Module III Analysis of Financial Statements

Cash flow Statement as Per AS-3 and Ratio Analysis

I. CASH FLOW STATEMENT

It is a technique for analysis of financial statement .An analysis of cash flow is useful for short-term
planning. A firm needs sufficient cash to pay debts maturing in the near future, to pay interest and other
expenses and to pay dividend to shareholders.

The firm can make projections of cash inflow and outflows for the near future to determine the availability
of cash. The cash balance can be matched with the firm’s need for cash during the period and accordingly,
arrangement can be made to meet the deficit or invest the surplus cash temporarily.

A historical analysis of cash flows provides insight to prepare reliable cash flow projections for immediate
future. Cash flow statement depicts the changes in financial position on cash basis. It summarizes the
causes of changes in cash position between dates of two balance sheets.

It indicates the sources and uses of cash. The cash flow statement is similar to funds flow statement except
that it focuses attention on cash (immediate or near term liquidity) instead of working capital of funds
(potential or medium term liquidity).
Thus this statement analyses changes in non-current accounts as well as current accounts (other than cash)
to determine the flow of cash.

“Cash flow is better than fund flow for decision making”

Cash Flow Statement which describes the source and application of funds received and dispensed during
the reporting period by comparing the opening balances with the closing balances on cash or cash
equivalent accounts. The cash flow statement ties together all the details from the income statement and
the balance sheet to give you a summary of the overall picture of your cash inflows and outflows which is
a routine requirement of business. Fund flow analysis is based on concept of working capital and required
for long term planning. So for operational decision making cash flow will give

Cash and cash equivalent as per AS-3.

Cash and cash equivalents are the most liquid assets found within the asset portion of a company's
balance sheet. Cash equivalents are assets that are readily convertible into cash, such as money market
holdings, short-term government bonds or Treasury bills, marketable securities and commercial paper.
Cash equivalents are distinguished from other investments through their short-term existence.. Although
cash equivalents are not cash, they are generally presented on the statement of financial position together
with cash using the title "Cash and Cash Equivalents"

1
Aim/Objectives of a cash flow statement

The aim of a cash flow statement should be to assist users:

to assess the company's ability to generate positive cash flows in the future
to assess its ability to meet its obligations to service loans, pay dividends etc
to assess the reasons for differences between reported and related cash flows
to assess the effect on its finances of major transactions in the year.

The statement therefore shows changes in cash and cash equivalents rather than working capital.

SOURCES AND USES OF CASH

INTERNAL SOURCES like cash from operations
EXTERNAL SOURCES like Issue of shares, Debentures , Bonds (on cash only), bank loans and other
short term borrowings, sale of investments and fixed assets etc.
How to prepare Cash Flow Statement
Step No 1: Cash from Operations
For calculation of cash from operation we will follow following steps:
Net Profit ××××
Add: Depreciation charged during the year ( and all other NON CASH EXPENCES) ××
Amortisation of intangible Asset like Goodwill Written off ××
Loss on sale of Fixed asset and investments ××
Transfer to reserves ××
Less: Profit on sale of Fixed asset and investments ××
= Cash from Operations

Step No. 2 : Adjustment of Current Assets and Current Liabilities in Cash from Operations
Cash from Operations
Add: + Decrease in Current Asset
+ Increase in Current Liabilities
Less: - Increase in Current Asset
- Decrease in Current Liabilities
= Cash flow from operation after adjustments

Step No.3 : Preparation of Cash Flow Statement –Direct Method

2
Format of Cash Flow Statement
Cash Flow Statement
For the year ending on ------------------------------
Opening Balance – Cash account & Bank Account
Add: Sources of cash
Cash flow from operation after adjustments
Issue of shares , Debentures and Bonds
Raising of short term and Long term loans
Sale of fixed assets and Investments
Less: Application of Cash:
Cash flow from operation after adjustments (If Negative)
Redemption of shares , Debentures and Bonds
Repayment of short term and Long term loans
Purchase of fixed assets and Investments
Income Tax paid
Dividend paid
= Closing balance of – Cash account & Bank Account

Adjustment for change in Current Assets and Current Liability

Change in Current Assets
Increases in current assets (that is, end of the year balance exceeding the beginning balance) reduce cash
from operations while decreases in current assets (that is, beginning balance exceeding end of the year
balance) increases cash flow. For example:
Increase in debtors implies that cash collections from customers are less than the sales figure (shown in
the profit and loss statement), while decrease in debtors indicates that the cash collections are greater than
the sales figure,

Changes in current Liabilities

Increase in current liabilities increases cash flow from operations while decrease in current
liabilities reduces it. For example :
Increase in creditors implies that cash payments to creditors is less than the purchase figures (as shown in
the profit and loss statement) while decrease in creditors indicates that cash payment to creditors are
greater than the purchases figure.

