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MBA130

FINANCIAL
MANAGEMENT

SECTION - D
Unit 8
Understanding Financial Statements

Unit 9
Financial Statement Analysis: Ratio Analysis

Unit 10
Break-Even Analysis

Dr. Hanuman Praasd, Associate Professor, FMS, MLSU, Udaipur,


Email: drhanu73@yahoo.com
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UNIT 8

UNDERSTANDING FINANCIAL
STATEMENTS

Objectives
This unit is designed to:
Develop understanding of Financial Statements
Inculcate understanding of different items of Balance Sheet
Explain concept of Income Statements and various types of
accounts prepared for income measurement.
Develop understanding about various cost classifications and
earning measurement.
Structure
8.1
Introduction
8.2
Concept of Financial Statements
8.3
Balance Sheet
8.4
Items of Balance Sheet
8.5
Income Statements
8.6
Manufacturing Account
8.7
Trading Account
8.8
Profit and Loss Account
8.9
Summary
8.10 Key Words
8.11 Self Assessment Questions
8.12 Suggested Readings

8.1

INTRODUCTION

Accounting records business transactions taking place during an


accounting period with a view to prepare financial statements. Thus,
it is the final output of an accounting cycle or process.
Communication of financial information to the different users of
accounting information is one of the prime objectives of accounting.
The financial statement contains financial information which is used
for financial planning and decision making. The management of a
firm decides future course of action on the basis of these financial
information.

8.2

CONCEPT OF FINANCIAL
STATEMENTS

The financial statements are prepared on the basis of accounting


information. The ledger balances are first put in a sheet called trial
balance to check arithmetical accuracy and then the balances are
systematically categorized to show financial position and annual
performance in terms of earnings. Thus financial statement is a
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logically compiled and consistently organized accounting data in


consonance with prevalent accounting principles. Firms communicate
financial information by sending annual report containing financial
statements to different users like shareholders, management, creditors
etc. Financial statements communicate its users how a business has
prospered under the leadership of management. It provides
information about firms the financial position by showing its assets
and liabilities and annual performance through profit and loss
account. The basic objective of financial statements is to provide
quantitative financial information about the enterprise that is useful to
the users of these information in making economic decision.
According to American Institute of Certified Public Accountants
(AICPA), financial statements are prepared for the purpose of
presenting a periodical review or report on the progress by the
management and deal with (i) the status of investments in the
business and (ii) result achieved during the period under review.
Apart from this, here are some objectives which are behind the
preparation of financial statements:
Provide information to the external users about the economic
activities of the business.
Investors and creditors provide funds and credit to the
organization. In the absence of financial information they will
never dare to invest in a firm. Thus they are provided with
financial information to facilitate in their decision making.
To attract the potential investors for investment in firm by
giving information about the earning power of the
organization.
Provide information to the investors for comparing the
performance of the organization with other similar
organization and make judgment regarding retention or
disinvestment.
Provide information to owners for evaluation of management
efficiency.
The financial statements have two parts i.e. Balance Sheet and
income statements. Balance sheet is prepared to ascertain the
financial position of the business while Revenue statements or
income statements (trading and profit and loss statement) is prepared
to measure the business income. The forthcoming section gives
details about balance sheet and income statement.

8.3

BALANCE SHEET

Balance sheet is the most important statement of financial statement.


It indicates financial status of a business at a particular moment of
time. So it is also known as statement of financial position. It
contains information about a firms holdings, obligations and owners
interest. In other words, it communicates information about what the
firm owns and how these owned items are financed in the form of
liabilities and ownership interest. Thus, it is screen picture of
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financial condition of a business. In accounting language, balance


sheet gives information about assets, liabilities and owners equity of
a company or business organization on a particular date. It is a
detailed expression of the basic accounting equation i.e. Assets =
Liabilities + Stockholders Equity. The whole financial accounting
model, double entry system is based on this accounting equation. In
words of Messrs Smith and Keith the balance sheet, sometimes
called as statement of financial position, shows the economic
resources of the business at a point in time and sources of those
resources at the point of time.
The main features of balance sheet are as follows:
It is prepared on a particular date. Normally, at the end of a
session or accounting period that is either 31st, March or 31st
December.
It shows financial position of an enterprise on that date. The
business firm may not have the same position after or before
that date.
It is a position statement and not a valuation statement. Thus,
it is not exactly based on facts and current prices but on a
historical price basis after making adjustments as per
accounting procedures, assumptions and principles.
It may be prepared either in horizontal form or vertical form.
The horizontal form of balance sheet has two sides. Under
horizontal form of balance sheet the assets are shown on right
hand side and sources of financing these assets (owners
capital & liabilities) on left hand side. While under vertical
form of balance sheet sources of financing assets are written
first followed by assets.
The companies act 1956 section 211, schedule VI, part I prescribes
the format of balance sheet. As it has been discussed that balance
sheet of a company shall be in either horizontal form or vertical form.
The vertical form of balance sheet is most commonly used by the
business firms while explaining contents horizontal form is the most
convenient. The balance sheets prepared horizontally and vertically
are shown in exhibits 8.1 and 8.2 respectively. The assets and
liabilities are arranged either in order of permanence or in order of
liquidity. In order of permanence, the fixed assets and long term
liabilities of non liquid or long-term nature are stated first followed
by items of less permanent and liquid nature. The items of assets and
liabilities shown in exhibit 8.1 and 8.2 are arranged in order of
permanence. The assets and liabilities of liquid nature are stated first
followed by less liquid or permanent items in order of liquidity. If
assets and liabilities shown in exhibit are arranged in the reverse
order then it will be shown in the balance sheet in order of liquidity.
Activity 8.1
Why Financial Statements are prepared. List any four reasons.

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8.4

ITEMS OF BALANCE SHEET

The balance sheet is based on accounting equation which is capital


+liabilities = Assets. The capital and liabilities are the items of
obligations of a business. While the items of assets are related with
what is owned by a business firm. A detailed discussion on both
liabilities and assets are being presented as shown:
8.4.1

Liabilities (Capital + Liabilities):

A business firm needs money or funds to build necessary


infrastructure and run routine operations. These funds are either
contributed by owners and lenders or by creditors through supply of
goods or services on credit. All these sources of funds are claims of
fund providers against a business firm. These claims against a
business firm are known as liabilities. It is defined as what the
business owes others (including owners). In other words, these are
amounts owed by business to people who have lent money or
supplied goods or services on credit. In all fund requirements of a
business firm is met through two major categories of investorsowners and lenders. As, these amounts are payable to them in future
and considered as their claim against business firm, they are shown
on liabilities side of balance sheet. The items of liabilities side may
broadly be classified into long term liabilities and short term or
current liabilities. Lenders are outsiders and the funds contributed by
them are covered in the category of outsiders claim. These funds
may be borrowed for a period of one or more years. The funds
borrowed for a period of more than one year is termed long term
liabilities. In other words, obligations of long period of time are
called long term liabilities. These are payable in a period of time for
more than a year. The total long term obligation against a business
firm is sum of owners equity and long term liabilities. As the long
term liabilities are outsiders claim, in the similar manner owners
equity is claim of owners against a business firm. The long term
liabilities include secured and unsecured loans while equity share
capital and reserves and surplus are included in owners equity. The
borrowings of short term are also claims of outsiders but they are
payable within one accounting period. Thus, they are grouped to form
another category called current liabilities. Following are the major
items of liabilities side of balance sheet.

i.

Share Capital: The term capital represents amount


contributed by owners of the firm. Share capital is the capital
shared by a number of persons. In other words, this capital is
collected from general public or a group of persons and it is
divided in to small amounts to have approachability of
general public. This capital may further be divided into two

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categories viz. equity share capital and preference share


capital. The amount collected by issuance of equity shares is
known as equity share capital (Ordinary Shares Capital).
The companies act 1956 under section 85 equity shares have
been defined as a share which is not a preference share. The
holders of equity shares are theoretically owners of the
business. As an owner, they have to bear risk of loss in
business. They are also entitled for share in profits which is
distributed in the form of dividends. The rate of dividend
distribution is decided by the share holders in annual general
meeting. The uncertainly exists regarding the distribution of
dividend and rate of dividend. They also have right to
interfere in the important affairs of a business. They are asked
to vote in the event of dispute on any important resolution.
Following are the various terms related to equity shares which
are visible in the balance sheets of business firms.
Authorized Share Capital: This is the maximum amount of
capital for which a business is authorized to issue. It is the
maximum amount of capital beyond which a company
cannot raise fund by issuing equity share capital. This
amount is mentioned in the memorandum of association of
the company.
Issued Share Capital: It is that portion of authorized share
capital or face value of share capital which is offered to
public for subscription including shares offered to vendors or
others in cash consideration and other than cash
consideration.
Subscribed Share Capital: It is that part of issued capital
which represents the face value or nominal value of shares
subscribed for by public or applied by prospective
shareholders and allotted by the company. This also includes
the face value of shares issued by the company for
consideration other than cash.
Called up Share Capital: The amount demanded by a
company on its subscribed capital. In other words, it is the
amount called on allotted shares by a firm. A firm may ask
its shareholders to pay face value in installment. The portion
which is not yet called is known as uncalled capital.
Paid up Share Capital: The amount of called up capital which
has actually been paid by the share holders is known as paid
up share capital.
Unpaid Capital: That portion of called up capital which has
not been received by the firm is called as unpaid capital. It
may be possible that some shareholders may fail to pay the
amount called up by the firm.
Forfeited Shares: In the event of non payments of any of the
calls by shareholders, the firm may forfeit those shares. The
amount already received on forfeited shares is kept under
this category.

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The contribution of preference share holders is known as preference


share capital. The holders of preference shares have two preferential
rights over equity share holders i.e. to receive dividends annually and
to receive principle amount back at liquidation of company. This
capital is also known as hybrid capital as it contains mix features of
equity and debt capital. The rate of dividend on preference shares is
prefixed and disclosed at the time of issue. The distribution of
dividend is a feature of equity shares while fixed rate of return is a
feature of debt capital. In the similar manner preference shares may
be redeemable after certain time like debt capital or irredeemable like
equity shares.
ii.

Reserves and Surplus: The result of annual operations is


profit or loss. If firms total revenues exceeds the costs, the
firm earns profit and vice versa. The net result of annual
profitable operations after payment to all outsiders belongs to
owners. This profit may be distributed to the owners or it may
be retained by a firm for future uses. Normally, a portion of
profits is distributed as dividends and the rest is retained. The
retained portion of earnings is known as retained earnings.
These earnings are transferred to revenue reserves. The
reserves may be earmarked or free reserves. The earmarked
reserves like capital reserve, share premium account, capital
redemption reserve etc. are kept for specific purposes and are
not distributed as dividends. The free reserves are available
for dividend distribution.

iii.

Secured and Unsecured Loans: Loans are borrowings of a


business firm. It is also known as debt capital. The basic
feature of borrowings which distinguishes it from equity is its
creditor ship nature. It bears a rate of interest which is
annually payable and its principle amount is repayable on a
certain maturity date. Secured loans are borrowings which
are secured against the assets of the business. In other words,
loans against which security or collateral security is provided
are referred as secured loans. The loans of secured nature are
debentures, loans from financial institutions or banks etc. A
debenture is a written acknowledgement of debt by company
usually under its seal. It is normally divided in small
denominations. It contains information about rate and
payment of interest and repayment of principle. Unsecured
Loans are the debts or borrowings against which no collateral
security is provided. The components of unsecured loans
involves unsecured loans from banks, fixed deposits; inter
corporate deposits, loans and advances from promoters, loans
from subsidiary etc.

8.4.2

Current Liabilities:

As it has been discussed that funds borrowed with an intention to pay


them within an accounting year are called current or short term
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liabilities. These obligations will become due for payment within an


accounting period. These funds may be borrowed or arranged in cash
form or kind (non cash) form. Banks and financial institutions
provide short term loans and temporary financing to finance routine
operations of business in form of bank overdraft, cash credit, working
capital loans etc. In kind form, short term funds are indirectly
arranged by way of availing advantage of credit extended by
suppliers. The payments of all operational requirements and recurring
expenses like purchase of raw materials, wages, operating expenses
etc. is mode from the cash or bank balances (Current Assets).
Purchase of goods on credit or any other deferrals postpones
immediate payment burden. Therefore, the firm has to maintain fewer
current assets to meet its routine expenses. In other words the firms
operational or working capital requirements are indirectly financed
by current liabilities.
8.4.3 Assets:
Assets are shown on the right hand side of horizontal form of balance
sheet. These are economic resources owned by the firm. These
resources are used to generate income by the business firm. These are
called assets as business firm owns it and can utilize it for productive
purposes or can recover money by liquidating it. The assets can be
broadly classified into two categories viz. long term assets (Fixed
Assets) and Short term assets (Current Assets). Fixed assets are
acquired with an intention to retain for more than one year. The
current assets are maintained to run day to day operations of a
business firm. They are converted in liquidity within a year. The
items covered in both category of fixed and current assets are
discussed as below.
i. Fixed Assets: The fixed assets are also known as long term
assets. They are held for periods longer than the accounting
period. The benefits of these assets are available over several
accounting periods. The fixed assets indirectly contribute to firms
earnings. It provides value addition by facilitating the process of
production or trade. They are recorded at a price that is paid to
acquire it (purchase price). The cost of tangible assets is allocated
over useful life in the form of depreciation and it is charged
against production. Thus the book values of these assets are
reduced every year by the amount of depreciation. The net book
value of assets after depreciation is also termed as net block
(Gross Block Accumulated Depreciation). Gross block is the
term used to represent cost or purchase price of the assets and
cumulative depreciation as accumulated depreciation. The
following example will make clear concept of Gross Block and
Net Block:.
Suppose a firm buys machinery for Rs. 20, 00,000 in the
beginning of financial year. Its MRP is Rs. 22, 00,000. The
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machine has useful life of 10 years. The machine will have no


scrap value at the end of its life.
Recording in books of accounts
Machinery will be recorded at
purchase price i.e. (Gross Block)
20, 00,000
At the end of first year it will be
represented in Balance Sheet as:
Machinery Gross Block
20, 00,000
Less: Depreciation
2, 00,000
(Cost Scarp Value)/Life of Asset
-----------Net Bock (Net Value)
18, 00,000
-----------At the end of Next Year
Machinery WDV
20, 00,000
Less: Depreciation
4, 00,000
(Cost Scarp Value)/Life of Asset
-----------Net Bock (Net Value)
16, 00,000
-----------This process of providing depreciation will continue and the
net value at the end of each year will be shown in balance
sheet. At the expiry of assets life the value of asset
(machinery) will be zero. The amount of depreciation charged
in each year will also be shown on debit side of profit and loss
account as it is to be charged against the current years
operations.
The fixed assets further are classified as tangible fixed assets
and intangible fixed assets. The tangible fixed assets are those
assets which have physical existence. These can be seen or
touched. The items included in this category are land,
building, machinery, equipments, furniture, vehicle, live
stocks etc. The intangible fixed assets do not have physical
existence but represent firms rights. Even if they do not have
physical existence they represent intrinsic value. The items
like patents, copyright, trademark, goodwill falls under this
category. The costs of intangible assets are amortized over
their useful lives. The material effect of amortization and
depreciation is similar.
ii. Current Assets: Current assets are also known as liquid or
short term assets. They are held by the organization for an
operating cycle or an accounting year. These assets held either
in cash form or are expected to be converted in cash within an
accounting period. In other words the current assets may be
defined as the assets which are either in cash form or can be
converted in cash within an accounting year. The most of
them have direct contribution in revenue generation process
of a firm. They are purchased for resale or for sale after
processing. The items included in this category are raw
materials; semi finished and finished goods, debtors, bills
receivables, cash at bank, cash in hand etc. All these items are
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important components of operating cycle. The operating cycle


