1

ANALYSIS AND INTERPRETATION OF

FINANCIAL STATEMENTS

Unit Structure:

1.0 Objectives
1.1 Introduction
1.2 Purposes and Objectives of Financial Statements
1.3 Nature of Financial Statements
1.4 Characteristics of Financial Statements
1.5 Qualities of Ideal Financial Statements
1.6 Preparation of Financial Statements
1.7 Vertical Financial Statement Statements of a Proprietor
1.8 Vertical Statements for Companies
1.9 Exercise

1.0 OBJECTIVES

After studying the unit the students will be:

Know the purpose and objectives of Financial Statements.
Understand the nature of Financial Statement.
Explain the Characteristics of Financial Statement.
Know the qualities of Ideal Financial Statement.
Explain the Vertical Format of Financial Statements.

1.1 INTRODUCTION

Government legislations require certain organizations like

limited companies, public utilities, and co-operative to maintain
proper account and draw financial statement. Public can
understand from the financial statement the extent to which a
company is discharging its social responsibilities. While issuing
shares bonds, financial statement become necessary as
prospective investors can judge whether to by the share or bonds,
from the information regarding the financial soundness, gathered
from the financial statement. Workers union may study the financial
statement and ascertain whether they can enforce their demand.
Whiten an organization also, financial statement assist the
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management in taking various decisions. Consumer, all over the

world, are becoming increasingly aware of their right and are using
financial statement extensionally today to find out the degree of
exploitation by the industries. Tax legislature makes it obligatory on
the part of business entities to draw fair and objective financial
statement. The financial statement serves as instruments to
regulate equity and debentures issued by companies.

1.2 PURPOSES AND OBJECTIVES OF FINANCIAL

STATEMENTS

Financial statements are very useful as they serve varied

affected group having a economic interest in the activities in the
business entity. Let us analyse the purpose served by financial
statement.

a) The basic purpose of financial statement is communicate to

their interested users, quantitative and objective information are
useful in making economic decisions.
b) Secondly, financial statements are intended to meet the
specialized needs of conscious creditors and investors.
c) Thirdly, financial statements are prepared to provide reliable
information about the earning of a business enterprise and it
ability to operate of profit in future. The users who are
interested in this information are generally the investors,
creditors, suppliers and employees.
d) Fourthly, financial statements are intended to provide the base
for tax assessments.
e) Fifthly, financial statement are prepare in a way a provide
information that is useful in predicting the future earning power
of the enterprise.
f) Sixthly, financial statements are prepares to provide reliable
information about the changes in economic resources.
g) Seventhly, financial statements are prepares to provide
information about the changes in net resources of the
organization that result from profit directed activities.

Thus, financial statement satisfy the information

requirements of a wide cross-section of the society representing
corporate managers, executives, bankers, creditors, shareholders
investors, labourers, consumers, and government institution.
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Executives

Trade
Consumers Creditors
& Society

Financial
Information

Shareholders
& Prospective
Labourers
Investors

Bankers

Fig. 1.1

a) Executives :

Financial statements provide sufficient accounting

information to the executives and managers to enable them to
decide on important issues facing them. The common issues facing
corporate managers to-day, like efficient capital utilization,
maintaining the profitability though cost control, dividend paying
capacity of the company and observing credit standards, can be
tackled effectively, if the executives have a proper understanding of
analysis of the financial statement.

b) Bankers :

Bankers take precautions before advancing loans to their

constituents. Every banker, before sanctioning credit, wishes to be
assured the borrower‘s ability to repay the loans when they become
due; to ascertain the company‘s ability to pay interest charges on
loans and their respective due dates. Therefore, they scrutinize and
study the financial statements in depth and analyse them to
ascertain the borrower‘s liquidity, solvency, profitability of his
business and his financial strength.
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c) Trade Creditors :

Credit facilities mass distributors of goods produced but a

manufactures or a wholesalers would not provide credit facilities
indiscreetly to everyone. Before opening an account of the trader
concerned, the manufacturer and wholesaler studies the financial
statements of the trader, supplemented by various trade and bank
references, to ascertain his creditworthiness. This information could
be obtained from the financial statement.

d) Shareholders and Prospective Investors :

Shareholders, who have permanent interest in the life and

operations of the company, are ever desirous of knowing about
their company‘s year to shareholders are particularly interested in
the future of the company. The financial statements provide the
share-holders all the information they require. What is said for the
shareholders holds equally good for the prospective investors.

e) Labourers :

Labourers contribute to the earnings of the company and

they are the people who work on raw materials with the aid of
capital goods to produce wealth. They are also interested in their
wages and salaries, bonus and working conditions. As far as
bonus, working conditions and other incentives are concerned, they
largely depend on the company‘s profitability and liquidity. The
labourers are also interested in the business as a ‗going concern‘
as it only ensures their permanent employment.

f) Consumers and society :

Consumers attempt to find out whether they are being

exploited by the producers. Society is interested in an enterprise‘s
that result in the increase of employment opportunities, wealth and
standard of living of the people. They are also concerned about the
enterprise‘s contribution to social welfare, environment and national
wealth and prestige. Study of financial statements enables the
consumers and the society to gain knowledge on these matters.

1.3 NATURE OF FINANCIAL STATEMENTS

Financial statements are plain statements based on

historical recorded facts and figures. They are uncompromising in
their objectives, nature and truthfulness. They reflect a judicious
combination of recorded facts, accounting principles, concepts and
conventions, personal judgements and sometimes estimates.
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Thus, financial statements are affected by three factors i.e.,

recorded facts, accounting conventions and personal
judgements.

a) By recorded facts is meant the data contained in statements

which have already recorded in accounting records.
Example: Cash in hand and at bank, cost of fixed assets,
amounts due from customers and due to suppliers of goods are
all recorded facts represented numerically.
b) Financial statements are prepared by adhering to certain
concepts and established conventions.
c) In agreement with the recorded facts and accounting concepts
and conventions, the role of personal judgements, estimates
and opinions, are to be emphasised especially when two or
more alternative procedures are available and which are
equally acceptable.
Example: an asset could be depreciated under several
methods, and inventory could be valued under different
methods. Under such circumstances, personal opinion and
judgement play an important role as to which of the methods
are in closer conformity with the accounting standards and
concepts in a particular circumstance or case.

1.4 CHARACTERISTICS OF FINANCIAL

STATEMENTS

Financial statements are regarded as indices of an

enterprise‘s performance and position. As such, extreme care and
caution should be exercised while preparing these statements.
Financial statements generally reflect the following observable
characteristics:

a) Internal Audience
b) Articulation
c) Historical Nature
d) Legal & Economical Consequences
e) Technical Terminology
f) Summarization and Classification
g) Money Terms
h) Valuation Methods
i) Accrual Basis
j) Estimates and Judgement
k) Verifiability
l) Conservatism
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a) Internal Audience : financial statements are intended for those

who have an interest in a given business enterprise. They have
to be prepared on the assumption that the user is generally
familiar with business practices as well as the meaning and
implication of the terms used in that business.

b) Articulation : The basic financial statements are interrelated

and therefore are said to be ‗articulated‘.
Example : Profit and Loss account shows the financial results
of operations and represents an increase or decrease in
resources that is reflected in the various balances in the
balance sheet.

c) Historical Nature : Financial statements generally report what

has happened in the past. Though they are used increasingly
as the basis for the future by prospective investors and
creditors, they are not intended to provide estimates of future
economic activities and their effect on income and equity.

d) Legal and economic consequences : Financial statements

reflect elements of both economics and law. They are
conceptually oriented towards economics, but many of the
concepts and conventions have their origin in law.
Example : Conventions of disclosure and materiality

e) Technical Terminology : Since financial statements are

products of a technical process called ―accounting‖, they
involve the use of technical terms. It is, therefore, important that
the users of these statements should be familiar with the
different terms used therein and conversant with their
interpretations and meanings.

f) Summarization and Classification : The volume of business

transaction affecting the business operations are so vast that
summarization and classification of business events and items
alone will enable the reader to draw out useful conclusions.
g) Money Terms : All business transactions are quantified,
measured and related in monetary terms. In the absence of this
monetary unit of measurement, financial statements will be
meaningless.

h) Various Valuation Methods : The valuation methods are not

uniform for all items found in a Balance Sheet.
Example : Cash is stated at current exchange value; Accounts
receivable at net realizable value; inventories at cost or market
price whichever is lower; fixed assets at cost less depreciation.
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i) Accrual Basis : Most financial statements are prepared on

accrual basis rather than on cash basis i.e., taking into account
all incomes due but not received, and all expenses due but not
paid.

j) Need for Estimates and judgement : Under more than one

circumstance, the facts and figures to be presented through
financial statements are to be based on estimates, personal
opinions and judgements.
Example : Rate of depreciation, the useful economic life of a
fixed asset, provision for doubtful debts are all instances where
estimates and personal judgements are involved.

k) Verifiability : it is essential that the facts presented through

financial statements are susceptible to objective verification, so
that the reliability of these statements can be improved.

i) Conservatism : Wherever and whenever estimates and

personal judgements become essential during the course of
preparation of financial statements, such estimates, should be
based moderately on a conservative basis to avoid any
possibility of overstating the assets and incomes.

1.5 QUALITIES OF IDEAL FINANCIAL STATEMENTS

Financial statements, to serve the purposes of different

users, have to be well prepared and presented. The following
qualities are recognised as essential for ideal financial statements:
a) Clarity
b) Intelligibility
c) Objectivity
d) Emphasis on materiality
e) Precision and brevity
f) Systematic classification of heads and items
g) Consistency.

1.6 PREPARATION OF FINANCIAL STATEMENTS

Let us now see the contents of financial statements and the

methodology of constructing them.

1.6.1 Financial Statements :

Financial statements consist of ‗Revenue Account‘ and
‗Balance Sheet‘. Revenue Account refers to ‗Profit and Loss
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Account‘ or ‗Income and Expenditure Account‘ or simply ‗Income

Statement‘.

Revenue Account may be split up or divided into

‗Manufacturing Account‘, ‘Trading Account‘, ‘Profit and Loss
Account‘ and ‗Profit and Loss Appropriation Account‘, Revenue
Account is prepared for a period, covering one year.

1.6.2 Objects of preparing Revenue Accounts :

Manufacturing Account is prepared to find out the total ‗Cost

of Goods Manufactured‘ in the period. It will also reveal the cost of
material consumed, labour and other manufacturing expenses or
costs.

Trading Account is prepared to ascertain the trading result

i.e. gross profit or gross loss made on sale of goods.

Profit and Loss Account is prepared covering the same

period to ascertain the net profit or net loss during the year under
review, from the usual business.

Profit and Loss Appropriation Account is prepared wherein

all other items of expenses and appropriations are reflected to
reveal the net profit or net loss. Generally this includes items
related to earlier years or charge of interest or salary payable to
proprietor or partners.

Sole proprietary concerns, partnership firms and companies

prepare the above mentioned accounts. In case of companies, the
Revenue Account i.e. profit and loss account is to be prepared
taking note of the requirements of Schedule VI Part II to the
Companies Act refers to profit and loss account only.

1.6.3 Manufacturing Account :

A manufacturing concern may prepare the ‗Manufacturing

Account‘ and ‗Trading Account‘ is prepared separately. But in small
manufacturing concerns, only one combined account known as
‗Manufacturing and Trading Account‘ may be prepared. The
distinction between a Trading Account and a Manufacturing
Account is that a Manufacturing Account deals only with all costs
and expenses of manufacture. Trading Account deals only with
finished goods and expenses relating to them showing the cost of
manufacture. Finished goods are those goods which are ready for
sale. Such goods may be manufactured in the concern or may be
purchased from outside. The cost of goods manufactured as shown
by the Manufacturing Account, is transferred to the Trading
Account.
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The purpose of preparing the Manufacturing Account, as

already mentioned, is to ascertain the cost of goods manufactured.
It should, therefore, include all the expenses relating to
manufacture of goods, i.e. purchase of raw materials, i.e. expenses
such as carriage, freight etc. and all others expenses incurred to
convert raw materials into finished goods.

To give a clear idea the elements of cost are enumerated

under various heads like prime cost, factory cost etc. Manufacturing
or Production A/c is prepared to describe the various elements of
cost in creating the finished goods.

Cost Elements :

There are three major elements of production cost viz.

a) Direct materials,
b) Direct labour, and
c) Factory overheads direct material and direct labour constitute
‗direct cost‘ and the latter constitutes ‗indirect cost‘.

a) Direct Materials :

It refers to such materials which are incorporated into the

physical units of product manufactured. It is readily and definitely
ascertainable.

b) Direct Labour :

It refers to the labour performed in physical contact with the

product. It is the amount of wages paid to the workers who are
engaged in converting raw materials into finished goods. It can be
easily ascertained.

c) Factory or Production overhead :

It is not easily assignable to a particular product. It is an

indirect cost and includes :

i) Indirect labour (foremen, Works manager, Storekeeper etc.)

ii) Indirect materials (factory supplies)
iii) Depreciation of factory Building, Plant and machinery.
iv) Amortization of parents.
v) Insurance on building, machinery and materials etc.
vi) Maintenance of factory, and
vii) Water, heat, light and parts used in factory.
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Important point regarding Manufacturing Account :

a. Stocks :

The distinguishing feature of a manufacturing concern is the

type of stock held. A trading concern holds only stock of finished
goods. A manufacturing concern holds stock of materials, semi
finished or work in process as well as finished goods.

b. Direct Material Consumed :

It is customary to show in the Manufacturing A/c the value of

raw materials consumed for manufacturing goods during a
particular period.

It is computed as follows :

Rs.
Opening stock of Raw Materials XX
Add : Purchase of Raw Materials XX
Add : Carriage or Freight Inwards XX
Less : Rejected or returned Materials XX
Less : Closing stock of Raw Materials XX
XX

c. Work in Process :

This represents materials put in process which is not

completely converted in Finished Goods. Opening and closing
works in process are shown in the Manufacturing A/c on Debit side
and Credit side respectively. However, their figure (difference)
appears on the debit side either as an addition or deduction.

d. Sale of Scrap :

In manufacturing operations there may be certain scrap

which may or may not have a sale value. In order to find out correct
cost of manufacturing the goods it is necessary to credit
manufacturing A/c by the amount of scrap.

e. Factory Expenses :

These expenses include for processing or manufacturing

goods i.e. converting raw materials into finished goods. These
include expenses like (1) Power and Fuel, (2) Rent, Rates, Taxes,
Insurance, Repairs and Depreciation on assets used for
manufacture, (3) Factory Stores and Spares, (4) Factory
Supervision.
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1.6.4 Balance Sheet :

Balance Sheet defined :

It is not possible to define the whole Balance Sheet except in

vague terms. The definition of the balance sheet given by the
American Institute Certified Public Accountants is as follows :

―Balance Sheet is a list of balances in the asset, liability or

net worth accounts‖. This definition is accurate but not meaningful.

Accounting Standards Board, India has defined balance

Sheet as ―a statement of the financial position of an enterprise as at
a given date which exhibits its assets, liabilities, capital, reserves
and other account balances at their respective book values.

A more meaningful definition of balance Sheet will be as

under:

―Balance Sheet shows the sources from which funds

currently used to operate the business have been obtained (i.e.
liabilities and owners‘ equity) and the types of property and property
rights, in which these funds are currently locked up (i.e. assets)‖.

Balance Sheet may be considered as a summarised sheet of

balances remaining in the books of account, after the preparation of
the profit and Loss Account. Thus a Balance Sheet can be rightly
called as a statement of position as it now contains assets and
liabilities generally. It is a document of the financial position of an
enterprise, as it indicates what the business owns and what it owes
on a particular date. The things that the business owns are called
‗Assets‘ and the various sums of money that it owes are called
‗liabilities‘ (including that of the owners).

The term ‗Balance Sheet‘ comes from the fact that the total
assets must be equal to total liabilities, they balance each other.
The liabilities side shows the various sources from which money
made available for the assets, and the assets side shows the way
those funds are employed in the business.

While preparing final accounts, all nominal accounts from the

trial Balance are closed by transferring them to Trading and Profit
and Loss Account. The other account balances, not transferred to
Revenue Accounts, will be either personal or real accounts A
collection of all these balances is known as a ‗Balance Sheet‘. So,
we can rightly term the Balance sheet as ‗a sheet of balances.‘

As we have seen earlier, a balance Sheet is so called

because it's two aides must always balance, i.e., the assets
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must be equal The Liabilities plus owners' funds. This can be

expressed in the form of an equation.

Assets = Liabilities + Net Capital

A = L + NC (Capital + Reserves – Fictitious Assets)

The entire balance sheet rests on the above equation. Thus,

the above equation is called the Balance Sheet Equation or
Accounting Equations.

Fig. 1.3

The Balance Sheet is given various titles as follows :

1. General Balance Sheet.
2. Statement of Financial position.
3. Statement of Financial Condition.
4. Statement of Asset and Liabilities.
5. Statement of Resources and Liabilities.
6. Statement of Availability of Resources and their application.
7. Statement of Assets, Liabilities and Capital.
8. Statement of worth.
9. Statement of Net worth.
10. Financial statement, etc.
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Thus, Balance Sheet may be rightly called as the Statement

of Assets and Liabilities that shows the financial position of a
business enterprise on a particular date. All items appearing in
Balance Sheet are either capital receipts or capital payments or
personal accounts and balance of undistributed profits.

Why Balance Sheet Balance :

Balance sheet is a statement of assets and liabilities. Are

business transaction are recorded in the books of accounts under
the double entry system recording both the credit and debit
aspects of each and every business transaction. The total of all
debits must be equal to the total of all credit and therefore, the
resulting balance also must be agree.

This can also be explained thus : since the liabilities side

(left hand side) on the balance sheet shows the sources of fund
and the assets side (right hand side) show the employment of
funds the total assets must be equal to total liabilities.

Function of the Balance Sheets :

The three important function performed by balance sheet are :

a) It gives the summery of the firms assets and liabilities.
b) It is a measure of the firm liquidity.
c) It is measure of the firms solvency.

Format of Balance Sheets :

A balance sheet may be presented in various forms. They are :

1. Conventional format
2. Vertical format
3. Step format.

1. Conventional Format :
The conventional from or the customary form of balance
sheets is also called ‗horizontal‘ form or ‗account‟ form or ‗T‘ form
of the balance sheets. It shows the assets i.e. debit balance on the
right and side and liabilities i.e. the credit balances and owners
equity on the left hand side.

But, in countries like the U.S. and Canada, the assets

(debit items) are shown on the left hand side and liabilities (credit
items) on the right hand side of the balance sheet.

This method of presenting the balance sheet is also known

as ‗balance array form‘.
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Arrangement of assets and liabilities :

In the horizontal form of balance sheet presentation, the

assets are shown either in order of liquidity or in order of
permanence.

The arrangement in order of liquidity shows the order in

which the assets could be realized to satisfy business liabilities and
the liabilities in the order of earliest, relative maturity or discharge.
The order of liquidity is adopted by concern whose operations are
mostly cash like banking companies, investment and finance
companies, etc.

The order of permanency indicates the relative degree of

permanency of assets and liabilities .mostly ,manufacturing and
trading companies adopted this order of showing fixed assets first
followed by less fites and current asset ‗and on the liabilities side ,
the liability to be paid last as the first , followed by relatively less
permanent liabilities.

A. in order of liquidity

Liability Assets
Current Liability Current Assets
Long term liability Fixed Assets
Capital & Reserve Other Assets

B. in order of permanence

Capital & Reserve Fixed Assets

Long term Liability Current Liability
Current Liability Other Assets

1.7 VERTICAL FINANCIAL STATEMENT

STATEMENTS OF A PROPRIETOR:

1.7.1 Income statement Income statement for the year ended-

Rs. Rs.

Net sales
Cross Sales
Less : Returns
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Less : Cost Of Goods Sold

Opening Stock
Purchase
Less : Return
Carriage
Import Duty
Doctor
Fright
Wages and Salaries
Motive Power
Depreciation on Machinery
Less : Closing Stock
Gross Profit
Less : Operating Expenses
A. Office and Administration Expenses :
Staff Salaries
Rent, Rates and Taxes
Unproductive Wages
Repairs
Insurance
Printing and Stationary
Water & Electricity
Office Cleaning
Postage and Telephones
Staff Welfare Expenses
Conveyance Charges
Misc. Expenses
Depreciation on Office Bldg. & Furniture
B. Selling Expenses :
Carriage Outwards
Commission Allowed
Travelling Expenses
Entertainment Expenses
Sales Promotion Expenses
Advertising
Bad Debts
Warehouse Expenses
C. Finance Expenses :
Cash Discount
Bank Charges
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Bad Debts
Provision for Discount
Provisions for Bad Debts
Interest on Loans
Net Operating Profit / Loss
Add : Non Operating Income
Interest Earned
Misc. Incomes
Profit on sale of Fixed Asset
Interest on Loan given to Outsiders
Dividend on Investments
Compensation received as per Court Order
Less : Non Operating Expenses & Losses
Loss on sale of Fixed Asset
Loss by Fire
Penalty
Net Profit before Tax
Less : Income Tax
Net Profit after Tax

1.7.2 Vertical Balance Sheet of a Sole Proprietor

Vertical Balance Sheet as on ________

Rs. Rs.
SOURCES OF FUNDS :
Proprietors‟ Funds
Capital
Add : Net Profit
Less : Net Loss
Add : Additional Capital Introduced
Add : Interest on Capital
Less : Drawings
Interest on Drawings
Reserves
General Reserve
Capital Reserve
Loan Fund
Secured Loans
Unsecured Loans

TOTAL
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APPLICATIONS OF FUNDS :
Fixed Assets
Goodwill
Land & Building
Plant & Machinery
Furniture & Fixtures
Vehicles
Patents & Copyrights

Current Assets
Stock of goods
Debtors
Bills Receivable
Marketable Investments
Cash & Bank
Prepaid Expenses
Less : Current Liabilities
Creditors
Bills Payable
Bank Overdraft
Expenses payable

Working Capital

TOTAL
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Balance Sheet as on 31st march, 2009

Rs. Rs.
SOURCES OF FUND :
Own Fund
Capital Fund 2,43,825
Add : Surplus 20,895
Add : Donations 16,000
2,80,720
Funds
Prize Trust Funds 18,250
Investment Fluctuation Fund 20,000 38,250
TOTAL 3,18,970

APPLICATIONS Of FUND :
Fixed Assets
Buildings 73,125
Furniture 11,000
Library Books 16,845 1,00,970

Investments
Prize Fund Investments 17,875
General Investments 2,00,000 2,17,875
Current Assets
Debtors 3,000
Outstanding Subscriptions 2,400
Interest accrued 450
Cash 200
Bank 7,500
Prize Trust Bank Balance 375
Prepaid Insurance 250
A 14,175
Current Liabilities
Sundry Creditors 12,500
O/s Salaries 1,200
Subscriptions in advance 350
B 14,050
Working Capital (a – b) 125
TOTAL 3,18,970
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1.8 VERTICAL STATEMENTS FOR COMPANIES:

1.8.1 Vertical Balance Sheet :

Balance Sheet as on _________
Rs. Rs.
SOURCES OF FUNDS
I. SHAREHOLDER‟S FUNDS
A. CAPITAL
Equity Share Capital
Preference Share Capital
Less : Unpaid Calls
Add : Forfeited Shares

B. RESERVES & SURPLUS

Capital Reserve
Capital Redemption Reserve
Securities Premium
General Reserve
Sinking Fund
Dividend Equalisation Reserve
Workmen‘s Compensation Fund
Revaluation Reserve
Development Reserve
Other Reserves
P&L A/c Credit Balance

LESS : FICTITIOUS ASSETS :

P&L A/c Debit Balance
Preliminary Expenses
Share Issue Expenses
Discount on issue of Shares and Debentures
Underwriting Commission
Formation Expenses
Deferred Revenue Expenditure

OWN FUND / NET WORTH

II. LOAN FUNDS
A. SECURED LOANS
Debentures
Bonds
Bank Loans
Loans from Financial Institutions
Other Loans
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B. UNSECURED LOANS
Debentures
Bonds
Bank Loans
Loans from Financial Institutions
Public Deposits
Loans from Directors
Other Loans

TOTAL

APPLICATIONS OF FUNDS
I. FIXED ASSETS
TANGIBLE
Land and Building
Leasehold Property
Plant and Machinery
Furniture & Fittings
Vehicles
Live Stock
Railway Sidings
(At Cost less Depreciation)
INTANGIBLE
Goodwill
Patents
Copy rights
Trade Marks & Designs

II. INVESTMENT
Govt. Securities
Shares
Debentures
Immovable Properties
Capital of Partnership Firms
Long term Loans given
Sinking Fund Investments

III. CURRENT ASSETS, LOANS &

ADVANCES QUICK ASSETS
Cash & Bank
Debtors (Net)
Bills Receivable
Marketable Investments
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LOANS & ADVANCES

Other Current Assets
Inventory
Prepaid Expenses
Advance Tax
Advance for Goods

LESS : CURRENT LIABILITIES

QUICK LIABILITIES
Creditors
Bills Payable
Advances Received
Expenses Payable
Accrued Interest
Provision for Taxation
Provision for Dividend
Unclaimed Dividend
OTHER LIABILITIES
Bank Overdraft
NET CURRENT ASSETS/WORKING
CAPITAL

TOTAL

1.8.2 Understanding Corporate Balance Sheet :

1. Assets :

a. Fixed Assets :

Fixed Assets are called long-term assets. They do not flow

through the cash cycle of business within one year or the normal
operating cycle. They are used over several periods. They are
major sources of revenue to the business. They do not vary day in
and day out due to routine business transaction. They are intended
for long term use in the business. They are called ―bundle of future
services‖ or ―Sunk Costs‖. The group of fixed assets consists of the
following :
a) Land,
b) Buildings,
c) Plant and Machinery,
d) Vehicles,
e) Furniture & Fittings,
f) Railway sidings,
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g) Live stock
h) Development of Property
i) Intangible Assets such as patents, copyrights, goodwill, etc.

Classification of Fixed Assets :

a) Tangible movable assets;
b) Tangible immovable assets; and
c) Intangible assets.

a) Tangible movable assets are the assets which can be seen,

touched and moved from one place to another place. Plant and
Machinery, furniture and fixtures, transportation equipments
etc. are tangible movable assets.

b) Tangible immovable assets are the assets which can be

seen and touched but cannot be moved from one place to
another place. Such assets include land, buildings, mines, oil
wells, etc.

c) Intangible assets are the assets which cannot be seen and

touched. However, their existence can only be imagined such
as patents, trade marks, copyrights, goodwill, etc. Their
existence is very important for the business. Intangible assets
have several characteristics.

Fixed Assets = Tangible Assets + Intangible Assets

Characteristics of an Intangible Assets :

Intangible Assets :
a) enables business managers to attain the goals of profitability,
b) is long term in nature, and whose benefit is available to the
business for more than the current accounting period,
c) has a determinable acquisition cost, except in the case of self
generated assets.
d) is used in conducting business activities, and
e) provides certain rights or privileges to the business.

Presentation of Fixed Assets :

Gross Block
Less Provision for Depreciation
Net Blocks
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b. Wasting Assets :

Fixed assets normally get depreciated due to constant use,

wear and tear, and efflux of time. Mere passage of time is sufficient
for certain fixed assets to lose their values.

But there are certain fixed assets known as wasting assets

like mines, quarries which do not depreciate due to the passage of
time, but depreciation in their value is caused by extraction or
depletion.

Example : Forests, quarries, mines, oil wells, etc.

If there is no extraction from these assets, their values will

not decrease but still they can be depreciated under certain special
circumstances.

The depreciation of these assets is directly related to the

output. They are depreciated under ‗Depletion method‘. The
acquisition cost of the asset is reduced in the same proportion as
the actual output bears to the quantity of mineral contained in the
asset. Alternatively, the depletion cost per unit is calculated and
every year it is multiplied by the quantum of output and the amount
of depletion is computed.

Valuation of Fixed Assets :

Most fixed assets are valued at cost. Certain assets

depreciate or decrease in value due to usage.

The cost of an assets includes its purchase price plus all

other expenses necessary or incidental in acquiring and preparing
the asset to bring it into usable or working condition. To illustrate,
the cost of a fixed asset will include :

a) Invoice price,
b) Sales tax,
c) Cost of shipment and delivery charges to purchaser, such as
freight, insurance, customs duty and clearing charges,
d) Cost of insurance during installation,
e) Installation cost,
f) Cost of materials used to set up or operate the asset, and
g) Cost of material, labour etc., required to conduct trial runs of
the equipment.

The cost of an asset is to be written off during the life of the

asset on a graduated basis or on ‗time‘ basis or on ‗use‘ basis.
 24

Thus, fixed assets will appear in the balance sheet at cost less
depreciation. Since fixed assets are not acquired for resale, the
expected realizable value of such assets is not taken into account
while valuing them for balance sheet purposes.

2. Investments :

Investments may be short-term. Short-term investments

are marketable securities and they represent temporary
investments of idle funds. These investments can be disposed
off by the company at its own will at any time. Investments are
shown at cost. Cost includes brokerage, fees and all other
expenses incurred on acquisition of investments. However, the
market value is shown by way of a note.

Long-term investments are held for a long time. They are

required to be held by the very nature of business. Here the
intention of the investor is to retain the securities for a longer
period of time. For example, a company engaged in generating
electricity may be required to hold the bonds of the Electricity
Board. These bonds are retained by the company so long as the
company uses electric power.

As per Schedule VI of the Indian Companies Act 1956,

investments are shown separately, showing the nature of
investments and the mode of valuation of various classes of
securities. Clear cut distinction should be made between :
a) Investments in Government or Trust Securities.
b) Investments in shares, debentures or bonds showing
separately fully paid and partly paid shares.
The interest of Directors in companies and firms in which
investments are made must be stated clearly.
Trade investment means an investment by a company in
shares and debenture of another company for the purpose of
promoting the trade or business interests of the first company.
c) Investments in immovable property. (i.e. property held as an
investment and not for business purposes)
d) Investments in capital of partnership firms.

In respect of investments in shares and debentures, they

should be shown separately as fully paid and partly paid, and the
different classes of shares. Trade investments and other
investments should also be shown separately.

While preparing the balance sheet, the quoted and

unquoted investments and the market value of quoted investments
should be shown clearly, as given in the statement below :
 25

Quoted investments refer to securities in respect of

which permission has been granted to deal in a recognised
Stock Exchange.

Other investments should be considered as ‗unquoted

investments‘.

Note : The interest accrued on investments should be shown

under the heading ―current assets‖ and not under this head.

Investments – whether Fixed Assets or Current Assets :

The answer to this question lies in the classification of

investments. Investments, for balance sheet purposes can be
classified into long-term investments and marketable investments.

This basis of distinction, between long-term and marketable

investments, depends on the nature and purposes of such
investments.

Long term investments are those investments which satisfy any

of the following conditions :

a) They do not meet the test of ready marketability.

b) They are required to be held by the business by the very
nature and conditions of the business.
Example: Sometimes, an export house is required to
subscribe to the shares of the concerned Export Promotion
Council.
c) They are made to foster operational relationships with other
entities.
Example: An automobile manufacturing company may
subscribe to the share capital of a tyre manufacturing entity.
d) Investments may be made to exercise a degree of control over
a corporate entity.
Example: Recently, in 1982, Modi Rubbers Ltd., acquired
controlling interest in Firestone Tyre Company.
e) They may be made in order to promote and float a new
company. Before issuing the shares of a new company, the
promoters may acquire a reasonable percentage of the total
interest in the company so that it may create a favourable
impression in the minds of the investing public.
f) They may be used to develop closer ties with major suppliers
or retail outlets.
 26

g) They may be acquired to diversify and broad-base the

operations of a company.

Investments which satisfy any of the above conditions are

termed as ―Long term Investments‖ and classified as ‗fixed assets‘.
Long term investments are “Fixed Assets”.

Marketable Investments are those investments which

are acquired by the company by employing its surplus funds
or cash temporarily.

These investments can be disposed off by the company at

its free will and thus convert it into cash as and when the need
arises. Hence, these investments are considered as good as cash ,
and are often called ‗ secondary cash resources‘.

Short term investments are grouped under “Current

Assets”.

3. Current Assets and Quick Assets :

Current Assets :

―Current Assets include cash, assets that are likely to

become or converted into cash, or assets that are otherwise
consumed in the balance sheet date (or within the normal
operating business cycle, if it is longer than one year) and the cash
thus generated is available to pay current liabilities.‖

Current assets are not intended for long-term use in

business.

Current assets represent employment of money by the

company on a short-term basis. They circulate within the group.
For example, cash becomes raw material when material is
purchased, material becomes finished goods, finished goods
become cash or debtors when sold and so on. Usually, the
following assets are classified as current assets :

Current Assets include :

Stock
1. Stock of raw materials
2. Stock of work in progress
3. Stock of finished goods
4. Stock of packing materials
 27

Debtors
Gross
Less Provision for doubtful debts

Cash and Bank

1. Cash on hand
2. Bank Balance

Loans and Advances

1. to subsidiary
2. to firms

Marketable Investments
Other Current Assets:
1. Interest accrued on investments
2. Loose Tools
3. Bills of Exchange
4. Prepaid expenses, advance payment of tax
5. Balances with customs, port, trusts, etc.

Current Assets = Stock + Debtors + Cash & Bank + Loans &

Advances + Marketable Securities + Other
Current Assets

In fact, total current assets are known as ―Gross Working

Capital‖. Current assets less current liabilities are known as ‗net
working capital‘.

Quick Assets :
These assets are known as ‗near cash‘ assets. In other
words, quick assets are those which can be converted into
cash quickly. Therefore, they are also known as liquid assets.
Cash and bank balances are the most liquid assets. Debtors and
cash advances can be converted into cash at a short notice.
Therefore, they are also regarded as quick assets. Marketable
investments, if can be converted into cash, fall into the category of
quick assets. Inventory does not fall in this category of quick
assets, since it cannot be converted into cash quickly, as material
is to be converted into saleble goods and then they should be sold.
If sale is on credit, there is a further delay in realization.
Expenses paid in advance do not satisfy the criteria of quick
assets. They cannot be converted into cash. They can be received
in the form of services.

Quick Assets = Current Assets – Inventory – Prepayments

 28

Valuation of Quick Assets :

Quick assets, as we have seen earlier, include cash and

other assets that are quickly converted into cash. Quick assets
are current assets less inventories and prepaid expenses.

The quick assets are realized in cash in a very short time.

Some of the quick assets may be already in realized form as cash
and bank balance. As such, the quick assets should be shown at
their realizable value. For Example, Debtors and Bills Receivable
are shown less any provision for doubtful debts.

In order to arrive at a conservative valuation of these assets,

when there are any chances of bad debts or losses in their
realization, a provision has to be made to take care of the same
and the provision should be shown by way of deduction from the
respective asset.

Sometimes, it is possible that the realizable value of certain

quick assets, like marketable investments, may be more than their
cost. Under those circumstances, keeping in line with the
convention of conservatism, the investments should be valued at
cost or market value whichever is lower. However, it is in
agreement with the convention of disclosure, that a note should be
provided showing their market value. An illustrative extract of
Balance Sheet is provided below :

Balance Sheet as at_______

Assets Rs.
Investments (at cost) 5,00,000
(Market value Rs.7,50,000/-)

If the market value of the marketable securities is lower than

the cost, a provision be made to take care of the loss.

Nature of Current Assets :

1. Cash on hand :
‗Cash‘ in the balance sheet includes coins, currency,
cheques, pay orders, money on deposit in banks, postage stamps,
stamp papers, etc.

2. Bank balances :

As per the requirements of Indian Companies Act, 1956,

bank balance has to be disclosed in the balance sheet as under :
 29

Bank Balances:
a) With scheduled banks.
b) With others.

Information has to be disclosed about the balances with

scheduled banks on Current Accounts, Call Accounts and Deposit
Accounts. In the case of non-scheduled banks, the names of the
bankers, the balances lying with each such banker on Current
Accounts, Call Accounts and Deposit Accounts and the maximum
amount outstanding at any time during the year from each banker,
and the nature of interest of any director or his relative of the
company in each of them have to be disclosed.

The Act has not made any distinction between nationalized

and non- nationalized banks. All nationalized banks are scheduled
banks. Scheduled banks are those banks whose names appear in
the schedule released by the Reserve Bank of India.

3. Sundry Debtors :

The ability to ―buy now and pay later‖ is an accepted fact in

business. Selling ―on account‖ is one of the ways of attracting
customers. This creates debtors or accounts receivable. The total
amount receivable from debtors should be shown under this
heading. The provision for doubtful debts should be deducted from
debtors in the balance sheet. Debtors should be classified into two
categories as debtors due for more than six months and debtors
less than six months. Debtors should also be classified according
to their nature and reliability.

Debts due by directors or other officers of the Company or

any of them , either severally or jointly with any other person, or
debts due by firms or private companies respectively, in which any
director is a partner is to be separately stated. Debts due from
other companies under the same management have to be
disclosed with the names of the companies.

The maximum amount due by directors or other officers of

the company, at any time, during the year, to be shown by way of a
note.

Debtors appear in the balance sheet as under :

 30

Illustration 8 :
Balance Sheet as at _____

Rs. Rs.
Considered Good :
Over six months – Unsecured 28,000
Others :
Secured 18,00,000
Unsecured 6,00,000
Considered Doubtful : 2,00,000
26,28,000
Less : Provision for Doubtful Debts 2,00,000 24,28,000

Inventories or Stock-in-Trade :
Definition and Meaning :
In simple words, inventory may be defined as the aggregate
of all those items of materials and goods which are held for sale, or
for production or for processing. Inventory also includes the goods
sent on consignment and remaining with the consignee, goods-in-
transit, goods sent on sale or return basis and unapproved
(reduced to cost), etc. If there are any damaged or obsolete items,
they should be excluded from the stock or adequate provision
should be made for the same. Stock should be valued at their cost
or realizable value whichever is lower. Inventory includes the
following :
a) Raw Materials,
b) Work-in-progress,
c) Consumable stores,
d) Finished Goods and Merchandise,
e) Stores and spare parts,
f) Loose tools.
Impact of Inventory on Financial Statements :
Impact on Balance Sheet : Inventory values have direct impact on
current assets and the financial position of the concern. Balance
Sheet and the result of operations reflected by Profit and Loss
Account will not be true and fair, if inventory is overvalued, since
this will lead to over statement of profits. The overstatement of
profit in the Profit and Loss Account liability side of balance sheet
will be overstated. Under-valuation of inventory leads to
understatement of profit.
 31

Impact on Income Statement : Valuation of Inventory will affect

the cost of goods sold.
Cost goods sold is computed as under :

Goods available for Sale = Opening Inventory + Purchase

during the period – Returns
Cost of Goods Sold = Goods available for Sale – Closing
Inventory

Cost of goods sold has direct impact on net income. If

closing inventory is over-stated, cost of goods sold will be under-
stated and income will be over-stated. If the closing inventory is
understated, cost of goods sold will be over-stated and net income
will be under-stated.
If opening inventory is over-stated, cost of goods sold will be
over-stated, and income will be under-stated. If opening inventory
is under-stated, cost of goods sold will be under-stated and income
will be over-stated. Thus under-valuation or over-valuation of
stocks will invariably affect profit or loss and therefore, the Profit
and Loss account will not be true, fair and objective.

Valuation of Inventory :
The above paragraph shows clearly that the value of
inventory has strong influence on financial statements. Therefore,
inventory should be properly valued. The generally accepted
principle of valuation of inventory is “cost or market price
whichever is lower”. This principle is based on the convention of
conservatism. Cost of inventory may be computed under FIFO or
average cost methods.
In financial statements, the method of valuation of inventory
should be disclosed.

Illustration 9 :
Stocks, stores & spare parts : (As Valued & Certified by
the Management)

2009 (Rs)
a) Stores and Spares (at Cost) 13,00,000
b) Stock in Trade :
i) Finished Goods
(at cost or Estimated Realisable Value, whichever is
lower) 10,00,000
ii) Saleable Waste (at Estimated Realisable Value) 2,00,000
c) Raw materials (at Cost) 50,00,000
 32

Floating Assets :

„Floating Assets‟ are those current assets which are

produced or purchased and held in possession with a view to
convert them into cash in the normal course of business. They
are called ―floating assets‖ because their balances keep on
changing. They do not remain same or fixed.

Example : Stock in trade, raw materials, semi finished goods or

work-in-progress, sundry debtors, bills receivable etc.

Hidden Assets :

There are cases, where certain valuable assets are not

disclosed in the Balance Sheet, though they exist and the business
benefits from them. These assets are termed as „Hidden Assets‟.
They may consist of assts which through continue to exist
physically either written off completely – (charged to revenue) in
the year of acquisition or subsequently and therefore do not appear
in the balance sheet.

They may consist of assets which are generated or created

over the period of time for which no specific acquisition cost is
incurred like in the case of goodwill generated by running business.
The examples of such hidden assets are :

a) Machinery in respect which depreciation is allowed to be

claimed for @ 100% in the year in which it is put to use.
b) Scientific Research assets, which are also allowed to be
written off completely under the income Tax Act, in the year in
which they are put to use.
c) Technical know-how, built up by expenditure on research and
development over the years. Normally, R & D expenditure are
charged to revenue.
d) The value of secret processes or formulae developed.
e) Options of lease.
f) Cost of licences obtained which are charged against revenue.
g) Copyrights.
h) Exclusive trading agreements.
i) Patents, trade marks and brand names.
j) Goodwill created.

It is considered normally to be advantageous to have hidden

assets since these assets act as shock- absorbers during periods
of adversity. It is no doubt that the position of the business entity is
 33

strengthened by these hidden assets, but one should not overlook

the fact that what is reflected in the Balance Sheet is not the real
financial strength of the organization.

4. Loans and Advances :

Loans and advances given are current assets. It includes

different types of advances such as advances against salary,
advances against machinery, advances to subsidiary, prepaid
expenses on account of rent, taxes, insurance, etc.
The item, ―Current Assets, Loans and Advances‖ is divided into
two parts :
A. Current Assets, and
B. Loans and Advances.

This may appear as under :

Illustration 10 :

Balance Sheet as at 31st March, 2009

Assets Rs. Rs.

Loans and Advances :
(Unsecured and Considered Good)
Advances recoverable in cash or kind or for
value to be received :
Suppliers 10,00,000
Others 2,00,000
Duty Drawback Recoverable 1,00,000
Deposits 2,00,000
Prepaid Expenses 50,000
Tax deducted at Source 50,000
16,00,000

5. Fictitious Assets :

Fictitious Assets are really not assets but debit balances not
charged to revenue. These assets cannot be realized or
converted into cash. Hey are only expenses incurred (debit
items) shown on the assets side of the Balance Sheet. The reason
behind such a procedure is that these expenditures could not be
suitably charged to the profit and loss account of the year in which
they were incurred.

Fictitious Assets are not real and are shown in the balance
sheet of a company under ―Miscellaneous Expenditure‖ (to the
extent not written off or adjusted) on the Assets side.
 34

The examples of fictitious assets are :

a) Preliminary expenses.
b) Brokerage on issue of shares and debentures.
c) Discount on issue of shares and debentures.
d) Share or debenture issue expenses.
e) Heavy Advertisement and Publicity expenditure.

6. Miscellaneous Expenditure :

As we have seen earlier under Fictitious Assets,

Miscellaneous Expenditure includes items which satisfy the
condition of an asset but do not fit into the concept of fixed assets,
investments or current assets. This category includes :

a) Preliminary Expenses,
b) Commission and Brokerage on issue of shares,
c) Discount on issue of shares, and
d) Development expenditure not adjusted.
e) Interest paid out of capital during construction.

These expenses are to be shown in the balance sheet to the

extent to which they are not written off. If any of these expenditures
is written off, it is charged to the Profit and Loss Account of that
year.

Profit & Loss Account : debit balance (to the extend not
adjusted) :

The debit balance of Profit and loss Account after deduction

from uncommitted reserves, i.e., free reserves, if any, should be
shown separately.

Liquidity of Assets :

Liquidity means easy convertibility into cash. Though

ultimately all assets are converted into cash, the term liquidity
refers not only to the nature of assets but also to the purposes of
holding the assets.

Thus, fixed assets which are not meant for re-sale with a
view to make profit-unlike stock of finished goods are less liquid;
Current assets are more liquid, as they are converted into cash
within a very short time.

Assets are normally arranged in order of permanency i.e.,

from least liquid to most liquid.
 35

But, sole traders normally prefer to arrange their assets in

the order of liquidity i.e., from most liquid to least liquid.

1.8.3 Liabilities :

The term ‗liability‘ when used in accounting, means a debt.

A debt is something that a person or an organization owes to
another person or organization. A liability is recognised when a
legally binding obligation is created.

In other words, Liabilities are the claims of outsiders

against the business. It may also be said that liabilities are
various amounts that a business owes to outsiders other than the
owners. As we have discussed in the first chapter, the business is
a separate entity from the proprietors. From this point of view, the
funds belongings to the proprietors are also a liability to the
business; hence, capital appears on the liabilities side of the
Balance Sheet. But the dues to the proprietors will be paid after all
other external liabilities are paid off.

Technically speaking, all liabilities shown in a balance sheet

are claims against all assets shown in it. But, there may be certain
cases where a liability has a claim against a specific asset. Even
under such circumstances, the liabilities are shown separately, not
as a deduction from the specific assets.

Example: if machinery worth Rs.50,000/- is purchased on

cash payment of Rs.35,000/- and the balance to be paid at a later
date, the balance sheet would show Rs.50,000/- against machinery
on the assets side and liability of Rs.15,000/- on the liability side.

The balance sheet would not show Rs.15,000/- the

difference between Rs.50,000/- the value of the asset and
Rs.35,000/- the cash payment.

