Financial Accounting and Management - Unit 3 Notes

INDERPRASTHA ENGINEERING COLLEGE,
GHAZIABAD
AFFILIATED TO CHAUDHARY CHARAN SINGH UNIVERSITY, MEERUT
(COLLEGE CODE-1249)
63 SITE-IV, SAHIBABAD INDUSTRIAL AREA, SURYA NAGAR FLYOVER ROAD
SAHIBABAD, GHAZIABAD – UP
NOTES – UNIT 3
Subject Name: Financial Accounting and Management

Subject Code: BCA 205
Faculty Name: Ms. Aashi Jain
3.1 FINANCIAL STATEMENTS
Financial Statements, also called financial reports, are account balances arranged in an effective
and meaningful order so that the facts and concepts they portray may be readily interpreted and
used as bases for decisions by all people who are interested in the affairs of the business.
Usually, financial statements imply any such statements which contain financial information
related to business. But in accounting this term refers to two statements which the accountant
prepares at the end of a given period for the business enterprise. In India, the financial
statements are also termed as 'annual accounts' or 'annual reports.
These statements are
(1) Profit and Loss Account also known as Income Statement and
(2) Balance Sheet also known as Position Statement.
"The financial statements provide a summary of the accounts of a business enterprise, the
balance sheet reflecting the assets, liabilities, and capital as on a certain date and the income
statement showing the results of operations during a certain period."
~ John N. Myer
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Prepared by: Asst. Prof. Ms. Aashi Jain
Nature of Financial Statements
Financial Statements are the summaries of transactions of a business unit that occurred during
a particular period, generally one year. These statements are prepared based on recorded facts.
"Financial Statements are prepared for presenting a periodical review or report on progress
by the management and deal with the status of investment in the business and the results
achieved during the period under review. They reflect a combination of recorded facts,
accounting principles, and personal judgments and the judgments and conventions applied to
affect them materially."
~ American Institute of Certified Public Accountants
Attributes or Characteristics of Ideal Financial Statements

Financial statements are said to be ideal if they give a true and fair view of the financial position
and profitability of the business enterprise. The ideal financial statements have the following
characteristics:
1. Relevance: The financial statements should be relevant to the objectives of the
enterprise. This will be possible when the person preparing these statements can
properly utilise the accounting information. Efforts should be made to avoid irrelevant
data.
2. Easiness: Financial statements should be easily prepared. For this ledger accounts
should be so tailored that required balances are readily and easily available. The size of
the statements should not be too large and should be capable and convenient of being
processed mechanically. There should not be too many columns and should be prepared
in statement form (instead of account form).
3. Intelligible to the Common Man: The financial statements should be presented simply
and lucidly to make them easily understandable and intelligible even to the common
man. A person not well versed in accounting rules, principles, and terminology should
also be able to understand and analyse them without much difficulty. The use of simple,
non-technical, and currently in-vogue language makes them more intelligible and
useful.
4. Accuracy: The information contained in the financial statements should be precise and
true so that the user of these statements is not misled and can correctly assess the
position, progress, and prospects of the enterprise.
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5. Completeness: The financial statements should contain all relevant information and
data regarding the affairs of the business. But care should be taken to avoid unnecessary
and irrelevant details.
6. Attractive: The financial statements should be prepared in such a way that important
information is underlined or given in bold letters or different ink so that the attention of
the readers is automatically drawn and directed to the most significant items of financial
statements.
7. Comparability: The financial statements should facilitate all sorts of comparisons. The
columns should be so arranged that figures of the current year could be compared with
those of the previous year. Similarly, the actual results may be compared with the
budgeted ones or with standards. Such comparison can also be made with other
concerns of the same nature
8. Promptness: The financial statements should be prepared at the earliest possible so
that they can be presented immediately at the close of the financial year.
9. Analytical Representation: Financial statements should be presented in such a way
that items and figures required for analysis and interpretation could be available easily
and in a classified form. Certain important ratios may also be given in financial
statements.
10. Use of Schedules: If detailed information is to be given in respect of certain items, such
details should be given after the financial statements in the form of schedules. Though
these schedules are part of financial statements they make the main parts of statements
free from the complexities of figures.
Parties Interested in Financial Statements

Financial Statements are viewed as the eyes of a business concern. The information, which
they provide, is of great interest to various groups concerned with the activities of business
concern They are as follows:
(1) Management: In large business organisations, there is a separation of ownership and
management functions. The management is answerable to the owners. The financial
statements are the barometers of measuring the effectiveness of management plans,
policies, and decisions Management can base its decisions on the information derived
from these statements and frame sound financial policies for the future. These
statements also provide an opportunity for comparison of the results with other units in
the industry and with its past.
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(2) Bankers: Bankers and other financial institutions provide credit facilities to their
customers They are concerned not only with the full recovery of their loans but also
that they will be paid on the due date Hence, the bankers are interested in assessing the
liquidity, profitability and financial soundness of the borrowers The financial
statements help a lot in this respect. Bankers rely heavily upon financial statements for
determining the acceptability of a loan application A banker has a large number of
customers and it is not possible to supervise their business activities It is through the
financial statements that a banker can keep a watch on the business plan and
performances of its customers. The balance sheet is the most important document for a
banker It is by the analysis of this statement that a banker can assess the real and
technical solvency of his customers and determine the degree of financial risk.
(3) Trade Creditors: Trade creditors (i.e. suppliers of goods and services on credit) are
interested in knowing the creditworthiness and financial health of the concern before
granting credit. They can make a proper diagnosis of the purchaser's concerns with the
help of their financial statements.
(4) Investors: Investors, both present and prospective, are concerned with the liquidity,
profitability, and safety of their investments. They use financial statements to a great
extent in determining the relative merits of various investment opportunities.
(5) Government: Governments all over the world are using financial statements for
compiling statistics concerning business which, in turn, help in compiling national
accounts Actually, the financial statements of the business houses become the basis of
government future tax policy, production, price or profit control, grants, quota, license
and import and export facilities
(6) Regulatory Agencies: Various government departments and agencies (e.g. Company
Law Board. Registrar of Companies, SEBI, and various tax authorities) use financial
statements not only as a basis for tax assessment but also in evaluating how well various
businesses are operating under regulatory legislation Income tax and sales tax
assessments are also made based on information derived from financial statements.
(7) Employees: Employees are interested in the earnings of the enterprise they are serving
because their wage increase and payment of bonuses depend largely on the size of profit
earned. Labour unions often use financial statements, particularly Profit and Loss
Accounts, as a basis for supporting their wage demands.
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(8) Stock Exchange: Stock exchange brokers etc derive information regarding companies
they deal with from their financial statements. These statements provide them with
information for determining the share prices.
(9) Research Scholars: Financial statements are used by research scholars also in their
research in accounting theory as well as business affairs and practices.
In addition, financial analysts, the financial press and reporting agencies, trade associations,
consumers, and the public at large are interested in the financial statements of the business
enterprises.
Types of Financial Statements

