financial analysis and industrial financing

8/9/2019 Financial Analysis and Industrial Financing

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LESSON - 1

INTRODUCTION

Ratios are among the best-known and most widely used tools of financial analysis. Ratiois defined formally as "the indicated quotient of two mathematical expressions". Anoperational definition of a financial ratio is the relationship between two financialvalues. The word relationship implies that a financial ratio is the result of comparingmathematically two values. A company's total asset turnover is calculated by dividingthe company's total values into its sales figure. This ratio is the quantified relationshipbetween sales and total assets. The resulting figure is also and indexes because it tells ushow many times the values of total assets were incorporated into the firm's products. Itis worthwhile to mention that the ratio must express a relation-ship between the salesprices of an item on the one hand and its cost on the other. Consequently, the ratio ofcost of goods sold to sales is significant one in a sharper contrast to this, there is nounderstandable relationship between freight costs incurred and the marketablesecurities held by an enter-price and hence a ratio of one to the other has nosignificance.

Methods of Ratio Analysis

Accounting ratios can be expressed in various ways such as:

i. a pure ratio, say ratio of current assets to current liabilities, is 2:1 or

ii. a rate say current assets are two times of current liabilities oriii. a percentage say current assets are 200% of current liabilities

Each method of expression has a distinct advantage over the other. The analyst willselect that mode which will best suit his convenience and purpose.

Types of Analysis

(a) External Analysis by creditors, shareholders, banks and financial institutions.

(b) Internal Analysis - Analysis by the management.

(c) Horizontal Analysis - Comparative financial statements AICPA has observed."In any one year it is ordinarily desirable that the balance sheet, the Income statementant surplus statements be given for one or more presiding years as well as for thecurrent year.

(d) Vertical Analysis - Common size Balance Sheet Ratio is a study of a single statementfor the relationship of the components of the total by converting each amount in thestatement to a percentage of total amounts of the group.


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(e) Trend Ratios - These are computed in relation to a base year which must be a normalyear. These are index numbers of changes in financial data as compared to a base yeardata.

(f) Funds flow analysis and cash flow analysis.

(g) Break-even Analysis.

(h) Ratio Analysis - Balance Sheet Ratios, Profit and Loss account ratios.

Steps Involved in the Analysis

1. Compilation of financial data,2. Study of data,3. Systematic classification of data,4. Scientific arrangement of classified groups of data,

5. Establishing relationship with related data for further comparison6. Supplementing with appropriate comments,7. Analysis,8. Interpretation of the analysis

Tools of Analysis

1. Comparative financial statements,2. Common-size statements,3. Trend percentages,4. Ratio analysis,

5. Statement of changes in the working capital,6. Cash flow statements (FFS).

Objectives of Financial Analysis

1. To determine the financial soundness of the firm i.e. liquidity of the firm.

2. To judge the solvency of the firm by working out leverage rations.

3. To assess the profitably of the firm by the present shareholders and prospectiveinvestors.

4. Management can measure the operational efficiency of the firm by means operatingratios and turnover ratios.

5. It provides basis not only for intra-firm comparison but also for inter-firmcomparison.


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6. Comparison with base year financial statements will help the management incontrolling the affairs of the firm.

Dynamic Analysis versus Static Analysis

(a) Under dynamic analysis, a base year will be selected. The percentage of each itemover base year is calculated. A dynamic analysis of financial statements is based uponchanges over a long period of time. For this statement, a number of years are to beanalysed with reference to the percentage relationship of each item to the same item inthe base year balance sheet this study will indicate the trend of liquidity, profitabilityleverage and turnover rations etc. This helps in giving insight into die past' present,future affairs of the business enterprises. Dynamic Analysis is also called HorizontalAnalysis or Trend Analysis.

(b) A static analysis means explaining the current financial position if a firm byobserving a single balance sheet of the current year. This indicates in depth study ofsources and application of funds during the current year. Similarly, a study of internalrelationship between the various items appearing in P and L A/C of the current year isalso called "Static Analysis. It is basically one of linking and ascertaining relationshipwithin a single set of financial statement. It is also called as "Vertical Analysis" or"Structural Analysis" of financial statements.

(c) As stated above, ratios may be static, dynamic or inter-related. Dynamic ratiosemerge from the study of P and L A/c while static ratios from the study of items ofbalance sheet. The inter-related ratios emerge from the study of items of balance sheetin relation to the items of P and L A/c. These are also called as "combined ratios".

(d) According to AICPA Bulletin No.1, "The presentation of comparative statements in

annual and other reports enhances the usefulness of such reports and brings out moreclearly, the nature and trends, of current changes, affecting the enterprise, suchpresentation emphasises the fact that statements for a series of periods are far assentingsignificant than those for a single period and that accounts of one period are put aninstallment of what is essentially a centimeters history. In any one year, it is normallydesired, that the balance sheet the income statement and the surplus statement be givenfor one or more preceding years as well as current year".

Advantages of Ratio Analysis:

Ratio analysis stands for the process of determining and presenting the relationship of

items and groups of items in the financial statements. It is an important technique offinancial analysis. It is a way by which financial stability and health of a concern can bejudged. The following are the main points of importance of ratios analysis.

(a) Useful in financial position analysis: Accounting ratios reveal the financial positionof the concern. This helps the banks, insurance companies and other financialinstitutions in lending and making investment decisions.


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(b) Useful in simplifying accounting figures: Accounting ratios simplify, summarise andsystematise the accounting figures in order to make them more understandable and inlucid form. They highlight the interrelationship, which exists between various segmentsof the business as expressed by accounting statements. Often the figures standing alonecannot help them convey any meaning and ratios help them to relate with other figures.

(c) Useful in assessing the operational efficiency: Accounting ratios help to have an ideaof the working of a concern. The efficiency of the firm becomes evident when analysis isbased on accounting ratios. They help the managements to assess financialrequirements and the capabilities of various business units.

(d) Useful in forecasting purposes: If accounting ratios are calculated for a number ofyears, then a trend is established. This trend helps in setting up future plans andforecasting. For example, expenses as a percentage of sales can be easily forecasted onthe basis of sales and expenses of the past years.

(e) Useful in locating the weak spots of the business:Accounting ratios are of greatassistance in locating the weak spots in the business even though the overallperformance may be efficient. Weakness in financial structure due to incorrect policiesin the past or present are revealed through accounting ratios. For example, if a firmfinds that increase in distribution expenses is more than proportionate to the resultsexpected or achieved, it can take remedial steps to overcome this adverse situation.

(f) Useful in comparison of performance: Through accounting ratios comparison can bemade between one departments of a firm with another of the same firm in order toevaluate the performance of various departments in the firm. Manager is naturallyinterested in such comparison in order to know the proper and smooth functioning ofsuch departments. Ratios also help him to make any change in the organisation

structure.

Limitations of Ratio Analysis

Ratio analysis is very important in revealing the financial position and soundness of thebusiness. But, in spite of its advantages, it has some limitations, which restrict its use.These limitations should be kept in mind while making use of ratio analysis forinterpreting the financial statements. The following are the main limitations ofaccounting ratios:

(i) False results if based on incorrect accounting data. Accounting ratios can be correct

only if the data on which they are based) are correct. Sometimes, the information givenin the financial statements is affected by window dressing, i.e., showing position betterthan what actually is. For example, if inventory values are inflated or depreciation is notcharged on fixed assets, not only will one have an optimistic view of profitability of theconcern but also of its financial position. So the analyst must always be on the lookoutfor signs of window dressing, if any.


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(ii) No idea of probable happenings in future. Ratios are an attempt to make an analysisof the past financial statements; so' they are historical documents. Now-a-days keepingin view the complexities of the business, it is important to have an idea of the probablehappenings in future.

(iii) Variation in accounting methods. The two firms results are comparable with thehelp of accounting ratios only if they follow the same accounting methods or bases.Comparison will become difficult if the two concerns follow the different methods ofdifferent standards and methods, an analysis by reference to the ratios would bemisleading. Moreover, utilisation of inbuilt facilities, availability of facilities and scale ofoperation would affect financial statements of different firms. Comparison of financialstatements of such firms by means of ratios is bound to be misleading.

(iv) Price level changes. Changes in price levels make comparison for various yearsdifficult. For example, the ratio of sales to total assets in 1996 would be much higherthan in 1976 due to rising prices, fixed assets being shown at cost and not at marketprice.

