1. FINANCIAL STATEMENT ANALYSIS
MEANING OF FINANCIAL STATEMENTS
According to Himpton John, "A financial statement is an organized collection
of data according to logical and consistent accounting procedures. Its
purpose is to convey an understanding of some financial aspects of a
business firm. It may show assets position at a moment of time as in the
case of a balance sheet, or may reveal a series of activities over a given
period of limes, as in the case of an income statement ".
On the basis of the information provided in the financial statements,
management makes a review of the progress of the company and decides the
future course of action.
DIFFERENT TYPES OF FINANCIAL STATEMENTS
1. Income Statement
2. Balance Sheet
3. Statement of Retained earnings
4. Funds flow statement
5. Cash flow statement.
6. Schedules.
FUNDAMENTAL CONCEPTS OF ACCOUNTING
1. Going concern concept
2. Matching concept ( Accruals concept)
3. Consistency concept
4. Prudence concept ( conservation concept)
5. Business entity concept
6. Stable monetary unit concept
7 Money measurement concept
7. Objectivity concept
8. Materiality concept
9. Realization concept.
LIMITATIONS OF FINANCIAL STATEMENTS
1. In profit and loss account net profit is ascertained on the basis of
historical
costs.
2. Profit arrived at by the profit and loss account is of interim nature.
Actual profit can be ascertained only after the firm achieves the
maximum capacity.
3. The net income disclosed by the profit and toss account is not
absolute but only relative.

2. 4. The net income is the result of personal judgment and bias of
accountants cannot be removed in the matters of depreciation, stock
valuation, etc.,
5. The profit and loss account does not disclose factors like quality of
product, efficiency of the management etc.,
6. There are certain assets and liabilities which are not disclosed by the
balance sheet. For example the most tangible asset of a company is its
management force and a dissatisfied labour force is its liability which
are not disclosed by the balance sheet.
7. The book value of assets is shown as original cost less depreciation.
But in practice, the value of the assets may differ depending upon the
technological and economic changes.
8. The assets are valued in a Balance sheet on a going concern basis.
Some of the assets may not relate their value on winding up.
9. The accounting year may be fixed to show a favorable picture of the
business. In case of Sugar Industry the Balance sheet prepared in off
season depicts a better liquidity position than in the crushing season.
10. Analysis Investor likes to analyse the present and future prospectus of
the business while the balance sheet shows past position. As such the
use of a balance sheet is only limited.
11. Due to flexibility of accounting principles, certain liabilities like
provision for gratuity etc. are not shown in the balance sheet giving
the outsiders a misleading picture.
12. The financial statements are generally prepared from the point of view
of shareholders and their use is limited in decfsion making by the
management, investors and creditors.
13. Even the audited financial statements does not provide complete
accuracy.
14. Financial statements do not disclose the changes in managernent,
Loss of markets, etc. which have a vital impact on the profitability of
the concern.
15. The financial statements are based on accounting policies which vary
form company to company and as such cannot be formed as a reliable
basis of judgment.
FORMATS OF FINANCIAL STATEMENTS

3. The two main financial statements, viz the Income Statement and the
Balance sheet, can either be presented in the horizontal form or the vertical
form where statutory provisions are applicable, the statement has to be
prepared in accordance with such provisions.
Income Statement :
There is no legal format for the profit and loss A/C. Therefore, it can
be presented in the traditional T form, or vertically, in statement form. An
example of the two formats is given as under.
(i) Horizontal, or “T” form:
Manufacturing, Trading and profit and loss A/C of ………........... for
the year ending .........................
Dr Cr
Particulars Rs. Particualrs Rs.
To opening stock By cost of finished Goods Xxxx
c/d
Raw materials xxx By closing stock
Work in progress xxx Raw materials xxx
Work in progress xxx
To purchases of raw xxx
materials
To manufacturing wages xxx
To carriage inwards xxx
To other Factory Expenses xxx
xxx xxx
By sales xxx
To opening stock of xxx By closing stock of xxx
finished finished
goods goods
To cost of Finished goods xxx By Gross Loss c/d xxx
b/d
To Gross Profit c/d xxx
xxx xxx
To Gross Loss b/d xxx By Gross profit b/d xxx
To office and Admn. xxx By Miscellaneous Receipts xxx
Expense
To Interest and financial xxx By Net Loss c/d xxx
expenses
To provision for Income-tax xxx
To Net Profit c/d xxx
xxx xxx
To net loss b/d xxx By Balance b/d xxx
To general reserve xxx (from previous year)

4. To Dividend xxx By Net profit b/d xxx
To Balance c/f xxx
xxx xxx
(ii) Vertical Form
Income statement of ………… for the year ending ……………...
Particulars Rs. Rs.
Sales xxxx
Less: Sales Returns xxx
Sales Tax/ Exise Duty xxx xxxx
Net sales (1) xxxx
Cost of Goods Sold
Materials Consumed xxxx
Direct Labour xxxx
Manufacturing Expenses xxxx
Add / less Adjustment for change in stock xxxx
(2)
xxxx
Gross Profit (1) – (2) xxx
Less: Operating Expenses
Office and Administration Expenses
Selling and Distribution Expenses xxx
xxx xxx
Operating Profit Xxxx
Add: Non-operating Income Xxx
Less: Non-oprating Expenses (including Interest) xxxx
Profit before Tax xxx
xxxx
Less : Tax xxx
Profit After Tax xxxx
Appropriations
Transfer to reserves
Dividend declared /paid xxxx
Surplus carried to Balance sheet xxx
xxx
xxxx
Balance Sheet
The Companies Activities, 1956 stipulates that the Balance sheet of a
joint stock company should be prepared as per part I of schedule VI of the
Activities. However, the statement form has been emphasized upon by
accountants for the purpose of analysis and Interpretation. The permission
of the Centra! Government is necessary for adoption of the 'statement* form.
(i) Horizontal Form
Balance sheet of .................... as on ....................

5. Liabilities Rs. Assets Rs.
Share Capital xxx Fixed Assets:
(with all paticulars of 1. Goodwill xxx
Authorized, Issued, 2. Land & Building xxx
Subscribed capital) Called xxx 3. Leasehold property xxx
up capital 4. Plant and Machinery xxx
5. Furniture and Fittings xxx
Less: Calls in Arrears xxx 6. Patents and Trademarks xxx
Add: Forfeited Shares xxx 7. Vehicles xxx
Reserves and Surplus : Investments
1. Capital Reserve xxx Current Assets, loans and
2. Capital Redemption Advances
reserve xxx (A) Current Assets
3. Share premium xxx 1. Interest accured on
4. Other premium xxx Investments xxx
Less: debit balance of Profit xxx 2. Loose tools xxx
and loss A/C (if any) 3. Stock in trade xxx
5. Profit and Loss xxx 4. Sundry Debtors xxx
Appropriation A/C Less: Provision for doubtful
6. Sinking Fund xxx debts
5. cash in hand xxx
6. cash in Bank xxx
Secured Loans (B) Loans and Advances
Debentures xxx 7. Advances to subsidiaries xxx
Add: Outstanding Interest xxx 8. Bills Receivable xxx
Loans from Banks xxx 9. Prepaid Expenses xxx
Unsecured Loans Miscellaneous Expenditure
(to the extent not written off
or
Fixed Deposits xxx adjusted) xxx
Short-term loans and xxx
advances
Current Liabilities and 1. Preliminary expenses xxx
Provisions 2. Discount on Issue of xxx
shares
and debentures
A. Current Liabilites 3. Underwriting Commssion xxx
1. Bills Payable xxx
2. Sudnry Creditors xxx Profit and Loss account
(Loss),
3. Income received in xxx if any
advance
4. unclaimed Dividends xxx
5. Other Liabilities xxx
B. Provisions
6. Provisions for Taxation xxx

6. 7. Proposed Dividends xxx
8. Proposed funds & xxx
pension
fund contingent liabilities
not
Provided for
xxx xxx

