Engineering Economy

Dr. Bappa Acherjee

Department of Production Engineering
BIT Mesra
PE6009 ENGINEERING ECONOMY (3 Credits) Breadth Paper

Module 1

Accounting of Business Transactions

• Accounting Principles,
• Journal and Ledger Entries,
• Balance Sheet,
• Profit and Loss Statement,
• Ratio Analysis

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

Engineering economy

• Engineers play a vital role in capital investment decisions based upon their ability
and experience to design, analyze, and synthesize. The factors upon which a
decision is based are commonly a combination of economic and noneconomic
elements. Engineering economy deals with the economic factors. By definition:
• Engineering economy involves formulating, estimating, and evaluating the expected
economic outcomes of alternatives designed to accomplish a defined purpose.
Mathematical techniques simplify the economic evaluation of alternatives.
• Engineering economy are engineering economic analysis, capital allocation study,
economic analysis, and similar descriptors.

The estimates and the decision usually involve four essential elements:
• Cash flows
• Times of occurrence of cash flows
• Interest rates for time value of money
• Measure of economic worth for selecting an alternative

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

• Economy: Activity related to the production and distribution of goods and services in a
particular geographic region with proper and effective utilization of available resources for the
benefit of national growth.
• Economics: The theories, principles and models that deal with how the market process works.
It attempts to explain how wealth is created and distributed in communities, how people
allocate resources and have many alternative uses, and other such matters that arise in dealing
with human wants and their satisfactions.
• Economist: An individual who studies and interprets the data concerning the factors that
influence supply and demand, such as inflation and unemployment.
• Business: An organization or economic system where goods and services are exchanged for one
another or for money. Every business requires some form of investment and enough customers
to whom its output can be sold on a consistent basis in order to make a profit. Businesses can
be privately owned, not-for-profit or state-owned. An example of a corporate business is
Reliance Industries, while a Suruchi Catering business is a private enterprise.

Who are stakeholders? – anyone or any entity that has an interest in the economic performance
and well-being of a business
• Bankers and other creditors – need to ensure that the business has the ability to repay loans,
and on a timely basis
• Suppliers – need to ensure their customer (the business) will be around to purchase their
supplies and then be able to pay for them
• Customers – are interested in the business to determine if they will always be around to
provide a constant flow of goods and services
• Government – need to ensure that the business pays the correct amount of taxes
• Employees and Management– need to ensure that the business is doing well so that they will
have a job
Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra
Accounting
• Accounting is the language of business. The main objectives of Accounting is to safeguard the
interests of the business, its proprietors and others connected with the business transactions. This
is done by providing suitable information to the owners, creditors, shareholders, Government,
financial institutions and other related agencies.
Definition of Accounting
• The American Accounting Association defines accounting as "the process of identifying, measuring
and communicating economic information to permit informed judgements and decisions by the
users of the information."
Steps of Accounting
(1) Recording: Recording all the transactions in subsidiary books for purpose of future record or reference. It is
referred to as "Journal."
(2) Classifying: All recorded transactions in subsidiary books are classified and posted to the main book of
accounts. It is known as "Ledger."
(3) Summarizing: All recorded transactions in main books will be summarized for the preparation of Trail
Balance, Profit and Loss Account and Balance Sheet.
(4) Interpreting: Interpreting refers to the explanation of the meaning and significance of the result of financial
accounts and balance sheet so that parties concerned with business can determine the future earnings, ability to
pay interest, liquidity and profitability of a sound dividend policy.
Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra
Managers, investors, and other internal groups
want the answers to two important questions:

How well did

the organization Where does
perform? the organization
stand?

Financial Accounting

Managerial Accounting

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

Branches of Accounting
• The main function of accounting is to provide the required information for different parties who
are interested in the welfare of that enterprise concerned. In order to serve the needs of
management and outsiders various branches of accounting have been developed. The following are
the main branches of accounting:
(1) Financial Accounting.
(2) Cost Accounting.
(3) Management Accounting.
• (1) Financial Accounting: Financial Accounting is prepared to determine profitability and financial position of
a concern for a specific period of time.
• (2) Cost Accounting: Cost Accounting is the formal accounting system setup for recording costs. It is a
systematic procedure for determining the unit cost of output produced or service rendered.
• (3) Management Accounting: Management Accounting is concerned with presentation of accounting
information to the management for effective decision making and control.
Objectives of Accounting
• (1) Providing suitable information with an aim of safeguarding the interest of the business and its proprietors and
others connected with it.
• (2) To emphasis on the ascertainment and exhibition of profits earned or losses incurred in the business.
• (3) To ascertain the financial position of the business as a whole.
• (4) To ensure accounts are prepared according to some accepted accounting concepts and conventions.
• (5) To comply with the requirements of the Companies Act, Income Tax Act, etc.
Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra
Comparing Managerial and Financial Accounting

Differences

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

Generally Accepted Accounting Principles (GAAP) and Accounting Standards

• In order to maintain uniformity and consistency in accounting records throughout

the world, certain rules and principles have been developed which are generally
accepted by the accounting profession. These rules/ principles are called by different
names such as principles, concepts, conventions, postulates, assumptions. These
rules/principles are judged on their general acceptability rather than universal
acceptability. Hence, they are popularly called Generally Accepted Accounting
Principles (GAAP). The term “generally accepted” means that these principles must
have support, that generally comes from the professional accounting bodies. Thus,
Generally Accepted Accounting Principles (GAAP) refer to the rules or guidelines
adopted for recording and reporting of business transactions of financial statements.
• Accounting Standards: The term standard denotes a discipline, which provides both
guidelines and yardsticks for evaluation. As guidelines, accounting standard provides
uniform practices and common techniques of accounting. As a general rule,
accounting standards are applicable to all corporate enterprises. They are made
operative from a date specified in the standard. The Institute of Chartered Accountant
of India (ICAI) constituted the Accounting Standards Board (ASB) in April, 1977 for
developing accounting standards. However, the International Accounting Standards
Committee (IASC) was set up in 1973, with its headquarter in London (U.K.).

