MODULE -3

CMA
Cost &
MANAGEMENT
ACCOUNTING
Presented by:
DR. LOKESH AGARWAL (Associate Professor)
Arya Group Of Colleges, Kukas, Jaipur
 MODULE -3
CONTENT
Financial Statements preparation, analysis
and Interpretation:
Income statement
Comparative and common size statements
Analysis techniques- Ratio Analysis
Cash flow Statement analysis as per AS3 and
Fund flow statement analysis
 FINANCIAL STATEMENT
Financial analysis is a process of selecting,
evaluating, and interpreting financial data, along
with other pertinent information, in order to
formulate an assessment of a company’s present and
future financial condition and performance.

Financial statement analysis is a judgemental

process which aims to estimate current and past
financial positions and the results of the operation of
an enterprise, with primary objective of determining
the best possible estimates and predictions about the
future conditions.
 FINANCIAL STATEMENT
The term analysis means
Financial simplification of financial data
Statement by methodical classification
Includes given in the financial
statements.
Analysis Interpretation means explaining
the meaning and significance of
the data. These two are
Interpretation complimentary to each other.
Analysis is useless without
interpretation, and interpretation
without analysis is difficult or
even impossible.
 OBJECTIVE OF FINANCIAL STATEMENT
• These statements show an accurate state of a
company’s economic assets and liabilities.
• They help in predicting the extent of a
company’s capacity to earn profits. Stakeholders can use
this data to make their financial decisions.
• These statements depict the effectiveness of a company’s
management that how well a company is performing .
• Financial Statements help readers of these statements
know the accounting policies used in them.
• These statements also provide information relating to the
company’s cash flows to predict the company’s liquidity and
cash requirements.
• Finally, they explain the social impact of businesses. This
is because it shows how the company’s external factors
affect its functioning.
 FINANCIAL STATEMENT
FINANCIAL STATEMENT

ANALYSIS INTERPRETATION

Comparative Financial Statements

For Companies:
Statement of Profit and Loss Account
Common Size Financial Statements
For Sole Trade & Partnership Firms:
Trading A/c
Profit and Loss A/c
Cash Flow Statement

Ratio Analysis

Balance Sheet
Trend Analysis
 BUSINESS ACTIVITY

OWN Outside
CAPITAL Investment

FINANCE BUSINESS INVESTMENT

BORROWED Investment
/ DEBT in Own
CAPITAL Business

Operational
Activities
 Trading Account
Trading A/c for the year ended ……………….
Particulars Amount Particulars Amount
To Opening Stock By Sales
To Purchase (i) Credit Sales
(i) Credit Purchase (ii) Cash Sales
(ii) Cash Purchase Less: Sales Return
Less: Purchase Return
To Wages By Closing Stock
To Customs and import duty
To Carriage inward
To Royalty
To Manufacturing Expenses

To Gross Profit transferred By Gross Loss transferred to

to P&L A/c profit and loss account
 Profit & Loss Account
Profit and Loss account for the year ended ……….
Particulars Amount Particulars Amount
To Balance b/d (Gross Loss) By Balance B/d (Gross Profit)
To Indirect Expenses: By Indirect Incomes:
(i) Administrative Expenses (i) Commission Received
(ii) Selling Expenses (ii) Interest Received
(iii) Distribution Expenses (iii) Dividend Received

To Balance C/d (Net Profit) By Balance c/d (Net Loss)

Transferred to Capital a/c Transferred to Capital a/c
TOTAL TOTAL
 Balance Sheet
Balance Sheet as at……….
Liabilities Amount Assets Amount
Capital Fixed Assets
Add: Net Profit Building
Less: Net Loss Machine
Less:Drawings Loose Tools
Goodwill
Long Term Loan Patent

Current Liabilities: Investment

Creditors
Notes Payable Current Assets:
Accounts Payable Cash
Outstanding Expenses Short term Investment
Unearned Income Accounts Receivable
Bank Overdraft Prepaid Expenses
Accrued Income

TOTAL TOTAL
Questions:
1. From the following balances taken from the books of Simmi and Vimmi
Ltd. for the year ending March 31, 2020, prepare Trading Account.
(Rs.)
Closing Stock 2,50,000
Net sales during the year 40,00,000
Net purchases during the year 15,00,000
Opening stock 15,00,000
Direct expenses 80,000

Trading A/c of Simmi and Vimmi Ltd. For the year ended 31st March 2020
Particulars Amount Particulars Amount
To Opening Stock 1500000 By Sales a/c 4000000
To Purchase a/c 1500000 By Closing Stock 250000
To Direct Expenses a/c 80000
To Gross Profit transferred
to P&L A/c 1170000
4250000 4250000
Questions:
2. From the following balances extracted from the books of M/s Ahuja
and Nanda Prepare Trading A/c:
Particulars Amount (in
Rs)
Opening Stock 25000
Credit Purchases 750000
Cash Purchases 300000
Credit Sales 1200000
Cash Sales 400000
Commission Received 10000
Wages 100000
Salaries 140000
Rent 15000
Closing stock 30000
Sales return 50000
Purchases return 10000
Answer:

Trading A/c of M/s Ahuja and Nandu Ltd. For the year ended 31st March 2020
Particulars Amount Particulars Amount
To Opening Stock 25000 By Sales
To Purchase (i) Credit Sales 1200000
(i) Credit Purchase 750000 (ii) Cash Sales 400000
(ii) Cash Purchase 300000 1600000
1050000 Less: Sales Ret. 50000 1550000
Less: Purchase Ret. 10000 1040000
To Wages 100000 By Closing Stock 30000
To Gross Profit transferred
to P&L A/c 415000
1580000 1580000

Profit and Loss A/c of M/s Ahuja and Nandu Ltd. For the year ended 31st March 2020
Particulars Amount Particulars Amount
To Salary 140000 By Balance b/d (Gross Profit) 415000
To Rent 15000 By Commission 10000

To Net Profit transferred 270000

to Capital A/c
Questions:
3. Prepare trading and profit and loss account and balance sheet as on
March 31, 2020 :

Account Title Amount

Rs.
Machinery 27,000
Capital 60,000
Sundry debtors 21,600
Bills payable 2,800
Drawings 2,700
Sundry creditors 1,400
Purchases 58,500
Sales 73,500
Wages 15,000
Sundry expenses 600
Rent & taxes 1,350
Carriage inwards 450
Bank 4,500
Opening stock 6,000
Closing stock as on March 31, 2020 22,400
Answer:
Trading A/c for the year ended 31st March 2020
Particulars Amount Particulars Amount
To Opening Stock 6000 By Sales less return 73500
To Purchase less return 58500 By Closing Stock 22400
To Wages 15000
To Carriage Inwards 450

To Gross Profit transferred

to P&L A/c 15950
TOTAL 95900 TOTAL 95900

Profit and Loss A/c for the year ended 31st March 2020
Particulars Amount Particulars Amount
To Sundry Expenses 600 By Balance b/d (Gross Profit) 15950
To Rent & Taxes 1350

To Net Profit transferred

to Capital A/c 14000
TOTAL 15950 TOTAL 15950
Answer:
Balance Sheet as at 31st March 2020
Liabilities Amount Assets Amount
Capital 60000 Fixed Assets:
Add: Net Profit 14000 Machinery 27000
74000
Less: Drawings 2700 71300 Investments: Nil

Current Liabilities: Current Assets:

Bills Payable 2800 Cash at Bank 4500
Sundry Creditors 1400 Sundry Debtors 21600
Closing Stock 22400
TOTAL 75500 TOTAL 75500
 INCOME STATEMENT
The Income Statement is one of a company’s core financial statements
that shows their profit and loss over a period of time. The profit or
loss is determined by taking all revenues and subtracting all expenses
from both operating and non-operating activities.

An income statement is one of the three important financial

statements used for reporting a company's financial performance over
a specific accounting period, with the other two key statements being
the balance sheet and the statement of cash flows.

