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A study of top Indian companies with high return on capital employed (ROCE) shows that many of these companies have operated on negative working capital management. These companies are known to give good returns to their shareholders, both in terms of dividends and capital gains. Interestingly, most of these companies belong to the FMCG or the auto sector. Of the 30 stocks in the Sensex, seven stocks have negative working capital and ROCEs in the range of 20-80%. The total market capitalisation of these companies has moved up by 94% as against the entire Sensex, which moved up by 67% over the last one year. Industries like steel and cement, which are working capital-intensive, may not show high ROCEs on account of high capital costs. But some companies have begun to show negative working capital. A better credit management system will help these companies generate higher ROCEs in the long run. Today, cement companies carry a feedstock ranging from 5-6 days; it was earlier around 15-30 days. Overall, the cement industry's inventory turnover ratio is in the range of 10-12. Piling cement stocks in the warehouses of the companies is no longer a phenomenon. When the cement dispatches from the warehouses are growing at more than 20-30%, Indian cement companies are able to move cement from factories in less than a day. As a result of this, top cement companies such as ACC, Gujarat Ambuja, UltraTech Cement and Madras Cement have negative working capital. The same companies have given high returns to their shareholders in terms of dividends, bonuses as well as capital gains. Negative is positive HLL, Nestle and Godrej Consumers Products Ltd have ROCE in excess of 40%. The same goes for two-wheeler companies like Bajaj Auto, TVS and Hero Honda, which have given high returns on their investment. The success of this high return is associated with the way these companies have managed their working capital management cycles. These are the companies that first sell their goods and later on pay their raw material suppliers. This is possible only when the companies are huge in size and account for the bulk of turnover for their suppliers. In such a situation, they are always in a position to arm-twist the suppliers by taking more credit. Says Jigar Shah of broking firm KR Choksey: “Companies operating in industries like FMCG and automobiles have been able to manage working capital efficiently and, thus, create value for shareholders by way of high ROCE.” Leveraging on supply chain
HLL, which had a net negative working capital of Rs 183.3 crore in FY05, has been able to maintain its creditor days at 64 as compared to receivable days at 16. The company has generated a ROCE at 44.1%. On the other hand, Godrej Consumer Products (GCPL) is another company with negative working capital of Rs 45.48 crore and creditor days at 53, compared to average debtors of six days only. The company has earned an ROCE at almost 158%. Says Sunil Sapre, vice-president, finance, Godrej Consumer Products (GCPL): “Effective use of ERP systems, involving trade partners in planning and monitoring working capital items, following win-win policies, efficient operations at all levels enable GCPL to manage working capital efficiently. It has given us an advantage of higher sales and better ROCE.” The strong distribution and dominant position in the FMCG industry has made these companies to bargain with the debtors and creditors to expand the payment cycle in favour of the company. The FMCG companies have been able to keep their creditors almost equal to debtors and inventory, which have resulted in a lot of cash generation for these companies, which is again invested in the business. These companies also make investment in short-term papers and call money, which allows them to earn good returns. “Traditionally, the FMCG companies are known for maintaining negative working capital which is leveraged on strong supply chain management. Since this industry accounts for very negligible amount of debtors, the whole trade is financed by creditors from the production side and vendors and dealers from the supply side,” says an FMCG analyst. The fast track For the automobile industry, the most critical factor of the working capital is inventory management. In the two-wheeler segment, Hero Honda and Bajaj Auto have negative working capital of Rs 1047 crore and Rs 344 crore and generate RoCE of 81% and 21.6%, respectively. The Indian automobile industry has come a long way in terms of managing inventory. The inventory-turnover ratio in the last five years has improved more than two times. Companies have been able to produce fast and sell in the market and realise the cash. Hero Honda, which had an inventory turnover ratio of as low as 18.50 in FY01 has improved significantly to 47.59 and Bajaj Auto notched it from 17.14 for FY01 to 32.37 in FY05. Says Ravi Sud, CFO, Hero Honda, “Hero Honda has asked its major suppliers to have their warehouses around its manufacturing locations to reduce the inventory at our end. The concept of direct on line has been implemented for about 100 vendors where the material is supplied directly on the assembly line without being stored.”
Hero Honda has managed its working capital very efficiently and has been having negative working capital for the last six years. The inventory number of days has come down from 29 days in 1999 to 10 days in 2005 due to indigenous production. Imported inventory has reduced to about 30 days stock in the factory and similar stock is kept in transit due to long transportation time. It is evident that the companies have significantly reduced the level of inventory. In the four-wheeler and commercial vehicle segment, Tata Motors has a negative working capital of Rs19.92 crore and a ROCE of 32.76%. The companies with good brand image have been the major beneficiaries of the country's booming automobiles market. On the one hand, these companies have been giving bulk orders to auto ancillaries companies while sourcing the auto parts with the condition of extended credit cycles. On the other hand, the dealers have been pushed to pay upfront or in advance. Companies like Hero Honda, Bajaj Auto and TVS Motors enjoy a significant gap of number of days between the payment to creditors and their receivables. Receivables are managed through implementing a credit policy, which rewards efficient dealers and penalises inefficient ones. The dealers are required to keep 15 days paid-up stock and then enjoy 15 days credit for stock beyond 15 days. If the payment is not received within 15 days, the interest is charged from day one. This does not mean that companies with high working capital do not generate returns to their shareholders. It is in the nature of some businesses to sustain efficiency in managing their working capital, while some industries are simply working capital-intensive. But even for industries that have high working capital, they need to generate higher revenues to maintain a healthy operating ratio. But negative working capital is one important parameter that no successful investor has ever missed. Multi Page Format
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Successful investors have always given a lot of thrust on working capital management. A study of top Indian companies with high return on capital employed (ROCE) shows that many of these companies have operated on negative working capital management. These companies are known to give good returns to their shareholders, both in terms of dividends and capital gains. Interestingly, most of these companies belong to the FMCG or the auto sector.
Of the 30 stocks in the Sensex, seven stocks have negative working capital and ROCEs in the range of 20-80%. The total market capitalisation of these companies has moved up by 94% as against the entire Sensex, which moved up by 67% over the last one year. Industries like steel and cement, which are working capital-intensive, may not show high ROCEs on account of high capital costs. But some companies have begun to show negative working capital. A better credit management system will help these companies generate higher ROCEs in the long run. Today, cement companies carry a feedstock ranging from 5-6 days; it was earlier around 15-30 days. Overall, the cement industry's inventory turnover ratio is in the range of 10-12. Piling cement stocks in the warehouses of the companies is no longer a phenomenon. When the cement dispatches from the warehouses are growing at more than 20-30%, Indian cement companies are able to move cement from factories in less than a day. As a result of this, top cement companies such as ACC, Gujarat Ambuja, UltraTech Cement and Madras Cement have negative working capital. The same companies have given high returns to their shareholders in terms of dividends, bonuses as well as capital gains. Negative is positive HLL, Nestle and Godrej Consumers Products Ltd have ROCE in excess of 40%. The same goes for two-wheeler companies like Bajaj Auto, TVS and Hero Honda, which have given high returns on their investment. The success of this high return is associated with the way these companies have managed their working capital management cycles. These are the companies that first sell their goods and later on pay their raw material suppliers. This is possible only when the companies are huge in size and account for the bulk of turnover for their suppliers. In such a situation, they are always in a position to arm-twist the suppliers by taking more credit. Says Jigar Shah of broking firm KR Choksey: “Companies operating in industries like FMCG and automobiles have been able to manage working capital efficiently and, thus, create value for shareholders by way of high ROCE.” Leveraging on supply chain HLL, which had a net negative working capital of Rs 183.3 crore in FY05, has been able to maintain its creditor days at 64 as compared to receivable days at 16. The company has generated a ROCE at 44.1%. On the other hand, Godrej Consumer Products (GCPL) is another company with negative working capital of Rs 45.48 crore and creditor days at 53, compared to average debtors of six days only. The company has earned an ROCE at almost 158%.
Says Sunil Sapre, vice-president, finance, Godrej Consumer Products (GCPL): “Effective use of ERP systems, involving trade partners in planning and monitoring working capital items, following win-win policies, efficient operations at all levels enable GCPL to manage working capital efficiently. It has given us an advantage of higher sales and better ROCE.” The strong distribution and dominant position in the FMCG industry has made these companies to bargain with the debtors and creditors to expand the payment cycle in favour of the company. The FMCG companies have been able to keep their creditors almost equal to debtors and inventory, which have resulted in a lot of cash generation for these companies, which is again invested in the business. These companies also make investment in short-term papers and call money, which allows them to earn good returns. “Traditionally, the FMCG companies are known for maintaining negative working capital which is leveraged on strong supply chain management. Since this industry accounts for very negligible amount of debtors, the whole trade is financed by creditors from the production side and vendors and dealers from the supply side,” says an FMCG analyst. The fast track For the automobile industry, the most critical factor of the working capital is inventory management. In the two-wheeler segment, Hero Honda and Bajaj Auto have negative working capital of Rs 1047 crore and Rs 344 crore and generate RoCE of 81% and 21.6%, respectively. The Indian automobile industry has come a long way in terms of managing inventory. The inventory-turnover ratio in the last five years has improved more than two times. Companies have been able to produce fast and sell in the market and realise the cash. Hero Honda, which had an inventory turnover ratio of as low as 18.50 in FY01 has improved significantly to 47.59 and Bajaj Auto notched it from 17.14 for FY01 to 32.37 in FY05. Says Ravi Sud, CFO, Hero Honda, “Hero Honda has asked its major suppliers to have their warehouses around its manufacturing locations to reduce the inventory at our end. The concept of direct on line has been implemented for about 100 vendors where the material is supplied directly on the assembly line without being stored.” Hero Honda has managed its working capital very efficiently and has been having negative working capital for the last six years. The inventory number of days has come down from 29 days in 1999 to 10 days in 2005 due to indigenous production. Imported inventory has reduced to about 30 days stock in the factory and similar stock is kept in transit due to long transportation time.