is the time required for investment of cash into raw materials
and again recovery of cash from sales. In detail it is time
taken to convert raw material into finished goods, sell finished
goods and recover cash from receivables (debtors or bills
receivables). The items of current assets in order of degree of
liquidity are discussed as below:
a. Cash and Bank Balances: Cash is the most liquid item of
current assets as it is available for use or payment without
any processing. It involves the balance of currency notes
held by the firm. It may be used for transaction,
precaution, speculative purposes. The bank balance of a
firm is also have liquidity at par with cash balance as it
can also be used without any lengthy processing.
Payments may be done either by withdrawal or by cheque.
b. Temporary investments: To make productive use of
surplus available temporarily in cash, firm invests it into
short term or marketable securities with an intention to
withdraw money in the events of shortfalls. Normally it
appears in balance sheet as marketable securities. These
securities can be sold in markets at any moments in
working hours.
c. Accounts Receivables: Most of the organizations sale
goods on credit. The customers who have bought goods
on credit are known as debtors of a firm. The amounts
owed to the company by debtors are known as accounts
receivables. In other words, the amounts owed to firm by
unpaid customers up to a balance sheet date are shown as
debtors. In normal course of business, the credit to
customers is extended on the basis of individuals
reputation judgment of the merchandiser. Thus, credit
sales transactions are not secured by any asset. Every year,
some account receivable default and become
uncollectible. The defaulters are known as bad debts. Bad
debts are a loss of revenue nature for a firm. Based on
convention of conservatism an organization has to make
provisions for losses in advance. Therefore, the amount of
bad debts has to be estimated in advance and adjusted in
profit and loss account. As the exact estimation of bad
debts impossible, the management estimates quantum of
bad debts on the basis of past years experience. This
amount of bad debt is deducted from gross value of
debtors shown on assets side of the balance sheet. It is
also shown in debit side of profit and loss account as loss.
Bills receivables are also debtors (credit sales) against
promissory notes. In other words, the credit sale
evidenced by formal written promises to pay on maturity
date is known as bills receivables. The bills are negotiable
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instruments and these can be assigned to another party or


bank for immediate liquidity.
d. Inventories: Inventories are goods and materials held
available in stock by a business firm. For a manufacturing
firm, the material required to manufacture product i.e. raw
materials, or materials in the process i.e. work in process
or goods manufactured or finished goods are included in
inventories. Following convention of conservatism the
inventories are valued at cost or market price whichever is
less. All these inventories takes time to be converted in to
cash therefore are treated less liquid as compared to other
current assets mentioned as above.
e. Prepaid Expenses: These are expenses paid in advance.
The services against these payments are not utilized in the
current accounting period. In normal course of business
some expenses are paid in advance viz. taxes, rent,
insurance etc. As the services against it can be utilized in
next financial year, therefore these are included in current
assets.
iii. Other Assets: Some assets are neither included in fixed
assets nor in current assets. These are shown under the head
other assets. Mostly assets shown under this category are of
deferred revenue nature. Deferred revenue nature assets are
expenditures of revenue nature but as the amount of
expenditure is heavy and also is expected to give benefits for
certain number of future years, the value of these expenditures
is amortized in certain number of years. Therefore, these are
also known as fictitious assets. A part of these assets is
amortized and charged against current years operations and
remaining portion which is yet to amortize is shown as assets
under the head Deferred Revenue Expenditure. This process
continues till the value of their become zero. The preliminary
expenses, heavy advertisement expenses, research and
development expenses, discount on issue of shares and
debentures etc are examples of such expenditures.

Exhibit: 8.1
Horizontal Form of Balance Sheet
The Balance sheet of . as on
(Name of the Company)
(Date of preparation)
LIABILITIES
Yearly
ASSETS
Yearly
Figures
Figures
X1 X2
X1
X2
Share Capital
Fixed Assets
Authorized shares
Intangible Assets
of Rs. each
Goodwill
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Issued:
shares of Rs.
. each
Subscribed
shares of Rs.
. each
Rs. per share
Called up
Less: unpaid calls
Add: Forfeited
shares
Reserves and
Surplus
Capital Reserve
Capital Redemption
Reserve
Share Premium
Account
Other Reserves
Sinking Fund
Secured Loans
Secured Loans
Debentures
Loans and advances
from banks
Loans and advances
from subsidiaries
Other loans and
advances
Unsecured loans
Fixed Deposits
Unsecured Loans &
advances from banks
or subsidiaries
Current Liabilities
and Provisions
Current Liabilities
Bills Payables
Sundry creditors
Unclaimed dividends
Outstanding
liabilities
Advance income
Provisions
Provision for
Taxation
Proposed Dividends
Provision for
contingencies
Provident fund
schemes

Patents
Trade mark
Copyright
Tangible Assets
Land
Buildings
Leaseholds
Railway sidings
Plant and
Machinery
Furniture and
fittings
Livestocks
Vehicles
Investments
Investment in
Government or
Trust securities
Investments in
shares and
debentures or
bonds
Immovable
properties
Capital of
partnership firms
Current Assets,
Loans and
Advances
Current Assets
Interest Accrued
on Investments
Stores and spare
parts
Loose tools
Stock in trade
Sundry debtors
Bank balance
Cash balance
Loans and
Advances
Advance and loans
to subsidiaries
Bills of Exchange
Balances with
custom, port trust
Miscellaneous
Expenditure
Preliminary
expenses
Expenses or

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commission or
brokerage on issue
of shares and
debentures
Discount allowed
on the issue of
shares and
debentures
Other similar
nature items
Profit and Loss
a/c (Loss Balance)

Exhibit: 8.2
Vertical Form of Balance Sheet
The Balance sheet of . ...as on ..
(Name of the Company)
(Date of preparation)
Particulars
Schedule
Yearly Figures
Previous
Current
SOURCES OF FUNDS
Shareholders Fund
Share Capital
A
.
.
Reserves and Surplus
B
.
.
Loan Funds
Secured loans
C
.
.
Unsecured Loans
D
.
.
APPLICATION OF
FUNDS
Fixed Assets
Investments
Currents Assets, Loans
and Advances
Less : Current Liabilities
and provisions
Net Current Assets
Miscellaneous
Expenditure

E
F
G
H
I

.
.
.
.
.
.
___________

.
.
.
.
.
.
___________

Summarized Balance Sheet in Practice: An Example of Suzlon


Energy Limited
As it has been discussed that one of the prime objective of accounting
is communication of financial information to its users and it is done
by way of distribution of annual reports. Annual reports contains
information about company, financial highlights, reports on corporate
responsibility, corporate governance, directors and auditors reports,
information and financial information about subsidiary firms etc.
Annual report also contains financial information in the form of
summarized financial statements. The detailed calculations about a
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particular item is given in the schedules mentioned against that item.


Summarized balance sheet of Suzlon Energy Limited is presented in
Exhibit 8.3. The following points may be noted about the Suzlon
Energy Limited. The net worth of suzlon has declined from 6947
crores in 2008 to 6485 crores in the year 2009. The capital employed
of the firm has increased from 10,032 crores to 13,909 crores in the
said period. This increase was due to substantial increase in secured
loans. The Fixed Assets of suzlon include heavy amounts invested in
investments. The current assets have also increased from 6954 crores
to 9040 crores. Similarly, current liabilities have also increased by
1000 crores. The net increase in Net Current assets is also
approximately 1000 crores (5368-4372). It can be observed that
increase in current assets is due to remarkable increase in loans and
advances item of current assets which increased by 200%. The
increase in net current assets is less as compared to current assets
because simultaneous increase in current liability. The net current
assets are calculated by deducting current assets from current
liabilities.

Activity 8.2
Do you remember the items of current assets and current liabilities
nature? List them:
Current Assets
Current Liabilities
.
..
.
..
.
..
.
..

Exhibit 8.3
Suzlon Energy Limited
Balance Sheet as at March 31, 2009
Particulars

Schedule

(Rs. In Crores)
As at 31st March
2009
2008

SOURCES OF FUNDS
Shareholders Fund
Share Capital
Employee Stock Options
Outstanding
Reserves and Surplus

A
B

299.66
8.25

299.39
10.22

6177.41
6485.32

6638.05
6947.66

Share Application Money pending


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refund
Loan Funds
Secured loans
Unsecured Loans

D
E

95.00

--

4006.23
3323.25
7329.48

672.26
2412.48
3084.74

13,909.80

10,032.40

APPLICATION OF FUNDS
Fixed Assets (including intangible
assets)
Gross Block
Less Depreciation / amortization
Net block
Capital work in progress

915.83
364.33
551.50
286.97
838.47

779.20
266.98
512.22
134.64
646.86

Investments

7127.80

4919.48

175.40

93.64

Deferred tax assets


Foreign currency monetary item
translation difference account
Currents Assets, Loans and
Advances
Inventories
Sundry debtors
Cash and bank balances
Loans and advances
Less : Current Liabilities and
provisions
Current Liabilities

399.26
H

Net Current Assets


Significant accounting policies and
notes to accounts

1383.62
4745.14
212.40
2698.75
9039.91

1483.23
3306.59
875.50
1289.15
6954.47

3301.77
369.27
3671.04
5368.87
13,909.80

1946.39
635.66
2582.05
4372.42
10,032.40

The Schedules referred to above and notes to accounts form an integral part of the balance
sheet.

8.5

INCOME STATEMENTS

The prime objective of investing in a business is to earn profits. At


the end of each financial year, business man wants to know whether
he has earned profits or incurred losses. The amount of profit earned
becomes a basis for determination of tax liability and financial status
at the end of each accounting year. This statement gives the detail
about expenses incurred, revenues earned and net profit or loss
incurred during a particular period. Therefore, this statement is
popularly known as profit and loss account. The three main
components of income statements are manufacturing account, trading
account and profit and loss account. The manufacturing account is
prepared by manufacturing firms only. Trading firms prepare trading
account and profit and loss account. These statements are prepared in
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sequential order. First of all manufacturing account is prepared then


trading account followed by profit and loss account. The balance of
manufacturing account is transferred to trading account and the
balance of trading account is transferred to profit and loss account.
Finally, the balance of profit and loss account transferred to P & L
appropriation account and the balance of this a/c ultimately carried to
balance sheet. There is no legal format of profit and loss account. It
may be prepared in T format or report format. A prototype of both
formats is being given in exhibits 8.4 and 8.5.

8.6

MANUFACTURING ACCOUNT

As discussed earlier that manufacturing firms prepare manufacturing


account along with trading and profit and loss account. The primary
objective of preparing manufacturing account is to know about the
cost of production of the goods produced during the year.
Manufacturing concerns after preparing the manufacturing account
transfers the balance of this account known as cost of production to
trading account. Thus it can be said that it is a part of trading account.
The first part of exhibit 8.4 is manufacturing account. The cost of raw
materials, manufacturing wages and direct factory overheads are
recorded on debit side of manufacturing account. The balance of
debit side after deducting closing stock of raw materials and work in
process reveals cost of production which is transferred to trading
account.

8.8

TRADING ACCOUNT

Trading account shows the results of trading activities of a concern


for the year i.e. buying and selling. It is prepared to know gross profit
earned or gross loss incurred as a result of trading activities. The
second section of income statements is known as trading account in
which opening stock of finished goods is debited on credit side sales
and stock of finished goods are shown. If credit side of trading
account is exceeds debit side the difference is termed as gross profit.
Trading costs comprises of cost of production/ purchase and direct
expenses. In reverse situation, if debit side is greater than credit the
difference is termed as gross loss. The gross profit or gross loss are
transferred to the final part of the statement i.e. profit and loss
account.

8.9

PROFIT AND LOSS ACCOUNT:

Profit and loss account is a summary statement prepared for


measuring firms profitability. It gives summary of indirect expenses,
revenues and net income of a firm. All indirect items are recorded in
this statement. The indirect expenses like administrative expenses,
selling and distribution expenses, financial losses and other losses of
business are shown on the debit side of profit and loss account. The
gross loss shown by trading account is also shown in debit side of
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this statement. Administrative expenses are the expenses incurred for


office administration like rent, salaries, postage and stationary,
printing expenses etc. Selling and distribution expenses are incurred
to generate and accelerate sales. It involves expenses incurred on
advertising, salesmen commission, travelling allowance, packaging
etc. Financial losses are losses incurred against financing policy of
the firm like interest payments, dividends paid, commission paid etc.
Other losses include loss on sale of machinery, loss by fire, loss by
theft etc.
On credit side of profit and loss account, gross profit from trading
account and indirect incomes earned during the accounting period are
shown. The dividends received, commissions received, interest
received etc. are some examples of indirect incomes. If the credit side
of Profit and loss account is greater than debit side, the difference is
termed as net profit and is shown on debit side and vice versa. The
amount of net profit and net loss is transferred to P&L appropriation
a/c in case of a co. In sole proprietorship or partnership businesses,
this amount of net profit or net loss is transferred in capital account
and profit and loss account is closed. But in most of companies this is
transferred to profit and loss appropriation account. The amounts are
allocated from this appropriation account to reserves, dividends and
balance. In this situation, profit and loss accumulated balance
separately appears in balance sheet.
The revenues and expenses shown in income statements are also
categorized as operating and non operating. The revenues or
expenses arising from main operational activities of business firm are
called as operating revenues and expenses. Revenues from sale of
goods manufactured by a business firm, sales of trading goods for
trading firm are operating revenues. Similarly, the operating costs
incurred to convert goods saleable like cost of production,
administrative expenses, selling and distribution expenses are
operating expenses. Non operating expenses and revenues are
indirect or incidental to main operations. These do not emerge as a
result of firms business operations. The examples of non operating
revenues are dividends, receipts from sale of old equipments etc. In
the same way, non operating expenses include loss on sale of old
assets, dividends paid, interest paid etc.
Summarized Income Statement in Practice: An Example of
Suzlon Energy Limited
As it has already been discussed in earlier section that financial
information is communicated to users by distribution of annual
reports. Annual reports contain along with other information detailed
financial statements. Income statement is also an important part of
financial statement. The income statement of Suzlon Energy is
presented in exhibit 8.6 as an example to make you familiar that how
income statement is disclosed by business firms. The summary of
important revenue and expenses items are presented in income
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statement with schedules. The schedules may be referred for detailed


information about calculation of a particular item. As the schedules
are lengthy thus these have not been inserted here and just a reference
is given. The schedules are the part of annual report is thus there can
easily be referred if required. It can be observed that Suzlon Energy
Ltd has negative profit before tax (loss) in the year 2009 while in
2008 it was having 1319.79 crores profits before tax. The increase in
sales revenues is lower as compared to increase in expenditures. In
the year 2009, the operating and other expenses have also increased
remarkably

8.10 P & L APPROPRIATION ACCOUNT:


The net profit shown by profit and loss account is transferred to profit
and loss appropriation account. The distribution of profit to various
activities like general reserve, proposed dividend etc is shown in this
account. The format P&L appropriation account is as under:
Dr.
Cr.
Particulars
Amount Particulars
Amount
To Balance b/d
By Balance b/d
To P&L (Net Loss)
By P&L a/c (Net
To Transfer to General
Profit)
Reserve
By Balance c/d
To Proposed Dividend
To Interim Dividend

Activity 8.3
Recall at least two examples of following expenses.
Operating Expenses
.
.
Selling & Distribution Exp .
.
Administrative Expenses
.
.
Financial Expenses
.
.
Non Operating Expenses
.
.
Activity 8.4
Find out following things from Suzlons Energy Financial Statements
for the years 2009 and 2008.
Reserves and Surplus
.
.
Net Profit
.
.
Loan Funds
.
.
Financial Charge
.
.
Profits transferred to
Balance sheet
.
.

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Exhibit 8.4: Horizontal Form of Income Statements


Manufacturing, Trading and Profit and Loss Account of
.(name of firm) for the year ending (Ending
date of Accounting Year)

Dr.
Particulars

Cr.
Amount in
Rs.

Particulars

Amount in
Rs.

Raw Materials

Xx

Work in process

Xx

Xxxx

By Cost of Finished
Goods c/d
By Closing Stock

To Purchases of
Raw Materials
To Manufacturing Wages

Xxxx

Raw Materials

xx

Xxxx

Work in process

xx

To Carriage inwards

Xxxx

To Other Factory overheads

Xxxx

To Opening stock

------------To Opening Stock of Fin


Goods
To Cost of Finished Goods b/d
To Gross Profit c/d
(if Cr.>Dr.)