Income Statement is also known as the profit and loss statement or

the statement of revenue and expense.
 INCOME STATEMENT
KEY POINTS:
 An income statement is one of the three (along with balance sheet
and statement of cash flows) major financial statements that reports
a company's financial performance over a specific accounting
period.
 Net Income = (Total Revenue + Gains) – (Total Expenses + Losses)
 Total revenue is the sum of both operating and non-operating
revenues while total expenses include those incurred by primary
and secondary activities.
 Revenues are not receipts. Revenue is earned and reported on the
income statement. Receipts (cash received or paid out) are not.
 An income statement provides valuable insights into a company’s
operations, the efficiency of its management, under-performing
sectors and its performance relative to industry peers.
 Form of Balance Sheet
Name of the Company
(as on………. In (Rs.)
Particulars Note Current Year Previous Year

I. Equity and Liabilities

(1) Shareholders Fund
(a) Share Capital
(b) Reserves and Surplus
(c) Money Received Against Share Warrants
(2) Share Application Money Pending Allotment
(3) Non Current Liabilities
(a) Long-term Borrowings
(b) Deferred Tax Liabilities (net)
(c) Other Long-term Liabilities
(d) Long term Provision
(4) Current Liabilities
(a) Short term Borrowings
(b) Trade Payable
(c) Other Current Liabilities
(d) Short term Provision
Total
II. Assets:
(1) Non-Current Assets
(a) Fixed Assets
(i) Tangible Assets
(ii) Intangible assets
(iii) Capital Work in Progress
(iv) Intangible Assets Development
(b) Non Current Investment
(c) Deferred Tax Assets (Net)
(d) Long term Loans and Advances
(e) Other Non-Current Assets
(2) Current Assets
(a) Current Investment
(b) Inventories
(c) Trade Receivables
(d) Cash and Cash Equivalents
(e) Short term Loans and Advances
(f) Other Current Assets
Total
 Form of Statement of Company profit and Loss
Name of the Company
(Profit and Loss Statement for the year ended………. In (Rs.)
Particulars Note Current Year Previous Year
I Revenue from Operations
II Other Income
III Total Revenue (I + II)
IV Expenses:
Cost of Materials Consumed
Purchases of Stock-in-Trade
Change in inventories of Finished Goods, WIP and Stock in Trade
Employee Benefit Expenses
Finance Costs
Depreciation and Amortization Expenses
Other Expenses
V Profit before Exceptional and Extra-ordinary items and tax (III – IV)
VI Exceptional Items
VII Profit Before Extra-ordinary items and Tax (V - IV)
VIII Extra-ordinary Items
IX Profit before Tax (VII – VIII)
X Tax Expenses:
(1) Current Tax
(2) Deferred Tax
XI Profit/Loss for the period from Continuing Operation (IX – X)
XII Profit/Loss from Discontinuing Operations
XIII Tax Expenses for Discontinuing Operations
XIV Profit/Loss from Discontinuing Operations after tax (XII – XIII)
XV Profit/Loss for the period (XI + XIV)
 Techniques of Financial Analysis

(1)Comparative Financial Statements

(2)Common Size Financial Statements
(3)Trend Analysis
(4)Financial Ratios
(5)Funds Flow Statement
(6)Cash Flow Statement
(7)Break Even Analysis
 Comparative Financial Statements
The comparative financial statements are statements of the financial
position at different periods; of time. These statements also help in
determining the profitability of the business by comparing financial data
from two or more accounting periods. Any statement prepared in a
comparative form will be covered in comparative statements.
From practical point of view, generally, two financial statements (balance
sheet and income statement) are prepared in comparative form for
financial analysis purposes. Not only the comparison of the figures of two
periods but also be relationship between balance sheet and income
statement enables an in depth study of financial position and operative
results.

The comparative statement may show:

(i) Absolute figures (rupee amounts).
(ii) Changes in absolute figures i.e., increase or decrease in absolute figures.
(iii) Absolute data in terms of percentages.
(iv) Increase or decrease in terms of percentages.
 Comparative Balance Sheet
Steps To Prepare a Comparative Balance Sheet:

Step 1
Firstly, specify absolute figures of assets and liabilities relating to the current and
previous accounting periods for analysis in Column I and Column II of the
comparative balance sheet.

Step 2
Find out the absolute change (increase or decrease) in the items mentioned in the
balance sheet in Column III of the comparative balance sheet.
Absolute Change = Current Year figure – Previous Year Figure

Step 3
Finally, calculate the percentage change in the assets and liabilities by assuming
previous year as the base year. It is mentioned in Column V of the comparative
balance sheet.
Percentage Change = Absolute Increase or Decrease x 100
.

Absolute Figure of the Previous Year’s

 Namira Ltd.
Comparative Balance Sheet
(as on 31st March 2020 In (Rs.)

Particulars Note 2019-20 2018-19 Absolute Percentage

Change (Inc/dec)
(Inc/Dec)
A B C = A –B D= C/B X 100

I. Equity and Liabilities

(1)Shareholders Fund
(a) Share Capital 50000 50000 - -
(b)Reserves and Surplus 41000 20000 21000 105.0
(2) Non Current Liabilities
(a) Long-term Borrowings 10000 12000 (2000) (16.7)
(3) Current Liabilities 10000 8000 2000 +25.0
Total 111000 90000 + 21000 23.33
II. Assets:
(1)Non-Current Assets
(a)Fixed Assets 78000 60000 18000 30.0
(2) Current Assets
(a) Inventories 18000 22500 (4500) (20.0)
(b)Other Current Assets 15000 7500 7500 100 .0
Total 111000 90000 + 21000 23.33
 Comparative Income Statement
Steps To Prepare a Comparative Income Statement:

Step 1
Firstly, specify absolute figures such as cost of goods sold, net sales, selling
expenses, office expenses, etc. relating to the current and previous accounting
periods for analysis in Column I and Column II of the comparative Income
Statement.

Step 2
Find out the absolute change (increase or decrease) in the items mentioned in the
Income Statement in Column III of the comparative Income Statement.
Absolute Change = Current Year figure – Previous Year Figure

Step 3
Finally, calculate the percentage change in the Income Statement items by assuming
previous year as the base year. It is mentioned in Column V of the comparative
balance sheet.
Percentage Change = Absolute Increase or Decrease x 100
.

Absolute Figure of the Previous Year’s

Example:

From the following profit and loss account of Priyanshu Ltd., for the
year ending 31-3-2019 and 31-3-2020. You are required to prepare a
comparative profit and Loss Account and interpret the results:
Particulars 31-3-2019 31-3-2020
Net Revenue from Operation 240000 300000
Cost of Revenue from Operation 150000 187500
Manufacturing Overheads 9000 12000
Administrative Overheads 33000 45000
Selling and Distribution Expenses 27000 21000
Non Operation Income 1500 1500
Non Operating Expenses 3000 1500
 Priyanshu Ltd.
Comparative Profit and Loss Account
For the year ending 31-3-2020
Particulars Note For the For the Absolute Percentage
year ending year ending Change (Inc/dec)
2018-19 2019-20 (Inc/Dec)
A B C=B–A D= C / A X 100

I. Revenue from Operation 240000 300000 60000 25.00

II. Other Income (Non-OP) 1500 1500 - -
III. TOTAL REVENUE 241500 301500 60000 24.84
IV. Expenses:
Cost of Revenue from Operation 150000 187500 37500 25.00
Manufacturing OH 9000 12000 3000 33.33
Administrative OH 33000 45000 12000 36.36
Selling and Distribution OH 27000 21000 (6000) (22.22)
Other Expenses (Non-operating) 3000 1500 (1500) (50.00)
TOTAL EXPENSES 222000 267000 45000 20.27
V. Net Profit (III – IV) 19500 34500 15000 76.92
Example:

The income statement of Megha Ltd. are given for the year ending
31st December 2018 and 2019. Rearrange the figures in a
comparative form and study the profitability of the concern:
Particulars 2018 2019
Net Sales 350000 450000

Expenses:
Salaries 35000 36000
Audit Fees 40000 45000
Interest on Bank Loans 12500 15000

Income Tax 35000 40000

 Megha Ltd.
Comparative Profit and Loss Account
For the year ending 31-3-2019
Particulars Note For the year For the year Absolute Percentage
ending 2018 ending 2019 Change (Inc/dec)
(Inc/Dec)
A B C=B–A D= C / A X 100

I. Revenue from Operation 350000 450000 100000 28.57

II. Other Income (Non-OP) - - - -
III. TOTAL REVENUE 350000 450000 100000 28.57
IV. Expenses:
Salaries 35000 36000 1000 2.86
Audit Fees 40000 45000 5000 12.50
Interest on bank Loan 12500 15000 2500 20.00
TOTAL EXPENSES 87500 96000 8500 9.771
V. Net Profit before Tax (III – IV) 262500 354000 91500 34.85
Vi. Income Tax 35000 40000 5000 14.29
VII. Net Profit after Tax (V-VI) 227500 314000 86500 38.02
Interpretation:
1. The increase in profit after tax is sufficient to cover the total expenses. There is an increase of Rs. 86500 i.e., 38.02%.
2. There has been an increase in net sales of 100000 i.e., 28.57%.
3. The Salary is increased by 1000 i.e., 2.86%.
4. In is concluded from the above analysis that there is sufficient progress in the performance of the company and the
overall profitability of the company is good.
 Common Size Financial Statements
Common size analysis (vertical analysis) is a technique to analyze and
interpret the financial statements. This technique helps in assessing
the financial statements by considering each line item as a percentage
of the base amount for that period.

In case of the income statement:

Net Sales is taken as the base and each line item in the income
statement is expressed a percentage of total sales.
In case of balance sheet:
The amount of total assets is taken as the base and each item in the
balance sheet is appropriated as a percentage of total assets.
 Common Size Balance Sheet
Steps to Prepare Common Size Balance Sheet:

Step 1
Firstly, specify absolute figures of assets and liabilities relating to the
current and previous accounting periods for analysis in Column I and
Column II of the comparative balance sheet.

Step 2
Each item on the asset side is taken as the percentage of total assets.
Similarly, each item on the liability side is taken as a percentage of total
liabilities by using following formula:
Percentage Change = Individual Assets or Individual Liabilities x 100
Total of Balance Sheet

Note: Specify the percentages as calculated above in Column III and IV year
wise of the Common Size Balance Sheet.
 Namira Ltd.
Common Size Balance Sheet
(as on 31st March 2020 In (Rs.)

Particulars Note 2019-20 2018-19 % of B/S % of B/S

Total Total
(2019-20) (2018-19)
I. Equity and Liabilities
(1)Shareholders Fund
(a) Share Capital 50000 50000 45.00 55.55
(b)Reserves and Surplus 41000 20000 37.00 22.22
(2) Non Current Liabilities
(a) Long-term Borrowings 10000 12000 9.00 13.33
(3) Current Liabilities 10000 8000 9.00 8.88
Total 111000 90000 100 100
II. Assets:
(1)Non-Current Assets
(a)Fixed Assets 78000 60000 70.27 30.0
(2) Current Assets
(a) Inventories 18000 22500 16.21 (20.0)
(b)Other Current Assets 15000 7500 13.50 100 .0
Total 111000 90000 + 21000 23.33
 Common Size Income Statement
Steps to Prepare Common Size Income Statement:

Step 1
Firstly, specify absolute figures such as cost of goods sold, net sales,
selling expenses, office expenses, etc. relating to the current and
previous accounting periods for analysis in Column I and Column II
of the comparative Income Statement.

Step 2
Each item of the income statement is taken as the percentage of total sales
by using following formula:
Percentage Change = Individual item of Income Statement x 100
Net Sales

Note: Specify the percentages as calculated above in Column III and IV year
wise of the Common Size Balance Sheet.
 Ravi Limited
Common Size Income Statement
For the year ending 31-3-2020
Particulars Note Rs. (In lakhs) Percentage
I. Revenue from Operation (Net Sales) 1600 100.00
II. Other Income (Non-OP) 40 2.50
III. TOTAL REVENUE 1640 102.50
IV. Expenses:
Cost of Operating Revenue 1000 62.50
Other Expenses (Non-operating) 40 2.50
Interest 200 12.50
TOTAL EXPENSES 1240 77.50
V. Net Profit before tax(III – IV) 400 25.00
Less: Provision for Tax 200 12.50
VI. Net Profit after tax 200 12.50
Less: Dividends 140 8.75
60 3.75
Add: Capital Profit 20 1.25
Increase in Retained Earnings 80 5.00
 RATIO ANALYSIS
With the help and study of some key financial ratios, we can look at the
financial health of a organization. Ratio analysis can also be used as a
diagnostic tool to find the sources of financial trouble at a company.

In a normal words, ratio is a numerical relationship between two

things or items. A ratio shows the relative sizes of two or more values.

“Ratios are simply a means of highlighting in arithmetical terms the

relationship between figures drawn from financial statements.”
- Pearson and Charles
“Ratio analysis is used to describe significant relationship which exists
between figures shown on a balance sheet, in a profit and loss account
in a budgetary control system or in any other part of the accounting
organizations.”
- J. Batty
 Ratios can be shown in different ways:

RATIOS

SIMPLE RATIO AS PERCENTAGE

(using the ":" to AS A (as a percentage, after
separate example MULTIPLICATION dividing one value by
values) the total)

Example:
Current Assets (CA) : 400000 Rs.
Current Liabilities (CL) : 200000 Rs.
Now we can express the relation between CA and CL as follows:
As a simple Ratio =2:1
As a multiplication system = CA is double from the CL or CL is Half of the CA
As a percentage = CA is 200% of CL or CL is 50% of CA
 Classification of Ratios

Profit and Loss

Balance Sheet Ratio Combined Ratio
Account Ratio

Relation between two Relation between two

Relation between two
items or group of items one appearing
items or group of
items appearing in in the Balance Sheet
items appearing in
the Profit and Loss and the other in the
the balance Sheet
A/c Profit and Loss A/C
(Current Ratio)
(Gross Profit Ratio) (Earning per Share)
 Classification of Ratios

Leverage or Capital Profitability Ratios

Liquidity Ratio Activity Ratios
Structure Ratios

A. BASED ON SALES
Gross Profit
Net Profit
Inventory Turnover Operation Profit
Debt-Equity Ratio
Debtors Turnover Operating Ratio
Proprietary Ratio
Creditors Turnover
Fixed Assets Ratio
Current Ratio Assets Turnover B. BASED ON CAPITAL
Solvency Ratio EMPLOYED
Quick Ratio Fixed Assets Turnover
Capital Gearing Ratio Return on Equity
Current Assets Turnover
Debt Service Ratio
Capital Turnover Return on Total Assets
Networth Turnover Return on Capital
Employed

C. BASED ON EARNINGS
ON SHARE
LIQUIDITY RATIO OR SHORT TERM SOLVENCY RATIOS:

Liquidity is the ease with which assets may be converted into cash without loss.

Liquidity Ratios:
1) Current Ratio
2) Quick or Liquid Ratio

1) Current Ratio:
Meaning: Relationship between current assets and current liabilities.
Objective: to measure the ability of the concern to meet its short term
obligations and to depict the short term financial soundness of a concern.
 Components of Current Ratios:

CURRENT LIABILITIES CURRENT ASSETS

1. Bills Payable Cash in hand
2. Creditors Cash at bank
3. Short term borrowings/Loans Stock/Inventory
4. Bank Overdraft Short term Investment or
5. Outstanding Expenses Marketable Securities
6. Tax provisions Bills Receivable
7. Un-claimed dividends Accrued Income
8. Proposed dividend Prepaid Expenses
9. Advances from customers Advance Payments
10. Deposits from dealers
11. Provision for Bad & Doubtful Debts
Current Ratio:

Current Assets .

