Dr.

Mohammed Anam Akhtar

Lecturer Accounting & Finance
Dr. Anam 1
 Definition
According to American Institute of Certified Public Accountants, “
Accounting is the art of recording, classifying & summarizing in a significant
manner and in terms of money, transactions and events which are, in part,
at least, of a financial character and interpreting the result thereof.”

The information system that measures business activities, processes that

information into reports and financial statements, and communicates the results to
decision makers.
Harrison and Horngren, 2006
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 Financial Accounting features
Basis of Difference Financial Accounting

1. Primary users External – Investors, creditors, government &

regulatory bodies

2. Purpose of information Help investors and creditors make investment decision

and regulatory bodies to charge taxes etc.

3. Focus and time dimension of the information Primary focus is on past like all the transactions of the
last year are taken into consideration

4. Rules and restrictions Required to follow IFRSs or GAAP as applicable

5. Scope of information Generally reports company as a whole on a quarterly

or annual basis

6. Behavioral Implications Concerns about behavioral implications is secondary in

financial accounting

Dr. Anam 3
 Paytm debacle

• Paytm is backed by Chinese tycoon Jack Ma’s Ant Group, Japan’s SoftBank and Warren

Buffett’s Berkshire Hathaway, which together own around a third of the company.
• The Paytm IPO was the biggest stock listing India had ever seen – and also the biggest
trading flop in the country’s primary market history.
• Fintech Paytm’s initial public offering (IPO) had promised to turn investors’ dreams into
reality, but it ended up being a nightmare.
• It was listed at an IPO price of INR 2150/- & slumped 40 percent within the time period of a
week.
• Analysts say that Paytm’s valuation – at about 26 times its estimated price-to-sales ratio for
the financial year 2023 – was inflated and unrealistic, given that the fintech group had
projected that profitability would remain elusive
Dr. Anam for a long time. 4
RIL (Balance sheet 2018-19)

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RIL (Balance sheet 2019-20)

Dr. Anam 6
RIL (Balance sheet 2020-21)

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EPS

2017-18 2018-19 2019-20 2020-21

53.08 55.48 55.45 49.66

P/E 30.28

Beta 1.04

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Dr. Anam 9
 Financial Statement Analysis

Vertical Analysis
( Eg; Common
Size Statement,
Comparative
Statements)
Horizontal
RATIO
Analysis (Eg;
ANALYSIS
Trend Analysis)

Financial
Statement
Analysis

Dr. Anam 10
 Horizontal Analysis
• When we compare the financial figures of a company over a period of time it
is called horizontal analysis. In such analysis the financial statement data of
historical time frame is used for the purpose of analysis. The change in data
in the financial statement can be measured either in absolute terms (for eg,
AED wise change in sales figure over a period of past 5 years) or in terms of
percentage (for e.g., percentage wise change in the sales value over a period
of last 5 years).
• One of the commonly used technique for horizontal analysis is Trend
Analysis.

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 Trend Analysis
• In financial analysis the direction of change over a period of years is of crucial
importance. Trend Analysis indicates just the same that is the direction of
change. Thus, helping the management of the company to decide whether the
company is moving towards the desired goal or not.
• This kind of analysis is particularly more applicable in case of analysis of profit
and loss account or income statement.
• The company can use trend analysis to analysis its trend of sales or net income
thereby facilitating the organization to evaluate its competitive position.
• In trend analysis one year is taken as base year and all the values of different
years are compared with base year.

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RAK Cement Company
Trend Analysis

Particulars 2015 2016 2017

Sales 100 120.8 154.9
EBIT 100 143.6 184.8
PAT 100 132.8 161.0
Current Assets 100 162.2 216.0
Current Liabilities 100 160.1 221.7
Fixed Assets 100 128.8 141.0
Total Assets 100 146.4 185.3
Net Worth 100 114.0 131.6
Dividend 100 116.7 133.3

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 Vertical Analysis

• Unlike horizontal analysis in which each item of different years are

compared with a year which is chosen as base year, in vertical analysis
each item of income statement or balance sheet is compared with a
common base which may be past year or a component of the financial
statement itself (for eg, all the items of the income statement of a year are
compared with the value of sales & are mentioned as a percentage of
sales, or all the items of balance sheet are expressed as either percentage
of assets or percentage of liabilities).
• The statements prepared in such a manner are called either comparative
statements or another method can be common size statements.