To Gross Loss b/d


To Office and admn. Exp.
To Selling and Distribution
Exp.
To Interest and Financial Exp.
To Provision for Income Tax
To Net Profit c/d

To Balance b/d
To Net Loss b/d
To General Reserve
To Dividends
To Balance c/f

xxxx

xxxx

-------------

Xxxx

By Sales

xxxx

Xxxx
Xxxx

By Closing Stock
By Gross Loss c/d
(If Dr. >Cr)

xxxx
xxxx

------------Xxxx
Xxxx
Xxxx
Xxxx
Xxxx
Xxxx
------------Xxxx
Xxxx
Xxxx
Xxxx
-------------

By Gross Profit b/d


By Miscellaneous
Receipts
By Net Loss c/d

------------xxxx
xxxx
xxxx

By Balance b/d

------------xxxx

By Net Profit b/d

xxxx

-------------

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Exhibit 8.5 Vertical Form


Income Statement of (Name of Firm) for the year ending
(Ending date of accounting year)
Particulars
Amount in
Rs.
Sales
Xxxx
Less Sales Returns
Xx
Sales Tax / Excise Duty
Xx Xxxx
Xxxx
Net Sales
Total
(1) Xxxx
Cost of Goods Sold
Materials consumed
Xx
Direct Labour
Xx
Manufacturing Expenses
Xx Xxxx
Add/Less: Adjustment for change in stock
Xxxx
Total
(2) Xxxx
Gross Profit
Total
Xxxx
(1-2)
Less Operating Expenses
Xx
Office and Administrative Expenses
Xx
Selling and Distribution Expenses
Xx xxxx
Operating Profit
xxxx
Add Non Operating Incomes
xxxx
Less Non operating expenses (including interest)
Profit before interest and tax
Less Interest
Profit Before Tax
Less Tax
Profit after tax
Appropriations
Transfer to reserves
Dividends paid/ declared
Surplus carried to Balance Sheet

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xxxx
xxxx
xxxx
xxxx
xxxx

xxxx
xxxx
xxxx

Exhibit 8.6: Income Statement of Suzlon Energy Ltd


Profit and Loss account for the year ended March 31, 2009
All amounts in rupees crores unless otherwise stated

Particulars
INCOME
Sales [See Schedule O, Note 2]
Other Income
EXPENDITURES
Cost of Goods sold
Operating and other expenses
Employee remuneration and benefits
Financial charges
Depreciation/ Amortization

Schedule

2009

2008

7235.58
177.14
7412.72

6926.01
125.61
7051.62

4543.85
1803.47
199.07
433.97
99.16
7079.52
333.20

4226.99
854.47
139.34
139.61
96.21
5446.62
1605.00

873.16

285.21

(539.96)
---(81.76)
11.07
(469.27)
2268.44
________
1799.17

1319.79
155.00
(89.00)
0.13
(23.49)
11.44
1265.71
1477.86
_______
2743.57

-0.13
(1.05)

149.69
-25.44

-________
1800.09
=======

300.00
________
2268.44
=======

3.13

8.70

3.13

8.47

K
L
M
N
F

PROFIT BEFORE TAX AND


EXCEPTIONAL ITEMS
Less: Exceptional items (See
Schedule O, Note 3)
PROFIT / (LOSS) BEFORE TAX
Current tax
MAT credit entitlement
Earlier year current tax
Deferred tax
Fringe benefit tax
NET PROFIT/(LOSS)
Balance brought forward
PROFIT AVAILABLE FOR
APPROPRIATIONS

APPROPRIATIONS
Proposed dividend on equity shares
Residual dividend of previous
Tax on dividends [see schedule O
Note13(g)]
Transfer to general reserve
Surplus carried to balance sheet
Earnings (loss) per share (in Rs) [see
schedule O, note B]
- Basic [Nominal value of share
Rs. 2/-]
- Diluted [Nominal value of share
Rs. 2/-]
Significant accounting policies and notes to
accounts

The schedules referred to above and the notes to accounts form an integral part of the profit and loss
account.

8.11 SUMMARY
In this unit we have discussed financial statements in detail. The
financial statements are logically compiled and consistently
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organized accounting data in consonance with prevalent accounting


principles. It consists of Balance Sheet and Income Statements.
Balance sheet is screen picture of financial condition of a business. It
is a statement of assets, liabilities and owners capital as on a
particular point of time. Income statements include manufacturing
account, trading account and profit and loss account. Manufacturing
account is an additional account prepared by manufacturing concerns.
All trading firms prepare trading and profit and loss account. Most of
organizations prepare only a single profit and loss account instead of
preparing three separate accounts. This profit and loss account
summarizes all revenues and expenses of an accounting period. P&L
Appropriation is also prepared by companies.

8.12 KEY WORDS


Liabilities are claims of people who have lent money or supplied
goods or services on credit. These include even money supplied by
owners, lenders and creditors.
Assets are economic resources owned by the firm. These resources
are used to generate income by the business firm. These are called
assets as business firm owns it and can utilize it for productive
purposes or can recover money by liquidating it.
Current Liabilities are the claims against the assets of business that
are borrowed with an intention to pay them within an accounting
year. The current liabilities are called current or short term liabilities.
The items included in this category are creditors, bills payables, tax
or other claims payables, bank overdraft etc.
Current Assets are those assets which are either in cash form or can
be converted in cash within one accounting year. Current assets
include items such as inventories, debtors, bills receivables,
marketable securities, bank balances, cash etc.
Tangible fixed assets are those assets which have physical existence.
These can be seen or touched. The items included in this category are
land, building, machinery, equipments, furniture, vehicle, live stocks
etc.
Intangible fixed assets do not have physical existence but represent
firms rights. Though they do not have physical existence but they
represent intrinsic value. Patents, copyright, trademark, goodwill are
included in this category.
Owners Equity is the owners claim against the assets of a business
firm. It includes paid up value of equity capital and reserves and
surplus or retained earnings. It is also known as net worth.
Contingent Liability is not a liability right now but may become
liability after happening of certain event. Thus, it is not recognized as
liability by a business firm but it may become liability on the
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happening of a certain future event. For example, probability of


liability arising out of a pending law suit.
Administrative expenses are the expenses incurred for office
administration like rent, salaries, postage and stationary, printing
expenses etc.
Selling and distribution expenses are incurred to generate and
accelerate sales. It involves expenses incurred on advertising,
salesmen commission, travelling expenses, packaging etc.
Financial Expenses are expenses incurred against financing policy
of the firm like interest payments, dividends paid, commission paid
etc.

8.13

SELF ASSESSMENT QUESTIONS

Objective Type Questions:


1. Which one of the following is not correct about Balance
Sheet:
a. It shows assets of business
b. It shows obligations of business against assets
c. It is a position statement
d. It is a valuation statement
2. Which one of the following is not a current asset:
a. Cash
b. Inventories
c. Bank overdraft
d. Bills receivables.
3. Which one of the following is not an intangible fixed asset:
a. Goodwill
b. Patents
c. Trademark
d. Live stock
4. Which one of the following is non cash expense:
a. Depreciation
b. Rent paid
c. Interest
d. Postage
e.
5. Which one of the following is selling and distribution
expense:
a. Packaging charges
b. Rent paid
c. Salaries paid to supervisor d. Stationary expenses
Ans: 1. (d), 2. (c), 3. (d), 4. (a), 5. (a)
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Short Answer Type Questions:


i.
ii.
iii.
iv.
v.

What do you mean by current assets? Give the list of current


assets
What do you mean by contingent liabilities? Give two
examples of it.
What do you mean by income statement? Why is it prepared?
What do you mean by liabilities? Is owners capital a
liability?
What do you mean by operating expenses?

Long Answer Type Questions:


i. What do you mean by financial statements? Why these
statements are prepared.
ii. What do you mean by Balance Sheet? Discuss main features of
balance sheet.
iii. Balance sheet is a position statement not a valuation
statement. Elucidate.
iv. What do you mean by assets? Discuss in detail various kinds of
assets held by an organization.
v. What do you mean by income statements? Discuss in detail
various items and types of accounts prepared for income
measurement.

8.14 FURTHER READINGS


Pandey I. M . 2005, Financial Management, Vikas Publishing House:
New Delhi.
Kishore R. M , 2005, Financial Management, Taxmann Allied
Services (P.) Ltd.
Khan M.Y. and Jain P. K. Theory and Problems in Financial
Management, Tata McGraw Hills Publishing Company Ltd., Delhi.
Gitman L. J., 2005, Principles of Managerial Finance, Indian branch
of Pearson Education, Delhi.
Bhatt S. 2009, Management Accounting, Excel Books, New Delhi.

UNIT 9

FINANCIAL STATEMENT
ANALYSIS: RATIO ANALYSIS

Objectives
The objective of this unit is to familiarize you with
Concept of financial statement analysis
The techniques of financial analysis
Ratio analysis
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Using ratio analysis for examining an organizations liquidity,


solvency, activity and profitability.
Structure
9.1
Introduction
9.2
Concept of Financial Analysis
9.3
Ratio Analysis
9.4
Liquidity Ratios
9.5
Activity Ratios
9.6
Solvency Ratios
9.7
Profitability Ratios
9.7.1 Profitability Ratios related to Sales
9.7.2 Profitability Ratios related to Investments: Return
Measurement
9.7.3 Profitability in relation to Investment: Stock Market
Ratios
9.8
DuPont Analysis
9.9
Summary
9.10 Key Words
9.11 Self Assessment Questions
9.12 Suggested Readings

9.1

INTRODUCTION

In previous section, we have discussed about financial statements.


These statements provide information regarding annual operating
performance and financial position of a concern. These kinds of
information are used by various users like management, creditors,
investors etc. for their decision making. The information contained in
financial statements is in absolute terms and thus are not self
explanatory. They may not be useful until these are not transformed
in relative terms. Therefore, the users may require assistance of
experts and analysts to draw conclusions from financial reports. The
financial statement analysis is an attempt to draw significant
conclusions by establishing relationship between various data
obtained from financial reports. Analysis is done by using various
tools and techniques. It gives an insight to the users about strengths
and weaknesses of a business firm. The financial analysis may be
made by the management of the firm or by outsiders the firms like
owners, creditors, investors etc.

9.2

CONCEPT OF FINANCIAL ANALYSIS

The financial statement analysis is the study of relationship amongst


various factors in a business as disclosed by financial statements. It is
the process of identifying the financial strengths and weaknesses of
the firm by establishing proper relationships between items of the
balance sheet and the profit and loss account. The nature of
relationships will differ according to the users and purpose for which
analysis is required. The evaluation of firms liquidity position will
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be required by creditors as they are concerned with firms ability to


meet their short term obligations. Banks, financial institutions and
other providers of long term fund will need an over all analysis of
long term solvency, profitability and ability to pay interests and repay
principal on the maturity date. In the similar manner, investors look
for steady growth in firms earnings. Thus they concentrate their
analysis on present and future earnings. The management of the firm
has overall responsibility to see that resources of the firms are applied
most effectively and efficiently. They analyze financial statements
from all the angles and use this analysis for corrective actions if
deficiency is observed.
Objectives of Financial Analysis
The main aim of financial analysis is to examine the financial
strength and weakness of a firm. It is done by analyzing financial
reports from various angles. Analysis of financial statements is done
to satisfy following objectives:
i.
Assess Financial Health: The prime objective of financial
statement analysis is to judge the financial health or position
of a business firm. The financial health is analyzed from
different angles i.e. liquidity, solvency, profitability, debt
servicing ability etc.
ii.
Assess Profitability: Most of the users of financial
information are interested in knowing profitability of a firm.
The absolute figures of profits may not serve the purpose of
many of them. Thus the firms profitability in relation to sales
and various investment measures is calculated. Profitability in
relation to sales gives an idea about firms operational
efficiency and profitability in relation to investment gives an
idea about returns on investment.
iii.
Assess Solvency Position: The financial analysis generates
data about firms ability to meet both short term as well as
long term obligations. This assists bankers and creditors to
take decision about extending credit.
iv.
Gauge the Debt Servicing Capacity: Another important
objective is to examine firms ability to service debt. Debt
servicing means outflows expected on debts must be timely
paid. Thus, it is examined that whether the firms earnings are
sufficient to meet outflows on debt i.e. annual payments of
interests and principal installments.
Techniques of Financial Analysis
The financial statements are rearranged to reveal relative significance
of one item on another. Various techniques are used to establish
relationship between various items. Some important tools and
techniques of financial analysis are as follows:
i. Comparative Financial Statements
ii. Common Size Statements
iii. Trend Analysis
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iv.
Ratio Analysis
v.
Funds Flow analysis
vi.
Cash Flow Analysis
vii.
Break Even Analysis
viii. Value added Analysis
Ratio analysis is most useful and popularly used among the various
techniques. This will be discussed in detail in the forthcoming
discussion. Whereas another popular technique of financial i.e. break
even analysis will be discussed in the next chapter.
Activity 9.1
Do you know why financial statement analysis is done? List your
arguments below.

9.3

RATIO ANALYSIS

Ratio analysis is a powerful tool to analyze the financial strengths and


weaknesses of a business firm. It facilitates management in future
decision making by analyzing past performance. It concentrates on
interrelationships between various items of financial statements.
Websters new collegiate dictionary defines a ratio as the indicated
quotient of two mathematical expressions and as relationship
between two or more things. The financial statements disclose
absolute accounting figures. It does not provide meaningful
understanding until it is converted in figure related to some other
relevant information. Disclosure of net profits of 10 crores may look
impressive but when it is related to investments of 100 crores, the
performance can be said to be average. When this relationship is
expressed between two items of financial statements or accounting
figures, then it is known as accounting ratios. In opinion of J Betty
the term accounting ratio is used to describe significant relationships
which exist between figures shown in a balance sheet, in a profit and
loss account, in a budgetary control system or in any other part of
accounting organization. The use of ratios enables users to
summarize large quantities of data and make qualitative decisions
about the firms financial performance. The quantitative calculation
of ratios is relatively easier than proper relative analysis and
qualitative interpretation. Interpretation will depend on individuals
understanding of ratios and accounting skill. The analysts have to
consider the limitations inherent to accounting system while giving
interpretations.
Basis of Comparison
Ratio is not only limited to calculation of accounting ratios but
interpretation of ratio is also equally important. A single ratio does
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not communicate meaningful interpretations until it is compared with


some standards or benchmarks. The healthiness of any ratio can only
be found if it is compared with some standard ratios. The ratios of
firms previous years financial statements or its competitors may be
taken as basis for comparison. The basis of comparisons can be
broadly categorized in two categories i.e. intra and inter firm
comparisons.
i.

Intra firm comparison: The comparison of same firms ratios


over time are used for comparison. The current year ratios are
compared with previous years ratios of same firm. It is also
known as trend ratios or time series analysis as it evaluates
firms financial performance over time. The comparison of
current years ratios with past years enables analysts to assess
firms progress. A multiyear ratio analysis can generate
developing trends in a particular ratio. As we have taken
previous years ratios to compare current year ratios in the
similar manner the ratios of projected financial statements can
also be used to compare present year ratios.

ii.

Inter firm comparison: It involves comparison of the ratios of


a firm with those of others in the same line of business at the
same point in time. The ratios may be compared either with
industry average ratios or with any progressive competitor
firm ratios. It is also known as cross sectional analysis. The
ratios compared with industry averages helps to ascertain the
financial standing and capability of the firm as compared to
other firms in industry. The comparison of ratios with some
selected firms existing in same industry helps to examine
strength and weakness as against those firms.

