Unit - 4

INTRODUCTION TO ACCOUNTING AND FINANCIAL ANALYSIS

Introduction and Meaning:

Double entry system was introduced in 1494 by an Italian merchant ‘Luca
Pacioli’. According to double entry system, every business transaction has two aspects. One aspect is
receiving and the other aspect is giving. The receiving aspect is termed as “debit” and the giving aspect is
termed as “credit”.
When we receive something, we give something else in return also. For example,
when we sell goods for cash, we receive cash and give goods in return. Thus, on any date, the total of all
debits must be equal to the total of all credits, because every debit has a corresponding credit. This is
known as the fundamental principle of double entry system.

 Advantages of Double Entry System: The following are the advantages of double entry system:

1. Complete and Scientific Record: The main advantage of the double entry system is that it helps
to maintain a complete and scientific record of business transactions as both the aspects of each
and every transaction are recorded in it.

2. Full Information: Full and authentic information can be had about all transactions as the trader
maintains the ledger with all types of accounts.

3. Assessment of Profit or Loss: The businessman will be able to know correctly whether he had
earned profit or sustained loss.

4. Assessment of Financial Position: The businessman will be able to know fully about the financial
position of the firm by prepare the balance sheet.

5. Helpful in Comparison: This system is helpful in making comparison of current year business
result those of previous years.

6. Helpful in preventing Errors and Frauds: The systematic and scientific recording of business
transactions on the basis of this system minimizes the chances of errors and frauds. These can be
easily detected by vouching, verification and auditing of accounts.

7. To Meet Legal Requirements: Proper maintenance of books will satisfy the tax authorities and
facilitates accurate assessment. In India joint stock companies should maintain accounts under
double entry system.

 Classification of Accounts:

All the business transactions are broadly classified into three categories: (i) those relating to
persons, (ii) those relating to property (assets), and (iii) those relating to income and expenses. Thus, three
classes of accounts are maintained for recording all business transactions. They are:

A) Personal Accounts
B) Real Accounts, and
C) Nominal Accounts
 Accounts

Personal Accounts Real Accounts Nominal Accounts

A) Personal Accounts: Accounts relating to names of persons, firms or companies are called as
‘Personal Accounts’. Ex: Rama Account, Gopal Account, Nagarjuna Finance Limited Account,
Andhra Bank Account etc.
 Debit-Credit Rule: Debit the receiver
and
Credit the giver

B) Real Accounts: Accounts relating to properties or assets are known as ‘Real Accounts’. Ex:
Machinery Account, Furniture Accounting, Cash Account etc.
 Debit-Credit Rule: Debit what comes in
and
Credit what goes out

C) Nominal Accounts: Accounts relating to expenses, losses, incomes and gains are known as
‘Nominal Accounts’. Ex: Salaries Account, Commission Received Account, Interest paid Account
etc.
 Debit-Credit Rule: Debit all expenses and losses
and
Credit all incomes and gains

 JOURNAL

The word “Journal” is derived from the Latin word ‘Journ’ which means a day. Therefore, journal means a
day book where in day-to-day business transactions are recorded in chronological order (in order of dates).

Journal is treated as the book of original entry of first entry or prime entry. All the business
transactions are first entered in this book before they are posted in the ledger. The process of recording a
transaction in the journal is called ‘journalizing’. The entries made in the books are called ‘journal entries’.
Journal Proforma
Date Particulars L.F. Debit Credit
(Rs.) (Rs.)
Name of the account to be debited
Name of the account to be credited
(Narration or Explanation)

1. Date: The year is written at the top of the date column of each page of the journal. Thereafter on
the next line of the date column, the month and date of the first entry are written.

2. Particulars: The name of the account to be debited is entered on the extreme left of the particulars
‘column’ and “Dr” is written at the right end. The name of the account to be credited is entered on
the next line with a prefix “To”. A short explanation of the transaction (i.e., narration) is given
immediately below the account credited. The narration should be adequate to explain the
transaction and should always appear within brackets. It always starts with the word ‘Being’. At
the end, a thin line is drawn to indicate that the entry of a transaction is complete from all aspects.
 3. Ledger Folio (L.F): In this column, the page number of the ledger on which the debit and credit
accounts are posted is recorded. Practically this column is not used, because the page number of
ledger is not known beforehand.

4. Debit (Rs.): The amount to be debited is entered in this column.

5. Credit (Rs.): The amount to be credited is entered in this column.

 LEDGER

After recording a transaction in the journal, the next stage is the transfer of transactions in the respective
accounts in the form of ledger.

Ledger is the principal book of accounts. It contains all the accounts of a business whether
personal, real or nominal. It is also called the book of final entry.

Definition:

A ledger may be defined as “a summary statement of all transactions relating to a person,

asset, expense or income, which have taken place during a given period of time and
shows their net effect.”
Dr. Proforma of Ledger Cr.
Date Particulars J.F Amount Date Particulars J.F Amount
(Rs.) (Rs.)
To the name of By the name of debit
credit account
account

In ledger, each account is prepared in ‘T’ shape. Each account is divided into two equal parts by
a vertical line. The left hand side of the account is known as debit (Dr.) and the right hand side is known as
credit (Cr.). Each of the two sides is further divided into four columns. They are: date, particulars, journal
folio, and amount.

