FINANCE Financial statement is that statement which provides information on the firms position at a point in time and its

operation over a period of time. Financial statement contains information about the wealth of the organization, which if well analyzed and interpreted can provide valuable insight into firms performance and its operations. Analysis of financial statement is of interests to lenders, investors, owners, outsiders, shareholders and others. Due to ongoing advancements in technology, new legislation, and other innovation, the field of finance is rapidly changing. Introduction to finance develops the three components of finance in an interactive framework that is consistent with the responsibilities of all- financial professionals, managers, intermediaries, and investors in today's economy. In the last decade, the academic study of finance has experienced an infusion of new concept and quantitative methodologies that pace it among the most sophisticated and growing areas of business and economics. New developments in the traditional areas of finance theory of rational investor portfolio choice, interpretation and determination of security prices, efficient corporate decision making has been approached from the perspective of a single integrating paradigm derived from economic theory. In our present day economy finance is defined as provision of money at a time when it is required. Every enterprise whether it is big, medium or small needs finance to carry out its operation and to achieve its target. In fact finance is so indispensable today that it is rightly said to be lifeblood of enterprise without adequate finance no enterprise can possibly accomplish it objectives. The importance of corporation finance has arisen because of the fact that present day business activities are predominantly on a company or corporate form of organization. The advent of corporate enterprises has resulted into:
1

 the increase in size and influence of the business enterprise wide distribution of corporate ownership separation of ownership and management These factors have increased the importance of finance.

AIMS OF FINANCE Acquiring sufficient funds Proper utilization of funds Increasing profitability Maximizing firms value Estimating financial requirements Deciding capital structure Selecting a source of finance Selecting a pattern of investment Proper cash management Implementing financial control Proper use of surplus

FINANCIAL ACCOUNTING
Financial accounting is the process of systematic recording of the business transactions in the various books of accounts maintained by the organization with the ultimate intention of preparing the financial statement there from. These financial statements are basically in two forms. One, profitability statement which indicates the result of operations carried out by the organization during a given period of time and second balance sheet which indicates the state of affairs of the organization at any given point of time in terms of its assets and liabilities.

Main purpose of financial accounting is to ascertain profit or loss and to indicate financial position of an enterprise. Two fundamental statements of financial accounting are income and expenditure statement and balance sheet. The profit and loss account or income and expenditure account is prepared for a particular period to find out the profitability of the firm and balance sheet is prepared on a particular date to determine the financial position of the firm. Financial accounting summaries transactions taking place during a period with the objective of preparing the financial statement.

BUSINESS FINANCE Business finance is the activity, which is concerned with the acquisition and conservation of capital funds in meeting the financial requirements and overall objectives of the firm. Business finance deals primarily with raising, administering and disbursing funds by private own business units operating in non- financial fields of industry. To sum up in simple words we can say that financial management as practiced by business firms can be called corporation finance or business finance.

FINANCIAL STATEMENTS Financial statements (or financial reports) are formal records of a business' financial activities. It is a collection of data organized according to logical and consistent accounting procedures. These statements provide an overview of a business' profitability and financial condition in both short and long term. A sound understanding of financial statements helps you:

 Identify unfavorable trends and tendencies in your business's operations (for example, the unhealthy buildup of inventory or accounts receivable) before the situation becomes critical. Monitor your cash flow requirements on a timely basis, and identify financing needs early. Monitor important indicators of financial health (for example, liquidity ratios, efficiency ratios, profitability ratios, and solvency ratios). Monitor periodic increases and decreases in wealth (specifically, owners' or stockholders' equity). Monitor your performance against your financial plan, if you have developed one.

DEFINITION According to John N. Myer the financial statements provide a summary of the accounts of a business enterprise, the balance sheet reflecting the assets and liabilities and the income statement showing the results of operations during a certain period

OBJECTIVES OF FINANCIAL STATEMENT The primary objective of financial statements is to assist in decision making. To provide reliable financial information about economic resources and obligations of a business firm. To provide other needed information about changes in such economic resources and obligations.
4

 To provide reliable information about changes in net resources (resources less obligations) arising out of business activities.

To provide financial information that assists in estimating the earning potentials of business.

TYPES OF FINANCIAL STATEMENTS Generally Accepted Accounting Principles (GAAP) specify that a complete set of financial statements must include:

1) Balance Sheet The American Institute of Certified Public Accountants defines Balance Sheet as, A tabular statement of summary of balances (debits and credits) carried forward after an actual and constructive closing of books of account and kept according to principles of accounting. The purpose of the balance sheet is to show the resources that the company has, i.e., its assets, and from where those resources come from, i.e. its liabilities and investments by owners and outsiders. The balance sheet shows all the assets owned by the concern and all the liabilities and claims it owes to owners and outsiders. The Companies Act, 1956 has prescribed a particular form for showing assets and liabilities in the balance sheet for companies registered under this act.

