Analysis of Financial Statements

Class 12th Chapters

10. Financial Statement of a Company
11. Analysis of Financial Statements
12. Accounting Ratios
13. Cash Flow Statement

Financial Statement of a Company

Topic - 1 | FINANCIAL STATEMENTS

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Study Material & Notes

Study Material & Notes for the Chapter 8

FINANCIAL STATEMENTS

I. FINANCIAL STATEMENTS

Every company registered under The Companies Act 2013 shall prepare its Balance Sheet, Statement of Profit and Loss and Notes to account thereto in accordance with the manner prescribed in the revised Schedule III to the Companies Act, 2013 to harmonise the disclosure requirement with the accounting standards and to converge with new reforms.
The financial statements i.e., Balance sheet and Statement of Profit and Loss are required for external reporting and also for internal needs of the management like planning, decision-making and control.
Balance Sheet: The Balance sheet shows all the assets owned by the concern, all the obligations or liabilities payable to outsiders or creditors and claims of the owners on a particular date. It is one of the important statements depicting the financial position or status or strength of an undertaking.
Statement of Profit and Loss: The Statement of profit and loss is prepared for a specific period to determine the operational results of an undertaking. It is a statement of revenue earned and the expenses incurred for earning the revenue. It is a performance report showing the changes in income, expenses, profits and losses as a result of business operations during the year between two balance sheet dates.

Quiz [2]

Topic - 2 | FORMAT OF BALANCE SHEET

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Study Material & Notes

Study Material & Notes for the Chapter 8

FINANCIAL STATEMENTS

II. FORMAT OF BALANCE SHEET

Quiz [2]

Topic - 3 | FORMAT OF PROFIT AND LOSS ACCOUNT

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Study Material & Notes

Study Material & Notes for the Chapter 8

FINANCIAL STATEMENTS

III. FORMAT OF PROFIT AND LOSS ACCOUNT

Quiz [2]

