Nmims: Financial Statement Analysis

FINANCIAL STATEMENT ANALYSIS
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COURSE DESIGN COMMITTEE
Chief Academic Officer

Dr. Shalini Kalia
NMIMS Global Access – School for Continuing Education
Content Reviewer TOC Reviewer

Dr. Purva Shah Dr. Purva Shah
Assistant Professor, NMIMS Global Assistant Professor, NMIMS Global
Access - School for Continuing Education Access - School for Continuing Education
Specialization: Finance Specialization: Finance
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Author: CA Sapna Jain

Reviewed By: Dr. Purva Shah
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Copyright:
2022 Publisher
ISBN:
978-93-91540-72-2
Address:
4435/7, Ansari Road, Daryaganj, New Delhi–110002
Only for
NMIMS Global Access - School for Continuing Education School Address
V. L. Mehta Road, Vile Parle (W), Mumbai – 400 056, India.
NMIMS Global Access - School for Continuing Education

C O N T E N T S
CHAPTER NO. CHAPTER NAME PAGE NO.
Financial Statement Analysis – Introduction

1 1
and Application
2 Overview of Vertical Statement Analysis 21
3 Understanding of Annual Reports 37
Case Studies 1 to 3 55
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4 Concept of Director’s Report 61
Disclosure of Accounting Policies,

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and Deferred Taxes
Introduction to IAS 10 – Events after

6 109
the Reporting Period

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7 Segment Reporting 139
8 Horizontal Analysis 159

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9 Overview of Ratio Analysis 181
10 Overview of Profitability Ratios 219
11 Cash Flow Statement 237
Economic Value Added (EVA) &

12 269
Market Value Added (MVA)

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F I N A N C I A L S TATE ME N T AN A LY SIS
C U R R I C U L U M
Financial Statement Analysis – Introduction and Application: Introduction to Financial State-

ment Analysis, Tools for Financial Statement Analysis, Applications of Financial Statement Anal-
ysis, Evaluation of the Past Financial Performance, Forecasting of Future Net Income and Cash
Flow, Assessment of Credit Quality for Debt Investment, Screening the Potential Equity Invest-
ments, Comparison by Making Appropriate Adjustments in Financial Statements, Advantages and
Limitations of Financial Statement Analysis.
Overview of Vertical Statement Analysis: Introduction to Vertical Statement Analysis, Need for
Vertical Statement Analysis and its Advantages, Types of Comparative Statements, Profit & Loss
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Account, Balance Sheet, Performing Vertical Statement Analysis, P&L Account, Balance Sheet,
Cash Flow Statement.
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Understanding of Annual Reports: Meaning of Annual Reports, Sections of Annual Report.
Concept of Director’s Report: Concept of Director’s Report, Draft Format of Director’s Report,
Purpose of Director’s Report, Contents of Director’s Report, Contents of Director’s Report as Per
Companies Act, 2013, Contents of Director’s Report as Per Companies (Accounts) Rules, 2014, Ad-
ditional Contents of Director’s Report for Listing Companies, Penalty for Non-Preparing the Direc-
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tor’s Report.
Disclosure of Accounting Policies, and Deferred Taxes: Disclosures of Accounting Policies,

Fundamental Accounting Assumptions, Nature of Accounting Policies, Areas in which Different
Accounting Policies are Possible, Considerations in the Selection of Accounting Policies, Main
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Principles for Disclosure, Non-compliance of Accounting Policies, Disclosures of Deferred Taxes,

Calculating a Deferred Tax Balance, Allocating the Deferred Tax Charge or Credit, Disclosures,
Solved Illustrations.
Introduction to IAS 10 – Events After the Reporting Period: Introduction to IAS 10 (Events after
the Reporting Period), Meaning and Concept of IAS 10 (Events after the Reporting Period), Stan-
dard History of IAS 10, Objectives of IAS 10, Types of Events, Adjusting Events after the Reporting
Period, Non-Adjusting Events after the Reporting Period, Disclosure about Events after the Re-
porting Period.
Segment Reporting: Overview of Segment Reporting, Objectives of Segment Reporting, Appli-

cability of AS 17, Segment Reporting Rules, Factors included in Segment Reporting, Identifying
Reportable Segments, Primary and Secondary Segment Reporting, Business and Geographical
Segments, Reportable Segments.

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Horizontal Analysis: Overview of Horizontal Analysis, Meaning of Comparative Statements, Types of

Comparative Statements, Trend Analysis, Ratio Analysis.
Overview of Ratio Analysis: Overview of Ratio Analysis, Objectives of Ratio Analysis, Advantages and
Limitations of Ratio Analysis, Classification of Ratios, Liquidity Ratios, Current Assets Ratio, Acid Test
Ratio, Super Quick Assets Ratio, Solvency Ratios, Debt-Equity Ratio, Proprietary Ratio, Fixed Assets
Ratio, Coverage Ratios, Profitability Ratios, Gross Profit Ratio, Net Profit Ratio, Operating Profit Ratio,
Return on Assets Ratio, Return on Capital Employed, Turnover Ratios, Stock Turnover Ratio, Debtors
Turnover Ratio, Creditors Turnover Ratio, Relevance of Ratio Analysis, Solved Illustrations.
Overview of Profitability Ratios: Introduction to Profitability Ratios, Meaning of Profitability Ratios,

Types of Profitability Ratios, Solved Illustrations.
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Cash Flow Statement: Introduction to Cash Flow Statement, Meaning of Cash Flow Statement, Clas-
sification of Activities for Cash Flow Statement, Preparation of Cash Flow Statement, Objectives of
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Cash Flow Statement, Methods of Cash Flow Statement, Direct Cash Flow Method, Indirect Cash Flow
Method, Limitations of Cash Flow Statement, Solved Illustrations.
Economic Value Added (EVA) & Market Value Added (MVA): EVA & MVA, Objectives of EVA & MVA,
Relevance of EVA & MVA, Practical Application of EVA in the Real World.
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C H A
1 P T E R
FINANCIAL STATEMENT ANALYSIS –

INTRODUCTION AND APPLICATION
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CONTENTS
1.1 Introduction
1.2 Introduction to Financial Statement Analysis
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1.2.1 Tools for Financial Statement Analysis
Self Assessment Questions
Activity
1.3 Applications of Financial Statement Analysis
1.3.1 Evaluation of the Past Financial Performance
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1.3.2 Forecasting of Future Net Income and Cash Flow

1.3.3 Assessment of Credit Quality for Debt Investment
1.3.4 Screening the Potential Equity Investments
1.3.5 Comparison by Making Appropriate Adjustments in Financial Statements
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Activity
1.4 Advantages and Limitations of Financial Statement Analysis
Activity
1.5 Summary
1.6 Multiple Choice Questions
1.7 Descriptive Questions
1.8 Higher Order Thinking Skills (HOTS) Questions
1.9 Answers and Hints
1.10 Suggested Readings & References

2 FINANCIAL STATEMENT ANALYSIS
INTRODUCTORY CASELET
COMPARATIVE INCOME STATEMENT OF ABC LTD.
A comparative income statement shows the operating results for

Case Objective several accounting periods. The following is information pertain-
The case let explains how ing to two accounting periods, i.e., 2020 and 2021 of ABC Ltd.:
comparative statement
analysis is performed. Particulars 2020 (in `) 2021 (`)
Net Sales 2,00,000 2,50,000
Cost of Goods Sold 1,50,000 1,80,000
Selling, General and Administrative Expenses 25,000 30,000
Other Income 12,000 18,000
Taxes 8,000 16,000
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Interest 17,000 18,000
Comparative Income Statement format of ABC Ltd. for the period

ended 2016 and 2017 is as follows:
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Particulars 2020 (in `) 2021 (in `) Absolute Percentage
Change Change
Net Sales 2,00,000 2,50,000 50,000 25%
Less: Cost of Goods 1,50,000 1,80,000 30,000 20%
Sold
Gross Profit 50,000 70,000 20,000 40%
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Less: Selling, 25,000 30,000 5,000 20%

General and
Administrative
Expenses
Net Operating Profit 25,000 40,000 15,000 60%
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Add: Other Income 12,000 18,000 6,000 50%

Earnings before 37,000 58,000 21,000 56.76%
Interest and Taxes
Less: Interest 17,000 18,000 1,000 5.88%
Earnings before 20,000 40,000 20,000 100%
Taxes
Less: Taxes 8,000 16,000 8,000 100%
Net Profit 12,000 24,000 12,000 100%
Based on the above Comparative Income Statement of ABC Ltd.,

it can be analysed how an increase in sales (25% over the previous
year) has impacted the Net profit (increased by 100% in absolute
terms over the previous year) and how various lines items have
contributed.

FINANCIAL STATEMENT ANALYSIS – INTRODUCTION AND APPLICATION 3
LEARNING OBJECTIVES
After studying this chapter, you will be able to:

>> Explain the concept of financial statement analysis
>> List the tools for financial statement analysis
>> Discuss the applications of financial statements
>> Explain the advantages and limitations of financial state-
ments
1.1 INTRODUCTION
Financial statements are summarised financial reports that provide
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information on the operating results and financial position of com-
panies. The information contained therein is useful for assessing the
operational efficiency and financial soundness of a company. Thus,
these statements require proper analysis and interpretation of such
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information for which a number of techniques (tools) have been devel-
oped by financial experts.
Financial statement analysis is the process of reviewing and analys-

ing a company’s financial statements to make better economic deci-
sions. These statements include the income statement, balance sheet,
statement of cash flows and a statement of changes in equity. In this
chapter, you will study about financial statement analysis, its tools,
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advantages and limitations.
The financial statements are primarily aimed to calculate the profits of

the business organisations, Let’s understand the process of calculat-
ing gross profit of the organisation with the help of following example:
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Example 1: Following balances taken from the books of Akash Ltd. for
the year ending March 31, 2021, calculate the amount of gross profit
Particulars (`)
Closing Stock 3,50,000
Net sales during the year 30,00,000
Net purchases during the year 10,00,000
Opening stock 15,00,000
Direct expenses 80,000
Solution: The following trading account can be used to calculate the

amount of gross profit for the year:
Particular (`) Particular (`)

Opening stock 15,00,000 Net sales 30,00,000

Particular (`) Particular (`)

Net purchases 10,00,000 Closing stock 3,50,000
Direct expenses 80,000
Gross profit 7,70,000
33,50,000 33,50,000
Hence, the gross profit is `7,70,000
In this chapter, you will study the financial statement analysis, tools
for financial statement analysis, applications of financial statement
analysis, evaluation of the past financial performance, forecasting of
future net income and cash flow, assessment of credit quality for debt
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investment, screening the potential equity investments, comparison
by making appropriate adjustments in financial statements, advan-
tages and limitations of financial statement analysis etc. in details.
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1.2
STATEMENT ANALYSIS
As stated earlier, financial statements are meant for specific group of
users. However, these statements lose their sole purpose if the users
do not interpret them from their own perspectives for decision mak-
ing. Different users have different needs and situations. Statements
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describing the facts need to be analysed as per the requirements of

users. Here, the role of financial statement analysis comes into the
picture.
Financial statement analysis is the process of assessing the financial

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statements of a company for decision-making purposes. To put simply,

the process of critically evaluating financial information contained in
the financial statements in order to understand and make decisions
regarding the operations of a company is called ‘Financial Statement
Analysis’. External stakeholders analyse financial statements of a com-
pany to understand its overall financial health and business value. On
NOTE the other hand, internal stakeholders assess financial statements as a
The term ‘financial statement monitoring tool for managing funds.
analysis’ includes both ‘analysis’,
and ‘interpretation’. A difference
must, hence, be made between
The main objective of financial statement analysis is to predict the
both the terms. The word performance of an organisation. However, the following are some
‘analysis’ is utilised to mean other objectives:
the convenience of financial
data by systematic grouping of To assess the current profitability and operational efficiency of the
the data given in the financial firm as a whole as well as its different departments so as to judge
statements, ‘interpretation’
the financial health of the firm
implies, ‘explaining the meaning
and significance of the data so To ascertain the relative importance of different components of
simplified.’
the financial position of the firm

To identify the reasons for change in the profitability/financial

position of the firm
To judge the ability of the firm to repay its debt and assess the
short-term as well as the long-term liquidity position of the firm
1.2.1 TOOLS FOR FINANCIAL STATEMENT ANALYSIS
Financial statements are prepared to have complete information

pertaining to profit and loss, assets, liabilities, equity, reserves and
expenses of a company. Analysing and interpreting financial state-
ments.
Some of common tools for analysing financial statements are explained
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as follows:
COMMON-SIZE STATEMENTS
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These are the statements that relate different items in a financial state-
ment with a common item through expressing each item as a percent-
age of that common item. Therefore, the percentage calculated can be
easily compared with the results of corresponding percentages of the
previous year or of some other firms, as the numbers are brought to
common base. In this way, an analyst can compare the operating and
financing characteristics of two firms of different sizes in the same
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industry. Thus, common size statements are useful, both, in intra-firm

comparisons over different years and also in making inter-firm com-
parisons for the same year or for several years. This type of analysis is
done vertically, converting complex data into a concise form.
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Let’s understand the concept of common size balance sheet with the
help of following example:
Example 2: Prepare a common size balance sheet of business ltd.,

with the help of following data furnished by them:
Particulars 31-3-2021 31-3-2020

Reserves 8,00,000 7,00,000
Share capital 18,00,000 18,00,000
Fixed assets 35,50,000 29,15,000
Current Assets 26,60,000 24,00,000
Non-Current Liabilities 25,45,000 19,50,000
Current liabilities 10,65,000 8,65,000

Solution:
Common size balance sheet of Business ltd
As on 31 march 2020 and 31 march 2021:
Percentage Percentage
Amount
Note Amount of total bal- of total bal-
Particulars (31-3-
no (31-3-2021) ance sheet ance sheet
2020)
(31-3-2020) (31-3-2021)
I. Equity and liabili-
ties
1. Shareholder’s
funds
a. Share Capital 18,00,000 18,00,000 33.86 28.98
b. Reserves and
Surplus
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7,00,000 8,00,000 13.18 12.88
2. Non-Current 19,50,000 25,45,000 36.69 40.99
liabilities
3. Current liabilities 8,65,000 10,65,000 16.27 17.15
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II. Assets
1. Non-Current
Assets 29,15,000 35,50,000 54.84 57.16
2. Current assets 24,00,000 26,60,000 45.16 42.84
Total 53,15,000 62,10,000 100.00 100.00
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COMPARATIVE STATEMENTS
These statements reflect the profitability and financial position of a

company for different time periods in a comparative form to give an
idea about the position of two or more periods. It usually applies to
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two important financial statements, namely, balance sheet and state-

ment of profit and loss prepared in a comparative form. Financial
data can be comparative only when same accounting principles are
used in preparing these statements. If not, the deviation in the use of
accounting principles is mentioned as a footnote. Comparative figures
indicate the trend and direction of financial position and operating
results. This analysis is also called horizontal analysis.
EXHIBIT
Types of Comparative Statements

Comparative Balance Sheet
The development of the firm can be observed by tracing various

assets and liabilities of the company on multiple dates to make the
comparison of balances between the dates. To comprehend and
analyse the comparative balance sheet, it can have two columns
to carry the data of actual balance sheets. A third one is utilised
to show increases/decrease in figures. Another fourth column

indicates the percentage increase or decrease. By analysing the

balance sheets of different dates, one can see the below mentioned
aspects:
Current financial standing and liquidity position
Long-standing financial position
Profitability of the concern
Example 3: Prepare a comparative balance sheet of Vipin ltd using

the following data furnished by them:
Note 31st March 31st March

Particulars
no. 2022 2021
I. Equity and Liabilities
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1. Shareholder’s funds
a. Share capital 8,20,000 7,00,000
b. Reserves and Surplus 3,00,000 1,50,000
2. Non-current liabilities
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Long-term borrowings 5,10,000 3,50,000
3. Current liabilities Bills payable 2,40,000 2,00,000
Total 18,70,000 14,00,000
II. Assets
1. Non-Current assets
Fixed Assets:
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i. Tangible Assets 5,60,000 4,20,000

ii. Intangible Assets 4,20,000 3,75,000
2. Current Assets
a. Trade Receivables 6,50,000 2,80,000
b. Cash and cash equivalents
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2,40,000 3,25,000
Total 18,70,000 14,00,000
Solution:
Vipin Ltd.
Comparative Balance Sheet as at 31st march 2021 and 31st March
2022
Per-
Absolute
31st 31st centage
Note Change
Particulars March March Change
no. (Increase/
2022 2021 (Increase/
Decrease)
Decrease)
c. Share capital 8,20,000 7,00,000 1,20,000 17.14
d. Reserves and 3,00,000 1,50,000 1,50,000 100.00
Surplus

2. Non-current liabilities 5,10,000 3,50,000 1,60,000 47.05

Long-term borrowings
3. Current liabilities Bills
payable 2,40,000 2,00,000 40,000 20.00
Total 18,70,000 14,00,000 4,70,000 33.57
II. Assets
Fixed Assets:
iii. Tangible Assets 5,60,000 4,20,000 140,000 33.33
iv. Intangible Assets 4,20,000 3,75,000 45,000 12.00
4. Current Assets
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c. Trade Receivables 6,50,000 2,80,000 370,000 132.1
d. Cash and cash
equivalents 2,40,000 3,25,000 (85,000) (26.15)
Total 18,70,000 14,00,000 4,70,000 33.57
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Comparative Income Statement
Traditionally known as trading and profit and loss A/c. Net sales,
cost of products sold, selling expenditures, office expenditures etc.
are important components of an income statement. To compare the
profit, particulars of profit & loss are compared with the equiva-
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lent figures of previous years individually. In order to estimate the

profitability of the business, the alterations in money value and per-
centage is identified. By comparing the profits of different dates,
one can observe the following aspects:
The rise/drop in gross profit.
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The understanding of operational profits

The increase or decrease in net profit
Study of the overall profitability of the business
Example 4: Prepare the comparative income statement of Sahil ltd,

from the following furnished data:
31st march 31st March

Particulars
2022 2021
Revenue from operations 17,80,000 12,00,000
Cost of Revenue from operations 8,50,000 620,000
Operating expenses 1,00,000 80,000
Interest on the given investment is 40,000 and tax payable is 50%

Solution:
Comparative Income statement
For the years ended 31st March 2021 and 31st March 2022
Per-
Absolute
31st 31ST centage
Note Change
Particulars March March Change
no. (Increase/
2022 2021 (Increase/
Decrease)
Decrease)
I. Revenue from 17,80,000 12,00,000 5,80,000 48.33
operations
II. Other Income 40,000 40,000 0 48.33
III. Total Income (I+II) 18,20,000 12,40,000 5,80,000
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IV. Expenses
Cost of goods sold 8,50,000 620,000 2,30,000 37.09
Operating expenses 1,00,000 80,000 20,000 25.00
Total expenses 9,50,000 7,00,000 2,50,000 35.71
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V. Profit before Tax 8,70,000 5,40,000 3,30,000 61.11
(III-IV)
Less: Income Tax 4,35,000 2,70,000 1,65,000 61.11
VI. Profit After tax 4,35,000 2,70,000 1,65,000 61.11
TREND ANALYSIS
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Trend analysis is a technique of assessing operational results and

financial position over a series of years. It is performed by observing NOTE
percentage changes over time in the selected data. Trend percentage Horizontal analysis is performed
refers to the percentage relationship in which each item of different horizontally across time periods,
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years bear to the same item in the base year. Trend analysis is import- while vertical analysis is
ant because, with its long run view, it may point to basic changes in performed vertically inside of
a column. Horizontal analysis
the nature of the business. By looking at a trend in a particular ratio,
represents changes over
one may find whether the ratio is falling, rising or remaining relatively years or periods, while vertical
constant. From this observation, a problem is detected or the sign of analysis represents amounts as
good or poor management is detected. percentages of a base figure.
Example 5: Three year trend percentage of Innox ltd., Can be calcu-

lated as follows using the following historical data of the company:
Historical data of Innox ltd.:
Account 2020 2021 2022

Net Sales 21,000 24,000 22,000
Cost of goods sold 8,000 11,000 10,500
Gross Profit 13,000 13,000 11,500
Operating Expenditure 6,500 5,000 7,000
Income Before taxes 6,500 8,000 4,500

Solution:
Calculation of trend Percentage:
2021 Cal- 2022 Cal-

Particulars 2020 2021 2022
culation culation
Net sales 100% 114.28% 24,000/21,000 91.66% 22,000/24,000
× 100 × 100
Cost of goods 100% 137.50% 11,000/8,000 95.45% 10,500/11,000

sold × 100 × 100
Gross Profit 100% 100.00% 13,000/13,000 88.46% 11,500/13,000

× 100 × 100
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Operating 100% 76.92% 5,000/6,500 × 140.00% 7,000/5,000 ×
expenses 100 100
Income before 100% 123.07% 8,000/6,500 × 56.25% 4,500/8,000 ×

taxes 100 100
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SELF ASSESSMENT QUESTIONS
1. The process of critically evaluating financial information

contained in the financial statements in order to understand
and make decisions regarding the operations of a company is
called __________.
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a. Company analysis
b. Financial statement analysis
c. Customer analysis
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d. Monetary analysis
2. Financial statements are prepared to have complete
information pertaining to __________.
a. Profit and loss
b. Assets and liabilities
c. Reserves and expenses of a company
d. All of these
ACTIVITY
Suppose an investor wants to compare the percentage increase or

decrease in net profit in the past three years between XYZ Ltd. and
ABC Ltd. Find out the ways in which this can be done. What are the
contributors and observations from such a comparison?

APPLICATIONS OF FINANCIAL
1.3
STATEMENT ANALYSIS
Analysing financial statements can help an analyst assess the profit-
ability and liquidity of a company. Let us discuss the scope of financial
statement analysis in detail.
1.3.1 EVALUATION OF THE PAST FINANCIAL

PERFORMANCE
The statistics used in estimating a company’s previous financial per-

formance may be extracted from multiple sources. Such sources
comprise financial statements, trade publications, proxies, corporate
press releases and industry surveys. The data can be dealt with by
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common-sizing the financial statements, computing financial ratios
and analysing or calculating business parameters.
Businesses relish discretion pertaining to their discretion of

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accounting standards (IFRS, US GAAP or other home-country
GAAP), the assumptions they make and the assessments that they
depend on when making financial statements. This may meaningfully
restrict the comparability of financial data through companies. As a
consequence, sometimes tunings are made to a business’s financial
statement data to enable comparison with other businesses or with
the overall industry.
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A comparison of financial performance and trend financial data of

a company can offer insight into the performance of the company.
The firm’s management might also project views on the likely causes
of this performance in the Management, Discussion and Analysis
(MD&A) unit of the firm’s annual report and during periodic confer-
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ence calls with analysts and investors. Added information may also be
found from industry information or consumer surveys.
An assessment of a firm’s financial performance over a period can

show how successful the firm is in attaining its strategic objectives.
For example, approaches that centre on product differentiation, lower
input costs and/or alteration in sales mix are typically planned to lead
to a company recording higher gross margins.
1.3.2
FORECASTING OF FUTURE NET INCOME AND CASH
FLOW
Forecasting a firm’s future net income and cash flow begins with
forecasting its sales. A top-down approach is usually adopted. This
engages the forecasting industry sales on the basis of their past asso-
ciation with a macroeconomic indicator such as GDP growth. At the
specific company level, sales forecasts could be based out of previous
financial outcomes and could be very detailed. A similar forecast can,
for example, focus on each business section of the corporation.

Taking into consideration that the business sales have been forecast,
the next phase would include forecasting the company’s market share
considering its historical market share and a forward-looking assess-
ment of its competitive position. The business’s sales are then pre-
dicted by multiplying its projected market share by the forecasted
total industry sales.
Post the sales forecast, the net income and cash flow of a business are
generally forecast. This is completed based on a prediction of profit
margins (gross or operating) or expenditure and the kind of invest-
ment in working and fixed capital required to support the forecast
sales. Historically, operating profit margins have a habit of being less
reliable than gross profit margins in the predictions of future margins
for a new or relatively volatile business or one with significant fixed
costs. Gross profit margins may also be detailed and can be based on
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past results or forecast relationships.
Predicting future financial performance over many periods is required

in valuation models that assess the value of a company or its equity
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by discounting future cash flows. The GDP by itself is not enough as
an indicator and the trend of historical results is dependent on many
other factors which don’t guarantee future profits.
1.3.3 ASSESSMENT OF CREDIT QUALITY FOR DEBT

INVESTMENT
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The financial statements of a company both projected and historical

are important resources of information for measuring credit quality.
On the other side, the calculation of a firm’s financial ratios is valuable
in the determination of its creditworthiness; the firm’s comparative
creditworthiness may be ascertained by comparing its financial ratios
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with those of its rivals. Normally, assessed financial ratios for such
situations contain EBITDA/Average assets; Debt/EBITDA; Retained
cash flow to debt and free cash flow to net debt.
Furthermore, credit study, or the estimate of credit risk, involves the

projection of a business’s period-by-period cash flows. It takes into
account return measures pertaining to operating cash flow as this
signifies the cash that is produced internally and is available for the
payment of creditors.
There are four sets of quantitative factors that are used in credit
analysis, which are:
Scale and diversification: This pertains to a business’s sensitivity
to hostile events or economic situations and other influences such
as entry to capital markets which may impact its debt-paying abil-
ity.
Tolerance for leverage: This pertains to a firm’s capacity to ser-
vice its indebtedness.

Operational efficiency: This pertains to a firm’s cost structure.

Companies with lower costs are better positioned to handle finan-
cial stress.
Margin stability: This pertains to the previous stability of profit
margins. Higher margin stability is related with lower credit risk.
1.3.4 SCREENING THE POTENTIAL EQUITY INVESTMENTS
An analyst derives ratios from financial statements of a company

along with other information to shortlist stocks of different companies
to identify potential candidates for investment. Ratios can be derived
using both top-down or bottom-up approaches. In a top-down
approach, firstly industries or geographical segments are shortlisted
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and then individual companies are selected; however, in a bottom-up
approach, all companies are considered in an investment universe.
While using ratios for screening, it is crucial to decide which metrics
to use, in what weight and at what cut-off value. For example, if an
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analyst sets two screens, profit margin > 15% (which is satisfied
by 50% of the companies in the investment universe) and dividend
payout > 40% (satisfied by 30% companies), the ultimate companies
that would pass through the filter would most likely be greater than
15% (=50% × 30%).
1.3.5 COMPARISON BY MAKING APPROPRIATE

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ADJUSTMENTS IN FINANCIAL STATEMENTS
Analysts often make adjustments to a company’s reported financial

statements when comparing such statements with ones from another
company that uses various accounting systems, assumptions or esti-
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mates. Alterations include those pertaining to investments, prop-

erty, inventory, plant and equipment, goodwill and off-balance-sheet
financing.
3. The statistics used in estimating a company’s previous

financial performance might be extracted from multiple
sources. Such sources comprise __________.
a. Financial statements b. Trade publications
c. Proxies d. All of these
4. An assessment of a firm’s financial performance over a period
can show how successful the firm is in attaining__________.
a. Strategic objectives b. Revenues
c. Sales d. None of these

ACTIVITY
Take the financial statement of any company of your choice and

look at the factors that can be considered for financial statement
analysis.
ADVANTAGES AND LIMITATIONS OF

1.4
FINANCIAL STATEMENT ANALYSIS
Financial statement analysis assesses the performance or value of a
company through its balance sheet, income statement or statement
of cash flows. The following are the advantages of financial statement
analysis:
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1. After analysing financial statements, the existing position of an
organisation can be determined.
2. Financial statement analysis helps in examining sequences of
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events, economic and related facts.
3. It allows for getting expert opinions after considering facts and
statements.
4. It determines the socio-economic position of the company in
which it operates.
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Although financial statement analysis is quite helpful in determining

financial strengths and weaknesses of a firm, it suffers from certain
limitations. Some of these limitations include:
1. Financial statements are derived from historical costs:
However, some entities, such as marketable securities, are
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tweaked to correspond to changes in their market values, yet

other items, like fixed assets, do not change.
2. The sums on the balance sheet related to assets and liabilities:
The sum on the balance sheet related to assets and liabilities will
look unusually low if the inflation rate is proportionally high,
because they are not adjusted for inflation.
3. Financial statements do not have intangible assets: Several
intangible assets are not written down as assets. On the other
hand, any expense for making an intangible asset is directly
linked with expense. This rule can radically underestimate the
value of a business.
4. Financial statements only cover a specific period of time: By
simply examining at one reporting period, a user of financial
statements might get an erroneous picture of a company’s
financial results or cash flows.
5. Financial statements may not be comparable: When comparing
the results of numerous firms, the financial statements are not

necessarily comparable because the attributes adopt different

accounting standards.
6. Due to fraud, financial statements might be incorrect: A
company’s management may purposefully distort the results
given.
7. Non-financial issues are not addressed in financial statements:
Non-financial aspects, such as a company’s environmental
emphasis or how well it interacts with the local community, are
not reflected in the financial accounts.
8. Financial statements do not predict anything: A set of financial
statements contains information regarding either past outcomes
or a company’s financial status as of a certain date.
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5. Which of the following is a limitation of financial statement

analysis?
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a. Financial statements are derived from historical costs
b. Financial statements are not adjusted for inflation
c. Financial statements do not have intangible assets
d. All of these
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ACTIVITY
Find reasons why financial statement analysis is not suitable for

inflationary conditions.
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1.5 SUMMARY S
Financial statement analysis is the process of assessing the finan-
cial statements of a company for decision-making purposes.
The main objective of financial statement analysis is to predict the
performance of an organisation.
Analysing financial statements can help an analyst assess the prof-
itability and liquidity of a company.
Analysing financial statements can help an analyst in evaluating
past financial performance, forecasting future net income and
cash flow, assessing credit quality for debt investment, screening
potential equity investments and so on.
Financial statement analysis assesses the performance or value of
a company through its balance sheet, income statement or state-
ment of cash flows.

After analysing financial statements, the existing position of an

organisation can be determined.
Although financial statement analysis is quite helpful in determin-
ing financial strengths and weaknesses of a firm, it suffers from
certain limitations. For example, financial statements do not have
intangible assets.
KEY WORDS
EBITDA: The earnings before interest, taxes, depreciation, and

amortisation, a measure of a company’s overall financial perfor-
mance
Horizontal analysis: An analysis wherein items of the present
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financial year are compared with the base year’s amount, in
both absolute and percentage terms
Vertical analysis: A method of financial statement analysis in
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which each line item is listed as a percentage of a base figure
within the statement
1.6 MULTIPLE CHOICE QUESTIONS

MCQ
1. Which of the following is an objective of financial statement
analysis?
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a. To assess the current profitability and operational efficiency

of the firm
b. To ascertain the relative importance of different components
of the financial position of the firm
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c. To identify the reasons for change in the profitability/finan-

cial position of the firm
d. All of these
2. Which of the following statements are analysed vertically?
a. Common-size statements
b. Comparative statements
c. Trend analysis
d. Ratio analysis
3. Forecasting a firm’s future net income and cash flow begins with
forecasting its __________.
a. Gross margin
b. Revenue
c. Sales
d. All of these

4. In a __________, firstly industries or geographical segments are

shortlisted and then individual companies are selected.
a. Top-down approach
b. Bottom-up approach
c. Top-up approach
d. Bottom-down approach
5. Which of the following pertains to a firm’s cost structure?
a. Margin stability
b. Tolerance for leverage
c. Operational efficiency
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d. Scale and diversification
6. Higher margin stability is related with __________ credit risk.
a. Lower
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b. Higher
c. Neither lower nor higher
d. No such relation exists
7. Which of the following pertains to a firm’s capacity to service its
debt?
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a. Margin stability
b. Tolerance for leverage
c. Operational efficiency
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d. Scale and diversification

8. Companies with __________ costs are better positioned to handle
financial stress.
a. Lower
b. Higher
c. Nominal
d. Economic
9. While using __________ for screening, it is crucial to decide which
metrics to use, in what weight and at what cut-off value.
a. Lines
b. Ratios
c. Sequences
d. Values

10. Which of the following are the advantages of financial statement

analysis?
a. After analysing financial statements, the existing position of
an organisation can be determined
b. Financial statement analysis helps in examining sequences of
events, economic and related facts
c. It allows for getting expert opinions after considering facts
and statements
d. All of these
1.7 DESCRIPTIVE QUESTIONS

?
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1. Write a short note on financial statement analysis.
2. What do you understand by the term trend analysis?
3. What are the four sets of quantitative factors used in credit
IM analysis?
4. What are the advantages of financial statement analysis?
5. List the limitations of financial statement analysis.
HIGHER ORDER THINKING SKILLS

1.8
(HOTS) QUESTIONS
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1. Mr. Rudra is an analyst and he wants to analyse financial

statements by expressing each item as a percentage of that
common item. Which types of statements are going to be analysed
by Mr. Rudra?
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a. Common-size statements
b. Comparative statements
c. Trend analysis
d. Ratio analysis
2. If an analyst sets two screens, profit margin > 15% (which is
satisfied by 50% of the companies in the investment universe)
and dividend payout > 40% (satisfied by 30% companies), the
ultimate companies that would pass through the filter would
most likely be greater than __________.
a. 15%
b. 30%
c. 25%
d. 20%

1.9 ANSWERS AND HINTS
ANSWERS FOR SELF ASSESSMENT QUESTIONS
Topic Q. No. Answer

Introduction to Financial 1. b. Financial statement analysis
Statement Analysis
2. d. All of these
Applications of Financial 3. d. All of these
Statement Analysis
4. a. Strategic objectives
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Advantages and Limitations 5. d. All of these
of Financial Statement
Analysis
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ANSWERS FOR MULTIPLE CHOICE QUESTIONS
Q. No. Answer
1. d. All of these
2. a. Common-size statements
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3. c. Sales
4. a. Top-down approach
5. c. Operational efficiency
6. a. Lower
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7. b. Tolerance for leverage

8. a. Lower
9. b. Ratios
10. d. All of these
HINTS FOR DESCRIPTIVE QUESTIONS

1. Financial statement analysis is the process of assessing the
financial statements of a company for decision-making purposes.
Refer to Section 1.2 Introduction to Financial Statement
Analysis
2. Trend analysis is a technique of assessing operational results
and financial position over a series of years. Refer to Section 1.2
Introduction to Financial Statement Analysis
3. Scale and diversification, tolerance for leverage, operational
efficiency and margin stability are the four sets of quantitative

factors used in credit analysis. Refer to Section 1.3 Applications

of Financial Statement Analysis
4. Financial statement analysis assesses the performance or value
of a company through its balance sheet, income statement or
statement of cash flows. Refer to Section 1.4 Advantages and
Limitations of Financial Statement Analysis
5. Financial statements are derived from historical costs. However,
some entities, such as marketable securities, are tweaked to
correspond to changes in their market values, yet other items,
like fixed assets, do not change. Refer to Section 1.4 Advantages
and Limitations of Financial Statement Analysis
ANSWERS FOR HIGHER ORDER THINKING SKILLS (HOTS)
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QUESTIONS
Q. No. Answer
IM 1. a. Common-size statements
2. a. 15%
1.10 SUGGESTED READINGS & REFERENCES
SUGGESTED READINGS
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Raiyani, J., Raiyani, J., & Bhatasna, R. (2014). Financial Ratios and
Financial Statement Analysis. New Delhi: New Century Publica-
tions.
E-REFERENCES
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(2022). Retrieved 10 April 2022, from https://ncert.nic.in/textbook/

pdf/leac204.pdf

C H A
2 P T E R
OVERVIEW OF VERTICAL STATEMENT ANALYSIS
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CONTENTS
2.1 Introduction
2.2 Introduction to Vertical Statement Analysis
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2.2.1 Need for Vertical Statement Analysis and its Advantages
Activity
2.3 Types of Comparative Statements
2.3.1 Profit & Loss Account
2.3.2 Balance Sheet
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Activity
2.4 Performing Vertical Statement Analysis
2.4.1 P&L Account
2.4.2 Balance Sheet
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2.4.3 Cash Flow Statement

Activity
2.5 Summary

VERTICAL ANALYSIS OF INCOME STATEMENT
Consider the following example of an income statement of the

Case Objective ABC Ltd.:
The caselet explains how
vertical analysis is performed. Year 1 (in `) Year 2 (in `) Year 3 (in `)
Sales 3,50,000 4,25,000 5,00,000
Cost of Goods Sold 1,00,000 1,35,000 1,70,000
Gross Profit 2,50,000 2,90,000 3,30,000
Salaries 95,000 98,000 1,00,000
Rent and Utilities 30,000 35,000 40,000
Marketing 20,000 25,000 30,000
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Other Expenses 10,000 12,000 15,000
Total Expenses 1,55,000 1,70,000 1,85,000
If we divide each line item for the year with the sales for that year,
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the common size analysis of the income statement of the company
will look as:
Year 1 Year 2 Year 3

Sales 100% 100% 100%
Cost of Goods Sold 29% 32% 34%
Gross Profit 71% 68% 66%
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Salaries 27% 23% 20%

Rent and Utilities 9% 8% 8%
Marketing 6% 6% 6%
Other Expenses 3% 3% 3%
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Total Expenses 44% 40% 37%

Net Income 27% 28% 29%
Interpretation
By converting each number by the sales number for the year, the
comparison between the line items over the years is easy.
The Gross Profit of the Company grew, but the gross profit %
dropped over the years. This shows that the cost of the raw
materials and goods has increased and is not in line with the
increase in sales.
The salaries of the employees have decreased over the years.
Rent and utilities, marketing, and other expenses have
remained more or less constant as a percentage of the sales.
The net income has increased by about 1% every year.
Source: https://www.wallstreetmojo.com/vertical-analysis-of-income-statement/

OVERVIEW OF VERTICAL STATEMENT ANALYSIS 23
LEARNING OBJECTIVES

>> Discuss the concept of vertical statement analysis
>> Explain the types of comparative statements
>> Describe how to perform vertical statement analysis
2.1 INTRODUCTION
In the previous chapter, you have studied the importance of financial Quick Revision
statement analysis.
Vertical analysis refers to an accounting tool proportionally analyses
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financial statements. While performing a vertical analysis, every line
item on a financial statement is entered as a percentage of another
item. For example, on an income statement, every line item is stated
in terms of the percentage of gross sales. Financial statements can
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be analysed vertically or horizontally depending on the needs of an
organisation.
In this chapter, you will understand the concept of vertical statement

analysis, its advantages and limitations.
INTRODUCTION TO VERTICAL
2.2
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STATEMENT ANALYSIS
Vertical analysis or vertical statement analysis refers to a method of
analysing financial statements wherein each line item is shown as a
percentage of a base figure within the statement. Therefore, on an
income statement, line items can be stated as a percentage of gross
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sales, while line items on a balance sheet can be stated as a percent-

age of total assets or liabilities and on a cash flow statement each cash
inflow or outflow is shown as a percentage of the total cash inflows.
Vertical statement analysis allows an analyst to easily compare finan-
cial statements of one company with another and across industries. As
a result, one can see the relative proportions of account balances. It
additionally makes it easier to compare previous periods for statistical
analysis wherein quarterly and annual figures are compared over a
number of years.
Financial statements that embody vertical analysis clearly show point

percentages in a separate column. Financial statements that are
analysed using the vertical analysis method are called common-size
statements and are employed by several corporations to get insight
into a company’s financial position. Common-size money statements
typically incorporate comparative money statements that embody col-
umns examination every point to an antecedent rumoured amount.
Vertical analysis is additionally helpful for visualising relative changes
in accounts over time.

2.2.1 NEED FOR VERTICAL STATEMENT ANALYSIS AND

ITS ADVANTAGES
Vertical analysis is the most commonly used method for analysing

financial statements for a single reporting period, for example, quar-
terly. It is done so that accountants can ascertain the relative propor-
tions of the balances of each account. Vertical analysis is useful while
charting regression analysis or ratio analysis. It enables the accoun-
tant to see relative changes in company accounts over a given period
of time. The analysis is especially convenient to do on a comparative
basis. The following points explain the advantages of vertical analysis:
1. As items are expressed in a percentage, vertical analysis
simplifies the correlation between single items on a balance
sheet and the bottom line. The percentages obtained can be
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used by the company’s management to set goals and threshold
limits. For example, management may consider shutting down a
particular unit if profit per unit falls below a particular threshold
percentage.
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2. It reflects corresponding changes in the finances of a particular
unit/account/department over a certain period of time.
3. It is also useful in comparing the financial statement of a company
to the average trends in the industry. Common-size percentages
solve such a problem and facilitate industry comparison.
4. It is also highly effective while comparing two or more companies
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operating in the same industry but with different sizes. Vertical

analysis enables accountants to create common-size measures,
which enable them to compare and contrast amounts of different
magnitudes in an efficient manner.
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1. Vertical analysis is the most commonly used method for

analysing financial statements for a __________.
a. Single reporting period
b. Double reporting period
c. Triple reporting period
d. Multiple reporting period
2. __________ allows an analyst to easily compare financial
statements of one company with another and across industries.
a. Horizontal analysis
b. Vertical analysis
c. Diagonal analysis
d. Corporate analysis

ACTIVITY
Take the financial statement of any company of your choice and

make a list of factors that can be considered for making vertical
analysis of that statement.
2.3 TYPES OF COMPARATIVE STATEMENTS

Comparative financial statements are statements of the financial posi-
tion at different periods. The elements of financial position are shown
in a comparative form so as to give an idea of financial position at
two or more periods. Any statement prepared in a comparative form
will be covered in comparative statements. A comparative statement
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shows absolute figures, changes in absolute figures, absolute data in
terms of percentages, increase or decrease in terms of percentages
and so on. Generally, two financial statements are prepared in a com-
parative form for financial analysis purposes, namely balance sheet
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and income statement (P&L statement). Let’s study the types of com-
parative statements in the next sections.
2.3.1 PROFIT & LOSS ACCOUNT
The term profit and loss (P&L) statement reflects the revenues, costs
and expenses incurred in a particular period of time, typically quarter
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or year. In other words, an income statement presents the results of

the operation, i.e., profit or loss. This statement reflects a company’s
ability or inability to get profit by increasing revenue, reducing prices
or both. The income statement enables an analyst to have a look at
the results of business operations. The comparative income statement
gives an idea of the progress of a business over a period of time. The
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changes in absolute data in money values and percentages can be

determined to analyse the profitability of the business. Like compara-
tive balance sheet, income statement also has four columns. First two
columns give figures of various items for two years. Third and fourth
columns are used to show increase or decrease in figures in absolute
amounts and percentages, respectively.
The following is an example of a trading and profit and loss account of

a company as of March 2021:
Dr. Cr.
Expenses/Losses Amount (in `) Revenues/Gains Amount (in `)
Purchases 75,000 Sales
Wages 8,000 Closing Stock 15,000
Gross Profit c/d 57,000
1,40,000 1,40,000
Salaries 25,000 Gross Profit b/d 57,000

Dr. Cr.
Expenses/Losses Amount (in `) Revenues/Gains Amount (in `)
Rent of Building 13,000 Commission 5,000
Received
Bad Debts 4,500
Net Profit (Transferred 19,500
to Company’s Capital
A/c
62,000 62,000
Company XYZ ltd is in the textile business and produces and sells a
variety of ready-to-wear items on the market. The company has a pol-
icy of creating a monthly profit and loss statement and then, at the end
of the fiscal year, a single profit and loss statement.
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Sales of clothing for the month of June 2022 brought in 100,000 for the
company, despite the cost of items sold being 60,000. Additionally, the
company earns 9,000 by selling the leftover fabric from creating the
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outfits, as well as 4,000 in interest income.
On the expense side, the company pays 5,500 in rent for its property
during the month, 15,000 in salary for manufacturing workers, 7,700
for annual depreciation, and 9,000 for utilities.
Create the company’s profit and loss statement for the month of June
2022 that ends on June 31.
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Company XYZ Ltd.

Profit and loss statement
For the month ending June, 31, 2022
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Particulars Amount Amount

Revenues
Sales 1,00,000
Scrap sales 9,000
Interest Income 4,000
Total Revenues (A) 1,13,000
Expenses
Cost of goods sold 60,000
Rent 5,500
Wages 15,000
Depreciation 7,700
Utilities 9,000
Total Expenses 97,200
Net Income 15,800

2.3.2 BALANCE SHEET
Comparative balance sheet analysis is a method of assessing the trend

of the same items, group of items and computed items in two or more
balance sheets of a same company on different dates. The changes in
periodic balance sheet items reflect the conduct of a business. The
changes can be observed by comparing the balance sheet at the begin-
ning and at the end of a period. These changes can help in forming an
opinion about the progress of an organisation. The comparative bal-
ance sheet has two columns for the data of original balance sheets. A
third column is used to show increases in figures. The fourth column
may be added for giving percentages of increases or decreases. A com-
parative balance sheet can be analysed by:
Ascertaining short-term solvency position/liquidity position/work-
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ing capital position
Ascertaining long-term solvency position
Having a look at the net worth of the company
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Analysing the liquidity position of the company
The following is an example of a balance sheet of a company as of

March 2021:
Liabilities Amount Assets Amount

(in `) (in `)
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Owners Funds Non-current Assets

Capital 12,000 Furniture 15,000
Add Net Profit 19,500 31,500 Current Assets
Non-current Debtors 15,500
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Liabilities
Long-term Loan 5,000 Bank 5,000
Current Liabilities Cash 1,000
Creditors 15,000 Closing Stock 15,000
51,500 51,500
The following particulars are furnished by Mr Suresh, prepare a bal-

ance sheet in an appropriate format.
Capital `5,50,000
Drawings `10,000
Debtors `1,00,000
Creditors `80,000
Loan `20,000

Net profit `1,60,000
Stock at the end `50,000
Plants `1,50,000
Space `1,20,000
Land ` 3,00,000
Goodwill ` 50,000
Furniture and Fixtures `30,000
Mr Suresh
Balance sheet
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As on March 31st, 2021

Capital5,50,000 Fixed assets
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Add: Net profit 1,60,000 Goodwill 50,000
7,10,000 Building 1,20,000
Less: Drawings 10,000 7,00,000 Land 3,00,000
Plant and Machinery 1,50,000

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Furniture and fixture 30,000

Loan 20,000 Closing stock 50,000
Creditors 80,000 Debtors 1,00,000
8,00,000 8,00,000
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3. The elements of financial position are shown in a __________ so

as to give an idea of financial position at two or more periods.
a. Tabular form
b. Graphical form
c. Comparative form
d. Lingual form
ACTIVITY
Make a list of elements that can be compared in the profit and loss
(P&L) statement of an organisation.

PERFORMING VERTICAL STATEMENT

2.4
ANALYSIS
As stated earlier, vertical analysis is a method of analysing financial
statements that list every item as a share of a base figure inside the
statement. The primary line of the statement shows the bottom figure
at 100%, with every following item representing a share of the full. For
example, every line of an income statement represents a percentage of
shares of gross revenue, whereas every line of income statement rep-
resents every money flow or outflow as a share of total money flows.
The following are the steps in vertical statement analysis:
1. Select a financial statement: Firstly, it is important to select the
financial statement that is to be analysed by the organisation.
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In most cases, vertical analysis is done on the current year’s
statement, however, it can also be performed to analyse the
previous year’s statement.
2. Analyse amounts located in the same column of the statement:
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Next, the appropriate column of the statement should be chosen
and the numbers that are located vertically within the column
are looked upon.
3. Calculate each amount as a percentage of a base figure:
Finally, the amounts from the column should be taken and each
amount as a percentage of the base figure having a value of
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100% should be calculated. Thereafter, the ratios to determine

the company’s financial state should be reviewed and necessary
recommendations must be made.
2.4.1 P&L ACCOUNT

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A P&L account shows the annual profit or net loss of a business. The
P&L account may be an element of ultimate accounts. Now, let us
consider a company’s income statement. Assume the company’s net
income is `50,00,000. In this case, `50,00,000 is the base figure, which
has a value of 100%. The company’s utility costs are `50,000. If `50,000
is divided by `50,00,000, the result obtained will be 0.01, which equates
to 1%. Therefore, the company’s utility costs are expressed as 1% of
the base figure. The same process for the rest of the items on the
income statement can be followed, including rent payments, sales and
miscellaneous expenses.
An example of comparative vertical analysis of profit and loss state-

ment is given below:
Amount Percent- Amount Percentage

Particulars
(2022) age (2022) (2022) (2021)
Sales 14,98,000 100% 12,00,000 100%
Cost of goods sold 10,43,000 69.6% 8,20,000 68.3%

Amount Percent- Amount Percentage

Particulars
(2022) age (2022) (2022) (2021)
Gross profit 4,55,000 30.4% 3,80,000 31.7%
Selling expenses 1,91,000 12.8% 1,47,000 12.3%
General Expenses 1,04,000 6.9% 97,400 8.1%
Total operating expenses 2,95,000 19.7% 2,44,400 20.4%
Operating income 1,60,000 10.7% 1,35,600 11.3%
Other income 8,500 0.6% 11,000 0.9%
1,68,500 11.3% 1,46,600 12.2%
Other expenses 6,000 0.4% 12,000 1.0%
Income before income taxes 1,62,500 10.9% 1,34,600 11.2%
Income tax 71,500 4.8% 58,100 4.8%
Net income 91,000 6.1% 76,500 6.4%
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2.4.2 BALANCE SHEET
A balance sheet refers to a financial statement that reports a com-

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pany’s assets, liabilities and shareowner equity at a selected purpose
in time. Let us assume that a company’s total assets are `80,00,000.
This is the base figure, which has a value of 100%. The company’s real
estate is `40,00,000. If ` 40,00,000 is divided by ` 80,00,000, the result
obtained is 0.5, which equates to 50%. Therefore, the company’s real
estate can be expressed as 50% of its total assets and its other assets
add up to the other 50%.
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An example of vertical analysis of a balance sheet is given below:
Amount Percentage Amount Percentage

Particulars
(2022) (2022) (2022) (2021)
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ASSETS
Current assets 5,50,000 48.3% 5,33,000 43.3%
Investment 95,000 8.3% 1,77,500 14.4%
Plant and machinery 4,44,500 39.0% 4,70,000 38.2%
Intangibles 50,000 4.4% 50,000 4.1%
Total Assets 11,39,500 100.0% 12,30,500 100.0%
LIABILITIES
Current liabilities 2,10,000 18.4% 2,43,000 19.7%
Non-Current liabilities 1,00,000 8.8% 2,00,000 16.3%
Total liabilities 3,10,000 27.2% 4,43,000 36%
STOCKHOLDER’S
EQUITY
10% Preferred 1,50,000
Common Shares 5,00,000
Retained Earnings 1,79,500
Total stockholder’s
equity 8,29,500
Total liabilities and
stockholder’s equity 11,39,500

2.4.3 CASH FLOW STATEMENT
A financial document called the cash flow statement (CFS) outlines the
inflow and outflow of a company’s cash and cash equivalents (CCE).
The CFS gauges how effectively a business manages its cash position,
or how successfully it generates cash to cover its debt payments and
finance its operating costs. The balance sheet and the income state-
ment are two of the three primary financial statements, and the CFS
is the third.
An understanding of changes in your cash on hand can be gained from

a cash flow statement. This indicates that it addresses three crucial
facets of your business operations. These are listed below:
Operating activities: These are routine business operations. Rev-
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enue from the sale of goods or services, dividends received by the
company, interest, and other financial receipts are examples of
inflows. Payroll, overhead, taxes, and payments to suppliers and
vendors are examples of outflows.
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Activities related to investing: This includes gains and losses
from investments. Outflows consist of purchases of assets and
loans taken out by your company. Inflows consist of sales from
business assets and payments from loans made by your company.
Financial activities: These involve raising money from outside
sources. Borrowings and the sale of securities issued by your busi-
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ness are both considered inflows.
An example of cash flow statement vertical analysis is as follows:
Cash flow statement

For the year ending March 2022
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Particulars Amount Percentage

Cash flow from operating activities
Net Income 15,00,000
Add: Non cash expenditures:
Depreciation: 10,000
Decrease in account receivables 18,000
Increase in account payable 18,000
Increase in taxes payable 2,000
Less: Decrease in cash:
Increase In Inventory (32,000)
Net cash flow from operating activities (A) 15,16,000 147.75%
Cash flow from Investing Activities
Purchase of Equipment (5,00,000)
Net cash flow from Investing activities (B) (5,00,000) (48.73%)

Particulars Amount Percentage

Cash flow from Financing Activities
Issue of Notes payable 10,000
Net cash flow from financing activities (C) 10,000 0.97%
Net cash flow for financial year march 10,26,000 100.00
2022 (A + B + C)
4. The primary line of the statement shows the bottom figure at

__________, with every following item representing a share of
the full.
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a. 90%
b. 80%
c. 70%
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d. 100%
ACTIVITY
Performing the steps discussed above, perform vertical statement

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analysis of balance sheet of a company.
S 2.5 SUMMARY
Vertical analysis or vertical statement analysis refers to a method
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of analysing financial statements wherein each line item is shown

as a percentage of a base figure within the statement.
Financial statements that embody vertical analysis clearly show
point percentages in a separate column.
Vertical analysis is the most commonly used method for analys-
ing financial statements for a single reporting period, for example,
quarterly. It is done so that accountants can ascertain the relative
proportions of the balances of each account.
Generally, two financial statements are prepared in a comparative
form for financial analysis purposes, namely balance sheet and
income statement (P&L statement).
The steps in vertical statement analysis include selecting a finan-
cial statement, analysing amounts located in the same column of
the statement and calculating each amount as a percentage of a
base figure.