2) Income Statement (Profit and Loss Account) Income statement is prepared to determine the operational position of the concern. It is a statement of revenues earned and the expenses incurred for earning that revenue. If there is excess of revenues over expenditures it will show a profit
5

and if the expenditures are more than the income then there will be a loss. The income statement may be prepared in the form of a Manufacturing Account to find out the cost of production, in the form of Trading Account to determine gross profit or gross loss, in the form of a Profit and Loss Account to determine net profit or net loss. A statement of Retained Earnings may also be prepared to show the distribution of profits. 3) Statement of Changes in Owners Equity (Retained Earnings) The term owners equity refers to the claims of the owners of the business (shareholders) against the assets of the firm. It consists of two elements: Paid-up share capital, i.e. the initial amount of funds invested by the Shareholders Retained earnings or reserves and surplus representing undistributed Profits. The statement of changes in owners equity simply shows the beginning balance of each owners equity account, the reasons for increases and decreases in each, and its ending balance. A statement of retained earnings is also known as Profit and Loss Appropriation Account or Income Disposal Statement. As the name suggests it shows appropriations of earnings. The balance in this account will show the amount of profit retained in hand and carried forward.

4) Statement of Changes in Financial Position. The basic financial statements, that is; the balance sheet and the profit and loss account or income statement of a business reveal the net effect of the various transactions on the operational and financial position of the company. But there are many transactions that do not operate through profit and loss account. Thus, for a better understanding another statement called statement of changes in financial
6

position has to be prepared to show the changes in assets and liabilities from the end of one period to the end of another point of time. The objective of this statement is to show the movement of funds (working capital or cash) during a particular period. The statement of changes in financial position may take any of the following two forms: Funds Flow Statement: The funds flow statement is designed to analyze the changes in the financial condition of a business enterprise between two periods. The word Fund is used to denote working capital. This statement will show the sources from which the funds are received and the uses to which these have been put. This statement helps the management in policy formulation and performance appraisal. Cash Flow Statement: A statement of changes in the financial position of a firm on cash basis is called Cash Flow Statement. It summarizes the causes of changes in cash position of a business enterprise between dates of two balances sheets. This statement is very much similar to the statement of changes in working capital, that is; funds flow statement. A cash flow statement focuses attention on cash changes only. It describes the sources of cash and its uses.

CHARACTERISTICS OF IDEAL FINANCIAL STATEMENT The financial statements are prepared with a view to depict financial position of the concern. The financial statements should be prepared in such a way that they are able to give a clear and orderly picture of the concern. The ideal financial statements have the following characteristics:
7

 Depict True Financial Position: The information contained in the financial statements should be such that a true and correct idea is taken about the financial position of the concern. No material information should be withheld while preparing these statements. Effective Presentation: The financial statements should be presented in a simple and lucid way so as to make them easily understandable. A person who is not well versed with accounting terminology should also be able to understand the statements without much difficulty. This characteristic will enhance the utility of these statements. Relevance: Financial statements should be relevant to the objectives of the enterprise. This will be possible when the person preparing these statements is able to properly utilize the accounting information. The information which is not relevant to the statements should be avoided, otherwise it will be difficult to make a distinction between relevant and irrelevant data. Attractive: The financial statements should be prepared in such a way that important information is underlined so that it attracts the eye of the reader. Easiness: Financial statements should be easily prepared. The balances of different ledger accounts should be easily taken to these statements. The calculation work should be minimum possible while preparing these statements. The size of the statements should not be very large. The columns to be used for giving the information should also be less. This will enable the saving of time in preparing the statements.

 Comparability: The results of financial analysis should be in a way that can be compared to the previous years statements. The statement can also be compared with the figures of other concerns of the same nature. Sometimes budgeted figures are given along with the present figures. The comparable figures will make the statements more useful. The comparison of figures will enable a proper assessment for the working of the concern. Analytical Representation: The information should be analyzed in such a way that similar data is presented at the same place. A relationship can be established in similar type of information. This will be helpful in analysis and interpretation of data. Brief: If possible, the financial statements should be presented in brief. The reader will be able to form an idea about the figures. On the other hand, if figures are given in details then it will become difficult to judge the working of the business.

IMPORTANCE OF FINANCIAL STATEMENTS The financial statements are mirror which reflects the financial position and operating strength or weakness of the concern. These statements are useful to management, investors, creditors, bankers, workers, government and public at large. Following major uses of financial statements: As a report of stewardship. As a basis for fiscal policy. To determine the legality of dividends. As guide to advice dividend action. As a basis for the granting of credit.
9

 As informative for prospective investors in an enterprise As a guide to the value of investment already made. As an aid to government supervision. As a basis for price or rate regulation. As a basis for taxation.

USERS OF FINANCIAL STATEMENTS Financial statements are used by a diverse group of parties, both inside and outside a business. Generally, these users are: 1) Internal Users: It includes owners, managers, employees and other parties who are directly connected with a company. Owners and managers require financial statements to make important business decisions that affect its continued operations. Financial analysis are then performed on these statements to provide management with a more detailed understanding of the figures. These statements are also used as part of management's report to its stockholders, as it form part of its Annual Report. Employees also need these reports in making collective bargaining agreements (CBA) with the management, in the case of labor unions or for individuals in discussing their compensation, promotion and rankings.

2) External Users: It includes potential investors, banks, government agencies and other parties who are outside the business but need financial information about the business for a diverse number of reasons.

