UNIT - III: FINANCIAL ANALYSIS: Analysis and Interpretation of Financial statements from investor and company point of view- Horizontal Analysis and Vertical Analysis of Company Financial Statements – Ratios (Conversion of ratios) - Liquidity – Leverage - Solvency and Profitability ratios -Statement of Changes in Working Capital - Funds from Operations Funds Flow & Cash Flow statements - Pre packaged Accounting software - Extensive Business Reports Language (XBRL).

1. UNIT-III
FINANCIAL ANALYSIS
FINANCIAL ANALYSIS: Analysis and Interpretation of Financial statements from
investor and company point of view - Horizontal Analysis and Vertical Analysis of Company
Financial Statements – Ratios (Conversion of ratios) - Liquidity – Leverage - Solvency and
Profitability ratios - Statement of Changes in Working Capital - Funds from Operations Funds
Flow & Cash Flow statements - Pre packaged Accounting software - Extensive Business Reports
Language (XBRL).
INTRODUCTION
The term financial statements generally refers to two basic statements
(i) The Income Statement, and (ii) The Balance Sheet. Of course, a business may
also prepare a Statement of Retained Earnings, and a Statement of Changes in financial
Position in addition to the above two statements.
Financial statements are prepared primarily for decision-making. They play a
dominant role in setting the framework of managerial decisions. But the information provided
in the financial statements is not an end in itself as no meaningful conclusions can be drawn
from these statements alone. However, the information provided in the financial statements is
of immense use in making decisions through analysis and interpretation of financial
statements. Financial analysis is the process of identifying the financial strengths and
weaknesses of the
Firm by properly establishing relationship between the items of the balance
sheet and the profit and loss account. There are various methods or techniques used in
analyzing financial statements, such as comparative statements, common-size statements,
trend analysis, and schedule of changes in working capital, funds flow, cash flow analysis and
ratio analysis.
MEANING OF ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS
An analysis of financial statements is the process of critically examining in detail
accounting information given in the financial statements. For the purpose of analysis, individual
items are studied, their interrelationships with other related figures are established, the data is
sometimes rearranged to have better understanding of the information with the help of
different techniques or tools for the purpose. Analyzing financial statements is a process of
evaluating relationship between component parts of financial statements to obtain a better
understanding of firm's position and performance. The analysis of financial statements thus
refers to the treatment of the information contained in the financial statements in a way so as
to afford a full diagnosis of the profitability and financial position of the firm concerned. For
this purpose financial statements are classified methodically, analyses and compared with the
figures of previous years or other similar firms.
The term 'Analysis' and 'interpretation' though are closely related, but distinction
can be made between the two. Analysis means evaluating relationship between components of

2. financial statements to understand firm's performance in a better way. Various account
balances appear in the financial statements. These account balances do not represent
homogeneous data so it is difficult to interpret them and draw some conclusions. This requires
an analysis of the data in the financial statements so as to bring some homogeneity to the
figures shown in the financial statements. Interpretation is thus drawing of inference and
stating what the figures in the financial statements really mean. Interpretation is dependent on
interpreter himself. Interpreter must have experience, understanding and intelligence to draw
correct conclusions from the analyzed data.
OBJECTIVES OF FINANCIAL ANALYSIS
1. Assessment of past performance:
Past performance is a good indicator of future performance. Investors and creditors are
interested in the trend of past sales, cost of goods sold, operating expenses, net income, cash
flows and return on investment. These trends offer a means for judging managements past
performance and are possible indicators of future performance.
2. Assessment of current position:
Financial statement analysis shows the current position of the firm in terms of the types of
fixed assets owned by a business firm and the different liabilities due against the enterprise.
3. Prediction of profitability and growth prospects:
Financial statement analysis helps in assessing and predicting the earning prospects and
growth rates in earning which are used by investors while comparing investment alternatives
and other users in judging earning potential of business enterprise.
4. Prediction of bankruptcy and failure:
Financial statement analysis is an important tool in assessing and predicting bankruptcy and
probability of business failure.
5. Assessment of the operational efficiency:
Financial statement analysis helps to assess the operational efficiency of the management of a
company. The actual performance of the firm which are reveled in the financial statements can
be compared with some standards set earlier and the deviation of any between standards and
actual performance can be used as the indicator of efficiency of the management.
Advantages of Financial Statement Analysis
1. Measuring short term solvency:
Whether the firm is in a position to pay its short term liabilities or not, this can be judged
by analyzing its financial statements. If the information is positive, the creditors would like
to lend and financially the firm is considered as solvent.
2. Measuring long- term solvency:
Whether the firm is in a position to meet its long term obligations or not, this can again be
studied from the analysis of financial statements. Long term liabilities mean debentures
and other secured loans. Both the debentures holders and lenders of money are interested
to have interest and safety of return of their investment in the form of loans given to the
business.
3. Measuring operationally efficiency:
Whether the business is running at a profit or loss can be made clear only from the analysis
of financial statements. If there is any loss, corrective steps may be taken to wipe off
losses, if any or minimize it in order to make it a viable business.
4. Measuring Profitability:
Financial statement analysis is used to ascertain its earning capacity as well as prediction
relating to its future earnings. This sort of information can be inferred from the financial
analysis. Which may be used by the investors, in general and financial institutions, in

3. particular? Thus, analysis of financial statements helps in measuring profitability of the
business.
5. Comparison of inert firm position:
The analysis of financial statements makes it possible for an analyst to compare inert-firm
position and draw necessary conclusions relating to financial soundness etc.
6. Forecasting, Budgeting and Declining future line of action:
Analysis of financial statement predicts the growth potential of the business. Comparison
of actual performance with the desired performance shows our shortcomings. The analysis
provides sufficient information regarding the profitability, performance and financial
soundness of the business. On the basis of these information’s one can make effective
forecasting, budgeting and planning.
Disadvantages of Financial Statement Analysis
The disadvantages of financial statement analysis are as follows:
1. Absence of standard universally accepted terminology:
Accounting is not an exact science. It does not have standard universally accepted
terminology.
2. Ignoring qualitative aspects:
Financial analysis does not measure the qualitative aspects of the business. It is the
quantitative measurement of performance.
3. Result in absent of absolute data:
Results shown by financial analysis may be misleading in the absence of absolute data.
4. Ignoring price level changes:
The comparability of ratios suffers if the prices of the commodities in two different years
are not the same. Change in price affects the cost of production, sales and also the value of
assets.
5. Suffering statements are affected by the personal ability and bias of analyst:
Financial statement suffers from variety of weaknesses. Balance sheet is prepared on
historical record of the value of assets.
6. Financial statements are affected by window dressing:
The management displays rosy picture of the enterprise through financial statements.
Sometimes material information is considered.
7. Suffering from limitations of financial statements:
The figures of financial statements do not speak themselves. This information are analyzed
an interpreted by shrewd analyst, who may have their own views, reflected in the analysis.
8. Financial analysis is only a tool, not the final remedy:
Analysis of statement is a tool to measure the profitability, efficiency and financial
soundness of the business. It should be noted that personal judgment of the analyst are
most important in financial analysis.
9. Financial analyst spots the symptoms but does not arrive at diagnosis:
Financial analysis shows the trend of the affairs of the business. It may spot symptoms of
financial unsoundness and operational in-efficiency but that cannot be accepted.

4. TOOLS OF FINANCIAL ANALYSIS
Financial Analyst can use a variety of tools for the purposes of analysis and interpretation of financial
statements particularly with a view to suit the requirements of the specific enterprise. The principal tools are as
under:
 Comparative Financial Statements
 Common-size Statements
 Trend Analysis
 Cash Flow Statement
 Ratio Analysis
 Funds Flow statements
Comparative Financial Statements: Comparative financial statements are those statements which
have been designed in a way so as to provide time perspective to the consideration of various elements of
financial position embodied in such statements. In these statements figures for two or more periods are placed
side by side to facilitate comparison.
Both the Income Statement and Balance Sheet can be prepared in the form of Com-parative Financial
Statements.
a) Comparative Income Statement
The comparative Income Statement is the study of the trend of the same items/group of items in two
or more Income Statements of the firm for different periods. The changes in the Income Statement items over
the period would help in forming opinion about the performance of the enterprise in its business operations.
The Interpretation of Comparative Income Statement would be as follows:
The changes in sales should be compared with the changes in cost of goods sold. If increase in
sales is more than the increase in the cost of goods sold, then the profitability will improve.
An increase in operating expenses or decrease in sales would imply decrease in operating profit
and a decrease in operating expenses or increase in sales would imply increase in operating profit.
The increase or decrease in net profit will give an idea about the overall profitability of the
concern.
Illustration 1 : The Income Statement of Sumit Ltd. are given for the years 2001 and 2002. Rearrange
the figures in a comparative form and study the profitability position of the firm:
Items 2001 (Rs.) 2002 (Rs.)
Net Sales 17,00,000 22,00,000
Less Cost of Goods Sold 12,00,000 15,00,000
Gross Profit 5,00,000 7,00,000

