ACCOUNTING

MEANING OF ACCOUNTING:

Accounting is the process of recording, classifying, summarizing, analyzing and

interpreting the financial transactions of the business for the benefit of
management and those parties who are interested in business such as shareholders,
creditors, bankers, customers, employees and government. Thus, it is concerned
with financial reporting and decision making aspects of the business.

The American Institute of Certified Public Accountants Committee on

Terminology proposed in 1941 that accounting may be defined as, “The art of
recording, classifying and summarizing in a significant manner and in terms of
money, transactions and events which are, in part at least, of a financial character
and interpreting the results thereof”.

BRANCHES OF ACCOUNTING:

Accounting can be classified into three categories:

1. Financial Accounting

2. Cost Accounting, and

3. Management Accounting
 FINANCIAL ACCOUNTING

MEANING OF FINANCIAL ACCOUNTING:

American Institute of Certified Public Accountants has defined ‘Financial

Accounting’ as “the art of recording, classifying and summarizing in a significant
manner and in terms of money transactions and events which are in part atleast of
a financial character and interpreting the result thereof”.

NATURE AND SCOPE OF FINANCIAL ACCOUNTING:

Financial accounting is a useful tool to management and to external users such as

shareholders, potential owners, creditors, customers, employees and government.
It provides information regarding the results of its operations and the financial
status of the business. The following are the functional areas of financial
accounting:-

1. Dealing with financial transactions:

Accounting as a process deals only with those transactions which are measurable
in terms of money. Anything which cannot be expressed in monetary terms does
not form part of financial accounting however significant it is.
2. Recording of information:

Accounting is an art of recording financial transactions of a business concern.

There is a limitation for human memory. It is not possible to remember all
transactions of the business. Therefore, the information is recorded in a set of
books called Journal and other subsidiary books and it is useful for management
in its decision making process.

3. Classification of Data:

The recorded data is arranged in a manner so as to group the transactions of similar

nature at one place so that full information of these items may be collected under
different heads. This is done in the book called „Ledger‟. For example, we may
have accounts called “Salaries”, “Rent”, “Interest”, “Advertisement”, etc. To
verify the arithmetical accuracy of such accounts, trial balance is prepared.

4. Making Summaries:

The classified information of the trial balance is used to prepare profit and loss
account and balance sheet in a manner useful to the users of accounting
information. The final accounts are prepared to find out operational efficiency and
financial strength of the business.
5. Analyzing:

It is the process of establishing the relationship between the items of the profit and
loss account and the balance sheet. The purpose is to identify the financial strength
and weakness of the business. It also provides a basis for interpretation.

6. Interpreting the financial information:

It is concerned with explaining the meaning and significance of the relationship

established by the analysis. It should be useful to the users, so as to enable them
to take correct decisions.

7. Communicating the results:

The profitability and financial position of the business as interpreted above are
communicated to the interested parties at regular intervals so as to assist them to
make their own conclusions.

FUNCTIONS OF FINANCIAL ACCOUNTING

The progress and reputation of any business is built upon sound financial footing.
There are a number of parties who are interested in the accounting information
relating to business. Accounting is the language employed to communicate
financial information of a concerned to parties – Owners Management, Creditors,
Employees, Investors, Government, Consumers etc. the final accounting
providing information regarding the status of the business and result of its
operations. The following are the main functions, in brief:

1. Record Keeping Function:

The primary function of accounting relates to recording, classification and

summary of financial transactions – journalism, posting, and preparation of final
statements. These facilities to know operating results and financial positions. The
purpose of this function is to report regularly to the interested parties by means of
financial statements the accounting thus performs historical function i.e., attention
on the past performance of a business; and this facilitates decision-making
programme for future activities.

2. Managerial function:

Decision-making programme is greatly assisted by accounting. The managerial

function and decision-making programmers, without accounting, may mislead.
The day-to-day operations are compared with some predetermined standard. This
is an actual operations with the pre-determined standards and their analysis are
possible only with the help of accounting.

3. Legal Requirement function:

Auditing is compulsory in case of registered firms. Auditing is not possible

without accounting. Thus accounting becomes compulsory to comply with legal
requirements. Accounting is a base and with its help various returns, documents,
statements etc., are prepared.

4. Language of business:

Accounting is a language of There are many parties-owners, creditors,

government employees, etc., who are interested in knowing the result of the firm
and this can be communicated only through accounting. The accounting shows a
real and true position of the firm or the business.

5. Interpretation function:

This aspect helps in unfolding the total financial picture of an undertaking and
investing the same with more meaning. Interpretation part is very important for
decision-making. The recorded financial data is interpreted in a manner that the
end-users can make a meaningful judgement about the financial condition and
profitability of the business operations.

LIMITATIONS OF FINANCIAL ACCOUNTING

Financial accounting is concerned with the preparation of final accounts. The

business has become so complex that mere final accounts are not sufficient in
meeting financial needs. Financial accounting is like a post-mortem report. At the
most it can reveal what has happened so far, but it cannot exercise any control
over the past happenings. The limitations of financial accounting are as follows:-

1. It records only quantitative information.

2. It records only the historical cost. The impact of future uncertainties has no
place in financial accounting.

3. It does not take into account price level changes.

4. It provides information about the whole concern. Product-wise, process-wise,

department-wise or information of any other line of activity cannot be obtained
separately from the financial accounting.
5. Cost figures are not known in advance. Therefore, it is not possible to fix the
price in advance. It does not provide information to increase or reduce the selling
price.

6. As there is no technique for comparing the actual performance with that of the
budgeted targets, it is not possible to evaluate performance of the business.

7. It does not tell about the optimum or otherwise of the quantum of profit made
and does not provide the ways and means to increase the profits.

8. In case of loss, whether loss can be reduced or converted into profit by means
of cost control and cost reduction? Financial accounting does not answer this
question.

9. It does not reveal which departments are performing well? Which ones are
incurring losses and how much is the loss in each case?

10. It does not provide the cost of products manufactured

11. There is no means provided by financial accounting to reduce the wastage.

12. Can the expenses be reduced which results in the reduction of product cost and
if so, to what extent and how? No answer to these questions.

13. It is not helpful to the management in taking strategic decisions like

replacement of assets, introduction of new products, discontinuation of an existing
line, expansion of capacity, etc.
14. It provides ample scope for manipulation like overvaluation or undervaluation.
This possibility of manipulation reduces the reliability.

15. It is technical in nature. A person not conversant with accounting has little
utility of the financial accounts.

COST ACCOUNTING:

An accounting system is to make available necessary and accurate information for

all those who are interested in the welfare of the organization. The requirements
of majority of them are satisfied by means of financial accounting. However, the
management requires far more detailed information than what the Conventional
financial accounting can offer. The focus of the management lies not in the past
but on the future.

For a businessman who manufactures goods or renders services, cost accounting

is a useful tool. It was developed on account of limitations of financial accounting
and is the extension of financial accounting. The advent of factory system gave an
impetus to the development of cost accounting.

It is a method of accounting for cost. The process of recording and accounting

for all the elements of cost is called cost accounting.

The Institute of Cost and Works Accountants, London defines costing as, “the
process of accounting for cost from the point at which expenditure is incurred or
committed to the establishment of its ultimate relationship with cost centers and
cost units. In its wider usage it embraces the preparation of statistical data, the
application of cost control methods and the ascertainment of the profitability of
activities carried out or planned”.