Preparation of Cash Flow Statement –Indirect Method As per AS 3

Format of Cash Flow Statement

3
Cash flow from operating Activity (A)
Cash flow from operation after adjustments
(Step No 1,2) *******

Cash flow from Investment Activity (internal +external)

(B)

Purchase of Building ***********

Purchase of Land
Sale of fixed asset
Cash Flow from Financing Activity(C)

Issue of shares or Increase in Capital

Bank Borrowing and other Loan ********************
Redemption of shares
Repayment of Loan
Net Cash Flow A+B+C $$$$$$$$$$$$$$$$$$$
Opening Cash and Bank Balance

Closing Cash and Bank Balance

Change in cash (Opening - Closing Balance) @@@@@@@@@@@@@@ (Must be equal to
Net Cash Flow)

Below is the format of Cash Flow Statement by indirect method:-

Cash Flow Statement of Ltd. for the year ended______

4
Q1.Balance sheet of A and B on 1january 2013 and 31 December 2013 were as follows:
Liabilities 1.01.2013 31.12.2013 Assets 1.01.2013 31.12.2013
Capital 1,25,000 1,53,000 Building 35,000 60,000

5
Bank Loan 40,000 50,000 Land 40,000 50,000
Creditors 40,000 44,000 Machinery 80,000 55,000
Mrs. A Loan 25,000 --- Debtor 30,000 50,000
-- Stock 35,000 25,000
Cash in hand 10,000 7,000
2,30,000 2,47,000 2,30,000 2,47,000

During the year, a machine costing Rs.10,000 ( Accumulated Depreciation Rs.3,000) was sold for
Rs.5,000. The provision for depreciation against machinery as on 1 .01.13 was Rs.25, 000 and
31.12.13 was Rs. 40,000. Net profit for the year 2013 amount to Rs. 45,000. You are required to
prepare cash flow statement.
Cash Flow Statement
Cash flow from operating Activity
Net profit Rs. 45,000
Add: Depreciation on Machinery Rs.18,000
+ Loss on sale of Machinery Rs.2,000
Add Decrease in current Asset and increase in current
liability

Stock + Rs.10,000
Creditors + Rs.4,000
Less: Decrease in current liability and increase in current
assets
Debtors (Rs.20,000) Rs.59,000

Cash flow from Investment Activity

Purchase of Building (Rs. 25,000)

Purchase of Land ( Rs.10,000) (Rs.30,000)
Sale of machinery Rs.5,000
Cash Flow from Financing Activity

Drawing Rs. 17,000

Bank Loan Rs. 10,000
Redemption of Mrs.ALoan (Rs. 25,000) (Rs.32,000)
Net Cash Flow (Rs.3,000)
Opening cash Balance Rs.10,000

Closing cash Balance Rs.7,000

Change in cash (Rs.3,000)

Q2 :From the following summarized financial statement of Nova Steel Ltd. as on 31 st March, 2014
and 2015 respectively, prepare cash flow statement.
Liabilities 2014 2015 Assets 2014 2015
Share capital 15,00,000 20,00,000 Land 2,30,000 2,30,000
Security Premium -- 50,000 Building less 6,40,000 6,10,000
Depreciation
General Reserve 6,00,000 7,00,000

6
Profit & loss account 3,60,300 4,90,640 Plant & 18,35,000 22,20,400
Machinery
Less
Depreciation
Secured Loans 8,60,000 8,60,000 Investment 50,000 75,600
Proposed Dividend 1,00,000 1,50,000 Stocks 8,40,430 9,16,340
Sundry creditors 11,79,700 12,39,360 Debtors 9,85,370 13,68,650
Cash in hands 19,200 69,010

46,00,000 54,90,000 46,00,000 54,90,000

During 2014-15 depreciation provided on assets amounted to Rs.30, 000 on building and Rs.2,40,500 on
plant and machinery. The final dividend for previous year amounting to Rs.1,00,000 was paid on 10th
November 2014.

Cash Flow Statement

Particulars Amount
Cash From Operating Activity(A)
Net Profit of current Year 1,30,340
Add: Transfer to general reserve 1,00,000
Depreciation on Building ,Plant& Machinery 2,70,500
Proposed Dividend 1,50,000
Increase in sundry creditor 59,660
Less: Increase in stock (75910)
Less: Increase in Debtor (3,83,280)
Cash From Operating Activity 2,51,310
Cash From Investment Activity(B)
Purchase of Plant &Machinery (625900)
Purchase of Investment (25,600)
Cash From Investment Activity (6,51,500)
Cash From Financing Activities(C)
Issue of Share Capital 5,00,000
Issue of Share Premium 50,000
Dividend Paid 1,00,000
Cash From Financing Activities 4,50,000
Total Cash Inflow A+B+C 49,810
Opening Cash Balance 19,200
Closing Cash Balance 69,010
Increase in Cash Balance 49,810

University theory question on Cash Flow Statement

Q1:Define the terms cash generated from investing activity, cash generated from financing activity
and cash from operating activity.

Cash flows from operating activities:

7
Operating activities includes cash effects of those transactions and events that enter into the determination
of net profits or loss. Following are examples of cash flows from operating activities:

- cash receipts from the sale of goods and the rendering of services.

- cash receipts from royalties, fees, commissions, and other revenues

- cash payments to suppliers for goods and services

- cash payments to and on behalf of employees

Cash flows from Investing Activities:

These includes the following:

- cash payments to acquire fixed assets (including intangibles)

These payments include those relating to capitalized research and development costs and self-constructed
fixed assets.

- cash receipts from disposal of fixed assets (including intangibles)

- cash payments to acquire shares, warrants, or debit instruments of other enterprises and interests in joint
ventures.

- cash receipts from disposal of shares, warrants, or debt instruments of other enterprises and interest in
joint ventures.

Cash flows from Financing Activities:

Financing activities are activities that result in changes in the size and composition of owner’s capital.

- cash proceeds from issuing shares or other similar instruments.