5. Less Operating Expenses
(Administration, Selling Distribution Expenses) 75,000 1,00,000
Operating Profit 4,25,000 6,00,000
Add Other Incomes 25,000 40,000
Earnings before Interest & Tax 4,50,000 6,40,000
Less Interest 40,000 40,000
Earnings before Tax 4,10,000 6,00,000
Less Tax Payable 84,000 1,60,000
Profit after Tax 3,26,000 4,40,000
Solution:
Comparative Income Statement
For the year ended 31st March, 2001 and 2002
Items 31.03.01 31.03.02 Increase Percentage
Rs. Rs. (Decrease) Increase
(Rs.) (Decrease)
Net Sales 17,00,000 22,00,000 5,00,000 29.41
Less Cost of Goods Sold 12,00,000 15,00,000 3,00,000 25.0
Gross Profit 5,00,000 7,00,000 2,00,000 40.0
Less Operating Expenses
(Administration Selling & Distribution
Expenses) 75,0000 1,00,000 25,000 33.3
Operating Profit 4,25,000 6,00,000 1,75,000 41.17
Add Other Incomes 25,000 40,000 15,000 60.0
Earnings before Interest & Tax 4,50,000 6,40,000 1,90,000 42.2
Less Interest 40,000 40,000 – –
Earnings before tax 4,10,000 6,00,000 1,90,000 46.34
Less Tax 84,000 1,60,000 76,000 90.5
Earnings after Tax 3,26,000 4,40,000 1,14,000 34.97
b) Comparative Balance Sheet
The comparative Balance Sheet analysis would highlight the trend of various items and groups of
items appearing in two or more Balance Sheets of a firm on different dates. The changes in periodic balance
sheet items would reflect the changes in the financial position at two or more periods. The Interpretation of
Comparative Balance Sheets are as follows:

6. The increase in working capital would imply increase in the liquidity position of the firm over the
period and the decrease in working capital would imply deterioration in the liquidity position of the firm.
An assessment about the long-term financial position can be made by studying the changes in
fixed assets, capital and long-term liabilities. If the increase in capital and long-term liabilities is more than the
increase in fixed assets, it implies that a part of capital and long-term liabilities has been used for financing a
part of working capital as well. This will be a reflection of the good financial policy. The reverse situation will be
a signal towards increasing degree of risk to which the long-term solvency of the concern would be exposed to.
The changes in retained earnings, reserves and surpluses will give an indication about the trend in
profitability of the concern. An increase in reserve and surplus and the Profit and Loss Account is an indication
of improvement in profitability of the concern. The decrease in these accounts may imply payment of
dividends, issue of bonus shares or deterioration in profitability of the concern.
Illustration 2 : From the following Balance Sheets of Ram Ltd. as on 31st December,
2000 and 2001, prepare a comparative Balance Sheet for the concern :
Balance Sheet of Ram Ltd. as on
Liabilities 2000 (Rs.) 2001(Rs.) Assets 2000(Rs.) 2001Rs.)
Equity share capital 5,00,000 6,00,000 Land & Building 4,00,000 3,50,000
Reserves & surpluses2,00,000 1,00,000 Plant & Machinery 2,40,000 2,90,000
Debentures 1,00,000 1,50,000 Furniture 25,000 30,000
Mortgage loan 80,000 1,00,000 Bills receivables 75,000 45,000
Bills Payable 30,000 25,000 S. Debtors 1,00,000 1,25,000
S. Creditors 50,000 60,000 Stock 1,13,000 1,72,000
Other current Liabilities5,000 10,000 Prepaid Expenses 2,000 3,000
Cash & Bank Balance 10,000 30,000
9,65,000 10,45,000 9,65,000 10,45,000
Solution :
Comparative Balance Sheet of Ram Ltd.
Item Year Ending Increase Increase/
31.12.2000 31.12.2001 (Decrease) (Decrease)
(Rs.) (Rs.) (Rs.) (Percentage)
Fixed Assets
Land & Building 4,00,000 3,50,000 (50,000) (12.5)
Plant & Machinery 2,40,000 2,90,000 50,000 20.83
Furniture 25,000 30,000 5,000 20.0
Total Fixed Assets 6,65,000 6,70,000 5,000 0.75

7. Current Assets
Bills receivable 75,000 45,000 (30,000) (40.0)
S. Debtors 1,00,000 1,25,000 25,000 25.0
Stock 1,13,000 1,72,000 59,000 52.2
Prepaid Expenses 2,000 3,000 1,000 50.0
Cash & Bank Balance 10,000 30,000 20,000 200.0
Total Current Assets 3,00,000 3,75,000 75,000 25.0
Total Assets 9,65,000 10,45,000 80,000 8.29
Shareholders' Funds
Equity Share Capital 5,00,000 6,00,000 1,00,000 20.0
Reserves & Surpluses 2,00,000 1,00,000 (1,00,000) (50.0)
Total Shareholders’ Funds 7,00,000 7,00,000 00,000 0.0
Long-Term Loans
Debentures 1,00,000 1,50,000 50,000 50.0
Mortgage Loan 80,000 1,00,000 20,000 25.0
Total Long-Term Loans 1,80,000 2,50,000 70,000 38.9
Current Liabilities
Bills Payable 30,000 25,000 (5,000) (16.7)
S. Creditors 50,000 60,000 10,000 20.0
Other Current Liabilities 5,000 10,000 5,000 100.0
Total Current Liabilities 85,000 95,000 10,000 11.8
Total Liabilities 9,65,000 10,45,000 80,000 8.29
Common-size Financial Statements: Common-size Financial Statements are those in which figures
reported are converted into percentages to some com-mon base. In the Income Statement the sale figure is
assumed to be 100 and all figures are expressed as a percentage of sales. Similarly in the Balance sheet the
total of assets or liabilities is taken as 100 and all the figures are expressed as a percentage of this total.
a) Common Size Income Statement
In the case of Income Statement, the sales figure is assumed to be equal to 100 and all other figures
are expressed as percentage of sales. The relationship between items of Income Statement and volume of sales
is quite significant since it would be helpful in evaluating operational activities of the concern. The selling
expenses will certainly go up with increase in sales. The administrative and financial expenses may go up or
may remain at the same level. In case of decline in sale, selling expenses should definitely decrease.
Illustration 3 : From the following Profit and Loss Accounts and the Balance Sheets of Swadeshi
Polytex Ltd. for the year ended 31st December 2000 and 2001, you are required to prepare common size
statements.
Profit and Loss Account

8. Particulars 2000 2001 Particulars 2000 2001
Rs. Rs. Rs. Rs.
To Cost of Goods sold 600 750 By Net Sales 800 1,000
To Operating Expenses :
Administration Expenses 20 20
Selling Expenses 30 40
To Net Profit 150 190
800 1,000 800 1,000
Balance Sheet
As on 31st December
(in lakhs of Rs.)
Liabilities 2000 2001 Assets 2000 2001
Bills Payable 50 75 Cash 100 140
Sundry Creditors 150 200 Debtors 200 300
Tax Payable 100 150 Stock 200 300
14% Debentures 100 150 Land 100 100
16% Preference Capital 300 300 Building 300 270
Equity Capital 400 400 Plant 300 270
Reserves 200 245 Furniture 100 140
1,300 1,520 1,300 1,520
Solution :
Swadeshi Polytex Limited
COMMON-SIZE INCOME STATEMENT
For the years ended 31st December 2000 and 2001
(Figures in percentages)
Particulars 2000 2001
Net Sales 100 100
Cost of Goods Sold 75 75
Gross Profit 25 25
Operating Expenses :
Administration Expenses 2.50 2
Selling Expenses 3.75 4
Total Operating Expenses 6.25 6
Operating Profit 18.75 19
Interpretation: The above statement shows that though in absolute terms, the cost of goods sold has
gone up, the percentage of its cost to sales remains consis-tent at 75%. This is the reason why the Gross Profit
continues at 25% of sales. Similarly, in absolute terms the amount of administration expenses remains the
same but as percentage to sales it has come down by 5%. Selling expenses have increased by 25%. This all leads
to net increase in net profit by 25% (i.e., from 18.75% to 19%).