Current Liabilities
Ideal Ratio= 2:1

Quick or Liquid Ratio:

Quick Assets (Current Assets – Inventory)
Current Liabilities
Ideal Ratio = 1:1
Example:
From the following figures,
computed the Current Ratio and
Quick Ratio:
(i) Sundry Debtors 35000
(ii) Prepaid Expenses 20000 (i) Inventories 20000
(iii) Bills Payable 15000 (ii) Accrued Income 5000
(iv) Debentures 80000 (iii) Sundry Creditors 25000
(iv) Outstanding Exp. 10000
Current Ratio: Current Assets/Current Liabilities
Current Assets: Sundry Debtors + Prepaid Expenses
+ Inventories +Accrued Income
35000 + 20000 + 20000 + 5000 = 80000
Current Liabilities: Bills payable +Sundry Creditors + O/S Exp.
15000 + 25000 + 10000 = 50000
Current Ratio: 80000 / 50000 = 1.6 : 1

Quick Ratio : (Current Assets – Inventory) / Current Liabilities

(80000 – 20000) / 50000 = 1.2 : 1
Example 2:
The current assets and current liabilities of Sagrika Ltd. as on 31st march, 2020 were
Rs. 80000 and Rs. 40000. Calculate the effect of the following transactions
individually and totally on the current ration of Sagrika Ltd.
(i) Purchase of building for Rs. 30000 to be paid in cash.
(ii) Purchase of a machinery for Rs. 10000 to be financed through a long-term bank
loan.
(iii) Payment of final dividend of Rs. 10000 and payment of dividend tax Rs. 1000.
(iv) Purchase of tradable goods for Rs. 5000 on credit.

Answer:
Current Ratio: 80000 / 40000 = 2:1
(i) When building for Rs. 30000 is purchased, current assets would decrease by
30000 because cash is the part of CA, hence new current ratio will be:
(80000 – 30000) / 40000 = 1.25 : 1

(ii) Machinery is the part of Non-current Assets and Long term bank loan is also
Non-current liabilities. So both will not affect current assets and current
liabilities hence current ration will remain the same.
Example 2:
The current assets and current liabilities of Sagrika Ltd. as on 31st march, 2020 were
Rs. 80000 and Rs. 40000. Calculate the effect of the following transactions
individually and totally on the current ration of Sagrika Ltd.
(i) Purchase of building for Rs. 30000 to be paid in cash.
(ii) Purchase of a machinery for Rs. 10000 to be financed through a long-term bank
loan.
(iii) Payment of final dividend of Rs. 10000 and payment of dividend tax Rs. 1000.
(iv) Purchase of tradable goods for Rs. 5000 on credit.

Answer:
Current Ratio: 80000 / 40000 = 2:1
(iii) Payment of final dividend of Rs. 10000 and payment of dividend tax Rs. 1000
will decrease current assets and current liabilities by Rs. 10000; hence
Current Ratio: (80000 – 11000) / (40000 – 11000) = 2.38 : 1

(iv) Purchase of tradable goods for Rs. 5000 on credit would increase both current
assets and current liabilities by Rs. 5000; hence
Current Ratio: (80000 + 5000) / (40000 + 5000) = 1.89:1
 Shefali Ltd. Balance Sheet as on 31st March 2020
Particulars Note 2019-20
I. Equity and Liabilities
(1) Shareholders Fund
(a) Share Capital 200000
(b) Reserves and Surplus 20000
(2) Non Current Liabilities
(a) 10% Debentures 80000
(3) Current Liabilities
(a) Trade Payables 50000
(b) Short term Provisions (Taxation) 10000
Total 360000
II. Assets:
(1)Non-Current Assets
(a)Fixed Assets 250000
(2) Current Assets
(a) Inventories 40000
(b) Trade Receivables 30000
(c) Cash and Cash Equivalents:
Cash 25000
Bank 10000
(d) Other Current Assets (Prepaid Expenses) 5000
Total 360000
The following figures are extracted from the Balance Sheet of Megha
Limited as at 31st March 2019 and 2020:
Items 2019 2020
Inventories 30000 40000
Debtors 10000 15000
Cash at Bank 8000 5000
Creditors 12000 25000
Bills Payable 5000 4000
Bank Overdraft 5000 10000
Provision for Taxes 2000 1000
Answer:

Current Ratio (2019): Current Assets / Current Liabilities

Current Assets: Inventories + Debtors + Cash at Bank
30000 + 10000 + 8000 = 48000
Current Liabilities: Creditors + Bills Payable + Bank Overdraft +
Provision for Taxes
12000 + 5000 + 5000 + 2000 = 24000
Current Ratio: 48000 / 24000 = 2:1
Liquid Ratio (2019): (Current Assets – Inventory)/Current Liabilities
(48000 – 30000) / 24000 = 0.75 : 1
Current Ratio (2020): Current Assets / Current Liabilities
Current Assets: Inventories + Debtors + Cash at Bank
40000 + 15000 + 5000 = 60000
Current Liabilities: Creditors + Bills Payable + Bank Overdraft +
Provision for Taxes
25000 + 4000 + 10000 + 1000 = 40000
Current Ratio: 60000 / 40000 = 1.5:1

Liquid Ratio (2019): (Current Assets – Inventory)/Current Liabilities

(60000 – 40000) / 40000 = 0.50 : 1
LEVERAGE OR CAPITAL STRUCTURE RATIO:

CAPITAL STRUCTURE

OWN BORROWED /DEBT

CAPITAL CAPITAL

Equity Share Capital

Debentures
Preference Share Capital
Long term loans
Reserve and Surplus –
Bonds
fictitious Assets
LEVERAGE OR CAPITAL STRUCTURE RATIO:

FINANCE

EQUITY SHARE CAPITAL

(Variable Cost Capital)
INVESTMENT
PREFERENCE SHARE CAPITAL
(Fixed Cost Capital)

RESERVE AND SURPLUS

FIXED ASSETS

INVESTMENT (OUTSIDE)
DEBENTURES
(Fixed Cost Capital)

LONG TERM BORROWINGS

(Fixed Cost Capital)
 LEVERAGE OR CAPITAL STRUCTURE RATIO:

Leverage or Capital Structure Ratios are calculated to judge the long term financial
position of the firm. These ratios reveal the funds provided by owners and outsiders.

Liquidity Ratios:
1) Debt-equity Ratio
2) Proprietary Ratio
3) Fixed Assets Ratio
4) Solvency Ratio

1) Debt-Equity Ratio

_____Debt______
Equity

Debt: Long term Borrowings + Short-term Borrowings

Equity: Equity Share Capital + Preference Share Capital +Reserve and Surplus
- Fictitious Assets
2) Proprietary Ratio

Proprietor’s Fund
Total Assets
Proprietors’ Fund:
Equity Share Capital + Preference Share Capital+Reserve and
Surplus - Fictitious Assets

3) Fixed Assets Ratio

Net Fixed Assets (after Depreciation)
Total Long term Funds

2) Solvency Ratio or Debt to Total Assets Ratio

Total Debts or Total Outsiders’ liabilities
Total Assets
Question: From the following statement, Calculate: (i) Current Ratio (ii) Quick Ratio (iii)
Debt-Equity Ratio (iv) Proprietary Ratio (v) Solvency Ratio and (vi) Fixed Assets Ratio.