- cash proceeds from issuing debentures, loans, notes, bonds and other short-term borrowings

- payment of dividend etc.

Q2: “The cash flow statement is very useful to management for short term planning of business”.
Discuss this statement and show the similarities and differences between cash flow and fund flow
statements.

A cash flow statement is useful in short-term planning. A business firm requires sufficient cash to meet its
various obligations in the near future. An analysis of different sources and applications of cash will enable
the management to make reliable estimates about inflows and outflows of cash. On the basis of such
estimates, management can plan out for investment of surplus cash or for meeting any cash deficit.

8
The main advantages of a cash flow statement are as follows.

(i) Cash flow statement helps in efficient cash management. It is useful in evaluating financial policies and
cash position of the business. Cash is the basis of all financial operations. Therefore, a projected cash flow
statement will enable the management to plan and control the financial operations properly. The
management can know how much cash is needed from which source it will be derived, and how much
cash can be generated internally and 1 much could be obtained from outside.

(ii) Cash flow statement helps in internal financial management. It is useful in formulation of financial
plans, e.g., possibility of repayment of long-term loans dividend policy replacement of plant and
machinery, etc.

Table of Difference between Funds Flow Statement and Cash Flow Statement

Basis of
Funds Flow Statement Cash Flow Statement
Difference
1. Basis of Funds flow statement is based on Cash flow statement is based on narrow
Analysis broader concept i.e. working capital. concept i.e. cash, which is only one of the
elements of working capital.
2. Source Funds flow statement tells about the Cash flow statement stars with the opening
various sources from where the funds balance of cash and reaches to the closing
generated with various uses to which balance of cash by proceeding through
they are put. sources and uses.
3. Usage Funds flow statement is more useful in Cash flow statement is useful in
assessing the long-range financial understanding the short-term phenomena
strategy. affecting the liquidity of the business.
4. Schedule of In funds flow statement changes in In cash flow statement changes in current
Changes in current assets and current liabilities assets and current liabilities are shown in the
Working are shown through the schedule of cash flow statement itself.
Capital changes in working capital.
5. End Result Funds flow statement shows the Cash flow statement shows the causes the
causes of changes in net working changes in cash.
capital.
6. Principal of Funds flow statement is in alignment In cash flow statement data obtained on
Accounting with the accrual basis of accounting. accrual basis are converted into cash basis.

Generally, cash flow statement may be used for the following purposes

(i) Projected cash flow statement may enable the financial manager to plan the acquisition and uses of
cash, so that the minimum financial costs and sound financial position may be achieved.

9
(ii) It helps the management to evaluate its ability to meet its obligations i.e. payment to creditors,
repayment of bank loans, payment of interest, taxes and dividends.

(iii) Cash flow statement may also be used for making appraisal of various capital investment projects just
to determine their viability and profitability.

(iv) It provides detailed information for making plans for more immediate future, i.e. short term financial
planning is greatly facilitated by this statement.

(v) It is also very useful to external analyst particularly to the bankers. Now a days, financial institutions
including bank, review the financial position of the borrowers and such review is greatly facilitated by
cash flow statement.

Limitations of Cash Flow Statement:

Cash flow statement is a very useful tool of financial analysis.

However, it suffers from some limitations. These limitations are:

i) Cash flow statement only reveals the inflow and outflow of cash. But the cash balance disclosed by this
statement may not depict the true liquid position of the business. True liquid position is obscured by the
exclusion of some near cash items from the cash flow statement.

ii) Cash flow statement is not a substitute for income statement. Cash flow statement should not be
equated with income statement. The net cash flow disclosed by cash flow statement does not necessarily
mean net income of the business, because net income is determined by taking into account both cash and
non-cash items.

iii) Cash used to signify fund is a narrow concept. It does not give a complete picture of the financial
position of the concern. Even the term cash is not precisely defined.

iv) Cash flow statement suffers from all those limitations which limit the use of fund flow statement.

v) The cash balance is too easily influenced by postponing purchases and other payments.

10
II. Financial statement analysis(or financial analysis) is the process of reviewing and
analyzing a company's financial statements to make better economic decisions. These statements include
the income statement, balance sheet, statement of cash flows. Financial statement analysis is a method or
process involving specific techniques for evaluating risks, performance, financial health, and future
prospects of an organization.

It is used by a variety of stakeholders, such as credit and equity investors, the government, the public, and
decision-makers within the organization. These stakeholders have different interests and apply a variety of
different techniques to meet their needs. For example, equity investors are interested in the long-term
earnings power of the organization and perhaps the sustainability and growth of dividend payments.
Creditors want to ensure the interest and principal is paid on the organizations debt securities (e.g., bonds)
when due.

Common methods of financial statement analysis include fundamental analysis, DuPont analysis,
horizontal and vertical analysis and the use of financial ratios. Historical information combined with a
series of assumptions and adjustments to the financial information may be used to project future
performance.

11
12
 RATIO ANALYSIS

Meaning of Ratio Analysis

The ratio analysis is one of the most useful and common methods for analyzing financial
statements.The financial statements i.e., balance sheet and profit and loss account carry a mass of
data and needs close analysis and need to be interpreted meaningfully.

With the help of ratio analysis a banker or a lender or a creditor or a decision maker can take better
and safer decisions.

A ratio is a relationship of two or more things. More simply it is the relationship of two accounting
figures, expressed mathematically.

It helps to summaries large quantities of abstract data and helps the user to make qualitative
judgment. It can be expressed as a percentage or a simple number.

