ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS

ANALYSIS AND INTERPRETATION OF
FINANCIAL STATEMENTS
Introduction
Shareholders, Managers, Tax Authorities and other interested groups seek answers to the following
important questions about a firm:
? What is the financial position of the firm at a given point, of time?
? How did the firm perform financially over a given period of time?
To answer the above questions, one has to prepare two major financial statements - the Balance Sheet
and the Income Statement. The Balance Sheet shows the financial position or condition of the firm at a
given point of time. It provides a snapshot and may be regarded as a static picture. The Income
Statement or Profit and Loss Account reflects the performance of the firm over a period of time. In other
words, "Financial Statements are prepared for the purpose of presenting a periodical review or report
on the progress by the management and deal with (a) the status of investments in the business and (b)
the results achieved during a period under review.” The statement disclosing status of investments is
known as Balance Sheet and the statement showing the result is known as Profit and Loss Account.
A firm communicates financial information to the users through financial statements and reports. The
financial statements contain summarized information of the firm's financial affairs, organized
systematically. They are means to present the firm's financial situation to users. The preparation of the
financial statements is the responsibility of top management. The two basic financial statements
prepared for the purpose are the two statements, that is, Balance Sheet and Profit and Loss Account. As
these statements are used by investors and financial analysts to examine the firm's performance in
order to make investment decisions, they should be prepared very carefully and contain as much
information as possible.
Recently a number of schedules are also being used to supplement the data and information contained
in the above statements. Thus, Schedule of Fixed Assets, Schedule of Debtors, Schedule of Creditors,
Schedule of Reserves etc., is some of the schedules which are generally attached to the statements. The
schedules are considered as part of the statements for the purpose of analysis and, in fact, they
constitute the first step towards the analysis of certain data in financial statements. The financial
statements are prepared from the accounting records maintained by the firm. The generally accepted
accounting principles and procedures are followed to prepare these statements. It seems quite desirable
to discuss the nature of each of the financial statements.
Balance Sheet
The Balance Sheet comprises of a list of assets, liabilities and capital at a given date. It is static in
character because it tells about the financial position of a business as on a certain date. At the same
time, business is dynamic while Balance Sheet is static. It records only periodic changes rather than
continuous ones. More specifically, Balance Sheet contains information about resources and obligations
of a business entity and about owners' interests in the business at a particular point of time. Thus, the
Balance Sheet of a firm prepared on 31st December reveals the firm's financial position on this specific
date. In simple language or in a layman's language, a Balance Sheet may be called as a statement of
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Study Material by SUBRAHMANYA KUMAR N., Senior Lecturer, Srinivas Institute of Management Studies,
Pandeshwar, Mangalore. @ 2009

equality in which equality is established by representing assets values on one side and the values of
liabilities and owners’ fund on the other side of it. "The Balances Sheet is a statement which reports the
property's value-owned by the enterprise and the claims of the creditors and owners against these
properties". The amount of value is obtained by posting and balancing the individual accounts of each
item.
A Balance Sheet is called by different names. Generally the following titles are used in respect of a
Balance Sheet:
1. Balance Sheet or General Balance Sheet
2. Statement of financial position or condition
3. Statement of Assets and Liabilities
4. Statement of Resources and Liabilities
5. Statement of Assets, Liabilities and Owners' Fund, etc.
However, the title "Balance Sheet" is mostly used. Let us look a few definitions:
"Balance Sheet is a classified summary of the ledger balances remaining after closing all revenue items
into the Profit and Loss Account." —Cropper
"The Balance Sheet is a statement which reports the values owned by the enterprise and the claims of
the creditors and owners against these properties." —Howard
"Balance Sheet is a screen picture of the financial position of a going business at certain moment." —
Francis
A clear and correct understanding of the basic divisions of the Balance Sheet and the meanings which
they signify and the amount which they represent is very essential for the proper interpretation of
financial statements. The various items of the Balance Sheet for the purpose of analysis may be grouped
into the following categories:


Basic Divisions of Balance Sheet
Assets Liabilities
? Current Assets ? Current Liabilities
? Fixed Assets ? Non-current Liabilities
? Intangible Assets ? Net Worth
? Other Assets
? Deferred Expenditure

The important functions served by a Balance Sheet are:
? It gives a concise summary of the firm's resources and liabilities and owners equity.
? It is a measure of the firm's liquidity.
? It is a measure of the firm's solvency.
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Study Material by SUBRAHMANYA KUMAR N., Senior Lecturer, Srinivas Institute of Management Studies,
Pandeshwar, Mangalore. @ 2009

A brief discussion regarding the meaning, nature and contents of various groups of Balance
Sheet is given below:
Current Assets
"The goods of the merchant yield him no revenue profit till he sells them for money and the money
yields him as little till it is again exchanged for goods." His capital is continuously going from him in one
shape and returning to him in another and it is only by means of such circulation or successive
exchanges that it can yield him any profit. Such a capital can be properly called circulating capital. The
term Current Assets, in the words of Alexander Wall, "are such assets as in the ordinary and natural
course of business move onward, through the various processes of production, distribution and
payment for goods, until they become cash or its equivalent, by which debts may be rapidly and
immediately paid." Current Assets are the assets acquired through cash and easily convertible into cash
during the normal course of business. The normal course takes a period of one year. The accounting
period is of one year duration. In other words, Current Assets are those resources of the firm which are
either held in the form of cash or are expected to be converted into cash within the accounting period
or the operating cycle of the business. The operating cycle is the time period which is taken to convert
raw materials into finished goods, sell finished goods, and convert receivables into cash. All assets which
are acquired for reselling during the course of business are to be treated as Current Assets. For instance,
furniture purchased by a furniture dealer will be treated as Current Asset: whereas furniture purchased
by a hotel-owner will be treated as non-current asset. Thus, it is clear that the nature i.e., current asset
or non-current asset is to be decided with reference to its objective of acquisition and not to its name by
which it has been termed in the accounting system. Generally, the operating cycle is equal to or less
than the accounting period. The following are generally included in Current Assets.
? Cash in hand and at Bank
? Book debts (or Debtors or Accounts Receivables)
? Bills Receivables (or Notes Receivables)
? Stocks—Raw Materials, Work-in-progress, Finished Goods
? Government and other marketable securities
? Advance Payments.
Fixed Assets
Fixed assets are those assets which are acquired for the purpose of using them in the conduct of
business operations and not for reselling to earn profit. They are of such a nature that they will be used
over a considerable period of time, and are not meant for resale. Since these are not for reselling, these
assets are not readily convertible into cash in the normal course of business operations. Some examples
of assets coming into the fixed asset categories are;
? Land
? Buildings
? Plant, Machineries, Equipment etc.
? Furniture and Fixtures
? Leasehold Improvements etc.
The above list is not exhaustive one. A number of other assets may be included in the list, if they are
acquired primarily for the purpose of continuous use in the business operations.
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Pandeshwar, Mangalore. @ 2009

Intangible Assets
Fixed Assets may be either tangible or intangible. The tangible assets have a definite physical existence.
They can be seen and can, if necessary, be sold separately. The intangible assets cannot be seen though
their existence has some effect, often very material, on the profit-earning capacity of the business.
While the tangible assets often have a value as things apart from their profit-earning capacity, the
intangible assets usually have no physical value whatever. They are not available for the payment of the
debts of a going concern. They depreciate greatly in case of liquidation. Intangible assets represent the
firm's rights and include the following:
? Patents and Trademarks
? Copyright, Formula, License etc.
? Goodwill etc.
Patents are the exclusive rights granted by the Government enabling the holder to control the use of an
invention. Copyrights are the exclusive rights to reproduce and sell literary, musical and artistic works.
Franchises are the contracts giving exclusive rights to perform certain functions or to sell certain services
or products. Goodwill represents the excessive earning power of a firm due to special advantages that it
possesses. Costs of intangible fixed assets are amortized over their useful lives.
Other Assets
All other assets which cannot be included in any of the above categories are grouped as Other Assets.
These assets possess a tangible form but these are not directly used in the operations of business. Such
assets may be:
? Investments excluding marketable securities
? Non-trade Debtors
? Fund earmarked for assets.
? Deferred Expenditures
There are certain expenditures which are not incurred repeatedly or which are not of recur¬ring nature
and which do not arise from the present operations. These expenditures contribute income or benefit in
the future years also. These expenditures are written off gradually over several years of operations,
treating each year's share in such expenditure as a charge on operational profit for that year. The
amount of such expenditure not written off at a point of time is shown as an asset in the Balance Sheet
at that point of time. Prepayments for services or benefits for period longer than the accounting period
are referred to as deferred charges and include advertising expenditure, preliminary expenses etc.
Current Liabilities
Current liabilities include such debts and obligations or charges which are payable either at demand or
within one year from the date of Balance Sheet. All short-term obligations generally due and payable
within one year are described as Current Liabilities. All long-term loans and borrowings may take the
character of current liabilities as and when they become due for payment. Typical examples of current
liabilities are:
? Trade Creditors or Accounts Payables
? Bills Payables or Notes Payables
? Short-term Public Deposits
? Outstanding or accruals
? Short-term Loans
? Bank overdraft but not bank loan
? Provision for Taxes
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Study Material by SUBRAHMANYA KUMAR N., Senior Lecturer, Srinivas Institute of Management Studies,
Pandeshwar, Mangalore. @ 2009

? Unclaimed Dividends
? Current maturity of long-term debt due payable within the Period of the current year.
Non-Current Liabilities
These are also called Long-Term liability or debt. All such liabilities payable over a longer period of time,
say after one year, are known as Non-current liabilities. Some examples of such liabilities are :
? Loan on Mortgage
? Debentures or Bonds
? Bank Loan
? Loans from Financial Institutions etc.
Net Worth
The financial interests of owners are called owners' equity. The owners' interest is residual in nature,
reflecting the excess of the firm's assets over its liabilities. It has several names, such as Net Assets,
Shareholders' Fund, Owners' Equity, and Net Capital Employed etc. What remains after deducting all
liabilities (both current and long-term) from total assets is called Net Worth or Shareholders' Fund. As
liabilities are the claims of outside parties, owners' equity represents owners' claim against the business
entity as of the Balance Sheet date. The nature of the owners' claim is not same as the claims of
creditors. Creditors' claims are defined and have to be met within a specified period. The claim of
owners’ changes and the amount payable to them can be determined only when the firm is liquidated.
In the beginning stage, owners' equity arises on account of the funds invested by them. But it changes
due to the earnings of the firm and their distribution. The firm's earnings (or losses) do not affect
creditors' claims. Owners' equity will increase when the firm makes earnings and retains whole or a part
of it. If the losses are incurred by the firm, owners' claim will be reduced. Shareholders' equity or capital
has two parts (i) Paid up share capital and (ii) Reserves and surplus (retained earnings), i.e., representing
undistributed profits.
? Preference Share Capital
? Equity Share Capital
? General Reserve
? Capital Reserve
? Other Reserves and undistributed profits
Form of Balance Sheet
A Balance Sheet reflects the financial position of a firm. Balance Sheet can be prepared in the Account
Form or the Report Form. The Account form of Balance Sheet has two sides. The right hand side lists the
various assets and left hand side shows the liabilities and owners’ equity. The total of the two sides are
equal i.e., Total Assets = Total Liabilities + Owners’ Equity. The Balance Sheet does not convey anything
very special, as the two sides must always balance.
In the Report Form of Balance Sheet, the figures should be arranged properly. Usually instead of two-
column (T Form) statement as ordinarily prepared, the statement is prepared in single-vertical column
form. A specimen is given below:



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Study Material by SUBRAHMANYA KUMAR N., Senior Lecturer, Srinivas Institute of Management Studies,
Pandeshwar, Mangalore. @ 2009

Report Form of Balance Sheet
Balance Sheet As On …………………………………

Balance Sheet Equation
Both sides of the Balance Sheet should be equal. This is, the assets must be equal to liabilities plus
owners' capital. We can express this equality of the Balance Sheet in an equation form. The equation is
known as Balance Sheet Equation, also known as Accounting Equation. The relationship can be
expressed in the following equation. Total Assets = Total Liabilities + Owners' Equity We have noted
earlier that Owners' Equity is a residue i.e., it is the difference between assets and liabilities. Thus:
Total Assets - Total Liabilities = Owners' Equity We can obtain more equations if we elaborate the above
equation. For instance, Liquid Assets = Current Assets - Stock of all types Working Capital = Current
Assets - Current Liabilities Capital Employed = Total Assets - Current Liabilities The equation can be
technically stated as "for every debit there is an equivalent credit." As a matter of fact the entire system
of double entry book-keeping is based on this concept.
Profit and Loss Account
The Balance Sheet, as we know it, is a pictorial presentation of the financial health of a business on a
certain date. "It fails to indicate whether a concern is making or losing money." This financial statement
merely indicates the resources and liabilities of a business enterprise at a particular date. In short, the
Balance Sheet is nothing but a snapshot of the financial condition of a business at a given moment. But
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Pandeshwar, Mangalore. @ 2009

every transaction has immediate and direct impact on the items of the Balance Sheet and items do
change due to this impact.
The earning capacity and potential of the firm are reflected by the Income Statement i.e., Profit and Loss
Account. The Profit and Loss Account is the "Score-board" of the firm's performance during a particular
period of time. The Profit and Loss Account may also be called by various names, such as:
? Statement of Income and Earned Surplus
? Income Statement
? Statement of Revenue and Expenses
? Profit and Loss Account
? Operating Statement etc.
The Profit and Loss Account presents the summary of revenues, expenses and net income or net loss of
a firm for a period of time. It serves as a measure of the firm's profitability. Net income which is an
indicator of the firm’s profitable operations is the amount by which the revenues earned during a period
exceed the expenses incurred during that period. If the firm's operations prove to be unprofitable, total
expenses will exceed total revenues and the difference is referred to as net loss. Revenues are the
amounts which the customers pay to the firm for providing them the goods and services. Profit and Loss
Account is an explanation of the impact of profit-seeking operations on shareholders' equity. The
statement of Profit or Loss is the condensed and classified record of the gains or losses causing changes
in the owners' interest in the business for a period of time. A comparison of earnings and expenses
incurred in the earning of those incomes is made in this statement and the difference between the two
is known as net profit or loss. The Indian Companies Act 1956 fails to prescribe any legal pro-forma for
Profit and Loss Account, as it has prescribed for Balance Sheet. As a result, the Profit and Loss Account is
being prepared in varying form due to diversity in the nature of industry and also in business interest.
Again Profit and Loss Account in the statement form can be prepared in two ways for the purpose of
analysis.
(a) Single Step Form:
In Single Step Form records all revenues (Operating or non-operating) and all expenses (operating or
non-operating) in one stroke. The items of revenues and expenses are not grouped into distinct heads or
sub-heads. A specimen is given below:
















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Study Material by SUBRAHMANYA KUMAR N., Senior Lecturer, Srinivas Institute of Management Studies,
Pandeshwar, Mangalore. @ 2009

Statement of Revenues and Expenses

(b) Multi Step Method
Multistep income statement gives more useful information. Each item of revenue and expenses are
considered step by step. It makes a distinction between operating revenue and non-operating revenue.
This method of preparing the statement of incomes and expenses are much useful for the purposes of
analysis and interpretation. A specimen is given below:






















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Pandeshwar, Mangalore. @ 2009

Operating Income Statement for the period ending……………………….