1. Date: This column records year, month and date of transaction

2. Particulars: This column records the name of the account to be credited on the debit side and the
name of the account to be debited on the credit side. The names of the account in particulars
column on the debit and credit sides are preceded by words ‘To’ and ‘By’.

3. Journal Folio: It records page number of the journal from which the posting to the ledger takes
place.

4. Amount: Amount columns on the Dr. and Cr. Sides of the account record the amount of each and
every transaction.
Exercise: From the following transactions pass Journal entries and post them in the appropriate Ledger
Accounts in the books of Avinash& Co.

2014 May 1 Started business with Rs.100000

May 5 Purchased goods from Rahul & Co. Rs. 10000
May 7 Sold goods worth Rs. 20000
May 10 Salaries paid Rs. 1500
May 11 Purchased Stationery worth Rs. 1000
May 15 Bought furniture worth Rs. 20000
May 18 Cash deposited into bank Rs. 9000
May 20 Paid wages Rs. 5000
May 24 Cash withdrawn from bank Rs. 3000
May 28 Paid rent by cheque Rs. 1800
 FINAL ACCOUNTS

Final accounts are prepared by an organization at the end of the financial year to
know the operational efficiency and financial position of the business. Financial accounts for a trading firm
refer to:
1. Trading and Profit and Loss Account
2. Balance Sheet
Trail balance is the basis for preparing of final accounts.

 Trading Account: This account is prepared by those concerns, which deal in the purchase and sale
of goods. It is prepared to find out the amount of gross profit or gross loss in a particular period.
Gross profit or gross loss is the amount of difference between the cost of goods sold and the selling
price. Gross profit of loss can be ascertained with the help of the following equations:

Gross profit = Sales – Cost of goods sold.

Gross loss = Cost of goods sold – Sales.

When the amount of sales is more than the cost of goods sold, the result is gross profit. If the
amount of sales is less than the cost of goods sold, the result is gross loss. The gross profit or gross loss
earned in this account is transformed to profit and loss account.

Dr. Trading Account of ---------------- for the year ending------------ Cr.

Particulars Amoun Particulars Amoun
t t
(Rs.) (Rs.)
To Opening stock xxxx By Sales xxxx
To Purchases xxxx Less: Sales returns xx xxxx
Less: Purchase returns xx xxxx (or) return inward
(or) return outward By Closing stock xxxx
Direct expenses: By Gross loss c/d xxxx
To Carriage inward xxxx (Transferred to P&L
To Coal, Gas and Water etc xxxx a/c)
To Power or Motive power xxxx
To Octroi xxxx
To Import duty xxxx
To Custom duty xxxx
To Wages or wages & salaries xxxx
To Factory expenses xxxx
To Manufacturing expenses xxxx
To Royalty xxxx
To Consumable Stores xxxx
To Salary of foremen/works xxxx
manager
To Gross Profit c/d xxxx
(Transferred to P&L a/c) xxxx xxxx

 Profit And Loss Account: This account is prepared to calculate the net profit of the business. The
trading accounts simply depict the gross profit or gross loss made by a businessman on the sale and
purchase of goods. It does not take into account the other operating or indirect expenses incurred
by him during the course of running the business. Hence, the P&L account is prepared to find out
the indirect amount of net profit of net loss of the firm in a particular period.
 Dr. P&L Account of ------------for the year ending------- Cr.
Particulars Amount Particulars Amount
(Rs.) (Rs.)
To Gross loss b/d xxxx By Gross profit b/d xxxx
To Administrative & Office By Income received:
expenses: By Interest received xxxx
To Rent, rates and taxes xxxx By Discount xxxx
To Office salaries xxxx By Commission xxxx
To Printing and stationery xxxx By Dividends xxxx
To Postage and telegram xxxx By Income from investments xxxx
To Heating and lighting xxxx By Rent from tenants xxxx
To Insurance xxxx By Apprenticeship premium xxxx
To Audit fee xxxx By Insurance claims xxxx
To Legal charges xxxx By Miscellaneous receipts xxxx
To Repairs and maintenance xxxx By Bad debts recovered xxxx
To General expenses xxxx By Net loss transferred to capital xxxx
To Depreciation xxxx account c/d
To Selling and distribution
expenses:
To Advertising and publicity xxxx
To Salesmen’s salaries xxxx
To Packing expenses xxxx
To Bad debts xxxx
To Godown rent xxxx
To Export expenses xxxx
To Salesmen’s commission xxxx
To Delivery van’s expenses xxxx
To Carriage outwards xxxx
To Travelling expenses xxxx
To Agents’ commission xxxx
To Brokerage xxxx
To Provision for bad debts xxxx
To Financial expenses:
To Interest on capital xxxx
To Interest on debentures xxxx
To Interest on loans xxxx
To Discount on bills xxxx
To Discount allowed xxxx
To Bank charges xxxx
ToExtraordinary Expenses:
To Loss by fire (not covered xxxx
by insurance)
To Loss on sale of fixed xxxx
assets xxxx
To Loss by theft xxxx
To Cash defalcations xxxx
To Net profit transferred to
capital account c/d.
xxxx xxxx
  Balance Sheet: The third part of the final accounts is called the balance sheet. After ascertaining
the net profit or net loss of the business, a trader wants to know the financial position of his
business. He prepares a statement of assets and liabilities which is popularly known as the balance
sheet. Balance sheet explains the financial position of business as on particular date.
Balance sheet of --------- as on -------
Liabilities Amount Assets Amount
(Rs.) (Rs.)
Current Liabilities: Current Assets:
Sundry creditors xxxx Cash in hand xxxx
Bills payable xxxx Cash in bank xxxx
Bank over draft xxxx Bills receivable xxxx
Short-term loans xxxx Sundry debtors xxxx
Outstanding expenses Prepaid expenses xxxx
Long-term Liabilities: Closing stock xxxx
Debentures xxxx Stock-in-trade XXXX
Long-term loans xxxx Short-term investments XXXX
Fixed Liabilities: Fixed Assets: XXXX
Capital Investments
xxxx Land and building xxxx
Add/less:NetProfit/loss Plant and machinery xxxx
xxx xxxx Furniture and fittings xxxx
xxxx Vehicles xxxx
Add: Interest on capital Goodwill xxxx
xxx Trademark xxxx
Less: Drawings Copy rights xxxx
xxx xxxx Patents xxxx
Less: Income tax xxxx XXXX
xxx XXXX
xxxxx

