Financial Management Full Notes

SRM INSTITUTE OF HOTEL
MANAGEMENT
(Affiliated to National Council for Hotel Management & Catering Technology, Noida)
B.Sc. HOSPITALITY & HOTEL ADMINISTRATION
FIFTH SEMESTER
STUDY MATERIAL
SUBJECT CODE: BHM307
SUBJECT NAME: FINANCIAL MANAGEMENT
1
BHM307 - FINANCIAL MANAGEMENT
S.No. Topic Page No
1. FINANCIAL MANAGEMENT MEANING & SCOPE

A. Meaning of business finance
B. Meaning of financial management 3
C. Objectives of financial management
2. FINANCIAL STATEMENT ANALYSIS AND INTERPRETATION
A. Meaning and types of financial statements
B. Techniques of financial analysis 6
C. Limitations of financial analysis D. Practical problems
3. RATIO ANALYSIS
A. Meaning of ratio
B. Classification of ratios
C. Profitability ratios 20
D. Turnover ratios
E. Financial ratios
F. Du Pent Control Chart G. Practical Problems
4. FUNDS FLOW ANALYSIS
A. Meaning of funds flow statement
B. Uses of funds flow statement 40
C. Preparation of funds flow statement
D. Treatment of provision for taxation and proposed dividends (as non-
current liabilities) E. Practical problems
5. CASH FLOW ANALYSIS
A. Meaning of cash flow statement
B. Preparation of cash flow statement 48
C. Difference between cash flow and funds flow analysis
D. Practical problems
6. FINANCIAL PLANNING MEANING & SCOPE
A. Meaning of Financial Planning
B. Meaning of Financial Plan 53
C. Capitalisation D. Practical problems
7. CAPITAL EXPENDITURE
A. Meaning of Capital Structure
B. Factors determining capital structure 57
C. Point of indifference D. Practical problems
8. WORKING CAPITAL MANAGEMENT
A. Concept of working capital
B. Factors determining working capital needs 60
C. Over trading and under trading
9. BASICS OF CAPITAL BUDGETING
A. Importance of Capital Budgeting
B. Capital Budgeting appraising methods 63
C. Payback period
D. Average rate f return
E. Net Present Value
F. Profitability index
G. Internal rate of return H. Practical problems
2
CHAPTER 1. FINANCIAL MANAGEMENT MEANING & SCOPE
A. Meaning of business finance B. Meaning of financial management C. Objectives of
financial management
MEANING OF FINANCE
Finance may be defined as the art and science of managing money. It includes
financial service and financial instruments. Finance also is referred as the provision of money
at the time when it is needed. Finance function is the procurement of funds and their effective
utilization in business concerns.
The concept of finance includes capital, funds, money, and amount. But each word is having
unique meaning. Studying and understanding the concept of finance become an important part
of the business concern.
DEFINITION OF FINANCE
According to Khan and Jain, “Finance is the art and science of managing money”.
DEFINITION OF BUSINESS FINANCE

According to the Wheeler, “Business finance is that business activity which concerns with
the acquisition and conversation of capital funds in meeting financial needs and overall
objectives of a business enterprise”.
TYPES OF FINANCE
Finance is one of the important and integral part of business concerns, hence, it plays a major
role in every part of the business activities. It is used in all the area of the activities under the
different names.
Finance can be classified into two major parts:
MEANING OF FINANCIAL MANAGEMENT

Financial management refers to the efficient and effective management of money
(funds) in such a manner as to accomplish the objectives of the organization. It is the
specialized function directly associated with the top management.
3
Financial Management means planning, organizing, directing and controlling the
financial activities such as procurement and utilization of funds of the enterprise. It means
applying general management principles to financial resources of the enterprise.
Scope/Elements of Financial Management
1. Investment decisions includes investment in fixed assets (called as capital budgeting).

Investments in current assets are also a part of investment decisions called as working
capital decisions.
2. Financial decisions - They relate to the raising of finance from various resources
which will depend upon decision on type of source, period of financing, cost of
financing and the returns thereby.
3. Dividend decision - The finance manager has to take decision with regards to the net
profit distribution. Net profits are generally divided into two:
a. Dividend for shareholders- Dividend and the rate of it has to be decided.
b. Retained profits- Amount of retained profits has to be finalized which will
depend upon expansion and diversification plans of the enterprise.
Objectives of Financial Management

The financial management is generally concerned with procurement, allocation and control of
financial resources of a concern. Financial Management may be broadly divided into two
parts such as:
1. Profit maximization
2. Wealth maximization.
Profit Maximization
Main aim of any kind of economic activity is earning profit. A business concern is
also functioning mainly for the purpose of earning profit. Profit is the measuring techniques to
understand the business efficiency of the concern. Profit maximization is also the traditional
and narrow approach, which aims at, maximizes the profit of the concern. Profit
maximization consists of the following important features.
1. Profit maximization is also called as cashing per share maximization. It leads to maximize
the business operation for profit maximization.
2. Ultimate aim of the business concern is earning profit, hence it considers all the possible
ways to increase the profitability of the concern.
Wealth Maximization
Wealth maximization is one of the modern approaches, which involves latest
innovations and improvements in the field of the business concern. The term wealth means
4
shareholder wealth or the wealth of the persons those who are involved in the business
concern.
Wealth maximization is also known as value maximization or net present worth
maximization. This objective is universally accepted concept in the field of business.
1. To ensure regular and adequate supply of funds to the concern.

2. To ensure adequate returns to the shareholders which will depend upon the earning
capacity, market price of the share, expectations of the shareholders.
3. To ensure optimum funds utilization. Once the funds are procured, they should be
utilized in maximum possible way at least cost.
4. To ensure safety on investment, i.e, funds should be invested in safe ventures so that
adequate rate of return can be achieved.
5. To plan a sound capital structure-There should be sound and fair composition of
capital so that a balance is maintained between debt and equity capital.
Functions of Financial Management
1. Estimation of capital requirements: A finance manager has to make estimation with

regards to capital requirements of the company. This will depend upon expected costs
and profits and future programmes and policies of a concern. Estimations have to be
made in an adequate manner which increases earning capacity of enterprise.
2. Determination of capital composition: Once the estimation has been made, the
capital structure have to be decided. This involves short- term and long- term debt
equity analysis. This will depend upon the proportion of equity capital a company is
possessing and additional funds which have to be raised from outside parties.
3. Choice of sources of funds: For additional funds to be procured, a company has
many choices like-
a. Issue of shares and debentures
b. Loans to be taken from banks and financial institutions
c. Public deposits to be drawn like in form of bonds.
Choice of factor will depend on relative merits and demerits of each source and period
of financing.
4. Investment of funds: The finance manager has to decide to allocate funds into
profitable ventures so that there is safety on investment and regular returns is possible.
5. Disposal of surplus: The net profits decisions have to be made by the finance
manager. This can be done in two ways:
a. Dividend declaration - It includes identifying the rate of dividends and other
benefits like bonus.
b. Retained profits - The volume has to be decided which will depend upon
expansional, innovational, diversification plans of the company.
6. Management of cash: Finance manager has to make decisions with regards to cash
management. Cash is required for many purposes like payment of wages and salaries,
payment of electricity and water bills, payment to creditors, meeting current liabilities,
maintenance of enough stock, purchase of raw materials, etc.
7. Financial controls: The finance manager has not only to plan, procure and utilize the
funds but he also has to exercise control over finances. This can be done through
many techniques like ratio analysis, financial forecasting, cost and profit control, etc.
5
CHAPTER: 2 FINANCIAL STATEMENT ANALYSIS AND INTERPRETATION
A. Meaning and types of financial statements B. Techniques of financial analysis C.

Limitations of financial analysis D. Practical problems
Meaning of Financial Statements:

Financial statements are the summary of the accounting process, which provides
useful information to both internal and external parties.
Definition of Financial Statements:

John N. Nyer defined as “Financial statements provide a summary of the accounting
of a business enterprise, the balance-sheet reflecting the assets, liabilities and capital as on a
certain data and the income statement showing the results of operations during a certain
period”.
Financial statements generally consist of two important statements:
(i) The income statement or profit and loss account.
(ii) Balance sheet or the position statement.
A part from that, the business concern also prepares some of the other parts of
statements, which are very useful to the internal purpose such as:
(i) Statement of changes in owner’s equity.
(ii) Statement of changes in financial position.
Income Statement
 Income statement is also called as profit and loss account, which reflects the
operational position of the firm during a particular period. Normally it consists of one
accounting year.
 Income statement helps to ascertain the gross profit and net profit of the concern.
Gross profit is determined by preparation of trading or manufacturing a/c and net
profit is determined by preparation of profit and loss account.
Balance Sheet Statement

 Position statement is also called as balance sheet, which reflects the financial position
of the firm at the end of the financial year.
6
 Position statement helps to ascertain and understand the total assets, liabilities and
capital of the firm. One can understand the strength and weakness of the concern with
the help of the position statement.
Statement of Changes in Owner’s Equity

 It is also called as statement of retained earnings. This statement provides information
about the changes or position of owner’s equity in the company. How the retained
earnings are employed in the business concern. Nowadays, preparation of this
statement is not popular and nobody is going to prepare the separate statement of
changes in owner’s equity.
Statement of Changes in Financial Position

 Income statement and position statement shows only about the position of the finance,
hence it can’t measure the actual position of the financial statement.
 Statement of changes in financial position helps to understand the changes in financial
position from one period to another period.
 Statement of changes in financial position involves two important areas such as fund
flow statement which involves the changes in working capital position and cash flow
statement which involves the changes in cash position.
TYPES OF FINANCIAL STATEMENT ANALYSIS

Analysis of financial statement may be broadly classified into two important types on
the basis of material used and methods of operations.
1. Based on Material Used

Based on the material used, financial statement analysis may be classified into two
major types such as External analysis and internal analysis.
A. External Analysis
 Outsiders of the business concern do normally external analyses but they are indirectly
involved in the business concern such as investors, creditors, government
organizations and other credit agencies.
7
 External analysis is very much useful to understand the financial and operational
position of the business concern.
 External analysis mainly depends on the published financial statement of the concern.
This analysis provides only limited information about the business concern.
B. Internal Analysis
 The company itself does disclose some of the valuable information to the business
concern in this type of analysis.
 This analysis is used to understand the operational performances of each and every
department and unit of the business concern.
 Internal analysis helps to take decisions regarding achieving the goals of the business
concern.
2. Based on Method of Operation

Based on the methods of operation, financial statement analysis may be classified into
two major types such as horizontal analysis and vertical analysis.
A. Horizontal Analysis
 Under the horizontal analysis, financial statements are compared with several years
and based on that, a firm may take decisions.
 Normally, the current year’s figures are compared with the base year (base year is
consider as 100) and how the financial information are changed from one year to
another.
 This analysis is also called as dynamic analysis.
B. Vertical Analysis
 Under the vertical analysis, financial statements measure the quantities relationship of
the various items in the financial statement on a particular period.
 It is also called as static analysis, because, this analysis helps to determine the
relationship with various items appeared in the financial statement.
LIMITATIONS OF FINANCIAL STATEMENT ANALYSIS:
Analysis of financial statements helps to ascertain the strength and weakness of the
business concern, but at the same time it suffers from the following limitations.
1. It analyses what has happened till date and does not reflect the future.
2. It ignores price level changes.
3. Financial analysis takes into consideration only monetary matters, qualitative aspects are
ignored.
4. The conclusions of the analysis is based on the correctness of the financial statements.
5. Analysis is a means to an end and not the end itself.
6. As there is variation in accounting practices followed by different firms a valid comparison
of their financial analysis is not possible.
TECHNIQUES OF FINANCIAL STATEMENT ANALYSIS:

Financial statement analysis is interpreted mainly to determine the financial and
operational performance of the business concern. A number of methods or techniques are
8
used to analyse the financial statement of the business concern. The following are the
common methods or techniques, which are widely used by the business concern.
1. Comparative Statement Analysis
A. Comparative Income Statement Analysis
B. Comparative Balance Sheet Statement Analysis
2. Trend Analysis
3. Common Size Analysis
4. Fund Flow Statement
5. Cash Flow Statement
6. Ratio Analysis
COMPARATIVE STATEMENT ANALYSIS
Comparative statement analysis is an analysis of financial statement at different period

of time. This statement helps to understand the comparative position of financial and
operational performance at different period of time.
Comparative financial statements again classified into two major parts such as
comparative balance sheet analysis and comparative profit and loss account analysis.
1. Comparative Balance Sheet Analysis

 Comparative balance sheet analysis concentrates only the balance sheet of the concern
at different period of time.
 Under this analysis the balance sheets are compared with previous year’s figures or
one-year balance sheet figures are compared with other years.
 Comparative balance sheet analysis may be horizontal or vertical basis. This type of
analysis helps to understand the real financial position of the concern as well as how
the assets, liabilities and capitals are placed during a particular period.
2. Comparative Profit and Loss Account Analysis