Topic - 4 | CONTENTS OF THE BALANCE SHEET

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Study Material & Notes

Study Material & Notes for the Chapter 10

FINANCIAL STATEMENTS

IV. Contents of the Balance Sheet

Category	Main Head	Sub-Head	Item
Liability	Shareholders’ Funds	Share Capital	Equity Shares
Liability	Shareholders’ Funds	Share Capital	Preference Shares
Liability	Shareholders’ Funds	Share Capital	Calls-in-Arrears (Less)
Liability	Shareholders’ Funds	Reserves and Surplus	Forfeited Shares
Liability	Shareholders’ Funds	Reserves and Surplus	Capital Reserve
Liability	Shareholders’ Funds	Reserves and Surplus	Capital Redemption Reserve
Liability	Shareholders’ Funds	Reserves and Surplus	Securities Premium Reserve
Liability	Shareholders’ Funds	Reserves and Surplus	Debentures redemption Reserve
Liability	Shareholders’ Funds	Reserves and Surplus	Revaluation Reserve
Liability	Shareholders’ Funds	Reserves and Surplus	Shares Options Outstanding Amount
Liability	Shareholders’ Funds	Reserves and Surplus	Other Reserves
Liability	Shareholders’ Funds	Reserves and Surplus	Surplus i.e., Balance in Statement of Profit and Loss (Profit/Loss)
Liability	Non-Current Liabilities	Long-term Borrowings	Debentures
Liability	Non-Current Liabilities	Long-term Borrowings	Bonds
Liability	Non-Current Liabilities	Long-term Borrowings	Term Loan from Bank/Others
Liability	Non-Current Liabilities	Long-term Borrowings	Public Deposits
Liability	Non-Current Liabilities	Long-term Borrowings	Other Loans and Advances
Liability	Non-Current Liabilities	Deferred Tax Liabilities (Net)	Deferred Tax Liabilities
Liability	Non-Current Liabilities	Deferred Tax Liabilities (Net)	Deferred Tax Assets
Liability	Non-Current Liabilities	Other Long-term Liabilities	Premium Payable on Redemption of Preference Shares
Liability	Non-Current Liabilities	Long-term Provisions	Premium Payable on Redemption of Debentures
Liability	Non-Current Liabilities	Long-term Provisions	Provision for Employees Retirement Benefits
Liability	Non-Current Liabilities	Long-term Provisions	Provision for Gratuity
Liability	Non-Current Liabilities	Long-term Provisions	Provision for Earned Leaves
Liability	Non-Current Liabilities	Long-term Provisions	Provision for Warranty Claims
Liability	Current Liabilities	Short-term Borrowings	Loans repayable on demand
Liability	Current Liabilities	Short-term Borrowings	Bank Overdraft
Liability	Current Liabilities	Short-term Borrowings	Cash Credit from Banks
Liability	Current Liabilities	Short-term Borrowings	Current Maturities of Long-Term Debts
Liability	Current Liabilities	Short-term Borrowings	Loans repayable within 12 months
Liability	Current Liabilities	Short-term Borrowings	Deposits
Liability	Current Liabilities	Short-term Borrowings	Other Loans and Advances
Liability	Current Liabilities	Trade Payables	Sundry Creditors
Liability	Current Liabilities	Trade Payables	Bills Payable
Liability	Current Liabilities	Other Current Liabilities	Interest Accrued but not due on Borrowings
Liability	Current Liabilities	Other Current Liabilities	Interest Accrued and due on Borrowings
Liability	Current Liabilities	Other Current Liabilities	Income received in advance
Liability	Current Liabilities	Other Current Liabilities	Unpaid Dividends
Liability	Current Liabilities	Other Current Liabilities	Excess application money refundable and interest thereon
Liability	Current Liabilities	Other Current Liabilities	Unpaid matured deposits and interest accrued thereon
Liability	Current Liabilities	Other Current Liabilities	Unpaid matured debentures and interest accrued thereon
Liability	Current Liabilities	Other Current Liabilities	Calls-in-Advance
Liability	Current Liabilities	Other Current Liabilities	Outstanding Expenses
Liability	Current Liabilities	Other Current Liabilities	Provident Funds Payable
Liability	Current Liabilities	Other Current Liabilities	ESI Payable
Liability	Current Liabilities	Other Current Liabilities	Other Payables within Operating Cycle/12 months
Liability	Current Liabilities	Short-term Provisions	Provision for Employee Benefits (within Operating Cycle/12 months)
Liability	Current Liabilities	Short-term Provisions	Provision for Expenses (within Operating Cycle/12 months)
Liability	Current Liabilities	Short-term Provisions	Provision for Tax (within Operating Cycle/12 months)
Liability	Current Liabilities	Short-term Provisions	Other Provisions (within Operating Cycle/12 months)
Assets	Non-Current Assets	Property, Plant and Equipment and Intangible Assets	Property Plant & Equipments
Assets	Non-Current Assets	Property, Plant and Equipment and Intangible Assets	Intangible Assets
Assets	Non-Current Assets	Property, Plant and Equipment and Intangible Assets	Capital Work in Progress
Assets	Non-Current Assets	Property, Plant and Equipment and Intangible Assets	Intangible Assets under Development
Assets	Non-Current Assets	Property, Plant and Equipment and Intangible Assets-Property Plant & Equipments	Land
Assets	Non-Current Assets	Property, Plant and Equipment and Intangible Assets-Property Plant & Equipments	Building
Assets	Non-Current Assets	Property, Plant and Equipment and Intangible Assets-Property Plant & Equipments	Machinery
Assets	Non-Current Assets	Property, Plant and Equipment and Intangible Assets-Property Plant & Equipments	Furniture & Fixtures
Assets	Non-Current Assets	Property, Plant and Equipment and Intangible Assets-Property Plant & Equipments	Computers
Assets	Non-Current Assets	Property, Plant and Equipment and Intangible Assets-Property Plant & Equipments	Vehicles
Assets	Non-Current Assets	Property, Plant and Equipment and Intangible Assets-Property Plant & Equipments	Office Equipment
Assets	Non-Current Assets	Property, Plant & Equipment and Intangible Assets-Intangible Assets	Goodwill
Assets	Non-Current Assets	Property, Plant & Equipment and Intangible Assets-Intangible Assets	Brands
Assets	Non-Current Assets	Property, Plant & Equipment and Intangible Assets-Intangible Assets	Trademarks
Assets	Non-Current Assets	Property, Plant & Equipment and Intangible Assets-Intangible Assets	Computer Software
Assets	Non-Current Assets	Property, Plant & Equipment and Intangible Assets-Intangible Assets	Mining Rights
Assets	Non-Current Assets	Property, Plant & Equipment and Intangible Assets-Intangible Assets	Copy Rights
Assets	Non-Current Assets	Property, Plant & Equipment and Intangible Assets-Intangible Assets	Patents
Assets	Non-Current Assets	Property, Plant & Equipment and Intangible Assets-Intangible Assets	Licenses
Assets	Non-Current Assets	Property, Plant & Equipment and Intangible Assets-Intangible Assets	Franchise
Assets	Non-Current Assets	Property, Plant & Equipment and Intangible Assets-Capital Work in Progress	Tangible Assets under Construction
Assets	Non-Current Assets	Property, Plant & Equipment and Intangible Assets-Intangible Assets under Development	Patents under Development
Assets	Non-Current Assets	Property, Plant & Equipment and Intangible Assets-Intangible Assets under Development	Intellectual Property rights under Development
Assets	Non-Current Assets	Non-Current Investments	Investments in Property (to be sold after 12 months)
Assets	Non-Current Assets	Non-Current Investments	Investments in Equity Instruments (to be sold after 12 months)
Assets	Non-Current Assets	Non-Current Investments	Investments in Preference Shares (to be sold after 12 months)
Assets	Non-Current Assets	Non-Current Investments	Investments in Government or Trust Securities (to be sold after 12 months)
Assets	Non-Current Assets	Non-Current Investments	Investments in Debentures (to be sold after 12 months)
Assets	Non-Current Assets	Non-Current Investments	Investments in Bonds (to be sold after 12 months)
Assets	Non-Current Assets	Non-Current Investments	Investments in Mutual Funds (to be sold after 12 months)
Assets	Non-Current Assets	Non-Current Investments	Investments in Partnership Firms (to be sold after 12 months)
Assets	Non-Current Assets	Deferred Tax Assets (Net)	Deferred Tax Assets (Net)
Assets	Non-Current Assets	Long-term Loan and Advances	Capital Advances (for tangible/intangible assets)
Assets	Non-Current Assets	Long-term Loan and Advances	Long-term Loans to Employees
Assets	Non-Current Assets	Long-term Loan and Advances	Long-term Advances to Vendors
Assets	Non-Current Assets	Other Non-current Assets	Security Deposits given (> 12 months/Operating Cycle)
Assets	Non-Current Assets	Other Non-current Assets	Long-term Trade Receivables (> 12 months/Operating Cycle)
Assets	Non-Current Assets	Other Non-current Assets	Unamortized Expenses/Losses
Assets	Non-Current Assets	Other Non-current Assets	Insurance Claims Recoverable
Assets	Current Assets	Current Investments	Investments in Equity Instruments (to be sold within 12 months)
Assets	Current Assets	Current Investments	Investments in Preference Shares (to be sold within 12 months)
Assets	Current Assets	Current Investments	Investments in Government or Trust Securities (to be sold within 12 months)
Assets	Current Assets	Current Investments	Investments in Debentures (to be sold within 12 months)
Assets	Current Assets	Current Investments	Investments in Bonds (to be sold within 12 months)
Assets	Current Assets	Current Investments	Investments in Mutual Funds (to be sold within 12 months)
Assets	Current Assets	Current Investments	Investments in Partnership Firms (to be sold within 12 months)
Assets	Current Assets	Inventories	Raw Materials
Assets	Current Assets	Inventories	Work-in-Progress
Assets	Current Assets	Inventories	Finished Goods
Assets	Current Assets	Inventories	Stock-in-Trade
Assets	Current Assets	Inventories	Goods Purchased for Trading
Assets	Current Assets	Inventories	Stores & Spares
Assets	Current Assets	Inventories	Loose Tools
Assets	Current Assets	Trade Receivables	Debtors
Assets	Current Assets	Trade Receivables	Provision for Doubtful Debts
Assets	Current Assets	Trade Receivables	Bills Receivables
Assets	Current Assets	Cash and Cash Equivalents	Cash in hand
Assets	Current Assets	Cash and Cash Equivalents	Credit Balance as per Bank Accounts
Assets	Current Assets	Cash and Cash Equivalents	Cheques in hand
Assets	Current Assets	Cash and Cash Equivalents	Drafts in hand
Assets	Current Assets	Cash and Cash Equivalents	Fixed Deposits with Banks
Assets	Current Assets	Short-term Loans and Advances	Loans and Advances realized within 12 months/Operating Cycle
Assets	Current Assets	Other Current Assets	Prepaid Expenses
Assets	Current Assets	Other Current Assets	Accrued Income
Assets	Current Assets	Other Current Assets	Dividend Receivable
Assets	Current Assets	Other Current Assets	Advance Taxes

