National Institute of

Business Management
Master of Business
Administr
Administraation (MBA)
(MBA)

Financial Management
ELECTIVE PART - I
MODULES - I & II
Financial Management
ELECTIVE PART - I
MODULE - I
 CONTENTS
Chapter Title Page No.

I MANAGEMENT ACCOUNTING 5

II THE FUNDS STATEMENT 13

III FINANCIAL STATEMENTS ANALYSIS 36

IV ACCOUNTING RATIOS 48
 CHAPTER - I
MANAGEMENT ACCOUNTING
OBJECTIVE
Management accounting is a specialty within the accounting discipline that deals primarily with
the problems of reporting quantitative information to managers for decision making purposes. Course
emphasis includes 1) understanding, recording, and analyzing the operations of organizations under
various conditions of cost application; 2) creating cost models and budgets to plan future operations; 3)
creating performance reports and variance analyses for management control of activities; 4) generating
cost information and identifying relevant information for strategic and operating decisions.
Management Accounting is “the process of identification, measurement, accumulation, analy-
sis, preparation, interpretation and communication of information used by management to plan, evalu-
ate and control within an entity and to assure appropriate use of and accountability for its resources.
Management accounting also comprises the preparation of financial reports for non management groups
such as shareholders, creditors, regulatory agencies and tax authorities”

DEFINITION AND SCOPE

The Association of Certified and Corporate Accounts has defined Management Accounting
as “the application of accounting and statistical techniques to the specified purpose of producing and
interpreting information designed to assist management in its functions of promoting maximum efficiency
and in envisaging, formulating and co-ordinating their execution.

According to the Institute of Chartered Accountants of England and Wales, “any form of
accounting which enables a business to be conduced more efficiently can be regarded as Management
Accounting”. Management Accounting relates to all the services which the accounting department of
a business can render to the management to enable the various departments of the business to operate
with the maximum efficiency.

It is apparent from the above that management accounting may be defined as a form of
accounting technique which enables the business to be conducted more purposefully. It is a kind of
accounting which is useful to the management in carrying on the business operations with plans and
forecasting. It is intended more for internal purposes and service as an aid to the management not
only at top levels but also at all levels as regards the progress of a business. It is system of presentation
of information with a view to assist the management not only in the formulation of policy but also in
the efficient execution of that policy vis-à-vis the operation of the business. This involves the various
accounting methods and techniques so ably evolved as to assist the management in its object to get
the maximum profits. To achieve the highest efficiency, information is provided for all levels of the
management by the use of this system. Its main methods are: (1) preparation of various types of
budgets, (2) installation of effective budgetary control, and (3) reporting to management. It embraces
financial accounting, cost accounting, techniques of statistics and budgeting.

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Advantages:

The following advantages are derived from management accounting:

1. It increases efficiency in business operation.

2. The activities of a business are well regulated by installation of efficient system of planning

and budgeting.

3. It enables the actual performance to be measured by a comparison with the budget.

4. It enables the business to get the maximum return on capital employed.

5. It enables the management to improve its service to its customers.

6. It creates harmony in the relations between the management and labour.

Methods of Management Accounting

The following are the main methods adopted in management accounting:

1. Budgetary Control

2. Financial Planning and Control.

3. Standard Costing

4. Marginal Costing.

5. Reporting.

1. Budgetary control: The use of the budgets enables the management to control the various

aspects of the business.

2. Financial planning and control: This deals with how the business is to be financed; to

permanent capital required may be obtained and how credit policies are to be evolved

and followed.

3. Standard costing: It is a system of cost accounting by means of which certain norms

based on realizable efficiency are developed for the various elements of cost. Actual
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 performance is compared with the standard to spotlight the deviations from the standard.

The system may be said to be the extension of the idea ‘management by exception’. The

deviations from the standard are technically called ‘variances’.

4. Marginal costing: It is essentially a technique of segregating the fixed cost form the

variable cost and concentrating on the response of variable cost to the different levels of

industrial or business operations. Fixed costs are termed ‘period cost’ which costs incurred

whatever be the level of operations. The variable costs are described as ‘product cost’

which vary with the variation in production levels. Marginal costing system is based on

the theory that the allocation of fixed expenditure to production introduces an element of

unnecessary confusion often misleading business decisions. It is claimed that marginal

costing techniques contribute significantly to the measurement of profitability of different

lines of products, various departments and divisions of a business.

5. Reporting or communication: Refers to reporting to the management by preparation

of reports, statements and charts, etc. in respect of operating results or information

affecting very important activities which require to be brought to the notice of the

management.

Management Accounting and Financial Accounting Compared

1. Financial accounting is confined to preparation of financial statements for the use of outsiders

like debenture holders, creditors and banks and also for the information of share holders to

show the manner in which the business operations are conducted during a specified period.

Management accounting on the other hand concerns itself with presentation of statement

containing information for management.

2. Financial accounting has, as one of its objects, the furnishing of information to outsiders who

have a right to get the same under certain well-defined and accepted principles and rules.

On the other hand, management accounting need not conform to the standards or rules laid

down for the use of outsiders but for management accounting the management can follow

its own rules and principles for the efficient achieving of its objectives.
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3. Financial accounting is absolutely compulsory but management accounting is only optional.

4. Financial accounting is mainly concerned with the historical information, namely, what has

happened whereas management accounting is concerned not only with the past information

but also with information about the future.

5. In financial accounting there is the recording of the business transactions in which the values

of the assets and liabilities are ascertained on a specified date by the preparation of a balance

sheet, expenses and income are summed up in the Profit and Loss Account for a specified

period and the result of the trading ascertained. In management accounting the two main

terms are planning and budgeting with the help of which the management will be in a position

to forecast the future possibilities.

6. Financial accounting will not reveal whether the plans formulated and the decisions arrived

at by the management are being followed rigidly and, if not, what part of them are not

followed, but management accounting will reveal them.

7. In management accounting, the principles adopted are not necessarily those adopted in

financial accounting even though the information obtained for management accounting are

from financial accounting.

8. The main objective of financial statements is to report to the outsiders about the overall

performance of the business as a whole but in management accounting, the focus is only on

parts and not on the whole. Management accounting may deal with reports about a particular

department, division or inventory of the business.

9. To enable the management to make use of the information furnished effectively, the information

should be furnished as quickly as possible as opposed to financial accounting.

10. In financial accounting, there is precision in the information collected while in management

accounting, much emphasis is not made on precision as only approximate figures may be

used.

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Objectives of Management Accounting

1. To assist the management in promoting efficiency. Efficiency includes best possible service
to its customers, investors and employees.

2. To formulate policy and planning, management accountant should provide to the management
information so that the management could formulate a plan for the future. He should assist
the management by furnishing statements of past results and also future probabilities and the
benefits that would accrue by following the policies laid down. There should be proper
allocation of responsibilities to the personnel and there should be well-designed organization
for carrying out the plan.

3. The actual work done should be compared with standards to enable the management to
control the performance effectively.

4. Preparation of budget covering all aspects of a business, e.g. production, selling, distribution,
research and finance.

5. Analysis of financial and physical transactions to enable effective comparisons to be made

between the forecast and actual performance.

6. Presenting to the management at intervals, operating statements and short-term financial

statements.

7. Interpretation of financial statements to enable the management to formulate future policy

and operations.

8. The principal objective of management accounting is “ to serve the needs of management”

or “to enable manager to manage better”. To enable manager, to take more intelligent
decision, he is able to get the necessary data through accounting procedures by “responsibility
accounting”, direct costing and other approaches. Management accounting provides a means
for bringing meaningful knowledge promptly to the management for their use.

9. Management accounting helps in the establishment of methods for controlling business

operations by imparting information to those who need the same.

10. Management accounting serves the purposes of ‘developing itself into information retrieval
system and information dissemination system’. These involve receiving and giving information.
These developments have been necessitated by enormous growth in the nature and size of

modern business operations. On account of the pressure of system development, the business
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 organization is changing fast and consequently changes in the concept and in practice of
management are coming up.

Functions of the Controller

The Chief Accounting Officer generally bears the title of the Controller. The functions of the controller
may be classified as under:-

1. Accounting: Developing and maintaining the accounting system to accomplish the proper
recoding, measuring and reporting of all operations, transactions, assets and liabilities of the
company.

2. Developing and maintaining a cost accounting system for the measurement of operating
efficiency; the costing of production, shipments and inventory and the costing of products.

3. Developing and maintaining proper accounting records and determining depreciation policies,
rates and methods.

4. Budgets: Developing and maintaining a system of budgetary control, administering or assisting

in the administration of the company budget programme.

5. Financial statements: Preparing and issuing financial statements, preparing and asserting
in the preparation of reports.

6. Statistics: Analyzing and interpreting statistics on operations.

7. Taxations: Detecting effect of tax changes on company’s operations.

The Concept of Controllership

The concept of controllership and the duties of the controller have been defined by the ‘Financial
Executives’ Institute as follows:

1. To establish, co-ordinate and administer as an integral part of the management, an adequate

plan for the control of operations. Such a plan would provide, to the extend required in the

business, profit planning, programmes for capital investing and for financing, sales forecasts,

expense budgets and cost standards, together with the necessary procedures to effectuate

the plan.

2. To compare performance with operating plans and standards, to report and interpret the

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 results of operations to all levels of management and the owner of the business. This function

includes the formulation and administration of accounting policy and the compilation of

statistical records and special reports as required.

3. To consult with all segments of management responsible for policy or action concerning any

phase of the operation of the business as it relates to the attainment of objectives and the

effectiveness of policies, organization, structure and procedures.

4. To administer the tax policies and procedures.

5. To supervise or co-ordinate the preparation of reports to governmental agencies.

6. To assure fiscal protection for the assets of the business through adequate internal control

and proper insurance cover.

7. To continuously appraise economic and social forces and government influences and interpret

their effect upon the business.”

Management Accounting Challenged

“Management accounting stands challenged and accused just at a time when its practitioners

had begum to feel that they had raised their profession to its highest stature in value and services to

business. The accusation is in three parts. It alleges that accounting does not-

1. Serve as an information system with nearly the precision, speed and effectiveness of other

modern means;

2. Mesh with the new realities of business organization;

3. Relate to the new realities of business management.

Management accounting will have to prove this accusations untrue. In doing so, it may have

to change its focus, its methods and perhaps even its philosophy in some respects. It may even have

to embrace new developments of the information revolution and make then its own.

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 It has faced challenges before and has not only survived but flourished in the face of adversity.

Now is the time for it to show that it can do so again”.

SUMMARY
Management accounting is concerned with the provisions and use of accounting information to
managers within organizations, to provide them with the basis in making informed business decisions
that would allow them to be better equipped in their management and control functions. Unlike financial
accountancy information (which, for public companies, is public information), management accounting
information is used within an organization (typically for decision-making) and is usually confidential and
its access available only to a select few. A management accountant applies his or her professional
knowledge and skill in the preparation and presentation of financial and other decision oriented infor-
mation in such a way as to assist management in the formulation of policies and in the planning and
control of the operation of the undertaking. Management Accountants therefore are seen as the “value-
creators” amongst the accountants. They are much more interested in forward looking and taking
decisions that will affect the future of the organization, than in the historical recording and compliance
(scorekeeping) aspects of the profession. Management accounting knowledge and experience can
therefore be obtained from varied fields and functions within an organization, such as information man-
agement, treasury, efficiency auditing, marketing, valuation, pricing, logistics, etc.”
1. Formulating strategies;
2. Planning and constructing business activities;
3. Helps in making decision;
4. Optimal use of resources;
5. Supporting financial reports preparation; and
6. Safeguarding assets
The most significant recent direction in managerial accounting is throughput accounting, which
recognises the interdependencies of modern production processes and provide managers with a tool
that will allow them to measure the contribution per unit of constrained resource for any given product,
customer or supplier.

QUESTIONS

1. Define Management Accounting.

2. What are the advantages and methods of management accounting?
3. Distinguish between Management Accounting and Financial Accounting.
4. What are the objectives of Management Accounting?
5. What are the functions of a controller?
6. Explain the concept and duties of the controller.

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 CHAPTER – II
THE FUNDS STATEMENT
OBJECTIVE
Funds statements are formal records of a business’ financial activities. These statements pro-
vide an overview of a business’ profitability and financial condition in both short and long term. There
are four basic funds statements:
Balance sheet: also referred to as statement of financial position or condition, reports on a company’s
assets, liabilities and net equity as of a given point in time.
Income statement: also referred to as Profit or loss statement, reports on a company’s results of
operations over a period of time.
Statement of retained earnings: explains the changes in a company’s retained earnings over the
reporting period.
Statement of cash flows: reports on a company’s cash flow activities, particularly its operating,
investing and financing activities.
For large corporations, these statements are often complex and may include an extensive set of
notes to the funds statements and management discussion and analysis. The notes typically describe
each item on the balance sheet, income statement and cash flow statement in further detail. Notes to
financial statements are considered an integral part of the funds statements.

What is a Funds Statement ?

The financial statements of a business provide only some information about the financial
activities of a business in a limited manner. The income statement deals solely with the operations and
the balance sheet shows the changes in the assets and liabilities that have taken place since the last
one. Both the income statement and balance sheet are helpful to some extend in presenting information
on the financial activities of a business. The income statement indicates in a general way the resources
provided by operations. The balance sheet helps to show what new assets have been acquired and
what liabilities have been discharged and what new liabilities have been incurred. They do, therefore,
include certain information on resources provided and applied. But they do not give anything like a
complete report of the financial activities of all resources provided during the period and the uses to
which they are put. The financial statements, therefore, fail to show how the net income for a period
is disposed of and effect of flow of funds through the business.