10

 Prospective investors make use of financial statements to assess the viability of investing in a business. Financial analysis are often used by investors and is prepared by professionals (Financial Analysts), thus providing them with the basis in making investment decisions. Financial institutions (banks and other lending companies) use them to decide whether to grant a company with fresh working capital or extend debt securities (such as a long-term bank loan or debentures) to finance expansion and other significant expenditures. Government entities (Tax Authorities) need financial statements to ascertain the propriety and accuracy of taxes and other duties declared and paid by a company. Media and the general public are also interested in financial statements for a variety of reasons. LIMITATIONS OF FINANCIAL STATEMENTS The following are the main limitations of the financial statements: Interim and not final reports: Financial statements do not depict the exact position and are essentially interim reports. The exact position can be only known if the business is closed. Lack of precision and definiteness: Financial statements may not be realistic because these are prepared by following certain basic concepts and conventions. Lack of objective judgment: Financial statements are influenced by the personal judgment of the accountant. He may select any method for depreciation, valuation of stock, amortization of fixed assets and treatment
11

of deferred revenue expenditure. Such judgment if based on integrity and competency of the accountant will definitely affect the preparation of the financial statements. Record only monetary facts: Financial statements disclose only monetary facts, that is; those transactions are recorded in the books of accounts which can be measured in monetary terms. Those transactions which cannot be measured in monetary terms such as, conflict between production manager and marketing manager may be very important for a business concern but not recorded in the business books. Historical in nature: These statements are drawn after the actual happening of the events. They attempt to present a view of the past performance and have nothing to do with the accounting for the future. Modern management is forward looking but these statements do not directly help them in making future estimates and taking decisions for the future. Artificial view: These statements do not give a real and correct report about the worth of the assets and their loss of value as these are shown on historical cost basis. Thus, these statements provide artificial view as market or replacement value and the effect of the changes in the price level are completely ignored. Scope of manipulations: These statements are sometimes prepared according to the needs of the situation or the whims of the management. A highly efficient concern may conceal its real profitability by disclosing loss or minimum profit whereas an inefficient concern may declare dividend by wrongly showing profit in the profit and loss account. For this under or over
12

valuation of inventory, over or under charge of depreciation, excessive or inadequate provision for anticipated losses and other such Manipulation may be resorted to. Inadequate information: There are many parties who are interested in the information given in the financial statements but their objectives and requirements differ. The financial statements as prepared under the provisions of the Companies Act, 1956, fail to meet the needs of all. These are mainly prepared to safeguard the interest of shareholders.

FINANCIAL PERFORMANCE ANALYSIS

Financial performance analysis is the process of identifying the financial strengths and weaknesses of the firm by properly establishing the relationship between the items of balance sheet and profit and loss account. It also helps in short term and long term forecasting and growth can be identified with the help of financial performance analysis. The dictionary meaning of analysis is to resolve or separate a thing into its elements or components parts for tracing their relation to the things as whole and each other.

FINANCIAL ANALYSIS The term financial analysis also known as analysis and interpretation of financial statements, refers to the process of determining financial strengths and weaknesses of the firm by establishing strategic relationship between the items of balance sheet, profit and loss account and other operative data.

13

The purpose of financial analysis is to diagnose the information contained in financial statements so as to judge the profitability and financial soundness of the firm. It is an attempt to determine: The significance and meaning of the financial statement data so that forecast may be made of the future earnings. Ability to pay interest and debt maturities (both current and long term) Profitability of a sound business policy. The operational efficiency of the concern as a whole and of its various parts or departments. The comparative study in regard to one firm with another firm or one department with another department

TYPES OF FINANCIAL STATEMENT ANALYSIS Different types of financial statements analysis can be made on the basis of: 1) According to the nature of the analyst and the material used by him: External Analysis: It is made by those persons who are not connected with the enterprise. They do not have access to the enterprise. They do not have access to the detailed record of the company and have to depend mostly on published Statements. Such type of analysis is made by investors, credit agencies, governmental agencies and research scholars. Internal Analysis: The internal analysis is made by those persons who have access to the books of accounts. They are members of the organization. Analysis of financial statements or other financial data for managerial purpose is the internal type of analysis. The internal analyst can give more

14

reliable result than the external analyst because every type of information is at his disposal.

2) According to the objectives of the analysis. Long-term Analysis: This analysis is made in order to study the long-term financial stability, solvency and liquidity as well as profitability and earning capacity of a business concern. The purpose of making such type of analysis is to know whether in the long-run the concern will be able to earn a minimum amount which will be sufficient to maintain a reasonable rate of return on the investment so as to provide the funds required for modernization, growth and development of the business and to meet its costs of capital. Short-term Analysis: This is made to determine the short-term solvency, stability and liquidity as well as earning capacity of the business. The purpose of this analysis is to know whether in the short run a business concern will have adequate funds of readily available to meet its short-term requirements and sufficient borrowing capacity to meet contingencies in the near future. This analysis is made with reference to items of current assets and current liabilities (working capital analysis).

3) According to the modus operandi of the analysis: Horizontal (or dynamic) Analysis: This analysis is made to review and analyze financial statements of a number of years and, therefore, based on financial data taken from several years. This is very useful for long-term

15

trend analysis and planning. Comparative financial statement is an example of this type of analysis. Vertical (or Static) Analysis: This analysis is made to review and analyze the financial statements of one particular year only. Ratio analysis of the financial year relating to a particular accounting year is an example of this type of analysis.

