Management Accounting Unit - 4. B.Com(Hons)/B.Com/BBA/MBApdf

Management Accounting B.Com (Hons) Semester 4th
1 | Page Prepared by UMA KANT (Research Scholar “LU”, JRF(Commerce), UGC NET(Management), M.Com, MBA
Management Accounting
B.Com (Hons) Semester - 4th
Unit -4
University of Lucknow,
Lucknow
Financial Statement Analysis:
The term ‗financial analysis‘, also known as analysis and interpretation of
financial statements‘, refers to the process of determining financial strengths
and weaknesses of the firm by establishing strategicrelationship between the
items of the balance sheet, profit and loss account and other operative data.
―Analyzing financial statements,‖ according to Metcalf and Titard, ―is a
process of evaluating therelationship between component parts of a financial
statement to obtain a better understanding of a firm‘s position and
performance.‖
In the words of Myers, ―Financial statement analysis is largely a study of
relationship among the various financial factors in a business as disclosed by
a single set-of statements and a study of the trend of these factors as shown
in a series of statements.‖

Objectives and Importance of Financial Statement Analysis:
The primary objective of financial statement analysis is to understand and
diagnose the information contained in financial statement with a view to
judge the profitability and financial soundness of the firm, and to make
forecast about future prospects of the firm. The purpose of analysis depends
upon the person interested in such analysis and his object.
However, the following purposes or objectives of financial
statements analysis may be stated to bring out the significance
of such analysis:
1) To assess the earning capacity or profitability of the firm.
2) To assess the operational efficiency and managerial effectiveness.
3) To assess the short term as well as long term solvency position of the
firm.
4) To identify the reasons for change in profitability and financial
position of the firm.
5) To make inter-firm comparison.
6) To make forecasts about future prospects of the firm.
7) To assess the progress of the firm over a period of time.
8) To help in decision making and control.
9) To guide or determine the dividend action.
10) To provide important information for granting credit.

Parties Interested in Financial Analysis:
The following parties are interested in the analysis of financial
statements:
1) Investors or potential investors.
2) Management.
3) Creditors or suppliers.
4) Bankers and financial institutions.
5) Employees.
6) Government.
7) Trade associations.
8) Stock exchanges.
9) Economists and researchers.
10) Taxation authorities
Limitations of Financial Statement Analysis:
Some of the important limitations of financial analysis are, however,
summed up as below:
1) It is only a study of interim reports
2) Financial analysis is based upon only monetary information and
non-monetary factors areignored.
3) It does not consider changes in price levels.
4) As the financial statements are prepared on the basis of a going
concern, it does not give exact position. Thus accounting concepts
and conventions cause a serious limitation to financial analysis.

5) Changes in accounting procedure by a firm may often make financial
analysis misleading.
6) Analysis is only a means and not an end in itself. The analyst has to
make interpretation and draw his own conclusions. Different people
may interpret the same analysis in different ways.
Tools or Techniques of Financial Statement Analysis
1) Comparative Statement or Comparative Financial and Operating
Statements.
2) Common Size Statements.
3) Trend Ratios or Trend Analysis.
4) Average Analysis.
5) Statement of Changes in Working Capital.
6) Fund Flow Analysis.
7) Cash Flow Analysis.
8) Ratio Analysis.
9) Cost Volume Profit Analysis
A brief explanation of the tools or techniques of financial statement analysis
presented below.
1) Comparative Statements
Comparative statements deal with the comparison of different items of the
Profit and Loss Account and Balance Sheets of two or more periods.
Separate comparative statements are prepared for Profit and Loss Account as
Comparative Income Statement and for Balance Sheets.
As a rule, any financial statement can be presented in the form of

comparative statement such as comparative balance sheet, comparative profit
and loss account, comparative cost of production statement, comparative
statement of working capital and the like.
2) Comparative Income Statement
Three important information are obtained from the Comparative Income
Statement. They are Gross Profit, Operating Profit and Net Profit. The
changes or the improvement in the profitabilityof the business concern is find
out over a period of time. If the changes or improvement is not satisfactory,
the management can find out the reasons for it and some corrective action can
betaken.
3) Comparative Balance Sheet
The financial condition of the business concern can be find out by preparing
comparative balance sheet. The various items of Balance sheet for two
different periods are used. The assets are classified as current assets and
fixed assets for comparison. Likewise, the liabilitiesare classified as current
liabilities, long term liabilities and shareholders‘ net worth. The term
shareholders‘ net worth includes Equity Share Capital, Preference Share
Capital, Reserves and Surplus and the like.
4) Common Size Statements
A vertical presentation of financial information is followed for preparing
common-size statements. Besides, the rupee value of financial statement
contents are not taken into consideration. But, only percentage is considered
for preparing common size statement.
The total assets or total liabilities or sales is taken as 100 and the balance

