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1MODULE -I
1
BASICS OF BALA NCE SHEET A ND
PROFIT A NDL O S SA C C O U NT
Unit structure:
1.1 Objectives
1.2 Introduction
1.3 Meaning and Types of Financial Statements
1.4 Parties Interested In Financial Statements
1.5 Basics of Income Statement and Balance Shee t
1.6 Limitation of financial statement
1.7 Exercise
1.1 OBJECTIVE
After studying the unit, the students will be able to -
Understand the meaning and types of financial statement.
Know the parties interested in Financial statements
Understand the object ives of Financial statements
Explain the basics of Financial statements
1.2 INTRODUCTIO N
Government legislations require certain organizations to maintain
proper accounts and draw financial statement. Public can understand from the
financial statement th e extent to which a company is discharging its social
responsibilities. While issuing shares, bonds, financial statement
become necessary as prospective investors can judge the financial
position of the organization and able to take a proper decision. Work ers
union may study the financial statement and ascertain whether they can
enforce their demand. Tax legislature makes it obligatory for the business
entities to draw fair and objective financial statement. The financial statement
serves as instruments to regulate equity and debentures issued by companies.
1.3 MEA NINGANDT Y P E SO FF I NANCIAL
STATEME NTS
Meaning:
Financial statements are plain statements based on historical
records, facts and figures. They are uncompromising in their objectives,munotes.in
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2nature and truthfulness. They reflect a judicious combination of recorded facts,
accounting principles, concepts and conventions, personal judgements and
sometimes estimates.
Financial statements consist of ‘Revenue Account’ and ‘Balance
Sheet’.
1.Revenue Account / I ncome Statement:
Revenue Account refers to ‘Profit and Loss Account’ or ‘Income
and Expenditure Account’ or simply ‘Income Statement’. Revenue Account
may be split up or divided into ‘Manufacturing Account’, ’Trading
Account’, ’Profit and Loss Account’ and ‘Profit and Loss Appropriation
Account’, Revenue Account is prepared for ap e r i o d ,c o v e r i n go n ey e a r .T h i s
statement shows the expenses incurred on production and distribution of the
product and sales and other business incomes. The final result of this
statement may be profit of loss for a particular period.
2.Balance Sheet:
Balance sheet shows the financial position of a business as on a
particular date. It represents the assets owned by the business and the claims
of the owners and creditors against the assets in the form of liabilities as on
the date of the statement.
3.Funds Flow Statement –
It describes the sources from which the additional funds were
derived and the use of these funds. Funds flow statement helps to
understand the changes in the distrib ution of resources between two balance
sheet periods. The statement reveals the sources of funds and their
application for different purposes.
4.Cash flow Statement:
A cash flow statement shows the changes in cash position from one
period to another. It sho ws the inflow and outflow of cash and helps the
management in making plans for immediate future. An estimated cash flow
statement enables the management to ascertain the availability of cash to meet
business obligations. This statement is useful for short term planning by the
management.
5. Schedules:
Schedule explains the items given in income statement and
balance sheet. Schedules are a part of financial statements which give
detailed information about the financial position of a business organization.
1.4 PARTIES I NTERESTED I NFINANCIAL
STATEME NTS
In recent years, the ownership of capital of many public companies
has become truly broad based due to dispersal of shareholding. Therefore,
one may say that the public in general has become interested in fin ancialmunotes.in
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3statements. However, in addition to the share holders, there are other persons
and bodies who are also interested in the financial results disclosed by the annual
reports of companies. Such persons and bodies include:
1.Creditors, potential suppliers or others doing business with the
company;
2.Debenture -holders;
3.Credit institutions like banks;’
4.Potential Investors;
5.Employees and trade unions;
6.Important customers who wish to make a long standing contract with the
company;
7.Economists and investment analy st;
8.Members of Parliament, the Public Accounts Committee and the
Estimates Committee in respect of Government Companies;
9.Taxation authorities;
10.Other departments dealing with the industry in which the
company is engaged; and
11. The Company Law Boa rd
Financial Statement analysis, therefore, has become of general
interest.
1.5 OBJECTIVES OF FI NANCIAL STATEME NTS
The main object of financial statements is to provide information
about the financial position, performance and changes taken place in an
enterprise. Financial statements are prepared to meet the common needs of
most users. The important objectives of financial statements are given below:
1. Providing information for taking Economic decisions:
The economic decisions that are taken by users of financial statements
require an evaluation of the ability of an enterprise to generate cash and cash
equivalents and of the timing and certainty of their generation. This ability
ultimately determines the capacity of an enterprise to pay its employees a nd
suppliers meet interest payments, repay loans and make distributions to its
owners.
2.Providing information about financial position:
The financial position of an enterprise is effected by the economic
resources it controls, its financial structures its liquidity and solvency
and its capacity to adapt to changes in the environment in which it operates.
Information about financial structure is useful in predicting future
borrowing needs and how future profits and cash flows will be distributed
among those with an interest in the enterprise. This information is useful in
predicting how successful the enterprise is likely to be in raising furthermunotes.in
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4finance. Information about liquidity and solvency is useful to predicting the
ability of the enterprise to meet the financial commitments as fall due.
3.Providing information about performance(working results) of an
enterprise:
Another important objective of the financial statements is that it
provides information about the performance and in particular its
profitabil ity, which requires in order assessing potential changes in the
economic resources that are likely to control in future. Information about
performance is useful in predicting the capacity of the enterprise to
generate cash inflows from its existing resourc ebase as well in forming
judgment about the effectiveness with which the enterprises might
employ additional resources.
4. Providing Information about changes in financial position:
The financial statements provide information concerning changes in
the financial position of an enterprise, which is useful in order to assess its
investing, financing and operating activities during the reporting periods.
This information is useful in providing the user with a basis to assess the
ability of the enterprise to generate cash and cash equipments and the
needs of the enterprise to utilize those cash flows.
1.6 BASICS OF I NCOME STATEME NTANDB A L A NCE
SHEET
Each business firm has to prepare two main financial statements viz.
Income Statement and Balance sheet. The i ncome statement reveals the profit
of loss during a particular period generated from the activities of a
business. Balance sheet shows the financial position of a business on a
particular date.
Income statement
Income statement summaries the incomes /gain sa n d expenses
/losses of a Business for a particular financial period. The format of Income
statement explains in detail the items to be included in the statement. It
ispresented in the traditional T Format and also in the vertically statement form.
1.Horizontal Form T form Manufacturing Trading and Profit and Loss
Account For the year ending
Dr. Cr.
Particulars Rs. Particulars Rs.
To Opening stock By Closing stock
Raw materials Raw Material
Work in progress Work in progress
To Purchase of raw
materialsBy Cost of finished
goods c/d
To Manufacturing wages By Salesmunotes.in
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5To Carriage/ Freight
inwardsBy Closing stock of
Finished Goods
To Custom duty By Gross Loss c/d
To Other factory Expenses By Gross profit b/d
To Opening stock By Business incomes
and Gains
Finished Goods By Net Loss c/d
To Cost of finished By Balance b/d from
Previous year
Goods b/d By Net Profit b/d
To Gross profit c/d
To Gross loss b/d
To Office and
administration Expenses
To Interest and financial
Expenses
To Provision for Income
tax
To Net Profit c/d
To Net loss b/d
To Transfer toGeneral
reserve
To Dividend
To Balance c/f
Particulars Rs. Rs.
Gross Sales xxx
Less : Sales returns xxx
Sales tax / Excise du ty
Net Sales xxx
Less : Cost of goods sold
(Materials consumed +
Direct Labour+
Manufacturing Expenses)xxx
xxx
xxx
Add / Less : Adjustment for change in stock xxx xxx
Gross Profit xxx
Less : Operating expenses xxx
a.Office and administration Expenses xxx
b.Selling and distribution Expenses xxx xxx
Add : Operating Income xxx
Operating Profit xxxmunotes.in
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6Add : Non Operating Income xxx
Less : Non Operating expenses (including
interest)xxx
Profit before interest and tax xxx
Less : Interest xxx
Profit before tax xxx
Less : Appropriations: xxx xxx
a.Transfer to reserves xxx xxx
b.Dividends declared / paid xxx
Surplus carried to Balance Sheet xxx
Balance sheet:
It is one of the major financial statements which presents a company's
finan cial position at the end of a specified date. Balance sheet has been
described as a "snapshot" of the company's financial position at a moment
for e.g. the amounts reported on a balance sheet dated March 31st,2 0 1 6
reflects that all the transactions throug hout December 31sthave been
recorded. The balance sheet provides information related to the assets,
liabilities and the shareholders’ equity of the company as on a specific date.
Total Assets = Total Liabilities + Share holders’ equity
The companies Act, 1956 stipulates that the balance sheet of a joint
stock company should be prepared as per Part I of Schedule VI of the Act.
However, the statement form has been emphasized upon by accountants for the
purpose of analysis and interpretation.
Understanding Corporate Balance Sheet: A.
Assets side:
1. Fixed Assets:
Fixed Assets are called long -term assets. These assets are used over
several periods. They are major sources of revenue to the business. They are
intended for long term use in the business. They are called “bundle of future
services” or “Sunk Costs”. The group of fixed assets is explained in the
proforma. Generally the Fixed assets are classifies as:
a)Tangible movable assets;
b)Tangible immovable assets; and
c) Intangible assets.
a)Tangible movable assets are the assets which can be seen, touched and
moved from one place to another place. Plant and Machinery, furniture
and fixtures, transportation equipments etc. are tangible movable
assets.munotes.in
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7b)Tangible immovable assets are the assets which can be seena n d
touched but cannot be moved from one place to another place. Such
assets include land, buildings, mines, oil wells, etc.
c) Intangible assets are the assets which cannot be seen and touched.
However, their existence can only be imagined such as pate nts,
trademarks, copyrights, goodwill, etc.
The Fixed Assets are presented as:
Gross Block -Provision for Depreciation = Net Blocks
2. Investments:
Investments may be short -term or long term. Short -term investments
are marketable securities and they rep resent temporary investments of
idle funds. These investments can be disposed off by the company at any
time. Investments are shown at cost. Cost includes brokerage, fees and all
other expenses incurred on acquisition of investments. However, the market
value is shown by way of a note.
Long -term investments are held for a long time. They are required
to be held by the business by the very nature and conditions of the
business. For example, a company engaged in generating electricity may be
required to hold the bonds of the Electricity Board. These bonds are
retained by the company so long as the company uses electric power.
As per Schedule VI of the Indian Companies Act 1956, investments
are shown separately, showing the nature of investments and the
mode of valuation of various classes of securities.
Long term Investments are grouped under fixed assets and short term
investments under current assets.
3.Current Assets, Loans and Advances:
The item, “Current Assets, Loans and Advances” is divided into two
parts:
a.Current Assets, and
b.Loans and Advances.
a.Current Assets and Quick assets:
“Current Assets include cash and the other assets that are likely to
be converted into cash and the cash thus generated is available to pay
current liabilities. Current asset sa r en o ti n t e n d e d for long -term use in
business. Current assets represent employment of money by the company
on a short -term basis. They circulate within the group. For example, cash
becomes raw material when material is purchased, material becomes
finish edgoods, finished goods become cash or debtors when sold and so
on.
Current Assets = Stock + Debtors + Cash & Bank + Loans &
Advances + Marketable Securities + Other Current Assets
In fact, total current assets are known as “Gross Working Capital”.
Curre nt assets less current liabilities are known as ‘net working capital’.munotes.in
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8Quick Assets are known as ‘near cash’ assets. In other words,
quick assets are those which can be converted into cash quickly. Therefore,
they are also known as liquid assets. Cash and bank balances are the most
liquid assets. Debtors and cash advances can be converted into cash at a
short notice. Therefore, they are also regarded as quick assets. Marketable
investments can be converted into cash, fall into the category of quick assets.
Inventory does not fall in this category of quick assets, since it cannot be
converted into cash quickly, as material is to be converted into
finished goods and then they should be sold. Expenses paid in advance do
not satisfy the criteria of quick assets. They cannot be converted into cash.
They can be received in the form of services.
Therefore Quick Assets = Current Assets –Inventory –Prepayments
b.Loans and Advances:
Loans and advances given are current assets. It includes different
types of advances such as advances against salary, advances against
machinery, advances to subsidiary, prepaid expenses on account of rent,
taxes, insurance, etc.
4. Miscellaneous Expenditures and losses:
This heading covers Fictitious Assets and other expenses which are
made for future on a mass basis. These expenses are really not assets but
the whole balance on the account of these items is not charged to current
year’s Profit and Loss A/c therefore the amount to the extent not written
off or adjusted is shown on the Ass ets side as Miscellaneous
expenditures.
Theexamples of fictitious assets are:
a.Preliminary expenses.
b.Brokerage on issue of shares and debentures.
c.Discount on issue of shares and debentures.
d.Share or debenture issue expenses.
e.Heavy Advertisement and Public ity expenditure.
f.Profit and Loss A/c debit balance.
Liquidity means easy convertibility into cash. Though
ultimately all assets are converted into cash, the term liquidity refers not
only to the nature of assets but also to the purposes of holding the ass ets.
Assets are normally arranged in order of permanency i.e., from least liquid
to most liquid.
B. Liabilities Side
The term ‘liability’ when used in accounting, means a debt. A debt is
something that a person or an organization owes to another person or
organization. In other words, Liabilities are the claims of outsiders against the
business. Technically speaking, all liabilities shown in a balance sheet are
claims against all assets shown in it. But, there may be certain cases where
al i a b i l i t yh a sac laim against a specific asset. Even under such
circumstances, the liabilities are shown separately, not as a deduction from
the specific assets.munotes.in
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9Classification of Liabilities:
The liabilities of an enterprise may be classified into three
categories
1.Permane nt Funds or Proprietors’ Funds.
2.Semi -permanent Funds or Long -term Borrowings.
3. Current liabilities and Provisions.
1. Proprietor’s Funds:
These are the funds provided by the proprietors (owners) or the
shareholders. Proprietors’ fund represents the inte rest of the proprietors in the
business. This is the amount belonging to the proprietors. Proprietors’ fund is
also called as ‘Proprietors’ Equity’, ‘Owners’ Funds’, or ‘Shareholders’
Funds’. This is also known as the ‘Net Worth’ of the business. Owners’
Equity refers to the claim of the owners it includes:
Owners’ Equity = Capital (May be Equity Share Capital only or Equity
and Preference Share Capital) + Reserves + Profit and Loss A /c credit
balance –Accumulated losses and Fictitious assets.
Owners’ e quity increase either through fresh investments by
the owners or by way of increasing the earnings retained i.e., profits not
distributed. (Retained earnings are that part of the total earnings which have
been retained for use in the business)
a. SHARE CA PITAL:
Share capital is the amount that is raised by a company
from the public at large, through the issue of shares. There are different
concepts of share capital from the legal and accounting points of view.
The following chart details the different conc epts of capital :
Company’s Share Capital
munotes.in
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10i.Authorised Capital : Authorised Capital is the maximum capital a
company can raise as mentioned in the Memorandum of Association
under its Capital Clause.
ii.Issued Capital : A company usually does not need t he entire registered
capital. Issued capital is that part of the Authorised capital; which is
actually offered to the prospective investors for subscription. The balance of
the Authorised capital which is not issued is called the ‘unissued
capital.’
iii.Subsc ribed Capital : Subscribed capital is that part of the issued
capital which has been subscribed or taken up by the public.
Therefore, the subscribed capital may be equal to or less than the
issued capital.
Called up Capital Uncalled Capital: The company, therefore, may collect
the capital in several instalments as per its need. The called -up capital is that
portion of the subscribed capital which has been called or demanded by the
company to be paid. The capital that is not demanded from the
shareholders i s called uncalled capital.
iv.Paid up Capital: Paid up capital is that part of the called up capital
which has been actually paid by the members. The paid -up capital is the
called -up amount less calls not paid. (Calls unpaid or calls -in-arrears).
v.Reserve Ca pital : It is that part of the uncalled capital which may only
be demanded on winding up or liquidation, but not when the company
is a going on. A company may determine this amount by a Special
Resolution.
b. RESERVES A NDS U R P L U S :
Ab u s i n e s sm a yh a v et om eet certain compulsory or
voluntary, foreseen or unforeseen, recurring or non -recurring obligations
in future. It is advantageous to for the organization to make provision in
advance to meet them. If not sudden payment may adversely affect the
financial he alth of the company. In order to avoid such situations some
part of profit are retained in each year which is termed as ‘Retained
Earnings’ or ‘Plough Back of profits’. It means the reserves represent
amounts set aside out of divisible profits. They are ap propriations of
profits. Indian Companies Act requires every company to transfer a
specific percentage (upto 10%) of the profits to “Reserve” accounts.
Reserve created for a specific purpose is called as a “Specific
Reserve” and a reserve created for a ge neral purpose is called as a
“General Reserve.” General reserves are free and can be utilized for
Payment of Dividends, Development and expansion purpose or for any other
purpose the company thinks proper.munotes.in
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11According to Companies Act “Reserve shall not i nclude any amount
written off by way of providing for depreciation, renewals or diminution in
value of assets or retained by way of providing for any known liability.”
It is compulsory for the business organization to disclose each
individual head of the reserves in the balance sheet with its opening balance
as per last balance sheet, additions thereto and deductions there from in the
current yare.
2.LONG-TERM LIABILITIES:
A company raises finance either from owners or through external
borrowings. External borrowings of a company which constitute its
“owed funds” are important sources of long -term finance. These
borrowings are termed as ‘fixed liabilities’ or ‘term liabilities’ or ‘long
term-loans’. They may take various forms such as debentures, public
depo sits, bank loans, deferred payments, etc. They may be fully secured
or partly secured or unsecured.
3.CURRE NTL I A B I L I T I E SA NDP R O V I S I O NS:
a.Current Liabilities:
Current liabilities are those short -term obligations of an enterprise
which mature within one yea r or within the operating cycle. They
constitute short -term sources of finance. It includes Sundry Creditors,
Bills Payable, Interest accrued but not due, outstanding expenses, Unclaimed
dividends and Bank Overdraft.
These liabilities are not normally sec ured and no interest is payable on
them with the exception of bank overdrafts. These liabilities, are generally
paid off by utilizing current assets or by creating a current liability.
Actually all current liabilities are payable within a short period
oftime. However, Bank Overdraft is the current liability which is not paid
immediately or in a very short -time, in practice. Therefore, Bank Overdraft
is not considered as a quick liability. It is a permanent arrangement with
the banker. Hence
Quick Liabili ties = Current Liabilities –Bank Overdraft
b.Provisions:
‘Provision’ means any amount retained by way of providing for any
known liability of which the amount cannot be determined with substantial
accuracy. Provisions have to be made for maintaining the in tegrity of
assets or for known liabilities. Although the amount of liability is not
certain organization has to made provision on best estimates. The
examples of provisions are Provision for depreciation on assets, Provision
for doubtful debts, Provision f or proposed dividends, Provision for
taxation.munotes.in
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124. CO NTINGENTL I A B I L I T I E S :
According to ICAI, Contingent liability refers to an obligation relating
to an existing condition or situation which may arise in future depending
on the occurrence or non -occurren ce of one or more uncertain future events.
These liabilities may or may not be converted into actual liabilities at some
future date. It is a liability which may or may not occur. But on the date of
the Balance Sheet, it is not known definitely whether the liability would
arise or not. But as a matter of caution, it is indicated in the balance sheet
for the sake of information and disclosure, under the head “Contingent
Liabilities. Some of the examples of Contingent Liabilities are
Discounted Bills of Excha nge, Disputed liability on account of
income -tax, etc., about which appeal has been filed, Uncalled amount
on partly paid -up shares and debentures held by the company as
investments, Cumulative preference dividend in arrears, Matters referred
to arbitratio n, Claims not acknowledged as debts, Estimated amount of
contracts remaining to be executed on capital account and not provided for,
Guarantees given by the company, Bonds executed. and debentures held
by the company as investments, Cumulative preference d ividend in arrears,
Matters referred to arbitration, Claims not acknowledged as debts,
Estimated amount of contracts remaining to be executed on capital account
and not provided for, Guarantees given by the company, Bonds executed.
Following are the profo rma of the Balance sheet
1) Horizontal Form:
Liabilities Rs Assets Rs
Share Capital Fixed Assets
(with all particulars of 1.Goodwill
authorized, issued,
subscribed and Called up2.Land and Building
3.Lease hold Property
capital) 4.Plant and Machinery
Less: Calls in arrears 5.Furniture and fixture
Add: Forfeited shares 6.Patents and trade marks
7.Vehicles
Reserve and SurplusInvestments
1.Capital Reserve Current assets, Loans and
2.Capital RedemptionAdvancesReservea.Current assets3.Share premium1.Interest accrued on4.Other Reserves Investment
2.Loose tools
Less: P&L a/c Debit balance3.Stock in Trade5.Profit and Loss4.Sundry debtorsappropriation A/cLess Provision for Bad debts6.Sinking fund A/c 5.Cash in Hand
6.Cash atBankmunotes.in
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13Long term loans
a.Secured loan
Debentures
Add: Outstanding Interest
Loan from Banksb.Loans and Advances
1.Advances to
subsidiaries
2.Bills receivables
3. Prepaid expenses
b.Unsecured loans Miscellaneous expenditureFixeddeposits1.Preliminary expensesShort term loans and2.Discount on issue ofadvancesshares and Debentures3.Underwriting commissionCurrent liabilities and 4.Profit and Loss a/c (debit
Provisionsa.Current liabilitiesbalance)
1.Bills payables2.Sundry creditors3.Bank overdraft4.Income received inadvance5.Unclaimed Dividends6.Other liabilities
b.Provisions
1.Provision for taxation
2.Proposed dividends
3.Provident fund and
Pension fund
Contingent Liabilities
2. Vertical Form
Income Statement of ............... for the year ending ................
Previous Particulars Schedule Current Year
I. Sources of Funds
1.Shareholders’ Funds
a.Capital
b.Reserves and surplus
2.Loan funds
a.Secured loan
b.Unsecured loans
TOTAL
II. Application of Funds
1. Fixed Assets
a. Gross Block
Less Depreciationmunotes.in
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14b. Net Block
2.Investments
3.Current Assets, LoansandAdvances
Less Current LiabilitiesandProvisions
Net Current Assets
4. Miscellaneous expenditur etothe extent not writtenoff oradjusted Profit and Loss a/c
debit balance
TOTAL
Statement of Retained Earnings:
The Statement of Retained Earnings is prepared to show how
the balance in Profit and Loss accounts is appropriated for various
purpo ses like provision for dividend, transfer to reserves etc. The
balance on this account is finally shown on the Balance sheet Under the
heading Reserve and Surplus.
1.6 LIMITATIO NOF FI NANCIAL STATEME NT
Following are the limitations of financial statement s:
1.The information being of historical nature does not reflect the
future.
2.It is the outcome of accounting concept, convention combined with
personal judgement.
3. The statement portrays the position in monetary term. The profit or
loss position excludes f rom their purview things which cannot be
expressed or recorded in term of money.
To overcome from the limitations it becomes necessary to analyse the
financial statements.
1.7 EXERCISE
1.Discuss the meaning, nature and limitations of Financial
Statement.
2.Explain the several parties interested in Financial statements..
3. Discuss the horizontal and vertical analysis of Balance sheet.
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152
ANALYSES OF THE FI NANCIAL
STATEME NTS
(Comparative Statements, Common
size statements, Trend analysis)
Unit Structure
2.1 Introduction and Meaning of Analysis
2.2 Objects of Analysis
2.3 Arrangement of Figures for Analysis
2.4 Tools of Analyses
2.5 Co mparative Statements
2.6 Common -Size Statement
2.1 INTRODUCTIO NANDM E A NINGO FA NALYSIS
Financial statements viz. the income and the position statement i.e.
the balance sheet, are indicators of two significant factors : profitability and
financial soundn ess. Analysis of statements means such a treatment of the
information contained in the two statements as to afford a full
diagnosis of the profitability and financial position of the firm
concerned.
To have a clear understanding of the profitability and financial
position, the data provided in the financial statements should be methodically
classified and compared with figures of previous periods or other similar
firms. Thereafter, the significance of the figures is established. Such a
comparative study wo uld lead us to further questioning, the answers for
which have to be brought out by further and deeper analysis. We may work
out the figure of income of two firms A and B for a period but to analyze
systematically one should (i) arrange the cost and revenu e, (ii) relate the
income to the capital employed and (iii) compare the result. On this basis we
may come to know that A is more profitable than B (vice versa). The next
question is why is a more profitable than B. This question will require
further analys isand study of the underlying situation.
We may define financial statement analysis as the process of
methodical classification, comparison and raising pertinent questions and
then seeking answers for them.munotes.in
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162.2 OBJECTS OF A NALYSIS
The different part ies look at the company from their respective
points of view, but the objects generally looked for are : (i) profitability and
(ii) financial condition. It can be said that the objective of financial statement
analysis is a detailed cause and effect study of the profitability and financial
position.
The objectives of financial statement analysis may also be broadly
classified on the basis of the persons interested in the analysis as
(i)External: An external analyst usually has to rely only on the
published in formation.
(ii)Internal: An internal analyst would really know the full story behind
each and every figure of the financial statement, he would also get
further supplementary information to properly assess the significance of
the figures. Such analysis would b emore reliable than that done by an
outsider. However, internal analysis may be biased; external analysis
would be unbiased and impartial.
2.3 ARRA NGEME NT OF FIGURES FOR A NALYSIS
Before meaningful analysis can be made, the figure have to be
arranged pro perly. For analysis purpose usually instead of the two column (T
Form) statements as ordinarily prepared, the statements are prepared in
single (vertical) column form which one should throw up significant
figures by a process of addition or subtraction. Th ec h i e fa d v a n t a g eo fs u c h
presentation is that figures for a number of firms or number of years can be
set aside by side for comparison purposes.
