Accounting For Management

Accounting for Management
S.N.Selvaraj, M.B.A., M.Phil., Assistant Professor, Email: sn.selvaraj@yahoo.com Page 1

Semester I

UNIT III ANALYSIS OF FINANCIAL STATEMENTS
Analysis of Financial Statements Financial Ratio Analysis Cash Flow (as per
Accounting Standard 3) and Funds Flow Statement Analysis

ANALYSIS OF FINANCIAL STATEMENTS
Financial statement analysis is also referred as financial analysis. The term financial
analysis also known as an analysis and interpretation of financial statements, refers
to the process of determining financial strengths and weakness of firm by establishing
strategic relationship between the items of balance sheet, profit and loss account and
other operative data.

According to Myers, Financial statements analysis is largely a study of relationship
among the various financial factors in a business as disclosed by single-set of
statements, and study of the trend of these factors as shown in a series of statement.

Analysis of financial statements is the systematic numerical calculation of the
relationship between one fact with the other to measure the profitability, operational,
efficiency, solvency and the growth potential of the business.

According to Hampton, Analysis of financial statement is the process of determining
the significant operating and financial characteristics of a firm from accounting data.

Financial Statements
Formal and original statements prepared by a business concern to disclose its financial
information. Financial statements are prepared for the purpose of presenting a
periodical review or report on the progress by the management and deal with the
status of investments in the business and the results achieved during the period under
review.

The following are the important financial statements that are prepared by the business
concern:
Profit and Loss Account (or) Income Statement: The Profit and Loss account presents
the summary of revenues, expenses and net income or net loss of a firm for a specific
period of time. A comparison of incomes and expenses incurred to earn those
incomes is made in the statement and the difference between the two is known as net
profit or loss.

Surplus Statement (or) Retained Earnings: Retained earnings refer to accumulated
excess profits over losses and dividends. Such retained earnings are taken to Balance
sheet from the retained earnings statement. The retained earnings statement is a link
between the Balance sheet and the income statement.



Supplementary Schedules: One can look into the schedule to have detailed
information and glance at the Balance sheet to get a summarized picture of the data.
Schedules help in reducing the length of the financial statements and make them brief
and informative.

Balance Sheet: The Balance sheet comprises of a list of assets, liabilities and capital
fund at a given date. It reflects the assets owned by the concern and the sources of
funds used in the acquisition of those assets. It is prepared in such a way that true
financial position is revealed in a form easily readable and understandable by the
people concerned.

Types of Financial Statement Analysis

External Internal Horizontal Vertical Short Long
Analysis Analysis Analysis Analysis Term Term

External Analysis: The external analysis of financial statements done by the outside
agencies like investors, financial analysts, lenders, government agencies, research
scholars, etc. The details records and accounting information is not available to the
outside agencies and they rely mostly on published financial statements and
information for analysis.

I nternal Analysis: The internal analysis done by those who have access to detailed
financial records of the firm. Generally, management is interested in the analysis of
financial statements for measuring the effectiveness of its own policies and decisions.
Sometimes, officers appointed by court or government under statute will conduct
internal analysis.

Horizontal Analysis: When evaluation is done for several years simultaneously at a
time for making conclusions, it is called horizontal analysis. This is based on the
data from year-to-year rather than the one time available information. Horizontal
analysis is done for finding the trend ratios and in comparative financial statements.

Vertical Analysis: It is the study of quantitative relationship of one financial item to
another based on financial statement on a particular data. Common size statements
and ratio analysis are the examples of vertical analysis.

Types of Financial Statement Analysis

On the Basis of
Materials used
On the Basis of
Modes operandi
On the Basis of
Period


Long-term Analysis: The long-term analysis of financial statements is done with a view
to evaluate the long-term solvency, profitability, liquidity, financial health, earning
capacity of the firm, debt servicing capacity, etc. of a business enterprises. The
objective of long-term analysis is to determine whether the earning capacity of the
firm is sufficient to meet the targeted rate of return on investment, and is adequate for
future growth and expansion of business.

Short-term Analysis: The short-term analysis of financial statements is undertaken
mainly to determine the liquidity position of the firm and short-term solvency of the
firm. The analysis is oriented on efficiency of working capital management and
profitability of current operations.

Parties Interested in Financial Statement Analysis
Management
Financial institutions including Banks
Perspective Investors
Customers
Creditors
Stock Exchange
Government
Society

Objectives/Importance of Financial Statement Analysis
1) Measuring Short-term Solvency
2) Measuring Long-term Solvency
3) Measuring Operating Efficiency
4) Measuring Profitability
5) Comparison of Inter-firm
6) Forecasting, Budgeting and Deciding Future Line Action
7) Indicating Trend of Achievements
8) Assessing Growth Potential of the Business
9) Simplified, Systematic and Intelligible Presentation of Facts

Business Concern
Society
Government
Stock Exchange

Banks
Management
Investors

Customers
Creditors


Limitations of Financial Statement Analysis
o Absence of Standard Universally Accepted Terminology
o Ignoring Qualitative Aspects
o Misleading Result in Absence of Absolute Data
o Ignoring the Price Level Changes
o Suffering from Limitation of Financial Statements
o Financial Statements are Affected by Window Dressing
o Financial statements are affected by the Personal Ability and Bias of Analyst
o Financial Analysis is only a Tool, not the Final Remedy
o Financial Analysis Spots the Symptoms but does not Arrive at Diagnosis

Techniques of Financial Statement Analysis
A financial analyst can adopt one or more of the following techniques/tools of
financial analysis:

(1) Financial Ratio Analysis: An accounting ratio shows the relationship in
mathematical terms between two interrelated accounting figures. A financial analyst
may calculate different accounting ratios for different purposes.

(2) Funds Flow Statement Analysis: The statement of changes in financial position,
prepared to determine only Sources and Uses of Working Capital between two dates
of balance sheets, is known as the Funds Flow Statement. It brings out in open the
changes which have taken place behind the Balance Sheet.

(3) Cash Flow Statement Analysis: The statement of changes in financial position on
Cash Basis, commonly known as Cash Flow Statement. It summarizes the causes of
changes in cash position between dates of two balance sheets. It indicates the sources
and uses of cash. It focuses attention on cash, instead of working capital or funds.

(4) Comparative Financial Statements: The comparative financial statements are
statements of financial position at different periods of time. In these statements figures
for two or more periods are placed side by side to facilitate comparison. Both the
Income Statement and Balance Sheet can be prepared in the form of Comparative
Financial Statements.
Tools of Financial Statement Analysis
Financial
Ratio
Analysis
Funds
Flow
Analysis

Cash
Flow
Analysis

Comparati
ve
Statements

Common-
size
Statements

Trend
Analysis



(i) Comparative I ncome Statement: The Income Statement discloses Net Profit or
Net Loss on account of operations. Since the figures for two or more periods
are shown side by side, the reader can quickly ascertain whether sales have
increased or decreased, whether cost of sales has increased or decreased etc.

(ii) Comparative Balance Sheet: Comparative Balance Sheet as on two or more
different dates can be used for comparing assets and liabilities and finding out
any increase or decrease in those terms.

(5) Common-size Financial Statements: Common-size Financial Statements are those
in which figures reported are converted into percentages to some common base. In the
Income Statement the sale figure is assumed to be 100 and all figures are expressed as
a percentage of this total. Similarly the whole Balance Sheet is converted into
percentage form. Such converted Balance Sheet is known as Common-size Balance
Sheet.

(6) Trend Analysis: Trend percentages are immensely helpful in making a comparative
study of the financial statements for several years. The method of calculating trend
percentages involves the calculation of percentage relationship that each item bears to
the same item in the base year. Any year may be taken as the base year. It is usually
the earliest year. Each item of base year is taken as 100 and on that basis the
percentages for each of the items of each of the years are calculated.

FINANCIAL RATIO ANALYSIS
A ratio is a simple arithmetical expression of the relationship of one number to
another. It may be defined as the indicated quotient of two mathematical expressions.
This quantitative relationship (i.e. ratio) may be expressed in either of the following
ways:
I n Proportion: In this form the amounts of the two items are being expressed in a
common denominator. The example of this form of expression is the relationship
between current assets and current liabilities as 2:1

I n Rate (or) Times (or) Coefficient: In this form, a quotient obtained by dividing one
item by another item is taken as unit of expression. For example, if out of 100
students in a class, 80 are present, the attendance ratio can be expressed as: 80/100
= 0.8 times.

I n Percentage: In this form, a quotient obtained by dividing one item by another is
multiplied by one hundred and it becomes the percentage form of expression. For
instance, in the above example, the attendance ratio as a percentage of the total
number of students is as follows: 0.8*100 = 80 %



Meaning and Definition of Ratio Analysis
Ratios are relationships expressed in mathematical terms between figures which are
connected with each other in some manner. One of the most important financial tools
which have come to be used very frequently for analyzing financial strengths and
weaknesses of the enterprise is ratio analysis. It is a technique of analysis and
interpretation of financial statements.

According to Myers, Ratio analysis is a study of relationship among the various
financial factors in a business.

Thus, ratio analysis measures the profitability, efficiency and financial soundness of
the business.

Objectives of Ratio Analysis
1. Measuring the Profitability
2. Judging the Operational Efficiency of Business
3. Assessing the Solvency of the Business
4. Measuring Short and Long-Term Financial Position of the Company
5. Facilitating Comparative Analysis of the Performance

Advantages of Ratio Analysis
Helpful in Financial Analysis
Helpful in Explaining Financial Health of the Enterprise
Helpful in Locating Shortcoming/Weakness
Helpful in Future Forecasting
Helpful in Comparing Inter-Firm Performance
Helpful in Simplifying Accounting Figures
Helpful in Assessing Operating Efficiency of the Business

Importance of Ratio Analysis
The inter relationship that exists among the different items appeared in the financial
statements, are revealed by accounting ratios. Ratio analysis of a firms financial
statements is of interest to a number of parties, mainly, shareholders, creditors,
financial executives etc. Shareholders are interested with earning capacity of the firm.
Creditors are interested in knowing the ability of the firm to meet its financial
obligations. Financial executives are concerned with evolving analytical tools that will
measure and compare costs, efficiency, liquidity and profitability with a view to
making intelligent decisions.

Classification of Ratios
The use of ratio analysis is not confined to financial manager only. There are different
parties interested in the ratio analysis for knowing the financial position of a firm for
different purposes. In the view of various users of ratios, there are many types of
ratios which can be calculated from the information given in the financial statements.
Ratios can be classified into different categories depending upon the basis of
classification.



Various accounting ratios can be classified as follows:
Ratios

Traditional Classification Functional Classification Significant Ratios
(or) (or) (or)
Statement Ratio Ratios According to Tests Ratios Importance

1) Balance Sheet Ratios 1) Liquidity Ratios 1) Primary Ratios
(or) 2) Leverage Ratios 2) Secondary Ratios
Position Statement Ratios 3) Activity Ratios
4) Profitability Ratios
2) Profit & Loss A/c Ratios
(or)
Income Statement Ratios

3) Composite/Mixed Ratios
(or)
Inter Statement Ratios

(I) TRADITIONAL CLASSIFICATION (OR) STATEMENT RATIOS
(a) Balance Sheet (or) Position Statement Ratios: Balance sheet ratios deal with the
relationship between two balance sheet items, e.g. the ratio of current assets to current
liabilities, or the ratio of proprietors fund to fixed asset. Both the items must,
however, pertain to the same balance sheet. The various balance sheet ratios have
been named in the following chart.