TECHNIQUES OF FINANCIAL ANALYSIS The following techniques can be used in connection with analysis and interpretation of financial statements:

1) Comparative financial statements The comparative financial statements are statements of the financial position at different periods of time. The elements of financial position are shown in a comparative form so as to give an idea of financial position at two or more periods. The statements of two or more periods are prepared to show absolute data of two or more years, increases or decreases in absolute data in value and in terms of percentages. The two comparative statements are: Comparative Balance Sheet: the comparative balance sheet analysis is the study of the trend of the same items, group of items and computed items in two or more balance sheets of the same business enterprise on different dates. Comparative Income Statement: the comparative income statement gives the results of the operations of a business. It gives an idea of the progress of a business over a period of time.
16

 Trend percentage analysis: Trend analysis is an important tool of horizontal financial analysis. This analysis enables to know the changes in the financial function and operating efficiency between the time period chosen. By studying the trends of each item we can know the direction of changes and based upon the direction of changes, the opinions can be formed. These trend ratios may be compared with industry in order to know the strong or weak points of a concern
.

Common size statement: Common size financial statements are those in which figures reported are converted to some common base. Vertical analysis is required for an interpretation of underlying causes of changes over a period of time. For this, items in the financial statements are presented as percentages or ratios to total of the items and a common base for comparison is provided. Common size statements may be used for: a) Common Size Balance Sheet: a statement in which balance sheet items are expressed as the ratio of each asset to total assets and the ratio of each liability is expressed as a ratio of total liabilities. b) Common Size Income Statement: the items in income statement can be shown as percentages of sales to show the relation of each item to sales. A significant relationship can be established. 2) Funds Flow Statement (or Analysis) This statement is prepared in order to reveal clearly the various sources where from the funds are procured to finance the activities of a business concern during the accounting period and also brings to highlight the uses to which these funds are put during the said period.

17

3) Cash Flow Statement (or Analysis) This statement is prepared to know clearly the various items of inflow and outflow of cash. It is an essential tool for short-term financial analysis and is very helpful in the evaluation of current liquidity of a business concern. It helps the business executives of a business in the efficient cash management and internal financial management. 4) Statement of Changes in Working Capital (Net Working Capital Analysis) This statement is prepared to know the net change in working capital of the business between two specified dates. It is prepared from current assets and current liabilities of the said dates to show the net increase or decrease in working capital.

5) Ratio Analysis It is done to develop meaningful relationship between individual items or group of items usually shown in the periodical financial statements published by the concern. An accounting ratio shows the relationship between the two inter-related accounting figures as gross profit to sales, current assets to current liabilities, loaned capital to owned capital etc. Ratios should not be calculated between the two unrelated figures as it will not serve any useful purpose.

LIMITATIONS OF FINANCIAL STATEMENT ANALYSIS Analysis of financial statements is a very important device but the person using this device must keep in mind its limitations. The following are the main limitations of the analysis:

18

 Historical nature of financial statements: The basic nature of these statements is historical, that is; relating to the past period. Past can never be a precise and infallible index of the future and can never be hundred per cent helpful for the future forecast and planning. No substitute for judgment: Analysis of financial statements is a tool which can be used profitably by an expert analyst but may lead to faulty conclusions if used by unskilled analyst. The results of analysis, thus, should not be taken as judgments or conclusions. Reliability of figures: The reliability of analysis depends on reliability of the figures of the financial statements under scrutiny. The entire working of analysis will be vitiated by manipulations in the income statement, window dressing in the balance sheet, questionable procedures adopted by the accountant for the valuation of fixed assets and such other factors. Single year analysis is not much valuable and useful: The analysis of these statements relating to a single year only will have limited use and value. It will not be advisable to depend fully on such analysis. Analysis should be extended over a number of years so that the results may be compared to draw meaningful conclusions. Results may have different interpretation: The results or indications derived from the analysis of these statements may be differently interpreted by different users. For example, a high current ratio may suit the banker, a supplier of goods or the short-term lender but it may be index of inefficiency of the management due to non-utilization of funds.

19

 Change in accounting methods: Analysis will be effective if the figure derived from the financial statements are comparable. Due to change in accounting methods (i.e., depreciation method, or method of valuation of stock), the figures of the current period may have no comparable base, then the whole exercise of analysis will become futile and will be of little value. Pitfalls in inter-firm comparison: When different firms are adopting different procedures, records, objectives, policies and different items under similar headings, comparison will become more difficult. If done, it will not provide reliable basis to assess the performance, efficiency, profitability and financial condition of the firm as compared to industry as a whole. Price level changes reduce the validity of the analysis: The continuous and rapid changes in the value of money, in the present day economy, also reduce the validity of the analysis. Acquisition of assets at different levels of prices make comparison useless as no meaningful conclusions can be drawn from a comparative analysis of such items relating to several accounting periods. Shortcoming of the tool of analysis: There are different tools of analysis available to the analyst. Which tool is to be used in a particular situation depends on the skill, training, intelligence and expertise of the analyst. If wrong tool is used, it may give misleading results and may lead to wrong conclusions or inferences which may be harmful to the interest of business.