Traditionally financial statements refer to two basic statements –
(i) the balance sheet or position statement and
(ii) the profit and loss account or income statement. However, Generally Accepted
Accounting Principles (GAAP) specify that a complete set of financial statements
must include the following:
• A balance sheet,
• An income statement,
• A statement of changes in owners' accounts, and
• A statement of changes in financial position.
Balance Sheet
"Balance Sheet is a screen picture of the financial position of a going business at a certain
moment."
~ Francis R. Stead
"The Balance Sheet is a statement which reports the values owned by the enterprise and the
claims of the creditors and owners against these properties."
~ Howard and Upton
In simple words, we can say that a balance sheet is a classified summary statement of ledger
balances that shows the financial position of the business concerned on a particular date. It
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shows the resources that the concern has, i.e., its assets and the claims it owes to owners and
outsiders. It is the result of all accounting operations for some time.
Income Statement or Profit and Loss Account
"The summary of changes in the owners' claim or equity resulting from operations of a period,
properly arranged is called the profit and loss statement."
~ Howard and Upton
"The accounting report that summarises the revenue items, the expense items, and the
difference between them (net income) for an accounting period is called the income statement
(or the profit and loss statement, statement of earnings, or statement of operations)."
~ Robert Anthony
Thus, it is clear from the above definitions that an income statement is a dynamic document
that shows the results of the operations of an enterprise for a particular period.
In this statement, revenues of a particular period are matched with expenses of that period. The
excess of revenues over expenses is known as net income and excess of expenses over revenues
is known as net loss.
Statement of Changes in Owners' Equity (or Retained Earnings)

The term owners' equity consists of share capital reserves and surplus. This statement shows
the beginning balance of the owner's equity account, the reasons for its increases and decreases,
and its ending balance. This statement is also known as the profit and loss appropriation account
because it shows the appropriation of earnings.
Statement of Changes in Financial Position

The Balance Sheet shows the financial position of the business at a particular moment and the
Income Statement discloses the results of the operations of the business over some time.
However, for a better understanding of the affairs of the business, it is essential to identify the
movement of funds in and out of the business. Such information can be made available by
preparing a statement of changes in the financial position of the business. This statement may
take any of the following two forms:
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(i) Funds Flow Statement: This statement analyses the changes in working capital
between two balance sheet dates.
(ii) Cash Flow Statement: This statement analyses the changes in cash between two
balance sheet dates.
The preparation, form, content, and uses of these statements have been discussed in detail as
separate chapters later in the book.
Limitations of Financial Statements

Financial statements have often been criticised by businessmen, accountants, and others for
their inherent deficiencies. The main deficiencies are the following:
1. Lack of precision in data: financial statements tend to give an appearance of finality

and accuracy because they are expressed in exact monetary amounts. However, the
precision of the financial statement’s information is impossible because they deal with
matters that cannot be measured precisely for example, the values of assets shown in
the balance sheet rarely represent the amount of cash that would be realized on
liquidation. Though the data are produced by conventional procedures developed by
the accounting profession through many years of experience, the opinion, judgment,
and estimate of accountant and management play an important role in their
measurement. Furthermore, in the measurement process, the use of different procedures
may give rise to different answers, yet each answer can be supported as the product of
'generally accepted principles. Hence, precision is impossible in financial statements.
2. No true picture of financial position: Financial statements do not give a true and fair
view of the financial position and operating results of a business enterprise because they
include only those facts that can be measured in terms of money. Hence, facts of
qualitative nature, such as the reputation and prestige of the business, its credit rating,
efficiency and loyalty of employees, efficiency and integrity of management, change in
competitive position, change in political situation, etc. are not included in financial
statements.
3. Historical Documents: Financial statements are primarily historical documents
because they are prepared based on historical cost Thus, no attempt is made to reflect
the changes in the market value of the items. This fact may make the financial
statements misleading especially in respect of assets the values of which are always
misleading.
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4. No Future Planning: Financial statements provide a post-mortem analysis of the past
and ignore the planning of the future. However, an investor is more concerned with the
present and future.
5. Interim Reports: Financial statements are essentially interim reports and, therefore,
cannot be final because the actual gain or loss of a business can be determined only
after it has put down its shutters. But for various reasons, it is necessary to have
accounting in the form of financial statements at relatively frequent periods (usually a
year after) during the life of a business. This gives rise to the problem of allocation of
cost as well as income to an accounting period that involves personal judgment.
Financial statement data cannot be exact under such conditions. Other factors that tend
to make statements of assets and liabilities imprecise are the existence of contingent
assets and liabilities, deferred maintenance, etc.
6. Price Level Changes: Financial statements are prepared on the assumption of stable
monetary units but this assumption is unrealistic and false. This makes the financial
statements incomparable. Thus, conclusions based on an inadequate analysis of
comparative data may be quite misleading.
7. Lack of Objectivity: Personal judgment and discretion of the accountant and the
management play an important role in determining the figures of many items of
financial statements. Provision for depreciation, provision for doubtful debts, stock
valuation, etc. are based on personal judgment, and, therefore, financial statements lack
objectivity. This provides chances of manipulation in accounting results.
3.2 ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS
"Financial statement analysis is largely a study of relationships among the various financial
factors in a business, as disclosed by a single set of statements, and a study of trends of these
factors, as shown in a series of statements."
~ John N. Myer
"The analysis and interpretation of financial statements are an attempt to determine the
significance and meaning of the financial statement data so that the forecast may be made of
the prospects for future earnings, ability to pay interest and debt maturities (both current and
long-term) and profitability of a sound dividend policy."
~ R. D. Kennedy and S. Y. Mc Muller
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"Analysing financial statements is a process of evaluating the relationship between parts of
financial statements to obtain a better understanding of a firm's position and performance."
~ Metcalf and Titard
Process of Analysis and Interpretation

Analysis and interpretation of financial statements is an art. This includes activities such as
analysis, arrangement, comparison trend study, and concluding on their basis. Its process can
broadly be divided into the following four parts:
1. Analysis: It implies classifying and arranging facts given in financial statements in some
convenient form by applying scientific methods so that meaningful conclusions can be drawn.
This activity consists of the following two steps
a) Presenting the data in a convenient form: The human mind can grasp and understand
small and precise figures more easily. Besides, mathematical calculations become easier based
on small figures. Hence, original and actual long figures shown in the statements should be
precise by applying approximation to make them more intelligible and suitable for analysis and
interpretation.
b) Arrangement of facts duly reclassified: Items of financial statements are classified into
proper and clear groups and rearranged in desired statement form. This process assumes
increased significance particularly when statements are being prepared in account form. As the
form of reorganisation and rearrangement of different items depends to a large extent upon the
objectives of the analysis, hence it’s no standard form can be given
2. Comparison: After the rearrangement of the items of financial statements, their relative
quantities are measured. For this purpose, a comparative relationship between various items is
established by applying different tools of interpretation. Ratios and comparative statements are
the tools that are generally used for such comparison.
3. Study of Trend: After a comparative study of different items of financial statements, an
analyst measures future trends of significant items. For this purpose, trend ratios, trend
percentages, graphs, and diagrams are used.
4. Drawing Conclusion: The main objective of financial statement analysis is to draw
conclusions and express opinions about the financial condition of the enterprise. These
conclusions are based on economic facts and are presented before the management for
consideration.
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Objects of Analysis and Interpretation
1. To estimate the earning capacity of the firm.
2. To assess the financial strength and weaknesses of the firm.
3. To determine the long-term solvency as well as short-term liquidity of the firm.
4. To determine the debt capacity of the firm.
5. To examine the managerial efficiency and operating performance of the firm.
6. To assess the prospects of the firm.
7. To make a comparative study of the firm with other units of the same industry, i.e., intrafirm
comparison.
The objectives of analysis of these statements depend to a large extent on the point of view of
the analyst, the degree of his interest in the company the need for depth of inquiry, and finally
on the amount and quality of the data available. A trade creditor considering what action to take
on a long overdue account may well focus his inquiry on the immediate financial condition of
the firm and the liquidity of the resources. In contrast, a security analyst considering a purchase
of equity shares may tend to centre his efforts on the measurement of the financial condition
and future profitability of the firm. The object of the analysis determines the extent, depth arid
nature of the analysis. If a thorough analysis is desired and the full data needed are not available
or if the suspicion exists that the firm is trying to hide or confuse its real position, the financial
analyst must virtually be a detective to find out the truth.
Parties Interested in Financial Analysis and Interpretation

