Working Papers of Dr. B.C.M.patnaik

working papers of Dr.B.C.M.
Patnaik, Associate Professor, School of Management, KIIT University, Bhubaneswar
Management Reporting
Information is the life blood of a business. The efficiency of an organization is to a large extent governed by the pertinence and regularity of the information provided to those who perform the functions of management. As a matter of fact, the ultimate effectiveness of the information is itself dependent upon the form and timing of its presentation. It is, therefore, necessary to evolve and operate effective and efficient management information or reporting system. Without information, the managers, working at different levels in the organization, cannot carry out the functions of planning, controlling and decision making efficiently. No planning and control procedure is complete without prompt and accurate feedback of operating results. Therefore, one of the main functions of accounting is to provide management with necessary information which may be communicated in the form of reports, statements, or in any other form.
Management Reporting System or Management Information System

A management reporting system can be defined as an organized method of providing each manager with all the data and only those data which he needs for his decisions, when he needs them and in a form which aids his understanding and stimulates his action. The organization can design such a system only after it has established its goals, broad policies and the basic organization structure. The management reporting is sometimes known as reporting to the management or internal reporting also. The large production has rendered the business operations more complex in nature. Management today cannot himself observe, analyze and assimilate all significant facts regarding the entire organization. It is through reporting only that they get a full insight into the activities of the vast organization. Thus, the primary object of reporting to management is two-fold: Appraising the management with actual performance To enable the management to make scientific and sound decisions. The process of management reporting essentially involves: Proper selection of financial and operating data and other relevant facts and figures which are to be communicated. Organization of data to put the information in a proper form that can be rapidly understood and appreciated by the management and Selecting the appropriate method of reporting. Thus, we observe that the process of management reporting is deeply concerned with the communication of financial and non-financial information to the management. The routine system of accounting does not cater this need. Hence, the management accountant is concerned with the task of obtaining, arranging, analyzing and interpreting the necessary data and then communicated to the management often largely determine the success or failure of management at various levels in the organization.
Essentials of Good Reporting System

Evaluation of each The system should yield information required for the managers area of evaluation of each managers area of responsibility in relation to the goals of the organization. responsibility Proper flow of There should be proper flow of information. It should 1
working papers of Dr.B.C.M.Patnaik, Associate Professor, School of Management, KIIT University, Bhubaneswar
information originate from the right place and should be transmitted to the proper level of authority where the decisions are to be made. Moreover, complete and consistent information should flow in a systematic manner. The information should be communicated in a proper form so that management may appreciate it and use it in decision making without any difficulty. The system should ensure furnishing of the information at the proper time i.e neither too late or neither too early. There should be constant evaluation of the cost incurred in collecting and supplying the information and the benefit derived therefore. The system should be capable of being adjusted according to the requirement of the user.
Proper form
Proper time Cost benefit analysis
Flexibility
Meaning of Report
As indicated earlier, management reporting refers to the formal system whereby through reports relevant information is constantly fed to the management. Thus, report is the essence of any management information system. The term Report, may be defined as a formal communication which moves upward. It differs from the word communication. The superior communicates the orders to the subordinate. The subordinate communicates the results. The word Report is generally used for factual communication by a lower level to a higher level of authority. Thus, orders are communicated, while results and reports are reported.
Modes of Reporting
Written Report These includes the following: Formal financial statement : such statements may deal with one or more of the following: Actual against the budgeted figures. Comparative statement over a period of time Tabulated statistics: The report may deal with statistical analysis of a particular type of expenditure over a period of time or sales of a product over a period in different territories etc. Accounting ratios: These may be part of the formal financial statements prepared or may be given in the form of a separate statement. Sometimes, information may be supplied in the form of Charts, Diagrams, and Pictures etc. also. Graphic Reports have the advantage of facilitating quick grasp of significant trends by those who receive the information but they cannot be interpreted as accounting ratios. Information may be communicated orally also. Group meeting and conferences with individuals are most common forms of such communication. However, it will always be appropriate to 2
Graphic Reports
Oral Reports
make written reports as the basis for important managerial decisions.
Role of reports in a System of Control

A good and efficient management reporting system is very useful instrument in the hands of management. It helps the management in future planning and control of business operations. The reports are designed to measure the actual performance with the budgeted standards. They show the extent of variance and identify the causes which can possibly be assigned to it. The reports, usually furnish a detailed view of operating activity and focus the off-standard or above standard performance during the period under consideration. They enable the management at all level to keep itself abreast of past performances as well as developments and it can keep a check on individual operating levels. These reports inform to the management as to what is happening where, who is responsible for failures. Reports also set out the trends in actual performance. They highlight the deviation calling attention during a given period. The effectiveness of the control system increases with decrease in the time interval of reporting. As a matter of fact, reports are important tools of control, but it is important to realize that reports and reporting methods are not in themselves, a control. They are only tool. The success and effectiveness of control system, to a large extent, will depend upon the manner of use of this system by the management Principles of Sound and Effective Reporting: The drafting of accounting reports is an art. The rendered reports should be useful and efficient and to make them serviceable to the maximum possible extent certain principles should be observed. These principles are general guidelines to the accountant. There are not standardized set of rules which are to be followed strictly in preparing each report. However, here are general rules and principles which should be followed in this respect: The draft of the report should be simple. The report should be prcised, specific and accurate. It should bear a suitable title. It must follow the organizational lines. Reports must contain up-to-date information. Reports should be presented in time. They should be specific and definite. They should be economical. It must suit to the end-users requirements. They must comparable They must be consistent and correct as to information. It must be attractable. It must distinguish between controllable and uncontrollable cost. The report should highlight the trouble spot. It must provide for exceptional circumstances.
Requisites of Good Report

A report is vehicle carrying information. The fruitfulness of the work done by the different executives not only depends on the quality of the work itself but also the way in which the
information or results are conveyed to their superiors. Thus, good reporting is necessary for effective communication. A good report should, therefore, have the following requisites:
Good form and content
The report should possess good format and must be rich in contents. The report should have a suggestive title, headings, sub-headings and paragraph divisions. The other important aspects in this respect are as follows: In case statistical figures are to be quoted in the report, only the significant totals may be given in the body of the report. The other statistical details should be given in the appendix. The report should contain facts rather than opinions. In case opinions are expressed, there should logical sequence of facts presented in the report. In case report is response to a request or letter, cross reference of such request or letter should be given. The report should bear the date on which it is put up. The names of the persons whom the report has been addressed should be perfectly served by the contents of the report. The objectives of the report should be perfectly served by the contents of the report. The contents should follow a logical sequence in respect of : The summary of the personal position. The course that might be taken and the expected results. The recommendations and reasons for the submission. The report should be submitted as soon as possible. Information delayed is information denied. Reports are meant for action. The sooner the report is made, quicker can be action be taken. In some cases promptness in presentation is more important than any other general principles of reporting. Sometimes even accuracy may have to be sacrificed to achieve the objective of promptness. In order to ensure the promptness of reports, the following steps will be very useful: A proper record- keeping system, tailored according to the requirements of submission of different reports, should be established in the organization. In order to avoid clerical errors and increase productivity, mechanical accounting devices may be used. Accounting work should be departmentalized in order prevent bottlenecks in reporting. Employees may be asked to report immediately about any abnormal or extraordinary situation. Reports are also meant for comparison. This is possible only when 4
Promptness
Comparability
information contained in the report is placed in some perspective i.e time norms of standards. Figures should be given for some previous period such as last month or some month of for last year,etc . Actual figures may also be placed side by side with corresponding budgets, standards or estimates. The objective is to highlight significant deviations from the previous periods standard of estimates. The principle of management by exception should be applied while drafting report. Consistency is closely linked with comparability since comparison is Consistency possible only when reports are prepared and information embodied in the report emanates from a common source. Moreover, uniform procedure should be followed over a period of time for collection, classification and presentation of accounting information. The report should be in simple, unambiguous and concise form. Simplicity Professional or technical jargon should be avoided since those who receive the report may be quite unfamiliar with expression the accountant takes for granted. It should also be readable. Both conciseness and rounding off figures to a significant point add to the readability of the report which is another dimension to simplicity. The report should be appropriate for the person for whom it is Appropriateness meant. The following points are of significance in this context: Report should be related to the responsibilities of the recipients. For example, the production manager should be supplied with only such reports which relates to his division or area of control. Report should be designed to suit the level of management for whom it is meant. The general principle is higher the level of management, the more concise should be the report. In order to have appropriate response of the report, it is necessary Controllability that every report should be addressed to a responsibility center and should contain a message about the variances which are controllable at that point. There is no objection to the mention of all variances relating to the area covered in order to make the report complete. But variances which are beyond the control of the executive receiving the report should be mentioned separately in the report The report should be reasonably accurate. The degree of accuracy Accuracy will depend upon the purpose for which the information is required. Such inaccuracies which will not alter the significance of the information may be ignored. Consideration of The reporting system should not become an unnecessary drag on resources of the business. The cost of maintaining the system should cost be commensurate with the benefits derived therefrom. Reports that communicate effectively to all levels of management Effective stimulate action and influence decisions. Persons responsible for communication designing and preparing management reports must know and 5
understand the problems and methods of management.
Types of Reports
There are several ways of classifying the reports. They can be classified by their form, contents frequency or so on. The following chart gives a snapshot view of the different types of reports: Reports Form wise Purpose wise Contents wise Frequency wise Nature wise Descriptive Internal report Production Routine report Operating Tabular External report report Special report report Graphical Sales report Information Cost report report Financial report Control report Operating Financial report report Static report Dynamic report
Reports according to Form:

Descriptive report These types of reports are written out in a descriptive style. These reports usually do not take the help of tables and graphs. They may include tables and graphs in order to lay emphasis on some of the points discussed. The language used is very important factor in such reports. The language should be simple, direct and capable of conveying the idea of the reporter to the management. The report should have the suitable heading and sub-headings and it should be suitably paragraphed. The main report should be summarized, so that the recipient of that report should be able to discover the exceptional matters, and the recommendations without going into the details of the report. Descriptive reports are considered to be less effective devices as compared to tabular and graphical devices of illustrating points involved in the reports. Such a report does not attract the eye more quickly and forcibly. Such reports are presented in the form of comparative statements. This form of reporting applied in case of periodical reports covering production, costs, sales and finance. These reports should use same standard form of statements or tables from period to period so that proper comparison may be made between the present and past performances. Examples of this type of reporting are statement of cost, statement of profit, statement of material cost, labour efficiency report, idle time report etc. these reports are more effective as compared to descriptive reports because they create more impression on the mind of the recipients of such reports. It is very important method of presenting information to management in a pictorial manner and attracts the eye of the recipient more quickly and forcibly. Recently graphs and diagrams are becoming very popular 6
Tabular report
Graphic presentation
because they are the most effective media for disclosing trends and making comparison over fairly long periods within a short space. Graphs and diagrams make the otherwise dull and confusing figures interesting and attractive. This method of presenting information can effectively depict production costs, fluctuations in input and output, position and movement of stocks, variances, components of cost of production etc.
Report according to Purposes

Internal reports: These reports are submitted by the management accounting department to the various level of management. Their main purpose is to inform the management what is happening where and to assist in planning and control. Such reports may be of the following types. General /periodical or routine report: These are the reports that are rendered at periodic intervals. The intervals at which routine reports are to be presented should be fixed for each report say week, month, quarter or one year. For certain matters, even daily reports can be prepared and submitted. For example, production reports should be rendered at shorter intervals because delayed reporting on production may lead to a continuous loss for a longer period. The examples of routine reports are as follows: Production report. Sales report Production cost report Operating report Schedule of debtors Research and development report Different short-term budgets as cash budget etc. Special reports: These are reports which are prepared and submitted to the management for any special purpose. They do not relate to the day-to-day problems. They are to be presented after making an investigation of any special problem which requires to be investigated. The following matters may be covered by special reports: Effect of idle capacity on cost of production of different products. Make or buy decisions. Exploring new market Cost reduction schemes Whether to purchase or hire a fixed cost Research and development expenditure problems The effect of labour disputes on production and cost of production and so on. Management Level Report This group of reports includes the different types of reports which are submitted to the various levels of management. They may include: the reports to foreman, reports to first line managers, reports to departmental managers, reports to the top management and board directors. The information to be presented and the method of reporting should meet the specific requirements of these levels of management. Lower the level of management, more detailed should be the report, higher the level of management, more summarized should be report. More frequent reports are submitted to the lower levels of management. 7
External Reports: In external reporting the reports ( annual report) to the share holders, return to the stock exchange authority, tax-return to the income tax authorities, reports and various statements to banks and other credit institutions are included.
Report according to contents

According to the contents of the report they may be production reports, production cost reports, sales reports, cost report, financial report so on. These are actually routine reports and their main purpose is to provide periodical information which is used by the management for planning and policy determination. Report according to Frequency of Report: According to the frequency of reports may be of two types. Regular or routine reports and special reports. The balance sheet, income statement, income tax return, directors report are the examples of routine reports. On the other hand, investigation reports are special reports which are irregular in nature and meant for a particular purpose. These reports contain a special message and deal with the causes and remedies of special problems.
Reports according to Nature

According to the nature of reports, they may be classified in to operating and financial reports: Operating reports: this may consist the following: These reports are designed to measure the actual performance Control reports with the budgeted standards. They show the extent of variance and the causes which can possibly be assigned to it. They are prepared weekly, fortnightly, monthly, or yearly. These reports serve the management for decision making. The entire operating activity is divided into different segments, each segment being known as responsibility center. A control report is prepared for each centre giving an insight in to the performance of the centre. A well devised control report is very much helpful in planning and controlling the business operations. Current reports may also be of two types: Current control report: They indicate deviation of actual performance from planned performance of operations so that prompt action may be taken to stop further losses. Summary control report: These reports summarize the deviation of actual performance from planned performance over a period of time (generally a month or a quarter), check on current control reports and give an indication of the overall effectiveness of the performance of responsible executives. Such reports are used by the management for planning and Information reports policy determination. They may also be of two types: trend reports and analytical reports. Trend reports reflect the result of the same or a group of operations over a period of time 8
comparing the periodical result over the time. Analytical reports make a comparative study of the results on horizontal basis as well as vertical basis. Financial reports: These reports highlight the financial position, strength and structure of the business enterprise. They have a two-fold purpose: To report on the degree of efficiency with which available financial resources are being utilized To report on the financial position and solvency and liquidity position of the firm. Financial report may also may also be of two types: Static Financial These are the reports which provide for the analysis of financial structure and financial position of the business. Balance sheet or Reports position statement is a glaring example of such report. Dynamic Financial The managements need for accounting information is dynamic and frequent. The management needs more information, faster, Reports more complete and more prompt. Hence, the need of dynamic financial report arises. These reports may also be of three types: Financial control reports Reports measuring the effectiveness of the use of funds Reports of changes in financial condition.
Reports useful for Different Level of Management

From the managerial view point, we can classify all internal reports in three categories: Report means for the top management. Report meant for middle level of management. Reports meant for junior level of management. Report meant for top management: The top management is concerned with the following: Formulating the basic goal of enterprise. Evolving proper plans keeping the basic objective in view. Proper delegation of responsibility to subordinate executives with the objectives of getting efficient and effective utilization of the resources. Promoting appropriate development schemes. Thus, the top management is primarily concerned with planning and organizing and not with the execution of plans. The information submitted to them should not therefore, be in minute details giving day-to-day report of operating activity. They should rather be supplied with summary reports giving an overall view of the operating activities together with a comparison of actual with planned performance. The following reports should be sent at the intervals mentioned therein to the top management: Board of Directors Quarterly balance sheet and profit and loss account. Quarterly funds flow statement Quarterly production cost statement. Quarterly machine and labour utilization statement. Production Director Monthly production cost statement. 9
Monthly machine utilization statement-department-wise. Monthly labour utilization statement- department wise. Material scrap statement- department wise. Overhead cost statement- department wise Monthly production statement showing quantity budgeted, quantity produced and orders outstanding. Sales Director Monthly report of orders received, orders executed, orders kept pending- division wise. Monthly report of finished goods stock position. Monthly report of selling and distribution cost-division wise. Monthly report of credit collection, arrears and bad debts-division-wise. Finance Director: Monthly Funds Flow Statement Monthly abstract of receipts and payments. Reports meant for middle management: The middle management is concerned with the execution of plans formulated by the top management. They function as coordinating executives to administer policies, direct the operating supervisors and evaluation of their performance. Thus, the reports submitted to them should be such which would assist them in performing these functions. Following is the list of such reports: Works Manager Weekly report of the idle time and idle capacity- department wise. Weekly report of scrap department wise. Weekly report of production statement showing quantity budgeted, quantity produced, orders outstanding. Sales Division Manager Fortnightly report of budgeted and actual sales- area wise and product wise. Fortnightly report of credit collections, outstanding and bad debts. Fortnightly report of orders booked, orders executed and orders outstanding. Fortnightly report of stock position. Reports for junior level management: This level of management consists of foremen, supervisors etc., who are interested in reports which will keep them abreast of progress of jobs under their charge. The following is the list of reports which will suit their purposes: Shop Foreman Daily report of idle time and machine utilization. Daily scrap report Daily report of production- budgeted and actual Sales area supervisors Weekly report of sales- salesman-wise Weekly report of orders booked, executed and outstanding. Weekly report of credit collections, outstanding and bad debts. The following is the list of some other reports that would be helpful to the supervisory level of management in the successful operation of budgetary control system: Sales force progress of work Sales Sales promotion work 10
Exports Publicity and advertisement. Cost of sales Efforts to be made to cover lower actual Inventory Work-in-progress Capital expenditure Progress of capital works Direct workers employment estimates- approved and proposed. Other workers employment- approved and proposed Approximate cost of present and proposed staff Estimates based on past trends. New items Accounts receivable position and estimates. Accounts payable position and estimates.
Production
Personnel
Overheads Finance
11
Financial Statement Analysis and Interpretation