Balance Sheet
as on 31st March 2020 In (Rs.)
Particulars Note 2019-20
I. Equity and Liabilities
(1) Shareholders Fund
(a) Share Capital 100000
(b) Reserves and Surplus 50000
(2) Non Current Liabilities
(a) Long-term Borrowings (10% Debentures) 200000
(3) Current Liabilities
(a) Creditors 30000
(b) Bills Payable 20000
Total 400000
II. Assets:
(1)Non-Current Assets
(a)Fixed Assets 270000
(2) Current Assets
(a) Inventories 80000
(b) Trade Receivables 30000
(c) Cash and Cash Equivalents 20000
Total 400000
ANSWER:
1. Current Ratio:Current Assets / Current Liabilities
130000 / 50000 = 2.6 : 1
Current Assets: Cash + Trade Receivables + Inventories
20000 + 30000 + 80000 = 130000
Current Liabilities: Creditors + Bills Payable
30000 + 20000 = 50000

2. Quick Ratio: Quick Assets / Current Liabilities

130000-80000 / 50000 = 1 : 1

3. Debt-Equity Ratio: Total Outsiders’ Liabilities / Shareholders’ Funds

250000 / 150000 = 1.67 : 1
Outsiders’ Liabilities: 10% Debentures + Creditors + B/P
200000 + 30000 + 20000 = 250000
Shareholders’ Funds: Share Capital + Reserves and Surplus
100000 + 50000 = 150000

4. Proprietary Ratio: Proprietary Fund / Total Assets

150000 / 400000 = 0.375 : 1

5. Solvency Ratio: Total Outsiders’ Liabilities / Total Assets

250000 / 400000 = 0.625 : 1
ANSWER:
1. Current Ratio:Current Assets / Current Liabilities
130000 / 50000 = 2.6 : 1
Current Assets: Cash + Trade Receivables + Inventories
20000 + 30000 + 80000 = 130000
Current Liabilities: Creditors + Bills Payable
30000 + 20000 = 50000

2. Quick Ratio: Quick Assets / Current Liabilities

130000-80000 / 50000 = 1 : 1

3. Debt-Equity Ratio: Total Outsiders’ Liabilities / Shareholders’ Funds

250000 / 150000 = 1.67 : 1
Outsiders’ Liabilities: 10% Debentures + Creditors + B/P
200000 + 30000 + 20000 = 2500000
Shareholders’ Funds: Share Capital + Reserves and Surplus
100000 + 50000 = 150000

4. Proprietary Ratio: Proprietary Fund / Total Assets

150000 / 400000 = 0.375 : 1

5. Solvency Ratio: Total Outsiders’ Liabilities / Total Assets

250000 / 400000 = 0.625 : 1
ACTIVITY OR EFFICIENCY RATIO:

Activity ratios are computed to evaluate the efficiency with which the firm manages
and utilises its assets. These ratios are also called turnover ratios because they
indicate the rapidity with which assets are being converted or turned over into sales.

Activity or Efficiency Ratios:

1) Inventory Ratio
2) Debtors Ratio
3) Creditors Ratio

1) Inventory Ratio
_____Cost of Revenue from Operation______
Average Stock

Cost of Revenue from Operation: Opening Stock + Purchases + Direct Expenses

–Closing Stock
Average Stock: (Opening Stock + Closing stock) / 2
ACTIVITY OR EFFICIENCY RATIO:

Calculate the Stock Turnover Ratio from the information given below:
Opening Stock 20000 Revenue from Operation (Sales) 75000
Purchase 40000 Closing Stock 15000
Carriage Inward 5000

Solution:
STR : _____Cost of Revenue from Operation______
Average Stock

STR : 50000 / 17500 = 2.86 Times

Cost of Revenue from Operation: Opening Stock + Purchase + Carriage Inward –

Closing Stock
20000 + 40000 + 5000 – 15000 = 50000 Rs.

Average Stock : (Opening Stock + Closing Stock) / 2

: (20000 + 15000) / 2
: 17500 Rs.
ACTIVITY OR EFFICIENCY RATIO:

Calculate the Stock Turnover Ratio from the information given below:
Opening Stock 20000 Revenue from Operation (Sales) 400000
Closing Stock 30000 Gross Profit 30% of Sales

Solution:
STR : _____Cost of Revenue from Operation______
Average Stock

STR : 50000 / 17500 = 2.86 Times

Cost of Revenue from Operation:Sales – Gross Profit

400000 – (30% of 400000) = 280000

Average Stock : (Opening Stock + Closing Stock) / 2

: (20000 + 30000) / 2
: 25000 Rs.
2) Debtors Ratio
_____Net Credit Revenue from Operation______
Average Receivables

Net Credit Revenue from Operation: Gross Credit Revenue from Operation –
Revenue from Operation Return (Sales Return)

Average Receivables: (Opening Debtors and B/R) + (Closing Debtors and B/R)
2

Average Collection Period:

__ Average Receivables___x 365__

Net Credit Revenue from Operation
2) Creditors Ratio
_____Net Credit Purchase______
Average Payables

Average Payables: (Opening Creditors and B/P) + (Closing Creditors and B/P)
2

Average Payment Period:

__ Average Payables___x 365__

Net Credit Purchase
 PROFITABILITY RATIOS :

(A) Profitability Ratios Based on Sales:

1) Gross Profit Ratio
2) Net Profit Ratio
3) Operation Ratio

(B) Profitability Ratios Based on Capital Employed

1) Return on Capital Employed or Return on Investment

(C) Profitability Ratios Based on Earning on Shares

1) Earning Per Share (EPS)
2) Price Earning Ratio (P/E Ratio)
3) Dividend Pay Out Ratio
4) Dividend Yield Ratio
 PROFITABILITY RATIOS :

(A) Profitability Ratios Based on Sales:

1) Gross Profit Ratio
__ __Gross Profit_ __ X 100
Net Revenue from Operation
Gross Profit: Net Revenue from Operation – Cost of Revenue from Operation

2) Operating Profit Ratio

__ Operating Net Profit before Interest and Tax_ __

X 100
Net Revenue from Operation
OR
__ Operating Net Profit after Interest and Tax_ __
X 100
Net Revenue from Operation

Operating Profit: Net Profit + Non-operating Expenses – Non Operating Incomes

 PROFITABILITY RATIOS :

(A) Profitability Ratios Based on Sales:

3) Net Profit Ratio

__ Net Profit after Interest and Tax_ __ X 100

Net Revenue from Operation
 PROFITABILITY RATIOS :

(A) Profitability Ratios Based on Capital Employed:

1) Return on Capital Employed or Return on Investment

__ Net Profit before Interest and Tax_ __

Capital Employed or Investment

Capital Employed or Investment:

Equity Share Capital + Preference Share Capital + Undistributed Profit + Reserves
and Surplus + Fixed Liabilities – Fictitious Assets
Or
Fixed Assets + Current Assets – Current Liabilities.
 PROFITABILITY RATIOS :

(A) Profitability Ratios Based on Earning on Shares:

1) Earning per Share (EPS)

Net Profit after Tax and Preference Dividend __
No. of Equity Shares

2) Price-Earning Ratio (P/E Ratio)

Market Price Per Equity Share (MPS) __
Earning per Share (EPS)

3) Dividend Pay-out Ratio

Dividend Per Share (DPS) __ X 100
Earning per Share (EPS)

4) Dividend Yield Ratio

Dividend Per Share (DPS)
X 100
Market Price Per Equity Share (MPS)
Question:
Calculate the earnings per share, Price Earning Ratio, Dividend pay out ratio and
Dividend Yield Ratio from the following data:
Net profit before tax Rs.2,00,000, Taxation at 50% of net profit, 10% Preference
share capital (Rs.10 each) Rs.2,00,000, Equity share capital (Rs.10 share)
Rs.1,00,000, Proposed Equity Dividend 20000 and Market Price Per Share is 160.
1) Earning per Share (EPS)
Net Profit after Tax and Preference Dividend __
No. of Equity Shares
Net Profit after Tax and Preference Dividend:
Net Profit before Tax – Tax – Preference Dividend
200000 – 100000 (50% of Net Profit) – 20000 = 80000
Earning Per Share: 80000 / 10000 = 8 Rs.