7. (ii) Vertical Form:
Balance sheet of ………………………. as on …………………
Particulars Schedule No. Current Previous
year Year
I. Source of funds
1. Share holders funds
a. capital xxxx xxxx
b. Reserves and surplus xxxx xxxx
2. Loans funds
a. Secured Loans xxxx xxxx
b. Unsecured Loans xxxx xxxx
Total
II. Application of funds
1. Fixed Assets
a. Gross Block xxxx xxxx
b. less Deprciation xxxx xxxx
c. Net block xxxx xxxx
d. Capital work in progress xxxx xxxx
2. Investments xxxx xxxx
3. Current Assets, Loans and Advances
a. Inventions xxxx xxxx
b. Sundry Debtors xxxx xxxx
c. Cash and Bank balance xxxx xxxx
d. other current assets xxxx xxxx
e. Loans and Advances xxxx xxxx
Less : current Liabilities and Provisions
a. Current Laibilities xxxx xxxx
b. Provisions xxxx xxxx
xxxx xxxx
Net Current Assets
4. a. Miscellaneuos Expenditure to xxxx xxxx
the extent not written off or adjusted
b. Profit and Loss Account (debit) xxxx xxxx
Total xxxx xxxx

8. (ii) Vertical Form for analysis
Balance sheet of ……… as on ……………..
Particulars Rs.
ASSETS
Current Assets
Cash and Bank Balances xxxx
Debtors xxxx
Stock xxxx
Other Current Assets xxxx
(1) xxxx
Fixed Assets xxxx
Less: Depreciation xxxx
Investments xxxx
(2) xxxx
Total (1) + (2) xxxxx
LIABILITIES
Current Liabilities :
Bills Payable xxxx
Creditors
Other Current Liabilities
(3) xxxx
Long Term Debt
Debentures xxxx
Other Long-term Debts xxxx
(4) xxxx
Capital and Reserves
Share Capital xxxx
Reserves and surplus xxxx
(5) xxxx
Total Long term funds
Total (3)+(4)+(5) xxxxx
Statement of Retained Earnings:
Profit and Loss Appropriation Account
Particulars Rs. Particulars Rs.
To transfer to xxx By Last year’s xxx
Reserves balance
To Dividend xxx By Current Year’s net xxx
profit (Transferred
from profit and loss
A/C)
To Dividend proposed xxx
To surplus carried to xxx By Excess provisions xxx
Balance sheet (which are no longer

9. required)
By Reserves
withdrawn
(if any) xxx
xxx xxxx
Techniques of Financial Statement Analysis:
The following techniques are adopted in analysis of financial
statements of a business organization:
Comparative Statements
Common size Statements
Trend Analysis
Funds flow Analysis
Cash flow Analysis
Ratio Analysis
Value Added Analysis.
Comparative Financial Statements
Comparative financial statements are statements of financial position
of a business designed to provide time perspective to the consideration of
various elements of financial position embodied in such statements.
Comparative Statements reveal the following: .
i. Absolute data (money values or rupee amounts)
ii. Increase or reduction in absolute data (in terms of moiwy
values)
iii. Increase or reduction in absolute data (in terms of
percentages)
iv. Comparison (in terms of ratios)
v. Percentage of totals.
a. Comparative Income Statement or Profit and Loss Account:
A comparative income statement shows the absoluie figures for two or
more periods and the absolute change from one period to another. Since the
figures are shown side by side, the user can quickly understand the
operational performance of the firm in different periods and draw
conclusions.
b. Comparative Balance Sheet
Balance sheet as on two or more different dates are used for
comparing the assets, liabilities and the net worth of the company
Comparative balance sheet is useful for studying the trends of analysis
undertaking.
Financial Statements of two or more firms can also be compared for
drawing inferences. This is called interfirm Comparison.

10. Advantages:
Comparative statements vidicate trends in sales, cost of production,
profits etc., and help the analyst to evaluate the performance of the
company.
Comparative statements can also be used to compare the performance
of the industry or inter-firm comparison. This helps in identification of the
weaknesses of the firm and remedial measures can be taken; accordingly.
Weaknesses:
Inter-firm comparison can be misleading if the firms are not identical
in size and age and when they follow different accounting procedures with
regard to depreciation, inventory valuation etc.,
Inter-period comparison may also be misleading if the period has
witnessed changes in accounting policies, inflation, recession etc.
Illustration 3:
The following is the profit and loss account of Ashok Ltd., for the years
2010 and 2011. Prepare comparative Income Statement and comment on
the profitability of the undertaking.

11. Particulars 2010 2011 Particulars 2010 2011
Rs. Rs. Rs. Rs.
To Cost of 2,31,625 2,41,950 By Sales 3,60,728 4,17,125
goods sold
To Office 23,266 27,068 Less Returns 5,794 6,952
expenses
To Interest 45,912 57,816 3,54,934 4,10,173
expenses
To Loss on 627 1,750 By Other
sale of fixed incomes :
To Income 21,519 40,195 By Discount on 2,125 1,896
Tax purchase
To Net Profit 35,371 44,425 By Profit on 1,500
sale of land
3,60,457 4,13,379 3,60,457 4,13
,379

12. Solution:
ASHOK LTD.
Comparative Income Statement for the years ending 2000 and 2001
Particulars 2000 Rs. 2001 Rs. Increase (+) Increase (+)
Decrease (-) Decrease (-)
Amount (Rs.) Percentages
Sales 3,60,728 4,17,125 +56,397 +15.63
Less: Sales returns 5,794 6,952 +1.158 +19.98
3,54,934 4,10,173 +55,239 +15.56
Less: Cost of goods 2,31,625 2,41,950 + 10,325 +4.46
sold
Gross Profit 1,23,309 1,68,223 +44.914 +36.42
Operating Expenses:
Office expenses 23,266 27,068 +3,802 + 16.34
Selling expenses 45,912 57,816 +11,904 +25.93
Total operating 69,178 84,884 +15,706 +22.70
expenses
Operating profit 54,131 83,339 +29,208 +53.96
Add: Other incomes 5,523 3,206 -2,317 -41.95
59,654 86,545 +26.891 +45.08
Less: Other expenses 2,764 1,925 -839 -30.35
Profit before tax 56,890 84,620 +27,730 +48.74
Less: Income tax 21,519 40,195 +18,676 +86.79
Net Profit after tax 35,371 44,425 +9,054 +25.60
The comparative Income statement reveals that while the net sales
has been increased by 15.5%, the cost of goods sold increased by 4.46%. So
gross profit is increased by 36.4%. The total operating expenses has been
increased by 22.7% and the gross profit is sufficient to compensate increase
in operating expenses. Net profit after tax is 9,054 (i.e., 25.6%) increased.
The overall profitability of the undertaking is satisfactory.
Illustration: 4
The following are the Balance Sheets of Gokul Ltd., for the years
ending 31s1 December, 2000,2001.
Particulars 2000 2001

13. Rs. Rs.
Liabilities
Equity share capital 2,00,000 3,30,000
Preference share capital 1,00,000 1,50,000
Reserves 20,000 30,000
Profit and Loss a/c 15,000 20,000
Bank overdraft 50,000 50,000
Creditors 40,000 50,000
Provision for taxation 20,000 25,000
Proposed Dividend 15,000 25,000
Total 4,60,000 6,80,000
Fixed Assets
Less: Depreciation 2,40,000 3,50,000
Stock 40,000 50,000
Debtors 1,00,000 1,25,000
Bills Receivable 20,000 60,000
Prepaid expenses 10,000 12,000
Cash in hand 40,000 53,000
Cash at Bank 10,000 30,000
Total 4,60,000 6,80,000
COMMON SIZE STATEMENTS
The figures shown in financial statements viz. Profit / Loss Account
and Balance sheet are converted to percentages so as to establish each
element to the total figure of the statement and these statement are called
Common Size Statements. These statements are useful in analysis of the
performance of the company by analyzing each individual element to the
total figure of the statement. These statements will also assist in analyzing
the performance over years and also with the figures of the competitive firm
in the industry for making analysis of relative efficiency. The following
statements show the method of presentation of the data.
Illustration: 5
Common Size Income Statement of XYZ Ltd., for the year ended 31st
March, 2001.
Particulars Amount (Rs.) % to Sales
Sales (A) 14,00,000 100
Raw materials 5,40,000 16.4
Direct wages 2,30,000 16.4
Faciory expenses 1,60,000 11.4

