Management Accounting-munotes

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INTRODUCTION TO MANAGEMENT
ACCOUNTING
Unit Structure :
1.0 Objectives
1.1 Introduction
1.2 Meaning and Nature of Management Accounting
1.2.1 Meaning and Definition
1.2.2 Nature of Management Accounting
1.3 Function of Management Accounting
1.4 Scope of Management Accounting
1.5 Difference between Management Accounting and Financial
Accounting
1.6 Exercise
1.0 OBJECTIVES
After studying the unit the students will be able to:
Define the term Management accounting.
Explain the nature and functions of Management Accounting
Discuss the role of management accountant.
Explain the difference between Management accounting and
financial accounting.
Understand the limitations of MA.
1.1INTRODUCTION
Management accounting can be viewed as
Management -oriented Accounting. Basically it is the study of
managerial aspect of financial accounting, "accounting in relation to
management function”. It shows how the accounting function can be
re-oriented so as to fit it within the framework of management
activity. T he primary task of management accounting is, therefore, to
redesign the entire accounting system so that it may serve the
operational needs of the firm. If furnishes definite accounting
information, past, present or future, which may be used as a basis for
management action. The financial data are so devised and
systematically development that they become a unique tool for
management decision.munotes.in

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21.2 MEANING AND NATURE OF MANAGEMENT
ACCOUNTING
1.2.1 Meaning and Definition
The term " Management Accounting”, ob serves Broad and
Carmichael covers all those services by which the accounting
department can assist the top management and other departments
in the formation of policy, control of execution and appreciation of
effectiveness.
The Report of the Anglo -Ameri can Council of Productivity
(1950) has also given a definition of management accounting, which
has been widely accepted. According to it, "Management accounting
is the presentation of accounting information in such a way as to
assist the management in crea tion of policy and the day to day
operation of an undertaking". The reasoning added to this statement
was, "the technique of accounting is of extreme importance because
it works in the most nearly universal medium available for the
expression of facts, so that facts of great diversity can be
represented in the same picture. It is not the production of these
pictures that is a function of management but the use of them." An
analysis of the above definition shows that management needs
information for better d ecision -making and effectiveness. The
collection and presentation of such information come within the area
of management accounting. Thus, accounting information should be
recorded and presented in the form of reports at such frequent
intervals, as the man agement may want. These reports present a
systematic review of past events as well as an analytical survey of
current economic trends. Such reports are mainly suggestive in
approach and the data contained in them are quite up to date. The
accounting data s o supplied thus provide the informational basis of
action. The quality of information so supplied depends upon its
usefulness to management in decision -making.
1.2.2 Nature of Management Accounting
Following points explains the nature of Management
Accou nting:
1.The term management accounting is composed of 'management'
and 'accounting'. The word 'management' here does not signify
only the top management but the entire personnel charged with
the authority and responsibility of operating an enterprise.
2.The task of management accounting involves furnishing
accounting information to the management, which may base its
decisions on it.
3.It is through management accounting that the management gets
the tools for an analysis of its administrative action and can lay
suitable stress on the possible alternatives in terms of costs,munotes.in

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3prices and profits, etc. but it should be understood that the
accounting information supplied to management is not the sole
basis for managerial decisions.
4.Along with the accounting informat ion, management takes into
consideration or weighs other factors concerning actual
execution. For reaching a final decision, management has to
apply its common sense, foresight, knowledge and experience of
operating an enterprise, in addition to the inform ation that is
already has.
5.The word 'accounting' used in this phrase should not lead us to
believe that it is restricted to a mere record of business
transactions i.e., book keeping only.
6.Management accounting has no set principles such as the double
entry system of bookkeeping. In place of generally accepted
accounting principles, the philosophy of cost benefit analysis is
the core guide of this discipline. It says that no accounting system
is good or bad but is can be considered desirable so long as it
brings incremental benefits in excess of its incremental costs.
1.3FUNCTIONS OF MANAGEMENT ACCOUNTING
The basic function of management accounting is to assist the
management in performing its functions effectively. The functions of
the management are pl anning, organizing, directing and controlling.
Management accounting helps in the performance of each of these
functions in the following ways:
1.Provides data: Management accounting serves as a vital source
of data for management planning. The accounts and documents
are a repository of a vast quantity of data about the past progress
of the enterprise, which are a must for making forecasts for the
future.
2.Modifies data: The accounting data required for managerial
decisions is properly compiled and classifie d. For example,
purchase figures for different months may be classified to know
total purchases made during each period product -wise,
supplier -wise and territory -wise.
3.Analyses and interprets data: The accounting data is analyzed
meaningfully for effectiv e planning and decision -making. For this
purpose the data is presented in a comparative form. Ratios are
calculated and likely trends are projected.
4.Serves as a means of communicating: Management
accounting provides a means of communicating management
plans upward, downward and outward through the organization.
Initially, it means identifying the feasibility and consistency of the
various segments of the plan. At later stages it keeps all partiesmunotes.in

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4informed about the plans that have been agreed upon and thei r
roles in these plans.
5.Facilitates control: Management accounting helps in translating
given objectives and strategy into specified goals for attainment
by a specified time and secures effective accomplishment of
these goals in an efficient manner. All t his is made possible
through budgetary control and standard costing which is an
integral part of management accounting.
6.Uses also qualitative information: Management accounting
does not restrict itself to financial data for helping the
management in decis ion making but also uses such information
which may not be capable of being measured in monetary terms.
Such information may be collected form special surveys,
statistical compilations, engineering records, etc.
1.4SCOPE OF MANAGEMENT ACCOUNTING
Manage ment accounting is concerned with presentation of
accounting information in the most useful way for the management.
Its scope is, therefore, quite vast and includes within its fold almost
all aspects of business operations. However, the following areas can
rightly be identified as falling within the ambit of management
accounting:
1.Financial Accounting: Management accounting is mainly
concerned with the rearrangement of the information provided by
financial accounting. Hence, management cannot obtain full
control and coordination of operations without a properly
designed financial accounting system.
2.Cost Accounting: Standard costing, marginal costing,
opportunity cost analysis, differential costing and other cost
techniques play a useful role in operation a nd control of the
business undertaking.
3.Revaluation Accounting: This is concerned with ensuring that
capital is maintained intact in real terms and profit is calculated
with this fact in mind.
4.Budgetary Control: This includes framing of budgets,
comparis on of actual performance with the budgeted
performance, computation of variances, finding of their causes,
etc.
5.Inventory Control: It includes control over inventory from the
time it is acquired till its final disposal.
6.Statistical Methods: Graphs, chart s, pictorial presentation,
index numbers and other statistical methods make the
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57.Interim Reporting: This includes preparation of monthly,
quarterly, half -yearly income statements and the related reports,
cash fl ow and funds flow statements, scrap reports, etc.
8.Taxation: This includes computation of income in accordance
with the tax laws, filing of returns and making tax payments.
9.Office Services: This includes maintenance of proper data
processing and other off ice management services, reporting on
best use of mechanical and electronic devices.
10.Internal Audit: Development of a suitable internal audit system
for internal control.
CHECK YOUR PROGRESS
1.“The basic function of management accounting is to assist the
management in performing its functions effectively”. Discuss.
2.Enlist the points explaining the scope of Management
Accounting.
1.5 DIFFERENCE BETWEEN MANAGEMENT
ACCOUNTING AND FINANCIAL ACCOUNTING
Financial accounting and managem ent accounting are closely
interrelated since management accounting is to a large extent
rearrangement of the data provided by financial accounting.
Moreover, all accounting is financial in the sense that all accounting
systems are in monetary terms and ma nagement is responsible for
the contents of the financial accounting statements. In spite of such a
close relationship between the two, there are certain fundamental
differences. These differences can be laid down as follows:munotes.in

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6Financial Accounting Manag ement Accounting
1.Objectives
Financial accounting is designed
to supply information in the form
of profit and loss account and
balance sheet to external parties
like shareholders, creditors,
banks, investors and
Government. Information is
supplied periodi cally and is
usually of such type in which
management is not much
interested.Management Accounting is
designed principally for providing
accounting information for internal
use of the management. Thus,
financial accounting is primarily an
external reporti ng process while
management accounting is primarily
an internal reporting process.
2.Analyzing performance
Financial accounting portrays the
position of business as a whole.
The financial statements like
income statement and balance
sheet report on overal l
performance or statues of the
business.
Financial accounting deals with
the aggregates and, therefore,
cannot reveal what part of the
management action is going
wrong and why.Management accounting directs its
attention to the various divisions,
departme nts of the business and
reports about the profitability,
performance, etc., of each of them.
Management accounting provides
detailed analytical data for these
purposes.
3.Data used
Financial accounting is
concerned with the monetary
record of past event s. It is a
post-mortem analysis of past
activity and, therefore, out the
date for management action.Management accounting is
accounting for future and, therefore,
it supplies data both for present and
future duly analyzed in detail in the
'management lang uage' so that it
becomes a base for management
action.
4.Monetary measurement
In financial accounting only such
economic events find place,
which can be described in
money.Management is equally interested in
non-monetary economic events,
viz., technical i nnovations,
personnel in the organization,
changes in the value of money, etc.
These events affect management's
decision and, therefore,
management accounting cannot
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75.Periodicity of reporting
The period of reporting is much
longer i n financial accounting as
compared to management
accounting. The Income
Statement and the Balance
Sheet are usually prepared
yearly or in some cases
half-yearly.
Management requires
information at frequent intervals
and, therefore, financial
accounting fai ls to cater to the
needs of the management.In management accounting there is
more emphasis on furnishing
information quickly and at
comparatively short intervals as per
the requirements of the
management.
6.Nature
Financial accounting is more
objective.Management accounting is more
subjective because management
accounting is fundamentally based
on judgment rather than on
measurement.
7.Legal compulsion
Financial accounting has more or
less become compulsory for
every business on account of the
legal pro visions of one or the
other Act.A business is free to install or not to
install system of management
accounting.
1.6EXERCI SE
1.What are the functions of a management account ing?E l a b o r a t e
each one of them.
2.Distinguish management accounting from finan cialaccounting.
3.Objective Type Questions:
a.Match Group A With Group B
Group A Group B
a)Financial Accounting 1.Function of management
accounting
b)Reports of Management 2.Mandatory
c)Management Accounting 3.Technique of management
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8e)Reports of Financial
Accounting5.Optional
f)Budgetary Control 6.Historical Data
Ans. a –6, b–5,c-4, d -1,e –2,f-3
b.Fill in the Blanks with proper words / phase.
1.Inventory control is ________ in m anagement accounting.
2.Financial accounting deals with ___________ data.
3.Management accounting is ________ oriented.
4.There is no legal format for management
accounting____________.
5.In management accounting publication of reports is
______________.
6.Manageme nt account is __________in nature.
(Answer: 1. Included, 2. Historical, 3. Future, 4. Reports, 5.
Optional,
6. Analytical)
c.State whether following statement are True or False.
1.Management accounting is analytical in nature.
2.Management accounting is dynamic.
3.Management accounting provides decisions to the management.
4.Management accounting is future oriented.
5.Management accounting includes Standard Costing.
6.Financial Accounting is future oriented.
(Answer: 1. True 2.True 3. False 4. True 5.True 6. False )
d.Multiple Choice Questions.
1.Financial accounting records only
a)Actual Figures
b)Budgeted figures
c)Standard Figures
d)All of the above
2.The use of management accounting is
a)Mandatory
b)Optional
c)Compulsory
d)All of the above
3.Management Accounting includes
a)Financial Accounting
b)Cost Accounting
c)Budgetary control
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94.Management Accounting is
a)Analytical
b)Future oriented
c)Dynamic
d)All of the above
5.Financial Accounting deals with
a)Determination of cost
b)Determination of profit
c)Determination o f prices
d)None of the above
6.Management accounting relates to
a)Recording of accounting data
b)Recording of costing data
c)Presentation of accounting data
d)None of the above
(Answer: 1. a, 2. b, 3.d, 4.d, 5. b, 6.c)

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2
ANALYSIS AND INTERPRET ATIONO F
FINANCIALSTATEMEN TS
Unit Structure :
2.0 Objectives
2.1 Introduction
2.2 Meaning and Nature of Financial Statements
2.2.1 Meaning
2.2.2 Nature of Financial Statements
2.2.3 Objective of Financial Statements
2.2.4 Limitations of Financial Statements
2.3 Analysis and Interpretations of Financial Statements
2.3.1 Need of interpretation
2.3.2 Meaning of Analysis and Interpretations
2.4 Preparation of Financial Statements
2.0OBJECTIVES
After studying the unit the s tudents will be able to:
Understand the objectives and nature of Financial Statements.
Know the characteristics of Financial Statements.
Discuss about the qualities of Ideal Financial Statements.
Interpret the financial statements.
2.1INTRODUCT ION
The j oint stock companies are legally required to prepare set
of financial statement to periodically assess the profit earned and to
know the financial position of the company as on a specified date.
Thus, as in the case of other business enterprises, a limited
company prepare the income statement and the balance sheet.
However, in the case of companies registered under Companies
Act, the Act specifies the books of accounts to be maintained and
also prescribes the format and content of financial statement. In
addition, the accounts must be statutorily audited by the external
person called the auditor and it is duty of the auditor to submit a
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Since the owner or shareholder elect a board of director to
manage th e company and rely on the ability and skills of these
directors to conduct the business in the most profitable manner, the
Companies Act tries to protect the shareholders’ interest by
prescribing a set of covenants according to which the financial
statemen ts are to be prepared and presented to the shareholders.
The objective of the Company Act in laying down the various
provisions with respect to accounts and audit is to ensure that
adequate information is provided to be shareholders in order for
them to ju dge the performance of the directors during an
accounting period. The legal requirement laid down by the
Companies Act therefore, assume a great importance in the
preparation of the financial statements.
2.2 MEANING AND NATURE O FF I N A N C I A L
STATEMENTS
2.2.1Meaning :
Every business concern wants to know the various financial
aspects for effective decision making. The preparation of financial
statement is required in order to achieve the objectives of the firm
as a whole. The term financial statement refers to an organized
collection of data on the basis of accounting principles and
conventions to disclose its financial information. Financial
statements are broadly grouped in to two statements:
I.Income Statements (Trading, Profit and Loss Account)
II.Balance Sh eets
In addition to above financial statements supported by the
following statements are prepared to meet the needs of the
business concern:
(a)Statement of Retained Earnings
(b)Statement of Changes in Financial Position
The meaning and importance of the fina ncial statements are
as follows :
Income Statements: The term 'Income Statements' is also known
as Trading, Profit and Loss Account. This is the first stage of
preparation of final accounts in accounting cycle. The purpose of
preparing Trading, Profit and Loss Accounts to ascertain the Net
Profit or Net Loss of a business concern during the accounting
period.
Balance Sheet: Balance Sheet may be defined as "a statement of
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moment of time its a ssets, at cost, depreciated cost, or other
indicated value, its liabilities and its ownership equities." In other
words, it is a statement which indicates the financial position or
soundness of a business concern at a specific period of time.
Balance Sheet may also be described as a statement of source and
application of funds because it represents the source where the
funds for the business were obtained and how the funds were
utilized in the business.
Statement of Retained Earnings: This statement is con sidered to
be as the connecting link between the Profit and Loss Account and
Balance Sheet. The accumulated excess of earning over losses
and dividend is treated as Retained Earnings. The balance of
retained earnings shown on the Profit and Loss Accounts a nd it is
transferred to liability side of the balance sheet.
Statement of Changes in Financial Position: Income Statements
and Balance sheet do not disclose the operational efficiency of the
concern. In order to measure the operational efficiency of the
concern it is essential to identify the movement of working capital or
cash inflow or cash outflow of the business concern during the
particular period. To highlight the changes of financial position of a
particular firm, the statement is prepared may empha size of the
following aspects :
1.Fund How Statement is prepared to know the changes in the
firm's working capital.
2.Cash Flow Statement is prepared to understand the changes in
the firm's cash position.
3.Statement of Changes in Financial Position is used for the
changes in the firm's total financial position.
2.2.2 NATURE OF FINANCIAL STATEMENTS
Financial Statements are prepared on the basis of business
transactions recorded in the books of Original Entry or Subsidiary
Books, Ledger, and Trial Balance. Recor ding the transactions in the
books of primary entry supported by document proofs such as
Vouchers, Invoice Note etc.
According to the American Institute of Certified Public
Accountants, "Financial Statement reflects a combination of
recorded facts, accoun ting conventions and personal judgments
and conventions applied which affect them materially." It is
therefore, nature and accuracy of the data included in the financial
statements which are influenced by the following factors :
(1)Recorded Facts.
(2)Generally Accepted Accounting Principles.
(3)Personal Judgments.
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2.2.3 OBJECTIVES OF FINANC IAL STATEMENTS
The following are the important objectives of financial
statements:
1.To provide adequate information about the source of finance
and obligati ons of the finance firm.
2.To provide reliable information about the financial performance
and financial soundness of the concern.
3.To provide sufficient information about results of operations of
business over a period of time.
4.To provide useful information about the financial conditions of
the business and movement of resources in and out of
business.
5.To provide necessary information to enable the users to
evaluate the earning performance of resources or managerial
performance in forecasting the earning pote ntials of business.
2.2.4 LIMITATIONS OF FINANCIAL STATEMENTS
1.Financial Statements are normally prepared on the basis of
accounting principles, conventions and past experiences.
Therefore, they do not communicate much about the
profitability, solvency, st ability, liquidity etc. of the undertakers to
the users of the statements.
2.Financial Statements emphasize to disclose only monetary
facts, i.e., quantitative information and ignore qualitative
information.
3.Financial Statements disclose only the historical information. It
does not consider changes in money value, fluctuations of price
level etc. Thus, correct forecasting for future is not possible.
4.Influences of personal judgments leads to opportunities for
manipulation while preparing of financial statement s.
5.Information disclosed by financial statements based on
accounting concepts and conventions. It is unrealistic due to
difference in terms and conditions and changes in economic
situations.
2.3 ANALYSIS AND INTERPR ETATIONS OF
FINANCIAL STATEMENTS
2.3.1 Need of interpretation
Presentation of financial statements is the important part of
accounting process. Following are some points:
1.To provide more meaningful information
2.To enable the owners, investors, creditors or users of financial
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3.Toe valuate the operational efficiency of the concern during the
particular period.
4.More useful information is required from the financial statements
to make the purposeful decisions about the profitability and
financial soundness of the concern.
5.In order to fulfill the needs of the above, it is essential to
consider analysis and interpretation of financial statements.
2.3.2 Meaning of Analysis and Interpretations
The term "Analysis" refers to rearrangement of the data
given in the financial statements. In ot her words, simplification of
data by methodical classification of the data given in the financial
statements.
The term "interpretation" refers to "explaining the meaning
and significance of the data so simplified."
Both analysis and interpretations are c losely connected and
inter related. They are complementary to each other. Therefore
presentation of information becomes more purposeful and
meaningful —both analysis and interpretations are to be considered.
Metcalf and Tigard have defined financial stateme nt analysis and
interpretations as ,“a process of evaluating the relationship between
component parts of a financial statement to obtain a better
understanding of a firm's position and performance ”.
The facts and figures in the financial statements can be
transformed into meaningful and useful figures through a process
called "Analysis and Interpretations.
In other words, financial statement analysis and
interpretation refer to the process of establishing the meaningful
relationship between the items of t he two financial statements with
the objective of identifying the financial and operational strengths
and weaknesses.
2.4PREPARATION OF FINANCIALSTATEMENTS
Financial statements should be rearranged for proper
analysis and interpretations of these state ments. It enables to
measure the performance of operational efficiency and profitability
of a concern during particular period. The items of operating
revenues, non -operating revenues, operating expenses and non -
operating expenses are rearranged into diffe rent heads and sub -
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Vertical Profit and Loss:
Profit and loss account is a statement showing the net result
of business operations during the period, usually a year.
Vertical Profit and loss for the year ended__________
Particular s Rs. Rs. Rs
Gross Sales
Cash Sales Xx
Credit Sales Xx
Less : Returns and allowance (xx)
Net Sales XX
Less: Cost of Goods Sold
Opening Stock of Raw Material Xx
Purchases of Ra wM a t e r i a l Xx
Less : Closing Stock of Raw Material (xx)
Raw Material Consumed Xx
Less:
Direct expenses ( Factory Expenses)
Carriage inwards Xx
Factory power Xx
Wages Xx
Other factory expenses Xx
Depreciation on Machinery Xx
Depreciation on Factory Building Xx
Depreciation on Patterns and Patents Xx
Total xx
Add: Opening stock of Finished goods Xx
Add: Purchases of Finished Goods Xx
Less: Closing Stock of Finished Goods (xx)
Cost of Goods Sold (xx)
Gross Profit / Gross Margin xx
Less:
a) Administration Expenses
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Office Rent , Rates and Taxes Xx
Insurance, Office Electricity Xx
Printing and stationery, Audit Fees Xx
Repairs, other office expenses, Directors Fees Xx
Depreciation on office Assets Xx
Postage and telegrams Xx
Total Administrative Expenses xx
b) Selling and Distribution Expenses
Salaries to salesman Xx
Rent of shop, show room Xx
Exhibitions, Trade fair, Sales Discount/
CommissionXx
Normal Bad Debts Xx
Depreciation on Delivery Van Xx
Advertisement and publicity Xx
Travelling / Van Expenses Xx
Total Selling and Distribution Expenses Xx
c) Finance Charges / Expenses
Cash Discount Xx
Bank Chagres Xx
Abnormal bad Debts Xx
Total Finance Charges / Expenses Xx
Total Operating Expenses (Except Interest) (xx)
Operating Profit Before Interest Xx
Less:
Interest Paid
Interest on Debentures Or Bonds Xx
Interest on Loans Xx
Interest on public deposits Xx
Interest on short term loans Xx
Interest Paid (xx)
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Add: Non -operating Income
Dividend on shares Xx
Interest on debentures, loans et c. Xx
Profit on sale of Fixed assets / investment Xx
Damages received Xx
Royalty / shares transfer fees Xx
Total Non-operating Income Xx
Less:
Non-operating Expenses
Loss on sale of Fixed assets / Investment Xx
Damages paid / due Xx
Preliminary expenses written off Xx
Fine and penalty Xx
Total Non-Operating Expenses (xx)
Net Profit Before Tax Xx
Less : Income Tax (xx)
Net Profit After tax Xx
Add: Profit and Loss A/c (Op. Balance) Xx
Less:
Appropriations
Transfer to Sinking Fund Xx
Dividend Paid Xx
Interim Dividend Xx
Transfer to Reserve Xx
Appropriation (xx)
Retained Ea rnings / Balance Transfer to
Balance SheetXx
From the above rearrangement of operating statements, the
following accounting equations may be given:
1.Net Sales = Cost of sales + operating expenses + Non -
operating expenses
2.Gross Profit = Net sales –Costo fg o o d ss o l d
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4.Gross Sales: Gross sales also called ‘Turnover’ is the amount
of total sales of goods and services. This includes both cash
and credit sales.
Gross sales = Credit sales + cash sales
5.Cost of Goods Sold: This is the cost of purchases or cost of
manufacturing the goods, which are sold during the year.
Cost of Goods Sold = Opening stock + Purchases + Direct
Expenses + Depreciation –less closing stock
6.Gross Profit: This is the major sourc e of operating income of
an organization. This is the amount of profit earned on
purchases, manufactures and sales of goods and services.
Gross Profit = Net Sales –Cost of goods sold
7.Operating Expenses: These are the expenses incurred in the
course of nor mal conduct of business, which are related to the
business activities. Broadly, operating expenses are classified
into the following categories.
a.Administrative Expenses: These are the expenses pertaining
to general office administrative of an organization.
b.Selling and Distribution Expenses : These are the expenses
incurred for the purpose of increasing and maintaining the sales,
distributing and delivering the goods.
c.Finance Chagres :T h i s includes: Cash discount, Bad debts
(Abnormal), Bank charges, bank Com mission.
Operating Expenses = Administrative Expenses + Selling &
Distribution Expenses + Finance Expenses
8.Operating Profit: Excess of operating income over operating
expenses is called net operating profit. This is the amount of
profit earned during the normal course of business. Operating
profit may be
a.Operating Profit before Interest: Gross Profit -
Operating expenses (Before Interest)
b.Operating Profit After Interest : Operating profit (before
Interest) -Interest
9.Non-operating Income: Income not relate dt ot h eo r d i n a r y
course of business i.e. Interest on investment is not an
operating income to a company, which is engaged in buying and
selling of goods and services of goods. But for an investment
company, interest will be considered as an operating inco me.
10.Non-Operating Expenses: These are the expenses, which do
not relate to day to day conduct of business operations. These
expenses arise due to certain unusual events and unexpected
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11.Net Profit : This is the excess of total operating and non -
operating income over the total operating and non -operating
expenses. It is therefore, ultimate profit earned by the
organization.
a.Net Profit before Tax = Net operating profit + N et non -
operating Income
b.Net profit After Tax =Net profit before tax -Income tax
12.Retained Earnings: Net profit after tax -dividend
Vertical Balance Sheet:
Balance sheet is a statement of assets and liabilities.
Vertical Balance sheet as on __________________
Particulars Rs. Rs. Rs.
A.Sources of Funds
1)Owners funds
a) Share capital
Equity share capital Xx
Preference share capital Xx
Less: Unpaid calls/ (xx)
Add: Forfeiture shares Xx Xx
b) Reserve and Surplus
Capital Reserve / Capital Redemption Reserve Xx
Share premium /General Reserve Xx
Other reserve / Sinking Fund xx xx
c) Losses & Fictitious Assets
Profit and loss A/c Debit Balance Xx
Miscellaneous Expenditure Not Written off Xx
Preliminary Expenses Xx
Shares Issue Expenses Xx
Discount on Issue of shares or Debenture Xx (xx)
Own F unds or Net Worth ( a+b-c) xx
2)Loan Funds
a)Long term Loans
Debentures or bonds Xx
Loans from banks Xxmunotes.in