The Institute of Cost and Works Accountants, India defines cost accounting as,
“the technique and process of ascertainment of costs. Cost accounting is the
process of accounting for costs, which begins with recording of expenses or the
bases on which they are calculated and ends with preparation of statistical data”.
To put it simply, when the accounting process is applied for the elements of costs
(i.e., Materials, Labour and Other expenses), it becomes Cost Accounting.

OBJECTIVES OF COST ACCOUNTING:

Cost accounting was born to fulfill the needs of manufacturing companies. It is a

mechanism of accounting through which costs of goods or services are ascertained
and controlled for different purposes. It helps to ascertain the true cost of every
operation, through a close watch, say, cost analysis and allocation. The main
objectives of cost accounting are as follows:-

1. Cost Ascertainment

2. Cost Control

3. Cost Reduction

4. Fixation of Selling Price

5. Providing information for framing business policy.

1. Cost Ascertainment:

The main objective of cost accounting is to find out the cost of product, process,
job, contract, service or any unit of production. It is done through various methods
and techniques.

2. Cost Control:

The very basic function of cost accounting is to control costs. Comparison of

actual cost with standards reveals the discrepancies (Variances). The variances
reveal whether cost is within control or not. Remedial actions are suggested to
control the costs which are not within control.

3. Cost Reduction:

Cost reduction refers to the real and permanent reduction in the unit cost of goods
manufactured or services rendered without affecting the use intended. It can be
done with the help of techniques called budgetary control, standard costing,
material control, labour control and overheads control.

4. Fixation of Selling Price:

The price of any product consists of total cost and the margin required. Cost data
are useful in the determination of selling price or quotations. It provides detailed
information regarding various components of cost. It also provides information in
terms of fixed cost and variable costs, so that the extent of price reduction can be
decided.

5. Framing business policy:

Cost accounting helps management in formulating business policy and decision

making. Break even analysis, cost volume profit relationships, differential costing,
etc. are helpful in taking decisions regarding key areas of the business like-
a. Continuation or discontinuation of production

b. Utilization of capacity

c. The most profitable sales mix

d. Key factor

e. Export decision

f. Make or buy

g. Activity planning, etc.

NATURE AND SCOPE OF COST ACCOUNTING:

Cost accounting is concerned with ascertainment and control of costs. The

information provided by cost accounting to the management is helpful for cost
control and cost reduction through functions of planning, decision making and
control. Initially, cost accounting confined itself to cost ascertainment and
presentation of the same mainly to find out product cost. With the introduction of
large scale production, the scope of cost accounting was widened and providing
information for cost control and cost reduction has assumed equal significance
along with finding out cost of production. To start with cost accounting was
applied in manufacturing activities but now it is applied in service organizations,
government organizations, local authorities, agricultural farms, extractive
industries and so on. Cost accounting guides for ascertainment of cost of
production. Cost accounting discloses profitable and unprofitable activities. It
helps management to eliminate the unprofitable activities. It provides information
for estimate and tenders. It discloses the losses occurring in the form of idle time
spoilage or scrap etc. It also provides a perpetual inventory system. It helps to
make effective control over inventory and for preparation of interim financial
statements. It helps in controlling the cost of production with the help of budgetary
control and standard costing. Cost accounting provides data for future production
policies. It discloses the relative efficiencies of different workers and for fixation
of wages to workers.

LIMITATIONS OF COST ACCOUNTING:

i) It is based on estimation: As cost accounting relies heavily on predetermined

data, it is not reliable.

ii) No uniform procedure in cost accounting: as there is no uniform procedure,

with the same information different results may be arrived by different cost
accounts.

iii) Large number of conventions and estimate: There are number of

conventions and estimates in preparing cost records such as materials are issued
on an average (or) standard price, overheads are charged on percentage basis,
Therefore, the profits arrived from the cost records are not true.

iv) Formalities are more: Many formalities are to be observed to obtain the
benefit of cost accounting. Therefore, it is not applicable to small and medium
firms.

v) Expensive: Cost accounting is expensive and requires reconciliation with

financial records.

vi) It is unnecessary: Cost accounting is of recent origin and an enterprise can

survive even without cost accounting.

vii) Secondary data: Cost accounting depends on financial statements for a lot of
information. Any errors or short comings in that information creep into cost
accounts also.

MANAGEMENT ACCOUNTING

Management accounting is the term used to describe the accounting methods,

systems and techniques which, coupled with special knowledge and ability, assist
management or its task of maximizing profits or minimizing losses.”

“Any form of accounting which enables a business to be conducted more

efficiently can be regarded as management accounting.”
NATURE & CHARACTERISTICS OF MANAGEMENT
ACCOUNTING

It is concerned with accounting information which is useful to management in

maximizing profits or minimizing losses. The following are the main
characteristics of Management Accounting.

1. Forecasting:

It is concerned with future. It is not confined only to the collection of historical

data or facts but also attempts to highlight upon” What should have been.” That
is it helps in planning for the future because decisions are always taken for future
course of action. All techniques of it are concerned with future.

2. Supply Information:

It provides information to the management and not decisions. It can inform but it
cannot prescribe. The way in which the data is used depends upon the efficiency
of the management`

3. Increase in efficiency:

It is basically concerned with “the problem of choice. A comparative study of

various related alternative plans have to be undertaken and only that alternative is
normally selected which seems to be more attractive and profitable.

4. Techniques and Concepts:

It uses special techniques and concepts to make accounting data more useful. It
makes a study of costs by dividing the total costs into fixed, semi-variable and
variable components. The techniques usually used includes marginal costing,
break-even analysis, uniform costing etc.

5. Cause and Effect Analysis:

It attempts to examine the “Cause” and “Effect” of different variables. For

instance, if there is a loss the reasons for the loss are probed. Similarly, if there is
a profit, the factors directly influencing the profitability are also studied. This may
be the reason that management accounting is called as science.

6. No Fixed Norms:

It has no set of rules and formats like double entry system of book-keeping.
Though the tolls of management accounting are the same but their use differs from
concern to concern. The analysis of data depends upon the person using it.

7. Assists Management:

It assists management in several ways in its functions but does not replace it. It is
an integral part of business management. It provides all assistance to management
in all of its functions. By providing the accounting information in the required
form, and at the required time. It enables management to perform its functions
effectively.

8. Achieving of Objectives:

The principal objective of management accounting is “to serve the needs of

management” or “to enable manager to manage better.” To take more intelligent
decision, he is able to get the necessary data through accounting procedures by
responsibility accounting, direct costing and other approaches. Management
accounting provides means for bringing meaningful knowledge promptly to the
management for their use.
SCOPE OF MANAGEMENT ACCOUNTING

The scope or field of management accounting is very wide and broad based and it
includes within its fold, a variety if aspects of business operations. The main aim
is to help management in its functions of planning, directing and controlling. The
following are some of the areas of specialization included within the ambit of
management accounting.

1. Financial Accounting:

Financial accounting is the general accounting which relates to the recording of

business transactions in the books of prime entry, posting them into respective
ledger accounts, balancing them and preparing a trial balance. Then a Profit and
Loss Account showing the results of the business and also a Balance Sheet
depicting assets and liabilities of the business concern are prepared. This in turn
forms the basis for analysis and interpretation for furnishing meaningful data to
the management. Hence management accounting cannot obtain full control and
coordination of operations without a well-designed financial accounting system.