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

Accounting Principles

• In order to maintain uniformity and consistency in preparing and maintaining books of

accounts, certain rules or principles have been evolved. These rules/principles are
classified as concepts and conventions. These are foundations of preparing and
maintaining accounting records.

Accounting Concepts
Accounting concept refers to the basic assumptions and rules and principles which work as
the basis of recording of business transactions and preparing accounts. Those are
• Business Entity Concepts,
• Money Measurement Concepts,
• Going Concern Concepts,
• Accounting Period Concepts,
• Cost Concepts,
• Duality Aspect concepts,
• Realisation Concepts,
• Accrual Concepts, and
• Matching Concepts.

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

Business Entity Concepts
• This concept assumes that, for accounting purposes, the business enterprise and its
owners are two separate independent entities. Thus, the business and personal
transactions of its owner are separate. the accounting records are made in the books
of accounts from the point of view of the business unit and not the person owning the
business. This concept is the very basis of accounting.

Money Measurement Concepts

• This concept assumes that all business transactions must be in terms of money, that
is in the currency of a country. In our country such transactions are in terms of
rupees.

Going Concern Concepts

• This concept states that a business firm will continue to carry on its activities for an
indefinite period of time. Simply stated, it means that every business entity has
continuity of life. Thus, it will not be dissolved in the near future. This is an important
assumption of accounting, as it provides a basis for showing the value of assets in the
balance sheet.

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

Accounting Period Concepts
• All the transactions are recorded in the books of accounts on the assumption that
profits on these transactions are to be ascertained for a specified period. This is
known as accounting period concept. Thus, this concept requires that a balance sheet
and profit and loss account should be prepared at regular intervals.

Cost Concepts
• Accounting cost concept states that all assets are recorded in the books of accounts at
their purchase price, which includes cost of acquisition, transportation and
installation and not at its market price. It means that fixed assets like building, plant
and machinery, furniture, etc. are recorded in the books of accounts at a price paid
for them.

Duality Aspect concepts

• Dual aspect is the foundation or basic principle of accounting. This concept assumes
that every transaction has a dual effect, i.e. it affects two accounts in their respective
opposite sides. Therefore, the transaction should be recorded at two places. It means,
both the aspects of the transaction must be recorded in the books of accounts. For
example, goods purchased for cash has two aspects which are (i) Giving of cash (ii)
Receiving of goods. These two aspects are to be recorded.
Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra
Realisation Concepts
• This concept states that revenue from any business transaction should be included in the
accounting records only when it is realised. The term realisation means creation of legal right
to receive money. Selling goods is realisation, receiving order is not. Revenue is said to have
been realised when cash has been received or right to receive cash on the sale of goods or
services or both has been created.

Accrual Concepts
• The meaning of accrual is something that becomes due especially an amount of money that is
yet to be paid or received at the end of the accounting period. Though cash is received or not
received and the expenses are recognised when they become payable though cash is paid or
not paid. Both transactions will be recorded in the accounting period to which they relate. The
accrual concept under accounting assumes that revenue is realised at the time of sale of
goods or services irrespective of the fact when the cash is received.

Matching Concepts
• The matching concept states that the revenue and the expenses incurred to earn the revenues
must belong to the same accounting period. The matching concept implies that all revenues
earned during an accounting year, whether received/not received during that year and all cost
incurred, whether paid/not paid during the year should be taken into account while
ascertaining profit or loss for that year.
Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra
Accounting conventions
In accounting, there are many conventions or practices which are used while recording the
transactions in the books of accounts. Apart from these, the Institute of Chartered
Accountants of India (ICAI), which is the main regulatory body for standardisation of
accounting policies in the country has issued a number of accounting standards from time
to time to bring consistency in the accounting practices.

Convention of consistency
• The convention of consistency means that same accounting principles should be used for
preparing financial statements year after year. A meaningful conclusion can be drawn
from financial statements of the same enterprise when there is comparison between them
over a period of time.
• While charging depreciation on fixed assets or valuing unsold stock, once a particular
method is used it should be followed year after year so that the financial statements can
be analysed and compared provided the depreciation on fixed assets is charged or unsold
stock is valued by using particular method year after year. This can be further clarified as
: in case of charging depreciation on fixed assets accountant can decide to adopt any one
of the methods of depreciation such as diminishing value method or straight line method.

Convention of full disclosure

• Convention of full disclosure requires that all material and relevant facts concerning
financial statements should be fully disclosed. Full disclosure means that there should be
full, fair and adequate disclosure of accounting information. Adequate means sufficient set
of information to be disclosed. Fair indicates an equitable treatment of users. Full refers to
complete and detailed presentation of information.

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

Convention of materiality
• The convention of materiality states that, to make financial statements meaningful,
only material fact i.e. important and relevant information should be supplied to the
users of accounting information. The question that arises here is what is a material
fact. The materiality of a fact depends on its nature and the amount involved. Material
fact means the information of which will influence the decision of its user.
• According to this convention important and significant items should be recorded in
their respective heads and all immaterial or insignificant transactions should be
clubbed under a different accounting head

Convention of conservatism
• This convention is based on the principle that “Anticipate no profit, but provide for all
possible losses”. It provides guidance for recording transactions in the books of
accounts. It is based on the policy of playing safe in regard to showing profit.
• Thus, this convention clearly states that profit should not be recorded until it is
realised. But if the business anticipates any loss in the near future, provision should
be made in the books of accounts for the same. If profit shows more than actual, it
may lead to distribution of dividend out of capital. This is not a fair policy and it will
lead to the reduction in the capital of the enterprise.

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

 The Accounting Equation

The Basic Accounting Equation

• Both liabilities and owners' equity represent claims on the assets of a business.
• Liabilities are claims by people external to the business.
• Owners' equity is a claim by the owners.

Transaction analysis is the central component of the financial accounting process.

• Remember that every transaction must keep the accounting equation in balance.