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Loans from financial Institutions Xx
Public deposit Xx Xx
Other Loans Xx
Owed Fund (a+b) Xx
Total Funds Available / Capital Emplo yed xx
B.Application of Funds
1)Net Fixed Assets
a)Tangible Assets
Land and building (Cost) Xx
Leaseholds, Plant and Machinery ( Cost) Xx
Furniture and fitting, Vehicles (Cost) Xx
Less: PFD (xx) Xx
b)Intangible Assets
Goodwill Xx
Patents, Trademarks, And Designs Xx Xx
Total Fixed Assets ( a+b) Xx
2)Long Term Investment
Investment in Govt. Securities Xx
Investment immovable properties Xx
Investment in capital of partnership firm Xx
Long term loans given Xx Xx
3)Working Capital
a)Quick Assets
Cash and Bank Xx
Debtors xx
Less: RDD (xx) Xx
Bills Receivable / Trade receivable Xx
Current Investmen t Xx
Accrued Income Xx
Loans and Advance Xx
Inventory Xxmunotes.in

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Prepaid Expenses Xx
Advance Tax Xx
Advance for goods Xx Xx
Less:
b)Current Liabilities
Creditors Xx
Bills Payable / Trade Payable Xx
Advance Received Xx
Expenses Paya ble Xx
Accrued Interest Xx
Provision for taxation Xx
Provision for dividend Xx
Unclaimed Dividend Xx
Provision for dividend Distribution Tax Xx
Bank Overdraft Xx
Income received in advance Xx (Xx)
Net current assets ( a-b) Xx
Total Application of Fund Xx
Application of Funds
1.Fixed Assets:
Fixed Assetsarecalledlong-termassets.Theydonotflowthrough
thecashcycleofbusinesswithinoneyearorthenormaloperating
cycle.Theyareusedoverseveralperiods.
ClassificationofFixedAssets:
a.Tangiblemovableassets;
b.Tangibleimmovableassets;and
c.Intangibleassets.
a)Tangib lemovableassetsaretheassetswhichcanbeseen,
touchedandmovedfromoneplacetoanotherp lace.Plantand
Machinery,furnitureandfixtures, transportationequipme ntetc.
Aretangiblemovableassets.
b)Tangib le immo vableasse tsaretheassetswhich c anbeseen
andtouchedbutcannotbemovedfromoneplacetoanother
place.Suchassetsincludeland,buildings,mines,oilwells,etc.
c)Intangible assetsaretheassetswhichcanno tbeseenand
touched.However,theirexistencecanonlybeimaginedsuchmunotes.in

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aspatents, trademarks, c opyrights,goodwilletc.Theirexistence
isveryimportantforthebusiness.
FixedAssets = T angible Assets + Intangible Assets
2.Investments:
Long terminvestments are“FixedAssets”. Marketable
Investments are those in vestments whichareacquiredbythe
compa nybyemployingitssurplus funds or cashtempor arily.
Short term investments are groupedunder “Current
Assets”.
3.Current AssetsandQuickAssets :
a)Current Assets:
Currentassets re presentemploymentofmoneybythe
companyonashort-termbasis.
Current Assets = Stock+D e b t ors + Cash&B a n k+ L o ans
&Advances+Marketable S ecurities+ O t h e rC u r r e n t Assets
b)QuickAssets:
Theseassetsareknownas‘nearcash’assets.Inother
words, quickasse tsarethose whichcanbeconverted into cash
quickly.Therefore,theyarealsoknownasliquidassets.
QuickAssets =CurrentAssets–Inventory–Prepayments
Sources of Fund
1.Propri etor’sFunds
Thesearethefunds providedbytheproprietorsorthe
shareholders.Proprietorsfundi salsocalledasP r o prietors Equity,
OwnersFunds,OwnersEquity,orShareholdersFunds.Thisisalso
knownastheNetWorthofthebusiness.Owners’Equityrefersto
theclaimoftheownersanditismadeupofcontributions of
propri etorsbywayo f :
Share Ca pital(MaybeEquityShareCapitalonlyorEquityand
PreferenceShareCapital)
Plus: Reserves
Plus: ProfitandLossAccount(Credit)Balance(Surplus)
Less:AccumulatedLosses
Less:Fictit iousAssets(Ifany)
a)ShareCapital:
Sharecapital istheamount thatisraisedbyacompa nyf rom
thepublic atlarge,through theissueofshares.Therearedifferent
conceptsofsharecapitalfromthelegalandaccountingpointsof
view.munotes.in

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i.AuthorisedC a p i t a l : AuthorisedCapitalisthemaximumcapital
acompanycan raise asmentionedintheMemorandumof
Associationunderits Ca pitalClause.I ti s also c alledasthe
Registered Ca pitalorN ominalCapitaloftheCompany.
ii.Issued and U nissuedCapital: Acompanyusuallydoesnot
needtheentirer egistered c apital.The capitalmayberaised as
andwhennecessary.Onlyapartoftheauthorisedcapitalmay
beissuedatatime.Issuedcapitali sthatpartoftheauthorised
capitalwhichisactuallyofferedtotheprospectiveinvestorsfor
subscription.
iii.Subs cribedCapital: The issu edcapitalmaynotbefully
subscribedbythepublic. Subscribedcapitalis thatp arto ft he
issued capital whichhasb e ensubscribedo rt a kenu p bythe
public.
iv.Calledu p andUncalledC a p i t a l : Thecompanymaynotneed
theentirecapitalsubscribedbythepublic.Thecompany,
therefore,maycollectthecapitalinseveralinstalments.The
called-upcapitalisthatportion ofthesubscribedcapitalwhich
hasbeencalledordemandedbythecompanytobepaid.The
capitalthatisnotdemandedfromtheshareholdersiscalled
uncalledcapital.
v.Paid up C apital:Paidupcapitalisthatpartofthecalledup
capitalwhichhasbeenactuallypaidbythemembers.The paid-
upcapitalisthecalled-upamountl esscallsnotpaid.(calls
unpa idorcalls-in-arrears).
b)ReservesandSurplus:
According toComp aniesAct ,Reserveshallnotincludeany
amountwrittenofforr etainedbywayofprovidingfordepreciation,
renewals ordiminutioninvalueofassetsorretainedbywayof
provid ingforanyknownliability.Generally reserves are divided into
two categories viz. Specific Reserves and General Reserves.
Reservecreatedforaspecificpurposei s calledasa “specific
reserve”and a reservecreated f orag e n eralp u r p osei s calleda
“generalreserve.Generalreservesarefreeandcanbeutilizedfor:
a.PaymentofDividends.
b.Developmentandexpansion,
c.Anyotherpurposethecompanythinks proper.
GeneralReserveisalsocalledasrevenuereserve orafree
reserve.Afreereserveisareservewhichisavailableforany
purpose,includingpaymentsofdividend.Itisnotmarkedforany
specificpurpose.munotes.in

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2.Capital Reserves:
Capitalreserveiscreatedoutofcapitalprofitswhichdonot
ariseinthenormalcourseofbusiness.The followingreservesare
capitalreserves:
a.Profitsprior toincorporation
b.Profitonredemptionofpreferenceshares,
c.Profitonredemptionofdebentures,
d.Securitiespremium,
e.Profitonforfeitureofshares,
f.Profitonsalesoffixedassets,
g.Profitonrevaluationoffixedassets,
h.Capitalredemptionoffixedassets,
3.Long -term Liabilities
Externalborrowingsofacompanywhich c onstitute its owed
fundsareimportantsources oflong-term finance.These
borrowingsare termedasfixedliabilities orterm liabilitiesorlong
term-loans.
a)Securedloans: Itreferstoloanswhicharesecuredbyafixed
orfloatingchargeontheassetsofthebusiness.Itincludes:
i.Debenture
ii.Loanandadvancefrombanks,
iii.Loanandadvancefromsubsidiariesand
iv.Otherloanandadvances.
b)Unsecuredloans:Itreferstotheloanswhicharenotsecured
byassetsofthebusiness.I tisnotcoveredbyanysecurity.It
includes:
i.Fixeddeposits,
ii.Loansandadvancefromsubsidiaries,
iii.Otherloansandadvance:loanfromdirectors,secretaries,
treasurersandmanagers sh ouldbeshownseparately.
Loan Fund= Securedloans +un securedloans
4.Current LiabilitiesandProvisions
a)Current Liabilities
Current liabilitiesarethose short-term obligations ofan
enterprisewhichmaturewithin one yearo r within t heo p e r ating
cycle.Theyareasfollows:
i.SundryCreditors–whengoodsarepurchased
ii.Bills P ayable–byacceptanceofbillsdrawnbycreditor–
(Accountspayable)
iii.Interestaccruedbutnotdue
iv.Wagesandsalariespayable–outstandingexpenses.
v.Unclaimeddividends.
vi.BankOverdraft.munotes.in

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b)Provisions:
Provisionmeansanyamount r etainedbywayo fp r oviding for
anyknownliabilityofwhichtheamount cannot be det erminedwith
substanti alaccuracy.Theyareatbestestimates.The examplesof
provisionsareasunder:
i.Provisionfordepreciat iononassets.
ii.Provisionfordoubtfuldebts.
iii.Provisionforproposeddividends.
iv.Provisionfortaxation.
Provisionsr e l a ting to s pecificassetsare shownasdeduction
fromthespecificassets.
c)QuickLiabilities:Thesearethecurrentliabilitieswhichmature
within averyshortperiod of tim e.
QuickLiabilities=CurrentLiabilities–BankOverdraft
Check Your Progress :
1.Give the formulas of t he following:
a)Proprietors Fund
b)Quick Liabilities
c)Quick Assets
d)Net profit before tax
e)Retained earnings
f)Cost of goods sold
g)Operating expenses
2.Give the examples of the following:
a)Current Liabilities
b)Provisions
c)Secured loan
d)Capital Reverses
e)Curren t Assets
f)Fictitious Assets
g)Non-operating Income
h)Administration expensesmunotes.in

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2.5 SOLVED PROBLEMS
Illustration 1
Following is the trial balance of Good Luck Ltd. as on 31.3.2014
Trial Balance
Particulars Amt. Particulars Amt.
Preliminary Expenses
(Not yet written off)20,000 Equity Shares
Capital (Rs.100)7,00,000
Administrative Expenses 4,00,000 Gross Sales 20,40,000
Land And Building 8,00,000 General Reserve 3,20,000
Plant & Machinery 6,00,000 Profit and loss A/c
(Cr.)2,00,000
Selling Expe nses 1,00,000 12.5% Debentures 4,00,000
Furniture 3,00,000
Cost of production 9,60,000
Return Inward 40,000
Finished Goods 2,40,000Provision for
Depreciation
On Land & Building
On Plant &
Machinery
On Furniture2,00,000
1,00,000
80,000Government Bonds 2,80,000 Trade Expenses 4,00,000Advance Tax2,00,000Trade Receivable5,00,000
44,40,000 44,40,000
Other Information:
1.Closing stock of Finished goods as on 31.3.2014 was
Rs.1,60,000.
2.Provide Dividend on Equity Shares at 10%.
3.Make provision for Income Tax of Rs.2,00,000.
From the following information you are required to prepare
Income Statement for the year ended 31.3.2014 and balance sheet
as on that date in vertical form suitable for analysis.munotes.in

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Solution
Income Stateme nt for the year ended 31.3.2014
Particulars Amt. Amt.
Gross Sales 20,40,000
Less :R e t u r nI n w a r d 40,000
Net Sales 20,00,000
Cost of Production 9,60,000
Add Opening stock 2,40,000
Less Closing Stock (1,60,000 )
Cost of Goods Sold 10,40,000
Gross Profit 9,60,000
Less: Operating Expenses
1.Administrative Expenses 4,00,000
2.Selling Expenses 1,00,000
Total Operating Expenses 5,00,000
Operating Profit before Interest 4,60,000
Less :D e b e n t u r eI n t e r e s t 50,000
Profit After Interest before Tax 4,10,000
Less: Tax 2,00,000
Profit after tax 2,10,000
Add: Profit and loss balance 2,00,000
Total Profit 4,10,000
Less: Appropriation
Equity Dividend 70,000
Retained Earning 3,40,000
Balance Sheet as on 31.3.2014
Particulars Amt. Amt.
Sources of Fund
1.Share Holders Fund
Equity Share Capital 7,00,000
Reserve and Surplus
General Reserve 3,20,000
Profit and loss A/c 3,40,000
Total 6,60,000munotes.in

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Less : Preliminary Expenses (20,000) 6,40,000
Share Holders Fund 13,40,000
2.Loan Fund
12.5% Debentures 4,00,000
Total Sources of Fund 17,40,000
Application of Fund
1.Fixed Assets
Land & Building (8,00,000 –2,00,000) 6,00,000
Plant & Machinery (6,00,000 –1,00,000) 5,00,000
Furniture (3,00,000 –80,000) 2,20,0 00 13,20,000
2.Investment Government Bonds 2,80,000
3.Working Capital
a.Current Assets
Trade Receivable 5,00,000
Stock of Finish Goods 1,60,000
Advance Tax 2,00,000Total current assets8,60,000
b.Current Liabilit ies
Trade Payable 4,00,000
Provision for tax 2,00,000
Equity Dividend 70,000
Debenture Interest outstanding 50,000
Total Current Liabilities 7,20,000
NetWorking Capital (a-b) 1,40,000
Total Application of Fund 17,40,000
Illustration 2
Following is the Trial balance of M/s. Anand Ltd. As on 31.3.2015.
Particulars Amt. Amt.
Sales 20,00,000
Fixed Assets 10,00,000
Bills Receivable & Bills Payable 2,00,000 1,50,000
Cash and Bank Balance 50,000
Opening Stock 1,00,000munotes.in

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Bank Overdraft 1,00,000
Purchases 12,50,000
Administrative Expenses 30,000
Legal Expenses 20,000
Salaries 50,000
Advertisement 40,000
Warehouse Rent 20,000
Depreciation On Machinery 50,000
Interest on Bank Overdraft 10,000
Equity Shares Capital 6,00,000
General Reserve 1,00,000
Lap Top Repairs 20,000
Direct Expenses 20,000
Investment 40,000
Debtors And Creditors 1,00,000 50,000
Total 30,00,000 30,00,000
Additional Information:
1.Closing Stock on 31.3.2.15 was valued at Rs.50,000
2.Cash sales were 1/3 of credit sales.
You are required to prepare vertical Income statement for
the year ended 31.3.2015 and vertical Balance sheet as on that
date for financial analysis.
Solution
Income Statement for the year ended 31.3.2015
Particulars Amt. Amt.
Sales : Cash 5,00,000
Credit 15,00,000 20,00,000
Less: Cost of Goods Sold
Opening Stock 1,00,000
Add: Purchases 12,50,000
Add: Di rect expenses 20,000
Less: Closing Stock 50,000
Depreciation On Machinery 50,000 13,70,000munotes.in

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Gross Profit 6,30,000
Less:
a.Operating Expenses
Administrative Expenses 30,000
Legal Expenses 20,000
Salaries 50,000
Lap Top R epairs 20,000Total Operating Expenses1,20,000
b.Selling & Distribution Expenses
Advertising 40,000
Warehouse rent 20,000
Total Selling expenses 60,000
Total ( a+b) 1,80,000
Net profit Before Interest 4,50,000
Less: Interest on Bank overdraft 10,000
Net profit before Tax 4,40,000
Balance Sheet as on 31.3.2015
Particulars Amt. Amt.
Sources of Fund
1.Share Holders Fund
Share capital 6,00,000
Reserve and Surplus
General Reserve 1,00,000
Profit and loss A/c 4,40,000
Share Holders Fund 11,40,000
2.Loan Fund
Bank Overdraft 1,00,000
Total Sources of Fund 12,40,000
Application Of Fund
1.Fixed Assets
Tangible Assets 10,00,000
2.Investment 40,000
3.Working Capitalmunotes.in

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a.Current Assets
Inventories 50,000
Trade receivable 1,00,000
Debtors 2,00,000
Cash 50,000
Total Current Assets 4,00,000
b.Current Liabilities
Creditors 50,000
Bills Payable 1,50,000
Total Current Liabilities 2,00,000
NetWorking Capital (a-b) 2,00,000
Total Application of Fund 12,40,000
Illustration 3
M/s. A vinash Ltd. has provided you the following information
for the year ended 31.3 .2015.
Particulars Amt. Particulars Amt.
Sales 20,00,00
0Return Inward 50,000
Opening Stock ofR a w
Material1,10,000 Purchases of Raw Mat erial 5,00,000
Staff Salaries 1,50,00 0Commission allowed 5,000
Salesmen Salaries 25,000 Proposed Dividend 1,50,000
Bank Charges 10,000 Exhibition Expenses 35,000
Freight Inwards 40,000 Repairs of Computer 5,000
Office Rent and
Insurance45,000 Closing stock of WIP 40,000
Debenture Inte rest 50,000 Wages 70,000
Loss on sale of
Machinery10,000 Purchases of Finish Goods 80,000
Printing & Stationery 5,000 Interest Received on
Investment40,000
Direct expenses 50,000 Provision for Income Tax 2,00,000
Profit &Loss A/c (Credit) 2,40,000 Closing Stock of Raw
Material80,000
Depreciation on patterns 10,000 Sale of scrap 20,000
Depreciation on
Machinery20,000munotes.in

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You are required to rearrange the above information and
prepare vertical income statement, suitable for analysis.
Solution
Income Statement for the year ended 31.3.2015
Particulars Amt. Amt.
Sales 20,00,000
Less: Return Inwards 50,000 19,50,000
Less: Cost of Material
Opening Stock 1,10,000
Add: Purchases 5,00,000
Add: Freig ht Inwards 40,000
Less: Closing Stock 80,000
Cost of Material 5,70,000
Wages 70,000
Direct Expenses 50,000
Depreciation Machinery 20,000
Depreciation Pattern 10,000
Total Direct Expenses 7,20,000
Less: Closing stock of WIP 40,000
6,80,000
Less: Sale of Scrap 20,000
Cost of production 6,60,000
Add: Purchases of Finish Goods 80,000 7,40,000
Gross Margin 12,10,000
Less: Operating Expenses
a)Administrative Expenses
Staff Salaries 1,50,000
Office rent & Insurance 45,000
Printing and Stationery 5,000
Repairs and computers 5,000Total Administrative Exp2,05,000
b)Selling & Distribution Expenses
Salesman Salaries 25,000munotes.in

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Commission allowed 5,000
Exhibition expenses 5,000
Total Selling Exp. 65,000
c)Finance ExpensesBank charges10,000
Total Exp. (a+b+c) 2,80,000
Net profit before Interest 9,30,000
Less: Interest o nD e b e n t u r e 50,000
Net profit after Interest 8,80,000
Add: Non -operating Income
Interest on Investment 40,000
9,20,000
Less: Non -operating Expenses
Loss on sale of Machinery 10,000
Net profit before tax 9,10,000
Less: Provision for Tax 2,00,000
Net profit after tax 7,10,000
Add: P/L A/c balance 2,40,000
9,50,000
Less: Proposed Dividend 1,50,000
Net profit carried to Balance sheet 8,00,000
Illustration 4
The following balances appear in the books of M/s Ram Ltd.
as on 31.3.2015. You are required to prepare a balance sheet in
the vertical form.
Particulars Amt. Particulars Amt.
Sundry Debtors 2,00,000 Creditors 1,50,000
Trade Investment 2,50,000 Capital Reserve 1,50,000
Bank Overdraft 1,00,000 Short term
Investment50,000
Public deposit 3,00,000 Plant and
Machinery12,00,000
Bills Payable 7,90,000 Outstanding
Expenses1,20,000munotes.in

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General Reserve 1,00,000 Cash at Bank 7,00,000
Bills Payable 2,00,000 Profit and loss
A/c (Credit )4,00,000
Vehic les 9,00,000 Stocks 5,00,000
10% Pref. Sh. Capital 8,00,000 Land and
Building12,00,000
Commission on issue of
shares( not w/off)40,000 Preliminary
Expenses (not
w/off)10,000
Provision for tax 1,00,000 Equity shares
capital16,00,000
Bank Loan 3,00,000 Debentures 5,00,000
Advance tax 3,00,000 Proposed
Dividend3,00,000
Prepaid Expenses 1,00,000 Advance to
suppliers60,000
Solution
Balance Sheet as on 31.3.2015
Particulars Amt. Amt.
Sources of Fund
1.Share Holders Fund
a)Share Capital
Equity sh. Capital 16,00,000
10% Pref.sh Capital 8,00,000
Total (a) 24,00,000
b)Reserve And Surplus
GeneralReserve 1,00,000
P&LA / c 4,00,000
Capital Reserve 1,50,000
Total (b) 6,50,000
Total (a+b) 30,50,000
Less: Preliminary Expenses 10,000
Commission on shares 40,000 30,00,000
2.Loan Fund
Debentures 5,00,000
Public Deposit 3,00,000munotes.in

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Bank Loan 3,00,000 11,00,000
Total 41,00,000
Application of F unds
1.Fixed Assets
Tangible Assets
Land and Building 12,00,000
Plant and Machinery 12,00,000
Vehicles 9,00,000 33,00,000
2.Investments
Trade Investment 2,50,000
3.Working Capital
a)Current Assets
Stock 5,00,000
Sundry Debtors 2,00,000
Bills Receivable 2,00,000
Short Term Investment 50,000
Cash & bank 7,00,000
Adv. To suppliers 60,000
Adv. Tax 3,00,000
Prepaid Expenses 1,00,000
Total Current Assets 21,10,000
b)Current Liabilities
Creditors 1,50,000
Outstanding Expenses 1,20,000
Bank Overdraft 1,00,000
Bills Payable 7,90,000
Provision for Tax 1,00,000
Proposed Dividend 3,00,000
Total Current Labilities 15,60,000
Working Capital ( a-b) 5,50,000
Total 41,00,000munotes.in

