Form 4 Accounting Test - End of month First term 2024

Quick Ratio – Apple (Info is taken from the Balance sheet)
Accounting and Its Significance

Accounting is a systematic way of recognizing, recording, measuring, classifying,
analyzing and communicating financial information with a purpose of revealing Profit or
loss incurred in the given period and position of assets and liabilities of the business.
According to the American Institute of Certified Public Accountants (AICPA)

"The art of recording, classifying, and summarizing, in a significant manner and in terms of
money, transactions and events which are, in part at least, of financial character, and interpreting
the results thereof."
Basically, accounting is the language of finance conveying the information about the financial
position of the company to the user of financial statements and furthermore facilitating the
decision-making process.
Accountancy is the flow or process of communicating financial transactions about a business

entity. Generally, it is a communication in the form of financial statements like Balance sheet,
income statement, cash flow etc. also we can say that it is an information system which
identifies, measures and communicates the economic/business information of an entity to its
users who need the information for decision making. Accounting identifies financial transactions
and business events of a specific entity.
Objectives of Accounting
 To Keep a Systematic Record of Financial Transactions:

The primary objective of accounting is the recording of financial transactions that are made
within the firm. This process of recognizing and recording financial transactions can also be
referred to as bookkeeping.
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 To Determine the Results of the Operation/Production:

Accounting is required in every business to estimate and determine the final outcome of any
operational or production activities.
 To Interpret the Liquidity Position:

There are various ratios used in accounting to calculate the measure of liquidity, such as; current
ratio and quick ratio.
 To Facilitate Business Decision Making:

Accountancy provides your investors and creditors with the structure of analysis to assess the
financial position, solvency and creditworthiness of a business and hence, facilitates the
decision-making process.
 To Comply With the Requirements of Law:

Accounting and bookkeeping are required in every business to keep the necessary records and
documentation required by the law.
Significance of Accounting
Accounting plays a vital role in running a business because it helps you track income and
expenditures, ensure statutory compliance, and provide investors, management, and
government with quantitative financial information which can be used in making business
decisions. The significance of accounting is to record and report on financial information
regarding the performance, financial position, and cash flows of a business.
The Primary Significance of Accounting are as follows:
 It helps in evaluating in performance of the business.

 It helps in monitoring working capital and regulated the Cash flow management.
 It ensures statutory compliance promptly.
 It helps to create a budget and future projections.
 It helps in filing financial statements.
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Financial Accounting
Financial accounting is a specialized branch of accounting that keeps track of a company's

financial transactions. The transactions are recorded, summarized, and presented in a financial
report using standardized guidelines. It deals with the procurement of funds and their effective
utilization in the business. It remains a focal point of all activities and concerned with the raising
of funds, deciding capital structure, utilization of fundraised (capital budgeting, portfolio,
working capital, etc.), making provision for refund when money is not required in the business
(dividend distribution or repayment of the loan, etc.), deciding most profitable investment, etc.
Financial Accounting has common rules known as accounting standards such as Generally
Accepted Accounting Principles (GAAP) and International Financial Reporting
Standards (IFRS).
Some Related Areas of Financial Accounting
 Double Entry and Financial Accounting:

Double-entry bookkeeping is a way of bookkeeping where every financial entry to an account
requires a corresponding entry to a different account. Every financial transaction affects two
accounts in financial accounting.
 Accrual Basis of Accounting and Cash Basis of Accounting:

The Accrual basis of accounting makes a distinction between the actual receipt of cash and the
right to receive cash as regards revenue and actual payment of cash and obligation to pay cash
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as regards expenses. Revenue is recognized when realized, and expenses are recognized when
they become due and payable irrespective of the time of actual cash receipt or cash payment.
Cash basis of accounting is accounting where all receipt of cash and expenses are recognized
when they are received or paid.
 Financial Statements:
Financial statements are the document prepared by every entity, whether profit-making or not.
They are the documents prepared by the entity to evaluate and identify their financial position
of the business.
Financial Statements Consists of:
o Balance Sheet
o Income Statement
o Cash Flow Statement
o Statement of Changes in Equity
o Notes to Accounts
 Financial Reporting
Financial reporting is the communication of financial information to the users of financial
statement and disclosure of performance of the business over the financial year.
Users of Financial Statements:
 Stakeholders
 Management
 Employees
 Suppliers
 Lenders
 Government
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Importance of Financial Accounting
Financial Accounting is the most important for all business enterprises. It plays a vital role in the
accounting of sufficient fund acquisition, utilization and increment of profitability of the
business and maximization of value of the organization and ultimately, the shareholder's wealth.
Importance of Financial Accounting is Further Highlighted in the Points Below:
 Estimating the Requirement of Funds: Both for long term purposes, i.e. investment in
fixed assets and for the short term, i.e. for working capital. Forecasting the requirement
of funds involves the use of techniques of budgetary control and long-range planning.
 The Decision Regarding Capital Structure: Once the requirement of the fund has been
estimated, a decision regarding various sources from which these funds would be raised
has to be taken. A proper balance has to be made between the loan funds and their own
funds. i.e. Debt and Capital
 Investment Decision: The investment of funds in a project has to be made after careful
assessment of various projects through capital budgeting. Assets management policies
are to be laid down regarding various items of current assets, e.g., receivable in
coordination with a sales manager, inventory in coordination with the production
manager, etc.
 Financial Negotiation: Financial accounting plays a significant role in carrying out
negotiations with the financial institutions, banks and public depositors for raising of
funds on favourable terms.
 Cash Management: The finance manager lays down the cash management and cash
disbursement policies to supply adequate funds to all units of organization and to
ensure that there is no excessive cash.
 Fulfilling Tax Obligations: Proper financial accounting and the financial decision can
actually help you in fulfilling tax obligations in a more efficient way and provide you with
tax savings if appropriately managed.
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 Planning For the Future: Financial accounting helps in constant review of the financial
performance of the various units of organization generally in terms of return and
investment. Such review helps the management in seeing how the funds have been
utilized in various divisions and plan accordingly for the future through an analysis of
fund flow, cash flow and ratio analysis.
Management Accounting
Management accounting is the process of accounting for cost which begins with the recording
of income and expenditure or the bases on which they are calculated and ends with the
preparation of periodical statements and reports for ascertaining and controlling costs. The
emergence of management accounting is due to the limitations of financial accounting to meet
the informational needs of the management.
The Institute of Cost and Management Accountants, London, has defined Management
Accounting as: "The application of professional knowledge and skill in the preparation of
accounting information in such a way as to assist management in the formulation of policies and
the planning and control of the operation of the undertakings.
"Similarly, according to the American Accounting Association: "It includes the methods and
concepts necessary for effective planning for choosing among alternative business actions and
for control through the evaluation and interpretation of performances."
Objectives of Management Accounting

Given below are the significant objectives of Management Accounting:
 Ascertainment of Cost: Management accounting provides cost ascertainment and

information to the management promptly, thereby enabling it to take necessary
corrective action on time.
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 Determination of Selling Price: Business enterprises run on profit-making basis. It is,

thus, necessary that revenue should be higher than the expenditure incurred in
producing goods and services from which the revenue is to be derived. Cost and
management accounting provides data regarding the necessary product or services.
 To Determine Price: Management accounting provides information which enables the
management to fix remunerative selling prices for various items of products and services
in different circumstances.
 To Make Decisions: Most of the decisions in a business undertaking involve correct
statements of the likely effects on profits and management accounting is of vital help in
this respect.
 Budgeting: Budgeting is done to ensure that a practicable course of action can be
chalked out and the actual performance corresponds with the estimated or budget
performance. The preparation of the budget is one of the significant objectives of
management accounting.
Management Accounting is beneficial in the following areas:
 Planning
 Decision Making
 Problem Identification
 Curtailment of Loss during the Offseason
 Strategic Management
 Measuring Efficiency
 Cost Control and Cost Reduction
 Pricing
 Budgeting
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Financial Information, Users, and Financial Statements