14. (B) 9,30,000 66.4
GrossProfit (A) - 4,70,000 33.6
(B)
Less: Administrative 1,10,000 7.9
expenses
Selling and distribution 80,000 5.7
expenses
Operating Profit 2,80,000 20.0
Add: Non-operative income 40,000 2.9
3,20,000 22.9
Less: Non-operating 60,000 43
expenses
Profit before tax 2,60,000 18.6
Less: Income tax 80,000 5.7
Profit after tax 1,80,000 12.9
Common Size Balance Sheet of XYZ
Particulars Amount (Rs.) % to Total
ASSETS
Fixed Assets
Land 50,000 5.3
Buildings 1,10,000 11.7
Plant and Machinery 2,50,000 26.6
Current Assets :
Inventory
Raw materials 80,000 8.5
Work-in-progress 50,000 5.3
Finished goods 1,60,000 17.0
Sundry debtors 2,10,000 22.4
Cash at Bank 30,000 3.2
Total 9,40,000 100.0
Capital and Liabiltiies
Euqity Share capital 2,50,000 26.6

15. Preference Share Capital 1,00,000 10.6
General reserve 1,60,000 17.0
Debentures 80,000 8.5
Current Liabilities
Sundry Creditors 2,20,000 23.4
Creditors for expenses 40,000 4.3
Bills payable 90,000 9.6
9,40,000 100.0
Analysis of performance and position can be made from the above
Common Size Statements.
llustration: 6
From the following P&L A/c prepare a Common Size Income
Statement-
Particulars 2000 2001 Particulars 2000 2001
Rs. Rs. Rs. Rs.
To Cost of goods 12,000 1 5,000 By Net Sales 16,000 20,000
sold
To Administrative 400 400
expenses
To Selling 600 800
expenses
To Net Profit 3,000 3,800
16,000 20,000 16,000 20,000
Common Size Income Statement
Particulars 2000 2001
Rs. % Rs. %
Net sales 16,000 100.00 20,000 100.00
Less: Cost of goods sold 12,000 75.00 15,000 7500
Gross 4,000 25.00 5,000 25.00
Profit
Less: Operating
expenses
Administration 400 2.50 400 2.00
expenses

16. Selling expenses 600 3.75 800 4.00
Total Operating 1,000 6.25 1,200 6.00
expenses
Net Profit 3,000 18.75 3,800 19.00
Illustration: 7
Following are Balance sheet of Vinay Ltd. for the year ended 31st
December 2000 and 2001.
Liabilities 2000 2001 Assets 2000 2001
Rs. Rs. Rs. Rs.
Equity capital 1,00,000 1 ,65,000 Fixed Assets (Net) 1 ,20,000 1,75,000
Pref. Capital 50,000 75,000 Stock 20,000 25,000
Reserves 10,000 15,000 Debtors 50,000 62,500
P&L A/c 7,500 10,000 Bills receivable 10,000 30,000
Creditors 20,000 25,000 Cash at Bank 20,000 26,500
Provision 10,000 12,500 Cash in hand 5,000 15,000
for taxation
Proposed 7,500 12,500
dividends
2,30,000 3,40,000 2,30,000 3,40,000
Prepare a common size balance sheet and interpret the same.

17. TREND ANALYSIS
In trend analysis ratios of different items are calculated for various
periods for comparison purpose. Trend analysis can be .done by trend
percentage, trend ratios and graphic and diagrammatic representation.
The trend analysis is a simple technique and does not involve tedious
calculations.
Illustration: 8
From the following data, calculate trend percentage taking 1999 as
base.
Particulars 1999 2000 2001
Rs. Rs. Rs.
Sales 50,000 75,000 1,00,00
0
Purchases 40,000 60,000 72,000
Expenses 5,000 8,000 15,000
Profit 5,000 7,000 13,000
Solution:
Particulars 1999 Rs. 2000 2001 Rs. Trend Percentage Base 1999
Rs.
Rs. Rs. Rs. 1999 2000 2001
Purchases 40,000 60,000 72,000 100 150 180
Expenses 5,000 8,000 15,000 100 160 300
Profit 5,000 7,000 13,000 100 140 260
Sales 50,000 75,000 1,00,000 100 150 200
Illustration: 9
From the following data, calculate trend percentages (1999 as base)
Particulars 1999 2000 2001
Rs. Rs. Rs.
Cash 200 240 160
Debtors 400 500 650
Stock 600 800 700
Other Current Assets 450 600 750

18. Land 800 1,000 1,000
Buildings 1,600 2,000 2,400
Plant 2,000 2,000 2,400
Solution:
Particulars 2000 2001 (Base Year 1999)
Rs. Rs. Rs. 1999 2000 2001
Cash 200 240 160 100 120 80
Debtors 400 500 650 100 125 163
Other Current 450 600 750 100 133 167
Assets
Total Current 1,650 2,140 2,260 100 130 137
Assets
Fixed Assets:
Land 800 1,000 1,000 100 125 125
Buildings 1,600 2,000 2,400 100 125 150
Plant 2,000 2,000 2,400 100 100 120
Total Fixed Assets 4,400 5,000 5,800 100 114 132

19. RATIO ANALYSIS
INTRODUCTION
The financial statements viz. the income statement, the Balance sheet
The Income statement, the Statement of retained earnings and the
Statement of changes in financial position report what has actually
happened to earnings during a specified period. The balance sheet presents
a summary of financial position of the company at a given point of time. The
statement of retained. earnings reconciles income earned during the year
and any dividends distributed with the change in retained, earnings between
the start and end of the financial. year under study. The statement of
changes in financial position provides a summary of funds flow during the
period of financial statements.
Ratio analysis is a very powerful analytical tool for measuring
performance of an organisation. The ratio analysis concentrates on the
interrelationship among the figures appearing in the aforementioned four
financial-statements. The ratio analysis helps the management to analyse
the past. performance of the firm and to make further projections. Ratio
analysis allow1-interested parties like shareholders, investors, creditors,
Government analysts to make an evaluation of certain aspects of a firm's
performance.
Ratio analysis is a process of comparison of one figure against
another, which make a ratio, and the appraisal of the ratios to make proper
analysis about the strengths and weaknesses of the firm's operations. The
calculation of ratios is a relatively easy and simple task but the proper
analysis and interpretation of the ratios can be made only by the skilled
analyst. While interpreting the financial information, the analyst has to be
careful in limitations imposed by the accounting concepts and methods of
valuation. Information of non-financial nature will also be taken into
consideration before a meaningful analysis is made.
Ratio analysis is extremely helpful in providing valuable insight into a
company's financial picture. Ratios normally pinpoint a business strengths
and weakness in two ways:
Ratios provide an easy way to compare today's performance with past.
Ratios depict the areas in which a particular business is competitively
advantaged or disadvantaged through comparing ratios to those of
other businesses of the same size within the same industry.
CATEGORIES OF RATIOS
The ratio analysis is made under six broad categories as follows:
Long-term solvency ratios
Short-term solvency ratios
Profitability ratios

20. Activity ratios
Operating ratios
Market test ratios
Long-Term Solvency Ratios
The long-term financial stability of the firm may be considered as
dependent upon its ability to meet all its liabilities, including those not
current payable. The ratios which are important in measuring the 'long-term
solvency L as follows:
Debt-Equity Ratio
Shareholders Equity Ratio .
Debt to Networth Ratio
Capital Gearing Ratio
Fixed Assets to Long-term Funds Ratio
Proprietary Ratio
Dividend Cover
Interest Cover
Debt Service Coverage Ratio
1. Debt-Equity Ratio:
Capital is derived from two sources: shares and loans. It is quite hkely
for only shares to be issued when the company is formed, but loans are
invariably raised at some later date. There are numerous reasons for issuing
loan capital. For instance, the owners might want to increase their
investment but avoid the'risk which attaches to share capital, and they can
do this by making a secured loan. Alternatively, management might require
additional finance which the shareholders are unwilling to supply and so a
loan is raised instead. In either case, the effect is to introduce an element of
gearing or leverage into the capital structure :of the company. There are
numerous ways of measuring gearing, but the debt-equity ratio is perhaps
most commonly used.
Long - term debt
Share holders funds
This ratio indicates the relationship between loan funds and net worth
of the company, which is known as gearing. If the proportion of debt to
equity is low, a company is said to be low-geared, and vice versa. A debt
equity ratio of 2:1 is the norm accepted by financial institutions for
financing of projects. Higher debt-equity ratio may be permitted for highly
capital intensive industries like petrochemicals, fertilizers, power etc. The
higher the gearing, the more volatile the return to the shareholders.