FINANCIAL RATIO ANALYSIS Financial ratio analysis is the calculation and comparison of ratios which are derived from the information in a company's financial statements. The level and
20

historical trends of these ratios can be used to make inferences about a company's financial condition, its operations and attractiveness as an investment. When you compare changes in your business's ratios from period to period, you can pinpoint improvements in performance or developing problem areas. By comparing your ratios to those in other businesses, you can see possibilities for improvement in key areas. A number of sources, including many trade or business associations and organizations, provide data for comparison purposes; they are also available from commercial services.

USE AND SIGNIFICANCE OF RATIO ANALYSIS The ratio analysis is one of the most powerful tools of financial analysis. The use of ratios is not confined to financial managers only. There are different parties interested in the ratio analysis for knowing the financial position of a firm for different purposes. The supplier of goods on credit, banks, financial institutions, investors, shareholders and management all make use of ratio analysis as a tool in evaluating the financial position and performance of a firm for granting credit, providing loans or making investments in the firm. With the use of ratio analysis one can point out whether the condition of the firm is strong, good, questionable or poor. The conclusions can also be drawn as to whether the performance of the firm is improving or deteriorating. Thus, ratios have wide applications and are of immense use today.

1) Managerial Uses of Ratio Analysis Ratio analysis helps in making decisions from the information provided in these financial statements. It helps in financial forecasting and planning.

21

 The financial strength and weakness of a firm are communicated in a more easy and understandable manner by the use of ratios. Ratios even help in co-ordination which is of utmost importance ineffective. Ratio analysis even helps in making effective control of the business. These are so many other uses of the ratio analysis. It is an essential part of the budgetary control and standard costing.

2) Utility to Shareholders/Investors An investor in the company will like to assess the financial position of the concern where he is going to invest. His first interest will be the security of his investment and then a return in the form of dividend or interest. For the first purpose he will try to assess the value of fixed assets and the loans raised against them. The investor will feel satisfied only if the concern has sufficient amount of assets. Long-term solvency ratios will help him in assessing financial position of the concern. Profitability ratios, on the other hand, will be useful to determine profitability position. Ratio analysis will be useful to the investor in making up his mind whether present financial position of the concern warrants further investment or not.

3) Utility to Creditors The creditors or suppliers extend short-term credit to the concern. They are interested to know whether financial position of the concern warrants their payments at a specified time or not. The concern pays short- term creditors out of its current assets. If the current assets are quite sufficient to meet current liabilities then the creditor will not hesitate in extending credit facilities. Current and acidtest ratios will give an idea about the current financial position of the concern.

22

4) Utility to Employees The employees are also interested in the financial position of the concern especially profitability. Their wage increases and amount of fringe benefits are related to the volume of profits earned by the concern. The employees make use of information available in financial statements. Various profitability ratios relating to gross profit, operating profit, net profit, etc. enable employees to put forward their viewpoint for the increase of wages and other benefits.

5) Utility to Government Government is interested to know the overall strength of the industry. Various financial statements published by industrial units are used to calculate ratios for determining short-term, long-term and overall financial position of the concerns. Profitability indexes can also be prepared with the help of ratios. Government may base its future policies on the basis of industrial information available from various units. The ratios may be used as indicators of overall financial strength of public as well as private sector. In the absence of the reliable economic information, governmental plans and policies may not prove successful.

CLASSIFICATIONS OF RATIO Ratios may be classified from the point of view of financial management or Objectives: Liquidity Ratios. Capital Structure Ratios. Turnover Ratios. Profitability Ratios.

1) LIQUIDITY RATIOS (Short Term Solvency)

23

Liquidity means ability of a firm to meet its current liabilities. The liquidity ratios, therefore, try to establish a relationship between current liabilities, which are the obligations soon becoming due and current assets, which presumably provide the source from which these obligations will be met. The failure of a company to meet its obligation due to lack of adequate liquidity will result in bad credit ratings, loss of creditors confidence or even in law suits against the company. The following ratios are commonly used to indicate the liquidity of business: Current Ratio (Working Capital Ratio) This ratio is most commonly used to perform the short-term financial analysis. Also known as the working capital ratio, this ratio matches the current assets of the firm to its current liabilities. Current ratio = Current Assets Current Liabilities Current assets include cash in hand and at bank, readily marketable securities, bills receivable, debtors less provision for bad and doubtful debts, stock in trade, prepaid expenses, any other asset which, in the normal course of business will be converted in cash in a years time. Current Liabilities include all obligations maturing within a year, such as sundry creditors, bills payable, bank overdraft, income tax payable, dividends payable, outstanding expenses, provision for taxation and unclaimed dividends. Significance and Objective: Current ratio throws good light on the short term financial position and policy. It is an indicator of a firms ability to promptly meet its short-term liabilities. A relatively high current ratio indicates that the firm is liquid and has the ability to meet its current liabilities. On the other hand, a
24

relatively low current ratio indicates that the firm will find it difficult to pay its bills. Normally a current ratio of 2:1 is considered satisfactory. In other words, current assets should be twice the amount of current liabilities A very high current ratio is also not desirable because it indicates idleness of funds which is not a sign of efficient financial management. Quick Ratio This ratio is also known as acid test ratio or liquid ratio. It is a more severe test of liquidity of a company. It shows the ability of a business to meet its immediate financial commitments. It is used to supplement the information given by the current ratio. Quick ratio = Quick (or Liquid) Assets Quick Liabilities