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RAK Cement Company
Common size income statement
Particulars 2015 2016 2017
Net Sales 100.00 100.00 100.00
Less: Cost of goods 82.5 82.2 82.1
sold
Gross Profit 17.5 17.8 17.9
Less: Selling & 10.2 9.3 9.6
administrative
expenses
Operating Income 7.3 8.5 8.3
Add: other income 0.7 0.9 1.0
EBIT 8.0 9.4 9.3
Less: Interest 2.6 4.4 3.9
PBT 5.4 5.0 5.4
Less: Taxes 1.8 1.1 1.7
PAT 3.6 3.9 3.7

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 Ratio Analysis

It is a systematic tool of financial analysis. It is widely used in order to interpret the

financial statements so that the strengths & weaknesses of the firm as well as the
historical & current financial position be determined.

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 How to use Ratios
• We can compare the performance of the same firm over
several years.

• We can compare the performance of the firm with the

nearest competitor.

• We can compare the performance of the firm with the

industry.

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 Types of Ratios
Liquidity Ratios

Capital Structure Ratios

Activity Ratios

Profitability Ratios

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 Financial Statements
Profit & Loss A/c
For the year ending 31st December
2011 2012 2013
Ne t Sa l e s (A) 2338.9 2825.69 3717.23
Cos t of good s s ol d (B) 1929.04 2322.8 3053.66
Gros s Profi t (C=A-B) 409.86 502.89 663.57
Le s s Se l l i n g & a d m e xp (D) 239.72 262.1 357.87
Ope ra ti ng I ncome (E=C-D) 170.14 240.79 305.7
Add Oth e r I ncome (F) 15.24 25.38 36.91
EBI T ( G=E+F) 185.28 266.17 342.61
Le s s I n te re s t (H) 59.84 124.98 143.46
PBT (I =G-H) 125.54 141.19 199.15
Prov for Ta x (J) 41.79 30 64.29
PAT (K= I -J) 83.75 111.19 134.86
Eff e cti ve ta x ra te (L)** 33% 21% 32%
Di vi d e nd d i s tri b ute d (M) 33.75 39.38 45
Re ta i n e d e a rn i ngs (N) 50 71.81 89.86

Depreciation is charged along with tax

All figures in AED

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 Financial Statements
Statement of Cost of goods sold
For the year ending 31st March
2011 2012 2013
Raw Materials (A) 1587.34 2019.54 2751.52
Direct Labor (B) 138.13 170.86 228.94
Depreciation (C ) 23.07 38.64 41.59
Other mfg expenses (D) 205.34 255.72 329.44
Total (E=A+B+C+D) 1953.88 2484.76 3351.49
Add Opening stock in process (F) 57.09 85.74 150.55
Total (G= E+F) 2010.97 2570.5 3502.04
Less Closing stock in process (H) 85.74 150.55 230.83
Cost of Prodn (I = G-H) 1925.23 2419.95 3271.21
Add Opening stock of finished goods (J) 150.93 147.12 244.26
Total (K = I + J) 2076.16 2567.07 3515.47
Less Closing stock of fi nished goods (L) 147.12 244.26 461.81
Cost of goods sold (M = K -L) 1929.04 2322.81 3053.66
All figures in AED

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 S h a re C a p it a l (B ) 225 225 225

