Management accounting book

MANAGEMENT ACCOUNTING


BABASAB PATIL (BEC DOMS)


LESSON – 1
INTRODUCTION

The term “Management Accounting” is of recent origin. It was first coined by
the British Team of Accountants that visited the U.S.A. under the sponsorship of
Anglo-American Productivity Council in 195 with a view of highlighting utility of
Accounting as an “effective management tool”. It is used to describe the
modern concept of accounts as a tool of management in contrast to the
conventional periodical accounts prepared mainly for information of proprietors.
The object is to expand the financial and statistical information so as to throw
light on all phases of the activities of the organisation.

All techniques which aim at appropriate control, such as financial control,
budgeted control, efficiency in operations through standard costing,
cost-volume-profit theory etc, are combined and brought within the purview of
Management Accounting.

Management Accounting evolves a scheme of accounting which lays emphasis
on the planning of future (logical forecasting), simultaneously finding the
deviations between the actual and standards. Another significant feature of
Management Accounting is reporting to top-management. Finally, accounting
information should be presented in such a way as to assist the management in
the formulation of policy and in the day-to-day conduct of business. For
example, the published accounts of business concerns do not furnish
management with information in a form that suggest the line on which
management policies and actions should proceed. It requires further analysis
classification and interpretation before the management can draw lessons from
them for their guidance and action.

DEFINITION OF MANAGEMENT ACCOUNTING

Management Accounting may be defined as “the presentation of accounting
information in such a way as to assist the management in the creation of the



policy and day-to-day operation of an undertaking” – Management Accounting
of the Anglo-American to productivity.

The Institute of Chartered Accountants of England has defined it –

“Any form of accounting which enables a business to be conducted more
efficiently can be regarded as Management Accounting”.

Robert N. Anthony has defined Management Accounting as follows-

“Management Accounting is concerned with accounting information that is
useful to management.”

According to American Accounting Association, “Management Accounting
includes the methods and concepts necessary for effective planning for,
choosing among alternative business actions and for control through the
evaluation and interpretation of performance”. This definition is fairly
illustrative.

According to Kohler, Forward Accounting includes “Standard costs, budgeted
costs and revenues, estimates of cash requirements, break even charts and
projected financial statements and the various studies required for their
estimation, also the internal controls regulating and safeguarding future
operating.”

Blending together into a coherent whole financial accounting, cost accounting
and all aspects of financial management”. He has used this term to include “the
accounting methods, systems and techniques which, coupled with special
knowledge and ability, assist manageme4nt in its task of maximizing profits or
minimizing losses.” – James Batty.



Thus all accounting which directly or indirectly providing effective tools to
managers in enterprises and government organizations lead to increase in
productivity is “Management Accounting.”

OBJECTIVES OF MANAGEMENT ACCOUNTING:

The basic objective of Management Accounting is to assist the management in
carrying out its duties efficiently.

The objectives of Management Accounting are:
1. The compilation of plans and budgets covering all aspects of the
business e.g., production, selling, distribution research and finance.
2. The systematic allocation of responsibilities for implementation of plans
and budgets.
3. The organization for providing opportunities and facilities for performing
responsibilities.
4. The analysis of all transactions, financial and physical, to enable effective
comparisons to be made between the forecasts made and actual
performance.
5. The presentations to management, at frequent intervals, of up-to-date
information in the form of operating statements.
6. The statistical interpretation of such statements in a manner which will be
of utmost assistance to management in planning future policy and
operation.

To achieve the above objectives, Management Accounting employs three
principles devices, viz.,-

1. Forward Looking Principle – basis on the past and all other available
data, forecasting the future and recommending wherever appropriate, the
course of action for the future.



2. Target Setting Principle – fixation of an optimum target which is
variously known as standard, budget etc., and through continuous review
ensuring that the target is achieved or exceeded.
3. The Principle of Exception – instead of concentrating on voluminous
masses of data, Management Accounting concentrates on deviations from
targets (which are usually known as variances) and continuous and
prompt analysis of the causes of these deviations on which to base
management action.

SCOPE OF MANAGEMENT ACCOUNTING:

The scope of Management Accounting is wide and broad based. It encompasses
within its fold a searching analysis and branches of business operations.
However, the following facets of Management Accounting indicate the scope of
the subject.

1. Financial Accounting.
2. Cost Accounting
3. Budgeting & Forecasting
4. Cost Control Procedure
5. Statistical Methods
6. Legal Provisions
7. Organisation & Methods

1. Financial Accounting: This includes recording of external transactions
covering receipts and payments of cash, recording of inventory and sales
and recognition of liabilities and setting up of receivables. It also
preparation of regular financial statements. Without a properly designed
accounting system, management cannot obtain full control and
co-ordination.
2. Cost Accounting : It acts as a supplement to financial accounting. It is
concerned with the application of cost to job, product, process and



operation. It plays an important role in assisting the management in the
creation of policy and the operation of undertaking.
3. Budgeting & Forecasting: These are concerned with the preparation of
fixed and flexible budgets, cash forecast, profit and loss forecasts etc., in
co-operation with operating and other departments. Management is
helped by them.
4. Cost Control Procedure: It is concerned with the establishment and
operation of internal report in order to convert the budget in to operating
service. Management is helped by them by measuring actual results
budgetary standards of performance.
5. Statistical Methods : These are concerned with generating statistical and
analytical information in the form of graphs charts etc. of all department
of the organization. Management need not waste time in understanding
the facts and more time and energy can be utilized in sound plans and
conclusions.
6. Legal Provisions: Many management decisions depend upon the
provisions of various laws and statutory requirements. For example, the
decision to make a fresh issue of shares depends upon the permission of
controller of capital issues. Similarly, the form of published accounts, the
external audit the authority to float loans, the computation and
verification of income, filing tax returns, making tax payments for excise,
sales, payroll income etc., all depend on various rules and regulations
passes from time to time.
7. Organization & Methods: They deal with organization, reducing the cost
and improving the efficiency of accounting as also of office operations,
including the preparation and issuance of accounting and other manuals,
where these will prove useful.

It is clear that Management Accounting has a vital relation with all those areas
explained above.

FUNCTIONS OF MANAGEMENT ACCOUNTING:
The functions of management accounting may be said to include all activities
connected with collecting, processing, interpreting and presenting information
to management. The Management Accounting satisfies the various needs of



management for arriving at appropriate business decisions. They may be
described as follows:

1. Modification of Data:

Accounting data required for decision – making purposes is supplied by
management accounting through resort to a process of classification and
combination which enables to retrain similarities of details without eliminating
the dissimilarities (e.g.) combination of purchases for different months and
their breakup according to class of product, type of suppliers, days of purchase,
territories etc.

2. Analysis & Interpretation of Data:

The data becomes more meaningful with the analysis and interpretation. For
example, when Profit and Loss account and Balance Sheet data are analyzed by
means of comparative statements, ratios and percentages,
cash-flow-statements, it will open up new directions for its use by
management.

3. Facilitating Management Control

Management Accounting enables all accounting efforts to be directed towards
control of destiny of an enterprise. The essential features in any system of
control are the standards for performance and measure of deviation therefrom.
This is made possible through budgetary control and standards costing which
are an integral part of Management Accounting.

4. Formulation of Business Budgets:
One of the primary functions of management is planning. It is done by
Management Accounting through the process of budgeting. It involves the
setting up of objectives, and the selection of the most appropriate strategies by
comparing them with reference to some discriminating criteria. Probability,
Probability, forecasting, and trends are some of the techniques used for this
purpose.

5. Use of Qualitative Information:



Management Accounting draws upon sources, other than accounting, for such
information as is not capable of being readily convertible into monetary terms.
Statistical compilations, engineering records and minutes of meeting are a few
such sources of information.

6. Satisfaction of Informational Needs of Levels of Management:

It serves management as a whole according to its requirements it serves top
middle and lower level managerial needs to subserve their respective needs. For
instance it has a system of processing accounting data in a way that yields
concise information covering the entire field of business activities at relatively
long intervals for the top management, technical data for specialized personnel
regularly and detailed figures relating to a particular sphere of activity at short
intervals for those at lower rungs of organizational ladder.