2. Cost Accounting:

Costing is a branch of accounting. It is the process and technique of ascertaining

costs. Planning, decision-making and control and the basic managerial functions.
The cost accounting system provides the necessary tools such as Standard
Costing, Budgetary Control, and Inventory Control Marginal Costing etc. for
carrying out such functions efficiently.

3. Budgeting and forecasting:

Budgeting means expressing the plans, policies and goals of the enterprise for a
definite period in future. Forecasting on the other hand, is a prediction of what
will happen as a result of a given set of circumstances. Targets are set for different
departments and responsibility is fixed for achieving these targets. The
comparison of actual performance with budgeted figures will give an idea about
the performance of departments.

4. Statistical Methods:

Statistical tools such as graphs, charts, and diagrams, pictorial restock Level,
notation, index numbers etc. make the information more impressive,
comprehensive and intelligible: other tools such as time series, regression
analysis, sampling technique etc. are highly useful for planning and forecasting.

5. Inventory Control.

It includes control over inventory from the time it is acquired till its final disposal.
Inventory control is significant as it involves large sums. The management should
determine different levels of stocks- Minimum stock level, Maximum Stock
Level, Re-ordering Stock Level, for inventory control. The study if inventory
control will be helpful for taking managerial decisions.

6. Interpretation of Data:

Analysis and interpretation of financial statement are important parts of

management accounting. Financial statements may be studied in comparison to
statements of earlier periods or in comparison with the statements of similar other
firms. After analyzing, the interpretation is made and the reports drawn from these
analysis are presented to the management in a simple language.

7. Reporting:
The interpreted information in the form of quantitative expression must be
communicated to those who are interested in it or to whom it carries vital
importance. At the same time these data should be communicated within
reasonable time. Delay in passing on the data makes the data useless and
obsolete. The reports may cover Profit and Loss Account, Cash and Flow
Statement, Stock Reports etc. Reports may be sent monthly, quarterly, half yearly
etc.

8. Internal Audit:

It needs devising a system of internal control by establishing internal audit

coverage for all operating units. Internal audit helps the management in fixing
responsibility of different individuals.

9. Tax Accounting:

Income statements are prepared and tax liabilities are calculated. The
management is informed about tax burden from Central Government, State
Government and Local Authorities. This includes the computation of taxable
income as per tax law, filing of returns etc. Apart from this, some of the Acts
which have their influence on management decisions are the Companies Act, The
Controller of capital Issues Act, MRTP Act etc.

10.Methods and procedures:

This includes maintenance of proper data processing and other office

management services, reporting on best use of mechanical and electronic devices.
It provides statistical data to the various departments of the organization. It
undertakes special cost studies and estimations, reports on cost-volume-profit
relationships, under changing conditions.
OBJECTIVES OF MANAGEMENT ACCOUNTING:

The fundamental objective of management accounting is to enable the

management to maximize profits or minimize losses. The evolution of
management accounting has given a new approach to the function of accounting.
The main objectives of management accounting are as follows:
1. Planning and policy formulation:

Planning involves forecasting on the basis of available information, setting goals;

framing polices determining the alternative courses of action and deciding on the
programme of activities. Management accounting can help greatly in this
direction. It facilitates the preparation of statements in the light of past results and
gives estimation for the future.

2. Interpretation process:

Management accounting is to present financial information to the management.

Financial information is technical in nature. Therefore, it must be presented in
such a way that it is easily understood. It presents accounting information with the
help of statistical devices like charts, diagrams, graphs, etc.

3. Assists in Decision-making process:

With the help of various modern techniques management accounting makes

decision-making process more scientific. Data relating to cost, price, profit and
savings for each of the available alternatives are collected and analyzed and
provides a base for taking sound decisions.

4. Controlling:

Management accounting is a useful for managerial control. Management

accounting tools like standard costing and budgetary control are helpful in
controlling performance. Cost control is effected through the use of standard
costing and departmental control is made possible through the use of budgets.
Performance of each and every individual is controlled with the help of
management accounting.

5. Reporting:

Management accounting keeps the management fully informed about the latest
position of the concern through reporting. It helps management to take proper and
quick decisions. The performance of various departments is regularly reported to
the top management.

6. Facilitates Organizing:

“Return on Capital Employed” is one of the tools of management accounting.

Since management accounting stresses more on Responsibility Centers with a
view to control costs and responsibilities, it also facilitates decentralization to a
greater extent. Thus, it is helpful in setting up effective and efficiently
organization framework.
7. Facilitates Coordination of Operations:
Management accounting provides tools for overall control and coordination of
business operations. Budgets are important means of coordination.

FUNCTIONS OF MANAGEMENT ACCOUNTING

Management accounting is closely associated with the process called

“management control”. Management control is the process of assuring that
resources are obtained and used effectively and efficiently in the
accomplishment of an organizations objectives. The basic function of
management accounting is to assist the management in performing its functions
effectively. Management accounting is a part of accounting. It has developed out
of the need for making more and more use of accounting for taking managerial
decisions. Management accounting functions may be set to include all activities
with collecting, processing, interpreting and presenting data to management. The
manner in which management accounting satisfies the requirement of the
management for arriving at appropriate business decisions may be described as
follows

a. Modification of data
Accounting data as such are not suitable for managerial decision making
and control purposes. Management accounting modifies the available
accounting data by re arranging in such a way that it becomes useful for
management. The modification of data in similar groups makes the data
more useful and understandable. For eg, sales figures for different months
 may be classified, to know the total sales made during the period, product
wise, salesman wise and territory wise.

b. Planning and forecasting

Under the process of planning, management formulates policies and
executes plans to achieve the desired objectives. Management accounting
can help greatly in this process. Planning and forecasting are essential for
achieving business objectives. The most important function of management
accounting is to make short term and long term forecast and planning the
future operations of the business. Management accounting provides
necessary information and data for forecasting. It uses various techniques
such as budgeting, standard costing, marginal costing, fun floor statement,
trend ratio, correlation etc., these are important tools of management
accounting in planning.

c. Financial analysis and interpretation

The accounting data is analyzed and interpreted meaningfully for effective
planning and decision making. The interpretation is most important
function of management accounting. The top management people are not
always well versed in accounting techniques. They may not understand the
financial data in its raw form. Management accounting selects useful data,
analyses it and presents interpretation before management in a non-
technical manner along with comments and suggestions. Thus, analysis and
interpretation of data are considered as backbone of management
accounting.
d. Communication
Management accounting is an important medium of communication.
Different levels of management need different types of information. The
top management needs concise information at relatively long intervals,
middle management needs information regularly and the lower
management are interested in detailed information at short intervals.
Management accounting establishes communication within the
organization and with outside world.

e. Facilitate managerial control

Management accounting is very useful in controlling performance.
Management accounting enables all accounting efforts to be directed
towards the attainment of goals efficiently by controlling the operations of
the company more effectively. The standards of various departments and
individuals are set up. The actual performance is recorded and variations
are calculated. This process enables the management to assess the
performance of everyone in the organization.

f. Use of qualitative information

Mere financial data and its analysis and interpretation are not sufficient for
decision making purposes. Management accounting does not confine itself
merely to financial data to assist the management in decision making
process. But frequently draws upon various sources other than accounting
for qualitative information which cannot be converted into monetary terms.
For this purpose, engineering records, case studies, special surveys,
productivity reports etc., are greatly relied upon.
 g. Decision-making
Management accounting furnishes accounting data and statistical
information required for the decision making process which vitally affects
the survival and the success of the business. Management accounting
supplies analytical information regarding various alternatives and the
choice of management is made easy.
h. Coordinating
Co-ordination is the essence of managerial activity. The targets and
performances of different departments are communicated to the
management from time to time. Different tools such as budgeting, financial
analysis and interpretation etc. are provided. It helps to increase the
efficiency of various sections there by increasing profitability of the
concern. The supply of adequate information at the proper time will
increase the efficiency of the management.