Similarly, when 12% mortgage Debentures of

Rs.50,00,000/- are issued against the security of Land and
Buildings worth Rs.1 Crore, the Debentures will appear on the
liabilities side of the balance sheet at Rs.50 Lakhs and Land and
Building at Rs.1 Crore on the assets side.

a) Debts and obligations.

b) Estimates of future debts arising out of past dealings.
c) Adjustments to the estimated of future liability for taxes
required to apportion actual tax demands over the periods for
which taxes are due.
d) The constituents of owners‘ equity.
 36

Classification of Liabilities :

The liabilities of an enterprise may be classified into three

categories

a) Permanent Funds or Proprietors‘ Funds.

b) Semi-permanent Funds or Long-term Borrowings.
c) Current liabilities and Provisions.

A specimen of the liabilities side of a balance sheet is

shown below, for a clear understanding of the above classification.

Illustration 11:
AB Ltd.
Balance Sheet as at 31st December, 2009

Liabilities Rs. Assets Rs.

Proprietors‘ Funds : Sundry Assets 1,30,000
Share Capital 50,000
Reserves 15,000 65,000
Long term loans :
15% Debentures 30,000
12% Bank Loan 10,000 40,000
Current Liabilities &
Provisions:
Bank O/d 5,000
Creditors 12,000
Provision for Tax 8,000 25,000

1,30,000 1,30,000

Let us now discuss the liabilities side in detail.

1.8.4 Proprietor‟s Funds :

These are the funds provided by the proprietors or the

shareholders.

In case of a sole trading concern, the sole trader is the

single proprietor of the business. In case of partnership firms,
partners are the proprietors and in case of companies, the
shareholders are the proprietors. Proprietors‘ fund represents the
interest of the proprietors in the business. This is the amount
belonging to the proprietors. Proprietors‘ fund is also called as
‗Proprietors‘ Equity‘, ‗Owners‘ Funds‘, ‗Owners‘ Equity‘, or
 37

‗Shareholders‘ Funds‘. This is also known as the ‗Net Worth‘ of the

business. Owners‘ Equity refers to the claim of the owners and it is
made up of:

Contributions by the proprietors by way of :

Share Capital
(May be Equity Share Capital only or Equity and Preference
Share Capital)
Plus : Reserves
Plus : Profit and Loss Account (Cr.) Balance (Surplus)
Less : Accumulated Losses
Less : Fictitious Assets (If any)

Proprietors‘ Funds are regarded as shock absorbers. Any

reduction in the value of assets of the company is absorbed by
proprietors‘ funds. They provide the ‗margin of safety‘ to the
creditors. So long as the reduction in assets does not exceed
proprietors‘ funds, creditors have no problem as they can expect
full payment of their dues.

Owners‘ equity or proprietors‘ funds increase either through

fresh investments by the owners or by an increase in the earnings
retained i.e., profits not distributed.

Retained earnings is the difference between the total

earnings to date and the total cash appropriations (dividends, etc,)
to date. In other words, retained earnings is that part of the total
earnings which have been retained for use in the business.

Decrease in owners‘ equity is caused either by withdrawals

of cash or assets by the owners or through losses suffered by the
business from unprofitable activities.

The presentation of proprietors‘ funds in balance sheet

depends on the type of business organization and statutory
requirements. This can be illustrated as under :

1.8.5 Share Capital :

Share capital is the amount that is raised by a company

from the public at large, through the issue of shares.

There are different concepts of share capital from the legal

and accounting points of view.
 38

The following chart details the different concepts of capital :

Company‟s Share Capital

Authorised Capital
(Registered or Nominal Capital)

1. Issued Capital + 2. Unissued Capital

1. Subscribed Capital + 2. Unsubscribed Capital

1. Called up Capital + 2. Uncalled Capital + 3. Reserve Capital

1. Paid up Capital + Calls-in-Arrears or Calls Unpaid

A. Authorised Capital :

Authorised Capital is the maximum capital a company can

raise as mentioned in the Memorandum of Association under its
Capital Clause. It is also called as the Registered Capital or
Nominal Capital of the Company.

B. Issued and Unissued Capital :

A company usually does not need the entire registered

capital. The capital may be raised as and when necessary. Only a
part of the authorised capital may be issued at a time. Issued
capital is that part of the authorised capital; which is actually
offered to the prospective investors for subscription. Therefore, the
issued capital may be equal to or less than the authorised capital.
The balance of the authorised capital which is not issued is called
the ‗unissued capital.‘

Some authors prefer to define issued capital as ‗the nominal

amount of that part of authorised capital which is allotted by the
company and includes the shares taken up by the subscribers to
 39

the Memorandum of Association. This definition is to keep in line

with schedule VI part I of the Indian Companies Act, 1956.

C. Subscribed Capital :

The issued capital may not be fully subscribed by the public.

Subscribed capital is that part of the issued capital which has
been subscribed or taken up by the public i.e., aggregate
nominal value of the shares for which applications are received
from the public. Therefore, the subscribed capital may be equal to
or less than the issued capital.

D. Called up Capital Uncalled Capital :

The company may not need the entire capital subscribed by

the public. The company, therefore, may collect the capital in
several installments. The called-up capital is that portion of the
subscribed capital which has been called or demanded by the
company to be paid. The capital that is not demanded from the
shareholders is called uncalled capital.

E. Paid up Capital :

Paid up capital is that part of the called up capital which has

been actually paid by the members. The paid-up capital is the
called-up amount less calls not paid. (calls unpaid or calls-in-
arrears).

F. Reserve Capital :

A company may determine by a special Resolution that any

portion of its subscribed capital shall not be called up except in
the event of and for the purpose of the company being wound up.
Such portion of the subscribed capital not to be called except for
the said purpose is known as ―Reserve Capital‖. It is that part of
the uncalled capital which may only be demanded on winding up or
liquidation, but not when the company is a going concern.

―Reserve Capital‖ is different from ―Capital reserve‖,

―reserves‖ and ―reserve funds,‖ which are profits of a company set
aside or provided for emergencies or to be utilized for a particular
purpose.
 40

Y Ltd.
Balance Sheet as at 31st December, 2009

Rs.
Share Capital :
Authorised :
45,00,000 Equity Shares of Rs.10/- each. 4,50,00,000
1,50,000 Preference Shares of Rs.100/- each. 1,50,00,000
6,00,00,000
Issued :
37,00,000 Equity Shares of Rs.10/- each. 3,70,00,000
40,000 9.5% Redeemable Cumulative Preference
Shares of Rs.100/- each. 40,00,000
4,10,00,000
Subscribed :
37,00,000 Equity Shares of Rs.10/- each fully called up. 3,70,00,00
(of the above 10,000 Equity Shares of Rs.10/- each
allotted as fully paid up in pursuant to a contract to
vendors of machinery, for consideration other than cash)
40,000, 9.5% Redeemable Cumulative Preference
Shares of Rs.100/- each fully called. 40,00,000
4,10,00,000
Less: Calls unpaid – (Other than Directors) 15,000

4,09,85,000

Note : If any amount is due from Directors remaining unpaid in

respect of calls, it must be indicated separately.

1.8.6 Reserves and Surplus :

A business may have to meet certain unforeseen obligations

in future. These obligations may be compulsory or voluntary,
foreseen or unforeseen, recurring or non-recurring. Whatever may
be the nature of these obligations, it is desirable that the
organization makes provision in advance to meet them. If no
arrangements are made to meet these obligations, sudden
payment may adversely affect the financial health of the company.
This may create a drain on financial resources of the company. In
order to avoid such a reserve is also termed as ‗Retained Earnings‘
or ‗Plough Back‘ profits. Indian Companies Act requires every
company to transfer a specific percentage (upto 10%) of the profits
to ―Reserve‖ accounts.
According to Companies Act ―Reserve shall not ….include
any amount written off or retained by way of providing for
 41

depreciation, renewals or diminution in value of assets or retained

by way of providing for any known liability.‖

G. Revenue Reserves or Free Reserves :

These reserves represent amounts set aside out of divisible
profits. They are appropriations of profits. Reserves may be
created for a specific purpose or for a general purpose. Reserve
created for a specific purpose is called a “specific reserve”
and a reserve created for a general purpose is called a
“general reserve.” General reserves are free and can be utilized
for :
a) Payment of Dividends.
b) Development and expansion,
c) Any other purpose the company thinks proper.

General Reserve is also called a revenue reserve or a free

reserve. A free reserve is a reserve which is available for any
purpose, including payments of dividend. It is not earmarked for
any specific purpose.

H. Capital Reserves :

Schedule VI of the Companies Act does not really define the

term ―Capital Reserve‖. It states that it shall not include any amount
regarded as free for distribution through the Profit and Loss
Account. The term ‗capital reserve‘ is used to describe reserves
which cannot legally be distributed as dividends e.g., share
premium, capital redemption reserve account, etc.

Capital reserve is created out of capital profits which do not

arise in the normal course of business. the following reserves are
capital reserves :
a) Profits profit to incorporation
b) Profit on redemption of preference shares,
c) Profit on redemption of debentures,
d) Securities premium,
e) Profit on forfeiture of shares,
f) Profit on sales of fixed assets,
g) Profit on revaluation of fixed assets,
h) Capital redemption of fixed assets,
 42

Capital Reserves are not available for distribution as

dividends; but they can be utilized for :

a) Writing off intangible assets

b) Writing off preliminary expenses
c) Writing of losses on issue of shares and debenture
d) Issue of bonus shares
e) Adjusting the premium payable on redemption of debenture
f) Writing off losses on sales or revaluation of fixed assets.

According to Companies Act 1956 ‗‘the expression ‗Capital

Reserve‘ shall not include any amount regarded as free for
distribution through the Profit and loss account; and the expression
revenue reserve shall mean any reserve other than a Capital
Reserve‖.

However, it may be noted that the profit on revaluation of

fixed assets should not be utilized for issue of Bonus Shares;
it must be shown separately, say, as ―Revaluation Reserve‖.

I. Contingency Reserves :

Contingency is an unexpected event of adverse nature. In

business, such contingencies are not uncommon. A few of them
are quoted below :

a) Decline in inventory values.

b) Loss on purchase contracts.
c) Devaluation of currency.
d) Issue of bonus shares,
e) Adjusting the premium payable on redemption of debentures,
f) Writing off losses on sale or revaluation of fixed assets.

According to Companies Act 1956 ―the expression ‗Capital

Reserve‘ shall not include any amount regarded as free for
distribution through the Profit and Loss Account; and the
expression ‗revenue reserve‘ shall mean any reserve other than a
Capital Reserve.‖

A business concern must provide for such probable losses.

A reserve which is created to meet the above contingencies is a
contingency reserve. Contingency reserve is not charged to Profit
& Loss Account. It is created by debiting profit and loss
appropriation account and appears in the Balance Sheet on the
liability side under the head ‗Reserves and Surplus‘.
 43

J. Secret Reserves :

Secret reserves are those reserves which exist but are not
disclosed in the balance sheet. They are not created either by
debiting Profits and Loss Account or Profit and Loss Appropriation
account. Such reserves are created as a result of certain
manipulations and adjustments.

For example:

a) Charging higher rate of depreciation than normal.

b) Charging capital expenditure as revenue expenditure.
c) Under-valuation of inventory and other assets.
d) Creating more provision than is necessary against current
liabilities.

Such reserves are built in the financial system. They can be

located only by a close scrutiny of the financial statements and not
otherwise.

Secret Reserve is a double-edged sword, as it may be used

to improve the financial position or may be misused by the
management for manipulation.

Disclosure of Reserves in Balance Sheet :

Under each individual head of the reserves, the balance as

per last balance sheet, additions thereto and deductions there from
should be clearly stated.

The word ―Funds‖ in relation to any ―Reserve‖ should be

used only where such reserve is specifically represented by
earmarked investments.

In case of securities premium, details of its utilization should

be shown in the year of utilization.

Under the head ‗Surplus‘, the balance of Profit Loss

Account, after making all appropriations, should be shown.

Debit balance of profit and Loss Account should be shown

by way of deduction from uncommitted reserves, if any.

1.8.7 Long-term Liabilities :

As we have seen already, a company raises finance either

from owners or through external borrowings. External borrowings
of a company which constitute its ―owed funds‖ are important
 44

sources of long-term finance. These borrowings are termed as

‗fixed liabilities‘ or ‗term liabilities‘ or ‗long term-loans‘. They may
take various forms such as debentures, public deposits, bank
loans, deferred payments, etc. they may be fully secured or partly
secured or unsecured.

Technically, a long-term liability can be defined as ―a liability

falling due on a date later than the expiration of one whole
accounting period‖.

A. Secured loans :

It refers to loans which are secured by a fixed or floating

charge on the assets of the business. It includes :

a) Debunkers,
b) Loan and advance from banks,
c) Loan and advance from subsidiaries and
d) Other loan and advances.

The natures of securities should be specified in each case.

The interest accrued and due on secured loan should be include
under the appropriate subheads under the head ‗secured loan‘ but
the interest accrued and not due on secured loans is required to be
shown under ‗current liabilities‘. Loans from directors, securities,
treasurers and mangers should be shown under this head, if such
loans are guaranteed. In respect of debentures, the terms of
redemptions or conversion should be stated. The particulars of any
redeemed debentures which the company has power to reissue
should be stated by way of note.

B. Unsecured loans :

It refers to the loans which are not secured by assets of the

business. It is not covered by any security. It includes :

a) A fixed deposits,
b) Loans and advance from subsidiaries,
c) Short-term loan and advances:
i) from banks, ii) from other,
d) Other loans and advance : loan from directors, secretaries,
treasurers and managers should be shown separately.

Loan Fund = Secured loans + unsecured loans

 45

1.8.8 Distinction between Own Fund and owed Fund :

Own Fund Owed Fund

1. Nature It is an internal source of It is an external source of
finance. finance.
2. Claimant It is a claim of owners. It is a claim of outsiders.
3. Income It earns dividend. It earns interest.
4. Stability of Income is not stable. It is stable.
Income
5. Tenure It is a permanent fund. It is semi-permanent fund.
6. Refund on It is refunded last. It is refunded before own
liquidation fund.
7. Security

The following illustration will make it clear as to how secured

and unsecured loans should be shown in the Balance Sheet.

Illustration 13:
R.K. Ltd.
Balance Sheet as at 31st March, 2009 (Extract)

Liabilities Rs. Rs.

Secured Loans :
15% Debentures (Secured against Plant and 2,00,000
Machinery)
Bank Loan (Secured against Stock-in-trade) 1,00,000
Other loans 50,000
Interest Accrued and Due on Secured Loans 10,000 3,60,000

Unsecured Loans:
Public Deposits 50,000
From Banks 40,000
Other Loans and Advances 20,000
Interest Accrued and Due on Unsecured Loans 5,000 1,15,000

1.8.8 Current Liabilities and Provisions :

A. Current Liabilities :

Current liabilities are those short-term obligations of an

enterprise which mature within one year or within the
operating cycle. They constitute short-term sources of finance.
Current liabilities arise in the regular current operations of the
business.
 46

They are as follows :

i) Sundry Creditors – when goods are purchased
ii) Bills Payable – by acceptance of bills drawn by creditor –
Accounts payable
iii) Interest accrued but not due
iv) Wages and salaries payable – outstanding expenses.
vi) Unclaimed dividends.
vii) Bank Overdraft.

These liabilities are not normally secured and no interest is

payable on them with the exception of bank overdrafts. But,
interest may be charged when payment of these liabilities becomes
overdue. These liabilities, are generally paid off by utilizing
current assets or by creating a current liability.

The Accounting Principles Board of the American Institute of

Certified Public Accountants gives a more detailed definition, as
follows :

―The term current liability is used principally to designate

obligations whose liquidation is reasonably expected to require the
use of existing resources properly classifiable as current assets, or
the creation of other current liabilities. As a balance sheet
category, the classification is intended to include obligations for
items which have entered into the operating cycle, such as
payables incurred in the acquisition of materials, and supplies to be
used in the production of goods or in providing services to be
offered for sale, collections received in advance of the delivery of
goods or in providing services to be offered for sale, collections
received in advance of the delivery of goods or performance of
services, and debts which from operations, directly related to the
operating cycle, such as accruals for wages, salaries,
commissions, rentals, royalties and income and other taxes. Other
liabilities whose regular ordinary liquidation is expected to occur
within a relatively short period of time, usually 12 months, are also
intended for inclusion, such as short-term debts arising from the
acquisition of capital assets, serial maturities of long-term
obligations, amounts required to be expended within one year
under sinking fund provisions, and agency obligations arising from
collection or acceptance of cash or other assets for the account of
third persons‖.

It is thus clear from the above definition that current liabilities

are those liabilities that are to be settled within one year either from
current assets or by creating current liabilities.
 47

B. Provisions :
„Provision‟ means any amount retained by way of
providing for any known liability of which the amount cannot
be determined with substantial accuracy. They are at best
estimates. Provisions have to be made for maintaining the integrity
of assets or for known liabilities. Although the amount of liability is
not certain it has to be provided for, on best estimates. The
examples of provisions are as under :
a) Provision for depreciation on assets.
b) Provision for doubtful debts.
c) Provision for proposed dividends.
d) Provision for taxation.
Provisions relating to specific assets are shown as
deduction from the specific assets.

C. Quick Liabilities :
These are the current liabilities which mature within a
very short period of time. Actually all current liabilities are
payable within a short period of time. However, there are certain
current liabilities such as ‗Bank Overdraft‘ which are not payable
immediately or in a very short-time, in practice. Therefore, Bank
Overdraft is not considered as a quick liability. It is a
permanent arrangement with the banker.
Hence, all quick liabilities are current liabilities but all
current liabilities are not quick liabilities.

Quick Liabilities = Current Liabilities – Bank Overdraft

1.8.9 Contingent Liabilities :

According to ICAI, Contingent liability refers to an obligation
relating to an existing condition or situation which may arise in
future depending on the occurrence or non-occurrence of one or
more uncertain future events. These liabilities may or may not be
converted into actual liabilities at some future date. It is a liability
which may or may not occur. But on the date of the Balance Sheet,
it is not known definitely whether the liability would arise or not. But
as a matter of caution, it is indicated in the balance sheet for the
sake of information and disclosure, under the head ―Contingent
Liabilities.‖ This amount is not included in the Balance Sheet
figures but shown outside as it is not recorded in the accounts. It is
shown as a footnote to the Balance Sheet. The amount of a
contingent liability may or may not be known on the date of the
balance sheet. The following are some of the examples of
Contingent Liabilities :
 48

a) Discounted Bills of Exchange.

b) Disputed liability on account of income-tax, etc., about which
appeal has been filed.
c) Uncalled amount on partly paid-up shares and debentures held
by the company as investments.
d) Cumulative preference dividend in arrears.
e) Matters referred to arbitration.
f) Claims not acknowledged as debts.
g) Estimated amount of contracts remaining to be executed on
capital account and not provided for.
h) Guarantees given by the company.
i) Bonds executed.

There are two types of contingent liabilities. Certain

liabilities, which when paid create an asset of corresponding value.

For example, when a liability on account of construction

work arises and is paid off, it results in the increased value of
assets.

Certain other liabilities, when paid off, do not create or

increase the value of assets but on the contrary will result in the
decrease of assets and cause decrease or increase in revenue
expenditure.

For example: When the labour court orders to increase wages

retrospectively, the discharge of this liability will result in decrease
of current assets i.e., cash and increase expenses on wages.

1.9 EXERCISE

1. Discuss the nature of Financial Statement what are the

limitation of such statement?
2. Define financial statement analysis. Explain in what ways
such an analysis may benefit managerial personal, owners,
and creditor.
3. Distinguish between horizontal and vertical analysis of
financial statement data.
 49

Illustration:

Balance Sheet as on 30th September, 2009

Liabilities Rs. Assets Rs.

Paid-up Share Capital 4,75,000 Factory Premises 2,25,000
Capital Redemption Reserve 32,500 Plant & Machinery 1,74,586
Profits & Loss A/c 12,929 Motor Car 35,520
Sundry Creditors 25,515 Stock 52,320
Outstanding Wages 6,415 Debtors 45,790
Provision for Taxation 8,950 Cash 16,595
Taxes paid in Advance 3,998
Preliminary Expenses 7,500

5,61,309 5,61,309

Re-arrange the above balance sheet in the form suitable for

analysis and calculate the following :

a) Total Funds employed,

b) Proprietors‘ Funds,
c) Long-term Liabilities,
d) Current Liabilities.



TOOLS OF ANALYSIS OF FINANCIAL

STATEMENTS

Unit Structure:
 50

2.0 Objectives
2.1 Introduction
2.2 Analysis of the Financial Statements
2.3 Trend Ration and Trend Analysis
2.4 Comparative Statement
2.5 Common-size Statement
2.6 Exercise

2.0 OBJECTIVES

After studying the unit the students will be able to:

Explain the meaning of financial statement analysis.
Know the meaning and utility of Trend analysis.
Understand the meaning of Comparative and Common Size
Statements
Prepare the Comparative and Common Size Statements from
the given information.

2.1 INTRODUCTION

Financial statements are the result of the accounting process

which begins with recording of transaction. Accounting process
involves recording, classifying and summarizing business
transaction. Financial Statement relate to the third process Viz.
summarising. The financial statements are based on certain
accounting conventions which cannot be said to be fool proof.

Various techniques have been developed for the analysis of

financial statement the selection of appropriate analytical technique
would depend upon the objective of the analysis. Usually group of
technique is used for a result oriented analysis. The commonly
used techniques are Comparative financial statement, Common
trend analysis, Ratio analysis and Fund and Cash flow statement.
Any financial statement that reports the comparison of dada of two
or more consecutive accounting periods is known as comparative
financial statement.

2.2 ANALYSIS OF THE FINANCIAL STATEMENTS

Financial statement analysis is defined as the process of

identifying financial strengths and weaknesses of the firm by
properly establishing relationship between the items of the balance
sheet and the profit and loss account.
 51

There are various methods or techniques that are used in

analyzing financial statements, such as comparative statements,
schedule of changes in working capital, common size percentages,
funds analysis, trend analysis, and ratios analysis.

Financial statements are prepared to meet external reporting

obligations and also for decision making purposes. They play a
dominant role in setting the framework of managerial decisions.
Following are the limitations of Financial Statements:

2.2.1 Limitation of Financial statement :

Following are the limitations of financial statements:

1. The information being of historical nature does not reflect the
future.
2. It is the outcome of accounting concept, convention combined
with personal judgement.
3. The statement portrays the position in monetary term. The profit
or loss position excludes from their purview things which cannot
be expressed or recorded in term of money.

As the information provided in the financial statements is not

an end in itself as no meaningful conclusions can be drawn from
these statements alone. However, the information provided in the
financial statements is of immense use in making decisions through
analysis and interpretation of financial statements. To overcome
from the limitations it becomes necessary to analyse the financial
statements. The analytical tools generally available to an analyst for
this purpose are:

1. Comparative financial and operating Statements

2. Common-size statement
3. Trend ration and trend analysis
4. Average Analysis
5. change in working capital
6. Fund-flow and cost-flow analysis
7. Ratio analysis

(1) Comparative Financial and Operating Statement :

Comparative financial statement are of financial position of a
business so designed as to provide time perspective to the
Consideration of various element of position embodied in such
statement The balance sheet and Income Statement I, e. Profit and
loss account are prepared in a Comparative from as the impact of
the conduct of business is brought to bear on the Balance Sheet,
Comparative statement are made to show –
 52

1. Absolute date (money values or rupee amount).

2. Increases and decreases in absolute data in term of money
values.
3. Increases or decreases in absolute data in term of percentage.
4. Comparisons expressed in ration.
5. Percentage of total.

Comparative financial statement are very useful to the

analyst as they Provide information necessary for the study of
financial and operating trend over a period of years They indicate
the duration of the movement With respect of the financial position
and operating results Financial data become more meaningful
When compared with similar data for a previous period or a number
of prior periods such statement are very helpful in measuring the
effect of the conduct of a business during the period under
Consideration The comparative profit and loss account Will present
a review of operating activities of the business The comparative
balance sheet shows the effect of operations on the assets and
liability I, e change in the financial position during the period under
consideration.

Comparisons loss their significant and tend to become

misleading if the date being compared do not reflect the consistent
application of generally accepted accounting principles from date to
date or period to period The absence of the comparability of
statement should be indicated in the footnotes that accompany the
financial statement as well as in the accounts report In the
preparation of comparative financial statement uniformity is
essential Care must be taken to see that all account heads or group
of these like administrative expenses; fixed assets; current assets;
long term fund‘ short term fund etc have the same connotation
Otherwise; comparison will be vitiated.

(2) Common size Statement :

Comparative statement that give only the vertical percentage
or ration for financial data without giving rupee value are known as
common size statement A comparison of two years figures of a
concern can be easily made under the companies Act Companies
must Show in their profit and loss account and balance sheet the
corresponding figures for the previous year. Sometime, however,
the figures do not signify anything as the heads of items are
regrouped and are in comparable; they should precisely have the
some meaning from one year to another.
 53

It is better to work out the ratio of various items to sales in

term of percentage and enter these also in the statement As
common size statement are most valuable in marketing
Comparisons between the companies in the some industry. A
common size statement shows the relation of each component to
the whole. It is useful in vertical financial analysis and comparison
of two business enterprises at a certain date.

(3) Trend Analysis :

The analysis is an important and useful technique of analysis
and interpretation of financial statement under the technique the
ration of different items for various periods are calculate for the
company over a definite period of time say three to five years and
then we can analysis trend highlighted by this ratio Trend analysis
can be done in three following way.

(i) Trend percentage,

(ii) Trend ratio,
(iii) Graphic and diagrammatic representation.

In the statement the percentage column are more relevant

than the figure.

Utility of Trend Analysis :

a) It is a simple technique. it does not involve tedious calculation
and required trained experts
b) It is brief method to indicate the future trend
c) It is reduces the chances of errors as it provides the opportunity
to compare the percentage with absolute figures

(4) Average Analysis :

It is an improment over trend analysis method. When trend
ratio have been determined these figure are compared with industry
averages These trend can be presented on the graph paper also in
the shape of curve in this from the analysis and comparation
become more comprehensive and impressive.

(5) Statement of changes in Working Capital :

To Know an increase or decrease in working capital over a
period of time, the preparation of a statement of change in Working
Capital is also very useful The statement give an accurate
summary of the events That effected the amount of working capital
The amount of net working capital as determined by deducting the
total of current liability from the total of the current assets It is a
rough estimated which may be arrived at by using balance sheet
 54

data only But it does not explain the detailed reasons for the
changes in working capital and methods of financing additional
requirement of working capital Hence the preparation of fund flow
statement becomes necessary.

(6) Funds flow and Cash flow Analysis :

The statement of sources and application of funds also
called were got were gone statement provides the missing link in
the complement of final account statement It demonstrates the
manner by which periods activities call upon and generate the
financial resources of the business unit and the resultant ebb and
flow of these resources through the temporary reservoirs of firm
assets. In the process, it high lights the changes in the financial
structure of an undertaking funds flow analysis is a valuable aid to
the financial executive and creditor For evaluating the use of funds
by the firm and determining how these uses were financed A Funds
flow statement indicates where fund come from and the here it was
used during the period under review These statement can be
prepared separately also The are important tool of communication
and are very helpful for financial executives in planning the
intermediate and long – term financing of the firm.

(7) Ratio Analysis :

An absolute figure after does not convey much meaning It is
only in the light of other information that the significance of a figure
is realized A person.‘ S weight is 80 kg. Is he fact? One can not
answer this question unless one knows Known unless together with
the amount of profit the amount of figures expressed mathematical
is called ratio The ratio between 4 and 10 is 0 4 or 40% 0 4 and
40% are ratios Accounting ratio relationships expressed in
mathematical terms between figures Which have a causes an effect
relationship or which are connected with each other in some
manner or the other Obviously no purpose will be served by
working out ratio between entirely unrelated figure such as discount
on debenture and sales Ratio may be worked out on the basis of
figure contained in the financial statement and, therefore, may be
classified as follows :
(a) Income statement ratio
(b) Position statement (balance sheet) ratio, and
(c) Inter-statement ratio

Ratio as tools for establishing true profitability and financial

position of a company may be classified as:
1. Profitability ratios.
2. Turn over ratios
 55

3. Financial ratio

To say the same thing in different word, ratios will portray the
financial position while others will portray the causes that lead to a
change in it In the net shall ratio analysis give the answer of the
following problem – whether the capital structure of the business is
in proper order, whether the profitability of the business is
satisfactory, Whether the credit policy in relation to sales and
purchases is sound and whether the company is credit worthy.

2.3 TREND RATION AND TREND ANALYSIS

This type of analysis is an important and useful technique of

analysis and interpretation of financial statement. Under this
technique the ration of different items for various periods are
calculate for the company over a definite period of time say three to
five years and then we can analysis trend highlighted by this ratio

2.3.1 Trend analysis can be done in three following way:

(i) Trend percentage,

(ii) Trend ratio,
(iii) Graphic and diagrammatic representation.

In the statement the percentage column are more relevant

than the figure.

2.3.2 Utility of Trend Analysis:

d) It is a simple technique. it does not involve tedious calculation
and required trained experts
e) It is brief method to indicate the future trend
f) It is reduces the chances of errors as it provides the opportunity
to compare the percentage with absolute figures

Trend analysis one of the important tool of analyzing the

financial data. It computes the percentage change for different
variables over a long period and then makes a comparative study
of them. The trend percentage helps the analytics to study the
changes that have occurred during the period. Such an analysis
indicates the progress of business by showing ups and downs in it
activity. The calculation of trend percentage involves the following
steps.
1) Selection of base year.
2) Assigning a weight of 100 to be value of the variable of the base
year and
 56

3) Expressing the percentage change in value of variable from

base year as shown below.

2.3.3 Following is the example of Trend analysis

Percentage
Years Sales ( + ) Increase or
( - ) Decrease
1980 20,000 100 (Base year )
1981 35,000 175
1982 28,000 140
1983 30,000 150
1984 35,000 175
1985 14,000 70
1986 22,000 110

A trend for single financial item is seldom very informative. A

comparison of trend for relative items often help to analysis in
perfect understanding of the business fact as is clear from the
below mentioned comparative balance sheet.

Comparative Balance Sheet

Trend Percentage
Assets
1986 1987 1988 ( base year – 1988 )
Rs. Rs. Rs.
1986 1987 1988

A) Current Assets
Inventory 20,000 30,000 25,000 100 150 125
Debtor 30,000 50,000 60,000 100 167 200
Cash balance 20,000 55,000 30,000 100 175 150

Total (A) 70,000 1,15,000 1,15,000 100 164 164

B) Fixed Assets
Building 250,000 300,000 3,00,000 120
100 120
Plant 1,25,000 150,000 1,60,000 128
100 120
Investment 80,000 1,00,000 1,20,000 150
100 125
Total (B)
4,55,000 5,50,000 5,80,000 100 121 127
Total Assets (A + B)
5,25,000 6,65,000 6,95,000 100 127 132

2.3.4 ILLUSTRATION:

Calculate trend percentage from the following figures of X L

td, taking 1979 as the base and interpret.
 57

Year Sales Stock Profit before tax

1979 1,881 709 321
1980 2,340 781 435
1981 2,655 816 458
1982 3,021 944 527
1983 3,768 1,154 672

Solution :
Trend percentage

Profit before
Years Sales (Rs. Stock (Rs. Profit
Tax (Rs. in Sales Stock
before in Lakhs) in Lakhs) Tax
Lakhs)
1979 1,881 709 321 100 100 100
1980 2,340 781 435 124 110 136
1981 2,655 816 458 141 115 143
1982 3,021 944 527 161 133 164
1983 3,768 1,154 672 200 162 209

Interpretation :

The study of the above given statement of Trend percentage

reveals that –

(i) The sales of the farm as continuously increased over a period of

a five year commencing from 1979. However there has been a
substantial increase in the amount of sales in the 1983 when it
increased by 39%.
(ii) The trend of Stock is also upward although the increase in this
item has been constant yet in 1983 the increased has been
exceptionally.
(iii) The Profit of the firm has increased at much higher rat in
comparison to increase in Sale and Stock during the period
under study.

The overall analysis of the financial items indicated that the

firm is doing well, and therefore, its financial position it bound to be
good.

2.3.5 Trend percentage:

A horizontal comparison of various items one by one along

with their percentage to the total can be done to know the trend of
that particular item over a period. The study of a trend will indicate
 58

the direction of movement over a long time One can gate a better
view of things unaffected by short term influences by study of long
term trend percentage. For example if the total assets of a
company growing steadily at a certain period that is the Percentage
over a long period it is increasing steadily it is definitely a good
indicator of the growth of a company. If a company is suffering
losses uniformly over a long period it is not a good indicator of the
operation position of the company. See celebration of a statement
showing trend percentage on the next page.

In the statement the percentage columns are more relevant

that the figures. A horizontal corporation over the reveals the
following significant point.

2. Sales volume has been steadily rising over the 10.year period
except a small setback in 1979.
3. The percentage of goods consumed has rising over the 10 year
period from 34.93 of sales to 42.43 A rise of nearly 25% the
rise in staff cost over the 10 year period is nearly 40% from
`17.66% of Sales to 24.28%. Similarly, there has been a
substantial rise in other expenses from 13.60% to 18.93 of
sales. All costs have been rising excepting a small decline in
depreciation content.
4. The consequence of the rise in all cost components is the
decline in the profit margin. The operating income has declined
from 27.35% in 1971 gradually to 7.33% in 1980.

In absolute figure through the sales have increased to 2.73

time over a 10 year period, the operating income has declined from
Rs.728 Lakhs to Rs.518 Lakhs. However, the after tax profit has
increased from Rs.288 Lakhs to Rs.348 Lakhs mainly as a
consequence of other sources of other income of and taxation
burden. The analysis shows the profitability of a sound and well
managed company.

2.4 COMPARATIVE STATEMENT

The comparative statements are important tool of horizontal

financial analysis. Financial data become more meaningful when
compared with similar data for previous period or a number of
previous periods. Such analysis helps as in forming an opinion
regarding the progress of the enterprise.

2.4.1 Comparative statements definition:

Foulke has defined these statement as ―statement of
financial position of business so designed as to provide time
perspective to the consideration of various elements of financial
 59

position embodied in such statement.‘‘ In any comparative

statement columns for more than one year‘s position or working
can be drawn and figures may be provided. The annual date can be
compared with similar monthly or quarterly data can be compared
with similar data for the same months or quarterly of previous
years. In such statement the figure can be shown at the following
value.
a. In absolute money value
b. Increase or decrease in absolute values
c. By the way of percentages
d. By the way of common—size statement

Two comparable units can be compared regarding

profitability and financial position. The two organization may not
have the identical heads of account In order to get over the
difficulty, the data must first be property set before comparison In
the preparation of comparative financial statement, uniformity is
essential.

2.4.2 Importance of Comparative Statement:

These statements are very useful in measuring the effect of
the conduct of a business enterprise over the period under
consideration. Regardless of its financial strength at a given point
of time, the enterprises must operate successfully if it hopes to
continue as a going concern. The income statement measures the
effects of operation. But the progress of these operations may be
viewed over number of periods by preparing the income statement
in a comparative form. Similarly the effect of operation of financial
position and the progress of a business in term of financial position
can be presented by means of a comparative balance sheet. The
accounting authorities in U. S. A. have strongly recommended and
encouraged the preparation of financial statement in the
comparative from Recognising the importance of comparative
financial date for two years, the Indian companies Act 1956 has
made this fact compulsory that in the balance sheet of a company
the figure for the previous year should also be given to facilitated
comparison. Though the balance sheet is a useful statement, the
comparative balance sheet is even more useful for the it contains
not only the data of a single balance sheet but also for the past
years which may be useful in studying the trends.

2.4.3 Preparation of Comparative Statements:

The form of comparative balance sheet consists of two or

more columns according to the number of year we prepare the
balance sheet, for the date of original balance sheet and columns
 60

for the increases or decreases in various items. Here is a proforma

of comparative balance sheet for two years
ABC Co. Ltd.
Specimen of Comparative Balance Sheet for the ended 31st
Dec. 1980 and 1981
(Amount in Lakhs of rupees)
Increase
Dec. 31 Dec. 31 (+) /
Decrease % Rate
1980 1981 (-)
Amount
Assets :
Current Assets :
Cash 240 80 - 160 - 66 1.24
Debtors less reserve for 120 96 - 24 - 40 1.60
doubtful debts
Merchandise Inventory 260 320 + 66 + 46 2.46
Prepaid Expenses 100 80 - 20 - 40 1.60
Total Current Assets 720 656 - 64 - 18 1.82
Fixed Assets :
Land and Building less 480 720 + 240 + 100 2.0
Depreciation
Furniture &Fixture less 60 80 + 20 + 66 2.66
Depreciation
Plant and Machinery 240 480 + 240 + 200 4.00
less Depreciation
Total fixed Assets 780 1,280 + 500 + 128 2.20
Total Assets 1,500 1,936 + 436 + 58 2.58
Liabilities and Capital :
Current Liability :
Trend creditors 234 510 + 276 + 108 3.08
Accrued Expenses 400 360 - 40 - 20 1.08
Total Current liabilities 634 870 + 236 + 74 2.74
Equity Capital 400 500 + 100 + 50 2.50
Retained Earnings 466 566 + 100 + 42 2.42
Total Capital 866 1,066 + 200 + 46 2.46
Total Liabilities and 1,500 1,936 + 436 + 58 2.58
Capital

2.4.4 Preparation of a Comparative Income Statement:

An Income Statement shows the Net Profit or Net Loss from

business operation of a definite accounting period. Like a balance
 61

sheet, a comparative income statement show the operating results

for a number of accounting periods so that the changes in absolute
date from one period to another may be explained and analysis.
The Comparative income statement contains the some columns as
the comparative balance sheet and provides the same in the
figures.
Specimen of a Comparative Income Statement

ABC Co. Ltd.

Comparative Income Statement for the year ended 31st Dec.
1980 and 1981

(Amount in Lakhs of Rupees)

Dec. 31 Dec. 31 Increase (+)
/ Decrease %
1980 1981 ( - ) Amount
Net Sales 1370 1442 + 72 + .6
Less : Cost of Goods Sold 838 926 + 88 + 21.0
Gross Profit 532 516 - 16 - 6.4
Operating Expenses :
Selling Expenses 188 182 -6 - 6.4
Gen. and Admn. Expenses 94 92 -2 - 4.2
Total Operating Expenses 282 274 -8 - 5.6
Operating Profit 250 242 -8 - 6.4
Add : Other Income
Dividend 44 50 +6 + 2.8
294 292 -2 - 1.4
Less : Other Deduction
Interest Paid 44 44 Nil Nil
250 248 -2 - 1.6
Less : Income Tax 124 124 Nil Nil
Net Profit after Tax 126 124 -2 - 3.2

2.5 COMMON-SIZE STATEMENT

Financial statements that depict financial data in the shape

of vertical statement percentage are known as common size
statements. Such statements provide readers with vertical analysis
of the profit and loss account and balance sheet. In such statement
all figure are converted to a common unit by expressing than as
percentage of a key figure in the statement. The total of financial
statement is reduced to 100 and each item is shown as component
to the whole. For example profit and loss account, the figure of
each item of the financial expressed as a percentage of sales
 62

likewise, assets and liabilities can be shown as percentage of total

assets and total equities respectively in common sized balance
sheet. Thus expressing each monetary item of financial statement
as a percentage of some total of which that item as apart
transforms a financial statement what is referred as common size
statement such a statement show the relative significance of the
items contend in the financial statement and facilitate comparisons.
It point out efficiencies and in efficiencies that are otherwise
difficult to see and of this reason is a valuable management tool a
common size statement is especially useful when data for more
than one year are used.

Vertical analysis is the procedure of preparing and

presenting common size statements. Common size statement is
one that shows the items appearing on it in percentage form as well
as in dollar form.

Common size statements are particularly useful when

comparing data from different companies.

Common size statements are also very helpful in pointing

out efficiencies and inefficiencies that might otherwise go unnoticed

Illustration 1
The balance sheet of Shaheen Ltd are given for the year
2007 and 2008 convert them into common size balance size
balance sheet and interpret the changes.
Balance sheet

2007 2008
Liabilities Assets 2007 Rs. 2008 Rs.
Rs Rs.
Equity share 1,46,800 1,91,000 Buildings 1,80,000 2,00,000
Capital reserve 50,000 70,000 Plant and machinery 40,000 55,000
Revenue reserve & 20,000 30,000 Furniture 10,000 20,000
surplus
Freehold property 20,000 12,000
Trade creditors 30,000 40,000 Goodwill 25,000 30,000
Bills payable 80,000 60,000 Cash balance 25,000 20,000
Bank overdraft 90,000 80,000 Sunday debtors 30,000 35,000
Provisions 30,000 20,000 Inventories Bills 70,000 57,000
receivable(temporary)

4,46,800 4,91,000 4,46,800 4,91,000

Common size Balance Sheet

 63

1987 1987
Assets
Amt. (Rs.) Percentage Amt. (Rs.) Percentage
A. Current Assets
Sundry Debtor 30,000 6.71 35,000 7.13
Cash balance 25,000 5.59 20,000 4.07
Inventories 70,000 15.71 57,000 11.60
Investment (Temporary) 36,500 8.17 42,000 8.55
Bill Receivable 10,300 2.30 20,000 4.08
Total (A) 1,71,800 38.44 1,74,000 35.43

B. Fixed Assets
Building 1,80,000 40.29 2,00,000 40.75
Plant and Machinery 40,000 8.95 55,000 11.20
Furniture 10,000 2.24 20,000 4.07
Freehold Property 20,000 4.48 12,000 2.44
Goodwill 25,000 5.60 30,000 6.11
Total (B) 2,75,000 61.5 3,17,000 64.57
Total Assets (A+B) 4,46,800 100.00 4,91,000 100.00

Liabilities
C. Current Liabilities
Trade Creditors 30,000 6.17 40,000 8.15
Bill Payable 80,000 17.91 60,000 12.22
Bank Overdraft 90,000 20.14 80,000 16.29
Provision 30,000 6.71 20,000 4.07
Total (C) 2,30,000 51.47 200,000 40.73
 64

D. Long-term Liabilities
Equity Share 1,46,800 32.86 1,91,000 38.90
Capital Reserve 50,000 11.19 70,000 14.26
Revenue Reserve and 20,000 4.48 30,000 6.11
Surplus
Total (D) 2,16,800 48.53 2,91,000 59.27
Total Liabilities (C+D) 4,46,800 100.00 4,91,000 100.00

Interpretation :
1. Out of every rupee of sales 60.72 per cent in 1986 and 63.63
per cent in 1987 account for cost of goods sold.
2. The percentage ratio of gross profit to sales was 39.28 per cent
in 1986 which was reduced 36.37 percent 1987.
3. The operating expenses increased from 15.71 per cent of sales
in 1986 to 16.37 per cent in 1987 All this reduced the
percentage ratio of net income after taxi to sales from 14.15 per
cent in 1986 to 12.00 per cent in 1987.
4. The operating expenses increased from 15.71 per cent of sales
in 1986 to 16.37 per cent in 1987 All this reduced to percentage
ratio of net income after tax to sales from 14.15 per cent in
1987.
In the ultimate analysis it can be said that the operating
efficiency of the concern has not been satisfactory during the period
under study.

Illustration 2 : Following the Balance Sheet of X Co. Ltd and Y Co.

Ltd as on 31.12.1990.

Particulars X Co. Ltd Y Co. Ltd

Assets 27 72
Sundry Debtors 220 226
Stock 100 174
Prepaid Expenses 11 21
Other Current Assets 10 21
Total Current Assets 368 514
Fixed Assets (Net) 635 513
Total 1,003 1,027
Liabilities
Sundry Creditors 42 154
Other 78 62
Total Current Liabilities 120 216
Fixed Liabilities 225 318
Total Liabilities 345 534
Capital 658 493

Total 1,003 1,027

 65

Interpretation:

1. The study of common size balance show that 61.56 per cent
total asset in 1986 were fixed This percentage increased 64.57
per cent 1987 if concern requires considerable investment in
fixed assets these percentage might be acceptable if the
company needs be acceptable if the company need liquid
assets the interested parties might have cause to be concerned
about the decreasing trend liquidity.

2. There was a wide shift from the use of creditor provided fund to
the use of owner equity fund in 1986 external equity (current
liability) and owner equity (long term liability) accounted from
51.47 per cent and 48.73 per cent for external equities and
59.27 per cent for owner equity These changes indicate that the
concern has started to use internal sources more frequently than
external sources more frequently than external sources in the
generation of fund for this business.
3. The concern has not only succeeded in getting its current
liability down from 51.47 per cent in 1986 to 40.73 per cent in
1987 of their respective of the total equity In but it has also
increased the percentage of its revenue and surplus from 4.48
per cent in 1986 to 6.11per cent in 1987 of other respective total
equities.

Illustration 3: From the income statement give below you are

required to prepare common – sized income statement.

1986 1987
Particulars
Rs. Rs.
Sales 1,40,000 1,65,000
Less : Cost of Goods Sold 85,000 1,05,000
Gross Profit 55,000 60,000
Operating Expenses
Selling and Distribution Expenses 12,000 16,000
Administrative Expenses 10,000 11,000
Total Operating Expenses 22,000 27,000

Net Income before Tax 33,000 33,000

Income Tax (40%) 13,000 13,200
Net Income 19,800 19,800
 66

Solution :
Common size income statement
(For the year ending 1986 and 1987)

1986 1987
Particulars
Amt. (Rs.) Percentage Amt. (Rs.) Percentage
Sales 1,40,000 100.00 1,65,000 100.00
Less : Cost of Sales 85,000 60.72 1,05,000 63.63
Gross Profit 55,000 39.28 60,000 36.37
Selling & Distribution 12,000 8.57 16,000 9.70
Expenses
Administrative Exp. 12,000 7.14 11,000 6.67
Total operating Exp. 22,000 15.71 27,000 16.67
Net Income before Tax 33,000 23.57 33,000 20.00
Income Tax (40%) 13,000 9.42 13,200 8.00
Net Income after Tax 19,800 14.15 19,800 12.00

Solution:
Common Size Balance Sheet (as on 31st December 1992)
X Co. Ltd Amount Y Co. Ltd Amount
(Rs. in Lakhs) (Rs. in Lakhs)
percentage percentage

Assets :
A) Current Assets
Cash 27 2.69 72 7.01
Sundry Debtor 220 21.93 226 22.01
Stock 100 9.97 174 16.94
Prepaid Expenses 11 1.10 21 2.04
Other 10 1.00 21 2.04
Total (A) 368 36.69 514 50.04
B) Fixed Assets 635 63.61 513 49.96
Total (B) 635 63.31 513 49.96
Total Assets (A+B) 1003 100.00 1027 100.00

Liabilities :
C) Current Liabilities
Sundry Debtor 42 4.19 154 14.99
Others 78 7.78 62 6.04
Total (C) 120 11.97 216 21.03
D) Long Term Liabilities
Fixed Liabilities 225 22.43 318 30.97
Capital 658 65.60 493 48.00
Total (D) 883 88.03 811 78.97
Total liabilities (C+D) 1003 100.00 1027 100.00
 67

Comments :
1. The study of common size balance sheet show that 63.31 per
cent of total assets of the X. company L t d were fixed whereas
the some percentage for Y Co was 49.96.
2. The current liability of X Co L td were 11.97 per cent of total
liability and for Y Co L td this percentage was 21.03 both the
companies have used more equity capital.