items are compared to the total assets, total liabilities or sales in terms of
percentage. Thus, a common size statement shows the relation of each
component to the whole. Separate common size statement is prepared for
profit and loss account as Common Size Income Statement and for balance
sheet as Common Size Balance Sheet.
5) Trend Analysis
The ratios of different items for various periods are find out and then
compared under this analysis. The analysis of the ratios over a period of years
gives an idea of whether the businessconcern is trending upward or downward.
This analysis is otherwise called as Pyramid Method.
6) Statement of Changes in Working Capital
The extent of increase or decrease of working capital is identified by
preparing the statement of changes in working capital. The amount of net
working capital is calculated by subtracting the sum of current liabilities
from the sum of current assets. It does not detail the reasons for changes in
working capital.
7) Fund Flow Analysis
Fund flow analysis deals with detailed sources and application of funds of the
business concern for a specific period. It indicates where funds come from
and how they are used during the period under review. It highlights the
changes in the financial structure of the company.
8) Cash Flow Analysis
Cash flow analysis is based on the movement of cash and bank balances. In
other words, the movement of cash instead of movement of working capital

would be considered in the cash flow analysis. There are two types of cash
flows. They are actual cash flows and notional cashflows.
9) Ratio Analysis
Ratio analysis is an attempt of developing meaningful relationship between
individual items (or group of items) in the balance sheet or profit and loss
account. Ratio analysis is not only useful to internal parties of business
concern but also useful to external parties. Ratio analysis
highlights the liquidity, solvency, profitability and capital gearing.
Funds Flow Statement:
Funds flow statement is a statement which discloses the analytical
information about the different sources of a fund and the application of the
same in an accounting cycle. It deals with the transactions which change
either the amount of current assets and current liabilities (in the form of
decrease or increase in working capital) or fixed assets, long-term loans
including ownership fund.
It gives a clear picture about the movement of funds between the opening
and closing dates of the Balance Sheet. It is also called the Statement of
Sources and Applications of Funds, Movement of Funds Statement; Where
Got—Where Gone Statement: Inflow and Outflow of Fund Statement, etc.
No doubt, Funds Flow Statement is an important indicator of financial
analysis and control. It is valuable and also helps to determine how the funds
are financed. The financial analyst can evaluate the future flows of a firm on

the basis of past data.
This statement supplies an efficient method for the financial manager in
order to assess the:
a. Growth of the firm,
b. Its resulting financial needs, and
c. To determine the best way to finance those needs.
Objective of preparing a Funds Flow Statement is multifaceted:
a. Revealing Sources and Applications of Funds: It clarifies the important
items related to the sources and uses of funds for fixed assets, long-term
loans, and capital, indicating whether assets derived from business activities
are being utilized properly.
b. Detailing Fund Acquisition and Utilization: It shows how funds are
acquired, whether through asset disposal, issuing shares or debentures, loans,
or normal business activities, and how these funds are utilized, such as for
acquiring fixed assets, repaying loans, or paying taxes and dividends.
c. Informing Management for Budgeting and Policy Formulation: It assists
management in preparing budgets and formulating future operational
policies based on insights into fund utilization and acquisition.
The significance of Funds Flow Statements can be summarized as follows:
a. Analysis of Financial Statement: It provides a dynamic view of financial
activities, explaining the causes and effects of changes in a firm's financial
position, addressing questions like changes in working capital, asset sales,

dividend payments, utilization of profits, debt repayment, and sources of
increased working capital.
b. Guiding Dividend Policy: It helps firms make sound dividend decisions,
even in the presence of sufficient profits but a lack of liquid resources.
c. Allocation of Resources: It aids management in making informed decisions
about resource allocation by projecting future fund flows.
d. Future Planning: It acts as a guide for future financial provision, enabling
firms to anticipate and avoid potential financial problems.
e. Working Capital Appraisal: It helps assess the efficient use of working
capital and suggests improvements based on present challenges.
Basis for
comparison
Cash flow Fund flow
Meaning A cash flow statement is a
statement showing the inflows and
outflows of cash and cash
equivalents over a period.
A fund flow statement is a
statement showing the changes
in the financial position of
the entity in different
accounting years.
Purpose
o
fPreparation
To show the reasons for
movements in the cash at the
beginning and at the end of the
accounting period.
To show the reasons for the
changes in the financial
position, with respect to
previous year and current
accounting year.

Basis Cash Basis of Accounting. Accrual Basis of Accounting.
Analysis Short Term Analysis of cash
planning.
Long Term Analysis of
financialplanning
Discloses Inflows and Outflows of Cash Sources and applications of
funds
Opening
an
d closing
balance
Contains opening and closing
balance of cash and cash
equivalents.
Does not contains opening
balance of cash and cash
equivalents.
Part of
Financial
Statement
Yes No
Cash Flow Statement
A cash flow statement provides information about the changes in cash and
cash equivalents of a business by classifying cash flows into operating,
investing and financing activities. It is a key report to be prepared for each
accounting period for which financial statements are presented by an
enterprise.
Monitoring the cash situation of any business is the key. The income
statement would reflect the profits but does not give any indication of the
cash components. The important information of what the business has been

doing with the cash is provided by the cash flow statement. Like the other
financial statements, the cash flow statement is also usually drawn up
annually, but can be drawn up more often. It is noteworthy that cash flow
statement covers the flows of cash over a period of time (unlike the balance
sheet that provides a snapshot of the business at a particular date). Also, the
cashflow statement can be drawn up in a budget form and later compared to
actual figures.
Objectives of preparing Cash Flow Statement
1) Cash flow statement shows inflow and outflow of cash and cash
equivalents from various activities of a company during a specific
period under the main heads i.e., operating activities, investing
activities and financing activities.
2) Information through the Cash Flow statement is useful in assessing the
ability of any enterprise to generate cash and cash equivalents and the
needs of the enterprise to utilize those cash flows.
3) Taking economic decisions requires an evaluation of the ability of an
enterprise to generate cash and cash equivalents, which is provided by
the cash flow statement
Cash and cash equivalents generally consist of the following:
o Cash in hand
o Cash at bank
o Short term investments that are highly liquid
o Bank overdrafts comprise an integral element of the organization‘s treasury
management