The gist of Management Accounting can be expressed thus, it is a part of over
all managerial activity – not something grafted on to it from outside – guiding
and servicing management as a body, to derive the best return form its
resources, both the itself and for the super system within which it functions.

From the above discussions, one may come to the following conclusions about
the fundamental approach in Management Accounting.

Firstly, the Management Accounting functions is a managerial activity and it
puts its finger in very pie without itself making them it guides and aids setting
of objectives, planning coordinating, controlling etc. But it does not itself
perform these functions.

Secondly it serves management as a whole – top middle and lower level –
according to its requirements. But in doing so it never fails in keeping in focus
the macro-approach to the business as a whole.

Thirdly, it brings in the concept of cost-Benefits analysis. The basic approach is
to split all costs and benefits into two groups – measurable and non measurable.
It is easy to deal with measurable costs which are expressed in terms of money.
But there are several ventures such as office canteens where the cost-benefits
may not be monetarily measurable.



LIMITATIONS OF MANAGEMENT ACCOUNTING

Comparatively, Management Accounting is a new discipline and is still very
much in a state of evolution. There fore it comes across the same impediments
as a relatively new discipline has to face-sharpening of analytical tools and
improvement of techniques creating uncertainty about their applications.

1. There is always a temptation to make an easy course of arriving at
decision to intuition rather than taking the difficulty of scientific
decision-making.
2. It derives its information from financial accounting, cost accounting and
other records. Therefore, strength and weakness of Management
Accounting depends upon the strength and weakness of basic records.
3. It is one thing to record, interpret and evaluate an objectives historical
event converted into money figures, while it is something quite different
to perform the same function in respect of post possibilities, future
opportunities and unquantifiable situation. Execution of the conclusions
drawn by the management accountant will not occur automatically.
Therefore, a continuous effort to achieve the goal must be made at all
levels of management.
4. Management Accounting will not replace the management and
administration. It is only a toll of management. Of course, it will save the
management from being immersed in accounting routine and process the
data and put before the management the facts deviating from the
standard in order to enable the management to take decisions by the rule
of exception.



LESSON – 2

FINANCIAL ACCOUNTING AND MANAGEMENT ACCOUNTING

The terms financial accounting, and management accounting, are not prices
description of the activities they comprise. All accounting is financial in the
sense that all accounting systems are in monetary terms and management, of
course, is responsible for the content of financial accounting reports. Despite
this close interrelation, there are some fundamental differences between the
two and they are:

1. Subject Matter : Managements need to focus attention on internal details
is the origin of the basic differences between financial accounting and
management accounting. In financial accounting, the enterprise as a
whole is dealt with while, in management accounting, attention is
directed towards various parts of the enterprise which is regarded mainly
as a combination of these segments. Thus financial statements, like
balance-sheets and income statements, report on the overall status and
performance of the enterprise but most management accounting reports
are concerned with departments products, type of inventories, sales or
other sub-division of business entity.
2. Nature – Financial accounting is concerned almost exclusively with
historical records whereas management accounting is concerned with the
future plans and policies. Management’s interest in the past is only to the
extent that it will be of assistance in influencing company’s future. The
historical nature of financial accounting can be easily understood in the
context of the purposes for which it was designed but management
accounting does not end with the analysis of what has happened in the
past and extends to the provision of information for use in improving
results in future.
3. Dispatch – In Management Accounting, there is more emphasis on
furnishing information quickly then is the case with financial accounting.
This is so because up-to-date information is absolutely essential as a
basis for management action and management accounting would lose
much of its utility if information required the time lag between the end of
accounting period and the preparation of accounting records for the
same, it has not been, and cannot be, totally eliminated.
4. Characteristics – Financial accounting places great stress on those
qualities in information which can command universal confidence, like
objectivity, validity absoluteness, etc. whereas management accounting
emphasizes those characteristics which enhance the value of information



in a variety of uses, like flexibility, comparability etc. This difference is so
important that a serious doubt has been raised as to whether both the
types of characteristics can be preserved within the same framework.
5. Type of Data Used Financial accounting makes use of data which is
historical quantitative, monetary and objective, on the other hand
management accounting used data which is descriptive, statistical
subjective and relates to future. Therefore management accounting is not
restricted, as financial accounting is, to the presentation of data that can
be certified by independent auditors.
6. Precision – There is less emphasis in precision in management accounting
because approximations are often as useful as figures worked out
accurately.
7. Outside Dictates – As financial accounting ahs been assigned the role of a
reference safeguarding the interests of different parties connected with
the operation of a modern business undertaking, outside agencies have
laid down standards for ensuring the integrity of information processed
and presented in financial accounting statements. Consequently, financial
accounting statements are standardized and are meant for external use.
So, far as management accounting is concerned, there is no need for
clamping down such standards for the preparation and presentation of
accounting statements as management is both the initiator and user of
data. Naturally, therefore, management accounting can be smoothly
adapted to the changing needs of management.
8. Element of compulsion – These days, for every business, financial
accounting has become more or less compulsory indirectly if not directly,
due to a number of factors but a business is free to install, or not to
install, a system of management accounting.



LESSON – 3
FUNCTIONS OF FINANCIAL CONTROLLER

The gradual growth of management accounting has brought with it a
recognition of the desirability of segregating the accounting function from
other activities of a secretarial and financial nature in order to make possible a
more accurate accounting control over multifarious, complex and sprawling
business operations. As a natural corollary, controller has come into being by
way of a skilled business analyst who, due to his training and experience, is the
best qualified to keep the financial records of the business and to interpret
these for the guidance of the management.

It is not surprising, therefore, that controllership function has developed pari
passu with the development of management accounting so much so that there
is a tendency to record the two as synonymous. In a way, this is true because
of controller in the United States does all that management accounting is
expected to accomplish, in fact, controller is the pivot round which system of
management accounting revolves.

Generally speaking, controllership function embraces within its broad sweep
and wide curves, all accounting functions including advice to management on
course of action to be taken in a given set of circumstances with the object of
completely eliminating the role of intuition in business affairs.

Concept:

There is no precise concept of controllership as it is still in an evolutionary state.
Even if the concept was possible of being described, it cannot be said that,
wherever a controller is in existence, he exercises all the functions that a
theoretical controller is expected to do because the real meaning of the term is
dependent upon the agreement between him and the undertaking the seeks to
serve. However, the controllers’ Institute of America has drafted a seven-point
concept of modern controllership. The hallmarks of the concept are:

i. To establish, coordinate and administer, as an integral part of
management, an adequate plan for the control of operations. Such a plan
would provide, to the extent required in the business, for profit planning,
programs for capital investing and financing, sales forecast, expense



budgets and cost standards, together with the necessary procedure to
effectuate the plan.
ii. To compare performance with operating plans and standards and to
report and interpret the results of operations to all levels of management
and to the owners of business. This function includes the formulation and
administration of accounting policy and the compilation of statistical
records and special reports as required.
iii. To consult with all segments of management responsible for policy or
action concerning any phase of the operations of business as it relates to
the attainment of objectives and the effectiveness of policies,
organization structure and procedures.
iv. To administer tax policies and procedures.
v. To supervise and coordinate the preparation of reports to governmental
agencies.
vi. To assure fiscal protection to the assets of the business through
adequate internal control and proper insurance coverage.
vii. To continuously appraise economic and social forces and government
influences and interpret their effect on business.

The controllers’ Institute, as well as the National Industrial conference Board of
the United States, have spelt out the functions of the controller in still greater
detail but the seven-point concept of modern controllership is board enough to
leave no phase of policy or organization beyond the controller’s jurisdiction.
Through the concept has been laid down mainly from the functional point of
view, it lifts the notion of controllership from pedestrian paper-shuffling to a
top-management attitude that aids decision – making, it broadens controller’s
outlook and provides him with specific goals.

Status of Controller:
There is no fixed place for the controller in the hierarchy of management. It is
sometimes said that the status of controller is not ensured simply by virtue of
his holding the office but depends, in no small measure, upon hi personality,
mental equipment, industrial background and his capacity to convince others of
his ability as well as integrity. Moreover, it would depend upon the terms of his
appointment and, therefore, it is bound to vary with every individual
undertaking. The terms of appointment may be fixed by the Board of Directors
or may be included in the Articles of Association of the Company.