Illustration 4 : You given the following common size

percentage of AB Company Ltd for 1997 and 1988.

1997 1998
Inventory 5.20 5.83
Debtors 10.39 ?
Cash ? 7.35
Machinery 49.35 45.35
Building 27.27 29.59
Creditors 20.78 ?
Overdraft ? 10.81
Total Current Liabilities 31.17 ?
Capital 51.95 49.67
Long-term loan 16.88 17.91
Total Liabilities 3,85,000 4,63,000

From the above information, compute the missing common

size percentage. Also calculate the value of all assets and liabilities.

Solution :
Common Size Balance Sheet
(as on 31 December 1997 and 1998)
1997 1998
Assets
Amt. (Rs.) Percentage Amt. (Rs.) Percentage
Assets :
A. Current Assets
Inventory 20,000 5.20 27,000 5.83
Debtors 40,000 10.39 55,000 11.88
Cash 30,000 7.79 34,000 7.35
Total (A) 90,000 23.38 1,16,000 25.06
B. Fixed Assets
Machinery 1,90,000 49.35 2,10,000 45.35
Building 10,05,000 27.27 1,37,000 29.59
Total (B) 2,95,000 76.62 3,47,000 74.94
Total Assets (A+B) 3,85,000 100.00 4,63,000 100.00
 68

Liabilities :
C. Current Liabilities
Creditors 80,000 20.78 1,00,000 21.59
Overdraft 40,000 10.39 50,000 10.81
Total (C) 1,20,000 31.17 1,50,000 32.40
D. Long-term Liabilities
Capital 2,00,000 51.95 2,30,000 49.67
Loan 65,000 16.88 83,000 17.91
Total (D) 2,65,000 68.83 3,13,000 67.55
Total Liabilities (C+D) 3,85,000 100.00 4,63,000 100.00

Note : Calculation have been made to the nearest rupee.

(i) Calculation of percentage of Cash for 1997

Cash = 23.38* – 15.59*
= 7.79
* Current = Total Assets – Fixed Assets
= 100 – 76.62
= 23.38
** Inventory + debtor = 5.20 + 10.39 = 15.59

(ii) Calculation of Percentage of overdraft for 1997

Total Current Liability – Creditor = 31.17 – 20.78 = 10.39

(iii) Calculation of percentage of Debtors for 1998

Debtor = 25.06* – 13.18 = 11.88
* Current Assets = Total Assets – Fixed Assets
= 100 – 74.94
= 25.06

2.6 EXERCISE

1. Define common size financial statement and explain their

usefulness during financial statement analysis.
2. Why might it be unwise to predict a farm s financial future
based on trend derived from historical financial information?
3. What are the steps involved in the financial statement analysis?
4. Discuss various techniques of financial statement.
 69

5. Write short note on

a. Comparative financial statement
b. Trend analysis
c. Qualification of financial analysis
6. What do you understanding by comparative financial
statement? What information is required to prepare a
comparative balance sheet?
7. Explain the procedure of preparing common size balance
sheet.
8. The following are the balance sheet of a concern as on 31st
December, 1987 and 1988.
9. Critically examine the various tools available to the financial
analysis. What are the limitations of such tool?

Practical Problems:
1.

1987 1988 1987 1988

Liability Assets
Rs. Rs. Rs. Rs.

Sundry Creditors 55,000 83,000 Cash 25,000 18,000

Bills Payable 20,000 16,000 Sundry Debtors 1,60,000 2,00,000
Proposed Dividend 40,000 50,000 Bills Receivable 20,000 30,000
Proposed Dividend 42,000 50,000 Stock in trend 77,000 1,09,000
6% Debenture 1,50,000 1,00,000 Machinery 80,000 2,00,000
General Reserve 40,000 70,000 Building 2,00,000 1,70,000
Profit and Loss A/c 30,000 48,000 Goodwill 1,15,000 90,000
Capital 3,00,000 4,00,000

6,77,000 8,17,000 6,77,000 8,17,000

Prepare a comparative balance sheet of the concern and

study its financial position.
 70

2. From the following information prepare a comparative statement

and make brief comments.
Income Statement
(For the year ended 31st March 1987 and 1988)

1987 1988
Particulars
Rs. Rs.

Sales 2,80,000 3,10,000

Less : Cost of Good Sold 1,92,000 2,22,000
Gross Profit 88,000 88,000
Less : Administrative Expenses 15,000 12,000
Selling and Distribution Expenses 18,000 18,000
Total Operating Expenses 33,000 30,000
Net Income before Tax 55,000 58,000
Less : Tax (40%) 22,000 23,200
Net Income after Tax 33,000 34,800

3. Convert the following balance sheet into common size balance

sheet and make brief comments.

Balance Sheet (as on 31 March 1983 and 1984)

1983 1984 1983 1984

Liabilities Assets
Rs. Rs. Rs. Rs.

Share Capital 5,00,000 6,50,000 Machinery 2,80,000 3,20,000

6% Debenture 3,40,000 2,00,000 Building 3,50,000 3,50,000
Sundry creditor 1,60,000 67,000 Investment 2,65,000 2,65,000
Provision for Goodwill 70,000 55,000
doubtful debtor 45,000 3,000
Bank balance 40,000 30,000
Profit and loss A/c 75,500 1,65,000
Inventory 60,000 40,000
Bill receivable 40,000 25,000

10,80,000 10,85,000 10,80,000 10,85,000

 71

4. Following income statement of a business is given the for the

year ending 31st December, 1987 and 1988 prepare a common size
statement and make comments on the business result.

Income Statement (for the ending on 31st Dec. 1987 and 1988)

1987 1988
Particulars
Rs. Rs.

Gross Sales 7,20,000 8,40,000

Sales Return and Allowance 40,000 50,000
Net Sales 6,80,000 7,90,000
Cost of Good Sold 5,00,000 5,80,000
Gross Profit from Sales 1,80,000 2,10,000
Operating Expenses :
Selling Expenses
Advertising Expenses 10,000 12,000
Sales Salary 12,000 16,000
Delivery Expenses 7,000 5,000
Depreciation Expenses 10,000 16,000
Total Selling Expenses 39,000 49,000
General and Administrative Expenses
Office Salaries 50,000 75,000
Insurance 20,000 35,000
Depreciation 5,000 16,000
Bad Debs 3,000 12,000
Total General and Administrative Expenses 78,000 1,38,000
Total Operating Expenses 1,17,000 1,87,000
Operating Income 63,000 23,000


 72

3
RATIO ANALYSIS AND
INTERPRETATION – I
Unit Structure :
3.0 Objectives
3.1 Introduction
3.2 Meaning of Ratio
3.3 Modes of Expressing an Accounting Ratio
3.4 Objectives of Ratios
3.5 Classification of Ratios
3.5.1 Traditional Classification
3.5.2 Functional Classification of Ratios
3.5.3 Classification from the view point of user
3.6 Balance Sheet Ratio
3.6.1 Current Ratio
3.6.2 Liquid Ratio
3.6.3 Proprietary Ratio
3.6.4 Stock Working Capital Ratio
3.6.5 Capital Gearing Ratio
3.6.6 Debt-Equity Ratio
3.7 Revenue Statement Ratios
3.7.1 Gross Profit Ratio
3.7.2 Operating Ratio
3.7.3 Expenses Ratio
3.7.4 Net Profit Ratio
3.7.5 Net Operating Profit Ratio
3.7.6 Stock Turnover Ratio
3.8 Combines Ratio / Composite Ratios
3.8.1 Return on Capital Employed
3.8.2 Return on Proprietors Funds
3.8.3 Return on Equity Share Capital
3.8.4 Earning per Share
3.8.5 Dividend Payout Ratio
3.8.6 Price Earnings Ratio
3.8.7 Debt Service Ratio
3.8.8 Debt Service Coverage Ratio
3.8.9 Creditors Turnover Ratio
3.8.10 Debtor‘s Turnover Ratio
 73

3.9 Limitations of Ratios

3.0 OBJECTIVES :-
After studying the unit the students will be able to
Understand meaning of Ratios.
Know the modes of expressing ratios.
Know the objectives of ratios analysis.
Classify the ratios.

3.1 INTRODUCTION :-

During the half of the 19th century, the bankers have started
using accounting ratios for analyzing credit standing of prospective
buyer (debtors). But the ratios analysis of bankers was very much
restricted to the study of current ratios only.

In 1919, Alexander was has criticized such restrictions and

narrow analysis and pointed out the possible dangers of such
analysis. He expressed in his view that in order is get clear picture
of financial health of the business enterprise, one has to take into
account various other relationships other than current ratios. Then
the ratio analysis is considered as strong and efficient tools of
analyzing the financial statement.

Ratio analysis is the method or process of expressing

relationship between items or group of items in the financial
statement are computed, determined and presented. It is an
attempt to draw quantitative measures or guides concerning the
financial health and profitability of an enterprise. It can be used in
trend and static analysis.

It is the process of comparison of one figure or item or group

of items with another, which make a ratio, and the appraisal of the
ratios to make proper analysis of the strengths and weakness of the
operations of an enterprise.

3.2 MEANING OF RATIOS :-

A ratio is one figure expressed in terms of another figure. It
is mathematical yardstick of measuring relationship of two figures
or items or group of items, which are related, is each other and
mutually inter-dependent. It is simply the quotient of two numbers.
It can be expressed in fraction or in decimal point or in pure
number.

Accounting ratio is an expression relating to two figures or

two accounts or two set accounting heads or group of items stated
in financial statement.
 74

3.3 MODES OF EXPRESSING AN ACCOUNTING

RATIO.

An accounting ratio may be expressed in different ways as under.

I) Simple or pure ratio :- It is merely a quotient arrived by simple

division of one number by another.

Example : When current assets of the business enterprise are

Rs. 1, 00,000 and current liabilities are Rs. 25,000. The ratio
between current assets and current liabilities will be expressed
1,00,000
as 04 OR it is expressed as 4:1.
25,000

II) Percentages :- It is expressed as percentage relationship when

simple or pure ratio is multiplied by 100.

Example : The current ratio in above example is expressed in

percentage by multiplying 4 by 100.
i.e. 100 x 4 = 400%

III) Rate :- The ratio is expressed as rates which refer to the ratio
over a period of time.

Example : Stock has turned over 8 times a year.

IV) Number of days or week or month :- Certain items of the

financial statements are expressed better in the form of days or
weeks or months.

Example : Debtors' collection period, credit payment period,

movement of stock, etc are expressed in days or weeks or
months in a year.
If stock turnover ratio is 8 times, they movement of stock is
expressed as under :
360 52 12
45 days, 6.5 weeks or 1.5 months
8 8 8

V) Rupees :- In this case numerator is divided by denominator and

figure of result is expressed in rupees.

Example : Earnings per share, dividend per share etc are

expressed in rupees.
It net profit after tax is Rs. 12,500 and number of shares of a
company are 1250.
NPAT 12,500
Earning per share = Rs.10 per share
No. of shares 1,250
 75

The ratios are useful for the following parties.

1. Investors, both present as well as potential investors.
2. Financial analysist.
3. Stock broker and stock exchange authorities.
4. Government.
5. Tax Department.
6. Competitors
7. Research analysist and students.
8. Creditors and supplier.
9. Banks and financial institutions.
10. Company's management.
11. Finance managers
12. Mutual funds.
13. Other interested parties like credit rating agencies.

3.4 OBJECTIVES OF RATIOS :-

The accounting ratios are very useful in assessing the

performance of business enterprise i.e. financial position and
profitability. This is possible to achiever by comparison of ratios of
the year or with the previous year.

The ratios are worked out to analyse the following aspect or

areas of business organization.
1) Solvency: -
a) Long-term solvency
b) Short-term solvency
c) Immediate solvency
2) Stability
3) Profitability
4) Operational efficiency
5) Credit standing
6) Structural analysis.
7) Utilization of resources and
8) Leverage or external financing.

Check your progress :

1. Define the following terms.
a) Percentages c) Rates
b) Simple / Pure Ratio d) Ratio
2. Explain the objectives of Ratio analysis.
 76

3.5 CLASSIFICATION OF RATIOS: -

The ratios are used for different purposes, for different users
and for different analysis.

The ratios can be classified as under:

a) Traditional classification
b) Functional classification
c) Classification from user‘s point of view

3.5.1 Traditional classification :

As per this classification, the ratios readily suggest through

their names, their respective resources. From this point of view,
the ratios are classified as follows.

a) Balance Sheet Ratio :- This ratio is also known as financial

ratios. The ratios which express relationships between two
items or group of items mentioned in the balance sheet at the
end of the year.
Example : Current ratio, Liquid ratio, Stock to Working Capital
ratio, Capital Gearing ratio, Proprietary ratio, etc.

b) Revenue Statement Ratio :- This ratio is also known as

income statement ratio which expresses the relationship
between two items or two groups of items which are found in the
income statement of the year.
Example : Gross Profit ratio, Operating ratio, Expenses Ratio,
Net Profit ratio, Stock Turnover ratio, Operating Profit ratio.

c) Combined Ratio :- These ratios shows the relationship

between two items or two groups of items, of which one is from
balance sheet and another from income statement (Trading A/c
and Profit & Loss A/c and Balance Sheet).
Example : Return on Capital Employed, Return on Proprietors'
Fund ratio, Return on Equity Capital ratio, Earning per Share
ratio, Debtors' Turnover ratio, Creditors Turnover ratio.

3.5.2 Functional Classification of Ratios :

The accounting ratios can also be classified according their

functions as follows.

a) Liquidity Ratios :- These ratios show relationship between

current assets and current liabilities of the business enterprise.
Example : Current Ratio, Liquid Ratio.
 77

b) Leverage Ratios :- These ratios show relationship between

proprietor's fund and debts used in financing the assets of the
business organization.
Example : Capital gearing ratio, debt-equity ratio, and
proprietary ratio.
This ratio measures the relationship between proprietors fund
and borrowed funds.

c) Activity Ratio :- This ratio is also known as turnover ratio or

productivity ratio or efficiency and performance ratio. These
ratios show relationship between the sales and the assets.
These are designed to indicate the effectiveness of the firm in
using funds, degree of efficiency, and its standard of
performance of the organization.
Example : Stock Turnover Ratio, Debtors' Turnover Ratio,
Turnover Assets Ratio, Stock working capital Ratio, working
capital Turnover Ratio, Fixed Assets Turnover Ratio.

d) Profitability Ratio :- These ratios show relationship between

profits and sales and profit & investments. It reflects overall
efficiency of the organizations, its ability to earn reasonable
return on capital employed and effectiveness of investment
policies.
Example : i) Profits and Sales : Operating Ratio, Gross Profit
Ratio, Operating Net Profit Ratio, Expenses
Ratio etc.
ii) Profits and Investments : Return on Investments,
Return on Equity Capital etc.

e) Coverage Ratios :- These ratios show relationship between

profit in hand and claims of outsiders to be paid out of profits.
Example : Dividend Payout Ratio, Debt Service Ratio and Debt
Service Coverage Ratio.

3.5.3 Classification from the view point of user :

Ratio from the users' point of view are classified as follows.
a) Shareholders' point of view :- These ratios serve the
purposes of shareholders. Shareholders, generally expect the
reasonable return on their capital. They are interested in the
safety of shareholders investments and interest on it.
Example : Return on proprietor's funds, Return on capital,
Earning per share.
 78

b) Long term creditors :- Normally leverage ratios provide useful

information to the long term creditors which include debenture
holders, vendors of fixed assets, etc. The creditors interested to
know the ability of repayment of principal sum and periodical
interest payments as and when they become due.
Example : Debt equity ratio, return on capital employed,
proprietary ratio.

c) Short term creditors :- The short-term creditors of the

company are basically interested to know the ability of
repayment of short-term liabilities as and when they become
due. Therefore, the creditors has important place on the
liquidity aspects of the company's assets.
Example : a) Liquidity Ratios - Current Ratio, Liquid Ratio.
b) Debtors Turnover Ratio.
c) Stock working capital Ratio.

d) Management :- Management is interested to use borrowed

funds to improve the earnings.
Example : Return on capital employed, Turnover Ratio,
Operating Ratio, Expenses Ratio.

3.6 BALANCE SHEET RATIOS

3.6.1 Current Ratio :

This ratio is also known as working capital ratio. This
expresses the relationship between current assets and current
liabilities. This ratio is calculated by dividing current assets by
current liabilities. It is expressed as pure ratio standard current ratio
is 2:1. Means current assets should be double the current
liabilities.
Current Assets
Current Ratio =
Current Liabilities
a) Current assets includes I) Inventories of raw materials, finished
goods, work-in-progress, stores & spare, loose tools, II) Sundry
debtors, III) Short-term loan, deposits, advance, IV) Cash on
hand and bank, V) Prepaid expenses, accrued income, VI) Bills
receivables, VII) Marketable investments, short term securities.
b) Current liabilities includes sundry creditors, bills payables,
outstanding expenses, unclaimed dividends, interest accrued
but not due on secured and unsecured loans, advances
received, income received in advance, provision for tax,
purposed dividend loan installment of secured and unsecured
loan payable within 12 months.
 79

c) Significance : This ratio tests the credit strength and solvency

of an organization. It shows strength of working capital, it
indicates ability to discharge short term liabilities.

3.6.2 Liquid ratio :

This ratio expresses the relationship between liquid assets

and liquid liabilities. This ratio is also known as quick ratio or acid
test ratio. This ratio is calculated by dividing liquid assets by liquid
liabilities. Standard quick ratio is 1:1.

Liquid Assets / Quick Assets

Liquid Ratio =
Quick or Current Liabilities

a) Liquid assets = Current assets less (Stock, prepaid expenses

and advance tax etc)
b) Liquid liabilities = Current liabilities less (Bank overdraft and
cash credit etc)
c) Significance :-
1) Indicate immediate solvency of enterprise.
2) Unlike CR it is more qualitative concept
3) As it eliminates inventories, it is rigorous test of liquidity.
4) More important for financial institutions.

3.6.3 Proprietary ratio :

Proprietary ratio is a test of the financial and credit strength

of the business. It establishes relationship between proprietors to
total assets. This ratio determines the long term solvency of the
company.

Alternatively this ratio is also known as Worth Debt Ratio.

Net worth to Total Assets Ratio, Equity Ratio, Net Worth Ratio or
Assets Backing Ratio, Proprietor's funds to Total Assets Ratio or
Share holders Funds to Total Assets Ratio.

This ratio is expressed in percentage.

a) Formula :-
Proprietors' or Shareholders' Fund
Proprietory Ratio= 100
Total Assets
b) Components :-
1) Proprietors Funds = Paid up equity + Reserves and surplus
less accumulated loss + paid up preference capital.
2) Total assets = Fixed assets + investment + current assets.
 80

c) Purpose: - This ratio is exercised to indicate the long term

solvency of the business.

d) Significance: -
This ratio shows general financial strength of the business.
1) It determines the extent of trade on equity.
2) It indicates long term solvency of business.
3) It tests credit strength of business.
4) It can be used to compare proprietary ratio with others firms
or industry.

3.6.4 Stock-working capital ratio :

This ratio establishes relationship between stock and

working capital. Alternatively it is known as "Inventory-working
capital ratio".

a) Formula :-
Stock
Stock-Working Capital Ratio =
Working Capital

b) Components :-
1) Stock (closing stock)
2) Working capital i.e. current assets less current liabilities.

It can be expressed in percentage also by multiplying this ratio

by 100.

c) Purpose :- This ratio shows the extent to which the working

capital is blocked in inventories.

d) Significance :-
1) This ratio highlights the predominance of stocks in current
financial position of organization.
2) A higher ratio indicates week working capital.
3) This ratio is the indicator of the adequacy of working capital.

e) Standard Ratio :- Standard stock working capital ratio is 1:1.

3.6.5 Capital Gearing Ratio :

This ratio brings out the relationship between capital carrying

fixed rate of interest or fixed dividend and capital that doesn't carry
fixed rate of interest or fixed dividend. This ratio indicates degree
to which capital has been geared in the capital structure of the
company.
 81

Alternatively this ratio is also known as "Leverage ratio" or

"Financial leverage ratio" or " Capital structure ratio".

a) Formula :-
Capital bearing Fixed Interest or dividend
Capital Gearing Ratio=
Capital not bearing Fixed Interest or dividend

b) Components :-
1) Capital bearing fixed interest or dividend comprises of
debentures, secured and unsecured loans, and preference
share capital.
2) Capital not bearing fixed interest or dividend is equity share
capital and reserve & surplus.

This ratio also can be expressed in %age by multiplying this

ratio by 100.

c) Purpose :- This ratio is used to understand the effective capital

structure of the company.

d) Significance :-
1) It is mechanism to ascertain the extent to which the
company is practicing trade or equity.
2) It brings one balanced capital structure.

3.6.6 Debt Equity Ratio :

This ratio express the relationship between external equities

and external equities i.e. owners' capital and borrowed capital.

a) Formula :-
Debt Long Term Debts
Debt equity ratio = OR OR
Equity Shareholders Fund

Long Term Debts

Shareholders Funds + Long Term Debts

b) Components :-
1) Debts includes all liabilities including short term & long term
i.e. mortgage loan and debentures.
2) Shareholders' funds consist of Preference share capital,
Equity share capital, Capital and Revenue Reserves,
Surplus, etc.
 82

c) Significance :-
1) It shares favorable or non favorable capital structure of the
company.
2) It shows long term capital structure.
3) It reveals high margin of safety to creditors.
4) It makes us understand the dependence on long terms
debts.

d) Standard :- Standard debt- equity ratio is 2:1. It means debts

should be double the shareholders funds.

3.7 REVENUE STATEMENT RATIOS: -

Revenue statement ratios are the ratios which highlights the

relation between two items from revenue statements i.e. Trading
Account and Profit and Loss Account.

3.7.1 Gross profit ratio :

Gross profit ratios express the relationship between gross

profit and net sales. This ratio is also known as "Turnover ratio"
OR "Margin ratio" OR "Gross margin ratio" OR "Rate of gross
profit". This ratio is expressed in percentage of net sales. This ratio
says about %age gross profit to net sales.

a) Formula :-
Gross Profit
Gross Profit Ratio= × 100
Sales

b) Components of this ratio are :-

1) Net sales = Total sales less sales return
2) Gross profit = Sales - Cost of sales
3) Cost of sales = (opening stock + purchases + direct labour +
other direct charge) - closing stock

c) Significance :-
1) This ratio analyse the basic profitability of business.
2) It shows the degree to which the selling price per unit may
decline without resulting in loss from operations.
3) Yearly comparisons of gross profit ratio reveal the trend of
trading results.

3.7.2 Operating Ratio :

This ratio studies the relationship between cost of activities

and net sales i.e. cost of goods sold and net sales. This ratio
 83

shows the percentage of cost of goods sold with net sales. This
ratio is expressed in percentage.

a) Formula :-
Operating Cost
Operating Ratio = × 100
Net Sales

b) Components :- Operating cost is equal to cost of goods sold

and other operating expenses like administrative expenses,
selling & distribution expenses etc. excluding finance expenses,
income taxes, loss on sale of assets, etc.

c) Purpose :- Purpose of operating ratio is to ascertain the

efficiency of the management regarding operation of business
concern.

d) Significance :-
1) It is used to test operational efficiency of business.
2) This ratio is the yardstick which measures the efficiency of
all operational activities of business i.e. production,
management, administration, sales, etc.

e) Limitation of operating ratio :-

1) It cannot test profitability of business without considering
extra - ordinary items.
2) The utility of operating ratio is limited owing to its
vulnerability to changes in management decisions.

3.7.3 Expenses Ratio :

This ratio explains relationship of items or group of expense

to net sales. Such ratios are collectively known as expanses ratio.
This is calculated and expressed in percentage. This ratio
expresses the percentage of items of expenses with net sales.

a) Formula :-
Item or Group of Expenses
Expenses Ratio = 100
Net sales

b) Various expenses ratios are as follows :-

Administrative expenses
1) Administrative expenses ratio= 100
Net sales
Selling & Dist. expenses
2) Selling & Dist. expenses ratio = 100
Net sales
 84

Cost of material sonsumed

3) Cost of material consumed ratio= 100
Net sales
Manufacturing expenses
4) Manufacturing expenses ratio = 100
Sales
Non operating expenses
5) Non-operating expenses ratio = 100
Net sales

c) Purpose and significance :-

1) This ratio helps us to know the cause behind overall
changes in operating ratio
2) Purpose of this ratio is to take corrective action.
3) It indicates the efficiency of management in controlling
expenses and improving profitability.
4) This ratio enables the income tax department to judge the
correctness and reliability of income disclosed in income tax
returns.
5) Analytical study of this ratio can be judged by trend of
expenses.
6) Comparative study of year to year expenses can be
possible.

3.7.4 Net profit ratio :-

Net profit ratio indicates the relationship between net profit

and net sales. Net profit can be either operating net profit or net
profit after tax or net profit before tax. Alternatively this ratio is also
known as "Margin on sales ratio". Normally this ratio is calculated
& expressed in percentage.

a) Formula :-

Net profit NPAT

Net profit ratio = 100 OR 100
Net sales Net sales

NPBT ONP
OR 100 OR 100
Net sales Net sales

b) Significance :-
1) It measures overall profitability of business.
2) It is very useful in judging return on investments.
3) It provides useful inferences as to the efficiency and
profitability of business.
 85

4) It indicates the portion of net sales is available for

proprietors.
5) It is clear index of cost control, managerial efficiency, sales
promotion, etc.

3.7.5 Net operating profit ratio :

Operating profit ratio indicates the relationship between

operating profit and net sales. This ratio is expressed in
percentage.

a) Formula :-
Net operating profit
Net operating profit ratio= 100
Net sales

b) Components :-
1) Net operating profit is equal to gross profit minus all
operating expenses or sales minus cost of goods sold and
operating expenses.
2) Net sales are equal to sales minus sales returns.

c) Significance :-
1) It signifies higher operating efficiency of management and
control over operating cost.
2) It indicates profitability of various operations of the
organization i.e. buy, manufacture, sales, etc.
3) It shows ability of organization to generate operating profit
out of its daily operations.

3.7.6 Stock Turnover Ratio :

Stock turnover ratio shows relationship between costs of

goods sold and average stock. This ratio is also known as
"Inventory Ratio" or "Inventory Turnover Ratio" or "Stock Turn
Ratio" or "Stock Velocity Ratio" or "Velocity of Ratio".

This ratio measures the number of times of stock turns or

flows or rotates in an accounting period compared to the sales
affected during that period. This ratio indicated the frequency of
inventory replacement. This ratio is expressed as rate.

a) Formula :-
Cost of goods sold
Stock Turnover Ratio =
Average stock

b) Components :-
1) Cost of goods sold = Sales – Gross Profit
 86

Opening stock + closing stock

2) Average Stock=
2

* If opening stock is not given, the closing stock is treated as

average stock.

c) Alternative method of stock turnover ratio :- This ratio can

be calculated by using average stock at selling price at as the
denominator. Under this method, average stock at selling price
is related to net sales.
Net sales
Stock Turnover Ratio=
Average inventory at selling price

d) Purpose :- Purpose of stock turnover ratio is to

1) Calculate the speed at which the stock is being turned over
into sales.
2) Calculate the stock velocity to indicate the period takes by
average stock to be sold out.
3) Judge how efficiently the stock are managed and utilised to
generate sales.

3.8 COMBINES RATIO / COMPOSITE RATIOS :-

Combined or composite ratios relate two items or group of

items of which one is from balance sheet and another from revenue
statements of an enterprise.

3.8.1 Return on capital employed :

This ratio explains the relationship between total profit

earned by business and total investment made or total assets
employed. It is expressed in percentage. This ratio is also known
as "Return on Investment", or "Return on Total Resources".

a) Formula :-

Profit before tax Interest

Return on capital employed = 100
Capital Employed
b) Components :-
1) Net profit before tax, interest & dividends (PBIT)
2) Capital employed
Capital employed = i) Equity share capital
ii) Add. Preference share capital
reserve & surplus
iii) Add. Long term borrowings (Term
loan + Debentures)
 87

iv) Less: Fictitious assets like

miscellaneous expenses not written
off.
v) Less profit & loss A/c Dr. Balance
(loss)
c) Purpose :-
1) Purpose of this ratio is to measure overall profitability from
the total funds made available by owners and leaders.
2) Purpose of this ratio is to judge how efficient the business
concern is in managing the funds at its disposal.

d) Significance: -
1) This ratio is effective tools to measure overall managerial
efficiency of business.
2) Comparison of this ratio with other company and this
information can be obtained for determining future course of
action.
3) This ratio indicate the productivity of capital employed and
measure the operating efficiency of the business.

3.8.2 Return on Proprietors Funds :

This ratio measures the relationship between net profit after

tax & interest and proprietors fund. This ratio is alternatively known
as "Return on proprietors' equity" or "Return on shareholders'
investment" or "Investors' ratio". This ratio is expressed in
percentage.

a) Formula :-
Net profit after tax & Interest (NPATI)
Return on Proprietor's Fund = 100
Pr oprietors' Fund

b) Components :-
1) Net profit after tax and interest
2) Proprietors' funds
Term proprietors fund is explained in para 3.6.3 - b)
c) Purpose: -
1) Purpose of this ratio is to measure the rate of return on the
total fund made available by the owners.
2) This ratio helps to judge how efficient the concern is in
managing owners' funds at its disposal.

d) Significance: -
1) This ratio is very significant to prospective investors and
shareholders.
 88

2) With the help of this ratio company can decide to rise finance
from external sources even from public deposit it ratio is
satisfactory.
3) Shareholders can expect to capitalize its reserves and issue
bonus shares when ratio is higher for reasonable period of
time.

3.8.3 Return on equity share capital :

This ratio explains relationship between net profit (after tax

and interest and dividend on preference share) and equity share
holders' funds. This ratio is expressed in percentage.

a) Formula :-
Net profit after tax less preference dividend
Return on Equity Capital = 100
Equity share capital

Alternatively this ratio may be calculated by using following

formula for calculating the return per equity shares.

Net profit after tax less preference dividend

Return on Equity Shares =
Number of Equity share

b) Components :-
1) Net profit after tax & interest and preference dividend.
2) Equity share capital by adding reserves or deducting
miscellaneous expenditures.

c) Purpose :-
Purpose of this ratio is to calculate amount of profit available to
take care of equity dividend, transfer to reserves, etc.

d) Significance :-
1) It is useful to the investors while deciding whether to
purchase or sale of shares.
2) This ratio helps to make comparative study of equity capital
with other company and it will be appreciate if there is high
return.

3.8.4 Earning per share :

Earning per share is calculated to find out overall profitability

of the organization. It represents earnings of the company whether
or not dividends are declared.

Earning per share is determined by dividing net profit by the

number of equity shares.
 89

a) Formula :-
Net profit after tax - preference dividend
Earning per shares (EPS) =
Number of Equity share

b) Components :-
1) Net profit after tax & interest - less preference dividend.
2) No. of equity shares.

c) Purpose :-
Purpose of this ratio is to calculate the amount of profits
available on each equity share to take care of equity dividend,
transfer to reserves, etc.

d) Significance :-
1) This ratio helps the investors or shareholders to take
decision while purchasing or selling shares.
2) This ratio shows the possibilities of issue of bonus shares.
3) Higher ratio indicates overall profitability.

3.8.5 Dividend payout ratio :

This ratio shows relationship between dividends paid to

equity shareholders out of profit available to the equity share
holders.

a) Formula: -
This ratio is calculated as follows.
Dividend per equity shares
Dividend payout ratio =
Earning per shares

b) Components: -
1) Dividend per equity shares means total dividend paid to
equity shareholder dividend by number of equity shares.
2) Earning per shares as per Para 3.8.4.

c) Purpose: - Purpose of this ratio is to measure the dividend

paying capacity of the company.

d) Significance: -
1) Higher ratio signifies that the company has utilized the larger
portion of its earning for payment of dividend to equity
shareholders.
2) It says lesser amount of earning has been retained.
 90

3.8.6 Price earnings ratio (PE Ratio) :

This ratio measures relationship between market price of

equity shares and earnings per share. It is usually expressed as a
fraction.

a) Formula: -
Market price per Equity shares
Price Earning Ratio=
Earning per Equity shares

b) Components: -
1) Market price per equity share = quoted price of a listed
equity share.
2) Earnings per equity share = as worked out in Para 3.8.4.

c) Purpose: -
1) Purpose of this ratio is to show the effect of the earning on
the market price of the share.
2) It helps the investors while deciding whether to purchase,
keep or sell the equity shares.
3) It helps to ascertain the value of equity share.

3.8.7 Debt service Ratio :

Debt service ratio shows relationship between net profit and

interest payable on loans. This ratio is also called as interest
coverage ratio. This ratio is expressed as a pure number.

a) Formula :-
Net profit before interest & tax
Debt service ratio =
Interest charges

b) Components :-
1) Profit before interest & tax means net profit before payment
of interest on loan and tax.
2) Interest means interest on long term loans.

c) Purpose :-
1) Purpose of this ratio is to measure the interest paying
capacity the company.
2) The purpose of this ratio is to find out the number of times
the fixed financial charges are covered by income before
interest and tax.
 91

d) Significance :-
1) It is important from the lenders' point of view.
2) It indicated whether the company will earn sufficient profits to
pay periodical interest charges.
3) It shows that the company will be able is pay interest
regularly.

3.8.8 Debt service coverage ratio :

Debt service coverage ratio shows the relationship between

net profit and interest plus loan installments payable. This ratio is
expressed in pure number.

a) Formula :-
Cash profit available for debt servicing
Debt service coverage Ratio =
Interest + Installment due on loan

b) Components :-
1) Net profit + non-cash debit to P & L A/c (depreciation +
goodwill written off, deferred revenue expenditure written off,
loss on sale of fired assets) = cash profit for debit servicing.
2) Interest means interest on long term loan.
3) Installments means installments due on long term loan
during the year.

c) Purpose :- Purpose of this ratio is to measure the debt

servicing capacity of the company.

3.8.9 Creditors Turnover Ratio :

This ratio shows relationship between the net credit

purchases and the average creditors. This ratio is express as a
rate.

a) Formula :-
Net credit purchases Credit purchases
Creditors' Turnover Ratio= OR
Average creditors Creditors + Bills payable

365 day or 12 months

Credit payment period OR (Creditors velocity) = OR
Creditors turnover ratio

Creditors + Bills payable

=
Daily credit purchases
 92

b) Components: -
1) Credit purchases means gross credit purchases minus
purchases returns.
2) Average creditors mean average of opening and closing
amount of creditors. If details are not given then only closing
creditors may be considered as average creditors.
3) Amount of bills payable.

c) Purpose: -
Purpose of this ratio is to.
1) Calculate the speed with which creditors are paid off on aan
average during the year.
2) Calculate the creditors' velocity to indicate the period taken
by the average creditors to be paid off.
3) Judge how efficiently the creditors are managed.

3.8.10 Debtors' Turnover Ratio :

This ratio shows relationship between credit sales and

average trade debtors. Alternatively this ratio is known as
"accounts receivable turnover ratio" or "turnover of debtors' ratio".
This ratio is expressed as a rate.

a) Formula :-
Credit sales Credit sales
Debtors turnover ratio = OR
Average debtors Accounts receivable

Credit sales
OR
Debtors + Bills receivable

Debtors + Bills Receivable

Average collections period = OR
Daily credit sales

365 days or 12 months 365 days

OR Average debtors
Debtors turnover ratio Credit sales

b) Components :-
1) Sundry debtors
2) Accounts receivables i.e. bills receivables.
3) Average daily sales.
 93

c) Purpose :- Purpose of this ratio is to.

1) Calculate the speed with which debtors get settled on an
average during the year.
2) Calculate debtors' velocity to indicate the period of credit
allowed to average debtors.
3) Judge how efficiently the debtors are managed.

3.9 LIMITATIONS OF RATIOS: -

1. Ratios are mainly based on financial statements therefore

weaknesses of financial statements are carried forward in
the ratios.

2. Ratios calculated between two unrelated items or groups

would be useless. e.g. ratio between cost of goods sold and
preliminary expenses.

3. Ratios are just indicators. Just calculation of ratios cannot

improve the financial position. Corrective and preventive
steps should be taken to improve financial position and
profitability of business.

4. Standard ratios changes from industry to industry.

Maintenance of ratios is not only the objective but improving
the financial stability and solvency and profit maximization
should be the objective.

5. Increase or decrease in the ratio may be due to change in

the economic factors of the country or due is inflation. Such
increase or decrease not due to efficiency or inefficiency of
the management of the business organization.

6. It is very difficult make correct inter-comparison of the firm

because two firms are not similar in age, size and in system
of following accounting policies.

7. Financial statements are prepared at ending the year. It

might be subject to window dressing for covering bad
financial position and ratios are not reliable which are based
on manipulated financial statement.

Check your progress :

1. Give the formula and significance of the following ratios.
a) Debtor‘s Turnover Ratio
b) Earning per share Ratio
c) Return on Proprietors Ratio
 94

d) Operating Ratio
e) Capital Gearing Ratio
2. Give the formula and components of the following ratios.
a) Debt Service Ratio
b) Price Earning Ratio
c) Return of Equity Share Capital Ratio
d) Stock Turnover Ratio
e) Net Profit Ratio
f) Debt Equity Ratio
g) Proprietary Ratio



4
RATIO ANALYSIS AND
INTERPRETATION – II
Unit Structure :
4.0 Objectives
4.1 Illustration
4.2 Exercise

4.0 OBJECTIVES :-
After studying the unit the students will be able to
Calculate the ratios if the Balance Sheet and Profit
Statements are given.

4.1 ILLUSTRATIONS :-

1. Following is the trading A/c and profit and loss A/c for the
year ended 31st December, 2009.
 95

Particulars Rs. Particulars Rs.

To Opening Stock 40,000 By Sales 9,00,000
To Purchases 4,00,000 By Closing Stock 1,60,000
To Wages 1,00,000
To Factory Expenses 1,40,000
To Gross Profit c/d 3,80,000

10,60,000 10,60,000
To Administrative Expenses 1,20,000 By Gross Profit b/d 3,80,000
To Selling Expenses 80,000 By Interest Received 10,000
To Interest on Loan 10,000
To Debenture Interest 16,000
To Net Profit c/d 1,64,000

3,90,000 3,90,000
To Tax Provision 40,000 By net profit b/d 1,64,000
To Proposed Dividend 40,000
To Balance Profit 84,000

1,64,000 1,64,000
 96

Balance sheet as on 31st December, 2009

Liabilities Rs. Assets Rs.

Equity share capital (Rs.10) 4, 00,000 Land and building 3,50,000

9% preference share capital 3,00,000 Machinery 3,00,000
8% debentures 2,00,000 Furniture 2,00,000
Reserves 1,00,000 Goodwill 1,00,000
Profit & Loss A/c 60,000 Patents 1,00,000
Short term loan (Repaid within Vehicles 2,80,000
one year)
2,00,000 Investment 1,00,000
Bank overdraft
1,50,000 Stock 1,60,000
Sundry creditors
2,80,000 Debtors 1,80,000
Bills payable
60,000 Bills receivable 60,000
Provision for tax
40,000
proposed dividend
40,000

18,30,000 18,30,000

Market price of equity share is Rs. 8 calculate the following ratios.

a) Current ratio
b) Acid test ratio
c) Capital gearing ratio
d) Stock turnover ratio
e) Debtors turnover ratio
f) Creditors turnover ratio
g) Return on capital employed ratio
h) Stock working capital ratio
i) Operating ratio
j) Earnings per share
k) Price earnings ratio
l) Net profit ratio
m) Gross profit ratio
n) Debt equity ratio
o) Proprietary ratio
p) Operating profit ratio
q) Debtors' collection period.
 97

Solution :
Current Assets 4,00,000
a) Current Ratio = 0.519 : 1
Current Liabilities 7,70,000

CA Stock 4,00,000 1,60,000

b) Acid Test Ratio =
CL Bank Overdraft 7,70,000 1,50,000

2,40,000
0.387 : 1
6,20,000

c) Capital Gearing Ratio

Pref. Share Capital + Borrowed Funds

=
Equity Share Capital + Reserve Misc. Expenses

3,00,000 2,00,000
4,00,000 1,00,000 60,000 NIL

5,00,000
0.893
5,60,000

Cost of Goods Sold

d) Stock Turnover Ratio =
Average Stock

5,20,000
5.20 times
1,00,000

* Cost of Goods Sold = Sales Closing Stock

= 9, 00,000 3, 80,000
= 5, 20,000

Opening Stock + Closing Stock

* Average stock =
2

40,000 1,60,000
2

2,00,000
1,00,000
2

Credit Sales
e) Debtor Turnover Ratio =
Debtors + B.R.

9,00,000
3.75
1,80,000 60,000
 98

Debtors + B.R.
f) Debtor Collection Period = No. of working
Credit Sales days in a year
1,80,000 + 60,000
= 360
9, 00,000

2,40,000
360 = 96 days
90,000

Credit Purchases
g) Creditors Turnover Ratio =
Creditors + BP

4,00,000
2,80,000 60,000
4,00,000
1.716
3, 40,000

h) Return on Capital Employed Ratio

Profit before Interest & Tax

= 100
Capital Employed

(1,64,000 16,000)
100
10,60,000
1,80,000
100 16.98%
10,60,000

Closing Stock
i) Stock Working Capital Ratio =
Working Capital

1,60,000
0.43
3,70,000

(Cost of Goods Sold + Operating Expenses)

j) Operating Ratio = 100
Sales

(5,20,000 1,20,000 80,000 10,000)

100
9,00,000
7,30,000
100 81.11%
9,00,000
 99

k) Earnings per Share = Net Profit after Tax and

Preference Dividend
=
No. of Equity Shares

1,64,000 40,000 27,000

40,000
97,000
Rs.2.425
40,000

Market price of Equity Shares

l) Price Earning Ratio =
Earning per Shares

8
3.298
2.425

Net Profit after Tax & Interest

m) Net Profit Ratio = 100
Sales

1,64,000 – 40,000
= 100
9,00,000

1,24,000
100 13.78%
9,00,000

Gross Profit
n) Gross Profit Ratio = 100
Sales

3,80,000
100 42.22%
9,00,000

Proprietors Fund
o) Proprietory Ratio = 100
Total Assets

8,60,000
100 46.99%
18,30,000

Borrowed Fund
p) Debt Equity Ratio =
Proprietor's Fund

2,00,000
8,60,000
0.232 : 1
 100

Operating Profit
q) Operating Profit Ratio = 100
Sales

1,70,000
100
9,00,000
18.89%

Working Notes: -

W.N.1 Vertical income statement for the year ended 31st

December, 2009.

Particulars Rs. Rs. Rs.

1. Net Sales 9,00,000
2. Less: Cost of Goods Sold
Opening Stock 40,000
Purchases 4,00,000
Wages 1,00,000
Factory Expenses 1,40,000 6,80,000
Less: Closing Stock 1,60,000
cost of Cost sold 5,20,000
3. Gross Profit 3,80,000
4. Less: Operating Expenses
a) Administrative Expenses 1,20,000
b) Selling Expenses 80,000
c) Financing Expenses
- Interest on Share Term Loan 10,000 2,10,000 2,10,000
5. Operating Profit 1,70,000
6. Add: Nom-operating Income
- Interest received 10,000
7. Net Profit interest & Tax 1,80,000
8. Less: Interest on Debenture 16,000
9. Net Profit before Tax 1,64,000
10. Less: Income Tax 40,000
11. Net Profit after Tax 1,24,000
12. Less: Preference Dividend 27,000
(9% of 3, 00,000)
13. Net Profit available for Equity 97,000
shareholders.
14. Less: Equity Dividends 13,000
(40,000 - 27,000)
15. Retained Earnings 84,000
 101

W.N.2 Vertical balance sheet as on 31st December, 2009.

Particulars Rs. Rs. Rs.

. Sources of Funds
I. Owner's / shareholder's funds
a) Equity Share Capital 4,00,000
b) Reserves & Surplus
Reserve 1,00,000
P & L A/c 60,000 1,60,000
c) Preference Share Capital 3,00,000 8,60,000
II. Borrowed / Loan Funds
8% Debentures 2,00,000
CAPITAL EMPLOYED (I + II) 10,60,000

B. Application of funds
I. Fixed Assets
Land & Building 3,50,000
Machinery 3,00,000
Furniture 2,00,000
Vehicles 2,80,000
Goodwill 1,00,000
Patents 1,00,000 13,30,000
II. Investments 1,00,000
III. Working Capital
a) Current Assets
Quick Assets
Debtors 1,80,000
Bills Receivables 60,000
Non-quick Assets 2,40,000
Closing Stock 1,60,000 4,00,000
b) Less: Current Liabilities
Quick Liabilities
Creditors 2,80,000
Bills Payable 60,000
Provision for Tax 40,000
Proposed Dividends 40,000
Short Term Loan 2,00,000
6,20,000
Non-quick Liabilities
Bank Overdraft 1,50,000 (7,70,000)
Working Capital (CA-CL) (3,70,000)
CAPITAL EMPLOYED (I+II+III) 10,60,000
 102

2. M/s Raj & Sons presents you the following balance sheet as
on 31st December, 2008.

Liabilities Rs. Assets Rs.