Types of Ratios
A number of ratios can be calculated from the accounting data. It can
be categorized into various classes according to financial activity or
functions evaluated. Various financial authorities have classified
ratios from different angles. Some classify ratios according to the
statements with which they are related like balance sheet ratios,
income statement ratios and combined ratios. Bombay stock
exchange classifies ratios into two categories i.e. primary and
secondary ratios. The classification according to the requirements of
users of ratios is most commonly used in accounting literatures. As
stated earlier that the users of accounting ratios are short and long
term creditors, investors, management and employees. The short term
creditors are concerned with liquidity of the firm while long term
creditors are interested in profitability and long term solvency. In the
same way management has to protect interest of all concerned. They
also monitor growth and efficiency in business. The investors or
owners are interested in returns and profitability. According to needs
of users, ratios are broadly categorized in four categories:
Liquidity ratios
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9.4

Activity Ratios
Solvency or leverage Ratios
Profitability Ratios

LIQUIDITY RATIOS:

The liquidity of a firm is measured by its ability to meet its short term
obligations as and when they become due. It is referred to the ease
with which a firm can spare cash to pay its bills and dues of short
time. The liquidity ratios are good indicators of cash flow problems
in a business. Quantum and quality of current assets held by business
determines the liquidity position. The quantum here is related with
amount and structure of current assets held by business. The quality
here means its ability to meet cash requirements. The ratios used to
gauge liquidity of firm are known as liquidity ratios.
The important ratios measuring liquidity are current ratio, quick ratio,
absolute liquidity ratio and defensive interval ratio.
i. Current Ratio
It is one of the most widely used ratios. It establishes
relationship between current assets and current liabilities. It
measures firms ability to meet current liabilities from fund
arising out of realization from current assets. This ratio has
great significance in assessing working capital position. Net
working capital is excess of current assets over current
liabilities. This ratio is calculated by dividing current assets
by current liabilities.
Current Ratio =

Current Assets
Current Liabilities

Current Assets: Current assets includes those assets which


are either in cash form or can be converted into cash with in a
years time. Current Assets = Cash in Hand + Cash at Bank +
B/R + Short Term Investment + Debtors (Debtors
Provision) + Stock (Stock of Finished Goods + Stock of Raw
Material + Work in Progress) + Prepaid Expenses.
Current Liabilities: Current liabilities include those
liabilities which are repayable in a years time. Current
Liabilities = Bank Overdraft + B/P + Creditors + Provision
for Taxation + Proposed Dividend + Unclaimed Dividends +
Outstanding Expenses + Loans Payable with in a Year.
Generally, a firm is considered to be liquid if its current ratio
is higher. A current ratio of 2:1 is widely accepted as ideal
ratio. But its acceptability depends on the industry in which
the firm operates. For example 2:1 current ratio may be
acceptable for manufacturing industry but not in public utility
firms like electricity boards, PHED etc. A very high current
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ratio too will have adverse effect on profitability of the


organization and a very low ratio may cause liquidity crunch
and shortage of working capital. A very high current ratio
may be due to piling up of inventories, inefficient collections
form debtors, high cash and bank balances. The funds blocked
in these assets are considered to be less productive.
ii. Quick Ratio
It is also known as liquid or acid test ratio. This ratio is
similar to current ratio except that it excludes inventories and
prepaid expenses. Inventories and prepaid expenses are
considered to be less liquid current assets. Inventories and
prepaid expenses take more time to convert it in cash as
compared to other current assets (Quick Assets). It is argued
that inventories cannot be easily sold in market and even if it
is sold normally it is converted in receivables which in turn
consume time to convert in cash. In the similar manner
prepaid expenses cannot be recovered and only services
against it can be used to generate sales. Thus, it would be
prudent to exclude these both items for computing quick ratio.
It is calculated by dividing quick assets by current liabilities.
Quick Ratio =

Quick Assets
Current Liabilities

Quick Assets = Current Assets (Stock + Prepaid Expenses)


A quick ratio of 1:1 is considered as ideal ratio but like current ratio
its acceptability will depend on type of industry. This ratio
measures greater intensity of liquidity as compared to current ratio.

iii. Absolute liquidity Ratio


A variation of quick ratio is super quick ratio or absolute
liquidity ratio. It is the ratio of absolute liquid assets to current
liability. This ratio shows firms ability to meet obligations on
the spot or immediately. It is the ratio between cash or cash
equivalents with current liabilities.
Absolute
Liquidity Ratio

Cash + Mkt Securities + Bank


Current Liabilities

The ideal absolute liquidity ratio is taken as 1:2 or 0.5:1. The ratio
greater than this means idle cash funds lying in the firm.

vi. Defensive Interval Ratio


The ability of a firm to pay its current liabilities has been
discussed in the above three ratios. The defensive Interval
Ratio measures liquidity position of a firm in relation to its
ability to meet projected daily expenditure from operations. It
is calculated by dividing quick assets by projected daily cash
requirements.
Defensive Interval Ratio=

Quick Assets or Liquid Assets

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Projected Daily Cash Requirement


Projected Daily
Cash Requirement=

Projected Cash Operating Expenditure


Number of Days in a Year (365)

Projected Cash Operating Expenditure includes all estimated


cash expenses excluding depreciation and amortizations.
Alternatively it can be calculated by adding cost of goods sold
excluding depreciation, selling and distribution expenses,
administration expenses and other ordinary cash expenses.
This ratio shows the number of days for which operating
expenses can be met by quick assets. The higher ratio means
quick assets are sufficient to meet more days operating
expenses requirements.

9.5

ACTIVITY RATIOS

Activity ratios are concerned with evaluating the efficiency with


which firms assets are utilized. The firm invests in assets to generate
sales and if assets are managed efficiently, it will produce larger
amount of sales. The velocity or speed with which the assets are
converted into sales is indicated by activity ratios. These are also
called as turnover ratios as it shows how many times assets are turned
over into sales. Thus activity ratio may be defined as a test of the
relationship between sales and various assets of the business. The
activity ratios are explained below:
i. Inventory (stock) turnover ratio:
This ratio shows velocity of inventories in a business firm. It
indicates number of times inventories have been replaced
during the year. A considerable amount of a firms capital
invested in inventories or stock. If the inventories are replaced
many a times during a year, the money tied up in financing
inventories will be less. If firm produces larger amount of
sales by investing less amount in inventories, the firms
inventory management will be considered efficient. The
inventories are classified into three categories i.e. raw
material inventory, work in process inventory and finished
goods inventory. In a manufacturing firm finished goods
inventory is used to calculate inventory turn over ratio. It is
calculated by dividing cost of goods sold by the average
inventory.
Inventory Turnover Ratio =

Cost of Goods Sold


Average Inventory

Where,
Cost of goods sold = Net Sales Gross Profit
Average Inventory = Opening Inventory + Closing Inventory
2
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The average inventory is average of opening balance


(inventory amount of previous year balance sheet) and closing
balance (inventory amount of current year balance sheet).
Another method of finding average inventory is to use
monthly average inventory. It is calculated by adding thirteen
months (January to January if accounting year begins on
January) to opening inventories and dividing it by thirteen.
This data may not be available to external analysts thus
earlier approach of using opening and closing inventory for
finding average inventories is widely used. The cost of goods
sold can be calculated by deducting gross profit from net
sales.
Some times cost of goods sold figure may also not be
available to an outside analyst. In that situation inventory
turnover can be calculated by dividing net sales by inventory.
The ratio on the basis of net sales to inventory is not logical
because the numerator- sales is at market prices while
denominator inventory is valued at cost price. Even then in a
situation when its impossible to find out cost of goods sold
and average inventory, this ratio may be used for approximate
efficiency measurement.
Inventory Turnover Ratio = Net Sales
Inventory

Inventory conversion period:


This is further extension of inventory turn over ratio. It gives
no of days in which inventories will be converted in sales. It
is also known as days of inventory holdings i.e. how many
days inventory firm maintains. Days, months or weeks in a
year are divided by inventory turnover ratio to find inventory
conversion period.
Inventory conversion Period= Days/Months/weeks in a year
Inventory turnover
OR
=Average inventory X Days or weeks or Months in a year
Cost of goods sold
It has been discussed that finished goods inventory is used to
calculate inventory turnover ratio. If an analyst wants to know
levels of raw material inventories and work in process
inventories, the analyst can use following ratios which
establish relationship of raw materials inventories with raw

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materials consumed and cost of production with work in


process inventories.
Raw material inventory
Turn over ratio =
Material consumed
Average raw material inventory
Work in process inventory
Turn over ratio =
Cost of Production
Average Work in Process Inventory
Interpretation:
Inventory turnover ratio is the test of efficiency in managing
inventory management efficiency. The ratio must be
compared with previous years ratios or industry averages to
judge its efficiency. A high ratio is implies good inventory
management and a low ratio is indicative of excessive
inventory levels. If inventory turnover is high, the inventory
conversion period will be lower i.e. lesser days inventories are
maintained by firm which implies that fewer funds are
blocked with inventories. A very high inventory turnover is
also not good and needs immediate attention otherwise it will
adversely affect firms ability to meet customer demands. It
also poses danger of firms being out of stock and imposes
stock out costs and ordering costs. If this ratio is low, the
inventory conversion will be high, means firm maintains more
investments in inventories which is dangerous. Carrying
excessive inventories involves cost of funds locked up,
inventory carrying costs, possible wastage and deterioration.
ii. Debtors turn over ratio:
Debtors are created when a firm sells goods on credit. Debtors
are included in current assets as credit extended to them is for
short period. They are converted into cash with in an
accounting period therefore they are important ingredient of
firms liquidity. Debtors turnover ratio shows how quickly
receivables or debtors are converted into sales. Debtors
turnover establishes relationship between credit sales and
debtors of the firm. It shows number of times debtors turnover
in a year. It is calculated by applying this formula
Debtors turnover ratio=
Credit Sales
Average debtors + Average bills receivables
The credit sales figure can be reached by deducting cash sales
from total sales and average debtors and bills receivables by
adding opening and closing because of these and dividing it
by two. In case if figures of credit sales and opening and
closing receivable are not available than alternative figures of
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net sales and debtors may be used for calculating debtors


turnover ratio.
Debtors turnover = Net Sales
Debtors + Bills Receivables
Collection Period:
Another extension of debtors turnover is average collection
period. It is calculated by diving the days or weeks or months
in a year by the debtors turnover ratio.
Average collection
period
= Months or days or weeks in a year
Debtors turn over
Interpretation:
The higher the debtors turnover ratio, the shorter will be the
collection period which is considered to be good. It indicates
that firms investment in debtors is less and its collection
management is efficient. If debtors turn over is low, the
collection period will be larger which means firm has larger
debtors. A firm having larger debtors has greater risk of
default in receivables (bad debts). On one hand a firms
investment in debtors causes interest cost on funds blocked,
and on the other, risk of loss by default. Thus a shorter
collection period is preferred. A very high creditors turn over
or a very low collection period may also be dangerous as it
may have adverse effect on the volume of sales of firm. A
firm should not have very low or very high debtors turn over
ratio. Reasonability of collection period can be judged by
comparing it with industry practices or examining in relation
to credit terms and policy of the firm. The other aspect related
to collection period is aging schedule.
Aging Schedule:
Aging schedule gives detailed idea about quality of debtors. It
enables to identify slow paying debtors. It breaks down
debtors according to the length of time for which they have
been outstanding. A hypothetical aging schedule is being
given in the following table.
Table: Aging Schedule-An example
Outstanding period ( in Outstanding
Percentage of
days)
amount of debtors total debtors
(in Rs.)
0 to 30
4,00,000
20
31 to 45
8,00,000
40
46 to 60
4,00,000
20
Above 60
2,00,000
20
Total
20,00,000
100
It can be seen from the table that 20 per cent of its debtors are
overdue for one month. If firms average collection period is
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45 days in that case almost 40 percent of debtors remain


outstanding for more than collection period. Therefore, the
aging schedule shows how much debtors remain overdue for
how long period.
iii. Assets turn over ratio:
Sales are generated by utilizing assets of firm. Therefore to
maximize sales a firm should manage and utilize its assets
efficiently. This is also known as investment turnover ratio. It
is based on the relationship of cost of goods sold and assets of
a firm. Depending on different concepts of assets employed,
several assets turnover ratios can be calculated.
Total Assets Turn Over Ratio: it shows firms ability to
generate sales using total assets. It is calculated by diving cost
of goods sold by total assets. For an external analyst, if the
figure of cost of goods sold is not available the figure of sales
may be used instead of cost of goods sold.
Total assets turn over Ratio= Cost of goods sold or Sales
Total Assets
Here, total assets include net fixed assets and current assets.
In other words total assets are net of depreciation and are
exclusive of fictitious assets i.e. preliminary expenses, loss
balance of profit and loss etc.
Fixed Assets Turn Over Ratio: It shows firms efficiency in
utilizing fixed assets. Cost of goods sold or sales is divided by
net fixed asset to find out this ratio.
Fixed assets turnover Ratio= Cost of goods sold or Sales
Fixed Assets
Fixed assets are net of depreciation. In the absence of
information about cost of goods sold, sales may be used to
find out this ratio.
Capital Employed Turnover Ratio: It is also known as net
assets turn over ratio. It is calculated by dividing cost of
goods sold or sales by capital employed or net assets.
Capital Employed
turnover Ratio
= Cost of goods sold or Sales
Capital Employed
Capital employed is a term used to represent total long term
fund employed in the organization. It is also known as net
assets and it can be calculated by adding net fixed assets and
net current assets. Net current asset is excess of current assets
over current liabilities (CA-CL). A simple formula to
calculate capital employed is FA+CA-CL.
Current Assets Turnover Ratio: It is also calculated in the
similar manner. It shows efficiency of current assets in
producing sales.
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Current assets turnover Ratio= Cost of goods sold or Sales


Current Assets
The current assets are those assets which can be converted in
liquidity within one year. The concept and items included in
current assets has already been discussed in earlier section of
this chapter.
Working Capital Turnover Ratio: An analyst may be
interested in knowing efficiency of net current assets or
working capital. The analyst may relate working capital with
cost of goods sold or sales.
Working Capital turnover Ratio= Cost of goods sold or Sales
Working Capital
Working capital is excess of current assets over current
liabilities. It is also known as net current assets.
Interpretation
Earlier, it has been discussed that assets turnover ratios
measures efficiency of firm in managing and utilizing
particular assets. A high turn over ratio is an indication of
optimum utilization and proper management of assets while a
low assets turnover indicates underutilization of assets.
Turnover ratios must be compared with past years ratio or
industry averages to judge efficiency of assets.
Activity 9.2
Do you know how quick assets are calculated? How these are
different from current assets.

Illustration

9.1

From the following financial statement extracted from annual report


of Alfa Limited, calculate some important ratios to examine liquidity
and activity position of the firm.
Income Statements for the year ending 31st March, XXXX
Particulars
Amount in
Rs.
Net Sales
1000000
Less : Cost of goods sold
Opening stock
144500
Purchases
638500
Freight &Carriage
14000
Less: Closing Stock

797000
-197000

600000

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Gross Profit
Less : Operating Expenses
Selling and Dist Expenses
Administration Expenses
Operating Profit
Add: Non operating Income
Interest on Bonds, Dividends etc
Less : Non operating expenses
Loss on sale of bonds
Net Profit

400000
38000
202000

240000
160000
12000
172000
-4000
168000

Balance Sheet as on 31st March, XXXX


Share Capital
5000 7% Pref. Share Capital of Rs. 20 each
100000
20000 Equity Shares of
Rs. 20 each Rs. 12.5 paid up
250000
Reserves and Surplus:
Capital Reserve
20000
General Reserve
104000
Reserve for Contingencies
50000
Profit and Loss
A/c
80000
Shareholders' Fund
Current Assets
Stock
197000
Receivables
221600
Payment in Advance
10000
Current Liabilities
Creditors
180000
Bills payables
20000
Accrued Charges
3100
Bank overdraft
40100
Working Capital CA-CL
Fixed Assets
Freehold Land and Building
406600
Less
Depreciation
38000
Plant and Machinery
90000
Less
Depreciation
40000
Total

350000

254000
604000

428600

243200
185400

368600

50000
604000

Solution
Liquidity Ratios:
Current Ratio =

Current Assets

428600

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Current Liabilities
1.8 : 1

243200

Stock, receivables and payment in advance are included in current


assets. Current liabilities are calculated by adding bills payables,
accrued charges, bank overdraft and creditors. The current ratio of
firm is near to the ideal ratio of 2:1 which is an indication of good
overall liquidity.
Quick Ratio

Quick Assets
221600
Current Liabilities
243200
=
.91 : 1
To calculate quick ratio, quick assets are to be calculated. Quick
assets are calculated by deducting stock and payments in advance
from the current assets. Only one item of current assets is left after
deducting these two items i.e. receivables. The quick ratio is also near
to ideal ratio thus this ratio also proves good liquidity and supports
the results of current ratio.
It is surprising to note that the firm does not have cash or cash
equivalent assets thus absolute liquidity ratio cannot be calculated.
This is an indication that despite above two favorable liquidity ratios,
the firms ability to meet immediate payments is not good. Thus
serious attention is needed to raise absolute liquidity. A little
deficiency in the both of these ratios may be caused by firms
inability to hold cash balances.
Activity Ratios:
Inventory Turnover Ratio:

Cost of Goods Sold


Average Stock
=
600000
170750
=
3.5 times
Average Stock
=
144500+197000
2
Inventory Conversion period= 12 months in a Year
Inventory Turnover ratio
= Aprox. 3 months
Debtors Turnover Ratio:

Collection period

Sales
Debtors
=
1000000
221600
=
4.5 times
=
12 months in a Year
Debtors Turnover ratio
= Aprox. 2.67 months

12
3.5

12
4.5

Both of these turnover ratios are towards higher range. In the absence
of ideal ratios the holding of inventories approximately for 3 to 4
months is not considered optimal. However it depends on the nature
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of industry too. Thus comparison of these ratios with industry ratio


would give true interpretations. Similarly credit of three months
seems to be more.
Creditors Turnover Ratio:

Creditors
=
200000
=
Payment period

Purchases
Creditors
=
638500
200000
=
3.19 times
Creditors +bills payables
180000+20000
=
12 months in a Year
Creditors Turnover ratio
= Aprrox 3.75 months

12
3.19

The firms CTR is high but high CTR is considered to be good as


firm gets credit for longer time. Similarly, other turnover ratios may
also be calculated.