Adjustments:

A. Closing Stock: Closing stock is the stock of unsold at the end of the accounting year. It involves raw-
materials, semi-finished goods, and finished goods. The valuation of stock is done at the cost price or
the market price whichever is less.
1. Shown on the credit side of the trading account as “By Closing stock”.
2. Shown as an asset in the balance sheet
B. Outstanding Expenses: Outstanding expenses are those expenses which have incurred during the
accounting period but are not paid yet. Eg: Outstanding salaries, rent yet to be paid, etc.
1. Shown in the concerned account on the debit side of the trading or P&L a/c.
2. Shown on the liabilities side of the balance sheet.
C. Prepaid (or Unexpired) Expenses: Prepaid expenses are those expenses, the payment of which are
made in advance in the current accounting period but which relate to the next accounting period. Eg:
Insurance pre-paid.
1. Deducted from those particular expenses on the debit side of the P&L a/c.
2. Shown on the assets side of the balance sheet.
D. Accrued Income (or Outstanding Income): Accrued income is that which has been earned or has
become due but not received till the end of an accounting period. Eg: Rent receivable, Interest
receivable etc.
1. Added to the concerned account on the credit side of P&L a/c.
2. Shown as an Asset in the balance sheet.

E. Income Received in Advance (or Unearned Income): Income received during an accounting period,
which belongs to the next accounting period are called as income earned in advance.
1. Deducted from the concerned income on the credit side of P&L a./c
2. Shown as a liability in the balance sheet.

F. Depreciation: It is the reduction in the value of an asset due to usage, wear and tear, or obsolescence.
It is an expense.
1. Shown on the debit side of the P&L a/c.
2. Deducted from the concerned asset on the assets side of the balance sheet.

G. Bad Debts: When goods are sold on credit basis, the buyer of the goods is called as “debtor”. If the
debtor does not pay the amount payable, such an amount is considered to be a “Bad debt”.
1. Shown on debit side of P&L a/c
2. Deduct the amount from sundry debtors on the assets side of balance sheet.

H. Provision for Bad and Doubtful Debts: Sometimes a businessman feels, at the end of the year, that
certain debts may not be recoverable or doubtful of recovery. So he creates a provision to cover such
debts, which is known as ‘provision for bad and doubtful’.

1. It will appear on the debit side of the P&L a/c or will be added to bad debts, and old provision for
doubtful debts at the beginning of the year will be deducted.

2. It will appear on the assets side of the balance sheet by way of deduction from sundry debtors
(after deduction of further bad debts, if any).

I. Interest on Capital: It is the interest charged by the proprietor from business on the amount invested
by him.
1. Shown on the debit side of P&L a/c.
2. Added to capital in the liabilities side of the balance sheet.