KEY WORDS
Comparative income statement: A document that presents the

results of multiple accounting periods in separate columns
Ratio analysis: A method of comparing line-item data from a
company’s financial statements to reveal insights regarding
profitability, liquidity and operational efficiency
Regression analysis: A set of statistical methods used to esti-
mate relationships between a dependent variable and one or
more independent variables

MCQ
S
1. Which of the following statement is not correct about the vertical
statement analysis?
a. Vertical statement analysis allows an analyst to easily com-
IM
pare financial statements of one company with another
b. Vertical analysis is the most commonly used method for ana-
lysing financial statements for multiple reporting periods
c. Vertical analysis is useful while charting regression analysis
or ratio analysis
d. Vertical analysis enables the accountant to see relative
M
changes in company accounts over a given period of time

2. Which of the following are the advantages of vertical statement
analysis?
a. Vertical statement analysis reflects corresponding changes in
the finances of a particular unit/account/department over a
N
certain period of time

b. Vertical statement analysis is also useful in comparing the
financial statement of a company to the average trends in the
industry
c. Vertical statement analysis is highly effective while compar-
ing two or more companies operating in the same industry
but with different sizes
d. All of these
3. The term __________ reflects the revenues, costs and expenses
incurred in a particular period of time, typically quarter or year.
a. Profit and loss (P&L) statement
b. Balance sheet
c. Cash flow statement
d. Trend statement

4. The first step in vertical statement analysis is to __________.

a. Select a financial statement
b. Analyse amounts located in the same column of the state-
ment
c. Calculate each amount as a percentage of a base figure
d. None of these
5. A balance sheet refers to a financial statement that reports a
company’s __________.
a. Assets
b. Liabilities
c. Shareowner equity
S
d. All of these

?
IM
1. Write a short note on vertical statement analysis.
2. What are the advantages of vertical statement analysis?
3. Briefly describe profit and loss (P&L) statement.
4. What do you understand by the term comparative balance sheet
analysis?
M
5. What are the steps in performing vertical statement analysis?

2.8
(HOTS) QUESTIONS
1. Assume the company’s net income is `80,00,000 (base figure
N
having a value of 100%) and utility costs are `80,000. What

percentage the company’s utility costs be expressed of the base
figure?
a. 1%
b. 2%
c. 3%
d. 4%
2. Assume that a company’s total assets are `40,00,000 (base
figure, which has a value of 100%). The company’s real estate
is `20,00,000. What percentage will the company’s real estate be
expressed of its total assets?
a. 60%
b. 50%
c. 70%
d. 80%

Topic Q. No. Answer

Introduction to Vertical Statement 1. a. Single reporting period
Analysis
2. b. Vertical analysis
Types of Comparative Statements 3. c. Comparative form
Performing Vertical Statement 4. d. 100%
Analysis
S
Q. No. Answer
1. b. Vertical analysis is the most commonly used method for
IM
analysing financial statements for multiple reporting
periods.
2. d. All of these
3. a. Profit and loss (P&L) statement
4. a. Select a financial statement
5. d. All of these
M

1. Vertical analysis or vertical statement analysis refers to a method
of analysing financial statements wherein each line item is shown
as a percentage of a base figure within the statement. Refer to
N
Section 2.2 Introduction to Vertical Statement Analysis

2. Vertical analysis simplifies the correlation between single items
on a balance sheet and the bottom line. Refer to Section 2.2
Introduction to Vertical Statement Analysis
3. The term profit and loss (P&L) statement reflects the
revenues, costs and expenses incurred in a particular period
of time, typically quarter or year. Refer to Section 2.3 Types of
Comparative Statements
4. Comparative balance sheet analysis is a method of assessing
the trend of the same items, group of items and computed items
in two or more balance sheets of a same company on different
dates. Refer to Section 2.3 Types of Comparative Statements
5. Selecting a financial statement, analysing amounts located in the
same column of the statement and calculating each amount as
a percentage of a base figure. Refer to Section 2.4 Performing
Vertical Statement Analysis


QUESTIONS
Q. No. Answer
1. a. 1%
2. b. 50%
SUGGESTED READINGS
Financial Statement Analysis. New Delhi: New Century Publica-
tions.
S
E-REFERENCES
Vertical Analysis. (2022). Retrieved 10 April 2022, from https://cor-
IM
poratefinanceinstitute.com/resources/knowledge/accounting/verti-
cal-analysis/
M
N

C H A
3 P T E R
UNDERSTANDING OF ANNUAL REPORTS
S
CONTENTS
3.1 Introduction
3.2 Meaning of Annual Reports
IM
3.2.1 Sections of Annual Report
Activity
3.3 Summary
M

N

ANNUAL REPORT CAN REVEAL THE SECRETS A COMPANY

WANTS TO HIDE
Generally, people who invest on the basis of tips invest blindly.

Case Objective But even investors who study the fundamentals of companies
The case let explains the before buying stocks usually restrict the research to basic details
importance of annual report. such as revenues, net profit, Earnings Per Share (EPS) and Price
to Earnings Ratio (PE ratio). This information is available in the
quarterly numbers declared by companies, so most investors do
not feel it necessary to read the bulky annual report that comes
once in a year. However, experts say that reading annual reports
is necessary because they contain a lot of information that is not
available otherwise.
S
The annual report is a bulky document, sometimes running into
180-200 pages. Experts say one should read the full document.
“Investors should go through each line of the annual report,” says
Daljeet S. Kohli, Director & Head of Research, India Nivesh Secu-
IM
rities. To begin with, focus on the first part of the report. “Most
companies give financial highlights of the past 10 years. While
these numbers may not be of much use to institutional investors,
they are useful for retail investors to understand how the com-
pany has grown in the past,” says Anand Shah, Deputy CEO
& CIO, BNP Paribas Mutual Fund. “Read the notice because it
gives a lot of information and sets the agenda of the annual gen-
M
eral meeting. Investors should also read the chairman’s speech

that gives a clear vision about the future and the directors’ report
(along with management discussion and analysis) which explains
current business structure before going to the net profit figure,”
says Deven Choksey, Managing Director, KR Choksey Securities.
N
Other experts also highlight the importance of the management

discussion. “The management discussion tells where the com-
pany is headed in future,” says Kunj Bansal, Executive Director &
CIO, Centrum Capital. “Management commentary is very import-
ant because they usually talk about plans for the next 3-5 years,”
says Anand Shah of BNP Paribas Mutual Fund. Investors should
also read notes to accounts, schedules, cash flow statements, etc.,
also because they give information in more detail.
Source: https://economictimes.indiatimes.com/wealth/invest/annual-report-can-reveal-
the-secrets-a-company-wants-to-hide-heres-how-to-uncover/articleshow/59190442.cms

UNDERSTANDING OF ANNUAL REPORTS 39
LEARNING OBJECTIVES

>> Explain the meaning of annual report
>> Discuss the importance of annual report
>> Describe the different sections of an annual report
3.1 INTRODUCTION
In the previous section, you have studied the significance of vertical Quick Revision
statement analysis. In this chapter, you will study about the various
aspects of annual reports.
S
The annual report of a company provides information on the perfor-
mance of the company’s business to shareholders, stakeholders, the
media and community in a fiscal year. Annual reports provide infor-
mation on the company’s mission and history and summarise the com-
IM
pany’s achievements in the past year. While financial achievements
are included, other achievements also are noted such as research
advances, market share gains or honours awarded to the company or
its employees.
In this chapter, you will study about annual report, its importance and
different sections.
M
3.2 MEANING OF ANNUAL REPORTS

An annual report is a document that all public corporations must
provide annually to the shareholders that best describes their oper-
N
ations and financial conditions. Annual reports became a regulatory

requirement for all public companies following the stock market crash
of 1929, when all the lawmakers mandated standardised corporate
financial reporting. Typically, an annual report will then contain the
following information:
General corporate information
Operating and financial highlights
All letters to the shareholders from the CEO
Management’s discussion and analysis MARK IT!
Financialstatements, including the balance sheet, income state- The annual report of a company
is assumed to be official. Thus,
ment and cash flow statement any misrepresentation of facts
Notes to financial statements in the annual report can be held
against the company. An annual
Auditor’s report report contains the auditor’s
notes certifying the sanctity of
Summary of financial data the financial data included in the
annual report.
Accounting policies

3.2.1 SECTIONS OF ANNUAL REPORT
Annual reports are publications that are issued annually with the
primary objective of sharing the information with shareholders and
investors of a company, apart from the reasons related to regulatory
compliance. Annual reports share vital information on a company’s
operations and financial conditions. The different sections of an
annual report of a company are:
GENERAL CORPORATE INFORMATION
The general corporate information section provides an overview of

what the company does. The general corporate information section
includes the following information:
S
Vision and mission: Vision and mission statements are of high
value as they make their own way for discussions about how well
or not the organisation is actually doing in fulfilling that mission
IM & vision.
Corporate information: Corporate information includes the
details of management officials and others associated with the
company such as their directors, bankers, auditors and registered
and corporate offices.
Product overview: This section provides details about the prod-
M
ucts that are offered by the company and data on each segment’s
performance of last few years.
Report on corporate governance: This report explains a set of
rules, policies and practices that dictate how a company’s board of
directors manages and oversees the business operations.
N
OPERATING AND FINANCIAL HIGHLIGHTS
This section summarises the key financial details of a company. These

details may include:
Acquisition summaries
Dividends
Earnings per share

Liquidity statistics
Money flows
New product performance
Performance statistics
Profitableness
Revenues

MANAGEMENT’S DISCUSSION AND ANALYSIS
MD&A is the key section that demonstrates the company’s commit-

ment to its vision and mission. It additionally includes activities admin-
istrated by operational departments of the company like Board of
Directors, chief officer and alternative chiefs, their reportage officers/
controllers of varied departments– human resources (people), finance
and selling, production and operations, etc., and the remaining mid-
dle and lower management levels. The main objective of MD&A is to
address the investor’s perception of the risks related to the corporate.
LETTER TO SHAREHOLDERS FROM THE CEO
An investor letter is written by a firm’s prime executives to any or
S
all its shareholders. The letter usually covers the firm’s basic mone-
tary results and its current position in the market. It may also speak
of particular events that have happened throughout the year. It is a
IM
likelihood for all of the executives of a firm to talk on to all sharehold-
ers. The investor letter is then usually written once per annum and is
enclosed at the start of the firm’s annual report.
FINANCIAL STATEMENTS
Financial statements are written records that convey business activ-

M
ities and the financial performance of the whole company. Financial

statements are often audited by government agencies, accountants,
firms, etc. to ensure accuracy for tax, financing or investing purposes.
Financial statements also include:
Balance sheet
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Income statement
Cash flow statement
Example 1:
Trial Balance of Ankit

As on March 31, 2022
Particular L.F Debit Credit

Cash in hand 1,000
Cash at bank 5,000
Wages for workers 8,000
Salaries 25,000
Furniture 15,000

Particular L.F Debit Credit

Rent of building 13,000
Debtors 15,500
Bad debts 4,500
Purchases 75,000
Equity 12,000
Sales revenue 1,25,000
Sundry creditors 15,000
Long-term loan 5,000
S
Commission 5,000
Total 1,62,000 1,62,000
Additional information:
IM
1. The stock at the end of the year is ` 15,000
2. Wages worth 500 is outstanding
3. Salary worth 5,000 is prepaid
4. Commission was accrued for 1,500
Prepare the Trading account, P&L account and balance sheet of

M
Ankit.
Solution:
Trading and P&L account of Ankit

N
for the year ended March 31, 2022
Particulars Amount Particulars Amount
Purchases 75,000 Sales 1,25,000

Wages for employees 8,000 Closing stock 15,000
Add: Outstanding wages 500
Gross profit 56,500
1,40,000 1,40,000
Salaries 25,000 Gross profit 56,500

Less: Prepaid salaries (5,000) Commission 5,000
Rent of building 13,000 Add: Accrued commission 1,500
Bad debts 4,500
Net profit (Transferred to 25,500
Ankit’s capital account)
63,000 63,000

Balance sheet of Ankit

as at March 31, 2022

Equity Fixed assets
Capital12,000 Furniture 15,000
Add: Profit 25,500 37,500 Current assets
Non-current liabilities Debtors 15,500
Long-term loan 5,000 Prepaid salary 5,000
Current Liabilities Accrued commission 1,500
Creditors 15,000 Bank 5,000
Outstanding wages 500 Cash 1,000
Closing stock 15,000
S
58,000 58,000
Cash flow example:

IM
Example 2: With the help of the following balance sheet and income
statement of Ashima ltd., Prepare a cash flow statement as per the
appropriate accounting standard.
Liabilities 1.1 2021 31.12.2021 Assets 1.1 2021 31.12.2021
Share capital 180,000 2,22,000 Non-Current

assets:
M
Profit of the year 75,900 81,900 Land 24,000 48,000
Sundry Creditors 120,000 1,17,000 Building 1,80,000 2,88,000
Out. expenses 12,000 24,000 Current Assets:

N
Provision for tax 6,000 6,600 Cash 30,000 36,000
Building 60,000 66,000 Debtors 84,000 93,000

depreciation
Stock 137,000 48,000
Advances 8,900 4,500
4,53,900 5,17,600 4,53,900 5,17,600
Information: The building cost 36,000 was sold during the year.
Profit and loss account

For the year ended 31.12.2021

Cost of sales 9,90,000 Net sales 12,60,000
Wages 1,20,000
Gross Profit 1,50,000


12,60,000 12,60,000
Operating Exp. 40,000 Gross Profit 1,55,000
Depreciation 30,000 Profit on sales of building 6,000
Provision for tax 44,000
Net profit 42,000
1,56,000 1,56,000
Proposed dividend 36,000 Balance b/d 75,900
Profit carried to 81,900 Net profit 42,000
balance sheet
S
1,17,900 1,17,900
Solution
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Cash flow statement of Ashima Ltd.
For the year ending on 31.12.2021

(1) Cash flow from operating activities
Profit before tax 1,10,000
M
Add/Less: Working capital changes

Inc. in outstanding expenses 12,000
Inc. In debtors (9,000)
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Inc. in advances (600)

Dec. in stock 84,000
Dec. in creditors (3,000)
Cash flow from operating activities 1,93,400
Less: Taxes 43,400
Net cash from operating activities (A) 1,50,500
(2) Cash flow from investing activities

Land purchase (24,000)
Building purchase (1,44,000)
Building sale 18,000
Net cash flow from Investing activities (B) (1,50,000)


(3) Cash flow from financing activities
Fresh issue of equity 42,000
Dividend payment (36,000)
Net cash flow from financing activities (C) 6,000
Total increase/decrease in cash and cash 6,000
equivalents (A+B+C)
Add: Opening balance for cash and bank 30,000
Closing Cash equivalents balance 36,000
Provision for tax A/C
S
Bank (Tax paid) 43,400 Balance b/d 6,000
IM
Balance c/d 6,600 P & L A/C 44,000
50,000 50,000
Building A/C

M
Balance b/d 1,80,000 Depreciation 24,000

P&L A/C 6,000 Bank 18,000
Bank 1,44,000 Balance c/d 2,88,000
3,30,000 3,30,000
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Depreciation Account (Building)

Building 24,000 Balance b/d 60,000
Balance c/d 66,000 P&L A/c 30,000
90,000 90,000
Adjusted Profit and loss account

Provision for tax 44,000 Balance b/d 75,900
Provision for building 30,000 Profit on building sale 6,000
dep. Adjusted Profit 1,10,000
Dividend payment 36,000
Balance c/d 81,900
90,000 90,000

DIRECTOR’S RESPONSIBILITY STATEMENT
Financial reporting is necessary for companies as it then provides all

the details of the company and its compliance with all financial, corpo-
rate social responsibility and accounting standards. All public and pri-
vate limited companies file a financial document called the directors’
report at the end of the complete financial year. The directors’ report
is prepared by the Board of Directors of the company and is attached
to every financial statement. It then outlines the financial state of the
company.
NOTES TO FINANCIAL STATEMENTS
For any large organisation, financial statements may be complex and

may include an extensive set of all footnotes to all of the financial
S
statements. The notes typically then describe each item on the main
balance sheet, income statement and cash flow statement. Notes to
all of the financial statements are then considered an integral part of
financial statements.
IM
AUDITOR’S REPORT
Auditor’s reports are basically considered to be important tools when

reporting financial information to the users, particularly in all of the
business. Many of the third-party users prefer or even they require
all financial information to be certified by an independent external
auditor. Creditors and investors then use audit reports from Supreme
M
Audit Institutions to make decisions on financial investments.
ACCOUNTING POLICIES
Accounting policies are the specific principles and procedures imple-

N
mented by a company’s management team that are then used to pre-

pare all its financial statement. These policies include accounting
methods and measurement systems and procedures for presenting all
disclosures.
SUMMARY
A summary presents the major elements discussed in the annual

report. The main goal is to list all key points discussed so the reader
do not have to dig through the report for more information. The sum-
mary should provide a complete idea of what the report entails.
FINANCIAL RATIOS
Calculation of financial ratios helps in the financial statement analy-

sis. The following ratios are helpful in summarising the financial state-
ment of any business organisation:
1. Liquidity ratios
2. Profitability ratios

3. Solvency ratios
4. Activity ratios
Example 3: Calculate the Trade receivables turnover ratio from the

following information:
Total Revenue from operations 4,00,000
Cash Revenue from operations 20% of Total Revenue from operations
Trade receivables as at 1.4.2014 40,000
Trade receivables as at 31.3.2015 1,20,000
Solution:
S
Trade Receivables Turnover Ratio = Net Credit Revenue from Oper-
ations / Average Trade Receivables
IM
Credit Revenue from operations = Total revenue from operations −
Cash revenue from operations
Cash Revenue from operations = 20% of 4,00,000
= 4,00,000 × 20 / 100 = 80,000
Credit Revenue from operations = 4,00,000 − 80,000 = 3,20,000

M
Average Trade Receivables = Opening Trade Receivables + Closing

Trade Receivables / 2
= 40,000 + 1,20,000 / 2 = 80,000

N
Trade receivable turnover ratio = Net Credit Revenue Form Oper-

ations / Average Inventory
= 3,20,000 / 80,000 = 4 times
Example 4: Calculation of profitability ratios:
Given the following information:
Revenue from Operations 3,90,000
Cost of Revenue from Operations 1,50,000
Selling expenses 80,000
Administrative Expenses 40,000
Calculate Gross profit ratio and Operating ratio.

Solution:
Gross Profit = Revenue from Operations − C

ost of Revenue from
Operations
= 3,90,000 − 1,50,000
= 2,40,000
Gross Profit Ratio = Gross Profit / Revenue from operation × 100
= 2,40,000 / 3,90,000 × 100
= 61.5%
Operating Cost = Cost of Revenue from Operations + Selling Expenses
S
+ Administrative Expenses
= 1,50,000 + 80,000 + 40,000 = 2,70,000

IM
Operating Ratio = Operating Cost / Net Revenue from Operations
× 100
= 2,70,000 / 3,90,000 × 100 = 69.23%
Example 5:
M
Calculate the amount of diluted EPS of ABC ltd.

Net income 1,10,00,000
Preferred dividends 10,00,000
Number of shares outstanding 2,00,00,000
N
Employee stock options 50,00,000

Convertible bonds 1,50,00,000
Solution:
Diluted EPS =
(Net income – Preferred dividend)/(Outstanding
Shares + Diluted shares
= ( 1,10,00,000 – 10,00,000)/2,00,00,000 + 50,00,000 +

1,50,00,000)
=1,00,00,000/4,00,00,000 = 0.25 or 25%
You can have a look at the Integrated Annual Report of Reliance

Industries for the financial year 2020-21 by visiting the following
link:
Source: https://www.bseindia.com/bseplus/AnnualReport/500325/68509500325.pdf

1. __________ includes the details of management officials and

others associated with the company such as their directors,
bankers, auditors and registered and corporate offices.
a. Corporate information
b. Product overview
c. Report on corporate governance
d. Vision and mission
2. The main objective of __________ is to address the investor’s
perception of the risks related to the corporate.
S
a. MD&A
b. Investment detailing report
c. Earnings per share
d. Letter
IM
3. An __________ is usually written once per annum and is
enclosed at the start of the firm’s annual report.
a. Investment detailing report
b. Earnings per share
M
c. MD&A
d. Investor letter
4. The __________ is prepared by the Board of Directors of the
company and is attached to every financial statement. It then
outlines the financial state of the company.
N
a. Directors’ report
b. Balance sheet
c. Income statement
d. Cash flow statement
ACTIVITY
Find the annual report of a company and look at its sections and the
information provided in those sections.
3.3 SUMMARY S
An annual report is actually a document that all public corpora-
tions must provide annually to the shareholders that best describes
their operations and financial conditions.

Annual reports are publications that are issued annually with the
primary objective of sharing the information with shareholders
and investors of a company, apart from the reasons related to reg-
ulatory compliance.
The main sections of an annual report includes General Corporate
Information, Operating and Financial Highlights, Management’s
Discussion and Analysis, Letter to Shareholders from the CEO,
Financial Statements, Director’s Responsibility Statement, Notes
to Financial Statements, Auditor’s Report, Accounting Policies
and Summary.
KEY WORDS
Earnings Per Share (EPS): A company’s profit divided by the
S
outstanding shares of its common stock
Financial reporting: A set of standard practices of giving stake-
holders an accurate depiction of a company’s finances, such as
IM revenues, expenses, profits, capital, and cash flow, as formal
records that provide in-depth insights into financial informa-
tion
Management discussion and analysis (MD&A): A section in a
company’s annual report or quarterly filing where executives
analyse the company’s performance
M

MCQ 1. Annual reports became a regulatory requirement for all public
companies following the stock market crash of __________.
N
a. 1919
b. 1929
c. 1939
d. 1949
2. Which of the following information does an annual report
contain?
a. General corporate information
b. Operating and financial highlights
c. All letters to the shareholders from the CEO
d. All of these
3. Vision and mission is the part of __________.
a. General corporate information
b. Operating and financial highlights

c. Management’s discussion and analysis

d. Letter to shareholders from the CEO
4. __________ includes the details of management officials and
others associated with the company.
a. Vision and mission
b. Report on corporate governance
c. Corporate information
d. Product overview
5. Acquisition summaries, dividends, earnings per share, etc., are
the part of __________ section of an annual report.
a. Operating and financial highlights
S
b. Management’s discussion and analysis
c. Director’s responsibility statement
d. Notes to financial statements
IM
6. __________ are basically considered to be important tools when
reporting financial information to the users, particularly in all of
the business.
a. Auditor’s reports
b. Accounting policies
M

d. Corporate information
7. A __________ presents the major elements discussed in the
annual report.
N
a. Accounting policies
b. Management’s discussion and analysis
c. Corporate information
d. Summary
8. All public and private limited companies file a financial document
called the __________ at the end of the complete financial year.
a. Directors’ report
b. Balance sheet
d. Income statement

?
1. What do you mean by annual report?
2. Write a short note on the general corporate information section
of an annual report.

3. Explain operating and financial highlight section.

4. What do you mean by director’s responsibility statement?
5. Discuss accounting policies section.

3.6
(HOTS) QUESTIONS
1. You have an annual report of a company wherein you are looking
at activities administrated by operational departments of the
company such as the Board of Directors, Chief Executive Officer
and alternative chiefs. Which section of the annual report are
you exactly looking at?
a. Financial statements
S
b. General corporate information
c. Management’s Discussion and Analysis
d. Director’s responsibility statement
IM
2. An investor wants to look at liquidity statistics of a company.
Which section of the annual report should the investor look at?
a. Financial statements
b. General corporate information
M
d. Operating and financial highlights

N
Topic Q. No. Answer

Meaning of Annual Reports 1. a. Corporate information
2. a. MD&A
3. d. Investor letter
4. a. Directors’ report
Q. No. Answer
1. b. 1929
2. d. All of these
3. a. General corporate information

Q. No. Answer
4. c. Corporate information
5. a. Operating and financial highlights
6. a. Auditor’s reports
7. d. Summary
8. a. Directors’ report

1. An annual report is actually a document that all public
corporations must provide annually to the shareholders that
S
best describes their operations and financial conditions. Refer to
Section 3.2 Meaning of Annual Reports
2. The general corporate information section provides an overview
of what the company does. Refer to Section 3.2 Meaning of
IM
Annual Reports
3. The operating and financial highlight section summarises the
key financial details of a company. Refer to Section 3.2 Meaning
of Annual Reports
4. The directors’ report is prepared by the Board of Directors of the
company and is attached to every financial statement. Refer to
M
Section 3.2 Meaning of Annual Reports

5. Accounting policies are the specific principles and procedures
implemented by a company’s management team that are then
used to prepare all its financial statement. Refer to Section 3.2
Meaning of Annual Reports
N
ANSWER FOR HIGHER ORDER THINKING SKILLS (HOTS)

QUESTIONS
Q. No. Answer
1. c. Management’s Discussion and Analysis
2. d. Operating and financial highlights
SUGGESTED READINGS
Financial Statement Analysis.. New Delhi: New Century Publica-
tions.

E-REFERENCES
Investopedia. 2022. Writing and Reading an Annual Report.
[online] Available at: <https://www.investopedia.com/terms/a/
annualreport.asp> [Accessed 20 July 2022].
My Accounting Course. 2022. What is an Annual Report? - Defi-
nition | Meaning | Example. [online] Available at: <https://www.
myaccountingcourse.com/accounting-dictionary/annual-report>
[Accessed 20 July 2022].
S
IM
M
N

CASE STUDIES
1 TO 3
CONTENTS
Case Study 1 Ratio Analysis – A Part of Financial Statement Analysis

Case Study 2 Vertical Analysis of XYZ’s Income Statement
Case Study 3 Hidden Information in Company Annual Reports
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CASE STUDY 1
RATIO ANALYSIS – A PART OF FINANCIAL STATEMENT

ANALYSIS
The following figures are extracted from the balance sheets of a

Case Objective company:
The case study explains how 2002 2003 2004
ratio analysis is performed.
Assets
Cash 20,000 11,000 30,000
Inventory 15,000 17,000 20,000
Short-term investments 12,000 15,000 25,000
Accounts receivable 9,000 10,000 15,000
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Land and building 27,000 40,000 50,000
Machinery and equipment 19,000 32,000 20,000
Total Assets 1,02,000 1,25,000 1,60,000
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Liabilities
Paid up capital (` 10 shares - ` 7-50 56, 000 56, 000 56, 000
paid up)
Profit and loss account 10, 000 13, 000 15, 000
Trade Creditors 11, 000 26, 000 39, 000
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Bank 25, 000 30, 000 50, 000

Total Liabilities 1,02,000 1,25,000 1,60,000
Sales 1,00,000 1,50,000 1,50,000

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Gross profit 25, 000 30, 000 25, 000

Net profit 5, 000 7, 000 5, 000
Dividend paid 4, 000 4, 000 3, 000
The opening stock at the beginning of the year 2002-03 was ` 4,000.
QUESTIONS
1. Suppose you are a financial analyst. Comment on the

comparative short-term, solvency, profitability and finan-
cial position of the company during the three year period.
(Hint: Calculate current and quick ratio.)
2. What ratios will be calculated to test the operational effi-
ciency of the company?
(Hint: Debtors turnover ratio and inventory turnover
ratio.)

Case study 2: Vertical Analysis of XYZ’s Income Statement 57
CASE STUDY 2
VERTICAL ANALYSIS OF XYZ’S INCOME STATEMENT
The following is the income statement of XYZ Ltd. over a three-

year period, which will be used as the starting point to do a verti- Case Objective
cal analysis. The case study explains
how to do vertical statement
Income Statement of XYZ Ltd. (All amounts in `) analysis.
Year 1 Year 2 Year 3
Sales 4,00,000 4,25,000 5,00,000
Cost of Goods Sold 1,20,000 1,23,250 2,00,000
Gross Profit 2,80,000 3,01,750 3,00,000
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Salaries 95,000 97,000 1,50,000
Rent 25,000 25,000 25,000
Marketing 20,000 20,000 50,000
Utilities 5,000 5,000 5,000
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Other Expenses 7,500 10,000 8,000
Total Expenses 1,52,500 1,57,000 2,38,000
Net Income 1,27,500 1,44,750 62,000
The company’s sales have grown over this time period, but net
income is down sharply in year three. Salaries and marketing
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expenses have risen, which is logical, given the increased sales.

However, these expenses do not, at first glance, appear large
enough to account for the decline in net income.
To do that, a “common size income statement” will be created

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and vertical analysis will be performed. For each account on the

income statement, the given number will be divided by the com-
pany’s sales for that year.
QUESTIONS
1. In year one, if the company’s “Salaries” expense $95,000

is divided by its sales for that year, $400,000. What result
will appear on the vertical analysis table beside Salaries
for year one?
(Hint: 24%)
2. What can be determined if all elements of the statement
are considered for the vertical analysis of XYZ?
(Hint: Salaries grew as a percentage of sales, a significant
decrease in gross profits, etc.)

CASE STUDY 3
HIDDEN INFORMATION IN COMPANY ANNUAL

REPORTS
A company’s annual report is an ocean of information for inves-

Case Objective tors. From financial figures to salaries of directors and CEOs, it
The case study explains how has all the information an investor is likely to need. It also gives
to find useful information an account of how the company has performed in the preceding
hidden in company annual year and throws light on its future plans.
reports.
“In terms of marketable securities or new offerings, we’ve never
bought anything that’s been pitched to us by an investment bank-
er or broker. We read hundreds and hundreds of annual reports
every year.” - Legendary Investor Warren Buffett.
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A company’s annual report is an ocean of information for inves-
tors. From financial figures to salaries of directors and chief ex-
ecutive officers, it has all the information an investor is likely to
need. It also gives an account of how the company has performed
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in the preceding year and throws light on its future plans.
While the most searched figures in annual reports are sales, net
profit, operating profit and the different financial ratios, there are
a lot of other important points that are ignored by all but the most
seasoned investors and which can tell a lot about a company.
Harsha Upadhyaya, head of equities, Kotak Mutual Fund, says,

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“The statement gives the big picture. It is about the progress in

the preceding year and prospects. Even the goals may be men-
tioned. Overall, it enables investors to understand the strategic
direction of the company.”
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“In fundamental analysis, investors need to keep a close eye on

the way companies keep managements in check and ensure full
financial disclosure and board independence and see to it that
shareholder rights are protected. Good governance can increase
a company’s valuation and positively impact its bottom line,” says
Sunil Goyal, managing director, Ladderup Corporate Advisory.
“Information about management salaries is important and should

be examined in the context of the company’s overall performance.
Market practices, along with industry-specific nuances, need to
be understood for properly interpreting this information,” says
Rakesh Mehta, assistant research manager, Fullerton Securities
& Wealth Advisors.

Case study 3: HIDDEN INFORMATION IN COMPANY ANNUAL REPORTS 59
CASE STUDY 3
QUESTIONS
1. What are the most searched figures in annual reports?

(Hint: Sales, net profit, operating profit and different
financial ratios)
2. How good governance help a company?
(Hint: Increases a company’s valuation and positively
impacts its bottom line)
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C H A
4 P T E R
CONCEPT OF DIRECTOR’S REPORT
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CONTENTS
4.1 Introduction
4.2 Concept of Director’s Report
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4.2.1 Draft Format of Director’s Report
4.2.2 Purpose of Director’s Report
Activity
4.3 Contents of Director’s Report
4.3.1 Contents of Director’s Report as Per Companies Act, 2013
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4.3.2 Contents of Director’s Report as Per Companies (Accounts) Rules, 2014

4.3.3 Additional Contents of Director’s Report for Listing Companies
4.3.4 Penalty for Non-Preparing the Director’s Report
Activity
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4.4 Summary

PERFORMANCE OF ABC PVT. LTD. AS MENTIONED IN

DIRECTOR’S REPORT
The given caselet explains the performance of ABC Pvt. Ltd. as

Case Objective mentioned in its Director’s Report.
The caselet explain how the
performance of a company On a consolidated basis, revenue for the year was `70,215 million
is explained in the director’s signifying a growth of 28.5% in Rupee terms. Revenue increased
report. due to better traction from all the verticals mainly led by Travel
and Hospitality and Hi Tech and Media as well as weakening of
INR against major currencies, mainly US$. Your Company had
349 active customers as on March 31, 2019 as against 338 as on
March 31, 2018. During the year, 23 customers had revenue in
excess of US$ 10 million as against 17 customers previous year.
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Total employee benefit expense has increased by 24%. The increase
is in line with business-growth and increase in head count (March
31, 2019: 20,204, March 31, 2018: 17,723). Other expenses increased
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by 33% in line with revenue and mainly attributable towards travel
expenses, subcontractor expenses, recruitment expenses, lease
rentals and others. Earnings Before Interest, Taxes and Depreci-
ation Allowance (EBITDA) for FY 19 was `10,645 million against
`7,405 million for FY 18 and has grown at 43.8% over the year.
EBITDA margin improved by 160 basis points from 13.6% in FY
18 to 15.2% in FY 19. Employee benefits expense, as a percentage
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to revenue, improved from 65% to 63% due to better utilisation.

Our effective tax rate is at 23.6% when compared to 23.2% in the
previous year. PAT has grown by 32% attributable towards growth
in EBITDA. The standalone results mirror the consolidated
results as the impact of consolidation of subsidiaries results with
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consolidated results is insignificant. Accordingly, the commentary

provided for explaining the company’s consolidated performance
also applies to company’s standalone performance.

CONCEPT OF DIRECTOR’S REPORT 63
LEARNING OBJECTIVES

>> Explain the importance of director’s report
>> Discuss the format of the director’s report
>> Describe the contents of director’s report
>> Summarise the penalty for not preparing director’s report
4.1 INTRODUCTION
In the previous chapter, you have studied about the meaning and sec-
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Quick Revision
tions of annual report in detail.
The requirement for directors’ reports arose out of the need for trans-
parency in company governance. A director’s report is helpful for
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shareholders to seek out problems such as whether or not the corpo-
rate has smart finances, whether or not the market has potential and
whether or not the business has the structural capability to expand
into new opportunities. So as for shareholders to form well-read
choices once casting their votes at annual or different conferences,
the directors’ report provides a part of that essential knowledge.
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A directors’ report should be disclosed to the general public and then

additionally function as a source of supply of public info as a sort
of social accounting. Following its introduction, the reports (under
numerous names) had a rough history.
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In this chapter, you will study about the concept of director’s report
and its format. The applicability and purpose of director’s report will
be discussed. Also, you will study about contents of director’s report
as per Companies Act, 2013 and penalty for non-preparing the direc-
tor’s report.
4.2 CONCEPT OF DIRECTOR’S REPORT

Private limited companies need to provide a set of financial reports
known as statutory accounts at the end of each accounting year. Study
Among these accounts, a directors’ report outlines the financial state Hint
of the company and is produced by the board of directors. In other Reports which make up a
words, a director’s report refers to a financial document that every company’s statutory accounts
other than the director’s
large limited companies needs to file at end of the financial year. report include balance sheet,
profit and loss statement and
Director’s report may be a money revelation created by a director to auditor’s report.
the shareholders of the corporate. It is envisaged to disclose money
standing of the corporate by revealing company’s affairs.

4.2.1 DRAFT FORMAT OF DIRECTOR’S REPORT
Every private limited company registered in India is required to con-

duct an Annual General Meeting (AGM) and file the company’s annual
return with the Ministry of Corporate Affairs. In the company’s AGM,
it is mandatory for the Board of Directors of the company to pres-
ent the director’s report to the shareholders in addition with audited
financial statements and auditor’s report. Let us discuss the Directors
Report Format that is acceptable under Companies Act, 2013.
1. Highlights of Financial Performance: The Company has
recorded the following financial performance, for the year ended
March 31, 20XX:
Year Ended 31st Year Ended 31st

Particulars
March, 20XX March, 20XX
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Total Income
Profit Before Interest,
Depreciation & Tax (EBITDA)
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Finance Charges
Depreciation
Provision for Income Tax
Profit/(Loss) After Tax
Transferred to General Reserve
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Closing Balance
2. Summary of Operations: In Case of Profit

NOTE During the year, the net revenue from operations of your
In the summary of operations, Company increased by ____%, from ` ____ Crores to `____
a company mentions the Crores.
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percentage by which the net

revenue has increased with The Company’s profit after tax stood at ` ____ crore vis-à-
amount. Similarly in the case vis ` _____ crore in the previous year, registering a growth of
of loss during the year and no ______%.
activity during the year.
In Case of Loss
During the year, the net revenue from operations of your
Company decreased by ____%, from ` ____ Crores to ` ____
Crores due to ___________.
The Company’s recorded a loss of `______ in the financial
year ended 31st March, 20XX.
In Case of No Activity
During the year, the company did not commence any oper-
ations. Hence, the company has not recorded any revenue.
The company has charged an amount of ` _____ to the profit
& loss account as expenses which were for setting up of the
business.

3. State of Affairs: The Company is engaged in the business of:

Business Activity 1 MARK IT!
Business Activity 2
Dividend refers to the share
There has been no change in the business of the Company during of profit which is paid to the
shareholders of the company.
the financial year ended 31st March, 20XX.
4. Dividends: In case Dividends were Declared
Your Directors are pleased to recommend a dividend of `XXX
per share for the current financial year. The dividend if approved
and declared in the forthcoming Annual General Meeting would
result a Dividend outflow of `XX and dividend Distribution Tax
of `XX aggregating a total outflow of `XXXX.
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In case Dividends were Not Declared
No dividend was declared for the current financial year due
to conservation of profits and continued investment in the
business.
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No dividends were declared for the current financial year
due to loss incurred by the company.
4. Details of Subsidiaries, Joint Ventures or Associate Companies
(Only if applicable): The Company does not have any Subsidiary,
Joint Venture or Associate Company.
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In case Company has Subsidiaries, Joint Ventures or Associate

Companies
The names of companies which are subsidiaries, joint ventures or
associate companies during the year under review are provided
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below:
S. No. Name of Company Type Remarks

1.
2.
5. Internal Financial Control: The Company has in place adequate

internal financial control with reference to financial statements.
During the year, such controls were tested and no reportable
material weakness in the design or operation was noticed.
6. Directors & Key Managerial Personnel (KMP): There has
been no change in the constitution of Board of Directors during
the year under review i.e. the structure of the Board remains the
same.
In Case of Changes to Board of Directors

The following changes have been made to the Board of Directors

of the Company during the year:
S. Appointment Appointment Date
Name Designation
No. or Resignation or Resignation Date
In view of the applicable provisions of the Companies Act, 2013,

the Company is not mandatorily required to appoint any whole
time KMPs.
7. Meeting of Board of Directors: A total of XX Board Meetings
were held during the financial year ended 31st March 20XX.
The maximum gap between any two Board Meetings was less
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than one 120 days. The names of members of the Board, their
attendance at the Board Meetings are as under:
Number of Meetings Attended/ Total

Name of Directors
Meetings Held
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Ms.____________ XX / XX
Ms.____________ XX / XX
8. Board’s Comment on Auditor’s Report: The observations of the
Statutory Auditors, when read together with the relevant notes
to the accounts and accounting policies are self-explanatory and
do not call for any further comment.
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In case of Adverse Remark or Qualified Report

(Explanation or comment by the Board on every qualification,
reservation, adverse remark or disclaimer made by the statutory
auditor in his report and/or by the secretarial auditor in the
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secretarial Audit Report).

9. Statutory Auditors: The Auditors, M/s. _____________, Chartered
Accountants, Firm Registration No. _________________, hold
office until the conclusion of this Annual General Meeting. The
Directors recommended that M/s._____________, Chartered
Accountants, Firm Registration No. _________________, be
ratified as the Statutory Auditors of the Company at the
forthcoming Annual General Meeting of the Company to hold
office till the conclusion of the next Annual General Meeting of
the Company.
10. Loans and Investment: The Company has not made any
investment, given guarantee and securities during the year
under review. There for no need to comply with provisions of
Section 186 of Companies Act, 2013.
In case Company has made Loans and Investments

Details of Loans, Guarantees and Investments covered under the

provisions of Section 186 of the Companies Act, 2013 are given in
the notes to the Financial Statements.
11. Extract of Annual Return: The extract of Annual Return in Form
No.MGT-9 as required under Section 92 of the Companies Act,
2013, for the financial year ending March 31, 20XX is annexed
and forms part of this report.
12. Related Party Transactions: All related party transactions that
were entered into during the financial year ended 31st March,
20XX were on an arm’s length basis and were in the ordinary
course of business. Therefore, the provisions of Section 188 of
the Companies Act, 2013, were not attracted.
Also, there are no materially significant related party transactions
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during the year under review made by the Company with
Promoters, Directors or other designated persons which may
have a potential conflict with the interest of the Company at
large. Thus, disclosure in Form AOC-2 is not required. However,
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the disclosure of transactions with related party for the year, as
per Accounting Standard-18 Related Party Disclosures is given
in Note no. 24 to the Balance Sheet as on 31st March, 20XX.
In case of existence of related party transactions
The particulars of contracts or arrangements with related
parties referred to in sub section (1) of section 188 entered by the
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Company during the financial year ended 31st March, 20XX is

attached in prescribed Form AOC-2 and forms part of this report.
13. Conservation of Energy and Technology Absorption: The
particulars as required under the provisions of Section 134(3) (m)
of the Companies Act, 2013, in respect of conservation of energy
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and technology absorption have not been furnished considering

the nature of activities undertaken by the company during the
year under review.
In case Company is into manufacturing
The information pertaining to conservation of energy and
technology absorption, as required under Section 134 (3)(m) of
the Companies Act, 2013, read with Rule 8(3) of the Companies
(Accounts) Rules, 2014, is furnished in Annexure and is attached
to this report.
14. Foreign Exchange Earnings and Outgo: The company had a
total foreign exchange earnings and outgo as provided below
during the year ended 31st, March 20XX:
Foreign Exchange Earnings Amount in INR

Foreign Exchange Outgo Amount in INR

15. Risk Management Policy: The Company has developed and

implemented a risk management policy which identifies major
risks which may threaten the existence of the Company. The
same has also been adopted by the Board and is also subject to its
review from time to time. Risk mitigation process and measures
have been also formulated and clearly spelled out in the said
policy.
16. Deposits: The Company has not accepted any deposits during
the year under review.
17. Material Changes and Commitments: No material changes and
commitments affecting the financial position of the Company
occurred between the end of the financial year to which this
financial statement relates and the date of this report.
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In case of any material changes or financial occurrences
The following material changes and commitment occurred
during the year under review affecting the financial position of
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the Company:
Material Change 1
Material Change 2
18. Significant and Material Orders Passed by Regulators, Courts
and Tribunals: No significant and material order has been
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passed by the regulators, courts, tribunals impacting the going

concern status and Company’s operations in future.
In case any orders were passes
The details of a significant material order passed by the Hon’ble
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High Court which may impact the going concern status of the
Company and its future operations is provided in Annexure and
forms part of this report.
19. Corporate Social Responsibility (CSR): The Corporate Social
Responsibility Committee (CSR Committee) of the Company has
formulated and recommended to the Board, a Corporate Social
Responsibility Policy (CSR Policy) indicating the activities to be
undertaken by the Company, which has been approved by the
Board.
During the year, the Company spent an amount of `XXXX
identified as CSR activities. The Annual Report on CSR activities
is enclosed as per prescribed format as Annexure and forms part
of this report.
If CSR Provisions are Not Applicable
CSR provisions are not applicable for the Company.

20. Safe & Conducive Workplace: The Company is committed to

provide a safe and conducive work environment to its employees. NOTE
During the year under review, there were no cases filed pursuant The Sexual Harassment
of Women at Workplace
to the Sexual Harassment of Women at Workplace (Prevention,
(Prevention, Prohibition and
Prohibition and Redressal) Act, 2013. Redressal) Act was passes in
2013 in India to protect women
21. General: Your Directors state that no disclosure or reporting from sexual harassment at their
is required in respect of the following items as there were no place of work.
transactions on these items during the year under review:
1. Issue of shares (including sweat equity shares) to employees
of the Company under any scheme.
2. The Company has no subsidiary and neither the Manag-
ing Director nor the Whole-time Directors of the Company
receive any remuneration or commission from any of its sub-
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sidiaries.
22. Directors Responsibility Statement: Pursuant to Section 134(3)
(c) of the Companies Act, 2013 the Board of Directors of the
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Company confirms that:
1. In the preparation of the annual accounts for the year ended
March 31, 20XX, the applicable accounting standards read
with requirements set out under Schedule III to the Act, have
been followed and there are no material departures from the
same.
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2. The Directors have selected such accounting policies and

applied them consistently and made judgements and esti-
mates that are reasonable and prudent so as to give a true and
fair view of the state of affairs of the Company as at March
31,20XX and of the profit of the Company for the year ended
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on that date.
3. The Directors have taken proper and sufficient care for the
maintenance of adequate accounting records in accordance
with the provisions of the Act for safeguarding the assets of
the Company and for preventing and detecting fraud and
other irregularities. NOTE
1. There are certain additional
4. The Directors have prepared the annual accounts on a ‘going event based disclosures
concern’ basis. mandated to be disclosed as
per the Act. The same may
5. The Company being unlisted, sub clause (e) of section 134(3) be required to be additionally
of the Companies Act, 2013, pertaining to laying down inter- disclosed upon happening of
nal financial controls is not applicable to the Company. the event.
2. All applicable annexure
6. The Directors have devised proper systems to ensure compli- needs to be additionally
ance with the provisions of all applicable laws and that such enclosed as a part of this
system are adequate and operating effectively. report. As mentioned in the
report, some annexure are
23. Acknowledgement: Your Directors would like to express their to be prepared as per the
sincere appreciation for the assistance and co-operation received prescribed format provided in
the Act.

from the customers, employees, banks, Government authorities,

vendors and members during the year under review.
For and on behalf of the Board
Date:
Place:
Director Name: Director Name:

Designation Designation
DIN: DIN:
Address: Address:
4.2.2 PURPOSE OF DIRECTOR’S REPORT
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As per Section 134(3) of the Companies Act, 2013, the administrators
TURN TO THE of an organisation should prepare the directors’ report every year. The
WEB boards’ report or the directors’ report ensures transparency in the
Check the director’s report of
company’s affairs. The information provided by the directors’ report
JK Cement of 2018 from the
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following link: helps shareholders to understand:
https://www.jkcement.com/ What is the health of company’s finances?
frontTheme/pdf/directors_
report17_18.pdf Does the company have the capacity to expand and grow?
How well the company is performing within its market and how
well the market is performing in general?
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Does the company comply with financial regulations, accounting

standards and social responsibility requirements?