R e s e rv e (C ) 2 8 6 .13 3 5 7 .9 5 4 4 7 .8 1

Ne t Wo rt h (B + C) 5 11. 13 5 8 2 .9 5 6 7 2 .8 1

Lo n g t e rm d e b e n t u re s (E ) N IL 7 5 .7 5 7 6 .4 6

O t h e rs ( F ) 19 9 .8 7 2 8 5 .9 3 12 .7 3

Lo n g t e rm d e b t (G ) 19 9 .8 7 3 6 1.6 5 3 8 9 .19

S h o rt t e rm B a n k Lo a n (H ) 4 4 2 .9 2 6 4 1.3 9 8 3 9 .8 7

B o rro win g s (D = E + F + G + H ) 6 4 2 .7 9 10 0 3 . 0 4 12 2 9 . 0 6

C a p it a l E m p l o ye d (I =A +D ) 115 3 . 9 2 15 8 5 . 9 9 19 0 1. 8 7

G ro s s B lo c k o f F ixe d A s s e t s (K) 6 5 3 .4 9 8 4 1.6 4 9 2 1.5 5

Les s Deprecia ti on (L) 159.55 194.46 235.44

Ne t Bl ock ( M = K -L) 493.94 647.18 686.11
Othe r non curre nt a s s ets (N) 52.76 16.44 60.72
Ne t fixe d asse ts ( J ) 546.7 663.62 746.83
Ra w ma teria ls (1) 243.42 384.06 457.74
Stock in proce s s (2) 85.74 150.55 230.84
Fi nis he d goods (3) 147.12 244.28 461.61
Inve ntorie s (1+2+3) 476.28 778.89 1150 .39
De btors (4) 253.16 340.61 483.18
Ca s h & Ba nk (5) 8.37 98.84 26.08
Othe rs (6 ) 128.27 186.21 211.27
C u rre n t A s s e ts (N ) 8 6 6 .0 8 14 0 4 . 5 5 18 7 0 . 9 2

T ra d e C re d it o rs (1) 3 5 .9 9 2 11.2 1 3 3 9 .3 5

P ro v s io n & o t h e rs (2 ) 2 2 2 .8 7 2 7 0 .9 7 3 7 6 .5 3

C u rre n t Li a b i l i t i e s ( O) 2 5 8 .8 6 4 8 2 . 18 7 15 . 8 8

N e t C u rre n t A s s e t s ( P =C A - C L) 6 0 7 .2 2 9 2 2 .3 7 115 5 .0 4
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Ne t A s s e ts ( J + P ) 115 3 . 9 2 15 8 5 . 9 9 19 0 1. 8 7
 Liquidity Ratio

• This ratio is calculated in order to measure the ability of the

firm to pay it current liabilities out of the current assets.
Liquidity ratios can be further sub-divided as:

1. Current Ratio

2. Acid Test Ratio or Quick Ratio

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 Current Ratio
• Current Ratio is calculated in order to find the ability of a firm to dispose it’s short-term
liabilities out of short-term assets. A higher ratio would mean that a firm is very efficient to
pay it short-term liabilities but it may also indicate excess liquidity which can lead to loss of
profitability. Generally, in accounting terms a ratio of 2:1 is the ideal one.
• It is calculated by the following formula;
Current Ratio= Current Assets ÷ Current Liabilities
• In order to illustrate;
Liabilities Amount (2018) Amount (2017) Assets Amount (2018) Amount (2017)

Bills Payable 1,00,000 1,00,000 Inventory 3,00,000 1,50,000

• Therefore the Current Ratio will be applying formula;

• CR (2018)= 3,00,000/1,00,000
= 3:1
• Whereas for 2017, CR = 1.5: 1
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 Solution based on financial statements
Current Ratio for the year( 2013)
Since Current ratio = CA/CL
Therefore, CA = 1870.92
Current Liability = current liability + short term bank loan
= 715.88 + 839.87
= 1555.75

Therefore current ratio = 1870.92/1555.75

= 1.20 : 1

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 Acid Test Ratio or Quick Ratio

• This ratio again measures the liquidity position of the

organization but instead of taking into consideration all the
current assets it compares the short-term obligations with the
most liquid assets (called quick assets).
• Since this ratio checks the ability of the firm to convert it’s
most near cash items into cash it is also called Acid Test Ratio.
• Quick Ratio = Quick Assets ÷ Current Liabilites
• Quick Assets= Current Assets – (Stock + Prepaid Expenses)
• Ideally it should be 1:1

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 Acid Test Ratio or Quick Ratio
• Illustratation:
Cash 1000
Debtors 2000
Inventory 12000
Bills Payable 8000
Prepaid Expenses 1000

• Calculate Current & Quick Ratio?