Financial Information
Financial information is the data and facts related to the financial transactions of the company.
The users of financial information are bound to keep it confidential and secure. Financial
information is diverse and may have various facets, depending on the reviewer and the objective
of the study. Many corporate data summaries provide bits of financial information that
management relies on to make decisions and steer operating activities to financial success. Data
sets incorporating financial information include budgets, pro forma reports, production
worksheets and financial statements.
Uses of Financial Information:
 Provides information about results of operations carried out in the course of business.
 Helps in decision making regarding the use of resources.
 Helps us understand the overall condition of the business.
 Helps us understand the present situation of our financial resources.
 They are used in the selection of an appropriate source of fund and financing.
 They are used in the analysis regarding cost reduction and evaluation of profits.
 Helps in comparison and analysis of business activities using various ratios.
Financial Statements
Financial statements are the financial documents of data and information produced and
presented to the users of financial statement. The general purpose of financial statements is to
provide information about the financial position, financial performance, and cash flows of an
entity that is useful to a wide range of users in making economic decisions.
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To meet that objective, Financial Statements provide information about an entity's:
 Assets and Liabilities

 Owner's Equity
 Income and Expenses, Including Gains and Losses.
 Contributions by and Distributions to Owners. (in their capacity as owners)
 Cash Flow and Fund Flow
Different Financial Statements:
 Balance Sheet: A balance sheet shows the position of assets and liabilities of the
business as on the date. It records the total assets, liabilities, and equity (net worth) of a
business as of a specific day.
 Income Statement: The income statement, also known as the Profit and Loss Account,
shows the net results of operations during the financial year. Business revenue, expenses,
and the resulting profit or loss over a given period of time are detailed in the Income
Statement.
 Cash Flow Statement: Cash Flow statement shows the position of cash flows from
investing, operating and financing activities. Cash is the lifeblood of a small business – if
the business runs out of cash, the chances are good that the business is out of business.
 Statement of Changes in Equity: It shows the changes in equity investment in the
reporting period. Also known as the Statement of Retained Earnings, it details the
movement in owners' equity over a period. Shareholders equity is the amount that
shows how the company has been financed with the help of common shares and
preferred shares.
 Note to Accounts: These are the explanatory notes which explain various adjustments in
the financial statements and basis of preparation of accounts. These are an integral part
of accounts.
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Users of Financial Statements:
o Shareholders and Investors: To know the position of their investment in the business.
o Management: To evaluate the business operations and their own performance.
o Employees: To demand bonus and other prerequisites (benefits) as a matter of claiming
their rights.
o Trade Creditors and Suppliers: To identify the creditworthiness of the business.
o Lenders: To know whether the business can repay the debts.
o Government: To identify the taxable income and impose the tax.
Accounting Standards
Accounting Standard
An Accounting Standard is a common set of principles, standards and procedures that define
the basis of financial accounting policies and practices. Accounting standards seek to describe
the accounting principles, the valuation techniques and the methods of applying the accounting
principles in the preparation and presentation of financial statements so that they give an
accurate and fair view. Accounting standards improve the transparency of financial reporting in
all countries.
Accounting Standards deal with the issues of:
 Recognition of events and transactions in the financial statements.

 Measurement of these transactions and events.
 Presentation of these tractions and events in the financial statements in a manner that is
meaningful and understandable to the reader.
 Disclosure requirements which should be there to enable the public at large and the
stakeholders and the potential investors, in particular, to get an insight into what these
financial statements are trying to reflect and thereby facilitating them to take prudent
and informed business decisions.
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In the United States, the Generally Accepted Accounting Principles form the set of accounting
standards widely accepted for preparing financial statements.
International companies follow the International Financial Reporting Standards, which are set by
the International Accounting Standards Board and serve as the guideline for non-U.S. GAAP
companies are reporting financial statements.
Generally Accepted Accounting Principles – GAAP
The phrase "Generally Accepted Accounting Principles" (or "GAAP") consists of three
valuable sets of rules:
 The basic accounting principles and guidelines.

 The detailed rules and standards issued by the Financial Accounting Standards Board
(FASB) and its predecessor the Accounting Principles Board (APB).
 The generally accepted industry practices.
If a company distributes its financial statements to the public, it is required to follow generally
accepted accounting principles in the preparation of those statements.
International Financial Reporting Standards - IFRS

International Financial Reporting Standards (IFRS) are a set of international accounting standards
stating how particular types of transactions and other events should be reported in financial
statements. IFRS are issued by the International Accounting Standards Board (IASB).
They specify precisely how accountants must maintain and report their accounts. IFRS was
established to have a common accounting language, so business and accounts can be
understood from company to company and country to country.
The setting of Accounting Standards has the following advantages:
 Standards reduce to a reasonable extent or eliminate together confusing variations in

the accounting treatments used to prepare financial statements.
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 There are certain areas where vital information is not statutorily required to be disclosed.
Standards may call for disclosure beyond that required by law.
 Provides reliability and uniformity in accounting.

The setting of accounting standards helps in the prevention of fraud and manipulations in
accounting.
GAAP and IFRS

IFRS VS GAAP
IFRS is considered to be more principle-based than GAAP. Differences exist between IFRS and
other countries' Generally Accepted Accounting Principles (GAAP) that affect the way a financial
ratio is calculated.
Another difference between IFRS and GAAP is the specification of the way inventory is
accounted for. There are two ways to keep track of this, first in first out (FIFO) and last in first out
(LIFO). FIFO means that the most recent inventory is left unsold until older inventory is sold; LIFO
means that the most recent inventory is the first to be sold. IFRS prohibits LIFO, while American
standards and others allow participants to use either freely.
Key Differences
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Convergence
The convergence of accounting standards refers to the goal of establishing a single set of
accounting standards that will be used internationally, and in particular, the effort to reduce the
differences between the US Generally Accepted Accounting Principles (US GAAP), and the
International Financial Reporting Standards (IFRS).
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Basic Accounting Principles

Basic Accounting Principles & Guidelines
To maintain uniformity and consistency in preparing and maintaining books of accounts, specific
rules or principles have been evolved. These rules and principles are classified as concepts,
principles, theory and conventions. The main objective of these basic accounting principles and
guidelines is to maintain uniformity and consistency in accounting records. These concepts
constitute the basis and a fundamental framework of accounting.
Following are the various accounting concepts, principles and guidelines discussed in
various sections:
 Business Entity Concept: This concept assumes that, for accounting purposes, the
business/economic entity and its owners are two separate independent entities.
Therefore, the personal transactions of its owner are separated from the transactions of
the business. For example: when the owner invests money in the business, it is recorded
as liability of the business to the owner.
 Monetary Measurement Concept: This concept assumes that all business transactions
must be measured in terms of money. As per this concept, transactions which can be
expressed in terms of money are recorded in the books of accounts and taken into
accounting. But the transactions which cannot be expressed in monetary value are not
recorded. For example, sincerity, the loyalty of employees are not recorded in the books
of accounts because they cannot be expressed or measured in terms of money.
 Going Concern Concept: This concept states that a business entity will continue to carry
on its business activities for an infinite period. Every business has the continuity of life
and considered that it wouldn't be dissolved or liquidated in the future. On this same
basis, depreciation is charged on a fixed asset. In the absence of this concept, the cost of
a fixed asset will be treated as an expense in the year of its purchase. It is an essential
principle of accounting because it provides the basis of showing the value of assets in
the Balance sheet/Statement of Financial Position.
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 Accounting Period Concept: All the transactions are recorded in the books of accounts
on the assumption that profits on these transactions are to be ascertained for a specified
period. This is known as the accounting period concept or Period concept. Thus, this
concept requires the timely preparation of Balance Sheet and Income statement over a
regular interval of time.
 Historic Cost Concept: This principle states that all assets are recorded in the books of
accounts at their purchase price, which includes the cost of acquisition, transportation
and installation and not at its market price. It helps in calculating depreciation on fixed
assets.
 Matching Concept: The matching concept states that the revenue and the expenses
incurred to earn the revenues must belong to the same accounting period. So, once the
revenue is realized, the next step is to allocate it to the relevant accounting period.
 Revenue Realization Concept: This concept states that revenue from any business
should be included in the accounting records only when it is realized. For example;
Selling goods is the realization of revenue; receiving order is not. Revenue is said to have
been realized when cash has been received o right to receive cash on the sale of goods
or services, or both have been created.
Materiality
This principle talks about the material items and their treatment in accounting. Material items
are those items in financial statements which affect the decision of users of financial statement.
The materiality depends upon the nature and size of the entity's business. For example: For
small entity, purchase of laptop worth $500 may be a material item but for a real estate
company which transacts in millions of dollars, the purchase of laptop may not be a material
item and thus insignificant.
In overall, Characteristics of Accounting Information are:
 Reliability
 Consistency
 Comparability
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Financial Decision Making
Financial decision making should be focused to maximize the wealth of the firm. Financial
decision making has the main objective to manage funds in such a way that it ensures their
optimum utilization and their procurement in a manner that the risk, cost and control are
balanced correctly in a given situation.
Types of Financial Decisions
According to the Inter-American Investment Corporation (IIC), the role of the Financial
Managers in the decision-making process can be divided into four main areas:
 Investment Decisions: The investments of funds, in a project, has to be made after