NEED AND IMPORTANCE OF MANAGEMENT

ACCOUNTING

Management accounting is the application of appropriate techniques and concepts

in processing historical and projected economic data of a business entity to assist
its management in implementing plans for realizing its objectives. In the present
complex industrial world, management accounting has become an integral part of
management. It guides and advices management at every step. The following are
the advantages of management accounting.
a. It increases the efficiency of various business functions. The targets of
different departments are fixed in advance. The achievement of these goals
is a tool for measuring their efficiency.
b. The activities of the concern are planned in a systematic manner. Various
operations can be planned with the help of accounting information-
budgeting and forecasting.
c. The different tools of management accounting have provided validity,
objectivity and reliability in business management.
d. Different techniques of management accounting help in effective control of
business operation. The maximum utilization of capital and maximum
return on capital invested in business becomes feasible through application
of accounting techniques.
e. It creates harmony in the relationship between the management and
employees. It enables the management to improve its services to its
customers.
f. The management aims to control the cost of production and at the same time
increase the efficiency of employees. When cost of production is reduced,
it will increase the profit.
g. The business gets rid of seasonal and cyclical fluctuations on account of the
use of management accounting.
h. Unacceptable standards are substandard, which are often responsible for
unhealthy and bad relation between management and employees, can be
remote by the use of management accounting. There arise improved and
healthier relations.
i. The use of management accounting may control or even eliminate various
types of wastages, production defectives etc.
 j. Management accounting helps in communicating up to date information to
various parties interested in successful working of business organization.

FINANCIAL ANALYSIS

NATURE OF FINANCIAL ANALYSIS

The focus of financial analysis is on the key figures contained in the financial
statements and the significant relationship that exists between them. “Analyzing
financial statements is a process of evaluating the relationship between
component parts of the financial statements to obtain a better understanding of a
firm’s position and performance”. The type of relationship to be investigated
depends upon the objective and purpose of evaluation. The purpose of evaluation
of financial of financial statements differs among various groups: creditors,
shareholders, potential investors, management and so on.

TYPES OF FINANCIAL ANALYSIS

Financial analysis may be classified on the basis of parties who are undertaking
the analysis an on the basis of methodology of analysis. On the basis of the
parties who are doing the analysis, financial analysis is classified into external
analysis and internal analysis.
EXTERNAL ANALYSIS

When the parties external to the business like creditors, investors, etc. do the
analysis, the analysis is known as external analysis. This analysis is done by
them to know the credit worthiness of the concern, its financial viability, and its
profitability, etc.

INTERNAL ANALYSIS

This analysis is done by persons who have control over the bools of accounts
and other information of the concern. Normally this analysis is done by
management people to enable them to get relevant information to take vital
business decision.

On the basis of methodology adopted for analysis, financial analysis may be

either horizontal or vertical.

Horizontal analysis

When financial statements of a number of years are analyzed

TOOLS OF FINANCIAL ANALYSIS

1. Common sixe financial statements

2. Comparative financial statements
3. Trend percentages
4. Funds flow analysis
5. Cash flow analysis
6. Ratio analysis
1. COMMON-SIZE FINANCIAL STATEMENTS

In this type of statements, figures in the original financial statements are

converted into percentages in relation to a common base. The common base
may bee sales in the case of income statements (profit and loss account) and
total of assets or liabilities in the case of balance sheet. For e.g. In the case of
common-size income statement, sales of the traditional financial statement are
takenawss 100 and every other item in the income statement is converted into
percentages with reference to sales. Similarly, in the case of common-size
balance sheet, the total of asset/liability side will be taken as 100 and each
individual asset/liability is converted into relevant percentages.

2. COMPARATIVE FINANCIAL STATEMENTS

This type of financial statements are ideal for carrying out horizontal analysis.
Comparative financial statements are designed to give them perspective to the
review and analysis of the various elements of profitability and financial
position displayed in such statements. In these statements, figures for two or
more periods are compared to find out the changes both in absolute figures and
in percentages that have taken place in the latest year as compared to the
previous years. Comparative financial statements can be prepared both for
income statement and balance sheet.
3. TREND PERCENTAGES

Analysis of one year figures or analysis of even two years figures will not
reveal the real trend of profitability or financial stability or other wise of any
concern. To get an idea about how consistent is the performance of a concern,
figures of a number of years must be analyzed and compared. Here comes the
role of trend percentages and the analysis which is done with the help of
these percentages is called as trend analysis.

TREND ANALYSIS

It is a useful tool for the management since it reduces the large amount of
absolute data into a simple and easily readable form. The trend analysis is
studied by various methods. The most popular forms of trend are year to year
trend change percentage and the index-number trend series. The year to year
trend change percentage would be meaningful and manageable where the
trend for a few years, say a five year or six year period is to be analyzed.

Generally trend percentage are calculated only for some important items
which can be logically related with each other. For e.g. Trend ratio for sales,
though shows a clear-cut increasing tendency, becomes meaningful in the
real sense when it is compared with cost of goods sold which might have
increased at a lower level.
 FUND FLOW ANALYSIS

The purpose of this analysis is to go beyond and behind the information

contained in the financial statements. Income statement tells the quantum of
profit earned or loss suffered for a particular accounting year. Balance sheet
gives the assets and liabilities position as on a particular date. But in an
accounting year a number of financial transactions take place which have a
bearing on performance of the concern but which are not revealed by the
financial statements. For e.g. a concern collects finance through various
sources and uses them for various purposes. But these details could not be
known from the traditional financial statements. Funds flow analysis gives an
opening in this respect. All the more, funds flow analysis gives an opening in
this respect. All the more, funds flow analysis reveals the changes in working
capital position. If there is a decrease in working capital what caused the
decrease etc. Will be made available through funds flow analysis.

CASH FLOW ANALYSIS

While funds flow analysis studies the reason for the changes in working
capital by analyzing the sources of application of funds, cash flow analysis
pays attention to the changes in cash position that has taken place between
two accounting periods. These reasons are not available in the traditional
financial statements. Changes in the cash position can be analyzed with the
help of a statement know as cash flow statement. A cash flow statement
summarizes the change in cash position of the concern. Transactions which
increase the cash position of the concern are labelled as ‘inflows’ of cash and
those which decrease the cash position as ‘outflows’ of cash.
 RATIO ANALYSIS

Ratio analysis is an important and age old technique of financial analysis.

The data given in financial statements, in absolute form, are dump and are
unable to communicate anything. Ratios are relative form of financial data
and are very useful technique to check upon the efficiency of a firm. Some
ratios indicate the trend or progress or downfall of the firm.

