31

POST GRADUATE DIPLOMA IN

FINANCIAL MANAGEMENT

SEM - I

FINANCIALSTATEMENT
ANALYSIS
 © UNIVERSITY OF MUMBAI

Prof. Suhas Pednekar

Vice-Chancellor,
Universityof Mumbai,

Prof. Ravindra D. Kulkarni Prof. Prakash Mahanwar

Pro Vice-Chancellor, Director,
Universityof Mumbai, IDOL, Universityof Mumbai,

Program Co-ordinator : Dr. Santosh Rathod

Associate Professor, Dept. of English,
IDOL, University of Mumbai, Mumbai

Course Co-ordinator : Samina Shaikh

IDOL, University of Mumbai, Mumbai

Course Writer : Dr. Madhura Kulkarni

Lecturer-Cum.Asst. Director
IDOL, Universityof Mumbai
: Mr. Subhash Dalvi
Alkesh Dinesh Mody Institute
Universityof Mumbai
: Natika Poddar
SPDT College,
Andheri (E), Mumbai

December 2021, Print 1

Published by : Director
Institute of Distance and Open Learning ,
University of Mumbai,
Vidyanagari, Mumbai - 400 098.

DTP composed & : Mumbai UniversityPress

Printed by : Vidyanagari, Santacruz (E), Mumbai
 CONTENTS
Unit No. Title Page No.

Module I
1. Basics of Balance Sheet and Profit & Loss Account 01
2. Analyses of The Financial Statements 15
Module II
3. Introduction to Fund Flow Statement 43
4. Introduction to Cash Flow Statement 55
Module III
5. Ratio Analysis 68
6. Introduction to Dupont Analysis 122
Module IV
7. Free Cashflow Analysis 126


 I

Syllabus
Post Graduate Diploma in Financial Management
Financial Statement Analysis

Unit Syllabus
I  Basics of Balance Sheet and Profit & Loss Account
statement.
 Analysis of Financial Statements through Trend Analysis,
Common Size Statements.
II  Introduction to Funds Flow Statement, Calculating Funds
from Operation, Analysis of Funds flow Statement,
Importance of Funds Flow Analysis
 Introduction to Cash Flow Statement, Calculating Operation
/ Financing and Investing Cash Flows, Analysis of Cash flow
Statement, Importance of Cash Flow Analysis.
III  Introduction to Ratio Analysis, Importance of Ratio
Analysis, Understanding Liquidity / Leverage & Coverage /
Turnover / Expense and Profitability ratios, using ratios to
analyse the financial performance of a company,
Introduction to DuPont Analysis.
IV  Understanding Annual Report of a Company; Director’s
Report, Management Discussion and Analysis, Notes to
Account.
 Basic computation of Free Cash Flows for Equity.

Reference Books :

1) Financial Management - Prasanna Chandra

2) Financial Management - I.M. Pandey
3) Financial Management - Khan & Jain
4) Corporate Finance - Brealey & Mayers
5) Techniques of Financial Analysis - Erich A. Helfert (Tata McGraw
Hill)
6) Understanding Financial Statements - Interpretation and Analysis - A.
A. Gopalkrishnan.


 MODULE - I

1
BASICS OF BALANCE SHEET AND
PROFIT AND LOSS ACCOUNT
Unit structure:
1.1 Objectives
1.2 Introduction
1.3 Meaning and Types of Financial Statements
1.4 Parties Interested In Financial Statements
1.5 Basics of Income Statement and Balance Sheet
1.6 Limitation of financial statement
1.7 Exercise

1.1 OBJECTIVE

After studying the unit, the students will be able to -

 Understand the meaning and types of financial statement.
 Know the parties interested in Financial statements
 Understand the objectives of Financial statements
 Explain the basics of Financial statements

1.2 INTRODUCTION

Government legislations require certain organizations to maintain

proper accounts and draw financial statement. Public can understand from the
financial statement the extent to which a company is discharging its social
responsibilities. While issuing shares, bonds, financial statement
become necessary as prospective investors can judge the financial
position of the organization and able to take a proper decision. Workers
union may study the financial statement and ascertain whether they can
enforce their demand. Tax legislature makes it obligatory for the business
entities to draw fair and objective financial statement. The financial statement
serves as instruments to regulate equity and debentures issued by companies.

1.3 MEANING AND TYPES OF FINANCIAL

STATEMENTS

Meaning:
Financial statements are plain statements based on historical
records, facts and figures. They are uncompromising in their objectives,
1
nature and truthfulness. They reflect a judicious combination of recorded facts,
accounting principles, concepts and conventions, personal judgements and
sometimes estimates.

Financial statements consist of ‘Revenue Account’ and ‘Balance

Sheet’.

1. Revenue Account / Income Statement:

Revenue Account refers to ‘Profit and Loss Account’ or ‘Income
and Expenditure Account’ or simply ‘Income Statement’. Revenue Account
may be split up or divided into ‘Manufacturing Account’, ’Trading
Account’, ’Profit and Loss Account’ and ‘Profit and Loss Appropriation
Account’, Revenue Account is prepared for a period, covering one year. This
statement shows the expenses incurred on production and distribution of the
product and sales and other business incomes. The final result of this
statement may be profit of loss for a particular period.

2. Balance Sheet:
Balance sheet shows the financial position of a business as on a
particular date. It represents the assets owned by the business and the claims
of the owners and creditors against the assets in the form of liabilities as on
the date of the statement.

3. Funds Flow Statement –

It describes the sources from which the additional funds were
derived and the use of these funds. Funds flow statement helps to
understand the changes in the distribution of resources between two balance
sheet periods. The statement reveals the sources of funds and their
application for different purposes.

4. Cash flow Statement:

A cash flow statement shows the changes in cash position from one
period to another. It shows the inflow and outflow of cash and helps the
management in making plans for immediate future. An estimated cash flow
statement enables the management to ascertain the availability of cash to meet
business obligations. This statement is useful for short term planning by the
management.

5. Schedules:
Schedule explains the items given in income statement and
balance sheet. Schedules are a part of financial statements which give
detailed information about the financial position of a business organization.

1.4 PARTIES INTERESTED IN FINANCIAL

STATEMENTS

In recent years, the ownership of capital of many public companies

has become truly broad based due to dispersal of shareholding. Therefore,
one may say that the public in general has become interested in financial
2
statements. However, in addition to the share holders, there are other persons
and bodies who are also interested in the financial results disclosed by the annual
reports of companies. Such persons and bodies include:

1. Creditors, potential suppliers or others doing business with the

company;
2. Debenture-holders;
3. Credit institutions like banks;’
4. Potential Investors;
5. Employees and trade unions;
6. Important customers who wish to make a long standing contract with the
company;
7. Economists and investment analyst;
8. Members of Parliament, the Public Accounts Committee and the
Estimates Committee in respect of Government Companies;
9. Taxation authorities;
10. Other departments dealing with the industry in which the
company is engaged; and
11. The Company Law Board

Financial Statement analysis, therefore, has become of general

interest.

1.5 OBJECTIVES OF FINANCIAL STATEMENTS

The main object of financial statements is to provide information

about the financial position, performance and changes taken place in an
enterprise. Financial statements are prepared to meet the common needs of
most users. The important objectives of financial statements are given below:

1. Providing information for taking Economic decisions:

The economic decisions that are taken by users of financial statements
require an evaluation of the ability of an enterprise to generate cash and cash
equivalents and of the timing and certainty of their generation. This ability
ultimately determines the capacity of an enterprise to pay its employees and
suppliers meet interest payments, repay loans and make distributions to its
owners.

2. Providing information about financial position:

The financial position of an enterprise is effected by the economic
resources it controls, its financial structures its liquidity and solvency
and its capacity to adapt to changes in the environment in which it operates.

Information about financial structure is useful in predicting future

borrowing needs and how future profits and cash flows will be distributed
among those with an interest in the enterprise. This information is useful in
predicting how successful the enterprise is likely to be in raising further
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finance. Information about liquidity and solvency is useful to predicting the
ability of the enterprise to meet the financial commitments as fall due.

3. Providing information about performance(working results) of an

enterprise:
Another important objective of the financial statements is that it
provides information about the performance and in particular its
profitability, which requires in order assessing potential changes in the
economic resources that are likely to control in future. Information about
performance is useful in predicting the capacity of the enterprise to
generate cash inflows from its existing resource base as well in forming
judgment about the effectiveness with which the enterprises might
employ additional resources.

4. Providing Information about changes in financial position:

The financial statements provide information concerning changes in
the financial position of an enterprise, which is useful in order to assess its
investing, financing and operating activities during the reporting periods.
This information is useful in providing the user with a basis to assess the
ability of the enterprise to generate cash and cash equipments and the
needs of the enterprise to utilize those cash flows.

1.6 BASICS OF INCOME STATEMENT AND BALANCE

SHEET

Each business firm has to prepare two main financial statements viz.
Income Statement and Balance sheet. The income statement reveals the profit
of loss during a particular period generated from the activities of a
business. Balance sheet shows the financial position of a business on a
particular date.

 Income statement
Income statement summaries the incomes /gains and expenses
/losses of a Business for a particular financial period. The format of Income
statement explains in detail the items to be included in the statement. It
is presented in the traditional T Format and also in the vertically statement form.

1. Horizontal Form T form Manufacturing Trading and Profit and Loss

Account For the year ending

Dr. Cr.
Particulars Rs. Particulars Rs.
To Opening stock By Closing stock
Raw materials Raw Material
Work in progress Work in progress
To Purchase of raw By Cost of finished
materials goods c/d
To Manufacturing wages By Sales

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To Carriage/ Freight By Closing stock of
inwards Finished Goods
To Custom duty By Gross Loss c/d
To Other factory Expenses By Gross profit b/d
To Opening stock By Business incomes
and Gains
Finished Goods By Net Loss c/d
To Cost of finished By Balance b/d from
Previous year
Goods b/d By Net Profit b/d
To Gross profit c/d
To Gross loss b/d
To Office and
administration Expenses
To Interest and financial
Expenses
To Provision for Income
tax
To Net Profit c/d
To Net loss b/d
To Transfer to General
reserve
To Dividend
To Balance c/f

Particulars Rs. Rs.

Gross Sales xxx
Less : Sales returns xxx
Sales tax / Excise duty
Net Sales xxx
Less : Cost of goods sold
(Materials consumed + xxx
Direct Labour+ xxx
Manufacturing Expenses) xxx
Add / Less : Adjustment for change in stock xxx xxx
Gross Profit xxx
Less : Operating expenses xxx
a. Office and administration Expenses xxx
b. Selling and distribution Expenses xxx xxx
Add : Operating Income xxx
Operating Profit xxx

5
 Add : Non Operating Income xxx
Less : Non Operating expenses (including xxx
interest)
Profit before interest and tax xxx
Less : Interest xxx
Profit before tax xxx
Less : Appropriations: xxx xxx
a. Transfer to reserves xxx xxx
b. Dividends declared / paid xxx
Surplus carried to Balance Sheet xxx

 Balance sheet:
It is one of the major financial statements which presents a company's
financial position at the end of a specified date. Balance sheet has been
described as a "snapshot" of the company's financial position at a moment
for e.g. the amounts reported on a balance sheet dated March 31st, 2016
reflects that all the transactions throughout December 31st have been
recorded. The balance sheet provides information related to the assets,
liabilities and the shareholders’ equity of the company as on a specific date.
Total Assets = Total Liabilities + Share holders’ equity

The companies Act, 1956 stipulates that the balance sheet of a joint
stock company should be prepared as per Part I of Schedule VI of the Act.
However, the statement form has been emphasized upon by accountants for the
purpose of analysis and interpretation.

Understanding Corporate Balance Sheet: A.

Assets side:
1. Fixed Assets:
Fixed Assets are called long-term assets. These assets are used over
several periods. They are major sources of revenue to the business. They are
intended for long term use in the business. They are called “bundle of future
services” or “Sunk Costs”. The group of fixed assets is explained in the
proforma. Generally the Fixed assets are classifies as:
a) Tangible movable assets;
b) Tangible immovable assets; and
c) Intangible assets.

a) Tangible movable assets are the assets which can be seen, touched and
moved from one place to another place. Plant and Machinery, furniture
and fixtures, transportation equipments etc. are tangible movable
assets.

6
b) Tangible immovable assets are the assets which can be seen and
touched but cannot be moved from one place to another place. Such
assets include land, buildings, mines, oil wells, etc.

c) Intangible assets are the assets which cannot be seen and touched.
However, their existence can only be imagined such as patents,
trademarks, copyrights, goodwill, etc.

The Fixed Assets are presented as:

Gross Block - Provision for Depreciation = Net Blocks

2. Investments:
Investments may be short-term or long term. Short-term investments
are marketable securities and they represent temporary investments of
idle funds. These investments can be disposed off by the company at any
time. Investments are shown at cost. Cost includes brokerage, fees and all
other expenses incurred on acquisition of investments. However, the market
value is shown by way of a note.

Long-term investments are held for a long time. They are required
to be held by the business by the very nature and conditions of the
business. For example, a company engaged in generating electricity may be
required to hold the bonds of the Electricity Board. These bonds are
retained by the company so long as the company uses electric power.

As per Schedule VI of the Indian Companies Act 1956, investments

are shown separatel y, showing the nature of investments and the
mode of valuation of various classes of securities.

Long term Investments are grouped under fixed assets and short term
investments under current assets.

3. Current Assets, Loans and Advances:

The item, “Current Assets, Loans and Advances” is divided into two
parts:
a. Current Assets, and
b. Loans and Advances.

a. Current Assets and Quick assets:

“Current Assets include cash and the other assets that are likely to
be converted into cash and the cash thus generated is available to pay
current liabilities. Current assets are not intended for long-term use in
business. Current assets represent employment of money by the company
on a short-term basis. They circulate within the group. For example, cash
becomes raw material when material is purchased, material becomes
finished goods, finished goods become cash or debtors when sold and so
on.
Current Assets = Stock + Debtors + Cash & Bank + Loans &
Advances + Marketable Securities + Other Current Assets

In fact, total current assets are known as “Gross Working Capital”.

Current assets less current liabilities are known as ‘net working capital’.

7
 Quick Assets are known as ‘near cash’ assets. In other words,
quick assets are those which can be converted into cash quickly. Therefore,
they are also known as liquid assets. Cash and bank balances are the most
liquid assets. Debtors and cash advances can be converted into cash at a
short notice. Therefore, they are also regarded as quick assets. Marketable
investments can be converted into cash, fall into the category of quick assets.
Inventory does not fall in this category of quick assets, since it cannot be
converted into cash quickly, as material is to be converted into
finished goods and then they should be sold. Expenses paid in advance do
not satisfy the criteria of quick assets. They cannot be converted into cash.
They can be received in the form of services.

Therefore Quick Assets = Current Assets – Inve ntor y – Prepayments

b. Loans and Advances:

Loans and advances given are current assets. It includes different
types of advances such as advances against salary, advances against
machinery, advances to subsidiary, prepaid expenses on account of rent,
taxes, insurance, etc.

4. Miscellaneous Expenditures and losses:

This heading covers Fictitious Assets and other expenses which are
made for future on a mass basis. These expenses are really not assets but
the whole balance on the account of these items is not charged to current
year’s Profit and Loss A/c therefore the amount to the extent not written
off or adjusted is shown on the Assets side as Miscellaneous
expenditures.

The examples of fictitious assets are:

a. Preliminary expenses.
b. Brokerage on issue of shares and debentures.
c. Discount on issue of shares and debentures.
d. Share or debenture issue expenses.
e. Heavy Advertisement and Publicity expenditure.
f. Profit and Loss A/c debit balance.

Liquidity means easy convertibility into cash. Though

ultimately all assets are converted into cash, the term liquidity refers not
only to the nature of assets but also to the purposes of holding the assets.
Assets are normally arranged in order of permanency i.e., from least liquid
to most liquid.

B. Liabilities Side
The term ‘liability’ when used in accounting, means a debt. A debt is
something that a person or an organization owes to another person or
organization. In other words, Liabilities are the claims of outsiders against the
business. Technically speaking, all liabilities shown in a balance sheet are
claims against all assets shown in it. But, there may be certain cases where
a liability has a claim against a specific asset. Even under such
circumstances, the liabilities are shown separately, not as a deduction from
the specific assets.

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Classification of Liabilities:
The liabilities of an enterprise may be classified into three
categories
1. Permanent Funds or Proprietors’ Funds.
2. Semi-permanent Funds or Long-term Borrowings.
3. Current liabilities and Provisions.

1. Proprietor’s Funds:
These are the funds provided by the proprietors (owners) or the
shareholders. Proprietors’ fund represents the interest of the proprietors in the
business. This is the amount belonging to the proprietors. Proprietors’ fund is
also called as ‘Proprietors’ Equity’, ‘Owners’ Funds’, or ‘Shareholders’
Funds’. This is also known as the ‘Net Worth’ of the business. Owners’
Equity refers to the claim of the owners it includes:
Owners’ Equity = Capital (May be Equity Share Capital only or Equity
and Preference Share Capital) + Reserves + Profit and Loss A /c credit
balance – Accumulated losses and Fictitious assets.
Owners’ equity increase either through fresh investments by
the owners or by way of increasing the earnings retained i.e., profits not
distributed. (Retained earnings are that part of the total earnings which have
been retained for use in the business)
a. SHARE CAPITAL:
Share capital is the amount that is raised by a company
from the public at large, through the issue of shares. There are different
concepts of share capital from the legal and accounting points of view.
The following chart details the different concepts of capital :
Company’s Share Capital

9
i. Authorised Capital : Authorised Capital is the maximum capital a
company can raise as mentioned in the Memorandum of Association
under its Capital Clause.

ii. Issued Capital : A company usually does not need the entire registered
capital. Issued capital is that part of the Authorised capital; which is
actually offered to the prospective investors for subscription. The balance of
the Authorised capital which is not issued is called the ‘unissued
capital.’

iii. Subscribed Capital : Subscribed capital is that part of the issued

capital which has been subscribed or taken up by the public.
Therefore, the subscribed capital may be equal to or less than the
issued capital.

Called up Capital Uncalled Capital: The company, therefore, may collect

the capital in several instalments as per its need. The called-up capital is that
portion of the subscribed capital which has been called or demanded by the
company to be paid. The capital that is not demanded from the
shareholders is called uncalled capital.

iv. Paid up Capital: Paid up capital is that part of the called up capital
which has been actually paid by the members. The paid-up capital is the
called-up amount less calls not paid. (Calls unpaid or calls-in-arrears).

v. Reserve Capital : It is that part of the uncalled capital which may only
be demanded on winding up or liquidation, but not when the company
is a going on. A company may determine this amount by a Special
Resolution.

b. RESERVES AND SURPLUS:

A business may have to meet certain compulsory or
voluntary, foreseen or unforeseen, recurring or non-recurring obligations
in future. It is advantageous to for the organization to make provision in
advance to meet them. If not sudden payment may adversely affect the
financial health of the company. In order to avoid such situations some
part of profit are retained in each year which is termed as ‘Retained
Earnings’ or ‘Plough Back of profits’. It means the reserves represent
amounts set aside out of divisible profits. They are appropriations of
profits. Indian Companies Act requires every company to transfer a
specific percentage (upto 10%) of the profits to “Reserve” accounts.

Reserve created for a specific purpose is called as a “Specific

Reserve” and a reserve created for a general purpose is called as a
“General Reserve.” General reserves are free and can be utilized for
Payment of Dividends, Development and expansion purpose or for any other
purpose the company thinks proper.

10
 According to Companies Act “Reserve shall not include any amount
written off by way of providing for depreciation, renewals or diminution in
value of assets or retained by way of providing for any known liability.”

It is compulsory for the business organization to disclose each

individual head of the reserves in the balance sheet with its opening balance
as per last balance sheet, additions thereto and deductions there from in the
current yare.

2. LONG-TERM LIABILITIES:
A company raises finance either from owners or through external
borrowings. External borrowings of a company which constitute its
“owed funds” are important sources of long-term finance. These
borrowings are termed as ‘fixed liabilities’ or ‘term liabilities’ or ‘long
term-loans’. They may take various forms such as debentures, public
deposits, bank loans, deferred payments, etc. They may be fully secured
or partly secured or unsecured.

3. CURRENT LIABILITIES AND PROVISIONS:

a. Current Liabilities:
Current liabilities are those short-term obligations of an enterprise
which mature within one year or within the operating cycle. They
constitute short-term sources of finance. It includes Sundry Creditors,
Bills Payable, Interest accrued but not due, outstanding expenses, Unclaimed
dividends and Bank Overdraft.

These liabilities are not normally secured and no interest is payable on

them with the exception of bank overdrafts. These liabilities, are generally
paid off by utilizing current assets or by creating a current liability.

Actually all current liabilities are payable within a short period

of time. However, Bank Overdraft is the current liability which is not paid
immediately or in a very short-time, in practice. Therefore, Bank Overdraft
is not considered as a quick liability. It is a permanent arrangement with
the banker. Hence

Quick Liabilities = Current Liabilities – Bank Overdraft

b. Provisions:
‘Provision’ means any amount retained by way of providing for any
known liability of which the amount cannot be determined with substantial
accuracy. Provisions have to be made for maintaining the integrity of
assets or for known liabilities. Although the amount of liability is not
certain organization has to made provision on best estimates. The
examples of provisions are Provision for depreciation on assets, Provision
for doubtful debts, Provision for proposed dividends, Provision for
taxation.

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4. CONTINGENT LIABILITIES:
According to ICAI, Contingent liability refers to an obligation relating
to an existing condition or situation which may arise in future depending
on the occurrence or non-occurrence of one or more uncertain future events.
These liabilities may or may not be converted into actual liabilities at some
future date. It is a liability which may or may not occur. But on the date of
the Balance Sheet, it is not known definitely whether the liability would
arise or not. But as a matter of caution, it is indicated in the balance sheet
for the sake of information and disclosure, under the head “Contingent
Liabilities. Some of the examples of Contingent Liabilities are
Discounted Bills of Exchange, Disputed liability on account of
income-tax, etc., about which appeal has been filed, Uncalled amount
on partly paid-up shares and debentures held by the company as
investments, Cumulative preference dividend in arrears, Matters referred
to arbitration, Claims not acknowledged as debts, Estimated amount of
contracts remaining to be executed on capital account and not provided for,
Guarantees given by the company, Bonds executed. and debentures held
by the company as investments, Cumulative preference dividend in arrears,
Matters referred to arbitration, Claims not acknowledged as debts,
Estimated amount of contracts remaining to be executed on capital account
and not provided for, Guarantees given by the company, Bonds executed.

Following are the proforma of the Balance sheet

1) Horizontal Form:

Liabilities Rs Assets Rs

Share Capital Fixed Assets

(with all particulars of 1. Goodwill
authorized, issued, 2. Land and Building
subscribed and Called up 3. Lease hold Property
capital) 4. Plant and Machinery
Less: Calls in arrears 5. Furniture and fixture
Add: Forfeited shares 6. Patents and trade marks
7. Vehicles

Investments
Reserve and Surplus
1. Capital Reserve Current assets, Loans and
2. Capital Redemption Advances
Reserve a. Current assets
3. Share premium 1. Interest accrued on
4. Other Reserves Investment
2. Loose tools
Less: P&L a/c Debit balance 3. Stock in Trade
5. Profit and Loss 4. Sundry debtors
appropriation A/c Less Provision for Bad debts
6. Sinking fund A/c 5. Cash in Hand
6. Cash at Bank

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Long term loans b. Loans and Advances
a. Secured loan 1. Advances to
Debentures subsidiaries
Add: Outstanding Interest 2. Bills receivables
Loan from Banks 3. Prepaid expenses
b. Unsecured loans Miscellaneous expenditure
Fixed deposits 1. Preliminary expenses
Short term loans and 2. Discount on issue of
advances shares and Debentures
3. Underwriting commission
Current liabilities and 4. Profit and Loss a/c (debit
Provisions balance)
a. Current liabilities
1. Bills payables
2. Sundry creditors
3. Bank overdraft
4. Income received in
advance
5. Unclaimed Dividends
6. Other liabilities
b. Provisions
1. Provision for taxation
2. Proposed dividends
3. Provident fund and
Pension fund
Contingent Liabilities

2. Vertical Form
Income Statement of ............... for the year ending ................

Previous Particulars Schedule Current Year

I. Sources of Funds
1. Shareholders’ Funds
a. Capital
b. Reserves and surplus
2. Loan funds
a. Secured loan
b. Unsecured loans

TOTAL
II. Application of Funds
1. Fixed Assets
a. Gross Block
Less Depreciation

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 b. Net Block
2. Investments
3. Current Assets, Loans and
Advances
Less Current Liabilities and
Provisions
Net Current Assets
4. Miscellaneous expenditure to
the extent not written off or
adjusted Profit and Loss a/c
debit balance
TOTAL

 Statement of Retained Earnings:

The Statement of Retained Earnings is prepared to show how
the balance in Profit and Loss accounts is appropriated for various
purposes like provision for dividend, transfer to reserves etc. The
balance on this account is finally shown on the Balance sheet Under the
heading Reserve and Surplus.