• Current ratio = CA/CL
• CA = 16000
• CL = 8000
• Therefore CR= 2:1

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 Calculation of Acid Test ratio
• Acid Test ratio = Quick Assets/Current Liabilites
Since Quick Assets = CA – (Stock+ Prepaid Exp)
= 16000 – (12000+1000)
= 16000- 13000
= 3000
Therefore ,
Quick ratio = 3000/8000
= 0.375 : 1

Dr. Anam 27
 Solution based on financial statements
• Acid Test or Quick ratio (2013)
• Since Acid Test ratio = Quick Assets/ Current Liabilities
Quick Assets (2013) = CA – (Stock+ Prepaid Exp)
= 1870.92 – (1150.39)
= 720.53
Current Liability = current liability + short term bank loan
= 715.88 + 839.87
= 1555.75
Therefore Quick ratio = 720.53/1555.75
= 0.46:1

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 Capital Structure Ratios
• While the liquidity ratios are calculated for those who are
interested in knowing the short-term financial position of the
firm like the creditors and lender for short-term time duration.
• But every firm has certain long-term obligations also like
shares & bonds, such parties are not so much interested in
short-term position of the organization but they are more
interested in long-term financial capabilities of the firm.
• In order to provide information to long-term lenders the
capital structure ratios are used.
• The long-term creditors are more interested in the proportion
of debt and equity used in the capital structure.
• Some of the important capital structure ratios are:-

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 Debt to Capital Employed Ratio

• This ratio is calculated in order to calculate the proportion of debt in the total
capital used.
• It is used for analyzing the risk component of the organization as debt is
considered more risky than equity (shares).
• This ratio is calculated by dividing the value of total debt (TD) by Capital
Employed or Net Assets.
• Total debt will include short and long term loans from financial institutions,
bonds, debentures etc.
• Capital employed includes both debt & equity (shares).
• Therefore, Debt ratio = Total Debt(TD)/Capital Employed .
• Capital Employed = Net Assets.

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 Solution based on financial statements

• Debt ratio (2013) = Total Debt/ Capital Employed or Net Assets

• Total Debt = Long term debt + Short term debt
= 389.19 + 839.87
= 1229.06
Capital Employed = 1901.87

Therefore for 2013 Debt ratio= 1229.06/1901.87

= 0.65:1

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 Debt-Equity Ratio

• While debt to capital employed ratio establishes a relationship between total debt and
the overall capital employed by the organization the debt-equity ratio is calculated in
order to find the amount contributed by borrowers (lenders) per rupee contributed by
the owners (share holders)
• Debt-Equity ratio is calculated by using the following formula;
• Debt-Equity Ratio= Total Debt (TD)/ Net Worth

Dr. Anam 32
 Solution based on financial statements
• For the year 2013;
• Total Debt = 1229.06
• Net Worth = 672.81

Therefore,
• Debt-Equity Ratio= 1229.06÷ 672.81
= 1.83:1
• It also gives a similar result that the proportion of debt is high.

Dr. Anam 33
 Activity Ratios
• Activity ratios are calculated in order to measure the efficiency with which firm uses or
manages it’s resources or assets.
• They are also called turnover ratios because they indicate the speed with which the
assets are being converted or turned into sales.