Financial analysis is an important and very useful activity The end-users of financial statements
of any business are interested in these statements primarily as an aid to determine the financial
position and the results of the operations. There are different parties interested in the financial
analysis of these statements and their aims and objectives of analysis also differ significantly
the following are the uses of financial statement analysis for different parties
(1) To the Financial Executives: The first party interested in the financial statement analysis
is the finance department of the business concern itself to the financial manager such analysis
provides a deep insight into the financial condition of the enterprise and a view of the past
performance which helps in future decision-making. The financial statements give vital
information concerning the financial position of the enterprise as well as the result of the
business operations.
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(2) To the Top Management: The top management of the concern is also interested in the
analysis of these statements because it helps them reach conclusions regarding the overall
operations of the business. The management is interested in every aspect of the financial
analysis. It is their overall responsibility to see that the resources of the firm are used most
effectively and efficiently and that the firm's financial position is sound. As such, Return on
Investment (ROI) analysis is very important for them.
(3) To the Creditors: The analysis of these statements is very useful to the creditors also. Some
of the aspects of an enterprise's operations that are of interest to the creditors are liquidity of
funds, soundness of the financial structure, profitability of the operations, effectiveness of
working capital management, etc. The bankers and trade creditors of a business enterprise are
interested in its cash generation and creditworthiness. They want to assess whether the
enterprise will be able to meet commitments relating to repayments of the principal amount
advanced as well as interest payments due as per agreed schedules. They get all this information
from the analysis of the balance sheet and income statement of the company.
(4) To the Investors and Others: Investors, present as well as prospective, are also interested
in the measurement of the earning capacity of the securities. Investors have been increasingly
concerned with the cash generation capability of an enterprise primarily in terms of the
flexibility available to such enterprise to acquire other business and new assets on an
advantageous basis. For this purpose, cash-flow analysis and funds-flow analysis have proved
to be very useful.
Besides the above-mentioned parties, the information provided by the analysis and
interpretation of various financial statements is important and useful to those groups also that
are interested in the working of the business due to one or the other motive. They are employees
of the business and their unions, government, consumers and general public
Types of Financial Analysis

The distinction between different types of financial analysis can be made either based on the
material used for the analysis or according to the modus operandi of the analysis or object of
the analysis It is important to distinguish between different types of analysis because the
techniques of analysis and interpretation differ according to the type of analysis. The following
chart gives a snapshot view of financial analysis:
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(1A) External Analysis: External analysis of financial statements is made by those who do not
have access to the detailed accounting records of the company, i.e., banks, creditors, investors,
government agencies, and the general public. These people depend almost entirely on
published financial statements. Such analysis is of limited use. The main objective of such
analysis varies from party to party.
(1B) Internal Analysis: Such analysis is made by the finance and accounting department to
help the top management. These people have a direct approach to the internal and unpublished
financial records so they can peep behind the two basic financial statements (B.S. & Income
Statement) and narrate the inside story. Such analysis emphasizes the performance appraisal
and assessing the profitability of different activities and hence it serves the meaningful purpose
of internal management and employees.
(2A) Short-term Analysis: The short-term analysis of financial statements is mainly
concerned with working capital analysis, activity analysis, return on investment analysis, etc.
In the short run, a company must have ample funds readily available to meet its current needs
and sufficient borrowing capacity to meet the contingencies. Hence, in short-term analysis, the
current assets and current liabilities are analysed and the cash position (liquidity) of the concern
is determined. For short-term analysis, the ratio analysis is very useful.
(2B) Long-term Analysis: In the long run the company must earn a minimum amount
sufficient to maintain a suitable rate of return on the investment, to provide for the necessary
growth and development of the company, and to meet the cost of capital. Financial planning is
also necessary for the continued success of a company. Thus, in the long-run analysis, the stress
is on the stability and earning potentiality of the concern. In long-term analysis, the fixed asset’s
structure, leverage analysis, ownership pattern of securities, etc. are analysed.
(3A) Horizontal Analysis: When financial statements of several years are reviewed and
analysed, the analysis is called 'horizontal analysis. Under its year-by-year changes of each
item are shown and thus the periodical trend of various items is ascertained This analysis is not
based on data from any one year or an accounting period, on the contrary, it is based on data
from many years or periods. This analysis is also known as the dynamic Analysis or Trend
Analysis Ratio method, funds-flow analysis, trend analysis, comparative financial statements,
etc techniques of financial statements analysis are examples of horizontal analysis. This
analysis is very useful for long-term planning as it involves the trend study of financial data.
(3B) Vertical Analysis: It is also known as 'static analysis' or structural analysis" as it is a study
of quantitative relationships existing among the various items at a particular date. Average
analysis and common-size statements are good examples of vertical analysis. In this type of
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analysis, the sum of the items of the statement of a period or date is taken as base and this base
is taken to be equal to 100, and various items shown in the statement are expressed as
percentages to the base This relationship can be expressed by ratio analysis technique also.
Though both methods of analysis can be used for financial statements analysis, each method
provides a specific type of information but of these two, the first method is better because, in
vertical analysis on the change in 'base item' or 'item used as current item or both, the
percentage calculated earlier may also change. Moreover, its present position cannot be
explained concerning the past. Only after a continuous study for several years calculated data
can be comparable. Horizontal analysis is free from both these defects; hence this analysis is
more suitable for financial statements analysis.
Methods, Devices, or Tools of Analysis and Interpretation

The following are the important tools of financial analysis:
(1) Comparative Financial Statements
(2) Common-Size Statements
(3) Trend Analysis
(4) Average Analysis
(5) Ratio Analysis
(6) Funds Flow and Cash-flow Analysis
3.3 RATIO ANALYSIS