Methods, Devices or tools of Analysis and Interpretation
Following are the important tools of financial analysis Comparative financial statement Common size statements Trend analysis Average analysis Ratio analysis Funds flow analysis Cash flow analysis
(A) Comparative Income Statement or comparative statement of Profit and loss account.
An income statement reveals the operational results of the business for a stipulated period of time. The comparative income statement shows the operational results of the business for a number of accounting periods so that changes in absolute figures from one period to another period may be stated in terms of money and percentage. Presentation of comparative income statement is very simple. In the first two columns the given information in the question is arranged according to the purpose sought to be achieved. The third column indicates absolute changes in the current years figures over the previous years figures. In the fourth column absolute changes are shown in terms of percentages. These are calculated as follows: Increase or decrease in current year over the previous year X 100 Absolute figure of previous year Note: Cost of goods sold or cost of sales: Sales Gross profit Or Sales + gross loss Or Opening stock + net purchases + direct expenses closing stock Net profit = Gross profit operating expenses non operating expenses Operating profit = Gross profit operating expenses 12
Example: 1 The income statements of a concern are given for the years ending on 31st March 2008 and 2009. Rearrange the figures in comparative form and study the profitability position of the concern: Particulars 2008 2009 Rs(000) Rs (000) Net sales 850 1,100 Cost of goods sold 500 600 Operating expenses General expenses 100 110 Selling expenses 90 100 Non- operating expenses Interest paid 30 40 Income tax paid 80 90 Solution: Comparative Income Statement For the year ended 31st March 2008 and 2009 Particulars 31st 31st Increase Increase(+) March March (+)/Decrease /Decrease 2008 2009 (-) (-) in % Net sales 850 1,100 250 250/850 X100=29.41 (-) Cost of goods sold 100/500 X100=20 500 600 100 150/350 Gross profit (A) 350 500 150 X100=42.88 Operating expenses: General expenses Selling expenses
100 90 190
110 100 210
10 10 20
10/100 X100=10
10/90X100=11.11 20/190 Total operating expenses (B) X100=10.53 160 290 130 130/160 Operating profit (A-B) 30 40 10 X100=81.25 (-) Interest paid 130 250 120 120/130 Net profit before tax X100=92.31 (-) income tax 80 90 10 10/80 X100=12.5 Net profit after tax 50 160 110 110/50 X100=220 Interpretation: It is clear from the above comparative income statement that there is an increase of 29.4% in net sales, while there is a jump of 20% in cost of goods sold. On account of this, gross profit has been increased by 42.8%. Although there is increase of 10.53% in operating profit is increased by 81.25%. There is increase of 220% in neat profit. Despite increase of 33.33% and 12.5% in interest and income tax. In short we can say that the progress of company is satisfactory. The profitability of company is also satisfactory.
(B) Comparative Balance Sheet

13
The effect of all operations of a business firm are visible in the balance sheet in the form of increase or decrease in the value of different assets, liabilities and owners equity. These changes can be studied by comparing the opening and closing balance sheet of the same business enterprise. For this comparison, the technique of comparative balance sheet can be used. In comparative balance sheet, items of balance sheet prepared at two different dates are presented in such a way that the changes in each related item between the two dates could be found easily. However, such comparison can also be undertaken between balance sheets of the same date of two or more business enterprises. Preparation of comparative Balance sheet For showing comparative position of different items of Balance Sheet of two periods, a summary of balance sheet changes is prepared. It will have two columns for the data of original balance sheet and third column for showing increases or decreases in various items. A fourth column, showing percentages of increase or decrease may also be added. For showing these changes in the form of ratios, one additional column may also be added. The use of ratios avoids the use of plus or minus signs because when ratio is less than one, it implies that the amount of current year is less than the amount of base year and vice versa. Importance of Comparative Balance Sheet The comparative balance sheet is a useful technique of analysis and interpretation of balance sheet. Its main advantages are as under: A single balance sheet provides information about the balances of accounts on a particular date whereas a comparative balance sheet shows not only the balances of accounts at different dates but also the extent of changes in such balances between the two dates. A balance sheet is a static document as it shows financial position of an enterprise on a particular date whereas in a comparative balance sheet the stress is more on changes. Hence, it is dynamic in its approach. Comparative balance sheet highlights the trend of changes in assets and liabilities over a period of time. A comparative balance sheet serves as a link between balance sheet and income statement as it reflects the effects of its operations on assets and liabilities of the business. Weakness of Comparative Balance Sheet An important weakness of changes shown in summary of changes in Balance Sheet is that the relationship of different items with total assets, liabilities and capital and year-to-year changes in these relationships are not shown in it. Hence, no meaningful comparison can be made of the data of one concern with that of other concerns or whole industry. To overcome this weakness comparative common-size balance sheet can be prepared. Example:2 The Balance Sheet of Raj Ltd. as on 31st March 2008 and 2009are as follows Liabilities 2008 2009 Assets 2008 2009 Equity share 4,000 5,000 Land and building 2,000 3,000 capital Plant 1,000 1,500 Capital reserve 150 900 Investment 600 800 10% debentures 600 800 Debtors 400 500 creditors 250 300 Stock 800 900 Cash 200 300 14
5,000 7,000 5,000 7,000 Draw a comparative balance sheet showing increase or decrease both in absolute figures and in percentage and then interpret the changes. Solution: Items 2008 2009 (+ )or( -) (+) or (-) in % In absolute figure Assets: Fixed asset: Land and building 2,000 3,000 1,000 50% Plant 1,000 50% 1,500 500 Total of fixed assets 3,000 4,500 1,500 50% Investments Current assets : Debtors Stock Cash Total of current assets Total of assets Liabilities: Equity share capital Reserve and surplus 10% Debenture (secured loan) Total of fixed liabilities Creditors Total of liabilities 600 400 800 200 1,400 5,000 4,000 150 600 4,750 250 5,000 800 500 900 300 1,700 7,000 5,000 900 800 6,700 300 7,000 200 100 100 100 300 2,000 1,000 750 200 1,950 50 2,000 33.33% 25 12.5% 50% 21.43 40% 25% 500% 33.33% 41.05 20% 40%
Comments: There is an increase of 50% in fixed assets. Source of this increase is share capital and debenture i.e. increase in fixed liability is 58.33%. The increase in investment is 33% and in current assets is 21.43%. Current liability shows an increase of 20%. There is adequate increase in reserve and surplus which is equal to 500%. In brief, the overall position of the company is satisfactory.
(C) Common size income statement

In this statement relationship is established between items of income statement and volume of sales in percentage form. In other words, in a common-size income statement, each item of income statement is shown in percentage based on net sales. To avoid too much detail, income statement should be presented in condensed form. Example:3 Convert the following Income Statement in to Common-size Income Statement and in the light of the conditions in2008, interpret the changes in 2009. Income statement Particulars 2008 2009 15
Gross sales Less Sales return and allowances Net sales Cost of sales Gross profit on sales Operating expenses: Sales expenses Administrative expenses Income from operation Other income Total income Other expenses Net income for the year Solution: Common size income statement Particulars Gross sales Less Sales return and allowances Net sales Cost of sales Gross profit on sales Operating expenses: Sales expenses Administrative expenses Income from operation Other income Total income 15,300 300 15,000 9,100 5,900 3,000 1,500 1,400 150 1,550 200 1,350 18,360 350 18,010 10,125 7,885 3,300 1,700 2,885 200 3,085 300 2,785
2008 Amount 15,300 300 15,000 9,100 5,900 3,000 1,500 1,400 150 1,550 200 1,350
2008 % 102.0 2.0 100.0 60.7 39.3 20.0 10.0 9.3 1.0 10.3 1.3 9.0
2009 Amount 18,360 350 18,010 10,125 7,885 3,300 1,700 2,885 200 3,085 300 2,785
2009 % 101.9 1.9 100.0 56.2 43.8 18.3 9.4 16.1 1.1 17.2 1.7 15.5
Other expenses Net income for the year Interpretation: The cost of sales has been reduced in 2009 as compared to 2008. This may be due to fall in material prices and /or efficiency of purchase department. As a result of reduction in cost of sales, the gross profit percentage has been increased from 39.3 % in 2008 to 43.8% in 2009. Though the amount of operating expenses has increased in 2009 but it is less than proportionate to increase in sales during the period. This is why the percentage of operating expenses to net sales has reduced in 2009 from 30% to 27.7%. It may be viewed as a proof of operating efficiency and economy in expenses of the concern. The combined effect of reduction in cost of sales and economy in operating expenses is that the percentage of net profit to sales of the concern has increased from 9.3% in 2008 to 16.1% in 2009. 16
The increase in non-operating expenses in 2009 is significant and there is no justification of this increase. It is clear from this analysis that the concern has been operated more efficiently in 2009 as compared to 2008. Alternative Presentation: Income statement for the year ended March 31st 2008 and 2009 Items 2008 2009 Gross sales (-) returns Net sales (-) cost of goods sold Gross profit (-) selling expenses Operating profit (-) interest EBIT (-) tax EAT 370 20 350 190 160 50 110 20 90 31.5 58.5 480 30 450 215 235 72 163 17 146 51.5 94.5
Solution: Income statement (Common size) for the year ended March 31st Items 2008 Net sales 100 Cost of goods sold 54.3 Gross profit 45.7 Selling expenses 14.3 Operating profit 31.4 Interest 5.7 Earnings before tax (EBIT) 25.7 Taxes 9 Earnings after tax (EAT) 16.7
2009 100 47.8 52.2 16 36.2 3.8 32.4 11.4 21
(D) Common size Balance Sheet

Example -4 The following Balance sheet of KIIT Ltd. as on 31st March Items 2008 Liabilities Equity share capital 240 General reserve 96 Long-term loans 182 Creditors 67 Outstanding expenses 6 (in 000) 2009 240 182 169.5 52 --17
Other current liabilities Assets: Plant Cash Debtors Inventories 9 600 402 54 60 84 600 2008 40 16 56 30.3 11.2 1 1.5 13.7 100 67 9 10 14 33 100 6.5 650 390 78 65 117 650 2009 36.9 28 64.9 26.1 8 Nil 1.0 9 100 60 12 10 18 40 100
Solution: Items Owners equity Equity capital General reserve Long term borrowings Loans Current liability Creditors Outstanding expenses Other liabilities Total liabilities Fixed assets : Plant Current assets : Cash Debtors Inventories Total assets
Trend analysis of Financial Statement:

Trend analysis is also an important and useful technique of financial statement analysis. Trend means any general tendency. Analysis of these general tendencies is called Trend analysis. It discloses the direction of change-upward or downward-in financial and operating data during the period under review by linking each statement item to the same item in the base year. Generally first year is taken as base year. The analyst then analyses the trend (or tendency) highlighted. Such analysis is very significant for forecasting the business events. It might be also useful to compare such trends with similar trends in the firm generally and the industry concerned particularly. Being a horizontal analysis of financial statements, it is often called a Pyramid Method of ratio analysis. Trend analysis can be done in three ways. Trend percentages Trend ratios Graphic and diagrammatic representation. Trend percentage:
18
Percentages changes are calculated in comparative statements also but these percentage are not fit for comparing the statements of more than two periods because in these statements every rate of increase or decrease is calculated on the basis of related last year figure. Thus, in these statements base of percentages of each year changes as a result this method suffers from lack of continuity. To remove this weakness trend percentages are calculated. In this method, percentage increase or decrease of other years is calculated taking statement of a year (usually the first year) as the base. Such fixed base percentages are called trend percentages. In fact, these show rates of changes in various years with reference to a base year. However, trend percentages are not treated well for comparison because in it plus (+) minus (-) signs have to be used. Trend ratios are calculated to make trend analysis free from this weakness. Example: 5 Year I II III IV V Inventory Rs25,000 Rs30,000 Rs21,750 Rs16,250 Rs24,000 Calculate Trend Percentages. Solution Calculation of trend percentages: Year Percentage of increase or decrease from first year II + 20 III -13 IV -35 V -4 Trend ratios: The calculation of trend ratio involves the ascertainment of arithmetical relationship which each item of several years bears to the same item of base year. One particular year out of many years (usually first year) is taken as base. The base year figure taken as 100 and then the figures of subsequent years are shown in terms of percentages. To calculate trend ratio, each years figure is divided by the base years figure and then multiplied by 100. The trend ratios for above example will be as follows: Year I II III IV V Trend ratio 100 120 87 65 96 As is clear from the above calculations, these ratios are like fixed base index numbers which indicate movements in various financial facts of the business. Continuity of series is maintained in it. Hence, an analyst can make meaningful interpretation of operating results with these ratios but financial positions of the business cannot be appraised. However the interpretation of trend analysis involves a cautious study. The mere increase or decrease in trend percentage or ratios may give misleading results if studied isolation. For example, in the previous example for drawing correct conclusion in respect of trend of inventory, it can be compared with the sales trend. Similarly, trend of change in current asset should be studied with the trend of change in current liabilities and conclusions should be drawn on the basis of changes in the both. Example: 6 Particulars 2009 2008 2007 2006 Sales 1,300 1,200 950 1,000 Less Cost of goods sold 728 696 589 600 Gross profit 572 504 361 400 Less selling expenses 120 110 97 100 19
Net operating profit Solution: Particulars Sales Cost of goods sold Gross profit Selling expenses Net operating expenses 452 394 264 300
Trend ratio ( 2006 =100) 2006 2007 2008 2009 100 95 120 130 100 98 116 121 100 90 126 143 100 97 110 120 100 88 131 151 Graphic and diagrammatic representation: Business enterprise use graphs and diagrams in annual financial statements to depict the trends. Absolute figures as well as trend ratios both can be shown on these graphs. Such presentation relives the reader from the complexity of figures and makes possible to appraise the progress of the concern at a glance.
Importance of Trend Analysis:
It is a simple technique. It does not involve tedious calculations, and does not require trained persons. A less qualified person can also analyze and draw conclusion by this technique. It is a technique of presenting the problem in brief. It reduces the chances of errors as it provides the opportunity to compare the results of percentage changes with absolute figures and thus conclusions can be rectified. Limitations of Trend Analysis. The trend ratio of any single item has limited importance in itself. Hence, the analyst should draw conclusion by comparing the trend of one item with the trend of other related items. The conclusion drawn only on the basis of trend ratios ignoring the original ( or absolute) figures may be inconsistent ,illogical and misleading. Therefore, likewise comparative statements, it is necessary to study the original data along with trend percentage ratios. Lack of uniformity and continuity in following accounting principles and policies may make the data incomparable and trend analysis may lose its importance in such cases. Similarly, the changes in price level also make comparability of data doubtful and out of tune. The base year should be careful selected. The base year should be a normal year otherwise trend ratios or percentages may give misleading results. Trend ratios should not be assigned undue importance. If the value of the item in the base year is very small, even an insignificant change may highlight to a significant change in the form of trend percentage. Managerial effectiveness cannot be measured by trend analysis.
Assignments: Analysis and interpretation of financial statements

Set-A : True or False
1. The term financial statements refer to the preparation of profit and loss account and balance sheet. 2. The balance sheet and statement of financial position are not synonyms. 3. When all the figures in the balance sheet are expressed as percentage of the total, it is called horizontal analysis. 20
4. When ratios of current year are compared with previous years they are called trend ratios. 5. Analysis leads to interpretation. 6. Analysis includes interpretation. 7. When financial statements of several years are analyzed, it is called vertical analysis. 8. Vertical analysis is also known as dynamic analysis. 9. Interpretation requires analysis and comparison. 10. Static analysis is not very useful for long-term financial planning. 11. Common-size income statements present the various items as a percentage of gross profit. 12. Common-size balance sheets show relative values of various items.
Cash Flow Analysis

A cash flow statement is a statement depicting change in cash position from one period to another period. Here, the term cash stands for cash and cash equivalents, while flow means movement of cash. Thus cash flow statement may be defined as a summary of receipts and disbursements (or payments),reconciling the opening cash and bank balance with closing balance concerned period related to various items appearing in the Balance Sheet and Profit/ Loss Account. In brief, we can say that a cash flow statement explains reasons for changes in cash position of a concern. Transactions which increase the cash position of the concern are known as inflow of cash and those decreases the cash position are known as out flow of cash.
Funds Flow Vs Cash Flow

Basis Concept Funds Flow It is based on concept of working capital. It is concerned with total provision of funds. Need for A statement of change in statement of working capital is prepared change in along with funds flow. working capital Shows the causes of changes in View point Cash Flow It is based on concept of cash. It is concerned with cash only Only one statement is prepared that is cash flow statement.
It shows the causes for change in 21
net working capital. It is a broader outlook The opening and closing balances are shown in working capital management. It is based on accrual basis of accounting Here current assets and current liabilities are shown separately in a statement known as statement of changes in working capital. Operating net profit is shown separately as source of funds. It is useful for assessing long term financial strategy. From liquidity point of view it not more acceptable cash. It is a narrower outlook. Opening and closing cash balances are shown The data obtained on accrual basis converted in to cash basis. Here increase and decrease of all current accounts are adjusted in the calculation of cash flow operating activities. Here it is included in cash flow from operating activities. It is of short term financial strategy. It is more acceptable from liquidity point of view.
Cash balance
Basis of accounting Adjustment of current assets and current liabilities Operating profit Period Usefulness
Cash Flow Vs Cash Budget