1.6 LIMITATION OF FINANCIAL STATEMENT

Following are the limitations of financial statements:

1. The information being of historical nature does not reflect the
future.
2. It is the outcome of accounting concept, convention combined with
personal judgement.
3. The statement portrays the position in monetary term. The profit or
loss position excludes from their purview things which cannot be
expressed or recorded in term of money.

To overcome from the limitations it becomes necessary to analyse the

financial statements.

1.7 EXERCISE

1. Discuss the meaning, nature and limitations of Financial

Statement.
2. Explain the several parties interested in Financial statements..
3. Discuss the horizontal and vertical analysis of Balance sheet.



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 2
ANALYSES OF THE FINANCIAL
STATEMENTS
(Comparative Statements, Common
size statements, Trend analysis)
Unit Structure
2.1 Introduction and Meaning of Analysis
2.2 Objects of Analysis
2.3 Arrangement of Figures for Analysis
2.4 Tools of Analyses
2.5 Comparative Statements
2.6 Common-Size Statement

2.1 INTRODUCTION AND MEANING OF ANALYSIS

Financial statements viz. the income and the position statement i.e.
the balance sheet, are indicators of two significant factors : profitability and
financial soundness. Analysis of statements means such a treatment of the
information contained in the two statements as to afford a full
diagnosis of the profitability and financial position of the firm
concerned.

To have a clear understanding of the profitability and financial

position, the data provided in the financial statements should be methodically
classified and compared with figures of previous periods or other similar
firms. Thereafter, the significance of the figures is established. Such a
comparative study would lead us to further questioning, the answers for
which have to be brought out by further and deeper analysis. We may work
out the figure of income of two firms A and B for a period but to analyze
systematically one should (i) arrange the cost and revenue, (ii) relate the
income to the capital employed and (iii) compare the result. On this basis we
may come to know that A is more profitable than B (vice versa). The next
question is why is a more profitable than B. This question will require
further analysis and study of the underlying situation.

We may define financial statement analysis as the process of

methodical classification, comparison and raising pertinent questions and
then seeking answers for them.

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2.2 OBJECTS OF ANALYSIS

The different parties look at the company from their respective

points of view, but the objects generally looked for are : (i) profitability and
(ii) financial condition. It can be said that the objective of financial statement
analysis is a detailed cause and effect study of the profitability and financial
position.

The objectives of financial statement analysis may also be broadly

classified on the basis of the persons interested in the analysis as
(i) External: An external analyst usually has to rely only on the
published information.
(ii) Internal: An internal analyst would really know the full story behind
each and every figure of the financial statement, he would also get
further supplementary information to properly assess the significance of
the figures. Such analysis would be more reliable than that done by an
outsider. However, internal analysis may be biased; external analysis
would be unbiased and impartial.

2.3 ARRANGEMENT OF FIGURES FOR ANALYSIS

Before meaningful analysis can be made, the figure have to be

arranged properly. For analysis purpose usually instead of the two column (T
Form) statements as ordinarily prepared, the statements are prepared in
single (vertical) column form which one should throw up significant
figures by a process of addition or subtraction. The chief advantage of such
presentation is that figures for a number of firms or number of years can be
set aside by side for comparison purposes.

A useful form of financial statement was suggested as early as

1917 by the federal reserve Board of the U.S.A. This suggestion was made
by the Board to its member banks so that the latte may insist on that
presentation while getting the financial statements of their clients for granting
of loans etc. This form, it was thought would facilitate the member banks in
analyzing the statement. Later this form was also approved by the American
Institute of Accountants as suitable for annual reports to the shareholders.
The following form (based on the form recommended by the
federal reserve Board) is considered suitable for presentation of financial
information to shareholders mainly for two reasons:

(1) It provides the information in an easily understandable manner; and

(2) I provides the appropriate figures facilitating further analysis

To facilitate these advantages the financial statements have to

arrange in a vertical format which are explained below:

16
17
18
An attempt could be made to present the income statement too in a
similar manner. The following form of presentation is
recommended :

19
2.4 TOOLS OF ANALYSES

As in balance sheet, so in the revenue statement, as shown above,

ready figures can be obtained for the purpose of further analysis. For instance,
gross profit, net profit, materials consumed, prime cost, works cost, cost of
goods sold, etc. are readily available. This would facilitate the calculation of
ratios.
As the information provided in the financial statements is not an
end in itself as no meaningful conclusions can be drawn from these
statements alone. However, the information provided in the financial
statements is of immense use in making decisions through analysis and
interpretation of financial statements. To overcome from the limitations it
becomes necessary to analyse the financial statements. The analytical tools
generally available to an analyst for this purpose are:
1. Comparative financial and operating Statements
2. Common-size statement
3. Trend ration and trend analysis
4. Average Analysis
5. change in working capital
20
 6. Fund-flow and cost-flow analysis
7. Ratio analysis

1. Comparative Financial and Operating Statement:

Here the Balance Sheet and Income Statement are prepared in a
Comparative from as the impact of the conduct of business is brought to bear
in the Balance Sheet, Comparative statement are made to show –
a. Increases and decreases in absolute data in term of money values.
b. Increases or decreases in absolute data in term of
percentage.
c. Comparisons expressed in ration.
d. Percentage of total.

Comparative financial statements are very useful to the analyst as

they provide information necessary for the study of financial and operating
trend over a period of years. They indicate the duration of the
movement with respect to the financial position and operating results.
Financial data become more meaningful when compared with similar data for
a previous period or a number of prior periods. The comparative profit and
loss account presents a review of operating activities of the business. The
comparative balance sheet shows the effect of operations on the assets and
liability and changes in the financial position during the period under
consideration.

2. Common size Statement:

Comparative statement showing only the vertical percentage or
ration for financial data without giving any rupee value are known as
common size statement.

3. Trend Analysis:
This is an important and useful technique of analysis and interpretation of
financial statement. In this technique the ration of different items for various
periods are calculate over a definite period of time say three to five years and
then we can analysis trend highlighted by this ratio. Trend analysis can be
done in three following way:
(i) Trend percentage,
(ii) Trend ratio,
(iii) Graphic and diagrammatic representation.

Here the percentage column are more relevant than the figure.
4. Average Analysis:
It is an improvement over trend analysis method. Here the trend can be
presented on the graph paper also in the shape of curve. In this from the
analysis and comparison become more comprehensive and impressive.

5. Statement of changes in Working Capital:

This statement is prepared to know an increase or decrease in
working capital over a period of time. The statement gives an accurate
summary of the events that affects on the amount of working capital.
21
6. Funds flow and Cash flow Analysis:
Funds flow analysis is a valuable aid for the financial executive and
creditor for the evaluation of the use of funds by the firm and determining
how the funds for the uses are generated. A Funds flow statement
indicates the sources of funds and the application of during the period
under review.

7. Ratio Analysis:
An absolute figure does not convey much meaning. Ration means the
relationships expressed in mathematical terms between two figures which
are connected with each other in some manner.

2.5 COMPARATIVE STATEMENTS

The comparative statements are important tool of horizontal

financial analysis. Financial data become more meaningful when compared
with similar data for previous period or a number of previous periods. Such
analysis helps as in forming an opinion regarding the progress of the
enterprise.

Comparative statements definition:

Foulke has defined these statement as “statement of financial
position of business so designed as to provide time perspective to the
consideration of various elements of financial position embodied in such
statement.’’ In any comparative statement columns for more than one
year’s position or working can be drawn and figures may be provided. The
annual date can be compared with similar monthly or quarterly data can be
compared with similar data for the same months or quarterly of previous years.
In such statement the figure can be shown at the following value.
a. In absolute money value
b. Increase or decrease in absolute values
c. By the way of percentages
d. By the way of common—size statement

Two comparable units can be compared regarding profitability and

financial position. The two organization may not have the identical heads of
account In order to get over the difficulty, the data must first be property
set before comparison In the preparation of comparative financial statement,
uniformity is essential.

Importance of Comparative Statement:

These statements are very useful in measuring the effect of the
conduct of a business enterprise over the period under consideration.
Regardless of its financial strength at a given point of time, the
enterprises must operate successfully if it hopes to continue as a going
concern. The income statement measures the effects of operation. But the
progress of these operations may be viewed over number of periods by
preparing the income statement in a comparative form. Similarly the effect
of operation of financial position and the progress of a business in term of

22
financial position can be presented by means of a comparative balance sheet.
The accounting authorities in U. S. A. have strongly recommended and
encouraged the preparation of financial statement in the comparative from
recognising the importance of comparative financial date for two years, the
Indian companies Act 1956 has made this fact compulsory that in the balance
sheet of a company the figure for the previous year should also be
given to facilitated comparison. Though the balance sheet is a useful
statement, the comparative balance sheet is even more useful for the it
contains not only the data of a single balance sheet but also for the past
years which may be useful in studying the trends.

PREPARATION OF COMPARATIVE STATEMENTS:

The form of comparative balance sheet consists of two or more
columns according to the number of year we prepare the balance sheet, for
the date of original balance sheet and columns for the increases or
decreases in various items. Here is a proforma of comparative balance
sheet for two years

Specimen of Comparative Balance Sheet for the ended 31st

Dec. 1980 and 1981
(Amount in Lakhs of rupees
Dec. 31 Dec. 31 Increase (+)
/ Decrease % Rate
1980 1981
(-)Amount
Assets:
Current Assets:
Cash 240 80 -160 -66 1.24
Debtors less reserve for 120 96 - 24 - 40 1.60
doubtful debts
Merchandise 260 320 + 66 + 46 2.46
Inventory
Prepaid Expenses 100 80 -20 -40 1.60
Total Current Assets 720 656 - 64 - 18 1.82
Fixed Assets:
Land and Building 480 720 + 240 + 100 2.0
less Depreciation
Furniture &Fixture 60 80 + 20 + 66 2.66
less Depreciation
Plant and Machinery 240 480 + 240 + 200 4.00
less Depreciation
Total fixed Assets 780 1,280 + 500 + 128 2.20
Total Assets 1,500 1,936 + 436 + 58 2.58

23
Liabilitie
s and
Capital:
Current
Trend creditors 234 510 + 276 + 108 3.08
Accrued
400 360 - 40 - 20 1.08
Expenses
Total 634 870 + 236 + 74 2.74

Current
Equity Capital 400 500 + 100 + 50 2.50
Retained 466 566 + 100 + 42 2.42
Earnings
Total Capital 866 1,066 + 200 + 46 2.46
Total Liabilities 1,500 1,936 + 436 + 58 2.58
and
Capital

Preparation of a Comparative Income Statement:

An Income Statement shows the Net Profit or Net Loss from
business operation of a definite accounting period. Like a balance sheet, a
comparative income statement show the operating results for a number of
accounting periods so that the changes in absolute date from one period to
another may be explained and analysis. The Comparative income statement
contains the some columns as the comparative balance sheet and provides
the same in the figures.

Specimen of a Comparative Income Statement for the year

ended 31st Dec. 1980 and 1981
(Amount in Lakhs of Rupees
Increase (+) /
Dec. 31 Dec. 31
Decrease (-) %
1980 1981
Amount
Net Sales 1370 1442 +72 +.6
Less: Cost of Goods Sold 838 926 + 88 + 21.0
Gross Profit 532 516 - 16 - 6.4
Operating Expenses:
Selling Expenses 188 182 -6 - 6.4
Gen. and Admn. Expenses 94 92 -2 - 4.2
Total Operating Expenses 282 274 -8 - 5.6
Operating Profit 250 242 -8 - 6.4
Add : Other Income
Dividend 44 50 +6 + 2.8
294 292 -2 -1.4
Less : Other Deduction
Interest Paid 44 44 Nil Nil
250 248 -2 -1.6
Less:IncomeTax 124 124 Nil Nil
Net Profit after Tax 126 124 -2 - 3.2

24
Illustration
The following is the Profit and Loss Account of TATA MOTORS
Ltd. for December 2004 and 2005. Prepare comparative Income
statement and comment on the profitability of the undertaking.

Particulars 2004 2005 Particulars 2004 2005

To Cost of 2,31,625 2,41,950 B y Sa l e s 3,60,728 4,17,125,

goods sold Less Returns 5,794 6,952

To Office 23,266 27,068

expenses
To Selling 45,912 57,816 By other 3,54,934 4,10,173
expenses income
To Interest paid 2,137 1,750 B y i n t e re s t 1,898 1,310
and dividend
To loss on sale of 627 175 By discount 2,125 1,898
fixed Assets on purchases
To Income tax 21,519 40,195
To Net Profit 35,371 44,425 By Profit on 1,500
sale of land
3,60,457 4,13,379 3,60,457 4,13,379

Comparative statement of TATA MOTORS Ltd

Particulars December December Increase (+) %
2004 Rs. 2005 Rs. Decrease (-)
Sales + 15.63
3,60,728 4,12,125 + 56,397
Less : Sales returns 5,794 6,952 + 1,158 + 19.98

3,54,934 4,10,173 + 55,239 + 15.56

Less: Cost of goods 2,31,625 2,41,950 + 10,325 + 4.46

Sold
Gross Profit (i) 1,23,309 1,68,223 + 44,914 + 36.42

Less: Operating
expenses
Office expenses 23,266 27,068 + 3,802 + 16.34
Selling expenses 45,912 57,816 + 11,094 + 25.93

69,178 84,884 + 15,706 + 22.70

Total Operating
Expenses(ii)

25
Operating Profit 54.131 83,339 + 29,208 + 53.96
(i) – (ii)

Add: Other incomes 5,523 3,206 - 2,317 - 41,95

59,654 86,545 + 26,891 + 45.08

2,764 1,925 -839 - 30.35
Less : Other
expenses
Profit before tax 56,890 84,620 + 27,730 + 48.74

Less:Incometax 21,519 40,195 + 18,676 +86.79

Net Profit after tax 35,371 44,425 + 9.054 + 25.60

Interpretation
The comparative income statement reveals that while the net
sales has been increased by 15.5% the cost of goods sold increased by
4.46% Gross profit is increased by 36.4%. The total operating expenses
has been increased by 22.7% and the gross profits is suffice to
compensate increase in operating expends. Net profit after tax is
Rs.9.054 (i.e. 25.6%) increased. The overall profitability of the
undertaking is satisfactory.

Illustration
The following are the Balance Sheets of GODWINS Ltd. for the years
ending 31st March, 2004, 2005.

Particulars 2004 2005

Liabilities
Equity share capital 2,00,000 3,30,000

Preference share capital 1,00,000 1,50,000

Reserves 20,000 30,000

Profit and loss account 15,000 20,000

Bank overdraft 50,000 50,000

Creditors 40,000 50,000

Provision for taxation 20,000 25,000

Proposed dividend 15,000 25,000

4,60,000 6,80,000

26
 Fixed Assets (Less: Depreciation) 2,40,000 3,50,000
Stock 40,000 50,000
Debtors 1,00,000 1,25,000
Bills receivable 20,000 60,000
Prepaid expenses 10,000 12,000
Cash in hand 40,000 53,000
Cash at bank 10,000 30,000
4,60,000 6,80,000

Comparative Statement of Financial position

Particulars Increase(+)
31st 31st March
Decrease (-)
March 2004 2005

(Rs) (Rs) (Rs) (Rs.)

Assets
Current Assets
Cash at bank and in hand 50,000 83,000 + 33,000 +66
Bills receivable 20,000 60,000 + 40,000 + 200
Debtors 1,00,000 1,25,000 + 25,000 +25
Stock 40,000 50,000 + 10,000 +25
Prepaid expenses 10,000 12,000 + 2,000 +20
(1) 2,20,000 3,30,000 +1,10,000 +50
Fixed Assets (2) 2,40,000 3,50,000 +1,10,000 + 45.83
Total Assets side (1) + (2) 4,60,000 6,80,000 +2,20,000 + 47.83

Liabilities
Current liabilities
Bank overdraft 50,000 50,000 ... ----
Creditors 40,000 50,000 +10,000 + 25
Proposed dividend 15,000 25,000 +10,000 + 66.67
Provision for taxation 20,000 25,000 +5,000 +25
(a) 1,25,000 1,50,000 + 25,000 +20
Capital and Reserves
Equity Share capital 2,00,000 3,30,000 +1,30,000 +65
Preference share 1,00,000 1,50,000 +50,000 +50
Capital
Reserves 20,000 30,000 +10,000 +50
Profit and loss account 15,000 20,000 +5,000 +33.33
(b) 3,35,000 5,30,000 + 1,95,000 + 58.21
Total of Liabilities side 4,60,000 6,80,000 + 2,20,000 + 47.83
(a) + (b)

27
Interpretation –
1. The above comparative balance sheet reveals the current assets has
been increased by 50% while current liabilities increased by 20%
only. Cash is increased by Rs.33,000 (i.e.66%). There is an
improvement in liquidity position.
2. The fixed assets purchased was for Rs.1,10,000. as there are no
long term funds, it should have been purchased partly from share
capital.
3. Reserves and profit and loss account increased by 50% and 33.33%
respectively. The company may issue bonus shares in near
future.
4. Current financial position of the company is satisfactory. It can raise
more long term funds.

Illustration
The following details are provided by C ltd. For the year ended 31st March,
2015 and 2016 prepare Comparative Statement:

Particulars 31/03/15 31/03/16

Share capital 24,00,000 26,10,000
General Reserves 2,40,000 2,90,000
Profit and Loss A/c 4,20,000 6,00,000
11% Debentures 10,00,000 6,00,000
Goodwill 2,00,000 1,60,000
Land &Building 14,00,000 13,00,000
Plant and Machinery 12,00,000 13,20,000
Investment (Non trading) 4,80,000 4,40,000
Creditors 3,70,000 4,30,000
Provision for Tax 1,60,000 2,10,000
Proposed Dividend 2,72,000 2,88,000
Stock 8,00,000 7,70,000
Debtors 5,76,000 8,30,000
Cash at Bank 1,76,000 1,86,000
Prepaid Expenses 30,000 22,000

28
Solution:

Particulars 31/03/15 31/03/16 Changes %

Share Capital 24,00,000 26,10,000 2,10,000 9%
General reserves 2,40,000 2,90,000 50,000 21%
Profit and Loss A/c 4,20,000 6,00,000 1,80,000 43%
11% Debentures 10,00,000 6,00,000 - -
Total 40,60,000 41,00,000 4,00,000 40%
Goodwill 2,00,000 1,60,000 40,000 1%
Land and Building 14,00,000 13,00,000 -40,000 -
Plant and Machinery 12,00,000 13,20,000 - 20%
Fixed Assets Total 28,00,000 27,80,000 1,00,000 -7%
Investments 4,80,000 4,40,000 1,20,000 10%
Current Assets -20,000 -1%
Stock 8,00,000 7,70,000 -40,000 -8%
Debtors 5,76,000 8,30,000
Cash at Bank 1,76,000 1,86,000 -30,000 -4%
Prepaid expenses 30,000 22,000 2,54,000 44%
C.A Total 15,82,000 18,08,000 10,000 6%

Less: Current Liabilities -8,000 -

Creditors 3,70,000 4,30,000 2,26,000 27%
Provision for tax 1,60,000 2,10,000
Proposed dividend 2,72,000 2,88,000 60,000
Net Working Capital 7,80,000 8,80,000 50,000 16%
40,60,000 41,00,000 16,000 31%
1,00,000 6%
40,000 13%

2.6 COMMON-SIZE STATEMENT

Common Size Income Statement

In common size income statement the sales figures is taken as
100 and all other figures of costs and expenses are expressed as
percentage to sales. When other costs and expenses are reduced from
sales figure of 100, the balance figure is taken as net profit. This reveals
the efficiency of the firm in generating revenue which leads to
profitability and we can make analysis of different components of
costs proportion to sales. Inter firm comparison of common size income
statements reveal the relative efficiency of costs incurred.

Common Size Balance Sheet

In common size balance sheet, the total of assets side or
liabilities side is taken as 100 and all figures of assets and liabilities
capital and reserves are expressed as a proportion to the total i.e. 100.
The common size balance sheet reveals the proportion of fixed assets to
current asserts composition of fixed assets and current assets proportion of
29
long term funds to current liabilities and provisions composition of
current liabilities etc. It also helps in making inter firm comparison and
highlights the financial health and long term solvency ability to meet short
term obligations and liquidity position of the enterprise.
Speciman Common Size Income Statement For the year ending
31st March, 2005

Particulars Amount %
(Rs.) to
Sales (a) 14,00,000 100

Raw materials 5,40,000 38.6

Direct wages 2,30,000 16.4

Factory expenses 1,60,000 11.4

Cost of goods sold (b) 9,30,000 66.4

Gross profit (a) – (b) 4,70,000 33.6

Less : Administrative expenses 1,10,000 7.9

Selling and distribution expenses 80,000 5.7

Operating profit 2,80,000 20.0

Add : Non-operating income 40,000 2.9

3,20,000 22.9

Less : Non-operating expenses 60,000 4.3

Profit before tax 2.60,000 18.6

Less :Income tax 80,000 5.7

Profit after tax 1,80,000 12.9

30
Common Size Balance Sheet as at 31st March, 2005

Particulars Amount Rs. % to total

Fixed Assets
Land 50,000 5.3
Buildings 1,10,000 11.7
Plant and machinery 2,50,000 26.6
Current Assets
Inventory
Raw materials 80,000 8.5
Work in process 50,000 5.3
Finished goods 1,60,000 17.0
Sundry debtors 2,10,000 22.4
Cash and Bank 30,000 3.2
9,40,000 100.0

Capital and Liabilities

Equity share capital 2,50,000 26.6

Preference share capital 1,00,000 10.6
General reserve 1,60,000 17.0
Debentures 80,000 8.5
Current Liabilities
Sundry creditors 2,20,000 23.4
Creditors for expenses 40,000 4.3
Bills payable 90,000 9.6

9,40,000 100.0

Illustration 1
The balance sheet of S Ltd are given for the year 2014 and 2015
convert them into common size balance sheet and interpret the changes.

31
 Balance sheet

2014 2015 2014 2015

Liabilities Assets
Rs Rs. Rs. Rs.
Equity share 1,46,800 1,91,000 Buildings 1,80,000 2,00,000
Capital 50,000 70,000 Plant and 40,000 55,000
reserve machiner
Revenue 20,000 30,000 yFurniture 10,000 20,000
reserve & Freehold 20,000 12,000
surplus property
T rade 30,000 40,000 Goodwill 25,000 30,000
creditors
Bills payable 80,000 60,000 Cash balance 25,000 20,000
Bank overdraft 90,000 80,000 Sunday debtors 30,000 35,000
Provisions 30,000 20,000 Inventories 70,000 57,000
Bills receivable
(temporary)
4,46,800 4,91,000 4,46,800 4,91,000

Common size Balance Sheet

2014 2015
Assets
Amt. Percentage Amt. Percentage
(Rs.) (Rs.)
A. Current Assets
Sundry Debtor 30,000 6.71 35,000 7.13
Cash balance 25,000 5.59 20,000 4.07
Inventories 70,000 15.71 57,000 11.60
Investment(Temporar 36,500 8.17 42,000 8.55
y)
Bill Receivable 10,300 2.30 20,000 4.08
Total (A) 1,71,800 38.44 1,74,000 35.43
B. Fixed Assets
Building 1,80,000 40.29 2,00,000 40.75
Plant and Machinery 40,000 8.95 55,000 11.20
Furniture 10,000 2.24 20,000 4.07
Freehold Property 20,000 4.48 12,000 2.44
Goodwill 25,000 5.60 30,000 6.11
Total (B) 2,75,000 61.5 3,17,000 64.57
Total Assets 4,46,800 100.00 4,91,000 100.00

32
 (A+B)

Liabilities
C. Current
Liabilities
Trade Creditors 30,000 6.17 40,000 8.15
Bill Payable 80,000 17.91 60,000 12.22
Bank Overdraft 90,000 20.14 80,000 16.29
Provision 30,000 6.71 20,000 4.07
Total (C) 2,30,000 51.47 200,000 40.73

D. Long-term
Liabilities
Equity Share 1,46,800 32.86 1,91,000 38.90
Capital Reserve 50,000 11.19 70,000 14.26
Revenue 20,000 4.48 30,000 6.11
Reserve and Surplus
Total (D) 2,16,800 48.53 2,91,000 59.27
Total
4,46,800 100.00 4,91,000 100.00
Liabilities(C+D)

Interpretation:
1. Out of every rupee of sales 60.72 per cent in 2014 and 63.63 per cent in
2015 account for cost of goods sold.
2. The percentage ratio of gross profit to sales was 39.28 per cent in 2014
which was reduced 36.37 percent 2015.
3. The operating expenses increased from 15.71 per cent of sales in
2014 to 16.37 per cent in 2015 all this reduced the percentage ratio of
net income after tax to sales from 14.15 per cent in 2014 to 12.00 per
cent in 2015.
4. The operating expenses increased from 15.71 per cent of sales in
2014 to 16.37 per cent in 2015 all this reduced to percentage ratio of net
income after tax to sales from 14.15 per cent in 2015.