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1. The information provided by the directors’ report helps

shareholders to understand:
a. What is the health of company’s finances?
b. Does the company have the capacity to expand and grow?
c. How well the company is performing within its market and
how well the market is performing in general?
d. All of these
2. In the company’s ___________, it is mandatory for the Board
of Directors of the company to present the director’s report to
the shareholders in addition with audited financial statements
and auditor’s report.
a. Sales meeting
b. Marketing meeting
c. Annual general meeting
d. HR meeting

ACTIVITY
Find and analyse the director’s report of any company.
4.3 CONTENTS OF DIRECTOR’S REPORT

Section 134(3) of the Companies Act, 2013 and Rule 8 of the Compa-
nies (Accounts) Rules, 2014, mentions the information to be provided
in the directors’ report. The listed firms ought to add additional dis-
closures provided beneath Rule 5 of the Companies (Appointment and
Remuneration of group action Personnel) Rules, 2014, in their direc-
tor’s report.
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4.3.1 CONTENTS OF DIRECTOR’S REPORT AS PER
COMPANIES ACT, 2013
The Section 134(3) of the Companies Act, 2013, talks about the con-
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tent of the director’s report. The following is the information provided
under the Section:
There shall be attached to statements laid before a company in general

meeting, a report by its Board of Directors, which shall include—
(a) the web address, if any, where annual return referred to in sub-
section (3) of section 92 has been placed]
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(b) number of meetings of the Board;

(c) Director’s Responsibility Statement; details in respect of frauds
reported by auditors under sub-section (12) of section 143 other
than those which are reportable to the Central Government;]
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(d) a statement on declaration given by independent directors under

sub-section (6) of section 149;
(e) in case of a company covered under sub-section (1) of section 178,
company’s policy on director’s appointment and remuneration
including criteria for determining qualifications, positive
attributes, independence of a director and other matters provided
under sub-section (3) of section 178;
(f) explanations or comments by the Board on every qualification,
reservation or adverse remark or disclaimer made—
(i) by the auditor in his report; and
(ii) by the company secretary in practice in his secretarial audit
report;
(g) particulars of loans, guarantees or investments under section 186;
(h) particulars of contracts or arrangements with related parties
referred to in sub-section (1) of section 188 in the prescribed form;

(i) the state of the company’s affairs;

(j) the amounts, if any, which it proposes to carry to any reserves;
(k) the amount, if any, which it recommends should be paid by way of
dividend;
(l) material changes and commitments, if any, affecting the financial
position of the company which have occurred between the end of
the financial year of the company to which the financial statements
relate and the date of the report;
(m) the conservation of energy, technology absorption, foreign exchange
earnings and outgo, in such manner as may be prescribed;
(n) a statement indicating development and implementation of a
risk management policy for the company including identification
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therein of elements of risk, if any, which in the opinion of the Board
may threaten the existence of the company;
(o) the details about the policy developed and implemented by the
IM company on corporate social responsibility initiatives taken
during the year;
(p) in case of a listed company and every other public company having
such paid-up share capital as may be prescribed, a statement
indicating the manner in which formal annual evaluation of
the performance of the Board, its Committees and of individual
directors has been made;
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(q) such other matters as may be prescribed.
(4) The report of the Board of Directors to be attached to the financial

statement under this section shall, in case of a One Person Company,
mean a report containing explanations or comments by the Board on
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every qualification, reservation or adverse remark or disclaimer made

by the auditor in his report.
(5) The Director’s Responsibility Statement referred to in clause (c) of

sub-section (3) shall state that—
(a) in the preparation of the annual accounts, the applicable accounting
standards had been followed along with proper explanation
relating to material departures;
(b) the directors had selected such accounting policies and applied
them consistently and made judgments and estimates that are
reasonable and prudent so as to give a true and fair view of the
state of affairs of the company at the end of the financial year and
of the profit and loss of the company for that period;
(c) the directors had taken proper and sufficient care for the
maintenance of adequate accounting records in accordance with
the provisions of this Act for safeguarding the assets of the company
and for preventing and detecting fraud and other irregularities;

(d) the directors had prepared the annual accounts on a going concern
basis; and
(e) the directors, in the case of a listed company, had laid down
internal financial controls to be followed by the company and that
such internal financial controls are adequate and were operating
effectively.
(f) the directors had devised proper systems to ensure compliance
with the provisions of all applicable laws and that such systems
were adequate and operating effectively.
(6) The Board’s report and any annexures thereto under sub-section (3)
shall be signed by its chairperson of the company if he is authorised by
the Board and where he is not so authorised, shall be signed by at least
two directors, one of whom shall be a managing director or by the direc-
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tor where there is one director.
(7) A signed copy of every financial statement, including consolidated

financial statement, if any, shall be issued, circulated or published along
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with a copy each of—
(a) any notes annexed to or forming part of such financial statement;
(b) the auditor’s report; and
(c) the Board’s report referred to in sub-section (3).
Contravention Sec. 134 (8)
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If a company contravenes the provisions of this section, the company

shall be punishable with fine which shall not be less than fifty thousand
rupees but which may extend to twenty-five lakh rupees and every offi-
cer of the company who is in default shall be punishable with imprison-
N
ment for a term which may extend to three years or with fine which shall
not be less than fifty thousand rupees but which may extend to five lakh
rupees or with both. Source- Section 134 of Companies Act, 2013
Let us start the concept of understanding director’s report with the

help of preparing a profit and loss account.
Example 1: From the following given information, prepare the Profit

and loss account of Ashok trading ltd.
Amount Amount
Particulars Particulars
(Dr.) (Cr.)
Opening stock 20,000 Sales expenses 2,45,000
Cash at bank 5,000 Creditors 10,000
Cash in hand 10,000 Bills Payables 4,000
Carriage expense 1,500 Capital 2,00,000
Purchases 1,90,000
Drawings 9,000

Amount Amount
Particulars Particulars
(Dr.) (Cr.)
Wages 55,000
Machinery 1,00,000
Debtors 27,000
Postage 300
Sundry Expenses 1,700
Rent 4,500
Furniture 35,000
Total 4,59,000 Total 4,59,000
Additional information:
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1. The Closing stock is worth 8,000
2. The wages are outstanding worth 5,000
3. The machinery is depreciated @ 10%
IM
4. Rent is prepaid worth 500
Prepare the Profit and loss account of Ashok trading ltd.
Solution:

M
Opening stock 20,000 Closing stock 8,000

Purchases 1,90,000 Sales 2,45,000
Carriage expenses 1,500 Gross loss 18,500
Wages 55,000
N
Add: Outstanding 5,000

Total 2,71,500 Total 2,71,500
Gross loss 18,500 Net loss 34,500
Postage 300
Sundry expenses 1,700
Rent 4,500
Less: Prepaid (500)
Depreciation 10,000
Total 34,500 Total 34,500
Example 2: From the following information, calculate the financial

ratio of Ashima ltd. That is useful for the director’s report.
Profit before interest and taxes = 10,000
Total assets = 10,00,000
Liabilities = 6,00,000

Solution:
Calculation of Return on capital employed:
Return on capital employed = Profit before interest and taxes/Capital

employed,
Where, capital employed = Total assets – Liabilities
Capital employed = 10,000,000 – 6,00,000 = 4,00,000
Return on capital employed = 10,000/4,00,000 = 0.025 or 2.5%
4.3.2 CONTENTS OF DIRECTOR’S REPORT AS PER

COMPANIES (ACCOUNTS) RULES, 2014
S
Rule 8 of the Companies (Accounts) Rules, 2014, provides that the
board’s report should include the following information:
The directors must prepare the board’s report on the basis of
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stand-alone financial statements of the company
The director’s report must contain a separate section where a
report on the financial position and performance of all associates,
subsidiaries and joint venture companies included in the consoli-
dated financial statements is presented.
The following are the details relating to the conservation of energy:
M
The impact or steps taken on the conservation of energy

The steps taken for the usage of alternate sources of energy
The capital investment in energy conservation equipment
N
Contents of boards’ report as per Companies Act, 2013

The following are the details relating to technology absorption:
The efforts made towards technology absorption
The benefits derived like cost reduction, product development,
product improvement or import substitution
In the case of imported technology, i.e. imported during the
previous three years, details of technology imported, year of
import, whether the technology has been fully absorbed and
the areas and reasons where absorption has not taken place
The expenditure incurred on research and development
The earned foreign exchange in terms of actual inflows during the
year
The outgo foreign exchange during the year in terms of actual out-
flows

The financial highlights or summary

Any changes in the nature of business
The details of key managerial personnel or directors who were
appointed or resigned during the year
The names of companies that have ceased or become its joint ven-
tures, subsidiaries or associate companies during the year
The following details relating to:
Deposits accepted during the year
Unpaid deposits or unclaimed deposits at the end of the year
Default in payment or repayment of deposits or payment of in-
terest during the year, number of such default and the total
S
amount involved at the beginning of the year, maximum during
the year and at the end of the year
Details of deposits that are not in compliance with the require-
IM ments of Chapter V of the Act
The details of material and significant orders passed by the regu-
lators, tribunals or courts impacting the company’s operations in
future and going concern status
The details regarding the adequacy of internal financial controls
concerning the financial statements
M
Example 3: From the following information, prepare the income state-

ment, that must be disclosed in the director’s report of ABC ltd.
31st march 31st March

Particulars
2022 2021
N
Revenue from operations 17,80,000 12,00,000

Cost of Revenue from operations 8,50,000 620,000
Operating expenses 1,00,000 80,000
Interest on the given investment is 40,000 and tax payable is 50%
Solution:

For the years ended 31st March 2021 and 31st March 2022
Absolute Percentage
Particulars 31st 31ST
Note Change Change
March March
no. (Increase/ (Increase/
2022 2021
Decrease) Decrease)
I. Revenue from oper- 17,80,000 12,00,000 5,80,000 48.33
ations
II. Other Income 40,000 40,000 0

Absolute Percentage
Particulars 31st 31ST
Note Change Change
March March
2022 2021
Decrease) Decrease)
III. Total Income (I+II) 18,20,000 12,40,000 5,80,000 48.33

IV. Expenses
Cost of goods sold 8,50,000 620,000 2,30,000 37.09
Operating expenses 1,00,000 80,000 20,000 25.00
Total expenses 9,50,000 7,00,000 2,50,000 35.71
V. Profit before Tax 8,70,000 5,40,000 3,30,000 61.11
(III-IV)
Less: Income Tax 4,35,000 2,70,000 1,65,000 61.11
VI. Profit After tax 4,35,000 2,70,000 1,65,000 61.11
S
Example 4: From the following given information of Review ltd., pre-
pare the Balance sheet in a comparative format, to be used in the
director’s report.
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Particulars 31st 31st
Note
March March
no.
2022 2021

M
a) Share capital 8,20,000 7,00,000
b) Reserves and Surplus 3,00,000 1,50,000
2. Non-current liabilities
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Long-term borrowings 5,10,000 3,50,000

3. Current liabilities
Bills payable 2,40,000 2,00,000
Total 18,70,000 14,00,000
II. Assets
Fixed Assets:
(i) Tangible Assets 5,60,000 4,20,000
(ii) Intangible Assets 4,20,000 3,75,000
2. Current Assets
a) Trade Receivables 6,50,000 2,80,000
b) Cash and cash equivalents 2,40,000 3,25,000
Total 18,70,000 14,00,000

Solution:
Review Ltd.
Comparative Balance Sheet as at 31st march 2021 and
31st March 2022
Absolute Percentage
31st 31st
Note Change Change
Particulars March March
2022 2021
Decrease) Decrease)
a) Share capital 8,20,000 7,00,000 1,20,000 17.14
b) Reserves and 3,00,000 1,50,000 1,50,000 100.00
Surplus
c) Non-current
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liabilities 5,10,000 3,50,000 1,60,000 47.05
Long-term
borrowings 2,40,000 2,00,000 40,000 20.00
d) Current liabilities 18,70,000 14,00,000 4,70,000 33.57
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Bills payable
Total
II. Assets
Fixed Assets:
(iii) Tangible Assets 5,60,000 4,20,000 140,000 33.33
(iv) Intangible Assets 4,20,000 3,75,000 45,000 12.00
M
4. Current Assets
a) Trade Receivables 6,50,000 2,80,000 370,000 132.1
b) Cash and cash 2,40,000 3,25,000 (85,000) (26.15)
equivalents
Total 18,70,000 14,00,000 4,70,000 33.57
N
Example 5: The financial report, to be presented in the director’s

report, is as follows:
The two important financial statements that a director’s report must

contain is a statement of comprehensive income and a balance sheet,
both are shown below:
Statement of comprehensive income
For the year ended 30 June 2022
Particular Note no. 2022 2021

Revenue 19,17,172 18,05,275
Less: Expenses
Employee benefit expense (4,91,292) (3,91,524)
Occupancy expense (2,65,265) (2,16,512)
Consultancy costs (4,75,500) (5,12,516)
Sampling cost (1,11,500) (2,13,512)
IT costs (2,12,255) (1,12,555)
Director’s fees (50,210) (78,512)

Particular Note no. 2022 2021

Surplus/Deficit before income
taxes 1,11,150 2,80,144
Less: Income tax expenses 0 0
Net income 1,11,150 2,80,144
Add: Other comprehensive
income for the year 0 0
Total comprehensive income 1,11,150 2,80,144
Statement of Financial Position

As at 30 June 2022
Particulars Note 2022 2021
S
Current assets
Cash and cash equivalents 6,95,237 5,92,258
Receivables 21,60,327 1,66,851
Other assets 25,02,296 1,549,890
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Total current assets 53,57,860 2,308,999
Non-current assets
Intangible assets 759,189 1,895,280
Property, plant and equipment 696,699 936,685
2,831,965
Total non-current assets 1,455,888 5,140,964
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Total assets 6,813,748

Current liabilities
Payables 2,275,721 2,106,738
Provisions 1,136,661 974,841
3,081,579
Total current liabilities 3,412,382
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Non-current liabilities
Payables 1,217,532 4,320 397,236
Provisions 431,010
Total non-current liabilities 1,648,542 401,556
Total liabilities 50,60,924 3,483,135
Net assets 1,752,824 1,657,829
Accumulated funds
Retained surplus 1,752,824 1,657,829
Total accumulated funds 1,752,824 1,657,829
4.3.3 ADDITIONAL CONTENTS OF DIRECTOR’S REPORT

FOR LISTING COMPANIES
Section 197(12) of the Companies Act, 2013, prescribes that the listed
firms ought to disclose the remuneration quantitative relation of all
administrators to the median employee’s remuneration and such
alternative details within the board’s report.

According to Rule 5 of the Companies (Appointment and Remunera-

tion of Social Control Personnel) Rules, 2014, the board’s report ought
to embrace the subsequent information:
The increase within the share of the remuneration of every chief
treasurer, director, chief military officer, manager or company sec-
retary within the year, if any
The increase within the share within the median remuneration of
the workers within the year
The number of permanent workers on the rolls of the corporate
The explanation on the link between company performance and a
median increase in remuneration
Comparison of the remuneration of the KMP (Key social control
S
personnel) against the performance of the corporate
Variations within the company’s capitalisation and price-earnings
quantitative relation as on the point in time of the present year and
IM former year
Average grade increase created within the employees’ salaries
apart from the social control personnel within the previous year
The key parameters for variable elements of remuneration availed
by the administrators
The remuneration quantitative relation of the very best paid direc-
M
tor to it of the workers World Health Organisation don’t seem to

be administrators however receive remuneration higher than the
very best paid director throughout the year
Affirmation that the remuneration is in step with the remunera-
tion policy of the corporate
N
A statement consisting the name of each worker of the corporate

indicating the following:
Designation of the worker
Remuneration
Nature of employment, whether or not written agreement or oth-

erwise
Experience and qualifications of the worker
Date of commencement of employment
Age of the worker
The last employment control by the worker before connexion the
corporate
The equity shares share control by the worker within the company
Whether such worker could be a relative of manager or director of

the corporate and name of such manager or director

4.3.4 PENALTY FOR NON-PREPARING THE DIRECTOR’S

REPORT
The board’s report or directors’ report and its annexes need to be

signed by the company’s chairperson once the board authorises
them. If the board does not authorise the chairperson, minimum two
directors need to sign the report, one in each of whom ought to be an
administrator. A signed copy of the directors’ report need to be circu-
lated, issued or written on the company’s data processor.
When an organisation defaults at intervals, the preparation of the

board’s report and directors’ report, the company should pay a pen-
alty of `3 lakh and every officer of the company in default should pay
a penalty of `50,000/-.
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3. The board’s report or director’s report and its annexes need

to be signed by the company’s _________ once the board
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authorises them.
a. Chairperson
b. Marketing manager
c. Director
d. Chief Executive Office
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ACTIVITY
Organise a discussion session and discuss the Section 134(3) of the

Companies Act, 2013 in detail.
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4.4 SUMMARY S
A director’s report refers to a financial document that every large
limited companies needs to file at end of the financial year.
In the company’s AGM, it is mandatory for the Board of Directors
of the company to present the director’s report to the shareholders
in addition with audited financial statements and auditor’s report.
As per Section 134(3) of the Companies Act, 2013, the administra-
tors of an organisation should prepare the directors’ report at the
tip of every year.
Section 197(12) of the Companies Act, 2013, prescribes that the
listed firms ought to disclose the remuneration quantitative rela-
tion of all administrators to the median employee’s remuneration
and such alternative details within the board’s report.
When an organisation defaults at intervals, the preparation of
the board’s report and directors’ report, the company should pay

a penalty of `3 lakh and every officer of the company in default

should pay a penalty of `50,000/-.
KEY WORDS
Director’s report: A financial document that larger limited

companies are required to file at end of the financial year
Dividend: The part of profit which is paid to the shareholders
Social control: A set of social processes by which the behaviour
of individuals or groups is regulated

MCQ 1. Private limited companies need to provide a set of financial
S
reports known as _________________ at the end of each accounting
year.
a. Statutory accounts
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b. Balance accounts
c. Savings accounts
d. Current accounts
2. The particulars as required under the provisions of Section 134(3)
(m) of the Companies Act, 2013 are related to _____________ in
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the director’s report.

a. Extract of Annual Return
b. Related Party Transactions
c. Conservation of Energy and Technology Absorption
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d. Foreign Exchange Earnings and Outgo

3. In case a company has made loans and investments, details
of Loans, Guarantees and Investments covered under the
provisions of __________ of the Companies Act, 2013, are given in
the notes to the Financial Statements.
a. Section 185
b. Section 186
c. Section 187
d. Section 188
4. Which of the following statement is related to risk management
policy given in the director’s report?
a. A risk management policy identifies major risks which may
threaten the existence of the company.
b. The Board reviews the risk management policy from time to
time.

c. Risk mitigation process and measures have been also formu-

lated and clearly spelled out in the said policy.
d. The company has not accepted any deposits during the year
under review.
5. Pursuant to Section 134(3) (c) of the Companies Act, 2013 the
Board of Directors of the Company confirms that:
a. The Directors have prepared the annual accounts on a ‘going
concern’ basis.
b. The Company being unlisted, sub clause (e) of section 134(3)
of the Companies Act, 2013 pertaining to laying down inter-
nal financial controls is not applicable to the Company.
c. The Directors have devised proper systems to ensure compli-
S
ance with the provisions of all applicable laws and that such
system are adequate and operating effectively.
d. All of these
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6. The listed firms ought to add additional disclosures provided
beneath ___________ of the Companies (Appointment and
Remuneration of group action Personnel) Rules, 2014, in their
directors’ report.
a. Rule 5
b. Rule 6
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c. Rule 7
d. Rule 8
7. Rule 8 of the Companies (Accounts) Rules, 2014, provides that
the board’s report should include the following information:
N
a. The directors must prepare the board’s report on the basis of

stand-alone financial statements of the company
b. A separate section where a report on the financial position
and performance of all associates, subsidiaries and joint ven-
ture companies included in the consolidated financial state-
ments is presented.
c. The earned foreign exchange in terms of actual inflows during
the year
d. All of these
8. A __________copy of the directors’ report got to be circulated,
issued or written on the company data processor.
a. Signed
b. Sealed
c. Printed
d. None of these

9. Under Section 134(3) of the Companies Act, 2013, the

administrators of an organisation should prepare the directors’
report:
a. One year
b. Four year
c. Every year
d. None of these
10. Dividend is given to whom?
a. Debtors
b. auditors
c. Debenture holders
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d. Shareholders

?
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1. What do you mean by director’s report?
2. Discuss the contents of the director’s report.
3. Is there any penalty in case director does not submit report?
Elaborate.

M
4.7
(HOTS) QUESTIONS
1. The director’s report of ABC Pvt. Ltd. during the year under
review mentioned that there were no cases filed pursuant to
the Sexual Harassment of Women at Workplace (Prevention,
N
Prohibition and Redressal) Act, 2013. Which section of the

director’s report is being talked about?
a. Safe & Conducive Workplace
b. General
c. Directors Responsibility Statement
d. Deposits
2. A director of the corporate has to prepare and submit a same
report back to_________ of the corporate at each annual general
meeting each year so as to take care of transparency within the
company.
a. Directors
b. Financers
c. Shareholders
d. None of these

Topic Q. No. Answer

Concept of Director’s Report 1. d. All of these
2. c. Annual general meeting
Contents of Director’s Report 3. a. Chairperson
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Q. No. Answer
1. a. Statutory accounts
2. c. Conservation of Energy and Technology Absorption

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3. b. Section 186
4. d. The company has not accepted any deposits during the

year under review.
5. d. All of these
6. a. Rule 5
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7. d. All of these
8. a. Signed
9. c. Every year
N
10. d. Shareholders

1. A director’s report outlines the financial state of the company
and is produced by the board of directors. Refer to Section 4.2
Concept of Director’s Report
2. Section 134(3) of the Companies Act, 2013 and Rule 8 of the
Companies (Accounts) Rules, 2014 mentions the information to
be provided in the directors’ report. Refer to Section 4.3 Contents
of Director’s Report
3. When an organisation defaults at intervals, the preparation of
the board’s report and directors’ report, the company should pay
a penalty of `3 lakh and every officer of the company in default
should pay a penalty of `50,000/-.
Refer to Section 4.3 Contents of Director’s Report


QUESTIONS
Q. No. Answer
1. a. Safe & Conducive Workplace
2. c. Shareholders
SUGGESTED READINGS
S
tions.
Riley, R., & Rezaee, Z. (2013). Financial statement fraud. Hoboken,
N.J.: Wiley.
IM
E-REFERENCES
AAFM India is a standard setting body set up by AAFM USA for
Wealth Management(CWM),Equity Analysis, Financial Planning,
Project Management, PMS, Real Estate. (2022). Retrieved 21 April
2022, from https://www.aafmindia.co.in/financial-statement-analy-
sis-tools-limitation-uses-process
M
Bragg, S., & Bragg, S. (2022). Directors’ report definition — Accoun-

tingTools. Retrieved 13 May 2022, from https://www.accounting-
tools.com/articles/directors-report
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C H A
5 P T E R
DISCLOSURE OF ACCOUNTING POLICIES,

AND DEFERRED TAXES
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CONTENTS
5.1 Introduction
5.2 Disclosures of Accounting Policies
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5.2.1 Fundamental Accounting Assumptions
5.2.2 Nature of Accounting Policies
5.2.3 Areas in Which Different Accounting Policies are Possible
5.2.4 Considerations in the Selection of Accounting Policies
5.2.5 Main Principles for Disclosure
5.2.6 Non-compliance of Accounting Policies
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Activity
5.3 Disclosures of Deferred Taxes
5.3.1 Calculating a Deferred Tax Balance
5.3.2 Allocating the Deferred Tax Charge or Credit
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5.3.3 Disclosures
5.3.4 Solved Illustrations
Activity
5.4 Summary

NON-COMPLIANCE OF ACCOUNTING POLICIES
In one of the organisations, the components of Cash and Cash

Case Objective equivalents as reported in the balance sheet included Cash in
Hand, Cash at Bank, Earmarked Balance against LC, Gratuity &
The aim of this caselet is to
describe the non-compliance
Superannuation, etc., Unpaid Dividend Account, Interest accrued
of accounting policies. on Fixed Deposits and the total of these components matches with
the closing cash & cash equivalents as reported in the cash flow
statement.
However, as per paragraph 5.2 of AS 3, it was observed that:

The balance of ‘Cash and cash equivalents’ as reported in the
Cash Flow Statement is same as that in the balance sheet, i.e.,
S
`XXX.
Further, it was noted from the components of cash and cash
equivalents that it includes balances of unpaid dividend,
accrued interest on FDs and earmarked balances against LC,
IM
Gratuity & Superannuation, etc., which are not readily avail-
able with the enterprise for its use, thus the same cannot be
included in ‘Cash and Cash Equivalents’.
M
N

DISCLOSURE OF ACCOUNTING POLICIES, AND DEFERRED TAXES 89
LEARNING OBJECTIVES

>> Explain the disclosures of accounting policies
>> Discuss the fundamental accounting assumptions
>> Describe the nature of accounting policies
>> Analyse the disclosures of deferred taxes
5.1 INTRODUCTION
In the previous chapter, you studied the concept of director’s report Quick Revision
and the contents of director’s report. The requirement for directors’
S
reports arose out of the need for transparency in company governance.
A director’s report is helpful for shareholders to seek out problems
such as whether or not the corporate has smart finances, whether or
not the market has potential and whether or not the business has the
IM
structural capability to expand into new opportunities.
Corporate reporting has become a core business activity. GAAP,

Accounting Standards, Companies Act, 2013, Income-tax Act, 1961,
provides the guidelines for the purpose of Finalisation of Annual
Accounts and thereafter Reports. In India, there are two sets of books
of accounts for financial accounts and other for income tax purpose.
Pre-financial Income derived by Financial Books will differ with Tax-
M
able Income. This difference in taxable liability is temporary imbal-

ance between reported amount of income and its taxable income. This
difference in tax deferred in the books of accounts, according to the
case and is termed as deferred tax.
N
In this chapter, you will study the disclosures of accounting policies,

fundamental accounting assumptions, nature of accounting policies,
areas in which different accounting policies are possible, consider-
ations in the selection of accounting policies, main principles for dis-
closure, non-compliance of accounting policies, disclosures of deferred
taxes, calculating a deferred tax balance, allocating the deferred tax
charge or credit etc. in detail.
DISCLOSURES OF ACCOUNTING
5.2
POLICIES
As you are already aware, information given in financial statements
reveal the financial position of an organisation. However, the profit
or loss of an organisation can be affected by the accounting policies
followed to a large extent. Accounting policies are basically account-
ing principles adopted by an organisation for preparing their financial
statements. The accounting policies followed vary across organisa-
tions. Thus, it is important to disclose significant accounting policies

followed to make financial statements understandable. The disclosure

is required by law in certain cases. In past few years, organisations in
India have adopted the practice of including a separate statement of
accounting policies followed in their annual reports to shareholders.
Some organisations mention about their accounting policies fol-

lowed in the notes to their financial statements, while some mention
accounting policies as supplementary information. There is no con-
sistency in the disclosures among organisations. The purpose of this
standard is to promote a better understanding of financial statements
by establishing the practice of disclosure of significant accounting pol-
icies followed and the manner in which they are disclosed in financial
statements. Such disclosure would also facilitate a more meaningful
comparison between financial statements of different organisations.
S
5.2.1 FUNDAMENTAL ACCOUNTING ASSUMPTIONS
There are certain assumptions that are used in the preparation of

IM
financial statements. They are usually not specifically stated because
they are assumed to be followed. Disclosure is necessary only if they
are not followed. The following have been generally accepted as fun-
damental accounting assumptions:
1. Going concern: An organisation is generally viewed as a going
NOTE concern, which means it will be in continuing operations for the
Going concern assumption is foreseeable future. It is assumed that the organisation has neither
M
necessary for the GAAP i.e.,

Generally Accepted Accounting
the intention nor the necessity of shutting down or reducing the
Principles and International scale of operations.
Financial Reporting Standards
(IFRS).
This assumption is important because it permits for the
acceptable accounting of fixed assets and depreciation. Generally,
the historical cost method for valuation of assets is used as it is
N
assumed that the business is in no danger of being stop working

within the future. If this can be the case, then such assets ought
to be valued at market price. However, within the case of a going
concern, the increase/decrease in costs of assets is considered.
2. Consistency: It is assumed that accounting policies are
consistently followed from one period to another. No frequent
changes are expected. When the accounting treatments and
methodologies stay the same over the years, conclusions can be
drawn regarding the performance of an organisation. However,
this does not mean that entity cannot change accounting policies
to remain relevant with times. This assumption does not fully
command modification.
3. Accrual: Under this assumption, accounting transactions are
recorded within the books of accounts once they occur. This is
often referred to as the mercantilism. Thus, as critical the money
system, in accumulation thought, the revenue or expenditure is
recognised within the year they are completed.

Example 1: What is the accounting equation that is used to satisfy

double entry book keeping system? Explain with the help of numeri-
cal and scenarios.
The accounting equation or balance sheet equation is as follows:
Assets = Liabilities + Capital
Where assets are the resources that a business organisation owns in a

specific accounting period, liabilities are the outside obligations, and
capital is the amount invested by the owners of the organisation.
Let us try to explain this concept with the help of following transac-
tions;
S
Example 1: Put all the following transactions in an accounting equa-
tion format.
i. Commence business with cash `200,000 and Land `50,000.
ii. Bought merchandising for cash `80,000.
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iii. Cash sales of worth `25,000.
iv. Bought goods on credit from Salman of worth `50,000.
v. Sales on account to Ali Raza `12,000.
Solution:
M
S. Liabili-
Assets = + Capital
No. ties
Cash + Inventory + Land + Account
Receivables
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i. 2,00,000 + 0 + 50,000 + 0 0 2,50,000

ii. -80,000 + 80,000 + 0 +0 0 0
iii. 25,000 – 25,000 + 0 +0 0 0
iv. 0 + 50,000 + 0 +0 50,000 0
v. 0 - 12,000 + 0 + 12,000 0 0
Hence following the disclosure and reporting principles of account-

ing, the above transactions satisfies the balance sheet or accounting
equation.
5.2.2 NATURE OF ACCOUNTING POLICIES
There is no single list of accounting policies applicable in all circum-

stances. The differing circumstances in which organisations operate
in a situation of diverse and complex economic activity make alterna-
tive accounting principles and methods of applying those principles
acceptable.

The choice of the appropriate accounting principles and the meth-

ods of applying those principles in the specific circumstances of each
organisation requires considerable judgement by the management of
the organisation.
5.2.3 AREAS IN WHICH DIFFERENT ACCOUNTING

POLICIES ARE POSSIBLE
The following are examples of areas in which different accounting

policies may be adopted by organisations:
MARK IT! Methods of depreciation, depletion and amortisation
Contingent liabilities refer to the
Treatment of expenditure during construction
potential losses that may occur
S
in the coming time or in future Conversion or translation of foreign currency items
depending on the outcome of a
specific event. Valuation of inventories
Treatment of goodwill
IM
Valuation of investments
Treatment of retirement benefits
Recognition of profit on long-term contracts
Valuation of fixed assets
M
Treatment of contingent liabilities
5.2.4 CONSIDERATIONS IN THE SELECTION OF

ACCOUNTING POLICIES
N
The main consideration in the selection of accounting policies by an

organisation is that financial statements should represent a true and
fair picture of the financial position for the period. For this, an organ-
isation adopts the following major considerations related to the selec-
tion and application of accounting policies:
Prudence: In view of uncertainty of future events, profits are not
anticipated but recognised only when earned, though not neces-
sarily in cash. However, provision is made for all known liabilities
and losses even though the amount cannot be determined with
certainty and represents only an estimate.
Substance over form: The accounting treatment and presentation
of transactions and events in financial statements should be gov-
erned by their substance and not merely by the legal form.
Materiality: Financial statements should disclose all “material”
items, i.e., items, the knowledge of which might influence the deci-
sions of the user of the financial statements.

5.2.5 MAIN PRINCIPLES FOR DISCLOSURE
Disclosure of any accounting policies involves disclosure of any affair

or the event that then influence financial statements. Companies
make such disclosures in annual reports as well as various other pub-
lications. The following are the accounting related disclosures made
by organisations:
Financial statements
Balance sheet
Cash flow statement
Retained earnings
Any change in paid-up capital
S
Liabilities
Continuing operations and their results

Net sale
IM
Total profit and loss
5.2.6 NON-COMPLIANCE OF ACCOUNTING POLICIES
Some companies omit to disclose significant accounting policies with

regard to the following:
M
Borrowing costs
Valuation of inventories
Accounting for investments
Employee benefits
N
Accounting for taxes on income

Impairment of assets
Provisions, contingent liabilities and contingent assets
Example 2: Show the following items in the balance sheet as per the
provisions of the Companies Act, 2013 in Schedule III, following all
the principles and standards of Financial disclosure.
Particular Amount Particulars Amount

Preliminary expenses 2,40,000 Goodwill 30,000
Discount on issue of share 20,000 Loose tools 12,000
10% Debenture 2,00,000 Motor vehicles 4,75,000
Stock in trade 1,40,000 Provision for tax 16,000
Cash at bank 1,35,000
Bills receivables 1,20,000

Solution:
Balance sheet extract

As at March 31, 2022
Particulars Note Amount

1. Shareholder’s fund
a. Share capital
b. Reserves and surplus
2. Non-Current liabilities
a. Long-term borrowings 2,00,000
S
3. Current liabilities
a. Other current liabilities
b. Short term provisions 16,000
IM
II. Assets
1. Non-Current Assets
a. Fixed Assets
i. Tangible Assets 4,75,000
ii. Intangible Assets 30,000
M
b. Non-Current Investments
2. Current Assets
a. Inventories 1,52,000
b. Trade Receivables 1,20,000
N
c. Cash and cash equivalents 1,35,000

d. Other current Assets 2,60,000
Example 3: XYZ ltd. is engaged in the Manufacturing business and

uses different machinery, currently the data related to the different
machineries are shown below:
Particulars Cost
Machinery 1 5,00,000
XYZ ltd. follows the practice of charging depreciation using written

down value method, for all fixed assets at the rate of 15%. All the three
machines have useful life of five years. Prepare the machinery account
and depreciation account for all machines for the first three years fol-
lowing the concept of historical cost, going concern and consistency.

Machinery Account
Date Particulars Amount Date Particulars Amount

Year 1 Balance b/d Year 1 Depreciation
Machinery 1 5,00,000 Machinery 1 75,000
Machinery 2 10,00,000 Machinery 2 1,50,000
Machinery 3 12,00,000 Machinery 3 180,000
Balance c/d 22,95,000
27,00,000 27,00,000
Year 2 Balance b/d 22,95,000 Year 2 Depreciation
Machinery 1 63,750
S
Balance c/d 19,50,750
22,95,000 22,95,000
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Year 3 Balance b/d 19,50,000 Year 3 Depreciation
Machinery 1 54,187.5
Machinery 2 1,08,375.0
Balance c/d 16,57,387.5
M
19,50,000 19,50,000.0
Depreciation Account
Date Particulars Amount Date Particulars Amount

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Year Machinery account

1 Machinery 1 75,000 Profit and 4,05,000
Machinery 2 1,50,000 loss account
4,05,000 4,05,000
2 Machinery 1 63,750 Profit and 3,44,250
Machinery 2 1,27,500 loss account
3,44,250 3,44,250
3 Machinery 1 54,187.5 Profit and 2,92,612.5
Machinery 2 1,08,375.0 loss account
2,92,612.5 2,92,612.5

OUTCOMES
It was actually observed that the company in general, may have

then borrowed funds, inventories, investments, employees, taxes on
income & assets which may be then subject to impairment. Further,
there is always a need to then carry certain provisions for meeting the
contingent liabilities. As per Paragraph 24 of AS 1, all of the significant
accounting policies are adopted in the preparation & presentation of
all the financial statements should be disclosed. Accordingly, all the
subject to circumstances, a company is actually expected to disclose
the accounting policies as adopted by it with all in regard to each of
them.
S
1. The __________ of an organisation can be affected by the
accounting policies followed to a large extent.
a. profit or loss
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b. balance and margin
c. trading
d. None of these
2. Disclosure of any accounting policies involves disclosure of
any affair or the event that then influence what?
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a. financial statements
b. financial affairs
c. Dividend
d. Balancesheet
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ACTIVITY
Study in detail the principles for disclosure.
5.3 DISCLOSURES OF DEFERRED TAXES

Taxation in any economy is a complex process as it includes a num-
ber of micro units which make up the entire tax regime of any coun-
try. Taxes levied on individuals and organisations make up the whole
income tax accountable to the government. Deferred tax refers to a
form of tax levied on companies that has:
Either been deducted in advance and is eligible for carrying over
to the subsequent financial years
Or it can be a tax that has been exempted on account of the advance
of an accounting expense

Thus, these two forms of deferred tax are known as Deferred Tax Lia-
bilities and Deferred Tax Assets. Deferred tax can arise as a result of
timing difference or temporary differences in accounting.
DEFERRED TAX ASSET
Deferred tax assets take place when the tax amount is paid or carried
forward but has still not been recognised in the income statement. NOTE
The value of deferred tax assets is created by taking the difference Any deferred tax asset is useful
between the book income and the taxable income. For example, a case in dropping the company’s future
of deferred tax may arise if the tax authority recognises revenue or tax liability.
expenses at different points of time than that set by an accounting
standard.
S
SITUATIONS WHEN DEFERRED TAX ASSETS MAY ARISE
Following are the situations which give rise to deferred tax assets:
Expenses are taken into account by the taxing authority even
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before they are recognised
Revenue earned is taxed even before the time when it should be
recognised
Tax rules or base for assets and liabilities are different
DEFERRED TAX LIABILITY

M
Deferred tax liability arises when there is a difference between what

a company can deduct as tax and the tax that is there for accounting
purposes. A deferred tax liability signifies that a company may in the
future pay more income tax because of a transaction in the present.
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5.3.1 CALCULATING A DEFERRED TAX BALANCE
How all the delayed liabilities work? It is actually calculated because

the company’s anticipated a charge per unit times of all the distinction
between its subject financial gain and accounting earnings before the
taxes. Delayed liabilities that are the quantity of any taxes in an organ-
isation has “underpaid” which is then able to be created up within all
of the future.
5.3.2 ALLOCATING THE DEFERRED TAX CHARGE OR

CREDIT
The approach to allocating the postponed tax charge or even the credit
for the year to the various parts of the financial statements.
All continued operations at intervals of profit or loss
An interrupted operations at intervals of profit or loss

Alternative comprehensive financial gain or equity

Final goodwill
5.3.3 DISCLOSURES
IAS-12 contains all revelation needs. During all this, disclosures are
listed and samples are provided. These disclosures include:
All of the details of the parts of this and delayed tax charge
A reconciliation of all the overall tax charge to the profit which is
increased by the applicable rate
All details of the temporary variations forming the delayed of tax
plus or all of its liability
S
Details of any of the unprovoked delayed tax
Nature of the proof which is supporting the popularity of a delayed
tax plus
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DETAILS OF THE COMPONENTS OF THE CURRENT AND
DEFERRED TAX CHARGE
Word delayed springs from the word ‘Deferments’ which suggests

arrangement for one thing to happen at a later date. Thus, delayed
tax is that the tax for those things that area unit accounted in Profit
& Loss A/c, however, not accounted in assessable financial gain which
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can be accounted in future assessable financial gain and the other way
around. The delayed tax is also a liability or assets because the case is
also. As per AS-22, Current tax is that the quantity of tax determined
to be correctable (recoverable) in respect of the assessable financial gain
(tax loss) for an amount.
N
If we have a tendency to take some advantage of tax sections and pay

less tax in current year, we have a tendency to might got to pay tax in
future thereon advantage being reversed. Within the same manner if
we have to pay a lot of tax by not permitting any expense in current
year, it’ll be allowed in future and in this year tax are reduced. There-
fore, we have a tendency to might get some profit or loss on account of
distinction in book profit and assessable profit.
Expenses amortised within the books over an amount of years how-

ever area unit allowed for tax functions whole within the 1st year. (e.g.,
substantial ad expenses to introduce a product, etc., treated as delayed
revenue expenditure within the books). If we have a tendency to cre-
ate provision of bonus collectable, provident fund contribution, Provi-
sion for employees leave encashment, etc., however do not pay before
filing of come they are disallowed in this year however are allowed
within the year of payment. If we have a tendency to create half pay-
ment out of this before filing of come {that quantity that quantity}
really paid are allowed for tax purpose and therefore the remaining

amount are allowed within the year of payment. This is often referred
to as temporary temporal order distinction. However, if we have a ten-
dency to pay higher than `20,000/- this expense will not be allowed for
tax purpose any time. Thus, this is often permanent distinction.
A RECONCILIATION OF THE TOTAL TAX CHARGE TO THE PROFIT

MULTIPLIED BY THE APPLICABLE TAX RATE
What is postponed Tax plus and postponed liabilities (DTA&DTL)?
Deferred tax assets (DTA) originate when the amount of tax has either
been paid or has been carried forward but it has still not been acknowl-
edged in the statement of income. The actual value of the deferred
tax asset is generated by comparing the book income with the taxable
income. Deferred tax liabilities (DTL), on the other hand originate
S
when a company underpays the amount of taxes due, which it would
eventually pay in the future. These temporary variations square mea-
sure accounted for, recognised and carried forward within the books
of accounts and consequently, postponed tax plus A/c and postponed
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liabilities A/c square measure created.
DETAILS OF THE TEMPORARY DIFFERENCES FORMING THE

DEFERRED TAX ASSET OR LIABILITY
Major distinction between postponed tax plus and postponed tax lia-
bility is shown in Table 5.1:
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Deferred Tax Asset Deferred Tax Liability

When profits as per tax laws are When profits as per tax laws is
more than profits as per books of less than profits as per books of
accounts, a deferred tax asset is also accounts, deferred tax liability is
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required to be created. required to be created.

The creation of deferred tax assets Creation of deferred tax liability
is subject to the principles of is subject to payment of minimum
prudence. Alternative Tax (MAT)
Deferred Tax Asset journal Deferred Tax liability journal
entry entry
Deferred Tax Asset A/c……. Dr Profit & Loss A/c ……. Dr.
To Profit & Loss A/c………. To Deferred Tax Liability A/c……
It is shown under the head of Non- It is shown under the head of Non-
Current Assets in the mentioned Current Liability in the balance
balance sheet. sheet.
Let us consider the example relating to presentation/disclosure of

deferred tax in the balance sheet of a company with Ledger accounts
as follows:
A company, XYZ Ltd., prepares its accounts annually on 31st March.

On 1st April, 2019, it purchases a machine at a cost of `1,50,000. The

machine has a useful life of three years and an expected scrap value
of zero. Although it is eligible for a 100% first year depreciation allow-
ance for tax purposes, the straight-line method is considered appro-
priate for accounting purposes. XYZ Ltd. has profits before depreci-
ation and taxes of `2,00,000 each year and the corporate tax rate is 40
per cent each year. The purchase of machine at a cost of `1,50,000 in
2019 gives rise to a tax saving of `60,000. If the cost of the machine is
spread over three years of its life for accounting purposes, the amount
of the tax saving should also be spread over the same period as shown
below:
Statement of Profit and Loss (for the three years ending 31st March,
2019, 2020, 2021)
(Rupees in thousands)
S
2019 2020 2021
Profit before depreciation and taxes 200 200 200
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Less: Depreciation for accounting purposes 50 50 50
Profit before taxes 150 150 150
Less: Tax expense
Current tax
0.40 (200 – 150) 20
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0.40 (200) 80 80
Deferred tax
Tax effect of timing differences originating
during the year
0.40 (150 – 50) 40
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Tax effect of timing differences reversing

during the year
0.40 (0 – 50) (20) (20)
Tax expense 60 60 60
Profit after tax 90 90 90
Net timing differences 100 50 0
Deferred tax liability 40 20 0
In 2019, the amount of depreciation allowed for tax purposes exceeds

the amount of depreciation charged for accounting purposes by
`1,00,000 and, therefore, taxable income is lower than the accounting
income. This gives rise to a deferred tax liability of `40,000. In 2020
and 2021, accounting income is lower than taxable income because
the amount of depreciation charged for accounting purposes exceeds
the amount of depreciation allowed for tax purposes by `50,000 each
year. Accordingly, deferred tax liability is reduced by `20,000 each in

both the years. As may be seen, tax expense is based on the account-
ing income of each period.
In 2019, the profit and loss account is debited and deferred tax lia-
bility account is credited with the amount of tax on the originating
timing difference of `1,00,000 while in each of the following two years,
deferred tax liability account is debited and profit and loss account is
credited with the amount of tax on the reversing timing difference of
`50,000.
The following Journal entries will be passed:
Year 2019
Profit and Loss A/c Dr. 20,000
S
To Current tax A/c 20,000
(Being the amount of taxes payable for the year 2019 provided for)

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To Deferred tax A/c 40,000
(Being the deferred tax liability created for originating timing differ-
ence of `1,00,000)
Year 2020
M
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Deferred tax A/c Dr. 20,000
To Profit and Loss A/c 20,000
(Being the deferred tax liability adjusted for reversing timing differ-
ence of `50,000)
Year 2021
Deferred tax A/c Dr. 20,000
To Profit and Loss A/c 20,000
(Being the deferred tax liability adjusted for reversing timing differ-
ence of `50,000)

In year 2019, the balance of deferred tax account, i.e., `40,000 would be
shown separately from the current tax payable for the year in terms
of paragraph 30 of the Standard. In Year 2020, the balance of deferred
tax account would be `20,000 and be shown separately from the cur-
rent tax payable for the year as in year 2021. In Year 2022, the balance
of deferred tax liability account would be nil.
In the above illustration, the corporate tax rate has been assumed to
be same in each of the three years. If the rate of tax changes, it would
be necessary for the enterprise to adjust the amount of deferred tax
liability carried forward by applying the tax rate that has been enacted
or substantively enacted by the balance sheet date on accumulated
timing differences at the end of the accounting year. For example, if
in Illustration 1, the substantively enacted tax rates for 2019, 2020 and
2021 are 40%, 35% and 38%, respectively, the amount of deferred tax
S
liability would be computed as follows:
The deferred tax liability carried forward each year would appear in
the balance sheet as under:
IM
31st March, 2019 = 0.40 (1,00,000) = `40,000
31st March, 2020 = 0.35 (50,000) = `17,500
31st March, 2021 = 0.38 (Zero) = `Zero
Accordingly, the amount debited/(credited) to the profit and loss

M
account (with corresponding credit or debit to deferred tax liability)

for each year would be as under: 31st March, 2019 Debit = `40,000 31st
March, 2020 (Credit) = `(22,500) 31st March, 2021 (Credit) = `(17,500)
NATURE OF THE EVIDENCE SUPPORTING THE RECOGNITION OF

N
DEFERRED TAX ASSET
A differed tax asset is an item on a company’s record that reduces its

Study
non-exempt financial gain within the future. Such a point quality is
Hint
found once a business overpays its taxes. This cash can eventually
A differed tax quality will arise be come to the business within the sort of tax relief. Therefore, the
once there square measure overpayment becomes quality to the corporate. A differed tax qual-
variations in tax rules and
accounting rules or once there ity is that the opposite of postponed liabilities that indicates expected
is a carryover of tax losses. increase within the quantity of tax owed by a corporation.
A differed tax quality is item on the record that results from the over-
payment or the advance payment of taxes. It is the alternative of post-
poned liabilities that represents financial gain taxes owed.
5.3.4 SOLVED ILLUSTRATIONS
Illustration 1: ABC Pvt. Ltd. produces washing machines. The com-

pany assumes that the probability of a washing machines being sent
for warranty repairs is 2%. If ABC’s revenue for the financial year

2021 is `10, 00,000, then the following discrepancy arises in the income
statement and the tax authority statement.
Income Statement of Company
Revenue 10,00,000
Warranty Expense 20,000
Taxable Income 9,80,000
Taxes Payable (at 30%) 2,94,000
Statement of Tax Authority
Revenue 10,00,000
Warranty Expense 0
Taxable Income 10,00,000
S
Taxes Payable (at 30%) 3,00,000
In the given illustration, the difference obtained between the two

taxes payable is the deferred tax asset. The deferred tax asset in this
IM
case is (`3,00,000 – `2,94,000) = `6,000.
Illustration 2: Let’s take an example of the same company ABC which

produces washing machines. The company assumes that a manufac-
turing machine that costs `60,000 will last for 3 years and it pays a 30%
tax on profits. However, regular financial accounting will take into
account the `20,000 depreciation per year for the next 3 years. Hence,
M
each year income is reduced by `20,000 and `6,000 reduction in tax.
However, suppose the tax accounting allows depreciation in such a

way that `30,000 is the depreciation in the first year, `20,000 in the
next and `10,000 in the third year. So, for the first year, the company
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can claim `30,000 as depreciation and it gets a tax benefit of `9,000.

Although in doing so it creates a tax liability of:
`9,000 – `6,000 which is:
(Tax that the company should have paid on the basis of accounting) –
(The tax that it actually paid). Here, in this example a deferred tax lia-
bility of `3,000 has been created. This liability, the company will have
to make up for in its future transactions pertaining to taxes.
3. __________ arises when there is a difference between what

a company can deduct as tax and the tax that is there for
accounting purposes.
a. Deferred tax credit b. Deferred tax asset
c. Deferred tax liability d. Deferred tax balance

ACTIVITY
Study the difference between deferred tax asset and deferred tax
liability.
S 5.4 SUMMARY
Information given in financial statements reveals the financial
position of an organisation. However, the profit or loss of an organ-
isation can be affected by the accounting policies followed to a
large extent.
There are certain assumptions that are used in the preparation
of financial statements. They are usually not specifically stated
S
because they are assumed to be followed. Disclosure is necessary
only if they are not followed.
There is no single list of accounting policies applicable in all cir-
cumstances. The differing circumstances in which organisations
IM
operate in a situation of diverse and complex economic activity
make alternative accounting principles and methods of applying
those principles acceptable.
The main consideration in the selection of accounting policies by
an organisation is that financial statements should represent a
true and fair picture of the financial position for the period.
M
Disclosure of any accounting policies involves disclosure of any

affair or the event that then influence financial statements.
Taxation in any economy is a complex process as it includes a
number of micro units which make up the entire tax regime of any
country.
N
Deferred tax assets take place when the tax amount is paid or car-
ried forward but has still not been recognised in the income state-
ment.
Deferred tax liability arises when there is a difference between
what a company can deduct as tax and the tax that is there for
accounting purposes.
KEY WORDS
Accounting policies: The basic accounting principles adopted

by an organisation for preparing their financial statements
Differed tax asset: An item on a company’s record that reduces
its non-exempt financial gain within the future
Deferred tax liability: Arises when there is a difference between
what a company can deduct as tax and the tax that is there for
accounting purposes

Going concern: The organisation will be icontinuing opera-

tions for the foreseeable future
Taxation: A complex process as it includes a number of micro
units

MCQ
1. Some organisations mention about their accounting policies
followed in the notes to their financial statements, while some
mention accounting policies as
a. Supplementary information
b. Complementary information
S
c. Important information
d. None of these
2. An organisation is generally viewed as a __________, which means
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it will be in continuing operations for the foreseeable future.
a. consistency b. going concern
c. accrual d. All of these
3. Which of the following are examples of areas in which different
accounting policies may be adopted by organisations?
M
a. Treatment of expenditure during construction

b. Conversion or translation of foreign currency items
c. Valuation of inventories
d. All of these
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4. Which of the following are accounting related disclosures?

a. Financial statements b. Balance sheet
c. Cash flow statement d. All of these
5. Some companies omit to disclose significant accounting policies
with regard to
a. Borrowing costs
b. Valuation of inventories
c. Accounting for investments
d. All of these
6. Deferred tax assets take place when the tax amount is paid or
carried forward but has still not been recognised in the
a. Income statement b. Balance sheet
c. Profit and loss account d. None of these

7. A differed tax quality is that the opposite of postponed __________

that indicates expected increase within the quantity of tax owed
by a corporation.
a. assets b. liabilities
c. profits d. budget
8. It is shown under the head of Non- Current Liability in the
balance sheet.
a. DTA b. DTL
c. P/L Account d. Loans
9. The deferred tax liability carried forward each year would appear
in the __________.
S
a. Balance sheet b. Long term loans
c. Financial statement d. Ledger
10. Under this assumption, accounting transactions are recorded
within the books of accounts once they occur.
IM
a. Consistency b. Going concern
c. Accrual d. Materiality

? 1. What do you mean by disclosures of accounting policies?
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2. What are fundamental accounting assumptions?

