Ratio Analysis

Financial Management
FINANCIAL STATEMENT ANALYSIS.
The financial statements are prepared for the purpose of presenting a periodical review or report of the
progress made by the concern. It shows the 'status of the investment' in the business, and 'results achieved'
during the accounting period. Financial statements refer to at least two statements which are prepared at the end
of a given period. These statements are Income Statement (P'&L Account ) and Position Statement, (i.e. Balance
Sheet). The purpose of' Income statement' is to ascertain the net result of trading activities. Position statement is
prepared to find out the financial position of the business as on a particular date.In addition to P&L A/C and
Balance sheet, Statement of Retained Earnings, Fund Flow Statement and cash flow Statements are also
considered as important financial statements. The financial statements are of much interest to a number of
groups of persons. These groups are very much interested in the analysis of financial statements.
The process of critical evaluation of the financial information contained in the financial statements in
order to understand and make decisions regarding the operations of the firm is called ‘Financial Statement
Analysis’. It is basically a study of relationship among various financial facts and figures as given in a set of
financial statements, and the interpretation thereof to gain an insight into the profitability and operational
efficiency of the firm to assess its financial health and future prospects.
Analysis means to put the meaning of a statement in to simple terms for the benefit of a person.
Analysis comprises resolving the statements by breaking them in to simpler statements by a process of re
arranging, regrouping, and collection of information Broadly the term is applied to almost any kind of detailed
enquiry in to financial data. A financial manager has to evaluate the past performance, present financial position,
liquidity situation, enquire in to profitability of the firm and to plan for future operations. For all this, they have
to study the relationship among various financial variables in a business as disclosed in various financial
statements.
USERS OF FINANCIAL STATEMENT ANALYSIS.

Analysis of financial statements is linked with the objective and interest of the individual / agency
involved. Some of the agencies interested include Management, investors, creditors, bankers, workers,
Government, and public at large.
1 MANAGEMENT
Management is interested in the financial performance and financial condition of the enterprise. It
would like to know about its viability as an on going concern, management of cash, debtors, inventory and fixed
asset and adequacy of capital structure. Management would also be interested in the overall financial position
and profitability of the enterprise as a whole and its various departments and divisions.
2. INVESTORS
An investor is interested in the profitability and safety of his investment and would like to know
whether the business is profitable, has growth potential and is progressing on sound lines. The present investors
want to decide whether they should hold the securities of the company or sell them. Potential investors, on the
other hand, want to know whether they should invest in the shares of the company or not. Investors
(Shareholders or owners) and potential investors, thus, make use of the financial statements to judge the present
and future earning capacity of the business, to judge the operational efficiency of the business and to know the
safety of investment and growth prospects.
3. BANKERS AND LENDERS

Bankers and lenders are interested in serving of their loans by the enterprise, i.e. regular payment of
interest and repayment of principal amount on schedule dates. They also like to know the safety of their
investment and reliability of returns.
4. SUPPLIERS/ CREDITORS
Creditors dealing with the enterprise are interested in receiving their payments as and when fall due
and would like to know its ability to honor its short-term commitments.
5. EMPLOYEES
Employees interested in better emoluments, bonus and continuance of the business, would like to know
its financial performance and profitability.
6. GOVERNMENT
Govt and regulatory authorities would like to ensure that the financial statements prepared are as per
the specified laws and rules, and are to safe guard the interest of various concerned agencies. E.g.: Taxation
authorities would be interested in ensuring proper assessment of tax liability of the enterprise as per the laws.
NSS College Rajakumari.

7. STOCK EXCHANGE
Stock exchange uses the financial statements to analyze and thereafter, inform its members about the
performance, financial health, etc. of the company, to see whether financial statements prepared are in
conformity with the specified laws and rules and to see whether they safeguard the interest of various concerned
agencies.
Other Regulatory authorities (such as, Company Law Board, SEBI, Stock Exchanges, Tax Authorities
etc.) would like that the financial statements prepared are in conformity with the specified laws and rules, and
are to safeguard the interest of various concerned agencies. For example, taxation authorities would be
interested in ensuring proper assessment of tax liability of the enterprise as per the laws in force from time to
time.
8. CUSTOMERS
Customers are interested to ascertain continuance of an enterprise. For example, an enterprise may be
supplier of a particular type of consumer goods and in case it appears that the enterprise may not continue for a
long time, the customer has to find an alternate source.
9.. PUBLIC
Enterprises affect members of the public in a variety of ways. For example, enterprises may make a
substantial contribution to the local economy in many ways including the number of people, they employ and
their patronage of local suppliers. Financial statements may assist the public by providing information about
trends and recent developments in the prosperity of the enterprise and the range of its activities.
Different agencies thus look at the enterprise from their respective viewpoint and are interested in
knowing about its profitability and financial condition. In short a detailed cause and effect study of profitability
and financial condition is the over all objective of financial statement analysis.
TYPES OF FINANCIAL ANALYSIS

Following are the various types of financial analysis.
A. On the basis of material used.

1 External analysis
Analysis of financial statements may be carried out on the basis of published information. i.e information made
available in the Annual Report of the enterprise. Such analysis are usually carried out by those who do not have
access to the detailed accounting records of the Co. ie Banks, Creditors etc.
2 Internal Analysis.
Analysis may also be based on detailed information available within the Co, which is not available to the
outsiders. Such analysis is called internal analysis. This type of analysis is of a detailed one and is carried out on
behalf of the management for the purpose of providing necessary information for decision-making. Such
analysis emphasizes on the performance appraisal and assessing the profitability of different activities.
B. According to objectives of analysis.

1. Short Term Analysis
Short term analysis is mainly concerned with the working capital analysis. In the short run, a Co must have
ample funds readily available to meet its current needs and sufficient borrowing capacity to meet the
contingencies. In short term analysis the current assets and current liabilities are analyzed and liquidity is
determined.
2. Long Term Analysis.
In the long term a Co: must earn a minimum amount sufficient to maintain a reasonable rate of return on the
investment to provide for the necessary growth and development of the Co; and to meet the cost of capital.
Financial planning is also desirable for the continued success of a Co. Thus in the long term analysis the
stability and the earning potentiality of the Co is analyzed, i.e fixed assets, long term debt structure and the
ownership interest is analyzed.
C. According to the Modus Operandi of analysis.

1. Horizontal Analysis.
Analysis of financial statements involves making comparisons and establishing relationships among related
items. Such comparison or establishing of relationship may be based on financial statements of a Co for a
number of years and the financial statements of different Co's for the same year. Such analysis is called
Horizontal Analysis. It may take the following two forms.
a. Comparative Financial Statement Analysis

b. Trend Analysis.

2. Vertical Analysis.
Analysis of financial data based on relationship among items in a single period of financial statement is called
vertical analysis. From a single Balance Sheet or P&L A/C, relationships of various items may be established.
E.g., various assets can be expressed as percentage of total assets. Statements containing such analysis are also
called as common size statements. The common size P&L A/C is more useful in analyzing the operating results
and costs during the year. It shows each element of cost as a percentage of sales. Similarly common size
Balance Sheet shows fixed assets as a percentage to total assets.
TOOLS OF FINANCIAL ANALYSIS (METHODS)