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

The Basic Accounting Equation
• Financial accounting is based upon the accounting equation.
Assets = Liabilities + Owners' Equity
• This is a mathematical equation which must balance.
• If assets total $300 and liabilities total $200, then owners' equity must be $100.
Assets
• Assets are valuable resources that are owned by a firm.
• They represent probable future economic benefits and arise as the result of past
transactions or events.
Liabilities
• Liabilities are present obligations of the firm.
• They are probable future sacrifices of economic benefits which arise as the result of past
transactions or events.
Owners' Equity
• Owners' equity represents the owners' residual interest in the assets of the business.
• Residual interest is another name for owners' equity.
• Owners may make a direct investment in the business or operate at a profit and leave the
profit in the business.
• Yet another name for owners' equity is net assets.
• Indicates that owners' equity results when liabilities are subtracted from assets.
Owners’ Equity = Assets – Liabilities

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

 Owner’s Equity

Increased by Decreased by

Owner’s Owner’s
investments withdrawals
Revenues Expenses

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

Asset Accounts

Cash
Accounts
Land
Receivable

Buildings
Asset Notes
Receivable
Accounts
Prepaid
Equipment
Accounts
Supplies

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

Liability Accounts

Accounts Notes
Payable Payable

Liability
Accounts
Accrued Unearned
Liabilities Revenue

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

Equity Accounts

Owner’s Owner’s
Capital Withdrawals

Equity
Accounts

Revenues Expenses

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

Historical Cost
• Historical cost is used for the recording of an asset.
• It is the exchange price on the date of the acquisition of the asset.

Revenues and Expenses

• Revenues increase owners' equity.
• Expenses decrease owners' equity.
A company earns revenues by
➢ selling products - Sales
➢ providing services - Fees Earned
➢ renting out premises - Rent Revenue
➢ lending money - Interest Revenue
• Expenses that have paid for (or incurred) but not yet been used up are referred to as prepaid
expenses e.g. supplies.

Purchases Return or Returns Outward

• When goods are returned to the suppliers due to defective quality or not as per the terms of
purchase, it is called as purchases return. To find net purchases, purchases return is deducted
from the total purchases.
Sales Return or Returns Inward
• When goods are returned from the customers due to defective quality or not as per the terms of
sale, it is called sales return or returns inward. To find out net sales, sales return is deducted from
total sales.
Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra
Unearned Revenue
If a company has unearned revenue, then it may have earned revenue as time has elapsed
because it has provided the service to the customer.

Expenses
• Expenses occur when resources are consumed in order to generate revenue.
• They are the cost of doing business.
• Examples include rent, salaries and wages, insurance, electricity, utilities, and the like.
• The word "payable" is usually used in a liability title.

Examples of Payables
• Notes payable — written obligations.
• Accounts payable—unwritten obligations that arise in the normal operations of a business.
• Wages payable.

Rent
• If rent is prepaid, then as time elapses, the asset is used up, or consumed, and an expense is
incurred.

Income
• Income is the difference between revenue and expense.

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

Example 1: Transaction Analysis
Introduction of Capital

Purchase of Assets

Sale of Inventory (with a profit of 3000)

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

Drawings (500)

Expenses on Business (300)

Purchases on credit (3000)

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

Sale on credit (5000)

Settlement of Trade Receivable and Trade Payable

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra
Transaction Analysis (Overview of transactions on Balance Sheet)

Balance Sheet
January 31, 2000
Assets Liabilities and Owners’ Equity
Cash $ 32,500 Liabilities
Accounts receivable 4,400 Accounts payable $ 30,000
Prepaid rent 11,000 Unearned revenue 50
Inventory 27,800 Utilities payable 120
Equipment 27,792 Interest payable 133
Total assets $100,492 Notes payable 20,000
Total liabilities 50,303
H.Jacobs, capital 50,189
Total liabilities and
owners’ equity $100,492
Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra
Example 2: Transaction Analysis

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra
Example 3: Transaction Analysis

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra
Accounting cycle

(a) Recording of Transaction: As soon as a transaction

happens it is at first recorded in subsidiary book.
(b) Journal: The transactions are recorded in Journal
chronologically.
(c) Ledger: All journals are posted into ledger
chronologically and in a classified manner.
(d) Trial Balance: After taking all the ledger account closing
balances, a Trial Balance is prepared at the end of the
period for the preparations of financial statements.
(e) Adjustment Entries: All the adjustments entries are to
be recorded properly and adjusted accordingly before
preparing financial statements.
(f) Adjusted Trial Balance: An adjusted Trail Balance may
also be prepared.
(g) Closing Entries: All the nominal accounts are to be
closed by the transferring to Trading Account and Profit
and Loss Account.
(h) Financial Statements: Financial statement can now be
easily prepared which will exhibit the true financial
position and operating results.
Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra
Source Documents

Bills from
Checks Suppliers Purchase
Orders
Employee
Earnings
Records
Bank Statements

Sales Tickets

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

Steps Followed in an Accounting Process:

1. Collecting and Analyzing Accounting Documents: It is a very important step in which you
examine the source documents and analyze them. For example, cash, bank, sales, and
purchase related documents. This is a continuous process throughout the accounting period.
2. Posting in Journal: On the basis of the above documents, you pass journal entries using
double entry system in which debit and credit balance remains equal. This process is repeated
throughout the accounting period.
3. Posting in Ledger Accounts: Debit and credit balance of all the above accounts affected
through journal entries are posted in ledger accounts. A ledger is simply a collection of all
accounts. Usually, this is also a continuous process for the whole accounting period.
4. Preparation of Trial Balance: As the name suggests, trial balance is a summary of all the
balances of ledger accounts irrespective of whether they carry debit balance or credit balance.
Since we follow double entry system of accounts, the total of all the debit and credit balance as
appeared in trial balance remains equal. Usually, you need to prepare trial balance at the end
of the said accounting period.
5. Posting of Adjustment Entries : In this step, the adjustment entries are first passed through
the journal, followed by posting in ledger accounts, and finally in the trial balance. Since in
most of the cases, we used accrual basis of accounting to find out the correct value of revenue,
expenses, assets and liabilities accounts, we need to do these adjustment entries. This process
is performed at the end of each accounting period.