J. Interest on Drawings: It is the interest charged by the business from the proprietor on the amount
with drawn by the proprietor from the business for his personal use.
1. Shown on the credit side of the P&L a/c.
2. Deducted from capital in the liabilities side of the balance sheet.
Exercise: From the following Trail Balance of Surya & Sons’ Co prepare Trading and P&L a/c for the
year ended 31-03-2014 and a Balance Sheet as on that date:
Debit (Rs.) Credit (Rs.)
Sales 1,80,000
Purchases 1,15,000
Sales Returns 6,000
Purchase Returns 4,000
Opening Stock 13,000
Freight 1,200
Salaries 18,000
Interest Received 830
Wages 3,250
Office Expenses 2,650
Discount 650 450
Rent 6,300
Drawings 2,800
Bills Payable 5,550
Bills Receivable 8,560
Furniture 26,000
Machinery 76,000
General Expenses 1,500
Postage & Telegrams 850
Capital 1,01,500
Sundry Debtors 19,000
Cash in hand 1,250
Cash at bank 3,950
Sundry Creditors 13,630
Total 3,05,960 3,05,960

Adjustments:
Closing Stock Rs.27, 500
Outstanding Wages Rs.750
Prepaid Rent Rs.800
Depreciate Machinery by 10% and Furniture by 5%.
Write off bad debts Rs.1000 and provide 3% reserve for doubtful debts
Interest on Capital to be @10% per annum.
Ans: GP 72,300, NP 23,840, B/s 1,52,620
 FUNDS FLOW ANALYSIS

Introduction:
In a narrow sense the term ‘fund’ means cash only. In a broad sense the term ‘fund’
means working capital. Working capital indicates the difference between current assets and current
liabilities. The term working capital may be:
a) Grass Working Capital – it represents total of all Current Assets.
b) Net Working Capital – it refers to excess of Current Assets over Current Liabilities.

The term ‘flow’ means change and therefore the term ‘flow of funds’ means ‘change
of funds’ or ‘change in working capital’ in the normal course of business transactions.

Firm
Inflow of Funds Business Outflow of Funds
transactions

Definition:
“A statement of sources (inflows) and applications (outflows) of funds is a
technical device designed to analyze the changes in the financial condition of a business enterprise
between two dates (accounting periods)”.
--------- Foulke.
Objectives / Importance of Funds Flow Statement:

1. Analysis of Financial Position: Funds flow statement analyses how the funds were obtained and
used in the past.

2. Evaluation of Firm’s Financing: It reveals how the firm financed its developments projects in the
past i.e., from internal sources or from external sources.

3. An Instrument for Allocation of Resources: The amount of funds to be available for projects
shall be estimated by the financial manager with the help of funds flow statement. Based on the
funds availability they can take decision to financing.

4. Future Guide: An analysis of funds flow statements of several years reveals certain valuable
information for the financial manager for planning the future financial requirements of the firm.

5. Control Device: The statement compared with the budgeted figures will show to what extent, the
funds were utilized according to plan on this basis; the financial manager can take remedial steps if
there is any deviation.

 Components of Flow of Funds: In order to analyze the sources and application of funds, it is essential
to know the meaning and components of flow of funds given below :

(l) Current Assets

(2) Non-Current Assets (Fixed or Permanent Assets)
(3) Current Liabilities
(4) Non-Current Liabilities (Capital & Long-Term Liabilities)
(5) Provision for Tax
(6) Proposed Dividend
(1) Current Assets: The term "Current Assets" refer to the assets of a business of a transitory nature which
are intended for resale or conversion into different form during the course of business operations. For
example, raw materials are purchased and the amount unused at the end of the trading period forms part of
the current as stock on hand. Materials· in process at the end of the trading period and the labour incurred
in processing them also form part of current assets.

(2) Non-Current Assets (Permanent Assets): Non-Current Assets also refer to as Permanent Assets or
Fixed Assets. This class of asset includes those of tangible and intangible nature having a specific value
and which are not consumed during the course of business and trade but provide the means for producing
saleable goods or providing services. Land and Building, Plant and Machinery, Goodwill and Patents etc.
are the few examples of Non-Current ~assets.

(3) Current Liabilities: The term Current Liabilities refer to amount owing by the business which are
currently due for payment. They consist of amount owing to creditors, bank loans due for repayment,
proposed dividend and proposed tax for payment and expenses accrued due.

(4) Non-Current Liabilities: The term Non-Current Liabilities refer to Capital and Long-Term Debts. It
is also called as Permanent Liabilities. Any amount owing by the business which are payable over a longer
period time, i.e., after a year are referred as Non-Current Liabilities. Debenture, long-term loans and loans
on mortgage etc., are the few examples of non-current liabilities.

(5) Provision for Taxation: Provision for taxation may be treated as a current liability or an appropriation
of profit. When it is made during the year it is not used for adjusting the net profit, it is advisable to treat
the same as current liability. Any amount of tax paid during the year is to be treated as application of funds
or non-current liability. Because it is used for adjusting the net profit made during the year.

(6) Proposed Dividend: Like provision for taxation, it is also treated as a current liability and noncurrent
liability, when dividend may be considered as being declared. And thus, it will not be used for adjusting the
net profit made during the year. If it is treated as an appropriation, i.e., an non-current liability when the
dividend paid during the year.

(7) Provisions Against Current Assets and Current Liabilities: Provision for bad and doubtful debts,
provision for loss on inventories, provision for discount on creditors and provision made against
investment etc. are made during the year, they may be treated separately as current assets or current
liabilities or reduce the same from the respective gross value of the assets or liabilities.