It is evident that the companies have significantly reduced the level of inventory. In the four-wheeler and commercial vehicle segment, Tata Motors has a negative working capital of Rs19.92 crore and a ROCE of 32.76%. The companies with good brand image have been the major beneficiaries of the country's booming automobiles market. On the one hand, these companies have been giving bulk orders to auto ancillaries companies while sourcing the auto parts with the condition of extended credit cycles. On the other hand, the dealers have been pushed to pay upfront or in advance. Companies like Hero Honda, Bajaj Auto and TVS Motors enjoy a significant gap of number of days between the payment to creditors and their receivables. Receivables are managed through implementing a credit policy, which rewards efficient dealers and penalises inefficient ones. The dealers are required to keep 15 days paid-up stock and then enjoy 15 days credit for stock beyond 15 days. If the payment is not received within 15 days, the interest is charged from day one. This does not mean that companies with high working capital do not generate returns to their shareholders. It is in the nature of some businesses to sustain efficiency in managing their working capital, while some industries are simply working capital-intensive. But even for industries that have high working capital, they need to generate higher revenues to maintain a healthy operating ratio. But negative working capital is one important parameter that no successful investor has ever missed. Multi Page Format
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The basics of ratio analysis
N. R. Parasuraman WHILE the profit and loss (P&L) account of a company essentially contains revenue items, appropriation and provisions, the balance-sheet lists out the assets and liabilities. While it is useful to understand the absolute quantum of each asset, liability and revenue item in isolation, far greater understanding of its implication with respect to the trend and performance of the company can be achieved by a `relationship' study. For instance, if one studies profits in relation to sales for the current year and
compares it with the same relationship for a series of years, a greater understanding of the trend and performance can be had. The `relationship' study referred has two facets: i) the relationship of one item to another for the current or previous years, but in respect of the same company, and ii) the relationship of these parameters with industry figures or representative figur es of competitors or of firms of similar size and operations. The first set enables one to understand the performance of the company in isolation, while the second gives an insight as to where the company stands vis-a-vis the industry or competition. The intuitive way of arriving at a `relationship' is to develop ratios among key parameters. After the finalised statement of accounts is ready, one ascertains the ratio of one key parameter to another. A large number of ratios are in common use, but som e of these are useful only for specific end uses such as project appraisal, working capital analysis, securities analysis, and so on. This discussion is restricted to only those ratios which are universal in nature and which can be computed easily. The liquidity ratios give a clear indication of the extent to which a company is liquid. Liquidity and profitability are two separate yardsticks to gauge a company's performance. The current ratio gives an indication of the number of times by which the c urrent assets multiply the current liabilities. In a healthy industry, the current ratio should be upwards of 1.75. A figure of less than 1.25 would indicate that the company's working capital management has to be pretty rigid to keep the liquidity afloa t. The quick or acid test ratio is a modification of the current ratio in that only the `quick' assets are considered in the numerator, and inventory, which is the slowest of the current assets, is ignored. The measure gives the extent of fast liquidity enjoyed by the company. Just as important as liquidity is the level of profitability. While absolute figures of profitability may be adequate for some cases, a better understanding of the performance of a company can be had by studying the profits in relation to select paramete rs such as sales, capital employed and equity capital. These relationships are covered under profitability ratios. It may be noted that for return on equity, only the net income after interest is taken, whereas for return on assets, the net income before interest. This is because, in the latter ratio we are looking at what the total investment fetched and not what is left for the equity holders. The debt ratio can ascertain the extent of reliance of external financing. The debtequity ratio gives the proportion of debt to equity. In capital-intensive industries, this ratio can be as high as four -- that is, debt can be up to four times the equit y portion. Normally, a debt-equity ratio of two is considered acceptable. The `times interest earned ratio' is a matter or reassurance to the lenders that their interest dues are protected. If the company is doing well in terms of having a high times int erest earned ratio, it means that the interest liability is only a relatively small portion of the company's net surplus. However, if the ratio is small, there is cause for concern for the lender. Only the most essential and fundamental ratios are considered here. Depending on the specific needs of the user, more ratios can be utilised.
By comparing the various ratios with those of the previous year or years, the areas where the company has improved can be identified; as also the spheres where finances display a fall in the performance. This will act as a good planning tool. Ratios have far greater utility if compared with those of the industry as a whole and those of the competitors. Specific areas which need improvement can be identified and corrective action initiated. Concept check * A high profit-to-sales ratio means that the return on assets is also high. Do you agree? * Suppose you are viewing key ratios of a company from the angle of a term-lending institution, and find that the quick ratio is less than one but the current ratio and the times interest earned ratio are 1.2 and 2 respectively, what will be your assessm ent about the interest and principal repayment capacity of the company?
Parvatha Vardhini C A quicker way to understand a company’s performance, rather than poring over pages of accounts, notes and schedules in the annual report is through ‘ratio analysis’. Ratios can be classified into profitability ratios, coverage, turnover and financial ratios. We’ll take a look at a few ratios, their relevance and significance. Profitability/ Return on Investment ratio We start with profitability rations, as profit is the foremost objective of any business. Are the operations efficient enough to generate profits? This is what banks/financial institutions and creditors are worried about. After all, their money can be repaid only when the company is able to generate income from its operations, is it not? Shareholders, too, are equally concerned about profitability, as it broadly indicates the likely return they can earn on their investments. The profitability ratio is calculated as: Operating profit/capital employed x 100. Operating profit is the profit before interest and taxes (PBIT). Capital employed is share capital + reserve and surplus + long-term liabilities - (nonbusiness assets + fictitious assets). Suppose the return is 8 per cent, how will you know whether this is good or bad? As a thumb rule, if the company has borrowed funds at, say, 7 per cent, the ROI should be greater than 7 per cent for the business to be profitable. Coverage ratios The ROI will show if the company is profitable alright; but will the profits be enough to pay interest on loan or repay the amount? This is where the ‘fixed interest cover’ and ‘debt service coverage’ (DSCR) ratios come in. Calculated as PBIT/ Interest charges, the higher the fixed interest cover, the better. A comfortable interest cover would be at least two-three times. To find out whether a company can repay the principal portion of its loan on time, the DSCR is calculated — the formula being, PBIT/interest + (principal payment instalment / (1 – tax rate)). A DSCR of over 1 is considered appropriate. But here again, the higher the coverage, the better. Turnover ratios While the ROI is one indicator of profitability, the speed at which capital employed in the business rotates or is unlocked, is another. The higher the rotation, the greater the profitability. The ‘fixed assets turnover’ ratio (net sales/ net fixed assets) shows how much of the investment in fixed assets contribute towards sales. Ditto with the working capital ratios. High volume of sales with a relatively low working capital is an indicator of efficiency.
Credit sales/average accounts receivable will give the debtors turnover ratio. Say the turnover is three times, using this, we can calculate the collection period (months in a year/debtor’s turnover) as 12 / 3 = 4 months. This collection period indicates the promptness or the lack of it in money collection. Generally, the receivables should not exceed three-four months of credit sales. Such calculations can also be made for creditors. Similarly, a high inventory turnover (cost of goods sold/average inventory) ratio indicates good sales. A low ratio, in turn, indicates that money is locked up in stocks. The working capital ratios are useful in determining the company’s ability to generate future cash flows from operations. Financial ratios Liquidity and debt-equity ratios are widely used financial ratios. Liquidity ratio, also called the ‘short-term solvency’ ratio shows the adequacy or otherwise of working capital for a company’s day-to-day operations. It is calculated as current assets/current liabilities. An ideal current ratio would be 2, indicating that even if the current assets are to be reduced by half, the creditors will be able to able to get their money in full. But a lot depends on the composition of current assets. If a substantial portion of the current assets is made of slow-moving/obsolete stocks or if the debtors comprise ageing debts, the company may not be able to pay the creditors even if the current ratio is higher than 2. The debt-equity ratio is calculated as total long-term debt/shareholders’ funds. It is considered ideal if the ratio is 1. This ratio shows the extent of owners’ stake in the business as also the extent to which firm depends upon outsiders for existence.