Steps:
? Items of operating revenue (sales minus returns) and cost of goods sold are considered first,
which gives gross profit or gross margin. That is, Gross Profit = Sates minus Cost of goods
sold.
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Pandeshwar, Mangalore. @ 2009

? Secondly, all operating expenses are deducted from Gross Profit and the difference is known
as operating profit. (Operating expenses consisting of general, administrative, selling and
depreciation).
? Thirdly, non-operating incomes as addition and non-operating expenses as deduction are
taken up to the operating profit. This gives net profit before tax.
? Fourthly, provision for tax and interest are deducted from the Net Profit and the balance is
known as Net Profit after tax and interest.
The Profit and Loss Account up to net operating profit may be expressed in equation form, thus:
Gross Profit = Sales - Cost of Goods Sold
Net Operating profit = Gross Profit - Operating Expenses
Net Operating profit = Sales - (Cost of Sales + Operating Expenses)
Sales - Net Operating Profit = Cost of Sales + Operating Expenses
Sales = Cost of Sales + Operating Expenses + Net Operating Expenses
Financial statements are the result of accounting process involves recording, classifying and
summarizing business transactions. Financial statements are organized, collection of data according to
logical and consistent accounting procedures. Its purpose is to convey an understanding of some
financial aspect of a business firm.
Persons Interested in Financial Statement
The following are the groups who like to make use of financial statements.
1. Owners:
The owners provide funds or capital for the organization. They possess curiosity in knowing
whether the business is being conducted on sound lines or not and whether the capital is
being employed properly or not. Owners, being businessmen, always keep an eye on the
returns from the investment. Comparing the accounts of various years helps in getting good
pieces of information.
2. Management:
The management of the business is greatly interested in knowing the position of the firm.
The accounts are the basis, on which the management can study the merits and demerits of
the business activity. Thus, the management is interested in financial statements to find
whether the business carried on is profitable or not. The financial state merits are the "eyes
and ears of management and facilitate in drawing future course of action, further expansion
etc."
3. Creditors:
Creditors are the persons who supply goods on credit, or bankers or lenders of money. It is
usual that these groups are interested to know the financial soundness before granting
credit. The progress and prosperity of the firm, to which credits are extended, are largely
watched by creditors from the point of view of security and further credit. Profit and Loss
Account and Balance Sheet are nerve centers to know the soundness of the firm.
4. Employees:
Payment of bonus depends upon the size of profit earned by the firm. The more important
point is that the workers expect regular income for the bread. The demand for wage rise,
bonus, better working conditions etc., depends upon the profitability of the firm and in turn
depends upon financial position. For these reasons, this group is interested in financial
statements.
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Pandeshwar, Mangalore. @ 2009

5. Investors:
The prospective investors, who want to invest their money in a firm, of course wish to see
the progress and prosperity of the firm, before investing their money, by going through the
financial statement of the firm. This is to safeguard the investment. For this purpose, this
group is eager to go through the accounting statements which enable them to know the
safety of investment.
6. Government:
Government keeps a close watch on the firm which yield good amount of profits. The state
and central governments are interested in the financial statements to know the earnings for
the purpose of taxation. At present most of the business concerns are organized and
operated in the form of Joint Stock Companies. One of the main features of company form
of organization is that there is distinction between providers of capital and those entrusted
with the actual operation and the management of the business. Just to safeguard the
interest of former class, the government is interested in the financial statements.
7. Consumers:
These groups are interested in getting the goods at reduced price. Therefore, they wish to
know the establishment of proper accounting control, which in turn will reduce the cost of
production, in turn less price to be paid by the consumers. Researchers are also interested
for interpretation.
8. Stock Exchange:
The financial statements are
the blue prints of financial
affairs. These statements
facilitate the stock exchange
to protect the investors'
interests or to watch as a
watchdog of corporate
investors.
9. Professional societies like Chambers of Commerce, Indian Accounting Associations,
Employers’ Association, Banks, Financial institutions etc. are deeply interested in such
statements of business concerns.
Nature of Financial Statements
Financial statements are prepared for the purpose of presenting a periodical review or report on
progress by the management and deal with the status of investment in the business and the results
achieved during the period under review. According to the American Institute of Certified Public
Accountants, financial statements reflect "a combination of recorded facts, accounting conventions and
personal judgments and the judgments and conventions applied affect them materially." This implies
that data exhibited in the financial statements are affected by recorded facts, accounting conventions
and personal judgments.
1. Recorded Facts:
Record is made only of those facts which can be expressed in monetary terms. Facts which
have not been recorded in the financial books are not depicted in the financial statements.
Thus, the recorded facts consist of such data as the amount of cash on hand and in the bank,
the amount due from customers, the cost of fixed assets, the amounts payable to creditors
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Pandeshwar, Mangalore. @ 2009

etc. As the price level i.e., cost, as on the date of acquiring fixed assets is, as a rule, stated in
the accounts rather than the replacement cost ; the Balance Sheet does not show the
financial position of a business in terms of current economic conditions though, in some
cases, appraised values might be substituted for cost. Certain factors which may affect the
financial position of a business are not shown in the accounting records. Such items—
purchase and sale contracts, claims for refunds, guarantee etc. appear as footnotes to
Balance Sheet.
2. Accounting Conventions:
In spite of the accounting standards laid down by the various accounting bodies,
managements of concerns are free to choose an accounting policy suited to their concern.
Accounting policies differ with regard to valuation of inventory, depreciation, research,
development etc. Further provision is made for expected losses but expected profits are
ignored.
3. Personal Judgment:
Personal judgment plays a great part while dealing in various questions like method and rate
of depreciation to be adopted, valuation of inventories, provision for bad and doubtful
debts, amortization of fictitious assets etc. Accountant is free to exercise his discretion on
many matters on accounting.
4. Postulates:
Rupee values shown in the statements are not precise measurement of items incorporated
in them. That is, these values do not represent the market or saleable values of items. Data
disclosed by the financial statements are useful and meaningful only till concern survives.
Limitation of Financial Statement
Financial statements are based on historical costs and as such the impact of price level changes is
completely ignored. They are interim reports. The basic nature of financial statements is historic. These
statements are neither complete nor exact. They reflect only monetary transactions of a business. The
statements furnish only information and that too in the form of figures. Figures won't speak in
themselves and it is the duty of the analyst to make these figures speak of good or bad of the business
affairs. Generally the following limitations may be noted:
? The financial position of a business concern is affected by several factors—economic, social
and financial, but only financial factors are being recorded in these financial statements.
Economic and social factors are left out. Thus the financial position disclosed by these
statements is not correct and accurate.
? The profit revealed by the Profit and Loss Account and the financial position disclosed by the
Balanced Sheet cannot be exact: they are essentially interim reports. Exact position can be
known when the business is liquidated i.e., after it has put down its shutters.
? Facts which have not been recorded in the financial books are not depicted in the financial
statements. Only quantitative factors are taken into account. But qualitative factors—such
as reputation and prestige of the business with the public, the efficiency and loyalty of its
employees, integrity of management etc. which are equally important for the business
success, are not capable of being translated in terms of money, and as such, they do not
appear in the financial statements.
? The rupee of 2001, as for example, does not mean the same as the rupee of 2008 or the
rupee of 2009. The existing accounting system results in over-statement of profits in times
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Pandeshwar, Mangalore. @ 2009

of inflation and under-statement in depression. The existing historical accounting is based
on the assumption that the value of monetary unit, say rupee, remains constant and
accordingly assets are recorded by the business at the price at which they are acquired and
the liabilities are recorded at the amounts at which they are contracted for. But monetary
unit is never stable under inflationary conditions. This instability has resulted in a number of
distortions in the financial statements and is the most serious limitation of historical
accounting. The price level changes are not taken into account and as such financial
statements prepared on a historical cost basis fail to give realistic and correct picture of the
state of affairs of a firm.
? Many items are left to the personal judgment of the accountant. For instance, provision of
depreciation, stock valuation, bad debts provision etc. depends on the personal judgment of
accountant.
? On account of convention of conservation the income statement may not disclose true
income of the business since probable losses are considered while probable incomes are
ignored.
? The fixed assets are shown at cost less depreciation on the basis of "going concern concept."
But the value placed on the fixed assets may not be the same which may be realized on their
sale.
? The data contained in the financial s cue merits are dumb; they do not speak themselves. It
is also worthwhile to note that human judgment is always involved in the interpretation of
statements. It is the analyst or user who provides toung to those data and makes them to
speak. It rarely happens that the users of financial statements may have the same opinion
and meaning in respect of a particular accounting figure.
? Information conveyed by these statements may not be comparable on account of difference
between dates of preparation of these statements. Different methods of accounting
followed by different concerns or difference in the nature of business of different concerns
etc. may render the financial statements of two concerns impossible or difficult for the
purpose of comparison.
Essentials of Good Financial Statements
Different parties have interest in the financial statements with different objectives. It may not be
possible to the concerns to construct the statements to suit every interested person. However, such
statements should have at least the following essentials:
a. Figures which are incorporated in financial statements should be readily and easily available
from the books of accounts of the concern. The size of the form of financial statements should
not be abnormally too large.
b. The form should not be complex in nature. The various terms used should be in simple and
common language. The form should have suitable columns for additions and deductions and it
must arrest and retain the attention of users.
c. It must facilitate easy comparison. In addition to the figures of previous years, it is also essential
that uniformity in the form is maintained from year to year. This is for easy comparison.
d. The form and contents of the form should be designed in such a way that the attention of the
readers is automatically drawn and directed to most significant items.
e. All facts should be presented in such a way that required items and figures are easily obtained
for calculating various accounting ratios, to be used by the analysts.
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Pandeshwar, Mangalore. @ 2009

f. The information contained in the financial statements should be such that a true and correct
idea is taken about the financial position of the concern.
g. The comparable figures will make the statements more useful. The results of financial analysis
should be in a way that can be compared to the previous years' statements. The comparison of
the figures will enable a proper assessment for the working of the concern.
Analysis and Interpretation of Financial Statements:
Financial statements are prepared primarily for decision-making. The statements are not an end in
them, but are useful in decision making. Financial analysis is the process of determining the significant
operating and financial characteristics of a firm from accounting data. The profit and Loss Account and
Balance Sheet are indicators of two significant factors - Profitability and Financial Soundness. Analysis of
statement means such a treatment of the information contained in the two statements as to afford a
full diagnosis of the profitability and financial position of the firm concerned. Financial statement
analysis is largely a study of relationship among the various financial factors in a business as disclosed by
a single set of statements and a study of the trends of these factors as shown in a series of statements.
The main function of financial analysis is the pinpointing of the strength and weakness of a business
undertaking by regrouping and analysis of figures contained in the financial statements, by making
comparisons of various components and examining their content. The financial statements are the best
media of documenting the results of managerial efforts to the owners of the business, its employees, its
customers and the public at large, and thus become excellent tools of the public relations.
Analysis includes: (a) Breaking financial statements into simpler ones, (b) Regrouping, (c) Rearranging
the figures given in financial statements and (d) Finding out ratios and percentages. Thus all process
which help in drawing certain results from the financial statements are included in analysis. The data
provided in the financial statements should be methodically classified and compared with figures of
previous period or other similar firms. Thereafter, the significance of the figures is established. The work
of an accountant in making analysis of financial statements is the same as that of a pathologist, who
takes a drop of blood and analyzes it to point out its various components and gives a report on the basis
of his analysis. Similarly, an accountant makes analysis of each item appearing in financial statements
and then gives a report on the basis of his analysis. Analysis only establishes a relationship between
various amounts mentioned in Balance Sheet and Profit and Loss Account. After making analysis of the
financial statements, the next step is to use mind for forming an opinion about the enterprise. This is the
interpretation stage. The technique is called "Analysis and Interpretation" of financial statements.
Analysis consists in breaking down a complex set of facts or figures into simple elements. Interpretation,
on the other hand, consists in explaining the real significance of these simplified statements.
Interpretation includes both analysis and criticism.
To interpret means to put the meaning of statement into simple terms for the benefit of a person.
Interpretation is to explain in such a simple language the financial position and earning capacity of the
company which may be understood even by a layman, who does not know accounting. The analysis and
interpretation of financial statements requires a comprehensive and intelligent understanding of their
nature and limitations as well as the determination of the monetary valuation of the items. The analyst
must grasp what represent sound and unsound relationship reflected by the financial statements.
Interpretation is impossible without analysis. "Interpretation is not possible without analysis and
without interpretation analysis has no value". Analysis and interpretation act as a bridge between the
art of recording and reporting financial information and the act of using this information. Analysis refers
to the process of fact finding and breaking down complex set of figures into simple components while
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Pandeshwar, Mangalore. @ 2009

interpretation stands for explaining the real significance of these simplified components. Interpretation
is a mental process based on analysis and criticism.
Types of Financial Analysis
The process of financial statement analysis can be classified into different types on the basis of
information used and modus operandi of analysis.




External Analysis: This analysis is based on published financial statements of a firm made by the
outsiders, namely, creditors, suppliers, investors, government agencies, etc. Outsiders have limited
access to internal records of the concern. Therefore, they depend on the published financial statements.
This analysis serves very limited purpose.
Internal Analysis: The internal analysis is accomplished by those who have access to the books of
accounts and all other information related to the business. In other words, internal analysis is done by
the executives or other authorized officials of the company. This type of analysis is very significant for
the management for decision making and forward planning.
Horizontal Analysis: This analysis is also known as ‘dynamic’ or ‘trend’ analysis. The analysis is
done by analyzing the statements of a number of years. It involves the study of the behavior of each of
the entities in the statement over the period of time. Thus, under horizontal analysis we study the
behavior of each item shown in the financial statements. We examine as to what has been the
periodical trend of various items shown in the statements, whether they have increased or decreased
over the period of time.
Vertical Analysis: Vertical analysis is also known as static analysis or structural analysis. This
analysis is made on the basis of a single set of financial statements prepared on a particular date. Under
Financial
Statement
Analysis
On the Basis of
Information
Used
External
Analysis
Internal
Analysis
On the basis of
modus operandi
of analysis
Horizontal
Anaysis
Vertical Analysis
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Pandeshwar, Mangalore. @ 2009

vertical analysis, quantitative relationship is established between different items shown in a particular
statement.
A combination of vertical and horizontal analysis will provide better information for the purpose of
decision making.
Tools (Methods) of Financial Analysis:
A financial analyst can adopt the following tools for analysis of the financial statements. These are also
termed as methods of financial analysis.
1. Ratio Analysis
2. Statement of Changes in Financial Position
a. Cash flow Analysis
b. Funds flow Analysis
3. Comparative Financial Statements
4. Common Size Statements
5. Trend analysis
6. Net working Capital analysis:
a. Gross working capital and net working capital
b. Operating Cycle.
c. Estimating the requirements of Working Capital

RATIO ANALYSIS
The Balance Sheet and Profit and Loss Account are the basic financial statements of a business
enterprise. They undoubtedly, provide useful financial data regarding the operations of a firm. Financial
statements contain a wealth of information which, if properly analyzed and interpreted, can provide
valuable insights into a firm's performance and position. The information contained in the financial
statements is used by management, creditors, investors and others to form judgment about the
operating performance and other financial position of* the firm. Financial statement analysis may be
done for a variety of purposes, which ma) range from a simple analysis of short-term liquidity of the firm
to a comprehensive assessment of strength and weakness of the firm in various areas. However, they
fail to present all the useful financial data required for decision-making, specially financing decisions by
the management. A Balance Sheet reports the firm's assets and liabilities at a point of time. The Profit
and Loss Account presents the summary of items relating to the revenue and the expenses of a firm
during a particular period of time. Neither of these shows the nature of the transactions entered into
during the period to finance the firm's operations. Nevertheless, they provide some extremely useful
information. The Balance Sheet is a mirror of the financial position of a firm. It reveals the assets the
firm owns, the liabilities it is to pay to outsiders and the amount of internal liabilities in terms of capital
supplied by the owners at a particular point of time. The Profit and Loss Account shows the results of
business activities or operations during a certain period of time, usually a year. It presents the summary
of income obtained and the costs incurred by the firm during a year. Thus, the financial statements
provide a summarized view of the operations of a firm. Much can be learnt about a firm from careful
examination of its financial statements. The analysis of financial statements is an important aid to
financial analysis. Of the various methods of financial statement analysis, Ratio Analysis is by far the
most widely used. Ratio analysis is based on different ratios which are calculated from the accounting
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Pandeshwar, Mangalore. @ 2009

data contained in the financial statements. Different ratios are used for different purposes. Financial
analysis depends to a very large extent on the use of ratios though there are other equally important
tools of such analysis.
The company's financial information is contained in Balance Sheet and Profit and Loss Account. The
figures contained in these statements are absolute and sometimes unconnected with one another. An
absolute figure does not convey much meaning. However, ii is only in the light of other information that
the significance of a figure is realized. For instance, Mr. X weighs 50 Kg. Is he fat? We cannot give answer
unless we know his age and height. Similarly a company's profitability cannot be known unless together
with the amount of profit, the capital employed is also seen. The relationship of these two figures
expressed mathematically is called a RATIO. The ratio refers to the numerical or quantitative
relationship between two variables or items. A ratio is calculated by dividing one item of the relationship
with the other. The ratio analysis is one of the most useful and common method of analyzing financial
statements. As compared to other tools of financial analysis, the ratio analysis provides very useful
conclusions about various aspects of the working of an enterprise. The need for ratios arises due to the
fact that absolute figures are often misleading. Absolute figures are certainly valuable but their value
increases manifold if they are studied with another through ratio analysis. Ratios enable the mass of
data to be summarized and simplified. Ratio analysis is an instrument for diagnosis of the financial
health of an enterprise. Ratios, in fact, are full of meaning and communicate the relative importance of
the various items appearing in the Balance Sheet and Profit and Loss Account.
A ratio is a mathematical relation between one quantity and another. Suppose you have 200 apples and
100 oranges. The ratio of apples to oranges is 200 / 100, which we can more conveniently express as 2:1
or 2. Ratio analysis is a type of analysis that helps you better understand and guide the financial affairs
of your business. A financial ratio is a comparison between one bit of financial information and another.
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-very useful technique to check upon the efficiency of a firm. Some ratios
indicate the trend or progress or downfall of the firm. Ratios are used to analyze financial statements
and to explain relationships between individual amounts in the financial statements (i.e., revenues and
expenses; assets and liabilities; revenue to assets; and expenses to liabilities). A ratio in isolation is
typically of little value. Ratios become more meaningful when they are compared to:
? Organization’s past performance.
? Organizations of similar size.
? Standards by different associations or Industry Norms

