Accounting for Management_unit i

8/11/2019 Accounting for Management_unit i

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Accounting for Management

S.N.Selvaraj, M.B.A., M.Phil., Assistant Professor, Email:[email protected] Page 1

Semester I

UNITIII ANALYSIS OF FINANCIAL STATEMENTS

Analysis of Financial Statements Financial Ratio Analysis Cash Flow (as per

Accounting Standard 3) and Funds Flow Statement Analysis

ANALYSIS OF FINANCIAL STATEMENTS

Financial statement analysis is also referred as financial analysis. The term financial

analysis also known as an analysis and interpretation of financial statements, refers

to the process of determining financial strengths and weakness of firm by establishing

strategic relationship between the items of balance sheet, profit and loss account and

other operative data.

According to Myers, Financial statements analysis is largely a study of relationship

among the various financial factors in a business as disclosed by single-set ofstatements, and study of the trend of these factors as shown in a series of statement.

Analysis of financial statements is the systematic numerical calculation of therelationship between one fact with the other to measure the profitability, operational,

efficiency, solvency and the growth potential of the business.

According toHampton, Analysis of financial statement is the process of determining

the significant operating and financial characteristics of a firm from accounting data.

Financial Statements

Formal and original statements prepared by a business concern to disclose its financial

information. Financial statements are prepared for the purpose of presenting a

periodical review or report on the progress by the management and deal with the

status of investments in the business and the results achieved during the period under

review.

The following are the important financial statements that are prepared by the business

concern:Profit and Loss Account (or) Income Statement: The Profit and Loss account presents

the summary of revenues, expenses and net income or net loss of a firm for a specific

period of time. A comparison of incomes and expenses incurred to earn those

incomes is made in the statement and the difference between the two is known as net

profit or loss.

Surplus Statement (or) Retained Earnings: Retained earnings refer to accumulated

excess profits over losses and dividends. Such retained earnings are taken to Balance

sheet from the retained earnings statement. The retained earnings statement is a link

between the Balance sheet and the income statement.


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Supplementary Schedules: One can look into the schedule to have detailed

information and glance at the Balance sheet to get a summarized picture of the data.

Schedules help in reducing the length of the financial statements and make them brief

and informative.

Balance Sheet: The Balance sheet comprises of a list of assets, liabilities and capital

fund at a given date. It reflects the assets owned by the concern and the sources of

funds used in the acquisition of those assets. It is prepared in such a way that true

financial position is revealed in a form easily readable and understandable by the

people concerned.

Types of Financial Statement Analysis

External Internal Horizontal Vertical Short LongAnalysis Analysis Analysis Analysis Term Term

External Analysis: The external analysis of financial statements done by the outside

agencies like investors, financial analysts, lenders, government agencies, research

scholars, etc. The details records and accounting information is not available to the

outside agencies and they rely mostly on published financial statements and

information for analysis.

I nternal Analysis: The internal analysis done by those who have access to detailed

financial records of the firm. Generally, management is interested in the analysis of

financial statements for measuring the effectiveness of its own policies and decisions.

Sometimes, officers appointed by court or government under statute will conductinternal analysis.

Horizontal Analysis: When evaluation is done for several years simultaneously at a

time for making conclusions, it is called horizontal analysis. This is based on the

data from year-to-year rather than the one time available information. Horizontal

analysis is done for finding the trend ratios and in comparative financial statements.

Vertical Analysis: It is the study of quantitative relationship of one financial item to

another based on financial statement on a particular data. Common size statements

and ratio analysis are the examples of vertical analysis.

Types of F inancial Statement Analysis

On the Basis of

Materials used

On the Basis of

Modes operandi

On the Basis of

Period


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Long-term Analysis:The long-term analysis of financial statements is done with a view

to evaluate the long-term solvency, profitability, liquidity, financial health, earning

capacity of the firm, debt servicing capacity, etc. of a business enterprises. The

objective of long-term analysis is to determine whether the earning capacity of thefirm is sufficient to meet the targeted rate of return on investment, and is adequate for

future growth and expansion of business.

Short-term Analysis: The short-term analysis of financial statements is undertaken

mainly to determine the liquidity position of the firm and short-term solvency of the

firm. The analysis is oriented on efficiency of working capital management and

profitability of current operations.

Parties Interested in Financial Statement Analysis

Management Financial institutions including Banks

Perspective Investors

Customers Creditors

Stock Exchange Government

Society

Objectives/Importance of Financial Statement Analysis

1) Measuring Short-term Solvency

2) Measuring Long-term Solvency

3) Measuring Operating Efficiency

4) Measuring Profitability

5) Comparison of Inter-firm

6) Forecasting, Budgeting and Deciding Future Line Action7) Indicating Trend of Achievements

8) Assessing Growth Potential of the Business

9)

Simplified, Systematic and Intelligible Presentation of Facts

Business Concern

Society

Government

Stock Exchange

Banks

Management

Investors

CustomersCreditors


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Limitations of Financial Statement Analysis

o Absence of Standard Universally Accepted Terminologyo

Ignoring Qualitative Aspects

o Misleading Result in Absence of Absolute Datao

Ignoring the Price Level Changeso

Suffering from Limitation of Financial Statementso Financial Statements are Affected by Window Dressing

o Financial statements are affected by the Personal Ability and Bias of Analyst

o Financial Analysis is only a Tool, not the Final Remedyo Financial Analysis Spots the Symptoms but does not Arrive at Diagnosis

Techniques of Financial Statement Analysis

A financial analyst can adopt one or more of the following techniques/tools of

financial analysis:

(1) Financial Ratio Analysis: An accounting ratio shows the relationship inmathematical terms between two interrelated accounting figures. A financial analyst

may calculate different accounting ratios for different purposes.

(2) Funds Flow Statement Analysis: The statement of changes in financial position,

prepared to determine only Sources and Uses of Working Capital between two dates

of balance sheets, is known as the Funds Flow Statement. It brings out in open the

changes which have taken place behind the Balance Sheet.

(3) Cash Flow Statement Analysis:The statement of changes in financial position on

Cash Basis, commonly known as Cash Flow Statement. It summarizes the causes of

changes in cash position between dates of two balance sheets. It indicates the sources

and uses of cash. It focuses attention on cash, instead of working capital or funds.

(4) Comparative Financial Statements: The comparative financial statements are

statements of financial position at different periods of time. In these statements figures

for two or more periods are placed side by side to facilitate comparison. Both the

Income Statement and Balance Sheet can be prepared in the form of Comparative

Financial Statements.

Tools of Financial Statement Analysis

Financial

Ratio

Analysis

Funds

Flow

Analysis

Cash

Flow

Analysis

Comparati

ve

Statements

Common-

size

tatements

Trend

Analysis


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(i ) Comparative Income Statement: The Income Statement discloses Net Profit or

Net Loss on account of operations. Since the figures for two or more periods

are shown side by side, the reader can quickly ascertain whether sales have

increased or decreased, whether cost of sales has increased or decreased etc.

(ii)Comparative Balance Sheet: Comparative Balance Sheet as on two or more

different dates can be used for comparing assets and liabilities and finding out

any increase or decrease in those terms.

(5) Common-size Financial Statements: Common-size Financial Statements are those

in which figures reported are converted into percentages to some common base. In the

Income Statement the sale figure is assumed to be 100 and all figures are expressed as

a percentage of this total. Similarly the whole Balance Sheet is converted into

percentage form. Such converted Balance Sheet is known as Common-size Balance

Sheet.

(6) Trend Analysis: Trend percentages are immensely helpful in making a comparative

study of the financial statements for several years. The method of calculating trend

percentages involves the calculation of percentage relationship that each item bears to

the same item in the base year. Any year may be taken as the base year. It is usually

the earliest year. Each item of base year is taken as 100 and on that basis the

percentages for each of the items of each of the years are calculated.

FINANCIAL RATIO ANALYSIS

A ratio is a simple arithmetical expression of the relationship of one number to

another. It may be defined as the indicated quotient of two mathematical expressions.

This quantitative relationship (i.e. ratio) may be expressed in either of the following

ways:

I n Proportion:In this form the amounts of the two items are being expressed in a

common denominator. The example of this form of expression is the relationship

between current assets and current liabilities as 2:1

I n Rate (or) Times (or) Coeff icient:In this form, a quotient obtained by dividing oneitem by another item is taken as unit of expression. For example, if out of 100

students in a class, 80 are present, the attendance ratio can be expressed as: 80/100

= 0.8 times.