The analysis of financial statements consist of a study of relationship and trends to determine whether or not the
financial position of the concern and its operating efficiency have been satisfactory. In the process of this
analysis various tools or methods are used by financial analyst. These tools are,
1. Comparative statements
2. Common size statements
3. Trend Analysis
4. Average Analysis
5. Statement of changes in working capital
6. Fund Flow Analysis
7 Cash Flow analysis &
8. Ratio Analysis.
FUND FLOW ANALYSIS
The technique of fund flow has been developed to account for changes in assets and liabilities that take
place in the course of the accounting year. Financial accounting has a very limited role to perform in this regard.
Financial accounting provides essential basic accounting information. But its utility is very much limited for
analysis and interpretation. The balance sheet is a static summary of assets and liabilities on a particular date. It
doesn’t highlight the factors that were responsible for changes in balance sheet figures relating to two periods.
Certain important transactions which might take place during the accounting year may not find any place in the
balance sheet. To highlight changes in assets and liabilities, a statement is prepared which is called a fund flow
statement.
Fund flow analysis is the second tool of analysis of financial statement. (Ratio analysis occupies the
first position.). If we look at the balance sheets of a Company on two different days, we notice differences in
the figures of assets and liabilities. A fund flow statement attempts to account for this difference. In fact Fund
Flow analysis measures the changes in the assets and liabilities of a Company.
The changes in Current Assets and Current Liabilities are shown in the Schedule of changes in the
Working Capital and the changes in non current assets and non current liabilities are shown in Fund Flow
Statement. Fund Flow statement is also known as statement of sources and applications of funds.
MEANING OF FUND FLOW.
The term “Fund” has been used to convey a variety of meanings. To many writers the term fund means
cash. To others the term fund means working capital. These are the two extreme opinions. There are also two
concepts of working capital- Gross Concept and Net Concept.
Gross working capital refers to firms investments in total current assets. Net working capital refers to
the excess of current assets over current liabilities. The most widely acceptable view of fund is the Net Working
capital, which is the excess of Current Assets over Current Liabilities. Thus the term fund means Net Working
Capital.
The term Flow means movement or change. There fore, fund flow means change in funds. In other
words, fund flow means flaw of funds in and out of the area of net working capital. Thus fund flow statement
broadly measures the flow of fund in and out of the area of net working capital.
There are many transactions which result in the flow of fund, while there are transactions which do not
result in the flow of fund. Any external transaction which increases net working capital would be taken as a
source of fund and any such transaction which decreases net working capital will be considered as application of
fund.
1. Schedule of Changes in Working Capital.

Many expert have opined that only the net change in working capital should be shown in the fund flow
statement in place of individual changes in all current assets and current liabilities. For this purpose, a separate
statement or schedule of working capital is being prepared in which net change in the working capital is

ascertained. The increase in working capital is treated as application of fund and decrease in working capital is
termed as source of fund.
This statement or schedule is prepared in such a way as to indicate the amount of working capital at the
end of two years as well as increase or decrease in the individual items of current assets and current liabilities.
The difference in the amount of working capital at the end of two years will depict either increase or decrease in
net working capital.
While ascertaining the increase or decrease in individual items of current assets and current liabilities
and its impact on working capital, the following rules should be taken in to account.
1. Increase in the items of current asset will increase the working capital
2. Decrease in the items of current asset will decrease the working capital.
3. Increase in items of current liabilities will decrease working capital.
4. Decrease in items of current liabilities will increase working capital.
The following points should be taken in to consideration, while preparing a fund flow statement.
1. All changes in Current Assets and Current Liabilities are shown in the Schedule.
2. The schedule should be prepared exclusively from the items given in the Balance Sheet. The items
given in the adjustments do not affect the preparation of this schedule.
3. Current Assets or Current Liabilities, once taken in the schedule, will not require any further treatment
else where.
Treatment of Provision for Bad debt.

Some times it is shown as reserve for bad debt. This item should be shown along with current
liabilities, in the schedule of changes in working capital.
Provision for Tax.
1. If the problem itself classifies the provision for tax under current liabilities, then treat it as a current
liability. Once it is taken in the schedule, it will not find any place in the fund flow statement.
2. If this item is not specifically classified as a current liability, but is merely shown as one of the items on
the liability side, then this item may be taken as a non current liability. Thus it goes to the fund flow
statement.
Proposed dividend.
The same procedure is followed in respect of proposed dividend as has been given for provision for tax.
2. Fund Flow statement
This is second, but most important part of fund flow analysis. It is prepared on the basis of changes in
fixed assets, long term liabilities and share capital on the basis of values of these items shown in the balance
sheet. Of course additional information must also be considered.
Increase in fixed assets is application of fund and decrease in fixed asset on account of sale is a source
of fund. Increase in long term liabilities is source of fund and decrease in long term liabilities is application.
Thus the preparation of fund flow statement involves the ascertainment of increase or decrease in the various
items of fixed assets, long term liabilities, and share capital, in the light of additional information given.
Sources of Fund.
1. Issue of shares
2. issue of debentures
3. Raising of new loans
4. Sale of fixed assets
5. Fund from operation
6. Non trading income like dividend received, interest on deposit etc.
Application (Uses) of fund.

1. Redemption of Preference shares.
2. Redemption of debentures
3. Repayment of Loan
4. Purchase of Fixed Assets
5. Dividend Paid
6. Income Tax paid etc

3. Calculation of FUND FROM OPERATION.
P&L A/C closing balance xxx

Less: P&L A/C opening balance xxx
---------
Current year profit. xxx
Add:
Depreciation xx
Provision for tax xx
Proposed Dividend xx
Interim dividend paid xx
Loss on sale of asset xx
Amortisation of goodwill xx
Preliminary expenses-
written off xx
Transfer to reserve xx
---------------
xxxx
Less:
Dividend received xx
Profit on sale of asset xx
-----------------
Fund from Operation. xxxx
-----------------
CASH FLOW ANALYSIS
Cash flow analysis is another important technique of financial analysis. It involves preparation of cash
flow statement for identifying sources and application of cash. The term cash here stands for cash and bank
balance. A cash flow statement is a statement depicting changes in cash position from one period to another. It
explains the reasons for such inflows or out flows of cash .
A cash flow statement can be prepared on the same pattern on which a fund flow statement is prepared.
The changes in cash position from one period to another is computed by taking in to account ‘Sources and
Applications’ of cash.
Format of cash flow statement.
Source Rs Application Rs
Opening balance: Decrease in liabilities XXX
Cash XXX Increase in asset XXX
Bank XXX Redemption of preference shares XXX
Repayment of loan XXX
Sources of cash. Purchase of fixed asset XXX
Tax paid XXX
Increase in liabilities XXX Dividend paid XXX
Decrease in current assets XXX
Issue of shares XXX
Raising of long term loans XXX
Sale of fixed assets XXX
Short term borrowings. XXX Closing balance
Cash XXX
Cash from operations. XXX Bank XXX
XXXX XXXX
Calculation of cash from operation
(Refer calculation of fund from operation.)

RATIO ANALYSIS.
A companies financial information is contained in 3 basic financial statements- the Balance Sheet, the
Trading and P&L Account and the P&L Appropriation Account. These statements are very useful to different
partiers concerned such as management, creditors, investors and so on. These statements may be more fruitfully
used if they are analysed and interpreted to have an insight into the strengths and weakness of the firm.
Analysis of statements means such a treatment of the information contained in the two statements as to afford a
diagnosis of the profitability and financial position of the firm concerned. In the analysis of financial statements,
the analyst has a variety of tools available from which he can choose those best suited to his specific purpose.
The most important tools used now a days are Ratio analysis, Fund flow analysis and Comparative and common
size statements.
Ratio Analysis.
Ratios are well known and most widely used tools of financial analysis. A ratio gives the mathematical
relationship between one variable and another. Accounting ratios are relationships, expressed in quantitative
terms, between figures which have a cause and effect relationship or which are connected with each other in
some manner or the other. The analysis of a ratio can disclose the relationships as well as bass of comparison
that reveal conditions and trends that cant be detected by going through the individual components of the ratio.
The usefulness of ratios is ultimately dependent on their intelligent and skillful interpretation.
Classification of Ratios.
Ratios can be grouped into various classes according to financial activity or function to be evaluated. In
view of the requirements of the various users of ratios, we can classify them into the following categories.
• Liquidity ratios.
• Profitability Ratios
• Solvency ratios.
Liquidity Ratios.
Liquidity ratios measure the firms ability to meet current obligations; ie the ability to pay its
obligations as and when they become due. They show whether the firm can pay its short term obligations out of
short term resources or not. They establish a relationship between cash and other current assets to current
liabilities. If a firm has sufficient net working capital it is assumed to have enough liquidity. The most common
ratios which indicate the extent of liquidity are current ratio and quick ratio.
Current Ratio.
It is calculated by dividing the Current Assets by Current Liabilities.
Current Asset
Current ratio = ---------------------------------
Current Liabilities.
Current assets include cash, securities, debtors B/R, stock etc and current liabilities include creditors,
B/P, accrued expense, short term loan etc. Current ratio is a measure of the firms short term solvency. It
indicates the availability of a current asset in rupees for every one rupee of current liability . a ratio greater than
1 means that the firm has more current assets than current claims against them.
As a conventional rule, a Current ratio of 2:1 or more is considered satisfactory. This rule is based on
the logic that in a worse situation even the value of CA’s(current assets) becomes half, the firm will be able to
meet its obligations. The higher the current ratio, the more will be the firms ability to meet its current
obligations. In inter firm comparison, the firm with the higher current ratio has better liquidity or short term
solvency.
Quick Ratio. (Acid Test Ratio)

This ratio establishes a relationship between quick or liquid assets and current liabilities. An asset is
liquid, if it can be converted in to cash immediately or reasonably soon without a loss of value. Cash is the most
liquid asset. QA also include debtors, B/R and securities. Inventories are considered less liquid. They normally
require some time for realising in to cash.
Quick assets
Quick Ratio = ----------------------------------------

Quick assets = Current Assets – Inventories or stock
Generally a QR of 1:1 is considered to represent satisfactory current financial position.
Cash Ratio (Absolute Liquid Ratio).