As a matter of general principle, all accounting functions, even though remotely
connected with finance, are included in the responsibilities of the controller. As
the chief accounting authority, the controller normally has his place in the
top-level management along with the Treasurer who looks after bank accounts
and the safe custody of liquid assets. Usually, the elevation of Controller to the
post of Vice-President Finance in taken for granted and is considered only a
routine matter.

Modern Controller does not do any controlling, as is commonly understood, in
terms of line authority over other departments, his decision regarding the best
accounting procedures to be followed by line people are transmitted to the
Chief Executive who communicates them by a manual of instructions coming
down through line chain of command to all people affected by the procedures.

Limitation:
It is also necessary that the limitation of Controller’s role imposed by the very
nature of his work, must be borne in mind. Though the Controller helps in
bringing together all phases of management, he does not pretend to solve the
problems of production of marketing, he knows their nature and so can discuss
in detail with all levels of management the financial implications of solutions
they suggest.



LESSON – 4
FINANCIAL STATEMENTS:
According to the American Institute of Certified Public Accountants, “Financial
statements reflect a combination of recorded facts accounting conventions and
personal judgements and the judgements and conventions applied affect them
materially.” This statement makes clear that the accounting information as
depicted by the financial statements are influenced by three factors viz.
recorded facts, accounting conventions and personal judgements.

OBJECTIVES OF FINANCIAL STATEMENTS:
1. To provide reliable information about economic resources and
obligations of a business and other needed information about changes in
such resources or obligations.
2. To provide reliable information about changes in net resource [resources
less obligations] arising out of business activities and financial
information that assits in estimating the earning potentials of business.
3. To disclose to the extent possible, other information related to the
financial statements that is relevant to the needs of the users of these
statements.

USES AND USERS OF FINANCIAL STATEMENTS:
Different classes of people are interested in the financial statement analysis
with a view to assessing the economic and financial position of any business or
industrial concern in terms of profitability, liquidity or solvency. Such persons
and bodies include:

1. Shareholders
2. Debenture-holders
3. Creditors
4. Financial institutions and commercial banks
5. Prospective investors
6. Employees and trade unions
7. Tax authorities
8. Govt. departments
9. The company law board



10. Economists and investment analysis, etc.

IMPORTANCE OF FINANCIAL STATEMENTS

IMPORTANCE TO MANAGEMENT:
Financial statements help the management to understand the position,
progress and prospects of business results. By providing the management with
the causes of business results, they enable them to formulate appropriate
policies and courses of actions for the future. The management communicate
only through these financial statements their performance to various parties
and justify their activities and thereby their existence.

IMPORTANCE TO THE SHAREHOLDERS
These statements enable the shareholders to know about the efficiency and
effectiveness of the management and also the earning capacity and the
financial strength of the company.

IMPORTANCE TO LENDERS/CREDITORS:
The financial statements serve as a useful guide for the present suppliers and
probable lenders of a company. It is through a critical examination of the
financial statements that these groups can come to know about the liquidity
profitability and long-term solvency position of a company. This would help
them to decide about their future course of action.

IMPORTANCE TO LABOUR:
Workers are entitled to bonus depending upon the size of profit as disclosed by
audited profit and loss account. Thus, P & L a/c becomes greatly important to
the workers in wage negotiations also the size of profits and profitability
achieved are greatly relevant.

IMPORTANCE TO PUBLIC:
Business is a social entity. Various groups of the society, though not directly
connected with business, are interested in knowing the position, progress and
prospects of a business enterprise. They are financial analysts, lawyers, trade
associations, trade unions, financial press research scholars, and teachers, etc.



Importance of National Economy: The rise & growth of the corporate sector, to
a great extent, influences the economic progress of a country. Unscrupulous &
fraudulent corporate managements shatters the confidence of the general
public in joint stock companies which is essential for economic progress &
retard economic growth of the country. Financial Statements come to rescue of
general public by providing information by which they can examine & asses the
real worth of the company & avoid being cheated by unscrupulous persons.

Limitations of Financial Statements:

1. It shows only historical cost.
2. It does not take into account the price level changes.
3. It considers only monetary aspects but does not consider some vital
non-monetary factors.
4. It is based on convention and judgement. Hence there is no accuracy.
5. Comparison of Financial Statements depends upon the uniformity of
Accounting policies.
6. It is subject to window dressing.



LESSON – 5
ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS

Financial Statement are indicators of the two significant factors:

(i) Profitability, and (ii) Financial soundness

Analysis and interpretation of financial statements, therefore, refer to such a
treatment of the information contained in the income statement and the
Balance Sheet so as to afford full diagnosis of the profitability and financial
soundless of the business.

TYPES OF FINANCIAL ANALYSIS
Financial Analysis can be classified into different categories depending upon

(i) The materials used and (ii) The modus operandi of analysis

ON THE BASIS OF MATERIAL USED: According to this basis financial analysis
can be of two types.

(i) External Analysis: This analysis is done by those who are outsiders for the
business. The term outsiders includes investors, credit agencies, government
and other creditors who have no access to the internal records of the company.

(ii) Internal Analysis: This analysis is done by persons who have access to the
books of account and other information related to the business.

On the basis of modus operandi. According to this, financial analysis can also
be two types.

(i) Horizontal analysis: In case of this type of analysis, financial statements for
a number of years are reviewed and analyzed. The current year’s figures are
compared with the standard or base year. The analysis statement usually
contains figures for two or more years and the changes are shown recording
each item from the base year usually in the from of percentage. Such an



analysis gives the management considerable insight into levels and areas of
strength and weakness. Since this type of analysis is based on the data from
year to year rather than on the date, it is also termed as Dynamic Analysis.

(ii) Vertical analysis: In case of this type of analysis a study is made of the
quantitative relationship of the various terms in the financial statements on a
particular date. For example, the ratios of different items of costs for a
particular period may be calculated with the sales for that period such an
analysis is useful in comparing the performance of several companies in the
same group, or divisions or departments in the same company.

TECHNIQUES OF FINANCIAL ANALYSIS

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

1. Comparative Financial Statements: Comparative financial statements are
those statements which have been designed in a way so as to provide
time perspective to the consideration of various elements of financial
position embodied in such statements. In these statements figures for
two or more periods are placed side by side to facilitate comparison.
Both the income statement and Balance Sheet can be prepared in the
form of Comparative Financial Statements.

Comparative Income Statement: The Income statement discloses net profit or
Net Loss on account of operations. A comparative Income Statement will show
the absolute figures for two or more periods, the absolute change from one
period to another and if desired the change in terms of percentages. Since, the
figures for two or more period are shown side by side, the reader can quickly
ascertain whether sales have increased or decreased, whether cost of sales has
increased or decreased etc. Thus, only a reading of data included in
Comparative Income Statements will be helpful in deriving meaningful
conclusions.

Comparative Balance Sheet: Comparative Balance Sheet as on two or more
different dates can be used for comparing assets and liabilities and finding out



any increase or decrease in those items. Thus, while in a single Balance Sheet
the emphasis is on persent position, it is on change in the comparative Balance
Sheet. Such a Balance sheet is very useful in studying the trends in an
enterprise.

The preparation of comparative financial statements can be well understood
with the help of the following illustration.

ILLUSTRATION : From the following Profit and Loss Accounts and the Balance
Sheet of Swadeshi polytex Ltd. For the year ended 31st December, 1987 and
1988, you are required to prepare a comparative Income Statement and
Comparative Balance Sheet.