(b) Profit and Loss Account (or) Revenue/Income Statement Ratios: These ratios deal
with the relationship between two profit and loss account items, e.g. the ratio of gross
profit to sales, or the ratio of net profit to sales. Both the items must, however, belong
to the same profit & loss account. The various profit and loss ratios, commonly used,
are named in the following chart.

(c) Composite/Mixed Ratios (or) Inter Statement Ratios: These ratios exhibit the
relation between a profit and loss account (or) income statement and a balance sheet
item, .g. stock turnover ratio or the ratio of total assets to sales. The most commonly
used inter-statement ratios are given in the following chart.


Traditional Classification (or) Statement Ratios

Balance Sheet Ratios Profit & Loss A/c Ratios Composite/Mixed Ratios
(or) (or) (or)
Position Statement Ratio Income Statement Ratio Inter-Statement Ratios

1) Current Ratio 1) Gross Profit Ratio 1) Stock Turnover Ratio
2) Liquid Ratio 2) Operating Ratio 2) Debtors Turnover
(Acid Test or Quick Ratio) 3) Operating Profit Ratio 3) Payable Turnover Ratio
3) Absolute Liquidity Ratio 4) Net Profit Ratio 4) Fixed Assets Turnover
4) Debt Equity Ratio 5) Expense Ratio 5) Return on Equity
5) Proprietary Ratio 6) Interest Coverage Ratio 6) Return on Shareholders
6) Capital Gearing Ratio Fund
7) Assets-Proprietorship Ratio 7) Return on Capital
8) Capital Inventory to Working Employed
Capital Ratio 8) Capital Turnover Ratio
9) Ratio of Current Assets 9) Working Capital Turnover
to Fixed Assets 10) Return on Total
Resources
11) Total Assets Turnover

(II) FUNCTIONAL CLASSIFICATION (OR) RATIOS ACCORDING TO TESTS
(a) Liquidity Ratio: These are the ratios, which measures the short-term solvency or
financial position of a firm. These ratios are calculated to comment upon the short-
term paying capacity of a concern or the firms ability to meet its current obligations.
The various liquidity ratios are current ratio, liquid ratio and absolute liquid ratio.

(b) Leverage Ratio: Leverage ratios are the financial statement ratios which show the
degree to which the business is leveraging itself through its use of borrowed money.
By using a combination of assets, debt-equity, and interest payments, leverage ratios
are used to understand a companys ability to meet its long term financial obligation.
The leverage ratios can further be classified as: (i) Structure ratios (ii) Coverage ratios
and (iii) Capital Gearing Ratios

(c) Activity Ratio: Activity ratios are calculated to measure the efficiency with which
the resources of a firm have been employed. These ratios are called turnover ratios
because they indicate the speed with which assets are being turned over into sales, e.g.
debtors turnover ratio, etc. The various activity or turnover ratios have been given in
the following chart.

(c) Profitability Ratio: These ratios measure the result of business operations or overall
performance and effectiveness of the firm, e.g. gross profit ratio, operating ratio, etc.
The various profitability ratios have been given in the following chart.



Functional Classification (or) Ratios According to Tests

Liquidity Ratios Leverage Ratios Activity Ratios Profitability Ratios

A A Structure Ratios Capital Turnover A In relation to sales
Current ratio Debt Equity ratio ratio Gross Profit ratio
Liquid ratio Debt to Total Fixed Assets Operating ratio
(Acid test or capitalization Turnover ratio Operating profit
Quick ratio) Proprietary ratio Working capital ratio
Absolute Liquid Turnover ratio Net profit ratio
Ratio Inventory Turnover Expenses ratio
B B Coverage Ratios Ratio B In relation to
Debtors Turnover Interest Coverage Debtors/Receivables Investments
Ratio Ratio Turnover ratio Return on
Credits Turnover Cash Flow/ Debt Investments
Ratio Service Ratio Creditors/Payables Return on capital
Inventory Turnover Dividend Coverage Turnover ratio Return on Equity
Ratio Ratio Total Assets Capital
C Capital Gearing Turnover ratio Return on Total
Resources
Earnings per share

(III) SIGNIFICANT RATIOS (OR) RATIOS ACCORDING TO IMPORTANCE
(a) Primary Ratio: The primary ratio is one which is of prime importance to concern;
thus return on capital employed is named as primary ratio.

(b) Secondary Ratio: The other ratios which support and explain the primary ratio is
called secondary ratio, e.g. the relationship of operating profit to sales or the
relationship of sale to total asset of the firm.

LIQUIDITY RATIOS
Liquidity refers to the ability of a concern to meet its current obligations as and when
these become due. Liquidity ratios are calculated to measure short-term financial
soundness of the business.
1) Current ratio (or) Working capital ratio
2) Quick (or) Acid test (or) Liquid ratio
3) Absolute liquid ratio (or) Cash position ratio
Note:
The ideal current ratio is 2:1
The ideal quick ratio is 1:1
The ideal cash ratio is 05:1



(1) Current Ratio
Current Ratio is the most common ratio for measuring liquidity. Being related to
working capital analysis, it is also called the working capital ratio. Current ratio
expresses relationship between current assets and current liabilities. It is calculated by
dividing current assets by current liabilities. The ideal current ratio is 2:1

Current Ratio = Current Assets / Current Liabilities

(2) Quick Ratio (or) Acid Test (or) Liquid Ratio
This ratio establishes a relationship between quick assets and current liabilities. It
measures the firms capacity to pay off current obligations immediately and is a more
rigorous test of liquidity than the current ratio. It is used as complementary ratio to the
current ratio. It indicates rupees of quick assets available for each rupee of current
liability. The quick ratio of 1:1 is considered to be a satisfactory ratio.

Liquid Ratio = Quick or Liquid Assets / Liquid or Current Liabilities

Liquid Ratio = Current Assets (Stock and Prepaid Expenses)
Current Liabilities Bank Overdraft

(3) Absolute Liquid Ratio (or) Cash Position Ratio
Although receivables, debtors and bills receivable are generally more liquid than
inventories, yet there may be doubts regarding their realization into cash immediately
or in time. Absolute liquid assets include cash in hand and at bank and marketable
securities or temporary investments. This ratio is computed by dividing absolute
liquid assets by current liabilities. The acceptable norm for this ratio is 50% or 0.5:1
or 1:2
Absolute Liquid Ratio = Absolute Liquid Assets
Current Liabilities

Problem:
From the following Balance Sheet of a firm calculate current ratio and liquid ratio.
Comment upon the liquidity of the firm.

BALANCE SHEET
Rs. Rs.
Share Capital
Creditors
Bills Payable
Provision for Tax
Bank Overdraft
30,000
8,000
2,000
3,500
4,500
Fixed Assets
Cash in Hand
Cash at Bank
Debtors
Bills Receivable
Stock
Prepaid Expenses
Marketable Securities
12,000
2,500
3,000
6,000
2,000
17,500
500
4,500
48,000 48,000



Solution:
(1) Current Ratio = Current Assets / Current Liabilities
= Rs.36,000 / Rs.18,000 = 2:1

(2) Liquid Ratio = Liquid Assets / Current Liabilities
= Rs.18,000 / Rs.18,000 = 1:1

(3) Absolute Liquid Ratio = Absolute Liquid Assets / Current Liabilities
= Rs.10,000 / 18,000 = 0.55:1
Workings:
Current Assets
= Cash + Bank + Debtors + B/R + Stock + Prepaid Expenses
+ Marketable securities
(2500+3000+6000+2000+17500+500+4500) = 36000
Current Liabilities
= Creditors + Bills Payable + Provision for Tax + Bank O/D
(8000+2000+3500+4500) = 18000
Liquid Assets
= Cash + Bank + Debtors + B/R + Marketable securities
(2500 + 3000 + 6000 + 2000 + 4500) = 18000
Absolute Liquid Assets
= Cash in hand + Cash at bank + Marketable securities
(2500 + 3000 + 4500) = 10000

LEVERAGE / SOLVENCY RATIOS
These ratios provide an insight into the financial techniques used by a firm & focus, as
a consequence, on the long term solvency position with regard to, periodic payment of
interest during the period of loan, repayment of principal on maturity or in
predetermined installments on due dates.

The following ratios serve the purpose of determining the solvency of the concern.
1) Structure Ratios: The capital structure ratio shows the percent of long-term
financing represented by long-term debt.
a) Debt-Equity Ratio
b) Funded Debt to Total Capitalization Ratio
c) Proprietary Ratio (or) Equity Ratio
2) Coverage Ratios: This tells us the debt servicing commitments and sourcing the
funds to meet them. These ratios are used to test the adequacy of cash flows
generated through earnings for the purposes of meeting debt and lease
obligations.
a) Interest Coverage Ratio
b) Cash to Debt Service Ratio
c) Dividend Coverage Ratio
3) Capital Gearing Ratios


Debt-Equity Ratio: It indicates the margin of safety to long-term creditors. A low
debt-equity ratio implies the use of more equity than debt which means a larger safety
margin for creditors since owners equity is treated as the margin of safety by
creditors and vice versa.

Debt-Equity Ratio = Long-term Debts / Shareholders Funds
(Or)
Debt-Equity Ratio = External Equities/ Internal Equities

Problem:
Find out the Debt-equity Ratio from the following particulars:
Rs.
Preference Share Capital 3,00,000
Equity Share Capital 11,00,000
Capital Reserve 5,00,000
Profit and Loss Account 2,00,000
6% Debentures 5,00,000
Sundry Creditors 2,40,000
Bills Payable 1,20,000
Provision for Taxation 1,80,000
Outstanding Creditors 1,60,000

Solution:
Debt Equity Ratio = Long-term Debts or External Equities
Shareholders Fund Internal Equities

= 6% Debentures + Sundry Creditors + Bills Payable +
Provision for Taxation + Outstanding creditors
Preference Share Capital + Equity share capital +
Capital Reserve + Profit

= 5,00,000 + 2,40,000 + 1,20,000 + 1,80,000 + 1,60,000
3,00,000 + 11,00,000 + 5,00,000 + 2,00,000

= 12,00,000 = 0.57 or 4:7
21,00,000

It means that for every four rupees worth of the creditors investment, the
shareholders have invested seven rupees. That is external debt are equal to
57% of shareholders fund.

Debt to Total Capitalization Ratio: This ratio establishes link between the long-term
funds raised from outsiders and total long-term funds available in the business.
Though there is no rule of thumb but still the lesser the reliance on outsiders the
better it will be.


Funded Debt to Total Capitalization Ratio = Funded Debt 100
Total Capitalization

Problem:
From the following figures, find out the Funded Debt to Total Capitalization Ratio and
comment on this ratio.