9. Common Size Balance Sheet
For the purpose of common size Balance Sheet, the total of assets or liabilities is taken as 100 and all
the figures are expressed as percentage of the total. In other words, each asset is expressed as percentage to
total assets/liabilities and each liability is expressed as percentage to total assets/liabilities. This statement will
throw light on the solvency position of the concern by providing an analysis of pattern of financing both long-
term and working capital needs of the concern.
Swadeshi Polytex Limited
COMMON-SIZE BALANCE SHEET
For the years ended 31st December 2000 and 2001
(Figures in percentage)
2000 2001
Assets 100 100
Current Assets :
Cash 7.70 9.21
Debtors 15.38 19.74
Stock 15.38 19.74
Total Current Assets 38.46 48.69
Fixed Assets :
Building 17.7623.07
Plant 27.03 17.76
Furniture 7.70 9.21
Land 7.70 6.68
Total Fixed Assets 61.54 51.31
Total Assets 100 100
2000 2001
% %
Liabilities and Capital 100 100
Current Liabilities :
Bills Payable 3.84 4.93
Sundry Creditors 11.54 13.16
Taxes Payable 7.69 9.86
Total Current Liabilities 23.07 27.95
Long-term Liabilities :
14% Debentures 7.69 9.86
Capital & Reserves :
16% Preference Share Capital 23.10 19.72
Equity Share Capital 30.76 26.32
Reserves 15.38 16.15
Total Shareholder’s Funds 76.93 72.05
Total Liabilities and Capital 100 100

10. Interpretation: The percentage of current assets to total assets was 38.46 in 2000. It has gone up to
48.69 in 2001. Similarly the percentage of current liabilities to total liabilities (including capital) has also gone
up from 23.07 to 27.95 in 2001. Thus, the proportion of current assets has increased by a higher percentage
(about
as compared to increase in the proportion of current liabilities (about 5). This has improved the
working capital position of the company. There has been a slight deterioration in the debt-equity ratio though
it continues to be very sound. The proportion of shareholder’s funds in the total liabilities has come down from
69.24% to 62.19% while that of the debenture-holders has gone up from 7.69% to 9.86%.
3. Trend Analysis
The third tool of financial analysis is trend analysis. This is immensely helpful in making a comparative
study of the financial statements of several years. Under this method trend percentages are calculated for each
item of the financial statement taking the figure of base year as 100. The starting year is usually taken as the
base year. The trend percentages show the relationship of each item with its preceding year's percentages.
These percentages can also be presented in the form of index numbers showing relative change in the financial
data of certain period. This will exhibit the direction, (i.e., upward or downward trend) to which the concern is
proceeding. These trend ratios may be compared with industry ratios in order to know the strong or weak
points of a concern. These are calculated only for major items instead of calculating for all items in the financial
statements.
While calculating trend percentages, the following precautions may be taken :
The accounting principles and practices must be followed constantly over the period for which the
analysis is made. This is necessary to maintain consistency and comparability.
The base year selected should be normal and representative year.
Trend percentages should be calculated only for those items which have logical relationship with
one another.
Trend percentages should also be carefully studied after considering the absolute figures on which
these are based. Otherwise, they may give misleading conclusions.
To make the comparison meaningful, trend percentages of the current year should be adjusted in
the light of price level changes as compared to base year.
Illustration 4 : Interpret the results of operations of a trading concern using trend ratios, on the
following information :
(Amount in '000 Rupees)
For the year ended 31st March
Items 2001 2000 1999 1998
Sales (net) 13,000 12,000 9,500 10,000
Cost of goods sold 7,280 6,960 5,890 6,000

11. Gross Profit 5,720 5,040 3,610 4,000
Selling Expenses 1,200 1,100 970 1,000
Net Operating Profit 4,520 3,940 2,640 3,000
Solution :
Trend Ratios
31st March, 1998=100
Items 1998 1999 2000 2001
Sales 100 95 120 130
Gross of Goods sold 100 98 116 121
Gross Profit 100 90 126 143
Selling Expenses 100 97 110 120
Net Operating Profit 100 88 131 150
Interpretation
From the above statement the following points are worth noting :
The sales volume, cost of goods sold and selling expenses all declined in 1999 as compared to
1998 but the decrease in cost of goods sold and selling expenses was lesser to the decrease in sales volume.
The sales volume cost of goods sold and selling expenses in 2000 and 2001 have increased in
comparison to 1998 but the increase in cost of goods sold and selling expenses is lesser to the increase in sales
volume.
In conclusion, it can be said that a large proportion of cost of goods sold and selling expenses is fixed
and is not affected by changes in sales volume. This fact also becomes clear from this fact that in 1999 when
sales fell down, the decrease in the company's net operating profit was faster to sales volume and in 2001
when the sales volume increased; the increase i
Ratio Analysis
Ratio analysis is the most popular technique of financial analysis. It is “the
technique of analyzing and interpreting financial statements with the help of accounting
ratios”. A ratio is a mathematical relationship between two items expressed in
quantitative forms. It may be defined as the indicated quotient of two mathematical
expressions. But a financial ratio is the relationship between two accounting figures
expressed mathematically.
A ratio may be expressed in three methods. They are:
(i) Simple or pure Ratio:

12. Simple or pure ratios are expressed by the simple division of one number by
another. Current ratio is the most commonly used pure ratio.
Current Ratio=Current Assets/Current Liabilities
Ex: Current Assets-Rs. 6, 00,000 and Current Liabilities-Rs. 3, 00,000
The current ratio expressed as pure ratio in the above case is 2:1, i.e, current
assets are twice as those of current liabilities.
(ii) Percentage Ratio:
When the relation between two items is expressed in hundred, it is known as
percentage.
Gross profit and net profit are commonly expressed in percentage.
Ex: gross profit is 20%. Which indicate out of every Rs.100/- sales, the net
profit is Rs.20/-.
(iii) Rate:
When the relation between two items is expressed in number of times, it is
known as rate.
Ex: stock turnover ratio, debtor’s turnover ratio etc.
Objectives of Ratio Analysis
1. Measuring the profitability:
The profitability of the business can be measured by calculating gross profit, net
profit, expenses ratio and other.
2. Judging the operational efficiencyof business:
The operational efficiency of the business can be ascertained by calculating
operating ratio.
3. Assessing the solvency of the business:
It can be ascertained whether the firm is solvent or not by calculating solvency
ratio. Solvency ratios show relationship between total liabilities and total assets. If
total assets are lesser than the total liabilities it shows unsound position of the
business.
4. Measuring short and long term financial positionof the company:
Ratio analysis helps in knowing the short term and long term financial position of
the business by calculating various ratios. Current and liquid ratio indicates short
term financial position, where as debt equity ratio, fixed asset ratio and proprietary
ratio shows long term financial positions.
5. Facilitating comparative analysis of the performance:
Every firm has to compare its present performance with the previous and discover
the plus and minus points. These performances of other competitive firm can also
be made.
Uses or Advantages or Importance 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 of
financial analysis. It is a way by which financial stability and health of a concern can be
judged. The following are the main uses of Ratio analysis:

13. (i) Useful in financial position analysis: Accounting reveals the financial
position of the concern. This helps banks, insurance companies and other
financial institution in lending and making investment decisions.
(ii) Useful in simplifying accounting figures: Accounting ratios simplify,
summaries and systematic the accounting figures in order to make them more
understandable and in lucid form.
(iii) Useful in assessing the operational efficiency: Accounting ratios helps to
have an idea of the working of a concern. The efficiency of the firm becomes
evident when analysis is based on accounting ratio. This helps the management
to assess financial requirements and the capabilities of various business units.
(iv) Useful in forecasting purposes: If accounting ratios are calculated for number
of years, then a trend is established. This trend helps in setting up future plans
and forecasting.
(v) Useful in locating the weak spots of the business: Accounting ratios are of
great assistance in locating the weak spots in the business even through the
overall performance may be efficient.
(vi) Useful in comparison of performance: Managers are usually interested to
know which department performance is good and for that he compare one
department with the another department of the same firm. Ratios also help him
to make any change in the organization structure.
Limitations of Ratio Analysis: These limitations should be kept in mind while
making use of ratio analyses for interpreting the financial statements. The following
are the main limitations of ratio analysis.
1. False results if based on incorrect accounting data: Accounting ratios can be
correct only if the data (on which they are based) is correct. Sometimes, the
information given in the financial statements is affected by window dressing, i. e.
showing position better than what actually is.
2. No idea of probable happenings in future: Ratios are an attempt to make an
analysis of the past financial statements; so they are historical documents. Now-a-
days keeping in view the complexities of the business, it is important to have an
idea of the probable happenings in future.
3. Variation in accounting methods: The two firms’ results are comparable with
the help of accounting ratios only if they follow the some accounting methods or
bases. Comparison will become difficult if the two concerns follow the different
methods of providing depreciation or valuing stock.
4. Price level change: Change in price levels make comparison for various years
difficult.
5. Only one method of analysis: Ratio analysis is only a beginning and gives just a
fraction of information needed for decision-making so, to have a comprehensive
analysis of financial statements, ratios should be used along with other methods of
analysis.
6. No common standards: It is very difficult to by down a common standard for
comparison because circumstances differ from concern to concern and the nature
of each industry is different.
7. Different meanings assigned to the some term: Different firms, in order to
calculate ratio may assign different meanings. This may affect the calculation of