The list of Current Accounts and Non-Current Accounts are given below:

Current Accounts
Current Liabilities Current Assets
(1) Bills Payable (1)Cash in Hand
(2) Sundry Creditors (2)Cash at Bank
(3) Outstanding Expenses (3)Bills Receivable
(4) Dividends Payable (4)Sundry Debtors
(5) Bank Overdraft (5)Short-Term Investments
(6) Short-Term Loans (6)Marketable Securities
(7) Provisions against Current Assets (7)Stock of Raw Materials, Work-in-
(8) Provision for Taxation Progress & Finished Goods
(9) Proposed Dividend (8)Prepaid Expenses
(May be Current or Non-Current (9)Accrued Incomes
Liabilities)
 Non-Current Accounts
Non-Current or Permanent Liabilities Non-Current or Permanent Assets
(1) Equity Share Capital (1) Good will
(2) Preference Share Capital (2) Land
(3) Debentures (3) Building
(4) Long-Term Loans (4) Plant and Machinery
(5) Share Premium (5) Furniture and Fittings
(6) Share forfeited (6) Trade Marks
(7) Profit and Loss Account (7) Patent Right~
(8) Capital Reserve (8) Long-Term Investments
(9) Capital Redemption Reserve (9) Discount on Issue of Shares and Debentures
(10) Preliminary Expenses
(11) Other Deferred Expenses

 Preparation of Funds Flow Analysis Statements: Funds flow analysis involves the following
important three statements such as:

A. Funds from Operations

B. Statement of Changes in Working Capital
C. Funds flow Statement.

A. Funds from Operations:The main source of fund for an enterprise is the funds from operation. A
fund from operation means the actual amount of profit is generated by the business operations
such as purchase and sales.
Statement of Funds from Operations
Particulars Amount Amount
(Rs.) (Rs.)
Net profit or Retained earnings xxxx
(Closing balance of P/L A/c as given in the balance
sheet)
Add: Non-fund & non-operating items which have
been debited to P&L A/c: xxxx
1. Depreciation on fixed assets xxxx
2. Goodwill written off xxxx
3. Patents xxxx
4. Trademarks xxxx
5. Discount on issue of shares xxxx
6. Preliminary expenses written off xxxx
7. Transfer to reserves xxxx xxxx
8. Loss on sales of fixed assets xxxx
9. Proposed dividend
xxxx
Less: Non-fund or Non-operating items which have xxxx
been credited to P&L A/c: xxxx
1. Profit on sale of fixed assets
2. Profit on revaluation of asset xxxx
3. Profit on redemption of shares & xxxx
debentures. xxxx
4. Rent received xxxx
5. Dividend received xxxxx
6. Refund of income tax
7. Net profit or retained earnings
(Opening balance of P/L A/c)
Funds from operations
Note: If the P/L a/c shows a net loss, the above procedure will be reversed.
Alternative Specimen Format: The following is the specimen of adjusted profit and loss account to
calculate fund from operations:

Adjusted Profit and Loss Account

Particulars Amount Particulars Amount
Rs. Rs.
To Depreciation on Fixed xxxx By Opening Balance of P xxxx
Assets xxxx &L Alc xxxx
To Loss on Sale of Fixed xxxx By Profit on Sale of Fixed xxxx
Assets xxxx Assets xxxx
To Loss on Sale Investments xxxx By Excess provision written xxxx
To Goodwill written off xxxx back xxxx
To Discount on shares xxxx By Dividend received on
written off xxxx investment
To Transfer to reserve xxxx By Revaluation of fixed
To Preliminary expenses XXXX assets xxxx
written off By Fund From Operations
To Provision for Tax (Balancing Figure)
To Proposed Dividend
To Closing Balance of P &L
Alc

Exercise 1: From the following information of the ABC Company Ltd., calculate funds from operations:

Profit and Loss Account

Particulars Amount Particulars Amount Rs.
Rs.

To Expenses: By Gross profit 230000

Operations 120000 By Gain on sale of plant 22000
Depreciation 50000
To Loss on sale of building 12000
To Advertisement suspense A/c 6000
To Discount allowed to 1000
customers
To Discount on issue of shares 1000
written off 15000
To Goodwill 47000
To Net profit 252000 252000

Ans: Rs. 109000

Exercise 2: From the following information of ‘Z’ Company Ltd. On 31-03-2014, calculate ‘funds from
operations.

1. Net profit for the year ended 31-03-2014 Rs. 700000

2. Gain on the sale of building Rs. 40000
3. Goodwill appears in the books Rs. 200000 out of that 10% has been written off during the year
4. Old machinery worth Rs. 10000 has been sold for Rs. 8000 during the year.
5. Rs.140000 have been transferred to the general reserved fund
6. Depreciation at 10% has been provided during the year on machinery cost Rs. 400000.
Ans: Rs. 862000
Exercise 3: The following are the extracts from the balance sheet of the company as on 31-12-2013 and
2014. You are required to calculate “Funds from Operations”.