Quiz [2]

Topic - 5 | Interest on Debentures:

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Study Material & Notes

Study Material & Notes for the Chapter 9

COMPANY – ISSUE OF DEBENTURES

V. INTEREST ON DEBENTURES

When a company issues debentures, it has to pay interest thereon at fixed percentage periodically (quarterly/half yearly/yearly) until debentures are repaid
Interest is computed at the nominal value of debentures.
This percentage is usually as part of the name of debentures like 8% debentures, 10% debentures, etc.
Interest on debenture is a charge against the profit of the company and must be paid regularly even when Company suffers a loss or does not earn profits.
According to Income Tax Act, 1961, a company paying interest on debentures is required to deduct income tax at the prescribed rate from the gross amount of debenture interest (if it exceeds the prescribed limit) before any payment is made to the debenture holders (Tax Deducted at Source).

Illustration

Debenture Face Value	Rs. 100
Number of Debentures	10,000
Period	6 months
Interest rate	9% per annum
Profit & Loss A/c	Loss Rs. 75,00,000
Interest Amount	(10,000×100)x9%x6/12 = Rs. 45,000
Income Tax (TDS) @ 10%	45,000×10% = Rs. 4,500/-
Interest Net of TDS	45,000-4,500=Rs. 40,500

Interest on Debentures – Accrual

Interest may be paid periodically and the period may be quarterly, half-yearly or yearly
The date of payment of interest may be coincide with the end of the accounting period
For example interest is payable half yearly on 30th Jun and 31st December
In this case, at the end of the accounting year on 31st March, interest for the period 1st Jan to 31st Mar needs to be accrued in the books of accounts

Quiz [2]

Topic - 6 | Writing Off Discount/Loss on Issue of Debentures:

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Study Material & Notes

Study Material & Notes for the Chapter 9

COMPANY – ISSUE OF DEBENTURES

VI. WRITING OFF DISCOUNT/LOSS ON ISSUE OF DEBENTURES

Discount or Loss on issue of debentures is a capital loss and is written-off in the year it is incurred i.e. in the year debentures are allotted.
Discount or loss is written-off from the following:
- From Capital Reserve
- From Securities Premium Reserve [section 52(2)]
- From General Reserve
- Against revenue profits of the year

Quiz [2]

Multiple Choice Questions (MCQs)

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Accounting Ratios

Topic - 1 | LIQUIDITY RATIOS

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Study Material & Notes

Study Material & Notes for the Chapter 11

COMPANY – ACCOUNTING RATIOS

I. LIQUIDITY RATIOS

A. Meaning

The term liquidity refers to the ability of the company to meet its current liabilities.
Liquidity ratios are financial ratios that help in analyzing the ability of a business entity to meet its short-term obligations/liabilities.
Liquidity ratios measure the firms’ ability to fulfil short term commitments out of its liquid assets
These are analysed by looking at the amounts of current assets and current liabilities in the balance sheet.
Higher ratio means better capacity to meet its current obligation.

B. Type

1. Current Ratio

2. Liquid Ratio

C. Current Ratio

a. Meaning

The Current ratio measures the ability of a company to pay its current liabilities using its current assets.
A higher Current ratio indicates that the company has sufficient current assets to meet its current liabilities.

b. Formula

It is calculated by dividing Current Assets by Current Liabilities.
Current Ratio = Current AssetsCurrent Liabilities
Current Assets = Current Investments + Inventories (excluding stores & spares and Loose tools) + Trade Receivables (Net of provisions) + Cash & Cash equivalents + Short Term Loans & Advances + Other Current Assets
Current Liabilities = Short Term Borrowings + Trade Payables + Other Current Liabilities + Short Term Provisions
Working Capital = Current Assets – Current Liabilities

c. Important Considerations

The ratio is expressed pure i.e. 2:1
The ideal range for the Current ratio is 2:1
A Current ratio of less than 1 indicates that the company may have difficulty meeting its current liabilities.
Higher Current ratio means better capacity to meet its current obligations.
Very high Current ratio shows funds idleness

D. Liquid Ratio

a. Meaning

The Liquid ratio is a more stringent measure of liquidity. It measures the ability of a company to meet its current liabilities using its quick assets, which include cash, marketable securities, and accounts receivable.
Its based on highly liquid assets that can be converted into cash quickly
The Liquid ratio is also known as Quick ratio or Acid-test ratio.

b. Formula

It is calculated by dividing Liquid Assets by Current Liabilities.

Liquid Ratio = Liquid Assets/Current Liabilities

Liquid Assets = Current Investments + Trade Receivables (Net of provisions) + Cash & Cash equivalents + Short Term Loans & Advances + Other Current Assets excluding Prepaid Expenses

Current Liabilities = Short Term Borrowings + Trade Payables + Other Current Liabilities + Short Term Provisions
Liquid Assets = Current Assets – Inventories – Prepaid Expenses

c. Important Considerations

The ratio is expressed pure i.e. 2:1
The ideal range for the Liquid ratio is 1.5 : 1
A Liquid ratio less than 1 indicates that the company may have difficulty meeting its current liabilities even if all of its current assets are liquidated.
Higher Liquid ratio means better capacity to meet its current obligations.
Very high Liquid ratio shows funds idleness

Topic - 2 | SOLVENCY RATIOS

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Study Material & Notes

Study Material & Notes for the Chapter 11

COMPANY – ACCOUNTING RATIOS

II. SOLVENCY RATIOS

A. Meaning

The term ‘solvency’ refers to the ability of a concern to meet its long term obligations.
The long-term liability of a firm is towards debenture holders, financial institutions providing medium and long term loans and other creditors selling goods on credit
The Solvency ratios indicate firm’s ability to meet the fixed interest and its costs and repayment schedules associated with its long term borrowings.