Ratio Analysis Ratio Analysis is the most commonly used analysis to judge the financial strength of a company. A lot of entities like research houses, investment bankers, financial institutions and investors make use of this analysis to judge the financial strength of any company. This analysis makes use of certain ratios to achieve the above-mentioned purpose. There are certain benchmarks fixed for each ratio and the actual ones are compared with these benchmarks to judge as to how sound the company is. The ratios are divided into various categories, which are mentioned below: Profitability ratios Profitability ratios speak about the profitability of the company. The various profitability ratios used in the analysis are, operating margin (operating profit divided by net sales), gross margin (gross profit divided by net sales) net profit margin (net profit divided by net sales), return on equity (net profit divided by net worth of the company) and return on investment (operating profit divided by total assets). As obvious from the name, the higher these ratios the better for the company. Solvency ratios These ratios are used to judge the long-term solvency of a firm. The most commonly used ratios are – Debt Equity ratio (total debt divided by total equity), Long term debt to equity ratio (long term debt divided by equity). While the accepted norm for debt equity ratio differs from industry to industry, the usual accepted norm for D/E is 2:1. It should not be more than this. For certain industries, a higher D/E is accepted, e.g., in banking industry, a debt equity ratio of 12:1 is acceptable. Liquidity ratios
These ratios are used to judge the short-term solvency of a firm. These ratios give an indication as to how liquid a firm is. The most commonly used ratios are – Current ratio (all current assets divided by current liabilities) and quick ratio (current assets except inventory divided by current liabilities). The accepted norm for current ratio is 1.5:1. It should not be less than this. Turnover ratios These ratios give an indication as to how efficiently a company is utilizing its assets. The most commonly ratios are sales turnover ratio, inventory turnover ratio (average inventory divided by net sales) and asset turnover ratio (net sales divided by total assets). The higher these ratios, the better for the company. Valuation Ratios Valuation ratios give an indication as to whether the stock is underpriced or overpriced at any point of time. The most commonly used ratios are Price to Earnings (P/E) ratio and price to book value (PBV) ratio. But care has to be taken while interpreting these ratios. While P/E ratio of a company should be compared with the industry P/E and the P/E of the competitors, it is the PBV that can distort. While a lower PBV usually means a lower valuation, there can be a case where a low PBV can be because of a very huge capital base of the company. In such a case, the stock might be overvalued but the PBV will indicate that the stock is undervalued. On the other extreme, a higher PBV usually means overvalued stock but that can also be because the company has a very small capital base. So care has to taken while interpreting these ratios. Coverage ratios These ratios give an indication about the repayment capabilities of a company. The most commonly used coverage ratios are Interest coverage ratio (Interest outstanding divided by earnings before interest and taxes) and debt service coverage ratio (earnings before interest and taxes plus all non cash charges divided by interest outstanding plus the term loan repayment installment). The acceptable norm for DSCR is 2:1.
Ratio Analysis Not all corporates can raise capital from the market. Capital market is an information driven arena. The availability of market capital to an existing corporate depends solely on its perceived performance. The market watchers have, at their disposal, various tools to make this value judgement. Ratio analysis is one such oft used (or abused) tool. The trends in management, financial viability and other factors relevant from the point of view of the market can be studied from the various financial ratios such as: Leverage Indicators (debt-equity ratio)
Cost ratios Current ratios Retained earning ratios Dividend ratios etc. The indicators of profitability of companies are: Profits to sales ratios Profits (EBDIT) to total capital employed ratio, Operating profit to sales ratios and Profit to tangible Net worth ratio. Other ratios and percentages: Profit allocation ratios Profitability ratios Capital formation growth rates Ratios on sources and uses of funds Activity ratios Ratio analysis is a useful tool of for both micro and macro financial appraisal. Like all other analytical tools, its usefulness depends on the user and the purpose. There are no standard ratios applicable to all purposes and situations. Certain ratios are more useful at micro level and others at macro level. Broadly, ratios represent a relation between two variables chosen and the type of relation set out has to be seen for a particular purpose. Any number of such ratios can be designed depending upon the purpose of the analysis. In isolation, ratios can be used only for time-series analysis of the company' performance. In such an analysis, continuing inefficiencies built into the system of a corporate escape observation. Very important factors in ratio analysis, therefore, are benchmarking and cross-sectional analysis. With the availability of commercial databases in the market these tools can also be used to accurately analyse the performance of a corporate. Ratio analysis, therefore, should be applied, not in isolation but with reference to a group of companies within an industry to ascertain its financial viability, and other relevant factors. This same tool can also be used at the time of taking investment decisions.
RATIO ANALYSIS Mere statistics/data presented in the different financial statements do not reveal the true picture of a financial position of a firm. Properly analyzed and interpreted financial statements can provide valuable insights into a firm’s performance. To extract the information from the financial statements, a number of tools are used to analyse such statements. The most popular tool is the Ratio Analysis. Financial ratios can be broadly classified into three groups: (I) Liquidity ratios, (II) Leverage/Capital structure ratio, and (III) Profitability ratios. (I) Liquidity ratios: Liquidity refers to the ability of a firm to meet its financial obligations in the short-term which is less than a year. Certain ratios, which indicate the liquidity of a firm, are (i) Current Ratio, (ii) Acid Test Ratio, (iii)
Turnover Ratios. It is based upon the relationship between current assets and current liabilities. (i) Current ratio = Current Assets/ Current Liabilities The current ratio measures the ability of the firm to meet its current liabilities from the current assets. Higher the current ratio, greater the short-term solvency (i.e. larger is the amount of rupees available per rupee of liability). (ii) Acid-test Ratio = Quick Assets/ Current Liabilities Quick assets are defined as current assets excluding inventories and prepaid expenses. The acid-test ratio is a measurement of firm’s ability to convert its current assets quickly into cash in order to meet its current liabilities. Generally speaking 1:1 ratio is considered to be satisfactory. (iii) Turnover Ratios: Turnover ratios measure how quickly certain current assets are converted into cash or how efficiently the assets are employed by a firm. The important turnover ratios are: Inventory Turnover Ratio, Debtors Turnover Ratio, Average Collection Period, Fixed Assets Turnover and Total Assets Turnover Inventory Turnover Ratio = Cost of Goods Sold / Average Inventory Where, the cost of goods sold means sales minus gross profit. ‘Average Inventory’ refers to simple average of opening and closing inventory. The inventory turnover ratio tells the efficiency of inventory management. Higher the ratio, more the efficient of inventory management. Debtors’ Turnover Ratio = Net Credit Sales / Average Accounts Receivable (Debtors) The ratio shows how many times accounts receivable (debtors) turn over during the year. If the figure for net credit sales is not available, then net sales figure is to be used. Higher the debtors turnover, the greater the efficiency of credit management. Average Collection Period = Average Debtors / Average Daily Credit Sales Average Debtors Average Collection Period represents the number of days’ worth credit sales that is locked in debtors (accounts receivable). Average Collection Period = 365 Days / Debtors Turnover Fixed Assets turnover ratio measures sales per rupee of investment in fixed assets. In other words, how efficiently fixed assets are employed. Higher ratio is preferred. It is calculated as follows: Fixed Assets turnover ratio = Net. Sales / Net Fixed Assets Total Assets turnover ratio measures how efficiently all types of assets are employed. Total Assets turnover ratio = Net Sales / Average Total Assets (II) Leverage/Capital structure Ratios: Long term financial strength or soundness of a firm is measured in terms of its ability to pay interest regularly or repay principal on due dates or at the time of maturity. Such long term solvency of a firm can be judged by using leverage or capital structure ratios. Broadly there are two sets of ratios: First, the ratios based on the relationship between borrowed funds and owner’s capital which are computed from the balance sheet. Some such ratios are: Debt to Equity and Debt to Asset ratios. The second set of ratios which are calculated from Profit and Loss Account are: The interest coverage ratio and debt service coverage ratio are coverage ratio to leverage risk. (i) Debt-Equity ratio reflects relative contributions of creditors and owners to finance the business. Debt-Equity ratio = Total Debt / Total Equity The desirable/ideal proportion of the two components (high or low ratio) varies from industry to industry. (ii) Debt-Asset Ratio: Total debt comprises of long term debt plus current liabilities. The total assets comprise of permanent capital plus current liabilities. Debt-Asset Ratio = Total Debt / Total Assets The second set or the coverage ratios measure the relationship between proceeds from the operations of the firm and the claims of outsiders. (iii) Interest Coverage ratio = Earnings Before Interest and Taxes /Interest Higher the interest coverage ratio better is the firm’s ability to meet its interest burden. The lenders use this ratio to assess debt servicing capacity of a firm. (iv) Debt Service Coverage Ratio (DSCR) is a more comprehensive and apt to compute debt service capacity of a firm. Financial institutions calculate the average DSCR for the period during which the term loan for the project is repayable. The Debt Service Coverage Ratio is defined as follows: DSCR - Profit after tax Depreciation Other Non-cash Expenditure Interest on term loan / Interest on Term loan Repayment of term loan (III) Profitability ratios: Profitability and operating/management efficiency of a firm is judged mainly by the following profitability ratios: (i) Gross Profit Ratio (%) = Gross Profit / Net Sales * 100 (ii) Net Profit Ratio (%) = Net Profit / Net Sales * 100
Some of the profitability ratios related to investments are: (iii) Return on Total Assets = Profit Before Interest And Tax / (Fixed Assets Current Assets) (iv) Return on Capital Employed = Net Profit After Tax / Total Capital Employed (Here, Total Capital Employed = Total Fixed Assets + Current Assets - Current Liabilities) (v) Return on Shareholders’ Equity = Net profit After-Tax / Average Total Shareholders Equity or Net Worth (Net worth includes Shareholders’ equity capital plus reserves and surplus) A common (equity) shareholder has only a residual claim on profits and assets of a firm, i.e., only after claims of creditors and preference shareholders are fully met, the equity shareholders receive a distribution of profits or assets on liquidation. A measure of his well being is reflected by return on equity. There are several other measures to calculate return on shareholders’ equity of which the following are the stock market related ratios: (i) Earnings Per Share (EPS): EPS measures the profit available to the equity shareholders per share, that is, the amount that they can get on every share held. It is calculated by dividing the profits available to the shareholders by number of outstanding shares. The profits available to the ordinary shareholders are arrived at as net profits after taxes minus preference dividend. It indicates the value of equity in the market. EPS = Net profit AvailableToThe Shareholder / Number of Ordinary Shares Outstanding (ii) Price-earnings ratios = P/E Ratio = Market Pr ice per Share / EPS Abbreviations:NSE- National Stock Exchange of India Ltd.SEBI - Securities Exchange Board of IndiaNCFM NSE’s Certification in Financial MarketsNSDL - National Securities Depository LimitedCSDL - Central Securities Depository LimitedNCDEX - National Commodity and Derivatives Exchange Ltd.NSCCL National Securities Clearing Corporation Ltd.FMC – Forward Markets CommissionNYSE- New York Stock ExchangeAMEX - American Stock ExchangeOTC- Over-the-Counter MarketLM – Lead ManagerIPO- Initial Public OfferDP - Depository ParticipantDRF - Demat Request FormRRF - Remat Request FormNAV – Net Asset ValueEPS – Earnings Per ShareDSCR - Debt Service Coverage RatioS&P – Standard & PoorIISL India Index Services & Products LtdCRISIL- Credit Rating Information
Companies despatch their annual reports once every accounting year (normally 12 months). With these reports running into hundreds of pages, how do you quickly understand a company's performance over this period? As accounts are prepared using the double-entry system, every item is linked to at least one other item. Hence, understanding financial ratios would help profile a company. These ratios are broadly classified as leverage, liquidity, efficiency and profitability ratios. We shall first focus on the profitability ratios for, as investors, we are more concerned with the company's earnings than with its operational efficiency, capital structure or its ability to meet debt obligations.