A ratio analysis is a quantitative analysis of information contained in a

company’s financial statements. Ratio analysis is based on line items
in financial statements like the balance sheet, income statement and cash flow
statement; the ratios of one item – or a combination of items - to another item
or combination are then calculated. Ratio analysis is used to evaluate various
aspects of a company’s operating and financial performance such as its
efficiency, liquidity, profitability and solvency. The trend of these ratios over
time is studied to check whether they are improving or deteriorating. Ratios
are also compared across different companies in the same sector to see how
they stack up, and to get an idea of comparative valuations. Ratio analysis is a
cornerstone of fundamental analysis.

IMPORTANCE OF RATIO ANALYSIS

The inter relationship that exists among the different items appeared in the
financial statements, are revealed by accounting ratios. Ratio analysis of a firms
financial statements is of interest to a number of parties, mainly, shareholders
creditors, financial executives etc. Shareholders are interested with earning
capacity of the firm; creditors are interested in knowing the ability of the firm to
meet its financial obligations; and financial executives are concerned with
evolving analytical tools that will measure and compare cost efficiency, liquidity
and profitability with a view to making intelligent decisions.

The importance of ratio analysis is discussed below, in brief:

1. Aid to measure General Efficiency:

Ratios enable the mass of accounting data to be summarized and simplified.
They act as an index of the efficiency of the enterprise. As such they serve
as an instrument of management control.
2. Aid to measure Financial Solvency:
Ratios are useful tools in the hands of management and other concerned to
evaluate the firm’s performance over a period of time by comparing the
present ratio with the past ones. They point out firm’s liquidity position to
meet its short term obligations and long term solvency.
3. Aid in Forecasting and Planning:
Ratio analysis is an invaluable aid to management in the discharge of its
basic function such as planning, forecasting, control etc. The ratios that are
derived after analyzing and scrutinizing the past result help the management
to prepare budgets to formulate policies and to prepare the future plan of
action etc.
4. Facilitate decision-making:
It throws light on the degree of efficiency of the management and utilization
of the assets and that is why it is called surveyor of efficiency. They help
management in decision-making.
5. Aid in corrective Action:
 Ratio analysis interfere comparison. They highlight the factors associated
with successful and unsuccessful firms. If comparison shows an
unfavorable variance, corrective actions can be initiated, thus, it helps the
management to take corrective action.
6. Aid in Intra Firm Comparison:
Intra firm comparisons are facilitated. It is an instrument for diagnosis of
financial health of an enterprise. It facilitates the management to know
whether the firm’s financial position is improving or deterioration by setting
a trend with the help of ratios.
7. Act as a Good Communication:
Ratios are an effective means of communication and play a vital role in
informing the position of and progress made by the business concern to the
owners and other interested parties. The communications by the user of
simplified and summarized ratios are more easy and understandable.
8. Evaluation of Efficiency:
Ratio analysis is an effective instrument which, when properly used, is
useful to assess important characteristics of business – liquidity, solvency,
profitability etc. A study of these aspects may enable conclusions to be
drawn relating to capabilities of business.
9. Effective Tool:
Ratio analysis helps in making effective control of the business – measuring
performance, control of cost etc. Effective control is the keynote of better
management. Ratio ensures secrecy.

Figures, in their absolute forms, shown in the financial statements are

neither significant nor able to be compared. In fact, they are dump. But
ratios have power to speak.
CLASSIFICATION OF RATIOS

Financial ratios have been classified in several ways. A number of

standpoints may be used as a base for classifying the ratios.

To illustrate, the short term creditors main interest is in the liquidity position
or short term solvency of the firm; long term creditors are more interested in
the long term solvency and profitability analysis and the analysis of the
firm’s financial conditions; management is interested in evaluating every
activity of the firm because they have to protect the interest of all parties.
Thus accounting ratios may be classified on the following bases leading to
somewhat overlapping categories.

A. Classification by statements
The traditional classification is based on those statements from which
information is obtained for calculating the ratios. The ratios are classified
as follows
 CLASSIFICATION BY STATEMENTS

Balance Sheet ratios Profit & Loss A/c Inter-statement Ratios

(Financial ratios) Ratios (Composite/Mixed Ratios)
(Operating Ratios)
Egs: Egs:
Liquidity Ratio Egs: Return On Capital Employed
Current Ratio Gross Profit Ratio Return On Shareholders' Fund
Stock Ratio Net Profit Ratio Turnover Of Working Capital
Operating Ratio Debtors Turnover Ratio Etc.
Proprietory Ratio
Debt-Equity ratio Expense Ratio Etc.
Capital Gearing etc.

B. Classification by users
The classification is based on the parties who are interested in making the
use of ratios
 CLASSIFICATION BY USERS

Ratios For Shareholders

Ratios For Management Ratios For Creditors

Egs:
Egs: Egs:
Yield Rate
Operating Ratio Current Ratio
Proprietary Ratio
Debtors Ratio Solvency Ratio
Dividend Rate
Stock Turnover Fixed Asset Ratio
Capital Gearing
Solvency Ratio Creditors Turnover Ratio
Return On Capital Fund
Return On Capital Etc. Etc.
Etc.

C. Classification according to importance

This basis of classification of ratios have been recommended by the
British institute of management. They are of two types
 CLASSIFICATION BY IMPORTANCE

Primary Ratios Secondary Ratios

Egs: Egs:
Asset Turnover Working Capital Turnover
Profit Ratio Stocks To Current Assets
Operating Profit Ratio Stocks To Fixed Assets
Return On Capital Fund Etc. Fixed Assets To Total Asset Stock
Velocity
Expense Ratio Etc.

D. Classification be purpose/function
This is a classification based on the purpose for which an analyst
computes these ratios. The modern approach of classifying the ratios is
according to the purpose or object of analysis. Normally, ratios are used
for the purpose of assessing the profitability and sound positions. Thus,
ratios according to the purpose are more meaningful. There can be several
purposes which can be listed. For analysis, it is customary to group the
purposes into broad headings. The following are the categories of
accounting ratios from functional point of view.

CLASSIFICATION BY PURPOSE
 BALANCE SHEET RATIOS

1. Current Ratio

Current Ratio is the most common ratio for measuring liquidity.

Being related to working capital analysis, it is also called the working
capital ratio. Current ratio expresses relationship between current assets and
current liabilities. The current ratio is the ratio of total current assets to total
current liabilities. It is calculated by dividing current assets by current
liabilities, or

Current Ratio = Current Assets/Current Liabilities

Current assets are those, the amount of which can be realized within a period of
one year. That is, the current assets of a firm represent those assets which can be
in the ordinary course of business concerted in to cash within a period not
exceeding on year. Following are normally treated as current assets:

1. Cash in hand
2. Cash at Bank
3. Debtors
4. Bills receivable
5. Prepaid expenses
6. Money at call and short notice
7. Stock
8. Sundry supplies
9. Other amounts receivable within a year

Current liabilities are those amounts which are payable within a period of one year
Following are normally treated as current liabilities:

1. Creditors
2. Bills Payable
3. Bank Overdraft
4. Expenses Outstanding
5. Interest Due or Payable
6. Reserve for unbilled Expenses
7. Installment payable on long term- loans
8. Any other amount which is payable in short period.
(One year)

The current ratio of a firm measures its short – term solvency i.e., its ability to
meet short-term obligations. As a measure of short-term current financial
liquidity, it indicates the rupees of current assets available for each rupee of
current liability/obligation. The higher the current ratio, the larger the amount of
rupees available per rupee of current liability, the more the firm’s ability to meet
current obligations and the greater the safety of funds of short-term creditors.