14. ratio in different firms and such ratio when used for comparison may lead to
wrong conclusions.
8. Ignores qualitative factors: Accounting ratios are tools of quantitative analysis
only. But sometimes qualitative factors may surmount the quantitative aspects.
The calculations derived from the ratio analysis under such circumstances may get
distorted.
9. No use if ratios are worked out for insignificant and unrelated figure:
Accounting ratios should be calculated on the basis of cause and effect
relationship. One should be clear as to what cause is and what effect is before
calculating a ratio between two figures.
Classificationofratios:
All the ratios broadly classified into four types due to the interest of different parties for
different purposes. They are:
1. Profitability ratios
2. Activity or Turnover ratios
3. Liquidity or Short Term Solvency ratios
4. Leverage ratios or Long Term Solvency ratios
1. Profitability ratios: These ratios are calculated to understand the profit positions
of the business. These ratios measure the profit earning capacity of an enterprise.
These ratios can be related its save or capital to a certain margin on sales or
profitability of capital employ. These ratios are of interest to management. Who
are responsible for success and growth of enterprise? Owners as well as financiers
are interested in profitability ratios as these reflect ability of enterprises to generate
return on capital employ important profitability ratios are:
Profitability ratios in relation to sales: Profitability ratios are almost importance of
concern. These ratios are calculated is focus the end results of the business
activities which are the sole eritesiour of overall efficiency of organization.
1. Gross profit ratio: x 100
Note: Higher the ratio the better it is
Interpretation: there is no rule of thumb in relation to gross profit ratio. The
adequacy or otherwise of the ratio depends on operating expenses, non-operating
expenses, fixed charges, creation of reserves and the dividend. The gross profit
should be sufficient t meet all these items. A low gross profit ratio may indicate
unfavorable purchasing and markup policies, where as an increased gross profit
ratio may reflect an increase in sale price without any corresponding increase in
costs.
salesNest
profitgross

15. Significance: comparison of this ratio with the standard ratio for the industry will
furnish a clear picture of the profitability of the concern. This ratio can be
calculated for two or more years for the purpose of comparison of the company’s
profitability for realization of fixed overheads of the business. This ratio is also
useful for inventory management. In case a company sells more than one product,
this ratio has to be calculated separately for each product because there may be
gross profit for the company as a whole but some products may incur gross loss.
2. Net profit ratio: X 100
Note: Higher the ratio the better it is
Significance: this ratio is widely used as a measure of over-all probability. If this
ratio increases year after year, it indicates the profitability parameters of the company
are satisfactory. However, the financial analyst has to consider the other factors like
overall economy, industry return, debt service charges, controllable and
uncontrollable market factors etc. A high net profit ratio enables the company to reap
the benefits of favorable market conditions like rise in selling prices, reduced cost of
production, increasing demand for the product and accelerate its profits than a
company having lower net profit ratio.
3. Operating ratio (Operating expenses ratio)
X 100
Note: Lower the ratio the better it is
Significance: This ratio indicates the percentage of net sales absorbed by the cost of
goods sold and operating expenses. Generally, a high ratio is not considered as
favorable as it would leave a lesser margin to meet interest, dividends and other
corporate needs. While interpreting operating ratio, full recognition must be given to
the possibility of variations in expenses from year to year.
4. Operating profit ratio: X 100 = 100 operating ratio
Note: Higher the ratio the better it is cost of goods sold= opening stock + purchase +
wages + other direct expenses- closing stock (or) sales – gross profit.
Operating expenses:
= administration expenses + setting, distribution expenses operating profit= gross
profit – operating expense.
Expenses ratio = X 100
Note: Lower the ratio the better it is
salesNet
exensesoperatingsoldgoodsofCost 
salesNet
profitOperating
salesNet
expenseconcern
salesNet
Tax&interestafterprofitNet

16. Profitability ratios in relation to investments:
1. Return on investments: X 100
Share holders’ funds = equity share capital + preference share capital + receives &
surpluses +undistributed profits.
This is one of the key profitability ratios. It examines the overall operating
efficiency or earning power of the company in relation to total investment in
business. It indicates the percentage of re-turn on the capital employed in the
business. It is calculated on the basis of the following formula :
Operating Profit
Capital Employed
× 100
The term capital employed has been given different meanings by different
accountants. Some of the popular meanings are as follows:
Sum-total of all assets whether fixed or current.
Sum-total of fixed assets
Sum-total of long-term funds employed in the business, i.e.,
Share Capital + Reserves and Surplus + Long term Loans + Non-business
Assets + Fictitious Assets
In management accounting the term capital employed is generally used in the
meaning given in the point third above.
The term Operating Profit means Profit before Interest and Tax. The term Interest
means Interest on long-term Borrowings. Interest on short-term borrowings will
be deducted for computing operating profit. Non-trading incomes such as interest
on Government securities or non-trading losses or expenses such as loss on
account of fire, etc. will also be excluded.
The computation of ROI can be understood with the help of the following
illustration:
Note: Higher the ratio the better it is
2. Return on equity capital: X 100
Note: Higher the ratio the better it is
3. Earnings per share:
EPS measures the profit available to the equity shareholders on a per share
basis, that is, the amount that they can get on every share held. It is calculated by
dividing the profits available to the shareholders by the number of the outstanding
shares. The profits available to be the ordinary shareholders are represented by
net profits after taxes and preference dividend. Thus,
fundsholdersshare
ondepreciatilatest&after taxprofitNet
capitalshareequity
dividentpreference-interest&after taxProfitNet
dividentpreferecne-after taxprofitNet

17. EPS =
4. Return on capital employed = x 100
The ROCE is the second type of ROI. It is similar to the ROA except in
one respect. Here the profits are related to the total capital employed. The term
capital employed refers to long-tern funds supplied by the creditors and owners of
the firm. The higher the ratio, the more efficient is the use of capital employed.
The ROCE can be computed in different ways as shown below :
1. ROCE =
Net profit after taxes/EBIT
× 100
Average total capital employed
Net profit after taxes + Interest + Tax advantage on interest
2. ROCE = × 100
Average total capital employed
5. Return on total assets =
Here, capital employed = equity share capital + preference share capital + reserves &
surpluses + undistributed profits + debentures+ public deposit + securities + long term
loan + other long term liability – factious assets (preliminary expressed &
profit & loss account debt balance)
II. Turnover ratios or activityratios:
These ratios measure how efficiency the enterprise employees the resources of assets at
its command. They indicate the performance of the business. The performance if an
enterprise is judged with its save. It means ratios are also laced efficiencyratios.
These ratios are used to know the turn over position of various things in the
___________. The turnover ratios are measured to help the management in taking the
decisions regarding the levels maintained in the assets, and raw materials and in the
funds. These ratio s are measured in ratio method.
1. Stock turnover ratio =
The cost of goods sold means sales minus gross profit. The average inventory
refers to the simple average of the opening and closing inventory. The ratio
indicates how fast inventory is sold. A high ratio is good from the viewpoint of
employedcapital
profitoperating
AssetsTotal
interestandafter taxP.N.
stockaverage
soldgoodsofcost

18. liquidity and vice versa. A low ratio would signify that inventory does not sell
fast and stays on the shelf or in the warehouse for a loan time.
Here,
Average stock=
Note: Higher the ratio, the better it is
2. Working capital turnover ratio =
Note: Higher the ratio the better it is working capital = current assets – essential
liabilities.
3. Fixed assets turnover ratio =
Note: Higher the ratio the better it is.
3 (i) Total assets turnover ratio is:
Note: Higher the ratio the better it is.
4. Capital turnover ratio=
Note: Higher the ratio the better it is
5. Debtors turnover ratio=
Net credit sales consist of gross credit sales minus sales returns, if any, from
customers. Average debtors are the simple average of debtors at the beginning and at
the end of year. The ratio measures how rapidly debts are collected. A high ratio is
indicative of shorter time-lag between credit sales and cash collection. A low ratio
shows that debts are not being collectedrapidly.
5(i) Debtors collectionperiod=
Here,
Average debtors =
Debtors = debtors + bills receivable
Note: Higher the ratio the better it is.
2
stockclosingstockopening 
capitalworking
sales
assetsfixed
sales
assetstotal
sales
employedCapital
Sales
debtorsaverage
salesorsalescredits
ratioTurnove
12(or)365
2
bebtorsclosingdebitorsopening 