 Another comparative financial statement analysis is comparative profit and loss
account analysis.
 Under this analysis, only profit and loss account is taken to compare with previous
year’s figure or compare within the statement.
 This analysis helps to understand the operational performance of the business concern
in a given period. It may be analyzed on horizontal basis or vertical basis.
9
Percentage of Increase or Decrease = Current year – Base year X 100
Base year
Practical Problem: 1
From the following Profit and Loss Account and Balance Sheet of Ramco Ltd. For the
year ended 1999 and 2000, you are required to prepare a comparative income statement and a
comparative Balance Sheet.
Profit and Loss Account
Particulars 1999 2000 Particulars 1999 2000
Rs. Rs. Rs. Rs.
To Cost of Goods sold 6,000 7,500 By Net Sales 8,000 10,000
To Operating Expenses:
Administrative 200 200
Selling 300 400
To Net Profit 1,500 1,900
8,000 10,000 8,000 10,000
Balance Sheet as on 31st December

Liabilities 1999 2000 Assets 1999 2000
Rs. Rs. Rs. Rs.
Bills Payable 500 750 Cash 1,000 1,400
Sundry Creditors 1,500 2,000 Debtors 2,000 3,000
Tax Payable 1,000 1,500 Stock 2,000 3,000
6% Debentures 1,000 1,500 Land 1,000 1,000
10% Preference Capital 3,000 3,000 Buildings 3,000 2,700
Equity Capital 4,000 4,000 Plant 3,000 2,700
Reserves 2,000 2,450 Furniture 1,000 1,400
13,000 15,200 13,000 15,200
Solution:
RAMCO Limited Income Statement for the year ended 31st Dec. 1999 and 2000
Particulars 1999 2000 Increase(+) or Decrease (-)
Rs. Rs. Amount(Rs.) Percentage (%)
Net Sales 8,000 10,000 +2,000 +25
Less: Cost of goods sold 6,000 7,500 +1,500 +25
Gross Profit 2,000 2,500 +500 +25
(A)
Less: Operating Expenses: 200 200 - -
Administrative 300 400 +100 +33.3
Selling 500 600 +100 +20
Total Operating Expenses (B) 1,500 1,900 +400 +26.7
Operating Profit (A+B)
10
RAMCO Limited Income Statement for the year ended 31st Dec. 1999 and 2000
Rs. Rs. Amount(Rs.) Percentage
(%)
ASSETS:
Current Assets:
Cash 1,000 1,400 +400 +40
Debtors 2,000 3,000 +1,000 +50
Stock 2,000 3,000 +1,000 +50
Total Current Assets (A) 5,000 7,400 +2,400 +48
Fixed Assets:
Land 1,000 1,000 - -
Buildings 3,000 2,700 -300 -10
Plant 3,000 2,700 -300 -10
Furniture 1,000 1,400 +400 +40
Total Fixed Assets (B) 8,000 7,800 -200 -2.5
Total Assets (A+B) 13,000 15,200 +2,200 +17
LIABILITIES AND CAPITAL:

Current Liabilities: 750 +250 +50
Bills Payable 500 2,000 +500 +33.3
Sundry Creditors 1,500 1,500 +500 +50
Taxes Payable 1,000
Total Current Liabilities (A) 3,000 4,250 +1,250 +41.7
Long-term Liabilities:
6% Debentures 1,000 1,500 +500 +50
Total Liabilities (B) 4,000 5,750 +1,750 +43,75
Capital and Reserves:

10% Preference Capital 3,000 3,000 - -
Equity Capital 4,000 4,000 - -
Reserves 2,000 2,450 +450 +22.5
Total Shareholders’ Funds (C) 9,000 9,450 +450 +5
Total Liabilities and Capital(A+B+C) 13,000 15,200 +2,200 +17
11
The following is the Balance Sheets of MS Gupta for the years 2006 and 2007.
Prepare the comparative Balance Sheet and study the financial position of the concern.
Balance Sheet as on 31st December

Rs Rs Rs Rs
Equity share capital 500,000 700,000 Land and Building 270,000 1,70,000
Reserves and surplus 330,000 222,000 Plant and Machinery 400,000 600,000
Debentures 200,000 300,000 Furniture 20,000 25,000
Long term loan on 100,000 150,000 Other fixed assets 25,000 30,000
mortgage
Bill Payables 50,000 45,000 Cash in hand 20,000 40,000
Sundry creditors 100,000 120,000 Bill Receivables 100,000 80,000
Other current liabilities 5000 10,000 Sundry debtors 200,000 250,000
Stock 250,000 350,000
Prepaid Expenses — 2000
1285000 1547000 1285000 1547000
12
Solution:
Comparative Balance Sheet of MS Gupta for the year ending December 2006 and 2007

Rs. Rs. Amount(Rs.) Percentage
(%)
ASSETS:
Current Assets:
Cash in hand 20,000 40,000 +20,000 +100
Bill Receivable 1,00,000 80,000 -20,000 -20
Sundry Debtors 2,00,000 2,50,000 +50,000 +25
Stock 2,50,000 3,50,000 +1,00,000 +40
Prepaid expenses - 2,000 +2,000 +100
Total Current Assets (A) 5,70,000 7,22,000 +1,52,000 +26.67
Fixed Assets:
Land &Buildings 2,70,000 1,70,000 -1,00,000 -37.03
Plant & Machinery 4,00,000 6,00,000 +2,00,000 +50
Furniture 20,000 25,000 +5,000 +25
Other Fixed Assets 25,000 30,000 +5,000 +20
Total Fixed Assets (B) 7,15,000 8,25,000 +1,10,000 +13.49
Total Assets (A+B) 12,85,000 15,47,000 +2,62,000 +20.39
LIABILITIES AND CAPITAL:

Current Liabilities:
Bills Payable 50,000 45,000 -5,000 -10
Sundry Creditors 1,00,000 1,20,000 +20,000 +20
Other current liabilities 5,000 10,000 +5,000 +100
Total Current Liabilities (A) 1,55,000 1,75,000 +20,000 +12.9
Long-term Liabilities:
Debentures 2,00,000 3,00,000 +1,00,000 +50
Long term loan on mortgage 1,00,000 1,50,000 +50,000 +50
Total long term liabilities (B) 3,00,000 4,50,000 1,50,000 +50
Capital and Reserves:

Equity share capital 5,00,000 7,00,000 +2,00,000 +40
Reserves & surplus 3,30,000 2,22,000 -1,08,000 -32.73
Total Shareholders’ Funds (C) 8,30,000 9,22,000 +92,000 +50
Total Liabilities and Capital(A+B+C) 12,85,000 15,47,000 +2,62,000 +20.39
13
The income statements of a concern are given for the year ending 31st December 2006
and 2007. Rearrange the figures in a comparative form and study the profitability of the
concern
Details 2006 2007

Amount (Rs) Amount (Rs)
Net Sales 785,000 900,000
Cost of goods sold 450,000 500,000
Operating expenses :
General and administrative expenses 70,000 72,000
Selling expenses 80,000 90,000
Non-operating expenses :
Interest paid 25,000 30,000
Income tax 70,000 80,000
Solution:
Comparative income statement for the year ended 31st Dec 2006 and 2007
2006 2007 Increase (+) Increase (+)
Particulars Amount Amount Decrease (–) Decrease (–)
(Rs) (Rs) (Rs) (Percentage)
Net sales 785,000 900,000 +115000 +14.65
Less cost of goods sold 450,000 500,000 +50000 +11.11
Gross profit 335,000 400,000 +65000 +19.40
Less: Operating expenses :
General & Administrative 70,000 72,000 +2000 +2.8
Selling expenses 80,000 90,000 +10000 +12.5
Total operating expenses 150,000 162,000 +12000 +8.0
Operating profit 185,000 238,000 +53000 +28.65
Less: other deductions
Interest paid 25,000 30,000 +5000 +20
Net profit before tax 160,000 208,000 +48000 +30.0
Less: income tax 70,000 80,000 +10000 +14.28
Net profit after tax 90,000 128,000 +38000 +42.22
14
TREND ANALYSIS
 Trend analysis is a statistical method used in analyzing financial statements to

understand the trend in the components of the statements over a period of time.
 The financial statements may be analysed by computing trends of series of
information.
 Trend analysis helps to understand the trend relationship with various items, which
appear in the financial statements.
 Each component of the base year is expressed as 100%
From the following information, you are required to prepare a trend analysis taking 1998 as
the base year:
Particulars 1998 1999 2000 2001
Rs. Rs. Rs. Rs.
Hotel premises 2,000 2,400 2,800 2,400
Kitchen equipment 4,000 4,800 4,800 5,600
Cash in hand 400 480 800 440
Cash at bank 520 600 400 480
Sundry debtors 800 1,200 2,000 3,200
Closing stock 1,600 2,400 3,600 4,000
Solution:
Particulars 1998 1999 2000 2001 1998 1999 2000 2001

Rs. Rs. Rs. Rs. % % % %
Hotel premises 2,000 2,400 2,800 2,400 100 120 140 120
Kitchen equipment 4,000 4,800 4,800 5,600 100 120 120 140
Cash in hand 400 480 800 440 100 120 200 110
Cash at bank 520 600 400 480 100 115.4 77 92.3
Sundry debtors 800 1,200 2,000 3,200 100 150 250 400
Closing stock 1,600 2,400 3,600 4,000 100 150 225 250
The base year is assumed to be 1998, and hence the entire statement of 1998 is expressed as
100%. Therefore, the percentage of Hotel Premises for 1990 is:
If Rs. 2,000 is 100%
Therfore Rs. 2,400 is ?
Percentage of Hotel Premises for 1999 = 2,400 X 100 = 120 %
2,000
Similarly, the percentage of Hotel Premises for 2000 is:

If Rs. 2,000 is 100%
Therfore Rs. 2,800 is ?
Percentage of Hotel Premises for 1999 = 2,800 X 100 = 140 %
2,000
All other percentages can be calculated accordingly.
15
Calculate the Trend Analysis from the following information of Tamilnadu Mercantile Bank
Ltd., taking 1999 as a base year and interpret them (in thousands).
Year Deposits Advances Profit

1999 2,05,59,498 97,14,728 3,50,311
2000 2,66,45,251 1,25,50,440 4,06,287
2001 3,19,80,696 1,58,83,495 5,04,020
2002 3,72,99,877 1,77,26,607 5,53,525
2003 4,08,45,783 1,95,99,764 6,37,634
2004 4,40,42,730 2,11,39,869 8,06,755
Solution
Trend Analysis (Base year 1999=100)
(Rs. in thousands)
Deposits Advances Profits
Year Amount Trend Amount Trend Amount Trend
Rs. Percentage Rs. Percentage Rs. Percentage
1999 2,05,59,498 100.0 97,14,728 100.0 3,50,311 100.0
2000 2,66,45,251 129.6 1,25,50,440 129.2 4,06,287 115.9
2001 3,19,80,696 155.5 1,58,83,495 163.5 5,04,020 143.9
2002 3,72,99,877 181.4 1,77,26,607 182.5 5,53,525 150.0
2003 4,08,45,783 198.7 1,95,99,764 201.8 6,37,634 182.0
2004 4,40,42,730 214.2 2,11,39,869 217.6 8,06,755 230.3
COMMON SIZE ANALYSIS
 The common size statement represents the relationship of different items of a financial
statement with some common item by expressing each item as a percentage of the
common item.
 In the income statements, the sales figure is taken as basis and all other figures are
expressed as percentage of sales.
 Similarly, in the balance sheet the total assets and liabilities is taken as taken as base
and all other figures are expressed as percentage of this total.
16
The balance sheet of Mr Anoop Private (Pvt) Limited (Ltd) and Bansal Private Limited are
given below :
Balance Sheet as on 31st December, 2007
Liabilities Anoop Pvt Ltd Bansal Pvt Ltd
Rs Rs
Preference share capital 120,000 150,000
Equity share capital 140,000 410,000
Reserves and surpluses 24,000 28,000
Long-term loans 110,000 120,000
Bill Payables 7000 1000
Sundry creditors 12000 3000
Outstanding Expenses 15000 6000
Proposed Dividend 10000 90000
438,000 808,000
Land and Building 80,000 123,000
Plant and Machinery 334,000 600,000
Temporary Investments 5000 40,000
Investment 6000 20,000
Sundry Debtors 4000 13,000
Prepaid expenses 1000 2000
Cash and Bank balance 8000 10,000
438,000 808,000
Compare the financial position of two companies with the help of common size balance sheet.
17
Solution :
Common size Balance Sheet as on 31st December 2007
Anoop Pvt Ltd Bansal Pvt Ltd
Amount % Amount %
Rs Rs
Fixed assets
Land and Building 80,000 18.26 123,000 15.22
Plant and machinery 334,000 76.26 600,000 74.62
Total Fixed Assets 414,000 94.52 723,000 89.48
Current asset
Temporary investment 5000 1.14 40,000 4.95
Investment 6000 1.37 20,000 2.48
Sundry Debtors 4000 0.91 13,000 1.61
Prepaid Expenses 1000 0.23 2,000 0.25
Cash and Bank 8000 1.83 10,000 1.25
Total current assets 24000 5.48 85,000 10.54
Total Assets 438,000 100.00 808,000 100.00
Share Capital and Reserves
Preference share capital 120,000 27.39 150,000 19.80
Equity share capital 140,000 31.96 410,000 50.74
Reserve and surpluses 24,000 5.48 28,000 3.47
Total Capital and Reserves 284,000 64.83 588,000 74.01
Long term loans 110,000 25.11 120,000 14.85
Current liabilities
Bill Payables 7,000 1.60 1,000 0.12
Sundry creditor 12,000 2.74 3,000 0.37
Outstanding expenses 15,000 3.44 6,000 0.74
Proposed Dividend 10,000 2.28 90,000 11.15
39,000 10.06 109,000 12.38
Total liabilities 438,000 100.00 808,000 100.00
18
Common size income statement
The items in income statement can be shown as percentages of sales to show the relations of
each item to sales.
Practical Problems: 2
Following are the income statements of a company for the year ending 31st December 2006
and 2007
2006 2007
Rs Rs
Sales 500,000 700,000