I n Percentage:In this form, a quotient obtained by dividing one item by another is

multiplied by one hundred and it becomes the percentage form of expression. For

instance, in the above example, the attendance ratio as a percentage of the totalnumber of students is as follows: 0.8*100 = 80 %


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Meaning and Definition of Ratio Analysis

Ratios are relationships expressed in mathematical terms between figures which are

connected with each other in some manner. One of the most important financial tools

which have come to be used very frequently for analyzing financial strengths and

weaknesses of the enterprise is ratio analysis. It is a technique of analysis and

interpretation of financial statements.

According to Myers, Ratio analysis is a study of relationship among the various

financial factors in a business.

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

the business.

Objectives of Ratio Analysis

1. Measuring the Profitability

2.

Judging the Operational Efficiency of Business3. Assessing the Solvency of the Business

4. Measuring Short and Long-Term Financial Position of the Company

5. Facilitating Comparative Analysis of the Performance

Advantages of Ratio Analysis

Helpful in Financial Analysis

Helpful in Explaining Financial Health of the Enterprise Helpful in Locating Shortcoming/Weakness

Helpful in Future Forecasting

Helpful in Comparing Inter-Firm Performance Helpful in Simplifying Accounting Figures

Helpful in Assessing Operating Efficiency of the Business

Importance of Ratio Analysis

The inter relationship that exists among the different items appeared in the financial

statements, are revealed by accounting ratios. Ratio analysis of a firms financial

statements is of interest to a number of parties, mainly, shareholders, creditors,

financial executives etc. Shareholders are interested with earning capacity of the firm.

Creditors are interested in knowing the ability of the firm to meet its financial

obligations. Financial executives are concerned with evolving analytical tools that willmeasure and compare costs, efficiency, liquidity and profitability with a view to

making intelligent decisions.

Classification of Ratios

The use of ratio analysis is not confined to financial manager only. There are different

parties interested in the ratio analysis for knowing the financial position of a firm for

different purposes. In the view of various users of ratios, there are many types of

ratios which can be calculated from the information given in the financial statements.

Ratios can be classified into different categories depending upon the basis of

classification.


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Various accounting ratios can be classified as follows:

Ratios

Traditional Classification Functional Classification Significant Ratios(or) (or) (or)

Statement Ratio Ratios According to Tests Ratios Importance

1) Balance Sheet Ratios 1) Liquidity Ratios 1) Primary Ratios

(or) 2) Leverage Ratios 2) Secondary Ratios

Position Statement Ratios 3) Activity Ratios

4) Profitability Ratios

2) Profit & Loss A/c Ratios

(or)

Income Statement Ratios

3) Composite/Mixed Ratios(or)

Inter Statement Ratios

(I) TRADITIONAL CLASSIFICATION (OR) STATEMENT RATIOS

(a) Balance Sheet (or) Position Statement Ratios: Balance sheet ratios deal with the

relationship between two balance sheet items, e.g. the ratio of current assets to current

liabilities, or the ratio of proprietors fund to fixed asset. Both the items must,

however, pertain to the same balance sheet. The various balance sheet ratios have

been named in the following chart.

(b) Profit and Loss Account (or) Revenue/Income Statement Ratios:These ratios deal

with the relationship between two profit and loss account items, e.g. the ratio of gross

profit to sales, or the ratio of net profit to sales. Both the items must, however, belong

to the same profit & loss account. The various profit and loss ratios, commonly used,are named in the following chart.

(c) Composite/Mixed Ratios (or) Inter Statement Ratios: These ratios exhibit the

relation between a profit and loss account (or) income statement and a balance sheet

item, .g. stock turnover ratio or the ratio of total assets to sales. The most commonly

used inter-statement ratios are given in the following chart.


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Traditional Classification (or) Statement Ratios

Balance Sheet Ratios Profit & Loss A/c Ratios Composite/Mixed Ratios

(or) (or) (or)

Position Statement Ratio Income Statement Ratio Inter-Statement Ratios

1) Current Ratio 1) Gross Profit Ratio 1) Stock Turnover Ratio

2) Liquid Ratio 2) Operating Ratio 2) Debtors Turnover

(Acid Test or Quick Ratio) 3) Operating Profit Ratio 3) Payable Turnover Ratio3) Absolute Liquidity Ratio 4) Net Profit Ratio 4) Fixed Assets Turnover

4) Debt Equity Ratio 5) Expense Ratio 5) Return on Equity

5) Proprietary Ratio 6) Interest Coverage Ratio 6) Return on Shareholders

6) Capital Gearing Ratio Fund

7) Assets-Proprietorship Ratio 7) Return on Capital

8) Capital Inventory to Working Employed

Capital Ratio 8) Capital Turnover Ratio

9) Ratio of Current Assets 9) Working Capital Turnover

to Fixed Assets 10) Return on TotalResources

11) Total Assets Turnover

(II) FUNCTIONAL CLASSIFICATION (OR) RATIOS ACCORDING TO TESTS

(a) Liquidity Ratio:These are the ratios, which measures the short-term solvency orfinancial position of a firm. These ratios are calculated to comment upon the short-

term paying capacity of a concern or the firms ability to meet its current obligations.

The various liquidity ratios are current ratio, liquid ratio and absolute liquid ratio.

(b) Leverage Ratio:Leverage ratios are the financial statement ratios which show the

degree to which the business is leveraging itself through its use of borrowed money.

By using a combination of assets, debt-equity, and interest payments, leverage ratios

are used to understand a companys ability to meet its long term financial obligation.

The leverage ratios can further be classified as: (i) Structure ratios (ii) Coverage ratios

and (iii) Capital Gearing Ratios

(c) Activity Ratio:Activity ratios are calculated to measure the efficiency with which

the resources of a firm have been employed. These ratios are called turnover ratios

because they indicate the speed with which assets are being turned over into sales, e.g.

debtors turnover ratio, etc. The various activity or turnover ratios have been given in

the following chart.

(c) Profitability Ratio:These ratios measure the result of business operations or overall

performance and effectiveness of the firm, e.g. gross profit ratio, operating ratio, etc.

The various profitability ratios have been given in the following chart.


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Functional Classification (or) Ratios According to Tests

Liquidity Ratios Leverage Ratios Activity Ratios Profitability Ratios

A AStructure Ratios Capital Turnover AIn relation to salesCurrent ratio Debt Equity ratio ratio Gross Profit ratioLiquid ratio Debt to Total Fixed Assets Operating ratio

(Acid test or capitalization Turnover ratio Operating profit

Quick ratio) Proprietary ratio Working capital ratioAbsolute Liquid Turnover ratio Net profit ratio

Ratio Inventory Turnover Expenses ratioB BCoverage Ratios Ratio BIn relation to

Debtors Turnover Interest Coverage Debtors/Receivables Investments

Ratio Ratio Turnover ratio Return on

Credits Turnover Cash Flow/ Debt Investments

Ratio Service Ratio Creditors/Payables Return on capital

Inventory Turnover Dividend Coverage Turnover ratio Return on Equity

Ratio Ratio Total Assets CapitalCCapital Gearing Turnover ratio Return on Total

Resources

Earnings per share

(III) SIGNIFICANT RATIOS (OR) RATIOS ACCORDING TO IMPORTANCE

(a) Primary Ratio:The primary ratio is one which is of prime importance to concern;

thus return on capital employed is named as primary ratio.

(b) Secondary Ratio:The other ratios which support and explain the primary ratio is

called secondary ratio, e.g. the relationship of operating profit to sales or the

relationship of sale to total asset of the firm.

LIQUIDITY RATIOSLiquidity refers to the ability of a concern to meet its current obligations as and whenthese become due. Liquidity ratios are calculated to measure short-term financial

soundness of the business.

1) Current ratio (or) Working capital ratio2) Quick (or) Acid test (or) Liquid ratio

3) Absolute liquid ratio (or) Cash position ratio

Note:

The ideal current ratio is 2:1

The ideal quick ratio is 1:1

The ideal cash ratio is 05:1


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(1) Current Ratio

Current Ratio is the most common ratio for measuring liquidity. Being related to

working capital analysis, it is also called the working capital ratio. Current ratio

expresses relationship between current assets and current liabilities. It is calculated by

dividing current assets by current liabilities. The ideal current ratio is 2:1

Current Ratio = Current Assets / Current Liabilities

(2) Quick Ratio (or) Acid Test (or) Liquid Ratio

This ratio establishes a relationship between quick assets and current liabilities. It

measures the firms capacity to pay off current obligations immediately and is a more

rigorous test of liquidity than the current ratio. It is used as complementary ratio to the

current ratio. It indicates rupees of quick assets available for each rupee of currentliability. The quick ratio of 1:1 is considered to be a satisfactory ratio.