Significance of Current Ratio

Current ratio provides a margin of safety to the creditors. In a sound business, a

current ratio of 2:1 is considered an ideal one. If current assets are equal to current
liabilities, position is not good even though it appears that after releasing all the
amount of current assets, current liabilities can be paid off. This means the firm
has no working capital. Working capital is excess of current assets over current
liabilities. The current ratio must not only be equal to current liabilities but should
leave a comfortable margin of working capital after paying of the current debts
the reason in favor of prescribing current ratio as 2: 1 or 3 for 1 is that all the
current assets do not have the same liquidity, or in short, all current assets cannot
be immediately converted in to cash for a number of reasons. For instance, debts
may not be realized in full, credit sales may be higher than the cash sales etc. If
goods are always sold for cash, a small margin will suffice. But in case of credit
sales, margin will have to be increased. Therefore, the demand for a 100% margin
of current assets over current liabilities, as a precautionary measure, is preferred.
Secondly, prescribing the current ratio as 2: 1 or 200 % facilitates to keep the
surplus as working capital even if all current liabilities are paid off:

Current ratio is an index of the firm’s financial stability i.e., an index of technical
solvency and an index of the strength of working capital, which means excess of
current assets over current liabilities. A high current ratio is an assurance that the
firm will have adequate funds to pay current liabilities and other current payments.
Significance of Current Ratio, in brief:

1. Current ratio indicates the firm’s ability to pay its current liabilities i.e., day
– to – day financial obligations.
2. It shows short- term financial strength.
3. It is a test of credit strength and solvency of a firm.
4. It indicates the strength of the working capital.
5. It indicates the capacity to carry on effective operations.
6. It discloses the over – trading or under- capitalization.
7. It shows the tendency of over-investment in inventory.
8. Higher ratio i.e., more than 2: 1 indicates sound solvency position.
 2. Net Working Capital Ratio

Net working capital is not a ratio. The difference between current assets and
current liabilities is called net working capital. The term current assets
refers to assets which in the normal course of business get converted into
cash over a short period, usually not exceeding one year. Current liabilities
are those liabilities which are required to be paid in short period, normally
a year. It is a measure of company’s liquidity position. Generally it is
understood that between two firms, the one having a larger net working
capital has the greater ability to meet its current obligations. But this is not
necessarily so. The measure of liquidity is a relationship, rather than the
difference between current assets and current liabilities. At the same time,
it measures the firm’s potential reservoir of funds.

Net working capital Ratio = Net Working Capital/Net Assets

3. Quick Ratio

Quick ratio is also known as liquid ratio or acid test ratio or near money
ratio. It is the ratio between quick or liquid assets and quick liabilities. As
pointed out, the current ratio in the study of solvency may be sometimes
misleading due to high ratio of stock to current assets. This ratio is
calculated by dividing the quick assets by the current liabilities.

Liquid Ratio = Quick or Liquid assets/Liquid or Current Liabilities

= Current Assets – (Stock and Prepaid Expenses)/Current

Liabilities – Bank Overdraft.
It indicates the relation between strictly liquid assets whose value is almost certain
on the one hand, and strictly liquid liabilities on the other. The term quick assets
refers to current assets which can be converted into cash immediately or at a short
notice without diminution of value. Liquid assets comprise all current assets minus
bank overdraft. Stock is excluded from liquid assets on the ground that it is not
concerted into cash in the immediate future; prepaid expenses by their very nature
are not available to pay off current debts: and at the same time bank overdraft is
excluded on the ground that is not required to be paid off in the immediate future.

A comparison of current ratio with liquid ratio would give an indication regarding
inventory position.

4. Cash position ratio (absolute liquidity ratio)

It is a variation of quick ratio. When liquidity is highly restricted in terms of cash

and cash equivalents, this ratio should be calculated. Liquidity ratio measures the
relationship between cash and near cash items on the one hand, and immediately
maturing obligations on the other. The inventory and the debtors are excluded
from current assets, to calculate this ratio.

𝐂𝐚𝐬𝐡 + 𝐌𝐚𝐫𝐤𝐞𝐭𝐚𝐛𝐥𝐞 𝐒𝐞𝐜𝐮𝐫𝐢𝐭𝐢𝐞𝐬

Cash position ratio =
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐋𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬

Generally 0.75: 1 ratio is recommended to ensure liquidity. This test is more

rigorous measure of a firm`s liquidity position. If the ratio 1: 1, then the firm has
enough cash on hand to meet all current liabilities. This type of ratio is not widely
used in practice.

5. Debt equity ratio

The financing of total assets of a business concern is done by owners` equity (also
known as internal equity) as well as outside debts (known as external equity). How
much fund has been provided by the owners and how much by outsiders in the
acquisition of total assets is a very significant factor affecting the long term
solvency position of a concern. In other words, the relationship between borrowed
funds and owners` capital is a popular measure of the long-term financial solvency
of a firm. This relationship is shown by the debt-equity ratio. This ratio indicates
the relative proportion of debts and equity in financing the assets of a firm. This
ratio is calculated in various ways.

It is also known as External-Internal Equity ratio. Debt-Equity ratio is determined

to ascertain soundness of the long-term financial policies of the company. This
ratio relates all external liabilities to owners` recorded claims. Debts-equity ratio
is calculated as follows:

𝐄𝐱𝐭𝐞𝐫𝐧𝐚𝐥 𝐄𝐪𝐮𝐢𝐭𝐢𝐞𝐬
Debt-Equity Ratio = or
𝐈𝐧𝐭𝐞𝐫𝐧𝐚𝐥 𝐄𝐪𝐮𝐢𝐭𝐢𝐞𝐬

𝐎𝐮𝐭𝐬𝐢𝐝𝐞𝐫𝐬 𝐅𝐮𝐧𝐝𝐬
Debt-Equity Ratio =
𝐒𝐡𝐚𝐫𝐞𝐡𝐨𝐥𝐝𝐞𝐫𝐬 𝐅𝐮𝐧𝐝𝐬

As a long term financial ratio it may be calculated as follows:

 𝐓𝐨𝐭𝐚𝐥 𝐋𝐨𝐧𝐠 − 𝐓𝐞𝐫𝐦 𝐃𝐞𝐛𝐭𝐬
Debt-Equity Ratio = or
𝐓𝐨𝐭𝐚𝐥 𝐋𝐨𝐧𝐠 − 𝐓𝐞𝐫𝐦 𝐅𝐮𝐧𝐝𝐬

𝐓𝐨𝐭𝐚𝐥 𝐋𝐨𝐧𝐠 − 𝐓𝐞𝐫𝐦 𝐃𝐞𝐛𝐭𝐬

Debt-Equity Ratio =
𝐒𝐡𝐚𝐫𝐞𝐡𝐨𝐥𝐝𝐞𝐫𝐬` 𝐅𝐮𝐧𝐝𝐬

The term external equities refers to the total outside liabilities. The term internal
equities refers to all claims of preference shareholders and equity shareholders
such as share capital and reserves and surplus. Outside funds refer to all short term
debts like mortgage, bills, etc. when long term financial ratio is calculated, term
debts like debentures are to be considered. Shareholders` funds refer to preference
share capital, equity share capital, capital reserve, revenue reserve, reserves for
contingencies, sinking fund for renewal of a fixed asset or redemption of
debentures etc. less fictitious assets.