PROFIT AND LOSS ACCOUNT
(In Lakhs of Rs.)
Particular 1987 1988 *Assets 1987 1988
Rs. Rs. Rs. Rs.
To Cost of Goods sold 600 750 By Net 800 1,000
Sales
To operating Expenses
Administrative Expenses 20 20
Selling Expenses 30 40
To Net Profit 150 190
800 1,000 800 1,000



BALANCE SHEET AS ON 31ST DECEMBER
(In Lakhs of Rs.)
Liabilities 1987 1988 Assets 1987 1988
Rs. Rs. Rs. Rs.
Bills Payable 50 75 Cash 100 140

Sundry 150 200 Debtors 200 300
Creditors

Tax Payable 6% 100 150 Stock 200 300
Debentures 6% 100 150 Land 100 100
Preference 300 300 Building 300 270
Capital

Equity Capital 400 400 Plant 300 270

Reserves 200 245 Furniture 100 140
1300 1520 1300 1520



SOLUTION:
Swadeshi Polytex Limited
COMPARATIVE INCOME STATEMENT
FOR THE YEARS ENDED 31ST DECEMBER AND 1988
(In Lakhs of Rs.)
Absolute Percentage
increase or increase or
decrease in decrease in
1988 1988
1987 1988
Net Sales 800 1000 +200 +25
Cost of Goods 600 750 +150 +25
Sold
Gross Profit 200 350 +50 +25
Operating 20 20 - -
Expenses
Administration
Expenses
Selling 30 40 +10 +33.33
Expenses
Total 50 60 10 +20
Operating
Expenses
Operating 150 190 +40 +26.67
Profit



COMPARATIVE BALANCE SHEET
AS ON 31ST DECEMBER, 1987, 1988
Figures in lakhs of rupees
Assets 1987 1988 Absolute Percentage
increase or increase (+)
decrease or decrease
during 1988 (-) during
1988
Current Assets:
Cash 100 140 40 +40
Debtors 200 300 100 +50
Stock 200 300 100 +50
Total Current 500 740 240 +50
Assets
Fixed Assets:
Land 100 100 - -
Building 300 270 -30 -10%
Plant 300 270 -30 -10%
Furniture 100 140 +40 +40%
Total Fixed Assets 800 780 -20 -2.5%
Total Assets 1300 1520 220 +17%



Liabilities &
Capital:
Current Liabilities
Bills Payable 50 75 +25 +50%
Sundry Creditors 150 200 +50 +33.33%
Tax Payable 100 150 +50 +50%
Total Current 300 425 +125 +41.66%
Liabilities
Long-term 100 150 +50 +50%
Liabilities : 6%
Debentures
Total Liabilities 400 575 +175 +43.75%
Capital & Reserves
6% Pre. Capital 300 300 - -
Equity Capital 400 400 - -
Reserves 200 245 45 22.5
Total Shareholders’ 900 945 45 5%
Funds
Total Liabilities and 1300 1520 220 17%
Capital

2. Common – size Financial Statements: Common – size Financial
Statements are those in which figures reported are converted into
percentages to some common base. In the Income Statement that sale
figure is assumed to be 100 and all figures are expressed as a percentage
of this total.

Illustration: Prepare a Common – size Income Statement & Common-size
Balance Sheet of Swadeshi Polytex Ltd., for the years ended 31st December,
1987 & 1988

SOLUTION:
COMMON – SIZE INCOME STATEMENT



FOR THE YEARS ENDED 31ST DECEMBER 1987 AND 1988
(Figures in Percentage)
1987 1988
Net Sales 100 100
Cost of Goods Sold 75 75
Gross Profit 25 25
Opening Expenses:
Administration Expenses 2.50 2
Selling Expenses 3.75 4
Total Operating 6.25 6
Expenses
Operating Profit 18.75 19

Interpretation: The above statement shows that though in absolute terms, the
cost of goods sold has gone up, the percentage of its cost to sales remains
constant at 75%, this is the reason why the Gross Profit continues at 25% of
sales. Similarly, in absolute terms the amount of administration expenses
remains the same but as a percentage to sales it has come down by 5%. Selling
expenses have increased by 25%. This all leads to net increase in net profit by
25% (i.e., from 18.75% to 19%)



3. Trend Percentage: Trend Percentages are immensely helpful in making a
comparative study of the Financial statements for several years. The
method of calculating trend percentages involves the calculation of
percentage relationship that each item bears to the same item in the base
year. Any year may be taken as base year. It is usually the earliest year.
Any intervening year may also be taken as the base year. Each item of
base year is taken as 100 and on that basis the percentages for each of
the years are calculated. These percentages can also be taken as Index
Numbers showing relative changes in the financial data resulting with the
passage of time.
The method of trend percentages is useful analytical device for the
management since by substitution percentages for large amounts, the
brevity and readability are achieved. However, trend percentages are not
calculated for all of the items in the financial statements. They are usually
calculated only for major items since the purpose is to highlight
important changes.
Besides, Fund flow Analysis, Cash Flow Analysis and Ratio Analysis are
the other tools of Financial Analysis which have been discussed in detail
as separate chapters.



LESSON – 6
RATIO ANALYSIS

Meaning and Nature of ratio analysis

The term “ratio” simply means one number expressed in terms of another. It
describes in mathematical terms the quantitative relationship that exists
between two numbers, the terms “accounting ratio”. J. Batty points out, is used
to describe significant relationships between figures shown on a Balance Sheet,
in a Profit and Loss Account, in a Budgetary control System or in any other Part
of the accounting organisation. Ratio Analysis, simply defined, refers to the
analysis and interpretation of financial statements through ratios. Nowadays it
is used by all business and industrial concerns in their financial analysis. Ratio
are considered to be the best guides for the efficient execution of basic
managerial functions like planning, forecasting, control etc.

Ratios are designed to show how one number is related to another. It is worked
out by dividing one number by another. Ratios are customarily presented either
in the form of a coefficient or a percentage or as a proportion. For example, the
current Assets and current Liabilities of a business on a particular date are Rs.
2.5 Lakhs and Rs. 1.25 lakhs respectively. The resulting ratio of current Assets
and current Liabilities could be expressed as (i.e. Rs. 2,00,000/1,25,000) or as
200 per cent. Alternatively in the form of a proportion the same ratio may be
expressed as 2:1, i.e. the current assets are two times the current liabilities.

Ratios are invaluable aids to management and others who are interested in the
analysis and interpretation of financial statements. Absolute figures may be
misleading unless compared, one with another. Ratios provide the means of
showing the relationship which exists between figures. Though there is no
special magic in ratio analysis, many prefer to base conclusions on ratios as
they find them highly useful for making judgments more easily. However, the
numerical relationships of the kind expressed by ratio analysis are not an end
in themselves, but are a means for understanding the financial position of a
business. Generally, simple ratios or ratios compiled from a single year financial
statements of a business concern may not serve the real purpose. Hence, ratios
are to be worked out from the financial statements of a number of years.

Ratios, by themselves, are meaningless. They derive their status partly from the
ingenuity and experience of the analyst who uses the available data in a



systematic manner. Besides, in order to reach valid conclusions, ratios have to
be compared with some standards that are established with a view to represent
the financial position of the business under review. However, it should be borne
in mind that after computing the ratios one cannot categorically say whether a
particular ratio is god or bad as the conclusions may vary from business to
business. A single ideal ratio cannot be applied for all types of business. Speedy
compiling of ratios and their presentations in the appropriate manner are
essential. A complete record of ratios employed in advisable and explanation
of each, and actual ratios year by year should be included. This record may be
treated as a part of an Accounts Manual or a special Ratio Register may be
maintained.

CLASSIFICATION OF RATIOS:
Ratios can be classified into different categories depending upon the basis of
classification.

The traditional classification has been on the basis of the financial statement to
which the determinants of a ratio belong. On this basis of ratios could be
classified as:

1. Profit and loss Accounts Ratios, i.e. ratios calculated on the basis of the
items of the Profit and Loss account only e.g. Gross Profit ratio, stock
turnover ratio, etc.
2. Balance sheet ratios, i.e., ratio calculated on the basis of figures of
Balance sheet only, e.g., current ratio, debt-equity etc.
3. Composite ratios or inter-statements ratios, i.e., ratio on figures of profit
and loss account as well as the balance sheet, e.g. fixed assets turnover
ratio, overall profitability ratio etc.

However, the above basis of classification has been found to be guide and
unsuitable because analysis of Balance sheet and Balance sheet and income
statement can not be done in insalaion. The have to be studied together in
order to determine the profitability and solvency of the business. In order that
ratios serve as a toll for financial analysis, they are now classified as:

(1) Profitability Ratios, (2) Coverage Ratios, (3) Turn-over Ratios, (4) Financial
ratios, (a) Liquidity Ratios (b) Stability Ratios.