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

6. Adjusted Trial Balance: Taking into account the above adjustment entries, we create
adjusted trial balance. Adjusted trial balance is a platform to prepare the financial statements
of a company.
7. Preparation of Financial Statements: Financial statements are the set of statements like
Income and Expenditure Account or Trading and Profit & Loss Account, Cash Flow Statement,
Fund Flow Statement, Balance Sheet or Statement of Affairs Account. With the help of trial
balance, we put all the information into financial statements. Financial statements clearly
show the financial health of a firm by depicting its profits or losses.
8. Post-Closing Entries: All the different accounts of revenue and expenditure of the firm are
transferred to the Trading and Profit & Loss account. With the result of these entries, the
balance of all the accounts of income and expenditure accounts come to NIL. The net balance
of these entries represents the profit or loss of the company, which is finally transferred to the
owner’s equity or capital account. We pass these entries only at the end of accounting period.
9. Post-Closing Trial Balance: Post-closing Trial Balance represents the balances of Asset,
Liabilities & Capital account. These balances are transferred to next financial year as an
opening balance.

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

Classification of Accounts
• Every business deal with other “Person”, possesses “Assets”, pay “Expenses” and
receive “Income”.
• So from the above, we can see every business has to keep
❖An account for each person
❖An account for each asset and
❖An account for each expense or income.
✓ Accounts in the names of persons are known as “Personal Accounts”
✓ Accounts in the names of assets are known as “Real Accounts”
✓ Accounts in respect of expenses and incomes are known as “Nominal Accounts”

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

Personal Accounts
• Accounts in the name of persons or representatives are known as personal accounts.
Eg:- Babu A/C, Babu & Co. A/C, M/s General Trading, etc.

Real Accounts
• These are accounts of assets or properties. Assets may be tangible or intangible. Real
accounts are impersonal which are tangible or intangible in nature.
Eg:- Cash a/c, Building a/c, etc are Real Accounts related to things which we can
feel, see and touch.
Goodwill a/c, Patent a/c, etc are Real Accounts which are of intangible in
nature.

Nominal Accounts
• These accounts are impersonal, but invisible and intangible. Nominal accounts are
related to those things which we can feel, but can not see and touch. All “expenses
and losses” and all “incomes and gains” fall in this category.
Eg:- Salaries A/C, Rent A/C, Wages A/C, Interest Received A/C,
Commission Received A/C, Discount A/C, etc.

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

Debit and Credit
• Each accounts have two sides – the left side and the right side.
• In accounting, the left side of an account is called the “Debit Side” and the right side
of an account is called the “Credit Side”.
• The entries made on the left side of an account is called a “Debit Entry” and the
entries made on the right side of an account is called a “Credit Entry”.

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

Steps for finding the debit and credit aspects of a particular transaction:
• Find out the two accounts involved in the transaction.

• Check whether it belongs to Personal, Real or Nominal account.

• Apply the debit and credit rules for the two accounts.

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

Journal
• Journal is the prime or original book of entry in which all transactions are recorded in
the form of entries. Journalising is an act of recording or entering transactions in a
Journal in the order of date.

Example 1: Journal Entry

• Jan 1, 1981 Prakash Started a business Rs. 15,000/-

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

Example 2: Journal Entry (for illustration)

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra
Example 3: Journal Entry

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra
Ledger
• The book which contains accounts is known as the ledger. Since finding information
pertaining to the financial position of a business emerges only from the accounts, the
ledger is also called the Principal Book. As a result, all the necessary information
relating to any account is available from the ledger.
• As and when the transaction takes place, it is recorded in the journal in the form of
journal entry. This entry is posted again in the respective ledger accounts under
double entry principle from the journal. This is called ledger posting.

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

Example 1: Ledger posting

1) The posting in the account which is debited, is done on the debit side by writing the name of the account
or accounts that are credited with the prefix ‘To’.
2) The posting in the account which is credited, is done on the credit side by writing the name of the
account or accounts that are debited with the prefix “By’.

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

 This is Journal Entry for
the Example 3 (of
Journal), which is
already discussed. Let us
now see how we can
create ledger account for
the seven journal entries
that we passed for
Example 3 (of Journal).

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

 Example 2: Ledger posting

N.B.: Do you see some further

calculation in the cash A/c and Mr.
Vikas’s Capital A/c? What is done is
that after posting all transactions to
these accounts, the difference between
the debit and credit sides is calculated.
This difference is put on the side with
smaller amount in order to tally grand
totals of both sides. The convention is
to write “To Balance c/d” or “By
balance c/d” as the case may be. This
procedure is normally done at the end
of an accounting period. This process
is called as “balancing of ledger
accounts’.
Once the ledgers are balanced for one
accounting period, the balance needs
to be carried forward to the next
accounting period as a running
balance. This is done by writing “To
Balance b/d” or “By balance b/d” as
the case may be after the grand totals.
Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra
 N.B.: Please remember the
balances of personal and real
accounts only are carried down
to the next accounting period
as they represent resources and
obligations of the business
which will continue to be used
and settled respectively in
future. Balances of nominal
accounts (which represent
incomes or gains and expenses
or losses) are not carried down
to the next period. These
balances are taken to the Profit
and Loss account (or Income
statement) prepared for the
period. The net result of the P &
L Account will show either net
income or net loss which will
increase or decrease the
owner’s equity.

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

Trial balance
• Trial balance may be defined as a statement or a list of all ledger account balances taken
from various Ledger books on a particular date to check the arithmetical accuracy.
• According to Rolland, Trial Balance is defined as “The final list of balances, totaled and
combined, is called Trial Balance”.
• Trial Balance does not form part of books of account, but it is a report prepared by
extracting balances of accounts maintained in the books of accounts.

Debit Balance — All Assets,

Drawings, Debtors, Expenses and
losses.

Credit Balance — All liabilities,

Capital, Creditors, Gains and
Incomes.