Margin ratios, one of the key measures of profitability, show the efficiency of the firm in retaining revenues. These can be classified further into gross margin, operating margin and net margin ratios. The operating margin ratio is calculated by dividing the operating income (net sales minus production, administration and selling and distribution costs) by net sales. In other words, it is the percentage of revenue earned in excess of production, administration and selling and distribution costs. Realisations or billing rates and operating cost per unit are among the key factors that drive this ratio. Volumes, though not as pivotal as the earlier mentioned factors, also play a role. The operating margin also serves as an indicator of the cost-competitiveness compared to peers where individual costs cannot be determined easily. For example, while India Cements has an operating margin of about 13 per cent, its peer, Madras Cements has about 15 per cent.
The net profit margin, another key measure of profitability, is calculated by dividing post-tax earnings by net sales. It is the percentage of revenue that accrues to the owners of the entity. This ratio is a function of the operating margin, interest coverage and the rate of incidence of tax. While high margins are desirable, as they provide a cushion against the risk of adverse changes, investors need to look at the structure of the margins to determine the sustainability and scope for improvement. A significantly high margin needs to be treated with caution as threats from new entrants and substitute products are higher. Tendency to hike capacities, leading to overcapacity, is also more; the recent trend in the caustic soda industry is case in point. While the above two measures of profitability are derived from the income statement (simply, the profit-and-loss account) the following two return ratios are derived from both the income statement and the balance-sheet.
Return on capital employed
This ratio indicates the profitability of an entity's capital investments. Why does this ratio matter to an investor? If this ratio is lower than the rate at which the company borrows, any further rise in debt will lead to negative earnings growth.
Return on Net worth
This ratio indicates an entity's profitability and efficiency, and is arrived at by dividing earnings after taxes by the shareholder's funds. This ratio, a combination of three underlying factors, is related to profit margin, asset management, and leverage. When an investor goes by the price-to-book value measure, he should consider this ratio as it aids in measuring the rate at which a company improves its shareholder funds. Although a high RONW is desirable, the stability of this ratio plays a significant role. A key reason for the steady run-up in the price of Infosys Technologies is the fact that the company has recorded an average RONW of 40 per cent over the past five years. This would indicate that the company has grown more than four-fold in this period.
Analysis of Financial Statement Chapter VI Answers to the very short answers questions.
Ans.1 Analysis of Financial statement is the systematic process of identifying the financial strength and weaknesses of the firm by establishing the relationship between the items of the Balance Sheet and income statement.
Bank and financial institutions are interested to know the financial position and profitability of the firm before granting any loan to the firm.
In a comparative Balance sheet, assets, liabilities and capital of current year are compares with that of previous years.
It is that statement in which net sales figure is taken as 100 and all other figures are expressed as percentage of sales.
Ratio analysis is the process of computing, determining and presenting the relationship of items and groups of items in the financial statement, analysis of Financial statements on the basis of ratios is known as ratio analysis.
Cash flow statement is a statement which shows inflows and outflows of cash and cash equivalence of an enterprise during a specified period of time.
A mutual fund company is a financial enterprises and so a dividend of Rs. 25 lacs received by this company from its investment in units will be cash in flow from operating activities.
It is classified under financing activity. While preparing the cash flow statement according to AS-3 (Revised) the activities are classified into three groups : i) Operating activities ii) activities. Investing activities and (iii) Financing
Ans.10 Dividend paid by a manufacturing company is classified under Financing activities.
LIQUIDITY RATIOS Current Ratio Total current assets divided by total current liabilities. This ratio is a rough indication of a firm's ability to service its current obligations. Generally, the higher the current ratio, the greater the "cushion" between current obligations and your Company's ability to pay them. The composition and quality of current assets is a critical factor in the analysis of your Company's liquidity. Quick Ratio Cash plus trade receivables divided by total current liabilities. Also know as the "Acid Test" ratio, it is a refinement of the current ratio and is a more conservative measure of liquidity. The ratio expresses the degree to which your current Company's current liabilities are covered by the most liquid current assets. Generally, any value of less than 1 to 1 implies a "dependency" on inventory or other current assets to liquidate short-term debt. Sales/Receivables Net sales divided by average trade receivables.
Industry 12-31-03 12-31-04 12-31-05 Average
This ratio measures the number of times trade receivables turn over during the year. The higher the turnover of receivables, the shorter the time between sale and cash collection. If your Company's receivables appear to be turning slow, further research is needed and the quality of the receivables should be examined closely. A problem with this ratio is that it compares one day's receivables, shown at the balance sheet date, to total annual sales and does not take into consideration seasonal fluctuations. An additional problem in interpretation may arise when there is a large proportion of cash sales to total sales. Days' Receivables The sales/receivables ratio divided into 365 (days in year). This figure expresses the average time in days that receivables are outstanding. Generally, the greater number of days outstanding, the greater the probability of delinquencies in accounts receivable. Your Company's daily receivables may indicate the extent of the Company's control over credit and collections. Cost of Sales/Inventory Cost of sales divided by average inventory. This ratio measures the number of times inventory is turned over during the year. High inventory turnover can indicate better liquidity or superior merchandising. Conversely, it can indicate a shortage of needed inventory for sales. Low inventory turnover can indicate poor liquidity, possible overstocking, obsolescence, or in contrast to these negative interpretations a planned inventory buildup in the case of material 11.0 13.0 13.1 9.8 43 49 53 49
shortages. A problem with this ratio is that it compares one day's inventory to cost of goods sold and does not take seasonal fluctuations into account. Days' Inventory The cost of sales/inventory ratio divided into 365 (days in year). This figure expresses the average time in days that units are in inventory. Cost of Sales/Payables Cost of sales divided by average trade payables. This ratio measures the number of times trade payables turn over during the year. The higher the turnover of payables, the shorter the time between purchase and payment. If your Company's payables appear to be turning slow, then the Company may be experiencing cash shortages, disputing invoices with suppliers, enjoying extended terms, or deliberately expanding its trade credit. If your Company buys on 30-day terms, it is reasonable to expect this ratio to turn over in approximately 30 days. A problem with this ratio is that it compares one day's payables to cost of goods sold and does not take seasonal fluctuations into account. Days Payables The cost of sales/payables ratio divided into 365 (days in year). 46 61 65 41 8.0 5.9 5.6 8.9 33 28 28 37
This figure expresses the average time in days that payables are outstanding. Sales/Working Capital Net sales divided by working capital. 22.4 47.3 39.1 13.6
Working capital is a measure of the margin of protection for current creditors. It reflects the ability to finance current operations. Relating the level of sales arising from operations to the underlying working capital measures how efficiently working capital is employed. A low ration may indicate an inefficient use of working capital while a very high ratio often signifies overtrading - vulnerable position for creditors.