Since cash is the most liquid asset, a financial analyst may examine the ratio of cash and its equivalent
to current liabilities. Trade investments or marketable securities are equivalents to cash.
Cash / Bank balance + Marketable securities
Cash Ratio = --------------------------------------------------------------
Turn Over Ratio.
The liquidity ratios discussed so far relate to the liquidity of a firm as a whole. Another way of
examining the liquidity is to determine how quickly certain current assets are converted in to cash. The ratios to
measure these are referred to as turnover ratios.
Inventory Turnover Ratio.

It is computed by dividing the cost of goods sold by the average inventory.
Cost of goods sold
Inventory turnover Ratio = ------------------------------------------
Average inventory.
Cost of goods sold means sales – gross profit. Average inventory refers to the simple average of the
opening and closing sock. The ratio indicates how fast inventory is sold. A high ratio is good from the view
point of liquidity. A low ratio would signify that inventory does not sell fast.
Debtors Turn over Ratio.

It is determined by dividing the net credit sales by average debtors outstanding during the year.
Net credit sales
Debtors turnover Ratio = --------------------------------------
Average Debtors.
Net credit sales consists of gross sales – sales returns if any from debtors. Average debtors is the simple average
of opening balance of debtors and closing balance.
Debtors + B/R
Average debt collection period in days =----------------------------------- X 365
Net credit sales
Debtors + B/R
Average debt collection period in months =----------------------------------- X 12
Net credit sales
12 months
Or Debt collection period = --------------------------
Debtors turnover.
Debtors turnover measures how rapidly debts are collected. A high ratio is indicative of shorter time
lag between credit sales and cash collection. A low ratio shows that debts are not being collected rapidly.
Creditors Turnover Ratio.
It’s the ratio between net credit purchases and average amount of creditors outstanding during the year.
It is calculated as follows.
Net credit purchase
CTR = -------------------------------------------
Average Creditors.
Net credit purchase = Gross credit purchase – returns to suppliers.

Average creditors is the simple average of creditors at the beginning and at the end.
Creditors + B/P
Average debt Payment period in days = --------------------------------- x 365
Net credit purchases.

Creditors + B/P
Average debt Payment period in months = --------------------------------- x 12
Net credit purchases
12 months
Or Credit payment period = -------------------------------
Creditors turnover.
A low turnover reflects liberal credit terms granted by suppliers, while a high ratio shows that accounts
are to be settled rapidly. The creditors turnover ratio is an important tool of analysis as a firm can reduce its
requirements of current assets by relying on the suppliers credit.
Profitability Ratios.
A measure of profitability is the over all measure of efficiency. The management of the firm is
naturally eager to measure its operating efficiency. Similarly is the share holders or owners who invest their
funds in the expectation of reasonable returns. The profitability of a firm can be measured by its profitability
ratios. Profitability ratios can be determined on the basis of either sales or investments.
Gross profit margin.

The gross profit margin ratio is calculated as
Gross Profit
--------------------------------- X 100.
Sales
This ratio shows the profit relative to sales. A high ratio of gross profits to sales is a sign of good
management as it implies that the cost of production of the firm is relatively low.
Net Profit margin.

This measures the relationship between net profit and sales of a firm. Depending on the concepts of the
net profit employed, this ratio can be computed in two ways.
Earning Before interest and Tax (EBIT)

Operating profit Ratio = ------------------------------------------------------------ X 100
Sales
Earning after Interest and tax (EAIT)
Net profit Ratio = --------------------------------------------------------------X 100
Sales
Net profit
Or Net profit ratio = -------------------------X 100
Sales
The net profit margin is indicative of managements ability to operate the business with sufficient
success not only to recover from revenues, but also to leave a reasonable margin to the owners. A high net profit
margin would ensure adequate return to the owners as well as enable a firm to face adverse economic
conditions.
Expenses ratio.
Another profitability ratio related to sales is expense ratio. It is computed by dividing expenses by
sales.
Cost of goods sold
Cost of goods sold Ratio = --------------------------------------X100
Net sales
Administrative expense
Administrative expense ratio = ---------------------------------------X 100
Net sales
Operating expense
Operating expense Ratio = -------------------------------------- X 100
Net sales
Selling expense
Selling expense Ratio =--------------------------------------X 100
Net sales

The expense ratio is closely related to the profit margin, gross as well as net. The cost of goods sold
ratio shows what percentage share of sales is consumed by cost of goods sold and what proportion is available
for meeting expenses such as selling and general distribution expense as well as financial expenses consisting of
taxes, interest, dividends and so on. The expense ratio is very important for analysing the profitability of a firm.
It should be compared over a period of time with the industry average as well as firms of similar type. A low
ratio is favourable and a high ratio is unfavourable.
Profitability ratios related to Investments.
The profitability ratios can be computed by relating the profits of a firm to its investments. Such ratios
are popularly known as Return On Investments (ROI). There are 3 different concepts of investments and based
on each of them, there are 3 broad categories of ROI’s.
Return on Asset.
Here the profitability ratio is measured in terms of the relationship between net profits and assets. It is also
called profit – to –asset ratio.
Net profit after tax
Return on Asset = --------------------------------- X100
Average total assets.
Return on capital employed.

Here the profits are related to total capital employed. The term capital employed refers to long term
funds supplied by the creditors and owners of the firm. A comparison of those with similar firms, and with the
industry average would provide sufficient insight in to how efficiently the long term funds of owners and
creditors are being used. The higher the ratio, the more efficient is the use of capital.
Net profit after tax /EBIT

Return on capital employed = --------------------------------------------- X 100
Average total capital employed.
Return on Total shareholders equity.

According to this ratio, profitability is measured by dividing the net profits after tax by the average
total shareholders equity. The term share holders equity includes (1) preference share capital, (2) ordinary share
holder’s equity consisting of equity share capital, share premium, and reserves and surplus less accumulated
losses.
Net profit after tax
Return on total shareholders equity = ------------------------------------------------ X 100.
Average total shareholders equity.
The ratio reveals how profitably the owner’s funds have been utilised by the firm. A comparison of this
ratio with that of similar firms will show the performance of the firm.
Return on ordinary shareholders equity.(Net worth)
The real owners of the business are the ordinary share holders who bear all the risk, participate in
management and are entitled to profit remaining after all outside claims, including preference dividends are met
in full.
Net profit after tax- Preference dividend
Return on Equity Fund = ----------------------------------------------------------
Average ordinary shareholders equity.
This is probably the single most important ratio to judge whether the firm has earned a satisfactory
return for its equity share holders or not.
Earning Per Share.

EPS measures the profit available to the equity shareholders on a per share basis. – ie the amount that
they can get on every share held. The profits available to the ordinary shareholders are represented by the net
profits after taxes and preference dividend.
Net profit available to equity shareholders

EPS = ----------------------------------------------------------------------
Number of ordinary shares outstanding.