The quick assets include cash, debtors (excluding bad debts) and securities which can be realized without difficulty. Stock is not included in quick assets for the purpose of this ratio. Similarly prepaid expenses are also excluded as they cannot be converted into cash. Liquid or quick liabilities refer to all current liabilities except bank overdraft. Significance and Objective: When quick ratio is used along with current ratio, it gives a better picture of the firms ability to meet its sh ort-term liabilities out of its short-term assets. This ratio is of great importance for banks and financial institutions. Generally a quick ratio of 1:1 is considered to represent a satisfactory current financial position. On account of a low ratio, the business may find itself in serious financial difficulties. Absolute Liquid Ratio
25

Absolute Liquidity ratio =

(Cash + Short term marketable securities) Current liabilities

This is also known as super quick ratio or cash ratio. In calculating this ratio, both inventories and receivables are deducted from current assets to arrive at absolute liquid assets such as cash and easily marketable investments in securities. Significance and Objective: Higher the ratio, the higher is the cash liquidity. A low ratio is not a serious matter because the company can always borrow from the bank for short term requirements.

2) CAPITAL STRUCTURE RATIOS OR GEARING RATIOS Capital structure Ratios are also known as gearing ratios or solvency ratios or leverage ratios. These are used to analyze the long term solvency of any particular business concern. There are two aspects of long term solvency of a firm: Ability to repay the principal amount when due. Regular payment of interest. Important Capital Structure ratios are: Debt-Equity Ratio This ratio attempts to measure the relationship between long term debts and shareholders funds. In other words, this ratio measures the relative claims of long term creditors on the one hand and owners on the other hand, on the assets of the company. Debt Equity ratio = Long term debts Shareholders funds

26

Long term debts include debentures, long term loans, say from financial institutions. Shareholders funds on the other hand include share capital ( both equity and preference) and accumulated profits in the form of general reserve, capital reserve, and any other fund that belongs to the shareholders. Past accumulated losses and deferred expenditure like preliminary expenses should be deducted while computing shareholders funds. Significance and Objectives: This ratio shows the relative amount of funds supplied to the company by outsiders and by owners. A low debt equity ratio implies a greater claim of owners on the assets of the company than the creditors. On the other hand, a high debt equity ratio indicates that the claims of the creditors are greater than those of the owners. The debt equity ratio of 1: 1 is generally acceptable. The lower the ratio, the less the company has to worry in meeting its fixed obligations. This ratio also indicates the extent to which a company has to depend upon outsiders for its financial requirements.

Proprietary Ratio This is a variant of debt equity ratio. It measures the relationship between shareholders funds and total assets. Proprietary ratio = Shareholders funds Total assets Shareholders funds comprise of ordinary share capital, preference share capital and all items of reserves and surplus. Total assets include all tangible assets and only those intangible assets which have a definite realizable value.

27

Significance and objective: Proprietary ratio shows the extent to which shareholders own the business and thus indicates the general financial strength of the business. The higher the proprietary ratio, the greater the long term stability of the company and consequently greater protection to creditors. However, a very high proprietary ratio may not necessarily be good because if funds of outsiders are not used for long term financing, a firm may not be able to take advantage of trading on equity. Interest Coverage Ratio (Fixed Charges Cover) This ratio indicates whether the business earns sufficient profit to pay periodically the interest charges. Interest Coverage ratio = Earnings before tax and interest (EBIT) Fixed interest charges Significance and Objective: This ratio is very important from lenders point of view because it indicates the ability of a company to pay interest out of its profits. This ratio also indicates the extent to which he profits of the company may decrease without in any way affecting its ability to meet its interest obligations. The standard for this ratio for an industrial company is that interest charges should be covered six to seven times. Debt to Total Funds Ratio This ratio shows the relationship between debts and total funds employed in the business. Debts to Total Funds ratio = Debt Total Funds
28

The term debt includes long term loans and current liabilities like sundry creditors, bills payable, bank overdraft, outstanding expenses etc. Total funds employed includes shareholders funds, long term loans and current liabilities.

Significance and Objectives: This ratio shows the proportion of funds supplied by outsiders in the total funds employed in the business. The lower this ratio, the better it is for creditors because they are more secure and vice versa, higher this ratio it gives a feeling of insecurity to the creditors. In other words, a high ratio of debts to total funds employed is a danger signal for creditors. This ratio also serves the purpose of indicating the possibility of raising additional loans. Capital Gearing Ratio This is the ratio between the fixed interests bearing securities und equity share capital. Capital gearing ratio = Fixed income securities Equity shareholders fund Fixed income securities include debentures and preference share capital. Significance and Objectives: a company is highly geared if this ratio is more than one. If it is less than one, it is low geared. If the ratio is exactly one, it is evenly geared. A highly geared company has the advantage of trading on equity.