Share capital Fixed assets 10,00,000
Equity share of Rs. 10 each 10,00,000 Stock 4,00,000
Reserve fund 1,00,000 Debtors 3,00,000
7% debentures 3,00,000 Cash 2,00,000
Overdraft 2,00,000
Creditors 3,00,000
19,00,000 19,00,000

Calculate - I) Liquidity ratios

II) Solvency ratios
III) Debt-equity ratio

Solution :

1) Liquidity ratios :-
Current Assets 9,00,000
a) Current Ratio = 1.8 : 1 or 1.8
Current Liabilities 5,00,000

Liquid Assets
b) Acid Test Ratio =
Liquid Liabilities
Current Assets – Stock
Current Liabilities – Overdrafts

9,00,000 – 4,00,000 5,00,000

1: 66 : 1
5,00,000 – 2,00,000 3,00,000

OR

If Liquid Liabilities = Current Liabilities, then Acid Test Ratio is as

under –
5,00,000
1: 1
5,00,000
Stock
c) Stock Working Capital Ratio =
Working Capital

4,00,000
9,00,000 5,00,000
4,00,000
1: 1
4,00,000
 103

2) Solvency ratios :-
Shareholders Funds
(a) Proprietory Ratio =
Total Tangible Assets or Total Assets

11,00,000
0.58 : 1 or 0.58 100 = 58%
19,00,000

Note: I) Shareholders Fund= Eq. Share Capital + Reserve

= 10,00,000 + 1,00,000
= 11,00,000

II) Total Tangible Assets = Total Assets = Rs.19,00,000

Shareholders' Funds
(b) Equity to Fixed Assets Ratio =
Fixed Assets

11,00,000
1.1: 1
10,00,000
OR

= 1.1 100=11.1%

Shareholders' Funds
(c) Equity to Current Assets Ratio =
Current Assets

11,00,000
1.1: 1
10,00,000
OR

= 1.1 100=100%

Outsiders' Funds 8,00,000

3) Debt Equity Ratio = 0.73 : 1
Shareholder's Fund 11,00,000

Outsider's Fund = Debentures + Creditors + Overdraft

= 3,00,000 + 3,00,000 + 2,00,000
= Rs. 8,00,000
OR
It outsiders fund = Debentures only

Outsiders' Funds 3,00,000

Then Debt Equity Ratio = 0.373 : 1
Shareholder's Fund 8,00,000
 104

3. From the following financial statements of M/s Sunny Ltd.

calculate.

1) Current Ratio
2) Liquid Ratio
3) Gross Profit Ratio
4) Net Profit Ratio
5) Net Profit to Capital Employed Ratio
6) Fixed Assets Turnover Ratio
7) Sales to Capital Ratio
8) Debtors Turnover Ratio

Balance sheet as on 31st March, 2009.

Liabilities Rs. Assets Rs.

Share capital 1, 50,000 Fixed Assets (Net) 80,000

Reserve 60,000 Current Assets
Profit & Loss A/c 24,000 Stock 1, 88,000
Debentures 60,000 Debtors 1, 64,000
Current Liabilities 1, 52,000 Cash 14,000

4, 46,000 4, 46,000

Income statement for the year ending 31st March, 2009

Particulars Rs. Rs.

Sales : Cash 64,000
Credit 6,84,000 7,48,000
Less: cost of sales 5,96,000
Gross profit 1,52,000
Less: Expenses
Warehouse & Transport 48,000
Administration 38,000
Selling & Distribution 28,000
Debenture Interest 4,000 1,18,000
Net profit before tax 34,000
Less: Income tax 4,000
Net profit after tax 30,000
 105

Solution :
Current Assets
1) Current Ratio =
Current Liabilities

1,88,000 1,64,000 14,000

1,52,000
3,66,000
2.4078 : 1
1,52,000
2 : 41: 1

Liquid Assets
2) Liquid Ratio =
Liquid Liabilities

Current Assets - Stock

Liquid Liabilities = Current Liabilities
1,88,000 1,64,000 14,000 – 1,88,000
1,52,000
3,66,000 1,88,000 1,78,000
1.171: 1
1,52,000 1,52,000
1.17 : 1

Gross Profit
3) Gross Profit Ratio = 100
Sales

1,52,000
100 20.3208%
7, 48,000
20.32%

Net Profit after Tax

4) Net Profit Ratio = 100
Sales
30,000
100 4.010%
7,48,000
4.01%
OR
Net Profit beforeTax
100
Sales
34,000
100 4.545%
7,48,000
4.55%
 106

Net Profit after Tax

5) Net Profit to Capital Employed = 100
Capital Employed
30,000
100
2,94,000
10.20%
OR
If Net Profit before Tax is considered then Net Profit to Capital
employed will be as under.
Net Profit before Tax
= 100
Capital Employed
34,000
100
2,94,000
11.56%

Capital Employed = Fixed Assets + Investment + Working Capital

= 80,000 + 0000 + (3,66,000 - 1,52,000)
= 80,000 + 2,14,000
= 2,94,000

Cost of Goods Sold

6) Fixed Assets Turnover Ratio =
Fixed assets
5,96,000
80,000
7.45 Times

Sales
7) Sales to Capital Employed =
Capital Employed

7,48,000
2,94,000
2.54 Times

Net Credit Sales

8) Debtors Turnover Ratio =
Debtors
6,84,000
1,64,000
4.17 Times
 107

4. From the following financial statement of X co. Ltd. for the

year ended 31st December, 2009, calculated the following
ratios.

I) Current Ratio
II) Liquid Ratio
III) Operating Ratio
IV) Stock-Turnover Ratio
V) Turnover to Fixed Assets Ratio
VI) Return on Total Resources
VII) Return on Proprietors Fund
VIII) Net Profit to Capital Employed
IX) Debtors Velocity
X) Creditors' Turnover Ratio.

Balance sheet as on 31st March, 2009.

Liabilities Rs. Assets Rs.

Equity Share capital 5,00,000 Land & Buildings 3,50,000
General Reserve 3,00,000 Plant & Machinery 2,50,000
Profit & Loss A/c 2,00,000 Stock 3,00,000
Sundry Creditors 2,00,000 Sundry debtors 2,00,000
Cash & Bank 1,00,000

12,00,000 12,00,000
Trading and profit & Loss A/c for the ended 31st December
2009.

Particulars Rs. Particulars Rs.

To Opening Stock 1,00,000 By Sales 16,00,000
To Purchases (Credit) 8,00,000 By Closing Stock 2,00,000
To Gross Profit 9,00,000

18,00,000 18,00,000
To Office & By Gross Profit 9,00,000
Administrative Expenses 2,00,000 By Profit on Sale
To Selling & Distribution of Assets 25,000
Expenses 1,00,000
To Other Expenses 25,000
To Net Profit 6,00,000

9,25,000 9,25,000
 108

Solution :

Current Assets 3,00,000 2,00,000 1,00,000

I) Current ratio=
Current Liabilities 2,00,000
6,00,000
3 :1
2,00,000

Liquid Assets 2,00,000 1,00,000

II) Liquid Ratio =
Liquid Liabilities 2,00,000
3,00,000
1.5 : 1
2,00,000

Cost of Goods Sold + Operating Expenses

III) Operating Ratio =
Sales
7,00,000 3,25,000 10,25,000
0.64 : 1
16,00,000 16,00,000
OR

0.64 100 = 64%

COGS 7,00,000
IV) Stock Turnover Ratio=
Averages Stock (1,00,000 2,00,000)
2
7,00,000
4.67 Times
1,50,000

Turnover
V) Turnover to Fixed Assets Ratio =
Fixed Assets
16,00,000
2.67 : 1
6,00,000

Net profit after Tax & Interest

VI) Return on Proprietors Fund =
Proprietor's Fund
6,00,000
0.60 : 1
10,00,000
OR
= 0.60 100=60%
 109

Net Profit after Tax & Interest

VII) Net Profit to Capital Employed =
Capital Employed

6,00,000
0.60 : 1
10,00,000
OR
= 0.60 100 = 60%

Debtors
VIII) Debtors Velocity Ratio = 365
Credit Sales
2,00,000
365
16,00,000
46 Days

Creditors
IX) Creditors Velocity = 365
Credit Purchases
2,00,000
365
8,00,000
91 Days

4.2 EXERCISE :-

1. From the following financial statement of Sanket Ltd. calculate

the following ratios.
a) Current Ratios
b) Liquid Ratios
c) Stock Turnover Ratio
d) Debtors Turnover Ratio
e) Operating Ratio
f) Capital Gearing Ratio
g) Net Profit Ratio
h) Stock Working Capital Ratio
i) Earnings per Equity Share
j) Interest Coverage Ratio
k) Creditors Turnover Ratio
l) Dividend Payout Ratio
m) Gross Profit Ratio
 110

Trading and profit & Loss Account for the year ended 31st
December, 2009.

Particulars Rs. Particulars Rs.

To Opening Stock 1,50,000 By Sales 15,00,000
To Purchases 12,90,000 By Closing Stock 1,50,000
To Gross Profit c/d 2,10,000

16,50,000 16,50,000

To Administrative Expenses 20,000 By Gross Profit b/d 2,10,000

To Rent & Taxes 14,000 By Profit on Sale of Fixed
To Interest 22,500 Assets 27,500
To Selling Expenses 11,000
To Depreciation 50,000
To Income Tax Provision 60,000
To Net Profit 60,000
2,37,500 2,37,500

Balance sheet as at 31st December 2009

Liabilities Rs. Assets Rs.

Equity Share Capital of Fixed Assets 6,50,000
Rs. 10 each 2,50,000 Bank Balance 25,000
10% Preference Share Short term Investment 75,000
Capital 50,000 Debtors 1,00,000
General Reserve 2,00,000 Stock 1,50,000
12% Debentures 3,50,000
Creditors 30,000
Outstanding Expenses 55,000
Income Tax Provision 65,000

10,00,000 10,00,000

The company declared dividend on Equity Shares @ 20%.

2. The condensed balance sheet of Dixit Ltd. as on 31st March

2006 is as follows:

Liabilities Rs. Assets Rs.

Equity Share Capital 6,00,000 Fixed Assets 9,00,000
Reserve 2,00,000 Stock 3,00,000
6% Debentures 5,00,000 Marketable Investment 1,00,000
Current Liabilities 2,00,000 Debtors 1,50,000
Bank Overdraft 1,00,000 Cash and Bank balance 1,00,000
Preliminary Expenses 50,000

16,00,000 16,00,000
 111

Net profit for the years was Rs.75,000/-.

Prepare a statement suitable for analysis and indicate the

soundness of the financial positions of the company by calculating
the following ratios and comment on the same.

a) Current Ratio
b) Liquid Ratio
c) Proprietary Ratio
d) Return on Capital Employed
e) Return on Proprietors Equity
f) Return on Equity Capital
g) Stock Working Capital Ratio
(M.U.B.Com. April 1999)

3. The following is the Balance Sheet of Swapnaja Ltd. as on 31st

December 2009.

Liabilities Rs. Assets Rs.

Paid up Capital (Rs.10) 2, 00,000 Fixed Assets 3, 00,000
Reserves & Profit 1, 38,000 Stock 1, 00,000
Debentures 2, 00,000 Debtors 1, 22,000
Creditors 32,000 Bills Receivable 8,000
Bills Payable 12,000 Bank Balance 52,000

5, 82,000 5, 82,000

Sales Rs.4,00,000/-; Gross Profit Rs.1,20,000/-; Net Profit

Rs.80,000/-. Rearrange the above Balance Sheet in suitable form
for analysis and workout the following ratios.

a) Net Profit Ratio

b) Gross Profit Ratio
c) Current Ratio
d) Liquid Ratio
e) Return on Capital Employed
f) Debtors Turnover Ratio
g) Earnings per Share
h) Stock Turnover Ratio.
 112

Answer :-
1.
a) Current Ratio = 1.72:1
b) Liquid Ratio = 0.97:1
c) Stock Turnover Ratio - 8.6 Times
d) Debtors Turnover Ratio - 15
e) Operating Ratio - 89%
f) Capital Gearing Ratio - 1.012:1
g) Net Profit Ratio - 4%
h) Stock Turnover Ratio - 1.034
i) Earnings per Share - Rs.2.2 per share
j) Interest Coverage Ratio - Rs.6.33
k) Creditors Turnover Ratio - 43
l) Dividend Payout Ratio - 0.909
m) Gross Profit Ratio - 14%]

2.
a) Current Ratio - 1.83:1
b) Liquid Ratio - 1.25:1
c) Proprietary Ratio - 46.88%
d) Return on Capital Employed - 6%
e) Return on Proprietors Equity - 10%
f) Return on Equity Capital - 12.5%
g) Stock Working Capital Ratio - 1.2:1

3.
a) Net Profit Ratio - 20%
b) Gross Profit Ratio - 33%
c) Current Ratio - 6.41:1
d) Liquid Ratio - 4.14:1
e) Return on Capital Employed - 14.87%
f) Debtors Turnover Ratio - 3.077
g) Earnings per Share - Rs.04 per share
h) Stock Turnover Ratio - 2.8

Note: - Closing Stock = Average Stock


 113

5
RATIO ANALYSIS AND
INTERPRETATION – III
Unit Structure :
5.0 Objectives
5.1 Introduction
5.2 Reverse Ratios or Indirect Ratios
5.3 Illustrations
5.4 Exercise

5.0 OBJECTIVES :-
After studying the unit the students will be able to:
Understand the procedure of reverse or indirect ratios.
Solve the problems on reverse ratios.

5.1 INTRODUCTION :-

Every business organization prepares their financial

statements i.e. income statements and balance sheet on the last
date of the year or financial year. The financial statement is
prepared in the vertical form and presented before the
management for their kind considerations and information.

Then the required ratios are calculated, followed by its

interpretation and comments on them. This is very effective and
important tool of management.

5.2 REVERSE RATIOS OR INDIRECT RATIOS :-

The procedure of reverse or indirect ratios follows in reverse

order. In case of indirect ratios, Income statements and balance
sheets are prepared, with the help ratios given either in regular
format or in vertical format.

The reverse or indirect ratios are tricky than direct ratios and
to solve them an analytical understanding and conceptual clarity is
required. The formulas of all ratios, interrelationship amongst the
 114

ratios, the detailed knowledge of income statements and balance

sheet with all components and angles is essential. It is the
extension of direct ratios. The basis objective of indirect ratio is to
check the complete clarity and understanding of entire ratio
analysis. This system or angle of ratio analysis checks the
arithmetical accuracy of the financial statement.

5.3 ILLUSTRATION :-

1. Calculate from the following details furnished by Swaraj Ltd.

I) Current Ratio
II) Liquid Ratio
III) Creditors Turnover Ratio and Average Credit Period
IV) Debtors' Turnover Ratio and Average Credit Period.
V) Stock Turnover Ratio.
Rs.
Stock 8,00,000
Debtors 1,70,000
Cash 30,000
Creditors 3,00,000
Bank Overdraft 40,000
Outstanding Expenses 60,000
Total Purchases 9,30,000
Cash Purchases 30,000
Gross Profit Ratio 25%

Offer your comments on short term credit position of the

company.

Comments on individual ratio are not desirable.

Solution: -

Current Assets 8,00,000 1,70,000 30,000

I) Current Ratio =
Current Liabilities 3,00,000 40,000 60,000
10,00,000
2.5 : 1
4,00,000

Liquied Assets 1,70,000 30,000

II) Liquied Ratio =
Liquid Liabilities 3,00,000 60,000
2,00,000
0.55 : 1
3,60,000
 115

Credit Purchases
III) a) Creditors Turnover Ratio =
Average Creditors

9,30,000 30,000
3,00,000
9,00, 000
3 Times
3,00,000

No. of Working Days / Months / Week

b) Average Credit Period =
Creditors turnover ratio
365
121.67 122 Days
3
12
= 4 Months
3
52
= 17.33 17 Weeks
3

Credit Sales
IV) a) Debtors Trunover Ratio =
Average Debtors
12,40,000
1,70,000
7.39 Times

No. of Working Days / Months / Week

b) Average Credit Period =
Debtors Turnover Ratio
365
50.04 Days
7.29
52
= 7.12 Weeks
7.29
12
= 1.64 Months
7.29

Note: - I) It purchase is 75 - Gross Profit - 25

It purchase 9, 30,000 - ?
 116

9,30,000
25
75,000
Gross Profit = Rs. 3,10,000

II) Sales = Purchases + Gross Profit

= 9,30,000 + 3,10,000
=12,40,000 Rs.
Sales = Rs.12,40,000

Cost of Goods Sold

V) a) Stock Turnover Ratio =
Average Stock

(Sales - Gross Profit)

=
Average Stock
12,40,000 3,10,000
8,00,000
9,30,000
1.66 Times
8,00,000

No. of Working Days / Months / Weeks

b) Stock Velocity Ratio =
Stock Turnover Ratio
365
313.97 or 314 days
1.66
52
= 44.73 W eeks
1.66
12
10.32 Months
1.66

2. From the following details prepare statement of working capital.

I) Stock Turnover Ratio = 6
II) Gross Profit Ratio = 20%
III) Debtors Turnover Ratio : 2 months
IV) Creditors Turnover Ratio = 73 days
V) Gross Profit : Rs.60,000
VI) Closing Stock was Rs.5,000 in excess of Opening Stock

Solution :
 117

Gross profit
I) Gross profit ratio = 100
Sales
60,000
20 = 100
Sales
20 Sales = 60,000 100
100
Sales = 60,000
5
Sales = Rs. 3,00,000

II) Cost of goods sold = Sales – Gross profit

= 3,00,000 – 60,000

= Rs. 2,40,000

Cost of goods sold

III) Stock turnover ratio =
Average Stock

2,40,000
6=
Average stock
2,40,000
Average stock =
6
Average stock = 40,000

IV) Calculation of closing stock

Let the opening stock be .

( 5,000)
Average stock =
2
5,000
40,000
2
2 40,000 2 5,000

80,000 2 5,000
80,000 5,000 2

75,000
2
37,500
 118

Opening stock = Rs. 37,500

Closing stock = Opening stock + 5,000
= 37,500 + 5,000
= Rs. 42,500
V) Calculation of debtors

Debtors
Debtors turnover ratio = 12
Credit
Debtors
2= 12
3,00,000
12 Debtors = 3,00,000 2

3,00,000 2
Debtors =
12
Debtors = Rs. 50,000

Creditors
VI) Creditors turnover ratio = 365
2,45,000
Creditors
73 = 365
2,45,000
365 Creditors = 2,45,000 73
2,45,000 73
Creditors =
365
Creditors = Rs. 49,000

VII) Opening stock + Purchase - closing stock = Cost of goods sold

37,500 + Purchase - 42,500 = 2,40,000
Purchases = 2,40,000 + 42,500 - 37,500
Purchases = 2,45,000

Statement of Working Capital

Particulars Rs. Rs.

Current Assets
Debtors 50,000
Stock 42,500 92,500
Less: Current Liabilities
 119

Creditors 49,000 49,000

Working capital (CA – CL) 43,500

3. M/s Rajkumar & Co. gives you the following information.

Prepare Trading and Profit and Loss Account for the year ended
31st March 2009 and Balance Sheet as on that date.

Opening Stock Rs.45,000

Stock Turnover Ratio 10 Times
Net Profit Ratio on Turnover 15%
Gross Profit Ratio on Turnover 20%
Current Ratio 4:1
Long Term Loan Rs.1,00,000
Depreciation on Fixed Assets @ 10% Rs.10,000
Closing Stock Rs.51,000

Credit period allowed by suppliers one month. Average debt

collection period - Two months. On 31st March 2009 Current
Assets consists of Stock, Debtors and Cash only. There was no
Bank Overdraft. All Purchases are made on credit. Cash Sales
were 1/3rd of Credit Sales.

Solution :

Cost of Goods Sold

1) Stock Turnover Ratio =
Average Stock
Cost of Goods Sold
10 =
45,000 51,000
2
Cost of Goods Sold
10
96,000
2
Cost of Goods Sold
10
48,000

Cost of Goods Sold = 48,000 10

= 4,80,000

a) Cost of Goods Sold = 48,000 10 = Rs. 4,80,000

b) Gross Profit Ratio 20% on Sales
 120

Gross Profit = 20% on Sales = 25% on cost

Gross Profit = 25% of Rs.4,80,000
= Rs.1,20,000

c) Total sales = Cost of Goods Sold + Gross Profit

= 4,80,000 + 1,20,000
Rs.6,00,000
d) If Cash Sales are 1, Credit Sales are 3
Total Sales are 4
1
* Cash Sales = 6,00,000 Rs.1,50,000
4
3
* Credit Sales = 6,00,000 Rs.4,50,000
4
Opening Stock + Purchases + Gross Profit = Sales + Closing Stock
45,000 + Purchases + 1,20,000 = 6,00,000 + 51,000
Purchases = 6,51,000 - (45,000 + 1,20,000)
Purchases = 6,51,000 - 1,65,000
= Rs. 4,86,000

3) Calculation of Fixed Assets

If depreciation is Rs. 10 Fixed Assets is Rs. 100
If depreciation is Rs. 10,000, Fixed Assets - ?
10,000 10
Fixed Assets = Rs. 1, 00,000
1
Fixed Assets = Rs.1,00,000

4) Calculation of Net profit

Net profit
Net Profit Ratio 100
Sales
15 Net profit
100
1 6,00,000
15 6, 00,000 = Net Profit 100
15 6,00,000
Net Profit =
100
Rs. 90,000

5) Calculation of Expenses
 121

Expenses + Depreciation + Net Profit = Gross Profit

Expenses + 10,000 + 90,000 = 1,20,000
Expenses = 1,20,000 - 10,000 - 90,000
Expenses = Rs.20,000
6) Debtors Collection Period
12
Debtors Collection Period 2
Credit Sales
Debtors
2 12 1
1 4,50,000 n
Debtors
12 4,50,000
2
1 Debtors
12 Debtors = 2 4, 50,000
4,50,000 2
Debtors =
12
Rs.75,000

12
7) Creditors Collection Period =
Credit Purchases
Creditors
1 12
1 4,86,000
Creditors
4,86,000 12
1
Creditors 1
4,86,000
Creditors =
12
Creditors = Rs. 40,500

8) Current Ratio = 4:1

Current Assets
Current Assets =
Current Liabilities
 122

4 Current Assets
1 40,500
Current Assets = 40,500 4 = Rs. 1,62,000
Current Assets = Stock + Debtors + Cash
1,62,000 = 51,000 + 75,000 + Cash
Cash = 1,62,000 - 51,000 - 75,000
Cash = 1,62,000 - 1,26,000
Cash = 36,000
Cash = Rs.36,000
9) Calculation of Capital
Total Assets = Total Liabilities
2,52,000 = Capital + LTL + N.P. + Creditors
2,52,000 = Capital + 1,00,000 + 90,000+ 40,500
Capital = 2,52,000 - 1,00,000 - 90,000 - 40,500
= 2,52,000 - 2,30,500
= 21,500

Trading and profit & Loss A/c for the year ended 31st march
2009.

Particulars Rs. Particulars Rs.

To Opening Stock (given) 45,000 By Sales: Credit (I) 4,50,000
To Purchasing (Bal. figure) 4,86,000 Cash (I) 1,50,000
To Gross Profit (1b) C/d 1,20,000 By Closing Stock 51,000
(given)

6,51,000 6,51,000
By Gross Profit b/d
To Expenses (Bal. figure) 20,000 1,20,000
To Depreciation on 10,000
Fixed Assets (given)
To Net Profit (15% of Sales) 90,000

1,20,000 1,20,000

Balance sheet as at 31st March 2009

Particulars Rs. Rs. Rs.

 123

Capital (9) 21,500 Fixed Assets (3) 1,00,000

Net profit 90,000 Less: Depreciation 10,000 90,000
Long term loan (given) 1,00,000 Current Assets
Creditors (7) 40,500 Cash (8) 36,000
Stock (given) 51,000
Debtors (6) 75,000

2,52,000 2,52,000

4. Certain items of the annual accounts of ABC Ltd. are missing as

shown below:-
Trading and profit & Loss A/c for the year ending 31st March
2007.

Particulars Rs. Particulars Rs.

To Opening Stock 4,37,500 By Sales ?
To Purchasing ? By Closing Stock ?
To Direct Expenses 1,09,375
To Gross Profit c/d ?
? ?

To Administrative Expenses 2,66,000 By Gross Profit b/d ?

To Interest on Debentures 37,500 By Commission 62,500
To Provision for Tax ?
To Net Profit 3,30,000
? 1, 20,000

Balance sheet as on 31st March 2007

Liabilities Rs. Assets Rs.

Share capital 6,25,000 Plant and Machinery 7,75,000
General reserve ? Long term loan ?
Profit & Loss A/c 1,34,375 Stock ?
(Including opening balance) Debtors ?
10% debentures ? Bank 78,000
Creditors ?
Proposed dividend (C.Y) ?
Provision for tax (C.Y) ?
? ?
 124

You are required to complete the financial statement with the help
of the following information:-
1) Current Ratio is 2:1.
2) Stock Turnover Ratio is 1.60.
3) Proposed dividends are 25% of Share Capital.
4) Gross Profit Ratio is 50%.
5) Transfer to General Reserve is 70% of proposed dividends.
6) Provision for tax is 50% of net profit.
7) There is no opening balance in General Reserve A/c.
8) Creditors Turnover Ratio (on Purchase and Closing
Creditors) is 10:2.
Solution :

I) Proposed dividend = 25% of 6,25,000 = Rs.1,56,250

II) Transfer to General Reserve = 70% of proposed dividend

70% of 1,56,250 = Rs. 1,09,375

III) Provision for Tax - 50% of Net Profit

50% of 3,30,000 = Rs.1,65,000

IV) After debiting provision for tax Rs.1,65,000 to Profit & Loss A/c
Gross profit = Total of Dr. Side of P & L A/c - Commission
Received

Total of Debit side of Profit & Loss A/c = 2,66,000 + 37,500 +

1,65,000 + 3,30,000
= 7,98,500
Gross profit = 7,98,500 - 62,500
Gross profit = 7,36,000

V) Calculation of Sales
Gross Profit
Gross Profit Ratio = 100
Sales
7,36,000
50 100
Sales
50 Sales = 7,36,000 100

7,36,000 100
Sales =
50
Sales = Rs. 14, 72,000
 125

VI) Calculation of Closing Stock

Cost of Goods Sold
Stock Turnover Ratio
Average Stock
14,72,000 7,36,000
1.6
Average Stock

7,36,000
1.6
(Op. Stock + Closing Stock)
2
7,36,000
1.6
4,37,500 Closing Stock
2
4,37,500 Closing Stock
1.6 7,36,000
2
(1.6 4,37,500 1.6 Closing Stock) = 7,36,000 2

1.6 Closing Stock = 14,72,000 - 7,00,000

7,72,000
Closing Stock =
1.6
Rs.4,82,500

VII) (Opening stock + Purchases + Direct Expenses + Gross profit)

= Sales + Closing stock
4,37,500 + Purchases + 1,09,375 + 7,36,000 = 14,72,000 +
4,82,500
Purchases + 12,82,875 = 19,54,875
Purchases = 19,54,875 - 12,82,875
Purchases = Rs. 6,71,625

Purchases
VIII) Creditors' Turnover Ratio
Creditors
10 6,71,625
2 Creditors
6,71,625 2
Creditors =
10
Creditors = 1,34,325

IX) Current Ratio = 2:1

 126

Current Liabilities = Creditors + proposed dividend + provision

for tax
= 1,34,325 + 1,56,250 + 1,65,000
= 4,55,575
Current Assets = Current Liabilities 2
= 4,55,575 2
= 9,11,150

X) Current Assets = Stock + Debtors + Bank

9,11,150 = 4,82,500 + Debtors + 78,000
Debtors = 9,11,150 - 4,82,500 - 78,000
Debtors = 9,11,150 - 5,60,500
Debtors = Rs. 3,50,650

XI) Long Term Investment: -

Total Liabilities = Total Assets = Rs. 16,99,325
Total Assets = P & M + LTI + Stock + Debtors + Bank
16,99,325 = 7,75,000 + LTI + 4,82,500 + 3,50,650 + 78,000
Long Term Investment = 16,99,325 - 16,86,150
= Rs.13.175

XII) Calculation of Debentures

Debentures 10
Interest =
100
37,500 Debentures 10
1 100
100
Debentures = 37,500 Rs.3,75,000
10

Trading and P & L A/c for the year ended 31st March 2007

Particulars Rs. Particulars Rs.

To Opening Stock 4,37,500 By Sales (V) 14,72,000

To Purchases (VII) 6,71,625 By Closing Stock (VI) 4,82,500
To Direct Expenses 1,09,375
To Gross Profit C/d (IV) 7,36,000
19,54,500 19,54,500
2,66,000 7,36,000
To Administrative Expenses By Gross Profit b/d
37,500 62,500
To Interest on Debentures By Commission
1,65,000
To Provision for Tax (III)
3,30,000
 127

To Net Profit 7,98,500 7,98,500

Balance sheet as at 31st March 2007

Liabilities Rs. Assets Rs.

Share Capital 6,25,000 Plant and Machinery 7,75,000

General Reserve (II) 1,09,375 Long Term Investment (XI) 13,175
Profit & Loss A/c 1,34,375 Stock (VI) 4,82,500
(including opening balance) Debtors (X) 3,50,650
10% Debentures (XII) 3,75,000 Bank 78,000
Creditors (VIII) 1,34,325
Proposed Dividend (C.Y.) (I) 1,56,250
Provision for Tax (C.Y.) (II) 1,65,000

16,99,325 16,99,325
5. Complete the Balance Sheet of Titan Ltd. as on 31st December
2009

Liabilities Rs. Assets Rs.

Share Capital 3,00,000 Fixed Assets ?

Reserve and Surplus ? Current Assets :
Loan 30,000 Stock ?
Current Liabilities : Debtors ?
Bank Overdraft 70,000 Cash ?
Creditors ?
? ?

Ratio of the company are as follows: -

1. Reserves and Surplus to Share Capital - 1:1
2. Sales to Net Worth Ratio is 1:5:1
3. Sales to Debtors Ratio is 6:1
4. Gross Profit Ratio 20% on Sales
5. Net Working Capital is Rs.1,80,000
6. Stock Turnover Ratio is 6 times
7. Current Ratio - 2:5:1
8. Acid test Ratio - 1:5:1

Net worth = Share capital + Reserve and surplus

Solution :

1. Calculation of Current Liabilities

Current Assets
Current Ratio =
Current Liabilities
 128

Working Capital = Current Assets - Current Liabilities

Current Assets = Current Liabilities + Working Capital
Current Assets
Current Ratio =
Current Liabilities
2.5 Current Liabilities + Working Capital
=
1 Current Liabilities
2.5 Current Liabilities = CL + WC
2.5 CL = CL + 1,80,000
2.5 CL - CL = 1,80,000
1.5 CL = 1,80,000
CL = 1,80,000 x 1.5
= 2,70,000
= Rs.2,70,000

2. Calculation of Current Assets

Current Assets = Current Liabilities + WC
= 2,70,000 + 1,80,000
= Rs.4,50,000

3. Net Worth = Capital + Reserve and Surplus

Reserve and Surplus to Share Capital = 1:1
Net Worth = Share Capital + Reserve and Surplus
= 3,00,000 + 3,00,000
= Rs.6,00,000

4. Calculation of Sales
Sales to Net Worth = 1.5:1
Sales 1.5
Net Worth 1
Sales = 1.5 x 6,00,000
= Rs.9,00,000

5. Calculation of Debtors
Sales 6
Sales to Debtors = 6:1,
Debtors 1
9,00,000 6
Debtors 1
9,00,000
Debtors
6
= 1,50,000
Debtors = Rs.1,50,000
 129

6. Stock calculation
Cost of Goods Sold
Stock Turnover Ratio =
Average Stock

9,00,000 - 20% of 9,00,000

6=
Stock
9,00,000 - 1,80,000
6=
Stock
6 7,20,000
1 Stock
7,20,000
Stock = Rs.1,20,000
6

7. Current Assets = Stock + Debtors + Cash

4,50,000 = 1,20,000 + 1,50,000 + cash
Cash = 4,50,000 - 1,20,000 - 1,50,000
= 4,50,000 - 2,70,000
= 1,80,000
Cash = Rs. 1, 80,000

8. Creditors = CL - BOD
= 2,70,000 - 70,000
= Rs.2,00,000

Balance sheet as at 31st December 2009

Particulars Rs. Assets Rs.

Share Capital (given) 3,00,000 Fixed Assets (given) 4,50,000

Reserves & Surplus (3) 3,00,000 Current Assets
Loan 30,000 Stock (6) 1,20,000
Current Liabilities Debtors (5) 1,50,000
Creditors (8) 2,00,000 Cash (7) 1,80,000
Bank Overdraft(given) 70,000

9,00,000 9,00,000

5.4 EXERCISES :-
 130

1. From the following information of Abhay Ltd. prepare

summarized Balance Sheet as at 31st March 2009

Rs.
1. Working Capital 1,50,000
2. Reserve & Surplus 1,00,000
3. Bank Overdraft 25,000
4. Fixed Assets Proprietary Ratio 0.75
5. Current Ratio 2.5
6. Liquid Ratio 1.5

Your working notes should be part of the answer.

2. Using the following accounting ratios contruct the Balance

Sheet of ABC Ltd. as on 31st December 2009.
Balance sheet as on 31st December 2009.

Liabilities Rs. Assets Rs.

Share Capital ? Fixed Assets ?

Reserve & Surplus ? Stock ?
Bank Loan 2,00,000 Debtors ?
Creditors ?

? ?

Additional information :

1) Sales for the year (20% cash sales ) Rs. 45,00,000

2) Gross Profit Ratio = 20%
3) Debtors Turnover Ratio = 12 months
4) Stock Turnover Ratio = 12 Times
5) Debt Equity Ratio (debt / equity) = 20%
6) Reserve and Surplus to Capital = 25%
7) Current Ratio = 2
8) Fixed Assets Turnover Ratio = 0.20%
(Fixed Assets / Sales)

3. From the following information of financial ratios of Star Ltd.

prepare Balance Sheet as on 31st March 2009

a) Current Ratio 2.5

b) Liquid Ratio 1.5
c) Working Capital Rs.1,50,000
 131

d) Stock Turnover Ratio 5

e) Gross Profit Ratio 20%
f) Turnover Ratio to Fixed Assets (COGS to FA) 2
g) Average Debt Collection Period 2.4 months
h) Fixed Assets to Net Worth 0.80
i) Long Term Debt to Capital and Reserves 7/25

4. M/s Rajesh & Co. gives you the following information. Prepare
Trading and Profit & Loss Account for the year ended 31st
March 2004 and Balance Sheet as on that date.

Opening Stock 90,000

Stock Turnover Ratio 10 times
Net Profit Ratio on Turnover 15%
Gross Profit Ratio on Turnover 20%
Current Ratio 4:1
Long Term Loan Rs.2,00,000
Depreciation on Fixed Assets @ 10% Rs.20,000
Closing Stock Rs.1,02,000
Credit Period allowed by Supplier one month
Average Debt Collection Period two months

On 31st March 2004 Current Assets consists of Stock, Debtors

and Cash only. There was no Bank Overdraft. All Purchases
were on made on credit. Cash Sales were 1/3rd of Credit
Sales. (M.U. B.Com. April 2006)

5. From the following data, prepare Trading and Profit & Loss A/c

a) Sales Rs.10,00,000
b) Administration, Selling and Distribution
Expenses Rs.60,000
c) Stock Turnover Ratio 8 times
d) Net Profit Ratio 20%
e) Gross Profit Ratio 35%

Closing Stock is Rs. 8,000 greater than Opening Stock.

Answers :

Exercise No.
 132
1. Capital Rs.5,00,000, Reserve & Surplus Rs.1,00,000, Creditors Rs.75,000,
Bank Overdraft - Rs.25,000, Fixed Assets - Rs.4,50,00, Stock - Rs.1,37,500,
Liquid Assets - Rs.1,12,500 and Balance Sheet total Rs.7,00,000
2. Share Capital - Rs.8,00,000, Reserve & Surplus - Rs.2,00,000, Bank loan -
Rs.2,00,000, Creditors - Rs.3,00,000, Fixed Assets - Rs.9,00,000, Debtors -
Rs.3,00,000, Stock - Rs.3,00,000, Balance Sheet Total - Rs.15,00,000.
3. Net Worth - Rs.3,12,500, Long Term Loan - Rs.87,500, Current Liabilities -
Rs.1,00,000, Fixed Assets - Rs.2,50,000, Stock - Rs.1,00,000, Debtors -
Rs.1,00,000, Cash - Rs.50,000, Balance Sheet Total - Rs.5,00,000
4. Cash Sales - Rs.3,00,000, Credit Sales - Rs.9,00,000, Gross Profit -
Rs.2,40,000, Purchases (Bal. figure) - Rs.9,72,000, Net Profit - Rs.1,80,000,
Fixed Assets - Rs.2,00,000, Debtors - Rs.1,50,000, Cash - Rs.72,000,
Capital - Rs.43,000, Balance Sheet Total - Rs.5,04,000.
5. Opening Stock - Rs.77,250, Closing Stock - 85,250, Gross Profit -
Rs.3,50,000, Purchases - Rs.6,58,000, Net Profit - Rs.2,00,000, Other
expenses (Bal. figure) - Rs.90,000.



CASH FLOW STATEMENT / ANALYSIS

Unit Structure :

6.0 Objectives

6.1 Introduction

6.2 Preparation of Cash Flow Statement

6.2.1 Cash Flow from Operating Activities

6.2.2 Cash Flow from Investing Activities

6.2.3 Cash Flow from Financing Activities

6.3 Illustrations

6.4 Model Questions

 133

6.0 OBJECTIVES:

Objectives of this chapter are to be:

Understand the concept of Cash Flow Statement.

Study the difference between Cash Flow and Funds Flow.
Study the format of preparing Cash Flow Statement.
Prepare Cash Flow Statement as per Accounting Standard 3

6.1 INTRODUCTION:

Cash Flow Statement Analysis is another important tool of

financial analysis. It involves preparation of Cash Flow Statement for
identifying sources and application of cash. Thus, a Cash Flow
Statement is a statement depicting change in cash position from one
period to another. A proper planning of the cash resources enables the
management to have cash available whenever needed and put it to some
profitable or productive use in case there is surplus cash available. The
term ‗Cash‘ here stands for cash and cash balances. The following are
the points of difference between a Cash Flow Statement and a Fund Flow
Analysis.

1) A Cash Flow Statement is concerned only with the change in cash

position while a funds flow statement is concerned with change in
working capital position between two balance sheet dates.

2) A cash flow statement is merely a record of cash receipts and

disbursements.

3) Cash flow analysis is more useful to the management as a tool of

financial analysis in short period as compared to funds flow statement.

4) Inflow of cash results in inflow of funds but inflow of funds may not
necessarily result in inflow of cash.
 134

A Cash flow statement is useful for short-term planning. Business

enterprise needs sufficient cash to meet its obligations in the near future.
A historical analysis of the different securities and applications of cash
enables the management to make reliable cash flow projections for the
immediate future. Thus, a cash flow statement is an important financial
tool for management. However, it has its own limitations. Cash flow
statement cannot be equated with the income statement. The cash
balance as disclosed by the cash flow statement may not represents the
real liquid position of the business.

6.2 PREPARATION OF CASH FLOW STATEMENT:

According to Accounting Standard – 3, cash flow statement should

be presented in a manner that it reports cash flows, during the period
classifying by operating, investing and financing activities.

6.2.1 Cash Flow from operating activities :

Cash flows from operating activities are primarily derived from the
pre-revenue producing activities of the enterprise. The following are the
examples.

a) Cash received from sale of goods or rendering of services.

b) Cash received from fees, royalties, commission etc.

c) Cash payment to suppliers of goods and services.

d) Cash payment to employees.

e) Cash receipts and payments of an insurance company for premiums

and claims, annuities and other policy benefits.

f) Cash receipts and payments relating to the future contracts.

6.2.2 Cash flow from investing activities :

 135

These include activities on which expenditure has been incurred

for resources intended to generate future income and cash flows, such as
:

a) Cash payment to acquire fixed assets.

b) Cash receipts from disposal of fixed assets.

c) Cash payments to acquire shares, debentures, debt instruments of

other companies.

d) Cash receipts from disposal of shares, bonds, debentures etc.

e) Cash advances and loans made to third parties.

f) Cash receipt from the above.

g) Cash receipts from future contracts.

h) Cash payments for future contracts.

6.2.3 Cash flow from financing activities :

These include providers of funds, both capital and borrowing to

the company such as :

a) Cash receipts from issuing shares or debentures.

b) Cash proceeds from borrowings.

c) Cash repayments of amounts borrowed.

6.3 ILLUSTRATION :

1. You are required to calculate the cash from operations from the
following

Trading & Profit & Loss Account for the year

ended 31st March 2009
 136

Particulars Dr. Rs. Particulars Cr. Rs.

To Purchases 20,00,000 By Sales 30,00,000
To Wages 5,00,000
To Gross Profit 5,00,000

30,00,000 30,00,000
To Salaries 2,00,000 By Gross Profit b/f 5,00,000
To Rent 1,00,000 By Profit on Sale of
To Depreciation 1,00,000 Machinery 50,000
To Goodwill written
off 50,000
To Net profit 1,00,000

5,50,000 5,50,000

Solution :

Calculation of Cash from Operations

Cash from operations: Rs.

Net Profit as per P&L Account 1,00,000

Add: Non-cash items which do not result

in outflow of cash:

Depreciation 1,00,000

Goodwritten off 50,000 1,50,000

2,50,000

Less: Profit on Sale of Machinery which 50,000

is not a part of
 137

operating profit

Cash from business operations 2,00,000

2. The Balance Sheet of A Ltd. is given below:

Balance Sheet of A Ltd.

30.03.08 30.03.09 30.03.08 30.03.09

Liabilities (Rs. In (Rs. In Assets (Rs. In (Rs. In
Lakhs) Lakhs) Lakhs) Lakhs)

Share Cash &

Capital 125 150 Bank 10 12

Reserve &
Surplus 10 13 Debtors 30 45

Bank Loan 55 40 Stock 35 25

Creditors 40 44 Machinery 65 55

Land &
Building 90 110

230 247 230 247

During the year a machine costing Rs. 10 lakhs (Accumulated

depreciation Rs. 4 lakhs) was sold for Rs. 5,00,000, the depreciation
provided during the year was Rs. 4 lakhs. You are required to prepare
cash flow statement.
 138

Solution

(i) Working Rs Lakhs

1 Calculation of cash from operations:

Profit made during the year 3

(1300000-100000)

Depreciation 4

Loss on Sale of Machinery 1

Decrease in Stock 10

Increase in creditors 4

19

Less: Income in Debtors 15 4

Cash from operations 7

Machinery Account

Rs. Rs.
Lakhs Lakhs

To Balance b/d 65 By Bank 5

By Depreciation 4

By Loss on Sale 1

By Balance c/d 5

65 65

Cash Flow Statement (As-3)

 139

(Rs. (Rs.
1 Cash from Opening activities Lakhs) Lakhs)

Net profit made during the year 3

Add: (1) Depreciation 4

(2) Loss on sale of Machinery 1

Operating Profit before Working

Capital changes 8

(3) Decrease in Stock 10

(4) Increase in creditors 4

(5) Increase in Debtors 15

-1

Net Cash from operating activities 7

2 Cash Flow from Investing Activities:

(1) Sale of machinery 5

(2) Purchase of Land and

Building -20

Net cash from investing activities -15

3 Cash flow from financing activities

Proceeds from Issue of Shares 25

Repayment of bank loan -15

Net Cash from financing activities 10

Net increase in cash and cash

equivalent 2

Cash and cash equivalent of the

beginning 10

Cash and cash equivalent at the end 12

3. The following are the summarized Balance Sheet of Z Ltd.

 140

31.03.2008 31.03.2009

Liabilities

Share Capital 2,00,000 2,50,000

General Reserve 50,000 60,000

Profit & Loss 30,500 30,600

Secured Loans 70,000

Creditors 1,50,000 1,35,200

Provision for taxation 30,000 35,000

5,30,500 5,10,800

Assets

Land & Building 2,00,000 1,90,000

Plant & Machinery 1,50,000 1,69,000

Stock 1,00,000 74,000

Debtors 80,000 64,200

Cash 500 600

Bank - 8,000

Goodwill - 5,000

5,30,500 5,10,800

Additional information:

(1) Dividend of Rs. 23,000 was paid during the year.

(2) Assets of K Ltd were purchased for consideration of Rs. 50,000
payable in shares. The assets purchased were Stock Rs.
20,000 and Machinery Rs. 25,000
(3) Further Machinery was purchased for Rs. 8,000
(4) Depreciation written off on Machinery Rs. 12,000
(5) Income tax paid during the year was Rs. 33,000
 141

(6) Loss on Sale of Machinery Rs. 200 was written off to general reserve.
You are required to prepare the Cash Flow Statement as per AS-03

Solution

Cash Flow Statement

1 Cash Flow From Operating Activities:

Net Profit made during the year

(100+33,000+10,200+23,000) 66,300

Add: Depreciation on Building 10,000

Depreciation on Machinery 12,000

Operating profit before working capital charges 88,300

Decrease in Stock 46,000

Decrease in Debtors 15,800

Decrease in Creditors -14,800

Income tax paid -28,000 1,07,300

2 Cash Flow From Investing Activities:

Sale of Machinery 1,800

Purchase of Machinery -8,000 -6,200

3 Cash Flow From Financing Activities:

Repayment of Secured Loan -70,000

Dividend Payment -23,000

Cash Flow From Financing Activities: -93,000

Net increase in Cash and Cash equivalent 8,100

Cash and Cash equivalent at the beginning 500

Cash and Cash equivalent at the end

(Cash+Bank) 8,600
 142

Working:-

(1) Calculation of net operating profit :

Rs.