LESSON – 7

PROFITABILITY RATIOS:
Profitability is an indication of the efficiency with which the operations of the
business are carried on. Poor operational performance may indicate poor sales
and hence poor profits. A lower profitability may arise due to the lack of control
over the expenses. Bankers, financial institutions and other creditors look at the
profitability ratios indicator whether or not the firm earns substantially more
than it pays interest for the use of borrowed funds and whether the ultimate
repayment of their debt appears reasonably certain. Owners are interested to
know the profitability as it indicates the return which they can on their
investments. The following are the important profitability ratios:

1. OVERALL PROFITABILITY RATIOS:
It is also called “Return on investment” (ROI) or Return On Capital Employed
(ROCE) it indicates the percentage of return on the total capital employed in the
business. It is calculated on the basis of the following formula.

Operation Profit x 100
-------------------------------
Capital employed

The term capital employed has been given different meanings by different
accountants. Some of the popular meanings are as follows:

i) Sum-total of all assets whether fixed or current
ii) Sum-total of fixed assets
iii) Sum-total of long-term funds employed in the business, i.e.,

Share capital + Reserves & Surplus + Long Term loans + Non business assets +
Fictitious assets.

In Management accounting, the term capital employed is generally used in the
meaning given in the third point above.



The term “Operating profit” means “Profit before Interest & Tax.” The term
“Interested” means “Interested on long term borrowing”. Interest on short –
term borrowings will be deducted for computing operating profit. Non-term
borrowing will be deducted for computing operating profit. Non-trading
incomes such as interested on Government securities or non-trading losses or
expenses such as loss on account of fire, etc., will also be excluded.

2. Return on Shareholders “Funds”: In case it is desired to work out the
profitability of the company from the shareholders point of view, it
should be computed as follows:

Net Profit after interest & tax
---------------------------------------- x 100
Shareholders’ Funds

The term Net Profit here means “Net Incomes after Interest & Tax” It is different
from the “Net Operating Profit” Which is used for computing the “Return on
Total Capital Employed” in the business. This because the shareholders are
interested in Total Income after Tax including Net Non-operating Income (i.e.,
Non-operating Income – Non-operating Expenses)

3. Fixed dividend Cover: This ratio is important for preference shareholders
entitled to get dividend at a fixed rate in priority to other shareholders.
The ratio is calculated as follows:

Net Profit after Interest & tax
Fixed dividend cover =
-------------------------------------------------
Preference dividend

4. Debt service coverage ratio: The interest coverage ratio, as explained
above, does not tell us anything about the ability of a company to make
payment of principle amounts also on time. For this purpose debt service
coverage ratio is calculated as follows:
Net Profit before interest & tax
Debt service coverage ratio =
---------------------------------------------------
Principal Payment Instalment



Interest +
-----------------------------------------
1 – (Tax rate)

The principle payment instalment is adjusted for tax effects since such payment
is not deductible from net profit for tax purposes.
Net Profit Before Interest & Tax
5. Interest Coverage Ratio =
-------------------------------------------------------
Interest Charges

Gross Profit
6. Gross Profit Ratio =
------------------------------------------------- x 100
Net Sales

Net Profit
7. Net Profit Ratio =
------------------------------------------------ x 100
Net Sales

Operating Profit
Operating Profit Ratio =
-------------------------------------------- x 100
Net Sales

Operating Profit = Net Profit + Non-Operating expenses – Non – operating
income

Operating Cost
9. Operating Ratio = --------------------------------- x 100
Net Sales

Amount available to Equity Shareholders



10. Earnings Per Share (EPS) =
------------------------------------------------------------
Number of Equity Shares

Market Price per Share
11. Price – Earnings (P/E) Ratio =
-------------------------------------------
Earning Per Share



LESSON – 8

1. Fixed assets turnover ratio : This ratio indicates the extent to which the
investments in fixed assets contribute towards sales. If compares with a
previous period, it indicates whether the investment in fixed assets has
been judicious or not. The ratio is calculated as follows:

Net Sales
---------------------------------
Fixed Assets (NET)

2. Working Capital Turnover Ratio: This is also known as Working Capital
Leverage Ratio. This ratio indicates whether or net working capital has
been utilized in making sales. In case a company can achieve higher
volume of sales with relatively small amount of working capital, it is an
indication of the operating efficiency of the company. The ratio is
calculated as follows.

Net Sales
----------------------------------
Working Capital

Working capital turnover ratio may take different forms for different purposes.
Some of them are being explained below:

(i) Debtors” turnover ratio (Debtors, Velocity): Debtors constitute an
important constituent of current assets and therefore the quality of debtors to a
great extent determines a firm’s liquidity. Two ratios are used by financial
analysis to judge the liquidity of a firm. They are (i) Debtor’s turnover ratio, and
(ii) Debt collection period ratio.

The Debtor’s turnover ratio is calculated as under:
Credit sales
---------------------------------------------
Average accounts receivable

The term Accounts Receivable include “Trade Debtors” and Bill Receivable”.



In case details regarding and closing receivable and credit sales are not
available the ratio may be calculated as follows:

Total Sales
---------------------------------------------
Accounts Receivable

Significance: Sales to Accounts Receivable Ratio indicates the efficiency of the
staff entrusted with collection of book debts. The higher the ratio, the better it
is, Since it Would indicate that debts are being collected more promptly. For
measuring the efficiency, it is necessary to set up a standard figure, a ratio
lower then the standard will indicate inefficiency.

The ratio helps in Cash Budgeting, since the flow of cash form customers can
be worked out on the basis of sales.

(ii) Debt collection Period ratio: The ratio indicates the extent to which the
debts have been collected in time. It gives the average debt collection period.
The ratio is very helpful to the lenders because it explains to them whether
their borrowers are collecting money within a reasonable time. An increase in
the period will result in greater blockage of funds in debtors. The ratio may be
calculated by any of the following methods.

Months (or days) in a year
(a)
----------------------------------------------------
Debtors’ turnover

Average Accounts Receivable x Months (or days) in a year
(b)
-------------------------------------------------------------------
-------------------
Credit sales for the year

Accounts receivable
(c)
-------------------------------------------------------------------



Average monthly or daily credit sales

In fact, the two ratios are interrelated Debtor’s turnover ratio can be obtained
by dividing the months (or days)

In a YEAR by the average collection period (e.g., 12/2-6). Similarly Where the
number of months (or days) in a year are divided by the debtors turnover,
average debt collection period is obtained (i.e., 12/6 – 2 months)

Significance: Debtors’ collection period measures the quality of debtors since it
measures the rapidity or slowness with which money is collected from them. A
short collection period implied prompt payment by debtors. It reduces the
chances of bad debts.

A longer collection period implies too liberal and inefficient credit collection
performance. However, in order to measure a firm’s credit and collection
efficiency its average collection period should be compared with the average of
the industry. It should be neither too liberal nor too restrictive. A restrictive
policy will result in lower sales which will reduce profits.

It is difficult to provide a standard collection period of debtors. It depends upon
the nature of the industry, seasonable character of the business and credit
policies of the firm. In general, the amount of receivables should not exceed a
3-4 months’ credit sales.

(iii) Creditors’ turnover ratio (Creditors’ velocity): It is similar to debtors
‘Turnover Ratio. It indicates the speed with which the payment for credit
purchases are made to the creditors. The ratio can be computed as follows:

Credit Purchases
-------------------------------------------
Average accounts payable

The term Accounts payable include “Trade Creditors” and “Bills payable”

In case the details regarding credit purchases, opening closing accounts
payable have not been given, the ratio may be calculated as follows:



Total Purchases
----------------------------------
Account Payable

(iv) Debt payment period enjoyed ratio (Average age of payable):

The ratio give the average credit period enjoyed from the creditors. It can be
computed by any one of the following methods:
Month’s or days in a year
(a)
---------------------------------------------------
Creditors’ turnover

Average accounts payable x Months (or days) in a year
(b)
-------------------------------------------------------------------
---------------------
Credit purchases in the year

Average accounts payable
(c)
--------------------------------------------------------------
-----------
Average monthly (or daily) credit purchases

Significance: Both the creditors turnover ratio and the debt payment period
enjoyed ratio indicate about the promptness or otherwise in making payment of
credit purchases. A higher “creditors turnover ratio” or a “lower credit period
enjoyed ratio”. Signifies that the creditors are being paid promptly, thus
enhancing the credit worthiness of company. However, a very favourable ratio
to this effects also shows that the business is not taking full advantage of credit
facilities which can be allowed by the creditors.