In the ultimate analysis it can be said that the operating efficiency of

the concern has not been satisfactory during the period under study.

Illustration 3: From the income statement give below you are required to
prepare common – sized income statement.

33
 1986 1987
Particular
Rs. Rs.

Sales 1,40,000 1,65,000

Less : Cost of Goods Sold 85,000 1,05,000
Gross Profit 55,000 60,000
Operating Expenses
Selling and Distribution 12,000 16,000
Expenses
Administrative Expenses 10,000 11,000
Total Operating Expenses 22,000 27,000
Net Income before Tax 33,000 33,000
Income Tax (40%) 13,000 13,200
Net Income 19,800 19,800

Solution:
Common size income statement
(For the year ending 1986 and 1987)

1986 1987
Particulars Percentage Amt. (Rs.) Percentage
Amt.
(Rs.)
Sales 1,40,000 100.00 1,65,000 100.00
Less:Cost of 85,000 60.72 1,05,000 63.63
Sales
Gross Profit 55,000 39.28 60,000 36.37
Selling & 12,000 8.57 16,000 9.70
Distribution
Expenses
Administrative 12,000 7.14 11,000 6.67
Exp.
Total 22,000 15.71 27,000 16.67
operating Exp.
Net Income 33,000 23.57 33,000 20.00
before Tax
Income Tax 13,000 9.42 13,200 8.00
(40%)
Net Income 19,800 14.15 19,800 12.00
after Tax

34
Illustration : You given the following common size percentage of AB
Company Ltd for 1997 and 1988.

1997 1998
Inventory 5.20 5.83
Debtors 10.39 ?
Cash ? 7.35
Machinery 49.35 45.35
Building 27.27 29.59
Creditors 20.78 ?
Overdraft ? 10.81
Total Current Liabilities 31.17 ?
Capital 51.95 49.67
Long-term loan 16.88 17.91
Total Liabilities 3,85,000 4,63,000

From the above information, compute the missing common size

percentage. Also calculate the value of all assets and liabilities.

Solution:
Common Size Balance Sheet
(as on 31 December 1997 and 1998)

1997 1998
Assets A
Percentage Amt. Percentage
mt (Rs.)
.
Assets:
A. Current
Assets
Inventory 20,000 5.20 27,000 5.83
Debtors 40,000 10.39 55,000 11.88
Cash 30,000 7.79 34,000 7.35
Total (A) 90,000 23.38 1,16,000 25.06
B. Fixed
Assets
Machinery 1,90,000 49.35 2,10,000 45.35
Building 10,05,00 27.27 1,37,000 29.59
0
Total (B) 2,95,000 76.62 3,47,000 74.94
Total Assets 3,85,000 100.00 4,63,000 100.00
(A+B)

35
 Liabilities:
C. Current
Liabilities
Creditors 80,000 20.78 1,00,000 21.59
Overdraft 40,000 10.39 50,000 10.81
Total (C) 1,20,000 31.17 1,50,000 32.40
D. Long-term
Liabilities
Capital 2,00,000 51.95 2,30,000 49.67
Loan 65,000 16.88 83,000 17.91
Total (D) 2,65,000 68.83 3,13,000 67.55
Total 3,85,000 100.00 4,63,000 100.00
Liabilities
(C+D)

Note: Calculation have been made to the nearest rupee.

(i) Calculation of percentage of Cash for 1997
Cash = 23.38* – 15.59*
= 7.79
* Current = Total Assets – Fixed Assets
= 100–76.62
= 23.38
** Inventory + debtor = 5.20 + 10.39 = 15.59
(ii) Calculation of Percentage of overdraft for 1997
Total Current Liability–Creditor= 31.17–20.78 = 10.39
(iii) Calculation of percentage of Debtors for 1998
Debtor = 25.06*– 13.18 = 11.88
* Current Assets = Total Assets – Fixed Assets
= 100–74.94
= 25.06
Illustration
From the following Profit and Loss account prepare a Common Size Income
Statement

Particulars 2004 2005 Particulars 2004 2005

To Cost of goods 12,000 15,000 By Net 16,000 20,000
sold Sales
To Administrative 400 400
Expenses
To Selling 600 800
expenses
To net profit 3,000 3,800
16,000 20,000 16,000 20,000

36
Common Size Income Statement

Particulars 2004 % 2005 %

Rs. Rs.

Net Sales 16,000 100.00 20,000 100.00

Less: Cost of goods sold 12,000 75.00 15,000 75.00

Gross profit 4,000 25.00 5,000 25.00

Less Operating expenses
400 2.50 400 2.00
Administration expenses

Selling expenses 600 3.75 800 4..00

Total operating expenses 1,000 6.25 1,200 6.00

Net Profit 3,000 18.75 3,800 19.00

Illustration

Following are Balance Sheets of NELCO Ltd. for the year ended 31st
March, 2014 and 2015

Liabilities 2014 2015 Assets 2014 2015

1,00,000 1,65,000 1,20,000 1,75,000
Equity share Fixed assets
capital (net)
50,000 75,000 Stock 20,000 25,000
Preference
share Capital
Reserves 10,000 15,000 Debtors 50,000 62,500

Profit and loss 7,500 10,000 Bills 10,000 30,000

account receivable

Bank 25,000 25,000 Prepaid 5,000 6,000

overdraft expenses
Creditors 20,000 25,000 Cash in bank 20,000 26,500

Provision for 10,000 12.500 Cash in hand 5,000 15,000

taxation
7,500 12,500
Proposed
dividends
2,30,000 3,40,000 2,30,000 3,40,000

37
Common Size Balance sheet of NELCO Ltd. for the year ended 31sat
March, 2014 and 2015

Particulars 2014 2015

Rs. % Rs. %
Capital and Reserves

Equity share capital 1,00,000 43.48 1,65,.000 48.53

Preference share capital 50,000 21.74 75,000 22.05

Reserves 10,000 4.34 15,000 4,41

Profit and loss account 7,500 3.26 10,000 2.95

(i) 1,67,500 72.82 2,65,000 77.94

Current liabilities
Bank overdraft 25,000 10.87 25,000 7.35
Creditors 20,000 8.70 25,000 7.35
Provisions for taxation 10,000 4.35 12,500 3.68

Proposed dividends 7,5000 3.26 12,500 3.68

(ii) 62,500 27.18 75,000 22.06

(i) + (ii) 2,30,000 100.00 3,40,000 100.00

Fixed Assets (net) (a) (a) 1,20,000 52.17 1,75,000 51.47

Current Assets
Stock 20,000 8.70 25,000 7.35

Debtors 50,000 21.74 62,500 18.38

Bills receivable 10,000 4.34 30,000 8.82

Prepaid expenses 5,000 2.17 6,000 1.78

Cash in Bank 20,000 8,70 26,500 7.79

Cash in hand 5,000 2.18 15,000 4.41

(b) 1,10,000 47.83 1,65,000 48.53

Total Assets (a) + (b) 2,30,000 100.00 3,40,000 100.00

Interpretation -
1. In 2015, current assets were increased from 47,83% to 28.53%.
Cash balance is increased by Rs.16,500
2. Current liabilities were decreased from 27.18% to 22.06%. The
Company can pay off the current liabilities from current assets. The
liquidity position is reasonably good.

38
3. Fixed assets were increased from Rs.1, 20,000 in 2014 to Rs.1,75,000
in 2015. These were purchased from the additional share capital
issued.
4. The overall financial position is satisfactory.

Illustration
Following is the Balance sheet of Star Ltd. as on 31st March, 2016. You are
required to rearrange it in a common size form.

Liabilities Rs. Assets Rs.

Equity share Capital 2,50,000 Fixed Assets 6,50,000
General Reserve 1,50,000 Investments 2,00,000
Security Premium 12,500 Stock 4,25,000
10% Debentures 3,75,000 Sundry Debtors 2,50,000
Profit and Loss a/c 3,70,000 Prepaid expenses 20,000
Sundry Creditors 1,15,000 Advance Income tax 39,000
Bank overdraft 1,97,500 Cash and Bank bal. 31,000
Provision for taxation 90,000 Share issue expenses 5,000
Proposed dividend 75,000 Preliminary Expenses 15,000

16,35,000 16,35,000

TREND ANALYSIS
The trend ratios of different items are calculated for various
periods for comparison purpose. The trend ratios are the index numbers of
the movements of reported financial items in the financial statements
which are calculated for more than one financial year. The calculation of
trend ratios are based on statistical t3echnique called “Index numbers”.
The trend ratios help in making horizontal analysis of comparative
statements. It reflects the behaviour of items over a period of time. The
methodology used in computation of trend ratios is as follows:
(1) The accounting principles and policies should be
consistently followed throughout the period for which the trend
ratios are calculated.
(2) The trend ratios should be calculated only for the items
which have logical relationship with one another.
(3) The trend analysis should be made at least for four consecutive
years.
(4) The financial statements one financial year should be selected as
base statement and financial items of it should be assigned with
value as 100
(5) Then trend ratios of subsequent years’ financial statements
should be calculated by applying the following formula:

39
 Absolute figure of financial statement under study
= ------------------------------------------------------------------ x100
Absolute figure of same item in baser financial statement.
(6) Tabulate the trend ratios for analysis of trend over a
period

The trend percentages are calculated for select major financial

items in the financial statements to arrive at the conclusions for important
changes. The trend may sometimes be affected by external factors like
government policies economic conditions changes in income
distribution, technology development population growth, changes in
tastes and habits etc. the trend analysis is a simple technique and does not
involve tedious calculations.

Limitations The analysis through trend ratios is subject to the following

limitations :
 The trend ratios are incomparable, if there is inconsistency in
accounting policies and practices.
 The price level changes are represented in trend ratios -The trend
ratios musty be studied along with absolute data for correct analysis.
 While analyzing the trend ratios, non-financial data should also be
considered otherwise conclusions would be misleading.

Illustration
From the given data, calculate trend a percentage taking 2013 As base:
(Rs)
Particulars 2013 Rs. 2014 Rs. 2015 Rs.
Sales 50,000 75,000 1,00,000
Purchasers 40,000 60,000 2,000
Expenses 5,000 8,000 15,000
Profit 5,000 7,000 13,000

Particulars 2013 2014 2015 Trend percentage Base 2003

(Rs) (Rs) (Rs) 2003 2004 2005
Purchases 40,000 60,000 72,000 100 150 180
Expenses 5,000 8,000 15,000 100 160 300
Profit 5,000 7,000 13,000 100 140 260
---- ---------- -- ------
Sales 50,000 75,000 1,00,000 100 150

40
Illustration:
From the following data, calculate trend percentages (2013 as the base)
(Rs in Lakhs)
Particulars Rs.
2013 2014 2015
Cash 200 240 160

Debtors 400 500 650

Stock 600 800 700
Other current assets 450 600 750
Land 800 800 1,000
Buildings 1,600 1,600 2,400
Plant 2,000 2,000 2,400

Trend percentages (Base year 2013)

Current Assets 2013 2014 2015 2013 2014 2015
(Rs.) (Rs) (Rs)
Cash 200 240 160 100 120 80
Debtors 400 500 650 100 125 163
Stock 600 800 700 100 133 117
Other current 450 600 750 100 133 167
assets
TOTAL Current 1,650 2,140 2,260 100 130 137
Assets

Fixed Assets
Land 800 1,000 1,000 100 125 125

Buildings 1,600 2,000 100 125 150

2,400
Plant 2,000 2,000 100 100 120
2,400
TOTAL Fixed 4,400 5,000 5,800 100 114 11
Assets

41
Illustration
Complete the following Trend Analysis Statement for D Ltd.
Particulars 31/12/13 31/12/14 31/12/15 31/12/13 31/12/14 31/12/15
% % %
Sales 10,000 15,000 20,000 100 ? ?
Less: Cost of 7,000 ? ? 100 125 200
Goods sold
Gross Profit 3,000 ? ? 100 ? ?
Less: 1,000 1,250 1,500 100 125 150
Administrative
Expenses
Finance 500 625 750 100 ? ?
Expenses
Selling Expenses 250 375 500 100 ? ?
Net profit 1,250 4,000 3,250 100 320 260
before Tax
Less: Income 250 800 1,000 100 ? ?
Tax
Net profit after 1,000 ? ? 100 320 225
Tax

Solution
Particulars 31/12/13 31/12/14 31/12/15 31/12/13 31/12/14 31/12/15
% % %
Sales 10,000 15,000 20,000 100 150 200
Less: Cost of 7,000 8,750 14,000 100 125 200
Goods sold
Gross Profit 3,000 6,250 6,000 100 208.33 200
Less: 1,000 1,250 1,500 100 125 150
Administrative
Expenses
Finance 500 625 750 100 125 150
Expenses
Selling 250 375 500 100 150 200
Expenses
Net profit 1,250 4,000 3,250 100 320 260
before Tax
Less: Income 250 800 1,000 100 320 400
Tax
Net profit after 1,000 3,200 2,250 100 320 225
Tax

EXERCISE
1. Explain the tools of analyzing the financial statements
2. Write short notes:
a. Common size Statement b. Comparative statements c. Trend analyses


42
 MODULE –II

3
INTRODUCTION TO FUND FLOW
STATEMENT

Unit Structure
3.0 Learning Objectives:
3.1 Fund Flow Statement
3.2 Benefits of Fund Flow Statement
3.3 Procedure of Preparation of Fund Flow Statement
3.4 Importance of Fund Flow Analysis

3.0 LEARNING OBJECTIVES

 Understanding the concept of fund

 Calculation of fund from operation
 Calculation of changes in working capital
 Preparation of statement of Sources & Application of Funds

3.1 FUND FLOW STATEMENT

Funds flow statement is a financial statement which shows as to

how a business entity has obtained its funds and how it has applied or
employed its funds between the opening and closing balance sheet dates
(during the particular year/period). It can be described as – WHERE GOT-
WHERE GONE statement Funds usually refers to cash resources and funds
statement is prepared to show the net effect of various business events on
the current resources of the organization. In this topic fund should be
understood as working capital & funds flow as to mean any change in
working capital.

Funds Flow Statement is a statement prepared to analyse the

reasons for changes in the financial position of a company between 2
Balance Sheets. It shows the inflow & outflow of funds i.e. SOURCES and
APPLICATIONS of funds for a particular period. In other words Funds flow
statement is prepared to explain the changes in the working capital position
of a company. There are two types of inflows of funds –

43
 a. Long term funds raised by issue of Shares, Debentures or sale of
Fixed Assets
b. Funds generated from operations

If the long term fund requirements of a company are met just out of
the Long term Sources of funds, then the whole fund generated from
operations will be represented by increase in working capital. However if
the funds generated from operations are not sufficient to bridge a gap of
long term fund requirement, then there will be a decline in working
capital.

3.2 BENEFITS OF FUND FLOW STATEMENT

Funds flow statement is useful for long term analysis. It is very

useful tool in the hands of the management for judging the financial &
operating performance of the company. The Balance Sheet and the Profit &
Loss A/c (Income Statement) fails to provide the information which is
provided by the funds flow statement i.e. changes in Financial Position of an
enterprise. Such an analysis is of great help to the management,
shareholders, creditors etc.

Fund Flow Statement answers the following questions

 Where have the profits gone?
 Why is there an imbalance existing between liquidity position and
profitability position of an enterprise?
 Why is the concern financially solid in-spite of losses

Fund flow statement analysis helps the management to test whether

the working capital has been effectively used or not and the working
capital level is adequate or inadequate for the requirements of the
business. The working capital position helps the management in taking
policy decisions regarding payment of dividend etc.

Fund flow statement analysis helps the investors to decide whether the
company has managed the funds properly. It also indicates the credit
worthiness of a company which helps the lenders to decide whether to
lend money to the company or not. It helps the management to take policy
decisions and to decide about the financing policies and capital
expenditure for the future.

3.3 PROCEDURE OF PREPARATION OF FUND FLOW

STATEMENT

Step I - Prepare the statement of changes in working capital

Step II - Analyse the changes in non-current assets and noncurrent liabilities
to find out inflow or outflow of funds
Step III - Find out funds from operation

44
Step IV - Prepare statement of Sources & Application of Funds (Funds
Flow Statement)
Step – I

Step – II - Working Capital Changes

 Increase in Current Assets – Increase in Working Capital-
Outflow
 Increase in Current Liabilities – Decrease in Working Capital -
Inflow
 Decrease in Current Assets – Decrease in Working Capital -
Inflow
 Decrease in Current Liabilities – Increase in Working Capital -
Outflow

Step III – Finding Funds from Operations

In this step, we need to calculate the funds generated only from
the Operating activities of the business and not from the Investing /
Financing activities of the business. The funds from operations shall be
prepared as follows:

45
Step – IV – While preparing the fund flow statement, the sources and uses
of funds are to be disclosed clearly so as to highlight the sources from where
the funds have been generated and uses to which these funds have been
applied. This statement is also sometimes referred to as the sources and
applications of funds statement or statement of changes in financial position.

46
Sources of Funds
 Issue of Equity & Preference Shares
 Receipt of Securities Premium
 Issue of Debentures
 Receipt of Long Term Loans from Banks & Other Financial
Institutions
 Receipt of Public Deposits & other Unsecured Loans
 Sales of Fixed Assets, Sale of Investments
 Extraordinary receipt awarded in legal suit
 Income from long term investments
 Funds from operations
 Decrease in Working Capital

Application of Funds
 Redemption of Preference share capital, Redemption of
Debentures
 Premium paid on redemption of debentures and preference shares
 Repayment of temporary loans, secured & unsecured
 Purchase of Fixed Assets, Purchase of Investment
 Extraordinary payments and non recurring losses like loss by fire &
damages paid
 Payment of Dividend & Interim Dividend, Payment of Tax
 Increase in Working Capital

Formats of Fund Flow Statement

There is no prescribed format as such for the preparation of Funds
Flow Statement. The only point to be remembered is that it should be
presented in a clear and systematic manner. However, Funds Flow
Statements may be prepared in any of the following formats
 Report Form – Remainder Type
 Report Form – Self Balancing Type
 Report Form – Reconciling Type

47
Fund Flow Analysis
Flow analysis consists of two different analysis namely

Working Capital Analysis – is the analysis & reporting of working capital.

Working capital is the excess of current assets over current liabilities. This
analysis consist of two statements namely
 Statement of changes in working capital
 Statement of Sources & Application of Funds

Cash Flow Analysis – is the analysis of inflows and outflows of cash.

Cash flow analysis results in separate reports viz. Sources and
Applications of Cash Funds flow statement explains as to what caused the
changes in the balance sheet items between two balance sheet dates

3.4 IMPORTANCE OF FUND FLOW ANALYSIS

Funds flow statement is an important financial tool, which analyze

the changes in financial position of a firm showing the sources and
applications of its funds. It provides useful information about the firm's
operating, financing and investing activities during a particular period. The
following points highlight the importance of funds flow statement.
1) Helps in identifying the change in level of current assets
investment and current liabilities financing.
2) Helps in analyzing the changes in working capital level of a firm.
3) Sh ow s t h e r el a t i on sh i p of ne t i n com e t o t h e ch an ge s in
funds from business operation.
4) R e p o r t s a b o u t p a s t f u n d f l o w a s a n a i d t o p r e d i c t future
funds flow.
5) Helps in determining the firms' ability to pay interest and
dividend, and pay debt when they become due.
6) Shows the firms' ability to generate long-term financing to satisfy the
investment in long-term assets.
7) Helps in identifying the factor responsible for changes in assets, liabilities
and owners' equity at two balance sheet date.

48
49
50
51
52
53
Important Terms
 Fund – It refers to working capital, Flow – It is a movement of
fund
 Current Items – It includes current assets and current liabilities
 Non Current Items – It includes share capital, reserves, loans, fixed
assets, investments etc
 Fund from Operation – it is the cash profit generated from
operations
 Working Capital – Excess of current assets over current liabilities is
called as working capital.

Theory Questions
1. Why are funds flow statements important?
2. Explain – funds from operations
3. Explain the concept of fund & how the funds flow?

Practical Questions

54
 4
INTRODUCTION TO CASH FLOW
STATEMENT
Unit Structure
4.0 Learning Objectives
4.1 Cash Flow Statement
4.2 Analysis of Cash Flow Statement
4.3 Cash Flow from Operating Activities
4.4 Cash from Investing Activities
4.5 Cash from Financing Activities
4.6 Benefits/Importance of Cash Flow Analysis
4.7 Limitations of Cash Flow Analysis
4.8 Accounting Standard – AS3 on Cash Flow Statement
4.9 Distinction between Cash Flow V/S Funds Flow

4.0 LEARNING OBJECTIVES

 Understanding concept of cash flow

 Accounting standard for Cash Flow Statement (AS-3)
 Preparation of Cash Flow Statement
 Importance & Limitations of Cash Flow Statement

4.1 CASH FLOW STATEMENT

In financial accounting, a cash flow statement, also known

as statement of cash flows, is a financial statement that shows how
changes in balance sheet accounts and income affect cash and cash
equivalents, and breaks the analysis down to operating, investing and
financing activities.

Cash Flow Statement gives information about cash receipts

(sources) and cash payments (application). It contains opening balances &
closing balances of cash for a given period and explains how the closing
balance as per last balance sheet changed by various inflows & outflows
of cash to a closing balance of cash as per the next balance sheet. As per
AS-3, cash would include cash in hand and savings, current a/c balances
with banks & cash equivalents. Cash equivalents are short term & highly
liquid investments that are readily convertible into cash. An investment
would normally be called a cash equivalent only when it has a short term
maturity of say 3 months or less from the date of acquisition.

55
4.2 ANALYSIS OF CASH FLOW STATEMENT

The cash flow statement is distinct from the income statement and
balance sheet because it does not include the amount of future incoming
and outgoing cash that has been recorded on credit. Therefore, cash is not
the same as net income, which, on the income statement and balance
sheet, includes cash sales and sales made on credit. Cash flow is
determined by looking at three components by which cash enters and
leaves a company: core operations, investing and financing,

4.2 (a) Operations

Measuring the cash inflows and outflows caused by core business

operations, the operations component of cash flow reflects how much cash
is generated from a company's products or services. Generally, changes
made in cash, accounts receivable, depreciation, inventory and accounts
payable are reflected in cash from operations.

Cash flow is calculated by making certain adjustments to net

income by adding or subtracting differences in revenue, expenses and
credit transactions (appearing on the balance sheet and income statement)
resulting from transactions that occur from one period to the next. These
adjustments are made because non-cash items are calculated into net
income (income statement) and total assets and liabilities (balance sheet).
So, because not all transactions involve actual cash items, many items
have to be re-evaluated when calculating cash flow from operations.

For example, depreciation is not really a cash expense; it is an

amount that is deducted from the total value of an asset that has previously
been accounted for. That is why it is added back into net sales for
calculating cash flow. The only time income from an asset is accounted
for in CFS calculations is when the asset is sold.

Changes in accounts receivable on the balance sheet from

one accounting period to the next must also be reflected in cash flow. If
accounts receivable decreases, this implies that more cash has entered the
company from customers paying off their credit accounts - the amount by
which AR has decreased is then added to net sales. If accounts receivable
increase from one accounting period to the next, the amount of the
increase must be deducted from net sales because, although the amounts
represented in AR are revenue, they are not cash.

An increase in inventory, on the other hand, signals that a company

has spent more money to purchase more raw materials. If the inventory
was paid with cash, the increase in the value of inventory is deducted from
net sales. A decrease in inventory would be added to net sales. If inventory
was purchased on credit, an increase in accounts payable would occur on
the balance sheet, and the amount of the increase from one year to the
other would be added to net sales.
56
 The same logic holds true for taxes payable, salaries payable
and prepaid insurance. If something has been paid off, then the difference
in the value owed from one year to the next has to be subtracted from net
income. If there is an amount that is still owed, then any differences will
have to be added to net earnings.

4.2 (b) Investing

Changes in equipment, assets or investments relate to cash from

investing. Usually cash changes from investing are a "cash out" item,
because cash is used to buy new equipment, buildings or short-term assets
such as marketable securities. However, when a company divests of an
asset, the transaction is considered "cash in" for calculating cash from
investing.

4.2 ( c) Financing

Changes in debt, loans or dividends are accounted for in cash from

financing. Changes in cash from financing are "cash in" when capital is
raised, and they're "cash out" when dividends are paid. Thus, if a company
issues a bond to the public, the company receives cash financing;
however, when interest is paid to bondholders, the company is reducing its
cash.

Major Cash Inflows

• Issue of new shares for cash
• Receipt of short term & long term loans from banks, financial
institutions etc
• Sale of assets & investments, Dividend & Interest received,
• Cash generated from operations

Major Cash Outflows

• Redemption of preference shares, Purchase of fixed assets or
investments
• Repayment of long term and short term borrowings
• Decrease in deferred payment liabilities, Loss from operations
• Payment of tax, dividend etc.