Steps in Ratio Analysis
The first task of the financial analyst is to select the information relevant to the decision under
consideration from the statements and calculates appropriate ratios.
The second step is to compare the calculated ratios with the ratios of the same firm relating to past or
with the industry ratios. This step facilitates in assessing success or failure of the firm.
The third step involves interpretation, drawing of inferences and report-writing. Conclusions are drawn
after comparison in the shape of report or recommended course of action.
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 firm's financial statements is of interest to a number of
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Pandeshwar, Mangalore. @ 2009

parties, mainly, shareholders, creditors, financial executives etc. Shareholders are interested with
earning capacity of the firm: creditors are interested in knowing the ability of firm to meet its financial
obligations; and financial executives are concerned with evolving analytical tools that will measure and
compare costs, 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 provides inter-firm 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 deteriorating 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 use 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.
Nature of Ratio Analysis
Ratio analysis is a powerful tool of financial analysis. A ratio is defined as "the indicated quotient of two
mathematical expressions" and as "the relationship between two or more things". In financial analysis, a
ratio is used as an index or yardstick for evaluating the financial position and performance of a firm.
Analysis of financial statements is a process of evaluating relationship between component parts of
financial statements to obtain a better understanding of the firm's position and performance. Financial
analysis is used as a device to analyze and interpret the financial health of enterprise. The absolute
accounting figures reported in the financial statements do not provide a meaningful understanding of
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Pandeshwar, Mangalore. @ 2009

the performance and financial performance of a firm. An accounting figure conveys meaning when it is
related to some other relevant information. Just like a doctor examines his patient by recording his body
temperature, blood pressure etc., before making his conclusion regarding the illness and before giving
his treatment, a financial analyst analyses the financial statements with various tools of analysis before
commenting upon the financial health or weaknesses of an enterprise. A ratio is known as a symptom
like blood pressure, the pulse rate or the temperature of an individual. It is with help of ratios that the
financial statements can be analyzed more clearly and decisions are drawn from such analysis. The point
to note is that a ratio indicates a quantitative relationship, which can be, in turn, used to make a
qualitative judgment. Such is the nature of all financial ratios.
Limitations of Ratio Analysis
Ratio analysis is, as already mentioned, a widely-used tool of financial analysis. It is because ratios are
simple and easy to understand. But they must be used very carefully. They suffer from various
limitations. For instance, financial statements suffer from a number of limitations and may therefore;
affect the quality of ratio analysis. If due care is not taken, they might confuse rather than clarify the
situation. Different firms may use these terms in different senses or the same firm may use them to
mean different things at different times. Some of the limitations of the ratio analysis are given below:
1. Differences in Definitions: Comparisons are made difficult due to differences in definitions of
various financial terms. Lack of standard formula for working out ratios makes it difficult to
compare them. They are worked out on the basis of different items in different industries.
2. Limitations of Accounting Records: Ratio analysis is based on financial statements which are
themselves subject to limitations. Thus, ratios calculated on the figures gives in the financial
statements, also suffers from similar limitations.
3. Lack of Proper Standards: It is very difficult to ascertain the standard ratio in order to make
proper comparison. Because, it differs from firm to firm, industry to industry. Apart from this, it
may also have happened that in one firm, a current ratio of 2 : 1 is found to be quite
satisfactory, whereas in another firm 2.5 : 1 may be unsatisfactory. Again, a high current ratio
may not necessarily mean sound liquid position when current assets include large inventory or
inventory consisting of obsolete items.
4. No Allowances for Price Level Changes: Due to changes in price level of various years,
comparison of ratios of such years cannot give correct conclusions. A change in the price level
can seriously affect the validity of comparisons of ratios computed for different time periods.
For instance, a firm which has purchased an asset at a lower price, will show a higher return,
than the firm which has purchased the asset at a higher price.
5. Changes in Accounting Procedure: Comparison between two variables prove worth provided
their basis of valuation is identical. But in reality, it is not possible, such as methods of valuation
of stock (FIFO or LIFO) or charging different methods of depreciation on fixed assets etc. Thus, if
different methods are followed by different firms for their valuation, then comparison will
practically be of no use.
6. Qualitative Factors are ignored: Ratios are tools of quantitative analysis only and normally
qualitative factors which may generally influence the conclusions derived are ignored while
computing ratios. For instance, a high current ratio may not necessarily mean sound liquid
position when current assets include a large inventory consisting of mostly obsolete items.
Therefore, it is very difficult to generalize whether a particular ratio is good or bad.
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7. Limited use of Single Ratio: A single ratio would not be able to convey anything. Ratios can be
useful only when they are computed in a sufficient large number. If too many ratios are
calculated, they are likely to confuse instead of revealing meaningful conclusions.
8. Background is overlooked: When inter-firm comparison is made, they differ substantially in age,
size, nature of product etc. When an inter-firm comparison is made, these factors are not
considered. Therefore, ratio analysis cannot give satisfactory results.
9. Limited Use: Ratio analysis is only a beginning and gives just a fraction of information needed for
decision-making. Ratio analysis is not a substitute for sound judgment. But ratios are tools to aid
in applying judgment. Conclusions drawn from the ratio analysis are not sure indicators of bad
or good management. They merely convey certain observations which need further
investigations, otherwise wrong conclusions may be drawn. Computation of ratios is not useful
unless they are interpreted.
10. Personal Bias: Ratios have to be interpreted and different people may interpret the same ratio
in different ways. Ratios are only means of financial analysis but not an end in them. Ratios are
simple to understand and easy to calculate. Therefore, there is a tendency to over employ them.
It should be clearly noted that ratios are only tools and the personal judgment of analyst is more
important. The analyst has to carry further investigations and exercise his judgment in arriving
at a correct diagnosis.
11. Arithmetical Window Dressing: Window-dressing means manipulation of accounts in a way so as
to conceal vital Facts and present the statements in a way to show better position than what it
actually is. By doing so it is possible to cover up bad financial position. Therefore, ratios based
on such figures are not reliable.
12. Changing Policies: Ratios are computed on the basis of past result. Past is not an indicator of
future. Ratios computed from historical data are used for predicting and projecting the likely
events in the future. Such ratios may provide a glimpse of firm's past performance. But forecast
for the future may not be correct as several other factors like management policies, market
conditions etc. may induce future operations.
Ratios are only a post-mortem of what has happened between two Balance Sheet dates. The position in
the interim period is not revealed by ratio analysis. Besides, they give no clue to future. Ratio analysis
suffers from serious limitations. The analyst should not be carried away by its oversimplified nature,
easy computation with a high degree of precision. They are as good as data itself.
The analyst must have comprehensive but practical knowledge and experience about the concerns
whose statements have been used for calculating these ratios. Ratios are not an end in themselves but
they are means to achieve a particular end. Another limitation is that of standard ratio with which the
actual ratios may be compared. Generally, there is no such ratio which may be treated as standard for
the purpose of comparison, because conditions of one concern differ significantly from those of another
concern. The analyst must be able to examine the nature of the data carefully. If accounting data lack
uniformity particularly definitional uniformity, then ratios calculated on the basis of them will be
misleading. Ratio analysis is one of the many techniques of analysis and interpretation. Thus, while
attempting to draw any conclusion on this basis, other techniques should also be used.
Classification of Ratios
Financial ratios have been classified in several ways. A number of standpoints may be used as base for
classifying the ratios. It is a matter of great surprise that no uniformity has been achieved in this regard.
Different authors have classified the ratios in varying groups. 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
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Pandeshwar, Mangalore. @ 2009

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 interests 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:



(B) Classification by Users
This classification is based on the parties who are interested in making the use of ratios.


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Pandeshwar, Mangalore. @ 2009

(C) Classification According to Importance
This basis of classification of ratios has been recommended by the British Institute of Management. They
are of two types.

(D) Classification by 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 purpose or object of analysis. Normally, ratios are used
for the purpose of assessing the profitability and sound financial position. 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 broad categories of
accounting ratios from functional point of view:


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Pandeshwar, Mangalore. @ 2009

Liquidity Ratios:
Liquidity measures how easily you can turn assets into cash, in other words, Liquidity reflects the ability
of a company to meet its short-term obligations using assets that are most readily converted into cash.
Assets that may be converted into cash in a short period of time are referred to as liquid assets; they are
listed in financial statements as current assets. Current assets are often referred to as working capital
because these assets represent the resources needed for the day-to-day operations of the company's
long-term, capital investments. Current assets are used to satisfy short-term obligations, or current
liabilities. The amount by which current assets exceed current liabilities is referred to as the net working
capital.
Liquidity ratios provide a measure of a company’s ability to generate cash to meet its immediate needs.
There are two commonly used liquidity ratios;
1. Current Ratio:




2. Quick Ratio:





Quick Assets = Current Assets - Stock
The current ratio measures the degree to which current assets can be used to pay current debt
obligations. The quick ratio measures the degree to which very liquid current assets can be converted to
cash to meet current debt obligations. Generally, the larger these liquidity ratios, the better the ability
of the company to satisfy its immediate obligations. Is there a magic number that defines good or bad?
Not really. Consider the current ratio. A large amount of current assets relative to current liabilities
provides assurance that the company will be able to satisfy its immediate obligations. However, if there
are more current assets than the company needs to provide this assurance, the company may be
investing too heavily in these non- or low-earning assets and therefore not putting the assets to the
most productive use. Another consideration is the operating cycle. A company with a long operating
cycle may have more need to liquid assets than a company with a short operating cycle. That’s because
a long operating cycle indicate that money is tied up in inventory (and then receivables) for a longer
length of time.
Profitability Ratios:
Profitability measures the degree to which the business is profitable. Profitability ratios (also referred to
as profit margin ratios) compare components of income with sales. They give us an idea of what makes
up a company's income and are usually expressed as a portion of each rupee of sales. Generally, the
larger (more positive) the ratio, the more profitable the business.
Profitability analysis consists of two types of ratios.
a. Profit margin ratios: These ratios show the relationship between profits and sales. Examples are
gross profit ratio, net profit ratio, operating profit ratio, etc.
b. Rate of return ratios: These ratios indicate the relationship between profit and capital or
investment or sources of funds.

1. Gross Profit Ratio:
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Pandeshwar, Mangalore. @ 2009





2. Net Profit Ratio:




3. Operating Profit Ratio:





Operating profit (Profit Before interest and taxes (PBIT)/Earnings Before Interest and Taxes (EBIT)) = Net
profit + Non Operating expenses – Non operating incomes
Operating profit = Gross profit – Operating expenses
4. Operating Ratio: (Lower the ratio more is the efficiency)








5. Return on Investment:




Operating profit (Profit Before interest and taxes (PBIT)/Earnings Before Interest and Taxes (EBIT)) = Net
profit + Non Operating expenses – Non operating incomes
Operating profit = Gross profit – Operating expenses
6. Return on Shareholders’ Equity:




Shareholders’ equity includes equity share capital, preference share capital, all reserves and surplus
(P&L A/c Balance)
7. Return on Equity Shareholders’ Equity, Return on Equity, Return on Net worth:




Equity shareholders’ funds OR Equity shareholders’ equity OR Net worth refers to equity = Equity share
capital + Reserves + Profits – Accumulated Losses
8. Net income to Debt Service Ratio:




Operating profit (Profit Before interest and taxes (PBIT)/Earnings Before Interest and Taxes (EBIT)) = Net
profit + Non Operating expenses – Non operating incomes
Operating profit = Gross profit – Operating expenses
9. Cover for Preference Dividend:




10. Cover for Equity Dividend:




11. Productivity of Assets:
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Pandeshwar, Mangalore. @ 2009





Operating profit (Profit Before interest and taxes (PBIT)/Earnings Before Interest and Taxes (EBIT)) = Net
profit + Non Operating expenses – Non operating incomes
Operating profit = Gross profit – Operating expenses
12. Return on Total Resources:





Leverage OR Capital Structure Ratios:
A company can finance its assets either with equity or debt. Financing through debt involves risk
because debt legally obligates the company to pay interest and to repay the principal as promised.
Equity financing does not obligate the company to pay anything -- dividends are paid at the discretion of
the board of directors. There is always some risk, which we refer to as business risk, inherent in any
operating segment of a business. But how a company chooses to finance its operations -- the particular
mix of debt and equity -- may add financial risk on top of business risk financial risk is the extent that
debt financing is used relative to equity. Financial leverage ratios are used to assess how much financial
risk the company has taken on. There are two types of financial leverage ratios: component percentages
and coverage ratios. Component percentages compare a company's debt with either its total capital
(debt plus equity) or its equity capital. Coverage ratios reflect a company's ability to satisfy fixed
obligations, such as interest, principal repayment, or lease payments.

1. Debt Equity Ratio:




2. Total Debt to Equity:




3. Proprietary Ratio:




4. Borrowings to Total Assets:





5. Fixed Assets to Net worth:




6. Capital Gearing Ratio:




7. Cover for Senior charges




8. Number of times debenture interest covered
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Pandeshwar, Mangalore. @ 2009





9. Number of times preference dividend covered




10. Debt service coverage ratio




Activity Ratios OR Turnover Ratios OR Efficiency Ratios:
Activity ratios are measures of how well assets are used. In other words Efficiency measures the degree
to which the business is effectively utilizing its resources in generating sales and profits for the business.
Activity ratios - which are, for the most part, turnover ratios - can be used to evaluate the benefits
produced by specific assets, such as inventory or accounts receivable. Or they can be use to evaluate the
benefits produced by all a company's assets collectively. These measures help us gauge how effectively
the company is at putting its investment to work. A company will invest in assets – e.g., inventory or
plant and equipment – and then use these assets to generate revenues. The greater the turnover, the
more effectively the company is at producing a benefit from its investment in assets.