The Funds Statement is called by different names, viz., Source and Application of Funds,
Sources and Uses of Funds, Movements of Working Capital statement, Movements of Funds
statement and Where Got and Where Gone statement. This statement is prepared to indicate the
increase in the cash resources and the utilization of such resources of a business during a given period.
It is prepared to enable the management to know the movement in liquid assets between two dates.
Increases and decreases together with adjusted profits for the period and depreciation charges, taxation,
dividends paid will be shown. It shows the ebb and flow of funds into and out of the business. This

13
statement gives a clear picture of what has become of the net profits and of the funds obtained from
other sources. It is a means of analyzing in detail the items contained in the balance sheets by recast
of increase and decrease of certain figures not found in the balance sheets and linking in the analysis.
They are not intended to report the changes in the assets and liabilities from all aspects of a company’s
performance during an accounting period. The purpose of a funds statement is to report the process
of financial administration. This serves as an indication of the highlighting of the changes that have
taken place during the period in the financial statements of the concern.

Statement of Source and Application of Funds shows the various means by which
resources were obtained during the accounting period and the ways to which these resources were
employed. It summarizes the financial operations for the year indicating by what means new financing
was obtained and for what purposes it was utilized. We are able to get the following information
from the funds statement which is not available in the income statement and balance sheet:-

1. Resources provided by operations: As explained later, it should be noted that the amount
of resources provided by operations is not the same as the amount of income as appearing
in the income statement. There are certain factors which affect the net income such as
depreciation, writing off goodwill, etc., that have no effect on resources provided or applied
during the period. Transactions such as sale of investments provide resources. Therefore
operations constitute an important source of new assets and it is necessary to know exactly
the amount of resources provided by operations.

2. Services provided from other sources: A list of various new assets obtained enables to
review the operations which are aimed at obtaining the same and to judge the relative
importance in the financial programme.

3. Resources applied to specific purposes: A detailed list of resources applied enables to

review the use of the resources obtained.

4. The net effect of the financial operations on working capital: The working capital position

is revealed. Any tendency to deplete the working capital to provide resources required for

other purposes will be brought to the notice of the management. A comparison of resources

provided and applied will give an explanation why the working capital position has or has

not improved.

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The following questions will naturally be put by anyone reading the financial statements:

1. Where did the funds come from?

2. What was done with them?

3. What happened to the various asset items during the period?

4. Why did working capital decrease although earnings were favourable?

5. Why were dividends not larger?

6. Is the concern solvent?

7. Where did the funds for replacement or expansion come from?

8. What kinds of financial decisions were made during the period?

The funds statement will answer these questions. It helps the reader of the financial statements

to understand not only the financial stability of the concern but also the successful implementation of

the financial policies of the management. The high skill on the part of the management with which the

management decisions are arrive at can be reflected in the smooth flow of funds in and out of business.

This statement contains a summary of information regarding changes in working capital, cash and other

financial items.

Purposes

The purposes for which the funds statements are prepared are for internal and external use.
They are employed by the management in establishing and reviewing cash budgets. They help the
management in evaluating of alternative financing plans and of assessing the long-range forecasts of
cash requirements and availability. They indicate the estimated amount of funds available for this purpose.
This historical flow of funds is used as a device and guide for this purpose.

Outside investors are interested in the flow of funds to enable them to appraise the company’s

performance in using the funds that have been supplied by them. They are interested in the capacity

of the company in generating current funds in its normal of the methods of financing in the past. They
15
are also interested to know what current and long-term drains on the funds are likely to occur and

how the management has utilized liquid funds in the past.

Parties Interested

The following parties are most directly interested in the funds statement:-

1. Shareholders and prospective investors: They are interested in assessing the amount of

funds available for payment of dividends and for interest on their investments in the business

and the probable expected return on the future investments and also the ability of the

management in their effective use of the working capital.

2. Bankers and short-term creditors: They are interested in assessing the degree of risk that

may be involved in granting credit to the business.

3. Management itself is interested in assessing the extend to which the working capital has

been effectively put to use and to facilitate their policy decisions, budgetary control, dividends,

investments in stocks and capital expenditure.

Difference between Funds Statement and Receipts and Disbursements

Statement

The funds statement contains a summary of the inward and outward movement of all items

affecting the working capital of a business whereas a statement of receipts and disbursements contains

a summary of the inward and outward movement of cash which is part of working capital. The receipts

and disbursements account contains cash balance at the beginning of the period and all sources of

cash during the year and all cash disbursed and closes with the cash balance at the end of the period.

In other words, it represents a summarized cash account. On the other hand the funds statement

analyses the changes reflected in the balance sheets. This statement indicates in a general way expansion

or growth that has taken place in the business during the period, changes in the methods of financing,

additional assets acquired, sources of additional assets and connected matters.

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What are Funds?

The term “funds” is very ambiguous. It is not precisely defined in accounting theory or in

practice, because different concepts are put forth by different authors. Funds generally refer to working

capital. When it is equated with working capital, which is the difference between current assets like

cash, marketable securities and accounts receivable and stockless current liabilities, one can think of

receipt of funds as any receipt of a current asset except by conversion of another current asset or

creation of a current liability. It must be noted that the net income of a business may not all be collected

in cash-some may be in accounts receivable, and cash once collected may be spent in several ways.

Therefore if funds are equated with cash then the funds statement will amount to cash receipts and

payments accounts. Funds statement does not describe the flow of cash alone but also flow of working

capital. In a business current assets are often converted in cash which is used to meet the current

liabilities. Therefore at a given date, the net amount of liquid resources available in a business is

represented by the difference between current assets and current liabilities. In a broader sense,

therefore, funds can be defined only as working capital. In this sense, the statement of source and

application of funds is the same as the sources and uses of working capital or briefly, a statement of

working capital flow. It is for this reason that it is suggested by some accountants to use the word

working capital instead of funds. As already pointed out current assets are those that will be converted

into cash during a complete operating cycle of the business. Current liabilities are those that will become

due for payment within the same interval. Working capital therefore is equivalent to amount of liquid

funds under the control of the business. It is not correct to equate the same with cash only.

Uses of Funds Statement

A funds statement is very useful for the following reasons.

1. It serves as a tool for economic analysis which is a very useful technique.

2. Information about the sources from which a company obtains funds and the uses to which

such funds are put, may be useful for a variety of purposes affecting both operating and

investment decisions.
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 3. The published accounts are only record of statement of historical nature and therefore fail

to disclose the position. A funds statement is very useful in disclosing additional details required

for the management.

4. It helps to show the relationship between the working capital changes and the net income.

The funds from the operations in the funds statement explain the reasons why some concerns

continue to operate in spite of their incurring heavy losses and why businesses discontinue

even though they earn profits.

5. The funds statement prepared for a specified period will help the management to asses the

deficiencies and plan for the future and also in timing and duration.

6. A funds statement is not intended to be a substitute for either the income statement or the

balance sheet but it is prepared to present additional useful information not included in those

statements. It is designed to supplement rather than to supplant them.

7. It can assist in planning for obtaining resources in the future and in determining how they are
to be used.

8. It serves to analyze past activity. The statement will show how the resources have been

obtained and the uses to which they are put.

Sources and Application of Funds should equal

The statement contains two main groups of items- one of the means by which resources are

acquired and the other their disposition or utilization. These two sections of items will be equal in

amount since the resources which are provided by business operations are necessarily utilized in some

way. Resources are provided by decreases in assets, increase in liabilities or increase in net worth

and they are applied to increases in assets, decreases in liabilities or decrease in net worth.

Sources of Funds

1. Profit from operations.

2. Sale of fixed assets, long-term investments and other non-current assets.

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 3. Refund of taxes or similar external ordinary items.

4. Issue of shares or debentures.

5. Short-term loans raised.

6. Sale of investments.

7. Decrease in working capital.

Application of Funds

1. Repayment of long-term loans.

2. Redemption of debentures or preference shares.

3. Addition to fixed assets.

4. Purchase of investments.

5. Payment of dividends, income tax etc.

6. Loss from operations.

7. Increase in working capital.

Statement showing items affecting income from operations

Net Income

Plus

Depreciation

Income-tax provision

Write-off of goodwill

Write-off of intangibles

Write-off of discount on debentures

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 Non-operating losses

Extra-ordinary losses

Minus

Non-operating gains

Profit on sale of non-current assets

Profit on sale of investment.

Equal to

Income from operations.

Statement of changes in Working Capital

In order to ascertain the increase or decrease in the working capital between the two dates

of the balance sheets, a statement is prepared containing the current assets and current liabilities.

Current assets such as cash, temporary investments, stock, debtors less provision for doubtful debts

and prepaid expenses are taken and current liabilities such as sundry creditors, taxation due, expenses

outstanding, dividends payable, bank overdraft are deducted from the total of the current assets. The

net balances on the two dates represent the net current assets or working capital. The difference

between the two dates will indicate either increase or decrease in working capital. The decrease will

appear as a source and the increase as application.

This statement reflects the changes in the composition of the working capital. This can also

be prepared by showing the changes in each item of current assets and current liabilities or difference

between the total of the current assets and current liabilities for the two years. Sometimes changes in

the working capital may be greater than the net income as disclosed in the income statement. The

following illustration will disclose the same:

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 Sales .. 20,000
Less Cost of goods sold .. 14,000
Gross margin 6,000
Less operating expenses :
Depreciation 800
Other expenses 4,200 5,000
Net Income 1,000
Changes in working capital:
Decrease Increase
Rs Rs Rs
Sales 20,000 20,000
Costs of goods sold 14,000 14,000
6,000
Depreciation 800
Other expenses 4,200 4,200
5,000 18,200 20,000
Net Income 1,000
Increase in working capital 1,800
20,000 20,000
The net increase in working capital can be ascertained as under
Net Income 1,000
Add depreciation (non-current item) 8,00
Net increase in working capital 1,800

DEPRECIATION

It is not current to say that depreciation is a big source of funds. In fact, depreciation is

recorded in the books of account in the same way as a payment of funds out of the business. Since

this has not occurred or been incurred as an expense just like other outgoings, it is written back to

the profits as shown in the funds statement. It is this writing back which gives depreciation the

appearance of being a source of funds. We have already seen that funds are represented by two

things: cash and credit made available. Depreciation is neither of these, although it tends to conserve

funds in that profit available for dividend are reduced by depreciation allowance. Depreciation is only

a special amount taken out of revenue received by a company. It is not like payment of salary, rent
21
etc. made to outsiders; the depreciation expense is strictly considered as being paid to the company

itself. Therefore the amount of depreciation charges being a non-cash item, will not affect the income

of the period.

When depreciation is charged on fixed assets, the working capital is not affected thereby. If

funds from operations are to be computed, depreciation should not be deducted from the profits. If

the income arrived at is after charging depreciation, it is necessary to add back to the profits the

amount of depreciation to arrive at the income from operations. In the words of Bierman “ it is often

stated that funds are obtained from depreciation reserve. This is obviously an incorrect observation.

Funds are not generated by charging or accruing depreciation they are created by sales.

Working Capital: It has already been pointed out that working capital of a business is

represented by current assets less current liabilities. Since the working capital represents net current

assets, transactions affecting the current assets and current liabilities will naturally affect the working

capital because of the change. Change in working capital may be also caused by debits and credits

to non-current asset accounts with the contra debits and credits in the current asset accounts and

current liabilities accounts. When in a specified period, if the working capital has increased, it means

that more working capital was generated and in case of decrease in working capital, the reverse is

the case.

Transactions not affecting Working Capital

The following transactions do not affect the working capital:-

(1) Conversion of a current asset into another current asset.

When accounts receivable is collected, cash another current asset increases and the accounts

receivable- a current asset- decreases. This transaction does not affect working capital. Purchase of

inventory for cash is a similar transaction. In this case, inventory increases and cash decreases, the

working capital remaining unchanged.

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 (2) Increase in current asset, with corresponding increase of a current liability:

Purchase of inventory on credit, increases the current asset- inventory and also the accounts

payable a current liability. The working capital remains unchanged.

(3) Decrease in current asset and corresponding decrease in current liability:

Payment of account payable- a current liability- decreases the accounts payable and cash

current asset also decreases. This will not affect the working capital.

(4) Increase of an expense and decrease of a non-current asset:

Depreciation – an expense, when provided increases provision for depreciation account and

reduces the value of the non-current asset. This does not affect working capital.

(5) Increase of a non-current asset and a non-current liability:

By means of exchange transaction acquisition of land by issue of shares, or appreciation in

the value of non-current asset- building increases the non-current asset and also increases the capital

and capital reserve. These transactions do not affect working capital.

(6) Increase in non-current liability and decrease in non-current liability:

When preference shares are converted into debentures or when bonus shares are issued by

capitalization of reserve, one current liability decreases and another current liability increases. These

transactions do not affect working capital.

Transactions affecting Working Capital

The following transactions will affect the working capital:-

(a) Increasing working capital:

(1)Sale of fixed assets.

(2)Earning of miscellaneous income

(3)Issue of shares or debentures.

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 In these cases, there are debits to current asset accounts and current liability accounts, and

credits to non-current asset accounts. When a non-current asset is sold, current asset-cash is debited

and non-current asset- fixed asset is credited, when shares are issued cash-current asset is debited

and share capital- a non-current liability is credited.

(b) Decreasing working capital:

(1)Payment of expenses.

(2)Purchase of or addition or improvements to non-current assets.

(3)Redemption of debentures of preference shares.

(4)Declaration of dividends (excepting bonus shares).

In these cases, there are debits to non-current asset accounts and credits to current asset

accounts and current liability accounts.

The change between the working capital of a business at the beginning of the year and that

at the end of the year is due to several kinds of transactions that have occurred during the year. A

summary of the changes can be prepared from the balance sheet as at the beginning and as at the

end of the year by means of a statement called the “statement showing changes in working capital”.

Additional data required may be available in the profit and loss account.

Operating income: It should be remembered that funds from operations which form the main source

of funds will not be equal to the operating income as shown in the income statement. Net income as

per income statement is the balance arrived at after deducing from funds-generating revenues a number

of expenses some of which do not represent current drains on funds such as depreciation, or loss on

sale of property. In this respect, there is a lot of confusion among the authors. It will be noted that

the following items do not utilize the funds, i.e., decrease the current assets or increase current liabilities.