Classification of activities:
Cash flow activities are to be classified into three categories :This
is done to show separately the cash flows generated / used by these activities,
thereby helping to assess the impact of these activities on the financial
position and cash and cashequivalents of an enterprise.
1) Operating activities
2) Investing activities
3) Financing activities
Cash from Operating Activities:
Operating activities are the activities that comprise of the primary /
main activities of an enterprise during an accounting period. For
example, for a garment manufacturing company, operating activities
include procurement of raw material, sale of garments, incurrence of
manufacturing expenses, etc. These are the principal revenue
generating activities of the enterprise.
Profit before tax as presented in the income statement could be used
as a starting point to calculate the cash flows from operating activities.
Cash Inflows from operating activities:
o Cash receipts from sale of goods and rendering services.
o Cash receipts from fees, royalties, commissions and other revenues.

Cash Outflows from operating activities:
o Cash payments to suppliers for goods and services.
o Cash payments of income taxes unless they can be specifically
identified with financing and investing activities.
Following adjustments are required to be made to the profit
before tax to arriveat the cash flow from operations:
o Elimination of non cash expenses (e.g. depreciation,
amortization, impairment losses, bad debts written off, etc)
o Removal of expenses to be classified elsewhere in the cash
flow statement (e.g. interest expense should be classified under
financing activities)
o Removal of income to be presented elsewhere in the cash
flow statement (e.g. dividend income and interest income should
be classified under investing activities unless in case of forexample an
investment bank)
o Elimination of non cash income (e.g. gain on revaluation of
investments)
o The amount of cash from operations indicates the internal
solvency level of the company. It is
a key indicator of the extent to which the operations of the
enterprise have generated sufficient cash flows to maintain its
operating potential.

Cash from Investing Activities:
Cash flow from investing activities includes the movement in cash flows
owing to the purchase and sale of assets. It relates to purchase and sale of
long-term assets or fixed assets such as machinery, furniture, land and
building, etc.
a) Cash Outflows from investing activities
b) Cash payments to acquire fixed assets including intangibles and capitalized
R&D.
c) Cash advances and loans made to third party (other than advances and
loans made by a financial enterprise wherein it is operating activities).
d) Cash payments to acquire shares, warrants or debt instruments of
other enterprises other than the instruments those held for trading
purposes.
Cash Inflows from investing activities
a) Cash receipt from disposal of fixed assets including intangibles.
b) Cash receipt from the repayment of advances or loans made to third
parties (except in case offinancial enterprise).
c) Dividend received from investments in other enterprises.
d) Cash receipt from disposal of shares, warrants or debt instruments of
other enterprises exceptthose held for trading purposes.
Cash from Financing Activities:
It includes financing activities related to long-term funds or capital of an
enterprise. Financing activitiesare activities that result in changes in the size
and composition of the owners‘ capital and borrowings of the enterprise.

e.g., cash proceeds from issue of equity shares, debentures, raising long-term
loans, repayment of bank loans, etc.
Cash Inflows from financing activities
o Cash proceeds from issuing shares (equity / preference).
o Cash proceeds from issuing debentures, loans, bonds and other short/
long-term borrowings.
Cash Outflows from financing activities:
o Cash repayments of amounts borrowed.
o Interest paid on debentures and long-term loans and advances.
o Dividends paid on equity and preference capital.
Main heads of Cash Flow statement:
Cash Flow Statement (Main heads only)
(A)Cash flows from operating activities xxx
(B)Cash flows from investing activities xxx
(C)Cash flows from financing activities xxx
Net increase (decrease) in cash and cash xxx equivalents (A + B + C)
+ Cash and cash equivalents at the beginning xxx = Cash and cash
equivalents at the end xxxx
Methods of preparing the Cash Flow Statements
Operating activities are the main source of revenues and expenditures,
thereby cash flow from thesame needs to be ascertained. The cash flow can

be reported through two ways:
Direct method that discloses the major classes of gross cash receipts and
cash payments and Indirect method that has the net profit or loss
adjusted for effects of
1) transactions of a non-cash nature,
2) any deferrals or accruals of past/future operating cash receipts and
3) items of income or expenses associated with investing or financing
cash flows.
Direct method:
In the direct method, the major heads of cash inflows and outflows (such as cash
received from trade receivables, employee benefits, expenses paid, etc.) are to be
considered.
As the different line items are recorded on accrual basis in statement of profit
and loss, certainadjustments are to be made to convert them into cash basis such
as the following:
1) Cash receipts from customers = Revenue from operations + Trade
receivables in the beginning
– Trade receivables in the end.
2)
Cash payments to suppliers = Purchases + Trade Payables in the
beginning – Trade Payables inthe end.