1. Total Assets Turnover Ratio





2. Fixed Assets Turnover Ratio




3. Current Assets Turnover Ratio





4. Inventory Turnover Ratio




5. Stock Velocity




6. Debtors’ Turnover Ratio




7. Debtors’ Velocity or Average Collection Period





8. Cash Velocity




39 | C h 2 : A n a l y s i s a n d I n t e r p r e t a t i o n o f F i n a n c i a l S t a t e m e n t s

Study Material by SUBRAHMANYA KUMAR N., Senior Lecturer, Srinivas Institute of Management Studies,
Pandeshwar, Mangalore. @ 2009


9. Capital Turnover Ratio




10. Sales to Net worth






11. Creditors’ Turnover Ratio





12. Creditors’ Velocity or Payable Deferral Period






Thus, Ratio analysis is one of the most important tools available to financial analysts for their work. An
accounting ratio shows the relationship in mathematical terms between two interrelated accounting
figures. The figures have to be interrelated (e.g., Gross Profit and Sales, Current Assets and Current
Liabilities), because no useful purpose will be served if ratios are calculated between two figures which
are not at all related to each other, e.g., sales and discount on issue of debentures. A financial analyst
may calculate different accounting ratios for different purposes.
STATEMENT OF CHANGES IN FINANCIAL POSITION
As a student of accounting, you are aware of basic difference between Profit and Loss Account and
Balance Sheet on time scale. While Profit and Loss Account is prepared for a period, Balance Sheet
presents financial position at a particular point of time. Is there any way for users to convert the Balance
Sheet into a flow statement? If the answer is yes, what is the use of such conversion? Let us take the
second issue to understand the concept. Balance Sheet shows the sources of capital or funds for the
assets that the firm holds or how the firm spent its capital or funds on various assets. This is an
important useful information to the users of financial statements but it fails to tell how much of assets
have been added during the period and how such additional investments are funded. In other words,
the users would like to know whether the firm is growing or not and if it is growing, what is the source of
capital or funds. Users would also like to know whether there is any change in the pattern of funding
over the years. Therefore, there is a need for converting the point statement into flow statement.
The concept of Funds:
The term ‘Funds’ is a highly disputed one and conveys different meaning to different people. According
to Paul C. Hastings “The total amount of funds used in a firm’s operations is equal to the total assets
employed in an enterprise.” This view supports the broadest meaning of ‘funds’ as Total Resources.
According to International Accounting Standard – 7, the term ‘Fund’ generally refers to Cash, to Cash
equivalents or to the Working Capital. This view leans towards the narrower meaning of ‘Funds’.
40 | C h 2 : A n a l y s i s a n d I n t e r p r e t a t i o n o f F i n a n c i a l S t a t e m e n t s

Study Material by SUBRAHMANYA KUMAR N., Senior Lecturer, Srinivas Institute of Management Studies,
Pandeshwar, Mangalore. @ 2009

As a result of difference of opinion about the meaning of the term ‘Funds’ there evolved two different
statements for Financial Analysis.
? Funds Flow Statement: A Statement that summarizes for the period covered by it, the changes
in financial position including the sources from which funds were obtained by the enterprise and
the specific uses to which such funds were applied. Accounting Standard (Revised) - 3 has made
funds flow statement redundant and prescribed cash flow statement.
? Cash Flow Statement: A Financial statement that summarizes the cash receipts and payments
and net change in cash resulting from operating, financing, and investing activities of an
enterprise during a given period.”
The Concept of ‘Flow’:
The term 'flow' refers to change. Therefore, the term 'flow of funds' means change in funds.
In other words flow of funds refers to transfer of economic values from one form to another
or it is the change in the composition of funds and cash from one point of time to another.
FUNDS FLOW ANALYSIS
Accounting Standard (Revised) - 3 has made funds flow statement redundant and prescribed cash flow
statement. Despite that why do we feel funds flow statement is useful to users of accounts? Funds flow
statement provides some further insight into the Balance Sheet and particularly shows how the firm is
able to get money to take up several activities. It is possible to know what is the kind of funds mix that
the firm is using, particularly a comparison of internal and external funds. For instance, Ranbaxy heavily
uses internal funds and depend little on external funds. In contrast, Aurobindo Pharma Ltd. another
major player in the pharmaceutical industry uses debt substantially for the funding its activities.
Funds flow statement can also be used to know how the resources raised are used. For instance, we
observed Ranbaxy spends most of the resources for increasing current assets. Aurobindo Pharma also
uses substantial part of the funds for increasing current assets and it looks like that there is something
which is driving for the industry to build up more current assets. A further analysis shows that a
significant part of the currents assets are funding of receivables without corresponding increase in sales.
Though balance sheet also highlights an increase in receivables values, it is not apparent that substantial
part of the funds raised during the period goes for funding of such receivables. It is possible to examine
how healthy the financial policies of firms. For instance, many firms would like to avoid using short-term
capital for long-term purposes. It is possible to identify whether firms in which you are interested use
funds in a sub-optimal way.
Summary of Changes in Balance Sheet values of Ranbaxy Laboratories Ltd.
(Rs. in Crores)
Particulars 2002 2001 2000 1999
Share Capital 69.55 0.00 0.00 0.00
Reserves & Surplus 199.76 19.54 84.72 97.10
Loans -119.08 -129.83 -67.07 -102.05
Current Liabilities and Provision 348.70 168.69 109.27 1.22
Total 498.93 58.40 126.92 -3.73
Fixed Assets 62.34 -31.32 12.47 18.34
41 | C h 2 : A n a l y s i s a n d I n t e r p r e t a t i o n o f F i n a n c i a l S t a t e m e n t s

Study Material by SUBRAHMANYA KUMAR N., Senior Lecturer, Srinivas Institute of Management Studies,
Pandeshwar, Mangalore. @ 2009

Investments -5.02 52.49 7.26 -49.70
Current Assets, Loans & Advances 441.61 37.23 107.19 27.63
Total 498.93 58.40 126.92 - 3.73

Summary of Changes in Balance Sheet values of Aurobindo Pharma Ltd.
(Rs. in Crore)
Particulars 2002-03 2001-03 2000-03 1999-03
Share Capital 0.67 1.00 0.55 13.23
Reserves & Surplus 84.27 55.71 94.43 41.45
Debt 110.10 84.99 29.95 40.10
Total 195.04 141.70 124.93 94.78

FUNDS FLOW STATEMENT
The Balance Sheet gives a 'snapshot' view at a point in time for the sources from which a firm has
acquired its funds and the uses, which the firm has made of these funds. The flow statement explains
the changes that took place in the Balance Sheet account. Firms get funds from various sources. Broadly,
we classify the sources of funds into two categories namely; long-term funds and short-term funds,
Sources of long-term funds include equity share capital, funds provided by operation, term loan, etc.
Source of short-term funds consists of supplier credit and any short-term borrowing. The term fund is
broader compared to the term cash. For instance, when a firm sells goods on credit, there is no cash
flow and cash flow statement ignores such transactions. On the other hand, funds flow statement treats
this source of funds from operating activities and treat the increased accounts receivables as application
of funds for working capital purpose. On the other hand, if the firm collects receivables of last year, it
appears in cash flow statement, whereas it has no impact in funds flow statement because there is no
change in working capital. That is, while receivables decline its value, cash increases to that extent and
flow of funds is restricted within the working capital group. The concept of funds simply denotes
whether there is any change in Balance Sheet item at aggregate level and such changes lead to an
increase in fund or decrease in fund. The following are certain activities, which will not affect fund flow
statement and any effect that arises out of these activities will be restricted to working capital
statement.
1. Collection of bills receivable.
2. Payment of bills payable.
3. Purchase of Materials for cash or on credit basis.
4. Sale of goods on cash or credit basis (except for the profit or loss component).
The above items normally affect cash flow statement [cash part of item (c) and (d)]. There are several
items, which affects funds flow and not cash flow statement. A few of them are:
1. Sale or purchase of goods on credit basis — it affects funds from operation and to a minor
extent working capital statement.
2. Purchase of fixed assets on credit basis.
3. Expenses incurred but not paid.
4. Income accrued but not received.
5. Changes in value of closing stock.
42 | C h 2 : A n a l y s i s a n d I n t e r p r e t a t i o n o f F i n a n c i a l S t a t e m e n t s

Study Material by SUBRAHMANYA KUMAR N., Senior Lecturer, Srinivas Institute of Management Studies,
Pandeshwar, Mangalore. @ 2009

There are several items, which affect both funds flow and cash flow statement. A few of them are:
1. Fresh Equity
2. Fresh loan or repayment of loan
3. Purchase of fixed assets by paying cash
4. Cash sales and purchases
5. Cash Expenses
From the above discussion, it is clear that 'funds' in funds flow statement means changes in equity,
liability or working capital.
Flow of funds means 'change in fund position' or 'change in net working capital'. Whenever there is a
change in the funds, it is presumed that flow of funds has taken place. The flow of funds can be in the
form of a inflow or an outflow. An inflow of funds increases the working capital and an outflow of funds
decreases the working capital.
Flow of funds will takes place if a transaction involves a change in a current item and change in a non-
current item. A non-current item means either a non-current asset (Fixed asset) or a non-current liability
(long-term liability). There will be no change in net working capital (flow of funds) if a transaction
involves: (i) only the current items or (ii) only the non-current items. In other words, a transaction,
involving a fixed asset/fixed liability on the one hand and a current asset/current liability on the other,
will alone result in flow of funds. Let us understand these rules by taking up some examples.
1. Transactions involving items from both current and non-current categories which result in flow
of funds:
i) Purchased machinery for Rs. 30,000: This transaction increases machinery (a non-
current asset) and reduces cash (current asset).The reduction in cash reduces
current assets without any corresponding reduction in current liabilities. As a result,
the net working capital gets reduced.
ii) Shares issued for Rs. 2,00,000 : In this case, a non-current liability (i.e., share capital)
has increased and a current asset (i.e., cash) has increased. Thus the current asset
has increased without any corresponding change in current liabilities. As a result,
net working capital gets increased.

2. Transactions affecting items in the current category only which do not 1.result in flow of funds:
i) Cash collected from debtors Rs. 4000: This transaction results in an increase in cash
(a current asset) and a decrease in debtors (a current asset, again) by the same
amount. Thus the total current assets remain the same and there will be no change
in the net working capital.
ii) Acceptance given to creditors Rs. 3,000: Both creditors and bills payable are current
liabilities. By giving acceptance to creditors, the amount of creditors decreases and
that of bills payable increases by the same amount. Since this transaction does not
affect the total amount of current assets as also the total amount of current
liabilities, the difference between current assets and current liabilities remains
unchanged. Thus, there is no flow of funds and no change in the net working capital.
iii) Paid creditors Rs. 1,000: By paying the creditors’ cash (a current asset) is reduced
and the amount of creditors (a current liability) is also reduced by the same amount.
Therefore, the difference between the current assets and current liabilities will be
the same as it was before. So there will be no flow of funds, which means no change
in the net working capital.

43 | C h 2 : A n a l y s i s a n d I n t e r p r e t a t i o n o f F i n a n c i a l S t a t e m e n t s

Study Material by SUBRAHMANYA KUMAR N., Senior Lecturer, Srinivas Institute of Management Studies,
Pandeshwar, Mangalore. @ 2009

3. Transactions affecting items in the non-current category only which do not result in flow of
funds:
i) Land exchanged for machinery Rs. 10,00,000 : Both land and machinery are non-
current assets. By exchanging land for machinery, the book value of land is reduced
and that of machinery is increased, but the total of non- current assets remain
unaffected. Further, it does not affect any change in the current assets or the
current liabilities. Hence, there will be no change in the net working capital position.
ii) Preference shares are converted into equity shares Rs. 10,00,000: Both preference
share capital and equity share capital are non-current items. As a result of
conversion, the equity share capital stands increased and the preference share
capital gets reduced by the same amount. As no current item is affected, there will
be no change in net working capital.
iii) Purchased land worth Rs. 50,000 and issued shares in consideration thereof : This
transaction increases the debit balance of the land account and credit balance of
share capital account Both land and share capital are non- current items. Since no
current items are involved, the net working capital remains unaffected.
We can summarize the above analysis as follows:
1) There will be flow of funds if transaction involves;
a. Current assets and non-current liabilities.
b. Current assets and non-current assets.
c. Current liabilities and non-current assets.
2) There will be no flow of funds if a transaction involves ;
a. Non-current assets and non-current liabilities.
b. Current assets and current liabilities.
In order to know whether a transaction brings a change in working capital, it is better to journalize the
transaction and then classify the accounts of the transaction to which account it belongs. If both the
accounts of the transaction belong to current category or non-current category, there will be no change
in working capital. On the other hand if one account of transaction belongs to current item and the
other to non-current item, then there will be a change in working capital.


For easy reference, the list of non-current and current items is given below :
Non Current Liabilities Non-Current Assets
Equity Share capital Goodwill
Preference Share Capital Plant and Machinery
Debentures Furniture
Share Premium Trade Marks, Patnets, Copyrights
Forfeited Shares Land and Buildings
Current Liabilities Current Assets
Bank Overdraft Stock
Bills Payable Debtors
Creditors Bills Receivable
Outstanding Expenses Income Outstanding
Incomes received in advance Cash at bank
Cash in hand

44 | C h 2 : A n a l y s i s a n d I n t e r p r e t a t i o n o f F i n a n c i a l S t a t e m e n t s

Study Material by SUBRAHMANYA KUMAR N., Senior Lecturer, Srinivas Institute of Management Studies,
Pandeshwar, Mangalore. @ 2009

SOURCES AND USES OF FUNDS
You have learnt that, funds represent that portion of current assets which is not financed by current
liabilities but is financed from the long-term/non-current sources. You have also learnt that as and when
a change takes place in current items resulting from a change in non-current items the net working
capital will be affected. The increase and decrease in only non-current (long-term) assets and liabilities
alone will act as a source or an application (use) of funds. For the preparation of funds flow statement it
is necessary to find out the sources and application of funds. Let us now identify the sources and
application of funds.
? Sources of Funds: The sources of funds can be classified as external sources and internal
sources.
o External sources of funds refer to sources of funds from outside the business. These
are: (a) raising additional capital, (b) increasing long-term borrowings, and (c) sale of
fixed assets and long term investments.
o Internal sources consist of funds that are generated internally by the organization.
Every profitable sale brings in funds to the extent of the excess of sales revenue over
cost of goods sold. Such profits, called funds from operation, are also important internal
sources of funds.
? Application of funds: It may be noted that all funds raised through long term source are not
necessarily applied for financing the increase in net working capital. A substantial part of this
amount may be utilized for purchasing the fixed assets, redemption of debentures or preference
shares, payment of dividends and meeting losses from operations, if any. In fact whatever is left
the application of funds for these purposes, will be the amount used for financing the increase
in working capital. Uses of funds thus are: (i) purchase of fixed assets or long term investments,
(ii) redemption of debentures and preference shares, (iii) repayment of long term loans, (iv)
payment of dividends (v) meeting losses from operations (net loss), and (vi) financing the
increase in working capital.
PREPARATION OF FUNDS FLOW STATEMENT
Fund flow statement is intended to explain the magnitude, direction and the causes of changes in the
position of funds (net working capital) that took place during the two balance sheets dates. Thus, it
highlights the basic changes in the financial structure, asset structure and the liquidity position of a
business between two balance sheet dates. But primarily, it reveals changes in the financial position of
the company by identifying the sources and application of funds resulting from financing and investing
decisions that took place during a particular period.
The preparation of fund flow statement involves essentially the following three steps:
1. Schedule of Changes in Working Capital.
2. Statement of Funds from Operations.
3. Preparation of the Funds Flow Statement.
Schedule of Changes in Working Capital
The first step in the preparation of fund flow statement is to prepare the schedule of changes in working
capital. For this purpose, all non-current items are to be ignored as the net working capital is simply the
difference between current assets and current liabilities.
In order to ascertain the amount of increase or decrease in the net working capital, it could be noted
that
45 | C h 2 : A n a l y s i s a n d I n t e r p r e t a t i o n o f F i n a n c i a l S t a t e m e n t s

Study Material by SUBRAHMANYA KUMAR N., Senior Lecturer, Srinivas Institute of Management Studies,
Pandeshwar, Mangalore. @ 2009

? An increase in any current asset, between the two balance sheet dates, results in an increase
in net capital and a decrease in any current asset result in a decrease in net working capital; and
? An increase in any current liability, between the balance sheet dates, decreases the net working
capital whereas a decrease a in any current liability increases the net working capital.
The schedule of changes in working capital may be prepared with the help of the following specimen
statement:

Statement of Changes in Net Working Capital
Particulars Increase in Net
Working Capital
Amount (Rs.)
Decrease in Net
Working Capital
Amount (Rs.)
Increase in Current Assets ****
Decrease in Current Liabilities ****
Increase in Current Liabilities ****
Decrease in Current Assets ****
**** ****
Increase in Net Working Capital (Balancing Figure) ****
Decrease in Net Working Capital (Balancing Figure) ****
Total **** ****

Statement of Funds from Operations
You know that profit is an important source of funds. Profit is the result of revenue over expenses.
When a business earns profit the net working capital gets increased to the extent of the profit earned.
Therefore, the profit earned constitutes an important element of the funds provided by operations.
Certain items charged and revenues earned actually do not involve any flow of funds during the current
period. Similarly, certain deferred revenue expenses written off like preliminary expenses, discount on
issue of shares etc. do not involve any outflow of funds. Hence, these items are added back to the net
profit in order to arrive at the amount of funds from operations. Also there are certain non- operating
incomes and expenses like profit or loss on the sale of fixed assets, dividend from investment, etc. are
taken into account to arrive at net operating results of the business. The profit or loss arising out of
these transactions is not regular operations of business. Hence, the effect of these items must not be
taken into account while preparing funds from operations, i.e., the profit on such items are to be
excluded from the net profit and loss must be added back to the net profit to ascertain the amount of
funds from operations. There are many items which are charged and credited to profit and loss account
but do not affect working capital. Hence, all such items need adjustment to calculate funds from
operations.
There are two methods to calculate 'Funds from Operations’:
? Statement of Funds from Operations Method.
? Adjusted Profit and Loss Account Method.
Statement of Funds from Operations Method
Under statement form, all non-funds or non-trading charges which were already debited to Profit and
Loss Account are added back to net profit and all non-trading incomes which were already credited to
46 | C h 2 : A n a l y s i s a n d I n t e r p r e t a t i o n o f F i n a n c i a l S t a t e m e n t s

Study Material by SUBRAHMANYA KUMAR N., Senior Lecturer, Srinivas Institute of Management Studies,
Pandeshwar, Mangalore. @ 2009

profit and loss account are to be subtracted from the net profit. Funds from operations may be
calculated with the help of the following proforma:
Statement Showing Funds from Operations
Particulars Amount
(Rs.)
Profit and Loss A/c Balance as per current year Balance Sheet ****
Less: Profit and Loss A/c Balance as per previous year Balance Sheet ****
PROFIT TRANSFERRED TO BALANCE SHEET DURING THE CURRENT YEAR ****
Add: All items charged to the debit side of P&L Appropriation Account
a. Transfer to reserves(All the reserves created during the year) ****
b. Interim Dividend ****
c. Proposed Dividend ****
d. Other Items of Appropriation **** ****
NET PROFIT FOR THE YEAR AFTER TAXES ****
Add: All items of expenses debited to P&L A/c which do not involve flow of funds (All
non-fund expenses)

a. Provision for taxation ****
b. Depreciation written off ****
c. Preliminary Expenses written off ****
d. Discount/Commission on Issue of Shares, debentures, bonds, etc.
written off
****
e. Loss on sale of fixed assets, investments, etc. ****
f. Interest capitalized written off ****
g. Deferred revenue advertising expenditure written off ****
h. Heavy R&D expenditure capitalized written off ****
i. Patents, Goodwill, etc. Written off ****
j. Loose tools and other items written off **** ****
****
Less: Non fund incomes credited to P&L A/c during the year
a. Dividends received ****
b. Bad Debts Recovered ****
c. Interest received ****
d. Profit on sale of fixed assets, investments, etc. ****
e. Refund of taxes ****
f. Income from unusual sources **** ****
FUNDS FROM OPERATIONS~~ ****
~~If the value is negative it will be Outflow of Funds on Account of Operations

Note: In case Profit and Loss Account shows ''Net Loss'', it should be taken as an item which decreases
funds and therefore, all the items shown under 'Add' head above should be subtracted and those shown
under 'less' head should be added to the 'Net loss'.