Cash flow is prepared on the basis of historical data. According to IAS-7(Revised) and AS-3 (Revised) a cash flow statement shows cash and cash equivalent. It makes good or bad management of cash obvious. It is based on projected data for future. It shows the movement of cash only.
It is used to project cash needs, to identify cash surpluses and to highlight possible critical points in the income and outgo of cash. It is a technique of historical financial It is an indispensable technique of financial analysis forecasting. It is prepared on the basis of actual figures It is prepared on the basis of estimated figures It is useful for mangers, share holders, It is useful for internal management. debenture holders, creditors and the bankers.
Significance or uses of Cash Flow Analysis
Cash flow analysis is an important technique of short-term financial analysis. It provides to the users of financial statements a basis of assess the ability of the enterprise to generate cash and cash equivalents and the timing and certainty of their generation. It 22
enables users to develop models to assess and compare the present value of the future cash flows of different enterprises. It is also control device of management. A comparison of cash flow statement with the budgeted forecast of cash for the same period helps in comparison and control of cash expenditure. It helps management in determining the extent to which financial resources of the enterprise have been raised and used as per plan. If cash flow statement is prepared on the basis of estimates of next accounting periods, it proves to be a useful tool of planning and coordinating the financial operation of the firm. It determines the firms ability to meet financial commitments and pay dividends. It explains the causes of difference between the net income and net cash flows from operating activities. It highlights the factors contributing to the reduction of cash balance in spite of increase in profits and also increase in cash balances in spite of decrease in cash balances. It is helpful in short term financial decision relating to liquidity and wages and means position of the firm. By analyzing net cash flow from operating activities, an investor can make estimation regarding dividend from his company and a creditor can assess the debt repayment capacity of the company and there by estimates the risk in return of his loan. Historical cash flow information is often used as an indicator of the amount, timing and certainty of future cash flows. It is also useful for checking the accuracy of past assessment of future cash flows and in examining the relationship between profitability and net cash flow and the impact of changing prices. It enables the users to analyze the pattern of resources deployment in /out of assets and evaluating the changes in net assets of the enterprise. It helps the management in understanding past behavior of cash cycle and in controlling the use of cash in future.
Preparation of cash flow statement

The cash flow statement should report cash flows during the period under analysis classified in to following three categories. Cash flow from operating activities: Operating activities are the principal revenue-producing activities of a business enterprise. They generally result from transactions and other events that enter into the determination of net profit or loss. Examples of cash flow from operating activities are: Cash receipts from sale of goods and rendering of services. Cash receipts from royalties, fees, commissions and other revenues. Cash payments to suppliers for goods and services. Cash payment to and on behalf of employees. Cash receipts and cash payments of an insurance enterprise for premiums and claims, annuities and other policy benefits. Cash payments or refunds of income taxes unless they can specifically identified with financing and investing activities. Cash receipts and payments relating to future contracts, forward contracts, option contracts, and swap contracts when the contracts are held for dealing or trading purposes. Cash flow from investing activities: 23
Investing activities are the acquisitions and disposals of long-term productive assets and other investments not included in cash equivalents. They represent the extent to which expenditures have been made for resources intended to generate future income and cash flows. Examples of investing activities are as follows: Cash payments to acquire fixed assets including intangibles. These payments include those relating to capitalized research and development costs and self-constructed fixed assets. Cash receipts from disposal of fixed assets including intangibles. Cash payments to acquire shares, warrants, or debt instruments or other enterprises and interests in joint ventures. Cash receipts from disposal of shares, warrants or dents instruments of other enterprises and interests in joint venture. Cash advances and loans made to the third parties other than advances and loans made by a financial enterprise. Cash receipts from repayment of advances and loans made to third parties other than advances and loans of a financial enterprise. Cash payments of future contracts, forward contracts, option contracts and swap contracts except when the contracts are held for dealing or trading purposes, or the payments are classified as financing activities.
Cash flow from Financing Activities:

Financing activities are activities that result in changes in the size and comparison of the owners capital, including preference share capital, including preference share capital and borrowings of the enterprise. Separate disclosure of such cash flows is useful in predicting claims on future cash flows by providers of funds to the enterprise. Examples of such cash flows are as follows: Cash proceeds from issuing shares or other similar instruments. Cash proceeds from issuing debentures, loans, notes, bonds and other short or long term borrowings. Cash repayments of amounts borrowed i.e, redemption of preference shares, debentures, bonds and repayment of loans. Payments of dividends.
Impact of on cash position of a concern by the change in balance sheet items are given below:
Change in balance sheet items Increase in current assets other than cash Decrease in current assets other than cash Increase in non-current assets Decrease in non-current assets Increase in current liability Decrease in current liability Increase in long-term liability Decrease in long-term liability Impact on cash Out flow of cash Inflow of cash Outflow of cash Inflow of cash Inflow of cash Outflow of cash Inflow of cash Outflow of cash 24
Sources and application of cash
Sources of cash Issue of share capital Issue of long-term debt such as debentures Sale of assets Cash from operation Decrease in current assets Increase in current liability Application of cash Redemption of capital Purchase of fixed assets Repayment of long term debt Cash lost in operation Increase in current assets Decrease in current liability
Non cash transactions:

The non-cash transactions shall also be adjusted to net profit to prepare the cash flow statement. Some of the examples are Depreciation on fixed assets Profit/Loss on the sale of fixed assets Profit /Loss on revaluation of fixed assets Writing off intangible assets like patents, goodwill and trade mark Writing of miscellaneous expenses like preliminary expenses, discount on issue of share or debentures
Calculation of cash from operation

Particulars Net profit (as given in P/L Account) ADD Decrease in current assets Debtors Bills receivable Prepaid expenses Accrued income Increase in current liability Creditor Bills payable Outstanding expenses Income received in advance Non-fund items debited to P/L Account Depreciation Goodwill written off Loss on sale of assets Preliminary expenses written off Details Amount
25
LESS Increase in current assets Debtor Bills receivable Prepaid expenses Accrued income Decrease in current liability Creditors Bills payable Outstanding expenses Income received in advance Non-fund items credited to P/L account Profit on sale of assets Cash from operation Note: The current assets and current liability will not include cash balance and bank overdraft respectively in the determination of cash from operation
Format of cash flow statement as per AS-3 (Revised)

Particulars Details Amount
26
(A)cash flow from operating activities Step-I (discussed) Net cash from operating activities (B) Cash flow from investing activities Sale of fixed assets Sale of investment Purchase of fixed asset (-) Purchase of investment (-) Interest received Dividend received Loans to subsidiaries (-) Net cash from investing activities ( C ) Cash flow from financing activities Issue of shares and debentures Proceeds from long-term borrowings Repayment of long-term borrowings (-) Redemption of preference shares and debentures (-) Dividend paid (-) Interest paid (-) Net cash from financing activities Net increase (decrease) in cash and cash equivalent (A+B+C) ADD Cash and cash equivalent in the beginning Cash at the end ----
XXXX XXXXX XXXXX
27
Ratio Analysis
Meaning: - In general words, a ratio is an expression of relationship of one figure with another.
It may be defined as the relationship, or proportion that one amount bears to another. It is found by dividing a figure with another. A ratio may be expressed in percentage in which the base, is taken as equal to 100 and the quotient is expressed as per hundred of the base. Financial ratios expressed arithmetical relationship between two figures or two groups of figures which are related to each other. Accounting ratios express relationships worked out among various accounting data which are mutually interdependent and which influence each other in significant manner.
Expression of ratios:
(a) Pure ratio or simple ratio : In this form, the item of financial statements is expressed by simple division of one number by another e.g, if current assets of a company are Rs20,000 and current liabilities are Rs10,000, the ratio of current assets to current liabilities is shown as : Current ratio = Current assets / Current liabilities = 20,000 / 10,000 =2 :1 (b) Rate or so many times: In this form, it is calculated how many times a item is, in comparison to other item. For example, cost of goods sold of a company is Rs10, 000 and inventory is Rs2, 000 then stock turnover is 5 times in relation to cost of goods sold. (c) Percentage: Percentage is one kind of ratio in which the base is taken as equal to hundred (100) and the quotient is expressed as per hundred of the base. For example, if a institution earns a gross profit of Rs10, 000 and sales is Rs50, 000, the ratio of gross profit to sales, in terms of percentage is 10,000 / 50,000 X100=20%.
Importance or utility of ratio analysis:

1. Helpful to management The ratio analysis proves to be significant value to the management in the process of the discharge of its elementary functions such as planning, co-ordination, communication and control. In short, it paves the way for effective control of the enterprise in the matter of achieving the physical and monetary targets. The ratio analysis facilitates a firm to consider the time dimension in to account,i.e, whether the financial position of a firm is showing any improvement or deterioration over years. This is affected through the use of trend analysis. With the help of the financial analysis on can ascertain whether the trend is favourable or unfavourable. Ratio analysis, also helps in comparative 28
2.Helpful in trend analysis
3.Use in comparative study
study . It helps to make an inter-firm comparison either between the different departments of a firm or between two firms employed in the identical types of business or between the same firms on two different dates. Through ratio analysis, it is possible to know the changes that had taken place in the business between two periods. In this way the weakness of business concern can easily be found out. In brief, ratios are helpful in communication of information. Keeping in mind the old ratios and present operating efficiency, the standard can be fixed. In this way ratio analysis is considered to be essential part of budgetary control and standard costing. On the basis of ratios, by establishing standards the effective control can be exercised upon the activities of the firm. On the comparison of standard ratios with actual ratios adverse financial position can be found out and corrective measures can be taken. With the help of ratio analysis comparison of current year figures can be made with those of previous yearsSimilarly, comparision of profitability, effectiveness and financial soundness can be made between business concerns. In this way, the use of ratio analysis can be made for measuring the effectiveness of business concern. With the help of liquidity, solvency, profitability and capital gearing ratios, detailed information can be gathered related to financial soundness of any organization. Through ratio analysis the internal and external parties interested in the firm also get benefited. The workers of the firm may use the information presented in the financial statements as basis for requesting increase in wages and salaries. By studying profitability ratios, investors can take 29
4. Helpful for communication
5.Helpful in determining the standards
6.Helpful in effective control
7. Helpful in the evaluation of efficiency
8.Helpful in evaluation of financial standards
9.Helpful for interested parties in the firm
decision for investment or not.
Limitations of ratio analysis:

1. Limited use of single ratio A single ratio in itself is meaningless; it does not furnish a complete picture. In other words, one single ratio used without reference to other ratios may produce misleading results. Hence, a number of related ratios are to be calculated for proper analysis and interpretation of financial statements. For example, to test the liquidity makes use of all the liquidity ratios. The ratio facilitates wholly quantitative analysis only. The qualitative factors which are so important for the successful functioning of the organization are completely ignored and hence, whatever conclusions drawn may distorted It should also be remembered that ratio analysis helps in providing only a part of the information needed in the process of decision making. Any information drawn from the ratios must be used with that obtained from other sources so as to ensure a balanced approach in solving the ticklish issues. Ratio depends on figures of the financial statements. But in most cases, the figures are window dressed. As a result, the correct picture cannot be drawn up by the ratio analysis. Comparisons are also made difficult due to differences in definitions of various terms used in computing ratios. For example, terms like shareholders funds, capital employed, working capital etc.are used in different sense by different people. Hence, unless the meanings of relevant terms are properly defined, the use of ratios may lead to wrong comparisons and conclusions. Comparison between two variables proves worth provided their basis of valuation is 30
2. Ignores qualitative factors
3. Only a part of the information needed in the process of decision making
4.Possibility of window dressing
5.Different meaning to accounting terms
6.Variations in accounting policies
identical. But in reality, it is not possible, such as methods of valuation of stock in trade or charging different methods of depreciation on fixed assets etc. That is different method is followed by different firms for their valuation, in that case, comparision will practically be of no use. It is very difficult to ascertain the normal or standard ratio in order to make a proper comparison. Ratio developed in the past as they are obtained from the financial statements which are considered to be historical documents. A financial analyst is more concerned with the probable happenings in the future rather than those in the past. These ratios cannot be completely relied upon as reflecting current conditions. A change in price level can seriously affect the validity of comparison of ratios computed for different time periods. Ratios are only means of financial analysis and not an end itself. They can be affected with the personal ability and bias of the analyst. Generally, different analyst may interpret the same ratio in different ways.
7. Difficulty in evolving standard ratios
8.Historical analysis
9. Effect of price level changes are not taken into account 10.Personal bias
Steps of Ratio Analysis:
Arranging of data: This implies the representation of various items of financial statements after appropriate reshuffling in the form suitable for analysis and interpretation. No definite procedure may be laid down for arranging data; each case may involve different procedure depending upon the data required for calculating the required ratios. Calculation of appropriate ratios from the above data. Comparison of the calculated ratios with predetermined standards or norms set for the purpose. This comparison may be with the ratios of the same firm in the past or the ratios developed from the projected financial statements or the ratios of the competitive firms in the industry or the ratios of the industry to which the firm belongs. Interpretation of ratios. Ratios are not in themselves an end. They are a means of financial analysis. To make them useful they have to be interpreted. Interpretation of ratios needs skill, intelligence and foresightedness. The inherent limitations of ratio analysis should also
Interpretation of ratios
31
be kept in mind while interpreting ratios. The interpretation of ratios can be made in the following ways: Interpretation on the basis of single ratios: Broadly no meaningful conclusion can be drawn by one single ratio. However, there are few ratios which can be considered in isolation. For example, 2:1 is a well proven convention for current ratio. Hence, continuous fall in this ratio is considered as a sign of weak liquidity position of the concern. Such ratios are very few where rules of thumb may be applied and which alone are capable of some meaningful interpretation. Interpretation on the basis of group of related ratios : There are large number of ratios which are well interpreted when supported by certain other related ratios. For example, current ratios may be supported by liquidity ratios to draw more dependable conclusions. Similarly, ratios of profit of sales can be well interpreted when it is considered in reference to net worth turnover ratio. Interpretation on the basis of historical trends: In this method, a firms performance is compared with its own past over a period of time and trend is noted on the basis of figures of the same ratio of past few years. This is a most popular method of appraising the performance of the firm. When financial ratios are compared over a period of time it gives an indication of the direction of change. But while interpreting ratios from comparison over time, the analyst must pay attention to the changes in the firms policies and accounting procedures and also price level changes. Sometimes, current performance is evaluated by comparing the ratios with its past average. Interpretation on the basis of projected ratios ( or future expectations): Ratios for the future can be projected and these may be taken as standard for comparison with ratios calculated on the basis of actual performance. This method is not usually in practice. Interpretation on the basis of inter-firm comparison: Ratios of one firm can also be compared with the ratios of other firms in the same industry or with the average of all firms in the industry. But while making such comparison, the analyst has to be very careful regarding the difference of accounting methods, policies and procedures adopted by different firms. Interpretation on the basis of similar firms: If we compare the firm with similar firms in other industries, we often gain a better insight into the financial condition. For example, if we are examining a growth of firm in a non-growth industry, it makes sense to compare it with other growth firms in other industries. Interpretation on the basis of common sense: The analyst may also use his subjective judgment and reasons for the purpose. For example, a 20% return on investment may be considered reasonable as a norm. Classification of Ratios: Financial ratios are classified in various groups. Their actual classification depends upon the objects of analysis, nature of party interested in analysis and the source and quantity of data available. The following four forms of ratio classification are more common in actual use: Statement wise Balance sheet ratios Profit and loss account ratios classification Composite or mixed ratios Ratios for management Classification by users 32
Ratios for share holders Ratio for creditors Classification according to Primary ratios Secondary ratios importance Liquidity / solvency ratios Functional classification Leverage/ capital structure ratios Profitability ratios Activity ratios Statement wise classification: It is most traditional classification of financial ratios. This classification is based on accounting statement providing information necessary for the calculation of various ratios. There are three types of ratios on the basis of statements. Balance sheet ratios: When both Current ratio figures for ratio computation are Liquidity ratio extracted from the balance sheet of the Proprietary ratio business, the ratio is called balance Fixed asset ratio sheet ratio. Such ratios often called as Capital gearing ratio financial ratio also. Book value per share Profit and loss account ratio: When both figures for ratio computation are extracted from the profit and loss account, the ratio is called profit and loss ratio. Composite or mixed ratios: In such ratios, one items or a group of items is taken from balance sheet and the other from profit and loss account. Classification of ratios by users: Ratios for management Operating ratio Expenses ratio Net profit ratio Gross profit ratio Stock turnover ratio Return on capital employed Return on share holders fund Current assets turnover ratio Ratio of net sales to fixed assets Operating ratio Return on capital employed Stock turnover ratio Debtors turnover ratio Solvency ratio Current ratio Solvency ratio Creditors turnover ratio Fixed asset ratio Assets cover ratio Debt service ratio Return on share holders fund Capital gearing ratio Dividend cover ratio Yield rate Proprietary ratio 33
Ratios for creditors
Ratios for share holders
Dividend rate Assets cover of shares Classification by relative importance: This classification is being adopted by the British Institute of Management for inter-firm comparisons. In this classification, all the ratios are classified in to two groups: Primary ratio: This is one which is of prime importance to a concern e.g, return on capital employed, assets turnover etc. Secondary ratio: The ratios which support or explain the primary ratio is called secondary ratio. Functional classification: Current ratio Short Term solvency ratios Liquidity ratio Absolute liquid ratio Cash ratio Debt equity ratio Long Term solvency ratios Proprietary ratio Solvency ratio or debt to total assets ratio Fixed assets ratio Capital gearing ratio Debt-service ratio or interest coverage ratio Ratio based on sales: Profitability ratios or profit earning Gross profit ratio capacity ratios Operating ratio Expenses ratio Operating profit ratio Net profit ratio Ratio based on capital: Return on share holders fund Return on capital employed Return on equity capital Activity ratio : Total assets turnover ratio Fixed assets turnover ratio Working capital turnover ratio Inventory turnover ratio Debtors turnover ratio Creditors turnover ratio
Solvency Analysis or Financial Position Analysis

Solvency is the ability of the firm to meet it liabilities at the due date. Solvency has two dimensions- short-term solvency and long-term solvency.
Short term solvency or liquidity analysis:

The importance of adequate liquidity in the sense of the ability of a firm to meet its current /short-term obligations when they become due for payment can hardly be over-stressed. It reflects the short-term financial strength of the firm. Liquidity is basic to continuous 34
operations of the firm. In fact, it is pre-requisite for the very survival of a firm. The object of liquidity analysis is to examine the firms ability to meet its current obligations out of shortterm resources. The short term creditors of the firm (suppliers of goods on credit and commercial banks providing short-term loans) are primarily interested in the short term solvency or good liquidity, i.e adequate ready funds. This analysis provides an invaluable help in examining the efficiency and effectiveness of the management in utilizing working capital of the business. Besides, this analysis enables the shareholders and long-term creditors of the company in assessing the companys capacity to pay dividend and interest on time. However a very high degree of liquidity is not desirable because it implies that funds are idle of they earn very little. It is not good from profitability point of view. Hence, a proper balance between the two contradictory requirements i.e liquidity and profitability is required for efficient financial management. It becomes therefore necessary to determine the degree of liquidity of the firm. Two types of ratios can be calculated for assessing the short-term solvency of a firm: Liquidity ratios Current assets movement ratios Liquidity ratios: The ratios which indicate the liquidity of a firm are known as liquidity ratio. The following are ratios calculated to measure the liquidity of a firm. Current ratio Quick or acid test ratio or liquidity ratio Cash position ratio or absolute liquid ratio Basic Defensive Interval Cash ratio Current ratio: Current ratio is the most common and widely used ratio for measuring liquidity. Being related to working capital analysis, it is also called the working capital ratio. This ratio indicates the relationship between total current asset and total current liabilities of a firm. This is calculated by dividing current assets by current liabilities. Current ratio = Current assets/ Current liability Current assets Current liabilities (payable within one year) Cash in hand, cash at bank, debtors, Bills payable, income tax payable, prepaid expenses, short term deposits, bills creditors. Outstanding expenses, bank receivable, money at call and short notice, overdraft, provision for taxation, interest stock ,finished goods, work in progress due on fixed liabilities, reserve for unbilled stock of raw materials and sundry supplies expenses, installment payable on long-term loans. Current ratio is a good measure of liquidity. It indicates the rupees of current assets available for each rupee of current liability. Higher the current ratio, the larger the amount of rupees available per rupee of current liability, the more the firms ability to meet current obligations and greater the safety of funds of short-term creditors. But too high current ratio may be good from the creditors point of view, but it can never be good from the view of the owners. Too high current ratio shows weak, investment policy, excessive stock etc. Such a situation cannot be good for the profitability of the business. On the other hand, low current ratio shows shortage of working capital in the business and it may endanger the survival of the firm. Hence, the current ratio in business should be appropriate. A ratio of 2:1 (two times 35
current assets to current liabilities) is considered satisfactory as a rule of thumb. In interfirm comparison, the firm with the higher current ratio has better liquidity or short term solvency. It is important to note that the norm of 2:1 should not be followed blindly. We should pay attention to the quality and nature of current assets. If major portion of current assets consists of debtors, prepaid expenses and slow moving obsolete stock, then even twice the current assets may prove insufficient to pay the short-term liabilities when due for payment. On the other hand, if the firm is capable of making immediate arrangement of cash easily in case of emergency, then a lower than 2:1 ratio may be treated satisfactory. Hence, it would be necessary to consider the following factors while deciding standard of current ratio: Nature of business: If the business of speculative nature than a higher current ratio is necessary. Similarly, if the business is of seasonal nature then it would be appropriate to change current ratio according to fluctuations in output and sales. Plans to introduce by the firm in the near future and amount required for them. Credit period allowed and received. Nature of stock, if the major portion of inventory is of raw materials or it consists of slow moving and obsolete stock, then a higher current ratio would be essential. On the other hand, if inventory consists of fast moving finished goods, then possibility of their conversion in to cash would be higher and so even a lower current ratio may be good. In case of heavy fixed charges of long-term loans, a higher current ratio would be appropriate and essential. Limitations of current ratio: It is a crude measure of financial liquidity as it does not take in to account the liquidity of the individual components of current assets. Cash and bills receivable are more liquid in comparison to inventories, prepaid expenses and sundry debtors. But in computing this ratio they all are treated at par. The greatest weakness of current ratio is the possibility of window dressing and manipulation. The current ratio can be improved by making payment of current liability at the yearend or by over valuing current assets and under valuing current liabilities. The current ratio is largely affected by the seasonal fluctuations. Conclusions drawn from on single current ratio may be misleading because in spite of high current ratio, the firm may unable to pay its current liabilities. If major portion of current asset consists of raw materials, slow moving or obsolete finished goods or unrecoverable debtors. Hence, it is not proper to rely upon this ratio only for analyzing liquidity and solvency of the firm. Quick or Acid Test Ratio or Liquidity Ratio: This ratio is used as a compliment of current ratio. This ratio is calculated for assessing the capacity of the firm to make immediate payment of its liabilities. This ratio discloses the relationship between liquid assets and current liabilities. Liquid ratio = Liquid assets / Current liabilities Or Liquid ratio = Liquid assets / Liquid liability Liquid assets = Current assets Stock prepaid expenses 36
Liquid liability = Current liability Bank over draft Standard norm: 1 : 1 Absolute liquid ratio: It is more rigorous test of liquidity of a firm. It is calculated by dividing cash and marketable securities (termed as super-quick current assets) by quick or liquid liabilities. It is calculated Absolute liquid ratio = Absolute liquid assets / liquid liabilities Absolute liquid assets = Cash in hand, cash at bank and short term marketable securities. Standard norm: .5 :1 Basic Defensive Interval or BDI: This ratio indicates the ability of the firm to carry on its operations from own liquid assets, if there are no sale proceeds. It is calculated as follows: BDI = Total Defensive Assets / Projected daily operating expenditures Here, defensive assets are liquid assets ( cash and cash equivalents) of the firm and projected daily operative expenditure is obtained by dividing the total estimated operating expenditure of the firm for whole year by 365 days. Some authors prefer to calculate net cash interval in place of basic defensive interval. This is calculated as follows: Net cash interval = Working Capital / Projected cash operating cost X365 Net cash interval indicates the days for which the present resources of the firm will be sufficient to carry on its business operations. However, this ratio is not very common. Cash ratio: This measures the firms ability to make immediate payment of its liabilities. Cash ratio = Cash in hand and at bank / Current assets This ratio is rarely used in practice. Example -1 From the following information regarding current assets and current liabilities of KIIT Ltd, comment upon the liquidity of the concern: Current liabilities Amount Current assets Amount Creditors 27,000 Cash 42,000 Bills payable 12,000 Debtors 20,000 Outstanding expenses 5,000 Bills receivable 15,000 Provision for tax 18,000 Stock 35,000 Bank overdraft 10,000 Investment in government 24,000 securities Prepaid expenses 10,000 Interest receivable 1,000 72,000 1,47,000 Solution: Current ratio = Current assets / Current liabilities = 1,47,000 / 72,000 = 2.04 :1 Quick ratio = Liquid assets / Current liabilities = 1,02,000 / 72,000 = 1.4:1 Or Quick ratio = Liquid assets / Liquid liabilities = 1,02,000 / 62,000 = 1.6:1 Note : Liquid assets = Current assets stock and prepaid expenses Liquid liability = Current liability Bank overdraft Absolute liquid ratio = absolute liquid assets / Liquid liability 37
67,000/ 62,000 = 1.08 :1 Comment: All the three ratios show good liquidity position. Current assets movement ratios: In order to examine truly the liquidity of a firm, it is essential to measure the effectiveness and efficiency with which the firm is managing its current assets, specially debtors and stock. The object is to assess the rate of conversion of these assets in to cash. Hence, the following ratios may also be used for measuring the liquidity of a firm:
Stock turnover ratio or inventory turnover ratio:

This ratio is calculated to consider the justification of amount of capital employed in stock. Under it , rate of conversion of stock in to sales ( i.e stock velocity) is known by establishing relationship between cost of goods sold and inventory. This ratio indicates the amount of sales per rupee of investment in inventory. This is calculated by dividing cost of goods sold of a period by the average stock of that period. Stock Turnover Ratio = Cost of goods sold / Average inventory ( at cost) The cost of goods sold means sales minus gross profit. It may also be calculated by deducting closing stock from the sun of opening stock and purchases during the period. Average inventory is simple arithmetic average of opening stock and closing stock of inventory. Inventory, here will mean inventory of finished goods only. Because it only is capable of being sold, then this ratio may be calculated on the basis of net sales but in such situation average inventory will be taken at sale price. In departmental stores, where inventory is usually valued at sale price, this ratio is calculated on this basis ( i.e Net sales / average inventory at selling price). If average stock cannot be known then this ratio may be calculated with the figure of closing inventory ( i.e net sales / closing stock) In case of manufacturing concern inventory may be known separately for raw material and finished goods both applying the following formulae: Raw material turnover ratio = Raw material consumed / average inventory of raw material Finished goods turnover = Cost of goods sold / average inventory of finished goods This ratio is an indicator of velocity of flow of inventory in business. This shows the rate of conversion of stock in to sales. In fact, inventory policy of management and liquidity of firm both may be tested by this ratio. This is also a measure of marketing capacity of the firm. No any standard rate or norm can be determined for this ratio because it based more on nature of industry and sales policy of the firm. Hence, this ratio should be compared with the firms own past ratios and ratios of other similar firms or with industry average. Comparatively higher inventory turnover ratio is an indicator or of expansion of business (efficiency in sales increases) and efficient management of inventory because it shows higher sales with lesser investments in inventory. Such firms may earn high profits even at low margin of profit. On the contrary, a fall in this ratio is an indicator of dull business and over- investment in inventories. A too high inventory turnover ratio may not necessarily always imply a favourable situation. It may be the result of very low level of inventory which results in shortage of goods or a position of stock-out whenever demand increases. It may also be the result of firms policy to buy frequently in small lots at some higher prices. Similarly, a low inventory turnover may not necessarily always imply an unfavorable situation. It may be result of management policy 38
of keeping high inventory when price rise is anticipated or stock shortage in near future is anticipated, or when some sizeable order is anticipated, for which immediate supply is required. Hence, for drawing correct conclusion, causes of changes in this ratio should be examined precisely. Note: Stock velocity can be measured in months also by applying the following formula: Stock velocity ( in months) = Average stock / Cost of goods sold X 12 months This ratio indicates the period during which supply of goods may be maintained out of current stock without its replenishment. Average age of inventory: Some people calculate average age of inventory also together with inventory turnover. This represents the number of days, on an average, an item remains in the firms inventory. It is calculated as follows: Average age of inventory = 365 / Inventory turnover The shorter the average age of firms inventory, the more liquid or active it may be considered. Example -2 Compute the merchandise turnover of a certain company for each of the following there years shown below and give your interpretation of the result. Particulars 2009 2008 2007 Cost of goods sold 5,16,378 4,53,740 6,41,425 Average inventory 2,36,420 3,01,231 5,39,850 Solution: Stock Turnover Ratio ( STR) = Cost of goods sold / Average inventory 2009 = 5,16,378 / 2,36,420 = 2.19 times 2008= 4,53,740 / 3,01,231 = 1.51 times 2007 = 6,48,425/ 5,39,850 = 1.20 times Interpretation: As it is clear from the above calculations stock turnover has shown in increasing trend during the years under review. It implies that the sales level per rupee invested in stock has been increasing continuously. An analysis of absolute amounts of stock shows that the company is following the policy of reducing investments in stock each year. All this an indication of companys efficient inventory control policy and sales capability. Debtors Turnover ratio or Receivable Turnover Ratio (DTR) This ratio is a qualitative analysis of a firms marketing and credit policy and debtors realizations. It is calculated to know the uncollected portion of credit sales in the form of debtors by establishing relationship between trade debtors and net credit sales of the business. The following formula is applied for this purpose: DTR= Average trade receivables / net credit sales X100 Whereas average trade receivables = Debtors + Bills receivable A decrease in this ratio each year is an indicator of efficiency of marketing and credit policy of the firm. Some people express this relationship in the form of turnover in place of percentage form, i.e., it is found how much times credit sales are to total debtors. The formula is as follows: Debtors Turnover/ Velocity = Net credit sales / Average trade receivables Important points 39
Average trade receivable implies a simple average of opening and closing trade receivables. Trade receivables is the sum of trade debtors and bills receivable but debtors and bills receivable arising from irregular or non-trading activities ( such as bills receivable received on sale of a fixed assets) are not included in this calculation. The amount of provision for bad debts and doubtful debts is not deducted from debtors in the calculation of trade receivables. Net credit sales consist of gross credit sales minus sales returns. If cash sales are negligible, then calculation may be made from net total sales figure in place of net credit sales. Average collection period: In analyzing the debtors, usually average collection period is also calculated with debtors turnover ratio. This period indicates the period taken in the realization or collection of debtors. In other words, it represents the average number of days for which a firm has to wait before its receivables are converted into cash. The purpose of calculating this period is to find out the ratio of cash flow from collection of debtors. The following formula is used for it calculation: Average collection period or average age of receivables= Trade receivables/ sales per day Or Trade receivables / net credit sales X 365 days Or 365/ DTR The average collection period is compared with actual trade terms ( i.e credit period allowed in sales terms) to examine the managerial efficiency in debt collection. In this respect, the general rule is that average collection period should not exceed the stated credit period on trade terms plus 1/3rd of such period. If average collection period exceeds 4/3 of stated credit period, it will indicate either liberal credit policy or slackness of management in realizing debts. A higher average collection period also implies that chances of bad debts are larger. The average collection period is affected by change in sales terms, change in policy in respect of including or excluding cash and installment sales in the sales, special sales campaign at the close of the accounting year, direct sales to consumers, price changes, effectiveness of credit collection and sales department, strikes and lock-outs and nature of trade cycle. Example -3 A manufacture sells to retailer on terms 2.5% discount in 30 days, 60 days net. The debtors and receivable at the end of March of past three years and net sales for all these three years as under: Particulars 2007 2008 2009 Debtors 54,842 33,932 85,582 Bills receivable 4,212 3,686 9,242 Net sales 2,68,466 3,37,392 4,43,126 Determine the average collection period for each of these three years and comment. Solution: 40
Average collection period= Trade receivables/ Net credit sales X 365 days 2007 = 59,054/ 2,68,466 X365 = 80 days 2008 = 37,618/ 3,37,392 X365 = 41 days 2009 = 94,824/ 4,43,126 X365 = 78 days Comments: As stated credit period is 60 days, hence collection period should not exceed 60 +1/3rd of 60= 80 days. It is a matter of satisfaction that all the three years, firms average collection period has never crossed this limit. It may be taken as an indication of alertness of sales manager towards credit collection. Example -4 KSOM Ltd sells goods on cash as well as on credit. The following particulars are taken from their books of accounts for the year ending 31st March 2009. Particulars Amount Total sales 10,00,000 Cash sales 2,00,000 Sales return 70,000 Total debtors (31/3/2009) 90,000 Bill receivable (31/3/2009) 20,000 Provision for bad debts (31/3/2009) 10,000 Calculate the average collection period. Solution: Average collection period = Trade receivables / Net credit sales X365 1,10,000/ 7,30,000 X365 = 55 days. Whereas trade receivables = 90,000 +20,000= Rs1,10,000 Net credit sales= 10,00,000 -2,00,000- 70,000= 7,30,000 Creditors Turnover Ratio: Like debtors turnover ratio, creditors turnover ratio may also be calculated. The short-term creditors ( i.e, suppliers of goods and bankers) are very much interested in this ratio, as it shows the firms trend of payment to its short-term creditors. This ratio shows the relationship of credit purchases and trade creditors. Creditors or payable turnover ratio or CTR: CTR = Net credit purchases / Average payables (creditor +BP) Net credit purchase = Total purchase cash purchase purchase return Average payable = opening payable + closing payable / 2 Note : if opening and closing is not given then closing will be considered as average. This ratio indicates the velocity with which the creditors are turned over in relation to purchases. Higher the creditors velocity, better it is. A fall in this ratio shows delay in payment to creditors. While analyzing creditors, usually average period is also calculated. This period discloses the time taken by the firm in making payment to its trade creditors. Average payment period: Average payable / net credit purchase X no. of month or weeks or days Or No. of month or week or days / CTR 41
Average disbursement period is compared with credit period allowed by suppliers of goods to know promptness or delay in payment. Example -5 A trader purchases goods both on cash and credit terms. The following particulars are obtained from the books: Particulars Amount Total purchases 2,00,000 Cash purchases 20,000 Purchase return 34,000 Creditors at the end 70,000 Bills payable at the end 40,000 Reserve for discount on creditors 5,000 Calculate average payment period. Solution:
Step I : Net Credit Purchases

Total purchases- cash purchase- purchase returns 2,00,000-20,000-34,000= Rs1,46,000
Step-II : Average Payment period

Creditors + Bills payable / Net credit purchase X365 70,000 +40,000 /1,46,000 X365 = 275 days Example -6 The following ratios are taken from KSRM Traders: Particulars Details Stock velocity 5 months Debtors velocity 2.5 months Creditors velocity 3 months Gross profit ratio 30% Gross profit for the current year ended 31st March2009 amounts to Rs9,00,000. Closing stock of the year is Rs30,000 more than the opening stock. Bills receivable amounts to Rs 50,000 and bills payable to Rs30,000. Find out Amount of sales, sundry debtors, closing stock and sundry creditors. Solution: Amount of sales: Gross profit ratio= gross profit/ sales X100 30= 9,00,000/sales X100 Sales = 9,00,000/30 X100 =Rs30,00,000 Sundry debtors: Debtors velocity = debtors +BR/ Net credit sales X12 months 2.5 =debtors+50,000/ 30,00,000 X12 Debtors = 2.5 X30,00,000 /12 50,000 Therefore debtors = 6,25,000- 50,000 =Rs5,75,000 Closing stock: Stock velocity = Average stock / Cost of goods sold X 12 months Cost of goods sold = Sales- gross profit 42
30,00,000 30% of 30,00,000 =Rs21,00,000 5= average stock / 21,00,000 X12 Therefore average stock = 5 X21,00,000 /12 = Rs8,75,000 Average stock = opening stock +closing stock /2 8,75,000= opening stock +30,000 +opening stock /2 2 Opening stock = 8,75,000 X2 -30,000 Therefore opening stock = 17,20,000/2 =Rs8,60,000 Closing stock = Rs8,60,000 +30,000 = Rs8,90,000 Sundry creditors: Creditors velocity = creditors +BP / Net credit purchases X 12 months Net credit purchases = cost of goods sold + closing stock opening stock 21,00,000 +8,90,000 -8,60,000 = Rs21,30,000 3 = creditors +30,000 / 21,30,000 X12 Creditors = 3 x21,30,000/ 12 -30,000 Therefore creditors = 5,32,500 -30,000= Rs5,02,500
Long term Solvency Analysis or Test of Solvency