(v) Only one method of analysis. Ratio analysis is only a beginning and gives just afraction of information needed for decision-making. So, to have a comprehensiveanalysis of financial statements, ratios should be used along with other methods ofanalysis.

(vi) No common standards. It is very difficult to lay down a common standard forcomparison because circumstances differ from concern to concern and the nature ofeach industry is different. For example a business with current ratio or more than 2:1might not be in a position to pay current liabilities in time because of an unfavorabledistribution of current assets in relation to liquidity. On the other hand, another

business with a current ratio of even less than 2:1 might not be experiencing any difficultin making the payment of current liabilities in time because of its favorable distributionof current assets in relation to liquidity.

(vii) Different meanings assigned to the same term. Different firms, in order to calculateratio may assign different meanings. For example, profit for the purpose of calculating aratio may be taken as profit before charging interests and tax or profit before tax butafter interest or profit after tax and interest. This may affect the calculation of ratio indifferent firms and such ratio when used for comparison may lead to wrong conclusions.

(viii) Ignores qualification factors. Accounting ratios are tools of quantitative analysis

only. But sometimes qualification factor may surmount the quantitative aspects. Thecalculations derived from the ratio analysis under such circumstances may get distorted.For example, though credit may be granted to a customer on the basis of informationregarding his financial position yet the grant of credit ultimately depends on debtor'scharacter, honesty, past record and his managerial ability.

(ix) No use if ratios are worked out for insignificant and unrelated figures. Accountingratios may be worked for any two insignificant and unrelated figures as ratio of sales and


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investment in government securities. Such ratios may be misleading. Ratios should becalculated on the basis of cause and effective relationship. One should be clear as towhat cause is and what effect is before calculating a ratio between two figures.

- End of Chapter -

LESSON 2

TYPES OF RATIOS

The chart showing the various types of ratios is given below: (more than 50 ratios)

1. Liquidity Ratios

(a) Current Ratio

(b) Liquid Ratio

(c) Absolute Liquid Ratio

(d) Over-due Liability Ratio

2. Profitability Ratios

(a) Gross Profit Ratio.

(b) Operating Profit Ratio.

(c) Net Profit Ratio.

(d) Earning Power.

(e) Return on Investment

(f) Return on the Total Assets

(g) Return on the Total Equity

(h) Return on Common Equity4


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(i) Earnings per Share

(j) Dividends per share

(k) Dividend-Payout ratio

(l) Price-Earnings ratio,

(m) Dividend yield ratio,

(n) Earnings yield ratio

(o) Net profit to Net Worth

3. Leverage Ratios

(a) Debt-Equity Ratio

(b) Total Debt-Equity Ratio

(c) Debt to total capital ratio

(d) Equity Ratio

(e) Fixed Assets to Net Worth Ratio

(f) Current Assets to Net Worth Ratio

(g) Long-term Debt to Net Working Capital Ratio

(h) Current Liabilities to net Worth

(i) Total Liabilities to Net Worth

(j) Capital gearing ratio

(k) Fixed Assets to Long term funds.

(l) Interest coverage ratio

(m) Preference Dividend Coverage Ratio

4. Operating Ratios

(a) Operating Ratio


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(a) Current Ratio (CR)

Donald Miller describes the current ratio as one which is generally recognised as thepatriarch among ratios. He states at that one time, it commanded such widespreadrespect that many businessmen regarded it as being endowed with the infallibility of

nature's laws - it was a law of gravity applied to the Balance Sheet. By using the currentratio, a credit manager or lending officer can lay aside his "flipping coin" and arrive atdecisions based on some figures of logic and accuracy.

Current Assets

Current ratio = ----------------------------

Current Liabilities

The ratio should be ideally 2:1. But depending on each industry's own peculiarproblems, the ratio may vary between 1.5:1 to 3:1. If cash and marketable securitiesconstitute 10% of total current assets, even a current ratio of 1.5:1 will be satisfactory.

(b) Liquid Ratio (LR)

Current ratio is a liberal test of liquidity whereas liquid ratio is a more stringent test of afirm's ability to meet its current liabilities. It is also called as Acid Test Ratio (ATR) orQuick Ratio (QR). As the conversion of inventory into cash will take time, it is excludedfrom current assets in order to arrive at the amount of liquid assets. Prepared expensesare also excluded as these are already spent.

Liquid Assets

Liquid Ratio = ----------------------------

Liquid Liabilities

The ratio should be 1:1. If current ratio is more than 2:1 but liquid ratio is less than 1:1, itindicates excessive inventory.

As the bank overdraft is a permanent arrangement with the banker, it may be excludedto find out the liquid ratio. In such case, the formula will be as follows:

Current Assets (Inventory + Prepaid Expenses)

Liquid Ratio = -----------------------------------------------------------------------

Current Liabilities Bank Overdraft


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(c) Absolute Liquid Ratio (ALR)

It is still stringent test of liquidity. It may not be possible to realise amounts from all thedebtors and hence the amount of debtors also is treated non-liquid assets.

Cash + marketable securities

Absolute Liquid Ratio = ---------------------------------------------

Quick Liabilities

The ratio should be 0.5 : 1

(d) Overdue Liability Ratio (OLR)

The ratio should be 1.5 : 1. If OLR is lower, but current ratio is good, it indicates

excessive debtors and delay in realization of cash from debtors.

PROFITABILITY RATIOS

Christy and Roden state that profit is the figure at the bottom of the income statement -what is left for shareholders after all the changes have been paid. Profit is an absolutefigures and profitability is a ratio.

Gross Profit EBIT

(a) Gross Profit Ratio (GPR) = ------------------------ x 100 or ------------ x 100

Sales Sales

Profit after Tax (PAT)

(b) Net Profit Ratio (NPR) = -------------------------------------- x 100

Sales

Note: PBT (1 - T) = PAT, where T = Tax rate


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Earning before Interest and Tax (EBIT)

(c) Earning Power = -------------------------------------------------------------- x 100

Total Assets

PBT Sales

(d) Return on Investment (ROI) = ---------- x --------------------------- x 100

Sales Capital employed

PBT

= -------------------------- x 100

Capital employed


(e) Return on total assets = ------------------------------------- x 100

Total assets


(f) Return on total equity = ----------------------------------------- x 100

Total shareholders equity

PAT less Preference dividend

(h) Return on common equity = ------------------------------------------------- x 100

Common shareholders equity


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(i) Earnings per share (EPS) = --------------------------------------------------

Number of equity shares

DPS

(j) Dividend Payout Ratio = --------- x 100

EPS

Market Price per share

(k) Price Earnings Ratio (PER) = ---------------------------------------

EPS

DPS

(l) Dividend Yield Ratio (DYR) = ----------------------------------

Market Price per share


(m) Net Profit to Net Worth = ------------------------------------------- x 100

Equity capital + Reserves


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(d) The economic situation in the country.

Debt-equity ratio is one of the most critical parameters that an investor should look atfor the following reasons:

(i) A medium/high ratio (in the range of 1.5:1 to 4:1) would indicate that thecapital base is low and this would mean higher earnings per share in the futureonce the debt is redeemed.

(ii) A debt component also ensures that a financial institution appraises theproject. The latter would also monitor the utilization of funds during the projectimplementation stage as also once the company commences commercialoperations.

(iii) In a contrast situation, when a project is entirely financed by equity, thecompany loses the flexibility of rescheduling funds in future.

(iv) Then again, when a project is entirely financed by equity, the risk to theshareholder is higher as there is no financial appraisal, as the investors are neitherequipped nor have access to monitor the course of the project.

(v)The general norm for debt to equity is 1.5:1. But capital-intensive projects areallowed a debt/equity of 4:1 while finance companies can have a ratio as high as9:1.

Total Debt

(b) Total Debt Equity Ratio = ------------------------------

Shareholders Equity

Long term debt + Current liability

= ------------------------------------------------

Share holders Equity

Long term debt

(c) Debt to Total Capital Ratio = ------------------------------


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Total Capital

Note: The widely held approach adopted by CCI and financial institutions is that ofrelating the long term debt to shareholders equity.