Miscellaneous income 20,000 15,000
520,000 715,000
Expenses
Cost of sales 330,000 510,000
Office expenses 20,000 30,000
Interest 25000 30,000
Selling expenses 30,000 40,000
405,000 610,000
Net profit 115,000 105,000
520,000 715,000
Solution :
Common size Income Statement for the year ending 31st December 2006 and 2007.
2006 2007
Amount % Amount %
Rs Rs
Sales 500,000 100.00 700,000 100.00

Less : Cost of sales 330,000 66.00 510,000 72.86
Gross profit (A) 170,000 34.00 190,000 27.14
Operating expenses
Office expenses 20,000 4.00 30,000 4.29
Selling expenses 30,000 6.00 40,000 5.71
Total operating expenses (B) 50,000 10.00 70,000 10.00
Operating profit (A-B) 120,000 24.00 120,000 17.14
Miscellaneous income 20,000 4.00 15,000 2.14
Total income 140,000 28.00 135,000 19.28
Less : Non operating expenses 25,000 5.00 30,000 4.28
Net profit 115,000 23.00 105,000 15.00
19
Interpretation
– The sale and gross profit have increased in absolute figures in 2007 as compared to 2006.
But the percentage of gross profit to sales has gone down in 2007.
– The increase in cost of sales as a percentage of sales has brought the profitability from 34%
to 27.14%.
– Operating expenses have remained the same in both the years.
– Net profit has decreased both in absolute figures and as a percentage in 2007 as compared to
2006.
CHAPTER: 3 RATIO ANALYSES
A. Meaning of Ratio B. Classification of Ratios C. Profitability Ratios D. Turnover

ratios E. Financial Ratios F. Du Pont Control Chart G.
Practical problems
MEANING:
Ratio is an expression of one number in relation to another. Ratio analysis is the
process of determining and interpreting the numerical relationship between figures of
financial statements.
DEFINITION:
Kennedy and Mc Millan “the relationship of an item to another expressed in simple
mathematical form is known as a ratio”
OBJECTIVES:
The objectives of using ratios are to test the profitability, financial position (liquidity
and solvency) and the operating efficiency of a concern.
ADVANTAGES OF RATIO ANALYSIS:

Ratio analysis is an important technique in financial analysis. It is a means for judging
the financial soundness of the concern. The advantages of accounting ratios are as follows:
1. It is a useful device for analysing the financial statements.
2. It simplifies, summarizes the accounting figures to make it understandable.
3. It helps in financial forecasting.
4. It facilitates interfirm and intrafirm comparisons.
Ratio analysis is useful in finding the strength and weakness of a business concern. After
identifying the weakness, the ratios are also helpful in determining the causes of the
weakness.
20
CLASSIFICATION OF RATIOS
The classification of ratios on the basis of purpose is as follows:

Ratios
Liquidity Solvency Profitability Activity
(Turnover)
1. Current Ratio 1. Debt-Equity Ratio 1. Gross Profit Ratio 1. Capital Turnover Ratio
2. Liquid Ratio 2. Proprietory Ratio 2. Net Profit Ratio 2. Fixed Asset Turnover Ratio
3. Absolute Liquid Ratio 3. Operating Profit Ratio 3. Stock Turnover Ratio
4.. Operating Ratio 4. Debtors Turnover Ratio
5. Creditors Turnover Ratio
I. LIQUIDITY RATIOS
Liquidity Ratios measure the firms’ ability to pay off current dues i.e.,repayable
within a year. Liquidity ratios are otherwise called as Short Term Solvency Ratios. The
important liquidity ratios are
1. Current Ratio
2. Liquid Ratio
3. Absolute Liquid Ratio
1. CURRENT RATIO
This ratio is used to assess the firm’s ability to meet its current liabilities. The
relationship of current assets to current liabilities is known as current ratio. The ratio is
calculated as:
Current Assests
Current Ratio =
Current Liabilities
Current Assets are those assets, which are easily convertible into cash within one
year. This includes cash in hand, cash at bank, sundry debtors, bills receivable, short term
investment or marketable securities, stock and prepaid expenses.
Current Liabilities are those liabilities which are payable within one year. This
includes bank overdraft, sundry creditors, bills payable and outstanding expenses.
2. LIQUID RATIO
This ratio is used to assess the firm’s short term liquidity. The relationship of liquid
assets to current liabilities is known as liquid ratio. It is otherwise called as Quick ratio or
21
Acid Test ratio. The ratio is calculated as:
Liquid Ratio = Liquid Assets

Current Liabilities
Liquid assets means current assets less stock and prepaid expenses.
3. ABSOLUTE LIQUID RATIO

It is a modified form of liquid ratio. The relationship of absolute liquid assets to liquid
liabilities is known as absolute liquid ratio. This ratio is also called as ‘Super Quick Ratio’.
The ratio is calculated as:
Absolute Liquid Assets
Absolute Liquid Ratio =
Liquid Liabilities
Absolute liquid assets means cash, bank and short term investments.
Liquid liabilities means current liabilities less bank overdraft.
II. SOLVENCY RATIOS

Solvency refers to the firms ability to meet its long term indebtedness. Solvency ratio
studies the firms ability to meet its long term obligations. The following are the important
solvency ratios:
1. Debt-Equity Ratio
2. Proprietory Ratio
1. DEBT EQUITY RATIO
This ratio helps to ascertain the soundness of the long term financial position of the
concern. It indicates the proportion between total long term debt and shareholders funds. This
also indicates the extent to which the firm depends upon outsiders for its existence. The ratio
is calculated as:
Total long term Dept

Debt-Equity Ratio =
Shareholders funds
Total long term debt includes Debentures, long term loans from banks and financial
institutions. Shareholders funds includes Equity share capital, Preference share capital,
Reserves and surplus.
2. PROPRIETORY RATIO
This ratio shows the relationship between proprietors or shareholders funds and total
tangible assets. The ratio is calculated as:
Shere holders funds (Propreitors funds)
Proprietory Ratio =
Total tangible assets
Tangible assets will include all assets except goodwill, preliminary expenses etc.
(Note : All solvency ratios are expressed as a proportion.)
22
III. PROFITABILITY RATIOS
Efficiency of a business is measured by profitability. Profitability ratio measures the
profit earning capacity of the business concern. The important profitability ratios are
discussed below:
1. Gross Profit Ratio
2. Net Profit Ratio
3. Operating Profit Ratio
4. Operating Ratio
1. GROSS PROFIT RATIO
This ratio indicates the efficiency of trading activities. The relationship of Gross profit
to Sales is known as gross profit ratio. The ratio is calculated as:
Gross Profit
Gross Profit Ratio = x 100
Sales
Gross profit is taken from the Trading Account of a business concern.
Otherwise Gross profit can be calculated by deducting cost of goods sold from sales.
Sales means Net sales.
Gross Profit = Sales –– Cost of goods sold
Cost of goods sold = Opening Stock + Purchases –– Closing Stock
(or)
Sales –– Gross Profit
2. NET PROFIT RATIO

This ratio determines the overall efficiency of the business. The relationship of
Net profit to Sales is known as net profit ratio. The ratio is calculated as:
Net Profit
Net Profit Ratio = x 100
Sales
Net profit is taken from the Profit and Loss account of the business concern or the
gross profit of the concern less administration expenses, selling and distribution expenses and
financial expenses.
3. OPERATING PROFIT RATIO

This ratio is an indicator of the operational efficiency of the management. It
establishes the relationship between Operating profit and Sales. The ratio is calculated as:
Operating Profit
Operating Profit Ratio = x 100
Sales
Where operating profit is Net profit + Non-operating expenses – Non-operating income.

Where, Non-operating expenses are interest on loan and loss on sale of assets.
Non-operating income are dividend, interest received and profit on sale of asset. (or)
23
Operating profit = Gross profit – Operating expenses.
Operating expenses include administration, selling and distribution expenses.
Financial expenses like interest on loan are excluded for this purpose.
4. OPERATING RATIO
This ratio determines the operating efficiency of the business concern. Operating
ratio measures the amount of expenditure inurred in production, sales and distribution of
output. The relationship between Operating cost to Sales is known as Operating Ratio. The
ratio is calculated as:
Cost of goods sold+ Operating expenses

Operating Ratio = x 100
sales
(Note: All profitability ratios will be expressed in terms of percentage.)
IV. ACTIVITY RATIOS

Activity ratios indicate the performance of the business. The performance of a
business is judged with its sales (turnover) or cost of goods sold. These ratios arethus referred
to as turnover ratios. A few important activity ratios are discussed below:
1. Capital turnover ratio
2. Fixed assets turnover ratio
3. Stock turnover ratio
4. Debtors turnover ratio
5. Creditors turnover ratio
1. CAPITAL TURNOVER RATIO

This shows the number of times the capital has been rotated in the process of carrying
on business. Efficient utilisation of capital would lead to higher profitability. The relationship
between Sales and Capital employed is known as Capital Turnover Ratio. The ratio is
calculated as:
Sales
Capital Turnover Ratio =
Capital Employed
Where Sales means Sales less sales returns and Capital employed refers to total long
term funds of the business concern i.e., Equity share capital, Preference share capital,
Reserves and surplus and Long term borrowed funds.
2. FIXED ASSETS TURNOVER RATIO

This shows how best the fixed assets are being utilised in the business concern. The
relationship between Sales and Fixed assets is known as Fixed assets turnover ratio. The
ratio is calculated as:
Sales
Fixed assets turnover Ratio =
Fixed Assets
Fixed assets means Fixed assets less depreciation.

24
3. STOCK TURNOVER RATIO
This ratio is otherwise called as inventory turnover ratio. It indicates whether stock
has been efficiently used or not. It establishes a relationship between the cost of goods sold
during a particular period and the average amount of stock in the concern. The ratio is
calculated as:
Cost of goods sold
Stock turnover Ratio =
Average stock
Opening stock + closing stock

Average stock =
2
If information to calculate average stock is not given then closing stock may be taken
as average stock.
4. DEBTORS TURNOVER RATIO

This establishes the relationship between credit sales and average accounts receivable.
Debtors turnover ratio indicates the efficiency of the business concern towards the collection
of amount due from debtors. The ratio is calculated as:
Credit Sales
Debtors turnover Ratio =
Average Accounts Receivable
Accounts receivable includes sundry debtors and bills receivable.

Opening (debtors + bills receivable)
Average Accounts Receivable =
+ Closing (debtors + bills receivable)
2
In case credit sales is not given, total sales can be taken as credit sales
5. CREDITORS TURNOVER RATIO:

This establishes the relationship between credit purchases and average accounts
payable. Creditors turnover ratio indicates the period in which the payments are made to
creditors. The ratio is calculated as:
Credit Purchases
Creditors turnover Ratio =
Average Accounts payable
Accounts payable include sundry creditors and bills payable.
Opening (creditors + bills payable)

Average Accounts Receivable =
+ Closing (creditors + bills payable)
2
25
In case credit purchases is not given total purchases can be taken as credit purchases.
(Note: All turnover ratios will be expressed in terms of times.)
VI FINANCIAL RATIOS
A company can finance its assets either with equity or debt. Financing through debt
involves risk because debt legally obligates the company to pat interest and to repay the
principal as promised. Equity financing does not obligate the company to any anything, but
dividends are paid.
1. Debt to assets ratio
2. Long term debt to assets ratio
3. Debt to equity ratio
1. Debt to assets ratio:

Debt to assets ratio indicates the proportion of assets that are financed with debt (both short –
term and long- term debt):
Total debt
Total debt to assets ratio= __________
Total Assets
2. Long term debt to assets ratio

Long term debt to assets ratio indicates the proportions of the company’s assets that are
financed with long- term debt.
Long term debt
Long term debt to assets ratio = _______________
Total Assets
3. Debt to equity ratio

Debt to equity indicates the relative uses of debt and equity as sources of capital to
finance the company’s assets, evaluated using book values of the capital sources.
Total debt
Total debt to equity ratio = _____________________
Total shareholders equity
ABLE SHOWING SUMMARY OF ACCOUNTING RATIOS
S.No Description Formula Notes

of the ratio
1. Current ratio Current assets Current assets include cash
Current liabilities in hand, cash at bank, sundry
debtors, bills receivable, market-
able securities, stock and
prepaid expenses.
26
Current liabilities include Bank
overdraft, sundry creditors,
bills payable and outstanding
expenses.
2. Liquid Ratio Liquid assets Liquid assets mean current
Current liabilities assets less stock and prepaid
expenses
3. Absolute Liquid Absolute Liquid assets Absolute Liquid assets means
Ratio Liquid liabilities cash, bank and short term
investment.
Liquid liabilities means current

liabilities less bank overdraft.
4. Debt Equity Long Term Debts Long term debts include
Ratio Shareholders funds Debentures, long term loans
from banks and financial
institutions.
Shareholders funds include