B. Type

1. Debt Equity Ratio

2. Total Assets to Debt Ratio

3. Proprietary Ratio

4. Interest Coverage Ratio

C. Debt Equity Ratio

a. Meaning

It is calculated to know the relative claims of outsiders and the owners against the firm’s assets.
This ratio establishes the relationship between the outsiders funds and the shareholders funds

b. Formula

It is computed by dividing Long-term debts by Shareholders Funds

Debt Equity Ratio = Long-term DebtsShareholders Funds

Long Term Debts = Long Term Borrowings (i.e. debentures, mortgages, public deposits) + Long term provisions
Shareholders Funds = Equity Share Capital + Preference Share Capital + Reserves & Surplus – Fictitious Assets

Shareholders Funds = Non Current Assets (i.e. Tangible & Intangible assets, Non-current Investments + Long-term Loans & Advances) + Working Capital (i.e. Current Assets – Current Liabilities) Non-current Liabilities (i.e. Long-term Borrowings + Long-term Provisions)

c. Important Considerations

The Debt Equity ratio is expressed pure i.e. 1:1
The ideal range for the Debt Equity ratio is 2 or 2:5
A lower Debt Equity ratio is preferred as it indicates less debt on a company’s balance sheet.
The purpose of debt equity ratio is to derive an idea of the amount of capital supplied to the Organization by the Owners.
This ratio is very useful to assess the soundness of long term financial position of the firm.
It also indicates the extent to which the firm depends upon outsiders for its existence.
A low debt equity ratio implies the use of more equity than debt.

D. Total Assets to Debt Ratio

a. Meaning

Total Assets to Debt ratio measures the extent of the coverage of long-term debts by assets.
This ratio measures safety margin available to lenders of long term debt

b. Formula

It is computed by dividing Total Assets by Debt
Total Assets to Debt Ratio = Total Assets/(Debt i.e Long-term Loans)
Total Assets = Non-current assets + Current Assets
Long Term Debts = Long Term Borrowings (i.e. debentures, mortgages, public deposits) + Long term provisions
Non-current assets (i.e. Tangible & intangible assets, non current investments + long term loans & advances)
Current Assets (i.e. Current Investments + Inventories (excluding stores & spares and Loose tools) + Trade Receivables (Net) + Cash & Cash equivalents + Short Term Loans & Advances + Other Current Assets)

c. Important Considerations

The Total Assets to Debt ratio is expressed pure i.e. 2:1
This ratio measures the safety margin available to lenders of long-term debts. It measures the extent to which debt is being covered by assets
The ideal range for the Total Assets to Debt ratio is between 0.3 to 0.6. From a pure risk perspective, debt ratios of 0.4 or lower are considered better
The ideal range for the Total Assets to Debt ratio is between 0.3 to 0.6. From a pure risk perspective, debt ratios of 0.4 or lower are considered better
Total Assets to debt ratio of 0.6 or higher makes it more difficult to borrow money.

E. Proprietary Ratio

a. Meaning

Proprietary ratio establishes the relationship between Shareholders’ funds to Total assets of the firm
Proprietary ratio throws light on the general financial position of the enterprise. Proprietary Ratio shows the extent to which total assets have been financed by proprietor

b. Formula

It is computed by dividing Shareholder Funds by Total Assets
Proprietary Ratio = Shareholders or Proprietary Funds/Total Assets
Shareholders Funds = Equity Share Capital + Preference Share Capital + Reserves and Surplus
Total Assets = Non Current Assets + Current Assets
Non-current assets (i.e. Tangible & intangible assets, non current investments + long term loans & advances)
Current Assets (i.e. Current Investments + Inventories (excluding stores & spares and Loose tools) + Trade Receivables (Net) + Cash & Cash equivalents + Short Term Loans & Advances + Other Current Assets)

c. Important Considerations

The Proprietary ratio is expressed in fraction
The ideal range for Proprietary ratio is 0.5
A ratio below 0.50 may be alarming for the creditors since they may have to lose heavily in the event of company’s liquidation on account of heavy losses
A high ratio shows that there is safety for creditors of all types hence a higher ratio is better for the Organization
This ratio is of particular importance to the creditors who can ascertain the proportion of shareholders’ funds in the total assets employed in the firm.
Higher proportion of shareholders funds in financing the assets is a positive feature as it provides security to creditors

F. Interest Coverage Ratio

a. Meaning

It is a ratio which deals with the servicing of interest on loan.
It is a measure of security of interest payable on long-term debts
It expresses the relationship between profits available for payment of interest and the amount of interest payable.
It is also known as debt service ratio or fixed charges coverage ratio
Interest Coverage Ratio is computed to measure the debt servicing capacity of a firm so far as fixed interest on long-term debt is concerned.

b. Formula

It is computed by dividing Net Profit before by Interest on Long-term debts
Interest Coverage Ratio = Net Profit before Interest and Tax/(Interest on Long-term debts)

c. Important Considerations

The Interest coverage ratio is expressed in times
The ideal interest coverage ratio is 6 to 7 times
This ratio shows how many times the interest charges are covered by the profits available to pay interest
Higher the ratio, more secure the lender is in respect of payment of interest regularly.
A higher ratio indicates that the Organization can meet its interest burden regularly even if its earnings before interest and taxes is low and vice-versa.

Topic - 3 | ACTIVITY RATIOS

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Study Material & Notes

Study Material & Notes for the Chapter 11

COMPANY – ACCOUNTING RATIOS

III. ACTIVITY RATIOS

A. Meaning

Activity ratios measure the efficiency or effectiveness with which a firm manages its resources.
These ratios are also called turnover ratios because they indicate the speed at which assets are converted or turned over in Revenue from operations (sales).
Higher turnover ratio means better utilisation of assets and signifies improved efficiency and profitability
These ratios are expressed as ‘times’ and should always be more than one. These ratios are also known as Turnover or Efficiency ratios.