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

Liquid Ratio = Current Assets(Stock and Prepaid Expenses)

Current LiabilitiesBank Overdraft

(3) Absolute Liquid Ratio (or) Cash Position Ratio

Although receivables, debtors and bills receivable are generally more liquid than

inventories, yet there may be doubts regarding their realization into cash immediately

or in time. Absolute liquid assets include cash in hand and at bank and marketable

securities or temporary investments. This ratio is computed by dividing absolute

liquid assets by current liabilities. The acceptable norm for this ratio is 50% or 0.5:1or 1:2

Absolute Liquid Ratio = Absolute Liquid Assets

Current Liabilities

Problem:

From the following Balance Sheet of a firm calculate current ratio and liquid ratio.

Comment upon the liquidity of the firm.

BALANCE SHEETRs. Rs.

Share Capital

CreditorsBills Payable

Provision for Tax

Bank Overdraft

30,000

8,0002,000

3,500

4,500

Fixed Assets

Cash in HandCash at Bank

Debtors

Bills Receivable

Stock

Prepaid Expenses

Marketable Securities

12,000

2,5003,000

6,000

2,000

17,500

500

4,500

48,000 48,000


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Solution:

(1) Current Ratio = Current Assets / Current Liabilities

= Rs.36,000 / Rs.18,000 = 2:1

(2) Liquid Ratio = Liquid Assets / Current Liabilities

= Rs.18,000 / Rs.18,000 = 1:1

(3) Absolute Liquid Ratio = Absolute Liquid Assets / Current Liabilities

= Rs.10,000 / 18,000 = 0.55:1

Workings:Current Assets

= Cash + Bank + Debtors + B/R + Stock + Prepaid Expenses

+ Marketable securities

(2500+3000+6000+2000+17500+500+4500) = 36000

Current Liabilities= Creditors + Bills Payable + Provision for Tax + Bank O/D

(8000+2000+3500+4500) = 18000

Liquid Assets= Cash + Bank + Debtors + B/R + Marketable securities

(2500 + 3000 + 6000 + 2000 + 4500) = 18000

Absolute Liquid Assets

= Cash in hand + Cash at bank + Marketable securities

(2500 + 3000 + 4500) = 10000

LEVERAGE / SOLVENCY RATIOS

These ratios provide an insight into the financial techniques used by a firm & focus, as

a consequence, on the long term solvency position with regard to, periodic payment of

interest during the period of loan, repayment of principal on maturity or in

predetermined installments on due dates.

The following ratios serve the purpose of determining the solvency of the concern.

1)Structur e Ratios: The capital structure ratio shows the percent of long-term

financing represented by long-term debt.a) Debt-Equity Ratio

b) Funded Debt to Total Capitalization Ratioc) Proprietary Ratio (or) Equity Ratio

2)Coverage Ratios:This tells us the debt servicing commitments and sourcing the

funds to meet them. These ratios are used to test the adequacy of cash flows

generated through earnings for the purposes of meeting debt and lease

obligations.

a) Interest Coverage Ratio

b) Cash to Debt Service Ratio

c)

Dividend Coverage Ratio3)Capital Gearing Ratios


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Debt-Equity Ratio: It indicates the margin of safety to long-term creditors. A low

debt-equity ratio implies the use of more equity than debt which means a larger safety

margin for creditors since owners equity is treated as the margin of safety by

creditors and vice versa.

Debt-Equity Ratio = Long-term Debts / ShareholdersFunds

(Or)

Debt-Equity Ratio = External Equities/ Internal Equities

Problem:

Find out the Debt-equity Ratio from the following particulars:

Rs.

Preference Share Capital 3,00,000

Equity Share Capital 11,00,000

Capital Reserve 5,00,000

Profit and Loss Account 2,00,000

6% Debentures 5,00,000

Sundry Creditors 2,40,000

Bills Payable 1,20,000Provision for Taxation 1,80,000

Outstanding Creditors 1,60,000

Solution:

Debt Equity Ratio = Long-term Debts or External Equities

Shareholders Fund Internal Equities

= 6% Debentures + Sundry Creditors + Bills Payable +

Provision for Taxation + Outstanding creditors

Preference Share Capital + Equity share capital +

Capital Reserve + Profit

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

3,00,000 + 11,00,000 + 5,00,000 + 2,00,000

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

21,00,000

It means that for every four rupees worth of the creditors investment, the

shareholders have invested seven rupees. That is external debt are equal to

57% of shareholders fund.

Debt to Total Capitalization Ratio:This ratio establishes link between the long-term

funds raised from outsiders and total long-term funds available in the business.

Though there is no rule of thumb but still the lesser the reliance on outsiders the

better it will be.


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Funded Debt to Total Capitalization Ratio = Funded Debt 100

Total Capitalization

Problem:

From the following figures, find out the Funded Debt to Total Capitalization Ratio andcomment on this ratio.

Rs.

50,000 Equity Shares of Rs.10 each fully paid

20,000 9% Preference Shares of Rs.10 each fully paid

General Reserve

Share Premium

Profit & Loss Account

7 % Debentures

Mortgage Loans

Sundry CreditorsBills Payable

5,00,000

2,00,000

50,000

25,000

1,25,000

1,40,000

60,000

1,29,00074,500

13,03,500

Solution:

Funded Debt to Total Capitalization Ratio = Funded Debt 100


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

Total Capitalization = Proprietors Fund + Funded Debt(Or)

= Equity Share Capital + Preference Share Capital +

General Reserve + Share Premium + P&L A/c +

Debentures + Mortgage Loans

= Rs.5,00,000 + 2,00,000 + 50,000 + 25,000 +

1,25,000 + 1,40,000 + 60,000

= Rs.11,00,000

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

Rs.11,00,000

= 18.18%

The ratio of 18.18% is quite low. The company has not relied much on outside sources

for raising long-term funds. There is enough scope for the company to rise long-term

from outsiders.


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Proprietary Ratio / Equity Ratio: This ratio measures a relationship between

proprietors funds and the total assets.The objective of computing this ratio is to find

out how the proprietors have financed the assets. It is calculated by dividing

shareholders funds by the total assets.

Preference share capital and equity share capital plus all reserves and surplus items are

called shareholders fund. Total assets include all assets including goodwill. The

acceptable norm of the ratio is 1:3. The ratio shows the general strength of the

company.

Proprietary Ratio = Proprietors Fund (or) ShareholdersFund

Total Assets (or) Total Resources

Problem:

Proprietors fund are Rs.4,00,000 and total assets are Rs.6,00,000. Calculate

proprietary ratio.

Solution:

Proprietary Ratio = Proprietors Fund (or) ShareholdersFund

Total Assets (or) Total Resources

= 4,00,000 = 0.66 (or) 66% (or) 2:3

6,00,000

As proprietary /equity ratio represents the relationship of owners fund to total assets,

higher the ratio or the shares of the shareholders in the total capital of the company,better is the long-term solvency position of the company.

COVERAGE RATIOS

Coverage ratios tell us the debt servicing commitment and sourcing the funds to meet

them. These ratios are used to test the adequacy of cash flows generated through

earnings for the purposes of meeting debt and lease obligations.

Interest Coverage Ratio:This ratio establishes relationship between net profits before

interest and taxes and interest on long-term debt. The objective of computing thisratio is to measure the debt-servicing capacity of a firm so far as fixed interest on

long-term debt is concerned.

Interest Coverage Ratio = Net Profit before Interest and Taxes

Interest on Long-term Debt

Problem:

Net Profit before Interest and Tax Rs.3,20,000. Interest on Long term debt Rs.40,000.

Calculate Interest Coverage Ratio.

Solution:


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Interest Coverage Ratio = Net Profit before Interest and Taxes

Interest on Long-term Debt

= 3,20,000 / 40,000

= 8 times

Cash to Debt Service Ratio: This ratio is also known as Debt Cash Flow Coverage

Ratio, is an improvement over the interest coverage ratio. The logic of this ratio is that

the interest payments are to be made out of cash inflow of the business and not from

the profit and apart from interest, expenses sinking fund appropriations on debt (which

are generally made by various firms to enable itself to make repayment of the loans)

should be considered to find out debt cash flow coverage as a measure of long-term

solvency of a firm. Generally, higher the coverage better it is, as far as, long termsolvency of the firm is concerned.