COVERAGE RATIOS Earnings Before Interest and Taxes (EBIT)/Interest Earnings before annual interest expense and taxes divided by annual interest expense. This ratio is a measure of your Company's ability to meet interest payments. A high ratio may indicate that a borrower would have little difficulty in meeting the interest obligations of a loan. This ratio also serves as an indicator of your Company's capacity to take on additional debt. Net Profit + Depreciation, Depletion, Amortization/Current Maturities Long-Term Debt Net profit plus depreciation, depletion, and amortization expenses divided by the current portion of long-term debt. This ratio expresses the coverage of current maturities by cash flow from operations. Since cash flow is the primary source of debt retirement, this ratio measures the ability of your Company to service principal repayment and is an indicator of additional debt capacity. Although it is misleading to think that all cash flow is available for debt service, the ratio is a valid measure of the ability to service long-term debt. LEVERAGE RATIOS Fixes/Worth Fixed assets (net) divided by tangible net worth. This ratio measures the extent to which
Industry 12-31-03 12-31-04 12-31-05 Average
Industry 12-31-03 12-31-04 12-31-05 Average
owner's equity (capital) has been invested in plant and equipment (fixed assets). A lower ratio indicates a proportionately smaller investment in fixed assets in relation to net worth, and a better "cushion" for creditors in case of liquidation. Similarly, a higher ratio would indicate the opposite situation. The presence of substantial leased fixed assets (not shown on the balance sheet) may deceptively lower this ratio. Debt/Worth Total liabilities divided by tangible net worth. This ratio expresses the relationship between capital contributed by creditors and that contributed by owners. It expresses the degree of protection provided by the owners for the creditors. The higher the ration, the greater the risk being assumed by creditors. A lower ratio generally indicates greater long-term financial safety. A firm with a low debt/worth ratio usually has greater flexibility to borrow in the future. A more highly leveraged company has a more limited debt capacity. OPERATING RATIOS Profits Before Taxes/Tangible Net Worth Profit before taxes divided by tangible net worth. This ratio expresses the rate of return on tangible capital employed. While it can serve as indicator of management performance, one is cautioned to use it in conjunction with other ratios. A high return normally associated with effective management, could indicate an undercapitalized firm. Whereas, a low return, usually an indicator of inefficient management performance, could reflect a highly capitalized, conservatively operated 48.2% -16.8% 13.3% 22.4% Industry 12-31-03 12-31-04 12-31-05 Average 3.5 3.2 6.0 2.3
business. Profit Before Taxes/Total Assets Profit before taxes divided by average total assets. This ratio expresses the pre-tax return on total assets and measures the effectiveness of management in employing the resources available to it. A heavily depreciated plant and a large amount of intangible assets or unusual income or expense items will cause distortions of this ratio. Sales/Net Fixed Assets Net sales divided by net fixed assets. This ratio is a measure of the productive use of your Company's fixed assets. Largely depreciated fixed assets or a labor intensive operation may cause distortion of this ratio. Sales/Total Assets Net sales divided by net fixed asserts. This ratio is a general measure of your Company's ability to generate sales in relation to total assets. It should be used in conjunction with other operating ratios to determine the effective employment of assets. Depreciation Expense as Percentage of Property, Plant and Equipment (PPE) Annual depreciation expense divided by PPE (net) This ratio indicates the reasonableness and consistency of depreciation over time. It should be fairly stable unless changes occurred in depreciation methods, composition or life of assets. 72.0% 30.2% 54.0% NA 4.8 4.6 4.3 3.1 72.3 21.9 33.5 28.5 10.7% -2.7% 2.0% 6.0%
Repairs and Maintenance as Percentage of Property, Plant and Equipment (PPE) Annual repairs and maintenance expense divided by PPE (net) This ratio is used as a measure of reasonableness in determining classification errors between capital expenditures and expenses. EXPENSE TO SALES RATIO 20.9% 2.5% 5.1% NA
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Depreciation, Depletion, Amortization/Sales Annual depreciation, amortization and depletion expenses divided by net sales. This ratio relates depreciation, depletion and amortization expenses to net sales. Comparisons are convenient because the item, net sales, is used as a constant. Officers', Directors', Owners', Compensation/Sales Annual officers', directors'. owners' compensation divided by net sales. This ratio relates officers', directors' and owners' compensation to net sales. Comparisons are convenient because the item, net sales, is used as a constant. GOING-CONCERN EVALUATION "Z" Score Measure of Going-Concern Measures the Probability of Bankruptcy for the Company (Working Capital / Total Assets) *.717 0.15 0.16 0.06 0.09 0.08 0.10 Industry 12-31-03 12-31-04 12-31-05 Average 8.9% 12.8% 14.1% 3.4% 1.0% 1.4% 1.6% 1.0%
(Retained Earnings / Total Assets) *.847 (Operating Income / Total Assets) *3.107 (Net Worth / Total Liabilities) *3.107 (Sales / Total Assets) *.998 "Z" Score 0.43 0.12 4.79 5.65 -0.17 0.07 3.92 3.97 .013 0.07 4.08 4.45
"Z" Score Bankruptcy 1.10 or less 1.11 to 2.60 2.60 or higher
Probability of very high probability not sure (gray area) very low probability Industry 12-31-03 12-31-04 12-31-05 Average 31,191 682,770 8,041 3,839
FACTORS USED IN COMPUTATIONS Cash and equivalents Accounts receivable - beginning of year Accounts receivable - end of year Inventory - beginning of year Inventory - end of year Prepaid expenses Total current assets Total property, plant ad equipment Total accumulated depreciation Total assets - beginning of year
831,112 1,086,025 1,284,899 425,035 373,559 0 373,559 388,481 750 388,481 452,222 967
1,239,095 1,499,772 1,758,149 571,689 483,603 817,425 489,513 865,630 621,401
1,329,997 1,328,188 1,828,691 1,328,188 1,828,691 2,003,010
Total assets - end of year Current portion of long-term debt Accounts payable - beginning of year Accounts payable - end of year Total current liabilities Total long-term debt Total liabilities Notes payable to owners Retained earnings Stockholders' equity - beginning of year Stockholders' equity - end of year Prior year sales Current year sales Purchases Cost of sales Bad debt expense Officers', directors' and owners compensation Amortization expense Depreciation expense Repairs and maintenance Provision for Federal Income Taxes Operating expenses Interest expense 59,485 412,245 691,791 89,166 691,790 982,168 80,597 982,168 968,012
954,754 1,347,890 1,548,601 78,467 227,686 168,450
1,033,221 1,575,576 1,717,051 0 246,166 349,658 294,967 0 204,314 294,967 253,115 0 237,158 253,115 285,959
5,637,280 6,370,493 7,187,971 6,370,493 7,187,971 8,191,767 4,424,793 5,048,906 5,643,560 4,397,672 4,969,490 5,503,060 0 565,000 0 63,415 18,399 0 0 0
917,500 1,154,533 0 99,080 8,224 0 0 131,887 12,420 0
1,789,147 2,320,555 2,606,678 43,280 40,627 46,059
Other expenses (net) - including interest expense Net income (loss)
Financial and Management Accounting Unit 1 1. the success of a business entity depends on the combined effects of four factors – land , labour ,managements and a. capital b. finance c. share d. assets 2. without accounting a business entity cannot communicate with a. inside world b. outside world c. general d. majors 3. certain ground rules were initially set for financial accounting also called a. golden rules b. accounting conventions or concepts c. accounts results d. ledgers 4. a corporate entity is a separate legal entity , entirely divorced from its …….. a. company b. customer c. owners d. none 5. a ……………… normally comes to an end with the expiry of the owners. a. Partnership business b. Corporate business c. Sole proprietorship business d. Enterprise business 6. a ………………….. entity is not distributed at all on the expiry of any equity shareholders a. corporate b. sole proprietor c. assets d. liability 7. Human intervention normally ends with the preparation of necessary documents called
a. Vouchers b. Ledgers c. Accounts d. Balance sheets 8. the ………….. voucher is drawn to record all non-cash transaction and events. a. Journal b. Payment c. Receipt d. Memo 9. ……….. are end products of the accounting process. a. Balance sheet b. Profit and loss a/c c. Financial statements d. None 10. the three basic elements of balance sheets – a. assets b. liability c. equity d. cash 11. A…………. is a present obligation of the enterprises arising from past events a. Assets b. Liability c. Cash d. Profit 12. ………. Is the access of assets over liabilities a. equity b. Cash c. Profit d. None 13. fundamental accounting equation is a. A=L+E b. A=L-E c. A=L/E d. A=LxE 14. The amount at which equity is shown in the balance sheets is dependent on measuring of ……….. and ……….. a. Assets , liabilities b. Profit , loss c. Capital , liabilities d. Shares, debitors 15. the principle of the double entry accounting were first explained in print by …… ……. a. Luca Fra Pacioli b. Newton c. Summa de d. None
16. anticipates no profits but provide for all possible losses a. concept of prudence b. the realization concept c. accounting concept d. none 1. Unit 2 17. ……….. is a book of first entry or prime entry a. voucher b. journal c. primary book d. secondary book 18. journalise means …………… a. recording in primary book b. positing in secondary book c. preparation of vouchers d. none 19. in ground rule of journalization increase in assets and decrease in liabilities is called a. debit b. credit c. profit d. loss 20. in ground rule of journalization income and gains is also called a. debit b. credit c. both d. none 21. ………. Records bills raised by suppliers a. bills payable b. bills receivable c. bill quoted d. cash book 22. …………. Records all residual transaction a. bills payable b. bills receivable c. bill quoted d. journal proper 23. ……….. records credit sales of goods a. purchase day book b. sales day book c. return onward book d. return inward book 24. …………. Records goods returned to the suppliers a. purchase day book b. sales day book c. return onward book
d. return inward book 25. if debit side of the bank column is greater than the credit side the balance is a … ……………… balance a. favorable b. un favorable c. unit d. gain 26. bank balance analysis is done with a document called ………. statements a. bank reconciliation b. bank conciliation c. bank non reconciliation d. de reconciliation 27. ……….. is a journal and ledger a. cash book b. sales day book c. return onward book d. return inward book 1. Unit 3 28. date wise transaction is done in a. primary book b. ledgers c. balance sheets d. secondary books 29. …………. Is a self sufficient secondary book in the sense that all entries in the primary book will be posted in this ledgers a. general ledgers b. debtor ledgers c. creditor ledgers d. none 30. ………….. has separate accounts for each supplier a. general ledgers b. debtor ledgers c. creditor ledgers d. none 31. the motive behind having subsidiary ledgers is to reduce the burden on the …… ….. a. main ledgers b. general ledgers c. debtor ledgers d. none 32. the controls maintained under general ledger is called a. mondry b. sundry c. controller d. none 33. “To” is used to represent