Rs.
50,000 Equity Shares of Rs.10 each fully paid
20,000 9% Preference Shares of Rs.10 each fully paid
General Reserve
Share Premium
Profit & Loss Account
7 % Debentures
Mortgage Loans
Sundry Creditors
Bills Payable
5,00,000
2,00,000
50,000
25,000
1,25,000
1,40,000
60,000
1,29,000
74,500
13,03,500

Solution:
Funded Debt to Total Capitalization Ratio = Funded Debt 100

Funded Debt = 7 % Debentures + Mortgage Loans
= Rs.1,40,000 + Rs.60,000 = Rs.2,00,000

Total Capitalization = Proprietors Fund + Funded Debt (Or)
= Equity Share Capital + Preference Share Capital +
General Reserve + Share Premium + P&L A/c +
Debentures + Mortgage Loans
= Rs.5,00,000 + 2,00,000 + 50,000 + 25,000 +
1,25,000 + 1,40,000 + 60,000
= Rs.11,00,000

Funded Debt to Total Capitalization Ratio = Rs.2,00,000 100
Rs.11,00,000

= 18.18%

The ratio of 18.18% is quite low. The company has not relied much on outside sources
for raising long-term funds. There is enough scope for the company to rise long-term
from outsiders.



Proprietary Ratio / Equity Ratio: This ratio measures a relationship between
proprietors funds and the total assets. The objective of computing this ratio is to find
out how the proprietors have financed the assets. It is calculated by dividing
shareholders funds by the total assets.

Preference share capital and equity share capital plus all reserves and surplus items are
called shareholders fund. Total assets include all assets including goodwill. The
acceptable norm of the ratio is 1:3. The ratio shows the general strength of the
company.

Proprietary Ratio = Proprietors Fund (or) Shareholders Fund
Total Assets (or) Total Resources

Problem:
Proprietors fund are Rs.4,00,000 and total assets are Rs.6,00,000. Calculate
proprietary ratio.

Solution:
Proprietary Ratio = Proprietors Fund (or) Shareholders Fund
Total Assets (or) Total Resources
= 4,00,000 = 0.66 (or) 66% (or) 2:3
6,00,000

As proprietary /equity ratio represents the relationship of owners fund to total assets,
higher the ratio or the shares of the shareholders in the total capital of the company,
better is the long-term solvency position of the company.

COVERAGE RATIOS
Coverage ratios tell us the debt servicing commitment and sourcing the funds to meet
them. These ratios are used to test the adequacy of cash flows generated through
earnings for the purposes of meeting debt and lease obligations.

Interest Coverage Ratio: This ratio establishes relationship between net profits before
interest and taxes and interest on long-term debt. The objective of computing this
ratio is to measure the debt-servicing capacity of a firm so far as fixed interest on
long-term debt is concerned.

Interest Coverage Ratio = Net Profit before Interest and Taxes
Interest on Long-term Debt

Problem:
Net Profit before Interest and Tax Rs.3,20,000. Interest on Long term debt Rs.40,000.
Calculate Interest Coverage Ratio.

Solution:


Interest Coverage Ratio = Net Profit before Interest and Taxes
= 3,20,000 / 40,000
= 8 times

Cash to Debt Service Ratio: This ratio is also known as Debt Cash Flow Coverage
Ratio, is an improvement over the interest coverage ratio. The logic of this ratio is that
the interest payments are to be made out of cash inflow of the business and not from
the profit and apart from interest, expenses sinking fund appropriations on debt (which
are generally made by various firms to enable itself to make repayment of the loans)
should be considered to find out debt cash flow coverage as a measure of long-term
solvency of a firm. Generally, higher the coverage better it is, as far as, long term
solvency of the firm is concerned.

Cash to Debt Service Ratio (or) Debt Cash Flow Coverage Ratio
= Annual Cash Flow before Interest and Taxes
Sinking Fund Appropriation on Debt
Interest + 1 Tax Rate

Or CFCD = CF
1+ SFD
1 T
Where, CF = Annual Cash Flow before Interest and Tax
I = Interest Charges
SFD = Sinking Fund Appropriation on Debt
T = Rate of Tax

Problem:
Calculate cash to debt service ratio from the following particulars:
(a) Net profit after tax = Rs.22,500
(b) Fixed interest charges = Rs.2,000
(c) Depreciation charged = Rs.3,000
(d) Tax rate = 50%
(e) Sinking Fund Appropriation = 7 % of outstanding debentures
(f) 10% Debentures = Rs.20,000

Solution:
Cash to Debt Service Ratio (or) Debt Cash Flow Coverage Ratio
= Annual Cash Flow before Interest and Taxes
Sinking Fund Appropriation on Debt
Interest + 1 Tax Rate
= 22,500 + 22,500(tax) +2,000(fixed interest) +3,000(depreciation)
1500(Sinking Fund Appropriation)
2,000 + 1 50/100


= 50,000 = 50,000 = 50,000
2,000+ (1,500/0.5) 2,000+3,000 5,000
= 10 times

Dividend Coverage Ratio: This ratio measures the ability of a firm to pay dividend on
preference shares which carry a stated rate of return. This ratio indicates margin of
safety available to the preference shareholders. Higher the ratio is more desirable on
the part of preference shareholders.

Dividend Coverage Ratio = EAT / Preference Dividend

Problem:
Calculate dividend coverage ratio if the net profit after taxed of a firm is Rs.75,000
and its preference dividend is Rs.10,000.

Solution:
Dividend Coverage Ratio = EAT / Preference Dividend
= 75,000 / 10,000 = 7.5 times

Capital Gearing Ratio: The term capital gearing is used to describe the relationship
between equity share capital including reserves and surpluses to preference share
capital and other fixed interest-bearing loans. If preference share capital and other
fixed interest bearing loans exceed the equity share capital including reserves, the firm
is said to be highly geared. The firm is said to be in low geared if preference share
capital and other fixed interest-bearing loans are less than equity capital and services.

Capital Gearing Ratio = Equity Share Capital + Reserves & Surplus
Preference Capital + Long-term debt bearing fixed interest

Problem:
From the information given as under find out capital gearing ratios:
2008 2009
Equity share capital
Reserves & Surplus
8% Preference share capital
6% Debentures
5,00,000
3,00,000
2,50,000
2,50,000
4,00,000
2,00,000
3,00,000
4,00,000

Solution:
Capital Gearing Ratio = Equity Share Capital + Reserves & Surplus
Preference Capital + Long-term debt bearing fixed interest
2008 = 5,00,000 + 3,00,000 = 8:5 (low gear)
2,50,000 + 2,50,000


2009 = 4,00,000 + 2,00,000 = 6:7 (high gear)
3,00,000 + 4,00,000

Capital gearing ratio is very important leverage ratio. Gearing should be kept in such a
way that the company is able to maintain a steady rate of divided. High gearing ratio
is not good for a new company or a company in which future earnings are uncertain.

ACTIVITY RATIOS
Funds are invested in various assets in business to make sales and earn profits. The
efficiency with which assets are managed directly affects the volume of sales. The
better the management of assets, the larger is the amount of sales and the profit.
Activity ratios measure the efficiency or effectiveness with which a firm manages its
resources or assets. These ratios are also called turnover ratios because they indicate
the speed with which assets are converted or turned over into sales.

The following are the activity ratios:
1) Capital Turnover Ratio
2) Fixed Assets Turnover Ratio
3) Working Capital Turnover Ratio
4) Stock Turnover Ratio
5) Debtors Turnover Ratio (or) Receivables Turnover Ratio
6) Creditors Turnover Ratio (or) Payables Turnover Ratio

Capital Turnover Ratio: This ratio establishes relationship between net sales and
capital employed. It indicates the firms ability to generate sales per rupee of capital
employed. The higher the ratio, the greater is the sales made per rupee of capital
employed in the firm and hence higher is the profit. A low capital turnover ratio refers
to excessive capital being used in the firm.

Capital Turnover Ratio = Net Sales
Capital Employed

Net sales = Gross sales Sales return
Capital Employed = Long-term debt + Shareholders fund



Problem:
The balance sheet of Trisul Ltd. As at 31
st
March 2010 is as under:
Liabilities Rs. Assets Rs.
Equity Share Capital
18% Preference Capital
Reserves
Profit & Loss A/c
15% Debentures
Trade Creditors
Bills payable
Outstanding expenses
Bank overdraft
Provision for tax
1,00,000
1,00,000
60,000
2,40,000
8,00,000
40,000
30,000
20,000
10,000
2,40,000
Land & Building
Plant & Machinery
Furniture & Fixtures

Less: Depreciation

Long-term Investments
Stock
Debtors 3,40,000
Less: Provision 30,000
Marketable securities
Cash
Bills receivables
Prepaid expenses
Preliminary expenses
Underwriting commission
6,00,000
5,00,000
1,00,000
12,00,000
2,00,000
10,00,000
1,00,000
95,000

3,10,000
10,000
10,000
10,000
5,000
60,000
40,000
16,40,000 16,40,000
Net sales for the year amount to Rs.20,00,000.

Solution
Capital Turnover Ratio = Net Sales = 20,00,000 = 1.67 times
Capital Employed 12,00,000

Capital Employed
= Net Fixed Assets + Trade Investments + Current Assets Current
Liabilities
= 10,00,000 + 1,00,00 +4,40,000 +3,40,000 = Rs.12,00,000

Capital Employed
= Equity share capital + Preference share capital + Reserves + P&L
Account (Cr.) Preliminary expenses Underwriting commission +
Long term debts
= 1,00,000 + 1,00,00 +60,000 + 2,40,000 60,000 40,000 + 8,00,000
= Rs.12,00,000

Fixed Assets Turnover Ratio: This ratio enables a relationship between net sales and
fixed assets. The ratio is computed by dividing the net sales by the net fixed assets. It
indicates the firms ability to generate sales per rupee of investment in fixed assets. In
general, higher the ratio is the more efficient the management and utilization of fixed
assets and vice versa.


Fixed Assets Turnover Ratio = Net Sales
Net Total Fixed Assets
(Or)
Cost of goods sold

Net sales = Gross sales Sales return
Net Fixed (Operating) Assets = Gross Fixed Assets - Depreciation

Problem:
Fixed Assets (at cost) Rs.7,00,000, Accumulated Depreciation till date Rs.1,00,000,
Credit sales Rs.17,00,000, Cash Sales Rs.1,50,000, Sales Returns Rs.50,000.
Calculate Fixed Assets Turnover Ratio.

Solution

Fixed Assets Turnover Ratio = Net Sales

= 18,00,000 / 6,00,000 = 3 times

Net sales = Cash sales + Credit sales Sales returns
= Rs.1,50,000 + 17,00,000 50,000 = Rs.18,00,000

Net Fixed Assets = Fixed Assets (at cost) Depreciation
= Rs.7,00,000 1,00,000 = Rs.6,00,000

Working Capital Turnover Ratio: The ratio established relationship between net sales
and working capital. The objective of working capital turnover ratio is to indicate the
velocity of the utilization of net working capital. This indicates the number times the
working capital is turned over in the course of a year. Higher the ratio the more
efficient the management and utilization of working capital and vice versa.