careful assessment of various projects through capital budgeting. Asset management
policies are to be laid down regarding various sources from which these funds would be
raised has to be taken. In the investments area, the Financial Manager is responsible for
defining the optimal size of the company. In this regard, it is essential to have a market
study in place and be clear on the objectives that the company needs to meet. It is
essential to have correctly studied the demand, technology and equipment, financing
methods and human resources available.
 Financing Decisions: Defining a financing strategy is essential to the continuity of the
business over the long term. Access to financing is closely related to maintaining a
constant inflow of capital since the savings margin will not allow operations to continue
for much longer without the support of additional liquidity. The Financial Manager must
define several aspects of the financing strategy.
 Asset Management: Asset management is one of the main aspects for a company to
meet its obligations adequately and in turn, to position itself to meet the objectives or
growth targets that have been laid out. In other words, the Financial Manager must
stipulate and assure that the existing assets are managed in the most efficient way
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possible. The finance manager lays down the cash management and cash disbursement
policies to supply adequate funds to all units of organization and to ensure that there is
no excessive cash.
 Dividend Policy: One of the most critical financial decisions that a Financial Manager
must make is related to the company's dividend policy. It concerns how much of the
company's earnings will be paid out to shareholders. Specifically, it is necessary to
determine if generated earnings will be reinvested in the company to improve
operations or if they will be distributed among shareholders. The finance manager is
concerned with the decision as to how much to retain and what portion to pay as
dividend depending on the company's policy. The trend of earnings, trend of share
market prices, requirement of funds for future growth, cash flow situation is to be
considered.
The Objective of Financial Decision Making

An entity's financial decision making may often have the following as its objectives:
o The maximization of the entity's Profit
o The maximization of the entity's value/wealth
Wealth Maximization vs. Profit Maximization
The maximization of Profit is often considered as an implied objective of the business. To

achieve these various objective types of financing decisions may be taken. Sometimes, the
decision-makers make even opt for the policies yielding unreasonably high profits in short-run,
which may prove to be unhealthy for the growth, survival and overall interest of the business.
The wealth of an entity is the market price of the entity's stock. It takes into account present and
prospective future earnings per share, the timing and risk of these earnings, the dividend policy
of the business entity and other factors in the decision-making process.
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Therefore, the wealth maximization objective of the entity is superior to its profit
maximization objective due to the following reasons:
o Wealth maximization objective considers all future cash flows, dividends, earning per
share, risk of decision etc. whereas profit maximization objective does not consider it.
o A business entity with wealth maximization objective usually pays a dividend regularly,
whereas the business entity with profit maximization objective may refrain from paying
regular dividends.
Wealth maximization should be the primary objective of the business. However, the profit
maximization can be considered as a part of the wealth maximization strategy.
Income Statement
Meaning
The Income Statement is the statement prepared to show the financial performance of an
entity during a specific accounting period generally of one year. The income statement presents
the financial results of a business for a stated period of time and quantifies the amount of
revenue generated and expenses incurred by an organization during a reporting period, as well
as any resulting net profit or loss.
The income statement focuses on the four key items - revenue, expenses, gains, and losses. It
does not cover receipts (money received by the business) or the cash payments/disbursements
(money paid by the business).
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Common items of an Income Statement

The face of income statement shall include line items presenting the following amounts:
 Revenue (Sales)
o Sales return & allowances
o Cost of goods sold
 Gross Profit
o Operating expenses
 Operating Income
o Other revenues & expenses
 Earnings (before taxes & interest)

o Interest expense
 Earnings Before Taxes

o Provision for income taxes
 Net Profit or Loss for the Period
An entity shall not present any items of income and expense as extraordinary items, either in the
following face of the income statement or in the notes.
Circumstances that would give rise to separate disclosure of items of income and expense
include:
o Write-down of inventories to net realizable value or of property, plant and equipment to
recoverable amount, as well as reversals of such write-downs.

o Restructuring of the activities of any entity and reversals of any provision for the cost of
restructuring.
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 Disposals of Items of Property, Plant and Types of Equipment

o Disposal of Investments
o Discontinued Operations
o Litigation Settlement
o Other Reversals of Provisions
An entity shall present, either on the face of the income statement or in the notes to the income
statement, an analysis of expense using a classification on the face of the income statement.
Example – Apple’s Income Statement
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Understanding an Income Statement

Income Statement
The income statement presents the financial results of a business for a stated period of time.
The statement quantifies the amount of revenue generated and expenses incurred by an
organization during a reporting period, as well as any resulting net profit or loss.
Ways to Understand and Analyze an Income Statement
o Crunching the Numbers
o Consider Accounting Methods
o Keep an Eye on the Cash-Flow
o Look at the Source of Income
o Look at the Expenses
o Peer Comparison
Interpretation of Items of the Income Statement
 Income: Income is increased in economic benefits during the accounting period in the
form of includes of assets or decrease of liability that result in an increase in equity, other
than those relating to contribution from equity participants. The definition of income
encompasses both revenue and gains. Arises in the course of the ordinary activities of
an entity and is referred to by a variety of different names including sales, fees, interest
dividend and rent. Gains represent other items that meet the definition of income and
may or may not arise in the course of the ordinary activities of an entity. Gains represent
increases in economic benefits and as such are no different in nature from revenue.
Gains include, for example, those benefits arising on the disposal of non-current assets.
Definition of income also includes on realized gains example arising on the revaluation
of marketable securities and those resulting from increases in the carrying amount of
long-term assets.
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 Expenses: Expenses are decreases in economic benefits during the accounting period in
the form of outflows or depletions of assets or incurrence of liabilities that results in
decreases in equity, other than those relating to distributions to equity participants. The
definition of expenses encompasses losses as well as those expenses that arise in the
course of the activities if the entity. Expenses that arise in the course of the ordinary
activities of the entity include, for example, cost of sales, wages and depreciation. They
usually take the form of an outflow or depletion of assets such as cash and cash
equivalents, inventory, property, plant and equipment. Losses represent other items that
meet the definition of expenses and may or may not, arise in the course of the ordinary
activities of the entity.
Common Items in an Income Statement
 Heading
 Column Heading
 Revenue (Sales)
o Sales return & allowances
o Cost of goods sold
 Gross Profit
o Operating expenses
 Operating Income
o Other revenues & expenses
 Earnings (before taxes & interest)

o Interest expense
 Earnings Before Taxes

o Provision for income taxes
 Net Profit or Loss
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Understanding Apple’s Income Statement
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Income Statement – Samsung
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Balance Sheet
Balance Sheet
A balance sheet, also known as a "Statement of Financial Position," reveals a company's

assets, liabilities and owners' equity (net worth). If you are a shareholder of a company, it is
important that you understand how the balance sheet is structured, how to analyze it, and how
to read it.
It is the statement prepared to show the financial position of an entity on a specific date
generally as at the last date of the fiscal year. Capital, liabilities and assets are presented in the
statement of financial position.
Balance Sheet Formula:

Assets = Liabilities+ Owner’s Equity
Common Items in a Balance Sheet
The face of the balance sheet shall include the items which present the following items:
Assets
 Property, Plant and Equipment

 Cash and Cash Equivalents
 Accounts Receivables
 Inventory
 Other Current Assets
 Total Current Assets
 Long term Investments
 Fixed Assets
 Intangible Assets
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 Other Non-Current Assets

Total Assets
Equity and Liability
 Accounts and Notes Payable

 Financial Liabilities
 Accrued Liabilities
 Income Tax Payable
 Deferred Tax Liabilities
 Current Portion of Long-Term Deb
 Total Current Liabilities
 Long Term Debt
 Other
Total Liabilities
 Issued Capital and Reserves

 Total Equity
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Total Liabilities and Equity

General Outline of the Balance Sheet:
Balance sheet – Apple
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Understanding a Balance Sheet
A balance sheet, also known as a "statement of financial position," reveals a company's assets,
liabilities and owners' equity (net worth). If you are a shareholder of a company, it is important
that you understand how the balance sheet is structured, how to analyze it, and how to read it.
 Balance Sheet Formula: Assets = Liabilities+ Owner’s Equity
Owners’ Equity: or Shareholders Equity is the amount that shows how the company has been
financed with the help of common shares and preferred shares.
 Equity = Total Assets – Total Liabilities