3) Purchases = Cost of Revenue from Operations – Opening Inventory +
Closing Inventory.
4) Cash expenses = Expenses on accrual basis + Prepaid expenses
in the beginning and Outstanding expenses in the end – Prepaid
expenses in the end and Outstanding expenses in the beginning.
Purpose & Importance of Cash Flow Statements
1) Statement of cash flows provides important insights about the
liquidity and solvency of a company which are vital for survival and
growth of any organization.
2) It enables analysts to use the information about historic cash flows
for projections of future cash flows of an entity on which to base
their economic decisions.
3) By summarizing key changes in financial position during a period,
cash flow statement serves to highlight priorities of management.
4) Comparison of cash flows of different entities helps reveal the
relative quality of their earnings since cash flow information is more
objective as opposed to the financial performance reflected in
income statement.
Advantages of Cash Flow Statement
1) Cash Flow Statements help in knowing the liquidity / actual cash
position of the company which funds flow and P&L are unable to
specify.

2) As the liquidity position is known, any shortfalls can be arranged for
or excess can be used forthe growth of the business
3) Any discrepancy in the financial reporting can be gauged through the
cash flow statement bycomparing the cash position of both.
4) Cash is the basis of all financial operations. Therefore, a projected
cash flow statement will enable the management to plan and control
the financial operations properly.
5) Cash Flow analysis together with the ratio analysis helps measure the
profitability and financialposition of business.
6) Cash flow statement helps in internal financial management as it is
useful in formulation offinancial plans.
Disadvantages of Cash Flow Statement
1) Through the cash flow statement alone, it is not possible to arrive at
actual P&L of the company as it shows only the cash position. It has
limited usage and in isolation it is of no use and requires BL, P&L for
its projections. Cash flow statement does not disclose net income from
operations. Therefore, it cannot be a substitute for income statement
2) The cash balance as shown by the cash flow statement may not
represent the real liquidity position of the business because it can be
easily influenced by postponing the purchases and other payments
3) Cash flow statement cannot replace the funds flow statement. Each of
the two has a separate function to perform.

Ratio Analysis
Meaning:
A ratio is a mathematical number calculated as a reference to
relationship of two or more numbers and can be expressed as a
fraction, proportion, percentage and a number of times. When the
number is calculated by referring to two accounting numbers derived
from the financial statements, it is termed as accounting ratio.
It needs to be observed that accounting ratios exhibit relationship, if
any, between accounting numbers extracted from financial statements.
Ratios are essentially derived numbers and their efficacy depends a
great deal upon the basic numbers from which they are calculated.
Further, a ratio must be calculated using numbers which are
meaningfully correlated.
Objectives of Ratio Analysis:
Ratio analysis is indispensable part of interpretation of results
revealed by the financial statements. It provides users with crucial
financial information and points out the areas which require
investigation. Ratio analysis is a technique which involves
regrouping of data by application of arithmetical relationships,
though its interpretation is a complex matter. It requires a fine
understanding of the way and the rules used for preparing financial

statements. Once done effectively, it provides a lot of information
which helps the analyst:
1. To know the areas of the business which need more attention;
2. To know about the potential areas which can be improved with
the effort in the desired direction;
3. To provide a deeper analysis of the profitability, liquidity,
solvency and efficiency levels in the business;
4. To provide information for making cross-sectional analysis
by comparing the performance with the best industry standards;
and
5. To provide information derived from financial statements
useful for making projections and estimates for the future.
Importance (or Advantages) of Ratio Analysis:
1. Helps to understand efficacy of decisions: The ratio analysis
helps you to understand whether the business firm has taken the
right kind of operating, investing and financing decisions. It
indicates how far they have helped in improving the performance.
2. Simplify complex figures and establish relationships:
Ratios help in simplifying the complex accounting figures and
bring out their relationships. They help summarise the financial
information effectively and assess the managerial efficiency, firm‘s
credit worthiness, earning capacity, etc.
3. Helpful in comparative analysis: The ratios are not be

calculated for one year only. When many year figures are kept
side by side, they help a great deal in exploring the trends visible in
the business. The knowledge of trend helps in making projections
about the business which is a very useful feature.
4. Identification of problem areas: Ratios help business in
identifying the problem areas as well as the bright areas of the
business. Problem areas would need more attention and bright
areas will need polishing to have still better results.
5. Enables SWOT analysis: Ratios help a great deal in
explaining the changes occurring in the business. The information
of change helps the management a great deal in understanding the
current threats and opportunities and allows business to do its own
SWOT (Strength-Weakness-Opportunity-Threat) analysis.
6. Various comparisons: Ratios help comparisons with certain
bench marks to assess as to whether firm‘s performance is better
or otherwise. For this purpose, the profitability, liquidity, solvency,
etc. of a business, may be compared: (i) over a number of
accounting periods with itself (Intra-firm Comparison/Time Series
Analysis), (ii) with other business enterprises (Inter-firm
Comparison/Cross- sectional Analysis) and (iii) with standards set
for that firm/industry (comparison with standard (or industry
expectations).
Limitations of Ratio Analysis:

1. Lack of Precision and Finality: Accounting data may appear precise, but they are
influenced by recorded facts, conventions, and personal judgments, leading to
potential inaccuracies. Profit figures, for example, are subjective and dependent on
the competence and integrity of those involved, which can obscure the true state of
affairs in a business.
2. Ignoring Price-level Changes: Financial accounting typically assumes stable
money values, disregarding the impact of inflation or deflation. In reality, changes
in the price level render comparisons across different accounting periods
meaningless.
3. Neglecting Qualitative Aspects: While accounting focuses on quantitative
aspects, qualitative factors such as character, honesty, and managerial ability can
significantly affect business outcomes. Ratios derived from purely quantitative
analysis may fail to capture these qualitative dimensions.
4. Variations in Accounting Practices: Differing accounting policies among
businesses, such as inventory valuation methods and depreciation calculation,
hinder cross-sectional analysis and make valid comparisons challenging.
5. Limited Forecasting Ability: Historical analysis alone is insufficient for accurate
future forecasting. Predictions require consideration of non-financial factors, and
reliance solely on past financial data may lead to unreliable forecasts.
6. Inability to Provide Solutions: Accounting data serve primarily as indicators and
whistleblowers, highlighting issues rather than offering solutions to problems.
They lack the capacity to resolve underlying issues within a business.
Balance Sheet Ratios:

1. Current Ratio = Current Assets
Current Liabilities
2. Liquid Ratio = Quick (Liquid) Assets
Quick (Liquid) Liabilities
 Liquid assets are those which are readily converted into cash and
will include cash/ bank balances, bills receivable, sundry debtors and
short term investments. Inventories and Prepaid Expenses are not
included in liquid assets.
 Liquid Liabilities includes all items of current liabilities except Bank
Overdraft.
3. Proprietary Ratio = Proprietors funds
Total Assets
 Proprietor fund = Share capital(Equity & Pref.) + Retained earnings (less
loss if any) -Fictitious assets
 Total Assets = Fixed Assets + Current Assets-Fictitious assets
4. Stock Working capital Ratio = Closing Stock
Working Capital
 Working Capital = Current assets – Current liabilities
5. Capital Gearing Ratio = Fixed Interest & Dividend Bearing Funds
Equity Share holders fund
 Equity Share holders fund= Equity Sh. Capital + Retained earnings
(less loss if any) -Fictitious assets
6. Debt Equity Ratio = Long Term Debt
Proprietors Fund
Prob1:

Liabilities Rs. Assets Rs.
Equity Share Capital 5,00,000 Land & Building 1,00,000
Preference share capital 2,00,000 Machinery 4,00,000
General Reserve 1,00,000 Furniture 50,000
Secured Loan 3,00,000 Inventory 3,00,000
Sundry Creditors 1,00,000 Sundry Debtors
Cash/Bank Balance
3,00,000
50,000
12,00,00
0
12,00,00
0
Calculate Following Ratios from the above balance sheet:
1. Current Ratio
2. Liquid Ratio
3. Proprietary Ratio
4. Stock Working capital Ratio
5. Capital Gearing Ratio
6. Debt Equity Ratio
Solution:
1.
Current
ratio = Current assets/current liabilities
Current assets = inventory
(3,00,000)+ s.debtors(3,00,000) + cash
balance(50,000) = 6,50,000
Current liabilities = S.Creditors = 1,00,000
= 6,50,000/1,00,000
= 6.5:1
2. Liquid ratio = liquid assets/liquid liabilities
liquid assets = s.debtors(3,00,000) + cash
balance(50,000)
= 3,50,000
liquid liabilities = S.Creditors = 1,00,000
= 3,50,000/1,00,000
= 3.5:1
3. Proprietary Ratio Proprietors fund / total assets
Proprietor fund = Share capital(Equity & Pref.) +
Retained
earnings (less loss if any) -Fictitious assets
= 5,00,000 + 2,00,000 + 100,000 = 8,00,000

Total Assets = Fixed Assets + Current Assets-
Fictitious
assets
= 12,00,000
= 800,000/12,00,000
= 0.66 : 1
4. Stock
Workin
g
= closing stock / working capital
capital Ratio = 300,000 / 5,50,000
= 0.55:1
Working capital (CA-CL= 6,50,000 – 1,00,000 =
5,50,000)
5.
Capital
Gearin
g
= Fixed Interest & Dividend Bearing Funds
Ratio Equity Share holders fund
Fixed Interest & Dividend Bearing Funds = pref
sh.
(2,00,000) + secured loan (3,00,000) = 500,000
Equity Share holders fund = Eq. Shares (5,00,000) +
GR
(100,000) = 600,000
= 500,000 / 600,000
= 0.83 : 1
6. Debt Equity =Long Term Debt
Ratio Proprietors Fund
Long term debt = secured loan (300,000)
= 3,00,000/8,00,000
= 0.38 : 1
Prob 2:
Equity Share Capital 2,00,000 Machinery 5,92,000
12% Preference share capital 3,60,000 Investment 2,24,000
General Reserve 1,40,000 Stock 2,02,000
16% debentures 2,40,000 Bills Receivable 40,000
Trade payable 2,44,000 S. Debtors 98,000
Bank overdraft 40,000 Cash and Bank 76,000
Provision for Income Tax 36,000 Profit & Loss A/c 28,000
12,60,00
0
12,60,00
0
1. Current Ratio