Au s e f u lf o r mo ff i n a n c i a ls t a t e m e n tw a ss u g g e s t e da s early as
1917 by the federal reserve Board of the U.S.A .T h i s suggestion was made
by the Board to its member banks so that the latte may insist on that
presentation while getting the financial statements of their clients for granting
of loans etc. This form, it was thought would facilitate the member banks in
analyzing the statement. Later this form was also approved by the American
Institute of Accountants as suitable for annual reports to the shareholders.
The following form (based on the form recommended by the
federal reserve Board) is considered suitable for presentation of financial
information to shareholders mainly for two reasons:
(1) It provides the information in aneasily understandable manner; and
(2) I provides the appropriate figures facilitating further analysis
To facilitate these advantages the fin ancial statements have to
arrange in a vertical format which are explained below:munotes.in
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19An attempt could be made to present the income statement too in a
similar manner. The following form of presentation is
recommended :
munotes.in
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20
2.4 TOOLS OF A NALYSE S
As in balance sheet, so in the revenue statement, as shown above,
ready figures can be obtained for the purpose of further analysis. For instance,
gross profit, net profit, materials consumed, prime cost, works cost, cost of
goods sold, etc. are readily available. This would facilitate the calculation of
ratios.
As the information provided in the financial statements is not an
end in itself as no meaningful conclusions can be drawn from these
statements alone. However, the information provided in the fin ancial
statements is of immense use in making decisions through analysis and
interpretation of financial statements. To overcome from the limitations it
becomes necessary to analyse the financial statements. The analytical tools
generally available to an a nalyst for this purpose are:
1.Comparative financial and operating Statements
2.Common -size statement
3.Trend ration and trend analysis
4.Average Analysis
5.change in working capitalmunotes.in
Page 21
216.Fund -flow and cost -flow analysis
7. Ratio analysis
1. Comparative Financial and Op erating Statement:
Here the Balance Sheet and Income Statement are prepared in a
Comparative from as the impact of the conduct of business is brought to bear
in the Balance Sheet, Comparative statement are made to show –
a.Increases and decreases in absolute data in term of money values.
b.Increases or decreases in absolute data in term of
percentage.
c.Comparisons expressed in ration.
d.Percentage of total.
Comparative financial statements are very useful to the analyst as
they provide information necessary for t he study of financial and operating
trend over a period of years. They indicate the duration of the
movement with respect to the financial position and operating results.
Financial data become more meaningful when compared with similar data for
ap r e v i o u s period or a number of prior periods. The comparative profit and
loss account presents a review of operating activities of the business. The
comparative balance sheet shows the effect of operations on the assets and
liability and changes in the financial position during the period under
consideration.
2.Common size Statement:
Comparative statement showing only the vertical percentage or
ration for financial data without giving any rupee value are known as
common size statement.
3.Trend Analysis:
This is an imp ortant and useful technique of analysis and interpretation of
financial statement. In this technique the ration of different items for various
periods are calculate over a definite period of time say three to five years and
then we can analysis trend highl ighted by this ratio. Trend analysis can be
done in three following way:
(i)Trend percentage,
(ii)Trend ratio,
(iii) Graphic and diagrammatic representation.
Here the percentage column are more relevant than the figure.
4.Average Analysis:
It is an improvement ov er trend analysis method. Here the trend can be
presented on the graph paper also in the shape of curve. In this from the
analysis and comparison become more comprehensive and impressive.
5.Statement of changes in Working Capital:
This statement is prepared to know an increase or decrease in
working capital over a period of time. The statement gives an accurate
summary of the events that affects on the amount of working capital.munotes.in
Page 22
226.Funds flow and Cash flow Analysis:
Funds flow analysis is a valuable aid for the financial executive and
creditor for the evaluation of the use of funds by the firm and determining
how the funds for the uses are generated. A Funds flow statement
indicates the sources of funds and the application of during the period
under review.
7.Ratio Analysis:
An absolute figure does not convey much meaning. Ration means the
relationships expressed in mathematical terms between two figures which
are connected with each other in some manner.
2.5 COMPARATIVE STATEME NTS
The comparative statements are important tool of horizontal
financial analysis. Financial data become more meaningful when compared
with similar data for previous period or a number of previous periods. Such
analysis helps as in forming an opinion regarding the progress of the
enterpri se.
Comparative statements definition:
Foulke has defined these statement as “statement of financial
position of business so designed as to provide time perspective to the
consideration of various elements of financial position embodied in such
statement. ’’ In any comparative statement columns for more than one
year’s position or working can be drawn and figures may be provided. The
annual date can be compared with similar monthly or quarterly data can be
compared with similar data for the same months or q uarterly of previous years.
In such statement the figure can be shown at the following value.
a.In absolute money value
b.Increase or decrease in absolute values
c.By the way of percentages
d.By the way of common —size statement
Two comparable units can be compare dr e g a r d i n g profitability and
financial position. The two organization may not have the identical heads of
account In order to get over the difficulty, the data must first be property
set before comparison In the preparation of comparative financial statem ent,
uniformity is essential.
Importance of Comparative Statement:
These statements are very useful in measuring the effect of the
conduct of a business enterprise over the period under consideration.
Regardless of its financial strength at a given point of time, the
enterprises must operate successfully if it hopes to continue as a going
concern. The income statement measures the effects of operation. But the
progress of these operations may be viewed over number of periods by
preparing the income stateme nt in a comparative form. Similarly the effect
of operation of financial position and the progress of a business in term ofmunotes.in
Page 23
23financial position can be presented by means of a comparative balance sheet.
The accounting authorities in U. S. A. have strongly re commended and
encouraged the preparation of financial statement in the comparative from
recognising the importance of comparative financial date for two years, the
Indian companies Act 1956 has made this fact compulsory that in the balance
sheet of a compa ny the figure for the previous year should also be
given to facilitated comparison. Though the balance sheet is a useful
statement, the comparative balance sheet is even more useful for the it
contains not only the data of a single balance sheet but also f or the past
years which may be useful in studying the trends.
PREPARATIO NOF COMPARATIVE STATEME NTS:
The form of comparative balance sheet consists of two or more
columns according to the number of year we prepare the balance sheet, for
the date of origin al balance sheet and columns for the increases or
decreases in various items. Here is a proforma of comparative balance
sheet for two years
Specimen of Comparative Balance Sheet for the ended 31st
Dec. 1980 and 1981
(Amount in Lakhs of rupees
Dec. 31
1980Dec. 31
1981Increase (+)
/D e c r e a s e
(-)Amount% Rate
Assets:
Current Assets:
Cash 240 80 -160 -66 1.24
Debtors less reserve for
doubtful debts120 96 -24 -40 1.60
Merchandise 260 320 +6 6 +4 6 2.46
Inventory
Prepaid Expenses 100 80 -20 -40 1.60
Total Current Assets 720 656 -64 -18 1.82
Fixed Assets:
Land and Building
less Depreciation480 720 +2 4 0 +1 0 0 2.0
Furniture &Fixture
less Depreciation60 80 +2 0 +6 6 2.66
Plant and Machinery
less Depreciation240 480 +2 4 0 +2 0 0 4.00
Total fixed Assets 780 1,280 +5 0 0 +1 2 8 2.20
Total Assets 1,500 1,936 +4 3 6 +5 8 2.58munotes.in
Page 24
24Liabilitiesa n d
Capital:CurrentTrend creditors 234 510 +2 7 6 +1 0 8 3.08
Accrued
Expenses400 360 -40 -20 1.08TotalCurrent634 870 +2 3 6 +7 4 2.74
Equity Capital 400 500 +1 0 0 +5 0 2.50RetainedEarnings466 566 +1 0 0 +4 2 2.42
Total Capital 866 1,066 +2 0 0 +4 6 2.46Total Liabilitiesand1,500 1,936 +4 3 6 +5 8 2.58
Capital
Preparation of a Compar ative Income Statement:
An Income Statement shows the Net Profit or Net Loss from
business operation of a definite accounting period. Like a balance sheet, a
comparative income statement show the operating results for a number of
accounting periods so that thechanges in absolute date from one period to
another may be explained and analysis. The Comparative income statement
contains the some columns as the comparative balance sheet and provides
the same in the figures.
Specimen of a Comparative Income Stat ement for the year
ended 31stDec. 1980 and 1981
(Amount in Lakhs of Rupees
Dec. 31
1980Dec. 31
1981Increase (+) /
Decrease ( -)
Amount%
Net Sales 1370 1442 +72 +.6
Less: Cost of Goods Sold 838 926 +8 8 +2 1 . 0
Gross Profit 532 516 -16 -6.4
Operati ng Expenses:
Selling Expenses 188 182 -6 -6.4Gen. and Admn. Expenses94 92 -2 -4.2
Total Operating Expenses 282 274 -8 -5.6
Operating Profit 250 242 -8 -6.4
Add : Other Income
Dividend 44 50 +6 +2 . 8
294 292 -2 -1.4
Less : Other Deduction
Interest Paid 44 44 Nil Nil
250 248 -2 -1.6
Less:IncomeTax 124 124 Nil Nil
Net Profit after Tax 126 124 -2 -3.2munotes.in
Page 25
25Illustration
The following is the Profit and Loss Account of TATA MOTORS
Ltd. for December 2004 and 2005. Prepare compara tive Income
statement and comment on the profitability of the undertaking.
Particulars 2004 2005 Particulars 2004 2005
To Cost of
goods sold2,31,625 2,41,950 By Sales
Less Returns3,60,728
5,7944,17,125,
6,952
To Office
expenses23,266 27,068
To Selling
expenses45,912 57,816 By other
income3,54,934 4,10,173
To Interest paid 2,137 1,750 By interest
and dividend1,898 1,310
To loss on sale of
fixed Assets627 175 By discount
on purchases2,125 1,898
ToIncome tax 21,519 40,195
To Net Profit 35,371 44,425 By Profit on
sale of land1,500
3,60,457 4,13,379 3,60,457 4,13,379
Comparative statement of TATA MOTORS Ltd
ParticularsDecember
2004 Rs.December
2005 Rs.Increase (+)
Decrease ( -)%
Sales3,60,728 4,12,125 +5 6 , 3 9 7+1 5 . 6 3
5,794 6,952 +1 , 1 5 8 +1 9 . 9 8Less : S ales returns
3,54,934 4,10,173 +5 5 , 2 3 9 +1 5 . 5 6
Less: Cost of goods
Sold2,31,625 2,41,950 +1 0 , 3 2 5 +4 . 4 6
Gross Profit (i) 1,23,309 1,68,223 +4 4 , 9 1 4 +3 6 . 4 2
Less: Operating
expenses
Office expenses 23,266 27,068 +3 , 8 0 2 +1 6 . 3 4
Selling expenses 45,912 57,816 +1 1 , 0 9 4 +2 5 . 9 3
Total Operating
Expenses(ii)69,178 84,884 +1 5 , 7 0 6 +2 2 . 7 0munotes.in
Page 26
26Operating Profit
(i)–(ii)54.131 83,339 +2 9 , 2 0 8 +5 3 . 9 6
Add: Other incomes 5,523 3,206 -2,317 -41,95
59,654 86,545 +2 6 , 8 9 1 +4 5 . 0 8
Less : Other
expenses2,764 1,925 -839 -30.35
Profit before tax 56,890 84,620 +2 7 , 7 3 0 +4 8 . 7 4
Less:Incometax 21,519 40,195 +1 8 , 6 7 6 +86.79
Net Profit after tax 35,371 44,425 +9 . 0 5 4 +2 5 . 6 0
Interpretation
The comparative income statement reveals that while the net
sales has been increased by 15.5% the cost of goods sold increased by
4.46% Gross profit is increased by 36.4%. The total operating expenses
has been increased by 22.7% and the gross profits is suffic et o
compensate increase in operating expends. Netprofit after tax is
Rs.9.054 (i.e. 25.6%) increased. The overall profitability of the
undertaking is satisfactory.
Illustration
The following are the Balance Sheets of GO DWINS Ltd. for the years
ending 31stMarch, 2004, 2005.
Particulars 2004 2005
Liabilities
Equity share capital 2,00,000 3,30,000
Preference share capital 1,00,000 1,50,000
Reserves 20,000 30,000
Profit and loss account 15,000 20,000
Bank overdraft 50,000 50,000
Creditors 40,000 50,000
Provision for taxation 20,000 25,000
Proposed dividend 15,000 25,000
4,60,000 6,80,000munotes.in
Page 27
27Fixed Assets (Less: Depreciation) 2,40,000 3,50,000
Stock 40,000 50,000
Debtors 1,00,000 1,25,000
Bills receivable 20,000 60,000
Prepaid expenses 10,000 12,000
Cash in hand 40,000 53,000
Cash at bank 10,000 30,000
4,60,000 6,80,000
Comparative Statement of Financial position
31st
March 200431st March
2005Increase(+)
Decrease ( -)Particulars
(Rs) (Rs) (Rs) (Rs.)
Assets
Current Assets
Cash at bank and in hand 50,000 83,000 +3 3 , 0 0 0 +66
Bills receivable 20,000 60,000 +4 0 , 0 0 0 +2 0 0
Debtors 1,00,000 1,25,000 +2 5 , 0 0 0 +25
Stock 40,000 50,000 +1 0 , 0 0 0 +25
Prepaid expenses 10,000 12,000 +2 , 0 0 0 +20
(1) 2,20,000 3,30,000 +1,10,000 +50
Fixed Assets (2) 2,40,000 3,50,000 +1,10,000 +4 5 . 8 3
Total Assets side (1) + (2) 4,60,000 6,80,000 +2,20,000 +4 7 . 8 3
Liabilities
Current liabilities
Bank overdraft 50,000 50,000 ... ----
Creditors 40,000 50,000 +10,000 +2 5
Proposed dividend 15,000 25,000 +10,000 +6 6 . 6 7
Provision for taxation 20,000 25,000 +5,000 +25
(a) 1,25,000 1,50,000 +2 5 , 0 0 0 +20
Capital and Reserves
Equity Share capital 2,00,000 3,30,000 +1,30,000 +65
Preference share
Capital1,00,000 1,50,000 +50,000 +50
Reserves 20,000 30,000 +10,000 +50
Profit and loss account 15,000 20,000 +5,000 +33.33
(b) 3,35,000 5,30,000 +1 , 9 5 , 0 0 0 +5 8 . 2 1
Total of Liabilities side
(a) + (b)4,60,000 6,80,000 +2 , 2 0 , 0 0 0 +4 7 . 8 3munotes.in
Page 28
28Interpretation –
1.The above comparative balance sheet reveals the current assets has
been increased by 50% while current liabilities increased by 20%
only. Cash is increased by Rs.33,000 (i.e.66%). There is an
improvement in liquidity position.
2.The fixed assets purchased was for Rs.1 ,10,000. as there are no
long term funds, it should have been purchased partly from share
capital.
3.Reserves and profit and loss account increased by 50% and 33.33%
respectively. The company may issue bonus shares in near
future.
4.Current financial position of the company is satisfactory. It can raise
more long term funds.
Illustration
The following details are provided by C ltd. For the year ended 31stMarch,
2015 and 2016 prepare Comparative Statement:
Particulars 31/03/15 31/03/16
Share capital 24,00,00 0 26,10,000
General Reserves 2,40,000 2,90,000
Profit and Loss A/c 4,20,000 6,00,000
11% Debentures 10,00,000 6,00,000
Goodwill 2,00,000 1,60,000
Land &Building 14,00,000 13,00,000
Plant and Machinery 12,00,000 13,20,000
Investment (Non trading) 4,80,000 4,40,000
Creditors 3,70,000 4,30,000
Provision for Tax 1,60,000 2,10,000
Proposed Dividend 2,72,000 2,88,000
Stock 8,00,000 7,70,000
Debtors 5,76,000 8,30,000
Cash at Bank 1,76,000 1,86,000
Prepaid Expenses 30,000 22,000munotes.in
Page 29
29Solution:
Particulars 31/03/15 31/03/16 Changes %
Share Capital 24,00,000 26,10,000 2,10,000 9%
General reserves 2,40,000 2,90,000 50,000 21%Profit and Loss A/c4,20,0006,00,0001,80,00043%11% Debentures10,00,0006,00,000--Total40,60,00041,00,0004,00,00040%Goodwill2,00,0001,60,00040,0001%Land and Building 14,00,000 13,00,000 -40,000 -Plant and Machinery12,00,00013,20,000-20%Fixed Assets Total28,00,00027,80,0001,00,000-7%Investments4,80,0004,40,0001,20,00010%Current Asset s -20,000 -1%
Stock 8,00,000 7,70,000 -40,000 -8%Debtors5,76,0008,30,000Cash at Bank 1,76,000 1,86,000 -30,000 -4%Prepaid expenses30,00022,0002,54,00044%C.A Total 15,82,000 18,08,00010,000 6%
Less: Current Liabilities -8,000 -
Creditors 3,70,000 4,30,000 2,26,000 27%
Provision for tax 1,60,000 2,10,000
Proposed dividend 2,72,000 2,88,000 60,000
Net Working Capital 7,80,000 8,80,000 50,000 16%
40,60,000 41,00,000 16,000 31%
1,00,000 6%
40,000 13%
2.6 COMMO N-SIZE STA TEME NT
Common Size Income Statement
In common size income statement the sales figures is taken as
100 and all other figures of costs and expenses are expressed as
percentage to sales. When other costs and expenses are reduced from
sales figure of 100, the balance figure is taken as net profit. This reveals
the efficiency of the firm in generating revenue which leads to
profitability and we can make analysis of different components of
costs proportion to sales. Inter firm comparison of common size income
statements reveal the relative efficiency of costs incurred.
Common Size Balance Sheet
In common size balance sheet, the total of assets side or
liabilities side is taken as 100 and all figures of assets and liabilities
capital and reserves are expressed as ap r o p o r t i o nt o the total i.e. 100.
The common size balance sheet reveals the proportion of fixed assets to
current asserts composition of fixed assets and current assets proportion ofmunotes.in
Page 30
30long term funds to current liabilities and provisions composition of
current liabilities etc. It also helps in making inter firm comparison and
highlights the financial health and long term solvency ability to meet short
term obligations and liquidity position of the enterprise.
Speciman Common Size Income Statement For the year ending
31stMarch, 2005
Particulars Amount
(Rs.)%
to
14,00,000 100 Sales (a)
Raw materials 5,40,000 38.6
Direct wages 2,30,000 16.4
Factory expenses 1,60,000 11.4
Cost of goods sold (b) 9,30,000 66.4
Gross profit (a) –(b) 4,70,000 33.6
Less : Administrative expenses 1,10,000 7.9
Selling and distribution expenses 80,000 5.7
Operating profit 2,80,000 20.0
Add : Non -operating income 40,000 2.9
3,20,000 22.9
Less : Non -operating expenses 60,000 4.3
Profit before ta x 2.60,000 18.6
Less :Income tax 80,000 5.7
Profit after tax 1,80,000 12.9munotes.in
Page 31
31Common Size Balance Sheet as at 31stMarch, 2005
Particulars Amount Rs. %to totalFixed AssetsLand 50,000 5.3
Buildings 1,10,000 11.7
Plant and machinery 2,50, 000 26.6
Current AssetsInventoryRaw materials 80,000 8.5
Work in process 50,000 5.3
Finished goods 1,60,000 17.0
Sundry debtors 2,10,000 22.4Cash and Bank30,0003.29,40,000 100.0
Capital and Liabilities
Equity share capital 2,50,000 26.6
Preference share capital 1,00,000 10.6
General reserve 1,60,000 17.0
Debentures 80,000 8.5
Current Liabilities
Sundry creditors 2,20,000 23.4
Creditors for expenses 40,000 4.3
Bills payable 90,000 9.69,40,000100.0Illustration 1
The balance sheet of S Ltd are given for the year 2014 and 2015
convert them into common size balance sheet and interpret the changes.munotes.in
Page 32
32Balance sheet
Liabilities2014
Rs2015
Rs.Assets2014
Rs.2015
Rs.
Equity share 1,46,800 1,91,000 Buildings 1,80,000 2,00,000
Capital
reserve50,000 70,000 Plant and
machinery40,000 55,000
Revenue 20,000 30,000 Furniture 10,000 20,000
reserve &
surplusFreehold
property20,000 12,000
Trade
creditors30,000 40,000 Goodwill 25,000 30,000
Bills payable 80,000 60,000 Cash balance 25,000 20,000
Bank overdraft 90,000 80,000 Sunday debtors 30,000 35,000
Provisions 30,000 20,000 Inventories
Bills receivable
(temporary)70,000 57,000
4,46,800 4,91,000 4,46,800 4,91,000
Common size Balance Sheet
2014 2015
AssetsAmt.
(Rs.)Percentage Amt.
(Rs.)Percentage
A. Current Assets
Sundry Debtor 30,000 6.71 35,000 7.13
Cash balance 25,000 5.59 20,000 4.07
Inventories 70,000 15.71 57,000 11.60Investment(Temporary)36,500 8.17 42,000 8.55
Bill Receivable 10,300 2.30 20,000 4.08
Total (A) 1,71,800 38.44 1,74,000 35.43
B.Fixed Assets
Building 1,80,000 40.29 2,00,000 40.75
Plant andMachinery 40,000 8.95 55,000 11.20
Furniture 10,000 2.24 20,000 4.07
Freehold Property 20,000 4.48 12,000 2.44
Goodwill 25,000 5.60 30,000 6.11
Total (B) 2,75,000 61.5 3,17,000 64.57
Total Assets 4,46,800 100.00 4,91,000 100.00munotes.in
Page 33
33(A+B)
Liabilities
C.Current
Liabilities
Trade Creditors 30,000 6.17 40,000 8.15
Bill Payable 80,000 17.91 60,000 12.22
Bank O verdraft 90,000 20.14 80,000 16.29
Provision 30,000 6.71 20,000 4.07
Total (C) 2,30,000 51.47 200,000 40.73
D. Long -term
Liabilities
Equity Share 1,46,800 32.86 1,91,000 38.90
Capital Reserve 50,000 11.19 70,000 14.26
Revenue 20,000 4.48 30,000 6.11Reserve andSurplusTotal (D) 2,16,800 48.53 2,91,000 59.27
Total
Liabilities (C+D)4,46,800 100.00 4,91,000 100.00
Interpretation:
1.Out of every rupee of sales 60.72 per cent in 2014 and 63.63 per cent in
2015 account for cost of goods sol d.
2.The percentage ratio of gross profit to sales was 39.28 per cent in 2014
which was reduced 36.37 percent 2015.
3. The operating expenses increased from 15.71 per cent of sales in
2014 to 16.37 per cent in 2015 all this reduced the percentage ratio of
neti n c o m ea f t e rt a xt os a l e sf r o m1 4 . 1 5 per cent in 2014 to 12.00 per
cent in 2015.
4. The operating expenses increased from 15.71 per cent of sales in
2014 to 16.37 per cent in 2015 all this reduced to percentage ratio of net
income after tax to sales from 14.15 per cent in 2015.
In the ultimate analysis it can be said that the operating efficiency of
the concern has not been satisfactory during the period under study.
Illustration 3: From the income statement give below you are required to
prepare common –sized income statement.munotes.in
Page 34
34Particular1986
Rs.1987
Rs.
Sales 1,40,000 1,65,000
Less : Cost of Goods Sold 85,000 1,05,000
Gross Profit 55,000 60,000
Operating Expenses
Selling and Distribution 12,000 16,000
Expenses
Administrative Expenses 10,000 11,000
Total Operating Expenses 22,000 27,000
Net Income before Tax 33,000 33,000
Income Tax (40%) 13,000 13,200
Net Income 19,800 19,800
Solution:
Common size income statement
(For the year ending 1986 and 1987)
1986 1987
ParticularsAmt.
(Rs.)Percentage Amt. (Rs.) Percentage
Sales 1,40,000 100.00 1,65,000 100.00
Less:Cost of 85,000 60.72 1,05,000 63.63
Sales
Gross Profit 55,000 39.28 60,000 36.37
Selling & 12,000 8.57 16,000 9.70DistributionExpenses
Administrative 12,000 7.14 11,000 6.67
Exp.
Total
operating Exp.22,000 15.71 27,000 16.67
Net Income
before Tax33,000 23.57 33,000 20.00
Income Tax 13,000 9.42 13,200 8.00
(40%)
Net Income
after Tax19,800 14.15 19,800 12.00munotes.in
Page 35
35Illustration : You given th e following common size percentage of AB
Company Ltd for 1997 and 1988.
1997 1998
Inventory 5.20 5.83
Debtors 10.39 ?
Cash ? 7.35
Machinery 49.35 45.35
Building 27.27 29.59
Creditors 20.78 ?
Overdraft ? 10.81
Total Current Liabilities 31.17 ?
Capital 51.95 49.67
Long -term loan 16.88 17.91
Total Liabilities 3,85,000 4,63,000
From the above information, compute the missing common size
percentage. Also calculate the value of all assets and liabilities.
Solution:
Common Size Balance Sheet
(as on 31 December 1997 and 1998)
1997 1998
Assets A
mt.PercentageAmt.
(Rs.)Percentage
Assets:
A.Current
Assets
Inventory 20,000 5.20 27,000 5.83
Debtors 40,000 10.39 55,000 11.88
Cash 30,000 7.79 34,000 7.35
Total (A) 90,000 23.38 1,16,000 25.06
B.Fixed
Assets
Machinery 1,90,000 49.35 2,10,000 45.35
Building 10,05,00027.27 1,37,000 29.59
Total (B) 2,95,000 76.62 3,47,000 74.94
Total Assets 3,85,000 100.00 4,63,000 100.00
(A+B)munotes.in
Page 36
36Liabilities:
C.Current
Liabilities
Creditors 80,000 20.78 1,00,000 21.59
Overdraft 40,000 10.39 50,000 10.81
Total (C) 1,20,000 31.17 1,50,000 32.40
D.Long -term
Liabilities
Capital 2,00,000 51.95 2,30,000 49.67
Loan 65,000 16.88 83,000 17.91
Total (D) 2,65,000 68.83 3,13,000 67.55
Total 3,85,000 100.00 4,63,000 100.00Liabilities(C+D)
Note:Calculation have been made to the nearest rupee.