Shareholders equity

(d) Equity Ratio = -----------------------------

Total assets

It is also called Proprietary Ratio

Fixed assets at WDV (written down value)

(e) Fixed Assets to Net Worth Ratio = ------------------------------------------------------------------

Net Worth

Current Assets

(f) Current Assets to Net Worth ratio = ---------------------

Net Worth

Long term debt

(g) Long term Debt to Net Working Capital = -------------------------------

Net Working capital

This ratio should be 1:1; long term debt should not exceed net working capital


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Current liabilities

(h) Current liabilities to Net Worth = ----------------------------

Net Worth

Total liabilities

(i) Total liabilities to Net Worth = --------------------------

Net Worth

(j) Capital Gearing Ratio

This ratio indicates the relationship between fixed interest bearing securities (FIBS) andEquity Share Capital plus Reserves.

If FIBS is higher than equity share capital plus reserves, it is highly-geared capitalstructure, i.e., ratio is more than 1:1

If FIBS is lower than equity share capital plus reserves, it is low-geared capitalstructure, i.e., ratio is less than 1:1

If FIBS is higher than equity share capital plus reserves, it is evenly-geared capitalstructure, i.e., ratio is 1:1.

Its various formulas are:

FIBS / Equity Capital Debentures / Equity Capital (Debentures + Preference Capital) / Equity Capital FIBS / Total Capital employed FIBS / Equity shareholders funds (i.e. Net Worth)

FIBS include the Debentures, Term loans and preference shares (especially when theyare cumulative). The last formula is a better one.

A highly geared company may give higher return to equity shareholders, if profits aregood and rate of return of capital is more than the rate of interest on preferencedividend. After meeting the interest charges and preference dividend out of profits, thebalance of profits will be available to the Equity Shareholders.


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The following factorsmay affect the decision of the firm about capital gearing:

Trading on Equity Exercise of control Attitude towards risk

Statutory requirements Capital market conditions Fixed cost of financing Rate of return on capital

Fixed Assets at WDV

(k) Fixed Assets to long-term funds = ---------------------------------

Long term funds

Long-term funds include shareholders' equity and long term debt. The ratio should notexceed 1:1, it means that working capital is nil. Then current assets are financed fully bycurrent liabilities only.

EBIT

(l) Interest Coverage Ratio (ICR) = ------------------------------------

Fixed interest charges

It is also called "Debt Service Ratio". The ratio shows how many times the interest of theearnings cover charges before interest and tax (EBIT). It indicates the ability of a firm topay the interest charges. It is also an important test of satisfactory. If the ratio is 1:1,EBIT will be just sufficient to pay the interest charges. Then net profit will be nil and taxneed not be paid.

DSCR or Debt Service Coverage Ratio:

The company has to satisfy the lender by calculating DSCR which should indicate clearlyas to what extent it will be able to discharge the loan obligations. Each company shouldwork out its own DSCR for proper planning and monitoring which should be part ofinternal financial discipline.

If the internal generation of funds (i.e. cash inflow) is diverted for expansion,modification or diversification of activities, it may result into default of payment ofinterest and repayment of loan.


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(m) Preference Dividend Coverage Ratio (PDCR) = ------------------------------

Preference Dividend

OPERATING RATIOS

These ratios are calculated to show the variations of different expenses in the operatingcost. Generally, these are expressed as percentages to net sales.

Cost of goods sold + Operating expenses

(a) Operating Ratio = ------------------------------------------------------------- x 100

Net Sales

If the operating ratio shows 90%, the balance 10% will be the operating profit ratio. Thisshould cover interest, income tax, dividends and retained earnings.

Each item of expenses

(b) Expenses Ratio = ------------------------------------- x 100

Net Sales

It indicates the percentage of each item of expense in relation to net sales.

Net Sales

So, Expenses Ratio = -----------------------

Fixed Assets


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Net Sales

(c) Net Sales to Inventory = --------------------

Inventory

Net Sales

(c) Net Sales to Net Worth = ---------------------

Net worth

Net Sales

(d) Net Sales to Net Profit = ------------------------------ x 100

Net Profit after Tax

TURNOVER RATIOS

Turnover ratios indicate the effectiveness with which the assets are utilized in a firm.These are also called Activity Ratios.

(a) Inventory Turnover Ratio (ITR)

It is also called Stock Turnover Ratio. It is the number of times its average inventory issold during a year. There are three alternative formulas for this ratio, as given below:

ITR = Cost of goods sold / Average inventory at cost

ITR = Sales / Average inventory at cost

ITR = Sales / Average inventory at selling price

A ratio of 6 or 7 times is considered satisfactory. But there is one rule of thumb": a highinventory turnover is an indication of good inventory slow-moving and absolute itemsresulting in blocking of funds, or too highly frequent stock-outs. These situations shouldbe avoided. Holding of inventory may be expressed in number of days also as follows:


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Average holding period of inventory = days in a year / ITR

(b) Debtors Turnover Ratio (DTR)

This ratio indicates the speed at which the debtors are converted into cash. It is alsocalled "Receivable Turnover Ratio".

Credit Sales in a year

DTR = -----------------------------

Debtors

The optimum ratio is dependent on the credit policy of the firm and credit periodallowed to the customers. If the credit period is 30 days, the ratio should be 12:1.Suppose if the ratio is 12:2, i.e., 6:1 the realisation from debtors is taking two monthsinstead of credit policy of one month.

The debtors include the gross amount of debtors (i.e. without deducting the provisionsfor bad and doubtful debts and provision for discount on debtors) and outstanding billsreceivable which have not been discounted with the bankers. Sometimes, we have tocalculate the average collection period of debtors. In such case, the formula is as follows:

Average Collection Period = Days in a year / DTR

Or

Average Collection Period = (Debtors x days in a year) / Credit sales in ayear

(c) Creditors Turnover Ratio (CTR)

Similar to debtors Turnover Ratio, Creditors Turnover Ratio also can be calculated as:

Credit purchase in a year

CTR = -----------------------------------------

Creditor


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This ratio indicates the speed at which the creditors are paid. The ratio here also isdependent on the credit period allowed by suppliers. The creditors include the grossamount of creditors (i.e. without deducting the provision for discount on creditors) andbills payable.

Average payment period = Days in a year / CTR

Or

Average payment period = (Creditor x days in a year) / Credit purchases in ayear

Sales

(d) Fixed Assets Turnover = ---------------------

Fixed Assets

This ratio indicates the frequency with which the fixed assets are unutilized.

Sales

(e) Total Assets Turnover = ---------------------

Total Assets

Sales

(f) Working Capital Turnover = ------------------------

Working Capital

Working Capital

(g) Working Capital to Inventory = ----------------------------

Inventory


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Working Capital

(h) Working Capital to Total Assets = ----------------------------

Total Assets

Total cash and bank payment

(i) Total Assets Turnover = ------------------------------------------------

Average cash and bank balance

Sales

(j) Current Assets Turnover = -------------------------

Current Assets

Inventory

(k) Inventory to Working Capital = --------------------------

Working Capital

Debtors

(l) Debtors to Working Capital = ---------------------------

Working Capital

Cash

(m) Cash to Working Capital = ------------------------

Working Capital


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Capital

(n) Capital Output ratio = ------------------------------

Value of Production

- End of Chapter -

LESSONS - 3 & 4

SIGNIFICANCE OF IMPORTANT RATIOS

A Current Ratio

(a) indicates the firms ability to pay its current liabilities; i.e. day to day financialobligations.

(b) shows short-term financial strength.

(c) is a test of credit strength and solvency of a firm.

(d) indicates the strength of working of capital

(e) indicates the capacity to canyon effective operations.

(f) discloses the over-trading or under-capitalisation.

(g) shows the tendency of over-investment in inventory.

(h) more than 2:1 indicates sound solvency position.

(i) less than 2:1 indicates inadequate working capital.

(j) discloses the quantity of working capital position and not its quality.

(k) helps a credit manager or lending officer to arrive at decisions based on some figuresof accuracy.


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A Liquid Ratio

(a) is a more stringent test of a firm's ability to meet its intermediate liabilities.

(b) is true test of business solvency.

(c) is more of a qualitative concept whereas current ratio discloses quantitative aspect ofworking capital.

(d) indicates the inventory build-up when studied along with current ratio because ofthe following formula: Liquid Assets = Current Assets Inventory.

(e) is a stringent test of liquidity, because of eliminating inventory in its calculations.

(f) is a more important ratio for financial institutions.

(g) more than 1:1 indicates sound financial position.

(h) less than 1:1 indicates financial difficulty.

A Gross Profit Ratio

(a) indicates the basic profitability of a firm, i.e., trading results of a firm.