Compare the data of two years of Company A

Year 2019 Year 2020

Net profit Rs.10 lacs Rs.20 lacs

On the face of it appears that the company has doubled its net profit in 2020 as compared to net profit
in 2019

If we provide the figure of capital employed as follows.

Year 2019 Year 2020

Capital employed: Rs.100 lacs Rs 500 lacs.

If we calculate the percentage of net profit to capital employed the results will give true performance
of the company.

Year 2019 Year 2020

Return on capital employed 10% 4%

13
 The result shows that the company has performed poorly in 2020 but absolute figure shows doubling
of profits.

Ratio Analysis: Nature, Uses and Limitations

Nature of Ratio Analysis:

• Ratio analysis is a technique of analysis and interpretation of financial statements.

• It is the process of establishing and interpreting various ratios for helping in making certain
decisions. However, ratio analysis is not an end in itself. It is only a means of better understanding
of financial strengths and weaknesses of a firm.
• Calculation of mere ratios does not serve any purpose, unless several appropriate ratios are
analyzed and interpreted.
• There are a number of ratios which can be calculated from the information given in the financial
statements, but the analyst has to select the appropriate data and calculate only a few appropriate
ratios from the same keeping in mind the objective of analysis.
• The ratios may be used as a symptom like blood pressure, the pulse rate or the body temperature
and their interpretation depends upon the caliber and competence of the analyst.

Uses of Ratio Analysis:

The ratio analysis is one of the most powerful tools of financial analysis. It is used as a device to analyze
and interpret the financial health of enterprise. Just like a doctor examines his patient by recording his
body temperature, blood pressure, etc. before making his conclusion regarding the illness and before
giving his treatment, a financial analyst analyses the financial statements with various tools of analysis
before commenting upon the financial health or weaknesses of an enterprise.

(a) Managerial Uses of Ratio Analysis:

1. Helps in decision-making:

Financial statements are prepared primarily for decision-making. But the information provided in financial
statements is not an end in itself and no meaningful conclusion can be drawn from these statements alone.
Ratio analysis helps in making decisions from the information provided in these financial statements.

2. Helps in financial forecasting and planning:

Ratio Analysis is of much help in financial forecasting and planning. Planning is looking ahead and the
ratios calculated for a number of years work as a guide for the future. Meaningful conclusions can be
drawn for future from these ratios. Thus, ratio analysis helps in forecasting and planning.

3. Helps in communicating:

The financial strength and weakness of a firm are communicated in a more easy and understandable
manner by the use of ratios. The information contained in the financial statements is conveyed in a

14
meaningful manner to the one for whom it is meant. Thus, ratios help in communication and enhance the
value of the financial statements.

4. Helps in co-ordination:

Ratios even help in co-ordination which is of utmost importance in effective business management. Better
communication of efficiency and weakness of an enterprise results in better coordination in the enterprise.

5. Helps in Control:

Ratio analysis even helps in making effective control of the business. Standard ratios can be based upon
proforma financial statements and variances or deviations, if any, can be found by comparing the actual
with the standards so as to take a corrective action at the right time. The weaknesses or otherwise, if any,
come to the knowledge of the management which helps in effective control of the business.

6. Other Uses:

These are so many other uses of the ratio analysis. It is an essential part of the budgetary control and
standard costing. Ratios are of immense importance in the analysis and interpretation of financial
statements as they bring the strength or weakness of a firm.

(b) Utility to Shareholders/Investors:

An investor in the company will like to assess the financial position of the concern where he is going to
invest. His first interest will be the security of his investment and then a return in the form of dividend or
interest. For the first purpose he will try to assess the value of fixed assets and the loans raised against
them. The investor will feel satisfied only if the concern has sufficient amount of assets.

Long-term solvency ratios will help him in assessing financial position of the concern. Profitability ratios,
on the other hand, will be useful to determine profitability position. Ratio analysis will be useful to the
investor in making up his mind whether present financial position of the concern warrants further
investment or not.

(c) Utility to Creditors:

The creditors or suppliers extend short-term credit to the concern. They are interested to know whether
financial position of the concern warrants their payments at a specified time or not. The concern pays
short- term creditor, out of its current assets. If the current assets are quite sufficient to meet current
liabilities then the creditor will not hesitate in extending credit facilities. Current and acid-test ratios will
give an idea about the current financial position of the concern.

(d) Utility to Employees:

The employees are also interested in the financial position of the concern especially profitability. Their
wage increases and amount of fringe benefits are related to the volume of profits earned by the concern.
The employees make use of information available in financial statements. Various profitability ratios

15
relating to gross profit, operating profit, net profit, etc. enable employees to put forward their viewpoint
for the increase of wages and other benefits.

(e) Utility to Government:

Government is interested to know the overall strength of the industry. Various financial statements
published by industrial units are used to calculate ratios for determining short-term, long-term and overall
financial position of the concerns. Profitability indexes can also be prepared with the help of ratios.
Government may base its future policies on the basis of industrial information available from various
units. The ratios may be used as indicators of overall financial strength of public as well as private sector,
in the absence of the reliable economic information, governmental plans and policies may not prove
successful.

Limitations of Ratio Analysis:

The ratio analysis is one of the most powerful tools of financial management.

