TYPES OF BUSINESS ORGANISATIONS

Sole Proprietorship
One owner
Unlimited liability
The firm has no separate status from a legal and
tax point of view

Partnership
Two or more owners
Unlimited liability
The firm has a separate status

Private Limited Company

Upto 50 owners
Limited liability
A distinct legal person
TYPES OF BUSINESS ORGANISATIONS

Public Limited Company

Many owners
Limited liability
Distinct legal person
Free transferability of shares

Potential for growth is immense because of

access to substantial funds
Investors enjoy liquidity because of free
transferability of securities.

PUBLIC LIMITED COMPANYS

Requirement of Funds
ATTRACTION

Working Capital

Capital Expenditure
Expansion/ Modernisation/Acquisition

FINANCIAL DECISIONS IN A FIRM

Capital Budgeting
How to take decision when alternative investment plans
Capital Structure
What would be the sources / composition of finance
Company should relay upon more equity finance or long-term loans and
debt issue?
What should be the ideal Debt-Equity Ratio ?
Working Capital Management
How to finance everyday expenditure of the company ?
Should the company go for more short-term bank loan or issue
commercial papers?
What would be the ideal portion of short-term loan and long-term loans ?

MANAGERS FUNCTION
Funding Decision:
Sources of finance
Equity capital or Promoters money
Bank finance or Capital Market finance
Assessment and Provision of Working capital
Allocation of Funds/ Resources:
Distribution between short-term and Long-term
requirements
For different competing projects
Distribution of Profit:
Decision on Dividend
Decision to transfer to Networth

IMPORTANT QUESTIONS

Managers, shareholders, creditors and other interested groups

seek answers to the following important questions about a
firm:

What is the financial position of the firm at a given point of time?

How has the firm performed financially over a given period of time?

What have been the sources and uses of cash over a period of time?

Answer: Balance Sheet and Profit & Loss A/c

QUESTIONS ASKED BY
OWNERS/MANAGERS

Was it a good year or bad year?

What was the volume of operations?

What was the margin available on sales

realization?

The answer

Profit and Loss Account

7

PROFIT AND LOSS ACCOUNT

While a Balance Sheet
Reports value of assets, liabilities and owners equity
at a particular point in time
And Reflects net change in owner(s) equity brought
about by operations

A Profit & Loss Account shows a company's

earnings and expenses over a given period of time

It exclusively summarizes revenue and expenses

of the period and shows the net difference i.e.,
profit or loss of the period
8

FIXED ASSETS AND

DEPRECIATION

The cost of a fixed asset, written off or matched

as expense against the revenues of different
periods during which the asset is used

It is the expired cost of an asset during an

accounting period
Illustration A crushing machine purchased for Rs
50,000 having a five-year life and no salvage value is
used in a business. During the life of the asset, it will
be able to earn revenue of Rs 100,000

METHODS OF DEPRECIATION
Depreciation
Methods

Accelerated
Approach

Uniform
Approach

Larger amounts are

expired during the initial
years of life of the assets

Expires the cost

uniformly over the
useful life of the assets

Principle of Conservatism

Popular as it is an easy
method to follow
10

DEPRECIATION: SOME CONCEPTS

Original cost

Salvage value

Cost incurred in making the asset available for use at

the first instance. This amount is specific and known on
the acquisition of the asset
Recovery (or sales value) of the asset at the end of its
useful life. Value needs to be estimated (mostly).

Useful life

Expected time period for which the asset is to provide

economic service or productive life. Estimated based on
experience/technical factors
11

DEPRECIATION: SOME CONCEPTS

Depreciable cost
Original Cost of asset Salvage Value
Book value
Original Cost Accumulated Depreciation

12

STRAIGHT LINE METHOD

Depreciable cost of the asset is proportionately

allocated as expense against the revenues during
each year of useful life of the asset

Illustration
A company acquires a machine at the beginning of
operations at Rs 10,000. It is expected that
machine will last 10 years and will have no
salvage value at the end of its useful life
13