3) TURNOVER RATIOS Turnover ratios are used to indicate the efficiency with which assets and resources of the firm are being utilized. These ratios are known as turnover ratios because they indicate the speed with which assets are being converted or turned
29

over into sales. These ratios, thus, express the relationship between sales and various assets. A higher turnover ratio generally indicates better use of capital resources which in turn has a favorable effect on the profitability of the firm. Important turnover ratios are: Inventory turnover Ratio (Stock Turnover Ratio) This ratio is calculated by dividing the cost of goods sold by average inventory. It establishes the relationship between the cost of goods sold during a given period and the average amount of stock carried during the period. Inventory Turnover ratio = Cost of goods sold Average Stock (Inventory) Where, Cost of goods sold = Sales - Gross profit Cost of goods sold = Opening stock +Purchases + Carriage inward And other direct expenses - Closing stock Average Stock = 1/2 (Opening stock + Closing stock) Significance and Objectives: Inventory or stock turnover ratio indicates the efficiency of a firms management. This ratio gives the rate at which stocks are converted into sales and then into cash. A low inventory turnover ratio is an indicator of dull business, accumulation of inventory, over investment in inventory or unsaleable goods etc. Generally speaking, a high stock turnover ratio is considered better as it indicates that more sales are being produced by each rupee of investment in stock but a higher stock turnover ratio may not always be an indicator of favorable results. It may be the result of a very low level of stock which results in frequent out-of-stock positions. Such a situation prevents the company from meeting customers demands and the company cannot earn maximum profits.
30

 Debtors Turnover Ratio This ratio indicates the relationship between net credit sales and trade debtors. It shows the rate at which cash is generated by the turnover of debtors. Debtors Turnover ratio = Credit Sales Average Debtors The term debtors includes trade debtors and bills receivables. Doubtful debts are not deducted from debtors. Moreover, debtors that do not arise from regular sales should be excluded. Significance and Objectives: The significance of this ratio lies in the fact that debtors constitute one of the important items of current assets and this ratio indicates as to how many days average sales are tied up in the amount of debtors. The efficiency of debt collection is also indicated by this ratio. A higher debtor turnover ratio indicates that debts are being collected more quickly. Changes in this ratio show the changes in the companys credit policy or changes in its ability to collect from its debtors. Fixed Assets Turnover Ratio This ratio indicates the efficiency with which the firm is utilizing its investments in fixed assets such as plant and machinery, land and building etc. Fixed Assets Turnover = Sales (or Cost of Sales) Net Fixed Assets The term net fixed assets means depreciated value of fixed assets. Significance and Objectives: Generally speaking, a high ratio indicates efficient utilization of fixed assets in generating sales and a low ratio may signify that the firm has an excessive investment in fixed assets.
31

 Working Capital Turnover Ratio This ratio indicates the efficiency or inefficiency in the utilization of working capital in making sales. Working Capital Turnover ratio = Sa1es Net working Capital The term net working capital means current assets minus current liabilities. Significance and Objective: A high working capital turnover ratio shows the efficient utilization of working capital in generating sales. A low ratio, on the other hand, may indicate excess of net working capital. This ratio thus shows whether working capital is efficiently utilized or not. Capital Turnover Ratio This ratio shows the relationship between cost of sales (or sales) and the total capital employed. Capital Turnover ratio = Cost of Sales (or Sales) Total capital employed The term capital employed includes the long term liabilities and total of shareholders funds. From this are deducted non-operating assets (e.g., investments) and fictitious assets like preliminary expenses, discount on the issue of shares, debits balance of Profit and Loss Account, etc. Significance and Objectives: This ratio shows the efficiency with which capital employed in a business is used. A high capital turnover ratio indicates the possibility of greater profit and a low capital turnover ratio is a sign of insufficient sales and possibility of lower profits.

32

 Creditors Turnover Ratio This ratio also known as Payables Turnover Ratio, measures the relationship between credit purchases and average accounts payable. Creditors turnover ratio = Net credit purchases Average accounts payable Accounts payable include creditors and bills payable.

4) PROFITABILITY RATIOS Every business should earn sufficient profits to survive and grow over a long period of time. In fact efficiency of a business is measured in terms of profits. Profitability ratios are calculated to measure the efficiency of a business. Profitability of a business may be measured in two ways Profitability in relation to sales Profitability in relation to investment. If a company is not able to earn a satisfactory return on investment, it will not be able to pay a reasonable return to its investors and the survival of the company may be threatened. These ratios are:

Gross Profit Ratio This ratio expresses the relationship between gross profit and sales. Gross Profit ratio = Gross profit Net sales Net sales means sales minus sales returns. Gross profit is sales minus cost of goods sold.
33