Cash to Debt Service Ratio (or) Debt Cash Flow Coverage Ratio

= Annual Cash Flow before Interest and Taxes

Sinking Fund Appropriation on Debt

Interest + 1Tax Rate

Or CFCD = CF

1+ SFD

1TWhere, CF = Annual Cash Flow before Interest and Tax

I = Interest Charges

SFD = Sinking Fund Appropriation on Debt

T = Rate of Tax

Problem:

Calculate cash to debt service ratio from the following particulars:

(a)Net profit after tax = Rs.22,500(b)Fixed interest charges = Rs.2,000

(c)Depreciation charged = Rs.3,000

(d)Tax rate = 50%

(e)Sinking Fund Appropriation = 7 % of outstanding debentures(f)

10% Debentures = Rs.20,000

Solution:

Cash to Debt Service Ratio (or) Debt Cash Flow Coverage Ratio

= Annual Cash Flow before Interest and Taxes

Sinking Fund Appropriation on Debt

Interest + 1Tax Rate

= 22,500 + 22,500(tax) +2,000(fixed interest) +3,000(depreciation)

1500(Sinking Fund Appropriation)

2,000 + 150/100


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= 50,000 = 50,000 = 50,000

2,000+ (1,500/0.5) 2,000+3,000 5,000

= 10 times

Dividend Coverage Ratio:This ratio measures the ability of a firm to pay dividend on

preference shares which carry a stated rate of return. This ratio indicates margin of

safety available to the preference shareholders. Higher the ratio is more desirable on

the part of preference shareholders.

Dividend Coverage Ratio = EAT / Preference Dividend

Problem:

Calculate dividend coverage ratio if the net profit after taxed of a firm is Rs.75,000

and its preference dividend is Rs.10,000.

Solution:

Dividend Coverage Ratio = EAT / Preference Dividend

= 75,000 / 10,000 = 7.5 times

Capital Gearing Ratio:The term capital gearing is used to describe the relationship

between equity share capital including reserves and surpluses to preference share

capital and other fixed interest-bearing loans. If preference share capital and otherfixed interest bearing loans exceed the equity share capital including reserves, the firm

is said to be highly geared. The firm is said to be in low geared if preference share

capital and other fixed interest-bearing loans are less than equity capital and services.

Capital Gearing Ratio = Equity Share Capital + Reserves & Surplus

Preference Capital + Long-term debt bearing fixed interest

Problem:

From the information given as under find out capital gearing ratios:

2008 2009

Equity share capital

Reserves & Surplus

8% Preference share capital

6% Debentures

5,00,000

3,00,000

2,50,000

2,50,000

4,00,000

2,00,000

3,00,000

4,00,000

Solution:

Capital Gearing Ratio = Equity Share Capital + Reserves & Surplus

Preference Capital + Long-term debt bearing fixed interest

2008 = 5,00,000 + 3,00,000 = 8:5 (low gear)2,50,000 + 2,50,000


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

3,00,000 + 4,00,000

Capital gearing ratio is very important leverage ratio. Gearing should be kept in such away that the company is able to maintain a steady rate of divided. High gearing ratio

is not good for a new company or a company in which future earnings are uncertain.

ACTIVITY RATIOS

Funds are invested in various assets in business to make sales and earn profits. Theefficiency with which assets are managed directly affects the volume of sales. The

better the management of assets, the larger is the amount of sales and the profit.

Activity ratios measure the efficiency or effectiveness with which a firm manages its

resources or assets. These ratios are also called turnover ratiosbecause they indicate

the speed with which assets are converted or turned over into sales.

The following are the activity ratios:

1) Capital Turnover Ratio

2) Fixed Assets Turnover Ratio3) Working Capital Turnover Ratio

4) Stock Turnover Ratio

5) Debtors Turnover Ratio (or) Receivables Turnover Ratio

6)

Creditors Turnover Ratio (or) Payables Turnover Ratio

Capital Turnover Ratio: This ratio establishes relationship between net sales and

capital employed. It indicates the firms ability to generate sales per rupee of capital

employed. The higher the ratio, the greater is the sales made per rupee of capitalemployed in the firm and hence higher is the profit. A low capital turnover ratio refers

to excessive capital being used in the firm.

Capital Turnover Ratio = Net Sales

Capital Employed

Net sales = Gross salesSales returnCapital Employed = Long-term debt + Shareholders fund


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Problem:

The balance sheet of Trisul Ltd. As at 31stMarch 2010 is as under:

L iabil i ties Rs. Assets Rs.

Equity Share Capital

18% Preference Capital

ReservesProfit & Loss A/c15% Debentures

Trade Creditors

Bills payable

Outstanding expenses

Bank overdraft

Provision for tax

1,00,000

1,00,000

60,0002,40,0008,00,000

40,000

30,000

20,000

10,000

2,40,000

Land & Building

Plant & Machinery

Furniture & Fixtures

Less: Depreciation

Long-term Investments

Stock

Debtors 3,40,000

Less: Provision 30,000

Marketable securitiesCash

Bills receivables

Prepaid expenses

Preliminary expenses

Underwriting commission

6,00,000

5,00,000

1,00,000

12,00,000

2,00,000

10,00,000

1,00,000

95,000

3,10,000

10,000

10,00010,000

5,000

60,000

40,00016,40,000 16,40,000

Net sales for the year amount to Rs.20,00,000.

Solution

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

Capital Employed 12,00,000

Capital Employed

= Net Fixed Assets + Trade Investments + Current AssetsCurrent

Liabilities= 10,00,000 + 1,00,00 +4,40,000 +3,40,000 = Rs.12,00,000

Capital Employed

= Equity share capital + Preference share capital + Reserves + P&L

Account (Cr.)Preliminary expensesUnderwriting commission +

Long term debts= 1,00,000 + 1,00,00 +60,000 + 2,40,00060,00040,000 + 8,00,000= Rs.12,00,000

Fixed Assets Turnover Ratio:This ratio enables a relationship between net sales and

fixed assets. The ratio is computed by dividing the net sales by the net fixed assets. It

indicates the firms ability to generate sales per rupee of investment in fixed assets. In

general, higher the ratio is the more efficient the management and utilization of fixed

assets and vice versa.


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Fixed Assets Turnover Ratio = Net Sales

Net Total Fixed Assets

(Or)

Cost of goods soldNet Total Fixed Assets

Net sales = Gross salesSales return

Net Fixed (Operating) Assets = Gross Fixed Assets - Depreciation

Problem:

Fixed Assets (at cost) Rs.7,00,000, Accumulated Depreciation till date Rs.1,00,000,

Credit sales Rs.17,00,000, Cash Sales Rs.1,50,000, Sales Returns Rs.50,000.

Calculate Fixed Assets Turnover Ratio.

Solution

Fixed Assets Turnover Ratio = Net Sales

Net Total Fixed Assets

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

Net sales = Cash sales + Credit salesSales returns

= Rs.1,50,000 + 17,00,00050,000 = Rs.18,00,000

Net Fixed Assets = Fixed Assets (at cost)Depreciation

= Rs.7,00,0001,00,000 = Rs.6,00,000

Working Capital Turnover Ratio:The ratio established relationship between net salesand working capital. The objective of working capital turnover ratio is to indicate the

velocity of the utilization of net working capital. This indicates the number times the

working capital is turned over in the course of a year. Higher the ratio the more

efficient the management and utilization of working capital and vice versa.

Working Capital Turnover Ratio = Net Sales

Working Capital(Or)

Cost of goods sold

Net Working Capital

Problem:

Current Assets Rs.6,00,000, Current Liabilities Rs.1,20,000, Credit Sales

Rs.12,00,000, Cash Sales Rs.2,60,000, Sales Returns Rs.20,000. Calculate Working

Capital Turnover Ratio.


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Solution

Net sales = Cash sales + Credit salesSales returns

= Rs.2,60,000 + 12,00,00020,000 = Rs.14,40,000

Working Capital = Current AssetsCurrent Liabilities= Rs.6,00,0001,20,000 = Rs.4,80,000

Working Capital Turnover Ratio = Net Sales

Working Capital

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

Stock Turnover Ratio:The ratio establishes relationship between costs of goods sold

and average inventory. The objective of this ratio is to determine the efficiency with

which the inventory is utilized. It indicates the speed with which the inventory is

converted into sales.

Stock Turnover Ratio = Cost of Goods Sold

Average Inventory

Cost of goods sold = SalesGross profit

(Or)

= Opening stock + Purchases + Direct expensesClosing

Stock

Average stock = (Opening stock + Closing stock) / 2

Inventory Conversion Period (Stock Velocity):It may also be of interest to see average

time taken for clearing the stocks. This can be possible by calculating inventoryconversion period.