9.6

SOLVENCY RATIOS:

Debenture holders, financial institutions provide long term funds to a


firm. While investing they look for firms financial strength. They
judge financial strength in terms of firms ability to pay the interest
regularly and repay principal installment at the time of maturity.
Solvency ratios are used to examine long term financial strength or
position of a business firm. These are also known as leverage ratios
or capital structure ratios. These ratios indicate mix of debt and
owners equity used for financing assets of a business. Equity is that
portion of total long term funds which is contributed by owners or
shareholders of a firm. Debt is also known as outsiders fund and is
invested by long term creditors like banks, financial institutions,
debenture holders etc. The mix of debt and equity must be designed
in such a way that it enables a firm to earn larger return by causing
minimum risk. Debt causes risk to a firm as it has legal obligation to
pay interest on debt whether firm has earned profits or incurred
losses. On the other hand its use is advantageous. If firms return on
capital employed is grater than the interest charges on borrowings,
the employment of debt magnifies the earnings available to owners of
the firm. Debt holders do not have right to interfere in important
affairs of business thereby the control of equity shareholders is also
not diluted by employing debts. Leverages or debt can also work in
reverse direction and pose threat of insolvency if firms return on
capital employed is less than interest charges. Moreover, a firm
having excessive debt will find difficulty in raising additional
finance. The debt fund providers consider equity as a margin of
safety. They will feel unsafe in a firm which is less supported by
equity financing. The leverage ratios show the proportion of debt
financing used for financing assets. Following leverage ratios can be
used to test solvency of the firm.
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i. Debt Equity Ratio:


This ratio shows relationship between loan funds and owners
contribution. It is also know as capital gearing ratio. A firm
having low debt to equity ratio is said to have low gearing and
vice versa. A firm having higher gearing, the returns to
shareholders will also be more volatile. Many variants of this
ratio exist.
Ratio based on total long term funds =
Debt
Total Long Term Funds
Debt includes long term outsiders fund on which firm has to
pay fixed interest. The items included in this are debentures,
long term loans from bank and financial institutions, public
deposits and other interest bearing loans. Total long term
funds are the sum of debt and equity. Equity is the owners
contribution and is also known as net worth. It is calculated
by adding paid up value of equity share capital, reserves and
surplus and subtracting accumulated losses or fictitious assets.
A debt equity ratio of 0.67 may be considered good as
financial institutions accept this level for financing projects.
Ratio based on Debt Equity =

Debt
Equity
It is a ratio between long term debt and net worth. A ratio of
2:1 is considered good as it is the norm accepted by financial
institutions.
Ratio based on External Equities =

External Equities
Internal Equities
This ratio is another variant of debt equity. It is a relationship
between total outsiders fund and insiders fund. Outsiders
fund or external equities include both short term and long
term debt i.e. debt plus current liabilities. A ratio of 1:1 may
be taken as good.
In calculating all the above ratios, confusions may arise for
inclusion of preference shares in equity or debt. In fact it
depends on the purpose for which this ratio is calculated. If it
is calculated for showing impact of debt on magnification of
equity share holders earnings, preference shares are included
in debt. While if it is calculated to show firms riskiness
(financial risk), it is included in equity. This diverse treatment
may pose problems for external analysts thus normally
preference shares are included in equity if it is issued for more
than 12 years periods other wise included in debt.
Interpretation:
The acceptable levels of ratios have already been discussed
along with variants of ratios. But these norms cannot be
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followed worldwide as acceptable size of this ratio varies


from country to country and industry to industry. Britain is
conservative in using debts; Japan is aggressive in the same.
In the similar manner nature of industry is a key factor for
degree of leverages. Firms having a stable income such as
Electricity Company or capital intensive industries like
cement, higher debt equity ratio may be accepted.
ii.

Proprietary Ratio:
This ratio is also known as net worth to total assets.
Proprietors fund is also known as owners equity or net worth.
It establishes relationship between net worth and total assets
and shows the proportion of total assets financed by owners
fund.
Proprietary Ratio=

Owners Equity
Total Tangible Assets

Interpretation:
This ratio indicates the strength of financial foundation of a
concern and used to study the capitalization of a business
concern. If this ratio is higher, the long term solvency of a
business concern is treated as good and it indicates that the
external fund providers have got enough support from
owners. If the ratio is low, the external fund providers may
not feel safe with regards to solvency.
iii. Fixed Assets to Long Term Funds Ratio:
This ratio is calculated to find the proportion of long term
funds used to finance the fixed assets. An organization may
finance its assets i.e. Fixed Assets and Current Assets either
by short term funds or long term funds popularly known as
current and non current liabilities. Normally it is said to be
risky if fixed assets are invested by using short term funds. As
short term funds or currents liabilities become due for
payment within an operating cycle. Their use for financing
fixed assets may result in default in payment of current
liabilities. Therefore this ratio is used to examine firms risk
caused by financing strategy. This ratio is calculated by
applying this formula:
FA to LF =
Fixed Assets
Long Term Funds
Interpretation:
If this ratio is greater than one, this means that firm is risky as
fixed assets are financed by short term funds and firm is
following aggressive financing policy. On the same time firm
is able to attain advantages of aggressive financing in the
form of increased returns. If the ratio is lower than one, it is
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an indicator of firms conservative policy. The firm has


excess long term funds which are used to finance even current
liabilities. Conservative financing no doubt have less risk of
default but it has comparatively less return magnification. In
case, if ratio is equals to one, the firm is financing using
matching approach. The life of assets is matched with the life
of source of financing in matching approach for financing
assets.
iv. Debt Service Coverage Ratio:
This ratios shows firms ability to meet obligations caused by
debt. Debt equity ratio discussed in previous section shows
debt solvency with reference to equity and it fails to measure
firms ability to meet annual obligations caused by these
debts. The annual obligations caused by these debts may be
interest payments or principle installments or even both. In
case if only interest payments are to be made annually on
debts, interest coverage ratio is calculated to test firms debtservicing capacity. It is calculated by following formula:
Interest Coverage: Earning Before Interest and Taxes (EBIT)
Annual Interest Charges
The interest coverage indicates the number of times the
interest charges are covered by funds available for payment of
interests. The taxes are charged after deducting interests thus
earning before interest and taxes is available for distribution
of interest charges. Depreciation and amortizations are also
funds which are charged from profits but remain in the
organization. Hence these are also known as non cash items.
The funds equivalent to depreciation charges and
amortizations are also available for payment of interests. Thus
instead of using EBIT, use of earning before interest, tax,
depreciation and amortizations (EBITDA) would be more
appropriate.
Interest Coverage:

EBITDA
Annual Interest Charges
If annual obligations caused by debt include interest and
principal installments, the fixed charge coverage ratio is
calculated by applying the following formula
Fixed charge coverage:

EBITDA
Interest+ Principal Repayment
1 - Tax Rate

Interpretation:
As discussed earlier that these ratios measures how many
times, fixed charges have been covered by earnings available
for their payment. A higher ratio is desirable and is an
indication of a good debt serving ability of the firm. But a
very high ratio may not be good as it may be due to
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conservative policy adopted by the firm in utilizing debt. The


firms utilizing low leverages or debts may not avail the
advantages of debts for magnification of earning for
shareholders. A lower ratio may be dangerous, as it is an
indication of excessive use of debt or even inefficient
operations. A ratio less than one for long period may lead to
bankruptcy of the firm.
Activity 9.3
From the illustration 9.1, calculate owners equity from financial
statements of Alfa Ltd.? Is owners equity and capital employed of
Alfa Ltd same. If yes why is it so?

Illustration 9.2
Following is the balance sheet of Delta company as on 31st
December,09
Figures in Lacs

Liabilities
Equity Share Capital @100 each
7% Pref. Sh. Capital @100 each
General Reserves
P&L A/c (Current Year)
6% Mortgage loan
Sundry Creditors

Rs.
10
2
2
2
8
2

Assets
Land &Building
Plant & Machinery
Furniture
Investments
Stock
Debtors
Bills receivable
Cash and Bank
Preliminary Expenses

26
Examine the firms long term solvency.
Solution:
Debt Equity Ratio:

Debt/Total Long term Funds


800000/2300000 =.348
Total Long Term Funds: 10+2+2+2+8-1 (Prel. Exp.)= 23
Leverage Ratio:
Debt +Pref. Sh. /Total Long term Funds
8+2/23 =.43
(Refer last paragraph of debt equity ratio)
Proprietary Ratio:

Prop. Fund/ Total Tangible Assets


1500000/2500000 =.60

Fixed Asset Ratio:

FA/Total Long term Funds


1800000/2200000 = .82

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Rs.
6
8
2
2
3
1
1
2
1
26

DSCR

EBIT*/Interest Charges
476000/48000 = 9.91 times
*See calculation done in illustration 9.4.
It can be seen from above ratios that firm has sound solvency position
and sufficient earnings to meet annual obligations of debt though
degree of leverages used by organization are too less. It is advised
that firm may plan to invest additional opportunities by employing
debt.

9.7

PROFITABILITY RATIOS:

Profit is a term which is used to test economic efficiency of a


business firm. It is the difference between revenues and expenses of a
particular financial period. To survive for long period, a firm is
required to earn profits. The growth of a firm also depends on firms
profitability. The profitability of a firm depends on quantum of sales,
nature of costs and proper use of financial resources. Profit in
absolute terms may not be sufficient to communicate firms growth
and survival strength, therefore, relative measure of earning capacity
need to be calculated to examine profitability of a firm. The
profitability ratios are not only calculated for measuring economic
efficiency of the firm but also communicated to different users like
management, creditors and owners. The creditors judge firms debt
servicing ability (interest and loan repayment) using these ratios.
Owners use it to decide to remain invested in the firm or disinvest. If
owners get expected rate of return they remain invested. The relative
measures of profitability are classified in two broad categories.
Profitability in relation to sales
Profitability in relation to investment
Concepts of Profit:
Profit is measured in various ways. Many terminologies are used to
define profit. A brief explanation of these terminologies is given here.
These terms will be used to measure relative profitability in
forthcoming discussion.
Gross Profit: The difference between sales and cost of goods sold
(COGS) is known as gross profit. The cost of goods sold is
manufacturing costs of goods that have been sold. It includes raw
material costs and direct expenses incurred to manufacture the
product. The unsold finished goods are excluded from the total CGS
as theses are assets of business.

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Profit before depreciation, interest and taxes (PBDIT): It is also


known as earnings before interest, taxes and depreciation and
amortizations (EBITDA). It is equal to revenues minus all operating
expenses excluding depreciation, interest and taxes.
Operating Profit: It is the difference between gross profit and
operating expenses. It may also be calculated by deducting cost of
goods sold and operating expenses from sales. The cost of goods sold
is calculated by adding all manufacturing expenses and deducting
closing stocks from it. The operating expenses consist of
administrative expenses, selling and distribution and depreciation. It
measures firms performance without considering the impact of
sources of financing (Debt or Equity). The interests on borrowed
funds are not subtracted while calculating operating profit. Thus it
may also be known as profit before interest and taxes (PBIT or
EBIT).
Profit before taxes (PBT): The interests are deducted from profit
before interest and taxes to obtain profit before taxes. Thus PBT is
the difference between PBIT and Interest charges (PBT= PBIT
INT). The profit before taxes may also be calculated by adding
operating profits and non operating profits (non operating incomes
non operating expenses) and subtracting interests.
Profits after taxes (PAT): The profit after taxes is calculated by
deducting taxes from profit before taxes (PBT).
Net operating profits after tax (NOPAT): It can be calculated by
adding after tax interest in operating profits after taxes. In other
words, it is PBIT minus tax on PBIT [PBIT *(1-tax rate)].
9.7.1

Profitability in relation to sales

It has already been discussed that profit is measured in various ways.


These concepts will be used to establish its relation with sales to find
relative profitability in terms of sales.
i. Gross Profit Ratio:
It expresses the relation between gross profit or gross margin
and net sales. Net sales are sales after sales return. The figure
of sales shown in profit and loss account is net of returns.
Gross profit ratio

Sales Cost of Goods Sold


Sales

Gross Profit
Sales

The gross profit is a profit after deduction of production costs


only. One minus gross profit ratio shows relation between
production costs and sales. The interpretation of this ratio is
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possible if this ratio is compared with the industry average or


the ratio of similar firms of the same industry. The higher
gross profit ratio indicates the higher efficiency in production
costs. Growing trend of gross profit ratio over the years
implies that the firm is attaining continuous reduction in
production cost. In case of inter-firm comparison or industry
averages, high gross profit ratio implies that firm is able to
produce at cheaper costs through cost control and cost
reduction techniques. A low ratio reflects higher cost of goods
sold or inefficiency in utilizing resources. The factors which
are mainly responsible for improving net profit margin are
sales volume, selling price, purchase and utilization of raw
materials, utilization of plant and machinery etc.
ii. Net Profit Ratio:
This ratio measures managements efficiency in
manufacturing, administering and selling the product. It is
also known as net profit to sales ratio. It is calculated by
dividing net profit after tax by net sales.
Net profit ratio

Net Profit after Tax


Sales

Net profit after tax can be calculated by deducting all


expenses from all incomes. The incomes of a firm may be
categorized in operating and non-operating. The income from
business operations (sale of goods) is known as operating and
incomes from non operating activities like dividend income,
interest income for a manufacturing firm are non-operating. In
the similar manners costs are also bifurcated in operating and
non operating categories.
The net profit after tax is determined by deducting operating
costs (cost of goods sold +administrative expenses + selling
and distribution expenses) and non-operating expenses from
total revenues of the firm. If non-operating income figure is
substantial, it may be excluded from profit to see profitability
arising from sales.
Interpretation:
A high net profit ratio is desirable as it indicates firms ability
to survive in adverse conditions. A high net profit ratio is also
liked by owners as it implies greater amount of earnings
available to the owners. A low net profit ratio may pose
challenges to the firm in the situation of falling selling prices,
rising costs of production and declining demand for the
product.
iii. Operating profit ratio:
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This ratio is a reflection of operations of company or


management. It establishes relationship between operating
profits and sales. This ratio is better measurement of operating
efficiency of a business firm. The net profit ratio discussed
earlier is calculated on the basis of net profits after taxes. It
excludes amount of interest which depends on firms
financing policy i.e. debt equity proportion. The comparison
of two firms having different debt equity proportion may be
misleading. Thus true comparison of operating performance
of two firms can be done by ignoring effect of leverages or
debt-equity.
Operating Profit Ratio=

Operating profits after taxes


Sales
OR
EBIT (1 Tax rate)
Sales

This ratio may also be calculated on before tax basis as one


may not know exactly marginal corporate tax rate while
analyzing published data. Thus before tax approach is
popularly used.

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Operating Profit Ratio=

Operating profits
Sales
OR
EBIT
Sales

Operating profits are calculated by deducting operating costs


from operating incomes. The operating costs and operating
incomes have already been discussed.
Interpretation:
High operating ratio implies that firms resources are utilized
efficiently and management is performing efficiently.
iv. Operating Ratio:
It establishes relationship between operating costs and sales.
An analysis of operating cost ratio indicates whether the cost
content is high or low as compared to sale figures.
Operating Ratio:

Operating Costs
Sales

Operating cost is calculated by adding cost of goods sold and


operating expenses (administrative expenses and selling and
distribution expenses). 1 Operating cost ratio is operating
profit ratio and vice versa.
Interpretation:
High operating ratio indicates that higher proportion of sales
is consumed by operating costs. Thus fewer amounts of sales
left to cover interest taxes and earnings to owners. A low
operating ratio indicates greater degree of operating
efficiency.
v. Expenses ratios:
The ratios for various components of operating cost may also
be calculated. The expenses ratio shows proportion of each
component of cost to sales figures. It is calculated by dividing
particular expense by sales. The operating costs components
include material, labour, factory overheads, administrative
and selling and distribution expenses.