Increase in Profit and Loss account

(30600-30500) 100

Add: Depreciation 22,000

Income Tax provision 33,000

Transfer to Reserve 10,200

Dividend paid 23,000 88,200

Operating Profit for the year 88,300

(2) General Reserve A/c

Rs. Rs.

To Machinery (Loss) 200 By Balance b/d 50,000

To Balance c/f 60,000 By P&L A/c 10,200

60,200 60,200

(3) Provision for Taxation A/c

Rs. Rs.

To Bank 28,000 By Balance b/d 30,000

(Bal.figure) By P&L A/c 33,000

To Balance c/f 35,000

63,000 63,000
 143

(4) Machinery A/c

Rs. Rs.

To Balance b/d 1,50,000 By Depreciation 12,000

To Share Capital 25,000 By General Reserve (Loss) 200

To Bank 8,000 By Bank (Balance figure) 1,800

By Balance c/d 1,69,000

1,83,000 1,83,000

(5) Goodwill is arrived at as under:

Shares issued 50,000

Less: Assets Purchased

Stock 20,000

Machinery 25,000 45,000

Goodwill 5,000

4. From the following details relating to the accounts of G M Ltd. Prepare

Cash Flow Statement as per AS-3.

Balance Sheet

Liabilities 2008 2009 Assets 2008 2009

Rs. In Rs. In Rs. In Rs. In
Lakhs Lakhs Lakhs Lakhs
 144

Share capita 10.00 8.00 Machinery 7.00 5.00

Reserves & Surplus 3.00 2.10 Building 6.00 4.00

Debentures 2.00 - Investments 1.00 -

Provision for Taxation 1.00 0.70 Debtors 5.00 7.00

Proposed Dividend 2.00 1.00 Stock 4.00 2.00

Creditors 7.00 8.20 Cash & Bank 2.00 2.00

25.00 20.00 25.00 20.00

Additional Information:

(1) Depreciation at 25% was charged on the opening balance of

machinery.
(2) Old machine costing Rs. 50,000 (WDV Rs. 20,000) was sold during
the year for Rs. 35,000
(3) Income tax paid during the year was Rs. 50,000
(4) Building was under construction and hence not subject to
depreciation.
(5) Rs. 50,000 was transferred to reserve during the year.

Solution:

Cash Flow Statement for the year ended 31.03.2009

Particulars Rs. Rs.

A) Cash Flow from opening activities

1. Net Profit 0.40

2. Add: Non-Cash items

Proposed Dividend 2.00

Provision for Taxation 0.80

 145

General Reserve 0.50

Depreciation 1.25 4.55

3. Less: Loss on sale of machinery -0.15 4.80

4. Working Capital Changes

Increase in Stock -2.00

Decrease in Debtors 2.00

Decrease in Creditors -1.20 -1.20

5. Income Tax Paid -0.50

Net cash from opening activities 3.10

B) Cash Flow from Investing activities

1. Purchase of fixed asset -3.45

2. Capital expenditure on building -2.00

3. Increase in Investment -1.00

4. Sale of Machine 0.35 - 6.10

Net cash Flow from investing Activities

C) Cash Flow from financing activities

1. Issue of Shares 2.00

2. Issue of Debentures 2.00

3. Dividend payment -1.00 3.00

D) Net Increase in Cash (A+B+C) -

Cash at the beginning of the period 2.00

Cash at the end of the period 2.00

 146

Working

Rs.

1) Calculation of Net Profit

Reserve and Surplus at the end 3,00,000

Less: Reserves & Surplus at the beginning 2,10,000

Increase 90,000

Less: Transfer to Reserve 50,000

Net Profit 40,000

(2) Machinery A/c

Rs. Rs.

To Balance b/d 5,00,000 By Depreciation 1,25,000

To Bank 3,45,000 By Cash (Sales) 20,000

Balancing figures By Balance c/f 7,00,000

8,45,000 8,45,000

(3) Provision for Taxation A/c

Rs. Rs.

To Bank 50000 By Balance b/d 70000

To Balance c/d 100000 By P&L Bal. figures 80000

150000 150000

(4) Proposed Dividend A/c

 147

Rs. Rs.

To Bank 1,00,000 By Balance b/d 1,00,000

To Balance c/d 2,00,000 By P&L (Bal. figures) 2,00,000

3,00,000 3,00,000

5. From the following summary of cash/bank account of Anand Ltd.

Prepare Cash Flow Statement for the year ended 31st March 2009 in
accordance with AS-3 (Revised). The company does not have any cash
equivalents.

Cash/Bank A/c

Rs. Rs.

To Balance b/d (1.4.09) 50,000 By Creditors 20,00,000

To Issue of equity shares 3,00,000 By Purchase of fixed assets 2,00,000

To Debtors 28,00,000 By General Expenses 2,00,000

To Sale of fixed assets 1,00,000 By Wages & Salaries 1,00,000

By Income Tax 2,50,000

By Dividend 50,000

By Repayment of Bank Loan 3,00,000

By Balance c/d (31.03.09) 1,50,000

32,50,000 32,50,000

Solution

Anand Ltd.

Cash Flow Statement for the year 31.03.09

 148

Particulars Rs. Rs.

A) Cash Flow from opening activities

1 Cash receipts from debtors 2800000

2 Cash payment to Creditors -2000000

Cash payment to employees (Wages &

3 Salaries) -100000

4 Cash paid for business expenses -200000

5 Payment of Income Tax -250000

Net Cash from operating activities 250000

B) Cash Flow from investing activities

1 Purchased of fixed assets -200000

2 Sale of fixed assets 100000

Net cash from Investing activities -100000

C) Cash Flow from Financing Activities

1 Issue of Equity Shares 300000

2 Repayment of Bank Loan -300000

3 Dividend Payment -50000

Net Cash from financing activities -50000

Net increase in cash 100000

Cash at the beginning of the period 50000

Cash at the end of the period 150000

6. The Balance Sheet and Income Statement of Bharat Engineering Ltd.

are as follows:

Balance Sheet

Liabilities 31.3.08 31.3.09 Assets 31.3.08 31.3.09

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Share Capital 10.00 12.00 Fixed Assets 25.00 28.00

General
Reserves 2.25 2.50 (-) Accumulated Dep. 5.00 6.00

Retained
Earnings 1.10 1.25 20.00 22.00

10% Debentures 5.00 4.00 Stock 4.00 4.50

Bank Loan 2.00 2.50 Debtors 3.00 2.50

Creditors 6.60 5.45 Bank 1.10 1.40

Outstanding
Expenses 0.05 0.30 Preliminary Expenses 0.30 0.20

Provision for Tax 1.40 2.60

28.40 30.60 28.40 30.60

Income Statement for the year ended 31.3.06\9

Rs. Lakhs

Net Sales 40.00

Less: Cost of goods sold 31.00

Gross Profit 9.00

Less: General Expenses 2.90

Depreciation 1.00

Preliminary Expenses written off 0.10 4.00

Net Profit 5.00

Net Provision for Taxation 2.60

PAT 2.40

Less: Transfer of General Reserve 0.25

Payment of Dividend 2.00 2.25

Net Income 0.15

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Add: Retained Earning b/d 1.10

Balance c/d 1.25

Solution:

Cash Flow Statement for the year ended 30.03.09

Rs.
Particulars Rs. Lakhs Lakhs

A) 1 Sales 40.00

2 Add: Opening Balance of Debtors 3.00

43.00

Less: Closing Balance of Debtors 2.50

Cash received from Debtors 40.50 40.50

4 Cash paid to Creditors

Cost of Goods sold 31.00

Add: General Expenses 2.90

33.90

Add: Opening Balance of Creditors 6.60

Opening Balance of O/S expenses 0.05

Closing Stock 4.50

45.05

Less: Closing Balance of Creditors

5.45

Closing Balance of O/S. Exp.

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0.30

Opening stock 4.00 9.75

35.30

Cash Generated from Opening activities 5.20

Less: Income Tax paid 1.40

Net cash generated from opening activities 3.80

B) Cash Flow from Investment Activities

Purchase of fixed Assets -3.00

C) Cash Flow from Financing Activities

Loan from Bank 0.50

Issue of Shares 2.00

Redemption of Debentures -1.00

Payment of Dividend -2.00 -0.50

Net Cash used in Financing Activities

D) Net Increase in Cash 0.30

E) Cash at the beginning of the period 1.10

F) Cash at the end of the period 1.40

Note: Cash flow from operating activities can also be calculated using
indirect method as follows:

Net Profit as per Income Statement

Add: Non Cash Items 5.00

Depreciation 1.00

Preliminary Exp. Written off 0.10 1.10

Operating Profit 6.10

Add: Working Capital Changes

Decrease in Debtors 0.50

Increase in O/S Expenses 0.25

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Increase in Stock -0.50

Decrease in Creditors -1.15 0.90

Cash generated from operations 5.20

4.4 MODEL QUESTIONS :

Q.1
What is a Cash Flow Statement? How is it different from Funds Flow
Statement?
Q,2
State whether each of the following statement is True or False.

(1) Purchase of goods is an application of funds.

(2) A decrease in current liability increase the working capital.

(3) Funds-flow refers to change in long term funds.

(4) Working Capital is the difference between fixed assets and current
assets.

(5) Credit sales at Profit increases the working capital.

Q.3
From the following Profit & Loss Account you are required to compute
cash from operations.

Profit & Loss Account

Rs. Rs.

To Salaries 50,000 By Gross Profit b/d 2,50,000

To Rent 10,000 By 50,000

Profit on Sale of
 153

Land

Income Tax
To Depreciation 20,000 By Refund 30,000

To Loss on Sale of Plant 10,000

To Goodwill written off 40,000

To Proposed Dividends 50,000

To Provision for Taxation 50,000

To Net Profit 1,00,000

3,30,000 3,30,000

Q.4 The following are the summarized Balance Sheets of ‗B‘ Ltd.:-

Balance Sheet

Liabilities 2008 2009 Assets 2008 2009

Rs. In Rs. In Rs. In Rs. In
Lakhs Lakhs Lakhs Lakhs

12% Pref. Shares 10.00 Fixed Assets 41.00 40.00

Less:
Equity Shares 40.00 40.00 Depreciation 11.00 15.00

40.00 50.00 30.00 25.00

General Reserve 2.00 2.00 Debtors 20.00 24.00

Profit and Loss A/c 1.00 1.20 Stock 30.00 35.00

Debentures 6.00 7.00 Cash 1.20 3.50

Prepared
Creditors 12.00 11.00 Expenses 0.30 0.50

Provision for Tax 3.00 4.20

Proposed Dividend 5.00 5.80

Bank Overdraft 12.50 6.80

81.50 88.00 81.50 88.00

 154

You are required to prepare a Cash Flow Statement.

Q.5 W Ltd supplies you the following Balance Sheets:-

Balance Sheet

Liabilities 2008 2009 Assets 2008 2009

Rs. In Rs. In Rs. In Rs. In
Lakhs Lakhs Lakhs Lakhs

Share Capital 70.00 74.00 Bank 9.00 7.80

Debentures 12.00 6.00 Debentures 14.90 17.70

Creditors 10.00 12.00 Stock 49.20 42.70

RDD 0.70 0.80 Building 20.00 30.00

Reserve &
Surplus 10.40 10.40 Goodwill 10.00 5.00

103.10 103.20 103.10 103.20

Additional information

(1) Dividends amounted to Rs. 3.50 Lakhs were paid during the year.
(2) Building was purchased for Rs. 10 Lakhs.
(3) Rs. 5 Lakhs were written off on Goodwill.
(4) Debentures of Rs. 6 Lakhs were repaid during the course of the year.
You are required to prepare Cash Flow Statement.


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7
WORKING CAPITAL CONCEPT - I

Unit Structure:

7.0 Objectives
7.1 Introduction
7.2 Meaning of Working Capital
7.3 Definitions of Working Capital
7.4 Types of Working Capital
7.5 Importance or Advantages of adequate working capital
7.6 Danger of inadequate working capital
7.7 Danger of excess working capital
7.8 Factors determining working capital requirement
7.9 Importance of adequate working capital
7.10 Sources of working capital
7.11 Methods of projecting working capital requirements
7.12 Projection of working capital requirements
7.13 Exercise

7.0 OBJECTIVES :

After studying the unit the students will be able to:

Define Working Capital.
Explain types of working capital.
Understand the importance of adequate working capital.
Elaborate the determinants of working capital.
Know the sources of working capital.

7.1 INTRODUCTION :

Capital required for a business can be divided into two

categories i.e. Fixed capital and working capital. Fixed capital is
the part of total capital which is used for purchasing permanent a
fixed asset like land, Buildings, Plant and machinery, furniture and
 156

fixtures, vehicles, etc. This capital is invested by organization in the

beginning of running the business. In addition to fixed capital an
organization requires additional capital for financing day to day
activities like purchase of Raw materials, payment of direct and
indirect expenses, carrying out production, investment in stocks
and stores, receivables and assets to be maintained in the form of
cash is generally known as working capital (fluctuating capital). In
other words, this capital refers to the investment in current assets
such as cash inventory, receivables, etc. All such assets are likely
to be convertible into cash within one a year.

7.2 MEANING OF WORKING CAPITAL :

The capital used for performing day to day activities i.e.

purchases of Raw material, making payment of direct and indirect
expenses, carrying out of production of goods and services,
investment in stocks, stores, etc is called as working capital. All
assets consisting of working capital revolve around cash. Firstly,
cash is used to purchase of raw materials, which when certain
expenses are in carried on it gets itself converted into semi finished
goods and finally into inventory of finished products. Inventory
(finished goods), after adding certain profit margin to it, is sold to
the customers, which may take the form of cash or receivables or
debtors. Receivables or debtors when realized again take the form
of cash and the cycle goes on. The revolving nature of current
assets consisting of working capital has been cleared with the help
of following chart:

Receivables Sales

Cash Finished goods

Raw materials Work in progress

Because of this revolving nature of the assets consisting

working capital, later is also known as 'fluctuating' or 'floating' or '
circulating' capital.

7.3 DEFINITIONS OF WORKING CAPITAL :

7.3.1 J.M. Mill: - "The sum of the current assets is the working
capital of the business"
 157

7.3.2 Shubin: - "Working capital is the amount of funds necessary

to cover cost of operating the enterprise."

7.3.3 Hoaglandi: - "Working capital is descriptive of that capital

which is not fixed. But the more common use of the working
capital is to consider it as the difference between the block
value of the current assets and current liabilities."

7.3.4 Gerestenberg: - "Circulating capital wears current assets of

a company that are changed in the ordinary course of
business from one to another, as for example, from cash to
inventories, inventories to receivables, and receivables to
cash."

7.3.5 The accounting principles of board of American institute of

Certified Public Accountants has defined the working capital
as under:
"Working capital is represented by the excess of current
assets or current liabilities and identifies the relatively liquid
portion of the total enterprise capital which constitutes a
margin or buffer for maturing obligations within the ordinary
operating cycle of the business."

Thus working capital means investment made by a business

organization in short-term current assets like cash, debtors, etc.

7.4 TYPES OF WORKING CAPITAL :

The working capital is classified as under.

7.4.1 Gross working capital: Gross working capital means the

total current assets without deducting current liabilities. This equal
to the cash balance and the amount blocked in debtors stocks, etc.

7.4.2 Networking capital: Net working capital means total current

assets minus total current liabilities. It means net current assets.
This capital indicates the amount available to meet short term
liabilities or debt of the business organizations.

7.4.3 Permanent of fixed working capital: This capital

represents the value of the current assets required on continuing
basis over the entire year and for several years. Permanent
working capital is the minimum amount of current assets which is
needed to conduct business even during the dullest season of the
year. Thus, the minimum level of current assets is called permanent
or fixed working capital is the part of capital permanently blocked in
current assets. This amount changes from year to year depending
on growth of the company and the stage of the business cycle in
 158

which it operates. It is used to produce goods necessary to satisfy

the customer's demand.

It has the following characteristics

a) It is classified on the basis of time.

b) It constantly changes from one asset to another and
continuously remains in the business.
c) Size of this capital increases with the growth of business
operations.

7.4.4 Temporary or variable working capital

This component represents a certain amount of fluctuations

in current assets during a short period. These fluctuations are
increases or decreases in current assets. Generally these are in
cyclical nature. This is called as additional capital required at
different times during the operating year. This capital is used to
meet seasonal needs of a firm or organization is called seasonal or
variable working capital. Additional funds or capital specifically
used to meet extraordinary needs or contingencies arising due to
strikes, fire, unexpected competition, rising price tendencies
launching of advertisement campaigns.

Features:

a) It is not always gainfully employed, though it may change

from one asset to another, as permanent working capital
does.
b) It is particularly suited to business of a seasonal or
cyclical nature.
c) It is arranged from temporary source i.e. short term loan,
deposits, bank over drafts etc.

7.4.5 Balance sheet working capital: Usually this capital is

determined on the basis of current assets and current liabilities
shown in closing balance sheet of the concern. It means the net
current assets as on last date of the balance sheet.

7.4.6 Cash working capital: This capital is the net current assets
if realized at its book value. The cash realized from current
appearing is really less than the book value because i) Debtors
includes profit margin ii) Depreciation included in over valuation of
stock of finished goods. The concept of this capital makes proper
adjustment in balance sheet working capital for the items to arrival
 159

at cash working capital. The cash working capital indicated the

working capital at cost because stocks and debtors are at cost.

7.4.7 Positive working capital: When a net current asset is in

positive figure. Therefore it is called positive working capital. This
working capital shows favorable liquidity solvency position of the
company.

7.4.8 Negative working capital: In this case, difference between

current assets and current liabilities is negative figure. Therefore, it
is called are negative working capital. It means current liabilities are
more than the current assets. This capital indicates lack of liquidity
and adverse solvency position of the company.

7.5 IMPORTANCE OR ADVANTAGES OF ADEQUATE

WORKING CAPITAL :

Working capital is like the heart of business. If it becomes

weak, the business hardly can proper or survive. But no business
can run successfully without an adequate amount of working
capital. Following are the few advantages give importance of
adequate working capital in the business.

1. Cash discount: Adequate amount of working capital enables

the firm to avail cash discount facilities offered by suppliers. The
amount of cash discount reduces cost of purchases.

2. Creation of goodwill: Adequate amount of working capital

enables the firm to make prompt payment of short-term liabilities is
the base to create and maintain goodwill.

3. Ability to face crisis: Amount of adequate working capital

facilitates to meet situations of crisis and emergencies. It makes
able to withstand periods of depression smoothly.

4. Credit-worthiness: It enables the firm to run its business more

efficiently because there is no delay in getting loan from bank and
other financial institutions on easy and favorable terms and
conditions.

5. Regular supply of Raw materials: Adequate amount of

working capital permits the carrying of inventories of a level that
would enable a business to serve satisfactorily the need of its
customers. Thus it ensures regular supply of raw materials for
continuing productions in future.

6. Expansion of market: A firm having adequate working capital

can create favorable market condition. It is possible to purchases
 160

required material at lower rate and holds its inventories for higher
rate. Thus it helps to maximize profits.

7. Increase in productivity: Fixed assets of the firm cannot work

without sufficient amount of working capital. Because large scale
investment in various fixed assets is largely depending on the
manner in which its current assets are managed.

8. Research programmes: It is not possible to undertake

research programmes, innovations and technical developments
without having sufficient amount of working capital in the
organizations.

9. High morale: Maintaining of sufficient amount of working capital

makes us possible to create environment of security, confidence,
high morale among the staff and it helps in creating overall
efficiency of the business.

10. Liquidity and solvency: A sound position of working capital

enables a firm to make payment of dividends to its investors
regularly. This helps in gaining confidence in the mind of investors
and also helps in creating favorable market environment to raise
additional funds in the near future.

11. Contented labour force: A firm having enough amount of

working capital will be in a position to pay its workers well and in
advance. This way contented labour force contributes to increased
production of quality goods.

7.6 DANGER OF INADEQUATE WORKING CAPITAL:

When a firm had inadequate amount of working capital, it

faces the following problems.

a) It may not be able to take advantages of cash discount.

b) It cannot buy its requirements in bulk and unable to utilize

production facilities fully.

c) It may not be able to take advantages of profitable

business opportunities.

d) It may not be able to pay its dividends because of non

availability of funds.

e) It shows low liquidity leads low profitability. Low

profitability results in low liquidity.
 161

f) It is not possible to pay short terms liabilities due to

inadequate working capital. This leads to borrow loan or
funds at high rate of interest.

g) Credit worthiness of a firm may be damaged due to lack

of liquidity. It will lose its reputation. Thus firm may not
be able to get credit liabilities.

h) Low liquidity position may lead to liquidate the firm

because it cannot be able to meet its debts at the date of
maturity.

7.7 DANGER OF EXCESS WORKING CAPITAL :

When a firm has excess working capital arise the following

problems.

a) A firm may be tempted to over trade and lose heavily.

b) A firm may purchase more inventories unnecessarily

which leads the problem of theft, waste, losses, etc.

c) It created imbalance between liquidity and profitability.

d) Excess working capital means idle funds means not

earning of profits. In this case rate of return on
investments falls.

f) It may make greater production which may not have

matching demand. Fund will be blocked only. No
possibility of profits.

g) It may lead carelessness about cost of production. It

means there will be high cost of production and it leads to
less profit.

7.8 FACTORS DETERMINING WORKING CAPITAL

REQUIREMENT :

a) Nature of business: - Working capital requirements of an

enterprise are basically related to conduct of the business. Public
utility undertakings like electricity, water supply, Railways, etc need
very limited working capital because they offer cash sales only and
supply services, not products, and as such no funds are tied up in
inventories and receivables. But at the same time, trading firm
need large amount of working capital in current assets like
inventories, cash, receivables etc but they have less investment in
fixed assets.
 162

b) Terms of purchases and sales: - Credit terms granted by the

concerns to its customers as well as credit terms granted by its
supplier also affect the working capital. It credit terms of purchases
are more favorable and those sales less liberal, less cash will be
invested in the inventory. Working capital requirement can be
reduced it terms of credit are more. The ratio of credit and cost
purchases or sales affect the level of working capital. If firms
purchases on credit and sales cash then requires less working
capital and if firm purchases on cash and sales on credit, then it
requires large working capital. This means funds are tied up in
debtors and bills receivables.

c) Manufacturing cycle: - The quantum of work capital needed is

influenced by the length of manufacturing cycle. The
manufacturing process always involves time lag between the time
when raw materials are fed into the production line and finished
products are finally turned out by it. The length of period of
manufacture in turn needs on the nature of product as well as
production technology used by a concern.

d) Size of business unit: - Amount of working capital requirement

is depending on the scale of operation of the business organization.
Large business organization performs large business activities
which require huge working capital than small scale organization.

e) Turnover of inventories: - A business organization having low

turnover of inventory would need more working capital where as
high turnover of inventory need small or limited working capital.

f) Turnover of circulating capital: - The speed with which

circulating capital completes its cycle if conversion of cash into
inventory of raw material, raw material into finished goods, finished
goods into debts and debts into cash, which decides need of
working capital in the organization. Slow movement of working
capital cycle necessitates large provision of working capital.

g) Seasonal variations production: - In case of seasonal

production in the industries like sugar, oil, mills, etc need more
working capital during peak seasons as well as slack seasons.

h) Degree of mechanization: - In highly mechanized concerns

having low degree of independence, on labour, requirement of
working capital reduced. Conversely, in labour intensive industries
greater sum of working shall be required to pay wages and related
facilities.

i) Growth and expansion: - Every firm wants to grow over a period

of time and with the increase in its size, the working capital
 163

requirements are bound to increase. The growing company would

need, therefore, larger amount of working capital.

j) Policy regarding dividend: - Dividend policy of a firm will also

influence the working capital position. The company which
declares large amount of dividends in the form of cash requires
large working capital to pay off such dividends. But sometimes,
companies issues bonus shares by way of dividend in such cases
working capital requirements will be comparatively less. This is
depending on Psychology of shareholders i.e. whether they prefer
cash income or capital appreciation.

k) Inflation: - A business concern requires more working capital

during the inflation period. This factor may be compensated to
some extent by rise in selling price of inventory.

l) Changes in technology: - Changes in production technology

have an impact on the need of more working capital.

m) Depreciation policy: - Charges of depreciation on assets do

not involve any cash outflows. Depreciation affects tax liability and
retention profits. It is allowable expenditure while calculating net
profits. Higher depreciation will mean lower disposal of profit and
therefore dividend will be paid in smaller amount. Thus cash will be
preserved.

7.9 IMPORTANCE OF ADEQUATE WORKING

CAPITAL :

a) It enables a company to meet its obligations.

b) It ensures solvency position of the company.
c) It ensures credit standing of the company.
d) It facilitates obtaining credit from banks without problems.
e) It enables prompt payment of short terms debts.
f) It enables an organization to tide over difficult periods
successfully.
g) It enables the organization to enhance the goodwill by meeting
operational expenses and maturing liabilities in time.
h) It improves the prospectus and progress of the company.
 164

7.10 SOURCES OF WORKING CAPITAL :

Sources of working capital

Long term source Short-term source

1) Issue of shares
2) Issue of Debentures
3) Plugging back of profit Internal source External source
4) Loans from banks
5) Public deposits 1) Depreciation 1) Trade credit
2) Taxation provision 2) Credit paper
3) Accrued expenses 3) Bank credit
4) Customer's credit
5) Govt. Assistance
6) Loan from directors
7) Security of employees

7.11 METHODS OF PROJECTING WORKING

CAPITAL REQUIREMENTS :

7.11.1 Conventional method: In this method cash flow i.e. inflow

and out flow are matched with each other. Greater emphasis is laid
down on liquidity of a business organization.

7.11.2 Operating cycle method: This method refers to working

capital in a realistic way. The working capital is decided on the
basis of length of the operating cycle. It is calculated by dividing
operating expenditures by the number of operating cycle.

7.12 PROJECTION OF WORKING CAPITAL

REQUIREMENTS :

The businessman mainly faces the problem of determination

of working capital requirements for financing particular level of
activity. The finance manager has to perform the activities of
forecasting working capital requirements. This process involves the
following aspects.

1) Level of activity: - Estimation of working capital begins with the

level of activity. Therefore the finance manager has to ascertain
the required quantum of production in advance on the basis of past
experience, installed and utilized capacity of the factory and
demand.
 165

2) Raw materials: - The finance manager has to estimate the

quantity and cost of raw materials. Lengths of time of raw materials
remain in the store before issue for production is considered longer
period of stay of raw material need greater working capital. This
must be valued at cost.

3) Labour and overheads: - Expenses incurred on wages and

overheads are considered while ascertaining raw materials.

4) Work-in-progress: - While ascertaining work-in-progress the

‗period of processing' or 'period of production cycle' has to be
considered. Longer the production cycle, greater the working
capital requirement. Therefore, the finance manager has to
consider the amount required for raw materials, wages and
overheads while estimating volume of production.

5) Finished Goods: - The period of storing finished goods before

sale has to be taken into consideration. This is depending on
season, sales forecasting, etc. If the sales are seasonable and
production is throughout the year, then working capital requirement
would be the higher during the slack seasons.

6) Sundry Debtors: - While calculating amount of sundry debtors,

period credit allowed to customers is to be taken into consideration.
This period is known as "time lag in payment by debtors". If this
period is longer, required working capital will be higher in the
absence of similar time lag in payment to creditors. The sundry
debtors are value at sales price while calculating working capital.

7) Cash and bank balance: - As per past experience every

businessman is suppose to know the amount cash float or bank
balance necessary to pay day is day payments. This amount is
given in the information and added in the amount of working capital
required.

8) Prepaid Expenses: - There may be some expenses i.e.

insurance, sales promotion would be paid in advance and in this
case working capital requirement would be higher is that extent.

9) Sundry Creditors: - The period of credit allowed by supplier has

to be taken in to consideration while estimating required amount of
working capital. It longer the period credit from suppliers, lower will
be the working capital requirements.

10) Creditors for expenses: - Time lag in payment of wages and

overheads also should be considered while deciding amount of
working capital requirements. If there is no time lag in payment of
wages and overheads, more working capital will be required and
 166

there will be less requirement of working capital when there is time-

lag in payment of wages and overheads.

11) Advance from customers: - If and when advance required

from customers then there will be lower working capital
requirements.

12) Contingencies: - After calculating the amount of working

capital as discussed above, a provision for contingencies may be
made to make allowances for likely variations. This is the sort of
cushion against uncertainties involved in estimating working capital.

7.13 EXERCISE

1. Define Working Capital. Explain the types of Working Capital.

2. ―No business can run successfully without an adequate
amount of Working Capital‖. Discuss.
3. Which are the Determinants of Working Capital?
4. Write short notes:
1. Importance of Adequate of Working Capital.
2. Danger of Excess Working Capital.
3. Danger of Inadequate Working Capital.
4. Projection of Working Capital Requirements.


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8
WORKING CAPITAL CONCEPT - II

Unit Structure:

8.0 Objectives
8.1 Calculation of figures required for working capital projection
8.2 Illustrations
8.3 Exercises

8.0 OBJECTIVES :

After studying the unit the students will be able to:

Calculate the figures required for Working Capital Projection.
Draw the statement of Working Capital.
Solve the practical problems on Working Capital
requirement.

8.1 CALCULATION OF FIGURES REQUIRED FOR

WORKING CAPITAL PROJECTION :

8.1.1 Stock of raw materials: - The cost of raw materials

ascertained as under.

Raw material
Budgeted production x cost of material x holding period
(units) p.a per unit 365 days or 52
Weeks or 12 months

8.1.2 Work-in-progress: - The value of work-in-progress is

decided as follows:

Budgeted production x per unit cost x Process period

p.a (units) material 100% + 365 days or 52
Labour 50% + weeks or 12 months
overload 50%
 168

8.1.3 Stock of finished goods: - The investment in finished stock

by a firm is decided as follows:

Budget production Cost of goods Finished goods

p.a (units) x Produced p.u. x holding period
365 days or 52 weeks
or 12 months

8.1.4 Investment in debtors: - Debtors are calculated at sales

prices as well as at cost price as follows:

At sales price

Budgeted credit sales x Selling Price x Debtors collections period

P.a units per unit 365 days or 12 months
or 52 weeks

At Cost Price
Budgeted credit sales Cost of sale Debtors collections period
P.a units x per unit x 365 days or 12 months

8.1.5 Cost and bank balance: - Required amount of cash & bank
can be determined on the basis of cash budget. This budgeted
cash and bank balance should be enough to meet day to day
expenses. This is readily given in the problem and included in the
list of current assets.

8.1.6 Advance payment: - The payment of expenses for the

period which is not expired. It is calculated as follows.

Expenses
365 days or 52 weeks x Period of prepayment
or 12 months

8.1.7 Sundry Creditors: - The amount of creditors depends on

the credit purchases and the period of credit allowed by supplier is
calculated as follows:

Budgeted production Cost per unit Period of credit allowed

p.a units x of raw material x 365 days or 52 weeks or
12 months

8.1.8 Creditors for wages & overheads: - It is not necessary to

pay wages and expenses immediately which will ease working
capital requirements. This amount is calculated as follows:

Budgeted production x Wages or expenses x Lag in payment

P.a. unit per unit 365 days or 52
 169
Weeks or 12 months
8.1.9 Advance from customer: - The amount received from
customer in advance along with purchases result into less working
capital requirement. This amount is given in the problem.

8.1.10 Proforma of Working Capital Statement XYZ Co. Ltd.

Statement of Working Capital Requirement for the period ____
Particulars Working Rs. Rs.
A) Current Asset
I. Stock of Raw Material (Units x Rate x Period of
holding) xxx
II. Stock of WIP
a) Raw Material Labour (Units x Rate x Processing xxx
period)
b) Labour (Units x Rate x Processing
period x 1/2) xxx
c) Overheads (Units x Rate x Processing
Period x 1/2) xxx xxx
III. Stock of Finished Goods
a) Raw Material (Units x Rate x Period of xxx
holding)
b) Labour (Units x Rate x Period of xxx
holding)
c) Overheads Units x Rate x Period of xxx xxx
holding)

IV. Debtors at S.P. (Units X S.P. x Period of xxx

Credit)
OR
Debtors at Cost
a) Raw Materials (Unit x Rate x Period of xxx
credit)
b) Labour (Unit x Rate x Period of xxx
credit)
c) Overhead (Unit x Rate x Period of xxx xxx
credit)

V. Prepaid Expenses Units x Rate x Period of xxx

Payment
VI. Advance to Supplier xxx

VII. Cash & Bank xxx

Total xxxx
B.Less : Current Liabilities
I. Creditors for Materials (Units x Rate X period of
credit) xxx
II. Lag in payment Wages (Units x Rate x Lag in
a) Wages Payment) xxx
(Units x Rate x Lag in
b) Overheads Payment) xxx

III. Advance from Customers xxx

Total xxxx
C. Net xxxx
Current Assets (A - B)
Add: - Margin of Safety xxx
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D. Working Capital xxxx

8.2 ILLUSTRATIONS :

Solve problems:
1. Sanket Ltd. had an annual sale of 50,000 units, at Rs.100 per
unit. The company works for 50 weeks in the year.
The cost details of the company are as follows:
Elements of cost Cost per unit
Rs.
Raw Materials 30
Labour 10
Overheads 20
60
Profit per unit 40
Sales price per unit 100

The company has to practice of storing raw materials for 4

week's requirements. Wages and other expenses are paid after a
lag of 2 weeks. Further the debtors enjoy a credit of 10 weeks and
company gets a credit of 4 weeks from the suppliers. The
processing time is 2 weeks and finished goods inventory is
maintained for 4 weeks. From the above information prepare a
working capital estimates, allowing for a 15% contingency.

Solution:-

Working notes:
50, 000
a) Sales per week 1, 000 units per week.
50
b) Debtors are valued at selling price and finished goods at
sales loss profits.
c) It has been assumed that the labour and overheads
accrue on an average, so half the labour and overheads
would be included in work in progress.

Statement showing estimation of working capital.

Particulars Working (unit x Rate x Period) Rs. Rs.

A. Current Assets
I. Stock
Raw Materials (1000 x 80 Rs. x 4 week) 1,20,000
Work-in-progress
Raw materials (1000 x 30 Rs. x 2 week) 60,000
Labour (1000 x 10 x 2 weeks x 1/2) 10,000
Overheads (1000 x 20 x 2 weeks x 1/2) 20,000 90,000
Finished goods (1000 x 60 x 4 weeks) 2,40,000
II. Debtors (1000 x Rs. 100 x 10 week) 10,00,000

Total Current Assets 14,50,000

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B. Less: - Current Liabilities

I) Creditors (1000 x 30 Rs. x 4 weeks) 1, 20,000
II) Outstanding wages (1000 x Rs.10 x 2 week) 20,000
III) Outstanding Overheads (1000 x 20 x 2 weeks) 40,000
1, 80,000

Working Capital (A-B) 1, 27,000

Add. 15% Con. Reserve 1, 90,500
Net working capital 14, 60,500

2. A factory produces 48,000 units during the year and sells them
for Rs. 50 per unit. The cost structure of a product is as follows.

Raw Materials 60%

Labour 15%
Overheads 10%

85%
Profit 15%

Selling price 100%

The following additional information is available.

I. The activities of purchasing producing and selling occur
evenly through and the year.
II. Raw materials equivalent to 1 months supply is stored in
godown.
III. The production process takes are month.
IV. Finished goods equal to three month's production are carried
in stock.
V. Debtors get two month's credit.
VI. Time lag in payment of wages and overheads in 1/2 months.
VII. Cash and bank balance is to be maintained at 10% of the
working capital.
VIII. 10% of sales are made at 10% above the normal selling
price.

Draw the statement showing working capital requirement of

the factory.
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Solution:

Statement showing working capital requirement.

Particulars Working (units x Rate x period) Rs. Rs.
A. Current Assets
I. Stock
1
Raw Materials (48,000 x 12
x Rs.30 x 1m)
1,20,000
Work-in-progress 1
- Raw Materials (48,000 x 12
x Rs.30 x 1m) 1,20,000
1 1
- Labour (48,000 x x Rs.7.5 x m) 15,000
12 2

- Overheads (48,000 x
1
x Rs.5 x
1
m)
12 2 10,000 1,45,000
Finished Goods at cost 1 5,10,000
(48,000 x 12
x Rs.42.5 x 3 m)
II. Debtors at selling price 1
Normal (48,000 x 12
x 90% x Rs.50 x 2m) 3,60,000
1
Higher S.P. (48,000 x x 10% x Rs.55 x 2m) 44,000 4,04,000
12

Total 11,79,000
B. Current Liabilities
I. Sundry Creditors 1
(48,000 x x Rs.30 x 1.5m) 1,80,000
12
II. O/S wages 1 1
(48,000 x 12
x Rs.7.50 x 2 m) 15,000
1 1
III. O/S Overheads (48,000 x x Rs.5 x 2 m) 10,000 2,05,000
12

C. Working capital (A-B) (90%) 9,74,000

Add : 10% for cash & (10%)
Bank balance 1,08,222
i.e. 10% of cost
Required working capital (100%) 10,82,222

Working notes.

1) Cost Structure %age Cost per unit

Raw material 60 30.00
Labour/Wages 15 7.50
Overheads 10 5.00

85 42.50

Add. Profits 15 7.50

Selling price 50.00

2) Sundry debtors
Normal selling price Rs.50.00
10% above normal selling price Rs.55.00
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5 1
5 50 5 55
10
3) Cash & Bank balance

974000 10
Rs. 1, 08,222
90
= 10,8,222.222

4) M = Months

3. The Board of Directors of Century Rayon Ltd. requests you to

prepare a statement showing requirements of working capital for a
forecast level of activity of 52,000 units in the ensuring year (52
weeks) from the following information made available.

Cost per unit

Rs.
Raw Material 40.00
Labour 15.00
Overheads Manufacturing 20.00
Overheads Selling & Distribution 10.00
85.00

Additional Information:

a) Selling price - Rs. 100/- per unit.

b) Raw material in stock - average 4 weeks.
c) Work-in-progress - average 4 weeks.
d) Finished goods in stock - average 4 weeks.
e) Credit allowed to debtors - average 8 weeks.
f) Credit allowed by supplier - average 4 weeks.
g) Cash at bank is expected to be Rs. 50,000.
h) All sales are a credit basis.
i) All the activities are evenly spread out during the year.
j) Debtors are to be valued at sales.
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Solution:

Statement of working capital requirement.

Particulars Working (units x Rate x period) Rs. Rs.

A. Current Assets
I. Stock
1
Raw Materials (52,000 x x Rs.40 x 4 weeks) 1,60,000
52

Work-in-progress
Raw Materials (52,000 52 x Rs.40 x 4 weeks) 1,60,000
Labour 1
(52,000 52 x Rs.15 x 4 weeks x 2
) 30,000
1
Overheads (52,000 52 x Rs.20 x 4 weeks x ) 40,000 2,30,000
2

Finished Goods at cost (52,000 52 x Rs.75 x 4 weeks) 3,00,000

II. Debtors at selling price (52,000 52 x Rs.100 x 8 weeks) 8,00,000
III. Bank Balance 50,000
15,40,000
B.Less Current Liabilities
Sundry Creditors (52,000 52 x Rs.40 x 4 weeks ) 1,60,000
C. Working Capital (A-B) 13,80,000

Working Notes:

1) Particulars Cost per unit

Rs.
Raw materials 40.00
Labour 15.00
Manufacturing overheads 20.00
Cost of goods produced 75.00
Add: Selling & Distribution Expenses 10.00
Cost of goods sold 85.00
Add: Profit 15.00
Sales price 100.00

2) W= weeks
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4. From the following data, prepare a statement showing working

capital requirement for the year 2009:

a) Estimated activity for the year 1, 95,000 units (52 weeks).

b) Stock of raw material 2 weeks and material in progress 2
weeks, 50% of wages and overheads are incurred.
c) Finished goods 3 weeks storage.
d) Creditors 2 weeks.
e) Debtors 4 weeks.
f) Outstanding wages and overheads 2 weeks each.
g) Selling price per unit Rs. 30.
h) Cost analysis per unit is as follows.
I. Raw materials 1/3 of sales.
II. Labour and overheads in the ratio of 3:2 per unit.
III. Profit per unit is Rs. 10
i) Cash balance Rs.50,000

Assume that operations are evenly spread throughout the year.

Solution:

Working notes

1) Cost structer

Rs. Cost per unit for

195000 unit

Rs.
Raw Materials 19,50,000 10.00
Labour 11,70,000 6.00
Overheads 7,80,000 4.00
Total Cost Profit 39,00,000 20.00
Profit 19,50,000 10.00
Sales price 58,50,000 30.00
2) After deducting profit we get total cost per unit Rs.20.
3) Total cost Rs.20 includes Rs.10 cost of raw materials.
4) Balance Rs.10 per unit will be divided in the ratio of 3:2 i.e.
Rs.6 labour and Rs.4 overheads.
5) W = week
 176

Statement of working capital requirements for the year 2009.

Particulars Working (units x Rate Rs. Rs.

x period)
A. Current Assets
I. Raw Materials (19,5,000 52 x 10 x 2w) 75,000

II. Work-in-progress
Raw Materials (19,5,000 52 x 10 x 2w) 75,000

Labour (19,5,000 52 x 6 x 2w x 22,500

50%)
Overheads (19,5,000 52 x 4 x 2w x 15,000 11, 2,500
50%)

III. Finished Goods (19,5,000 52 x 20 x 2w) 1, 50,000

IV. Debtors (19,5,000 52 x 30 x 4w) 4, 50,000

V. Cash Given 50,000

Total 8, 37,500

B. Less Current Liabilities

I. Creditors (19,5,000 52 x 10 x 2w) 75,000
II. Outstanding wages (19,5,000 52 x 6 x 2w) 45,000
III. Outstanding overheads (19,5,000 52 x 4 x 2w) 30,000
Total 1, 50,000
C. Working Capital (A-B) 6, 87,500

5. Sangeet Swapna Ltd. Furnisher in the following information and

request you to prepare a statement showing the requirement of
working capital for the year ended 31st March 2009.

Budgeted for 2009

Production capacity for the year 10,000 units
Production 90%
Cost structure
Crude material Rs. 30 per unit
Other direct material Rs. 20 per unit
Wages Rs. 25 per unit
Overheads Fixed Rs. 9000 p.m.
and Rs. 15 variable
per unit
Profit 25% on sales
 177

Other information: -

I. Crude oil material remains in the stock for 2 months.

II. Other direct material remains stock for 1 month.
III. Finished goods remain in stock for 2 month. (to be valued at
direct cost)
IV. Production process takes place 1 month work-in-progress
valuation to be made crude material plus direct material at
cost; plus 50% of wages and variable overheads.
V. Time lag in payment of wages 1 month and variable
overhead half month.
VI. Fixed overhead payable quarterly in advance.
VII. Crude material purchased from suppliers against advance
payment of two months and other direct material suppliers
allow credit of 1 month.
VIII. Credit allowed to customers as under at sales price.
a) 50% of invoice price against acceptance of bill for
4 months.
b) 25% of invoice of time lag 2 months.
IX. Bank balance to be maintained Rs. 50,000.
X. Production and sales takes place evenly throughout the
year.

Solution: -

Working notes: -

1) Estimated production 90% of 10,000 = 9000 units.

2) Cost structure Rs.
Crude material 30.00
Other direct material 20.00
Wages 25.00
Fixed overhead (9000 x 12) 108000 9000 12.00
Variable overheads 15.00
Total Cost 102.00
Profit 25% on sales (Means 331/3 of cost) 34.00
Selling price 136.00
3) M = months
 178

Statement of working capital

Particulars Working (units x Rate Rs. Rs.
x period)
A. Current Assets
a) I. Stock: 75,000
Crude Material (9000 12 Rs.30 2 m) 45,000
Other direct material (9000 12 20 1 m) 15,000 60,000

II. Work-in-progress
Crude material (9000 12 30 1 m) 22,500
Other direct material (9000 12 20 1 m) 15,000
Wages (9000 12 25 1 m 50%) 9,375
Overheads (9000 12 15 1 m 50%) 5,625 52,500

III. Finished goods (9000 12 102 2 m) 1,53,000

b. Debtors (9000 12 136 1 m 50%) 51,000
c. Bills receivables (9000 12 136 4 50%) 2,04,000
d. Advance to suppliers (9000 12 30 2 m) 45,000
e. Prepaid fixed overhead (9000 x 3 x 1) 27,000
f. Bank balance Given 50,000
Total 6,42,500
B. Less Current Liabilities
I. Creditors (9,000 12 x 20 x 1 m) 15,000
II. Outstanding wages (9,000 12 x 25 x 1 m) 18,750
III. Outstanding overheads (9,000 12 x 15 x 0.5 m) 5,625
Total 39,375
C. Working Capital (A-B) 6,03,125

6. From the books of The Board of KEM Ltd. Pune prepare a

statement of working capital requirement to meet the programme
planned for the year 2011.
1) Issued share capital Rs. 4,00,000
5% Debentures Rs. 1,00,000
Fixed assets at cost Rs. 2,50,000
2) The expected ratio of the cost to selling price are:
Material 60%
Labour 10%
Overheads 20%
Profit 10%
3) Raw materials are in stores for an average of 2 months.
Finished goods are kept in warehouse for approximately
three months.
4) Production during the previous year was 1,20,000 units and
it is planned to maintain this level of activity in the current
year also.
5) Each unit of production is expected to be in process for one
month.
6) Credit given by suppliers is two months and allowed to
customers is 3 months.
 179

7) Selling price is Rs. 10 per unit.

8) There is regular production and sales cycle.
9) It is decided to maintain Rs. 30,000 cash balance.