Inventory Conversion Period = 12 months / 52 weeks / 365 days

Stock Turnover Ratio

Problem:

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

December 2010. Credit sales Rs.1,50,000, Cash sales Rs2,50,000, Return inward

Rs.25,000, Opening stock Rs.25,000, Closing stock Rs.35,000.

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

Conversion Period.

Solution

Inventory Turnover Ratio = Cost of Goods Sold

Average Inventory


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Cost of goods sold = Net SalesGross profit

Net sales = Rs.1,50,000 + 2,50,00025,000 = Rs.3,75,000

Gross Profit on Sales = 3,75,000 20 = Rs.75,000

100

Cost of goods sold = Rs.3,75,00075,000 = Rs.3,00,000

Average stock = (Opening stock + Closing stock) / 2

= (Rs.25,000 + 35,000) / 2

= 60,000 / 2 = Rs.30,000

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

Average Inventory 30,000

Inventory Conversion Period = 12 months / 52 weeks / 365 days

Stock Turnover Ratio

= 365 / 10 = 36.5 or 37 days

Debtors Turnover Ratio (or) Receivables Turnover Ratio: This ratio establishes a

relationship between net credit sales and average trade debtors. The objective of thisratio is to determine the efficiency with which the trade debtors are managed. The

higher value of debtors turnover the more efficient is the management of

debtors/sales.

Debtors Turnover Ratio = Net Credit Sales

Average Trade Debtors

Net Credit Sales = Gross Credit salesSales Returns

Trade Debtors = Sundry Debtors + Bills Receivable and Accounts

Receivables

Average Trade Debtors = Opening Trade Debtors + Closing Trade Debtors2

Debtors Collection Period (Debtors Velocity): The debt collection period represents

the average number of days for which a firm has to wait before its receivables are

converted into cash.Debt Collection Period = Average Trade Debtors (Drs + B/R)

Sales per day

Sales per day = Net SalesNo. of working days


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Problem:

Calculate the Debtors Turnover Ratio and Average Debt Collection Period for the year

2010-2011 from the following information:

Particulars 2010 (Rs) 2011 (Rs)

Sundry Debtors

Bills Receivables

Provision for Doubtful Debts

15,000

5,000

1,500

45,000

15,000

4,500

Total Sales Rs.2,10,000, Sales Returns Rs.10,000 and Cash Sales Rs.40,000.

Solution:

Net Credit Sales = Total SalesSales ReturnsCash Sales

= 2,10,00010,00040,000 = Rs.1,60,000

Average Debtors

= Opening Drs + Closing Drs + Opening B/R + Closing B/R

2

= 15,000 + 45,000 + 5,000 + 15,000 = Rs.40,000

2

Debtors Turnover Ratio = Net Credit SalesAverage Trade Debtors

= 1,60,000 / 40,000 = 4 times

Creditors Turnover Ratio (or) Payables Turnover Ratio: The ratio establishes a

relationship between net credit purchases and average trade creditors. The objective of

this ratio is to determine the efficiency with which the creditors are management.

Generally, lower the ratio, the better is the liquidity position of the firm and higher the

ratio, less liquid is the position of the firm.

Creditors Turnover Ratio = Net Credit Purchases

Average Trade Creditors

Net Credit Purchases = Gross Credit PurchasesPurchases Returns

Average Trade Creditor = Opening Trade Creditor + Closing Trading Cdr.

2

Debt Payment Period (Creditors Velocity):The debt collection period represents the

average number of days for which a firm has to wait before its receivables are

converted into cash.

Debt Payment Period = Average Trade Creditors

Average Net Credit Purchases per day

= 12 months / 52 weeks / 365 weeksCreditors Turnover Ratio


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Average Net Credit Purchases per day

= Net Credit Purchases for the year

No. of working days in the year

Problem:

Calculate the Creditors Turnover Ratio and Debt Payment Period from the followinginformation.

Particulars Rs. Particulars Rs.

Cash Purchases

Opening Sundry Creditors

Closing Bills Payable

Purchases Returns

1,00,000

25,000

25,000

7,000

Total Purchases (subject to

returns)

Closing Sundry Creditors

Opening Bills Payable

4,07,000

50,000

20,000

Solution

Net Credit Purchases = Total purchasesCash purchasesPurchases Returns

= 4,07,0001,00,0007,000

= 3,00,000

Average Creditors

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

Creditors Turnover Ratio = Net Credit Purchases / Average Trade Creditors

= 3,00,000 / 60,000 = 5 times

Debt Payment Period = 12 months / Creditors Turnover Ratio

= 12 / 5 = 2.4 times

Total Assets Turnover Ratio: This ratio is the relationship between sales and total

asset. The objective is to measure the overall performance and activity of the business

organization.

Total Turnover Ratio = Sales / Total Assets

Problem

Compute Total Assets Turnover from the following particulars:

Sales Rs.3,00,000

Sales Return Rs.40,000Assets:

Fixed Assets Rs.2,00,000

Current Assets Rs.1,50,000

Solution

Total Turnover Ratio = Sales / Total Assets

= 2,60,000 / 3,50,000 = 0.74:1


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PROFITABILITY RATIOS

The primary objective of a business undertaking is to earn profit. A business needs

profit not only for its existence but also for expansion and diversification. Profits are

thus, a useful measure of overall efficiency of a business. Profitability ratios are

calculated either in relation to sales or in relation to investment.

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

Profitability Ratios

Profitability Ratios in Profitability Ratios in

Relation to Sales Relation to Investment

Gross Profit Ratio Return on Total Assets

Net Profit Ratio Return on Capital / ROI

Operating Ratio Return on Equity

Operating Profit Ratio Earnings per Share/EPS

Expenses Ratio Capitalization RatioPrice Earnings Ratio or

P/E Ratio

Gross Profit Ratio:This ratio measures the relationship between gross profit and net

sales. This ratio is calculated to know whether the business is a position to meet

operating expenses or not and how much the shareholders can get after meeting such

expenses.

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

Gross Profit = Net salesCost of goods sold

Net Sales = Gross salesSales return

Problem

From the following particulars, calculate the Gross Profit Ratio.

Particulars Rs

Opening StockClosing Stock

Purchases

Wages

Sales

Carriage Inwards

18,00022,000

46,000

14,000

80,000

4,000

Solution

Gross Profit = (Sales + Closing stock)(Opening stock + Purchases + Wages

+ Carriage Inwards)

= (80,000 + 22,000)(18,000 + 46,000 + 14,000 + 4,000)

= (1,02,000)(82,000) = Rs.20,000


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

= (20,000 / 80,000) 100 = 25%

Net Profit Ratio:This ratio measures the relationship between net profit and net sales.

The objective of this ratio is to determine the overall profitability due to various such

as operational efficiency, trading on equity, etc. The figure of net profit may be taken

either before tax of after tax.

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

Gross Profit = Net salesCost of goods sold

Net Sales = Gross salesSales return

Problem

From the following information, calculate the Net Profit Ratio.

Particulars Rs

Total sales

Sales returnCost of sales

Indirect expenses

1,20,000

6,00080,000

5,500

Solution

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

Net sales = Total salesSales return

= 1,20,0006,000 = Rs.1,14,000

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

= Rs.1,14,00085,500 = Rs.28,500

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

= (28,500 / 1,14,000) 100 = 25%

Operating Ratio:This ratio measures the relationship between operation cost and net

sales. The objective of computing this ratio is to determine the operational efficiency

with which production and /or purchases and selling operations are carried on. This

ratio indicates an average operating cost incurred on a sale of goods worth Rs.100.

Lower the ratio, greater the operating profit to cover the non-operating expenses, to

pay dividend and to create reserves and vice versa.

The Operating Costcomprises (i) cost of goods sold and (ii) other operation expenses.

For example, administrative expenses, selling and distribution expenses, interest onshort-term loan, discount allowed and bad debts.


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Operating Ratio = (Operating Cost / Net Sales) 100

Operating Cost = Cost of goods sold + Operating expenses

Problem

From the following details, calculate the Operating Ratio.