Classification of Activities
As per AS-3 the cash flow statement should report cash flows during the
period classified by
• OPERATING ACTIVITIES
• INVESTING ACTIVITIES
• FINANCING ACTIVITIES

57
4.3 CASH FLOW FROM OPERATING ACTIVITIES
• The cash flows generated from major revenue producing activities of
the entities are covered under this head.
• Cash flow from operating activities is the indicator of the extent to
which the operations of the enterprise have generated sufficient cash to
maintain the operating capability to pay dividend, repay loans & make
new investments. Main Examples are
• Cash receipts from sale of goods & services
• Cash receipts from royalties, fees, commission etc
• Cash payments to employees
• Cash payments or refunds (receipt) of income tax
• Cash receipts & payments relating to future contracts, forward contract
etc
• Cash receipts and payments arising from purchase and sale of trading
securities

4.4 CASH FROM INVESTING ACTIVITIES

• These are the acquisition and disposal of long term assets and other
investments not included in cash equivalents. This represents the
extent to which the expenditures have been made for resources
intended to generate future incomes & cash flows, Examples are
• Cash payments for purchase of fixed assets
• Cash receipts from sale of fixed assets
• Cash payments for purchase of shares/debentures etc. in other entities
• Loans and advances given to third parties
• Repayments of loans given

4.5 CASH FROM FINANCING ACTIVITIES

• Financing activities are the activities that result in changes in the size
and composition of the owner’s capital and borrowings of the
enterprise.
• Separate disclosure is important because it is useful in predicting
claims on future cash flows by providers of funds
• Examples
• Cash receipts from issue of share capital , debentures & short term &
long term loans
• Cash Repayments of loans borrowed
• Cash payment to redeem preference shares

58
59
4.6 BENEFITS/IMPORTANCE OF CASH FLOW
ANALYSIS
• Efficient Cash Management – manage the cash resources in such a
way that adequate cash is available for meeting the expenses
• Internal Financial Management – useful for internal financial
management as it provides clear picture of cash flows from operations
• Knowledge of change in Cash Position – It enables the management
to know about the causes of changes in cash position

60
• Success or Failure of Cash Planning – Comparison of actual &
budgeted cash flow helps the management to know the success or
failure in cash management
• It is a supplement to fund flow statement as cash is a part of fund
• Cash Flow Statement is a better tool of analysis for short term
decisions

4.7 LIMITATIONS OF CASH FLOW ANALYSIS

• Misleading Inter Industry Comparison - Cash flow does not

measure the economic efficiency of one company in relation to another
company
• Misleading Inter Firm Comparison - The terms & conditions of
purchases & sales of different firms may not be the same. Hence inter
firm comparison becomes misleading
• Influence of Management Policies – Management policies influence
the cash easily by making certain payments in advance or by
postponing certain payments
• Cannot be equated with Income Statement – Cash flow statement
cannot be equated with income statement. Hence net cash flow does
not mean income of the business
• CFS cannot substitute the B/S & Funds Flow.

4.8 ACCOUNTING STANDARD – AS3 ON CASH FLOW

STATEMENT

Objective of AS-3 is to provide desired information about historical

changes in cash & cash equivalents of an enterprise classified in to
Operating, Investing and Financing activities.
• An enterprise should disclose the components of cash and cash
equivalents and should present a reconciliation of the amount in the
cash statement with the equivalent items reported in the balance sheet
• An enterprise should disclose the amount of cash & cash equivalent
balance held by the enterprises that are not available for use by it with
explanation of Management

61
4.9 DISTINCTION BETWEEN CASH FLOW V/S FUNDS
FLOW

Practical Sums

62
63
64
65
Key Terms:
Cash – It includes cash and demand deposits with Banks
Cash Equivalents – These are short term and highly liquid investments
Cash Flows – It is movement of cash
Non Cash Expenses – These are the expenses which do not involve any
cash payment
Revenue Activities - These are the activities which are revenue
producing
Investing Activities – These are related to acquisition and disposal of
long term assets
Financing Activities – These are the activities relating to changes in
capital & borrowings

Theory Questions:
1. Explain the technique of cash flow statement?
2. What is utility of cash flow statement to financial management?
3. Explain the concept of “Flow of Cash” & enumerate the sources of
cash?
4. What data would you require to prepare a cash flow statement?

Suggested Readings for Fund Flow & Cash Flow Statements

Management Accounting – Bhattacharya Debarshi
Introduction to Management Accounting – Dr.Varsha Ainapure (Manan
Prakashan)
Principles of Financial Management – Satish Inamdar (Everest Publishing
House)

66
Management Accounting – Chopde (Sheth Publishers)
Practical Sums:



67
 MODULE - III

5
RATIO ANALYSIS

Unit Structure
5.1 Introduction
5.2 Objective of ratio analysis
5.3 Advantages of ratio analysis
5.4 Meaning of ratios
5.5 Modes of expressing an accounting ratio
5.6 Importance of ratio analysis
5.7 Classification of ratios
5.8 Balance sheet ratios
5.9 Revenue statement ratios
5.10 Combine ratio / composite ratios
5.11 Limitation of ratios
5.12 Exercise with solution
5.13 Practice

5. 1 INTRODUCTION

Ratio analysis is the process of determining and interpreting

numerical relationships based on financial statements. A ratio is a
statistical yardstick that provides a measure of the relationship between
two variables or figures.

This relationship can be expressed as a percent or as a quotient.

Ratios are simple to calculate and easy to understand. The persons
interested in the analysis of financial statements can be grouped under
three heads,

i) Owners or investors
ii) Creditors and
iii) Financial executives

Although all these three groups are interested in the financial

conditions and operating results, of an enterprise, the primary information
that each seeks to obtain from these statements differs materially,
reflecting the purpose that the statement is to serve.

68
 Investors desire primarily a basis for estimating earning
capacity. Creditors are concerned primarily with liquidity and ability to
pay interest and redeem loan within a specified period. Management is
interested in evolving analytical tools that will measure costs, efficiency,
liquidity and profitability with a view to make intelligent decisions.

5.2 OBJECTIVE OF RATIO ANALYSIS:

The main objectives of analyzing financial statement with the help of

ratios are:

1. The analysis would enable the calculation of not only the present
earning capacity of the business but would also help in the estimation
of the future earning capacity.
2. The analysis would help the management to find out the overall as
well as the department – wise efficiency of the firm on the basis of
the available financial information.
3. The short term as well as the long term solvency of the firm can be
determined with the help of ration analysis.
4. Inter – firm comparison becomes easy with the help of ratios.

5.3ADVANTAGES OF RATIO ANALYSIS:

Financial statement prepared at the end of the year do not always

convey to the reader the real profitability and financial health of the
business. They contain various facts and figures and it is for the reader
to conclude what these figures indicated. Ratio Analysis is an important
tool for analyzing these financial statements .Some important advantage
derived by the firm by the use of accounting ratios are:

1. Help in Financial statement analysis

It is easy to understand the financial position of a business enterprise
in respect of short-term solvency, liquidity and profitability with the help
of ratio. It tells us the changes taking place in the financial condition of
the business.

2. Simplified accounting figures

Absolute figures are not of mush use. They become important when
relationships are established say between gross profit and sales.

3. Helps in calculating operation efficiency of the business enterprise

Ratio enables the user of financial information to determine operating
efficiency of a firm by relating. The profit figure to the capital employed
for a given period.

4. Facilities inter- firm comparison

Ratio analysis provides data for inter- fir m comparison. It revels
69
strong and weak firms, overvalues and undervalues firms as well as
successful and unsuccessful firms.

5. Makes inter- firms comparison possible

Ratio Analysis helps the firm to compare e its own performance
over a period of time as well as the performance of different divisions of
the firm. It helps in deciding which divisions are more efficient than
other.

6. Helps in forecasting
Ratio Analysis helps in planning and forecasting. Ratios provides
clues on trends and futures problems. E.g. if the sales of a firm during the
year are Rs. 10 lakhs and he average stock kept during the year Rs. 2
lakhs, it must be ready to keep a stock of Rs. 3 lakhs which is 20 % of the
Rs. 15 lakhs.

5.4. MEANING OF RATIOS :-

A ratio is one figure expressed in terms of another figure. It is

mathematical yardstick of measuring relationship of two figures or
items or group of items, which are related, is each other and
mutually inter-dependent. It is simply the quotient of two numbers. It
can be expressed in fraction or in decimal point or in pure number.

Accounting ratio is an expression relating to two figures or

two accounts or two set accounting heads or group of items stated in
financial statement.

5.5. MODES OF EXPRESSING AN ACCOUNTING

RATIO

An accounting ratio may be expressed in different ways as under.

I) Simple or pure ratio :- It is merely a quotient arrived by simple

division of one number by another.

Example : When current assets of the business enterprise are Rs.

1,00,000 and current liabilities are Rs.25,000. The ratio between
current assets and current liabilities will be expressed as 1,00,000 /
25,000 = 04 OR it is expressed as 4:1.

II) Percentages :- It is expressed as percentage relationship when

simple or pure ratio is multiplied by 100.

Example : The current ratio in above example is expressed in

percentage by multiplying 4 by 100.
i.e. 100 x 4 = 400%

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III) Rate :- The ratio is expressed as rates which refer to the ratio over
a period of time.

Example : Stock has turned over 8 times a year.

IV) Number of days or week or month:- Certain items of the

financial statements are expressed better in the form of days or weeks or
months.

Example: Debtors' collection period, credit payment period,

movement of stock, etc are expressed in days or weeks or months in a
year.

V) Rupees :- In this case numerator is divided by denominator and

figure of result is expressed in rupees.

Example : Earnings per share, dividend per share etc are expressed
in rupees. It net profit after tax is Rs. 12,500 and number of shares of a
company are 1250.

Earning per shares = NPAT/ No. Of Shares

12500/ 1250 = Rs. 10 per shares

5.6. IMPORTANCE OF RATIO ANAYSIS

The ratios are useful for the following parties.

1. Investors, both present as well as potential investors.
2. Financial analysist.
3. Stock broker and stock exchange authorities.
4. Government.
5. Tax Department.
6. Competitors
7. Research analysist and students.
8. Creditors and supplier.
9. Banks and financial institutions.
10. Company's management.
11. Finance managers
12. Mutual funds.
13. Other interested parties like credit rating agencies.

5.7. CLASSIFICATION OF RATIOS

Different types of ratios are computed depending on the purpose

for which they are needed. Broadly speaking, they are grouped under four
heads:

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1. Liquidity ratios
2. Solvency ratios
3. Turnover or Activity ratios
4. Profitability ratios
The ratios are worked out to analyze the following aspect or
areas of business organization.

1) Solvency: -
a) Long-term solvency
b) Short-term solvency
c) Immediate solvency
2) Stability
3) Profitability
4) Operational efficiency
5) Credit standing
6) Structural analysis.
7) Utilization of resources and
8) Leverage or external financing.

The ratios are used for different purposes, for different users and
for different analysis. The ratios can be classified as under:
a) Traditional classification
b) Functional classification
c) Classification from user‘s point of view

Traditional classification :
As per this classification, the ratios readily suggest through
their names, their respective resources. From this point of view, the
ratios are classified as follows.

a) Balance Sheet Ratio :- This ratio is also known as financial ratios.

The ratios which express relationships between two items or group of
items mentioned in the balance sheet at the end of the year.

Example : Current ratio, Liquid ratio, Stock to Working Capital ratio,

Capital Gearing ratio, Proprietary ratio, etc.

b) Revenue Statement Ratio :- This ratio is also known as

income statement ratio which expresses the relationship between two
items or two groups of items which are found in the income statement
of the year.

Example : Gross Profit ratio, Operating ratio, Expenses Ratio, Net

Profit ratio, Stock Turnover ratio, Operating Profit ratio.

72
c) Combined Ratio :- These ratios shows the relationship
between two items or two groups of items, of which one is from
balance sheet and another from income statement (Trading A/c and
Profit & Loss A/c and Balance Sheet).

Example : Return on Capital Employed, Return on Proprietors' Fund

ratio, Return on Equity Capital ratio, Earning per Share ratio,
Debtors' Turnover ratio, Creditors Turnover ratio.

Functional Classification of Ratios :

The accounting ratios can also be classified according their

functions as follows.

a) Liquidity Ratios :- These ratios show relationship between

current assets and current liabilities of the business enterprise.

Example : Current Ratio, Liquid Ratio.

b) Leverage Ratios :- These ratios show relationship between

proprietor's fund and debts used in financing the assets of the business
organization.

Example : Capital gearing ratio, debt-equityratio, and proprietary ratio.

This ratio measures the relationship between proprietors fund and
borrowed funds.

c) Activity/Turnover Ratio :- This ratio is also known as turnover

ratio or productivity ratio or efficiency and performance ratio. These
ratios show relationship between the sales and the assets. These are
designed to indicate the effectiveness of the firm in using funds,
degree of efficiency, and its standard of performance of the
organization.

Example : Stock Turnover Ratio, Debtors' Turnover Ratio, Turnover

Assets Ratio, Stock working capital Ratio, working capital Turnover
Ratio, Fixed Assets Turnover Ratio.

d) Profitability Ratio:- These ratios show relationship between

profits and sales and profit & investments. It reflects overall
efficiency of the organizations, its ability to earn reasonable return
on capital employed and effectiveness of investment policies.

Example:
i) Profits and Sales: Operating Ratio, Gross Profit Ratio, Operating net
profit Ratio, Expenses Ratio etc.

ii) Profits and Investments: Return on Investments, Return on Equity

Capital etc.

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e) Coverage Ratios: - These ratios show relationship between profit in
hand and claims of outsiders to be paid out of profits.

Example: Dividend Payout Ratio, Debt Service Ratio and Debt Service
Coverage Ratio.

Classification from the view point of user:

Ratios from the users’ point of view are classified as follows.

a) Shareholders' point of view: - These ratios serve the

purposes of shareholders. Shareholders, generally expect the reasonable
return on their capital. They are interested in the safety of shareholders
investments and interest on it.

Example: Return on proprietor’s fund, Return on Capital, Earning per

share.

b) Long term creditors:- Normally leverage ratios provide useful

information to the long term creditors which include debenture
holders, vendors of fixed assets, etc. The creditors interested to know
the ability of repayment of principal sum and periodical interest
payments as and when they become due.

Example: Debt equity ratio, return on capital employed, proprietary ratio.

c) Short term creditors: - The short-term creditors of the

company are basically interested to know the ability of repayment of
short-term liabilities as and when they become due. Therefore, the
creditors has important place on the liquidity aspects of the company's
assets.

Example:
a) Liquidity Ratios - Current Ratio, Liquid Ratio
b) Debtors Turnover Ratio
c) Stock working capital Ratio.
d) Management : - Management is interested to use borrowed funds to
improve the earnings.

Example : Return on capital employed, turnover Ratio, Operating Ratio,

and Expenses Ratio.

5.8. BALANCE SHEET RATIOS

Current Ratio:
This ratio is also known as working capital ratio. This expresses
the relationship between current assets and current liabilities. This ratio
is calculated by dividing current assets by current liabilities. It is
expressed as pure ratio standard current ratio is 2:1. Means current
74
assets should be double the current liabilities.
Current Assets
CurrentRatio 
CurrentLiabilities

a) Current assets includes I) Inventories of raw materials, finished

goods, work-in-progress, stores & spare, loose tools, II) Sundry debtors,
III) Short-term loan, deposits, advance, IV) Cash on hand and bank, V)
Prepaid expenses, accrued income, VI) Bills receivables, VII)
Marketable investments, short term securities.

b) Current liabilities includes sundry creditors, bills payables,

outstanding expenses, unclaimed dividends, interest accrued but not
due on secured and unsecured loans, advances received, income
received in advance, provision for tax, purposed dividend loan
installment of secured and unsecured loan payable within 12 months.

c) Significance: This ratio tests the credit strength and solvency of an

organization. It shows strength of working capital, it indicates ability to
discharge short term liabilities.

Liquid ratio:

This ratio expresses the relationship between liquid assets and

liquid liabilities. This ratio is also known as quick ratio or acid test ratio.
This ratio is calculated by dividing liquid assets by liquid liabilities.
Standard quick ratio is 1:1.

Liquid  Assets / Quick  Assets

Liquid Ratio 
Quick orCurrentLiabilities

a) Liquid assets = Current assets less (Stock, prepaid expenses and

advance tax etc)
b) Liquid liabilities = Current liabilities less (Bank overdraft and cash
credit etc)

c) Significance:-

1) Indicate immediate solvency of enterprise.

2) Unlike CR it is more qualitative concept
3) As it eliminates inventories, it is rigorous test of liquidity.
4) More important for financial institutions.

Proprietary ratio:

Proprietary ratio is a test of the financial and credit strength of

the business. It establishes relationship between proprietors to total
assets. This ratio determines the long term solvency of the company.

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 Alternatively this ratio is also known as Worth Debt Ratio. Net
worth to Total Assets Ratio, Equity Ratio, Net worth Ratio or Assets
Backing Ratio, Proprietor's funds to Total Assets Ratio or Share holders
Funds to Total Assets Ratio.

This ratio is expressed in percentage.

a) Formula:-

Pr oprietor' sShareholder' sFund

Pr oprietaryRatio   100
Total Assets

b) Components:-

1) Proprietors Funds = Paid up equity + Reserves and surplus less

accumulated loss +

Paid up preference capital.

2) Total assets = Fixed assets + investment + current assets.

c) Purpose: - This ratio is exercised to indicate the long term

solvency of the business.

d) Significance: -

This ratio shows general financial strength of the business.

1) It determines the extent of trade on equity.
2) It indicates long term solvency of business.
3) It tests credit strength of business.

4) It can be used to compare proprietary ratio with others firms or

industry.

Stock-working capital ratio:

This ratio establishes relationship between stock and working capital.

Alternatively it is known as "Inventory-working capital ratio".

a) Formula:-
Stock
Stock  Working CapitalRatio 
Working Capital

b) Components:-
1) Stock (closing stock)
2) Working capital i.e. current assets less current liabilities.

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 It can be expressed in percentage also by multiplying this ratio
by 100.

c) Purpose :- This ratio shows the extent to which the

working capital is blocked in inventories.

d) Significance:-

1) This ratio highlights the predominance of stocks in current financial

position of organization.

2) A higher ratio indicates week working capital.

3) This ratio is the indicator of the adequacy of working capital.

e) Standard Ratio: - Standard stock working capital ratio is 1:1

Capital Gearing Ratio:

This ratio brings out the relationship between capital carrying

fixed rate of interest or fixed dividend and capital that doesn't carry
fixed rate of interest or fixed dividend. This ratio indicates degree to
which capital has been geared in the capital structure of the company.
Alternatively this ratio is also known as "Leverage ratio" or "Financial
leverage ratio" or " Capital structure ratio".

a) Formula:-

Capitalbearing Fixed Interest ordividend

CapitalGearing Ratio 
Capitalnotbearing Fixed Interest or dividend

b) Components:-

1) Capital bearing fixed interest or dividend comprises of debentures,

secured a n d unsecured loans, and preference share capital.

2) Capital not bearing fixed interest or dividend is equity share capital

and reserve & surplus. This ratio also can be expressed in %age by
multiplying this ratio by 100.

c) Purpose: - This ratio is used to understand the effective capital

structure of the company.

d) Significance:-

1) It is mechanism to ascertain the extent to which the company is

practicing trade or equity.
2) It brings one balanced capital structure.

77
Debt Equity Ratio:

This ratio express the relationship between external equities and

external equities i.e. owners' capital and borrowed capital.

a) Formula:-

Debt Long TermDebts

DebtequityRatio  OR OR
Equity ShareholdersFund
LongTermDebts
Shareholders' FundsLong TermDebts

b) Components:-
1) Debts include all liabilities including short term & long term i.e.
mortgage loan and debentures.
2) Shareholders’ funds consist of preference share capital, Equity share
capital, Capital and Revenue Reserves, Surplus, etc.

c) Significance:-
1) It shares favorable or non favorable capital structure of the
company.
2) It shows long term capital structure.
3) It reveals high margin of safety to creditors.
4) It makes us understand the dependence on long term debts.

d) Standard: - Standard debt- equity ratio is 2:1. It means debts

should be double the shareholders funds.

5.9. REVENUE STATEMENT RATIOS:

Revenue statement ratios are the ratios which highlights the

relation between two items from revenue statements i.e. Trading Account
and Profit and Loss Account.

Gross profit ratio:

Gross profit ratios express the relationship between gross profit and
net sales. This ratio is also known as "Turnover ratio" OR "Margin
ratio" OR "Gross margin ratio" OR "Rate of gross profit". This
ratio is expressed in percentage of net sales. This ratio says about %age
gross profit to net sales. a) Formula:-

GrossPr ofit
GrossPr ofitRatio  100
Sales

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b) Components of this ratio are:-

1) Net sales = Total sales less sales return

2) Gross profit = Sales - Cost of sales
3) Cost of sales = (opening stock + purchases + direct labour + other
direct charge) - closing stock

c) Significance:-

1) This ratio analyzes the basic profitability of business.

2) It shows the degree to which the selling price per unit may decline
without resulting in loss from operations.
3) Yearly comparisons of gross profit ratio reveal the trend of trading
results.

Operating Ratio:

This ratio studies the relationship between cost of activities and

net sales i.e. cost of goods sold and net sales. This ratio shows the
percentage of cost of goods sold with net sales. This ratio is expressed
in percentage.

a) Formula:-

OperatingCost
Operating Ratio  100
NetSales

b) Components: - Operating cost is equal to cost of goods sold and

other operating expenses like administrative expenses, selling &
distribution expenses etc. excluding finance expenses, income taxes, loss
on sale of assets, etc.

c) Purpose : - Purpose of operating ratio is to ascertain the

efficiency of the management regarding operation of business concern.

d) Significance:-

1) It is used to test operational efficiency of business.

2) This ratio is the yardstick which measures the efficiency of all
operational activities of business i.e. production, management,
administration, sales, etc.

e) Limitation of operating ratio:-

1) It cannot test profitability of business without considering extra -

ordinary items.
2) The utility of operating ratio is limited owing to its
vulnerability to changes in management decisions.

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Expenses Ratio:

This ratio explains relationship of items or group of expense to

net sales. Such ratios are collectively known as expanses ratio. This is
calculated and expressed in percentage. This Ratio expresses the
percentage of items of expenses with net sales.

a) Formula :

ItemorGroupof Expenses
ExpensesRatio  100
NetSales
Ad min istrativeExpenses
1) Ad min istrativeExpensesRatio  100
NetSales
Selling&Dist.Expenses
2) Selling &Dist.exp
 ensesRatio   100
NetSales
Costof materialconsumed
3) Costof materialconsumed Ratio 
NetSales
ManufacturingExpenses
4) ManufacturingExpensesRatio   100
Sales
Nonoperating Expenses
5) Non  operating exp ensesRatio   100
NetSales

c) Purpose and significance:-

1) This ratio helps us to know the cause behind overall changes in

operating ratio
2) Purpose of this ratio is to take corrective action.
3) It indicates the efficiency of management in controlled
expenses and improving profitability.
4) This ratio enables the income tax department to judge the
correctness and reliability of income disclosed in income tax returns.
5) Analytical study of this ratio can be judged by trend of
expenses.
6) Comparative study of year to year expenses can be possible.

Net profit ratio:-

Net profit ratio indicates the relationship between net profit and
net sales. Net profit can be either operating net profit or net profit
after tax or net profit before tax. Alternatively this ratio is also known
as “Margin on sales ratio". Normally this ratio is
calculated & expressed in Percentage.

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a) Formula :
NetPr ofit NPAT
NetPr ofitRatio   100OR  100
NetSales NetSales
NPDT ONP
OR  100OR  100
NetSales NetSale

b) Significance :-

1) It measures overall profitability of business.

2) It is very useful in judging return on investments.
3) It provides useful inferences as to the efficiency and profitability of
business.
4) It indicates the portion of net sales is available for proprietors.
5) It is clear index of cost control, managerial efficiency, sales
promotion, etc.

Net operating profit ratio :

Operating profit ratio indicates the relationship between operating

profit and net sales. This ratio is expressed in percentage.

a) Formula :

Netoperating Pr ofit
NetOperating Pr ofitRatio  100
NetSales

b) Components :-

1) Net operating profit is equal to gross profit minus all operating

expenses or sales minus cost of goods sold and operating expenses.
2) Net sales are equal to sales minus sales returns.

c) Significance:-

1) It signifies higher operating efficiency of management and control

over operating cost.
2) It indicates profitability of various operations of the organization i.e.
buy, manufacture, sales, etc.
3) It shows ability of organization to generate operating profit out of
its daily operations.

Stock Turnover Ratio:

Stock turnover ratio shows relationship between costs of

goods sold and average stock. This ratio is also known as
81
"Inventory Ratio" or "Inventory Turnover Ratio" or "Stock Turn
Ratio" or "Stock Velocity Ratio" or "Velocity of Ratio".