19. The average age of sundry debtors (or accounts receivable), or average collection
period is more meaningful figure to use in evaluating the firm's credit and collection
policies. The main objective of calculating average collection period is to find out
cash inflow rate from realisationfrom debtors.
It is found by a simple transformationof the firm's accounts receivable turnover :
365
Average Age of Debtors = Debtors Trunover
It can be calculated as follows also :
Average Collection Period=
Trade Debtors
× No. of working days
Net Credit Sales
The average of collection period should not exceed the standard or stated credit
period in sales terms plus 1/3 of such days. If it happens, it will indicate either liberal
credit policyor slackness of management in realisingdebts or accounts receivable.
6. Creditors turnover ratio =
Net credit purchases = Gross credit purchases less returns to suppliers
Average creditors = Average of creditors outstanding at the beginning and
at the end of the year.
A low turnover ratio reflects liberal credit terms granted by suppliers,
while a high ratio shows that accounts are to be settled rapidly.
6 (i) creditors collectionperiod=
Here,
Average creditor=
Creditors = creditors + bills payable.
Note: lower the ratio the better it is.
3. Liquidity ratios:
Liquidity refers to ability of organization to meet its current obligation. These ratios are
used to measure the financial status of an organization. These ratios help to the
management to make the decisions about the maintained level of current assets & current
libraries of the business. The main purpose to calculate these ratios is to know the short
terms solvency of the concern. These ratios are useful to various parties having interest in
creditorsaverage
purchasesorpurchaserscredit
ratiournoverCreditor t
12(or)365
2
creditorsclosingopening 

20. the enterprise over a short period – such parties include banks. Lenders, suppliers,
employees and other.
The liquidity ratios assess the capacity of the company to repay its short term liabilities.
These ratios are calculated in ratio method.
1. Current ratio =
Note: The ideal ratio is 2:1
i. e., current assets should be twice. The current liabilities.
2. Quick ratio or liquid ratio or acid test ratio:
Quick assets = cash in hand + cash at bank + short term investments + debtors + bills
receivables short term investments are also known as marketable securities.
Here the ideal ratio is 1:1 is, quick assets should be equal to the current liabilities.
Absolute liquid ratio=
sliabilitiecurrent
assetsliquidabsolute
Here,
Absolute liquid assets=cash in hand + cash at bank + short term investments +
marketable securities.
Here, the ideal ratio is 0, 0:1 or 1:2 it, absolute liquid assets must be half of current
liabilities.
3. Cash ratio=
4. Leverage ratio of solvency ratios:
Solvency refers to the ability of a business to honour long item obligations like interest
and installments associated with long term debts. Solvency ratios indicate long term
stability of an enterprise. These ratios are used to understand the yield rate if the
organization.
Lenders like financial institutions, debenture holders, banks are interested in ascertaining
solvency of the enterprise. The important solvency ratios are:
1. Debt – equity ratio= =
Here,
Outsiders funds = Debentures, public deposits, securities, long term bank loans + other
long term liabilities.
sliabilitiecurrent
assetscurrent
sliabilitiecurrent
assetsquick
fundsholdersshare
fundsoutsiders
Equity
Debt

21. Share holders’ funds = equity share capital + preference share capital + reserves &
surpluses + undistributed projects.
The ideal ratio is 1:1
2. Proprietary ratio or equity ratio=
The ideal ratio is 1:3 or 0.33:1
3. Interest Coverage Ratio : This ratio measures the debt servicing capacity of
a firm insofar as fixed interest on long-term loan is concerned. It is
determined by dividing the operating profits or earnings before interest and
taxes (EBIT) by the fixed interest charges on loans. Thus,
Interest coverage =
EBIT
Interest
From the point of view of the creditors, the larger the coverage, the greater is the
ability of the firm to handle fixed-charge capabilities and the more assured is the
payment of interest to the creditors. However, too high a ratio may imply unused
debt capacity.
Problems:
Illustration 7 : From the following figures extracted from the Income Statement
and Balance Sheet of Anu Sales Pvt. Ltd., calculate the Return on Total Capital
employed (ROI) :
Particulars Amount Particulars Amount
Rs. Rs.
Fixed Assets 4,50,000 Reserves 1,00,000
Current Assets 1,50,000 Debentures 1,00,000
Investment in Govt. Securities 1,00,000 Income from Investments 10,000
Sales 5,00,000 Interest on Debentures at 10%
Cost of goods sold 3,00,000 Provision for tax at 50% of
Share Capital : Net Profits
10% Preference 1,00,000
Equity 2,00,000
Solution: It will be appropriate to prepare the Profit and Loss Account and the
Balance Sheet of the company before computation of the returns on capital em-
ployed.
assetstotal
fundsholdershare

22. Anu Sales Pvt. Limited
Profit and Loss Account
Particulars Amount Particulars Amount
Rs. Rs.
To Cost of goods sold 3,00,000 By Sales 5,00,000
To Interest on Debentures 10,000 By Income form Investments 10,000
To Provision for Taxation 1,00,000
To Net profit after tax 1,00,000
5,10,000 5,10,000
Balance Sheet as on..........
Liabilities Rs. Assets Rs.
Share Capital Fixed Assets 1,50,000
10% Preference 1,00,000 Current Assets 1,50,000
Equity 2,00,000 Investment in govt. Securities 1,00,000
Reserves 1,00,000
10% Debentures 1,00,000
Profit and Loss Account 1,00,000
Provision for Taxation 1,00,000
7,00,000 7,00,000
Return on total capital employed=
Net operating profit before interest and tax
Total capital employed
=
2,00,000
× 100
5,00,000
= 40%
Net Operating Profit = Net Profit + Provision for Tax – Income from
Investments + Interest on Debentures
= Rs.1,00,000 + Rs.1,00,000–Rs.10,000 + Rs. 10,000
= Rs. 2,00,000
Capital employed = Fixed Assets + Current Assets – Provision for Tax

23. = Rs. 4,50,000 + Rs. 1,50,000–Rs. 1,00,000
= Rs. 5,00,000
Or = Share Capital + Reserves + Debentures+Profit &Loss
Account Balance – Investment in Govt. Securities
= Rs. 3,00,000 + Rs. 1,00,000 + Rs. 1,00,000 +
Rs. 1,00,000 – Rs. 1,00,000
= Rs. 5,00,000
Illustration 3: A manufacturer of stoves sells to retailers on terms 2½% discount
in 30 days, 60 days net. The debtors and receivables at the end of December of
past two years and net sales for all these two years are as under :
2000 2001
Rs. Rs.
Debtors 33,932 85,582
Bills Receivables 3,686 9,242
Net Sales 3,37,392 4,43,126
Determine the average collectionperiod for both years and comment.
Solution:
Trade Receivables
Average Collection Period= × No. of Working Days
Net Credit Sales
2000 :
37,618
× 365 = 41 days
3,37,392
2001 :
94,824
× 365 = 78 days4,43,126
Comment: The average collectionperiod in both years has been within standard
period, i.e. 80 days (60+ É3of 60 days), hence it is good.
Illustration 4: The comparative statement of income and financial position of a
company are given below:
1999 2000
Rs. Rs.
Net Sales 75,000 92,000

24. Less Cost of Sales 50,000 69,000
Gross Profit 25,000 23,000
Less Operating Expenses (including
Rs. 3,000p.a. for Depreciation) 22,000 21,000
Net Profit 3,000 2,000
Cash in hand 6,000 7,000
Debtors 30,000 18,000
Stock at cost 12,000 9,000
Fixed Assets (Net) 51,000 53,000
99,000 87,000
Creditors and Bills Payable 19,000 10,000
Debentures 20,000 15,000
Share Capital 50,000 58,000
Surplus (earned) 10,000 4,000
99,000 87,000
During the year 1979, 10% Stock Dividend was declared and paid. The factors
for the change in earned surplus during 2000 are, inter-alia, profit and cash
dividends.
Compare the following:
4. Debtors turnover for two years
5. Liquidity Ratio for two years.
6. Current Ratio for two years.
7. Average collectionperiod assuming all sales as credit sales.
8. If desirable current ratio is 3:1 what should be the amount of current liabilities
at the end of 2000 ?
Solution:
(i) Debtors Turnover
Trade Receivables 30,000 18,000

25. ( Net Credit Sales
×100
) ×100 = 40% ×100= 19.56%92,00075,000
9. Liquidity Ratio = Liquid Assets/Current Liabilities
1999 :36,000/19,000 = 1.9 :1
2000 :25,000/10,000 = 2.5:1
10.Current Ratio = Current Assets/Current Liabilities
1999 :48,000/19,000 = 2.5:1
2000 : 34,000/10,000 = 3.4:1
(iv) Average Collection Period=
Trade Receivables
× No. of Working Days
Net Credit Sales
30,000
1999 : × 365 = 146 days
75,000
2000 : 18,000 × 365= 71 days
92,000
As the current assets for 2000 are Rs. 34,000 and the desirable Current Ratiois
3:1, the current liability must be one-third of the current assets, i.e., Current
Liabilities = 34,000 × ÉÕ = Rs. 11,333.
Illustration6 : Calculate the Gross Profit Ratio from the following figures :
Sales Rs. 1,00,000 Purchses Rs. 60,000
Sales Returns 10,000 Purchases Returns 15,000
Opening Stock 20,000 Closing Stock 5,000
Solution:
Gross Profit
Gross Profit Ratio = × 100
Net Sales
=
Net Sales – Cost of Goods sold
× 100
Net Sales

