The Quantus Group™

Elevating you

Pre MBA Programme 2009

Introduction to Accounting
 Contents

01 Basic Rules in Accounting

02 Double Entry Accounting

03 Finalization of Accounts

04 Statements of Cash Flows

05 Accounting Ratios

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 01 Basic Rules in Accounting
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 Basic Rules of Accounting

• Assets - things you own.

• Liabilities - things you owe.
• Equity - overall net worth.
• Income - increases the value of your accounts.
• Expenses - decreases the value of your accounts.

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 Example

• The cash in your bank account is an asset

• The house rent that you pay is a liability
• Your pay cheque is income
• The cost of dinner last night is an expense (unless
your date picked up the tab!).

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 Debit vs Credit?

• Debits are positive numbers

• Assets and expenses normally have debit
balances

• Credits are negative numbers

• Liabilities, fund balance and revenues
normally have credit balances

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 The Basic Accounting Rules
Assets - Liabilities = Equity
• Furthermore, you can increase your equity through income, and
decrease equity through expenses. This makes sense of course,
when you receive a paycheck you become "richer" and when you
pay for dinner you become "poorer". This is expressed
mathematically in what is known as the Accounting Equation:

Assets - Liabilities = Equity + (Income - Expenses)

• This equation must always be balanced, a condition that can only
be satisfied if you enter values to multiple accounts. For example: if
you receive money in the form of income you must see an equal
increase in your assets. As another example, you could have an
increase in assets if you have a parallel increase in liabilities.

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 The Three Rules of Accounting
• To identify the effect of a transaction on a account
there are rules:
–For Personal Account:
•Debit: the receiver
•Credit: the giver

-For Real Account:

•Debit: what comes in
•Credit: what goes out

-For Nominal Account:

•Debit: all expenses and losses
•Credit: all incomes and gains

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 02 Double Entry Accounting

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 Double Entry Accounting

• The basic accounting equation is the very heart of a double

entry accounting system. For every change in value of one
account in the Accounting Equation, there must be a
balancing change in another. This concept is known as
the Principle of Balance.
• Double entry accounting serves two purposes. The first is to
create an accounting trail, money always has to come from
somewhere and go to somewhere. Additionally, double
entry accounting historically served to double check the
math of an accountant. Because the numbers are entered
into multiple accounts simultaneously, there are multiple
places to check to make sure the totals match.

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 Double Entry Accounting (cont.)
• Accountants use the terms debit and credit to describe
whether money is being transferred to or from an account.
Money is recorded in the debit column, which is always the
left column, when it is being transferred to an account.
Money is recorded in the credit column, which is always the
right column, when it is being transferred from an account.
Money always flows from the right column of one account
to the left column of another account.
• The main rule of accounting is this: For every transaction,
total debits must equal total credits. This is just another
way of repeating the double entry rule, that for each
transaction, the amount of money
transferred from accounts must equal the amount
transferred to other accounts
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 Important terms in accounting

• Debtors
• Creditors
• Assets
• Liabilities
• Income
• Expenses
• Account

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 03 Finalization of Accounts

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 Finalization of Accounts

• At the close of every financial year, accounting books

have to be “Finalized” as per law
• At this juncture “Profit and Loss Account” and
“Balance Sheets” are prepared.
• All the expenses incurred throughout the year in the
business are noted down cumulatively in the P&L Account
• The Balance Sheet contains a list of all the assets and
liabilities of the firm, as they stand at the end of the year
• This gives an exact picture of the financial condition
of the firm at the end of the year.

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 P&L Account - Sample

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 Balance Sheet - Sample

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 04 Statement of Cash Flows

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 Statement of Cash Flows

• What is cash flow statement?

• Why cash flow statement?
• How to prepare cash flow statement?
– Cash from operating activities
– Cash from financing activities
– Cash from investing activities
– Change in cash and cash equivalents

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 05 Accounting Ratios

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 Ratio Analysis
• Accounting ratios is an expression showing the relationship
between two figures of financial statement. Accounting ratios
may be expressed in terms of fractions like 1/2 ,1/3 or rates like
two times, three times or percentage like 10%, 20%, etc. Many
times absolute figures do not help to understand the position
of the concern & the final account & financial statements
prepared there from may not reveal enough information which
will help in decision making. Therefore ratio analysis is
employed as a tool to analyze financial position & make logical
inferences out of the same.

There are three types of ratio:-

1) Balance Sheet ratios.
2) Revenue Statement ratios.
3) Combined ratios.