This ratio measures the number of times of stock turns or

flows or rotates in an accounting period compared to the sales affected
during that period. This ratio indicated the frequency of inventory
replacement. This ratio is expressed as rate.

a) Formula:-

Costof goodssold
Stock TurnoverRatio
AverageStock

b) Components:-

1) Cost of goods sold = Sales – Gross Profit

Opening stock clo sin g Stock 

2) AverageStock 
2

* If opening stock is not given, the closing stock is treated as average

stock.

c) Alternative method of stock turnover ratio: - This ratio can be

calculated by using average stock at selling price at as the denominator.
Under this method, average Stock at selling price is related to net sales.

NetSales
Stock TurnoverRatio
Averageinventoryatselling  price

d) Purpose: - Purpose of stock turnover ratio is to

1) Calculate the speed at which the stock is being turned over into
sales.
2) Calculate the stock velocity to indicate the period takes by average
stock to be sold out.
3) Judge how efficiently the stock are managed and utilized to generate
sales.

5.10. COMBINE RATIO / COMPOSITE RATIOS:

Combined or composite ratios relate two items or group of

items of which one is from balance sheet and another from revenue
statements of an enterprise.

Return on capital employed:

This ratio explains the relationship between total profit
earned by business and total investment made or total assets employed. It
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is expressed in percentage. This ratio is also known as "Return on
Investment", or "Return on Total Resources".

a) Formula:-
Pr ofitbeforetaxint erest
Returnonapitalemployed   100
CapitalEmployed

b) Components :
1) Net profit before tax, interest & dividends (PBIT)
2) Capital employed
Capital employed =
i) Equity share capital
ii) Add. Preference share capital reserve & surplus
iii) Add. Long term borrowings (Term loan + Debentures)
iv) Less: Fictitious assets like miscellaneous expenses not written
off.
v) Less profit & loss A/c Dr. Balance (loss)

c) Purpose :-

1) Purpose of this ratio is to measure overall profitability from the

total funds made available by owners and leaders.

2) Purpose of this ratio is to judge how efficient the business concern

is in managing the funds at its disposal.

d) Significance: -

1) This ratio is effective tools to measure overall managerial

efficiency of business.

2) Comparison of this ratio with other company and this information

can be obtained for determining future course of action.

3) This ratio indicates the productivity of capital employed and measures

the operating efficiency of the business.

Return on Proprietors Funds:

This ratio measures the relationship between net profit after tax
& interest and proprietors fund. This ratio is alternatively known as
"Return on proprietors' equity" or "Return on shareholders' investment"
or "Investors' ratio". This r a t i o is Expressed in percentage.

a) Formula :

NetPr ofitaftertax&Interest( NPATI )

ReturnonPr oprietor' sFund   100
Pr oprietor' sFund

83
b) Components:-

1) Net profit after tax and interest

2) Proprietors' funds

c) Purpose: -
1) Purpose of this ratio is to measure the rate of return on the total
fund made available by the owners.

2) This ratio helps to judge how efficient the concern is in

managing owners' funds at its disposal.

d) Significance: -
1) This ratio is very significant to prospective investors and
shareholders.
2) With the help of this ratio company can decide to rise finance from
external sources even from public deposit it ratio is satisfactory.
3) Shareholders can expect to capitalize its reserves and issue bonus
shares when ratio is higher for reasonable period of time.

Return on equity share capital:

This ratio explains relationship between net profit (after tax and
interest and dividend on preference share) and equity share holders'
funds. This ratio is expressed in percentage.

a) Formula:-

NetPr ofitaftertaxless preferencedividend

Re turnonEquityCapital  100
Equitysharecapital

Alternatively this ratio may be calculated by using following

formula for calculating the return per equity shares.

NetPr ofitaftertaxless preferencedividend

Re turnonEquityShares
Numberof Equityshare

b) Components:-

1) Net profit after tax & interest and preference dividend.

2) Equity share capital by adding reserves or deducting miscellaneous
expenditures.

c) Purpose:-
Purpose of this ratio is to calculate amount of profit available to
take care of equity dividend, transfer to reserves, etc.

84
d) Significance:-
1) It is useful to the investors while deciding whether to purchase
or sale of shares.

2) This ratio helps to make comparative study of equity capital with

other company and it will be appreciate if there is high return.

Earning per share :

Earning per share is calculated to find out overall profitability of
the organization. It represents earnings of the company whether or not
dividends are declared. Earning per share is determined by dividing net
profit by the number of equity shares.

a) Formula :-
NetPr ofitaftertax preferencedividend
Earning pershares EPS 
Numberof Equityshare

b) Components :-
1) Net profit after tax & interest - less preference dividend.
2) No. of equity shares.

c) Purpose :-
Purpose of this ratio is to calculate the amount of profit available
on each equity shares to take care of equity dividend , transfer to reserve,
etc.

d) Significance :-
1) This ratio helps the investors or shareholders to take decision while
purchasing or selling shares.
2) This ratio shows the possibilities of issue of bonus shares.
3) Higher ratio indicates overall profitability.

Dividend payout ratio :

This ratio shows relationship between dividend paid to equity
shareholders out of profit available to the equity shareholders.

a) Formula: -
This ratio is calculated as follows.

Dividend  perequityshares
Dividend  payoutratio
Earning  per shares

b) Components: -
1) Dividend per equity shares means total dividend paid to equity
shareholder dividend by number of equity shares.
2) Earning per shares refer to formula given above

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c) Purpose: - Purpose of this ratio is to measure the dividend
paying capacity of the company.

d) Significance: -
1) Higher ratio signifies that the company has utilized the larger portion
of its earning for payment of dividend to equity shareholders.
2) It says lesser amount of earning has been retained.

Price earnings ratio (P/E Ratio) :

This ratio measures relationship between market price of equity
shares and earnings per share. It is usually expressed as a fraction.

a) Formula: -

Market price perEquityshares

Pr iceEarning Ratio
Earning  per Equityshares

b) Components: -
1) Market price per equity share = quoted price of a listed equity
share.
2) Earnings per equity share refer to formula given above

c) Purpose: -
1) Purpose of this ratio is to show the effect of the earning on the
market price of the share.
2) It helps the investors while deciding whether to purchase, keep or
sell the equity shares.
3) It helps to ascertain the value of equity share.

Debt service Ratio :

Debt service ratio shows relationship between net profit and
interest payable on loans. This ratio is also called as interest coverage
ratio. This ratio is expressed as a pure number.

a) Formula :-

Net Pr ofitbeforeint erest&tax

DebtServiceRatio
InterestCh arg es

b) Components :-
1) Profit before interest & tax means net profit before payment of
interest on loan and tax.
2) Interest means interest on long term loans.

86
c) Purpose :-
1) Purpose of this ratio is to measure the interest paying capacity the
company.
2) The purpose of this ratio is to find out the number of times the
fixed financial charges are covered by income before interest and
tax.

d) Significance :-
1) It is important from the lenders' point of view.
2) It indicated whether the company will earn sufficient profits to pay
periodical interest charges.
3) It shows that the company will be able is pay interest
regularly.

Debt service coverage ratio :

Debt service coverage ratio shows the relationship between net
profit and interest plus loan installments payable. This ratio is
expressed in pure number.

a) Formula :-

Cash profitavailable for debtservicing

DebtServiceRatio
InterestInstallmentdueonloan

b) Components :-
1) Net profit + non-cash debit to P & L A/c (depreciation +
goodwill written off, deferred revenue expenditure written off, loss
on sale of fired assets) = cash profit for debit servicing.
2) Interest means interest on long term loan.
3) Installments means installments due on long term loan during the
year.

c) Purpose :- Purpose of this ratio is to measure the debt

servicing capacity of the company.

Creditors Turnover Ratio :

This ratio shows relationship between the net credit purchases and
theaverage creditors. This ratio is express as a rate.

b) Components: -
1) Credit purchases means gross credit purchases minus purchases
returns.

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2) Average creditors mean average of opening and closing amount
of creditors. If details are not given then only closing creditors
may be considered as average creditors.

3) Amount of bills payable.

c) Purpose: - Propose of this ratio is to measure the debt servicing

capacity of the company.

Creditors Turnover Ratio :

This ratio shows relationship between the net credit purchase and
the average creditors. This ratio is express as a rate.

a) Formula :

NetCreditPurchases Credit  purchases

Creditor' sTurnoverRatio OR
Averagecreditors CreditorsBills payable

365dayor12months
Credit  payment period OR( Creditorsvelocity )
Creditorsturnoverratio
CreditorsBills payable

Dailycredit  purchases
b) Components :
1) Credit purchases means gross credit purchases minus purchases
returns.
2) Average creditors mean average of opening and closing amount of
creditors. If details are not given then only closing creditors may be
considered as average creditors.
3) Amount of bills payable.

c) Purpose :

Purpose of this ratio is to.

1) Calculate the speed with which creditors are paid off on an average
during the year.
2) Calculate the creditors' velocity to indicate the period taken by the
average creditors to be paid off.
3) Judge how efficiently the creditors are managed.

Debtors' Turnover Ratio :

This ratio shows relationshipbetweencreditsales and average trade
debtors. Alternatively this ratio is known as "accounts receivable
turnover ratio" or "turnover of debtors' ratio". This ratio is expressed as a
rate.

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a) Formula :-

CreditSales Creditsales
DebtorsTurnoverRatio OR
Averagedebtors Averagereceivable

DebtorsBillsRe ceivable
Averagecollections period  OR
Dailycreditsales
365daysor12months 365days
 OR  Averagedebtors
Debtorsturnoverratio CreditSales

1) Sundry debtors
2) Accounts receivables i.e. bills receivables.
3) Average daily sales.

c) Purpose :- Purpose of this ratio is to.

1) Calculate the speed with which debtors get settled on an average
during the year.
2) Calculate debtors' velocity to indicate the period of credit allowed
to average debtors.
3) Judge how efficiently the debtors are managed.

5.11. LIMITATION OF RATIOS:

1) It is always a challenging job to find an adequate standard. The

conclusions drawn from the ratios can be no better than the standards
against which they are compared.
2) When the two companies are of substantially different size, age and
diversified products,, comparison between them will be more
difficult.
3) A change in price level can seriously affect the validity of
comparisons of ratios computed for different time periods and
particularly in case of ratios whose numerator and denominator are
expressed in different kinds of rupees.
4) Comparisons are also made difficult due to differences of the terms
like gross profit, operating profit, net profit etc.
5) If companies resort to ‘window dressing’, outsiders cannot look into
the facts and affect the validity of comparison.
6) Financial statements are based upon part performance and part events
which can only be guides to the extent they can reasonably be
considered as dues to the future.
7) Ratios do not provide a definite answer to financial problems. There
is always the question of judgment as to what significance should be

89
 given to the figures. Thus, one must rely upon one’s own good sense in
selecting and evaluating the ratios.

5.12. EXERCISE WITH SOLUTION

EX. 1 X Ltd. has a current ratio of 3.5:1 and quick ratio of 2:1. If excess
of current assets over quick assets represented by stock is Rs. 1,50,000,
calculate current assets and current liabilities.
Solution
Let Current Liabilities = x
Current Assets = 3.5x
And Quick Assets = 2x
Stock = Current Assets – Quick Assets
1,50,000 = 3.5x – 2x
1,50,000 = 1.5x
x = Rs.1,00,000
Current Assets = 3.5x = 3.5 × 1,00,000 = Rs. 3,50,000.

EX.2 Calculate the current ratio from the following information :

Working capital Rs. 9,60,000; Total debts Rs.20,80,000;
Long-term Liabilities Rs.16,00,000; Stock Rs.
4,00,000; prepaid expenses Rs. 80,000.

Solution
Current Liabilities = Total debt- Long term debt
= 20,80,000 – 16,00,000
= 4,80,000
Working capital = Current Assets – Current liability
9,60,000 = Current Assets – 4,80,000
Current Assets = 14,40,000

Quick Assets = Current Assets - (stock + prepaid expenses)

= 14,40,000 - (4,00,000 + 80,000)
= 9,60,000
Current ratio = Current Assets / Current liabilities
= 14,40,000 / 4,80,000
= 3:1
Quick ratio = Quick Assets / Current liabilities
= 9,60,000 / 4,80,000
= 2:1
EX.3 Calculate Debt Equity, from the following information:
10,000 preference share of Rs. 10 each Rs. 1,00,000
5,000 equity shares of Rs. 20 each Rs. 1,00,000
Creditors Rs. 45,000
Debentures Rs. 2,20,000
Profit and Loss accounts (Cr.) Rs. 70,000
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Solution
Debt = Debentures = Rs. 2,20,000
Equity = Equity share capital + Preferences Share Capital + profit and
Loss accounts

= Rs. 1,00,000 + Rs. 1,00,000 + Rs. 70,000

= Rs. 2,70,000

Debt Equity Ratio = Long term debt/ shareholders’ funds

= Rs. 2,20,000 / Rs. 2,70,000
= 0.81:1
EX.4 Calculate Debt Equity Ratio, from the following information :
Total Debts Rs. 3,00,000; Total assets Rs. 5,40,000; Current
liabilities Rs. 70,000.

Solution
Long-term Debt = Total Debt – Current Liabilities
= Rs. 3,00,000 – Rs. 70,000 = Rs. 2,30,000

Shareholders Funds = Total Assets – Total Debts

= Rs. 5,40,000 – Rs. 3,00,000
= Rs. 2,40,000

Debt Equity Ratio = Long term debt/ Shareholders’ funds

= Rs. 2,30,000/Rs. 2,40,000
= 0.96:

EX.5 Shareholders’ funds Rs. 80,000; Total debts Rs. 1,60,000; Current
liabilities Rs. 20,000. Calculate Total assets to debt ratio.

Solution

Long term debt = Total Debt - Current liabilities

= Rs. 1,60,000- Rs. 20,000
= Rs. 1,40,000

Total Assets = Shareholders’ funds + Total debt

= Rs. 80,000 + Rs. 1,60,000
= Rs. 2,40,000

Total Assets to debt ratio = Total Assets/ Debt

= Rs. 2,40,000 / Rs. 1,40,000
= 12:7
= 1.7:1
EX.6 From the following balance sheet of a company, calculate debt
equity ratio, total assets to debt ratio and proprietary ratio

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 Balance Sheet of X ltd as on 31.12.2007

Preference Share Capital 7,00,000 Plant and Machinery 9,00,000

Equity Share Capital 8,00,000 Land and Building 4,20,000

Reserves 1,50,000 Motor Car 4,00,000

Debentures 3,50,000 Furniture 2,00,000

Current Liability 2,00,000 Stock 90,000

Debtors 80,000

Cash and Bank 1,00,000

Discount on Issue of 10,000

Shares
22,00,000 22,00,000

Solution

Debt equity Ratio = Long-term Debt/Equity

Total Assets Ratio= Total Assets / long term Debt
Proprietary Ratio = Shareholders Funds/Total assets
Debt equity ratio = Rs. 3,50,000 / Rs. 16,40,000 = 0.213
Total Assets Ratio= Rs. 21,90,000 / Rs. 3,50,000 = 6.26
Proprietary Ratio = Rs. 16,40,000 / Rs. 21,90,000 = 0.749

EX.7 From the following information, calculate Debt Equity Ratio, Debt
Ratio, Proprietary Ratio and Ratio of Total Assets to Debt.

Balance Sheet as on December 31, 2006

Equity share Capital 3,00,000 Fixed Assets 4,50,000

Preference Share Capital 1,00,000 Current Assets 3,50,000
Reserves 50,000 Preliminary Expenses 15,000
Profit & loss A/C 65,000
11 % Mortgage Loan 1,80,000
Current liabilities 1,20,000

8,15,000 8,15,000

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Solution

Shareholders Funds = Equity Shares capital + Preference Shares capital +

Reserves + profit % loss A/C - Preliminary Expenses
= Rs. 3,00,000 + Rs. 1,00,000 + Rs.50,000 + Rs. 65,000 -
Rs. 15,000
= Rs. 5,00,000

Debt Equity Ratio = Debt / Equity

= Rs. 1,80,000 / Rs. 5,00,000 = 0.36: 1

Proprietary Ratio = Proprietary funds / Total Assets

= Rs. 5,00,000 / Rs. 8,00,000
= 0.625:1
Total Assets to Debt Ratio = Total Assets / Debt
= Rs. 8,00,000 / Rs. 1,80,000
= 4.44:1

EX.8 The debt equity ratio of X Ltd. is 1:2. Which of the following would
increase / decrease or not change the debt equity ratio?
i) Issue of new equity shares
ii) Cash received from debtors
iii) Sale of fixed assets at a profit
iv) Redemption of debentures
v) Purchase of goods on credit.

Solution :
a) The ratio will decrease. This is because the debt remains the same,
equity increases.
b) The ratio will not change. This is because neither the debt nor equality
is affected.
c) The ratio will decrease. This is because the debt remains unchanged
while equity increases by the amount of profit.
d) The ratio will decrease. This is because debt decreases while equity
remains same.
e) The ratio will not change. This is because neither the debt nor equity
is affected.

EX.9 From the following information, calculate stock turnover ratio.

Opening stock Rs 58,000; Excess of Closing stock opening stock
Rs. 4,000; sales Rs. 6,40,000; Gross Profit @ 25 5 on cost

Solution :
Cost of goods Sold = Sales - Gross Loss
= Rs. 6,40,000 – 25/125(6,40,000)
= Rs. 5,12,000

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Closing stock = Opening stock + Rs. 4000
= Rs. 58,000 + Rs 4,000
= Rs. 62,000
Average stock = (Opening stock + Closing Stock)/2
= (58,000 +62,000)/2
= Rs. 60,000
Stock Turnover Ratio = Cost of Goods Sold/ Average Stock
= Rs.5,12,000 / Rs. 60,000 = 8.53 times.
EX.10 A trader carries an average stock of Rs. 80,000. His stock turnover
is 8 times. If he sells goods at profit of 20% on sales. Find out the profit.
Solution
Stock Turnover Ratio = Cost of Goods Sold/ Average Stock
= Cost of Goods Sold/Rs. 80,000
Cost of Goods Sold = Rs. 80,000 × 8
= Rs. 6,40,000
Sales = Cost of Goods Sold × 100/80
= Rs. 6,40,000 × 100/80
= Rs. 8,00,000
Gross Profit = Sales – Cost of Goods Sold
= Rs. 8,00,000 – Rs. 6,40,000
= Rs. 1,60,000.
EX.11 Calculate the Debtors Turnover Ratio and debt collection period
(in months) from the following information:
Total sales = Rs. 2,00,000
Cash sales = Rs. 40,000
Debtors at the beginning of the year = Rs. 20,000
Debtors at the end of the year = Rs. 60,000
Solution
Average Debtors = (Rs. 20,000 + Rs. 60,000)/2 = Rs. 40,000
Net credit sales = Total sales - Cash sales
= Rs.2,00,000 - Rs.40,000
= Rs. 1,60,000
Debtors Turnover Ratio = Net Credit sales/Average Debtors
= Rs. 1,60,000/Rs. 40,000
= 4 Times.

Debt collection period = 12 months/52 weeks/365 days

Debtors’ turnover
= 12/4
= 3 months

94
EX.12 Cash purchased ratio Rs. 1,00,000; cost of goods sold Rs.
3,00,000; opening stock Rs. 1,00,000 and closing stock Rs. 2,00,000.
Creditors turnover ratio 3 times. Calculate the opening and closing
creditors if the creditors at the end were 3 times more than the creditors at
the beginning.
Solution
Total Purchase = Cost of goods sold + closing stock - opening stock
= Rs. 3,00,000 + Rs. 2,00,000 – Rs. 1,00,000
= Rs. 4,00,000
Credit purchases = Total Purchase - cash purchase
= Rs. 4,00,000- Rs. 1,00,000
= Rs. 3,00,000
Creditor Turnover Ratio = Net Credit Purchase / Average Creditor
Average Creditor = Rs. 3,00,000/ 3
= Rs. 1,00,000

(opening Creditor + Closing Creditor)/2 = Rs. 1,00,000

opening Creditor + Closing Creditor = Rs. 2,00,000
(opening Creditor + (opening Creditor + 3opening Creditor)
= Rs. 2,00,000
Opening Creditor = Rs. 40,000
Closing Creditor = Rs. 40,000 +(3 X Rs. 40,000)
= Rs. 1,60,000

EX.13 From the following information, calculate (i) Fixed Assets

Turnover and (ii) Working Capital Turnover Ratios :

Preference Shares Capital 6,00,000 Plant and Machinery 6,00,000

Equity Share Capital 4,00,000 Land and Building 7,00,000
General Reserve 2,00,000 Motor Car 2,50,000
Profit and Loss Account 2,00,000 Furniture 50,000
15% Debentures 3,00,000 Stock 1,70,000
14% Loan 1,00,000 Debtors 1,20,000
Creditors 1,40,000 Bank 90,000
Bills Payable 30,000 Cash 20,000
Outstanding Expenses 30,000
20,00,000 20,00,000

Sales for the year were Rs. 60,00,000.

95
Solution
Sales = Rs 60,00,000
Fixed Assets =Rs. 6,00,000 + Rs.7,00,000 + Rs. 2,50,000 + Rs. 50,000
Working capital = Current Assets – Current Liabilities
Current Assets = Stock + Debtors + bank + cash
Rs. 1.70,000 + Rs. 1.20,000 + Rs. 90,000 + Rs. 20,000
Rs. 4,00,000

Current Liabilities = Creditors + BIP + OIS Exp

= Rs. 1,40,000 + Rs. 30,000 + Rs. 30,000
= Rs. 2,00,000

Working capital = Rs. 4,00,000 + Rs. 2,00,000

= Rs. 2,00,000

Fixed Turn over Ratio = Net sale / Fixed assets

= Rs. 60,00,000/ Rs. 16,00,000 = 3.75 times

Working capital Turnover = Net Sale / Working Capital

= Rs. 60,00,000/ Rs. 2,00,000 = 30 times.

EX.14 Calculate Gross Profit ratio from the following information:

Opening stock Rs. 50,000; closing stock Rs. 75,000; cash sale Rs.
1,00,000; credits sales Rs 1,70,000; Returns outwards Rs. 15,000;
purchased Rs. 2,90,000; advertisement expenses Rs. 30,000; carriage
inwards Rs.
10,000.

Solution :
Cost of goods sold = Opening stock + net purchases + direct expenses –
closing stock
= Rs. 50,000 + (Rs. 2,90,000- Rs. 15,000) + Rs. 10,000 - Rs.
75,000
= Rs. 2,60,000

Total Sales = Cash Sales + Credits Sales

= Rs. 1,00,000 + Rs 1,70,000
= Rs. 2,70,000

Gross profit = Total Sales - Cost of goods sold

= Rs. 2,70,000- Rs. 2,60,000
= Rs. 10,000

Gross profit Ratio = 10,000 X 100

2,70,000
= 3.704 %
96
EX.15 Calculated price earnings ratio from the following information:
Equity share capital (Rs. 10 per Share) Rs 2,50,000
Reserves (including current year’s profit) Rs 1,00,000
10 % Preference Share Capital Rs 2,50,000
9 % Debentures Rs 2,00,000
Profit before interest Rs 3,30,000
Market Price per Share Rs 50.
Tax rate 50 %

Solution :
P/E Ratio = Market price of a Share/Earnings per Share

Earning per share = Profit available for equity shareholders/ No. of Equity
Share

Profit available for equity shareholders:

Profit before interest = Rs. 3,30,000

Less interest on debentures = Rs 18,000

Rs 3,12,000
Less tax ( 50 % of Rs. 3,12,000) = Rs. 1.56,000
Less preference dividend = Rs. 25,000
Earning after Tax = Rs 1,31,000

Earning per share = Earning after tax / No.of equity shares

= Rs 1,31,000/ 25,000
= Rs. 5.24

P/E Ratio = Market price share / Earning per share

= Rs. 50/ Rs. 5.24
= Rs. 9.54

Ex.16 Following is the trading and profit and loss account for the year
ended 31 st March 2014 and balance sheet as on that date of Sun. ltd.

Trading and profit and loss account for the year ended 31st March 2014.

Particulars Amt. Particulars Amt.

To Opening Stock 2,50,000 By Sales ( Credit) 37,00,000
To Purchases 26,00,000 By Closing Stock 5,00,000
To Gross Profit c/d 13,50,000
Total 42,00,000 Total 42,00,000
To Administration Exps. 2,70,000 By Gross Profit 13,50,000
To Interest 72,000 By Profit on sale of Assets 50,000

97
 To Rent 60,000
To Selling Exps 1,00,000
To Depreciation 1,20,000
To Provision for I.Tax 2,78,000
To Proposed Dividend 1,00,000
To Net Profit 4,00,000
Total 14,00,000 14,00,000

Balance sheet as on 31.3.2014

Liabilities Amt. Assets Amt.