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Material cost ratio:

Materials consumed * 100


Sales
Labour cost ratio:
Labour Cost *100
Sales
Factory Overhead Ratio:
Factory Expenses * 100
Sales
Administrative Expense Ratio: Administrative Expenses * 100
Sales
Selling and Distribution
Selling and Distribution
Expenses Ratio
:
Expenses
*100
Sales
Interpretation
To attain efficiency, each organization would prefer to
minimize the expenses ratios. Thus low expenses ratios are
considered to be good. Trend analysis of expenses ratios may
give a clue about requirement of cost cutting efforts.
Illustration 9.3
Examine the profitability position of Alfa Limited (Illustration 9.1).
Gross Profit Ratio

=
GP/Sales *100
=
400000/1000000*100 =40%
Net Profit Ratio
=
NP/Sales *100
=
168000/1000000*100=16.8%
Operating Profit Ratio =
Operating Profit/Sales *100
=
160000/1000000*100=16%
Operating Cost Ratio =
OC/Sales *100
=
840000/1000000*100=84%
Operating Cost= Cost of Goods sold+ Selling& Dist.+
Administration
840000
=600000+38000+202000
Expenses Ratios:
Cost of Goods Sold =600000/1000000*100
Selling and Dist. Exp. =38000/1000000*100
Administrative Exp. =202000/1000000*100

=60%
=3.8%
=20.2%

These profitability ratios must be compared either by other


companies engaged in the same industry or with companys past
period relevant ratios to derive relevant interpretations. Profits are
always welcome thus increasing trend in profit is given higher and
good valuation by investors.
9.7.2 Profitability in relation to investment: Return
Measurement
The term investment is related to firms total assets. Assets are
financed by long term and short term liabilities. The portion of total
assets which is financed by long term liabilities (Capital Employed)
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is known as net assets. The long term liabilities include long term
debts and net worth. The net worth is also known as shareholders
fund or equity. The funds of long term debt providers and share
holders are their investments in firm. A relationship between profit
figures available for distribution to them and their investment is
established in profitability ratios related to investment.
i. Return on Investment (ROI):
This ratio measures profits earned on each rupee of
investment. Traditionally, this ratio was calculated by
dividing net profits after tax by total assets. For inter firm
comparison use of net profits after tax may give misleading
results as it is affected by capital structure. Two firms with
equal earnings before interests and taxes (EBIT) but having
different debt equity proportion (capital structure) may
possibly have different profit after taxes. It will be possible
as interests are deducted before charging taxes on income.
Thus firm gets advantage of tax shield. The difference in
amount of interest of two firms results in difference in tax
shield which ultimately creates difference in profit after tax
(PAT). Therefore use of PAT for inter firm comparison is
not advisable. The following example will make it more
clear.
Firm A
Firm B
Capital Structure (total 10 lacs)
All Equity
3:7
EBIT
100000
100000
Less Interest
No Interest
30000
(Debt is available on 10% interest)
Taxable income
100000
70000
Less Tax 50%
50000
35000
Profit after tax (PAT)
50000
35000
In this example firm A and B both are having equal earnings
but capital structure of both the firm is different. Firm A is
all equity firm and has no debt capital. While firm B has Rs.
300000 debt raised at 10% rate of interest and remaining Rs.
700000 through equity. The PAT of both the firms is
different. If this PAT is used as numerator and investment
of 10 lacs as denominator to calculate ROI, it will
conceptually be unsound. On the one hand numerator of
firm Bs ROI does not takes into account tax saving of Rs.
15000 (Tax A-B Firm) on the other it includes debt
investment amount of rupees 3 lacs in denominator, the
required return (interest) which has already being paid and
deducted. Moreover the capital structure decision depends
on acumen of financial manager of the firm. It has nothing
to do with the firms operating efficiency. Similarly taxes
are non controllable and firms opportunities for availing tax
incentives differ. Thus use of EBIT for calculating ROI
would be more prudence.
ROI =
EBIT
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Total Assets*
*Total assets include total tangible assets but if something
has been paid to acquire intangible assets then those may
also be included.
ii. Return on Net Capital Employed:
It is also known as return on net assets. It is calculated by
dividing EBIT by net capital employed. It is calculated to
see return available on long term capital (equity and debt).
ROCE=
EBIT
Net Capital Employed*
*Net Capital employed is sum of long term debts and net
worth. Alternatively, it can be calculated as fixed assets plus
current assets minus current liabilities.
iii. Return on Equity:
It is also known as return on net worth. It measures
profitability of owners investment. The profit available to
equity share holders will be after payment to debt,
preference share and taxes are earnings of. An organization
not having preference share capital, the profit after taxes
will be available as earnings to equity share holders.
ROE = Profit after Interest Tax and Pref. Share Dividend
Equity Shareholders Fund
The equity shareholders fund is also known as net worth or
proprietors fund. It includes paid up value of equity share
capital, share premium and reserves and surplus less
accumulated losses.
Interpretation
The above three ratios shows how efficiently the internal as
well as external resources of internal as well as external
fund providers have been utilized. It is desired that firm
should attain satisfactory return on all kinds of investments.
The ROE represents the extent to which earnings
expectations of shareholders have been met. The dividends
to be distributed to the equity shareholders are not fixed; but
earnings of the firm after distribution to all outside parties
are considered to be earnings of equity shareholders it may
fully or partially be distributed or retained. Each firm has
main objective to maximize the return of equity
shareholders.

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Illustration 9.4
Using the data of Delta company find the Profitability ratios related
to Investment.
Solution
The data set of Delta Company gives only information about profits
transferred to balance sheet in the current year i.e. Rs. 200000.
The EBIT may be derived by taking certain assumptions.
Like firms corporate tax rate is say 50% and the net profits shown in
balance sheet are after preference share dividends.
The EBIT figure may be calculated
Balance sheet figure of profit (current year)
200000
Dividends distributed on Pref. Shares
14000
Net profit after tax before Pref. Div. 214000
Adjusting tax effect of 50%
+214000
Profits before taxes
428000
Add Interest Charges 6% of 8 Lacks
48000
EBIT
476000
Return on Investments:
EBIT/Total Tangible Assets
476000/2500000=.19
Return on Net Capital Employed:

EBIT/ Net Capital Employed


476000/2300000=.2069

Return on Equity:

Net profit after tax and pref


dividend/Equity Shareholders fund
200000/1300000
Equity Shareholders fund
= Eq. Sh. Capital+ Gen. Res. + P& L
Fictitious Assets.
13=10+2+2-1(in lacs)
9.7.3 Profitability in relation to Investment: Stock Market
Ratios
The profitability in relation to investment can also be measured in
many other ways. Some such measures will be discussed in the
forthcoming discussion. These ratios are prominently used by
shareholders for their decision to invest or divest in a firm. Similarly
these ratios are frequently used by market analysts for forwarding
their opinion to their clients.
i. Earnings Per Share (EPS):
This ratio is a reflection of firms earning power on per share
basis. This is calculated by dividing the profits after tax,
interest and preference share dividends by number of
outstanding ordinary shares outstanding.
EPS =
Earnings available to equity shareholders*
No. of outstanding Equity shares
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*The earnings available to equity shareholders is the profit


after taxes and preference share dividend, to elaborate more
it is the profits after interest, tax and preference shares
dividends.
Interpretation:
The profitability of shareholders investment is measured by
EPS. The maximization of EPS results in grater satisfaction
amongst the shareholders. A trend analysis of EPS figures
(EPS figures over the years) indicates pattern of changes in
earnings per share. The EPS figures must be compared with
industry averages or EPS of other competitors/ firms of
similar nature.
ii. Dividends per Share (DPS):
As discussed earlier that the net profits after interests, tax
and preference dividend belongs to equity share holders. A
firm distributes dividend to equity shareholders out of the
earnings available to equity share holders. Distribution or
retention of earnings available to equity share holders
depends on firms dividend policy. The earning not
distributed as dividend amongst the share holders is known
as retained earnings. DPS ratio measures dividends
distributed on a share. It is calculated by dividing dividends
distributed by no. of outstanding equity shares.
DPS=
Dividends distributed to share holders
Number of outstanding equity shares
iii. Dividend pay out ratio:
It shows the percentage or proportion of dividends
distributed out of earnings. It can be calculated by dividing
DPS by EPS.
Dividends pay out: DPS
EPS
Interpretation
Both of these ratios are related with earnings distribution to
shareholders. From shareholders point of view if a firm does
not have enough profitable opportunities to plug back these
earnings, a higher distribution ratio is desired. Even it is
said that if firms earnings expectations are less to satisfy
the expectations of shareholders, the firm should distribute
its earnings to the maximum extent. 1- Dividend payout
ratio is known as retention ratio. For a firm having lot of
growth opportunities, the retention ratio must be higher to
enable firm in enhancing its earning ability. So the firm will
be in position to distribute greater amount of dividends after
its expansion.
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iv. Dividends and earnings yield:


This ratios shows return on market value of share holders
investment. The practical difficulty with this ratio is that the
market value of shares is not disclosed by a firm in its
audited financial results and it continues to vary according
to the demand and supply of firms share in the market.
Therefore the values of yields may change accordingly.
These can be calculated by applying the following formula:
Earnings yield:
Earnings per Share
Market Value per Share
Dividend yield:

Dividend per Share


Market Value per Share

v. Price Earning Ratio:


This ratio indicates the judgment of investors about firms
performance. Therefore it is widely used by security
analysts to value firms performance. This ratio is reciprocal
of the earnings yield. It is calculated by applying the
following formula:
Price earnings ratio=
Market price per share
Earnings per share
vi. Market value to book value (MV/BV) ratio:
This ratio is calculated to see the appreciation in the wealth
of equity shareholders based on market value. It can be
calculated by dividing market value of shares by book value
of shares. The net worth of the firm is taken as book value
of shares and market value is calculated by multiplying
number of equity shares outstanding by market price of the
share. Alternatively, it may also be calculated by dividing
market value per share by book value per share. Where
market value per share may be taken from stock market and
book value per share may be calculated by dividing net
worth by number of shares outstanding.
MV/BV
=
Market value of Shares
Book value of shares (net worth)
OR
MV/BV
=
Market value per share
Book value per share

Activity 9.4
Identify the current assets and current liabilities of Delta Ltd. Also
calculate liquidity ratios of Delta Ltd.
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9.8

FIRMS EARNING POWER


EVALUATION: THE DUPONT
ANALYSIS

DuPont Company of America has designed a chart to evaluate its


earning power. This chart is mainly based on two aspects profit and
investments. The DuPont model is concerned with finding return on
investment (net assets) as it is taken as measure of efficiency.
According to this model, return on assets is product of net profit
margin and assets turnover (investments or net assets). Net profit
margin is difference of sales and operating costs. The operating cost
consists of cost of goods sold, office and administrative expenses and
selling and distribution expenses. The investments or net assets are
the aggregate of fixed assets and net working capital. The net
working capital equal to current assets minus current liabilities.
Figure 9.1

DuPont Chart

Due to the shift of business firms objectives from maximizing ROA


to maximizing ROE, Thomas J Liesz suggested Modified DuPont
Analysis. The model states that the Return on Equity (ROE) is the
product of operating profit margin, capital turnover, financial cost
ratio, financial structure ratio and tax effect ratio.
ROE= (EBIT/Sales)*(Sales/Net Assets)*(EBT/EBIT)*(Net Assets/
Equity or Net worth)* (EAT/EBT)
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OR

eliminating Sales and EBT (as common in numerator and


denominator)
ROE= (EBIT/Net Assets)* (EAT/EBIT)* (Net Assets/Equity or NW)
In the similar manner if we eliminate all common items in numerator
and denominator, only two items are left i.e. EAT and Equity or net
worth which is already in use for calculating ROE. But this
relationship explained in DuPont explains how ROE is affected by
five components. Thus these can be used to maximize the ROE.
Activity 9.5
The current ratio of a firm is 2.5 and its working capital is Rs. 60,000.
Calculate the amount of current assets and current liability.

Illustration 9.5
You have been asked by the management of the Y. M Ltd. To project
a trading and profit and loss account and the Balance Sheet on the
basis of the following estimated figures and ratios for the next
financial year ending on March 31, 1995.
Ratio of Gross Profit
20%
Stock Turnover Ratio
5 times
Average Debt Collection Period
3 months
Creditors velocity
3 months
Current Ratio
2
Proprietary Ratio(FA to Capital Employed)
75%
Capital Gearing Ratio
30%
(Pref. Shares &Debentures to CE)
Net profit to Issued Capital (Equity)
10%
General Reserve and P&L to issued capital (equity) 25%
Preference share capital to Debentures
2
Cost of goods sold consists of 50% for materials
Gross Profit Rs. 6,25,000.
Show working notes clearly and also comment on financial
position of Y. M. Ltd.
Solution
Sales : Gross Profit ratio
=
`
20% =
20 Sales=
Sales =
Sales =
Cost of goods sold
=
=
=
Materials
=
=
Direct Expenses
=

(GP/Sales) *100
(625000/Sales) *100
625000
625000/20
3125000
Sales Gross Profit
3125000-625000
2500000
50% of 2500000
1250000
Cost of Goods Sold Materials

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=
Current Assets
Stock
Stock Turnover ratio
5
Stock
Stock
Debtors
Debtors collection
3
Debtors
Current Assets

2500000-1250000 = 1250000

=
=
=
=

Cost of Goods sold/stock


2500000/stock
2500000/5
500000

=
=
=
=
=

(Debtors/sales) *12 (months)


(Debtors/3125000)*12
781250
Stock +Debtors
500000+781250 =1281250

Current Liabilities
Current Ratio =
2
=
Current Liab. =
=
Creditors
Creditors velocity
=
3
=
Creditors
=
Bank overdraft
=
=
=
Fixed Assets FA to LF
As long term fund employed
FA/LF= 75/100
=
Working Capital
=
640625
=
Fixed Assets =
Capital Employed (LF)=
=
=
Capital gearing 30% =
30% =
Pref. Sh Cap. +Debenture
Equity Shareholder Fund

CA/CL
1281250/CL
1281250/2
640625
(Creditors/Credit purchases)*12
(creditors/1250000 (material)*12
312500
Current Liabilities-Creditors
640625-312500
328125
=
75%
=
FA+WC (Working Capital)
WC/LF=25/100
CA-CL
1281250-640625
(640625/25)*100
FA+CA-CL
1921875+1281250-640625
2562500
Pref. Sh. Cap. +Debenture/ CE
Pref. Sh. Cap. +Deb./ 2562500
=
30%*2562500
=
768750
=CE-(Pref. Sh . Cap. + Debenture)
=
2562500-768750
=
1793750
=
768750 *2/3 = 512500
=
768750 *1/3 = 256250

Preference Share Capital


Debentures
General Reserve and P&L
25% of Equity Share Capital =
25/125*1793750=358750
Equity Share Capital
=Equity Sh. Fund Reserves &P&L
=
1793750-358750 =1435000
Profit 10% of Equity Sh. Cap.=
10% of 1435000 =143500
General Reserve
=
Res. & Profit Profit
=
358750 -143500 =215250
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Income statement of Y. M . Ltd for the year ending 31st March,


1995
Sales
3125000
Less Cost of Goods Sold
Materials
1250000
Direct Expenses
1250000
2500000
625000
Gross Profits
Indirect Expenses (Balancing Fig.)
481500
Net Profits
143500
Balance Sheet of Y. M. Ltd. As on 31st March, 1995
Liabilities
Equity Share Capital
1435000
General Reserves
215250
Profit and loss A/c
143500
Shareholders Fund
1793750
Preference Share Capital
512500
Debentures
256250
Total
2562500
Assets
Fixed Assets
1921875
Current Assets
Stock
500000
Debtors
781750
Total Current Assets
1281250
Current Liabilities
Creditors
312500
Bank overdraft
328125
Total Current Liabilities
640625
640625
Net Current Assets (CA-CL)
Total
2562500

9.9

SUMMARY

This unit has explained the analysis of financial statement for the
purpose of drawing significant conclusions by establishing
relationship between various data given in financial reports i.e.
balance sheet and the profit and loss account. Financial analysis is
used to identify the financial strengths and weaknesses of the firm.
There are various techniques which can be used for the purpose of
financial analysis. The ratio analysis is one of the most widely used
techniques of financial analysis. This technique is used to examine an
organization from the angle of liquidity, solvency, activity and
profitability. Liquidity and solvency position of business exhibits
firms ability to meet its short term and long term obligations. While
the activity and profitability ratio exhibits firms efficiency in
operations. The firms earning power can also be examined by using
DuPont chart.

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9.11 KEY WORDS


Accounting ratio is a relationship between two or more data
obtained from financial statements.
Liquidity measures the firms ability to meet its short term
obligations as and when they become due. It is referred to ease with
which a firm can spare cash to pay its bills and dues of short time.
Activity is the velocity or speed by which assets are converted into
sales. Activity ratios measure the efficiency in utilizing firms assets.
Solvency measures firms ability to pay interest regularly and repay
principal installment at the time of maturity. Solvency ratios are used
to examine long term financial strength or position of a business firm.
Owners Equity is the owners claim against the assets of a business
firm. It includes paid up value of equity capital and reserves and
surplus or retained earnings accumulated losses. It is also known as
net worth.
Debt includes long term outsiders fund on which firm has to pay
fixed interest. The items included in this are debentures, long term
loans from bank and financial institutions, public deposits and other
interest bearing loans.
Profitability is a relative measure of earning capacity of a firm. The
profitability ratios are calculated for measuring economic efficiency
of the firm and are communicated to different users.

9.12

SELF ASSESSMENT QUESTIONS

Objective Type Questions:


1. Which of the following actions can a firm take to increase its
current ratio?
a. Issue short-term debt and use the proceeds to buy back
long-term debt with a maturity of more than one year.
b. Reduce the companys days sales outstanding to the
industry average and use the resulting cash savings to
purchase plant and equipment.
c. Use cash to purchase additional inventory.
d. None of the above statements are correct.
2. Company J and Company K each of them recently reported the
same earnings per share (EPS). Company Js stock, however,
traded at a higher price. Which of the following statements is the
most correct?
a. Company J must have a higher P/E ratio.
b. Company J must have a higher market value to book value
ratio.
c. Company J must be riskier.
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d. All of the statements above are correct.