Dividend Per Share.
This is the dividend paid to the shareholders on a ‘per share’ basis. It is net distributed profit belonging
to the shareholders dividend by the number of ordinary shares.
Dividend paid to equity shareholders

DPS = ---------------------------------------------------------
Number of equity shares.
Dividend Pay –Out Ratio.
This is also known as pay out ratio. It measures the relationship between the earnings belonging to the
ordinary shareholders and the dividend paid to them. It can be calculated by dividing the total dividend paid to
the owners by the total profits available to them.
Total dividend to equity shareholders

DPR = ---------------------------------------------------------- X 100.
Net profit belonging to equity shareholders
Or DPS
------------------ X 100
EPS
Price Earning Ratio
This ratio gives the relationship between the market price of the stock and its earnings by revealing
how earnings affect the market price of the firms stock.
Market price of share

P E Ratio = --------------------------------
EPS.
Other important Ratios.
Debt Equity Ratio.
The relationship between borrowed funds and owners capital is a popular measure of the long term
financial solvency of the firm. This relationship is shown by the debt equity ratio.
Debt Outsiders fund
Debt Equity Ratio = ------------- or ---------------------------
Equity. Share holders fund.
The term debt refers to the total outside liabilities. It includes all current liabilities and other outside liabilities
like loan debenture etc. The term equity refers to networth or shareholders fund.
Proprietary ratio.
This ratio shows the long term solvency of the business. It is calculated by dividing shareholders funds
by total assets.
Share holders fund

Proprietary ratio = -------------------------------
Total assets.
Capital gearing ratio.
This is also known as Leverage ratio. This is mainly used to analyse the capital structure of a company.
The term capital gearing normally refers to the proportion between fixed income bearing securities and non
fixed income bearing securities. The former includes preference share capital and debentures and the later
includes equity share capital and reserves and surplus.
Fixed interest bearing funds

Capital gearing Ratio = ----------------------------------------------------
Equity share capital + Reserves and Surplus.

Working Capital Turnover

This reflects the turnover of the firm’s net working capital in the course of the year.
Net sales
Working capital turnover Ratio = -------------------------------
Net working capital.
Operating Ratio.
It shows the proportion that the cost of sales bears to sales. Cost of sales includes direct cost of goods
sold as well as other operating expenses. It is calculated by dividing the total operating cost by net sales. Total
operating expenses include all costs like administration, selling and distribution expenses etc, but do not include
financing cost and income tax. Lower the ratio, the more profitable are the operations indicating an efficient
control over costs and appropriate selling price.
(Cost of goods sold + Operating expense)

Operating Ratio = --------------------------------------------------------x 100
Net sales
Problem 1
The following is the Balance sheet of ABC ltd as on 31st December 2005.
Balance Sheet
Liabilities Rs Assets Rs
Share capital 2 00 000 Fixed assets 1 60 000
Reserves and surplus 30 000 Stock 50 000
Creditors 20 000 Debtors 20 000
Bills payable 5 000 Bills receivable 15 000
Bank overdraft 17 000 Prepaid expense 5 000
Outstanding expense 8 000 Cash at bank 30 000
Provision for tax 20 000 Cash in hand 20 000
3 00 000 3 00 000
Calculate 1) Current ratio, 2) Quick ratio, 3) Absolute liquid ratio.

Answer.
Current asset 1 40 000

Current ratio = -------------------------- = -------------------= 2:1
Current Liability 70 000
Quick asset 85 000

Quick ratio = -------------------- = ----------------- = 1.21 :1
Current Liability 70 000
cash and bank balance 50 000

Absolute liquid asset. = --------------------------------------- = --------------------- = 0.71 :1
Current liabilities 70 000
Problem 2.
The following is the Balance sheet of XYZ ltd, as on 31st March 2005.
Equity share capital 2 00 000 Land and buildings 1 50 000

Preference share capital 2 00 000 Plant and machine 2 50 000
General reserve 80 000 Furniture 50 000
Profit and loss account 40 000 Stock 1 50 000
12 % debentures 2 20 000 Debtors 70 000
Creditors 1 00 000 Bills receivable 80 000
Bills payable 50 000 Cash at bank 1 00 000
Cash in hand 40 000
8 90 000 8 90 000
Calculate 1). Current Ratio. 2) Quick ratio, 3) debt Equity ratio, 4) Proprietary ratio, 5)Fixed asset to net worth,
6) Capital gearing ratio.

Answer.
Current assets 4 40 000
Current ratio = ------------------------ = ---------------------- = 2.93 :1
Current liabilities 1 50 000
Quick assets 2 90 000

Quick ratio = -------------------------- = ----------------- = 1.93 : 1
Debt
Debt equity ratio = ------------------
Equity
(Debt = debenture + creditors + bills payable
Equity = Equity share capital + Pref share + General reserve + P& L account )
Shareholders fund 5 20 000

Proprietary ratio = ---------------------------------- = ---------------------- = 0.58 : 1
Total assets. 8 90 000
(Where, share holders fund = 2 00 000+ 2 00 000+ 80 000+ 40 000 = 5 20 000).
Fixed asset 4 50 000

Fixed asset to net worth ratio = -------------------- = -------------------- = .86 :1.
Net worth.(share holders fund) 5 20 000
Preference share capital + debentures

Capital gearing ratio = Equity share capital + Reserves and surplus.
= 2 00 000 + 2 20 000 = 1.31:1

2 00 000 + 80 000+ 40 000
Problem 3
From the following, work out 1) Gross profit ratio, 2)Net profit ratio, 3)Operating profit ratio, and 4)Operating
ratio.
Trading and P&L Account.

particulars Rs Particulars Rs
To Opening stock 40 000 By Sales 5 00 000
Purchases 4 00 000 Closing stock 1 00 000
Direct expenses 60 000
Gross profit c/d 1 00 000
6 00 000 6 00 000
To operating expense By gross profit b/d 1 00 000

Administration exp 20 000
Selling expense 10 000
Finance expense 20 000
Income tax 10 000
Net profit 40 000
1 00 000 1 00 000
Gross profit ratio = gross profit x 100 = 1 00 000 x 100

Sales 5 00 000
Net profit ratio = Net profit after interest and tax x 100 = 40 000 x 100 = 8 %.
Net sales 5 00 000
Operating ratio = cost of goods sold + operating expense x 100

Net sales

Cost of goods sold = sales – gross profit

( ie opening stock + purchases + direct expense ) – Closing stock
ie 5 00 000 – 1 00 000 = 4 00 000.
Operating ratio = 4 00 000 + 30 000 x 100 = 86 %.

5 00 000
Operating profit ratio = 100 – Operating ratio.

= 100 – 86 = 14 %.
Problem. 4
The following are the final accounts of Tata consultancy limited for the years ended 31st March
2005 and 2006.
BALANCE SHEET
LIABILITIES 2004 2005 ASSSETS 2004 2005
Share capital Property, plant and
Equity shares of 10 each 2 39 150 2 32 570 equipment 6 08 060 3 67 730
14% Preference shares 32 650 0 Less depreciation 2 00 830 1 02 810
4 07 230 2 64 920
P&L Account 82 050 62 280
General Reserve 2 13 430 1 61 560 Patent etc 0 2 490
Other fixed assets 4 290 800
12 % debentures of Current assets
Rs100 3 20 000 92 500 Stock 2 32 820 68 690
Book debts 2 90 530 1 92 500
Sundry creditors 1 03 680 53 370 Prepaid expense 6 640 4 150
Outstanding expense 13 090 6960 Bank 1 18 430 1 04 360
Other current liabilities 55 890 28 670
10 59 940 6 37 910 10 59 940 6 37 910
REVENUE STATEMENT
2005 2004 2005 2004
Cost of sales 12 84 340 6 07 760 Sales 19 32 130 9 19 540
Gross profit 6 47 790 3 11 780
19 32 130 9 19 540 19 32 130 9 19 540
Administration and 2 63 690 1 38 440 Gross profit . 6 47 790 3 11 780
selling expense .
Bonus paid 98 310 41 670 Other income 9 560 2 730
Interest paid 38 400 11 100
Provision for taxation 1 47 120 69 340
Transfer to reserve 37 200 36 300
Net income 72 630 17 660
6 57 350 3 14 510 6 57 350 3 14 510
From the above,
1) Work out various ratios for the management.
2) With the help of ratios, give a clear account of the profitability and financial condition of the Co in 2004 – 05
, on a comparative scale.

Solution:
Ratios 2005 2004

Profitability Ratios.
Return on capital employed based on 2 85 790 1 31 670

operating profit, before interest and tax. --------------x 100 = 32.21 % ------------ x 100 = 23.99%
8 87 280 5 48 910
Net profit Ratio 2 85 790 1 31 670

------------ x 100 = 14.79 % ------------ x 100 = 14.32 %
19 32 130 9 19 540
Gross profit ratio 6 47 790 3 11 780

-------------- x 100 = 33. 53 % --------------- x 100 = 33.91%
19 32 130 9 19 540
12 84 340 6 07 760
Cost of sales ratio(cost of sales / sales) -------------- x 100 = 66. 47 % -------------- x 100 = 66.09%
19 32 130 9 19 540
Operating Ratio. 16 46 340 7 87 870

(cost of sales + operating exp) --------------- x 100 = 85. 21% ---------------- x 100 = 85.68%
------------------------------------ x 100 19 32 130 9 19 540
Sales
Turnover Ratios.
19 32 130 9 19 540
General turn over ratio -------------- = 2.18 ---------------- =1. 68
(sales / capital employed) 8 87 280 5 48 910
19 32 130 9 19 540
Turn over of fixed capital --------------- = 4. 74 ---------------- = 3.44
4 07 230 2 67 410
19 32 130 9 19 540
Turnover of net working capital -------------- = 4. 06 ------------------ = 3. 28
4 75 760 2 80 700
Stock turnover ratio 12 84 340 6 07 760

(cost of sales/ closing stock.) -------------- = 5.52 ----------------- = 8.85
2 32 820 68 690
2 90 530 1 92 500
Average debt collection period ------------ x 12 = 1.8 months ------------x 12 = 2.51months
19 32 130 9 19 540
Financial Position Ratios.