(i)Calculation of percentage of Cash for 1997
Cash =2 3 . 3 8 * –15.59*
=7 . 7 9
*C u r r e n t =T o t a lA s s e t s –Fixed Assets
=1 0 0 –76.62
=2 3 . 3 8
** Inventory + debtor =5 . 2 0+1 0 . 3 9=1 5 . 5 9
(ii)Calculation of Percentage of overdraft for 1997
Total Current Liability –Creditor= 31.17 –20.78 = 10.39
(iii) Calculation of percentage of Debtors for 1998
Debtor =2 5 . 0 6 * –13.18 = 11.88
* Current Assets = Total Assets –Fixed Assets
=1 0 0 –74.94
=2 5 . 0 6
Illustration
From the following Profit and Loss account prepare a Common Size Income
Statement
Particulars 2004 2005 Particulars 2004 2005
To Cost of goods
sold12,000 15,000 By Net
Sales16,000 20,000
To Administrative
Expenses400 400
To Selling
expenses600 800
To net profit 3,000 3,800
16,000 20,000 16,000 20,000munotes.in
Page 37
37Common Size Income Statement
Particulars2004
Rs.% 2005
Rs.%
Net Sales 16,000 100.00 20,000 100.00
Less: Cost of goods sold 12,000 75.00 15,000 75.00
Gross profit 4,000 25.00 5,000 25.00
Less Operating expenses
Administration expenses400 2.50 400 2.00
Selling expenses 600 3.75 800 4..00
Total operating expenses 1,000 6.25 1,200 6.00
Net Profit3,00018.753,80019.00
Illustration
Following are Balance Sheets of NELCO Ltd. for the year ended 31st
March, 2014 and 2015
Liabilities 2014 2015 Assets 2014 2015
Equity share
capital1,00,000 1,65,000Fixed assets
(net)1,20,000 1,75,000
Preference
share Capital50,000 75,000 Stock 20,000 25,000
Reserves 10,000 15,000 Debtors 50,000 62,500
Profit and loss
account7,500 10,000Bills
receivable10,000 30,000
Bank
overdraft25,000 25,000Prepaid
expenses5,000 6,000
Creditors 20,000 25,00 0 Cash in bank 20,000 26,500
Provision for
taxation10,000 12.500 Cash in hand 5,000 15,000
Proposed
dividends7,500 12,500
2,30,000 3,40,000 2,30,000 3,40,000munotes.in
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38Common Size Balance sheet of NELCO Ltd. for the year ended 31sat
March, 2014 a nd 2015
Particulars 2014 2015
Rs. % Rs. %
Capital and Reserves
Equity share capital 1,00,000 43.48 1,65,.000 48.53
Preference share capital50,000 21.74 75,000 22.05
Reserves 10,000 4.34 15,000 4,41
Profit and loss account 7,500 3.26 10,000 2.95(i)1,67,50072.822,65,00077.94Current liabilities
Bank overdraft 25,000 10.87 25,000 7.35
Creditors 20,000 8.70 25,000 7.35
Provisions for taxation 10,000 4.35 12,500 3.68
Proposed dividends7,5000 3.26 12,500 3.68
(ii) 62,500 27.18 75,00 0 22.06
(i) + (ii) 2,30,000 100.00 3,40,000 100.00
Fixed Assets (net) (a) (a) 1,20,000 52.17 1,75,000 51.47
Current Assets
Stock 20,000 8.70 25,000 7.35
Debtors 50,000 21.74 62,500 18.38
Bills receivable 10,000 4.34 30,000 8.82
Prepa id expenses 5,000 2.17 6,000 1.78
Cash in Bank 20,000 8,70 26,500 7.79
Cash in hand 5,000 2.18 15,000 4.41
(b) 1,10,000 47.83 1,65,000 48.53
Total Assets (a) + (b) 2,30,000 100.00 3,40,000 100.00
Interpretation -
1.In 2015, current assets were increased from 47,83% to 28.53%.
Cash balance is increased by Rs.16,500
2.Current liabilities were decreased from 27.18% to 22.06%. The
Company can pay off the current liabilities from current assets. The
liquidity position is reasonably good.munotes.in
Page 39
393.Fixed assets were increased from Rs.1, 20,000 in 2014 to Rs.1,75,000
in 2015. These were purchased from the additional share capital
issued.
4.The overall financial position is satisfactory.
Illustration
Following is the Balance sheet of Star Ltd. as on 31stMarch, 2016 .Y o ua r e
required to rearrange it in a common size form.
Liabilities Rs. Assets Rs.
Equity share Capital 2,50,000 Fixed Assets 6,50,000
General Reserve 1,50,000 Investments 2,00,000
Security Premium 12,500 Stock 4,25,000
10% Debentures 3,75,000 Sundr yD e b t o r s 2,50,000
Profit and Loss a/c 3,70,000 Prepaid expenses 20,000
Sundry Creditors 1,15,000 Advance Income tax 39,000
Bank overdraft 1,97,500 Cash and Bank bal. 31,000
Provision for taxation 90,000 Share issue expenses 5,000
Proposed dividend 75,000 Preliminary Expenses 15,000
16,35,000 16,35,000
TRENDANALYSIS
The trend ratios of different items are calculated for various
periods for comparison purpose. The trend ratios are the index numbers of
the movements of reported financial items in the financial statements
which are calculated for more than one financial year. The calculation of
trend ratios are based on statistical t3echnique called “Index numbers”.
The trend ratios help in making horizontal analysis of comparative
statements. It reflects the behaviour of items over a period of time. The
methodology used in computation of trend ratios is as follows:
(1)The accounting principles and policies should be
consistently followed throughout the period for which the trend
ratios are calculated.
(2)The trend ratios should be calculated only for the items
which have logical relationship with one another.
(3) The trend analysis should be made at least for four consecutive
years.
(4) The financial statements one financial year should be selected as
base statemen ta n df i n a n c i a li t e m so fi t should be assigned with
value as 100
(5) Then trend ratios of subsequent years’ financial statements
should be calculated by applying the following formula:munotes.in
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40Absolute figure of financial statement under study
=-------------------------------- -------------------------------- --x100
Absolute figur e of same item in baser financial statement.
(6) Tabulate the trend ratios for analysis of trend over a
period
The trend percentages are calculated for select major financial
items in the financial statements to arrive at the conclusions for important
changes .T h et r e n dm a ys o m e t i m e sb e affected by external factors like
government policies economic conditions changes in income
distribution, technology development population growth, changes in
tastes and habits etc. the trend analysis is a simple technique and does not
involve tedious calculations.
Limitations The analysis through trend ratios is subject to the following
limitations :
The trend ratios are incomparable, if there is inconsistency in
accounting policies and practices.
The price level changes are r epresented in trend ratios -The trend
ratios musty be studied along with absolute data for correct analysis.
While analyzing the trend ratios, non -financial data should also be
considered otherwise conclusions would be misleading.
Illustration
From the given data, calculate trend a percentage taking 2013 As base:
(Rs)
Particulars 2013 Rs. 2014 Rs. 2015 Rs.
Sales 50,000 75,000 1,00,000
Purchasers 40,000 60,000 2,000
Expenses 5,000 8,000 15,000
Profit 5,000 7,000 13,000
Particulars 2013 2014 2015 Trend percentage Base 2003
(Rs) (Rs) (Rs) 2003 2004 2005
Purchases 40,000 60,000 72,000 100 150 180
Expenses 5,000 8,000 15,000 100 160 300
Profit 5,000 7,000 13,000 100 140 260
---- ---------- --------
Sales 50,000 75,000 1,00,000 100 150munotes.in
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41Illustration:
From the following data, calculate trend percentages (2013 as the base)
(Rs in Lakhs)
Particulars Rs.
2013 2014 2015
Cash 200 240 160
Debtors 400 500 650
Stock 600 800 700
Other current assets 450 600 750
Land 800 800 1,000
Buildings 1,600 1,600 2,400
Plant 2,000 2,000 2,400
Trend percentages (Base year 2013)
Current Assets 2013 2014 2015 2013 2014 2015
(Rs.) (Rs) (Rs)
Cash 200 240 160 100 120 80
Debtors 400 500 650 100 125 163
Stock 600 800 700 100 133 117
Other current
assets450 600 750 100 133 167
TOTAL Current
Assets1,650 2,140 2,260 100 130 137
Fixed Assets
Land 800 1,000 1,000 100 125 125
Buildings 1,600 2,000
2,400100 125 150
Plant 2,000 2,000
2,400100 100 120
TOTAL Fixed
Assets4,400 5,000 5,800 100 114 11 munotes.in
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42Illustration
Complete the following Trend Analysis Statement for D Ltd.
Particulars 31/12/13 31/12/14 31/12/15 31/12/13
%31/12/14
%31/12/15
%
Sales 10,000 15,000 20,000 100 ? ?
Less: Cost of
Goods sold7,000 ? ? 100 125 200
Gross Profit 3,000 ? ? 100 ? ?
Less:
Administrative
Expenses1,000 1,250 1,500 100 125 150
Finance
Expenses500 625 750 100 ? ?
Selling Expenses 250 375 500 100 ? ?
Net profit
before Tax1,250 4,000 3,250 100 320 260
Less: Income
Tax250 800 1,000 100 ? ?
Net profit after
Tax1,000 ? ? 100 320 225
Solution
Particulars 31/12/13 31/12/14 31/12/15 31/12/13
%31/12/14
%31/12/15
%
Sales 10,000 15,000 20,000 100 150 200
Less: Cost of
Goods sold7,000 8,750 14,000 100 125 200
Gross Profit 3,000 6,250 6,000 100 208.33 200
Less:
Administrative
Expenses1,000 1,250 1,500 100 125 150
Finance
Expenses500 625 750 100 125 150
Selling
Expenses250 375 500 100 150 200
Net profit
before Tax1,250 4,000 3,250 100 320 260
Less: Income
Tax250 800 1,000 100 320 400
Net profit after
Tax1,000 3,200 2,250 100 320 225
EXERCISE
1.Explain the tools of analyzing the financial statements
2.Write short notes:
a.Common size Statement b.Comparative statements c.Trend analyses
munotes.in
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43MODULE –II
3
INTRODUCTIO NTO FU NDF L O W
STATEME NT
Unit Structure
3.0 Learning Objectives:
3.1 Fund Flow Statement
3.2 Benefits of Fund Flow Statement
3.3 Procedure of Preparation of Fund Flow Statement
3.4 Importance of Fund Flow Analysis
3.0 LEAR NINGOBJECTIVES
Understanding the concept of fund
Calculation of fund from operation
Calculation of changes in working capital
Preparation of statement of Sources & Application of Funds
3.1 FU ND FLOW STATEME NT
Funds flow statement is a financial statement w hich shows as to
how a business entity has obtained its funds and how it has applied or
employed its funds between the opening and closing balance sheet dates
(during the particular year/period). It can be described as –WHERE GOT -
WHERE GONE statement Fund susually refers to cash resources and funds
statement is prepared to show the net effect of various business events on
the current resources of the organization. In this topic fund should be
understood as working capital & funds flow as to mean any change in
working capital.
Funds Flow Statement is a statement prepared to analyse the
reasons for changes in the financial position of a company between 2
Balance Sheets. It shows the inflow & outflow of funds i.e. SOURCES and
APPLICATIONS of funds for a parti cular period. In other words Funds flow
statement is prepared to explain the changes in the working capital position
of a company. There are two types of inflows of funds –munotes.in
Page 44
44a.Long term funds raised by issue of Shares, Debentures or sale of
Fixed Assets
b.Fund s generated from operations
If the long term fund requirements of a company are met just out of
the Long term Sources of funds, then the whole fund generated from
operations will be represented by increase in working capital. However if
the funds generate d from operations are not sufficient to bridge a gap of
long term fund requirement, then there will be a decline in working
capital.
3.2 BE NEFITS OF FU ND FLOW STATEME NT
Funds flow statement is useful for long term analysis. It is very
useful tool in the hands of the management for judging the financial &
operating performance of the company. The Balance Sheet and the Profit &
Loss A/c (Income Statement) fails to provide the information which is
provided by the funds flow statement i.e. changes in Financia l Position of an
enterprise. Such an analysis is of great help to the management,
shareholders, creditors etc.
Fund Flow Statement answers the following questions
Where have the profits gone?
Why is there an imbalance existing between liquidity position and
profitability position of an enterprise?
Why is the concern financially solid in -spite of losses
Fund flow statement analysis helps the management to test whether
the working capital has been effectively used or not and the working
capital level is ade quate or inadequate for the requirements of the
business. The working capital position helps the management in taking
policy decisions regarding payment of dividend etc.
Fund flow statement analysis helps the investors to decide whether the
company has ma naged the funds properly. It also indicates the credit
worthiness of a company which helps the lenders to decide whether to
lend money to the company or not. It helps the management to take policy
decisions and to decide about the financing policies and ca pital
expenditure for the future.
3.3 PROCEDURE OF PREPARATIO NOF FU NDF L O W
STATEME NT
Step I -Prepare the statement of changes in working capital
Step II -Analyse the changes in non -current assets and noncurrent liabilities
to find out inflow or outflo w of funds
Step III -Find out funds from operationmunotes.in
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45Step IV -Prepare statement of Sources & Application of Funds (Funds
Flow Statement)
Step –I
Step –II-Working Capital Changes
Increase in Current Assets –Increase in Working Capital -
Outflow
Increase in Current Liabilities –Decrease in Working Capital -
Inflow
Decrease in Current Assets –Decrease in Working Capital -
Inflow
Decrease in Current Liabilities –Increase in Working Capital -
Outflow
Step III –Finding Funds from Operations
In this s tep, we need to calculate the funds generated only from
the Operating activities of the business and not from the Investing /
Financing activities of the business. The funds from operations shall be
prepared as follows:munotes.in
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46
Step –IV–While preparing t he fund flow statement, the sources and uses
of funds are to be disclosed clearly so as to highlight the sources from where
the funds have been generated and uses to which these funds have been
applied. This statement is also sometimes referred to as the s ources and
applications of funds statement or statement of changes in financial position.
munotes.in
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47Sources of Funds
Issue of Equity & Preference Shares
Receipt of Securities Premium
Issue of Debentures
Receipt of Long Term Loans from Banks & Other Financial
Institutions
Receipt of Public Deposits & other Unsecured Loans
Sales of Fixed Assets, Sale of Investments
Extraordinary receipt awarded in legal suit
Income from long term investments
Funds from operations
Decrease in Working Capital
Application of Funds
Redemption of Preference share capital, Redemption of
Debentures
Premium paid on redemption of debentures and preference shares
Repayment of temporary loans, secured & unsecured
Purchase of Fixed Assets, Purchase of Investment
Extraordinary payments and non recurring losses like loss by fire &
damages paid
Payment of Dividend & Interim Dividend, Payment of Tax
Increase in Working Capital
Formats of Fund Flow Statement
There is no prescribed format as such for the preparation of Funds
Flow Statement. The only point to be remembered is that it should be
presented in a clear and systematic manner. However, Funds Flow
Statements may be prepared in any of the following formats
Report Form –Remainder Type
Report Form –Self Balancing Type
Report Form –Reconciling Type
munotes.in
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48Fund Flow Analysis
Flow analysis consists of two different analysis namely
Working Capital Analysis –is the analysis & reporting of working capital.
Working capital is the excess of current assets over current liabilities. This
analysis consist o f two statements namely
Statement of changes in working capital
Statement of Sources & Application of Funds
Cash Flow Analysis –is the analysis of inflows and outflows of cash.
Cash flow analysis results in separate reports viz. Sources and
Applicatio ns of Cash Funds flow statement explains as to what caused the
changes in the balance sheet items between two balance sheet dates
3.4 IMPORTA NCE OF FU NDF L O WA NALYSIS
Funds flow statement is an important financial tool, which analyze
the changes in fi nancial position of a firm showing the sources and
applications of its funds. It provides useful information about the firm's
operating, financing and investing activities during a particular period. The
following points highlight the importance of funds f low statement.
1)Helps in identifying the change in level of current assets
investment and current liabilities financing.
2)Helps in analyzing the changes in working capital level of a firm.
3)Shows the relationship of net income to the changes in
funds from bus iness operation.
4)Reports about past fund flow as an aid to predict future
funds flow.
5)Helps in determining the firms' ability to pay interest and
dividend, and pay debt when they become due.
6)Shows the firms' ability to generate long -term financing to satis fythe
investment in long -term assets.
7)Helps in identifying the factor responsible for changes in assets, liabilities
and owners' equity at two balance sheet date.munotes.in
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54Important Terms
Fund –It refers to working capital, Flow –It is a moveme ntof
fund
Current Items –It includes current assets and current liabilities
Non Current Items –It includes share capital, reserves, loans, fixed
assets, investments etc
Fund from Operation –it is the cash profit generated from
operations
Working Capita l–Excess of current assets over current liabilities is
called as working capital.
Theory Questions
1.Why are funds flow statements important?
2.Explain –funds from operations
3. Explain the concept of fund & how the funds flow?
Practical Questions
munotes.in
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554
INTRODUCTIO NTO CASH FLOW
STATEME NT
Unit Structure
4.0 Learning Objectives
4.1 Cash Flow Statement
4.2 Analysis of Cash Flow Statement
4.3 Cash Flow from Operating Activities
4.4 Cash from Investing Activities
4.5 Cash from Financing Activities
4.6 Benefits/Importance of Cash Flow Analysis
4.7 Limitations of Cash Flow Analysis
4.8 Accounting Standard –AS3 on Cash Flow Statement
4.9 Distinction between Cash Flow V/S Funds Flow
4.0 LEAR NING OBJECTIVES
Understanding concept of cash flow
Accounting standard for Cash Flow Statement (AS -3)
Preparation of Cash Flow Statement
Importance & Limitations of Cash Flow Statement
4.1 CASH FLOW STATEME NT
In financial accounting, a cash flow statement ,a l s ok n o w n
asstatement ofcash flows , is a financial statement that shows how
changes in balance sheet accounts and income affect cash and cash
equivalents, and breaks the analysis down to operating, investing and
financing activities.
Cash Flow Statement gives information about cash receipts
(sources) and cash payments (application). It contains opening balances &
closing balan ces of cash for a given period and explains how the closing
balance as per last balance sheet changed by various inflows & outflows
of cash to a closing balance of cash as per the next balance sheet. As per
AS-3, cash would include cash in hand and savings ,c u r r e n ta / cb a l a n c e s
with banks & cash equivalents. Cash equivalents are short term & highly
liquid investments that are readily convertible into cash. An investment
would normally be called a cash equivalent only when it has a short term
maturity of say 3 months or less from the date of acquisition.munotes.in
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564.2 A NALYSIS OF CASH FLOW STATEME NT
Thecash flow statement is distinct from the income statement and
balance sheet because it does not include the amount of future incoming
and outgoing cash that has been recorded on credit. Therefore, cash is not
the same as net income , which, on the income statement and balance
sheet, includes cash sales andsales made on credit. Cash flow is
determined by looking at three components by which cash enters and
leaves a company: core operations, investing and financing ,
4.2 (a) Operations
Measuring the cash inflows and outflows caused by core business
operations, the operations component of cash flow reflects how much cash
is generated from a company's products or services. Generally, changes
made in cash, accounts receivable ,depreciation ,inventory andaccounts
payable are reflected in cash from operations.
Cash flow is calculated by making certain adjustments to net
income by adding or subtracting differences in revenue, expenses and
credit transact ions (appearing on the balance sheet and income statement)
resulting from transactions that occur from one period to the next. These
adjustments are made because non -cash items are calculated into net
income (income statement) and total assets andliabilities (balance sheet).
So, because not all transactions involve actua l cash items, many items
have to be re -evaluated when calculating cash flow from operations .
For example, depreciation is not really a cash expense; it is an
amount that is deducted from the total value of an asset that has previously
been accounted for. That is why it is added back into net sales for
calculating cash flow. The only time income from an asset is accounted
for in CFS calculations is when the asset is sold.
Changes in accounts receivable on the balance sheet from
oneaccounting period to th e next must also be reflected in cash flow. If
accounts receivable decreases, this implies that more cash has entered the
company from customers paying off their credit accounts -the amount by
which AR has decreased is then added to net sales. If accounts receivable
increase from one accounting period to the next, the amount of the
increase must be deducted from net sales because, although the amounts
represented in AR are revenue, they are not cash.
An increase in inventory, on the other hand, signals th at a company
has spent more money to purchase more raw materials . If the inventory
was paid with cash, the increase in the value of inventory is deducted from
net sales. A decrease in inven tory would be added to net sales. If inventory
was purchased on credit, an increase in accounts payable would occur on
the balance sheet, and the amount of the increase from one year to the
other would be added to net sales.munotes.in
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57The same logic holds true for taxes payable, salaries payable
andprepaid insurance . If something has been paid off, then the difference
in the value owed from one year to the next has to be subtracted from net
income. If there is an amount that is still owed, then any differences will
have to be added to net earnings.
4.2 (b) Investing
Changes in equipment, assets or investments relate to cash from
investing. Usually cash changes from investing are a "cash out" item,
because cash is used to buy new equipment, buildings or short -term assets
such as marketable securities . However, when a company divests of an
asset, the transactio n is considered "cash in" for calculating cash from
investing.
4.2 ( c) Financing
Changes in debt, loans or dividends are accounted for in cash from
financing. Changes in cash from financing a re "cash in" when capital is
raised, and they're "cash out" when dividends are paid. Thus, if a company
issues a bond to the public, the company receives cash financing;
however, when interest is paid to bondholders , the company is reducing its
cash.
Major Cash Inflows
•Issue of new shares for cash
•Receipt of short term & long term loans from banks, financial
institutions etc
•Sale of assets & investments, Dividend & Interest received,
•Cash ge nerated from operations
Major Cash Outflows
•Redemption of preference shares, Purchase of fixed assets or
investments
•Repayment of long term and short term borrowings
•Decrease in deferred payment liabilities, Loss from operations
•Payment of tax, dividend etc.
Classification of Activities
As per AS -3 the cash flow statement should report cash flows during the
period classified by
•OPERATING ACTIVITIES
•INVESTING ACTIVITIES
•FINANCING ACTIVITIESmunotes.in
Page 58
584.3 CASH FLOW FROM OPERATI NG ACTIVITIES
•The cash flows generated from major revenue producing activities of
the entities are covered under this head.
•Cash flow from operating activities is the indicator of the extent to
which the operations of the enterprise have generated sufficient cash to
maintain the operating capability to pay dividend, repay loans & make
new investments. Main Examples are
•Cash receipts from sale of goods & services
•Cash receipts from royalties, fees, commission etc
•Cash payments to employees
•Cash payments or refunds (receipt) of in come tax
•Cash receipts & payments relating to future contracts, forward contract
etc
•Cash receipts and payments arising from purchase and sale of trading
securities
4.4 CASH FROM I NVESTI NG ACTIVITIES
•These are the acquisition and disposal of long term a ssets and other
investments not included in cash equivalents. This represents the
extent to which the expenditures have been made for resources
intended to generate future incomes & cash flows, Examples are
•Cash payments for purchase of fixed assets
•Cash receipts from sale of fixed assets
•Cash payments for purchase of shares/debentures etc. in other entities
•Loans and advances given to third parties
•Repayments of loans given
4.5 CASH FROM FI NANCING ACTIVITIES
•Financing activities are the activities that result in changes in the size
and composition of the owner’s capital and borrowings of the
enterprise.
•Separate disclosure is important because it is useful in predicting
claims on future cash flows by providers of funds
•Examples
•Cash receipts from issue of share capital , debentures & short term &
long term loans
•Cash Repayments of loans borrowed
•Cash payment to redeem preference sharesmunotes.in
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60
4.6 BE NEFITS/IMPORTA NCE OF CASH FLOW
ANALYSIS
•Efficient Cash Management –manage the cash resources in such a
way that adequate cash is available for meeting the expenses
•Internal Financial Management –useful for internal financial
management as it provides clear picture of cash flows from operations
•Knowledge of change in Cash Position –It enables the management
to know about the causes of changes in cash positionmunotes.in
Page 61
61•Success or Failure of Cash Planning –Comparison of actual &
budgete d cash flow helps the management to know the success or
failure in cash management
•It is a supplement to fund flow statement as cash is a part of fund
•Cash Flow Statement is a better tool of analysis for short term
decisions
4.7 LIMITATIO NSO FC A S HF L O W ANALYSIS
•Misleading Inter Industry Comparison -Cash flow does not
measure the economic efficiency of one company in relation to another
company
•Misleading Inter Firm Comparison -The terms & conditions of
purchases & sales of different firms may not be the same. Hence inter
firm comparison becomes misleading
•Influence of Management Policies –Management policies influence
the cash easily by making certain payments in advance or by
postponing certain payments
•Cannot be equated with Income Statement –Cash flow statement
cannot be equated with income statement. Hence net cash flow does
not mean income of the business
•CFS cannot substitute the B/S & Funds Flow .
4.8 ACCOU NTING STA NDARD –AS3 O NCASH FLOW
STATEME NT
Objective of AS -3 is to provide desired information about historical
changes in cash & cash equivalents of an enterprise classified in to
Operating, Investing and Financing activities.
•An enterprise should disclose the com ponents of cash and cash
equivalents and should present a reconciliation of the amount in the
cash statement with the equivalent items reported in the balance sheet
•An enterprise should disclose the amount of cash & cash equivalent
balance held by the ente rprises that are not available for use by it with
explanation of Managementmunotes.in
Page 62
624.9 DISTI NCTIO NBETWEE NCASH FLOW V/S FU NDS
FLOW
Practical Sumsmunotes.in
Page 66
66
Key Terms:
Cash –It includes cash and demand deposits with Banks
Cash Equivalents –These are short term and highly liquid investments
Cash Flows –It is movement of cash
Non Cash Expenses –These are the expenses which do not involve any
cash payment
Revenue Activities -These are the activities which are revenue
producing
Investing Activities –These are related to acquisition and disposal of
long term assets
Financing Activities –These are the activities relating to changes in
capital & borrowings
Theory Questions:
1.Explain the technique of cash flow statement?