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

Preparation of Trial Balance:
• It may be prepared on a loose sheet of paper.
• The ledger accounts are balanced at first. They will have either “debit-balance” or “credit balance” or “nil-
balance”.
• The accounts having debit-balance is written on the debit column and those having credit-balance are written
on the credit column.
• The sum total of both the balances must be equal, for “Every debit has its corresponding and equal credit”.
Purpose of a Trial Balance
• It serves the following purposes :
• To check the arithmetical accuracy of the recorded transactions.
• To ascertain the balance of any ledger Account.
• To serve as an evidence of fact that the double entry has been completed in respect of every transaction.
• To facilitate the preparation of final accounts promptly.
Trial Balance – Utility and Interpretation
(1) It forms the basis for preparation of Financial statements i.e. Profit and Loss Account and Balance sheet.
(2) A tallied trial balance ensures the arithmetical accuracy of the entries made. If the trial balance does not
tally, the errors can be found out, rectified and then financial statements can be prepared.
(3) It acts as a quick reference. One can easily find out the balance in any ledger account without actually
referring to the ledger.

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

Errors in Trial Balance
There are certain type of errors that will not affect tallying of the T.B. i.e. it will tally but still there will be errors.
These are as follows:
(a) Error of omission: if any entry is totally missed, the T.B. will tally but will be incorrect and incomplete.
(b) Compensating error: if there are two errors that are compensating each other, still the T.B. will tally but not
accurate.
(c) Wrong Account head: if entry for insurance paid is wrongly debited to Commission A/c, tallying of T.B. will not
be affected.
(d) Error of duplication: if a transaction is recorded twice, again the T.B. will match.
(e) Error of principle: if interest received is wrongly entered as debit to interest and credit to cash, there won’t be
any mismatch in the T.B.
Errors which are not disclosed by a Trial Balance
(a) Errors of Omission : When the transaction is not at all recorded in the books of accounts, i.e. neither in the
debit sider nor in the credit side of the account – trial balance will agree.
(b) Errors of Commission : Where there is any variation in figure/amount, e.g. instead of Rs. 800 either Rs. 80 or
Rs. 8,000 is recorded, in both sides of ledger accounts – trial balance will agree.
(c) Errors of Principal : When accounts are prepared not according to double entry principle e.g. Purchase of a
Plant wrongly debited to Purchase Account – Trial balance will agree.
(d) Errors of Misposting : When wrong posting is made to a wrong account instead of a correct one although
amount is correctly recorded, e.g., sold goods to B but wrongly debited to D’s Account – trial balance will agree.
(e) Compensating Errors : When one error is compensated by another error e.g. Discount Allowed Rs. 100 not
debited to Discount Allowed Account, whereas interest received Rs. 100, but not credit to Interest Account – trial
balance will agree. Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra
Example 1: Trial Balance

Hints:
• Capital - Credit - Liability, Sales – Credit - Income/Decrease in stock, Purchase – Debit- Expense/Increase in stock,
Current a/c - Credit – Liability (Capital), Petty Cash – Debit – Assets, Bad Debts - Debit – Losses, Salaries - Debit -
Expenses, Carriage Inwards – Debit – Expenses, Discount Allowed - Debit – Losses, Building – Debit – Assets,
Outstanding Expenses - Credit – Liability, Insurance – Debit – Expenses, Depreciation - Debit - Losses, Cash at Bank
- Debit - Assets, Loan Secured - Credit - Liability, Profit and Loss A/c (Cr.) - Credit - Gains, Bad Debts Recovered – Credit -
Gains, Interest received – Credit - Income, Accrued Incomes – Debit - Assets, Investments – Debit - Assets, Reserve
/Provision for Bad & Doubtful Debt (Opening) - Credit – Gains,
[Accrued income is earned in a fund or by a company for providing a service or selling a product that has yet to be received.
The provision for bad debts might refer to the balance sheet account also known as the Allowance for Bad Debts, Allowance
for Doubtful Accounts, or Allowance for Uncollectible Accounts. In this case Provision for Bad Debts is a contra asset account
(an asset account with a credit balance)]

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra
Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra
Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra
Exercise 1: Trial Balance

Exercise 2: Trial Balance

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

Preparation of Final Accounts

• The basic objective of every concern maintaining the book of accounts is to find out the
profit or loss in their business and the position of the business at the end of the year.
The determination of profit or loss is done by preparing a Trading, Profit and Loss
accounts. The purpose of preparing the Balance Sheet is to know the financial
soundness of a concern as a whole during the particular period.
• Steps in the Process of Finalization of Accounts
1. Trading Account.
2. Profit and Loss Account.
3. Balance Sheet.

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

• Profitability Statement – This statement is related to a complete accounting period. It shows the
outcome of business activities during that period in a summarized form. The activities of any
business will include purchase, manufacture, and sell.
• Balance Sheet – Business needs some resources which have longer life (say more than a year).
Such resources are, therefore, not related to any particular accounting period, but are to be used
over the useful life thereof. The resources do not come free. One requires finance to acquire them.
This funding is provided by owners through their investment, bank & other through loans,
suppliers by way of credit terms. The Balance Sheet shows the list of resources and the funding of
the resources i.e. assets and liabilities (towards owners and outsiders). It is also referred as sources
of funds (i.e. liabilities & capital) and application of funds (i.e. assets).
• Trading Account: It is an account which is prepared by a merchandising concern which
purchases goods and sells the same during a particular period. The purpose of it to find out the
gross profit or gross loss which is an important indicator of business efficiency.