Stock Turnover Ratio: This ratio indicate whether investments in inventory is
efficiently used or not. It therefore, explains whether investment in inventories
is within proper limits or not. The ratio is calculated as follows:



Cost of goods sold during the year
------------------------------------------------------
Average inventory

Average inventory is calculated by taking stock levels of raw materials work – in
– process, finished goods at the end of each months, adding them up and
dividing by twelve.

Inventory ratio can be calculated regarding each constituent of inventory. It may
thus be calculated regarding raw materials, Work in progress & finished goods.
Cost of goods sold
1*
--------------------------------------------------
Average stock of finished goods

Materials consumed
2** ----------------------------------------------
Average stock of raw materials

Cost of completed work
3*** ------------------------------------------
Average work in progress

The method discussed above is as a matter of fact the best basis for computing
the stock Turnover Ratio. However, in the absence of complete information, the
inventory Turnover Ratio may also be computed on the following basis.

Net sales
-------------------------------------------------
Average inventory at selling Prices

The average inventory may also be calculated on the basis of the average of
inventory at the beginning and at the end of the accounting period.



Inventory at the beginning of the accounting period +
Inventory at the end of the accounting period
Average Inventory =
-------------------------------------------------------------------
-------------------
2

Significance: As already stated, the inventory turnover ratio signifies the
liquidity of the inventory. A high inventory turnover ratio indicates brisk sales.
The ratio is, therefore, a measure to discover the possible trouble in the form of
overstocking or overvaluation. The stock position is known as the graveyard of
the balance sheet. If the sales are quick such as a position would not arise
unless the stocks consists of unsalable items. A low inventory turnover ratio
results in blocking of funds in inventory becoming obsolete or deteriorating in
quality.

It is difficult to establish a standard ratio of inventory because it will differ from
industry. However, the following general guidelines can be given.

(i) The raw materials should not exceed 2-4 months’ consumption of the year.
(ii) The finished goods should not exceed 2-3 months’ sales
(iii) Work in progress should not exceed 15-30 days’ cost of sales.

PRECAUTIONS: While using the Inventory Ratio, care must be taken regarding
the following factors:

(i) Seasonable conditions: If the balance sheet is prepared at the time of slack
season, the average inventory will be much less (if calculated on the basis of
inventory at the beginning of the accounting period & inventory at close of the
accounting period). This may give a very high turnover ratio.

(ii) Supply conditions: In case of conditions of security inventory may have to
be kept in high quality for meeting the future requirements.



(iii) Price trends: In case of possibility of a rise in prices, a large inventory may
be kept by business. Reverse will be the case if there is a possibility of fall in
prices.

(iv) Trend of volume of business: In case there is a trend of sales being
sufficiently higher than sales in the past, a higher amount of inventory may be
kept.



LESSON – 9

FINANCIAL RATIOS
Financial Ratios indicate about the financial position of the company.
Accompany is deemed to be financially sound if it is in a position to carry on its
business smoothly and meetits obligions, both short – term as well as longterm,
without strain. It is a sound principle of finance that the short-term
requirements of funds should be met out of short term funds and long-term
requirements should be met out of long-term funds. For example if the
payment for raw materials purchases are made through the issue debentures it
will create a permanent interest burden on the enterprise. Similarly, if fixed
assets are purchased out of funds provide by bank overdraft, the firm will come
to grief because such assets cannot be sold away when payment will be
demanded by the bank.

Financial ratios can be divided into two broad categories:

(1) Liquidity Ratios & (2) Stability Ratios

(1) LIQUIDITY RATIOS: These ratios are termed as “working capital” or
“short-term solvency ratios”. As enterprise must have adequate working-capital
to run its day-to-day operations. Inadequacy of working capital may bring the
entire business operation to a grinding halt because of inability of enterprise to
pay for wages, materials & other regular expenses.

CURRENT RATIOS: This ratio is an indicator of the firm’s commitment to meet
its short-term liabilities. It is expressed as follows:

Current assets
-----------------------------
Current Liabilities

Current assets mean assets that will either be used up or converted into cash
within a year’s of time or normal operating cycle of the business, whichever is
longer. Current liabilities means liabilities payable within a year or operating
cycle, whichever is longer, out of existing current assets or by creation of
current liabilities. A list of items include in current assets & current liabilities



has already been given in the performs analysis balance sheet in the preceding
chapter.

Book debts outstanding for more than six months & loose tools should not be
included in current assets. Prepaid expenses should be taken as current assets.

An ideal current ratio is 2. The ratio of 2 is considered as a safe margin of
solvency due to the fact that if the current assets are reduced to half, i.e., 1
instead of 2, then also the creditors will be able to get their payments in full.
However a business having seasonal trading activity may show a lower current
ratio at a creation period of the year. A very high current ratio is also not
desirable since it means less efficient use of funds. This is because a high
current ratio means excessive dependence on long-term sources of raising
funds. Long-term liabilities are costlier than current liabilities & therefore, this
will result in considerably lowering down the profitability of the concern.

It is to be noted that the mere fact current ratio is quite high does not mean
that the company will be in position to meet adequately its short-term liabilities.
In fact, the current ratio should be seen in relation to the component of current
assets & liquidity. If a large portion of the current assets comprise obsolete
stocks or debtors outstanding for a long term, time, the company may fail even
if the current ratio is higher then 2.

The current ratio can also be manipulated very easily. This may be done either
by either postponing certain pressing payments or postponing purchase of
inventories or making payment of certain current liabilities.

Significance: The current ratio is an index of the concern’s Financial stability
since it shows the extent of working capital which is the amount by which the
current assets exceed the current liabilities. As stated earlier, a higher current
ratio would indicate inadequate employment of funds while a poor current ratio
is a danger signal to the management. It shows that business is trading beyond
its resources.

(II) QUICK RATIO: This ratio is also termed as “acid test ratio” or “liquidity ratio”.
This ratio is ascertained by comparing the liquid assets (i.e., assets which are
immediately convertible into cash without much loss) to current liabilities
prepaid expenses and stock are not taken as liquid assets. The ratio may be
expressed as:



Liquid assets
---------------------------
Current liabilities

Some accountants prefer the term “Liquid Liabilities” for “Current Liabilities” or
the purpose of ascertaining this ratio. Liquid liabilities means liabilities which
are payable within a short period. The bank over-draft (if it becomes a
permenant mode of financing) & cash credit faculties will be excluded from
current liabilities in such a case.

The ideal ratio is 1.

This ratio is also an indicator of short-term solvency of the company.

A comparison of the current ratio to quick ratio shall indicate the inventory
hold-ups. For example if two units have the same current ratio but different
liquidity ratio, it indicates over-stocking by the concern having low liquidity
ratio as compared to the concern which has a higher liquidity ratio.

Thus, debtors are excluded from liquid assets for the purpose of comparing
super – quick ratio. Current liabilities & liquid liabilities have the same meaning
as explained above. The ratio is the more measure of firms’ liquidity position.
However, it is not widely used in practice.

STABILITY RATIO: These ratios help in ascertaining long term solvency of a firm
which depends basically on three factors:

(i) Whether the firm has adequate resources to meet its long term funds
requirements.

(ii) Whether the firm has used an appropriate debt-equity mix to raise
long-term funds.

(iii) Whether the firm earns enough to pay interest & instalment of long-term
loans in time.



The capacity of the firm to meet the last requirement can be ascertained by
computing the various coverage ratios, already explained in the preceding
pages. For the other two requirements, the following ratios can be calculated.

(1) FIXED ASSETS RATIO: This ratio explains whether the firm has raised
adequate long-term funds to meet its fixed assets requirements. It is expressed
as follows:

Fixed assets
---------------------------
Long – Term funds

The ratio should not be more than 1. If it is less than 1, it shows that a part of
the working capital has been financed through long-term funds. This is
desiarable to some extent because a part of working capital termed as “Core
Working Capital” is more or less is a fixed nature. The ideal ratio is 67.