21. The use of debt capital has direct implications for the profit accruing
to the ordinary shareholders, and expansion is often financed in this
manner with the objective of increasing the shareholders' rate of return.
This objective is achieved only if the rate earned on the additional funds
raised exceeds that payable to the providers of the loan.
The shareholders of a highly geared company reap disproportionate
benefits when earnings before interest and tax increase. This is because
interest payable on a large proportion of total finance remains unchanged.
The converse is also true, and a highly geared company is likely to find itself
in severe financial difficulties if it suffers a succession of trading losses. It is
not possible to specify an optimal level of gearing for companies but, as a
general rule, gearing should be low in those industries where demand is
volatile and profits are subject to fluctuation.
A debt-equity ratio which shows a declining trend over the years is
usually taken as a positive sigh reflecting on increased cash accrual and
debt repayment. In fact, one of the indicators of a unit turning sick is a
rising debt-equity ratio. Usually in calculating the ratio, the preference share
capital is excluded from debt, but if the ratio is to show effect of use of fixed
interest sources on earnings available to the shareholders then it is to be
included. On the other hand, if the ratio is to examine financial solvency,
then preference shares shall form part of the capital.
2. Shareholders Equity Ratio :
This ratio is calculated as follows:
Shareholders Equity
Total assets (tan gible)
It is assumed that larger the proportion of the shareholders' equity,
the stronger is the financial position of the firm, This ratio will supplement
the debt-equity ratio. In this ratio the relationship is established between
the shareholders funds and the total assets. Shareholders funds represent
both equity and preference capital plus reserves and surplus less losses. A
reduction in shareholder's equity signaling the over dependence on outside
sources for long-term financial needs and this carries the risk of higher
levels of gearing. This ratio indicates the degree to which unsecured
creditors are protected against iosr in the event of liquidation.
3. Debt to Net worth Ratio :
This ratio is calculated as follows:
Long - term debt
Networth
The ratio compares long-term debt to the net worth of the firm i.e., the
capital and free reserves less intangible assets. This ratio is finer than the

22. debt-equity ratio and includes capital which is invested in fictitious assets
like deferred expenditure and carried forward tosses. This ratio would be of
more interest to the contributories of long-term finance to the firm, as the
ratio gives a S factual idea of the assets available to meet the long-term
liabilities.
4. Capital Gearing Ratio :
It is the proportion of fixed interest bearing funds to Equity
shareholders, funds:
Fixed int eresi bearing funds :
Equity Shareholder's funds
The fixed interest bearing funds include debentures, long-term loans and
preference share capital. The equity shareholders funds include equity share
capital, reserves and surplus. Capital gearing ratio indicates the degree of
vulnerability of earnings available for equity shareholders. This ratio signals
the firm which is operating on trading on equity. It also indicates the
changes in benefits accruing to equity shareholders by changing the levels of
fixed interest bearing funds in the organisation.
5. Fixed Assets to Long-term Funds Ratio :
The fixed assets is shown as a proportion to long-term funds as
follows:
Fixed Assets
Long - term Funds
The ratio includes the proportion of long-term funds deployed in fixed
assets. Fixed assets represents the gross fixed assets minus depreciation
provided on this till the date of calculation. Long-term funds include share
capital, reserves and surplus and long-term loans. The higher the ratio
indicates the safer the funds available in case of liquidation. It also indicates
the proportion of long-term funds that is invested in working capital.
6. Proprietor Ratio :
It express the relationship between net worth and total asset
Net worth
Total Assets
Net worth = Equity Share Capital-t-Preference Share Capital+Fictitious
Assets Total Assets = Fixed Assets + Current Assets (excluding fictitious
assets)
Reserves earmarked specifically for a particular purpose should not be
included in calculation of Net worth. A high proprietory ratio indicative of
strong financial position of the business. The higher the ratio, the better it
is.

23. 7. Interest Cover:
Profil before interest depreciationand tax
Interest
The interest coverage ratio sLjws how many times interest charges are
covered by funds that are available for payment of interest. An interest cover
of 2:1 is considered reasonable by financial institutions. A very high ratio
indicates that the firm is conservative in using debt and a very low ratio
indicates excessive use of debt.
8. Dividend Cover :
Net Profit after tax
Dividend
This ratio indicates the number of times the dividends are covered by
net profit his highlights the amount retained by a company for financing of
future operations.
9. Debt Service Coverage Ratio :
It indicates whether the business is earning sufficient profits to pay
not only the interest charges, but also the instalments due to the 'principal'
amount. It is calculated as:
PBIT
Interest + Periodic Loan Instalment
(1 - Rate of Income Tax)
The greater the debt service coverage ratio, the better rs the servicing
ability of the organisation.
Short-term Solvency Ratios
The short-term solvency ratios, which measure the liquidity of the firm
and its liability of the firm and its ability to meet it- maturing short-term
obligations. Liquidity is defined as the ability to realise value in money, the
most liquid of assets. It refers to the ability to pay in cash, the obligations
that -are due.

24. The corporate liquidity has two dimensions viz., quantitative and
qualitative concepts. The quantitative concept includes the quantum,
structure and utilisation of liquid assets and in the qualitative concept, it is
the ability to meet all present and potential demands on cash" from any
source in a manner that minimizes cost and maximizes the value of the firm.
Thus, corporate liquidity is, a vital factor in business - excess liquidity,
though a guarantor of solvency would reflect lower profitability, deterioration
in managerial efficiency, increased speculation and unjustified expansion,
extension of too liberal credit and dividend policies. Too little liquidity then
may lead to frustration' of-i business objectives, reduced rate of return,
business opportunity missed and& weakening of morale. The important
ratios in measuring short-term solvency are:
(1) Current Ratio
(2) Quick Rarip
(3) Absolute Liquid Ratio
(4) Net working capital ratio
1. Current Ratio :
Current Assets, Loans & Advances
Current Liabilities & Provisions
This ratio measures the solvency of the company in the short-term.
Current assets are those assets which can be converted into cash within a
year. Current liabilities and provisions are those liabilities that are payable
within a year. A current ratio 2:1 indicates a highly solvent position. A
current ratio 1.33:1 is considered by banks as the minimum acceptable level
for providing working capital finance. The constituents of the current assets
are as important as the current assets themselves for evaluation of a
company's solvency position, A very high current ratio will have adverse
impact on the profitability of the organisation. A high current ratio may be
due to the piling up of inventory, inefficiency in collection of debtors, high
balances in Cash and Bank accounts without proper investment
2. Quick Ratio or Liquid Ratio:
Current Assets, Loans & Advances - Inventories
Current Liabilities & Provisions- Bank Overdraft
Quick ratio used as measure of the company's ability to meet its
current obligations. Since bank overdraft is secured by the inventories, the
other current assets must be sufficient to meet other current liabilities. A
quick ratio of 1:1 indicates highly solvent position. This ratio is also called
acid test ratio. This ratio serves as a supplement to the current ratio in
analysing liquidity.