a. credit b. debit c. both d. none 34. balancing account is also known as a. opening account b. closing account c. renaming account d. re opening account 35. the suffix ‘c/d ‘ denotes a. carried debit b. carried down c. carried debtors d. none 36. due date is normally calculated after ……………… days grace from the date of maturity. a. 1 b. 2 c. 3 d. 4 37. ………….. is a formal record of a particular type of transaction a. credit b. balance c. account d. ledger 38. Sundry creditor means a. Customer b. Supplier c. Organization d. Entity Unit 4 39. the purpose of preparing a ………………. Is to check arithmetic accuracy as well as overview of the operation on a particular date a. balance sheet b. trial balance c. profit and loss a/c d. none 40. An error committed because of lack of knowledge of the basic accounting principles is called a. Error of omission b. Error of principles c. Error of accounting d. None
41. when wages paid for installation of machinery is debited to wages account instead of machinery account and also not recorded in journal , it will cause a. Error of omission b. Error of principles c. Error of accounting d. None 42. if the effect of one error is set off by other called a. Error of omission b. Error of principles c. Error of accounting d. Compensating error 43. from gross profit if we deduct indirect administration and selling expenses and add other income we get a. net profit b. net loss c. net income d. net expense 44. ………….. is arrived at by deducting he direct cost of goods sold from sales proceeds. a. Gross profit b. net loss c. net income d. net expense 45. …………. Shows the gross profit or loss earned or incurred by a business entity during an accounting period. a. Trading account b. Compensation c. Accounting trial d. None 46. an artificial account which appears in the trail balance to accopunt for undetected errors. a. Memo account b. General account c. Suspense account d. None 1. Unit 5 47. …………. Is the nucleus of management process a. decision making b. management information c. queries d. none 48. decision making is linked with a. planning b. control c. implementation d. execution
49. ……….. is the last phase of management accounting a. communication of information b. communication of management c. execution of information d. none 50. analysis and interpretation of accounting reports and financial statements. a. Interpretation phase b. communication of information c. communication of management d. execution of information 51. maintenance of books and recording transactions comes under a. book keeping b. stock handling c. cost accounting d. management accounting 52. finalization of accounts , preparation of financial statements comes under a. book keeping b. stock handling c. cost accounting d. financial accounting 53. ………….. shifted focus of accounting from recording and analyzing financial transactions to gathering information for management decisions. a. book keeping b. stock handling c. cost accounting d. management accounting 54. ………. Involves identification of various cost elements , classification of cost into fixed and variable elements and identifying relevant costs in decision making situation a. Cost analysis b. Stock analysis c. Financial analysis d. None 55. CVP relation ship means a. Cost volume Profit relationship b. Credit volume purchase relationship c. Credit volume Profit relationship d. None 56. ……………. Is an essential pre condition for management a. implementation b. planning c. control d. execution 57. ….. , ……….. and ………….. are three important financial characteristics of a business entity. a. Liquidity
b. Solvency c. Profitability d. Scalability 58. financial accounting lays emphasis on the past while management accounting stresses the futures a. true b. false 1. Unit 6 59. Ratio is a relationship between two or more variable expressed in a. Percentage b. Rate c. Proportion d. None 60. is an important techniques of financial analysis a. ratio analysis b. percentage analysis c. cost analysis d. none 61. liquid ratio is also known as a. acid test ratio b. quick ratio c. cash ratio d. bank ratio 62. equity ratio is a. liquidity ratio b. solvency ratio c. profitability ratio d. activity ratio 63. inventory turnover is a. liquidity ratio b. solvency ratio c. profitability ratio d. activity ratio 64. gross profit ration is a. liquidity ratio b. solvency ratio c. profitability ratio d. activity ratio 65. debt equity ratio is a. liquidity ratio b. solvency ratio c. profitability ratio d. activity ratio 66. accounting ratio will be correct only if the accounting data on which they are based are correct a. true
b. false Unit 7 Funds flow analysis 67. …………is a technical device designed to highlight the changes in the financial conditions of a business enterprise between two balance sheets. a. funds flow analysis b. costs analysis c. market analysis d. management analysis 68. objectives of funds flow statement is to find out financial strength and weakness of the business a. a true b. b false 69. first steps in preparation of funds flow statement is preparation of schedule changes in working capital a. a true b. b false 70. funds flow statement includes a. non trading incomes b. b issue of shares c. c non operating exp. d. d all of the above 71. for the purpose of fund flow statement the term fund means… a. net working capital b. net assets c. capital d. net liability 72. FFO stands for a. Fund form operation b. Fund From operation c. Funds For operation d. None 73. the fund flow statement describes the sources from which additional funds were derived and the uses to which these funds were put, is said by a. newmen b. Robert newman c. Robert Anthony d. None Unit 8. cash flow analysis
74. ……………reveals the inflow and outflow of cash during a particular period. a. Cash flow statements: b. Funds flow statements c. Both d. None 75. show the factors contributing to the reduction of cash balance in spite of increasing profit or decreasing profit. is one of the objective of CFS a. true b. false 76. are the steps of preparing cash flow statements a. opening of accounts for non –current items ( to find hidden information ) b. preparation of adjusted p & L account c. comparisons of current items d. preparation of cash flow statements 77. cash from operation can be calculated from a. cash sales –( cash purchase + cash operation expenses ) b. cash sales+( cash purchase + cash operation expenses ) c. cash sales –( cash purchase -cash operation expenses ) d. cash purchase –( cash sales + cash operation expenses ) 78. net profit method involves a. adjustment by profit & loss a/c b. adjustment by balance sheet c. adjustment by ledger d. adjustment by cash book 79. fund flow is less useful than cash flow a. true b. false 80. sound position of cash flow means sound fund a. true b. false 81. cash flow statements is based on a. receipts and payments b. adjusted PL c. balance sheet d. none 82. for funds flow statements Increase in assets means increase in working capital a. true b. false 83. cash flow statements takes consideration of a. cash position b. working capital c. assets d. none 84. ………. Are cost which have been applied against the revenue of a particular period
a. expenses b. cost c. marginal cost d. standard cost 85. on the basis of …………. Costs are classified as direct and indirect costs a. nature of elements b. traceability c. behavior d. operation or functions 86. administration cost is a type of cost under …………. Cost classification a. nature of elements b. traceability c. behavior d. operation or functions 87. …………. Cost which doesnot changes in total amount for a given period of time in spite of changes in quantity of ouput and volume of activity. a. Fixed cost b. Variable cost c. Standard cost d. Mixed cost 88. Cost which does changes in total amount for a given period of time in proportion of changes in quantity of ouput and volume of activity. a. Fixed cost b. Variable cost c. Standard cost d. Mixed cost 89. Partly variable and partly fixed costs are also called a. Semi variable costs b. Semi fixed costs c. Semi marginal cost d. Standard cost 90. ………. Cost remains constant for given volume of output and at a higher level of output it increases in a fixed amount a. Fixed cost b. Variable cost c. Standard cost d. Step costs 91. Non –controllable cost is based on ….. classification of cost a. nature of elements b. traceability c. controllability d. operation or functions 92. relevant costs are also called a. past cost b. future cost c. today cost
d. tomorrow cost 93. ……. Is the cost of opportunity lost a. opportunity cost b. past cost c. future cost d. today cost 94. cost which is normally incurred at a given level of output under normal conditions of operations is called a. opportunity cost b. past cost c. future cost d. normal cost 95. refers to an increase in cost from one alternatives to another a. opportunity cost b. incremental cost c. future cost d. normal cost 96. the difference of total costs between any two alternatives a. opportunity cost b. incremental cost c. future cost d. differential cost 97. cost per unit is also called a. opportunity cost b. incremental cost c. average cost d. differential cost 98. the cash cost associated with an activity is also known as a. out of packet costs b. incremental cost c. average cost d. differential cost 99. cost that have been already incurred also known as a. sunk cost b. incremental cost c. average cost d. differential cost 100.the difference between selling price and marginal cost is called a. margin of benefit b. contribution c. profit margin d. none
Analysis of Financial Statement Short Answer
Ans.1 Liabilities Shree Capital Reserve and Surplus secured loans Unsecured Loans Current Liabilities and Provisions Balance Sheet as on .......................... Amount Assets Fixed Assets Investment, current, Assets, Loans and Advances Miscellaneous Expenditure Profit & Loss A/c Ans.2 i) Preliminary expenses. Amount
Expenses including commission or brokerage on underwriting or subscription of shares or debentures.
iii) iv) v) Ans.3 i) ii) iii) iv) v) Ans.4
Discount allowed on the issue of shares or debentures. Intererst paid out of capital during construction. Development expenditure not adjusted Capital Reserve Capital Redemption reserve Security premium account General reserve Credit balance in profit and loss a/c
The liabilities existences of which depends on a happening in future is known as contingent liabilities. Such liabilities are disclosed by way of a note. Examples of contingent liabilities are : i) ii) Claim against the company not acknowledge as debt. Uncalled liability on shares partly paid Current assets Loans and advances Current liabilities Miscellaneous expenditure Reserve and surplus Fixed Assets
i) ii) iii) iv) v) vi)
Solution : Horizontal Form Pyramid Ltd. BALANCE SHEET as on 31st March, 2008
Share Capital Fixed Assets Authorised Capital At Gross Value17,00,000 ....Equaity shares of Rs. ....each.... Less : Depreciation2,40,000 14,60,000 Issued, Subscribed and Paid-up======= -------------....Equity share sof Rs. ...each .... Fully paid-up in Cash 12,00,000 Reserves and Surplus General Reserve 3,00,000 11,40,000 Profit and Loss A/c 1,80,000 Secured Loans .... Debentures 40,000 10% Debentures 4,00,000 Unsecured Loans Current Liabilities Provisions Current Liabilities 5,60,000 -------------------26,40,000 ======= Investments Current Assets, Loans and Advances Current Assets Miscellaneous Expenditure Discount on issue
The Objectives of Financial Analysis are : i) ii) iii) To judge the financial stability of an enterprise. To measure the enterprise's short-term and long-term solvency. to measure the enterprise's operating efficiency and profitability.