Equity Share Capital ( Rs.10) 5,00,000 Fixed Assets (at cost) 12,40,000

11% Preference Sh. Capital 3,00,000 Short Term Capital 1,00,000

General Reserve 4,00,000 Trade Receivable 9,50,000

12% Debenture 6,00,000 (Last Year Rs. 9,00,000)

Trade Payable 3,00,000 Inventories 5,00,000

Proposed Dividend 1,00,000 Cash and Bank 1,50,000

Bank Overdraft 2,00,000 Discount on Issue of Shares 60,000

Provision For Depreciation 4,00,000

Provision for Tax 2,00,000

30,00,000 30,00,000

From the above information calculate following ratios and comment on

current ratio.

1. Current ratio
2. Inventory Turnover Ratio
3. Return on Proprietors Fund
4. Operating Ratio
5. Debtors Turnover Ratio
6. Capital Gearing Ratio
7. Dividend Payout Ratio

Assume 360 days in a year.

Note : Drafting of Vertical Financial Statement is not expected. Ans. :

98
S. Ratio Formula Calculation Ans.
No.
1. Current CA 1,700 2.13:1
Ratio CL 300
2. Inventory COGS 2,350 6.27
Turnover Avg.Stock 375 Times
Ratio
3. Return on NPAT 500 43.86%
 100  100
Proprietors Pr op.Fund 1140
Fund
4. Operating COGS  Op.ExpsInt. 2,350  550  72 80.32%
Ratio  100  100
NetSales 3700
5. Debtors CreditSales 3,700 4
Turnover Avg. A / cRe ceivable 925 Times
Ratio 90 days
No.Days 1,700
DTR 300
6. Capital 
Pr ef .Cap LTC 300  600 1.07
Gearing EquitySh.HolderFund 840
Ratio
7. Dividend Eq.Dividend 1,00,000 21.41%
Payout Pr ofit Available forEq.Sh.Ho. 5,00,000  33,000
Ratio

Current Ratio is more than standard Current Ratio is more than standard
current Ratio 2:1 This shows favorable short term financial position.

Ex.17 Following is the balance sheet of Bliss Happiness Ltd. as at 31st

March 2013
Balance sheet as at 31.3.2013

Liabilities Amt. Assets Amt.

Equity Share Capital 1,00,000 Machinery 2,96,000
General Reserve 70,000 Investment 1,12,000
10% Preference Capital 1,80,000 Stock In Trade 1,01,000
15% Debenture 1,20,000 Bills Receivable 20,000
Trade Payable 1,22,000 Trade Receivable 49,000
Bank Overdraft 20,000 Cash and Bank 38,000
Provision for Tax 18,000 Profit and Loss A/c 14,000
6,30,000 6,30,000

99
 Sale for the year Rs.7,00,000; Gross profit Rate 25% and Opening Stock
is Rs.1,09,000. Profit before

Tax for the year ending 31.3.13 is Rs.2,10,000.

You are required to compute the following ratios and comment on current
ratio.

1. Current Ratio
2. Acid Test Ratio
3. Stock turnover Ratio
4. Capital Gearing Ratio
5. Proprietary Ratio
6. Debt Equity Ratio ( Debt / Net worth)
7. Return on Capital Employed

Redrafting the given Balance sheet in vertical format is not expected.

Ans.

Current Current Assets 1,01,000  20,000  49,000  38,000 1.3

Ratio 1,22,000  20,000  18,000
CurrentLiabilities
Acid Test Liquid  Assets 20,000  49,000  38,000 .76
Ratio 1,22,000  18,000
Quick Liabilities
Stock Costof goodssold 7,00,000  1,75,000 5 Time
Turnover
Op.Cl.Stock  / 2 1,09,000  1,01,000  / 2
Capital Fixed Int.BearingSecurities 1,80,000  1,20,000 1.92
Gearing Eq.ShCap.Re s&SurplusLoss
Ratio 1,00,000  70,000  14,000
Proprietory Pr oprietor' sFund 1,00,000  1,80,000  70,000  14,000
 100
54.44%
Ratio  100 2,96,000  1,12,000  2,08,000
Total Assets
Debt. Debt 1,20,000 36
Equity 1,00,000  1,80,000  70,000  14,000
Ratio NetWorth
Return on NPBIT 2,10,000  18,000 50%
capital  100  100
employed CapitalEmployed 1,20,000  3,36 ,000

Current ratio is 1:3. It is lower than the standard of 2:1. The current
assets for every rupee of current liabilities. Current assets are not
sufficient to pay current liabilities short tern solvency position of the
company is not satisfactory.

Ex.18 M/s Sumit Ltd. Presents the following Trading and Profit & Loss
A/c for the year ended 31.3.2014 and balance sheet as on that date.

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Trading and profit and loss account for the year ended 31.3.2014.

Particulars Amt. Particulars Amt.

To Opening Stock 2,00,000 By Sales 12,00,00
To Purchases 5,00,000 By Closing Stock 4,00,000
To Wages 3,00,000
To Gross Profit c/d 6,00,000
16,00,000 16,00,00
To Salaries 1,50,000 By Gross Profit b/d 6,00,000
To Rent 60,000 By Profit on sale of 5,000
To Commission 12,000 By Interest 15,000
To Advertising 20,000
To Interest 83,000
To Depreciation 30,000
To Provision For tax 50,000
To Net Profit c/d 2,15,000
6,20,000 6,20,000
To Proposed Dividend 80,000 By balance b/f 1,85,000
To Preference Dividend 16,000 By Net profit b/d 2,15,000
To Balance c/d 3,04,000
4,00,000 4,00,000

Balance sheet as on 31.3.2014

Liabilities Amt. Assets Amt.

Equity share capital 8,00,000 Land and Building 6,00,000
( Rs.100)
8% Pref. Sh. Capital 2,00,000 Plant and Machinery 5,50,000
Reserve and surplus 3,04,000 Furniture 4,00,000
7% Debentures 5,00,000 Investment 2,70,000
Loan from IDBI 6,00,000 Stock 4,00,000
Creditors 1,50,000 Debtors 2,00,000
Bills Payable 50,000 Bills Receivable 1,60,000
Provision for tax 50,000 Advance tax 30,000
Dividend Payable 96,000 Prepaid expenses 40,000
Cash in Hand 20,000
Bank Balance 60,000
Dis. On Issue of 20,000
Debentures
27,50,000 27,50,000

Additional Information:
1. The Market Price of equity shares as on 31.3.2014 was Rs.90.
2. Out of total sales, 30% are cash sales and out of total Purchases, 50%
are credit purchases. You are required to calculate the following
Ratios.
a) Return on capital employed d) Creditors Turnover Ratio
b) Price Earning ratio e) Return on Equity capital
c) Debt Service Ratio
101
 Ans :

Return on NOPBIT 1,01,000  20,000  49,000  38,000 14..39%

Capital  100 1,22,000  20,000  18,000
Employed CapitalEmployed
Creditors CreditPurchases 2,50,000 1.25
Turnover Time

Av.Creditors  Bills payable 2,00,000

365 365
Payment 292 days
Period CTR 1.25
Price MP 7,00,000  1,75,000 3.62
Earning
Ratio EPS 1,09,000  1,01,000  / 2
EPS NetPr ofitPr ef .Div. 2,15,000  16 ,000
24.88
 EquityShares
No.of 8,000

Return on NPAT  Pr ef .Div. 2,15,000  16 ,000 24.875%

Equity Eq.ShCap.
 100
Capital 8,00,000
Debt NPBIT 2,15,000  50,000  83,000 4.19
Equity Times
Ratio Interest 83,000

Ex.19 The following is the summarized profit and loss A/c of M/s Hema
Ltd. For the year ended 31.32014.

Particulars Amt. Particulars Amt.

To Opening Stock 5,00,000 By Sales 50,00,000
To Purchases 25,00,000 By profit on sale of 50,000
assets
To Wages 25,000 By Interest 25,000
To Freight and Octroi 80,000 By Dividend 10,000
To Direct Expenses 75,000 By Closing Stock 7,50,000
To Office Insurance 80,000
To Office Staff Salaries 2,00,000
To Gen. Manager Salary 50,000
To Staff Welfare Expenses 40,000
To Printing and Stationery 5,000
To Interest 50,000
To Audit Fees 15,000
To Office Rent 2,00,000
To Computer Repairs 75,000
To Advertising 2,50,000
To Bad Debts 5,000
To Traveling 20,000
To Commission 75,000

102
 To Dep. On Furniture 30,000
To Depn. On Building 40,000
To Depn on Vehicles 20,000
To Interim Dividend 50,000
To Loss on sale of Assets 1,00,000
To Income Tax 50,000
To Net Profit 13,00,000
58,35,000 58,35,000
Calculate the following Ratio;
1. Gross Profit Ratio
2. Operating Profit Ratio
3. Office Expense Ratio
Vertical statement is not expected. Ans.

Gross GrossPr ofit 1,01,000  20,000  49,000  38,000 51.4%

Profit Ratio  100 1,22,000  20,000  18,000
NetSales
Operating Operating Cost 24,30,000  11,55,000 71.7%
Ratio  100  100
NetSale 50,00,000
COGS + Operating Exps. =
Operating cost
Office OfficeExpense 7,55,000
 100
15.1%
Expense  100
Ratio NetSales 50,00,000

Ex. 20 The following is the balance sheet of M/s Shyam Ltd. Ason
31.3.2014.

Balance sheet as on 31.3.2014

Liabilities Amt. Assets Amt.

Equity share capital (Rs.10) 4,00,000 Goodwill 1,25,000
9% Pref. Sh. Cap. (Rs.10) 2,00,000 Furniture & Fitting 3,00,000
General Reserve 1,00,000 Land and Building 4,00,000
Profit and Loss A/c 1,00,000 Stock 1,00,000
10% Mortgage Loan 2,00,000 Debtors 2,00,000
Accounts Payable 1,00,000 Cash and Bank 60,000
Adv. From Customer 50,000 Prepaid Expenses 40,000
Prov. For Tax. 60,000 Preliminary Expenses 15,000
Proposed Dividend 40,000 Dis. on Issue of Deb. 10,000
12,50,000 12,50,000

103
 The following further information is also given for the year;

Total sales Rs.10,00,000 net profit rate 15%. Out of total sales 20% are
cash sales. Purchases Rs.5,00,000. No. of days in a year 360. Calculate
the following Ratio :
a) Proprietory Ratio
b) Acid Test Ratio
c) Creditors Turnover Ratio
d) Debt Equity Shares
e) Stock Working Capital Ratio
f) Capital Gearing Ratio
g) Operating Ratio

Ans:

Operating OperatingCost 1,01,000  20,000  49,000  38,000

Ratio  100 1,22,000  20,000  18,000
Sales

Acid Test Liquid  Assets 2,00,000  60,000 1.3:1

Ratio 1,00,000  60,000  40,000
Quick Liabilities
Creditors CreditPurchases 5,00,000 5 Times
Turnover 1,00,000
Ratio Creditors
Capital Fixed Int.Bearing Securities 2,00,000  2,00,000 0.07:1
Gearing Eq.ShCap.  Re s&SurplusLoss 4,00,000  1,00,000  1,00,000 15,000 10,000
Ratio
Proprietory Pr oprietor' sFund 4,00,0002,00,0001,00,0001,00,00015,00010,000
100
 100
Ratio Total Assets 12,50,00015,00010,000

Debt Equity Debt 2,00,000 0.26:1

Ratio
NetWorth 7,75,000
Stock Clo sin g Stock 1,00,000 0.67:1
Working
Capital Working Capital  2,00,000  60,000  1,00,000  40,000
Ratio

Ex21 Calculate Gross Profit Ratio:

Particulars Amt. Particulars Amt.

To Opening Stock 60,000 By Sales 4,00,000
To Purchases 2,50,000 By Goods Destroyed by fire 20,000
To Carriage Inward 30,000 By Closing Stock 80,000
To Office Expenses 50,000
To Selling Expenses 40,000
To Loss by fire 20,000
To Net Profit 50,000
5,00,000 5,00,000
104
 GrossProfit
GrossProfitRatio:  100
Sale
1,60,000
  100  40%
4,00,000

Gross Profit = 4,00,000 – (60,000+ 2,50,000 -20,000 +30,000 - 80,000)

Ex.22 Following is the Revenue Statement of Promod Ltd.

Trading , Profit & Loss account for the year ended 31.3.2014

Particulars Amt. Particulars Amt.

To Opening Stock 27,150 By Sales 2,55,000
To Purchases 1,63,575 By Closing Stock 42,000
To Carriage Inward 4,275 By Interest received on Invt. 2,700
To Office Expenses 45,000
To Sales Expenses 13,500
To Loss on sale of Fixed asset 1,200

To Net Profit c/d 45,000

2,99,700 2,99,700
Calculate the following ratio:
a) Gross Profit Ratio
b) Stock Turnover Ratio
c) Net Profit before tax ratio
d) Operating Ratio
e) Office Expense Ratio

Ans.

Gross GrossPr ofit 1,02,000

 100
40%
Profit Ratio  100
NetSales 2,55,000

Operating Operating Cost 1,53,000  58,500 82.94%

Ratio  100  100
NetSale 2,55,000
COGS + Operating Exps. =
Operating cost
Office OfficeExpense 45,000
 100
17.65%
Expense  100
Ratio NetSales 2,55,000

Stock COGS 1,53,000 4.43

Turnover 45,000 Times
Ratio Avg.Stock
Net Profit 45,000 17.65%
NPBT  100
before tax  100 2,55,000
Ratio NetSales

105
 Ex.23 The summarized balance sheet of Bad Luck ltd. As on 31.3.2014
is as follow.

Balance sheet as on 31.3.2014 (In lakh)

Liabilities Amt. Assets Amt.
Equity share capital (Rs.100) 150 Fixed Assets (at cost) 420

9% Pref. Sh. Cap. (Rs.10) 80 Less: Depreciation 50 370

Reserve and Surplus 90 Stock 50
Profit and Loss A/c 40 Debtors 60
10% Debentures 50 Cash at bank 30
Provision for Taxation 20
Sundry Creditors 80
510 510

The following particulars are also given for the year.

Rs. In Lakhs
Net Sales (Credit) 240
Profit before interest and Tax 65
Net profit after tax 40
Market Price per equity shares is Rs.150

Calculate the following ratio:

a) Acid test Ratio
b) Debtors turnover Ratio (360 days in a year)
c) Capital Gearing Ratio
d) Debt service Ratio
e) Return on Proprietor’s Fund

Ans.: (Rs. In Lakh)

Debtors NetCreditSales 240 4 Times

Turnover
Ratio DebtorsB.R. 60

Creditors Liquid  Assets 60  30 0.9:1

Turnover 20  80
Quick Liabilities
Capital Fixed Int.Bearing Securities 80  50 0.46:1
Gearing 150  90  40
Ratio 
Eq.Sh.Cap.  Re s&Surplus  Loss
Debt Net profitbeforeInt.&
 Tax 65 13
Service Interest Times
Ratio 5
Return on NPAT 40,00,000 11.11%
Proprietor’s  100  100
Fund Pr oprietor' sFund 3,60,00,000

106
 Ex.24 Following is the balance sheet of M/s Moon Ltd.

Balance sheet as on 31.3.2014

Liabilities Amt. Assets Amt.

Equity share capital 5,00,000 Fixed Assets 13,00,000
General Reserve 3,00,000 Investment 4,00,000
Securities Premium 25,000 Stock 8,50,000
10% Debenture 7,50,000 Sundry Debtors 5,00,000
Profit & Loss A/c 7,40,000 Prepaid Expenses 40,000
Sundry Creditors 2,30,000 Adv. Income tax 78,000
Bank Overdraft 3,95,000 Cash and Bank Bal. 62,000
Prov. For Taxation 1,80,000 Share Issue Expenses 10,000
Prop. Equity Dividend 1,50,000 Preliminary Expenses 30,000
32,70,000 32,70,000

You are required to compute the following ratio and give your comments
on each ratio with reference to standard ratio.
a) Current Ratio
b) Liquid Ratio
c) Proprietory Ratio
d) Stock working capital Ratio
Ans:

Current Current Assets 15,30,000 1.6:1

Ratio
CurrentLiabilities 9,55,000

Acid Test Liquid  Assets 5,62,000 1:1

Ratio
Quick Liabilities 5,60,000

Stock Stock 8,50,000 5 Time

Working
Ratio Working Capital 5,75,000

Proprietory NetWorth 15,25,000 47.21%

Ratio  100  100
Total Assets 32,30,000

Comments:
1. Short term solvency of the company is satisfactory. In industry,
current ratio of 1.50 is considered satisfactory Rs.1 current liabilities
are supported by Rs.1.60 current assets.
2. Immediate solvency of the company is quite satisfactory as the
company has sufficient quick assets to pay off its quick liabilities. The
company can meet its urgent liabilities.
3. Long term solvency of the company is not satisfactory. Only 47.12%
of its total assets are financed by own fund. Margin of safety for the
lenders of the company is not satisfactory. The company should
improve this ratio by increasing shareholders fund to bring it to 65%
or above. The company does not have financial stability.
107
4. Company stock is 147.83% of its working capital. Company is
carrying excess stock. Company inventory management is not
satisfactory. Stock may contain defective or slow moving items.
Ideally stock should not exceed working capital. Working capital
position of the company is unsatisfactory. There is excessive
incidence of inventory in working capital management.

Ex.25
a) The current ratio of a company is 4:1 and its current liabilities are
Rs.50,000. The quick ratio is 2:1. Calculate the value of stock.
b) A trader carries an average stock (valued at cost) of Rs.50,000 and
turns this over five times a year at a G.P. ratio of 20%. His
administrative and selling and distribution overheads amount to
Rs.20,000 in the year. Find the net profit

a) Stock turnover5Times
Current Assets COGS
CurrentRatio  Stock Turnover 
CurrentLiabilities Avg.Stock
4 Current Assets
  5
COGS
1 50,000 50,000
Current Assets2,00,000 COGS  2,50,000
Quick  Assets GrossPr ofit  20%onsales
Quick Ratio
Quick Liabilities
b) i.e.25%onCOGS
Current Assets  Stock
Quick Ratio 
G.P.62,500
CurrentLiabilities
NetPr ofit
2 2,00,000  Stock
  GrossPr ofit62,500
1 50,000
Stock 1,00,000 Less : Selling Exps. 20,000
Net profit42,500

Ex.26 Following are the ratio relating to the activities of Indo ltd.

Debtors velocity 3 months; Stock velocity 8 months; Creditors velocity 2

months; gross profit 25%. G.P. for the year amounting to Rs.4,00,000;
Closing stock is Rs.10,000 above opening stock. Bills receivable
Rs.25,000; Bills Payable Rs.10,000.
Find out : a) Sales b) Debtors c) Closing stock d) Creditors.

108
 GrossPr ofit b) Debtors
GrossPr ofitRatio   100 Debtors  BillsRe ceivable
NetSales Velocity  12
25 4,00,000 Netcreditsales
 Debtors  25,000
100 NetSales  12
a)
NetSales16 ,00,000 16 ,00,000
COGS  Sales  G.P. Debtors  3,75,000
 16 ,00,000  4,00,000 Avg.Stock
Stock Velocity   12
 12,00,000 COGC
Avg.Stock
8   12
12,00,000
Avg.Stock  8,00,000
Op.Stock  Cl.Stock
Avg.Stock 
2
x  x  10,000
8,00,000 
2
X  7,95,000
 Opening Stock
c) d) Creditors
Clo sin gStock  X  1,00,000 Creditors  1,00,000
Velocity   12
 7,95,000  10,000 NetCreditPurchases
 8,05,000 Creditors  1,00,000
2  12
Purchase  COGC  Op.Stock  Cl.Stock 12,10,000
 12,00,000  7,95,000  8,05,000 Creditor  1,91,656
 12,10,000

Ex.27
a) Current Ratio is 2.5, Liquid Ratio is 1.5, Working capital is
Rs.50,000. Ascertain current Assets and inventory.
b) Turnover is fixed assets ratio is 1:1.5: value of goods sold is
Rs5,00,000. Compute the value of Fixed assets.

Ans.

a) b)
1) TurnovertoFixed  Assets
Current Assets 2.5
CurrentRatio   Turnover
CurrentLiabilities 1 
2 Fixed  Assets
SoCurrent Assets  2.5Current Assets  Current Liabilities
50,000  2.5CL  CL 1 5,00,000
50,000  1.5CL 
CL  33,333
1.5 Fixed  Assets
CA  WC  CL Fixed  Assets  7,50,000
CA  50,000  33,333
CA  83,333

109
2)
Quick  Assets
Quick Ratio
Quick Liabilities
CA  Stock
1.5
CL
83,333  Stock
1.5 
33,3333
Stock 33,333

Ex.28
a) Gross profit on sales is 25%; cost of goods sold Rs.4,00,000. Find out
sales.
b) Average stock of a firm is Rs.1,00,000 and its opening stock is
Rs.10,000 less than closing.

Calculate its opening and closing stock.

SalesCOGS GP Avg.Stock  1,00,000

10075 25 Op.Stock  Cl.Stock

a) 25 2
GrossPr ofit4,00,000 
75 Henceassumeopening Stock asx
b)
 1,33,333 SoClo sin g Stock x  10,000
x  x  10,000
1,00,000 
2
X  95,000
Opening Stock =95,000
So Closing Stock =95,000+1,00,000

5.13. PRACTICE

A - PRATICAL QUESTIONS

1 From the following financial statement of Sanket Ltd. calculate the

following ratios.
a) Current Ratios b) Liquid Ratios
c) Stock Turnover Ratio d) Debtors Turnover Ratio
e) Operating Ratio f) Capital Gearing Ratio
g) Net Profit Ratio h) Stock Working Capital Ratio
i) Earnings per Equity Share j) Interest Coverage Ratio
k) Creditors Turnover Ratio l) Dividend Payout Ratio
m) Gross Profit Ratio

110
Trading and profit & Loss Account for the year ended 31st
December, 2009.

Particulars Rs. Particulars Rs.

To Opening Stock 1,50,000 By Sales 15,00,000
To Purchases 12,90,000 By Closing Stock 1,50,000
To Gross Profit c/d 2,10,000

16,50,000 16,50,000
To Administrative Expenses 20,000 By Gross Profit b/d 2,10,000
To Rent & Taxes 14,000 By Profit on Sale 27,500
To Interest 22,500 of Fixed Assets
To Selling Expenses 11,000
To Depreciation 50,000
To Income Tax Provision 60,000
To Net Profit 60,000
2,37,500 2,37,500

Balance sheet as at 31st December 2009

Liabilities Rs. Assets Rs.

Equity Share Capital of Fixed Assets 6,50,000
Rs. 10 each 2,50,000 Bank Balance 25,000
10% Preference Share Short term Investment 75,000
Capital 50,000 Debtors 1,00,000
General Reserve 2,00,000 Stock 1,50,000
12% Debentures 3,50,000
Creditors 30,000
Outstanding Expenses 55,000
Income Tax Provision 65,000
10,00,000 10,00,000

The company declared dividend on Equity Shares @ 20%.

2 The condensed balance sheet of Dixit Ltd. as on 31st March 2006
is as follows:

Liabilities Rs. Assets Rs.

Equity Share Capital 6,00,000 Fixed Assets 9,00,000
Reserve 2,00,000 Stock 3,00,000
6% Debentures 5,00,000 Marketable Investment 1,00,000
Current Liabilities 2,00,000 Debtors 1,50,000
Bank Overdraft 1,00,000 Cash and Bank balance 1,00,000
Preliminary Expenses 50,000
16,00,000 16,00,000

111
Net profit for the years was Rs.75,000/-.
Prepare astatement suitable for analysis and indicate the soundness of
the financial positions of the company by calculating the following
ratios and comment on the same.

a) Current Ratio
b) Liquid Ratio
c) Proprietary Ratio
d) Return on Capital Employed
e) Return on Proprietors Equity
f) Return on Equity Capital
g) Stock Working Capital Ratio

3 The following is the Balance Sheet of Swapnaja Ltd. as on 31st

December 2009.

Liabilities Rs. Assets Rs.

Paid up Capital (Rs.10) 2, 00,000 Fixed Assets 3, 00,000
Reserves & Profit 1, 38,000 Stock 1, 00,000
Debentures 2, 00,000 Debtors 1, 22,000
Creditors 32,000 Bills Receivable 8,000
Bills Payable 12,000 Bank Balance 52,000
5, 82,000 5, 82,000

Sales Rs.4,00,000/-;
Gross Profit Rs.1,20,000/-;
Net ProfitRs.80,000/-.
Rearrange the above Balance Sheet in suitable form for analysis and
workout the following ratios.
a) Net Profit Ratio
b) Gross Profit Ratio
c) Current Ratio
d) Liquid Ratio
e) Return on Capital Employed
f) Debtors Turnover Ratio
g) Earnings per Share
h) Stock Turnover Ratio.

4 From the following information of Abhay Ltd. prepare summarized

Balance Sheet as at 31st March, 2009.