2. Liquid Ratio
Solution:
1. Current ratio = Current assets/current liabilities
Current assets = stock (2,02,000)+ BR
(40,000)+ s.debtors(98000) + cash
balance(76,000) = 4,16,000
Current liabilities = trade payable (2,44,000) +
Bank o/d(40,000) + provision for income tax (36,000) =
320,000
= 4,16,000/3,20,000
= 1.3:1
2. Liquid ratio = liquid assets/liquid liabilities
liquid assets = BR (40,000)+ s.debtors(98000) +
cash balance(76,000) = 2,14,000
liquid liabilities = trade payable (2,44,000) provision
for income tax (36,000) = 2,80,000
= 2,14,000/2,80,000
= 0.76:1
3. Proprietary Ratio Proprietors fund / total assets
Proprietor fund = Share capital(Equity & Pref.) +
Retained
earnings (less loss if any) -Fictitious assets
= 2,00,000 + 3,60,000 + 140,000-28,000 = 6,72,000
Total Assets = Fixed Assets + Current Assets-
Fictitious
assets
= 12,60,000 – 28,000 = 12,32,000
= 6,72,000/12,32,000
= 0.55 : 1

4. Capital
Gearin
g Ratio
= Fixed Interest & Dividend Bearing Funds
Equity Share holders fund
Fixed Interest & Dividend Bearing Funds = pref
sh. (3,60,000) + debentures (2,40,000) = 6,00,000
Equity Share holders fund = Eq. Shares (2,00,000) +
GR
(1,40,000) – profit & loss (28000) = 3,12,000
= 600,000 / 3,12,000
= 1.92 : 1
5. Debt
Equit
y Ratio
=Long Term Debt
Proprietors Fund
Long term debt = debentures (2,40,000)
= 2,40,000/6,70,000
= 0.36 : 1
Practice problems:
Prob 3:
Equity Share Capital 1,00,000 Furniture 2,96,000
10% Preference share capital 1,80,000 Trademarks 1,12,000
General Reserve 70,000 Stock 1,01,000
15% debentures 1,20,000 Bills Receivable 20,000
Trade payable 1,22,000 Trade Receivables 49,000
Bank overdraft 20,000 Cash and Bank 38,000
Provision for Tax 18,000 Profit & Loss A/c 14,000
6,30,000 6,30,000
1. Current Ratio
2. Liquid Ratio
Prob 4:
The Balance Sheet of Trident Limited as on 31‐12‐2017 was as follow:
Equity Share Capital 40,000 Plant & Machinery 24,000
Capital Reserve 8,000 Land & Building 40,000
Profit & Loss A/c 12,000 Furniture & Fixtures 16,000

7% Mortgage Loan 32,000 Stock 12,000
Creditors 16,000 Debtors 12,000
Bank overdraft 4,000 Investment (Short-term) 4,000
Provision for Income Tax 8,000 Cash at bank 12,000
1,20,000 1,20,000
You are required to Calculate Following Ratios:
1. Current Ratio (1.43:1)
2. Liquid Ratio (1.17:1)
3. Proprietary Ratio (0.5: 1) or 50%)
4. Capital Gearing Ratio (0.53: 1)
5. Debt Equity Ratio (0.53: 1) or 53%)
Prob 5:
The Balance Sheet of omega Limited as on 31‐12‐2018 was as follow:
Equity Share Capital 20,00,000 Machinery 35,00,000
8% Pref. Share Capital 15,00,000 Patents & Trademarks 20,00,000
Reserves & Surplus 11,00,000 Stock 1,75,000
10% Debenture 10,00,000 Debtors 3,50,000
9% Secured Loan 5,00,000 Bills Receivables 50,000
Creditors 1,00,000 Cash at bank 2,25,000
Bank overdraft 1,50,000 Fictitious Assets 1,00,000
Bills Payable 45,000
Outstanding Expenses 5,000
64,00,000 64,00,000
4. Capital Gearing Ratio (1: 1)
Prob 6:
Following is the summarised Balance Sheet of Borkar tiles Ltd. as on 31‐3‐19.
Equity Shares of Rs. 10 Each 10,00,000 Fixed Assets 20,00,000
10% Pref. Shares of Rs. 100 4,00,000 Investments 2,00,000
each Closing Stock 2,00,000
Reserves and surplus 7,00,000 S. Debtors 4,60,000
15% Debentures 5,00,000 Bills Receivables 60,000
Sundry Creditors 2,40,000 Cash Balance 60,000

Bank Overdraft 1,60,000 Preliminary Expenses 20,000
30,00,000 30,00,000
4. Capital Gearing Ratio (0.54: 1)
INCOME STATEMENT RATIOS:
1. Gross Profit Ratio = Gross Profit X100
Net Sales
Purpose: Indicates the efficiency of production and trading operations
.
2. Operating Ratio = Cost of Goods Sold + Operating Expenses X100
Net Sales
Purpose: index of managerial ability to control operating expenses.
3. Expenses Ratio= Operating Expenses X100
Net Sales
(Expenditure may be cost of production or Cost of sales, administrative or Selling or
distribution expenses or any other Element of Group)
Purpose: Indicates the direction in which economies ought to be effected.
4. Net Operating Profit Ratio = Operating Profit X100
Net Sales
Purpose: Index of Operating Efficiency.
5. Net Profit Ratio = Net Profit After Tax X100
Net Sales
Purpose: Indicates Net Margin on