Ratio Analysis is a technique of Financial Statements Analysis. It is the most widely used tool
to interpret the quantitative relationship between two variables of the financial statements.
"The term accounting ratio is used to describe significant relationships which exist between
figures shown in a Balance Sheet, in a Statement of Profit and Loss, in a budgetary control
system or any part of the accounting organization"
Ratio analysis is a process of determining and presenting the relationship of items and groups
of items in the statements." It involves the calculation, comparison, and interpretation of ratios
between two or more items of financial statements for some specified purpose. As compared
to other tools of financial analysis, the ratio analysis highlights more useful facts about various
aspects of the working (i.e., financial position, solvency, stability, liquidity, and profitability)
of an enterprise.
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The term 'ratio' refers to the numerical or quantitative relationship between two items/variables.
As such, ratios are simply a means of highlighting in arithmetical terms the relationship
between two or more figures drawn from the financial statements. In the words of Robert
Anthony, "A ratio is simply one number expressed in terms of another". When this ratio is
expressed concerning the items shown in financial statements, then it is called "accounting
ratio.
OBJECTIVES
Ratio analysis serves the purpose of various users who are interested in financial statements. It
simplifies, summarises, and systematizes the figures in the financial statements. The objectives
of ratio analysis are:
1. To simplify the accounting information.
2. To determine liquidity (Short-term solvency. i.e., ability of the enterprise to meet its
short-term financial obligations) and Long-term solvency (i.e., ability of the enterprise
to pay its long-term liabilities) of the business.
3. To assess the operating efficiency of the business.
4. To analyse the profitability of the business.
5. To help in comparative analysis, i.e., inter-firm and intra-firm comparisons.
ADVANTAGES
1. Useful Tool for Analysis of Financial Statements: Accounting ratios are useful for
understanding the financial position of an enterprise Bankers, investors, creditors, etc,
all analyse Balance Sheet and Statement of Profit and Loss using ratios.
2. Simplifies Accounting Data: The accounting ratio simplifies, summarises, and
systematizes accounting data to make it understandable. Its main contribution lies in
communicating precisely the interrelationships that exist between various elements of
financial statements. In the words of Biramn and Dribin, "Financial Ratios are useful
because they summarise briefly the results of detailed and complicated computation"
3. Useful in Assessing the Operating Efficiency of Business: Accounting ratios are
useful for assessing the financial health and performance of an enterprise. It is assessed
by evaluating liquidity, solvency, profitability, etc.
4. Useful for Forecasting: Accounting ratios are helpful in business planning and
forecasting. The trend of ratios is analysed and used as a guide for future planning.
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What should be the course of action in the immediate future is decided, many times,
based on the trend of ratios, i.e., ratios are calculated for several years.
5. Useful in Locating the Weak Areas: Accounting ratios assist in locating the weak
areas of the business even though the overall performance may be good. The
management can then pay attention to the weaknesses and take remedial action.
LIMITATIONS
1. Limited Use of a Single Ratio: A single ratio has limited value in ratio analysis because
the trend is more significant in the analysis. A change in a particular ratio is meaningful
only when it is interpreted concerning other related ratios. For example, a weak current
ratio may be due to a weak price-cost relationship. Such a situation cannot be cured by
increasing funds, rather it requires a reduction in cost or an increase in the selling price
2. Lack of Qualitative Analysis of the Problem: Ratio analysis is an instrument of
quantitative analysis. It overlooks qualitative factors of the problem even if they are
more important than quantitative factors. For example, the decision of credit to a
customer is taken based on data on his financial position but here his integrity, history,
and managerial ability are more important than his financial position
3. Arithmetical Window Dressing: In ratio analysis arithmetical window dressing is
possible. For example, by restricting credit sales and postponing certain cash
expenditures at the year-end, a firm may be successful in depicting its better liquidity
position
4. Different Accounting Procedures: A comparison of results of two firms becomes
difficult and misleading if they are using different procedures concerning certain items
such as inventory valuation, amortization of intangible assets, capitalization of
expenditures, etc. For example, in periods of rising or falling prices, FIFO and LIFO
methods substantially affect the value of the cost of sales and closing stock.
5. Lack of Proper Standards: There are no well-accepted standards or rules of thumb
for all ratios that can be applied as norms. It makes the interpretation of ratios difficult.
Not only this, there are many terms used in this analysis (e.g. current liabilities, capital
employed, etc) due to a lack of uniformity concerning their definitions, inter-firm
comparison or comparison with industry average ratios is not possible
6. Calculating Ratios between Unrelated Items: Accounting ratios can be calculated for
any two items even if they are completely unrelated, e.g. the ratio of sales with
investment in government securities. Such ratios would lead to misleading inferences
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7. Ratios devoid of absolute figures are sometimes misleading: In fact, they must be
used as supplementary to and not substitute for the original absolute figures. For
example, if the output of one firm goes up from 5,000 units to 10,000 units, the ratio
would show a 100% increase. On the other hand, if the output of the second firm
increases from 10,000 units to 18,000 units, the ratio would reflect an increase of only
80%. Based on the ratios, one would conclude that the first firm is more active than the
second, although, in terms of absolute figures, the contribution of the second firm is
more than the first.
CLASSIFICATION
Accounting ratios, as a tool of analysis, may be classified into the following four categories:
I. Liquidity Ratios: These ratios show the ability of the enterprise to meet its short-term
financial obligations. Important Liquidity Ratios are (i) Current Ratio, and (ii) Quick
Ratio.
II. Solvency Ratios: These ratios are calculated to assess the long-term financial position
of the enterprise. Solvency means the ability of the enterprise to meet its long-term
financial obligations, i.e., liabilities. Important Solvency Ratios are (i) Debt to Equity
Ratio, (ii) Total Assets to Debt Ratio, (iii) Proprietary Ratio, and (iv) Interest Coverage
Ratio.
III. Activity Ratios or Turnover Ratios: These ratios show how efficiently a company is
using its resources. Important Activity Ratios are (i) Inventory Turnover Ratio, (ii)
Trade Receivables Turnover Ratio, (iii) Trade Payables Turnover Ratio, and (iv)
Working Capital Turnover Ratio.
IV. Profitability Ratios: The profitability of a firm can be measured by its profitability
ratios. Important Profitability Ratios are (i) Gross Profit Ratio, (ii) Operating Ratio, (iii)
Operating Profit Ratio, (iv) Net Profit Ratio, and (v) Return on Investment (ROI).
1. CURRENT RATIO
The current ratio is the most common and widely used ratio for measuring liquidity Being
related to working capital analysis, it is also called the working capital ratio. This ratio indicates
the relationship between total current assets and total current liabilities of a firm.
Current Ratio = Current Assets

Current Liabilities
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Current Assets = Cash in Hand+ Cash at Bank + B/R+ Marketable Securities + Good Debtors
+ Prepaid Expenses + Work-in-progress + Stock in Hand + Accrued Income
Current Liabilities = Sundry Creditors + B/P+ Bank Overdraft + Outstanding and Accrued
Expenses + Short-term Advances + Income-tax payable + Income Received in Advance +
Unclaimed Dividend + Provision for Taxation.
The current ratio is a good measure of liquidity. The more the ability of the firm to meet current
obligations and greater the safety of funds of short-term creditors.
A ratio of 2:1 is considered satisfactory as per the rule of thumb.
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2. QUICK RATIO/ LIQUIDITY RATIO/ ACID TEST RATIO
This ratio is used as a complement to the current ratio. this ratio is calculated for assessing the
capacity of the firm to make immediate payment of liabilities. The ratio indicates the
relationship between liquid assets and current liabilities.
Liquidity Ratio = Liquid Assets OR

Quick Assets
Current Liabilities Quick Liabilities
Liquid Assets = Current Assets – Stock – Prepaid Expenses
Liquid ratio provides a more rigorous test for evaluating the short-term solvency of a firm.
A liquid ratio of 1:1 is considered satisfactory.
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3. DEBT TO EQUITY RATIO
This ratio indicates the relationship between external Equities and internal equities. This is also
known as the External-Internal Equity Ratio.
Debt-Equity Ratio = Debt External Equities OR

Long-term Debts
OR
Equity Internal Equities Shareholders’ Funds
External Equities = Short-term Debts + Long-term Debts
Internal Equities (or Shareholders Funds or Proprietary Funds) = Share Capital + Reserves and
Surplus + Excessive Provisions - Fictitious Assets
This ratio is very important for examining the long-term solvency of a concern. This ratio
indicates the extent of cushion available to the creditors on liquidation of the borrower concern.
The lower the ratio, the greater is security for the creditors. A high debt-equity ratio is a danger
signal for the creditors because, in case of a fall in profits of the concern, it may not be able to
bear the heavy burden of interest and also not be able to repay its debts on time.
Ordinarily, a 1:1 debt-equity ratio is considered satisfactory.
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4. PROPRIETORY RATIO
This ratio is also known as Equity Ratio or Shareholders Equity to Total Equities Ratio or Net
Worth to Total Assets Ratio. It indicates the relationship of owners' funds (shareholders' equity)
to total assets or total equities.
Proprietary Ratio = Proprietary or Shareholders’ Funds or Shareholders’ Equity