1) Working Capital 1,50,000

2) Reserve & Surplus 1,00,000
3) Bank Overdraft 25,000
4) Fixed Assets Proprietary Ratio 0.75
5) Current Ratio 2.5
6) Liquid Ratio 1.5
112
Your working notes should be part of the answer.

5 Using the following accounting ratios construct the Balance

Sheet of ABC Ltd. as on 31st December 2009.
Balance sheet as on 31st December 2009.

Liabilities Rs. Assets Rs.

Share Capital ? Fixed Assets ?
Reserve & Surplus ? Stock ?
Bank Loan Creditors 2,00,000 Debtors ?
? ?

Additional information :
1) Sales for the year (20% cash sales) Rs. 45,00,000
2) Gross Profit Ratio = 20%
3) Debtors Turnover Ratio = 12 months
4) Stock Turnover Ratio = 12 Times
5) Debt Equity Ratio (debt / equity) = 20%
6) Reserve and Surplus to Capital = 25%
7) Current Ratio = 2
8) Fixed Assets Turnover Ratio = 0.20% (Fixed Assets / Sales)

6 From the following information of financial ratios of Star Ltd.

prepare Balance Sheet as on 31st March 2009
a) Current Ratio 2.5
b) Liquid Ratio 1.5
c) Working Capital Rs.1,50,000
d) Stock Turnover Ratio 5
e) Gross Profit Ratio 20%
f) Turnover Ratio to Fixed Assets (COGS to FA) 2
g) Average Debt Collection Period 2.4 months
h) Fixed Assets to Net Worth 0.80
i) Long Term Debt to Capital and Reserves 7/25

7 M/s Rajesh & Co. gives you the following information. Prepare
Trading and Profit & Loss

Account for the year ended 31st March 2004 and Balance Sheet as on
that date.
Opening Stock 90,000
Stock Turnover Ratio 10 times Net Profit Ratio on
Turnover 15% Gross Profit Ratio on
Turnover 20% Current Ratio 4:1
Long Term Loan Rs. 2,00,000
Depreciation on Fixed Assets @10% Rs. 20,000
Closing Stock Rs. 1,02,000
113
Credit Period allowed by Supplier one month
Average Debt Collection Period two month

On 31st March 2004 Current Assets consists of Stock, Debtors and Cash
only. There was no Bank Overdraft. All Purchases were on made on
credit. Cash Sales were 1/3rd of Credit Sales.

8 From the following data, prepare Trading and Profit & Loss A/c

a) Sales Rs.10,00,000
b) Administration, Selling and Distribution Expenses Rs.60,000
c) Stock Turnover Ratio 8 times
d) Net Profit Ratio 20%
e) Gross Profit Ratio 35%
Closing Stock is Rs. 8,000 greater than Opening Stock.

Find out current ratio.

Gross Debtors Rs. 20,000; Provision for Bad debts Rs. 3,000; Bills
receivable Rs. 13,000; Stock twice of net debtors; Cash in hand Rs.
16,000; Advance to suppliers Rs. 15,000; Creditors for goods Rs.
27,000; Bills payable Rs. 8,000; Outstanding expenses Rs. 15,000;
Prepaid expenses Rs. 5,000 Investment (Long term) Rs. 12,000;

9. Find out current liabilities when current ration is 2.5:1 and current
assets are Rs. 75,000.

10. The ratio of current assets (Rs. 6,00,000) to current liabilities is

1.5:1. The accountant of this firm is interested in maintaining a current
ratio of 2:1 by paying some part of current liabilities. You are required to
suggest him the amount of current liabilities which must be paid for this
purpose.

[Ans. Rs. 2,00,000]

11. A firm had current liabilities of Rs. 90,000. It then acquired stock-in-
trade at a cost of Rs. 10,000 on credit. After this acquisition the current
ratio was 2:1. Determine the size of current assets and working capital
after and before the stock was acquired.

12. A Ltd. company has a current ratio of 3.5:1 and acid test ratio of
2:1. If the inventory is Rs. 30,000, find out its total current assets and
total current liabilities.

13. Given: Current ratio 2.8; Acid test ratio 1.5; Working capital = Rs.
1,62,000.

Find out: Current assets;, Current liabilities; Liquid Assets.

14. From the following, calculate Debt-Equity Ratio.

114
Equity share capital Rs. 1,50,000. Preference Share capital Rs. 50,000,
General reserves Rs. 1,00,000, Accumulated profits Rs. 60,000,
Debentures Rs. 1,50,000. Sundry creditors Rs. 80,000, Expenses
payable Rs. 20,000. Preliminary Expenses not yet written off Rs. 10,000.

15. Calculate Debt Equity Ratio from the Balance Sheet of X Ltd. as on
31st March 2007

Liabilities Rs. Assets Rs.

Equity shares of Rs. 10 each 8,00,000 Land and Buildings 6,20,000
11% preference share capital 4,00,000 Plant and Machinery 12,00,000
Securities premium account 80,000 Furniture and fittings 1,80,000
General reserve 5,80,000 Stock 5,30,000
Profit and Loss account 1,40,000 Trade debtors 4,70,000
12% Debentures of Rs. 100 each 10,00,000 Cash in hand 65,000
Bills payable Trade creditors 80,000 Cash at bank 3,00,000
Outstanding 1,40,000 Bills receivable 1,35,000
Expenses Provision for tax 60,000
2,20,000

35,00,000 35,00,000

16. From the following calculate debt-equity ratio:

Rs.
Preference share capital 2,00,000
Equity share capital 4,00,000
Capital reserves 1,00,000
Profit & Loss account 1,00,000
14% Debentures 2,00,000
Unsecured loans 1,00,000
Creditors 40,000
Bills payable 20,000
Provision for taxation 10,000
Provision for dividends 20,000

17. The debt-equity ratio of a company is 1:2. Which of the following

suggestions would (i) increase, (ii)
decrease, and (iii) not change it.
a) Issue of equity shares,
b) Cash received from debtors
c) Redemption of debentures for cash,
d) Purchased goods on credit,
e) Redemption of debentures by conversion into shares,
115
f) Issue of shares against the purchase of a fixed asset,
g) Issue of debentures against the purchase of a fixed asset.

18. Debtors in the beginning Rs. 90,000; debtors at the end Rs. 96,000
credit sales during the year Rs. 4,65,000. calculate debtors turnover
ration.

19. Rs. 1,75,000 is the net credit sales of a concern during 1989. If
debtors turnover is 8 times, calculate debtors in the beginning and at the
end of the year. Debtors at the end is Rs. 7,000 more than at the
beginning.

20. From the following figures, compute the debtors turnover ratio:

Year I Rs. Year II Rs.

Gross sales 9,50,000 8,00,000
Sales returns 50,000 50,000
Debtors in the beginning of year 86,000 1,17,000
Debtors at the end 1,17,000 86,000
Provision for doubtful debts 7,000 6,000

21. Opening stock Rs. 76,250; Closing Stock Rs. 98,500; Sales Rs.
5,20,000; Sales Returns Rs. 20,000; Purchases Rs. 3,22,250. Calculate
stock turnover ratio.

22. Average stock carried by a trader is Rs. 60,000 stock turnover ratio is
10 times. Goods are sold at a profit of 10% on cost. Find out the profit.

23. If inventory turnover ratio is 5 times and average stock at cost is Rs.
75,000, find out cost of goods sold.

24. You are given the following data.

Gross profit at 30% on sales = Rs. 60,000

Stock turnover = 7 times
The opening stock is 5,000 less then the closing stock.
Accounts payable (opening) Rs. 30,000; Accounts payable (closing) Rs.
38,000.
Find out (a) Net purchases (b) Accounts payable turnover (c) Average age
of creditors.

116
25. From the following information, calculate creditors at the beginning of
the year: Rs.

Rs.
Total purchases 22,00,000
Cash purchases (included in above) 10,00,000
Creditors turnover ratio-4 times creditor 2,50,000

26. Calculate working capital turnover ratio from the following data:

Rs.
Cost of goods sold 1,50,000
Current assets 1,00,000
Current liabilities 75,000

27. From the following, compute working capital turnover;

Rs.
Sales 25,20,000
Current assets 15,60,000
Current liabilities 6,00,000

28. Find out the working capital turnover ratio:

Rs.
Cash 10,000
Bills receivable 5,000
Sundry debtors 25,000
Stock 20,000
Sundry creditors 30,000
Cost of sales 1,50,000

29. Capital employed Rs. 1,00,000, Working capital Rs. 20,000, Cost of
goods sold Rs. 3,20,000, Gross profit Rs. 80,000. Calculate fixed assets
turnover ratio assuming that there were no long- term investments.

30. Calculate Gross Profit ratio:

Sales 1,60,000 Purchases 90,000
Sales return 10,000 Purchases returns 10,000
Opening stock 30,000 Closing Stock 10,000

117
31. From the following details calculate the operating ratio:

(a) Rs.

Cost of goods sold 5,20,000

Operating expenses 1,80,000
Net sales 8,00,000

(b)
Cost of goods sold 8,00,000
Operating expenses 40,000
Sales 10,50,000
Sales return 50,000

c)
Sales less Return 1,00,000
Gross Profit 40,000
Administrative expenses 10,000
Selling Expenses 10,000
Income from Investments 5,000
Loss due to fire 3,000

d) Trading and Profit & Loss Account for the year ended 31st
December,2007

Particulars Rs. Particulars Rs.

To stock 1.4.93 35,000 By Sales 4,00,000
To Purchase 2,25,000 By Stock at end 50,000
To Wages 6,000
To gross profit 1,84,000
4,50,000 4,50,000
To administrative exp. 10,000 By Gross Profit 1,84,000
To selling & distribution exp. 14,000
To loss on sale of plant
To net profit 10,000
1,50,000

1,84,000 1,84,000

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32. The following is the Balance Sheet of Vinod Mills Ltd. as on 31 st
December, 2006:
Rs.

Sundry Creditors 60,000 Bank 50,000

Bills payable Tax 1,00,000 Trade investments 1,50,000
Provision Outstanding 1,30,000 Book Debts (Debtors) 2,00,000
Expenses 10,000 Stock 3,00,000
12% Debentures 7,00,000 Fixed Assets 18,00,000
10% Preference share capital 1,00,000 Less: Depreciation 5,00,000 13,00,000
Equity share capital 5,00,000
Reserve Fund 4,00,000
20,00,000 20,00,000

Other information supplied is as follows

Rs.
Net sales 30,00,000
Cost of goods sold 25,80,000
Operating expenses 2,20,000

(a) Quick ratio; (b) Total assets to debt ratio; (c) Current ratio; (d)
Gross profit ratio; (e) Operating ratio (f) Net profit ratio.

33. From the following information, calculate stock turnover ratio,

operating ratio; fixed assets turnover ratio and current assets turnover
ratio:-
Rs. Opening stock 56,000
Closing stock 44,000
Purchases 92,000
Sales 1,80,000
Sales Returns 20,000
Carriage Inwards 8,000
Office Expenses 8,000
Selling & Distribution Expenses 4,000
Fixed assets 70,000
Current assets 60,000

34 From the following data, calculate:-

a) Gross profit ratio,
b) Net profit ratio
c) Working capital turnover ratio
d) Debt-equity ratio
e) Proprietary ratio
Net sales 30,00,000
Cost of sales 20,00,000
Net Profit 3,00,000
Fixed Assets 6,50,000
Current Assets 6,00,000
Paid-up share Capital 5,00,000
Debentures 2,50,000
119
35. With the help of the given information, calculate any three of the
following ratios:

a) Operating ratio
b) Quick ratio
c) Working capital turnover ratio
d) Debt equity ratio.

Information: Equity share capital Rs. 50,000; 12% preference share

capital Rs. 40,000; 12% debentures Rs. 30,000; General Reserve Rs.
40,000; Sales Rs. 3,00,000; Opening stock Rs. 20,000; Purchases Rs.
1,40,000; Wages Rs. 30,000; Closing stock Rs. 40,000; Selling and
distribution expenses Rs. 18,000; Other Current assets Rs. 1,00,000 and
current liabilities Rs. 60,000.

B - THEORY QUESTIONS:
1 What are the limitations of Ratio Analysis.
2 Discuss the benefit of Ratios.
3 How are the ratio classified from the point of view of users.
4. What are the significance of gross profit ratio.
5. Write short notes on
A Quick Ratio
B Creditors Turnover Ratio
C Debtors Turnover Ratio
D Distinguish between over trading and under trading.
E. Trading on Equity
6. Explain in detail importance of Balance Sheet Ratio.
7. Define Current Ratio. Give its purpose.

RATIOS AT A GLANCE
Ratio Formulae
1. Current ratio Current assets
Current liabilities
2. Quick ratio Quick assets
Current liabilities
3. Inventory turnover ratio Cost of goods sold
Average inventory
4. Debtors (receivables) turnover ratio Annual Net credit sales
Average accounts
receivables
5. Debt (receivables) collection period 365 days/52 weeks/ 12
months
Debtors turnover ratio
6 Creditors turnover ratio Net Credit Purchase
Average Creditor Net

120
7. Average Credit Payment period 365 days/52 weeks/ 12
months
Creditor turnover ratio
8. working capital Turnover Net Sale
working Capital
9. Fixed Asset Turnover ratio Net sale or cost of sale
Net fixed assets
10. Current assets turnover ratio Net sales
Current assets
11. Debt- equity ratio Total long term debt
Shareholders’ funds
12. Total assets to debts Total assets
Long term debts
13. Proprietary ratio Shareholders Funds
Total assets
14. Gross Profit ratio Gross Profit/Net Sales × 100

15. Net Profit Ratio Net profit / Net Sales × 100

16. Operating ratio Operating cost X 100

Net sales
17. Operating profit ratio Operating profit X 100
Net sales
18. Return on capital employed (ROI) Net profit before interest, tax
& dividend X 100

19. Earnings per share (EPS) Capital employed

Net income after interest, tax
and preference dividend X
100

20. Dividends per share Dividends amount

Numbers of equity share

21. Price earning ratio Market price of share

EPC
22. Dividend payout ratio Dividend per share
Earning per share



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 6
INTRODUCTION TO DUPONT ANALYSIS
6.1 Meaning
6.2 Formula
6.3 Analysis
6.4 Exercise with solution
6.5 Practice

6.1. MEANING

The Dupont analysis also called the Dupont model is a financial

ratio based on the return on equity ratio that is used to analyze a
company's ability to increase its return on equity. In other words, this
model breaks down the return on equity ratio to explain how companies can
increase their return for investors.

The Dupont analysis looks at three main components of the ROE

ratio.

 Profit Margin
 Total Asset Turnover
 Financial Leverage

Based on these three performances measures the model concludes that a

company can raise its ROE by maintaining a high profit margin,
increasing asset turnover, or leveraging assets more effectively.

The Dupont Corporation developed this analysis in the 1920s. The name
has stuck with it ever since.

6.2. FORMULA

The Dupont Model equates ROE to profit margin, asset turnover,

and financial leverage. The basic formula looks like this.

Return on Equity = Profit Margin x Total Asset Turnover x

Financial Leverage

Since each one of these factors is a calculation in and of itself, a

more explanatory formula for this analysis looks like this.

Pr ofitM arg in Total AssetsTurnover

ReturnonEquity  
NetIncome /  NetSales NetSales /  Avg.Total
  Assets
122
 FinancialLeverage

Total Assets / TotalEquity

Every one of these accounts can easily be found on the financial

statements. Net income and sales appear on the income statement, while
total assets and total equity appear on the balance sheet.

6.3. ANALYSIS

This model was developed to analyze ROE and the effects

different business performance measures have on this ratio. So investors
are not looking for large or small output numbers from this model.
Instead, they are looking to analyze what is causing the current ROE.
For instance, if investors are unsatisfied with a low ROE, the
management can use this formula to pinpoint the problem area whether it
is a lower profit margin, asset turnover, or poor financial leveraging.

Once the problem area is found, management can attempt to

correct it or address it with shareholders. Some normal operations lower
ROE naturally and are not a reason for investors to be alarmed. For
instance, accelerated depreciation artificially lowers ROE in the
beginning periods. This paper entry can be pointed out with the analysis
and shouldn't sway an investor's opinion of the company.

6.4. EXERCISE WITH SOLUTION

Ex.1 Seeta’s Retailers and Rama's Retailers. Both of the companies

operate in the same apparel industry and have the same return on equity
ratio of 45 percent. This model can be used to show the strengths and
weaknesses of each company. Each company has the following ratios:

Ratio Seeta Rama

Profit Margin 30% 15%
Total Asset Turnover .50 6.0
Financial Leverage 3.0 .50

As you can see, both companies have the same overall ROE, but the
companies' operations are completely different.

Ans:
DuPont Analysis
45% = .30 x .50 x 3.0
45% = .15 x 6.0 x .50

Seeta's is generating sales while maintaining a lower cost of

goods as evidenced by its higher profit margin. Seeta’s is having a
difficult time turning over large amounts of sales.
123
 Rama's business, on the other hand, is selling products at a smaller
margin, but it is turning over a lot of products. You can see this from its
low profit margin and extremely high asset turnover.

This model helps investors compare similar companies like these

with similar ratios. Investors can then apply perceived risks with each
company's business model.

EX.2 Parrot Packaging’s ROE last year was 2.5 percent, but its
management has developed a new operating plan designed to improve
things. The new plan calls for a total debt ratio of 50 percent, which will
result in interest charges of Rs.240 per year. Management projects an
EBIT of Rs.800 on sales of R s . 8,000, and it expects to have a total
assets turnover ratio of 1.6. Under these conditions, the federal-plus-state
tax rate will be 40 percent. If the changes are made, what return on
equity will Parrot earn?

a. 2.50% b. 13.44% c. 13.00% d. 14.02% e. 14.57%

EX. 3 Brother Corporation Balance Sheet as on 31st March 2015

Liabilities Rs. Assets Rs.

Accounts Payable 250 Cash and Marketable 50
Securities
Accrued Liabilities 250 Accounts Receivable 200
Notes Payable 500 Inventories 250
Long Term Debts 250 Net Fixed Assets 1500
Common Stock 400
Retained Earnings 350
2,000 2,000

Ans:

ROE = Profit margin × Total assets turnover × Equity multiplier

= NI / Sales × Sales / TA × TA / Equity.

Now we need to determine the inputs for the equation from the data
that were given. On the left we set up an income statement, and we put
numbers in it on the right:

124
 Rs.
Sales (given) 8,000
Cost NA
EBIT (given) 800
Interest (given) 240
EBT 560
Taxes (40%) 224
Net Income 336

Now we can use some ratios to get some more data: Total assets
turnover = S/TA = 1.6 (given).
D/A = 50%, so E/A = 50%, and therefore TA/E = 1/(E/A) = 1/0.5 = 2.00.

Now we can complete the Extended Du Pont Equation to determine ROE:

ROE = 336/8,000 1.6 2.0 = 13.44%.

6.5. PRACTICE

Q.1Explain DuPont Analysis in detail.

Q.2Discuss in detail the formula for calculating ROE under DuPont
Analysis.
Q.3Explain in detail the factors to be taken into account for calculating
ROE under DuPont Model.
Q.4Write Short Not On Du Pont Model.



125
 MODULE - IV

7
FREE CASHFLOW ANALYSIS
Unit Structure
7.0 Learning Objectives
7.1 Introduction
7.2 Meaning of Free Cash Flow

7.0 LEARNING OBJECTIVES

After studying this chapter, the student will be able to:

1. Understand the meaning of free cashflows
2. Differentiate between Different types of free cashflows
3. Calculate FCFF and FCFE under various methods
4. Importance of Free Cash Flows with respect to Valuation
5. Calculate the value of the firm from FCFF and of Equity from
FCFE of the firm

7.1 INTRODUCTION

You have already learnt in your earlier chapters, concepts and

importance of a cash flow statement. You have also learnt the methods of
preparation of cash flow statement and the uniqueness of a cash flow
statement vis-à-vis other financial statements.

You may recall that the term ‘cash flows’ refers to the cash inflows
as well as cash outflows. Further, you would also appreciate that analysis
of cash inflows and outflows is carried out on the basis of Operating
Activities, Financing Activities and Investing Activities.

In this unit, we will be discussing about concepts relating to free

cash flows, techniques of computation of different kinds of free cash
flows, their importance in relation to financial analysis and valuation of a
firm and that of equity holders’ interests.

7.2 MEANING OF FREE CASH FLOW

The term ‘Free Cash Flow’ refers to a sum of cash net inflows or
outflows in relative contexts. There are three important such relative cash
flows. It moves in a hierarchical order. At the top, it relates the free cash
126
flows and the operations. Second one in order relates the cash flow
available to the firm (Long Term Debt + Shareholders), while the third
one relates the cash flows available only to the shareholders. They are as
follows.

a. Operating Free Cash Flows

b. Free Cash Flows to the Firm
c. Free Cash Flows to the Equity

Now let us discuss each of the above in detail.

 Operating Free Cash Flows

As the term indicates, Operating Free Cash Flows refer to the cash
flows that are available in the context of operations, after having met the
cash requirement for investment in non-current assets and net working
capital. Now the question would arise as to what type of investment in
non-current assets and net working capital would qualify for deduction. It
needs to be answered that for a given project, whatever additional
expenditure is required in the form of non-current assets and the net
working capital would be deducted. Any additional expenditure that may
arise due to expansion outside of the current project in respect of which
the Free Cash Flows is computed need not be deducted. This would enable
comparative study with peers and / or competitors, by analysts much
relevant.

It may be understood from the previous paragraph that the cash

flows that are generated as above are the ones that are available for

 Historical vs Prospective Operating Free Cash Flows

We can compute Operating free cash flows for historical periods as
well as for future periods. We compute historical operating free cash
flows, by deducting Investments if any in operating non-current assets
from “Cash Flows from Operating Activities”. However, in both the
cases, we recognize “Tax” as an operating cash flow. We compute
prospective (future) operating free cash flows as below.

After Tax Operating Earnings xxxxx

Add:Depreciation / Amortization / Impairment Write off / of xxxx
Tangible and Intangible Assets
Deduct: Investments in Long Term Assets (Operating) xxxx
Deduct: Investments in additional net working capital xxxx
Operating Free Cash Flows xxxxx

127
 Adjustments that are mentioned above are like the ones you have
already learnt while computing ‘Cash from Operating Activities’ in
preparing a cash flow statement under indirect method. However, there are
two notable differences. They are as below.
1. Deductions in respect of Investments made in Long Term Assets
This deduction is made todetermine the cash flows that are available
after meeting the requirements for expanding operations / sales or to
maintain the existing operations / sales of the entity. When we prepare
a cash flow statement, such an item is shown as an outflow of cash
under ‘Investing Activity’.
2. Deduction in respect of net investment in working capital
While we calculate historical cash flow from operating activities, we
add back increase in current liabilities and decrease in current assets
other than cash and cash equivalents and deduct decrease in current
liabilities and increase in current assets other than cash and cash
equivalents. In computing projected “Operating Free Cash Flows”, we
deduct the estimated net investment in net working capital, so that we
are able to ascertain the available cash flows that can be used for
payments to lenders and then ultimately to the shareholders, without
any interruptions of whatsoever as far as the operations of the business
entity are concerned.

 Importance of Operating Free Cash Flows Analysis

It is to be appreciated that a business is in existence to generate
cash flows to provide returns to the providers of long term funds, namely
lenders and shareholders. The extent of the cash flows generated by a
business out of its operations portrays an entity’s ability to meet the
additional investment required to expand the market share, to provide
returns in the form of interest to the lenders and dividends to the
shareholders and repayment of the loans / capital.

Illustration 1:
Assume that a company generated Rs. 25 crores of operating
cashflow and has spent 5 crores for capital expenditure during the year and
an additional net investment of Rs. 1 Crore in Net Working Capital.

In this case, the entity has generated a surplus, ie, free cashflow of
19 crores for the year. Out of this free cash flow, the entity would pay
returns to its lenders, repay the loans, pay dividends, if any to shareholders
and the redeem the shares, if any, as per covenant obligations.

128
Illustration 2:
An entity provides the following information.

Particulars Rs. In Mns.

Before tax Operating earnings (EBIT) 100
Tax rate 30% on Taxable Profit
Trade Debtors in the beginning 5
Trade Debtors at the end (estimated) 7
Trade Creditors at the beginning 6.90
Trade Creditors at the end (estimated) 5.75
Cash and Bank Balances at the beginning 0.50
Inventories at the beginning 3
Inventories at the end (estimated) 4.50
Cash at the end (estimated) 0.60
Bank balance at the end (estimated OD) 0.75
Depreciation on Tangible Assets 15.50
Amortization of Intangible Assets 4.50
Impairment of Tangible Assets 3.00
Assume that the firm is debt free. The firm needs to invest Rs. 25 Mn in the
next year out of which Rs. 10 Mn is in order to maintain the existing level
of operations and Rs. 15Mn for expansion of sales in the subsequent years.