(b) indicates the degree of efficiency of the production department, purchasedepartment, sales department and the degree of cost control (i.e. material control,labour efficiency and overheads control).

(c) indicates the trend of trading results by doing a comparison of GP ratios over 5 to 10years.

(d) shows whether the percentage of mark up on the goods is maintained or not.

(e) higher ratio indicates the higher profitability.

(f) lower ratio indicates the lower profitability and unfavourable markup policy.

A Net Profit Ratio

(a) indicates the relationship between net profit and net sales.

(b) is the most significant of all revenue ratios as it indicates the ultimate profitability ofthe firm.

(c) is useful to the share holders for knowing the earnings per share (EPS).


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(d) is useful to investors in judging the prospects of return on their investments.

(e) indicates the degree of efficiency and profitability of the firm upon studying withoperating ratio.

(f) indicates scale of company's non-operating expenses and non-operating income,upon studying with operating net profit ratio.

(g) indicates scale of company s non-operating expenses and non-operating income,upon studying with GP Ratios.

(h) is described as an index of "Operational Efficiency".

(i) higher ratio indicates higher profitability,

(j) lower ratio indicates lower profitability.

Note: A high NP Ratio is not always a favourable indication of a firm's profitability.

For a detailed study of the firm's profitability, the following factorsare also to bestudied:

1) Market Conditions,

2) Sales Volume

3) Pricing policy

4) Sales Mix

5) Stock turnover ratio

6) Debtors turnover ratio

7) Cost of capital

8) Return on investment (ROI) of other firms in the same industry etc.

Earning Power or Return on Total Resources

(a) is an index of earning power of a firm.

(b) is an index of optimum utilisation of funds or economic productivity capital.

(c) indicates the degree of efficiency of management.


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(d) provides a standard measure of operating efficiency.

(e) helps to make capital investment decisions.

(f) higher ratio is favourable and lower ratio is unfavorable

Note: Total Resources = Total Assets Employed

Return on Total Equity

a) shows the earning capacity of proprietors funds (including preference shareholders).

b) is important to prospective investors and shareholders.

c) high ratio will improve the market price of the share in stock exchange.

d) high ratio enables the management to raise finances easily even from externalresources.

(e) high ratio gives scope for more retained earnings which can be used for expansion,diversification and consequential development of business.

(f) When the ratio has been high for a period of 4 or 5 years, shareholders can expect thecompany to issue bonus shares.

Note: While calculating the above ratio, the preference dividend need not be deducted.

Return on Common Equity

(a) shows the efficiency in the management of equity share holders funds.


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(b) higher ratio indicates higher profitability and higher EPS

(c) lower ratio indicates lower profitability and ineffective utilisation of equity shareholders funds.

(d) If EPS is higher, the market value of equity shares will be higher in stock exchangeand issue of bonus shares will also be feasible.

Note: The Preference shares are considered as "Non-participating"

Earnings Per Share (EPS)

(a) indicates the earning power of equity share capital.

(b) helps in dividend declaration.

(c) helps in estimating the market price of shares.

(d) if higher, market value of equity share will be higher in the stock exchange.

(e) if it has been high for a period of 4 to 5 years, issue of bonus share will also befeasible.

(f) can be improved by use of borrowed funds to a greater extent.

Note: Dividend Per Share (DPS) = Dividend declared / No. of equity shares

Proprietary Ratio

(a) indicates long-term financial solvency of the firm.

(b) shows the general financial strength of the firm.

(c) shows the proportion of assets financed by the proprietors.

(d) measures the extent of protection available to the creditors.


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(e) is a test of long-term credit strength.

(f) determines the extent of trading on equity.

(g) higher ratio (more than 75%) shows lesser dependence on external sources, sound

financial position, greater security available to creditors, no trading on equity.

(h) lower ratio (less than 60%) shows more dependence on external sources andunsound financial position. It is dangerous during the period of depression.

Note: It can never exceed 1:1 i.e. 100%. When there are outside liabilities, the ratiowould be 1:1 and the standard ratio would be 60% to 75%.

Capital Gearing Ratio

(a) analyses the capital structure of a company effectively.

(b) helps to ascertain whether a company is practicing trading on equity and if so, towhat extent.

(c) low gearing indicates trading on equity, over capitalization and low EPS.

(d) aids in regulating a balanced capital structure in a company.

(e) high gearing indicates under capitalization. It is favourable for a company earninghigh profits. EPS will be higher but it will fall disproportionately against a slight fall innet profits,

(f) It affects the dividend policy of the company.

Note: According to capital issues control act a ratio of 1:4 between equity andpreference capital is reasonable.

Operating Ratio

(a) brings out the relationship between cost of goods sold + operating expenses and netsales.

(b) is useful to ascertain the administration efficiency.

(c) is a test of operational efficiency of the business.

(d) is useful for ejecting the areas of inefficiency and consequential lower profits.

(e) low ratio indicates operational efficiency and higher profits.

(f) high ratio indicates the lower profits.


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(g) when trend analyses is done for a period of 5 to 10 years, reasons can be analysed forany rise or fall in operational efficiency.

Expense Ratios

(a) bring out the relationship between various elements of operating costs and net sales.

(b) enable the management in controlling costs and improving the managerialefficiency.

(c) when studied over a period of 5 to 10 years, trend analysis can be done to improveprofitability.

Inventory Turnover Ratio (ITR)

(a) indicates the number of times its averages inventory has been sole and replaced

during the year.

(b) is an important factor that controls profitability of firm.

(c) indicates whether investment in inventory is high or not. This ratio can be useful forintroducing effective inventory management in the areas mentioned below.

(d) helps in controlling inventory levels to avoid over-stocking and stock-outs, avoidingslow-moving, non-moving inventories and surplus or obsolete stores etc.

(e) indicates whether capital is blocked in slow-moving inventories and therebyindicates the possibility of reducing selling prices of those items.

(f) reflects excess stock and/or accumulation of obsolete items in stock.

(g) when studied with inventory to working capital ratio, it becomes more significant.

(h) of 6 or 7 times is considered satisfactory. A high inventory turnover is an indicationof good inventory management and favourable trading situation. A low ratio indicatesexcessive inventory including slow-moving and obsolete items resulting in blocking offunds.

Note: A too high inventory turnover ratio may be the result of low level includingfrequent stock-outs. This situation should be avoided.

Debtors Turnover Ratio (DTR)

(a) If the credit period is 30 days, the ratio should be 12:1. If the ratio is 6:1, it meansthat the realization from debtors is taking 2 months instead of credit policy of 1 month.Hence, lower DTR indicates poor collection from the debtors. Then, bad debts would


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increase, and profits will be lower. Hence, suitable measures are to be taken to improvethe credit collection.

(b) indicates the quality of debtors also, i.e. good, doubtful or bad etc it is useful in thepreparation of working capital budgets.

(c) is useful in the preparation of working capital budgets.

(d) is a very useful supplementary test to the current ratio.

(e) shows the effectiveness of credit control.

(f) indicates the speed at which the debtors are converted into cash.

Inventory to Working Capital Ratio

(a) shows the extent to which working capital is blocked in inventory. Working capital isrequired for the firm but it should not be blocked up in inventory.

(b) if more than 1:1, indicates unsound working capital, i.e., excessive inventory.

(c) if less than 1:1, indicates sound working capital position and effective inventorymanagement.

(d) indicates whether working capital is adequate or not.

(e) is related to current ratio as well as liquid ratio.

PROBLEMS & SOLUTIONS

1. Calculate the following for the years 1990 and 1991 using figures made available:

a. Return on capital employed

b. Current Ratio

c. Debt/Equity Ratio

d. Fixed Assets Turnover Ratio

e. Inventory Turnover Ratio

f. Earnings Per Share

g. Dividend Cover


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Solution:


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2. Summarized Balance Sheet of M/s Arun and Co. for the years 1987 and 1988 is asfollows:


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Using the technique of ratio analysis comment on the performance of the companyduring 1988.

Solution:

The ratios for assessing the performance:


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Comments:

i. Performance of the company has declined in 1988 due to:

(a) Lower turnover

(b) Higher capital employed

(c) Higher material consumption (40% of turnover)

(d) Higher working capital and higher current assets

(e) Higher wages, other costs and interest on loan

ii. Dividend-payout Ratio was 88% in 1988. The company should not have paid so manydividends in view of lower earnings. 12% dividend should have been declared on Equity

Capital Ratio of Rs.17 lakhs i.e. Rs.3.04 lakhs dividends. Then the Dividend-payoutRatio would have been: (2.04 / 5) x 100 = 40.8%

iii. The Profit / Capital Employed has come down from 30% to 8.62%.