26. =
Rs. 90,000 – Rs. 60,000
× 100
Rs. 90,000
=
Rs. 30,000
× 100 = 33.33%
Rs. 90,00
FUNDS FLOW STATEMENT ANALYSIS:
Every business establishment usually prepares the balance sheet at the end of the
year which highlights the financial position. Normally, Balance sheet reveals the
financial position of the business only at the end of the year, not at the beginning of the
year. It never discloses the changes in financial position of the firm at two different time
periods/dates.
MEANING:
A report on the movement of funds or working capital. In a narrow sense the term fund
means cash i.e., cash receipts and cash payments. In a broader sense the term fund means
working capital i.e., the differences between the current assets and current liabilities. The
term flow denotes the change. Flow of funds means the change in funds or in working
capital. The change on the working capital leads to the net changes taken place on the
working capital i.e., increase or decrease in the working capital.
DEFINITIONS:
According Foulke, "A statement of source and application of funds is a technical device
designed to analyze the changes to the financial condition of a business enterprise in
between two dates".
According to R.N Anthony, “Fund flow is a statement prepared to indicate the increase
in cash resources and the utilization of such resources of a business during the accounting
period”.
According to Smith Brown, “Fund flow is prepared in summary form to indicate
changes occurring in terms of financial condition between two different balance sheet
dates”.

27. OBJECTIVES:
1. The main purpose of preparing a Funds Flow Statement is that it reveals clearly
the important items relating to sources and applications of funds of fixed assets,
long-term loans including capital.
2. It also informs how far the assets derived from normal activities of business are
being utilized properly with adequate consideration.
3. It also reveals how much out of the total funds is being collectedby disposing of
fixed assets, how much from issuing shares or debentures, how much from long-
term or short-term loans, and how much from normal operational activities of the
business.
4. It also provides the information about the specific utilization of such funds, i.e.
how much has been applied for acquiring fixed assets, how much for repayment of
long-term or short-term loans as well as for payment of tax and dividend etc.
5. It helps the management to prepare budgets and formulate the policies that will be
adopted for future operational activities.
STEPS:
Steps in the preparation of Fund Flow Statement:
Step 1: Preparation of Statement of changes in working capital
Step 2: Preparation of Non- Current A/c items
Step 3: Preparation Adjusted Profit& Loss A/c
Step 4: Preparation of fund flow statement
I SCHEDULE OF CHANGES IN WORKING CAPITAL:
The purpose of preparing the schedule of changes in the working capital is to know the
changes in the volume of net working capital which is either sources or application of
fund.
The schedule of changes is focused as follows:
Increase in Current Assets ------------------------ Increase in Working Capital
Decrease in Current Assets ------------------ ---- Decrease in Working Capital
Increase in Current Liabilities ----------------------------- Decrease in Working Capital
Decrease in Current Liabilities---------------------------- Increase in Working Capital
Format of schedule of changes in working capital
Particulars
Previou
s Year
Current
Year
Increase in
Working
Capital (+)
Decrease in
Working
Capital (-)
Current Assets:
Cash In Hand
Cash at Bank
Marketable Securities
Bills Receivable

28. Sundry Debtors
Closing Stock
Prepaid Expenses
Current Liabilities:
Creditors
Bills Payable
Outstanding expenses
Pre received Income
Provision for doubtful and
bad
Debts
Net Working Capital(A-B)
Increase/Decrease Working
Capital
II. PREPARATION OF ADJUSTED PROFIT & LOSS A/C:
Method of Fund From Operations:
(a) Net Profit Method Add Non Operating Expenses less Non Operating Incomes
(b) Sales Method Less-Payments(Application)
Note: The first method is widely used method for n determining the volume of Fund from
Operations (FFO)
(a) Net Profit Method:
Under this method, Fund from operations can be determined in two different ways.
The first method is through the statement format
Net Profit from the Profit & Loss A/c xxxxx
Add:
(a) Non Funding Expenses:
Loss on Sale of Fixed Assets xxxx
Loss on Sale of Long Term Investments xxxx
Loss on Redemption Debentures/Preference Shares xxxx
Discount on Debentures /Share xxxx
(b) Non Operating Expenses:
Depreciation of fixed Assets xxxx
(c) Intangible Assets:
Amortization of Goodwill xxxx
Amortization of Patent xxxx
Amortization of Trade Mark xxxx
(d) Fictitious Assets:
Writing off Preliminary expense xxxx
Writing off Discount on Shares/Debentures xxxx
(e) Profit Appropriation

29. Transfer to General Reserve xxxx
Xxxxx
xxxxx
Less:
(f) Non funding Profits:
Profit on Sale of Fixed Assets xxxx
Profit on Sale of Long Term Investments xxxx
Profit on Redemption Debentures/Preference Shares xxxx
(g) Non Operating Incomes:
Dividend Received xxxx
Interest Received xxxx
Rent Received xxxx
xxxxx
Fund From operations / Fund Lost in Operations xxxxx
(a) Sales Method:
The second method of determining the fund from operations under the first classification
is the Accounting Statement Format.
Sources:
Sales xxxxx
Stock at the end xxxxx
Less:
Application:
Stock at Opening xxxx
Dr Cr
To Depreciation xxxx By Opening Balance Profit xxxx
To Goodwill Written off xxxx By Profit on sale of Fixed
Assets
xxxx
To Patent Written off xxxx By Profit on Sale of
Investments
xxxx
To Loss on Sale of Fixed Asset xxxx By Profit on redemption of
To Loss on Sale of Investment xxxx Liability xxxx
To Loss on redemption of
Liability
xxxx By Transfer from General
Reserve
To Preliminary Expenses off xxxx xxxx
To Proposed Dividend xxxx By Balancing Figure xxxx
To Transfer to General Reserve xxxx Fund From Operations(FFS)
To Current Year Provision for
Taxation xxxx
To Current Year Provision for
Depreciation xxxx
To Balancing Figure xxxx
(Fund Lost in Operations)
Adjusted Profit & Loss A/c

30. Net Purchases (Purchase-Returns) xxxx
Wages xxxx
Salaries xxxx
Telephone expenses xxxx
Electricity charges xxxx
Office stationery expenses xxxx
Other operating cash expenses xxxx
Fund from operations xxxxx
III PREPARATION OF FUND FLOW STATEMENT:
Sources of funds Uses of funds
 Funds from Business Operation
 Non trading Incomes
 Sale of Non-Current Assets
 Sale of Long Term Investments
 Issue of shares
 Acceptance of deposits
 Long Term Borrowings
 Decrease in Working Capital
 Funds Lost in Operations
 Redemption of Preference
Share Capital
 Repayment of Loans
 Purchase of Long Term
Investments
 Purchase of Fixed Assets
 Payment of Taxes
 Payment of Dividends
 Drawings
 Loss of Cash
 Increase in Working Capital
ADVANTAGES:
It is the only statement to study the changes in the working capital in between two
different periods from the balance sheet of a firm through structured analysis on the basis
of working capital position
1. To fulfill the Primary Objective of the Financial Management:
It not only elucidates the mode of financing but also the application of resources after
rising. It answers to the following queries viz:
 How the outsider's liabilities are redeemed?
 What is the role of the fund from operation generated?
 How the raised funds applied into business?
 How the decrease in working capital was applied?
 What is the mode of rising of financial resources for an increase in the working
capital?
2. Facilitationthrough Financial Planning

31. The projected fund flow statement from the past performance facilitates the firm to
anticipate the future requirement of financial resources. It guides the management to
prioritize the application in the future to the tune of scarce resources.
3. Guide to Working Capital Management
It acts as a guide to the management to maintain the working capital at optimum level
through either purchase or sale of marketable securities during the periods of adequate
and inadequate working capital respectively.
4. Indicator of Yester Track Path of the Firm:
The insight on the financial performance of the firm can be had by the lending
institutions through fund flow statement at the time of extending financial assistance to
the firm.
LIMITATIONS:
 It is an extension of financial statements but it cannot be leveled with the
emphasis of them
 It is not a resultant of the transaction instead it is an arrangement of among the
available information
 Projectedfund flow statement ever only to the tune of financial statements which
are
historic in feature
CASH FLOW STATEMENT ANALYSIS:
INTRODUCTION:
Cash is considered one of the important sources of the firm to meet day to day
financial commitments. The cash is considered to be as most important source of life
blood of the business. The cash resources are availed through two different types of
receipts viz. sales, dividends, interests known as regular receipts and sale of assets,
investments known as irregular receipts of the business enterprise. To have smooth flow
of business enterprise, it should have sufficient cash resources for its operations. The
availability of cash resources is mainly depending on the cash inflows of the enterprises.
The smoothness in operations of the enterprise is obtained through an appropriate
matching of cash inflows and cash outflows. The smoothness could be attained by way of
an appropriate planning analysis on the cash resources of the firm. The meaningful
analysis is only possible through cash flow statement analysis which facilitates the firm