25. 3. Absolute Liquid Ratio (Super Quick Ratio):
It is the ratio of absolute liquid assets to quick liabilities. However, for
calculation'purposes, it is taken as ratio of absolute liquid assets to current
liabilities. Absolute liquid assets include cash in hand, cash at bank and
short term or temporary investments.
Absolute Liquid Assets
Current Liabilities
Absolute Liquid Assets =Cash in Hand + Cash at Bank + Short term
investments
The ideal Absolute liquid ratio is taken as 1:2 or 0.5.
Activity Ratios or Turnover Ratios
Activity ratios measure how effectively the firm employs its resources.
These ratios are also called turnover ratios which involve comparison
between the level of sales and investment in various accounts - inventories,
debtors, fixed assets etc. activity ratios are used to measure the speed with
which various accounts are converted into sales or cash. The following
activity ratios are calculated for analysis:
1. Inventory :
A considerable amount of a company's capital may be tied up in the
financing of raw materials, work-in-progress and finished goods. It is
important to ensure that the level of stocks is kept a low as possible,
consistent with the need to fulfill customer's orders in time.
Inventory Turnover Ratio = Cost of goods sold
Average Inventory
Sales
Average Inventory
Average inventory = Opening stock+Closing stock
2
The higher the stock turn over rate the lower the stock turnover
period the better, although the ratios will vary between companies. For
example, the stock turnover rate in a food retailing company must be higher

26. than the rate in a manufacturing concern. The level of inventory in a
company may be assessed by the use of the inventory ratio, which measures
how much has been tied up in inventory.
Inventory Ratio = Inventory
Current Assets X 100
The inventory turnover ratio measures how many times a company's
inventory has been sold during the year. If the inventory turnover ratio has
decreased from past, it means that either inventory is growing or sales are
dropping. In addition to that, if a firm has a turnover that is slower than for
its industry, then there may be obsolete goods on hand, or inventory stocks
may be high. Low inventory turnover has impact on the liquidity of the
business.
2. Debtors :
The three main debtor ratios are as follows:
(1) Debtor Turnover Ratio
Debtor turnover, which measures whether the amount of resources
tied up in debtors is reasonable and whether the company has been efficient
in converting debtors into cash. The formula is:
Credit Sales
Average Debtors
The higher the ratio, the better the position.
(ii) Average Collection Period
Average collection period, which measures how long it take to collect
amounts from debtors. The formula is:
Average debtors
Credit Safes X 365
The actual collection period can be compared with the stated credit
terms of the company. If it is longer than those terms, then this indicates
some insufficiency in the procedures for collecting debts.
(ii) Bad Debts
Bad debts, which measures the proposition of bad debts to sales:
Bad debts
Sales
This ratio indicates the efficiency of the credit control procedures of
the company. Its level will depend on the type of business. Mail order-
companies have to accept a fairly high level of bad debts, white retailing
organisations should maintain very low levels or, if they do not allow credit
accounts, none at all. The actual ratio is compared with the target or norm
to decide whether or not it is acceptabie.
3. Creditors:

27. (i) Creditors Turnover Period
The measurement of the creditor turnover period shows the average
time taken to pay for goods and services purchased by the company. The
formula is:
Average creditors
Purchases X 365
In general the longer the credit period achieved the better, uecause
delays in payment mean that the operation of the company are being
financed interest free by, suppliers of funds. But there will be a point
beyond which-delays in payment will damage relationships with suppliers
which, if they are operating in a seller's market, may harm the company. If
too long a period is taken to pay creditors, the credit rating of the company
may suffer, thereby making it more difficult to obtain suppliers in the
future.
(ii) Creditors Turnover Ratio
Credit purchases
Average creditors
The term creditors include trade creditors and bills payable.
4. Assets Turnover Ratios:
This measures the company's ability to generate sales revenue in
relation to the size of the asset investment A low asset turnover may be
remedied by increasing sales or by disposing of certain assets or both. To
assist in establishing which part of the asset structure is not being used
efficiently, the asset turnover ratio should be sub-analysed.
(i) Fixed Assets Turnover Ratio
Sales
Fixed assets
This ratio will be analysed further with ratios for each main category
of asset This is a difficult set of ratios to interpret as asset values are based
on historic cost An increase in the fixed asset figure may result from the
replacement of an asset at an increased price or the purchase of an
additional asset intended to increase production capacity. The later
transaction might be expected to result in increased sales whereas the
former would more probably be reflected in reduced operating costs.
The ratio of the accumulated depreciation provision to the total of
fixed assets at cost might be used as an indicator of the average age of the
assets; particularly when depreciation rates are noted in the accounts.
The ratio of sales value per share foot of floor space occupied is particularly
significant, for trading concerns, such as a wholesale warehouse or a
department store.

28. (ii) Total Assets Turnover Ratio
This ratio indicates the number of times total assets are being turned over in
a year.
Sales
Total assets
The higher the ratio indicates overtrading of total assets while a low
ratio indicates idle capacity.
5. Working Capital Turnover Ratio :
This ratio is calculated as follows:
Sales
Working capital
This ratio indicates the extent of working capital turned over in
achieving sales of the firm.
6. Sales to Capital Employed Ratio :
This ratio is ascertained by dividing sales with capital employed.
Sales
——————————
Capital employed
This ratio indicates, efficiency in utilisation of capital employed in
generating revenue.
Profitability Ratios
The purpose of study and analysis of profitability ratios are to help
assess the adequacy of profits earned by the company and also to discover
whether profitability is increasing or declining. The profitability of the firm is
the net result of a large number of policies and decisions. The profitability
ratios are measured with reference to sales, capital employed, total assets
employed; shareholders funds etc. The major profitability rates are as
follows:
(a) Return on capital employed (or Return on investment) [ROI or
ROCE]
(b) Earnings per share (EPS)
(c) Cash earnings per share (Cash EPS)
(d) Gross profit margin
(e) Net profit margin
(f) Cash profit ratio
(g) Return on assets

29. (h) Return on Net worth (or Return on Shareholders equity)
I. Return on Capital Employed (ROCE) or Return on Investment (ROI)
The strategic aim of a business enterprise is to earn a return on
capital. If in any particular case, the return in the long-run is not
satisfactory, then the deficiency should be corrected or the activity be
abandoned for a more favourable one. Measuring the historical performance
of an investment center calls for a comparison of the profit that has been
earned with capital employed. The rate of return on investment is
determined by dividing net profit or income by the capital employed or
investment made to achieve that profit.
ROI = Profit
X 100
Invested capital
ROI consists of two components viz, I. Profit margin, and fl.
Investment turnover, as shown below:
ROI = Net profit = Net profit Sales
X
Investment Sales Investment in assets
It will be seen from the above formula that ROI can be improved by
increasing one or both of its components viz., the profit margin and the
investment turnover in any of the following ways:
Increasing the profit margin
Increasing the investment turnover, or
Increasing both profit margin and investment turnover
The obvious generalisations that can be made about the ROI formula are
that any action is beneficial provided that it:
Boosts sales
Reduces invested capital
Reduces costs (while holding the other two factors constant)

30. Table-1: Computation of Capital Employed
Share capital of the company xxx
Reserves and surplus xxx
Loans (secured/ unsecured) xxx
xxx
Less: (a) Capital-in-progress xxx
(b) Investment outside the business xxx
(c) Preliminary expenses
(d) Debit balance of Profit and Loss xxx xxx
A/c
Capital employed xxx
Return on in vestment analysis provides a strong incentive for optimal
utilisation of these assets of the company. This encourages mangers to
obtain, assets that will provide a satisfactory return on investment and to
dispose of assets that are not providing an acceptable return. In selecting
amongst alternative long-term investment proposals, ROI provides a suitable
measure for assessment of profitability of each proposal.
2. Earnings Per Share (EPS):
The objective of financial Management is wealth or value maximisation
of a corporate entity. The value is maximized when market price of equity
shares is maximised. The use of the objective of wealth maximisation or net
present value maximisation has been advocated as an appropriate and
operationally feasible criterion to choose among the alternative financial
actions. In practice, the performance of a corporation Is better judged in
terms of its earnings per share (EPS). The EPS is one of the important
measures of economic performance of a corporate entity.
The flow of capital to the companies under the present imperfect
capital market conditions woold be made on the evaluation of EPS. Investors
lacking inside and detailed information would look upon the EPS as the best
base to lake their investment decisions. A higher EPS means better capital
productivity.
EPS = Net Profit after tax and preference dividend
No. of Equity Shares
I EPS when Debt and Equity used
= (EBIT – 1) (1 – T)
N
II. EPS when Debt, Preference and Equity used
= (EBIT – I ) (1 – T) - DP
N
Where EBIT = Earnings before interest and tax
I = Interest
T = Rate of Corporate tax
DP = Preference Dividend
N = Number of Equity shares