The term solvency refers to the ability of the concern to meet its long-term commitments. Long-term solvency is examined with reference to the firms capacity to pay interest regularly and eventually repay on maturity the sum borrowed. Long-term creditors as well as present and prospective shareholders are interested in the analysis of long-term solvency of a company. The following ratios are calculated for examining long-term solvency of a concern. Debt- Equity Ratio or Debt- worth ratio: This ratio indicates the relationship between external equities and internal equities. This is also known as External-Internal Equity Ratio. It is calculated as follows: Debt equity ratio = Outsiders fund / shareholders fund Outsiders fund Debt, long-term or short term, whether in the form of mortgage, bills or debentures Shareholders fund Preference share capital, equity share capital, capital reserves, retained earnings and any other reserves representing the accumulated profit.
Alternative: Debt equity ratio = long-term debt / share holders fund or net worth Note: in this case current liabilities will be ignored. Standard norm: 2 : 1, however lending institutions prefer 1:1 A low ratio signifies a smaller claim of creditors. More precisely, the greater the debtequity ratio, greater the risk to the creditor This ratio is very important for examining the long-term solvency of a concern. This ratio indicates the extent of cushion available to the creditors on liquidation of the borrower concern. Lower the ratio, greater security for the creditors. A high debt equity ratio is a danger signal for the creditors because in case of fall in profits of the concern, it may not be able to bear the heavy burden of interest and also not able to repay its debts on time. But share holders stand to gain from the high debt equity ratio because
43
They can retain the control of the company with less contribution and thus bearing lesser risks. In case of increase in the profitability of the company, their earning per share will increase very fast. This is called trading on equity. Low debt equity ratio provides sufficient safety margin to creditors but it indicates companys failure to use low-cost outsiders fund to magnify shareholders earnings. Proprietary Ratio: This ratio is also known as Equity Ratio or Shareholders Equity to Total Equity Ratio or N Standard norm: 2 : 1, however lending institutions prefer 1:1 A low ratio signifies a smaller claim of creditors. More precisely, the greater the debtequity ratio, greater the risk to the creditor et Worth to Total Assets Ratio. It indicates the relationship of owners funds (share holders equity) to total assets or total equities. Proprietary ratio = Share holders fund / Total assets or Total equities This ratio can be represented in percentage also which will indicate the percentage of owners funds to the total assets. The purpose of this ratio is to know the proportion of total assets financed by the owners. There are no generally accepted norms for this ratio. Higher the ratio lesser the dependence for working capital on outside sources, better the long-term solvency and stability and greater the protection to the creditors of the firm. In case of stability in earnings of the firm, comparability a lower ratio can also be accepted. Solvency Ratio or debt to total asset ratio: It is also known as Debt Ratio. It is a difference of 100 and proprietary ratio. This ratio indicates the relationship of total liabilities of the firm to its total assets. This is why it is also known as the ratio of total liabilities to total assets. It measures the proportion of total assets financed by outside creditors. It is calculated as follows: Solvency Ratio = Total Liabilities / Total Assets The higher this ratio, the greater is the dependence of the firm on outsiders for its financing.
Fixed Assets to Net worth Ratio or Ratio of Fixed Assets to Proprietors Fund
An important aspect of financial soundness is that all fixed assets of the business are financed out of shareholders funds. If fixed assets are more than owners funds then it implies that fixed assets have been financed with outside sources ( i.e borrowed money) also. In such a case, if the creditors demand for repayment of their loans, the firm may have to face serious financial problems because amount invested in fixed assets cannot be taken back. Hence, if owners funds exceed the fixed assets, it is treated as a good proof of firms long-term solvency. This ratio is calculated by dividing the value of fixed assets after depreciation by proprietors funds. Fixed asset to net worth ratio = Fixed assets (after depreciation) /Total long term funds This ratio should not exceed 1:1. On the contrary, lesser the ratio, better the position because in such a case proprietors funds will be available for working capital needs also. Usually, a ratio of 0.67:1 ( i.e fixed assets are about two-third of the proprietors funds) is considered satisfactory.
Fixed Assets to Total Long-term Fund ratio or Fixed Assets Ratio

44
This is an improvement over fixed assets to net worth ratio. The modern view of financial experts is that fixed assets could be financed by long-term loans also together with proprietors funds. Hence for long-term solvency analysis the relationship of fixed assets should be established with total long term funds (proprietors funds plus long-term loans). Fixed assets ratio is calculated for this purpose. It is calculated as follows: Fixed assets ratio= Fixed assets (after depreciation) / Total long-term funds This ratio should not exceed 1:1. If it exceeds 1:1. It implies that short-term funds of the firm have also been applied for acquiring fixed assets which in no way be considered appropriate. The general rule is that fixed assets should not exceed 2/3rd of total long-term funds so that rest of the long-term funds could be utilized for meeting working capital requirement.
Ratio of current assets to proprietors fund

This is calculated by dividing the total current assets by proprietors funds. Current assets/ Proprietors funds This ratio indicates the extents to which proprietors fund are invested in current assets. This ratio indicates financial capability of the firm. There is no rule of thumb for this ratio.
Ratio of current assets to total liabilities

This is calculated as follows Current assets / Total liabilities This ratio is a measure of financial stability of the firm.
Proprietors liabilities ratio

This ratio indicates the relationship between two main sources of financing proprietors fund and outsides loans ( or liabilities). It is calculated as follows: Proprietors funds / Total liabilities Higher the ratio better is the security of creditors.
Ratio of tangible assets to total debts

This ratio indicates the relationship of tangible assets to total debts. Tangible assets / Total debt This ratio measures the ability of the firm to pay its debts, as it shows the extent to which total liabilities of the firm can be repaid by its tangible assets. Higher the ratio, greater is the security of the creditors. Example -7 Extracts from financial accounts of KISS Ltd are given below: Particulars Assets for Assets for Liabilities Liabilities 2008 2009 for 2008 for 2009 Stock 10,000 20,000 Debtors 30,000 30,000 Payments in advance 2,000 Nil Cash in hand 20,000 15,000 Creditors 25,000 30,000 Acceptances 15,000 12,000 Bank overdraft Nil 5,000 62,000 65,000 40,000 47,000
45
Sales amounted to Rs3,50,000 in the first year and Rs3,00,000 in the second year. You are required to comment on the solvency position of the concern with the help of accounting ratios.
Solution:
Short term solvency analysis

Current ratios = Current assets / current liabilities For 2008= 10,000 +30,000 + 2,000 +20,000 / 25,000 +15,000 =1.55:1 For 2009 = 20,000 +30,000 +15,000 / 30,000 +12,000 +5,000 = 1.38:1 Liquid or quick ratio = Liquid assets / Liquid liabilities For 2008 = 30,000 +20,000 +2,000 / 25,000 +15,000 = 1.30 : 1 For 2009 = 30,000 +15,000 / 30,000 +12,000 = 1.07:1 Note : Bank overdraft is not included in liquid liabilities, as it intend to become some sort of a permanent assumed. Inventory turnover ratio = Net sales / Average inventory For 2008 = 3,50,000 /10,000 = 35:1 For 2009 = 3,00,000 /15,000 = 20:1 Inventory- current assets ratio = Inventory / Current assets X100 For 2008 = 10,000 /62,000 X100 = 16% For 2009 = 20,000 / 65,000 X100 = 31% Average collection period = Trade receivable / Net sales X 365 For 2008 = 30,000 / 3,50,000 X365 = 31.3 days For 2009 = 30,000 / 3,00,000 X365 = 36.5 days Comments: The liquid position or short term solvency of the company is not sound. The current ratio in the first year, 1.55:1 does not appear to be good enough as it is below the norm of 2:1. In the second year, the position has further deteriorated to 1:38 :1. The later ratio shows a definite weakening in the solvency position of the company. As regards Quick or acid test ratio, it is satisfactory in the first year and not alarming ( although deteriorated to some extent) in the second year, as is above the generally accepted standard of 1:1. However, the fall in the cash balance and appearance of bank overdraft in the second year shows a definite deterioration in the short-term solvency position of the company. Moreover, because of factors concerning sales, stock and debtors, quick ratio is likely to soon deteriorate. As regards inventory turnover ratio, it indicates an alarming deterioration in the second year. The disproportionate rise in the percentage of stock to total current assets from 16% in the first year to 31% the second year is also a matter of concern. This shows excessive purchase of raw material which needs a thorough investigation. A comparison of debtors turnover ratio of the two years indicates worsening of the companys liquid position. There will be much cause of worry, if the sale is only to a few customers.
Long-term solvency Analysis

Debt to equity ratio = external equities / Internal Equities 46
For 2008 = 25,000 +15,000 / 62,000-40,000 =1.82:1 For 2009 = 30,000 +12,000 +5,000 / 65,000 -47,000 = 2.61:1 Proprietary Ratio = Shareholders equity / Total equity For 2008 =22,000 /62,000 = .35:1 For 2009 = 18,000 / 65,000 = .28:1 Comments: From the long-term point of view, the financial position of the company is very unsatisfactory as the debt to equity ratio and proprietary ratio is far off the norm in both the years. The situation has worsened in the second year resulting in serious decline in the share holders equity. The company seems to be heavily banking upon creditors funds. The overall conclusion of the above analysis is that the solvency position of the company is not satisfactory and has deteriorated in the second year.
Debt service ratio (DSR) or Interest coverage ratio

This ratio is calculated to evaluate the debt-servicing capacity of the firm. It is calculated by dividing the net profit before interest and taxes by fixed interest charges. DSR = Net income (before charging interest and income tax) / Fixed charges This ratio is very meaningful for the long-term creditors of the firm because it measures the firms capacity to pay interest on its loans on due dates. It also measures the margin of safety for the lenders. Higher the ratio better is the position of long-term creditors. But a too high interest coverage ratio may mean that firm is not taking adequate advantage of trading on equity to increase the earnings per share. Eight to nine times interest cover is considered as satisfactory for an industrial concern. A sharp decline in this ratio may endanger payment of interest and the firm will find it difficult to raise additional funds. The interest coverage ratio does not take into account other fixed obligations like payment of preference dividend and repayment of loan instalments. Hence, the following variants are suggested: Preference Dividend Coverage Ratio: It is calculated as follows: Preference Dividend Coverage Ratio (or No. of times Preference dividend earned)= Net income after interest and tax/ Preference Dividend This ratio is an index of the risk accruing to the preference share holders. Coverage of at least 2 is considered standard. Cash to debt service ratio or debt cash flow coverage ratio: Some authors find cash to debt service ratio as a better measure to judge firms ability to meet its all long-term obligations. As the firm has to pay debt service charges in cash, so in order to analyze firms long-term liquidity, it is better to calculate this ratio on the basis of total cash inflows instead of net income. If the firm has created sinking fund to repay the long-term loans, then, annual contribution to sinking fund shall also be added to interest charges and the following formula shall be applied: Annual cash flow before interest and tax / interest + sinking fund appropriation on debt /1tax rate If it is not possible to calculate precisely the amount of annual cash inflows, then the amount arrived at by adding depreciation and other non-cash expenses to the amount of net profit before interest and tax may be used in place of annual cash inflows. High coverage would be required in firms whose incomes are very instable and the firms whose incomes are stable; comparatively a low coverage will be sufficient. 47
Example -8 From the following information calculate 1. Interest Coverage Ratio 2. Debt cash flow coverage ratio Particulars Details Net income after tax Rs1,56,370 Depreciation charged Rs20,000 Tax rate 50% of net income 5% Mortgage Bonds Rs 2,50,000 Fixed Interest Charges Rs14,750 Sinking fund appropriation 5% of outstanding debentures Solution: Interest Coverage Ratio = Net profit before interest and income tax/ Fixed interest charges 1,56,370 +1,56,370 +14,750 / 14,750 = 22 times approximately. Debt cash flow coverage ratio= Annual cash flow before interest and tax _________________________________ Interest payment + SF appropriation / 1- tax rate 1,56,370 +1,56,370 +14,750 + 20,000 _______________________________ 14,750 + 12,500 / 1-50 3,47,490 / 39,750 = 8.7 times.
Profitability Analysis
A business firm is basically a profit earning organization. The profitability is generally treated as an indicator or efficiency of business activities. It depends upon the amount of sales, nature of costs and efficient use of resources. Profitability is analyzed by different parties according to their interest. To the management, profits are the test of efficiency and a measure of control; to owners, a measure of worth of their investments, To the creditors, the margin of safety, to employees, a source of fringe benefits, To government, a measure of taxpaying capacity and the basis legislation action, To customers a hint to demand for price cut; To an enterprise, less cumbersome source of finance for growth and existence and to the country, an index of economic progress. For reliable and meaningful analysis of profitability, three of four ratios should be calculated. A single ratio may lead to misleading conclusions. This analysis is two kinds General profitability analysis Overall profitability analysis
General profitability analysis

For this purpose following ratios are calculated: Gross Profit ratio: This ratio establishes relationship between gross profit and net sales. This indicates gross profit margin to net sales and usually expressed in percentage. The formula is as follows: 48
Gross profit / Net sales X100 The two main components of this ratio are gross profit and net sales. Gross profit is the excess of net sales over cost of goods sold and a net sale is found out of deducting sales returns from gross or total sales. Gross profit ratio is very important ratio of measuring profitability of an enterprise. It indicates to the management the margin of the profit left to cover indirect expenses. In other, words, it indicates the extent to which the selling prices of goods may decline without resulting the losses. Higher the ratio, better it is. But there is no rule of thumb for gross profit ratio. It may vary from business to business, industry to industry and also for different units within the same industry. Hence, a firms gross profit ratio should be compared with own past ratio or with ratio of the competitive firms. However, the gross profit should be adequate to cover, administrative, selling and distribution expenses and to provide for fixed charges, dividends and desired reserves. A decrease in gross profit ratio may be due to any of the following causes: Reduction in selling price without corresponding decrease in cost. Increase in raw material prices without corresponding increase in sales price. Theft, damage or misappropriation of stock Under valuation of closing stock Increase in cost of production due to over investment in plant and machinery and their unfavourable location. Rise in wages rate and direct costs. Goods purchased for personal use wrongly included in the purchase of the business. Increase in gross profit ratio may be due to Increase in sales price Decrease in raw material and other direct cost Under valuation of opening stock and over valuation of closing stock Inflating sales by including goods sent on consignment or goods sent on sale of approval basis. Operating ratio: This ratio is calculated by dividing the operating cost ( i.e cost of goods sold plus all operating expenses) by net sales. Cost of goods sold + operating expenses/ Net sales X100 Operating expenses means the sum of administrative, selling and distribution expenses. 100 minus operating ratio is operating profit ratio. Operating profit ratio measures efficiency and general profitability of the business. Lower the ratio, higher the profit left for recouping the nonoperating expenses and higher the net profits. There is no rule of thumb for this ratio as it may differ from firm to firm depending upon the nature of the business. However, 75 to 85 percent may be considered to be a satisfactory rate in case of manufacturing concern. Though operating ratio is good indicator of operating efficiency of the firm but it should be used cautiously because it reflects a combined effect of number of factors. Expenses ratio: It is calculated to show the relationship of each item of manufacturing cost and operating expenses to net sales. These ratios help in analyzing the causes of variation of operating ratio. The following formula is used Particular expenses / Net sales X100 These ratios show how much part of net sales is involved in recouping various operating expenses. By comparing these ratios with respective past ratios or with the standards determined by management or with ratios of similar firms in the industry, economy or diseconomy of each 49
item of expenses can be determined. These ratios throw light on managerial efficiency and profitability of the firm. The lower the ratio, the greater is the profitability of the firm. It is to be remembered that these ratios should be calculated separately for each item of fixed and variable expenses. The ratio of variable expenses should remain constant while the ratio of fixed expenses should fall with the increase in sales. Net profit ratio: This ratio measures the rate of net profit on sales. This is calculated as follows: Net profit after tax / Net sales X100 Some authors calculate this ratio on the basis of net operating profit after tax in place of net profit after tax. In calculating net operating profit, non operating incomes and expenses are excluded. This ratio expresses the part of sales revenue which is of the owners of the firm. This ratio is the measure of overall profitability and efficiency of the firm. The higher the ratio, the better is the profitability of the firm. Example-9 Following is the Income Statement of Raman Ltd for the year ending 31st March 2009: Particulars Amount Particulars Amount To opening stock 45,750 By sales 3,00,000 To purchases 1,89,150 By closing stock 59,100 To carriage 1,200 To wages 3,000 To Gross Profit 1,20,000 3,59,100 3,59,100 To administrative 60,600 To finance expenses Interest 720 Discount 1,440 Bad debts 2,040 To selling expenses 7,200 To non-operating 1,200 expenses To net profit 50,400 1,23,600 You are required to calculate Expenses ratio Gross profit ratio Net profit ratio Operating ratio Operating profit ratio Solution: By Gross Profit 1,20,000 By non-operating income Interest 900 Dividend 2,250 By profit on sale of 450 securities
1,23,600
Expenses ratio
Administrative expenses ratio = Administrative expenses / sales X100 60,600/ 3,00,000 X100 = 20.2% 50
Finance expenses ratio = Finance expenses/ sales X100 4,200 / 3,00,000 X100 = 1.4% Selling and distribution expenses ratio = selling and distribution expenses / sales X100 7,200 /3,00,000 X100 = 2.4% Non operating expenses ratio = Non-operating expenses/ sales X100 1,200 / 3,00,000 X100 = 0.4%
Gross profit ratio