Depending on the nature of business, the income statement is prepared in different forms like:
(a) In case of manufacturing concern, a manufacturing, trading and P & L A/c is prepared
(b) In case of a trading or service organization, a trading and P & L A/c is prepared
The manufacturing and trading accounts show Gross margins (or gross losses) and the P & L A/c shows
Net Profit or net loss.
Trading Account is prepared to find out the gross profit (or loss) while manufacturing account shows the cost of
the goods produced. A trading account is prepared to find out the results (profit or loss) of trading activities. A
manufacturing account is prepared to find out cost of production.
The Balance Sheet exhibits the list of assets (which indicate resources owned) and the liabilities & owners’
capital and equity (which shows how the resources are funded).
Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra
Trading Account
The following items will appear in the debit side of the Trading Account:
(i) Opening Stock: In case of trading concern, the opening stock means the finished goods only. The amount of
opening stock should be taken from Trial Balance.
(ii) Purchases: The amount of purchases made during the year. Purchases include cash as well as credit
purchase. The deductions can be made from purchases, such as, purchase return, goods withdrawn by the
proprietor, goods distributed as free sample etc.
(iii) Direct expenses: it means all those expenses which are incurred from the time of purchases to making the
goods in suitable condition. This expenses includes freight inward, wages etc.
(iv) Gross profit: If the credit side of trading A/c is greater than debit side of trading A/c gross profit will arise.
The following items will appear in the credit side of Trading Account:
(i) Sales Revenue: The sales revenue denotes income earned from the main business activity or activities. The
income is earned when goods or services are sold to customers. If there is any return, it should be deducted from the
sales value. As per the accrual concept, income should be recognized as soon as it is accrued and not necessarily
only when the cash is paid for. For example, if an invoice is made for sale of goods and the term of sale is door
delivery; then sale can be recognized only on getting the proof of delivery of goods at the door of customer. If such
proof is pending at the end of accounting period, then this transaction cannot be taken as sales, but will be treated
as unearned income.
(ii) Closing Stocks: In case of trading business, there will be closing stocks of finished goods only. According to
convention of conservatism, stock is valued at cost or net realizable value whichever is lower.
(iii) Gross Loss: When debit side of trading account is greater than credit side of trading account, gross loss will
appear.
Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra
Example 1: Trading Account

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

Note: (a) Stock should be valued as per cost price or market price whichever is lower.
(b) The claim which was admitted by insurance company and the loss of stock, will not appear in Trading
Account.
Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra
Profit and Loss Account:

The following items will appear in the debit side of the Profit & Loss A/c:
(i) Cost of Sales: This term refers to the cost of goods sold. The goods could be manufactured and
sold or can be directly identified with goods.
(ii) Other Expenses: All expenses which are not directly related to main business activity will be
reflected in the P & L component. These are mainly the Administrative, Selling and distribution
expenses. Examples are salary to office staff, salesmen commission, insurance, legal charges,
audit fees, advertising, free samples, bad debts etc. It will also include items like loss on sale of
fixed assets, interest and provisions. Be careful to include accrued expenses as well.
(iii) Abnormal Losses: All abnormal losses are charged against Profit & Loss Account. It includes
stock destroyed by fire, goods lost in transit etc.
The following items will appear in the credit side of Profit & Loss A/c:
(i) Revenue Incomes: These incomes arise in the ordinary course of business, which includes
commission received, discount received etc.
(ii) Other Incomes: The business will generate incomes other than from its main activity. These
are purely incidental. It will include items like interest received, dividend received, etc .The end
result of one component of the P & L A/c is transferred over to the next component and the net
result will be transferred to the balance sheet as addition in owners’ equity. The profits actually
belong to owners of business. In case of company organizations, where ownership is widely
distributed, the profit figure is separately shown in balance sheet.
Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra
Example 1: P & L Account

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

Example 2: P & L Account

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra
Profit and Loss Appropriation Account:
• We know that the net profit or loss is added to or deducted from owner’s equity. The net
profit may be used by the business to distribute dividends, to create reserves etc. In
order to show these adjustments, a P & L Appropriation A/c is maintained. Distribution
of profits is only appropriation and does not mean expenses. After passing such
distribution entries, the remaining surplus is added in owner’s equity.

Example 3: P & L Account

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra
Balance Sheet

A. Liabilities
(a) Capital: This indicates the initial amount the owner or owners of the business contributed. This
contribution could be at the time of starting business or even at a later stage to satisfy requirements of funds
for expansion, diversification etc. As per business entity concept, owners and business are distinct entities, and
thus, any contribution by owners by way of capital is liability.
(b) Reserves and Surplus: The business is a going concern and will keep making profit or loss year by year.
The accumulation of these profit or loss figures (called as surpluses) will keep on increasing or decreasing
owners’ equity.
(c) Long Term or Non-Current Liabilities: These are obligations which are to be settled over a longer
period of time say 5-10 years. These funds are raised by way of loans from banks and financial institutions.
Such funds are usually raised to meet financial requirements to procure fixed assets. These funds should not
be generally used for day-to-day business activities.
(d) Short Term or Current Liabilities: A liability shall be classified as Current when it is expected to be
settled in the organisation’s normal Operating Cycle. It is held primarily for the purpose of being traded, and it
is due to be settled within 12 months after the Reporting Date. Current liabilities comprise of :
i. Sundry Creditors,
ii. Advances from customers,
iii. Outstanding Expenses,
iv. Bills Payable,
v. Bank Overdrafts
Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra
B. Assets
In accounting language, all debit balances in personal and real accounts are called as assets. Assets are
broadly classified into fixed assets and current assets.
(a) Fixed Assets: These represent the facilities or resources owned by the business for a longer period of
time. The basic purpose of these resources is not to buy and sell them, but to use for future earnings. The fixed
assets could be in tangible form such as buildings, machinery, vehicles, computers etc, whereas some could be
in intangible form viz. patents, trademarks, goodwill etc. The fixed assets are subject to wear and tear which is
called as depreciation. In the balance sheet, fixed assets are always shown as “original cost less depreciation”.
(b) Investments: These are funds invested outside the business on a temporary basis. At times, when the
business has surplus funds, and they are not immediately required for business purpose, it is prudent to
invest it outside business e.g. in mutual funds or fixed deposit. The purpose if to earn a reasonable return on
this money instead of keeping them idle. These are assets shown separately in balance sheet.
(c) Current Assets: An asset shall be classified as Current when it is expected to be realised in, or is
intended for sale or consumption in the organisation’s normal Operating Cycle. It is held primarily for the
purpose of being traded. Current assets comprise of:
i. Stocks
ii. Debtors
iii. Bills receivables
iv. Cash in Hand
v. Cash at Bank
vi. Prepaid Expenses
vii. Advances to suppliers
Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra
Illustration of a Balance Sheet

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

Example 1: Balance Sheet

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra
Exercise 1: Preparation of final accounts (Trading A/c., P & L A/c., Balance Sheet)

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

Analyzing Financial Statements - Ratio analysis

Solvency Profitability
Ratios Ratios

Activity
Ratios
Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra
Ratio analysis

Accountants, financial analysts, and engineering economists frequently utilize business

ratio analysis to evaluate the financial health (status) of a company over time and in
relation to industry norms. Because the engineering economist must continually
communicate with others, she or he should have a basic understanding of several ratios.
The ratios are classified according to their role in measuring the corporation.
• Solvency ratios: Assess ability to meet short-term and long-term financial obligations.
• Efficiency ratios: Measure management’s ability to use and control assets.
• Profitability ratios: Evaluate the ability to earn a return for the owners of the
corporation.