31. EPS is one of the most important ratios which measures the net profit
earned per share. EPS is one of the major factors affecting the dividend
policy of the firm and the market prices of the company. Growth in EPS is
more relevant for pricing of shares from absolute EPS. A steady growth in
EPS year after year indicates a good track of profitability.
3. Cash Earnings Per Share :
The cash earnings per share (Cash EPS is calculated by dividing the
net profit before depreciation with number of equity shares.
Net profit + Depreciation
No. of Equity Shares
This is a more reliable yard stick for measurement of performance of
companies, especially for highly capital intensive industries where provision
for depreciation is substantial. This measures the cash earnings per share
and is also a relevant factor for determining the price for the company's
shares. However, this method is not as popular as EPS and is used as a
supplementary measure of performance only.
4. Gross Profit Margin :
The gross profit margin is calculated as follows:
= Sales - Cost of goods sold Gross profit X 100
Sales X 100 Sales
The ratio measures the gross profit margin on the total net sales made
by the company. The grosi, profit represents the excess of sales proceeds
during the 1 period under observation over their cost, before
taking into account administration, selling and distribution and
financing charges. The ratio . measures the efficiency of the company's
operations and this can also be; compared with the previous years results to
ascertain the efficiency partners with respect to the previous years.
When everything normal, the gross profit margin should remain
unchanged, irrespective of the level of production and sales, since it is based
on the assumption that all costs deducted when computing gross profit
which are directly variable with sales. A stable gross profit margin is
therefore, the norm and any variation from it call for careful investigations,
which may be caused; due to the following reasons:
(i) Price cuts: A company need to reduce its selling price to achieve the
desired increase in sales.

32. (ii) Cost increases: The price which a company pay its suppliers during
period of inflation, is likely to rise and this reduces the gross profit
margin unless an appropriate adjustment is made to the selling price.
(iii) Change in mix: A change in the range or mix of products sold causes
the overall gross profit margin assuming individual product lines earn
different gross profit percentages.
(iv) Under or Over-valuation of stocks.
If closing stocks are under-valued, cost of goods sold is inflated and
profit understated. An incorrect valuation may be the result of an error
during stock taking or it may be due to fraud The gross profit margin may
be compared with that of competitors in the industry to assess the
operational performance relative to the other players in the industry.
5. Net Profit Margin:
The ratio is calculated as follows:
Net profit before interest and tax
X 100
Sales
The ratio is designed to focus attention on the net profit margin
arising from business operations before interest and tax is deducted. The
convention is to express profit after tax and interest as a percentage of sales.
A drawback is that the percentage which results, varies depending on the
sources employed to finance business activity; interest is charged 'above the
line while dividends are deducted 'below the line'. It is for this reason that
net profit i.e. earnings before interest and tax (EBIT) is used.
This ratio reflects nt: profit margin on the total sales after deducting
all expenses but before deducting interest and taxation. This ratio measures
the efficiency of operation of the company. The net profit is arrived at from
gross profit after deducting administration, selling and distribution
expenses. The non-operating incomes and expenses are ignored in
computation of net profit before tax, depreciation and interest
This ratio could be compared with that of the previous year's and with
that of competitors to determine the trend in net profit margins of the
company and its performance in the industry. This measure will depict the
correct trend of performance where there are erratic fluctuations in the tax
provisions from year to year. It is to be observed that majority of the costs
debited to the profit and loss account are fixed in nature and any increase in
sales will cause the cost per unit to decline because of the spread of same
fixed cost over the increased number of units sold.
6. Cash Profit Ratio
Cash profit
Sales X 100
Where Cash profit = Net profits Depreciation

33. Cash profit ratio measures the cash generation in the business as a
result of trie operations expressed in terms of sales. The cash profit ratio is a
more reliable indicator of performance where there are sharp fluctuations in
the profit before tax and net profit from year to year owing to difference in
depreciation charged. Cash profit ratio eva)'iates the efficiency of operations
in terms of cash generation and is not affected y the method of depreciation
charged. It also facilitate the inter-firm comparison of performance since
different methods of depreciation may be adopted by different companies.
7. Return on Assets :
This ratio is calculated as follows:
Net profit after tax
Total assets X 100
The profitability, of the firm is measured by establishing relation of net
profit with the total assets of the organisation. This ratio indicates the
efficiency of utilisation of assets in generating revenue.
8. Return on Shareholders Funds or Return on Net Worth
Net profit after interest and tax
Net worth X 100
Where, Net worth = Equity capital + Reserves and Surplus.
This ratio expresses (he nel profit in Icrms of the equity shareholders
funds. This ratio is an important yardstick of performance of equity
shareholders since it indicates the return on the funds employed by them.
However, this measure is based on the historical net worth and will be high
for old plants and low for new plants.
The factor which motivates shareholders to invest in a company is the
expectation of an adequate rate of return on their funds and periodically,
they will want to assess the rate of return earned in order to decide whether
to continue with their investment. There are various factors of measuring
the return including the earnings yield and dividend yield which are
examined at later stage. This ratio is useful in measuring the rate of return
as a percentage of the book value of shareholders equity.
The further modification of this ratio is made by considering the
profitability from equity shareholders point of view can also be worked out
by taking the profits after preference dividend and comparing against capital
employed after deducting both long-term loans and preference capital.
Operating Ratios
The ratios of all operating expenses (i.e. materials used, labour,
factory-overheads, administration and selling expenses) to sales is the
operating ratio. A comparison of the operating ratio would indicate whether

34. the cost content is high or low in the figure of sales. If the annual
comparison shows that the sales has increased the management would be
naturally interested and concerned to know as to which element of the cost
has gone up. It is not necessary that the management should be concerned
only when the operating ratio goes up. If the operating ratio has fallen,
though the unit selling price has remained the same, still the position needs
analysis as it may be the sum total of efficiency in certain departments and
inefficiency in others, A dynamic management should be interested in
making a complete analysis.
It is, therefore, necessary to break-up the operating ratio into various
cost ratios. The major components of cost are: Material, labour and
overheads. Therefore, it is worthwhile to classify the cost ratio as:
1. Materials Cost Ratio = MaterialsConsumed
Sales X 100
2. Labour Cost Ratio = Labour Cost Sales 100
X
Sales
3. Factory Overhead Ratio = Factory Expenses
Sales X 100
4. Administrative Expense Ratio = Administrative Expenses
X 100
Sales
5. Selling and distribution
expenses ratio = Selling and Distribution Expenses X 100
Sales
Generally all these ratios are expressed in terms of percentage. Then total
up all the operating ratios. This is deducted from 100 will be equal to the net
profit ratio. If possible, the total expenditure for effecting sales should be
divided into two categories, viz. Fixed and variable and then ratios should be
worked out. The ratio of variable expenses to sales will be generally
constant; that of fixed expenses should fall if sales increase, it will increase
if sales fall.
Market Test Ratios
The market test ratios relates the firm's stock price to its earnings and
book value per share. These ratios give management an indication of what
investors think of the company's past performance and future prospectus. If
firm's profitability, solvency and turnover ratios are good, then the market
test ratios will be high and its share price is also expected to be high. The
market test ratios are as follows: -
1. Dividend payout ratio
2. Dividend yield ;
3. Book value