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2.6EXERCISE
1.Discuss thenatureofFinancialStatement.
2.Definefinancial statementanalysis. Explain the need and
importance of it.
3.Define Assets. Explain various types of Assets.
4.Objective type Questions
A.Match Group A With Group B
Group A Group B
a) Source of Fund 1. Current Assets
b) Liquid Assets Fund 2. Net Worth + Loan Fund
c) Call in Arrears 3. Current Asset -Stock
d) Retained Earnings 4. Deduct from subscribed
capital
e) Over subscription 5. Profit & Loss A/c balance
f) Loose tool s 6. Subscribed capital is more
than issued capital
(Answer :a–2,b–3,c-4,d-5,e–6,f–1)
B.Fill in the Blanks with proper words / phase.
1.Trade Mark is an ______________ assets.
2.Advance tax is shown under _________________.
3.Current Liabili ties = _________________ -Current Assets.
4.Fictitious Assets are _________________ .
5.Securities Premium forms part of ______________.
6.Capital Employed = Fixed Assets +___________ capital.
(Answer : 1. Intangible , 2. Loans and Advances, 3. Working Capi tal,
4.Intangible, 5. Reserve & Surplus 6.Working. )
C.State whether following statement are True or False.
1.Balance sheet shows result of activities.
2.Goodwill will be shown under fictitious assets.
3.Arrears of preference dividend are contingent liabili ties.
4.All quick liabilities are current liabilities.
5.Operating expenses are incurred to conduct the operations
smoothly.
6.Public deposit is a secured loan.
(Answer: 1. False 2. False 3.True 4.True 5.True 6. False )
D.Multiple Choice Questions.
1.Patents and Copyrights is an
a)Intangible Assets
b)Movable assets
c)Intangible fixed assets
d)Fictitious Assetsmunotes.in

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2.Balance sheet is a
a)Statement of assets and liabilities
b)Statement of operating results
c)Statement of working capital
d)None of the above
3.Income Statement is a
a)Statement of working results
b)Statement of Sources of Fund
c)Statement of Cash Flow
d)Fund from Operation
4.Fixed assets are Rs.5, 00,000; Current Assets are Rs.3, 00,000;
Current Liabilities are Rs. 1, 00,000. There is no investment,
Find out capital employed .
a)8,00,000
b)7,00,000
c)9,00,000
d)6,00,000
5.Sales are Rs.5, 00,000; operating cost is Rs.2, 00,000; profit on
sale of machinery is Rs.10, 000, find out operating profit.
a)3,00,000
b)3,10,000
c)3,10,000
d)3,50,000
6.Short term investments are shown under which head in t he
vertical balance sheet.
a)Investment
b)Current Assets
c)Current Liabilities
d)Fictitious Assets
(Answer: 1. c, 2. a, 3. d, 4. b, 5.a, 6.b)
munotes.in

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3
TOOLS OF ANALYSIS OF FINANCIAL
STATEMENTS
Unit Structure:
3.1 Objectives
3.2 Introduct ion
3.3 Trend Ration and Trend Analysis
3.3.1 Meaning
3.3.2 Utility of Trend Analysis
3.3.3 Steps involved in calculation of trend percentage
3.3.4 Following is the example of Trend analysis
3.3.5 Comparative Balance Sheet
3.3.6 Illustration
3.4 Comparative Statement
3.4.1 Meaning and Definition
3.4.2 Importance of Comparative Statement
3.4.3 Preparation of Comparative Statements
3.4.4 Preparation of a Comparative Income Statement
3.5 Common size statement
3.5.1 Meaning
3.6 Exercise
3.1 OBJECTIVES
After studying the unit the students will be able to :
Explain the meaning of financial statement analysis .
Know the meaning and utility of Trend analysis .
Understand the meaning of Comparative and Common Size
Statements
Prepare the Comparative an dC o m m o nS i z eS t a t e m e n t sf r o m
the given information.
3.2 INTRODUCTION
Financial statements are prepared to meet external reporting
obligations and also for decision making purposes. They play a
dominant role in setting the framework of managerial decisi ons. 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
financial statements is of immense use in making decisions through
analysis and interpretation of financial statements. To overcomemunotes.in

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from the limitations it becomes necessary to analyse the financial
statements. The analytical tools generally available to an analyst 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 capital
6.Fund -flow and cos t-flow analysis
7.Ratio analysis
3.3 TREND RATION AND TREND ANALYSIS
3.3.1 Meaning
Trend analysis is an importa nt and useful technique of
analysis and interpretation of financial statement .Under th is
technique the ration of different items for various periods are
calculate for the company over a definite period of time say three to
five years and then we can analy sis trend highlighted by this ratio .
Trend analysis can be done in following way :
i)Trend percentage,
ii)Trend ratio,
iii)Graphic a nd diagrammatic representation.
3.3.2 Utility of Trend Analysis:
a)It is a simple technique. it does not involve tedious calculation
andnotrequire strained experts
b)It is brief method to indicate the future trend
c)It reduces the chances of errors as it provides the opportunity to
compare the percentage with absolute figures
d)It computes the percentage change for different variables o ver a
long period and then makes a comparative study of them.
e)The trend percentage helps the analytics to study the changes
that have occurred during the period. Such an analysis indicates
the progress of business by showing ups and downs in it
activity.
3.3.3 Steps involved in calculation of trend percentage
The calculation of trend percentage involves the following steps.
a)Selection of base year .
b)Assigning a weight of 100 to be value of the variable of the base
year and
c)Expressing the percentage change in value of variabl ef r o m
base year as shown below.munotes.in

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3.3.4 Following is the example of Trend analysis
Years SalesPercentage
(+) Increase or
(-) Decrease
1980
1981
1982
1983
1984
1985
198620,000
35,000
28,000
30,000
35,000
14,000
22,000100 (Base year )
175
140
150
175
70
110
A trend for single financial item is seldom very informative .A
comparison of trend for relative items often help to analysis in
perfect understanding of the business fact as is clear from the
below ment ioned comparative bal ance sheet.
3.3.5 Comparative Balance Sheet
Trend Percentage
(b a s ey e a r –1988 )Assets1986
Rs.1987
Rs.1988
Rs.
1986 1987 1988
20,000
30,000
20,00030,000
50,000
55,00025,000
60,000
30,000100
100
100150
167
175125
200
150
70,000 1,15,000 1,15,000 100 164 164
250,000
1,25,000
80,000300,000
150,000
1,00,0003,00,000
1,60,000
1,20,000100
100
100120
120
125120
128
150
4,55,000 5,50,000 5,80,000 100 121 127A) Current Assets
Inventory
Debtor
Cash balance
Total (A)
B) Fixed Assets
Building
Plant
Investment
Total (B)
Total Assets (A + B)
5,25,000 6,65,000 6,95,000 100 127 132
3.3.6 Illustration :
Calculate trend percentage from the following figures of X L
td, taking 1979 as the base and inter pret.
Year Sales Stock Profit before tax
1979 1,881 709 321
1980 2,340 781 435
1981 2,655 816 458
1982 3,021 944 527
1983 3,768 1,154 672munotes.in

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Solution :
Trend percentage
Years
beforeSales
(Rs. in
Lakhs)Stock
(Rs. in
Lakhs)Profit
before Tax
(Rs. in
Lakhs)Sales StockProfit
Tax
1979 1,881 709 321 100 100 100
1980 2,340 781 435 124 110 136
1981 2,655 816 458 141 115 143
1982 3,021 944 527 161 133 164
1983 3,768 1,154 672 200 162 209
Interpretation:
The study of the above given statement of Trend percentage
reveals that –
i)The sales of the f irmhave continuously increased over a period
of a five year commencing from 1979 .However there has
been a substantial increase in the amount of sales in the 1983
when it increased by 39%.
ii)The trend of Stock is also upward although the increase in this
item has been constant yet in 1983 the increased has been
exceptionally .
iii)The Profit of the firm has increased at much higher rat in
comparison to increase in Sale and Stock during the pe riod
under study.
The overall analysis of the financial items indicated that the firm is
doing well, and therefore, its financial position it bound to be good.
3.4 COMPARATIVE STATEMENT
3.4.1 Meaning and Definition :
The comparative statements are animportant tool of
horizontal financial analysis .Financial data become more
meaningful when compared with similar data for previous period or
an u m b e ro fp r e v i o u sp e r i o d s .Such analysis helps as in forming an
opinion regarding the progress of the enterprise.
Comparative statements are defined as:
Foulke has defined these statement as “statement of
financial position of business so desig ned 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 orcan be compared with similar data for the same
month lyor quarterly data oftheprevi ous years .munotes.in

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In such statement the figure can be shown at the following
value .
a.Absolute date (money values or rupee amount) .
b.Increase or decrease in absolute values
c.By the way of percentages
d.By the way of common —size stat ement
Two comparable units can be compared regarding
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
thepreparation of comparative financial statement, uniformity is
essential.
3.4.2 Importance of Comparative Statement:
Following points explain the importance of these statements:
1.Thes es t a t e m e n t sare very useful in me asuring the effect of the
conduct of a b usiness enterpri seo v e rt h ep e r i o du n d e r
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 .
2.The income statement measures the effects of op eration .But
the progress of these op eration smay be viewed over number of
periods by preparing the income statement in a comparative
form.
3.Similarly the effect of operation of financial position and the
progress of a business in term of financial position can be
presented by means of a comparative balance sheet .
4.The accounting a uthorit ies in U. S. A. have strongly
recom mended and enco uraged the prep aration of financial
statement in the comparative from Recognising the importance
of comparative financial date for two years .
5.The Indian companies Act 1956 has made this fact compulsory
that in the balance sheet of a company the figure for the
previous year sho uld also be given to facil itate comparison .
Though the balance sheet is a useful statement, the
comp arative balance sheet is even more useful for the contains
not only the data of a single balance sheet but also for the past
years which may be useful in studying the trends.
3.4.3 Preparation of Comparative Statements :
The form of comparative balance she et consists of two or
more columns according to the number of year we prepare the
balance sheet, for the date of original balance sheet and co lumns
for the increases or decreases in various items.
Proforma of comparative balance sheet for two yearsmunotes.in

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ABC Co.Ltd.
Specimen of Comparative Balance Sheet
As on 31stDecember 1980 and 1981
(Amount in Lakhs of rupees)
31st
Dec.
198031st
Dec.
1981Increase (+)
/Decrease ( -)
Amount% Rate
Assets :
Current Assets :
Cash 240 80 -160 -66 1.24
Debtors less reserve for
doubtful debts120 96 -24 -40 1.60
Merchandise Inventory 260 320 +6 6 +4 6 2.46
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 +100 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 2.58
Liabilities and Capital:
Current Liability :
Trend creditors 234 510 +2 7 6 +1 0 8 3.08
Accrued Expenses 400 360 -40 -20 1.08
Total Current liabilities 634 870 +2 3 6 +7 4 2.74
Equity Capital 400 500 +1 0 0 +5 0 2.50
Retained Earnings 466 566 +1 0 0 +4 2 2.42
Total Capital 866 1,066 +2 0 0 +4 6 2.46
Total Liabilities and
Capital1,500 1,936 +4 3 6 +5 8 2.58
3.4.4 Prep aration of a Comparative 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 the changes in absolute
date from one period to another may be explained and analysis .munotes.in

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The Comparative income statement contains th e some columns as
the comparative balance sheet and provides the same in the
figures.
Specimen of a Comparative Income Statement
ABC Co. Ltd.
Comparative Income Statement
Forthe year ended 31stDec. 1980 and 1981
(Amount in Lakhs of Rupees)
31st
Dec.
198031st
Dec.
1981Increase (+) /
Decrease (-)
Amount%
Net Sales 1370 1442 +7 2 +0.6
Less : Cost of Goods Sold 838 926 +8 8 +2 1
Gross Profit 532 516 -16 -6.4
Operating Expenses :
Selling Expenses 188 182 -6 -6.4
Gen. and Admn. Expenses 94 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 : Income Tax 124 124 Nil Nil
Net Profit after Tax 126 124 -2 -3.2
3.5COMMON SIZE STATEMENT
3.5.1 Meaning
Financial statements that depict financial data in the shape
of vertical statement percentage are known as common si ze
statements. Such statements provide readers with vertical analysis
of the profit and loss account and balance sheet .In such statement
all figure are converted to a common unit by expressing than as
percentage of a key figure in the statement .The tota l of financial
statement is reduced to 100 and each item is shown as component
to the whole .For example profit and loss account, the figure of
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likewise, assets and liabilities can be shown as percentage of total
assets and total equities respectively in common sized balance
sheet .Thus expressing each monetary item of financial statement
as a percentage of some total of which that item as apart
transforms a financial statement what is refer red as common size
statement such a statement show the relative significance of the
items contend in the financial statement and facilitate comparisons .
It point out efficiencies and in efficiencies that are otherwise difficult
to se eand of this reason i s a valuable management tool a common
size statement is especially useful when data f or more than one
year are used.
Vertical analysis is the procedure of preparing and
presenting common size statements .Common size statement is
one that shows the items a ppearing on it in percentage form as well
as in dollar form.
Common size statements are particularly useful when
comparing data from different companies.
Common size statements are also very helpful in pointing out
efficiencies and inefficiencies that mi ght otherwise go unnoticed
Illustration 1
The balance sheet of Shaheen Ltd are given for the year
2007 and 2008 convert them into common size balance size
balance sheet and interpret the changes .
Balance Sheet
Liabilities2007
Rs2008
Rs.Assets2007
Rs.2008
Rs.
Equity share 1,46,800 1,91,000 Buildings 1,80,000 2,00,000
Capital reserve 50,000 70,000 Plant and machinery 40,000 55,000
Furniture 10,000 20,000 Revenue reserve &
surplus20,000 30,000
Freehold property 20,000 12,000
Trade c reditors 30,000 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 4,91,000munotes.in

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Common size Balance Sheet
1987 1987 Assets
Amt. (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 57,00 0 11.60
Investment (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 and Machinery 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 (A+B) 4,46,800 100.00 4,91,000 100.00
Liabilities
C.Current Liabili ties
Trade Creditors 30,000 6.17 40,000 8.15
Bill Payable 80,000 17.91 60,000 12.22
Bank Overdraft 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 Reserve and
Surplus20,000 4.48 30,000 6.11
Total (D) 2,16,800 48.53 2,91,000 59.27
Total Liabilities (C+D) 4,46,800 100.00 4,91,000 100.00munotes.in

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Interpre tation :
1.Out of every rupee of sales 60.72 per cent in 1986 and 63.63
per cent in 198 7 account for cost of goods sold.
2.The percentage ratio of gross profit to sales was 39.28 per cent
in 1986 which was reduced 36.37 percent 1987.
3.The operating expenses increased from 15.71 per cent of sales
in 1986 to 16.37 per cent in 1987 All this reduced the
percentage ratio of net income after taxi to sales from 14.15 per
cent in 1986 to 12.00 per cent in 1987.
4.The operating expenses increased from 15.71 per cent of sales
in 1986 to 16.37 per cent in 1987 All this reduced to percentage
ratio of net income after tax to sa les from 14.15 per cent in 1987.
In the ultimate analysis it can be said that the operating
efficiency of the concern has not been satisfact oryd u r i n gt h ep e r i o d
under study.
Illustration 2:Following the Balance Sheet of X Co .Ltdand Y Co.
Ltd as on 31. 12.1990 .
Particulars X Co. Ltd Y Co. Ltd
Assets 27 72
Sundry Debtors 220 226
Stock 100 174
Prepaid Expenses 11 21
Other Current A ssets 10 21
Total Current Assets 368 514
Fixed Assets (Net) 635 513
Total 1,003 1,027
Liabilities
Sundry Creditors 42 154
Other 78 62
Total Current Liabilities 120 216
Fixed Liabilities 225 318
Total Liabilities 345 534
Capital 658 493
Total 1,003 1,027munotes.in

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Solution :
Common Size Balance Sheet (as on 31stDecember 1992)
X Co. Ltd Amount
(Rs. in Lakhs)
percentageY Co. Ltd Amount
(Rs. in Lakhs)
percentage
27
220
100
11
10
368
635
6352.69
21.93
9.97
1.10
1.00
36.69
63.61
63.3172
226
174
21
21
514
513
5137.01
22.01
16.94
2.04
2.04
50.04
49.96
49.96
1003 100.00 1027 100.00
42
78
120
225
658
8834.19
7.78
11.97
22.43
65.60
88.03154
62
216
318
493
81114.99
6.04
21.03
30.97
48.00
78.97Assets :
A) Current Assets
Cash
Sundry Debtor
Stock
Prepaid Expenses
Other
Total (A)
B) Fixed Assets
Total (B)
Total Assets (A+B)
Liabilities :
C) Current Liabilities
Sundry Debtor
Others
Total (C)
D) Long Term Liabilities
Fixed Liabilities
Capital
Total (D)
Total liabilities (C+D)
1003 100.00 1027 100.00
Comments:
1.The study of common size balance sheet show that 63.31 per
cent of total assets of X company Ltd were fixed whereas the
same percentage for Y Co was 49.96.
2.The current liabil ity of X Co L td were 11.97 per cent of total
liability and for Y Co L td this percentage was 21.03 both the
companies have used more equity capital .
Illustration 3: From the income statement give below you are
required to prepare common –sized income s tatement .munotes.in

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Particulars1986
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 Expenses 12,000 16,000
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 stat ement
(For the year ending 1986 and 1987)
1986 1987
Particulars
Amt. (Rs.) Percentage Amt. (Rs.) Percentage
Sales 1,40,000 100.00 1,65,000 100.00
Less : Cost of Sales 85,000 60.72 1,05,000 63.63
Gross Profit 55,000 39.28 60,000 36.37
Selling & Distribution
Expenses12,000 8.57 16,000 9.70
Administrative Exp. 12,000 7.14 11,000 6.67
Total operating Exp. 22,000 15.71 27,000 16.67
Net Income before Tax 33,000 23.57 33,000 20.00
Income Tax (40%) 13,000 9.42 13,200 8.00
Net Income after Tax 19,800 14.15 19,800 12.00
Interpretation:
1.The study of common size balance show that 61.56 per cent
total asset in 1986 were fixed This percentage increased 64.57
per cent 1987 if concern requires considerable investment in
fixed assets these percentag e might be acceptable if the
company needs be acceptable if the company need liquid assets
the interested parties might have cause to be concerned about
the decreasing trend liquidity.
2.There was a wide shift from the use of creditor provided fund to
the us e of owner equity fund in 1986 external equity (current
liability) and owner equity (long term liability) accounted frommunotes.in

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51.47 per cent and 48.73 per cent for external equities and
59.27 per cent for owner equity These changes indicate that the
concern has started to use internal sources more frequently than
external sources more frequently than external sources in the
gener ation of fund for this business.
3.The concern has not only succeeded in getting its current liability
down from 51.47 per cent in 1986 t o 40.73 per cent in 1987 of
their respective of the total equity In but it has also increased the
percentage of its revenue and surplus from 4.48 per cent in
1986 to 6.11per cent in 1987 of other respective total equities.
Illustration 4: You ha vegiven the 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
(Ason 31 December 1997 and 1998)
1997 1998 Assets
Amt. (Rs.) Percentage Amt. (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 45.35munotes.in

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Building 10,05,000 27.27 1,37,000 29.59
Total (B) 2,95,000 76.62 3,47,000 74.94
Total Assets (A+B) 3,85,000 100.00 4,63,000 100.00
Liabilities :
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 Liabilities (C+D) 3,85,000 100.00 4,63,000 100.00
Note : Calculation have been made to the nearest rupee.
(i)Calculation of percentage of Cash for 1997
Cash =23.38* –15.59*
=7.79
*Current Assets =Total Assets –Fixed Assets
=1 0 0 –76.62
=23.38
**Inventory + debtor =5.20 +10.39 = 15.59
(ii)Calculation of Percentage of overdraft for 1997
Total Current Liability –Creditor =31.17 –20.78 = 10.39
(iii)Calculat ion 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
=25.06
3.6EXERCISE
1.Define common size financial statement and explain their
usefulness duri ng financial statement a nalysis.
2.What are the steps involved in the financial statement analysis?
3.Discuss various techniques of f inancial statement.
4.Write short note on
a.Comparative financial statement
b.Trend analysis
c.Qualification of financial analysismunotes.in

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5.What do you understandi ng by comparative financial
statement ?W h a ti n f o r m a t i o ni sr e q u i r e dt op r e p a r ea
comparative balance shee t?
6.Explain the procedure of prep aring common size balance
sheet.
7.The following are the balance sheet of a concern as o n3 1st
December, 1987 and 1988.
8.Critically examine the various tools available to the financial
analysis. What are the limitations of such tool?
9.Objective Type Questions
A.Rewrite the following sentences by selecting correct choice.
a)An asset which is shown in the balance sheet but it has no real
balance.
(i) Fixed Asset
(ii) Current Asset
(iii)Wasting Asset
(iv)Intangible Asset
b)An expenditure from which no future ben efit is expected.
(i)Capital Expenditure
(ii)Revenue Expenditure
(iii)Deferred Re venue Expenditure
(iv)Misc. Expenditure
c)Which of the following is not a fi nancial statement?
(i) Balance Sheet
(ii) Profit & Loss account
(iii)Funds Flow Statement
(iv)Trial Balance
d)The comparative income statement shows the increase or
decrease over______
(i) Previous Year
(ii) Future Year
(iii)Current Year
(iv)Percentage
e)In common size balance sheet analysis , the total assets are
taken as
(i) 100 %
(ii) 50 %
(iii)10 %
(iv)0%
(Answers: a) -(iii), b)-(ii), c)-(iv), d)-(i), e)-(i) )
B.Fill in the blanks : -
a)In a common size income statement _____ is taken
as 100.
b)_______ form of balance sheet shows the as sets on
the right side and the liabilities on the left side.munotes.in

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c)_______ Reserves are not available for distribution of
dividend.
d)Receipts from customer for sale of goods are known as
______ receipts.
e)The excess of current assets over current liabilities is
known as ______.
(Answers: i) Total Assets, ii) Horizontal, iii) Capital,
iv)Revenue, v) Working Capital )
C.Match the following: -
Group A Group B
1.Bank overdraft
2.Owned Funds3.Intangible Asset
4.Loss on sale of fixed
assets
5.Depreciationa)Reserve and Surplus
b)Fixed Asset
c)Non-operating Expenditure
d)Current Liability
e)goodwill
(Answer: 1. d), 2. a) 3. e), 4. c), 5. b) )
D.State whether the following statements are true or false: -
(i)Issue of shares is an internal source of Finance.
(ii)A comparative balance sheet is prepared for the purpose
of intra -firm comparison
(iii)Common size statements are used for vertical analysis
only.
(iv)Analysis of profit & loss account means breaking down
the profit & loss account into its various components.
(v)Accounting principles are generally accepted guidelines
used by accountants for the purpose of preparing the
financial statements.
(Answers: (i) True, (ii) False ,(iii) False ,(iv) True ,(v) False )
10.Practical Problems:
1.Prepare a comparative balance sheet of the concern a nd study
its financial position.
Liability1987
Rs.1988
Rs.Assets1987
Rs.1988
Rs.
55,000
20,000
40,000
42,000
1,50,000
40,000
30,000
3,00,00083,000
16,000
50,000
50,000
1,00,000
70,000
48,000
4,00,00025,000
1,60,000
20,000
77,000
80,000
2,00,000
1,15,00018,000
2,00,000
30,000
1,09,000
2,00,000
1,70,000
90,000Sundry Credi tors
Bills Payable
Proposed Dividend
Proposed Dividend
6% Debenture
General Reserve
Profit and Loss A/c
Capital
6,77,000 8,17,000Cash
Sundry Debt ors
Bills Receivable
Stock in trend
Machinery
Building
Goodwill
6,77,000 8,17,000munotes.in