Equity share capital, Preference
share capital, Reserves and
surplus.
5. Proprietory Shareholders funds Tangible assets include
Ratio Total tangible assets all assets except goodwill,
preliminary expenses etc.
6. Gross Profit Gross Profit x 100 Gross profit = Sales – Cost of

Ratio Sales goods sold.
Cost of goods sold = Opening
stock + Purchases – Closing
stock
Net sales = Total sales (cash &

credit) – Sales returns
7. Net Profit Ratio Net Profit x 100 Net profit = Gross profit –
(Administration, Selling and
Sales
distribution and financial
expenses)
8. Operating Profit Operating Profit x 100 Operating profit = Net profit +
Ratio Sales Non-operating expenses – Non-
operating income [OR]
Gross profit – Operating
27
Expenses
9. Operating Ratio Cost of goods sold +
Operating expenses x 100
Sales
10. Capital Turnover Sales Capital employed = Equity share
Ratio Capital Employed capital + Preference share
capital + reserves and surplus +
long term borrowed funds
11. Fixed Assets Sales Fixed assets = Fixed assets –
Turnover Ratio Fixed Assets Depreciation
12. Stock Turnover Cost of goods sold Average stock = opening stock +
Ratio Average stock closing stock divided by two.
13. Debtors Average accounts receivable
Turnover Ratio is calculated by dividing the
opening balance of debtors
and bills receivable and closing
balance of debtors and bills
receivable by two.
14. Creditors Credit Purchases Average accounts payable
Turnover Ratio Average accounts is calculated by dividing the
opening balance of creditors
payable (Creditors +
and bills payable and closing
Bills payable)
balance of creditors and bills
payable by two.
28
DUPONT ANALYSIS
DuPont Analysis (also known as the DuPont identity, Du Pont equation, DuPont
Model or the DuPont method) is an expression which breaks ROE (return on equity) into
three parts.
The name comes from the DuPont Corporation that started using this formula in the
1920s. DuPont explosives salesman Donaldson Brown invented this formula in an internal
efficiency report in 1912.
DEFINITION
DuPont analysis is a model widely used in financial ratio analysis to designate the
ability of a company to increase its return on equity ratio (ROE). The model breaks down
ROE ratio into three components: profit margin, asset turnover, and financial leverage.
FORMULA
The DuPont model is expressed as follows:
ROE = Profit margin × Asset Turnover × Financial Leverage

Or
Net Income Net Sales Total Assets
ROE = × ×
Net Sales Total Assets Total Shareholders’ Equity
OBJECTIVE:
The goal of DuPont analysis isn’t to calculate ROE but to identify factors affecting it.
If investors are not satisfied with the current ROE ratio, management can analyze what
problems caused its current value and attempt to solve them.
DUPONT MODEL INTERPRETATION
DuPont analysis breaks down return on equity into three major components to determine the
impact of each of them.
 Profit margin. This ratio reflects a company’s strength in generating profit from each
dollar of sales.
 Asset turnover. This ratio measures how efficiently a company uses its assets to
generate sales.
 Financial leverage or equity multiplier. This ratio shows the extent to which a
company uses debt financing. The greater the value of a ratio, the greater the risk and
uncertainly of expected ROE.
29
PRACTICAL PROBLEMS
Practical Problem : 1 The following is the Trading & Profit and Loss Account of a firm for
the year ended 31.3.04.
Trading and Profit and Loss Account of Lilly & Co. for the year ended 31.3.2003
Particulars Rs. Particulars Rs.

To Opening stock 35,000 By Sales 4,00,000
To Purchases 2,25,000 By Closing stock 50,000
To Wages 10,000
To Gross profit 1,80,000
4,50,000 4,50,000
To Administration expenses 10,000 By Gross profit 1,80,000

To Interest 5,000 By Dividend 2,000
To Loss on sale of machinery 2,000
To Selling Expnes 10,000
To Net Profit 1,55,000
1,82,000 1,82,000
Calculate profitability ratios.
Solution:
Gross Profit
1. Goss Profit Ratio = x 100
Sales
1,80,000
= x 100
4,00,000
= 45%
30
Net Profit
2. Net Profit Ratio = x 100
Sales
1,55,000
= x 100
4,00,000
= 38.75%
Operating Profit
3. Operating Profit Ratio = x 100
Sales
Operating profit = Net Profit + Non-operating expenses – Non-
operating income
= Net Profit + Interest + Loss on sale of machinery
– Dividend
= 1,55,000 + 2,000 + 5,000 – 2,000
= Rs. 1,60,000
1,60,000
Operating Profit Ratio = x 100
4,00,000
= 40 %
Cost of goods + Operating Expenses

4. Operating Ratio =
Sales
Cost of goods sold = Sales – Gross Profit
= 4,00,000 - 1,80,000
= Rs. 2,20,000
Operating Expenses = Administration + Selling Expenses
= 10,000 + 10,000
= Rs. 20,000
Operating Ratio 2,20,000 + 20,000

= x 100
4,00,000
= 60%
31
Practical Problem : 2 Following is the Profit & Loss Account for the period ending 31/3/10. Calculate
(a) gross profit ratio (b) Net profit ratio (c) Operating ratio (d) Administrative expenses ratio.
Trading account and Profit & Loss Account for the period ended on 31/03/10
Particulars Amount (Rs.) Particulars Amount (Rs.)
To opening stock 1,00,000 By sales 5,60,000
To Purchases 3,50,000 By Closing stock 1,00,000
To Wages 9,000
To Gross Profit 2,01,000
6,60,000 6,60,000
To Administrative exp. 20,000 By Gross Profit 2,01,000
To Selling & Marketing 89,000 By interest 10,000
To Non-operating exp. 30,000 By Profit on sale of 8,000

investment
To Net Profit 80,000
2,19,000 2,19,000
Solution:
(a) Gross Profit Ratio = Gross Profit ÷ Sales × 100
= 2,01,000 ÷ 5,60,000 × 100 = 35.89%
(b) Net Profit Ratio = Net Profit ÷ Sales × 100
= 80,000 ÷ 5,60,000 × 100 = 14.28%

(c) Operating Ratio = Cost of sales + operating expenses ÷ sales × 100
(i) Cost of sales = Sales – Gross Profit
Cost of sales = 5,60,000 – 2,01,000
= 3,59,000
So Operating Ratio = Cost of sale + operating expenses ÷ Sales × 100
= 3,59,000 + 1,09,000 ÷ 5,60,000 × 100

32
= 4,68,000 ÷ 5,60,000 × 100
= 83.57 %
(Operating expenses = Administrative expenses and Selling & marketing exp.)
(d) Administrative expenses = Administrative expenses ÷ Sales × 100
= 20,000 ÷ 5,60,000 × 100
= 3.57 %
Practical Problem : 3 The following is Profit & Loss for the year ended 31st December 2010 and the
Balance Sheet of the Company as on that date:
Profit & Loss Account For the period ended on 31st December
To opening stock 80,000 By Sales 9,50,000
To Direct Expenses 10,500 By Closing stock 1,19,000
To Purchases 3,40,000
10,69,000 10,69,000
To Administrative expenses 2,00,000 By Gross Profit 6,38,500

To Selling expenses 30,000
To interest on loan 17,000
To loss on sale of assets 2,000

To Net Profit 3,89,500
6,38,500 6,38,500
Balance Sheet as on 31st December 2010

Liabilities Amount (Rs.) Assets Amount (Rs.)
Equity Shares 2,80,000 Plant 1,00,000
Long term loan 70,000 Land & Building 2,50,000
Bank overdraft 15,000 Stock 76,000
Outstanding expenses 10,000 Debtors 50,000
Sundry creditors 80,000 Bills Receivables 9,000
Retained Earnings Cash at Bank 30,000
5,15,000 5,15,000
Calculate (a) Quick ratio (b) current ratio (c) Debt Equity ratio (d) Proprietary ratio (e) Stock
Turnover ratio (f) Fixed Assets Turnover ratio (g) Net Profit ratio.
33
(a) Current ratio = Current Assets ÷ Current Liabilities
= Cash at bank + Bills receivable + Debtors + Stock

Bank overdraft + Sundry Creditors + Outstanding expenses
30,000 + 9,000 + 50,000 + 76,000

= 15,000 + 80,000 + 10,000
= 1,65,000 = 1.57
1,05,000
(b) Quick Ratio = Liquid Assets ÷ Current Liabilities
= Cash at bank + Bills Receivables + Debtors

Bank overdraft + Sundry Creditors + Outstanding expenses
= 30,000 + 9,000 + 50,000

15,000 + 80,000 + 10,000
= 89,000 = 0.84
1,05,000
(c) Debt Equity Ratio = Debt ÷ Equity
Debt = Long term Loan
Equity = Equity Share (Shareholders fund) + Retained Earnings
= 70,000
2,80,00 + 1,60,000
= 70,000
3,40,000
= 0.20
(d) Proprietary Ratio = Equity Share (Shareholders Fund) ÷ Total Assets
Equity Share = 2,80,000, Retained earnings = 60,000.
Total Equity = 3,40,000.
= 3,40,000 = 0.66
5,15,000
34
(e) Stock Turnover Ratio = Cost of goods sold ÷ Average Stock
Net Sales Less Gross Profit = Cost of sales
= 9,50,000 – 6,38,500 = 3,11,500
Average Stock = Opening Stock + Closing stock ÷ 2
= 80,000 + 1,19,000 ÷ 2
= 99,500
Stock Turnover Ratio = Cost of sale ÷ Average Stock
= 3,11,500 ÷ 99,500
= 3.14
(f) Fixed Assets Turnover Ratio = Cost of goods sold ÷ Fixed Assets
= 3,11,500 ÷ 3,50,000 = 0.89
(g) Net Profit Ratio = Net Profit ÷ Net Sales x 100
= 3,89,000 ÷ 9,50,000 x 100
= 41%
Practical Problem : 4 The following are the financial statements of Kamala Traders. You are
required to calculate the ratios a) Current ratio. b) Quick ratio. c) Debtors turnover ratio d) Inventory
turnover ratio. e) Total debts to shareholder’s equity.
Profit & Loss Account
To Opening stock 80,000 By sales 2,40,000
To Purchases 1,20,000 By closing stock 1,00,000
3,40,000 3,40,000
To selling expenses 30,000 By Gross Profit 1,40,000
35
To General expenses 40,000
To Interest paid 4,200
To Income tax 29,800
To Net Profit 36,000
1,40,000 1,40,000
Balance Sheet
Liabilities Amount Assets Amount)

Equity Share Capital 50,000 Plant & Equipment 40,000
6% Preference Capital 20,000 Inventory 1,00,000
Profit & Loss A/C 44,000 Debtors ) 60,000
5% Mortgage Loan 80,000 Short term Investments 24,000
Bills Payable 30,000 Cash 20,000
Taxes Payable 20,000
2,44,000 2,44,000
Solution:
(a) Current Ratio = Current Assets ÷ Current Liabilities
Inventory + Debtors + Cash + Short term Investment

= Bills Payable + Taxes Payable
= 1,00,000 + 60,000 + 20,000 + 24,000
30,000 + 20,000
= 2,04,000 = 4.08
50,000
(b) Acid Test / Quick Ratio = Quick Assets ÷ Current Liabilities
Quick assets includes all current assets items except inventories and prepaid expenses
= Debtors + Short term investment + Cash = 60,000 + 24,000 + 20,000
Bills payable + Taxes payable 30,000 + 20,000
= 1,04,000 = 2.08
50,000
36
(c) Debtors Turnover Ratio = Credit Sales ÷ Average Debtors
Average Debtors = Opening value + Closing value ÷ 2
= 60,000 + 40,000 ÷ 2 = 1,00,000 ÷ 2 = 50,000
Credit sales = 2,40,000
Debtors Turnover Ratio = 2,40,000 = 4.08

50,000
(d) Inventory Turnover Ratio = Cost of goods sold ÷ Average Inventory
Cost of goods sold = Opening stock + Purchases – Closing stock
= 80,000 + 1,20,000 – 1,00,000 = 1,00,000
Average Inventory = Stock in beginning + Stock at end ÷ 2
= 80,000 + 1,00,000 ÷ 2
= 90,000
So Inventory Turnover Ratio = 1,00,000 ÷ 90,000
= 1.1
(e) Total debts to Shareholder’s equity =
Mortgage loan + Bills payable + Taxes payable

= Equity Share Capital + Preference Capital + Retained Earnings (Profit & Loss)
= 80,000 + 30,000 + 20,000 = 1,30,000 = 1.14

50,000 + 20,000 + 44,000 1,14,000
37
Practical Problem : 5 Calculate the following ratios from the Balance Sheet given here under:
(a)Current ratio (b)Stock turnover ratio (c)Return on capital employed (d)Fixed assets turnover ratio
Balance Sheet
Liabilities Amount Assets Amount

Shares 2,00,000 Fixed Assets 2,30,000
Reserves & Surplus 80,000 Current Assets (Stock 2,40,000
80,000)
Long-term loan 70,000
Current Liabilities 1,20,000
4,70,000 4,70,000
Assumes sales 8,00,000 and profit for the year 60,000
Solution:
(a) Current Ratio = Current Assets = 2,40,000 = 2