32. to identify the possible sources of cash as well as the expenses and expenditures of the
firm.
MEANING:
The cash flow statement is being prepared on the basis of extracted information of
historical records of the enterprise. Cash flow statements can be prepared for a year, for
six months, for quarterly and even for monthly. The cash includes not only means that
cash in hand but also cash at bank.
Features or characteristics ofCash Flow Statement:
1. It is a periodical statement as it covers a particular period of time, say, month or year.
2. It shows movement of cash in between two balance sheet dates.
3. It establishes the relationship between net profit and changes in cash position of the
firm.
4. It does not involve matching of cost against revenue.
5. It shows the sources and application of funds during a particular period of time.
6. It records the changes in fixed assets as well as current assets.
7. A projected cash flow statement is referredto as cash budget.
8. It is an indicator of cash earning capacity of the firm.
9. It reflects clearly how financial position of a firm changes over a period of time due to
its operating activities, investing activities and financing activities.
Objectives of Cash Flow Statement:
1. It shows the cash earning capacity of the firm.
2. It indicates different sources from which cash been collected and various purposes for
which cash has been utilized during the year.
3. It classifies cash flows during the period from operating, investing and financing
activities.
4. It gives answers to various perplexing questions often encountered by management,
such as why the firm is unable to pay dividend instead of making enough profit? Why is
there huge idle cash balance in spite of loss suffered? Where have the proceeds of sale of
fixed assets gone? etc.
5. It helps the management in cash planning and control so that there is no shortage or
surplus of cash at any point of time.
6. It evaluates the ability of the firm to meet obligations such as loan repayment,
dividends, taxes etc.

33. 7. A prospective investor consults the cash flow statement to ensure t hat his investment
gets regular returns in future.
8. It discloses the reasons for differences among net income, cash receipts and cash
payments.
9. It helps the management in taking capital budgeting decisions more scientifically. 10.
It ensures optimum use of funds for the maximum benefit of the enterprise.
Utilityor Importance of Cash Flow Statement:
Cash Flow Statement is useful for short-term planning and control of cash. A business
entity needs sufficient amount of cash to meet its various obligations in the near future
such as payment for purchase of fixed assets, payment of debts, operating expenses of the
business etc.
It helps the financial manager to make a cash flow projection for the immediate future
taking the data relating to cash inflows and cash outflows from past records. As such, it
becomes easy for him to know the cash position which may either result in a surplus or a
deficit one. Thus, cash flow statement is another important tool of financial analysis for
the management.
Its main advantages are:
1. Evaluation of Cash Position:
It is very helpful in understanding the cash position of a firm. Since cash is the basis for
carrying on business operations smoothly, the cash flow statement is very useful in
evaluating the current cash position of the business.
2. Planning and Control:
A projected cash flow statement enables the management to plan and coordinate the
financial operations properly. The financial manager can know how much cash is needed,
from where it will be derived, how much can be generated internally, and how much
could be obtained from outside.
3. Performance Evaluation:
A comparison of actual cash flow statement with the projected cash flow statement will
disclose the failure or success of the management in managing cash resources. Deviations
will indicate the need for corrective actions.
4. Framing Long-term Planning:
The projected cash flow statement helps financial manager in exploring the possibility of
repayment of long-term debts which depends upon the availability of cash.
5. Capital Budgeting Decision:

34. A projected cash flow statement also helps the management in taking capital budgeting
decisions.
6. Liquidity Position:
Liquidity position of a firm refers to its ability to meet short-term obligations such as
payment of wages and other operating expenses etc. From cash flow statement the
financial manager is able to understand how well the firm is meeting these obligations.
At the same time the ability of the firm in cash earning can be known from cash flow
statement. As a matter of fact, a firm’s profitability is ultimately dependent upon its cash
earning capacity.
7. Answers to Different Questions:
Cash flow statement is able to explain some questions often encountered by the financial
manager such as, why is the firm not able to pay dividend in spite of making huge profit?
Why there is huge cash balance in spite of loss etc.
Limitations of Cash Flow Statement:
Cash Flow Statement is, no doubt, an important tool of financial analysis which discloses
the complete story of cash management. The increase in—or decrease of—cash and
reasons thereof, can be known, However, it has its own limitation.
These limitations are:
1. Since cash flow statement does not consider non-cash items, it cannot reveal the actual
net income of the business.
2. Cash flow statement cannot replace fund flow statement or income statement. Each of
them has a separate function to perform which cannot be done by the cash flow
statement.
3. The cash balance as disclosed by the projected cash flow statement may not represent
the real liquid position of the business since it can be easily influenced by the managerial
decisions, by making certain payments in advance or by post pending payments.
4. It cannot be used for the purpose of comparison over a period of time. A company is
not better off in the current year than the previous year because its cash flow has
increased.
5. It is not helpful in measuring the economic efficiency in certain cases e.g., public
utility service where generally heavy capital expenditure is involved.
In spite of these limitations, it can be said that cash flow statement is a useful
supplementary instrument. It helps management in knowing the amount of capital
blocked up in a particular segment of the business. The technique of cash flow analysis—

35. when used in conjunction with ratio analysis—serves as a barometer in measuring the
profitability and financial position of the business.
Cash flow statement vs Fund flow statement
Cash flow statement Fund flow statement
Cash inflow and outflow are only
considered
Increase or decrease in the working capital is
registered
Causes & changes of cash position Causes & changes of working capital position
Considers only most liquid assets
pertaining to cash resource ; which fosters
only for very short span of planning
Considers in general i-e current assets ; the
duration of the liquidity of the current assets are
longer in gestation than the liquid assets ; which
paves way for long span of planning
Opening and closing balances of cash
resources are considered for the
preparation
Increase or decrease of working capital is
considered but not the opening and closing
balance for preparation
The flow in the statement means real cash
flow
The flow in the statement need not be real cash
flow
STEPS:
Prepare Non – current accounts to identify the flow cash
Cash Inflows Cash out flows
Sale of Assets or Investments, Raising Purchase of Assets or
Investments,
of financial resources Redemption of financial
resources
Balancing Figure
Preparation of Adjusted Profit and Loss Account
Adjusted Profit & Loss Account
Net profit method
Accounting Profit to be adjusted
To find out the cash Profit/Loss
Addition of Non cash & Non
Operating Expenses
Deduction of Non cash & Non operating Incomes
Cash from operations or Cash lost in operations
Alternate method:
Net Profit:

36. Add: Decrease in current assets & Increase in current liabilities
Less: Increase in current assets & Decrease in current liabilities
Comparison of Current items to determine the inflow of cash or outflow of cash:
Increase in current assets------------------ Outflow of cash
Decrease in current assets------------------ Inflow of cash
Decrease in current liabilities-------------- Outflow of cash
Increase in current liabilities---------------- Inflow of cash
Preparation of cash flow statement
Sources of funds Uses of funds
Opening cash balance
Cash from in operations
Sale of assets
Issue of shares
Issue of debentures
Raising of loans
Collection from debentures
Refund of tax
Redemption of preference shares
Redemption fo debentures
Repayment of loans
Payment of dividends
Payment of tax
Cash lost in operations
PROCEDURE FOR PREPARING A CASH FLOW STATEMENT
Cash flow statement shows the impact of various transactions on cash position of a
firm. It is prepared with the help of financial statements, i.e., balance sheet and profit and
loss account and some additional information. A cash flow statement starts with the
opening balance of cash and balance at bank, all the inflows of cash are added to the
opening balance and the outflows of cash are deducted from the total. The balance, i.e,
opening balance of cash and bank balance plus inflows of cash minus outflows of cash is
reconciled with the closing balance of cash. The preparation of cash flow statement
involves the determining of :
SOURCE OF CASH INFLOWS
Cash from Operations or Cash Operating Profit
Cash from trading operations during the year is a very important source of cash inflows.
The net effect of various transactions in a business during a particular period is either net
profit or net loss. Usually, net profit results in inflow of cash and net loss in outflow of
cash. But it does not mean that cash generated from trading operations in a year shall be
equal to the net profit or that cash lost in operations shall be identical with net loss. It may
either be more or less. Even, there may be a net loss in a business, but yet there may be a
cash inflow from operations. It is so because of certain non-operating (expenses or
incomes) charged to the income statement, i.e., Profit and Loss Account.