Particulars Rs

Sales

Opening stock

Purchases

Carriage Inwards

Closing stock

Depreciation

Administrative expenses

Selling expensesLoss on sale of Assets

8,50,000

99,500

5,50,500

14,000

1,54,000

20,000

1,50,000

30,0004,000

Solution

Operating Ratio= Cost of goods sold + Administrative expenses + Selling

& Distribution expenses 100

Sales


Gross profit = (Sale + Closing stock)(Opening stock + Purchases +

Carriage Inward)

= (8,50,000 + 1,54,000)(99,500 + 5,50,500 + 14,000)

= 10,04,0006,64,000

= Rs.3,40,000


= 8,50,0003,40,000 = Rs.5,10,000

Operating Ratio = 5,10,000 + 1,50,000 + 20,000 + 30,000 100

8,50,000

= (7,10,000 / 8,50,000) 100 = 83.53%

Operating Profit Ratio:This ratio measures the relationship between operation profit

and net sales. The objective of computing this ratio is to determine the operational

efficiency of the management. This ratio indicates an average profit margin earned on

sale of Rs.100 and what portion of sales is left to cover non-operating expenses, to paydividend and to create reserves. Higher the ratio, the more efficient is operation.


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

Operating Profit = Net SalesOperating Cost(Or)

= Net Sales(Cost of goods sold + Administrative and

Office expenses + Selling and Distributive expenses)

This ratio can also be calculated as:

Operating Profit Ratio = 100Operating Ratio

Problem

From the following particulars, calculate the Operating Profit Ratio.

Particulars Rs

Cost of goods sold

Administrative & Office expensesSelling & Distributive expenses

Net sales

4,00,000

35,00045,000

6,00,000

Solution

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

Operating Profit = Sales(Cost of goods sold + Administrative and

Office expenses + Selling and Distributive expenses)

= 6,00,000(4,00,000 + 35,000 + 45,000)

= Rs.1,20,000

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

Expenses Ratio:Expenses ratio indicates the relationship of various expenses to net

sales. The objective of this ratio is to provide information about increase or decrease

in expenses. Lower expense ratio is considered better for the business. The expense

ratio indicates about efficiency of the business.

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

One can also calculate separate expenses ratios, such as ratio of administrative

expenses to net sales, ratio of selling and distribution expenses to sales, financial

expenses to sales, etc.

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


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Problem:

The balance sheet of Business Ltd. As at 31stMarch 2010 is as under:




ReservesProfit & Loss A/c15% Debentures

Trade Creditors

Bills payable


Bank overdraft

Provision for tax

1,00,000

1,00,000

60,0002,40,0008,00,000

40,000

30,000

20,000

10,000

2,40,000

Land & Building

Plant & Machinery


Less: Depreciation


Stock

Debtors 3,40,000

Less: Provision 30,000

Marketable securitiesCash

Bills receivables

Prepaid expenses

Preliminary expenses


6,00,000

5,00,000

1,00,000

12,00,000

2,00,000

10,00,000

1,00,000

95,000

3,10,000

10,000

10,00010,000

5,000

60,000

40,00016,40,000 16,40,000

Net sales for the year amount to Rs.20,00,000. Calculate Return on Total Assets.

Solution

Particulars Rs

Calculation of Net Profit before Interest & TaxA.Net profit after interest & tax

B.Add:TaxC.Net profit after interest but before tax

D.Add:Interest on Debentures

E.Net profit before interest & tax

Calculation of Total Assets

A.Net Fixed Assets

B. Trade Investments

C. Current Assets

D.

Total Assets

2,40,000

2,40,000

4,80,000

1,20,000

6,00,000

10,00,0001,00,000

4,40,000

15,40,000

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

Total Assets

= (6,00,000 / 15,40,000) 100 = 38.9%

Return on Capital Employed / Return on Investment: This ratio measures the

relationship between net profit before interest and tax, and capital employed. The

objective of this ratio is to find out how efficiently the long term funds supplied by the

creditors and shareholders have been used. Generally return on capital employed istaken as return on investment. This ratio indicates the firms ability of generating


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

management in utilization of capital employed.

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

The term capital employed refers to the total of investment made in a business and

can be defined in a number of the following ways:

1. Gross Capital Employed = Fixed Assets + Current Assets

2. Net Capital Employed = Fixed Assets Current Assets

3. Proprietors Net Capital Employed

= Fixed Assets + Current AssetsOutside Liabilities (both long

term and shot term)

Problem:From the following details, Calculate Return on Capital Employed or Return

on Investment.

Particulars Rs

Share Capital

A. Equity Capital

B. Preference Capital

General Reserve

10% Debentures

Current LiabilitiesDiscount on SharesNet Profit (after debenture interest but before

income tax)

4,00,000

1,00,000

1,89,000

4,00,000

1,00,0005,00080,000

Assume the income tax rate @ 50%

Solution

Return on Investment = Net Profit before Interest and Tax 100

Capital Employed

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

Capital Employed = Equity + Preference capital + 10% Debentures +

General Reserve + ProfitDiscount on shares

= 4,00,000 + 1,00,000 + 4,00,000 + 1,89,000 + 40,000

5,000

= 11,24,000

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


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Return on Equity (or) Equity Shareholders Fund:This ratio measures the relationship

between net profit after interest and tax, and preference dividend, and equity

shareholders fund. The objective of this ratio is to find out how efficiently the funds

supplied by the equity shareholders have been used. Higher the ratio, the more isefficient management in utilization of equity shareholders fund.

Problem:

The balance sheet of Kannan Ltd. As at 31stMarch 2010 is as under:




Reserves

Profit & Loss A/c

15% DebenturesTrade Creditors

Bills payable


Bank overdraft

Provision for tax

1,00,000

1,00,000

60,000

2,40,000

8,00,00040,000

30,000

20,000

10,000

2,40,000

Land & Building

Plant & Machinery


Less: Depreciation


Stock

Debtors 3,40,000Less: Provision 30,000

Marketable securities

Cash

Bills receivables

Prepaid expensesPreliminary expenses


6,00,000

5,00,000

1,00,000

12,00,000

2,00,000

10,00,0001,00,000

95,000

3,10,000

10,000

10,000

10,000

5,000

60,000

40,00016,40,000 16,40,000

Net sales for the year amount to Rs.20,00,000. Calculate Return on Equity

Shareholders Fund.

Solution

Particulars Rs

A: Net Profit after Interest and Tax

B:Less:Preference Dividend (1,00,000 18/100)

C: Net Profit after Interest, Tax and Pref. Dividend

Calculation of Equity Shareholders FundA.Net Fixed Assets

B. Trade Investments

C.Current AssetsD. Total Assets

E.Less:Current Liabilities

F. Capital Employed

G.Less:Long-term Debt (Debenture)

H. Shareholders FundsI. Less:Pref. Share Capital

J.

Equity Shareholders Fund (HI)

2,40,000

18,000

2,22,000

10,00,000

1,00,000

4,40,000

15,40,000

3,40,000

12,00,000

8,00,000

4,00,000

1,00,000

3,00,000


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Earnings Per Share (EPS): This ratio measures the earnings available to an equity

shareholder on a per share basis. This is to measure the profitability of the firm on per

equity share basis. Higher the figure better it is and vice versa.

While interpreting this ratio, it must be seen whether there is any increase in equity

shareholders fund as a result of retained earnings without any change in number of

outstanding shares. For example, in the case of a company which is following a

practice of ploughing back of profits and which is not capitalizing its profits by way of

issue of bonus shares, the interpretation of EPS without considering the effect of

profits ploughed back in the business on earnings, will not be appropriate.

Earnings per Share (EPS)

= Net Profit after Interest, Tax, and Preference Dividend

No. of Equity Shares

Problem

Calculate earnings per share from the following data:

Particulars Rs

10,000 Equity shares of Rs.10 each10,000 10% Preference shares of Rs.10 each

Net Profit before paying dividend to Pref. shares

1,00,0001,00,000

40,000

Solution

Particulars Rs

Net Profit as per P&L A/c

Less:Dividend to Preference shareholders 10%

Balance of profit available to equity shareholders

40,000

10,000

30,000

Earnings per Share (EPS)

= Net Profit after Dividend on Preference Shares

No. of Equity Shares

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

Capitalization Ratio: This ratio measures the relationship between market price and

earnings per share. If market price is taken along with dividend received, this is

known as Dividend Yield Ratio. Only change is that in place of earnings per share,dividend per share is written.

Capitalization Ratio = Earnings per Share 100

Market Price per Share

Dividend Yield Ratio = Dividend per Share 100Market Price per Share


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Problem:From the following data, calculate Dividend Yield Ratio:

10,000 Equity Shares of Rs.100 each

Dividend paid during the year 20%Market Price per share Rs.120

Solution

Dividend Yield Ratio = Dividend per Share 100


= 20 100 = 16.67%120

Price Earnings Ratio (or) P/E Ratio (Earnings Yield Ratio): This ratio measures the

relationship between market price per equity share and earnings per share. The

objective of this ratio is to make an estimate of appreciation in the value of a share of

a company and is widely used by investors to decide whether or not to buy shares in a

particular company. Higher the price-earnings ratio, the better it is. If the P/E ratio

falls, the management should look into the causes.