Working Capital Turnover Ratio = Net Sales
Working Capital
(Or)
Cost of goods sold
Net Working Capital

Problem:
Current Assets Rs.6,00,000, Current Liabilities Rs.1,20,000, Credit Sales
Rs.12,00,000, Cash Sales Rs.2,60,000, Sales Returns Rs.20,000. Calculate Working
Capital Turnover Ratio.


Solution
Net sales = Cash sales + Credit sales Sales returns
= Rs.2,60,000 + 12,00,000 20,000 = Rs.14,40,000

Working Capital = Current Assets Current Liabilities
= Rs.6,00,000 1,20,000 = Rs.4,80,000

Working Capital Turnover Ratio = Net Sales
Working Capital

= 14,40,000 / 4,80,000 = 3 times

Stock Turnover Ratio: The ratio establishes relationship between costs of goods sold
and average inventory. The objective of this ratio is to determine the efficiency with
which the inventory is utilized. It indicates the speed with which the inventory is
converted into sales.

Stock Turnover Ratio = Cost of Goods Sold
Average Inventory

Cost of goods sold = Sales Gross profit
(Or)
= Opening stock + Purchases + Direct expenses Closing
Stock
Average stock = (Opening stock + Closing stock) / 2

Inventory Conversion Period (Stock Velocity): It may also be of interest to see average
time taken for clearing the stocks. This can be possible by calculating inventory
conversion period.
Inventory Conversion Period = 12 months / 52 weeks / 365 days
Stock Turnover Ratio

Problem:
M/s Rakesh & Co supplies the following information for the year ending 31
st

December 2010. Credit sales Rs.1,50,000, Cash sales Rs2,50,000, Return inward
Rs.25,000, Opening stock Rs.25,000, Closing stock Rs.35,000.

Find out (i) Inventory Turnover when Gross Profit Ratio is 20% and (ii) Inventory
Conversion Period.

Solution
Inventory Turnover Ratio = Cost of Goods Sold
Average Inventory


Cost of goods sold = Net Sales Gross profit

Net sales = Rs.1,50,000 + 2,50,000 25,000 = Rs.3,75,000

Gross Profit on Sales = 3,75,000 20 = Rs.75,000
100
Cost of goods sold = Rs.3,75,000 75,000 = Rs.3,00,000

Average stock = (Opening stock + Closing stock) / 2
= (Rs.25,000 + 35,000) / 2
= 60,000 / 2 = Rs.30,000

Inventory Turnover Ratio = Cost of Goods Sold = 3,00,000 = 10 times
Average Inventory 30,000

Inventory Conversion Period = 12 months / 52 weeks / 365 days
Stock Turnover Ratio
= 365 / 10 = 36.5 or 37 days

Debtors Turnover Ratio (or) Receivables Turnover Ratio: This ratio establishes a
relationship between net credit sales and average trade debtors. The objective of this
ratio is to determine the efficiency with which the trade debtors are managed. The
higher value of debtors turnover the more efficient is the management of
debtors/sales.

Debtors Turnover Ratio = Net Credit Sales
Average Trade Debtors

Net Credit Sales = Gross Credit sales Sales Returns
Trade Debtors = Sundry Debtors + Bills Receivable and Accounts
Receivables

Average Trade Debtors = Opening Trade Debtors + Closing Trade Debtors
2

Debtors Collection Period (Debtors Velocity): The debt collection period represents
the average number of days for which a firm has to wait before its receivables are
converted into cash.
Debt Collection Period = Average Trade Debtors (Drs + B/R)
Sales per day

Sales per day = Net Sales
No. of working days


Problem:
Calculate the Debtors Turnover Ratio and Average Debt Collection Period for the year
2010-2011 from the following information:
Particulars 2010 (Rs) 2011 (Rs)
Sundry Debtors
Bills Receivables
Provision for Doubtful Debts
15,000
5,000
1,500
45,000
15,000
4,500
Total Sales Rs.2,10,000, Sales Returns Rs.10,000 and Cash Sales Rs.40,000.

Solution:
Net Credit Sales = Total Sales Sales Returns Cash Sales
= 2,10,000 10,000 40,000 = Rs.1,60,000

Average Debtors
= Opening Drs + Closing Drs + Opening B/R + Closing B/R
2
= 15,000 + 45,000 + 5,000 + 15,000 = Rs.40,000
2

Debtors Turnover Ratio = Net Credit Sales
= 1,60,000 / 40,000 = 4 times

Creditors Turnover Ratio (or) Payables Turnover Ratio: The ratio establishes a
relationship between net credit purchases and average trade creditors. The objective of
this ratio is to determine the efficiency with which the creditors are management.
Generally, lower the ratio, the better is the liquidity position of the firm and higher the
ratio, less liquid is the position of the firm.

Creditors Turnover Ratio = Net Credit Purchases
Average Trade Creditors

Net Credit Purchases = Gross Credit Purchases Purchases Returns
Average Trade Creditor = Opening Trade Creditor + Closing Trading Cdr.
2

Debt Payment Period (Creditors Velocity): The debt collection period represents the
average number of days for which a firm has to wait before its receivables are
converted into cash.
Debt Payment Period = Average Trade Creditors
Average Net Credit Purchases per day
= 12 months / 52 weeks / 365 weeks
Creditors Turnover Ratio


Average Net Credit Purchases per day
= Net Credit Purchases for the year
No. of working days in the year

Problem:
Calculate the Creditors Turnover Ratio and Debt Payment Period from the following
information.
Particulars Rs. Particulars Rs.
Cash Purchases
Opening Sundry Creditors
Closing Bills Payable
Purchases Returns
1,00,000
25,000
25,000
7,000
Total Purchases (subject to
returns)
Closing Sundry Creditors
Opening Bills Payable
4,07,000

50,000
20,000

Solution
Net Credit Purchases = Total purchases Cash purchases Purchases Returns
= 4,07,000 1,00,000 7,000
= 3,00,000

Average Creditors
= (Opening Creditor + Opening B/P + Closing Creditor + Closing B/P) / 2
= (25,000 + 20,000 + 50,000 + 25,000) / 2 = Rs.60,000

Creditors Turnover Ratio = Net Credit Purchases / Average Trade Creditors
= 3,00,000 / 60,000 = 5 times

Debt Payment Period = 12 months / Creditors Turnover Ratio
= 12 / 5 = 2.4 times

Total Assets Turnover Ratio: This ratio is the relationship between sales and total
asset. The objective is to measure the overall performance and activity of the business
organization.
Total Turnover Ratio = Sales / Total Assets

Problem
Compute Total Assets Turnover from the following particulars:
Sales Rs.3,00,000
Sales Return Rs.40,000
Assets:
Fixed Assets Rs.2,00,000
Current Assets Rs.1,50,000

Solution
Total Turnover Ratio = Sales / Total Assets
= 2,60,000 / 3,50,000 = 0.74:1


PROFITABILITY RATIOS
The primary objective of a business undertaking is to earn profit. A business needs
profit not only for its existence but also for expansion and diversification. Profits are
thus, a useful measure of overall efficiency of a business. Profitability ratios are
calculated either in relation to sales or in relation to investment.

To measure the profitability of a firm, the following ratios can be calculated:

Profitability Ratios

Profitability Ratios in Profitability Ratios in
Relation to Sales Relation to Investment

Gross Profit Ratio Return on Total Assets
Net Profit Ratio Return on Capital / ROI
Operating Ratio Return on Equity
Operating Profit Ratio Earnings per Share/EPS
Expenses Ratio Capitalization Ratio
Price Earnings Ratio or
P/E Ratio

Gross Profit Ratio: This ratio measures the relationship between gross profit and net
sales. This ratio is calculated to know whether the business is a position to meet
operating expenses or not and how much the shareholders can get after meeting such
expenses.
Gross Profit Ratio = (Gross Profit / Net Sales) 100

Gross Profit = Net sales Cost of goods sold
Net Sales = Gross sales Sales return

Problem
From the following particulars, calculate the Gross Profit Ratio.
Particulars Rs
Opening Stock
Closing Stock
Purchases
Wages
Sales
Carriage Inwards
18,000
22,000
46,000
14,000
80,000
4,000

Solution
Gross Profit = (Sales + Closing stock) (Opening stock + Purchases + Wages
+ Carriage Inwards)
= (80,000 + 22,000) (18,000 + 46,000 + 14,000 + 4,000)
= (1,02,000) (82,000) = Rs.20,000


Gross Profit Ratio = (Gross Profit / Net Sales) 100
= (20,000 / 80,000) 100 = 25%

Net Profit Ratio: This ratio measures the relationship between net profit and net sales.
The objective of this ratio is to determine the overall profitability due to various such
as operational efficiency, trading on equity, etc. The figure of net profit may be taken
either before tax of after tax.

Net Profit Ratio = (Net Profit / Net Sales) 100

Gross Profit = Net sales Cost of goods sold
Net Sales = Gross sales Sales return

Problem
From the following information, calculate the Net Profit Ratio.
Particulars Rs
Total sales
Sales return
Cost of sales
Indirect expenses
1,20,000
6,000
80,000
5,500

Solution
Net Profit = Net Sales (Cost of sales + Indirect expenses)

Net sales = Total sales Sales return
= 1,20,000 6,000 = Rs.1,14,000

Net Profit = Rs.1,14,000 (80,000 + 5,500)
= Rs.1,14,000 85,500 = Rs.28,500

Net Profit Ratio = (Net Profit / Net Sales) 100
= (28,500 / 1,14,000) 100 = 25%

Operating Ratio: This ratio measures the relationship between operation cost and net
sales. The objective of computing this ratio is to determine the operational efficiency
with which production and /or purchases and selling operations are carried on. This
ratio indicates an average operating cost incurred on a sale of goods worth Rs.100.
Lower the ratio, greater the operating profit to cover the non-operating expenses, to
pay dividend and to create reserves and vice versa.

The Operating Cost comprises (i) cost of goods sold and (ii) other operation expenses.
For example, administrative expenses, selling and distribution expenses, interest on
short-term loan, discount allowed and bad debts.


Operating Ratio = (Operating Cost / Net Sales) 100

Operating Cost = Cost of goods sold + Operating expenses

Problem
From the following details, calculate the Operating Ratio.
Particulars Rs
Sales
Opening stock
Purchases
Carriage Inwards
Closing stock
Depreciation
Administrative expenses
Selling expenses
Loss on sale of Assets
8,50,000
99,500
5,50,500
14,000
1,54,000
20,000
1,50,000
30,000
4,000

Solution
Operating Ratio
= Cost of goods sold + Administrative expenses + Selling
& Distribution expenses 100
Sales


Gross profit = (Sale + Closing stock) (Opening stock + Purchases +
Carriage Inward)
= (8,50,000 + 1,54,000) (99,500 + 5,50,500 + 14,000)
= 10,04,000 6,64,000
= Rs.3,40,000

= 8,50,000 3,40,000 = Rs.5,10,000

Operating Ratio = 5,10,000 + 1,50,000 + 20,000 + 30,000 100
8,50,000
= (7,10,000 / 8,50,000) 100 = 83.53%

Operating Profit Ratio: This ratio measures the relationship between operation profit
and net sales. The objective of computing this ratio is to determine the operational
efficiency of the management. This ratio indicates an average profit margin earned on
sale of Rs.100 and what portion of sales is left to cover non-operating expenses, to pay
dividend and to create reserves. Higher the ratio, the more efficient is operation.