6 48 420 3 69 700
Current ratio --------------- = 3.76 : 1 ------------- = 4.15 : 1
1 72 660 89 000
4 08 960 2 96 860
Liquidity ratio -------------- = 2.37 : 1 ---------------- = 3.3.4 :1
1 72 660 89 000
3 20 000 92 500
Debt equity ratio -------------- = 0.36 --------------- = 0.17
8 87 280 5 48 910

4 07 230 2 67 410
Fixed asset ratio ---------------- = 0.51 :1 --------------= 0.55 :1
8 05 230 4 86 630
1 09 830 53 960
EPS -------------- = Rs 4. 59 --------------- = Rs 2.32
23 915 23 257
ASSESSMENT.
The activity of the company (derived from sales figures) during 2005 as compared to 2004 has more
than doubled. Correspondingly, the gross profit has also more than doubled.
He overall profitability ( return on capital employed) has shown a rise. It means in the year 2005 the profit has
increased not only in volume corresponding to the increase in sales, but more than proportionate to the increase
in sales.
Though the net profit and gross profit ratio were almost maintained, still the return on capital employed
has increased. This is mainly due to the increase in turnover of the capital employed. On the whole the
performance is satisfactory.
On the financial side there have been some setbacks. The liquidity position has worsened and so has
debt equity ratio. Though the situation is not serious yet a close watch should be kept.
Ther have been very heavy long term borrowings. During the year money has been raised from
preference shares and debentures from long term assets. This has pushed the debt equity ratio to a level beyond
which probably it cannot go. It may be better for the company to broaden the equity base by reducing
outstanding debentures and raising additional funds from equity shares.
Problem 5
The ratios relating to Cosmos Limited are given below as follows.
Gross profit ratio : 15 %
Stock velocity : 6 months
Debtors velocity : 3 months
Creditors velocity : 3 months
Gross profit for the year ending 31 st December amounts to Rs 6 00 000. Closing stock is equal to opening
stock.
Find out 1) sales, 2) Closing stock, 3 ) Sundry debtors, 4 ) Sundry creditors.
Solution.
Gross profit ratio = Gross profit x 100

Sales
15% = Rs 6 00 000
Sales
Sales = 6 00 000 x 100 = 4 00 000.
15
Closing Stock.
Stock velocity = Cost of goods sold

Average stock
Cost of goods sold = Sales – Gross profit = 4 00 000 – 60 000 = 3 40 000.

12 = 3 40 000 x 6 = Rs 1 70 000.
6 12
Since opening and closing stock are the same ; closing stock is Rs 1 70 000.
Sundry Debtors
Debtors velocity = Total debtors x No of months
Sales
3= Total debtors x 12
4 00 000

Total debtors = 4 00 000 x 3 = 1 00 000.

12
Sundry Creditors
For calculating sundry creditors, the figure for credit purchases will be required.
Cost of goods sold = Opening stock + Purchases – Closing stock
Rs 3 400 000 = Rs 1 70 000 + Purchases – Rs 1 70 000
Purchases = Rs 3 40 000.
Creditors velocity = Total creditors x No of months

Purchases
3= Total creditors x 12
3 40 000
Total creditors = 3 40 000 x 3 = Rs 85 000.

12
Problem 6
Prepare a Balance sheet in the given format, with the help of the following ratios.
Total assets / Net worth : 3.5
Sales / Fixed assets :6
Sales / current assets :8
Sales / Inventory : 15
Sales / debtors :18
Current ratio : 2.5
Annual sales : Rs 25 00 000.
Balance sheet
Net worth ------ Fixed assets -----
Long term debt ----- Inventory -----
Current liabilities ----- Debtors -----
Liquid assets -----
------- -------
Solution.
1. Sales / Fixed assets = 6 :1

Sales = Rs 25 00 000 ( ie 6)
Fixed assets = 25 00 000 x 1 = Rs 4 16 667.
6
2. Sales / Current assets = 8 :1

Sales = Rs 25 00 000 ( ie 8)
Current assets = 25 00 000 x 1 = Rs 3 12 500.
8
3. Sales / Inventory = 15 times.

Inventory = 25 00 000 x 1 = Rs 1 66 667.
15
4. Sales / Debtors = 18 times.

Debtors = 25 00 000 x 1 = Rs 1 38 889.
18
5. Current assets = Inventory + Debtors+ Liquid assets

There fore, liquid assets = current assets – (inventory + debtors)
Liquid assets = 3 12 500 – (1 66 667 + 1 38 889)

Liquid assets = Rs 6 944.
6. Current Ratio = Current assets = 2.5

Current liabilities
Current assets = 3 12 500 (ie 2.5)
Current liabilities = 3 12 500 x 1 = Rs 1 25 000.

2.5
7. Total assets / Networth = Total assets = 3.5 :1

Networth
Where total assets = Fixed assets +Inventory +Debtors +Liquid assets.

Total assets = 4 16 667 + 1 66 667 + 1 38 889 + 6 944 = Rs 7 29 167.
Networth = 7 29 167 x 1 = Rs 2 08 333.

3.5
8. Long term debt = Total liabilities – (current liabilities + net worth)
Long tem debt = 7 29 167 - ( 1 25 000 + 2 08 333)= Rs 3 95 834.
Balance sheet
Net worth 2 08 333 Fixed assets 4 16 667
Long term debt 3 95 834 Inventory 1 66 667
Current liabilities 1 25 000 Debtors 1 38 889
Liquid assets 6 944
7 29 167 7 29 167
Problem 7
You are given the following figures.
Current ratio -2.5 Liquidity ratio- 1.5 Net working capital-Rs 300 000
Stock turnover - 6 times Gross profit ratio 20 % Fixed asset turnover ratio
Average debt collection period Fixed asset / shareholders net (on cost of asset)- 2 times
- 2 months. worth 0.08 Reserves and surplus to capital
Gross profit ratio 20 % 0.50
Draw up the Balance Sheet of the company.
Solution.
Working capital:-
If current liabilities are 1, current assets are 2.5.
It means the difference or working capital 1.5.
Working capital Rs 3 00 000.
There for current assets = 3 00 000 X 2.5 = 5 00 000.

1. 5
Current liabilities = 3 00 000 X 1 = 2 00 000.

1.5
As liquidity ratio = 1.5 and current liabilities 2 00 000,

Liquid assets are = 2 00 000 x 1.5 = 3 00 000.
Stock ( 5 00 000 – 3 00 000, ie current assets – liquid assets ) Rs 2 00 000.
Cost of sales ( as stock turnover ratio is 6) = 12 00 000.
Sales ( as gross profit ratio is 20 % 12 00 000 + 20 x 12 00 000 = 15 00 000.

80
Fixed assets are ( since fixed assets turnover ratio is 2 ) Rs 12 00 000 = 6 00 000.
2
Debtors are ( since debt collection period is 2 months )15 00 000 = 2 50 000.
6
Shareholders Net worth 6 00 000 = 7 50 000
0.80
Out of shareholders net worth reserves and surplus = 2 50 000
There fore share capital = 5 00 000.
Liabilities Rs Assets . Rs
Share capital 5 00 000 Fixed assets 6 00 000
Reserves and surplus 2 50 000 Stock 2 00 000
Long term borrowings 1 50 000 Debtors 2 50 000
( balancing figure ) 2 00 000 bank 50 000
Current liabilities
11 00 000 11 00 000
Income Statement – Model form.
Rs Rs
Sales X XXX
Less sales returns XX
Net sales. X XXX
Less. Cost of goods sold
Opening stock of material XXX

Add: Purchases of material XXX
Add: Direct expense XXX
Manufacturing expense XXX
X XXX
Less: Closing stock of material XXX
Cost of production
X XXX
Add: Opening stock of finished product
XXX
XXX X
Less :Closing stock of finished product XXX
(Cost of goods sold) XXXX
Gross profit XXX
Less. Operating expense

Administration exp Xxx
Selling and distribution exp Xxx
Operating exp Xxx

Xxxx
Add: Non trading income Xxx
Xxxx
Less: Non trading expense
Xxx
EBIT ( Earning before Interest and Tax)
XXXX
Less. Interest on debenture

Xxx
Net income Xxxx
Less. Tax Xxx
Net profit after tax. / EAIT.