(ii) CAPITAL STRUCTURE RATIOS: These ratios explains how the capital
structure of firm is made up or the debt-equity mix adopted by the firm. The
following ratios fall in the category.

(a) Capital Gearing Ratio: Capital gearing (or leverage) refers to the proportion
between fixed interest or dividend bearing funds & non-fixed interest or
dividend bearing funds in the total capacity employed in the business. The
fixed interest or dividend bearing funds include the funds provided by the
debenture holders & preference shareholders. Non-fixed interest or dividend
bearing funds are the funds provided by the equity shareholders. The amount,
therefore, includes the Equity Share Capital & other Reserves. A proper
proportion between the two funds is necessary in order to keep the cost of
capital at the minimum.

The capital gearing ratio can be ascertained as follows:

Funds bearing fixed interest or fixed dividend
-------------------------------------------------------------------
-
Equity Shareholder’s Funds



(b) DEBT-EQUITY RATIO: The debt-equity ratio is determined to ascertain the
soundness of the long-term financial position of the company. It is also known
as “External – Internal” equity ratio.

Total long-term debt
Debt – Equity Ratio = ------------------------------------------
Shareholder’s funds

Significance: The ratio indicates the preparation of owners’ stake in the
business. Excessive liabilities tend to cause insolvency. The ratio indicates the
extent to which the firm depends upon outsiders for its existence. The ratio
provides a margin of safety to the creditors. It tells the owners the extent to
which they can gain the benefits or maintain control with a limited investment.

(c) Proprietary ratio : It is a variant of debt-equity ratio. It establishes
relationship between the proprietor’s funds & the total tangible assets. It may
be expressed as:

Shareholder’s funds
= --------------------------------
Total tangible assets

Significance: This ratio focuses the attention on the general financial strength
of the business enterprise. The ratio is of particular importance to the creditors
who can find out the proportion of shareholders funds in the total assets
employed in the business. A high proprietary ratio will indicate a relatively little
danger to the creditor’s etc., in the event of forced reorganization or winding
up of the company. A low proprietary ratio indicates greater risk to the
creditors since in the event of losses a part of their money may be lost besides
loss to the properties of the business. The higher the rate, the better it is. A
ratio below 50 percent may be alarming for the creditors since they may have to
lose heavily in the event of company’s liquidation on account of heavy losses.

ADVANTAGES OF RATIO ANALYSIS

Following are some of the advantages of ratio analysis:



1. Simplifies financial statements: Ratio Analysis simplified the
comprehension of financial statements. Ratios tell the whole story of
changes the financial condition of the business.
2. Facilitates inter-firm comparison: Ratio Analysis provides date for
inter-firm comparison. Ratios highlight the factors associated with
successful & unsuccessful firms. They also reveal strong firms & weak
firms, over-valued & under valued firms.
3. Makes intra-firm comparision possible: Ratio Analysis also makes
possible comparision of the performance of the different divisions of the
firm. The ratios are helpful in deciding about their efficiency or otherwise
in the past & likely performance in the future.
4. Helps in planning: Ratio Analysis helps in planning & forecasting. Over a
period of time a firm or industry develops certain norms that may
indicate future success or failure. If relationship changes in firms data
over different time periods, the ratios may provide clues on trends and
future problems.

Thus “Ratio can assist management in its basic functions of forecasting
planning coordination, control and communication”.

LIMITATIONS OF ACCOUNTING RATIOS

1. Comparative study required: Ratios are useful in judging the efficiency
of the business only when they are compared with the past results of the
business or with the results of a similar business. However, such a
comparision only provides a glimpse of the past performance and
forecasts for future may not be correct since several other factors like
market conditions, management policies, etc. may affect the future
operations.
2. Limitations of financial statements: Ratios are based only on the
information which has been recorded in the financial statements which
suffer from a number of limitations.

For example non-financial charges though important for the business are not
revealed by the financial statements. If the management of the company
changes, it may have adverse effect on the future profitability of the company
but this cannot be judged by having a glance at the financial statements of the
company.



Financial statements show only historical cost but not market value.

The comparision of one firm with another on the basis of ratio analysis without
taking into account the fact of companies having different accounting policies
will be misleading and meaningless.

3. Ratios alone are not adequate : Ratios are only indicators they cannot be
taken as final regarding good or bad financial position of the business
Other things have also to be seen.
4. Window dressing: The term window dressing means manipulations of
accounts in a way so as to conceal vital facts and present the financial
statements in a way to show a better position than what it actually is. On
account of such a situation presence of a particular ratio may not be a
definite indicator of good or bad management.
5. Problem of price level changes: Financial analysis based on accounting
ratios will give misleading results if the effects of changes in price level
are not taken into account.
6. No fixed standards: No fixed standards can be laid down for ideal ratios.
For example, current ratio is generally considered to be ideal if current
assets are twice the current liabilities. However, in case of these concerns
which have adequate arrangements with their bankers for providing
funds when they require, it may be perfectly ideal if current assets are
equal to slightly more than current liabilities.
7. Ratios area composite of many figures: Ratios are a composite of many
different figures. Some cover a time period, others are at an instant of
time while still others are only averages. A balance sheet figures shows
the balance of the account at one moment of one day. It certainly may not
be representative of typical balance during the year. It may, therefore, be
conducted that ratio analysis, if done mechanically, is not only misleading
but also dangerous.

The computation of different accounting ratios & the analysis of the financial
statements on their basis can be very well understood with the help of the
illustrations given in the following pages:

COMPUTATION OF RATIOS



Illustration 1: Following is the Profit and Loss Account and Balance Sheet of Jai
Hind Ltd., Redraft the for the purpose of analysis and calculate the following
ratios:

i. Gross Profit Ratios
ii. Overall Profitability Ratio
iii. Current Ratio
iv. Debt-Equity Ratio
v. Stock Turnover Ratios
vi. Liquidity Ratios

PROFIT AND LOSS ACCOUNT

Db. Cr.
Particulars
Opening stock of finished 1,00,000 Sales 10,00,000
goods
Opening stock of raw 50,000 Closing stock of raw 1,50,000
materials materials
Purchase of raw materials 3,00,000 Closing stock of finished 1,00,000
goods
Direct wages 2,00,000 Profit on sale of shares 50,000

Manufacturing expenses 1,00,000
Administration expenses 50,000
Selling & Distribution 50,000
expenses
Loss on sale of plant 55,000
Interest on Debentures 10,000
Net Profit 3,85,000

13,00,000 13,00,000



BALANCE SHEET
Liabilities Rs. Assets Rs.
Share Capital: Fixed Assets 2,50,000
Equity Share Capital 1,00,000 Stock of raw materials 1,50,000
Preference share capital 1,00,000
Reserves 1,00,000 Stock of finished 1,00,000
Debentures 2,00,000 Sundry debtors 1,00,000
Sundry Creditors 1,00,000 Bank Balance 50,000
Bills Payable 50,000

6,50,000 6,50,000

SOLUTION:
INCOME STATEMENT

Sales Rs.
10,00,000

Less: Cost of sales
Raw material consumed (op. Stock + Purchases 2,00,000
– Closing Stock)



Direct Wages 2,00,000
Manufacturing expenses 1,00,000
Cost of production 5,00,000
Add: Opening stock of finished goods 1,00,000
6,00,000
Less: Closing stock of finished goods. Cost of 1,00,000 5,00,000
goods sold
Gross Profit 5,00,000
Less: Operating Expenses:
Administration expenses 50,000
Selling and distribution expenses 50,000 1,00,000
Net operating profit 4,00,000
Add: Non-trading income: 50,000
Profit on sale of shares 4,50,000

Less: Non-trading expenses or losses:
Loss on sale of plant 55,000
Income before interest & tax 3,95,000
Less: Interest on debentures 10,000
Net Profit before tax 3,85,000

BALANCE SHEET (OR POSITION STATEMENT)
Rs.
Bank balance 50,000
Sundry debtors 1,00,000
Liquid assets 1,50,000
Stock of raw materials 1,50,000