37. How to Calculate Cash from Operations or Cash Operating Profit?
There are three methods of determining cash from operations:
From Cash Sales : Cash from operations can be calculated by deducting cash
purchases and cash operating expenses from cash sales, i.e. Cash from
Operations=
(Cash Sales) – (Cash Purchases + Cash Operating Expenses).
Cash sales are calculated by deducting credit sales or increase in receivables from the total
sales. From the cash sales, the cash purchases and cash operating expenses are to be
deducted. In the absence of any information, all expenses may be assumed to be cash
expenses. In case outstanding and prepaid expenses are known/given, any decrease in
outstanding expenses or increase in prepaid expenses should be deducted from the
corresponding figure.
From Net Profit/Net Loss
Cash from operations can also be calculated with the help of net profit or net loss. Under
this method, net profit or net loss is adjusted for non-cash and non-operating expenses and
incomes as follows :
Calculationof Cash from Trading Operations
Amount
Net Profit (as given)
Add : Non cash and Non-operating items which have already been debited to P & L A/c :
Depreciation
Transfer to Reserves
Transfer to Provisions
Goodwill written off
Preliminary expenses written off
Other intangible assets written off
Loss on sale or disposal of fixed assets
Increase in Accounts Payable
Increase in outstanding expenses
Decrease in prepaid expenses
Less : Non-cash and Non-operating items which have already been credited to P & L A/c :
Increase in Accounts Receivables
Decrease in Outstanding Expenses
Increase in Prepaid Expenses
Cash from Operations
Cash Operating Profit
Cash operating profit is also calculated with the help of net profit or net loss. The
difference in this method as compared to the above discussed method is that increase or

38. decrease in accounts payable and accounts receivable is not adjusted while finding cash
from operations and it is directly shown in the cash flow statement as an inflow or outflow
of cash as the cash may be. The cash from operations so calculated is generally called
operating profit.
Calculationof Cash Operating Profit
Amount
Net Profit (as given) or Closing Balance of Profit and Loss A/c Add : Non-cash and non-
operating items which have already been debited to P& L A/c :
Depreciation
Transfers to Reserves and Provisions
Writing off intangible assets
Outstanding Expenses (current year)
Prepaid Expenses (previous year)
Loss on Sale of fixed Assets
Dividend Paid, etc.
Less: Non-cash and non-operating items which have already been credited to P& L A/c :
Profit on Sale or disposal of fixed assets
Non-trading receipts such as dividend received, rent received, etc.
Re-transfers from provisions
(excess provisions charged back)
Outstanding income (current year)
Pre-received income (in previous year)
Opening balance of P&L A/c
Cash Operating Profit
Note: Generally the cash operating profit method has to be followed because of its
similarity with calculating funds from operations. However, if this method is followed the
following two points need particular care:
Outstanding/Accrued Expenses: The outstanding/accrued expenses represent those
expenses which are although charged to profit and loss account but no cash in paid during
the year. For this reason, outstanding/accrued expenses of the current year are added back
while calculating cash operating profit. However if some outstanding e xpenses of the
previous year are also given, these may be assumed to have been paid during the year and
hence shown as an outflow of cash in the cash flow statement.
Prepaid Expenses: Prepaid expenses are those expenses which are paid in advance
and hence result in the outflow of cash but are not charged to profit and loss account
because they do not relate to the current period of profit and loss account. For this reason,
prepaid expenses of the current year should be taken as an outflow of cash in the cash flow
statement. But the expenses if any, paid in the previous year do not involve outflow of cash

39. in the current year but are charged to profit and loss account. Therefore, prepaid expenses
of the previous year (related to the current year) should be added back while calculating
cash operating profit. In the similar way, we can deal with outstanding and pre-received
incomes.
Illustration5. Calculate Cash from operations from the following information’s:
Rs.
Sales 70,000
Purchases 40,000
Expenses 8,000
Creditors at the end of the year 15,000
Creditors in the beginning of the year 12,000
Solution:
Rs. Rs.
Sales 70,000
Less : Purchases 40,000
Expenses 8,000 48,000
Profit for the year 22,000
Add : Creditors a the end of the year 15,000
Less : Creditors at the beginning of the year
37,000
12,000
Cash from operations 25,000
Increase in Existing Liabilities or Creationof new Liabilities
If there is an increase in existing liabilities or a new liability is created during the
year, it results in the flow of cash into the business. The liability may be either a fixed
long-term liability such as equity share capital, preference share capital, debentures, long-
term loans, etc. or a current liability such as sundry creditors, bills payable, etc.
The inflow of cash may be either Actual of Notional
There is an actual inflow of cash when cash is actually received and generally
long-term liabilities result into actual inflow of cash, e.g.
For issue of Shares, during the year, the journal entry shall be
Cash A/c Dr.
To Share Capital A/c
So, actual cash flows into the business. In the same manner, issue of debentures,
raising of loans for cash, etc. result into actual inflows of cash. But when the fixed
liabilities are created in consideration of purchase of assets, i.e., other than cash, there is no
inflow of actual cash. The journal entry for the issue of debentures in lieu of purchase of
machinery is :

40. Plant and Machinery A/c Dr.
To Debentures A/c
Usually, current liabilities result into inflow of notional cash. For example,
increase in sundry creditors implies purchase of goods on credit. In this case although no
cash in actually received but we may say that creditors have given us loans which have
been utilised in purchasing goods from them. Hence, increase in the current liabilities may
be taken as a source of inflow of cash and decrease in current liabilities as an outflow of
cash.
Reduction in or Sale of Assets
Whenever a reduction in or sale of any asset-fixed or current-takes place
(otherwise than depreciation) it results into inflow of actual or notional cash. There is an
actual inflow of cash when assets are sold for cash and notional cash flows in when assets
are sold or disposed off on credit. Thus, sale of building, machinery or even reduction in
current assets like stocks, debtors, etc. result in inflow of actual notional cash.
Non-Trading Receipts
Sometimes, there may be non-trading receipts like dividend received, rent
received, refund of tax, etc. Such receipts or incomes are although non-trading in nature but
they result into inflow of cash and hence taken in the cash flow statement.
APPLICATIONS OF CASH OR CASH OUTFLOWS
Cash Lost in Operations: Sometimes the net result of trading in a
particular period is a loss and some cash may be lost during that period in trading
operations. Such loss of cash in trading in called cash lost in operations and is shown as an
outflow of cash in Cash Flow Statement.
Decrease in or Discharge of Liabilities: Decrease in or discharge of any
liability, fixed or current results in outflow of cash either actual or notional. For example,
when redeemable preference shares are redeemed and loans are repaid, it will amount to an
outflow of actual cash. But when a liability is converted into another, such as issue of
shares for debentures, there will be a notional flow of cash into the business.
Increase in or Purchase of Assets: Just like decrease in or sale of assets is
a source or inflow of cash, increase or purchase of any assets is a outflow or application of
cash.
Non Trading Payments: Payment of any non-trading expenses also
constitute outflow of cash. For example, payment of dividends, payment of income-tax,
etc.

41. EXAMPLE OF CFS
Illustration 6: The following details are available from a company.
Liabilities 31-12-98 31-12-99 Assets 31-12-98 31-12-99
Rs Rs. Rs. Rs.
Share Capital 70,000 74,000 Cash 9,000 7,800
Debentures 12,000 6,000 Debtors 14,900 17,700
Reserve for doubtful debts 700 800 Stock 49,200 42,700
Trade Creditors 10,360 11,840 Land 20,000 30,000
P & L A/c 10,040 10,560 Goodwill 10,000 5,000
1,03,100 1,03,200 1,03,100 1,03,200
Additional Information :(i) Dividend paid total Rs. 3,500, (ii) Land was purchased
for Rs. 10,000. Amount provided for amortization of goodwill Rs. 5,000 and (iii)
Debentures paid off Rs. 6,000
Prepare Cash Flow Statement.
Solution:
Cash Flow Statement
(for the year ended 31.12.1999)
Rs. Rs.
Opening balance of cash Cash Outflows
on 1.1.1999 9,000 Purchase of Land 10,000
Add : Cash Inflows : Increase in Debtors 2,800
Issue of Share Capital 4,000 Redemption of Debentures 6,000
Increase in trade creditors 1,480 Dividends Paid 3,500
Cash inflow from operations 9,120 Closing balance of cash on
Decrease in stock 6,500 31.12.1999 7,800
30,10030,100
Workings:
Cash inflow from operations
Adjusted Profit And Loss A/c
Rs. Rs.
To Dividend (non-operating) 3,500 By Balance b/d 10,040
To Goodwill (non-fund/cash) 5,000 By Cash inflow from operation 9,120

42. To Reserve for doubtful debts 100
To Balance c/d 10,560
19,160 19,160
Alternatively Rs.
Balance of P & L A/c on 31.12.1999 10,560
Add : non-fund/cash and non-operating items which
have already been debited to P & L A/c :
Dividend paid 3,500
Goodwill written off 5,000
Reserve for doubtful debts 100
Less : Opening balance of P & L A/c and non-operating
19,160
incomes :
Opening balance of P/L A/c
(on 31.12.1998) 10,040 10,040
Cash Inflow from operations 9,120