Gross profit /sales X100 = 1,20,000 / 3,00,000 X100 = 40%
Net profit ratio

Net profit / sales X100 = 50,400 /3,00,000 X100 = 16.8% Alternatively, Net profit ratio = Net operating profit/ sales X100 48,000/ 3,00,000 X100 = 16%
Operating ratio
Cost of goods sold + operating expenses / sales X100 1,80,000 +72,000 / 3,00,000 X100 = 84%
Operating profit ratio

100 Operating ratio = 100- 84 = 16%
Overall profitability ratios

Overall profitability is measured by relating profits to investments made in the business. Following ratios are calculated to measure it. Return on capital employed: This ratio is calculated by dividing the net profits available to equity share holders ( i.e net profit after tax and preference dividend) by capital invested by these shareholders. It is usually expressed in percentage as below: Return on equity capital = Net profit (after tax and preference dividend)/ equity capital X100 A small variation of this ratio is to calculate the return on equity share holders total equity in the company which is equal to the sum of paid up equity share capital, reserves, surplus and security premium amount. If there is change in equity share capital during the year, then a simple average of opening and closing capital would be taken to calculate this ratio. This ratio is more meaningful to the equity shareholders. It examines the earning capacity of equity share capital. In fact the ratio provides the real test of managerial efficiency in utilizing the equity share holders money. There is no rule of thumb for this ratio. Hence, higher the ratio, better it is. However, the ratio may be compared with that of similar firms or with the firms own past. Earnings per share (EPS) : It is small variation of return on equity capital. Here, earnings are expressed per share instead of in percentage. Earnings per share are calculated by dividing net profits after tax and preference dividend by the total number of equity shares. EPS = Net profit after tax and preference dividend / Number of equity shares Earnings per share are a good measure of profitability. Market value of a share is usually determined on the basis of its EPS. Higher the EPS, better it is. EPS of a company may be compared with that of similar companies or the companies own past.
Return on Shareholders investment or Proprietor fund or net worth

51
This ratio measures the profitability of the concern in relation to total investments made by the share holders (or proprietors) in the business. It is calculated by dividing net profit after interest and taxes by share holders fund. Return on Investments (ROI)= Net profit (after interest and tax) / Share holders fund X100 The excess of total assets over total outsiders liability of an enterprise is known as share holders funds or proprietors funds or net worth. Alternatively, the sum of share capital (whether equity or preference) and accumulated profits (capital reserves plus all revenue reserves plus undistributed profits) minus losses, if any, is also known as share holders investment. Experts suggest that in calculating this ratio, average share holders investment should be used in place of share holders investments. Average share holders funds ( or average proprietors fund is the simple average of share holders investment ( or proprietors funds) at the beginning and at the end of the year. However, if fresh capital has been introduced in the business at the end of the year, such capital should be excluded in this calculation. As this ratio reveals the efficiency of utilization of shareholders fund, higher the ratio better are the results. Significance: This ratio provides a good basis of evaluating overall profitability and managerial ability of financing the business. In fact, it is one of the most important relationships used in financial statement analysis. This ratio is great importance to the present and prospective share holders as well as the management of the company. Some main uses of this ratio are as follows: This return determines the earning power of shareholders investment. As the primary objective of business is to maximize its earnings, this ratio indicates the extent which this objective is being achieved. A comparison of this ratio of the firm with that of the other firms or with industry average determines the adequacy of return. This ratio helps in forecasting future earning capacity of the business. For this purpose, trend analysis is most helpful. Return on Total Investment: This is measure of managerial efficiency of utilizing funds invested in the firm. This is calculated as follows: Net Profit before interest and tax/ Total Investment X100 Total investment implies shareholders funds plus long-term liabilities. Higher the ratio, greater is the profitability of the company. Return on total assets or total resources: Profitability can be measured in terms of the relationship between net profits and total assets of the firm. This ratio is also called as profit to asset ratio. This is calculated as follows: Net profit before interest and tax / total assets X100 Higher the ratio, better it is. Example -10 M/S Anita Ltd. presents you the following: Balance Sheet as on 31st March 2009. Liabilities Amount Assets Amount Equity share capital 1,00,000 Fixed assets 1,75,000 10% Preference share 20,000 Investments 50,000 capital Stock 60,000 Reserve fund 80,000 Debtors 27,000 9% Debenture 40,000 Bank 14,000 52
Sundry creditors Profit 2008 2009 60,000 Preliminary expenses 16,000
2,000 40,000 3,42,000 3,42,000 The directors intend to transfer a sum of Rs10,000 out of the current years profits to provision for tax. You are required to calculate the following. Current ratio Ratio of fixed assets to net worth Ratio of debt equity Productivity of owners equity Productivity of assets employed. Solution:
Current ratio
Current assets / Current liability = 1,01,000 / 70,000 = 1.44:1
Fixed assets to net worth

Fixed assets / net worth = 1,75,000 / 2,16,000 = 0.81:1 Whereas net worth = 1,00,000 +20,000 +80,000+ 42,000 -10,000 -16,000 = Rs2,16,000
Debt to equity
Total debt / owners equity = 1,10,000 / 194,000 = 0.567 :1 Owners equity = share capital + reserve fund + profits preliminary expenses provision for tax- preference dividend 1,00,000 +80,000 +42,000 -16,000 -10,000 -2,000 = Rs1,94,000
Productivity of owners equity

Net profit before tax and preference dividend / owners equity X100 28,000 / 1,94,000 X100 = 14.43%
Productivity of assets employed

Net profit before tax/ total assets X100 40,000 / 3,26,000 X100 = 12.27% Return on capital employed: A study of profit in relation to size of investment is known as return on capital employed. In other words, return on capital employed implies finding out ratio of net profit on capital employed in the firm. This is only satisfactory measure of examining the overall operating efficiency or profitability of a business entity. In fact, it is an evaluation of efficiency in using funds entrusted to management. Calculation of return on capital employed: Step I : Investment Turnover Sales / Capital employed Step-II : Percentage of profit on sales Profit / sales X 100 Step III : Return on capital employed Sales / capital employed X profit / sales X100 Or Profit before tax / capital employed X100 Example -11 53
Compute the return on capital employed (total assets basis) from the following information relating to company A and B Particulars A B Net sales for the year Rs5,50,000 Not known Total assets Not known Rs85,000 Net profit on sales 4% 19% Turnover of total assets 6 times Not known Gross margin 38% Rs9,360 (25%)
Solution:
Company A:
Investment turnover = 6 times Net profit percentage = 4% Return on capital employed = Investment turnover X N.P % 6 X4 = 24%
Company B:
Step I Computation of sales Gross margin = Gross profit / sales X100 25 = 9,360 / sales X100 Therefore sales = 9,360 X100 / 25 = Rs37,440 Step II : Investment turnover Sales / total assets = 37,440 / 85,000 = 0.44 Step III : Return on capital employed Turnover X NP % 0.44 X19 = 8.36% Increase in capital employed: If the management is eager to increase the return on investments, then, either the volume of sales or rate of return on sales would have to be increased or investments would have to be reduced. If it is not possible to reduce the volume of investments and increase the volume of sales then in order to increase return on investment the only option left to the management is either to increase the sales price of the product and/ or reduce its per unit cost. Example -12 For the year 2009, a company had sales of Rs60,000, variable costs were Rs30,000 and its fixed costs were Rs24,000. Its income-tax rate was 50%. The capital employed was Rs50,000. The CEO of the company wishes to establish an objective of 3 points improvement in return on capital employed. What changes would be required to achieve this objective? In sales volume with no change in variable costs and capital employed. In fixed costs with no change in sales, capital employed and variable cost. In capital employed with no change in costs or sales volume. Solution: Particulars Details Amount Sales 60,000 54
Less Variable cost Fixed cost Profit before tax 30,000 24,000
54,000 6,000
Return on capital employed = 6,000 / 50,000 X100 = 12% Now the CEO wishes to increase the present return by 3 points, i.e., he wishes to obtain a return of 15%.
Changes to be required In sales volume: Particulars Net profit before tax ( 15% on Rs50,000) Add Variable expenses Fixed expenses Sales volume required Less existing sales volume Increase in sales volume required Percentage of increase = 1,500/ 60,000 X100 = 2.5% In fixed cost Particulars Sales Less variable cost Contribution Less Expected profit before tax Required fixed cost Existing fixed cost Decrease in fixed cost required
Details
Amount 7,500
30,000 24,000
54,000 61,500 60,000 1,500
Amount 60,000 30,000 30,000 7,500 22,500 24,500 1,500
Percentage of decrease = 1,500 / 24,000 X100 = 6.25% Required capital employed at 15% = 6,000 X100/15 = Rs40,000 Hence capital employed should be decreased by 50,000-40,000 = Rs10,000. Percentage would decrease by 20%. Meaning of capital employed: The term capital employed has been defined by various committees and experts in various forms. The term is mainly used in the following three meanings: Gross capital employed: It implies the sum of all fixed and current assets of the firm. It is also sometimes called total resources of the concern. Thus, return on gross capital employed is
55
the same as return on total resources ( or assets) discussed earlier. However the following concept may also be used for this calculation. Gross capital employed = Equity share capital + preference share capital +reserve and surplus + all long and short term external loans Or All net fixed assets + current assets + including goodwill of the firm but fictitious assets are not included Net capital employed: It is calculated by deducting the current liabilities from the sum of all fixed and current assets. Alternatively, the sum of fixed assets and working capital is net capital employed. It is also known as total investment, i.e share holders funds plus long-term liabilities minus fictitious assets ( e.g preliminary expenses) and non-operating assets (e.g investments made outside business). Net capital employed = Equity share capital + preference share capital + reserve and surplus + long term loans
Proprietors Net capital employed: It is calculated by deducting all outside liabilities from
the sum of total fixed and current assets. Alternatively, it may be calculating by taking sum of paid up share capital, reserves and undistributed profits and deducting losses and fictitious assets from the sum. The return on proprietors net capital employed is the same as return on share holders investment. Proprietors net capital = Equity share capital + preference share capital + reserves and surplus accumulated losses, if any Choice of appropriate concept: The choice of appropriate concept out of three mentioned above depends upon the purpose of computation of return on capital employed. If the purpose is to show proprietors ( or the share holders) the profit earned or return on capital employed, then the concept of proprietors net capital employed should be used. But if the purpose is to indicate effectiveness of the business or to reflect the efficiency of internal management, then the use of the concept of gross capital employed is most suitable. However, of these two, the concept of net capital employed is preferred. The concept of average capital employed: Capital employed should represent truly the capital invested in the business throughout the year. For this purpose, it is better to calculate average capital employed in place of capital employed. The logic is that profits are earned in the business throughout the year and they remain in use in the business and dividend is distributed out of it only at the end of the year. Hence for taking in to consideration the profit earned during the year average capital employed should be calculated in the following two ways: By taking simple average of capital employed at the beginning and end of the year. In other words, it may be found out by dividing the sum of opening and closing capital employed by two. By adjusting half of the profits of the year in capital employed. If net capital employed at the end of the year is known, then half of the profits (after deducting interest and tax) should be deducted to calculate average net capital employed. On the contrary, if the net capital employed in the beginning of the year is known, and 56
then half of the profits earned during the year would be added. However, no such adjustment is required if gross capital employed is used for calculating the return. Items included in capital employed: The following assets and liabilities are included in calculation of capital employed. Fixed assets: All fixed assets are included in the calculation of capital employed. There are three accepted alternatives of valuing fixed assets. Gross value, net value and replacement cost. Out of these, net value basis is generally used but due to inflationary trend in the economy for the last six decades, the accountants consider replacement cost an appropriate basis for the valuation of fixed assets but this would require recomputation of provision for depreciation. If any fixed asset remains idle due to abnormal or unusual events, such as trade recession, fire or obsolescence or under work, then, it should not be included in capital employed. But idle machines and tools required for normal operation of plant would be included in capital employed. Intangible assets: These assets such as goodwill, patent, trade mark, copy right etc. are not considered in the computation of capital employed but when assets are taken at their historical cost and payment has been made for acquiring goodwill etc. in that case such intangible asset should be included in the computation of capital employed. Cash in hand and at bank: Cash, by nature, is an idle asset. Hence, only so much amount of cash should be included in capital employed which is essential for normal working of the business. If there has been abnormal inflow cash in to business (such as on issue of fresh issue of shares or sale of fixed assets), then, such cash should not be included in the cash computation of capital employed. As cash requirement of a business vary from period to period, it would be appropriate to treat average cash requirement as the normal amount of cash for the purpose of computation of capital employed. Debtors: Trade debtors are included in capital employed after deducting the bad debts and provision to this effect. Stocks: All type of stocks excluding obsolete and useless stocks are included in capital employed. Stock should be valued on proper basis and there must be consistency in respect of method of valuation. Investments: Considerable difference is found in respect of investments according to nature and purpose of computation. If the purpose of computing return on capital employed is to assess the effectiveness of the business and efficiency of the management, then all those investments should be excluded which do not affect managerial efficiency, such as investments outside the business, i.e non- trading investments. In such a case, income from non-trading investments should not be included in profit. On the contrary, internal investment and trade investments for enhancing of the company should be included in capital employed. If the amount of outside investment is substantial, return on capital employed may be calculated in two ways. One by including such investments and the other by excluding such investments. Fictitious assets: Fictitious assets such as preliminary expenses, deferred revenue expenditures, discount on issue of shares or debentures etc. should always be excluded for capital employed.
Profit Determination
The meaning and definition of profit will differ according to the method of computation and meaning of capital employed. Profit for this purpose should be determined taking into account the following rules: 57
Profit must match with the capital employed. Hence, if any asset is not included in capital employed, income from that asset or loss from its write off should not be included for calculating profit for this purpose. For example, if non-trading investments are not included in capital employed, income from such investments should not be included in profits. Hence, income from such investments should be deducted from given net profits. Similarly, write off of fictitious assets and intangible assets should be added back to nullify their effect. If long-term liabilities are a part of capital employed, interest paid on such loans should be added back to the profits. Similarly, if return to be calculated on gross capital employed, interest on short term loans should also be added back to the profits because these liabilities also form part of gross capital employed. Abnormal and non-recurring losses or gains should not be included in the profits. Hence, appropriate adjustment in net profit should be done to nullify their effect. If fixed assets are valued at replacement cost, then depreciation charged to profit and loss account should be based on their replacement cost. Profit should match with capital employed with reference to period also. It means that income of any previous year or of subsequent year should not be included in the current years profit. In determining profit due consideration should be given to all accepted principles and conventions of accounting. A clear distinction has to be made between revenue expenditure and capital expenditure in calculating profit and a conservative approach should be adopted in the calculation of profit. Return on capital employed should be calculated on the basis of net profits before tax because income-tax is not a business expenses and it has no relationship with profit earning capacity of the business and it is paid only after the profit is earned.
Objectives, Significance or Advantages of Computing Return on Capital Employed

The success of a business firm is measured in terms of its earnings. Higher the profit, more efficient is the firm. But true assessment of a firms operating efficiency and overall profitability is possible only by measuring profits in reference to investments in the business. Return on capital employed is calculated with this very objective. It measures the overall efficiency of a business and indicates how well the management has used the investments made by owners and creditors into the business. Following specific uses of this tool for a business enterprise. Measure of overall efficiency: It is a most suitable measure of overall efficiency or profitability of the concern because it is calculated keeping in view profit, sales and capital employed. In fact, it is good measure of efficiency in utilizing funds entrusted to the management. Disclosure of Borrowing Policy: This clarifies borrowing policy of the firm. A firm should not borrow normally at a rate of interest higher than return on capital employed. Basis of inter-company comparisons: It provides a sound basis for inter-company comparison. If the magnitude of the profits of two companies is the same, it does not necessarily mean that efficiency level of the two is equal. Its true examination is possible 58
only by calculating return on capital employed. Higher the return, more efficient is the firm. Basis of inter-departmental comparison: This return can be used in appraising and comparing divisional or departmental performances. Similarly, in a multiple product firms, profitability of various products inter-departmentally can be examined by calculating their returns separately. Helpful in capital budgeting decisions: This technique is also used to examine the profitability of a capital expenditure proposal or in the project evaluation. Projects providing a return less than return on capital employed are normally not considered. Thus, return on capital employed provides a yardstick of approving or disapproving a capital expenditure project. Integral part of budgetary control system: Return on capital employed can become an integral part of a budgetary control system. Significant percentage and ratios are incorporated in master budget and by finding profit variance the management can evaluate the progress of the business and takes necessary corrective action. Helpful in projecting long-term pricing policy: The technique is also used both for tactical and strategic decisions particularly in deciding long-term pricing policy. The price of the product should be fixed in such a way that the price recovers not only the cost of the product but ensures a reasonable rate of return on capital employed. Helpful in designing the capital structure: This ratio can also be usefully employed in designing the overall capitalization and capital structure. It means that management should borrow funds from the market only when the return on capital employed is more than the fixed charges on such funds.
Activity Analysis- Sales Ratios