(Earning After Interest and Tax) XXX
Problem 8
Following is the P&L Account and Balance Sheet of Jai hind Ltd. Re draft them for the purpose of
analysis and calculate the following ratio.
1) Gross Profit Ratio 2) Overall profitability Ratio 3) Current Ratio 4) Debt Equity Ratio 5)
Stock Turnover Ratio 6) Liquidity Ratio.
P&L Account
Particulars Rs Particulars Rs
Opening stock of finished goods 1 00 000 Sales 10 00 000
Opening stock of materials 50 000 Closing stock of materials 1 50 000
Purchases of materials 3 00 000 Closing stock of finished goods 1 00 000
Direct wages 2 00 000 Profit on sale of shares 50 000
Manufacturing expense 1 00 000
Administration expense 50 000
Selling and distribution expense 50 000
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
Equity share capital 1 00 000 Fixed assets 2 50 000
Preference share capital . 1 00 000 Stock of raw materials . 1 50 000
Reserves 1 00 000 Stock of finished stock 1 00 000
Debentures 2 00 000 Sundry debtors 1 00 000
Sundry debtors 1 00 000 Bank balance 50 000
Bills payable 50 000
6 50 000 6 50 000
Solution
Income Statement
Sales 10 00 000
Less: Cost of sales:
Raw material consumed
(Opening stock + Purchases – closing stock) . 2 00 000
Direct wages 2 00 000
Manufacturing expense 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 1 00 000
Cost of goods sold. 5 00 000
Gross Profit. 5 00 000
Less : Operating expense:

50 000
Administration expense 1 00 000
50 000
Selling and distribution expense 4 00 000
Net operating profit
Add : Non trading income:
Profit on sale of shares 50 000

4 50 000
Less : Non trading expense or loss.
Loss on sale of plant 55 000
Income before interest and tax 3 95 000
Less : Interest on debentures 10 000
Net profit before tax. 3 85 000
Solution
1) Gross profit Ratio = Gross profit x 100 = 5 00 000 x 100 = 50 %

Sales 10 00 000
2) Overall profitability Ratio = Operating profit x 100 = 4 00 000 x 100 = 80 %

Capital employed 5 00 000
3) Current Ratio = Current assets x 100 = 4 00 000 = 2 .67

4) Debt equity Ratio = External equities x 100 = 3 50 000 = 1.17

Internal equities 3 00 000
Or
Total long term debt = 2 00 000 = 0.67

Share holders fund 3 00 000
5) Stock turnover ratio = Cost of goods sold = 5 00 000 = 2.5

Average Inventory 2 00 000
6) Liquid Ratio = Liquid Assets = 1 50 000 =1

Current Liabilities 1 50 000
COMPARATIVE FINANCIAL STATEMENTS.
The preparation of comparative financial statement is an important device of horizontal analysis.

Financial data becomes more meaningful when compared with similar data for a previous period or a number of
periods. Statements prepared in a form that reflect financial data for two or more periods are known as
comparative statements. Annual data can be compared with similar data for prior years. Such statements are
very helpful in measuring the effects of the conduct of a business during the period under consideration.
Financial statements of two or more firms may also be compared for drawing inferences. This is
known as inter-firm comparison. Comparative statements can be of two types. Comparative Balance Sheet
and Comparative P&L A/C.
The following steps may be followed to prepare the comparative statements:

Step 1 : List out absolute figures in rupees relating to two points of time (as shown in columns 2 and 3 of
Figure 4.1.).
Step 2 : Find out change in absolute figures by subtracting the first year (Col.2)from the second year (Col.3)
and indicate the change as increase (+) or decrease (–) and put it in column 4.
Step 3 : Preferably, also calculate the percentage change as follows and put it in Column 5.

Advantages
1. These statements indicate trends in sales, cost of production, profits, etc., helping the analyst to evaluate
the performance, efficiency and financial condition of the undertaking. For example, if the sales are increasing
coupled with the same or better profit margins, it indicates healthy growth.
2. Comparative statements can also be used to compare the position of the firm with the average performance
of the industry or with other firms. Such a comparison facilitates the identification or weaknesses and
remedying the situation.
Disadvantages
1. Inter-firm comparison may be misleading if the firms are not of the same age and size, follow different
accounting policies in relation to depreciation, valuation of stock, etc., and do not cater to the same market.
2. Inter-period comparison will also be misleading if the period has witnessed frequent changes in accounting
policies.
COMPARATIVE BALANCE SHEET

The comparative Balance Sheet Analysis is the study of the trend of the same items, group of items and
computed items in two or more balance sheets of the same Co's on different dates. The changes in balance
sheet items reflect the conduct of business and the changes can be observed by comparison of the balance
sheet at the beginning and at the end of the period and these changes can help in forming an opinion about
the progress of the Co.
COMPARATIVE INCOME STATEMENT

The comparative income statement gives an idea of the progress and profitability of a business over a period of
time. The changes in absolute data in money values and percentage can be determined to analyze the
profitability of a business.
The following statements illustrate the comparative financial statements :
Brief Comments

1. The comparative income statement suggests that there is a jump of 30 per cent in gross profit because of
increase in sales and increase in the profit margin. Increase in the gross profit margin can be ascertained from
the fact that the 10 per cent increase in sales is not accompanied by a proportionate increase in the cost of
production. However, the net profit is reduced by Rs.10, 000 because of the increase in operating expenses.
The overall position of the income statement indicates as favorable situation.
2. The analysis of balance sheet changes indicates an increase of 33 1/3 % in capital employed due to 25 per
cent increase in fixed assets and 100 per cent increase in working capital. There is no increase in debenture
liability and the increase in the current liabilities is only marginal. Therefore the increase in the total assets is
substantially due to increase in owners’ equity indicating a very satisfactory financial position.
Illustration 1
Convert the following Income Statement into a comparative income statement of BCR Co. Ltd and interpret the
changes in 2005 in the light of the conditions in 2004.




Interpretation
1. The comparative balance sheet of the company reveals that during the year
2006, there has been an increase in fixed assets by Rs.1,10,000, i.e. 13.5%
while long-term liabilities have relatively increased by Rs.1,50,000 and equity
share capital has increased by Rs.2 lakhs. This fact depicts that the policy of
the company is to purchase fixed assets from long-term source of finance, thereby not affecting the working
capital.
2. The current assets have increased by Rs.1,52,000, i.e. 24.52%. The current
liabilities have increased only by Rs.20,000, i.e. 12.9%. This shows an
improvement in the liquid position of the Company.
3. Shareholder’s funds (share capital plus reserves) have shown an increase of Rs. 92,000.
4. The overall financial position of the company is satisfactory.
COMMON SIZE STATEMENTS

Comparative statements that give only the vertical percentage ratio for financial data with out giving
Rupee values are known as common size statements For xample, if the Balance sheet items are expressed as
the ratio of each asset to total assets and the ratio of each liability to total liabilities, it will be called a common
size balance sheet. Thus a common size statement shows the relation of each component to the whole. It is
useful in vertical financial analysis and comparison of two business enterprises at a certain date.
Common size statements include : Common size Balance Sheet and Common size Income Statement.
Common size Balance Sheet - A statement in which Balance Sheet items are expressed as percentage of each
asset to total asset and percentage of each liability to total liabilities is called Common Size Balance sheet. This
statement establishes relation between each asset and total value of asset and each liability against total
liabilities
Common Size Income Statement. A Common Size Income statement is a statement in which each item of
expense is shown as a percentage of net sale. A significant relationship can be established between items of
income statement and volume of sales.
The following procedure may be adopted for preparing the common size
statements.
1. List out absolute figures in rupees at two points of time, say year 1, and year 2 (Column 2 & 4 of Exhibit 2)
2. Choose a common base (as 100). For example, Sales revenue total
may be taken as base (100) in case of income statement, and total
assets or total liabilities (100) in case of balance sheet.
3. For all items of Col. 2 and 4 work out the percentage of that total. Column 3 and 5 portray these
percentages in Figures 4.2.