3. What are the areas in which different accounting policies are
possible?
4. Write a short note on deferred tax liability.
N

5.7
(HOTS) QUESTIONS
1. Which of the following is not a fundamental accounting
assumption?
a. Going Concern b. Consistency
c. Accrual d. Materiality
2. __________ accountants will advance into management positions
at a team or company-wide level, looking on the character of the
firm.
a. Public b. Forensic
c. Government d. None of these
3. GAAP stands for __________.
a. Generally Accepted Accounting Principles
b. Globally Accepted Accounting Principles

c. Generally Acknowledged Accounting Principles

d. Generally Accepted Accounting Positions
Topic Q. No. Answer

Disclosures of Accounting Policies 1. a. profit or loss
2. a. financial statements
Disclosures of Deferred Taxes 3. c. deferred tax liability
S
Q. No. Answer
1. a. Supplementary information
2. b. going concern
IM
3. d. All of these
4. d. All of these
5. d. All of these
6. a. Income statement
7. b. liabilities
M
8. b. DTL
9. a. Balance sheet
10. c. Accrual

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1. It is important to disclose significant accounting policies followed

to make financial statements understandable. The disclosure is
required by law in certain cases. Refer to Section 5.2 Disclosures
of Accounting Policies
2. There are certain assumptions that are used in the preparation
of financial statements. They are usually not specifically stated
because they are assumed to be followed. Refer to Section 5.2
Disclosures of Accounting Policies
3. Methods of depreciation, depletion and amortisation, treatment
of expenditure during construction, conversion or translation
of foreign currency items, valuation of inventories, etc. are
examples of areas in which different accounting policies may be
adopted by organisations. Refer to Section 5.2 Disclosures of
Accounting Policies
4. Deferred tax liability arises when there is a difference between
what a company can deduct as tax and the tax that is there

for accounting purposes. Refer to Section 5.3 Disclosures of

Deferred Taxes

QUESTIONS
Q. No. Answer
1. d. Materiality
2. a. Public
3. a. Generally Accepted Accounting Principles
S
SUGGESTED READINGS
IM tions.
Bakker, A., van den Berg, T., & Janssen, B. (2015). Tax Accounting.
Amsterdam: IBFD.
E-REFERENCES
AAFM India is a standard setting body set up by AAFM USA for
M
Wealth Management(CWM),Equity Analysis, Financial Planning,

Project Management, PMS, Real Estate. (2022). Retrieved 21 April
2022, from https://www.aafmindia.co.in/financial-statement-analy-
sis-tools-limitation-uses-process
QuickBooks, A. (2022). Accounting Standard 1: Disclosure of
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Accounting Policies - QuickBooks. Retrieved 13 May 2022, from

https://quickbooks.intuit.com/in/resources/accounting/as-1/

C H A
6 P T E R
INTRODUCTION TO IAS 10 – EVENTS AFTER

THE REPORTING PERIOD
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CONTENTS
6.1 Introduction
6.2 Introduction to IAS 10 (Events after the Reporting Period)
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6.2.1 Meaning and Concept of IAS 10 (Events after the Reporting Period)
6.2.2 Standard History of IAS 10
Activity
6.3 Objectives of IAS 10
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Activity
6.4 Types of Events
6.4.1 Adjusting Events after the Reporting Period
6.4.2 Non-Adjusting Events after the Reporting Period
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Activity
6.5 Disclosure about Events after the Reporting Period
Activity
6.6 Summary

EVENTS AFTER THE REPORTING PERIOD
Events after the reporting period are those events, favourable

Case Objective and unfavourable, that occur between the statement monetary of
This caselet explains the economic position date and therefore the date once the financial
events after the reporting statements are authorised for issue.
period.
Two varieties of events are often identified:
a. People who give proof of conditions that existed at the
statement of monetary position date (adjusting events when
the news period) and
b. People who are indicative of conditions that arose when the
S
statement of monetary position date (non-adjusting events
when the news period).
The method concerned in authorising the money statements for

IM
issue can vary relying upon the management structure, statutory
needs and procedures followed in making ready and finalising the
financial statement.
In some cases, associate entity is needed to submit its money

statements to its shareholders for approval when the financial
statements are issued. In such cases, the money statements are
authorised for issue on the Date of issue, not the date once share-
M
holders approve the money statements.
Let’s take an example.
The management of associate entity completes draft money state-

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ments for the year to thirty one Gregorian calendar months 2021
on 28th.
February 2022. On 18th of March 2021, the main board of adminis-

trators reviews the money statements & then authorises them for
all issue. The entity announces its profit and elite different money
info on 19th March 2022. The financial statements are created
obtainable to shareholders et al. on 1th April 2022.
The money statements are authorised for issue on March 2022

(date of board authorisation for issue).
EC workers consolidated version as of twenty seven Gregorian

calendar months 2009, linear unit – EU IAS 10 for info functions
solely.
In some cases, the management of associate entity is needed to

issue its money statements to a higher-up board (made up exclu-

INTRODUCTION TO IAS 10 – EVENTS AFTER THE REPORTING PERIOD 111
sively of non-executives) for approval. In such cases, the money

statements are authorised for issue once the management autho-
rises them for issue to the higher-up board.
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LEARNING OBJECTIVES

>> Explain what is an event in the scope of IAS-10
>> Discuss an event after completing the reporting period
>> Differentiate between adjusting and non-adjusting events
>> Describe the concept of going concern and its relation to
IAS-10
6.1 INTRODUCTION
Quick Revision In the precious chapter, you studied about the disclosures of account-
S
ing policies and deferred taxes. Corporate reporting has become a
core business activity. GAAP, Accounting Standards, Companies Act,
2013, Income-tax Act, 1961, provides the guidelines for the purpose
of Finalisation of Annual Accounts and thereafter Reports. In India,
IM
there are two sets of books of accounts for financial accounts and
other for income tax purpose. Pre-financial Income derived by Finan-
cial Books will differ with Taxable Income.
Preparing all financial statements takes time. It would not be practi-

cable for preparers to actually finalise all of the financial statements
without a period of time actually elapsing between all of the end of the
reporting period and the date on which whole of the financial state-
M
ments are been authorised for issues. Therefore, the question arises
as to what extent events occurring between the end of the reporting
period and all approvals should be reflected in the financial state-
ments.
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This chapter will explain the appropriate accounting treatment and

the disclosure requirements of all events that can occur between the
end of the reporting period and the date when all the financial state-
ments are been authorised for any issues.
INTRODUCTION TO IAS 10 (EVENTS

6.2
AFTER THE REPORTING PERIOD)
Events after the reporting period are those events, which are favour-
NOTE able and unfavourable that can occur between the end of the report-
Here, IAS stands for ing period and the date when all of its financial statements are autho-
International Accounting rised for issue.
Standards.
IAS-10 events after all the Reporting Period prescribes when an entity
should adjust all its financial statements for the events after the report-
ing period and the main disclosures that an entity should give about
the date and when all of the financial statements were authorised and
about events after the reporting period.

6.2.1 MEANING AND CONCEPT OF IAS 10 (EVENTS AFTER

THE REPORTING PERIOD)
IAS 10 prescribes:
When an entity should be adjusting all of its financial statements
for all the events after the reporting period
The disclosures that an entity should be given about the date when
all of the financial statements were actually authorised for issue
and about all the events after the reporting period.
The two types of events are:

Those that can provide evidence of all conditions that can exist at
the end of all the reporting period (adjusting events) and NOTE
S
Those that are actually indicative of all conditions that can arose Adjusting events also includes
the events that indicates the
after all the reporting period (non-adjusting events). going concern assumption in
relation to the whole or part of
An entity adjusts all of the amounts recognised in its financial state- the company is not appropriate.
IM
ments to then reflect all adjusting events, but what it does is by not
adjusting those amounts to actually reflect non-adjusting events. If at
all non-adjusting events after the reporting period are material, then
IAS-10 prescribes disclosures.
6.2.2 STANDARD HISTORY OF IAS 10

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Standard history
In Gregorian calendar month 2001, the IAS board that adopted IAS
10 Events once the total Balance Sheet Date, that had been originally
been issued by all the IAS Committee in 1999. IAS-10 Events once the
N
most record date replaced and elements of IAS-10 Contingencies &

Events Occurring once the total record Date that was issued in June
1978 which weren’t replaced by IAS thirty seven Provisions & Contin-
gent Assets & Contingent Liabilities (issued in 1998).
And then in Dec 2003, the Board issued a revised IAS-10 with all the
changed title — events once the record date. And this revised IAS-10
was then a part of all the Board’s initial agenda of the technical out- MARK IT!
comes. As a result of these changes in word created by IAS one Pre-
IFRS stands for International
sentation of the monetary Statements in 2007, the title of IAS-10 was Financial Reporting Standards.
then modified to Events after the reporting period. These are accounting standards
that are issued by the IFRS
Other Standards have then created minor important amendments Foundation and the IAS Board.
to IAS-10. They’ll then embody IFRS-13 truthful price measure that
was issued in could 2011), IFRS-9 monetary instruments that was
then issued in Gregorian calendar month 2014 & Definition of fabric
(Amendments to IAS one and IAS-8) that was issued Oct 2018).

1. Which board in Dec 2003, issued a revised IAS-10 with all the
changed title — events once the record date?
a. WHO b. World Bank
c. RBI d. IAS
2. IFRS stands for __________.
a. International Financial Reporting Standards
b. Indian Financial Reporting Standards
c. International Fiscal Reporting Standards
d. International Financial Result Standards
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ACTIVITY
Discuss in group about Standard History of IAS-10 and points for

IM
the same and how it differ now.
6.3 OBJECTIVES OF IAS 10

Objective
The objective of IAS-10 is to prescribe:
M
a. Once associate entity ought to change its monetary statements

for events once the news amount associated.
b. The disclosures that an entity ought to offer concerning the date
once the financial statements were authorised for issue and
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concerning events once the news period.

The target of this customary is to prescribe:
a. once associate entity ought to change its financial statements for
events once the news period and
b. the disclosures that associate entity ought to offer concerning
the date once the financial statements were authorised for issue
and concerning events once the news amount.
The Standard conjointly needs that associate entity should not pre-
pare its financial statements on a going concern basis if events once
the news amount indicate that the going concern assumption is not
acceptable.
Example 1: In few cases, the financial statements of a corporate must

be approved by the shareholders. In these cases, the date of finan-
cial statements should be considered as the date of issue, not the date
on which shareholder’s approve the financial statements. Let’s try to
understand this, with the help of following scenario.

On February 28th, 2020, a company’s management completes the pre-

liminary financial accounts for the fiscal year that ends on December
31th, 2020. The board of directors approves the financial accounts for
release on March 18th, 2022. On March 19th, 2022, the entity releases its
profit and a few other financial details. On April 1st, 2022, the financial
accounts are made available to public to shareholders and others. At
their annual meeting on May 15th, 2022, the shareholders accept the
financial statements. On May 17th, 2022, the approved financial state-
ments are subsequently filed with a regulatory agency.
In this case, the authorised date of financial statement issue is 18th

May, 2022, when the board of directors issue the statements.
Example 2: In few cases, the financial statements must be issued to a

supervisory board, in this case the date of issue is the date on which
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management approve to issue the financial statements to the supervi-
sory date, not on which the supervisory board approves the financial
statements.
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An entity’s management authorises the release of financial statements
to its supervisory board on March 18th, 20X2. The supervisory board
is entirely comprised of non-executives, though it may include con-
tain representatives of the workforce and other external interests. On
March 26th, 20X2, the supervisory board certifies the financial state-
ments. On April 1st, 2020X2, the financial accounts are made public
to shareholders and others. The financial statements are approved by
M
the shareholders at their annual meeting on May 15th, 20X2, and on

May 17th, 20X2, they are submitted to a regulatory authority.
In the given case, the financial statements are authorised to issue on

18th May, 2022, when the management issue it to the supervisory board.
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3. What is the objective of IAS-10?

a. Once associate entity ought to change its monetary state-
ments for events once the news amount.
b. The disclosures that an entity ought to offer concerning
the date once the financial statements were authorised for
issue and concerning events once the news period.
c. Both a. and b.
d. None of these
4. The __________ that associate entity ought to offer concerning
the date once the financial statements were authorised for
issue and concerning events once the news amount.
a. report b. rules
c. disclosures d. None of these

ACTIVITY
Discuss all the main objective of IAS-10 and make a note of it by

diving the class in 2 parts.
6.4 TYPES OF EVENTS

There are two types of events that take place, which are:
Adjusting events
Non-adjusting event
Figure 6.1 shows the adjusting and non-adjusting events:
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Events after the Reporting Period
IM
Adjusting Non-Adjusting
Provide additional evidence Concern conditions which did

of conditions existing at the not exist at the reporting date.
reporting date.
Adjust the financial statements

M
Impact going Do not impact

to reflect the event.
concern. going concern.
Adjust the
Do not adjust
financial
the financial
statements to
statements.
N
present on the
break-up basis.
Disclose by note if
important to users’
understanding
Figure 6.1: Adjusting and Non-Adjusting Events
Let us understand these events in detail.
6.4.1 ADJUSTING EVENTS AFTER THE REPORTING

PERIOD
Adjusting events are events occurring at the end of the reporting

period. What is associate adjusting subsequent event?
1. Adjusting events: An incident that has further data regarding
pre-existing conditions that existed on the record date.

2. What is adjustment of post record events?

3. Adjusting events area unit post record events which offer further
proof of conditions existing at the record date.
Examples of adjusting events include:

Events that indicate that the going concern assumption in relation
to the whole or part of the entity is not appropriate;
Settlements after reporting date of court cases that confirm the
entity had a present obligation at reporting date;
Receipt of information after reporting date indicating that an asset
was impaired at reporting date;
Bankruptcy of a customer that occurs after reporting date that
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confirms a loss existed at reporting date on trade receivables;
Sales of inventory after reporting date that give evidence about
their net realisable value at reporting date;
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Discovery of fraud or errors that show the financial statements are
incorrect.
6.4.2 NON-ADJUSTING EVENTS AFTER THE REPORTING

PERIOD
Non-adjusting events area unit indicative of a condition that arose

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when the tip of the news amount and do not end in adjustment to the
monetary statements. They must be disclosed if of such importance
that non-disclosure would have an effect on the power of the users to
create correct evaluations and selections.
What area unit non-adjusting events examples?
N
Examples of non-adjusting events given in IAS-10 area units

Decline in market price of investments
Announcement of an inspiration to discontinue a part of the enter-
prise
Major purchases and sales of assets
Destruction of a serious plus by hearth, etc.
Sale of a serious subsidiary
Major dealings within the company’s standard shares
NOTE
How area unit non-adjusting events treated? Do not change statements
for non-adjusting events. The
Non-adjusting event subsequent revelation shall
be made: the character of the
Accounting treatment: Do not change statements for non-adjusting event, and associate degree
events. The subsequent revelation shall be made: the character of the estimate of its financial result
event, and associate degree estimate of its financial result or a state- or a statement that such an
ment that such an estimate cannot be created. estimate cannot be created.

Example 3: ABC ltd. Is about to finalise their financial statements,

For the year ended June, 30, 2022. The intended authorisation date of
financial statements is September 15, 2022.
Following are the events that occurred since June 30, 2022, explain the
type of event and their treatment in financial statements.
S. No. Event
1. On July 12, 2011, word came in that a foreign client had filed
for liquidation in May of that year. There are currently no
opportunities for this debt to be recovered.
2. The company offered 1,000 copies of Product A for just ` 12
each on July 15, 2011. The price per unit was ` 20. However,
due to damage brought on by improper handling on June 25,
S
2011, this Product’s value has been reduced to its NRV of ` 15
per unit on June 30, 2011.
3. Due to damage from water spoilage on August 5, 2011, the
IM company sold 1,000 pieces of Product B for just ` 12 each on
August 15. The price per unit was `20. However, on June 30,
2011, this Product had been valued at its NRV of `15 per unit.
4. On June 27, 2011, an asset was acquired and put into service.
However, on July 5, 2011, an invoice was received.
5. ABC Limited declared on July 7, 2011, that it would stop
making Product C due to high losses, which accounted for 22%
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of total sales.
Solution:
S. No. Type Treatment

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1. Adjusting The debt should be written off

2. Adjusting Inventory valuation should be at `12
3. Non adjusting The inventory valuation should be same at ` 15
4. Adjusting Asset recognition should be in the financial
statements
5. Non adjusting Only disclosure is required, as per the
materiality.
5. Quote one example of non-adjusting event.

a. Decline in market price of investments.
b. Major purchases and sales of assets.
c. Sale of a serious subsidiary.
d. All of these

6. ___________ treatment: do not change statements for non-

adjusting events
a. Marketing
b. Accounting
c. Financial
d. None of these
DISCLOSURE ABOUT EVENTS AFTER

6.5
THE REPORTING PERIOD
When entity ought to regulate its monetary statements for events after
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the reporting period; and, the disclosures that entity ought to provide
concerning the date once the monetary statements were authorised
for issue and concerning events once the reportage amount.
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Disclosure of following information is required:
a. Date once the monetary statements were approved for issue.
b. Disclosures concerning conditions that existed after the reporting
period ought to be updated within the new information received
once the reportage amount.
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c. Entity ought to disclose the subsequent in respect of fabric

non-adjusting events: the character of events – estimate of its
monetary result or a press release that such an estimate cannot
be created.
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Example 4: Earley Inc. is completing its financial statements for the

fiscal year that concluded on December 31, 2014. The financial direc-
tor has requested your input regarding the year-end accounts due to
the following developments.
1. Trade receivables at the end of 2014 included a sum of `2,50,000
related to Nedengy Inc. When the total debt reached `2,00,000 on
March 8, 2015, Nedengy Inc. entered receivership. According to
recent discussions with the receiver, unsecured creditors won’t
receive a dividend.
2. Whitley Wood, the company’s former headquarters facility,
was sold by Earley Inc. on March 15, 2015, for `2.7 million. The
building was vacant and held a value of `3.1 million at the end of
the year.
3. At year’s end, inventories comprised `6,50,000 worth of the
Opasney, a brand-new electric tricycle. The tricycle’s sale was
outlawed by the European Union in January 2015 because it was

deemed hazardous. After the proper procedure was followed in

the European Parliament in the months before, this declaration
was issued. Although the present pricing is anticipated to be 30%
less, a different market in Bongolia is being examined.
Solution:
1. According to IAS-10, events that occur after the statement of
financial position date that give further evidence relative to
conditions prevailing at the statement of financial position date
shall be taken into account when adjusting assets and liabilities.
It especially uses the example of bad debts, when there is
evidence of a debtor’s insolvency after the end of the fiscal year.
Because Nedengy appears to have partially paid the obligation
S
in this instance, just `2,00,000 must be given.
According to IFRS-15, when doubt exists over the capacity to
collect an amount that has already been recorded as revenue,
IM
the amount should be recorded as an expense.
2. Unless it can be established that the collapse in the real estate
market occurred after the year’s end, it is likely that the decrease
in the property’s value will come under the IAS-10 description of
adjusting events indicated in (a) above (in which case it will be
regarded as non-adjusting event)
M
3. Inventory must be reported in accordance with AS-2 at the lower

of cost and net realisable value.
The inventory in this scenario must be written down by 30% if
the Bongolia option is chosen. It might be essential to write down
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the tricycles to scrap value if the Bongolian alternative fails.
7. What all information is required to follow disclosure?

a. Date once the monetary statements were approved for
issue
b. Disclosures concerning conditions that existed at the tip
c. Entity ought to disclose the subsequent in respect of fabric
non-adjusting events
d. All of these
8. The disclosures that entity ought to provide concerning the
date once the monetary statements were authorised.
a. True
b. False

ACTIVITY
Prepare a PPT on the disclosure of events after the reporting period.
6.6 SUMMARY S
Events after the reporting period are those events, which are
favourable and unfavourable that can occur between the end of
the reporting period and the date when all of its financial state-
ments are authorised for issue.
There are two types of events that take place, which are adjusting
events and non-adjusting events.
Adjusting events are those that can provide evidence of all condi-
S
tions that can exist at the end of all the reporting period.
Non-adjusting events are those that are actually indicative of all
conditions that can arose after all the reporting period.
IM
When entity ought to regulate its monetary statements for events
after the reporting period; and, the disclosures that entity ought to
provide concerning the date once the monetary statements were
authorised for issue and concerning events once the reportage
amount.

M
1. __________ events ought to be disclosed if they are of such MCQ

importance that non-disclosure would have an effect on the
flexibility of users to form correct evaluations and selections.
a. Non-adjusting
N
b. Adjusting
c. Companies
d. Non-Profit Organisation
2. __________ event is that the event that after the reporting period
and provides any proof of conditions that existed.
a. Adjusting
b. Non-disclosure
c. Non-adjusting
d. Uncertain
3. __________ should discloses the date once the monetary
statements were authorised for issue and UN agency gave that
authorisation.
a. Firms
b. Companies

c. Agencies
d. Debenture holders
4. An estimate of its __________ impact or associate degree that
such an estimate cannot be created.
a. firm
b. non-disclosure
c. money
d. None of these
5. Non-adjusting events ought to be disclosed if they are of such
importance that __________ would have an effect on the flexibility
of users to form correct evaluations and selections.
S
a. Non-disclosure
b. Disclosure
IM c. Adjusting
d. Both a. and c.
6. An entity adjusts all of the amounts recognised in its __________
statements to then reflect all adjusting events, but what it does
is by not adjust those amounts to actually reflect non-adjusting
events.
M
a. company
b. financial
c. firm
N
d. balance sheet
7. A company ought to update _____________ disclosures that relate
to conditions that existed at the tip of the coverage amount to
mirror any new data that it receives once the coverage amount
concerning those conditions.
a. Operational
b. Financial
c. Technical
d. Statistical
8. If at all non-adjusting events after the reporting period are
material, then __________ prescribes disclosures.
a. IAS-10
b. IFRS-11

c. IAS-12
d. IAS-9
9. These are accounting standards that are issued by the IFRS
Foundation and the IAS Board.
a. IAS
b. IFRS
c. IAS committee
d. IFRS committee
10. Sales of inventory after reporting date that give evidence about
their net realisable value at reporting date; is an example of
which of the following?
S
a. Adjusting event
b. Non-adjusting event
c. Uncertain event
IM
d. Crucial event
6.8 DESCRIPTIVE QUESTIONS ?

1. Define IAS 10 (Events after the Reporting Period).
2. Explain the standard history of IAS-10.
M
3. What are the types of events?

6.9
(HOTS) QUESTIONS
N
1. Adjust monetary statements for adjusting events - events once

the record date that give more proof of conditions that existed
at the tip of the coverage amount, as well as events that indicate
that the going concern assumption in respect to the total or a
part of the enterprise is not acceptable.
a. True
b. False
2. A company ought to update disclosures that relate to conditions
that existed at the tip of the coverage amount to mirror any new
data that it receives once the coverage amount concerning those
conditions. [IAS 10.19]
a. True
b. False

3. The __________ statements are authorised for issue on March

2022 (date of board authorisation for issue).
a. Money
b. Finance
c. Liability
d. None of these
Topic Q. No. Answer
S
Introduction to IAS 10 (Events 1. d. IAS
after the Reporting Period)
IM
2. a. International Financial
Reporting Standards
Objectives of IAS 10 3. c. Both a. and b.
4. c. Disclosures
Types of Events 5. d. All of these

M
6. b. Accounting
Disclosure about Events after the 7. d. All of these

Reporting Period
N
8. a. True
Q. No. Answer
1. a. Non-adjusting
2. a. Adjusting
3. c. Agencies
4. c. money
5. a. non-disclosure
6. b. financial

Q. No. Answer
7. b. Financial
8. a. IAS-10
9. b. IFRS
10. a. Adjusting event

1. IAS 10 events after all the Reporting Period prescribes when an
entity should adjust all its financial statements for the events
S
after the reporting period and the main disclosures that an
entity should give about the date and when all of the financial
statements were authorised and about events after the reporting
period. Refer to Section 6.2 Introduction to IAS 10 (Events after
the Reporting Period)
IM
2. In Gregorian calendar month 2001, the International Accounting
Standards Board (Board) that adopted IAS 10 Events once the
total Balance Sheet Date, that had been originally been issued
by all the International Accounting Standards Committee in
1999. Refer to Section 6.2 Introduction to IAS 10 (Events after
the Reporting Period)
M
3. There are two types of events that take place, which are adjusting
events and non-adjusting events. Refer to Section 6.4 Types of
Events
N

QUESTIONS
Q. No. Answer
1. a. True
2. a. True
3. a. Money
SUGGESTED READINGS
Greuning, H., Scott, D., & Terblanche, S. (2011). International
financial reporting standards. Washington, D.C.: World Bank.
International Accounting Standards Board. (2014). Investment
entities. London.

E-REFERENCES
Standards, I., Navigator, I., & Period, I. (2022). IFRS - IAS 10 Events
after the Reporting Period. Retrieved 13 May 2022, from https://
www.ifrs.org/issued-standards/list-of-standards/ias-10-events-af-
ter-the-reporting-period/
IAS 10 - Events after the Reporting Period (detailed review). (2022).
Retrieved 13 May 2022, from https://www.readyratios.com/articles/
ifrs/ias10-events-after-the-reporting-period.html
S
IM
M
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CASE STUDIES
4 TO 6
CONTENTS
Case Study 4 Advance to the Directors of Company in India

Case Study 5 Incorrect Disclosure of Valuation of Inventories
Case Study 6 Scope of IAS 10 at the time of COVID
S
IM
M
N

CASE STUDY 4
ADVANCE TO THE DIRECTORS OF COMPANY IN INDIA
FACTS
Case Objective
1. Medical equipment selling is the primary activity of M/s.
The case explains the norms ABC Private Limited (The Company), which was estab-
for director’s report in the
lished on April 1st, 2011, in accordance with the Companies
India.
Act, 1956.
2. The Company’s Managing Director is X.
3. During FY 2021–2022, the Company has awarded Mr. X a
salary increase of INR 5 Lacs.
4. Additionally, the business gave Mr. X an advance payment of
S
INR 1 lac for business costs for FY 2021–2022;
QUERIES
IM1. Whether a wage rise for the managing director would violate
Sections 185 and 186 of the 2013 Companies Act;
2. If so, whatever compliances must be adhered to by the Direc-
tor and the Company;
3. Certain regulations must be adhered to by the Company in
order for the Directors to get an advance for daily costs;
M
4. The requirements of Sections 185 and 186 of the Companies

Act, 2013, will apply to salary advances to regular directors
who are neither managing directors nor full-time directors.
ANALYSIS
N
1. The Companies Act of 2013’s Section 185 addresses “Loan

To Directors.” No corporation may lend money to a director
of the business in accordance with the aforementioned reg-
ulations.
Nothing in this section, however, applies to loans given to
Managing Directors or Whole-Time Directors as part of the
company’s employee service agreements or in accordance
with any plan endorsed by the members via a special resolu-
tion;
2. The Companies Act of 2013’s Section 186 addresses “Loan
and Investment by Company.” According to the aforemen-
tioned regulations, board and/or shareholder consent is nec-
essary before lending money to anybody.
If the loan exceeds 60 percent of the paid-up capital, free
reserves, and securities premium account, or 100 percent of
the free reserves and securities premium account, which-

Case study 4: Advance to the Directors of Company in India 129
CASE STUDY 4
ever is greater, shareholders must approve it by special res-

olution.
3. Both of the aforementioned sections discuss “LOAN.” The
aforementioned laws make no reference of “ADVANCE OR
SALARY ADVANCE.” Although the Companies Act of 2013
does not specify loans or advances, these words have dis-
tinct meanings. So, the major issue in this situation is still
open. Does a salary advance constitute a loan?
4. On March 10, 2015, the Ministry of Corporate Affairs (MCA)
released specific circular regarding advances against sala-
ries.
According to the circular, “The Ministry has received many re-
S
ferrals requesting clarifications on the application of Section 186
regulations related to issue of loans and advances to the workers.
The matter has been investigated, and it is thus made clear that
section 186 of the Companies Act of 2013 does not apply to loans
IM
and/or advances given by corporations to their workers who are
not managing or full-time directors (who are covered by section
185).
EXEMPTIONS
1. By announcement dated June 5, 2015, the MCA exempts pri-
M
vate firms from Section 185’s application:

a. Which share capital has not been invested in by any oth-
er body corporate?
b. If the firm borrows less than twice its paid-up share cap-
N
ital or 50 crore Indian Rupees from banks and financial

institutions and
c. There is no loan default on the part of the corporation.
2. Giving a loan to a Managing Director or Whole-Time Direc-
tor is not subject to Section 185:
a. As a provision of the terms of service provided by the
business to all of its workers,
b. In accordance with any plan endorsed by the members
via a special resolution:
CONCLUSIONS
After examining the relevant facts and provisions, we may say

that:
1. Whether a wage increase to the Managing Director would
violate Sections 185 and 186 of the 2013 Companies Act:

CASE STUDY 4
According to the circular of March 10, 2015, all workers

save the Managing Director and Whole-Time Director are
excluded from paying interest on loans. Therefore, the Man-
aging Director and Whole-Time Director will be subject to
the restrictions of Sections 185 and 186 of the Act if they
receive salary advances from the firm.
2. If so, the following compliances must be adhered to by the
Company and the Managing Director:
Compliances under Section 185:
a. If the loan is given as a condition of service extend-
ed by the company to all of its employees (as a part
of company policy for its employee and the same is
S
mentioned in employment letter), no compliances
are required to be followed in accordance with the
exemptions provided under Section 185 of the Com-
panies Act, 2013.
IM
b. For the loan to be approved under any plan, a sepa-
rate resolution from the shareholders is necessary.
Compliances under Section 186:
a. The board meeting’s approval of the board of direc-
tors;
b. if the loan amount is more than 60% of the paid-up
M
capital, free reserves, and securities premium ac-

count, or 100% of the paid-up capital, free reserves,
and securities premium account, whichever is great-
er, shareholders must approve the loan by special
resolution at the annual meeting;
N
c. Such salary advance should bear interest at a rate

not less than the yield of the one Taxguru.in has
copyright.
Which regulations must the Company follow in order to
advance funds to the Directors for ongoing expenses?
Giving an advance for daily business expenditures is not
subject to compliance requirements since it will be offset by
the real business expenses incurred.
4. The requirements of Sections 185 and 186 of the Companies
Act, 2013, will apply to salary advances to regular directors
who are neither managing directors nor full-time directors:
All executive directors and other directors who work for the
business and are covered by an employment contract are
considered to be employees of the company. As a result, Sec-
tions 185 and 186 of the 2013 Companies Act will not apply to
salary advances to such staff directors.

Case study 4: Advance to the Directors of Company in India 131
CASE STUDY 4
However, the salary advance granted to independent directors or

other directors not covered by the company’s employment agree-
ment would be regarded as a loan paid to the directors, which is
prohibited under Section 185 of the Companies Act of 2013, ac-
cording to the Companies Act of 2013.
QUESTIONS
1. Discuss the section of Companies Act 2013 that addresses

“Loan to Directors”.
(Hint: The Companies Act of 2013’s Section 185 addresses
“Loan to Directors.)
2. Discuss the section of Companies Act 2013 that addresses
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“Loan and Investment by Company”.
(Hint: The Companies Act of 2013’s Section 186 addresses
“Loan and Investment by Company.”)
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CASE STUDY 5
INCORRECT DISCLOSURE OF VALUATION

OF INVENTORIES
The accounting policies regarding the valuation of inventories as

Case Objective actually disclosed in the Annual Report of many other companies
The aim of this case is to that are listed below:
explain the inaccurate
Stocks of Cards are then valued at cost and on FIFO basis
disclosure of valuation of
inventories. and also include all of the applicable overheads which is in
bringing the inventories to their present location & condition.
Work in progress is actually a valued at Cost.
Work-in-Progress is then valued at direct raw material cost &
appropriate cost of completed process.
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Raw materials are valued at average cost. Raw materials
which are at bonded warehouse stores, spares, consumables,
packing material, coal & fuel are valued at cost.
Work in Process is then valued at all raw material cost.
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Cost of finished goods & work in progress are then determined
on estimated cost basis.
Cost is determined by then using the first in first out all
formula. Cost comprises all literally all.
CONCLUSION
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How to fix Inventory Errors in Financial Statements
A counting error or inaccurate pricing of inventory goods may

both lead to inventory mistakes. These mistakes might cause the
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closing inventory balance to be inflated or underestimated, which

would have an impact on the computations of the cost of goods
sold and net income. Because the starting inventory of one peri-
od equals the ending inventory of the next, inventory problems
often include two periods. Reverse the mistake as soon as it is dis-
covered, record the appropriate accounting entries, and restate
previous period financial statements to remedy inventory inac-
curacies.
Step 1
What effect has the inventory mistake had? According to the web-
site for Cliffs Notes, ending inventory overstatement or begin-
ning inventory understatement results in an understatement of
the cost of goods sold and an overstatement of net income, while
ending inventory understatement or beginning inventory over-
statement results in an understatement of the cost of goods sold
and net income. Net income and cost of goods sold are accounts

Case study 5: Incorrect Disclosure of Valuation of Inventories 133
CASE STUDY 5
on the income statement. The bottom line of a business is its net

income, which is what remains after deducting cost of products
sold, operating costs, interest, and taxes from sales. For the pe-
riod in which the mistake occurs, the balance sheet accounts for
inventories and retained profits are impacted. The retained earn-
ings account is impacted because the ending retained earnings
balance for a period is calculated by adding the period’s net in-
come, minus dividend payments, to the period’s starting retained
earnings balance.
Step 2
If an inventory error is discovered within the same time, recti-

fy the mistake and record the appropriate journal entries. To re-
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pair a mistake, debit or raise cash and credit or reduce invento-
ry by $9,000 ($10,000 - $1,000 each), respectively. As an example,
suppose you accidentally record a cash inventory transaction as
$10,000 rather than $1,000.
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Step 3
Fix an inventory mistake from a previous quarter. For instance,

if the ending inventory for the prior year was $1 million underes-
timated the starting inventory and retained profits balances for
the current year is similarly $1 million understated. To correct
the prior-period mistake, debit or raise inventories by $1 million
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and credit or increase retained profits by the same amount. Your

financial accounts for this year and the following years shouldn’t
include any inventory-related problems if you count the invento-
ry accurately this year.
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Step 4
Restate the financial statements from the preceding period. It

may be necessary to adjust the inventory and retained profits ac-
counts on the balance sheet as well as the cost of products sold
and net income accounts on the income statement. Using the
same example, make the following adjustments: add $1 million
to the net income account on the prior-period income statement;
subtract $1 million from the cost of goods sold amount on the pri-
or-period income statement; and add $1 million to the inventory
and retained earnings accounts on the prior-period balance sheet.
Step 5
Describe the nature and effects of the inventory inaccuracy in

disclosure notes. For the current quarter, create a single disclo-
sure note outlining the adjustment to the starting inventory and
beginning retained profits balances. Create a second disclosure

CASE STUDY 5
note outlining the adjustments to the financial statements from

the preceding period.
Source: https://gandhidham-icai.org/Pdf/Study-material/Commonly-found-errors-in-FS-
Gandhidham.pdf
QUESTIONS
1. Define inventories. Should inventories measure at lower

for cost and net realisable value?
(Hint: all the items, goods, merchandise, and materials
held for selling to earn a profit)
2. What should the cost of inventories comprise of?
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(Hint: Stocks of Cards are then valued at cost and on
FIFO basis, Work-in-Progress is then valued at direct raw
material cost & appropriate cost of completed process.)
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Case study 6: Scope of IAS 10 at the time of COVID 135
CASE STUDY 6
SCOPE OF IAS 10 AT THE TIME OF COVID
COVID-19 CEASES TO BE AN ADJUSTING EVENT WHEN?

Case Objective
For reporting periods that concluded on or before December 31,
The case study explains the
2019, the effect of COVID-19 would, in our opinion, be a subse- scope of IAS-10 at the time of
quent event that would not need adjustment. As a result, the rec- COVID.
ognition and measurement of assets and liabilities in an entity’s
financial statements would be unaffected. Although the World
Health Organization (WHO) received reports of cases of the virus
in Wuhan City, China, on December 31, 2019, there was little con-
clusive evidence of human-to-human transmission at the time,
and the WHO did not declare the outbreak a public health emer-
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gency of international concern until January 31, 2020.
As a result, it is assumed that COVID-19 did not mature and

spread significantly until January 2020. The substantial impacts
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of the COVID-19 pandemic must be excluded from financial state-
ments for a business whose reporting period ends on or before
December 31, 2019, since they should only represent the situation
as of that date.
However, each reporting entity must decide if it needs to provide

further information about the outbreak’s effects during the suc-
ceeding events period. In general, events that occur during the
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period after the financial statements’ date but that have a major
impact on assets or liabilities in the following period and will like-
ly or maybe have a significant impact on the entity’s future oper-
ations should be disclosed. IAS-10 mandates that for significant
non-adjusting events, a business shall disclose (a) a description
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of the event’s nature; and (b) either an estimate of the financial

impact or a declaration that such an assessment is not possible.
Non-adjusting incident examples that would typically need dis-

closure include:
Plans made by management to address the COVID-19
outbreak’s impact and if there is a significant doubt about the
entity’s capacity to be a continuing concern
Breach of covenants, waivers, or changes to the terms of the
financing agreements
Supply-chain Breakdowns
Considering certain purchase or sale agreements to be
burdensome contracts
Declaring a decision to end an operation
Declaring or starting to conduct a significant reorganisation
or reduction (temporarily or permanently)

CASE STUDY 6
Reduced fair value of assets held beyond the reporting period

(e.g. pension plan investments)
Very steep drops or increases in asset prices or currency rates,
and
Engaging into substantial agreements or conditions, such as
providing substantial assurances to connected parties.
What circumstances might COVID-19 qualify as an adjusting

event?
The number of COVID-19 cases and nations impacted outside of

China has increased significantly since late January 2020, and on
March 11, 2020, the WHO proclaimed COVID-19 to be a world-
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wide pandemic. Governments and several private sector organi-
sations made major steps to limit the virus at this time, including
quarantines and closures of schools, stores, plants, and borders.
Since late February 2020, the outbreak’s effects have also caused
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a large amount of instability in the world’s financial markets.
In general, we believe that enough information concerning the

pandemic was available for preparers and market participants to
reflect and, if required, amend the assumptions and assessments
for reporting periods that concluded on or after 31th January 2020.
Additionally, the number of COVID-19-related outcomes that
must be taken into account for any adjusting event determina-
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tions and disclosures increases the later the annual reporting pe-
riod is after this date (i.e., 31th March 2020, 30th June 2020, or 30th
September 2020).
Because the same condition may have various effects on different

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reporting entities for the same reporting date, each reporting en-
tity must carefully analyse the circumstances and how they affect
the reporting entity. IAS 10 makes it clear that management must
take into account the particular conditions related to the entity’s
activities and the pertinent events occurring in the relevant time
period. When evaluating the accuracy of their estimations and de-
cisions taken before the information became available, manage-
ment should take the following information into account that may
have been obvious after period-end:
Travel limitations both domestically and internationally
The financial effects of social estrangement, which lead to
venue and event capacity limitations
The possibility that projections won’t be met because of
market circumstances
The end of any non-essential services

Case study 6: Scope of IAS 10 at the time of COVID 137
CASE STUDY 6
Delays in the delivery of goods or services

Clients using the administrative system, or
Government assistance.
This judgement should be declared in line with IAS-1 when it sig-

nificantly affects the amounts in the financial statements.
If it is found that COVID-19 was an event that occurred and had

an effect on operations at or before the reporting date, it should
be recorded in accordance with IAS 10 as an adjusting event.
QUESTIONS
1. Discuss the result of recognition and measurement of
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assets and liabilities in the financial statements.
(Hint: The recognition and measurement of assets and
liabilities in an entity’s financial statements would be
unaffected.)
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2. Discuss the number of COVID 19 cases outside of China.
(Hint: The number of COVID-19 cases and nations
impacted outside of China has increased significantly
since late January 2020, and on March 11, 2020, the WHO
proclaimed COVID-19 to be a worldwide pandemic.)
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C H A
7 P T E R
SEGMENT REPORTING
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CONTENTS
7.1 Introduction
7.2 Overview of Segment Reporting
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7.2.1 Objectives of Segment Reporting
7.2.2 Applicability of AS 17
7.2.3 Segment Reporting Rules
7.2.4 Factors Included in Segment Reporting
Activity
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7.3 Identifying Reportable Segments

7.3.1 Primary and Secondary Segment Reporting
7.3.2 Business and Geographical Segments
7.3.3 Reportable Segments
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Activity
7.4 Summary

SEGMENT REPORTING PRACTICES IN INDIA: A CASE

STUDY OF TCS
Companies with multi-product and multi-location operations must

Case Objective report segment-wise activities in both their annual and quarterly
This caselet highlights the reports, according to segment reporting requirements. Financial
segment reporting practices statements are used by a variety of people for a variety of reasons.
used by TCS in India. Stakeholders are the primary users of accounting data, and they
are primarily interested in financial data from various company
areas. The idea of segment reporting in a codified form dates back
nearly 32 years.
When the Financial Accounting Standard Board (FASB) of the

United States produced Statement of Financial Accounting Stan-
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dards (SFAS)-14 in 1974, it was suggested. In 1981, the Interna-
tional Accounting Standards Committee developed IAS-14 for seg-
ment reporting of financial data. Both SFAS-14 and IAS-14 have
been updated to improve segment reporting. The FASB updated
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SFAS-14 in 1997 with the publication of SFAS-131, whereas IAS-
14 was updated in 1998. Several nations have now made segment
reporting mandatory by standards published by their respective
governmental agencies. In India, AS-17 requires public and pri-
vate firms to publish financial data in segments. The current case
study focuses on Tata Consultancy Services’ segment reporting
(TCS).
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How does segment reporting critical analysis work and how may
external users benefit from it? Using data from annual reports,
this study creates an empirical proxy for the quality of segment
reporting. Information on a company’s geographical and business
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sectors is useful in determining the risks and returns of a diver-

sified or multinational company, which is sometimes difficult or
impossible to get from aggregated data.

SEGMENT REPORTING 141
LEARNING OBJECTIVES

>> Explain the concept of segment reporting
>> Discuss the applicability of AS-17
>> Describe the factors included in segment reporting
>> Elucidate how to recognise reportable segment types
7.1 INTRODUCTION
In the previous chapter, you studied about the Indian accounting stan- Quick Revision
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dard-10, i.e., events after the reporting period. IAS-10 Events After
the Reporting Period specifies when financial statements should be
amended for events that occur after the end of the reporting period.
Adjusting events are those that show conditions at the conclusion of
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the reporting period, whereas non-adjusting events show conditions
that occur after the reporting period has ended (the latter being dis-
closed where material).
The reporting of a company’s operating segments in the disclosures

that accompany its financial statements is known as segment report-
ing. Segment reporting is mandatory for publicly traded companies
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but not for privately owned companies. Investors and creditors can
utilise segment reporting to get information about the financial per-
formance and position of a business’s most important operational
divisions, which they can use to make choices about the firm.
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An operating segment, according to Generally Accepted Accounting

Principles (GAAP), engages in business activities from which it may
earn revenue and incur expenses, has discrete financial information
available and whose results are reviewed on a regular basis by the
entity’s chief operating decision maker for performance evaluation
and resource allocation decisions.
A business segment is a distinguishable unit of an organisation

engaged in providing individual product or service or a group of
related products or services. Further, it is subject to risk and returns
that are different from those of other business segments.
Thus, all its operating activities and profit and loss are shared sepa-
rately with shareholders.
Accounting Standard (AS)-17 deals with segment reporting and was

established to help better understand performance risk and returns of
an organisation. It contains provisions pertaining to the reporting of

segment information in order to meet the needs of the users of finan-

cial statements.
In this chapter, you will study the overview of segment reporting,

meaning of segment reporting, segment reporting rules, factors
included in segment reporting, objective of segment reporting, identi-
fying reportable segments, primary and secondary segment reporting,
business and geographical segments, reportable segments reportable
segments etc. in details.
7.2 OVERVIEW OF SEGMENT REPORTING

Segment reporting refers to the process of reporting the operating
segments of a company in the disclosures along with its financial state-
NOTE
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ments. As per Generally Accepted Accounting Principles (GAAP),
Segment reporting is mandatory
for publicly-held companies, and
an operating segment is the one that is involved in business activi-
is not required for privately held ties from which it may earn revenue and incur expenses. Thus, this
ones. segment has separate financial information available and its results
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are reviewed on a regular basis for making decisions related to per-
formance assessment and resource allocation decisions. The main
objective of segment reporting is to provide information to investors
and creditors regarding the financial results and position of the most
important operating units of a company so that they can be used as
the basis for taking decisions related to the company.
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Segment reporting provides a complete picture of a company’s oper-

ations for shareholders, upper management and investors which help
MARK IT! them in better decision making. Segment reporting provides informa-
Information about different types tion about different types of business activities in which a particular
of products and services of an segment of an organisation engages and the different economic envi-
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organisation and its operations ronments in which it operates.

in different geographical areas
(called segment information) This information helps investors to:
helps investors in assessing
risks and returns of a diversified Evaluate a company’s performance
or multi-locational organisation
that may not be determinable Assess its prospects for future net cash flows
from the aggregated data.
Understand the business as a whole
Make more informed judgments about the company
Make clearer decisions about their investments
7.2.1 OBJECTIVES OF SEGMENT REPORTING
Segment reporting is the reporting of the operating segments or units

of a company in its financial statements. Segment reporting is required
for publicly held entities, but not required for privately held ones.
As stated earlier, segment reporting aims to provide information to

investors about different operating units of an organisation so that

they can better make investment decisions. Apart from that, the fol-
lowing are the objectives of segment reporting:
To keep accounts more transparent and easier to understand
To make better decisions by keeping in mind the business from
different segments
To better analyse the risk and returns of the organisation
To analyse the most profitable or loss-making units
7.2.2 APPLICABILITY OF AS-17
The following are the categories of organisations to which Accounting

Standard (AS)-17 applies for a given accounting period:
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Organisations with equity or debt securities listed in India and
outside India
Organisations in the process of listing their equity or debt securi-
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ties as acknowledged by board of directors
Banks including cooperative banks
Financial institutions
Organisations into insurance business
Organisations having turnover exceeding `50 crores immediately
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preceding the accounting period. Here, turnover does not include

other income
Organisations having borrowings including public deposits
exceeding `10 crores during a given accounting period holding
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and subsidiary organisations of any of the above during a given

accounting period
7.2.3 SEGMENT REPORTING RULES
Financial statement consumers may also gain a clearer understanding

of the swings that may impact overall figures for each section by using
segment reporting. If a company’s earnings are much greater than
projected, segment reporting might reveal where those profits are
coming from. A stakeholder can examine the following in the report to
see if the figures are reliable:
Reportable segment: A reportable segment is a company or geo-
graphic area that may be recognised using the criteria above and
for which this Standard specifies that segment information must
be provided.
Segment revenue: Revenue that is directly traceable to or logi-
cally assignable to a segment, including intersegment revenue,

only if the segment is a financial section, and includes interest

and dividend income as well as associated securities gains (bank,
insurance company, etc.).
Asset: A resource having economic worth that a person, business,
or nation possesses or controls with the hope that it would some-
day be useful is referred to as an asset.
Expenses: An expenditure is a business’s operational cost incurred
to produce income. It takes money to earn money, as the adage
goes.
Liabilities: Liabilities are a debt that a person or business has,
often in the form of money. Through the transmission of economic
advantages like money, products, or services, liabilities are even-
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tually satisfied.
Accounting policies: Accounting policies are the precise tenets,
foundations, customs, guidelines, and procedures that a company
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ments. An entity must follow the IFRS Standard or IFRS Inter-
pretation that particularly relates to a transaction, other event, or
circumstance.
The following are the rules of segment reporting:

Aggregate the results of segments if they have similar products,
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services, processes, customers, distribution ways and regulative

environments.
Report a phase if it is a minimum of 10% of the revenues, 10% of
the profit or loss or 10% of the combined assets of the entity.
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If the entire revenue of the segments chosen underneath the pre-

ceding criteria comprises 75% of the entity’s total revenue, then
add a lot of segments till the threshold is reached.
Add segments on the far side the minimum simply noted and think
about a discount if the entire exceeds 10 segments.
7.2.4 FACTORS INCLUDED IN SEGMENT REPORTING
Financial information about a corporation is divided up into divi-

sions, subsidiaries, or other types of business segments in business
segment reporting. Business sector reporting gives shareholders
a realistic view of a public company’s performance in an annual
report. Management assesses each company division’s overall health,
including profitability and possible dangers, using business seg-
ment reporting to analyse each division’s revenue, costs, assets, and
liabilities.

A segment is a part of a company that develops its own income streams,

product lines, and service offers. Generally, a business segment may
be categorised as a unit of a firm that can be taken out of a bigger
organisation and continue to function independently.
Accounting rules for business segment reporting are established

by the Financial Accounting Standards Board (FASB). The FASB
Accounting Standards Codification (ASC) 280-10-10-1 stipulates that
a company’s business segments must all be in accordance with its
reporting structure. However, a firm is not required to disclose all of
its business sectors. According to US Generally Accepted Accounting
Principles (GAAP), public corporations must disclose a segment if it
contributes 10% or more to total assets, earnings, or sales. Interna-
tional norms vary a little.
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FOR SHAREHOLDERS AND MANAGEMENT
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Shareholders of a corporation may get a thorough view of the busi-
ness activities with the aid of segment reporting. Decision-making
by senior management depends on the precise insight that segment
reporting brings.
FOR INVESTORS
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A public company’s many business operations and the various eco-

nomic situations in which it conducts those activities are described
in segment reporting. Investors may use this knowledge to more fully
comprehend and assess a company’s performance, evaluate its poten-
tial for future cash flows, comprehend the company as a whole, more
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knowledgeable decisions regarding the business, and make more

informed choices about their finances.
Business segment reporting often appears in a company’s financial

statements as a series of footnotes. The segment footnote is significant
to investors and other consumers of financial statements when mak-
ing investment choices.
1. Which of the following describes segment reporting guidelines?

a. Aggregate the results of segments if they have similar prod-
ucts, services, processes, customers, distribution ways and
regulative environments.
b. Report a phase if it is a minimum of 10% of the revenues,
10% of the profit or loss or 10% of the combined assets of
the entity.

c. If the entire revenue of the segments chosen underneath

the preceding criteria comprises 75% of the entity’s total
revenue, then add a lot of segments till the threshold is
reached.
d. All of these
ACTIVITY
Take the example of any conglomerate and find its segments.
7.3 IDENTIFYING REPORTABLE SEGMENTS
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A business segment or geographical segment ought to be known as a
reportable phase if: (a) its revenue from sales to external customers
and from transactions with different segments is 10% or more of the
full revenue, external and internal, of all phases or (b) its segment
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result, whether profit or loss.
7.3.1 PRIMARY AND SECONDARY SEGMENT REPORTING
The Ministry of Corporate Affairs has given the following provisions

in this regard:
The dominant source and nature of risks and returns of an organ-
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isation should govern whether its primary segment reporting for-

mat will be business segments or geographical segments. If the
risks and returns of an organisation are affected predominantly by
differences in the products and services it produces, its primary
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format for reporting segment information should be business seg-

ments, with secondary information reported geographically. Sim-
ilarly, if the risks and returns of the organisation are by the fact
that it operates in different countries or other geographical areas,
its primary format for reporting segment information should be
geographical segments, with secondary information reported for
groups of related products and services.
Internal organisation and management structure of an enterprise
and its system of internal financial reporting to the board of direc-
tors and the chief executive officer should normally be the basis
for identifying the predominant source and nature of risks and
differing rates of return facing the enterprise and, therefore, for
determining which reporting format is primary and which is sec-
ondary, except as provided in sub-paragraphs (a) and (b):
a. if risks and returns of an enterprise are strongly affected both
by differences in the products and services it produces and by
differences in the geographical areas in which it operates, as

evidenced by a ‘matrix approach’ to managing the company

and to reporting internally to the board of directors and the
chief executive officer, then the enterprise should use business
segments as its primary segment reporting format and geo-
graphical segments as its secondary reporting format and
b. if internal organisational and management structure of an en- NOTE
terprise and its system of internal financial reporting to the For most enterprises, the
board of directors and the chief executive officer are based predominant source of risks
and returns determines how
neither on individual products or services or groups of relat- the enterprise is organised
ed products/ services nor on geographical areas, the directors and managed. Organisational
and management of the enterprise should determine whether and management structure of
the risks and returns of the enterprise are related more to the an enterprise and its internal
financial reporting system
products and services it produces or to the geographical areas normally provide the best
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in which it operates and should, accordingly, choose business evidence of the predominant
segments or geographical segments as the primary segment source of risks and returns of the
enterprise for the purpose of its
reporting format of the enterprise, with the other as its second-
segment reporting.
ary reporting format.
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7.3.2 BUSINESS AND GEOGRAPHICAL SEGMENTS
A business sector is a division of a firm that can be distinguished by

the products it sells, the services it offers or the geographic areas in
which it operates. In other words, it is a discrete section of a firm that
can be distinguished from the rest of the company by its clients, goods
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or market areas.
Companies are frequently divided into business segments by manage-

ment to determine which aspects of the organisation are operating
well and which areas require improvement. During periods of poor
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economic development, management divides firm performance into

divisions in order to make judgments about whether to stop operating
in specific markets or eliminate whole departments.
Example 1: The majority of businesses operate in numerous markets.