Current Liabilities 1,20,000
(b) Stock Turnover Ratio = Sales

Average Inventory
Average Inventory = Opening Stock +Closing Stock
2
= 8,00,000 = 10
80,000
(c) Return on Capital employed = Profit before interest & tax
Capital employed
Capital employed = 2,00,000 + 80,000 + 70,000 =3,50,000
= 60,000 X 100
3,50,000
= 17.14%
(d) Fixed Assets Turnover Ratio = Net Sales

Fixed Assets (Net)
8,00,000
= --------------- = 3.48
2,30,000
38
Practical Problem : 6 The following are the summarized Profit & Loss Account of Krishna Hotel for
the year ending 31st Dec.2010 and the Balance Sheet as on that date:
Trading and Profit & Loss Account
Particulars Amount Particulars Amount

To Opening stock 9,950 By Sales 85,000
To Purchases 54,525 By Closing Stock 14,900
To Direct expenses 1,425
To Gross Profit 34,000
99,900 99,900
To operating expenses 19,500 By Gross Profit b/d 34,000
To loss on sale of assets 400 By Profit on sale of 600
shares
To Net Profit 15,000 By Interest 300
34,900 34,900
Balance Sheet of Krishna Hotel
Liabilities Amount Assets Amount

Share Equity Capital 20,000 Land & Building 15,000
Reserves 9,000 Plant & Machinery 8,000
Current Liabilities 13,000 Stock 14,900
Profit & Loss A/C 6,000 Sundry Debtors 7,100
Cash & Bank balances 3,000
48,000 48,000
You are required to calculate: (a) Current ratio (b) Operating ratio (c) Stock turnover ratio (d)
Return on total resource (e) Turnover of fixed assets
Solution:
Net Profit 15,000

(a) Return on total resources = ------------------- = ---------------- X 100 = 31.25%
Total Assets 48,000
Net Sales 85,000

(b) Turnover of Fixed Assets = --------------------- = ------------ = 3.70: 1
Fixed Assets 23,000
***************
39
CHAPTER: 4 FUNDS FLOW STATEMENT
A. Meaning of funds flow statement B. Uses of funds flow statement C. Preparation of funds flow
statement D. Treatment of provision for taxation and proposed dividends (as non-current liabilities)
E. Practical problems
FUNDS FLOW STATEMENT

Funds flow statement is one of the important tools, which is used in many ways. It helps to
understand the changes in the financial position of a business enterprise between the beginning and
ending financial statement dates. It is also called as statement of sources and uses of funds.
Definition of Funds Flow Stataement:

Smith and Brown defines as, "Funds Flow Statement is prepared to indicate in summary form,
changes occurring in items of financial position between two different balance sheet dates."
Institute of Cost and Works Accounts of India, funds flow statement is defined as “a statement
prospective or retrospective, setting out the sources and application of the funds of an enterprise. The
purpose of the statement is to indicate clearly the requirement of funds and how they are proposed to be
raised and the efficient utilization and application of the same”.
Uses / advantages of Fund Flow Statement :

1. Fund flow statement helps the management in the assessment of long range forecasts of a cash
requirements and availability of liquid resources. The manager can judge the quality of management
decisions.
2. With the help of Fund Flow Statement, the investors are able to measure as to how the company has
utilized the funds supplied by them and its financial strength. Also, the investors can judge the
company’s capacity to generate funds from operations.
3. It serves as effective tools to the Management for economic analysis as it supplies additional
information which can not be provided by financial statement based on historical data.
4. Fund flow statement explains the relationship between changes in working capital and net profits.
5. Fund flow statement helps the management in making planning process of a company. It is also
useful in assessing the resources available and the manner of utilization of the resources.
6. It explains the financial consequences of business activities. It also provides explicit and clean
answer to questions regarding liquid and solvency position of the company.
7. Fund Flow Statement provides clues to the creditors and financial institutions as to the ability of a
company to use funds effectively in the best interest of the investors, creditors and owners of the
company.
Limitations of Fund Flow Statements

1. It should not be overlooked that Fund Statements ignore non-cash transactions, therefore it is
considered as cruder device than the financial statement.
2. Fund Flow Statements merely rearrange a part of the information contained in financial statements.
They do not serve as original evidence of financial status.
3. Though changes in cash resources are more significant, they are not highlighted by Fund Statements
except being shown by them as a part of working capital.
4. As Fund Flow Statements are prepared from information provided by financial statements, they are
essentially historical in nature.
40
PROCEDURES FOR PREPARING FUNDS FLOW STATEMENT
The preparation of a funds flow statement consists of three steps
1. Schedule of changes in working capital which shows whether there is increase in working
capital or decrease in working capital.
2. Funds from operation or adjusted profit and loss account which exhibits funds from operation
3. Funds flow statement reveals the sources and uses of funds
I. The preparation of Statement of Schedule of Changes in Working Capital is as follows.
Effects of Fund Flow on Working Capital

 Increase in the current year current assets than previous year - Increase in Working Capital
 Decrease in the current year current assets than previous year -Decrease in Working Capital
 Increase in the current year current liabilities than previous year - Decrease in Working Capital
 Decrease in the current year current liabilities than previous year - Increase in Working Capital
Schedule of changes in working capital
Current Assets Previous Current Working capital

year year Increase Decrease
Cash in hand xxx xxx xxx -
Cash at bank xxx xxx xxx -
Bills receivable xxx xxx - xxx
Debtors. xxx xxx - xxx
Stock. investment xxx xxx xxx -
Prepaid expense xxx xxx xxx -
Current Liabilities
Creditors xxx xxx - xxx
Bill payable xxx xxx xxx -
Bank overdraft xxx xxx - xxx
Outstanding xxx xxx xxx -
expenses
Provision for xxx xxx xxx -
Doubtful debts
Increase / Decrease xxx xxx
in working capital
Total xxx xxx
II. Funds from Operations- Adjusted P&L Account

Calculation of Funds From Operation
Particulars Rs. Rs.
Net profit for the current year
Add: Non-operating expenses
General reserve xxxx
Goodwill written off xxxx
Preliminary expenses written off xxxx
Patents written off xxxx
Miscellaneous expenses xxxx
41
Provision for depreciation xxxx
Depreciation xxxx
Loss on sale of fixed asset xxxx
Provision for tax xxxx
Proposed dividend xxxx
Interim dividend xxxx
Premium on redemption of debenture xxxx
Discount on issue of shares xxxx xxxx
Less: Non-operating income xxxx

Profit on sale of fixed assets xxxx
Refund of double taxation xxxx
Dividend on investment xxxx xxxx
Discount on redemption of debenture
xxxx
Funds from operation
III. Preparation of Fund Flow Statement

A funds flow statement is prepared on the basis of information contained in the consecutive two
years Balance Sheet and that is based on the Profit and Loss Account for the period concerned. This
statement consists of two parts:
– Sources of funds
– Application of funds
FORMAT – HORIZONTAL

(STATEMENT OF SOURCES AND APPLICATION OF FUNDS)
Sources of Funds Amount Application of Funds Amount
Issue of Equity Shares ---- Purchase of Fixed Assets ----
Issue of Preference shares ---- Purchase of Investments ----
Issue of Debentures ---- Redemption of shares ----
Loan borrowed --- Redemption of debenture ----
Sale of Fixed Assets ---- Payment of loan ----
Sale of Investments ---- Payment of Tax ----
Non-trading incomes ---- Payment of Dividend ----
Fund from Operation (profit) ---- Non-trading losses ----
Decrease of working capital ---- Increase of working capital ----
Fund from operation (loss) ----
------- -------
42
Practical Problem: 1 From the following balance sheet of A Company Ltd. you are required to prepare
a schedule of changes in working capital and statement of flow of funds.
Balance Sheet of A Company Ltd., as on 31st March

Share Capital 1,00,000 1,10,000 Land and Building 60,000 60,000
Profit and Loss a/c 20,000 23,000 Plant and Machinery 35,000 45,000
Loans — 10,000 Stock 20,000 25,000
Creditors 15,000 18,000 Debtors 18,000 28,000
Bills payable 5,000 4,000 Bills receivable 2,000 1,000
Cash 5,000 6,000
1,40,000 1,65,000 1,40,000 1,65,000
Solution:
Schedule of Changes in Working Capital
Particulars 2004 2005 Increase Decrease
Rs. Rs. Rs. Rs.
Current Assets
Stock 20,000 25,000 5,000 —
Debtors 18,000 28,000 10,000 —
Bills Receivable 2,000 1,000 — 1,000
Cash 5,000 6,000 1,000
Total Current Assets A 45,000 60,000
Less: Current Liabilities

Creditors 15,000 18,000 3,000
Bills Payable 5,000 4,000 1,000
Total Currents Liabilities B 20,000 22,000 17,000 4,000
Increase in W.C. — 13,000
17,000 17,000
Fund Flow Statement
Sources Rs. Application Rs.

Purchase of Plant and
Issued Share Capital 10,000 Machinery 10,000
Loan 10,000 Increase in Working Capital 13,000
Funds From Operations 3,000
23,000 23,000
43
Practical Problem: 2 Form the following Balance Sheets as on 31 December, 1996 and 31 December,
1997, you are required to prepare a Schedule of Changes in the Working Capital and a Funds flow
Statement taking the provision for tax and proposed dividends as non-current liabilities.
BALANCE SHEET as on 31 December
Rs Rs Rs Rs
Share Capital 10,000 15,000 Fixed Assets 10,000 20,000

Profit and Loss A/c 4,000 6,000 Current Assets 13,000 14,500
Provision for Tax 2,000 3,000
Proposed Dividends 1,000 1,500
Sundry Creditors 4,000 6,000
Outstanding
Expenses 2,000 3,000
23,000 34,500 23,000 34,500
Additional Information
(i) Tax paid during 1997 Rs 2,500
(ii) Dividends paid during 1997 Rs 1,000
Solution:
SCHEDULE OF CHANGES IN WORKING CAPITAL
Increase Decrease
Particulars 1996 1997 (+) (–)
Rs. Rs. Rs Rs
Sundry Creditors 4,000 6,000 2,000
Outstanding Expenses 2,000 3,000 1,000

Current Assets 13,000 14,500 1,500
Decrease in Working Capital 1,500
3,000 3,000
FUNDS FROM OPERATIONS

Particulars Rs. Rs.
Net Profit (Rs. 6000- Rs. 4000) 2,000
Add: Provision for Tax (Rs 3,000 + Rs 2,500 – Rs 2,000) 3,500
Proposed Dividends (current year) 1,500 5,000
Funds from operations 7,000
44
Source: Rs
Increase in Share Capital 5,,000
Funds from Operations 7,000
Net Decrease in Working Capital 1,500
Total Sources 13,500
Applications:
Fixed assets purchased 10,000
Tax paid (during year) 2,500
Dividends paid (during year) 1,000
Total Applications 13,500
Practical Problem:3 From the following balance sheets of X Ltd. on 31 December, 1995 and 1996,
you are required to prepare: (a) A schedule of changes in working capital, (b) A funds flow statement.
1995 1996 1995 1996
Liabilities Rs Rs Assets Rs Rs
Share Capital 1,00,000 1,00,000 Goodwill 12,000 12,000

General Reserve 14,000 18,000 Building 40,000 36,000
Profit and Loss A/c 6,000 3,000 Plant 37,000 36,000
Sundry Creditors 8,000 5,400 Investments 10,000 11,000
Bills Payable 1,200 800 Stock 30,000 23,400
Provision for Taxation 16,000 18,000 Bills Receivable 2,000 3,200
Provision for Doubtful Debts 400 600 Debtors 18,000 19,000
Cash/Bank 6,600 15,200
1,55,600 1,55,800 1,55,600 1,55,800
The following additional information has also been given:

(i) Depreciation charged on Plant was Rs 4,000 and on Building Rs 4,000.
(ii) Provision for taxation of Rs 19,000 was made during the year 1996.
(iii) Interim dividend of Rs 8,000 was paid during the year 1996.
45
Solution:
SCHEDULE OF CHANGES IN WORKING CAPITAL
Increase Decrease
Particular 1995 1996 (+) (–)
Rs Rs Rs Rs
Current Assets:
Cash at Bank 6,600 15,200 8,600 -
Debtors 18,000 19,000 1,000 -
Bills receivable 2,000 3,200 1,200 -
Stock 30,000 23,400 - 6,600
Current Liabilities:
Provision for doubtful
debts 400 600 - 200
Bills payable 1,200 800 400 -
Sundry creditors 8,000 5,400 2,600 –
Net Increase in working
capital - 7,000
13,800 13,800

Particulars Rs
Source:
Funds from Operations (See Note 1) 36,000
Total Sources 36,000
Applications:
Purchase of plant (See Note) 3,000
Tax paid (See Note 3) 17,000
Investments purchased (See Note 4) 1,000
Interim dividend paid 8,000
Total Applications 29,000
Net Increase in Working Capital 7,000
36,000
46
Working Notes:
1. Funds from operations:
Particulars Rs Rs
Profit and loss A/c balance on 31 December, 1996 13,000

Add: Items which do not decrease funds from operations
Transfer to general reserve 4,000
Provision for tax 19,000
Depreciation:
Plant 4,000
Building 4,000
Interim dividend paid 8,000 39,000
52,000
Add: Profit and Loss Account balance on 31 December, 1996 16,000
Funds from operations for the year 36,000
2. Purchase of Plant: This has been found out by preparing the Plant Account.
PLANT ACCOUNT
Particulars Rs Particulars Rs
To Balance b/d 37,000 By Depreciation 4,000