To compare intra-firm position, inter-firm position and pattern industry.
position within v) Ans.8
To assess the future prospects of the enterprise.
Limitations of Analysis of Financial Statements are; (i) Limitations of Financial Statements: Financial Statements are the
basis f financial analysis. Hence, the limitations of financial statements, such as influence of accounting concepts and conventions, personal judger disclosure of only monetary events, etc., are also the limitations of analysis and financial statements. (ii) Ignores the Price-Level, Changes: Financial analysis fails to
disclose current worth of the enterprise, since it is based on .financial statements, which are merely a record of historical cost. (iii) Not. Free from Bias: In many situations, the accountant has to make a choice out of various alternatives available, e.g., choice in the method of depreciation choice in the method of inventory valuation. Since, the subjectivity is interest in personal judgment, the financial statements are therefore not free from bias. As a result, financial analysis also cannot be said to be free from bias. (iv) Window Dressing: The term window dressing means presentation of account that conceals vital facts and showing better position than what it actually is. On account of such a situation, financial analysis may not be a definite indicator of good or bad management. Ans.9 Solution :
Absolute Figure 2006 2007
Change (Base Year : 2006) Absolute Change Percentage Change % 50% 75% 12.5% -10% 35% 35% 35%
(Rs.) Sales Less : Cost of Goods Sold Gross Profit Less : Indirect Taxes Net Profit before Tax Less : Tax 50% Net Profit after Tax 20,00,000 12,00,000 ,8,00,000 4,00,000 4,00,000 2,00,000 2,00,000
(Rs.) 30,00,000 21,00,000 9,00,000 3,60,000 5,40,000 2,70,000 2,70,000
(Rs.) 10,00,000 9,00,000 1,00,000 (-40000) 1,40,000 70,000 70,000
COMPARATIVE BALANCE SHEET
Particulars 2005 (Rs.) 2006 (Rs.) 3,44,000 4,38,000 78,000 8,60,000 4,30,000 4,000 8,60,000 Absolute Increase/ Decrease (82,000) (2,58,000) (2,20,000) (5,60,000) (1,38,000) (2,000) (4,20,000) (5,60,000) Percentage Increase/ Decrease (19.2) (37.1) 73.8 (39.4) (24.3) (33.3) 49.6 (39.4)
Sources of Funds Share Capital Long-term Loan Current Liabilities Application of Funds Fixed Assets Investments Current Assets 5,68,000 6,000 8,46,000 4,26,000 14,20,000 4,26,000 6,96,000 2,98,000 14,20,000
Ans.11 Solution: Since current ratio is 2 : 1, let us assume the CA = Rs. 20,000 and CL = Rs. 10,000. i) Repayment of current liability will improve Current Ratio because fall in current asset will be less than twice the fall in current liability.
(Suppose Rs. 5,000 are repaid out of current liability, balance would be CA = Rs. 15,000 and CL = Rs. 5,000. .-. Ratio will improve to 3 : 1) ii) Purchase of goods on cash will not change the ratio, neither the total current assets nor the total currert liabilities are affected since there is only a conversion of one current asset into another current asset. iii) Sale of office equipment will improve the ratio because current asset (cash) will increase without any change in current liability. iv) Sale of goods for Rs 11,000; cost being Rs 10,000 will improve the current ratio because current asset will increase by Rs. 1,000. v) Payment of dividend will reduce the total of current assets and total of current liabilities by the same amount. Therefore, the current ratio will improve. Ans.12 Statement showing the effect of different items on Debt-Equity Ratio : Transaction i) Increase Shareholders' Funds remain unchanged ii) No Effect Neither the total long-term debts nor Effect Reason
Total long-term debts are increased but total
the total Shareholders' Funds are affected. iii) Increase Total Shareholders' Funds are decreased by
the amount of
loss but unchanged. iv) Decrease the amount of
term debt remain
Total Shareholders' Funds are increased by
profit but total long-term debts remain unchanged. v) Decrease Total Shareholders' Funds are increased by
the amount of cash received but remain unchanged. vi) No Effect Neither the total long-term debts nor the total long-term debts
total Shareholders' Fund are affected conversion of accumulated profit into share capital. vii) Decrease Shareholders' Funds remain unchanged. viii) Decrease total Shareholders' Funds are increased by the same amount. Ans.13 Solution : Gross Profit Cost of Goods sold = 25% of Rs. 3,20,000 = Rs. 80,000 = Sales - Gross Profit = Rs. 3,20,000 - Rs. 80,000 = Rs. 2,40,000 Total long-term debts are decreased and Total long-term debts are decreased but total since there is only a
= (Opening Stock + Closing Stock) /2 = (Rs. 29,000 + Rs. 31,000)/ 2 = Rs. 30,000
Stock Turnover Ratio
Cost of Goods Sold Rs. 2,40,000 = Average Stock = Rs.30,000 = 8 Times.
Ans.14 Solution : Stock Turnover Ratio 12 Cost of Goods Sold Let selling price be Profit Cost = = = = = =
Cost of Goods Sold Average Stock Cost of Goods Sold Rs. 75,000
Rs. 75,000 x 12 = Rs. 9,00,000 Rs. 1000 Rs. 20 Rs. 100 - Rs. 20 = Rs. 80 Rs. 100 x Rs. 9,00,000 = Rs.
If cost is Rs. 80 then selling price = If cost Rs. 9,00,000, then sales 11,25,000 Profit 2,25,000 = =
Rs.100 = Rs. 80
Sales - Cost of Goods Sold Rs. 11,25,000 - Rs. 9,00,000 = Rs.
Ans.15 Solution : Debtors Turnover Ration = Average Debtors =
Net Credit Sales Average Debtors
OIpening Debtors + Closing Debtors 2
8 = Average Debtors Let Closing Debtors Opening Debtors = = = = 2x x Closing Debtors Opening Debtors = = = =
3,50,000 Average Debtors
3,50,000 = 43.750 8
x x - 14,000
x + x - 14,000 = 43,750 2
(43,750 x 2) + 14,000 50,750 Rs. 50,750 50,750 - 14,000 = 36,750
Ans.17 Solution : Cash Sales total Sales 6,00,000 Gross Profit on cost = = =
Rs. 4,00,000 2 = Rs. 2,00,000
Rs. 4,00,000 + Rs./ 2,00,000 = Rs. 20%
20 Gross Profit on sale will be; 120 (Let the CP=10, Profit=20, SP=100+20=120
1/6 of Rs. 6,00,000 = Rs., 1,00,000
Rs.1,00,00 0 Gross Profit Gross Profit Ratio = Net Sales x 100 = Rs. 6,00,000 x 1000 = 16.67%
Ans.18 Cash Sales = 25% of total sales. It means that credit sales will be 75% of total sales. If credit sales (75% of total sales) = Rs. 2,40,000 Total Sales will be Let Opening Stock Cost of Goods Sold = = = = Rs. 2,40,000 x 100/75 = Rs. 3,20,000
x, then Closing Stock = x + Rs. 20,000 Opening Stock + Purchases -Closing Stock x + Rs. 2,76,000 - (x + Rs. 20,000)
= = Gross Profit = = Thus, Note : Gross Profit Ratio
x + Rs. 2,76,000 - x - Rs. 20,000 Rs. 2,56,000 Sal;es - Cost of Goods Sold Rs. 3,20,000 - Rs. 2,56,000 = Rs. 64,000
Rs.64,000 Rs. 3,20,000 = x 100 = 20%
Profit before INterest and Tax = Net Profit 6 IOnterest on Debentures = Rs. 80,000 + Rs. 40,000 = Rs. 1,20,000 Capital Employed = Equity Sahre Capital + Preference
Share Capital + General Reserve + Debentures - Discount on Shares Rs. 10,84,000 = Rs. 4,00,000 + Rs. 1,00,000+ Rs. 1,89,000 + Rs. 4,00,000 - Rs. 5,000 x 100 = 49.76%. Solution: i)
Gross Profit Gross Profit Ratio = Net Sales x 100
Rs.7,87,50 0 - Rs.3,95,60 0 Rs.7,87,50 0 = x 100 = 49.76% Cost of Goods Sold ii) Stock Turnover Ratio = Average Stock Rs. 3,95,600 = Rs. 1,97,800 = 2 times
Debt (Long - term Loans) Shareholders' Funds Debt-Equity Ratio =
Rs.87,000 + Rs. 1,25,000 Rs.2,12,00 0 Rs.3,75,00 0 = = Rs.3,75,00 0 = 0.57 : 1
Cost of Goods Sold or Sales iv) Working Capital Turnover Ratio = Working Capital (CA - CL) Rs.7,87,50 0 = Rs.162,000 = 2.44 Times
Working Capital Turnover Ratio = = 4.86 Times
(Based on sales)
Ans.21 Solution Current Ratio = Current Ratio =
Current Assets Current Liabilitie s R.3,00,000 + Rs. 20,000 Rs. 3,20,000 Rs.1,40,00 0 + Rs. 20,000 = Rs.1,60,00 0 = 2 : 1
Ans.22 Solutions : Current Liabilities are Rs. 1,00,000 and Current Ratio is 2.5 : 1; therefore, Current Assets = Rs. 1,00,000 x 2.5 = Rs. 2,50,000 After paying Rs. 25,000 Current Assets = Rs. 2,50,000 - Rs. 25,000 = Rs. 2,25,000 Current Liabilities = Rs. 1,00,000 - Rs. 25,000 = Rs. 75,000
Current Assets Current Ratio = Current Liabilitie s = = 3 : 1
Ans.23 Solution : Current Ratio
Current Assets Current Liabilitie s
Rs. 6,00,000 Rs.4,00,00 0
Let the amount paid towards Current Liabilities = X. After the payment = Rs. 8,00,000-2X = Rs.6,00,000-X Rs. 80,00,000 - Rs.6,00,000,= 2X - X Rs. 2,00,000 = X
Current Liabilities to be paid off Rs. 2,00,000.