Price Earnings Ratio = Market Price per Equity

Earnings per Share

Earnings Yield Ratio = Earnings per Share 100


Problem: The market price of a share of Rs.10 is Rs.50. The profits available forequity shareholders are Rs.2,00,000 and number of equity shares is 50,000. Calculate

Earnings per Share and Earnings Yield Ratio.

Solution:

Earnings per Share = Profits available for equity shareholders

No. of equity shares= 2,00,000 / 50,000 = Rs.4 per share

Earnings Yield Ratio = Earnings per Share 100


= (Rs.4 / Rs.50) 100 = 8%

Problem:The capital of Star Company Ltd is as follows:

Particulars Rs

80,000 Equity shares of Rs.10 each

30,000 9% Preference shares of Rs.10 each

8,00,000

3,00,000

11,00,000


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The following information has been obtained from the books of the company:

Particulars

Profit after tax at 60%

Depreciation

Equity dividend paidMarket price of equity share

Rs.2,70,000

Rs.60,000

20%Rs.40

You are required to calculate the price earnings ratio.

Solution

Price Earnings Ratio = Market Price per Equity

Earnings per Share

= 40 / 3.04 = 13.1:1

SUMMARY OF RATIOS & FORMULAS

Liquidity Ratios:

Short-term financial position (or) Test of liquidity

1) Current RatioCurrent Assets

Current Liabilities

2) Quick or Acid Test orLiquid Ratio

Liquid/Quick AssetsCurrent Liabilities

3) Absolute Liquid RatioAbsolute Liquid Assets

Current LiabilitiesSolvency Ratios:

Analysis of Long-term financial position (or) Test of solvency

1) Debt-Equity Ratio

Outsiders Funds

Shareholders Funds

(Or)

External Equities

Internal Equities

2) Funded Debt to Total

Capitalization Ratio

Funded Debt 100


3) Proprietary or Equity

Ratio

Shareholders Fund

Total Assets

4) Interest Coverage Ratio Net Profit before Interest and TaxesInterest on Long-term Debt

5) Cash to Debt Service

Ratio

Annual Cash Flow before Interest and Taxes

Interest + Sinking Fund Appropriation on Debt

1Tax rate

6) Capital Gearing Ratio

Equity Share Capital + Reserve & Surplus

Preference Capital + Long term debt bearing

fixed interestActivity Ratios:These ratios measure the efficiency with which a firm manages its resources/assets

1) Capital Turnover RatioSales or Cost of sales

Capital Employed


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2)

Fixed Assets Turnover

Ratio

Cost of goods sold

Net total fixed assets

3) Working Capital

Turnover Ratio

Net sales or Cost of goods sold

Working Capital Net Working Capital

4)

Stock Turnover RatioCost of goods sold

Average Inventory

5) Debtor Turnover RatioNet Credit Sales

Average Trade Debtors

6)

Creditor Turnover RatioNet Credit Purchases

Average Trade Creditors

7) Total Assets Turnover

Ratio

Sales

Total AssetsProfitability Ratios:These ratios measure the profit earning capacity of the company.

(a)

Profi tabili ty Ratios in r elation to Sales:1) Gross Profit Ratio

Gross Profit 100

Net Sales

2)Net Profit RatioNet Profit 100

Net Sales

3) Operating RatioOperating Cost 100

Net Sales

4) Operating Profit RatioOperating Profit 100

Net Sales

5) Expenses RatioParticular Expense 100

Net Sales(b)Profi tabili ty Ratios in relation to I nvestment:

1) Return on Total AssetsNet Profit before Interest and Taxes 100

Total Assets

2) Return on Capital

Employed / Return onInvestment

Net Profit before Interest and Taxes 100

Capital Employed

3) Return on ShareholdersFund / Return on Equity

Shareholders Fund

Net Profit after Interest, Tax, and Pref.Dvnd 100

Equity Shareholders Fund

4)

Earnings Per Share (EPS) Net Profit after Interest, Tax, and Pref.Dvnd 100No. of Equity Shares

5) Capitalization RatioEarnings per Share 100

Market price per share

6) Price-Earnings Ratio

(P/E Ratio)

Market price per share 100

Earnings per Share


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CASH FLOW (AS PER ACCOUNTING STANDARD 3)

Cash plays a very important role in the entire economic life of a business. It is very

essential for a business to maintain an adequate balance of cash. But many times a

concern operates profitably and yet it becomes very difficult to pay taxes and

dividends. This may be because (i) although huge profits have been earned yet cashmay not have been received or (ii) even if cash has been received; it may have drainedout i.e. used for some other purposes. This movement of cash is of vital importance of

the management.

A statement of changes in the financial position of firm on cash basis is called a cash

flow statement. Such a statement enumerates net effects of the various business

transactions on cash and takes into account receipts and disbursements of cash. A cash

flow statement summarizes the causes of changes in cash position of a businessenterprise between dates of two balance sheets. The term cash here stands for cash and

bank balances.

Uses of Cash Flow Statement

A Cash Flow Statement is of primary importance to the financial management. It is

an essential tool of short-term financial analysis. Its main uses are as follows:

1. Cash Flow Statement facilitates to prepare sound financial policies. It also

helps to evaluate the current cash position.

2. A projected Cash Flow Statement can be prepared in order to know the future

cash position of a concern so as to enable a firm to plan and coordinate its

financial operations properly.

3.

It helps in taking loan from Banks and other financial institutions. Therepayment capacity of the firm can be understood by going through the Cash

Flow Statement.4. It helps the management in taking short-term financial decisions.

5. Cash is the soul and heart of the business. Cash is pivot of all business

activities.

6. The statement explains the causes for poor cash position in spite of substantial

profits in a firm by throwing light on various applications of cash made by the

firm.

Advantages of Cash Flow Statement

Helps in Efficient Cash Management

Helps in Internal Financial Management

Disclose the movement of Cash

Discloses Success or Failure of Cash Planning

Helpful in Declaring Dividends etc.

Disadvantages of Cash Flow Statement

o Ignores Basic Principle of Accountingo

Not Suitable for Judging Profitability

o

Cannot be equated with Income Statemento

May not Represent Real Liquid Position


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DISTINCTION BETWEEN FUND FLOW AND CASH FLOW STATEMENT

Basis of

DifferenceFunds F low Statement Cash F low Statement

1) Object

Its object is to help in providing

information relating to firms

ability to meet its long termliabilities.

Its object is to provide the

firms ability to meet its shortterm liabilities.

2) Dependence

Funds flow statement can be

prepared if cash flow statement

is there.

Cash flow statement is

prepared only when schedule

of changes in working capital

along with funds flow

statement is there. Thus, it is

dependent.

3) Nature of

Statement

It deals with the changes in

working capital.

It deals with the changes in

cash position only.

4) Opening

BalanceThere is no such balance.

There is always cash openingbalance (or) it is prepared with

the opening balance of cash in

hand.

5) Difference

of Sides

Difference of both the sides of

funds flow statement is either

the increase or decrease in

working capital.

Difference of both the sides of

cash flow statement is the

closing balance or cash.

6) Additional

Statement

Whenever funds flow statement

is prepared an additional

statement in the name of

schedule showing changes in

working capital is also

prepared.

No additional statement isprepared when cash flow

statement is prepared.

7) PlanningFund flow is helpful in long

term planning.

Cash flow is useful in short

term planning.

8) Period It is prepared for longer period.It is prepared for shorter

period.

Cash Flow Statement as per Accounting Standard 3 (Revised)

The Institute of Chartered Accountants of India has issued in 1997 the Accounting

Standard AS-3 (revised) relating to cash flow statement which has superseded AS-3

issued earlier. As per recent proposed format issued by the SEBI it is mandatory foreach company to give a copy of its cash flow statement along with a copy of its final

accounts.

The cash flow statement can be classified into following activities:

1) Operating Activities

2)

Investing Activities3) Financing Activities


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A single transaction may include cash flow that is classified differently. For example,

when the installment paid in respect of a fixed asset, acquired on deferred payment

basis includes both interest and loan. The interest element is classified under financingactivities and the loan element is classified under investing activities.

1. Cash F low f rom Operating Activities: Cash flows from operating activities are

primarily derived from pre-revenue producing activities of the enterprise.