Compute (1) Operating Free Cash Flows (OFCF) and (2) Cash From
Operating Activities

Solution:

(1) Computation of Operating Free Cash Flows

Particulars Rs. (in Mns)
Before Tax Operating Earnings (EBIT) 100
Less: Tax (30)

After Tax Earnings 70

Add:
Depreciation
15.50
Amortization
4.50

129
Impairment 23
3.00

Less:
Investment in Non-Current Assets (25)

Investment in Net Working Capital

Trade Debtors in the beginning
5.00
Trade Debtors at the end(estimated)
7.00 (2.00)

Trade Creditors at the beginning

6.90
Trade Creditors at the end (estimated)
5.75 (1.15)

Inventories at the beginning

3.00
Inventories at the end (estimated) (1.50)
4.50

Cash and Bank Balances at the beginning

0.50
Cash at the end (estimated)
0.60
Bank balance at the end (estimated OD) (4)
0.75 0.65

Operating Free Cash Flows 64

(2) Computation of Cash Flows From Operating Activities

After Tax Earnings 70

Add: Depreciation, Amortization and 23
Impairment
Less: Net Increase in Current Assets (4.65) ie., (2.00 +1.15 +1.50)
or Decrease in Current Liabilities
(other than cash and cash
equivalents)
Cash from Operating Activities 88.35

Illustration 3:
Continuing the above illustration, suppose that in addition to the
above information, there had been revaluation of assets upwards, resulting

130
in recognition of Rs. 10 Mn in the pretax earnings. What would be the
change in the cash flows computed earlier.

Solution:
Both Operating Free Cash Flows and the Cash From Operating
Activities would decrease by Rs. 10 Mn, because, revaluation of assets
does not result in any increase in the cash flows. However, the same
amount had been considered in computation of the pre-tax earnings.

 Free Cash Flows to the Firm

Free cash flow to the Firm (FCFF) refers to the cash flow available
to all investors in the company — both shareholders and bondholders after
consideration for taxes, capital expenditure and working capital
investment. It enables a firm’s ability to service its lenders and enables
comparison between a leveraged firm and an unleveraged firm. This is
because interest payments are considered as returns payable to lenders and
not as an operating expense.

However, it must be noted here that non-operating income and cash flows
are also considered to be a part of the FCFF. Arithmetically, its
computation is explained below.

Operating Free Cash Flows xxxxx

Add: After Tax non operating income xxxx
Add: Decrease in Non-Operating Assets xxxx
Deduct: Increase in Non-Operating Assets xxxx
Free Cash Flows to Firm xxxxx

Let us explain the computation of FCFF by an illustration.

Illustration 4:
A manufacturing entity is projecting that its Operating Free Cash
Flows for the year ending 31st March 2018 would amount to Rs. 70 Mn.
The entity provides the following additional information.
a. Estimated purchase of Investments in Securities– Rs. 5 Mn
b. Income that will be received from the above investment – Rs. 1Mn
c. Estimated Cost of Acquisition of Land for use after 10 years -
Rs.5Mn
d. Applicable tax rate - 30%
e. An existing investment in securities amounting to Rs. 2 Mn,
yielding a taxable return of 25%, will be sold on 31st march 2018
Compute the Free Cash Flows to the Firm

131
Solution:

Computation of Free Cash Flows to the Firm

Particulars Rs. (In Mns)

Operating Free Cash Flows 70.00
Add: After Tax non-operating Income
-old Investment 0.50 Mn(@25% on
Less tax 0.15 Mn 0.35
-new Investment 1.00 Mn
Less Tax 0.30 Mn 0.70
Add: Decrease in Investments 2.00
Less: Increase in Investments in Securities (5.00)
Increase in Non-Current Assets (5.00)

FCFF 63.05

 Importance of Free Cash Flows to the Firm

As explained earlier, Free Cash Flows refer to the cash flows that
are available in the business from the perspective of providers of long term
sources of funds, namely, Lenders, Preference Shareholders and Ordinary
Share Holders.

A comparative analysis of two or more firms based on the FCFF is

important, particularly when we are comparing the firms which have
different capital structures over different periods of time.

 Free Cash Flows to the Equity

Free Cash Flows to the Equity can be categorized into two types.
They are (a) Free Cash Flows to the Preference Shareholders and (b) Free
Cash Flows to the Ordinary Shareholders. Adjustments are made to FCFF
with respect to cash flows that would be arising becauseof payments to
lenders and fresh loans raised. In the case of puttable share capital with
constant rates of dividend, the payments to and capital raised from such
shareholders need to be adjusted against FCFF to arrive at the FCFE.
Computation of FCFE is arrived at as below.

132
Particulars FCF to Preference FCF to ordinary
Shareholders Shareholders
FCFF xxxx xxxx
Less: Interest (Less Tax xxx xxx
Advantage)
Less: Repayment of Loans
Add: New Borrowings
Less: Preference Dividend Not Applicable xxx
+ with holding Tax
Less: Redemption of Not Applicable xxx
Preference Share Capital
Add: Issue of Preference Not Applicable xxx
Share Capital
FCF to Preference FCF to ordinary
Shareholders Shareholders

A split up analysis of Free Cash Flows to Equity into FCF to

Preference Shareholders and Ordinary Shareholders respectively, provides
a better analysis of the free cash flows of a business. However, when we
compare two or more business entities over a period, comparison on the
basis of FCFE, as a single category provides better comparability.

Illustration 5:
Following information relates to Hypothetical Co Ltd., for the year ending
31st March 2017.

Particulars Rs. (In Mns)

FCFF 100
10% Preference Share Capital 75
Withholding Tax on Preference Share Capital 10%
Dividend
Long Term Loans at the beginning of the year 50
Additional Loans borrowed during the middle of the 30
year
Instalments relating to the old loans repaid at the end 10
of the year
Rate of Interest on Loans 8%
10% Additional Preference Share Capital raised at the 7
end of the year
10% Preference Share Capital Redeemed at the end of 7
the year
Applicable tax rate for the company is 30%.

Compute the FCF to Preference Share Holders and to the Ordinary

Shareholders respectively.

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Solution:

Particulars FCF to Preference FCF to ordinary

Shareholders Shareholders
FCFF 100 100
Less: Interest (Less 5.20 (8% * 50 +8% 3.60
Tax Advantage) *30/2)
1.60 = 3.60
Less: Repayment of 10 10
Loans
Add: New Borrowings 30 30
Less: Preference Not Applicable 8.25 (10% on
Dividend + with Preference Share
holding Tax Capital +Tax @10%
on Preference
Dividend)
Less: Redemption of Not Applicable 7.000
Preference Share
Capital
Add: Issue of Not Applicable 7.000
Preference Share
Capital
116.40 108.15

Free Cash Flows to Ordinary Shareholders may also be calculated

from Free Cash Flows available to Preference Shareholders as well. Such
a Computation is shown below.

FCF to Ordinary Shareholders = FCF to Preference Shareholders –

Preference Dividend +Net Issue / Redemption of Preference Share Capital
= 116.40 -8.25 +7.00 -7.00 = 108.15 Mn.

 Hierarchy of Free Cash Flows

As you would have appreciated by now, there is a hierarchical
order in the conceptual perspectives of various kinds of Free Cash Flows.
At the base level, it is known as Operating Free Cash Flows and down the
level it ends up with Free Cash Flows to the Ordinary Shareholders.

A thematic presentation of Free Cash Flows into its major elements

emphasizes this aspect.

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 As the diagram indicates, Operating Free Cash Flows forms the
basis of a business entity’s ability to generate cash flows over a long
period. At every level, an appropriate reduction in the Operating Cash
Flows that forms part of the free cash flows respective to the hierarchy
takes place. However, it needs to be understood that other than on account
of Operations, the cash flows may either increase or decrease. For
example, for a business that has an OFCF of Rs. 25 Mn can have an FCFE
of Rs. 45 Mn, due to additional issue of share capital. On the other hand,
an entity having Rs. 50 Mn as Cash from Operating Activities may be
having an FCFF of Rs. (-) 25 Mn, because of huge investment in non-
current assets.

A collective presentation of the items that get into computation of

the respective free cash flows is given below, for ease of understanding.

Particulars OFCF FCFF FCF to FCF to Ordinary

Preference Shareholders
Shareholder
s
After Tax Operating xxxxx xxxxx xxxxx xxxxx
Earnings
Add: Depreciation / xxxx xxxx xxxx xxxx
Amortization /
Impairment Write off
/ of Tangible and
Intangible Assets
Deduct: Investments xxxx xxxx xxxx xxxx
in Long Term Assets
(Operating)
Deduct: Investments xxxx xxxx xxxx xxxx
in additional net
working capital
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Operating Free Cash xxxxx xxxxx xxxxx xxxxx
Flows
Add: After Tax non Not xxxx xxxx xxxx
operating income Applicable
Add: Decrease in Not xxxx xxxx xxxx
Non-Operating Applicable
Assets
Deduct: Increase in Not xxxx xxxx xxxx
Non-Operating Applicable
Assets
Free Cash Flows to Not xxxxx xxxxx xxxx
Firm Applicable
Less: Interest (Less Not Not xxxx xxx
Tax Advantage) Applicable Applicable
Less: Repayment of Not Not xxx xxx
Loans Applicable Applicable
Add: New Not Not xxx xxx
Borrowings Applicable Applicable
Less: Preference Not Not Not xxx
Dividend + with Applicable Applicable Applicable
holding Tax
Less: Redemption of Not Not Not xxx
Preference Share Applicable Applicable Applicable
Capital
Add: Issue of Not Not Not xxx
Preference Share Applicable Applicable Applicable
Capital
Total OFCF FCFF FCF – FCF-Ordinary
Preference Shareholders
Shareholder
s

The table given above provides us an easier understanding of

relationship between different kinds of free cash flows and the
components that get into their computation.

 Cash Flow and valuation of a firm

In our discussion, so far, we explained the meaning, concepts and
importance of different kinds of free cash flows. We also explained the
technique of computation of free cash flows. It must be understood that, as
explained earlier, computation of free cash flows helps analysts and
investors to understand the ability of a business in generation and effective
utilization of cash. Besides, an entity’s worthiness ultimately depends
upon its ability to pay returns in the form of cash flows to lenders and
shareholders either directly by way of dividend / buy back of shares or
indirectly by way of increased market price of securities that can help the
holders to generate cash flows. Whether it is by way of direct flows or
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indirect flows to the investor, our focus point is the ability of a business in
generation of cash flows. You also need to appreciate the fact that the cash
flows that an investor would be getting not directly from the business
entity but from the stock exchanges or private deals among the investors
also depend upon the ability of the business in effective generation and
utilization of the cash. This drives us to the point that an entity’s value
very much depends upon the ability to generate / utilize the cash.

 Basic aspects of valuation

You might have already learnt about the basic concepts relating to
valuation of a capital project under “Capital Budgeting” and of securities
in portfolio management and securities analysis. Valuation of a business
based on free cash flows also requires application of the same fundamental
concepts. Philosophy of valuation requires two important aspects, namely
cash flows associated with an asset or a project or an entity and the
relevant cost of capital.

As a recall of the concepts relating to valuation, let us illustrate

with the following example.

Illustration 6:
ABC Ltd., which has many projects is contemplating acquisition of
an existing business from DEF Ltd., ABC Ltd wants to be a financial
investor in DEF Ltd., for a period of five years, after which, it would
dispose of its entire holdings in DEF Ltd., Following Information are
provided by ABC Ltd.,

Particulars Year 1 Year 2 Year 3 Year 4 Year 5

Operating FCF (Rs. Mn) 275 340 450 600 700
Non-Operating Income (Rs. 10 10 10 10 10
In Mn)
Tax Rate 30% 30% 30% 30% 30%
Capital Structure –10% 40% 40% 40% 40% 40%
Debt
Capital Structure – 60% 60% 60% 60% 60%
Ordinary Share Capital
Market rate of return 15% 15% 15% 15% 15%
expected
Risk Free Rate 9% 9% 9% 9% 9%
Beta for ABC Ltd 1.40 1.40 1.40 1.40 1.40

Advise ABC Ltd., the price it can pay for investment in DEF Ltd
as a Financial Investor for a period of five years, so that ABC Ltd can
create value for its own shareholders.

Solution:
ABC Ltd needs to determine the present value of the Free Cash
Flows as far as DEF Ltd is concerned. Since it will be disposing the
acquisition in five years, we need to consider the present value of the Free
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Cash Flows of the Firm that will be received over the next five years.
Determination of present value of Free Cash Flows to the Firm as far as
DEF Ltd is concerned requires the following procedure.
a. Computation of Free Cash Flows of the Firm that relates to DEF
Ltd., (as explained earlier)
b. Computation of Weighted Average Cost of Capital
- Computation of Post Tax cost of debt
- Computation of Cost of Equity based on Capital Asset Pricing
Model
- Computation of the Weighted Average Cost
c. Compute the Present Value of FCFF by discounting the FCFF by
applying the WACC

Valuation of DEF Ltd., to be acquired by ABC Ltd.,

Computation of Free Cash Flows
Particulars Year 1 Year 2 Year 3 Year 4 Year 5
Operating FCF 275 340 450 600 700
After Tax Non-Operating 7 7 7 7 7
Income (After Tax @ 30%)
FCFF 282 347 457 607 707

Computation of Weighted Average Cost of Capital

Computation of Post Tax Cost
of Debt
Pre-Tax Cost of Debt 10%
Tax Rate 30%
Post tax Cost of Debt = Pre =10% (1-0.30) = 7%
Tax Cost *(1-Tax Rate)

Cost of Equity
Capital Asset Pricing Model = Risk Free Rate + (Market Rate – Risk Free Rate)* Beta
= 9% +(15%-9%)1.4 = 9% +8.40% = 17.40%

Weighted Average Cost of

Capital
Component Weight Cost WACC
Debt 0.40 7.00 2.80
Ordinary Share Capital 0.60 17.40 10.44
13.24%

Present Value of FCFF = FCFF/ (1+0.1324)^n

FCFF (as Computed earlier) 282 347 457 607 707
Present Value (Rs. Mn) 1583.16 249.03 270.60 314.71 369.14 379.68
Thus, the value of firm DEF Ltd is determined at Rs. 1583.13 Mn. IF ABC Ltd. can negotiate
the deal by paying any price equivalent to or less than the present value, ABC Ltd will be able
to create value to its shareholders.

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 Free Cash Flows and Valuation of Equity

Based on the cash flows available to firm and to the equity share
holders, over the valuation period, we can find the value of equity of a
firm. The formulas for ascertaining the value of equity of a firm are as
below.

 Valuation based on the free Cash flow of the firm

Value of Equity = Value of the firm based on FCFF – debt value of
the firm. Let us explain with the help of an illustration as below.

Illustration 7:
A firm which has a capital of Rs. 1000 Mn, equally divided
between Debt and Ordinary Share Capital, determines the present value of
its FCFF at Rs. 2,000 Mn. Determine the Value of Equity .

Solution
Present Value of Firm = Rs. 2,000 Mn.
Book Value of Debt = Rs. 500 Mn. (50% of Rs. 1,000 Mn)

Hence Value of Equity = Rs. 1,500 Mn.

 Determination of Present Value of Firm based on Infinity

In our Illustration 6, we determined the value of the firm based on
a specified period of 5 years. However, it must be appreciated that, in
practice, we consider that an entity is expected to generate cash flows over
its entire life period, which may be infinite. In such a scenario, the
following formula is applied.
∞
Value of the firm based on FCFF = ∑ {FCFF t/[(1+WACC)^t]}
t=1
Where, ‘WACC’ is the weighted average cost of capital. However, the
above formula can not be applied in a straight- jacket manner.

Valuation of free cash flows relating to an indefinite period is split

into two or more separate time periods. Time period (s) in respect of
which growth and cash flows can be forecast on a justifiable basis are
known as explicit periods. Forecast of cash flows subsequent to the
explicit period is determined on a perpetual basis based on FCFF at the
end of the explicit period, that immediately precedes the uncertain period.
Once the value of firm is determined, we can deduct the values of
Debt and Preference Share Capital, if any to arrive at the value of equity.

 Valuation based on the free Cash flow to the equity shareholders

∞
Value of the firm based on FCFE = ∑ {FCFE t/[(1+r)^t]}
t=1
Where, ‘r’ is the expected return of the shareholders.

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 Here again, the above formula is based on an infinity period.We
had earlier discussed the method of determining the value of equity from
the value of the firm by applying the WACC of the firm on the Free Cash
Flows to the Firm. The above formula helps us determine the Value of
Equity directly from the Free Cash Flows to the Equity.
Additional Illustrations:

Illustration 1
Rs. (in crores)
EBITDA 1000
Depreciation 400
Interest Expense 150
Tax rate 30%
Purchase of fixed assets 500
Change in Working capital 50
Net borrowing 80
Equity dividends 200

 Calculate FCFF and FCFE under various methods:

FCFF under Net income, EBIT, EBITDA, Cashflow from Operations

methods in this FCFE under FCFF, Net income, Cashflow from
Operations methods FCFF and FCFE from end use perspective method

Solution
A. FCFF Calculation
1 – Calculation from Net Income
Calculation of FCFF, in this case involves, the following steps.
a. Computation of Net Income
b. Computation of FCFF from Net Income

a. Computation of Net Income

We first must obtain net income from the example provided, which is the
EBITDA after depreciation, interest, and taxes
Net income= (EBITDA- Depreciation- Interest) (1- Tax rate)
Net income= (1000-400-150) (1-.3) = 315 crores

b. Computation of FCFF
FCFF= Net income + Non cash charges + Interest (1-Tax Rate) - Capital
Expenditure - Investment in working capital
Assuming that depreciation expense (of 400) is the only non cash charges,
the resulting value for FCFF is 270.
FCFF= 315+ 400+ 150(1-0.30)- 500- 50= Rs 270 crores
Notice that to get net income, we subtracted depreciation and
interest from EBITDA. To get FCFF, we added them back. This suggests
that we could have calculated FCFF more easily by working higher on the
income statement at EBITDA. This is what we do on the method
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2 Calculation of FCFF from EBIT and EBITDA
We first must obtain EBIT from the example provided, which is the
EBITDA after depreciation:
EBIT= EBITDA- Depreciation = 1000- 400= Rs 600 crores

Computation of FCFF from EBIT

FCFF= EBIT (1-tax rate) + Non cash charges - Capital Expenditure -

Investment in working capital
FCFF= 600(1-0.30)+ 400- 500- 50= Rs 270 crores

Computation of FCFF from EBITDA

FCFF= EBITDA (1- tax rate) + Non cash charges (tax rate) - Capital
Expenditure - Investment in working capital
FCFF= 1000(1-0.30)+ 400(0.30)- 500- 50=Rs 270 crores

Starting higher on the income statement at EBITDA, we again

arrive at Rs.270 crores.

Recall our discussion from the previous method where we first

examined the EBIT and EBITDA formulas:

If starting with EBIT, we add back depreciation because it was

subtracted to obtain EBIT. If starting with EBITDA, we add back only the
depreciation tax shield (Dep × Tax Rate = Amount the firm saves on taxes
by being able to claim the noncash depreciation expense). We add it back
because although EBITDA is before depreciation, the depreciation tax
shield saves the firm on taxes and adds to its cash flows.

c. Calculating FCFF from Cashflow from Operations

We first must obtain Cashflow from Operations from the example
provided, which is the net income plus depreciation minus the change in
working capital:

Cashflow from Operations= Net Income+ Depreciation- Working Capital

Investment
Cashflow from Operations= 315+ 400- 50= Rs 665 crores
FCFF= Cashflow from operating activities + interest (1-tax rate) -
Capital expenditure
FCFF= 665+ 150(1-0.30)- 500= Rs 270 crores

We add back interest because it was subtracted out to obtain CFO and
it is available to one of the firm’s capital providers (the debtholders). The
investment in fixed capital is a cash outflow that was not included in the
calculation of CFO, so it is subtracted out.

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B. FCFE calculation
1. Calculating from FCFF
FCFE= FCFF- Interest(1-Tax rate)+ Net Borrowing
FCFE= 270- 150(1-0.30)+ 80= Rs 245 crores

2. Calculating from Net Income

FCFE= net income + non cash charges - capital expenditure - investt in
working capital+ Net Borrowing
FCFE= 315+ 400- 500- 50+ 80= Rs 245 crores

3. Calculating from Cash from Operations

FCFE= Cashflow from operating activities - Capital expenditure+ Net
Borrowing
FCFE= 665- 500+ 80= Rs 245 crores

Illustration 2
Current FCFF Rs 60,00,000
Target Debt to capital ratio 0.25
Market value of debt Rs 3,00,00,000
Shares Outstanding 29,00,000
Required return on equity 12%
Cost of debt 7%
Long term growth in FCFF 5%
Tax Rate 30%
Estimate the value of a company using Free cashflow model

Solution
1. We first must calculate the WACC for the firm.

The formula says the WACC is determined by debt and equity component
costs.

MV(Debt) = current market value of debt

MV(Equity) = current market value of common equity
rd = before-tax cost of debt (which is transformed into the after-tax cost by
multiplying by 1 – Tax Rate)
r = cost of equity

To calculate the debt component, the tax rate is used because in

most jurisdictions, the interest payments on debt are tax deductible, which
reduces the effective cost of debt financing. Equity financing, however, is
not subject to such favorable tax treatment because the payment of
dividends does not reduce the firm’s taxable income.

WACC= [0.25*7%*(1-0.30)]+ [0.75* 12%]= 10.23%

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 Note that the debt-to-capital ratio of 0.25 means that 25% of firm
assets are financed with debt and the other 75% are financed with equity.
In some cases (as in this example), analysts use the ratio of target debt to
capital instead of using current market value weights because they
frequently assume that the targeted debt ratio is that which the firm will
use over the long term.

Note that here, market value of equity is not available, hence we have
to use debt and equity ratios of 0.25 and 0.75 instead of using actual
market values of debt and equity

2. Firm value
The general model to value a firm from its FCFF is,
∞
Value of the firm based on FCFF = ∑ {FCFF t/[(1+WACC)^t]}
t=1

However, as growth rates are given, the formula simplifies to;

We grow the current $6 million in FCFF out one period at 5% to arrive at

next period’s FCFF.
FCFF1= FCFF0*(1+g)
FCFF1= 60,00,000(1.05)

Firm value= 60,00,000(1.05)/(0.1023- 0.05)= Rs 12.05 crores

Note also that here the FCFF is discounted by the firm’s WACC. If the
FCFE were provided, it would be discounted by the shareholder’s required
return to obtain the equity value.

Summary

Free Cash Flows refer to cash flows that are from specific set of
commitments from a specific set of perspectives. Free Cash Flows from
the perspective of operations refer to cash flows that are available after
meeting operational cash flows and meeting investment commitments
with respect to capital expenditure and net working capital in order to
allow smooth operations within the planned capacity. ‘Free Cash Flows to
the Firm’ present cash flows of a business entity from the perspective of
‘what is available to the long term providers of funds’ and out of which
allocations to them can be made. FCFE, as you would have gone through
goes a step further and presents a cash flow picture from the perspective of
Shareholders, which again may be classified into preference shareholders
and ordinary shareholders. Valuation of a firm depends upon an entity’s
ability to generate and effectively utilize the cash, which in turn decides
about the worthiness of a firm. Valuation can be made for a firm from
which values of debt and equity can be segregated. Additionally, value of
143
shareholders can be independently made on the basis of cash flows
available to the shareholders. Weighted average cost of capital and
expected rate of return are applied in determining the value of the firm and
of shareholders, respectively.

Key Words
WACC, Operating Free Cash Flows, Free Cash Flows to the Firm, Free
Cash Flows to Equity,

Review Questions and Exercises

1. Define OCF, FCFF and FCFE
2. What is WACC ? How is it computed?
3. Valuation of a firm or equity depends upon appropriate free cash
flows. Validate the statement
4. List out the adjustments made to OFCF to arrive at FCFF and FCFE
5. Explain the meaning of “Explicit Period”
6. Applying the concepts explained in this chapter, determine the FCFE
of your Organization

7. Calculate FCFF and FCFE under various methods learnt:

Rs. (in crores)

EBITDA 2000
Depreciation 800
Interest Expense 300
Tax rate 30%
Purchase of fixed assets 1000
Change in Working capital 100
Net borrowing 160
Equity dividends 400

8. Calculate FCFF and FCFE under the various methods studied

Rs. (in crores)

EBITDA 500
Depreciation 200
Interest Expense 300
Tax rate 30%
Purchase of fixed assets 250
Change in Working capital 25
Net borrowing 40
Equity dividends 100

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9. Calculate value of firm using FCFE method
Current FCFE Rs 45,00,000
Shares Outstanding 29,00,000
Required return on equity 12%
Cost of debt 7%
Long term growth in FCFE 5%
Tax Rate 30%
Estimate the value of a company using Free cashflow model

10. Calculate value of firm using FCFF method

Current FCFF Rs 40,00,000
Target Debt to capital ratio 0.30
Required return on equity 12%
Cost of debt 10%
Long term growth in FCFF 7%
Tax Rate 35%
Estimate the value of a company using Free cashflow model



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