Particulars 2013 2014

Profit and loss appropriation a/c. 30000 40000
General reserves 20000 25000
Goodwill 10000 5000
Preliminary expenses 6000 4000
Provision for depreciation on machinery 10000 12000
Ans: Rs.24000

Exercise 4: From the following balance sheet prepare funds flow statement.
Liabilities 2012 2013 Assets 2012 2013
Share capital 10000 15000 Fixed assets 10000 20000
P&L a/c 4000 6000 Current assets 13000 14500
Provision to tax 2000 3000
Proposed dividend 1000 1500
Sundry creditors 4000 6000
Outstanding expenses 2000 3000

Other information:
Tax paid during the year Rs.2500
Dividend paid Rs.1000
Ans: Rs. 7000

B. Statement of Changes in Working Capital: This statement is prepared from current assets and
current liabilities in order to calculate the increase or decrease in working capital. This statement
prepare with the help of current assets and current liabilities of two periods.

 Rules of Preparing Statement of Changes in Working Capital:

Items Effect on Working Capital
1. Increase in current assets Increase (+)
2. Decrease in current assets Decrease (-)
3. Increase in current liabilities Decrease (-)
4. Decrease in current liabilities Increase (+)
 Proforma of Statement of Changes in Working Capital
Particulars End of the year Working capital changes
Previous Current Increase Decrease
Year (Rs.) Year (Rs.) (Rs.) (Rs.)
Current Assets:
Cash in hand --------- ---------
Cash in bank --------- --------
Bills receivables -------- ---------
Sundry debtors --------- ---------
Stock --------- ---------
Prepaid expenses --------- ---------
--------- ---------
---------

Total Current Assets (A) XXXX XXXX

Current Liabilities:
Bills payable --------- ---------
Sundry creditors -------- --------
Outstanding expenses -------- --------
Bank Over Draft -------- ---------
Short-term loans -------- ---------
Dividends payable --------- ---------
--------- --------

Total Current Liabilities XXXX XXXX

(B)
Net working capital (A-B) -------- ------
Net increase/decrease in working XXXX XXXX XXXX XXXX
capital

Exercise 1: From the following balance sheet of Bharat Company, prepare a schedule of working capital
changes.
Ending on 31st December
1996 1997
Sundry creditors 70,000 80,000
Sundry debtors 1,30,000 1,50,000
Bills receivables 10,000 8,000
Bills payables 7,000 5,000
Prepaid expenses 1,000 1,500
Outstanding expenses 5,000 6,500
Stock 1, 80,000 1, 70,000
Investment in Govt. Securities ----- 30,000

Ans: Total --- 2, 68,000— 2, 68,000 ---- 52,500 --- 52,500

Exercise 2: From the following balance sheet you are require to prepare a schedule of change in working
capital.
Liabilities 2013 2014 Assets 2013 2014
Share capital 50000 50000 Cash 40000 45000
12% Debentures 20000 30000 Inventory 15000 10000
Sundry creditors 20000 40000 Account receivables 20000 25000
Outstanding expenses 20000 20000 Land 20000 30000
Tax payable 15000 20000 Plant 60000 70000
Retained earnings 30000 20000
155000 180000 155000 180000
Ans: 20000---20000---30000---30000
C. Funds Flow Statement: Funds flow statement is a statement which represents various sources from
which funds are obtained and used to which during a particular period. The different sources and
applications of funds are:
Sources of Funds

Funds from Issue of Shares Sale of Fixed Borrowings

Operations Assets

Funds

Purchase of Payment of Losses Payment of taxes,

Fixed Assets Loans dividends.

Uses of Funds

Proforma of Funds Flow Statement: Generally, this statement is prepared in two formats. They are:
i) Report form
ii) Account form
Report Form of Funds-Flow Statement
Particulars Amount (Rs.)
Sources of Funds:
Funds from operations xxxx
Issue of share capital xxxx
Issue of debentures xxxx
Long-term loans xxxx
Sale of fixed assets xxxx
Non-trading receipts i.e., dividends or donations xxxx
Decrease in working capital (as per schedule) xxxx
Total sources xxxx
Applications of Funds:
Trading Losses (If any)
Redemption of preference share capital/ debentures xxxx
Repayment of long-term debts xxxx
Purchase of any fixed asset xxxx
Non-trading payments xxxx
Increase in working capital (as per schedule) xxxx
Total Applications
xxxxx
 Account Form of Funds-Flow Statement
Sources Amount Application Amount
(Rs.) (Rs.)
Funds from operations xxxx Trading Losses (If any) xxxx
Issue of share capital xxxx Redemption of preference share capital/
Issue of debentures xxxx debentures xxxx
Long-term loans xxxx Repayment of long-term debts xxxx
Sale of fixed assets xxxx Purchase of any fixed asset xxxx
Non-trading receipts i.e., dividends or Non-trading payments xxxx
donations xxxx Increase in working capital (as per xxxx
Decrease in working capital (as per xxxx schedule)
schedule) xxxx xxxxx

CASH FLOW STATEMENT

According to this concept, the word ‘fund’ is used as cash only and does not include even most liquid
current assets.