Operating Profit Ratio = (Operating Profit / Net Sales) 100

Operating Profit = Net Sales Operating Cost
(Or)
= Net Sales (Cost of goods sold + Administrative and
Office expenses + Selling and Distributive expenses)

This ratio can also be calculated as:
Operating Profit Ratio = 100 Operating Ratio

Problem
From the following particulars, calculate the Operating Profit Ratio.
Particulars Rs
Cost of goods sold
Administrative & Office expenses
Selling & Distributive expenses
Net sales
4,00,000
35,000
45,000
6,00,000

Solution
Operating Profit Ratio = (Operating Profit / Net Sales) 100

Operating Profit = Sales (Cost of goods sold + Administrative and
Office expenses + Selling and Distributive expenses)
= 6,00,000 (4,00,000 + 35,000 + 45,000)
= Rs.1,20,000

Operating Profit Ratio = (1,20,000 / 6,00,000) 100 = 20%

Expenses Ratio: Expenses ratio indicates the relationship of various expenses to net
sales. The objective of this ratio is to provide information about increase or decrease
in expenses. Lower expense ratio is considered better for the business. The expense
ratio indicates about efficiency of the business.

Expenses Ratio = (Amount of Expenses / Net Sales) 100

One can also calculate separate expenses ratios, such as ratio of administrative
expenses to net sales, ratio of selling and distribution expenses to sales, financial
expenses to sales, etc.

For Administrative Expenses to Net Sales Ratio
= (Administrative & Office Expenses / Net Sales) 100


For Selling & Distribution Expenses to Net Sales Ratio
= (Selling & Distribution Expenses / Net Sales) 100

For Financial Expenses to Net Sales Ratio
= (Financial Expenses and Interest / Net Sales) 100

Problem:
Following is the Profit & Loss Account of Adarsh Trading House for the year ended
31.3.2010.
Particulars Rs. Particulars Rs.
To Administrative expenses
To Selling & Distribution
To Financial expenses
To Other non-operating exp
To Net Profit
85,000
40,000
6,000
3,000
71,000
By Gross Profit
By Interest on Investments
2,00,000
5,000
2,05,000 2,05,000
The Net Sales during the year were Rs.5,00,000. You are required to calculate:
(1) Administrative Expenses Ratio
(2) Selling & Distribution Expenses Ratio
(3) Financial Expenses Ratio

Solution
(1) For Administrative Expenses Ratio
= (Administrative Expenses / Net Sales) 100
= (85,000 / 5,00,000) 100 = 17%

(2) For Selling & Distribution Expenses Ratio
= (Selling & Distribution Expenses / Net Sales) 100
= (40,000 / 5,00,000) 100 = 8%

(3) For Financial Expenses Ratio
= (Financial Expenses / Net Sales) 100
= (6,000 / 5,00,000) 100 = 1.2%

Return on Total Assets: This ratio measures the relationship between net profit before
interest and tax, and total asset. The objective of this ratio is to find out how
efficiently the total assets have been used by the management. This ratio indicates the
firms ability of generating profit per rupee of total assets. Higher the ratio is the more
efficient management in utilization of assets.

Return on Total Assets = Net Profit before Interest and Tax 100
Total Assets


Problem:
The balance sheet of Business Ltd. As at 31
st
Reserves
Profit & Loss A/c
15% Debentures
Trade Creditors
Bills payable
Bank overdraft
Provision for tax
1,00,000
1,00,000
60,000
2,40,000
8,00,000
40,000
30,000
20,000
10,000
2,40,000
Land & Building
Plant & Machinery

Less: Depreciation

Stock
Debtors 3,40,000
Cash
Bills receivables
Prepaid expenses
6,00,000
5,00,000
1,00,000
12,00,000
2,00,000
10,00,000
1,00,000
95,000

3,10,000
10,000
10,000
10,000
5,000
60,000
40,000
16,40,000 16,40,000
Net sales for the year amount to Rs.20,00,000. Calculate Return on Total Assets.

Solution
Particulars Rs
Calculation of Net Profit before Interest & Tax
A. Net profit after interest & tax
B. Add: Tax
C. Net profit after interest but before tax
D. Add: Interest on Debentures
E. Net profit before interest & tax
Calculation of Total Assets
A. Net Fixed Assets
B. Trade Investments
C. Current Assets
D. Total Assets

2,40,000
2,40,000
4,80,000
1,20,000
6,00,000

10,00,000
1,00,000
4,40,000
15,40,000

Return on Total Assets = Net Profit before Interest and Tax 100
Total Assets
= (6,00,000 / 15,40,000) 100 = 38.9%

Return on Capital Employed / Return on Investment: This ratio measures the
relationship between net profit before interest and tax, and capital employed. The
objective of this ratio is to find out how efficiently the long term funds supplied by the
creditors and shareholders have been used. Generally return on capital employed is
taken as return on investment. This ratio indicates the firms ability of generating


profit per rupee of capital employed. Higher the ratio, the more is efficient
management in utilization of capital employed.

Return on Capital Employed = Net Profit before Interest and Tax 100
Capital Employed

The term capital employed refers to the total of investment made in a business and
can be defined in a number of the following ways:

1. Gross Capital Employed = Fixed Assets + Current Assets
2. Net Capital Employed = Fixed Assets Current Assets
3. Proprietors Net Capital Employed
= Fixed Assets + Current Assets Outside Liabilities (both long
term and shot term)

Problem: From the following details, Calculate Return on Capital Employed or Return
on Investment.
Particulars Rs
Share Capital
A. Equity Capital
B. Preference Capital
General Reserve
10% Debentures
Current Liabilities
Discount on Shares
Net Profit (after debenture interest but before
income tax)

4,00,000
1,00,000
1,89,000
4,00,000
1,00,000
5,000
80,000
Assume the income tax rate @ 50%

Solution
Return on Investment = Net Profit before Interest and Tax 100
Capital Employed

Profit before Interest and Tax = Net Profit + Debenture Interest
= 80,000 + 40,000 = Rs.1,20,000

Capital Employed = Equity + Preference capital + 10% Debentures +
General Reserve + Profit Discount on shares
= 4,00,000 + 1,00,000 + 4,00,000 + 1,89,000 + 40,000
5,000
= 11,24,000

Return on Investment = (1,20,000 / 11,24,000) 100 = 10.68%


Return on Equity (or) Equity Shareholders Fund: This ratio measures the relationship
between net profit after interest and tax, and preference dividend, and equity
shareholders fund. The objective of this ratio is to find out how efficiently the funds
supplied by the equity shareholders have been used. Higher the ratio, the more is
efficient management in utilization of equity shareholders fund.

Problem:
The balance sheet of Kannan Ltd. As at 31
st
Reserves
Profit & Loss A/c
15% Debentures
Trade Creditors
Bills payable
Bank overdraft
Provision for tax
1,00,000
1,00,000
60,000
2,40,000
8,00,000
40,000
30,000
20,000
10,000
2,40,000
Land & Building
Plant & Machinery

Less: Depreciation

Stock
Debtors 3,40,000
Cash
Bills receivables
Prepaid expenses
6,00,000
5,00,000
1,00,000
12,00,000
2,00,000
10,00,000
1,00,000
95,000

3,10,000
10,000
10,000
10,000
5,000
60,000
40,000
16,40,000 16,40,000
Net sales for the year amount to Rs.20,00,000. Calculate Return on Equity
Shareholders Fund.

Solution
Particulars Rs
A: Net Profit after Interest and Tax
B: Less: Preference Dividend (1,00,000 18/100)
C: Net Profit after Interest, Tax and Pref. Dividend
Calculation of Equity Shareholders Fund
A. Net Fixed Assets
B. Trade Investments
C. Current Assets
D. Total Assets
E. Less: Current Liabilities
F. Capital Employed
G. Less: Long-term Debt (Debenture)
H. Shareholders Funds
I. Less: Pref. Share Capital
J. Equity Shareholders Fund (H I)
2,40,000
18,000
2,22,000

10,00,000
1,00,000
4,40,000
15,40,000
3,40,000
12,00,000
8,00,000
4,00,000
1,00,000
3,00,000


Earnings Per Share (EPS): This ratio measures the earnings available to an equity
shareholder on a per share basis. This is to measure the profitability of the firm on per
equity share basis. Higher the figure better it is and vice versa.

While interpreting this ratio, it must be seen whether there is any increase in equity
shareholders fund as a result of retained earnings without any change in number of
outstanding shares. For example, in the case of a company which is following a
practice of ploughing back of profits and which is not capitalizing its profits by way of
issue of bonus shares, the interpretation of EPS without considering the effect of
profits ploughed back in the business on earnings, will not be appropriate.

Earnings per Share (EPS)
= Net Profit after Interest, Tax, and Preference Dividend
No. of Equity Shares

Problem
Calculate earnings per share from the following data:
Particulars Rs
10,000 Equity shares of Rs.10 each
10,000 10% Preference shares of Rs.10 each
Net Profit before paying dividend to Pref. shares
1,00,000
1,00,000
40,000

Solution
Particulars Rs
Net Profit as per P&L A/c
Less: Dividend to Preference shareholders 10%
Balance of profit available to equity shareholders
40,000
10,000
30,000

Earnings per Share (EPS)
= Net Profit after Dividend on Preference Shares

= 30,000 / 10,000 = Rs.3 per share

Capitalization Ratio: This ratio measures the relationship between market price and
earnings per share. If market price is taken along with dividend received, this is
known as Dividend Yield Ratio. Only change is that in place of earnings per share,
dividend per share is written.

Capitalization Ratio = Earnings per Share 100
Market Price per Share

Dividend Yield Ratio = Dividend per Share 100


Problem: From the following data, calculate Dividend Yield Ratio:
10,000 Equity Shares of Rs.100 each
Dividend paid during the year 20%
Market Price per share Rs.120

Solution
Dividend Yield Ratio = Dividend per Share 100
= 20 100 = 16.67%
120

Price Earnings Ratio (or) P/E Ratio (Earnings Yield Ratio): This ratio measures the
relationship between market price per equity share and earnings per share. The
objective of this ratio is to make an estimate of appreciation in the value of a share of
a company and is widely used by investors to decide whether or not to buy shares in a
particular company. Higher the price-earnings ratio, the better it is. If the P/E ratio
falls, the management should look into the causes.

Price Earnings Ratio = Market Price per Equity
Earnings per Share

Earnings Yield Ratio = Earnings per Share 100

Problem: The market price of a share of Rs.10 is Rs.50. The profits available for
equity shareholders are Rs.2,00,000 and number of equity shares is 50,000. Calculate
Earnings per Share and Earnings Yield Ratio.

Solution:
Earnings per Share = Profits available for equity shareholders
No. of equity shares
= 2,00,000 / 50,000 = Rs.4 per share

Earnings Yield Ratio = Earnings per Share 100
= (Rs.4 / Rs.50) 100 = 8%

Problem: The capital of Star Company Ltd is as follows:
Particulars Rs
80,000 Equity shares of Rs.10 each
30,000 9% Preference shares of Rs.10 each
8,00,000
3,00,000
11,00,000



The following information has been obtained from the books of the company:
Particulars
Profit after tax at 60%
Depreciation
Equity dividend paid
Market price of equity share
Rs.2,70,000
Rs.60,000
20%
Rs.40
You are required to calculate the price earnings ratio.