They do not generate funds. To arrive at the figure of funds from operations to be included in the

statement, it is the practice to prepare an adjusted profit and loss account. The following items should

be added back to the income and as appearing in the income statement:-

24
 1. Depreciation.

2. Write-off of fixed assets.

3. Write-off of intangible assets, like goodwill, patents etc.

4. Loss on sale of non-current assets.

5. Write-off of discount of debentures, preliminary expenses etc.

6. Transfer to general reserves.

7. Provision for taxation.

8. Provision for proposed dividends.

The following items should be deducted.

Profit on sale of non-current assets: If the profit and loss account and profit and loss

appropriation account are given, the net income as shown in the profit and loss account should be

taken and adjustments made to the same as explained about to arrive at the profit from operation to

be taken into statement. If no profit and loss account is given, but the balances in the profit and loss

account as at the beginning and at the close of the year are given adjusted profit and loss account

should be prepared be taking the opening and closing balances.

Items which do not affect the working capital as enumerated above should be charged to

the profit and loss account and items of profit not affecting working capital should be credited to this

account. The difference represents the profits from operations to be taking to the statement.

“The statement of source and application of funds serves as a bridge between successive

balance sheets. It ties up the balance sheet and income statement together by using information taken

from both. Unlike income statement, it is emphasizes the most important characteristics of operational

results after the income itself-the flow of funds derived from income and other services. This is very

useful in highlighting aspect of operations not apparent from financial statements such as the ability to

pay dividends, adequacy of company’s working capital to generate sufficient earnings to supply the

needs of the company”.

25
Profit or loss on sale of non-current and current assets

Profit on sale of land, buildings, machinery investments etc., if already credited to the profit

and loss account and loss on sale of the assets debited to the profit and loss account, it is necessary

to add back the loss and deduct the profit from the income. When investments-current assets- are

sold, there is the substitution of cash in the place of investments. The sale proceeds being a source of

funds should be included in source. Profit on sale of investments is also a source of working capital.

Loss on sale will reduce the working capital. Proceeds of sale of fixed assets is another source of

working capital. The sale results in increasing cash and reducing fixed assets. Profit or loss and sale

of fixed asses may be reflected in the profit and loss account and the correct profit should be arrived

at by making adjustments for profit or loss. According to the recommendation of A.B. Board. “A

statement of source and application of funds is helpful because it presents other information which

ordinarily cannot be obtained from the financial statements and because it presents articulated

information about the flow of funds”.

Sources

1. Profit from operations: We have seen that in all businesses, the main source of funds

is from operations. In a concern whose sales being inflow of funds, exceeds the cost of such sales

and expenses connected with the business operations and the excess will provide the source of funds.

On the other hand, if the inflows of sales and outflows like the cost of goods sold and expenses is

less, this difference will be the application of funds. Therefore the amount of profits provided from

operations will not be the same as the income arrived at in the income statement. If a business is to

continue, the operations of the business must result in the use of funds.

2. Sale of non-current assets: We have already seen that when non-current assets are

sold, a concern gets working capital. The sale represents a sale so long as current assets are received.

It is needless whether the sale is made at a profit or less because the current asset, to the extend of

the sale, whether more or less than cost, is increased. Therefore this transaction is a source of funds.

26
 3. Long-term borrowing: Such as debentures, results in the increase of current assets.

It increases the working capital. Short-term borrowing such as on bill do not affect the working capital

because cash- a current asset-increases and bills payable a current liability increases.

4. Issue of shares: When shares are issued for cash just as issue of debentures, the

transaction results in the increase of working capital investments in shares, therefore a source of funds.

Technique of operating funds statement

1. The purpose of preparing a statement of source and application of funds is to explain

the reasons for the change in the working capital during a specified period. This can be fulfilled only

when a statement is prepared setting forth a list of source and application. The first step taken is the

preparation of statement showing change in working capital. As already pointed out the current assets

and current liabilities are listed in the statement and the difference represents the increase or decrease

in working capital. Decrease will appear in source and increase will appear in application.

The next step will be construction of fixed asset accounts. The opening balances and the

closing balances of these accounts should be compared. See whether there have been any sales during

the year. Pass entries in the accounts for the sale transfer from provision for depreciation account of

the amount of accumulated depreciation on the asset sold, and transfer to profit and loss account any

profit or loss on sale. The difference in that account will represent additions to the fixed assets, which

will be taken to application and the sale proceeds will be taken to source. In respect of provision for

depreciation on fixed assets, open separate accounts for each of the fixed assets. Show the opening

and closing balances in the accounts. After transfer of the accumulated depreciation to the respective

asset accounts, the balance in the account will represent the depreciation for the year, and the same

transferred to the debit side of the adjusted profit and loss account.

If the balance sheet contains provision for taxation and included in the opening and closing

balance sheets, they will ordinarily be taken to statement of working capital but if it is noted that tax

for a certain amount was paid during the year, instead of taking the balances to the working capital

statement, provision for taxation account should be prepared. The opening and the closing balances
27
of provision should be noted in the account. The amount of tax paid should be debited to the provision

account. The amount of provision made for the year will be noted in the credit side. Entries in respect

of over-provision or under-provision of taxation of previous year, if any, should be made in this

account. Entries in respect of provision for the current year will be to the debit of profit and loss

account.

Similarly an account will be opened in respect of investment to ascertain the amount of

purchase or sale of investments during the year.

The next step will be the preparation of adjusted profit and loss account. The opening and

closing balances of this account will be noted in this account. As already pointed out, non-cash items

like depreciation, write-off of goodwill, discount on debentures, preliminary expenses, provision for

income-tax and declaration of dividends and loss on sale of assets and profit on sale of assets should

be adjusted to arrive at the profit from operations to be taken to source.

The next step involves the scrutiny of the long-term liabilities and non-current asset balances

at the beginning and at the end of the year to know whether any changes in these accounts have

taken place between the period. They should be listed either in the source or application.

It should be noted that profit or revaluation of fixed assets, if taken to separate account like

capital reserve or profit on redemption of long-term liabilities such as debenture, if taken to a separate

account like profit on redemption of debentures will not affect the working capital and should not

therefore be taken to funds statement.

In respect of dividends provision for the previous year and appearing as opening balance if

paid during the year should be shown under application and the balance appearing in the closing balance

sheet being provision created for the current year should be charged to the adjusted profit and loss

account. Interim dividend paid, if any, during the year should be charged to the adjusted profit and

loss account.

28
PROBLEM NO:1

From the following balances as at 31st December, 1979 and 1980, prepare a Funds Statement:

Liabilities 1979 1980

Rs Rs
Share capital 2,00,000 3,00,000
Share premium 10,000
Capital Reserve- profit on redemption of debentures 1,000
Profit and Loss Account Balance b/f 40,000 40,000
Profit for the year 45,000
5% Debentures 1,00,000 75,000
Sundry Creditors 60,000 1,04,000
Taxation Account 20,000 5,000
Proposed Dividends 10,000 10,000
4,30,000 5,90,000
Assets
Rs Rs
Building at cost 1,50,000 2,30,000
Plant and machinery at cost 2,60,000 3,20,000
Less depreciation 85,000 1,75,000 95,000 2,25,000
Shares in subsidiary company 20,000 20,000
Stock 45,000 49,000
Sundry debtors 15,000 18,000
Bank 25,000 48.000
4,30,000 5,90,000

During the year 1980, Plant costing Rs. 15,000 (accumulated depreciation thereon Rs.8,000)

was sold for Rs. 5,000, the loss on sale being charged to Profit and Loss Account.

SOLUTION

Statement showing Source and application of Funds during the year ended 31st December, 1980

29
Funds provided by
Rs Rs
Profit for the year (2) 57,000
Add Non-cash item- Depreciation(5) 18,000 75,000
Share issue proceeds 1,00,000
Share premium 10,000 1,10,000
Sale of plant 5,000
1,90,000
Funds applied by
Purchase of buildings (3) 80,000
Purchase of plant (4) 75,000
Debentures repaid (1,00,000-76,000) 24,000 1,79,000
Dividends paid 10,000
Increase in working capital (1) 1,000
1,90,000
Workings:
(1) Statement showing change is working capital
1979 1980
Rs Rs
Stock 45,000 49,000
Debtors 15,000 18,000
Bank 25,000 48,000
85,000 1,15,000
Creditors 60,000 1,04,000
Provision for taxation 20,000 5,000
80,000 1,09,000
Working capital 5,000 6,000
Increase 1,000
6,000 6,000
(2) Profit for the year Rs
Net profit as per Balance Sheet 45,000
Add Loss on sale of plant 2,000
47,000
Add proposed dividend 10.000
57,000

30
(3) Building Account

Rs Rs

50,000 By Balance c/d 2,30,000

To purchases 80,000

2,30,000 2,30,000

(4)Plant Account

Rs Rs

To Balance b/f 2,60,000 By Sale 5,000

To Purchases 75,000 By Dept. provision 8,000

By loss on sale 2,000

By balance c/d 3,20,000

3,35.000 3,35,000

Provision for Depreciation on Plant Account

Rs Rs

To plant a/c 8,000 By Balance b/f 85,000

To Balance c/d 95,000 By Depreciation 18,000

1,03,000 1,03,000

Taxation account balances are treated as current liabilities as there is no indication in the
problem as to the amount of taxation paid. Hence included in the statement of working capital.
The provision of proposed dividend appearing in the opening balance sheet has been shown
in the application as payment. The closing balance being provision for the year has been charged to
the adjusted profit and loss account to arrive at the profit from operations. Alternatively the two balances
may be included in the working capital statement.

PROBLEM NO: 3
From the following Balance as at Ist January and 31st December 1980, prepare a Movement
of Funds Statement showing the increase or decrease in working capital:-

31
 Ist Jan. 31st Dec. Ist Jan 31st Dec
1980 1980 1980 1980
Rs. Rs. Rs. Rs.
Equity share capital 1,00,000 1,20,000 Land &Building 55,400 1,13,200
Share Premium 10,000 Machinery 35,600 51,300
General Reserve 6,000 1,000 Furniture & Fittings 2,400 2,500
Profit & Loss Account 7,500 20,700 Stock 36,500 38,000
5% Debentures 26,000 Sundry Debtors 32,100 38,000
Sundry Creditors 33,50 36,400 Bank 4,800 4,000
Provision for Taxation 9,800 10,900
Proposed Dividend 10,000 12,000

1,66,800 2,47,000 1,66,800 2,47,000

Depreciation written off during the year:

Rs.
Machinery 12,000
Furniture & Fittings 400

SOLUTION

Movement of Funds Statement for the year ending 31st December, 1980

Source Rs. Rs.

Share capital issued 20,000

Share premium received 10,000
Debentures issued 26,000
Profit from operations 30,600
86,600

Application

Increase in working capital 600

Addition to land & building 57,800
Additions to machinery 27,700
Addition to furniture 500
86,600

32
PROBLEM NO: 2

The following are the summarized Balance Sheets of X Ltd. as at 31st March 1979 and 1980:

1979
Liabilities Rs. Assets Rs.

Share Capital 4,50,000 Fixed Assets 4,00,000

General Reserve 3,00,000 Investments 50,000

Profit and Loss Account 56,000 Stock Debtors 2,40,000

Sundry Creditors 1,68,000 Sundry debtors 2,10,000

Provision for Taxation 75,000 Bank 1,49,000

10,49,000 10,49,000

1980
Liabilities Rs. Assets Rs.
Share Capital 4,50,000 Fixed assets 3,20,000

General Reserve 3,10,000 investments 60,000

Profit and Loss Account 68,000 Stock 2,10,000
Mortgage Loan 2,70,000 Sundry debtors 4,55,000

Sundry Creditors 1,34,000 Bank 1,97,000

Provision for Taxation 10,000

12,42,000 12,42,000

CASH FLOW STATEMENT

PURPOSE
We have seen that the purpose of preparing the financial statement is to disclose the changes
in the working capital during a specified period. Similarly a statement of financial events can also be
accounted for by the preparation of a cash flow statement. The flow of cash instead of flow of working
capital is another method of presenting the changes in cash. The term ‘cash flow’ is used in different
ways. The most popular and generally accepted one would mean a statement of cash acquired by
the business and the purpose for which it is used. Such a statement can be prepared from an analysis
of the cash transactions or by converting financial information prepared on accrual basis of the cash
basis. But the term ‘cash flow’ is used in a different sense also. It is used to indicate the amount of
resources provided by operations, the net income adjusted for depreciation and certain other changes.
33
This does not represent the flow of cash through the enterprises and therefore accountants do not
recommend in this sense in accounting. The change in the cash balance at the beginning and at the
end can be accounted for by this statement. This is called ‘cash flow’ statement. This is particularly
useful to the management, credit grantors, investors, and others. As regards the management it is
helpful in budgeting cash requirements. The causes of the changes in cash are determined by analyzing
the changes in all accounts excepting cash.

SUMMARY

The objective of funds statements is to provide information about the financial strength, perfor-
mance and changes in financial position of an enterprise that is useful to a wide range of users in making
economic decisions.” Funds statements should be understandable, relevant, reliable and comparable.
Reported assets, liabilities and equity are directly related to an organization’s financial position. Re-
ported income and expenses are directly related to an organization’s financial performance.
Funds statements are intended to be understandable by readers who have “a reasonable knowl-
edge of business and economic activities and accounting and who are willing to study the information
diligently. Financial statements are used by a diverse group of parties, both inside and outside a busi-
ness. Generally, these users are:

1. Internal Users: are owners, managers, employees and other parties who are directly connected
with a company. Owners and managers require financial statements to make important business deci-
sions that affect its continued operations. Financial analysis are then performed on these statements to
provide management with a more detailed understanding of the figures. These statements are also used
as part of management’s report to its stockholders, as it form part of its Annual Report.

Employees also need these reports in making collective bargaining agreements (CBA) with the man-
agement, in the case of labor unions or for individuals in discussing their compensation, promotion and
rankings.