To Bank (Purchase of plant— 3,000 By Balance c/d 36,000
balancing figure)
40,000 40,000
3. Tax paid during the year has been found out by preparing a provision for tax account.
PROVISION FOR TAX ACCOUNT
Particulars Rs Particulars Rs
To Bank (being tax paid—Bal. figure) 17,000 By Balance b/d 16,000

To Balance c/d 18,000 By P. & L. A/c 19,000
35,000 35,000
********************
47
CHAPTER: 5 CASH FLOW STATEMENT
A. Meaning of cash flow statement B. Preparation of cash flow statement

C. Difference between cash flow and funds flow analysis D. Practical problems
CASH FLOW STATEMENT

Cash flow statement is a statement which shows the sources of cash inflow and uses of cash out-
flow of the business concern during a particular period of time. It is the statement, which involves only
short-term financial position of the business concern. Cash flow statement provides a summary of
operating, investment and financing cash flows and reconciles them with changes in its cash and cash
equivalents such as marketable securities. Institute of Chartered Accountants of India issued the
Accounting Standard (AS-3) related to the preparation of cash flow statement in 1998.
Objectives of Cash Flow Statement

 Cash flow statement aims at highlighting the cash generated from operating activities.
 Cash flow statement helps in planning the repayment of loan schedule and replacement of fixed
assets, etc.
 Cash is the centre of all financial decisions. It is used as the basis for the projection of future
investing and financing plans of the enterprise.
 Cash flow Statement helps in efficient and effective management of cash.
 It is very useful in the evaluation of cash position of a firm.
Classification of Cash Flows

The statement of cash flows categorizes cash receipts and cash payments as operating, investing, and
financing activities.
1. Operating activities include receiving cash from customers for the sale of goods and services,
receiving interest and dividends on loans and investments, and making cash payments for wages,
goods and services purchased, interest, and taxes.
2. Investing activities include purchasing and selling long-term assets and marketable securities (other
than cash equivalents), as well as making and collecting on loans.
3. Financing activities include issuing and buying back capital stock, as well as borrowing and
repaying loans on a short- or long-term basis (issuing bonds and notes). Dividends paid are also
included in this category, but the repayment of accounts payable or accrued liabilities is not.
Difference between Funds Flow and Cash Flow Statement

Funds Flow Statement Cash Flow Statement
1. Funds flow statement is the report on the Cash flow statement is the report
movement of funds or working capital. showing sources and uses of cash.
Funds flow statement explains how Cash flow statement explains the inflow
2. working capital is raised and used and out flow of cash during the
during the particular particular period.
3. The main objective of fund flow The main objective of the cash flow
statement is to show the how the statement is to show the causes of
resources have been balanced mobilized changes in cash between two balance
and used. sheet dates.
48
4. Funds flow statement indicates the Cash flow statement indicates the
results of current financial management. factors contributing to the reduction of
cash balance in spite of increase in
profit and vice-versa.
5. In a funds flow statement increase or In a cash flow statement only cash
decrease in working capital is recorded. receipt and payments are recorded.
6. In funds flow statement there is no Cash flow statement starts with opening
opening and closing balances. cash balance and ends with closing cash
balance.
Cash from Operations =
Net Profit + (Increase in Current Liabilities & Decrease in Current Assets)
– (Increase in Current Assets & Decrease in Current Liabilities)
Practical Problem: 1 From the Balance Sheets of M/s. XYZ Hotel, you are required to prepare
cash flow statement: 21.11.2015
Solution:
Cash from operations
Particulars Rs. Rs.

Profit made during the year (6,15,000 – 7,39,000) Net Loss 5,000
Add: Increase in C.L & Decrease in C.A

Stocks 10,000
Sundry Creditors 5,000
Bills payable 5,000 20,000
Less: Increase in C.A & Decrease in C.L 25,000
Debtors
5,000 5,000
Cash from operations 20,000
49
Cash flow statement
Particulars Rs. Rs.

Cash Balance as on 31.3.2014 10,000
Add: Source of cash (Cash inflows)
Cash from operations 20,000
Share Capital 20,000
50,000
Less: Application of cash (Cash outflows)
Debentures 10,000
Purchase of Buildings 15,000
Purchase of Furniture 20,000
Cash Balance as on 31.3.2014 5,000

Practical Problem: 2 From the following balances you are required to calculate cash from operations:
31 December
1993 Rs. 1994 Rs.
Debtors 50,000 47,000

Bills Receivable 10,000 12,500
Creditors 20,000 25,000
Bills Payable 8,000 6,000
Outstanding Expenses 1,000 1,200
Prepaid Expenses 800 700
Accrued Income 600 750
Income received in advance 300 250
Profit made during the year — 1,30,000
Solution:
CASH FROM OPERATIONS

Particulars Rs. Rs.
Profit made during the year 1,30,000

Add: Decrease in Debtors 3,000
Increase in Creditors 5,000
Increase in Outstanding Expenses 200
Decrease in Prepaid Expenses 100 8,300
1,38,300
Less: Increase in Bills Receivable 2,500
Decrease in Bills Payable 2,000
Increase in Accrued Income 150
Decrease in Income received in Advance 50 4,700
Cash from Operations 1,33,600
50
Practical Problem: 3 Following information is available from the books of Standard Company Ltd:
Calculate cash flow from operations.
Solution:
51
Practical Problem: 4 From the following calculate cash from operations:
Solution:
***************
52
CHAPTER: 6 FINANCIAL PLANNING MEANING & SCOPE
A. Meaning of Financial Planning B. Meaning of Financial Plan C. Capitalization

D. Practical problems
Definition of Financial Planning

Financial Planning is the process of estimating the capital required and determining it’s
competition. It is the process of framing financial policies in relation to procurement, investment and
administration of funds of an enterprise.
Objectives and scope of Financial Planning

a. Determining capital requirements- This will depend upon factors like cost of current and fixed
assets, promotional expenses and long- range planning. Capital requirements have to be looked
with both aspects: short- term and long- term requirements.
b. Determining capital structure- The capital structure is the composition of capital, i.e., the
relative kind and proportion of capital required in the business. This includes decisions of debt-
equity ratio- both short-term and long- term.
c. Framing financial policies with regards to cash control, lending, borrowings, etc.
d. A finance manager ensures that the scarce financial resources are maximally utilized in the
best possible manner at least cost in order to get maximum returns on investment.
Importance of Financial Planning
1. Adequate funds have to be ensured.

2. Financial Planning helps in ensuring a reasonable balance between outflow and inflow of funds
so that stability is maintained.
3. Financial Planning ensures that the suppliers of funds are easily investing in companies which
exercise financial planning.
4. Financial Planning helps in making growth and expansion programmes which helps in long-run
survival of the company.
5. Financial Planning reduces uncertainties with regards to changing market trends which can be
faced easily through enough funds.
6. Financial Planning helps in reducing the uncertainties which can be a hindrance to growth of the
company. This helps in ensuring stability an d profitability in concern.
Process of Financial Planning
 Preparation of sales conjecture (assumption) .

 Decide the number of funds – fixed and working capital.
 Conclude the expected benefits and profile ts to decide the number of funds that can be provided
through internal sources.
 This causes us to evaluate the requirement from external sources.
 Recognize the conceivable sources and set up the money spending plans consolidating these
variables.
53
CAPITALIZATION
MEANING OF CAPITAL
The term capital refers to the total investment of the company in terms of money, and assets. It is also
called as total wealth of the company.
The capital requirements of the business concern may be classified into two categories:
(a) Fixed capital
(b) Working capital.
Fixed Capital
Fixed capital is the capital, which is needed for meeting the permanent or long-term purpose of the
business concern. Fixed capital is required mainly for the purpose of meeting capital expenditure of the
business concern and it is used over a long period. It is the amount invested in various fixed or
permanent assets, which are necessary for a business concern.
Definition of Fixed Capital
According to the definition of Hoagland, “Fixed capital is comparatively easily defined to include land,
building, machinery and other assets having a relatively permanent existence”.
Character of Fixed Capital

● Fixed capital is used to acquire the fixed assets of the business concern.
● Fixed capital meets the capital expenditure of the business concern.
● Fixed capital normally consists of long period.
● Fixed capital expenditure is of nonrecurring nature.
● Fixed capital can be raised only with the help of long-term sources of finance.
Working Capital
Working capital is the capital which is needed to meet the day-to-day transaction of the business
concern. It may cross working capital and net working capital. Normally working capital consists of
various compositions of current assets such as inventories, bills, receivable, debtors, cash, and bank
balance and prepaid expenses.
According to the definition of Bonneville, “any acquisition of funds which increases the current
assets increase the Working Capital also for they are one and the same”.
Working capital is needed to meet the following purpose:
● Purchase of raw material
● Payment of wages to workers
● Payment of day-to-day expenses
● Maintenance expenditure etc.
54
CAPITALIZATION: Meaning
Capitalization refers to the process of determining the quantum of funds that a firm needs to run
its business. Capitalization is only the par value of share capital and debenture and it does not include
reserve and surplus.
Definition of Capitalization
According to Guthman and Dougall, “capitalization is the sum of the par value of stocks and bonds
outstanding”.
According to Arhur. S. Dewing, “capitalization is the sum total of the par value of all shares”.
TYPES OF CAPITALIZATION
Capitalization may be classified into the following three important types based on its nature:
• Over Capitalization
• Under Capitalization
• Water Capitalization
1. Over Capitalization
Over capitalization refers to the company which possesses an excess of capital in relation to its
activity level and requirements. In simple means, over capitalization is more capital than actually
required and the funds are not properly used.
According to Bonneville, Dewey and Kelly, over capitalization means, “when a business is unable
to earn fair rate on its outstanding securities”.
Example
A company is earning a sum of Rs. 50,000 and the rate of return expected is 10%. This company will be
said to be properly capitalized. Suppose the capital investment of the company is Rs. 60,000, it will be
over capitalization to the extent of Rs. 1,00,000. The new rate of earning would be:
50,000/60,000×100=8.33%
When the company has over capitalization, the rate of earnings will be reduced from 10% to 8.33%.
Causes of Over Capitalization
Over capitalization arise due to the following important causes:
• Over issue of capital by the company.
• Borrowing large amount of capital at a higher rate of interest.
• Excessive payment for acquisition of goodwill.
2. High rate of taxation.
3. Under estimation of capitalization rate.
Effects of Over Capitalization
Over capitalization leads to the following important effects:
• Reduce the rate of earning capacity of the shares.
• Difficulties in obtaining necessary capital to the business concern.
• It leads to fall in the market price of the shares.
• It creates problems on re-organization.
55
• It leads under or misutilisation of available resources.
Remedies for Over Capitalization
Over capitalization can be reduced with the help of effective management and systematic design of the
capital structure. The following are the major steps to reduce over capitalization.
• Efficient management can reduce over capitalization.
• Redemption of preference share capital which consists of high rate of dividend.
• Reorganization of equity share capital.
• Reduction of debt capital.
2. Under Capitalization
Under capitalization is the opposite concept of over capitalization and it will occur when the company’s
actual capitalization is lower than the capitalization as warranted by its earning capacity. Under
capitalization is not the so called inadequate capital.
Under capitalization can be defined by Gerstenberg, “a corporation may be under capitalized when
the rate of profit is exceptionally high in the same industry”.
Hoagland defined under capitalization as “an excess of true assets value over the aggregate of
stocks and bonds outstanding”.
Causes of Under Capitalization
Under capitalization arises due to the following important causes:
• Under estimation of capital requirements.
• Under estimation of initial and future earnings.
• Maintaining high standards of efficiency.
Effects of Under Capitalization
Under Capitalization leads certain effects in the company and its shareholders.
• It leads to manipulate the market value of shares.
• It increases the marketability of the shares.
xi Consumers feel that they are exploited by the company.
xii It leads to high competition.
Remedies of Under Capitalization
Under Capitalization may be corrected by taking the following remedial measures:
= Under capitalization can be compensated with the help of fresh issue of shares.
= Increasing the par value of share may help to reduce under capitalization.
= Under capitalization may be corrected by the issue of bonus shares to the existing shareholders.
= Reducing the dividend per share by way of splitting up of shares.
3. Watered Capitalization
If the stock or capital of the company is not mentioned by assets of equivalent value, it is called as
watered stock. In simple words, watered capital means that the realizable value of assets of the company
is less than its book value.
According to Hoagland’s definition, “A stock is said to be watered when its true value is less than
its book value.”
56
Causes of Watered Capital
Generally watered capital arises at the time of incorporation of a company but it also arises during the
life time of the business. The following are the main causes of watered capital:
1. Acquiring the assets of the company at high price.
2. Adopting ineffective depreciation policy.
3. Worthless intangible assets are purchased at higher price.
*********************
CHAPTER: 7 CAPITAL EXPENDITURE
A. Meaning of Capital Structure B. Factors determining capital structure C. Point of

indifference D. Practical problems
Meaning of Capital Structure

Capital structure refers to the kinds of securities and the proportionate amounts that make up
capitalization. It is the mix of different sources of long-term sources such as equity shares, preference
shares, debentures, long-term loans and retained earnings.
The term capital structure refers to the relationship between the various long-term source financing
such as equity capital, preference share capital and debt capital.
Definition of Capital Structure