Solution
Price Earnings Ratio = Market Price per Equity
Earnings per Share
= 40 / 3.04 = 13.1:1

SUMMARY OF RATIOS & FORMULAS
Liquidity Ratios:
Short-term financial position (or) Test of liquidity
1) Current Ratio
Current Assets
Current Liabilities
2) Quick or Acid Test or
Liquid Ratio
Liquid/Quick Assets
Current Liabilities
3) Absolute Liquid Ratio
Absolute Liquid Assets
Current Liabilities
Solvency Ratios:
Analysis of Long-term financial position (or) Test of solvency
1) Debt-Equity Ratio
Outsiders Funds
Shareholders Funds
(Or)
External Equities
Internal Equities
2) Funded Debt to Total
Capitalization Ratio
Funded Debt 100
3) Proprietary or Equity
Ratio
Shareholders Fund
Total Assets
4) Interest Coverage Ratio
Net Profit before Interest and Taxes
5) Cash to Debt Service
Ratio
Annual Cash Flow before Interest and Taxes
Interest + Sinking Fund Appropriation on Debt
1 Tax rate
6) Capital Gearing Ratio
Equity Share Capital + Reserve & Surplus
Preference Capital + Long term debt bearing
fixed interest
Activity Ratios:
These ratios measure the efficiency with which a firm manages its resources/assets
1) Capital Turnover Ratio
Sales or Cost of sales
Capital Employed


2) Fixed Assets Turnover
Ratio
Cost of goods sold
Net total fixed assets
3) Working Capital
Turnover Ratio
Net sales or Cost of goods sold
Working Capital Net Working Capital
4) Stock Turnover Ratio
Cost of goods sold
Average Inventory
5) Debtor Turnover Ratio
Net Credit Sales
6) Creditor Turnover Ratio
Net Credit Purchases
Average Trade Creditors
7) Total Assets Turnover
Ratio
Sales
Total Assets
Profitability Ratios:
These ratios measure the profit earning capacity of the company.
(a) Profitability Ratios in relation to Sales:
1) Gross Profit Ratio
Gross Profit 100
Net Sales
2) Net Profit Ratio
Net Profit 100
Net Sales
3) Operating Ratio
Operating Cost 100
Net Sales
4) Operating Profit Ratio
Operating Profit 100
Net Sales
5) Expenses Ratio
Particular Expense 100
Net Sales
(b) Profitability Ratios in relation to Investment:
1) Return on Total Assets
Net Profit before Interest and Taxes 100
Total Assets
2) Return on Capital
Employed / Return on
Investment
Net Profit before Interest and Taxes 100
Capital Employed
3) Return on Shareholders
Fund / Return on Equity
Shareholders Fund
Net Profit after Interest, Tax, and Pref.Dvnd 100
Equity Shareholders Fund
4) Earnings Per Share (EPS)
Net Profit after Interest, Tax, and Pref.Dvnd 100
5) Capitalization Ratio
Earnings per Share 100
Market price per share
6) Price-Earnings Ratio
(P/E Ratio)
Market price per share 100
Earnings per Share



CASH FLOW (AS PER ACCOUNTING STANDARD 3)
Cash plays a very important role in the entire economic life of a business. It is very
essential for a business to maintain an adequate balance of cash. But many times a
concern operates profitably and yet it becomes very difficult to pay taxes and
dividends. This may be because (i) although huge profits have been earned yet cash
may not have been received or (ii) even if cash has been received; it may have drained
out i.e. used for some other purposes. This movement of cash is of vital importance of
the management.

A statement of changes in the financial position of firm on cash basis is called a cash
flow statement. Such a statement enumerates net effects of the various business
transactions on cash and takes into account receipts and disbursements of cash. A cash
flow statement summarizes the causes of changes in cash position of a business
enterprise between dates of two balance sheets. The term cash here stands for cash and
bank balances.

Uses of Cash Flow Statement
A Cash Flow Statement is of primary importance to the financial management. It is
an essential tool of short-term financial analysis. Its main uses are as follows:
1. Cash Flow Statement facilitates to prepare sound financial policies. It also
helps to evaluate the current cash position.
2. A projected Cash Flow Statement can be prepared in order to know the future
cash position of a concern so as to enable a firm to plan and coordinate its
financial operations properly.
3. It helps in taking loan from Banks and other financial institutions. The
repayment capacity of the firm can be understood by going through the Cash
Flow Statement.
4. It helps the management in taking short-term financial decisions.
5. Cash is the soul and heart of the business. Cash is pivot of all business
activities.
6. The statement explains the causes for poor cash position in spite of substantial
profits in a firm by throwing light on various applications of cash made by the
firm.

Advantages of Cash Flow Statement
Helps in Efficient Cash Management
Helps in Internal Financial Management
Disclose the movement of Cash
Discloses Success or Failure of Cash Planning
Helpful in Declaring Dividends etc.

Disadvantages of Cash Flow Statement
o Ignores Basic Principle of Accounting
o Not Suitable for Judging Profitability
o Cannot be equated with Income Statement
o May not Represent Real Liquid Position


DISTINCTION BETWEEN FUND FLOW AND CASH FLOW STATEMENT
Basis of
Difference
Funds Flow Statement Cash Flow Statement
1) Object
Its object is to help in providing
information relating to firms
ability to meet its long term
liabilities.
Its object is to provide the
firms ability to meet its short
term liabilities.
2) Dependence
Funds flow statement can be
prepared if cash flow statement
is there.
Cash flow statement is
prepared only when schedule
of changes in working capital
along with funds flow
statement is there. Thus, it is
dependent.
3) Nature of
Statement
It deals with the changes in
working capital.
It deals with the changes in
cash position only.
4) Opening
Balance
There is no such balance.
There is always cash opening
balance (or) it is prepared with
the opening balance of cash in
hand.
5) Difference
of Sides
Difference of both the sides of
funds flow statement is either
the increase or decrease in
working capital.
Difference of both the sides of
cash flow statement is the
closing balance or cash.
6) Additional
Statement
Whenever funds flow statement
is prepared an additional
statement in the name of
schedule showing changes in
working capital is also
prepared.
No additional statement is
prepared when cash flow
statement is prepared.
7) Planning
Fund flow is helpful in long
term planning.
Cash flow is useful in short
term planning.
8) Period It is prepared for longer period.
It is prepared for shorter
period.

Cash Flow Statement as per Accounting Standard 3 (Revised)
The Institute of Chartered Accountants of India has issued in 1997 the Accounting
Standard AS-3 (revised) relating to cash flow statement which has superseded AS-3
issued earlier. As per recent proposed format issued by the SEBI it is mandatory for
each company to give a copy of its cash flow statement along with a copy of its final
accounts.

The cash flow statement can be classified into following activities:
1) Operating Activities
2) Investing Activities
3) Financing Activities


A single transaction may include cash flow that is classified differently. For example,
when the installment paid in respect of a fixed asset, acquired on deferred payment
basis includes both interest and loan. The interest element is classified under financing
activities and the loan element is classified under investing activities.

1. Cash Flow from Operating Activities: Cash flows from operating activities are
primarily derived from pre-revenue producing activities of the enterprise.
Examples of cash flows from operating activities are:
(a) Cash receipts from the sale of goods and the rendering of services;
(b) Cash receipts from royalties, fees, commissions and other revenue;
(c) Cash payments to suppliers for goods and services;
(d) Cash payments to and on behalf of employees;
(e) Cash receipts and cash payments of an insurance enterprise for premiums
and claims, annuities and other policy benefits;
(f) Cash payments or refunds of income taxes unless they can be specifically
identified with financing and investing activities; and
(g) Cash receipts and payments relating to futures contracts, forward contracts,
option contracts and swap contracts when the contracts are held for dealing
or trading purposes.

2. Cash Flows from I nvesting Activities: These include activities on which
expenditure has been incurred for resources intended to generate future income
and cash flows. Examples of such activities are:
(a) Cash payments to acquire fixed assets (including intangibles). These
payments include those relating to capitalized research and developments
costs and self-constructed fixed assets;
(b) Cash receipts from disposal of fixed assets (including intangibles);
(c) Cash payments to acquire shares, warrants or debt instruments of others
enterprises and interests in joint ventures (other than payments for those
instruments considered to be cash equivalents and those held for dealing or
trading purposes);
(d) Cash receipts from disposal of shares, warrants or debts instruments of
other enterprises and interest in joint ventures (other than receipts from
those instruments considered to be cash equivalents and those held for
dealing or trading purposes);
(e) Cash advances and loans made to third parties (other than advances and
loans made by a financial enterprise);
(f) Cash receipts from the repayment of advances and loans made to third
parties (other than advances and loans of a financial enterprise);
(g) Cash payments for future contracts, forward contracts, option contracts and
swap contracts excepts when the contracts are held for dealing or trading
purposes, or the payments are classified as financing activities; and
(h) Cash receipts from future contracts, forward contracts, option contracts and
swap contracts except when the contracts are held for dealing or trading
purposes, or the receipts are classified as financing activities.


3. Cash flows from Financing Activities: These include providers of funds (both
capital and borrowings) to the enterprise. Examples of such activities are:
(a) Cash proceeds from issuing shares or other similar instruments;
(b) Cash proceeds from issuing debentures, loans, notes bonds and other short
or long-term borrowings; and
(c) Cash repayments of amounts borrowed.

PREPARATION CASH FLOW STATEMENT
There are two methods of preparing cash flow statement:
1) Traditional Method: The traditional method does not have any standard format.
There is no classification of inflow and outflow under operation, investment
and finance activities, separately.
2) Preparing Under AS-3: The basic difference from traditional method is
presentation of cash flow statement. There are two methods of reporting cash
flow from operating activities: (i) Direct Method and (ii) Indirect Method

Problem (Traditional Method):
Balance Sheets of A and B are as follows:
BALANCE SHEETS
LIABILITIES
1.1.2008
Rs.
31.12.2008
Rs.
ASSETS
1.1.2008
Rs.
31.12.2008
Rs.
Creditors
Mrs. As Loan
Loan form Bank
Capital
40,000
25,000
40,000
1,25,000
44,000
---
50,000
1,53,000

Cash
Debtors
Stock
Machinery
Land
Building
10,000
30,000
35,000
80,000
40,000
35,000
7,000
50,000
25,000
55,000
50,000
60,000
2,30,000 2,47,000 2,30,000 2,47,000

During the year a machine costing Rs.10,000 (accumulated depreciation Rs.3,000)
was sold for Rs.5,000. The provision for depreciation against machinery as on
1.1.2008 was Rs.25,000 and on31.12.2008 Rs.40,000. Net profit for the year 2008
amount to Rs.45,000.

You are required to prepare Cash Flow Statement.



Solution:
CASH FLOW STATEMENT
(Traditional Method)

Cash Balance as on 1.1.2008
Add: SOURCES
Cash from Operations
Loan from Bank
Sale of Machinery
Less: APPLICATIONS
Purchase of Land
Purchase of Building
Mrs.As Loan repaid
Drawings

Cash Balance as on 31.12.2008
Rs.