B. Type

1. Inventory Turnover Ratio

2. Trade Receivables Turnover Ratio

3. Trade Payables Turnover Ratio

4. Working Capital Turnover Ratio

C. Inventory Turnover Ratio

a. Meaning

It determines the number of times inventory is converted into revenue from operations during the accounting period under consideration
It expresses the relationship between the cost of revenue from operations and average inventory.
It determines how many times inventory is purchased or replaced during a year.

b. Formula

It is computed by dividing Cost of Revenue from Operations by Average Inventory
Inventory Turnover Ratio = Cost of Revenue from Operation/Average Inventory

(i) Cost of Revenue From Operations = Net Sales +/– Gross Profit/Loss

(ii) Average Inventory = (Opening Inventory+Closing Inventory)/2

(iii) Cost of Revenue From Operations = Opening Inventory + Purchases (net) + Direct Expenses – Closing Inventory

c. Important Considerations

The Inventory Turnover ratio is expressed in times
This ratio measures how fast Inventory is moving and generating sales.
The objective of calculating inventory turnover ratio is to ascertain whether investment in stock in trade is reasonable or not, ie, only the required amount is invested in stock-in-trade.
It throws light on utilisation of inventory of goods. High turnover is good but it must be carefully interpreted as it may be due to buying in small lots or selling quickly at low margin to realise cash.
Low turnover of inventory may be due to bad buying, obsolete inventory, etc., and is a danger signal.
When figure of Cost of Revenue from Operations is not available, the Revenue from Operations may be put in place of Cost of Revenue from Operations. Similarly, if only closing inventory is given in the question, it may be treated as average inventory.

D. Trade Receivables Turnover Ratio

a. Meaning

The liquidity position of the firm depends upon the speed with which trade receivables are realised.
This ratio indicates the number of times the receivables are turned over and converted into cash in an accounting period
It expresses the relationship between credit revenue from operations and trade receivable.

b. Formula

It is computed by dividing Credit Revenue from Operations by Average Trade Receivables
Trade Receivables Turnover Ratio = Credit Revenue from Opertions/Average Trade Receivables

(i) Credit Revenue From Operations = Total Revenue From Operations – Cash Revenue from Operation

(ii) Average Trade Receivables = (Opening Trade Receivables+Closing Trade Receivables)/2

(iii) Trade Receivables = Debtors + Bills Receivables

Note: Provision for doubtful debts is not deducted

c. Important Considerations

The Trade Receivables Turnover ratio is expressed in times
This ratio shows efficiency in the collection of amount due from trade receivables.
Higher the ratio, better it is since it indicates that debts are being collected more quickly.
In general, a high ratio indicates the shorter collection period which implies prompt payment by debtor and a low ratio indicates a longer collection period which implies delayed payment for debtors.
If Credit Sales is not specified, then total sales will be deemed as Credit Sales.
If there is no mention of the opening trade receivables in the problem, then only closing trade receivables (debtors & bill receivables) we be considered as average trade receivables.

E. Average Collection Period

a. Meaning

This ratio indicates in how many days receivables are getting collected by the Organization
This is also known as Debt Collection Period or Credit period

b. Formula

- It is computed by dividing Number of days/weeks/months in a year by Trade Receivables Turnover ratio
Average Collection Period = Number of days or weeks or months in a year/Trade Receivables Turnover Ratio

c. Important Considerations

The actual collection period can be compared with the stated terms of the organization
If it is longer than stated credit terms, then this indicates inefficiency in the process of collecting debtors.

F. Trade Payables Turnover Ratio

a. Meaning

Trade payables turnover ratio indicates the pattern of payment of trade payable.
This ratio helps in finding out the exact time a firm is likely to take in repaying to its trade payables.
As trade payable arise on account of credit purchases, it expresses relationship between credit purchases and trade payable.

b. Formula

It is computed by dividing Net Credit Purchases by Average Trade Payables
Trade Payables Turnover Ratio = Net Credit Purchases/Average Trade Payables

(i) Net Credit Purchases = Total Purchases – Purchase Returns – Cash Purchases

(ii) Average Trade Payables = Opening Trade Paybles+Closing Trade Paybles/2

(iii) Trade Payables = Creditors + Bills Payables

G. Average Payment Period

a. Meaning

This ratio helps in finding out the exact time a firm is likely to take in repaying to its trade payables

b. Formula

It is computed by dividing Number of days/weeks/months in a year by Trade Payables Turnover ratio
Average Payment Period = Number of days or weeks or months in a year/Trade Payables Turnover Ratio

c. Important Considerations

The average payment period can be compared with credit period offered by the suppliers.
If it is longer than stated credit terms, then this indicates inefficiency in the process of settlement of creditors which may affect organization availability to get purchases on credit in future.
A shorter payment period shows, organization is availing less credit period or making early payments.

H. Working Capital Turnover Ratio

a. Meaning

Working capital turnover ratio measures the efficiency at which the working capital is utilised for business operations
This ratio shows the relationship between working capital and revenue from operations.
It shows the number of times the working capital has been rotated in generating sales in a year.

b. Formula

It is computed by dividing Revenue From Operations by Working Capital
Working Capital Turnover Ratio = Revenue from Operations/Working Capital
Working Capital = Current Assets – Current Liabilities

c. Important Considerations

The Working Capital Turnover ratio is expressed in times
This ratio shows the number of times working capital has been employed in the process of carrying on business
The objective of calculating Working Capital Turnover Ratio is to ascertain whether or not working capital has been utilized effectively in making revenue from operations
A higher ratio indicates efficient utilisation of working capital in generating sales and a low ratio indicates the working capital is not properly utilised.

If the figure of cost of revenue from operations is not given, then the figure of revenue from operations (sales) can be used
If opening working capital is not given then working capital at the year end will be used.