Total Assets or Total Equities
Proprietors' Funds can be computed by following either the Liabilities Side Approach or the
Assets Side Approach:
(a) Liabilities Side Approach: Share Capital (Equity + Preference) + Reserves and Surplus.
(b) Assets Side Approach: Non-current Assets + Working Capital (i.e., Current Assets - Current
Liabilities) - Non-current Liabilities.
It should be kept in mind that the result under both approaches will be the same.
The higher the ratio lesser the dependence for working capital on outside sources, the better
the long-term solvency and stability, and the greater the protection to the creditors of the firm.
In case of stability in the earnings of the firm, comparatively, a lower ratio can also be accepted.
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5. INTEREST COVERAGE RATIO
Proprietors' Funds can be computed by following either the Liabilities Side Approach or Assets.
Interest Coverage Ratio = Profit before Interest and Tax = …. Times

Interest on Long-term Debt
A high ratio is considered better for the lenders as it shows a higher margin to meet interest
costs.
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6. INVENTORY TURNOVER RATIO
This ratio is calculated to consider the justification of the amount of capital employed in stock.
Under it, the rate of conversion of stock into sales (i.e., stock velocity) is known by establishing
a relationship between the cost of goods sold and inventory.
Inventory Turnover Ratio = Cost of Goods Sold

Average Inventory
Cost of Goods Sold = Opening Stock + Purchases + Direct Expenses – Closing Stock
Average Inventory = Opening Stock + Closing Stock
2
Stock Velocity (in months) = Average Inventory X Number of months in a year

Cost of Goods Sold
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7. TRADE RECEIVABLE TURNOVER RATIO
This ratio is a qualitative analysis of a firm's marketing and credit policy and debtors'
realizations. It is calculated to know the uncollected portion of credit sales in the form of
debtors by establishing a relationship between trade debtors and net credit sales of the business.
Debtor Turnover Ratio = Average Trade Receivable X 100

Net Credit Sales
Average Trade Receivable = Debtors + Bills Receivable
A decrease in this ratio each year is an indicator of the efficiency of the marketing and credit
policy of the firm. The higher the value of debtors’ turnover, the more efficient the management
of debtors. An increase in this ratio is an indication of the firm's marketing superiority and
efficiency in credit realization
Average Collection Period = Number of days in a year

Trade Receivable Turnover Ratio
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8. TRADE PAYABLE TURNOVER RATIO
Like the debtor's turnover ratio, creditors' turnover ratio may also be calculated. The short-term
creditors (e. suppliers of goods and bankers) are very much interested in this ratio, as it shows
the firm's trend of payment to its short-term creditors. This ratio shows the relationship between
credit purchases and trade creditors.
Creditors Turnover Ratio = Average Accounts Payable

Net Credit Purchase
Average Trade Payable = Creditors + Bills Payable
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The lower the ratio, the better the liquidity position of the firm Higher creditors turnover ratio
indicates a weak liquid position. A continuous increase in this ratio shows delays in payments.
Average Payment Period = Number of days in a year
Trade Payable Turnover Ratio
9. GROSS PROFIT RATIO

The two main components of this ratio are gross profit and net sales. Gross profit is the excess
of net sales over cost of goods sold and net sales is found out by deducting sales returns from
gross or total sales.
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The Gross Profit Ratio is a very important ratio for measuring the profitability of an enterprise.
It indicates to the management the margin of the profit left to cover indirect expenses. In other
words, it indicates the extent to which selling prices of goods may decline without resulting in
losses. The higher the ratio, the better it is.
Gross Profit Ratio = Gross Profit X 100

Net Sales
10. NET PROFIT RATIO

This ratio measures the rate of net profit on sales. Some authors calculate this ratio based on
net operating profit after tax in place of net profit after tax in calculating net operating profit,
non-operating incomes, and expenses are excluded. This ratio expresses the part of sales
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revenue which is of the owners of the firm. This ratio is the measure of the overall profitability
and efficiency of a firm. The higher the ratio, the better the profitability of the firm.
Net Profit Ratio = Net Profit after Tax x 100

Net Sales
11. OPERATING RATIO

Operating expenses are the sum of administrative, selling, and distribution expenses. 100 minus
the operating ratio is the operating profit ratio. The operating ratio is a measure of the efficiency
and general profitability of the business. The lower the ratio, the higher the profit left for
recouping the non-operating expenses and the higher the net profit. There is no rule of thumb
for this ratio as it may differ from firm to firm depending upon the nature of its business.
However, 75 to 85 percent may be considered to be a satisfactory rate in case of a
manufacturing concern. Though the operating ratio is a good indicator of the operating
efficiency of the firm it should be used cautiously because it reflects a combined effect of
several factors.
Operating Ratio = Cost of Revenue from Operations + Operating Expenses X 100

Net Sales
12. EXPENSE RATIO

Expense ratios are calculated to show the relationship of each item of manufacturing cost and
operating expenses to net sales. These ratios help in analysing the causes of variation in the
operating ratio. These ratios show how much part of net sales is involved in recouping various
operating expenses. By comparing these ratios with their respective past ratios with the
standards determined by management or with ratios of similar firms in the industry, economy,
or diseconomy of each item of expense can be determined. These ratios throw light on the
managerial efficiency and profitability of the firm. The lower the ratio, the greater the
profitability of the business. It is to be remembered that these ratios should be calculated
separately for each item of fixed and variable expenses. The ratio of variable expenses should
remain constant while the ratio of fixed expenses should fall with the increase in sales.
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Particular Expense Ratio = Particular Expense × 100
Net Sales
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13. RETURN ON CAPITAL EMPLOYED
A study of profit about the size of investment is known as return on capital employed. In other
words, return on capital employed implies finding out the ratio of net profit on capital employed
in the firm. This is the only satisfactory measure of examining the overall operating efficiency
or profitability of a business entity. It is an evaluation of efficiency in using funds entrusted to
management.
Return on Capital Employed = Profit before Interest, Tax, and Dividend X 100
Capital Employed
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3.4 FUNDS FLOW STATEMENT
A statement prepared to show the movement of funds between two balance sheet dates is known
as a funds flow statement.
“A Statement of Sources and Application of Funds is a technical device designed to analyse
the changes in the financial condition of a business enterprise between two dates.”
~ Roy A. Foulke
“The Funds Flow Statement describes the sources from which additional funds were derived
and the use to which these funds were put.”
~ Robert N. Anthony
Concept of Funds
The term "funds" has been defined in several ways in financial circles. The two most common
usages of the term are cash and working capital. One school of thought considers "funds in the
sense of total financial resources also. We shall examine here all three concepts of "funds":
(i) Cash - In a narrow sense, the term "funds" is used in the sense of cash. The general public
also views the term funds in this sense. Viewed in this sense, the Statement of Changes in
Financial Position explains only the changes in cash. Accordingly, this statement is called a
"Cash Flow Statement." This statement aims to list the various items that bring about changes
in the cash balance between two balance sheet dates. Thus, this statement becomes a summary
of cash receipts and disbursements. Such cash flow analysis is very useful for the management
of cash planning and control.
(ii) Working Capital - In a popular sense, the term 'funds' is used in the sense of working
capital (current assets minus current liabilities) It is an alternative measure of the changes in
the financial position of concern. All those transactions that increase or decrease working
capital are included in this statement, while it excludes all such items that do not affect working
capital, e.g., payment of current liabilities, purchase of inventories on short-term credit,
collection of receivables and short-term borrowing, purchases of treasury bills or short-term
government securities.
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(iii) Total Financial Resources - In a broader sense, the term 'funds" is used in the sense of
total financial resources, The Cash approach and working capital approach both are incomplete
and inadequate to the extent that they omit a few major financial and investment transactions.
Such items, of course, do not affect net working capital, but, if included would certainly provide
qualitative information for decision-making.
Meaning of Funds Flow