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The Management makes the following estimates for the year ending 31st March, 1993:

Purchases upto February, 1993 Rs. 30,40,000

And during March, 1993 Rs. 2,10,000

Sales upto February 1993 Rs. 44,80,000

And during March, 1993 Rs. 5,00,000

Management decides to invest Rs.3,00,000/- in purchases of fixed assets which aredepreciated to 10%. The time lag for payment to creditors and receipts from debtors isone month. The business earns a gross profit of 33 1/3% on turnover. Sundry expensesagainst gross profit will amount to 12% of the turnover excluding depreciation of fixedassets.

Prepare a proforma balance sheet of the company for the year ending 31st March, 1993.

Solution:


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EXERCISES

1. The following are summarized Profit & Loss account for the year ending 31-12-1996and the Balance Sheet as at the date:


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Additional information:

i. Average Debtors Rs.12,500

ii. Average Credit Purchases Rs.40,000

You are required to calculate:

a) Stock Turnover Ratio

b) Debtors Turnover Ratio

c) Creditors Turnover Ratio

d) Sales to Working Capital

e) Sales of Fixed Assets

f) Sales to Capital Employed


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g) Sales to Capital Employed

h) Return on Shareholders

i) Investment

j) Current Ratio

k) Acid Test Ratio

l) Gross Profit Ratio

m) Net Profit Ratio

n) Operation Ratio

2. The following is the Balance Sheet of a Limited Company as on 31 March 1996.

Calculate a) Current Ratio; b) Quick Ratio; c) Inventory to Working Capital Ratio; d)Debt to Equity Ratio; e) Proprietary Ratio, f) Capital Gearing Ratio, g) Current Assets toFixed Assets Ratio.

3. Summarized balance sheets of Alpha Ltd. as of 31 March 1992, 1993, 1994 are given

below:


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From the above balance sheet, compute the following as at 31st March 1992, 1993 and1994:

a) Debt Equity Ratio, b) Current Ratio, c) Working Capital, d) Fixed Assets Ratio.

4. Mr. Desai intends to supply goods on credit to A Ltd. and B Ltd. The relevant financialdata relating to the companies for the year ended 30th June, 1994 are as under:

Advice with reasons as to which of the companies he should prefer to deal with?

5. You have been asked by the management of "The Wonderful Supplies Limited" toproject a trading and Profit & Loss account and Balance Sheet on the basis of thefollowing estimated figures and ratios for the next financial year ending march 31st,1994:


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Capital Employed Rs.50,00,000; Ratio of Gross Profit 25%; Stock Turnover Ratio 5times; Average Debt Collection period 3 months; Creditors Velocity 3 months; CurrentRatio 2; Proprietary Ratio (Fixed Assets to Capital Employed) 80%; Capital GearingRatio (Preference Shares and Debentures to Capital Employed) 30%; Net Profit toissued Equity Capital 10%; General Reserve and Profit & Loss to issued Equity Capital

25%; Preference Share Capital to Debentures 2; Cost of Sales Consists of 50% formaterial; Gross Profit Rs.12,50,000. Working notes should be clearly shown.

6. The Accounts of ABC Ltd. consists of fixed assets while its current liabilities comprisebank credit and trade credit in the ratio of 2:1. From the following figures relating to thecompany for the year 1996, prepare its balance sheet showing the details of working.

7. You are given the following information about two companies:

i) Calculate Liquidity Ratios for the two companies.

ii) Give your interpretation of the liquidity position of the two companies as revealed bythe ratios.


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8. From the following particulars pertaining to current assets and current liabilitiesgiven in the comparative Balance Sheet of Bharat Co. Ltd. You are required to commenton the liquidity position of the company with the help of accounting ratios.

Hint: Calculate Current Ratio, Quick Ratio, Stock Turnover Ratio, and Debtors Turnover

Ratio.

QUESTIONS

1. Discuss the significance of financial ratios as a tool of decision making. What are thelimitations of ratio analysis?

2. How are financial ratios classified? What do these ratios convey?

3. Discuss the merits and shortcomings of ratio analysis?

4. What ratios would you calculate to measure long-term solvency position of acompany?

5. What ratios would you use to measure profitability of a company?

6. Describe with illustrations the usefulness of following ratios:

a. Gross Profit Ratio;

b. Net Profit Ratio;

c. Stock Velocity Ratio;

d. Working Capital Ratio;

e. Current Ratio;


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f. Operating Leverage;

g. Financial Leverage;

h. Operating Ratio;

i. Sales to Fixed Assets;

j. Net Worth to Fixed Assets.

7. Explain and illustrate the following terms used in accounting:

a) Price Earnings Ratio

b) Capital Gearing

c) Inventory Turnover

d) Net Income - Debt Service Ratio

e) Gross Profit Ratio

f) Expense Ratio

g) Payout Ratio

h) Earnings per Share

8. Describe the various ratios that are likely to help the management of a manufacturingunit in forming an opinion on the solvency position of business.

9. Examine the relationship between liquidity, solvency and profitability.

10. Explain five accounting rations that are likely to help the management of amanufacturing unit in forming an opinion on the efficiency of business.

11. Ratio Analysis is a tool to examine the health of a business with a view to make thefinancial results more intelligible? Explain.

- End of Chapter -

LESSON - 5

INTRODUCTION TO FUNDS FLOW ANALYSIS


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2. It gives the information how the funds have been obtained from different sources i.e.External, Internal etc. and how they have been spent.

3. It helps to know where the profits went.

4. It helps the management for declaration of dividends or panning of a dividend policyor issue of bonus shares.

5. It suggests the ways to improve the working capital position

6. It helps in planning for retirement of long-term debts.

7. Sometimes companies will be having funds in spite of net loss. Institutional financedepreciation is higher than net loss, there will be fund form operations, and sometimes afirm will not have funds in spite of profits. All these will be known through funds flowstatement.

8. This is useful to the bankers while sanctioning the credit to the firms.

9. It helps the finance manager in financial planning, decision-making and allocatingthe resources for productive investments.

10. It helps to know the changes in working capital and determine the efficiency ofworking capital management.

According to Perry Mason, funds statements reflect changes in capital structure and themanagement in recommending the ways and means of straightening the working capitalposition.

The National Association of Accountants states the following uses of funds statements:

1. Estimating the amount of funds needed for growth;

2. Improving the rate of income assets;

3. Planning the temporary investment of idle funds;

4. Securing additional working capital when needed;

5. Securing economies in the centralized management of cash in organizations whosemanagement is decentralized;

6. Planning the payment of dividend to shareholders and interest to creditors- and

7. Easing the effects of insufficient cash balance.

Funds flow statement provides ready answer to the following questions:


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(a) Where did profits go?

(b) Why were dividends no larger in spite of adequate profits?

(c) How was it possible to pay dividends in excess of profits or despite a loss?

(d) How was working capital financed?

(e) How much capital was newly raised?

(f) Where was Increase in share capital utilised?

(g) Where is the value of fixed assets purchased?

(h) Whether the external financing was necessary to purchase assets?

(i) What are the sales proceeds of fixed assets sold? Why were they sold?

(j) How much debenture finance was currently raised? And why were the debentureissued? How were these capitals?

(k) What is the change in working capital?

(l) Why should be money borrowed to finance purchase of raw materials plant andmachinery

(m) How was the increase in working capital financed? Why are the net current assetsdecreased although the net profit has increased?

(n) Why are the net current assets decreased although the net profit has increased?

(o) Why are the net current assets increased although the net profit has increased?

(p) How was repayment of debit arranged?

(q) How was the expansion in a plant and equipment financed?

(r) How did the net worth increase?

(s) What happened to the assets that resulted from the increase of net worth?

Application of funds / Utilization of funds

The following are the purposes for which funds may be utilized:

(a) Purchase of fixed assets.


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(b) Purchase of investments.

(c) Increase of working capital.

(d) Redemption of preference share capital.

(e) Payment of loans & long-term debt.

(f) Non-trading payments like payment of equity dividends, interim dividend, andpreference dividends.

(g) Purchase of own debentures in the markets.

Limitations of funds:

(a) Non-fund transactions are ignored and hence it cannot provide full financial analysis

unless supported by ratio analysis etc.