Though ratios are simple to calculate and easy to understand, they suffer from some serious
limitations:

1. Limited Use of a Single Ratio:A single ratio, usually, does not convey much of a sense. To make a
better interpretation a number of ratios have to be calculated which is likely to confuse the analyst than
help him in making any meaningful conclusion.

2. Lack of Adequate Standards:There are no well accepted standards or rules of thumb for all ratios
which can be accepted as norms. It renders interpretation of the ratios difficult.

3. Inherent Limitations of Accounting:Like financial statements, ratios also suffer from the inherent
weakness of accounting records such as their historical nature. Ratios of the past are not necessarily true
indicators of the future.

4. Change of Accounting Procedure:Change in accounting procedure by a firm often makes ratio

analysis misleading, e.g., a change in the valuation of methods of inventories, from FIFO to LIFO
increases the cost of sales and reduces considerably the value of closing stocks which makes stock
turnover ratio to be lucrative and an unfavorable gross profit ratio.

5. Window Dressing:Financial statements can easily be window dressed to present a better picture of its
financial and profitability position to outsiders. Hence, one has to be very careful in making a decision
from ratios calculated from such financial statements. But it may be very difficult for an outsider to know
about the window dressing made by a firm.

6. Personal Bias:Ratios are only means of financial analysis and not an end in itself. Ratios have to be
interpreted and different people may interpret the same ratio in different ways.

7. Un-comparable:Not only industries differ in their nature but also the firms of the similar business
widely differ in their size and accounting procedures, etc. It makes comparison of ratios difficult and

16
misleading. Moreover, comparisons are made difficult due to differences in definitions of various financial
terms used in the ratio analysis.

8. Absolute Figures Distortive:Ratios devoid of absolute figures may prove distortive as ratio analysis is
primarily a quantitative analysis and not a qualitative analysis.

9. Price Level Changes:While making ratio analysis, no consideration is made to the changes in price
levels and this makes the interpretation of ratios invalid.

10. Ratios no Substitutes:Ratio analysis is merely a tool of financial statements. Hence, ratios become
useless if separated from the statements from which they are computed.

11. Clues not Conclusions:Ratios provide only clues to analysts and not final conclusions. These ratios
have to be interpreted by these experts and there are no standard rules for interpretation.

Types of Ratios

Financial ratio analysis groups the ratios into categories that tell us about the different facets of a
company's financial state of affairs. Some of the categories of ratios are described below:

17
18
LIQUIDITY RATIOS

Liquidity refers to the ability of a firm to meet its short-term (usually up to 1 year) obligations. The ratios which
indicate the liquidity of a company are Current ratio, Quick/Acid-Test ratio, and Cash ratio. These ratios are
discussed below.

CURREN Ratio is the ratio of total current assets (CA) to total current liabilities (CL). Current assets include cash and
bank balances; inventory of raw materials, semi-finished and finished goods; marketable securities; debtors (net of
provision for bad and doubtful debts); bills receivable; and prepaid expenses. Current liabilities consist of trade creditors,
bills payable, bank credit, provision for taxation, dividends payable and outstanding expenses. This ratio measures the
liquidity of the current assets and the ability of a company to meet its short-term debt obligation.

Current Ratio = Current Assets / Current Liabilities

CR measures the ability of the company to meet its CL, i.e., CA gets converted into cash in the operating cycle of the
firm and provides the funds needed to pay for CL. The higher the current ratio, the greater the short-term
solvency. While interpreting the current ratio, the composition of current assets must not be overlooked. A firm with
a high proportion of current assets in the form of cash and debtors is more liquid than one with a high proportion of
current assets in the form of inventories, even though both the firms have the same current ratio. Internationally, a
current ratio of 2:1 is considered satisfactory.

QUICK OR ACID-TEST RATIO

Quick Ratio (QR) is the ratio between quick current assets (QA) and CL. QA refers to those current assets that can be
converted into cash immediately without any value dilution. QA includes cash and bank balances, short-term
marketable securities, and sundry debtors. Inventory and prepaid expenses are excluded since these cannot be
turned into cash as and when required.

Quick Ratio = Quick Assets / Current Liabilities

Quick Asset = CA- Stocks/Inventory - Prepaid Exp.

QR indicates the extent to which a company can pay its current liabilities without relying on the sale of inventory.
This is a fairly stringent measure of liquidity because it is based on those current assets which are highly liquid.
Inventories are excluded from the numerator of this ratio because they are deemed the least liquid component of
current assets. Generally, a quick ratio of 1:1 is considered good. One drawback of the quick ratio is that it ignores
the timing of receipts and payments.

19
CASH RATIO

Since cash and bank balances and short term marketable securities are the most liquid assets of a firm, financial
analysts look at the cash ratio. The cash ratio is computed as follows:

Cash Ratio = (Cash and Bank Balances + Current Investments) / Current Liabilities

The cash ratio is the most stringent ratio for measuring liquidity.