sales.
Prob. 1:
Following is the Income Statement of Urja Auto. Ltd. For the year ended 31st
Dec 2019.
You are required to calculate: 1) Gross Profit Ratio; 2) Operating Ratio; 3) Net operating
Profit Ratio and 4) Net Profit Ratio.
Particulars Rs.
Sales 20,00,000
Less: Cost of goods Sold 12,00,000
Gross Profit 8,00,000
Less: Operating Expenses 4,80,000
Operating Profit 3,20,000
Add: Non –operating income 48,000
3,68,000
Less: Non –operating Expenses 16,000
Profit before Tax 3,52,000
Less: Tax @ 30% 1,05,600
Net Profit After Tax 2,46,400
Solution: (Hint: only needs to replace available figures with respective formula to arrive at
answer)
1. Gross Profit Ratio = 800000/20,00,000 x 100 = 40%
2. Operating ratio = 12,00,000 + 4,80,000 X100 = 84%
20,00,000
3. Net operating profit Ratio = 3,20,000/20,00,000 x 100 = 16%
4. Net profit ratio = 2,46,400/20,00,000 x 100 = 12.3%
Prob. 2:
The following Trading and Profit and Loss Account of Tiptop Ltd. for the year 31‐3‐2019 is given
below:
Particulars Rs. Particulars Rs.

To opening stock
To purchases
To Carriage inward
To wages
To Gross profit c/f
76,250
3,15,250
2,000
5,000
2,00,000
By Sales
By Closing stock
5,00,000
98,500
5,98,500 5,98,500
To Administrative
exp.
To Selling & dist.
Exp.
To non operating
exp.
To financial exp.
To net profit c/d
1,01,000
12,000
2,000
7,000
84,000
By Gross profit b/d
By interest on securities
By dividend on shares
By profit on sale of
shares
2,00,000
1,500
3,750
750
2,06,000 2,06,000
Calculate: Gross profit ratio, Expense ratio, operating ratio, net operating profit ratio & net
profit ratio.
Solution:
1. Gross profit ratio = 2,00,000/500,000 x 100 = 40%
2. Expense ratio = operating exp. / net sales x 100
1,13,000+5,00,000 x 100 = 22.60%
3. Operating ratio = cost of goods sold +operating Exp / net sales x100
3,00,000 + 1,13,000 x100
5,00,000
(Cost of Goods sold = Op. stock + purchases + carriage inward + wages – Closing Stock)
4. Operating profit ratio = operating profit / net sales
= 87,000 /5,00,000 x 100 = 17.40%
(Operating profit = sales – (cost of goods sold + operating exp.)
5. Net profit ratio = Net profit/net sales x 100
84,000 / 5,00,000 x 100 = 16.8%
Practice problems:

Prob. 3:
Following is the Income Statement of Durv Pvt. Ltd. For the year ended 31st
March 2017.
Particulars Rs.
Net Sales 12,00,000
Less: Cost of goods Sold 7,00,000
Gross Profit 5,00,000
Less: Operating Expenses 2,00,000
Operating Profit 3,00,000
Add: Non –operating income 45,000
3,45,000
Less: Non –operating Expenses 25,000
Profit before Tax 3,20,000
Tax Rate is 40%
Calculate: 1) Gross Profit Ratio; 2) Operating Ratio; 3) Net operating Profit Ratio and 4)
Net Profit Ratio.
Prob. 4:
From the following information for the year ended 31st
Dec 2018, You are required to
calculate: 1) Gross Profit Ratio; 2) Operating Ratio; 3) Net operating Profit Ratio and 4) Net
Profit Ratio.
Total Sales- Rs. 5,00,000/-
Sales Return- Rs. 50,000/-
Gross Profit – 40% of Net
Sales. Cost of goods sold –
Rs. ??
Operating Expenses –
Rs.60,000/- Non-operating
Income – Rs. 21,000/- Tax Rate is
50%
Hint: first prepare income statement and then calculate ratios.

FUNCTIONAL CLASSIFICATION OF RATIOS
Liquidity Ratios
Long-Term Solvency
and Leverage Ratios
Activity Ratios Asset
Management Ratios
Profit Abilities Ratios
(A)
 Current
Ratio
 Liquid Ratio
 Absolute
Liquid or
Cash Ratios
 Interval
Measure
(B)
 Debtors
Turnover
Ratio
 Creditor
Turnover
Ratio
 Inventory
Turnover
Ratio
 Debt/Equity
Ratio
 Debt to total
Capital Ratio
 Interest
Coverage
Ratio
 Cash Flow/
Debt
 Capital
Gearing
 Inventory
Turnover
Ratio
 Debtors
Turnover
Ratio
 Fixed
Assets
Turnover
Ratio
 Total Assets
Turnover
Ratio
 Working
Capital
Turnover
Ratio
 Payable
Turnover
Ratio
 Capital
Employed
Turnover
Ratio
(A) In relation to sales
 Gross Profit
Ratio
 Operating
Ratio
 Operating
Ratio
 Operative
Profit Ratio
 Net Profit
Ratio
 Expenses
Ratio
(B) In relation to
Investments
 Return on
Investment
 Return on
Capital
 Return on
Equity
 Return on
Total
 Resources
 Earnings per
Share
 Price
Earnings
Ratio
Common Size Statement?
Common size statement is a form of analysis and interpretation of the financial
statement. It is also known as vertical analysis. This method analyses financial

