

Assets = Liabilities + Owners Fund

Owners Fund = Assets – Liabilities

Owners Fund = Capital + Retained Earnings

Where, A= Assets, L= Liability and O= owner’s fund

(Refer Slide Time: 22:28)

There is another example which is in 3 b: that is collection of debtors, company has