2. External Users: are potential investors, banks, government agencies and other parties who are
outside the business but need financial information about the business for a diverse number of reasons.

Prospective investors make use of financial statements to assess the viability of investing in a business.
Financial analyses are often used by investors and is prepared by professionals (financial analysts), thus
providing them with the basis in making investment decisions.

Financial institutions (banks and other lending companies) use them to decide whether to grant
a company with fresh working capital or extend debt securities (such as a long-term bank loan or
debentures) to finance expansion and other significant expenditures. Government entities (tax authori-
ties) need financial statements to ascertain the propriety and accuracy of taxes and other duties de-
34
clared and paid by a company. Media and the general public are also interested in funds statements for
a variety of reasons.

QUESTIONS

1. What is a funds statement? What is its purpose?

2. Distinguish between funds statement, receipt and disbursement statements.

3. What are funds? What are its uses?

4. What are the sources and application of funds?

5. What is depreciation?

6. What are the transactions that do not affect working capital?

7. What are the transactions that affect working capital?

8. What is an operating income?

9. What is profit on sale of non current assets?

10. Explain the techniques of operating funds statement.

11. What is the purpose of a cash flow statement?

35
 CHAPTER - III
FINANCIAL STATEMENTS ANALYSIS
OBJECTIVE
Accounting is a system that accumulates and measures economic data about an enterprise and
communicates that data to various decision makers. Accounting’s primary functions are to record,
classify and summarize financial transactions, culminating in the preparation of financial statements.
A. Financial statements are the primary means by which businesses communicate their financial posi-
tion and the result of operations. There are four main financial statements:
The balance sheet.
The income statement.
The statement of cash flows.
The retained earnings statement.
B. Bookkeeping is that aspect of the accounting process that focuses on measuring a firm’s daily
activities. The bookkeeping process begins with a transaction (an economic event that is accounted
for) and results in financial statements. Whether the bookkeeping system is manual or computerized, it
follows the same basic principle:
Transactions » Journal » Ledger » Financial Statement
Financial Statements- Nature
Financial statements are those which are prepared at the end of a financial year. There are
two important financial statements, the balance sheet and the income statement. These two statements
summarise all the information contained in the books of account of a business. The Balance Sheet is
also called ‘Statement of financial position’ and the Profit and Loss Account is called ‘Statement of
income’. The purpose of balance sheet which is prepared at the end of each financial year contains a
list of assets and liabilities of the business and also the position of the owner’s equity. The profit and
Loss Account discloses the net income or loss resulting from the operations of a business during a
specified period. It discloses the increase or decrease in the owner’s equity of an entity arising from
profit seeking operations during a given period.

“Financial statements are prepared for the purpose of presenting a periodical review or report
on progress by the management and deal with the status of the investment in the business and the
results achieved during the period under review. They reflect a combination or recorded facts,
accounting conventions, and personal judgments and conventions applied affect them materially. The
soundness of the judgments necessarily depends upon the competence and integrity of those who
make them and on their adherence to generally accepted accounting principles and conventions”.
(American Institute of Accountants). The Balance Sheet has significant uses of its own. The information
regarding the assets, liabilities and the owner’s equity contained in the balance sheet is a very useful
complement to the Profit and Loss Account. The Balance Sheet implies two main concepts of financial
position. (1) Historical Cost concept, and (2) Current Cost concept. Under the first concept, assets
are essentially based on original cost less estimated depreciation or amortization whereas under the

36
second category assets are based upon their current replacement cost or net realization values. The
first approach only generally accepted and the second rarely practice except by the investment
companies.

Uses
Financial statements are very useful for the following reasons:-

They supply the reader relevant information to enable him to make material economic
decisions. The most important users of the financial statement are the present and prospective
shareholders, creditors, employees, financial analysis, customers and some Government agencies. These
uses have different needs for the kinds of financial information from the statements. They are concerned
with investment decisions, evaluation of management credit decisions, employment terms and other
related economic matters. It is generally agreed that the income statement is more important than the
balance sheet. “The first possible presentation of the periodic net income, with neither material over
statement non-under statement is important…..with the increasing importance of income statement,
there has been a tendency to regard the balance sheet as the connecting link between successive
income statements; however this concept should not obscure the fact that the balance sheet has
significant use of its own”:.

Sources of Information

As already point out, outsiders who want to make analysis do not have access to the internal

accounting records. They have to rely upon the published accounts to a considerable extend. These

are usually published by the business concerns annually. In the case of large concerns, these statements

are usually accompanied by additional reports, containing supplementary information. The following

parties are generally interested in the financial statements analysis.

1. Equity shareholders: An equity shareholders is the supplier of basic risk capital. This equity
capital, we will discuss in detail later, provides a cushion or shield to the preference or loan
capital which are fixed interest bearing securities. Equity interest is usually referred to as
‘residual interest’. The claims for divided as a Going Concern operations are of residual or
deferred interest, i.e., after the interest of the preference and loan capital holders are paid.
In view of these circumstances, their investment is of a risky nature. The share value may

fluctuate depending upon the amount of profit earned in the business. They are therefore

37
 interested to know the prospects if the business and to what extent their interest will be
affected to know the prospectus of the business and to what extent their interest will be
affected by the result of the business operations, the profitability and financial condition and
as to the future earnings and the return on their capital.

2. Credit granters: A concern receives short-term and long-term credit on loans from various
sources. Short-term credit is usually provided by the owners or banks or other individuals.
Long-term credit is provided in the form of long-term loans by financials institutions and
other special type of banks and by issue of debentures to the public. The credit granter as
opposed to the equity shareholder is primarily concerned with the security provided for his
loan. He is concerned with the market value of the assets hypothecated for the repayment
of the principle and payment of interest charges regularly. He has therefore to rely on the
financial statements analysis with a view to satisfy himself as to the ability of the management
to maintain sound financial condition for the safeguard of his interests.

3. Management: An analysis of data contained in financial statement is an important tool

adopted by the management. This analysis comprises the use of ratios, trends etc. Their
primary purpose in utilizing the tool of analysis by the management is to exercise control
over the business operations to know the changes in the financial and operating conditions
and to check adverse trends then and there, if any.

Financial Statement Analysis- Techniques

The purpose of financial statement analysis is merely to regard the results “ as signals which
require further investigation to determine their cause”. The purpose is to suggest questions or areas
for further investigation, rather than provide answers. According to Mr.W.H. Beaver “there are
two broad purposes of financial statements analysis: (1) Solvency determination, and (2) Profitability
evaluation. Solvency determination involves determination of the assessment of the probability that an
undertaking will fail. By the use of trend percentages technique, it is possible to predict the failure of
a business. The ratios of failed firms implied substantially higher probability of failure that the population
as a whole and this higher probability of failure was evident in the ratio data five years before failure”.

The purpose of the profitability evaluation is to assess the probability in the matter of return
on investment in an undertaking.

In analyzing the financial statements, the analyst has a number of tools to employ. He can
choose the best to suit his need. The following are the principal tools of analysis.

1. Comparative financial statements.

2. Trend percentages.

3. Common-size financial statements.

4. Ratio analysis.

5. Specialized analysis.
38
 6. Statement of changes in working capital or funds flow analysis.

Significance of Financial Statement Data

In analysis the data contained in the financial statements, several devices are used. Each
device is aimed at disclosure or emphasizing the significance of the information contained therein. The
usefulness of these devices can be understood only when their significance can be known.

Financial statements have significance in the following aspects:

1. As measures of quantity.

2. In comparing with the similar amounts for other periods and similar companies.

3. When considered along with the other figures.

Use of measurements

In interpreting the financial statements, the analyst uses data that show the financial conditions
of the business. The objective of the measurement by a financial analyst defers from that of an
economist. The difference lies in the measurement fundamental forces governing economic behaviour
by the economist and the measurement of fundamental forces in the behaviour by the analyst. But in
both cases, precise measurement could not be made. The analyst cannot formulate valid conclusions
unlike the physical scientist as regards the financial statement ratios used. The analyst therefore
considers his measurement only as indicators. He will concentrate his attention on any factor which
may be abnormal or disproportionate. If the analyst finds there is variation, he tries to seek an
explanation for it. It should therefore be remembered that the various ratios are not ends in themselves
but only means to an end. The analyst is able to form opinions from financial statement by working
suitable adjustments depending upon his experience. It is not necessarily that he should make mechanical
mathematical calculations. If the analyst concentrates only on internal data available from the financial
statements to him, his conclusions may not be real. This must be supplemented by external data
such as information relating to that particular type of business and the general conditions prevailing
industries. The success of the analyst in interpretation therefore depends upon analyzing the statements
keeping in mind the limitations of the data in the financial statements.

Comparative Financial Statements

The changes in the financial data over a period can be best understood if the statements
containing data for a period of two or more years are placed side by side in adjustment columns.
Such statements are called Comparative Financial Statements. Published annual reports in foreign
countries often contain comparative financial statements covering a period of about 10 years. by
comparing the change in various items, period by period, the analyst will be able to get some valuable
clues as to the growth and other important trends relating to the business.

The analysis of financial statements involves a study of the relationships and trends to determine
39
whether or not financial position and the results of the operations to measure the relationships among
the financial statements items of signal set of statements and the change that have occurred in the
items as shown by the financial statements of subsequent periods. The work of the analyst consists of
reducing the data in an understandable manner, analyzing and interpreting the same. A study of the
financial positions of a company and the results of its operations for a period is more meaningful if the
analyst has available the statements of financial positions and income statements for several periods
when comparison is made. If two or more financial statements are available, the trends can be better
assessed. Statements of three years are usually prepared by large companies for purpose of
comparison.

Horizontal and Vertical Analysis

There are two types of analysis, called the horizontal and vertical which form the “backbone”
of financial statement analysis.

Horizontal statement is a statement containing the balance sheet figures of successive

periods. The current year’s figures are compared with the standard or base year. Usually the statement
will contain figures for two years and in one column, the figures for the current year. The next column
will show the rupee changes in percentage. The percentage change is arrived at by dividing the net
rupee change by the older of the two figures. The change column indicates the changes in the balance
sheet figures that have taken place during the current year. The first if these columns shows the changes
in the rupee amounts and the second in terms of percentage. These figures are useful in assessing the
change in proper perspective. This will reveal major changes in the nature of current assets to total
assets. Similarly, the items in the income statement are prepared in horizontal form. This will disclose
the percentage change in sales to other items in the statements; such as selling, general and administrative
expenses. Analysis of change in the statements will give the management considerable insight into the
levels and areas of strength or weakness. This is considered as the dynamic type of analysis because
it shows the changes that have taken place. The behaviour of each of the entities in the statements
can be assessed.

Vertical Statement will contain each item in the balance sheet expressed as percentage of
total assets and in the income statement the net sales is used as the base. They are useful in analyzing
and comparing several companies in the same group or divisions within a company. The comparison
will be useful in analyzing and comparing will be useful because of the analysis of comparing common
size statements. This is a static type of analysis. This deals with the study of the quantitative relationships
of the various items in the statements at a particular date.

Comparative Balance Sheets

As against a single balance sheet having the balance of accounts after the accounts are closed,
the comparative balance sheet contains the balances on different dates, and also the extent of their
increases or decreases in columnar form. The increases and decreases are the results of the changes
in the assets and the business operations. Usually the increases and decreases will be represented
40
not only in amounts but also by way of percentages. This facilities easy comparison of the trends of
the business. The comparative balance sheet forms a connecting link between the balance sheet and
income statement of different dates. A balance sheet shows the assets, liabilities and the owner’s equity
of a business at specified dates. A comparative balance sheet shows the assets, liabilities and owner’s
equity of a business for two or more dates with increases and decreases in the absolute data in terms
of rupees and percentages. The change contained in the statements are very important because they
indicate the direction to which the financial characteristics are developing. The changes in the balance
sheet items consist of the result of the profit and loss, acquisition of assets, changes in current assets,
conversion of liabilities into another form, payment of liabilities and issue of shares.

Comparative Income Statements

The profit and loss account shows the net income or net loss for a specified period. The
comparative income statement will show the operating results for two or more dates. The changes in
the data will be shown in terms of rupees and percentages. All items in the income statement are
expressed as a percentage of net sales. Such a statement is sometimes called a common-size income
statement.

Common Size Balance Sheet

In analyzing the balance sheet, a statement is prepared to work out the ratio of each asset
to total assets and each liability and capital to total liabilities and capital. This statement is known as a
common-size or 100 percent balance sheet. This is so called because, the total of the assets and
also the liabilities and capital is 100 percent. This statement discloses the relationship of each asset to
total assets and each liability and capital item to total liabilities and capital.

The common final balance sheet is converted into common-size balance sheet by dividing
each item by total assets and arriving at a percentage figure. The income statement is also converted
by dividing each item by sales. The financial statements of different periods are compared on an item
by item basis as to detect differences in percentage, for a given item between the financial periods.

Common-size Income Statement

Just as the common-size balance sheet is prepared, the common-size income statement is
prepared with a view to compare the various items in the statement to the total amount of sales. For
example, items such as cost of goods sold, selling, administrative expenses and also item of income
are reduced to percentage by taking the sales figures as 100%. The changes in the cost of goods
sold to sales are very important in financial statement analysis. The difference represents the gross
margin which must be sufficient enough to cover the fixed expenses incurred in running the business.
The net income is arrived at after adjustment of expenses against the gross profit. The net income of
a business should be reasonable when compare to sales. Similar to common-size balance sheets, a
vertical common-size income statement is prepared.

41
 Common-size income statement can also be prepared in a horizontal form. It is easy to
construct the ratios of the various items of expenses to sales for a number of periods and easily
interpreted. This will disclose the trends of the expense items to sales. It is also the practice to prepare
the common-size income statements of two concerns so that the results of the operations are compared
to the other.