59,000
10,000
5,000

10,000
25,000
25,000
17,000

Rs.
10,000

74,000
84,000

77,000

7,000

Working Notes:
CASH FROM OPERATIONS
Rs. Rs.
Profit made during the year 45,000
Add: Depreciation on Machinery 18,000
Loss on Sale of Machinery 2,000
Decrease in Stock 10,000
Increase in Creditors 4,000 34,000
79,000
Less: Increase in Debtors 20,000
Cash from Operations 59,000

Direct Method [As per AS-3 (revised)]:
Under the direct method, cash receipts (inflows) from operating revenues and cash
payments (outflows) for operating expenses are calculated to arrive at cash flows from
operating activities. The difference between the cash receipts and cash payments is the
net cash flow provided by (or used in) operating activities. The listed companies
should present the cash flow statement only under the direct method as prescribed in
AS-3.

Problem (Direct Method):
The following data are provided for Z Ltd. You are required to prepare the statement
of Cash Flows using the Direct Method [AS-3 (revised)].
Income Statement Data
Particulars Rs Rs.
Revenues
Cost of goods sold
Depreciation expenses
84,000
(48,000)
(4,000)


Interest expenses
Other expenses
Net Income
(6,000)
(22,000)
4,000

Comparative Balance Sheet Data
2008 (Rs) 2009 (Rs)
Current Assets
Cash
Debtors (net)
Stock in hand
Non-current Assets
Plant and Machinery
Less: Accumulated Depreciation
Total Assets

Liabilities
Creditors
Non-current notes payable
Less: Discount on notes

Owners Equity
Retained Earnings

20,000
12,000
16,000

24,000
(8,000)
64,000

12,000
20,000
(1,600)
30,400

24,000
9,600
33,600

16,000
7,000
14,000

20,000
(4,000)
53,000

14,000
20,000
(2,000)
32,000

14,000
7,000
21,000

Solution: Direct Method
Z Ltd.
Cash Flow Statement for the year ended 31
st
December 2009 [AS-3 (revised)]
Rs Rs
Cash Flows from Operating Activities
Cash receipts from customers
Cash paid to suppliers and employees
Net Cash from Operating Activities
Cash Flows from Investing Activities
Purchase of Plant and Machinery
Net Cash used in Investing Activities
Cash Flows from Financing Activities
Proceeds from issue of share capital
Interest paid
Dividends paid
Net Cash from Financing Activities
Net Increase in Cash and Cash Equivalents
Cash and Cash Equivalents at the beginning of the period
Cash and Cash Equivalents at the end of the period

79,000
(73,600)

(4,000)

10,000
(6,000)
(1,400)

5,400

(4,000)

2,600
4,000
16,000
20,000


Working Notes:
1) Dividends Paid have been calculated as under:
Retained earing at the beginning
Add: Net Income

Less: Retained earnings at the end

2) Calculation of Cash Receipts from Customers:
Revenues
Add: Debtors in the beginning

Less: Debtors at the end

3) Calculation of Cash Paid to Suppliers and Employees:
Cost of goods sold
Other expenses [22,000 400 (discount on sale)]
Add: Creditors in the beginning
Inventories at the end
Less: Creditors at the end
Inventories at the beginning

7,000
4,000
11,000
9,600
1,400

84,000
7,000
91,000
12,000
79,000

48,000
21,600
14,000
16,000
(12,000)
(14,000)
73,600

Indirect Method: [As per AS-3 (revised)]
Under the indirect method, net profit is taken as base and is adjusted instead of
individual items appearing in the profit and loss account to arrive at cash from
operations.
Net profit or loss is adjusted for the following:
1) Non-cash items such as depreciation, writing off goodwill and preliminary
expenses, etc.
2) Changes in inventories, operating receivables and payable during the period.
3) All other items which affect cash included in financing and investing activities
such as loss/gain on sale of fixed assets and loss/gain on sale of investments,
etc.

Problem: Balance Sheets of A and B are as follows:
BALANCE SHEETS
LIABILITIES
1.1.2008
Rs.
31.12.2008
Rs.
ASSETS
1.1.2008
Rs.
31.12.2008
Rs.
Creditors
Mrs. As Loan
Loan form Bank
Capital
40,000
25,000
40,000
1,25,000
44,000
---
50,000
1,53,000

Cash
Debtors
Stock
Machinery
Land
Building
10,000
30,000
35,000
80,000
40,000
35,000
7,000
50,000
25,000
55,000
50,000
60,000
2,30,000 2,47,000 2,30,000 2,47,000



During the year a machine costing Rs.10,000 (accumulated depreciation Rs.3,000)
was sold for Rs.5,000. The provision for depreciation against machinery as on
1.1.2008 was Rs.25,000 and on31.12.2008 Rs.40,000. Net profit for the year 2008
amount to Rs.45,000. You are required to prepare Cash Flow Statement.

Solution:
CASH FLOW STATEMENT (Indirect Method)
[As per AS-3 (Revised)]

1. Cash Flows from Operating Activities:
Net Profit made during the year
Adjustment for depreciation
Loss on sale of machinery
Operating profit before working capital
changes
Decrease in Stock
Increase in Creditors
Increase in Debtors
Net Cash Flow from Operating
Activities

2. Cash Flows from I nvesting Activities:
Sale of Machinery
Purchase of Land
Purchase of Building
Net Cash Flow from Investing
Activities

3. Cash Flows from Financing Activities:
Loan from Bank
Mrs. As Loan repaid
Drawings
Net Cash Flow from Financing
Activities

Net Increase (Decrease) in cash and cash equivalent
Cash and Cash equivalent at the beginning of the
year
Cash and Cash equivalent at the end of the year
Rs.

45,000
18,000
2,000
65,000

10,000
4,000
(20,000)

5,000
(10,000)
(25,000)

10,000
(25,000)
(17,000)

Rs.

59,000

(30,000)

(32,000)

(3,000)
10,000

7,000

Notes:
1. Cash comprises cash in hand and demand deposits
2. Cash equivalents are short-term highly liquid investments that are readily
convertible into known amounts of cash and which are subject to an
insignificant risk of changes in value.



FUNDS FLOW STATEMENT ANALYSIS
In business concerns funds flow from different sources and similarly funds are
invested in various sources of investment. It is a continuous process. The study and
control of this funds flow process is the main objective of financial management to
assess the soundness and the solvency of a firm. The traditional statements Balance
Sheet and Profit and Loss Account of a business tell little about its flow of funds, i.e.
financing and investing activities over the related period.

Hence, the need of another statement to account for periodical increase or decrease of
funds of an enterprise is known as Fund Flow Statement. The effectiveness of
financial management in generating funds from various sources and using them
effectively for generating income without sacrificing the financial health of the entity
is reflected in the statement of funds.

Concept of Funds
The funds ordinarily means cash and wealth, but here it means cash in short term
and working capital in long term. This is why the term fund is used as cash in cash
flow statement and as working capital in funds flow statement.

The concept of funds includes the following:
1) Literal cash
2) Short-term Monetary Assets
3) Net Monetary Assets
4) Working Capital
5) Financial Resources

Meaning and Definition of Funds Flow Statement
The statement of changes in financial position, prepared to determine only Sources
and Uses of working capital between dates of two balance sheets, is known as Funds
Flow Statement. Fund Flow Statement indicates the changes in the firms working
capital position. It discloses the total financial resources.

According to Anthony, The funds flow statement describes the sources from which
additional funds were derived and the use to which these sources were put

According to Foulke, A statement of sources and application of funds is a technical
device designed to analyze the changes in the financial condition of a business
enterprises between two dates.

The fund flow statement is also termed as:
Statement of Sources and Application of funds
Funds Statement
Statement of changes in Financial Position
Statement of Inflow and Outflow of Funds
Statement of Sources and Uses of Funds



Parties Interested in Funds Flow Statement
1) Management
2) Banks and Financial Institutions
3) Shareholders and other Investors
4) Debenture holders
5) Trade Creditors

Advantages of Funds Flow Statement
Helps in the analysis of financial operations
Throws light on many confusing questions of general interest
Helps in the formation of a realistic dividend policy
Helps in the proper allocation of resources
Acts as a future guide
Helps in appraising the use of working capital
Helps knowing the overall creditworthiness of a firm

Disadvantages of Funds Flow Statement
o Fails to cover sufficient information
o Secondary nature
o Doubtful statement
o Crude device
o Fails to reveal continuous changes

Working capital
In a broader sense, the term fund refers to money values in whatever form it may
exist. Here funds mean all financial resources in the form of men, materials, money,
machinery, etc. But in popular sense, the term funds mean working capital, i.e. the
excess of current assets over current liabilities. When funds move inwards or
outwards, they cause a flow or rotation of funds. The word fund here means net
working capital.

According to Shubin, Working capital is the amount of funds necessary to cover the
cost of operating the enterprise.

According to Genestenberg, Circulating capital means current assets of a company
that are changed in the ordinary course of business from one to another, as for
example, from cash to inventories, inventories to receivables, receivables to cash.

There are two concepts of working capital:
1) Gross Working Capital
2) Net Working Capital

Gross Working Capital: In the broad sense, the term working capital refers to the gross
working capital and represents the amount of funds invested in current assets. Current
assets are those assets which in the ordinary course of business can be converted into
cash within a short period of normally one accounting year.


Examples of Current Assets are:
1) Cash in hand and bank balances
2) Bills receivables
3) Sundry debtors
4) Short term loans and advances
5) Inventories (include raw materials, work-in-process, finished goods)
6) Temporary investment of surplus funds
7) Prepaid expenses
8) Accrued incomes

Net Working Capital: In a narrow sense, the term working capital refers to the net
working capital. Net working capital is the excess of current assets over current
liabilities. i.e. current assets current liabilities. Net working capital may be positive
or negative. When the current assets exceed the current liabilities the working capital
is positive and if the current liabilities are more than current assets then, the working
capital is negative.

Current liabilities are those liabilities which are intended to be paid in the ordinary
course of business within a short period of normally one accounting year.

Examples of Current Liabilites are:
1) Bills payable
2) Sundry creditors or Accounts payable
3) Accrued or Outstanding expenses
4) Short-term loans and advances and deposits
5) Dividends payable
6) Bank overdraft
7) Provision for taxation

Procedure of Preparing Funds Flow Statement
Statement of changes in Working Capital
Statement of Sources and Application/Uses of Funds

STATEMENT OF CHANGES IN WORKING CAPITAL
The working capital does change due to various transactions. The working capital
position at the beginning of the period is changed to a different position at the end of
that period.

A statement of working capital is prepared to depict the changes in working capital.
Working capital represents the excess of Current Assets over Current Liabilities. Since
several items i.e. all current assets and current liabilities are the component of working
capital, it is necessary to measure the increase or decrease therein, by preparing a
Statement or Schedule of changes in Working Capital. This statement is prepared
with current assets and current liabilities as appearing in the Balance sheet under
consideration.