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 Inventory Turnover Ratio
• This ratio talks about the efficiency of the firm in producing and selling it’s products. It is
calculated by dividing the cost of goods sold by average inventory.
• Inventory Turnover = Cost of goods sold ÷ Average Inventory

• Average Inventory = Opening + Closing balance of inventory

2
• Generally in manufacturing organization they use stock of finished goods as opening and
closing.
• Higher the Inventory Turnover the better it is for the organization as it means it is
converting it’s inventory into receivables very quickly.
• Through Inventory Turnover we can calculate days of inventory holdings by a simple
formula;
• Days of Inventory Holding = 360/Inventory Turnover Ratio
• The longer the inventory holding period the lesser the efficiency of the firm.

Dr. Anam 35
 Solution based on financial statements
• For year 2013;
• Cost of goods sold= 3053.66
• Average Inventory = 244.26 + 461.81
2
= 353.03
Therefore, Inventory Turnover Ratio= 3053.66/353.03
= 8.6 times

• Therefore, Days of Inventory Holding (DIH) = 360/8.6

= 42 days.

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Dr. Anam 37
 Debtors Turnover Ratio
• In every organization apart from cash sales credit sales also exists. This credit
sales leads to the creation of debtors. These debtors are expected to be converted
into cash within a year.
• Therefore, in other to calculate how effectively the debtors are being managed
we use ;
• Debtors Turnover Ratio= Credit sales / Average Debtors.
• If the information about credit sales & debtors balances is not given then total
sales and year end balance of debtors are used.
• Then the ratio can be written as;
• Debtors Turnover Ratio = Sales/Debtors
• This ratio is used to calculate Average Collection Period then;
• Average Collection Period (ACP) = 360/Debtors Turnover Ratio

Dr. Anam 38
 Solution based on financial statements

• For 2013;
• The value of Sales= 3717.23
• Debtors = 483.18
• Therefore, the DTR= 3717.23 ÷ 483.18
= 7.7 times

• On the basis of DTR we can calculate ACP = 360 ÷ 7.7

= 47 days

Dr. Anam 39
 Assets Turnover Ratio

• Assets are the resources of the organization and must be

used for the purpose of generating revenues for the
business. Therefore, Assets Turnover Ratio (ATR) is
calculated in order to establish a relationship between sales
and net assets in order to analyze how effectively the assets
are being utilized.
• Net Assets Turnover Ratio= Sales/ Net Assets

Dr. Anam 40
 Solution based on financial statements
• 2013;
• Sales = 3717.23
• Net Assets = 1901.87

• Therefore, Net Asset Turnover Ratio= 3717.23÷ 1901.87

= 1.95: 1

• This ratio indicates that for every 1 AED invested in Asset they are generating an
income of AED 1.95, thus the higher the ratio the better it is.

Dr. Anam 41
 Profitability Ratios

• The essence of any business activity is profit. Any business is started in

anticipation of profits only. If a business runs into profits it survives for a longer
duration of time. Therefore, it is absolutely vital for any business organization to
evaluate it’s performance through profitability ratios.

• Some of the important profitability ratios are:-

• Gross Profit Margin
• Net Profit Margin &;
• Return on Investment (ROI)

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 Gross Profit Margin

• On of the most initial step towards analyzing the performance of a firm in terms
of profitability is calculation of gross profit margin. It is calculated by establishing
a relationship between gross profit and sales.

• Thus, Gross Profit Margin= Gross Profit / Sales

• Where, Gross Profit= Sales – Cost of goods sold

Dr. Anam 43
 Solution based on financial statements
• 2013;
• Gross Profit= 663.57
• Sales = 3717.23

• Therefore, Gross Profit Margin = 663.57 ÷ 3717.23

= 0.179 or 17.9%

• It shows the efficiency with which the business manufactures product in order to
achieve a higher profitability.
• Thus, higher the ratio the better it is.

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 Net Profit Margin

• It is calculated when we adjust the operating expenses, interest and taxes in the
value of gross profit.
• It is calculated by using the following formula;

• Net Profit Margin = Profit After Tax (PAT) / Sales

• It is calculated in order to find whether the firm is having strict control over it’s
operating expenses or not.
• It shows the efficiency of the management to convert each rupee of sale in net
profit.
• Thus, once again the higher the ratio the better it is.