Only that transaction can affect the working capital which on the one side effects a current
account (i.e., any current asset or current liability) and on the other side, it affects a non-current
account (i.e., a fixed asset, long-term investment, long-term liability, or proprietors’ funds).
Uses or Objects of Funds Flow Analysis (or F.F. Statement)

Fund flow analysis is a very useful technique of financial statement analysis. Under is
technique a funds flow statement is prepared to reflect the movement of funds between the
balance sheet dates. This statement is very helpful to improve the understanding of the
operation and activities of an enterprise for the reporting period. This statement reflects the
effectiveness of financial management in generating funds from various sources and using
them effectively for generating income without sacrificing the financial heat of und using
Therefore, this statement is of great significance to all management of the business,
shareholders, bankers, and creditors.
Managerial Uses
The funds flow statement is an important managerial tool. The main uses of this statement for
a financial manager are as follows:
(1) Financial Analysis and Control: The funds flow statement presents an analytical picture
of the financial position of a business. This statement shows the various sources of working
capital and its uses in the period under analysis. The analysis of past events becomes the base
for future planning of working capital and its control. This statement provides the following
important information to the management.
(2) Future Guidance: Analysis of funds flow statement provides much such information that
is not available from traditional financial statements. Based on information derived from the
funds flow statement, the management can formulate its future financial policies.
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(3) Aid in Comparative Study: The fund's flow statement is prepared based on comparative
balance sheets of the two periods which in turn help in comparative study.
(4) Helpful in getting loans: Financial institutions, such as banks, insurance companies, etc.
require the borrowing concerns to file a funds-flow statement along with their loan applications
to assess their repayment capacity. The financial manager can prove the creditworthiness and
solvency of his concern with the help of this statement.
(5) Scheme of Better Utilisation of Funds: Based on future estimates of funds from business
operations and other sources, a finance manager can plan the proper utilization of funds. Thus,
this statement becomes a tool for the allocation of resources of the firm.
(6) This statement also helps in the determination of dividend policy, inventory policy, and
capital expenditures of the firm.
Application or Uses of Funds

The transactions that result decrease in net working capital are the application of funds.
Following may be the application to funds in a firm
(1) Loss from Operations - Trading loss is an application of funds
(2) Purchase of non-current assets - If a fixed asset (or long-term investment) is purchased
for cash it is an application of funds
(3) Redemption or Repayment of non-current liabilities - Amount paid on redemption of
debentures, bonds, or preference shares (including premium on redemption, if any) or
repayment of long-term loans is an application of funds
(4) Payment of cash dividend - The declaration of cash dividend in A.G.M. whether paid or
not during the year reduces the working capital and is an application of funds. But the proposed
dividend is not an application of funds. It is to be noted that last year's proposed dividend and
current year's interim dividend both are supposed to have been paid during the year and hence
are shown as application of funds
(5) Withdrawals by proprietors: The withdrawals of cash or any other current asset e.g.,
goods in trade) by the proprietor (or partners) is the use of funds.
(6) Purchase of intangible assets such as goodwill, patents, trademarks, etc for cash and other
current assets is an application of funds
(7) Payment of non-operating expenses such as preliminary expenses, underwriting
commission, etc are shown as an application of funds.
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(8) Other applications - Loss by embezzlement, expenses of a suit, compensation paid on
losing a suit, donations, etc, are applications of funds
(9) Increase in working capital - Increase in working capital as shown by Statement of
Changes in Working Capital, is shown as an application of funds.
In brief, uses of funds are indicated by increases in assets and decreases in equities.
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3.5 CASH FLOW STATEMENT
A cash flow statement is a statement that shows the inflows and outflows of cash during a fixed
period.
Objectives
• To ascertain the sources and the applications of Cash and Cash Equivalents from the
operating, investing, and financing activities of the enterprise.
• To ascertain net changes in Cash and Cash Equivalents.
• To highlight the major activities that have provided cash and that have used cash during
a particular period and showed an effect on the overall cash balance.
Advantages
1) It allows measurement of the enterprise’s capacity to meet its fixed costs.
2) It is useful in bringing to the forefront the business enterprise’s reputation concerning its
Liquidity and Solvency throughout dangerous conditions.
3) It is beneficial in assessing the adjustments in ‘Cash Position’ among ‘Profit & Loss
Account’ and ‘Balance Sheet’ gadgets of two consecutive accounting durations.
4) Disclosures made through the ‘Cash Flow Statement ' permit the management of a
commercial enterprise agency to provoke preventive measures in financially tough conditions.
5) Identification of Discretionary Cash Flows from business transactions becomes feasible via
Cash Flow Analysis.
6) It enables listing out the ‘Potential Financial Flows,’ which can be positioned for use during
crises.
7) The Cash Flow Statement is famous for the data concerning the availability of cash. Such
facts could be very useful in identifying the quantum of “Dividend’ to be dispensed to the
shareholders or, in extreme instances, whether or not to bypass a dividend fee altogether.
Disadvantages
1) Non-Cash Transactions are Overlooked: The full attention of the Cash Flow Statement is
completely on the ‘Inflows and Outflows of cash. Non-cash transactions like buying homes
through issuing shares/debentures to the companies or the difficulty of bonus shares are out of
its purview.
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2) Not a Substitute for an Income Statement: An Income Statement of an enterprise
corporation covers each Cash and Non-Cash gadget and reveals the Net Income. Cash Flow
Statement, on the other hand, takes into attention only ‘Cash Flows’ and, as such, can show the
simplest ‘Net Cash Flows’ (inflows or outflows). It cannot expose the ‘Net Profit/Loss of the
corporation.
3) Limited Use: Cash Flow Statement has very restricted use in isolation. While its miles
follow using different ‘Financial Statements’ like ‘Balance Sheet’ and ‘Profit & Loss Account,’
it affords a few meaningful and beneficial effects.
4) Historical: Preparation of Cash Flow Statement includes rearranging different Financial

Statements, viz. ‘Balance Sheet’ and ‘Profit & Loss Account”, which include beyond statistics
and are historical. It might have been extra useful and prospective when followed with a
Projected Cash Flow Statement’.
5) Ignoring the Accrual Concept: The Accrual Concept, one of the fundamental accounting
concepts, must be addressed simultaneously as making ready a coin go with the flow
announcement.
CASH AND CASH EQUIVALENTS

• Cash at hand
• Cash at bank
• Current Investments
• Marketable Securities
• Cheques and Drafts at hand
Significance or Uses of Cash Flow Analysis