47 | C h 2 : A n a l y s i s a n d I n t e r p r e t a t i o n o f F i n a n c i a l S t a t e m e n t s

Study Material by SUBRAHMANYA KUMAR N., Senior Lecturer, Srinivas Institute of Management Studies,
Pandeshwar, Mangalore. @ 2009

Adjusted Profit and Loss Account Method
'Funds from Operations' may also be computed in an 'Account Form' which is as follows:
Adjusted Profit and Loss Account


When all the information is available, it is relatively easy to calculate the amount of funds from
operations. Sometimes, full information is not available and it becomes necessary to dig out the hidden
information on the basis of clues available. Let us now study a few situations involving such items and
learn how will these be ascertained and adjusted for determining the amount of funds from operations.
Depreciation: It is a practice in every business to write off depreciation on fixed assets which is debited
to Profit and loss account and a corresponding credit to fixed asset account. Since, both profit and loss
account and the fixed asset account are non-current accounts, depreciation is a non-fund item. It is
neither a source nor an application of funds. It is added back to operating profit to find out Funds from
operations.
When the profit and loss account is given, whether in full or as a summary thereof, the amount charged
as depreciation can be easily ascertained. But when any details regarding the income statement are not
given, the depreciation amount is to be ascertained from the data given in the balance sheet and from
the other available information. If the figures given in two Balance Sheets show the opening and closing
balances of the asset concerned at their depreciated value (cost less depreciation till date) and there is
no mention of purchase and sale of the asset during that year, the difference between the opening and
closing balance may be considered as the depreciation charged during the years. Sometime, the fixed
assets are shown at cost on the assets side and the depreciation or, as a provision for depreciation or as
accumulated depreciation, are either shown as a deduction from the fixed asset concerned or appear on
the liabilities side. In such a situation, the increase in the amount of accumulated depreciation during
the year (assuming that there were no purchases and sales of fixed assets) must be taken as the amount
of depreciation charged during that year. Study the example given below and learn how will the amount
of depreciation is to be ascertained.
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Study Material by SUBRAHMANYA KUMAR N., Senior Lecturer, Srinivas Institute of Management Studies,
Pandeshwar, Mangalore. @ 2009


Profit or Loss on Sale of Fixed Assets: When a fixed asset is sold at a price which is higher than its
book value, the profit on its sale is credited to profit and loss account. Hence, this amount will have to
be deducted from the net profit in order to ascertain the amount of funds from operations. Similarly,
when a fixed asset is sold at a loss (price is less than its book value), the loss is charged to profit and loss
account and it becomes necessary to add back this amount to the net profit so as to show the correct
amount of funds from operations. The purpose of adjusting the amounts of profit or loss on sale of fixed
assets in the net profit is to avoid double counting of such profit or loss as the same is already included
or is excluded in the amounts from the sale of the fixed assets which would be shown separately as a
source of fund. Thus, the actual sale of fixed assets are shown as a source of funds, and, if there is a
profit on sale it must be subtracted from the net profit, and, if there is a loss the same must be added
back to the net profit. This adjustment is necessary for ascertaining the correct amount of funds
provided by operations.
If complete information is available with regard to purchase and sale of fixed assets it will not be a
problem to ascertain the amount of depreciation, value of assets purchased, sale proceeds, gain or loss
on such a sale and depreciation charged till the date of sale of the assets sold. When detailed
information is not available, then you have to ascertain the hidden information. Look at the following
example
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Study Material by SUBRAHMANYA KUMAR N., Senior Lecturer, Srinivas Institute of Management Studies,
Pandeshwar, Mangalore. @ 2009



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Study Material by SUBRAHMANYA KUMAR N., Senior Lecturer, Srinivas Institute of Management Studies,
Pandeshwar, Mangalore. @ 2009


If we had merely compared the opening and closing balances of the accumulated depreciation account,
we would have wrongly concluded that depreciation charged during the year was only Rs. 25,000. The
sale of an old asset required that the accumulated depreciation in respect thereof should be transferred
from accumulated depreciation account to the concerned asset account, and it is only after
incorporating this entry that the actual depreciation charged during the year can be correctly
ascertained Thus, the depreciation charged during the year works out to Rs. 30,000 and not Rs. 25,000.
This amount of depreciation charged during the year has been added back to the net profit, in order to
ascertain funds from operations as the same must have been debited to profit and loss account earlier.
Profit or Loss on sale of Long term Investments: If a company made long term investment in other
company, such investment must be considered as non-current item like a fixed asset. If there is any
profit or loss on their sale, it would be dealt in the same manner as the profit or loss on the sale of fixed
assets. On the other hand, if the investments made are only for a short period, in such a case the
investments must be treated as an item of current asset. Any changes in short term investments will
appear in the schedule of changes in working capital, otherwise it would appear directly in funds flow
statement.
Amortization of Expenses and Writing Off of Intangible Assets: Sometimes, a firm decides to
write off a portion of its intangible assets like goodwill, patents, copy rights, etc., by charging it to the
profit and loss account. Similarly, it may decide to write off deferred revenue expenses, like preliminary
expenses, discount on issue of shares, etc., by charging some amount to the profit and loss account.
These write off amounts, like depreciation, are non-cash costs and reduce the amount of profit. But they
do not affect flow of funds. For this reason, such amounts must be added back to the net profit to
determine the amount of funds provided by operations.
Provision for Taxation: Provision for taxation represents the amount likely to be paid as tax after the
assessment is complete during the next accounting period. Thus, provision for taxes is shown as a
current liability in the balance sheet, and if for purposes of preparing fund flow statement it is treated as
such, this would appear in the schedule of changes in working capital, and the amount of tax paid during
the year will not be shown as an application in the fund flow statement. However, as per practice, tax on
profits is normally treated as a non-current item for preparing the fund flow statement. Hence, this will
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Study Material by SUBRAHMANYA KUMAR N., Senior Lecturer, Srinivas Institute of Management Studies,
Pandeshwar, Mangalore. @ 2009

not be taken to the statement of changes in working capital. In fact, the provision made during the
current year will have to be added back to net profit to find out the amount of funds from operations, as
the same must have been debited to profit and loss account earlier. As for the amount of tax paid, it
must be shown as an application of fund in the fund flow statement. It may be noted that if no
additional information is available, the provision for tax shown in the previous year's balance sheet shall
be taken as the tax paid during the year, and the provision for tax shown in current years' balance sheet
be treated as the amount of tax provided during the current by debiting it to the current year's profit
and loss account. Of course, this amount will have to be added back to net profit for ascertaining funds
from operations. This treatment of taxation is in strict conformity with the requirements of the
Accounting Standard on State of Changes in Position of Funds (AS-3).
Proposed Dividends: Proposed dividend, as in the case of provision of taxation, can be treated either
a current liability or as a non-current liability and its treatment will differ accordingly. In case it is treated
as a current liability, it will appear as one of the items in the schedule of changes in working capital and
the amount of dividend paid will not be shown as an application of funds in fund flow statement. But, as
per the requirement of AS-3, the proposed dividends are also to be treated as a non-current item for
purposes of fund flow statement. As such proposed dividends will not find a place in the schedule of
changes in working capital. The amount of proposed dividends relating to current year if already
deducted from profits shall be added back for ascertaining the amount of funds from operations, and
the dividends actually paid during the year will be shown as an application of funds. It may be noted
that, just like provision for tax, if no details are available, the proposed dividends shown in the previous
year's balance sheet shall be taken as dividends paid during the year and the proposed dividends shown
in current year's balance sheet shall be treated as the amount of dividends provided during the current
year by debiting it to the current year's profit and loss appropriation account.
Provision for Doubtful Debts: Provision for doubtful debts is treated as a current item as it relates to
an item of current asset (debtors) and therefore it should appear in the schedule of changes in working
capital.
Preparation of Funds Flow Statement
Funds flow statement is a statement which explains about the movement of funds where from working
capital originates and where into the same goes during the accounting period. While preparing funds
flow statement, current assets and current liabilities are to be ignored and only changes in non-current
assets and non-current liabilities are taken into account. In other words, funds flow statement is
prepared on the basis of the changes in fixed assets, long term liabilities and share capital shown in the
Balance Sheet after taking into account the additional information given, if any. This statement has two
parts, Sources of funds and Application of funds. The difference between sources and application of
funds shows the net changes in the working capital during a specified period. The transactions which
increase working capital are sources of funds and the transactions which decrease working capital are
application of funds. Therefore, funds flow statement is also called as a Statement of Sources and
Application of Funds, Inflow-outflow of Funds Statement etc.
This can be prepared either in a (1) Account Format or (2) Statement Form as given below:






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Study Material by SUBRAHMANYA KUMAR N., Senior Lecturer, Srinivas Institute of Management Studies,
Pandeshwar, Mangalore. @ 2009

1. Account Format
Funds Flow Statement for the period ending__________________
Sources Funds
(Rs.)
Application Funds
(Rs.)
Issue of Shares **** Redemption of Shares (What is
actually paid)
****
Issue of
Debentures/Bonds/Public
Deposits
**** Repayment of
Debentures/Bonds/Public
Deposits
****
Borrowings **** Repayment of Borrowings ****
Sale of Fixed Assets (Take
exact amount received)
**** Purchase of Fixed Assets ****
Sale of Investments **** Investments Made ****
Dividend/Interest Received **** Dividend Paid ****
Tax Refunds **** Taxes Paid ****
Bad Debts Recovered **** ****
**** ****
**** ****
**** ****
**** ****
**** ****
Funds From Operations **** Funds Lost in Operations ****
Cash From Operations Cash Loss From Operations
Decrease in Net Working
Capital
**** Increase in Net Working Capital ****
Decrease in Cash and Bank
Balance
Increase in Cash and Bank
Balance

**** ****















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Pandeshwar, Mangalore. @ 2009

2. Statement Form

The funds flow statement explains the differences in various assets and liabilities items of balance sheet
between the beginning of the year and end of the year. It converts balance sheet into a flow statement.
An increase in liability side means the organization has generated funds during the period. There are
broadly three sources of funds - funds from operation, funds from other long-term sources like equity,
loan, etc. and funds generated from working capital (e.g. increase in payables). Thus, Funds flow
statement throws some insight further on the flow of funds between long-term and short-term needs of
organization.
Funds flow statement is not required under the current Accounting Standards and hence very few
companies provide such statement. Further, funds flow statement is not free from window dressing
since uses only the two principal financial statements. Many organizations prepare funds flow statement
for internal purpose and normally it is compared with budgets to set right deviation from budgets.
CASH FLOW STATEMENT
The statement of cash flows, required by the Accounting Standard-3, is a major development in
accounting measurement and disclosure because of its relevance to financial statement users. Cash Flow
Statement is reasonably simple and easy to understand. It is also difficult to fudge or manipulate the
cash flow numbers and hence often used as a way to test the real profitability of the firm. For instance,
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Pandeshwar, Mangalore. @ 2009

if your company approaches a bank for a loan, your company will normally highlight the profitability of
your business as your strength. But the bank manager may not be sure how you arrived at the profit,
particularly when we read lot of accounting related scams. Hence, the bank manager would like to
examine whether you have actually earned the profit or not. Cash Flow Statement will be useful to
examine whether the profits are realized and if so, to what percentage of profit a firm has realized. In
other words, a company that shows high level of profit need not be liquid in cash. Suppliers of goods will
also be interested to examine the cash flow position of the company before supplying goods on credit.
Investors, who have no control on management, will also be interested in examining the cash flow to
supplement their analysis on profitability of the business.
NEED FOR CASH FLOW STATEMENT
The primary objective of the statement of cash flows is to provide information about an entity's cash
receipts and cash payments during a period. The net effect of cash flow is provided under different
heads namely cash flow from operating, investing and financing activities. It helps users to find answers
to the following important questions:
? Where did the cash come from during the period?
? What was the cash used for during the period?
? What was the change in the cash balance during the period?
The AS-3 identifies two important uses of cash flow statement as follows:
a. A cash flow statement, when used in conjunction with the other financial statements, provides
information that enables users to evaluate the changes in net assets of an enterprise, its
financial structure (including its liquidity and solvency) and its ability to affect the amounts and
timing of cash flows in order to adapt to changing circumstances and opportunities. Cash flow
information is useful in assessing the ability of the enterprise to generate cash and cash
equivalents and enables users to develop models to assess and compare the present value of
the future cash flows of different enterprises. It also enhances the comparability of the
reporting of operating performance by different enterprises because it eliminates the effects of
using different accounting treatments for the same transactions and events.
b. Historical cash flow information is often used as an indicator of the amount, timing and certainty
of future cash flows. It is also useful in checking the accuracy of past assessments of future cash
flows and in examining the relationship between profitability and net cash flow and the impact
of changing prices.
A Statement issued by Securities and Exchange Board of India in 1995 when it made the cash flow
statement mandatory also lists the above are primary objective of requiring the listed companies to
provide cash flow statement to the investors.
Preparation of Cash Flow Statement
Cash flow analysis focuses attention on cash instead of working capital. When the movements of cash
(i.e., cash inflow and cash outflow) are depicted in a statement, it is called Cash Flow Statement. Thus, a
cash flow statement summarizes the causes of changes in cash position of a business between two
balance sheet dates. The flow of cash may be inflow or outflow. When cash inflows are more than the
cash outflows, there would be an increase in cash balance. On the other hand, if cash outflows are more
than the cash inflows, there would be decrease in cash balance. The term cash includes both cash and
bank balances.
Availability cash, generally, determines the ability to meet the maturing obligations. If cash is not
available and current obligations cannot be met, it may result in technical insolvency. Therefore, it is
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Pandeshwar, Mangalore. @ 2009

very essential for a business to maintain adequate cash balance. A proper planning of the cash resources
will enable the management to have cash available whenever needed and employs surplus cash, if any,
to the most profitable or productive use. For this purpose, we prepare cash flow statement which shows
the sources and application during a year and the resultant effect on cash balance.
The change in the cash position is computed by considering 'Sources' and 'Applications' of cash which
are as follows:
Sources of cash: Cash from Operations, Issue of Shares, Issue of Debentures, Long term Loans Raised,
Sale of Fixed Assets
Application (uses) of cash: Redemption of Preference Shares, Redemption of Debentures, Repayment of
Loans, Purchase of Fixed Assets, Payment of Dividends, Payment of Taxes.
Ascertaining Cash from Operations
You have learnt that the main purpose of preparing a cash flow statement is to explain the
increase/decrease in the cash balance between the two balance sheet dates and that it is prepared on
the same pattern as the fund flow statement. Just as the net profit is adjusted to ascertain the amount
of funds from operations, the funds from operations are now adjusted to ascertain the cash from
operations. For this purpose, you have to look at the changes in current assets and current liabilities that
have taken place during the year.
Conversion of 'Funds from Operations' to 'Cash from Operations' is necessary because, under the
working capital concept, funds from operations are based on accrual concept of accounting, and total
sales (whether credit or cash) and total purchases (whether credit or cash) are recognized as sources
and uses of working capital respectively. But under a cash concept of funds only cash sales and receipts
from debtors are treated as sources of cash, while cash purchases and payment to creditors are
regarded as uses of cash. The same holds good for the other incomes and expenses. Therefore, funds
from operations (based on the accrual concept) require conversion into cash from operations (based on
cash accounting).
Statement Showing Cash from Operations
Particulars Amount
(Rs.)
Funds from Operations ( As per the Statement Showing Funds from Operations) ****
Add: Decrease in Current Assets other than Cash and Bank Balance ****
Add: Increase in Current Liabilities other than Bank Over Draft ****
****
Less: Increase in Current Assets other than Cash and Bank Balance ****
Less: Decrease in Current Liabilities other than Bank Over Draft ****
CASH FROM OPERATIONS ****