DEPRECIATION @ 10% PER ANNUM: STRAIGHTLINE METHOD

Year

Cost

Annual
Depreciation

Accumulated
Depreciation

Remaining Book
Value

10000

10000

1000

1000

9000

10000

1000

2000

8000

10000

1000

3000

7000

10000

1000

4000

6000

10000

1000

5000

5000

10000

1000

6000

4000

10000

1000

7000

3000

10000

1000

8000

2000

10000

1000

9000

1000

10

10000

1000

10000

14

WRITTEN DOWN VALUE METHOD

Depreciation is taken as a certain rate applied to

the written down value of the asset as at the
beginning of each year

The amount of expiration of the cost of the asset

is higher during the initial years

15

WRITTEN DOWN VALUE METHOD:

@20% PER ANNUM
Year

Original
Cost

Annual
Depreciation

Accumulated
Depreciation

Remaining Book
Value

10000

10000

10000

2000

2000

8000

Since there
is no salvage 3600
value for
10000
1600

the asset 1280

at the end of its4880
useful
10000

6400
5120

life, the terminal year depreciation

10000
1024
5904
will be taken as Rs. 1,342 i.e., Rs.
10000
819
268 (the depreciation
for 6723
the
10000
655Rs 1074 (the7379
period) plus
terminal
value of the
10000
524asset).
7903

10000

419

8322

1678

10000

336

8658

1342

10

10000

268

8926

1074

4
5
6

4096
3277
2621
2097

16

PROFIT & LOSS A/C HORIZONTAL FORMAT

Tools India Ltd.
Profit & Loss Account For the year ended December 31, 2000
Schedule

Amount

Sales net

255

Other income

Total Revenue

260

Cost of goods sold

Gross profit

130
130

Operating expenses:
Personnel

49

Depreciation

11

Other expenses

28

Operating profit

42

Interest

Profit

before

taxes

Income tax provision

Net

profit

12
30
12

after

tax

18

BALANCE SHEET
I.

Sources of Funds
(1) Shareholders funds:
(a) Capital
(b) Reserves and Surplus
(2) Loan funds:
(a) Secured loans
(b) Unsecured loans

II. Application of funds

(1) Fixed assets
(2) Investments
(3) Current assets, loans and advances
Less: Current liabilities and provisions:
Net current assets
(4) Miscellaneous expenditures and losses

PROFIT & LOSS A/C ITEMS

Gross Profit
Reflects the direct input costs
To a great extent variable with the volume of
operations
Operating Expenses
All those costs of making the inventory available
for sale
Are directly or indirectly traceable to the inventory
to be sold
Usually segregated under two groups selling
19
expenses & administrative expenses

PROFIT & LOSS A/C ITEMS

Operating Profit
Measure of operational efficiency
Obtained by deducting personnel, depreciation and
other expenses from gross profit
Usually referred to as OPBIT or EBIT
Interest Expense
Arises out of managements decision to finance part
of the assets from borrowings
The level of interest expense presents the amount of
risk the company is carrying in terms of fixed
20
commitments

PROFIT & LOSS A/C ITEMS

Net Profit before Tax

The surplus after meeting all expenses including interest
The profit available as a result of both operating and financing
performance
Income Taxes
Determined by profit before tax
Tax payable is determined by tax laws
Net profit or Profit after Tax
It is the net amount of surplus earned by the company
The amount ultimately available for appropriation
Can be either distributed as dividends or retained
21

EXPLANATIONS TO ITEMS

Gross Sales (or Gross Turnover): The aggregate

amount for which product sales are effected (or services
rendered) by an enterprise (inclusive of taxes paid)

Net Sales (or Net Turnover): The sales after deduction

of sales returns & allowances, sales discounts, etc.

Operating Income: The net income arising from the

normal operations and activities of an enterprise without
taking into account extraneous transactions and
expenses of a purely financial nature
22

EXPLANATIONS TO ITEMS

Gross Profit (or Gross Margin or Gross Loss):

The excess of the proceeds of goods sold and
services, rendered during a period over their cost,
before taking into account administration, selling,
distribution and financing expenses

Net Income (or Net Profit or Net Loss): The

excess of revenue during a particular accounting
period
23

DIVIDENDS & RETAINED EARNINGS

Dividends
An appropriation of profits among owners not an
expense
Technically the withdrawals by owners of the business
In Joint Stock Companies, it is subject to Company Law

Retained Earnings
After subtracting dividends declared from the net profit,
any surplus remaining is added to (accumulated)
retained earnings. Also referred to as reserves and
surplus
Sometimes designated to signify retention of earnings
for different future purposes such as redemption of debt
(redemption reserve), replacement of assets etc.