Or, Equity = Shared Capital + Retained Earnings – Treasury Shares
Ways to Understand and Analyze a Balance Sheet
o Crunching the Numbers.
o Understand Working Capital by Looking at Current Liabilities and Current Assets.
o Look at the Current Ratio.
o Look at the Quick Ratio.
o Compare Debt and Equity.
 Assets: An asset is a resource controlled by the entity as a result of past events and from
which future economic benefits are expected to flow to the entity. The future economic
benefit embodied in an asset is the potential to contribute, directly or indirectly, to the
flow of cash and cash equivalents to the entity. Many assets, for example, Property, plant
and equipment, have a physical form. However, physical form is not essential to the
existence of an asset. Hence, patents and copyrights are also assets if future economic
benefits are expected to flow from them to the entity and if they are controlled by the
entity.
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 Liabilities: A liability is a present obligation of the entity arising from the past events, the
settlement of which is expected to result in an outflow from the entity of resources
embodying economic benefits. For example, the acquisition of goods and the use of
services give rise to trade payables (unless paid in advance or on delivery) and the
receipt of bank loan results in an obligation to repay the loan. An entity may also
recognize future rebates based on annual purchase by customers liabilities; in this case,
the sale of goods in the past is the transaction that gives rise to the liability. The
businesses have different forms of liabilities such as; non-current interest-bearing
liabilities and other long-term liabilities, current liabilities, tax liabilities, provisions etc.
 Equity: Equity is the residual interest in the assets of the entity after deducting all its
liabilities. For example, in a corporate entity, funds contributed by shareholders, retained
earnings, reserves, etc. They may also reflect the fact that parties with ownership
interests in the entity having different rights in relation to the receipt of dividends or the
repayment of capital.
The Balance Sheet of Apple
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Mark as Completed
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Statement of Shareholders Equity
The statement of shareholders' equity is a financial document a company issues as part of its
balance sheet. It highlights the changes in value to stockholders' or shareholders' equity, or
ownership interest in a company, from the beginning of a given accounting period to the end of
that period. Typically, the statement of shareholders' equity measures changes from the
beginning of the year through the end of the year.
Changes in an entity’s equity between two statements of financial position dates reflect the
increase or decrease in its net assets or wealth during the period, under the particular
measurement principles adopted and disclosed in the financial statements. Except for changes
resulting from transactions with shareholders such as capital contributions and dividends, the
overall change in equity represents the total gains and losses generated by the entities activities
during the period.
An entity shall present a statement of changes in equity showing on the face of statement
and those includes:
 Profit or loss for the period.

 Each item of income and expense for the period, which, as required by other standards,
is recognized in equity, and the total of these items.
 Total income and expense for the period, showing the total amounts attributable to
equity holders of the parent and to minority interest and separately.
 The cumulative effect of changes in accounting policies and correction of fundamental
errors dealt with under the benchmark treatments.
 The balance of accumulated profit or loss at the beginning of the period.
 A reconciliation between the carrying amount of each class of equity capital, share
premium and each reserve at the beginning and the end of the period, separately
disclosing each movement.
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In its simplest form, shareholders' equity is determined by calculating the difference between a
company's total assets and total liabilities. The statement of shareholders' equity highlights the
business activities that contribute to whether the value of shareholders' equity goes up or down.
Balance Sheet Formula:

Assets = Liabilities+ Owner’s Equity
Here, Equity = Total Assets – Total Liabilities
Or, Equity = Share Capital + Retained Earnings – Treasury Shares
Ways to Understand and Analyze a Statement of Changes in Equity:
 Crunching the Numbers.

 Understand Working Capital by Looking at Current Liabilities and Current Assets.
 Look at the Current Ratio.
 Look at the Quick Ratio.
 Compare Debt and Equity.
Ratios and Analysis

Classification of Ratios
Meaning
The ratio is the relationship between the two figures. The accounting ratio is the relationship
between two accounting figures. An absolute figure generally conveys no meaning. Hence. The
rations are a useful tool for financial analysis.
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Here, we shall discuss four categories of Accounting Ratios, namely:
 Financial Ratios
 Solvency Ratios/Liquidity Ratios
 Profitability Ratios
 Activity Ratios
Benefits and Limitations

Benefits
o Analysis of Financial Information
o Simplifies Figures
o Determines Trends in the Long Run
o Identifies Weakness – Strength
o Compares Performances
o Assess Efficiency
Limitations
o Based on Historical Data.
o Changes in Real Value of Monetary Unit.
o No Standard Interpretation.
o Ignoring Qualitative Aspects.
o The Difference in Accounting Methods make Comparison Difficult.
o Ambiguity in Terms Used.
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Financial Ratios provides an overview of the health of a business, highlighting the strength and
weaknesses of the organization. Although the analysis does not detail the underlying reasons
behind an organization’s business performance, they assist in benchmarking the performance of
the organization with respect to the competitors in the market. (Atrill, 2012)
The financial ratio refers to the tendency of disproportionate change in earning per share (EPS)
with a change in earnings before Interest and Tax (EBIT). i.e., EPS changes at a higher rate than
the rate of change in EBIT. If EBIT increases, EPS increases at a higher rate. If EBIT decreases, EPS
decreases at a higher rate. This happens if the concern has fixed interest and fixed dividends
bearing funds. Fixed interest-bearing funds refer to debentures/long term loans.
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If the financial leverage ratio is high, it is an indication that the firm is using a cheaper source of
finance. Higher financial leverage ratio indicates a higher risk to the company, and hence, a
company with owner financial ratios won’t have much difficulty as its burden f interest and
preference dividend is low.
Financial Ratios:
o Standardizes financial information for comparison.
o Compares performance with past performances.
o Compares performance against other firms and across the industry.
o Studies the efficiency and risk of business operations.
Cash Flow Statement
The Statement of Cash Flows (also referred to as the cash flow statement) is one of the three
key financial statements that report the cash generated and spent during a specific period
of time (e.g., a month, quarter, or year). The statement of cash flows acts as a bridge between
the income statement and balance sheet by showing how money moved in and out of business.
Details about the cash flows of an entity are significant in providing users of financial statements
with a basis to assess the ability of the entity to generate cash and cash equivalents and the
needs of the entity to utilize those cash flows. The economic decisions that are taken by users
require an evaluation of the ability of an entity to generate cash and cash equivalents and the
timing and certainty of their generation.
Use of Cash Flow Information:
A statement of cash flow provides the information required to evaluate the changes in net
assets of an entity, its financial structure and its ability to affect the amounts and timing of cash
flows in order to adapt to changing circumstances and opportunities. Cash flow information is
essential in assessing the ability of the business to generate cash and cash equivalents and
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allows the users of financial statements to develop models to assess and compare the present
value of the future cash flows of different entities.
 Cash Flow Activities:

There are three types of cash flow activities which are listed below. We will be discussing
these activities and understanding the concept of cash flow statement further, in the next unit.
o Cash inflow and outflow through Operating activities
o Cash inflow and outflow through Financing activities
o Cash inflow and outflow through Investing activities
Common Components of a Cash-Flow Statement
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Cash-Flow Statement – Apple
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Current Ratios
Solvency Ratios
The term solvency refers to the ability to meet liabilities. Solvency ratios may be studied
in 2 parts:
 Short Term Solvency Ratio

 Long Term Solvency Ratio
Short Term Solvency Ratios
Short term solvency refers to the ability to meet current liabilities, in-time out of current assets.
Hence, short term solvency ratios are based on current assets and current liabilities. Two
important ratios are calculated to study short term solvency firm:
o Current Ratio
o Quick Ratio
 Current Ratio:
The current ratio is also known as working capital ratio, net current assets ratio, current assets
ratio. Current ratio includes cash, bank, marketable securities, debtors, stock, bills receivable,
short term loans and advances and prepaid expenses. Current liabilities include creditors, bills
payable, outstanding expenses, income received in advance, bank overdraft and provisions.
Current is a liquidity ratio that measures a company's ability to pay short-term

obligations.
 The ratio is mainly used to give an idea of the company's ability to pay back its short-
term liabilities with its short-term assets.
 The higher the current ratio, the more capable the company is of paying its obligations.
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 A ratio under 1 suggests that the company would be unable to pay off its obligations if
they came due at that point.
Current Ratio = Current Assets/Current Liabilities
The ideal Current Ratio preferred by Banks is 1.33: 1
Ideal level – 2: 1 (Industry Benchmark)
Current Ratio – Apple (Info is taken from the Balance sheet)
For 2018: For 2017:

Current Ratio = 1.27 Current Ratio = 1.12
Quick Ratio
Quick Ratio
The quick ratio, also known as the acid-test ratio, is a liquidity ratio that further refines the
current ratio by measuring the level of the most liquid current assets available to cover current
liabilities.
While calculating the current ratio, we overlook the composition of current assets. A firm with a
high proportion of current assets in the form of cash and receivable is more liquid than one with
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a higher proportion of current assets in the form of inventories even though both the firms have
the same current ratio. This impairs the usefulness of the current ratio. Hence, we need some
other ratios which may overcome this defect. This, another ratio is the quick ratio.
The quick ratio is more conservative than the current ratio because it excludes inventory and
other current assets, which generally are more difficult to turn into cash. A higher quick ratio
means a more liquid current position.
Interpretation and Significance
 A low and quick decreasing ratio might be telling us that the company’s balance sheet is
over-leveraged. Or it could be saying the company’s sales are decreasing, the company is
having a hard time collecting its account receivables or perhaps the company is paying
its bills too quickly.
 A company with a high and increasing quick ratio is likely experiencing revenue growth,
collecting its accounts receivable and turning them into cash quickly and likely turning
over its inventories quickly.
 A common rule of thumb is that companies with a Quick ratio of greater than 1.0 are
sufficiently able to meet their short-term liabilities.
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For 2018: For 2017:

Quick Ratio = 1.087 Quick Ratio = 1.238
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Asset Turnover Ratio
Efficiency ratios are also known as Activity ratios and evaluates performance of the company on
the basis of utilization of its assets and other resources.
The asset turnover ratio measures the efficiency with assets are utilized; a low rate reflects an
inefficient use of such assets; therefore, higher is better. Asset Turnover works as an indicator of
the effectiveness of a company is using its assets to generate earnings, so it measures how many
dollars were generated in the sales for each dollar invested in assets (Kimmel et al., 2009).
Asset Turnover = Sales or Revenues / Total Assets

Or,
Total Assets Turnover Ratio = Cost of Goods Sold/ Average total assets
Fixed Assets Turnover Ratio = Cost of Goods Sold / Average fixed assets
Importance
It is meant to assess how well a company utilized its assets to generate sales. Higher turnover
indicates the effective utilization of funds. This ratio measures how efficiently a firm uses its
assets to generate sales, so a higher ratio is always more favorable. Higher turnover ratios mean
the company is using its assets more efficiently. Lower ratios mean that the company isn’t using
its assets efficiently and most likely have management or production problems.
For instance, a ratio of 1 means that the net sales of a company equal the average total assets
for the year. In other words, the company is generating 1 dollar of sales for every dollar invested
in assets. Like with most ratios, the asset turnover ratio is based on industry standards. Some
industries use assets more efficiently than others. To get a true sense of how well a company’s
assets are being used, it must be compared to other companies in its industry.
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Asset Turnover Ratio– Apple
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For 2018:
Asset Turnover Ratio = Net Sales ÷ Average total assets
Asset Turnover Ratio = 265595 ÷ 370522
Asset Turnover Ratio = 0.72
Profitability Ratios
Profitability ratios are the financial ration used to measure and evaluate the company’s ability to
generate profit. Profitability ratios include the following:
o Return on Equity (ROE)
o Return on Capital Employed (ROCE)
o Return on Assets (ROA)
o Gross Profit Ratio
o Net Profit Ratio
o Operating Profit Margin Ratio
 Return on Equity:
It is obtained by dividing ‘profit after interest and tax before dividend’ by ‘Equity’. This ratio
measures the profitability of the concern from the point of view of owners. Higher the ratio,
better is the position because the higher ratio will result in more possibility of solvency in the
long run.
 Return on Capital Employed:
It is obtained by dividing ‘profit before interest and tax’ by ‘capital employed’. Capital employed
means equity plus long-term debt. The ratio provides a test of probability in relation to long
term funds. It provides insight into how efficiently the long run funds are used. Higher the ratio,
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better it is. A higher ratio indicates a more efficient use of capital employed, which helps the firm
in being solvent in the long run.
 Return on Assets (ROA):
Return on Assets, commonly known as ROA, is a measurement of management performance.

ROA tells the investor how well a company uses its assets to generate income. A higher ROA
denote a higher level of management performance.
ROA = Net profit After Taxes / Average Total Assets

Or,
ROA = Net profit After Taxes / Average Fixed Assets
Or,
ROA = Net Profit After Taxes / Average Tangible Assets
A rising ROA may initially appear good but turn out to be unimpressive if other companies in its
industry have been posing higher returns and greater improvements in ROA. The ROA ratio may
thus be more useful when compared to the risk-free rate of return. Technically, a company
should produce a ROA higher than the risk-free rate of return to be rewarded for the additional
risks involved in operating the business. If the company’s ROA is equal or even less than the
risk-free rate, investors would be better off just purchasing a bond with a guaranteed yield.
 Gross Profit Margin Ratio:
Gross Profit Margin is a profitability ratio that measures how much of every dollar of revenues.
It is calculated by subtracting the cost of goods sold (COGS from total revenue and dividing that
number by total revenue.
Gross Profit Margin Ratio= (Revenue-Cost of Goods sold)/ Revenue

Example,
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Suppose a company ABC makes shoes. If ABC reported $5.0 million in total revenue for
the year and cost of goods sold (cost of materials and direct labour) of $2.0 million, then we can
use the formula above to find ABC's gross profit margin:
Gross Profit Margin = ($5,000,000 - $2,000,000) / $5,000,000 = 60%
The gross profit margin percentage tells us that Company ABC has 60% of its revenues left over
after it pays the direct costs associated with making its shoes (its cost of goods sold (COGS).
This gross profit, which equates to $3.0 million in the above example ($5.0 million in revenues
minus $2.0 million in COGS), represents money left over that Company ABC can use for
operating expenses, interest, taxes, dividend payouts, etc.
 Operating Profit Margin Ratio:
Operating profit means profit before interest and tax, i.e., this profit is before non-operating
items like income from non-trade investments, profit /loss on the sale of fixed assets, etc. This
profit is also referred to as EBIT (earnings before interest and tax). Operating margin is a
measurement of the proportion of a company's revenue that is left over after paying for variable
costs of production such as wages, raw materials, etc.; basically, all the operating expenses.
Operating profit margin ratio indicates the relationship between the operating profit and sales.
It also represents the overall earnings of the company. One can get a clear idea of the efficiency
of a company from its operating profit ratio.
A healthy operating margin is required for a company to be able to pay for its fixed costs, such
as interest on the debt. For example, investments in a subsidiary company, investments in such
company from which we get raw materials, investment in the company of which we have
dealership or agency, investments for replacement of fixed assets, investments for repayment of
debentures, etc. In the entire case, a higher ratio is considered better.
Operating Profit Margin Ratio= (Operating Profit / Net Sales) x 100
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Higher operating profit margin indicates operational efficiency & measures overall profitability.
Industry-standard is 18-20%.
 Net Profit Margin Ratio:
Net Profit Margin Ratio is the percentage of revenue left after all expenses have been deducted
from sales. The measurement reveals the amount of profit that a business can extract from its
total sales. The net sales part of the equation is gross sales minus all sales deductions, such
as sales allowances.
Net Profit Margin Ratio = (Net profits ÷ Net sales) x 100

Profitability Ratios for Apple
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 Gross Profit Margin (2018)

×100 = 38%
 Operating Profit Margin (2018)

×100 = 26.69%
 Net Profit Margin (2018)

×100 = 22.41%
Return on Capital Employed (ROCE)
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Return on Capital Employed
The return on capital employed (ROCE) ratio is most important of all. It measures how efficiently
and effectively management has deployed the resources available to it, irrespective of how
those resources have been financed.” (Pyke, 2007)
It is the percentage of return on funds invested in the business by its owners. In short, this ratio
tells the owner whether or not all the effort put into the business has been worthwhile. It is
obtained by dividing “profit before interest and tax” by “capital employed”. Capital employed
means equity plus long-term debt. The ratio one of the profitability ratios, which provides a test
of profitability in relation to long term funds. It provides insight into how efficiently the long run
funds are used. Higher the ratio, the better. A higher ratio indicates a more efficient use of
capital employed, which helps the firm in being solvent in the long run.
ROCE = (Net Profit Before Interest & Tax / Capital Employed) x 100
Intangible assets should be included in capital employed. But no fictitious asset should be
included within capital employed. This calculation helps us understand how well a company is
generating returns relative to what has been invested in the business. ROCE provides us with
insight as to how a company’s use of leverage impacts their profits.
Components of ROCE:
Profit Before Interest and Tax (Operating income):
 Profit before the deduction of interest and tax expenses is frequently referred to as
“operating income.”
 Here, “interest” means “interest” on long term loans.
 If the company pays “interest expenses” on long-term borrowings, that is deducted to
arrive at “operating income.”
Capital Employed:
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Either of the Following:
 Total of fixed and current assets.