PREPARATION OF CASH FLOW STATEMENT
The cash flow statement is similar to fund flow statement. Apart from cash from operations, the source
and uses of cash are the same as those shown in the fund flow statement. Usually, cash flow statement
starts with the opening cash balance followed by the details of sources and uses of cash. The opening
balance plus the sources of cash minus the uses of cash should be exactly to the closing balance of cash
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Pandeshwar, Mangalore. @ 2009

which is shown as the last item in the cash flow statement. A cash flow statement can be prepared
either in Vertical form or an Account form as shown below:
1. Vertical Form
Cash Flow Statement for the Year Ending ____________________

2. Account Format
Cash Flow Statement for the Year Ending ____________________

Cash flow statement and Funds flow statement can be combined together to prepare it simultaneously
as below:
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Pandeshwar, Mangalore. @ 2009

Statement Showing Funds Flow and Cash Flow/Funds Flow and Cash Flow
Statement/Statement of Changes in Financial Position
Sources Funds
(Rs.)
Cash
(Rs.)
Application Funds
(Rs.)
Cash
(Rs.)
Issue of Shares **** **** Redemption of Shares (What is
actually paid)
**** ****
Issue of
Debentures/Bonds/Public
Deposits
**** **** Repayment of
Debentures/Bonds/Public
Deposits
**** ****
Borrowings **** **** Repayment of Borrowings **** ****
Sale of Fixed Assets (Take
exact amount received)
**** **** Purchase of Fixed Assets **** ****
Sale of Investments **** **** Investments Made **** ****
Dividend/Interest Received **** **** Dividend Paid **** ****
Tax Refunds **** **** Taxes Paid **** ****
Bad Debts Recovered **** **** **** ****
**** **** **** ****
**** **** **** ****
**** **** **** ****
**** **** **** ****
**** **** **** ****
Funds From Operations **** Funds Lost in Operations ****
Cash From Operations **** Cash Loss From Operations ****
Decrease in Net Working
Capital
**** Increase in Net Working Capital ****
Decrease in Cash and Bank
Balance
**** Increase in Cash and Bank
Balance
****
**** **** **** ****

REGULATIONS RELATING TO CASH FLOW STATEMENT
Accounting standards in India are formulated by the Accounting Standards Board (ASB) of the Institute
of Chartered Accountants of India (ICAI). Though International Accounting Standard Committee has
revised the International Accounting Standard-7 (IAS-7) in 1992 and switched over to cash flow
statement, Accounting Standard-3 (AS-3) of ASB, which is equivalent to earlier IAS-7, was not revised till
1997. In 1997, ASB of ICAI revised the AS-3 in line with revised IAS-7 and issued an accounting standard
on reporting cash flow information (see AS-3 full text given in http://www.icai.org.). However, this
standard was not been made mandatory immediately in 1997. However, AS-3 was made mandatory for
the accounting period starting on or after 1 st April 2001 for the following enterprises:
o Enterprises whose equity or debt securities are listed on a recognized stock
exchange in India, and enterprises that are in the process of issuing equity or
debt securities that will be listed on a recognized stock exchange in India as
evidenced by the board of directors' resolution in this regard.
o All other commercial, industrial and business reporting enterprises, whose
turnover for the accounting period exceeds Rs. 50 crore.
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Since ASB of ICAI took a long time for the introduction of cash flow statement, the SEBI had formed a
group consisting of representatives of SEBI, the Stock Exchanges, ICAI to frame the norms for
incorporating Cash Flow Statement in the Annual Reports of listed companies. The group has
recommended cash flow statement to be supplied by listed companies. SEBI, following the
recommendation of the group, has instructed the Governing Board of all the Stock Exchanges to amend
the Clause 32 of the Listing Agreement as follows:
"The company will supply a copy of the complete and full Balance Sheet, Profit and Loss Account and the
Directors Report to each shareholder and upon application to any member of the exchange. The
company will also give a Cash Flow Statement along with Balance Sheet and Profit and Loss Account. The
Cash Flow Statement will be prepared in accordance with the Annexure attached hereto".
Cash Flow Statement, as a requirement in the Listing Agreement, has been made effective for the
accounts prepared by the companies and listed entities from the financial year 1994-95. Cash Flow
Statement, as a requirement of the Listing Agreement, has been made effective for the accounts
prepared by the companies listed in stock exchanges from the financial year 1994-95.
USES OF CASH FLOW STATEMENT
Cash flow statement is very useful to the financial management. It is used as a tool for financial analysis
for short term planning.
The preparation of cash flow statement has several uses. The more important uses are as follows:
1) Changes in cash balance between two points of time and the contributing factors for such
change are clearly revealed.
2) The cash flow statement explains the reasons for:
a. the presence of very low cash balance in spite of huge operating profits: or
b. the presence of a higher cash balance in spite of a very low level of profits
3) Projected cash flow statements help the management in short-term planning and several other
ways like:
a. Determination of additional cash requirements during a given period and making timely
arrangements
b. Identification of the size of surplus and the time for which such surplus funds are likely
to be available
c. Judging the ability of the firm to repay/redeem debentures/preferences shares.
d. Examining the possibility of maintaining/increasing dividends
e. Assessing the capability of finance, replacement of fixed assets
f. Assessing the capacity of the firm to finance expansion.
g. More efficient and effective management of cash flows.
DISTINCTION BETWEEN CASH FLOW ANALYSIS AND FUND FLOW
ANALYSIS
Following are the major points of difference between cash flow analysis and fund flow analysis:
1) Fund flow analysis deals with the change in working capital position between two balance sheet
dates, whereas the cash flow analysis is concerned with the change in cash position.
2) Cash flow analysis is more useful as a tool in short-term financial planning, whereas fund flow
analysis is more useful in long-term financial planning.
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3) An increase in current liability or decrease in current asset (other than cash) results in an
increase in cash whereas such changes result in decrease in the net working capital. Similarly, a
decrease in any current liability or an increase in current asset (other than cash) results in a
decrease in cash, whereas such changes increase the net working capital.
4) Cash flow statement recognizes 'cash basis of accounting' where as funds flow statement is
based on accrual basis of accounting.
5) Cash flow analysis explains only the causes of cash variations; whereas funds flow analysis
discloses the causes of overall working capital variations.
Thus, Cash Flow Statement and cash flow analysis have assumed importance particularly when many
companies have started adopting creative accounting and earnings management. Realizing the needs of
new users as well as others, regulating agencies have made reporting of cash flow statements
mandatory. Cash flow statement is easy to understand and difficult to manipulate. It provides three
important pieces of information on cash flow movements of the firm — how much cash is generated
through operation, financing and how much cash is spent for investment? It gives a clear and real
picture about the internal activities of the firm. There are two methods of preparation of cash flow
statements, namely direct and indirect method. While direct method gives more details on cash flow
from operating activities and also reader-friendly, indirect method is more accounting oriented and fails
to provide any additional information. Unfortunately, many companies use indirect method though the
accounting standards allow both methods. This indirectly shows the eagerness of management to
withhold information unless it is required by the regulation. Fortunately, the final figure is adequate to
get good insight though additional information will always be useful. Cash flow analysis is typically done
by comparing the changes in cash flow from operating activities from period to period with the changes
in profit levels of the firm. Such comparison is useful to understand the quality of reported profit. Also,
the cash flow from operating activities is used to compare whether they are sufficient to meet the
liabilities of lenders and also contribute for further investments.
COMPARATIVE FINANCIAL STATEMENTS
Comparative financial statements are those statements which have been designed in a way so as to
provide time perspective to the consideration of various elements of financial position embodied in such
statements. In these statements figures for two or more periods are placed side by side to facilitate
comparison. Both the Income Statement and Balance Sheet can be prepared in the form of Comparative
Financial Statements.
Comparative Income Statement:
The Income Statement discloses Net Profit or Net Loss on account of operations. A Comparative Income
Statement will show the absolute figures for two or more periods, the absolute change from one period
to another and, if desired, the change in terms of percentages. Since the figures for two or more periods
are shown side by side, the reader can quickly ascertain whether sales have increased or decreased,
whether cost of sales has increased or decreased, etc. Thus, only a reading of data included in
Comparative Income Statements will be helpful in deriving meaningful conclusions.
Comparative Balance Sheet:
Comparative Balance Sheet as on two or more different dates can be used for comparing assets and
liabilities and finding out any increase or decrease in those items. Thus; while in a single Balance Sheet
the emphasis is on present position, it is on change in the comparative Balance Sheet. Such a Balance
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Sheet is very useful in studying the trends in an enterprise. The preparation of comparative financial
statements can be well understood with the help of the following example:

Example (i): From the following Profit and Loss Account and the Balance Sheet of Swadeshi Polytex Ltd.
for the year ended 31st December, 1997 and 1998, you are required to prepare a Comparative Income
Statement and a Comparative Balance Sheet.



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Pandeshwar, Mangalore. @ 2009




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Study Material by SUBRAHMANYA KUMAR N., Senior Lecturer, Srinivas Institute of Management Studies,
Pandeshwar, Mangalore. @ 2009

Comparative Financial Statements can be prepared for more than two periods or more than two dates.
However, it becomes very cumbersome to study the trend with more than two period's data. Trend
percentages are more useful in such cases. The American Institute of Certified Public Accountants has
explained the utility of repairing the Comparative Financial Statements as follows:

The presentation of comparative financial statements is annual and other reports enhances the
usefulness of such reports and brings out more clearly the nature and trend of rent changes affecting
the enterprise. Such presentation emphasizes the fact that statement for a series of periods is far more
significant than those of a single period and that the accounts of one period are but an installment of
what is essentially a continuous history. In anyone year, it is ordinarily desired that the Balance Sheet,
the Income Statement and the Surplus Statement be given for one or more preceding years as well as
for the current year."

The utility of preparing the Comparative Financial Statements has also been realized in our country. The
Companies Act, 1956, provides that companies should give figures for different items for the previous
period, together with current period figures in their Profit and loss Account and Balance Sheet. 2.

COMMON-SIZE FINANCIAL STATEMENTS
Common-size Financial Statements are those in which figures reported are converted into percentages
to some common base. In the Income Statement the sale figure is assumed to be 100 and all figures are
expressed as a percentage of this total.

Example (ii): On the basis of data given in example (i), prepare a Common-size Income statement and
Common Size Balance Sheet of Swadeshi Polytex Ltd., for the years ended 31st March, 1997 and 1998.

Swadeshi Polytex Limited


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Interpretation:
The above statement shows that though in absolute terms, the cost of goods sold has gone up, the
percentage of its cost to sales remains constant at 75%. This is the reason why the Gross Profit
continues at 25% of the sales. Similarly, in absolute terms the amount 01 administration expenses
remains the same but as a percentage to sales it has come down by 5%. Selling expenses have increased
by 0.25%. This all leads to net increase in net profit of 0.25% (i.e. from 18.75% to 19%).

Swadeshi Polytex Limited



Interpretation:
The percentage of current assets to total assets was 38.46 in 1997. It has gone up to 48.69 in 1998.
Similarly the percentage of current liabilities to total liabilities (including capital) has also gone up from
23.07 in 1997 to 27.95 in 1998. Thus, the proportion of current assets has increased by a higher
percentage (about 10) as compared to increase in the proportion of current liabilities (about 5). This has
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improved the working capital position of the Company. There has been a slight deterioration in the
debt-equity ratio though it continues toil very sound. The proportion of shareholder's funds in the total
liabilities has come down from 69.24% to 62.19% while that of the debenture-holders has gone up from
7.69% to 9.86%.

COMPARATIVE UTILITY OF COMMON-SIZE FINANCIAL STATEMENTS:
The comparative common size financial statements show the percentage of each item to the total in
each period but not variations in respective items from period to period. In other words common-size
financial statements when read horizontally do not give information about the trend of individual items
but the trend of their relationship to total. Observation of these trends is not very useful because there
are no definite norms for the proportion of each item to total. For example, if it is established that
inventory should be 30% of total assets, the computation of various ratios to total assets would be very
useful. But since there are no such established standard proportions, calculation of percentages of
different items of assets or liabilities to total assets or total liabilities is not of much use. On account of
this reason common size financial statements are not much useful for financial analysis. However,
common-size financial statements are useful for studying the comparative financial position of two or
more businesses. However, to make such comparison really meaningful, it is necessary that the financial
Instatements of all such companies should be prepared on the same pattern, e.g., all the companies
should be more or less of the same age, they should be following the same accounting practices, the
method of depreciation on fixed assets should be the same.
TREND PERCENTAGES
Trend percentages are immensely helpful in making a comparative study of the financial statements for
several years. The method of calculating trend percentages involves the calculation of percentage
relationship that each item bears to the same item in the base year. Any year may be taken as the base
year. It is usually the earliest year. Any intervening year may also be taken as the base year. Each item of
base year taken as 100 and on that basis the percentages for each of the items of each of the fears is
calculated. These percentages can also be taken as Index

Numbers showing relative changes in the financial data resulting with the passage of time. The method
of trend percentages is a useful analytical device for the management since by substituting percentages
for large amounts; the brevity and readability are achieved. However, trend percentages are not
calculated for all of the items in the financial statements. They are usually calculated only for major
items since the purpose is to highlight important changes.

While calculating trend percentages, care should be taken regarding the following matters:

? The accounting principles and practices followed should be constant throughout the period for
which analysis is made. In the absence of such consistency, the comparability will be adversely
affected.
? The base year should be carefully selected. It should be a normal year and be representative of the
items shown in the statement.
? Trend percentages should be calculated only for items having logical relationship with one another.
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? Trend percentages should be studied after considering the absolute figures on which they are based;
otherwise, they may give misleading results. For example, one expense .may increase from Rs. 100
to Rs. 200 while the other expense may increase from Rs. 10,000 to Rs. 15,000. In the first case
trend percentage will show 100% increase while in the second case it will show 50% increase. This is
misleading because in the first case the change though 100% is not at all significant in real terms as
compared to the other. Similarly, unnecessary doubts may be created when the trend percentages
show 100% increase in debt while only 50% increase in equity. This doubt can be removed if
absolute figures are seen, e.g., the amount of debt may increase from Rs. 20,000 to Rs. 40,000 while
that of equity from Rs. 1,00,000 to Rs. 1,50,000..
? The figures for the current year should also be adjusted in the light of price level changes as
compared to the base year, before calculating the trend percentages.

In case this is not done, the trend percentages may make the whole comparison meaningless. For
example, if prices in the year 1998 have increased by 100% as compared to 1997, the increase in sales in
1998 by 60% as compared to 1997 will give misleading results. Figures of 1998 must be adjusted on
account of rise in prices before calculating the trend percentages.