2) Price-Earning Ratio (P/E Ratio)

Market Price Per Equity Share (MPS) __
Earning per Share (EPS)

or 160 / 8 = 20:1
3) Dividend Pay-out Ratio
Dividend Per Share (DPS) __ X 100
Earning per Share (EPS)

Dividend Per Share: Equity Dividend / No of Equity Shares

20000 / 10000 = 2 Rs.
Dividend Pay Out Ratio: 2 / 8 x 100 = 25%

4) Dividend Yield Ratio

Dividend Per Share (DPS)
Market Price Per Equity Share (MPS)

2 / 160 x 100 = 1.25 %

 CASH FLOW STATEMENT
A Cash flow statement shows inflow and outflow of cash and cash
equivalents from various activities of a company during a specific
period. The primary objective of cash flow statement is to provide
useful information about cash flows (inflows and outflows) of an
enterprise during a particular period under various heads, i.e., operating
activities, investing activities and financing activities. This information
is useful in providing users of financial statements with a basis to
assess the ability of the enterprise to generate cash and cash
equivalents and the needs of the enterprise to utilise those cash flows.

Cash flow statement is a statement setting out the flow of cash under
different heads of sources and their utilizations to determine the
requirements of cash during the given period and to prepare for its
adequate provision.
-Institute of Cost Accountants of India
Cash and Cash Equivalents
As stated earlier, cash flow statement shows inflows and outflows of
cash and cash equivalents from various activities of an enterprise
during a particular period.
As per AS-3,
‘Cash’ comprises cash in hand and demand deposits with banks.
‘Cash equivalents’ means short-term highly liquid investments that
are readily convertible into known amounts of cash and which are
subject to an insignificant risk of changes in value.
(Note: An investment normally qualifies as cash equivalents only when it has
a short maturity, of say, three months or less from the date of acquisition.
Investments in shares are excluded from cash equivalents unless they are in
substantial cash equivalents. For example, preference shares of a company
acquired shortly before their specific redemption date, provided there is only
insignificant risk of failure of the company to repay the amount at maturity.
Similarly, short-term marketable securities which can be readily converted
into cash are treated as cash equivalents and is liquidable immediately
without considerable change in value.)
Cash Flows:
‘Cash Flows’ implies movement of cash in and out due to
some non-cash items. Receipt of cash from a non-cash item
is termed as cash inflow while cash payment in respect of
such items as cash outflow. For example, purchase of
machinery by paying cash is cash outflow while sale
proceeds received from sale of machinery is cash inflow.
Other examples of cash flows include collection of cash from
trade receivables, payment to trade payables, payment to
employees, receipt of dividend, interest payments, etc. Cash
management includes the investment of excess cash in cash
equivalents. Hence, purchase of marketable securities or
short-term investment which constitutes cash equivalents is
not considered while preparing cash flow statement.
Classification of Activities for the Preparation of
Cash Flow Statement
1. Cash Flows From Operating Activities:
Cash flows from operating activities are primarily derived from the main activities of the
enterprise. They generally result from the transactions and other events that enter into the
determination of net profit or loss. Examples of cash flows from operating activities are:

Cash Inflows from operating activities:

cash receipts from sale of goods and the rendering of services.
cash receipts from royalties, fees, commissions and other revenues.

Cash Outflows from operating activities:

Cash payments to suppliers for goods and services.
Cash payments to and on behalf of the employees.
Cash payments to an insurance enterprise for premiums and claims, annuities, and other
policy benefits.
Cash payments of income taxes unless they can be specifically identified with financing and
investing activities.

The net position is shown in case of operating cash flows. An enterprise may hold securities and
loans for dealing or for trading purposes. In either case they represent Inventory specifically
held for resale. Therefore, cash flows arising from the purchase and sale of dealing or trading
securities are classified as operating activities. Similarly, cash advances and loans made by
financial enterprises are usually classified as operating activities since they relate to main
activity of that enterprise.
2. Cash from Investing Activities:
As per AS-3, investing activities are the acquisition and disposal of long-term
assets and other investments not included in cash equivalents. Examples of
cash flows arising from investing activities are:
Cash Outflows from investing activities
Cash payments to acquire fixed assets including intangibles and capitalised
research and development.
Cash payments to acquire shares, warrants or debt instruments of other
enterprises other than the instruments those held for trading purposes.
Cash advances and loans made to third party (other than advances and loans
made by a financial enterprise wherein it is operating activities).
Cash Inflows from Investing Activities
Cash receipt from disposal of fixed assets including intangibles.
Cash receipt from the repayment of advances or loans made to third parties
(except in case of financial enterprise).
Cash receipt from disposal of shares, warrants or debt instruments of other
enterprises except those held for trading purposes.
Interest received in cash from loans and advances.
Dividend received from investments in other enterprises.
3. Cash from Financing Activities:
Financing activities relate to long-term funds or capital of an enterprise.
Examples of financing activities are:

Cash Inflows from financing activities

Cash proceeds from issuing shares (equity or/and preference).
Cash proceeds from issuing debentures, loans.
Increase in Bank Overdraft and Cash Credit.

Cash Outflows from financing activities

Redemption of Preference Shares.
Cash repayments of amounts borrowed.
Interest paid on debentures and long-term loans and advances.
Dividends paid on equity and preference capital.
Decrease in Bank Overdraft and Cash Credit.
 Cash Flow Statement
for the year ended 31st March…..
Particulars Rs. Rs.
(A) Cash Flow from Operating Activities:
Net Profit before Tax xxx
Add: Non Cash and Non Operating Expenses:
Depreciation xxx
Loss on Sale of Fixed Assets or Investment xxx
Goodwill, Patent, Trade mark written off xxx
Preliminary Expenses written off xxx
Interest paid (Included in Statement of P & L) xxx
Premium on Redemption of Shares/Debentures xxx
Less: Non Cash and Non Operating Incomes:
Profit on Sale of Fixed Assets/Investments xxx
Transfer from Reserves xxx
Dividend received (Included in Statement of P & L) xxx
Interest received (Included in Statement of P & L) xxx

Operating Profit before Working Capital Changes xxx

Add: Decrease in Current Assets xxx
Less: Increase in Current Assets xxx
Add: Increase in Current Liabilities xxx
Less: Decrease in Current Liabilities xxx
Cash generated from operations xxx
Less: Income Tax Paid P.T.O.
xxx
Net Cash Flow from Operating Activities (A) xxx
 Cash Flow Statement
for the year ended 31st March…..

Particulars Rs. Rs.

(B) Cash Flow from Investing Activities:
Sale of Fixed Assets xxx
Purchase of Fixed Assets (xxx)
Sale of Long-term Investments xxx
Purchase of Long-term Investment (xxx)
Dividend received xxx
Interest received xxx
Net Cash Flow from Investing Activities (B) xxx

(C) Cash Flow from Financing Activities: xxx

Issue of Share Capital and Debentures xxx
Increase in Security Premium Xxx
Increase in Loan (Short term + Long term) (xxx)
Re-payment of Loan (xxx)
Redemption of Preference Share Capital and Debentures (xxx)
Buy back of equity share capital (xxx)
Dividend Paid (xxx)
Interest paid (xxx)
Net Cash Flow from Financing Activities (C) xxx

Net Increase/Decrease in Cash and Cash Equivalents xxx

Add: Opening Cash and Cash Equivalents xxx
Closing Cash and Cash Equivalents xxx
 Capital Budgeting:
Capital budgeting is mainly a decision-making process for investment in
assets that have long-term implication, affect the future growth and
profitability of the firm, and basic composition and assets-mix of the firm.
The term, ‘capital budgeting’ refers to the allocation of investible funds to
different long term assets. Capital budgeting decision denotes a decision
situation where lump sum funds are invested in initial stages of projects. In
other words, the system of capital budgeting is employed to evaluate
expenditure decisions which involve current outlays but are likely to produce
benefits over a period of time longer than one year. Capital budgeting,
therefore, includes addition, disposition, modification and replacement of
fixed assets.