Topic - 4 | PROFITABILITY RATIOS

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Study Material & Notes for the Chapter 11

COMPANY – ACCOUNTING RATIOS

IV. PROFITABILITY RATIOS

A. Meaning

These ratios are called profitability ratios because it measure the profitability of a business and helps in assessing the overall efficiency of the business.
Profitability ratios examine the earning capacity and current operating performance of the organization which is the outcome of utilization of resources employed in the business.
These ratios are helpful for the management to take remedial measures if there is a declining trend. Higher turnover ratio means better utilisation of assets and signifies improved efficiency and profitability
These ratios are expressed as ‘percentage’

B. Type

1. Gross Profit Ratio

2. Operating Profit Ratio

3. Operating Ratio

4. Net Profit Ratio

5. Return on Investment

C. Gross Profit Ratio

a. Meaning

Gross profit ratio as a percentage of revenue from operations is computed to have an idea about gross margin
It expresses the relationship of gross profit to revenue from operations (net sales). Gross profit ratio shows the margin of profit.

b. Formula

It is computed by dividing Gross Profit by Revenue From Operations
Gross Profit Ratio = (Gross Profit/Revenue from Operations) X 100
Gross Profit = Revenue from Operations – Cost of Revenue from Operations
Cost of Revenue from Operations = Opening Inventory (excluding Stores and Spares and Loose Tools) + Net Purchases + Direct Expenses – Closing Inventory (excluding Stores and Spares and Loose Tools)
Cost of Revenue from Operations = Cost of Materials Consumed + Purchases of Stock-in-Trade + Changes in Inventories of Finished Goods, WIP and Stock-in-Trade + Direct Expenses.

c. Important Considerations

The Gross Profit ratio is expressed in percentage form
It indicates gross margin on products sold.
It also indicates 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 both.
A higher ratio is always considered a good sign as it means lower cost of goods sold as well as good returns for the owners.
A low ratio may indicate unfavourable purchase and sales policy.

D. Operating Ratio

a. Meaning

Operating Ratio is calculated to assess the operational efficiency of the business.
It establishes relationship between cost of operations and revenue from operation (net sales).

b. Formula

It is computed by dividing Operating Cost by Revenue from Operations
Operating Ratio = (Operating Cost/Revenue from Operations) X 100
Operating Cost = Cost of Revenue from Operations + Operating Expenses
Operating Cost = Revenue from Operations – Gross Profit
Cost of Revenue from Operations = Opening Inventory (excluding Stores and Spares and Loose Tools) + Net Purchases + Direct Expenses – Closing Inventory (excluding Stores and Spares and Loose Tools)
Operating Expenses = Employees benefit expenses + expenses directly related to business (Office & administrative, selling & distribution, depreciation & amortisation)

c. Important Considerations

The Operating ratio is expressed in percentage form
This ratio is calculated to assess the operational efficiency of the business.
A lower operating ratio is considered a healthy sign as it means higher margin, and thus, more profit
It is very useful for inter-firm and intra-firm comparisons

E. Operating Profit Ratio

a. Meaning

Operating Profit Ratio is calculated to assess the operating margin.
It establishes relationship between operating profit and revenue from operation (net sales).

b. Formula

It is computed by dividing Operating Profit by Revenue from Operations
Operating Profit Ratio = (Operating Profit/Revenue from Operations) X 100
Operating Profit = Gross Profit + Operating Income – Operating Expenses
Operating Profit = Net Profit before tax + Non-operating Expenses – Non-operating Income
Non-operating Expenses = Interest on Long-term Borrowings + Loss on Sale of Fixed Assets + Loss by theft/fire + Charity/Donation
Non-operating Income = Interest received on investments + Profit on Sale of Fixed Assets + Interest/dividend received + Insurance Claim received

c. Important Considerations

The Operating Profit ratio is expressed in percentage form
This ratio is calculated to assess the operational efficiency of the business.
Higher the ratio, the better is the profitability of the business
It is very useful for inter-firm and intra-firm comparisons

d. Operating Ratio and Operating Profit Ratio

Operating ratio and Operating profit ratio are complementary to each other and thus, if one each ratio Is deducted from 100, other ratio is obtained. In the form of formula :
Operating Profit Ratio + Operating Ratio = 100
Operating Profit Ratio = 100 – Operating Ratio
Operating Ratio = 100 – Operating Profit Ratio

F. Net Profit Ratio

a. Meaning

Net profit ratio is based on all inclusive concept of profit
It relates revenue from operations to net profit after operational as well as non-operational expenses and incomes.
Net profit ratio determines overall efficiency of the business.
It expresses the relationship of Net profit to Revenue from operations (net sales).

b. Formula

It is computed by dividing Profit after Tax by Revenue From Operations
Net Profit Ratio = (Profit after Tax /Revenue from Operations) X 100
Profit after Tax = Gross Profit + Other Income – Indirect Expenses – Tax

c. Important Considerations

The Net Profit ratio is expressed in percentage form
It reflects the overall efficiency of the business, assumes great significance from the point of view of investors.
A firm with a high net profit ratio is in an advantageous position to survive in case of rising cost of production and falling selling prices.
Where the net profit ratio is low, the firm will find it difficult to withstand these types of adverse conditions.

G. Return on Investment

a. Meaning

This ratio indicates how efficiently the management has utilised the funds employed by owners and lenders.
It assesses the overall performance of the enterprise. It measures, how efficiently the resources entrusted to the business are used.
It establishes the relationship between Net profit before interest, tax & dividend to Capital Employed (equity & debts).

b. Formula

It is computed by dividing Profit before Interest Tax and Dividend by Capital Employed
Return on Investments = (Profit before Interest, tax and Dividend / Capital Employed) X 100
Capital Employed (Liabilities Approach): Share Capital + Reserves and Surplus + Long-term Borrowings + Long-term Provisions
Capital Employed (Assets Approach): Non-Current Assets (Tangible Assets + Intangible Assets) + Non-current Investments + Long-term Loans and Advances) + Working Capital.

c. Important Considerations

The Return on Investments ratio is expressed in percentage form
The objective of calculating return on investment is to measure the earning power of the net assets of the business.
This ratio is very important from Investors’ point of view in assessing whether their investment in the firm generates a reasonable return or not.
The higher the Return on Investments, the more efficient the management is considered to be in using the funds employed.
For inter-firm comparison, return on capital employed funds is considered a good measure of profitability

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Cash Flow Statement

Topic - 1 | INTRODUCTION AND BASIC CONCEPTS

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Study Material & Notes

Study Material & Notes for the Chapter 12

CASH FLOW STATEMENT

I. INTRODUCTION AND BASIC CONCEPTS

i. Meaning

Cash Flow Statement is a statement that shows the cash flows, i.e., inflow and outflow of Cash and Cash Equivalents during a particular period
Transactions that increase Cash and Cash Equivalents are inflows of Cash and Cash Equivalents and transactions that decrease it are outflows of Cash and Cash Equivalents.