2.What is utility of cash flow statement to financial management?
3.Explain the concept of “Flow of Cash” & enumerate the sources of
cash?
4.What data would you require to prepare a cash flow statement?
Suggested Readings for Fund Flow & Cash Flow Statements
Management Accounting –Bhattacharya Debarshi
Introduction to Management Accounting –Dr.Varsha Ainapure (Manan
Prakashan)
Principles of Financial Management –Satish Inamdar (Everest Publishing
House)munotes.in
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67Management Accounting –Chopde (Sheth Publishers)
Practical Sums:
munotes.in
Page 68
68MODULE -III
5
RATIOANALYSIS
Unit Structure
5.1 Introduction
5.2 Objectiveofratio analysis
5.3 Advantagesofratio analysis
5.4 Meaning ofratios
5.5 Modesofexpressinganaccountingratio
5.6 Importance of ratio ana lysis
5.7 Classi fication ofratios
5.8 Balancesheetratios
5.9 Revenuestatementratios
5.10 Combineratio/compositeratios
5.11 Limitationofratios
5.12 Exercisewithsolution
5.13 Practice
5.1INTRODUCTION
Ratioanalysisistheprocessofdetermining andinterpreting
numericalrelationships basedonfinancialstatements.Aratioisa
statisticalyardstickthatprovidesameasure oftherelationship between
twovariablesorfigures.
This relationship canbeexpressedasapercentorasaquotient.
Ratios aresimpletocalculateandeasytounderstand.Thepersons
interestedintheanalysisoffinancialstatementscanbegroupedunder
threeheads,
i)Owners orinvestors
ii)Creditors and
iii)Financial executives
Althoughallthesethreegroups areinterestedinthefinancial
conditions andoperatingresults,ofanenterprise,theprimary information
thateachseekstoobtainfrom thesestatementsdiffersmaterially,
reflecting thepurpose thatthestatementistoserve.munotes.in
Page 69
69Investors desireprimarilyabasisforestimating earning
capacity.Creditorsareconcernedprimarilywith liquidity andabilityto
payinterestandredeemloanwithin aspecifiedperiod.Managementis
interestedinevolvinganalyticaltools thatwill measurecosts,efficiency,
liquidity andprofitability with aviewtomakeintelligentdecision s.
5.2OBJECTIVE OFRATIO ANALYSIS :
The mainobjectiveso fa n a l y z i n gf i n a n c i a ls t a t e m e n tw i t ht h eh e l po f
ratios are :
1.The analysiswould enablethecalculation ofnotonlythepresent
earning capacityofthebusinessbutwould alsohelpintheestimation
ofthefuture earningcapacity.
2.The analysiswould helpthemanagementtofind outtheoverallas
wellasthedepartment–wiseefficiencyofthefirmonthebasisof
theavailablefinancialinformation.
3.The short termaswellasthelong termsolvencyofthefirmcanbe
determinedwith thehelpofrationanalysis.
4.Inter–firmcomparison becomeseasywiththehelpofratios.
5.3ADVANTAG ESOFRATIO ANALYSIS:
Financialstatementpreparedattheendoftheyeardonotalways
conveytothereadertherealprofitability and financial health of the
business.Theycontainvarious factsandfiguresanditisforthereader
toconcludewhatthesefiguresindicated.RatioAnalysisisanimportant
toolforanalyzingthesefinancials tatements.Someimportantadvantage
derivedbythefirmbytheuseofaccounting ratiosare:
1.HelpinFinancialstatementanalysis
Itiseasytounderstandthefinancialpositionofabusinessenterprise
in respectofshort -termsolvency,liquidity andprofitabilitywith thehelp
ofratio.Ittellsusthechangestaking placeinthefinancialcondition of
thebusiness.
2.Simplifiedaccountingfigures
Absolute figuresarenotofmushuse.Theybecomeimportantwhen
relationships areestablishedsaybetweengrossprofitandsales.
3.Helpsincalculatingoperation efficiencyofthebusinessenterprise
Ratioenablestheuseroffinancialinformationtodetermineoperating
efficiencyofafirm byrelating.Theprofitfiguretothecapitalemployed
foragivenperiod.
4.Facilitiesinter-firmcomparison
Ratioanalysisprovidesdataforinter-fir m comparison.Itrevelsmunotes.in
Page 70
70strong andweakfirms,overvaluesandundervaluesfirmsaswellas
successfulandunsuccessfulfirms.
5.Makesinter-firmscomparisonpossible
RatioAnalysishelpsthefirmtocompare eitsownperformance
overaperiod oftimeaswellastheperformanceofdifferentdivisions of
thefirm.Ithelpsindecidingwhichdivision sa r e moreefficientthan
other.
6.Helpsinforecasting
RatioAnalysishelpsinplanning andforecasting .Ratiosprovides
cluesontrendsandfuturesprobl ems.E.g.ifthesalesofafirmduring the
yearareRs.10lakhsandheaveragestockkeptduring theyearRs.2
lakhs,itmustbereadytokeepastockofRs.3lakhswhichis20%ofthe
Rs.15lakhs.
5.4.MEANINGOFRATIOS:-
Aratioisonefigureexpressedintermsofanotherfigure.Itis
mathematicalyardstickofmeasuring relationship oftwofiguresor
itemso r group ofitems,whicharerelated,iseachotherand
mutuallyinter-dependent.Itissimplythequotientoftwonumbers.It
canbeexpressedinfractionorindecimalpointorinpurenumber.
Accountingratioisanexpressionrelatingtotwofiguresor
twoaccounts ortwosetaccountingheadsorgroup ofitemsstatedin
financialstatement.
5.5. MODESOFEXPRESSINGANACCOUNTING
RATIO
Anaccountingratiomayb e expressedindifferentwaysasunder.
I)Simpleorpureratio:-Itismerelyaquotientarrivedbysimple
divisionofonenumberbyanother.
Example:WhencurrentassetsofthebusinessenterpriseareRs.
1,00,000andcurrentliabilitiesareRs.25,000.Theratiobetween
currentassetsandcurrentliabilitieswillbeexpresseda s 1 , 0 0 , 0 0 0/
25,000 = 04 OR it is expressed as 4:1.
II) Percentages:-Itisexpressedaspercentagerelationship when
simpleorpure ratioismultipl iedby100.
Example:Thecurrentratioinaboveexampleisexpressedin
percentagebymultiplying4by100.
i.e.100x4=400%munotes.in
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71III)Rate :-The ratioisexpressedasrateswhichrefertotheratioover
aperiodoftime.
Example:Stockhasturnedover8timesayear.
IV)Numberofdaysorweekormonth:-Certainitemsofthe
financialstatementsareexpressedbetterintheformofdaysorweeksor
months.
Example:Debtors' collectionperiod, credit payment period,
movementofstock,etcareexpressedindaysorweeksormonthsina
year.
V)Rupees:-Inthiscasenumeratorisdividedbydenominatorand
figureofresultisexpressedinrupees.
Example:Earningspershare,dividendpershareetcareexpressed
inrupees.ItnetprofitaftertaxisRs.12,500 andnumberofsharesofa
companyare1250 .
Earning per shares = NPAT/ No. Of Shares
12500/ 1250 = Rs. 10 per shares
5.6. IMPORTA NCE OF RATIO A NAYSIS
Theratiosareusefulforthefollowingparties.
1.Investors,both presentaswellaspotentialinvestors.
2.Financialanalysist.
3.Stockbrokerandstockexchangeauthorities.
4.Government.
5.TaxDepartment.
6.Competitors
7.Rese archanalysistandstudents.
8.Creditorsandsupp lier.
9.Banksandfinancialinstitutions.
10.Company'smanagement.
11.Financemanagers
12.Mutualfunds.
13.Otherinterestedpartieslikecreditratingagencies.
5.7.CLASSI FICATIO NOFRATIOS
Differenttypesofratiosarecomputeddepending onthepurpose
forwhichtheyareneeded.Broadlyspeaking,theyaregroupedunderfour
heads:munotes.in
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721.Liquidity ratios
2.Solvencyratios
3.Turno verorActivityratios
4.Profitabilityratios
Theratiosareworkedouttoanalyzethefollowingaspector
areasofbusinessorganization.
1)Solvency:-
a)Long-termsolvency
b)Short-termsolvency
c)Immed iatesolvency
2)Stability
3)Profitability
4)Operationalefficiency
5)Creditstanding
6)Structuralanalysis.
7)Utilizationofresourcesand
8)Leverageorexternalfinancing.
Theratiosareusedfordifferentpurpo ses,fordifferentusersand
fordifferentanalysis.Theratioscanbeclassifiedasunder:
a)Traditionalclassification
b)Functionalclassification
c)Classificationfromuser‘spoint ofview
Traditionalclassification:
Asperthisclassification, theratiosreadilysuggestthrough
theirnames,theirrespectiveresources.Fromthispointofview,the
ratiosareclassifiedasfollows.
a)BalanceSheetRatio :-Thisratioisalsoknownasfinancialratios.
Theratioswhichexpressrelationships be tweentwoitemsorgroup of
itemsmentionedinthebalancesheetattheendoftheyear.
Example:Currentratio,Liquidratio,StocktoWorkingCapitalratio,
CapitalGearing ratio,Proprietaryratio,etc.
b)RevenueStatementRatio :-This ratioisalso knownas
incomestatementratiowhichexpressestherelationship betweentwo
itemsortwogroupsofitemswhicharefound intheincomestatement
oftheyear.
Example:Gross Profitratio,Operatingratio,ExpensesRatio,Net
Profitratio,StockTurnoverratio,OperatingProfitratio.munotes.in
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73c)CombinedRatio :-Theseratiosshowstherelationship
betweentwoitemsortwogroups ofitems,ofwhichoneisfrom
balancesheetandanotherfromincomestatement(TradingA/cand
Profit&LossA/candBalanceSheet).
Example:Return onCapitalEmployed,ReturnonProprietors'Fund
ratio,ReturnonEquity Capitalratio,Earning perShareratio,
Debtors' Turnoverratio,CreditorsTurn overratio.
FunctionalClassificationofRatios :
Theaccoun tingratioscanalsobeclassifiedaccording their
functionsasfollows.
a)LiquidityRatios :-Theseratiosshow relationship b etween
currentassetsandcurrentliabilitiesofthebusinessenterprise.
Example:CurrentRatio,LiquidRatio.
b)LeverageRatios :-Theseratiosshow relationship between
proprietor'sfund anddebtsusedinfinancingtheassetsofthebusiness
organization.
Example:Capitalgearingratio,debt-equity ratio,a n d proprietaryratio.
Thisratiomeasurestherelationship betweenproprietors fund and
borrowedfunds.
c)Activity/TurnoverRatio :-Thisratioisalsoknownasturnover
ratioorproductivityratioorefficiency andperformance ratio .These
ratiosshow relationshipbetweenthesalesandtheassets.Theseare
designedtoindicatetheeffectivenessofthefirm in using funds,
degreeofefficiency,anditsstandard ofperformanceofthe
organization.
Example:StockTurnoverRatio,Debtors'Turn overRatio,Turnover
AssetsRatio,StockworkingcapitalRatio,workingcapitalTurnover
Ratio,FixedAssetsTurnoverRatio.
d)ProfitabilityRatio:-Theseratiosshow relationship between
profitsand salesand p rofit&investments.Itreflectsoverall
efficiencyoftheorganizations, itsabilitytoearnreasonablereturn
oncapitalemployedandeffectivenessofinvestmentpolicies.
Example:
i)ProfitsandSales:OperatingRatio,Gross ProfitRatio, Operating net
profit Ratio, Expenses Ratio etc.
ii)ProfitsandInvestments:Return onInvestments ,Return onEquity
Capitaletc.munotes.in
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74e)CoverageRatios :-These ratios show relationship betweenprofitin
handandclaimsofoutsiderstobepaidoutofprofits.
Example:DividendPayoutRatio,DebtServiceRatioandDebtService
CoverageRatio.
Classificationfromtheviewpointofuser:
Ratiosf r o mt h eu s e r s ’p o i n to fv i e wa r e classifiedasfollows.
a)Shareholders'pointofview:-Theseratios servethe
purpo sesofshareholders.Shareholders,generallyexpectthereasonable
returnontheircapital.Theyareinterestedinthesafetyofshareholders
investmentsandinterestonit.
Example:Return on proprietor’s fund, Return on Capital, Earning per
share.
b)Longtermcreditors:-Normallyleverageratiosprovideuseful
informationtothelongterm creditors whichinclude debenture
holders,vendors offixedassets,etc.Thecreditorsinterestedtoknow
theabilityofrepayment ofprincipalsum and periodical int erest
paymentsasandwhentheybecomedue.
Example:Debt equity ratio, return on capital emplo yed,proprietaryratio.
c)Shorttermcreditors:-The short-term creditors ofthe
companyarebasicallyinterestedtoknow theabilityofrepaymentof
short -termliabilities asand whenthey becomedue. Therefore,the
creditorshasimportantplaceontheliquid ityaspectsofthecompany's
assets.
Example:
a)Liquidity Ratios-CurrentRatio,LiquidRatio
b)DebtorsTurn overRatio
c)StockworkingcapitalRatio.
d)Management:-Managementis interested to use bo rrowedfunds to
improvetheearnings.
Example:Return on capital employed, tu rnoverRatio,OperatingRatio,
and Expenses Ratio.
5.8.BALANCESHEE TRATIOS
CurrentRatio :
Thisratioisalsoknownasworkingcapitalratio.Thisexpresses
therelationship betweencurrentassetsandcurrentliabilities.Thisratio
iscalculatedbydividingcurrentassetsbycurrentliabilities.Itis
expressedaspure ratiostandardcurrentratiois2:1.Mean scurrentmunotes.in
Page 75
75assetsshould bedoublethecurrentliabilities.Current AssetsCurrent RatioCurrent Liabilitiesa)CurrentassetsincludesI)Inventoriesofrawmaterials,finished
goods,work-in-progress,stores&spare,loosetools, II)Sundry debtors,
III)Short-termloan,deposits,advance,IV)Cashonhandandbank,V)
Prepaidexpenses,accruedincome,VI) Billsreceivables,VII)
Marketableinvestments,shorttermsecurities.
b)Currentliabilitiesincludessundrycreditors, billspayables,
outstanding expenses,u nclaimeddividends,interestaccruedbut not
due on securedandunsecuredloans,advancesreceived,income
receivedinadvance,provision fortax,p u r poseddividendloan
installmentofsecuredandunsecuredloanpayablewithin12months.
c)Significance:Thisratioteststhecreditstrengthandsolvencyofan
organization .It shows strength of working capital, it indicates ability to
discharge short term liabilities.
Liquidratio:
Thisratio expresses therelationship between liquid assets and
liquid liabilities.Thisratioisalsoknownasquickratiooracidtestratio.
Thisratioiscalculatedbydividingliquid assetsbyliquid liabilities.
Standardquickratiois1:1.Liquid Assets / Quick AssetsLiquid RatioQuick or Current Liabilities
a)Liquidassets=Currentassetsless(Stock,prepaidexpensesand
advancetaxetc)
b)Liquidliabilities=Currentliabilitiesless(Bankoverdraftandcash
creditetc)
c)Significance:-
1)Indicateimmediatesolvencyofenterprise.
2)UnlikeCRitismorequalitativeconcept
3)Asiteliminatesinventories,itisrigorous testofliquidity.
4)Moreimportantforfinancialinstitutions.
Proprietaryratio:
Proprietaryratioisatestofthefinancialandcreditstrengthof
thebusiness.Itestablishesrelationship betweenproprietorstototal
assets.This r atiodeterminesthelongtermsolvencyofthecompany.munotes.in
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76Alternativelythis ratioisalsoknownasWorthDebt Ratio .Net
worth to TotalAssetsRatio,Equity Ratio,Networth RatioorAssets
BackingRatio,Proprietor'sfunds toTotalAssetsRatioorShareholders
Funds toTotalAssetsRatio.
Thisratioisexpressedinpercentage.
a)Formula:-
Pr oprietor' s Shareholder' s FundPr oprietary Ratio 100Total Assets b)Components:-
1)ProprietorsFunds =Paidupequity +Rese rvesandsurplusless
accumulatedloss+
Paid uppreferencecapital.
2)Totalassets=Fixedassets+investment+currentassets.
c)Purpose:-Thisratioisexercisedto indicate the long term
solvencyofthebusiness.
d)Significance:-
Thisratioshowsgeneralfinancialstrengthofthebusiness.
1)Itdeterminestheextentoftradeonequity.
2)Itindicateslongtermsolvencyofbusiness.
3)Ittestscreditstrengthofbusiness.
4)Itcanbeusedtocompareproprietaryratiowithothersfirmsor
industr y.
Stock-workingcapitalratio:
Thisratioestablishesrelationshipbetween stock andworking capital .
Alternativelyitisknownas"Inventory-workingcapitalratio".
a)Formula:-
StockStock Working Capital RatioWorking Capital
b)Components:-
1)Stock(closing stock)
2)Workingcapitali.e.currentassetslesscurrentliabilities.munotes.in
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77Itcanbeexpressedinpercentagealsobymultiplyingthisratio
by100.
c)Purpose :-This ratio showsthe extenttowhichthe
working capitalisblockedininventories.
d)Significance:-
1)This ratio highlights the predominance of stocks in current financial
positio n of organization.
2)Ahigherratioindicatesweekworkingcapital.
3)Thisratioistheindicatoroftheadequacyofworkingcapital.
e)StandardRatio :-Standardstockworkingcapitalratiois1:1
CapitalGearingRatio :
Thisratiobringsouttherelationshipbetweencapitalcarrying
fixedrateofinterestorfixeddividendandcapital thatdoesn'tcarry
fixedrate ofinterest orfixed dividend .Thisratio indicatesdegreeto
whichcapitalhasbeengearedinthecapitalstructureofthecompany.
Alternativelythis ratio isalsoknownas"Leverageratio"or"Financial
leverageratio"or"Capitalstructureratio".
a)Formula:-Capital bearing Fixed Interest or dividendCapital Gearing RatioCapital not bearing Fixed Interest or dividend
b)Components:-
1)Capital bearing fixed interest or dividend comprises of debentures,
securedand unsecuredl o a n s , andpreferencesharecapital.
2)Capitalnotbearingfixedinterestordividendisequitysharecapital
andreserve&surplus. Thisratioalsocanbeexpressedin%ageby
multiplyingthisratioby100.
c)Purpose:-Thisratioisusedtounderstandtheeffectivecapital
structureofthecompany.
d)Significance:-
1)Itismechanism toascertaintheextenttowhichthecompanyis
practicingtradeorequity.
2)Itbringsonebalancedcapitalstructure.munotes.in
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78DebtEquityRatio :
Thisratioexpresstherelationsh ipbetweenexternalequitiesand
externalequitiesi.e.owners'capitalandborrowedcapital.
a)Formula:-
Debt Long Term DebtsDebt equity Ratio OR OREquity Shareholders Fund
Long Term DebtsShareholders' Funds Long Term Debtsb)Components:-
1)Debtsinclude allliabilitiesincluding short term &longtermi.e.
mortgageloananddebentures.
2)Shareholders’ funds consist of preference sh arecapital,Equity share
capital,CapitalandRevenueReserves,Surplus,etc.
c)Significance:-
1)Itsharesfavorable ornon favorable capitalstructure ofthe
company.
2)Itshowslongtermcapitalstructure.
3)Itrevealshighmarginofsafetytocreditors.
4)It makes us understand the dependence on long term debts.
d)Standard:-Standarddebt-equity ratiois2:1.Itmeansdebts
shouldbedouble theshareholdersfunds.
5.9.REVENUESTATEMENTRATIOS:
Revenuestatementratiosaretheratioswhichhighlightsthe
relationbetweentwo items fromrevenue statementsi.e.TradingAccount
andProfitandLossAccount.
Grossprofitratio:
Gross profitratiosexpresstherelationshipbetweengrossprofitand
netsales.This ratioisalsoknownas"Turnoverratio"OR "Margin
ratio"OR"Gross marginratio"OR"Rateofgrossprofit".This
ratioisexpressedinpercentageofnetsales.Thisratiosaysabout%age
grossprofittonetsales.a)Formula:-
Gross Pr ofitGross Pr ofit Ratio 100Sales munotes.in
Page 79
79b)Componentsofthisratioare:-
1)Netsales=Totalsaleslesssalesreturn
2)Gross profit=Sales-Costofsales
3)Costofsales=(openingstock+purchases+directlabour +other
directcharge)-closingstock
c)Significance:-
1)Thisratioanalyzesthebasicprofitabilityofbusiness.
2)Itshowsthedegreetowhichthesellingpriceperunit maydecline
without resultinginlossfromoperations.
3)Yearlycomparisons ofgross profitratiorevealthetrend oftrading
results.
OperatingRatio :
Thisratiostudiestherelationsh ipbetweencostofactivitiesand
netsalesi.e.costofgoods sold andnetsales.This ratio showsthe
percentageofcostofgoods soldwithnetsales.Thisratioisexpressed
inpercentage.
a)Formula:-
Operating CostOperating Ratio 100Net Sales b)Components:-Operatingcostisequaltocostofgoods sold and
other operating expenseslikeadministrativeexpenses,selling &
distributionexpensesetc.excluding financeexpenses,incometaxes,loss
onsaleofassets,etc.
c)Purpose :-Purposeofoperatingratio istoascertainthe
efficiencyofthemanagemen tregarding operationofbusinessconcern.
d)Significance:-
1)Itisusedtotestoperationalefficiencyofbusiness.
2)Thisratioistheyardstickwhichmeasurestheefficiencyofall
operationalactivitiesofbusinessi.e.production, management,
administration,sales,etc.
e)Limitationofoperatingratio:-
1)Itcannot testprofitabilityofbusinesswithout consideringextra-
ordinaryitems.
2)Theutilityof operating ratioislimitedowing toits
vulnerabilitytochangesinmanagementdecisions.munotes.in
Page 80
80Expenses Ratio :
Thisratioexplainsrelationship ofitemsorgroup ofexpenseto
netsales.Suchratiosarecollectivelyknownasexpansesratio.Thisis
calculatedandexpressedinpercentage.This Ratio expressesthe
percentageofitemsofexpenseswithnetsales.
a)Formu la :
Item or Group of ExpensesExpenses Ratio 100Net Sales 1)Ad ministrative ExpensesAd ministrative Expenses Ratio 100Net Sales 2)Selling & Dist. ExpensesSelling & Dist.exp enses Ratio 100Net Sales 3)Cost of material consumedCost of material consumed RatioNet Sales 4)Manufacturing ExpensesManufacturing Expenses Ratio 100Sales 5)Non operating ExpensesNon operating exp enses Ratio 100Net Sales
c)Purposeandsignificance:-
1)This ratio helps us to know the cause behind overall changesin
operatingratio
2)Purposeofthisratioistotakecorrectiveaction.
3)It indicates the efficiency ofmanagement in controlled
expenses andimproving profitability.
4)This ratioenablestheincometaxdepartmenttojudgethe
correctnessandreliabilityofincomedisclosedinincometaxreturns.
5)Analyticalstudy ofthis ratiocanbejudgedbytrendof
expenses.
6)Comparative study of year to year expenses can be possible .
Netprofitratio:-
Netprofitratioindicatestherelationship betweennetprofitand
netsales.Netprofitcanbeeither operating netprofitornetprofit
aftertaxornetprofitbeforetax.Alternativelythisratio is alsoknown
as“Marginonsales ratio ". Normallythis ratio is
calculated &expressedinPercentage.munotes.in
Page 81
81a)Formula :
Net Pr ofit NPATNet Pr ofit Ratio 100 OR 100Net Sales Net Sales
NPDT ONPOR 100 OR 100Net Sales Net Sale
b)Significance:-
1)Itmeasuresoverallprofitabilityofbusiness.
2)Itisveryusefulinjudgingreturnoninvestments.
3)Itprovidesusefulinferencesastotheefficiencyandprofitability of
business.
4)It indicates the portion of net sales is available for proprietors.
5)Itisclearindexofcostcontrol, managerialefficiency,sales
promotion,etc.
Netoperatingprofitratio:
Operating profit ratio indicate s the relationship between operating
profit and netsales.This ratio isexpressed inpercentage.
a)Formula :
Net operating Pr ofitNet Operating Pr ofit Ratio 100Net Sales
b)Components:-
1)Netoperatingprofitisequaltogross profitminus alloperating
expensesorsalesminuscostofgoods sold andoperatingexpenses.
2)Netsalesareequaltosalesminussalesreturns.
c)Significance:-
1)Itsignifieshigheroperatingefficiencyofmanagementandcontrol
overoperatingcost.
2)Itindic atesprofitabilityofvariousoperationsoftheorganizationi.e.
buy,manufacture ,sales,etc.
3)Itshowsabilityoforganizationtogenerateoperatingprofitoutof
itsdailyoperations.
StockTurnoverRatio :
Stockturnoverratio showsrelationship betweencosts of
goods so ldand averagestock.This ratioisalsoknownasmunotes.in
Page 82
82"InventoryRatio"or"InventoryTurnoverRatio"or"StockT u r n
Ratio"or"StockVelocityRatio"or"VelocityofRatio".
Thisratiomeasuresthenumberoftimesofstockturns or
flowsorrotatesinanaccounting periodcompared tothesalesaffected
duringthatperiod.Thisratioindicatedthefrequencyofinventory
replacement.This ratioisexpressedasrate.
a)Formula:-Cost of goods soldStock Turnover RatioAverage Stock
b)Components:-
1)Costofgoods sold=Sales–Gross Profit
2)Opening stock clo sin g StockAverage Stock2
*Ifopeningstockisnotgiven,theclosingstockistreatedasaverage
stock.
c)Alternativemethodofstockturnoverratio:-This ratiocanbe
calculatedbyusingaveragestock atselling priceatasthedenominator.
Underthismethod,averageStock atsellingpriceisrelatedt onetsales.