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 Important Ratios
Balance Sheet Ratios Revenue Statement
Ratios
i) Current ratio i) Gross profit
ii) Quick ratio ratio
iii) Proprietary ratio ii) Operating ratio
iv) Debt Equity ratio iii) Stock- turnover
ratio
iv) Net profit ratio
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Combined Ratios
i) Return on Investment
ii) Return on Proprietor’s
Fund
iii) Return of Equity
Capital
iv) Earning per share
v) Price earning ratio
vi) Dividend Payout ratio
vii) Debt Service ratio
viii) Debtor’s turnover ratio
ix) Creditors Turnover ratio
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 Current Ratio
• Current ratio = Current Asset/Current Liabilities
• It Indicates short term solvency or short term financial
strength of company.
• It shows whether the company is capable of paying off its
short term commitments easily out of its current assets
• Too high & too low ratios not desirable. A high current
ratio indicates presence of idle funds whereas low ratio
indicates inadequacy of funds.

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 Quick Ratio
• Quick ratio = Quick Asset/Quick Liabilities
• It Indicates immediate solvency / financial strength of
company.
• It shows whether the organization is in a position to
pay its liabilities within a very short period of time out
of assets which can realize money quickly.

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 Proprietary Ratio
• Proprietary Ratio = Share holders Funds / Total
Assets
• Total Assets = Fixed Assets + Investments + Current Assets.
• It Indicates long term solvency or long term financial strength of
company.
• Proprietors funds should be equal to atleast fixed assets but it
may not be possible in all industries.

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 Debt Equity Ratio
• Debt Equity Ratio = Debt Funds / Equity Funds
• It Indicates borrowing capacity of organization &
emphasizes that more the borrowing, the more is the rate
of return for owners.
• However there should be a suitable compromise as far as
this ratio is concerned.
• In earlier years business should have more owned funds
whereas after establishment i.e. in subsequent years
business should resort to more external funds.

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 Gross Profit Ratio
• Gross Profit ratio = GPX100/ Sales\
• It shows the trading efficiency of management.
• It should be sufficient enough to cover operating and non-
operating expenses to assure final profits.

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 Stock Turnover Ratio

• Stock – Turnover Ratio = Cost of goods sold /

Average Stock
• It shows amount blocked in stock & how fast it can be
converted into sales & finally cash.
• It indicates efficiency of company in inventory
management.
• Sometimes too high ratio also indicates a possibility
of stock out.

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 Return on Investment or capital
employed
• ROI = NP before tax & Interest/ Capital Employed
• It Indicates management efficiency in utilizing
shareholder’s & borrowed funds. & is a clear index of
earning capacity.
• Higher ratio indicates higher returns & hence can
attract additional funds from lenders.
• Higher earning power indicate more punctual
repayment of interest & principal amount.

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 Return on Proprietors Funds
• Return on net worth = NP after tax and interest / Net
Worth
• It indicates profitability on proprietor’s funds and
efficiency of company in utilizing shareholder’s fund.
• It is used by share holders before investing additional
funds into business.
• Higher profitability attracts higher funds from
shareholders & can also increase market price of
shares in anticipation of higher dividends & bonus
shares.

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 Return on Equity Capital
• Ret on Eq,Capital = Pt. after tax – Pref Dividend /
Equity Capital
• It indicates earning for equity holders and
management’s efficiency in utilizing equity capital.
• Dividend percentage is also determined on the basis
of above ratio after taking decisions of retention of
some portion of profit for expansion of diversification
schemes.

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 Earnings per share
• EPS = (NP after tax - Pref Div) / No. of eq. Shares
• It indicates absolute earning per share which affect a
market prices of shares.
• High EPS encourages prospective investors.

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 Price Earning Ratio
• Price Earning ratio = MPS / EPS
• It indicates market price as compared to earning per share.
• Lower ratio generally attracts investors for purchase of share.

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 Dividend Payout Ratio
• Dividend – payout ratio = (DPSX100) / EPS
• It indicates extent of dividend declared out of earnings.
• Lower ratio indicates greater portion kept for self
financing.
• Short term investors are always interested in higher ratio
& vice versa for long terms investors.

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 Debt service coverage ratio
• DSCR = (NP bef int tax and dep) / Interest +Installment due
in next year
• It indicates ability to meet current interest & instalment
due.
• It is an index of long term solvency.
• Higher ratio indicates more safety for lenders.

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 Debtor Turnover ratio and collection
period

• Drs turnover ratio = Sales / Average receivables

• It indicates efficiency of company in management of
account receivables.
• Higher the index, better is the ratio & result.

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 Creditors turnover ratio and average
payment period
• Crs Turnover ratio = Purchase / Average Payables
• It helps to know creditor’s velocity i.e. average period
offered by suppliers for making payment.
• Lower the turnover, better is the result as it indicates
more period offered by suppliers to make payment.

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 Importance of Ratios in financial
statement analysis
• Liquidity Position and working capital financing
• Minimum permissible bank finance
• Profitability ratio
• ROCE, dividend payout ratio, PE ratio and the investors
preferences.

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 Exercise
Class Exercise on Ratios…..

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