• Ratios of short-term solvency measure the ability of the firm to meet recurring financial
obligations (that is, to pay its bills). The most widely used measures of accounting
liquidity are the current ratio and the quick ratio.
Current ratio = Total current assets/ Total current liabilities
Quick ratio= *Quick assets/ Total current liabilities (also known as acid test ratio)
* Quick assets= Total current assets- inventories

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

Advantages of Ratio Analysis

• It is powerful tool to measure short and long-term solvency of a company.

• It is a tool to measure profitability and managerial efficiency of a company.
• It is an important tool to measure operating activities of a business.
• It helps in analyzing the capital structure of a company.
• Large quantitative data may be summarized using ratio analysis.
• It relates past accounting performances with the current.
• It is useful in coordinating the different functional machineries of a company.
• It helps the management in future decision-making.
• It helps in maintaining a reasonable balance between sales and purchase and estimating
working capital requirements.

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

Classification on the Basis of Financial Statement

• Balance Sheet Ratios: Ratios calculated from taking various data from the balance
sheet are called balance sheet ratio. For example, current ratio, liquid ratio, capital
gearing ratio, debt equity ratio, and proprietary ratio, etc.
• Revenue Statement Ratio: Ratios calculated on the basis of data appearing in the
trading account or the profit and loss account are called revenue statement ratios. For
example, operating ratio, net profit ratio, gross profit ratio, stock turnover ratio.
• Mixed or Composite Ratio: When the data from both balance sheet and revenue
statements are used, it is called mixed or composite ratio. For example, working
capital turnover ratio, inventory turnover ratio, accounts payable turnover ratio, fixed
assets turnover ratio, return of net worth ratio, return on investment ratio.

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

Functional Classification of Ratios

Ratios can be further classified based on their functional aspects as discussed below.
• Liquidity Ratios: Liquidity ratios are used to find out the short-term paying capacity of a firm, to comment
short term solvency of the firm, or to meet its current liabilities. Similarly, turnover ratios are calculated to
know the efficiency of liquid resources of the firm, Accounts Receivable (Debtors) Turnover Ratio and Accounts
Payable (Creditors).
• Long-Term Solvency and Leverage Ratios: Debt equity ratio and interest coverage ratio are calculated to
know the efficiency of a firm to pay long-term debts and to meet interest costs. Leverage ratios are calculated to
know the proportion of debt and equity in the financing of a firm.
• Activity Ratios: Activity ratios are also called turnover ratios. Activity ratios measure the efficiency with which
the resources of a firm are employed.
• Profitability Ratios: The results of business operations can be calculated through profitability ratios. These
ratios can also be used to know the overall performance and effectiveness of a firm.

➢ In order that ratios serve as a tool for financial analysis, they are classified according to their
functions as follows:
A. Profitability Ratios,
B. Turnover Ratios, and
C. Financial Ratios.

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

A. Profitability Ratios
• Profitability is an indication of the efficiency with which the operations of the business are
carried on. Poor operational performance may indicate poor sales and hence poor profits. A
lower profitability may arise due to the lack of control over the expenses. Bankers, financial
institutions and other creditors look at the profitability ratios as an indicator of whether or not
the firm earns substantially more than it pays interest. Owners are interested to know the
profitability as it indicates the return which they can get on their investments.
• The following are the important profitability ratios:
1. Overall Profitability Ratio
2. Earning Per Share (EPS).
3. Price Earning Ratio (PER)
4. Gross Profit Ratio
5. Net Profit Ratio.
6. Operating Ratio
7. Fixed Charges Cover
8. Debt Service Coverage Ratio
9. Payout Ratio
10. Dividend Yield Ratio
Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra
1. Overall Profitability Ratio

• It indicates the percentage of return on the total capital employed in the business. It is calculated
on the basis of the following formula:

• The term ‘Operating Profit’ means ‘Profit before Interest, Tax and dividend’. Capital is the
aggregate of all the capital at the disposal of the company, viz., equity capital, preference capital,
reserves, debentures, etc.
• The term capital employed has been given different meanings by different accountants. Some of
the popular meanings are as follows:
(i) Sum‐total of all assets whether fixed or current
(ii) Sum‐total of fixed assets
(iii) Sum‐total of long‐term funds employed in the business
The term capital employed is generally used in the meanings given in the point third above.
Significance of ROI:
• The Return on Capital invested is a concept that measures the profit which a firm earns on investing a unit of
capital.
• The profit being the net result of all operations, the return on capital expresses overall efficiency or
inefficiency of business.
• On this basis, there can be comparison of the efficiency of one department with that of another, of one plant
with that of another, one company with that of another and one industry with that of another.
Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra
2. Earning Per Share (EPS)

• In order to avoid confusion on account of the varied meanings of the term capital employed, the
overall profitability can also be judged by calculating earning per share (each outstanding share
of common stock) with the help of the following formula.

3. Price Earning Ratio (PER)

• This ratio (P/E ratio or price multiple) indicates the number of times the earning per share is
covered by its market price. This is calculated according to the following formula

4. Gross Profit Ratio

This ratio expresses relationship between gross profit and net sales. Its formula is:

5. Net Profit Ratio (Profit margin)

This ratio indicates net margin earned on a sale of Rs 100. It is calculated as follows:

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

B. Turnover Ratios

• The turnover ratios or activity ratios indicate the efficiency with which the capital employed is
rotated in the business. The overall profitability of the business depends on two factors:
i. the rate of return of capital employed; and
ii. the turnover, i.e., the speed at which the capital employed in the business rotates. Higher the
rate of rotation, the greater will be the profitability.
• Thus, overall profitability ratio can be classified into:
1. Net Profit Ratio
2. Turnover Ratio

• When these two ratios are put together, we get the return on capital invested (ROCE).
Return on capital invested = Net Profit Ratio × Turnover Ratio

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

C. Financial Ratios

Financial ratios indicate the financial position of the company. A company is deemed to
be financially sound if it is in a position to carry on its business smoothly and meet all
its obligations both long‐term as well as short‐term without strain.
Important ratios which are calculated in order to judge the financial position of the
company are as follows:
1. Fixed Assets Ratio
2. Current Ratio
3. Liquidity Ratio
4. Debt‐equity Ratio.
5. Proprietary Ratio.