OPERATIONAL/TURNOVER RATIOS

These ratios determine how quickly certain current assets can be converted into cash. They are also called
efficiency ratios or asset utilization ratios as they measure the efficiency of a firm in managing assets. These ratios
are based on the relationship between the level of activity represented by sales or cost of goods sold and levels of
investment in various assets. The important turnover ratios are debtors turnover ratio, average collection period,
inventory/stock turnover ratio, fixed assets turnover ratio, and total assets turnover ratio. These are described
below:

DEBTORS TURNOVER RATIO (DTR)or Debtors’

Velocity

DTO is calculated by dividing the net credit sales by

average debtors outstanding during the year. It measures
the liquidity of a firm's debts. Net credit sales are the
gross credit sales minus returns, if any, from customers.
Average debtors is the average of debtors at the Average Debtors = ½ Opening (Debtor+B/R) + Closing
beginning and at the end of the year. This ratio shows (Debtor+B/R)
how rapidly debts are collected. The higher the DTO, the
better it is for the organization. Net Credit Sales = Sales – Sales Return
If separate opening & closing Debtor is not given
Debtors Turnover Ratio = Net Credit Sales / Average then available debtor will be taken for calculation
Debtors or Average Accounts receivables

In case details regarding credit sales , opening &

closing Debtor have not been given then ratio may be
calculated as follows:

Total net sales /(Debtors + Bills receivables)

20
Calculate debtor turnover ratio from the following figure :

Q1: The data of a trading company is given below:

Total sales 5,500,000

Cash sales 2,500,000
Debtors – opening 400,000
Debtors – closing 250,000
Bills receivables – opening 150,000
Bills receivables – closing 200,000

Required: How many times (on average) company collects accounts receivables?

Hint: Compute accounts receivable/debtors turnover ratio.

Solution:

= 3,000,000* / 500,000**

6 times

On average, the company collects its receivables 6 times a year.

*Credit sales:
5,500,000 –2,500,000 = 3,000,000

**Average receivables:
(400,000+250,000+150,000+200,000)/2 = 500,000

AVERAGE COLLECTION PERIOD (ACP)

ACP is calculated by dividing the days in a year by the debtors' turnover. The average collection period represents
the number of day's worth of credit sales that is blocked with the debtors (accounts receivable). It is computed as
follows:

Average Collection Ratio = Months (days) in a Year / Debtors Turnover or Debtor’s Velocity

21
The ACP and the accounts receivables turnover are related as:

ACP = 365 / Accounts Receivable Turnover

The ACP can be compared with the firm's credit terms to judge the efficiency of credit management. For example,
if the credit terms are 2/10, net 45, an ACP of 85 days means that the collection is slow and an ACP of 40 days
means that the collection is prompt.

INVENTORY OR STOCK TURNOVER RATIO (ITR)

ITR refers to the number of times the inventory is sold and replaced during the accounting period. It is calculated
as follows:

Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory

COGS = NET SALES – GROSS PROFIT

However in absence of complete information ITR may be computed on following basis :

Inventory Turnover Ratio = Net Sales / Average Inventory

Average Inventory = ½ (opening inventory + closing inventory )

ITR reflects the efficiency of inventory management. The higher the ratio, the more efficient is the management
of inventories, and vice versa. However, a high inventory turnover may also result from a low level of inventory
which may lead to frequent stock outs and loss of sales and customer goodwill. For calculating ITR, the average
of inventories at the beginning and the end of the year is taken. In general, averages may be used when a flow
figure (in this case, cost of goods sold) is related to a stock figure (inventories).

ACCOUNTS PAYABLE TURNOVER RATIO (also known as creditors turnover ratio or creditors’
velocity) is computed by dividing the net credit purchases by average accounts payable. It measures the number of
times, on average, the accounts payable are paid during a period. Like receivables turnover ratio, it is expressed
in times.

Formula:

In above formula, numerator includes only credit purchases. But if credit purchases are not known, the total net

22
purchases should be used.

Average accounts payable are computed by adding opening and closing balances of accounts payable (including
notes payable) and dividing by two. If opening balance of accounts payable is not given, the closing balance
(including notes payable) should be used.

In case details regarding credit purchase, opening & closing creditor have not been given then ratio may
be calculated as follows:

Total purchase/(creditors+ Bills Payables )

Example:

P&G trading company has good relations with suppliers and makes all the purchases on credit. The following
data has been extracted from the financial statements of P&G for the year 2012 and 2011:

• Credit Purchases during 2012: 220,000

• Purchases returns during 2012: 20,000
• Accounts payable on 31 December, 2011: 40,000
• Accounts payable on 31 December, 2012: 20,000
• Creditors on 31 December, 2011: 8,000
• Creditors on 31 December, 2012: 12,000

Required: Compute accounts payable turnover ratio (creditors’ velocity).

Solution:

= 200,000* / 40,000**

= 5 times

It means, on average, P&G company pays its creditors 5 times in a year.

* 220,000 – 20,000
** [(40,000 + 8,000) + (20,000 + 12,000)] / 2

Significance and Interpretation:

Accounts payable turnover ratio indicates the creditworthiness of the company. A high ratio means prompt
payment to suppliers for the goods purchased on credit and a low ratio may be a sign of delayed payment.

Accounts payable turnover ratio also depends on the credit terms allowed by suppliers. Companies who enjoy
longer credit periods allowed by creditors usually have low ratio as compared to others.

A high ratio (prompt payment) is desirable but company should always avail the credit facility allowed by the

23
suppliers.

FIXED ASSETS TURNOVER

The FAT ratio measures the net sales per rupee of investment in fixed assets. It can be computed as follows:

FAT = Net sales / Net fixed assets

Net fixed assets = Fixed asset –Depreciation

This ratio measures the efficiency with which fixed assets are employed. A high ratio indicates a high degree of
efficiency in asset utilization while a low ratio reflects an inefficient use of assets. However, this ratio should be
used with caution because when the fixed assets of a firm are old and substantially depreciated, the fixed assets
turnover ratio tends to be high (because the denominator of the ratio is very low).