As acceptable norm for this ratio is considered to be 2: 1. A higher debt-equity

ratio is allowed in the case of capital-intensive industries, a norm of 4: 1 is used
for fertilizer and cement units and a norm of 6: 1 is used for shipping units.

Whatever way the debt-equity ratio is calculated, it shows the extent to which debt
financing has been used in the business. A high ratio shows that the claims of
creditors are greater than those of owners. A very high ratio is unfavourable from
the firm’s point of view. This introduces inflexibility in the firm’s operations due
to the increasing interferences and pressures from creditors. A high debt company,
also known as highly leveraged or geared, is able to borrow funds on very
restrictive terms and conditions. A low debt equity ratio implies a greater claim
structure of the business since a high proportion of equity provides a larger margin
of safety for them.
 6. Gross Profit Ratio OR Cent Ratio

The Gross Profit Ratio is also known as Gross Margin Ratio, Trading Margin
Ratio etc. It is expressed as a “Per Cent Ratio.” The difference between Net Sales
and Cost of Goods Sold is known as Gross Profit. Gross Profit is highly
significant. The earning capacity of the business can be ascertained by taking the
margin between cost of goods sold and sales. It is very useful as a test of
profitability and management efficiency. It is generally contented that the margin
of gross profit should be sufficient enough to recover all operating expenses and
other expenses and also leave adequate amount as Net Profit in relation to sales
and owners’ equity. Thus, in a trading business, gross profit is net sales minus
trading cost of sales.

Cost of Goods Sold

= [Opening Stock] + [Purchase] – [Closing Stock] + All direct

expenses

(All direct expenses means the expenses relating to purchases i.e.., all expenses
charged to Trading Account.)

Cost of Goods Sold, in the case of manufacturing concern, is the sum of the cost
of raw materials used, wages, direct expenses and all manufacturing expenses. Net
sales means total sales minus sales return.

𝐆𝐫𝐨𝐬𝐬 𝐏𝐫𝐨𝐟𝐢𝐭
Gross Profit Ratio = x 100
𝐍𝐞𝐭 𝐒𝐚𝐥𝐞𝐬

𝐒𝐚𝐥𝐞𝐬 − 𝐂𝐨𝐬𝐭 𝐨𝐟 𝐆𝐨𝐨𝐝𝐬 𝐒𝐨𝐥𝐝

= x 100
𝐍𝐞𝐭 𝐒𝐚𝐥𝐞𝐬
Gross Profit Ratio shows the gap between revenue and trading costs. Maintenance
of steady gross profit ratio is important. An analysis of Gross Profit Margin should
be carried out in the light of information relating to purchasing, increasing or
reducing the sales price of goods sold by mark up and mark downs, credit and
collections and merchandising policies.

If Gross Profit Ratio is deducted from 100, then the balance will represent the ratio
between Cost of Sales and Sales i.e., direct opening ratio. This ratio also indirectly
highlights upon the margin of gross profit of the concern.

A higher ratio may be the result of one or all of the following:

1. Increasing in the selling price of goods sold without any corresponding

increase in the cost of goods sold.
2. Decrease in the cost of goods sold without corresponding decrease in
selling price.
3. Both selling price and cost of goods sold may have changed, the
combined effect being increase in gross margin.
4. Out of sales-mixes, product having higher gross profit margin, should
have been sold in larger quantity.
5. Under-valuation of opening stock or over-valuation of closing stock.

On the other hand, if the Gross Profit Ratio is very low, it may be an indicator

Of lower and poor profitability. A lower ratio may be the result of the following
factors:

1. Decrease in the selling price of goods sold, without corresponding

decrease in cost of goods sold.
2. Increase in cost of goods sold without any increase in selling price.
3. Unfavourable purchasing policies.
 4. Over-valuation of opening stock or under-valuation of closing stock.
5. Inability of management to improve sales volume.

Normally, the Gross Profit Ratio should remain the same from year to year,
because cost of sales will normally vary directly and in the same proportion with
sales. Higher ratio is better. The financial manager must be able to detect the
causes of a falling gross margin and initiate action to improve the situation. A ratio
of 25% to 30%may be considered good.

6. NET PROFIT RATIO

It is also called Net Profit Ratio (=Profit margin). The profit margin is
indicative of management’s ability to operate the business with sufficient
success not only to recover from revenues of the period, the cost of
merchandise or services, the expenses of operating business and the cost of
borrowed funds, but also to leave a margin of reasonable compensation to
the owners for providing their capital at risk. Higher the ratio of net operating
profit to sales, better is the operational efficiency of the concern.

𝐍𝐞𝐭 𝐏𝐫𝐨𝐟𝐢𝐭
Net Profit Ratio = x 100
𝐍𝐞𝐭 𝐒𝐚𝐥𝐞𝐬

This ratio is used to measure the overall profitability and hence it is very useful to
proprietors. It is an index of efficiency and profitability when used with gross
profit ratio and operating ratio.
 7. INVENTORY (STOCK) TURNOVER

This is also known as stock velocity. This ratio is calculated to consider the
adequacy of the quantum of capital and its justification for investing in inventory.
A firm must have reasonable stock in comparison to sales. It is the ratio of cost of
sales and average inventory. This ratio reveals the number of times finished stock
is turned over during a given accounting period. This ratio is used for measuring
the profitability. The various ways in which Stock Turnover ratio may be
calculated are as follows:

𝐂𝐨𝐬𝐭 𝐨𝐟 𝐆𝐨𝐨𝐝𝐬 𝐒𝐨𝐥𝐝

Stock Turnover Ratio = or
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐈𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲 𝐚𝐭 𝐜𝐨𝐬𝐭

𝐍𝐞𝐭 𝐒𝐚𝐥𝐞𝐬
Stock Turnover Ratio = or
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐈𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲 𝐚𝐭 𝐜𝐨𝐬𝐭

𝐍𝐞𝐭 𝐬𝐚𝐥𝐞𝐬
Stock Turnover Ratio = or
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐈𝐧𝐯𝐞𝐧𝐭𝐨𝐫𝐲 𝐚𝐭 𝐬𝐞𝐥𝐥𝐢𝐧𝐠 𝐩𝐫𝐢𝐜𝐞

𝐍𝐨.𝐨𝐟 𝐔𝐧𝐢𝐭𝐬 𝐒𝐨𝐥𝐝

Stock Turnover Ratio =
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐍𝐨.𝐨𝐟 𝐮𝐧𝐢𝐭𝐬 𝐢𝐧 𝐬𝐭𝐨𝐜𝐤

Stock turnover ratio can be calculated by employing any one of the above
formulae. The first and third formulae are considered more reasonable. The second
can be used when the cost of goods sold is not known. The fourth formulae is used
to eliminate the effect of changing prices.