Every huge corporation has a plethora of various parts. For example,
Apple. Apple was founded in 1976 as a personal computer firm. They
have basically always made software to assist their hardware opera-
tions.
Apple now makes laptops, tablets, phones, headphones, music play-

ers and other products. Apple’s management may use these items
to break down the firm’s overall performance into smaller sectors,
allowing them to see where the company is succeeding. You may think
Apple’s constant revenues come from the iPad because it is one of the
newest items to be released if you didn’t know about this segmenta-
tion. In truth, Apple tablet sales have dropped in recent quarters due
to lower customer demand. The sustained success of Apple’s phone
business is still credited with the company’s consistent profitability.

With this knowledge, Apple’s management may decide whether the

corporation should enhance some areas or discontinue producing
items entirely.
As you can see, segmenting a firm into separate business segments

aids management in analysing not just the company’s present struc-
ture, but also performance depending on goods, customers and mar-
ket regions.
Geographic segmentation may be the most straightforward sort of

market segmentation to grasp, yet there are still lots of applications
that organisations overlook.
Depending on your company’s demands, the size of the area you tar-
get should alter. In general, the larger the company, the broader the
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sectors you will be focusing on. After all, addressing each postcode
individually will not be cost-effective with such a large potential audi-
ence.
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There are six characteristics that may be utilised to establish client
segments and are related to geographic segmentation:
1. Location (country, state, city, ZIP code)
2. Timezone
3. Climate and season
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4. Cultural preferences
5. Language
6. Population type and density (urban, suburban, exurban or rural)
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Benefits of Geographic Segmentation
The following are some benefits of geographic segmentation:

Easy to implement: Geographic segmentation differs from other
market segmentation methods (particularly psychographic and
behavioral) in that it requires fewer data points.
As a result, it provides a rapid and efficient path into targeted
marketing, as well as concrete ways to reach out to potential clients
using simply their location as a starting point.
Higher product relevancy: This not only helps to increase reve-
nue, but it also helps to enhance the customer-business connec-
tion. Customers’ experiences are improved when relevant goods
are presented to them, minimising the amount of effort they must
expend to find what they want.
Improved advertising effectiveness: By showing more tailored
adverts, you may ensure that more of your marketing money is

spent on people who need or want your product and less is wasted
on those who don’t. This is not to argue that using a geographic
segmentation plan is always the best option.
It is tailored to the needs of various businesses and sectors. Small

firms that operate in confined locations will reap significant benefits
by concentrating their marketing efforts in these areas. Large corpo-
rations with items that will be hotspots for consumers in certain loca-
tions will also profit.
Customers in rural locations will buy more huge four-wheel drive cars
from an international manufacturer than those who drive crowded
metropolitan streets. Businesses selling items that are not dependent
on regional trends, on the other hand, will not gain as much from
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geographic segmentation. Corn Flakes consumers are likely to be as
numerous in one location as they are in another.
As per the Ministry of Corporate Affairs of India,

IM
Business and geographical segments of an enterprise for exter-
nal reporting purposes should be those organisational units for
which information is reported to the board of directors and to the
chief executive officer for the purpose of evaluating the unit is
performance and for making decisions about future allocations of
resources, except as provided in paragraph 25.
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Ifinternal organisational and management structure of an enter-

prise and its system of internal financial reporting to the board
of directors and the chief executive officer are based neither on
individual products or services or groups of related products/ser-
vices nor on geographical areas, paragraph 20(b) requires that the
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directors and management of the enterprise should choose either

business segments or geographical segments as the primary seg-
ment reporting format of the enterprise based on their assessment
of which reflects the primary source of the risks and returns of
the enterprise, with the other as its secondary reporting format. In
that case, the directors and management of the enterprise should
determine its business segments and geographical segments for
external reporting purposes based on the factors in the definitions
in paragraph 5 of this Standard, rather than on the basis of its
system of internal financial reporting to the board of directors and
chief executive officer,
a. if one or more of the segments reported internally to the direc-
tors and management is a business segment or a geographical
segment based on the factors in the definitions in paragraph 5
but others are not, sub-paragraph
b. below should be applied only to those internal segments that
do not meet the definitions in paragraph 5 (that is, an internal-

ly reported segment that meets the definition should not be

further segmented), (b) for those segments reported internally
to the directors and management that do not satisfy the defi-
nitions in paragraph 5, management of the enterprise should
look to the next lower level of internal segmentation that re-
ports information along product and service lines or geograph-
ical lines, as appropriate under the definitions in paragraph 5
and
c. if such an internally reported lower-level segment meets the
definition of business segment or geographical segment based
on the factors in paragraph 5, the criteria in paragraph 27 for
identifying reportable segments should be applied to that seg-
ment.
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7.3.3 REPORTABLE SEGMENTS
The term “reportable segment” refers to the International Financial

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Reporting Standards (IFRS), which are a set of international account-
ing guidelines. If an operational segment accounts for at least 10% of
the whole business’s revenues or assets, it is considered a reportable
segment. Public corporations must disclose each segment’s financial
activity individually and incorporate that information in the corpo-
ration’s aggregate statements, according to international accounting
rules. Consider how this may effect the bookkeeping of your small
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business.
A reportable section of exploitation is one that fits one or more of the

following criteria: The segment’s regular income is equal to or greater
than 10% of the company’s total income, the segment’s total gains or
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losses for the year are equal to or greater than 10% of the company’s
total gains or losses; or the segment’s assets are equal to or greater
than 10% of the company’s total assets.
A business segment or geographical segment should be identified
as a reportable segment if:
a. Its revenue from sales to external customers and from trans-
actions with other segments is 10 per cent or more of the total
revenue, external and internal, of all segments or
b. Its segment result, whether profit or loss, is 10 per cent or more
of - (i) the combined result of all segments in profit or (ii) the
combined result of all segments in loss, whichever is greater in
absolute amount or
c. Its segment assets are 10% or more of the total assets of all seg-
ments.
A business segment or a geographical segment which is not a
reportable segment as per paragraph 27, may be designated as a

reportable segment despite its size at the discretion of the man-

agement of the enterprise. If that segment is not designated as a
reportable segment, it should be included as an unallocated rec-
onciling item.
If total external revenue attributable to reportable segments con-
stitutes less than 75% of the total enterprise revenue, additional
segments should be identified as reportable segments, even if they
do not meet the 10% thresholds in paragraph 27, until at least
75% 30.
The 10% thresholds in this Standard are not intended to be a guide
for determining materiality for any aspect of financial reporting
other than identifying reportable business and geographical seg-
ments.
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A segment identified as a reportable segment in the immediately
preceding period because it satisfied the relevant 10% thresholds
should continue to be a reportable segment for the current period
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notwithstanding that its revenue, result and assets all no longer
meet the 10% thresholds.
If a segment is identified as a reportable segment in the current
period because it satisfies the relevant 10% thresholds, preced-
ing-period segment data that is presented for comparative pur-
poses should, unless it is impracticable to do so, be restated to
reflect the newly reportable segment as a separate segment, even
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if that segment did not satisfy the 10% thresholds in the preceding
period.
Example 2: A Ltd. has eight product-based units. Each division deals

with various items. Each unit’s revenue, profits, and assets are dis-
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played as follows:
(Amount in $ in Million)
Unit Unit Unit Unit Unit Unit Unit Unit

Particulars Total
A B C D E F G H
Assets 40 60 50 80 79 65 55 51 480
Revenue 420 750 400 600 1050 830 900 650 5600
Profit 9 6.5 4 5.5 12 10 5.6 3.4 56
What units must be reported in accordance with segment reporting?
Solution:
As per segment reporting, the unit must be reported if:

The unit’s assets exceed or are equivalent to 10% of the organisa-
tion’s overall assets.

More than 10% of the organisation’s overall profit or loss is consid-

ered to be profit or loss.
Revenue is greater than or equivalent to 10% of the organisation’s
overall revenue.
As a result, each unit’s computation for segment reporting is as fol-

lows:
Particulars Unit A Unit B Unit C Unit D Unit E Unit F Unit G Unit H Total
Assets 60 60 40 80 79 65 55 51 490
Revenue 420 750 400 600 1050 830 900 650 5600
Profit 9 6.5 4 5.5 12 10 5.6 3.4 56
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Percentage 12.24% 12.24% 8.16% 16.33% 16.12% 13.27% 11.22% 10.41%
of Assets to
Total Assets
(60/490) (60/490) (40/490) (80/490) (79/490) (65/490) (55/490) (51/490)

×100 ×100 ×100 ×100 ×100 ×100 ×100 ×100
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Percentage 7.50% 13.39% 7.14% 10.71% 18.75% 14.82% 16.07% 11.61%
of Revenue
to Total
Revenue
(420/5600) (750/5600) (400/5600) (600/5600) (1050/5600) (830/5600) (900/5600) (650/5600)

×100 ×100 ×100 ×100 ×100 ×100 ×100 ×100
Percentage 16.07% 11.61% 7.14% 9.82% 21.43% 17.86% 10.00% 6.07%

of Profit to
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Total Profit
(9/56) (6.5/56) (4/56) ×100 (5.5/56) (12/56) ×100 (10/56) (5.6/56) (3.4/56)
×100 ×100 ×100 ×100 ×100 ×100
Units C is not to be reported individually since the total income, assets,

or profit are less than 10% of the total for that region of the organisa-
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tions as a whole. Instead, units A, B, D, E, F, G and H are to be reported

as segments in accordance with segmental reporting.
2. A business segment or a geographical segment which is not

a reportable segment as per __________, may be designated
as a reportable segment despite its size at the discretion of
the management of the enterprise. If that segment is not
designated as a reportable segment, it should be included as
an unallocated reconciling item.
a. Paragraph 27
b. Paragraph 28
c. Paragraph 29
d. Paragraph 30

ACTIVITY
Find examples of segment reporting of any two Indian organisa-

tions.
7.4 SUMMARY S
The reporting of a company’s operating segments in the disclo-
sures that accompany its financial statements is known as segment
reporting. Segment reporting is mandatory for publicly traded
companies but not for privately owned companies.
An operating segment, according to Generally Accepted Account-
ing Principles (GAAP), engages in business activities from which it
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may earn revenue and incur expenses, has discrete financial infor-
mation available and whose results are reviewed on a regular basis
by the entity’s chief operating decision maker for performance
IM
evaluation and resource allocation decisions.
Accounting Standard (AS)-17 deals with segment reporting and
was established to help better understand performance risk and
returns of an organisation. It contains provisions pertaining to the
reporting of segment information in order to meet the needs of the
users of financial statements.
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Segment reporting refers to the process of reporting the operat-

ing segments of a company in the disclosures along with its finan-
cial statements. As GAAP, an operating segment is the one that is
involved in business activities from which it may earn revenue and
incur expenses.
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Segment reporting provides a complete picture of a company’s

operations for shareholders, upper management and investors
which help them in better decision making.
Segment reporting is the reporting of the operating segments or
units of a company in its financial statements. Segment reporting
is required for publicly held entities, but not required for privately
held ones.
Financial statement consumers may also gain a clearer under-
standing of the swings that may impact overall figures for each
section by using segment reporting.
Segment reporting divides a company’s operations into digestible
chunks or segments. The financial statements for each operational
segment must thereafter be recorded in detail by public corpora-
tions.
A business sector is a division of a firm that can be distinguished
by the products it sells, the services it offers or the geographic

areas in which it operates. In other words, it is a discrete section of

a firm that can be distinguished from the rest of the company by
its clients, goods or market areas.
The term “reportable segment” refers to the International Finan-
cial Reporting Standards (IFRS), which are a set of international
accounting guidelines. If an operational segment accounts for at
least 10% of the whole business’s revenues or assets, it is consid-
ered a reportable segment.
KEY WORDS
Accounting Standard (AS): Authoritative standards for finan-

cial reporting
S
Operating segments: A component of an entity that engages in
business activities from which it may earn revenues and incur
IM Reporting period: The time span for which a company reports
its financial performance and financial position
Segment reporting: A company’s financial data by company

divisions, subsidiaries or other kinds of business segments

M
MCQ
1. Segment reporting refers to the process of reporting the
___________ of a company in the disclosures along with its
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a. Operating segments
b. Separate segments
c. Profitable segments
d. Under loss segments
2. As per __________, an operating segment is the one that is
involved in business activities from which it may earn revenue
and incur expenses.
a. Generally Accepted Accounting Procedures (GAAP)
b. Generally Accepted Accounting Principles (GAAP)
c. Generally Accepted Accounting Practices (GAAP)
d. Generally Accepted Accounting Processes (GAAP)
3. The main objective of segment reporting is to provide information
to investors and creditors regarding the ______________ of the

most important operating units of a company so that they can

use as the basis for decisions related to the company.
a. Financial results and position
b. Number of employees
c. Number of offices
d. Number of products
4. Segment reporting information helps investors to
a. Evaluate a company’s performance
b. Assess its prospects for future net cash flows
c. Understand the business as a whole
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d. All of these
5. Which of the following describes the segment reporting’s
objectives?
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a. To keep accounts more transparent and easier to understand
b. To make better decisions by keeping in mind the business
from different segments
c. To better analyse of the risk and returns of the organisation
d. All of these
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6. Which of the following are the categories of organisations to which

Accounting Standard (AS)-17 applies for a given accounting
period?
a. Organisations with equity or debt securities listed in India
and outside India.
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b. Organisations in the process of listing their equity or debt

securities as acknowledged by board of directors.
c. Banks including cooperative banks.
d. All of these
7. The information included in segment reporting
a. The types of products and services sold by every segment
b. The basis of organisation
c. Revenues
d. All of these
8. A business segment or geographical segment should be identified
as a reportable segment if:
a. Its revenue from sales to external customers and from trans-
actions with other segments is 10 per cent or more of the total
revenue, external and internal, of all segments or

b. Its segment result, whether profit or loss, is 10% or more of

- (i) the combined result of all segments in profit or (ii) the
combined result of all segments in loss, whichever is greater
in absolute amount or
c. Its segment assets are 10% or more of the total assets of all
segments.
d. All of these

?
1. What do you mean by segment reporting?
2. What are the objectives of segment reporting?
3. What are the factors included in segment reporting?
S
7.7
(HOTS) QUESTIONS
IM
1. A business entity’s section is reportable once a major proportion
of its revenue springs from the sale of merchandise and services
to external purchasers and __________.
a. Customers
b. Financer
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c. Servicers
d. None of these
2. Segment reporting need companies particularly those that are
multi-product and multi-location to disclose their segment-wise
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operations in their annual reports still as in their __________

reports.
a. Yearly
b. Half-yearly
c. Quarterly
d. None of these
Topic Q. No. Answer

Overview of Segment Reporting 1. d. All of these
Identifying Reportable Segments 2. a. Paragraph 27

Q. No. Answer
1. a. Operating segments
2. b. Generally Accepted Accounting Principles (GAAP)
3. a. Financial results and position
4. d. All of these
5. d. All of these
6. d. All of these
7. d. All of these
8. d. All of these
S
1. Segment reporting refers to the process of reporting the
operating segments of a company in the disclosures along with its
IM
financial statements. Refer to Section 7.2 Overview of Segment
Reporting
2. Segment reporting aims to provide information to investors
about different operating units of an organisation so that they can
better make investment decisions. Refer to Section 7.2 Overview
of Segment Reporting
M
3. The information included in segment reporting is the types

of products and services sold by every segment, the basis of
organisation, revenues, interest expense, depreciation and
amortisation. Refer to Section 7.2 Overview of Segment
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Reporting

QUESTIONS
Q. No. Answer
1. a. Customers
2. c. Quarterly
SUGGESTED READINGS
2004. Segment reporting. Melbourne, Vic.: The Board.
1981.
Reporting financial information by segment. (U.K.): The
Committee.
Cohen, T., n.d. Segment reporting.

E-REFERENCES
Mca.gov.in. 2022. [online] Available at: <https://www.mca.gov.in/
Ministry/notification/pdf/AS_17.pdf> [Accessed 16 June 2022].
Bragg, S. and Bragg, S., 2022. Segment reporting definition —
AccountingTools. [online] AccountingTools. Available at: <https://
www.accountingtools.com/articles/what-is-segment-reporting.
html> [Accessed 16 June 2022].
Gocardless.com. 2022. What Is Segment Reporting?. [online] Avail-
able at: <https://gocardless.com/en-us/guides/posts/what-is-seg-
ment-reporting/> [Accessed 16 June 2022].
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C H A
8 P T E R
HORIZONTAL ANALYSIS
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CONTENTS
8.1 Introduction
8.2 Overview of Horizontal Analysis
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8.2.1 Meaning of Comparative Statements
8.2.2 Types of Comparative Statements
Activity
8.3 Trend Analysis
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Activity
8.4 Ratio Analysis
Activity
8.5 Summary
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APPROACHES TO HORIZONTAL ANALYSIS
The value of horizontal analysis permits analysts to assess the

Case Objective company’s past performance and current money position or
The caselet explains the growth and project the helpful insights gained into the long run.
approaches an analyst can For example, an analyst could get wonderful results once the pres-
choose for horizontal analysis. ent period’s financial gain is compared thereupon of the previous
quarter. However, it is important for an analyst to decide which
approach to be adopted for horizontal analysis. There are several
options:
Direct comparison: In this comparison, simply the results of
one accounting period to another are compared. For example,
if 2018 revenue of a company was `20,000 and 2019 revenue
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was `27,000, the difference would be `7,000. The comparison
method allows to quickly view any changes from period to
period, and whether those changes are beneficial or require
further research.
IM
Variance: Variance can be calculated between the chosen peri-
ods to determine whether the impact was positive or negative.
The variance method is particularly helpful when horizontal
analysis is being used to determine the financial health of the
business by those outside the business such as investors and
creditors.
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Percentage: The percentage method is helpful if the analyst

is looking for more in-depth analysis. Using the percentage
method, the first period of the income statement or balance
sheet is considered the base period, with each subsequent
period comparing line-by-line results to the base year.
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HORIZONTAL ANALYSIS 161
LEARNING OBJECTIVES

>> Explain the concept of horizontal analysis
>> Discuss comparative statements
>> Describe the concept of trend analysis
>> Summarise the importance of ratio analysis
8.1 INTRODUCTION
In the previous chapter, you studied about segment reporting. The Quick Revision
reporting of a company’s operating segments in the disclosures that
S
accompany its financial statements is known as segment reporting.
Segment reporting is mandatory for publicly-traded companies but
not for privately-owned companies. Investors and creditors can utilise
segment reporting to get information about the financial performance
IM
and position of a business’s most important operational divisions,
which they can use to make choices about the firm.
Horizontal analysis is a process of comparing line items in compara-

tive financial statements across a number of years in an effort to track
the history and progress of a company’s performance. In other words,
it is a way for analysts to compare accounts or performance metrics
over time to see if the company is improving or declining.
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Horizontal analysis uses a line-by-line comparison to compare the

totals. For example, if you want to compare the income statements
for 2014 and 2015, horizontal analysis allows you to compare revenue
totals for both years to see if it increased, decreased or remained rel-
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atively stagnant.
In this chapter, you will study the overview of horizontal analysis,

meaning of comparative statements, types of comparative statements,
trend analysis, ratio analysis, etc., in detail.
8.2 OVERVIEW OF HORIZONTAL ANALYSIS

Horizontal analysis refers to a process of comparing historical finan-
cial information of different reporting periods. In this process, histor-
ical data, such as ratios or line items, are compared over a number of
accounting periods.
In horizontal analysis, either absolute comparisons or percentage

comparisons are used, where the numbers in each succeeding period
are expressed as a percentage of the amount in the baseline year, with
the baseline amount being listed as 100%. This is also known as base-
year analysis.

While conducting horizontal analysis, it is always advised that all

financial statements are analysed at the same time so that one can see
the complete impact of operational results on a company’s financial
condition over the review period. For instance, the income statement
analysis may show that a company has an excellent second year, but
the related balance sheet analysis may show that the company has
trouble funding growth, decline in cash, increase in accounts payable
and debt and so on.
The main advantage of horizontal analysis is that it can help users by

visually identifying errors from long-running trends. Changes in the
data are more readily apparent by presenting data on a comparative
basis.
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8.2.1 MEANING OF COMPARATIVE STATEMENTS
A comparative statement refers to a document that is used for com-

paring a particular financial statement with prior period statements.
IM
Comparative statements represent the impact of business decisions on
a company’s bottom line. Trends are identified and the performance
of new lines of business and new products can be evaluated. Analysts,
investors and business managers use a company’s income statement,
balance sheet, and cash flow statement for comparative purposes.
8.2.2 TYPES OF COMPARATIVE STATEMENTS

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The comparative financial statements provide information about the

financial situation at various points in time. To offer an impression
of the financial condition at two or more times, the components of
financial position are presented in a comparison format. Comparative
statements will encompass any statement presented in a comparative
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format.
For comparative purposes, there are two types of comparative state-

ments used, namely comparative earnings report and comparative
balance sheet.
COMPARATIVE BALANCE SHEET
The examination of the trend of the same items, groups of items and
calculated things in two or more balance sheets of the same commer-
cial company on various dates is known as a comparative balance
sheet analysis.
By comparing the balance sheet at the beginning and end of a

period, changes may be seen and these changes can aid in generating
an opinion on how an enterprise is doing. Two columns on the
comparative balance sheet include the information from the original
balance sheets. Increases in figures are displayed in a third column.

For percentage increases or decreases, a fourth column may be added.
While interpreting comparative balance sheet, the interpreter is

expected to study the following aspects:
(1) Current financial position and liquidity position.
(2) Long -term financial position.
(3) Profitability of the concern.
1. One should look at the working capital in both years when
analysing a company’s present or short-term financial status. The
working capital statistics will be determined by the difference
between current assets and current liabilities. The business’s
present financial status will improve as working capital increases.
S
The short-term financial situation will not improve if a rise in
current assets is not followed by an increase in current liabilities
of the same amount. In order to examine the current financial
condition, student needs research the growth or decline in
IM
current assets and current liabilities.
The liquidity position of the company should be examined as
the second factor in the present financial situation. The liquidity
position of the business will be improved if liquid assets, such as
cash in hand, cash in the bank, bills receivable or debtors, grow
in the second year compared to the first year.
M
Stocks building up due to a lack of consumers, a decline in demand

or ineffective sales promotion activities can all contribute to an
increase in inventory. Even while a rise in inventory may result
in a rise in working capital, the firm will not benefit from this.
2. By examining changes in fixed assets, long-term obligations and
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capital, the long-term financial situation of the company may be

examined.
Financing fixed assets by the issuance of long-term securities
such as debentures, bonds, loans from financial institutions
or new share capital will be the correct financial policy to be
concerned with.
A rise in long-term loans and capital should be contrasted with
a rise in fixed assets. If the growth in fixed assets exceeds the
growth in long-term securities, then some of the growth in fixed
assets has been funded by working capital. On the other hand, if
the rise in long-term securities is more than the increase in fixed
assets, then working capital has also received some financing
from long-term sources in addition to fixed assets. Financing
fixed assets with long-term money is a sensible course of action.
To create a judgment on the potential for future output, it is also
important to investigate the types of assets that have risen or
reduced. The concern’s production capacity will rise as a result

of the increase in equipment. In terms of liabilities, a rise in

loaned money will result in a greater obligation to pay interest,
as opposed to an increase in share capital, which will result in
a smaller need to do so. After considering the aforementioned
factors, a conclusion on the long-term financial status should be
reached.
3. The profitability of the business is the next topic to be looked
at in a comparative balance sheet enquiry. The interpreter will
be able to determine if profitability has increased or decreased
by examining changes in retained profits, various resources and
surpluses, among other things. The profitability of the business
will rise in direct proportion to the balance of the profit and loss
account and other resources derived from earnings. The decline
in these accounts might indicate the issuance of dividends,
S
the issuance of bonus shares or a decline in the company’s
profitability.
4. A conclusion on the financial status of the business should be
IM reached after examining various assets and liabilities. It is
impossible to predict if a positive short-term financial situation
would result in a positive long-term financial situation or vice
versa. The report must finish with a final statement regarding
the overall financial situation.
Illustration 1:
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From the following information, prepare a comparative balance sheet

of Geetanjali Ltd.:
Particular 31.03.2021 31.03.2020

Equity Share Capital 50,00,000 50,00,000
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Fixed Assets 72,00,000 60,00,000

Reserves and Surplus 12,00,000 10,00,000
Investments 10,00,000 10,00,000
Long-term Loans 30,00,000 30,00,000
Current Assets 21,00,000 30,00,000
Current Liabilities 11,00,000 10,00,000
Solutions:

As on 31.03.2020 and 31.03.2021
Absolute Percentage
2020 2021
Changes Changes (%)
Assets
Fixed Assets 60,00,000 72,00,000 12,00,000 20
Investment 10,00,000 10,00,000 - -


As on 31.03.2020 and 31.03.2021
Absolute Percentage
2020 2021
Changes Changes (%)
Current Assets 30,00,000 21,00,000 (9,00,000) (-) 30
Total Assets 1,00,00,000 1,03,00,000 3,00,000 3
Liabilities And
Capital
Equity Share 50,00,000 50,00,000 - -
Capital
Reserve and 10,00,000 12,00,000 2,00,000 20
Surplus
Long-term Loan 30,00,000 30,00,000 - -
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Current 10,00,000 11,00,000 1,00,000 10
Liabilities
1,00,00,000 1,03,00,000 3,00,000 3
IM
Illustration 2:
Following is the balance sheet of Rachna Ltd. As on 30th June 2020 and
2021
Liabilities 2020 2021 Assets 2020 2021

Share Capital 10,00,000 1,50,000 Fixed Assets 2,00,000 3,00,000
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Reserve 1,00,000 1,00,000 Current 50,000 80,000

Assets
Loan 20,000 80,000
Current Liabilities 30,000 50,000
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2,50,000 3,80,000 2,50,000 3,80,000
Prepare a Comparative Balance Sheet
Solution:
Comparative Balance Sheet of Rachna Ltd.

As on 30th June 2020 and 2021
Absolute Percentage
2020 2021
Changes Changes (%)
A. Fixed Assets 2,00,000 3,00,000 1,00,000 50
B. Working Capital
Current Assets 50,000 80,000 30,000 60
Less: Current 30,000 50,000 20,000 66.67
Liabilities
20,000 30,000 10,000 50

Comparative Balance Sheet of Rachna Ltd.

NOTE As on 30th June 2020 and 2021
A comparative record not solely
offers an image of the assets Absolute Percentage
2020 2021
and liabilities in numerous Changes Changes (%)
accounting periods but also C. Capital Employed 2,20,000 3,30,000 1,10,000 50
reveals the extent to which
(A+ B)
the assets and liabilities have
modified throughout such D. Loan 20,000 80,000 60,000 300
periods. E. Shareholder’s 2,00,000 2,50,000 50,000 25
Funds (C-D)
Represented By:
F. Share Capital 1,00,000 1,50,000 50,000 50
G. Reserves 1,00,000 1,00,000 - -
Shareholder’s Funds 2,00,000 2,50,000 50,000 25
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(F+G)
COMPARATIVE INCOME STATEMENT

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A comparative income statement is the income statement in which
multiple periods of the income statement are dealt and compared
MARK IT! simultaneously so as to allow the users to compare the incomes from
a previous year and make investment decisions on whether to invest
A business owner needs to
in the company.
study the following aspects of a
comparative balance sheet:
yyCapital
The income statement displays a company’s operating performance.
M
The comparative income statement provides insight into a company’s

yyChanges in long term, assets,
liabilities and capital development over time. To examine the profitability of the firm, abso-
yyProfitability lute data changes in dollar values and percentages may be found. The
income statement includes four columns, same as the comparative
balance sheet. The first two columns include data for numerous things
N
over a two-year period. Increase or decrease in numbers is displayed

in the third and fourth columns, respectively, as absolute amounts and
percentages.
The following steps will be included in the examination and interpre-

tation of the income statement:
1. It is important to compare changes in sales volume to changes
in cost of products sold. Increased sales may not necessarily
translate into more profits. If the rise in sales exceeds the
increase in cost of products sold, profitability will increase. The
initial step should involve researching the gross profit margin.
2. Examining operational earnings need to be the second stage of
examination. To determine operational profits, the operating
costs, such as selling and distribution costs, office and
administrative costs and other related costs, should be subtracted
from the gross profit.
The improvement in sales position and management of
operational expenditures will lead to an increase in operating

profit. A rise in operational expenses might be the cause of a

decline in operating profit.
Costs or a decline in revenues. It is important to examine how
individual costs have changed. The growth of business operations
may cause certain expenditures to rise, while managerial
inefficiencies may cause other expenses to rise.
3. The change in net profit will provide information about the
company’s overall profitability. The amount of operational profit
is reduced by non-operating costs such interest paid, losses from
asset sales, deferred expense write-offs, tax payments, etc. The
amount of net profit is obtained by subtracting operational profit
from all non-operating costs. There may also be certain non-
operating earnings, which will raise net profit. A rise in net profit
S
will give us a better understanding of how the business is doing.
4. An assessment of the company’s profitability should be made
and it should be provided at the conclusion. Whether or if the
overall profitability is good should be highlighted.
IM
Illustration 3:
From the following information, prepare a comparative income state-

ment of Java Ltd.
Particular 2020 2021

M
Sales 120% of cost of goods sold 50% of cost of goods sold

Cost of Goods Sold ` 20,00,000 ` 25,00,000
Indirect Expenses 10% of gross profits 10% of gross profits
Rate of Income 50% of net profit before 50% of net profit before
Tax tax tax
N
Solution:
Comparative Income Statement of JAVA Ltd.

Absolute Percentage
Particular 2020 2021
Changes Changes (%)
Sales 24,00,000 37,50,000 13,50,000 56.25
Less: Cost of Goods 20,00,000 25,00,000 5,00,000 25.00
Sold
Gross Profit 4,00,000 12,50,000 8,50,000 212.50
Less: Indirect 40,000 1,25,000 85,000 212.50
Expenses
Profit Before Tax 3,60,000 11,25,000 7,65,000 212.50
Less: - Income Tax 1,80,000 5,62,500 3,82,500 212.50
Net profit after Tax 1,80,000 5,62,500 3,82,500 212.50

Illustration 4:
For the years ending on December 31, 2020 and 2021, a company pro-
vides its financial statements. Study the profitability position of the
company by rearranging the numbers in a comparable format.
2020 2021
Particular
(000) (000)
Net Sales 785 900
Cost of Goods Sold 450 500
Operating expenses
General and Administrative Expenses 70 72
S
Selling Expenses 80 90
Non-Operating Expenses
Interest Paid 25 30
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Income Tax 70 80
Solution:

For the year ended 31st Dec. 2020 and 2021
31 Dec.
M
Increase (+)
2020 2021 Increase (+)
Particular Decrease (-)
(000) (000) Decrease (-)
Percentage (%)
Net Sales 785 900 +115 +14.65
N
Less: Cost of 450 500 +50 +11.0

Goods Sold
Gross Profit 335 400 +65 +19.40
Operating
Expenses
General & 70 72 +2 +2.8
Administrative
NOTE Expenses
The following aspects need to
be checked in the comparative Selling Expenses 80 90 +10 +12.5
income statement:
yyComparing sales with price of Total Operating 150 162 +12 +8.0
products sold Expenses
yyAmendment in operative Operating Profit 185 238 +53 +28.65
profits
yyProfit of a business Less: -Other 25 30 +5 +20.00
Deductions
Interest Paid


For the year ended 31st Dec. 2020 and 2021
31 Dec.
Increase (+)
2020 2021 Increase (+)
Particular Decrease (-)
(000) (000) Decrease (-)
Percentage (%)
Net Profit before 160 208 +48 +30.0
Tax
Less: -Income Tax 70 80 +10 +14.30
Net Profit after 90 128 +38 +42.22
Tax
S
1. In horizontal analysis, either absolute comparisons or

IM
percentage comparisons are used, where the numbers in
each succeeding period are expressed as a percentage of the
amount in the baseline year, with the baseline amount being
listed as
a. 80%
b. 90%
M
c. 100%
d. 150%
2. What do analysts, investors and business managers use for
comparative purposes?
N
a. A company’s income statement

b. Balance sheet
d. All of these
3. Which of the following aspects of a comparative balance sheet
a business owner needs to study?
a. Capital
b. Changes in long-term, assets, liabilities and capital
c. Profitability
d. All of these
ACTIVITY
Find comparative statements of any two organisations of your

choice and see what information they provide.

8.3 TREND ANALYSIS

Financial statements provide a picture on interrelations among var-
ious components of income statement and balance sheet, but cannot
provide information about the overall trend of the business or indicate
the trend of the individual or group of components of the statements.
For this purpose, statements over a number of years are to be com-
pared. This is where the role of trend analysis comes into the picture.
Trend analysis is a process of collecting information from multiple

periods and representing the collected information on a horizontal
line to find actionable patterns from the given information. Trend
analysis helps in viewing current trends to predict future ones.
To uncover useful patterns from the supplied information, trend anal-
S
ysis entails gathering data from several time periods and visualising
the data on a horizontal line. Trend analysis is employed in finance
for both stock technical and accounting analysis. We study the sales
and net profit performance over time for Colgate, assuming that 2013
IM
is the base case.
Over the past eight years, sales have increased by 16.3%. (2014-
2021).
We also note that the overall net profit has decreased by 20.3%
over the eight years.
M
Figure 8.1 shows the trend analysis of sales and net profit of Colgate:
Trend Analysis
150.0%
130.0% 116.3%
N
110.0%
90.0% 100.0%
70.0% 79.7%
50.0%
30.0%
Dec. 2013 Dec. 2014 Dec. 2015 Dec. 2016 Dec. 2017 Dec. 2018 Dec. 2019 Dec. 2020 Dec. 2021
Sales Net Profit
Figure 8.1: Trend Analysis of Sales and Net Profit of Colgate
Managers and stakeholders, including potential investors, can benefit

from trend research that makes use of corporate data. The internet
traffic for any particular firm, for example, may be used to undertake
a trend study.
Figure 8.2 displays the overall website traffic for firm A’s, an online
retailer of presents, during the previous six months. According to
data, there was an upward trend during the Christmas season, peak-
ing on December 20.

There has been a comparatively horizontal trend since the first part
of January. In other words, you might assess your success against this
business if you owned a rival gift shop. Although simple, this trend
analysis example enables you to forecast future performance and
compare this company’s operations to those of competitors.
On desktop & mobile web, in the last 6 months

1.25M
1M
750K
500K
250K
0
S
Oct 20 Nov 20 Dec 20 Jan 21 Feb 21 Mar 21
Figure 8.2: Upward Trend Analysis

IM
When studying the share price of a financial asset to aid in the deci-
sion-making process, one of the most popular trend analysis tech-
niques is used. For instance, Figure 8.3 contrasts the share prices of X
and Y over the course of a year:
160
M
140
120
100
N
80
60
40
20
0
Jan Feb Mar Apr Mar Jun Jul Aug Sep Oct Nov Dec
Company X Company Y
Figure 8.3: Share Prices of X and Y over the Course of a Year
The past year has seen an overall climb for Company X, with a little
trend reversal in February. But firm Y’s trend was horizontal for the
first six months before it started to decline.
Due to the difficulty in predicting when and whether a price may

change its direction, investors are typically more cautious when there

is a horizontal trend. If you add this stock to your portfolio, it will cost
you money because the share price is steadily falling.
This stock is an excellent addition to an investor’s portfolio if you have

a long-term investing plan because of Company X’s developing ten-
dency, which may help you forecast future occurrences.
? DID YOU KNOW When doing a trend analysis, other data should be taken into account,
In finance, trend analysis is including details about the business itself, the market as a whole and
used for technical analysis and
the state of the economy. Investors have a variety of options for mea-
accounting analysis of stocks.
suring an asset’s profitability, including trend analysis.
4. In __________, trend analysis is used for technical analysis and
S
accounting analysis of stocks.
a. finance b. accounting
c. trends d. ratios
IM
ACTIVITY
Find the advantages and limitations of trend analysis.
8.4 RATIO ANALYSIS

M
Ratio analysis refers to a quantitative method of gaining insight into a

company’s liquidity, operational efficiency and profitability by study-
ing its financial statements such as the balance sheet and income
statement.
N
Ratio analysis helps analysts in comparing line-item data from a com-

pany’s financial statements to reveal insights regarding profitability,
liquidity, operational efficiency and solvency. Ratio analysis can mark
how a company is performing over time, while comparing a company
to another within the same industry or sector. While ratios offer useful
insight into a company, they should be paired with other metrics, to
obtain a broader picture of a company’s financial health.
Comparing line items in a company’s financial accounts is known as

ratio analysis. Ratio analysis is used to assess a variety of aspects of
a company, including its profitability, operational effectiveness and
liquidity. Corporate insiders have better access to more in-depth oper-
ational data about the company, making ratio analysis less beneficial
to them. When used in the following two ways, it is quite helpful:
Trend line analysis: To determine whether there is a pattern in
the derived information, calculate each ratio across a significant
number of reporting periods. If ratios were just being looked at
for a particular time, the trend may reveal financial issues that

would not otherwise be obvious. The direction of future ratio per-

formance may also be predicted using trend lines.
Industry comparison: Comparing the outcomes for all of the firms
examined, compute the same ratios for rival businesses in the
same sector. The findings of a ratio analysis should be comparable
since these companies most likely have similar fixed asset invest-
ments and capital structures. If this is not the case, it may point to
a problem or it may show that a company is able to make profits
that are far larger than those of its competitors. In order to identify
which companies within a given industry are the most (and least)
valuable, sector analysis uses the industry comparison technique.
Various kinds of financial ratios available are broadly grouped into the
following six types:
S
1. Liquidity Ratios
2. Solvency Ratios
3. Profitability Ratios
IM
4. Efficiency Ratios
5. Coverage Ratios
6. Market Prospect Ratios
Let’s explain all of them in detail:
M
1. Liquidity ratios: A financial ratio called a liquidity ratio is

used to assess a company’s capacity to settle its short-term loan
commitments. The statistic aids in figuring out if a business can
utilise its liquid or current, assets to pay its current liabilities.
N
The current ratio, quick ratio and cash ratio are the three
liquidity ratios that are most frequently employed. For each of
the liquidity ratios, the numerator of the equation is the quantity
of liquid assets and the denominator is the amount of current
liabilities.
2. Solvency ratios: Prospective business lenders frequently utilise
a solvency ratio as a significant indicator of a company’s capacity
to pay down its long-term loan commitments. A company’s
financial health may be gauged by looking at its solvency ratio,
which shows if its cash flow is sufficient to cover its long-term
obligations. An unfavorable ratio might suggest a chance that a
corporation would fail to pay its debts.
3. Profitability ratios: Using information at a single moment in
time, profitability ratios are a class of financial measurements
that are used to evaluate a company’s capacity to make profits in
relation to its revenue, operating costs, balance sheet assets or
shareholders’ equity over time.

Efficiency ratios, which evaluate how well a corporation uses

its resources internally to create money, can be contrasted to
profitability ratios (as opposed to after-cost profits).
4. Efficiency ratios: Efficiency ratios are measurements that are
used to assess how well a business can utilise its assets and
money to generate revenue. In essence, the ratios show what
type of income or profit a firm may produce from the amount
it spends to run its business. They do this by comparing costs
incurred to revenues generated.
Efficiency ratios, often known as activity ratios, gauge how well
businesses use their resources to create revenue. Efficiency
ratios frequently examine the length of time it takes businesses to
produce sales or to turn their inventory into cash, from customers.
S
In addition to creditors and outside investors examining the
business’ operations and profitability, management uses these
ratios to assist the company grow.
5. Coverage ratios: In general, a coverage ratio is a metric used
IM
to assess a company’s capacity to pay off debt and fulfill other
financial commitments such as dividends and interest payments.
The simpler it should be to pay dividends or make interest
payments on its debt, the greater the coverage ratio. Analysts
and investors may examine the evolution of coverage ratios over
time to determine changes in a company’s financial status.
M
Coverage ratios occur in a variety of formats and can be used to

detect businesses that may be experiencing financial difficulties,
albeit low ratios are not always a sign that a business is having
problems. These ratios are based on a variety of criteria and in
order to determine the health of a firm, it is frequently advised to
go further into its financial records.
N
6. Market prospect ratios: Market Prospect ratios are used to

contrast the stock prices of publicly listed firms with other
financial indicators such as profits and dividend yields. Market
prospect ratios are used by investors to assess stock price
patterns and determine the existing and future market worth of
a firm.
To put it another way, market prospect ratios inform investors
NOTE of the expected returns on their investments. Future dividends,
Ratio analysis is a cornerstone earnings or just an increased stock value might be given to them.
of fundamental equity analysis. These ratios are useful for predicting future stock values based
on current earnings and dividend data for investors.
5. Various kinds of financial ratios available include:

a. Liquidity ratios b. Solvency ratios
c. Profitability ratios d. All of these

ACTIVITY
Find some limitations of ratio analysis.
8.5 SUMMARY S
Horizontal analysis is a process of comparing line items in compar-
ative financial statements across a number of years in an effort to
track the history and progress of a company’s performance.
Horizontal analysis uses a line-by-line comparison to compare the
totals. For example, if you want to compare the income statement
for the year of 2014 and 2015, horizontal analysis allows you to com-
pare revenue totals for both years to see if it increased, decreased
S
or remained relatively stagnant.
Horizontal analysis refers to a process of comparing historical
financial information of different reporting periods. In this pro-
IM
cess, historical data, such as ratios or line items, are compared
over a number of accounting periods.
Inhorizontal analysis, either absolute comparisons or percentage
comparisons are used, where the numbers in each succeeding
period are expressed as a percentage of the amount in the baseline
year, with the baseline amount being listed as 100%.
A comparative statement refers to a document that is used for
M
comparing a particular financial statement with prior period state-

ments. Comparative statements represent the impact of business
decisions on a company’s bottom line.
The examination of the trend of the same items, groups of items
N
and calculated things in two or more balance sheets of the same

commercial company on various dates is known as a comparative
balance sheet analysis.
A comparative income statement is the income statement in which
multiple periods of the income statement are dealt and compared
simultaneously so as to allow the users to compare the incomes
from a previous year and make investment decisions on whether
to invest in the company.
Financial statements provide a picture on interrelations among
various components of income statements and balance sheets, but
cannot provide information about the overall trend of the business
or indicate the trend of the individual or group of components of
the statements.
Ratio analysis refers to a quantitative method of gaining insight
into a company’s liquidity, operational efficiency and profitability
by studying its financial statements such as the balance sheet and
income statement.

A financial ratio called a liquidity ratio is used to assess a compa-

ny’s capacity to settle its short-term loan commitments. The statis-
tic aids in figuring out if a business can utilise its liquid or current,
assets to pay its current liabilities.
Prospective business lenders frequently utilise a solvency ratio
as a significant indicator of a company’s capacity to pay down its
long-term loan commitments.
Using information at a single moment in time, profitability ratios
are a class of financial measurements that are used to evaluate a
company’s capacity to make profits in relation to its revenue, oper-
ating costs, balance sheet assets or shareholders’ equity over time.
Efficiency ratios are measurements that are used to assess how
S
well a business can utilise its assets and money to generate rev-
enue. In essence, the ratios show what type of income or profit a
firm may produce from the amount it spends to run its business.
In general, a coverage ratio is a metric used to assess a company’s
IM
capacity to pay off debt and fulfill other financial commitments
such as dividends and interest payments.
Market Prospect ratios are used to contrast the stock prices of pub-
licly listed firms with other financial indicators such as profits and
dividend yields. Market prospect ratios are used by investors to
assess stock price patterns and determine the existing and future
M
market worth of a firm.
KEY WORDS
Comparative statement: A document used to compare a partic-

N
ular financial statement with prior period statements

Horizontal analysis: An approach to analyse financial state-
ments by comparing specific financial information for a certain
accounting period
Ratio analysis: A comparison of line items in the financial state-
ments of a business

MCQ 1. ___________ refers to a process of comparing historical financial
information of different reporting periods.
a. Horizontal analysis
b. Vertical analysis
c. Diagonal analysis
d. None of these

2. Which of the following statements is correct about horizontal

analysis?
a. While conducting horizontal analysis, it is always advised
that all financial statements are analysed at the same time.
b. The main advantage of horizontal analysis is that it can help
users by visually identifying errors from long-running trends.
c. In horizontal analysis, either absolute comparisons or per-
centage comparisons are used.
d. All of these
3. A ___________ represents the financial position of an organisation
over different periods for which comparison is made.
S
a. Comparative cash flow statement
b. Comparative income sheet
c. Comparative balance sheet
IM
d. Comparative trading account
4. Which of the following aspects need to be checked in the
comparative income statement?
a. Comparing sales with price of products sold
b. Amendment in operative profits
M
c. Profit of a business
d. All of these
5. ____________ is a process of collecting information from
multiple periods and representing the collected information
N
on a horizontal line to find actionable patterns from the given

information.
a. Trend analysis
b. Ratio analysis
c. Vertical analysis
d. None of these
6. ___________ refers to a quantitative method of gaining insight
into a company’s liquidity, operational efficiency and profitability
by studying its financial statements such as the balance sheet
and income statement.
a. Trend analysis
b. Ratio analysis
c. Horizontal analysis
d. Vertical analysis

? 8.7 DESCRIPTIVE QUESTIONS

1. Write a short note on horizontal analysis.
2. Define comparative statement.
3. Write a short note on trend analysis.
4. What is ratio analysis?

8.8
(HOTS) QUESTIONS
1. Horizontal analysis will either use absolute comparisons or
proportion comparisons, wherever the numbers in every
succeeding amount area unit expressed as a proportion of the
S
number within the baseline year, with the baseline quantity
being listed as 100%.
a. True
IM b. False
2. Analysts believe current and past ___________ statements
to get knowledge to gauge the monetary performance of an
organisation.
a. Comparative
b. Financial
M
c. Ratio
d. None of these
3. Horizontal analysis shows a company’s growth and monetary
position versus competitors.
N
a. True
b. False
Topic Q. No. Answer

Overview of Horizontal Analysis 1. c. 100%
2. d. All of these
3. d. All of these
Trend Analysis 4. a. finance
Ratio Analysis 5. d. All of these

Q. No. Answer
1. a. Horizontal analysis
2. d. All of these
3. c. Comparative balance sheet
4. d. All of these
5. a. Trend analysis
6. b. Ratio analysis
S
1. Horizontal analysis refers to a process of comparing historical
financial information of different reporting periods. Refer to
Section 8.2 Overview of Horizontal Analysis
IM
2. A comparative statement refers to a document that is used for
comparing a particular financial statement with prior period
statements. Refer to Section 8.2 Overview of Horizontal
Analysis
3. Trend analysis is a process of collecting information from
multiple periods and representing the collected information
M
on a horizontal line to find actionable patterns from the given

information. Refer to Section 8.3 Trend Analysis
4. Ratio analysis helps analysts in comparing line-item data from
a company’s financial statements to reveal insights regarding
profitability, liquidity, operational efficiency and solvency. Refer
N
to Section 8.4 Ratio Analysis

QUESTIONS
Q. No. Answer
1. a. True
2. b. Financial
3. a. True
SUGGESTED READINGS
tions.

Farrell, J. and Shapiro, C., 1989. Horizontal mergers. [Palo Alto,

Calif.]: Hoover Institution, Stanford University.
Byun, J., n.d. Horizontal and vertical intra-industry trade of Korea.
E-REFERENCES
Corporate Finance Institute. 2022. Horizontal Analysis. [online]
Available at: <https://corporatefinanceinstitute.com/resources/
knowledge/finance/horizontal-analysis/> [Accessed 18 June 2022].
WallStreetMojo. 2022. Horizontal Analysis. [online] Available
at: <https://www.wallstreetmojo.com/horizontal-analysis/>
[Accessed 18 June 2022].
Formula, H., 2022. Horizontal Analysis Formula | Calculator
S
(Example with Excel Template). [online] EDUCBA. Available
at: <https://www.educba.com/horizontal-analysis-formula/>
Bragg, S. and Bragg, S., 2022. Horizontal analysis definition —
IM
AccountingTools. [online] AccountingTools. Available at: <https://
www.accountingtools.com/articles/horizontal-analysis> [Accessed
18 June 2022].
M
N

C H A
9 P T E R
OVERVIEW OF RATIO ANALYSIS
S
CONTENTS
9.1 Introduction
9.2 Overview of Ratio Analysis
IM
9.2.1 Objectives of Ratio Analysis
9.2.2 Advantages and Limitations of Ratio Analysis
9.2.3 Classification of Ratios
Activity
9.3 Liquidity Ratios
M
9.3.1 Current Assets Ratio

9.3.2 Acid Test Ratio
9.3.3 Super Quick Assets Ratio
Activity
N
9.4 Solvency Ratios

9.4.1 Debt-Equity Ratio
9.4.2 Proprietary Ratio
9.4.3 Fixed Assets Ratio
9.4.4 Coverage Ratios
Activity
9.5 Profitability Ratios
9.5.1 Gross Profit Ratio
9.5.2 Net Profit Ratio
9.5.3 Operating Profit Ratio
9.5.4 Return on Assets Ratio
9.5.5 Return on Capital Employed
Activity

CONTENTS
9.6 Turnover Ratios

9.6.1 Stock Turnover Ratio
9.6.2 Debtors Turnover Ratio
9.6.3 Creditors Turnover Ratio
Activity
9.7 Relevance of Ratio Analysis
Activity
9.8 Solved Illustrations
9.9 Summary
S
IM
M
N

OVERVIEW OF RATIO ANALYSIS 183
IMPORTANCE OF RATIO ANALYSIS
Ratios analysis is the mode of deciding and showing in arith-

metical terms the connections figures and gatherings of figures Case Objective
drawn from announcements. A ratio communicates the outcomes The case let explains the
based on correlation of two figures in numerical terms. A ratio is significance of ratio analysis.
a factual measuring stick that gives a proportion of connection
between two accounting figures. It portrays the noteworthy rela-
tionship which exists between figures appears on an asset report
in a benefit and misfortune account in a budgetary control frame-
work or in any of the piece of accounting organisation.” Following
are the importance of ratio analysis:
1. Test of solvency: Ratios can provide light on a company’s
S
solvency. For instance, it demonstrates adequate working
capital when the ratio of current assets to current liabilities
rises. Therefore, it is simple to pay debtors.
IM
2. Helpful in decision-making: Financial statements are
primarily intended to educate users of the company’s
financial status and to assist managerial staff in making
decisions.
3. Useful in discovering profitability: Ratios may also be
used to compare the profitability of various businesses. For
instance, ratios between the present and the past may be
M
analysed to identify trends in the past and potential future

performance of businesses.
4. Liquidity position: Ratio analysis can be used to draw
findings that are significant regarding the firm’s strong
N
liquidity situation. If a company can pay its obligations when

they are due, its liquidity situation is strong.
5. Useful for operating efficiency: Ratios give managers
the ability to gauge the effectiveness of their assets from a
management standpoint. It is a sign of increased efficiency
when sales and their contribution to net profit grow every
year.