Trend Percentages

Comparative financial statements for several years may be expressed in terms of trend
percentages. Changes in financial statements between periods can be easily studied by establishing a
base-year and expressing other years in terms of the base year. The trend percentage statement is an
‘analytical device for condensing the absolute rupee data’ by comparative statements. This device is
valuable to the management because by the substitution of percentages for large amounts the brevity
and readability are achieved. They are generally computed for major items in the statements; minor
amounts are omitted. The purpose is to highlight significant changes. Trend percentages require careful
analysis of the items. Favourable trends are increase in sales, accompanied by a decrease in the cost
of goods sold, and selling expenses and increase in current assets with corresponding decrease in

current liabilities. Unfavourable trends include an upward trend in debtors and stock with downward
trend in sales. Trend percentages indicate the degree of increase or decrease but they cannot indicate
the causes for the changes. Changes may have been due to inconsistency in the application of accounting
principles by fluctuating price level and increases in stock. A series of financial statements are available
where each item measured in terms of its growth or decline relative to the base period. Selection of a
typic as year as base year is very important.

Trend percentage can be represented in the following ways:

(1) Horizontal manner- where the percentage of each year appears one after the other.
(2) Vertical manner- when the percentage appears for each year one below the other.
(3) By a chart containing inventory and sales for some years in rupees.
(4) On semi-logarithmetic scale showing the inventory and sales for some years in rupees.
(5) Showing the trends of average selling prices using as the trend of X as index.
Therefore the trends may be prepared to show the graphic history of a concern by slotting
curves of the trend ratios for several years.

Financial Statements – Limitations

Financial statements cannot serve the purpose of giving a free and complete picture of the
financial position, the financial ‘health’ and capabilities of an enterprise because of the following
limitations:
1. The data contained in the financial statements cannot be expected to be precise because
they are prepared on the basis of the application of residence, conventions, postulates, assumptions and

42
 personal judgement of the accountant preparing them. As the preparation of the statements
require the use of judgment and estimates of the accountant, they may not be uniform and
reliable owing to differences in the exercise of personal judgment. Principals governing the
preparation of financial statements vary from one company to another. There is no agreement
as to the principles adopted by the company. Not all companies apply the general principles
governing the preparation of financial statements. If alternative practices are followed, the
results will be different.
2. Although the shareholder is interested in a reasonable return on the investment, yet payment
of dividends depends upon the liquid position of the concern which can be ascertained only
from the balance sheet. In order to assess the liquid position of a company, the working
capital position is essential. This can be construct from the current assets, and current
liabilities.

3. As the statements are prepared for the use of ‘an average reader’ it will not be possible to

satisfy the requirements of the user for special purpose.

4. The financial statements do not contain full details necessary for the proper assessment of
the company’s position as regards profitability and solvency. There are many factors which
do not form part of financial statements and which have important bearing on the financial
position. Unless the data contained in the statements are converted into ratios and
percentages, they cannot be said to disclose the real position of an undertaking.
5. The values of the assets contained in a balance sheet do not reflect the current market value
at the date of the balance sheet. It is only a historical document and therefore does not purport
to show the realizable value of the assets appearing therein. It is not a statement of net worth
of an undertaking. A balance sheet is prepared on the basis of ‘ going concern’ concept
and as such the assets are stated at their historical cost. The assets do not reflect what they
will fetch if the business is sold. Items of deferred revenue expenditure like preliminary
expenses, advertising expenses, and discount on issue of debentures appearing a assets in
the balance sheet have no value in liquidation. Even though the rupee values contained in
the statements may be accurate, they may be different on the basis of concept of value
ascribed by the reader of the statements. The user has to make his own assessment of value.
He must be aware of the methods adopted for valuation in the financial statements. Investors
rely upon the balance sheets in appraising their holdings in a company. They are interested
only in the market value of the assets, viz., the investment, inventory and fixed assets. The
balance sheet contains only the historical costs and therefore not useful to them. The value
of the rupee is marketed falling with the result that its purchasing power has recorded a
downward trend. For example, a machine which has erected 20 years ago cannot now be
replaced even for twice its original cost. Therefore depreciation charged in this machine will
be half of the amount to be charged on replacement basis. If there is increase in sales value,
the increase may not necessarily be due to increase in the number of units sold but it may
be due to increase in the selling price without a similar increase in costs.

43
 6. Financial statements prepared are only for interim periods and therefore they cannot be
considered final. To determine the accurate profit or loss of an undertaking a long period of
time is required. For various reasons, it has been found necessary to have the accounting
period generally for a period of twelve months and the statements have to be prepared for
that period. Transactions affecting income and expense have to be “cut off” at the date of
closing the accounts and this regard, numerous differences of opinion are experienced. As
the fixed assets are used for a longer period, the uses to which they are put in the business
is based only on estimates. There is therefore greater amount of uncertainty in the financial
statements and the data contained in the financial statements cannot be considered to be
accurate.
The statements include primarily only information that can be stated in monetary units and
hence represented only a portion of the total information required for many decisions.
7. Financial statements do not reflect many factors affecting financial conditions because they
cannot be recorded in the books in monetary terms. Examples are:
Goodwill created by a company, efficiency in the management of business operations, the
reputation of the company, and the company’s cordial relationship with its employees. They do not
contains information as regards the quality of research and development, plant efficiency, marketing
organization, product levels, and future planning. In the absence of uniform unit of measurement, financial
statements cannot be reliable.
8. It will be very difficult to correctly understand the positions of a company if the financial
statements have been prepared under abnormal conditions. During the war period if
production is concentrated by an understanding in difference types of goods for supplies to
war and thereby production and sales volumes increase and when normal policies of
production and sales are not followed, it is natural that the items contained in the financial
statements may result in overstatement or understatement.
9. As the financial statements to be presented involve highly complex and diverse economic
activities, it is necessary to portray the same in a simple and summarized form to enable the
user of the data to understand the same, without difficulty. In most cases, in the financial
statements prepared, simplicity is not achieved. If the statements are to be kept within
reasonable size, high degree of summarization is involved not only at the time of recording
the transactions but also in presentation of the statement. In this process, comprehensiveness
and clarity are usually lost. Financial statements include only selected quantitative terms which
for further clarity are condensed. In order to be useful, unbiased and non misleading financial
statements should disclose all significant financial data essential for making rational economic
decisions.
10. There is a lag between the time a gain or loss occurs and the time it appears in the income
statements.
11. Occurrences of extraordinary and non-recurring items may distort the net income for a given
period.

44
 12. Tax regulations may inappropriately influence the method of reporting. Example: Tendency
top treat an item as revenue rather than capitalize the same.
13. Some assets like discovery values sof minerals, gas and oil and liabilities like lease contracts
are omitted in the financial statements.
14. Gains or losses by holding non-monetary assets occur but they are not reported in financial
statements.
SUMMARY
Financial Statement Analysis Provides information on financial statement analysis especially
drawing ratio analysis to explain financial circumstances. A financial ratio helps investors in analysis of
financial health of the company and forms the basis on which investments are planned. Lets look at
some of the widely used ratios for analysis of various aspects related to financial health of the company.
® Current Ratio
Current Ratio tells us the current financial strength of the company, primarily in terms of the
cash and credit standing of the company. It answers questions like ‘Is the company spending too much
or is it holding too much cash back?
Current Ratio = Current Assets / Current Liabilities
® Debt to Equity Ratio
Debt to Equity ratio tells us the amount of debt of the company against the shareholders equity
Debt to Equity ratio = Total Liabilities / Total Shareholders Equity
® Asset Turnover Ratio
The ratio tells us the kind of revenue that is generated using the total assets of the company It is
an indicator on performance of the assets, whether they under performing or over performing.
Asset Turnover Ratio = Sales / Average Total Assets
® Interest Coverage Ratio
The ratio tells us the amount of earnings that company holds to make interest payments of its
debt.
Interest Coverage ratio = Income Before Interest and Income Tax Expenses / Interest Expense
® Inventory Turn Ratio
The ratio tells us how many times a business turns its inventory over a period of time. It indi-
cates if the company has most of its assets tied up in inventory and if they are under performing.
Inventory Turnover Ratio = Cost of Goods Sold / Average Inventories
® Operating Profit Margin Ratio
The ratio tells us the operating efficiency of the company. The percentage of profit it makes
after deduction of its operating expenses.
Operating Profit Margin Ratio = Net Income – Operating Expenses / Total Sales

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® Quick Test Ratio
Investors widely use the Quick Test Ratio to arrive at the liquidity strength of the company and
its overall financial standing.
Quick ratio = Quick Assets / Current Liabilities
A. At the outset, it is important to note that if statements are prepared on a cash basis, only transactions
that involve cash are recorded. Small businesses will often use this accounting convention - “cash basis”
® Quick Test Ratio
Investors widely use the Quick Test Ratio to arrive at the liquidity strength of the company and
its overall financial standing.
Quick ratio = Quick Assets / Current Liabilities
A. At the outset, it is important to note that if statements are prepared on a cash basis, only transactions
that involve cash are recorded. Small businesses will often use this accounting convention - “cash basis”
- even though it is not in accordance with generally accepted accounting principles. “Cash basis” state-
even though it is not in accordance with generally accepted accounting principles. “Cash basis” state
ments will not recognize accounts receivable from or accounts payable to outside sources.
The accrual method is the generally accepted method of accounting. This method accounts for
transactions in the period in which the business activity occurred, regardless of the period in which the
cash was actually received or disbursed. An important concept in accrual basis accounting is the theory
of “matching” the expenses with the revenue that it produced.
B. Levels of Outside Accountant’s Involvement
Compiled financial statements - Prepared from accounting records supplied by the com-
pany. The CPA must disclaim any opinion on the financial report and no negative assurance may be
given either.
Reviewed financial statements - The CPA provides limited, negative assurance on the reli-
ability of the financial statements. A review consists principally of inquiries of company personnel and
analytic procedures applied to financial data. It is substantially less in scope than an audit.
Audited financial statements - The CPA plans and performs extensive tests on the account-
ing data and systems underlying the financial statements with a view toward rendering an opinion as to
the material fairness of the financial statements and their conformity with generally accepted accounting
principles.
C. The Four Main Financial Statements
1. The Balance Sheet
A balance sheet is a financial statement that lists an entity’s assets, its liabilities and the equity of
the owners at a specific point in time.
Assets are economic resources that are owned by the business entity.
Liabilities represent the claims of creditors against these assets.
Owner’s equity represents the owners residual claim to the assets of an entity after the creditor’s
claim has been satisfied.

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 At any given time, the assets of a business equal the total claims against those assets by its
creditors and owners. This relationship is contained in the balance sheet or accounting equation which
is expressed as follows:
Assets = Liabilities + Owners’ Equity
Assets are generally classified into three categories.
Current assets - include cash and other assets expected to be converted into cash within one year,
such as marketable securities, accounts receivable, notes receivable, inventories and prepaid expenses.
Property, plant and equipment (fixed assets) - includes business assets that have relatively long lives.
These assets are typically not for resale and are used in the production or sale of other goods and
services. Examples: land, plant, equipment, machinery, furniture and fixtures.
Other assets - include the company’s investments in securities, such as stocks and bonds, an intan-
gible asset (valuable rights), such as patents, franchise costs and copyrights.
Liabilities are generally divided into two classes.
Current liabilities - the amounts owed to creditors that are due within one year, such as accounts
payable, notes payable and accrued liabilities.
Long-term liabilities - claims of creditors that do not come due within one year. Included in this
category are mortgages, bonded indebtedness and long-term bank loans.
Owners’ equity - the claims of owners against the business. This is a residual amount computed by
subtracting liabilities from assets. Its balance is increased by any profit and reduced by any losses
incurred by the business.
Note the following points about a balance sheet:
- It is prepared as of a specific date.
- Assets and liabilities are generally listed in order of liquidity.
Most assets are listed at historical cost less depreciation. Investments are usually the only
assets to be stated at the lower of cost or market.
There are assets that may not be listed on the balance sheet. Examples would be goodwill that
was not purchased, quality workforce or research and development costs.
Contingent liabilities are usually not included on a balance sheet.

QUESTIONS
1. Explain the nature of a financial statement.
2. What is the use of a financial statement?
3. Who are interested in financial statement analysis?
4. Explain the technique of a financial statement analysis.
5. What is the significance of a financial statement data?
6. Explain the types of analysis.
7. Write notes on
(i) Comparative Balance Sheets
(ii) Comparative Income Statements
(iii) Common Balance Sheets
(iv) Common Size Income Statement
(v) Trend Percentages
8. What are the limitations of a financial statement?

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 CHAPTER - IV
ACCOUNTING RATIOS
OBJECTIVE
Any successful business owner is constantly evaluating the performance of his or her company,
comparing it with the company’s historical figures, with its industry competitors, and even with suc-
cessful businesses from other industries. To complete a thorough examination of your company’s effec-
tiveness, however, you need to look at more than just easily attainable numbers like sales, profits, and
total assets. You must be able to read between the lines of your financial statements and make the
seemingly inconsequential numbers accessible and comprehensible.
This massive data overload could seem staggering. Luckily, there are many well-tested ratios
out there that make the task a bit less daunting. Comparative ratio analysis helps you identify and
quantify your company’s strengths and weaknesses, evaluate its financial position, and understand the
risks you may be taking. As with any other form of analysis, comparative ratio techniques aren’t defini-
tive and their results shouldn’t be viewed as gospel. Many off-the-balance-sheet factors can play a role
in the success or failure of a company. But, when used in concert with various other business evaluation
processes, comparative ratios are invaluable.
This discussion contains descriptions and examples of the eight major types of ratios used in
financial . Ratios are highly important profit tools in financial analysis that help financial analysts imple-
ment plans that improve profitability, liquidity, financial structure, reordering, leverage, and interest
coverage. Although ratios report mostly on past performances, they can be predictive too, and provide
lead indications of potential problem areas.
Ratio analysis is primarily used to compare a company’s financial figures over a period of time,
a method sometimes called trend analysis. Through trend analysis, you can identify trends, good and
bad, and adjust your business practices accordingly. You can also see how your ratios stack up against
other businesses, both in and out of your industry.
There are several considerations you must be aware of when comparing ratios from one finan-
cial period to another or when comparing the financial ratios of two or more companies.
If you are making a comparative analysis of a company’s financial statements over a certain
period of time, make an appropriate allowance for any changes in accounting policies that occurred
during the same time span.When comparing your business with others in your industry, allow for any
material differences in accounting policies between your company and industry norms. When compar-
ing ratios from various fiscal periods or companies, inquire about the types of accounting policies used.
Different accounting methods can result in a wide variety of reported figures.
Determine whether ratios were calculated before or after adjustments were made to the bal-
ance sheet or income statement, such as non-recurring items and inventory or pro forma adjustments.
In many cases, these adjustments can significantly affect the ratios.
Carefully examine any departures from industry norms.
Definition

A ratio is a simple mathematical expression. Ratios may be expressed by a number of ways.