statements by taking into consideration each of the line items as a percentage of the
base amount for that particular accounting period.
Common size statements are not any kind of financial ratios but are a rather easy way
to express financial statements, which makes it easier to analyse those statements.
Common size statements are always expressed in the form of percentages. Therefore,
such statements are also called 100 per cent statements or component percentage
statements as all the individual items are taken as a percentage of 100.
Types of Common Size Statements
There are two types of common size statements:
1. Common size income statement
2. Common size balance sheet
1. Common Size Income Statement
This is one type of common size statement where the sales is taken as the base for all
calculations. Therefore, the calculation of each line item will take into account the sales
as a base, and each item will be expressed as a percentage of the sales.
Use of Common Size Income Statement
It helps the business owner in understanding the following points
1. Whether profits are showing an increase or decrease in relation to the sales obtained.
2. Percentage change in cost of goods that were sold during the accounting period.
3. Variation that might have occurred in expense.
4. If the increase in retained earnings is in proportion to the increase in profit of the business.
5. Helps to compare income statements of two or more periods.
6. Recognises the changes happening in the financial statements of the organisation, which will
help investors in making decisions about investing in the business.
2. Common Size Balance Sheet:

A common size balance sheet is a statement in which balance sheet items are being
calculated as the ratio of each asset in relation to the total assets. For the liabilities,
each liability is being calculated as a ratio of the total liabilities.
Common size balance sheets can be used for comparing companies that differ in size.
The comparison of such figures for the different periods is not found to be that useful
because the total figures seem to be affected by a number of factors.
Standard values for various assets cannot be established by this method as the trends
of the figures cannot be studied and may not give proper results.
Common Size Income Statement Format
The common size income statement format is as follows:

Preparing Common Size Balance Sheet
(1) Take the total of assets or liabilities as 100.
(2) Each individual asset is expressed as a percentage of the total assets, i.e., 100 and
different liabilities are also calculated as per total liabilities. For example, suppose total
assets are around Rs. 4 lakhs, and inventory value is Rs. 1 lakh. In that case, it will be
counted as 25% of the total assets.
Limitations of Common Size Statement
Following are the limitations discussed

1. It is not helpful in the decision-making process as it does not have any approved benchmark.
2. For a business that is impacted by fluctuations due to seasonality, it can be misleading.
Comparative Statements?
Comparative statements or comparative financial statements are statements of financial
position of a business at different periods. These statements help in determining the
profitability of the business by comparing financial data from two or more accounting
periods.
The data from two or more periods are updated side by side, which is why it is also
known as Horizontal Analysis. The advantage of such an analysis is that it helps
investors to identify the trends of business, check a company’s progress and also
compare it with that of its competitors.
The financial data will be considered to be comparative only when the same set
of accounting principles are being used for preparing the statements.
Types of Comparative Statements
There are two types of comparative statements which are as follows
1. Comparative income statement
2. Comparative balance sheet
Comparative Income Statement
Income statements provide the details about the results of the operations of the
business, and comparative income statements provide the progress made by the
business over a period of a few years. This statement also helps in ascertaining the
changes that occur in each line item of the income statement over different periods.
The comparative income statement not only shows the operational efficiency of the
business but also helps in comparing the results with the competitors, over different

time periods. This is possible by comparing the operational data spanning multiple
periods of accounting.
The following points should be studied when analysing a comparative income statement
1. Compare the increase or decrease in sales with a relative increase in the cost of
goods sold
2. Studying the operational profits of the business
3. Overall profitability of the business can be analysed by an increase or decrease in the
net profit
Steps in preparing a comparative income statement
The below steps are followed
1. Specify absolute figures of all the items related to the accounting period under
consideration.
2. Determine the absolute change that has occurred in the items of the income
statement. It can be achieved by finding the difference between previous year values
with the current year values.
3. Calculate the percentage change in the items present in the current statement with
respect to previous year statements.
The format of a comparative income statement is as follows:

Comparative Balance Sheet
Comparative balance sheet analyses the assets and liabilities of business for the
current year and also compares the increase or decrease in them in relative as well as
absolute parameters.
A comparative balance sheet not only provides the state of assets and liabilities in
different time periods, but it also provides the changes that have taken place in
individual assets and liabilities over different accounting periods.
The following points should be studied when analysing a comparative balance sheet
1. The present financial and liquidity position (study working capital)
2. The financial position of the business in the long term

3. The profitability of the business
Steps in preparing a comparative balance sheet
The below steps can be followed
1. Determine the absolute value of assets and liabilities related to the accounting
periods.
2. Determine absolute changes in the items of the balance sheet relative to the
accounting periods in question.
3. Calculate the percentage change in assets and liabilities by comparing current year
values with values of previous accounting periods.
The format of a comparative balance sheet is as follows:

difference between the comparative and common size financial statements.

Comparative Financial Statement Common Size Financial Statement
Definition
Comparative financial statement is a kind of
document that presents the financial performance of
the organisations side by side with the previous year
performances, in order to compare the growth of
business over a period of time
Common size financial statement is a way of
presenting financial information of a business by
expressing the components of financial statements
as percentages.
Type of analysis
Comparative statements are also known as
horizontal analysis as financial statements are
compared side by side
Common size statements are also known as vertical
analysis as data is analysed vertically
Purpose
Comparative statements are used for comparing
financial performance for internal purposes and for
inter-firm comparison
Common size statements are prepared for the
reference of stakeholders.
Types of comparison made
Comparative statements make use of both absolute
figures and percentages
Common size statements use only percentage form

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