35. 4. Price/Earnings ratio
1. Dividend Payout Ratio:
Dividend per share
Earnings per share
Dividend payout ratio is the dividend per share divided by the
earnings per share. Dividend payout indicates the extent of the net profits
distributed to the shareholders as dividend. A high payout signifies a liberal
distribution policy and a low payout reflects conservative distribution policy.
2. Dividend Yield
Dividend per share
Market price X 100
This ratio reflects the percentage yield that an investor receives on
this investment at the current market price of the shares. This measure is
useful for
investors who are interested in yield per share rather than capital
appreciation.
3. Book Value:
Equity Capitalf +Reserves - Prqfit&Lass debit balance.
Total number of equity shares;
This ratio indicates the net worth per equity share. The book value is
a reflection of the past earnings and the distribution policy of the company.
A high book value indicates that a company has huge reserves and is a
potential bonus candidate. A low book value signifies liberal distribution
policy of bonus and dividends, or alternatively, a poor track record of
profitability. Book value is considered less relevant for the m^ker price as
compared to EPS, as it reflects the past record whereas the market
discounts the future prospects.
4. Price Earnings Ratio (P/E Ratio):
Current market price
Earnings per share
This ratios measures the number of times the earnings of the latest
year at which the share price of a company is quoted. It signifies the
number of years, in which the earnings can equal to current market price.
This ratio reflects the market's assessment of the future earnings potential
of the company. A high P/e ratio reflects earnings potential and a low P/E
ratio low earnings potential. The P/E ratio reflects the market's confidence
in the company's equity. P/e ratio is a barometer of the market sentiment
Companies with excellent track record of profitability, professional

36. management and liberal distribution policy have high P/E ratios whereas
companies with moderate track record, conservative distribution policy
and average prospects quote a low P/E ratios. The market price discounts
the expected earnings of a company for the current year as opposed to the
historical EPS.
LIMITATIONS IN THE USE OF RATIO ANALYSIS
Ratios by themselves mean nothing. They must always be compared
with:
a norm or a target
previous ratios in order to assess trends
the ratios achieved in other com; arable companies (inter-company
comparisons), and
caution has to be exercised in using ratios.
The following limitations must be taken into account:
 Ratios are calculated from financial statements w'.ach are affected by
the financial bases and policies adopted on such matters as
depreciation and the valuation of stocks.
 Financial statements do not represent a complete picture of the
business, but merely a collection of facts which can be expressed in
monetary terms. They may not refer to other factors which affect
performance.
 Over use of ratios as controls on managers could be dangerous, in
that management might concentrate more on simply improving the
ratio than on dealing with the significant issues. For example, the
return on capital employed can be improved by reducing assets rather
than increasing profits.
 A ratio is a comparison of two figures, a numerator and a
denominator In comparing ratios it may be difficult to determine
whether differences are due to changes in the numerator, or in the
denominator or in both.
 Ratios are inter-connected. They should not be treated in isolation.
The effective use of ratios, therefore, depends on being aware of all
these limitations and ensuring that, following comparative analysis,
they are used as a trigger point for investigation and corrective action
rather than being treated as meaningful in themselves.
 The analysis of ratios clarifies trends and weaknesses in performance
as a guide to action as long as proper comparisons are made and the
reasons for adverse trends or deviations from the norm are
investigated thoroughly.
Illustration 1: From the given Balance Sheets calculate:

37. (a) Debt-equity ratio
(b) Liquid ratio
(c) Fixed assets to current assets ratio
(d) Fixed assets to Net worth ratio
Balance Sheet
Liability Rs. Assets Rs.
Share Capital 1,00,000 Goodwill 60,000
Reserve 20,000 Fixed assets (Cost) 1,40,000
Profit and Loss a/c 30,000 Stock 30,000
Secured Loans 80,000 Debtors 30,000
Creditors 50,000 Advances 10,000
Provisions for taxation 20,000 Cash 30,000
3,00,000 3,00,000
Solution:
(a) Debt-equity ratio = Outsiders Funds
Shareholders Funds
Outsider's Funds Rs. Shareholders' Rs.
Funds
Secured Loans 80,000 Share Capital 1,00,000
Creditors 50,000 Reserves 20,000
Provisions for taxation 20,000 Profit and Loss a/c 30,000
1,50,000 1,50,000
Debt-equity ratio = 1,50,000
= 1:1
1,50,000
(b) Liquid ratio = Liquid Assets
Current Liabilities
Note: Advances are treated as current asset.
Secured Joans are treated as current liability.
Liquid ratio = 70,000
1,50,000 = 0.47:1
(c) Fixed Assets to Currents Assets Ratio = Fixed Assets
Current Liabilities
Fixed Assets = 1,40,000 Current Assets (Rs)
Cash 30,000

38. Stock 30,000
Debtors 30,000
Advances 10,000
1,00,000
Fixed assets to current assets ratio = 1,40,000
1,00,000 = 1.4:1
(d) Fixed Assets to Net worth Ratio = Fixed Assets
Net worth
1,00,000
Share Capital
Reserves 20,000
P & L a/c 30,000
1,50,000
Less: Provision for taxation 20,000
1,30,000
Fixed Assets to Net worth ratio = 1,40,000
= 1.08:1
1,30,000
Illustration 2: From the following data calculate;
(a) Current ratio
(b) Quick ratio
(c) Stock Turnover ratio
(d) Operating ratio
(e) Rate of return on equity capital
Balance Sheet as on Dec., 31,2001
Liabilities Rs. Assets Rs.
Equity Share 1,00,000 Plant and Machinery 6,40,000
Capital (Rs. 10 shares)
Profit and loss 3,68,000 Land and buildings 80,000
account
Creditors 1,04,000 Cash 1, 60,000
Bills payable 2,00,000 Debtors
3,60,000
Less: Provision for 3,20,000
bad debts
40,000

39. Other Current 20,000 Stock 4,80,000
liabilities
Prepaid Insurance 12,000
16,92,000 16,92,000
Income Statement for the year ending 31st Dec., 2001
(Rs.)
Sales 4,00,000
Less: Cost of goods sold 30,80,000
9,20,000
Less: Operating expenses 6,80,000
Net Profit 2,40,000
Less: Income tax paid 50% 1,20.000
New Profit after tax 1,20,000
Balances at the beginning of the year:
Debtors Rs. 3,00,000
Stock Rs. 4,00,000
Solution:
(a) Current ratio = Current Assets
Current Liabilities
Current Assets Rs. Current Liabilities Rs.
Cash Creditors 1,04,000
Debtors 3,20,000 Bills Payable 2,00,000
Stock 4,80,000 Other Current 20,000
Liabilities
Prepaid insurance 12,000
9,72,000 3,24,000
Current ratio = 9,72,000
3:1
3,24,000
(b) Quick ratio = Liquid Assets
Current Liabilities
Liquid assets (Rs.)
Current liabilities Rs.3,24,000

40. Cash Debtors 1,60,000
3,20,000
4,80,000
Liquid ratio = 4,80,000
= 1.48:1
3,24,000
(c) Stock Turnover Ratio = Cost of goods sold
Average slock
Cost of goods sold = 30,80,000
Average Stock = Opening Stock + Closing Stock
2
= 4,00,000 + 4,80,000 = 4,40,000
2
Stock Turnover Ratio = 3,80,000
4,40,000 = 7 times
(d) Operating Ratio = Cost of goods sold + Operating expresses X 100
Net Sales
= 30,80,000 + 6,80,000 + 40,00,000 X 100 = 94%
40,00,000
(e) Rate of return on equity capital:
= Net profit afer lax
Equity share capital
= 1,20,000 X 100 = 12%
10,00,000
Illustration 3: The following are the Trading and P&L A/c for the year
ended 31st December 2001 and the Balance Sheet as on that date of K. Ltd.
Trading and P & L A/c
Particulars Rs. Particulars Rs.
To Opening Stock 9,950 By Sales 85,000
To Purchases 54,5.25 By Closing Stock 14,900

41. To Wages 1,425
To Gross Profit 34,000
99,900 99,900
To Administrative 15,000 By Gross Profit 34,000
Expenses
To Selling Expenses 3,000 By Interest 300
To Financial Expenses 1,500 By Profit on sale 600
of shares
To Loss on sale of assets 400
To Net Profit 15,000
34,900 34,900
Balance Sheet
Liabilities Rs. Assets Rs.
Share Capital 20,000 Land and Buildings 15,000
Reserves 9,000 Plant & Machinery 8,000
Current Liabilities 13,000 Stock 14,900
P&LA/c 6,000 Debtors 7,1000
Cash at Bank 3,000
48,000 48,000
You are required to Calculate;
(a) Current Ratio
(b) Operating Ratio
(c) Stock Turnover Ratio
(d) Net Profit Ratio
(e) Fixed Assets Turnover Ratio
Solution:
(a) Current ratio = Current Assets
Current Liabilities
Current Assets (Rs.)
Cash at Bank 3,000
Current liabilities Rs. 13,000