Stock of finished goods 1,00,000
Current assets 4,00,000
Sundry creditors 1,00,000
Bills Payable 50,000
Current liabilities 1,50,000
Working Capital (Rs. 4,00,000 – Rs. 1,50,000) 2,50,000
Add Fixed assets 2,50,000
Capital employed 5,00,000
Less Debentures 2,00,000
Shareholders’ net worth 3,00,000
Less Preference share capital 1,00,000
Equity shareholders’ net worth 2,00,000
Equity shareholders’ net worth is represented by: 1,00,000
Equity Share capital 1,00,000
Reserves 2,00,000

Ratios:
Gross Profit x 100 50,000 x 100
(i) Gross Profit Ratio ----------------------------
-------------------------- = 50%
Sales 10,00,000

Operating Profit x 100 4,00,000 x 100
(ii) Overall Profitability Ratio = ------------------------------- =
--------------------- = 80%
Capital employed 5,00,000

Current assets 4,00,000
(iii) Current Ratio = ------------------------------- =
-------------------------- = 2.67




External equities 3,50,000
(iv)Debt Equity Ratio: = -------------------------- =
--------------------- = 1.17
Internal equities 3,00,000

(or)

Total long- term debt 2,00,000
------------------------------ =
----------------- = 0.40
Total long-term funds 5,00,000

(or)

Total long-term debt 2,0,00,000
----------------------------- =
-------------------- = 0.67
Shareholders’ funds 3,00,000

(v) Stock turnover ratio:

Cost of goods sold 5,00,000
(a) As regards average total inventory = ----------------------------
= ----------------- = 2.5
Average inventory* 2,00,000

(*) of raw materials as well as finished goods)

(b) As regards average inventory of finished goods:
Cost of goods sold 5,00,000



--------------------------------------------------
= ---------------- = 5
Average inventory of finished goods 1,00,000

(c) As regard average inventory of raw materials:

Materials consumed 2,00,000
--------------------------------------------------
= ---------------- = 2
Average inventory of materials 1,00,000

Liquid assets 1,50,000
(iv) Liquid Ratio: ------------------------- = ----------------- =
1

ILLUSTRATION 2 : Following are the ratios to the trading activities of National
Traders Ltd.

Debtor’s Velocity 3 Months
Stock Velocity 8 Months
Creditor’s Velocity 2 Months
Gross Profit Ratio 25 percent

Gross profit for the year ended 31st December, 1988 amount to Rs. 4,00,000/-
closing stock of the year is Rs. 10,000 above the opening stock. Bills receivable
amount to Rs. 25,000 and Bills payable to Rs. 10,000.

Find out: (a) Sales, (b) Sundry Debtors; (c) Closing Stock & (d) Sundry Creditors

SOLUTION :

(a) Sales:



Gross profit
Gross Profit Ratio = ------------------------- x 100
Sales

Gross profit = Rs. 4,00,000/-

4,00,000
Sales = ----------------------------- x 100 = Rs. 16,00,000
25

(b) Sundry Debtors :
Debtor’s
Debtor’s Velocity = --------------------- x 12
Sales

“Debtor’s Velocity of 3 months” Presumably means that Accounts Receivable
equal to 3 months’ Sales or ¼ of the year’s sales.
Rs.
1,60,000
Account Receivable = --------------------- x 1 4,00,000
4

Less Bills Receivable 25,000
-------------------------
Sundry Debtors 3,75,000
-------------------------

(c) Closing Stock:
Cost of goods sold



Stock Velocity =
------------------------------------------
Average stock

Cost of goods sold = Sales – Gross profit
= 16,00,000 – 4,00,000 = Rs. 12,00,000

12,00,000
Average Stock = ------------------------- x 8 = Rs. 8,00,000
12

Total of Opening and Closing stock = 8,00,000 x 2 = 16,00,000

Closing Stock is higher than Opening Stock by Rs. 10,000

16,00,000 - 10,000
Therefore, Opening Stock = ---------------------------------
2
= 7,95,000

Hence, Closing Stock = 7,95,000 + 10,000 or Rs. 8,05,000

(d) Sundry Creditor’s:

Total Creditor’s
Creditor’s Velocity i.e., = ------------------------------ x 12
Purchases

Purchases = Cost of goods sold + Closing Stock – opening Stock
= 12,00,000 + 8,05,000 – 7,95,000 = Rs. 12,10,000



Creditor’s Velocity is 2 months, it means that Account Payable are 1/6th of the
Purchases for the year

Hence Account Payable = Rs. 2,01, 667
Less : Bills Payable = 10,000
--------------------
Sundry Creditor’s Rs. 1,91,667
--------------------



LESSON – 10
FUNDS FLOW ANALYSIS

The technique of Funds Flow Analysis is widely used by the financial analyst,
credit granting institutions and financial managers in performance of their jobs.
It has become a useful tool in their analytical kit. This is because the financial
statements, i.e., “Income Statement” and the “Balance Sheet” have a limited role
to perform. Income statement measures flow restricted to transactions that
pertain to rendering of goods or services to customers. The Balance Sheet is
merely a static statement. It is a statement of assets and liabilities which does
not focus major financial transactions which have been behind the balance
sheet changes. One has to draw inferences after comparing the balance sheets
of two periods. For example, if the fixed assets worth Rs. 2,00,000 are
purchased during the current year by raising share capital of Rs. 2,00,000 the
balance sheet will simply show a higher capital figure and higher fixed assets
figure. In case, one compares the current year’s balance sheet with the previous
year, then only one can draw an inference that fixed assets were acquired by
raising share capital of Rs. 2,00,000. Similarly, certain important transaction
which might occur during the course of the accounting year might not find any
place in the balance sheet. For example, if a loan of Rs. 2,00,000 was raised
and paid in the accounting year the Balance sheet will not depict this
transaction. However, a financial analyst must know the purpose for which the
loan was utilized and the source from which it was raised. This will help him in
making a better estimate about the company’s financial position and policies.

The term “fund” generally refers to cash, to cash and cash equivalents, or to
working capital. Of these the last definition of the term is by far the most
common definition of “fund”.

There are also two concepts of working capital – gross and net concept. Gross
working capital refers to the firm’s investment in current asset while the term
net working capital means excess of current assets over current liabilities. It is
in the latter sense in which the term ‘funds’ is generally used.

Current Assets: The term ‘Current Assets’ includes assets which are acquired
with the intention of converting them into cash during the normal business
operations of the company.

The broad categories of current assets, therefore, are



1. Cash including fixed deposits with banks.
2. Accounts receivable, i.e., trade debtors and bills receivable,
3. Inventory i.e., stocks of raw materials, work-in-progress, finished goods,
stores and spare parts.
4. Advances recoverable, i.e., the advances given to supplier of goods and
services or deposit with government or other public authorities, e.g.,
customer, port authorities, advance income tax, etc.
5. Pre-paid expenses, i.e. cost of unexpired services e.g., insurance
premium paid in advance, etc.

Current Liabilities: The term ‘Current Liabilities’ is used principally to
designate such obligations whose liquidation is reasonably expected to require
the use of assets classified as current assets in the same balance sheet or the
creation of other current liabilities or those expected to be satisfied within a
relatively short period of time usually one year. However, this concept of
current liabilities has now undergone a change. The more modern version
designates current liabilities as all obligations that will require within the
coming year or the operation cycle, whichever is longer. The use of existing
current assets or the creation of other current liabilities . in other words, the
more fact that an amount is due within a year does not make it current liability
unless it is payable out of existing current assets or by creation of current
liabilities. For example debentures due for redemption within a year of the
balance sheet date will not be taken as a current liability if they are to be paid
out of the proceeds of a fresh issue of shares / debentures or out of the
proceeds realized on account of sale of debentures redemption fund
investments.

The term current liabilities also includes amounts set apart or provided for any
known liability of which the amount cannot be determined with substantial
accuracy e.g., provision for taxation, pension etc., These liabilities are
technically called provisions rather than liabilities.

The broad categories of current liabilities are:

1. Accounts payable e.g., bill payable and trade creditors.
2. Outstanding expenses, i.e., expenses for which services have been
received by the business but for which the payment has not made.
3. Bank-over drafts.


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