 Total of fixed assets only.
 Fixed assets plus working capital.
 Total of long-term funds. Long term funds include capital, Reserve and surplus etc.
ROCE for Apple
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ROCE (2018)
×100 = 1.30
Capital employed taken is fixed assets plus working capital.
Gearing Ratio
The gearing ratio measures the proportion of a company's borrowed funds to its equity. The
ratio indicates the financial risk to which a business is subjected since excessive debt can lead to
financial difficulties. A high gearing ratio represents a high proportion of debt to equity, and a
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low gearing ratio represents a low proportion of debt to equity. This ratio is similar to the debt
to equity ratio, except that there are a number of variations on the gearing ratio formula that
can yield slightly different results.
Gearing Ratio (%) = (Interest Bearing Debt) / (Share Capital + Retained Earnings +
Interest Bearing Debt)
Or,
Gearing Ratio = Total Liabilities/Shareholders Equity
Or,
Gearing Ratio =Long term debt + short term debt + Bank overdraft / Shareholders Equity
 Interpretation and Significance:
The higher the ratio, the more the business is exposed to interest rate fluctuations and to having
to pay back interest and loans before being able to re-invest earnings. Increased gearing ratios
are risky, and when a company is unable to repay its debt, it can lead to bankruptcy. At the same
time, a very low gearing ratio when compared to other similar companies in the same industry is
also not ideal since the cost of debt is lower than the cost of equity.
Companies should find a balance that is in line with the needs of the company, the ability to
raise debt or capital (creditworthiness), the needs and desires of its shareholders and also in line
with the industry and market standards.
Lenders have priority over equity investors on an enterprise’s assets. Lenders want to see that
there is some cushion to draw upon in case of financial difficulty. The more equity there is, the
more likely a lender will be repaid. Most lenders impose limits on the debt/equity ratio,
commonly 2:1 for small business loans. Too much debt can put your business at risk, but too
little debt may limit your potential. Owners want to get some leverage on their investment to
boost profits. This has to be balanced with the ability to service debt.
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Gearing Ratio for Apple
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Gearing for Apple
USD in millions Calculation 2018 2017
Term Debt – Short 8784 6496

Term
Term Debt – Long
93,735 97,207
term
Total Interest-
D 102,519 103,703
Bearing Debt
Total Shareholders’
E 107,147 134,047
Equity
Gearing ratio (a
D/E 0.96 0.77
common definition)
Gearing ratio D/(D+E) 0.49 0.44
 Debt Equity Ratio
The relationship between borrowed funds and owner’s capital is a popular measure of the long-
term financial solvency of a firm. This relationship is shown by the Debt equity ratio. This ratio
reflects the relative claims of creditors and shareholders against the assets of the firm.
Alternatively, this ratio indicates the relative proportions of debt and equity in financing the
assets of the firm.
Debt Equity Ratio = Total Debt/Shareholder’s Fund
The debt-equity ratio is an important tool of financial analysis to appraise the financial structure
of the firm. It has important implications from the viewpoint of the creditors, owners and the
firm itself. The ratio reflects the relative contribution of creditors and owners of the business in
its financing. A high ratio shows a large share of financing by the creditors of the firm.
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Interest Coverage Ratio
Interest coverage ratio gives a picture of the company’s ability to pay the interest charges on
their debt. It is sometimes known as income gearing. It is obtained by dividing earnings before
interest and taxes (EBIT) by the interest expense for the measurement period.
Interest Coverage Ratio = Earnings Before Interest and Taxes/ Interest Expense
It measures the firm’s interest burden as compared to its profits. If the interest is a small
proportion of profit earned by the firm, they will bear interest burden easily, and hence there is
every possibility that the firm would be solvent in the long run if interest is a large proportion of
profit, the possibility of a firm’s being solvent in future reduced: higher the interest coverage
ratio, the better. Anything in excess of four is usually considered to be safe. (ACCA Global, 2016)
Analysis
Analyzing a coverage ratio can be tricky because it depends largely on how much risky the
creditor or investor is willing to take. Depending on the desired risk limits, a bank might be more
comfortable with a number than another.
 If the computation is less than 1, it means the company isn’t making enough
money to pay its interest payments. A company with a calculation less than 1 can’t even
pay the interest on its debt. This type of company is beyond risky and probably would
never get bank financing.
 If the coverage equation equals 1, it means the company makes just enough
money to pay its interest; the company still can’t afford to make the principal payments.
It can only cover the interest on the current debt when it comes due.
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 If the coverage measurement is above 1, it means that the company is making more
than enough money to pay its interest obligations with some extra earnings left over to
make the principal payments
Interest Coverage Ratio – Apple
(In Millions)
 Interest paid in 2017 is $2320

 Interest paid in 2018 is $3240
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Interest Coverage Ratio (2018)

72,903 ÷ 3240 = 22.50
Interest Coverage Ratio (2017)
64089 ÷ 2320 = 27.62
Why Procure Funds?
Finance is the lifeblood of any business enterprise. It is very important to procure funds to
manage finances in the business because it provides access to all kinds of resource to carry
out manufacturing and merchandising activities.
Procuring of funds implies necessarily securing/getting/purchasing of goods and administrations

principally for business purposes. The process incorporates the planning and preparing of interest
just as the end receipt and endorsement of instalment. It frequently includes buying arranging,
norms and particulars assurance, provider exploration and choice, financing, value arrangement,
and stock control.
It is rightly said that a business needs money/funds to make money. But that can be only possible
if the procured funds are properly managed. Therefore, financing decision is very important to
keep the business running without bearing the probable loss.
Why do Business Need Finance?
 To start a business.
 To increase production capacity.
 To develop new products.
 To enter new markets.
 To move to new premises.
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Choosing the Right Source of Finance!
Financing decisions relate to acquiring optimum finance to meet financial objectives and
ensuring the effective management of fixed and working capital. The financial manager needs to
possess the good knowledge of the sources of available funds and their respective costs, and need
to ensure that the company has a sound capital structure. Such managers also need to have a clear
understanding about the profits and cash flows, bearing in mind that profit is of little avail unless
the organization is adequately supported by cash to pay for assets and sustain the working capital
cycle. Financing decisions also call for a good knowledge of evaluation of risk. The right source
of finance should be selected carefully to manage all these factors.
The decision of choosing the right source of finance depends on many factors, including:
 Amount
 Time
 Feasibility
 Risk
 Length
Classification of Sources of Finance
Sources of finance/funds can be classified in a number of ways depending upon the

characteristics of these sources.
Usually, the classification is done on the basis of the following three criteria:
 On the basis of period/Time