Interpretation :
1. In 2005, both current assets and current liabilities decreased as compared to
2004, but the decrease in current assets is more than the decrease in the current
liabilities. As a result, the firm may face liquidity problem.
2. In 2005 both fixed assets and the long-term liabilities increased, but the increase
in the fixed assets is more than the increase in long-term liabilities. The firm sold
some investments to acquire fixed assets and used short-term funds to purchase
fixed assets.
3. The firm has undertaken expansion programme reflected in addition to land and
buildings.
The overall financial position of the firm is satisfactory. It should improve its liquidity.
Illustration 5
From the following , prepare Common Size Statements for the year ended March 31, 2004,& 2005.


Interpretation :
1. On comparison of the percentage of the cost of goods sold, it is observed that the company has tried to
reduce its cost to improve its profit margin.
2. The profitability of the company has improved as compared to the previous year as the profit after tax
percentage has gone up by 13.28%.
3. The company has issued share capital in order to finance the purchase of fixed assets like furniture and land
and buildings.
4. The company has improved its liquidity position as reflected in the increase of its current assets.
Thus, there is an improvement in the working of the company.
Illustration 6
From the following income statement of X – has Ltd. for the years ending December 31, 1978 and 1979 you
are required to prepare common-size statements:
Solution= X –‘has Ltd. COMMON-SIZE STATEMENT


Interpretation
(i) An analysis of pattern of financing of both the companies shows that Bansal Ltd is more
traditionally financed as compared to Anoop Ltd. The former company has depended more on its own
funds as is shown by balance sheet. Out of total investment, 74.01% of the funds are proprietory funds
and outsiders funds account only for 25.9%. In Anoop Ltd proprietors’ fund are 64.83% while the
share of outsiders funds is 34.17% which shows that this company has depended more upon outsiders
funds.
(ii) Both the companies are suffering from shortage of working capital. The percentage of current
liabilities is more than the percentage of current assets in both the companies.
(iii) A close look at the balance sheet shows that investments in fixed assets have been from working
capital in both the companies. In Anoop Ltd. fixed assets account for 94.52% of total assets while in
Bansal Ltd fixed assets account for 89.48%.
(iv) Thus, both the companies face working capital problem and immediate steps should be taken to
issue more capital or raise long term loans to improve working capital position.


Interpretation
(i) Bansal Ltd has depended more on its own funds as is shown by balance sheet. Out of total
investment, 74.01% of the funds are proprietory funds and outsiders funds account only for
25.9%. In Anoop Ltd proprietors’ fund are 64.83% while the share of outsiders funds is
34.17% which shows that this company has depended more upon outsiders funds.
(ii) Both the companies are suffering from shortage of working capital. The percentage of
current liabilities is more than the percentage of current assets in both the companies.
(iii) A close look at the balance sheet shows that investments in fixed assets have been from
working capital in both the companies. In Anoop Ltd. fixed assets account for 94.52% of total
assets while in Bansal Ltd fixed assets account for 89.48%.
(iv) Thus, both the companies face working capital problem and immediate steps should be
taken to issue more capital or raise long term loans to improve working capital position.

Interpretation
– The sale and gross profit have increased in 2007 as compared to 2006. But the percentage of
gross profit to sales has gone down in 2007. –
– The increase in cost of sales as a percentage of sales has brought the profitability from 34% to
27.14%. – Operating expenses have remained the same in both the years.
– Net profit have decreased both in absolute figures and as a percentage in 2007 as compared to
2006.

CAPITAL SRTUCTURE.
In order to run and manage a company, funds are needed. Right from the promotional stage up to end,
finances play an important role in a company's life. If funds are inadequate, or not properly managed, the entire
organisation suffers. It is, therefore, necessary that correct estimate of the current and future need of capital be
made to have an optimum capital structure which shall help the organisation to run its work smoothly and
without any stress.
Capital structure of a company refers to the make up of its capitalisation. A company procures funds by
issuing various types of securities i.e. ordinary shares, preference shares, bonds and debentures. According to
Gerestenbeg, "Capital structure of a company refers to the composition or make-up of its capitalisation and it
includes all long-term capital resources viz : loans, reserves, shares and bonds." The capital structure is made up
of debt and equity securities and refers to permanent financing of a firm. It is composed of long-term debt,
preference share capital and shareholder's funds.For example, a company has equity shares of Rs. 1,00,000,
debentures Rs. 1,00,000, preference shares of Rs. 1,00,000 and retained earnings of Rs. 50,000. The term
capitalisation is used for total long-term funds. In this case it is of Rs. 3,50,000. The term capital structure is
used for the mix of capitalisation. In this case it will be said that the capital structure of the company consists of
Rs. 1,00,000 in equity shares, Rs. 1,00,000 in preference shares, Rs. 1,00,000 in debentures and Rs. 50,000 in
retained earnings
Before issuing any of these securities, a company should decide about the kinds of securities to be
issued. In what proportion will the various kinds of securities be issued, should also be considered.
CAPITALISATION, CAPITAL STRUCTURE AND FINANCIAL STRUCTURE.

The terms, capitalisation, capital structure and financial structure, do not mean the same. Capitalisation
refers to the total amount of securities issued by a company while capital structure refers to the kinds of
securities and the proportionate amounts that make up capitalisation. For raising long-term finances, a company
can issue three types of securities viz. Equity shares, Preference Shares and Debentures. A decision about the
proportion among these types of securities refers to the capital structure of an enterprise.
Some authors on financial management define capital structure in a broad sense so as to include even the
proportion of short-term debt. In fact, they refer to capital structure as financial structure. Financial structure
means the entire liabilities side of the balance sheet.
OPTIMUM CAPITAL STRUCTURE; and FACTORS DETERMINING CAPITAL STRUCTURE

The optimum or balanced capital structure means an ideal combination of borrowed and
owned capital that may attain the marginal goal, ie maximizing of market value per share or minimization of
cost of capital. The market value will be maximised or the cost of capital will be minimised when the real cost
of each source of fund is the same.
The capital structure of a company is to be determined initially at the time the company is floated.
Great caution is required at this stage, since the initial capital structure will have long-term implications. Of
course, it is not possible to have an ideal capital structure but the management should set a target capital
structure and the initial capital structure should be framed and subsequent changes in the capital structure should
be done keeping in view the target capital structure. Thus, the capital structure decision is a continuous one and
has to be taken whenever a firm needs additional finances.
Following are the factors which should be kept in view while determining the capital structure of a company:
(1) Trading on Equity.
A company may raise funds either by issue of shares or by debentures. Debentures carry a fixed rate of interest
and this interest has to be paid irrespective of profits. Of course, preference shares are also entitled to a fixed
rate of dividend but payment of dividend depends upon the profitability of the company. In case the rate of
return (ROI) on the total capital employed (shareholders' funds plus long-term borrowed funds) is more than the
rate of interest on debentures or rate of dividend on preference shares, it is said that the company is trading on
equity. For example, the total capital employed in a company is a sum of Rs. 2 lakhs. The capital employed
consists of equity shares of Rs. 10 each. The company makes a profit of Rs. 30,000 every year. In such a case
the company cannot pay a dividend of more than 15% on the equity share capital. However, if the funds are
raised in the following manner, and other things remain the same, the company may be in a position to pay a
higher rate of return on equity shareholders' funds:

(2) Retaining Control.