LEARNING OBJECTIVES

>> Define ratio analysis
>> Explain the objectives of ratio analysis
>> Classify different types of ratios
>> Describe liquidity and solvency ratios
>> Discuss the importance of profitability and turnover ratios
>> Summarise the importance of ratio analysis
9.1 INTRODUCTION
S
Quick Revision In the previous chapter, you have studied about horizontal analysis
of financial statements. Horizontal analysis is a process of compar-
ing line items in comparative financial statements across a number of
years in an effort to track the history and progress of a company’s per-
IM
formance. In other words, it is a way for analysts to compare accounts
or performance metrics over time to see if the company is improving
or declining.
As studied in previous chapters, the most commonly used techniques

of financial statements analysis are comparative statements, common
size statements, trend analysis, accounting ratios and cash flow analy-
M
sis. Comparing line items in a company’s financial accounts is known

as ratio analysis. Ratio analysis is used to assess a variety of aspects
of a company, including its profitability, operational effectiveness,
and liquidity. Given that financial statements are their only source of
knowledge about a company, this kind of research is especially bene-
N
ficial to analysts who work for companies that are not their own. Cor-
porate insiders have better access to more in-depth operational data
about the company, making ratio analysis less beneficial to them.
In this chapter, you will study the overview of ratio analysis, objectives
of ratio analysis, advantages and limitations of ratio analysis, liquidity
ratios, solvency ratios, profitability ratios, turnover ratios, relevance
of ratio analysis etc. detail.
9.2 OVERVIEW OF RATIO ANALYSIS

A ratio refers to a mathematical number that is calculated as a ref-
erence to relationship of two or more numbers. It can be expressed
NOTE as a fraction, proportion or percentage. If the number is calculated
As ratios provide useful insight by referring to two accounting numbers derived from financial state-
into a company’s performance
they have to be paired with ments, it is called an accounting ratio. Ratio analysis is a quantitative
different metrics to induce a technique of gaining insight into a company’s liquidity, operational
broader image of the company’s potency and profit from its financial statements. For example, if the
cash health. gross profit of a company is `20,000 and the Revenue from Opera-

tions are `2,00,000, it can be said that the gross profit is 10% (20,000/
2,00,000) × 100 of the Revenue from Operations. This ratio is called QUICK TIP
gross profit ratio. Remember accounting
ratios show a relationship,
A ratio must be calculated using numbers which are meaningfully cor- if any, between accounting
numbers derived from financial
related. A ratio calculated by using two unrelated numbers will not statements. Thus, their efficacy
serve any purpose. For instance, the furniture of a business is `50,000 largely depends upon the basic
and purchases are `1,50,000. The ratio of purchases to furniture is 3 numbers from which they are
(1,50,000/50,000) but it has no relevance. The reason is that there is no calculated.
relationship between these two aspects.
9.2.1 OBJECTIVES OF RATIO ANALYSIS
Ratio analysis is a crucial part of interpretation of results derived from

financial statements. If done effectively, it provides a lot of information
S
which helps the analyst:
To identify the areas of improvement in business
To identify the potential areas of opportunity
IM
To provide deep insight into the profitability, liquidity, solvency NOTE
and efficiency levels in the business If the financial statements
contain some errors the derived
To compare the company’s performance against the best industry ratios will also present an
standards inaccurate scenario.
To making projections and estimates for the future based on the
M
information provided
9.2.2 ADVANTAGES AND LIMITATIONS OF RATIO

ANALYSIS
N
If done effectively, ratio analysis helps an analyst to have insight into

various problem areas and opportunities for a business. The following
are the advantages of ratio analysis:
Helps in understanding whether a business firm has made the
right operating, investing and financing decisions.
Simplifies complex accounting figures and brings out their rela-
tionships; thereby assessing the managerial efficiency, firm’s credit
worthiness, earning capacity, etc.
Exploresthe trends visible in the business, which further helps in
making projections about the business
Provides information on current threats and opportunities; thereby
allowing a business to do its own SWOT (Strengths, Weaknesses,
Opportunities and Threats) analysis
The limitations of financial statements also form the limitations of the

ratio analysis. Any error in financial statements can lead to inaccurate
ratio analysis.

The following are the limitations of ratio analysis:

Does not provide a true picture of the business if financial state-
ments do not reveal the true state of affairs
Does not take into account price-level changes
Ignores non-monetary or qualitative aspects
9.2.3 CLASSIFICATION OF RATIOS
Ratios are classified into two ways namely traditional classification

and functional classification. Traditional classification is done based
on financial statements to which the numbers for ratio analysis belong.
On the other hand, functional classification is done based on the pur-
pose for which a ratio is computed. Figure 9.1 shows the classification
S
of ratios:
Classification of Ratios
IM
Traditional Classification Functional Classification
Statement of Profit and

Liquidity Ratios
Loss Ratios
Balance Sheet Ratios Solvency Ratios

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Activity (or Turnover)

Composite Ratios
Ratios
Profitability Ratios
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Figure 9.1: Classification of Ratios
In this chapter, we will focus more on functional classification.
1. Ratio analysis is a quantitative technique of gaining insight

into a company’s
a. Liquidity b. Operational potency
c. Profit d. All of these
2. If the gross profit of a company is `40,000 and the Revenue
from Operations are `4,00,000, it can be said that the gross
profit is
a. 10% b. 20%
c. 30% d. 40%

ACTIVITY
Find information on ratios given under traditional classification.
9.3 LIQUIDITY RATIOS

Liquidity ratios are calculated for measuring solvency of the business
in the short run, i.e., the firm’s ability to meet its current obligations.
These are analysed by looking at the amounts of current assets and
current liabilities in the balance sheet. The two ratios included in this
category are current ratio and Quick ratio. Let us have a look at the
types of liquidity ratios.
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CURRENT RATIO
It is the proportion of current assets to current liabilities and can be

expressed mathematically as:
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Current Ratio = Current Assets / Current Liabilities
EXHIBIT
CURRENT ASSETS AND CURRENT LIABILITIES
Current Assets Current Liabilities

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zz Current investments zz Short-term borrowings

zz Inventories zz Trade payables (creditors and
zz Trade receivables bills payables)
zz Cash and cash equivalents

Short-term loans and advances
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zz
zz Prepaid expenses
zz Advance tax and accrued income
Example 1: Company XYZ has current assets worth of `5 lakhs, while

the liabilities amount to `3 lakhs. What is the current ratio of the firm?
Solution:
Current Ratio = Current Assets / Current Liabilities
Current Ratio = 5/3 = 1.666 (approx.)
The ideal norm is that 2:1; which means that every one rupee of cur-
rent liability is appropriately covered by Two rupees of current assets.
Quick Ratio
It is the ratio of quick assets to current liabilities and can be expressed

as:
Quick Ratio = Quick Assets / Current Liabilities

Quick assets are defined as those assets which are quickly convertible
into cash. While calculating quick assets, inventories at the end and
other current assets such as prepaid expenses, advance tax, etc., are
excluded from the current assets.
As non-liquid current assets are excluded, it is considered better than

current ratio as a measure of liquidity position of the business.
Standard quick ratio of 1:1 is optimal. It indicates that the business is

unable to pay its immediate present obligations, which might result in
technical solvency. In order to ensure that the ratio is above level 1:1,
one should take action to lower the investment in the inventory. 1:1 is
the optimal standard ratio.
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9.3.1 CURRENT RATIO
The current ratio measures a company’s ability to pay short obliga-

tions or those due at intervals one year. It tells investors and analysts
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whether a corporation will maximise these assets on its record to sat-
isfy its current debt and alternative liabilities.
The current ratio that is in line with the business average or slightly
higher is mostly thought-about acceptable. A current magnitude rela-
tion that is under the business average could indicate the next risk of
distress or default. Similarly, if a corporation contains a terribly high
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current magnitude relation compared with its generation, it indicates

that management might not mistreat its assets expeditiously.
The current ratio is named current as a result of, in contrast to another

liquidity ratios, it incorporates all current assets and current liabil-
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ities. This magnitude relation is usually known as the assets magni-

tude relation.
9.3.2 ACID TEST RATIO
The acid-test ratio uses a firm’s record information as indicator of

whether or not it is spare short assets to hide its short liabilities.
It is a ratio expresses the relationship in between the quick assets

and current liabilities. This ratio is to replace the bottleneck asso-
ciated with the current ratio. It considers only the liquid assets
which can be easily translated into cash to meet out the financial
commitments.
Acid Test Ratio (Quick Ratio) × Liquid Assets / current Liabilities
Example 2: A company has a closing stock of `30,000 while its prepaid

expenses are `5,000. What will be its quick assets ratio if the current
assets are worth `50,000 while current liabilities are worth `15,000?

Solution:
NOTE
Liquid Asset = Current Assets – (Closing Stock + Prepaid Expenses) The acid-test or fast magnitude
relation, compares an
= 50000 – (30000 + 5000)
organisation’s most short-term
= 15000 assets to its most short-term
liabilities to visualise if a
Acid Test Ratio (Quick Assets Ratio) × Liquid Assets / Current Liabil- company has enough money to
pay its immediate liabilities such
ities as short-term debt.
= 15000/15000 = 1:1
3. Which of the following are not current assets?
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a. Current investments b. Trade receivables
c. Trade payables d. Prepaid expenses
4. Complete the following ______________. Current Assets /
Current Liabilities
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a. Current Ratio b. Quick Ratio
c. Liquidity Ratio d. Debt-Equity Ratio
ACTIVITY
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Take the financial statements of a company and check how liquid-

ity ratios can be calculated.
9.4 SOLVENCY RATIOS

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Solvency ratios are calculated to determine the ability of a business to

service its debt in the long run. Solvency ratios are usually employed
by prospective lenders once evaluating a company’s trustworthiness
in addition as by potential bond investors.
9.4.1 DEBT-EQUITY RATIO
The debt-to-equity (D/E) ratio is employed to gauge a company’s

money leverage and is calculated by dividing a company’s total liabil-
ities by its stockholder equity. The D/E magnitude relation is a crucial
metric utilised in finance.
Debt-Equity Ratio =
Short-term Debt + Long-term Debt + Other Fixed Payment
Shareholder’s Equity
Around 1 to 1.5 is a decent debt to equity ratio. But as different busi-

nesses employ different amounts of debt finance, different industries
will have different optimum debt to equity ratios. Capital-intensive

businesses with higher ratios that can exceed 2 include the banking
and industrial sectors.
The balance sheet’s right side contains the debt and equity compo-
nents. Debt is the amount plus interest that the company owes its
creditors. Only long-term debt is factored into the debt-to-equity ratio.
Debt with a maturity of more than a year is considered long-term debt.
Mortgages, long-term leases, and other long-term loans are all exam-
ples of long-term debt.
Investors can usually modify the D/E magnitude relation to concen-

trate on long-run debt solely as a result of the risks related to long-run
liabilities area unit totally different than Short-term debt and liabili-
ties.
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9.4.2 PROPRIETARY RATIO
The proprietary ratio (also referred to as the equity ratio) is the pro-
portion of shareholders’ equity to total assets, and intrinsically pro-
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vides a rough estimate of the amount of capitalisation presently accus-
tomed. If the relation is high, this implies that a company includes an
enough amount of equity to support the functions of the business, and
probably has space in its cash structure to any debt, if necessary.
Proprietors Funds
Proprietary Ratio =
Total Assets
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Where,
Proprietors funds refers to the funds provided by equity shareholders

and total assets refer to the combined funds of both debt (financing
obtained from outside) and equity (shareholder or proprietors funds).
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Conversely, occasional relation indicates that a business is addition-

ally making use of excessive quantity of debt or trade liabilities, rather
than equity, to support operations (which might place the company
in peril of bankruptcy). Thus, the equity relation can be a general
indicator of economic stability. It has to be compelled to be used in
conjunction with net profit relation examination of the statement of
cash flows to realise a better outline of financial circumstances of a
business. These any measures reveal the ability of a business to earn
a profit and generate cash flows.
9.4.3 FIXED ASSETS RATIO
The fixed assets ratio is employed by analysts to have insight into

operational performance. This potency ratio relation compares net
sales (income statement) to fixed assets (balance sheet) and measures
a company’s ability to come up with income from its fixed-asset invest-
ments, particularly property, plant, and equipment (PP&E).

The fixed ratio balance is employed as a web of accumulated depre-

ciation.
A better fixed assets turnover ratio indicates that an organisation has

effectively used investments in fixed ratio to come up with sales.
Net Fixed Assets
Fixed Assets Ratio =
Long-term Fund
Example 3:
Particulars Company ABC

Short-Term Debt ` 70,000
Long-Term Debt ` 55,000
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Other Fixed Payments ` 25,000
Shareholder’s Equity ` 2,00,000
Share Capital ` 57,000
Reserves & Surplus
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Total Assets ` 90,000
Net Fixed Assets ` 85,000
Long-Term Funds ` 65,000
Calculate all the following ratios are:

a. Debt-Equity Ratio
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b. Proprietary Ratio
c. Fixed Assets Ratio
Solution:
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a. Debt-Equity Ratio is:

Debt-Equity Ratio
= (Short-Term Debt + Long-Term Debt + Other Fixed Payments)
/ Shareholder’s Equity
= (`70,000 + `55,000 + `25,000) / `2,00,000
= `1,50,000 / `2,00,000
= 075:1
b. Proprietary Ratio is:
Proprietary Ratio
= (Share Capital + Reserves & Surplus) / Total Assets
= (`57,000 + `35,000) / `90,000
= `92,000 / `90,000
= 1.02:1

c. Fixed Assets Ratio is:

NOTE
Fixed Assets Ratio
The fixed assets ratio reveals
how economical an organisation = Net Fixed Assets / Long-Term Funds
is at generating sales from its
existing assets. = `85,000 / `65,000
= 1.31:1
9.4.4 COVERAGE RATIOS
A coverage ratio, broadly, may be a metric to a company’s ability to

service its debt and meet its money obligations such as interest pay-
ments or dividends. The upper the coverage ratio, the better it ought
to be to create interest payments on its debt or pay dividends. The
trend of coverage ratios over time is additionally studied by analysts
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and investors to establish the amendment in an exceedingly compa-
ny’s money position.
Coverage ratios occur in a variety of formats and can be used to detect

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businesses that may be experiencing financial difficulties, all low
ratios are not always a sign that a business is having problems. These
ratios are based on a variety of criteria, and in order to determine the
health of a firm, it is frequently advised to go further into its financial
records.
The financial statement components that should be scrutinised are

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net income, interest expenditure, the amount of debt outstanding, and

total assets. Liquidity and solvency ratios, which measure a compa-
ny’s capacity to repay short-term debt, should be examined to deter-
mine whether the business is still a going concern (i.e., convert assets
into cash).
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INTEREST COVERAGE RATIO
The corporations are required to consistently pay interest on the total

amount of borrowings. This ratio makes it easier for a potential lender
to determine if a business will be able to consistently pay interest out
of its overall income. Interest coverage ratio, sometimes referred to as
debt service coverage ratio, is the study of the ability to pay interest.
Only the Earnings Before Interest and Taxes (EBIT) is available to

analyse the capability of the businesses.
Greater the ratio, and vice versa, the better the firm’s ability to pay
interest as well as greater the safety.
Interest Coverage Ratio = Earnings before Interest and Taxes / Inter-

est
Example 4: Mr Ashmit Ahuja had an earning of `3,00,000 before he

paid the interests and taxes. What will be the interest coverage ratio if
he pays `30,000 as an interest? What will it mean?

Solution:
Interest Coverage Ratio = Earnings before Interest and Taxes/Interest
= 3,00,000/30,000
= 10: 1
Since the interest coverage ratio is substantially high, it means that

Mr. Ahuja has quite a good capacity in making the payment of interest
and has a high safety.
DIVIDEND COVERAGE RATIO
It demonstrates the enterprises’ capacity to pay preference dividends

using earnings that remain in their possession after taxes have been
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paid. The cushion for the payment of the preferred dividend increases
with the magnitude of the earnings after taxes, and vice versa.
Regardless of the income the company has left over after taxes, pref-
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erence dividends must be paid without fail.
Earnings after Taxation
Dividend Coverage Ratio =
Preference Dividend
Example 5: Hindustan Manufacturers have to make a preference div-

idend of ` 60,000. The earnings after taxation is `3,00,000. What will be
the dividend coverage ratio? What does it mean?
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Solution:
Earning after Taxation
Dividend Coverage Ratio =
Preference Dividend
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=3,00,000/60,000
NOTE
= 5: 1
Common coverage ratios include
interest coverage ratio, debt
Since, the value of the dividend coverage ratio is quite high, the com-
service coverage ratio and plus
pany has a strong cushion for the payment of preference dividend. coverage ratio.
5. The ______________ is employed to gauge a company’s money

leverage and is calculated by dividing a company’s total
liabilities by its stockholder equity.
a. Debt-to-equity (D/E) ratio b. Proprietary ratio
c. Fixed assets ratio d. Coverage ratio
6. Common coverage ratios include
a. Interest coverage ratio b. Debt service coverage ratio
c. Plus coverage ratio d. All of these

ACTIVITY
Find information on the limitations of solvency ratios.
9.5 PROFITABILITY RATIOS

Profitability ratios are the category of economic metrics that assess
a business’s ability to get earnings relative to its revenue, operative
prices, record assets, or shareholders’ equity over time, exploitation
knowledge from a particular purpose in time. Profitability ratios indi-
cate how expeditiously an organisation generates profit and price for
shareholders.
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9.5.1 GROSS PROFIT RATIO
Gross profit ratio is a percentage of revenue from operations. It is com-

puted to have an idea about gross margin. It is computed as follows:
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Gross Profit Ratio = Gross Profit/Net Revenue of Operations × 100
Gross profit ratio indicates gross margin on products sold. It also indi-
cates the margin available to cover operating expenses, non-operating
expenses, etc. Change in gross profit ratio may be due to change in
selling price or cost of revenue from operations or a combination of
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both. A low ratio may indicate unfavourable purchase and sales policy.
Higher gross profit ratio is always a good sign.
Example 6: Om enterprises has earned a gross profit of `6,00,000 in

the first quarter. Calculate the gross profit ratio if the corresponding
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sales amounted to a value of `30,00,000. What does it imply?
Solution:
Gross Profit Ratio = Gross Profit/Net Revenue of Operations × 100

= 6,00,000/3,00,000× 100 = 20: 1
9.5.2 NET PROFIT RATIO
The net profit ratio measures what proportion of net profit is gener-
ated as a proportion of revenue. It is the magnitude relation of profits
to revenues for an organisation or business. Earnings margin is often
expressed as a proportion described in decimal type.
Net profit ratio = (Net Profit ÷ Net Sales) × 100
Example 7: Om enterprises has earned a net profit of `3,00,000 in the

first quarter. Calculate the net profit ratio if the corresponding sales
amounted to a value of `30,00,000. What does it imply?

Solution:
Net profit ratio = (Net profit ÷ Net sales) × 100

= 30,000/30,00,000 × 100
= 1:1
Significance of Net Profit Ratio

The entire profitability of a corporation may be determined by
looking at the net margin.
Since the net profit ratio is expressed as a percentage, it calculates
the profit made from each rupee of sales while also taking into
account all company costs incurred to obtain those revenues.
A high net profit ratio shows that a business can successfully con-
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trol expenses while offering products or services at a price that is
much greater than its costs.
With the help of gross margin, you may identify an organisation’s
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profitability within the confines of production and comprehend
the changes in its COGS.
The net margin reveals a company’s effectiveness over time in
implementing cost-cutting strategies.
Net profit ratio helps investors to assess if a company’s management

is generating enough sales and whether operational prices and over-
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head prices are being contained. Net profit ratio is one among the
foremost necessary indicators of a company’s overall money health.
9.5.3 OPERATING PROFIT RATIO

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The operating profit ratio measures what proportion a corporation

makes on sales when paying for variable prices of production, such as
wages and raw materials, before paying interest or tax. It is calculated
by dividing a company’s operative financial gain by its income. Higher
ratios are typically higher illustrating the corporate is economical in
its operations and is sweet at turning sales into profits.
Operating profit Ratio = Operating Profit / Net Sales × 100
Where, Operating profit = Net profit + Non-operating Expenses –

Non-Operating Incomes
And, Operating Profit Ratio = 100 – Operating Ratio or
Operating Profit = Gross Profit – Operating Expenses or
Operating profit = Net sales – (Cost of Goods Sold + Administrative

and Office Expenses + Selling and Distribution Exp.)
Example 8: Calculate the operating profit ratio from the following

data available for Green Joy Enterprise.

Net Sales – `1,00,000, Gross Profit – `1,50,000, Administration expenses

– `50,000, Selling Expenses – `30,000.
Solution:
Operating profit = Gross Profit – Operating Expenses
Here Operating expenses are administration and selling expenses

which translates to
Operating Expenses = 50,000 + 30,000

= 80,000
Now, Operating Profit = 1,50,000 – 80,000

= 70,000
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Therefore, Operating Profit Ratio = Operating Profit / Net Sales × 100
= 70,000 / 1,00,000 × 100
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= 70%
Because it demonstrates how robust and successful a company’s oper-

ations are, this ratio is significant to creditors as well as investors. For
instance, if a business generates 30% of its revenue from operations,
it is likely running its business successfully and is supported by this
money. Additionally, it indicates that this business depends on operat-
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ing revenue. The business will need to find a new source of revenue if
activities begin to wane.
In contrast, investors and creditors may have concerns about a busi-

ness that only converts 3% of its revenue to operational income. In
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1990s, the auto sector saw a similar change. Gross margin was earn-
ing more money from auto loans than from producing and selling the
vehicles itself. This obviously did not work out well for them. Gross
margin is a good illustration of the significance of this ratio.
9.5.4 RETURN ON ASSETS RATIO
The term return on assets (ROA) ratio indicates how profitable a cor-
poration is in respect to its total assets. The management, analysts and
investors will use ROA to work how expeditiously a corporation uses
its assets to get a profit. The metric is usually expressed as a share by
employing a company’s earnings and its average assets. A better ROA
means that a corporation is additional economical and productive
at managing its record to get profits whereas a lower ROA indicates
there’s area for improvement.
Net Income
Return on Assets Ratio =
Average Total Assets

An essential accounting statistic for assessing a company’s profit-

ability is the return on assets ratio. To analyse a firm’s performance
through time and compare it to the present, or to compare a compa-
ny’s performance to another company with a similar scale of opera-
tions, is frequently done in order to help decision-makers make better
choices. When evaluating the performance of two distinct firms, it is
crucial to take into account the size of the two organisations and the
scope of their operations.
Industries of various sorts have varying ROAs. Since its high asset
values will raise the value of the denominator in the ROA calculation,
a capital-intensive corporation with heavy activities and a high value
of fixed assets will have a lower ROA. If the company’s income is like-
wise sufficiently large, the ratio might be greater.
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The asset-intensiveness or asset-lightness of a corporation may also
be determined using ROAs. The firm is more asset-intensive in the
case of lower ROA. A vehicle or aircraft firm, for instance, will have a
lower ROA.
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A corporation is less asset-intensive in the case of greater ROA. The
corporation has little assets, to use another phrase. A software firm or
an advertising agency are two examples of businesses with less assets.
9.5.5 RETURN ON CAPITAL EMPLOYED

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Return on Capital Employed (ROCE) can be a money magnitude rela-

tion which will be accustomed to assess a company’s profitableness
and capital potency. In different words, this magnitude relation will
facilitate to know how well an organisation is generating profits from
its capital because it is place to use. The ROCE magnitude relation
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is one among many profitableness ratios such as money managers,

stakeholders and potential investors might use once analysing an
organisation for investment.
EBIT
Return on Capital Employed =
Capital Employed
where:
EBIT=Earnings before Interest and Tax
Capital Employed = Total Assets − Current Liabilities
Return on Investment based on how well a firm uses its capital in their
business. In order to evaluate a company’s ability to generate returns,
an investor must consider the ROCE ratio.
1. Before making an investment selection, investors can compare
several market firms using the ROCE ratio. Investors may
use ROCE to determine which firm uses its capital the most
effectively to produce profitable returns.

2. When comparing firms that depend on huge capital for their

operations, ROCE is quite helpful. These businesses include
factories that produce automobiles, aircraft, railroads, and
steel producers, among others. Because these businesses have
made significant capital investments, making effective use of
that capital may present a sound investment opportunity to any
prospective investor.
3. Since ROCE gauges profitability after taking into account the
amount of capital utilised to generate that level of profitability, it
is a helpful indicator of financial efficiency.
4. Any potential investor may get a comprehensive understanding
of the company’s financial situation and return-generating
potential by using ROCE and ratios such as Return on Equity
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(ROE), Return on Assets (ROA), and Return on Equity (ROE)
using the DuPont Analysis programme.
5. ROCE is helpful for comparing businesses in the same sector.
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6. In addition to being helpful for investors, ROCE is also a
valuable indicator for businesses since it enables them to assess
their performance, identify their strengths and weaknesses, and
identify areas for performance development.
Example 9:
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Net Sales `80,000
Gross Profit `20,000
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Net Profit `30,000

Operating Profit `35,000
Operating Income `25,000
Total Assets `60,000
Operating Profit `45,000
Capital Employed `90,000

a. Gross Profit Ratio
b. Net Profit Ratio
c. Operating Profit Ratio
d. Return on Assets Ratio
e. Return on Capital Employed

Solution:
a. Gross Profit Ratio is:
= (Gross Profit / Net Sales) × 100
= (`20,000 / `80,000) × 100
= 25%
b. Net Profit Ratio is:
= (Net Profit / Net Sales) × 100
= (`30,000 / `80,000) × 100
= 37.50%
c. Operating Profit Ratio is:
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= (Operating Profit / Net Sales) × 100
= (`35,000 / `80,000) × 100
= 43.75%
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d. Return on Assets Ratio is:
= Operating Income / Total Assets
= `25,000 / `60,000
= 41.67%
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e. Return on Capital Employed is:

= (Operating Profit / Capital Employed) × 100
= (`45,000 / `90,000) × 100
= 50%
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7. Complete the following:

Gross Profit Ratio = Gross Profit/_____________ × 100
a. Net Revenue of Operations
b. Gross Revenue of Operations
c. Total Revenue of Operations
d. None of these
ACTIVITY
Find more information about profitability ratios.

9.6 TURNOVER RATIOS

The turnover ratio measures the worth of a company’s sales or reve-
NOTE nues relative to the worth of its assets. The turnover quantitative rela-
tion will be used as an indicator of the potency with that a corpora-
Turnover is the quantitative
measure of total sales or tion is exploitation its assets to get revenue. The higher the turnover
revenue to average assets. This ratio, the higher are the revenues generated by an organisation from
metric helps investors perceive its assets.
how effectively firms exploit
their assets to get sales.
9.6.1 STOCK TURNOVER RATIO
The term stock turnover ratio refers to the performance ratio that
helps to confirm how sensible an organisation is in managing its stock
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inventory whereas generating sales throughout a given period of time.
In other words, this ratio indicates what number of times throughout
a selected amount of time (usually a year) an organisation is ready to
sell its inventory. The formula for a stock turnover ratio is derived by
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dividing the value of products sold by the amount of inventory. Math-
ematically, it is expressed as:
Stock Turnover Ratio = Value of Products Sold / Average Inventory
9.6.2 DEBTOR’S TURNOVER RATIO
Debtor’s turnover ratio measures how well a corporation uses and

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manages the credit it extends to customers and the way quickly that
short-run debt is collected or is paid. A firm that is economical at col-
lection on its payments due can have the next assets turnover magni-
tude relation. It is helpful to check a firm’s turnover ratio therewith of
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its peers within the same business to determine whether or not it is on

par with its competitors.
Debtors Turnover Ratio = Net Credit Sales/Average Account Receiv-

able
9.6.3 CREDITORS TURNOVER RATIO
A creditor’s turnover ratio is also known as liabilities turnover ratio,

trade liabilities turnover ratio and accounts due turnover magnitude
relation. These totally different terms will be slightly confusing, how-
ever all mean constant factor. In essence, a creditor’s turnover magni-
tude relation shows how well a company pays off its debts to suppliers
in a given accounting amount.
The formula for calculating creditors’ turnover ratio
This ratio shows the relationship between net credit purchases and
average accounts payables outstanding in a business’s books.

It is computed as follows:
Annual Net Credit Purchase
Creditor turnover ratio =
Average Account Payment
Sometimes, the cost of goods sold (COGS) is also used in the numera-
tor in place of net credit purchases.
Accounts payables include both creditors and bills payables. They are
taken into account net of any returns made to suppliers.
ASSET TURNOVER RATIO
The assets turnover ratio estimates the worth of an organisation’s

deals or incomes comparative with the worth of its assets. The assets
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turnover ratio can be utilised as a sign of the proficiency with which
an organisation is utilising its assets for produce income.
The higher the assets turnover ratio, the more productive an organ-
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isation is at creating income from its assets. On the other hand, on
the off chance that an organisation has a low assets turnover ratio, it
demonstrates that it is not proficiently utilising its resources for pro-
duce deals.
Total Sales
Asset Turnover =
Beginning Assets + Ending Assets
2
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Where:
Total Sales = Annual sales total
Beginning Assets = Assets at start of year
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Ending Assets = Assets at end of year
WORKING CAPITAL TURNOVER
A ratio called working capital turnover assesses how well a business

uses its working capital to promote sales and expansion. Working cap-
ital turnover, also known as net sales to working capital, gauges the
connection between the resources utilised to finance an organisation’s
operations and the revenues that organisation earns to maintain oper-
ations and make a profit.
Net Annual Sales
Working Capital Turnover =
Average Working Capital
Where,
Net annual sales are the sum of a company’s gross sales minus its
returns, allowances, and discounts over the course of a year.
Average working capital is average current assets less average
current liabilities.

Example 10:

Cost of Goods Sold `60,000
Average Inventory `40,000
Net Credit Sales `1,05,000
Average Trade Receivables `35,000
Net Credit Purchases `1,25,000
Average Trade Payables `50,000

a. Stock Turnover Ratio
b. Debtor’s Turnover Ratio
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c. Creditors Turnover Ratio
Solution:
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a. Stock Turnover Ratio is:
Stock Turnover Ratio
= Cost of Goods Sold / Average Inventory
= `60,000 / `40,000
= 1.5:1
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b. Debtor’s Turnover Ratio is:

Debtor’s Turnover Ratio
= Net Credit Sales / Average Trade Receivables
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= `1,05,000 / `35,000
= 3:1
c. Creditors Turnover Ratio is:
Creditors Turnover Ratio
= Net Credit Purchases / Average Trade Payables
= `1,25,000 / `50,000
= 2.5:1
8. The term __________ refers to the performance ratio that helps

confirm how sensible an organisation is in managing its stock
inventory whereas generating sales throughout a given period
of time.
a. debtor’s turnover ratio
b. stock turnover ratio

c. creditors turnover ratio

d. return on assets ratio
9. The word __________ narrows things right down to payments
created to anyone whom a business owes cash to.
a. creditor
b. debtor
c. owner
d. investor
ACTIVITY
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Find information on how debtors and creditors affect a business.
9.7 RELEVANCE OF RATIO ANALYSIS

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Ratio analysis is crucial for the company to analyse its financial posi-
tion, liquidity, profitability, risk, solvency, efficiency, operations effec-
tiveness, and proper utilisation of funds. It also shows the trend or
comparison of financial results, which can be useful for decision-mak-
ing for investment by the company’s shareholders. The relevance of
ratio analysis is explained through the following points:
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Aids to measure general efficiency: Ratios summarise and sim-

plify data. They act as an index of the potency of the firm.
Aids to measure financial solvency: Ratios help in judging the
performance of a company over a period of time by scrutinising
the current magnitude relation with the past ones. They denote
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firm’s liquidity position to fulfil its short-term obligations and long-

run financial condition.
Aids in forecasting and planning: Ratio analysis is a useful aid
to management within the discharge of it basic operations. Ratios
help the management to arrange budgets to formulate policies and
arrange long-term actions.
Facilitates decision making: It throws lightweight on the degree
of potency of the management and use of the assets which is why
it is referred to as surveyor of potency. They assist management in
decision making.
Aids in corrective action: Ratio analysis shows unfavourable vari-
ance, thereby helping in taking corrective actions.
Aids in intra-firm comparison: It facilitates the management to
understand whether or not the firm’s money position is rising or
deteriorating by setting a trend with the assistance of ratios.

DUPONT ANALYSIS
DUPONT INC., USA created this analysis to investigate the return

on investment. It was the first business to create a chart showing the
effects of return on investment.
Two crucial statistics, net profit ratio and capital turnover ratio, were
examined by the corporation to determine the return on investment.
Any variation in any of the two ratios has an immediate impact on
return on investment.
To analyse the influence of the firm’s profitability, numerous related

elements are taken into account. This kind of study to fix the issues
not only pinpoints the precise reason that negatively impacts profit-
ability but also looks for potential solutions to raise profitability. The
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chart that was created for analysis was known as the DUPONT Chart.
Figure 9.2 shows DUPONT chart:
Sales
IM Cost of Goods Sold
Net
Profit
Net Profit
Expenses
Ratio Administrative,
Sales Selling and
Distribution
Expense
Return on
Capital
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Employed
Current
Sales Assets
Working
Capital
Capital
Turnover Ratio Current
Capital
Liabilities
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Employed
Fixed
Asset
Figure 9.2: DUPONT chart
10. Relevance of ratio analysis

a. Aids to measure general efficiency
b. Aids to measure financial solvency
c. Aids in forecasting and planning
d. All of these
ACTIVITY
Find information on how ratio analysis actually helps organisations.

9.8 SOLVED ILLUSTRATIONS

Illustration 1:
Calculate the Liquid Ratio from the following information:
Current liabilities = `1,00,000
Current assets = `1,60,000
Inventories = `40,000
Advance tax = `10,000
Prepaid expenses = `10,000
Solution:
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Liquid Ratio = Liquid Assets/Current Liabilities
Liquid Assets = Current assets – (Inventories + Prepaid expenses +

Advance tax)
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= `1,60,000 – (`40,000 + ` 10,000 + `10,000) = `1,00,000
Liquid Ratio = `1,00,000/`1,00,000 = 1:1
Illustration 2:
From the following balance sheet of XYZ Co. Ltd. as on March 31,
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2022. Calculate debt equity ratio:
Particulars Amount (in `)

1. Shareholders’ funds
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a. Share Capital 12,00,000

b. Reserves and Surplus 2,00,000
c. Money Received against Share Warrants 1,00,000
2. Non-current Liabilities
a. Long-term Borrowings 4,00,000
b. Other long-term Liabilities 40,000
c. Long-term Provisions 60,000
3. Current Liabilities
a. Short-term Borrowings 2,00,000
b. Trade Payables 1,00,000
c. Other Current Liabilities 50,000
d. Short-term Provisions 1,50,000
25,00,000
II. Assets
1. Non-Current Assets


a. Fixed Assets 15,00,000
b. Non-current Investments 2,00,000
c. Long-term Loans and Advances 1,00,000
2. Current Assets
a. Current Investments 1,50,000
b. Inventories 1,50,000
c. Trade Receivables 1,00,000
d. Cash and Cash Equivalents 2,50,000
e. Short-term Loans and Advances 50,000
25,00,000
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Solution:
Debt-Equity Ratio = Debts/ Equity
Debt = Long-term borrowings + Other long-term liabilities + Long-

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term provisions
= ` 4,00,000 + ` 40,000 + ` 60,000 = ` 5,00,000
Equity = Share capital + Reserves and surplus + Money received

against share warrants
= ` 12,00,000 + ` 2,00,000 + ` 1,00,000 = ` 15,00,000

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Debt Equity Ratio = 50,0000/15,00,000 = 0.33
Illustration 3:
The following is the balance sheet of a company as on 31-3-2021

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Liabilities ` Assets `
Equity Shares 40,00,000 Land & building 40,00,000
Reserves & Surplus 20,00,000 Plant & machinery 40,00,000
Debentures 30,00,000 Investments 30,00,000
Long-term Loans 50,00,000 Stock 25,00,000
Creditors 8,00,000 Debtors 15,00,000
Other current Liabilities 12,00,000 Other current assets 10,00,000
1,60,00,000 1,60,00,000
Calculate:
a. Current ratio
b. Stock to working capital ratio
c. Debt-Equity ratio
d. Net-worth ratio/proprietor/ratio

e. Fixed assets to net worth ratio

f. Current assets to net worth ratio
g. Solvency ratio
Solution
a. Current ratio = Current Assets/Current Liabilities
= 50,00,000/20,00,000 = 2.5
b. Stock to working capital ratio = Stock/Inventory/Working capital
× 100 Working capital= Current Assets – Current Liabilities
= 50,00,000 – 20,00,000 = 30,00,000
= 25,00,000/30,00,000 × 100 = 83.33%
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c. Debt-Equity ratio = Debt/Equity
Debt = Long-term loans 30,00,000+50,00,000=80,00,000 Equity
= Share capital + Reserves + Surplus
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= 40,00,000 + 20,00,000 = 60,00,000
= 80,00,000/60,00,000 = 1.33
d. Net worth or proprietary ratio = Net worth (equity)/Total assets
(Net worth) = Share capital + Reserves & Surplus
= 60,00,000/1,60,00,000 = 0.375
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e. Fixed assets to net worth ratio = Net fixed assets

= 80,00,000/60,00,000 = 1.33
f. Current assets to net worth ratio = Current assets/Net worth
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= 50,00,000/60,00,000 = 0.833
g. Solvency ratio = Total assets/Total liabilities
Total assets = Total of asset side of balance sheet.
Total liabilities = Both long-term and current liabilities.
= 1,60,00,000/1,00,00,000 = 1.6
Illustration 4:
The following figure relates to Poonam Traders Ltd. for the year ended
31st March, 2021.
Treading and Profit & Loss Account for the year ended 31st March,
2021 Poonam Traders Ltd.
Particulars ` ` Particulars ` `
To Opening Stock 1,50,000 By Sales 10,40,000
To Purchases 6,50,000 Less: Returns 40,000
To Gross Profit c/d 4,00,000 10,00,000

Particulars ` ` Particulars ` `
By Closing Stock 2,00,000
12,00,000 12,00,000
To Administration 80,000 By Gross Profit b/d 4,00,000
To Selling & 50,000 By Dividend 18,000
Distribution Income
1,30,000 By Profit on Sale 22,000
of Share
To Loss on Sale of 10,000 40,000
Assets
To Net Profit c/d 3,00,000
4,40,000 4,40,000
Balance Sheet on 31st March, 2021 of Poonam Traders Ltd.
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Liabilities ` Assets `
Issued capital
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4000 Equity Shares of 4,00,000 Land and Building 3,00,000
` 100 Each
Reserves 1,80,000 Plant and Machinery 1,60,000
Current liabilities 3,00,000 Stock 3,20,000
Profit & Loss A/c 1,20,000 Debtors 1,60,000
Cash at Bank 60,000
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10,00,000 10,00,000
Calculate the following ratios:

i. Gross Profit Ratio
ii. Operating Ratio
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iii. Operating Profit Ratio

iv. Net Profit Ratio
Solution:
i. Gross Profit Ratio
Gross Profit Ratio = Gross Profit / Sales × 100
While calculating the gross profit ratio, which sales should be
taken into consideration?
The net sales alone have to be taken into consideration for the
computation of calculating the gross profit ratio. What is meant
by net sales?
Net Sales = Gross Sales – Sales Return
The company has not profited from the sales returns made by
its clients or consumers. The sales return should be subtracted

from the gross sales if the company did not get benefit from
it. Customers who return items are not required to pay in this
respect, thus there is no potential for the business to make a
profit at that time. In general, the chance of making a profit only
exists at the time of customer payment.
Gross Profit Ratio = 4,00,000/10,00,000 × 100
= 40%
ii. Operating Ratio
(Cost of Goods Sold + Administration Expenses + Selling &
Distribution Expenses) / Net Sales × 100
The information pertaining to cost of goods sold is not available
directly. The cost of goods sold could be found out in two different
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ways:
Cost of Goods Sold = Opening Stock + Purchases -Closing stock
Substitute the values in the above equation
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= `1,50,000 + `6,50,000 - `2,00,000
= `6,00,000
Alternately, the cost of goods sold could be found out as follows:
Cost of Goods Sold = Sales – Gross Profit
= `10,00,000 - `4,00,000
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= `6,00,000
Operating Ratio =(6,00,000 + 1,30,000) / 10,00,000 × 100
=73%
iii. Operating Profit Ratio
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Operating Profit Ratio = (Operating Profit / Net Sales) × 100

To find out the operating profit from the profit & loss account,
the following methodology will help to determine as effectively
as possible.
Pro forma for finding out the operating profit
Particulars `
Net Profit XXXX
Add: Non operating expense/loss XXXX
Less: Non operating income XXXX
Operating income XXXX
Operating Profit = `3,00,000 - `40,000 + `10,000 = 2,70,000
Operating Profit Ratio = (2,70,000/10,00,000) × 100
= 27%

iv. Net Profit Expenses Ratio = Net Profit/ Net sales × 100
= 3,00,000/10,00,000 × 100
= 30%
S 9.9 SUMMARY
A ratio refers to a mathematical number that is calculated as a ref-
erence to relationship of two or more numbers.
Ratio analysis is a quantitative technique of gaining insight into a
company’s liquidity, operational potency and profit from its finan-
cial statements.
Ratio analysis is a crucial part of interpretation of results derived
from financial statements.
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Ratios are classified into two ways namely traditional classifica-
tion and functional classification.
Traditional classification is done based on financial statements to
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which the numbers for ratio analysis belong. On the other hand,
functional classification is done based on the purpose for which a
ratio is computed.
In traditional classification, ratios are grouped into liquidity ratios,
solvency ratios, profitability ratios and turnover ratios.
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KEY WORDS
Capital structure ratios: Leverage and coverage ratios are

used to analyse the capital structure condition
Current assets: Current assets are those that are readily con-
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verted into cash, are equivalent to cash or are in the form of

cash
Current liabilities: Within a year, current liabilities are short-
term financial resources or obligations that must be paid quickly
Income statement ratios: These ratios are derived from the
enterprise’s trading, profit and loss account statements

MCQ
1. Which of the following are the objectives of ratio analysis?
a. To identify the areas of improvement in business
b. To identify the potential areas of opportunity
c. To compare the company’s performance against the best
industry standards
d. All of these

2. Which of the following ratios does not come under functional

classification?
a. Liquidity ratios
b. Solvency ratios
c. Balance sheet ratios
d. Profitability ratios
3. Which of the following ratios is also referred to as equity ratio?
a. Proprietary ratio
b. Debt-to-equity (D/E) ratio
c. Fixed ratio
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d. All of these
4. A ________ is a metric to a company’s ability to service its debt
and meet its money obligations such as interest payments or
dividends.
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a. coverage ratio
b. proprietary ratio
c. fixed assets ratio
d. solvency ratio
5. __________ helps investors assess if a company’s management
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is generating enough sales and whether operational prices and

overhead prices are being contained.
a. Gross profit ratio
b. Net profit ratio
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c. Proprietary ratio
d. Solvency ratio
6. Which of the following are included under the traditional
classification?
a. Statement of profit and loss ratios
b. Balance sheet ratios
c. Composite ratios
d. All of these
7. Liquidity ratios are calculated for measuring solvency of the
business in the short run, i.e., the firm’s ability to meet its current
obligations. Which of the following option is correct regarding
the above statement?
a. Liquidity ratios
b. Solvency ratios

c. Coverage ratios
d. All of these
8. Which of the following is helpful to check a firm’s turnover ratio
therewith of its peers within the same business to determine
whether or not it is on par with its competitors?
a. Debtor’s turnover ratio b. Creditors turnover ratio
c. Stock turnover ratio d. All of these
9. The __________ is employed by analysts to have insight into
operational performance. Which of the following option is correct
regarding the above statement?
a. Proprietary ratio b. Debt-equity ratio
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c. Fixed assets ratio d. None of these
10. Which of the following is the relevance of ratio analysis?
a. Aids to measure financial solvency
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b. Aids in forecasting and planning
c. Aids in corrective action
d. All of these

?
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1. Write a short note on ratio analysis.

2. What are liquidity ratios?
3. Explain D/E ratio.
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4. What do you mean by gross profit ratio?

5. Explain the importance of ratio analysis.

9.12
(HOTS) QUESTIONS
1. What will be the gross profit ratio if Revenue from Operations is
`3,40,000; Cost of Revenue from Operations is `1,20,000; selling
expenses are `80,000 and administrative expenses are `40,000?
a. 62.31% b. 64.71%
c. 65.23% d. 62.42%
2. Calculate the liquid ratio if current liabilities is `50,000; Current
assets is `80,000; Inventories are `20,000; Advance tax is `5,000
and prepaid expenses are `5,000.
a. 2:1 b. 1:1
c. 3:1 d. 4:1

Topic Q. No. Answer

Overview of Ratio Analysis 1. d. All of these
2. a. 10%
Liquidity Ratios 3. c. Trade payables
4. a. Current Ratio
Solvency Ratios 5. a. Debt-to-equity (D/E) ratio
6. d. All of these
Profitability Ratios 7. a. Net Revenue of Operations
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Turnover Ratios 8. b. stock turnover ratio
9. a. creditor
Relevance of Ratio Analysis 10. d. All of these
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Q. No. Answer
1. d. All of these
2. c. Balance sheet ratios
3. d. All of these
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4. a. coverage ratio
5. b. Net profit ratio
6. d. All of these
7. a. Liquidity ratios
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8. d. All of these
9. c. Fixed Assets Ratio
10. d. All of these

1. Ratio analysis is a quantitative technique of gaining insight into
a company’s liquidity, operational potency and profit from its
financial statements. Refer to Section 9.2 Overview of Ratio
Analysis
2. Liquidity ratios are calculated for measuring solvency of the
business in the short run, i.e., the firm’s ability to meet its current
obligations. Refer to Section 9.3 Liquidity Ratios
3. The debt-to-equity (D/E) ratio is employed to gauge a company’s
money leverage and is calculated by dividing a company’s total
liabilities by its stockholder equity. Refer to Section 9.4 Solvency
Ratios

4. Gross profit ratio indicates gross margin on products sold. It also

indicates the margin available to cover operating expenses, non-
operating expenses, etc. Refer to Section 9.5 Profitability Ratios
5. Ratios summarise and simplify data. They act as an index of the
potency of the firm. Refer to Section 9.7 Relevance of Ratio
Analysis

QUESTIONS
Q. No. Answer
1. b. 64.71%
2. b. 1:1
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SUGGESTED READINGS AND
9.14
REFERENCES
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SUGGESTED READINGS
tions.
La Rosa, N., n.d. Analysing financial performance.
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Morley, M., 1984. Ratio analysis. wokingham.
E-REFERENCES
Corporate Finance Institute. 2022. Ratio Analysis. [online] Avail-
N
able at: <https://corporatefinanceinstitute.com/resources/knowl-

edge/finance/ratio-analysis/> [Accessed 21 June 2022].
WallStreetMojo. 2022. Ratio Analysis. [online] Available at:
<https://www.wallstreetmojo.com/ratio-analysis/> [Accessed 21
June 2022].
Bragg, S. and Bragg, S., 2022. Ratio analysis definition — Accoun-
tingTools. [online] AccountingTools. Available at: <https://www.
accountingtools.com/articles/ratio-analysis.html> [Accessed 21
June 2022].

CASE STUDIES
7 TO 9
CONTENTS
Case Study 7 Calculation for Segment Reporting

Case Study 8 Horizontal Analysis
Case Study 9 Calculating Ratios
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CASE STUDY 7
CALCULATION FOR SEGMENT REPORTING
ABC Ltd. has 8 units based on product-wise. Each unit deals with
Case Objective different products. The Revenue, Profits, and the Assets of each
The case explains how unit are shown as follows:
to make calculations for
segment reporting. (Amount in ` in Crores)
Particu- Unit Unit Unit Unit Unit Unit Unit Unit Total
lars 1 2 3 4 5 6 7 8
Assets 50 70 40 60 89 78 52 46 485
Revenue 650 870 350 800 950 750 990 590 5950
Profit 7 7.5 3.5 4 9 5 3.2 2.8 42
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Accordingly, the calculation of each unit given above for segmen-
tal reporting is under:
Particulars Unit Unit Unit Unit Unit Unit Unit Unit Total
IM 1 2 3 4 5 6 7 8
Assets 50 70 40 60 89 78 52 46 485
Revenue 650 870 350 800 950 750 990 590 5950
Profit 7 7.5 3.5 4 9 5 3.2 2.8 42
Percentage 10.31% 14.43% 8.25% 12.37% 18.35% 16.08% 10.72% 9.48%
of Assets to
Total Assets
Percentage 10.92% 14.62% 5.88% 13.45% 15.97% 12.61% 16.64% 9.92%
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of Revenue
to Total
Assets
Percentage 16.67% 17.86% 8.33% 9.52% 21.43% 11.90% 7.62% 6.67%
of Profit to
Total Profit
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QUESTIONS
1. What is the importance of segment reporting?

(Hint: To better understand the performance of an organ-
isation)
2. Which units are to be reported as per segmental report-
ing?
(Hint: A, B, D, E, F and G)

Case study 8: Horizontal Analysis 217
CASE STUDY 8
HORIZONTAL ANALYSIS
Horizontal analysis of the balance sheet is generally in a two-year

format, i.e. a variance showing the difference between the two Case Objective
years for each line item. An alternative format is to add as many This case study highlights
years without showing a variance, so that general changes in ac- the Horizontal Analysis of a
counts can be seen over multiple years. The following table shows balance sheet.
a two-year format horizontal analysis:
(Each amount is in `)
20XX 20XX Variance

Cash 1,00,000 80,000 (20,000)
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Accounts Receivable 3,50,000 5,25,000 1,75,000
Inventory 1,50,000 2,75,000 1,25,000
Total Current Assets 6,00,000 8,80,000 2,80,000
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Fixed Assets 4,00,000 800,000 4,00,000
Total Assets 10,00,000 16,80,000 6,80,000
Accounts Payable 1,80,000 3,00,000 1,20,000

Accrued Liabilities 70,000 1,20,000 50,000
Total Current Liabilities 2,50,000 4,20,000 1,70,000
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Notes Payable 3,00,000 5,25,000 2,25,000

Total Liabilities 5,50,000 9,45,000 3,95,000
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Capital Stock 2,00,000 2,00,000 0

Retained Earnings 2,50,000 5,35,000 2,85,000
Total Equity 4,50,000 7,35,000 2,85,000
Total Liabilities And Equity 10,00,000 16,80,000 6,80,000
QUESTIONS
1. What is the alternative format of horizontal analysis?