(b) It is criticized for just re-arranging the financial information obtained from thefinancial statements.

(c) It does not give anything new or original over and financial statements.

(d) FFS is an historical statement and it does not indicate any price level changes.

(e) It does not show changes in working capital for which a separate statement has to beprepared.

These limitations should be taken into consideration while analysing thefunds flow statement:

(i) Not Fool-proof: The financial statement is not completely fool-proof, as it dependsupon conventional financial statement, viz., balance sheet, income statement, etc.

(ii) No Introduction of New Items: It does not introduce any new or original items whichcan enhance or reduce the financial data appearing elsewhere, that is, in theconventional financial statements and supplementary schedules and focus attention onthose facts which are significant for any investigation.

(iii) Not Relevant: A study of changes in cash is more relevant than a study in changes infunds.

(iv) Historical: The statement of changes, like other financial statements, is essentiallyhistorical in nature. It does not estimate sources and applications of funds for the nearfuture.


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(iii) Non-operating incomes such as dividend received or accrued rent. Theseitems increase funds but they are non-operating incomes. They will be shownunder separate heads as "sources of funds" in the Funds Flow Statement.

In case the Profit and Loss Account shows 'Net Loss' this should be taken as an item

which decreases the funds

Statement of Sources and Application of Funds:

1. Funds from Operations: It is an internal source of funds. Funds from operationsare to be calculated as per the method stated above.

2. Funds from long-term loans: Long-term loans such as debentures, borrowingsfrom financial institutions will increase the working capital and therefore, there will beinflow of funds. However, if the Debentures have been issued in consideration of somefixed assets, there will be no inflow of funds.

3. Sale of fixed assets: Sale of land, buildings, and long-term investments will resultin Generation of funds.

4. Funds from increase in share capital: Issue of shares for cash or for any othercurrent asset or in discharge of a current liability is another source of funds. Howevershares allotted in consideration of some fixed assets will not result in funds. However, itis recommended that such purchase of fixed assets as well as issue of securities to payfor them be revealed in Funds Flow Statement.

5. Decrease in Working Capital: Decrease in Working Capital is the result ofdecrease in current assets or increase in current liabilities. In both the cases in flow offunds takes place. Suppose stock, a current asset reduces from Rs.15,000 to Rs.12,000.The decrease of Rs.3,000 is assumed to be due to the disposal of stock, which wouldbring funds into the business. In the same way, increase in current liabilities meanslesser payment, so retaining funds is also a source.


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- End of Chapter -

LESSON 6

FUNDAMENTAL FLOW STATEMENT

Total Resources Basis

The preparation of the funds flow statements on total resources basis is fairly simple.The successive balance sheets are compared and changes in each balance sheet item isnoted and classified as a source of funds or a use of funds as follows:

Fundamental Flow Statement: Working Capital basis

The sources and uses of funds statement, on working capital basis, presents (i) thesources of working capital (ii) the uses of working capital, and (iii) the net change in


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working capital. Here, working capital is defined as the net working capital, which issimply the difference between current assets and current liabilities.

What are the sources of working capital? What are the users of working capital?

Sources of Working Capital:

The Sources of working capital are -

The operation of the business generates revenues and entails expenses. Revenuesaugment, working capital expenses, other than depreciation and other a motivations,decrease working capital. Hence the working capital increase on account of operations isequal to profit after tax + depreciation.

As issue of share capital results in an inflow of working capital because it brings cashinflow of an increase in short-term receivable.

When a long-term loan is taken there is an increase in working capital because of cashinflow. A short-term loan, however, does not have any effect on working capital. Why? Ashort-term loan increases a current asset (cash) and current liability (short-term loan)by the same amount, leaving the working capital position unchanged.

When a fixed asset, a long-term investment, or any other non-current asset is sold theredo cash or short-term receivables represent a working capital inflow?

Uses of Working Capital

The uses of Working capital are:

The payment of dividend results in a cash (working capital) outflow.

The repayment of long-term loans, debentures, and other long-term liabilities involvescash outflow and hence a use of working capital. The repayment of a current liability, itmay be noted, does not affect the working capital position because it entails an equalreduction in current liabilities and current assets.

When a firm purchases fixed assets, long-term investments, or other non-current assets,it pays cash or incurs a short-term debt. Hence, working capital decreases.

Funds Flow Statement: Cash basis

The sources and uses of funds statement, on cash basis shows (i) the sources of cash, (ii)the uses of cash, and (iii) the net change in cash. The sources of cash are sources ofworking capital plus changes within the working capital account, which augment thecash resources of the business. What are these working capital account changes? Theyare simply the decreases in current assets other than cash, of course. The uses of cash,again, are the uses of working capital plus changes within the working capital account,


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is an application of cash. A separate statement of changes in working capital is notrequired in this case. In addition to changes in current assets, changes in non-currentaccounts are also analysed to determine the inflow and outflow of cash.

Thus a cash flow statement is a financial statement indicating the increase or decreasein cash of a company during a period. It shows the inflow and outflow of cash during theperiod and finally the balance.

While preparing the cash flow statement, "actual cash concept" is used. Where theinformation regarding the actual cash inflow and outflow is not available, notional cashconcept can be used.

Cash Flow Statement for a Period


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The governing body of the Bombay Stock Exchange has amended Clause 32 of the listingagreement. The following new clause has substituted in its place:

"The company will supply a copy of the complete and full Balance Sheet, Profit and LossAccount and the Directors' Report to each shareholder and upon application to anymember of the Exchange. The company will also give a cash flow statement along withthe Balance sheet and profit and loss account. The cash flow statement will be preparedin accordance with the requirements prescribed by SEBI.

In view of this amendment, all listed Companies/Entities whose financial year-ends onMarch 1996 and thereafter will be required to give Cash Flow Statement along with

Balance Sheet and Profit and Loss Account. The above amendment comes into effectimmediately i.e. wef 15-2-1996.

The proforma of Cash Flow Statement is given below:

ABC LTD.

Cash flow statement for .


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A . Cash f l ow f r om oper a t i n g a ct i v i t i es

Net Profit before Tax and Extraordinary Items

Adjustments for;

depreciation

foreign exchange

investments

interest / dividend

Operating Profit Before Working Capital Change

Adjustments For;

Trade and Other Receivables

Inventories

Trade Payable

Cash Generated From Operations

Interest Paid

Direct Taxes Paid

Cash Flow Before Extraordinary Items

Extraordinary Items

Net Cash From Operating Activities

B . Cash F l ow F r om I n v est i n g Ac t i v i t i e s

Purchase of Fixed Assets

Sale of Fixed Assets

Acquisitions of Companies

(as Per Annexure)


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Purchase Of Investments

Sale Of Investments

Interest Received

Dividend Received

Net Cash Used In Investing Activities

C. Cash F l ow F r om F i n an c i n g Ac t i v i t i e s

Proceeds From Issue Of Share Capital

Proceeds From Long Term Borrowing

Repayment Of Finance Lease Liabilities

Dividends Paid

Net Cash Used In Financing Activities

Net Increase In Cash And Cash Equivalents

Cash And Cash Equivalents As At.

(Opening Balance)

Cash And Cash Equivalents As At .

(Closing Balance)

- End of Chapter -

LESSON 7

DIFFERENCES BETWEEN FUNDS FLOW AND CASH FLOW STATEMENTS


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DEFINITIONS

Cash comprises cash on hand and demand deposits.

Cash equivalentsare short-term, highly liquid investments that are readilyconvertible to known amounts of cash and which are subject to an insignificant risk ofchanges in value.

Cash flowsare inflows and outflows of cash and cash equivalents.

Operating activitiesare the principal revenue-producing activities of the enterpriseand other activities that are not investing or financing activities.

Investing activitiesare the acquisition and disposal of long -term assets and other

investments not included in cash equivalents.

Financing activitiesare activities that result in changes in the size and composition ofthe equity capital and borrowings of the enterprise.

OBJECTIVE


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Information about the cash flows of an enterprise in useful in providing users offinancial statements with a basis to assess the ability of the enterprise to generate cashand cash equivalents and the needs of the enterprise to utilize those cash flows. Theeconomic decisions that are taken by users require an evaluation of the ability of anenterprise to generate cash and cash equivalents and the timing and certainty of their

generation.