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2.From the following information pr epare a comparative st atement
and make brief comments.
Income Statement
(For the year ended 31stMarch 1987 and 1988)
Particulars1987
Rs.1988
Rs.
Sales
Less : Cost of Good Sold
Gross Profit
Less : Administrative Expenses
Selling and Distr ibution Expenses
Total Operating Expenses
Net Income before Tax
Less : Tax (40%)
Net Income after Tax2,80,000
1,92,000
88,000
15,000
18,000
33,000
55,000
22,000
33,0003,10,000
2,22,000
88,000
12,000
18,000
30,000
58,000
23,200
34,800
3.Convert th e following balance sheet into common size balance
sheet and make brief comments.
Balance Sheet (as on 31 March 1983 and 1984)
Liabilities1983
Rs.1984
Rs.Assets1983
Rs.1984
Rs.
Share Capital
6% Debenture
Sundry creditor
Provision for
doubtful de btor
Profit and loss A/c5,00,000
3,40,000
1,60,000
45,000
75,5006,50,000
2,00,000
67,000
3,000
1,65,000Machinery
Building
Investment
Goodwill
Bank balance
Inventory
Bill receivable2,80,000
3,50,000
2,65,000
70,000
40,000
60,000
40,0003,20,000
3,50,000
2,65,000
55,000
30,000
40,000
25,000
10,80,000 10,85,000 10,80,000 10,85,000
4.Following income statement of a business is given the for the
year ending 31stDecember, 1987 and 1988 prepare a common
size statement and make comments on t he business result.
Income Statement (for the ending on 31stDec. 1987 and 1988)
Particulars1987
Rs.1988
Rs.
Gross Sales
Sales Return and Allowance
Net Sales
Cost of Good Sold
Gross Profit from Sales
Operating Expenses :
Selling Expenses7,20,000
40,000
6,80,000
5,00,000
1,80,000
10,0008,40,000
50,000
7,90,000
5,80,000
2,10,000
12,000munotes.in

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Advertis ing Expenses
Sales Salary
Delivery Expenses
Depreciation Expenses
Total Selling Expenses
General and Administrative Expenses
Office Salaries
Insurance
Depreciation
Bad Debs
Total General and Administrative Expenses
Total Operating Expenses
Operat ing Income12,000
7,000
10,000
39,000
50,000
20,000
5,000
3,000
78,000
1,17,000
63,00016,000
5,000
16,000
49,000
75,000
35,000
16,000
12,000
1,38,000
1,87,000
23,000




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4
RATIO ANALYSIS AND
INTERPRETATION –I
Unit Structure:
4.0 Objectives
4.1 Introduction
4.2 Meaning and Objectives of Ratios
4.2.1 Meaning
4.2.2 Objectives
4.3 Modes of Expressing an Accounting Ratio
4.4 Classification of Ratios
4.4.1 Traditional Classification
4.4.2 Functional Classification of Ratios
4.4.3 Classification from the view point of user
4.5 Balance sheet Ratio
4.5.1 Current Ratio
4.5.2 Liquid Ratio
4.5.3 Proprietary Ratio
4.5.4 Stock -Working Capital Ratio
4.5.5 Capital Gea ring Ratio
4.5.6 Debt Equity Ratio
4.6 Revenue Statement Ratio
4.6.1 Gross Profit Ratio
4.6.2 Operating Ratio
4.6.3 Expenses Ratio
4.6.4 Net Profit Ratio
4.6.5 Net Operating Profit Ratio
4.6.6 Stock Turnover Ratio
4.7 Combines Ratio / Compos ite Ratios
4.7.1 Return on Capital Employed
4.7.2 Return on Proprietors Funds
4.7.3 Return on Equity Share Capital
4.7.4 Earning per Share
4.7.5 Dividend Payout Ratio
4.7.6 Debt Service Ratio
4.7.7 Creditors’ Turnover Ratio
4.7.8 Debtors’ Turnover R atio
4.8 Limitation of Ratio
4.9 Exercisemunotes.in

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4.0OBJECTIVES: -
After studying the unit the students will be able to
Understand meaning of Ratios .
Know the modes of expressing ratios .
Know the objectives of ratios analysis .
Classify the ratios.
4.1INTRODUC TION: -
During the half of the 19th century, the bankers have started
using accounting ratios for analyzing credit standing of prospective
buyer (debtors). But the ratios analysis of bankers was very much
restricted to the study of current ratios only.
In 1919, Alexander was has criticized such restrictions and
narrow analysis and pointed out the possible dangers of such
analysis. He expressed in his view that in order is get clear picture
of financial health of the business enterprise, one has to tak ei n t o
account various other relationships other than current ratios. Then
the ratio analysis is considered as strong and efficient tools of
analyzing the financial statement.
Ratio analysis is the method or process of expressing
relationship between it ems or group of items in the financial
statement are computed, determined and presented. It is an
attempt to draw quantitative measures or guides concerning the
financial health and profitability of an enterprise. It can be used in
trend and static analy sis.
It is the process of comparison of one figure or item or group
of items with another, which make a ratio, and the appraisal of the
ratios to make proper analysis of the strengths and weakness of the
operations of an enterprise.
4.2MEANING AND OBJ ECTIVES OFRATIOS: -
4.2.1 Meaning
A ratio is one figure expressed in terms of another figure. It
is mathematical yardstick of measuring relationship of two figures or
items or group of items, which are related, is each other and
mutually inter -dependent . It is simply the quotient of two numbers.
It can be expressed in fraction or in decimal point or in pure
number.
Accounting ratio is an expression relating to two figures or
two accounts or two set accounting heads or group of items stated
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4.2.2 Objectives
The accounting ratios are very useful in assessing the
performance of business enterprise i.e. financial position and
profitability. This is possible to achiever by comparison of ratios of
the year or with the previous year.
The ratios are worked out to analyse the following aspect or
areas of business organization.
1.Solvency: -
a.Long -term solvency
b.Short -term solvency
c.Immediate solvency
2.Stability
3.Profitability
4.Operational efficiency
5.Credit standing
6.Structural analysis.
7.Utiliz ation of resources and
8.Leverage or external financing.
The ratios are useful for the following parties.
1)Investors, both present as well as potential investors.
2)Financial analysist.
3)Stock broker and stock exchange authorities.
4)Government.
5)Tax Department.
6)Competitors
7)Research analysist and students.
8)Creditors and supplier.
9)Banks and financial institutions.
10)Company's management.
11)Finance managers
12)Mutual funds.
13)Other interested parties like credit rating agencies.
4.3 MODES OF EXPRESSING AN ACCOUNTING
RATIO
An accounting ratio may be expressed in different ways as under.
I)Simple or pure ratio :-It is merely a quotient arrived by simple
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Example :When current assets of the business enterprise are
Rs.1, 00,000 and curren t liabilities are Rs. 25,000. The ratio
between current assets and current liabilities will be expressed
as1, 0 0 , 0 0 00425,000OR it is expressed as 4:1.
II)Percentages :-It is expressed as percentage relationship when
simple or pure ratio is multiplied by 100.
Example :The current ratio in above example is expressed in
percentage b ym u l t i p l y i n g4b y1 0 0 .
i.e. 100 x 4 = 400%
III)Rate :-The ratio is expressed as rates which refer to the ratio
over a period of time.
Example :Stock has tu rned over 8 times a year.
IV)Number of days or week or month :-Certain items of the
financial statements are expressed better in the form of days or
weeks or months.
Example :Debtors' collection period, credit payment period,
movement of stock, etc ar e expressed in days or weeks or
months in a year.
Ifstock turnover ratio is 8 times, they movement of stock is
expressed as under :360845 days,5286.5 weeks or1281.5 months
V)Rupees :-In this case numerator is divided by denominator and
figure of result is expressed in rupees.
Example :Earnings per share, dividend per share etc are
expressed in rupees.
It net profit after tax is Rs. 12,500 and number of shares of a
company are 1250.
Earning per share =NPAT 12,500No. of shares 1 ,250 Rs.10 per share
Check your progress:
1.Define the following terms.
a)Percentages c)Rates
b)Simple / Pure Ratio d)Ratiomunotes.in

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2.Explain the objectives of Ratio analysis.
4.4 CLASSIFICATION OF RATIOS: -
The ratios are used for different purposes, for different users
and for different analysis.
The ratios can be classified as under:
a)Traditional classification
b)Functional classification
c)Classification from user’s poi nt of view
4.4.1Traditional classification :
As per this classification, the ratios readily suggest through
their names, their respective resources. From this point of view, the
ratios are classified as follows.
a)Balance Sheet Ratio :-This ratio is also known as financial
ratios. The ratios which express relationships between two
items or group of items mentioned in the balance sheet at the
end of the year.
Example: Current ratio, Liquid ratio, Stock toWorking Capital
ratio, Capital Gearing ratio, Proprietary ratio, etc .
b)Revenue Statement Ratio :-This ratio is also known as income
statement ratio which expresses the relationship between two
items or two groups of items which ar e found in the income
statement of the year.
Example: Gross Profit ratio,Operating ratio, Expenses Ratio,
Net Profit ratio, Stock Turnover ratio, Operating Profit ratio.
c)Combined Ratio :-These ratios shows the relationship
between two items or two groups of items, of which one is from
balance sheet and another from income statement (Trad ing A/c
and Profit & Loss A/c and Balance Sheet) .
Example : Return on Capital Employed ,Return on Proprietors'
Fund ratio, Return on Equity Capital ratio, Earning per Share
ratio,Debtors' Turnover ratio,Creditors Turnover ratio.
4.4.2Functional Classification ofRatios :
The accounting ratios can also be classified according their
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a)Liquidity Ratios : -These ratios show relationship between
current assets and current liabilities of the business enterprise.
Example : Current Ratio ,Liquid Ratio .
b)Leverage Ratios :-These ratios show relationship between
proprietor's fund and debts used in financing the assets of the
business organization.
Example : Capital gearing ratio, debt -equity ratio, and proprietary
ratio.
This ratio measures the relationship between proprietors fund and
borrowed funds.
c)Activity Ratio :-This ratio is also known as turnover ratio or
productivity ratio orefficiency and performance ratio. These
ratios show relationship between the sales and the assets.
These are designed to indicate the effectiveness of the firm in
using funds, degree of efficiency, and its standard of
performance of the organization.
Example : Stock Turnover Ratio ,Debtors' Turnover Ratio ,
Turnover Assets Ratio ,Stock working capital Ratio , working capital
Turnover Ratio ,Fixed Assets Turnover Ratio .
d)Profitability Ratio :-These ratios show relationship between
profits and sales and profit & investments. It reflects overall
efficiency of the organizations, its ability to earn reasonable
return on capital employed and effectiveness of investment
policies.
Example : i)Profits and Sales :O p e r a t i n g Ratio , Gross Profit Ratio ,
Operating Net Profit Ratio ,Expenses Ratio etc. ii) Profits and
Investments :R e t u r no n Investments ,Return onEquity Capital etc.
e)Coverage Ratios :-These ratios show relationship between
profit in hand and claims of outsiders to be paid out of profits.
Example: Dividend Payout Ratio ,Debt Service Ratio and Debt
Service Coverage Ratio .
4.4.3Classifica tion from the view point of user:
Ratios from the users’ point of view are classified as follows.
a)Shareholders' point of view: -These ratios serve the purposes
of shareholders. Shareholders, generally expect the reasonable
return on their capital. They are interested in the safety of
shareholders investments and interest on i t.
Example: Return on proprietor's funds, Return on capital,
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b)Long term creditors: -Normally leverage ratios provide useful
information to the long term creditors which include debenture
holders, vendors of fixed assets, etc. The creditors interested to
know the ability of repayment of principal sum and periodical
interest payments as and when they become due.
Example: Debt equity ratio, return on capit al employed,
proprietary ratio.
c)Short term creditors: -The short -term creditors of the
company are basically interested to know the ability of
repayment of short -term liabilities as and when they become
due. Therefore , the creditors has important pl ace on the
liquidity aspects of the company's assets.
Example: a) Liquidity Ratios -Current Ratio ,Liquid Ratio .
b) Debtors Turnover Ratio .
c) Stock working capital Ratio .
d)Management: -Management is interested to use borrowed
funds to improv e the earnings.
Example: Return on capital employed, Turnover Ratio ,
Operating Ratio ,Expenses Ratio .
4.5 BALANCE SHEET RATIOS
4.5.1Current Ratio :
This ratio is also known as Working Capital Ratio .T h i s
expresses the relationship between current ass ets and current
liabilities. This ratio is calculated by dividing current assets by
current liabilities. It is expressed as pure ratio .Standard current
ratio is 2:1. ItMeans current assets should be double the current
liabilities.Current AssetsCurrent Ratio =Current Liabilities
a)Current assets includes I) Inventories of raw materials, finished
goods, work -in-progress, stores & spare, loose tools, II) Sundry
debtors ,III) Short -term loan, deposits, advance, IV) Cash on
hand and bank ,V) Prepaid expenses, a ccrued income, VI) Bills
receivables ,VII) Marketable investments, short term securities.
b)Current liabilities includes sundry creditors, bills payables,
outstanding expenses, unclaimed dividends, interest accrued
but not due on secured and unsecured loans, advances
received, income received in advance, provision for tax,
purposed dividend loan installment of secured and unsecured
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c)Significance:
1)This ratio tests the credit strength and solvency of an
organization.
2)It shows strength of working capital,
3)It indicates ability to discharge short term liabilities.
4.5.2Liquid Ratio:
This ratio expresses the relationship between liquid assets
and liquid liabilities. This ratio is also known as Quick Ratio o r
Acid Test Ratio .T h i sr a t i o is calculated by dividing liquid assets by
liquid liabilities. Standard quick ratio is 1:1.Liquid Assets / Quick AssetsLiquid Ratio =Quick or Current Liabilities
a)Liquid assets = Current assets less (Stock, prepaid expenses
and advance tax etc)
b)Liquid liabilities =C u r r e n tl i a b i l i t i e s less (Bank overdraft and
cash credit etc)
c)Significance :-
1)Indicate immediate solvency of enterprise.
2)Unlike CR it is more qualitative concept
3)As it eliminates inventories, it is rigorous test of liquidity .
4)More important for financial in stitutions.
4.5.3Proprietary Ratio:
Proprietary ratio is a test of the financial and credit strength
of the business. It establishes relationship between proprietors to
total assets. This ratio determines the long term solvency of the
company.
Alternatively this ratio is also known as Worth Debt Ratio .
Net worth to Total Assets Ratio ,Equity Ratio ,Net Worth Ratio or
Assets Backing Ratio ,Proprietor's funds to Total Assets Ratio or
Share holders Funds toTotal Assets Ratio .
This ratio is expressed in percentage.
a)Formula :-
Proprietors' or Shareholders' FundProprietory Ratio= 100Total Assets
b)Components: -
1)Proprietors Funds =P a i du pe q u i t y + Reserves and surplus
less accumulated loss + paid up preference capital.
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c)Purpose: -This ratio is exercised to indicate the long term
solvency of the business.
d)Significance: -
This ratio shows general financial strength of the business.
1)It determines the extent of trade on equity.
2)It indicates long term solvency of bu siness.
3)It tests credit strength of business.
4)It can be used to compare proprietary ratio with others firms
orindustry.
4.5.4Stock -Working Capital Ratio:
This ratio establishes relationship between stock and
working capital. Alternatively it is k nown as "Inventory -working
capital ratio".
a)Formula : -
StockStock-Working Capital Ratio =Working Capital
b)Components :-
1)Stock ( closing stock)
2)Workin g capital i.e. current assets less current liabilities.
It can be expressed in percent age also by multiplying th is ratio by
100.
c)Purpose: -This ratio shows the extent to which the working
capital is blocked in inventories.
d)Significance: -
1)This ratio highlights the predominance of stocks in current
financial position of organization.
2)Ah i g h e rr a t i oi n d i cates week working capital.
3)This ratio is the indicator of the adequacy of working capital.
e)Standard Ratio: -Standard stock working capital ratio is 1:1 .
4.5.5Capital Gearing Ratio :
This ratio brings out the relationship between capital carrying
fixed rate of interest or fixed dividend and capital that doesn't carry
fixed rate of interest or fixed dividend. This ratio indicates degree to
which capital has been geared in the capital structure of the
company.
Alternatively this ratio is also kno wn as "Leverage ratio" or
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a)Formula : -
Capital bearing Fixed Interest or dividendCapital Gearing Ratio=
Capital not bearing Fixed Interest or dividendb)Components :-
1)Capital bearing fixed interest or dividend comprises of
debentures, secured and unsecured loans, and prefer ence
share capital.
2)Capital not bearing fixed interest or dividend is equity share
capital and reserve & surplus.
This ratio also can be expressed in %age by multiplying this
ratio by 100.
c)Purpose :-This ratio is used to understand the effective capital
structure of the company.
d)Significance :-
1)It is mechanism to ascertain the extent to which the company
is practicing trade or equity.
2)It brings one balanced capital structure.
4.5.6Debt Equity Ratio :
This ratio express the relationshi pb e t w e e ne x t e r n a le q u i t i e s
and external equities i.e. owners' capital and borrowed capital.
a)Formula : -
Debt equity ratio =Debt Long Term DebtsOREquity Shareholders FundOR
Long Term DebtsShareholders Funds + Long Term Debtsb)Components :-
1)Debts include all liabiliti es including short term & long term
i.e. mortgage loan and debentures.
2)Shareholders' funds consist of Preference s hare capital,
Equity share capital, Capital and Revenue Reserves ,
Surplus , etc.
c)Significance: -
1)It shares favorable or non favorable capital structure of the
company.
2)It shows long term capital structure.
3)Itreveals high margin of safety to creditors.
4)It makes us understand the dependence on long terms
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d)Standard: -Standard debt -equity ratio is 2:1. It means debts
should be double the shareholders funds.
4.6 REVENUE STATEMENT RATIOS: -
Revenue statement ratios are the ratios which highlights the
relation between two items from re venue statements i.e. Trading
Account andProfit andLoss Account .
4.6.1Gross profit ratio :
Gross profit ratios express the relationship between gross
profit and net sales. This ratio is also known as "Turnover ratio"
OR "Margin ratio" OR "Gross margin ratio" OR "Rate of gross
profit". This ratio is expressed in percentage of net sale s. This
ratio says about %age gross profit to net sales.
a)Formula :-
Gross ProfitGross Profit Ratio= × 100Salesb)Components of this ratio are :-
1)Net sales = Total sales less sales return
2)Gross profit = Sales -Cost of sales
3)Cost of sales = (ope ning stock + purchases + direct labour +
other direct charge) -closing stock
c)Significance: -
1)This ratio analy se the basic profitability of business.
2)It shows the degree to which the selling price per unit may
decline without resulting in loss from operati ons.
3)Yearly comparisons of gross profit ratio reveal the trend of
trading results.
4.6.2Operating Ratio :
This ratio studies the relationship between cost of activities
and net sales i.e. cost of goods sold and net sales. This ratio
shows the percen tage of cost of goods sold with net sales.
a)Formula :-
Operating CostOperating Ratio = × 100Net Sales
b)Components: -
Operating cost =Cost of goods sold +Other Operating Expenses
(administrative expenses, selling & distribution expenses etc. )-
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c)Purpose :-Purpose of operating ratio is to ascertain the
efficiency of the management regarding operation of business
concern.
d)Significance :-
1)It is used to test operational efficiency of business.
2)This ratio is the yardstick which measures the efficiency of all
operational activities of business i.e. production,
management, administration ,sales, etc.
e)Limitation of operating ratio :-
1)It cannot test profitability of business without consideri ng
extra -ordinary items.
2)The utility of operating ratio is limited owing to its
vulnerability to cha nges in management decisions.
4.6.3Expenses Ratio :
This ratio explains relationship of items or group of expense
to net sales. Such ratios are c ollectively known as expanses ratio.
This is calculated and expressed in percentage. This ratio
expresses the percentage of items of expenses with net sales.
a)Formula :-
Item or Group of ExpensesExpenses Ratio = 100Net sales 
b)Various expenses ratios are as follows :-
1)Administrative expensesAdministrative expenses ratio= 100Net sales
2)Selling & Dist. expensesSelling & Dist. expenses ratio = 100Net sales
3)Cost of material sonsumedCost of material consumed ratio= 100Net sales
4)Manufacturing expensesManufacturing expenses ratio = 100Sales
5)Non operating expensesNon-operating expenses ratio = 100Net sales
c)Purpose and significance: -
1)This ratio helps us to know the cause behind overall changes
in opera ting ratio
2)Purpose of this ratio is to take corrective action.
3)It indicates the efficiency of management in controlling
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4)This ratio enables the income tax department to judge the
correctness and reliability of income disclosed in income tax
returns.
5)Analytical study of this ratio can be judged by trend of
expenses.
6)Comparative study of year to year expenses can be
possible.
4.6.4NetProfit Ratio: -
Net profit ratio indicates the relationship between net profit
and net sales. Net profit can be either operating net profit or net
profit after tax or net profit before tax. Alternatively this ratio is also
known as "Margin on sales ratio". Normally this ratio is calculated
& expressed in percentage.
a)Formula :-
Net profit NPATNet profit ratio = 100 OR 100Net sales Net sales  
NPBT ONPOR 100 OR 100Net sales Net sales 
b)Significance :-
1)It measures overall profitability of business.
2)It is very useful in judging return on investments.
3)It provides useful inferences as to the efficiency and
profitability of business.
4)It indicates the portion of net sales is available for
proprietors.
5)It is clear index of cost control, managerial efficiency, sales
promotion, etc.
4.6.5NetOperating Profit Ratio:
Operating Profit Ratio indicates the relati onship between
operating profit and net sales. This ratio is expressed in
percentage.
a)Formula :-
Net operating profitNet operating profit ratio= 100Net sales
b)Components: -
1)NetOperating Profit = Gross Profit -All Operating Expenses
orSales -Cost Of Goods Sold andOperating Expenses .
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c)Significance :-
1)It signifies higher operating efficiency of management and
control over operating cost.
2)It indicates profitability of various operations of the
organization i.e. buy, manufacture ,sales, etc.
3)It shows ability oforganization to generate operating profit
out of its d ailyoperations.
4.6.6Stock Turnover Ratio :
Stock turnover ratio shows relationship between costs of
goods sold and average stock. This ratio is also known as
"Invento ryRatio "or"Inventory Turnover Ratio "or"Stock Turn
Ratio "o r" S t o c k Velocity Ratio "or"Velocity of Ratio ".
This ratio measures the number of times of stock turns or
flows or rotates in an accounting period compared to the sales
affected during that period. This ratio indicated the frequency of
inventory replacement. This ratio is expressed as rate.
a)Formula :-Cost of goods soldStock Turnover Ratio =Average stock
b)Components :-
1)Cost of goods sold =S a l e s –Gross Profit
2)Opening stock + closing stockAverage Stock=2*If openin g stock is not given, the closing stock is treated as
average stock.
c)Alternative method of stock turnover ratio :-This ratio can
be calculated by using average stock at selling price at as the
denominator .Under this method, average stock at selling price
is related to net sales.
Net salesStock Turnover Ratio=Average inventory at selling priced)Purpose: -Purpose of stock turnover ratio is to
1)Calculate the speed at which the stock is being turned over
into sales.
2)Calculate the stock velocity to indicate the period takes by
average stock to be sold out.
3)Judge how efficiently the stock are managed and utilised to
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4.7 COMBINES RATIO / COMPOSITE RATIOS :-
Combined or composite ratios relate two items or group of
items of which one is from balance sheet and ano ther from revenu e
statements of an enterprise.
4.7.1Return on Capital Employed (including Long Term
Borrowings):
This ratio explains the relationship between total profit
earned by business and total investment made or total assets
employed. It is expr essed in percentage. This ratio is also known
as "Return on Investment ",or"Return on Total Resources ".
a)Formula :-
Profit before tax InterestReturn on capital employed = 100Capital Employed 
b)Components :-
1)Net profit before tax, interest & dividends (PBIT)
2)Capital employed = Equity Share Capital+ Preference
Share Capital + Reserve & Surplus+ Long term borrowings
(Term loan + Debentures) -Fictitious assets like
misce llaneous expenses not written off -Profit & Loss A/c
DebitBalance (loss)
c)Purpose: -
1)Purpose of this ratio is to meas ure overall profitability from
the total funds made available by owners and leaders.
2)Purpose of this ratio is to judge how efficient the business
concern is in managing the funds at its disposal.
d)Significance: -
1)This ratio is effective tools to m easure overall managerial
efficiency of business.
2)Comparison of this ratio with other company and this
information can be obtained for determin ingfuture course of
action.
3)This ratio indicates the productivity of capital employed and
measures the ope rating efficiency of the business.
4.7.2Return on Proprietors Funds (Share Holders Fund and
Preference Capital):
This ratio measures the relationship between net profit after
tax & interest and proprietors fund. This ratio is alternatively known
as "Return on proprietors' equity" or"Return on shareholders'
investment" or"Investors' ratio". This ratio is expressed in
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a)Formula :-
Net profit after tax & Interest (NPATI)Return on Proprietor's Fund= 100Pr oprietors' Fund 
b)Components :-
1)Net profit after tax and interest
2)Proprietors' Funds
(Term Proprietors Fund is explained in para 4.5.3 -b)
c)Purpose: -
1)Purpose of this ratio is to measure the rate of return on the
total fund made available by the owners.
2)This ratio helps to judge how efficient the concern is in
manag ing owners' fun ds at its disposal .
d)Significance: -
1)This ratio isvery significant to prospective investors and
shareholders.
2)With the help of this ratio company can decide to rise finance
from external sources even from public deposit it ratio is
satisfactory.
3)Shareholders can expect to capitalize its reserves and issue
bonus shares when ratio is higher for reasonable period of
time.
4.7.3Return on Equity Share Capital :
This ratio explains relationship between net profit (after tax
and interest and divid end on preference share) and equity share
holders' funds. This ratio is expressed in percentage.
a)Formula :-
Net profit after tax less preference div idendReturn on Equity Capital = 100Equity share capital
Alternatively this ratio may be calculated by using following
formula for calculating the return per equity sh ares.
Net profit after tax less preference dividendReturn on Equity Shares =
Number of Equity share
b)Components :-
1)Net profit after tax & interest and preference dividend.
2)Equity share capital by adding reserves or deducting
miscellaneous expenditures.
c)Purpose :-
Purpose of this ratio is to calculate amo unt of profit available to
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d)Significance :-
1)It is useful to the investors while deciding whether to
purchase or sale of shares.
2)This ratio helps to make comparative study of equity capital
with other company and it will be appreciate if there is high
return.
4.7.4Earning Per Share :
Earning per share is calculated to find out overall profitability
of the organization. It represents earnings of the company whether
or not dividends are dec lared.
Earning per share is determined by dividing net profit by the
number of equity shares.
a)Formula :-Net profit after tax - preference dividendEarning per shares (EPS) =
Number of Equity share
b)Components :-
1)NetProfit after Tax & Interest -Preference Dividend.
2)Number of equity shares.
c)Purpose :-
Purpose of this ratio is to calculate the amount of profits
available on each equity share to take care of equity dividend,
transfer to reserves ,etc.
d)Significance :-
1)This ratio helps the investors or shareholders to take
decision while purchas ing or selling shares.
2)This ratio shows the possibilities of issue of bonus shares.
3)Higher ratio indicates overall profitability.
4.7.5Dividend Payout Ratio :
This ratio shows relationship between dividends paid to
equity shareholders out of profit available to the equity share
holders.
a)Formula: -
This ratio is calculated as follows.Dividend per equity sharesDividend payout ratio =Earning per shares
b)Components: -
1)Dividend per equity shares means total dividend paid to
equity shareholder dividend by number of equity shares.
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c)Purpose: -Purpose of this ratio is to measure the dividend
paying capacity of the company.
d)Significance: -
1)Higher ratio signifies that the company has utilized the larger
portion of its earning for pay ment of dividend toequity
shareholders.
2)It says lesser amount of earning has been retained.
4.7.6 Debt Service Ratio :
Debt service ratio shows relationship between net profit and
interest payable on loans. This ratio is also called as Interest
Covera ge Ratio. This ratio is expressed as a pure number.
a)Formula :-Net profit before interest & taxDebt service ratio =Interest charges
b)Components :-
1)Profit Before Interest & Tax means net profit before payment
of interest on loan and tax.
2)Interest means interest on long term loans.
c)Purpose :-
1)Purpose of this ratio is to measure the interest paying
capacity the company.
2)The purpose of this ratio is to find out the number of times
the fixed financial charges are covered by income before
interest and tax.
d)Significance :-
1)It is important from the lenders' point of view.
2)It indicated whether the company will earn sufficient profits to
pay periodical interest charges.
3)It shows that the company will be able is pay interest
regularly.
4.7.7 Creditors ’Turnover Ratio :
This ratio shows relationship between the net credit
purchases and the average creditors. This ratio is express as a
rate.
a)Formula :-
Net credit purchases Credit purchasesCreditors' Turnover Ratio= ORAverage creditors Creditors + Bills payable365 day or 12 months
Credit payment period OR (Creditors velocity) = ORCreditors turnover ratiomunotes.in