TOTAL ASSETS TURNOVER

TAT is the ratio between the net sales and the average total assets. It can be computed as follows:

TAT = Net sales / Average total assets

This ratio measures how efficiently an organization is utilizing its assets.

LEVERAGE/CAPITAL STRUCTURE RATIO

These ratios measure the long-term solvency of a firm. Financial leverage refers to the use of debt finance.
While debt capital is a cheaper source of finance, it is also a risky source. Leverage ratios help us assess
the risk arising from the use of debt capital. Two types of ratios are commonly used to analyze financial
leverage - structural ratios and coverage ratios. Structural ratios are based on the proportions of debt and
equity in the financial structure of a firm. Coverage ratios show the relationship between the debt
commitments and the sources for meeting them.

RATIOS COMPUTED FROM

BALANCE SHEET
Debt-Equity: This ratio shows the relative Debt –Equity Ratio = Total long term Debt
proportions of debt and equity in financing the assets
of a firm. The debt includes short-term and long- Shareholders’ fund
term borrowings. The equity includes the net worth
(paid-up equity capital and reserves and surplus) and
preference capital. It can be calculated as:

24
 Debt / Equity

Debt –Equity Ratio = Total long term Debt

Total long term funds (Equity

share capital+ R/s + P/L a/c (credit balance))

Total long term Debt meansDebentures,secured and

unsecured loans ,preference share capital)

Debt-Asset Ratio: The debt-asset ratio measures the

extent to which the borrowed funds support the
firm's assets. It can be calculated as:

Debt / Assets

The numerator of the ratio includes all debt, short-

term as well as long-term, and the denominator of
the ratio includes all the assets (the balance sheet
total).

PROFITABILITY RATIOS

These ratios help measure the profitability of a firm. There are two types of profitability ratios:

• Profitability ratios in relation to sales and

• Profitability ratios in relation to investments.(ROI)

PROFITABILITY RATIOS IN RELATION TO

SALES

A firm which generates a substantial amount of

profits per rupee of sales can comfortably meet its
operating expenses and provide more returns to its
shareholders. The relationship between profit and
sales is measured by profitability ratios. There are

25
two types of profitability ratios: Gross Profit Margin
and Net Profit Margin.

Gross Profit Margin: This ratio measures the

relationship between gross profit and sales. It is
calculated as follows:

Gross Profit Margin = Gross Profit/Net sales * 100

Sales = no of units sold*selling price per unit

This ratio shows the profit that remains after the manufacturing costs have been met. It measures the
efficiency of production as well as pricing.

Net Profit Margin: This ratio is computed using the following formula:

Net profit / Net sales *100

This ratio shows the net earnings (to be distributed to both equity and preference shareholders) as a
percentage of net sales. It measures the overall efficiency of production, administration, selling, financing,
pricing and tax management. Jointly considered, the gross and net profit margin ratios provide an
understanding of the cost and profit structure of a firm.

PROFITABILITY RATIOS IN RELATION TO INVESTMENT

These ratios measure the relationship between the profits and investments of a firm. There are three such
ratios: Return on Assets, Return on Capital Employed, and Return on Shareholders' Equity.

Return on Assets (ROA): This ratio measures the profitability of the assets of a firm. The formula for
calculating ROA is:

ROA = EAT + Interest - Tax Advantage on Interest / Average Total Assets*100

Return on Capital Employed (ROCE): Capital employed refers to the long-term funds invested by the
creditors and the owners of a firm. It is the sum of long-term liabilities and owner's equity. ROCE
indicates the efficiency with which the long-term funds of a firm are utilized. It is computed by the
following formula:

ROCE = (EBIT / Average Total Capital Employed) * 100

EBIT= Earning Before Interest and Tax

26
Return on Shareholders' Equity: This ratio measures the return on shareholders' funds. It can be calculated
using the following methods:

• Rate of return on total shareholders' equity.

• Rate of return on ordinary shareholders.
• Earnings per share.
• Dividends per share.
• Dividend pay-out ratio.
• Earning and Dividend yield.

(i) Return on Total Shareholders' Equity

The total shareholders' equity consists of preference share capital, ordinary/equity share capital consisting
of equity share capital, share premium, reserves and surplus less accumulated losses.

Return on total shareholders' equity = (Net profit after taxes) * 100 /Average total shareholders' equity

(ii) Return on Ordinary Shareholder's Equity (ROSE)

This ratio is calculated by dividing the net profits after taxes and preference dividend by the average
equity capital held by the ordinary shareholders.

ROSE = (Net Profit after Taxes - Preference Dividend) * 100 / Networth

(iii) Earnings per Share (EPS)

EPS measures the profits available to the equity shareholders on each share held. The formula for
calculating EPS is:

EPS = Net Profits Available to Equity Holders or (Net Profit after Taxes - Preference Dividend)

/ Number of Ordinary Shares Outstanding

(iv) Dividend per Share (DPS)

DPS shows how much is paid as dividend to the shareholders on each share held. The formula for
calculating EPS is:

DPS = Dividend Paid to Ordinary Shareholders / Number of Ordinary /equity Shares Outstanding

(v) Dividend Pay-out Ratio (D/P Ratio)

27
D/P ratio shows the percentage share of net profits after taxes and after preference dividend has been paid
to the preference equity holders.