Definition:

“A cash flow statement explains the changes in cash position between the two periods”

Cash flow statement is a statement which indicates sources of cash inflows and
transactions of cash out flows of a firm during an accounting period.

 Advantages of Cash Flow Statement:

1. Planning and Coordination of Financial Operations: It is useful in evaluating financial policies

and current cash position. The management comes to know – how much cash is needed in the
future and – at what time needed – how can it be arranged – how much can be generated internally
– how much can be generated externally.

2. A Control Device: A comparison of cash flow statement of previous year with the budget for the
year would indicate to what extent the resources of the firm were raised and applied according to
the plan.

3. Useful in Internal Financial Management: Since it gives a clear picture of cash inflows from
operations it is very useful to internal financial management in considering the possibility of
retiring long-term debts, in planning replacement of plant facilities or in formulating dividend
policies.

4. Profit and Cash Position: It enables the management to account for situation when business has
earned huge profits yet run without money or when it has suffered a loss and still has plenty of
money at the bank.

5. Short-run Financial Decisions: It helps the management in taking short-term financial decisions.
Suppose, if firm wants to know its state of solvency after one month from to-date, it is possible
only from cash flow analysis and not from funds flow statement.
 Distinction between Funds Flow Statement and Cash Flow Statement:

Distinction between Funds Flow Statement and Cash Flow Statement

Basis Funds Flow Cash Flow
Subject Matter Funds flow statement is concerned with Cash flow statement is concerned only
changes in working capital position with the changes in cash position
between two balance sheet dates between two balance sheet dates
Concept of Fund It is based on a wider concept of funds It is based on the narrow concept of
i.e., working capital funds i.e., cash only, which is only one
component of working capital.
Schedule of A schedule of working capital changes is No such schedule is prepared in the
Working Capital prepared in the case of funds flow case of cash flow statement
Change statement
Nature of Statement It deals with the changes in working It deals with the changes in cash
capital position only
Opening and The statement does not start with any The statement starts with the opening
Closing Balance opening of balance of any account and cash and bank balances and ends with
does not end with any such closing the closing cash and bank balances in
balance of any account most of the cases.
Difference of Sides Difference of both sides of funds flow Difference of both the sides of cash
statement is either the increase or flow statement is the closing balance
decrease in working capital of cash.
Current Liabilities It shows the changes in the current It does not show the changes in the
liabilities like sundry creditors, bills current liabilities of the enterprise
payable etc.
Utility Fund flow is helpful in long-term Cash flow is useful in short-term
planning. planning
Period It is prepared for longer period It is prepared for shorter period

RATIO ANALYSIS

Introduction:

The term ‘Ratio’ refers to the mathematical relationship between two items expressed in
quantitative form. These ratios can be expressed by as i). Percentages ii) Fractions iii) Proportion of
number ex: 1:4. Computing ratios, it is easy to understand the financial position of the firm.

Definition:

“Ratio is a yardstick used to evaluate the financial condition and performance of a firm,
relation to two pieces of financial data to each other”.
---------James C. Van Horne.

 Advantages of Ratio Analysis:

1. Aid to measure liquidity position: Ratios are helpful in assessing liquidity position and
profitability of a firm.

2. Long-Term Solvency: Ratio Analysis is equally useful for assessing the long-term financial
viability of a firm. The long-term solvency is measured by the leverage and profitability ratios
which focus on earning power and operating efficiency.
 3. Operating Efficiency: Yet another dimension of the usefulness of the ratio analysis is that it
throws light on the degree of efficiency of management and utilization of its assets.

4. Overall Profitability: The management is constantly concerned about the overall profitability of
the firm. That is, they are concerned about the ability of the firm to meet its short-term and long-
term obligations to its creditors, to ensure a reasonable return to its owners and secure optimum
utilization of the assets of the firm. This is possible if an integrated view is taken and all the ratios
are concerned together.

5. Inter-firm Comparison: Ratio analysis not only throws light on the financial position of a firm
but also serves as a stepping stone to remedial measures. This is made possible due to inter-firm
comparison and comparison with industry averages.

6. Aid in Forecasting and Planning: Ratio analysis helps in forecasting and planning. Over a period
of time a firm develops certain norms that may indicate future success or failure.

 Limitations of Ratio Analysis:

1. Financial ratios of a firm have meaning only when they are compared with same standards.
2. The comparison of the ratios of two companies becomes difficult and meaningless when they are
operating in different situations.
3. The financial ratios are generally calculated from the historical financial statements. The concerned
parties of concern are interested in the concern’s future than its past.

 Types of Ratios:Based on their nature, the ratios can broadly be classified into four categories.
A. Liquidity Ratios
B. Turnover Ratios
C. Solvency Ratios
D. Profitability Ratios

A. Liquidity Ratio:
Liquidity Ratios means the firm’s ability to meet its current obligations such as payment
of taxes, wages and salaries and so on. The liquidity ratios are calculated by comparing cash and
other current assets with current liabilities. Liquidity ratios can be classified into two types.

i). Current ratio: It is also known as working capital ratio. It measures the short-term debt payment
ability of the firm. Current ratio is the ratio between current assets and current liabilities. The
standard norm of current ratio is 2:1 and may vary from industry to industry.

ii). Quick ratio: It also called as ‘acid test ratio’ or ‘liquid ratio’. Quick assets refer to all those
current assets which are quickly converted into cash without a loss of value. The standard norm of
current ratio is 1:1.