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74Creditors + Bills payable=Daily credit purchasesb)Components: -
1)Credit Purchases = Gross Credit Purchases -Purchases
Returns.
2)Average creditors mean average of opening and closing
amount of creditors. If details are not given then only closing
creditors may be considered as average creditors .
3)Amount of bills payable.
c)Purpose: -
1)Calculate the speed with which creditors are paid off onaan
average during the year.
2)Calculate the creditors' velocity to indicate the period taken
by the average creditors to be paid off.
3)Judge how efficiently the creditors are managed.
4.7.8 Debtors' Turnover Ratio:
This ratio shows relationship between credit sales and
average trade debtors. Alternatively this ratio is known as
"Accounts Receivable Turnover Ratio "o r" Turnover o f
Debtors' Ratio ". This ratio is expressed as ar a t e .
a)Formula :-
Credit sales Credit salesDebtors turnover ratio = ORAverage debtors Accounts receivableCredit salesORDebtors + Bills receivableDebtors + Bills ReceivableAverage collections period = ORDaily credit sales
365 days or 12 months 365 daysOR Average debtorsDebtors turnover ratio Credit sales
b)Components :-
1)Sundry debtors
2)Accounts receivables i.e. bills receivables .
3)Average daily sales.
c)Purpose :-Purpose of this ratio is to.
1)Calculate the speed with which debtors get settled on an
average during the year.
2)Calculate debtors' velocity to indicate the period of credit
allowed to average debtors.
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4.8 LIMITATIONS OF RATIOS: -
1.Ratios are mainly based on financial statements therefore
weaknesses of financial statements are carried forward in the
ratios.
2.Ratios calculate dbetween two unrelated items or groups w ould
be useless. e.g. ratio between cost of goods sold and
preliminary expenses.
3.Ratios are just indicators. Just calculation of ratios cannot
improve the financial position .Corrective and preventive steps
should be taken to improve financial position an dp r o f i t a b i l i t yo f
business.
4.Standard ratios changes from industry to industry. Maintenance
of ratios is not only the objective but improving the financial
stability and solvency and profit maximization should be the
objective.
5.Increase or decrease in the ratio may be due to change in the
economic factors of the country or due is inflation. Such
increase or decrease not due to efficiency or inefficiency of the
management of the business organization.
6.It is very difficult make correct inter -comparison of t he firm
because two firms are not similar in age, size and in system of
following accounting policies.
7.Financial statements are prepared at ending the year. It might
be subject to window dressing for covering bad financial position
and ratios are not reli able which are based on manipulated
financial statement.
4.9 EXERCISE
1.Explain the term Ration and explain its advantages and
limitations.
2.Give the formula and significance of the following ratios.
a)Debtor’s Turnover Ratio
b)Earnings per share Ratio
c)Return on Proprietors Ratio
d)Operating Ratio
e)Capital Gearing Ratio
3.Give the formula and components of the following ratios.
a)Stock Turnover Ratio
b)Net Profit Ratio
c)Debt Equity Ratio
d)Proprietary Ratio
e)Debt Service Ratiomunotes.in

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4.Objective type Questions
A.Re–write the following sentences by selecting correct choice.
i)An Accounting ratio is an expression relating to two
_____________
(a)Accounts (b) Figures (c) Balance (d) Assets.
ii)The Balance sheet ratios deal with the relationship between
two ____________.
(a)Asse ts (b) Liabilities (c) Items (d) Capital
iii)The relationship between capital entitled to fixed rate of
return and the capital not so entitled to fixed rate of return is
known as:
(a)Fixed Capital (b) Working Capital (c) Gearing Capital
(d) owned Capit al .
iv)Decrease in gross profit ratio may be due to
a)Decrease in cost of goods sold
b)Increase in selling price
c)Overvaluation of Stock (closing)
d)Decrease in cost of materials.
v)The relationship between net operating profit and net sales is
expressed in ______ ____________.
(a)Percentage (b) Figures (c) Ratios (d) Standard Deviation.
(Answer: i –b, ii –C, iii -C, iv –b, v –a)
B.Fill in the blanks
a)A ratio is one figure expressed in forms of
another_______________
b)Leverage ratio measures the relationship be tween
proprietor’s fund and _______________.
c)_________________ is the difference between current
assets and current liabilities.
d)Those current assets which can be realized immediately at
short notice are _________________ assets.
e)_________________ Ratio i s a test of the financial and
credit strength of the business.
(Answer: a) Figure (b) Borrowed Funds (c) Working Capital
(d) Quick (e) Proprietary )
C.Match the following:
Group A Group B
1.Gross profit Ratio a.Net Profit
2.Current Ratio b.Cost of goods sold
3.Operating ratio c.Trading results
4.Capital gearing d.Short term liquidity
5.Stock Turnover ratio e.Debenture capital
(Answer: 1 -c, 2 –d, 3 –a, 4 –e, 5 –b)munotes.in

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D.State Whether the following state ments are true or false:
a)The ratio should be expressed in percentage.
b)Over trading means increase in activities without adequate
funds.
c)It is difficult to establish a standard inventory ratio as
inventory levels differ from industry to industry.
d)The re turn on capital employed measures the overall
efficiency of the business operations.
e)High debtors’ turnover ratio indicates overall efficiency in
collecting receivables.
(Answer: (a) False (b) True (c) True (d) True (e) False )

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5
RATIO ANALYSIS AND
INTERPRETATION –II
Unit Structure :
5.0 Objectives
5.1 Illustrations
5.2 Exercise
5.0OBJECTIVES
After studying the unit the students will be able to
Calculate the ratios if the Balance Sheet and Profit Statements
are given.
5.1ILLUSTRATIONS
1.Following is the trading A/c and profit and loss A/c for the
year ended 31st December, 2009.
Particulars Rs. Particulars Rs.
40,000
4,00,000
1,00,000
1,40,000
3,80,0009,00,000
1,60,000ToOpening Stock
ToPurchases
ToWages
ToFactory Expenses
ToGross Profit c/d
10,60,000BySales
ByClosing Stock
10,60,000
1,20,000
80,000
10,000
16,000
1,64,0003,80,000
10,000ToAdministrative Expenses
ToSelling Expenses
ToInterest onLoan
ToDebenture Interest
ToNet Profit c/d
3,90,000ByGross Profit b/d
ByInterest Received
3,90,000
40,000
40,000
84,0001,64,000 ToTax Provision
ToProposed Dividend
ToBalance Profit
1,64,000By net profit b/d
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Balance sheet as on 31st December, 2009
Liabilities Rs. Assets Rs.
Equity share capital (Rs.10)
9% preference share capital
8% debentures
Reserves
Profit & Loss A/c
Short term loan (Repaid within
one year)
Bank overdraft
Sundry creditors
Bills payable
Provision for tax
proposed dividend4, 00,000
3,00,000
2,00,000
1,00,000
60,000
2,00,000
1,50,000
2,80,000
60,000
40,000
40,000Land and building
Machinery
Furniture
Goodwill
Patents
Vehicles
Investment
Stock
Debtors
Bills receivable3,50,000
3,00,000
2,00,000
1,00,000
1,00,000
2,80,000
1,00,000
1,60,000
1,80,000
60,000
18,30,000 18,30,000
Market price of equity share is Rs. 8 calculate the following ratios.
a)Current ratio
b)Acid test ratio
c)Capital gearing ratio
d)Stock turnover ratio
e)Debtors turnover ratio
f)Creditors turnover ratio
g)Return on capital employe dr a t i o
h)Stock working capital ratio
i)Operating ratio
j)Earnings per share
k)Price earnings ratio
l)Net profit ratio
m)Gross profit ratio
n)Debt equity ratio
o)Proprietary ratio
p)Operating profit ratio
q)Debtors' collection period.
Solution :
Current Assets 4,00,000a) Current Ratio = 0.519 : 1Current Liabilities 7,70,000 CA Stock 4,00,000 1 ,60,000b) Acid Test Ratio =CL Bank Overdraft 7,70,000 1 ,50,000  
2, 40, 0000.387 :16, 20,000 munotes.in

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80c) Capital Gearing RatioPref. Share Capital + Borrowed Funds=Equity Share Capital + Reserve Misc. Expenses
3,00,000 2,00,0004,00,000 1 ,00,000 60,000 NIL  
5,00,0000.8935, 60,000 Cost of Goods Soldd) Stock Turnover Ratio =Average Stock5, 20,0001, 0 0 , 0 0 05.20 times* Cost of Goods Sold =S a l e sClosing Stock
=9 ,0 0 , 0 0 03, 80,000
=5 ,2 0 , 0 0 0
* Average stockOpening Stock + Closing Stock=240,000 1 ,60,00022, 00, 00021, 0 0 , 0 0 0Credit Salese) Debtor Turnover Ratio =Debtors + B.R.9,00,0003.751, 8 0 , 0 0 0 6 0 , 0 0 0 f) Debtor Collection PeriodDebtors + B.R.=N o . o f w o r k i n gCredit Salesdays in a year
1,80,000 + 60,000=3 6 09, 00,000
2, 40, 00036090,000 =9 6d a y s
g)Creditors Turnover RatioCredit Purchases=Creditors + BP4,00,0002, 80, 000 60, 0004,00,0001.7163, 40,000
 munotes.in

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81h) Return on Capital Employed RatioProfit before Interest & Tax=1 0 0Capital Employed
(1 ,64,000 16,000)10010,60,000
1, 8 0 , 0 0 0100 16.98%10,60,000 
 Closing Stocki) Stock Working Capital Ratio =Working Capital1, 6 0 , 0 0 00.433,70,000 
(Cost of Goods Sold + Operating Expenses )j) Operating Ratio = 100Sales
(5,20,000 1 ,20,000 80,000 10,000)1009,00,000
7,30,000100 81.11%9,00,000   
 
k) Earnings per Share =N e t Profit after TaxandPreferenceDividend=No. of Equity Shares1, 6 4 , 0 0 0 4 0 , 0 0 0 2 7 , 0 0 040,000
97,000Rs.2.42540,000 
 Market price of Equity Sharesl) Price Earning Ratio =Earning per Shares
83.2982.425
Net Profit after Tax & Interestm) Net Profit Ratio = 100Sales
1,64,000 – 40,000=1 0 09,00,000
1, 2 4 , 0 0 0100 13.78%9,00,000 munotes.in

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Gross Profitn) Gross Profit Ratio = 100Sales3,80,000100 42.22%9,00,000 
Proprietors Fundo) Proprietory Ratio = 100Total Assets
8,60,000100 46.99%18,30,000 Borrowed Fundp) Debt Equity Ratio =Proprietor's Fund2, 00, 0008, 60,0000.232 :1Operating Profitq) Operating Profit Ratio = 100Sales
1, 7 0 , 0 0 01009,00,00018.89% Working Notes: -
W.N. 1Vertical income statement for the year ended 31st
December, 2009.
Particulars Rs. Rs. Rs.
1.NetSales
2. Less: Cost of Goods Sold
Opening Stock
Purchases
Wages
Factory Expenses
Less: Closing Stock
cost of Cost sold
3. Gross Profit
4. Less: Operating Expenses
a) Administrative Expenses
b) Selling Expenses
c) Financing Expenses
-Interest on Share Term Loan
5. Operating Profit
6. Add: Nom -operating Income
-Interest received
7. Net Profit interest & Tax
8. Less: Interest on Debenture40,000
4,00,000
1,00,000
1,40,000
1,20,000
80,000
10,00 06,80,000
1,60,000
2,10,0009,00,000
5,20,000
3,80,000
2,10,000
1,70,000
10,000
1,80,000
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9. Net Profit before Tax
10. Less: Income Tax
11. Net Profit after Tax
12. Less: Preference Dividend
(9% of 3, 00,000)
13. Net Profit available for Equity
shareholders.
14. Less: Equity Dividends
(40,000 -27,000)
15. Retained Earnings1,64,000
40,000
1,24,000
27,000
97,000
13,000
84,000
W.N.2 Vertical balance sheet as on 31st December, 2009.
Particulars Rs. Rs. Rs.
.Sources of Funds
I.Owner's / shareholder's funds
a) Equity Share Capital
b) Reserves & Surplus
Reserve
P & L A/c
c) Preference Share Capital
II. Borrowed / Loan Funds
8%Debentures
CAPITAL EMPLOYED (I + II)
B.Application of funds
I. Fixed Assets
Land & Building
Machinery
Furniture
Vehicles
Goodwill
Patents
II. Investments
III. Working Capital
a) Current Assets
Quick Assets
Debtors
Bills Receivables
Non-quick Assets
Closing Stock
b) Less: Current Liabilities
Quick Liabilities
Creditors
Bills Payable
Provision for Tax
Proposed Dividends
Short Term Loan
Non-quick Liabilities
Bank Overdraf t
Working Capital (CA-CL)
CAPITAL EMPLOYED (I+II+III)1,00,000
60,000
1,80,000
60,000
2,40,000
1,60,000
2,80,000
60,000
40,000
40,000
2,00,000
6,20,000
1,50,0004,00,000
1,60,000
3,00,000
3,50,000
3,00,000
2,00,000
2,80,000
1,00,000
1,00,000
4,00,000
(7,70,000)8,60,000
2,00,000
10,60,000
13,30,000
1,00,000
(3,70,000)
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2.M/s Raj & Sons presents you the following balance sheet as
on 31st December, 2008.
Liabilities Rs. Assets Rs.
Share capital
Equity share of Rs. 10 each
Reserve fund
7% debentures
Overdraft
Creditors10,00,000
1,00,000
3,00,000
2,00,000
3,00,000Fixed assets
Stock
Debtors
Cash10,00,000
4,00,000
3,00,000
2,00,000
19,00,000 19,00,000
Calculate -I) Liquidity ratios
II) Solvency ratios
III) Debt -equity ratio
Solution :
1) Liquidity ratios :-Current Assetsa) Current Ratio =Current Liabilities9,00,0001.8 :1 or 1.85,00,000 Liquid Assetsb) Acid Test Ratio =Liquid LiabilitiesCurrent Assets – StockCurrent Liabilities – Overdrafts
9,00,000 – 4,00,000 5,00,0001: 66 :15,00,000 – 2,00,000 3,00,000  
OR
If Liquid Liabilities = Current Liabilities, then Acid Test Ratio is as
under –5,00,0001:15,00,000
Stockc) Stock Working Capital Ratio =Working Capital4,00,0009,00,000 5,00,0004,00,0001:14,00,000
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2) Solvency ratios :-
Shareholders Funds(a) Proprietory Ratio =Total Tangible Assets or Total Assets11 ,00,0000.58 :1 or19,00,000  0.58100 = 58%
Note: I)Shareholders Fund= Eq. Share Capital + Reserve
=1 0 , 0 0 , 0 0 0+1 , 0 0 , 0 0 0
=1 1 , 0 0 , 0 0 0
II) Total Tangible Assets =T o t a l Assets = Rs.19,00,000Shareholders' Funds(b) Equity to Fixed Assets Ratio =Fixed Assets
11 ,00,0001.1:110,00,000
OR=1 . 1 1 0 0 = 1 1 . 1 % 
Shareholders' Funds(c) Equity to Current Assets Ratio =Current Assets
11 ,00,0001.1:110,00,000
OR=1 . 1 1 0 0 = 1 0 0 % 

3) Debt Equity RatioOutsiders' Funds=Shareholder's Fund8,00,0000.73 : 111 ,00,000 
Outsider's Fu nd = Debentures + Creditors + Overdraft
=3 , 0 0 , 0 0 0+3 , 0 0 , 0 0 0+2 , 0 0 , 0 0 0
= Rs. 8,00,000
OR
It outsiders fund = Debentures onlyOutsiders' FundsThen Debt Equity Ratio =Shareholder's Fund3,00,0000.373 :18,00,000 munotes.in

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3.From the following financial st atements of M/s Sunny Ltd.
calculate.
1)Current Ratio
2)Liquid Ratio
3)Gross Profit Ratio
4)NetProfit Ratio
5)NetProfit toCapital Employed Ratio
6)Fixed Assets Turnover Ratio
7)Sales to Capital Ratio
8)Debtors Turnover Ratio
Balance sheet as o n3 1 s tM a r c h ,2 0 0 9 .
Liabilities Rs. Assets Rs.
Share capital
Reserve
Profit & Loss A/c
Debentures
Current Liabilities1, 50,000
60,000
24,000
60,000
1, 52,000Fixed Assets (Net)
Current Assets
Stock
Debtors
Cash80,000
1, 88,000
1, 64,000
14,000
4,46,000 4, 46,000
Income statement for the year ending 31st March, 2009
Particulars Rs. Rs.
Sales : Cash
Credit
Less: cost of sales
Gross profit
Less: Expenses
Warehouse & Transport
Administration
Selling & Distribution
Debenture Interest
Net profit before tax
Less: Income tax
Net profit after tax64,000
6,84,000
48,000
38,000
28,000
4,0007,48,000
5,96,000
1,52,000
1,18,000
34,000
4,000
30,000
Solution :Current Assets1) Current Ratio =Current Liabilities1, 8 8 , 0 0 0 1, 6 4 , 0 0 0 1 4 , 0 0 01, 5 2, 0 0 0
3, 66,0002.4078 :11, 5 2, 0 0 0
2:4 1:1 
 
munotes.in

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87Liquid Assets2) Liquid Ratio =Liquid LiabilitiesCurrent Assets - Stock
Liquid Liabilities = Current Liabilities1, 8 8 , 0 0 0 1, 6 4 , 0 0 0 1 4 , 0 0 0 – 1, 8 8 , 0 0 01, 5 2, 0 0 0
3,66,000 1 ,88,000 1 ,78,0001.171:11, 5 2, 0 0 0 1, 5 2, 0 0 01.17 :1
 
  Gross Profit3) Gross Profit Ratio = 100Sales
1, 5 2, 0 0 0100 20.3208%7, 48,00020.32% Net Profit after Tax4) Net Profit Ratio = 100Sales
30,000100 4.010%7, 48,000
4.01%
OR
Net Profit beforeTax100Sales
34,000100 4.545%7, 48,000
4.55% 

 
 

Net Profit after Tax5) Net Profit to Capital Employed = 100Capital Employed
30,0001002, 94, 00010.20% OR
If Net Profit before Tax is considered then Net Profit to Capital
employed will be as under.
Net Profit before Tax=1 0 0Capital Employedmunotes.in

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34,0001002, 94, 00011.56% Capital Employed =F i x e d Assets + Investment + Working Capital
=8 0 , 0 0 0+0 0 0 0+( 3 , 6 6 , 0 0 0 -1,52,000)
=8 0 , 0 0 0+2 , 1 4 , 0 0 0
=2 , 9 4 , 0 0 0Cost of Goods Sold6) Fixed Assets Turnover Ratio =Fixed assets
5,96,000
80,0007.45 TimesSales7) Sales to Capital Employed =Capital Employed7, 48,000
2,94,0002.54 TimesNet Credit Sales8) Debtors Turnover Ratio =Debtors
6,84,000
1, 6 4 , 0 0 04.17 Times4.From the following financial statement of X co. Ltd. for the
year ended 31st December, 2009, calculated the follo wing
ratios.
I)Current Ratio
II)Liquid Ratio
III) Operating Ratio
IV) Stock -Turnover Ratio
V) Turnover to Fixed Assets Ratio
VI) Return on Total Resources
VII) Return on Proprietors Fund
VIII) NetProfit toCapital Employed
IX) Debtors Velocity
X) Cred itors' Turnover Ratio .munotes.in