Example (iii): From the following data relating to the assets side of the Balance Sheet of Kamdhenu Ltd.,
for the period 31st Dec., 1995 to 31st December, 1998, you are required to calculate the trend
percentage taking 1995 as the base year. (Rupees in thousands)


Solution:

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Pandeshwar, Mangalore. @ 2009




NET WORKING CAPITAL ANALYSIS
Financial management can be divided into two broad areas of responsibility as the management of long-
term capital and the management of short-term funds or working capital. The management of working
capital which constitutes a major area of decision-making for financial managers is a continuous
function which involves the control of the every ebb and flow of financial resources circulating in the
enterprise in one form or another. It also refers to the management of current assets and current
liabilities. Efficient management of working capital is an essential pre-requisite for the successful
operation of a business enterprise and improving its rate of return on the capital invested in short-term
assets.
Virtually every business enterprise requires working capital to pay-off its short-term obligations.
Moreover, every firm needs working capital because it's not possible that production, sales, cash
receipts and payments are all instantaneous and synchronised. There elapses certain time for converting
raw materials into finished goods: finished goods into sales and finally realisation of sale proceeds.
Hence, funds are required to support all such activities in the firm. A number of terms like working
funds, circulating capital, temporary funds are used synonymously for working capital. However, the
expression, Working Capital, is preferred by many due to its popularity and simplicity.
DEFINITION OF WORKING CAPITAL
Working capital may be defined in two ways, either as the total of current assets or as the difference
between the total of current assets and total of current liabilities.
Like, most other financial terms the concept of working capital is used in different connotations by
different writers. Thus, there emerged the following two concepts of working capital.
? Gross concept of working capital
? Net concept of working capital
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Pandeshwar, Mangalore. @ 2009

Gross concept:
No special distinction is made between the terms total current assets and working capital by authors like
Mehta, Archer, Bogen, Mead and Baker. According to them working capital is nothing but the total of
current assets for the following reasons:
? Profits are earned with the help of the assets which are partly fixed and partly current. To a
certain degree, similarity can be observed in fixed and current assets in that both are partly
borrowed and yield profit over and above the interest costs. Logic then demands that current
assets should be taken to mean the working capital of the corporation.
? With every increase in funds, the gross working capital will increase while according to the net
concept of working capital there will be no change in the funds available for the operating
manager.
? The management is more concerned with the total current assets as they constitute the total
funds available for operating purposes than with the sources from which the funds came, and
that
? The net concept of working capital had relevance when the form of organisation was single
entrepreneurship or partnership. In other words a close contact was involved between the
ownership, management and control of the enterprise and consequently the ownership of
current and fixed assets is not given so much importance as in the past.
Net concept:
Contrary to the aforesaid point of view, writers like Smith, Guthmann and Dongall. Howard and Gross,
consider working capital as the mere difference between current assets and current liabilities. According
to Keith. V. Smith, a broader view of working capital would also include current liabilities such as
accounts payable, notes payable and other accruals. In his opinion, working capital management
involves the managing of individual current liabilities and the managing of all inter-relationships that link
current assets with current liabilities and other balance sheet accounts. The net concept is advocated for
the following reasons:
? In the long-run what matters is the surplus of current assets over current liabilities.
? It is this concept which helps creditors and investors to judge the financial soundness of the
enterprise.
? What can always be relied upon to meet the contingencies is the excess of current assets over
current liabilities, since it is not to be returned; and
? This definition helps to find out the correct financial position of companies having the same
amount of current assets.
In general, the gross concept is referred to as the Economics concept, since assets are employed to
derive a rate of return. What rate of return is generated by different assets is more important than the
analysed difference between assets and liabilities. On the contrary, the net concept is said to be the
point of view of an accountant. In this sense, working capital is viewed as a liquidation concept.
Therefore, The solvency of the firm is seen from the point of view of this difference Generally, lenders
and creditors view this as the most pertinent approach to the problem of working capital.
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Pandeshwar, Mangalore. @ 2009

CONSTITUENTS OF WORKING CAPITAL
No matter how, we define working capital, we should know what constitutes current assets and current
liabilities. Let us refer to the Balance Sheet of Lupin Laboratories Ltd. for this purpose.
Current Assets: The following are listed by the Company as current assets:
? Inventories:
o Raw materials and packing materials
o Work-in-progress
o Finished/Traded goods
o Stores, Spares and fuel
? Sundry Debtors:
o Debts outstanding for a period exceeding six months
o Other debts
? Cash and Bank balances:
o With Scheduled Banks
? in Current accounts
? in Deposit accounts
o With others
? in Current accounts
? Loans and advances:
o Secured Advances
o Unsecured (considered good)
? Advances recoverable in cash or kind for value to be received
? Deposits
? Balances with customs and excise authorities
Current liabilities: The following items are included under this category.
? Current Liabilities:
o Sundry creditors
o Unclaimed dividend warrants
o Unclaimed debenture interest warrants
? Short term credit:
o Short term loans
o Cash credit from banks
o Other short term payables
? Provisions
o For Taxation
o Proposed Dividend
? on preference shares
? on equity shares
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Pandeshwar, Mangalore. @ 2009

Besides, items like prepaid expenses; certain advance payments are also included in the list of current
assets. Similarly, bills payable, income received in advance for the services to be rendered are treated as
current liabilities. Nevertheless, there is difference of opinion as to what is current. In the strict sense of
the term, it is related to the, operating cycle, of the firm and current assets are treated as those that can
be converted into cash within the operating cycle. The period of the operating cycle may be more or less
compared to the accounting period of the firm. In case of some firms the operating cycle period may be
small and in an accounting period there can be more than one cycle. In order to avoid this confusion, a
more general treatment is given to the, currentness, of assets and liabilities and the accounting period
(generally one-year) is taken as the basis for distinguishing current and non-current assets.
TYPES OF WORKING CAPITAL
Sometimes, working capital is divided into two varieties as:
? Permanent working capital
? Variable working capital
Permanent Working Capital: Though working capital has a limited life and usually not exceeding a year,
in actual practice some part of the investment in that is always permanent. Since firms have relatively
longer life and production does not stop at the end of a particular accounting period some investment is
always locked up in the form of raw materials, work-in-progress, finished stocks, book debts and cash.
The investment in these components of working capital is simply carried forward to the next year. This
minimum level of investment in current assets that is required to continue the business without
interruption is referred to as permanent working capital. While suggesting a methodology for financing
working capital requirements by commercial banks, the Tandon committee has also recognised the need
to maintain a minimum level of investment in current assets. It referred them as, hard core current
assets. The Committee wanted the borrowers to meet this portion of investment out of their own
sources and not to depend on commercial banks.
Variable Working Capital: This is also known as the circulating or transitory working capital. This is the
amount of investment required to take care of the fluctuations in the business activity. While
permanent working capital is meant to take care of the minimum investment in various current assets,
variable working capital is expected to care for the peaks in the business activity. While investment in
permanent portion can be predicted with some probability, investment in variable portion of working
capital cannot be predicted easily as sudden changes in the business activity causes variations in this
portion of working capital.
Working Capital Behaviour
One of the implications of the division of working capital into two types is to understand its behaviour
over a period of time. Investment in working capital is related to sales volume. A variation in sales
volume over time would consequently bring about a change in the investment of working capital. This is
said to vary depending upon the type of working capital. These variations with respect to different types
of firms are presumed to vary as indicated in Fig. 1.1
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Figure 1.1 exemplifies the behaviour of different types of working capital in diverse firms affected by
seasonal and cyclical variations in production or sales. In case of non-growth non-seasonal and non-
cyclical firms, all the working capital can be considered permanent as shown in (A). Similarly, growing
firms require more working capital over a period of time, but fluctuations are not assumed to occur. As
such, in this case also, no variable portion of working capital is present. In the third case (growing
seasonal and non-cyclical firms), there are two types of working capital. On the contrary, in case of
growing, seasonal and cyclical firms, all the working capital is assumed to be of varying type.
CYCLICAL FLOW AND CHARACTERISTICS OF WORKING CAPITAL
For every business enterprise there will be a natural cycle of activity. Due to the interaction of the
various forces affecting the working capital, it transforms and moves from one to the other. The role of
the financial manager then, is to ensure that the flow proceeds through different working capital stages
at an effective rate and at the appropriate time. However, the successive movements in this cycle will be
different from one enterprise to another, based on the nature of the enterprises. For example:
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Pandeshwar, Mangalore. @ 2009


But in real business situations, the cyclical flow of working capital is not simple and smooth going, as one
may be tempted to conclude from these simple flows. This cyclical process is repeated again and again
and so do the values keep on changing as they move through the cash to cash path. In other words the
cash flows arising from cash sales and collections from debtors will either exceed or be lower than cash
outflows represented by the amounts spent on materials, labour and other expenses. An excess cash
outflow over cash inflow is a clear indication of the enterprise having suffered a loss. Thus it is apparent,
that the amount of working capital required and its level at any particular time will be governed directly
by the frequency with which this cash cycle can be sustained and repeated. The faster the cycle the
lesser will be the investment needed in working capital.
Form the aforesaid discussion; one can easily identify three important characteristics of working capital,
namely, short life span, swift transformation and inter-related asset forms and synchronization of
activity levels.
Short-life Span
Components of working capital are short-lived. Typically their life span does not exceed one year. In
practice, however, some assets that violate this criterion are still classified as current assets.
Swift Transformation and Inter-related Asset Forms
In addition to their short span of life, each component of the current assets is swiftly transformed into
the other asset. Thus cash is utilised to replenish inventories. Inventories are diminished when sales
occur that augment accounts receivable and collection of accounts receivable increases cash balances.
Thus a natural corollary of this quick transformation is the frequent and repetitive decisions that affect
the level of working capital and the close interaction that exists among the members of the family of
working capital. The latter entails the assumption that efficient management of one asset cannot be
undertaken without simultaneous consideration of other assets.
Assets Forms and Synchronization of Activity Levels
A third characteristic of working capital components is that their life span depends upon the extent to
which the basic activities like production, distribution and collection are non-instantaneous and
unsynchronized. If these three activities are only instantaneous and synchronized, the management of
working capital would obviously be a trivial problem. If production and sales are synchronized there
would be no need to have inventories. Similarly, when all customers pay cash, management of accounts
receivable would become unnecessary.
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Pandeshwar, Mangalore. @ 2009

PLANNING FOR WORKING CAPITAL
Planning provides a logical starting point for many of the decisions. It is very much true for working
capital decision also. Unless, we plan for procurement and effective use we will not be in a position to
get best out of working capital. In a way, effective planning leads to appropriate allocation of the money
among different components of working capital. Drawing a distinction of the kind of Peter F. Drucker,
between efficiency (doing things right) and effectiveness (during right things). Planning clearly embraces
the latter. It is for this reason planning for working capital is considered highly appropriate and inclusive
of the present discussion on conceptual framework.
While planning should logically begin at the top of the organisational hierarchy, responsibility for
planning exists at all levels within the organisation. While working capital planning is a part of financial
planning the responsibility permits among different managers within the organisation responsible for
managing different components of working capital. At the level of planning for individual components of
working capital persons like materials manager, credit manager and cash manager are involved.
However, the overall responsibility for coordinating the planning of working capital typically rests with
the top management.
Tools of Planning for Working Capital
It should be interesting to know how to identify the relevant tools for completing the planning exercise.
Treating the planning for working capital as part of financial planning. We can note down the following
tools of analysis with respect to time- frame.
? Short term planning - Cash Budgeting
? Medium term planning - Determination of appropriate levels of working capital items
? Long term planning -Projected pay outs and returns to shareholders in terms of CVP and funds
flow analysis.
Cash budget: In the short term cash budgeting is considered a handy device for planning working capital.
The use of cash budget technique as a means of determining the size of the cash flows is considered
superior to the use of proforma balance sheets or judging by the past experience. A cash budget is a
comparison of estimated cash inflows and outflows for a particular period such as a day, a week, a
month, a quarter or year. Typically Cash budget is designed to cover one-year period and the period
covered is sub-divided into intervals. It can be prepared in various ways like the one based on cash
receipts and disbursements method, or the adjusted net income method, or the working capital
differential method.
The budgeting process begins with the beginning balance to which are added expected receipts. This
amount is reached by multiplying expected cash receipts by the probability distribution that the
management budgetary will prevail during the budgetary period. If outlays exceed the beginning
balance plus anticipated receipts the difference must be financed from external sources. If an excess
exist, management must make a decision regarding its disposal either in terms of investing in short-term
securities, repaying the existing debts or returning the funds to the share-holders.
The preparation of the cash budget helps management in many ways. Management will be able to ward
off the disadvantages of excessive liquidity, since there will be information on how and when such cash
results in. Similarly it will be able to contact different sources of finance to tide over a situation of cash
shortage and can avoid rushing to obtain finance at whatever cost. It allows the management to relate
the maturity of the loan to the need and determine the best source of funds, since the information
furnished by the budget reflects the amounts and time for which funds are needed. Further, cash
Budget establishes a sound basis for controlling the cash position.
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Pandeshwar, Mangalore. @ 2009

Of the several methods of preparing the cash budget, Receipts and Payments method is popular among
many undertakings. Moreso the preparation of cash budgets in the organisations was an integral part of
the budgetary process, since the whole of the budgetary structure was divided into revenue budgets,
expenditure budgets and cash budgets. Cash budget was prepared by the organisations by borrowing
figures from various other budgets which they prepared such as the:
? Production budgets.
? Sales budget.
? Cost of production estimates with its necessary subdivisions for example.
o materials purchase estimates:
o labour and personnel estimates:
o plant maintenance estimates: etc.
? Manpower budget.
? Township and welfare estimates
? Profit and loss estimates.
? Capital expenditure budget.
Thus, cash budget is prepared as a means of identifying the past cash flows and determine the future
course of action. Cash budgets, generally are prepared by all enterprises on yearly basis having monthly
break-ups.
Medium term planning: In the medium term determining appropriate level of working capital is
considered a focal point. In unit 3 of this course on 'Determination of working Capital', we have
discussed in detail the following three approaches to determine optimum investment in working capital.
? Industry Norm Approach
? Economic Modelling Approach Theories and Approaches
? Strategic Choice Approach
Therefore, students are advised to refer to that particular unit and hence discussion on them is not
repeated here.
CVP Analysis: As a measure of long term planning, macro- level techniques like C-V-P and funds flow are
considered helpful in making an effective planning. These are helpful not only for working capital
planning but also for the entire financial planning. At the level of working capital planning, we are
required to establish relationships between costs, volume and profits. Though the regular break-even
point is used to determine that level of sales or production which equals total costs, in the area of
working capital, we can be cautious about the costs and revenues akin to working capital items such as
inventory, receivables and cash. Firms often face a dilemma of whether to place an order to keep a
particular level of inventory or not and whether a customer be provided credit or not. These matters can
be effectively dealt with orientation towards the C-V-P relationships.
In this context, a distinction may be made between cash break-even point and profit break-even point,
which represents liquidity and profitability respectively. Cash break-even point, which is defined as that
level of sales per period for which sales revenue just equals the cash outlays associated with the product
or business. This kind of an analysis helps in focusing on the areas of cash deficit and cash surplus
leading to better liquidity management. When we appreciate the fact that working capital is a
liquidation concept, the utility of CVP concept in making better exercise in planning for working capital
needs no special emphasis.
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Pandeshwar, Mangalore. @ 2009

Funds Flow: Funds flow is yet another tool used in the long run to analyse the financial position of a
company. Though the term funds can be understood to include all financial resources, preparation of
funds flow statements on working capital basis are more common in finance. The preparation of such
flow statements gives an idea as to the movement of funds in the organisation. The particulars relating
to the funds generated from operations and changes in net working capital position are highly relevant
in this analysis. A firm's capacity to pay off its current debts depends mainly on its ability to secure funds
from operations. The prime objective of funds flow statement (prepared on the basis of working capital
movements) is to show the ebb and flow of funds through working capital and to shed light on factors
contributing to the movements. As a matter of fact the internal movement of wealth (to a large extent)
usually takes place among working capital items. An analysis of these movements therefore would
provide an understanding of the efficiency of working capital management.
Whereas the schedule of working capital is designed to measure, the flow of funds through working
capital. For that matter, one has to ascertain changes in current assets and current liabilities during the
two balance sheet dates and record variations in working capital. This would help in identifying the net
changes. i.e., increases and decreases in working capital position.