The objective of this standard is to require the provision of information about thehistorical changes in cash and cash equivalents of an enterprise by means of a cash flowstatement which classifies cash flows during the period from operating, investing andfinancing activities.

SCOPE

1. An enterprise should prepare a cash flow statement in accordance with therequirements of this Standard and should present it as an integral part of its financialstatements for each period for each period for which financial statements are presented.

2. This Standard supersedes International Accounting Standard IAS 7, Statement ofChanges in Financial Position Approved in July 1977.

3. Users of an enterprise's financial statements are interested in how the enterprisegenerates and uses cash and cash equivalents. This is the case regardless of the nature ofthe enterprise activities and irrespective of whether cash can be viewed as the product ofthe enterprise, as may be the case with a financial institution. Enterprises need cash foressentially the same reasons however different their principal revenue-producingactivities might be. They need cash to conduct their operations, to pay their obligations,and to provide returns to their investors. Accordingly, this Standard requires all

enterprises to present a cash flow statement.

BENEFITS OF CASH FLOW INFORMATION

A cash flow statement, when used in conjunction with the rest of the financialstatements, provides information that enables users to evaluate the changes in netassets of an enterprise, its financial structure (including its liquidity and solvency) andits ability to affect the amounts and timing of cash flows in order to adapt to changingcircumstances and opportunities. Cash flow information is useful in assessing the abilityof the enterprise to generate cash and cash equivalents and enables users to developmodels to assess and compare the present value of the future cash flows of different

enterprises. It also enhances the comparability of the reporting of operatingperformance by different accounting treatments for the same transactions and events.

Historical cash flow information is often used as an indicator of the amount, timing andcertainty of future cash flows. It is also useful in checking the accuracy of pastassessments future cash flows and in examining the relationship between profitabilityand net cash flow and the impact of changing prices.


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The following are the uses of cash flow analysis:

1. It is very helpful in understanding the cash position of a firm. Since cash is the basisfor carrying on business operations, the cash flow statements is very useful in evaluatingthe current cash position.

2. It helps the management to understand the past behavior of the cash cycle, and tocontrol the uses of cash in future.

3. The repayment of loans, replacement of assets and other such programmes can beplanned on its basis.

4. It throws light on the factors contributing to the reduction of cash balance in spite ofincrease in income or vice-versa.

5. A comparison of the cash flow statement with the cash budget for the same periodhelps in comparing and controlling cash expenditure.

6. The cash flow statement is helpful in making short-term financial decisions relating toliquidity, and the ways and means position of the firm.


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- End of Chapter -

LESSON - 8

PREPARATION OF CASH FLOW ANALYSIS

Steps in the Preparation of Cash Flow Analysis:

Cash flow statement takes into account only those transactions which result in

immediate inflow and outflow of cash. The preparation of cash flow statement involvesthe following stapes.

1. Calculation of cash from operations.

(a) Operational profit.

(b) Changes in the current assets and current liabilities.


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2. Changes in non-current liabilities, i.e. share capital, debentures, loans, andmortgages.

3. Changes in non-current assets i.e. building, plant, machine and furniture etc.

CASH FROM OPERATIONS

It includes cash received against profit and inflow or outflow of cash due to change incurrent assets and current liabilities. Calculation of cash from operation involves thefollowing:

Calculation of Operational profit:

Excess of current years profit over the previous year's profit is assumed to be in theform of cash, if all transactions are in cash. It should be, noted that profit here meansoperating net profit. While calculating this operating net profit we have to take intoaccount only operating income and operating expenses will be added to it and non-operation income are to be deducted. In case of adjustment it is advisable to prepareadjusted profit and loss account and calculate profit from operation in the same way, aswe do calculate in case of 'Funds Flow Statement'. The following adjustments are to bemade to the net profit:

Non -ope r a t i ng Expenses: These expenses do not result in outflow of cash but thenet profit is reduced due to the effect of these expenses. In other words, cash fromoperation increases in comparison to profit.

Dep r e c i a t i o n : Depreciation is charged on fixed assets. It appears at the debit side ofprofit and loss a/c and thus reduces profit. Depreciation is non-cash item, so it does notreduce cash. In order to ascertain operating profit depreciation will be added to netprofit. When preparing profit and loss account to find out profit earned during the year,the depreciation account will be written at the debit side of profit and loss a/c.

Am o r t i s a t i o n o f i n t a n g i b l e a s set s : Intangible assets consist of those assets, whichcannot be seen or touched. These assets are goodwill, patents right and trademarks etc.In order to calculate cash generated from operations, we have to add back these items tothe profit made during the year. In case of preparing adjusted profit and loss accountintangible assets written off is posted at the debit side to calculate profit earned duringthe year.

Am o r t i s a t i o n o f de f er r ed ex pen s es : These expenses are actually revenueexpenditure but they are capitalised and written off over certain year's preliminaryexpenses, discount or loss on issue of shares, debentures and deferred revenueexpenditure. When these assets are written off, they are charged out of profit and lossaccount and thus reduce profit. Cash will not be reduced. It is, therefore, necessary thatthe amount written off for these assets should be added to profit to find out the profitearned during the year.


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L oss on sa l e o f f i xed a sset s: The profit of the year will reduce with this loss but cashwill not reduce. It is, therefore necessary that this item should be added to the profit toascertain the amount of operating profit.

P r o v i si o n f o r d oub t f u l d eb t s and d i scoun t on debt o r s : This provision reduces

profit without reducing cash. As such the item should be added to profit ascertain theoperating net profit.

Crea t i on o f r eser v es: Certain reserves and funds are created to meet certain knownor unknown liabilities. These reserve and funds may be general reserve, reserve fund,sinking fund, capital redemption reserve, dividend equalization and workmencompensation funds etc. These funds are charged out of profit and loss a/c so theyreduce profit. These are not cash items, so the outflow of cash does not take place. Inorder to calculate operating net profit these reserves and funds are added to profit tocalculate operating net profit.

Non-operating income:

Income not concerned with the day-to-day affairs of the business is known as not-operating income. Profit or gain on sale of fixed assets, refunds of taxes, receipts ofinterest, dividend and compensation are the examples of the non-operating income.These items are posted at the credit side of profit and loss account, so they increaseprofit of the business without increasing cash balance. Non-operating income should bededucted from profit to find out operating net profit.

Chan ges i n t h e cu r r en t l i a b i l i t i es an d cu r r en t a sset s ( excep t cash ) : Currentassets consist of debtors, stock, bills receivable prepaid expenses, accrued income,short-term investment, etc. Values of individual current assets may either increase or

decrease.

Chan ges i n N on - cu r r en t l i a b i l i t i es : Changes in non-current liabilities may alsoresult in inflow and outflow of cash. Inflow of cash will takes place in the followingcases.

I ssue o f sh a r es o r i n c r ease i n cap i t a l : Increase in the value of share capital duringthe current year in comparison to previous year is supposed to be the issue of shares,which will undoubtedly bring cash into business and inflow of cash will take place.

I ssue o f D eben t u r es: If additional debentures have been issued during the current

ear, inflow of cash will take place. Increase the balance of debenture current year ascompared to the previous year is assumed to be issue of debentures.

I n cr ea se i n l o a n o r m o r t g a g e : If the balance of loan or mortgage increases duringthe current year, it will be assumed that additional loans have been borrowed and cashflow inside the business has taken place.


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The change in the value of non-current liabilities will result in the outflowof cash in the following cases:

Redem p t i o n o f Sha r e cap i t a l o r decr ea se i n s ha r e cap i t a l : In certain casescompany redeems its redeemable preference shares and thus outflow of cash takes

place. Decrease in the balance of capital during the current year is assumed to be theredemption.

Repay m en t o f deben t u r es : Debentures are the loans taken by the company. Thesedebentures are redeemed as per the terms of issue. Redemption of debentures results inoutflow of cash. Decrease in the value of debentures is assumed to be payment ofdebentures.

De cr ea se i n l o a n o r m o r t g a g e : In case of payment of loan or mortgage, cash willreduce and outflow of cash will takes place. .

Pa ym en t o f t a x a n d d i v i d en d : Payment of taxes and dividend is the normal featureof the company. Whenever taxes and dividends are paid cash goes outside the business.If the balance of provision for taxation regarding previous and current years is given, itmay be assumed that the previous year's provision of taxes has been paid during thecurrent year. In case of adjustment, provision fox tax account is prepared to calculatethe amount of taxes paid during the year. The same treatment is accorded to dividend.