42. Debtors 7,100
Stock 14,900
25,000
Rs. 1.923:1
Current ratio = 25,000
13,000
(b) Operating Ratio = Cost of goods sold + Operating expresses
X 100
Net Sales
Cost of goods sold = 9,950 + 54,525 + 1,425 - 14,900 = 51,000
Operating expenses = 19,500
Operating Ratio = 51,000 + 19,500 X 100 = 82.94%
85,000
(c) Stock Turnover Ratio = Cost of goods sold
Average stock
Average Stock = 9,950 + 14,900
= 12,425
2
Stock Turnover Ratio = 51,000
= 4.1 times
12,425
(d) Net Profit Ratio = Net Profit = 100
Net Sales
= 15,000 = 17.65%
= 100
85,000
(e) Fixed Assets Turnover Ratio = Net Sales
Fixed Assets
= 85,000
= 3.7 times
23,000

43. Illustration 4; The following is the Trading and Profit and Loss a/c and
Balance Sheet of a firm.
Trading and P & L A/c
Particulars Rs. Particulars Rs.
To Opening Stock 10,000 By Sales 1,00,000
To Purchases 55,000 By Closing Stock 15,000
To Gross Profit c/d 50,000
1,15,000 1,15,000
To Administrative Expenses 15,000 By Gross Profit b/d 50,000
To Interest 3,000
To Selling Expenses 12,000
To Net Profit 20,000
50,000 50,000
Balance Sheet
Liabilities Rs. Assets Rs.
Capital 1,00,000 Land and Buildings 50,000
Profit and Loss a/c 20,000 Plant & Machinery 30,000
Creditors 25,000 Stock 15,000
Bills Payable 15,000 Debtors 15,000
Bills receivable 12,500
Cash at Bank 17,500
Furniture 20,000
1,60,000 1,60,000
Calculate the following ratios:
(a) Inventory turnover ratio
(b) Current Ratio
(c) Gross profit ratio
(d) Net profit ratio
(e) Operating ratio
(f) Liquidity ratio
(g) Proprietary ratio

44. Solution:
(a) Inventory Turnover ratio = Cost of goods sold
Average stock
Cost of goods sold
Opening Stock 10,000
Purchases 55,000
65,000
Less: Closing Stock 1 5,000
50,000
Average Stock = Opening Stock + Closing Stock
2
= 10,000 + 15,000
2 = 12,500
Stock Turnover ratio = 50,000
= 4 times
12,500
(b) Current ratio = Current Assets
Current Liabilities
Current Assets (Rs.)
Current Assets Rs. Current liabilities Rs.
Stock 15,000 Creditors 25,000
Debtors 15,000 Bills Payable 15,000
B/R 12,500
Cash at Bank 17,500
60,000 40,000
Current ratio = 60,000
40,000 = 1.5:1
(b) Gross Profit Ratio = Gross Profit
Net Sales X 100 = 50%
(c) Net Profit Ratio = Net Profit
X 100
Net Sales
= 20,000
= 20%
1,00,000

45. (d) Operating Profit = Cost of goods sold + Operating expresses = 100
Net Sales
Cost of goods sold = 50,000
Operating expenses (Rs.)
Administration expenses Selling expenses 15,000
12,000
27,000
Operating ratio = 50,000 + 27,000
X 100 77 %
1,00,000
(e) Liquidity ratio = Liquid Assets
Current Liabilities
Current Assets (Rs.)
Liquid Assets Rs. Current liabilities Rs.
Cash at Bank 17,500 Creditors 25,000
Bills Receivable 12,500 Bills Payable 15,000
Debtors 15,000
45,000 40,000
Liquidity ratio = 45,000
40,000
(f) Proprietary ratio = Shareholder’s Funds
X 100
Total Assets
Shareholder's Furuis (Rs.)
Capital Profit and Loss a/c 1,00,000
Total Assets Rs. 1,60,000
20,000
1,20,000
Proprietary ratio = 1,20,000
X 100 = 75%
1,60.000
Illustration 5: A company has a profit margin of 20% and asset turnover of
3 times. What is the company's return on investment? How will this return
on investment vary if –

46. (i) Profit margin is increased by 5% ?
(ii) Asset turnover is decreased to 2 times?
(iii) Profit margin is decreased by 5% and asset turnover is increased to
4 times.
Calculation of impact of change in profit margin and change in asset
turnover on return on investment
Return on investment = Profit Margin x Asset Turnover
= 20% x 3 times = 60%
(i) If profit margin is increased by 5% :
ROI = 25% x 3 = 75%
(ii) If asset turnover is decreased to 2 times:
ROI = 20% x 2 = 40%
(iii) If profit margin decreased, by 5% and asset turnover is increased to 4
times:
ROI = 15% x 4 = 60%
Illustration 6: There are three companies in the country manufacturing a
particular chemical. Following data are available for the year 2000-2001.
(Rs. lakhs)
Company Net Sales Operating Cost Operating Assets
A Ltd. 300 255 125
B Ltd. 1,500 1,200 750
C Ltd. 1,400 1,050 1,250
Which is the best performer as per your assessment and why?
Comparative Statement of Performance
Particulars A Ltd. B Ltd. C Ltd.
Sales 300 1,500 1,400
Less: Operating Cost 255 1,200 1,050
OperatingProfit (A) 45 300 350
Operating Assets (B) 125 750 1,250
Return on capital employed 36% 40% 28%
(A) / (B) x 1 00
Analysis: Basing on the return on capital employed, B Ltd., is the best
performer as compared to A Ltd. and C Ltd.

47. Illustration 7: Calculate the P/E ratio from the following:
(Rs.)
Equity Share Capital (Rs. 20 each) 50,00,000
Reserves and Surplus 5,00,000
Secured Loans at 15% 25,00,000
Unsecured Loans at 12.5% 10,00,000
Fixed Assets 30,00,000
Investments 5,00,000
Operating Profit 25,00,000,
Income-taxRate50% (Rs.)
Operating Profit 25,00,000
Less: Interest on
Secured Loans @ 15% 3,75,000
Unsecured Loans @ 12.5% 1,25,000 5,00,000
Profit before tax (PBT) 20,00,000
Less: Income-tax @ 50% 10,00,000
Profit aaer tax (PAT) 10,00,000
No. of Equity shares 2,50,000
EPS = Profit after tax
No. of Equity shares
= Rs. 10,00,000 = Rs. 4
Rs. 2,50,000
Market price per share = Rs. 50
P/E Ratio = Market price per share / EPS
= Rs.50/Rs.4 = 12.50
Illustration 8: The capital of Growfast Co. Ltd., is as follows:

48. 10% Preference shares of Rs.10 each 50,00,000
Equity shares of Rs. 100 each 70,00,000
1,20,00,000
Additional information:
Profit after tax at 50% Rs. 15,00,000
Deprication Rs. 6,00,000
Equity dividend paid 10%
Market price per equity share Rs. 200
Calculate the following:
(i) The cover for the preference and equity dividends
(ii) The earnings per share
(iii) The price earnings ratio
(iv) The net funds flow
Solution:
(i) The cover for the Preference and Equity dividends:
Profit after tax
= Preference dividend + Equity dividend
= Rs. 15,00,000
= 1.25 times
Rs. 5,00,000 + to 7,00,000
(ii) The Earning Per Share:
= Net profit after preference dividend
No. of Equity Shares
= Rs. 15,00,000 – Rs. 5,00,000 = Rs. 14.29
Rs.7,00,000
(iii) The Price Earnings Ratio:
= Market price per share
Earning per share
= Rs.200
= 14 times

49. Rs. 14.29
(iv) The Net Funds Flow:
(Rs.)
Profit after tax 15,00,000
Add: Depreciation 6,00,000
21,00,000