Ans.24 Solution : Calculation of Quick Assets : Quick Ratio
Quick Assets Quick Assets = Current Liabilitie s = Rs. 40,000 = 1.5
Quick Assets = Rs. 40,000 x 1.5 = Rs. 60,000 Calculation of Stock : Stock = Current Assets - Quick Assets = Rs. 1,00,000 - Rs. 60,000 = Rs. 40,000 Ans.25 Solution : Calculation of Current Assets and Current Liabilities : Current Assets - Current Liabilities = Working Capital Current Assets - Current Liabilities = Rs. 60,000 Current Assets / Current Liabilities = 2.5 or, Current Assets - 2.5 Current Liabilities = 0 Subtracting Eqn. 2 from Eqn. 1, 1.5 Current Liabilities Current Liabilities Current Assets= = = Rs. 60,000 s. 60,000/1.5 = Rs. 40,000
Rs. 40,000 x 2.5 = Rs. 1,00,000
Ans.26 Solutions : Current Ratio =
Current Assets Current Liabilitie s
Rs.17,00,0 00 Current Liabilitie s
Rs.17,00,0 00 2.5 Current Liabilities = = Rs. 6,80,000
Liquid Assets Current Liabilitie s
Liquid Assets 0.95 = Rs.6,80,00 0 ; Liquid Assets = Rs. 6,46,000
Stock (Inventory) = Current Assets - Liquid Assets = Rs. 17,00,000 - Rs. 6,46,000 = Rs. 10,54,000.
Ans.27 The objectives of cash flow statement are : i) To ascertain the specific sources (ie, operating / investing financing activities) of cash and cash equivalents generated by an enterprise. ii) To ascertain the specific uses (ie., operating / investing / financing activities ) of cash and cash equivalents used by an enterprise. iii) To ascertain the net change in cash and cash equivalents (sources minus uses of cash and cash equivalents) between the date of two Balance Sheets. Ans.28 a) b) c) d) Financing Activities Investing Activities Operating Activities Operating Activities
Ans.29 Solution : Statement Showing Cash Flow from Operating Activities Particulars Net Profit before Tax and Extraordinary Items Adjustment for : Add : Goodwill Amortized Loss on Sale of Building Depreciation 82,000 Less : Profit on Sale of Machinery Dividend Received Operating Profit before Working Capital Changes Less : Increase in Current Assets & Decrease in Current Liabilities : 5,000 3,000 8,000 74,000 8,000 5,000 20,000 33,000 Rs. 49,000
Commission Accrued Cash Generated from Operations Less : Tax Paid Cash Flow from Operating Activities Note :
4,000 70,000 15,000 55,000
Net Profit before Tax and Extraordinary items is calculated by adding Provision for Tax and Proposed Dividend to the amount of Net Profit, i.e,, Rs. 24,000 + Rs. 15,000 + Rs. 10,000.
Ans.30 Solution : COMPUTATION OF CASH FLOW FROM OPERATING ACTIVITIES Particulars Net Profit for the year Add : Transfer to General Reserve Net Profit before Tax Add : Depreciation Loss on Sale of Machine Preliminary Expenses Written Off Less : Profit on Sale of Furniture Operating Profit before Working Capital Changes Add : Decrease in Bills receivable Increase in Bills Payable Increase in Outstanding Expenses Less: Increase in Debtors Increase in Stock Increase in Prepaid Expenses Decrease in Creditors 2,000 10,000 1,000 5,000 3,000 1,000 2,000 11,000 13,000 1,08,000 Rs. 50,000 10,000 60,000 20,000 10,000 10,000 1,00,000 5,000 95,000
Cash Flow from Operating Activities
Ans.31 Solution : CASH FLOW FROM OPERATING ACTIVITIES Particulars Net Profit Add : Transfer to General Reserve Net Profit before Tax Adjustment for non-cash and non-operation expenses : Add : Depreciation Goodwill Written Off Less : Gain on Sale of Machinery Operating Profit before working capital changes Add : Decrease in Current Assets and Increase in Current Liabilities Increase in Creditors Decrease in Bills Receivable 10,000 3,000 13,000 1,67,000 Less : Increase in Current Assets and Decrease in Current Liabilities : Increase in Debtors Increase in Prepared Expenses Decrease in Bill s Payable Decrease in Outstanding Expenses Cash Flow from Operating Activities Ans.32 Solution : Rajan Ltd. CASH FLOW STATEMENT for the year ended 31st December, 2002 6,000 200 4,000 2,000 12,200 1,54,800 20,000 7,000 27,000 3,000 24,000 1,54,000 Rs. 1,00,000 30,000 1,30,000
Particualrs A. Cash Flow from Operating Activities B. Net Profit before tax : Closing Balanced of Profit and Loss A/c Closing Balance of Profit and Loss A/c Add : Transfer to General Reserve
24,000 15,000 39,000
Less : Opening Balance of Profit and Loss A/c15,000 Net Profit before tax and extraordinary items Adjustments for : Add : Depreciation on Plant Depreciation on Building Goodwill written off Adjustments for : Increase in Creditors Increase in Debtors Increase in Stock Net Cash from operating activities B. Cash Flow from Investing Activities Purchase of Plant (Note 2) Purchase of Building (Note 1) Net cash used in investing activities (1,10,000) C. Cash Flow from financing Activities Issue of Equity Shares Redemption of 12% Preference Shares Net Cash from financing activities Net decrease in cash and cash equivalents (A+B+C) (3,500) Cash and cash equivalents at the beginning of the year 12,500 Cash and cash equivalents at the close of the year 9,000 50,000 (25,000) (C) 25,000 (70,000) (40,000) (B) 12,000 (35,500) (5,000) (28,500) (A) 81,500 10,000 60,000 16,000 86,000 1,10,000 24,000
Operating profit before working capital changes
Working Notes : 1. Dr. Date Particulars To Balance b/d 60,000 To Bank A/c BUILDING ACCOUNT Rs. 80,000 70,000 1,20,000 2. Dr. Date Particulars To Balance b/d 10,000 To Bank A/c PLANT ACCOUNT Rs. 40,000 70,000 1,10,000 Date Particulars By Depreciation Date Particulars By Depreciation Cr. Rs. A/c
By Balance c/d
60,000 1,20,000 Cr. Rs. A/c
By Balance c/d 1,00,000 1,10,000
Ans.33 Solution : Particualrs A. Cash Flow from operating Activities Closing Balance of General Reserve A/c Less : Operating Balance of General Reserve Net Profit before taxation and extraordinary items Add : Items to be added Goodwill amounted Interest on long term loans 8,000 12,000 20,000 40,000 70,000 (50,000) 20,000 Rs. Rs.
Operating Profit before Working Capital changes Add : Decrease in Current Assets and Increase in Current Liabilites Increase in Creditors for goods Increase in Bills Payable Current Liabilities : Decrease in Outstanding Expenses Increase in Debtors (5,000) (20,000) 20,000
Less : Increase in Current Assets and Decrease in
Increase in Stock Cash generated from operations Less : Income taxes paid (Net of Refund) Net Cash from Operating Activities B. Cash Flow from Investing Activities Purchase of Land and Building Purchase of Machinery Net Cash used in Financing Activities (1,10,000) C. Cash Flow from Financing Activities Proceeds from issue of Equity Shares Repayment of long-term borrowings Interest on Long-term loans Net Cash inflow from Financing Activities
(20,000) (45,000) 95,000 .... 95,000 (80,000) (30,000)
50,000 (20,000) (12,000) 18,000
D. Net Increase / Decrease in a Cash and Cash equivalent (A+B+C) 3,000 E. Cash and Cash Equivalents at Beginning period Cash in Hand F. Cash and Cash Equivalents at End of period (D+E) Cash in Hand *Debenture interest @ 12% on Rs. 1,00,000. 18,000 15,000
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