The capital structure of a company is also affected by the extent to which the promoter/existing
management of the company desire to maintain control over the affairs of the company. The preference
shareholders and debentureholders have not much say in the management of the company. It is the
equity shareholders who select the team of managerial personnel. It is necessary, therefore, for the
promoters to own majority of the equity share capital in order to exercise effective control over the
affairs of the company. The promoters or the existing management are not interested in losing their grip
over the affairs of the company and at the same time, they need extra funds. They will, therefore, prefer
preference shares or debentures over equity shares so long they help them in retaining control over the
company.
(3) Nature of Enterprise

The nature of enterprise also to a great extent affects the capital structure of the company. Business enterprises
which have stability in their earnings or which enjoy monopoly regarding their products may go for debentures
or preference shares since they will have adequate profits to meet the recurring cost of interest/fixed dividend.
This is true in case of public utility concemes. On the other hand, companies which do not have this advantage
should rely on equity share capital to a greater extent for raising their funds. This is, particularly, true in case of
manufacturing enterprises.
(4) Legal Requirements

The promoters of the company have also to keep in view the legal requirements while deciding about the capital
structure of the company. This is particularly true in case of banking companies which are not allowed to issue
any other type of security for raising funds except equity share capital on account of the Banking Regulation
Act.
(5) Purpose of Financing
The purpose of financing also to some extent affects the capital structure of the company. In case funds are
required for some directly productive purposes, for example, purchase of new machinery, the company can
afford to raise 4he funds by issue of debentures. This is because the company will have the capacity to pay
interest on debentures out of the profits so earned. On the other hand, if the funds are required for non-
productive purposes, providing more welfare facilities to the employees such as construction of school or
hospital building for company's employees, the company should raise the funds by issue of equity shares.
(6) Period of Finance

The period for which finance is required also affects the determination of capital structure of companies. In case,
funds are required, say for 3 to 10 years, it will be appropriate to raise them by issue of debentures rather than
by issue of shares. This is because in case the funds are raised by issue of shares, their repayment after 8 to 10
years (when they are not required) will be subject to legal complications. Even if such funds are raised by issue
of redeemable preference shares, their redemption is also subject to certain legal restrictions. However, if the
funds are required more or less permanently, it will be appropriate to raise them by issue of equity shares.
(7) Market Sentiments

The market sentiments also decide the capital structure of the company. There are periods when people want to
have absolute safety. In such cases, it will be appropriate to raise funds by issue of debentures. At other periods,
people may be interested in earning high speculative incomes; at such times, it will be appropriate to raise funds,
by issue of equity shares. Thus, if a company wants to raise sufficient funds, it must take into account market
sentiments; otherwise its issue may not be successful.
(8) Requirement of Investors

Different types of securities are to be issued for different classes of investors. Equity shares are best suited for
bold or venturesome investors. Debentures are suited for investors who are very cautious while preference
shares are suitable for investors who are not very cautious. In order to collect funds from different categories of
investors, it will be appropriate for the companies to issue different categories of securities. This is particularly
true when a company needs heavy funds.
(9) Size of the Company

Companies which are of small size have to rely considerably upon the owners' funds for financing. Such
companies find it difficult to obtain long-term debt. Large companies are generally considered to be less risky
by the investors and, therefore, they can issue different types of securities and collect their funds from different
sources. They are in a better bargaining position and can get funds form the sources of their choice.
(10) Government Policy

Government policy is also an important factor in planning the company's capital structure. For example, a
change in the lending policy of financial institutions may mean a complete change in the financial pattern.

Similarly, by virtue of the Securities & Exchange Board of India Act, 1992 and the Rules made there under, the
Securities & Exchange Board of India can also considerably affect the capital issue policies of various
companies. Besides this, the monetary and fiscal policies of the Government also affect the capital structure
decision.
(11) Provision for the Future

While planning capital structure the provision for future should, also be kept in view. It will always be safe to
keep the best security to be issued in the last instead of issuing all types of securities in one installment. In the
words of Gerestenberg, "Manager of corporate financing operations must always think of rainy days or the
emergencies. The general rule is to keep your best security or some of your best securities till the last".
Cross-sectional analysis
It is also known as inter firm comparison. This analysis helps in analysing financial characteristics of an
enterprise with financial characteristics of another similar enterprise in that accounting period. For example, if
company A has earned 15% profit on capital invested. This does not say whether it is adequate or not. If we
analyse further and find that a similar company has earned 16% during the same period, then only we can make
a conclusion that company B is better. Thus, it turns into a meaningful analysis.
(ii) Time series analysis
It is also called as intra-firm comparison. According to this method, the relationship between different items of
financial statement is established, comparisons are made and results obtained. The basis of comparison may be :
– Comparison of the financial statements of different years of the same business unit.
– Comparison of financial statement of a particular year of different business units.
(iii) Cross-sectional cum time series analysis

This analysis is intended to compare the financial characteristics of two or more enterprises for a defined
accounting period. It is possible to extend such a comparison over the year. This approach is most effective
in analysing of financial statements.
DU-PONT CONTROL CHART.
A system of management control designed by an American company named Du-Pont paint Company
is popularly called Du-Pont Control Chart., This system uses the ratio inter-relationship to provide charts for
managerial attention. The standard ratios of the company are compared to present ratios and changes in
performance are judged.
The chart is based on two elements i.e., Net profit and capital employed. Net profit is related to
operating expenses. If the expenses are under control then profit margin will increase. The earnings as a
percentage of sales or earnings divided by sales give us percentage of profitability. Earnings can be calculated
by deducting cost of sales from sales. Cost of sales includes cost of goods sold plus office and administrative
expenses and selling and distributive expenses. Capital employed, on the other hand, consists of current assets
and net fixed assets. Current assets include debtors, stock, bills receivables, cash, etc. Fixed assets are taken
after deducting depreciation. So profit margin is divided by capital employed and is multiplied by 100.
So ratio will be Profit margin x 100

capital employed .

DU PONT CHART
Net profit ratio Investment Turnover
Sales / Investments
Operating profit / Sales
Investments
Sales Operating Expense Fixed assets + Working capital
Cost of goods sold + Selling

administrative and others.
The efficiency of a concern depends upon the working operations of the concern. The return on
investment becomes a yardstick to measure efficiency because return influences various operations. The profit
margin will show the efficiency with which assets of the business have been used. The efficiency can be
improved either by a better relationship between sales and costs or through more effective use of available
capital. The profitability can be increased by controlling costs and/or increasing sales. The investments turnover
can be raised by having a control over investments in fixed assets and working capital without adversely
affecting sales. The sales may also be increased with the use of same Capital. The management is able to
pinpoint weak spots and take corrective measures. The performance can be better judged by having inter-firm
comparison. The ratios of return on investment, assets turnover and profit margins of comparable companies can
be calculated and these can be used as standards of performance.

Ratio Analysis

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Ratio Analysis

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Financial Management

FINANCIAL STATEMENT ANALYSIS.

USERS OF FINANCIAL STATEMENT ANALYSIS.

3. BANKERS AND LENDERS

NSS College Rajakumari.

TYPES OF FINANCIAL ANALYSIS

A. On the basis of material used.

B. According to objectives of analysis.

C. According to the Modus Operandi of analysis.

a. Comparative Financial Statement Analysis

NSS College Rajakumari.

TOOLS OF FINANCIAL ANALYSIS (METHODS)

MEANING OF FUND FLOW.

1. Schedule of Changes in Working Capital.

NSS College Rajakumari.

Treatment of Provision for Bad debt.

2. Fund Flow statement

Application (Uses) of fund.

NSS College Rajakumari.

3. Calculation of FUND FROM OPERATION.

P&L A/C closing balance xxx

CASH FLOW ANALYSIS

Format of cash flow statement.

(Refer calculation of fund from operation.)

NSS College Rajakumari.

Quick Ratio. (Acid Test Ratio)

NSS College Rajakumari.

Quick assets = Current Assets – Inventories or stock

Generally a QR of 1:1 is considered to represent satisfactory current financial position.

Cash Ratio (Absolute Liquid Ratio).

Turn Over Ratio.

Inventory Turnover Ratio.

Debtors Turn over Ratio.

Creditors Turnover Ratio.

Net credit purchase = Gross credit purchase – returns to suppliers.

NSS College Rajakumari.

Gross profit margin.

Net Profit margin.

Earning Before interest and Tax (EBIT)

NSS College Rajakumari.

Profitability ratios related to Investments.

Return on capital employed.

Net profit after tax /EBIT

Return on Total shareholders equity.

Return on ordinary shareholders equity.(Net worth)

Earning Per Share.

Net profit available to equity shareholders

NSS College Rajakumari.

Dividend Per Share.

Dividend paid to equity shareholders

Dividend Pay –Out Ratio.

Total dividend to equity shareholders

Market price of share

Other important Ratios.

Debt Equity Ratio.

Share holders fund

Capital gearing ratio.

Fixed interest bearing funds

NSS College Rajakumari.

Working Capital Turnover

(Cost of goods sold + Operating expense)

Calculate 1) Current ratio, 2) Quick ratio, 3) Absolute liquid ratio.