𝐎𝐩𝐞𝐧𝐢𝐧𝐠 𝐬𝐭𝐨𝐜𝐤+𝐜𝐥𝐨𝐬𝐢𝐧𝐠 𝐒𝐭𝐨𝐜𝐤

Average stock =
𝟐

Cost of goods sold may be calculated as under:

i. In case of Trading Concerns:

 Cost of goods sold = {opening stock + purchases + direct expenses}
– (closing stock)

ii. In case of Manufacturing concerns:

Cost of Goods sold = {Total cost + Opening stock of finished goods}

– {closing stock of finished goods}

Total Cost = {raw materials consumed (cost) + Labour Cost +

Overheads cost}

iii. In all cases where Gross Profit is known:

Cost of goods sold = sales – gross profit

This ratio indicates whether investment in inventory is within proper limit or not.
The quantum of stock should be sufficient to meet the demands of the business
but it should not be too large to indicate unnecessary lock-up of capital in stock
and danger of stock-items obsolete and getting it wasted by passing of time.

The inventory turnover ratio measures how quickly inventory is sold. It is a test
of efficient inventory management. To judge whether the ratio of a firm is
satisfactory or not, it should be compared over a time on the basis of trend analysis.

8. DEBTORS TURNOVER RATIO

This is also called “Debtors Velocity” or “Receivable Turnover”. A firm sells

goods on credit and cash basis. When the firm extends credits to its customers,
book debts (Debtors or Account Receivable) are created in the firms account:
debtors expected to be converted into cash over a period and thus included in
current assets. Debtors include the amount of bills receivables and book debts at
the end of accounting period. It is most essential that a reasonable quantitative
relationship between outstanding receivables and sales should always be
maintained. If the firm has not been able to collect its debtors within a reasonable
time, its funds are unnecessarily locked up in receivables. In such case short-term
loans have to be arranged for paying off its current liabilities. The liquidity
position of the firm depends on the quality of debtors to a great extent. Financial
analysts employ two ratios to judge the quality or liquidity of debtors- debtors
turnover and average collection period.

The question of account receivables arises only against credit sales. Debtors
turnover establishes the relationship between net sales of the year and average
receivables. That is, it measures the number of times the receivables rotate in a
year in terms of sales. It shows how quickly debtors are converted into cash.

𝐂𝐫𝐞𝐝𝐢𝐭 𝐒𝐚𝐥𝐞𝐬
Debtors Turnover =
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐃𝐞𝐛𝐭𝐨𝐫𝐬

𝐎𝐩𝐞𝐧𝐢𝐧𝐠 𝐁𝐚𝐥𝐚𝐧𝐜𝐞+𝐂𝐥𝐨𝐬𝐢𝐧𝐠 𝐁𝐚𝐥𝐚𝐧𝐜𝐞

Average Debtors =
𝟐

The purpose of this ratio is to measure the liquidity of the receivables or to find
out the period over which receivables remain uncollected.

To solve the difficulty arising out of the non-availability of the information in the
respect of credit sales and average debtors the alternative method is to calculate
the Debtors turnover in terms of the relationship between Total sales and Closing
Balance of Debtors. Thus:

𝐓𝐨𝐭𝐚𝐥 𝐒𝐚𝐥𝐞𝐬
Debtors Turnover =
𝐂𝐥𝐨𝐬𝐢𝐧𝐠 𝐃𝐞𝐛𝐭𝐨𝐫𝐬
It is important to note that the first approach to the computation of the debtors
turnover is superior. The effect of adopting the second approach would be to
inflate the Debtors Turnover ratio.

The second type of the ratio for measuring the liquidity of a firm’s debtors is the
average collection period. This ratio is, in fact, interrelated with, and dependent
upon, the receivables turnover ratio. Debt collection period is calculated by any of
the following ratios:

𝐌𝐨𝐧𝐭𝐡𝐬(𝐨𝐫 𝐝𝐚𝐲𝐬)𝐢𝐧 𝐚 𝐲𝐞𝐚𝐫

(a)
𝐃𝐞𝐛𝐭𝐨𝐫𝐬 𝐭𝐮𝐫𝐧𝐨𝐯𝐞𝐫
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐃𝐞𝐛𝐭𝐨𝐫𝐬 𝐱 𝐌𝐨𝐧𝐭𝐡𝐬 (𝐨𝐫 𝐝𝐚𝐲𝐬)𝐢𝐧 𝐚 𝐲𝐞𝐚𝐫
(b)
𝐍𝐞𝐭 𝐂𝐫𝐞𝐝𝐢𝐭 𝐒𝐚𝐥𝐞𝐬 𝐟𝐨𝐫 𝐭𝐡𝐞 𝐲𝐞𝐚𝐫
𝐀𝐜𝐜𝐨𝐮𝐧𝐭𝐬 𝐑𝐞𝐜𝐞𝐢𝐯𝐚𝐛𝐥𝐞
(c)
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐌𝐨𝐧𝐭𝐡𝐥𝐲 𝐨𝐫 𝐃𝐚𝐢𝐥𝐲 𝐂𝐫𝐞𝐝𝐢𝐭 𝐒𝐚𝐥𝐞𝐬

9. CREDITORS TURNOVER RATIO

This is also known as Accounts Payable or Creditors Velocity. A business firm

usually purchase on credit goods, raw materials and services from other firms. The
amount of total payable of a business concern depends upon the purchases policy
of the concern, the quantity of purchases and suppliers’ credit policy. Longer the
period of outstanding payable is, lesser is the problem of working capital of the
firm. But when the firm does not pay off its creditors within time, it may have
adverse effect on the business.

Creditors Turnover indicates the number of times the payable rotate in a year. It
signifies the credit period enjoyed by the firm paying Creditors. Accounts payable
include Sundry Creditors and Bills Payable.
Payable Turnover shows the relationship between Net Purchases for the whole
year and Total Payable (Average or Outstanding at the end of the year.)

Months in a year

Average Payment Period = ------------------------------------------------------

Creditors Turnover Ratio

Average Accounts Payable x Months in a Year

(Or) = ---------------------------------------------------------------------

Credit purchases in the year

Average Accounts Payable

(Or) = ------------------------------------------------------------

Average Monthly credit purchases

Net Purchase = All Credit Purchases – Purchase Returns

A higher ratio shows that the creditors are not paid in time. A lower ratio shows
that the business is not taking the full advantage of credit period allowed by the
creditors.

WORKING CAPITAL TURNOVER RATIO

This ratio is a measure of the efficiency of the employment of the working capital.
It indicates the number of times the working capital is turned over in the course of
a year. This ratio finds out the relation between cost of sales and working capital.
It helps in determining the liquidity of a firm in as much as it gives the rate at
which inventories are converted to sales and then to cash.

Cost of Sales

Working Capital Turnover Ratio = -------------------------------

Net working Capital

( Net Working Capital = Current Assets – Current

Liabilities)

Higher sales in comparison to working capital means overtrading and lower sales
in comparison to working capital means under trading. A higher Working Capital
Turnover Ratio shows that there is low investment in working capital and there is
more profit.

FIXED ASSETS TURNOBER RATIO

It is also known as Sales to Fixed Asset Ratio. This ratio measures the efficiency
and profit earning capacity of the firm. Higher the ratio, greater is the intensive
utilization of fixed assets. Lower ratio means under - utilization of fixed assets.

Cost of Sales

Fixed Asset Turnover Ratio = --------------------------------------

Net Fixed Assets

(Net Fixed assets = Value of assets – Depreciation)