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Balance sheet as on 31st March, 2009.
Liabilities Rs. Assets Rs.
Equity Share capital
General Reserve
Profit & Loss A/c
Sundry Creditors5,00,000
3,00,000
2,00,000
2,00,000Land & Buildings
Plant & Machinery
Stock
Sundry debtors
Cash & Bank3,50,000
2,50,000
3,00,000
2,00,000
1,00,000
12,00,000 12,00,000
Trading and profit & Loss A/c for the ended 31st December
2009.
Particulars Rs. Particulars Rs.
ToOpening Stock
ToPurchases (Credit)
ToGross Profit1,00,000
8,00,000
9,00,000BySales
ByClosing Stock16,00,000
2,00,000
18,00,000 18,00,000
ToOffice &Administrative ExpensesTo Selling &DistributionExpenses
ToOther Expenses
ToNet Profit2,00,000
1,00,000
25,000
6,00,000ByGross Profit
ByProfit onSale
ofAssets9,00,000
25,000
9,25,000 9,25,000
Solution :Current Assets 3,00,000 2,00,000 1 ,00,000I) Current ratio=Current Liabilities 2,00,000
6,00,0003:12, 00, 000 
 Liquid Assets 2,00,000 1 ,00,000II) Liquid Ratio =Liquid Liabilities 2,00,000
3,00,0001.5 : 12, 00, 000
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90Cost of Goods Sold + Operating ExpensesIII) Operating Ratio =Sales
7,00,000 3,25,000 10,25,0000.64 :116,00,000 16,00,000
OR  
0.64 100 = 64% 
COGS 7,00,000IV) Stock Turnover Ratio=(1 ,00,000 2,00,000)Averages Stock
2
7,00,0004.67 Times1, 5 0 , 0 0 0
 
TurnoverV) Turnover to Fixed Assets Ratio =Fixed Assets
16,00,0002.67 :16,00,000
 Net profit after Tax & InterestVI) Return on Proprietors Fund =Proprietor's Fund
6,00,0000.60 :110,00,000
 
OR
=0 . 6 0 1 0 0 = 6 0 %
 Net Profit after Tax & InterestVII) Net Profit to Capital Employed =Capital Employed
6,00,0000.60 :110,00,000 
OR
=0 . 6 0 1 0 0=6 0 % 
DebtorsVIII) Debtors Velocity Ratio = 365Credit Sales
2,00,00036516,00,000
46Days
 
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CreditorsIX) Creditors Velocity = 365Credit Purchases
2,00,0003658,00,000
91 Days
  

5.2EXERCISE
1.From the following financial statement of Sanket Ltd. calculate
the following ratios.
a)Current Ratios
b)Liquid Ratios
c)Stock Turnover Ratio
d)Debtors Turnover Ratio
e)Opera tingRatio
f)Capital Gearing Ratio
g)NetProfit Ratio
h)Stock Working Capital Ratio
i)Earnings per Equity Share
j)Interest Coverage Ratio
k)Creditors Turnover Ratio
l)Dividend Payout Ratio
m)Gross Profit Ratio
Trading and profit & Loss Account fo rt h ey e a re n d e d3 1 s t
December, 2009.
Particulars Rs. Particulars Rs.
ToOpening Stock
ToPurchases
ToGross Profit c/d1,50,000
12,90,000
2,10,000BySales
ByClosing Stock15,00,000
1,50,000
16,50,000 16,50,000
To Administrative Expenses
To Rent &T a x e s
To Interest
To Selling Expenses
To Depreciation
To Income Tax Provision
To Net Profit20,000
14,000
22,500
11,000
50,000
60,000
60,000By Gross Profit b/d
ByProfit on Sale of Fixed
Assets2,10,000
27,500
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Balance she et as at 31st December 2009
Liabilities Rs. Assets Rs.
Equity Share Capital of
Rs. 10 each
10% Preference Share
Capital
General Reserve
12% Debentures
Creditors
Outstanding Expenses
Income Tax Provision2,50,000
50,000
2,00,000
3,50,000
30,000
55,000
65,000Fixed Assets
Bank Balance
Short term Investment
Debtors
Stock6,50,000
25,000
75,000
1,00,000
1,50,000
10,00,000 10,00,000
The company declared dividend on Equity Shares @ 20%.
2.The condensed balance sheet of Dixit Ltd. as on 31st March
2006 is as follows:
Liabilities Rs. Assets Rs.
Equity Share Capital
Reserve
6% Debentures
Current Liabilities
Bank Overdraft6,00,000
2,00,000
5,00,000
2,00,000
1,00,000Fixed Assets
Stock
Marketable Investment
Debtors
Cash and Bank balance
Preliminary Ex penses9,00,000
3,00,000
1,00,000
1,50,000
1,00,000
50,000
16,00,000 16,00,000
Netprofit for the years was Rs.75, 000/-.
Prepare a statement suitable for analysis and indicate the
soundness of the financial positions of the company by calculating
thefollowing ratios and comment on the same.
a)Current Ratio
b)Liquid Ratio
c)Proprietary Ratio
d)Return on Capital Employed
e)Return on Proprietors Equity
f)Return on Equity Capital
g)Stock Working Capital Ratio
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3.The following is the Balance Sheet of Swapnaja Ltd. as on 31st
December 2009.
Liabilities Rs. Assets Rs.
Paid up Capital (Rs.10)
Reserves & Profit
Debentures
Creditors
Bills Payable2, 00,000
1, 38,000
2, 00,000
32,000
12,000Fixed Assets
Stock
Debtors
BillsReceivable
Bank Balance3, 00,000
1, 00,000
1, 22,000
8,000
52,000
5, 82,000 5, 82,000
Sales Rs. 4,00,000 /-;Gross Profit Rs.1,20,000 /-;Net Profit
Rs.80,000 /-.Rearrange the above Balance Sheet in suitable form
for analysis and workout the following ratios.
a)NetProfit Ratio
b)Gross Profit Ratio
c)Current Ratio
d)Liquid Ratio
e)Return on Capital Employed
f)Debtors Turnover Ratio
g)Earnings per Share
h)Stock Turnover Ratio .
Answer :-
1.
a)Current Ratio = 1.72:1
b)Liquid Ratio = 0.97:1
c)Stock Turnover Ratio -8.6 Times
d)Debtors Turnover Ratio -15
e)Operating Ratio -89%
f)Capital Gearing Ratio -1.012:1
g)NetProfit Ratio -4%
h)Stock Turnover Ratio -1.034
i)Earnings per Share -Rs.2.2 per share
j)Interest Coverage Ratio -Rs.6.33
k)Creditors Turnover Ratio -43
l)Dividend Payout Ratio -0.909
m)Gross Profit Ratio -14%]
2.
a)Current Ratio -1.83:1
b)Liquid Ratio -1.25:1
c)Proprietary Ratio -46.88%
d)Return on Capital Employed -6%
e)Return on Proprietors Equity -10%
f)Return on Equity Capital -12.5%
g)Stock Working Cap ital Ratio -1.2:1munotes.in

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3.
a)NetProfit Ratio -20%
b)Gross Profit Ratio -33%
c)Current Ratio -6.41:1
d)Liquid Ratio -4.14:1
e)Return on Capital Employed -14.87%
f)Debtors Turnover Ratio -3.077
g)Earnings per Share -Rs.04 per share
h)Stock Turnover Ratio -2.8
Note: -Closing Stock = Average Stock
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6
WORKING CAPITAL MANAGEMENT -I
Unit Structure:
6.0 Objectives
6.1 Introduction
6.2 Meaning and Definition of Working Capital
6.2.1 Meaning
6.2.1 Definition
6.3 Types of working capital
6.4 Factors Determining Working Capital Requirement
6.5 Sourc es of working capital
6.6 Projection o f Working Capital Requirements
6.6.1 Methods of projecting working capital requirements
6.6.2 Projection of working capital requirements
6.7 Exercise
6.0OBJECTIVES :
After studying the unit the students will be able to:
Define Working Capital.
Explain types of working capital.
Elaborate the determinants of working capital.
Know the sources of working capital.
Understand the concept projection of working capital
6.1INTRODUCTION
Capital required for a business can be divided into two
categories i.e. Fixed Capital and Working Capital . Fixed capital is
the part of total capital which is used for purchasing permanent a
fixed asset like land, Buildings, Plant and machinery, furniture and
fixtures, vehicles, etc. T his capital is invested by organization in the
beginning of running the business. Inaddition to fixed capital an
organization requires additional capital for financing day to day
activities like purchase of Raw materials ,payment of direct and
indirect e xpenses, carrying out production, investment in stocks
and stores, receivables and assets to be maintained in the form of
cash is generally known as working capital (fluctu ating capital). In
other words, this capital refers to the investment in current as sets
such as cash inventory, receivables, etc. All such assets are likely
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6.2MEANING AND DEFINITION OF WORKING
CAPITAL
6.2.1 Meaning
The capital used for performing day to day activities i.e.
purchases of Raw material ,making payment of direct and indirect
expenses, carrying out of production of goods and services,
investment in stocks, stores, etc is called as working capital. All
assets consisting of working capital revolve around cash. Firstly ,
cash i s used to purchase of raw materials, which when certain
expenses are in carried on it gets itself converted into semi finished
goods and finally into inventory of finished products. Inventory
(finished goods), after adding certain profit margin to it, is sold to
the customers, which may take the form of cash orreceivables or
debtors. Receivables or debtors when realized again take the form
of cash and the cycle goes on. The revolving nature of current
assets consisting of working capital has been cleare dw i t ht h eh e l p
of following chart:
Because of this revolving nature of the assets consisting
working capital, later is also known as 'fluctuating' or'floating' or '
circulating' capital.
6.2.2 Definition
J.M. Mill: -"The sum of the current assets is the working capital
of the business"
Shubin: -"Working capital is the amount of funds necessary to
cover co st of operating the enterprise."
Hoaglandi: -"Working capital is descriptive of that capital which is
not fixed. But the more common use of the working capital is to
consider it as the difference between the block value of the current
assets and current liabilities."
Gerestenberg: -“Circulating capital wears current assets of a
company that are cha nged in the ordinary c ourse of business from
one to another, as for example, from cash to inventories,
inventories to receivables, and receivables to cash."ReceivablesSalesCashFinished goodsRaw materialsWork in progressmunotes.in

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The accounting principles of board of American institute of
Certified Public Accountants has defined the working capital as:
“Working capital is represented by the excess of current assets or
current liabilities and identifies the relatively liquid portion of the
total enterprise capital which constitutes a margin or buffer for
maturing obligations within the ordinary oper ating cycle of the
business."
Thus working capital means investment made by a business
organization in short -term current assets like cash, debtors, etc.
6.3TYPES OF WORKING CAPITAL
The working capital is classified as under:
1.Gross Working Capital :Gross working capital means the total
current assets without deducting current liabilities. This equal to
the cash balance and the amount blocked in debtors and
stocks, etc.
2.NetWorking Capital :Net working capital means total current
assets minus total current liabilities. It means net current assets.
This capital indicates the amount available to meet short term
liabilities or debt of the business organizations.
3.Permanent o rFixed Working Capital :This capital represents
the value of the current assets required on continuing basis over
the entire year and for several years. Permanent working capital
is the minimum amount of current assets which is needed to
conduct business even during the dullest season of the year.
Thus, the minimum level of current a ssets is called permanent
or fixed working capital is the part of capital permanently
blocked in current assets. This amount changes from year to
year depending on growth of the company and the stage of the
business cycle in which it operates. It is used to produce goods
necessary to satisfy the customer's demand.
It has the following characteristics :
a)It is classified on the basis of time.
b)It constantly changes from on e asset to another and
continuously remains in the business.
c)Size of this capital inc reases with the growth of business
operations.
4.Temporary or Variable Working Capital :This component
represents a certain amount of fluctuations in current assets
during a short period. These fluctuations are increases or
decreases in current assets. Gen erally these are in cyclical
nature. This is called as additional capital required at different
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seasonal needs of a firm or organization is called seasonal or
variable working capital. Additio nal funds or capital specifically
used to meet extraordinary needs or contingencies arising due
to strikes, fire, unexpected competition, rising price tendencies
launching of advertisement campaigns.
It has the following f eatures :
a)It is not always ga infully employ ed, though it may change from
one asset to another, as permanent working capital does.
b)It is particularly suited to busines s of a seasonal or cyclical
nature.
c)It is arranged from temporary sourc e i.e. short term loan,
deposits, bank over draf ts etc.
5.Balance Sheet Working Capital :Usually this capital is
determined on the basis of current assets and current liabilities
shown in closing ba lance sheet of the concern. It means the net
current assets as on last date of the balance sheet.
6.Cash Working Capital: This capital is the net current assets if
realized at its book value. The cash realized from current assets
is really less than the book value because i) Debtors includes
profit margin ii) Depreciation included in over valuation of stock
of finished goods. The concept of this capital makes proper
adjustment in balance sheet working capital for the item sto
arrival at cash working capital. The cash working capital
indicate sthe working capital at cost because stocks and debtors
are at cost.
7.Positive Working Capital: When a net curren t asset is in
positive figure, it is called aspositive working capital. It means
the current assets are more than the current liabilities. This
working capital shows favorable liquidity solvency position of the
company.
8.Negative Working Capital: In this case, difference between
current assets and current liabilities is negative figure.
Therefore, it is called are negative working capital. It means
current liabilities are more than the current assets. This capita l
indicates lack of liquidity and adverse solvency position of the
company.
6.4 FACTORS DETERMIN ING WORKING CAPITAL
REQUIREMENT
Normally following factors determines the need of working
capital:
1.Nature of business: -Working capital requirements of an
enterprise are basically related to conduct of the business.
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Railways, etc need very limited working capital because they
offer cash sales only and supply services, not products, and as
such no fu nds are tied up in inventories and receivables. But at
the same time, trading firm need large amount of working capital
in current assets like inventories, cash, receivables etc but they
have less investment in fixed assets.
2.Terms of purchases and sales: -Credit terms granted by the
concerns to its customers as well as credit terms granted by its
supplier also affect the working capital. I fcredit terms of
purchases are more favorable and those sales less liberal, less
cash will be invested in the invent ory. Working capital
requirement can be reduced i fterms of credit are more .The
ratio of credit and cost purchases or sales affects the level of
working capital. If firm purchases on credit and sales oncash
then itrequires less working capital and if f irm purchases on
cash and sales on credit, then it requires large working capital.
This means funds are tied up in debtors and bills receivables.
3.Manufacturing cycle: -The quantum of work capital needed is
influenced by the length of manufacturing cycle .The
manufacturing process always involves time lag between the
time when raw materials are fed into the production line and
finished products are finally turned out by it. The length of
period of manufacture in turn needs on the nature of product as
well as production technology used by a concern.
4.Size of business unit: -Amount of working capital requirement
depends on the scale of operation of the business organization.
Large business organization performs large business activities
which require huge working capital than small scale
organization.
5.Turnover of inventories: -A business organization having low
turnover of inventory would need more working capital where as
high turnover of inventory need small or limited working capital.
6.Turnover of cir culating capital: -The speed with which
circulating capital completes its cycle if conversion of cash into
inventory of raw material, raw material into finished goods,
finished goods into debts an d debts into cash, which decides
need of working capital in the organization .Slow movement of
working capital cycle necessitates large provision of working
capital.
7.Seasonal variations production :-In case of seasonal
production in the industries like sugar ,oil mills, etc need more
working capital during peak seasons .
8.Degree of mechanization :-In highly mechanized concerns
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working capital. Conversely, in labour intensive industries
greater sum of working shall be required to pay wages and
related faci lities.
9.Growth and expansion :-Every firm wants to grow over a
period of time and with the increase in its size, the working
capital requirements are bound to increase. The growing
company would need therefore, larger amount of working
capital.
10.Policy r egarding dividend: -Dividend policy of a firm will also
influence the working capital position. The company which
declares large amount of dividends in the form of cash requires
large working capital to pay off such dividends. But sometimes,
companies’ issues bonus shares by way of dividend in such
cases working capital requirements will be comparatively less.
This is depending on Psyc hology of shareholders i.e. whether
they prefer cash income or capital appreciation.
11.Inflation: -A business concern r equires more working capital
during the inflation period. This factor may be compensated to
some extent by rise in selling price of inventory.
12.Changes in technology :-Changes in production technology
have an impact on the need of more working capital.
13.Depreciation policy :-Charges of depreciation on assets do
not involve any cash outflows. Depreciation affects tax liability
and retention profits. It is allowable expenditure while calculating
net profits. Higher depreciation will mean lower disposal of profit
and therefore dividend will be paid in smaller amount .Thus
cash will be preserved.
6.5 SOURCES OF WORKING CAPITAL :
Sources of working capital
Long term source Short -term source
1) Issue of shares
2) Issue of Debentures
3) Plugging ba ck of profit Internal source External source
4) Loans from banks
5) Public deposits 1) Depreciation 1) Trade credit
2)Taxation provision 2) Credit paper
3)Accrued expenses 3) Bank credit
4) Customer's credit
5) Govt. Assistance
6) Loan from directors
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6.6 PROJECTION OF WORKING CAPITAL
REQUIREMENTS
6.6.1 Methods of projecting working capital requirements
1.Conventional method: In this method cash flow i.e. inflow and
out flow are matched with each other. Greater emphasis is laid
down on liquidity of a business organization.
2.Operating cycle method: This method refers to working capital
in a realistic way. The working capital is decided on the basis of
length of th e operating cycle. It is calculated by dividing
operating expenditures by the number of operating cycle.
6.6.2 Projection of working capital requirements
The businessman mainly faces the problem of determination
of working capital requirements for financ ing particular level of
activity. The finance manager has to perform the activities of
forecasting working capital requirements. This process involves the
following aspects.
1.Level of activity: -Estimation of working capital begins with the
level of a ctivity. Therefore the finance manager has to ascertain
the required quantum of production in advance on the basis of
past experience, installed and utilized capacity of the factory
and demand.
2.Raw materials: -The finance manager has to estimate the
quantity and cost of raw materials. Lengths of time of raw
materials remain in the sto re before issue for production is
considered longer period of stay of raw material need greater
working capital. This must be valued at cost.
3.Labour and overheads: -Expe nses incurred on wages and
overheads are considered while ascertaining raw materials.
4.Work -in-progress: -While ascertaining work -in-progress the
‘period of processing' or'period of production cycle' has to be
considered. Longer the production cycle, gr eater the working
capital requirement. Therefore ,the finance manager has to
consider the amount required for raw materials, wages and
overheads while estimating volume of production.
5.Finished Goods: -The period of storing finished goods before
sale has to be taken into consideration. This is depending on
season, sales forecasting, etc. If the sales are seasonable and
production is throughout the year, then working capital
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6.Sundry Debtors: -While calculating amount of sundry debtors,
period credit allowed to customers is to be taken into
consideration. This period is known as "time lag in payment by
debtors". I fthis period is longer, required working capital will be
higher in the absence of s imilar time lag in payment to creditors.
The sundry debtors are value at sales price while calculating
working capital.
7.Cash and bank balance: -As per past experience every
businessman is suppose to know the amount cash float or bank
balance necessary t o pay day is day payments. This amount is
given in the information and added in the amount of working
capital required.
8.Prepaid Expenses: -There may be some expenses i.e.
insurance, sales promotion would be paid in advance and in this
case working capit al requirement would be higher is that extent.
9.Sundry Creditors: -The period of credit allowed by supplier
has to be taken in to consideration while estimating required
amount of working capital. It longer the period credit from
suppliers ,lower will be the working capital requirements.
10.Creditors for expenses: -Time lag in payment of wages and
overheads also should be considered while deciding amount of
working capital requirements. If there is no time lag in payment
of wages and overheads, more worki ng capital will be required
and there will beless requirement of working capital when there
is time -lag in payment of wages and overheads.
11.Advance from customers: -If and when advance required
from customers then there will be lower working capital
requ irements.
12.Contingencies: -After calculating the amount of working
capital as discussed above, a provision for contingencies may
be made to make allowances for likely variations. This is the
sort of cushion against uncertainties involved in estimating
working capital .
6.7EXERCISE
1.Define Working Capital. Explain the types of Working Capital.
2.Which are the Determinants of Working Capital?
3.Write short note on Projection of Working Capital Requirements.
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A.Rewrite the following sent ences by selecting correct
choice -
1)The period required for the whole operation starting with cash
and ending up with Cash plus –
i)Operating cycle ii) Trading Cycle
iii) Working Cycle iv) Main Cycle
2)Cross working Capital is equal to –
i) Total Current Assets ii) Total fixed assets
iii) Total Assets iv) Net Assets
3)The cost to be excluded from the cost of goods sold for the
purpose of determining working in process and finished goods is
–
i) Interest ii) Depreciation
iii) Taxation iv)D i v i d e n d
4)The primary objective of Working Capital Management is to
manage –
i) Current Assets ii) Current Liabilities
iii) Current Assets and Current Liabilities iv) Fixed Assets
5)It Is a normal principles that current assets should be valued at
cost or market value whichever is
i) Higher ii) Lower iii) More iv) earlier
(Answer: . 1) -i, 2) -iii, 3) -ii, 4) -iii, 5) –ii)
B.Fill in the blanks
1)Advances received from customer will --------------- the work ing
capital requirements.
2)Provision for contingencies may be made to make allowances
for likely variations or for ------- expenses.
3)In valuation of world in progress labor & overhead are assumed
to be incurred to the extent of --------------
4)It would be m ore practical if investment in debtors is a cetined at
cost of sales, not as -------- price.
5)The Capital required to meet seasonal requirements is called as
-------- working capital.
Answer: 1)–Reduce 2)–unforeseen 3)–50% 4)–selling 5)-circulat ing
C.Match the following
Group A Group B
1) Gross working capital a.Receivables
2) Negative working capital b.Excess of current Assets
3) Debtors c.Total current Assets
4)Bank Balance d.Excess of current liabilities
5) Net working capital e. Quick Assets
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D.State whether the following statements are true or false
a)Closing stock of raw material is a liquid asset.
b) Profit included in debtors is an expense hence; it is a part of
current asset.
c)Finished goods stock should be valued at FIFO basis.
d)Working capital management aims to strike a judicious balance
between current assets & current lib eralities.
e) Prepaid expenses increase the amount of working capital.
(Answer: a–False, b –False, c –False, d –True, e -True)
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7
WORKING CAPITAL MANAGEMENT -II
Unit Structure:
7.0 Objectives
7.1 Introduction
7.2 Calculation ofF i g u r e sR e q u i r e d for Working Capital
Projection
7.2.1 Calculations
7.2.2 Proforma of Working Capital Statement
7.3 Solves Problems
7.4 Exercise
7.0OBJECTIVES
After studying the unit the students will be able to:
Calculate the figures required for Working Capital Projection.
Draw the statement of Working Capital.
Solve the practical problems on Working Capital requirement.
7.1INTRODUCTION
In the previous unit we have studied the concept Working
Capital in detail. That unit have already explained the types of
working capital, elaborate the determinants and sources of working
capital. That unit also explained the concept projection of working
capital. In this unit we are going to study how to estimate the
requirement of working capital and related calculations.
7.2CALCULATION OF FIGURES REQUIRED FOR
WORKING CAPITAL PROJECTION
7.2.1 Calculations
1.Stock of raw materials: -The cost of raw materials ascertained
as under.
Raw material
Budgeted production xcost of material xholding period
(units) p.a per unit (365days or 52
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2.Work -in-progress: -The value of work -in-progress is decided
as follows:
Budgeted production x per unit cost x Process period
p.a(units) material 100% + (365 days or 52
Labour 50% + weeks or 12 months )
overhead 50%
3.Stock of finished goods: -The investment in finished stock by
a firm is decided as follows:
Budget production Cost of goods Finished goods
p.a(units) x Produced p.u. x holdi ng period
(365 days or 52 weeks
or 12 months )
4.Investment in debtors: -Debtors are calculated at sales prices
as well as at cost price as follows:
At sales price
Budgeted credit sales x Selling Price x Debtors collections period
p.aunits per unit (365 days or 12 months
or 52 weeks )
At Cost Price
Budgeted credit sales Cost of sale Debtors collections period
p.aunits x per unit x 365 days or 12 months
5.Cost and bank balance: -Required amount of cash & bank
can be determined on the basis of cash budget. This budgeted
cash and bank balance should bee n o u g ht om e e td a yt od a y
expenses. This is r eadily given in the problem and included in
the list of current assets.
6.Advance payme nt:-The payment of expenses for the period
which is not expired. It is calculated as follows.
Expenses
(365days or 52 weeks x Period of prepayment
or 12 months)
7.Sundry Creditors: -The amount of creditors depends on the
credit purchases and the period of credit allowed by supplier is
calculated as follows:
Budgeted production Cost per unit Period of credit allowed
p.aunits x of raw material x 365 days or 52 weeks or
a.12 monthsmunotes.in