Solution: -

a) Budgeted output 1, 20,000 units (given).

b) Budgeted sales - 1, 20,000 x 10 = Rs. 12, 00,000
c) Cost Structure:
R. M. 60% of Rs. 10 = Rs. 6.00 per unit
Labour 10% of Rs. 10 = Rs. 1.00 per unit.
Overheads 20% of Rs. 10 = Rs. 2.00 per unit.
d) Annual expenditure
Raw material (1, 20,000 x Rs. 6) = 7,20,000
Labour (1, 20,000 x Rs. 1) = 1,20,000
Overheads (1, 20,000 x Rs. 2) = 2,40,000

Total 10, 80,000

Profit (1,20,000 x Rs.1) 1,20,000

Selling price 12, 00,000
e) M = months

Statement of working capital requirements

Particulars Working (units x Rs. Rs.

Rate x Period)

A. Current Assets
1, 20, 000 6
I. Stock of Raw materials 2m 1, 20,000
12
II. Work-in-progress
1, 20, 000 6
Raw Materials 1m 60,000
12
1, 20, 000 1 1
Labour m 5,000
12 2

1, 20, 000 2 1
Overheads m
12 2 10,000 21,000
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III. Finished goods 1, 20, 000 9

3m 2, 70,000
12
IV. Debtors
a) Raw materials 1, 20, 000 6
3m 1, 80,000
12
b) Labour 1, 20, 000 1
3m 30,000
12
c) Overheads 1, 20, 000 2
3m 60,000 2,70,000
12
V. Cash 30,000

Total 7, 11,000
B. Less: Current liabilities
1, 20, 000
Creditors 6 2m 1, 20,000 1, 20,000
12

Working Capital (A – B) 5, 91,000

8.3. EXERCISES :

1. You are required to prepare a statement showing the working

capital required to finance the level of activity of 27,000 units per
year from the following information.
Per unit
Rs.
Raw materials 24.00
Direct labour 6.00
Overheads 18.00
Total Cost 48.00
Profit 12.00
Selling price 60.00

Information:
I. Raw materials are in stock an average for two months.
II. Materials are in process on an average for half a month.
III. Finished goods are in stock on an average for two months.
IV. Credit allowed by creditors is two months of raw materials
supplied.
V. Credit allowed to debtors is three months.
VI. Lag in payment a wages is half month.
VII. Cash on hand Rs. 4,000 and bank balance Rs. 10,000
 181
(Ans. Raw materials - Rs. 1,08,000; work in progress - Rs. 40,500; Finished
stock - Rs. 2, 16,000; Debtors Rs. 4, 05,000; Creditors Rs. 10, 8,000;
Labour/wages Rs. 6,750; working capital Rs. 6, 23,750)

2. From the following data provided by M/s Alfa Ltd. estimate

working capital requirements for the year ended 31st March 2006.

a) Estimate activity of operation for the year 2, 60,000 units (52

weeks)
b) Raw materials remain in stock for 2 weeks and production
cycle takes two weeks.
c) Finished goods remain in stock for two weeks.
d) Two weeks credit is allowed by supplier.
e) Four weeks credit is allowed to debtors.
f) Time lag in payment of wages and overheads is two weeks.
g) Cash and bank balance to be maintained Rs. 25,000
h) Selling price per unit is Rs. 15
i) Analysis of cost per unit as follows:
1
i. Raw material 33 % of sales
3
ii. Labour and overheads in the ratio of 6:4 per unit.
iii. Profit is at Rs. 5 per unit.

Assume that operations are evenly throughout the year;

wages and overheads accrue similarly. Manufacturing process
required feeding a material fully at the beginning. Degree of work-
in-progress is 50%. Debtors are to be estimated as selling price.

(T.Y.B.Com March 2006)

(Ans. Stock Rs. 50,000 work-in-progress Rs. 75,000 debtors Rs.1,00,000,

creditors Rs. 50,000, outstanding wages Rs. 30,000, outstanding overheads
Rs. 20,000, working capital Rs. 4, 50,000)

3. From the following details, prepare a statement showing working

capital requirement for the year ended 31st March 2009.

Production 90,000 units

Selling price per unit Rs. 10.00
Raw Materials 60% of selling price
Direct wages 10% of selling price
Overheads 20% of selling price
Materials in hand 2 months requirement
Production time 1 month
Finished goods in stores 4 month
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Credit for material 2 month

Credit allowed to customers 3 month
Average cash balance Rs. 30,000
Average bank balance Rs. 20,000

Wages and overheads are paid at the beginning of the

month following. In Production all the required materials are
charged in the initial stage and wages and overheads accrue
evenly.

(Ans. Raw materials Rs. 90,000, WIP- Rs. 56,250, Finished goods Rs. 2,70,000,
Debtors - Rs. 2, 25,000, Creditors - 90,000, O/s wages Rs. 7,500, O/s overheads
Rs. 15,000 - working capital 6, 78,750)

4. From the following data, prepare a statement of working capital

requirement for the year 2009

Rs. Rs.
Budgeted sales 3, 60,000
Less: cost of materials 1, 08,000
Direct labour 1, 44,000
Overheads 72,000 3, 24,000
Net profit 36,000

It is estimated that:
a) Raw materials are carried in stock for one months and
finished goods for 15 days only.
b) The production cycle take one month.
c) One month's credit is granted both for purchase of raw
materials and sales of finished goods.
d) Production and overheads are even through the year.

(Ans. Raw materials Rs, 9,000, WIP Rs. 18,000 finished goods Rs. 13,500,
Debtors Rs. 30,000, Creditors Rs. 9,000, working capital Rs. 61,500)

5. The management of Fast and Thin Ltd. desires to know the

working capital required with effect from 1st January, 2010 to
finance. the production programme. Percentage cost structure of
selling price is as follows.

Raw Materials 50%

Labour 20%
Overheads 10%
You are further informed that:
a) Raw materials remain in the stores on an average for one
month before issue to production.
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b) Finished goods remain in the godown for 2 months before

sales.
c) Each unit of production will be in process for one month.
d) Credit allowed by creditors is one month and allowed to
debtors is 2 months.
e) Selling price per unit is Rs. 9.00
f) Production in 2010 is expected to be 1, 00,000 units.

(Ans. Raw materials - Rs. 37,500, work-in-progress- Rs. 48,750, Finished goods
- Rs. 1, 20,000, Debtors - Rs. 1, 20,000, Creditors - Rs. 37,500, working capital -
Rs. 2, 88,750)



CAPITAL BUDGETING

Unit Structure:

9.0 Objectives

9.1 Introduction

9.2 Meaning of a project

9.3 Project Planning

9.4 Project Report

 184

9.5 Types of projects

9.6 New concepts of projects

9.7 Feasibility study and report

9.8 Project financing

9.9 Cost of Project

9.10 Means of Finance

9.11 Promoters contribution

9.12 Margin Money

9.13 Capital structure

9.14 Optimum capital structure

9.15 Trading on Equity

9.16 Servicing of Interest and Debt

9.17 Sources of long-term finance

9.18 Institutional considerations

9.19 Venture Capital

9.20 Project appraisal

9.21 Model Questions

9.0 OBJECTIVES :

The objectives of this topic are as follows:

(i) to understand the concept of capital budgeting

(ii) to understand the concept of project and budgeting report
(iii) to understand the sources of project financing
(iv) to understand the important considerations for capital budgeting

9.1 INTRODUCTION :
 185

The financial requirements of business can be classified as short-

term and long-term financial requirements. Short-term funds are required
for meeting working capital needs. It is usually required for a period up to
one year. Long-term funds are required to a great extent for meeting the
fixed capital requirements of the business. It is required for a period of 1
to 5 years or more. Fixed capital is required for investment in land,
building, plant and machinery, vehicles and furniture etc. Short-term
funds are required for making day to day payments like wages, raw
materials, traveling, stationery etc. the requirements of short-term funds
are usually met by taking short-term loans, overdraft or getting the bills
discounted from the banks. The long-term funds are raised by issue of
shares, debentures, loans from financial institutions and banks.

Capital investment involves a cash outflow in the immediate future

in anticipation of returns of a future date. The planning and control of
capital expenditure is called as capital budgeting decisions. Capital
budgeting is an art of finding assets that are worth more than their cost of
achieve the objectives i.e. optimizing the wealth of a business enterprise.
A key challenge for the companies is to identify projects which fit the
objectives and promise to be profitable. Capital expenditure decisions
usually involve large sums of money, long-time spans and carry some
degree of risk and uncertainty. Realistic investment appraisal requires
the financial evaluation of many factors such as the choice of size, type,
location, timing of investments, taxation, opportunity cost of funds
available and alternative forms of financing the projects.

9.2 MEANING OF A PROJECT :

A Project is a scheme for investing resources. It is a proposal of

something to be done, plan or scheme. Every business plan is a project.
The entrepreneur has to identify an opportunity to undertake a new
venture. The business opportunity can be generated through various
techniques like market research observations at market places,
consultation with experts and brainstorming sessions. The entrepreneur,
should conduct cost-benefit analysis of each of every idea. The costs can
be measured in terms of resources required to implement the opportunity
and the benefits can be measured in terms of sales, profits etc. Thus, a
project is a business plan. It describes the future direction of the
business. The entrepreneur should prepare a sound business plan in
order to exploit the opportunity. A good business plan is important in
 186

determining the resources required, obtain the resources and effectively

manage the business venture.

9.3 PROJECT PLANNING:

Project planning is deciding in advance the future course of action.

The first stage in the process is recognition of opportunities. The involves
a continuous search for investment opportunities which are compatible
with the firm‘s objective. Survival and profitability are two most important
objectives to be achieved. Therefore, each proposal is subjected to a
preliminary screening process in order to assess whether it is technically
feasible, economically, viable, resources required are available and then
expected returns are adequate to compensate for the risks involved. The
alternative plans are screened and further investigated. If a proposal
satisfies the screening process it is then analyzed in more detail by
gathering technical, economic and other details. Projects are also
classified into new projects, expansions or improvements and rank them
within each classification with respect to profitability, risk and degree of
urgency. The alternative projects are evaluated on the basis of the
investment cash inflow and outflows. Once evaluation is completed then
the best proposal is forwarded to a higher level management for
authorization and to take up the project. The project will be implemented,
if approved and its progress is monitored with the aid of feedback reports.

9.4 PROJECT REPORT:

A project report is a written document containing complete

information about the proposed project. Thus, a project report is a blue
print guiding the entrepreneur to reach the destination as envisaged by
the entrepreneur. A project report is prepared by an expert after detailed
study and analysis of the different aspects of the project. The various
aspects of the project includes analysis of the market, technology,
finances, manpower, production facilities etc. It is prepared to analyze
the extent of opportunities in the proposed project. It is useful to financial
institutions, government authorities, investors and the entrepreneur. The
project report spells out the advantages and disadvantages of allocating
resources of enterprise to the production of specific goods and services.
The contents of the project report should be arranged in a logical manner.
An original project report runs into several pages.
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9.5 TYPES OF PROJECTS :

There are different types of projects undertaken by the business.

The important types of projects are given below:-

(1) Modernization Project: Modernization projects involve

removal of old machines and installation of new machines in
their place to cope with dynamic and competitive business
environment.
(2) Expansion Projects: Expansion projects are undertaken to
enlarge the plant capacity with a view to produce a large
volume of production than the current level of production.
(3) Diversification Projects: Diversification project is an
investment decision to set up an entirely new project which is
not connected with the exiting line of business.
(4) Balancing Projects: New plant and machinery is installed in
order to remove the bottlenecks (imbalance) and to increase
the capacity utilization of the total plant. In installing balancing
equipment, these would be free flow in the process and
uninterrupted production is ensured and there will be increase
in the revenue.
(5) Replacement Project: Replacement of an existing asset with
more economic one is a replacement project. By replacement,
the operational efficiency is increased, cost of production is
reduced, cost of maintenance is reduced and profitability is
increased.

9.6 NEW CONCEPTS OF PROJECTS:

In recent economic liberalization programme in India, few projects

are emerging with new concept for financing and execution of project.
Such new concepts of projects are given below:

(1) Building Operate and Transfer (BOT): Under this concept,

the private sector is allowed to put the investment in bringing
the project and the Government allows them to operate for
certain period and then transfer the project to the Government.
For example, super express highways.
(2) Build, Own and Operate (BOD): Under this concept, the
private entrepreneurs are allowed to build the project from
their own resources, and then they will own the project and
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they are also entitled to operate the project subsequent to their

commercial launching. For example, power sector.
(3) Lease, Rehabilitate, Operator and Transfer (LROT): Under
LROT concept, the Government gives a running plant to the
private entrepreneur for rehabilitation to put the plant on
profitability track.
(4) Turnkey Projects: When a single contractor undertakes the
responsibility for the entire work and completes it so that the
owner merely turns the key and operates the plant is known as
―Turnkey‖ project. It covers the complete responsibility of
engineering, design, manufacturing, supply, construction and
commissioning the project.

9.7 FEASIBILITY STUDY AND REPORT:

A feasibility study is a preliminary study undertaken to determine a

project‘s viability. The results of the study are used to make a decision
whether or not to proceed with the project. It is an analysis of possible,
alternative solutions to a problem and a recommendation on the best
alternative.

A business plan is prepared only when the business venture is

feasible. A feasibility study provides an investigating function. It is
conducted by an outside expert. The expert conducting the feasibility
study has to work with the group to identify the best alternative for the
situation. If the business plan is not feasible, others are made to correct
the deficiencies and other alternatives may be explored. The feasibility
study covers the following areas:-

(1) Technical feasibility: It involves the question whether the

technology needed for the project exists, the cost of
technology and the suitability of the technology to the firm.
(2) Market feasibility: It covers the potential impact of consumer
demand, supply, competition, price and profits.
(3) Economic feasibility: This involves the feasibility of the
proposed project to generate economic benefits.
(4) Financial feasibility: It involves the capability of the firm to
raise appropriate funds needed to implement the proposed
project.
Feasibility report is written document containing in detail the
finding of the feasibility study in respect of the project. It is prepared by
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exports or by lending institutions. It is prepared after conducting the

feasibility study. It is useful to find out commercial viability of the project
and rate of success or failure of the project.

9.8 PROJECT FINANCING:

The financing decision is an important managerial decision. It

influences the shareholders‘ returns and risk. As a result, the market
value of the share may be affected by the financing decision. The
financing decision relates to the composition of relative proportion of
various sources of finance. The financial management weighs the merits
and demerits of different sources of finance while taking the financing
decisions. A project can be financed from either the shareholders‘ funds
or borrowings from outside agencies. The shareholders‘ funds include
equity share capital, preference share capital and the accumulated profits
whereas borrowings from outsides include borrowed funds like
debentures and loans from financial institutions. The borrowed funds
have to be paid back with interest and some amount of risk is involved if
the principal and interest is not paid. Equity has no fixed commitment
regarding payment of dividends or principal amount and therefore no risk
is involved. It is the decision of the business to decide the ratio of the
borrowed funds and owned funds. Most of the companies use a
combination of both the shareholders‘ fund and borrowed funds. Both the
types of funds incur cost and it is called cost of capital to the company.

Funds requirement decision and the financing decision are two

major areas of financial decision making. Funds requirement decision is
concerned with the estimation of the total funds or capital requirements
for the business enterprise, while the financing decision is concerned with
the sources from which the funds are to be raised. It is also necessary to
raise the funds at proper time, and at reasonable cost. Therefore, there
should be proper financial planning which includes:

(a) Estimating the amount of capital to be raised.

(b) Determining the form and proportionate amount of securities.
(c) Laying down the policies as to the administration of the financial
plan.
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9.9 COST OF PROJECT :

Cost of project is the aggregate of costs estimated to be incurred

on various heads for bringing the project into existence. The cost of the
project usually comprises the following:

(a) Fixed Capital requirement, and

(b) Working capital requirements.

The fixed capital requirements include the following costs:-

i) Land and site development.

ii) Factory Building.
iii) Plant and Machinery.
iv) Other Fixed Assets.
v) Technical know how.
vi) Preliminary expenses.

The working capital refers to the capital required for day to day
operations of a business enterprise. It includes the following costs.

i) Purchase of raw materials

ii) Payment of wages and salaries.
iii) Payment of routine expenses.
iv) Contingencies.

9.10 MEANS OF FINANCE:

It is necessary to raise finance from various sources for

implementation of the project. The scheme of finance will be determined
after consideration of various aspects attached to different sources of
finance. The scheme of finance will comprise the following:

(a) Share capital – Preference shares and equity shares.

(b) Debentures.
(c) Term loan from financial institutions.
(d) Unsecured loans – banks, promoters, others.
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9.11 PROMOTERS CONTRIBUTION:

The persons who are involved in the implementation of a project

are known as promoters. An entrepreneur who promotes the project is
also required to participate in the scheme of finance of the project. The
extent of promoter‘s contribution in the project is a sign of interest of the
promoter in the project. Promoter‘s contribution indicates the extent of
their involvement in the project. The promoters‘ contribution can be
provided in the form of subscribing to equity and preference shares
issued by the company, unsecured loans, seed capital assistance,
venture capital assistance and internal accrual of funds. The Bank and
Financial institutions normally participate in the scheme of project finance
and they ask the promoters to bring in a certain portion of total funds
required which is normally between 25% to 50% of the cost of the project
into the equity share capital of the company. The promoter‘s contribution
can be arranged from outside sources like friends and relatives. For
eligibility of the project financing the financial institution may stipulate
minimum promoter‘s contribution which is to be arranged by the promoter.

9.12 MARGIN MONEY:

The banks and financial institutions maintain a margin while

financing the project cost. They ask the borrowers to bring a certain
amount of the cost of the project cost as margin money to safeguard from
the changes in the value of assets that are being financed and provided
as a security. The quantum of margin money depends upon the
creditworthiness of the borrower and nature of security provided to the
institution. Margin money is one of the important factors which is
evaluated by the financial institutions while considering the project for
financial assistance. The margin money required for working capital will
be provided in the project cost. The RBI guidelines provide the amount of
working capital margin money. The margin money should be brought by
the promoters in project financing.

9.13 CAPITAL STRUCTURE :

Capital structure refers to the mix of a firm‘s capitalization and

includes long-term sources of funds such as debentures, preference
shares, equity shares and retained earnings. The decisions regarding the
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forms of financing their requirements and their relative proportions in total

capitalization are known as capital structure decision. A firm has the
choice to raise funds for financing its project from different sources in
different proportions as follows:

(a) Exclusive use of equity capital

(b) Use of equity and preference capital
(c) Use of equity and debt capital
(d) Use of equity, preference and debt capital
(e) Use of a combination of debt, equity and preference capital in
different proportions.

The choice of combination of these sources is called as capital

structure mix.

9.14 OPTIMUM CAPITAL STRUCTURE:

The theory of optional capital structure deals with the issue of the
right mix of debt and equity in the long-term capital structure of a firm.
This theory states that if a company takes on debt the value of the firm
increases up to a point. Beyond that point if debt continues to increase
then the value of the firm will start to decrease. If the company is unable
to repay the debt within the specified period, then it will affect the goodwill
of the company in the market. Therefore, the company should select its
appropriate capital structure with due consideration to the factors of debt
and equity.

9.15 TRADING ON EQUITY:

The term ‗trading on equity‘ is derived from the fact that debts are
contracted and loans are raised mainly on the basis of equity capital. The
concept of trading on equity provides that the capital structure of a
company should include equity as well as debt. Again the proportion of
debt in the capital structure should also be optimal. Those who provide
debt have a limited share in the firm‘s earnings and hence want to be
protected in terms of earnings and values represented by equity capital.
Since fixed charges do not vary with the firm‘s earnings before interest
and tax, a magnified effect is produced on earnings per share. The
determination of optional level of debt is a formidable task and is a major
policy decision. EBIT – EPS analysis is a widely used tool to determine
the level of debt in a firm.
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9.16 SERVICING OF INTEREST AND DEBT:

In order to analyze the borrower‘s capacity in payment of interest

and debt installment regularly, interest coverage ratio and debt service
coverage ratio are considered.

(a) Interest Coverage Ratio:

The interest coverage ratio shows how many times interest

charges are covered by funds are available for payment of interest. It is
determined as follows:

PBIT

Interest Coverage Ratio = --------------------

Interest on Debt

Where, PBIT means profit before interest and taxes.

A very high interest coverage ratio indicates that the firm is

conservative in using debt and a very low ratio indicates excessive use of
debt. Interest cover indicates how many times a company can cover its
current interest payments out of current profits.

(b) Debt-Service Coverage Ratio:

Debt service coverage ratio (DSCR)s is the key indicator to the

lender to assess the extent of ability of the borrower to service the loan in
regard to timely payment of interest and repayment of loan installment. It
indicates whether the business is earning sufficient profits to pay not only
the interest charges but also the installments due to the principal amount.
The DSCR is calculated as follows:

Profit after tax + Depreciation + Interest on Loan

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DSCR = ------------------------------------------------------------

Interest on Loan + Loan repayment in a year

A ratio of two or more is considered satisfactory by the financial

institution. The higher debt service coverage ratio indicates the better
debt servicing capacity of the company.

9.16.1 Illustration 1

Preeti Ltd. has the following data for projections for the next five
years. It has an existing term-loan of Rs. 360 lakhs repayable over the
next 5 years and has got sanctions for new term loan for Rs. 450 lakhs
which is also repayable in 5 years. As a finance manager you are
required to calculate (a) interest coverage ratio and (b) debt service
covering ratio for each of the 5 years and offer your comments

Rs. In Lakhs

Particulars 1 2 3 4 5
Profit after tax 480 575 635 650 685
Depreciation 155 150 140 135 120
Taxation 125 203 254 275 299
Interest on Term Loan 162 125 87 50 16
Repayment of Term Loan 178 178 178 178 178

Solution

(a) Calculation of interest coverage ratio:

Particulars 1 2 3 4 5 Total
PBIT 767 903 976 975 1000 4621
Interest 162 125 87 50 16 440
Interest Coverage 4.73 7.22 11.22 19.5 62.5 10.50

(b) Calculation of debt service coverage ratio:

Particulars/Years 1 2 3 4 5 Total
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PAT 480 575 635 650 685 3025

Depreciation 155 150 140 135 120 700
Interest on Loan 162 125 87 50 16 440
Total 797 850 862 835 821 4165
Interest on Term Loan 162 125 87 50 16 440
Repayment of Term Loan 178 178 178 178 148 860
Total 340 303 255 228 164 1300
DSCR 2.34 281 3.25 3.66 5.00 3.20

(c) Comments: Average interest coverage ratio is 10.50 times and

average debt service coverage ratio is 3.20 times. As DSCR is higher
than 2 it indicates the better debt servicing capacity of the company.
Interest coverage ratio is also higher and it indicates that the company is
conservative in using its debt.

9.16.2 Illustration 2

BEST Ltd. is a profit making company having paid up capital of

Rs. 100 lakhs consisting of 10 lakh ordinary shares of Rs. 10 each.
Currently it is earning an annual pre-tax profit of Rs. 60 lakhs. The
company‘s shares are listed on BSE and are quoted in the range of Rs.
50 to Rs. 80. The management wants to diversify production and has
approved a project which will cost Rs. 50 lakhs and which is expected to
yield a pre-tax profit of Rs. 40 lakhs per annum. To raise this capital, the
following options are under consideration of the management.

(a) To issue equity capital for the entire additional amount. It is

expected that the new shares (face value of Rs. 10) can be sold at
a premium of Rs. 15 each.
(b) To issue 16% non-convertible debentures of Rs. 100 each for the
entire amount.
(c) To issue equity capital of Rs. 25 lakhs (face value of Rs. 10) and
16% non-convertible debentures for the balance amount. In this
case, the company can issue shares at a premium of Rs. 40 each

You are required to advise the management as to how the

additional capital can be raised, keeping in mind the management wants
to maximize the earnings per share to maintain its goodwill. The
company is paying income tax at 30%.

Solution:

(a) Calculation of earnings per share under the three options:

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Option Option Option

I II III
(Rs. (Rs. (Rs.
Lakhs) Lakhs) Lakhs)
Estimated total income
i) Current operations 60 60 60
ii) New operations 40 40 40
PBIT 100 100 100
Less: Interest on 16% Debentures - 8 4
Profit before tax 100 92 96
Less: Tax @ 30% 30 27.60 28.80
Profit after tax 70 64.40 67.20
Number of equity shares (lakhs) 12 10 10.50
EPS 5.83 6.44 6.4
Earning per share can be maximized with option II. Hence, it is
advised to issue 16 % debentures is the most suitable.

Check your progress

1. Define the following terms:

1. Project

2. Project Planning

3. Project Report

4. Replacement Project

5. Feasibility Study

6. Cost of Project

7. Promoters

8. Margin Money

9. Trading on Equity

9.17 SOURCES OF LONG-TERM FINANCE :

There are different sources of funds available to meet long-term

needs of the business. These sources may be broadly classified as
under:-
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(a) Share capital

(b) Debenture or bonds
(c) Retained earnings
(d) Loans from financing institutions
(e) Loans from commercial banks.

(a) Share Capital:

A public limited company can raise capital from issue of shares to

the public. It is called public issue of shares. A private company can
raise capital by issue of shares to the friends and relatives but not from
the public through public issue. Shares capital is the owner‘s capital.
Every company can raise capital by issue of shares. Partnership and
sole traders cannot issue shares. Public limited companies can raise any
amount of capital by issue of shares because there is no limit on the
maximum number of shareholders‘ or members. There are two types of
shares.

(i) Preference Shares: Preference shares are those shares which have
first preference for payment of dividend and refund of capital at the time
of winding up of the company. Long-term funds can be revised by public
limited companies through a public issue of shares. The preference
shares carry a fixed rate of dividend. If the company cannot raise capital
by issue of equity shares due to depression in the stock market, it can
raise capital by issue of preference shares. However, a very few
companies in India have issued preference shares for raising long-term
funds. Preference shares are normally cumulative i.e. the dividend
payable in a year of loss gets carried over to the next year till there are
adequate profits to pay the cumulative dividends. The Companies Act,
1956 provides that ―no profit, no dividend‖.

Preference share capital is a hybrid from of financing because it

possesses some characteristics of equity capital and some attributes of
debt capital. Preference shares may be convertible which can be
converted into equity shares after a certain period. These shares are
attractive for projects with a long gestation period. Preference shares can
also be redeemable at a certain period. This enables the promoters to
withdraw their capital from the company. Preference shares have gained
importance after Finance Bill, 1997 as dividends became tax free in the
hands of the individual investors and are taxable in the hands of the
company as a tax on dividend distribution.
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(ii) Equity or Ordinary Shares: Ordinary shares are those shares which
are not preference shares. Ordinary shares are a source of permanent
capital. Ordinary shares holders are owners of the company and they
undertake the risk of the business. They are entitled to dividends after
the income claims of other stakeholders are satisfied. Similarly in the
event of winding up, ordinary shareholders‘ can exercise their claim on
assets after the claims of the other suppliers of capital have been met.
They elect the directors to run and manage the business of the company.
The cost of equity shares is usually highest. This is due to the fact that
the shareholders‘ expect higher rate or return on their investment as
compared to other suppliers of long-term funds. Thus, ordinary
shareholders‘ carry a higher amount of risk and so expect a higher return.
A company, having substantial ordinary share capital may find it easier to
raise funds, in view of the fact that share capital provides a security to
other suppliers of funds.

(b) Debenture or Bonds:

Issue of debentures or bonds are sources of borrowed capital. It

is a source of long-term capital. A debenture is an acknowledgement of
debt issued by a company. Normally the debentures are issued by the
public limited companies in private sector. However, bonds are issued by
the government companies or public sector undertakings. Debentures or
bonds are issued in different denominations ranging from Rs. 100 to Rs.
1000 and carry different rates of interest. A company has to make public
issue for issuing debentures or bonds. It is just like issue of shares. The
debentures are also traded in the stock market. Thus, debentures
provide a more convenient mode of long-term funds. The cost of capital
raised through debentures is quite low because the interest payable on
debentures can be charged as an expenses before tax. From the
investor‘s point of view, debentures offer a more attractive prospect than
the preference shares since interest on debentures is payable, whether or
not the company makes profits.

Debentures in India, are considered as secured loan. They are

protected by a charge on the assets of the company. The debentures
can also be convertible debentures. They are partly convertible or fully
convertible into shares of the company. Debentures are converted into
equity shares as per the terms of the issue in relation to price and the
time of conversion. Interest on debentures is fixed at the time of issue
and interest on convertible debentures is generally lower than the non-
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convertible debentures. Indian companies have been issuing convertible

debentures or bonds with a number of schemes, options, incentives like
warrants etc. The issue of convertible debenture has distinct advantages
from the point of view of the issuing company. Such an issue enables the
management to raise equity capital indirectly without diluting the equity
holding, until the capital raised has started earning an added return to
support the additional shares. Such securities can also be issued even
when the equity market is not very good. Convertible bonds are normally
unsecured and, therefore, their issuance may ordinarily not impair the
borrowing capacity. The debentures or bonds are issued subject to the
SEBI guidelines. Public issue of debentures now require that the issue
be rated by a credit rating agency. The credit rating is given after
evaluating factors like track record of the company, profitability, debt
servicing capacity, creditworthiness and the perceived risk of lending.

(c) Lending-term financial institutions:

Long-term loans are provided by specialized financial institutions

in India. The following are the specialized financial institutions:

(1) The Industrial Finance Corporation of India

(2) Industrial Development Bank of India
(3) Industrial Reconstruction Corporation of India.
(4) Small Industries Development Bank of India
(5) Life Insurance Corporation of India
(6) State Financial Corporations
(7) Exim Bank

Term loans are provided by these institutions at different rates of

interest under different schemes of financial institutions. It is also to be
repaid according to a stipulated repayment schedule. These institutions
stipulate a number of conditions regarding the management and certain
other financial policies of the company.

Term loans represent secured borrowings. It is the most

important source of finance for new projects. They generally carry a rate
of interest inclusive of interest tax depending on the credit rating of the
borrower, the perceived risk of lending and the cost of funds. The loans
are generally repayable over a period of 6 to 10 years in annual, half
yearly or quarterly installments. For large scale projects, all India
financial institutions provide the bulk of term finance either singly or in
consortium with other financial institutions.
 200

(d) Loans from commercial banks:

The banks in India also provide term loans to the companies.

Banks normally provide term loans to projects in the small and medium
scale sectors. The primary role of commercial banks is to cater to the
short-term requirements of the industry. However, banks have started
taking an interest on term financing of industries in several ways. The
proceeds of the term loan from banks are generally used for fixed assets
or for expansion of plant capacity. Their repayment is scheduled over a
period of time. Term loans proposals involve an element of risk because
of changes in the conditions affecting the borrowers. The bank making
such a proposal has to access the situation to make a proper appraisal.
The decision in such a situation would depend upon various factors
affecting the conditions of the industry concerned and the earning
potential of the borrower.

(e) Retained earnings:

Retained earnings are the profits retained in the business. Every

company retains certain portion of profit every year in the form of reserve.
Even the balance of profit after declaration of dividend is also carried
forward in the balance sheet. It is known as ploughing back of profits.
Such funds belong to the ordinary shareholders‘ and increase the net
worth of the company. A public limited company has to plough back a
reasonable amount of profit every year keeping in view the legal
requirements and its own expansion plans. However, retained earnings
can be used by existing and financially sound companies. A new
company or a loss making company cannot follow this method. Retained
earning is used as a long-term capital without any cost.

9.18 INSTITUTIONAL CONSIDERATIONS :

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The sources from which a business meets its financial

requirements can be classified according to the period, ownership and
source of generation. The sources of funds according to the period in
undue long-term sources of funds such as shares, debentures and term
loans and short-term, sources such as public deposits, advances from
customers and trade creditors. According to ownership the share capital
and retained earnings are owned sources. While debentures and term
loans are borrowed funds. According to source of generation, internal
sources are retained earnings and funds and external sources such as
shares and debentures or term loans.

For the sake of convenience, the different sources of funds can be

classified into the three categories. These categories are security
financing, internal financing and loan financing. A large number of
specialized financial institutions have been set up in the country after
independence to meet the specific term financial needs of the companies.
They are popularly known as Development Banks. Development banks
seek to mobilize scarce resources, such as capital, technology
managerial and entrepreneurial talents and channelize them into
industrial activities in accordance with plan priorities. It has, therefore, to
share its policies, procedures and functions in a way so as to cater to
development needs of specific sectors as well as economy in general.

9.19 VENTURE CAPITAL :

The venture capital financing refers to the financing of the new

and high risky projects promoted by qualified entrepreneur, who lack
experience and funds to give shape to their ideas. Under this scheme,
venture capitalists make investment to purchase equity shares or debt
securities from inexperienced entrepreneur who undertake risky ventures
with a potential of success.

Venture capital financing was first the responsibility of

development financial institutions such as the Industrial Development
Bank of India, the Technical Development and Information Corporation of
India and State Financial Corporations. In the year 1988, the
Government of India took a policy initiative and announced guidelines for
venture capital funds. In the same year, a technology development fund
financed by the levy on all payments for technology, imports was
established. This fund was meant to facilitate the financing of innovative
and high risk technology programmes through the IDBI.
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SEBI also issued guidelines in 1996 for venture capital funds to

follow. These guidelines described a venture capital fund as a fund
established in the form of company or trust, which raises money through
loans, donations, issue of securities or units and makes or proposes to
make investments in accordance with the regulations. This move was
instrumental in the entry of various foreign venture capital funds to enter
India. The guidelines were further amended in April 2000 with the
objective of fuelling the growth of venture capital activities in India. A few
venture capital companies operate as both investment and fund
management companies, others set up funds and function as asset
management companies.

Venture capital is a fund-based financial service. It has emerged

the world over to fill gaps in the conventional financing. Venture capital is
basically a equity finance in relation to new listed companies. Debt
financing is only supplementary to ensure running yield on the portfolio of
the venture capitalists. It is a long-term investment in growth-oriented
small and medium companies. There is a substantial degree of active
involvement of VC institutions with the promoters of venture capital
undertakings, to provide managerial skills without interfering in the
management. The venture capital financing involves high-risk return
spectrum. It is not technology finance though technology finance may
form a sub-set of such financing.

The first step in venture capital financing is the selection of the

investment. It includes stages of financing methods to evaluate deals and
the financial instruments to structure a deal. Early stage includes seed
capital, pre-start-up, start up and second round financing. The later stage
of venture capital financing covers mezzanine, development capital
bridge finance, expansion, buyouts and turn around financing. The
venture investments are generally idea-based and growth-based. The
structure of venture capital deal is a mix of the available financial
instruments i.e. equity and debt. The equity investments include ordinary
non-voting deferred, ordinary, preference warrants, cumulative
convertible preference and participating preference capital. The main
types of debt instruments are conventional loans, conditional loans,
income notes, FCDs, PCDs, zero interest bonds, secured premium notes
and deep discount bonds.

9.20 PROJECT APPRAISAL:

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Project appraisal is a detailed evaluation of the project to

determine the technical feasibility, economic necessity, financial viability
of the project and managerial competence required for its successful
operation. Such an appraisal is done at two stages:

i) by the promoter for identifying the right project and

ii) by the financial institution for the purpose of determining whether
the project should be financed by them or not.

The promoters have to use project appraisal to ascertain whether

the project is expected to give the required rate of return or not. In case
of several projects, the promoters may select the project which suits them
most keeping in view the urgency, the rate of return and finances required
for the project. The project so selected is then submitted to the financial
institutions for obtaining the necessary funds.

The financial institutions also use project appraisal technique to

ascertain the contribution that the project is likely to make to the national
economy and to determine the repaying capacity of the enterprise. This
requires the study of technical feasibility, economic necessity and
financial viability. Thus, the project appraisal is done by the financial
institution to satisfy itself regarding the following:

(i) The total estimated cost of the project is complete and reasonable.
(ii) The financial arrangement suggested in the project report is
comprehensive and ensures availability of cash at the time of need.
(iii) The estimates regarding operating cost and earnings are realistic
and reasonable.
(iv) The project will generate necessary cash required for repayment of
money borrowed.

9.21 MODEL QUESTIONS :

1
What is a project? What is project financing
2
What are the sources of long-term finance?
3
Explain the concept of financial feasibility of a project.
4
Explain the system of project appraisal followed by the term lending
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institutions in India.
5
Examine the effectiveness of project appraisal and project monitoring by
financial institutions.
6
What is project appraisal? What are the factors considered in project
appraisal?

7
What is venture capital financing? What are the methods of venture capital
financing?
8
Explain the advantages of equity financing.
9
What is debenture (debt) financing? Why are debentures considered
cheaper than equity as a source of long-term finance?
10
Write short notes on the following:-

a) Debt service coverage ratio.

b) Trading on equity

c) Promoter‘s contribution

d) Project report

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

10
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CAPITAL BUDGETING TECHNIQUES

Unit Structure:

10.0 Objectives

10.1 Capital Budgeting

10.2 Project appraisal techniques

10.3 Model Questions

10.0 OBJECTIVES:-

The objectives of studying this chapter are:

To understand the capital budgeting techniques.

To calculate the Net Present Values.
To calculate Internal Rate of Return
To decide the best Profitable Project

10.1 CAPITAL BUDGETING:

Capital budgeting is a process of planning capital expenditure. It

is made to maximize the long-term profitability of the organization.
Capital budgeting is a long-term planning exercise in selection of the
projects which generates returns over a number of years in future. The
heavy expenditure is incurred in the initial years of the project to generate
returns over the life of the project. The capital budgeting decision is a
decision as to whether or not money should be invested in long-term
projects. It is a financial analysis of various proposals of capital
expenditure. The finance manager uses various tools and techniques for
assisting the management in taking a proper capital investment decision.
For the purpose of project appraisal, the cash flow is the incremental cash
receipts less the incremental cash expenditure solely attributable to the
 206

investment. The future costs and revenues associated with each

investment alternative are:

(1) Capital costs

(2) Operating costs
(3) Revenue
(4) Depreciation
(5) Residual value
An investment decision implies the choice of an objective, a
technique of appraisal, and length of service i.e. the life of the project.
The life of the project may be determined by taking into consideration the
following factors:

(a) Technological obsolescence

(b) Physical deterioration
(c) A decline in demand for the output of the project

10.2 PROJECT APPRAISAL TECHNIQUES:

In order to maximize the return to the shareholders of a company,

it is important that the most profitable investment projects should be
selected. It is absolutely necessary that the method adopted for appraisal
of capital investment proposals is a sound one. Any appraisal method
should provide for the following:-

(i) A basis of distinguishing between acceptable and non-acceptable

projects.
(ii) Ranking of projects in order of their desirability.
(iii) Choosing among several alternatives.
(iv) Recognizing the fact that bigger benefits are preferable to smaller
ones and early benefits are preferable to later ones.

There are several methods used for evaluating and ranking the
capital investment proposals. The basic approach is to compare the
investment in the project with benefits derived there-from. Following are
the important methods or techniques of capital budgeting:

10.2.1 Pay Back Period:

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The term pay-back period refers to the period in which the project
generates the necessary cash to recoup the initial investments. The pay-
back period is generally expressed in years. The method recognizes the
recovery of original investment in a project. While deciding between the
two or more projects, the usual decision is to accept the project which has
a shortest payable payback is a rough measure of liquidity and rate of
profitability. Thus, the payback period is the number of years required to
recover the cost of the investment. The pay-back period is determined
as follows:

Initial Investment

Pay-back Period = ------------------------

Annual Cash Inflow

Illustration 1

A project requires an initial investment of Rs. 2,00,000 and the

annual cash inflows for 5 years are Rs. 60,000, Rs. 80,000, Rs. 50,000,
Rs. 40,000 and Rs. 30,000 respectively. What is the payback period?

Year Cash Inflows (Rs/) Cumulative Cash Inflows

(Rs.)
1 60,000 60,000
2 80,000 1,40,000
3 50,000 1,90,000
4 40,000 2,30,000
5 30,000 2,60,000

The pay-back period falls in the fourth year. In the first 3 years
Rs. 1,90,000 are recovered. Rs. 10,000 are left out from the initial
investment. The actual pay-back period can be determined as under:-

10,000

Pay-back Period = 3 + --------- x 2

40,000
 208

= 3 + 0.25 years

= 3.25 years

10.2.2 Accounting Rate of Return:

The capital investment proposals are judged on the basis of their

relative profitability. The accounting rate of return is also known as return
on investment or return on capital employed. It is normal accounting
technique used to measure the increase in profit expected to result from
an investment by expressing the net accounting profit arising from the
investment as a percentage of that capital invested. The rate of return is
determined as follows:-

Average Annual Profit after tax

Accounting Rate of Return = -------------------------------------- x 100

Average Investment

Initial investment + Salvage value

Average Investment = -----------------------------------------

The term average annual net profit is the average of earning (after
depreciation and tax) over the whole of the economic life of the project.
The projects can be ranked on the basis of their accounting rate of return.
The project which gives higher rate of return will be preferred for
investment.

Illustration 2
 209

A machine is available for purchase of a cost of Rs. 8,00,000. It

is expected to have a life of 5 years and have a scrap value of Rs.
1,00,000 at the end of five years period. The machine will generate the
following profits over its life as under:-

Year Amount (Rs.)

1 2,00,000
2 3,00,000
3 4,00,000
4 1,50,000
5 50,000

The above estimates are profits before depreciation. You are

required to calculate the accounting rate of return.

Solution

Total profit before depreciation over the life of machine = Rs. 11 lakhs

11,00,000

Average Profit = ----------- = Rs. 2,20,000

Total Depreciation over the life of the machine

= 8,00,000 – 1,00,000 = Rs. 7,00,000

7,00,000

Average Depreciation = ----------- = Rs. 1,40,000

Average Annual Profit after depreciation

= Rs. 2,20,000 – 1,40,000

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= Rs. 80,000

Original Investment = Rs. 8,00,000

80,000

Rate of Return = ------------ x 100 = 10%

8,00,000

8,00,000 + 1,00,000

Average Investment = Rs. ----------------------- = 4,50,000

80,000

Accounting Rate of Return = ----------- x 100

4,50,000

= 17.78%

10.2.3 Discounted Cash Flow Technique:

The discounted cash flow technique is an improvement on the pay

back period method. It takes into account the interest factor as well as
the return after the pay-back period. This method involves the following
stages:

(a) Calculation of cash flows i.e. cash inflows as well as cash

outflows, over the full life of an asset.
(b) Discounting the cash flows by a discount factor.
(c) Aggregating the discount cash inflows and comparing them with
the total discounted cash outflows.
 211

The objective of the firm is to create wealth by using existing and

future resources to produce goods and services. In order to create
wealth, the discounted cash inflows must exceed the present value of
cash outflows. Thus, the net present value is obtained by discounting all
cash inflows and outflows attributable to a capital investment project. For
this purpose, rate of discount is chosen suitably. There are three
methods of discounting cash flows, which are given below:-

(i) Net present value method:

Net present value method (NPV) is the most suitable method used
for evaluating the capital investment projects. Under this method cash
inflows and outflows associated with each project are worked out. The
present value of the cash flows is calculated by discounting the cash
flows at the rate of return acceptable to the management. The rate of
return is considered as a cut-off rate. It is generally determined on the
basis of cost of capital suitably adjusted to allow for the risk element
involved in the project. The cash outflows represent the investment and
commitments of cash in the project at various points of time. The working
capital is taken as a cash outflow in the initial year. The cash inflow
represents the net profit after tax but before depreciation. As depreciation
is non-cash expenditure, it is added back to the net profit after tax in order
to determine the cash inflows. The cash inflows and outflows are
discounted at a certain rate and present value of cash flows are
calculated. The difference between the present value of cash inflows and
present value of cash outflows is called net present value (NPV). If the
NPV is positive, the project is accepted and if it is negative, the project is
rejected. This exercise involved in calculating the present value is called
‗discounting‘.

Discounted cash flow is an evaluation of the future net cash flows

generated by a project. This method considers the time value of money
concept and hence it is considered better for evaluation of investment
proposals. If there are mutually exclusive projects, this method is more
useful. Thus, the following formula is used to determine the net present
value:

Net present value (NVP) = Present value of future cash inflows –

Present value of cash outflows.

Illustration 3
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An investment project costs Rs. 1,00,000 initially. It is expected to

generate cash flow as follows:

Year Cash inflows (Rs.)

1 50,000
2 40,000
3 30,000
4 20,000

(a) What is the net present value of the project assuming a 10 % risk-free
rate? Should the project be accepted?

(b) If the project is risky and it is decided to use a higher rate to allow for
the perceived risk. Assuming that rate is 15%, what will be the net
present value of the project? Should the project be accepted?

Solution:

(a)

Net Present Value at 10% discounting rate

Year Cash inflows Discount factor at Present value (Rs.)

(Rs) 10%

1 50000 0.9091 45455

2 40000 0.8254 33056
3 30000 0.7513 22539
4 20000 0.6830 13660

Present value of cash inflows 114710

- Present value of cash outflow 100000

Net present value 14700

The project should be accepted at risk free rate of 10% because
net present value is positive.

(b)

Net Present Value at 15% discounting rate

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Year Cash inflows Discount factor at Present value (Rs.)

(Rs) 15%

1 50000 0.8696 43480

2 40000 0.7561 30244

3 30000 0.6575 19725

4 20000 0.5718 11436

Present value of cash inflows 104885

- Present value of cash outflow 100000

Net present value 4885

The project can be accepted at 15% because net present value is

positive

(ii) Profitability Index:

The net present value method uses discounted cash flows. It

express cash flows in present rupees. The NPV of different projects can
be compared. It implies that each project can be evaluated independent
of others on its own merit. Sometimes we have to compare a number of
projects each involving different amount of cash inflows and outflows. If
the cash flows are different and period of the project are also different and
two or more projects give positive net present value, then we have to use
the technique two or more projects give positive net present value, then
we have to use the technique of profitability index which is as follows:

Present value of cash inflows

Profitability Index = ------------------------------------

Present value of cash outflows

The project is acceptable if the profitability index value is higher.

Illustration 4
 214

X Ltd is considering purchase of a machine in replacement of an

old one. Two models viz. ‗modern‘ and ‗sky‘ are offered at price of Rs.
22.5 lakhs and Rs. 30 lakhs respectively. Further particulars regarding
these models are given below:-

Particulars Modern Sky

(I) Economic life in years 5 6
(II) After tax annual cash inflows
Years Rs. Lakhs Rs. Lakhs
1 5.00 6.00
2 7.50 8.00
3 10.00 10.00
4 9.00 12.00
5 8.50 10.50
6 - 9.50
(III) Present value factors at 12% per annuam are as follows
Years P.V.Factor
1 0.893
2 0.797
3 0.712
4 0.636
5 0.567
6 0.507

(a) Evaluate the two proposals.