Dr. Anam 45
 Solution based on financial statements

• 2013;
• PAT= 134.86
• Sales = 3717.23

• Thus, Net Profit Margin= 134.86 ÷ 3717.23

= 3717.23
= 0.036 or 3.6 %

Dr. Anam 46
 Return on Investment (ROI)

• Return on Investment is calculated in order to find the profitability

generated by the assets. Therefore, it can be either ROI with
respect to total assets or ROI with respect to Net Assets. For our
ease we have calculated ROI with respect to Net Assets which can
also be called as Capital Employed.

• ROI = EBIT ÷ Net Assets

• The higher the ratio the better it is for the business because it will
mean that the assets are generating that much amount of profit.

Dr. Anam 47
 Solution based on financial statements

• 2013;
• EBIT = 342.61
• Net Assets = 1901.87

• Therefore, ROI = 342.61 / 1901.87

= 0.1801 or 18 %

Dr. Anam 48
 Return on Equity (ROE)
• The equity shareholders are also called as the residual owners of the
organization because they are paid at last after paying all the other
obligations like interest, dividend to preference shareholders etc. The
rate of dividend that is paid to the equity shareholders is also not fixed;
they may be paid by the company or their dividend may be retained.
Nevertheless, the Profit After Tax (PAT) represents their return. The ROE
is calculated in order to find the profitability of the investment made by
the shareholders. It is calculated by the following formula;

ROE= PAT÷ Net Worth

• Where Net Worth includes paid-up share capital, share premium and
reserves and surplus less accumulated losses.
• Net Worth can also be calculated by subtracting the amount of Total
Liabilities from Total Assets.

Dr. Anam 49
 Solution based on financial statements
• 2013;
• PAT= 134.86
• Net Worth = 672.81

• Therefore, ROE= 134.86 ÷ 672.81

= 0.2004 or 20% Ans.

Dr. Anam 50
 ROI
• Alternatively, the ROI can be calculated using the following formula;
• Operating Income / Average operating Assets = ROI

• Controllable margin is the excess of contribution over fixed cost.

• Suppose ,
Sales $2000,000
Variable cost $ 1100,000
Contribution $900,000
Fixed cost $300,000
Operating Income $ 600,000

• Now if the Average operating Assets are given as $45,00,000

• Then, ROI = 600,000/4500,000
= 13.3% Dr. Anam 51
 Residual Income (RI)
• Residual Income approach is yet another method of performance evaluation
adopted by the companies.
• It is the income that remains after subtracting from the controllable margin the
minimum rate of return required on the company’s operating assets.
• It is calculated using the following formula;
• Controllable margin – Minimum rate of return x Avg. operating assets = RI

• Suppose, Controllable margin = $260,000, Minimum return = 10% & Avg.

operating assets = $ 2000,000

• Therefore RI= 260,000 – 10% x 2000,000

= $60,000/-

Dr. Anam 52
 Try it yourself
Q1. You are given the following information with respect to DVD & e-learning divisions of Smart Touch
online solution Limited:

Smart Touch e-Learning DVD

Operating Income $ 450,000 $ 975,800
Average Total Assets $ 2500,000 $ 6500,000
Sales $ 7500,000 $ 243,600
The target rate of return is 16%. Calculate the financial performances of DVD & e-Learning division
using Residual Income (RI) & Return on Investment (ROI) approach.

Dr. Anam 53
 One More
Swift company has three divisions & expects each division to earn a 16 % target rate of return. The
company has the following results last year:
Division Profit margin ratio Asset turnover ratio ROI
1 7.2% 2.737 19.7%
2 11.7% 1.584 18.5%
Division 3 reported the following data;
Operating Income $ 1,450,000
Average total assets 16,100,000
Net sales 26,500,000

a. You are required to calculate ROI & RI for Division 3?

b. What conclusion you can draw on the basis of performance of the three divisions? (3+3=6
marks) Dr. Anam 54
Dr. Anam 55