24

USING FINANCIAL RATIOS

Company performance is usually analyzed

on two parameters
Profitability
Liquidity

25

PROFITABILITY RATIOS
Gross

Margin
on sales

Profit

Margin

Operating Profit Margin

Earnings Before Interest & Tax
Profit before tax
Net Profit Margin (i.e., Profit after tax)

Return on
Investment

Operating Profit to Operating Assets

Net Income to Total Assets
Return on Equity
Total

Asset

Turnover
26

Efficiency
Operating Asset Turnover

SOLVENCY RATIOS
Net

Short-term

Working

Capital

Current Ratio
Quick Ratio
Accounts Receivable Turnover
Collection Period
Inventory Turnover
Conversion Period

Total

Long-term

Debt

to

Total

Long Term Debt to Total Capital

Long Term Debt to Fixed Assets
Interest Cover

Capital
27

PBT, PAT, AND RETAINED

EARNINGS

Profit Before Tax

It is the surplus amount obtained after meeting interest expense

Influenced to a great extent by the financing decisions

Profit After Tax (a.k.a. Net Income)

Overall surplus available out of sales to shareholders

This is influenced by three major factors namely, operating

efficiency, financing efficiency and taxation

As a percentage of sales it is known as Net Profit Margin and is

used to compare margins of players in the same industry

Retained Earnings (a.k.a Retained Profit)

Amount of profit remaining after the distribution of dividends

28

RETURN ON INVESTMENT

Profitability has to be judged on the basis of the amount of resource used

in obtaining the profit

The management has to be evaluated on the basis on to how far they had
been successful in profitably utilizing the assets

The assets used is to be related to the profit earned

Return on Operating Assets (ROA)

Operating profit to operating assets is obtained by dividing the

operating profit by average value of operating assets used during the year

Operating assets refer to total current assets and fixed assets used
29

ROTA
AND ROE

Return on Total Assets (ROTA)

The rate of profit the company is able to earn after meeting the cost of
financing of a portion of the total assets

It is the amount available to the shareholders in relation to the total amount

of resources used in the business

Here again the average total assets is used (Why?)

Return on Equity (ROE)

Net income is the amount available to owners for compensating their

investment and the risk being carried by them

ROE measures the net income as a percentage of shareholders investment

30

Performance Measurement
Financial Ratios
Comparative Analysis

FINANCIAL RATIOS
Liquidity Ratios
Leverage Ratios
Turnover Ratios
Profitability Ratios
Valuation Ratios

HORIZON LIMITED: PROFIT & LOSS

ACCOUNT FOR THE YEAR ENDING 31ST
MARCH 20X1
(Rs.in crore)
20X0
Net sales
62.3
Cost47.5
of goods sold
Stocks
37.0
Wages
5.5 and salaries
expenses
6.3 Other manufacturing
5.0
Gross
14.8 profit
Operating
4.9 expenses
2.6 Depreciation
General
1.1administration
Selling
1.2
Operating
profit
9.9
Non-operating
surplus/deficit
0.6
Profit before
10.5 interest and tax
Interest
2.2
Profit
8.3 before tax
Tax
4.1
Profit4.2
after tax

20X1
70.1
55.2
42.1
6.8
14.9
6.0
3.0
1.2
1.8
8.9

8.9
2.1
6.8
3.4
3.4

HORIZON LIMITED : BALANCE SHEET AS ON

31ST MARCH
20X1
(Rs.in million)
I.

Sources of Funds
(1)
Shareholders funds
25.60

(a) Share capital

15.00
15.00
(b) Reserves and surplus
10.60
(2)
Loan funds
15.60
(a) Secured loans
13.10

20X1

20X0
26.20
11.20

21.20
14.30

(b) Unsecured loans

2.50
Total
41.20

6.90
47.40

II. Application of Funds

(1)
Fixed assets
32.20
(2)
Investments
1.00

(3)
Current assets,
23.40
15.60loans and advances
(a) Cash & bank
0.60
(b) Debtors

33.00
1.00
1.00
11.40

LIQUIDITY RATIOS
Current Ratio
Current assets

23.4
=

Current liabilities

= 2.23
10.5

Acid-Test Ratio
Quick assets

12.9
=

liabilities

= 1.23
10.5

LEVERAGE RATIOS
Debt-equity Ratio (or Gearing Ratio)
Debt

21.2
=

Equity

= 0.809

26.2

Interest Coverage Ratio

PBIT

8.9
=

Interest

= 4.23
2.1

TURNOVER RATIOS
Inventory Turnover
Net sales
70.1
=
= 6.68
Inventory
10.5
Debtors Turnover
Net credit sales
=
Debtors