(Hint: To add as many years without showing a variance,
so that general changes in accounts can be seen over mul-
tiple years)
2. In the given case study, what is the variance of inventory?
(Hint: `1,25,000)

CASE STUDY 9
CALCULATING RATIOS
ABC Pvt. Ltd. is a manufacturer of leather shoes. This company

Case Objective make arrangement of their raw materials from the dealers estab-
This case study highlights the lished in America, Egypt and Thailand. The manufacturing of the
calculation of different ratios. leather shoes are done in India to sell their goods in the global
market. Global market includes all the countries across the world.
The company requires audit to find out some ratios such as cur-
rent ratio and liquid ratio which helps to manage the inventory
stock of particular period of time against the current liabilities of
ABC Pvt. Ltd.
ABC Pvt. Ltd. is a manufacturer of leather shoes. Following infor-

mation is given by the company from its books of accounts as on
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March 31, 2018:

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Inventory 1,00,000
Total Current Assets 1,60,000
Shareholders’ Funds 4,00,000
13% Debentures 3,00,000
Current Liabilities 1,00,000
Net Profit Before Tax 3,51,000
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Cost of Revenue from Operations 5,00,000
QUESTIONS
1. Calculate the current ratio.

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(Hint: 1.6:1)
2. Calculate the liquid ratio.
(Hint: 0.6:1)

C H
10 A P T E R
OVERVIEW OF PROFITABILITY RATIOS
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CONTENTS
10.1 Introduction
10.2 Introduction to Profitability Ratios
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10.2.1 Types of Profitability Ratios
Activity
Activity
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10.4 Summary
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IMPORTANCE OF DUPONT ANALYSIS
In the context of the study of economic and financial performance,

Case Objective a very useful tool is the DuPont model. The analysis by the DuPont
This caselet highlights the model is realised through the decomposition rate of return ROE
overview of the DuPont (Return on Equity) according to other rates of return, such as ROS
Analysis. (Return on Sales), ROA (Return on Assets) or Equity Multiplier.
Regarding the DuPont analysis model, the name of the model or

analysis comes from the DuPont corporation that began using this
formula in 1920, known as the “strategic profit model” (Gold ring).
DuPont is a mathematical model represented as a factorial anal-
ysis of profitability from the financial Return on Equity or ROE.
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Decomposing ROE in factors is one way by which the influences
of each model rate on financial performance for the analysed com-
pany can be highlighted. The core of the DuPont analysis con-
siders the calculation of the ROE. One of the advantages of the
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DuPont model is the extensive use of the rates of return in the
analysis in the specialists’ practice at international level, proving
to be applicable to both small companies and large companies in
the economy.
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OVERVIEW OF PROFITABILITY RATIOS 221
LEARNING OBJECTIVES

>> Explain the concept of profitability ratios
>> Discuss the importance of profitability ratios
>> Describe the types of profitability ratios
>> Evaluate the price earnings ratio
>> Assess the DuPont analysis
10.1 INTRODUCTION
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In the previous chapter, you have studied about ratio analysis in detail. Quick Revision
Ratio analysis is the study of several financial data points seen in a
company’s financial statements. They are mostly used by outside ana-
lysts to assess a company’s profitability, liquidity, and solvency, among
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other factors.
Using information at a single moment in time, profitability ratios are a

class of financial measurements that are used to evaluate a company’s
capacity to make profits in relation to its revenue, operating costs, bal-
ance sheet assets or shareholders’ equity over time.
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Efficiency ratios, which evaluate how well a corporation uses its

resources internally to create money, can be contrasted to profitability
ratios (as opposed to after-cost profits).
A profitability ratio is an economic metric that that assesses a busi-

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ness’s ability to generate pertaining to its revenue, operational prices,

assets, or shareholders’ equity over time. In other words, profitabil-
ity ratios provide insight into how well an organisation uses its assets
internally to come up with financial gain (as against after-cost profits).
Profitability ratios indicate the efficiency of an organisation of gener-

ating profit. Higher profitability ratio is typically favourable.
In this chapter, you will study about profitability ratios and their types
in detail.
INTRODUCTION TO PROFITABILITY
10.2
RATIOS
Profitability ratios are most helpful when put next to similar corpora-
tions, the company’s own history, or average ratios for the company’s
trade.

10.2.1 MEANING OF PROFITABILITY RATIOS

NOTE
Gross profit margin is one A company’s capacity to generate profits from sales or activities, bal-
amongst the foremost wide used ance sheet assets, or shareholders’ equity is evaluated using profit-
profitability or margin ratios. ability ratios.
Gross profit is basically the
difference between revenue and
For the majority of profitability ratios, a greater number in compar-
the costs of production—called
Cost of Goods Sold (COGS). ison to a competitor’s ratio or to the same ratio from a prior period
indicates the company’s success. When compared to comparable busi-
nesses, the business’s own past, or typical ratios for its sector, profit-
ability ratios are most helpful.
Operations in several sectors are subject to seasonality. For instance,

during the year-end Christmas season, shops often see much greater
sales and profitability. Therefore, because they are not directly com-
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parable, it would be useless to compare a retailer’s fourth-quarter
gross profit margin to its first-quarter gross profit margin. It would be
significantly more instructive to compare a retailer’s fourth-quarter
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profit margin to its fourth-quarter profit margin from the prior year.
10.2.2 TYPES OF PROFITABILITY RATIOS
Profitability ratios are the most commonly used metrics used in finan-
cial analysis, and they generally fall into two categories namely margin
ratios and return ratios. Margin ratios provide insight into a compa-
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ny’s ability to turn sales into a profit. On the other hand, return ratios
offer several different ways to examine how well a company generates
return for its shareholders.
Based on these two categories, the following are the types of profit-
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ability ratios:
Gross Profit Ratio: It establishes a relationship between net
income and revenue from operations and can be expressed math-
ematically as:
Gross Profit Ratio = (Gross Profit/Revenue from Operations) ×
100
Revenue from operations is the revenue earned by a business from
its operations. It includes income and commission (for non-finance
corporations) and interest earned, dividend, profit on the sale of
securities, etc. (for finance corporations).
NOTE Gross Profit = Revenue from Operations – Cost of Goods Sold
Cost of operations is additionally
referred to as value of products Revenue from Operations = Gap Inventory + Purchases + Direct
sold. Expenses – Closing Inventory
Example 1: A Ltd. has a revenue from operations of `1,00,000 and
cost of goods sold of `80,000. Calculate the gross profit ratio.

Solution:
Gross profit ratio is:
= (Gross Profit / Revenue from Operations) × 100
= (`20,000 / `1,00,000) × 100
= 20%
Working Note:
Gross Profit is
= Revenue from Operations – Cost of Goods Sold
= `1,00,000 – `80,000
= `20,000
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Operating Ratio: It establishes a relationship between operational
prices and revenue from operations.
Operating Ratio = (Cost of Goods Sold + Operating Expenses/
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Revenue from Operations) × 100
Example 2: Company B is shoe manufacturing company in India.
The company has cost of goods sold of `1,20,000, operating expenses
of `30,000, and revenue from operations of `6,00,000. Calculate the
operating ratio.
Solution:
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Operating Ratio is
= [(Cost of Goods Sold + Operating Expenses) / Revenue from
Operations] × 100
= [(`1,20,000 + `30,000) / `6,00,000] × 100
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= 25%
Operating Profit Ratio: It establishes a link between operating
profit and revenue from operations, i.e., net sales.
Operating profit ratio can be calculating by dividing Operating
profit with revenue from operations (Net Sales) and is categorical
in share.
Operating Profit Ratio = (Operating Profit/Revenue from
Operations) × 100
Example 3: Company X has the operating profit of `6,000 and
revenue from operations of `80,000. Calculate the operating profit
ratio.
Solution:
Operating Profit Ratio is
= (Operating Profit / Revenue from Operations) × 100

= (`6,000 / `80,000) × 100

= 7.5%
Net Profit Ratio: Net profit ratio measures the link between prof-
its and income. It shows the proportion of profits earned on Reve-
nue from Operations.
Net Profit Ratio = (Net Profit/Net Sales) × 100
Net Profit = Revenue from Operations – Price of Revenue from
Operations – Operational Expenses – Non-operating Expenses +
Non-operating Incomes – Tax
Example 4: Determine net profit ratio, if Company B has net profit
of `10,000 and net sales of `60,000.
Solution:
S
Net Profit Ratio is
= (Net Profit / Net Sales) × 100
IM = (`10,000/ `60,000) × 100
= 16.67%
Return on Investment: It shows the link of profit (profit before
interest and tax) with capital used. All the results of operations of
the business are either profit or either a loss.
Return on Investment = (Net Profit before Interest, Tax and
M
Dividend/Cost of Investment) × 100

Example 5: Company XYZ has net profit before interest, tax and
dividend of `50,000 and cost of investment of `1,50,000. Calculate
the return on investment.
N
Solution:
Return on Investment is
= (Net Profit before Interest, Tax and Dividend / Cost of Investment)
× 100
= (`50,000 / `1,50,000) × 100
= 33.33%
EARNINGS PER SHARE
Earnings per share (EPS) may be a company’s profits divided by the

quantity of common stock it’s outstanding. EPS indicates what quan-
tity of cash an organisation makes for every share of its stock and may
be a wide used metric for estimating company worth.
NOTE A higher EPS indicates larger worth as a result of investors can pay
The higher a company’s EPS the a lot for a company’s shares if they assume the corporate has higher
higher is its profitability. profits relative to its share value.

Earnings per share worth is calculated as profit (also referred to as

profits or earnings) divided by offered shares. A lot of refined calcula-
tion adjusts the dividend and divisor for shares that might be created
through choices, convertible debt, or warrants. The dividend of the
equation is additionally a lot of relevant if it’s adjusted for continued
operations.
Example 6: In the third quarter, Ram Corporation had a net income of

` 1.5 million. The business declares dividends of `3,50,000 There are
now 1,00,00,000 shares outstanding. Calculate the Earnings Per Share
(EPS).
Solution:
Earnings per share is
S
= (Net Income – Dividends) / Number of Shares Outstanding
= (`1,50,00,000 – `3,50,000) / 1,00,00,000

IM
= `1.465
Each share would receive `1.465 because each share receives an equal
share of the net income pie.
PRICE EARNINGS RATIO

M
The price earnings ratio (P/E ratio) is the ratio for valuing a corpo-
ration that measures its current share worth relative to its EPS. The
ratio is additionally generally referred to as the worth multiple or the
earnings multiple.
N
P/E ratios are employed by investor’s analysts to see the relative price
of a company’s shares in an apples-to-apples comparison. It can even
be wont to compare a corporation against its own history or to match
combination markets against each other or over time. P/E is also cal-
culable on a trailing (backward-looking) or forward (projected) basis.
The P/E ratio relates a company’s share price to its earnings per
share. A high P/E ratio might mean that a company’s stock is overval-
ued, alternatively that investors predict high growth rates within the
future.
Example 7: The markets price of an XYZ Company share is `80, while

the share’s profits are `20. Calculate price earnings ratio.
Solution:
Price Earnings Ratio is
= Market Price per Share / Earnings per Share

= ` 80 / ` 20
=4
Therefore, the P/E ratio for XYZ Ltd. is 4, it is clear that investors are
prepared to part with `4 for every rupee in corporate profits.
PRICE EARNINGS TO GROWTH RATIO
The price/earnings to growth quantitative relation (PEG quantitative

relation) can be a stock’s price-to-earnings (P/E) ratio divided by the
expansion rate of its earnings for a given period of time. The PEG
quantitative relation is employed to see a stock’s price whereas con-
jointly factorisation within the company’s expected earnings growth
and it’s thought to supply an additional complete image than the addi-
S
tional normal P/E ratio.
The PEG quantitative relation enhances the P/E ratio by adding in

expected earnings growth into the calculation. To calculate the PEG
IM
quantitative relation, an analyst has to either find or calculate the P/E
ratio of the corporate in question. The P/E ratio is calculated because
the worth per share of the corporate divided by the earnings per share
(EPS), or worth per share/EPS.
Example 8: The market price of Sham Co. equity shares is `64 per
share, with `8 in earnings per share. The corporation pays out a div-
idend at a rate of 75%. There are no preference shares and 110,000
M
shares of `20 equity shares. Shares have a `54 book value. Earnings
per share are increasing at a 20% clip. Analyse the effect of Sham Co.’s
price/earnings-to-growth (PEG) ratio.
Solution:
N
Price Earnings to Growth Ratio is
= Price-to-Earnings Ratio / Growth Rate of Earnings Per Share
= 8 / 10
= 0.4
As a result, Andy Company’s price/earnings-to-growth ratio is 0.4. It

will be deemed cheap since the PEG ratio is less than its growth rate
or one.
Working Note:
Price-to-Earnings Ratio is
= Market Price Per Share / Earnings Per Share
= `64 / `8
=8

RELATIVE PRICE EARNINGS RATIO
Price-earnings relative refers to the price-earnings ratio of a stock

divided by the price-earnings ratio of a broader market measure. The
price-earnings ratio, often written as P/E, is equal to a stock’s or broad
market’s market price divided by a measure of the stock’s or market’s
earnings.
FORWARD AND TRAILING PRICE EARNINGS RATIO
The trailing worth to earnings ratio – trailing P/E ratio – is that the
most ordinarily used P/E variations (trailing versus forward). The
trailing P/E ratio accounts for a company’s actual earnings rather
than its projected earnings. The trailing P/E ratio offers the foremost
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correct valuation of a corporation.
The forward P/E ratio is a smaller amount usually compared to cur-

rent costs to projected earnings within the future, the projected num-
IM
bers will be modified or adjusted to assist the corporate look addi-
tional enticing.
The forward P/E ratio is totally different and somewhat less in style.
The forward P/E ratio divides a stock’s current share worth by future
earnings. The formula is typically cited as calculable worth to earn-
ings.
M
The P/E ratio aids investors in estimating a stock’s market value

in relation to its earnings. The P/E ratio, or price to earnings ratio,
demonstrates what the market is ready to pay now for a company
based on its current or projected earnings. A high P/E may indicate
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that a stock’s price is excessively high in relation to its earnings. On

the other hand, a low P/E can suggest that the present stock price is
undervalued in comparison to earnings.
The major drawback to the forward P/E ratio is that corporations typ-
ically attempt to beat the system. They will at the start claim higher
earnings, and then regulate the figure as they head into consequent
announcement of earnings. Or, they will claim a lower earnings figure
in one quarter in order that consequent quarter beats the estimate.
Example 9: Hit Technology Inc. has the following information:

The net income for the year-end 2017 – `450,000
The preferred dividends paid in 2017 – `30,000
At the beginning of the year 2017, the common shares outstanding
were 50,000 shares. In the middle of the year, Hit Technology Inc.
issued another 40,000 common shares.
Find out the earnings per share of Hit Technology Inc.

Solution:
In the example, we know the net income and the preferred dividends.
That means we know all the information needed for the numerator.
However, we do not know the weighted average of common shares
outstanding; because we need to calculate that from the data given.
Let us calculate the weighted average number of common shares out-

standing first.
It’s said that at the beginning of the year, the firm had 50,000 common
shares. And in the middle, 40,000 new common shares were issued.
So we can consider 50,000 shares for the entire year and 40,000 shares
for the last six months.
S
Here is the calculation:
Weighted Average Number of Common Shares = (50,000 × 1) +
(40,000 × 0.5) = 50,000 + 20,000 = 70,000 shares.
IM
Now, we will find out the EPS formula:
EPS formula = (Net Income – Preferred Dividends) / Weighted
Average Number of Common Shares
Or. EPS formula = (`450,000 – `30,000) / 70,000
Or, EPS = `420,000 / 70,000 = `6 per share.
M
DU PONT ANALYSIS
The DuPont analysis (also referred to as the DuPont identity or

DuPont model) could also be a framework for analysing elementary
performance popularised by the DuPont Corporation. DuPont anal-
N
ysis could also be a useful technique used to decompose the varied

drivers of return on equity (ROE). The decomposition of ROE permits
investors to focus on the key metrics of economic performance one by
one to identify strengths and weaknesses.
DuPont analysis could also be a useful technique used to decompose

the varied drivers of come back on equity (ROE).
The DuPont associate degree is expanded return on equity formula,

calculated by multiplying net profit margin by the turnover by the
equity variety.
DuPont Analysis = Net Profit Margin × AT × EM
Where:
Net Profit Margin = Profits
Revenue
AT = Asset turnover

Asset Turnover = Sales
Average Total Assets
EM = Equity variety
Equity Multiplier = Average Total Assets
1. __________ may be a company’s profits divided by the quantity

of common stock it’s outstanding.
a. Earnings per share (EPS)
b. Trailing P/E ratio
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c. Forward P/E ratio
d. None of these
2. The __________, a variation of the standard z-score in
IM
statistics, relies on 5 money ratios that may be calculated from
knowledge found on a company’s annual 10-K report.
a. DuPont analysis
b. P/E ratio
c. Altman Z-score
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d. Gross profit margin
ACTIVITY
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Find examples of any two organisations that have applied DuPont

Analysis to have insight into their profitability.

Illustration 1:
Dividends of 25,000 euros will be paid out by Organisation X. The

net income should not be diverted by profit distributions. The three
parentheses are computed as follows using the information provided
below:
If the profit margin is 15.15%, asset turnover is 0.75, and equity mul-
tiplier is 1.54.
Solution:
DuPont Analysis is
= Profit Margin × Asset Turnover × Equity Multiplier

= 15.15% × 0.75 × 1.54

= 17.50%
Illustration 2:
ABC Corporation reported a net income of `2,50,00,000 during the

third quarter. The company announces dividends of `5,00,000. There
are now 1,500,000,000 shares in circulation. Figure out the earning per
share (EPS).
Solution:
Earnings per share is
= (Net Income – Dividends) / Number of Shares Outstanding
S
= (`2,50,00,000 – `5,00,000) / 1,50,00,000
= `1.633
Each share would receive `1.633 because each share receives an equal
IM
share of the net income pie.
Illustration 3:
A XYZ Company share is valued at `100 on the open market, whereas

the share’s earnings are `40. Determine the price-to-earnings ratio.
M
Solution:
Price Earnings Ratio is
= Market Price per Share / Earnings per Share
= `100 / `40
N
= 2.5
Therefore, the P/E ratio for XYZ Ltd. is 2.5, it is clear that investors
are prepared to part with `2.5 for every rupee in corporate profits.
Illustration 4:
Dividends of 40,000 euros will be paid out by Organiszation A. The

net income should not be diverted by profit distributions. The three
parentheses are computed as follows using the information provided
below:
If the profit margin is 18.50%, asset turnover is 0.82, and equity mul-
tiplier is 1.85.
Solution:
DuPont Analysis is
= Profit Margin × Asset Turnover × Equity Multiplier

= 18.50% × 0.82 × 1.85

= 28.06%
10.4 SUMMARY S
A profitability ratio is an economic metric that that assesses a busi-
ness’s ability to generate pertaining to its revenue, operational
prices, assets or shareholders’ equity over time. In other words,
profitability ratios provide insight into how well an organisation
uses its assets internally to come up with financial gain (as against
after-cost profits).
Profitability ratios indicate the efficiency of an organisation of gen-
erating profit. Higher profitability ratio is typically favourable.
S
A company’s capacity to generate profits from sales or activities,
balance sheet assets, or shareholders’ equity is evaluated using
profitability ratios.
For the majority of profitability ratios, a greater number in com-
IM
parison to a competitor’s ratio or to the same ratio from a prior
period indicates the company’s success.
Profitability ratios are the most commonly used metrics used
in financial analysis, and they generally fall into two categories
namely margin ratios and return ratios.
Margin ratios provide insight into a company’s ability to turn sales
M
into a profit. On the other hand, return ratios offer several differ-
ent ways to examine how well a company generates a return for its
shareholders.
Earnings per share (EPS) may be a company’s profits divided by
the quantity of common stock it’s outstanding. EPS indicates what
N
quantity of cash an organisation makes for every share of its stock

and may be a wide used metric for estimating company worth.
The price earnings ratio (P/E ratio) is the ratio for valuing a cor-
poration that measures its current share worth relative to its EPS.
The price/earnings to growth quantitative relation (PEG quantita-
tive relation) can be a stock’s price-to-earnings (P/E) ratio divided
by the expansion rate of its earnings for a given period of time.
Price-earnings relative refers to the price-earnings ratio of a stock
divided by the price-earnings ratio of a broader market measure.
The price-earnings ratio, often written as P/E, is equal to a stock’s
or broad market’s market price divided by a measure of the stock’s
or market’s earnings.
The forward P/E ratio offers many advantages. It helps compare
a company’s current earnings to people who it’s track on the right
track heading within the right direction not off course to form in
the future.

The DuPont analysis (also referred to as the DuPont identity or

DuPont model) could also be a framework for analysing elemen-
tary performance popularised by the DuPont Corporation. DuPont
analysis could also be a useful technique used to decompose the
varied drivers of return on equity (ROE).
KEY WORDS
Financial analysis: The process of evaluating businesses, proj-

ects, budgets, and other finance-related transactions to deter-
mine their performance
Metrics: A system or standard of measurement
Profitability ratio: A type of accounting ratio that helps in
S
determining the financial performance of business at the end of
an accounting period
Revenue: Money regularly received by a government, company,
IM etc

MCQ
1. Which of the following are most helpful when put next to similar
corporations, the company’s own history, or average ratios for
the company’s trade?
M
a. Profitability ratios
b. Liquidity ratios
c. Solvency ratios
N
d. All of these
2. Which of the following is one amongst the foremost wide used
profitability or margin ratios?
a. Net profit margin
b. Gross profit margin
c. Both a. and b.
d. None of these
3. Margin ratios provide insight into a company’s ability to turn
sales into a
a. Expense
b. Loss
c. Profit
d. None of these

4. It establishes a relationship between operational prices and

revenue from operations. Which of the following option is correct
regarding the above statement?
a. Operating profit ratio
b. Operating ratio
c. Net profit ratio
d. Gross profit ratio
5. The ratio measures the link between profits and income. It shows
the proportion of profits earned on revenue from operations.
Which of the following option is correct regarding the above
statement?
S
a. Net profit ratio
b. Operating profit ratio
c. Operating ratio
IM
d. All of these
6. It shows the link of profit (profit before interest and tax) with
capital used. All the results of operations of the business are
either profit or either a loss. Which of the following option is
correct regarding the above statement?
M
a. Gross profit ratio

b. Operating Profit Ratio
c. Return on investment
d. Operating ratio
N
7. Which of the following may be a company’s profits divided by the

quantity of common stock it’s outstanding?
a. Earnings per share
b. Price Earnings ratio
c. Price Earnings to growth ratio
d. Relative price earnings ratio
8. Which of the following refers to the price-earnings ratio of a
stock divided by the price-earnings ratio of a broader market
measure?
a. Price earnings to growth ratio
b. Price earnings ratio
c. Relative price earnings ratio
d. None of these

9. Which of the following accounts for a company’s actual earnings

rather than its projected earnings?
a. Price earnings to growth ratio
d. Trailing price earnings ratio
10. Which of the following could also be a framework for
analysing elementary performance popularised by the DuPont
Corporation?
a. DuPont analysis
S
d. All of these
IM
?
1. What is gross profit ratio?
2. Explain earnings per share.
3. What is DuPont analysis?

M
10.7
(HOTS) QUESTIONS
1. An Altman Z-score getting ready to zero suggests an organisation
may well be headed for __________, whereas a score nearer to
three suggests an organisation is in solid money positioning.
N
a. profitability b. bankruptcy
c. finance d. None of these
2. The formula takes under consideration gain, leverage, __________,
solvency, and activity ratios.
a. liquidity b. assets
c. ratios d. None of these
Topic Q. No. Answer

Introduction to Profitability Ratios 1. a. Earnings per share
2. c. Altman Z-score

Q. No. Answer
1. a. Profitability ratios
2. b. Gross profit margin
3. c. Profit
4. b. Operating Ratio
5. a. Net Profit Ratio
6. c. Return on Investment
7. a. Earnings per Share
S
8. c. Relative Price Earnings Ratio
9. d. Trailing Price Earnings Ratio

IM
10. a. DuPont analysis

1. Gross Profit ratio establishes a relationship between net income
and Revenue from Operations, i.e., income of associate degree
enterprise. Refer to Section 10.2 Introduction to Profitability
M
Ratios
2. The ensuing variety is associate degree indicator of a company’s
profit. It’s common for an organisation to report EPS that’s
adjusted for extraordinary things and potential share dilution.
N
Refer to Section 10.2 Introduction to Profitability Ratios

3. The DuPont analysis (also referred to as the DuPont identity or
DuPont model) could also be a framework for analysing elementary
performance popularised by the DuPont Corporation. DuPont
analysis could also be a useful technique used to decompose the
varied drivers of come back on equity (ROE). The decomposition
of ROE permits investors to focus on the key metrics of economic
performance one by one to identify strengths and weaknesses.
Refer to Section 10.2 Introduction to Profitability Ratios

QUESTIONS
Q. No. Answer
1. b. bankruptcy
2. a. liquidity

SUGGESTED READINGS
Goel, S., n.d. Financial ratios.
1997. Performance of Singapore companies. Singapore: Dept. of
Statistics.
1970. Ten significant ratios for Canadian manufactures by size and
profitability classes. [Toronto].
E-REFERENCES
Corporate Finance Institute. 2022. Profitability Ratios. [online]
S
Available at: <https://corporatefinanceinstitute.com/resources/
knowledge/finance/profitability-ratios/> [Accessed 22 June 2022].
BYJUS. 2022. [online] Available at: <https://byjus.com/commerce/
profitability-ratios/> [Accessed 22 June 2022].
IM
Scripbox. 2022. Profitability Ratios. [online] Available at: <https://
scripbox.com/mf/profitability-ratios/> [Accessed 22 June 2022].
M
N

C H
11 A P T E R
CASH FLOW STATEMENT
S
CONTENTS
11.1 Introduction
11.2 Introduction to Cash Flow Statement
IM
11.2.1 Meaning of Cash Flow Statement
11.2.2 Classification of Activities for Cash Flow Statement
Activity
11.3 Preparation of Cash Flow Statement
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Activity
11.4 Objectives of Cash Flow Statement
Activity
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11.5 Methods of Cash Flow Statement

11.5.1 Direct Cash Flow Method
11.5.2 Indirect Cash Flow Method
Activity
11.6 Limitations of Cash Flow Statement
Activity
11.8 Summary

CASH FLOW STATEMENT
Shivay Textiles is a sole proprietorship firm that is owned by a sin-

Case Objective gle individual. The firm is based in the union territory of Chandi-
This caselet discuss the garh and has a staff of 32 employees. It owns many clothing stores
preparation of cash flow of readymade garments in the state capital region of Chandigarh
statement at Shivay textiles. and it is a famous merchandise store among local people.
Shivay Textiles needs a cash flow statement to understand the cash

position of the business. There are three main activities found in
various recording books of any firm or a company namely oper-
ating activities (core operations of the business), investing activ-
ities (sale and purchase of assets) and financing activities (cash
received from financing and cash paid to owners).
S
Preparing a cash flow statement required a proper format pre-
scribed by the Ministry of Corporate Affairs in the Companies Act
2013. As per the format, the header of the statement should be
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company name (Shivay Textiles in this case) and then below this
it must be stated that ‘Statement of Cash Flow’ for the accounting
period ending March 31, 20XX.
The first section is for ‘cash flow from operating activities. So as

per the format we start with the net profit and then various adjust-
ments were made in the given order. Under this section, we have
M
to add non-cash expenses such as depreciation and amortisation

and then subtract non-operating incomes such as profit on sale
of fixed assets. In this case, if the firm has purchased inventory
of merchandise on a cash basis, then we need to subtract it from
and add it to supplies. If there is a decrease in creditors or account
N
payable, it means that the firm has paid of its debts. This event is
a cash flow and it should be deducted from cash. Same treatment
should be done with tax payable.
Then next section is for investing activities and any increase or

decrease in assets should be recorded under it. In this case, if
Shivay Textiles buys a new clothing store for cash, then it will be
treated as cash outflow from investing activities.
The third and last section of cash flow statement is for cash flow
from financing activities. Under this section, any cash inflow or
outflow from financing activities (loans, issue of shares, issue of
debentures, so it is a cash inflow and it should etc.) are recorded
under this head. It also involves recording of various transactions
such as Interest received (Add), Sale of old machinery (Add), Div-
idend received (Add), repurchase of shares (Subtract), etc. In this
case, suppose Shivay Textiles buys a clothing store by borrowing
loan from a bank. This activity is a cash inflow from financing

CASH FLOW STATEMENT 239
activities and should be considered cash inflow from financing

activities. On the other hand, payment of loan is considered to
be cash outflow from financing activities. Now suppose the pro-
prietor of Shivay Enterprise withdraws money for personal use.
Then in this case it is considered as cash outflow and it should be
deducted from financing activities.
In the last step the total of all three sections has to be calculated
by using formula, cash inflows minus cash outflow. After calcu-
lating this, suppose Shivay Enterprise shows a change in positive
cash balance with `2,50,000 and the beginning cash balance was
`1,00,000. Then the total cash balance at the end will be calculated
by adding `2,50,000 and `1,00,000. Which is equal to `3,50,000 and
the ending cash in the balance sheet will be recorded as `3,50,000.
S
IM
M
N

LEARNING OBJECTIVES

>> Explain the cash flow statement
>> Discuss the objectives and importance of cash flow state-
ment
>> Describe how to prepare a cash flow statement
>> Summarise the methods of preparing cash flow statement
>> Analyse the limitations of a cash flow statement
11.1 INTRODUCTION
S
Quick Revision
In the previous chapter, you have studied about profitability ratios.
Using information at a single moment in time, profitability ratios are a
class of financial measurements that are used to evaluate a company’s
capacity to make profits in relation to its revenue, operating costs, bal-
IM
ance sheet assets, or shareholders’ equity over time. Efficiency ratios,
which evaluate how well a corporation uses its resources internally to
create money, can be contrasted to profitability ratios (as opposed to
after-cost profits).
Cash is king and it is the basis of any business. No bills, or employees

or for that not even one would be paid without cash. Expansions or
M
any addition to the businesses happen only through cash. Thus, it is

important for companies to have a track of all cash inflows and out-
flows of business.
Apart from balance sheet and income statement, there is also a third
important financial statement known as Cash flow statement, which
N
shows inflows and outflows of the cash and cash equivalents. This
statement helps the users of financial information to know about
the sources and uses of cash and cash equivalents of an organisation
over a period of time from various activities. It has gained substantial
importance in the last decade because of its practical utility to the
users of financial information.
The revised Accounting Standard-3 (AS-3) now deals with the prepa-
ration and presentation of cash flow statement. The revised AS-3 has
made it mandatory for all listed companies to prepare and present
a cash flow statement along with other financial statements on an
annual basis.
For a reporting period, an entity’s cash flows from operating, invest-

ing, and financing operations must be prepared and presented in
accordance with the principles and guidelines prescribed by Ind
AS 7. The purpose of Ind AS 7 is to give information on an entity’s his-
torical changes in cash and cash equivalents as a result of its operating,
investing, and financing activities throughout the reporting period.

Inflows and outflows of cash and cash equivalents are known as cash
flows. Cash is made up of demand deposits and cash on hand. Cash
equivalents are highly liquid, short-term assets with a low risk of losing
value that can be easily converted into known sums of cash. Demand
deposits, certain short-term investments and sometimes bank over-
drafts are examples of cash and cash equivalents.
Users of financial statements may evaluate an entity’s capacity to

produce cash and cash equivalents and its requirements for using
those cash flows using information about the entity’s cash flows. The
capacity of a company to create cash and cash equivalents, as well as
the time and certainty of their creation, must be assessed in order for
users to make economic choices.
Except in certain circumstances where cash flows are offset and
S
reported on a net basis, the statement of cash flows must include the
components of cash and cash equivalents at the beginning and end of
the reporting period, as well as cash flows broken down by operating,
investing, and financing activities.
IM
The cash flow statement is relevant to all businesses, and no organisa-
tion type is immune from having to prepare and submit one. However,
according to the current AS, small and medium-sized businesses are
not required to have one.
For each period for which financial statements are produced, a busi-
M
ness must compile a statement of cash flows in accordance with the

requirements of this standard and include it as a component of those
In this chapter, you will study the introduction to cash flow statement,
objectives of cash flow statement, classification of cash flow statement,
N
preparation of cash flow statement, methods of cash flow statement,

limitations of cash flow statement, etc., in detail.
INTRODUCTION TO CASH FLOW

11.2
STATEMENT
A cash flow statement is a mandatory record of an organisation’s
financial reports. It records the amount of cash and cash equivalents
entering and leaving an organisation in a given time period. Thus, it is
a statement which shows a change in cash balances during a specified
period. The cash flow statement enables investors to comprehend how MARK IT!
an organisation is performing in terms of its operations, the source of
Cash includes an organisation’s
its money resources and how the available cash is utilised.
cash in hand and deposits
with banks, whereas cash
A cash flow statement when combined with other financial statements equivalents short-term highly
provides information that allows investors to evaluate changes in net liquid investments that can be
assets of an organisation, its financial structure, its liquidity and sol- easily converted into cash such
vency conditions and the organisation’s ability to affect the amounts as treasury bills, liquid mutual
funds, etc.
and timing of cash flows. Cash flow details help in assessing the ability

of the organisation to generate cash and cash equivalents to enable

NOTE users in comparing the present value of the future cash flows of dif-
A cash flow statement is also ferent organisations. A cash flow statement provides with the infor-
believed to be the most intuitive mation about historical changes in cash and cash equivalents of an
of all the financial statements
because it then follows the cash
organisation by classifying cash flows in a period owing to different
made by all the business in 3 activities.
main ways—through operations,
investment and financing. The
sum of these 3 segments is
11.2.1 MEANING OF CASH FLOW STATEMENT
called net cash flow.
A financial statement that shows entire data is a cash flow statement.
include all cash outflows that cover the cost of trade activities and
finances throughout the course of a given time as well as cash inflows
that a business receives from its ongoing progress and outside sources
of funding. In other terms, a cash flow statement is a financial state-
S
ment that calculates the amount of cash that a company will create or
spend over a given period of time.
On the basis of information taken from the enterprise’s historical

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records, the cash flow statement is being generated. Cash flow state-
ments can be created for periods of one year, six months, three months,
or even one month. The term “cash” encompasses both cash on hand
and cash in a bank.
The key reasons for creating the cash flow statement are as follows:
1. To utilise the corresponding two distinct balance sheets to
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determine the reasons for the variations in the cash balance

between two different time periods.
2. To describe the variables that affect the decline in cash balance
and to explain why profits are produced during the year and vice
versa.
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11.2.2 CLASSIFICATION OF ACTIVITIES FOR CASH FLOW

STATEMENT
Every organisation uses a cash flow statement to have insight into

changes in the cash and cash equivalents. Although these statements
are pertaining to cash flows, these also help in assessing balance sheet
and income changes. In an organisation, cash is generated through
three major activities, which are shown in Figure 11.1:
Cash Flow Statement
Cash Flows due to Cash Flows due to Cash Flows due to

Operating Activities Investing Activities Financing Activities
Figure 11.1: Cash Flow Activities
Let us discuss these activities in detail.

CASH FLOW FROM OPERATING ACTIVITIES

NOTE
Operating activities are the primary/main activities of an organisa- Profit before tax as presented
tion during an accounting period. For example, for a garment man- in the income statement could
ufacturing company, operating activities include procurement of raw be used as a starting point
to calculate cash flows from
material, sale of garments, incurrence of manufacturing expenses, operating activities.
etc. These are the principal revenue generating activities of the
company.
Cash inflows from operating activities:

Cash receipts from sale of goods and rendering of services
Cash receipts from all the fees, royalties, commissions and other
revenues
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Cash outflows from operating activities:
Cash payments to all suppliers of goods and services
MARK IT!
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Cash payments of all income taxes unless they can be more specif-
ically identified with all financing and investing activities. The amount of cash from
operations indicates the internal
solvency level of the company.
Operating activities are the main source of revenues and expendi-
It is a key indicator of the extent
tures, thereby all the cash flow from the same needs to be ascertained. to which the operations of the
Cash flow from operations can be calculated using either the direct or enterprise have generated
indirect method. sufficient cash flows to maintain
its operating potential.
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Example 1: Calculate the cash flows from operating activities. Net profit
before tax, `1,10,000, depreciation on machinery, `55,000, increase in
creditors, `70,000, increase in bills payable, `30,000, increase in stock,
`10,000, increase in debtor, `50,000, and income tax paid, `45,000.
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Solution:
NOTE
Cash Flow from Operating Activities is
The following items are not
considered under the direct
= Net Profit before Tax + Depreciation on Machinery + Increase in method:
Creditor + Increase in Bills Payable – Increase in Stock – Increase in 1. Non-cash items, such as
Debtor – Income Tax Paid depreciation, discount on
shares, be written-off.
= `1,10,000 + `55,000 + `70,000 + `30,000 – `10,000 – `50,000 – `45,000 2. Items which are classified as
investing or financing activi-
= `1,60,000 ties such as interest received
or dividend paid.
CASH FLOW FROM INVESTING ACTIVITIES
Cash flow from all investing activities includes the movement in cash
flows which is then owing to the purchase and sale of assets. It relates
to purchase and sale of all long-term assets or fixed assets such as the
machinery, furniture, land and building.

Cash inflows from investing activities:

Cash receipt from the disposal of fixed assets including intangibles
Cash receipt from the repayment of all advances or of loans made

to all third parties except in case of all financial enterprise.
Dividend received from the investments in other organisations
Cash receipt from the disposal of shares, and warrants or debt
instruments of all other organisations except then those held for
trading purposes
Cash Outflows from investing activities:

Cash payments to acquire any of the fixed assets including intan-
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gibles and capitalised R&D
Cash advances & loans made to the third party (other than all
advances and loans made by the organisation wherein it is operat-
ing activities)
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Cash payments to acquire shares, warrants or debt instruments of
other organisations other than that of the instruments those held
for trading purposes
Example 2: Calculate the cash flows from investing activities. Net

profit before tax, `1,10,000, depreciation on machinery, `55,000,
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increase in creditors, `70,000, increase in debtor, `50,000, income tax

paid, `45,000, machinery purchased, `3,00,000, and equipment sold,
`30,000.
Solution:
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Cash Flow from Investing Activities is
= Machinery Purchased + Machinery Sold
= `(3,00,000) + `30,000
= `(2,70,000)
Example 3: Calculate the cash flows from investing activities. Net

profit before tax, `1,10,000, depreciation on machinery, `55,000,
increase in creditors, `70,000, increase in debtor, `50,000, income tax
paid, `45,000, machinery purchased, `50,000, and equipment sold,
`4,00,000.
Solution:
Cash Flow from Investing Activities is
= Machinery Purchased + Machinery Sold

= `50,000 + `4,00,000
= `4,50,000
CASH FLOW FROM FINANCING ACTIVITIES
Financing activities are related to long-term funds or capital of an

organisation. These activities result in changes in the size and compo-
sition of the owners’ capital and borrowings of the organisation. For
example, cash proceeds from issue of all equity shares, debentures,
raising long-term loans or even repayment of bank loans, etc.
Cash inflows from financing activities:

Cash proceeds from all issuing shares could be equity/preference
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Cash proceeds from all issuing debentures, loans, bonds and other
short/long-term borrowings
Cash outflows from all financing activities:

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Cash repayments of amounts borrowed
Interest paid on debentures, long-term loans and advances
Dividends paid on equity and preference capital
Example 4: Calculate the cash flows from financing activities. Issue

of shares, ` 2,00,000, increase in creditors, `70,000, increase in debtor,
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`50,000, income tax paid, `45,000, machinery purchased, `50,000, and

issue of debenture, `3,50,000.
Solution:
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Cash Flow from Financing Activities is

= Issue of shares + Issue of debenture
= `2,00,000 + `3,50,000
= `5,50,000
EXHIBIT
FORMAT OF CASH FLOW

1. Cash Flow Statement (Direct Method)
Cash Flow Statement (Direct Method)
Cash Flows from Operating Activities
Cash receipts from customers (xxx)
Cash paid to suppliers and employees xxx


Cash generated from operations (xxx)
Income-tax paid xxx
Cash flow before extraordinary items xxx
Proceeds from earthquake disaster xxx
settlement, etc.
Net cash flow from Operating Activities (a) xxx
Cash flows from Investing Activities

Purchase of fixed assets (xxx)
Proceeds from sale of equipment xxx
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Interest received xxx
Dividend received xxx
Net cash flow from Investing Activities xxx
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Cash flows from Financing Activities
Proceeds from issuance of share capital xxx
Proceeds from long-term borrowings xxx
Repayments of long-term borrowings (xxx)
Interest paid (xxx)
Dividend paid (xxx)
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Net Cash Flow from Financing Activities (b) xxx
Net increase (decrease) in cash and cash (a-b+c) xxx

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equivalents during the period

Cash and cash equivalents at beginning of xxx
period
Cash and Cash Equivalents at End of Period xxx
2. Cash Flow Statement (Indirect method)
Cash Flow Statement (Indirect Method)

(Accounting Standard-3 (Revised)
(`)
Cash Flow from Operating Activities
Net profit before tax and extraordinary items xxx
Adjustments for:
-Depreciation xxx
-Foreign exchange xxx
-Investments xxx

-Gain or loss on sale of fixed assets (xxx)

-Interest/dividend xxx
Operating Profit Before Working Capital xxx
Changes
Adjustment for:
-Trade and other receivables xxx
-Inventories (xxx)
-Trade payables xxx
Cash Generated from Operations xxx
-Interest paid (xxx)
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-Direct taxes (xxx)
Cash before Extraordinary Items xxx
Deferred revenue xxx
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Net Cash Flow from Operating Activities (a) xxx
Cashflow from Investing activities
Purchase of fixed assets (xxx)
Sale of fixed assets xxx
Sale of investments xxx
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Purchase of investments (xxx)

Interest received xxx
Dividend received xxx
Loans to subsidiaries xxx
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Net cashflow from investing activities (b) xxx
Cashflow from Financing Activities

Proceeds from issue of share capital xxx
Proceeds from long term borrowings xxx
Repayment to finance/lease liabilities (xxx)
Dividend paid (xxx)
Net cashflow from financing activities (c) xxx
Net Increase (decrease) in cash and cash (a + b xxx
equivalents during the period + c)
Cash and cash equivalents at the beginning of xxx
the year
Cash and cash equivalents at the end of the xxx
year

1. Which of the following includes the movement in cash flows

which is then owing to the purchase and sale of assets?
a. Cash flow from investing activities
b. Cash flow from financing activities
c. Cash flow from operating activities
d. Both a. and b.
2. A cash flow statement when combined with other financial
statements provides information that allows investors to
evaluate changes in:
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a. Net assets of an organisation
b. Financial structure
c. Liquidity and solvency conditions
IM d. All of these
ACTIVITY
Classify the following activities into operating activities, investing

activities, financing activities, cash equivalents:
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1. Purchase of machinery
2. Proceeds from issuance of equity share capital
3. Cash revenue from operations
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4. Proceeds from long-term borrowings

5. Proceeds from sale of old machinery
6. Cash receipt from trade receivables
7. Trading commission received
8. Purchase of non-current investment
9. Redemption of preference shares
10. Cash purchases
PREPARATION OF CASH FLOW

11.3
STATEMENT
A typical cash flow statement comprises three sections: cash flow from
operating activities, cash flow from investing activities, and cash flow
from financing activities.

The following are the steps in preparing the cash flow statement:
Determining the starting balance: The first step in preparing a
cash flow statement is to determine the starting balance of cash
and cash equivalents at the beginning of the reporting period.
Calculating cash flow from operating activities: Next is to cal-
culate cash flow from each operating activity. This is typically
thought as the most important section as it shows how much cash
is generated from operations.
Calculating cash flow from investing activities: After calculating
the cash flow from operating activities, cash flow from investing
activities needs to be calculated. It should be noted here that this
section includes only the investing activities involving cash and
not debt.
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Calculating cash flow from financing activities: The third sec-
tion of the cash flow statement covers cash inflows and outflows
related to financing activities. This also includes cash flows from
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both debt and equity financing. In other words, cash flows can be
associated with all raising cash and paying back debts to all the
investors and creditors.
Determining the ending balance: Finally, once cash flows from all
three main types of business activities are accounted for, one can
determine the ending balance of cash and cash equivalents at the
end of the reporting period.
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3. The first step in preparing a cash flow statement is to:

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a. Determine the starting balance of cash and cash equiva-

lents at the beginning of the reporting period
b. Calculate cash flow from operating activities
c. Calculate cash flow from investing activities
d. Calculate cash flow from financing activities
ACTIVITY
Prepare a cash flow statement for a manufacturing organisation.
OBJECTIVES OF CASH FLOW

11.4
STATEMENT
The primary objective of a cash flow statement is to supply the nec-
essary related to the generation of cash to all users of financial state-
ments. It also highlights the future or the prospective cash positions

i.e., cash or cash equivalent. In other words, it can be said that a cash
flow statement depicts an organisation’s liquidity position or its ability
to meet current expenses using available resources. All the inflows
and outflows of cash can be then represented with the help of this
statement. The following are other objectives of cash flow statement:
To provide knowledge of the cash position and indicate changes in
the cash position as well as the reasons for the changes
To provide a business with a general idea of how it will make ends
meet in the short run
To help investors analyse the liquidity and solvency of an organi-
sation.
To enable the management to prepare dividend and profit reten-
tion policies
S
To guide the management, evaluate the changes in the cash posi-
tion of an organisation
To provide the management with details about the performance of
IM operational, financial and investment activities for effective deci-
sion making
To provide information about the factors causing the cash flows
To guide the management to take a decision about short-term obli-
gations
To provide the details about the sources of cash and applications of
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cash during a given period

To provide a base for the preparation of cash budgets

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4. Which of the following are the objectives of a cash flow

statement?
a. To provide knowledge of the cash position
b. To help investors analyse liquidity
c. To provide information about the factors causing the cash
flows
d. All of these
ACTIVITY
Find the objectives of cash flow statement.
11.5 METHODS OF CASH FLOW STATEMENT

The Cash Flow Statement (CFS) is a financial statement that details
the inflow and outflow of Cash and Cash Equivalents (CCE) into and

out of a business. The CFS gauges how well a business manages its
cash position, or how successfully it produces cash to cover its debt
payments and finance its operational costs. The CFS is a financial
statement that complements the balance sheet and income statement
as one of the three primary financial statements. We’ll outline the
CFS’s structure and application to business analysis in this post.
The direct technique and the indirect method are the two approaches
for determining cash flow.
11.5.1 DIRECT CASH FLOW METHOD
All financial payments and receipts, including cash paid to suppliers,

cash received from consumers, and cash given out in salary, are added
up in the direct method. For extremely small enterprises that employ
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the cash basis accounting system, this CFS technique is more conve-
nient.
These statistics may also be obtained by assessing the net loss or rise
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in the accounts using the starting and ending balances of a variety of
asset and liability accounts. It is given in an easy-to-understand way.
11.5.2 INDIRECT CASH FLOW METHOD
Cash flow is estimated using the indirect approach by changing net

income by adding or removing differences from non-cash transactions.
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Non-cash items appear on the balance sheet as changes in assets and

liabilities from one period to the next. In order to determine an accu-
rate cash inflow or outflow, the accountant will identify any increases
and reductions in asset and liability accounts that need to be brought
back to or removed from the net income number.
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Cash flow must reflect changes in accounts receivable (AR) on the bal-
ance sheet from one accounting period to the next:
If AR falls, more money may have entered the firm as a result of
clients paying off their credit cards; the amount by which AR falls
is then added to net profits.
Because the sums reflected in AR are in revenue but not cash, a
rise in AR must be reduced from net profits.
What about inventory fluctuations in a business? On the CFS, they

are accounted for as follows:
Inventory growth indicates that a company spent more money on
raw materials. When you use cash, the rise in the value of your
inventory is subtracted from your net profits.
Net profits would be boosted by a reduction in inventories. Credit
purchases are recorded on the balance sheet as a rise in accounts
payable, and the amount of the increase from year to year is added
to net profits.

Taxes due, salary, and prepaid insurance all follow the same reason-
ing. If something has been paid off, net income must be reduced by
the difference in the amount owing from one year to the next. Any dis-
parities will have to be added to net profits if there is still an amount
payable.
DIFFERENCE BETWEEN DIRECT AND INDIRECT METHOD
Operating, investing, and financing are the three activities that are
included in the cash flow statement. The investing and financing sec-
tions are typically calculated in a similar manner.
However, two methods of calculation—the indirect method and the

direct method—are typically used when calculating cash flow from
operational activity.
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Net income serves as the foundation for the indirect cash flow method.
To convert the total net income to cash from operations, it makes the
necessary adjustments, i.e., by adding and removing the variables.
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The cash that is received from consumers and the cash that is paid to
suppliers, workers, and other parties are both included in the direct
method of cash flow in operational operations. In addition, the money
may be used to pay for interest, income tax, and other costs.
The direct cash flow technique ignores non-monetary activities and

begins with currency transactions such as cash received and cash
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paid.
The computation for the indirect cash flow technique, on the other
hand, begins with the net income and is adjusted as we go.
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5. All financial payments and receipts, including cash paid to

suppliers, cash received from consumers, and cash given out
in salary, are added up in the _________.
a. right method b. indirect method
c. direct method d. All of these
ACTIVITY
Find the limitations of direct and indirect methods.
LIMITATIONS OF CASH FLOW

11.6
STATEMENT
As a cash flow statement is based on cash flows and records the move-
ment of cash. In this way, only cash transactions are recorded and

the accrual concept of accounting is ignored. The following are some

limitations of a cash flow statement:
Fails to present net income: A cash flow statement actually fails
to present all the net income of a firm for a period since it does
not even consider non-cash items which can be easily ascertained
by the income statements. It can be used as a supplement to the
income statement.
Fails to actually assess the liquidity and solvency position: The
liquidity position of an organisation cannot be assessed from the
cash flow statement as it presents only the cash position at the end
of the period. It only helps on how much amount of obligation can
be met, which means a cash flow statement does not then repre-
sent the real liquidity position.
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Serves neither a substitute of the funds flow statement nor the
income statement: A cash flow statement is not a complete substi-
tute for the income statement nor for the profit and loss account.
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The net cash flow calculated in the cash flow statement cannot be
equal to the net profit calculated under a profit and loss account.
As it considers only the inflows and outflows of cash, the net cash
flow of a certain period does not necessarily mean the net profit of
the business, as net profit is determined using both cash as well as
non-cash transactions.
Does not assess profitability: Practically, all cash flows from oper-
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ations do not help to assess the profitability of a firm since it nei-

ther considers costs nor revenues.
Does not assess future cash flows: Since a cash flow statement is
prepared on the basis of the historical cost, thus it does not help to
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know the future/projected cash flows.

Does not provide a basis for inter-industry comparison: A cash
flow statement does not actually measure the economic efficiency
of a firm in comparison with that to other inter-industry compari-
son is not possible.
6. A cash flow statement actually fails to present all the net

income of a firm for a period since it does not even consider
non-cash items which can be easily ascertained by the income
statements.
a. Does not assess profitability
b. Fails to present net income
c. Fails to actually assess the liquidity and solvency position
d. All of the above

ACTIVITY
Take a cash flow statement of a company and find its limitations.