3. Other things held constant, which of the following will not affect
the quick ratio? (Assume that current assets equal current
liabilities.)
a. Fixed assets are sold for cash.
b. Cash is used to purchase inventories.
c. Cash is used to pay off accounts payable.
d. Accounts receivable are collected.
4. Other things held constant, which of the following will not affect
the current ratio, assuming an initial current ratio greater than
1.0?
a. Fixed assets are sold for cash.
b. Long-term debt is issued to pay off current liabilities.
c. Accounts receivable are collected.
d. Cash is used to pay off accounts payable.
5. Which of the following statements is the most correct?
a. An increase in a firm's debt ratio, with no changes in its sales
and operating costs, could be expected to lower its profit
margin on sales.
b. An increase in the DSO, other things held constant, would
generally lead to an increase in the total asset turnover ratio.
c. An increase in the DSO, other things held constant, would
generally lead to an increase in the ROE.
d. In a competitive economy, where all firms earn similar returns
on equity, one would expect to find lower profit margins for
airlines, which require a lot of fixed assets relative to sales,
than for fresh fish markets.
Ans: 1. (d), 2. (d), 3. (a), 4. (d), 5. (a)
Short Answer Type Questions:
1. What do you mean by accounting ratios? Enumerate various
types of ratios
2. What does a liquidity ratio show? Enumerate liquidity ratios.
3. Current liabilities of a company are Rs. 300000. Its current
ratio is 3:1 and quick ratio is 1:1. Calculate value of stock.
4. Current ratio of a firm is 2.5, acid test ratio 1.75 and stock Rs.
1,50,000. Calculate net working capital.
5. Gross profit of a firm is 20% of sales. Cost of goods sold is
Rs. 1,60,000. Find out the sales.
Answers - (3. Stock-6,00,000, 4. NWC-3,00,00 5. Sales2,00,000.)
Long Answer Type Questions:
1. What is DuPont model for calculating ROI? How Liesz model
is superior to it.
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2. What is accounting ratios? Discuss in detail various types of


ratios.
3. Accounting ratios are mere guide; complete reliance on it may
be suicidal. Elucidate
4. What do you mean by financial analysis? Discuss objectives
and techniques of financial analysis.
5. Comment on financial position of the company on the basis of
following reports.
Balance Sheet
Liabilities
Equity Share Capital @10 each
General Reserves
Secured loans
Total Long term Liabilities
Assets
Fixed Assets
Current Assets
Stock
Cash Balance
Total Current Assets
Current Liabilities
Creditors
Bank overdraft
Total Current Liabilities
Net Current Assets (CA-CL)
Total Assets

2007
700000
800000
220000
1720000

2008
700000
680000
240000
1620000

900000

920000

1100000
520000
1620000

1120000
400000
1520000

260000
540000
800000
820000
1720000

300000
520000
820000
700000
1620000

Earnings related details:


Sales
2500000
Gross Profit
880000
EBIT
420000
Interest 10%
22000
Tax bracket 30%
Dividend Payout 50%
Market price of the share is Rs. 25 per share.

2400000
960000
500000
24000

Hint: CR: 2.02 and 1.85, QR: .65 and.49 , Debt Equity=D/E .14 and
.17, EAT=EBIT-Int*(1-Tax Rate) =208900 and 248800, EPS= 2.98
and 3.55
Answers of activities:
(9.3)

(9.4)

The owners equity = paid up value of equity + reserves and


surplus (Excluding preference share holders) if issued for less
than 12years maturity.
605000-100000
=505000
CA
= Stock +Debtors+ BR+Cash and Bank
=3+1+1+2
=7

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CL
= S. Creditors = 2
CR
=CA/CL =7/2 =3.5
QR
=QA/CL 4/2 =2
ALR =Cash/CL 1/2 =.5
(9.5) CA-100000, CL-40000

9.13 FURTHER READINGS


Pandey I. M . 2005, Financial Management, Vikas Publishing House:
New Delhi.
Khan M.Y. and Jain P. K. Theory and Problems in Financial
Management, Tata McGraw Hills Publishing Company Ltd., Delhi.
Rao N.S., Dulawat M. S. and Sharma M. L. 2007, Pharmaceutical
Business Mathematics (including budgeting, costin, accounting and
auditing), Apex Publishing House, Udaipur.
Gitman L. J., 2005, Principles of Managerial Finance, Indian branch
of Pearson Education, Delhi.
Bhatt S. 2009, Management Accounting,
Rao M. E. T. 2004, Cost and Management Accounting, New Age
International (P) Limited, Delhi.

UNIT 10 BREAK EVEN ANALYSIS


Objectives
This unit is designed to:
Explain concepts of marginal costing.
Inculcate skills of examining cost volume profit analysis.
Develop understanding of behavior of costs related to
marginal costing.
Introduce the concept of break even analysis and its uses
Structure
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10.1
10.2
10.3
10.4
10.5
10.6
10.7
10.8
10.9
10.10

Introduction
Marginal Costing
Behavior of Costs
Cost Volume Profit Analysis
Break Even Analysis
Break Even Chart
Summary
Key Words
Self Assessment Questions
Suggested Readings

10.1 INTRODUCTION
As we know that profit is one of the most important factors to
measure performance of a business firm. Thus the profit planning is a
fundamental part of management function. This will be possible
when information about cost i.e. fixed and variable both and selling
prices are available in the hands of management. The profit planning
is possible by establishing relationship between cost, volume and
profit (CVP) in break even analysis through marginal costing
concepts. The CVP relationship studies impact of change in volume
and cost based on behavior of cost on profit. The marginal costing is
a technique of costing which classifies costs according to their
behavior and enables establishing CVP relationships. Therefore it is
essential to understand the concept of marginal costing and the
behavior of various types of costs used therein.

10.2 MARGINAL COSTING


It is one of the most useful techniques available to management for
determining price of the product, decision making and assessing
profitability of the organization. Marginal costing puts attention to
variable costs therefore it is also known as variable costing or direct
costing. We must first understand the concept of marginal costs.

Marginal Cost
Economists define marginal cost as costs incurred to produce an
additional unit of a product. But from cost accountants point of view
total costs obtained by adding prime cost and variable costs is
marginal cost. Since costs can be divided into fixed costs and variable
costs and fixed costs remain the same, hence, marginal cost tends to
be equal to total variable expenses and sometimes marginal cost is
described as variable cost.
Total cost = variable cost per unit quantity + fixed cost.
According to ICMA (London), Marginal cost is the amount, at any
given volume of output by which aggregate costs are changed, if the
volume output is increased or decreased by one unit. In simple
words, addition or changes in the total cost due to change in output
by one unit is known as marginal cost. For example, for producing
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400 units the total cost is Rs. 4000. If production is increased to 401
units, total cost is Rs. 4009. Thus, marginal cost = Rs. 4009 4000 =
Rs. 9
Marginal Costing
As it has been defined that marginal costing provides sound basis of
profit planning and decision making. The marginal costing
framework is based on cost behavior of various elements of cost. It
classifies total costs of production into two broad categories i.e. fixed
cost and variable cost on the basis of their variability. It may be
defined as ascertainment of marginal cost and of the effect on profit
of changes in volume or type or output by differentiating between
fixed and variable costs. In other words, it is a technique of
differentiating between variable and fixed costs primarily concerns
with (i) ascertainment of marginal costs; and (ii) determination of
cost volume profit relationships.
Features of Marginal Costing

Marginal costing categorizes total costs into fixed cost and


variable cost. If there is any other cost like semi variable cost
then its variable portion will be added to variable and fixed
portion to fixed cost.
Variable costs are considered as product costs and fixed costs
as period costs
Work in progress and finished goods are valued at marginal
costs.
Prices are determined on the basis of marginal costs and
desired contribution
Profitability is determined on the basis of the basic marginal
costing equation.
Sales Variable Cost = Fixed Cost +Profit=Contribution
Profit = Contribution Fixed cost
Break even analysis is prime component of this technique.

10.3 COST BEHAVIOR AND ITS IMPACT ON


MARGINAL COSTING
The marginal costing is based on behavior of costs. It classifies costs
on the basis of behavior to ascertain marginal costs and establish
CVP relationships. The costs can be classified in to three categories
on the basis of its behavior.
Fixed Cost
Fixed costs are those costs which remain constant irrespective of the
quantum of production within and up to the certain capacity that has
been built up. It is defined as a cost which accrues in relation to the
passage of time and which within certain output or turnover limits
tend to be unaffected by fluctuations in the level of activity. In other
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words, there are certain costs which tend to be unaffected in total by


the variations in the volume of activity within a specified capacity are
called as fixed costs. The examples include factory rent, depreciation,
insurance, salaries, maintenance etc. However it must be noticed that
total fixed costs remains constant whereas per unit fixed costs varies
inversely with the changes in volume of activity.
C
o
s
t
s

Total Fixed Costs

Level of output

Figure 10.1 Fixed Cost


Step Fixed Cost: Fixed costs remains same up to a capacity and if the
capacity is increased or if the production is increased beyond that
capacity then level of fixed costs may also increase. This is also
known as semi fixed cost or semi variable cost.
C
o
s
t
s

Step Fixed Costs

Level of output

Figure 10.2 Step Fixed Cost


The features of fixed costs are
i.
Total fixed costs are unaffected by the change in volume of
activity in total rupee amount.
ii.
Fixed costs are not directly assigned to a particular
departmental head and hence their control does not rest with
departmental heads.
iii. Per unit fixed cost changes inversely with the changes in the
volume of activity.
Variable Cost
Variable costs are those costs which vary in direct proportion to
output. They increase or decrease in the same proportion in which
output increases or decreases. Examples of variable costs include
direct material, direct labour and other direct expenses. Here it is
essential to clarify that variable costs per unit are assumed to be
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constant and variable costs that vary in direct proportion are total
variable costs.

C
o
s
t
s

Output

Figure 10.3 Total Variable Cost


Step Variable Cost: Some variable costs may also not vary strictly in
a linear fashion and may adopt a stepwise fashion. It may also adopt
convex or concave patterns. In convex linear variable cost each extra
unit of output causes a less than proportionate increase in cost. While
in concave pattern each extra unit of output causes a more than
proportionate increase in cost.
C
o
s
t
s

Concave

Convex

Level of output

Figure 10.4 Non-Linear Variable Cost


Features of variable costs
i. Variable costs change proportionately with the changes in the
volume of output.
ii. Variable costs are always traceable for a department and
hence are controlled by departmental heads. These costs are
also referred to as product cost, marginal cost or direct costs.
iii. Variable cost per unit remains constant.
Activity 10.1
Give at least four examples each of variable costs and fixed costs (at
least four each).

Semi Variable Cost

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Semi variable cost contains feature of fixed and variable cost. This
cost is a combination of fixed and variable costs. It remains fixed up
to a particular point and then changes with the change in production
or consumption. It changes with the change in the volume of
production or sales but may not be in direct proportion to the change
in output. The examples of semi variable cost include light,
telephone, maintenance etc.
C
o
s
t
s

Variable portion
Fixed portion

Level of output

Figure 10.5 Semi variable (mixed) costs

10.4 COST VOLUME PROFIT ANALYSIS


Cost-volume-profit (CVP) analysis is a technique that examines
changes in profits in response to changes in sales volumes, costs, and
prices. Accountants often perform CVP analysis to plan future levels
of operating activity and provide information about:
Which products or services to emphasize
the volume of sales needed to achieve a targeted level of
profit
the amount of revenue required to avoid losses
Whether to increase fixed costs or not
How much to budget for discretionary expenditures
Whether fixed costs expose the organization to an
unacceptable level of risk
Objectives of Cost-Volume-Profit Analysis

In order to forecast profits accurately, it is essential to


ascertain the relationship between cost and profit on one hand
and volume on the other.
Cost-volume-profit analysis is helpful in setting up flexible
budget which indicates cost at various levels of activities.
Cost-volume-profit analysis assists in evaluating performance
for the purpose of control.
Such analysis may assist management in formulating pricing
policies by projecting the effect of different price structures
on cost and profit.

Limitations of Cost-Volume Profit Analysis


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The CVP analysis is generally made under certain limitations and


with certain assumed conditions, some of which may not occur in
practice. Following are the main limitations and assumptions in the
cost-volume-profit analysis:
It is assumed that the production facilities anticipated for the
purpose of cost-volume-profit analysis do not undergo any
change. Such analysis gives misleading results if expansion or
reduction of capacity takes place.
In case where a variety of products with varying margins of
profit are manufactured, it is difficult to accurately forecast
the volume of sales mix which would optimize the profit.
The analysis will be correct only if input price and selling
price remain fairly constant which is difficult to find in
reality. Thus, if a cost reduction program is undertaken or
selling price is changed, the relationship between cost and
profit will not accurately be depicted.
In cost-volume-profit analysis, it is assumed that variable
costs are perfectly and completely variable at all levels of
activity and fixed cost remains constant throughout the range
of volume being considered. However, such situations may
not arise in practical situations.
It is assumed that the changes in opening and closing
inventories are not significant, though sometimes they may be
significant.
Inventories are valued at variable cost and fixed cost is treated
as period cost. Therefore, closing stock carried over to the
next financial year does not contain any component of fixed
cost. In reality, the inventory should be valued at full cost in
reality.

10.5 Break Even Analysis


One of the methods of presenting cost volume profit analysis is the
method of break even point. Rather it is a most popularly known
version of CVP analysis. Break even is that volume of sales at which
no profit or no loss is made. That is why it is also called as no profit
no loss point. It studies the relationship between revenues and costs
in relation to sales volume and determines the point where sales
revenues are just equal to total costs. In other words it is that level of
output at which total costs are equivalent to total revenues. According
to Charles T Horngreen, break even point is that point of activity
(sales volume) where total revenues and total costs are equal. If firm
produces beyond this level, it earns profit and loss are incurred if it
produces below this level.
Break even point as term is used to denote the intersection point of
total revenue and total cost line in break even chart.It can also be said
that at this point contributions are equivalent to fixed costs.

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Now, breakeven point can be easily calculated with the help of


fundamental marginal cost equation, P/V ratio or contribution per
unit.
Marginal Cost Equations and Breakeven Analysis
The basic marginal cost equation is
Sales Marginal cost (VC) = Contribution ......(1)
Fixed cost + Profit = Contribution ......(2)
By combining these two equations, we get the fundamental marginal
cost equation as follows:
Sales Marginal cost = Fixed cost + Profit ......(3)
The Break Even will be
S (sales) V (variable cost) = F (fixed cost) + P (profit)
At BEP P = 0, BEP = S V = F
Breakeven point in volume and rupees may also be calculated using
contribution and P/V ratio.
Contribution
Contribution is the difference between sales and marginal or variable
costs. It contributes toward fixed cost and profit. The concept of
contribution helps in deciding breakeven point, profitability of
products, departments etc. to perform the following activities:
Selecting product mix or sales mix for profit maximization
Fixing selling prices under different circumstances such as trade
depression, export sales, price discrimination etc.
Contribution can be calculated by fundamental marginal cost
equation.
Contribution = sales variable cost = fixed cost + profit
Contribution per unit = SP-VC per unit
i.e. C = S (F + P)
If C = 0, there is a loss of fixed costs.
If C is negative, loss is more than fixed costs.
If C is positive and more than fixed cost, there is profit.
If C = F, there is no profit and no loss.
Profit Volume Ratio (P/V Ratio)
The ratio of contribution to sales is P/V ratio or C/S ratio. It is the
contribution per rupee of sales and since the fixed cost remains
constant in short term period, P/V ratio will also measure the rate of
change of profit due to change in volume of sales. The P/V ratio may
be expressed as follows:
P/V Ratio
=
(Sales Variable Costs)/Sales
P/V Ratio
=
Contribution/Sales
P/V Ratio
=
Changes in Contribution /Changes in Sales
P/V Ratio
=
Changes in Profit/Changes in Sales
The concept of P/V ratio helps in determining the following:
Breakeven point
Profit at any given volume of sales
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Sales volume required to earn a desired quantum of profit


Profitability of products or Processes or departments
The contribution can be increased by increasing the sales price or by
reducing variable costs per unit. A fundamental property of marginal
costing system is that P/V ratio remains constant at different levels of
activity. A change in fixed cost does not affect P/V ratio. Thus, P/V
ratio can be improved by the following:
Increasing selling price per unit
Reducing marginal costs per unit by effectively utilizing men,
machines, materials and other services
Selling more profitable products, thereby increasing the
overall P/V ratio
Calculation of Break Even Point:
The break even point may be calculated by using the following
formulas.
Breakeven in Units
Fixed cost
Breakeven in units =
Contribution per unit
Break Even In Rupees
Contribution at BEP Fixed cost
Break even sales in rupees =
=
P/ V ratio
P/ V ratio
Margin of Safety (MOS)
Each enterprise tries to know how much they are above from the
breakeven point. This is technically called margin of safety. The
margin of safety is the difference between the total sales (actual or
projected) and the breakeven sales. It may be expressed in monetary
terms (value) or as a number of units (volume). A higher/larger
margin of safety indicates the soundness and financial strength of
business. Margin of safety can be improved by lowering fixed and
variable costs, increasing volume of sales or selling price per unit and
changing product mix favorably, so as to improve contribution and
overall P/V ratio.
Margin of Safety = Sales Break even sales
Or
M/S = ((S BEP Sales) / S) * 100
Or
Margin of safety =
Profit/P .V. Ratio
The size of margin of safety is an extremely valuable guide for
strengthen a business. If it is larger there can be substantial falling of
sales and yet a profit can be made. On the other hand, if margin is
smaller, any loss of sales may be a serious matter.
Activity 10.2

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A company earned a profit of Rs. 30,000 during the year 2000-01.