(b) Which model would you recommend any why?

Solution:

Calculation of Net Present Values

Years P.V.Factor Modern Sky

CFAT PV CFAT PV
1 0.893 5.00 4.465 6.00 5.358
2 0.797 7.50 5.977 8.00 6.376
3 0.712 10.00 7.120 10.00 7.120
4 0.636 9.00 5.724 12.00 7.632
5 0.567 8.50 5.954 10.50 5.953
6 0.507 - 9.50 6.084
2.50
Less Present Value of Cash 29.240 38.523
inflows
Present value of cash 22.500 30.000
 215

outflows
Net present value 6.740 8.523

(b) Considering net present value method, both the models have positive
net present value and their initial investments are different. Hence, the
decision will be based on Profitability Index which is calculated as
follows:-

Modern Sky

Profitability Index

PVCI 29.240 38.523

= --------- = ------- = -------

PVCO 22.500 30.00

1.299 1.284

(c) As the profitability index of model ‗Modern‘ is higher, it is

recommended

(iii) Internal Rate of Return:

Internal rate of return is that rate at which the sum of discounted

cash inflows equals the sum of discounted cash outflows. It is the rate
which discounts the cash flows to zero. This method also considers the
time value of money, the initial cash flows and all future cash flows from
the investment. The internal rate of return method does not use the
desired rate of return but estimates the discount rate that makes the
present value equal to the initial investment. The net present value of the
investment will be zero in case of IRR. This estimated rate of return is
then compared to a criterion rate of return that can be the company‘s
desired rate of return. Thus, internal rate of return is the maximum rate of
interest which a company can afford to pay on the capital invested in a
project. A project would quality to be accepted if IRR exceeds the cut-off
rate. While evaluating two or more projects, a project which gives a
 216

higher internal rate of return would be preferred. The internal rate of

return can be calculated by using trial and error method.

Illustration 5

X Ltd. is currently under examination a project which will yield the

following returns over a period of time:-

Year Gross yield Rs.

1 80,000
2 80,000
3 90,000
4 90,000
5 75,000
Cost of machinery to be installed amounts to Rs. 2,00,000 and the
machine is to be depreciated at 20% per annum at WDV basis. Income
tax rate is 30%. If the average cost of raising capital is 10%, would you
recommend accepting the project under the internal rate of return
method?

Present value of money at rates of interest is as under:-

Year At 10 % At 14 %
1 0.91 0.88
2 0.83 0.77
3 0.75 0.67
4 0.68 0.59
5 0.62 0.52

Solution

(a) Evaluation of project under IRR method:

Year Gross Depreciati Balance Income Tax Net Cash CFAT

Yield on (Rs.) 2 (Rs.) 3 (Rs.) 4 inflows (Rs.) (2+5) 6
(Rs.) 1 5
1 80,000 40,000 40,000 12,000 28,000 68,000
2 80,000 32,000 48,000 14,400 33,600 65,600
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3 90,000 25,600 64,400 19,320 45,080 70,680

4 90,000 20,480 69,520 20,856 48,664 69,144
5 75,000 81,920 - 8,920 - 75,000 81,920

(b) Calculation of Net present value:-

Year CFAT D.F. 10 % D.F. 14% PV @ 10 % PV @ 14%

1 68,000 0.91 0.88 61,880 59,840
2 65,600 0.83 0.77 54,448 50,512
3 70,680 0.75 0.67 53,010 47,356
4 69,144 0.68 0.59 47,018 40,795
5 81,920 0.62 0.52 50,790 42,598
2,67,146 2,41,101

The present value of cash flows at 14% rate works out to Rs.
2,41,101. Therefore, IRR lies above 14%.

The actual IRR can be calculated as follows:

Year CFAT D.F.@ D.F. D.F.@ PV PV PV

16 % @ 22 % (Rs) (Rs) (Rs)
18 %

1 68,000 0.862 0.847 0.820 58,616 57,596 55,760

2 65,600 0.743 0.718 0.672 48,741 47,100 44,063
3 70,680 0.641 0.609 0.551 45,305 43,044 38,945
4 69,144 0.552 0.516 0.451 38,167 32,912 31,184
5 81,920 0.476 0.437 0.370 38,994 35,791 30,310
2,29,823 2,16,443 2,00,282
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The Net present value at 22% discounting factor is around zero.

Hence, the actual IRR is 22 %. As the cost of capital is 10% which is a
cut-off rate, and IRR is 22%, the project is recommended.

Illustration 6

The FFM Ltd is in the tax bracket of 35%, and discounts its cash
flows at 16%, in the acquisition of an asset worth Rs. 10 lakhs. It is given
two offers either to acquire the asset by taking a loan @ 15% per annum
repayable in five yearly installments of Rs. 2,00,000 each plus interest or
to lease-in the asset at yearly rentals of Rs. 3,24,000 for five years. In
both the cases, the installment is payable at the end of the year.
Applicable rate of depreciation is 15% using written down value (WDV)
method.

You are required to suggest the better alternative PV factor at

16% are as follows:-

Years P.V. Factor

1 0.862
2 0.743
3 0.641
4 0.552
5 0.476

Solution:

(a) Present value of cash flows under buying options

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Year Principal Interest Depre. Tax Net D.F. D.V.

(Rs.) (Rs.) (Rs.) ( Rs.) Cash (Rs.)
Inflows
(Rs.)
1 2,00,000 1,50,000 1,50,000 1,05,000 24,500 0.862 2,11,190
2 2,00,000 1,20,000 1,27,500 86,625 2,33,375 0.743 1,73,398
3 2,00,000 90,000 1,08,375 69,431 2,20,569 0.641 1,41,385
4 2,00,000 60,000 92,118 53,241 2,06,759 0.532 1,14,131
5 2,00,000 30,000 78,301 37,905 1,92,095 0.476 91,437
Present value of Cash inflows 7,31,641

(b) Present value of Cash outflows in leasing option

Year Rental Tax Net D.F. P.V.

(Rs.) (Rs.) Cash (Rs.)
inflows.
(Rs.)
1 3,24,000 1,13,400 2,10,600 0.862 1,81,537
2 3,24,000 1,13,400 2,10,600 0.743 1,56,476
3 3,24,000 1,13,400 2,10,600 0.641 1,34,995
4 3,24,000 1,13,400 2,10,600 0.552 1,16,251
5 3,24,000 1,13,400 2,10,600 0.476 1,00,246
Present value of cash inflows 6,89,505

As the total present value of cash outflows under leasing option is

less than the purchase option, leasing is recommended.

10.3 MODEL QUESTIONS

Q.1 Arvind Ltd. is currently analyzing capital expenditure proposals for the
purchase of equipment. The company uses the net present value
technique to evaluate projects. The capital budget is limited to Rs.
5,00,000 which the company believe is the maximum capital it can raise.
The initial investment and projected net cash flows for each project are
given below. The cost of capital of the company is 12%. You are required
to compute the NPV of the different projects.

Projects A B C D
Initial Investment 2,00,000 2,00,000 2,40,000 2,10,000
(Rs.)
 220

Cash inflows
st
1 Year 50,000 40,000 75,000 75,000
nd
2 Year 50,000 50,000 75,000 75,000
rd
3 Year 50,000 70,000 60,000 60,000
th
4 Year 50,000 75,000 80,000 40,000
th
5 Year 50,000 75,000 1,00,000 20,000

Q.2 Which project would you recommend and why?

Calculate the internal rate of return of an investment of Rs. 1,36,000 which
yields the following cash flows:-
Year Cash inflows (Rs.)
1 30,000
2 40,000
3 60,000
4 30,000
5 20,000

Q.3 A choice is to be made between two competing projects which require an

equal investment of Rs. 50,000 and are expected to generate net cash
flow as under:
Year Project A (Rs.) Project B (Rs.)
1 25,000 10,000
2 15,000 12,000
3 10,000 18,000
4 - 25,000
5 12,000 8,000
6 6,000 4,000

The cost of capital of the company is 10%. The following are the present
value factors @ 10%.
Year PV Factors @ 10 %
1 0.9091
2 0.8264
3 0.7513
4 0.6830
5 0.6209
6 0.5645
Which project should be selected and why? Evaluate the project under:
(a) Payback method
(b) NPV method. 

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11

MANAGEMENT INFORMATION SYSTEM

Unit Structure:

11.0 Objectives

11.1 Introduction

11.2 Meaning and Components of Management Information System

11.3 Need for Management Information System or Role of MIS

11.4 Purpose and Significance of Management Information System

11.5 Levels of Management VIS-À-VIS Information Requirements

11.6 MIS and Computer

11.7 Problems in Installing and Operating the MIS

11.8 Knowledge required for study of MIS

11.9 Summing Up

11.10 Exercise

11.0 OBJECTIVES
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After studying the unit the students will be able to:

Understand the Components of MIS

Know the significance of MIS.
Explain the limitations of MIS
Know how to overcome from the limitations.

11.1 INTRODUCTION

An organization is in existence with the basic purpose of achieving

some objectives. The objectives of an organization may be different from
those of another organization. Even for the business enterprises, which
belong to the same industry, may have different objectives. An
organization‘s own objectives may be different from time to time. It would
not mean that the objectives which were in existence for an organization
at one point of time would become extinct at a different point of time. But
it could happen that the objectives which were very crucial might have
become dormant at a different point of time. For example, an
organization whose reputation has been spoilt because of an untoward
incident, at that particular point of time would make all the efforts under
the earth in order to clear the bad reputation. During such a difficult
situation, the objectives even though only short term would be undoing
the mistake. Once such a situation has become normal, the
organization‘s objectives would be towards strengthening its operations.
Thus the focus would get shifted from repairing the damage to building up
the operations. If you take the first situation, the organization has to keep
in constant touch will the external agencies, news media and other
relevant bodies besides constant sharing of the external and internal
information within the organization. In the second situation, the
organization needs constant information about the level and volume of
operations, its sales and growth in the market share. However, under
both the cases, the management needs the information to know about the
movement of the company towards attaining its objectives. If the
organization is not able to organize the information, which it needs, it may
not be able to successfully attain its objectives. Hence the organization
will make coordinated efforts in designing a structure within the
organization that can provide the information that is needed to reach the
desired destination. Such a structure will create and maintain a system
that will feed the Management with the information that is needed at any
particular point of time. The system that takes care of the Informational
needs of an organization is known as the ―Management Information
System‖. Every system has its components or subsystems. Similarly, a
Management Information System also has its own components. The
success of an organization depends upon its ability to get the right
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information at the right place for use by the right people at the right time.
Even if any one of these requirements is not fulfilled, the organization
cannot be successful in its mission.

11.2 MEANING AND COMPONENTS OF

MANAGEMENT INFORMATION SYSTEM

11.2.1 MEANING AND DEFINITION:

According to Kenneth C. Laudon and Jane Price Laudon

Management Information Systems means, ―A Contemporary
Perspective, an information system is "a set of procedures that
collects (or retrieves), processes, stores, and disseminates
information to support decision making and control." In most cases,
information systems are formal, computer based systems that play
an integral role in organizations. Although information systems are
computer based, it is important to note that any old computer or
software program is not necessarily an information system.
"Electronic computers and related software programs are the
technical foundation, the tools and materials, of modern information
systems, " Laudon and Laudon wrote. "Understanding information
systems, however, requires one to understand the problems they
are designed to solve, the architectural and design solutions, and
the organizational processes that lead to these solutions."

Though it is sometimes applied to all types of information

systems used in businesses, the term "management information
systems, " or MIS, actually describes specific systems that "provide
managers with reports and, in some cases, on-line access to the
organization's current performance and historical records, " Laudon
and Laudon noted. "MIS primarily serve the functions of planning,
controlling, and decision making at the management level." MIS are
one of a number of different types of information systems that can
serve the needs of different levels in an organization. For example,
information systems might be developed to support upper
management in planning the company's strategic direction or to
help manufacturing in controlling a plant's operations. Some of the
other types of information systems include: transaction processing
systems, which simply record the routine transactions needed to
conduct business, like payroll, shipping, or sales orders; and office
automation systems, which are intended to increase the
productivity of office workers and include such systems as word
processing, electronic mail, and digital filing. Ideally, the various
types of information systems in an organization are interconnected
to allow for information sharing.
 224

An 'MIS' is a planned system of the collecting, processing, storing

and disseminating data in the form of information needed to carry out the
functions of management. In a way it is a documented report of the
activities that were planned and executed.

11.2.2 COMPONENTS OF AN EFFECTIVE MIS:

There has to be a well defined Organizational Structure that

provides the scope and way for a proper, effective and efficient
functioning of a Management Information System. Besides this basic
requirement, the following are important components of an effective MIS.

1. Integration with the Objectives of the Organization : Management

Information System is a sub-system of the organization. It is an
integral part of the Organization. The objectives of the MIS should be
integrated with the organizational objectives. Hence there should be
a clear statement of purpose or Charter for the MIS which should
prescribe as to what is expected in relation to the fulfillment of the
objectives of the organization.

2. Organizational Relationship : There should be a clear

organizational structure as far as the position of MIS is concerned.
Because of the growing importance of the role of information
Technology in an organization‘s strategic Management, there should
be a clear definition of the Role, Authority, Responsibility and
Accountability of the MIS and the channels of communication. The
relevant organization structure of the MIS should be in accordance
with the Organizational Philosophy. For example, if the
Organizational structure in general is a flat one, the creation of a slot
for the MIS should not lead to a thicker organizational structure.

3. Infrastructure : The organization should provide the necessary

infrastructure that will facilitate the smooth functioning of the
Management Information System. This includes physical
infrastructure, hardware, required and a data processing centre with
the necessary capabilities.

4. Software : Software is the key as far as any automated Information

System is concerned. Under a manual Information System, the
 225

element of Software may be absent. In an automated Management

Information System, the software provides the necessary impetus that
is required to exploit the benefits arising out of the revolution in
information technology. We have to select the best software that can
provide the solutions in the form of best organizational practices that
can help the organization to forge ahead remain ahead of others.

5. Technology : Technology is changing fast, its growth changes are

measured in terms of nano seconds. But the organization needs to
adopt the technology that can be fairly stable and at the same time is
able to keep pace with the changing times.

6. Human Resources : Under the Automated Information System the

only single asset that is scarce because of the technology revolution
is ―human resource‖. Their services are at a premium. The
organization should be able to recruit the best human resources in
order to make the best of the infrastructure, technology and software.

7. Training : Basically because of the scarcity of the skilled human

resources available to exploit the opportunities arising out of the
Technology revolution, it becomes essential that organizations have
to train its existing employees to equip themselves to manage the
Management Information System. Even the skilled employees need
perpetual training to keep themselves abreast of the latest
developments that will enable them to update and adapt to the
changing situations.

8. Policies and Procedures : An organization‘s plans need to be

supported by its policies and procedures. Policies and procedures
help the management in communicating its aims and directions
across the organization and in implementing its plan of action. They
also help the operational management in making the decisions in
accordance with the management‘s philosophy. They also ensure a
disciplined approach towards attaining the objectives of the
organization.

9. Control Mechanism : The design of a new Management Information

System and the maintenance of an existing Management Information
System is very much influenced by the developments taking place in
the information and related Technology. There should be a
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mechanism, which would control the induction of new technology

products into the existing system. Any such inductions should be
based on the merits of the technology and the product. A cost benefit
analysis should be desired wherever possible.

10. Back up and Continuity of Service : Any break down in an

automated Management Information System would result in great loss
to an organization. The extent of loss could be pecuniary and could
even result in legal damages. It would also result in bad reputation to
the company. In order to avoid such consequences and in order to
ensure continuous growth every organization has to have a sound
Backup System. This also includes provision of alternative data
processing centers in case of exigencies say on account of fire, floods
etc.

11. Communication devices : In the present day business environment,

communications among the employees of the company as well as the
business partners are talking place more often through electronic
mails. Companies are in fact using separate and dedicated tunnels
provided by Internet Service Providers or using public e-mail services
for communication between units situated at distant places or for
sending and receiving. Thus, the use of communication devices and
related technology are playing an increasing role. Since the data are
coming into the public communication lines, it has to be borne in mind
that the data may be lost copied or stolen in transit. An organization
should take enough precautions to avoid any such mishaps.

12. Cost benefit analysis : Any decision to invest in a major Information

System Asset should be backed by a cost benefit analysis. Even
though benefits which are intangible in nature cannot be measured,
enough grading system must be in vogue to take into account such
benefits as well.

13. Security Policies : In the wake of the organization‘s Information

Asset published in the public and transactions being conducted
through the Internet, it is imperative that an organization is devising a
safe system of access to the right people and that the unauthorized
are not permitted to do any unwanted act. The organizations should
device Security Policies and implement them in the best interests of
the organization.
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14. Compliance with external requirements : As explained earlier, the

information and data including the personal of customers, which
happen to be the preserve of the company, are subjected to threats of
misuse and intrusion. Any such untoward incident could lead to huge
losses to the company in terms of money and reputation.

15. Critical Success Factors : Any success can be judged only against
some bench marks. In order to measure the success of an MIS, it
should be necessary that certain factors are identified that would
indicate the growth or maturity of the MIS as a process of the
organization. Comparison of the actual results against those Success
Factors is a good measure of performance. Such factors could
number of break down, uninterrupted service etc.

11.3 NEED FOR MANAGEMENT INFORMATION

SYSTEM OR ROLE OF MIS

Need :

In the present day of Competition, challenges and uncertainty, it is

the world of the survival of the fittest. An organization cannot ignore any
opportunities nor any threats. An organization‘s success lies in managing
its ―Strengths, Weaknesses, Opportunities and Threats.‖ If an
organization can effectively manage these factors, it stands to be
benefited. Otherwise, it stands only to lose. It has to be appreciated that
an organization which wants to manage these factors effectively needs to
take the right decisions at the right time. In order to take the right
decisions at the right time, the right information should be made available
to the right people at the right time in the right manner and in the most
efficient way. This will not be possible unless there is a proper and
coordinated system of Data Collection, Designing of IS, Processing and
Reporting.

Besides the need of MIS for effective decision making, the need
also arises from the point of view of planning and controlling. In order to
guide the management in planning the allocation of resources of the
Company, it becomes essential to know the results of operations. This
would help to plan about the allocation and or reallocation of resources
and to maximize the benefits.
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Similarly, from the point of view of Controlling, it becomes

necessary to know the progress of the organization towards attainment of
objectives. Controlling is an important and essential function of
Management in ensuring that the organization‘s objectives are being
achieved. It also provides the necessary feedback and rectification
mechanism to support the organizational functioning.

When information systems are designed to provide

information needed for effective decision making by managers, they
are called management information systems. MIS is a formal
system for providing management with accurate and timely
information necessary for decision making.

The system provides information on the past, present and project

future and on relevant events inside and outside the organization . It may
be defined as a planned and integrated system for gathering relevant
data, converting it in to right information and supplying the same to the
concerned executives. The main purpose of MIS is to provide the right
information to the right people at the right time.

The Concept of management information systems originated in

the 1960s and become the byword of almost all attempts to relate
computer technology and systems to data processing in business. During
the early 1960s , it became evident that the computer was being applied
to the solution of business problem in a piecemeal fashion, focusing
almost entirely on the computerization of clerical and record – keeping
tasks. The concepts of management information systems were developed
to counteract such in efficient development and in effective use of the
computer. The MIS concept is vital to efficient and effective computer use
in business of two major reasons:

It serves as a systems framework for organizing business

computer applications. Business applications of computers should be
viewed as interrelated and integrated computer – based information
systems and not as independent data processing job.

In emphasizes the management orientation of electronics

information processing in business. The primary goal of computer based
information systems should be the processing of data generated by
business operations.
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A management information system is an integrated man –

machine systems that provides information to support the planning and
control function of manager in an organization.

The output of an MIS is information that sub serves managerial

functions. When a system provides information to persons who are not
managers, then it will not be considered as part of an MIS. For .example,
an organization often processes a lot of data which it is required by law to
furnish to various government regulatory agencies. Such a system, while
it may have interfaces with an MIS, would not be a part of it, Instances of
such systems is salary disclosures and excise duty statements. By the
same token to sophisticated computer – aided design system for
engineering purposes would also not be a part of an MIS.

Generally, MIS deals with information that is systematically and

routinely collected in accordance with a well-defined set of rules. Thus,
and MIS is a part of the formal information network in an organization.
Information that has major managerial planning significance is sometimes
collected at golf courses. Such information is not part of MIS, however,
one- shot market research data collected to gauge the potential of a new
product does not come within the scope of an MIS by our definition
because although such information may be very systematically collected
it is not collected on a regular basis.

Normally, the information provided by an MIS helps the managers

to make planning and control decisions. Now, we will see, what is
planning and control. Every organization in order to function must
perform, certain operations. For Example, a car manufacturer has to
perform certain manufacturing activities, a wholesaler has o provide water
to its area of jurisdiction. All these are operations that need to be done.
Besides, these operations, an organization must make plans for them. In
other words it must decide on how many and what type of cars to make
next month or what commissions to offer retailers or what pumping
stations to install in the next five years.

Also an organization must control the operations in the light of the

plans and targets developed in the planning process. The car
manufacturer must know if manufacturing operations are in line with the
targets and if not, he must make decisions to correct the deviation or
revise his plans. Similarly the wholesaler will want to know the impacts
that his commissions have had on sales and make decisions to correct
adverse trends. The municipal corporation will need to control the
tendering process and contractors who will execute the pumping station
plans.
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Generally, MIS is concerned with planning and control. Often

there are elaborate systems for information that assists operations. For
example, the car manufacturer will have a system for providing
information to the workers on the shop floor about the job that needs to
be done on a particular batch of material. There may be route sheets,
which accompany the rate materials and components in their movement
through various machines. This system per se provides only information
to support operation. It has no managerial decision-making significance. It
I not part of an MIS. If, however, the system does provided information on
productivity, machine utilization or rejection rates, then we would say that
the system is part of an MIS.

Generally MIS has all the ingredients that are employed in

providing information support to manager to making planning and control
decisions. Managers often use historical data on an organization‘s
activities as well as current status data make planning and control
decisions. Such data comes from a data base which is contained in files
maintained by the organization . This data base is an essential
component of an MIS. Manual procedures that are used to collect and
process information and computer hardware are obvious ingredients of an
MIS . These also form part of the MIS. In summary , when we say that ―
an MIS is an integrated man – machine systems that provided information
to supports the planning and control function of managers in an
origination . It does the following function.

- sub serves managerial function

- collects stores , evaluates information systematically and routinely

- supports planning and control decisions

- Includes files , hardware , software , software and operations research

models.

Effective management information systems are needed by all

business organization because of the increased complexity and rate of
change of today‘s business environment . For Example, Marketing
manager need information about sales performance and trends, financial
manger returns, production managers needs information analyzing
resources requirement and worker productivity and personnel manager
require information concerning employee compensation and professional
development. Thus, effective management information systems must be
developed to provide modern managers with the specific marketing ,
financial, production and personnel information products they required to
support their decision making responsibilities .
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An MIS provides the following advantages:

1. It Facilitates planning: MIS improves the quality of plants by providing

relevant information for sound decision – making . Due to increase in the
size and complexity of organizations, managers have lost personal
contact with the scene of operations.

2. In Minimizes information overload: MIS change the larger amount of

data in to summarized form and there by avoids the confusion which may
arise when managers are flooded with detailed facts.

3. MIS Encourages Decentralization: Decentralization of authority is

possibly when there is a system for monitoring operations at lower levels.
MIS is successfully used for measuring performance and making
necessary change in the organizational plans and procedures.

4. It brings Co ordination: MIS facilities integration of specialized

activities by keeping each department aware of the problem and
requirements of other departments. It connects all decision centers in the
organization .

5. It makes control easier: MIS serves as a link between managerial

planning and control. It improves the ability of management to evaluate
and improve performance . The used computers has increased the data
processing and storage capabilities and reduced the cost.

6. MIS assembles, process, stores, Retrieves, evaluates and

Disseminates the information.

11.4 PURPOSE AND SIGNIFICANCE OF

MANAGEMENT INFORMATION SYSTEM

At the outset, it can be said that the need for Management

Information System arises for the purpose of fulfillment of the objectives
of the organization from a broader perspective. Let us briefly discuss the
purpose of Management Information System.

1. For meeting the day to day operational requirements : In order to

meet the day to day operational requirements of the organization, the
Operational Management needs information. Such information needs
to be continuously available on a day to day basis. Non-availability of
the information would result in operational failure.
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2. For meeting the Managerial requirements : The middle level

management needs to manage the organization in accordance with
the strategies formulated by the Top Level Management. While the
operational requirements of Information are on a day today basis, the
Managerial requirements of Information are tactical in nature. It is the
Middle level management whose interference is very much essential
in cases of the actual performance not in line with the planned results.
The Middle level management would not be able to ensure that the
strategies of the Top level management are achieved.

3. For directing the Company : It is the Top level management of an

organization which directs the strategic movement of the organization.
The informational requirements of the Top level management are very
vital and crucial. Such information has to be derived from both the
internal and external sources. While the internal information would be
about the company‘s operation and the market leadership, the
external information covers various aspects like, economic indicators,
competition, market share etc.

4. Effective and efficient allocation of resources : An organization‘s

resources are scarce in nature. There are differing needs for the
same resources. But at the same time, the Management of an
organization need to utilize the resources at their disposal in an
effective and efficient way so that the return is the maximum. It
entails the allocation of resources among the competing opportunities
in such a way that the maximum benefits are reaped. This would help
the organization and the economy as a whole.

5. To overcome uncertainty : An organization has to function in an

uncertain situation. There are uncertainties from various angles.
Uncertainty can arise from economic, political, international, legal,
social or cultural situations. Decisions Support Systems and Expert
Systems provide information and special analyses which help the
management to take into account the factors arising out of such
uncertainty. It thus helps an organization to be optimistic in its
approach.

6. Contingency Planning : Since Management Information System

provides the information about the various factors affecting the
functioning the organization at various levels, the Middle level
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management and the top level management are better placed as

related to the future in terms of uncertainty. Approaches like what if
analysis can help the organization in planning for steps to be taken
during an exigency.

7. Different Levels of Information Systems to suit different levels of

Management : Different types of Information Systems are available to
suit the information requirements of an organization. For example,
Transaction Processing System provides the information required at
operational levels. Management Information System and the Decision
Support System provide the information required at Middle Level
Management and the Expert System provides the information at the
Strategic level or Top Level Management.

11.5 LEVELS OF MANAGEMENT VIS-À-VIS

INFORMATION REQUIREMENTS

An organization has got different echelons of Management. The

number of levels of Management could be different from one organization
to another. This however, would depend upon the Organizational
Philosophy of the Management. Some organizations would prefer fat type
of organizational structure, while some others would prefer ‗flat‘ type
organizational structure. Nowadays, the trend for the organizations is to
prefer ‗flat‘ type because of various considerations. Whatever be the
nature of philosophy, the informational needs of an organization cannot
be different. All the organizations need information. Similarly all the
levels of management of an organization need. However, one set of
information needs of one level of management in an organization may be
needed by a different level of management in another organization.
Nonetheless, basically the information needs are not different. From this
point of view, the Information System of an organization is divided into 4
categories. They are:

1. Transaction Processing System

2. Knowledge Level System

3. Management Information System and Decision Support System

4. Expert System
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Let us discuss each type of Information System and its

requirement for a particular level of Management.

1. Transaction Processing System for Operational Level

Management: The largest part of the information is generated
through this system. This is at the operational level and is to take
care of the routine informational needs of the organization. Some of
the Transaction Processing System is the boundary between the
external world and the organization. For example, the Sales Order
Processing System of a Company provides the link between the
Company and its customers. Apart from Sales Order Processing
System, there are many other Transaction Processing Systems. They
are pay roll processing System, Financial Accounting System, Cash
Management, Employee record keeping etc. Transaction processing
systems are used at the Operational level management and satisfy
the informational requirements of Operational Level Management
(e.g. Supervisors). Even the Management Information System that
caters to the Informational requirements of the Middle Level
Management also sources their most of the data from Transaction
Processing Systems. The Operational level management needs to
take decisions to solve problems which are simple and well
structured. They make decisions, which are not complicated. For
example, a credit supervisor has to make a decision on allowing of
credit to a customer. He / she has to collect the information about the
customer like his previous trade history with the company if he is an
existing customer. If he is a new customer, he will obtain the financial
results of the customer and decide according to the merits and as per
the policy guidelines. Thus, the transaction processing systems cater
to the informational requirements of the Operational Level
Management. Some examples of TPS used in an organization are
given below.

Function TPS

Sales and Marketing : Order Tracking, Order Processing,

Reservation Processing

Manufacturing : Machine Control, Plant Scheduling, Job

Scheduling, Malt. Movement Control

Finance : Online Securities Trading and Cash

Management
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Accounting : Payroll, Accounts Payable, Accounts

Receivable and GL Accounting

Human Resources : Compensation, Training and Development

and Compensation.

2. Knowledge Level System for Knowledge Level

Management : This type of System caters to the information
requirements of knowledge level of the organization. They help an
organization in integration of new knowledge into the business and to
in controlling the flow of paper in its offices. There are two sets of
Knowledge level people. They are (1) knowledge workers and (2)
Data workers. Knowledge workers are like engineers, doctors,
lawyers etc. They in fact create new information for the purpose of
utilization in the business. Computer aided design is an example of
knowledge work system. The data workers consist of primarily
Secretaries, Accountants, Record Clerks and Managers. The people,
who use, manipulate and disseminate information fall under this
category. The system which is used by this category helps to do their
work faster. An example is Word processing. Such a system is also
known as Office automation System.

3. Management Information System and Decision Support System

for Middle Level Management : This caters to the Information
requirements of the Middle Level Management. This provides the
information not on an instant basis but periodically. Usually the MIS
reports are provided every week, fortnight or month or quarter etc.
The Middle Level Management would need the information on the
growth of the organization towards the attainment of the objectives.
The middle level management is vested with the responsibility of
running the affairs of the organization as per the directions of the Top
level management. In order to ensure that the company moves in the
right direction, the Middle Level Management needs the information
on the operation of the organization for the purposes of decision
making. They also need the information for the purpose of Planning
and Controlling. The Management Information System derives its
information both from the Transaction Processing System and from
external factors to create and design benchmark standards.

4. Executive Support System for Top Level Management : This

provides the information to the top management for taking strategic
decisions. While all other information systems provide information for
making decisions, in respect of structured or semi structured
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problems, the ESS provide the Top Level Management information to

address unstructured decisions and create a generalized computing
and communications environment rather instead of providing any
specific application. They provide information to the top level
management on external events such as new tax laws or other
regulations or about the competitors besides the summarized
information from internal management information system.

The need for different Management Information Systems as

discussed above arises from the fact that the natures of problems to
be solved are different as far as different levels of Management are
concerned. While the problems at the operational level are very
structured and routine in nature, the problems at the top level
management are semi-structured and involve lot of uncertainty.

11.6 MIS AND COMPUTER

At the start, works in businesses and other organizations, internal

reporting was made manually and only periodically, as a by-product of the
accounting system and with some additional statistic(s), and gave limited
and delayed information on management performance. Previously, data
had to be separated individually by the people as per the requirement and
necessity of the organization. Later, data was distinguished from
information, and so instead of the collection of mass of data, important
and to the point data that is needed by the organization was stored.

Early on, business computers were mostly used for relatively

simple operations such as tracking sales or payroll data, often without
much detail. Over time these applications became more complex and
began to store increasing amounts of information while also interlinking
with previously separate information systems. As more and more data
was stored and linked man began to analyze this information into further
detail, creating entire management reports from the raw, stored data. The
term "MIS" arose to describe these kinds of applications, which were
developed to provide managers with information about sales, inventories,
and other data that would help in managing the enterprise. Today, the
term is used broadly in a number of contexts and includes (but is not
limited to): decision support systems, resource and people management
applications, Enterprise Resource Planning (ERP), Supply Chain
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Management (SCM), Customer Relationship Management (CRM), project

management and database retrieval applications.

11.6.1 Meaning of „Computer‟ :

Computer may be defined as an electronic machine capable of

manipulation of large volumes of data with accuracy at lightning speeds.
It can also store data, accept data, store programmes, accept instructions
and report the results after manipulation of data. Thus, it is called as a
data processing machine. It is the machine which has revolutionized the
whole way of living. i.e. the way we speak, the way we communicate, the
way we study, the way we do business, the way we govern ourselves and
the way in which entertainment and fun are being brought. It has
conquered each and every field whether medicine, business, engineering,
education, conferencing, banking etc.

11.6.2 Components Of A Computer System:

Modern computer systems consist of a central processing unit,

primary storage, secondary storage, input, output and communication
devices.

• The central processing unit (CPU) manipulates data and controls

the other parts of the computer system

• Primary storage (RAM) temporarily stores data and program

instructions during processing.

• Secondary storage (hard disk drives) stores data and instructions

when they are not used in processing.

Hardware refers to the visible parts of a computer. As you would

know, a computer consists of a monitor (like a TV screen), Key board,
mouse, cables and the most important of all, the CPU (Central
Processing Unit). The aforementioned parts are examples of hardware.

Software is the key for a computer. A computer can be put into

use only with the help of software. A computer can only function as per
our instructions. We can give different sets of transactions based on our
requirements from a computer. For example if we want to use the
computer for a ‗Billing application‘, the instructions relating to such billing
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process will be written together and loaded into the computer. Such set
of transactions put together is called ‗software‘. While hardware is a
visible part of a computer, software is an invisible part of a computer.
Software is also denoted as ‗programme‘.

Software is basically of two types. They are Systems software

and Applications software. Systems software refers to the programmes
which are very essential for the basic functioning of the computer. Such
software is essential to start the computer, to act as an interface between
the user and the computer outside the application software. Examples of
Systems Application software are Operating Systems, (like DOS, OS/2,
Unix etc.)

Application Software refers to the actual application packages like,

Spread sheet application, Word processing application, pay roll
processing application, Financial Accounting Application etc. while
Software application package like Spreadsheet package (Lotus 1-2-3, MS
Excel, Quattro Pro etc.), Word Processing (Word Processing (World Star,
MS Word etc.) are general application software. Software Application
packages like Financial Accounting Software and Payroll processing are
specific application software.

Firmware represents the software written into the hardware part of

a computer. Brain ware represents the human resources involved either
in the hardware or software. In includes hardware engineers, technicians,
systems analysts, programmers etc. It also includes the users of the
computers.

With the introduction of the Internet and the Worldwide Web,

students are able to access information faster and more efficiently using
modern Computer Systems. In the past, one had to visit national and
school libraries and spend large amounts of time accessing information.
Presently any individual can quickly access, save and print information
from any location. One can access the internet from Cyber Cafes,
schools, mobile phones, at home and even at modern libraries through
internet service providers and telecommunication links. Apart from the
internet, information e.g. encyclopedias, tutorials and documentaries can
be accessed from Compact Discs which are read from computer systems.
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In most cases, information systems are formal, computer based

systems that play an integral role in organizations. Although information
systems are computer based, it is important to note that any old computer
or software program is not necessarily an information system. "Electronic
computers and related software programs are the technical foundation,
the tools and materials, of modern information systems.

A management information system (MIS) is a computer-based

system that provides the information necessary to manage an
organization effectively. An MIS should be designed to enhance
communication among employees, provide an objective system for
recording information and support the organization's strategic goals and
direction.

11.7 PROBLEMS IN INSTALLING AND OPERATING

THE MIS

Management Information System is considered to bring in benefits

and opportunities arising out of its implementation. In fact an organization
which has gone in for a complete Information System developed by
making use of latest developments in Information Technology and
applying modem concepts have a lot of expectations to derive from that.
The company has to make lot of investments and efforts in order to
acquire such up-to date technology, develop an Integrated MIS and
implement it. Hence it is essential that the company is expecting returns
out of such investments. But in practice, it becomes very difficult that all
such investments are bringing in returns as expected. There are
challenges and limitations which are making it very difficult to reap the
benefits and advantages, which MIS is supposed to bring. We have been
seeing many examples of companies going in for ERPs for the sake of
going in for ERR. This does not bring in the results as expected.
However, the failure is neither because of the technology nor because of
the decision. It is only due to the organization's failure in preparing itself to
exploit the benefits available with the new technology and concepts.

Limitations :
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ln this discussion we are going to discuss the problems in

Installing and operating he MIS and the Limitations of MIS. The following
limitations are identified.

1. Heavy Planning Element :

Management Information System helps an organization in the

functions of Planning, Organizing, Decision making and Controlling.
Management information System provides an organization the
capabilities of managing its various processes most effectively and
efficiently. The various processes are Marketing and Sales,
Manufacturing and Production, Finance and Accounting, Human
resources, Inventory Control etc. The outcome of the various processes
in relation to the environment within which the organization is functioning
is not quite certain. Lot of efforts, time and planning need to be devoted to
understand the various processes in the light of the environments viz.,
Political, economic, social, cultural, legal and various forces namely
employees, government, competition etc. This involves lot of outlay in
terms of time and money.

2. Difficult to predict the information needs :

The need for information arises for planning, decision-making and

control. Different types of information are needed at different times.
Again, the nature of information needed depends upon the Environment.
As the circumstances and situations keep changing, it is very difficult to
precisely predict the information needs. For example, in the case of
Decision Support Systems, in order to make what if analysis, we will be
making sensitive analysis wherein the expected behaviour of certain
factors are analysed. Similarly in the case of an Executive Support
System, the behaviour of economic indicators and the expected
competition are beyond certainty.

3. Large Data base :

Information Systems are basically based on large volume of data

which have been gathered over a period of time. Take the case of expert
systems. They are designed to make use of the expertise of the Senior
managers who had / have been working and make it available for the
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organization as a whole. In order to make this possible, it becomes

necessary to archive large volume of data to be Used under such
situations. In the case of new organizations, this may not be possible
because of paucity of large volume of data. Even in cases of old
Organizations, it becomes very difficult to maintain and protect the data
because of many threats associated with it.

4. Coherent Plan of Information System for the whole organization :

Whenever a Management Information System is planned, it

should be planned for the organization as a whole. In fact, it should be a
comprehensive and integrated one so that communication between
different Information Systems across the enterprise or the organization is
compatible. However, in practice, such integration rarely happens.
Different Information Systems suitable for different Management Levels
are prepared separately, without any coherence. Designing and
implementing an integrated Management Information System involves lot
of planning and time. But at the same time, designing separate MIS
results in increased cost and non-compatibility among themselves.

5. Competitive advantage is available only initially :

Organizations, in the present competitive world are continuously

striving to be ahead of the competitors. Information technology has been
helping companies to be ahead of their competitors by way of
implementation of most effective solutions which pave way for best
business practices. Implementation of such best business practices Make
them gain an edge over other players in the market. However, once other
companies realise this, they also go in for more advanced Solutions
which make the early movers stagnant in terms of growth. Thus the
competitive advantage which an organization gets in the beginning is
short term in nature.

6. Get carried away by the competitor's moves :

Many organizations follow their competitors in various aspects.

In the same way, when some players in an industry go in for advanced
technological solutions and derive advantages, their competitors would be
motivated to go in for the same. However, it can not be expected that the
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same solutions or similar solutions can bring in the same advantages

which the earlier movers have derived from implementing those solutions.

7. Difficult to make cost - benefit analysis :

Implementation of technologically advanced solutions are

expected to bring in benefits. The benefits can be in the form of higher
sales revenue or better service to the customers or reduced process
costs or expenses. Better service to the customers can build customer
loyalty and reputation. Similarly, through effective and efficient Customer
Relationship Management and Supply Chain Management Solutions can
reduce the inventory level required and thereby reduce the inventory
costs. But not all the benefits can be quantified. Benefits like increased
revenue and reduced Inventory level are easily measurable. However
benefits which arise on account of customer loyalty and reputation can
not be measured. No proper techniques are available to measure the
benefits in such cases.

8. Top Management's commitment and involvement :

Any new concept need to be supported by the Top Management

and well received among the Operational level and Rank and file
employees, if the concept is to succeed. As far as implementation is
concerned, top management may have concerns about the huge
investment required and the expected benefits. Getting the nod from the
Top level management would be difficult as one will not be able to
convince the top management in terms of the total benefits arising from
an MIS or by way of a satisfactory ROI or IRR.

9. Social Impact :

Organizations play an important role in a society. Society also

plays an important role in the functioning of an organization. When an
organization goes in for an automated Management information System
many of its processes tend to get reengineered. In the process the best
business practices get implemented. This may involve relocation or
retrenchment of labour. An organization's culture and philosophy also
may get changed. This would have an impact in the society and affect the
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society's perception about the company which may be either positive or

negative.

10. Change in organizational structure :

The role of Information Technology has been very revolutionary in

the way the business has been carried out. Prior to that, the role of an
Information Technology Officer was known as an EDP in Charge. But with
the developments, the role of IT has raised to the level of a Strategic
Component from that of an Operational Level. This has resulted in a
tremendous change in the organizational structure of a Business. An IT
officer was reporting to a Financial Controller or CFO has become a CIO
and is reporting to the Top level Management. Even though this has
resulted in a welcome change, the resultant structure has brought in
some inequalities. This is so because, some part of a CFO's responsibility
like "Controls" in organizational practices get overlapped between a CIO
and a CFO.

11. Organizational HR policies :

We have seen that there is a change in the role of an IT officer

from that of an Operational Level to that of a strategic level. Similarly
there has been a quantum change in the HR policies of IT organizations.
The Changes in HR policies include increased compensation, employee
participation in ownership and management and work schedule. This has
created a premium for the knowledge (IT) workers. Designing and
implementing effective and efficient requires qualified and experienced IT
staff. In the case of a manufacturing organization which recruits IT staff
would have to pay higher compensation to the IT staff in comparison with
average pay of the existing staff force of the organization. This will result
in a sort of insecurity or inferior complex in the minds of the existing non
IT staff, which can cause organizational problem.

12. MODEL cannot take into account all the variables - too many and
due to changing circumstances.

The IT solution model designed for implementation of an MIS

solution takes is in to account all the variables and parameters existing
both within an organization and outside relevant to the present business
practices. However there cannot be any assurance that the current
 244

business practices cannot be subject to change. Under such

circumstances, the IT model becomes out dated.

13. Business Continuity Planning :

Under traditional MIS most of the operations were carried out

manually. In case of disruptions in business, the business operations can
be resumed without many hue and cries. But In an automated MIS
environment, the MIS and Operations are so integrated that any failure in
the system will have huge repercussions in the operations of the
Organization. In order to avoid such failures, an organization should have
back up procedures and alternate facilities to reduce the impact of any
unforeseen failures and to resume the operations of the organization
without any loss of time. Alternate facilities would include Sites with all the
infrastructure facilities like Computers, Terminals, Printers,
Communication facilities etc. Such facilities can be either hired or owned.
If the facilities are hired it may not be available at times of need. On the
other hand, if they were owned, they would amount to a redundant
investment.

14. Exposed to Suppliers and Customers :

In an extended Enterprises Resources Planning, Supply Chain

Management and Customer Relationship Management form an integral
part of the Information System. In such a case, the quantum of
requirements of raw materials can be easily communicated to the
suppliers and the requirements of the finished goods by our customers
can be easily known. This has a threat of exposure of the organizational
data to our suppliers and customers.

15. Security problems :

Because of the availability of the organization's data base in the

internal net work, it would be possible for intruders to intrude into the
computers in the organization and create heavy losses to the company.
This results in Security threats to the organization's resources.

16. Become out dated very often :

 245

Because of the rapid change in the technology, methods,

solutions and practices become outdated very often

17. Training facilities :

We have seen that there are new concepts and new technology
products coming into the market every other day. It becomes very
essential that the employees of the organization be given training in order
to understand the benefits arising out of such new products and concepts
and to integrate them into our existing systems. Thus there is a necessity
of providing continuous training to the employees. This will increase the
HR Costs.

18. Failure will affect the Organization's functioning :

Incase an organization is not able to successfully implement a

Management Information System, owing to selection of a wrong model or
wrong set of solutions, it would have already caused waste of resources
in Terms of the investment in hardware, software, training etc. This would
also affect the functioning of an organization in general. Further, the
effect of this will be carried forward and will adversely affect our future
efforts in implementing different set of solutions as well.

19. Engulf between IT and non-IT employees :

We have seen that the Compensation available for IT resource

persons are very high in comparison to the other set of technical and
managerial personnel. This has resulted in an engulf between IT and
Non-IT employees in the society.

11.8 KNOWLEDGE REQUIRED FOR STUDY OF MIS

As all new technologies and Concepts are not without any

limitations, so also with MIS. However, most of the limitations can be
 246

overcome by observing precautions and following Objective practices for

information and related technology. The Information Systems Audit and
Control Association, (ISACA) USA has been constantly evolving practices
and Control objectives which can reduce the minimize the risks
associated with Information and related technology. Presently, the ISACA
has advocated COBIT-3. COBIT stands for Controlled Objectives for
Information and Related Technology.

Under this methodology, the IT processes are divided into 4

domains viz.,

1. Planning and Organization

2. Acquisition and Implementation
3. Delivery Support
4. Monitoring

The main objectives under each of the above domains are given
below.

1. Planning and Organization :

Define a strategic IT plan

Define the information architecture

Determine the technological direction

Define the IT organization and relationships

Manage the IT investment

Communicate management aims and direction

Manage human resources

Ensure compliance with external requirements

Assess risks

Manage projects

Manage quality

2. Acquisition and Implementation :

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Identify solutions

Acquire and maintain application software

Acquire and maintain technology architecture

Develop and maintain IT procedures

Install and accredit systems

Manage changes

3. Delivery & Support :

Define service levels

Manage third-party services

Manage performances and capacity

Ensure continuous service

Ensure systems security

Identify and attribute costs

Educate and train users

Assist and advise IT customers

Manage the configuration

Manage problems and incidents

Manage data

Manage facilities

Manage operations

4. Monitoring :

Monitor the processes

Assess internal control adequacy

Obtain independent assurance

Provide for independent audit

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11.9 SUMMING UP

Any organization needs information for the purpose of planning,

decision making and control. There are different levels of Management in
an organization. They are operational Level, Knowledge Level, Middle
Level and Top Level Management. The natures of problems which need
solutions at the different levels of Management are different in terms of
complexity and certainty. Hence separate Information Systems are
designed and put into use for the informational needs of the organization.
The information systems which cater to the information requirements are
Transaction Processing System, Knowledge Work System, Management
Information System and Decision Support System and Executive Support
System.