Activity ratios, also called as efficiency ratios or sales ratios are concerned with measuring efficiency with which the resources available to the firm are utilized. This implies profitable, efficient and judicious use of resources and facilities available to a concern in perfect consonance with clearly laid down financial policies relating to its operation. As these ratios are calculated on the basis of sales or cost of sales, they are also called as turnover ratios. These ratios are expressed in number of times. The following ratios are included in this category. Stock turnover ratio: It is already explained under current assets movement ratios. Debtors turnover ratio: It is already explained under current assets movement ratios. Creditors turnover ratio: It is also explained under current assets movement ratios. Total assets turnover ratio: This ratio shows relationship between total assets of the company and its total sales or cost of sales. This ratio is measure of effectiveness of the use of total assets in the working of the concern. It is calculated as follows: Net sales ( or cost of sales) / Total assets A 2:1 assets turnover is considered satisfactory. If the ratio is very high, it may be concluded that the concern is over trading on fixed assets and if it very low it indicates over-investment in assets and under utilization of total capacity. In order to make further intensive analysis of total assets turnover, it is classified as follows: Fixed assets turnover ratio or ratio of sales to fixed assets 59
This ratio measures managements ability of efficient and profitable use of fixed assets. It indicates the firms ability to generate sales per rupee of investments in net fixed assets. It is calculated as follows: Cost of sales ( or net sales) / Fixed assets( net) This ratio assumes more significance in manufacturing concerns because of comparatively higher investment in fixed assets in these concerns. Higher the ratio, better it is. But this ratio varies from one industry to other. In labour intensive industries, it is expected to be high and capital intensive industries (where investment in fixed assets is high), it is bound to be low. In manufacturing industry 5:1 is considered to be satisfactory. A high fixed assets turnover ratio indicates efficiency of management in utilizing the fixed assets but a very high fixed assets turnover is an indication of over trading on fixed assets. On the other hand, a low fixed assets turnover ratio indicates under or inefficient utilization of fixed assets or over-investment in fixed assets. As there is no direct relationship between the sales and fixed assets, this ratio is of use only in manufacturing concerns. Current assets turnover ratio: This ratio measures the utilization and effectiveness of current assets by establishing relationship of current assets with net sales. It is calculated as below: Net sales ( or cost of sales) / Current assets This ratio is useful for those concerns where use of fixed assets if negligible. Higher the ratio, better it is. Net tangible assets turnover ratio or ratio of sales to net tangible assets: It is calculated as follows: Net sales / Net tangible assets Net tangible assets are calculated by taking sum of all assets excluding intangible assets and deducting total liabilities from this sum. Higher the ratio better it is but if this is too high, it implies over-utilization of firms goodwill. This is called as over trading. Working capital turnover ratio or ratio of sales to working capital : This ratio is a measure of efficiency of working capital utilization. It is calculated as follows: Net sales ( or cost of sales)/ working capital A high working capital turnover ratio shows the efficient utilization of working capital. But too high or too low ratio indicates over-trading and under trading respectively. Both these situations are harmful for the smooth conduct of the business. However the ratio should be interpreted along with inventory turnover and debtors turnover ratios.
Capital or Net worth turnover ratio or ratio of sales to capital or net worth:
This ratio is measure of efficiency of utilization of shareholders capital. Efficient use of capital is an indicator of profitability of business and managerial efficiency. It is calculated as follows: Net sales/ Share capital or net worth Some authors suggest that total capital employed should match with net sales and they can calculate the ratio as follows: Net sales ( or cost of sales) / Total capital employed
60
Total capital implies share holders fund plus long-term debt. Higher the ratio, better it is. A higher ratio indicates more profits while low ratio would result low profits. A very high capital turnover ratio would indicate over-trading or under-trading.
Capital Structure Analysis or Leverage Ratios

A firms capital structure is the relation of debt to equity as sources of a firms asset. Ratios used for capital structure analysis are known as leverage ratios. These ratios measure the relationship between finances provided to the firm by the outsiders and the owners. They also indicate the risk of debt finance. Hence, the owners and creditors of the firm both are interested in the analysis of capital structure. The long-term creditors of the firm are interested mainly evaluating firms capacity of repayment of the principal and amount on the maturity and timely payment of interest on their loans. A finance manager can increase significantly rate of dividend and worth of investments of equity share holders by appropriate leverage. Following ratios may be calculated for leverage: Capital gearing ratio or gear ratio: This is the most important ratio for analyzing the capital structure of a concern. The term capital gearing denotes the extent of reliance of a company on fixed cost bearing securities (preference share capital and debt capital) as against equity funds ( i.e equity share capital plus reserves and surplus). In simple words, capital gearing implies financing of a business enterprise through fixed interest and dividend carrying securities. Capital gearing ratio express relationship between fixed cost bearing capital and variable cost bearing capital. CGR= Fixed cost bearing capital/ variable cost bearing capital Or CGR= variable cost bearing capital / Fixed cost bearing capital If fixed cost bearing capital is greater proportion than variable cost bearing capital (i.e the ratio is more than 1) the business enterprise said to be highly geared. The business enterprise said to be low geared when fixed cost capital is less than variable cost bearing capital ( i.e ratio is less than 1) . This ratio is expressed as follows also CGR= Fixed cost bearing capital / equity A company can increase the return on equity share holders by adopting high gearing policy. But this is possible only when rate of interest/dividend payable on fixed cost bearing capital is less than the rate of earnings on total capital employed in the firm. In the case of loan capital, there is also the benefit of tax shield because interest on loan capital is permissible deduction from profits for the purpose of ascertaining taxable income. Hence by adopting the policy of high gearing, return on equity share holders exceed even the return on total capital employed. This is known as trading on equity. But this policy is profitable only when the cost of capital is less than the additional earning from it. In case of reverse situation, the equity share holder may have not only to lose their dividend but sometimes their capital also to meet out this loss. Hence the policy of high gearing is very risky and speculative. The equity share holders dwell upon feast and fast under such circumstances. During boom, dividend on these shares and consequently their market value rise sharply and in reverse circumstances ( i.e during depression) they fall sharply. Example-13 Following is the capital structure of A Ltd and B Ltd as on 31st March 2008 Particulars A Ltd B Ltd Equity share capital 5,00,000 1,00,000 61
10% Preference share capital 1,00,000 2,00,000 12% Debentures Nil 3,00,000 General reserve 2,50,000 2,50,000 During the year 2009, each company earned profit of Rs2,00,000 before interest and taxes. The rate of tax is 50%. Comment on the capital gearing of the two companies. Solution: CGR= Fixed cost bearing capital / variable cost bearing capital A Ltd = 1,00,000 / 7,50,000 = 0.13 :1 B Ltd = 5,00,000 /3,50,000 = 1.43:1 Debt equity ratio : It is very important and useful ratio for capital structure analysis. It has already been discussed earlier in the chapter.
Ratio of total investments to Long-term liabilities: It expresses relationship of total

long-term funds to long-term liabilities. Long term fund (share holders fund + Long-term liabilities)/ Long-term liabilities. As a general rule the proportion of long-term liabilities should be very high. Ratio of fixed asset to funded debt: This ratio determines the margin of safety o funded debt, such as debentures. The debentures of a company are usually issued by mortgaging the fixed assets. Hence, higher the ratio of fixed assets to debentures, the greater will be the security of debenture holders. This ratio is calculated as follows: Fixed assets / Funded debt
Ratio of reserves to equity capital:

Revenue reserve / Equity capital X100 This ratio throws light on dividend policy of the management. Higher the ratio, more conservative is dividend policy of the management and better is the growth potentiality of the company. Ratio of current liabilities to proprietors funds: This ratio is calculated by Current liabilities / Proprietors fund This ratio measures short-term borrowings as compared to funds provided by the proprietors. The norm is 35%.
Purpose of leverage ratios

Identifying sources of funds: The firm finances all its resources from debt or equity sources. The amount of resources form each source is shown by these ratios. Measuring the finance risk: One measure of the degree of risk prevailing from debt financing is provided by these ratios. If the firm has been increasing the percentage of debt in its capital structure over a period of time, this may indicate an increase in risk for its share holders. Forecasting future borrowings prospects: If the firm is considering expansion and needs to raise additional money, the capital structure ratios offer an indication of whether debt funds will be available. If the ratios are too high, the firm may not be able to borrow.
Ratios for prospective investors

Earnings per share (EPS): The shareholders are interested mainly in capital appreciation of
their investment and higher dividend per share. Both the variables are affected mainly by
62
earnings of the company and the most suitable way of expressing these earnings is earning per share. Net profit after preference dividend / Number of equity shares Here, the number of equity shares excludes the shares authorized but not issued, forfeited, cancelled, surrendered or repurchased. Higher the ratio, better the performance and brighter the future of the company. The increasing trend of earnings per share increases the possibility of higher cash dividend and capital bonus and this affects favourably the market value of the share. Although earnings per share are the most widely published and used data, it should not be believed blindly. First, EPS cannot represent the various financial operations of the business. Secondly, comparison of the EPS of different companies can be distorted by the effect of different accounting procedure relating to stock in trade, depreciation and the like. Therefore, EPS should be examined with other ratios.
Book value per share: It implies the amount payable per share on liquidation of the
company. Share holders fund / Number of shares Investors compare this value of the share with market price. Now this ratio has lost importance because assets shown in the balance sheet are usually different from their current values. Price Earnings Ratio: This ratio expresses the relationship of market price of the share with its rate of earnings. Market price per share / earnings per share This is most widely used ratio in the stock exchange by the investors. This ratio indicates as to how much the public is ready to pay for future earnings prospects of the company. A high priceearnings ratio indicates investors faith in the stability and appreciation of company earnings. This ratio can be used in forecasting market value of the share on a certain future date. Market price per share = PE Ratio X EPS The market value of a share is affected by many market factors. Hence, this ratio is used for knowing the position of over valuation of the share. Sixteen times earnings multiple is considered appropriate. Hence, if price earnings ratio is more than 16 times, the share may be concluded as overvalued. This ratio may also be used in determine capitalization of a share. As this ratio largely depends upon market factors, it differs from company to company within the same industry and also for the same company over a period. Capitalization ratio: The ratio indicates as to what portion of share value is received back each year t in the form of earnings. It is calculated by dividing EPS by the market price per share. Earnings per share / Market price per share Dividend Yield Ratio: This ratio compares the rate of dividend with the market price of the share. This ratio is calculated to know the effective return of the owners. This is calculates as follows: DYR = Dividend per share / Market price per share Dividend is declared as percentage on paid-up capital. But the return, de facto is more or less, depends upon lower or higher market price of a share respectively. It is this rate which is crucial
63
from the point of view of fresh investors in particular who desire dividends as a source of income. Dividend payout ratio: This is a ratio of dividend per share to earnings per share. It indicates the extent to which earnings per share have been used for paying dividend and what portion of earnings has been retained in the business for growth and future uncertainties. DPR = Dividend per share / Earnings per share X100 Guidelines for this ratio vary widely. Companies often attempt to pay approximately 50% of their earnings as dividends. If the firm is experiencing a need for funds to support its operations, it might allow the dividends to decline in relation to earnings. But if the firm lacks opportunities to use funds generated by retained earnings, it might allow the dividends to increase in relation to earnings. In either case, consistency of dividend payment would be important to investors, so changes should be gradual.
Cover of Preference and Equity Dividends: This may be calculates as follows

Cover for preference Dividend =Earnings after tax / Preference dividend Cover for equity Dividend = Earnings after preference dividend / Equity dividend Higher the cover better it is. Example-14 The information provided by KIIT Co Ltd is as follow: Particulars Details 9% Preference Shares of Rs10 each 3,00,000 Equity share Rs10 each 8,00,000 Profit after tax 60% 2,70,000 Depreciation 60,000 Equity dividend 20% Market price per equity share Rs40 You are required to calculate the following 1. The dividend yield on equity shares 2. The cover for preference and equity shares 3. The earnings per share 4. The Price earnings ratio 5. The net cash flow Solution: Dividend yield= Dividend per share / Market price per share 2/40 = .05 or 5% Whereas Dividend per share= 20% of Rs10 = Rs2 Cover of preference dividend = Profit after tax / preference dividend 2,70,000 /27,000 = 10 times Cover for equity dividend = Net profit after preference dividend / equity dividend 2,70,000-27,000 / 1,60,000 = 1.52 times Earnings per share = Net profit after preference dividend / No. of equity shares 2,70,000- 27,000 / 80,000 = Rs3.04 Price earnings ratio = Market price per share / earnings per share 40/ 3.04 = 13.16:1 64
Total cash flow = N.P after tax + Non cash expenditure 2,70,000 +60,000 = Rs3,30,000 Net cash flow = Total cash flow Dividend on shares
Significance of ratios in inter-firm Comparison

Inter-firm comparison implies an analysis and interpretation of relative efficiency of two or more companies or trading concerns on the basis of financial data. The comparison is made with other firms in the same industry or the representative firm. The objective is to evaluate the operating efficiency or financial soundness or the both and to take necessary corrective measures to remove the inefficiency in future. Though absolute figures can be used for this comparison but such comparison usually proves useless. Hence, accounting ratios are used for this comparison. The following points should be considered for this purpose: Adequacy of profits: Profit is a principal measure of evaluating the success of a business concern. The most important basis of comparing profitability of different firms is return on capital employed. Return on investments ( ROI) may also be used for this purpose. Efficiency in selling: Sales is the basis of profit of a firm. The ratio of profit to sales and the ratio of sales to total assets adequately highlight upon the factors affecting earning capacity. The ratio of sales to total assets indicates the size of sales. For its further analysis fixed assets turnover, current assets turnover, stock turn over, debtors turnover etc. may also be calculated. Efficiency of production: The operating efficiency of business can be evaluated by establishing relationship of production cost, administrative cost, selling and distribution cost, advertising cost etc. with sales. Financial soundness: It is evaluated on the basis of current ratio, liquid ratio, debt-equity ratio, capital gearing ratio etc. Example-15 The following information was taken from the records of KIMS Ltd: Particulars Details Acid-test ratio 0.92 Average finished inventory 52,000 Average number of days sales uncollected 77 Expenses 2,12,000 Finished goods turnover 12.20 Ratio of net income to average total current assets 9.80% Net sales 9,00,000 Total current assets 4,25,000 Working capital turnover 4.50 From the above data find out Working capital Ratio Total quick assets Accounts receivable at the end of the year Cost of goods sold Turnover of average total current assets Solution: 65
Working capital ratio or current ratio =
Current assets / Current liabilities Working capital turnover ratio = Net sales / working capital Working capital = 9,00,000 / 4.5 = Rs2,00,000 Working capital = Current assets Current liabilities Current liability = Current assets working capital 4,25,000 -2,00,000 = 2,25,000 Working capital ratio = 4,25,000 /2,25,000 = 1.89:1 Total quick assets: Acid test ratio = quick assets / current liabilities 0.92 = quick asset / current liabilities Quick assets = 0.92 X2,25,000 = Rs2,07,000
Accounts receivable at the end

Average collection period= Accounts receivable / Net sales X360 77 =accounts receivable / 9,00,000 X360 Accounts receivable = 77 X 9,00,000 /360 = Rs1,92,500
Cost of goods sold

Finished goods inventory ratio = Cost of goods sold / average inventory 12.20 = cost of goods sold / 52,000 Cost of goods sold = 12.20 X52,000 = Rs6,34,400
Turnover of average total current assets

Net income = Net sales (cost of goods sold + expenses) 9,00,000 (6,34,400 +2,12,000) = Rs53,600 Ratio of net income to average total current assets Net income / average total current assets = 9.80% Average total current assets = 53,600 X100 / 9.8 = Rs5,46,940 Turnover of average total current assets Net sales / average total current assets 9,00,000 / 5,46,940 = 1.646 times Example -16 From the following information, make out a statement of proprietors funds with as many details as possible. Particulars Details Current ratio 2.5 Liquid ratio 1.5 Proprietary ratio ( fixed assets / proprietary funds) 0.75 Working capital Rs60,000 Reserves and surplus Rs40,000 Bank overdraft Rs10,000 There is no long-term loans or fictitious assets Solution: Current asset and current liabilities Let the current liabilities be Rs A So, current assets will be 2.5A 66
Since, current assets current liabilities = working capital 2.5 A A =Rs60,000 1.5A = Rs60,000 or A = 60,000/1.5 = Rs40,000 Thus current liability is Rs40,000 Since bank overdraft is Rs10,000, hence creditors and other liabilities will be Rs30,000. Again, current assets = 2.5A = 40,000 X2.5 = Rs1,00,000 Liquid asset = 1.5 X40,000 = Rs60,000 Stock = 1,00,000 60,000 = Rs40,000 Proprietors fund As proprietary ratio is 0.75, hence if proprietary fund are B, then fixed assets will be 0.75B Since, Proprietary funds Fixed assets = Working capital B- 0.75B = 60,000 B = 60,000 /0.25 = Rs2,40,000 Thus, proprietary funds are Rs2,40,000 As in the question, reserves and surplus are Rs40,000, the difference of proprietors fund and reserves and surplus will be share capital. Therefore share capital will be Rs2,00,000 ( 2,40,000 -40,0000 As proprietary ratio is 0.75 and proprietors fund are Rs2,40,000, hence fixed assets will be Rs2,40,000 X0.75 = Rs1,80,000.
Statement of Proprietors Fund

Particulars Investment of funds: Fixed assets Current assets: Stock Liquid assets Less current liabilities Bank overdraft Creditors Net current assets Proprietors fund: Equity share capital Reserves and surplus Details Amount 1,80,000 40,000 60,000 1,00,000 10,000 30,000 60,0000 2,40,000 2,00,000 40,000 2,40,000
Example-17 From the following details, prepare statement of Proprietors funds with as many details as possible. Particulars Details Stock velocity 6 Capital turnover ratio 2 Fixed assets turnover ratio 4 67
Gross profit turnover ratio 20% Debtors velocity 2 months Creditors velocity 73 days The gross profit was Rs60,000. Reserves and surplus Rs20,000. Closing stock Rs5,000 in excess of opening stock. Solution: Calculation of closing stock Sales = 60,000 X100 /20 = Rs3,00,000 Cost of goods sold = sales gross profit = 3,00,000 -60,000 = Rs2,40,000 Let the opening stock be A Therefore closing stock = A +5,000 Stock turn over = Cost of goods sold / Average inventory 6 = 2,40,000 / average inventory Average inventory = 2,40,000 /6 = Rs40,000 40,000 = A +A +5,000 /2 80,000 -5,000 = 2A A = Rs37,500 and closing stock = 37,500 +5,000 = Rs42,500 Debtors 3,00,000 X2/12 = Rs50,000 Creditors 2,45,000 X73/365 = Rs49,000 Fixed asset 2,40,000 /4 = Rs60,000 Share capital 2,40,000 /2 = Rs1,20,000 Cash balance Particulars Amount Total liabilities ( 1,20,000+20,000 +49,000) 1,89,000 Less total assets other than cash (60,000 +42,500 1,52,500 +50,0000 36,500 Note : If the capital is viewed in the sense of net worth, then this amount of Rs1,20,000 will include in itself the amount of reserves and surplus. In that case the amount of share capital would be (1,20,000 -20,000) =Rs1,00,000. If the share capital is Rs1,00,000, the amount of cash balance will be Rs16,500.
Statement of Proprietary fund