Net SalesStock Turnover RatioAverage inventory at selling price
d)Purpose:-Purposeofstockturnoverratioisto
1)Calculatethespeedatwhichthestockisbeingturnedoverinto
sales.
2)Calculatethestockvelocitytoindicatetheperiodtakesbyaverage
stocktobesoldout.
3)Judgehow efficientlythestockaremanagedandutilizedtogenerate
sales.
5.10.COMBINERATIO/COMPOSITERATIOS:
Combinedorcompositeratiosrelatetwoitemsorgroup of
itemsofwhichoneisfrom balancesheetandanotherfrom revenue
statementsofanenterprise.
Returnoncapitalemployed:
This ratioexplainstherelationship betweentotalprofit
earned by business and total inve stment made or total assets employed. Itmunotes.in
Page 83
83isexpressedinpercentage.This ratioisalsoknownas"Returnon
Investment",or"ReturnonTotalResources".
a)Formula:-
Pr ofit before tax int erestReturn on apital employed 100Capital Employed
b)Components :
1)Net profit before tax, interest & di vidends (PBIT)
2)Capital employed
Capital employed =
i)Equity share capital
ii)Add. Preference share capital reserve & surplus
iii)Add. Long term borrowings (Term loan + Debentures)
iv)Less: Fictitious assetslikemiscellaneousexpensesnotwritten
off.
v)Lessprofit& loss A/cDr.Balance(loss)
c)Purpose:-
1)Purposeofthisratioistomeasureoverallprofitabilityfromthe
totalfunds madeavailablebyownersandleaders.
2)Purposeofthisratioistojudgehow efficientthebusinessconcern
isinmanagingthefunds atitsdisposal.
d)Significance:-
1)This ratioiseffectivetools tomeasure overallmanagerial
efficiencyofbusiness.
2)Com parisonofthisratiowithothercompanyandthisinformation
canbeobtainedfordeterminingfuturecourse ofaction.
3)Thisratioindicatestheprodu ctivityofcapitalemployedandmeasures
theoperatingefficiencyofthebusiness.
ReturnonProprietorsFunds:
Thisratio measures therelationship between netprofit after tax
&interestandproprietorsfund.Thisratioisalternativelyknownas
"Return onproprietors' equity"or"Return onshareholders'investment"
or"Investors'ratio".This ratio isExpressed inpercentage.
a)Formula :
Net Pr ofit after tax & Interest ( NPATI )Return on Pr oprietor' s Fund 100Pr oprietor' s Fund munotes.in
Page 84
84b)Components:-
1)Netprofitaftertaxandinterest
2)Proprietors'funds
c)Purpose:-
1)Purposeofthisratioistomeasuretherateofreturnonthetotal
fundmadeavailablebytheowners.
2)This ratio helps tojudgehow efficienttheconcernisin
managingowners'fundsatitsdisposal.
d)Significance:-
1)This ratio isvery significanttoprosp ectiveinvestors and
shareholders.
2)Withthehelpofthisratiocompanycandecidetorisefinancefrom
externalsources evenfrom public deposit itratioissatisfactory.
3)Shareholderscanexpecttocapitalizeitsreservesandissuebonus
shareswhenratioishigherforreasonableperiodoftime.
Returnonequitysharecapital:
Thisratioexplainsrelationshipbetweennetprofit(aftertaxand
interestanddividendonpreferences h a r e ) andequity shareholders'
funds.Thisratioisexpressedinpercentage.
a)Formula:-
Net Pr ofit after tax less preference dividendReturn on Equity Capital 100Equity share capital
Alternativelythisratiomaybecalculatedbyusing following
formulaforcalculatingthereturnperequity shares.Net Pr ofit after tax less preference dividendReturn on Equity SharesNumber of Equity share
b)Components:-
1)Netprofitaftertax&interestandpreferencedividend.
2)Equity sharecapitalbyaddingreservesordeductingmiscellaneous
expenditures.
c)Purpose:-
Purposeofthisratioistocalculateamount ofprofitavailableto
takecareofequity d ividend,transfertoreserves,etc.munotes.in
Page 85
85d)Significance:-
1)Itisusefultotheinvestorswhiledecidingwhethertopurchase
orsaleofshares.
2)Thisratiohelpstomakecomparativestudy ofequity capitalwith
othercompanyanditwillbeappreciateifthereishighreturn.
Earningpershare:
Earning pershareiscalculatedtofindoutoverallprofitabilityof
theorganization.Itrepresentsearningsofthecompanywhetherornot
dividendsaredeclared.Earning pershareisdeterminedbydividingnet
profitbythenumberofequityshares.
a)Formula:-
Net Pr ofit after tax preference dividendEarning per shares EPSNumber of Equity share
b)Components:-
1)Netprofitaftertax&interest-lesspreferencedividend.
2)No.ofequity shares.
c)Purpose:-
Purpose of this ratio is to calculate the amount of profit available
on each equity shares to take care of equity dividend , transfer to reserve,
etc.
d)Significance:-
1)Thisratiohelpstheinvestorsorshareholderstotakedecisionwhile
purchasingorsellingshares.
2)Thisratioshowsthepossibi litiesofissueofbonus shares.
3)Higherratioindicatesoverallprofitability.
Dividendpayoutratio:
This ratio shows relationship between dividend paid to equity
shareholde rs out of profit available to the equity shareholders.
a)Formula:-
Thisratioiscalculatedasfollows.Dividend per equity sharesDividend payout ratioEarning per shares
b)Components:-
1)Dividendperequity sharesmeanstotaldividendpaidtoequity
shareholderdividendbynumberofequity shares.
2)Earning persharesrefer to formula given abovemunotes.in
Page 86
86c)Purpose:-Purposeofthisratioistomeasure thedividend
payingcapacityofthecompany.
d)Significance:-
1)Higherratiosignifiesthatthecompanyhasutilizedthelargerportion
ofitsearningforpaymentofdividendtoequity shareholders.
2)Itsayslesseramount ofearning hasbeenretained.
Priceearningsratio(P/ERatio) :
Thisratiomeasuresrelationshipbetweenmarketpriceofequity
sharesandearningspershare.Itisusuallyexpressedasafraction.
a)Formula:-Market price per Equity sharesPr ice Earning RatioEarning per Equity shares
b)Components:-
1)Marketpriceperequityshare=quotedpriceofalistedequity
share.
2)Earningsperequity sharerefer to formula given above
c)Purpose:-
1)Purposeofthisratioistoshow theeffectoftheearning onthe
marketpriceoftheshare.
2)Ithelpstheinvestorswhiledecidingwhethertopurchase,keepor
selltheequity shares.
3)Ithelpstoascertainthevalueofequity share.
DebtserviceRatio :
Debtserviceratioshowsrelationship betweennetprofitand
interestpayableonloans.Thisratioisalsocalledasinterestcoverage
ratio.Thisratioisexpressedasapure number.
a)Formula:-Net Pr ofit before int erest & taxDebt Service RatioInterest Ch arg es
b)Components:-
1)Profitbeforeinterest&taxmean snetprofitbeforepaymentof
interestonloanandtax.
2)Interestmeansinterestonlongtermloans.munotes.in
Page 87
87c)Purpose:-
1)Purposeofthisratioistomeasure theinterestpayingcapacitythe
company.
2)Thepurpo seofthisratioistofindoutthenumberoftimesthe
fixedfinancialchargesarecoveredbyincomebeforeinterestand
tax.
d)Significance:-
1)Itisimportantfromthelenders'point ofview.
2)Itindicatedwhetherthecompanywillearnsufficientprofitstopay
periodicalinterestcharges.
3)Itshowsthatthecompany willbe ableispayinterest
regularly.
Debtservicecoverageratio:
Debtservicecoverageratioshowstherelationship betweennet
profitandinterestplus loaninstallments payable.This ratiois
expressedinpure number.
a)Formula:-Cash profit available for debt servicingDebt Service RatioInterest Installment due on loan
b)Components:-
1)Netprofit+non-cashdebitto P &LA/c(depreciation+
goodwillwrittenoff,d eferredrevenueexpenditurewrittenoff,loss
onsaleoffiredassets)=cashprofitfordebitservicing.
2)Interestmeansinterestonlongtermloan.
3)Installmentsmeansinstallmentsdue onlong termloanduringthe
year.
c)Purpose :-Purpose ofthis ratio istomeasure thedebt
servicingcapacity of thecompany.
CreditorsTurnoverRatio:
Thisratioshowsrelationship betweenthenetcredit pur chasesand
theaveragecreditors.This ratioisexpressasarate.
b)Components:-
1)Creditpurchasesmeansgross creditpurchasesminuspurchases
returns.munotes.in
Page 88
882)Averagecreditorsmeanaverageofopeningandclosingamount
ofcreditors. Ifdetailsarenot giventhenonly closingcreditors
maybeconsideredasaveragecreditors.
3)Amount ofbillspayable.
c)Purpose:-Propose of this ratio is to measure the debt servicing
capacity of the company.
Creditors Turnover Ratio :
This ratio shows relationship between the net credit purchase and
the average creditors. This ratio is express as a rate.
a)Formula :
Net Credit Purchases Credit purchasesCreditor' s Turnover Ratio ORAverage creditors Creditors Bills payable 365 day or 12 monthsCredit payment period OR ( Creditors velocity )Creditors turnover ratioCreditors Bills payableDaily
credit purchases
b)Components :
1)Creditpurchasesmeansgross credit pu rchasesminuspurchases
returns.
2)Averagecreditorsmeanaverageofopeningandclosingamount of
creditors.Ifdetailsarenotgiventheno n l y closingcreditorsmaybe
consideredasaveragecreditors.
3)Amount ofbillspayable.
c)Purpose :
Purposeofthisratioisto.
1)Calculatethespeedwithwhichcreditorsarepaidoffonanaverage
duringtheyear.
2)Calculatethecreditors'velocitytoindicatetheperiodtakenbythe
averagecreditorstobepaidoff.
3)Judgehow efficientlythecreditorsaremanaged.
Debtors'TurnoverRatio :
Thisratioshowsrelationshipbetweencreditsalesandaveragetrade
debtors.Alternativelythisratio is kno wnas"accountsreceivable
turnoverratio"or"turnovero fdebtors'ratio".Thisratioisexpressedasa
rate.munotes.in
Page 89
89a)Formula:-
Credit Sales Credit salesDebtors Turnover Ratio ORAverage debtors Average receivable
Debtors Bills ReceivableAverage collections period ORDaily credit sales
365 days or 12 months 365 daysOR Average debtorsDebtors turnover ratio Credit Sales
1)Sundrydebtors
2)Accounts receivablesi.e.billsreceivables.
3)Averagedailysales.
c)Purpose:-Purposeofthisratioisto.
1)Calculatethespeedwithwhichdebtorsgetsettledonanaverage
duringtheyear.
2)Calculatedebtors'velocitytoindicatetheperiodofcreditallowed
toaveragedebtors.
3)Judgehow efficientlythedebtorsaremanaged.
5.11.LIMITATIONOFRATIOS:
1)Itisalwaysachallengingjobtofindanadequatestandard.The
conclusionsdrawnfrom theratioscanbenobetterthanthestandards
againstwhichtheyarecompared.
2)Whenthetwocompaniesareofsubstantiallydifferentsize,ageand
diversifiedprodu cts,,comparisonbetweenthemwill bemore
difficult.
3)Achangeinpricelevelcanseriously affectthevalidity of
comparisonsofratios computedfordifferenttimeperiods and
particularlyincaseofratioswhosenumeratoranddenominatorare
expressedindifferentkinds ofrupees.
4)Comparisons arealsomadedifficultduetodifferencesoftheterms
likegross profit,operatingprofit,netprofitetc.
5)Ifcompaniesresortto‘window dressing’,outsiderscannotlook into
thefactsandaffectthevalidity ofcomparison.
6)Financialstatementsarebasedupon partperformanceandpartevents
whichcanonlybeguidestotheextenttheycanreasonablybe
consid eredasduestothefutur e.
7)Ratiosdonotprovideadefiniteanswertofinancialproblems.There
isalwaysthequestionofjudgmentastowhatsignificanceshouldbemunotes.in
Page 90
90giventothefigures.Thus, onemustrelyupon one’sown goodsensein
selectingandevaluatingtheratios.
5.12.EXERCISEWITHSOLUTION
EX.1XLtd.hasacurrentratioof3.5:1andquickratioof2:1.Ifexcess
ofcurrentassetsoverquickassetsrepresentedbystockisRs.1,50,000,
calculatecurrentassetsandcurrentliabilities.
Solution
LetCurrentLiabilities=x
CurrentAssets =3.5x
And QuickAssets =2x
Stock=CurrentAssets–QuickAssets
1,50,000 =3.5x–2x
1,50,000 =1.5x
x =Rs.1,00,000
CurrentAssets =3.5x=3.5×1,00,000=Rs.3,50,000.
EX.2Calculatethecurrentratiofromthefollowi nginformation:
Working capitalRs.9,60,000; Totaldebts Rs.20,80,000;
Long-termLiabilitiesRs.16,00,000; StockRs.
4,00,000; prepaidexpensesRs.80,000.
Solution
CurrentLiabilities=Totaldebt-Longtermdebt
=20,80,000–16,00,000
=4,80,000
Working capital=CurrentAssets–Currentliability
9,60,000 =CurrentAssets–4,80,000
CurrentAssets =14,40,000
Quick Assets = Current Assets -(stock + prepaid expenses)
=1 4 , 4 0 , 0 0 0 -(4,00,00 0+8 0 , 0 0 0 )
=9 , 6 0 , 0 0 0
Current ratio = Current Assets / Current liabilities
=1 4 , 4 0 , 0 0 0/4 , 8 0 , 0 0 0
= 3:1
Quick ratio = Quick Assets / Current liabilities
=9 , 6 0 , 0 0 0/4 , 8 0 , 0 0 0
= 2:1
EX.3CalculateDebtEquity,fromthefollowi nginformation:
10,000preferenceshareofRs.10each Rs.1,00,000
5,000equity sharesofRs.20each Rs.1,00,000
Creditors Rs.45,000
Debentures Rs.2,20,000
ProfitandLossaccounts (Cr.) Rs.70,000munotes.in
Page 91
91Solution
Debt=Debentures=Rs.2,20,000
Equity =Equity sharecapital+PreferencesShareCapital+profitand
Lossaccounts
=Rs.1,00,000+Rs.1,00,000+Rs.70,000
=Rs.2,70,000
DebtEquity Ratio=Longtermdebt/shareholders’funds
=Rs.2,20,000/Rs.2,70,000
=0.81:1
EX.4CalculateDebtEquityRatio,fromthefollowing information:
TotalDebtsRs.3,00,000; TotalassetsRs.5,40,000;Current
liabilitiesRs.70,000.
Solution
Long-termDebt =TotalDebt–CurrentLiabilities
=Rs.3,00,000–Rs.70,000=Rs.2,30,000
ShareholdersFunds =TotalAssets–TotalDebts
=Rs.5,40,000–Rs.3,00,000
=Rs.2,40,000
DebtEquity Ratio =Longtermdebt/Shareholders’funds
=Rs.2,30,000/Rs.2,40,000
=0.96:
EX.5Shareholders’fundsRs.80,000; TotaldebtsRs.1,60,000; Current
liabilitiesRs.20,000.CalculateTotalassetstodebtratio.
Solution
Longtermdebt =TotalDebt-Currentliabilities
=Rs.1,60,000-Rs.20,000
=Rs.1,40,000
TotalAssets =Shareholders’funds +T o t aldebt
=Rs.80,000+Rs.1,60,000
=Rs.2,40,000
TotalAssetstodebtratio=TotalAssets/Debt
=Rs.2,40,000/Rs.1,40,000
=12:7
=1.7:1
EX.6From thefollowing balancesheetofacompany,calculatedebt
equity ratio, totalassetstodebt ratioandpropri etaryratiomunotes.in
Page 92
92BalanceSheetofXltdason31.12.2007
PreferenceShareCapital 7,00,000PlantandMachinery 9,00,000
Equity ShareCapital 8,00,000LandandBuilding 4,20,000
Reserves 1,50,000Motor Car 4,00,000
Debentures 3,50,000Furniture 2,00,000
CurrentLiability 2,00,000Stock 90,000
Debtors 80,000
CashandBank 1,00,000
Discount onIssue of
Shares10,000
22,00,000 22,00,000
Solution
DebtequityRatio=Long-termDebt/Equ ity
TotalAssetsRatio=TotalAssets/long termDebt
Propri etaryRatio=ShareholdersFunds/To talassets
Debtequityratio=Rs.3,50,000/Rs.16,40,000=0.213
TotalAssetsRatio=Rs.21,90,000/Rs.3,50,000=6.26
Propri etaryRatio=Rs.16,40,000/Rs.21,90,000=0.749
EX.7From thefollowing information,calculateDebtEquity Ratio,Debt
Ratio,Propri etaryRatioandRatioofTotalAssetstoDebt.
BalanceSheetasonDecember31,2006
Equity shareCapital
PreferenceShareCapital
Reserves
Profit&lossA/C
11%Mort gageLoan
Currentliabilities3,00,000
1,00,000
50,000
65,000
1,80,000
1,20,000FixedAssets
CurrentAssets
PreliminaryExpenses4,50,000
3,50,000
15,000
8,15,000 8,15,000munotes.in
Page 93
93Solution
ShareholdersFunds =EquitySharescapital+PreferenceSharescapital+
Reserves+profit%lossA/C -PreliminaryExpenses
=Rs.3,00,000+Rs.1,00,000+Rs.50,000+Rs.65,000-
Rs.15,000
=Rs.5,00,000
DebtEquity Ratio=Debt/Equity
=Rs.1,80,000/Rs.5,00,000=0.36:1
Propri etaryRatio = Propri etaryfunds /TotalAssets
=Rs.5,00,000/Rs.8,00,000
=0.625:1
TotalAssetstoDebtRatio=T o t alAssets/Debt
=Rs.8,00,000/Rs.1,80,000
=4.44:1
EX.8Thedebtequity ratioofXLtd.is1:2.Whichofthefollowing would
increase/decreaseornotchangethedebtequity ratio?
i)Issue ofnewequity shares
ii)Cashreceivedfromdebtors
iii)Saleoffixedassetsataprofit
iv)Redemptionofdebentures
v)Purchaseofgoods oncredit.
Solution:
a)The ratiowilldecrease.This isbecausethedebtremainsthesame,
equity increases.
b)Theratiowillnotchange.This isbecauseneitherthedebtnorequality
isaffected.
c)The ratiowilldecrease.This isbecausethedebtremainsunchanged
whileequity increasesbytheamount ofprofit.
d)The ratiowilldecrease.This isbecausedebtdecreaseswhileequity
remainssame.
e)Theratiowillnotchange.This isbecauseneitherthedebtnorequity
isaffected.
EX.9Fromthefollowing information,calculatestockturno verratio.
Opening stockRs58,000;ExcessofClosingstockopening stock
Rs.4,000;salesRs.6,40,000; Gross Profit@255oncost
Solution:
Costofgoods Sold=Sales-Gross Loss
=Rs.6,40,000–25/125(6,40,000)
=Rs.5,12,000munotes.in
Page 94
94Closing st ock=Opening stock+Rs.4000
=Rs.58,000+Rs4,000
=Rs.62,000
Averagestock=(Openingstock+Closing Stock)/2
=( 5 8 ,000+62,000)/2
=Rs.60,000
StockTurno verRatio=CostofGoods Sold/AverageStock
=Rs.5,12,000/Rs.60,000=8.53times.
EX.10A tradercarriesanaveragestockofRs.80,000. Hisstock turno ver
is 8times.Ifhesellsgoods at profit of20% onsales.Findouttheprofit.
Solution
StockTurno verRatio=CostofGoods Sold/AverageStock
=CostofGoods Sold/Rs.80,000
CostofGoods Sold =Rs.80,000×8
=Rs.6,40,000
Sales=CostofGoods Sold×100/80
=Rs.6,40,000×100/80
=Rs.8,00,000
Gross Profit=Sales–CostofGoods Sold
=Rs.8,00,000–Rs.6,40,000
=Rs.1,60,000.
EX.11CalculatetheDebtors Turno verRatioanddebtcollectionperiod
(inmonths) from thefollowing information:
Totalsales=Rs.2,00,000
Cashsales=Rs.40,000
Debtors atthebeginning oftheyear=Rs.20,000
Debtorsattheendoftheyear =Rs.60,000
Solution
AverageDebtors =(Rs.20,000+Rs.60,000)/2 =Rs.40,000
Netcreditsales=Totalsales-Cashsales
=Rs.2,00,000-Rs.40,000
=Rs.1,60,000
Debtors Turno verRatio=NetCreditsales/AverageDebtors
=Rs.1,60,000/Rs.40,000
=4Times.
Debtcollectionperiod=12months/52 w eeks/365 days
Debtors’ turno ver
=12/4
=3monthsmunotes.in
Page 95
95EX.12CashpurchasedratioRs.1,00,000; costofgoods sold Rs.
3,00,000;opening stockRs.1,00,000 andclosingstockRs.2,00,000.
Creditors turno verratio3times.Calculatetheopening andclosing
creditorsifthecreditors attheendwere3timesmorethanthecreditors at
thebeginnin g.
Solution
TotalPurchase=Costofgoods sold +closing stock-openingstock
=Rs.3,00,000+Rs.2,00,000–Rs.1,00,000
=Rs.4,00,000
Creditpurchases=TotalPurchase-cashpurchase
=Rs.4,00,000-Rs.1,00,000
=Rs.3,00,000
Creditor Turno verRatio=NetCreditPurchase/AverageCreditor
AverageCreditor =Rs.3,00,000/ 3
=Rs.1,00,000
(opening Creditor+ClosingCreditor)/2 =Rs.1,00,000
opening Creditor+ClosingCreditor =Rs.2,00,000
(opening Creditor+(opening Creditor +3opening Creditor)
=Rs.2,00,000
Opening Creditor =Rs.40,000
Closin gCreditor =Rs.40,000+(3XRs.40,000)
=Rs.1,60,000
EX.13From the followi nginformation,calculate(i)FixedA s sets
Turno verand(ii)Working CapitalTurno verRatios:
PreferenceSharesCapital 6,00,000 PlantandMachinery 6,00,000
Equity ShareCapital 4,00,000 LandandBuilding 7,00,000
GeneralReserve 2,00,000 Motor Car 2,50,000
ProfitandLossAccount 2,00,000 Furniture 50,000
15% Debentures 3,00,000 Stock 1,70,000
14% Loan 1,00,000 Debtors 1,20,000
Creditors 1,40,000 Bank 90,000
BillsPayable 30,000 Cash 20,000
Outst anding Expenses 30,000
20,00,000 20,00,000
SalesfortheyearwereRs.60,00,000.munotes.in
Page 96
96Solution
Sales =Rs60,00,000
FixedAssets=Rs.6,00,000+Rs.7,00,000+Rs.2,50,000+Rs.50,000
Working capital=CurrentAssets–CurrentLiabilities
CurrentAssets=Stock+Debtors +bank+cash
Rs.1.70,000+Rs.1.20,000+Rs.90,000+Rs.20,000
Rs.4,00,000
CurrentLiabilities =Creditors +BIP+OISExp
=Rs.1,40,000+Rs.30,000+Rs.30,000
=Rs.2,00,000
Working capital =Rs.4,00,000+Rs.2,00,000
=Rs.2,00,000
FixedTurn overRatio=Netsale/Fixedassets
=Rs.60,00,000/ Rs.16,00,000=3.75times
Working capitalTurno ver=NetSale/Working Capital
=Rs.60,00,000/ Rs.2,00,000=30times.
EX.14CalculateGross Profitratiofromthefollowing information:
Opening stockRs.50,000;closing stockRs.75,000;cashsaleRs.
1,00,000; credits salesRs1,70,000;Returns outw ards Rs.15,000;
purchasedRs.2,90,000; advertisementexpensesRs.30,000; carriage
inwardsRs.
10,000.
Solution:
Costofgoods sold=Opening stock+netpurchases+directexpenses–
closingstock
=Rs.50,000 +(Rs.2,90,000-Rs.15,000) +Rs.10,000 -Rs.
75,000
=Rs.2,60,000
TotalSales=CashSales+CreditsSales
=Rs.1,00,000+Rs1,70,000
=Rs.2,70,000
Gross profit=TotalSales-Costofgoods sold
=Rs.2,70,000-Rs.2,60,000
=Rs.10,000
Gross profitRatio=10,000X100
2,70,000
=3.704%munotes.in
Page 97
97EX.15Calculatedpriceearningsratiofromthefollowing information:
Equity sharecapital(Rs.10perShare) Rs2,50,000
Reserves(including currentyear’sprofit)Rs1,00,000
10%PreferenceShareCapital Rs2,50,000
9%Debentures Rs2,00,000
Profitbeforeinterest Rs3,30,000
MarketPriceperShare Rs50.
Taxrate 50%
Solution :
P/ERatio=MarketpriceofaShare/EarningsperShare
Earning pershare=Profitavailableforequityshareholders/No.ofEquity
Share
Profitavailableforequityshareholders:
Profitbeforeinterest=Rs.3,30,000
Lessinterestondebentures=Rs18,000
Rs3,12,000
Lesstax(50%ofRs.3,12,000) =Rs.1.56,000
Lesspreferencedividend =Rs.25,000
Earning afterTax =Rs1,31,000
Earning pershare =Earningaftertax/No.ofequityshares
=Rs1,31,000/ 25,000
=Rs.5.24
P/ERatio=Marketpriceshare/Earning pershare
=Rs.50/Rs.5.24
=Rs.9.54
Ex.16Following isthetrading andprofitandloss accountfortheyear
ended31stMarch2014 andbalancesheetasonthatdateofSun.ltd.
Trading andprofit andlossaccount fortheyearended31stMarch2014.
Particulars Amt. Particulars Amt.