“Capital budgeting involves the planning of expenditures for assets, the

returns from which will be realised in future time period.”
- Milton H. Spencer
 Capital Budgeting
Methods/Techniques

Traditional Discounted Cash

Methods: Flows or Time:
1. Payback Period 1. Net Present Value
2. Accounting Rate of 2. Internal Rate of
Return Return
(A)Traditional Methods
(1) Payback Period Method:
The payback period is known as the number of years required for the
proposal’s cumulative cash inflows to be equal to its cash outflow. In other
words, the payback period refers to the length of time required to recover the
initial cost of the project.
Computation of Payback Period:
(i) When annual cash inflows are equal:
P = I/C
Where, P = Payback period
I = Initial investment or cash outflow
C = Cash Inflow or Net profit after taxes but before depreciation.

Example: If a company by investing Rs. 800000 gets net annual income of Rs.
200000 before depreciation but after taxes continuously for 10 years, compute the
payback period.
Solution: P = I/C
P = 800000 / 200000 = 4 years.
Example:
Mohan Ltd wants to buy a new machine on the condition that its costs can be recovered in five
years by the savings therefrom. You are given the following information:
Cost of the machine Rs. 600000; Annual sales revenue generated by the new machine Rs.
800000; Variable Cost 60% of sales; Annual fixed cost other than depreciation Rs. 40000; Life
of the machine is 8 years; Taxation to be charged @ 50% of profits. Advise the management
whether the machine should be acquired or not.
Solution: Profitability Statement
Particulars Rs. Rs.
Sales Revenue 800000
Less: Variable Cost (60% of sales) 480000
Fixed Cost 40000 520000
Profit before Tax and Depreciation 280000
Less: Depreciation (600000 / 8) 75000
Profit before Tax 205000
Less: Income Tax (@ 50%) 102500
Profit after Tax 102500
Add: Depreciation 75000
Net Cash Inflow 177500

Payback Period = I / C
600000 / 177500 = 3.38 years.
(ii) When annual cash inflows are unequal:
Example: XYZ Ltd. Evaluates an investment proposal which costs Rs. 40000 and
yields (CFAT) cash flow after tax of Rs. 8000, 12000, 15000, 20000, 21000 and 24000
in the years 1 to 6 respectively.

Solution:
Year Annual CFAT Cumulative CFAT
1 8000 8000
2 12000 20000
3 15000 35000
4 20000 55000
5 21000 76000
6 24000 100000

Payback period of investment proposal:

3 + [(40000-35000) / 20000 x 12]
Payback period = 3.3 years.
(ii) When annual cash inflows are unequal:
Example: XYZ Ltd. Evaluates an investment proposal which costs Rs. 50000 and
yields (CFAT) cash flow after tax of Rs. 5000, 10000, 15000, 25000, 21000 and 24000
in the years 1 to 6 respectively.

Solution:
Year Annual CFAT Cumulative CFAT
1 5000 5000
2 10000 15000
3 15000 30000
4 25000 55000
5 21000 76000
6 24000 100000

Payback period of investment proposal:

3 + [(50000-30000) / 25000 x 12]
Payback period = 3.10 years.
(2) Post pay-back period profitability:
(Total Cash Inflow in Life + Scrap Value) – Initial Investment

Example: Ravi Ltd. Is considering the purchase of a machine. Two machines A and B are
available at the cost of Rs 60000 each. Scrap value of both the machines are 12000 and 15000
respectively. Earnings after taxes but before depreciation are expected as follows:
Year Cash Inflow of machine A Cash Inflow of machine B
1 25000 10000
2 20000 15000
3 15000 25000
4 10000 20000
5 10000 20000
Evaluate the two alternatives by using: (i) Pay-back Period Method; and (ii) Post pay-back
period profitability Method.
Solution (i):
Payback period of machine A: 25000+20000+15000 = 3 years.
Payback period of machine B: 10000+15000+25000 (3 years.) + [10000/20000 x 12] = 3.6 Years.

Solution (ii):
Post payback period profitability of machine A: (80000 + 12000) – 60000 = 32000
Post payback period profitability of machine B: (90000 + 15000) – 60000 = 45000
(2) Accounting Rate of Return on Average Investment (ARR):
ARR = Average Annual Income after Tax & Depreciation X 100
Average Investment
Here
Average Investment = Initial Investment + Scrap Value
2
Example:
ABC Ltd. Is contemplating an investment of Rs. 100000 in a new plant, which
will provide a salvage value of Rs. 8000 at the end of its economic life of 5
years. The profits after depreciating and tax for 5 years are estimated as 5000,
7500, 12500, 13000 and 8000 respectively. Calculate ARR.
Solution:
ARR = Average Annual Income after Tax & Depreciation X 100
Average Investment
= 9200 / 54000 x 100 =17.04%
Average Annual Profits: (5000+7500+12500+13000+8000) / 5 = 9200
Average Investment: (100000 + 8000) / 2 = 54000
Example:
Calculate the average rate of return for Project X and Y from the following:
Project X Project Y
Investment 40000 60000
Expected Life 4 years 5 years
Salvage Value 4000 8000
Projected net Income after tax and depreciation:
Years 1 2 3 4 5
Project X 4000 3000 3000 2000 -
Project Y 6000 6000 4000 2000 2000
If the required rate of return is 12% which project should be selected?
Solution:
ARR = Average Annual Income after Tax & Depreciation
X 100
Average Investment
Project X:
Average Annual Profits: (4000+3000+3000+2000) / 4 = 3000
Average Investment: (40000 + 4000) / 2 = 22000
ARR = 3000 / 22000 x 100 = 13.64% (Project X should be selected)
Project Y:
Average Annual Profits: (6000+6000+4000+2000+2000) / 5 = 4000
Average Investment: (60000 + 8000) / 2 = 34000
ARR = 4000 / 34000 x 100 = 11.76%
Example:
A Project costs Rs 25000 and has a scrap value of Rs 5000 after 5 years. The net profit before
depreciation and taxes for the five years period are expected to be 5000, 6000, 7000, 8000 and
10000. You are required to calculate the average rate of return assuming 30% rate of tax and
depreciation on straight line method.
Solution:
ARR = Average Annual Income after Tax & Depreciation X 100
Average Investment
Years 1 2 3 4 5
Profit before Depreciation and tax 5000 6000 7000 8000 10000
Less: Depreciation 4000 4000 4000 4000 4000
Profit before tax 1000 2000 3000 4000 6000
Less: Income Tax @ 30% 300 600 900 1200 1800
Profit after Depreciation and tax 700 1400 2100 2800 4200
Add: Depreciation 4000 4000 4000 4000 4000
Profit after tax 25000
Depreciation: – 5000
& before Depreciation
/ 5 = 4000 Rs. 4700 5400 6100 6800 8200
Average Annual Profits: (700+1400+2100+2800+4200) / 5 = 2240
Average Investment: (25000 + 5000) / 2 = 15000
ARR = 2240 / 15000 x 100 = 14.93%

Pay-back Period: (4700+5400+6100+6800) [4 Years + (2000 / 8200) x 12] = 4.3 Years

(B) Discounted Cash Flows or Time:
1. Net Present Value (NPV) Method
NPV = Present value of cash inflows – Present value of Cash
outflow or Initial Investment
PV = C1 _
(1 + r)n
Here: C1 = Cash Flow
r = rate of return
n = number of periods

Example:
A project involves a net cash inflow of Rs. 3 lacs a year for three years and the cost of capital is 8%. Find
the present value of cash inflows.

Solution:
PV = C1 + C2 + C3 _
(1 + r) (1 + r)2 (1 + r)3

PV = 300000 + 300000 + 300000 _

(1 + .08)1 (1 + .08)2 (1 + .08)3

= 277800 + 257100 + 238200 = 773100.