ii. Cash

Cash comprises of Cash on Hand, cash at bank and demand deposits (fixed deposits) with banks

iii. Cash Equivalents

Cash Equivalents are short-term, highly liquid investments that are readily convertible into cash and which are subject to an insignificant risk of change in value.
An investment normally qualifies as cash equivalent only when it has short maturity period of, say, three months or less from the date of acquisition, i.e., purchase.
Examples: Current/Short-term Investments, Short-term deposits with Banks, Marketable Securities, Commercial Papers, Preference shares

iv. Statutory Requirements

Cash Flow Statement is prepared according to the Accounting Standard-3 (Revised).
The AS-3 (Revised) prescribes that Cash Flow Statement be prepared either by (i) Direct Method or (ii) Indirect Method
Showing cash flow under three heads, namely:
1. Cash Flow from Operating Activities;
2. Cash Flow from Investing Activities; and
3. Cash Flow from Financing Activities.

v. Cash flow arising out of increase/decrease in Balance Sheet items

Cash Flow Statement is prepared according to the Accounting Standard-3 (Revised).
The AS-3 (Revised) prescribes that Cash Flow Statement be prepared either by (i) Direct Method or (ii) Indirect Method
Showing cash flow under three heads, namely:
1. Cash Flow from Operating Activities;
2. Cash Flow from Investing Activities; and
3. Cash Flow from Financing Activities.

vi. Cash flows are inflow & Outflow of Cash & Cash Equivalents

vii. Objectives

a. Knowledge of movement of cash

A cash flow statement discloses the speed at which the cash is being generated from current assets such as debtors, bills receivable, inventory etc., and the speed at which the current liabilities such as creditors, bills payable etc. are being paid.
This information is very useful in testing the capacity of a business to meet its short-term liabilities maturing, say within one month or in the Immediate future.
Thus, it enables the management to assess the true position of cash in future.

b. Helpful in decision-making

Cash flow statement gives information about cash inflow from operations of business. Such information is used by management for certain decision-making, e.g., repayment of long-term loans, purchase of fixed assets etc.

c. Knowledge of cash flow for different activities separately

An enterprise presents its cash flows from Operating, Investing and Financing activities. Classification by activity provides information that allows users to assess the impact of these activities on the financial position of the enterprise and the amount of its cash and Cash equivalents. This information may also be used to evaluate the relationship among these activities.

d. Knowledge of change in Cash

A business may have made profit and yet is running short of cash. Similarly, a business may have suffered a loss and still has sufficient cash balance. A cash flow statement reveals reasons for such increase or decrease of cash balance.

viii. Advantages

Cash Flow Statement is very useful in the evaluation of cash position of a firm. It helps in efficient and effective management of cash.
Cash flow statement aims at highlighting the cash generated from operating activities.
Cash flow statement helps in planning the schedule for repayment of loan schedule and replacement of fixed assets, etc.
Cash is the centre of all financial decisions. It is used as the basis for the projection of future investing and financing plans of the enterprise
Cash flow statement helps to ascertain the liquid position of the firm in a better manner. Banks and financial institutions mostly prefer cash flow statement to analyse liquidity of the borrowing firm.
The Management reviews cash flow statements to understand the internally generated cash which is best utilised for payment of dividends.

ix. Preparation of Cash Flow Statement

Compute Cash Flow from Operating Activities
Compute Cash Flow from Investing Activities
Compute Cash Flow from Financing Activities.
Cash flows under each activity, i.e., Operating Activity, Investing Activity and Financing Activity as computed under Steps 1, 2 and 3 are added in Cash Flow Statement and the resultant amount is Net Increase or Decrease in Cash and Cash Equivalents
Cash and Cash Equivalents balance in the beginning of the period is added to the cash flows as arrived under Step 4. The amount so determined should be equal to Cash and Cash Equivalents balance at the end of the year.

Topic - 2 | CASH FLOW FROM OPERATING ACTIVITIES

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Study Material & Notes

Study Material & Notes for the Chapter 12

CASH FLOW STATEMENT

II. CASH FLOW FROM OPERATING ACTIVITIES

i. Operating Activities

Operating activities are the activities that constitute the primary or main activities of an enterprise
These are the principal revenue generating activities (or the main activities) of the enterprise and these activities are not investing or financing activities.
Cash flows from operating activities generally result from the transactions and other events that enter into the determination of net profit or loss
The amount of cash from operations’ indicates the internal solvency level of the company, and is regarded as the key indicator of the extent to which the operations of the enterprise have generated sufficient cash flows to maintain the operating capability of the enterprise, paying dividends, making of new investments and repaying of loans without recourse to external source of financing.

ii. Operating Activities – Manufacturing/Trading/Service Co

iii. Operating Activities – Finance Companies

Presentation in the Cash Flow Statement

SN	Particulars	Amount
(A)	Net Profit before Tax and Extraordinary Items (as per Working Note)
	Net Profit as per Statement of Profit & Loss or Difference between Closing Balance and Opening Balance of Surplus, i.e., Balance in Statement of Profit & Loss
Add	Transfer to Reserves
	Dividend Payable (Proposed Dividend of previous year) paid during the year Interim Dividend paid during the year
	Provision for Tax for the current year
	Extraordinary Items, if any, debited to the Statement of Profit & Loss
Less	Extraordinary Items, if any, credited to the Statement of Profit & Loss
	Refund of Tax credited to the Statement of Profit & Loss
	Net Profit before Tax and Extraordinary Items
(B)	Items to be Added
	Depreciation
	Interest on Bank Overdraft/Cash Credit
	Interest on Borrowings (Short-term and Long term) and Debentures
	Writing off Underwriting Commission/Share Issue Expenses
	Loss on Sale of Fixed Assets
	Increase in Provision for Doubtful Debts*
(C)	Items to be Deducted
	Interest Income
	Dividend Income
	Rental Income
	Gain (Profit) on Sale of Fixed Assets
	Decrease in Provision for Doubtful Debts*
(D)	Operating Profit before Working Capital Changes (A+B-C)
(E)	Add: Decrease in Current Assets and Increase in Current Liabilities
	Decrease in Inventories (Stock)
	Decrease in Trade Receivables (Debtors and Bills Receivable)
	Decrease in Accrued Incomes
	Decrease in Prepaid Expenses
	Increase in Trade Payables (Creditors and Bills Payable)
	Increase in Outstanding Expenses
	Increase in Advance Incomes
(F)	Less: Increase in Current Assets and Decrease in Current Liabilities
	Increase in Inventories (Stock)
	Increase in Trade Receivables (Debtors and Bills Receivable)
	Increase in Accrued Incomes
	Increase in Prepaid Expenses
	Decrease in Trade Payables (Creditors and Bills Payable)
	Decrease in Outstanding Expenses
	Decrease in Advance Incomes
(G)	Cash Generated from Operations (D+E-F)
(H)	Less: Income Tax Paid (Net of Tax Refund)
(I)	Cash Flow before Extraordinary Items
	Extraordinary Items (+/-)
(J)	Cash Flow from (or Used in) Operating Activities