*100

Significance and Objectives: Gross profit ratio indicates the average margin on the goods sold. It shows whether the selling prices are adequate or not. It also indicates the extent to which selling prices may be reduced without resulting in losses. A low gross profit ratio may indicate a higher cost of goods sold due to higher cost of production. It may also be due to low selling prices. A high gross profit ratio, on the other hand, indicates relatively lower cost and is a sign of good management. Net Profit Ratio This is the ratio of net profit to net sales. Net Profit ratio = Net profit Net sales In calculating the net profit, all non- operating expenses and losses (e.g. loss on sale of old assets, provision for legal damages etc.) are deducted and all nonoperating incomes (e.g. dividend income, interest received on investments etc.) are added. Some accountants deduct income tax also for calculating the net profit. Significance and Objectives: The net profit ratio is the overall measure of a firms ability to turn each rupee of sales into profit. It indicates the efficiency with which a business is managed. A firm with a high net profit ratio is in an advantageous position to survive in the face of rising cost of production and falling selling prices. Where the net profit ratio is low, the firm will find it difficult to withstand these types of adverse conditions. Comparison of net profit ratio with other firms in the same industry or with the previous years will indicate the scope for improvement. This will enable the firm to maximize its efficiency. Operating Ratio
34

*100

This is also an important profitability ratio. This ratio explains the relationship between cost of goods sold and operating expenses on the one hand and net sales on the other. Operating ratio = (Cost of goods sold + operating expenses) Net sales Significance and Objective: The operating ratio is the yardstick to measure the efficiency with which a business is operated. It shows the percentage of net sales that is absorbed by cost of goods sold and operating expenses. A high operating ratio is considered unfavorable because it leaves a smaller margin of profit to meet non-operating expenses. On the other hand, a lower operating ratio is considered a good sign. Return on investment (ROI) or return on capital employed This is the most important test of profitability of a business. It measures the overall, profitability. It is ascertained by comparing profit earned and capital (or funds) employed to earn it. ROI = profit before interest and taxes Capital employed Significance and Objective: ROl is the only ratio which measures satisfactorily the overall performance of a business from the point of view of profitability. This ratio indicates how well the management has utilized the funds supplied by the owners and creditors. In other words, this ratio is intended to measure the earning power of the net assets of the business. The higher the ROI, the more efficient the management is considered to be in. Earning per share = (Net profit after taxes - Preference dividend) No. of equity shares
35

*100

* 100

EPS is one of the most commonly quoted and widely publicized ratio. Dividend Pay-out Ratio (Or Pay-out Ratio) It indicates the percentage of equity share earnings distributed as dividends to equity shareholders. Dividend Pay-out ratio = Dividend per share Earning per share (EPS) Dividend Yield Ratio Dividend is declared by a company as a percentage of par value or paid up value or a specific amount per equity share. Dividend Yield Ratio = Dividend per equity share Market price per equity share This ratio is important for those investors who make investment decisions for the purpose of earning a reasonable yield on the amount of investment. Price Earning Ratio (P/E Ratio) This ratio is the market price of shares expressed as multiple of earning per share (EPS). P/E ratio = Market price per equity share Earning per share This ratio guides investors to decide whether to buy shares of a company or not.

LIMITATIONS OF ACCOUNTING RATIOS Ratio analysis is very important in revealing the financial position and soundness of the business. But, in spite of its advantages, it has some limitations which restrict its use. These limitations should be kept in mind while making use of ratio
36

analysis for interpreting the financial statements. The following are the main limitations of accounting ratios: False results if based on incorrect accounting data: Accounting ratios can be correct only if the data (on which they are based) are correct. Sometimes, the information given in the financial statements is affected by window dressing, i.e., showing position better than what actually is. For example, if inventory values are inflated or depreciation is not charged on fixed assets, not only will one have an optimistic view of profitability of the concern but also of its financial position. So the analyst must always be on the lookout for signs of window dressing, if any. No idea of probable happenings in future: Ratios are an attempt to make an analysis of the past financial statements; so they are historical documents. Now-a-days keeping in view the complexities of the business, it is important to have an idea of the probable happenings in future. Variation in accounting methods: The two firms results are comparable with the help of accounting ratios only if they follow the same accounting methods or bases. Comparison will become difficult if the two concerns follow the different methods. Comparison of financial statements of such firms by means of ratios is bound to be misleading. Price level changes: Changes in price levels make comparison for various years difficult. For example, the ratio of sales to total assets in 2006 would be much - than in 1986 due to rising prices, fixed assets being shown at cost and not at market price.
37

 Only one method of analysis: Ratio analysis is only a beginning and gives just a fraction of information needed for decision-making. Therefore, to have a comprehensive analysis of financial statements, ratios should be used along with other methods of analysis. No common standards: It is very difficult to lay down a common standard for comparison because circumstances differ from concern to concern and the nature of each industry is different. Different meanings assigned to the same term: Different firms, in order to calculate ratio may assign different meanings. For example, profit for the purpose of calculating a ratio may be taken as profit before charging interest and tax or profit before tax but after interest or profit after tax and interest. This may affect the calculation of ratio in different firms and such ratio when used for comparison may lead to wrong conclusions. Ignores qualitative factors: Accounting ratios are tools of quantitative analysis on1y. But sometimes qualitative factors may surmount the quantitative aspects. The calculations derived from the ratio analysis under such circumstances may get distorted.

No use if ratios are worked out for insignificant and unrelated figures: Accounting ratios may be worked for any two insignificant and unrelated figures as ratio of sales and investment in government securities. Such ratios

38

may be misleading. Ratios should be calculated on the basis of cause and effect relationship.

39