The statement shows the changes in individual items of current assets and current
liabilities and their effect of working capital. The total increase and the total decrease
in the end is compared and the difference of total increase and total decrease shows
the net increase or net decrease in the working capital. A specimen of statement is
given below.

Particulars
Amount of
Previous year
Rs.
Amount of
Current year
Rs.
Effect on Working
Capital
Increase
(Dr.) Rs.
Decrease
(Cr.) Rs.
Current Assets:
Cash in hand
Cash at bank
Bills receivable
Sundry debtors
Temporary Investments
Stocks / Inventories
Prepaid Expenses
Accrued Incomes
Total Current Assets (A)
Current Liabilities:
Bills payable
Sundry creditors
Bank overdraft
Short-term advances
Dividends payable
Total Current Liabilities (B)

Working Capital (A B)
Net Increase/Decrease in
Working Capital

TOTAL

The following rules may be noted:
(a) Increase in a current asset item increases working capital
(b) Decrease in a current asset item decreases working capital
(c) Increase in a current liability item decreases working capital
(d) Decrease in a current liability item increases working capital

The increase or decrease in the Working Capital should be equal to that shown in the
Statement of Sources and Applications of Funds.


Problem:
You are given the following Balance Sheet of a Company:

31
st
December
2009 2010
Assets:
Cash
Accounts receivable
Land
Stock

Liabilities:
Account payable
Capital
Retained earnings

Rs.
3000
12000
5000
8000
Rs.
4700
11500
6600
9000
28000 31800

7000
20000
1000

4500
25000
2300
28000 31800

Prepare a statement showing the changes in working capital.

Solution:
Particulars
31
st
December Changes in Working Capital
2009 2010
Increase
(Dr.)
Decrease
(Cr.)

Current Assets:
Cash
Accounts
receivable
Stock
Total (A)

Current Liabilities:
Accounts payable
Total (B)

Working Capital (A B)
Net Increase/Decrease in
Working Capital
Rs.

3000
12000
8000
23000

7000
7000
16000

4700
Rs.

4700
11500
9000
25200

4500
4500
20700
Rs.

1700
- -
1000

2500

Rs.

- -
500
--

- -

4700
TOTAL 20700 20700 5200 5200



STATEMENT OF SOURCES AND APPLICATION/USES OF FUNDS
Funds flow statement is a statement which indicates various sources from which funds
(working capital) have been obtained during a certain period and the uses or
applications to which these funds have been put during that period.

Generally this statement is prepared in two formats:
i) Report Form
ii) T Form (or) Account Form (or) Self Balancing Type

FUNDS FLOW STATEMENT (Report Form)
Sources of Funds:
Issue of Shares
Issue of Debentures
Long-term Borrowings
Sale of Fixed Assets
Operating Profit
Total Sources
Applications of Funds:
Redemption of Redeemable Preference Shares
Redemption of Debentures
Payment of Other Long-term Loans
Purchasing of Fixed Assets
Operating Loss
Payment of Dividends, Tax, etc.
Total Uses
Net Increase / Decrease in Working Capital
(Total Sources Total Uses)
Rs.
--
--
--
--
--
--

--
--
--
--
--
--
--
--

The Funds Flow Statement can also be prepared in T shape as shown below:

FUNDS FLOW STATEMENT (T Form or Account Form)
Sources of Funds:
Issue of shares
Issue of Debentures
Long-term Borrowings
Sales of Fixed Assets
Operating Profit*
Decrease in Working Capital*
Rs.
--
--
--
--
--
--
Applications of Funds:
Redemption of Redeemable
Preference Shares
Redemption of Debentures
Payment of other Long-term
loans
Purchase of Fixed Assets
Operating Loss*
Increase in Working Capital*
Rs.
--

--
--
--
--
--
-- --
* Only one figure will be there.

The change in working capital disclosed by the schedule of changes in working
capital will tally with the change disclosed by the funds flow statement.


Note: Payment of dividend and tax will appear as an application of funds only when
these items are appropriation of profits and not current liabilities.

Steps in determining the Sources of Funds and Application of Funds
(1) Compute funds from operations
(2) Analyze the changes in non-current assets and liabilities in the balance sheet in
the beginning and at the end of the period with the help of additional
information provided to determine the net decreases in non-current assets and
net increases in non-current liabilities and equity, which represents the inflow
of funds. The net decrease in non-current liabilities and equity, and increases in
non-current assets represent the outflow or uses of funds.
(3) List all the sources on the left side on the statement and uses on the right side
of the statement.
(4) The two sides are totaled and the difference between them is recorded on the
side which is shorter in order to make the totals equal. Write net increases (if it
appears on the right side) or decreases (if it appears on the left side) in working
capital. This must be equal to the amount of net increase or decrease computed
while preparing schedule of changes in working capital.

In preparing the statement, following points are to be kept in view:
a) Every increase in current assets means increase in net working capital.
b) Every decrease in current assets denotes decrease in net working capital.
c) Every increase in current liability implies decrease in net working capital.
d) Every decrease in current liability represents increase in net working capital.

Sources of Funds Uses/Application of Funds
Funds from Operation / Operational
Profit
Funds Lost in Operations
Issue of Shares Redemption of Preference Share Capital
Issue of Debentures Redemption of Debentures
Raising Long-term Loans Repayment of Long-term Loans
Sale of Fixed Assets / Trade Investments Purchase of Fixed Assets
Sale of Non-current /Trade Investments Purchase of Non-current Assets
Net Decrease in Working Capital Payment of Tax and Dividends

FUNDS FROM OPERATIONS
The term operation means the day-to-day affairs of the business. It refers to those
activities which are trading. Non-trading items, such as depreciation, loss on sale of
assets, writing off of fictitious assets as goodwill, preliminary expenses, discount or
loss on issue of share and debentures are taken as non-operational.



Non-trading gains i.e. gain on sale of assets, refund of tax or receipts of compensation
are not treated as operational. Funds from operations are therefore, an operating
surplus. In other words, it may be calculated as calculation of funds from operations.

COMPUTATION OF FUND FROM OPERATIONS
There are two methods to find out the amount of Funds from Operations.
1. Statement form and
2. Account form

Statement Form: It can be prepared as under:

CALCULATION OF FUNDS FROM OPERATIONS
Rs. Rs.
Net Profit for the current year
Add: Non-Fund and Non-Trading Charges
already debited to P&L A/c:
Depreciation and Depletion
Amortization of Fictitious and Intangible assets:
Preliminary Expenses written off
Discount on Shares written off
Premium on Redemption written off
Goodwill or Patents written off
Appropriation of Retained Earnings:
Transfer to General Reserve
Sinking Fund etc.
Proposed Dividend
Loss on Sale of Fixed Asset written off
TOTAL

Less: Non-Fund and Non-Trading Incomes
already credited to P&L A/c:
Dividend Received / Receivable
Excess Provision written back
Profit on Sales of Fixed Asset
Profit on Revaluation of Fixed Assets
TOTAL

TRADING PROFIT OR FUNDS FROM OPERATIONS

--

--
--
--
--

--
--
--
--
--

--

--
--
--
--

--

--



Account Form: Alternatively, an adjusted Profit and Loss account may be written up
as follows and the balancing figure thus represents Trading Profit or Fund from
Operation.

ADJUSTED PROFIT AND LOSS ACCOUNT

To Depreciation
To Preliminary Expenses
written off
To Discount on Shares written
off
To Goodwill written off
To Premium on Redemption
To Transfer to Reserves
To Loss on Sale of Fixed
Assets
To Closing Balance of P&L
Appropriation A/c
Rs.
--
--
--
--
--
--
--

--

By Opening Balance of P&L
Appropriation A/c
By Dividend Received
By Excess Provision written
back
By Trading Profits (or) Fund
From Operation
(balancing

figure)
Rs.

--
--
--

--
-- --

Problem:
M/s. Anand & Company reported that the current profit is Rs.70,000 after
incorporating the following particulars:

Loss on sale of Equipment
Premium on Redemption of
Debentures
Discount on Issue of
Debentures
Depreciation on Machinery and
Buildings
Depletion of natural resources
Amortization of Goodwill
Interim Dividend
Rs.
10000

1500

2000

20000
10000
30000
25000

Gain from sale of non-
current assets
Excess Provision for
Taxation
Dividend income on
Investments
Preliminary Expenses
Profit on Revaluation of
Investments
Rs.

40000

22000

4000
5000
1000

2500

You are required to calculate funds from the operations.


Solution:
CALCULATION OF FUND FROM OPERATIONS

Net Profit for the current year
Add: Non-fund or Non-Operating debits:
Loss on sale of Equipment
Discount on issue of Debentures
Depreciation on Machinery and Buildgs.
Depletion of Natural Resources
Amortization of Goodwill
Excess provision for Taxation
Preliminary Expenses
Premium on Redemption of Debentures
Interim Dividend

Less: Non-fund or Non-Operating Credits:
Profit on Revaluation
Gain from Sale of non-current Assets
Dividend Income on Investments
Rs.

10000
2000
20000
10000
30000
22000
5000
1000
1500
25000
Rs.
70000

126500

2500
40000
4000
196500

46500
Net Inflow of funds from Operations 150000

Alternatively, this figure of Rs.1,50,000 may be derived by preparing an Adjusted
Profit and Loss Account:
ADJUSTED PROFIT AND LOSS ACCOUNT

To Loss on sale of Equipment
To Discount on issue of
Debentures
To Depreciation on Machinery
and Buildgs.
To Depletion of Natural
Resources
To Amortization of Goodwill
To Excess provision for
Taxation
To Transfer to General
Reserve
To Preliminary Expenses
To Premium on Redemption of
Debentures
To Interim Dividend
To Closing Balance (Reported
Profit)
Rs.
10000
2000
20000

10000
30000
22000
5000
1000
1500

25000

70000

By Profit on Revaluation of
Investments
By Gain from Sale of non-
current Assets
By Dividend Income on
Investments
By Operating fund
(Balancing figure)
Rs.
2500

40000

4000

150000

196500 196500


Part A Questions
1. State the meaning of financial statement.
2. What are the types of financial statement analysis?
3. Who are the users of financial statements?
4. What are the techniques of financial statement analysis?
5. What are the objectives of financial statement analysis?
6. Define Ratio Analysis.
7. What are accounting ratios?
8. What is cash flow statement?
9. Give the three components of a cash flow statement.
10. What is funds flow statement?

Part B Questions
1. Explain the tools of financial statement analysis.
2. Describe the various types of financial ratios.
3. Differentiate between fund flow and cash flow statements.
4. Draw the Proforma of fund flow and cash flow statements.
5. Problems Ratio Analysis Cash Flow Statement Fund Flow Statement.
************

Text Books & References:
1. M.Y.Khan & P.K.Jain, Management Accounting, Tata McGraw Hill, 2011.
2. R.Narayanaswamy, Financial Accounting A managerial perspective, PHI
Learning, New Delhi, 2011.
3. Jan Williams, Financial and Managerial Accounting The basis for business
Decisions, 13
th
edition, Tata McGraw Hill Publishers, 2010
4. Horngren, Surdem, Stratton, Burgstahler, Schatzberg, Introduction to
Management Accounting, PHI Learning, 2011.

Accounting For Management - Unit I

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