Particulars Investment of Funds: Fixed assets Current assets: Stock Debtors Cash Details Amount 60,000 42,500 50,000 36,500 68
Less Current liabilities Net current assets Proprietors Fund: Share capital Reserves and surplus 1,29,000 49,000 80,000 1,40,000 1,20,000 20,000 1,40,000
Example -18 From the following figures and ratios make out the Balance Sheet and Trading and Profit and loss account Particulars Details Share capital Rs3,60,000 Working capital Rs1,26,000 Bank overdraft Rs20,000 Current ratio 2.5 Quick ratio 1.5 Proprietary ratio ( fixed assets : Proprietary funds) 0.7 Gross profit ratio 20% Stock turnover ratio 4 Debtors turnover 36.5 days Net profit ratio ( to average capital employed) 10% There are no fictitious assets. In current assets there are no other than stock, debtors and cash. Closing stock is 20% higher than the opening stock. Solution: Current assets and current liabilities Let the liabilities be A Current assets will be 2.5A 2.5A-A = Rs1,26,000 A = Rs1,26,000 /1.5 = Rs84,000 Hence current liabilities is Rs84,000 Other current assets = 2.5 X 84,000 = Rs2,10,000 Current liabilities includes bank overdraft Rs20,000. Hence, other liabilities = 84,000 20,000 = Rs64,000 Closing stock Quick ratio = quick assets / current liabilities 1.5 = quick assets / 84,000 Quick assets = 84,000 X1.5 = Rs1,26,000 Current asset - quick assets = stock 2,10,000 -1,26,000 = Rs84,000 Opening stock As closing stock is 20% higher than the opening stock Hence opening stock = 84,000 X100 /120 = Rs70,000 Cost of sales Stock turn over = cost of sales / average stock 69
4 = cost of sales / 77,000 Cost of sales = Rs3,08,000 Whereas average stock = 84,000 +70,000 /2 = Rs77,000 Sales As gross profit is 20% on sales, so it will be 25% on cost of sales Sales = cost of sales + gross profit 3,08,000 +77,000 = Rs3,85,000 Debtors Debtors turnover = total debtors / net credit sales 36.5 = total debtors / 3,85,000 X365 Debtors = 36.5 X3,85,000 /365 = Rs38,500 Cash = quick assets debtors = 1,26,000 -38,500 = Rs87,500 Fixed assets Let proprietary funds be RsA Then fixed asset will be 0.7 A ( As proprietary ratio is 0.7) Proprietary funds- fixed assets = Current assets Current liabilities A-.7A = 2,10,000 -84,000 .3A 1,26,000 A = 1,26,000 /.3 = Rs4,20,000 Fixed assets = 4,20,000 X0.7 = 2,94,000 Net profit Let the net profit be A Then A = 10% of average capital employed A = 10% of ( opening capital employed + closing capital employed) A = 10% of ( 4,20,000 +A + 4,20,000) A = Rs40,000 Indirect expenses Expenses = Gross profit Net profit = 77,000 -40,000 = Rs37,000 Reserves Proprietary funds share capital profit = reserves 4,20,000 -3,60,000-40,000 = Rs20,000
Trading and Profit and loss account

Particulars To opening stock To purchases To gross profit c/d To expenses To net profit Amount 70,000 3,22,000 77,000 4,69,000 37,000 40,000 77,000 Amount 3,60,000 20,000 Particulars By sales By closing stock Amount 3,85,000 84,000 4,69,000 By gross profit b/d 77,000 77,000 Amount 2,94,000 38,500 70
Balance sheet
Liabilities Share capital Reserves Assets Fixed assets Debtors
Profit Bank overdraft Other liabilities 40,000 20,000 64,000 5,04,000 Stock Cash 84,000 87,500 5,04,000
Additional Examples Example -19 The balance sheet of Greenland Ltd. as at the end of the year 2008 has been given below Balance sheet of Greenland Ltd as on 31st December 2008 Liabilities Amount Assets Amount Sundry creditors 1,20,000 Cash in hand 10,000 Bills payable 70,000 Cash at bank 10,000 Bank Overdraft 1,00,000 Debtors 80,000 Provision for taxation 15,000 Bills receivable 70,000 Share capital 4,00,000 Inventory 3,50,000 Debentures 95,000 Investment in govt.security 80,000 Prepaid expenses 10,000 Land& building 1,10,000 Plant &machinery 80,000 8,00,000 8,00,000 Calculate (i) Current ratio,(ii) liquid ratio (iii) absolute liquid ratio (iv) cash ratio
Solution: Current ratio = CA/ CL = 6,10,000/3,05,000=2:1 Liquid ratio = LA / CL= 2,50,000 / 3,05,000= 0.82 :1 Absolute liquid ratio = ALA / CL = 1, 00,000/3, 05,00 =0.33:1 Cash ratio = Cash (in hand and bank) /CA= 20,000/6,10,000= 0.033 :1 Working notes: Liquid assets (LA) = Currents assets (inventory + prepaid expenses) Absolute liquid assets (ALA) = Cash in hand + bank +short term investments Liquid liability (LL) = Current liability bank overdraft Current assets (CA) = Cash in hand and at bank + debtors+ B/R+ inventory +investment + prepaid expenses Current liability = Creditors +B/P + BOD+ provision for taxation Example -20 The balance sheet of Vatsala Ltd as on 1/1/2009 is given below: Liability Amount Assets Amount Equity share capital 5,00,000 Fixed assets 8,75,000 9% preference capital 1,00,000 Investments 2,50,000 Reserves 4,00,000 Inventory 3,00,000 71
Debentures Creditors Bills payable Provision for tax Profit/loss 2,00,000 Debtors 1,00,000 2,00,000 Bills receivable 35,000 1,00,000 Cash in hand 20,000 50,000 Cash at bank 50,000 Preliminary expenses 1,60,000 80,000 17,10,000 17,10,000 Calculate (i) Current ratio (ii) Quick ratio (iii) Fixed assets to net worth ratio (iv) Debt equity ratio Solution: (i) Current ratio = CA/CL= 5,05,000/3,50,000=1.44:1 (ii) Quick ratio = LA / CL= 2,05,000/ 3,50,000=0.59:1 (iii) Fixed assets to net worth ratio =Fixed assets/net worth 8,75,000/10,80,000= 0.81:1 (iv) Debt equity ratio = outsiders fund / net worth 5,50,000/ 10,80,000= 0.51 :1 Working notes: CA= inventory + debtors +BR +Cash +Bank CL= Creditors +BP +provision for tax LA= CA- inventory Net worth = equity capital +Preference capital +Reserve+PL- preliminary expenses Outsiders fund = debentures + current liability Example -21 The following data pertaining to company for the year ending 2007 and 2008 Liabilities 2007 2008 Assets 2007 2008 Creditors 50,000 60,000 Inventory 20,000 40,000 Bills payable 30,000 24,000 Debtors 60,000 60,000 Bank overdraft 10,000 Prepaid expenses 4,000 Nil Cash 40,000 30,000 Sales 2007 -Rs7,00,000 and for 2008-Rs6,00,000 On the basis of above data, calculate the following ratios and give suitable comments on the basis of ratios computed. (i) Current ratio (ii) Quick ratio (iii) inventory turnover ratio (iv) Debtors turnover ratio (v) cash ratio (vi) average collection period Solution: (i) Current ratio = CA/CL For 2007 = 1,24,000/80,000=1.55:1 For 2008 = 1,30,000/94,000= 1.38 :1 (ii) Quick ratio = Quick assets / CL For 2007 = 1,04,000/ 80,000=1.3 :1 For 2008= 90,000/ 94,000= 0.96:1 (iii) Inventory turn over ratio =net sales / average stock Average stock = Opening stock + closing stock /2 For 2007= 7,00,000/20,000= 35 times For 2008= 6,00,000/ 30,000= 20 times 72
(iv) Debtors turnover ratio (DTR) = Sales / Average receivables For 2007= 7,00,000/60,000= 11.66 times For 2008= 6,00,000/60,000= 10 times Average receivables = Opening +Closing receivables /2 (v) Cash ratio = Cash / current assets For 2007 = 40,000/1,24,000= 0.32:1 For 2008= 30,000/ 1,30,000= 0.23:1 (vi) Average collection period = Receivables X360 / credit sales For 2007 = 60,000X360 /7,00,000= 31 days For 2008= 60,000 X360 / 6,00,000= 36 days Comments: Although the current ratio have declined as compared with those of the previous year; yet these ratios for 2008 show that the current financial policy of the company is satisfactory. The considerable decline in the inventory turnover ratio in 2008 (as compared to 2007) is certainly an adverse change and cause for worry. DTR and average collection period are normal in both the years. Example: 22 The following data for the preceding five years have been taken from the financial records of a manufacturing company Particulars 2005 2006 2007 2008 2009 Total sales 6000 7500 8000 10,000 13,800 Gross profit 1200 1500 2000 2300 3000 Opening stock 1400 1800 1200 1200 1600 Closing stock 1800 1200 1200 1600 2000 Calculate Inventory turnover ratio. Solution: Inventory turnover ratio (ITR) = Cost of sales / Average stock 2005= 4800/1600=3 times 2006=6000/1500= 4 times 2007=6000/1200= 5 times 2008=7700/1400=5.5 times 2009= 10800/1800= 6 times Example :23 The balance sheet of a company as on 31st December 2008 as follows Liabilities Amount Assets Amount Share capital 20,00,000 Fixed assets 22,50,000 Reserves 5,00,000 Stock 3,50,000 Debentures 2,50,000 Debtors 2,50,000 Creditors Cash 2,50,000 1,50,000 30,00,000 30,00,000 Sales for the year Rs90,00,000 Calculate a. Total capital turnover ratio b. Net capital turnover ratio c. Turnover of owners capital d. Working capital turnover ratio 73
e. Fixed assets turnover ratio f. Current assets turnover ratio Solution: (a) total capital turnover ratio Sales/ total capital = 90,00,000/30,00,000=3 times (b) Net capital turnover = Sales /Net capital employed 90,00,000/27,50,000=3.27 times ( c ) Owned capital turnover ratio Sales/ Share capital +reserves = 90,00,000/25,00,000= 3.6 times ( d) Working capital turnover ratio Sales / working capital= 90,00,000 /(7,50,000-2,50,000)= 18 times (e)Fixed assets turnover ratio Sales / fixed assets= 90,00,000/22,50,000= 4 times (f)current assets turnover ratio Sales / current assets = 90,00,000/7,50,000= 12 times Notes : Net capital employed = gross capital employed current liability 30,00,000-2,50,000= 27,50,000 Example: 24 Calculate the following ratios from the given data (a) Administrative expenses ratio (b) Financial expenses ratio (c) Selling and distribution expenses ratio (d) Gross profit ratio (e) Gross operating ratio (f) Net profit ratio (g) Overall operating ratio (h) Inventory turnover ratio
Trading and profit and loss account for the year ended 31st Dec2008 Particulars Amount Particulars Amount To Opening stock 15,250 By sales 1,00,000 To purchases 63,050 By closing stock 19,700 To carriage 400 To wages 1,000 To Gross Profit c/d 40,000 1,19,700 1,19,700 To administrative expenses 20,200 To Financial expenses By gross profit b/d 40,000 Interest By non-operating income : 240 Discount Interest on securities 480 300 Bad debts Dividend on shares 680 750 74
To selling expenses To Non-operating exp Loss on sale of securities Profit for legal contingency To Net profit 2,400 70 330 16,800 41,200 Profit on sale of shares 150
41,200
Solution: 1. Administrative expenses ratio = Administrative expenses / sales X100 20,200/1, 00,000 X100 = 20.2% 2. Financial expenses ratio = Financial expenses / sales X100 1,400/ 1,00,000 X100 = 1.4% 3. Selling expenses ratio = Selling expenses ratio / sales X100 2,400 / 1,00,000 X100 = 2.4% 4. Gross profit margin ratio = Gross profit / Sales X100 40,000 /1,00,000 X100 =40% 5. Gross operating Ratio = Cost of sales / Sales X100 = 60,000/1, 00,000 X100=60% 6.Net profit margin = Net profit /sales X100= 16,800/1,00,00X100=16.8% 7. Overall operating ratio = Sales-net profit / sales X100 (1,00,000-16,000)/1,00,000 X100 = 84% 8. Inventory turnover ratio = Cost of sales /Avg.stock 60,000/17,475 = 3.43 times Example -25 Balance sheet of Sri manufacturing company Ltd.as on 1st Jan2009 Liabilities Amount Assets Amount Share capital (Rs 10 per 40,00,000 Fixed assets 50,00,000 share) Current assets 18,00,000 Reserves 10,00,000 14% debentures 10,00,000 Current liabilities 8,00,000 68,00,000 68,00,000 Tax rate for the company is 50%. The earning before interest and taxes (EBIT) of the company are Rs15,00,000. The dividend pay-out ratio of the company is 50%. The market price per share is Rs 16 per share. On the basis of the above information, compute the following ratios for the company. 1. 2. 3. 4. 5. 6. 7. 8. Rate of return on gross capital Rate of return on net capital Rate of return on net worth or owned capital Rate of return on paid up equity capital Earning per share Dividend per share Earning Yield Dividend yield 75
9. Dividend cover Solution: Requirement 1. Rate of return on gross capital employed
Formulae EBIT/Total capital X100
Calculation 15,00,000/68,00,000 X100 =22.06% 15,00,000/60,00,000 X100 =25% 6,80,000 /50,00,000 X100 =13.6% 6,80,000/40,00,000 X100 =17% 6,80,000/4,00,000 =1.70
2. Rate of return on net capital EBIT/ Net capital employed employed X100 Profit after tax/ capital 3. Rate of return on net worth +reserve X100 Profits after tax/paid-up 4. Rate of return on paid up capital X100 capital Profit after tax/ Number of 5.Earning per share (EPS) shares 50% profit after tax / No. of shares EPS / Market price per share X100 DPS /Market price X100 EPS /DPS
3,40,000/4,00,000=0.85
6 Dividend per share(DPS) 7.Earning Yield 8.Dividend Yield
1.70 /16 X100 =10.625% 0.85 /16 X100= 5.31
1.70 /0.85 = 2 times 9.Dividend cover
Working notes: 1. Gross or total capital = Fixed assets + current assets 50,00,000 +18,00,000 =68,00,000 2. Net capital employed = gross capital employed current liabilities 68,00,000 -8,00,000 = 60,00,000 3. Net worth or owned capital = paid up share capital + reserves 40,00,000+ 10,00,000 = 50,00,000 4. Calculation of profit after tax Particulars Amount EBIT 15,00,000 Less Interest ( 14% of 10,00,000) 1,40,000 13,60,000 Less tax @50% of 13,60,000 6,80,000 6,80,000 76
77

Working Papers of Dr. B.C.M.patnaik

Caricato da

Informazioni sul documento

Descrizione originale:

Titolo originale

Copyright

Formati disponibili

Condividi questo documento

Condividi o incorpora il documento

Opzioni di condivisione

Hai trovato utile questo documento?

Questo contenuto è inappropriato?

Copyright:

Formati disponibili

Working Papers of Dr. B.C.M.patnaik

Caricato da

Copyright:

Formati disponibili

working papers of Dr.B.C.M.

Patnaik, Associate Professor, School of Management, KIIT University, Bhubaneswar

Management Reporting System or Management Information System

Essentials of Good Reporting System

Proper time Cost benefit analysis

Role of reports in a System of Control

Requisites of Good Report

Good form and content

Reports according to Form:

Report according to Purposes

Report according to contents

Reports according to Nature

Reports useful for Different Level of Management

Financial Statement Analysis and Interpretation

110 100 210

(B) Comparative Balance Sheet

(C) Common size income statement

2009 100 47.8 52.2 16 36.2 3.8 32.4 11.4 21

(D) Common size Balance Sheet

Trend analysis of Financial Statement:

Importance of Trend Analysis:

Assignments: Analysis and interpretation of financial statements

Cash Flow Analysis

Funds Flow Vs Cash Flow

It shows the causes for change in 21

Cash Flow Vs Cash Budget

Significance or uses of Cash Flow Analysis

Preparation of cash flow statement

Cash flow from Financing Activities:

Non cash transactions:

Calculation of cash from operation

Format of cash flow statement as per AS-3 (Revised)

XXXX XXXXX XXXXX

Importance or utility of ratio analysis:

2.Helpful in trend analysis

3.Use in comparative study

4. Helpful for communication

5.Helpful in determining the standards

6.Helpful in effective control

7. Helpful in the evaluation of efficiency

8.Helpful in evaluation of financial standards

9.Helpful for interested parties in the firm

Limitations of ratio analysis:

2. Ignores qualitative factors

3. Only a part of the information needed in the process of decision making

4.Possibility of window dressing

5.Different meaning to accounting terms

6.Variations in accounting policies

7. Difficulty in evolving standard ratios

Steps of Ratio Analysis:

Ratios for creditors

Ratios for share holders

Solvency Analysis or Financial Position Analysis

Short term solvency or liquidity analysis:

Stock turnover ratio or inventory turnover ratio:

Step I : Net Credit Purchases

Step-II : Average Payment period

Long term Solvency Analysis or Test of Solvency

Fixed Assets to Total Long-term Fund ratio or Fixed Assets Ratio

Ratio of current assets to proprietors fund

Ratio of current assets to total liabilities

Proprietors liabilities ratio