DETERMINATION OF WORKING CAPITAL
In the previous section, we have learnt about the crucial issues affecting the working capital decisions. A
survey of the policy aspects pertaining to monetary and credit policies has been attempted. These
developments are considered to affect the quantum and availability of working capital in the country.
More particularly, the recent changes in the economic liberalization of the country are expected to
produce a tremendous impact on the working of Indian industries.
Indian Industries today have value maximization as the major objective & to achieve it one should be
capable of estimating the requirements precisely. Both excessive and inadequate investment in working
capital items may lead to unnecessary strain on the objective function. Therefore, the finance manager
has to examine all the factors that determine the working capital requirements within the theoretical
and practical points of view. For, the theoretical considerations sometimes dominate the methodology
of assessment; while the firms are constrained to follow the restrictions imposed by the borrowers. The
finance manager, therefore, should consider all the factors that have a bearing on the working capital
including cash, receivables and inventories. Though certain models are developed to determine the
optimum investment in each of the working capital items, an aggregate approach is yet to be
formulated. In the mean time, firms are basing their computations on the concept of operating cycle.
These and other related issues are discussed in detail in this unit.
DETERMINATION OF WORKING CAPITAL NEEDS: DIFFERENT APPROACHES
The question that what is the adequate amount of working capital required to run a business, is
attempted to be answered in several ways. Theoreticians, by their natural inclination to construct
models, have based their analogy on certain foundations and constructed models to estimate the
optimum investment in working capital. Whereas, lenders such as banks, financial institutions have
based their decisions on production schedules and industry practices. In between, a new point of view
was developed calling for the adoption of a strategic approach to the decision-making. Let us now
discuss these theoretical issues to further our understanding of the subject matter.
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Industry Norm Approach
This approach is based on the premise that every company is guided by the industry practice. If a
majority of the units constituting a particular industry adopt a type of practice, other units may also
follow suit. This may finally, turn out to be an industry practice. This practice decides the normal level of
investment in different current asset items. As a matter of fact, optimum level of investment in
receivables is to a great extent influenced by the industry practices. If majority of the firms of a
particular industry have been granting say three months credit to a customer, others will have no other
way except to follow the majority; due to the fear of losing customers. Though there is no basis for such
a type of fear in fixing norms for other items of current assets, units generally prefer to follow majority.
? However, the problems in following this type of an approach are obvious: The classification of
units into a particular industry is not that easy. Firms may not be susceptible for such a neat
classification; when the units are multi-product firms.
? Deciding an average to represent a particular industry is highly difficult. The norms, thus,
developed can be less of a reality and more of a myth.
? Averages have no meaning to many firms, since the nature of firms differ.
? Industry norm approach may result in imitative behaviour resulting in damage to innovation.
? This approach may also promote 'hard mentality', thus limiting the scope for excellence. For
example, if X unit is able to maintain its production schedule with only one month requirement
of raw material, while the industry norm being 2 months, there is no wisdom as to why X should
also keep 2 months.
For the above reasons, industry norm approach is not suggested by many as a benchmark for making
investment in current assets. Nevertheless, this has been a practice followed by many as a tradition,
even the Tandon Committee has developed norms for maintenance of current assets on industry basis.
Economic Modelling Approach
Model building, of late, has become a crucial exercise in many disciplines. Theoreticians are making
efforts to be as much precise as possible. Widespread use of quantitative techniques has helped
theoreticians to develop a framework to test their hypotheses. Models attempt to suggest an optimum
solution to a given problem. As in the case of many disciplines, in the area of finance also model building
has been attempted. As far as working capital is concerned, optimum investment in inventory is sought
to be decided with the help of EOQ model.
This has turned out to be an important concept in the purchase of raw materials and in the storage of
finished goods and in-transit inventories.

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Pandeshwar, Mangalore. @ 2009

William J. Baumol has attempted to apply this inventory model to the determination of optimum cash
balances that can be held by an enterprise. The transactions demand for money is sought to be analysed
from this point of view. As per the model, the optimum level of cash is decided by the carrying cost of
holding cash and the cost of transferring marketable securities to cash and vice-versa.
His equation is as follows:

Similarly, the decision to sell to a particular account should be based objectively upon the application of
profit maximising model. In this regard, Robert M. Soldofsky developed a model for Accounts receivable
management. He has laid down the following formula for making a credit decision, leading to optimum
investment in receivables.

Though models are available to decide optimum investment in case of some important components of
working capital, for many other items, no such modelling is attempted; nor is there an attempt at the
aggregate level. Moreover, these models are subject to certain assumptions and conditions. Their utility
comes under scrutiny for want of these assumptions turning out to be far from reality. For this and
several other reasons, economic modelling is not much popular with Indian companies.
Strategic Choice Approach
Unlike industry norm approach and economic modelling approach, this is not a standard method which
suggests certain benchmarks to work with. The earlier methods suggest the use of certain yardsticks or
guidelines, irrespective of the differences in size of the business units, nature of industry, business
structure or competition. For example, optimum investment in inventory can be had by applying the
equation and it is almost universal for every business unit. Similarly, industry norm approach suggests
the same yardstick for every unit constituting that industry, in spite of variations in the size, nature of
business, terms of sale and purchase, and competition.
In contrast, the strategic choice approach recognises the variations in business practice and advocates
the use of 'strategy' in taking working capital decisions. The spirit behind this approach is to prepare the
unit to face challenges of competition and take a strategic position in the market place. The emphasis is
on the strategic behaviour of the business unit. The firm is independent in choosing its own course of
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action; not necessarily guided by the rules of the industry. This makes it obligatory on the part of the
firm to set its own targets for achievement in the area of working capital. For instance, if the firm has set
an objective like increasing market share from the present level of 20 percent to 40 percent, it can think
of devising a suitable credit policy. Such a policy may involve variations in the terms followed at present
such as extending the credit period, enhancing the credit limit or increasing the percentage of cash
discount, etc.
Thus, the strategic choice approach presupposes a highly competitive environment and the willingness
of the management to take risks. The success of the approach also depends on the ability of the
management to set realistic goals and prepare suitable strategy to achieve them. Any wrong planning
will lead the firm into trouble; much worse than what it was when either of the earlier methods were
being followed.
FACTORS INFLUENCING DETERMINATION
The working capital requirements of a firm depend on a number of factors. It is a common proposition
that the size of working capital is a function of sales. Sales alone will not determine the size of the
working capital, but instead it is constantly affected by the criss-crossing economic currents flowing in a
business. The nature of the firm's activities, the industrial health of the country, the availability of
materials, the ease or tightness of the money market, are all parts of these shifting forces. Of them, the
influence of operating cycle is considered paramount.
Operating Cycle
Since working capital is represented by the sum of current assets, the investment in the same is
determined by the level of each current asset item. To a large extent, the investment in current asset
items is decided by the 'Operating Cycle' (OC) of the enterprise. The concept of operating cycle is very
significant for computation of working capital requirements. The size of investment in each component
of working capital is decided by the length of O.C.
The term operating cycle can be understood to represent the length of time required for the completion
of each of the stages of operation involved in respect of working capital items. This helps portray
different stages of manufacturing activity in its various manifestations, such as peaks and troughs, along
with the required supporting level of investment at each stage in working capital. The sum of these
stage-wise investments is the total amount of working capital required to support the manufacturing
activity at different stages of the cycle. The four important stages of that can be identified as:
? Raw materials and stores inventory stage
? Work-in-progress stage
? Finished goods inventory stage
? Book Debts stage
The following is the formula used to arrive at the OC period in an enterprise.
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Study Material by SUBRAHMANYA KUMAR N., Senior Lecturer, Srinivas Institute of Management Studies,
Pandeshwar, Mangalore. @ 2009


The computations involved are:

The average inventory or book debts level can be arrived at by finding the mean between the relevant
opening and closing balances for the year. The average consumption or output or cost of sales or sales
per day can be obtained by dividing the respective annual figures by 365.
The first comprehensive and coherent exposition of the OC concept seems to be that of Park and
Gladson. They attempted to establish how current assets and liabilities were — the two determinants of
working capital. This search led them to the conclusion that the prevailing one-year temporal standard
applied in classifying assets or liabilities as current' was not universally valid. What was current or
noncurrent depended on the nature of the core business activity. Thus, for a fruit processing business
two to three months would be the correct criterion of currentness. For alumbering or wine-making
business, however, a period of longer than one year would be the standard. Between such extremes,
the currentness of period for each business would be a function of the nature of its basic activity as
dictated by the technological requirements and trading conventions.
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Study Material by SUBRAHMANYA KUMAR N., Senior Lecturer, Srinivas Institute of Management Studies,
Pandeshwar, Mangalore. @ 2009

Instead they used the term 'natural business year' within which an activity cycle is completed. Later, the
accounting principles board of the American Institute of the Certified Public Accountants while defining
working capital used this concept.
Determination of Working Capital Using O.C.
Now, we may attempt to determine the amount of working capital required for a firm using the above
concept.




Illustration:

Solution:
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Study Material by SUBRAHMANYA KUMAR N., Senior Lecturer, Srinivas Institute of Management Studies,
Pandeshwar, Mangalore. @ 2009


Notes:
? Raw material inventory is expressed in raw material consumption.
? Work-in-progress inventory is expressed in cost of production (COP) where, COP is deemed to
include materials, labour and overheads.
? Finished goods inventory is supposed to have been expressed in terms of cost of sales. Since
separate details are not given, the figures are worked out on COP.
? Debtors are expressed in terms of total sales value.
? Creditors are expressed in terms of raw material consumption, since separate figures are not
available for purchases.
Illustration
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Study Material by SUBRAHMANYA KUMAR N., Senior Lecturer, Srinivas Institute of Management Studies,
Pandeshwar, Mangalore. @ 2009


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Study Material by SUBRAHMANYA KUMAR N., Senior Lecturer, Srinivas Institute of Management Studies,
Pandeshwar, Mangalore. @ 2009


Notes: Workings are made as per assumptions given in Illustration excepting that the finished goods
inventory is expressed in terms of cost of sales, which is considered to be inclusive of raw materials,
manufacturing expenses and overheads.
Other Factors
In addition to the influence of operating cycle, there are a variety of factors that influence the
determination of working capital. A brief explanation of the same is provided hereunder:
Nature of Business: A company's working capital requirements are directly related to the type of
business operations. In some industries like public utility services the consumers are generally asked to
make payments in advance and the money thus received is used for meeting the requirements of
current assets. Such industries can carry on their business with comparatively less working capital. On
the contrary, industries like cotton, jute etc. may have to purchase raw materials for the whole of the
year only during the harvesting season, which obviously increases the working capital needs in that
period.
Management's Attitude towards Risk: Management's attitude towards risk also influences the size of
working capital in an undertaking. It is, of course, difficult to give a very precise and determinable
meaning to the management's attitude towards risk, but as suggested by Walker, the following
principles involving risk may serve as the basis of policy formulation:
? If working capital is varied relative to sales the amount of risk that firm assumes also varies and
the opportunity for gain or loss is increased;
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Study Material by SUBRAHMANYA KUMAR N., Senior Lecturer, Srinivas Institute of Management Studies,
Pandeshwar, Mangalore. @ 2009

? Capital should be invested in each component of working capital as long as the equity position
of the firm increases;
? The type of capital used to finance working capital directly affects the amount of risk that a firm
assumes as well as the opportunity for gain or loss and cost of capital; and
? The greater the disparity between the maturities of a firm's short-term debt instruments
and flow of internally generated funds, the greater the risk and vice-versa.
Briefly, these principles imply that the policies governing the size of the working capital are determined
by the amount of risk, which the management is prepared to undertake.
Growth and Expansion of Business: It is logical to expect that larger amounts of working capital are
needed to support the increasing operations of a business concern. But, there is no simple formula to
establish the link between growth in the company's volume of business and the growth of working
capital. The critical fact is that the need for increased working capital funds does not follow the growth
in business activity but precedes it. Citerus paribus, growth industries require more working capital than
those that are static.
Product Policies: Depending upon the kind of items manufactured by adjusting its production schedules
a company may be able to off-set the effects of seasonal fluctuations upon working capital. The choice
rests between varying output in order to adjust inventories to seasonal requirements and maintaining a
steady rate of production and permitting stocks of inventories to build up during off-season period. In
the first instance, inventories are kept to minimum levels; in the second, the uniform manufacturing rate
avoids high fluctuations of production schedules but enlarged inventory stocks create special risks and
costs.
Position of the Business Cycle: Besides the nature of business, manufacturing process and production
policies, cyclical and seasonal changes also influence the size and behaviour of working capital. During
the upswing of the cycle and the busy season of the enterprise, there will be a need for a larger amount
of working capital to cover the lag between increased need and the receipts. The cyclical and seasonal
changes mainly influence the size of the working capital through the inventory stock. As regards the
behaviour of inventory during the business cycles, there is no unanimity of opinion among economists. A
few say that inventory moves in conformity with business activity. While others hold the view that
business activity depends upon the behaviour of the inventory of finished goods which is determined by
the credit mechanism and short-term rate of interest. Whatever be the view points, the fact remains
that the cyclical changes do influence the size of the working capital.
Terms of Purchase and Sale: The magnitude of the working capital of a business is also affected by the
terms of purchase and sale. If, for instance, an undertaking purchases its materials on credit basis and
sells its finished goods on cash basis, it requires less working capital over an undertaking which is
following the other way of purchasing on cash basis, and selling on credit basis. It all depends on the
management's discretion to set credit terms in consideration with the prevailing market conditions and
industry practices.
Miscellaneous: Apart from the above mentioned factors some others like the operating efficiency, profit
levels, management's policies towards dividends, depreciation and other reserves, price level changes,
shifts in demand for products competitive conditions, vagaries in supply of raw materials, import policy
of the government, hazards and contingencies in the nature of business, etc., also determine the
amount of working capital required by an undertaking.
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Study Material by SUBRAHMANYA KUMAR N., Senior Lecturer, Srinivas Institute of Management Studies,
Pandeshwar, Mangalore. @ 2009

TANDON COMMITTEE NORMS
Since mid-sixties, the issue of financing working capital has been engaging the attention of industry and
the policy makers. The measures taken by the Reserve Bank of India included the introduction of Credit
Authorisation Scheme in November 1965, Constitution of the Dahejia Committee in October 1968,
Tandon Committee in July 1974 and the Chore Committee in March 1979. Over the years, attempt has
been made to streamline the flow of credit from the banking sector to the industry. The link between
financing of working capital and the recommendations of various committees is that the latter tried to
make out a case for fixing norms for the maintenance of various current assets; thus leading to the
determination of optimum working capital.
In this regard, Tandon Committee, for the first time, made an attempt to prescribe norms for holding
diverse current asset items. The committee wanted the commercial banks to quantify the desirable level
of net working capital and the maximum permissible lending by the banks. In its approach to the
methods of lending, the Committee sought to identify the 'Reasonable level of current assets' as the
basis of its calculation of different methods. In other words, the total of current assets is based on the
norms suggested by them rather than the actual current assets held by the undertakings. For this
purpose, the Committee suggested norms for carrying raw materials, work-in-progress, finished goods,
and receivables in respect of 15 major industries. The norms for the four kinds of assets are related in
the following manner:

The norms represent the maximum levels of inventories and receivables in each type of industry. It is
further laid down that, if the holding of any kind of asset is higher than the level fixed by the relative
norms, the surplus would be treated 'excess' holding to be shed off, failing which an amount equal to
the value thereof would be treated as excess borrowing and a levy of penal rate of interest is suggested
on such excess borrowing. Again, it is not permitted to set off such excess against any shortfall in the
holding of other current assets, as the norms represent the maximum permissible levels of holdings. The
list of fifteen industries included cotton textiles, synthetic textiles, jute, pharmaceuticals, rubber,
fertilisers, vanaspati, paper and engineering. This system of lending continued with little variations
almost up to the beginning of the present decade. But there is no change in the basic philosophy as to
the assessment of working capital norms, based on the industry norm approach.


SELF-ASSESSMENT QUESTIONS
1. What are the different types of financial ratios?
2. Discuss the importance of liquidity ratios?
3. Define and evaluate various leverage ratios?
4. Discuss the important turnover ratios.
5. Explain the important profit margin ratios?
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Study Material by SUBRAHMANYA KUMAR N., Senior Lecturer, Srinivas Institute of Management Studies,
Pandeshwar, Mangalore. @ 2009

6. Compare the following: rate of return ratios, return on total assets ratios, and returns on
equity?
7. Discuss key valuation ratios?
8. If the market price per share is equal to the book value per share, the following are equal, return
on equity, price earnings ratio, and total yield. Prove.
9. Write short notes on 'Debt Service Coverage Ratio'.
10. Explain proprietary ratio.
11. 'Ratios are indicators - sometimes pointers but not in themselves powerful tools of
management'. Explain.
12. Ratio analysis is only a technique for making judgments and not a substitute for judgments.
Examine.
13. Write short notes on (i) Return on investments (ii) Pay-out Ratio.
14. Explain the limitations of ratio analysis for evaluating investment proposals and liquidity
analysis.
15. Ratios are symptoms like blood pressures, the, pulse or the temperature of an individual'.
Explain, also name and explain in brief the ratios made use to judge the long-term solvency of a
concern.
16. Write short notes on 'Earnings per share'.
17. Distinguish between Operating Ratios and Turnover Ratio.
18. Ratio analysis is an important tool for judgment of the health of any organization. Elaborate.
19. Write notes on uses and limitations of 'Ratio Analysis'.
20. How cash flow statement is different from income statement? What are the additional benefits
to different users of accounting information from cash flow statement?
21. List down any four important accounting transactions that increase the profit but has no impact
on cash flow statement.
22. How does cash flow statement differ from funds flow statement? What are the uses of cash flow
statement?
23. How does cash flow analysis help the management in decision making?
24. What is a 'Cash Flow Statement'? Explain the techniques of preparing a cash flow statement.

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