Marginal cost and selling price of a product are Rs. 8 and Rs. 10 per
unit respectively. Find out the margin of safety.

Illustration 10.1
The following particulars are presented by ABC limited.
Sales
Rs. 40,000
Fixed Cost
Rs. 12,000
Variable Cost
Rs. 20,000
If production volume is 4000 units, find contribution, P.V. Ratio,
Break Even Volume and Margin of Safety.
Solution
Contribution

=
Sales Variable costs
=
40,000-20,000 =20,000
Contribution per Unit = Selling price per unit Variable Cost per unit
= (40,000/4,000)-(20,000/4,000)
= 10-5 = 5 per unit
P/V ratio
= Contribution /Sales
= 20,000/40,000 or 5/10
= .50 or 50%
Fixed cost
Breakeven in units =
Contribution per unit
Breakeven in units

12,000
5
= 2400 units

Contribution at BEP Fixed cost


=
P/ V ratio
P/ V ratio
12,000
12000
Break even sales in rupees =
or
.5
.5
Break even sales in rupees= Rs.24,000
It may also be calculated as
BE in Rs.
= BE in units *Selling Price per unit
=2,400*10 = Rs. 24,000
Profit
Margin of safety
=
P/V ratio
Profit
= Contribution Fixed cost
= 20,000-12,000 = 8,000
8,000
Margin of safety
=
.5
= 16000
M/S = Sales BEP Sales
Break even sales in rupees =

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16000 = 40000 24000


Illustration 10.2
You are given the following information
Period
Sales
Profit or Loss
August 2009
90,000
-10,000
July 2010
1,30,000
+10,000
Find out:
i. P/V ratio, fixed cost and break even point.
ii. Level of activity if Rs. 25,000 is to be earned as profit.
iii. Expected profit if sales are budgeted at Rs. 1,80,000.
Solution
i. P/V ratio, fixed cost and break even point.
P/V Ratio: as information about contribution is not available
but information about changes in sales and profit can be found
thus
Changes in Profit
P/V Ratio
=
Changes in Sales
= CY PY
= 10,000-(-10,000) =20,000
= 1,30,000- 90,000 =40,000
20,000
P/V Ratio
=
40,000
= .5
Fixed Cost: can be found by applying basic marginal cost
equation.
S-V=F+P=C or C=F+P
or F=C-P
And we know that PV Ratio is percentage contribution of
sales.
Thus Contribution
= P/V Ratio*Sales of any period
= .5* 90,000 =45,000
Fixed Cost
= 45,000-(-10,000)
= Rs. 55,000
Fixed cost
Break even sales in rupees
=
P/ V ratio
55,000
Break even sales in rupees
=
.5
= Rs. 1,10,000
Level of activity if Rs. 25,000 is to be earned as profit.
FC+Desired Profit
Sales required
=
P/V Ratio
55,000+25000
P/V Ratio
=
.5
Sales required for earning Rs. 25,000= 1,60,000
Changes
Profit
Sales

ii.

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iii.

Expected profit if sales are budgeted at Rs. 1,80,000.


Profit =Sales*P/V Ratio- Fixed Cost
=1,80,000*50%-55,000
=35,000

Illustration 10.3
A company producing a single article sells it at Rs.10 each. The
marginal cost of production is Rs.6 each and fixed cost is Rs.400 per
annum. You are required to calculate the following:
Profits for annual sales of 1 unit, 50 units, 100 units and 400 units
P/V ratio
Breakeven sales
Sales to earn a profit of Rs. 500
Profit at sales of Rs.3,000
New breakeven point if sales price is reduced by 10%
Margin of safety at sales of 400 units
Solution
Marginal Cost Statement
Particulars
Amount Amount Amount
Units produced
1
50
100
Sales (units * 10)
10
500
1000
Variable cost
6
300
600
Contribution (sales- VC)
4
200
400
Fixed cost
400
400
400
Profit (Contribution FC) -396
-200
0

Amount
400
4000
2400
1600
400
1200

Profit Volume Ratio (PVR) = Contribution/Sales * 100


= 0.4 or 40%
Breakeven sales (Rs.)
= Fixed cost / PVR
= 400/ 40 * 100 = Rs.1,000
Sales at profit Rs.500
Contribution at profit Rs. 500 = Fixed cost + Profit = Rs.900
Sales
= Contribution/PVR
= 900/.4 = Rs. 2,250 (or 225 units)
Profit at sales Rs. 3,000
Contribution at sale Rs.3,000 = Sales x P/V ratio
= 3000 x 0.4 = Rs.1,200
Profit
= Contribution Fixed cost
= Rs. 1200 Rs. 400 = Rs.800
New P/V ratio
= (9 6)/ 9 = 1/3
Rs. 400
Sales at BEP = Fixed cost/PV ratio =
= Rs. 1,200
1/3
Margin of safety (at 400 units) = 4000-1000/4000*100 = 75 %
(Actual sales BEP sales/Actual sales * 100)
Multiple Product Situations
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In real life, most of the firms turn out many products. However, the
assumption has to be made that the sales mix remains constant. This
is defined as the relative proportion of each products sale to total
sales. It could be expressed as a ratio such as 2:4:6, or as a percentage
as 20%, 40%, 60%. The calculation of breakeven point in a multiproduct firm follows the same pattern as in a single product firm. The
numerator will be the same fixed costs but the denominator now will
be weighted average contribution margin. The following formula may
be used for calculating BEP in case of multiple products.
Fixed costs
Breakeven point
(in units)
=
Weighted average contribution margin per unit
One should always remember that weights are assigned in proportion
to the relative sales of all products. Here, it will be the contribution
margin of each product multiplied by its quantity.
Breakeven Point in Sales Revenue
Here also, numerator is the same fixed costs. The denominator now
will be weighted average contribution margin ratio which is also
called weighted average P/V ratio. The modified formula is as
follows:
Fixed cost
B.E. point (in revenue) =
Weighted average P/V ratio

Illustration 10.4
Budget of Prima limited includes following data for the year 2009.
Fixed Overhears
3,00,000
Contribution Per Unit
Product A
Rs. 6/Product B
Rs. 2.5/Product C
Rs. 4/Sales forecasts
Product A
24,000 Units @Rs. 12.5/Product B
1,00,000 Units @Rs. 7/Product C
50,000Units @ Rs. 10/Calculate Composite Breakeven Point.
Solution
Profit Volume Ratio
Product A
=
6/12.5 = .48
Product B
=
2.5/7 = .357
Product C
=
4/10 =.4
Composite PV
Sales in Rs. Sales Mix PVR Composite PVR
Product A
3,00,000
.20
*.48 .96
Product B
7,00,000
.467 *.357 .1667
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Product C

5,00,000

.333

*.4

.1333
.396

Fixed cost
B.E. point (in revenue) =
Weighted average P/V ratio
30,000
B.E. point (in revenue) =
.369
=7,57,575
Activity 10.3
Find out P/V ratio and profit if sales are Rs. 20,000, fixed costs are
Rs. 4,000 and Break even sale is Rs. 10,000.

10.6 BREAKEVEN CHART


Apart from marginal cost equations, it is found that breakeven chart
and profit graphs are useful graphic presentations of this costvolume-profit relationship. Breakeven chart shows the relationship
between sales volume, marginal costs and fixed costs, and profit or
loss at different levels of activity. Apart from this relationship it also
shows the effect of change in one factor on other factors and exhibits
the rate of profit and margin of safety at different levels of activity.
A breakeven chart contains, inter alia, total sales line, total cost line
and the point of intersection of these lines called as breakeven point.
It is popularly called breakeven chart because it shows clearly
breakeven point (a point where there is no profit or no loss).
Assumptions underlying Break Even Analysis:
Break even analysis undertakes the following assumptions:
Total costs of production can easily be segregated into fixed
and variable cost components.
At each level of production, total fixed expenses remain
constant.
Variable costs vary in direct proportion to the volume of
production.
Change in production or sales quantities does not bring any
change in selling price per unit.
Only one product is produced or in case of more than one
product, the sales mix ratio once decided remains constant
Production and sales are equal means what ever is produced is
sold.
Construction of a Breakeven Chart

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The construction of a breakeven chart involves the drawing of fixed


cost line, total cost line and sales line. The break even charts may be
drawn in three different ways.
i. Simple break even chart
ii. Contribution break even chart
iii. Profit break even chart.
Simple Break even Chart
This chart is drawn to show break even point and CVP relationship.
Following steps may be taken to draw simple break even chart.
1. Select a scale for production on horizontal axis and a scale for
costs and sales on vertical axis.
2. Plot fixed cost on vertical axis and draw fixed cost line passing
through this point parallel to horizontal axis.
3. Plot variable costs for some activity levels starting from the fixed
cost line and join these points. This will give total cost line.
Alternatively, obtain total cost at different levels; plot the points
starting from horizontal axis and draw total cost line.
4. Plot the maximum or any other sales volume and draw sales line
by joining zero and the point so obtained.

Figure 10.6 Simple Break Even Chart

Contribution Break Even Chart


Contribution breakeven chart is prepared to exhibit contribution area
through chart. The process of drawing is similar to the simple break
even chart. The only difference in this chart is this that here variable
cost line is drawn first and above that fixed cost line is drawn.

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TR LINE
C
O
S
T
S

R
E
V
E
N
U
E
S

Profit Zone
Loss Zone
TC LINE
BEP
T
F
C
T
V
C

Angle of
Incidence

OUTPUT
Figure 10.7 Contribution Break Even Chart

Profit Break Even Chart


It establishes relationship between profit and volume thus it is also
known as P V chart. While constructing this graph different lines for
costs and revenues are omitted and only profit points are plotted.
Steps in construction of Profit BEP chart:
Determine an appropriate scale for sales volume on the
horizontal axis. This line should be drawn in the middle of the
graph so that profits can be shown above and losses below
this line.
Select vertical axis for profit and loss or fixed cost. Fixed
costs are shown below sales line on the left hand side of the
vertical axis and profits are shown on the right hand side
above the sales line.
Points are plotted for fixed costs which are connected by
straight line. This line intersects sales line on horizontal axis.
It is known as break even sales.

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Profit

Profit

in Rs.
BEP

F
Loss
I
X
E
D
C
O
S
Limitations ofT Breakeven Chart

Sales Line

Break even chart suffers from following limitations.


A simple breakeven chart gives correct result as long as
variable cost per unit, total fixed cost and sales price remain
constant. In practice, all these factors may change and the
original breakeven chart may give misleading results.
If a company sells different products having different
percentages of profit to turnover, the original combined
breakeven chart fails to give a clear picture when the sales
mix changes. In this case, it may be necessary to draw up a
breakeven chart for each product or a group of products.
A breakeven chart does not take into account capital
employed which is a very important factor to measure the
overall efficiency of business.
The assumption about fixed costs and variable costs may not
hold true. Fixed costs may increase at some level whereas
variable costs may sometimes start to decline. For example,
with the help of quantity discount on materials purchased, the
sales price may be reduced to sell the additional units
produced etc. These changes may result in more than one
breakeven points, or may indicate higher profit at lower
volumes or lower profit at still higher levels of sales.

10.7 SUMMARY
This chapter has explained about cost volume profit analysis (CVP).
CVP facilitates management in profit planning. Marginal costing
provides sound basis for profit planning and break even analysis is
most popular version of CVP analysis. Break even is a benchmark
point. Operations below it are loss making. If a firm operates above
this benchmark level it earns profit. But at this benchmark firm
neither earns profit nor incurs loss. Graphical presentation of break
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even point and cost volume profit relationship is known as break


even chart.

10.8 KEY WORDS


Break even point is intersection point of total cost and total revenue
line. At breakeven point firms total revenues are equivalent to total
costs. Thus it is also known as no profit no loss point.
Margin of safety is sales on which firm earns profits. It is the excess
of sales over break even sales.
Angle of incidence is an angle formed on break even chart at
intersection point of total cost and total revenue line.
Fixed Costs are the costs which tend to be unaffected in total by the
variations in the volume of activity within a specified capacity.
Variable costs are those costs which vary in direct proportion to
output.
Semi variable costs are those costs which remain constant up to
particular point or level of consumption and changes thereafter. But it
may not change in direct proportion to output.

10.9

SELF ASSESSMENT QUESTIONS

Objective Type Questions:


1. The break even point will be increased by:
a. A decrease in fixed cost
b. An increase in contribution margin
c. An increase in variable cost
d. A decrease in variable cost
2. If fixed cost decreases while variable cost per unit remains
constant, the new contribution margin in relation to the old
will be:
a. Unchanged
b. Higher
c. Lower
d. Cannot be decided
3. When P/V ratio is 40% and sales value Rs. 10,000, the
variable cost will be:
a. 4,000
b. 6,000
c. 10,000
d. Cannot be calculated
4. Which one of the following will not affect the contribution
per unit:
a. A 10% increase in Selling price
b. A 10% decrease in Variable cost per unit
c. A 10% decrease in Fixed cost
d. Non of the above
5. P/V Ratio is an indicator of:
a. Volume of Sales
b. Volume of Profit
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c. Rate at which goods are sold


d. All of the above
Ans: 1. (c), 2. (a), 3. (b), 4. (c), 5. (b)
Short Answer Type Questions:
i. What do you mean by angle of incidence? Explain it with the
help of a graph.
ii. What do you mean by semi variable cost? Give two examples
of it.
iii. What is the use of CVP analysis? How it is conducted?
iv.
Discuss the assumptions behind break even chart..
v. How profit break even chart is prepared?
Long Answer Type Questions:
i. What do you mean break even chart? Discuss assumptions and
limitations of break even analysis in detail.
ii. What do you mean by marginal costing? Discuss its features
and how cost behavior is used in CVP analysis. .
iii. What do you mean by break even chart? Discuss different types
of break even charts and its uses.
iv. A sales director requires you to compute the sales volume
necessary to
a. Break Even
b. Make a profit of Rs. 4 per unit
c. Make a profit of Rs. 30% of sales
d. Make a loss of 10% on sales
The cost data given are
Sales 10,000 Units @Rs. 10 per
Variable costs @5 per unit
Fixed Costs Rs. 30,000
Hint: b. is to be calculated using formula FC/(S-V+DP) or
FC/(10-5+4)=30,000 units, similarly c and d are to be
calculated answers are c-Rs. 1,50,000 d-Rs. 50,000.
v. The information about cost and sales relating to Smriti Ltd are
given as below:
Sales
Total Cost
Period 1
10,000
8,000
Period 2
15,000
11,000
You are required to calculate
PV Ratio, Break even point and fixed cost
Sales to earn Rs. 3000 as profit
Profit when Sales are 8000.
Activity Answers

10.10

(10.2- MOS 1,50,000; 10.3- VC 6000, PVR


40%, Profit 4000)

SUGGESTED READINGS

Pandikumar M. P. 2009, Management Accounting, Excel Books,


New Dehli.
Dr. Hanuman Praasd, Associate Professor, FMS, MLSU, Udaipur,
Email: drhanu73@yahoo.com
Page 80

Kishore R. M , 2005, Cost and Management Accounting, Taxmann


Allied Services (P.) Ltd.
Rao M. E. T.2004, Cost and Management Accounting, New Age
International (P) Ltd., New Delhi
Bhatt S. 2009, Management Accounting, Excel Books, New Delhi
Rao N. S., Dulawat M.S. and Sharma M. L.2007, Pharmaceutical
Business Methmetics-including budgeting, costing, accounting and
audit), Apex Publishing, Udaipur

Dr. Hanuman Praasd, Associate Professor, FMS, MLSU, Udaipur,


Email: drhanu73@yahoo.com
Page 81