Changes in Non-current Assets:

Change in non-current assets generally fixed assets also results in inflow or outflow ofcash.

Sa l e o r decr ease i n th e va l u e o f f i xed asse t s: Sometimes the company sells a partof its land, building, plant, machinery, furniture and vehicles etc. The sale fetches cashand inflow of cash takes place. Decrease in the value of fixed assets is assumed to be itssales.

Ca sh f r om o p er a t i o n s : Cash from operations: Cash from operations for the purposeof cash flow statement is the net flow (i.e., the difference between total receipts and totalpayments). Funds from operations represent the net flow in a rough way. Furtheradjustments as discussed above are required to arrive at the net flow of cash. This istabled below:


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PREPARATION OF CASH FLOW STATEMENT

The cash flow statement is prepared starting with cash balance at the beginning of theyear. To the opening balance, cash from operations and other inflows from long-term

assets and liabilities are to be added. Items to be deducted are those involving outflow-closing balance of cash. The format of cash flow statement is given below.


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The Funds Flow Statement for Excellent Limited for the year ended 31.3.1992 is given asfollows:

2. The Comparative Balance Sheets of XYZ Company are given below:

The income statement for XYZ Limited for 1991 is given below:


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a) Prepare a Sources and Uses of Funds Statement on total resources basis.

b) Prepare a Sources and Uses of Funds Statement on working capital basis.

Solution

Funds flow statement (total resources basis) for XYZ company for the year ended 1991:

Funds Flow Statement (working capital basis) for XYZ Limited for the year ended 1991:


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Solution:

4. A company had the following transactions during the year ended 31 July, 1989:

Rs.

(i) The Profit before Tax amounted 38,0000


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(ii) New equipment purchased on cash down basis 1,20,000

(iii) Bank loan raised from Bank of Baroda 1,00,000

(iv) Dividends paid to stockholders 50,000

(v) Insurance premium 10,000

There was an increase in accounts receivable by Rs.10,000. Land was sold forRs.1,00,000. Expenditure incurred on repairs amounted to Rs.5,000. You are requiredto prepare a statement of Sources and Uses of Funds for the company for the yearending 31st July, 1989.

Solution:

Note: the total of all sources arrives at Rs.2,38,000. However, the total use, exceptingcash, comes to Rs.1,95,000. Difference between these two amounts (Rs.2,38,000 Rs.1,95,000) is the increase in cash amounting to Rs.43,000 as indicated above.

5. The Comparative Balance Sheets of Excellent Ltd. are given below:


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(i) The net profit for the year after adjustment in respect of provision for dividendstaxation was Rs.10,00,000

(ii) There was addition to fixed assets during the year amounting to Rs.4,00,000 anddepreciation for the year was Rs.3,00,000

Prepare Statement of changes in Working Capital and Funds Flow Statement.

Solution:


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EXERCISES

1.From the following Profit and Loss A/C of Finolex Ltd., calculate funds fromoperations of business.

2. Calculate funds from operations from the following P & L account of Apple Ltd.


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3. Following are the summarized balance sheets of Modi Ltd as on 31stDecember 1994and 31stDecember 1995:

Calculate funds from operations.

4. From the following balance sheets of PAL Ltd. as on 31stMarch 1995 and 1996,prepare (i) a schedule of changes in working capital, and (ii) Statement of Sources andApplication of Funds for the year ended 31stMarch 1996.


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4. Calculate funds from operations from the following P&L account of Apple Ltd.

5. Following are the summarized balance sheets of Modi Ltd as on 31stDecember 1995and 1996.

Prepare a statement of changes in working capital.

6. What are the sources of working capital? What are the uses of working capital?

7. Funds flow statement presents a decisional view of business. Comment.

8. Discuss the salient features of the format for the cash flow statement recommendedby Institute of Chartered Accountants of India.


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- End of Chapter -

LESSON - 9

CAPITAL MARKET

A good capital market is an essential pre-requisite for industrial and commercialdevelopment of a country. Credit is generally, required and supplied on short-term andlong term basis. The money market caters to the short-term needs only. The capitalmarket meets the long-term capital needs. Capital market is a central coordinating and

directing mechanism for free and balanced flow of financial resources into the economicsystem operating in a country.

The development of a good capital market in a country is dependent upon theavailability of savings, proper organization of its constituent units and theentrepreneurship qualities of its people. Before independence, the capital market ofIndia was ill-developed because of its certain defects. But in recent years sinceindependence, the capital market of India has substantially changed and has beenchanging for the better.

What is Capital Market?

The term 'capital market' refers to the institutional arrangements for facilitating theborrowing and lending of long-term funds. In the widest sense, it consists of a series ofchannels through which the savings of the community are made available for industrialand commercial enterprises and public authorities. It is concerned with those privatesavings, individual as well as corporate, that are turned into investments through newcapital issues and also new public loans floated by government and semi-governmentbodies.

A capital market may be defined as an organized mechanism for effective and efficienttransfer of money-capital or financial resources form the investing parties, i.e.,individuals or institutional savers to the entrepreneurs (individuals or institutions)

engaged in industry or commerce in the business would either be in the private or publicsectors of an economy.

Objectives and importance of capital market

An efficient capital market is a pre-requisite of economic development. An organizedand well-developed capital market operating in a free market economy (i) ensures bestpossible coordination and balance between the flow of savings on the one hand and the


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flow of investment leading to capital formation on the other; (ii) directs the flow ofsavings into most profitable channels and thereby ensures optimum utilization offinancial resources.

Thus, an ideal capital market is one where finance is used as a handmaid to serve the

needs of industry. Finance is available at a reasonable rate of return for any proposition,which offers a prospective yield sufficient to make borrowing worthwhile thedevelopment of savings proper organization of intermediary institutions and theentrepreneurial qualities of the people. The capital market must facilitate the movementof capital to the point of highest yield. Thus a capital market strives for the mobilizationand import of foreign capital and investment to augment the deficit in the requiredfinancial resources so as maintain the expected rate of economic growth.

Importance:The pace of economic development is conditioned, among other thingsby the rate of long-term investment and capital formation. And capital formation isconditioned by the mobilization, augmentation and canalization of invisible funds. Thecapital market serves a very useful purpose by pooling the capital resources of thecountry and making them available to the enterprising investors. Well-developed capitalmarkets augment resources by attracting and lending funds on a global scale. TheEuro-currencyandEuro-bondmarkets are international finance markets in terms of both thesupply and demands for funds.

The increase in the size of the industrial units and business corporations due totechnological developments, economies of scale and other factors has created a situationwhere the capital at the disposal of one or few individuals is quite insufficient to meetthe investment demands. A developed capital market can solve this problem of paucityof funds. For an organized capital market can mobilize and pool to gather even the smalland scattered savings and augment the availability of ingestible funds. While the rapid

growth of joint stock companies has been made possible to a large extent by the growthof joint stock business, it has in its turn encouraged the development of capital markets.

A developed capital market provides a number of profitable investment opportunitiesfor the small savers.

Recent development in the Indian capital market

A number of developments have taken place in the Indian Capital Market with thelaunching of financial reforms since July 1991. In the process, the capital market isbeing built. Some of the important developments that have taken place in the Indian

capital market during the last few years are as below:

Year 1992

(1) Ordinance promulgated according statutory powers to the Securities and ExchangeBoard of India (SEBI) as a regulatory authority over various constituents of the capitalmarket.


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(2) CCI abolished and free pricing introduced.

(3) The Center Exchange of India begins operations as a second-tier course permittingsmaller companies to raise funds.

(4) Insider trading made an offence.

Year 1993

(5) A number of private sectors Mutual Funds launched schemes to mobilize fund forinvestment.

(6) Increase in minimum number of share applications and proportionate basis ofallotment introduced.

(7) Capital adequacy norms for brokers announced.

(8) Ordinance to amend FERA promulgated on January 8, 1993

(9) Foreign Institutional Investors (Floss) registered by SEBI

Year 1994

(10) National Stock Exchange (NSE) begins on line scrip-less trading in India.

(11) Private placement of issues with FIIs begins.

These developments have given rise to a number of new financial intermediaries in theIndian capital market. The important ones include (i) Merchant Banking; (ii) MutualFunds; (iii) Leasing and Hire Purchase Companies; and (iv) Venture Capital Companies.

The Indian capital market has undergone remarkabl

financial analysis and industrial financing

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