Examples of cash flows from operating activities are:

(a)Cash receipts from the sale of goods and the rendering of services;

(b)Cash receipts from royalties, fees, commissions and other revenue;

(c)Cash payments to suppliers for goods and services;

(d)Cash payments to and on behalf of employees;

(e)Cash receipts and cash payments of an insurance enterprise for premiums

and claims, annuities and other policy benefits;

(f)

Cash payments or refunds of income taxes unless they can be specifically

identified with financing and investing activities; and

(g)Cash receipts and payments relating to futures contracts, forward contracts,

option contracts and swap contracts when the contracts are held for dealing

or trading purposes.

2. Cash F lows fr om Investing Activities: These include activities on which

expenditure has been incurred for resources intended to generate future incomeand cash flows. Examples of such activities are:

(a)Cash payments to acquire fixed assets (including intangibles). These

payments include those relating to capitalized research and developments

costs and self-constructed fixed assets;

(b)Cash receipts from disposal of fixed assets (including intangibles);

(c)Cash payments to acquire shares, warrants or debt instruments of others

enterprises and interests in joint ventures (other than payments for those

instruments considered to be cash equivalents and those held for dealing or

trading purposes);

(d)Cash receipts from disposal of shares, warrants or debts instruments of

other enterprises and interest in joint ventures (other than receipts from

those instruments considered to be cash equivalents and those held fordealing or trading purposes);

(e)Cash advances and loans made to third parties (other than advances and

loans made by a financial enterprise);

(f)Cash receipts from the repayment of advances and loans made to third

parties (other than advances and loans of a financial enterprise);

(g)Cash payments for future contracts, forward contracts, option contracts andswap contracts excepts when the contracts are held for dealing or trading

purposes, or the payments are classified as financing activities; and

(h)

Cash receipts from future contracts, forward contracts, option contracts and

swap contracts except when the contracts are held for dealing or tradingpurposes, or the receipts are classified as financing activities.


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3.

Cash f lows fr om Financing Activiti es: These include providers of funds (both

capital and borrowings) to the enterprise. Examples of such activities are:

(a)Cash proceeds from issuing shares or other similar instruments;(b)

Cash proceeds from issuing debentures, loans, notes bonds and other short

or long-term borrowings; and

(c)Cash repayments of amounts borrowed.

PREPARATION CASH FLOW STATEMENT

There are two methods of preparing cash flow statement:

1) Traditional Method:The traditional method does not have any standard format.

There is no classification of inflow and outflow under operation, investment

and finance activities, separately.2) Preparing Under AS-3: The basic difference from traditional method is

presentation of cash flow statement. There are two methods of reporting cash

flow from operating activities: (i)Direct Methodand (ii)Indirect Method

Problem (Traditional Method):

Balance Sheets of A and B are as follows:

BALANCE SHEETS

LIABILITIES1.1.2008

Rs.

31.12.2008

Rs.ASSETS

1.1.2008

Rs.

31.12.2008

Rs.

Creditors

Mrs. As Loan

Loan form Bank

Capital

40,00025,000

40,000

1,25,000

44,000---

50,000

1,53,000

CashDebtors

Stock

Machinery

Land

Building

10,00030,000

35,000

80,000

40,000

35,000

7,00050,000

25,000

55,000

50,000

60,000

2,30,000 2,47,000 2,30,000 2,47,000

During the year a machine costing Rs.10,000 (accumulated depreciation Rs.3,000)

was sold for Rs.5,000. The provision for depreciation against machinery as on1.1.2008 was Rs.25,000 and on31.12.2008 Rs.40,000. Net profit for the year 2008amount to Rs.45,000.

You are required to prepare Cash Flow Statement.


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Interest expenses

Other expenses

Net Income

(6,000)

(22,000)

4,000

Comparative Balance Sheet Data2008 (Rs) 2009 (Rs)

Current Assets

Cash

Debtors (net)

Stock in handNon-current Assets

Plant and Machinery

Less: Accumulated Depreciation

Total Assets

Liabilities

Creditors

Non-current notes payable

Less: Discount on notes

Owners Equity


Retained Earnings

20,000

12,000

16,000

24,000

(8,000)

64,000

12,000

20,000

(1,600)

30,400

24,000

9,600

33,600

16,000

7,000

14,000

20,000

(4,000)

53,000

14,000

20,000

(2,000)

32,000

14,000

7,000

21,000

Solution: Direct Method

Z L td.

Cash F low Statement f or the year ended 31stDecember 2009 [AS-3 (revised)]

Rs Rs

Cash Flows from Operating ActivitiesCash receipts from customers

Cash paid to suppliers and employees

Net Cash from Operating ActivitiesCash Flows from Investing Activities

Purchase of Plant and MachineryNet Cash used in Investing Activities

Cash Flows from Financing ActivitiesProceeds from issue of share capital

Interest paid

Dividends paid

Net Cash from Financing Activities

Net Increase in Cash and Cash Equivalents

Cash and Cash Equivalents at the beginning of the periodCash and Cash Equivalents at the end of the period

79,000

(73,600)

(4,000)

10,000

(6,000)

(1,400)

5,400

(4,000)

2,600

4,000

16,000

20,000


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Worki ng Notes:

1) Dividends Paid have been calculated as under:

Retained earing at the beginningAdd:Net Income

Less:Retained earnings at the end

2) Calculation of Cash Receipts from Customers:

Revenues

Add:Debtors in the beginning

Less:Debtors at the end

3) Calculation of Cash Paid to Suppliers and Employees:

Cost of goods soldOther expenses [22,000400 (discount on sale)]Add:Creditors in the beginning

Inventories at the end

Less:Creditors at the endInventories at the beginning

7,000

4,000

11,000

9,600

1,400

84,000

7,000

91,00012,000

79,000

48,00021,600

14,000

16,000

(12,000)

(14,000)

73,600

Indirect Method: [As per AS-3 (revised)]

Under the indirect method, net profit is taken as base and is adjusted instead of

individual items appearing in the profit and loss account to arrive at cash fromoperations.

Net profit or loss is adjusted for the following:1)Non-cash items such as depreciation, writing off goodwill and preliminary

expenses, etc.

2) Changes in inventories, operating receivables and payable during the period.

3) All other items which affect cash included in financing and investing activities

such as loss/gain on sale of fixed assets and loss/gain on sale of investments,

etc.

Problem: Balance Sheets of A and B are as follows:BALANCE SHEETS

LIABILITIES1.1.2008

Rs.

31.12.2008

Rs.ASSETS

1.1.2008

Rs.

31.12.2008

Rs.

Creditors

Mrs. As Loan

Loan form Bank

Capital

40,00025,000

40,000

1,25,000

44,000---

50,000

1,53,000

CashDebtors

Stock

Machinery

Land

Building

10,00030,000

35,000

80,000

40,000

35,000

7,00050,000

25,000

55,000

50,000

60,000

2,30,000 2,47,000 2,30,000 2,47,000


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During the year a machine costing Rs.10,000 (accumulated depreciation Rs.3,000)

was sold for Rs.5,000. The provision for depreciation against machinery as on

1.1.2008 was Rs.25,000 and on31.12.2008 Rs.40,000. Net profit for the year 2008

amount to Rs.45,000. You are required to prepare Cash Flow Statement.

Solution:

CASH FLOW STATEMENT (Indirect Method)

[As per AS-3 (Revised)]

1. Cash F lows from Operating Activities:

Net Profit made during the year

Adjustment for depreciation

Loss on sale of machinery

Operating profit before working capital

changes

Decrease in StockIncrease in Creditors

Increase in Debtors

Net Cash Flow from Operating

Activities

2. Cash F lows from I nvesting Activities:

Sale of Machinery

Purchase of Land

Purchase of Building

Net Cash Flow from InvestingActivities

3.Cash F lows fr om Financing Activities:

Loan from Bank

Mrs. As Loan repaid

Drawings

Net Cash Flow from Financing

Activities

Net Increase (Decrease) in cash and cash equivalentCash and Cash equivalent at the beginning of the

year

Cash and Cash equivalent at the end of the year

Rs.

45,000

18,000

2,000

65,000

10,000

4,000

(20,000)

5,000

(10,000)

(25,000)

10,000

(25,000)

(17,000)

Rs.

59,000

(30,000)

(32,000)

(3,000)10,000

7,000

Notes:

1. Cash comprises cash in hand and demand deposits

2. Cash equivalents are short-term highly liquid investments that are readily

convertible into known amounts of cash and which a

Documents

Accounting for Management_unit i