ToOpeningStock 2,50,000 BySales(Credit) 37,00,000
ToPurchases 26,00,000 ByClosing Stock 5,00,000
ToGross Profitc/d 13,50,000
Total 42,00,000 Total 42,00,000
ToAdministrationExps. 2,70,000 ByGross Profit 13,50,000
ToInterest 72,000 ByProfitonsaleofAssets 50,000munotes.in
Page 98
98ToRent 60,000
ToSellingExps 1,00,000
ToDepreciation 1,20,000
ToProvision forI.Tax 2,78,000
ToPropos edDividend 1,00,000
ToNetProfit 4,00,000
Total 14,00,000 14,00,000
Balancesheetason31.3.2014
Liabilities Amt. Assets Amt.
Equity ShareCapital(Rs.10) 5,00,000 FixedAssets(atcost) 12,40,000
11% PreferenceSh.Capital 3,00,000 ShortTermCapital 1,00,000
GeneralReserve 4,00,000 TradeReceivable 9,50,000
12% Debenture 6,00,000 (LastYearRs.9,00,000)
TradePayable 3,00,000 Inventori es 5,00,000
Propos edDividend 1,00,000 CashandBank 1,50,000
BankOverdraft 2,00,000 Discount onIssue ofShares 60,000
Provision ForDepreciation 4,00,000
Provision forTax 2,00,000
30,00,000 30,00,000
From theaboveinformationcalculatefollowing ratiosandcomme nton
currentratio.
1.Currentratio
2.InventoryTurno verRatio
3.ReturnonPropri etorsFund
4.OperatingRatio
5.Debtors Turno verRatio
6.CapitalGearingRatio
7.DividendPayoutRatio
Assu me360daysinayear.
Note : Drafting of Vertical Financial Statement is not expected. Ans. :munotes.in
Page 99
99S.
No.Ratio Formula Calculation Ans.
1. Current
RatioCACL1,7003002.13:1
2. Inventory
Turnover
RatioCOGSAvg.Stock2,3503756.27
Times
3. Return on
Proprietors
FundNPAT100Pr op. Fund500100114043.86%
4. Operating
RatioCOGS Op. Exps Int.100Net Sales2,350 550 72100370080.32%
5. Debtors
Turnover
RatioCredit SalesAvg. A / c ReceivableNo. DaysDTR
3,7009251,7003004
Times
90 days
6. Capital
Gearing
RatioPr ef .Cap LTCEquity Sh. Holder Fund300 6008401.07
7. Dividend
Payout
RatioEq. DividendPr ofit Available for Eq.Sh. Ho. 1,00,0005,00,000 33,00021.41%
CurrentRatioismorethanstandardCurrentRatioismorethanstandard
currentRatio2:1This showsfavorableshort termfinancialpositio n.
Ex.17Following isthebalancesheetofBlissHappinessLtd.asat31st
March2013
Balancesheetasat31.3.2013
Liabilities Amt. Assets Amt.
Equity ShareCapital 1,00,000 Machinery 2,96,000
GeneralReserve 70,000 Investment 1,12,000
10% PreferenceCapital 1,80,000 StockInTrade 1,01,000
15% Debenture 1,20,000 BillsReceivable 20,000
TradePayable 1,22,000 TradeReceivable 49,000
BankOverdraft 20,000 CashandBank 38,000
Provision forTax 18,000 ProfitandLossA/c 14,000
6,30,000 6,30,000munotes.in
Page 100
100SalefortheyearRs.7,00,000; Gross profitRate25%andOpening Stock
isRs.1,09,000.Profitbefore
Taxfortheyearending 31.3.13isRs.2,10,000.
You arerequiredtocompute thefollowing ratiosandcommentoncurrent
ratio.
1.CurrentRatio
2.AcidTestRatio
3.Stockturno verRatio
4.CapitalGearingRatio
5.Propri etaryRatio
6.DebtEquity Ratio(Debt/Networth)
7.ReturnonCapitalEmployed
RedraftingthegivenBalancesheetinverticalformatisnotexpected.
Ans.
Current
RatioCurrent AssetsCurrent Liabilities1,01,000 20,000 49,000 38,0001,22,000 20,000 18,0001.3
Acid Test
RatioLiquid AssetsQuick Liabilities20,000 49,000 38,0001,22,000 18,000.76
Stock
TurnoverCost of goods soldOp. Cl.Stock / 2 7,00,000 1,75,0001,09,000 1,01,000 / 25 Time
Capital
Gearing
RatioFixed Int. Bearing SecuritiesEq.Sh Cap. Re s & Surplus Loss1,80,000 1,20,0001,00,000 70,000 14,0001.92
Proprietory
RatioPr oprietor' s Fund100Total Assets1,00,000 1,80,000 70,000 14,0001002,96,000 1,12,000 2,08,000 54.44%
Debt.
Equity
RatioDebtNet Worth1,20,0001,00,000 1,80,000 70,000 14,000 36
Return on
capital
employedNPBIT100Capital Employed2,10,000 18,0001001,20,000 3,36,00050%
Currentratiois1:3.Itislowerthanthestandardof2:1.The current
assetsforeveryrupeeofcurrentliabilities.Currentassetsarenot
sufficienttopaycurrentliabilitiesshort ternsolvencyposition ofthe
companyisnotsatisfactory.
Ex.18M/sSumitLtd.Presentsthefollowing Trading andProfit&Loss
A/cfortheyearended31.3.2014andbalancesheetasonthatdate.munotes.in
Page 101
101Trading andprofit andlossaccount fortheyearended31.3.2014.ParticularsAmt.ParticularsAmt.ToOpeningStock2,00,000BySales12,00,00ToPurchases5,00,000ByClosingStock4,00,000ToWages3,00,000ToGrossProfitc/d6,00,00016,00,00016,00,00ToSalaries1,50,000ByGrossProfitb/d6,00,000ToRent60,000ByProfitonsaleof5,000ToCommission12,000ByInterest15,000ToAdvertising20,000ToInterest83,000ToDepreciation30,000ToProvisionFortax50,000ToNetProfitc/d2,15,0006,20,0006,20,000ToProposedDividend80,000Bybalanceb/f1,85,000ToPreferenceDividend16,000ByNetprofitb/d2,15,000ToBalancec/d3,04,0004,00,0004,00,000Balancesheetason31.3.2014LiabilitiesAmt.AssetsAmt.Equity sharecapital
(Rs.100)8,00,000 LandandBuilding 6,00,0008%Pref.Sh.Capital2,00,000PlantandMachinery5,50,000Reserveandsurplus3,04,000Furniture4,00,0007%Debentures5,00,000Investment2,70,000LoanfromIDBI6,00,000Stock4,00,000Creditors1,50,000Debtors2,00,000BillsPayable50,000BillsReceivable1,60,000Provisionfortax50,000Advancetax30,000DividendPayable96,000Prepaidexpenses40,000CashinHand20,000BankBalance60,000Dis.OnIssue of
Debentures20,00027,50,00027,50,000Addition alInformation:
1.TheMarketPriceofequitysharesason31.3.2014 wasRs.90.
2.Outoftotalsales,30% arecashsalesandoutoftotalPurchases,50%
arecreditpurchases.You arerequiredtocalculatethefollowing
Ratios.
a)Returnoncapitalemployed d)Creditors Turno verRatio
b)PriceEarning ratio e)ReturnonEquity capital
c)DebtServiceRatiomunotes.in
Page 102
102Ans:
Return on
Capital
EmployedNOPBIT100Capital Employed1,01,000 20,000 49,000 38,0001,22,000 20,000 18,00014..39%
Creditors
Turnover
Payment
PeriodCredit PurchasesAv.Creditors Bills payable 365CTR2,50,0002,00,0003651.251.25
Time
292 days
Price
Earning
Ratio
EPSMPEPSNet Pr ofit Pr ef .Div.No.of Equity Shares 7,00,000 1,75,0001,09,000 1,01,000 / 22,15,000 16,0008,0003.62
24.88
Return on
Equity
CapitalNPAT Pr ef . Div.Eq.Sh Cap.2,15,000 16,0001008,00,00024.875%
Debt
Equity
RatioNPBITInterest2,15,000 50,000 83,00083,0004.19
Times
Ex.19Thefollowing isthesummarizedprofit andlossA/cofM/sHema
Ltd.Fortheyearended31.3201 4.ParticularsAmt.ParticularsAmt.ToOpeningStock5,00,000BySales50,00,000ToPurchases 25,00,000Byprofitonsaleofassets50,000ToWages25,000ByInterest25,000ToFreightandOctroi80,000ByDividend10,000ToDirectExpenses75,000ByClosingStock7,50,000ToOfficeInsurance80,000ToOfficeStaffSalaries2,00,000ToGen.ManagerSalary50,000ToStaffWelfareExpenses40,000ToPrintingandStationery5,000ToInterest50,000ToAuditFees15,000ToOfficeRent2,00,000ToComputerRepairs75,000ToAdvertising2,50,000ToBadDebts 5,000ToTraveling20,000ToCommission75,000munotes.in
Page 103
103ToDep.OnFurniture30,000ToDepn.OnBuilding40,000ToDepnonVehicles20,000ToInterimDividend50,000ToLossonsaleofAssets1,00,000ToIncomeTax50,000ToNetProfit13,00,00058,35,00058,35,000Calculatethefollowing Ratio;
1.Gross ProfitRatio
2.OperatingProfitRatio
3.OfficeExpenseRatio
Verticalstatementisnotexpected.Ans.
Gross
Profit RatioGross Pr ofit100Net Sales1,01,000 20,000 49,000 38,0001,22,000 20,000 18,00051.4%
Operatin g
RatioOperating Cost100Net SaleCOGS + Operating Exps. =
Operating cost24,30,000 11,55,00010050,00,00071.7%
Office
Expense
RatioOffice Expense100Net Sales7,55,00010050,00,00015.1%
Ex.20The following isthebalancesheetofM/sShyamLtd.Ason
31.3.2014 .
Balancesheetason31.3.2014LiabilitiesAmt.AssetsAmt.Equity sharecapital(Rs.10) 4,00,000 Goodwill 1,25,0009%Pref.Sh.Cap.(Rs.10)2,00,000Furniture&Fitting3,00,000GeneralReserve1,00,000LandandBuilding4,00,000ProfitandLossA/c1,00,000Stock1,00,00010%MortgageLoan2,00,000Debtors2,00,000AccountsPayable1,00,000CashandBank60,000Adv.FromCustomer 50,000 PrepaidExpenses 40,000Prov.ForTax.60,000PreliminaryExpenses15,000ProposedDividend40,000Dis.onIssueofDeb.10,00012,50,00012,50,000munotes.in
Page 104
104Thefollowing furtherinfor mationisalsogivenfortheyear;
TotalsalesRs.10,00,000netp rofitrate1 5%.O u t of totalsales2 0 % are
cashsales.PurchasesRs.5,00,000. No.ofdaysinayear360.Calculate
thefollowing Ratio:
a)Propri etoryRatio
b)AcidTestRatio
c)Creditors Turno verRatio
d)DebtEquity Shares
e)StockWorking CapitalRatio
f)CapitalGearingRatio
g)OperatingRatio
Ans:
Operating
RatioOperating Cost100Sales1,01,000 20,000 49,000 38,0001,22,000 20,000 18,000
Acid Test
RatioLiquid AssetsQuick Liabilities2,00,000 60,0001,00,000 60,000 40,0001.3:1
Creditors
Turnover
RatioCredit PurchasesCreditors5,00,0001,00,0005T i m e s
Capital
Gearing
RatioFixed Int. Bearing SecuritiesEq.Sh Cap. Re s & Surplus Loss2,00,000 2,00,0004,00,000 1,00,000 1,00,000 15,000 10,000 0.07:1
Proprietory
RatioPr oprietor' s Fund100Total Assets4,00,000 2,00,000 1,00,000 1,00,000 15,000 10 ,00010012,50,000 15,000 10,000
Debt Equity
RatioDebtNet Worth2,00,0007, 75,0000.26:1
Stock
Working
Capital
RatioClo sin g StockWorking Capital 1,00,0002,00,000 60,000 1,00,000 40,000 0.67:1
Ex21 CalculateGross ProfitRatio:ParticularsAmt.ParticularsAmt.ToOpeningStock60,000BySales4,00,000ToPurchases2,50,000ByGoodsDestroyedbyfire20,000ToCarriageInward 30,000ByClosing Stock 80,000ToOfficeExpenses50,000ToSellingExpenses40,000ToLossbyfire20,000ToNetProfit50,0005,00,0005,00,000munotes.in
Page 105
105GrossProfitGross Profit Ratio: 100Sale
1,60,000100 40%4,00,000
Gross Profit =4,00,000–(60,000+ 2,50,000-20,000 +30,000-80,000)
Ex.22Follo wingistheRevenueStatementofPromodLtd.
Trading ,Profit&Lossaccount fortheyearended31.3.2014ParticularsAmt.ParticularsAmt.ToOpeningStock27,150BySales2,55,000ToPurchases1,63,575ByClosingStock42,000ToCarriageInward4,275ByInterestreceivedonInvt.2,700ToOfficeExpenses45,000ToSalesExpenses13,500ToLossonsaleofFixedasset 1,200
ToNetProfitc/d 45,0002,99,7002,99,700Calculatethefollowingratio:
a)Gross ProfitRatio
b)StockTurno verRatio
c)NetProfitbeforetaxratio
d)OperatingRatio
e)OfficeExpenseRatio
Ans.
Gross
Profit RatioGross Pr ofit100Net Sales1,02,0001002,55,00040%
Operating
RatioOperating Cost100Net SaleCOGS + Operating Exps. =
Operating cost1,53,000 58,5001002,55,00082.94 %
Office
Expense
RatioOffice Expense100Net Sales45,0001002,55,00017.65%
Stock
Turnover
RatioCOGSAvg.Stock1,53,00045,0004.43
Times
Net Profit
before tax
RatioNPBT100Net Sales45,0001002,55,00017.65%munotes.in
Page 106
106Ex.23ThesummarizedbalancesheetofBadLuckltd.Ason31.3.2014
isasfollow.
Balancesheetason31.3.2014 (Inlakh)LiabilitiesAmt.AssetsAmt.Equity sharecapital(Rs.100) 150FixedAssets(atcost) 4209%Pref.Sh.Cap.(Rs.10)80Less:Depreciation50370ReserveandSurplus90Stock50ProfitandLossA/c40Debtors6010%Debentures50Cashatbank30ProvisionforTaxation20SundryCreditors80510510The following particulars are also given for the year.
Rs. In Lakhs
NetSales(Credit) 240
ProfitbeforeinterestandTax 65
Netprofitaftertax 40
MarketPriceperequity sharesisRs.150
Calculatethefollowing ratio:
a)AcidtestRatio
b)Debtors turno verRatio(360 daysinayear)
c)CapitalGearingRatio
d)DebtserviceRatio
e)ReturnonPropri etor’s Fund
Ans.:(Rs.InLakh)
Debtors
Turnover
RatioNet Credit SalesDebtors B.R.240604 Times
Creditors
TurnoverLiquid AssetsQuick Liabilities60 3020 800.9:1
Capital
Gearing
RatioFixed Int. Bearing SecuritiesEq.Sh.Cap. Re s & Surplus Loss80 50150 90 400.46:1
Debt
Service
RatioNet profit before Int.&TaxInterest65513
Times
Return on
Proprietor’s
FundNPAT100Pr oprietor' s Fund40,00,0001003,60,00,00011.11%munotes.in
Page 107
107Ex.24Following isthebalancesheetofM/sMoon Ltd.
Balancesheetason31.3.2014LiabilitiesAmt.AssetsAmt.Equitysharecapital5,00,000FixedAssets13,00,000GeneralReserve3,00,000Investment4,00,000SecuritiesPremium25,000Stock8,50,00010%Debenture7,50,000SundryDebtors5,00,000Profit&LossA/c7,40,000PrepaidExpenses40,000SundryCreditors2,30,000Adv.Incometax78,000BankOverdraft 3,95,000CashandBankBal. 62,000Prov.ForTaxation1,80,000ShareIssueExpenses10,000Prop.EquityDividend1,50,000PreliminaryExpenses30,00032,70,00032,70,000You arerequiredtocompute thefollowing r atioandgiveyourcomme nts
oneachratiowithreferencetostandardratio.
a)CurrentRatio
b)Liquid Ratio
c)Propri etoryRatio
d)Stockworking capitalRatio
Ans:
Current
RatioCurrent AssetsCurrent Liabilities15,30,0009,55,0001.6:1
Acid Test
RatioLiquid AssetsQuick Liabilities5,62,0005,60,0001:1
Stock
Working
RatioStockWorking Capital8,50,0005,75,0005 Time
Proprietory
RatioNet Worth100Total Assets15,25,00010032,30,00047.21%
Comme nts:
1.Short termsolvencyofthecompanyissatisfactory.Inindustry,
currentratioof1.50isconsideredsatisfactoryRs.1currentliabilities
aresupport edbyRs.1.60currentassets.
2.Imme diatesolvencyofthecompanyisquitesatisfactory asthe
companyhassufficientquickassetstopayoffitsquickliabilities.The
companycanmeetitsurgentliabilities.
3.Longtermsolvencyofthecompanyis not satisfactory.Only 47.12%
ofitstotalassetsarefinancedbyown fund.Marginofsafetyforthe
lendersofthecompanyisnotsatisfactory.The companyshould
improvethisratiobyincreasingshareholdersfundtobring itto65%
orabove.Thecompanydoesnothavefinancialstability.munotes.in
Page 108
1084.Companystockis147.83% ofitsworking capital.Companyis
carrying excessstock.Company in ventory managementisnot
satisfactory.Stockmaycontaindefectiveorslowmovingitems.
Ideally sto ckshouldnotexceedworking capital.Workingcapital
position ofthe companyisunsatisfactory.Thereisexcessive
incidenceofinventory inwork ingcapitalmanagement.
Ex.25
a)Thecurrentratioofacompanyis4:1anditscurrentliabilitiesare
Rs.50,000. The quickratiois2:1.Calculatethevalueofstock.
b)Atradercarriesanaveragestock(valuedatcost)ofRs.50,000and
turns thisoverfivetimesayearataG.P.ratioof20%.His
administrativeandsellinganddistrib ution overheadsamount to
Rs.20,000intheyear.Findthenetprofit
a)
Current AssetsCurrent RatioCurrent Liabilities4 Current Assets15 0 , 0 0 0
Current Assets 2,00,000
Quick AssetsQuick RatioQuick LiabilitiesCurrent Assets StockQuick RatioCu
rrent Liabilities2 2,00,000 Stock15 0 , 0 0 0
Stock 1,00,000
b)Stock turnover 5 TimesCOGSStock TurnoverAvg.StockCOGS550,000
COGS 2,50,000Gross Pr ofit 20% on salesi.e.25% on COGS
G.P.62,500
Net Pr ofitGross Pr ofit 62,500Less : Selling Exps. 20,000
Net profit 42,500
Ex.26Following aretheratiorelatingtotheactivitiesofIndo ltd.
Debtorsvelocity3months;Stockvelocity8months;Creditorsvelocity2
months; gross profit25%.G.P.fortheyearamountingtoRs.4,00,000;
ClosingstockisRs.10,000 aboveopening stock.Billsreceivable
Rs.25,000; BillsPayableRs.10,000.
Findout:a)Sales b)Debtors c)Closing stock d)Creditors.munotes.in
Page 109
109a)Gross Pr ofitGross Pr ofit Ratio 100Net Sales
25 4,00,000
100 Net Sales
Net Sales 16,00,000
COGS Sales G.P.
16,00,000 4,00,000
12,00,000
b) Debtors
Debtors Bills ReceivableVelocity 12Net credit sales
Debtors 25,0001216,00,000
Debtors 3,75,000
Avg.StockStock Velocity 12COGC
Avg.Stock81 212,00,000
Avg.Stock 8,00,000
Op.Stock Cl.StockAvg.Stock
2
xx1 0 , 0 0 08,00,0002
X7 , 9 5 , 0 0 0
Opening Stock
c)Clo sin g Stock X 1,00,0007,95,000 10,000
8,05,000
Purchase COGC Op.Stock Cl.Stock12,00,000 7,95,000 8,05,00012,10,000
d) Creditors
Creditors 1,00,000Velocity 12Net Credit Purchases
Creditors 1,00,00021 212,10,000
Creditor 1,91,656
Ex.27
a)CurrentRatiois2.5,Liquid Ratiois1.5,Working capitalis
Rs.50,000.Ascertaincurrent As setsandinventory.
b)Turno verisfixedassetsratiois1:1.5:valueofgoods sold is
Rs5,00,000. ComputethevalueofFixedassets.
Ans.
a)
1)
Current Assets 2.5Current RatioCurrent Liabilities 1
So Current Assets 2.5 Current Assets Current Liabilities50,000 2.5CL CL
50,000 1.5CL
CL 33,333
CA WC CL
CA 50,000 33,333
CA 83,333
b)
2Turnover to Fixed AssetsTurnover
Fixed Assets
15 , 0 0 , 0 0 0
1.5 Fixed AssetsFixed Assets 7,50,000
munotes.in
Page 110
1102)Quick AssetsQuick RatioQuick LiabilitiesCA Stock1.5CL
83,333 Stock1.533,3333
Stock 33,333
Ex.28
a)Gross profitonsalesis25%; costofgoods sold Rs.4,00,000.Findout
sales.
b)Averagestockofafirm isRs.1,00,000 anditsopening stockis
Rs.10,000lessthanclosing.
Calculateitsopeningandclosingstock.
a)Sales COGS GP
100 75 2525Gross Pr ofit 4,00,000751,33,333 b)Avg.Stock 1,00,000Op. Stock Cl.Stock2Hence assume opening Stock as xSo Clo sin g Stock x 10,000xx1 0 , 0 0 01,00,0002
X9 5 , 0 0 0
Opening Stock =95,000
So Closing Stock =95,000+1,00,000
5.13.PRAC TICE
A-PRATICAL QUESTIONS
1FromthefollowingfinancialstatementofSanketLtd.calculatethe
followingratios.
a)CurrentRatios b)LiquidRatios
c)StockTurnoverRatio d)DebtorsTurnoverRatio
e)OperatingRatio f)CapitalGearingRatio
g)NetProfitRatio h)StockWorkingCapitalRatio
i)EarningsperEquity Share j)InterestCoverageRatio
k)CreditorsTurno verRatio l)DividendPayoutRatio
m)Gross ProfitRatiomunotes.in
Page 111
111Tradingandprofit&LossAccountfortheyearended31st
December,2009.
Particulars Rs. Particulars Rs.
ToOpeningStock
ToPurchases
ToGrossProfitc/d1,50,000
12,90,0002,10,000BySales
ByClosingStock15,00,000
1,50,000
16,50,00016,50,000
ToAdministrativeExpenses
ToRent&Taxes
ToInterest
ToSellingExpenses
ToDepreciation
ToIncomeTaxProvision
ToNetProfit20,00014,00022,50011,00050,00060,00060,000ByGross Profitb/d
ByProfiton SaleofFixedAssets2,10,000
27,500
2,37,5002,37,500
Balancesheetasat31stDecember2009
Liabilities Rs. Assets Rs.
EquityShareCapitalof
Rs.10each
10% PreferenceShare
Capital
GeneralReserve
12% Debentures
Creditors
Outst andingExpenses
IncomeTaxProvision2,50,000
50,000
2,00,000
3,50,000
30,000
55,000
65,000FixedAssets
BankBalance
ShorttermInvestment
Debtors
Stock6,50,000
25,000
75,000
1,00,000
1,50,000
10,00,000 10,00,000
ThecompanydeclareddividendonEquity Shares@20%.
2ThecondensedbalancesheetofDixitLtd.ason31stMarch2006
isasfollows:
Liabilities Rs. Assets Rs.
EquityShareCapital
Reserve
6%Debentures
CurrentLiabilities
BankOverdraft6,00,000
2,00,000
5,00,000
2,00,000
1,00,000FixedAssets
Stock
MarketableInvestment
Debtors
CashandBankbalance
PreliminaryExpenses9,00,000
3,00,000
1,00,000
1,50,000
1,00,000
50,000
16,00,000 16,00,000munotes.in
Page 112
112NetprofitfortheyearswasRs.75,000/-.
Prepareastatementsuitableforanalysis andindicatethesoundn essof
thefinancialpositi onsofthecompanybycalculatingthefollowing
ratiosandcommentonthesame.
a)CurrentRatio
b)LiquidRatio
c)ProprietaryRatio
d)ReturnonCapitalEmployed
e)ReturnonProprietorsEquity
f)ReturnonEquity Capi tal
g)StockWorkingCapitalRatio
3ThefollowingistheBalanceSheetofSwapnajaLtd.ason31st
December2009.
Liabilities Rs. Assets Rs.
PaidupCapital(Rs.10)
Reserves&Profit
Debentures
Creditors
BillsPayable2,00,000
1,38,000
2,00,000
32,000
12,000FixedAssets
Stock
Debtors
BillsReceivable
BankBalance3,00,000
1,00,000
1,22,000
8,000
52,000
5,82,000 5,82,000
SalesRs.4,00,000/-;
Gross ProfitRs.1,20,000 /-;
NetProfitRs.80,000/-.
RearrangetheaboveBalanceSheetinsuitableformforanalysisand
workout thefollowingratios.
a)NetProfitRatio
b)Gross ProfitRatio
c)CurrentRatio
d)LiquidRatio
e)ReturnonCapitalEmployed
f)DebtorsTurnoverRatio
g)EarningsperShare
h)StockTurnoverRatio.
4FromthefollowinginformationofAbhayLtd.preparesummarized
BalanceSheetasat31stMarch, 2009.
1)Working Capital 1,50,000
2)Reserve & Surplus 1,00,000
3)Bank O verdraft 25,000
4)Fixed Assets Proprietary Ratio 0.75
5)Current Ratio 2.5
6)Liquid Ratio 1.5munotes.in
Page 113
113Yourworkingnotesshould bepartoftheanswer.
5Using thefollowing accountingratiosconstru cttheBalance
SheetofABCLtd.ason31stDecember2009.