 On the basis of ownership
 On the basis of source
Financial Need of a Business Can be Divided into:
 Long-term Financial needs relate to a period exceeding 5 to 10 years. All fixed

investments in plant, machinery, land, buildings, etc. are considered as long term
financial needs.
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 Medium-term Financial needs relate to a period exceeding one year but not
exceeding five years. Sometimes long-term requirements for which long term
funds cannot be arranged immediately may be financed from medium-term
sources. When long term funds are available, medium-term loans may be paid
off.
 Short-term Financial needs related to investment in current assets such as stock,
debtors, prepaid advances, cash and bank, etc. Such investment is called working
capital and period does not exceed the accounting period, one year on the basis
of ownership.
 Owned Share Capital
o Equity Share Capital: It is a permanent source of finance. The issue of
new shares increases the flexibility of the company. The company can
make a further issue of share capital by making the right issue. There is no
mandatory payment to equity shareholders. This is less risky for the
company, but the expectation of shareholders is high for return.
o Preference Share Capital: Preference share capital holders enjoy both as
regards to the payment of a fixed amount of dividend and repayment of
capital on winding up of the company. Preference share capital can be
redeemed after a specific period.
 Retained Earnings:
Retained earnings can be characterized as the benefit left in the wake of delivering a
profit to the investors or drawings by the capital proprietors. Retained earnings are the
benefit retained within the business as opposed to being paid out to investors as a
profit. Retained earnings are broadly viewed as the most significant long term source of
finance for a business.
Classification:
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Classification on the Basis of Generation
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External Sources of Finance – Short and Medium-Term
External sources of finance are those financing opportunities that come from outside of
an organization.
External Sources of Finance:
o Leasing
o Factoring
o Bank Overdraft
o Short Term Bank Loans
 Leasing: Leasing is a contract between the leasing company, the lessor, and the
customer (the lessee). The leasing company buys and owns the asset that the
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lessee requires. The customer hires the asset from the leasing company and pays
rental over a pre-determined period for the use of the asset. Leasing can be:
o Finance Lease
o Operating Lease
 Factoring: Factoring is a financial transaction whereby a business sells its
accounts receivable (i.e., invoices) to a third party (called a factor) at a discount
in exchange for immediate money. It is a course of action whereby the business
sells its account receivables/indebted individuals at a markdown. In this course of
action, the purchaser, who is known as the factor, gathers the cash from the
indebted individuals in the interest of the business and charges a premium for
this administration. In the event that the account holder doesn't pay under any
circumstances, the factor can return to the business for the instalment.
 Bank Overdraft: Bank overdraft is a basic method of momentary financing.
Organizations need cash for their everyday necessity which emerges because of a
delay between their assortments and instalments. To satisfy such prerequisites,
bank overdraft is a perfect external source of finance. This is where the business is
allowed to be overdrawn on its account. This means they can still write cheques,
even if they do not have enough money in the account.
 Trade Credit: Trade credit is only the credit given to a business by their
banks/providers. It permits a business to defer its instalments for some period.
The time of credit relies upon the credit terms between the business and the
providers.
External Sources of Finance – Long Term
External sources of finance are those financing opportunities that come from outside of
an organization. It is difficult to raise this capital as it requires a ton of lawful customs to
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be consented to or more every one of, the speculators ought to have confidence in the
organization.
External Sources of Finance:
 Equity Shares (Equity)

o Ordinary Shares
o Preference Shares
 Debt
o Debentures
o Bonds
o Bank Loans/Mortgage
o Merchant/Investment Banks
o Government Grants
 Equity Shares: Equity shares are a major external source of finance for huge
organizations. Not all organizations can utilize this source as it is represented by
a great deal of enactment. A key component of equity share is the 'sharing of
possession rights', and consequently, the current investors' privileges are
weakened somewhat.
Equity Finance Can be Raised in Many Forms Including:
o Public Offering
o Private Agreements
o Warrants
 Debt Financing: Major sources of Debt financing are:

o Debentures
o Bonds
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o Bank Loans and Mortgages

o Investment Banks/Grants
 Debentures and Bonds:
Debentures are other basic methods for account utilized by organizations who favour
obligation over the value. A debenture is viewed as the less expensive method of
financing than equity. The cost of capital raised through debentures or bonds is quite
low since the interest payable on debentures can be charged as an expense before tax.
Advantages of Raising Finance by the Issue of Debentures are:
 The cost of debenture is much lower than the cost of preference or equity capital
as the interest is tax-deductible. Also, investors consider debenture investment
safer than equity and hence, may require a lower return on debenture
investment.
 Debenture financing doesn’t result in dilution of control.
There are various kinds of bonds used for long-term financing such as:
o Deep Discount Bonds

o Double Option Bonds
o Inflation Bonds
o Floating-Rate Bonds etc.
 Term Loans:
The features of a term loan are fundamentally the same as debentures aside from that it
does exclude a lot of cost of giving since it is given by some bank or budgetary
organizations. The normal open isn't engaged with it. A thorough investigation of the
66 | P a g e
organization's financials and likely arrangements is finished by the bank to pass

judgment on the obligation adjusting limit of the organization. These advances are
additionally made sure about by certain advantages.
 Trade Credit:
It is the credit granted by suppliers of goods and services as an incident of sale. The
usual duration of such credit is 15 to 90 days.
Debt or Equity – A Critical Decision!
Equity and debt are two important sources of corporate finance. Generally, firms use
both sources of finance, but different firms have different proportions of debt and
equity. Picking the best source by limiting the hazard and augmenting the ROI is
exceptionally critical for an organization. Organizations can use an assortment of
sources, significantly broken into two classes, debt and equity.
Capital Structure = Debt + Equity
Should organizations go for Debt Financing or Equity Financing?
Let’s first have a look over some differences between the two.
We can differentiate between debt and equity financing on the following grounds:
 Meaning
 Involvement
 Cost of Capital
 Voting Rights
 Dividends
 Profit-Sharing
 Payment Time
Equity Financing
Pros of Equity Financing
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o The business is not obligated to reimburse the cash obtained through equity
financing. Equity shareholders get great returns as profits and offer worth, but
you don’t have to pay the interest as in the case of debt financing.
o Equity doesn't take the funds of business outside the company. Actually, it
reinvests the profits created out of venture to build the estimation of the offer
(for example Gaining per offer or EPS). Higher the EPS of an organization, the
better is its productivity.
Cons of Equity Financing
 Equity is generally more costly than debt and requires more legal formalities and
documentation.
 Dilution of control.
Debt Financing
Pros of Debt Financing
o Interest of debt is a deductible expense while calculating tax payable. Therefore,

you can get tax savings.
o Raising finance from debt is less costly than in the case of equity financing. It also
excludes a lot of documentation work and lawful charges.
Cons of Debt Financing
 Debt is typically raised against collateral security, which implies the lender has the
option to guarantee the borrower's advantages in case of default on
reimbursement.
 You are required to pay a fixed charge or interest rate, which is usually high.
At last, the financing choice among debt and equity relies upon the idea of business you
have and whether the focal points exceed the dangers. Doing some exploration on the
standards in your industry and keep a track on contenders makes a difference.
Numerous organizations utilize a mix of the two kinds of financing on the grounds that
the two sources are not generally free but rather frequently identified with one another.
It relies upon the quantum of the sum to compute the extent of debt and equity.
Capital Budgeting
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Capital budgeting is the process of planning expenditure on assets whose cash flows are
expected to extend beyond one year. Under capital budgeting, we make the evaluation
of long-term projects, i.e., financial analysis of a long period proposal. Normally the cash
outflows in project/equipment, the plant is at the beginning of the project. The project
provides cash inflows over its life. The amount invested in the project has some cost of
capital. Hence, the inflows arising at different point of time is converted into its present
value, and the present value of future inflows is compared with present value outflows
and decision is taken.
According to Pfeiffer and Schneider (2010), "Capital Budgeting serves to plan,

coordinate and motivate activities throughout an organization. The budgeting
process defines a set of rules to govern the way in which managers at different
levels of the hierarchy produce and share information on investment projects.’’
 Investment Involve Risk

 Investment Decisions are Irreversible
 Long term Decision
A number of factors combine to make capital budgeting perhaps the most important
financial managers and their staffs must perform. First, since the results of capital
budgeting decisions continue for many years, the film loses some of its flexibility—for
example, the purchase of an asset with an economic life of 10 years. Further, because
asset expansion is based on expected future sales, a decision to buy an asset that is
expected to last 0 years requires a 10-year sales forecast. Finally, a firm’s capital
budgeting decision defines its strategic direction because it moves into a new product,
services, or markets must be preceded by capital expenditures.
Capital Budgeting/ Investment Appraisal Process
The Following Steps Summarize the Various Steps During the Capital Budgeting
Process:
 Project Identification and Generation

 Project Screening and Evaluation
 Project Selection
 Implementation
 Performance Review
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Capital Budgeting Techniques
There are a number of techniques available for capital budgeting and can be classified
as presented below:
Payback Period
The payback period is the length of time required for an investment’s net revenues to
cover its cost. It is the time required to earn back the amount invested in an asset from
its net cash flows. It is a simple way to evaluate the risk associated with a proposed
project. An investment with a shorter payback period is considered to be better since
the investor's initial outlay is at risk for a shorter period of time.
The payback period, defined as the expected number of years required to recover the
original investment, was the first formal method used to evaluate capital budgeting
projects.
Payback Period = Year Before Full Recovery + (Unrecovered Cost at the Start of
the Year)/ Cash Flow During the Year
Payback Period
 Relatively straightforward
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 Measures cumulative cash inflows against cumulative cash outflows