11.10 EXERCISE

1. Discuss the need, significance and purpose of Management

Information System.

2. Discuss the need for different Management Information Systems for

an organization.

3. What are the different Components of a Management Information

System?

4. Explain the problems in installing and operating the MIS.



12

MANAGEMENT INFORMATION SYSTEM

AND BUSINESS
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Unit Structure:

12.0 Objectives

12.1 Introduction

12.2 Types of Information

12.3 Information Needs of Business

12.4 Levels of MIS

12.5 Decision Making Process and the Importance of Information

12.6 Business Functions and the Informational Needs

12.7 Summing Up

12.8 Exercise

12.0 OBJECTIVES

After studying the unit the students will be able to:

Explain the types of Information.

Know the need of information in the business.
Understand the Levels of MIS.
Explain the various business functions and the informational need
of the function.

12.1 INTRODUCTION

An organization needs to be managed most effectively and

efficiently under any given situation. It is to be noted that an organization's
outcome depends upon the sum total of the contribution by various
functional divisions constituting the organization. In order to manage each
such function effectively and efficiently, it becomes essential that each
function is handled by an expert who is known as a business manager /
 250

functional manager / process manager. Every business Manger or

Functional Manager or Process Manager needs to make decisions. The
manager has to make decisions in order to maximize the benefits by
utilization of resources available. When it comes to decision making, it
becomes important that the manager gets all the relevant information on
time. Unless the decision is made in the light of all the relevant and
required information, the decision cannot be a correct one. Hence it is
imperative that the informational needs of each function are properly
understood and a proper Information System as can help discharge of the
Decision-making, Planning and Control functions of a Manager is
designed and put in place.

12.2 TYPES OF INFORMATION

Information is basically divided into following categories. They are;

1. Operational
2. Knowledge
3. Tactical
4. Strategic
Let us briefly explain the above.

1. Operational :

Operational information is needed by the people at the lower levels of

management. Such information is necessary in order to carry out the day
to day operations of the management. It helps say for example, to decide
on the daily cash requirements or to decides about the daily stock
requirements at the show room. Similarly, information like the details
about the customers may be needed by a supervisor at the sales counter
in order to enable him to take a decision as to whether credit can be
allowed or extended. Such information is generated internally. Further the
requirement of such information would be very heavy because, of all the
decisions taken in a business organization, the number of decisions taken
at the operational level would be greater than any other decisions taken at
any other level of the organization. It is further to be added that this type
of information is used to solve structured problems. By 'structured
problems' we mean that the outcomes of a decision are certain at the
operational level.
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2. Knowledge level :

Informational requirements of people who are not at the hard core

operational level but at the support level are classified under this
category. Such people are Accountants, Engineers etc., For example, the
information which would be essential by an accountant who would need to
know regarding the Tax collectible on sale of goods. Information of this
type is also required in situations to solve problems which are structured
in nature.

3. Tactic level :

The type of information required at the Middle Level falls under

this category. This type of information is required in order to carry out the
plans of the top level management. Most of these decisions would be of
the nature necessitating the appropriation and allocation of resources.
This type of information helps to solve the problems which are less
structured in comparison with the other two types of informations.

4. Strategic level :

This type of information is required by the Top level management.

Information of this type is required by the Board of directors in order to
make strategic decisions which can help them lead the organization
ahead of the competitors. It means this type of information helps to solve
the problems which are very unstructured. Most of the information
required under this category is from external sources, viz, Competition,
Market Share, Plans and Strategies of Competitors, Political, Economic
and Social situations of the country.

12.3 INFORMATION NEEDS OF BUSINESS

Information requirements of one type of business would be

different from another type of business. This is because the Information
requirements are dependent upon the nature of business and its business
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objectives. After all, the Information System is expected to help the

management in making decisions in order to attain the objectives of the
business. For example, if the objective of a business is to become a
market leader, the performance of the company in terms of market share
would be very relevant information which the Management has to be
aware of very frequently. Similarly, in the case of a raw material intensive
manufacturing industry, the most critical piece of information would be
centered around the wastage of materials. But in the case of a Hotel
Industry, the importance would be on the No. of rooms lost without
selling. Apparently, the focus in the case of Manufacturing Industry, as it
seems is upon the scheduling and production, in the case of Hotel
Industry, it is upon Sales and Marketing. In fact, for the same type of
business, depending upon the locational requirements or legal
requirements or owing to some other external or internal factors, the
nature of information requirement, even though fundamentally would be
the same, some type of information which would be very relevant and
mandatory or critical in nature, in one particular location or environment
would not be required or would be irrelevant for the same size and type of
business functioning under another location or environment. For
example, for a Hotel Industry which is functioning in a place where water
is scarce or environment is of great concern, there would be great
emphasis on usage of water / disposal of waste while the importance of
water may not be that important in a place where water is available in
plenty. Thus it is very essential that the Information System should be
business objective specific.

12.4 LEVELS OF MIS

The Managerial echelon of a company can be classified into the

following levels.

a) Supervisory Level

b) Knowledge Level

c) Middle Managerial Level and

d) Strategic Level

a) Supervisory Level :

Each level of Management would be in need of information from

different perspectives. For example, a supervisor who is a charge of a
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scale of a Sales Counter may have to decide instantaneously whether to

extend credit to a particular customer. He may be needing information at
that instant in order to decide as to whether to give credit or not. The
information he would needing would be supplied by the sales department
and the Accounts department. This information is provided by the
Transaction Processing Systems viz., Sales Order Processing System
and accounts receivable processing system. Any system which produces
information at the transaction level is known as ―Transaction Processing
System‖. Transaction processing system generates the information in
large volumes and provides the source data for design of other
Information Systems. The transaction processing system is suitable for
solving well structured problems.

b) Knowledge Level :

The next level of Information System is focused towards the

knowledge level of an organization. This level of Management comprises
of skilled people like engineers who make use of systems like CAD
(Computer aided design) and the white collared people in the office, who
make use of systems like word processing, e-mail etc. The first set of
knowledge level people creates the information and the second set of
people process the data created by the first set. Like Transaction
Processing System, the Knowledge Systems is capable of solving only
well structured problems.

c) Managerial Level :

This level comprises of the Middle Level Management. There are

two types of Information Systems used by the middle level management.
They are:

1. Management Information System and

2. Decision Support System

The management information system is based on the information

generated by the transaction processing system. It caters to the
informational requirements of the middle level management, in performing
the day to day planning, decision making and controlling functions. It
presents the information generated by the transaction processing system
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and knowledge level system in a summarized form. It is prepared

periodically, say, every week fortnight or a month. The normal MIS takes
into account only the internal factors. The decision Support System takes
into account external factors also. For example, operational data like
volume of sales. Operational capability etc. of the competitors would be
included.

Analytical approaches like sensitivity analysis, ―what if‖ analysis

would find a common place in Decision Support Systems. Management
information system is useful for solving structured problems. DSS is used
to solve semi-structured problems.

d) Strategic Level :

The information system which is used by the top management is

known as Executive Support System. The Executive Support System
enables the top level management to take Strategic decisions. Apart
from containing relevant internal data great emphasis would be given to
the external factors. The presentation in the ESS may include graphs,
charts etc. to enable better understanding of the internal and external
environments. The ESS is used to solve un-structured problems.

12.5 DECISION MAKING PROCESS AND THE

IMPORTANCE OF INFORMATION

As seen earlier, managers, whether at the lower level or at the

middle level or at the top level, have to make decisions. They could reach
their objectives only by way effective handling of the Planning, Decision
making and controlling functions. He has to plan about his course of
actions among the alternative course of actions available, organize the
resources required in order to achieve the objectives and perform the
controlling activity in order to ensure that the desired results are achieved.
In case the desired results are not achieved, he has to make corrective
actions immediately.

Let us take an example :

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Assume that a Hypothetical Company is in an industry which is

highly raw material intensive. Supposing the Controller of the company
wants to reduce the material costs of the product in order to get a
strategic advantage over the competitors.

In the course of achieving this objective, three important elements

are involved. Viz. Planning, Decision making and controlling.

As a first step, he has to call for a meeting of the concerned

executives, discuss with them and then find out the various alternatives
available in older of priority and possibility. Subsequently, in consultation
with the concerned Middle level executives, a particular course of action
has to be chosen. Assuming that of the alternative courses of actions, it
has been decided that the wastage of materials has to be reduced to 3%.
Once it has been decided that the quantum of wastage of materials has to
be reduced, Standards have to be established and the Plan has to be
rolled out and there has to be a drive in implementation of it. Once the
implementation has been in place, an effective monitoring has to be set
in, to monitor the results of the action which the company has gone in for.
The monitoring process should collect the data related to the wastage of
materials after the new plan of action has been implemented. If the
company has been able to reach the desired objective viz., reduction in
the cost of materials wastage, the new plan of action may be refined in
order to achieve a better result. However, if the company is not able to
reach the desired objective, the controlling mechanism should provide for
a feedback analysis of the failure to reach the standards established to
meet the objective. Based on the analysis, corrective actions have to be
taken.

In the above example, you would notice that the Organization has
to plan for the course of action, fix standards and Control the result. For
all such managerial activities, the management is in need of the
information about the present material costs, the cost of wastage of
materials at present, the comparative study of the different options or
alternative courses of actions, the basis for selection of a particular
course of action You would have realised the importance of information
for decision making process.

12.6 BUSINESS FUNCTIONS AND THE

INFORMATIONAL NEEDS
 256

A business is normally divided into the following functions.

1. Marketing
2. Production
3. Human Resources
4. Purchasing
5. Finance and Accounting
6. Invetory control
7. Project Control
8. Management Reporting

Let us study in detail about the informational requirements of the

above mentioned functions.

1. Marketing and informational needs of Marketing function :

Under Marketing the requirement of informational needs can be

categorised into the following.

a) Competition and Market Share

b) Information on Sales and Sales Forecasting
c) Effectiveness of Marketing Plans.
d) Effectiveness of the Advertisement Plans.
e) Product Mix
f) After Sales service
g) Other Information

a) Competition and Market Share :- A marketing manager's regular

informational requirement comprises of the level of competition and
the organization's market share on a periodical basis. This information
will be required both for a particular period and cumulatively.

b) Information on sales and sales forecasting :- In order to keep a

vigil on the sales, the Marketing Manager would be in need of the
information on sales of different types of products of the company.
The analysis has to be made in terms of quantity, area or
geographical locations, customer category, market segment etc..
Sales forecasting is an important tool that will help a marketing
manager in establishing the sales policy and fixation of targets. Sales
forecasting is also needed to estimate the stock of quantities required.
 257

c) Effectiveness of marketing plans :- An organization can be floating

many marketing plans at any point of time. It becomes essential that
the Marketing manager needs information about the success of the
marketing plans which are launched. For example, he would need to
know the incremental quantity of products sold as a result of the
launch of a particular marketing plan.

d) Effectiveness of advertising plans :- As in the case of Marketing

Plans, the effectiveness of Advertising plans has to be analysed, in
order to judge their performance. Hence the information on
incremental sales of the products would be required in the course of
as well as after the implementation of such advertisement plans.

e) Product Mix :- Information on the Product mix is essential to enable

the Marketing Manager to understand the buying preferences of
customers.

f) After sales service:- This sort of information is required by a

marketing manager in order to give a proper feed back about the
quality of production to the production department as well as to study
about the satisfaction of the customers with the product.

g) Other information :- The following other information also would be

required for a marketing manager.
Effect of Pricing Policy - What has been the change in the pattern of
consumption of the customers after a change in price.

Customer Satisfaction - The level of satisfaction of the customers.

Market Research - Market research is an important tool in

understanding the changing market factors, customers' demands,
level of satisfaction or dissatisfaction. Market research will provide a
very important clue as to the company's unanswered questions and
can provide a valuable guide to the company's top management in
devising its marketing and sales strategies from the point of view of its
strategic planning. Market research can be conducted by either the
organization itself or can be out sourced from other professionals who
have expertise in Market research.

2. Production function and Informational needs of Production

function :

The Informational requirements of the Production function needs

to be interfaced with Sales and Purchasing. Production scheduling is the
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nerve centre of the Production Management System. Production

Scheduling involves planning for the Production quantity, the materials
required, job scheduling (assigning machine to appropriate skilled
labourers) and the maintenance of the Inventory of WIP. The materials to
be kept as WIP will form an important input as far as the purchasing
function is concerned. A well managed Production function contributes to
a better Inventory Control and hence higher Return on Investment. Thus it
boils down to the following aspects.

a) Materials Management
b) Production Planning
c) Job Scheduling

3. Human resources Function and Informational requirements:

The importance of Human Resources Function in the "New

Economy" age is getting very much important from the point of view of
new dimensions attached to the Personnel Management. The
revolutionary changes brought in by the "Knowledge employees" in the
organizational structures, work practices, training requirements,
performance measurement and Compensation methods the informational
requirements of the Human Resources Management warrant the
necessity to build new information data bases that can help the
organization to stay ahead of the Competitors. Different aspects of the
HR function that need such information are given below.

a) Personnel Selection
b) Personnel Recruitment
c) Personnel Training Methods
d) Organizational Policies as related to personnel
e) Performance Evaluation and Compensation Methods

4. Purchasing :

Nowadays in the context of extended Enterprise Resources

Planning, the Supply Chain Management is becoming so vital that the
participation by the suppliers in the Inventory management process is
required to keep inventory of the raw materials at the least possible
quantity. Infact, the organizations are moving towards the 'JIT' - Just In
Time Inventory practices. Under this practice, the materials will be
supplied by our suppliers at the time of need. This will practically
eliminate the necessity of Stocking the raw materials beforehand. In order
to attain such advantage, the suppliers have to be considered as
 259

Business Partners and the Data base about our production plan has to be
shared with them. The process also requires selection of vendors who are
capable of meeting our requirements without failure even once. This
needs information about the suppliers' History and the experience of the
firm with them in earlier occasions. A proper procedure has to be in place
for development of vendors who can co-operate with the firm regularly on
need.

5. Finance and Accounting :

Finance and Accounting has been the main repository of

information as far as any organization is concerned. The informational
requirements of the Finance and Accounting function is so vast that the
whole lot information which study about the performance of the
Organization as a whole from different view points need to be property
collated and analysed. The Finance function evaluates the Financial
Management function from the point of view of maximization of the wealth
and value of the shareholders. The Finance function also evaluates the
performance of the Organization from the point of view of Profitability,
Financial Stability, Solvency and Return on Investment or on Capital
Employed. "Accounting function" can be referred to as the single function
which needs the largest amount of information in any organization. Such
information flows from different sources both internally and externally and
from different functional areas. Information requirements with reference to
finance and accounting are in relation to the following aspects.

1) Financial Planning and Control.

2) General ledger reporting
3) Accounts Receivable Management
4) Accounts payable Management
5) Compliance with Legal requirements
6) Return on Investment or Return on Capital Employed.
7) Financial Reporting, Analysis and Interpretation of Financial
Statements.

6. Inventory Control :

While there are certain traditional models like ABC Analysis, VED
Analysis, FSND Analysis, Buffer Stock, Maximum Level, Minimum Level
etc. The present day's situation is that companies are moving towards the
"JIT", which stands for 'Just in time Inventory'. Under this concept, the
inventory has to be maintained at virtually 'zero level'. However, for the
 260

concept to work, the organization has to adopt the best practices in

relation to the Sales forecasting, co-ordination with the Sellers and the
buyers, Production scheduling and materials planning. Hence the
information on the quantum and schedule of off take by our customers
need to be known by the organization and at the same time, the
organization should share the information on the quantum of our off take
to our suppliers.

7. Project Control :

Any project, whether a short term one or Long term one should
adopt techniques of Project control like PERT and CPM. Programme
Evaluation and Review Techniques (PERT) help to adopt a modular
approach in managing the activities involved in the project and thus
enables to control the costs of the project. Critical Path Methods (CPM)
help to analyse the most critical path, which will have an impact on the
final completion of the project. This analysis would help in weighing
alternative ways of allocation of resources in order to complete the project
on time, if some exigencies arise.

8. Management Reporting :

There should be an established system of reporting whereby the

concerned level of management is supplied with the proper regular and
exception reports. The reports help the appropriate management be
informed about the progress of the planning. There should be a proper
mechanism whereby exceptions are reported without any loss of time, so
that appropriate corrective actions are taken without any loss of time and
the objectives are achieved. Such reports have to be built into the regular
MIS.

12.7 SUMMING UP

Information is very essential in order to carry out the functions of

Planning, Decision Making and Control. The organization's activities are
divided into various functions in order to enable handling of the functions
effectively and efficiently. Both for Long term and short term planning a
well established Information system can reduce the uncertainty involved
in the decision making process. The information is classified into
Operational, knowledge Level, Tactical and Strategic Informations.
 261

Various techniques and models are available in order to manage different

functions effectively. There should be a system of reporting to the
Management, who would be kept informed about the progress of planning
activities and to enable taking control actions to correct deviations.

12.8 EXERCISE

1. What are the different levels of MIS?

2. How the information is classified?
3. Explain the informational requirements of various Functions of
management. 




13

OBJECTIVE TYPE QUESTIONS

Chapter 1

Analysis and Interpretation of financial statements

1. Rewrite the following sentences by selecting correct choice.

a) An asset which is shown in the balance sheet but it has

no real balance.

(i) Fixed Asset

(ii) Current Asset

(iii) Wasting Asset

(iv) Intangible Asset

b) An expenditure from which no future benefit is expected.

(i) Capital Expenditure
 262

(ii) Revenue Expenditure

(iii) Deferred Revenue Expenditure

(iv) Misc. Expenditure

c) Which of the following is not a financial statement?

(i) Balance Sheet

(ii) Profit & Loss account

(iii) Funds Flow Statement

(iv) Trial Balance

d) The comparative income statement shows the increase

or decrease over______

(i) Previous Year

(ii) Future Year

(iii) Current Year

(iv) Percentage

e) In common size balance sheet analysis, the total assets

are taken as

(i) 100 %

(ii) 50 %

(iii) 10 %

(iv) 0%

2. Fill in the blanks :-

(i) In a common size income statement _____ is taken
as 100.

(ii) _______ form of balance sheet shows the assets on

the right side and the liabilities on the left side.

(iii) _______ Reserves are not available for distribution of

dividend.
 263

(iv) Receipts from customer for sale of goods are known as

______ receipts.

(v) The excess of current assets over current liabilities is

known as ______.

3. Match the following:-

Group A Group B
1. Bank overdraft Reserve and Surplus
2. Owned Funds Fixed Asset
3. Intangible Asset Non-operating Expenditure
4. Loss on sale of fixed assets Current Liability
5. Depreciation goodwill

4. State whether the following statements are true or false:-

(i) Issue of shares is an internal source of Finance.

(ii) A comparative balance sheet is prepared for the purpose
of intra-firm comparison.
(i) Common size statements are used for vertical analysis
only.
(ii) Analysis of profit & loss account means breaking down
the profit & loss account into its various components.
(iii) Accounting principles are generally accepted guidelines
used by accountants for the purpose of preparing the
financial statements.
Answers:

Q 1. (a)- (iii)

(b)- (ii)

(c)- (iv)

(d)- (i)
 264

(e)- (i)

Q 2. (i) Total Assets

(ii) Horizontal
(iii) Capital
(iv) Revenue
(v) Working Capital

Q 3. Group A Group B
(i) (iv)
(ii) (i)
(iii) (v)
(iv) (iii)
(v) (ii)

Q 4. (i) True
(ii) False
(iii) False
(iv) True
(v) False



Chapter 2

Ratio Analysis

Q.1 Re –write the following sentences by selecting correct choice.

i) An Accounting ratio is an expression relating to two _____________

(a) Accounts (b) Figures (c) Balance (d) Assets.

ii) The Balance sheet ratios deal with the relationship between two
____________.

(a) Assets (b) Liabilities (c) Items (d) Capital

 265

iii) The relationship between capital entitled to fixed rate of return and the
capital not so entitled to fixed rate of return is known as:

(a) Fixed Capital (b) Working Capital (c) Gearing Capital (d) owned
Capital .

iv) Decrease in gross profit ratio may be due to

a) Decrease in cost of goods sold

b) Increase in selling price

c) Overvaluation of Stock (closing)

d) Decrease in cost of materials.

v) The relationship between net operating profit and net sales is

expressed in __________________.

(a) Percentage (b) Figures (c) Ratios (d) Standard Deviation.

Q.2 Fill in the blanks

a) A ratio is one figure expressed in forms of another_______________

b) Leverage ratio measures the relationship between proprietor’s fund and

_______________.

c) _________________ is the difference between current assets and

current liabilities.

d) Those current assets which can be realized immediately at short notice

are _________________ assets.

e) _________________ Ratio is a test of the financial and credit strength

of the business.

Q.3 Match the following:

Group A Group B

1. Gross profit Ratio Net Profit

 266

2. Current Ratio Cost of goods sold

3. Operating ratio Trading results
4. Capital gearing Short term liquidity
5. Stock Turnover ratio Debenture capital

Q.4 State Whether the following statements are true or false:

a) The ratio should be expressed in percentage.

b) Over trading means increase in activities without adequate funds.

c) It is difficult to establish a standard inventory ratio as inventory levels

differ from industry to industry.

d) The return on capital employed measures the overall efficiency of the

business operations.

e) High debtors’ turnover ratio indicates overall efficiency in collecting

receivables.

Answers

Q.1 i –b, ii – C , iii - C , iv – b, v – a

Q.2 (a) Figure (b) Borrowed Funds (c) Working Capital (d) Quick
(e) Proprietary

Q.3 1 ---- iii

2 ----- iv

3 --- i

4 --- V

5 --- ii

Q.4 (a) False (b) True (c) True (d) True (e) False


 267

Chapter 3

Cash Flow Statement

Q.1 Choose the correct answer:-

(a) Cash from operations is equal to:-

(i) Net profit plus increase in outstanding expenses
(ii) Net profit plus increase in debtors
(iii) Net profit plus increase in stock
(iv) Net profit plus Depreciation
(b) Increase in the amount of debtors results in:-
(i) Decrease in cash
(ii) Increase in cash
(iii) No change in cash
(iv) Increase overdraft
(c) Cash flow statement reveals the effects of transactions involving:-
(i) Reduction in cash
(ii) Increase in cash
(iii) Movement of cash
(iv) Bank transactions
(d) Net cash flow does not necessarily mean net income of the:-
(i) Company
(ii) Firm
(iii) Business
(iv) Entity
(e) The amount of closing stock put on the credit side of trading account
increases the amount of net profit without increasing:-
(i) Funds from operations
(ii) Cash from operations
(iii) Surplus from operations
 268

(iv) Deficit from operations

Q 2. Fill in the blanks:-

(i) A cash flow statement depicts the change in cash position from one
______ to another.
(ii) Depreciation does not result in _______ of cash.
(iii) Increase in creditors from one period to another will result in ________
of cash from operations.
(iv) Payment of tax will result in decrease of cash and hence it is ________ of
cash.
(v) Cash Flow Statement is a useful ________ instrument.

Q 3. Match the following:-

Group A Group B
1. Cash flow statement i Sources of funds
2. Depreciation ii Reduction in net profit
3. Funds from operations iii Change in cash position
4. Opening stock iv Increase of cash from operations
5. Creditors v Non-cash item of expenses

Q 4. State whether the following statements are true or false:-

(a) Cash Flow Statement reveals the effects of transactions involving
movement of cash.
(b) The term Funds means Current assets in case of cash flow analysis.
(c) A cash flow statement can very well be equated with an income
statement.
(d) The funds flow statement and Cash flow statement are one and the
same.
(e) A company should keep large balance of cash in hand so that it can
meet all contingencies.

Answers:

Q.1 a – iv , b – i , c – iii , d – iii , e – ii

 269

Q.2 i- period , ii – outflow , iii – increase , iv – application , v–

supplementary

Q.3 1 – iii

2–v

3–i

4 – ii

5 – iv

Q.4 a – True, b – false, c – false, d – false, e – false





Chapter 4

Working Capital

Q.1 Rewrite the following sentences by selecting correct choice-

a) The period required for the whole operation starting with cash and
ending up with Cash plus –

i) operating cycle

ii) Trading Cycle

iii) Working Cycle

iv) Main Cycle

b) Cross working Capital is equal to –

i) Total Current Assets

ii) Total fixed assets

iii) Total Assets

 270

iv) Net Assets

c) The cost to be excluded from the cost of goods sold for the purpose of
determining working in process and finished goods is –

i) Interest

ii) Depreciation

iii) Taxation

iv) Dividend

d) The primary objective of Working Capital Management is to manage –

i) Current Assets

ii) Current Liabilities

iii) Current Assets and Current Liabilities

iv) Fixed Assets

e) It Is a normal principles that current assets should be valued at cost or

market value whichever is

i) Higher ii) Lower iii) More iv) earlier

Q. 2. Fill in the blanks

i) Advances received from customer will ---------------the working capital

requirements.
ii) Provision for contingencies may be made to make allowances for likely
variations or for -------expenses.
iii) In valuation of world in progress labor & overheded are assumed to be
incurred to the extent of --------------
iv) It would be more practical if investment in debtors is a cetined at cost
of sales, not as --------price.
V) The Capital required to meet seasonal requirements is called as --------
working capital.
 271

Q.3 Match the following

Group A Group B

1) Gross working capital 1. Receivables

2) Negative working capital 2. Excess of current Assets

3) Debtors 3. Total current Assets

4) Bank Balance 4. Excess of current liabilities

5) Net working capital 5. Quick Assets

Q. 4 State whether the following statements are true or false

a) Closing stock of raw material is a liquid asset.

b) Profit included in debtors is an expense hence; it is a part of current

asset.

c) Finished goods stock should be valued at FIFO basis.

d) Working capital management aims to strike a judicious balance between

current assets & current liberalities.

e) Prepaid expenses increase the amount of working capital.

Answers:

Q .1. a-i, b-iii, c-ii, d- iii, e-ii

Q .2 i – Reduce ii –unforeseen iii – 50% iv – selling v- circulating

Q.3 1 -3

2 -4

3 -1

4-5
 272

5-2

Q .4 a – False, b – False, c – False, d – True, e- True



Chapter 5

Capital Budgeting

Q.1 Choose the correct answers and complete the statements.

(a) While evaluating capital investment proposals the time value of money
is considered in case of –

(i) Pay back period

(ii) IRR

(iii) NPV

(iv) ARR

(b) Depreciation is included in cost in case of –

(i) ARR

(ii) Payback period

(iii) Profitability Index

(iv) NPV
 273

(c) The cash inflows on account of operations are presumed to have been
reinvested at the cut-off

rate in case of –

(i) ARR

(ii) DCF method

(iii) IRR

(iv) PI

(d) Cash flows from a project can be worked out only –

(i) On the basis of certain probabilities

(ii) On the basis of sales

(iii) On the basis of depreciation

(iv) On the basis of percentages

(e) Theoretically, a firm should undertake all investment proposals which –

(i) Results in increasing value of the firm

(ii) Results in higher IRR

(iii) Results in higher cash flows

(iv) Results in maximum profits

Q2. Fill in the blanks -

(i) The cut-off point refers to the point below which a project would not be
_______.

(ii) Capital budgeting includes both raising of long-term funds as well as their
________.

(iii) All capital investment proposals for increasing revenue require

additional _______ capital.

(iv) Different capital investment proposals have different degrees of risk and
________.
 274

(v) The term pay-back refers to the period in which the project will
generate the necessary cash to recoup the initial---

Q3. Match the following –

Group A Group B

1. DCF i. Accept or Reject

2. Pay back period ii. Discounts the cash flows to zero

3. Profitability index iii. NPV

4. Cut off rate iv. Benefit cost ratio

5. IRR v. Recoup initial investment

Q4. State whether the following statements are true or false –

(a) The internal rate of return and Net Present Value are synonymous terms.

(b) Tax concessions have no role to play in estimating the cash flows from a
project.

(c) Discounted cash flow technique takes into account the time value of
money.

(d) Pay back method takes into account the cash flows after the pay back
period.

(e) Cash flows from a project cannot be estimated accurately.

Answers:

Q.1 a – iii , b – i , c – ii , d – i , e – i

Q.2 i – accepted , ii – utilization , iii – working ,iv-uncertainty, v-

investment
 275

Q.3 1 - iii

2-v

3 - iv

4-i

5 – ii

Q.4 a – false

b – false

c – true

d – false

e – true



Chapter 6

MIS reports in computer Environment

Q 1. Rewrite the following sentences by selecting correct choice:-

a) The popular belief is that accuracy in reporting should

be of –

(i) Low order

(ii) High order

(iii) Medium order

(iv) Top order

b) MIS can be defined as a network of information that

supports management –

(i) Decision making

 276

(ii) Reporting

(iii) Planning

(iv) Controlling

c) The potential impact of computers and MIS on middle

management level is –

(i) Insignificant

(ii) Significant

(iii) Not significant

(iv) Less significant

d) Reports on stock levels are given to –

(i) Top management

(ii) Middle management

(iii) Lower management

(iv) Managing director

e) The success of MIS depends upon –

(i) Support of middle management

(ii) Support of top management

(iii) Support of lower management

(iv) Support of employees

Q.2 Fill in the blanks:-

(1) Operating reports and financial reports are the classification

on the basis of _______.

(2) The quality of the ________ of MIS is basically governed by

the quality of inputs and processes.
 277

(3) _______ is the glue that holds the functional systems

together.

(4) Accuracy in reporting is not of vital _______.

(5) The primary objective of MIS reporting is to enable the

management to make scientific and ________ decisions.

Q 3. Match the following

Group A Group B

1 Regular reports i. Control reports

2 Operating reports ii. Lower management

3 External reports iii. Quarterly reports

4 Report of overtime iv. Middle management

5 Report of idle time v. Shareholder s and Creditors

Q.4 State whether the following statements are true or false:-

(1) Balance sheet is an internal report.

(2) The reports should be selective and summarized at the

corporate level.

(3) Accuracy of data in MIS reports is an absolute ideal.

(4) MIS is necessary only for the top management.

(5) High accuracy is not required in MIS reports.

Answers:

(1) a – ii , b – i , c – ii , d – ii , e – ii

(2) (i) Functions (ii) Output (iii) Database (iv) Importance

(v) Sound

(3) Group A Group B

 278

1 iii
2 i
3 v
4 iv
5 ii
(4) (i) false (ii) true (iii) false (iv) false (v) true



Revised Syllabus of T.Y.B. Com

Financial Accounting and Auditing Paper – V

Related Applied Component-
Introduction to Management Accounting

Topics at Glance

Sr. Topics No. of

No. Lectures

1. Analysis and Interpretation of Financial 25

Statement

2. Ratio Analysis 20

3. Cash Flow Statement 15

4. Working Capital Concept 10

 279

5. Capital Budgeting 15

6. Concept of MIS Reports in computer 05

environment

Total 90
 280

Sr. Topics
No.

Analysis and Interpretation of Financial Statements

1

Study of Balance sheet and Income Statements/Revenue

1.1
Statements in Vertical form suitable for analysis.

Relationship between items in Balance Sheet and Revenue

1.2
Statement.

Tools of analysis of Financial Statements

1.3
(i) Trend Analysis

(ii) Comparative Statement

(iii) Common Size Statement

Note: i) Problems Based on trend analysis

ii) Short Problems on Comparative and Commonsized

statements

Ratio Analysis and Interpretation (Based on Vertical Form of

2
Financial Statements) Including Conventional and Functional
Classification Restricted to-

Computation and analysis of ratios

2.1
(A) Balance Sheet Ratios

(i) Current Ratio

(ii) Liquid Ratio

(iii) Stock Working Capital Ratio

(iv) Proprietary Ratio

(v) Debt Equity Ratio

(vi) Capital Gearing Ratio

(B) Revenue Statement Ratios

(i) Gross Profit Ratio

(ii) Expenses Ratio

(iii) Operating Ratio

 281

(iv) Net Profit Ratio

(v) Net Operating Profit Ratio

(vi) Stock Turnover Ratio

(C) Combined Ratios

(i) Return on Capital employed (Including Long Term Borrowings)

(ii) Return on proprietor‘s Fund

(iii) Return on Equity Capital

(iv) Earning per share (EPS)

(v) Price Earning Ratio (P/E Ratio)

(vi) Dividend Pay out Ratio

(vii) Debt Service Ratio

(viii) Debt service coverage Ratio

(ix) Debtors Turnover Ratio

(x) Creditors Turnover Ratio

Different Modes of Expressing Ratios: Rate, Ratio, Percentage,

2.2
Number etc. Limitations on the use of the Ratios, Inter-action of
Ratios.

Projection of the Financial Statements from the given ratios and

2.3
other information.

Preparation of Statement of Sources and Application of cash with

3
reference to Accounting Standard No. 3

(Cash Flow Statement)

Working Capital-Concept
4
Estimation / Projection of Requirements in case of Trading and
Manufacturing Organization.

Capital Budgeting
5

Introduction:
5.1
(i) Types of capital

(ii) Sources of capital

 282

(i) Evaluation of Capital Expenditure Proposals from given cash

5.2
flow Concept of Present Value

(ii) Techniques of appraisal of investment proposal

Pay back period method

Average Rate of Return method

Net Present Value method

Profitability Index method

Concept of MIS Reports in Computer Environment

6

Concept of MIS, Need for MIS, characteristics of MIS, Role of MIS,

6.1
problems in MIS, Knowledge required for studying MIS.

MIS and Business, MIS and Computer.

6.2

Pattern of question paper

Maximum Marks 100 Duration 3 Hours

No of questions to be asked 9

No of questions to be answered 6

Question No. 01 Compulsory Practical question 20 Marks

Question No. 02 Compulsory Objective 16 Marks

Question No. 03 to Question No. 09 16 Marks

each

Note:

(1) From Question No. 03 to Question No. 09 not more than one question
may be theory including short problems/questions.

(2) Student to answer any four out of Question No. 03 to Question No. 09.
 283

(3) Objective questions to be based on all topics and include Inter alia
questions like:

(a) Multiple choice (b) Fill in the blanks (c) Match the columns (d) True
or False

Reference Books

Title of Books Author /s Publishers

Cost and Management Ravi M. Kishore Taxmann

Accounting

Essential of Management P.N. Reddy Himalaya

Accounting

Advanced Management Robert S. Kailar Holl

Accounting

Financial Management S.R. Varshney Wisdom

Accounting

Introduction of Charles T Horngren Pearson Education

Management Accounting

Management Accounting I.M. Pandey Vikas Publishing

House

Cost and Management D.K. Mattal Galgotia

Accounting

Management Accounting Khan and Jain Tata McGraw Hill

Fundamentals of Financial Vyuptakesh Sharma Pearson Education

Management



 284

Question Paper
Financial Accounting and Auditing – Paper-V
April 2010

Duration: 3 Hours Total Marks: 100

N.B: (1) Question No.1 and 2 are compulsory and carry 20 Marks and
16 Marks respectively.
(2) Attempt any four questions from the rest, carrying 16 Marks
each.
(3) Working Notes should form part of your answer.
(4) Proper presentation and neatness is essentials.
(5) Use of simple calculator is allowed.

1. The Management of Kaka Ltd. has asked you to prepare an estimate

showing the working capital requirement for 2010-11, alongwith
estimated cost sheet. (20)
Present position: 2009-10
Operating Capacity 40% , giving output of 40,000 units for the year:
Cost Structure per unit:-
Raw Material Rs. 20
Direct Labour Rs. 15
Overheads Rs. 10
Profit Rs. 5

Estimates for the next year 2010-11

Operating Capacity 60%
Cost Structure-
Raw Material cost to increase by 10%
Direct Labour cost to increase by 20%
Overheads to increase by 20%
Selling Price to increase by 20%

The following further information is available:

1. The purchase, production and sales pattern is assumed be even
throughout the year.
2. The Raw Materials will remain in stock for 1 month.
3. The production process will take 1 month wherein labour and
overheads will accrue evenly during the process.
4. The Finished Goods will remain in the stock for 2 months.
5. The Customers will be allowed a credit of 2 months.
6. The Suppliers will allow a credit of 1 month.
 285

7. The time-lag in payment of labour will be 1 month.

8. The time-lag in payment of overheads will be half a month.
9. The cash and Bank Balance is expected to be Rs. 25,000/-
10. Calulate debtors on cost basis.
11. 20% of the purchase will be on cash basis.

2. (a) Re-write the following sentences by selecting correct choice.

(8)
A very high current ratio will-
(a) increase the profitability (c) Decrease the profitability
(b) Not affect the probability (d) Will increase Tax liability
One of the following is not liquid asset-
(a) Cash Balance (c) Stock
(b) Bank Balance (d) Marketable investment
A highly geared company exposes to –
(a) Business risk (c) Inflation risk
(b) Financial risk (d) Recession risk
Shareholders Equity does not include-
(a) Equity share capital (c) Reserves and Surplus
(b) Pref. share capital (d) Bank Loan
High inventory turnover means-
(a) Investment tied up in stocks
(b) Obsolete goods on stock
(c) Adverse impact on liquidity
(d) Over Trading
Return on Capital employed is known as –
(a) Return on total Assets (c) Return on investments
(b) Return on fixed Assets (d) Return on shareholders
fund
Standard Acid test ratio is –
(a) 2 : 1 (b) 3 :1 (c) 1 :1 (d) 4 :1
In cash flow statement machinery purchased is treated as –
(a) Operating activity (c) Financing activity
(b) Investing activity (d) Extraordinary activity
 286

(b) Match the coloumns and rewrite the following sentences –(8)

Group A Group B
1 Rly sidings 1 Efficiency in collection from
Debtors
2 Trend Analysis 2 Total current Assets
3 Gross Profit Ratio 3 More risk
4 Retained earnings 4 Period of recovery of cash out-lay
5 Dividend layout 5 Current liabilities
6 Payback period 6 Earlier year a base year
7 Gross working capital 7 Fixed Assets
8 Debtors turnover ratio 8 Trading efficiency
9 Dividend paying ability
10 P & L appropriation A/c Balance

3. From the following information for the year ended 31st March, 2010 of
M/s. NITIN Ltd. Prepare Balance-sheet with as many details as
possible. (16)

Current Ratio 2
Gross Profit Ratio 25%
Debtors Turnover 4 times
Cost of goods sold to creditors (COGS/creditors) 6
Stock Turnover (Cost of Goods sold / Closing Stock) 6 times
Cash Balance is 10% of Total Current Assets (Including
Cash)
Fixed Assets at cost Rs. 6,00,000
Accumulated Depreciation on Fixed Assets 1 th of cost
4
Current Liabilities Rs. 1,25,000
Reserve and surplus is 25% of Equity Share Capital
Debt Equity Ratio (Debt/Equity)
2:3
All purchases and sales are on Credit Basis
Current liabilities include only Creditors and Bills payable.

4. CHETAN LTD. is considering purchase of a machine two machines-

LPX machine and GPX machine are available, each costing Rs.
5,00,000.
In comparing profitability of machines, a discounted rate of 10% is to
be considered.
Expected profits after tax and before Depreciation are as follows:
(16)
 287

Year 1 2 3 4 5
LPX machine profit 1,60,000 2,00,000 2,50,000 1,50,000 2,00,000
GPX machine profit 60,000 1,50,000 2,00,000 3,00,000 2,00,000

Indicate which machine would be more profitable under following

methods –
(1) Pay back Period Method
(2) Net Present Value Method
(3) Pay back profitability

The net present value of Re. 1 @ 10% discounting factor is as follows:

Year 1 2 3 4 5
Present Value Factor 0.909 0.826 0.751 0.683 0.621

5. Following are the Balance-sheets of Abhishek Products Ltd.(16)

Liabilities 31st 31st Assets 31st 31st

March, March, March, March,
2009 2010 2009 2010
Rs. Rs. Rs. Rs.
Equity Share 10,00,000 12,00,000 Fixed 11,00,000 13,00,000
Capital Assets
10% Pref. 5,00,000 3,00,000 Investments 2,60,000 2,60,000
Share Capital
Capital ____ 2,00,000 Stock 7,40,000 8,99,000
Redemption
Reserve
Profit and 57,000 1,00,000 Sundry 10,50,000 9,90,000
Loss A/c Debtors
Sundry 13,73,000 12,50,000 Bills 1,50,000 2,10,000
Creditors Receivable
Proposed 1,50,000 1,80,000 Bank 1,00,000 80,000
Equity Balance
Dividend
Provision for 1,70,000 2,10,000 Cash in 30,000 20,000
Taxation Hand
Provision for 2,00,000 3,35,000 Preliminary 20,000 16,000
Depreciation Expenses
34,50,000 37,75,000 34,50,000 37,75,000
Additional Information:
(1) Preference Shares were redeemed on 1.4.2009. Company pays
Preference dividend on 31st March every year.
(2) Fixed Assets of Rs. 2,00,000/- were purchased on 31.03.2010 against
which equity shares of Rs. 2,00,000/- were issued at par.
 288

(3) Dividend received on investment was Rs. 26,000/-

(4) Proposed Equity Dividend for 2008-09 Rs. 1,50,000/- was paid during
2009-10.
(5) Provision for Taxation for 2008-09 Rs. 1,70,000/- was paid during
2009-10.

Prepare Cash Flow Statement for the year ended 31st March, 2010 by
indirect method as per AS-3 from the above information.

6. M/s. Sudesh Ltd. carrying on Business furnishes their position as on

31st December, 2007, 2008 and 2009 as under : (16)

Liabiliti 2007 Rs. 2008 2009 Assets 2008 Rs. 2008 2009
es Rs. Rs. Rs. Rs.
Equity 3,00,000 3,00,000 4,00,000 Fixed 3,00,000 3,00,000 4,00,000
Share Assets
Capital
Pref. 2,00,000 2,00,000 2,50,000 Investme 1,00,000 1,00,000 1,00,000
Share nts
Capital
General 50,000 1,00,000 1,00,000 Debtors 1,00,000 1,50,000 2,00,000
Reserve
Secured 1,00,000 1,00,000 50,000 Stock 50,000 1,00,000 50,000
Loan
Sundry 40,000 80,000 80,000 Advanced 50,000 50,000 50,000
Creditor paid
s
Bills 10,000 20,000 20,000 Cash 50,000 50,000 50,000
payable
Bank 25,000 40,000 45,000
Discount 25,000 10,000 5,000
on Issue
of Shares
7,00,000 8,00,000 9,00,000 7,00,000 8,00,000 9,00,000

Prepare vertical Trend Balance-sheet and offer your comments on Net

worth and working capital.

7. Rearrange the following Manufacturing and Trading A/c of M/s Dada

and Co. in a form suitable for financial analysis. (16)

Manufacturing and Trading A/c for the year ended 31st March, 2010

Particulars Rs. Particulars Rs.

To Opening Stock: By Sales 9,00,000
 289
Raw Materials 72,000 By Sales of Factory 6,000
Scrap
Work in Progress 12,000 By Closing Stock:
Finished Goods 48,000 Raw Materials 60,000
To Purchase of Raw 4,80,000 Work in Progress 18,000
Materials
To Freight 12,000 Finished Goods 72,000
To Octroi 48,000
To Import Duty 6,000
To Direct Wages 1,20,000
To Direct Expenses 36,000
To Factory Power 24,000
To Factory Salaries 12,000
To Factory Repairs 36,000
To Factory Rent 60,000
To Depreciation on 24,000
Machinery
To Gross Profit 66,000
Total 10,56,000 Total 10,56,000

8. Following is the Profit and Loss Account of Moon Enterprises Ltd. for
the year ended 31.03.2010. (16)

Particulars Rs. Particulars Rs.

To Opening Stock 4,00,000 By Sales-Credit 18,00,000
To Purchases 9,80,000 -Cash 7,00,000 25,00,000
To Wages 2,90,000 By Closing Stock 6,00,000
To Factory Expenses 1,90,000 By Sale of Scrap 10,000
To Office Salaries 1,20,000 By Dividend Received 1,000
To General 1,30,000
Administrative Exps.
To Selling Expenses 1,12,500
To Depreciation on 2,50,000
Machinery
To Provision for Tax 1,40,500
To Trf. To Gen. 2,00,000
Reserve
To Net Profit 2,98,000
31,11,000 31,11,000

You are required to compute the following ratios-

(1) Gross Profit Ratio
(2) Stock-Turnover Ratio
(3) Administrative Expenses Ratio
(4) Net Profit before Tax Ratio
Preparing Revenue Statement in vertical form is not required.

9. (a) Complete the following Comparative Statement of Himalaya

Products Ltd. by ascertaining the missing figures. (8)
 290

Particulars Year ended Year ended Increase/ % Increase/

31-03-2009 31-03-2010 (Decrease) (Decrease)
Rs. Rs. Rs.
Gross Profit ? ? ? ?
Less: Expps. 1,00,000 ? 20,000 20.00
Administrative
Selling 50,000 60,000 10,000 ?
Financial ? 25,000 5,000 25.00
Operating Net ? 2,00,000 1,00,000 100.00
Profit

(b) Complete the following Income Statement of Narayan Ltd. for the
year ended 31st March, 2010 and also prepare Commonsize
Revenue statement. (4)

Particulars Rs.
Net Sales 16,00,000
Less: Cost of goods sold ?
Gross Profit (25% on sales) ?
Less: Operating Expenses ?
Operating Net Profit 2,00,000
Add: Non Operating Income 1,00,000
Less: Non Operating Expenses ?
Net Profit before Tax 2,80,000

(c) Write short note (any one): (4)

(i) Essential Requirements of MIS
(ii) Concept of Working Capital