Illustration 1: From the following information, calculate cash flow
from operating activities using the direct method.
Statement of Profit and Loss for the year ended on March 31, 2021
Figures for current

Particulars Note
reporting period
i. Revenue from operations 2,20,000
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ii. Other Income _
iii. Total revenue (i+ii) 2,20,000
iv. Expenses
IM Cost of materials consumed 1,20,000
Employees benefits expenses 30,000
Depreciation 20,000
Other expenses
Insurance Premium 8,000
T
otal expenses Lines are not at 1,78,000
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appropriate place
v. Profit before tax (iii-iv) 42,000
Less Income tax (10,000)
vi. Profit after tax 32,000
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Additional information
Particulars April 01, 2020 March 31, 2021

Trade receivables 33,000 36,000
Trade payables 17,000 15,000
Inventory 22,000 27,000
Outstanding employees’ benefits 2,000 3,000
Prepaid insurance 5,000 5,500
Income tax outstanding 3,000 2,000
Solution:
Particulars `
Cash receipts from customers 2,17,000
Cash paid to suppliers (1,27,000)

Particulars `
Cash paid to employees (29,000)
Cash paid for insurance premium (8,500)
Cash generated from operations 52,500
Income tax paid (11,000)
Net cash inflow from operations 41,500
Working Notes:
1. Cash Receipts from Customers is calculated as under:
Cash Receipts from Customers = Revenue from Operations +
Trade Receivables in the beginning – Trade Receivables in the
end = `2, 20,000 + `33,000 – `36,000 = `2, 17,000
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2. Purchases = Cost of Revenue from Operations – Opening
Inventory + Closing Inventory
= `1, 20,000 – `22,000 + `27,000 = `1, 25,000
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3. Cash payment to suppliers = Purchases + Trade Payables in the
beginning – Trade Payables in the end
= `1, 25,000 + `17,000 – `15,000 = `1, 27,000
4. Cash Expenses = Expenses on Accrual basis – Prepaid Expenses
in the beginning and Outstanding Expenses in the end + Prepaid
Expenses in the end and Outstanding Expenses in the beginning
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5. Cash Paid to Employees = `30,000 + `2,000 – `3,000 = `29,000

6. Cash Paid for Insurance Premium = `8,000 – `5,000 + `5,500
= `8,500
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7. Income Tax Paid = `10,000 + `3,000 – `2,000 = `11,000

8. It is important to note here that there are no extraordinary items.
Illustration 2:
You must create a cash flow statement using the indirect method based
on the data from SLV Ltd.’s income statement and balance sheet.
Income Statement and Reconciliation of Earnings for the

year ended 31.3.2021
`
Net Sales 25,20,000
Less: Cost of sales 19,80,000
Depreciation 60,000
Salaries and wages 2,40,000
Operating expenses 80,000
Provision for taxation 88.000 24,48,000

`
Net operating profit 72,000
Non-recurring income:
Profit on sale of equipment 12,000
84,000
Retained earnings (balance in profit & loss 1,51,800
account brought forward)
2,35,800
Dividend declared and paid during the year 72,000
Profit & Loss account balance as on 31.3.2021 1,63,800
(a) Comparative Balance Sheets
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31.3.2020 31.3.2021
Particular Amount Amount
Fixed assets
IM
Land 48,000 96,000
Building and equipments 3,60,000 5,76,000
Current assets
Cash 60,000 72,000
Debtors 1,68,000 1,86,000
Stock 2,64,000 96,000
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Advances 7,800 9,000

9,07,800 10,35,000
Capital 3,60,000 4,44,000
Surplus in profit & loss A/c 1,51,800 1,63,800
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Sundry creditors 2,40,000 2.34,000

Outstanding expenses 24,000 48,000
Income tax payable 12,000 13,200
Accumulated depreciation on building and 1,20,000 1,32,000
equipments
9,07,800 10,35,000
Cost of equipment sold was ` 72,000.
Solution:
Indirect Method SLV Limited

Cash flow statement for the year ended 31.3.2021
Dr. Cr.
Cash Flows from Operating Activities: ` `
Net profit before taxation and extra-ordinary 1,60,000
item
Adjustments for:

Dr. Cr.
Depreciation 60,000
Operating profit before working capital changes 2,20,000
Increase in debtors (18,000)
Decrease in stock 1,68,000
increase in advances (1,200)
Decrease in creditors (6,000)
Increase in outstanding expenses 24,000
Cash generated from operation 3,86,800
Income tax paid (86,800)
Net Cash from Operating Activities 3,00,000
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Cash Flows from Investing Activities:
Purchase of land (48,000)
Purchase of building and equipments (2,88,000)
Sale of equipment
IM 36,000
Net Cash Used in Investing Activities (3,00,000)
Cash Flows from Financing Activities:

Issue of share capital 84,000
Dividend paid (72,000)
M
Net Cash from Financing Activities 12,000

Net Increase in Cash and Cash Equivalents 12,000
Cash and Cash Equivalents at the beginning 60,000
Cash and Cash Equivalents at the end 72,000
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Illustration 3:
Calculate cash from activities using the following profit and loss
account.
Profit and Loss Account for the year ending 31st Dec, 2021
Particular ` Particular `
To Salaries 10,000 By Gross profit 50,000
To Rent 2,000 By Profit on sale of land 10,000
To Depreciation 4,000 By Income tax refund 6,000
To Loss on sale of plant 2,000
To Goodwill written off 8,000
To Proposed dividend 10,000
To Provision for taxation 10,000
To Net profit 20,000
66,000 66,000

If a profit and loss statement is provided, the net profit should be mod-
ified to reflect the cash received from operations or the cash expended
during operations.
Non-operating and non-cash costs must be included to the net profit,

and non-operating and non-cash earnings must be subtracted.
Non-cash and non-operating expenditures are added in order to can-

cel out the deduction procedure that previously occurred at the time
the profits were determined.
Solution:
Cash from operations ` `

Net profit made during the year 20,000
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Add:
Non-cash expenses
Depreciation 4,000
IM
Loss on sale of plant 2,000
Goodwill written off 8,000
Non-operating expenses
Proposed dividend 10,000
Provision for taxation 10,000 34,000
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Less
Non-Operating/cash income
Profit on sale of land 10,000
Income tax refund 6,000 16,000
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38,000
Illustration 4:
Create a cash flow statement based on Sudhir Ltd.’s balance sheets

for the fiscal years ending March 31st, 2020, and 2021.
31.3.2020 31.3.2021
` `
Assets
Property 2,00,000 2,50,000
Plant and machinery 4,00,000 4,50,000
Less: Depreciation 1,40,000 2,60,000 1,50,000 3,00,000
Loans to subsidiary Co. — 15,000
Share in subsidiary Co. 20,000 20,000
Stock in trade 1,40,000 1,50,000
Debtors 1,00,000 1,50,000
Bank 35,000 1,57,000

31.3.2020 31.3.2021
7,55,000 10,42,000
Liabilities
Equity Share of ` 20 each 3,00,000 4,00,000
Share premium — 10,000
Profit & Loss 1,00,000 1,00,000
appropriation A/c
Profit for the year — 2,00,000
6% Debentures 1,50,000 1,00,000
Profit on Redemption of — 2,000
Debentures
Sundry creditors 1,40,000 1,10,000
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Provision for taxation 50,000 1,00,000
Proposed dividend 15,000 20,000
7,55,000 10,42,000
Additional Information:
IM
A plant that cost `50,000 was sold for `10,000 throughout the year.
This facility has accumulated `30,000 in depreciation. Plant sale losses
were applied to the profit and loss statement. The amount of income-
tax paid for the year was `60,000.
Solution:
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Sudhir Limited
Cash Flow Statement for the year ended 31.3.2021 Cash Flows
from Operating Activities
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Particular `
Net profit before tax and extraordinary items 2,00,000
Adjustments for:
Depreciation 40,000
Provision for taxation 1,10,000
Proposed dividend 20,000
Loss on sale of machinery 10,000
Operating profit before working capital changes 3,80,000
Adjustments for:
Increase in debtors (50,000)
Increase in stock-in-trade (10,000)
Decrease in creditors (30,000)
Cash generated from operations 2,90,000
Tax paid (60,000)
Net cash from operating activities 2,30,000

Particular `
Cash flows from investing activities

Purchase of property (50,000)
Sale of plant 10,000
Purchase of machinery (1,00,000)
Loans to subsidiaries (15,000)
Net cash used in Investing activities (1,55,000)
Cash flows from financing activities

Issue of equity share capital at premium 1,10,000
Redemption of debentures (48,000)
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Dividends paid 115,000)
Net cash from financing activities 47,000
Net increase in cash and cash equivalents
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(` 2,30,000 - ` 1,55,000 + 47,000) 1,22,000
Cash and cash equivalents at the beginning of the year 35,000
Cash and cash equivalents at the end of the year 1,57,000
Working Notes:
Property Account
M
Particulars ` Particulars `
To Balance b/d 2,00,000 By Balance c/d 2,50,000
To Bank (purchases)
(balancing figure) 50,000
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250,000 2,50,000
Plant & Machinery Account
To Balance b/d 4,00,000 By Bank (plant sold) 10,000
To Bank (purchases) 1,00,000 By Accumulated 30,000
depreciation
(balancing figure) (on plant sold)
By Loss on plant sold 10,000
By Balance c/d 4,50,000
5,00,000 5,00,000
Accumulated Depreciation Account
To Plant & machinery A/c 30,000 By Balance b/d 1,40,000

(on plant sold) By Dep. for the year 40,000
To Balance c/d 1,50,000 (balancing figure)
1,80,000 1,80,000
Loans to Subsidiary Account
To Bank (balancing figure) 15,000 By Balance c/d (closing) 15,000
15,000 15,000
Equity Share Capital Account
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To Balance c/d 4,00,000 By Balance b/d 3,00,000
By Bank (balancing figure) 1,00,000
4,00,000
IM 4,00,000
Share Premium Account
To Balance c/d 10,000 By Bank (balancing 10,000
figure)
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10,000 10,000
Debentures Account
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To Bank (balancing 48,000 By Balance b/d 1,50,000

figure)
To Profit on redemption 2,000
A/c
To Balance c/d 1,00,000
1,50,000 1,50,000
Profit on Redemption Account
To Balance c/d 2,000 By 6% Debentures A/c 2,000
2,000 2,000
Provision for Taxation
To Bank (tax paid) 60,000 By Balance b/d 50,000

To Balance c/d 1.00,000 By Transfer from P & 1,10,000
L A/c
1,60,000 1,60,000
Proposed Dividend
To Bank (dividends paid) 15,000 By Balance b/d 15,000
To Balance c/d 20.000 By Transfer from P & L 20,000
A/c
35,000 35,000
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S 11.8 SUMMARY
IM
financial reports. It records the amount of cash and cash equiva-
lents entering and leaving an organisation in a given time period.
Thus, it is a statement which shows a change in cash balances
during a specified period.
The cash flow statement enables investors to comprehend how an
organisation is performing in terms of its operations, the source of
M

A cash flow statement when combined with other financial state-
ments provides information that allows investors to evaluate
changes in net assets of an organisation, its financial structure, its
liquidity and solvency conditions and the organisation’s ability to
N
affect the amounts and timing of cash flows.

Cash flow details help in assessing the ability of the organisation to
generate cash and cash equivalents to enable users in comparing
the present value of the future cash flows of different organisa-
tions.
A cash flow statement provides with the information about histor-
ical changes in cash and cash equivalents of an organisation by
classifying cash flows in a period owing to different activities.
A financial statement that shows entire data is a cash flow state-
ment. include all cash outflows that cover the cost of trade activ-
ities and finances throughout the course of a given time as well
as cash inflows that a business receives from its ongoing progress
and outside sources of funding.
Every organisation uses a cash flow statement to have insight into
changes in the cash and cash equivalents. Although these state-
ments are pertaining to cash flows, these also help in assessing
balance sheet and income changes.

Operating activities are the primary/main activities of an organisa-

tion during an accounting period.
Cash flow from all investing activities includes the movement in
cash flows which is then owing to the purchase and sale of assets.
Financing activities are related to long-term funds or capital of
an organisation. These activities result in changes in the size and
composition of the owners’ capital and borrowings of the organi-
sation.
The primary objective of a cash flow statement is to supply the
necessary related to the generation of cash to all users of financial
statements. It also highlights the future or the prospective cash
positions i.e., cash or cash equivalent. In other words, it can be
said that a cash flow statement depicts an organisation’s liquid-
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ity position or its ability to meet current expenses using available
resources.
The Cash Flow Statement (CFS) is a financial statement that
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details the inflow and outflow of Cash and Cash Equivalents (CCE)
into and out of a business. The CFS gauges how well a business
manages its cash position, or how successfully it produces cash to
cover its debt payments and finance its operational costs.
Cash flow is estimated using the indirect approach by changing net
income by adding or removing differences from non-cash transac-
M
tions. Non-cash items appear on the balance sheet as changes in

assets and liabilities from one period to the next.
KEY WORDS
Cash flow statement: A financial statement that provides aggre-

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gate data regarding all cash inflows a company receives from its
on-going operations
Financing activities: Activities relating to the net flows of cash
that are used to fund a company
Investing activities: Activities that show the cash generated or
spent relating to investment activities
Operating activities: Activities that indicate the amount of
money a company brings in from its on-going, regular b usiness
activities

MCQ
1. Which of the following is not an objective of cash flow statement?
a. To provide the details about the sources of cash
b. To guide the management to take a decision about short-term
obligations

c. To provide information on current costs

d. To provide a base for the preparation of cash budgets
2. Which of the following are operating activities?
a. Procurement of raw materials
b. Sale of garments
c. Incurrence of manufacturing expenses
d. All of these
3. Which of the flowing is not an investing activity?
a. Cash receipt from the disposal of fixed assets
b. Cash proceeds from all issuing shares
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c. Cash advances
d. Dividend received from the investments
4. Cash repayment of amounts borrowed is a type of:
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a. Operating activity
b. Investing activity
c. Financing activity
d. None of these
5. __________ can be associated with all raising cash and paying
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back debts to all the investors and creditors.

a. Cash flows
b. Operating activities
c. Repayments
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d. Receipts
6. Calculating cash flow from each operating activity is the ________
step in the preparation of a cash flow statement.
a. first
b. second
c. third
d. fourth
7. Which is the last step in the preparation of a cash flow statement?
a. Determining the ending balance
b. Calculating cash flow from financing activities
c. Calculating cash flow from investing activities
d. Calculating cash flow from operating activities

8. The third section of the cash flow statement covers cash inflows
and outflows related to
a. Operating activities
b. Financing activities
c. Investing activities
d. None of these
9. Which of the following are not considered under the direct
method?
a. Depreciation
b. Discount on shares
c. Interest received
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d. All of these
10. Since a cash flow statement is prepared on the basis of
_____________, thus it does not help to know the future/projected
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cash flows.
a. historical costs
b. direct costs
c. indirect costs
d. current costs
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?
1. What do you mean by a cash flow statement?
2. What are the objectives of cash flow statement?
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3. Write a short note on cash flow from operating activities.

4. Discuss the methods for preparing cash flow statement.
5. Explain the limitations of a cash flow statement.

11.11
(HOTS) QUESTIONS
1. The following are the details of PVC Ltd. for the year ended
March 31, 2020:
Net income = `5,00,000
Depreciation = `2,00,000
Profit = `50,000 on assets sold (which was transferred to
Statement of Profit and Loss account)
Trade receivables (increased during the year) = `40,000
Trade payables increased by `60,000

What will be the amount of cash flow from operating activities by

the indirect approach?
a. `5,60,000
b. `6,70,000
c. `2,70,000
d. `3,70,000
2. ABC Ltd. has given you the following information:
Particular `
Machinery as on April 01, 2012 50,000
Machinery as on March 31, 2013 60,000
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Accumulated Depreciation on April 01, 2012 25,000
Accumulated Depreciation on March 31, 2013 15,000

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During the year, a machine costing `25,000 with accumulated
depreciation of `15,000 was sold for `13,000. What will be the
cash flow from investing activities on the basis of the above
information?
a. `22,000
b. `23,000
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c. `24,000
d. `25,000

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Topic Q. No. Answer

Introduction to Cash Flow 1. a. Cash flow from investing
Statement activities
2. d. All of these
Preparation of Cash Flow 3. a. Determine the starting

Statement balance of cash and cash
equivalents at the beginning
of the reporting period
Objectives of Cash Flow 4. d. All of these

Statement
Methods of Cash Flow 5. c. direct method

Statement

Topic Q. No. Answer

Limitations of Cash Flow 6. b. Fails to present net income
Statement
Q. No. Answer
1. c. To provide information on current costs
2. d. All of these
3. b. Cash proceeds from all issuing shares
4. c. Financing activity
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5. a. Cash flows
6. b. second
7. a. Determining the ending balance
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8. b. Financing activities
9. d. All of these
10. a. historical costs

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1. A cash flow statement is a mandatory record of an organisation’s

financial reports. It records the amount of cash and cash
equivalents entering and leaving an organisation in a given
time period. Refer to Section 11.2 Introduction to Cash Flow
Statement
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2. The primary objective of a cash flow statement is to supply

the necessary related to the generation of cash to all users of
financial statements. Refer to Section 11.2 Introduction to Cash
Flow Statement
3. Operating activities are the primary/main activities of an
organisation during an accounting period. Refer to Section 11.2
Introduction to Cash Flow Statement
4. Operating activities are the main source of revenues and
expenditures, thereby all the cash flow from the same needs
to be ascertained. Cash flow from operations can be calculated
using either the direct or indirect method. Refer to Section 11.4
Methods of Cash Flow Statement
5. As a cash flow statement is based on cash flows and records
the movement of cash. In this way, only cash transactions are
recorded and the accrual concept of accounting is ignored. Refer
to Section 11.5 Limitations of Cash Flow Statement


QUESTIONS
Q. No. Answer
1. b. `6,70,00
2. a. `22,000
SUGGESTED READINGS &

11.13
REFERENCES
SUGGESTED READINGS
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1991. Cash flow statements. London: International Accounting
Standards Committee.
Mason, P., 1961. “Cash flow” analysis and funds statement. New
York: American Institute of Certified Public Accountants.
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Paolone, F., n.d. Accounting, Cash Flow and Value Relevance.
E-REFERENCES
Investopedia. 2022. Understanding the Cash Flow Statement.
[online] Available at: <https://www.investopedia.com/investing/
what-is-a-cash-flow-statement/> [Accessed 23 June 2022].
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Corporate Finance Institute. 2022. Statement of Cash Flows.

[online] Available at: <https://corporatefinanceinstitute.com/
resources/knowledge/accounting/statement-of-cash-flows/>
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Essential Business Guides. 2022. What is a Cash Flow Statement?

| Example of Cash Flow Statement - Zoho Books. [online] Avail-
able at: <https://www.zoho.com/books/guides/what-is-a-cash-flow-
statement.html> [Accessed 23 June 2022].

C H
12 A P T E R
ECONOMIC VALUE ADDED (EVA) &

MARKET VALUE ADDED (MVA)
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CONTENTS
12.1 Introduction
12.2 EVA & MVA
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12.2.1 Objectives of EVA & MVA
12.2.2 Relevance of EVA & MVA
12.2.3 Practical Application of EVA in the Real World
Activity
12.3 Summary
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INTERPRETATION OF EVA AND MVA
In 1991, Stern Stewart & Co. revised and improved the compu-
Case Objective tation of Residual Income (RI) through a series of accounting
The interpretation of EVA and adjustments and the result was the trademarked variant of RI, the
MVA is highlighted in this EVA. McConville (1994), Jackson, Mauboussin and Wolf (1996),
caselet. Dierks and Patel (1997), Stewart (1998), Prober (2000), Ray (2001),
and Grant (2003) promoted the usefulness of EVA® as a financial
reporting tool and described it as a vital measure of total factor
productivity, one that reflects all the dimensions by which man-
agement can increase value. Stewart (1990) was the first to study
whether or not a relationship exists between EVA and MVA. For
the study, 18 U.S. companies were selected. The study concluded
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a strong correlation between EVA and MVA.
Kroll (1997) concluded that a successful business is one which

aims to generate the enough profits not only to cover the cost of
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debt but cost of equity too. Why equity shareholders should be
punished by not insuring them with their minimum expectation?
He suggested that the company which adopts economic value
added will show an exemplary improvement in its performance
as they set higher target for their managers. Many companies in
US have adopted economic value added and improved its perfor-
mance with the help of it. EVA has an added advantage of showing
true value of an enterprise, which in turn may help stakeholders
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in fetching the right value of the business.
Lehn and Makhija (1996) studied the effectiveness of both the

metric namely MVA and EVA as measures of performance. They
opined that the firms having greater focus primarily in their busi-
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ness activities had higher EVA and consequently higher MVA

than less focused counterparts.
Lehn & Makhija (1997) further investigated the degree of correla-

tion between different performance measures and stock market
returns. Their results indicated that EVA is the most highly cor-
related measure with stock returns than other traditional mea-
sures.
Bao and Bao (1998) investigated the usefulness of value added

and abnormal economic earnings of 166 US firms. The results
indicated that value added is a significant explanatory factor in
market returns, and its explanatory power is higher than that of
earnings.
Geyse & Hall (2004) and Russell (2005) found that there are sev-
eral methods to measure the performance of the company but the
best amongst these methods is economic value added which cre-

ECONOMIC VALUE ADDED (EVA) & MARKET VALUE ADDED (MVA) 271
ates its own space due to the performance value addition. Eco-
nomic value added calculates the true economic profit of the com-
pany with the help of net operating profit after tax and cost of
capital. If the profit is more than the cost of capital it means that
the company is creating the wealth for the shareholder.
Panigrahi (2005) undertook a case study of ITC Ltd. which has

adopted EVA as its performance measure. The study found that
by increasing EVA there was creation of shareholders’ wealth.
Thus, the study established the fact that EVA, as a measure of
performance, is superior to MVA.
Fountaine et al (2008) compared EVA and MVA using a portfolio

separation test and the results revealed the significant difference
S
between the highest and lowest performers. The portfolio separa-
tion test was further used to compare the best (highest) and worst
(lowest) EVA performers from each of the years between 1995 and
2004. The researchers concluded that EVA has explanatory power
IM
on relative shareholder wealth creation across both bull and bear
market environments.
Ramana Reddy (2012) studied the financial performance of

selected Indian cement companies in India and ranked them on
the basis of their mean EVA and MVA for the period from 2001-
02 to 2010-11. The study clearly proved that based on these two
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metrics viz. EVA and MVA, ACC Ltd, and Grasim Cements Ltd
etc. have performed satisfactorily with consistent returns to the
shareholders. The two measures are having relative importance
to assess the performance of a company.
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LEARNING OBJECTIVES

>> Explain the concept of EVA
>> Define the MVA
>> Describe the objectives of MVA and EVA
>> Discuss the MVA and EVA
12.1 INTRODUCTION
Quick Revision
In the previous chapter, you have studied about cash flow statement.
S
financial reports. It records the amount of cash and cash equivalents
entering and leaving an organisation in a given time period. Thus, it is
a statement which shows a change in cash balances during a specified
period. The cash flow statement enables investors to comprehend how
IM
an organisation is performing in terms of its operations, the source of
Economic value added (EVA) & market value added (MVA) are the
common ways an investor can use to assess a company’s value. EVA is
useful as a way to then measure a company’s economic success over a
specific period of time. On the other hand, MVA is useful as a wealth
measure, and assesses the whole level of value that a company has to
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build up over a given period of time.
The first thing to bear in mind is that lenders and investors utilise
several methods to determine a company’s worth. For individuals
seeking to invest in a certain company, it is very crucial. Additionally,
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valuations are used to assess a company’s credit risk.
Investors use two main techniques to determine the value of a com-

pany, namely:
1. ECONOMIC VALUE ADDED (EVA)
Economic Value Added (EVA), a concept developed by Stern Stew-

art & Co., quantifies the actual profits made by an organisation. In
essence, it’s utilised to assess how lucrative a company has gotten over
a specific time frame.
However, EVA is calculated by deducting the company’s net profit

after taxes from the sum of its starting capital and the percentage cost
of capital. Let’s have a look at the following example to demonstrate
the point:
In 2018, Company ABC achieved net earnings of `200,000 after taxes.

At an average cost of capital of 8.5 percent, the business invested
`2 million in capital.

To figure out ABC’s EVA:
`200,000 – (`2,000,000 × 8.5%) = `30,000
The `30,000 figure implies that Company ABC generated enough prof-
its to cover its initial cost of conducting business.
2. MARKET VALUE ADDED (MVA)
The difference between the company’s present market value and the
initial investments made by its investors, on the other hand, is known
as market value added.
MVA is not a performance measure, unlike what many people believe.

It is a wealth measurement metric instead. In essence, it is utilised to
S
calculate the precise amount of value that the company has gathered
through time.
When a business has been functioning successfully, its earnings have

IM
been kept in-house. Investors raise the price of their shares in expec-
tation of future earnings as a result of the earnings increasing the
book value of the company’s stocks. The entire procedure increases
the company’s market worth.
In this chapter, you will study the EVA & MVA, objectives of EVA &
MVA, relevance of EVA & MVA, practical application of EVA in the
M
real world etc. in detail.
12.2 EVA & MVA

The incremental difference in a company’s rate of return (RoR) over
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its cost of capital is known as EVA. It is used to determine the value

that a firm creates from monies invested in it. If a company’s EVA is
negative, it signifies that the cash invested in the firm are not produc-
ing value. A positive EVA, on the other hand, indicates that a firm is
generating value from the cash it has received.
The formula for calculating EVA is:

EVA = NOPAT – (Invested Capital × WACC)
Where:
NOPAT = Net Operating Profit After Taxes
Invested capital = Debt + Capital Leases + Shareholders’ Equity
WACC = Weighted Average Cost of Capital
MVA is the first-place investors turn when they want to assess how a
firm performs for its shareholders. The MVA of a firm is a measure of
its ability to generate shareholder value over time. Effective manage-
ment and good operational skills are shown by a high MVA. A low MVA

indicates that the value of management’s activities and investments is

less than the value of shareholder capital. A negative MVA indicates
that the value of capital invested by shareholders has been lowered
and reversed as a result of management’s activities and investments.
The formula for calculating MVA is:
MVA = Market Value of Shares – Book Value of Shareholders’ Equity
Example 1:
In 2020, Company XYZ had a net profit of `4,50,000 after taxes. The
corporation put `4 million into the project, with an average cost of
capital of 10 percent. To figure out ABC’s EVA, do the following:
Solution:
S
Economic Value Added (EVA)
= Net Profit – (Initial Investment × Average Cost of Capital)
IM
= `4,50,000 – (`4,00,00,00 × 10%)
= `4,50,000 – `4,00,000
= `50,000
Example 2:
Calculate the EVA. After taxes, Company XYZ made a net profit of
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`5,50,000 in 2010. The company invested `8 million in the project, with

a 5.5% average cost of capital.
Solution:
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= `5,50,000 – (`8,00,00,00 × 5.5%)
= `5,50,000 – `4,40,000
= `1,10,000
Example 3:
Determine the EVA. Company Ram achieved a net profit of `6,0,000

after taxes. With a 6 percent average cost of capital, the business spent
`7 million in the project.
Solution:
= `6,00,000 – (`6,00,00,00 × 6%)

= `6,00,000 – `3,60,000
= `2,40,000
Example 4:
Take the case of Company ABC, which has `85,00,00 in shareholder

ownership. The corporation has a total of 11,00,00 ordinary shares
and 6,000 preferred shares in circulation. The regular shares are now
worth `13.50 per share, whereas the preferred shares are at `110 per
share. Calculate the market value added (MVA).
Solution:
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Total Market Value of Shares – Market Value of Common
=
Shares + Market Value of Preferred Shares
= ` 2,14,50,00 – ` 1,48,50,00 + ` 66,00,00
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= `1,32,00,00
Working Notes:
a. Market Value of Common Shares:
= Number of Ordinary Common Shares × Cost Per Share
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= 11,00,00 × `13.50
= `1,48,50,00
b. Market Value of Preferred Shares
= Number of Preferred Shares × Cost Per Share
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= 6,000 × `110
= `66,00,00
c. Total Market Value of Shares:
= Market Value of Common Shares + Market Value of Preferred
Shares
= `1,48,50,00 + `66,00,00
= `2,14,50,00
Example 5:
Consider the situation of Company XYZ, which has a shareholder

ownership of `90,00,00. There are 12,00,00 ordinary shares and 8,000
preference shares in circulation for the company. The standard shares
now have a value of `15.00 per share, while the preferred shares have a
value of `150 per share. Calculate the additional market value (MVA).

Solution:

= Total Market Value of Shares – Market Value of common
Shares + Market Value of Preferred Shares
= ` 3,00,00,00 – ` 1,80,00,00 + ` 1,20,00,00
= `2,40,00,00
Working Notes:
a. Market Value of Common Shares:
= Number of Ordinary Common Shares × Cost Per Share
= 12,00,00 × `15.00
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= `1,80,00,00
b. Market Value of Preferred Shares:
= Number of Preferred Shares × Cost Per Share
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= 8,000 × `150
= `1,20,00,00
c. Total Market Value of Shares:
= Market Value of Common Shares + Market Value of Preferred
Shares
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= `1,80,00,00 + `1,20,00,00
= `3,00,00,00
12.2.1 MEANING OF EVA & MVA

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EVA is a performance measure that was introduced by Stern Stew-

art & Co. (now known as Stern Value Management). This measure
attempts to estimate the true economic profit produced by a company.
It is frequently also referred to as “economic profit,” and provides
a measurement of a company’s economic success (or failure) over a
period of time. EVA helps investors to determine how well a company
has produced value for its investors, which can be compared against
the company’s peers for a quick analysis of how well the company is
operating in its industry. Economic profit can be further calculated by
taking a company’s net after-tax operating profit and subtracting from
the whole product of the company’s invested capital multiplied by its
percentage cost of capital.
MVA, on the other hand, is the difference between the current total
market value of a company and the capital contributed by all inves-
tors. It is typically used for all the companies that are larger and pub-
licly-traded. MVA is not a performance metric such as EVA but it is
instead is a wealth metric, which is measuring the level of value a com-
pany has been accumulated over time.

As a company performs well over time, it will retain earnings. This

will improve the book value of the company’s shares, and investors
will likely bid up to the prices of those shares in expectation of future
earnings, causing the company’s market value to rise. As this occurs,
the difference between the company’s market value and the capital
contributed by investors (it’s MVA) represents the excess price tag the
market assigns to the company as a result of its past operating suc-
cesses. Unlike EVA, MVA is a simple metric of the operational capa-
bility of a business and, as such, does not incorporate the opportunity
cost of alternative investments.
12.2.2 OBJECTIVES OF EVA & MVA
EVA
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The goal of EVA is to quantify the cost for investing the capital into a
certain project and assessing whether it is actually generating enough
cash to be considered as a good investment. All the charge represents
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the minimum return that an investor requires to make their invest-
ment worthwhile. A positive EVA shows that a project is actually
generating returns in excess of the required minimum return. The
concept of all Economic Value Added (EVA) is gaining popularity glob-
ally by corporates as a tool to measure financial performance. On the
other hand, MVA is a wealth metric of the capital that shareholders
have invested in excess of all of the current value of the company. To
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put simply, it can determine whether a business has increased or even

decreased in value since its inception.
The following are the other objectives of EVA:

EVA is a technique that aids in concentrating managers’ attention
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on how their actions affect the wealth of shareholders.

EVA is a useful tool for investors since it allows them to assess if
a certain business is worthwhile from an investment standpoint.
EVA may be a starting point for valuing shares and goodwill.
In a decentralised business, EVA functions well as a controlling
mechanism. The management may use EVA to determine the EVA
contribution of each decentralised unit or business division.
It is possible to establish EVA-linked compensation plans for man-
agers and employees with the goal of preserving or even enhanc-
ing shareholders’ value.
MVA
MVA is computed by first finding of the total market value of the com-
pany’s shares. The total stockholder’s equity or initial capital is then
subtracted from the resulting sum. A higher MVA is actually preferred
because it indicates that the company is generating enough money to
cover the cost of capital.

The following are the objectives of MVA:

Increases the appeal of firms to prospective investors: Because
it demonstrates the company’s capacity to generate money for
its stakeholders, investors will always choose firms with greater
MVA. In other words, a high MVA indicates that the company is
successful and in good health, which indicates a high likelihood
of future big returns. Consequently, a company with a high MVA
seems to be a secure alternative for investors who are not inter-
ested in high-return investments.
Increases a company’s chances of surviving: Nothing in the busi-
ness world can be guaranteed. A business may be generating bil-
lions of dollars in profits one second before filing for bankruptcy
the next. However, a company’s chance of success is unquestion-
ably strong if it has a high MVA. A high MVA indicates that the
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business is making enough money to keep attracting investors. It
follows that it will keep growing its business, making more money,
and edging off rivals.
IM
12.2.3 RELEVANCE OF EVA & MVA
There are many differences between MVA & EVA, but both share a
relation as well. One way to actually calculate EVA is to get the net
present value of all the current & future cash flows of a company. So,
then this means MVA is the same as Net Present Value (NPV), one
can actually get it by calculating the present values of all future EVAs.
M
This is also because discounted EVA & discounted FCF are mathe-
matically the same.
Since the market value of a firm actually depends on how all investors
expect a firm to perform in the future, so in a way all the market value
N
is sensitive to all the changes in the current EVA & expectations of all
regarding EVA improvement.
So, we can also represent the market value of the firm in any terms of
EVA as well.
Market Value = Capital plus Value of current EVA as perpetuity Plus

Present value of expected EVA Improvement.
12.2.4 PRACTICAL APPLICATION OF EVA IN THE REAL

WORLD
Economic Value Added (EVA) is actually a measure of all surplus value

created on a given investment. When a person is actually investing
his funds, he does this only because he then expects to earn a profit
from all investments. Let us say, gold seems to be a good instrument
to invest with a high-profit margin.
Total investment (i.e., price at which gold is purchased) = `75,000
Brokerage paid to the dealer for the purchase of gold = ` 1100

In a year, one wants to sell off the gold on an account of a liquidity

crunch.
The selling price of gold = ` 90,000
Brokerage paid to the dealer on sale of gold = ` 750
In the above Economic Value-Added example,

EVA = Selling price – Expenses associated with selling the asset –
Purchase price – Expenses associated with buying the asset
EVA = ` 90,000 – ` 750 – `75,000 – ` 1100 = ` 13150
If we just see the complete profit, then the profit on selling all the gold
was `1100 – ` 750, i.e., ` 350. But the actual creation of wealth is only
` 13150 on account of expenses incurred. This is a very crude example
S
of EVA.
THE IMPORTANCE OF ECONOMIC VALUE ADDED

IM
Economic Value Added (EVA) is significant since it is used to gauge
how lucrative firm initiatives are, reflecting managerial effectiveness
in the process. EVA is based on the principle that companies can only
be really successful when they generate value for their shareholders,
and there are other ways to assess this than just looking at net income.
According to the theory of economic value added, enterprises should
generate returns that are greater than their cost of capital. The cal-
M
culation of economic value has various benefits. It summarises the

amount and sources of money that a firm generated. It encourages
managers to consider assets in addition to costs when making choices
by include the balance sheet in the computation. However, determin-
ing economic worth might take some time due to the endless finan-
N
cial changes involved. Additionally, the metric can still be impacted

by accrual distortions, particularly when it comes to discrepancies in
depreciation and amortisation. Economic value added also only per-
tains to the time that was assessed; it cannot be used to forecast future
performance, particularly for businesses that are in the process of
restructuring or that are about to undertake substantial capital invest-
ments. Because the EVA calculation mainly relies on capital invested,
it is most appropriate for solid, asset-intensive businesses. Therefore,
vehicle manufacturers would benefit more from EVA than, say, soft-
ware developers or services firms with a large amount of intangible
assets.
Example 6:
Assume Company XYZ has the following EVA components:
Operating Income = `20,00,000
Tax Rate = 40%

Capital Investment = `15,00,000
WACC = .089 or 8.90%
Solution:
Calculation of EVA will be:
EVA
= NOPAT – (Capital Investment × WACC)
= `12,00,000 – (`15,00,000 × 8.90%)
= `12,00,000 – `1,33,500
S
= `10,66,500
Working Note:
NOPAT is:
IM
= Operating Income × (1 – Tax Rate)
= `20,00,000 × (1 – 0.40)
= `12,00,000
M
1. Which of the following is a performance measure that was

introduced by Stern Stewart & Co. (now known as Stern
Value Management)?
N
a. Economic value added (EVA)

b. Market value added (MVA)
c. Economic profit
d. All of these
2. The difference between the current total market value of a
company and the capital contributed by all investors is known
as
a. Economic profit
b. Economic value added (EVA)
c. Market value added (MVA)
d. None of these
3. In a _________ business, EVA functions well as a controlling
mechanism. The management may use EVA to determine

the EVA contribution of each decentralised unit or business

division.
a. decentralised b. centralized
c. Both a. and b. d. None of these
ACTIVITY
Find the limitations of EVA and MVA.
12.3 SUMMARY S
Economic Value Added (EVA) & Market Value Added (MVA) are
the common ways an investor can use to assess a company’s value.
S
EVA is useful as a way to then measure a company’s economic
success over a specific period of time.
MVA is useful as a wealth measure, and assesses the whole level of
IM
value that a company has to build up over a given period of time.
Economic Value Added (EVA), a concept developed by Stern Stew-
art & Co., quantifies the actual profits made by an organisation. In
essence, it is utilised to assess how lucrative a company has gotten
over a specific time frame.
The difference between the company’s present market value and
M
the initial investments made by its investors, on the other hand, is

known as market value added.
MVA is not a performance measure, unlike what many people
believe. It is a wealth measurement metric instead. In essence, it is
utilised to calculate the precise amount of value that the company
N
has gathered through time.

The incremental difference in a company’s Rate of Return (RoR)
over its cost of capital is known as EVA. It is used to determine the
value that a firm creates from monies invested in it.
MVA is the first-place investors turn when they want to assess how
a firm performs for its shareholders. The MVA of a firm is a mea-
sure of its ability to generate shareholder value over time. Effec-
tive management and good operational skills are shown by a high
MVA.
EVA is a performance measure that was introduced by Stern Stew-
art & Co. (now known as Stern Value Management). This measure
attempts to estimate the true economic profit produced by a com-
pany.
MVA is the difference between the current total market value of a
company and the capital contributed by all investors. It is typically
used for all the companies that are larger and publicly-traded.

The goal of EVA is to quantify the cost for investing the capital into
a certain project and assessing whether it is actually generating
enough cash to be considered as a good investment.
MVA is computed by first finding of the total market value of the
company’s shares. The total stockholder’s equity or initial capital
is then subtracted from the resulting sum. A higher MVA is actu-
ally preferred because it indicates that the company is generating
enough money to cover the cost of capital.
Economic Value Added (EVA) is actually a measure of all surplus
value created on a given investment. When a person is actually
investing his funds, he does this only because he then expects to
earn a profit from all investments.
Economic Value Added (EVA) is significant since it is used to gauge
S
how lucrative firm initiatives are, reflecting managerial effective-
ness in the process. EVA is based on the principle that companies
can only be really successful when they generate value for their
shareholders, and there are other ways to assess this than just
IM
looking at net income.
KEY WORDS
Economic Value Added (EVA): A way of evaluating a compa-

ny’s financial performance that uses residual wealth
M
Market Value Added (MVA): A formula that displays the dis-

crepancy between a company’s market value and the total cap-
ital invested by shareholders and bondholders
Rate of Return (ROR): The net gain or loss of an investment
over a specified time period
N
Shareholder capital: The sum of cash invested in a firm by its

owners, represented by common and/or preferred shares

MCQ
1. EVA helps investors to determine how well a company has
produced value for its _________ , which can be compared
against the company’s peers for a quick analysis of how well the
company is operating in its industry.
a. suppliers
b. investors
c. customers
d. both a. and b.
2. MVA will improve the _________ of the company’s shares,
and investors will likely bid up to the prices of those shares in

expectation of future earnings, causing the company’s market

value to rise.
a. book value
b. market value
c. net realisable value
d. historical value
3. All the charge under EVA represents the _________ that an
investor requires to make their investment worthwhile.
a. risk-free return
b. maximum return
c. minimum return
S
d. None of these
4. A higher MVA is actually preferred because it indicates that the
company is generating enough money to cover the _________.
IM
a. risk
b. market value
c. cost of capital
d. book value
M
5. One way to actually calculate EVA is to get the _________ of all

the current & future cash flows of a company.
a. net present value
b. present value
N
c. future value
d. All of these
6. The _________ of a firm actually depends on how all investors
expect a firm to perform in the future.
a. historical value
b. net realizable value
c. book value
d. market value
7. Economic Value Added (EVA) is actually a measure of _________
all created on a given investment.
a. Lower value
b. Surplus value
c. Both a. and b.
d. None of these

8. The incremental difference in a company’s _________ over its

cost of capital is known as EVA.
a. risk-free rate of return
b. market return
c. rate of return (ROR)
d. None of these
9. Identify the relationship between EVA & MVA.
a. Direct
b. Indirect
c. Both a. and b.
S
d. None of these
10. A high MVA indicates that the company is successful and in good
health, which indicates a high likelihood of future big returns.
Which of the following option is correct regarding the above
IM
statement?
a. Increases a company’s chances of surviving
b. Increases the appeal of firms to prospective investors
c. Decreases a company’s chances of surviving
d. All of these
M

?
1. Define EVA and MVA.
2. Explain the objectives of EVA & MVA.
N
3. Describe the relevance of EVA & MVA.

12.6
(HOTS) QUESTIONS
1. Ram has the company under which the first place investors turn
when they want to assess how a firm performs for its shareholders.
The firm is a measure of its ability to generate shareholder value
over time. Which of the following is the correct option regarding
the above statement?
a. EVA
b. MVA
c. Both a. and b.
d. None of these
2. As a company performs well over time, it will retain earnings.
This will improve which of the following regarding the company’s

shares, and investors will likely bid up to the prices of those

shares in expectation of future earnings, causing the company’s
market value to rise.
a. Book value b. Market value
c. Historical value d. All of these
Topic Q. No. Answer

EVA & MVA 1. a. Economic value added (EVA)
2. c. Market Vlue Added (MVA)
S
3. a. Decentralised

IM
Q. No. Answer
1. b. investors
2. a. book value
3. c. minimum return
4. c. cost of capital
M
5. a. net present value

6. d. market value
7. b. surplus value
8. c. rate of return (ROR)
9. b. Indirect
N
10. b. Increases the appeal of firms to prospective investors

1. EVA is a performance measure that was introduced by Stern
Stewart & Co. (now known as Stern Value Management). MVA,
on the other hand, is the difference between the current total
market value of a company and the capital contributed by all
investors. Refer to Section 12.2 EVA & MVA
2. The goal of EVA is to quantify the cost for investing the capital into
a certain project and assessing whether it is actually generating
enough cash to be considered as a good investment. Refer to
Section 12.2 EVA & MVA
3. There are many differences between MVA & EVA, but both
share a relation as well. One way to actually calculate EVA is to
get the net present value of all the current & future cash flows of
a company. Refer to Section 12.2 EVA & MVA


QUESTIONS
Q. No. Answer
1. b. MVA
2. a. Book value
SUGGESTED READINGS &

12.8
REFERENCES
SUGGESTED READINGS
Acar, E., 2001. Added value in financial institutions. London:
S
Financial Times/Prentice Hall.
Schabel, M., n.d. Investitionssteuerung, Periodenerfolgsrechnung
und Economic Value Added.
IM
Nowak, K., 2003. Marktorientierte Unternehmensbewertung.
Wiesbaden: Deutscher Universitats Verlag.
E-REFERENCES
Investopedia. 2022. Market Value Added (MVA). [online] Available
at: <https://www.investopedia.com/terms/m/mva.asp> [Accessed
23 June 2022].
M
Corporate Finance Institute. 2022. Market Value Added (MVA).

[online] Available at: <https://corporatefinanceinstitute.com/
resources/knowledge/valuation/market-value-added-mva/>
N
Borad, S., 2022. MVA vs EVA. [online] eFinanceManagement.

Available at: <https://efinancemanagement.com/investment-deci-
sions/mva-vs-eva> [Accessed 23 June 2022].
Ift.world. 2022. CFA Free 101 Concepts. [online] Available at:
<https://ift.world/concept1/level-ii-concept-56-residual-income-
economic-value-added-eva-and-market-value-added-mva/>

CASE STUDIES
10 TO 12
CONTENTS
Case Study 10 COVID and Companies Gross Profit

Case Study 11 Calculation of Cash Flows
Case Study 12 Calculation of MVA
S
IM
M
N

CASE STUDY 10
COVID AND COMPANIES GROSS PROFIT
After the COVID-19 outbreaks, several corporations have faced

Case Objective economic challenges. This pandemic scenario has bogged down
This case study highlights the some corporations’ production processes or maybe stopped the
economic challenges faced by full production as a result of the regulations from the got and
several corporations after the therefore the limitation of native community’s activities. As a
COVID-19 outbreaks. result, several corporations experienced a decrease in financial
gain. In Indonesia alone, its economy had fallen 5.32% within the
second quarter of 2020. However, some companies experienced
a rise in financial gain such as food and liquid corporations. This
study aimed to investigate the distinction within the financial
performance of Pt. Jaffa Com feed Indonesia before and through
S
the COVID-19 pandemic that is between the years 2019 to 2020.
This study targeted on profit ratios that embody come back on
assets, come back on endowed capital, come back on equity, gross
margin share, and ratio as a locality of the money performance of
IM
the corporate. The info was collected from the company’s assort-
ment of consolidated money statements on its web site. The anal-
ysis technique employed in this study is Paired Sample T-Test, to
grasp if there are vital variations within the ability of the corpo-
rate to get financial gain before and through the COVID-19 pan-
demic. This study concludes that there aren’t any vital variations
between the profits of Pt. Jaffa Com feed Indonesia before and
M
through COVID-19. Promoting corporations to look at the impact

of the pandemic and develop methods to scale back the money
burden it’s going to result’s required to keep up company’s profit.
Source: https://seajbel.com/wp-content/uploads/2021/06/SEAJBEL24_712.pdfQ1
N
QUESTIONS
1. How much economy had fallen in 2020?

(Hint: Several corporations experienced a decrease in
financial gain. In Indonesia alone, its economy had fallen
5.32% within the second quarter of 2020.)
2. Discuss the conclusion of this case study.
(Hint: This study concludes that there aren’t any vital
variations between the profits of Pt. Jaffa Com feed Indo-
nesia before and through COVID-19.)

Case study 11: Calculation of Cash Flows 289
CASE STUDY 11
CALCULATION OF CASH FLOWS
The following are the details of Dakshin Pvt. Ltd. at the end of the
year March 31, 2021: Case Objective
Profit = `1,00,000 This case study highlights

how to calculate cash flows.
Depreciation = `20,000 on assets
A transfer to general reserve = `30,000.
Goodwill amortised = `7,000
Gain on sale of machinery = `3,00
Other information
S
Trade receivables showed an increase of `3,000
Trade payables showed an increase of `6,000
Prepaid expenses showed an increase of `200
IM
Outstanding expenses showed a decrease of `2,000.
QUESTIONS
1. Ascertain cash flow from operating activities.

(Hint: ` 1,54,800)
M
2. What will be the net profit before taxation and extraordi-

nary items?
(Hint: `1,30,000)
N

CASE STUDY 12
CALCULATION OF MVA
The following are the details of XYZ Pvt. Ltd.

Case Objective
Shareholders’ equity = ` 7, 50,000
This case study highlights the
calculation of MVA. No. of preferred shares = 5,000
Common shares outstanding = 1,00,000
The present market value for the common shares is `1,000 per
share and `20,000 per share for the preferred shares.
QUESTIONS
1. Calculate market value of common shares.
S
(Hint: Multiply common shares outstanding by its market
value)
2. Calculate the total market value of shares.
IM
(Hint: Add market value of common shares and market
value of preferred shares).
M
N

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FINANCIAL STATEMENT ANALYSIS

Chief Academic Officer

Content Reviewer TOC Reviewer

Author: CA Sapna Jain

NMIMS Global Access - School for Continuing Education

CHAPTER NO. CHAPTER NAME PAGE NO.

Financial Statement Analysis – Introduction

2 Overview of Vertical Statement Analysis 21

3 Understanding of Annual Reports 37

Disclosure of Accounting Policies,

Introduction to IAS 10 – Events after

Case Studies 4 to 6 127

7 Segment Reporting 139

8 Horizontal Analysis 159

9 Overview of Ratio Analysis 181

Case Studies 7 to 9 215

10 Overview of Profitability Ratios 219

11 Cash Flow Statement 237

Economic Value Added (EVA) &

Case Studies 10 to 12 287

NMIMS Global Access - School for Continuing Education

Financial Statement Analysis – Introduction and Application: Introduction to Financial State-

Disclosure of Accounting Policies, and Deferred Taxes: Disclosures of Accounting Policies,

Principles for Disclosure, Non-compliance of Accounting Policies, Disclosures of Deferred Taxes,

Segment Reporting: Overview of Segment Reporting, Objectives of Segment Reporting, Appli-

NMIMS Global Access - School for Continuing Education

Horizontal Analysis: Overview of Horizontal Analysis, Meaning of Comparative Statements, Types of

Overview of Profitability Ratios: Introduction to Profitability Ratios, Meaning of Profitability Ratios,

NMIMS Global Access - School for Continuing Education

FINANCIAL STATEMENT ANALYSIS –

1.3.2 Forecasting of Future Net Income and Cash Flow

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COMPARATIVE INCOME STATEMENT OF ABC LTD.

A comparative income statement shows the operating results for

Comparative Income Statement format of ABC Ltd. for the period

Less: Selling, 25,000 30,000 5,000 20%

Add: Other Income 12,000 18,000 6,000 50%

Based on the above Comparative Income Statement of ABC Ltd.,

NMIMS Global Access - School for Continuing Education

After studying this chapter, you will be able to:

Financial statement analysis is the process of reviewing and analys-

advantages and limitations.

The financial statements are primarily aimed to calculate the profits of

Solution: The following trading account can be used to calculate the

Particular (`) Particular (`)

NMIMS Global Access - School for Continuing Education

Particular (`) Particular (`)

Hence, the gross profit is `7,70,000

describing the facts need to be analysed as per the requirements of

Financial statement analysis is the process of assessing the financial

statements of a company for decision-making purposes. To put simply,

NMIMS Global Access - School for Continuing Education

 To identify the reasons for change in the profitability/financial

1.2.1 TOOLS FOR FINANCIAL STATEMENT ANALYSIS

Financial statements are prepared to have complete information

Some of common tools for analysing financial statements are explained

industry. Thus, common size statements are useful, both, in intra-firm

Example 2: Prepare a common size balance sheet of business ltd.,

Particulars 31-3-2021 31-3-2020

Share capital 18,00,000 18,00,000

Fixed assets 35,50,000 29,15,000

Current Assets 26,60,000 24,00,000

Non-Current Liabilities 25,45,000 19,50,000

To identify the reasons for change in the profitability/financial

The understanding of operational profits

1.3.1 EVALUATION OF THE PAST FINANCIAL

1.3.3 ASSESSMENT OF CREDIT QUALITY FOR DEBT

Operational efficiency: This pertains to a firm’s cost structure.

1.3.5 COMPARISON BY MAKING APPROPRIATE

After analysing financial statements, the existing position of an

EBITDA: The earnings before interest, taxes, depreciation, and