Cash flow analysis is a technique of analysis of the cash operations of an enterprise. Its main
uses are as follows:
(1) Cash flow analysis is an important technique of short-term financial analysis. It provides to
the users of financial statements a basis to assess the ability of the enterprise to generate cash
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and cash equivalents and the timing and certainty of their generation. It enables users to develop
models to assess and compare the present value of the future cash flows of different enterprises
(2) It is also a control device for the management. A comparison of the cash flow statements
with the budgeted forecast of cash for the same period helps in the comparison and control of
cash expenditures. It helps the management in determining the extent to which the financial
resources of the enterprise have been raised and used as per plan.
(3) If a cash flow statement is prepared based on estimates of the next accounting period, it
proves to be a useful tool for planning and coordinating the financial operations of the firm
(4) It determines the firm's ability to meet financial commitments and pay dividends.
(5) It explains the causes of the difference between net income and net cash flows from
operating activities. It highlights the factors contributing to the reduction in cash balances
despite the increase in profits and also the increase in cash balances despite the decrease in
profits.
(6) It is helpful in short-term financial decisions relating to liquidity and wage and means
position of the firm
(7) By analysing net cash flow from operating activities, an investor can estimate dividends
from his company and a creditor can assess the debt-repayment capacity of the company and
thereby estimate the risk in return for his loan.
(8) Historical cash flow information is often used as an indicator of the amount, timing, and
certainty of future cash flows. It is also useful in checking the accuracy of past assessments of
future cash flows and in examining the relationship between profitability and net cash flow and
the impact of changing prices.
(9) It enables the users to analyse the pattern of resource deployment in/out of assets and
evaluate the changes in the net assets of the enterprise.
(10) It helps the management understand past behaviour of the cash cycle and control the uses
of cash in the future
Cash Flow from Operating Activity

Operating activities are the main revenue-generating activities of an enterprise. As such, they
include cash flow from those transactions and events which enter into the ascertainment of net
profit or loss of an enterprise.
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Cash Flow from Investing Activity
Investing activity includes the purchase and sale of long-term assets not held for resale. These
activities also include the purchase and sale of such investments which are not included in cash
equivalents. Cash flow from investing activity discloses the expenditure incurred for resources
intended to generate future income and cash flows.
Cash Flow from Financing Activity

Financing activities are the activities that result in changes in capital and borrowings of the
enterprise.
Difference between Funds Flow Statement and Cash Flow Statement

(1) Concept: The funds flow statement is based on the concept of 'working capital' whereas
the cash flow statement is based on the concept of 'cash". Thus, cash flow is concerned with
cash only whereas fund flow is concerned with the total provision of funds. A funds flow
statement is a flexible device designed to disclose and emphasize all significant changes in the
current assets and current liabilities of the firm during the period under study.
(2) Viewpoint: The funds flow statement shows the causes of the changes in net working
capital whereas the cash flow statement shows the causes of the change in cash. Thus, in funds
flow analysis, a broader outlook is taken whereas in cash flow analysis a narrower outlook is
taken.
(3) Need for a statement of change in working capital: In funds flow analysis, a Statement
or Schedule of Changes in Working Capital is prepared together with a fund flow statement but
in cash flow analysis, only one statement, viz. cash flow statement is prepared.
(4) Cash Balance: The opening and closing balances of cash are shown in a cash flow
statement whereas, in fund flow analysis, they are shown in the Statement of Changes in
Working Capital.
(5) Basis of Accounting: The funds flow statement is related to the accrual basis of accounting,
while in the cash flow statement data obtained on an accrual basis are converted into the cash
basis.
(6) Adjustment of Current Assets and Current Liabilities: In funds flow analysis, current
assets and current liabilities are shown separately in a statement known as the statement of
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changes in working capital whereas in cash flow analysis increases and decreases of all current
accounts are adjusted in the calculation of cash flow from operating activities.
(7) Operating Profit In a funds flow statement operating net profits are shown separately as a
source of funds whereas in a cash flow statement, it is included in cash flow from operating
activities.
(8) Long-term v/s Short-term Strategy: Funds flow analysis is more relevant and useful in
assessing the long-range financial strategy, while cash flow analysis is useful in understanding
the short-term phenomena affecting the liquidity of the business.
(9) Usefulness: The Financial Accounting Standard Board, American, Institute of Chartered
Accountants of India, and SEBI all have accepted that cash flow analysis is more useful than
funds flow analysis because it throws light on factors affecting the liquidity of the enterprise.
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3.6 BREAK-EVEN ANALYSIS
Break-even analysis is an essential economic tool that helps to determine the point beyond
which a company earns a profit. It helps businesses calculate the volume of products that need
to be sold so that a company overcomes all the initial costs of investment. Reaching this break-
even point means that a company is no more in a state of loss.
Break-Even Point
In a business scenario, the break-even point is a perimeter at which the total expenses of the
enterprise equal the total revenue generated. Reaching this point indicates that a business has
overcome all the expenses and is no more in a state of loss. Since this calculation reveals such
vital information about a business, it is a necessity to learn and calculate break-even points
accurately.
To understand this further, consider this formula.

Break-even point = Fixed Cost / (Price per cost - Variable cost) = Fixed Cost / Gross Profit
Margin
Were,
• Fixed cost refers to the cost incurred in a business unit, which doesn’t depend upon the
volume of production. For example, rent, loans, insurance premiums, etc. comes under
fixed costs.
• Variable cost is the cost to produce one unit of product.
Example
Let us understand this equation by taking a break-even analysis example mentioned as follows.
A factory ABC Enterprises produces a particular kind of good wherein the total fixed costs
stand at Rs.50,000 and the variable cost to produce a good is Rs.30. The company sold these
goods with a sale price per unit of Rs.50.
In this case,
Break-even point = 50,000/ (50-30) = 2500 units
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So, from the above break-even analysis, it is evident that the BEP (break-even point) for ABC
enterprises stands at 2500. This means a company will have to sell at least 2500 units of the
product to overcome these fixed and variable costs incurred for production.
This can further help companies in determining the total sales achieved by the company. They
need to multiply the break-even point with the sale price per unit to do so. In this case, the
value of total sales made by the company at its break-even point will be equal to (2500*50)
Rs.1,25,000.
Numerical to Solve
1. A company produces goods at a variable cost of Rs.12 per unit, and the same is sold at
Rs.20 per unit. The fixed cost incurred by a company for a period stands at Rs.40,000.
Calculate the number of products a company needs to manufacture to attain a profit
target of Rs.10,000.
2. Check the following table to know about cost analysis for 6 months of a business
operation.
Material Cost ₹ 150 per set
Price ₹ 850 per set
Sets 1800
Other Variable Cost ₹ 150 per unit
Labour Cost ₹ 150 per set
Overheads ₹ 6,00,000 (for 6 months)
(i) Calculate the breakeven quantity

(ii) Draw a break-even chart for the 6 months of business operation
(iii) Determine the profit earned by an organization
3. The fixed costs of an enterprise are Rs.3,00,000, and the variable cost and selling price
of the product are Rs.42 per unit and Rs.72 per unit, respectively. The company expects
to sell 15,000 units of the product whereas it has a maximum factory capacity of 20,000
units. Draw a break-even chart depicting the break-even point and determine the profit
earned in this current situation.
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Significance of Break-Even Analysis
• Determined Volume of Products to be Sold: As per the break-even analysis definition,
its calculation can help companies determine the minimum number of goods to be sold
so that the total fixed and variable cost of production is met. Therefore, a company
already has an exact figure about the number of units to be sold to overcome losses.
• Deciding Budgets and Targets: Since break-even analysis gives businesses an idea
about the operational scenario, it helps plan the budget for various business operations.
Besides, they can set objectives to accelerate the production speed and achieve them
positively.
• Cost Control: Fixed and variable costs may have an impact on an organization's profit
margin. But, with a break-even analysis of the business operations, they will be able to
evaluate if any effects are changing the value of cost. In such scenarios, controlling
costs becomes a necessity to ensure they earn profit from business operations.
• Designing of Price Strategy: Pricing of products has a huge impact on the calculation
of break-even points. For instance, if the price of goods increases, then understandably
their break-even point will be reduced. For example, if earlier an organization needs to
sell 50 units of this product to reach breakeven, it will be attained at only 45 units if the
selling price is increased.
• Margin of Safety Management: Sales of goods can significantly decline in a situation
of financial crisis or breakdown. In such scenarios, managing the margin of safety
becomes easier with concepts like break-even analysis. That’s because the company
will have an idea of the minimum number of products, they need to sell to ensure their
organization doesn’t undergo any loss.
The margin of safety can be calculated by the following formula,