Balancesheetason31stDecember2009.
Liabilities Rs. Assets Rs.
?
?
2,00,000?
?
?ShareCapital
Reserve&Surplus
BankLoanCreditors
?FixedAssets
Stock
Debtors
?
Additionalinformation:
1)Salesfortheyear(20%cashsales)Rs.45,00,000
2)Gross ProfitRatio=20%
3)DebtorsTurnoverRatio=12months
4)StockTurnoverRatio=12Times
5)DebtEquity Ratio(debt/equity)=20%
6)ReserveandSurplus toCapital=25%
7)CurrentRatio=2
8)FixedAssetsTurnoverRatio=0.20% (FixedAssets/Sales)
6From thefollowinginformationoffinancialratiosofStarLtd.
prepareBalanceSheetason31st March2009
a)CurrentRatio 2.5
b)LiquidRatio 1.5
c)Working Capital Rs.1,50,000
d)StockTurnoverRatio 5
e)Gross ProfitRatio 20%
f)TurnoverRatiotoFixedAssets(COGS toFA)2
g)AverageDebtCollectionPeriod 2.4months
h)FixedAssetstoNetWorth 0.80
i)LongTermDebttoCapitalandReserves 7/25
7M/sRajesh&Co.givesyouthefollowinginformation. Prepare
TradingandProfit&Loss
Account fortheyearended31st March2004 andBalanceSheetason
thatdate.
OpeningStock 90,000
StockTurnoverRatio 10timesNetProfitRatioon
Turnover 15%Gross ProfitRatioon
Turnover 20% Current Ratio 4:1
Long Term Loan Rs. 2,00,000
Depreciation on Fixed Assets @10% Rs. 20,000
Closing Stock Rs. 1,02,000munotes.in
Page 114
114Credit Period allowed by Supplier one month
Average Debt Collection Period two month
On31stMarch2004 CurrentAssetsconsistsofStock,DebtorsandCash
only.TherewasnoBankOverdraft. All Purchaseswere on madeo n
credit.CashSaleswere1/3rdofCreditSales.
8Fromthefollowingdata,prepareTrading andProfit&LossA/c
a)Sales Rs.10,00,000
b)Administration,SellingandDistr ibutionExpensesRs.60,000
c)StockTurnoverRatio 8times
d)NetProfitRatio 20%
e)Gross ProfitRatio 35%
Closing StockisRs.8,000 greaterthanOpeningStock.
Findoutcurrentratio.
Gross Debtors Rs.20,000;Provision forBaddebtsRs.3,000;Bills
receivableRs.13,000; Stocktwiceofnetdebtors; CashinhandRs.
16,000; AdvancetosuppliersRs.15,000; Creditors forgoods Rs.
27,000; Bills p ayableRs.8,000; Outs tanding expensesRs.15,000;
PrepaidexpensesRs.5,000Investment(Longterm)Rs.12,000;
9.Findoutcurrentliabilitieswhencurrentration is2.5:1andcurrent
assetsareRs.75,000.
10.The ratioofcurrentassets(Rs.6,00,000) tocurrentliabilitiesis
1.5:1.The accountantofthisfirmisinterestedinmaintainingacurrent
ratioof2:1bypayingsomepartofcurrentliabilities.You arerequiredto
suggesthimtheamountofcurrentliabilitieswhichmustbepaidforthis
purpos e.
[Ans.Rs.2,00,000]
11.Afirm hadcurrentliabilitiesofRs.90,000.Itthenacquiredstock-in-
tradeatacostofRs.10,000oncredit.Afterthisacquisitionthecurrent
ratiowas2:1.Determinethesizeofcurrentassetsandworki ngcapital
afterandbeforethestockwasacquired.
12.ALtd.companyhasacurrentratioof3.5:1andacidtestratioof
2:1.Iftheinventory isRs.30,000,findoutitstotalcurrentassetsand
totalcurrentliabilities.
13.Given:Currentratio2.8;Acidtestratio1.5;Workingcapital=Rs.
1,62,000.
Findout:Currentassets;,Currentliabilities;Liquid Assets.
14.Fromthefollowi ng,calculateDebt-Equity Ratio.munotes.in
Page 115
115Equity sharecapitalRs.1,50,000.PreferenceSharecapitalRs.50,000,
GeneralreservesRs.1,00,000,Accumulatedprofits Rs.60,000,
DebenturesRs.1,50,000.Sundrycreditors Rs.80,000,Expenses
payableRs.20,000.PreliminaryExpensesnotyetwrittenoffRs.10,000.
15.CalculateDebtEquity Ratiofrom theBalanceSheetofXLtd.ason
31stMarch2007
Liabilities Rs. Assets Rs.
Equity sharesofRs.10each
11% preferencesharecapital
Securitiespremiumaccount
Generalreserve
ProfitandLossaccount
12% DebenturesofRs.100each
Bills payable Trade creditors
Outst anding
ExpensesProvision fortax8,00,000
4,00,000
80,000
5,80,000
1,40,000
10,00,000
80,000
1,40,000
60,000
2,20,000LandandBuildings
PlantandMachinery
Furniture andfittings
Stock
Tradedebtors
Cashinhand
Cashatbank
Billsreceivable6,20,000
12,00,000
1,80,000
5,30,000
4,70,000
65,000
3,00,000
1,35,000
35,00,000 35,00,000
16.Fromthefollowing calculatedebt-equity ratio:
Rs.
Preferencesharecapital 2,00,000
Equity sharecapital 4,00,000
Capitalreserves 1,00,000
Profit&Lossaccount 1,00,000
14% Debentures 2,00,000
Unsecuredloans 1,00,000
Creditors 40,000
Bills p ayable 20,000
Provision for taxation 10,000
Provision for dividends 20,000
17.The debt-equityratioofacompanyis1:2.Whichofthefollowing
suggestions would (i)increase,(ii)
decrease,and(iii)notchangeit.
a)Issue ofequity shares,
b)Cashreceivedfromdebtors
c)Redemption ofdebenturesforcash,
d)Purchasedgoods oncredit,
e)Redemption ofdebenturesbyconversion intoshares,munotes.in
Page 116
116f)Issue ofsharesagainstthepurchaseofafixedasset,
g)Issue ofdebenturesagainstthepurchaseofafixedasset.
18.Debtors inthebeginningRs.90,000; debtors attheendRs.96,000
creditsalesduring theyearRs.4,65,000.calculatedebtorsturno ver
ration.
19.Rs.1,75,000 isthenetcreditsalesofaconcernduring 1989. If
debtorsturnoveris8times,calculatedebtors inthebeginning andatthe
endoftheyear.Debtors attheendisRs.7,000 morethanatthe
beginnin g.
20.Fromthefollowing figures,compute thedebtors turnoverratio:
Year I Rs. Year II Rs.
Gross sales 9,50,000 8,00,000
Sales returns 50,000 50,000
Debtors in the beginning of year 86,000 1,17,000
Debtors at the end 1,17,000 86,000
Provision for doubtful debts 7,000 6,000
21.Opening stockRs.76,250;Closing StockRs.98,500; SalesRs.
5,20,000;SalesReturnsRs.20,000;PurchasesRs.3,22,250.Calculate
stockturno verratio.
22.AveragestockcarriedbyatraderisRs.60,000stockturno verratiois
10times.Goods aresoldataprofitof10% oncost.Findouttheprofit.
23.Ifinventory turno verratiois5timesandaveragestockatcostisRs.
75,000,findoutcostofgoods sold.
24.You aregiventhefollowingdata.
Gross profitat30% onsales=Rs.60,000
Stockturno ver=7times
Theopening stockis5,000lessthentheclosing stock.
Accounts payable(opening)Rs.30,000; Accountspayable(closin g)Rs.
38,000.
Findout(a)Netpurchases(b)Accountspayableturnover(c)Averageage
ofcreditor s.munotes.in
Page 117
11725.Fromthefollowing information,calculatecreditorsatthebeginning of
theyear:Rs.
Rs.
Total purchases 22,00,000
Cash purchases (included in above) 10,00,000
Creditors turnover ratio -4 times creditor 2,50,000
26.Calculateworking capitalturno verratiofromthefollowing data:
Rs.
Costofgoods sold 1,50,000
Currentassets1,00,000
Currentliabilities 75,000
27.Fromthefollowin g,compute working capitalturnover;
Rs.
Sales 25,20,000
Currentassets15,60,000
Currentliabilities 6,00,000
28.Findouttheworking capitalturno verratio:
Rs.
Cash 10,000
Billsreceivable 5,000
Sundrydebtors 25,000
Stock 20,000
Sundrycreditors 30,000
Costofsales 1,50,000
29.CapitalemployedRs.1,00,000,Working capitalRs.20,000,Costof
goodssoldRs.3,20,000,Gross profitRs.80,000.Calculatefixedassets
turnoverratioassumingthattherewerenolong-terminvestments.
30.CalculateGross Profitratio:
Sales 1,60,000 Purchases 90,000
Salesreturn 10,000 Purchasesreturns 10,000
Opening stock 30,000 Closing Stock 10,000munotes.in
Page 118
11831.Fromthefollow ingdetailscalculatetheoperatingratio:
(a) Rs.
Costofgoods sold 5,20,000
Operatingexpenses 1,80,000
Netsales 8,00,000
(b)
Costofgoods sold 8,00,000
Operatingexpenses 40,000
Sales 10,50,000
Salesreturn 50,000
c)
Sales less Return 1,00,000
Gross Profit 40,000
Administrative expenses 10,000
Selling Expenses 10,000
Income from Investments 5,000
Loss due to fire 3,000
d)Trading andProfit&Loss Account forthe yearended31st
December,2007
Particulars Rs. Particulars Rs.
Tostock1.4.93
ToPurchase
ToWages
Togrossprofit35,000
2,25,000
6,000
1,84,000BySales
ByStockatend4,00,000
50,000
4,50,000 4,50,000
Toadministrativeexp.
Toselling &distribution exp.
Tolossonsaleofplant
Tonetprofit10,000
14,000
10,000
1,50,000ByGross Profit 1,84,000
1,84,000 1,84,000munotes.in
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11932.The following istheBalanceSheetofVinod MillsLtd.ason31st
December,2006:
Rs.
SundryCreditors
BillspayableTax
Provision Outst anding
Expenses
12% Debentures
10% Preferencesharecapital
Equity sharecapital
ReserveFund60,0001,00,0001,30,00010,0007,00,0001,00,0005,00,0004,00,000Bank
Tradeinvestments
BookDebts(Debtors)
Stock
FixedAssets 18,00,000
Less:Depreciation5,00,00050,000
1,50,000
2,00,000
3,00,000
13,00,000
20,00,00020,00,000
Otherinformationsuppliedisasfollows
Rs.
Netsales 30,00,000
Costofgoods sold 25,80,000
Operatingexpenses 2,20,000
(a)Quickratio;(b)Totalassetstodebtratio;(c)Currentratio;(d)
Gross profitratio;(e)Operatingratio(f)Netprofitratio.
33.From the following information,calculatestockturnoverratio,
operating ratio;fixedassetsturno verratioandcurrentassetsturnover
ratio:-
Rs.Opening stock 56,000
Closing stock44,000
Purchases 92,000
Sales 1,80,000
Sales Returns 20,000
Carriage Inwards 8,000
Office Expenses 8,000
Selling & Distribution Expenses 4,000
Fixedassets 70,000
Currentassets60,000
34Fromthefollowing data,calculate:-
a)Gross profit ratio,
b)Net profit ratio
c)Working capital turnover ratio
d)Debt -equity ratio
e)Proprietary ratio
Netsales 30,00,000
Costofsales 20,00,000
Net Profit 3,00,000
Fixed Assets 6,50,000
Current Assets 6,00,000
Paid-up share Capital 5,00,000
Debentures 2,50,000munotes.in
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12035.Withthehelpofthegiveninformation,calculateanythreeofthe
followingratios:
a)Operatingratio
b)Quickratio
c)Working capitalturno verratio
d)Debtequityratio.
Information:Equity sharecapitalRs.50,000; 12% preferenceshare
capitalRs.40,000; 12%debenturesRs.30,000;GeneralReserveRs.
40,000;SalesRs.3,00,000;Opening stockRs.20,000;PurchasesRs.
1,40,000; WagesRs.30,000; ClosingstockRs.40,000; Selling and
distribu tionexpensesRs.18,000;OtherCurrentassetsRs.1,00,000and
currentliabilitiesRs.60,000.
B-THEORYQUESTIONS:
1Whatarethelimitations ofRatioAnalysis.
2DiscussthebenefitofRatios.
3How aretheratioclassifiedfromthepoint ofviewofusers.
4.Whatarethesignificanceofgrossprofitratio.
5.Writeshort noteson
AQuickRatio
BCreditors Turno verRatio
CDebtors Turno verRatio
DDistin guishbetweenovertrading andundertrading.
E.Trading onEquity
6.ExplainindetailimportanceofBalanceSheetRatio.
7.DefineCurrentRatio.Giveitspurpos e.
RATIOSATAGLANCE
Ratio Formulae
1.Currentratio Currentassets
Currentliabilities
2.Quickratio Quickassets
Currentliabilities
3.Inventory turno verratio Costofgoods sold
Averageinventory
4.Debtors(receivables)turnoverratio Annu alNetcreditsales
Average accountsreceivables
5.Debt(receivables)collectionperiod 365 days/52 weeks/12months
Debtors turno verratio
6Creditors turno verratioNetCreditPurchase
AverageCreditor Netmunotes.in
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1217. Average Credit Payment period365 days/52 weeks/ 12months
Creditor turnover ratio
8. working capital TurnoverNet Saleworking Capital
9. Fixed Asset Turnover ratioNet sale orcost of saleNet fixed assets10. Current assets turnover ratioNet salesCurrent assets
11. Debt -equity ratio Total long term debt
Shareholders’ funds
12. Total assets to debts Total assetsLong term debts13. Proprietary ratio Shareholders FundsTotal assets14. Gross Profit ratio Gross Profit/Net Sales ×100
15. Net Profit RatioNet profit / Net Sales ×10016. Operating ratio Operating cost X 100Net sales17. Operating profit ratio Operating profit X 100Net sales18. Return on capital e mployed (ROI)Net profit before interest, tax& dividend X 100Capital employed19. Earnings per share (EPS)Net income after interest, taxand preference dividend X
100
20. Dividends per share Dividends amountNumbers of equity share
21. Price earning ratio Market price of share
EPC
22. Dividend payout ratio Dividend per share
Earning per share
munotes.in
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1226
INTRODUCTIONTODUPONTANALYSIS
6.1Meaning
6.2Formula
6.3Analysis
6.4Exercisewithsolution
6.5Practice
6.1. MEA NING
The Dupont analysisalsocalledtheDupont modelisafinancial
ratiobasedonthereturn onequity ratiothatisusedtoanalyzea
company'sability toincreaseitsreturn on equity.Inotherwords, this
modelbreaksdown thereturnonequityratiotoexplainhow companiescan
increasetheirreturnforinvestors.
TheDupont analysislooksatthreemaincomponentsoftheROE
ratio.
ProfitMargin
TotalAssetTurno ver
FinancialLeverage
Basedonthesethreeperformancesmeasuresthemodelconcludesthata
companycanraiseitsROE bymaintaining a highprofitmargin,
increasingassetturno ver,orleveragingassetsmoreeffectively.
TheDupont Corpor ation d evelopedthisanalysisinthe1920 s.Thename
hasstuckwith iteversince.
6.2. FO RMULA
TheDupont ModelequatesROEtoprofitmargin,assetturno ver,
andfinancialleverage.The b asicformulalooks likethis.
Return on Equity = Profit Margin x Total Asset Turnover x
Financial Leverage
Sinceeachoneofthesefactorsisacalculationinandofitself,a
moreexplanatoryformulafor this analysislooks likethis.
Pr ofit M arg in Total Assets TurnoverReturn on EquityNet Income / Net Sales Net Sales / Avg.Total Assets munotes.in
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123Financial LeverageTotal Assets / Total Equity
Everyoneoftheseaccountscaneasilybefound onthefinancial
statements.Netincomeandsalesappearontheincomestatement,while
totalassetsandtotalequity appearonthebalancesheet.
6.3. ANALYSIS
This modelwasdevelopedtoanalyzeROE andtheeffects
differentbusinessperformancemeasureshaveonthisratio.Soinvestors
arenotlooking forlargeorsmalloutput numbersfrom thismodel.
Instead,theyarelooking toanalyzewhatiscausing thecurrentROE.
For inst ance,ifinvestors areunsatisfiedwith alow ROE, the
managementcanusethisformulatopinpoint theproblemareawhetherit
isalowerprofitmargin,assetturnov er,orpoor financialleveraging.
Oncetheproblemareaisfound,managementcanattemptto
correctitoraddressitwithshareholders.Somenormaloperations lower
ROEnaturallyandarenotareasonforinvestors to bealarmed.For
instance,accelerateddepreciationartificiallylowersROEinthe
beginning p eriods.Thispaperentry canbepointedoutwith theanalysis
andshouldn't swayan investor's opinion ofthecompany.
6.4. EXERCISEWITHSOLUTION
Ex.1 Seeta’s RetailersandRama 'sRetailers.Both of thecompanies
operatein thesameapparelindustryandhavethesamereturn onequity
ratioof45percent.This modelcanbeusedtoshow thestrengthsand
weaknessesofeachcompany.Eachcompanyhasthefollowing ratios:
Ratio Seeta Rama
ProfitMargin 30% 15%
TotalAssetTurno ver .50 6.0
FinancialLeverage 3.0 .50
Asyoucansee,both companieshavethesameoverallROE, butthe
companies'operations arecompletelydifferent.
Ans:
DuPont Analysis
45% = .30 x .50 x 3.0
45% = .15 x 6.0 x .50
Seeta 'sisgenerating saleswhilemaintaining alowercostof
goods asevidencedbyitshigherprofitmargin.Seeta’ sishavinga
difficulttimeturning overlargeamountsofsales.munotes.in
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124Rama's business,ontheotherhand,issellingprodu ctsatasmaller
margin,butitisturning overalotofprodu cts.You canseethisfromits
lowprofit marginandextremelyhighassetturno ver.
This modelhelpsinvestors comparesimilarcompanieslikethese
withsimilarratios.Investorscanthenapply perceivedrisks with each
company'sbusinessmodel.
EX.2Parrot Packaging’sROE l astyearwas2.5percent,but its
managementhasdevelopedanewoperating plandesignedtoimprove
things.Thenewplancallsforatotaldebtratioof50percent,whichwill
resultin interestchargesofRs.240 peryear.Managementprojectsan
EBITofRs.800onsalesofRs.8,000,anditexpectstohaveatotal
assetsturno verratioof1.6.Undertheseconditions,thefederal-plus-state
taxratewill be40 p ercent.Ifthechangesaremade,whatreturn on
equity willParrot earn?
a.2.50% b.13.44% c.13.00% d.14.02% e.14.57%
EX. 3 Brother CorporationBalanceShee ta s o n 3 1stMarch 2015
Liabilities Rs. Assets Rs.
Accounts Payable 250 Cash and Marketable
Securities50
Accrued Liabilities 250 Accounts Receivable 200
Notes Payable 500 Inventories 250
Long Term Debts 250 NetFixed Assets 1500
Common Stock 400
Retained Earnings 350
2,000 2,000
Ans:
ROE =Profitmargin×Totalassetsturno ver×Equity multipl ier
=N I /Sales×Sales/TA×TA/Equit y.
Now weneedtodeterminetheinputsfortheequationfromthedata
thatweregiven.Ontheleftwesetupanincomestatement,andweput
numbersinitontheright:munotes.in
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125Rs.
Sales (given) 8,000
Cost NA
EBIT (given) 800
Interest (given) 240
EBT 560
Taxes (40%) 224
Net Income 336
Now wecanusesomeratiostogetsomemoredata:Totalassets
turno ver=S/TA=1.6(given).
D/A =50%,soE/A=50%,andthereforeTA/E = 1/(E/A) =1/0.5=2.00.
Now wecancompletetheExtendedDuPontEquationtodetermineROE:
ROE=336/8,000 1.62.0=13.44%.
6.5.PRAC TICE
Q.1Explain Du PontAnalysis in detail.
Q.2Discuss in detail the formula for calculating ROE under DuPont
Analysis.
Q.3Explain in detail the factors to be taken into account for calculating
ROE under DuPont Model.
Q.4Write Short Not On Du Pont Model.
munotes.in
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126MODULE -IV
7
FREE CASHFLOW A NALYSIS
Unit Structure
7.0 Learning Objectives
7.1 Introduction
7.2 Meaning of Free Cash Flow
7.0 LEAR NING OBJECTIVES
After studying this chapter, the student will be able to:
1.Understand the meaning of free cashflows
2.Differentiate between Different types of free cashflows
3.Calculate FCFF and FCFE under various methods
4.Importance of Free Cash Flows wit h respect to Valuation
5.Calculate the value of the firm from FCFF and of Equity from
FCFE of the firm
7.1 INTRODUCTIO N
You have already learnt in your earlier chapters, concepts and
importance of a cash flow statement. You have also learnt the methods of
preparation of cash flow statement and the uniqueness of a cash flow
statement vis -à-vis other financial statements.
You may recall that the term ‘cash flows’ refers to the cash inflows
as well as cash outflows. Further, you would also appreciate that analysis
of cash inflows and outflows is carried out on the basis of Operating
Activities, Financing Activities and Investing Activities.
In this unit, we will b e discussing about concepts relating to free
cash flows, techniques of computation of different kinds of free cash
flows, their importance in relation to financial analysis and valuation of a
firm and that of equity holders’ interests.
7.2 MEA NINGO FF R E E CASH FLOW
The term ‘Free Cash Flow’ refers to a sum of cash net inflows or
outflows in relative contexts. There are three important such relative cash
flows. It moves in a hierarchical order. At the top, it relates the free cashmunotes.in
Page 127
127flows and the operations . Second one in order relates the cash flow
available to the firm (Long Term Debt + Shareholders), while the third
one relates the cash flows available only to the shareholders. They are as
follows.
a.Operating Free Cash Flows
b.Free Cash Flows to the Firm
c.Free Cash Flows to the Equity
Now let us discuss each of the above in detail.
Operating Free Cash Flows
As the term indicates, Operating Free Cash Flows refer to the cash
flows that are available in the context of operations, after having met the
cash re quirement for investment in non -current assets and net working
capital. Now the question would arise as to what type of investment in
non-current assets and net working capital would qualify for deduction. It
needs to be answered that for a given project, whatever additional
expenditure is required in the form of non -current assets and the net
working capital would be deducted. Any additional expenditure that may
arise due to expansion outside of the current project in respect of which
the Free Cash Flows i s computed need not be deducted. This would enable
comparative study with peers and / or competitors, by analysts much
relevant.
It may be understood from the previous paragraph that the cash
flows t hat are generated as above are the ones that are available for
Historical vs Prospective Operating Free Cash Flows
We can compute Operating free cash flows for historical periods as
well as for future periods. We compute historical operating free cash
flows, by deducting Investments if any in operating non -current assets
from “Cash Flows from Operating Activities”. However, in both the
cases, we recognize “Tax” as an operating cash flow. We compute
prospective (future) operating free cash flows as below.
After Tax Operating Earnings xxxxx
Add:Depreciation / Amortization / Impairment Write off / of
Tangible and Intangible Assetsxxxx
Deduct: Investments in Long Term Assets (Operating) xxxx
Deduct: Investments in additional net working capital xxxx
Operating Free Cash Flows xxxxxmunotes.in
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128Adjustments that are mentioned above are like the ones you have
already learnt while computing ‘Cash from Operating Activities’ in
preparing a cash flow statement under indirect method. However, there are
two notable differences. They are as below.
1.Deductions in respect of Investments made in Long Term Assets
This deduction is made todetermine the cash flows that are available
after meeting the requirements for expanding operations / sales or to
maintain the existing operations / sales of the entity. When we prepare
a cash flow statement, such an item is shown as an outflow of cash
under ‘Investing Activity’.
2.Deduction in respect of net investment in working capital
While we calculate historical cash flow from operat ing activities, we
add back increase in current liabilities and decrease in current assets
other than cash and cash equivalents and deduct decrease in current
liabilities and increase in current assets other than cash and cash
equivalents. In computing pro jected “Operating Free Cash Flows”, we
deduct the estimated net investment in net working capital, so that we
are able to ascertain the available cash flows that can be used for
payments to lenders and then ultimately to the shareholders, without
any inte rruptions of whatsoever as far as the operations of the business
entity are concerned.
Importance of Operating Free Cash Flows Analysis
It is to be appreciated that a business is in existence to generate
cash flows to provide returns to the providers of long term funds, namely
lenders and shareholders. The extent of the cash flows generated by a
business out of its operations portrays an entity’s ability to meet the
additional investment required to expand the market share, to provide
returns in the form of interest to the lenders and dividends to the
shareholders and repayment of the loans / capital.
Illustration 1:
Assume that a company generated Rs. 25 crores of operating
cashflow and has spent 5 crores for capital expenditure during the year and
an additional net investment of Rs. 1 Crore in Net Working Capital.
In this case, the entity has generated a surplus, ie, free cashflow of
19 crores for the year. Out of this free cash flow, the entity would pay
returns to its lenders, repay the loans, pay di vidends, if any to shareholders
and the redeem the shares, if any, as per covenant obligations.munotes.in
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129Illustration 2:
An entity provides the following information.
Particulars Rs. In Mns.
Before tax Operating earnings (EBIT) 100
Tax rate 30% on Taxable Profit
Trade Debtors in the beginning 5
Trade Debtors at the end (estimated) 7
Trade Creditors at the beginning 6.90
Trade Creditors at the end (estimated) 5.75
Cash and Bank Balances at the beginning 0.50
Inventories at the beginning 3
Inventories at the end (estimated) 4.50
Cash at the end (estimated) 0.60
Bank balance at the end (estimated OD) 0.75
Depreciation on Tangible Assets 15.50
Amortization of Intangible Assets 4.50
Impairment of Tangible Assets 3.00
Assume that the firm is debt free. The firm needs to invest Rs. 25 Mn in the
next year out of which Rs. 10 Mn is in order to maintain the existing level
of operations and Rs. 15Mn for expansion of s ales in the subsequent years.