70.1
= 6.15
11.4

Average Collection Period

365
=
Debtors turnover
Fixed Assets Turnover
Net sales
=
Net fixed assets

365
= 53.3 days
6.15

70.1
= 2.12
33.0

Total Assets Turnover

Net sales 70.1
=
Total assets
47.4

= 1.48

PROFITABILITY RATIOS
Gross Profit Margin Ratio
Gross profit

14.9
=

Net sales

= 0.21 or 21 percent
70.1

Net Profit Margin Ratio

Net profit

3.4
=

Net sales

= 0.049 or 4.9 percent

70.1

RETURN PER SHARE

Interest of a shareholder lies in the amount of dividend that can be

earned on the investment in shares and the increase in the price of
shares that can be had by holding the same

Earnings per share (EPS) is computed by dividing net income to

ordinary shareholders by the number of ordinary shares outstanding

Earnings per Share (EPS)

20X4

20X3

Profit After Taxes (PAT) (Rs Million)

27

24

Number of ordinary shares (Million)

3.7

3.7

7.30

6.49

Earnings per Share (EPS) (Rs)

39

EARNINGS-PRICE RATIO (E/P)

The earnings per share related to the current market price of the share
provides a measure of the rate of yield

Earnings Price Ratio= EPS / MP per share

This yield measure could be used by the shareholder in making decisions

about this investment in comparison to other alternate investments
Earnings-Price Ratios (E/P)

Earnings per Share (EPS) (Rs)

Market price per share (Rs)
Earnings/Price Ratio (%)
Price Earnings Ratio

20X4

20X3

7.30

6.49

30

28

24.3

23.18

4.1

4.31

40

DIVIDEND PER SHARE

It is a common practice to express the E/P ratio by reversing the

relationship to measure the price-earnings (P/E) relationship

Here, this relationship expresses market price as a certain multiple

of the earnings per share

Dividend per share is another per share calculation, which shows

the cash income available to the shareholder of a share
Dividend per Share (DPS) (Rs)
Dividend (Rs Million)
Number of ordinary shares (Million)
Dividend per Share (Rs)

20X4

20X3
2

3.7

3.7

0.54

0.54
41

SOLVENCY

Ability to meet all the short-term commitments and ability

to keep sufficient assets to cover all the liabilities in the
long run
Companies can be liquid (solvent) but not profitable.
For example, imagine a cash rich construction company
with no orders
Companies can be profitable but not liquid.
For example, a construction company with lot of orders but
no cash to execute them
Hence, we need both profitability and solvency
Solvency can be of two types Short Term and Long Term
42

EVALUATING SHORT-TERM
SOLVENCY

Liquidity is of major concern to short-term creditors and management

Sale of merchandise (inventory turnover) and collection of receivable

generates liquidity (receivable turnover)

Assessing excess of current assets over current liabilities Working

Capital

Net working capital is financed by long-term sources of funds and as such

provides a cushion for liquidity

This is obvious since it is financed by long-term sources it is not required

to be repaid in the short-term
43

EQUITY MULTIPLIER

Equity Multiplier = Total Assets / Owners Equity

The equity multiplier will show the extent of enhancement

of return to equity holder due to leverage or borrowing

Tools & Tools Ltd.

Total Debt (Rs Million)

20X4

20X3

195

160

Shareholders Equity (Rs Million)

135

110

Total Assets

330

270

Equity multiplier (Total Assets/Owners Equity)

2.44

2.45

Return on Total Assets (%)

8.18

8.89

Return on Equity ( ROTA * Equity Multiplier)(%)

20

21.8
44

DU PONT ANALYSIS

A combination of margin on sales ratio, efficiency ratio, and

long-term solvency ratio is popularly known as the DuPont
analysis

Return on Equity (ROE) =

Net Profit Margin (defined as Net Profit/Sales) x Asset
Utilization Ratio (defined as Sales/Total Asset) x Equity
Multiplier Ratio (Total Assets/Owners Equity)

The DuPont analysis approach helps in identifying and

pinpointing the reasons behind high or low profitability of a
firm vis--vis its competitors
45