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8.Creditors for wages & overheads: -It is not necessary topay
wages and expenses immediately which will ease working
capital requirements. This amount is calculated as follows:
Budgeted production x Wages or expenses x Lag in payment
p.a. unit per unit 365 days or 52
Weeks or 12 months
9.Advance from customer: -The amount received from
customer in advance along with purchases result into less
working capital requirement. This amount is given in the
problem.
7.2.2 Proforma of Working Capital Statement :
XYZ Co. Ltd.
Statement of Working Capital Requirement for the period ____
Particulars Working Rs. Rs.
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxxxxx
xxx
xxx
xxx
xxx
xxx
xxx
xxxA.Current Asset
1.Stock of Raw Material
2.Stock of WIP
a) Raw Material Labour
b) Labour
c) Overheads
3.Stock of Finished Goods
a)Raw Material
b)Labour
c)Overheads
4.Debtors atS.P.
OR
Debtors at Cost
a)Raw Materials
b)Labour
c)Overhead
5.Prepaid Expenses
6.Advance to Supplier
7.Cash & Bank
Total Current Assets(Units x Rate x Period of
holding )
(Unitsx Rate x Processingperiod)(Units x Rate x Processingperiod x 1/2)(Units x Rate x ProcessingPeriod x 1/2)
(Units x Rate x Period of
holding)
(Units x Rate x Period of
holding)
Units x Rate x Period of
holding)
(Units X S.P. x Period of
Credit)
(Unit x Rate x Period of
credit)
(Unit x Rate x Period of
credit)
(Unit x Rate x Period of
credit)
Units x Rate x Period of
Payment
xxxxmunotes.in

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B.Less: Current Liabilities
1.Creditors for Materials
2.Lag in payment Wages
a) Wages
b) Overheads
3.Advance from Customers
Total Current Liabilities(Units x Rate X period of
credit)
(Units x Rate x Lag in
Payment)
(Units x Rate x Lag in
Payment)xxx
xxx
xxx
xxx
xxxx
xxxx C.Net Current Assets
Add: -Margin of Safety
D.Working Capital(A-B) xxx
xxxx
7.3 SOLVED PROBLEMS
Illustration 1.
Sanket Ltd. had an annual sale of 50,000 units, at Rs.100
per unit. The company works for 50 weeks in the year .
The cost details of the company are as follows:
Elements of cost Cost per unit Rs.
Raw Materials 30
Labour 10
Overheads 20
60
Profit per unit 40
Sales price per unit 100
The company has to practice of storing raw materials for 4
week's requirements .Wages and other expenses are paid after a
lag of 2 weeks. Further the debtors enjoy a credit of 10 weeks and
company gets a credi t of 4 weeks from the suppliers. The
processing time is 2 weeks and finished goods inventory is
maintained for 4 weeks. From the above information prepare a
working capital estimates, allowing for a 15% contingency.
Solution: -
Working notes:
a)Sales per w eek50,0001,00050units per week.
b)Debtors are valued at selling price and finished goods at
sales loss profits .munotes.in

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c)It has been assumed that the labour and overheads accrue on
an average, so half the labour and overheads would be included
in work in progress.
Statement Showing Estimation of Working Capital.
Particulars Working (unit x Rate x Period) Rs. Rs.
A. Current Assets
I. Stock
Raw Materials
Work -in-progress
Raw materials
Labour
Overheads
Finished goods
II. Debtors(1000 x8 0R s .x4w e e k )
(1000 x 30 Rs. x 2 week)
(1000 x 10 x 2 weeks x 1/2)
(1000 x 20 x 2 weeks x 1/2)
(1000 x 60 x 4 weeks)
(1000 x Rs. 100 x 10 week)60,000
10,000
20,0001,20,000
90,000
2,40,000
10,00,000
Total Current Assets 14,50,000
B.Less:-Current Liabilities
I) Creditors
II) Outstanding wages
III) Outstanding Overheads(1000 x 30 Rs. x 4 weeks)
(1000 x Rs.10 x 2 week)
(1000 x 20 x 2 weeks)1, 20,000
20,000
40,000
1, 80,000
Working Capital (A -B)
Add. 15% Con. Reserve
Net working capital1, 27,000
1, 90,500
14, 60,500
Illustration 2 .
A factory produces 48,000 units during the year and sells
them for Rs. 50 per unit. The cost structure of a product is as
follows.
Raw Materials 60%
Labour 15%
Overheads 10%
85%
Profit 15%
Selling price 100%
The following additional information is available.
a)The activities of purchasing producing and selling occur evenly
through and the year.
b)Raw materials equivalent to 1 months supply is stored in
godown.
c)The production process takes are month.
d)Finished goods equal to three month's production are carried in
stock.
e)Debtors get two month's credit.munotes.in

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f)Time lag in payment of wages and overheads in 1/2 months.
g)Cash and bank balance is to be maintained at 10% of the
working capital.
h)10% of sales are made at 10% above the normal selling price.
Draw the statement showing working capital requirement of
the factory.
Solution :
Statement showing working capital requirement.
Particulars Working (units x Rate x period) Rs. Rs.
A. Current Assets
I. Stock
Raw Materials
Work -in-progress
-Raw Materials
-Labour
-Overheads
Finished Goods at cost
II. Debtors at selling price
Normal
Higher S.P.
B. Current Liabilities
I. Sundry Creditors
II. O/S wages
III.O/S Overheads
C. Working capital (A -B)
Add :10% for cash &
Bank balance
i.e. 10% of cost
Required working capital(48,000 x112xR s . 3 0x1 m )
(48,000 x112xR s . 3 0x1 m )
(48,000 x112xR s . 7 .5x12m)
(48,000 x112xR s . 5x12m)
(48,000 x112xR s . 4 2 . 5x 3m)
(48,000 x112x9 0 %xR s . 5 0x 2m)
(48,000 x112x1 0 %xR s . 5 5x2 m )
Total
(48,000 x112xR s . 3 0x1 . 5 m )
(48,000 x112xR s . 7 . 5 0x12m)
(48,000 x112xR s . 5x12m)
(90%)
(10%)
(100%)1,20,000
15,000
10,000
3,60,000
44,000
1,80,000
15,000
10,0001,20,000
1,45,000
5,10,000
4,04,000
11,79,000
2,05,000
9,74,000
1,08,222
10,82,222
Working notes .
1) Cost Structure %age Cost per unit
Raw material 60 30.00
Labour/Wages 15 7.50
Overheads 10 5.00
85 42.50
Add. Profits 15 7.50
Selling price 50.00munotes.in

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2) Sundry debtors
Normal selling price Rs.50.00
10% above normal selling price Rs.55.00
515 50 5 5510   3) Cash & Bank balance974000 1090Rs. 1, 08,222
=10,8, 222.2224) M=Months
Illustration 3.
The Board of Directors of Century Rayon Ltd. requests you
to prepare a stateme nt showing requirements of working capital for
a forecast level of activity of 52,000 units in the ensuring year (52
weeks) from the following information made available.
Cost per unit
Rs.
Raw Material 40.00
Labour 15.00
Overheads Manuf acturing 20.00
Overheads Selling & Distribution 10.00
85.00
Additional Information:
a)Selling price -Rs. 100/ -per unit.
b)Raw material in stock -average 4 weeks.
c)Work -in-progress -average 4 weeks.
d)Finished goods in stock -average 4 weeks.
e)Credit allowed to debtors -average 8 weeks.
f)Credit allowed by supplier -average 4 weeks.
g)Cash at bank is expected to be Rs. 50,000.
h)All sales are a credit basis.
i)All the activities are evenly spread out during the year.
j)Debtors are to be valued at sales .munotes.in

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Solution:
Statement of working capital requirement.
Particulars Working (units x Rate x period) Rs. Rs.
A.Current Assets
I. Stock
Raw Materials
Work -in-progress
Raw Materials
Labour
Overheads
Finished Goods at cost
II. Debtors a t selling price
III. Bank Balance
B.Less Current Liabilities
Sundry Creditors
C. Working Capital (A -B)(52,000 x152xR s . 4 0x4w e e k s )
(52,00052 x Rs.40 x 4 weeks)
(52,00052 x Rs.15 x 4 weeks x12)
(52,00052 x Rs.20 x 4 weeks x12)
(52,00052 x Rs.75 x 4 weeks)
(52,00052 x Rs.100 x 8 weeks)
(52,00052 x Rs.40 x 4 weeks )1,60,00030,000
40,0001,60,000
2,30,000
3,00,000
8,00,000
50,000
15,40,000
1,60,000
13,80,000
Working Notes:
1) Particulars Cost per unit
Rs.
Raw materials 40.00
Labour 15.00
Manufacturing overheads 20.00
Cost of goods produced 75.00
Add: Selling & Distribution Expenses 10.00
Cost of goods sold 85.00
Add: Profit 15.00
Sales price 100.00
2) W= weeks
Illustration 4.
From the following data, prepare a statement showing
working capital requirement for the year 2009:
a)Estimated activity for the year 1, 95,000 units (52 weeks).
b)Stock of raw material 2 weeks and material in progress 2
weeks, 50% of wages and overheads ar ei n c u r r e d .
c)Finished goods 3 weeks storage.
d)Creditors 2 weeks.
e)Debtors 4 weeks.
f)Outstanding wages and overheads 2 weeks each.
g)Selling price per unit Rs. 30.munotes.in

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h)Cost analysis per unit is as follows.
I.Raw materials 1/3 of sales.
II.Labour and overheads in the rati oo f3 : 2p e ru n i t .
III.Profit per unit is Rs. 10
i)Cash balance Rs.50,000
Assume that operations are evenly spread throughout the year.
Solution :
Working notes
1) Cost struct ure
Rs. Cost per unit Rs.
for195000 unit
Raw Materials 19,50,000 10.00
Labour 11,70,000 6.00
Overheads 7,80,000 4.00
Total Cost Profit 39,00 ,000 20.00
Profit 19,50,000 10.00
Sales price 58,50,000 30.00
2) After deducting profit we get total cost per unit Rs.20.
3) Total cost Rs.20 includes Rs.10 cost of raw materials.
4) Balance Rs. 10p e ru n i tw i l lb ed i v i d e di nt h er a t i oo f3 : 2i . e .
Rs.6 labour and Rs.4 overheads.
5) W=w e e k
Statement of working capital requirements for the year 2009.
Particulars Working (units x Rate
xp e r i o d )Rs. Rs.
75,000
11, 2,500
1, 50,000
4, 50,000
50,000
8, 37,500A.Current Assets
I. Raw Materials
II.Work -in-progress
Raw Materials
Labour
Overheads
III. Finished Goods
IV. Debtors
V. Cash
Total
B. Less Current Liabilities
I.Creditors
II. Outstanding wages
III. Outstanding o verheads
Total
C. Working Capital (A -B)(19,5,00052 x 10 x 2 w)
(19,5,00052 x 10 x 2w )
(19,5,00052x6x2 w x
50%)
(19,5,00052 x 4 x 2wx
50%)
(19,5,00052 x 20 x 2 w)
(19,5,00052 x 30 x 4 w)
Given
(19,5,00052 x 10x2w)
(19,5,00052 x 6x2w)
(19,5,00052x4x2w)75,000
22,500
15,000
75,000
45,000
30,000
1, 50,000
6, 87,500munotes.in

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Illustration 5.
Sangeet Swapna Ltd. Furnisher in the following information and
request y ou to prepare a statement showing the requirement of
working capital for the year ended 31st March 2009.
Budgeted for 2009
Production capacity for the year 10,000 units
Production 90%
Cost structure
Crude material Rs. 30 per unit
Other dire ct material Rs. 20 per unit
Wages Rs. 25 per unit
Overheads Fixed Rs. 9000 p.m.
and Rs. 15 variable
per unit
Profit 25% on sales
Other information: -
a)Crude oil material remains in the stock for 2 months.
b)Other direct materia l remains stock for 1 month.
c)Finished goods remain in stock for 2 month. (to be valued at
direct cost)
d)Production process takes place 1 month work -in-progress
valuation to be made crude material plus direct material at cost;
plus 50% of wages and variable overheads.
e)Time lag in payment of wages 1 month and variable overhead
half month.
f)Fixed overhead payable quarterly in advance.
g)Crude material purchased from suppliers against advance
payment of two months and other direct material suppliers allow
credit of 1m o n t h .
h)Credit allowed to customers as under at sales price.
a)50% of invoice price against acceptance of bill for 4 months.
b)25% of invoice of time lag 2 months.
i)Bank balance to be maintained Rs. 50,000.
j)Production and sales takes place evenly throughout t he year.
Solution :-
Working notes :-
1) Estimated production 90% of 10,000 = 9000 units.
2) Cost structure Rs.
Crude material 30.00
Other direct material 20.00
Wages 25.00munotes.in

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Fixed overhead (9000 x 12) 1080009000 12.00
Variable overheads 15.00
Total Cost 102.00
Profit 25% on sales (Means 331/3 of cost) 34.00
Selling price 136.00
3) M=m o n t h s
Statement of working capital
Particulars Working (units x Rate
xp e r i o d )Rs. Rs.
45,000
15,000A. Current Assets
a) I. Stock:
Crude Material
Other direct material
II. Work -in-progress
Crude material
Other direct material
Wages
Overheads
III. Finished goods
b. Debtors
c. Bills receivables
d. Advance to suppliers
e. Prep aid fixed overhead
f. Bank balance(900012Rs.302m )
(900012201m)
(900012301m)
(900012201m)
(900012251m50%)
(900012151m50%)
(9000121022m )
(9000121361m50%)
(900012136450%)
(900012302m)
(9000 x 3 x 1)
Given22,500
15,000
9,375
5,62575,000
60,000
52,500
1,53,000
51,000
2,04,000
45,000
27,000
50,000
Total 6,42,500
B.Less Current Liabilities
I.Creditors
II. Outstanding wages
III. Outstanding overheads(9,00012x20x1m)
(9,00012x25x1m)
(9,00012x15x0.5 m )15,000
18,750
5,625
Total 39,375
C. Working Capital (A -B) 6,03,125
Illustration 6.
From the books of The Board of KEM Ltd. Pune prepare a
statement of working capital requirement to meet the programme
planned for the year 20 11.
1) Issued share capital Rs. 4, 00,000
5% Debentures Rs. 1,00,000
Fixed assets at cost Rs. 2,50,000
2) The expected ratio of the cost to selling price are:
Material 60%
Labour 10%
Overheads 20%
Profit 10%
3) Raw material s are in stores for an average of 2 months.
Finished goods are kept in warehouse for approximately
three months.
4) Production during the previous year was 1,20,000 units and
it is planned to maintain this level of activity in the current
year also.munotes.in

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5) Each unit of production is expected to be in process for one
month.
6) Credit given by suppliers is two months and allowed to
customers is 3 months.
7) Selling price is Rs. 10 per unit.
8) There is regular production and sales cycle.
9) It is decided to maintain Rs. 30,000 cash balance.
Solution: -
a)Budgeted output 1, 20,000 units (given).
b)Budgeted sales -1, 20,000 x 10 = Rs. 12, 00,000
c)Cost Structure:
R.M.60% of Rs. 10 = Rs. 6.00 per unit
Labour 10% of Rs. 10 = Rs. 1.00 per unit.
Overheads 20% of R s. 10 = Rs. 2.00 per unit.
d)Annual expenditure
Raw material (1, 20,000 x Rs. 6) = 7,20,000
Labour (1, 20,000 x Rs. 1) = 1,20,000
Overheads (1, 20,000 x Rs. 2) = 2,40,000
Total 10, 80,000
Profit (1,20,000 x Rs. 1) 1,20,000
Selling price 12, 0 0,000
e)M=m o n t h s
Statement of working capital requirements
Particulars Working (units x
Rate x Period)Rs. Rs.
A.Current Assets
I. Stock of Raw materials
II.Work -in-progress
Raw Materials
Labour
Overheads
III. Finished goods
IV.Debtors
a)Raw materials1,20,000 6212m   1,20,000 6112m   1,20,000 1 1
12 2m   1,20,000 2 1
12 2m   1,20,000 9312m   60,000
5,000
10,000
1, 80,0001, 20,000
21,000
2, 70,000munotes.in

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30,000
60,000b)Labour
c)Overheads
V. Cash1,20,000 6312m   1,20,000 1312m   1,20,000 2312m   2,70,000
30,000
Total 7, 11,000
B.Less: Current liabilities
Creditors1,20,0006212m   1, 20,000 1, 20,000
C.Working Capital (A–B) 5, 91,000
7.4EXERCISES
1.You are required to prepare a statement showing the working
capital required to finance the level of activity of 27,000 u nits per
year from the following information.
Per unit
Rs.
Raw materials 24.00
Direct labour 6.00
Overheads 18.00
Total Cost 48.00
Profit 12.00
Selling price 60.00
Information:
I.Raw materials are in s tock an average for two months.
II.Materials are in process on an average for half a month.
III.Finished goods are in stock on an average for two months.
IV.Credit allowed by creditors is two months of raw materials
supplied.
V.Credit allowed to debtors is three month s.
VI.Lag in payment a wages is half month.
VII.Cash on hand Rs. 4,000 and bank balance Rs. 10,000
(Ans. Raw materials -Rs. 1,08, 000; work in progress -Rs. 40,500; Finished
stock -Rs. 2, 16,000; Debtors Rs. 4, 05,000; Creditors Rs. 10, 8,000;
Labour/wages Rs. 6,750; working capital Rs. 6, 23,750)munotes.in

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2.From the following data provided by M/s Alfa Ltd. estimate
working capital requirements for the year ended 31st March 2006.
a)Estimate activity of operation for the year 2, 60,000 units (52
weeks)
b)Raw materials remai n in stock for 2 weeks and production cycle
takes two weeks.
c)Finished goods remain in stock for two weeks.
d)Two weeks credit is allowed by supplier.
e)Four weeks credit is allowed to debtors.
f)Time lag in payment of wages and overheads is two weeks.
g)Cash and b ank balance to be maintained Rs. 25,000
h)Selling price per unit is Rs. 15
i)Analysis of cost per unit as follows:
i.Raw material133 %3of sales
ii.Labour and overheads in the ratio of 6:4 per unit.
iii.Profit is at Rs. 5 per unit.
Assume that o perations are evenly throughout the year;
wages and overheads ac crue similarly. Manufacturing process
required feeding a material fully at the beginning. Degree of work -
in-progress is 50%. Debtors are to be estimated as selling price.
(T.Y.B.Com March 2006)
(Ans. Stock Rs. 50,000 work -in-progress Rs. 75,000 debtors Rs.1,00,000,
creditors Rs. 50,000, outstanding wages Rs. 30,000, outstanding overheads
Rs. 20,000, working capital Rs. 4, 50,000)
3.From the following details, prepare a stateme nt showing working
capital requirement for the year ended 31st March 2009.
Production 90,000 units
Selling price per unit Rs. 10.00
Raw Materials 60% of selling price
Direct wages 10% of selling price
Overheads 20% of selling price
Mater ials in hand 2m o n t h sr e q u i r e m e n t
Production time 1m o n t h
Finished goods in stores 4m o n t h
Credit for material 2m o n t h
Credit allowed to customers 3m o n t h
Average cash balance Rs. 30,000
Average bank balance Rs. 20,000
Wages and overheads are paid at the beginning of the
month following . In Production all the required materials aremunotes.in

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charged in the initial stage and wages and overheads accrue
evenly.
(Ans. Raw materials Rs. 90,000, WIP -Rs. 56,250, Finished goods Rs.
2,70,000, Debtors -Rs.2, 25,000, Creditors -90,000, O/s wages Rs. 7,500,
O/s overheads Rs. 15,000 -working capital 6, 78,750)
4.From the following data, prepare a statement of working capital
requirement for the year 2009
Rs. Rs.
Budgeted sales 3, 60 ,000
Less: cost of materials 1, 08,000
Direct labour 1, 44,000
Overheads 72,000 3, 24,000
Net profit 36,000
It is estimated that:
a)Raw materials are carried in stock for one months and finished
goods for 15 days only.
b)The production c ycle take one month.
c)One month's credit is granted both for purchase of raw materials
and sales of finished goods.
d)Production and overheads are even through the year.
(Ans. Raw materials Rs, 9,000, WIP Rs. 18,000 finished goods Rs. 13,500,
Debtors Rs. 30, 000, Creditors Rs. 9,000, working capital Rs. 61,500)
5.The management of Fast and Thin Ltd. desires to know the
working capital required with effect from 1st January, 2010 to
finance. the production programme. Percentage cost structure of
selling pric e is as follows.
Raw Materials 50%
Labour 20%
Overheads 10%
You are further informed that:
a)Raw materials remain in the stores on an average for one
month before issue to production.
b)Finished goods remain in the godown for 2 months before sales.
c)Each unit of production will be in process for one month.
d)Credit allowed by creditors is one month and allowed to debtors
is 2 months.
e)Selling price per unit is Rs. 9.00
f)Production in 2010 is expected to be 1, 00,000 units.
(Ans. Raw materials -Rs. 37,500, work -in-progress -Rs. 48,750, Finished
goods -Rs. 1, 20,000, Debtors -Rs. 1, 20,000, Creditors -Rs. 37,500,
working capital -Rs. 2, 88,750)
munotes.in

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1208
CAPITAL BUDGETING
Unit Structure:
8.0 Objectives
8.1 Introduction
8.2 Capital Budgeting Project
8.2.1 Meaning
8.2.2 Types / Classification of Projects
8.2.3 New Concepts of Projects
8.3 Capital Budgeting Process
8.4 Capital Budgeting Techniques
8.5 Payback Period Methods
8.5.1 Meaning
8.5.2 The formula is:
8.5.3 Accept or reject criterion:
8.5.4 Advantages
8.5.5 Disadvantages
8.5.6 Solved Problems
8.6 Accounting Rate ofR e t u r n
8.6.1Meaning
8.6.2The formula is:
8.6.3Accept or reject crite rion:
8.6.4Advantages
8.6.5Disadvantages
8.6.6Solved Problems
8.7 Net present value method
8.7.1 Discounted Cash Flow Technique
8.7.2 Meaning of Net present value
8.7.3 How to calculate the Net Present Value
8.7.4 Accept or reject criterion
8.7.5 For mula
8.7.6 Solved Problem
8.8 Profitability Index
8.8.1 Meaning
8.8.2 Merits
8.8.3 Demeritsmunotes.in

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1218.8.4 Procedure
8.8.5 Formula
8.8.7 Accept / Reject criterion
8.8.8 Solved Problem
8.9 Discounted payback period
8.9.1 Meaning
8.9.2 Procedure to calculate Discou nted Payback Period
8.9.3 Solved Problem
8.10 Model Question
8.11 Exercise
8.0OBJECTIVES
After studying the unit the students will be able to
Know the concept of capital budgeting
Understand the concept of project and budgeting report
Understand the sources of project financing
Understand the important considerations for capital budgeting
8.1INTRODUCTION :
The financial requirements of business can be classified as
short -term and long -term financial requirements. Short -term funds
are required f or meeting working capital needs. It is usually
required for a period up to one year. Long -term funds are required
to a great extent for meeting the fixed capital requirements of the
business. It is required for a period of 1 to 5 years or more. Fixed
capital is required for investment in land, building, plant and
machiner y, vehicles and furniture etc. The long -term funds are
raised by issue of shares, debentures, loans from financial
institutions and banks.
Capital investment involves a cash outflow in the immediate
future in anticipation of returns of a future date. The planning and
control of capital expenditure is called as capital budgeting
decisions. Capital budgeting is an art of finding assets that are
worth more than their cost toachieve the objectives i.e. optimizing
the wealth of a business enterprise. A key challenge for the
companies is to identify projects which fit the objectives and
promise to be profitable. Capital expenditure decisions usually
involve large sums of money, long -time spans and carry some
degree of risk and uncertainty. Realistic investment appraisal
requires the financial evaluation of many factors such as the choicemunotes.in