48
It is a number expressed in terms of another number. It is a statistical yardstick that provides a measure
of relationship between two figures. Accounting ratio rates to the ratio expressed by analysis of
accounting data contained in the published accounts or financial statements.
In financial analysis, the relationship between two figures may be expressed as a rate percent
or as a quotient. Of these percentage is the most common popular one. Accounting ratio focuses
attention relationship which is significant. Ratios are aid to analysis and interpretation. They are substitute
for sound thinking. They help to thinking. They help to examine in detail the overall picture portrayed
by the financial statements by analysis and comparison to ensure that the financial position of the
concern is sound and that there is satisfactory return on the investment of the business. They are
employed to test the solvency, the liquidity of the assets and the profitability of the concern.

Past Performance of the Company

Comparison of the analytical data in the current period with those of the past years is very
useful in judging whether there is improvement in business or otherwise. The comparison with the
past is called the horizontal or dynamic analysis. If the review of the financial information is for only
one accounting period it is called vertical or static analysis, ratio and other relationships based on
past performance may be helpful in preceding future earnings and financial heath of a company.

Kinds

Accounting ratios may be classified broadly as follows;

1. Balance Sheet Ratios

2. Revenue Statement Ratios

3. Balance Sheet and Revenue Statement Ratios.

Balance Sheets Ratios

1. Current ratio known also as ‘Working Capital Ratio’, ‘Solvency Ratio’ and 2 to 1
Ratio’, expresses the relation between the current assets and current liabilities. Current assets comprise
those assets like cash, stock, debtors, bill of exchange and investments which are held by the business
for the purpose of immediate conversion into cash. Normally assets which will be converted within a
year, i.e., within the two dates of balance sheets may be regarded as current assets. During the usual
operation of business, such assets are expected to be realized. In the cycle of business operations,
these assets change in their forms during the period from last balance sheet. For example, just before
acquisition of materials, there is cash, after acquisition, cash is converted in to stock and when sales
are effected, stock is converted into cash.

This ratio is obtained by dividing the total current assets by the total current liabilities.

49
 Rs

Example: Current assets 6,30,000

Current liabilities 2,10,000
Working Capital 4,20,000

6,30,000
Ratio: = 3:1
2,10,000

Significance

This indicates that for every Re.1 of current liabilities, there are Rs. 3 of the current assets
available for meeting its obligations. The current assets are three times the current liabilities. This signifies
the company’s ability to meet its current obligation. The current assets are the sources from which
the current liabilities, namely, the business obligation have to met. The ratio is very commonly used
for finding out the test of the credit strength of a concern. It is a common feature that a business will
be able to meet its current liabilities provided it has equal current assets, but liabilities have to be paid
only when they become due and by then the current assets should be sufficient. Even after the current
liabilities are paid, fresh liabilities may be created. This ratio indicates the amount of conversion of
current assets for meeting current liabilities. This is called the ‘Working Capital Ratio’ as it represents
the working capital being the excess of the current assets over the current liabilities. It is traditionally
held that the ratio of current assets to current liabilities should be 2 to 1 but it should not be taken for
granted since in some cases even though the ratio is 2:1, get the balance sheet of a business may be a
strained one, and in other cases where it is less than 2, it may be very healthy. Further, where there is
temporary surplus of working capital due to increase in stock to meet seasonal sales, the increase
should be viewed with favour. The present tendency is to determine acceptable standards prevailing
within the industry.

Current ratio gives the analyst a general picture of the adequacy of working capital and of
company’s ability to meet its day-to-day payment obligations. It measures the margin of safety provided
for paying current debts in the event of a reduction in the value of current assets. The current ratio is
considered as the ‘patriarch’ among the ratios. The current ratio tests quantity, not quality. It measures
only total rupees worth of assets and total rupees worth of liabilities. Experience has taught that the
current ratio is subject to further questioning for the margin of error involved in blind reliance on a 2
to 1 figure which has proved to be too great. The influence of inventory on current ratio has to be
considered. Its impact on liquidity or debt paying ability is greater than accounts receivable. The values
of inventory fall with economic cycle and owing to fall in purchasing power. Therefore there is
considerable reason to view inventory as unreliable.

Limitations

In times of prosperity this ratio may fall because increase activity may lead to larger stocks

50
and more debtors but less cash. When trade is slowing down, stocks may be disposed of and debtors
may decrease.

Current ratio is subjected to qualitative tests. The components of the current assets must be
carefully assessed to determine their quality. Otherwise the ratio, may be misleading.

The current ratio is subject to influence of other financial forces like investment in fixed assets,
sales etc.

2 to 1 need not necessarily be maintained flatly for all industries. Each industry has its own
peculiar problems. It may differ between industry to industry. The current ratio presents a general
picture of the adequacy of working capital position of an undertaking.

Working capital represents the excess of current assets over current liabilities. If the current
liabilities are in excess of the current assets, the difference is called ‘Working Capital Deficit’.

It is the rule of finance that the working capital in a business should be sufficient when
compared to current liabilities to provide against the danger of the value of the current assets being
reduced. If a business is short of working capital, a time will come when it has to find out some new
sources for further funds to increase the working capital, otherwise the current assets would have to
be liquidated to pay off the current liabilities. The business should therefore acquire some fixed fund,
from the share holders or from long-term creditors. When liabilities become due for payment, the
business will not be in a position to meet its obligations. In periods of boom, current assets and current
liabilities will rise rapidly. When there is an increase in the volume of business, the working capital
must increase so that the business has a proper margin of safety. Business failure are generally caused
due to shortage of working capital. Inadequacy of working capital is generally due to the following
causes:

1. Payment of interest and dividend not earned;

2. Losses due to working of the business;

3. Extraordinary losses;

4. Current funds utilized for capital expenditure purposes;

5. Reduction of share capital or redemption of debentures;

6. Increase in the volume of business and current assets without corresponding increase in
working capital;

Adequate working capital connotes credit standing of a business.

Over-trading
A business is said to be over-trading when comparing the volume of its production with its
sales, the business does not prosper. It signifies that the business is expanding rapidly without sufficient
working capital. There may be a great volume of business as compared to its net tangible worth.
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When the sales are very rapid, there is shortage of working capital or current assets or cash to meet
its payment or liabilities, or no additional funds are available for investment in stocks or for purchases.
When a business is doing more business than is warranted by its working capital, there is over-trading
and it results in a failure. When the net tangible assets are reduced to nothing, the creditors will be
forced to lose a portion of their investment. This is an indication of financial weakness or instability.
In such cases, the solution is to bring more funds and thereby increase the tangible assets. If the
management could not find additional capital, the sales should necessarily be reduced and impose
strict credit control and pay more attention to the collection of debts.

The following are the symptoms of over-trading:

1. The business takes a longer period for its payments;

2. There is increase in creditors as compared to debtors;

3. There is increase in its borrowings which is disproportionate to the shareholders funds;

4. There is not steady increase or decrease in any of the figures.

Under trading means there is inadequate volume of business. Trade activities are reduced
with the result that the assets are not fully utilized when sales fall off to a very low level, the company
finds it difficult to meet its commitments. When a business does not have adequate volume of sales of
business as compared to the extent of the assets employed, there is said to be under-trading. If there
is a permanent increase in stock or in cash they indicate signs of under trading. There is fall in business
and it does not cover even its fixed expenses. This is the opposite to over-trading. In other words,
the return on capital employment is meager.

Over capitalization happens when there is disproportion between a company’s net tangible
worth (shareholders funds) to sales. It signifies the existence of capital far in excess of the company’s
requirements. In other words, there is a large proportion of capital invested in assets with the results
there is no adequate return on capital employed. So long as the concern is able to get satisfactory
profit proportionate to the volume of sales and the profits are sufficient for a reasonable return on
capital invested in the business, there need not at all be any reduction in capital.

One of the most common symptoms of over-capitalization is the existence of intangible assets
in the balance sheet. A company is said to be over-capitalized if (a) its capitalization is in excess of
the tangible assets, (b) when its earning power is too low as compared to its capitalization, and (c) its
capital structure is too heavy that the income does not commensurate.

Under capitalization happens when the capital of a business is disproportionate to the

amount of its business operations. It denotes shortage of capital to meet its requirements. This may
be the result of very heavy expenditure on assets disproportionate to the amount of profits retained in
the business. It may also be due to heavy investment in stocks and accumulation of and increase in
the amount of debtors. The following are the common symptoms of under-capitalization.

(1) Shortage of working capital;

(2) Existence of very low percentage of current ratio;

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 (3) Undue proportion of borrowed capital and creditors to the share holders funds.

To remedy the state of affairs, steps should be taken for the collection of outstanding
promptly to increase the ratio of stock turnover.

2. Liquid Ratio is also known as “quick assets ratio” or “acid test ratio” or “near money
ratio”. Quick or liquid assets include all current assets excepting stock, securities which are held
temporarily and which can be realized without difficulty are also included. In case of debtors, if there
are any bad debts, necessary provision should be made. Stock is not a liquid asset in as much as it
cannot be immediately converted into cash. Quick liabilities include all current liabilities excepting bank
overdraft since the same is normally a permanent arrangement like a fixed liability except when the
business is called upon to pay immediately.

3. (a) Proprietary ratio or Capital ratio is the ratio of the proprietors funds to total
assets. This is also called the “Equity ratio”. The term equity comprises the long term and short term
liabilities and the owners equity or share capital otherwise called external equities and internal equities.
In case of external equities, great importance is attached for the reason that if the debenture-holders
and creditors are not paid promptly, the company can be brought to liquidation by them. On the
other hand, there is not much risk attached to liabilities to the shareholders.

Net worth represents the total share capital and reserves of all types which belong to the
shareholders.

(b) Ratio of total assets to proprietor’s funds is obtained by dividing the total assets by the
total amount of proprietor’s funds.

Significance

This will indicate the credit strength of the business. The proprietor’s funds should be higher
than the external liabilities. Otherwise the business will be dependent upon creditors for augmenting
its working capital.

(c) Ratio of fixed assets to net tangible worth is obtained by dividing the net value of fixed
assets by the net tangible worth.

Significance

If the value of the fixed assets is greatly in excess of the proprietor’s funds, it signifies that
part of fixed assets is owned by outside creditors. This indicates the percentages of investment of
proprietors funds in fixed assets. In financial structure it is always a weakness to place reliance upon
creditors since it is impossible for business to meet its obligation immediately. Investment in fixed assets
should be maintained a low as possible. The tangible worth increases every year, if the business earns
profits and retains a substantial part thereof by way reserves and decreases if the dividends are paid
in excess of its incomings. Therefore if the net tangible worth is too much as compared to the fixed
assets, it indicates that the business is not making good progress. If the ratio is high, it indicates that
much of the shareholders funds in invested in fixed assets.

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 (d) Ratio of current assets to net tangible worth is established by comparing current assets

to net tangible worth.

Significance

If the percentage of the current assets is higher than that of the fixed assets, it is an indication

of the company’s financial strength.

(e) Ratio of external liabilities to proprietors funds is designed to know the interest of the

proprietors in the business as compared with that of external creditors.

Rs
Share holders funds 5,00,000
External liabilities 75,000
Ratio: 2:1

Significance

If the ratio is higher, it is an indication of the soundness of the financial structure of the business.

It signifies that the shareholders funds are in excess of the outside creditors and no reliance be placed

by the concern on outside creditors for its finance.

Revenue Statement Ratios

1. Gross profit ratio: This ratio is set up by comparison of the gross profit with net

sales. This is also called ‘Turnover ratio’. This will reveal the extent to which the business is managed

profitably. This also serves as an effective check on stock control.

Rs
Net Sales 1,50,000
Gross profit 1,00,000

54
Percentage of gross profit on sales: 20%

Significance: This indicates the margin of profit on sales effected and whether the average

percentage of mark-up on the goods is maintained.

(1) If there is increase in the percentage over the normal rate as compared to previous years

the following are the indications:

(a) There is increase in the sale price of the goods without corresponding increase in the

cost of goods sold;

(b) There is decrease in the cost of goods sold without corresponding decrease in the sale

price;

(c) There may be omission of sales.

(d)The valuation of the opening stock is lower than what is should be or the valuation of the

closing stock is higher than what is should be.

(2) Where there is decrease in the percentage of gross profit, the following are the indications:

(a) There is decrease in the same price without decrease in cost of goods sold.

(b)There is an increase in the cost of goods sold without corresponding increase in the sale

price.

(c) There may be omission of sales.

(d)Stock at end may have been valued at a figure lower that it should be.

(e) Stock at beginning may be valued at a figure higher than it should be.

2. Operating ratio is ascertained by comparing the cost of goods sold and other

operation excess with net sales.

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 Rs
Cost of goods sold 5,20,000
Operating expenses 1.80.000
7,00,000
Net sales 8,00,000
7,00,000
Operating ratio: =. 985 to 1
8,00,000

Significance

This is a test of the efficiency of the management in their business operations. It means of

operating efficiency. In normal conditions, the operating ratio should be low enough so as the leave a

proportion of the sales sufficient to give a fair return to the investors. When more capitals is needed,

the operating ratio should be lower.