Working Note

SN	Particulars	Amount
	Net Profit as per Profit & Loss Account or Closing – Opening P&L
	Add:
	Proposed Dividend (Previous year) paid during the year
	Interim/Final Dividend paid on Equity/Preference Shares
	Provision for Taxation (Current Year’s only) – Net of refund
	Transfer from P&L A/c to Reserves
	Loss/Expenses due to extraordinary items debited to P&L
	Less:
	Refund of Tax credited to P&L A/c
	Gain/Income due to extraordinary items
	Net Profit before Tax and Extraordinary Items

Topic - 3 | TREATMENT OF CERTAIN SPECIFIC ITEMS

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Study Material & Notes

Study Material & Notes for the Chapter 12

CASH FLOW STATEMENT

III. TREATMENT OF CERTAIN SPECIFIC ITEMS

i. Dividend

ii. Cash Flow from fixed Assets Movement

Increase in Fixed Assets vs previous year balance means more Fixed Assets have been acquired by the Organization leading to Cash Outflow
Decrease in Fixed Assets vs previous year balance means certain Fixed Assets have been disposed off by the Organization leading to Cash Inflow
Increase in Accumulated Depreciation/Provision for Deprecation means depreciation has been provided during the year

iii. Cash Flow from Income Tax Provision and Payment

AS-3 requires that cash flows arising from taxes on income should be separately disclosed and should be classified as Cash Flows from Operating Activities unless they can be specifically identified with financing and investing activities.
If there is no mention of Income tax paid in the Additional Information, it is assumed that opening balance of Provision for Taxation is paid during the year and closing balance of provision is created during the year
If Income tax paid during the year is provided in the Additional Information, Provision for Taxation General Ledger is prepared plotting Opening balance, Closing balance and Income Tax Paid. The balancing figure on the credit side is the Provision created during the year.

Topic - 4 | CASH FLOW FROM INVESTING ACTIVITIES

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Study Material & Notes

Study Material & Notes for the Chapter 12

CASH FLOW STATEMENT

IV. CASH FLOW FROM INVESTING ACTIVITIES

As per AS-3, investing activities are the acquisition and disposal of long-term assets and other investments not included in cash equivalents
Investing activities relate to purchase and sale of long-term assets or fixed assets which are not held for resale such as machinery, furniture, land and building, etc.
Transactions related to long-term investment are also investing activities. It includes investments made in long term instruments with an objective to generate income in the form of interest, dividend & capital gain.
Separate disclosure of cash flows from investing activities is important because they represent the extent to which expenditures have been made for resources intended to generate future income and cash flows.
In the Balance Sheet, if the Investment is classified under Current Assets, it is to be taken as Cash Equivalent and not Long-term Investment.

Presentation in the Cash Flow Statement

SN	Particulars	Amount
	Proceeds from Sale of Fixed Assets
	Proceeds from Sale of Investments (Other than Current Investments (to be included in Cash and Cash Equivalents) and Marketable Securities)
	Proceeds from Sale of Intangible Assets
	Interest and Dividend received (For Non-financial Companies only)
	Rent Received
	Payment for Purchase of Fixed Assets
	Payment for Purchase of Investments (Other than Marketable Securities)
	Payment for Purchase of Intangible Assets like Goodwill
	Extraordinary Items (eg. Insurance Claim) (+/-)
	Cash Flow from (or Used in) Investing Activities

Topic - 5 | CASH FLOW FROM FINANCING ACTIVITIES

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Study Material & Notes

Study Material & Notes for the Chapter 12

CASH FLOW STATEMENT

V. CASH FLOW FROM FINANCING ACTIVITIES

As per AS-3, financing activities are activities that result in changes in the size and composition of the owners’ capital (equity/preference shares) and borrowings of the enterprise.
Financing activities relate to long-term funds or capital of an enterprise, e.g., cash proceeds from issue of equity shares, debentures, raising long-term bank loans, repayment of bank loan, etc
Separate disclosure of cash flows arising from financing activities is important because it is useful in predicting claims on future cash flows by providers of funds ( both capital and borrowings ) to the enterprise.

Presentation in the Cash Flow Statement

SN	Particulars	Amount
	Proceeds from Issue of Shares and Debentures
	Proceeds from Other Long-term Borrowings
	Increase/Decrease in Bank Overdraft and Cash Credit
	Payment of Final Dividend (on Equity and Preference Share Capital)
	Payment of Interim Dividend
	Payment of Interest on Debentures and Loans (Short-term and Long-term)
	Repayment of Loans
	Redemption of Debentures/Preference Shares
	Payment of Share Issue Expenses or Underwriting Commission
	Payment for Buy-back of Shares as Extraordinary Activity
	Cash Flow from (or Used in) Investing Activities
IV	Net Increase/Decrease in Cash and Cash Equivalents (I+ II+ III)
V	Add: Cash and Cash Equivalents in the beginning of the year
	Cash on Hand
	Cash at Bank
	Short-term Deposits
	Current Investments
	Marketable Securities
	Add: Cash and Cash Equivalents in the beginning of the year
	Cash on Hand
	Cash at Bank
	Short-term Deposits
	Current Investments
	Marketable Securities
	Short-term Deposits

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