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

1. Fixed Assets Ratio.

Fixed assets include ‘net fixed assets’ (i.e., original cost–depreciation to date) and trade
investments including shares in subsidiaries. Long‐term funds include share capital, reserves and
long‐term loans. The ratio should not be more than 1.
If it is less than 1, it shows that a part of the working capital has been financed through long‐term
funds. This is desirable to some extent because a part of working capital termed as ‘core working
capital’ is more or less of a fixed nature.

2. Current Ratio. This ratio is an indicator of the firm’s commitment to meet its short term
liabilities. It is expressed as follows:

Current assets include cash and other assets convertible or meant to be converted into cash
during the operating cycle of the business (less than a year).
Current liabilities mean liabilities payable within a year’s time either out of existing current assets
or by creation of new current liabilities.
Book debts outstanding for more than six months and loose tools should not be included in current
assets. Prepaid expenses should be taken into current assets.
Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra
3. Liquidity Ratio
This ratio is also termed as ‘acid test ratio’ or ‘quick ratio’. This ratio is ascertained by comparing
the liquid assets (i.e., assets which are immediately convertible into cash without much loss) to
current liabilities. Prepaid expenses and stock are not taken as liquid assets.

4. Debt‐equity Ratio
The debt‐equity ratio is determined to ascertain the soundness of the long‐term financial policies
of the company. It is also known as ‘External‐internal’ equity ratio.

The term external equities refers to total outside liabilities. The term internal equities refers to
shareholders’ funds or the tangible net worth (as used in the proforma balance sheet given in the
preceding pages). In case the ratio is 1 (i.e., outsider’s funds are equal to shareholders’ funds), it is
considered to be quite satisfactory.

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

• Ratios (i) and (ii) give the proportion of long‐term debt/shareholders’ funds in total long‐term
funds (including borrowed as well as owned funds).
• While Ratio (iii) indicates the proportion between shareholders’ funds (i.e., tangible net worth),
and the total long‐term borrowed funds.
Significance.
• The ratio indicates the proportion of owners’ stake in the business. Excessive liabilities tend to cause
insolvency.
• The ratio indicates the extent to which the firm depends upon outsiders for its existence.
• The ratio provides a margin of safety to the creditors.
• It tells the owners the extent to which they can gain the benefits of maintaining control with a limited
investment.

5. Proprietary Ratio
It is a variant of debt‐equity ratio. It establishes relationship between the proprietors’ or
shareholders’ funds and the total tangible assets.

Significance.
• A high proprietary ratio will indicate a relatively little danger to the creditors, etc., in the event of forced
reorganisation or winding up of the company.
• A low proprietary ratio indicates greater risk to the creditors since in the event of losses a part of their
money may be lost besides loss to the proprietors of the business.
• The higher the ratio, the better it is.

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

Value
1. Market price
2. Price-to-earnings (P/E) ratio
3. Dividend Yield
4. Market-to-book (M/B) value ratio

1. Market price: The market price of a share of common stock is the price that buyers
and sellers establish when they trade the stock. The market value of the common equity
of a firm is the market price of share of common stock multiplied by the number of
shares outstanding.

2. Price-to-earnings (P/E) ratio: One way to calculate the P/E ratio is to divide the
current market price by the earnings per share of common stock for the latest year.

3. Dividend Yield= Dividends per share/ Market price per share.

Dividends yields are related to the market’s perception of future growth prospects for
firms. Firms with high growth prospects will generally have lower dividend yields.

4. Market-to-book (M/B) value ratio: It is calculated by dividing the market price per
share by the book value per share.

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra

References

1. Fundamentals of Accounting - Foundation Paper: 2, 2nd edition, The Institute of Cost Accountants of India, Kolkata, 2014.
2. S.N. Maheshwari, S.K. Maheshwari, Advanced Accountancy, Vol. 1, 7th edition, Vikas, 2012.
3. Ronald J. Ebert, Ricky W. Griffin, Business Essentials, 4th edition, Prentice Hall, Inc, 2003.
4. Horngren, Sundem, Burgstahler, Schatzberg, Introduction to Management Accounting, 7th edition, Prentice Hall, Inc, 2014.
5. Leland Blank, Anthony Tarquin, Engineering Economy: 7th edition, THM, 2012.
6. Learn Financial Accounting: Financial Accounting Basics, Tutorials Point (I) Pvt. Ltd., 2014.
7. ACCOUNTANCY, Module 1, http://download.nos.org/srsec320newE/320EL3.pdf
8. Chapter 1 – Introduction to Accounting and Business, ppt, www.rohanchambers.com/Courses/CBU1070/01-
Introduction/Ch01.ppt
9. Basics Financial Accounting, Chapter 3, ARORN Professional Tutors.
10. S.C. Galbreath, C.W. Cladwell, J.A. Booker, C.J. Rooney, Analyzing and Recording Transactions, ppt, McGrow Hill, 2013.
11. Weygandt, Kieso, Kimmel, Managerial Accounting, Accounting Principles, 8th Edition, ppt, (by D.R. Ward, S.P. Ward).
12. Classification of Accounts, Accounting, ppt, www.cuchd.in/e-library/resource_library/.../BBT-104-
Basic%20Accounting/(5).ppt
13. Basic Concepts of Financial Accounting, Chapter 2, ppt, www.swlearning.com/accounting/murray/ppt/02.PPT
14. Rania A. Azmi, Finance Basics, University of Alexandria, ppt

Dr. Bappa Acherjee, Dept. of Production Engg., BIT Mesra