Example: From the following information, calculate the net present value of the two projects and
suggest which of the two projects should be accepted assuming a discount rate of 10%.
Project A Project B
Initial Investment 30000 40000
Estimated Life 5 Years 5 Years
Scrap Value 2000 3000
The profits before Depreciation and after tax (Cash Flow) are as follows:

Years 1 2 3 4 5
Project A 7000 12000 12000 5000 4000
Project B 22000 12000 7000 5000 4000

Year Cash Inflow Cash Inflow P.V. Factor at Present Value Present Value
of Project A of Project B 10% of Project A of Project B
1 7000 22000 0.909 6363 19998
2 12000 12000 0.826 9912 9912
3 12000 7000 0.751 9012 5257
4 5000 5000 0.683 3415 3415
5 4000 4000 0.621 2484 2484
(Scrap) 2000 3000 0.621 1242 1863
TOTAL PRESENT VALUE 32428 42929
Net Present Value: Present Value of Cash Inflow – Initial Investment
Project A: 32428 – 30000 = 2428
Project B: 42929 – 40000 = 2929
Decision: Project B will be chosen because its NPV is greater.
Example:
No project is acceptable unless yield is 10%. Cash inflows of a certain project along with cash
outflows are given below:

Year Cash outflow (Rs) Cash Inflow (Rs)

0 150000 -
1 30000 20000
2 30000
3 60000
4 80000
5 30000

The salvage value at the end of 5th year is Rs. 40000. Calculate the net present value of the
project if discount factor at 10% for 5 year is 0.909, 0.826, 0.751, 0.683 and 0.621 respectively.

Solution: Calculation of present value of cash outflow

Year Cash outflow (Rs) PV factor at 10% Cash Outflow (Rs)

0 150000 1.00 150000
1 30000 0.909 27270
Present Value of Cash Outflow 177270

P.T.O.
Solution: Calculation of present value of cash Inflow

Year Cash inflow (Rs) PV factor at 10% Cash Inflow (Rs)

1 20000 0.909 18180
2 30000 0.826 24780
3 60000 0.751 45060
4 80000 0.683 54640
5 30000 0.621 18630
5 40000 0.621 24840
(Salvage value)
186130

NPV: Total Present Value of Cash Inflow – Total Present Value of Cash Outflow
186130 – 177270 = 8860
PROFITABILITY INDEX OR BENEFIT-COST RATIO:

PVI OR PI: Present Value of Cash Inflows / Present Value of Cash Outflow

Here: PVI: Present Value Index

Decision Rule: If the result is one or more then the project is accepted and if it is less
than 1, the project is rejected.

Example:
While using the figures of last example compute profitability index.

Total Present Value of Cash Inflow : 186130

Total Present Value of Cash Outflow : 177270

PVI OR PI: 186130 / 177270 = 1.04

Decision: The PI or PVI value is more than 1 so the project is accepted.

2. Internal Rate of Return Method (IRR)
The IRR is defined as “the discount rate which gives a zero NPV” i.e., the IRR is the
discount rate which will equate the present value of cash inflow with the present value of
cash outflows.

Calculation of IRR:
(a) When the annual cash inflows are equal:
Step 1: Calculate Present Value Factor = Initial Investment / Annual Cash Inflow
Step 2: Once PV factor is known, it is located in the Annuity Table on the line
which represents number of years corresponding to economic life of the
project. If accurate PV factor is not available then IRR will be in between
two factors and nearest factor is take as internal rate of return. It can be
computed by the following formula:

IRR = PV at LDR – I (HDR – LDR)

LDR +
.

PV at LDR – PV at HDR
Here:
IRR = Internal Rate of Return
LDR = Lower Discount Rate
HDR = Higher Discount Rate
I = Initial Investment

(b) When the annual cash inflows are unequal: In this case PV Factor will be calculated on
the basis of average cash inflow. Rest steps will be same as point (a).
Example (When Annual Cash Inflows are equal):

Determine the internal rate of return using annuity method from the following data:
Initial Investment Rs. 10000
Annual Cash Inflow for 5 years is 2637.83 in every year.

Solution:

Present Value (PV) Factor : Initial Investment / Annual Cash Inflow

10000 / 2637.83
3.791
By looking the present value table against five year the P.V. factor 3.791 and we
find it against 10%, therefore internal rate of return is 10%.
Example (When Annual Cash Inflows are unequal):
Determine the internal rate of return using annuity method from the following data:
Initial Investment Rs. 10000
Cash Inflow: 1st year 5000; 2nd year 5000; 3rd year 2000
Solution:
Present Value (PV) Factor : Initial Investment / Average Cash Inflow
Average cash inflow: (5000 + 5000 + 2000) / 3 = 4000
PV Factor: 10000 / 4000 = 2.5
The 2.5 P.V. value against column of three year is near to 10% rate, therefore we
shall take 10% and 12% rates for discounting:
Present Value at 10% and 12% Rate of Return
Year Cash Inflow P.V. Factor Present Value P.V. Factor at Present Value at
at 10% at 10% 12% 12%
1 5000 0.909 4545 0.893 4465
2 5000 0.826 4130 0.797 3985
3 2000 0.751 1502 0.712 1424
10177 9874
IRR = 10177 – 10000 (12 – 10)
10 +
.

10177 – 9874
IRR = 11.17%
Example:
The following is a summary of financial data in respect of five investment proposals:
Proposal Initial Outlay Net annual cash flow Life in years
A 60000 18000 15
B 88000 15000 25
C 2000 1000 5
D 20000 3000 10
E 42000 15000 20
Rank these proposals according to:
(i) Pay-back Period Method,
(ii) Average Rate of Return Method,
(iii) Net Present Value Method, and
The cost of capital being 6%.

SOLUTION:
(i) Ranking according to Pay Back Method:

Proposal Initial Outlay Net annual Pay-Back Period Ranking

cash Inflow (I / C)
A 60000 18000 3.33 years 3
B 88000 15000 5.87 years 4
C 2000 1000 2 years 1
D 20000 3000 6.67 years 5
E 42000 15000 2.8 years 2
(ii) Ranking according to Average Rate of Return Method:

Propos Initial Net Annual Income Average Average Ranking

al Outlay annual Depreci after tax Investment Rate of
(I) cash ation and Dep. (I + SV) / 2 Return
Inflow
1 2 3 4 5 = 3-4 6 7= (5/6 x100)
A 60000 18000 4000 14000 30000 46.67% 3
B 88000 15000 3520 11480 44000 26.09% 4
C 2000 1000 400 600 1000 60.00% 2
D 20000 3000 2000 1000 10000 10.00% 5
E 42000 15000 2100 12900 21000 61.43% 1

(iii) Ranking according to Net Present Value Method:

Propo Initial Life Net Present Present Value Net Present Ranking
sal Outlay in annual Value of Total Cash Value
years cash Factor Flow
Inflow at 6%
A 60000 15 18000 9.712 174816 114816 2
B 88000 25 15000 12.783 191745 103745 3
C 2000 5 1000 4.212 4212 2212 4
D 20000 10 3000 7.360 22080 2080 5
E 42000 20 15000 11.470 172050 130050 1
(3) Discounted pay-back period:
In this method all cash inflows are discounted with a discounted rate
equal to cost of capital. With the help of discounted cash inflows pay
back period is completed.
Example: Sagrika Limited is considering a project with an initial capital outlay of Rs.
50000. Its cash inflows are as follows:
Year 1 2 3 4 5
Cash Inflow 20000 15000 15000 10000 10000
The expected rate of return on the capital invested is 10% p.a. Calculate the
discounted pay back period of the project.
Solution:

Year Cash Inflow P.V. Factor Present Value Cumulative P.V.

at 10%
A 20000 0.909 18180 18180
B 15000 0.826 12390 30570
C 15000 0.751 11265 41835
D 10000 0.683 6830 48665
E 10000 0.621 6210 54875

Pay-Back Period: 4 years + (1335/6210) x 12 = 4.3 Years