Margin of safety = (current sales level – Break-even point)/ Current sales level
Or, Margin of safety = (current sales level – Break-even point)/ Selling price per unit
These are a few pointers that briefly discuss why it is important to calculate break-even points
and study them in a business environment.
Components of Break-even Analysis

The two components that help define break-even analysis are mentioned as follows
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1. Fixed Cost: Costs incurred in running a business that don’t vary with the volume of the
production are known as a fixed cost. Also known as an overhead cost, examples of
fixed costs are salaries, rent, premiums, loans, bills, etc.
2. Variable Cost: This is the cost that varies as the number of manufactured products
fluctuates. The cost of fuel, raw materials, packaging, etc. comes under this.
Applications of Break-Even Analysis

1. Planning in New Businesses: New businesses have a lot to plan before they introduce
a facility and start manufacturing goods for sale. To ensure the plans regarding cost and
pricing of goods are done right, break-even analysis is a necessity. One will be able to
analyse and state if the new business idea is productive or not.
2. Introduction of New Products: For cases in, which a company wishes to introduce the
production of new products in its business unit; the study of break-evens can emerge
very significant. Before they start producing the goods, analysing break-even will help
them understand the cost and pricing strategy.
3. Business Model Modification: Change in a business model may have an impact on
your business's productivity. The change of model doesn’t necessarily mean it will
affect the costs and expenses, but if that’s the case, it will help you change your selling
price accordingly. Hence, analysing break-even in this scenario is both feasible and
important.
Further, while discussing, the terms marginal costing and break-even analysis may appear
frequently. Marginal cost is the extra cost incurred in producing one extra unit of a good. This
can help determine how variable costs can affect the volume of production in a business unit.
Break-even analysis is an essential economic tool that is used to determine the cost structure
of a company or the number of units or services that need to be sold to cover the expenditure
done by it. Break-even is a condition in which the company makes no profit nor suffers any
loss, it just recovers all the money spent on the development of a product.
The break-even analysis is used to examine the relation between the fixed cost, variable cost,
and revenue generated by a company. Usually, a company with a low fixed cost will have a
low break-even point of sale.
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Importance of Break-Even Analysis
1. Determines the Size of Units to be Sold: Break-even analysis helps a company in
determining the number of units that need to be sold to cover the cost. Variable cost and
selling price of an individual product along with the total cost, are required to evaluate
the break-even analysis.
2. Budgeting and Setting Targets: It allows a company to set a budget fix a goal and
work accordingly since the owner knows at which point their company can break even.
It also helps the company in setting an achievable target.
3. Organizing the Margin of Safety: In times of a financial breakdown, when the
company is not performing well, it helps in deciding the minimum number of sales the
company requires to make a profit. With the margin of safety reports, the management
of the company can make its business decisions accordingly.
4. Monitors and Controls Cost: The fixed and variable costs of a product can affect the
profit margins of a company. Therefore, the break-even analysis can help the
management detect if any effects are changing the cost.
5. Helps to Design Pricing Strategy: If the selling price of a product is increased then
the quantity of product to be sold for break-even will be reduced. And like that, if the
selling price is reduced, then a company needs to sell extra to break even. So, it also
helps in designing the pricing strategy of a product.
Components of Break-Even Analysis

1. Fixed Costs: These costs are also known as overhead costs. These costs come into
existence once the financial activity of a business starts. The fixed costs include taxes,
salaries, rents, depreciation costs, labour costs, interests, energy costs, etc.
2. Variable Costs: These costs are called variable costs because they decrease or increase
according to the volume of the production. Variable costs include packaging cost, cost
of raw materials, fuel, and other materials related to production.
Applications of Break-Even Analysis

1. New Business: This guides the company regarding the productivity of a new business
so for a new venture, a break-even analysis is essential. It helps the management in
formulating the pricing strategy and is practical about the cost.
55 | P a g e
2. Manufacture New Products: Before launching a new product, the company needs to
check the break-even analysis before starting its production and see if the product adds
necessary expenditure to the company.
3. Change in Business Model: The break-even analysis helps a company in determining
whether they need to change the selling price of a product if there is any change in any
business model like shifting from retail business to wholesale business.
Break-Even Analysis Formula

Break-even point = Fixed cost/-Price per cost – Variable cost
Example of Break-Even Analysis

Suppose a company is selling a pen. The company first determines the fixed costs (lease,
property tax, and salaries) which sum up to ₹1,00,000. The variable cost determined by the
company for one pen is ₹2 per unit. And, the pen is sold at a price of ₹10.
Therefore, to determine the break-even point of the Company, the pen will be:
Break-even point = Fixed cost/Price per cost – Variable cost
= ₹1,00,000/ (₹12 – ₹2)
= 1,00,000/10
= 10,000
Therefore, with the given variable costs, fixed costs, and selling price of the pen, the company
would need to sell 10,000 units of pens to break even.
56 | P a g e

Financial Accounting and Management - Unit 3 Notes

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INDERPRASTHA ENGINEERING COLLEGE,

Subject Name: Financial Accounting and Management

3.1 FINANCIAL STATEMENTS

Attributes or Characteristics of Ideal Financial Statements

Parties Interested in Financial Statements

Types of Financial Statements

Income Statement or Profit and Loss Account

Statement of Changes in Owners' Equity (or Retained Earnings)

Statement of Changes in Financial Position

Limitations of Financial Statements

1. Lack of precision in data: financial statements tend to give an appearance of finality

3.2 ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS

Process of Analysis and Interpretation

Parties Interested in Financial Analysis and Interpretation

Types of Financial Analysis

Methods, Devices, or Tools of Analysis and Interpretation

3.3 RATIO ANALYSIS

Current Ratio = Current Assets

Liquidity Ratio = Liquid Assets OR

Debt-Equity Ratio = Debt External Equities OR

Proprietary Ratio = Proprietary or Shareholders’ Funds or Shareholders’ Equity

Interest Coverage Ratio = Profit before Interest and Tax = …. Times

Inventory Turnover Ratio = Cost of Goods Sold

Stock Velocity (in months) = Average Inventory X Number of months in a year

Debtor Turnover Ratio = Average Trade Receivable X 100

Average Collection Period = Number of days in a year

Creditors Turnover Ratio = Average Accounts Payable

9. GROSS PROFIT RATIO

Gross Profit Ratio = Gross Profit X 100

10. NET PROFIT RATIO

Net Profit Ratio = Net Profit after Tax x 100

11. OPERATING RATIO

Operating Ratio = Cost of Revenue from Operations + Operating Expenses X 100

12. EXPENSE RATIO

Meaning of Funds Flow

Uses or Objects of Funds Flow Analysis (or F.F. Statement)

Application or Uses of Funds

4) Historical: Preparation of Cash Flow Statement includes rearranging different Financial

CASH AND CASH EQUIVALENTS

Significance or Uses of Cash Flow Analysis

Cash Flow from Operating Activity

Cash Flow from Financing Activity

Difference between Funds Flow Statement and Cash Flow Statement

To understand this further, consider this formula.

(i) Calculate the breakeven quantity

The margin of safety can be calculated by the following formula,

Components of Break-even Analysis

Applications of Break-Even Analysis

Components of Break-Even Analysis

Applications of Break-Even Analysis

Break-Even Analysis Formula

Example of Break-Even Analysis

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