 Easy to use and understand, conservative
 Doesn’t take account of cash flows after payback or time value of money
Payback Period – Example
Accounting Rate of Return
The accounting rate of return of investment measures the average annual net income of
the project (incremental income) as a percentage of investment. It is the average net
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income an asset is expected to generate divided by its average capital cost, expressed as
an annual percentage. The ARR is a formula used to make capital budgeting decisions.
These typically include situations where companies are deciding on whether or not to
proceed with a specific investment (a project, an acquisition, etc.) based on the future
net earnings expected compared to the capital cost.
Accounting Rate of Return (ARR) = Average Annual Profit / Capital Investment
Or,
ARR= Average Income/Average Investment
The numerator is the average annual net income generated by the project over its useful
life. The denominator can be either the initial investment or the average investment over
the useful life of the project.
Advantages
 This technique uses readily available data that is routinely generated for financial
reports and does not require any special procedures o generate data.
 This method also evaluates performance on the operating results of an
investment and management performance.
 It considers all net incomes over the entire life of the project and provides a
measure of the investment’s profitability.
 It solves the definitional problems of profit and capital investment.
 It is easy to understand and use.
Limitations
The accounting rate of return technique, like the payback period technique, ignores the
time value of money and considers the value o all-cash flows to be equal.
Rather than cash flows, this technique uses net income. While net income is a useful
measure of profitability, the net cash flow is a better measure of an investment’s
performance.
Inclusion of only the book value of the invested asset ignores the fact that a project can
require commitments of working capital and other outlays that are not included in the
book value of the project.
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Accounting Rate of Return – Example
Time Value of Money
It is the basic concept of finance that, a dollar today is worth more than a dollar
tomorrow. The dollar today can be invested to state earning interest immediately. This
concept is referred to as the time value of money. Time Value of Money is the
compensation provided for investing money for a given period.
For example, you are offered a choice of $1000 today or $1000 two years from now.
Which one will you choose?
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Obviously, you will choose to receive money today. After all, if you receive money today,
you can invest the money and in two years could have much more than the original
Future Value and the Present Value of Money
The value today of future cash flow or series of cash flows is called the present value of
money. If we reverse the flow by saying that we expect a fixed amount after ‘n’ number
of years, and we also know the current prevailing interest rate, then by discounting the
future amount, at the given interest rate, we will get the present value of the investment
to be made.
The present value of a sum of m, only to be received at a future date is determined by

discounting the future value at the interest rate that the money could earn over the
period. This process is called discounting.
You are approached by your Best Friend who asks you to lend her £.1000. She promises
that should return £ 1200 in 2 years period. So your money lender is in a two-year
friendship bond and earns 6%. Now throw the friendship out of the window for a
moment to pause and think!... would you lend her money at all.
Considering Future Value:
Year
0 1000
 +60 1060
 +63.6 60
Considering Present Value using discount rate (1/1+r):
Year
0 1200
 94 1132.08
 89 1068
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Profitability Index
The profitability index (PI), also referred to as value investment ratio (VIR), or profit
investment ratio (PIR), describes an index that represents the relationship between the
costs and benefits of a proposed project.
Profitability Index = PV of Future Cash Flows/ Initial Investment
This method is also known as Benefit-cost ratio (B/C ratio) because the numerator
measures benefits and the denominator measures cost.
Profitability Index – Interpretation
In a sense, the profitability index can be seen as an extension to NPV. So, normally, it
shall consider the figures arrived from NPV to produce a simple Index which can be
used for evaluating profits. Some financial analyst and management accountants regard
this method of interpreting NPV.
It is similar to the NPV approach. The profitability index approach measures the present
value of returns per dollar invested, while NPV is base on the difference between the PV
of future cash inflows and PV of cash outlays. A major shortcoming of the NPV method
is that being an absolute measure, it is not a reliable method to evaluate projects
requiring different initial investments. The PI method provides a solution to this kind of
problem.
Accept or Reject Criteria
Using the profitability index, a project will qualify for acceptance if its PI exceeds one.
When PI equals, the firm is indifferent to the project, when PI is greater than, equal to or
less than, the NPV is greater than, equal or less than zero respectively.
Rule 1 – If cash flows are higher than initial investment resulting in Index value > 1,
Project is accepted.
Rule 2 – If cash flows are lesser than initial investment resulting in Index value < 1,
Project is rejected.
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All three projects are carrying positive NPV, however Project C has the highest value
among all and thus must be considered if funds are limited.
Let’s Consider the NPV Calculations to Arrive at the Profitability Index
Internal Rate of Return
Internal Rate of return is a method of ranking investment proposals using the rate of
return on an investment, calculated by finding the discount rate that equates the
present value of future cash inflows to the project’s cost. It is the discount rate that
makes the net present value (NPV) of a project zero. In other words, it is the expected
compound annual rate of return that will be earned on a project or investment.
When calculating IRR, expected cash flows for a project or investment are given, and the
NPV equals zero. Put another way, the initial cash investment for the beginning period
will be equal to the present value of the future cash flows of that investment.
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Internal Rate of Return – Formula
Interpretation
It is the available rate of return from the project. The fund is invested in the project its
cost is paid to the provider of funds. For this purpose, the cash inflows are discounted at
required rate of return (i.e. cost of capital) as the discount rate. It is the cost at which the
fund is raised and invested in various projects. So, by definition, it can be compared to
the rate of discount required to give an NPV of 0(zero). The IRR for the various projects
differs.
Another way of looking at this scenario is the maximum rate of interest that a company
can afford to service without suffering a loss on the project. IRR is compared with the
required return (cost of capital), and a decision is taken.
77 | P a g e
Example
78 | P a g e

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Quick Ratio – Apple (Info is taken from the Balance sheet)

Accounting and Its Significance

According to the American Institute of Certified Public Accountants (AICPA)

Accountancy is the flow or process of communicating financial transactions about a business

 To Keep a Systematic Record of Financial Transactions:

 To Determine the Results of the Operation/Production:

 To Interpret the Liquidity Position:

 To Facilitate Business Decision Making:

 To Comply With the Requirements of Law:

The Primary Significance of Accounting are as follows:

 It helps in evaluating in performance of the business.

Financial accounting is a specialized branch of accounting that keeps track of a company's

Some Related Areas of Financial Accounting

 Double Entry and Financial Accounting:

 Accrual Basis of Accounting and Cash Basis of Accounting:

Financial Statements Consists of:

o Cash Flow Statement

o Statement of Changes in Equity

Users of Financial Statements:

Importance of Financial Accounting

Importance of Financial Accounting is Further Highlighted in the Points Below:

Objectives of Management Accounting

 Ascertainment of Cost: Management accounting provides cost ascertainment and

 Determination of Selling Price: Business enterprises run on profit-making basis. It is,

Management Accounting is beneficial in the following areas:

Financial Information, Users, and Financial Statements

Uses of Financial Information:

To meet that objective, Financial Statements provide information about an entity's:

 Assets and Liabilities

Different Financial Statements:

Users of Financial Statements:

o Management: To evaluate the business operations and their own performance.

o Employees: To demand bonus and other prerequisites (benefits) as a matter of claiming

o Lenders: To know whether the business can repay the debts.

o Government: To identify the taxable income and impose the tax.

Accounting Standards deal with the issues of:

 Recognition of events and transactions in the financial statements.

Generally Accepted Accounting Principles – GAAP

 The basic accounting principles and guidelines.

International Financial Reporting Standards - IFRS

The setting of Accounting Standards has the following advantages:

 Standards reduce to a reasonable extent or eliminate together confusing variations in

GAAP and IFRS

Basic Accounting Principles

In overall, Characteristics of Accounting Information are:

Financial Decision Making

Types of Financial Decisions

 Investment Decisions: The investments of funds, in a project, has to be made after

The Objective of Financial Decision Making

o The maximization of the entity's Profit

o The maximization of the entity's value/wealth

Wealth Maximization vs. Profit Maximization

The maximization of Profit is often considered as an implied objective of the business. To

Common items of an Income Statement

o Cost of goods sold

 Earnings (before taxes & interest)

 Earnings Before Taxes

 Net Profit or Loss for the Period

o Write-down of inventories to net realizable value or of property, plant and equipment to