Where, Quick assets = Current assets – (stock + prepaid expenses)

Quick liability= Current liability- bank overdraft.
 B. Activity ratio/ Efficiency ratio/ Turnover ratio:

Activity ratios measure the operational efficiency of the firm. These ratios measure how efficiently
the assets are employed by the firm. Some of the important turnover ratios are:

i). Inventory Turnover Ratio: it is also called as stock turnover ratio. It indicates whether
investment in inventory is efficiently used or not.

From the inventory turnover ratio, we can determine the inventory holding period. It is determined as
given below.

ii). Debtors Turnover Ratio: It establishes the relationship between credit sales of the year and
average receivables. It measures the number of times the receivables rotate in a year in terms of
sales. It shows how quickly debtors are converted into cash.

iii). Creditors Turnover Ratio: It is also known as accounts payable turnover ratio.It reveals the
number of times the average creditors are paid during a given accounting period. In other words,
it shows how promptly the firm is in a position to pay its credits.

iv). Fixed Assets Turnover Ratio: It helps in assessing the contribution of investment in fixed assets
in the growth of sales.

v). Current Assets Turnover Ratio: This ratio attempts to measure the utilization and effectiveness
of the use of current assets.

vi). Total Asset Turnover Ratio: It reveals the relationship between total assets of the firm and sales
or cost of sales.

C. Solvency Ratios/ Capital Structure Ratios/ Leverage Ratios:

This ratio establishes relationship between owned and borrowed capital. These ratio are
reflect the firm’s ability to periodic payment of interest and repayment of a long-term loan on maturity.
The important solvency ratios are:

i). Debt-Equity Ratio: It establishes the relationship between long-term debt and shareholders’ funds. The
standard form of debt equity ratio is 2:1
ii). Interest Coverage Ratio: It is calculated to know the firm’s ability to pay the interest on debt it
borrows.

iii). Equity Ratio: It is also called as proprietary ratio. It establishes the relationship between shareholders
funds and total assets of the firm.

iv). Solvency Ratio: It establishes the relationship between the total liabilities to outsiders and total assets
of a firm.

D. Profitability Ratios:

Profitability ratios are measure the degree of operating success of a business firm in an
accounting period. The following are important profitability ratios.

i). Gross Profit Ratio: It indicates the efficiency of the production or trading operations. Gross profit
reflects the efficiency with which management produces each unit of product.

ii). Net Profit Ratio / Profit Margin Ratio: This ratio is used to measure overall profitability of the
firm.

iii). Operating Ratio: This ratio measures the relationship between operating cost and net sales.

iv). Operating Profit Ratio: This ratio measures the relationship between operating profit and net
sales.

v). Return on Investment Ratio: It is measure of overall profitability of the firm. It indicates the rate
of return earned on the investment made in the business. The term investment refers to total assets or
capital employed or shareholders funds. Therefore return on investment can be calculated as:

vi). Earnings Per Share: This ratio measures the earnings available to an equity shareholders on a per
share basis.
 vii). Dividend-yield Ratio: It shows the rate of return to shareholders in the form of dividends based
on the market price of the share.

RATIO ANALYSIS FORMULAS

I. Liquidity Ratios:

Quick Assets = Current Assets – (Stock + Prepaid Expenses)

Quick Liabilities = Current Liabilities – Bank Overdraft.

II. Solvency Ratio/ Leverage Ratio/ Capital Structure Ratio:

III. Profitability Ratios:

 Gross Profit = Net Sales – Cost of Goods sold (or)

 Cost of Goods Sold = Opening Stock + Net Purchases + Manufacturing expenses – Closing Stock.
 Net Sales = Total Sales – Sales Returns
 Net Purchases = Total Purchases – Purchase Returns.

 Operating Cost= Cost of Goods Sold+ Administrative Expenses+ Selling &Distribution Expenses

 Operating Profit = Net Sales- (Cost of Goods Sold + Net Operating Expenses)
IV. Activity Ratio/ Efficiency Ratio/ Turnover Ratio:

--------Net Credit Sales = Debtors +Bills Receivables

---------Net Credit Purchases = Creditors + Bills Payable

STANDARDS OF RATIOS
To interpret the ratio, it is necessary to know the standard ratio. The following are the standards of ratios.
S.NO. RATIOS STANDARD
1 Current Ratio 2:1
2 Quick Ratio 1:1
3 Debt-Equity Ratio 2:1
4 Equity Ratio 1:3
5 Interest Coverage Ratio 6 to 7 times
6 Operating Ratio 75 to 80%
7 Fixed Assets Ratio Less than 1:1
8 Total Assets Ratio 1:1