3. Expense ratio: There are several sub-divisions of this ratio. Some of the important

are;

(a) Cost of goods sold to the net sales ratio; This ratio is established between the cost of

goods sold to the net sales.

Rs.
Cost of goods sold 5,20,000
Net sales 9,00,000
5,20,000
Ratio: = .85 to 1
9,00,000

This indicates how far the management has been able to maintain the margin in their sales.

(b) Each item of expenses to net sales ratio: Each item of the expenses is compared to net

sale and ratios are established such as:

(i) Factory cost to sales;

(ii) Administration expenses to sales;

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 (iii)Distribution expenses to sales.

4. Net profit ratio: This is ascertained by finding out the ratio between the net profit to

net sales:

Rs.
Net profit 50,000
Net sales 9,00,000
5,000
Ratio: = 0625 to 1 or 6.25%
9,00,000

Significance

This is an effective measure to check the profitability of a business. This is an indication of

the company’s performance and its sales promotion. This shows that portion of sales which is left

over after deduction of all expenses.

Stock turnover ratio also known as ‘Inventory ratio’ is prepared to ascertain the number of

items the stock is turned over during the period. Inventory ratio is the relationship between inventory

and cost of goods sold. Since the sale figure is given at selling price and the inventory at cost, the

ratio is computed by dividing the cost of goods sold by the average inventory. The average should

be taken for the period.

Rs Rs
Cost of goods sold 5,20,000
Average stock:
Opening Stock 1,50,000
Closing Stock 2,00,000
3,50,000
3,50,000
Average stock = 1,75,000
2

57
 5,20,000
Ratio: = Appr. 3 times.
1,75,000

Significance

This is indication if the ‘velocity’ of the movement of the goods during the year. In case of

decrease in sales, this ratio will decrease. This serves as a check on the control of stock in a business.

This ratio will reveal the excess stock and accumulation of obsolete or damaged stock. What is

reasonable level of any stock to be held by a business depends upon the types stock and the nature

of the business. This ratio must also be compared with the ratio of stock to working capital. The

ratio of net sales to stock is a satisfactory relationship, if the stock is more than three-fourth of the

net working capital.

Stock is termed as ‘the graveyard of a business’ as this has been the cause of failure of

many businesses. This should be considered as an important factor since it has direct relation with

the profits earned by a business. If stocks are accumulated and if the profits fall, there is bound to be

loss to the business. If the business has too much stock heavy liabilities, it is a sign of bankruptcy. If

the rapidity of he turnover is not quick, there will certainly be loss as a result of fall in prices. It should

be noted that a business should maintain also enough stock to cope up with the sales, but on the

other hand, if more stock than is required be kept accumulated, it is an indication of out of control.

Therefore obsolete stock, if any, should be kept to the minimum level to avoid losses, but it is advisable

to co-ordinate production with sales. Only in exceptional cases, slow moving stock can be carried. If

sales are maintained at a fixed level with decreasing stock and if sales are expanded with reducing

stock, both the turnover and net profit will increase to the slightest extent.

Age of Stock

This is an important point to be considered. It the average stock maintained by a business

is composed of raw materials, work-in-progress and of different varieties of finished goods, the

application of the stock-turnover methods may not be effective. It is advisable to compare the monthly

quantities also with the quantities sold. This will then give a true picture of the turnover of the goods.
58
This can be done by taking the mean of high or low figures for the year or the average of the stock at

the beginning or at the end of the year.

Significance

If the ratio is high, it indicates the ability of the management to move the stocks quickly and

that they are maintaining high quality goods capable of being turned out rapidly. It signifies the ability

of the management in stock control.

If the ratio is low, it signifies the existence of slow-moving, obsolete, and shop-soiled goods

of low value or poor quality goods not capable of being pushed through.

Although high turnover is usually a sign of good management, the ratio varies widely from

one business to another. A high volume with low margin business can turn its inventory more often

than a similar business having a low volume margin policy.

Balance Sheet and Revenue Statement Ratios

1. Turnover to debtors: This is prepared to find out how many day’s credit is outstanding by

debtors.

Rs. Rs.

Net sales: 5,00,000

Total debtors 1,20,000
Bills receivable 40,000 1,60,000
Sales 5,00,000
Average daily sales: = =1,370
365 365
Debtors + Bills receivable
No. of day’s credit =
Average daily sales
1,60,000
= = Appr. 117 days.
1,370

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 2. Net profit to total assets: This is computed by comparing the net profit to total assets.

Significance

The percentage or ratio of net profit to total assets is ascertained to know the earning

capacity of the total assets. If the ratio of high, there is indication that the total assets are effectively

employed in earning the net profit.

3. Return on proprietors funds: This ratio is ascertained by comparing the net profits with

the shareholders funds. If there are preference shares, the dividend on the preference shares

should be deducted from the net profits and they should be compared with the equity

shareholders funds. Proprietors funds include share capital and all reserves both revenue

and capital.

Significance

The percentage indicates the actual return on the shareholders investments in the company.

If the percentage is high, the shares have a good marketable value and if low the return to the

shareholders is very poor.

Other ratios: There are many other ratios and some of them are:

1. Cost of sales to capital employed - to judge the effectiveness of use of capital.

2. Cost of sales to fixed assets - to assess whether the fixed assets are worked to full

capacity.

3. Cost of sales to current assets - to assess whether the current assets are not kept

4. Ratio of cash to operating expenses - This is set up to enable the cash balance not be

allowed to fall. A common practice is to set this at an amount equal to one week’s required

cash payments. This will enable the company to meet its weekly wages and other necessary

operating expenses, though in the meantime temporary financing may be made.

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 5. Ratio of sales to cash - This sets a ceiling to the cash balance. It is conventional to expect
cash balance of well managed companies to be maintained at a level no higher then 1/20 of
sales, cash ratio of no less than 20 times.

Earning Per Share (EPS)

Earning per share on equity share is one of the most significant measures of the success of

the management in the conduct of the affairs of a concern. The formula for computing this ratio is as

under:

Net profit - Pref. Dividend - tax

Number of equity shares

Price/Earning Ratio (P/E)

This ratio relates the market value of the share to earnings per equity share. If the market

price of an equity share if a company is Rs 100 and the earning per share is Rs.5, the formula to

determine this ratio is:

Market price 100

= = 20
Earning per share 5

A high price earning ratio indicates that investors are satisfied that the future earnings per

share will increase. On the other hand, a low price earning ratio indicates that the investors are

pessimistic as regards the possibility of the earnings per share to increase. This ratio in addition to

varying from company also varies with the business cycle and with secular changes. From the investor’s

point of view, this ratio is of high significance. A high ratio is a sign that the share prices are relatively

low in relation to recent earnings per share. It should be remembered that the purchase of a share

with a high price earning ratio does not always imply that the investors are indulging in foolish

speculation. They may be acting wisely because the ultimate performance of a share depends on the

future earnings per share, and not on the recent historical earnings per share. If these future earnings

per share increases, the ratio may not be too high.

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Sales to Debtors

It signifies the proportion of debtors to sales. It measures the credit and collection efficiency

by a company. It determines the probability of bad debts to be written-off.

Sales to Stock

This is the best measure to indicate the manner in which the inventory is turning. It signifies

the turnover of the inventory and the efficiency of the company.

Sales to Working Capital

This indicate the demand made on working capital in supporting sales volume of a concern.

As a company’s sales volume requires an amount of working capital, the higher the level of sales in

relation to available working capital, the greater the strain trade obligations. If the ratio is high, it points

out working capital deficiency.

Net Profit to Net Worth

This ratio measures the profit return on investments, “the reward for assumption of ownership

risk”. The formula is:

Net profit after tax and Pref. dividends

Shareholder’s funds

The company’s profits after tax and preference dividend are divided by the net worth (excess

of assets over liabilities after deducting intangibles). It serves to measure the adequacy of profit return

on investment, to provide a secondary test of both profit and net worth.

Sales to Fixed Assets

This ratio measures the efficiency with which a company is utilizing its investment in fixed

assets. This serves as a secondary test of the adequacy of sales volume. As fixed assets are acquired

62
to increase the sales volume, by increasing production and service and reducing costs or both, the

utilization assets must be measured by reference to sales activity. This serves as a good indication of

the company’s utilization of its investment in fixed assets.

Efficiency Ratio

This ratio is defined as ‘the standard hours, equivalent to the work produced, expressed as

a percentage of the actual hours spent in producing the work’.

Standard hours
X 100
Actual hours
budgeted direct labour hours
Standard hours are: Actual output X
Budgeted output

This is relationship between the actual number of working hours and the budgeted number.

Activity Ratio

This is defined as ‘the number of standard hours equivalent to the work produced expressed

as a percentage of the budgeted hours’.

Standard hours
X 100
Budgeted hours

According to Weston and Brigham in “Essential of Managerial Finance”, accounting ratios

are classified as under:

1. Liquid ratios.

2. Leverage ratios.

3. Activity ratios.

4. Profitability ratios.

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This classification includes the following ratios:

1. Liquidity:
(a) Current ratios.

(b)Quick ratios.

2. Leverage:

(a) Debt to total assets.

(b)Times interest earned.

(c) Fixed charge coverage.

3. Activity:

(a) Inventory turnover.

(b)Average collection period.

(c) Fixed assets turnover.

(d)Total assets turnover.

4. Profitability:

(a) Gross profit on sales.

(b)Return on total assets.

(c) Return on net worth.

According to James Horrigan (in Accounting Review, July 1965) financial ratios are classified under

the following main headings:

1. Short-term liquidity ratios.

2. Long-tern solvency ratios.

3. Capital turnover ratios.

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4. Profit margin ratios.

5. Return on investment ratios.

The classification under each of these headings are as follows:

1. Short-term liquidity:

(a) Current assets to current liabilities.

(b)Current assets less inventory to current liabilities.

(c) Cash plus marketable securities to current liabilities.

2. Long-term solvency:

(a) Net operating profit to interest (Times interest earned)

(b)Net worth to total liabilities.

(c) Net worth to long-term debt.

(d)Net worth to fixed assets.

3. Capital turn over:

(a) Sales to accounts receivable.

(b)Sales to inventory.

(c) Sales to working capital.

(d)Sales to fixed assets.

(e) Sales to net worth.

(f) Sales to total assets.

4. Profit margin:

(a) Net operating profit to sales.

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 (b)Net profit to sales.

5. Return on investment:

(a) Net operating profit to total assets.

(b)Net profit to net worth.

RETURN ON CAPITAL EMPLOYED

Capital employed

The principal motive of a business is to earn profits. The efficiency of a business therefore

should be measured by the amount of profits earned by the business. For the purchase of earning

income, investment is made in the business. The profit earned in a business therefore has a definite

bearing on its investments. If there is increase in investment, it naturally follows that there should be

increase in the profits also, even though, this may not be always correct, yet the fact remains that the

efficiency could be judged on a comparison of the investment in the business.

Net Capital consists of fixed and current assets less current liabilities. The ‘net capital

employed’ may also refer to the proprietor’s funds in the business. All assets excluding investments

and fictitious assets should be included. There differences of opinion as regards the value of the fixed

assets to be taken, whether at the written down value of the fixed assets or gross values without

deduction of depreciation or at current replacement values.

Computation of capital employed

There are three methods of calculating capital employed: These are: (1) Gross value cost

(2) Net value – cost less depreciation (3) Replacement value- as the value of the rupee is falling. In

this case, the assets have to be revalued at their current market value.

Assets like goodwill, patents, trade marks which are intangible are excluded. Investments in

Governments securities made outside the business are excluded as they are in the nature of non-trading

assets. Fictitious assets like preliminary expenses, discount on debentures etc., are also excluded.

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The following is the summary of the items included in capital employed.

(i) Issued share capital.

(ii) All reserves.

(iii) Profit and Loss account balance.

(iv) Debentures.

Alternatively:

(i) Fixed assets.

(ii) Investments inside the business.

(iii) Current assets.

(iv) Less current liabilities.

Return on capital employed

The best method of measuring the profits of a business for management purposes is the ratio

of profit after tax to total assets. In a business capital is a significant factor, it reflects the ability of the

management in the conduct of their business operations. Comparisons of profit to sales is also another

method of assessing the profitability of a business. This varies between industries and also within an

industry. If a company were to deal with different types of products, this will vary with the types of

products. The drawback in this method is it does not take in to account the amount of capital employed

in a business to produce the sales and earn profit. It sometimes happens that in some industries the

ratio of profit to sales will be higher than the ratio of profits to capital employed. In order to correctly

gauge the position, the ratio of profit to tangible net worth is employed.

Adjustments of profits

As regards profits to the taken for calculating return on capital employed, the following

adjustments are necessary.

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 Net profit as per profit and loss account

Add (1) Loss on sale of fixed assets;

(2) Interest on overdraft;

Less (3) Bad debts recovered;

(4) Additional depreciation charged on the replacement cost on fixed assets;

(5) Income from investments made outside the business.

Advantages

The Return on Capital Employed method has the following advantages in measuring the

efficiency of a business.

1. There is scope for comparing the progress of a business with that of a similar nature.

2. It is possible to compare the profitability of the various departments of a business;

3. By comparison of the capital employed, the relative profitability of the different types of

products produced and sold can be well assessed;

4. For purposes of future expansion of a business, it is possible to plan future course of action

by the application of this method.

5. In the preparation of the budget, this can be made an indispensable part;

6. A business can get indirect benefits if the return on capital is adequate.

CAPITAL GEARING

Definition: ‘Capital Gearing’ or Gearing Ratio’ is the relationship between the equity share

capital and the preference share capital and also loan capital. Another definition is the ratio between

the amount of fixed charges payable to preference shareholders in the form of preference divided
and the debentures in the form of debenture interest and the amount of profits available to the equity
shareholders.
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 When the preference share capital and debentures issued are proportionately higher to the

equity share capital, there is said to be ‘High Gearing’. If the preference share capital and the

debentures issued are proportionately less as compared to the equity share capital, there is said to

be ‘Low Gearing’. If the gearing is high, the dividend to be received by the equity shareholders

fluctuates according to the increase in profits.