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122of size, type, location, timing of investments, taxation, and
opportunity cost of funds available and alternative forms of
financing the projects.
8.2CAPITAL BUDGETING PROJECT
8.2.1 Meaning
A Project is a scheme for investing resources. It is a
proposal of something to be done , plan or scheme. Every business
plan is a project. The entrepreneur has to identify an opportunity to
undertake a new venture. The business opportunity can be
generated through various techniques like market research
observations at market places, consultation with experts and
brainstorming sessions. The entrepreneur should co nduct cost -
benefit analysis of each and every idea. The costs can be
measured in terms of resources required to implement the
opportunity and the benefits can be measured in terms of sales,
profits etc. Thus, a project is a business plan. It describes t he
future direction of the business. The entrepreneur should prepare a
sound business plan in order to exploit the opportunity. A good
business plan is important in determining the resources required,
obtain the resources and effectively manage the busin ess venture.
8.2.2 Types /C l a s s i f i c a t i o n of Projects
There are different types of projects undertaken by the
business. The important types of projects are given below: -
1.Modernization Project : Modernization projects involve removal
of old machines and i nstallation of new machines in their place
to cope with dynamic and competitive business environment.
2.Expansion Projects : Expansion projects are undertaken to
enlarge the plant capacity with a view to produce a large volume
of production than the current l evel of production.
3.Diversification Projects : Diversification project is an
investment decision to set up an entirely new project which is
not connected with the exiting line of business.
4.Balancing Projects : New plant and machinery is installed in
order t o remove the bottlenecks (imbalance) and to increase the
capacity utilization of the total plant. In installing balancing
equipment, these would be free flow in the process and
uninterrupted production is ensured and there will be increase in
the revenue.
5.Replacement Project : Replacement of an existing asset with
more economic one is a replacement project. By replacement,
the operational efficiency is increased, cost of production is
reduced, cost of maintenance is reduced and profitability is
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1238.2.3 New Concepts of Projects
In recent economic liberalization programme in India, few
projects are emerging with new concept for financing and execution
of project. Such new concep ts of projects are given below:
1.Building Operate and Transfer (BOT) :U n d er this concept, the
private sector is allowed to put the investment in bringing the
project and the Government allows them to operate for certain
period and then transfer the project to the Government. For
example, Super Express Highways.
2.Build, Own and Operate (BOD) : Under this concept, the
private entrepreneurs are allowed to build the project from their
own resources, and then they will own the project and they are
also entitled to operate the project subsequent to their
commercial launching. For exam ple, power sector.
3.Lease, Rehabilitate, Operator and Transfer (LROT) :U n d e r
LROT concept, the Government gives a running plant to the
private entrepreneur for rehabilitation to put the plant on
profitability track.
4.Turnkey Projects : When a single contract or undertakes the
responsibility for the entire work and completes it so that the
owner merely turns the key and operates the plant is known as
“Turnkey” project. It covers the complete responsibility of
engineering, design, manufacturing, supply, constru ction and
commissioning the project.
8.3CAPITAL BUDGETING PROCESS
Following are the major Stages of Capital Budgeting
Process :
1.Project identification and generation:
On this stage ideas and suggestions for possible investment
opportunities of enterpri se resources are identified. Here the
proposal for investments is generated taking into consideration the
various reasons for taking up investments in a business. The
reasons may be addition of a new product line or expanding the
existing one. It could be a proposal to either increase the
production or reduce the costs of outputs. Theinvestment
suggestions may be from inside the firm, such as from its
employees, or from outside the firm, such as from a firm’s advisors .
2.Project Screening and Evaluation:
Inthis phase ideas and suggestions having greatest income
potential are developed into complete and detailed investment
plans. This step mainly involves selecting all correct criteria’s to
judge the desirability of a proposal. The main object of this stage ismunotes.in

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124toavoid unnecessary wastage of resources like tim e, money and
effort. The tool of time value of money becomes useful in this step.
Also the estimation of the benefits and the costs needs to be done.
The total cash inflow and outflow along with the unce rtainties and
risks associated with the proposal has to be analyzed thoroughly
and appropriate provisioning has to be done for the same.
3.Project Selection:
In the third phase, investment plans are compared, and
those that appear to be in the best interes t of the enterprise are
selected. Here it has been checked whether the proposed
investment project would add value to the firm or not. Properly
defined method for the selection of a proposal for investments is
not there as different businesses have differe nt requirements.
4.Preparing the capital budget
Once the proposal has been finalized, the different
alternatives for raising or acquiring funds have to be explored by
the finance team. This is called preparing the capital budget. The
average cost of funds has to be reduced. A detailed procedure for
periodical reports and tracking the project for the lifetime needs to
be streamlined in the initial phase itself. The final approvals are
based on profitability, Economic constituents, viability and market
condi tions.
5.Theacceptance or rejection of the project:
In this phase it has been decided whether to accept or reject
a project. A ll information, coming from the financial appraisal and
qualitative results, is collected for making decisions. Managers with
experience and knowledge also consider other relevant information
using their routine information sources, expertise andjudgments .
6.Implementation and Monitoring :
Once an investment project is accepted, the nt h i sp h a s e
involves the setting up of manufacturi ng facilities, project and
engineering designs, negotiations and contracting, construction,
and training and plant commissioning etc. Here the investment
performance is monitored for any significant variations from
expectations to determine if goals are be ing met Money is spent
and thus proposal is implemented. The different responsibilities like
implementing the proposals, completion of the project within the
requisite time period and reduction of cost are allotted.
7.Performance review orPost -implementat ion audit :
This is the last phase which involves comparison of actual
results with the standard ones. Post-implementation audit can
provide useful feedback to project appraisal or strategy formulation .
The feedback helps to identify and remov ethe various difficulties of
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1258.4 CAPITAL BUDGETING TECHNIQUES
In order to maximize the return to the shareholders of a
company, it is important that the most profitable investment projects
should be selected. It is absolutely necessary that the method
adopted for appraisal of capital investment proposals is a sound
one. Any appraisal method should provide for the following: -
(i)A basis of distinguishing between acceptable and non -
acceptable projects.
(ii)Ranking of projects in order of their desirability.
(iii)Choosing among several alternatives.
(iv)Recognizing the fact that bigger benefits are preferable to
smaller ones and early benefits are preferable to later ones.
There are several methods used for evaluati ng and ranking
the capital investment proposals. The basic approach is to compare
the investment in the project with benefits derived there -from. The
important methods or techniques of capital budgeting are explained
below.
8.5PAY BACK PERIOD METHOD
8.5.1Meaning
It is the traditional technique of Capital Budgeting. The term
pay-back period refers to the period in which the project generates
the necessary cash to recoup the initial investments. The pay -back
period is generally expressed in years. The method recognizes the
recovery of original investment in a project. Thus, the payback
period is the number of years required to recover the cost of the
investment.
8.5.2 The formula is:
Pay-back PeriodInitial Investment Cash outflowsAnnual Cash Inflow
The terms used in this method: -
Cash outflows : It means the original cost of proposal or
investment
Cash inflows: It means the profits before depreciation but after
tax.
8.5.3 Accept or reject criterion: -
While deciding between the tw o or more projects, usual ly the
project having lowest payback period is accepted .munotes.in

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1268.5.4 Advantages
1.This method is easy to calculate
2.It is simple to understand
3.Here investment recovery period is calculated therefore
business unit can know about the period within which the funds
will remain tied up.
4.The project having short pay -back period are accepted here
this method is more suitable to the industries where risk of
obsolescence is high.
8.5.5Disadvantages
1.This method completely ignores all cash inflows after the pay -
back period. This can be very misleading as it does not consider
the total benefits occurring from the project.
2.It ignores the time value of money. In this method money
received now and receivable in future are considered as of
equal value.
3.This method does not take into consideration the entire life of
the project. As a result project with large cash inflows in the
latter part of payback period and less cash inflows in the earlier
years may be rejected.
4.This method ignores residual value.
In spite of these limitations the industries having high risk of
obsolescence prefer this method. Likewise where, quick return to
recover the investment is the primary goal this method is preferred.
8.5.6Solved Problems
A project requires an initial inves tment of Rs. 2 ,0 0 , 0 0 0 and
the annual cash inflows for 5 years are Rs. 60,000, Rs. 80,000, Rs.
50,000, Rs. 40,000 and Rs. 30,000 respectively. Calculate the
payback period .
Here the students have to prepare the column of
Cumulative Cash Inflows showed as below :
Year Cash Inflows (Rs/) Cumulative Cash
Inflows (Rs.)
0 (2,00,000) (2,00,000)
1 60,000 (1,40,000)
2 80,000 (60,000)
3X 50,000 (10,000) Y
4 40,000 Z 30,000
5 30,000 60,000munotes.in

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127X = is the last time per iod where the cumulative discounted cash flow
(CCF) was negative
Y = is the absolute value of the CCF at the end of that period X
Z = is the value of the DCF in the next period after X
Payback Period = X + Y /Z
The actual pay -back period can be determine da su n d e r : -
Pay-back Period10,000340,000
=3+0 . 2 5y e a r s
=3 . 2 5y e a r s
8.6ACCOUNTING RATE OF RETURN
8.6.1 Meaning
The capital investment proposals are judged on the basis of
their relative profitability. The accounting rate of return is also
known as return on investment or return on capital employed .
It is normal accounting technique used to measure the increase in
profit expected to result from an investment by expressing the net
accounting profit arising from the in vestment as a percentage of
that capital invested.
8.6.2 The formula is:
Accounting Rate of ReturnAverage Annual Profit after tax100Average Investment 
Average Investmen tInitial investment Salvage value2
The term average annual net profit is the average of earning
(after depreciation and tax) over the whole of the economic life of
the project. The projects can be ranked on the basis of their
accounting rate of return.
8.6.3Accept or reject criterion: -
The project which gives higher rate of return will be preferred
for investment.
8.6.4 Advantages:
1.It is very simple to understand and use.
2.It can be readily calculated using the accounting data.
3.It uses the entire stream of incomes in calculations.munotes.in

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1288.6.5 Disadvantages :
1.While appr aising the project it uses the accounting profits not
the cash inflows.
2.It ignores the time value of money
3.This technique does not consider the lengths of project lives .
8.6.6 Solved problem:
Am a c hine is available for purchase of a cost of Rs.
8,00,000. It is expected to have a life of 5 years and have a scrap
value of Rs. 1,00,000 at the end of five years period. The machine
will generate the following profits over its life as under: -
Year Amou nt (Rs.)
1 2,00,000
2 3,00,000
3 4,00,000
4 1,50,000
5 50,000
The above estimates are profits before depreciation. You
are required to calculate the accounting rate of return.
Solution
Total profit before depreciation over the life of machine = Rs .
11 lakhs
Average Profit11,00,000. 2,20,0005Rs  
Total Depreciation over the life of the machine = Cost -Scrap Value
=8 , 0 0 , 0 0 0 –1,00,000 = Rs. 7,00,000
Average Depreciation =7,00,000.1,40,0005Rs Average Annual
Profit after depreciation =Rs. 2,20,000 –1,40,000 =Rs. 80,000
Original Investment =R s .8 , 0 0 , 0 0 0
Rate of Return =80,000100 10%8,00,000
Average Investment =8,00,000 1,00,0004,50,0002
Accounting Rate of Return =80,0001004,50,000
=1 7 . 7 8 %munotes.in

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1298.7NET PRESENT VALUE METHOD
8.7.1 Discounted Cash Flow Technique:
The discounted cash flow technique is an improvem ent on
the payback period method. It takes into account the interest factor
as well as the return after the pay -back period. This method
involves the following stages:
(a)Calculation of cash flows i.e. cash inflows as well as cash
outflows, over the full l ife of an asset.
(b)Discounting the cash flows by a discount factor.
(c)Aggregating the discount cash inflows and comparing them
with the total discounted cash outflows.
8.7.2 Meaning of Net present value
The net present value is obtained by discounting all cas h
inflows and outflows attributable to a capital investment project.
For this purpose, rate of discount is chosen suitably. The difference
between the present value of cash inflows and present value of
cash outflows is called net present value (NPV).
8.7.3How to calculate the NetPresent Value
Net present value method (NPV) is the most suitable method
used for evaluating the capital investment projects. Net present
value is calculated as below:
1.Firstly the cash inflows and outflows associated with each
project are worked out.
2.The present value of the cash flows is calculated by discounting
the cash flows at the rate of return acceptable to the
management.
3.The rate of return is considered as a cut -off rate. It is generally
determined on the basis of cost of capital suitably adjusted to
allow for the risk element involved in the project.
4.The cash outflows represent the investment and commitments
of cash in the project at various points of time. The working
capital is taken as a cash outflow in the in itial year.
5.The cash inflow represents the net profit after tax but
before depreciation. As depreciation is non -cash expenditure,
it is added back to the net profit after tax in order to determine
the cash inflows.
6.The cash inflows and outflows are di scounted at a certain rate
and present value of cash flows is calculated.
7.The difference between the present value of cash inflows and
present value of cash outflows is called net present value
(NPV).munotes.in

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1308.7.4 Accept or reject criterion:
If the NPV is po sitive, the project is accepted and if it is
negative, the project is rejected.
8.7.5 Formula :
Discounted cash flow is an evaluation of the future net cash
flows generated by a project. This method considers the time value
of money concept and hence i t is considered better for evaluation
of investment proposals. If there are mutually exclusive projects,
this method is more useful. Thus, the following formula is used to
determine the net present value:
Net present value (NVP) = Present value of futur e cash inflows –
Present value of cash outflows.
8.7.6 Solved Problem
Illustration
An investment project costs Rs. 1,00,000 initially. It is
expected to generate cash flow as follows:
Year Cash inflows (Rs.)
1 50,000
2 40,000
3 30,000
4 20,000
(a) What is the net present value of the project assuming a 10 %
risk-free rate? Should the project be accepted?
(b) If the project is risky and it is decided to use a higher rate to
allow for the perceived risk. Assuming that rate is 15%, what will
be the net present value of the project? Should the project be
accepted?
The discounted factor @10% is:
Year 1 2 3 4
Discount factor 0.9091 0.8254 0.7513 0.6830
The discounted factor @15% is:
Year 1 2 3 4
Discount factor0.86960.7561 0.6575 0.5718munotes.in

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131Solution :
(a)
Net Present Value at 10% discounting rate
Year Cash inflows
(Rs)Discount factor at
10%Present value
(Rs.)
1 50000 0.9091 45455
2 40000 0.8254 33056
3 30000 0.7513 22539
4 20000 0.6830 13660
Present value of cash inflows 114710
-Present value of cash outflow 100000
Net present value 14700
The project should be accepted at risk free rate of 10%
because net present value is positive.
(b)
Net Present Value at 15% discounting rate
Year Cash inflows
(Rs)Discount factor at
15%Present value
(Rs.)
1 50000 0.8696 43480
2 40000 0.7561 30244
3 30000 0.6575 19725
4 20000 0.5718 11436
Present value of cash inflows 104885
-Present value of cash outflow 100000
Net present value 4885
The project can be accepted at 15% because net present
value is positive
8.8PROFITABILITY INDEX
8.8.1 Meaning
The net present value method uses discounted cash flows. It
expresses cash flows in present rupees. The NPV of differentmunotes.in

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132projects can be compared. It implies that each project can be
evalu ated independent of others on its own merit. Sometimes we
have to compare a number of projects each involving different
amount of cash inflows and outflows. If the cash flows are different
and period of the project are also different and two or more proj ects
give positive net present value, then we have to use the technique
of profitability index .It represents a ratio of the present value of
future cost benefit at the required rate of return to the initial cash
outflow of the investment.
8.8.2 Merits
1.This method is helpful in comparing the project having different
amounts of investment therefore it is superior to Net Present
Value method.
2.It considers the time value of money.
3.It considers all cash inflows.
8.8.3 Demerits
1.It is difficult to understand a nd to calculate.
2.In case of mutually exclusive nature investment the Present
Value Method is superior to this method.
8.8.4 Procedure
1.Calculate Cash out flows and its present value.
2.Calculate the present value of Cash Inflows.
3.Calculate the ratio of prese nt value of cash inflows to the
present value of cash outflows. This ratio is called as
profitability index.
8.8.6 Formula -
Profitability IndexPresent value of cash inflows PVCIPresent value of cash outflows PVCO
8.8.7 Accept / Reject criterion: -
The selecti on of project has based on ranking i.e. the project with
the highest Profitability Index is given the first rank followed by
others.
8.8.8 Solved Problem
Illustration
X Ltd is considering purchase of a machine in replacement
of an old one. Two models v iz. ‘modern’ and ‘sky’ are offered at
price of Rs. 22.5 lakhs and Rs. 30 lakhs respectively. Further
particulars regarding these models are given below: -munotes.in

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133Particulars Modern Sky
(I) Economic life in years 5 6
(II) After tax annual cash inflows
Years Rs. Lakhs Rs. Lakhs
1 5.00 6.00
2 7.50 8.00
3 10.00 10.00
4 9.00 12.00
5 8.50 10.50
6 - 9.50
(III) Present value factors at 12% per annuam are as follows
Years P.V.Factor
1 0.893
2 0.797
3 0.712
4 0.636
5 0.567
6 0.507
(a) Evaluate the two p roposals.
(b) Which model would you recommend any why?
Solution:
Calculation of Net Present Values
Modern Sky Years P.V.Factor
CFAT PV CFAT PV
1 0.893 5.00 4.465 6.00 5.358
2 0.797 7.50 5.977 8.00 6.376
3 0.712 10.00 7.120 10.00 7.120
4 0.636 9.00 5.724 12.00 7.632
5 0.567 8.50 5.954 10.50 5.953
6 0.507 - 9.50
2.506.084
Less Present Value of Cash
inflows29.240 38.523
Present value of cash
outflows22.500 30.000
Net present value 6.740 8.523
(b) Considering net present value method, b oth the models have
positive net present value and their initial investments are different.
Hence, the decision will be based on Profitability Index which is
calculated as follows: -munotes.in

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134Modern Sky
Profitability Index29.240 38.52322.500 30.001.299 1.284PVCI
PVCO(c) As the profitability index of model ‘Modern’ is higher, it is
recommended
8.9DISCOUNTED PAYBACK PERIOD
8.9.1 Meaning
The discounted payback period is a modified version of the
payback period th atconsiders thetime value of money .B o t h
metrics are used to calculate the amount of time that it will take for
a project to “break even”, or t o get the point where the net cash
flows generated cover the initial cost of the project. Both the
payback period and the discounted payback period can be used to
evaluate the profitability and feasibility of a specific project.
8.9.2 Procedure to calcul ateDiscounted Payback Period
There are two steps :
1.First, we must discount (i.e., bring to the present value) the net
cash flows that will occur during each year of the project.
2.Second, we must subtract the discounted cash flows from the
initial cost figure in order to obtain the discounted payback
period. Once we’ve calculated the discounted cash flows for
each period of the project, we can subtrac tt h e mf r o mt h ei n i t i a l
cost figure until we arrive at zero.Discounted Cash outflowsDiscounted Pay back PeriodDiscounted Cash Inflow 
8.9.3 Solved Problem
Illustration 1
ABC Ltd., is considering a given project. Below are some
selected data from the dis counted cash flow model created by the
company’s financial analysts:
The initial investment is Rs 75,000/ -
Year Discounted Cash inflows Rs.
1 10,000
2 15,000
3 20,000
4 30,000
5 30,000munotes.in

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135Solution
Year Discounted Cash Flow Rs. Cumulative Cash inflow s Rs.
0 (75,000) I nitial investment (75,000)
1 10,000 (65,000)
2 15,000 (50,000)
3 20,000 (30,000)
4X 30,000 0 Y
5 30,000 Z 30,000
X = is the last time period where the cumulative discounted cash flow
(CCF) was negative
Y = is the absolute value of the CCF at the end of that period X
Z = is the value of the DCF in the next period after X
Discounted Payback Period = X + Y /Z
=4 +0 / 3 0 , 0 0 0
= 4Years
In this case, we see that the project’s payback period is 4
years. Si nce the project’s life is calculated at 5 years, we can infer
that the project returns a positive NPV. Thus, the project will likely
add value to the business if pursued.
Illustration 2
Calculate theDiscounted Payback Period from the following
details. T heinitial investment is Rs. 23,40,000
Year Cash inflows Rs. Present Value
Factor @1 0 %
1 6,00,000 0.9009
2 6,00,000 0.8116
3 6,00,000 0.7312
4 6,00,000 0.6587
5 6,00,000 0.5935
6 6,00,000 0.5346munotes.in

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136Year1.
Cash
inflows Rs.2.
Present
Value
Factor
@10%3.
Discounted
Cash Flow
(Cash
inflow *
PV.)4.
Cumulative
Discounted
Cash Flow
0 (23,40,000) 1 (23,40,000) (23,40,000)
1 6,00,000 0.9009 5,40,541 (17,99,456)
2 6,00,000 0.8116 4,86,973 (13,12,486)
3 6,00,000 0.7312 4,38,715 (8,73,771)
4 6,00,000 0.6587 3,95,239 (4,78,532)
5X 6,00,000 0.5935 3,56,071(1,22,461)
Y
6 6,00,000 0.53463,20,785
Z1,98,324
X = is the last time period where the cumulative discounted cash flow
(CCF) was negative
Y = is the absolute value of the CCF at the end of that period X
Z = is the value of the DCF in the next period after X
Discounted Payback Period = X + Y /Z
=5+ (1,22,461 ÷3,20,785 )
=5+0 . 3 8
=5.38years
8.10MODEL QUESTION S
Q.1 Arvind Ltd. is currently analyzing capital expenditure
propos als for the purchase of equipment. The company uses
the net present value technique to evaluate projects. The
capital budget is limited to Rs. 5,00,000 which the company
believe is the maximum capital it can raise. The initial
investment and projected n et cash flows for each project are
given below. The cost of capital of the company is 12%. You
are required to compute the NPV of the different projects.munotes.in

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137Projects A B C D
Initial
Investment
(Rs.)2,00,000 2,00,000 2,40,000 2,10,000
Cash inflo ws
1stYear 50,000 40,000 75,000 75,000
2ndYear 50,000 50,000 75,000 75,000
3rdYear 50,000 70,000 60,000 60,000
4thYear 50,000 75,000 80,000 40,000
5thYear 50,000 75,000 1,00,000 20,000
Q.2 Which project would you recommend and why?
Calculate Payback period of the investment of Rs. 1,36,000
which yields the following cash flows: -
Year Cash inflows (Rs.)
1 30,000
2 40,000
3 60,000
4 30,000
5 20,000
Q.3 A choice is to be made between two competing projects which
requir e an equal investment of Rs. 50,000 and are expected
to generate net cash flow as under:
Year Project A (Rs.) Project B (Rs.)
1 25,000 10,000
2 15,000 12,000
3 10,000 18,000
4 10,000 25,000
5 12,000 8,000
6 6,000 4,000munotes.in

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138The cost of capi tal of the company is 10%. The following are
the present value factors @ 10%.
Year PV Factors @ 10 %
1 0.9091
2 0.8264
3 0.7513
4 0.6830
5 0.6209
6 0.5645
Which project should be selected and why? Evaluate the
project under:
a)Payback m ethod
b)NPV method.
c)Discounted Payback Period
8.11EXERCISE
1.Explain the major Stages of Capital Budgeting Process .
2.Discuss the different types of projects undertaken by the
business.
3.Explain in short the various techniques of Capital budgeting.
4.WriteS h o r tn o t e s :
a)Payback Period Method
b)Accounting rate of Return
c)Present Value Method
d)Discounted Pay back Period


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