Compute (1) Operating Free Cash Flows (OFCF) and (2) Cash From
Operating Activities
Solution:
(1)Computation of Operating Free Cash Flows
Particulars Rs. (in Mns)
Before Tax Operating Earnings (EBIT) 100
Less: Tax (30)
After Tax Earnings 70
Add:Depreciation15.50Amortization4.50munotes.in
Page 130
130Impairment3.0023
Less:
Investment in Non -Current Assets (25)
Investment in Net Working CapitalTrade Debtors in the beginning5.00Trade Debtors at the end(estimated)7.00 (2.00)Trade Creditors at the beginning6.90Trade Creditors at the end (estimated)5.75 (1.15)
Inventories atthe beginning3.00Inventories at the end (estimated)4.50(1.50)Cash and Bank Balances at the beginning0.50Cash at the end (estimated)0.60
Bankbalance at the end (estimated OD)0.75 0.65(4)
Operating Free Cash Flows 64
(2)Computation of Cash Flows From Operating Activities
After Tax Earnings 70
Add: Depreciation, Amortization and
Impairment23
Less: Net Increase in Current Assets
or Decrease in Current Liabilities
(other than cash and cash
equivalents)(4.65) ie., (2.00 +1.15 +1.50)
Cash from Operating Activities 88.35
Illustration 3:
Continuing the above illustration, suppose that in addition to the
above infor mation, there had been revaluation of assets upwards, resultingmunotes.in
Page 131
131in recognition of Rs. 10 Mn in the pretax earnings. What would be the
change in the cash flows computed earlier.
Solution:
Both Operating Free Cash Flows and the Cash From Operating
Activiti es would decrease by Rs. 10 Mn, because, revaluation of assets
does not result in any increase in the cash flows. However, the same
amount had been considered in computation of the pre -tax earnings.
Free Cash Flows to the Firm
Free cash flow to the Firm (FCFF) refers to the cash flow available
to all investors in the company —both shareholders and bondholders after
consideration for taxes, capital expenditure and working capital
investment. It enables a firm’s ability to service its lenders and enables
comparison between a leveraged firm and an unleveraged firm. This is
because interest payments are considered as returns payable to lenders and
not as an operating expense.
However, it must be noted here that non -operating income and cash flows
are also co nsidered to be a part of the FCFF. Arithmetically, its
computation is explained below.
Operating Free Cash Flows xxxxx
Add: After Tax non operating income xxxx
Add: Decrease in Non -Operating Assets xxxx
Deduct: Increase in Non -Operating Assets xxxx
Free Cash Flows to Firm xxxxx
Let us explain the computation of FCFF by an illustration.
Illustration 4:
A manufacturing entity is projecting that its Operating Free Cash
Flows for the year ending 31stMarch 2018 would amount to Rs. 70 Mn.
The entity provides the following additional information.
a.Estimated purchase of Investments in Securities –Rs. 5 Mn
b.Income that will be received from the above investment –Rs. 1Mn
c.Estimated Cost of Acquisition of Lan df o ru s ea f t e r1 0y e a r s -
Rs.5Mn
d.Applicable tax rate -30%
e.An existing investment in securities amounting to Rs. 2 Mn,
yielding a taxable return of 25%, will be sold on 31stmarch 2018
Comput e the Free Cash Flows to the Firmmunotes.in
Page 132
132Solution:
Computation of Free Cash Flows to the Firm
Particulars Rs. (In Mns)
Operating Free Cash Flows 70.00
Add: After Tax non -operating Income
-old Investment 0.50 Mn(@25% on
Less tax 0.15 Mn 0.35
-new Investment 1.00 Mn
Less Tax 0.30 Mn 0.70
Add: Decrease in Investments 2.00
Less: Increase in Investments in Securities (5.00)
Increase in Non -Current Assets (5.00)
FCFF 63.05
Importance of Free Cash Flows to the Firm
As explained earlier, Free Cash Flows refer to the cash flows that
are available in the business from the perspective of providers of long term
sources of funds, namely, Lenders, Preference Shareholders and Ordinary
Share Holders.
A comparative analysis of two or more firms based on the FCFF is
important, particularly when we are comparing the firms which have
different capital structures over different periods of time.
Free Cash Flows to the Equity
Free Cash Flows to the Equity can be categorized into two types.
They are (a) Free Cash Flows to the Preference Shareholders and (b) Free
Cash Flows to the Ordinary Shareholders. Adjustments are made to FCFF
with respect to cash flows that would be arising becauseof payments to
lenders and fresh loans raised. In the case of puttable share capital with
constant rates of dividend, the payments to and capital raised from such
shareholders need to be adjusted against FCFF to arrive at the FCFE.
Computation of FCFE is arrived at as below.munotes.in
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133Particulars FCF to Preference
ShareholdersFCF to ordinary
Shareholders
FCFF xxxx xxxx
Less: Interest (Less Tax
Advantage)xxx xxx
Less: Repayment of Loans
Add: New Borrowings
Less: Preference Dividend
+ with holding TaxNot Applicable xxx
Less: Redemption of
Preference Share CapitalNot Applicable xxx
Add: Issue of Preference
Share CapitalNot Applicable xxx
FCF to Preference
ShareholdersFCF to ordinary
Shareholders
A split up analysis of Free Cash Flows to Equity into FCF to
Preference Shareholders and Ordinary Shareholders respectively, provides
a better analysis of the free cash flows of a business. However, when we
compare two or more business entities over a period, comparison on the
basis of FCFE, as a single category provides better comparability.
Illustration 5:
Following information relates to Hypothetical Co Ltd., for the year ending
31stMarch 2017.
Particulars Rs. (In Mns)
FCFF 100
10% Preference Share Capital 75
Withholding Tax on Preference Share Capital
Dividend10%
Long Term Loans at the beginning of the year 50
Additional Loans borrowed during the middle of the
year30
Instalments relating to the old loans repaid at the end
of the year10
Rate of Interest on Loans 8%
10% Additional Preference Share Capital rai sed at the
end of the year7
10% Preference Share Capital Redeemed at the end of
the year7
Applicable tax rate for the company is 30%.
Compute the FCF to Preference Share Holders and to the Ordinary
Shareholders respectively.munotes.in
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134Solution:
Particulars FCF to Preference
ShareholdersFCF to ordinary
Shareholders
FCFF 100 100
Less: Interest (Less
Tax Advantage)5.20 (8% * 50 +8%
*30/2)
1.60 = 3.603.60
Less: Repayment of
Loans10 10
Add: New Borrowings 30 30
Less: Preference
Dividend + with
holding TaxNot Applicable 8.25 (10% on
Preference Share
Capital +Tax @10%
on Preference
Dividend)
Less: Redemption of
Preference Share
CapitalNot Applicable 7.000
Add: Issue of
Preference Share
CapitalNot Applicable 7.000
116.40 108.15
Free Cash Flows to Ordinary Shareholders may also be calculated
from Free Cash Flows available to Preference Shareholders as well. Such
a Computation is shown below.
FCF to Ordinary Shareholders = FCF to Preference Shareholders –
Preference Dividend +Net Issue / Redemption of Preference Share Capital
=1 1 6 . 4 0 -8.25 +7.00 -7.00 = 108.15 Mn.
Hierarchy of Free Cash Flows
As you would have appreciated by now, there is a hierarchical
order in the conceptual perspectives of various kinds of Free Cash Flows.
At the base level, it is known as Operating Free Cash Flows and down the
level it ends up with Free Cash Flows to the Ordinary Shareholders.
A thematic presentation of Free Cash Flows into its major elements
emphasizes this aspect.munotes.in
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135
As the diagram indicates, Operating Free Cash Flows forms the
basis of a business entity’s ability to generate cash flows over a long
period. At every level, an appropriate reduction in the Operating Cash
Flows tha t forms part of the free cash flows respective to the hierarchy
takes place. However, it needs to be understood that other than on account
of Operations, the cash flows may either increase or decrease. For
example, for a business that has an OFCF of Rs. 25 Mn can have an FCFE
of Rs. 45 Mn, due to additional issue of share capital. On the other hand,
an entity having Rs. 50 Mn as Cash from Operating Activities may be
having an FCFF of Rs. ( -) 25 Mn, because of huge investment in non -
current assets.
A colle ctive presentation of the items that get into computation of
the respective free cash flows is given below, for ease of understanding.
Particulars OFCF FCFF FCF to
Preference
Shareholder
sFCF to Ordinary
Shareholders
After Tax Operating
Earningsxxxxx xxxxx xxxxx xxxxx
Add: Depreciation /
Amortization /
Impairment Write off
/o fT a n g i b l ea n d
Intangible Assetsxxxx xxxx xxxx xxxx
Deduct: Investments
in Long Term Assets
(Operating)xxxx xxxx xxxx xxxx
Deduct: Investments
in additional net
working capitalxxxx xxxx xxxx xxxxmunotes.in
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136Operating Free Cash
Flowsxxxxx xxxxx xxxxx xxxxx
Add: After Tax non
operating incomeNot
Applicablexxxx xxxx xxxx
Add: Decrease in
Non-Operating
AssetsNot
Applicablexxxx xxxx xxxx
Deduct: Increase in
Non-Operating
AssetsNot
Applicablexxxx xxxx xxxx
Free Cash Flows to
FirmNot
Applicablexxxxx xxxxx xxxx
Less: Interest (Less
Tax Advantage)Not
ApplicableNot
Applicablexxxx xxx
Less: Repayment of
LoansNot
ApplicableNot
Applicablexxx xxx
Add: New
BorrowingsNot
ApplicableNot
Applicablexxx xxx
Less: Preference
Dividend + with
holding TaxNot
ApplicableNot
ApplicableNot
Applicablexxx
Less: Redemption of
Preference Share
CapitalNot
ApplicableNot
ApplicableNot
Applicablexxx
Add: Issue of
Preference Share
CapitalNot
ApplicableNot
ApplicableNot
Applicablexxx
Total OFCF FCFF FCF –
Preference
Shareholder
sFCF -Ordinary
Shareholders
The table given above provides us an easier understanding of
relationship between different kinds of free cash flows and the
components that get into their computation.
Cash Flow and valuation of a firm
In our discussion, so far, we explained the meaning , concepts and
importance of different kinds of free cash flows. We also explained the
technique of computation of free cash flows. It must be understood that, as
explained earlier, computation of free cash flows helps analysts and
investors to understand the ability of a business in generation and effective
utilization of cash. Besides, an entity’s worthiness ultimately depends
upon its ability to pay returns in the form of cash flows to lenders and
shareholders either directly by way of dividend / buy bac ko fs h a r e so r
indirectly by way of increased market price of securities that can help the
holders to generate cash flows. Whether it is by way of direct flows ormunotes.in
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137indirect flows to the investor, our focus point is the ability of a business in
generation of cash flows. You also need to appreciate the fact that the cash
flows that an investor would be getting not directly from the business
entity but from the stock exchanges or private deals among the investors
also depend upon the ability of the business in effective generation and
utilization of the cash. This drives us to the point that an entity’s value
very much depends upon the ability to generate / utilize the cash.
Basic aspects of valuation
You might have already learnt about the basic conce pts relating to
valuation of a capital project under “Capital Budgeting” and of securities
in portfolio management and securities analysis. Valuation of a business
based on free cash flows also requires application of the same fundamental
concepts. Philoso phy of valuation requires two important aspects, namely
cash flows associated with an asset or a project or an entity and the
relevant cost of capital.
As a recall of the concepts relating to valuation, let us illustrate
with the following example.
Illustration 6:
ABC Ltd., which has many projects is contemplating acquisition of
an existing business from DEF Ltd., ABC Ltd wants to be a financial
investor in DEF Ltd., for a period of five years, after which, it would
dispose of its entire holdings in DEF Ltd., Following Information are
provided by ABC Ltd.,
Particulars Year 1 Year 2 Year 3 Year 4 Year 5
Operating FCF (Rs. Mn) 275 340 450 600 700
Non-Operating Income (Rs.
In Mn)10 10 10 10 10
Tax Rate 30% 30% 30% 30% 30%
Capital Structure –10%
Debt40% 40% 40% 40% 40%
Capital Structure –
Ordinary Share Capital60% 60% 60% 60% 60%
Market rate of return
expected15% 15% 15% 15% 15%
Risk Free Rate 9% 9% 9% 9% 9%
Beta for ABC Ltd 1.40 1.40 1.40 1.40 1.40
Advise ABC Ltd., the price it can pay for investment in DEF Ltd
as a Financial Investor for a period of five years, so that ABC Ltd can
create value for its own shareholders.
Solution:
ABC Ltd needs to determine the present value of the Free Cash
Flows a s far as DEF Ltd is concerned. Since it will be disposing the
acquisition in five years, we need to consider the present value of the Freemunotes.in
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138Cash Flows of the Firm that will be received over the next five years.
Determination of present value of Free Cash Fl ows to the Firm as far as
DEF Ltd is concerned requires the following procedure.
a.Computation of Free Cash Flows of the Firm that relates to DEF
Ltd., (as explained earlier)
b.Computation of Weighted Average Cost of Capital
- Computation of Post Tax cost of d ebt
- Computation of Cost of Equity based on Capital Asset Pricing
Model
- Computation of the Weighted Average Cost
c.Compute the Present Value of FCFF by discounting the FCFF by
applying the WACC
Valuation of DEF Ltd., to be acquired by ABC Ltd.,
Computatio no fF r e eC a s hF l o w s
Particulars Year 1 Year 2 Year 3 Year 4 Year 5
Operating FCF 275 340 450 600 700
After Tax Non -Operating
Income (After Tax @ 30%)7 7 7 7 7
FCFF 282 347 457 607 707
Computation of Weighted Average Cost of Capital
Computation of Post Tax Cost
of Debt
Pre-Tax Cost of Debt 10%
Tax Rate 30%
Post tax Cost of Debt = Pre
Tax Cost *(1 -Tax Rate)=10% (1 -0.30) = 7%
Cost of Equity
Capital Asset Pricing Model = Risk Free Rate + (Market Rate –Risk Free Rate)* Beta
=9 %+ ( 1 5 % -9%)1.4 = 9% +8.40% = 17.40%
Weighted Average Cost of
Capital
Component Weight Cost WACC
Debt 0.40 7.00 2.80
Ordinary Share Capital 0.60 17.40 10.44
13.24%
Present Value of FCFF =F C F F /( 1 + 0 . 1 3 2 4 ) ^ n
FCFF (as Computed earlier) 282 347 457 607 707
Present Value (Rs. Mn) 1583.16 249.03 270.60 314.71 369.14 379.68
Thus, the value of firm DEF Ltd is determined at Rs. 1583.13 Mn. IF ABC Ltd. can negotiate
the deal by paying any price equivalent to or less than the present value, ABC Ltd will be able
to create value to its shareholders.munotes.in
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139Free Cash Flows and Valuation of Equity
Based on the cash flows available to firm and to the equity share
holders, over the valuation period, we can find the value of equity of a
firm. The formulas for ascertaining the value of equity of a firm are as
below.
Valuation based on the free Cash flow of the firm
Value of Equity = Value of the firm based on FCFF –debt value of
the firm. Let us explain with the help of an illustration as below.
Illustration 7:
A firm which has a capital of Rs. 1000 Mn, equally divided
between Deb t and Ordinary Share Capital, determines the present value of
its FCFF at Rs. 2,000 Mn. Determine the Value of Equity .
Solution
Present Value of Firm = Rs. 2,000 Mn.
Book Value of Debt = Rs. 500 Mn. (50% of Rs. 1,000 Mn)
Hence Value of Equity = Rs. 1,500 Mn.
Determination of Present Value of Firm based on Infinity
In our Illustration 6, we determined the value of the firm based on
a specified period of 5 years. However, it must be appreciated that, in
practice, we consider that an e ntity is expected to generate cash flows over
its entire life period, which may be infinite. In such a scenario, the
following formula is applied.
∞
Value of the firm based on FCFF = ∑{FCFF t/ [(1+WACC)^t]}
t=1
Where, ‘WACC’ is the weighted average cost of capital. However, the
above formula can not be applied in a straight -jacket manner.
Valuation of free cash flows relating to an i ndefinite period is split
into two or more separate time periods. Time period (s) in respect of
which growth and cash flows can be forecast on a justifiable basis are
known as explicit periods. Forecast of cash flows subsequent to the
explicit period is de termined on a perpetual basis based on FCFF at the
end of the explicit period, that immediately precedes the uncertain period.
Once the value of firm is determined, we can deduct the values of
Debt and Preference Share Capital, if any to arrive at the va lue of equity.
Valuation based on the free Cash flow to the equity shareholders
∞
Value of the firm based on FCFE = ∑{FCFE t/[(1+r)^t]}
t=1
Where, ‘r’ is the expected return of the shareholders.munotes.in
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140Here again, the above formula is based on an infinity period.We
had earlier discussed the method of determining the value of equity from
the value of the firm by applying the WACC of the fir m on the Free Cash
Flows to the Firm. The above formula helps us determine the Value of
Equity directly from the Free Cash Flows to the Equity.
Additional Illustrations:
Illustration 1
Rs. (in crores)
EBITDA 1000
Depreciation 400
Interest Expense 150
Tax rate 30%
Purchase of fixed assets 500
Change in Working capital 50
Net borrowing 80
Equity dividends 200
Calculate FCFF and FCFE under various methods:
FCFF under Net income, EBIT, EBITDA, Cashflow from Operations
methods in this FCFE under FCFF, Net income, Cashflow from
Operations methods FCFF and FCFE from end use perspective method
Solution
A.FCFF Calculation
1–Calculation from Net Income
Calculation of FCFF, in this case involves, the following steps.
a.Computation of Net Income
b.Com putation of FCFF from Net Income
a.Computation of Net Income
We first must obtain net income from the example provided, which is the
EBITDA after depreciation, interest, and taxes
Net income= (EBITDA -Depreciation -Interest) (1 -Tax rate)
Net income= (1000 -400-150) (1 -.3)=3 1 5c r o r e s
b.Computation of FCFF
FCFF= Net income + Non cash charges + Interest (1 -Tax Rate) -Capital
Expenditure -Investment in working capital
Assuming that depreciation expense (of 400) is the only non cash charges,
the resulting value for FCFF is 270.
FCFF= 315+ 400+ 150(1 -0.30) -500-50= Rs 270 crores
Notice that to get net income, we subtracted depreciation and
interest from EBITDA. To get FCFF, we added them back. This suggests
that we could have calculated FCFF more easily by working higher on the
income statement at EBITDA. This is what we do on the methodmunotes.in
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1412Calculation of FCFF from EBIT and EBITDA
We first must obtain EBIT from the example provided, which is the
EBITDA after depreciation:
EBIT= EBITDA -Depreciation = 1000 -400= Rs 600 crores
Computation of FCFF from EBIT
FCFF= EBIT (1 -tax rate) + Non cash charges -Capital Expenditure -
Investment in working capital
FCFF= 600(1 -0.30)+ 400 -500-50= Rs 270 crores
Computation of FCFF from EBITDA
FCFF= EBITDA (1 -taxrate) + Non cash charges (tax rate) -Capital
Expenditure -Investment in working capital
FCFF= 1000(1 -0.30)+ 400(0.30) -500-50=Rs 270 crores
Starting higher on the income statement at EBITDA, we again
arrive at Rs.270 crores.
Recall our discuss ion from the previous method where we first
examined the EBIT and EBITDA formulas:
If starting with EBIT, we add back depreciation because it was
subtracted to obtain EBIT. If starting with EBITDA, we add back only the
depreciation tax shield (Dep ×Tax R ate = Amount the firm saves on taxes
by being able to claim the noncash depreciation expense). We add it back
because although EBITDA is before depreciation, the depreciation tax
shield saves the firm on taxes and adds to its cash flows.
c.Calculating FCFF from Cashflow from Operations
We first must obtain Cashflow from Operations from the example
provided, which is the net income plus depreciation minus the change in
working capital:
Cashflow from Operations= Net Income+ Depreciation -Working Capital
Inves tment
Cashflow from Operations= 315+ 400 -50= Rs 665 crores
FCFF= Cashflow from operating activities + interest (1 -tax rate) -
Capital expenditure
FCFF= 665+ 150(1 -0.30) -500= Rs 270 crores
We add back interest because it was subtracted out to ob tain CFO and
it is available to one of the firm’s capital providers (the debtholders). The
investment in fixed capital is a cash outflow that was not included in the
calculation of CFO, so it is subtracted out.munotes.in
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142B.FCFE calculation
1.Calculating from FCFF
FCFE= FCFF -Interest(1 -Tax rate)+ Net Borrowing
FCFE= 270 -150(1 -0.30)+ 80= Rs 245 crores
2.Calculating from Net Income
FCFE= net income + non cash charges -capital expenditure -investt in
working capital +Net Borrowing
FCFE= 315+ 400 -500-50+ 80= Rs 24 5c r o r e s
3.Calculating from Cash from Operations
FCFE= Cashflow from operating activities -Capital expenditure +Net
Borrowing
FCFE= 665 -500+ 80= Rs 245 crores
Illustration 2
Current FCFF Rs 60,00,000
Target Debt to capital ratio 0.25
Market valu eo fd e b t Rs 3,00,00,000
Shares Outstanding 29,00,000
Required return on equity 12%
Cost of debt 7%
Long term growth in FCFF 5%
Tax Rate 30%
Estimate the value of a company using Free cashflow model
Solution
1.We first must calculate the WACC for the firm.
The formula says the WACC is determined by debt and equity component
costs.
MV(Debt) = current market value of debt
MV(Equity) = current market value of common equity
rd=b e f o r e -tax cost of debt (which is transformed into the after -tax cost by
multiplying by 1 –Tax Rate)
r = cost of equity
To calculate the debt component, the tax rate is used because in
most jurisdictions, the interest payments on debt are tax deducti ble, which
reduces the effective cost of debt financing. Equity financing, however, is
not subject to such favorable tax treatment because the payment of
dividends does not reduce the firm’s taxable income.
WACC= [0.25*7%*(1 -0.30)]+ [0.75* 12%]= 10.23%munotes.in
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143Note that the debt -to-capital ratio of 0.25 means that 25% of firm
assets are financed with debt and the other 75% are financed with equity.
In some cases (as in this example), analysts use the ratio of target debt to
capital instead of using current mark et value weights because they
frequently assume that the targeted debt ratio is that which the firm will
use over the long term.
Note that here, market value of equity is not available, hence we have
to use debt and equity ratios of 0.25 and 0.75 instead of using actual
market values of debt and equity
2.Firm value
The general model to value a firm from its FCFF is,
∞
Value of the firm based on FCFF = ∑{FCFF t/[(1+WACC)^t]}
t=1
However, as growth rates are given, the formula simplifies to;
We grow the current $6 million in FCFF out one period at 5% to arrive at
next period’s FCFF.
FCFF1= FCFF0*(1+g)
FCFF1= 60,00,000(1.05)
Firm value= 60,00,000(1.05)/(0.1023 -0.05)= Rs 12.05 crores
Note also that here the FCFF is discounted by the firm’s WACC. If the
FCFE were provided, it would be discounted by the shareholder’s required
return to obtain the equity value.
Summary
Free Cash Flows refer to cash flows that are from specific set of
commitments from a specific set of perspectives. Free Cash Flows from
the perspective of operations refer to cash flows that are available after
meeting opera tional cash flows and meeting investment commitments
with respect to capital expenditure and net working capital in order to
allow smooth operations within the planned capacity. ‘Free Cash Flows to
the Firm’ present cash flows of a business entity from the perspective of
‘what is available to the long term providers of funds’ and out of which
allocations to them can be made. FCFE, as you would have gone through
goes a step further and presents a cash flow picture from the perspective of
Shareholders, which again may be classified into preference shareholders
and ordinary shareholders. Valuation of a firm depends upon an entity’s
ability to generate and effectively utilize the cash, which in turn decides
about the worthiness of a firm. Valuation can be made f or a firm from
which values of debt and equity can be segregated. Additionally, value ofmunotes.in
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144shareholders can be independently made on the basis of cash flows
available to the shareholders. Weighted average cost of capital and
expected rate of return are appli ed in determining the value of the firm and
of shareholders, respectively.
Key Words
WACC, Operating Free Cash Flows, Free Cash Flows to the Firm, Free
Cash Flows to Equity,
Review Questions and Exercises
1.Define OCF, FCFF and FCFE
2.What is WACC ? How is it computed?
3.Valuation of a firm or equity depends upon appropriate free cash
flows. Validate the statement
4.List out the adjustments made to OFCF to arrive at FCFF and FCFE
5.Explain the meaning of “Explicit Period”
6.Applying the concepts explained in this ch apter, determine the FCFE
of your Organization
7.Calculate FCFF and FCFE under various methods learnt:
Rs. (in crores)
EBITDA 2000
Depreciation 800
Interest Expense 300
Tax rate 30%
Purchase of fixed assets 1000
Change in Working capital 100
Net borrowing 160
Equity dividends 400
8.Calculate FCFF and FCFE under the various methods studied
Rs. (in crores)
EBITDA 500
Depreciation 200
Interest Expense 300
Tax rate 30%
Purchase of fixed assets 250
Change in Working capital 25
Net borrowing 40
Equity dividends 100munotes.in
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1459.Calculate value of firm using FCFE method
Current FCFE Rs 45,00,000
Shares Outstanding 29,00,000
Required return on equity 12%
Cost of debt 7%
Long term growth in FCFE 5%
Tax Rate 30%
Estimate the value of a company using Free cashflow model
10.Calculate value of firm using FCFF method
Current FCFF Rs 40,00,000
Target Debt to capital ratio 0.30
Required return on equity 12%
Cost of debt 10%
Long term growth in FCFF 7%
Tax Rate 35%
Estimate the value of a company using Free cashflow model
munotes.in