If the capital structure gearing is very high, then further loans or preference share capital is

out of question and in that case the equity share are very speculate. When there are substantial profits,

the heavy fixed interest and preference dividend can be paid leaving the balance as payment of dividend

on equity shares. If a company’s capital structure is highly geared-when the preference share capital,

debentures and long-term loans are proportionately higher than the equity share capital and reserves-

there is said to be ‘trading on equity’.

Illustration

High Gearing
Share capital-
50,000- 8% Preference shares of Re. 1 each Rs. 50,000
10,000-Equity shares of Re. 1 each Rs. 10,000
Assuming that profits of a business for a particular year are Rs. 7,000 the payments of dividend will be
as under:
Preference dividend Rs. 4,000
Equity dividend (Balance) 3,000
7,000

Assuming that the profits of the business next year are Rs. 5,000, the dividend payable will

be as under:

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Preference divided Rs. 4,000
Equity dividend (Balance) 1,000
5,000
The equity share will fluctuate in the market value as the dividends they will receive are reduced.
Low Gearing
Share Capital—
10,000- 8% Preference shares of Re. 1 each Rs. 10,000
50,000- Equity shares of Re. 1 each 50,000

Assuming that the profits of the company are Rs.7, 000 as mentioned above, the divided

payments will be as under:

Preference divided Rs. 800

Equity dividend 6,200
7,000

On the other hand, if the profits are reduced to Rs.5, 000 as noted above, the dividends will be paid

as under:

Preference dividend Rs. 800

Equity dividend 4,200
5,000

It will be noted if the profits are reduced, the rate of dividend to the equity shareholders in

the case of low gearing, has been reduced. When there is high gearing such shares are consideration

to be speculative resulting in the fluctuating in their market value.

Illustration

There are two companies A and B which have assets and liabilities of similar values but

there is difference in the share capital gearing. The share of the two companies are:

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 A Ltd.
10,000 7% Preference shares of Rs. 10 each Rs. 1,00,000
500 Equity shares of Rs. 10 each 5,000
1,05,000
B Ltd
1,000 7% Preference shares of Rs. 10 each Rs. 10,000
9,500 Equity shares of Rs. 10 each 95,000
1,05,000

Assume that the profits of each of the two companies are:

1963 Rs. 20,000

1964 Rs. 8,000
The distribution of the dividend for the two years will be as under:
1963 1964
Pref. Equity Pref. Equity
dividend dividend dividend dividend
Rs. Rs. Rs. Rs.
A Ltd. A Ltd.
Profits 20,000 Profits 8,000
Less Pref. dividend 7,000 Less Pref. dividend 7,000
Balance to Equity Balance available to
Shareholders 13,000 Equity shareholders 1,000
260% 20%
B Ltd. B Ltd.
Profits 20,000 Profits 8,000
Less Pref. dividend 700 Less Pref. divided 700
Balance available to Balance available to
Equity shareholders 19,300 Equity shareholders 7,300

20.3% 7.7%

It is clear that even though the profits of the companies are the same, there is fluctuation in

the rate of divided of the equity shares. In the case of A Ltd. which has low proportion of equity

shares, the market value of the equity shares will be very high in prosperous years as compared with

the equity shares of B Ltd. Conversely its value will fall in period of depression.

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 Dividend cover refers to the number of times the dividend is covered by the amount of

profits available. As regards equity shares, divided cover represents the relation between the amount

of profits available after charging expenses like debenture interest and preference divided and the

amount of equity dividend. In the case of a high dividend cover on equity shares, the indication is that

the company is retaining high profits.

Assets cover represents the amount of share capital covered by the available assets. In

the case of equity share capital, the assets cover is the amount of net assets available after deducting

preference share capital and debentures. The assets cover for debentures is the amount of assets

representing security offered to the debenture holder.

INTER-FIRM COMPARISON

Objectives

Inter-term comparisons are the tools used by the management to compare its operating
performance and financial results with those of other similar firms in the same industry. The data are
complied to a common pool by similar industries. These comparisons help the management to draw
their attention to area of weakness which require improvement. They also help the management to
suggest lines of improvement to be achieved if the competition standards are to be maintained. The
result of the comparisons are expressed in the form of key ratios which can be easily understood by
the management.

Methods

The best way of understanding the extent top which inter-firm comparisons help the
management depends upon the results obtained by such firms. There are different types of comparisons
used. First example deals with the comparisons of figures “of particular relevance to those responsible
for the overall direction of manufacturing business”. Such comparison discloses how the financial success
compares with that of the other firms in his industry. If the manager were to find his firm inferior in
this respect, it will draw his attention to the particular department or activity of the business responsible.

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Financial and operating ratios are employed for comparison purposes. They consist of:

1. Profit to capital employed

2. Profit to sale

3. Sales to capital employed

4. Cost of production to sales

5. Marketing and distribution expenses to sales

6. Administration expenses to sales

7. Fixed assets to total assets

8. Average of debtors outstanding.

These ratios will indicate in what fields of activity- production, sales, administration and
marketing- the firm has carried on its operations more or less efficiency than others. This will also
reveal whether the return on investments is favourable as compared to others.

Forms: There are different forms of inter-firm comparisons. The methods adopted are:

1. The centre generally as body of organization collects the data required.

2. Information is provided to the management with a view to determine the efficiency or otherwise
of a business by comparing the performers of the other businesses.

3. If there is any area of weakness, the reason why the results vary from one business to another
are brought to the notice of the management.

The main purpose served by inter-firm comparison is to show to the management

improvements in efficiency or weakness in the conduct of the business operation. As already indicated
several businesses supply data to the centre- a body which is neutral regarding their businesses- in
confidence and the centre gives reports to the business on comparison being made as to the results.
Problems such as adequacy of profits, efficiency in marketing the merchandise and efficiency in
production methods are solved by inter-firm comparisons. The centre will focus its attention on the
weak spots if any, so that the management may change its policy and planning to achieve better results.

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STANDARD RATIOS

Purposes

We have seen that in addition to using comparative financial statements and trend

percentages, a number of individual ratios are also prepared to aid the analyst in his analysis. A single

ratio does not furnish a completer picture. Ratios like other statistical data merely represent a convenient

means to focusing the attention of the analyst on specific relationships which require further investigation.

Financial and operating relationships expressed by the ratio have very little significance unless they

are judged on the relative standards. In analyzing financial statements, the method of studying the

position of a business to compare the same with standards prepared from the statements. Unless the

analyst has before him measuring devices or standards of comparison it will not be possible for him

to determine whether the ratios indicate favorable or unfavourable trends. The first step in the analysis

and interpretation of financial statements is the establishment of ratios for that particular undertaking.

The method followed in the construction of standard ratios is to prepare as many statements as possible

for each type of industry; construct several ratios of the items in the statements, and then strike the

average of the ratios. These ratios are called ‘standards’.

Window dressing

When a person intending to give credit to a business examines the financial statements he

constructs the current ratio to satisfy himself whether this ratio warrants granting of credit. To satisfy

the intending credit-giver, as to the affairs, of the business, the financial statements are prepared is

such a manner as to create a satisfactory position from the view point of the intending investor. This

kind of manipulation is called ‘Window dressing’. This method is also resorted to by some businessman

before the Balance Sheet date to manipulate the Balance Sheet in such a way as to create a satisfactory

position to the persons who examine the same. One of the devices adopted to show a high current

ratio just before the Balance Sheet date is defer purchasing inventory for some time before closing

the accounts because if inventory is bought on credit, the current assets and current liabilities increase

by the same amounts resulting in the decrease of the ratio. Other devices adopted by concerns to
74
make the Balance Sheet position appear better than the actual one are:

(1) To keep the receipt book open even after the closing date.

(2) Contingent liabilities on bills discounted being omitted.

(3) Including in sundry debtors, items of sales billed but no agreed to by the purchaser.

(4) Including in stock, items of purchases but excluding from sundry creditors the liability for

purchases.

(5) Debtors are pressed for payment even before the due date and before the Balance Sheet

date to augment cash resources.

(6) Orders are accelerated to bring them within the financial period.

(7) After the declaration of the interim dividends and dispatch of dividend warrants, bank account

is not credited but unclaimed dividends account is credited, and shown in the Balance Sheet.

This is due to showing a larger bank balance by the amount of unpresented dividend warrens.

Ratio Analysis- Limitations

Ratio analysis is the study of specific relationship and forms the heart of statements analysis.

Ratios link parts of the financial statements in order to provide clues about the status of particular

aspects of the business. This requires a basis for comparison. Accordingly figures have little meaning

by themselves. They taken on meaning only when compared to something. The only way to determine

whether an amount is adequate, improving or deteriorating in or out of proportion is only by relating

it to other items. Some comparison is essential to put the analysis into proper perspective. The different

bases of comparison are used in different circumstances. They do not all necessarily lead to the same

judgements. The starting point is to relate specific statement items to each other. The study of the

specific statement relationships is called ‘ratio analysis’. The ratios themselves should be evaluated

by comparison with similar ratios.

1. Ratios are in the nature of generalizations and reflect conditions at a particular time. A

75
 particular ratio may be satisfactory at only certain circumstances and the same may not be

satisfactory at only certain circumstances. With the continuity of the operations of the business

the ratios are liable of change with the results, they may give misleading conclusions as regards

financial position of a business and therefore at times unreliable. To get a correct picture of

the business, in addition to employment of ratios, non-financial information should also be

analysed and both employed. In order that the ratios may be meaningful, it must be related

to the entire business unit. The ratio may fluctuate considerably during the course of the year.

2. Ratios are merely an aid in the evaluation of business. It is not possible for the financial

statements from which ratios are constructed to present all relevant information about the

business operations. Ratios relate to past data and can therefore tend to change at the future.

3. Ratios do not make decisions. They do not purport precise problems nor indicate cases.

They may aid in decision-making by high-lighting areas which are problems or which require

further investigation.

4. Ratios are more useful than absolute amounts because the claim that figures speak for

themselves is often quite unjustified. It may be necessary to translate them into a language

understandable to others or so as to arrange them that they speak more loudly. The object

of ratios is to measure facts and probabilities as to draw out their inner meaning which is

not evident from absolute amounts alone.

5. When used in their absolute form, ratios have rarely any great meaning but they may take

on a new significance when compared with other data or within themselves.

6. Percentages often tend to hide significant aspects of the original data but become more

meaningful when read in conjunction with the absolute figures or other ratios.

7. Unless adequate details of accounts are given, especially, in relation to consistent application

of generally accepted accounting principles, the ratios obtained cannot be relied upon.

8. Ratios should be used as financial tools. They should not be considered a ends themselves

76
 rather than as the means for an end. No ratio may be regarded as good or bad inter se. It

may be an indication that a firm is weak or strong but it must never be taken as proof of

either one. Ratios may be linked to railroads; they tell the analyst to “Stop, look and listen.

9. Another weakness in ratio analysis arises from the fact that they are normally computed

directly from a company’s certified financial statements, without any adjustments being made

by the analyst. For ratio use, conventional financial statements prepared in accordance with

the generally accepted accounting principles have a number of serious weakness that the

analyst, must consider if the ratios are to be meaningful. Unless the analyst takes the deficiency

in the accounting practice into consideration in his analysis, ratios calculated from published

financial statements of companies will be grossly misleading.

10. Another limitations arises from the problem of changing value of the rupee inflation. Financial

statements are prepared under constant rupee assumption, which strictly speaking, is not

valid. Because they fail to consider the changing value of the rupee, financial statements may

be wrong.

If the above limitation are properly discounted, ratio analysis can be the best tool. The

successful; analyst will utilize every available material in exercising his judgement.

SUMMARY

Accounting ratio is a ratio of selected values on an enterprise’s financial statements. There are
many standard ratios used to evaluate the overall financial condition of a corporation or other organiza-
tion. Financial ratios are used by managers within a firm, by current and potential stockholders (own-
ers) of a firm, and by a firm’s creditors. Security analysts use financial ratios to compare the strengths
and weaknesses in various companies. If shares in a company are traded in a financial market, the
market price of the shares is used in certain financial ratios.
Values used in calculating financial ratios are taken from the balance sheet, income statement,
cash flow statement and (rarely) statement of retained earnings. These comprise the firm’s “accounting
statements” or financial statements.
Ratios are always expressed as a decimal value, such as 0.10, or the equivalent percent value, such as
10%.
Financial ratios quantify many aspects of a business and are an integral part of financial state-
ment analysis. Financial ratios are categorized according to the financial aspect of the business which

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the ratio measures. Liquidity ratios measure the availability of cash to pay debt. Activity ratios measure
how quickly a firm converts non-cash assets to cash assets. Debt ratios measure the firm’s ability to
repay long-term debt. Profitability ratios measure the firm’s use of its assets and control of its expenses
to generate an acceptable rate of return. Market ratios measure investor response to owning a company’s
stock and also the cost of issuing stock.
Financial ratios allow for comparisons
Between companies
Between industries
Between different time periods for one company
Between a single company and its industry average.
The ratios of firms in different industries, which face different risks, capital requirements, and
competition, are not usually comparable.

QUESTIONS

1. Define accounting ratio.

2. How are accounting ratios classified? What are its significances and limitations?

3. What are the causes of inadequacy of working capital?

4. What is overtrading? What are its symptoms?

5. What is under trading, over capitalization and under capitalization?

6. Define liquid ratio. What is its significance?

7. Explain revenue statement ratio.

8. What is age of stock? What is its significance?

9. What is a balance sheet and revenue statement ratio?

10. What is a price/earning ratio?

11. Write a note on return on capital employed. What are its advantages?

12. Define capital gearing.

13. Write the objectives and methods of inter firm comparison.

14. Write a description on standard ratio.

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