According to the definition of Presana Chandra, “The composition of a firm’s financing consists
of equity, preference, and debt”.
According to the definition of R.H. Wessel, “The long term sources of fund employed in a
business enterprise”.
FINANCIAL STRUCTURE
The term financial structure is different from the capital structure. Financial structure shows the pattern
total financing. It measures the extent to which total funds are available to finance the total assets of the
business.
Financial Structure = Total liabilities
Or
Financial Structure = Capital Structure + Current liabilities.
57
The following points indicate the difference between the financial structure and capital structure.
Financial Structures Capital Structures
1. It includes both long-term and short-term sources of 1. It includes only the long-term sources
funds
2. It means the entire liabilities side of the balance sheet. 2. It means only the long-term liabilities of
the company.
3. Financial structures consist of all sources of capital. 3. It consists of equity, preference and
retained earning capital.
4. It will not be more important while determining the 4. It is one of the major determinations of
value of the firm. the value of the firm.
POINT OF INDIFFERENCE:
The cost indifference point analysis tool determines the point at which there is no difference in
cost between two alternative methods. Used to compare two strategies, this analysis can be used to
decide between different cost structures or selling prices.
Example
From the following information, calculate the capitalization, capital structure and financial structures.
Balance Sheet
Liabilities Assets
Equity share capital 50,000 Fixed assets 25,000
Preference share capital 5,000 Good will 10,000
Debentures 6,000 Stock 15,000
Retained earnings 4,000 Bills receivable 5,000
Bills payable 2,000 Debtors 5,000
Creditors 3,000 Cash and bank 10,000
70,000 70,000
(i) Calculation of Capitalization
S. No. Sources Amount
1. Equity share capital 50,000
2. Preference share capital 5,000
3. Debentures 6,000
Capitalization 61,000
(ii) Calculation of Capital Structures
S. No. Sources Amount Proportion

1. Equity share capital 50,000 76.92
2. Preference share capital 5,000 7.69
3. Debentures 6,000 9.23
4. Retained earnings 4,000 6.16
65,000 100%
58
(iii) Calculation of Financial Structure
S. No. Sources Amount Proportion

1. Equity share capital 50,000 71.42
2. Preference share capital 5,000 7.14
3. Debentures 6,000 8.58
4. Retained earnings 4,000 5.72
5. Bills payable 2,000 2.85
6. Creditors 3,000 4.29
70,000 100%
OPTIMUM CAPITAL STRUCTURE

Optimum capital structure is the capital structure at which the weighted average cost of capital is
minimum and thereby the value of the firm is maximum.
Optimum capital structure may be defined as the capital structure or combination of debt and equity,
that leads to the maximum value of the firm.
Objectives of Capital Structure
Decision of capital structure aims at the following two important objectives:
1. Maximize the value of the firm.
2. Minimize the overall cost of capital.
Forms of Capital Structure
Capital structure pattern varies from company to company and the availability of finance. Normally the
following forms of capital structure are popular in practice.
• Equity shares only.
• Equity and preference shares only.
• Equity and Debentures only.
• Equity shares, preference shares and debentures.
FACTORS DETERMINING CAPITAL STRUCTURE

The following factors are considered while deciding the capital structure of the firm.
1. Leverage
It is the basic and important factor, which affect the capital structure. It uses the fixed cost financing
such as debt, equity and preference share capital. It is closely related to the overall cost of capital.
2. Cost of Capital
Cost of capital constitutes the major part for deciding the capital structure of a firm. Normally long- term
finance such as equity and debt consist of fixed cost while mobilization. When the cost of capital
increases, value of the firm will also decrease. Hence the firm must take careful steps to reduce the cost
of capital.
59
(a) Nature of the business: Use of fixed interest/dividend bearing finance depends upon the nature
of the business. If the business consists of long period of operation, it will apply for equity than
debt, and it will reduce the cost of capital.
(b) Size of the company: It also affects the capital structure of a firm. If the firm belongs to large
scale, it can manage the financial requirements with the help of internal sources. But if it is small
size, they will go for external finance. It consists of high cost of capital.
(c) Legal requirements: Legal requirements are also one of the considerations while dividing the
capital structure of a firm. For example, banking companies are restricted to raise funds from
some sources.
(d) Requirement of investors: In order to collect funds from different type of investors, it will be
appropriate for the companies to issue different sources of securities.
3. Government policy
Promoter contribution is fixed by the company Act. It restricts to mobilize large, long-term funds
from external sources. Hence the company must consider government policy regarding the capital
structure.
*********************
CHAPTER: 8 WORKING CAPITAL MANAGEMENT
A. Concept of working capital B. Factors determining working capital needs C. Over trading
and under trading
DEFINITION OF WORKING CAPITAL

According to the definition of Shubin, “Working Capital is the amount of funds necessary to
cover the cost of operating the enterprises”.
According to Weston and Brigham, “Working capital generally stands for excess of current assets
over current liabilities. Working capital management therefore refers to all aspects of the administration
of both current assets and current liabilities”.
CONCEPT OF WORKING CAPITAL

Working capital can be classified or understood with the help of the following two important concepts.
60
1. Gross Working Capital
Gross Working Capital is the general concept which determines the working capital concept.
Thus, the gross working capital is the capital invested in total current assets of the business concern.
Gross Working Capital is simply called as the total current assets of the concern.
Gross Working Capital = Current Assets
2. Net Working Capital
Net Working Capital is the specific concept, which, considers both current assets and current liability of
the concern. Net Working Capital is the excess of current assets over the current liability of the concern
during a particular period. If the current assets exceed the current liabilities it is said to be positive
working capital; it is reverse, it is said to be Negative working capital.
Net Working Capital = Current Asset – Current Liabilities
COMPONENT OF WORKING CAPITAL

Working capital constitutes various current assets and current liabilities. This can be illustrated by the
following chart.
FACTORS DETERMINING WORKING CAPITAL REQUIREMENTS

1) Nature of Business : The quantum of Working Capital required by a business organisation is
related to the type and nature of its business activities. Public utilities (like railway companies) require
less Working Capital as they sell services on cash basis only. But a trading organisation requires
proportionately larger amount of Working Capital as it has to carry large inventories and allow credit to
customers.
2) Size of Business : It is an important factor for determining the proportion of Working Capital.
If the size of the business organisation in big, it require more Working Capital. On the other hand, small
scale organisation requires less amount of Working Capital.
61
3) Production Policies : Production policies of a business organisation exert considerable
influence on the requirement of Working Capital. But production policies depend on the nature of
product. The level of production, decides the investment in current assets which in turn decides the
quantum of working capital required.
4) Terms of Purchase and Sale : A business organisation making purchases of goods on credit
and selling the goods on cash terms would require less Working Capital whereas an organisation selling
the goods on credit basis would require more Working Capital. If the payment is to be made in advance
to suppliers, then large amount of Working Capital would be required.
5) Dividend Policies : Dividend policies of a business organisation also influence the
requirement of Working Capital. If a business is following a liberal dividend policy, it requires high
Working Capital to pay cash dividends where as a firm following a conservative dividend policy will
require less amount of Working Capital.
6) Seasonal Variations : In case of seasonal industries like Sugar, Oil mills etc. More Working
Capital is required during peak seasons as compared to slack seasons.
8) Business Cycle : Business expands during the period of prosperity and declines during the
period of depression. More Working Capital is required during the period of prosperity and less
Working Capital is required during the period of depression.
9) Change in Technology : Changes in Technology as regards production have impact on the
need of Working Capital. A firm using labour oriented technology will require more Working Capital to
pay labour wages regularly.
10) Inflation : During inflation a business concern requires more Working Capital to pay for raw
materials, labour and other expenses. This may be compensated to some extent later due to possible rise
in the selling price.
IMPORTANCE OF WORKING CAPITAL
a) Enables a company to meet its obligations.

b) Ensures the credit standing of a company.
c) Facilitates obtaining Credit from banks without any difficulty.
d) Ensures solvency of a company.
e) Enables a company to make prompt payments to its creditors and thereby take advantage of cash and
quantity discounts offered by them.
f) Improves the prospects of prosperity and progress of a company.
g) Enables an organisation to tide over difficult periods successfully.
OVER TRADING :
A company which is under-capitalized will try to do too much with the limited amount of capital
which it has. For example it may not maintain proper stock of stock. Also it may not extend much credit
to customers and may insist only on cash basis sales. It may also not pay the creditors on time.
UNDER TRADING :
Under-trading is the reverse of over-trading. It means keeping funds idle and not using them
properly. This is due to the under employment of assets of the business, leading to the fall of sales and
results in financial crises. This makes the business unable to meet its commitments and ultimately leads
to forced liquidation. Under trading is an aspect of over-capitalization and leads to low profit.
62
CHAPTER: 9 BASICS OF CAPITAL BUDGETING
A. Importance of Capital Budgeting B. Capital Budgeting appraising methods C. Payback period

D. Average rate of return E. Net Present Value F. Profitability index G. Internal rate of return
H. Practical problems
Capital Budgeting
The word Capital refers to be the total investment of a company of firm in money, tangible and
intangible assets. Whereas budgeting defined by the “Rowland and William” it may be said to be the art
of building budgets. Budgets are a blue print of a plan and action expressed in quantities and manners.
The examples of capital expenditure:
1. Purchase of fixed assets such as land and building, plant and machinery, good will, etc.
2. The expenditure relating to addition, expansion, improvement and alteration to the fixed assets.
3. The replacement of fixed assets.
4. Research and development project.
Definitions
According to the definition of Charles T. Hrongreen, “capital budgeting is a long-term planning for
making and financing proposed capital out lays.
According to the definition of Richard and Green law, “capital budgeting is acquiring inputs with
long-term return”.
Need and Importance of Capital Budgeting

1. Huge investments: Capital budgeting requires huge investments of funds, but the available
funds are limited, therefore the firm before investing projects, plan are control its capital
expenditure.
2. Long-term: Capital expenditure is long-term in nature or permanent in nature. Therefore
financial risks involved in the investment decision are more. If higher risks are involved, it needs
careful planning of capital budgeting.
3. Irreversible: The capital investment decisions are irreversible, are not changed back. Once the
decision is taken for purchasing a permanent asset, it is very difficult to dispose off those assets
without involving huge losses.
4. Long-term effect: Capital budgeting not only reduces the cost but also increases the revenue in
long-term and will bring significant changes in the profit of the company by avoiding over or
more investment or under investment. Over investments leads to be unable to utilize assets or
over utilization of fixed assets. Therefore before making the investment, it is required carefully
planning and analysis of the project thoroughly.
METHODS OF CAPITAL BUDGETING OF EVALUATION

By matching the available resources and projects it can be invested. The funds available are always
living funds. There are many considerations taken for investment decision process such as environment
and economic conditions.
63
The methods of evaluations are classified as follows:
(A) Traditional methods (or Non-discount methods)
(i) Pay-back Period Methods
(ii) Average (Accounts) Rate of Return
(B) Modern methods (or Discount methods)
(i) Net Present Value Method
(ii) Internal Rate of Return Method
(iii) Profitability Index Method
1. PAY-BACK PERIOD METHODS
Pay-back period is the time required to recover the initial investment in a project.
(It is one of the non-discounted cash flow methods of capital budgeting).
Pay – back period = Initial investment

Annual Cash inflows
Annual Cash inflows is always before depreciation and after tax
Merits of Pay-back method

The following are the important merits of the pay-back method:
1. It is easy to calculate and simple to understand.
2. Pay-back method provides further improvement over the accounting rate return.
3. Pay-back method reduces the possibility of loss on account of obsolescence.
Demerits
1. It ignores the time value of money.
2. It ignores all cash inflows after the pay-back period.
3. It is one of the misleading evaluations of capital budgeting.
Accept /Reject criteria
If the actual pay-back period is less than the predetermined pay-back period, the project would be
accepted. If not, it would be rejected.
Project cost is Rs. 30,000 and the cash inflows are Rs. 10,000, the life of the project is 5 years. Calculate
the pay-back period.
Annual Cash inflows
Rs. 30,000
Pay – back period = = 3 Years
Rs. 10,000
The actual pay-back period is (3 years) less than the predetermined pay-back period (5 year), the
project would be accepted.
64
From the following particulars, compute Payback period.
Cash outflow Rs. 1,00,000

Annual cash inflow Rs. 25,000
(After tax before depreciation)
Estimate Life 6 years

Annual Cash inflows
Pay – back period = Rs. 1,00,000 = 4 Years

Rs. 25,000
The actual pay-back period is (4 years) less than the predetermined pay-back period (6 year), the
project would be accepted.
Certain projects require an initial cash outflow of Rs. 25,000. The cash inflows for 6 years are Rs. 5,000,
Rs. 8,000, Rs. 10,000, Rs. 12,000, Rs. 7,000 and Rs. 3,000.
Solution
Year Cash Inflows (Rs.) Cumulative Cash Inflows (Rs.)