D/P ratio = Dividend per Share (DPS) / Earnings per Share * 100

Retention Ratio = 100%- D/P Ratio

Eg. D/P Ratio is 40%

DPS/EPS = 40%

DPS= 40% OF EPS

(vi) Earning & Dividend Yield

Earning yield is also known as earning-price ratio and is expressed in terms of the market value per share.

Earning Yield = EPS / Market Value per Share * 100

Dividend Yield is expressed in terms of the market value per share.

Dividend Yield = (DPS / Market Value per Share) * 100

VALUATION RATIOS
Valuation ratios indicate the performance of the equity stock of a company in the stock market. Since the
market value of equity reflects the combined influence of risk and return, valuation ratios play an
important role in assessing a company's performance in the stock market. The important valuation ratios
are the Price-Earnings Ratio and the Market Value to Book Value Ratio.

Price-Earnings (P/E) Ratio :

The P/E ratio is the ratio between the market price of

the shares of a firm and the firm's earnings per share.
The formula for calculating the P/E ratio is:

P/E ratio = Market Price of Share / Earnings per

Share

The price-earnings ratio indicates the growth

prospects, risk characteristics, degree of liquidity,
shareholder orientation, and corporate image of a

28
company.

Market Value to Book Value Ratio:

This is the ratio between the market price per share (MPS) and actual book value per share. It can be
calculated as follows:

Market Value to Book Value Ratio = Market Price per Share / Book Value per Share

This ratio reflects the contribution of a company to the wealth of its shareholders. When this ratio exceeds
1, it means that the company has contributed to the creation of wealth of its shareholders.

Practice Problems
Q1: Complete the following relation ship
a. Cost of goods sold + Gross Profit =
b. Total Sales – Cash Sale =
c. Share capital + Reserve and Surplus =
d. Current Assets – Current Liability =
e. PAT = PBT- ------------------.
f. D/P Ratio = 100% - ------------------.

Q2: From the following, you are required to comment upon the long term as well as short term solvency
of the company.
Liability Rs. Assets Rs.
Share Capital 15,00,000 Fixed Assets 18,00,000
Secured Loans 7,50,00 Liquid Assets 9,00,000
Current liability 7,50,000 Stock in Trade 3,00,000
30,00,000 30,00,000

Q3: With the help of following ratios and further information given below , prepare a trading account
,profit and loss account and balance sheet of Mr. Shri Narain Pandey.
Gross Profit Ratio 25%
Net profit Ratio 20%
Stock turnover Ratio 10
Net Profit to Capital 1/5
Capital to total liabilities 1/2
Fixed Asset to capital 5/4
Fixed Asset to Total Current Assets 5/7
Fixed Asset Rs. 25,00,000

29
Closing Stock Rs.2,50,000

Q4: From the following balance sheet and additional information calculate:
1. Fixed assets turnover ratio (sales Rs. 10,00,000)
2. Current Ratio
3. Quick ratio
4. Debt equity Ratio
5. Working Capital to fixed asset Ratio

Amount Amount
Liabilities (Rs) Assets (Rs)
Trade creditors 210000 Freehold premises 200000
Outstanding expenses 16000 Plant and Machinery 160000
Furniture and
Bank overdraft 24000 Fittings 40000
Long term loan 100000 Stock 240000
Reserve and surplus 5000 Trade Debtors 180000
Equity share Capital 467000 Prepaid Insurance 2000
822000 822000
Q5: To judge the financial soundness and profitability positions of the company what financial ratios are
required by users of accounting statement?
Q6:What do you mean by analysis of financial statements? What are different techniques of financial
analysis and what are advantages and disadvantages of such techniques.
Q8: With the help of following ratios regarding InduFlims , draw the Balance Sheet of the company for
the year 2014.
Current Ratio 2.5
Liquidity Ratio 1.5
Net Working Capital Rs.3,00,000
Stock turnover Ratio (cost of sales/closing stock) 6 times
Gross Profit Ratio 20%
Fixed Asset turn over Ratio( on cost of sales) 2 times
Debt collection Period 2 months
Fixed Assets to shareholders net worth 0.80
Reserve and Surplus to capital 0.50

Q9: Tide Ltd. is dealing in FMCG products and a growing company. The financial data for the year 2013
and 2014 is as under.
Profit Statement
2013 2014
(Rs.) (Rs.)
Net sales 10,00,000 15,00,000
Less: cost of sales 7,00,000 11,00,000
Gross Profit 3,00,000 4,00,000
Less: Operating Expenses 2,00,000 2,50,000
Net Profit 1,00,000 1,50,000

30
Balance Sheet as on 31st march,2013 and 31st march,2014
Liabilities 2013 2014 Assets 2013 2014
Equity Share 6,00,000 7,00,000 Cash in Hand 50,000 80,000
Capital
Reserve and 1,20,000 70,000 Bills 40,000 20,000
surplus Receivables
Creditors 3,60,000 1,20,000 Debtor 4,00,000 2,50,000
Bills payable 20,000 10,000 Stock 1,50,000 1,00,000
Mortgage 100,000 2,00,000 Fixed Asset 5,60,000 6,50,000
12,00,000 11,00,000 12,00,000 11,00,000

You are required to calculate following ratios for both the year( 2013& 2014) and give your opinion
about financial soundness of the company:
a. Current Ratio
b. Acid test Ratio
c. Debtor Turnover Ratio
d. Stock Turnover Ratio
e. Debt equity Ratio
f. Net Profit Ratio

31
32