1 5,000 5,000
2 8,000 13,000
3 10,000 23,000
4 12,000 35,000
5 7,000 42,000
6 3,000 45,000
The above calculation shows that in 3 years Rs. 23,000 has been recovered Rs. 2,000, is balance out
of cash outflow. In the 4th year the cash inflow is Rs. 12,000. It means the pay-back period is three to
four years, calculated as follows
Pay-back period = 3 years+2000/12000×12 months
= 3 years 2 months.
The actual pay-back period is (3 years 2 months) less than the predetermined pay-back period (6
year), the project would be accepted.
Practical Problem: 4 25.11.2013

There are two projects A & B. Each project require an investment of Rs. 2,00,000/-. Rank these projects
according to the ‘Pay Back Period’ method on the basis of the following information:
65
PROFIT/ INFLOWS OF CASH
Years Project A Project B
1 10,000 20,000
2 20,000 40,000
3 40,000 60,000
4 50,000 80,000
5 80,000 -
Years Project A Cumulative Project B Cumulative

Cash Inflows (Rs.) Cash Inflows Cash Inflows Cash Inflows
(Rs.) (Rs.) (Rs.)
1 10,000 10,000 20,000 20,000
2 20,000 30,000 40,000 60,000
3 40,000 70,000 60,000 1,20,000
4 50,000 1,20,000 80,000 2,00,000
5 80,000 2,00,000 0 2,00,000
Project A :
The above calculation shows that in 5th years Rs. 2,00,000 has been recovered. Therefore Pay-
back period for Project A is 5 years.
Project B
The above calculation shows that in 4th years Rs. 2,00,000 has been recovered. Therefore Pay-
back period for Project B is 4 years.
Hence the pay - back period of Project B is less than Project A. Therefore Project B would be
accepted.
Practical Problem: 5 21.11.2016
A project cost Rs.25,000/-. The net profits before depreciation and tax, and tax rate 20% for the five
years. Following are the expected cash flows to be:
Years Project A
1 5,000
2 6,000
3 7,000
4 8,000
5 10,000
You are required to calculate payback period.
Years Cash inflow Cash inflow Cumulative Cash

after tax Inflows (Rs.)
1 5,000 4,000 4,000
2 6,000 4,800 8,800
3 7,000 5,600 14,400
4 8,000 6,400 20,800
5 10,000 8,000 28,800
The above calculation shows that in 4 years Rs. 20,800 has been recovered, Rs. 4,200 is balance out
66
of cash outflow. In the 5th year the cash inflow is Rs. 8,000. It means the pay-back period is four to five
years, calculated as follows
Pay-back period = 4 years+4,200/8000×12 months
= 4 years 6 months.
2. ACCOUNTING RATE OF RETURN OR AVERAGE RATE OF RETURN (ARR)

Average rate of return means the average rate of return or profit taken for considering the project
evaluation. This method is one of the traditional methods for evaluating the project proposals:
Merits
1. It is easy to calculate and simple to understand.
2. It is based on the accounting information rather than cash inflow.
3. It is not based on the time value of money.
4. It considers the total benefits associated with the project.
Demerits
1. It ignores the time value of money.
2. It ignores the reinvestment potential of a project.
3. Different methods are used for accounting profit. So, it leads to some difficulties in the
calculation of the project.
Accept/Reject criteria
If the actual accounting rate of return is more than the predetermined required rate of return, the project
would be accepted. If not it would be rejected.
ARR = Annual Average net earnings X 100

Original investment
A company is considering investment of Rs. 10,00,000 in a project. The following are the income
forecasts, after depreciation and tax:
1st year loss Rs. 1,00,000 4th year profit Rs. 2,00,000
nd
2 year profit Rs.3,00,000 5th year profit Rs. 2,00,000
rd
3 year profit Rs.4,00,000
Calculate the Average rate of return.
Solution:
ARR = Annual Average net earnings X 100

Original investment
Annual Average net earnings = -1,00,000 + 3,00,000 + 4,00,000 + 2,00,000 + 2,00,000

5
67
= 10,00,000 = Rs. 2,00,000
5
ARR = 2,00,000 X 100 = 20 %
10,00,000
3. NET PRESENT VALUE

Net present value method is one of the modern methods for evaluating the project proposals. In
this method cash inflows are considered with the time value of the money. Net present value describes
as the summation of the present value of cash inflow and present value of cash outflow. Net present
value is the difference between the total present value of future cash inflows and the total present value
of future cash outflows.
Merits
1. It recognizes the time value of money.
2. It considers the total benefits arising out of the proposal.
3. It is the best method for the selection of mutually exclusive projects.
4. It helps to achieve the maximization of shareholders’ wealth.
Demerits
1. It is difficult to understand and calculate.
2. It needs the discount factors for calculation of present values.
3. It is not suitable for the projects having different effective lives.
If the present value of cash inflows is more than the present value of cash outflows, it would be
accepted. If not, it would be rejected.
Practical problem: 7 25.11.2013

Rank the following projects in the order of their desirability according to the Net Present Value Method:
Year 1 Year 2 Year 3 Year 4 Year 5

Rs. Rs. Rs. Rs. Rs.
Project x 5,000 10,000 10,000 3,000 2,000
Project y 20,000 10,000 5,000 3,000 2,000
Initial investment:
Project A - `20000
Project B - `30000
Discount rate 10%
Present value `1/- @10% (discount factor) using present value tables:
Year 1 2 3 4 5 6
Factor 0.909 0.826 0.751 0.683 0.621 0.564
68
Solution:
Cash Inflows Present Present Value of Net Cash

Value of Rs. Inflow
Year Project X Rs. Project Y Rs. 1 @ 10% Project X Rs. Project Y Rs.
1 5,000 20,000 0.909 4,545 18,180
2 10,000 10,000 0.826 8,260 8,260
3 10,000 5,000 0.751 7,510 3,755
4 3,000 3,000 0.683 2,049 2,049
5 2,000 2,000 0.621 1,242 1,242
Total present value 23,606 33,486

Initial investments 20,000 30,000
Net present value 3,606 3,486
Project Y should be selected as net present value of project Y is higher than project X.
Practical problem: 8 21.11.2015

From the following data, calculate the „Net Present Value‟ of two projects viz. X&Y and suggest which
of the two projects should be accepted assuming a discount rate of 10%:
Sl. Particulars Project X (Rs.) Project Y (Rs.)
No.
1 Initial Investment 50,000/- 60,000/-
2 Estimated Life 5 years 5 years
3 Scrap Value 1,000/- 1,000/-
The profits before depreciation and after taxes (cash flows) are as follows:
Rs. Rs. Rs. Rs. Rs.
Project x 10,000 15,000 10,000 15,000 10,000
Project y 10,000 15,000 15,000 15,000 15,000
Present value at 10% of Re.1/- is as under:

Year 1 2 3 4 5 6
Factor 0.909 0.826 0.751 0.683 0.621 0.564
69
Solution:

Value of Rs. Inflow
1 10,000 10,000 0.909 9,090 9,090
2 15,000 15,000 0.826 12,390 12,390
3 10,000 15,000 0.751 7,510 11,265
4 15,000 20,000 0.683 10,245 13,660
5 10,000 15,000 0.621 6210 9,315
Scrap Value 1,000 2,000 0.621 621 1,242
Project X should be selected as net present value of project X is higher than project Y.
4. INTERNAL RATE OF RETURN

Internal rate of return is time adjusted technique and covers the disadvantages of the traditional
techniques. In other words it is a rate at which discount cash flows to zero. It is expected by the
following ratio:
Factor to be located = Investment initial
Cash inflow
Merits
1. It consider the time value of money.
2. It takes into account the total cash inflow and outflow.
3. It does not use the concept of the required rate of return.
4. It gives the approximate/nearest rate of return.
Demerits
1. It involves complicated computational method.
2. It produces multiple rates which may be confusing for taking decisions.
3. It is assume that all intermediate cash flows are reinvested at the internal rate of return.
If the present value of the sum total of the compounded reinvested cash flows is greater than the present
value of the outflows, the proposed project is accepted. If not it would be rejected.
Practical problem: 8
A project costs Rs. 80,000 and is estimated to generate cash inflow of Rs. 20,000 for a period of 5 years.
Ascertain the internal rate of return (IRR).
Factor to be located = Investment initial

Cash inflow
70
F = I
C
F = 80,000
20,000
= 4
Factor of 4 should be located in annuity table II in the line of 5 years.

The discounting percentage is somewhere between 8 % and 6 %.
3.993 present value of annuity of Re. 1 8 %.
4.212 present value of annuity of Re. 1 6 %.
Since 3.993 is very near to 4.
IRR may be taken as 8 %.
5. PROBABILITY INDEX (P.I)

Probability technique refers to the each event of future happenings are assigned with relative
frequency probability. Probability means the likelihood of future event. The cash inflows of the future
years further discounted with the probability. The higher present value may be accepted.
Capital Rationing
In the rationing the company has only limited investment the projects are selected according to
the profitability. The project has selected the combination of proposal that will yield the greatest
portability.
Probability index = Present Value (present value of cash Inflows)

Initial Investment (present value of cash outflows)
Practical problem: 9
Rank the following projects in the order of their desirability according to the Net Present Value Method:

Rs. Rs. Rs. Rs. Rs.
Project x 5,000 10,000 10,000 3,000 2,000
Project y 20,000 10,000 5,000 3,000 2,000
Initial investment:
Project A - `20000
Project B - `30000
Discount rate 10%
Present value `1/- @10% (discount factor) using present value tables:
Year 1 2 3 4 5 6
Factor 0.909 0.826 0.751 0.683 0.621 0.564
71
Solution:

Value of Rs. Inflow
1 5,000 20,000 0.909 4,545 18,180
2 10,000 10,000 0.826 8,260 8,260
3 10,000 5,000 0.751 7,510 3,755
4 3,000 3,000 0.683 2,049 2,049
5 2,000 2,000 0.621 1,242 1,242

Project X
Probability index = 23,606 = 1.18

20,000
Project Y
Probability index = 33,486 = 1.12

30,000
Project X should be selected, as P.I project X is higher than project Y.
**********************
72

Financial Management Full Notes

Încărcat de

Informații document

Drepturi de autor

Formate disponibile

Partajați acest document

Partajați sau inserați document

Opțiuni de partajare

Vi se pare util acest document?

Este necorespunzător acest conținut?

Drepturi de autor:

Formate disponibile

Financial Management Full Notes

Încărcat de

Drepturi de autor:

Formate disponibile

SRM INSTITUTE OF HOTEL

B.Sc. HOSPITALITY & HOTEL ADMINISTRATION

SUBJECT CODE: BHM307

SUBJECT NAME: FINANCIAL MANAGEMENT

S.No. Topic Page No

1. FINANCIAL MANAGEMENT MEANING & SCOPE

DEFINITION OF BUSINESS FINANCE

MEANING OF FINANCIAL MANAGEMENT

Scope/Elements of Financial Management

1. Investment decisions includes investment in fixed assets (called as capital budgeting).

Objectives of Financial Management

1. To ensure regular and adequate supply of funds to the concern.

Functions of Financial Management

1. Estimation of capital requirements: A finance manager has to make estimation with

A. Meaning and types of financial statements B. Techniques of financial analysis C.

Meaning of Financial Statements:

Definition of Financial Statements:

Balance Sheet Statement

Statement of Changes in Owner’s Equity

Statement of Changes in Financial Position

TYPES OF FINANCIAL STATEMENT ANALYSIS

1. Based on Material Used

2. Based on Method of Operation

LIMITATIONS OF FINANCIAL STATEMENT ANALYSIS:

TECHNIQUES OF FINANCIAL STATEMENT ANALYSIS:

COMPARATIVE STATEMENT ANALYSIS

Comparative statement analysis is an analysis of financial statement at different period

1. Comparative Balance Sheet Analysis

2. Comparative Profit and Loss Account Analysis

Balance Sheet as on 31st December

LIABILITIES AND CAPITAL:

Capital and Reserves:

Balance Sheet as on 31st December

Liabilities 2006 2007 Assets 2006 2007

Debentures 200,000 300,000 Furniture 20,000 25,000

Bill Payables 50,000 45,000 Cash in hand 20,000 40,000

Sundry creditors 100,000 120,000 Bill Receivables 100,000 80,000

Other current liabilities 5000 10,000 Sundry debtors 200,000 250,000

Stock 250,000 350,000

Prepaid Expenses — 2000

1285000 1547000 1285000 1547000

Particulars 2006 2007 Increase(+) or Decrease (-)

LIABILITIES AND CAPITAL:

Capital and Reserves:

Total Liabilities and Capital(A+B+C) 12,85,000 15,47,000 +2,62,000 +20.39

Details 2006 2007

 Trend analysis is a statistical method used in analyzing financial statements to

Particulars 1998 1999 2000 2001 1998 1999 2000 2001

Similarly, the percentage of Hotel Premises for 2000 is:

All other percentages can be calculated accordingly.

Year Deposits Advances Profit

COMMON SIZE ANALYSIS

Sales 500,000 700,000

Sales 500,000 100.00 700,000 100.00

CHAPTER: 3 RATIO ANALYSES

A. Meaning of Ratio B. Classification of Ratios C. Profitability Ratios D. Turnover

ADVANTAGES OF RATIO ANALYSIS:

The classification of ratios on the basis of purpose is as follows:

Liquidity Solvency Profitability Activity

Liquid Ratio = Liquid Assets

3. ABSOLUTE LIQUID RATIO

II. SOLVENCY RATIOS

Total long term Dept

2. NET PROFIT RATIO